Item 1 - Business
Overview
1st Century Bancshares, Inc. (“Bancshares”), a Delaware corporation is registered with the Board of Governors of the Federal Reserve System (the “FRB”) as a bank holding company under the Bank Holding Company Act of 1956, as amended (the “BHC Act”). Bancshares has one subsidiary, 1st Century Bank, National Association (the “Bank”). The Bank is subject to both the regulation of and periodic examinations by the Office of the Comptroller of the Currency (the “OCC”), which is the Bank’s primary federal regulatory agency.
Bancshares and the Bank are collectively referred to herein as “we”, “our”, “us” or “the Company.”
Bancshares’ common stock trades on the NASDAQ Stock Market LLC Capital Market (“NASDAQ CM”) under the symbol “FCTY.” All companies listed on the NASDAQ CM must meet certain financial requirements and adhere to NASDAQ CM’s corporate governance standards.
Bancshares’ principal source of income is dividends from the Bank. Bancshares’ operating costs, including certain professional fees and stockholders’ costs are paid from dividends paid to Bancshares by the Bank.
At December 31, 2011, the Company had consolidated assets of $405.3 million, deposits of $332.5 million and stockholders’ equity of $45.1 million.
The Company maintains a website at http://www.1cbank.com. By including the foregoing website address link, the Company does not intend to and shall not be deemed to incorporate by reference any material contained therein. The Company makes 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, as soon as reasonably practicable after such reports are filed with or furnished to the U.S. Securities and Exchange Commission (the “SEC”).
The Bank
Headquartered in the West Los Angeles area of Los Angeles, California, known as Century City, the Bank is a full service commercial bank. The Bank was organized as a national banking association on October 27, 2003 and opened for business on March 1, 2004. In 2011, the Bank opened a relationship office in Santa Monica, California. The Bank’s primary focus is relationship banking to family and closely held middle market businesses, professional service firms, and high net worth individuals, real estate investors and entrepreneurs. The Bank also provides a wide range of banking services to meet the financial needs of the local residential community, with an orientation primarily directed toward owners and employees of our business client base.
The Bank’s founders and directors represent leading business executives and professionals in many industries with extensive personal contacts, and business, professional and community relationships throughout the Los Angeles area. The Bank’s strategy is to access the network of personal, business and professional relationships of our founders, directors, and investors by providing banking products and services with a high level of personal service. The Bank’s management team brings together a wealth of experience with complementary skills necessary to build and grow a superior community financial institution from these relationships.
Market Area
The general market area we serve is loosely defined as La Cienega Boulevard to the east, the Santa Monica Mountains to the north, the Pacific Ocean to the west and the Los Angeles International Airport to the south. This is a highly diversified market with most businesses operating in the service industry, and also includes a concentration of high net worth individuals. According to the Los Angeles Economic Development Corporation (the “LAEDC”), the average annual wage of the Westside of Los Angeles was $64,050 in 2009 exceeding all other regions of Los Angeles County. The average annual wage of Los Angeles County during the same period was $49,060. The LAEDC defines the Westside of Los Angeles as the five incorporated cities of Beverly Hills, Culver City, Malibu, Santa Monica, West Hollywood, as well as major portions of the city of Los Angeles. The latter includes some distinct communities such as Bel Air, Brentwood, Century City, Hollywood, Korea Town, Miracle Mile, Pacific Palisades, Westchester, Westwood and Venice.
The micro-economic market of Century City, where the Bank is based, is much more concentrated. Smaller businesses dominate this market with 67.2% of employers having less than 5 employees. According to the U.S. Department of Commerce, Bureau of the Census data for 2009, there are approximately 2,400 businesses located in Century City’s one square mile area, of which 567 (23.2%) are legal services firms. Other industries heavily represented in Century City include entertainment, financial services, real estate investment and accounting/business management.
Target Customers
The target market for our products and services is those middle market business and professional firms with basic borrowing needs between $250,000 and $5,000,000 and/or with the need for non-credit services, including operating account services and cash management needs. Loans in excess of our borrowing limits to one customer or related entities are participated out to other financial institutions as a way of accommodating customers with higher borrowing needs. Our market territory is characterized by a sizeable number of small businesses in proportion to the number of large employers. Service firms, merchandising, distribution and support industries make up the vast majority of firms and the employment base. Within the professional services markets, we have made loans to and attracted deposits from law firms, medical practices and individual physicians, business management and accounting firms, real estate professionals, managers and investors and other family and closely held corporations. We also supply credit and depository services to meet the personal needs of their principals, families and employees.
We develop business through personalized and direct marketing programs, utilizing experienced banking officers. We rely greatly on our ability to access our investor and founder base, along with referrals from satisfied clients. In addition, we have a very strong commitment to civic, community and business groups important to our client base.
Competition
The Bank competes with other banks and financial institutions to attract deposits. The Bank faces competition from established local and regional banks and savings banks. Many of them have larger customer bases, greater name recognition and brand awareness, greater financial and other resources and longer operating histories. In order to compete with the other financial service providers, the Company principally relies upon local promotional activities, personal relationships established by founders, investors, officers, directors, and employees with its customers, and specialized services tailored to meet its customers’ needs. In those instances where the Company is unable to accommodate a customer’s needs, the Company seeks to arrange for such loans on a participation basis with other financial institutions or to have those services provided in whole, or in part, by its correspondent banks. See Part I, Item 1 - “Business - Supervision and Regulation.”
Products and Services
The Bank’s goal is to deliver the most responsive and adaptive depository and lending products and services to our clientele. While the Bank will endeavor to maintain maximum flexibility with regards to structure, pricing and terms, the Bank’s product offerings are along the following lines:
Loans
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Business and personal lines of credit and term loans,
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Tenant improvement and equipment financing,
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Bridge and/or specific purpose loans,
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Commercial, industrial, multi-family and 1-4 single family residential real estate lending,
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Personal home equity loans and lines of credit, and
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Credit cards for business and personal use
Deposits
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Business checking, money market and certificates of deposit,
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Personal checking, money market and certificates of deposits,
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Attorney-Client trust accounts,
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Trust accounts,
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Cash management and on-line banking, and
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Debit cards
Loan Approval
Our Board of Directors (the “Board”) establishes lending policies to ensure the above objectives are met. The Board has established an approval process that generally requires a high level of review relative to any credit consideration.
The Board has granted loan approval authority to the President/Chief Executive Officer and the Executive Vice President/Chief Credit Officer, which may be exercised individual or jointly up to designated approval limits. The Board has also established the Bank’s Board of Directors’ Loan Committee (the “Directors’ Loan Committee”), which approves loans above designated amounts. The Directors’ Loan Committee consists of three outside Bank board members and has approval authority for any one loan up to the Bank’s legal lending limit, which was approximately $7.2 million at December 31, 2011.
In addition, the full Board must approve any loan that is subject to FRB Regulation O, which governs loans made by the Bank to the Company’s Directors, executive officers, and principal shareholders as those terms are defined in Regulation O.
Loan Review
We recognize that the proper monitoring of loans is essential for evaluating the quality of our loan portfolio and for ensuring that the allowance for loan losses is adequate. We have established a loan grading system consisting of nine different categories (Grades 1 through 4 and 4w, and 5 through 8). Grades 1 through 4 and 4w reflect strong, good and satisfactory risk. Grades 5 through 8 include Special Mention (criticized assets) and the classified assets categories of Substandard, Doubtful, and Loss. Loans graded 5 through 8 are evaluated for impairment.
The following describes grades 5 through 8 of our loan grading system:
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Special Mention - Grade 5. Loan assets categorized as “Special Mention” have potential weaknesses that deserve management’s close attention. Borrower and guarantor’s capacity to meet all financial obligations is marginally adequate or deteriorating.
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Substandard - Grade 6. Loan assets classified “Substandard” are inadequately protected by the paying capacity of the Borrower and/or collateral pledged. The borrower or guarantor is unwilling or unable to meet loan terms or loan covenants for the foreseeable future.
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Doubtful - Grade 7. Loan assets classified as “Doubtful” have all the weakness inherent in one classified as Substandard with the added characteristic that those weaknesses in place make the collection or liquidation in full, on the basis of current conditions, highly questionable and improbable.
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Loss - Grade 8. Loan assets classified as “Loss” are considered uncollectible or no longer a bankable asset. This classification does not mean that the asset has absolutely no recoverable value. In fact, a certain salvage value is inherent in these loans. Nevertheless, it is not practical or desirable to defer writing off a portion or all of a perceived asset even though partial recovery may be collected in the future.
It is the underwriting department’s responsibility to grade each credit. However, the grade may be changed as the loan moves through the approval process.
To further ensure proper risk grading of loans and administration of the loan portfolio, the Executive Vice President / Chief Risk Management Officer (who reports to the Audit Committee of the Board) performs ongoing reviews of the quality of (i) the current administration of the loans, (ii) loans that require the attention of management, and (iii) the risk grade identification. The review assesses credit quality, compliance with internal policies, loan agreement covenants, laws and regulations, and documentation. In addition, we hire an independent internal audit firm to conduct a review of our loan review process on an annual basis.
Concentrations/Customers
Approximately 60.9% of total loans at December 31, 2011, consisted of real estate loans, including first trust deeds on single family residential properties, undeveloped land, multi-family residential properties, commercial/industrial real estate, and construction-in-process. Of the total loans outstanding at December 31, 2011, there are 78 loans that have outstanding balances of $1,000,000 or more, which totals approximately $176.1 million or 75.6% of the total loan portfolio (some lending relationships will include more than one of these loans). Overall, the loan portfolio has changed from approximately 350 loans totaling $179.3 million at December 31, 2010 to approximately 410 loans totaling $233.0 million at December 31, 2011. Between December 31, 2010 and December 31, 2011, the average balance per loan has increased from $512,000 to $569,000. Substantially all of the Company’s loan, as well as deposit customers are located in Southern California.
Correspondent Banks
Correspondent bank deposit accounts are generally maintained to enable the Bank to transact types of activities that it would otherwise be unable to perform or would not be cost effective due to the size of the Bank or the volume of activity. The Bank has utilized several correspondent banks to process a variety of transactions.
Employees
At December 31, 2011, the Company had 49 total and full-time equivalent employees.
Economic Conditions, Government Policies, Legislation, and Regulation
Introduction
Our profitability, like most banks, is primarily dependent on interest rate differentials. In general, the difference between the interest rates paid by us on interest bearing liabilities, such as deposits and other borrowings, and the interest rates received by us on our interest-earning assets, such as loans extended to our clients and securities held in our investment portfolio, comprises the major portion of our earnings.
Our business is also influenced by the monetary and fiscal policies of the U.S. federal government and the policies of regulatory agencies, particularly the FRB. The FRB implements national monetary policies (with objectives such as curbing inflation and combating unemployment) through its open-market operations in U.S. Government securities by adjusting the required level of reserves for depository institutions subject to its reserve requirements, and by varying the target federal funds and discount rates applicable to borrowings by depository institutions. The actions of the FRB in these areas influence the growth of bank loans, investments, and deposits and also affect interest rates earned on interest-earning assets and paid on interest bearing liabilities. The nature and impact on us of any future changes in monetary and fiscal policies cannot be predicted.
From time to time, legislation, as well as regulations, are enacted which have the effect of increasing the cost of doing business, limiting or expanding permissible activities, or affecting the competitive balance between banks and other financial services providers. Proposals to change the laws and regulations governing the operations and taxation of banks, bank holding companies, and other financial institutions and financial services providers are frequently made in the U.S. Congress, in the state legislatures, and before various regulatory agencies. Such legislation may change banking statutes and our operating environment in substantial and unpredictable ways. If enacted, such legislation could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings banks, credit unions, and other financial institutions. We cannot predict whether any potential legislation will be enacted, and if enacted, the effect that it, or any implementing regulations, would have on our financial condition or results of operations. See Part I, Item 1 - “Business - Supervision and Regulation.”
Recent Economic Conditions
Negative developments beginning in the latter half of 2007 in the sub-prime mortgage market and the securitization markets for such loans and other factors have resulted in uncertainty in the financial markets, which continued through 2011. Dramatic
declines in the housing market, with decreasing home prices and increasing delinquencies and foreclosures, have negatively impacted the credit performance of mortgage and residential construction loans and resulted in significant write-downs of assets by many financial institutions. In addition, the values of real estate collateral supporting many commercial, as well as residential loans have declined and may continue to decline. General downward economic trends, reduced availability of commercial credit and increasing unemployment have negatively impacted the credit performance of commercial and consumer credit, resulting in additional write-downs. Concerns over the stability of the financial markets and the economy have resulted in decreased lending by financial institutions to their customers and to each other. This market turmoil and tightening of credit has led to increased commercial and consumer delinquencies, lack of customer confidence, increased market volatility and widespread reduction in general business activity. Competition among depository institutions for deposits has increased significantly. The bank regulatory agencies have been very aggressive in responding to concerns and trends identified in examinations, and this has resulted in the increased issuance of formal and informal enforcement orders and other supervisory actions requiring that institutions take action to address credit quality, liquidity and risk management and capital adequacy, as well as other safety and soundness concerns.
The Dodd-Frank Act
On July 21, 2010, financial regulatory reform legislation entitled the "Dodd-Frank Wall Street Reform and Consumer Protection Act" (the "Dodd-Frank Act") was signed into law. The Dodd-Frank Act implements far-reaching changes across the financial regulatory landscape, including provisions that, among other things, will:
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Centralize responsibility for consumer financial protection by creating a new agency, the Consumer Financial Protection Bureau, responsible for implementing, examining and enforcing compliance with federal consumer financial laws.
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Apply the same leverage and risk-based capital requirements that apply to insured depository institutions to most bank holding companies.
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Require the Office of the Comptroller of the Currency to seek to make its capital requirements for national banks, such as 1st Century Bank, countercyclical so that capital requirements increase in times of economic expansion and decrease in times of economic contraction.
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Change the assessment base for federal deposit insurance from the amount of insured deposits to consolidated assets less tangible capital, eliminate the ceiling on the size of the Deposit Insurance Fund ("DIF") and increase the floor of the size of the DIF.
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Impose comprehensive regulation of the over-the-counter derivatives market, which would include certain provisions that would effectively prohibit insured depository institutions from conducting certain derivatives businesses in the institution itself.
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Require large, publicly traded bank holding companies to create a risk committee responsible for the oversight of enterprise risk management.
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Implement corporate governance revisions, including with regard to executive compensation and proxy access by shareholders, that apply to all public companies, not just financial institutions.
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Make permanent the $250,000 limit for federal deposit insurance and increase the cash limit of Securities Investor Protection Corporation protection from $100,000 to $250,000 and provide unlimited federal deposit insurance until December 31, 2012 for non-interest bearing demand transaction accounts at all insured depository institutions.
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Repeal the federal prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts.
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Amend the Electronic Fund Transfer Act ("EFTA") to, among other things, give the FRB the authority to establish rules regarding interchange fees charged for electronic debit transactions by payment card issuers having assets over $10 billion and to enforce a new statutory requirement that such fees be reasonable and proportional to the actual cost of a transaction to the issuer.
Many aspects of the Dodd-Frank Act are subject to rulemaking and will take effect over several years, making it difficult to anticipate the overall financial impact on the Company, its customers or the financial industry more generally. Provisions in the legislation that affect the payment of interest on demand deposits are likely to increase the costs associated with deposits as well as place limitations on certain revenues those deposits may generate. Some of the rules that have been proposed and, in some cases, adopted to comply with the Dodd-Frank Act's mandates are discussed further below.
Supervision and Regulation
Introduction
The Company is extensively regulated under both federal and state laws. Regulation and supervision by the federal banking agencies is intended primarily for the protection of depositors and the DIF administered by the FDIC and not for the benefit of stockholders. Consequently, the growth and earnings performance of the Company can be affected not only by management decisions and general economic conditions, but also by the requirements of applicable state and federal statues, regulations and the policies of various governmental regulatory authorities, including the FRB and the OCC.
Set forth below is a summary description of the key laws and regulations that relate to our operations. These descriptions are qualified in their entireties by reference to the applicable laws and regulations.
Bancshares
As a bank holding company, the Company is subject to regulation and examination by the FRB under the BHC Act. Accordingly, the Company is subject to the FRB’s authority to:
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require periodic reports and such additional information as the FRB may require,
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require us to maintain certain levels of capital. See Part I, Item 1. “Business - Capital Standards”,
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require that bank holding companies serve as a source of financial and managerial strength to subsidiary banks and commit resources as necessary to support each subsidiary bank. A bank holding company’s failure to meet its obligations to serve as a source of strength to its subsidiary banks will generally be considered by the FRB to be an unsafe and unsound banking practice or a violation of FRB regulations or both,
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terminate an activity or terminate control of or liquidate or divest certain subsidiaries, affiliates or investments if the FRB believes the activity or the control of the subsidiary or affiliate constitutes a significant risk to the financial safety, soundness or stability of any bank subsidiary,
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regulate provisions of certain bank holding company debt, including the authority to impose interest ceilings and reserve requirements on such debt and require prior approval to purchase or redeem our securities in certain situations, and
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approve acquisitions and mergers with other banks or savings banks and consider certain competitive, management, financial and other factors in granting these approvals. Similar California and other state banking agency approvals may also be required.
Reports and Examinations
A bank holding company is required to file with the FRB annual reports and other information regarding its business operations and those of its nonbanking subsidiaries. It is also subject to supervision and examination by the FRB. Examinations are designed to inform the FRB of the financial condition and nature of the operations of the bank holding company and its subsidiaries and to monitor compliance with the BHCA and other laws affecting the operations of bank holding companies. To determine whether potential weaknesses in the condition or operations of bank holding companies might pose a risk to the safety and soundness of their subsidiary banks, examinations focus on whether a bank holding company has adequate systems and internal controls in place to manage the risks inherent in its business, including credit risk, interest rate risk, market risk (for example, from changes in value of portfolio instruments and foreign currency), liquidity risk, operational risk, legal risk, and reputation risk.
Enforcement Actions
Bank holding companies may be subject to potential enforcement actions by the FRB for unsafe or unsound practices in conducting their businesses or for violations of any law, rule, regulation or any condition imposed in writing by the FRB. Enforcement actions may include the issuance of cease and desist orders, the imposition of civil money penalties, the requirement to meet and maintain specific capital levels for any capital measure, the issuance of directives to increase capital, formal and informal agreements, or removal and prohibition orders against officers or directors and other “institution-affiliated” parties.
Source of Strength Doctrine
Bank holding companies are also subject to capital maintenance requirements on a consolidated basis that are parallel to those required for banks. Further, a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks and may not conduct its operations in an unsafe or unsound manner. In addition, it is the FRB’s view that, in serving
as a source of strength to its subsidiary banks, a bank holding company should stand ready to use available resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity and should maintain financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks. A bank holding company’s failure to meet its source-of-strength obligations may constitute an unsafe and unsound practice or a violation of the FRB’s regulations, or both.
The source-of-strength doctrine most directly affects bank holding companies where a bank holding company’s subsidiary bank fails to maintain adequate capital levels. In such a situation, the subsidiary bank will be required by the bank’s federal regulator to take “prompt corrective action.” Under the prompt corrective action regulations, the subsidiary bank will be required to submit to its federal regulator a capital restoration plan and to comply with the plan. Each parent company that controls the subsidiary bank will be required to provide assurances of compliance by the bank with the capital restoration plan. However, the aggregate liability of such parent companies will not exceed the lesser of (i) 5% of the bank’s total assets at the time it became “undercapitalized” and (ii) the amount necessary to bring the bank into compliance with the plan. Failure to restore capital under a capital restoration plan can result in the bank being placed into receivership. A bank subject to prompt corrective action also may affect its parent bank holding company in other ways. These include possible restrictions or prohibitions on dividends to the parent bank holding company by the bank, subordinated debt payments to the parent and other transactions between the bank and the holding company. In addition, the regulators may impose restrictions on the ability of the bank holding company itself to pay dividends; require divestiture of holding company affiliates that pose a significant risk to the bank; or require divestiture of the “undercapitalized” subsidiary bank.
Redemptions and Repurchases
A bank holding company is generally required to give the FRB prior notice of any redemption or repurchase of its own equity securities, if the consideration to be paid, together with the consideration paid for any repurchases in the preceding year, is equal to 10% or more of the company’s consolidated net worth.
Acquisition of a Bank or Bank Holding Company
A bank holding company is also required to obtain FRB approval before acquiring, directly or indirectly, ownership or control of any voting shares of any bank if it would thereby directly or indirectly own or control more than 5% of the voting stock of that bank, unless it already owns a majority of the voting stock. Prior approval from the FRB is also required in connection with the acquisition of another bank holding company, or business combinations with another bank holding company.
Non-Banking and Financial Activities
Subject to certain prior notice or FRB approval requirements, bank holding companies may engage in any, or acquire shares of companies engaged in, those non-banking activities determined by the FRB to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.
Securities Registration
Bancshares’ securities are registered with the SEC under the Exchange Act of 1934, as amended (the “Exchange Act”). As such, we are subject to the information disclosure, proxy solicitation, insider trading, corporate governance, and other requirements and restrictions of the Exchange Act.
The Sarbanes-Oxley Act
The Company is subject to the accounting oversight and corporate governance requirements of the Sarbanes-Oxley Act of 2002, including:
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required executive certification of financial presentations,
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increased requirements for board audit committees and their members,
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enhanced disclosure of controls and procedures and internal control over financial reporting,
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enhanced controls on, and reporting of, insider trading, and
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increased penalties for financial crimes and forfeiture of executive bonuses in certain circumstances.
The Bank
The Bank, as a nationally chartered bank, is subject to primary supervision, periodic examination, and regulation by the OCC. To a lesser extent, the Bank is also subject to certain regulations promulgated by the FRB. If, as a result of an examination of the Bank, the OCC should determine that the financial condition, capital resources, asset quality, earnings prospects, management, liquidity, or other aspects of the Bank’s operations are unsatisfactory or that the Bank or its management is violating or has violated any law or regulation, the OCC and separately the FDIC as the insurer of the Bank’s deposits, have residual authority to:
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require affirmative action to correct any conditions resulting from any violation or practice,
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direct an increase in capital,
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restrict the Bank’s growth geographically, by products and services or by mergers and acquisitions,
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enter into informal nonpublic or formal public memoranda of understanding or written agreements; enjoin unsafe and unsound practices and issue cease and desist orders to take corrective action,
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remove officers and directors and assess civil monetary penalties, and
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take possession and close and liquidate the Bank.
Various requirements and restrictions under the laws of the State of California and federal banking laws and regulations affect the operations of the Bank. State and federal statutes and regulations relate to many aspects of the Bank’s operations, including reserves against deposits, ownership of deposit accounts, interest rates payable on deposits, loans and investments, mergers and acquisitions, borrowings, dividends, locations of banking centers and capital requirements. Furthermore, the Bank is required to maintain certain levels of capital.
As a national bank, the Bank may form subsidiaries to engage in the many so-called “closely related to banking” or “nonbanking” activities commonly conducted by national banks in operating subsidiaries, and, further, pursuant to the Gramm-Leach-Bliley Act (“GLBA”), also known as the Financial Services Modernization Act of 1999, the Bank may conduct certain “financial” activities in a subsidiary to the same extent as may a national bank, provided the Bank is and remains “well-capitalized,” “well-managed” and in satisfactory compliance with the Community Reinvestment Act (“CRA”).
In September 2007, the SEC and the FRB finalized joint rules required by the Financial Services Regulatory Relief Act of 2006 to implement exceptions provided for in GLBA for securities activities which banks may conduct without registering with the SEC as broker-dealer or moving such activities to a broker-dealer affiliate. This rule became effective for the Bank on January 1, 2009. The FRB’s final Regulation R provides exceptions for networking arrangements with third party broker-dealers and authorizes compensation for bank employees who refer and assist retail and high net worth bank customers with their securities, including sweep accounts to money market funds, and with related trust, fiduciary, custodial and safekeeping needs. The final rules did not have a material effect on the current securities activities which the Bank now conducts for customers.
The Bank is a member and stockholder of the capital stock of the Federal Home Loan Bank of San Francisco. Among other benefits, each Federal Home Loan Bank (“FHLB”) serves as a reserve or central bank for its members within its assigned region and makes available loans or advances to its members. Each FHLB is financed primarily from the sale of consolidated obligations of the FHLB system.
Each FHLB makes available loans or advances to its members in compliance with the policies and procedures established by the Board of Directors of the individual FHLB. Each member of the FHLB of San Francisco is required to own stock in an amount equal to the greater of (i) a membership stock requirement with an initial cap of $25 million (100% of “membership asset value” as defined), or (ii) an activity based stock requirement (based on percentage of outstanding advances). At December 31, 2011, the Bank was in compliance with the FHLB’s stock ownership requirement and the investment in FHLB capital stock totaled $1.7 million.
Federal Reserve System
The FRB requires all depository institutions to maintain noninterest bearing reserves at specified levels against their transaction accounts (primarily checking and non-personal time deposits). Additionally, each member bank is required to hold stock in its regional federal reserve bank. The stock cannot be sold, traded, or pledged as collateral for loans. As specified by law, member banks receive a six percent annual dividend on their federal reserve bank stock. At December 31, 2011, the Bank was in compliance with these requirements and the investment in federal reserve bank stock totaled $1.3 million.
Dividends and Other Transfers of Funds
Holders of Bancshares’ common stock are entitled to receive dividends as and when declared by the Board out of funds legally available under the laws of the State of Delaware. Delaware corporations such as Bancshares may make distributions to their stockholders out of their surplus, or out of their net profits for the fiscal year in which the dividend is declared and for the preceding fiscal year. However, dividends may not be paid out of a corporation’s net profits if, after the payment of the dividend, the corporation’s capital would be less than the capital represented by the issued and outstanding stock of all classes having a preference upon the distribution of assets.
The FRB has advised bank holding companies that it believes that payment of cash dividends in excess of current earnings from operations is inappropriate and may be cause for supervisory action. As a result of this policy, banks and their holding companies may find it difficult to pay dividends out of retained earnings from historical periods prior to the most recent fiscal year or to take advantage of earnings generated by extraordinary items such as sales of buildings or other large assets in order to generate profits to enable payment of future dividends. Further, the FRB’s position that holding companies are expected to provide a source of managerial and financial strength to their subsidiary banks potentially restricts a bank holding company’s ability to pay dividends.
The Bank is a legal entity that is separate and distinct from Bancshares. Bancshares may receive income through dividends paid by the Bank. Subject to the regulatory restrictions described below, future cash dividends by the Bank will depend upon management’s assessment of future capital requirements, contractual restrictions, and other factors.
Bank regulators also have authority to prohibit a bank from engaging in business practices considered to be unsafe or unsound. It is possible, depending upon the financial condition of a bank and other factors, that such regulators could assert that the payment of dividends or other payments might, under certain circumstances, be an unsafe or unsound practice, even if technically permissible.
Capital Standards
Banks and bank holding companies are subject to various regulatory capital requirements administered by state and federal banking agencies. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations, involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weighting and other factors.
The FRB, the OCC and the FDIC have substantially similar risk-based capital ratio and leverage ratio guidelines for banking organizations. The guidelines are intended to ensure that banking organizations have adequate capital given the risk levels of assets and off-balance sheet financial instruments. Under the guidelines, banking organizations are required to maintain minimum ratios for Tier 1 capital and total capital to risk-weighted assets (including certain off-balance sheet items, such as letters of credit). For purposes of calculating the ratios, a banking organization’s assets and some of its specified off-balance sheet commitments and obligations are assigned to various risk categories. A depository institution’s or holding company’s capital, in turn, is classified in one of three tiers, depending on type:
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Core Capital (Tier 1). Tier 1 capital includes common equity, retained earnings, qualifying non-cumulative perpetual preferred stock, a limited amount of qualifying cumulative perpetual preferred stock at the holding company level, minority interests in equity accounts of consolidated subsidiaries, and qualifying trust preferred securities for certain banking organizations, less goodwill, most intangible assets and certain other assets.
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Supplementary Capital (Tier 2). Tier 2 capital includes, among other things, perpetual preferred stock and trust preferred securities not meeting the Tier 1 definition, qualifying mandatory convertible debt securities, qualifying subordinated debt, and allowances for possible loan and lease losses, subject to limitation.
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Market Risk Capital (Tier 3). Tier 3 capital includes qualifying unsecured subordinated debt.
The federal regulatory authorities’ risk-based capital guidelines are based upon the 1988 capital accord (“Basel I”) of the Basel Committee on Banking Supervision (the “Basel Committee”). The Basel Committee is a committee of central banks and bank supervisors/regulators from the major industrialized countries that develops broad policy guidelines for use by each country’s supervisors in determining the supervisory policies they apply. In 2004, the Basel Committee published a new capital accord (“Basel II”) to replace Basel I. Basel II provides two approaches for setting capital standards for credit risk - an internal ratings-based approach tailored to individual institutions’ circumstances and a standardized approach that bases risk weightings on external credit assessments to a much greater extent than permitted in existing risk-based capital guidelines. Basel II also sets capital requirements for operational risk and refines the existing capital requirements for market risk exposures.
The Dodd-Frank Act requires the FRB, the OCC and the FDIC to adopt regulations imposing a continuing "floor" of the Basel I-based capital requirements in cases where the Basel II-based capital requirements and any changes in capital regulations resulting from Basel III (see below) otherwise would permit lower requirements. In December 2010, the FRB, the OCC and the FDIC issued a joint notice of proposed rulemaking that would implement this requirement.
In December 2010, the Basel Committee released its final framework for strengthening international capital and liquidity regulation, now officially identified by the Basel Committee as "Basel III". Basel III, when implemented by the U.S. banking agencies and fully phased-in, will require bank holding companies and their bank subsidiaries to maintain substantially more capital, with a greater emphasis on common equity.
The Basel III final capital framework, among other things, (i) introduces as a new capital measure "Common Equity Tier 1" ("CET1"), (ii) specifies that Tier 1 capital consists of CET1 and "Additional Tier 1 capital" instruments meeting specified requirements, (iii) defines CET1 narrowly by requiring that most adjustments to regulatory capital measures be made to CET1 and not to the other components of capital and (iv) expands the scope of the adjustments as compared to existing regulations.
When fully phased in on January 1, 2019, Basel III requires banks to maintain (i) as a newly adopted international standard, a minimum ratio of CET1 to risk-weighted assets of at least 4.5%, plus a 2.5% "capital conservation buffer" (which is added to the 4.5% CET1 ratio as that buffer is phased in, effectively resulting in a minimum ratio of CET1 to risk-weighted assets of at least 7%), (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the capital conservation buffer (which is added to the 6.0% Tier 1 capital ratio as that buffer is phased in, effectively resulting in a minimum Tier 1 capital ratio of 8.5% upon full implementation), (iii) a minimum ratio of Total (that is, Tier 1 plus Tier 2) capital to risk-weighted assets of at least 8.0%, plus the capital conservation buffer (which is added to the 8.0% total capital ratio as that buffer is phased in, effectively resulting in a minimum total capital ratio of 10.5% upon full implementation) and (iv) as a newly adopted international standard, a minimum leverage ratio of 3%, calculated as the ratio of Tier 1 capital to balance sheet exposures plus certain off-balance sheet exposures (computed as the average for each quarter of the month-end ratios for the quarter).
Basel III also provides for a "countercyclical capital buffer," generally to be imposed when national regulators determine that excess aggregate credit growth becomes associated with a buildup of systemic risk, that would be a CET1 add-on to the capital conservation buffer in the range of 0% to 2.5% when fully implemented (potentially resulting in total buffers of between 2.5% and 5%).
The aforementioned capital conservation buffer is designed to absorb losses during periods of economic stress. Banking institutions with a ratio of CET1 to risk-weighted assets above the minimum but below the conservation buffer (or below the combined capital conservation buffer and countercyclical capital buffer, when the latter is applied) will face constraints on dividends, equity repurchases and compensation based on the amount of the shortfall.
The implementation of the Basel III final framework will commence January 1, 2013. On that date, banking institutions will be required to meet the following minimum capital ratios:
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3.5% CET1 to risk-weighted assets.
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4.5% Tier 1 capital to risk-weighted assets.
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8.0% Total capital to risk-weighted assets.
The Basel III final framework provides for a number of new deductions from and adjustments to CET1. These include, for example, the requirement that mortgage servicing rights, deferred tax assets dependent upon future taxable income and significant investments in non-consolidated financial entities be deducted from CET1 to the extent that any one such category exceeds 10% of CET1 or all such categories in the aggregate exceed 15% of CET1. Under current capital standards, the effects of accumulated other comprehensive income items included in capital are excluded for the purposes of determining regulatory capital ratios. Under the Basel III capital framework, the effects of accumulated other comprehensive items are not excluded, which could result in significant variations in level of capital depending upon the impact of interest rate fluctuations on the fair value of the Company’s securities portfolio.
Implementation of the deductions and other adjustments to CET1 will begin on January 1, 2014 and will be phased-in over a five-year period (20% per year). The implementation of the capital conservation buffer will begin on January 1, 2016 at 0.625% and be phased in over a four-year period (increasing by that amount on each subsequent January 1, until it reaches 2.5% on January 1, 2019).
The timing for the federal banking agencies’ publication of proposed rules to implement the Basel III capital framework and the implementation schedule is uncertain, but the federal banking agencies have indicated informally that rules implementing the Basel III capital framework will be published for comment during the first half of 2012. The rules ultimately adopted and made applicable to the Company may be different from the Basel III final framework as published in December 2010. Requirements to maintain higher levels of capital or to maintain higher levels of liquid assets could adversely impact the Company’s net income and return on equity.
Liquidity Requirements
Historically, regulation and monitoring of bank and bank holding company liquidity has been addressed as a supervisory matter, without required formulaic measures. The Basel III final framework requires banks and bank holding companies to measure their liquidity against specific liquidity tests that, although similar in some respects to liquidity measures historically applied by banks and regulators for management and supervisory purposes, going forward will be required by regulation. One test, referred to as the liquidity coverage ratio ("LCR"), is designed to ensure that the banking entity maintains an adequate level of unencumbered high-quality liquid assets equal to the entity's expected net cash outflow for a 30-day time horizon (or, if greater, 25% of its expected total cash outflow) under an acute liquidity stress scenario. The other, referred to as the net stable funding ratio ("NSFR"), is designed to promote more medium- and long-term funding of the assets and activities of banking entities over a one-year time horizon. These requirements will incent banking entities to increase their holdings of U.S. Treasury securities and other sovereign debt as a component of assets and increase the use of long-term debt as a funding source. The LCR has been implemented for an observation period beginning in 2011, but will not be introduced as a requirement until January 1, 2015, and the NSFR will not be introduced as a requirement until January 1, 2018. These new standards are subject to further rulemaking and their terms may well change before implementation.
Prompt Corrective Action
The Federal Deposit Insurance Act, as amended (the “FDIA”), requires among other things, the federal banking agencies to take “prompt corrective action” in respect of depository institutions that do not meet minimum capital requirements. The FDIA sets forth the following five capital tiers: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.” A depository institution’s capital tier will depend upon how its capital levels compare with various relevant capital measures and certain other factors, as established by regulation. The relevant capital measures are the total capital ratio, the Tier 1 capital ratio and the leverage ratio.
Under the regulations adopted by the federal regulatory authorities, a bank will be: (i) “well capitalized” if the institution has a total risk-based capital ratio of 10.0% or greater, a Tier 1 risk-based capital ratio of 6.0% or greater, and a leverage ratio of 5.0% or greater, and is not subject to any order or written directive by any such regulatory authority to meet and maintain a specific capital level for any capital measure; (ii) “adequately capitalized” if the institution has a total risk-based capital ratio of 8.0% or greater, a
Tier 1 risk-based capital ratio of 4.0% or greater, and a leverage ratio of 4.0% or greater and is not “well capitalized”; (iii) “undercapitalized” if the institution has a total risk-based capital ratio that is less than 8.0%, a Tier 1 risk-based capital ratio of less than 4.0% or a leverage ratio of less than 4.0%; (iv) “significantly undercapitalized” if the institution has a total risk-based capital ratio of less than 6.0%, a Tier 1 risk-based capital ratio of less than 3.0% or a leverage ratio of less than 3.0%; and (v) “critically undercapitalized” if the institution’s tangible equity is equal to or less than 2.0% of average quarterly tangible assets. An institution may be downgraded to, or deemed to be in, a capital category that is lower than indicated by its capital ratios if it is determined to be in an unsafe or unsound condition or if it receives an unsatisfactory examination rating with respect to certain matters. A bank’s capital category is determined solely for the purpose of applying prompt corrective action regulations, and the capital category may not constitute an accurate representation of the bank’s overall financial condition or prospects for other purposes.
The following table sets forth the regulatory capital guidelines for the Bank and the actual capitalization levels for the Bank and the Company as of December 31, 2011:
As of December 31, 2011, management believes that the Company’s capital levels met all minimum regulatory requirements and that the Bank was considered “well capitalized” under the regulatory framework for prompt corrective action.
FDIC Insurance
The FDIC is an independent federal agency that insures deposits, up to prescribed statutory limits, of federally insured banks and savings institutions and safeguards the safety and soundness of the banking and savings industries. The FDIC insures our customer deposits through the DIF up to prescribed limits for each depositor. Pursuant to the EESA, the maximum deposit insurance amount has been increased from $100,000 to $250,000. In November 2010, the FDIC issued a final rule to implement provisions of the Dodd-Frank Act that provide for temporary unlimited coverage for non-interest-bearing transaction accounts. The separate coverage for non-interest-bearing transaction accounts became effective on December 31, 2010 and terminates on December 31, 2012. The amount of FDIC assessments paid by each DIF member institution is based on its relative risk of default as measured by regulatory capital ratios and other supervisory factors. Pursuant to the FDIA, the FDIC is authorized to set the reserve ratio for the DIF annually at between 1.15% and 1.50% of estimated insured deposits. The FDIC may increase or decrease the assessment rate schedule on a semi-annual basis.
The FDIC may terminate a depository institution’s deposit insurance upon a finding that the institution’s financial condition is unsafe or unsound or that the institution has engaged in unsafe or unsound practices that pose a risk to the DIF or that may prejudice the interest of the bank’s depositors. The termination of deposit insurance for the Bank would also result in the revocation of the Bank’s charter by the OCC.
In May 2009, the FDIC issued a final rule which levied a special assessment applicable to all insured depository institutions totaling 5 basis points of each institution’s total assets less Tier 1 capital as of June 30, 2009, not to exceed 10 basis points of domestic deposits. The special assessment was part of the FDIC’s efforts to rebuild the DIF. Our deposit insurance expense during 2009 included $99,000 recognized in the second quarter related to the special assessment.
In November 2009, the FDIC issued a rule that required all insured depository institutions, with limited exceptions, to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012. The FDIC also adopted a uniform three-basis point increase in assessment rates effective on January 1, 2011. In December 2009, the Company paid $1.0 million in prepaid risk-based assessments. At December 31, 2011, the remaining prepaid balance to be applied against future risk-based assessments was $231,000.
In October 2010, the FDIC adopted a new DIF restoration plan to ensure that the fund reserve ratio reaches 1.35% by September 30, 2020, as required by the Dodd-Frank Act. Under the new restoration plan, the FDIC will forego the uniform three-basis point increase in initial assessment rates scheduled to take place on January 1, 2011 and maintain the current schedule of assessment rates for all depository institutions. At least semi-annually, the FDIC will update its loss and income projections for the DIF and, if needed, will increase or decrease assessment rates, following notice-and-comment rulemaking if required.
Effective April 1, 2011, the deposit insurance assessment base was changed from total domestic deposits to average total assets minus average tangible equity, as required by the Dodd-Frank Act.
FDIC insurance expense totaled $353,000 and $399,000 in 2011 and 2010, respectively.
Loans-to-One Borrower Limitations
With certain limited exceptions, the maximum amount of obligations, secured or unsecured, that any borrower (including certain related entities) may owe to a national bank at any one time may not exceed 15% of the unimpaired capital and surplus of the Bank, plus an additional 10%, of unimpaired capital and surplus for loans fully seasoned by readily marketable collateral. The Bank has established internal loan limits which are lower than these legal lending limits.
Extensions of Credit to Insiders and Transactions with Affiliates
The Federal Reserve Act and FRB Regulation O place limitations and conditions on loans or extensions of credit to:
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a bank or bank holding company’s executive officers, directors and principal shareholders (i.e., in most cases, those persons who own, control or have power to vote more than 10 percent of any class of voting securities),
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any company controlled by any such executive officer, director or shareholder, or
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any political or campaign committee controlled by such executive officer, director or principal shareholder.
Such loans and leases:
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must comply with loan-to-one-borrower limits,
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require prior full board approval when aggregate extensions of credit to the person exceed specified amounts,
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must be made on substantially the same terms (including interest rates and collateral) and follow credit-underwriting procedures no less stringent than those prevailing at the time for comparable transactions with non-insiders,
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must not involve more than the normal risk of repayment or present other unfavorable features, and
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in the aggregate limit not exceed the bank’s unimpaired capital and unimpaired surplus.
The Bank also is subject to certain restrictions imposed by Federal Reserve Act Sections 23A and 23B and FRB Regulation W on any extensions of credit to, or the issuance of a guarantee or letter of credit on behalf of, any affiliates, the purchase of, or investments in, stock or other securities thereof, the taking of such securities as collateral for loans, and the purchase of assets of any affiliates. Affiliates include parent holding companies, sister banks, sponsored and advised companies, financial subsidiaries and investment companies where the Bank’s affiliate serves as investment advisor. Sections 23A and 23B and Regulation W generally:
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prevent any affiliates from borrowing from the Bank unless the loans are secured by marketable obligations of designated amounts,
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limit such loans and investments to or in any affiliate individually to 10 percent of the Bank’s capital and surplus,
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limit such loans and investments to all affiliates in the aggregate to 20 percent of the Bank’s capital and surplus, and
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require such loans and investments to or in any affiliate to be on terms and under conditions substantially the same or at least as favorable to the Bank as those prevailing for comparable transactions with nonaffiliated parties.
Additional restrictions on transactions with affiliates may be imposed on the Bank under the FDIA prompt corrective action provisions and the supervisory authority of the Federal and state banking agencies.
Incentive Compensation
In June 2010, the FRB, the OCC and the FDIC issued comprehensive final guidance on incentive compensation policies intended to ensure that the incentive compensation policies of banking organizations do not undermine the safety and soundness of such organizations by encouraging excessive risk-taking. The guidance, which covers all employees that have the ability to materially affect the risk profile of an organization, either individually or as part of a group, is based upon the key principles that a banking organization's incentive compensation arrangements should (i) provide incentives that do not encourage risk-taking beyond the organization's ability to effectively identify and manage risks, (ii) be compatible with effective internal controls and risk management, and (iii) be supported by strong corporate governance, including active and effective oversight by the organization's board of directors.
The FRB will review, as part of the regular, risk-focused examination process, the incentive compensation arrangements of banking organizations that are not "large, complex banking organizations." These reviews will be tailored to each organization based on the scope and complexity of the organization's activities and the prevalence of incentive compensation arrangements. The findings of the supervisory initiatives will be included in reports of examination. Deficiencies will be incorporated into the organization's supervisory ratings, which can affect the organization's ability to make acquisitions and take other actions. Enforcement actions may be taken against a banking organization if its incentive compensation arrangements, or related risk-management control or governance processes, pose a risk to the organization's safety and soundness and the organization is not taking prompt and effective measures to correct the deficiencies.
Bank Secrecy Act and USA Patriot Act
The Bank Secrecy Act (“BSA”) is a disclosure law that forms the basis of the federal government’s framework to prevent and detect money laundering and to deter other criminal enterprises. Under the BSA, financial institutions such as the Bank are required to maintain certain records and file certain reports regarding domestic currency transactions and cross-border transportations of currency. Among other requirements, the BSA requires financial institutions to report imports and exports of currency in the amount of $10,000 or more and, in general, all cash transactions of $10,000 or more. The Bank has established a BSA compliance policy under which, among other precautions, the Bank keeps currency transaction reports to document cash transactions in excess of $10,000 or in the aggregate totaling more than $10,000 during one business day, monitors certain potentially suspicious transactions such as the exchange of a large number of small denomination bills for large denomination bills, and scrutinizes electronic funds transfers for BSA compliance. The BSA also requires that financial institutions report to relevant law enforcement agencies any suspicious transactions potentially involving violations of law.
The “USA PATRIOT Act” and its implementing regulations significantly expanded the anti-money laundering and financial transparency laws in response to the terrorist attacks in September 2001. The Bank has adopted additional comprehensive policies and procedures to address the requirements of the “USA PATRIOT Act”. Material deficiencies in anti-money laundering compliance can result in public enforcement actions by the banking agencies, including the imposition of civil money penalties and supervisory restrictions on growth and expansion. Such enforcement actions could also have serious reputational consequences for the Company.
Consumer Laws
The Bank and Bancshares are subject to many Federal and state consumer protection laws and regulations prohibiting unfair or fraudulent business practices, untrue or misleading advertising and unfair competition, which include but are not limited to:
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The Home Ownership and Equity Protection Act of 1994 (“HOEPA”), which requires extra disclosures and consumer protections to borrowers from certain lending practices, such as practices deemed to be “predatory lending.”
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Privacy policies required by Federal and state banking laws and regulations, which limit the ability of banks and other financial institutions to disclose non-public information about consumers to non-affiliated third parties.
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The Fair Credit Reporting Act, as amended by the Fair and Accurate Credit Transactions Act (the “FACT Act”), which requires financial firms to help deter identity theft, including developing appropriate fraud response programs, and gives consumers more control of their credit data.
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The Equal Credit Opportunity Act (“ECOA”), which generally prohibits discrimination in any credit transaction, whether for consumer or business purposes, on the basis of race, color, religion, national origin, sex, marital status, age (except in limited circumstances), receipt of income from public assistance programs, or good faith exercise of any rights under the Consumer Credit Protection Act.
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The Truth in Lending Act (“TILA”), which requires that credit terms be disclosed in a meaningful and consistent way so that consumers may compare credit terms more readily and knowledgeably.
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The Fair Housing Act, which regulates many lending practices, including making it unlawful for any lender to discriminate in its housing-related lending activities against any person because of race, color, religion, national origin, sex, handicap or familial status.
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The CRA, which requires insured depository institutions, while operating safely and soundly, to help meet the credit needs of their communities; directs the federal regulatory agencies, in examining insured depository institutions, to assess a bank’s record of helping meet the credit needs of its entire community, including low- and moderate-income neighborhoods, consistent with safe and sound banking practices and further requires the agencies to take a financial institution’s record of meeting its community credit needs into account when evaluating applications for, among other things, domestic branches, mergers or acquisitions, or holding company formations.
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The Home Mortgage Disclosure Act (“HMDA”), which includes a “fair lending” aspect that requires the collection and disclosure of data about applicant and borrower characteristics as a way of identifying possible discriminatory lending patterns and enforcing anti-discrimination statutes.
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The Real Estate Settlement Procedures Act (“RESPA”), which requires lenders to provide borrowers with disclosures regarding the nature and cost of real estate settlements and prohibits certain abusive practices, such as kickbacks.
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The National Flood Insurance Act, which requires homes in flood-prone areas with mortgages from a federally regulated lender to have flood insurance.
Item 1A.
Item 1A.
Risk Factors
The following section includes the most significant factors that may adversely affect our business and operations. This is not an exhaustive list, and additional factors could adversely affect our business and financial performance. Moreover, we operate in a very competitive and rapidly changing environment. New risk factors emerge from time to time and it is not possible for us to predict all such risk factors, nor can we assess the impact of all such risk factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. This discussion of risk factors may include forward-looking statements. For cautions about relying on such forward-looking statements, please refer to the section entitled “Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995” at the beginning of this Report immediately prior to Item 1.
Difficult market conditions have adversely affected our industry.
Declines in the housing market over the past several years, with falling home prices and increasing foreclosures, unemployment and under-employment, have negatively impacted the credit performance of mortgage loans and resulted in significant write-downs of asset values by financial institutions, including government-sponsored entities as well as major commercial and investment banks. These write-downs have caused many financial institutions to seek additional capital, to merge with larger and stronger institutions and, in some cases, to fail. Reflecting concern about the stability of the financial markets generally and the strength of counterparties, many lenders and institutional investors have significantly reduced or ceased providing funding to borrowers, including to other financial institutions. This market turmoil and tightening of credit have led to an increased level of commercial and consumer delinquencies, lack of consumer confidence, increased market volatility and widespread reduction of business activity generally. Such conditions could materially and adversely affect the credit quality of the Company’s loans, results of operations and financial condition.
A renewed deterioration of these conditions would likely exacerbate the adverse effects of these difficult market conditions on the Company and others in the banking industry. In particular, the Company may face the following risks in connection with these events:
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The Company expects to face increased regulation of the banking industry. Compliance with such regulation may increase costs and limit the Company’s ability to pursue business opportunities.
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Market developments may affect consumer confidence levels and may cause declines in credit card usage and adverse changes in payment patterns, causing increases in delinquencies and default rates, which could impact charge-offs and provision for credit losses.
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The process the Company uses to estimate losses inherent in its credit exposure or estimate the value of certain assets requires difficult, subjective, and complex judgments, including forecasts of economic conditions and how these economic predictions might impact the ability of our borrowers to repay their loans or affect the value of assets. During uncertain economic times, these assessments are more difficult, and can impact the reliability of the process.
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The Company’s ability to borrow from other financial institutions could be adversely affected by further disruptions in the capital markets or other events.
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Competition in the banking industry could intensify as a result of the increasing consolidation of financial services companies in connection with current market conditions.
The Company may have difficulty managing its growth which may divert resources and limit the Company’s ability to successfully expand its operations.
The Company has grown since it began operations in March 2004. At December 31, 2011, the Company had $405.3 million in total assets, $227.7 million in net loans and $332.5 million in deposits. The Company’s future success will depend on the ability of its officers and key employees to continue to implement and improve its operational, financial and management controls, reporting systems and procedures, and manage a growing number of customer relationships. The Company’s future level of profitability will depend in part on its continued ability to grow; however, the Company may not be able to sustain its historical growth rate or even be able to grow at all, which would have a material and adverse effect on our business, financial condition, results of operations, cash flows and stock price.
If the Company cannot attract deposits, its growth may be inhibited.
The Company plans to increase the level of its assets, including its loan portfolio. The Company’s ability to increase its assets depends in large part on its ability to attract additional deposits at competitive rates. The Company intends to seek additional deposits by continuing to establish and strengthen its personal relationships with its customers and by offering deposit products that are
competitive with those offered by other financial institutions in its markets. The Company cannot ensure that these efforts will be successful. The Company’s inability to attract additional deposits at competitive rates could have a material and adverse effect on its business, financial condition, results of operations, cash flows and stock price.
The Company relies heavily on its senior management team and other employees, the loss of whom could significantly harm its business.
The Company’s success depends heavily on the abilities and continued service of its executive officers, especially Alan I. Rothenberg, Chairman and Chief Executive Officer, Jason P. DiNapoli, President and Chief Operating Officer, Bradley S. Satenberg, Executive Vice President and Chief Financial Officer and J. Kevin Sampson, Executive Vice President and Chief Credit Officer. These four individuals are integral to implementing the Company’s business plan. If the Company loses the services of any of these executive officers, the Company’s business, financial condition, results of operations, cash flows and stock price may be materially and adversely affected. Furthermore, attracting suitable replacements may be difficult and may require significant management time and resources.
The Company also relies to a significant degree on the abilities and continued service of our deposit generating, lending, administrative, operational, accounting and financial reporting, marketing and technical personnel. Competition for qualified employees in the banking industry is intense and there are a limited number of qualified persons with knowledge of, and experience in, the California independent banking industry. The process of recruiting personnel with the combination of skills and attributes required to carry out the Company’s strategies is often lengthy. If the Company fails to attract and retain the necessary deposit generating, lending, administrative, operational, accounting and financial reporting, marketing and technical personnel, the Company’s business, financial condition, results of operations, cash flows and stock price may be materially and adversely affected.
If the Company’s underwriting practices are not effective, the Company may suffer losses in its loan portfolio and its results of operations may be affected.
The Company seeks to mitigate the risks inherent in its loan portfolio by adhering to specific underwriting practices. Depending on the type of loan, these practices include analysis of a borrower’s prior credit history, financial statements, tax returns and cash flow projections, valuation of collateral based on reports of independent appraisers and verification of liquid assets. If the Company’s underwriting criteria prove to be ineffective, the Company may incur losses in its loan portfolio, which would have a material and adverse effect on our business, financial condition, results of operations, cash flows and stock price.
A significant source of risk arises from the possibility that losses could be sustained because borrowers, guarantors and related parties may fail to perform in accordance with the terms of their loans. The underwriting and credit monitoring policies and procedures that the Company has adopted to address this risk may not prevent unexpected losses that could have a material adverse effect on the Company’s business, financial condition, results of operations, cash flows and stock price, particularly during the current global economic downturn. Unexpected losses may arise for a wide variety of reasons, many of which are beyond the Company’s ability to predict, influence or control. Some of these reasons could include a continued and prolonged economic downturn in the State of California or the United States, such as the current recession, a decline in the state or national real estate market, like the one we are currently experiencing, changes in the interest rate environment and natural disasters.
If the Company’s allowance for loan losses is inadequate to cover actual losses, the Company’s financial results would be affected.
Like all financial institutions, the Company maintains an allowance for loan losses to provide for loan defaults and non-performance. The Company’s allowance for loan losses may not be adequate to cover actual loan losses, and future provisions for loan losses could materially and adversely affect the Company’s business, financial condition, results of operations, cash flows and stock price. The Company’s allowance for loan losses reflects the Company’s best estimate of the losses inherent in the existing loan portfolio at the relevant balance sheet date and is based on management’s evaluation of the collectability of the loan portfolio, which evaluation is based on historical loss experience, the loss experience of other financial institutions, and other significant factors. The determination of an appropriate level of loan loss allowance is an inherently difficult process and is based on numerous assumptions. The amount of future losses is susceptible to changes in economic, operating and other conditions, including changes in interest rates that may be beyond the Company’s control, and these losses may exceed current estimates. While the Company believes that its allowance for loan losses is adequate to cover current losses, the Company cannot assure that it will not increase the allowance for loan losses further. This occurrence could materially and adversely affect the Company’s business, financial condition, results of operations, cash flows and stock price.
See discussion of the Company’s nonperforming assets and allowance for loan losses in Part II, Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition.”
Bank regulators may require the Company to increase its allowance for loan losses, which could have a negative effect on the Company’s financial condition and results of operations.
Bank regulators, as an integral part of their respective supervisory functions, periodically review the Company’s allowance for loan losses. They may require the Company to increase its provision for loan losses or to recognize further loan charge-offs based upon their judgments, which may be different from the Company’s. Any increase in the allowance for loan losses or further loan charge-offs required by bank regulators could have a material and adverse effect on the Company’s business, financial condition, results of operations, cash flows and stock price.
The Company’s lending limit may adversely affect the Company’s competitiveness.
The Company’s regulatory lending limit as of December 31, 2011 to any one customer or related group of customers was approximately $7.2 million. The Company’s lending limit is substantially smaller than those of most financial institutions with which it competes and it may affect the Company’s ability to attract or maintain customers or to compete with other financial institutions. Moreover, to the extent that the Company incurs losses and does not obtain additional capital, the Company’s lending limit, which depends upon the amount of its capital, will decrease, which could have a material and adverse effect on the Company’s business, financial condition, results of operations, cash flows and stock price.
The Company faces strong competition from financial services companies and other companies that offer banking services, and its failure to compete effectively with these companies could have a material adverse affect on the Company’s business, financial condition, results of operations, cash flows and stock price.
Within the Los Angeles metropolitan area, the Company faces intense competition for loans, deposits, and other financial products and services. Increased competition within the Company’s pricing market may result in reduced loan originations and deposits. Ultimately, the Company may not be able to compete successfully against current and future competitors. Many competitors offer the types of loans and banking services that the Company offers. These competitors include national banks, regional banks and other independent banks. The Company also faces competition from many other types of financial institutions, including finance companies, brokerage firms, insurance companies, mortgage banks and other financial intermediaries. In particular, the Company’s competitors include financial institutions whose greater resources may afford them a marketplace advantage by enabling them to maintain numerous banking locations and mount extensive promotional and advertising campaigns. Additionally, banks and other financial institutions with larger capitalization and financial intermediaries not subject to bank regulatory restrictions may have larger lending limits which would allow them to serve the credit needs of larger customers. These institutions, particularly to the extent they are more diversified than the Company, may be able to offer the same loan products and services the Company offers at more competitive rates and prices.
The Company also faces competition from out-of-state financial intermediaries that have opened loan production offices or that solicit deposits in the Company’s market areas. If the Company is unable to attract and retain banking customers, it may be unable to continue its loan growth and level of deposits, and its business, financial condition, results of operations, cash flows and stock price may be materially adversely affected.
Concerns of customers over deposit insurance may cause a decrease in deposits.
With recent increased concerns about bank failures, customers increasingly are concerned about the extent to which their deposits are insured by the FDIC. Customers may withdraw deposits in an effort to ensure that the amount they have on deposit with their bank is fully insured or may even withdraw their insured funds as well. Decreases in deposits may adversely affect our liquidity, funding costs, financial condition and operating results.
The Company relies on communications, information, operating and financial control systems technology from third-party service providers, and the Company may suffer an interruption in or break of those systems that may result in lost business and the Company may not be able to obtain substitute providers on terms that are as favorable if its relationships with its existing service providers are interrupted.
The Company relies heavily on third-party service providers for much of its communications, information, operating and financial control systems technology, including customer relationship management, general ledger, deposit, and servicing and loan origination systems. Any failure or interruption or breach in security of these systems could result in failures or interruptions in the Company’s customer relationship management, general ledger, deposit, and servicing and/or loan origination systems. The Company cannot assure that such failures or interruptions will not occur or, if they do occur, that they will be adequately addressed by it or the third parties on which the Company relies. The occurrence of any failures or interruptions could have a material adverse effect on the Company’s business, financial condition, results of operations, cash flows and stock price. If any of the Company’s third-party service providers experience financial, operational or technological difficulties, or if there is any other disruption in the Company’s relationships with them, the Company may be required to locate alternative sources of such services, and the Company cannot assure that it could negotiate terms that are as favorable to the Company, or could obtain services with similar functionality as found in its existing systems without the need to expend substantial resources, if at all. Any of these circumstances could have a material adverse effect on the Company’s business, financial condition, results of operations, cash flows and stock price.
The Company may experience certain risks in connection with its online banking services that could adversely affect its business.
The Company’s business depends in part upon the use of the internet and online services as a medium for banking and commerce by customers. The Company’s inability to modify or adapt its infrastructure in a timely manner or the expenses incurred in making such adaptations could have a material and adverse effect on the Company’s business. Additionally, any compromise in the secured transmission of confidential information over public networks could have a material and adverse effect on the Company’s business.
Changes in economic conditions, and in particular the current prolonged economic slowdown in the State of California and the United States, could have a material and adverse effect on the Company’s business.
The Company’s business is directly affected by factors such as economic, political and market conditions, broad trends in industry and finance, legislative and regulatory changes, changes in governmental monetary and fiscal policies and inflation, all of which are beyond the Company’s control. The Company is particularly susceptible to conditions and changes affecting the State of California and Southern California in particular in view of the concentration of its operations and collateral securing, and likely to secure its loan portfolio in Southern California. The deterioration in economic conditions, in California and Southern California in particular, has had and may continue to have the following consequences, any of which could have a material adverse effect on the Company’s business, financial condition, results of operations, cash flows and stock price:
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Renewed increases in problem assets and foreclosures.
·
Renewed increases in loan delinquencies.
·
Further decline in demand for loans and other products and services may continue.
·
Deposits may decrease.
·
Collateral for loans made by the Company, especially real estate, have and may continue to decline in value, in turn reducing customers’ borrowing power or capacity to repay, and reducing the value of assets and collateral associated with the Company’s existing loans.
In addition, because the Company makes loans to small to medium-sized businesses, many of the Company’s customers may be particularly susceptible to the recession and may be unable to make scheduled principal or interest payments during this and similar periods of recession.
The Company is subject to extensive government regulation and supervision
The Company is subject to extensive federal and state regulation and supervision. Banking regulations are primarily intended to protect depositors' funds, the DIF and the banking system as a whole, not stockholders. These regulations affect the Company's lending practices, capital structure, investment practices and growth. Congress and federal regulatory agencies continually review banking laws, regulations and policies for possible changes. The Dodd-Frank Act, enacted in July 2010, instituted major changes to the banking and financial institutions regulatory regimes in light of the recent performance of and government intervention in the financial services sector. Other changes to statutes, regulations or regulatory policies, including changes in interpretation or implementation of statutes, regulations or policies, could affect the Company in substantial and unpredictable ways. Such changes could subject the Company to additional costs, limit the types of financial services and products the Company may offer and/or increase the ability of non-banks to offer competing financial services and products, among other things. Failure to comply with laws, regulations or policies could result in sanctions by regulatory agencies, civil money penalties and/or reputation damage, which could have a material adverse effect on the Company's business, financial condition, results of operations, cash flows and stock price.
The recent repeal of federal prohibitions on payment of interest on demand deposits could increase the Company's interest expense.
All federal prohibitions on the ability of financial institutions to pay interest on demand deposit accounts were repealed as part of the Dodd-Frank Act. As a result, beginning on July 21, 2011, financial institutions are permitted to offer interest on demand deposits to compete for clients. If the Company begins offering interest on demand deposits to attract additional customers or maintain current customers, the Company's interest expense will increase and its net interest margin will decrease, which could have a material adverse effect on the Company's business, financial condition, results of operations, cash flows and stock price.
Many of the Company’s loans are secured by real estate, and the ongoing downturn in the real estate market could have a material adverse effect on the Company’s business, financial condition, results of operations, cash flows and stock price.
The current downturn in the real estate market has had and may continue to have an adverse effect on the Company’s business because many of the Company’s loans are secured by real estate. At December 31, 2011, approximately 60.9% of the Company’s total loans consisted of real estate loans. Real estate values and real estate markets are generally affected by changes in national, regional or local economic conditions, fluctuations in interest rates and the availability of loans to potential purchasers, changes in tax laws and other laws, regulations and policies and acts of nature. In addition, real estate values in California could be affected by, among other things, earthquakes and national disasters particular to the state. When real estate prices decline, the value of
real estate collateral securing the Company’s loans is reduced. As a result, the Company may experience greater charge-offs and, similarly, its ability to recover on defaulted loans by foreclosing and selling the real estate collateral may be diminished and as a result the Company is more likely to suffer losses on defaulted loans, which would have a material and adverse effect on the Company’s business, financial condition, results of operations, cash flows and stock price.
Our real estate lending also exposes us to the risk of environmental liabilities.
In the course of our business, we may foreclose and take title to real estate, and could be subject to environmental liabilities with respect to these properties. We may be held liable to a governmental entity or to third persons for property damage, personal injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination, or may be required to investigate or clean up hazardous or toxic substances, or chemical releases at a property. The costs associated with investigation or remediation activities could be substantial. In addition, as the owner or former owner of a contaminated site, we may be subject to common law claims by third parties based on damages and costs resulting from environmental contamination emanating from the property. If we ever become subject to significant environmental liabilities, our business, financial condition, results of operations, cash flows and stock price could be materially and adversely affected. In addition, we may not have adequate remedies against the prior owner or other responsible parties or could find it difficult or impossible to sell the affected properties, which could also materially adversely affect our business, financial condition, results of operations, cash flows and stock price.
A natural disaster or recurring energy shortage, especially in California, could harm the Company’s business.
Historically, Southern California has been vulnerable to natural disasters. Therefore, the Company is susceptible to the risks of natural disasters, such as earthquakes, wildfires, floods and mudslides. Natural disasters could harm the Company’s operations directly through interference with communications, as well as through the destruction of facilities and its operational, financial and management information systems. Uninsured or underinsured disasters may reduce a borrower’s ability to repay mortgage loans. Disasters may also reduce the value of the real estate securing the Company’s loans, impairing its ability to recover on defaulted loans. Southern California has also experienced energy shortages which, if they recur, could impair the value of the real estate in those areas affected. The occurrence of natural disasters or energy shortages in Southern California could have a material adverse effect on the Company’s business, financial condition, results of operations, cash flows and stock price.
The Company’s operations are concentrated in the Los Angeles metropolitan area.
The Company’s loan and deposit activities are largely based in the Los Angeles metropolitan area. As a result, the Company’s financial performance will depend largely upon economic conditions in this area. Adverse local economic conditions have caused and may continue to cause the Company to experience an increase in loan delinquencies, an increase in the number of borrowers who default on their loans and a reduction in the value of the collateral securing their loans, all of which could materially and adversely affect the Company’s business, financial condition, results of operations, cash flows and stock price.
The Company’s income, cash flows and asset values could be reduced by changes in interest rates.
The Company’s income and cash flows and the value of its assets depend to a great extent on the difference between the interest rates it earns on interest-earning assets, such as loans and investment securities, and the interest rates it pays on interest bearing liabilities such as deposits and borrowings. These rates are highly sensitive to many factors which are beyond the Company’s control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the FRB. Changes in monetary policy, including changes in interest rates, will influence not only the interest the Company receives on its loans and investment securities and the amount of interest it pays on deposits, it will also affect the Company’s ability to originate loans and obtain deposits and its costs in doing so. If the rate of interest the Company pays on its deposits and other borrowings increases more than the rate of interest it earns on its loans and other investments, the Company’s net interest income, and therefore its earnings, would be materially and adversely affected. The Company’s earnings would also be materially and adversely affected if the rates on its loans and other investments fall more quickly than those on its deposits and other borrowings.
The Company may be materially and adversely affected by the soundness of other financial institutions.
Financial institutions are inter-related as a result of trading, clearing, counterparty and other relationships. In the normal course of business, the Company executes transactions with counterparties in the financial services industry, including commercial banks, brokers and dealers and correspondent banks. These transactions expose the Company to credit risk in the event of a default by counterparty. On a quarterly basis, the Company reviews the counterparties’ financial information, such as SEC filings, Call Reports and press releases, as well as any announcements made by appropriate industry regulators and government agencies, to monitor the counterparties’ financial stability and/or any regulatory disciplinary actions imposed on such counterparties. As of December 31, 2011, the Company had not entered into any financial derivative contracts with any counterparties. In addition, at December 31, 2011,
the Company did not have any unsecured federal funds sold with any correspondent banks. However, no assurance can be given that the Company will not be materially and adversely affected as a result of a negative occurrence, such as a default, at one of the financial institutions with which the Company transacts business.
The Company may need to raise additional capital in the future, and such capital may not be available when needed or at all.
The Company may need to raise additional capital in the future to provide it with sufficient capital resources and liquidity to meet its commitments and business needs, particularly if its asset quality or earnings were to deteriorate. The Company’s ability to raise additional capital, if needed, will depend on, among other things, conditions in the capital markets at that time, which are outside of its control, and its financial performance. Economic conditions and the loss of confidence in financial institutions may increase the Company’s cost of funding and limit access to certain customary sources of capital, including inter-bank borrowings, repurchase agreements and borrowings from the FHLB.
The Company cannot assure that such capital will be available on acceptable terms or at all. Any occurrence that may limit the Company’s access to the capital markets, such as a decline in the confidence of debt purchasers, depositors of the Bank or counterparties participating in the capital markets may adversely affect the Company’s capital costs and its ability to raise capital and, in turn, its liquidity. Moreover, if the Company needs to raise capital in the future, it may have to do so when many other financial institutions are also seeking to raise capital and would have to compete with those institutions for investors. An inability to raise additional capital on acceptable terms when needed could have a materially adverse effect on the Company’s businesses, financial condition, results of operations, cash flows and stock price.
Item 1B.
Item 1B.
Unresolved Staff Comments
None.
Item 2.
Item 2.
Properties
The main and executive offices of Bancshares and the Bank are located at 1875 Century Park East, Los Angeles, California 90067 on the 1st and 14th floors of a multi-story commercial office building. The Bank has a branch office and a Private Banking Center at this same location. The Company’s main office consists of approximately 3,158 square feet of usable ground floor space for the branch office and administrative offices, and 8,108 square feet of usable space for the administrative offices on the 14th floor of the building with a lease term expiring in June 2014, as well as 2,746 square feet of usable ground floor space for the Bank’s Private Banking Center with a lease term expiring in November 2017. The total future minimum commitments for the leases at 1875 Century Park East at December 31, 2011 was $2.0 million.
In addition, the Bank opened a relationship office during 2011, which is located at 1148 4th Street, Santa Monica, California 90403. This office is approximately 1,957 square feet of usable space with a 12-month lease expiring in May 2012. The Company has an 18-month option to extend this lease through November 2013. The total future minimum commitments for this lease at December 31, 2011 was $29,600.
Item 3.
Item 3.
Legal Proceedings
At present, there are no pending or threatened proceedings against the Company which, if determined adversely, would have a material effect on the Company’s business, financial position, results of operations, cash flows or stock price. In the ordinary course of operations, the Company may be party to various legal proceedings.
Item 4.
Item 4.
Mine Safety Disclosures
Not applicable.
PART II
Item 5.
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market Information
The Company’s common stock trades on the NASDAQ CM under the symbol “FCTY”. All companies listed on the NASDAQ CM must meet certain financial requirements and adhere to NASDAQ CM’s corporate governance standards. Any investment in the Company’s common stock should be considered a long-term investment in the event that no active trading market for its stock develops. In addition, the price obtained is unpredictable.
Trading prices are based on information received from the NASDAQ CM based on all transactions reported on the NASDAQ CM. The following table sets forth the range of high and low closing prices of the Company’s common stock for the years ended December 31, 2011 and 2010.
As of December 31, 2011, there were 882 registered shareholders of record of the Company’s common stock, including the number of persons or entities holding stock in nominee or street name through various brokers or banks.
Dividends
As a bank holding company that currently has no significant assets other than its equity interest in the Bank, Bancshares’ ability to declare dividends depends primarily upon dividends it receives from the Bank. The Bank’s dividend practices in turn depend upon legal restrictions, the Bank’s earnings, financial position, current and anticipated capital requirements, and other factors deemed relevant by the Bank’s Board of Directors at that time.
The Bank’s regulators have the authority to prohibit the payment of dividends, depending upon the Bank’s financial condition, if such payment is deemed to constitute an unsafe or unsound practice. As a national bank, the Bank must obtain the prior approval of the OCC to pay a dividend if the total of all dividends declared by it in any calendar year would exceed its net income for the year combined with its retained net income for the preceding two calendar years, less any required transfers to surplus or to fund the retirement of any preferred stock. Currently, the Bank is prohibited from paying dividends to Bancshares until such time as its accumulated deficit is eliminated.
To date, Bancshares has not paid any cash dividends. Payment of stock or cash dividends in the future will depend upon the Company’s earnings and financial condition and other factors deemed relevant by its Board, as well as its legal ability to pay dividends. Accordingly, no assurance can be given that any cash dividends will be declared in the foreseeable future.
Additionally, the FRB’s policy regarding dividends provides that a bank holding company should not pay cash dividends exceeding its net income or which can only be funded in ways that weaken the bank holding company’s financial health, such as by borrowing.
Recent Sales of Unregistered Securities; Use of Proceeds from Registered Securities
None.
Purchases of Equity Securities
The table below summarizes the Company’s monthly repurchases of equity securities during the three months ended December 31, 2011.
(dollars in thousands, except per share data)
(1)
In August 2010, the Company’s Board of Directors authorized the purchase of up to $2.0 million of the Company’s common stock, which was announced by press release and Current Report on Form 8-K on August 16, 2010. Under the Company’s stock repurchase program, the Company has been acquiring its common stock in the open market from time to time beginning in August 2010. The Company’s stock repurchase program may be modified, suspended or terminated by the Board at any time without notice.
Item 6.
Item 6.
Selected Financial Data
Not applicable.
Item 7.
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Critical Accounting Policies and Estimates
The accounting and reporting policies followed by us conform, in all material respects, to accounting principles generally accepted in the United States, or GAAP, and to general practices within the financial services industry. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. While we base our estimates on historical experience, current information and other factors deemed to be relevant, actual results could differ materially from those estimates.
We consider accounting estimates to be critical to reported financial results if (i) the accounting estimate requires management to make assumptions about matters that are highly uncertain and (ii) different estimates that management reasonably could have used for the accounting estimate in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, could have a material impact on our financial statements. Accounting polices related to the allowance for loan losses and income taxes are considered to be critical, as these policies involve considerable subjective judgment and estimation by management. Critical accounting policies, and our procedures related to these policies, are described in detail below. See Note 1 “Summary of Significant Accounting Policies” in Part II, Item 8. “Financial Statements and Supplementary Data” for more information.
The allowance for loan losses is established through a provision for loan losses charged to operations and represents an estimate of credit losses inherent in the Company’s loan portfolio that have been incurred as of the balance sheet date. Loan losses are charged against the allowance when management believes that principal is uncollectible. Subsequent repayments or recoveries, if any, are credited to the allowance. Management periodically assesses the adequacy of the allowance for loan losses by reference to quantitative and qualitative factors that may be weighted differently at various times depending on prevailing conditions. The provisions reflect management’s evaluation of the adequacy of the allowance based, in part, upon estimates from historical peer group loan loss data, the loss experience of other financial institutions, as well as the historical loss experience of the loan portfolio, augmented by the experience of management with similar assets and the Company’s independent loan review process. Loss ratios for all categories of loans are evaluated on a quarterly basis. Loss ratios associated with historical loss experience are determined based on a rolling migration analysis of each loan category within the portfolio. This migration analysis estimates loss factors based on the performance of each loan category over a three-year time period. These loss factors are then adjusted, if necessary, for other identifiable risks specifically related to each loan category or risk grade. Management carefully monitors changing economic conditions, the concentrations of loan categories, values of collateral, the financial condition of the borrowers, the history of the loan portfolio, and historical peer group loan loss data to determine the adequacy of the allowance for loan losses. The allowance is based on estimates and actual losses may vary materially from the estimates. No assurance can be given that adverse future economic conditions will not lead to increased delinquent loans, further increases in the provision for loan losses and/or additional charge-offs of
loans. See Part II, Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operation - Allowance for Loan Losses” for further details considered by management in estimating the necessary level of the allowance for loan losses.
Provision for income taxes is the amount of estimated tax due reported on our tax returns and the change in the amount of deferred tax assets and liabilities. Deferred income taxes represent the estimated net income tax expense payable (or benefits receivable) for temporary differences between the carrying amounts for financial reporting purposes and the amounts used for tax purposes. A valuation allowance is required if it is “more likely than not” that a deferred tax asset will not be realized. The determination of the realizability of deferred tax assets is highly subjective and dependent upon management’s evaluation of both positive and negative evidence, including historic financial performance, forecasts of future income, existence of feasible tax planning strategies, length of statutory carryforward periods, and assessments of current and future economic and business conditions. Management evaluates the positive and negative evidence and determines the realizability of the deferred tax asset on a quarterly basis.
Summary of the Results of Operation and Financial Condition
For the years ended December 31, 2011 and 2010, the Company recorded net income of $1.0 million, or $0.11 per diluted share, and net loss of $2.0 million, or $0.22 per diluted share, respectively. The increase in net income for the year ended December 31, 2011, as compared to the same period last year, is primarily related to an increase in net interest income of $1.4 million, as well as a decrease in provision for loan losses of $2.5 million, partially offset by an increase in non-interest expenses of $818,000.
Total assets at December 31, 2011 were $405.3 million, representing an increase of approximately $96.9 million, or 31.4%, from $308.4 million at December 31, 2010. The increase in total assets is primarily attributable to increases in investment securities and loans, partially offset by a decrease in cash and cash equivalents. Investment securities at December 31, 2011 were $129.9 million, representing an increase of $71.4 million, or 122.2%, from $58.5 million at December 31, 2010. The increase in investment securities is primarily within agency mortgage-backed securities, which had an average life of 3.57 years at December 31, 2011. Total loans at December 31, 2011 were $233.0 million, representing an increase of $53.7 million, or 30.0%, from $179.3 million at December 31, 2010. Cash and cash equivalents at December 31, 2011 were $41.9 million, representing a decrease of $27.1 million, or 39.2%, from $69.0 million at December 31, 2010.
Total liabilities at December 31, 2011 increased by $96.2 million, or 36.4%, to $360.2 million, as compared to $264.0 million at December 31, 2010. This increase is primarily due to growth within our non-interest bearing deposits and money market deposits and savings of $31.3 million and $69.3 million, respectively, due to continued core deposit gathering efforts, partially offset by decreases in certificates of deposit and interest bearing demand deposits of $13.3 million and $12.9 million, respectively. Total core deposits, which include non-interest bearing demand deposits, interest bearing demand deposits and money market deposits and savings, were $285.6 million and $197.9 million at December 31, 2011 and December 31, 2010, respectively, representing an increase of $87.8 million, or 44.3%. The increase in total liabilities was also partially due to an $23.0 million increase in other borrowings, which were primarily utilized to fund additional loan production during 2011.
Average interest earning assets increased $77.8 million from $273.4 million for the year ended December 31, 2010 to $351.2 million for the year ended December 31, 2011. The weighted average interest rate on interest earning assets decreased to 3.48% for the year ended December 31, 2011 from 3.97% for the same period last year. This decrease is primarily attributable to a general decline in yields earned on interest earning assets during the year ended December 31, 2011, as compared to the same period last year, as well as an increase in the average balance of interest earning deposits at other financial institutions.
Set forth below are certain key financial performance ratios and other financial data for the periods indicated:
At December 31, 2011, stockholders' equity totaled $45.1 million, or 11.1% of total assets, as compared to $44.3 million, or 14.4% at December 31, 2010. The Company’s book value per share of common stock was $4.97 as of December 31, 2011, an increase of 4.2%, from $4.77 per share as of December 31, 2010.
Results of Operations
Net Interest Income
The management of interest income and interest expense is fundamental to the performance of the Company. Net interest income, which is the difference between interest income on interest earning assets, such as loans and investment securities, and interest expense on interest bearing liabilities, such as deposits and other borrowings, is the largest component of the Company’s total revenue. Management closely monitors both net interest income and net interest margin (net interest income divided by average earning assets).
Net interest income and net interest margin are affected by several factors including (1) the level of, and the relationship between the dollar amount of interest earning assets and interest bearing liabilities; and (2) the relationship between repricing or maturity of our variable-rate and fixed-rate loans, securities, deposits and borrowings.
The majority of the Company’s loans are indexed to the national prime rate. Movements in the national prime rate have a direct impact on the Company’s loan yield and interest income. The national prime rate, which generally follows the targeted federal funds rate, was 3.25% at December 31, 2011 and 2010. There was no change in the targeted federal funds rate during the years ended December 31, 2011 and 2010, remaining at 0.00%-0.25%.
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 Part II, Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operation - Liquidity and Asset/Liability Management.”
For the year ended December 31, 2011, net interest income was $11.3 million compared to $9.9 million for the same period last year. This increase is primarily related to an increase of $735,000 in interest earned on our investment securities and an increase of $576,000 in interest earned in connection with our loan portfolio. The increase in interest earned on our investment portfolio was primarily due to a $38.2 million increase in the average balance of residential mortgage-backed securities and CMOs, partially offset by a 83 basis point decline in the yield earned on these securities. The fluctuation in our loan interest income was primarily related to a $19.7 million increase in the average balance of loans, partially offset by a 23 basis point decline in our loan yield.
The Company’s net interest spread (yield on interest earning assets less the rate paid on interest bearing liabilities) was 3.02% for the year ended December 31, 2011 compared to 3.34% for the same period last year.
The Company’s net interest margin (net interest income divided by average interest earning assets) was 3.21% for the year ended December 31, 2011, compared to 3.62% for the same period last year. This decline is primarily attributable to a decrease in the yield on earning assets of 49 basis points, partially offset by a decline of 17 basis points in the cost of interest bearing deposits and borrowings. The decrease in yield on earning assets is primarily attributable to a decline in interest rates earned on these assets during the year ended December 31, 2011, as compared to the same period last year, which was caused by a general decline in interest rates during the current year compared to the same period last year, as well as competitive loan pricing conditions in our market, which have continued to intensify and compress loan yields during this period. Yield on earning assets were further impacted by an increase in the average balance of interest earning deposits at other financial institutions. These deposits yielded approximately 25 basis points during the current period. The decline in our net interest margin was partially offset by a decline in our cost of interest bearing deposits and borrowings, which is primarily attributable to a general decrease in interest rates paid on these accounts. The average cost of interest bearing deposits was 0.43% during the year ended December 31, 2011 compared to 0.52% for the same period last year. The average cost of borrowings was 1.40% during the year ended December 31, 2011 compared to 2.53% for the same period last year.
The following table sets forth our average balances, average yields on earning assets, average rates paid on interest bearing liabilities, net interest margins and net interest income/spread for the years ended December 31, 2011, 2010 and 2009.
(1)
Before allowance for loan losses and net deferred loan fees and costs. Included in net interest income was net loan origination cost amortization of $30,000, $95,000 and $84,000 for the years ended December 31, 2011, 2010 and 2009, respectively.
(2)
Includes average non-accrual loans of $6.8 million, $8.4 million and $8.1 million for the years ended December 31, 2011, 2010 and 2009, respectively.
The Volume and Rate Variances table below sets forth the dollar difference in interest earned and paid for each major category of interest earning assets and interest bearing liabilities for the noted periods, and the amount of such change attributable to changes in average balances (volume) or changes in average interest rates. Volume variances are equal to the increase or decrease in the average balance times the prior period rate and rate variances are equal to the increase or decrease in the average rate times the prior period average balance. Variances attributable to both rate and volume changes are equal to the change in rate times the change in average balance and are included below in the average volume column.
Provision for Loan Losses
The provision for loan losses was $275,000 and $2.8 million for the years ended December 31, 2011 and 2010, respectively. The decline in provision for loan losses recorded during the year ended December 31, 2011, as compared to the same period last year, is primarily due to the general improvement in the level of our criticized and classified loans, which consist of special mention, substandard and doubtful loans. Special mention, substandard and doubtful loans were $3.7 million, $11.0 million and none, respectively, at December 31, 2011, compared to $6.1 million, $17.0 million, and $1.1 million at December 31, 2010. We had net charge-offs of $274,000 during the year ended December 31, 2011, compared to net charge-offs of $3.0 million during the same period last year. The provision for loan losses was recorded based on an analysis of the factors discussed in Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation - Financial Condition - Allowance for Loan Losses.
During the year ended December 31, 2010, we recorded a provision for loan losses and corresponding net charge-off of approximately $2.0 million and $1.0 million, respectively, in connection with one commercial loan located in Southern California that emerged as a problem during the fourth quarter of 2010. As a percentage of our total loan portfolio, the amount of non-performing loans was 3.26% and 3.97% at December 31, 2011 and 2010, respectively. As a percentage of our total loan portfolio and other real estate owned (“OREO”), the amount of non-performing assets was 3.26% and 4.42% at December 31, 2011 and 2010, respectively.
Non-Interest Income
Non-interest income was $934,000 for the year ended December 31, 2011 compared to $945,000 for the same period last year. During the year ended December 31, 2011, the Company sold one Available for Sale security totaling $140,000, resulting in a realized gain of $2,000. During the year ended December 31, 2010, the Company sold two Available for Sale securities totaling $3.8 million, resulting in a realized gain of $44,000.
Non-interest income primarily consists of loan arrangement fees, service charges and fees on deposit accounts, as well as other operating income, which mainly consists of wire transfer and other consumer related fees. Loan arrangement fees are related to a college loan funding program the Company established with a student loan provider. The Company initially funds student loans originated by the student loan provider in exchange for non-interest income. All loans are purchased by the student loan provider within 30 days of origination. All purchase commitments are supported by collateralized deposit accounts. Service charges and other operating income includes service charges and fees on deposit accounts, as well as other operating income, which mainly consists of outgoing funds transfer wire fees. See Note 13 “Non-Interest Income” in Part II, Item 8. “Financial Statements and Supplementary Data” for more information regarding non-interest income for the years ended December 31, 2011 and 2010.
Non-Interest Expense
Non-interest expense was $10.8 million for the year ended December 31, 2011, compared to $10.0 million for the same period last year. Compensation and benefits was $5.8 million for the year ended December 31, 2011, compared to $5.2 million for the same period last year. Occupancy expense was $1.1 million for the year ended December 31, 2011, compared to $924,000 for the same period last year. These increases were primarily caused by additional costs incurred in connection with expanding the Bank’s business development team and the opening of our Santa Monica relationship office during the year. The variance in non-interest expense was further impacted by a $329,000 loss incurred during 2011 in connection with the sale of OREO. See Note 14 “Other Operating Expenses” in Part II, Item 8. “Financial Statements and Supplementary Data” for more information regarding other operating expenses for the years ended December 31, 2011 and 2010.
Income Tax Provision
During the year ended December 31, 2011, we recorded a tax expense of approximately $71,000, primarily related to amounts due for California State taxes. The taxes owed in connection with our pre-tax earnings would have typically been entirely offset by the Company’s net operating loss carryforwards, however, the State temporarily suspended the use of these carryforwards for the year ended December 31, 2011, and, as a result, the Company has recorded a tax liability for that period. Going forward, the Company does not anticipate owing any substantial taxes for Federal or State purposes, until the Company’s net operating losses are fully utilized. During the year ended December 31, 2010, we did not record an income tax provision.
See discussion of management’s evaluation regarding the valuation allowance for the deferred tax assets in Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Deferred Tax Asset.
Financial Condition
Assets
Total assets increased 31.4%, or $96.9 million, to $405.3 million at December 31, 2011, from $308.4 million at December 31, 2010. The increase in total assets is primarily attributable to increases in investment securities and loans, partially offset by a decrease in cash and cash equivalents. Investment securities at December 31, 2011 were $129.9 million, representing an increase of $71.4 million, or 122.2%, from $58.5 million at December 31, 2010. The increase in investment securities was primarily attributable to the purchase of agency mortgage-backed securities, which had an average life of 3.57 years at December 31, 2011. Loans at December 31, 2011 were $233.0 million, representing an increase of $53.7 million, or 30.0%, from $179.3 million at December 31, 2010. The most significant loan growth has been in our single-family residential real estate portfolio, which has increased by approximately $33.2 million, or 153.1%, during the year. Loan originations were $117.1 million during the year ended December 31,
2011, compared to $67.6 million during the same period last year. Cash and cash equivalents decreased $27.1 million, or 39.2%, from $69.0 million at December 31, 2010 to $41.9 million at December 31, 2011.
Cash and Cash Equivalents
Cash and cash equivalents totaled $41.9 million and $69.0 million at December 31, 2011 and 2010, respectively. Cash and cash equivalents are managed based upon liquidity needs by investing excess liquidity in higher yielding assets such as loans or investment securities. See the section “Liquidity and Asset/Liability Management” below.
Investment Securities
The investment securities portfolio is generally the second largest component of the Company’s interest earning assets, and the structure and composition of this portfolio is important to any analysis of the financial condition of the Company. The investment portfolio serves the following purposes: (i) it can be readily reduced in size to provide liquidity for loan balance increases or deposit balance decreases; (ii) it provides a source of pledged assets for securing certain deposits and borrowed funds, as may be required by law or by specific agreement with a depositor or lender; (iii) it can be used as an interest rate risk management tool, since it provides a large base of assets, the maturity and interest rate characteristics of which can be changed more readily than the loan portfolio to better match changes in the deposit base and other funding sources of the Company; and (iv) it is an alternative interest earning use of funds when loan demand is weak or when deposits grow more rapidly than loans.
At December 31, 2011, investment securities totaled $129.9 million compared to $58.5 million at December 31, 2010. The Company’s investment portfolio is primarily composed of residential mortgage-backed securities issued by the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC). The underlying loans for these securities are residential mortgages that were primarily originated beginning in 2003 through the current period. These loans are geographically dispersed throughout the United States. At December 31, 2011 and 2010, the weighted average rate and weighed average life of these securities were 2.60% and 3.64%, respectively, and 3.57 years and 3.43 years, respectively. During the year ended December 31, 2011, the Company increased the level of investment security purchases as a result of excess liquidity generated by deposit growth. We will continue to evaluate the Company’s investments and liquidity needs and will adjust the amount of investment securities accordingly.
See Note 2 “Investment Securities” in Part II, Item 8. “Financial Statements and Supplementary Data” for more information regarding investment securities at December 31, 2011 and 2010.
The following is a summary of the investments categorized as Available for Sale at December 31, 2009:
The Company did not have any investment securities categorized as “Held to Maturity” or “Trading” at December 31, 2011, 2010 or 2009.
Loans
Loans, net of the allowance for loan losses and deferred loan origination costs /unearned fees increased 30.9%, or $53.7 million, from $174.0 million at December 31, 2010 to $227.7 million at December 31, 2011. This increase in the loan portfolio is primarily within our residential real estate portfolio, which increased by $33.2 million, or 153.1% in 2011. As of December 31, 2011 and 2010, gross loans outstanding totaled $233.0 million and $179.3 million, respectively. Loan originations were $117.1 million and $67.6 million during the years ended December 31, 2011 and 2010, respectively. The following table sets forth the comparison of our loan portfolio by major categories as of the dates indicated:
(1)
Unsecured commercial loan balances were $11.5 million, $11.0 million, $17.5 million, $23.9 million, and $22.0 million at December 31, 2011, 2010, 2009, 2008, and 2007, respectively.
(2)
Unsecured consumer and other loan balances were $2.8 million, $1.9 million, $1.8 million, $4.1 million, and $5.9 million at December 31, 2011, 2010, 2009, 2008, and 2007, respectively.
As of December 31, 2011, substantially all of the Company’s loan customers are located in Southern California. Additionally, the Company does not have any subprime mortgages.
The table below reflects the maturity distribution for the loans (except for the consumer and other loans) in our loan portfolio at December 31, 2011:
As of December 31, 2011, $8.3 million of our floating rate loans were at or below their floor rates. The weighted average minimum interest rate on these loans was 4.68% at December 31, 2011.
Non-Performing Assets
The following table sets forth non-accrual loans and other real estate owned at December 31, 2011, 2010, 2009 and 2008:
There were no non-performing assets at December 31, 2007.
Non-accrual loans totaled $7.6 million and $7.1 million at December 31, 2011 and 2010, respectively. There were no accruing loans past due 90 days or more at December 31, 2011 and 2010. Gross interest income that would have been recorded on non-accrual loans had they been current in accordance with their original terms was $263,000 and $434,000 for the years ended December 31, 2011 and 2010, respectively.
At December 31, 2011, non-accrual loans consisted of four commercial loans totaling $2.2 million, two commercial real estate loans totaling $3.8 million, one commercial land loan totaling $1.3 million and one consumer and other loan totaling $345,000. At December 31, 2010, non-accrual loans consisted of four commercial loans totaling $1.7 million, three commercial real estate loans totaling $5.1 million and one consumer and other loan totaling $345,000.
As of December 31, 2011, there was no OREO. As of December 31, 2010, OREO consisted of two single-family residential properties totaling $845,000. These properties were located in Southern California and were recorded as and included in accrued interest and other assets on the Consolidated Balance Sheet.
At December 31, 2011 and 2010, the recorded investment in impaired loans was $7.6 million and $7.1 million, respectively. At December 31, 2011, the Company had a $700,000 specific allowance for loan losses on $1.1 million of impaired loans. At December 31, 2010, the Company had a $1.2 million specific allowance for loan losses on impaired loans of $2.4 million. There were $6.5 million and $4.7 million of impaired loans with no specific allowance for loan losses at December 31, 2011 and 2010, respectively. The average outstanding balance of impaired loans for the years ended December 31, 2011 and 2010 was $6.8 million and $8.4 million, respectively. No interest income was recognized on these loans subsequent to their classification as impaired. Furthermore, the Company stopped accruing interest on these loans on the date they were classified as non-accrual, reversed any uncollected interest that had been accrued as income and began recognizing interest income only as cash interest payments are received. There was no interest income recognized on these loans on a cash basis for the years ended December 31, 2011 and 2010.
Allowance for Loan Losses
The allowance for loan losses (“ALL”) is established through a provision for loan losses charged to operations and represents an estimate of credit losses inherent in the Company’s loan portfolio that have been incurred as of the balance sheet date. Loan losses are charged against the ALL when management believes that principal is uncollectible. Subsequent repayments or recoveries, if any, are credited to the ALL. Management periodically assesses the adequacy of the ALL by reference to many quantitative and qualitative factors that may be weighted differently at various times depending on prevailing conditions. These factors include, among other elements:
•
the risk characteristics of various classifications of loans;
•
general portfolio trends relative to asset and portfolio size;
•
asset categories;
•
potential credit concentrations;
•
delinquency trends within the loan portfolio;
•
changes in the volume and severity of past due and other classified loans;
•
historical loss experience and risks associated with changes in economic, social and business conditions; and
•
the underwriting standards in effect when the loan was made.
Accordingly, the calculation of the adequacy of the ALL is not based solely on the level of non-performing assets. The quantitative factors, included above, are utilized by our management to identify two different risk groups (1) individual loans (loans with specifically identifiable risks); and (2) homogeneous loans (groups of loan with similar characteristics). We base the allocation for individual loans on the results of our impairment analysis, which is typically based on the present value of the expected future cash flows discounted at the loan’s effective interest rate or by using the loan’s most recent market value or the fair value of the collateral, if the loan is collateral dependent. Homogenous groups of loans are allocated reserves based on the loss ratio assigned to the pool based on its risk grade. The loss ratio is determined based primarily on the historical loss experience of our loan portfolio, augmented by the experience of management with similar assets. Loss ratios for all categories of loans are evaluated on a quarterly basis.
Historical loss experience is determined based on a rolling migration analysis of each loan category within our portfolio. This migration analysis estimates loss factors based on the performance of each loan category over a three-year time period. These loss factors are then adjusted, if necessary, for other identifiable risks specifically related to each loan category or risk grade. Our ALL ratios are also compared to historical peer group loan loss data, as well as the loss experience of other financial institutions to further assess the reasonableness of these ratios. These quantitative calculations are based on estimates and actual losses may vary materially and adversely from the estimates.
The qualitative factors, included above, are also utilized to identify other risks inherent in the portfolio and to determine whether the estimated credit losses associated with the current portfolio might differ from historical loss trends or the loss ratios discussed above. We estimate a range of exposure for each applicable qualitative factor and evaluate the current condition and trend of each factor. Because of the subjective nature of these factors and the judgments required to determine the estimated ranges, the actual losses incurred may vary materially and adversely from the estimated amounts.
In addition, regulatory agencies, as a part of their examination process, periodically review the Bank’s ALL, and may require the Bank to take additional provisions to increase the ALL based on their judgment about information available to them at the time of their examinations. No assurance can be given that adverse future economic conditions will not lead to increased delinquent loans, further provisions for loan losses and/or charge-offs. Management believes that the ALL as of December 31, 2011 and 2010 was adequate to absorb probable credit losses inherent in the loan portfolio.
The following is a summary of the activity for the ALL for the year ended December 31, 2011:
The following is a summary of activity for the ALL for the years ended December 31, 2010, 2009, 2008 and 2007:
There were no loans acquired with deteriorated credit quality during the years ended December 31, 2011 and 2010.
The ALL was $5.3 million, or 2.27% of our total loan portfolio, at December 31, 2011, compared to $5.3 million, or 2.95% at December 31, 2010. Based on management’s assessment of the ALL, it was determined that the decline in our ratio of ALL to total loans was appropriate due to a reduction in the level of our criticized and classified loans, which generally consist of special mention, substandard and doubtful loans. Special mention, substandard and doubtful loans were $3.7 million, $11.0 million and none, respectively, at December 31, 2011, compared to $6.1 million, $17.0 million, and $1.1 million, respectively, at December 31, 2010.
During the year ended December 31, 2011, our non-performing loans increased to $7.6 million from $7.1 million at December 31, 2010. The ratio of our ALL to non-performing loans was 69.47% at December 31, 2011 compared to 74.21% at December 31, 2010. In addition, our ratio of non-performing loans to total loans was 3.26% and 3.97% at December 31, 2011 and 2010, respectively. The ALL is impacted by inherent risk in the loan portfolio, including the level of our non-performing loans, as well as specific reserves and charge-off activities. The remaining portion of our ALL is allocated to our performing loans based on the quantitative and qualitative factors discussed above.
Allocation of the Allowance for Loan Losses
Deferred Tax Asset
A valuation allowance is required if it is “more likely than not” that a deferred tax asset will not be realized. The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning management’s evaluation of both positive and negative evidence, including historic financial performance, the forecasts of future income, existence of feasible tax planning strategies, length of statutory carryforward periods, and assessments of the current and future economic and business conditions. Management evaluates the positive and negative evidence and determines the realizability of the deferred tax asset on a quarterly basis.
During the year ended December 31, 2009, we established a full valuation allowance against the Company’s deferred tax assets after we determined that it is “more likely than not” that the Company will not be able to realize the benefit of the deferred tax asset. During the years ended December 31, 2011 and 2010, management reassessed the continuing need for this valuation allowance and determined that as of December 31, 2011 and 2010, it was appropriate to maintain a full valuation allowance against the Company’s deferred tax assets. Management reached this conclusion as a result of the Company’s cumulative losses since inception, and the near term economic climate in which the Company operates. Management will continue to evaluate the potential realizability of the deferred tax assets and will continue to maintain a valuation allowance to the extent it is determined that it is more likely than not that these assets will not be realized.
At December 31, 2011 and 2010, the Company maintained a deferred tax liability of $1.1 million and $586,000, respectively, in connection with net unrealized gains on investment securities, and is included in Accrued Interest and Other Liabilities within the accompanying Consolidated Balance Sheets. We did not utilize this deferred tax liability to reduce our tax valuation allowance due to the fact that we do not currently intend to dispose of these investments and realize the associated gains.
See Note 16 “Income Taxes” in Part II, Item 8. “Financial Statements and Supplementary Data” for more information regarding the Company’s income taxes and deferred tax assets at December 31, 2011 and 2010.
Deposits
The Company’s activities are largely based in the Los Angeles metropolitan area. The Company’s deposit base is also primarily generated from this area.
At December 31, 2011, total deposits were $332.5 million compared to $258.0 million at December 31, 2010, representing an increase of 28.9%, or $74.5 million. This increase is primarily due to growth within our non-interest bearing deposits and money market deposits and savings of $31.3 million and $69.3 million, respectively, due to continued core deposit gathering efforts, partially offset by decreases in certificates of deposit and interest bearing deposits of $13.3 million and $12.9 million, respectively. Total core deposits, which include non-interest bearing demand deposits, interest bearing demand deposits and money market deposits and savings, were $285.6 million and $197.9 million at December 31, 2011 and December 31, 2010, respectively, representing an increase of $87.8 million, or 44.3%.
The following table reflects the summary of deposit categories by dollar and percentage at December 31, 2011 and 2010:
At December 31, 2011 and December 31, 2010, the Company had three certificates of deposit with the State of California Treasurer’s Office for a total of $34.0 million, which represented 10.2% and 13.2%, respectively, of total deposits. The Company was required to pledge $37.4 million of agency mortgage backed securities at December 31, 2011 and 2010 in connection with these certificates of deposit. Each of these deposits outstanding at December 31, 2011 are scheduled to mature during the first quarter of 2012. The Company intends to renew each of these deposits at maturity. However, given the current economic climate in the State of California, there can be no assurance that the State of California Treasurer’s Office will continue to maintain deposit accounts with the Company. For further information on the Company’s certificates of deposits with the State of California Treasurer’s Office, see Part II, Item 8. Financial Statements and Supplementary Data - Note 7 “Deposits.”
The aggregate amount of certificates of deposits of $100,000 or more at December 31, 2011, 2010 and 2009 was $44.9 million, $57.6 million and $68.8 million, respectively.
Scheduled maturities of certificates of deposits in amounts of $100,000 or more at December 31, 2011, including deposit accounts with the State of California Treasurer’s Office and CDARS were as follows:
(in thousands)
Liquidity, Asset/Liability Management and Capital Resources
Liquidity, as it relates to banking, is the ability to meet loan commitments and to honor deposit withdrawals through either the sale or maturity of existing assets or the acquisition of additional funds through deposits or borrowing. The Company’s main sources of funds to provide liquidity are its cash and cash equivalents, paydowns and maturities of investments, loan repayments, and increases in deposits and borrowings. The Company also maintains lines of credit with the FHLB and other correspondent financial institutions.
The liquidity ratio (the sum of cash and cash equivalents and Available for Sale investments, excluding amounts required to be pledged under borrowings and State of California deposit relationships and operating requirements, divided by total assets) was 30.9% at December 31, 2011 and 28.8% at December 31, 2010.
At December 31, 2011 and 2010, the Company had a borrowing/credit facility at the FHLB of $53.7 million and $45.8 million, respectively. This credit facility was secured by a blanket lien on eligible loans of $233.0 million and $179.3 million at December 31, 2011 and 2010, respectively. The Company had $25.0 million and $2.0 million of long-term borrowings under this borrowing/credit facility with the FHLB at December 31, 2011 and 2010, respectively. The Company had no short-term overnight borrowings outstanding at both December 31, 2011 and 2010.
The following table summarizes the outstanding long-term borrowings under this borrowing/credit facility secured by a blanket lien on eligible loans at the FHLB at December 31, 2011 and 2010 (dollars in thousands):
At December 31, 2011 and 2010, the Company had $27.0 million in Federal fund lines of credit available with other correspondent banks in order to provide an additional source of funds for loan commitments and to satisfy potential demands for deposit withdrawals. Each of these lines of credit is subject to conditions that the Company may not be able to meet at the time when additional liquidity is needed. The Company did not have any borrowings outstanding under these lines of credit at either December 31, 2011 and 2010. As of December 31, 2011, the Company had pledged $6.3 million of corporate notes in connection with these lines of credit.
Management believes the level of liquid assets and available credit facilities are sufficient to meet current and anticipated funding needs. In addition, the Bank’s Asset/Liability Management Committee oversees the Company’s liquidity position by reviewing a monthly liquidity report. Management is not aware of any trends, demands, commitments, events or uncertainties that will result or are reasonably likely to result in a material change in the Company’s liquidity.
As of December 31, 2011, the Company was not subject to any material commitments for capital expenditures. For capital adequacy, see Part I, Item 1. Business - “Capital Standards.”
At December 31, 2011, the Company had total stockholders’ equity of $45.1 million, which included $108,000 in common stock, $64.5 million in additional paid-in capital, $13.8 million accumulated deficit, $1.6 million in accumulated other comprehensive income, and $7.3 million in treasury stock. During the year ended December 31, 2011, the Company purchased 398,863 shares at an average price per share of $3.66, effectively reducing total stockholders’ equity by $1.5 million during the year.
See discussion of the Company’s stock repurchase program in Part II - Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities - “Purchases of Equity Securities”, and Item 8. Financial Statements and Supplementary Data - Note 10 “Stock Repurchase Program.”
Off-Balance Sheet Arrangements
In the normal course of business, the Company is a party to financial instruments with off-balance-sheet risk. These financial instruments include commitments to extend credit and letters of credit. To varying degrees, these instruments involve elements of credit and interest rate risk in excess of the amount recognized in the statement of financial position.
The Company maintains an allowance for unfunded commitments, based on the level and quality of the Company’s undisbursed loan funds, which comprises the majority of the Company’s off-balance sheet risk. As of December 31, 2011 and 2010, the allowance for unfunded commitments was unchanged at $203,000, which represented 0.35% and 0.33% of the undisbursed loan funds, respectively.
Management is not aware of any other material off-balance sheet arrangements or commitments outside of the ordinary course of the Company’s business.
For further information on commitments and contingencies, see Part II, Item 8. Financial Statements and Supplementary Data - Note 5 “Related Party Transactions” and Note 9 “Commitments and Contingencies.”
Item 7A.
Item 7A.
Quantitative and Qualitative Disclosure About Market Risk
Not applicable.
Item 8.
Item 8.
Financial Statements and Supplementary Data
Financial statements are filed as a part of this report hereof beginning on page 45 and are incorporated herein by reference.
Item 9.
Item 9.
Changes In and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A.
Controls and Procedures
Evaluation of Disclosure Controls and Procedures
The Company maintains disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act), designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported on a timely basis.
The Company’s management, with the participation of our Principal Executive Officer and Principal Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Annual Report on Form 10-K. Based on such evaluation, our Principal Executive Officer and Principal Financial Officer have concluded that, as of the end of such period, our disclosure controls and procedures are effective.
Management’s Report on Internal Control over Financial Reporting
Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s internal control over financial reporting is a process designed under the supervision of the Company’s principal executive and principal financial officers to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Company’s financial statements for external reporting purposes in accordance with U.S. generally accepted accounting principles.
As of December 31, 2011, management conducted an assessment of the effectiveness of the Company’s internal control over financial reporting based on the framework established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on this assessment, management has determined that the Company’s internal control over financial reporting as of December 31, 2011 is effective.
Changes in Internal Controls
There have not been any changes in the Company’s internal control over financial reporting that occurred during the quarter ended December 31, 2011, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
Item 9B.
Item 9B.
Other Information
None.
PART III
Item 10.
Item 10.
Directors, Executive Officers and Corporate Governance
Information required by this item will be contained in our definitive proxy statement for our 2012 Annual Meeting of Stockholders (the “Proxy Statement”), to be filed pursuant to Regulation 14A with the Securities and Exchange Commission within 120 days of December 31, 2011. Such Information is incorporated herein by reference.
Item 11.
Item 11.
Executive Compensation
Information required by this item will be contained in our Proxy Statement, to be filed pursuant to Regulation 14A with the Securities and Exchange Commission within 120 days of December 31, 2011. Such information is incorporated herein by reference.
Item 12.
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Information required by this item will be contained in our Proxy Statement to be filed pursuant to Regulation 14A with the Securities and Exchange Commission within 120 days of December 31, 2011.
Such information is incorporated herein by reference.
Item 13.
Item 13.
Certain Relationships and Related Transactions, and Director Independence
Information required by this item will be contained in our Proxy Statement to be filed pursuant to Regulation 14A with the Securities and Exchange Commission within 120 days of December 31, 2011. Such information is incorporated herein by reference.
Item 14.
Item 14.
Principal Accountant Fees and Services
Information required by this item will be contained in our Proxy Statement to be filed pursuant to Regulation 14A with the Securities and Exchange Commission within 120 days of December 31, 2011. Such information is incorporated herein by reference.
PART IV
Item 15.
Item 15.
Exhibits, Financial Statement Schedules
(a)
The following documents are filed as part of this Annual Report on Form 10-K:
1.
Consolidated Financial Statements. Reference is made to Part II, Item 8, of this Annual Report on Form 10-K.
2.
Consolidated Financial Statement Schedules. These schedules are omitted as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes.
3.
Exhibits. The exhibits to this Annual Report on Form 10-K listed below have been included only with the copy of this report filed with the Securities and Exchange Commission. Copies of individual exhibits will be furnished to shareholders upon written request to 1st Century Bancshares, Inc. and payment of a reasonable fee.
(b)
Exhibits - See exhibit index included in Item 15(a)3 of this Annual Report on Form 10-K.
(c)
Financial Statement Schedules - See Item 15(a)2 of this Annual Report on Form 10-K.
SIGNATURES
In accordance with section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 6th day of March, 2012.
1ST CENTURY BANCSHARES, INC.
By:
/s/ Alan I. Rothenberg.
Alan I. Rothenberg
Chairman and Chief Executive Officer
By:
/s/ Jason P. DiNapoli.
Jason P. DiNapoli
President and Chief Operating Officer
In accordance with the Securities Exchange Act of 1934, as amended, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature
Title
Date
/s/ Dave Brooks.
Director
March 6, 2012
Dave Brooks
/s/ Joseph J. Digange.
Director
March 6, 2012
Joseph J. Digange
/s/ Jason P. DiNapoli.
President and Chief Operating Officer, Director (Principal Executive Officer)
Jason P. DiNapoli
March 6, 2012
/s/ Eric M. George.
Director
March 6, 2012
Eric George
/s/ Alan D. Levy.
Director
March 6, 2012
Alan D. Levy
/s/ Robert A. Moore.
Director
March 6, 2012
Robert A. Moore
/s/ Barry D. Pressman.
Director
March 6, 2012
Barry D. Pressman, M.D.
/s/ Stanley R. Zax.
Director
March 6, 2012
Stanley R. Zax
Financial Statements and Supplementary Data
1st Century Bancshares, Inc.
Page
Consolidated Balance Sheets as of December 31, 2011 and 2010
Consolidated Statements of Operations for the years ended December 31, 2011 and 2010
Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income (Loss) for the years ended December 31, 2011 and 2010
Consolidated Statements of Cash Flows for the years ended December 31, 2011 and 2010
Notes to Consolidated Financial Statements
Reports of Independent Registered Public Accounting Firms
1st Century Bancshares, Inc.
Consolidated Balance Sheets
(in thousands, except share and per share data)
The accompanying notes are an integral part of these consolidated financial statements.
1st Century Bancshares, Inc.
Consolidated Statements of Operations
(in thousands, except per share data)
The accompanying notes are an integral part of these consolidated financial statements.
1st Century Bancshares, Inc.
Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income (Loss)
Years ended December 31, 2011 and 2010
(in thousands, except share data)
The accompanying notes are an integral part of these consolidated financial statements.
1st Century Bancshares, Inc.
Consolidated Statements of Cash Flows
(in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
1st Century Bancshares, Inc.
Notes To Consolidated Financial Statements
(1)
Summary of Significant Accounting Policies
Nature of Operations
1st Century Bancshares, Inc., a Delaware corporation (“Bancshares”) is a bank holding company with one subsidiary, 1st Century Bank, National Association (the “Bank”). The Bank commenced operations on March 1, 2004 in the State of California operating under the laws of a National Association (“N.A.”) regulated by the Office of the Comptroller of the Currency (the “OCC”). The Bank is a commercial bank that focuses on closely held and family owned businesses and their employees, professional service firms, real estate professionals and investors, the legal, accounting and medical professions, and small and medium-sized businesses and individuals principally in Los Angeles County. The Bank provides a wide range of banking services to meet the financial needs of the local residential community, with an orientation primarily directed toward owners and employees of the Bank’s business client base. The Bank is subject to both the regulations of and periodic examinations by the OCC, which is the Bank’s federal regulatory agency. Bancshares and the Bank are collectively referred to herein as “the Company.”
Basis of Presentation
The consolidated financial statements include the accounts of Bancshares and the Bank. All inter-company accounts and transactions have been eliminated in consolidation.
Certain items in the 2010 consolidated financial statements have been reclassified to conform to the 2011 presentation. Reclassifications had no effect on prior year net income or shareholders’ equity.
The Company’s accounting and reporting policies conform to GAAP and to general practices within the banking industry. A summary of the significant accounting and reporting policies consistently applied in the preparation of the accompanying consolidated financial statements follows:
Use of Estimates
Management is required 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 consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Significant assumptions and estimates used by management in preparation of the consolidated financial statements include assumptions and assessments made in connection with calculating the allowance for loan losses and determining the realizability of the Company’s deferred tax assets. It is at least reasonably possible that certain assumptions and estimates could prove to be incorrect and cause actual results to differ materially and adversely from the amounts reported in the consolidated financial statements included herewith.
Cash and Cash Equivalents
Cash and cash equivalents include cash and due from banks, interest earning deposits at other financial institutions with original maturities less than 90 days and all highly liquid investments with original maturities of less than 90 days.
Investment Securities
Investment securities are classified in three categories. Debt securities that management has a positive intent and ability to hold to maturity are classified as “Held to Maturity” or “HTM” and are recorded at amortized cost. Debt and equity securities bought and held principally for the purpose of selling in the near term are classified as “Trading” securities and are measured at fair value, with unrealized gains and losses included in earnings. Debt and equity securities not classified as “Held to Maturity” or “Trading” with readily determinable fair values are classified as “Available for Sale” or “AFS” and are recorded at fair value, with unrealized gains and losses excluded from earnings and reported in other comprehensive income. The Company uses estimates from third parties in arriving at fair value determinations which are derived in accordance with fair value measurement standards.
Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities. Declines in the fair value of investment securities below their cost that are deemed to be other-than-temporary are reflected in earnings as realized losses to the extent the impairment is related to credit losses. The amount of the impairment related to other factors is recognized in other comprehensive income provided that management does not have the intent to sell the securities and it is more
likely than not that management will not have to sell the security before recovery of its cost basis. In estimating other-than-temporary impairment losses, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method.
Federal Reserve Bank Stock and Federal Home Loan Bank Stock
The Bank is a member of the Federal Reserve System (“Fed” or “FRB”). FRB stock is carried at cost and is considered a nonmarketable equity security. Cash dividends from the FRB are reported as interest income on an accrual basis.
The Bank is a member and stockholder of the capital stock of the Federal Home Loan Bank of San Francisco (“FHLB of San Francisco” or “FHLB”). Members are required to own a certain amount of stock based on the level of borrowings and other factors, and may invest in additional amounts. FHLB of San Francisco stock is carried at cost and is considered a nonmarketable equity security. Both cash and stock dividends are reported as interest income.
Loans
Loans, net, are stated at the unpaid principal balances less the allowance for loan losses and unamortized deferred fees and costs. Loan origination fees, net of related direct costs, are deferred and accreted to interest income as an adjustment to yield over the respective maturities of the loans using the effective interest method.
Interest on loans is accrued as earned on a daily basis, except where reasonable doubt exists as to the collection of interest and principal, in which case the accrual of interest is discontinued and the loan is placed on non-accrual status. Loans are placed on non-accrual at the time principal or interest is 90 days delinquent. Interest on non-accrual loans is accounted for on a cash-basis or cost-recovery method, until qualifying for return to accrual status. In order for a loan to return to accrual status, all principal and interest amounts owed must be brought current and future payments must be reasonably assured, or the loan must be well secured and in the process of collection.
A loan is charged-off at any time the loan is determined to be uncollectible. Collateral dependent loans, which generally include commercial real estate loans, residential loans, and construction and land loans, are typically charged down to their net realizable value when a loan is impaired or on non-accrual status. All other loans are typically charged-off when, based upon current available facts and circumstances, it’s determined that either: (1) a loan is uncollectible, (2) repayment is determined to be protracted beyond a reasonable time frame, or (3) the loan is classified as a loss determined by either the Bank’s internal review process or by external examiners.
Loans are considered impaired when, based upon current information and events, it is probable that the Company will be unable to collect all principal and interest amounts due according to the original contractual terms of the loan agreement on a timely basis. The Company evaluates impairment on a loan-by-loan basis. Once a loan is determined to be impaired, the impairment is measured based on the present value of the expected future cash flows discounted at the loan’s effective interest rate or by using the loan’s most recent market value or the fair value of the collateral if the loan is collateral dependent. Loans that experience insignificant payment delays or payment shortfalls are generally not considered to be impaired.
When the measurement of an impaired loan is less than the recorded amount of the loan, a valuation allowance is established by recording a charge to the provision for loan losses. Subsequent increases or decreases in the valuation allowance for impaired loans are recorded by adjusting the existing valuation allowance for the impaired loan with a corresponding charge or credit to the provision for loan losses. The Company’s policy for recognizing interest income on impaired loans is the same as that for non-accrual loans.
Troubled Debt Restructurings
In situations where, for economic or legal reasons related to a borrower’s financial difficulties, management may grant a concession for other than an insignificant period of time to the borrower that would not otherwise be considered, the related loan is classified as a troubled debt restructuring (“TDR”). Management strives to identify borrowers in financial difficulty early and work with them to modify their loans to more affordable terms before their loan reaches nonaccrual status. Concessions may include interest rate reductions or below market interest rates, principal forgiveness, restructuring amortization schedules and other actions intended to minimize potential losses. Effective July 1, 2011, the Company adopted the provisions of Accounting Standards Update (“ASU”) 2011-02, Receivables (“Topic 310”) - A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring (“ASU 11-02”). As such, the Company reassessed all loan modifications occurring since January 1, 2011 for
identification as troubled debt restructurings. In cases where borrowers are granted a concession, management measures any impairment on the restructuring as noted above for impaired loans.
Allowance for Loan Losses
The allowance for loan losses is established through a provision for loan losses charged to operations and represents an estimate of credit losses inherent in the Company’s loan portfolio that have been incurred as of the balance sheet date. Loan losses are charged against the allowance when management believes that principal is uncollectible. Subsequent repayments or recoveries, if any, are credited to the allowance. Management periodically assesses the adequacy of the allowance for loan losses by reference to many quantitative and qualitative factors that may be weighted differently at various times depending on prevailing conditions. The provisions reflect management’s evaluation of the adequacy of the allowance based, in part, upon the historical loss experience of the loan portfolio, as well as estimates from historical peer group loan loss data and the loss experience of other financial institutions, augmented by the experience of management with similar assets and the Company’s independent loan review process. During this process, loans are separated into the following portfolio segments: commercial loans, commercial real estate, residential, land and construction, and consumer and other loans. The relative significance of risk considerations vary by portfolio segment. For commercial loans, commercial real estate loans and land and construction, the primary risk consideration is a borrower’s ability to generate sufficient cash flows to repay their loan. Secondary considerations include the creditworthiness of guarantors and the valuation of collateral. In addition to the creditworthiness of a borrower, the type and location of real estate collateral is an important risk factor for commercial real estate and land and construction loans. The primary risk consideration for residential loans and consumer loans are a borrower’s personal cash flow and liquidity, as well as collateral value. Loss ratios for all portfolio segments are evaluated on a quarterly basis. Loss ratios associated with historical loss experience are determined based on a rolling migration analysis of each portfolio segment within the portfolio. This migration analysis estimates loss factors based on the performance of each portfolio segment over a three-year time period. These loss factors are then adjusted, if necessary, for other identifiable risks specifically related to each portfolio segment or risk grade. Management carefully monitors changing economic conditions, the concentrations of loan categories, values of collateral, the financial condition of the borrowers, the history of the loan portfolio, and historical peer group loan loss data to determine the adequacy of the allowance for loan losses. As a part of this process, management typically focuses on loan-to-value (“LTV”) percentages to assess the adequacy of loss ratios of collateral dependent loans within each portfolio segment discussed above, trends within each portfolio segment, as well as general economic and real estate market conditions where the collateral and borrower are located. For loans that are not collateral dependent, which generally consist of commercial and consumer and other loans, management typically focuses on general business conditions where the borrower operates, trends within the portfolio, and other external factors to evaluate the severity of loss factors. The allowance is based on estimates and actual losses may vary from the estimates.
In addition, regulatory agencies, as a part of their examination process, periodically review the Bank’s allowance for loan losses, and may require the Bank to make additions to the allowance based on their judgment about information available to them at the time of their examinations. No assurance can be given that adverse future economic conditions will not lead to increased delinquent loans, and increases in the provision for loan losses and/or charge-offs. Management believes that the allowance as of December 31, 2011 and 2010 was adequate to absorb probable credit losses inherent in the loan portfolio.
Other Real Estate Owned
OREO represents real estate acquired through or in lieu of foreclosure. OREO is held for sale and is initially recorded at fair value less estimated costs of disposition at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of cost or estimated fair value less costs of disposition. OREO are included in accrued interest and other assets within the Consolidated Balance Sheets and the net operating results, if any, from OREO are recognized as non-interest expense within the Consolidated Statements of Operations.
Furniture, Fixtures and Equipment, net
Leasehold improvements and furniture, fixtures and equipment are carried at cost, less depreciation and amortization. Furniture, fixtures and equipment are depreciated using the straight-line method over the estimated useful life of the asset (three to five years). Leasehold improvements are depreciated using the straight-line method over the terms of the related leases or the estimated lives of the improvements, whichever is shorter.
Advertising Costs
Advertising costs are expensed as incurred.
Income Taxes
The Company files consolidated federal and combined state income tax returns. Income tax expense or benefit is the total of the current year income tax payable or refundable and the change in the deferred tax assets and liabilities (excluding deferred tax assets and liabilities related to components of other comprehensive income). Deferred tax assets and liabilities are the expected future tax amounts for the temporary differences between carrying amounts and tax basis of assets and liabilities, computed using enacted tax rates.
Deferred income tax assets and liabilities are determined using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is determined based on the tax effects of the temporary differences between the book and tax bases of the various balance sheet assets and liabilities and gives current recognition to changes in the rates and laws. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized. The Company records a valuation allowance if it believes, based on all available evidence, that it is “more likely than not” that the future tax assets will not be realized. This assessment requires management to evaluate the Company’s ability to generate sufficient future taxable income or use eligible tax carrybacks, if any, to determine the need for a valuation allowance.
During the year ended December 31, 2009, the Company established a full valuation allowance against the deferred tax assets due to the uncertainty regarding its realizability. At December 31, 2011 and 2010, management reassessed the need for this valuation allowance and concluded that a full valuation allowance remained appropriate. Management reached this conclusion as a result of the Company’s cumulative losses since inception, and the anticipated near term economic climate in which the Company will operate. Management will continue to evaluate the potential realizability of the deferred tax assets and will continue to maintain a valuation allowance to the extent it is determined that it is more likely than not that these assets will not be realized. At December 31, 2011 and 2010, the Company maintained a deferred tax liability of $1.1 million and $586,000, respectively, in connection with net unrealized gains on investment securities, which is included in Accrued Interest and Other Liabilities within the accompanying Consolidated Balance Sheets. The Company did not utilize this deferred tax liability to reduce its tax valuation allowance due to the fact that management does not currently intend to dispose of these investments and realize the associated gains.
At December 31, 2011 and 2010, the Company did not have any tax benefits disallowed under accounting standards for uncertainties in income taxes. A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded.
See Note 16 “Income Taxes” for further discussion regarding the Company’s tax positions at December 31, 2011 and 2010.
Comprehensive Income (Loss)
Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. However, certain changes in assets and liabilities, such as unrealized gains and losses on Available for Sale securities, are reported as a separate component of the equity section of the Consolidated Balance Sheets and, along with net income (loss), are components of comprehensive income (loss).
Earnings (Loss) per Share
The Company reports both basic and diluted earnings per share. Basic earnings per share is determined by dividing net income by the average number of shares of common stock outstanding, while diluted earnings per share is determined by dividing net income by the average number of shares of common stock outstanding adjusted for the dilutive effect of common stock equivalents. Potential dilutive common shares related to outstanding stock options and restricted stock are determined using the treasury stock method. However, diluted earnings per share is not adjusted for potentially dilutive common shares when a net loss occurs because conversion of potentially dilutive common shares is antidilutive. There were 107,682 dilutive shares that were excluded from the Company’s diluted earnings per share calculations at December 31, 2010 because of this antidilutive impact.
Fair Value of Financial Instruments
The Company is required to make certain disclosures about its use of fair value measurements in the preparation of its financial statements. These standards establish a three-level hierarchy for disclosure of assets and liabilities recorded at fair value. The classification of assets and liabilities within the hierarchy is based on whether the inputs to the valuation methodology used for measurement are observable or unobservable. Observable inputs reflect market-derived or market-based information obtained from independent sources, while unobservable inputs reflect management’s estimates about market data.
Level 1
Valuation is based upon quoted prices for identical instruments traded in active markets. Level 1 instruments include securities traded on active exchange markets, such as the New York Stock Exchange, as well as U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets.
Level 2
Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market. Level 2 instruments include securities traded in less active dealer or broker markets.
Level 3
Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.
Stock-Based Compensation
The Company has granted restricted stock awards to directors, employees, and a vendor under the 1st Century Bancshares 2005 Amended and Restated Equity Incentive Plan (the “Equity Incentive Plan”). The restricted stock awards are considered fixed awards as the number of shares and fair value is known at the date of grant and the fair value at the grant date is amortized over the vesting and/or service period.
Recent Accounting Pronouncements
In January 2010, the Financial Accounting Standards Board (“FASB”) issued ASU 2010-06, Fair Value Measurements and Disclosures (“Topic 820”): Improving Disclosures about Fair Value Measurements (“ASU 10-06”). ASU 10-06 revises two disclosure requirements concerning assets and liabilities that are measured at fair value on a recurring basis and clarifies two others. It requires separate presentation of significant transfers into and out of Levels 1 and 2 of the fair value hierarchy and disclosure of the reasons for such transfers. It requires the presentation of purchases, sales, issuances and settlements within Level 3 on a gross basis rather than a net basis. The amendments also clarify that disclosures should be disaggregated by class of asset or liability and that disclosures about inputs and valuation techniques should be provided for both recurring and non-recurring fair value measurements. The Company’s disclosures about fair value measurements are presented in Note 10: Fair Value Measurements. These new disclosure requirements were adopted by the Company during the three months ended March 31, 2010, with the exception of the requirement concerning gross presentation of Level 3 activity, which was adopted during the three months ended March 31, 2011. The adoption of this standard did not have a material impact on the Company’s financial position, results of operations, cash flows, or disclosures.
In July 2010, the FASB issued ASU 2010-20, Receivables (“Topic 310”) - Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses (“ASU 10-20”). ASU 10-20 requires a company to disaggregate new and existing disclosures based on how it develops its allowance for credit losses and how it manages credit exposures. Short-term accounts receivable, receivables measured at fair value or lower of cost or fair value, and debt securities are exempt from the ASU 10-20. For
public companies, the amendments that require disclosures as of the end of a reporting period were effective for periods ending on or after December 15, 2010. The adoption of this portion of ASU 10-20 did not have a material impact on the Company’s financial position, results of operations, or cash flows. The amendments that require disclosures about activity that occurs during a reporting period were effective for periods beginning on or after December 15, 2010. The adoption of this portion of the ASU did not have a material impact on the Company’s financial position, results of operations, or cash flows.
In January 2011, the FASB issued ASU 2011-01, Receivables (“Topic 310”) - Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20 (“ASU 11-01”). ASU 11-01 temporarily deferred the effective date for disclosures related to troubled debt restructurings (“TDRs”) to coincide with the effective date of the ASU, discussed below, related to troubled debt restructurings.
In April 2011, the FASB issued ASU 2011-02. ASU 11-02 amends the content in ASC 310 related to identifying TDRs and effectively nullifies ASU 2011-01. This ASU removes the deferral of the TDR disclosure requirements of ASU 2010-20 for public entities and thus establishes the effective date for those disclosures. ASU 11-02 is effective for the first interim or annual period beginning on or after June 15, 2011, and is to be applied retrospectively to modifications occurring on or after the beginning of the fiscal year of adoption. The Company adopted the provisions of ASU 11-02 on July 1, 2011. The adoption of this ASU did not have a material impact on the Company’s financial position, results of operations, or cash flows.
In May 2011, the FASB issued ASU 2011-04, Fair Value Measurement (“Topic 820”) - Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs (“ASU 11-04”). This ASU amends Topic 820, "Fair Value Measurements and Disclosures," to converge the fair value measurement guidance in U.S. generally accepted accounting principles and International Financial Reporting Standards. ASU 11-04 clarifies the application of existing fair value measurement requirements, changes certain principles in Topic 820 and requires additional fair value disclosures. ASU 11-04 is effective for annual periods beginning after December 15, 2011. Management does not believe that the adoption of this ASU will have a material impact on the Company’s financial position, results of operations, or cash flows.
In June 2011, the FASB issued ASU 2011-05, Comprehensive Income (“Topic 220”) - Presentation of Comprehensive Income (“ASU 11-05”). This ASU amends Topic 220, "Comprehensive Income," to require that all nonowner changes in stockholders' equity be presented in either a single continuous statement of comprehensive income or in two separate but consecutive statements. Additionally, ASU 11-05 requires entities to present, on the face of the financial statements, reclassification adjustments for items that are reclassified from other comprehensive income to net income in the statement or statements where the components of net income and the components of other comprehensive income are presented. The option to present components of other comprehensive income as part of the statement of changes in stockholders' equity was eliminated. ASU 11-05 is effective for annual periods beginning after December 15, 2011. Management does not believe that the adoption of this ASU will have a material impact on the Company’s financial position, results of operations, or cash flows.
In December 2011, the FASB issued ASU 2011-11, Balance Sheet (“Topic 210”) - Disclosures about Offsetting Assets and Liabilities (“ASU 11-11”). This ASU amends Topic 210, “Balance Sheet,” to require an entity to disclose both gross and net information about financial instruments, such as sales and repurchase agreements and reverse sale and repurchase agreements and securities borrowing/lending arrangements, and derivative instruments that are eligible for offset in the statement of financial position and/or subject to a master netting arrangement or similar agreement. ASU 11-11 is effective for annual and interim periods beginning on January 1, 2013. Management does not believe that the adoption of this ASU will have a significant impact on the Company’s financial position, results of operations, or cash flows.
In December 2011, the FASB issued ASU 2011-12 Comprehensive Income (“Topic 220”) - Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05 (“ASU 11-12”). This ASU defers changes in ASU 11-05 that relate to the presentation of reclassification adjustments to allow the FASB time to redeliberate whether to require presentation of such adjustments on the face of the financial statements to show the effects of reclassifications out of accumulated other comprehensive income on the components of net income and other comprehensive income. ASU 11-12 allows entities to continue to report reclassifications out of accumulated other comprehensive income consistent with the presentation requirements in effect before ASU 11-05. All other requirements in ASU 11-05 are not affected by ASU 11-12. ASU 11-12 is effective for annual and interim periods beginning after December 15, 2011. Management does not believe that the adoption of this ASU will have a significant impact on the Company’s financial position, results of operations, or cash flows.
(2)
Investment Securities
The following is a summary of the investments categorized as Available for Sale at December 31, 2011 and 2010:
The Company did not have any investment securities categorized as “Held to Maturity” or “Trading” at December 31, 2011 or 2010.
Additionally, at December 31, 2011 and 2010, the carrying amount of securities pledged to the State of California Treasurer’s Office to secure their deposits was $53.6 million and $56.3 million, respectively. Deposits from the State of California were $34.0 million at both December 31, 2011 and 2010.
The following table summarizes the fair value of AFS securities and the weighted average yield of investment securities by contractual maturity at December 31, 2011. Residential mortgage-backed securities are included in maturity categories based on their stated maturity date. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations. The weighted average life of these securities was 3.57 years at December 31, 2011.
(dollars in thousands)
A total of nine securities had unrealized losses at both December 31, 2011 and December 31, 2010. Information pertaining to securities with gross unrealized losses aggregated by investment category and length of time that individual securities have been in a continuous loss position, follows:
The Company’s assessment that it has the ability to continue to hold impaired investment securities along with its evaluation of their future performance provide the basis for it to conclude that its impaired securities are not other-than-temporarily impaired. In assessing whether it is more likely than not that the Company will be required to sell any impaired security before its anticipated recovery, which may be at their maturity, it considers the significance of each investment, the amount of impairment, as well as the Company’s liquidity position and the impact on the Company’s capital position. As a result of its analyses, the Company determined at December 31, 2011 and 2010 that the unrealized losses on its securities portfolio on which impairments had not been recognized are temporary.
The Company sold one available for sale security totaling $140,000 during the year ended December 31, 2011, resulting in a realized gain of $2,000. The Company sold two available for sale securities totaling $3.8 million during the year ended December 31, 2010, resulting in a realized gain of $44,000. These gains were reported in non-interest income within the accompanying Consolidated Statements of Operations.
(3)
Loans
Loans
As of December 31, 2011 and 2010, gross loans outstanding totaled $233.0 million and $179.3 million, respectively, within the following loan categories:
December 31,
(1)
Unsecured commercial loan balances were $11.5 million and $11.0 million at December 31, 2011 and 2010, respectively.
(2)
Unsecured consumer and other loan balances were $2.8 million and $1.9 million at December 31, 2011 and 2010, respectively.
As of December 31, 2011 and 2010, substantially all of the Company’s loan customers were located in Southern California.
Allowance for Loan Losses and Recorded Investment in Loans
The following is a summary of activities for the allowance for loan losses and recorded investment in loans as of December 31, 2011:
The following is a summary of activities for the allowance for loan losses for the year ended December 31, 2010:
The following is a summary of the allowance for loan losses and recorded investment in loans as of December 31, 2010:
There were no loans acquired with deteriorated credit quality as of December 31, 2011 and 2010.
In addition to the allowance for loan losses, the Company also estimates probable losses related to unfunded lending commitments. Unfunded lending commitments are subject to individual reviews and are analyzed and segregated by risk according to the Company’s internal risk rating scale. These risk classifications, in conjunction with an analysis of historical loss experience, current economic conditions, performance trends within specific portfolio segments and any other pertinent information, result in the estimation of the reserve for unfunded lending commitments. Provision for credit losses related to unfunded lending commitments is reported in other operating expenses in the Consolidated Statements of Operations. The allowance held for unfunded lending commitments is reported in accrued interest and other liabilities within the accompanying Consolidated Balance Sheets, and not as part of the allowance for loan losses in the above tables. As of December 31, 2011 and 2010, the allowance for unfunded lending commitments was $203,000 and is primarily related to commercial and home equity lines of credit and letters of credit which amounted to $59.7 million and $62.9 million at December 31, 2011 and 2010, respectively.
Non-Performing Assets
The following table presents an aging analysis of the recorded investment of past due loans as of December 31, 2011 and 2010. Payment activity is reviewed by management on a monthly basis to determine the performance of each loan. Loans are considered to be non-performing when a loan is greater than 90 days delinquent. Loans that are 90 days or more past due may still accrue interest if they are well-secured and in the process of collection. Total additions to non-performing loans during the years ended December 31, 2011 and 2010 were $2.5 million and $3.7 million, respectively. Non-performing loans represented 3.3% and 4.0% of total loans at December 31, 2011 and 2010, respectively. There were no accruing loans past due 90 days or more at December 31, 2011 and 2010.
The following table sets forth non-accrual loans and other real estate owned at December 31, 2011 and 2010:
Credit Quality Indicators
The following table represents the credit exposure by internally assigned grades at December 31, 2011 and 2010. This grading analysis estimates the capability of the borrower to repay the contractual obligations of the loan agreements in accordance with the loan terms. The Company’s internal credit risk grading system is based on management’s experiences with similarly graded loans. Credit risk grades are reassessed each quarter based on any recent developments potentially impacting the creditworthiness of the borrower, as well as other external statistics and factors, which may affect the risk characteristics of the respective loan.
The Company’s internally assigned grades are as follows:
Pass - Strong credit with no existing or known potential weaknesses deserving of management's close attention.
Special Mention - Potential weaknesses that deserve management’s close attention. Borrower and guarantor’s capacity to meet all financial obligations is marginally adequate or deteriorating.
Substandard - Inadequately protected by the paying capacity of the Borrower and/or collateral pledged. The borrower or guarantor is unwilling or unable to meet loan terms or loan covenants for the foreseeable future.
Doubtful - All the weakness inherent in one classified as Substandard with the added characteristic that those weaknesses in place make the collection or liquidation in full, on the basis of current conditions, highly questionable and improbable.
Loss - Considered uncollectible or no longer a bankable asset. This classification does not mean that the asset has absolutely no recoverable value. In fact, a certain salvage value is inherent in these loans. Nevertheless, it is not practical or desirable to defer writing off a portion or whole of a perceived asset even though partial recovery may be collected in the future.
There were no loans assigned to the Doubtful or Loss grade as of December 31, 2011. There were no loans assigned to the Loss grade as of December 31, 2010.
Impaired Loans
The following table includes the recorded investment and unpaid principal balances for impaired loans with the associated allowance amount, if applicable. Management determined the specific allowance based on the present value of expected future cash flows, discounted at the loan’s effective interest rate, except when the remaining source of repayment for the loan is the operation or liquidation of the collateral. In those cases, the current fair value of the collateral, less selling costs was used to determine the specific allowance recorded. Also presented in the table below are the average recorded investments in the impaired loans and the related amount of interest recognized during the time within the period that the impaired loans were impaired. When the ultimate collectability of the total principal of an impaired loan is in doubt and the loan is on nonaccrual status, all payments are applied to principal, under the cost recovery method. When the ultimate collectability of the total principal of an impaired loan is not in doubt and the loan is on non-accrual status, contractual interest is credited to interest income when received, under the cash basis method. The average balances are calculated based on the month-end balances of the loans of the period reported.
During the years ended December 31, 2011 and 2010, no interest income was recognized on these loans subsequent to their classification as impaired. Furthermore, the Company stopped accruing interest on these loans on the date they were classified as non-accrual and reversed any uncollected interest that had been previously accrued as income. The Company may begin recognizing interest income on these loans as cash interest payments are received, if collection of principal is reasonably assured.
Troubled Debt Restructurings
Troubled debt restructurings for the year ended December 31, 2011 are set forth in the following table.
The loan identified as a troubled debt restructuring by the Company was previously on non-accrual status and reported as an impaired loan prior to restructuring. The modification primarily related to extending the amortization period of the loan. This loan was on non-accrual status as of December 31, 2011. Because the loan was impaired both before and after restructuring, the modifications did not impact the Company's determination of the allowance for loan losses. As of December 31, 2011, there have been no defaults on any loans that were modified as troubled debt restructurings during the preceding twelve months. There were no troubled debt restructurings during 2010.
(4)
Comprehensive Income (Loss)
Comprehensive income (loss), which includes net income (loss), the net change in unrealized gains on investment securities available for sale and the reclassification of net (gains) losses included in earnings (losses), is presented below:
(5)
Related Party Transactions
In the normal course of business, the Company may make loans to officers and directors, as well as loans to companies and individuals affiliated with or guaranteed by officers and directors of the Company. Such loans are made in the ordinary course of business. Gross loan commitments for officers and directors of the Company at December 31, 2011 and 2010 were $1.4 million and $3.7 million, respectively. The outstanding balances for these loans were $987,000 and $1.9 million at December 31, 2011 and 2010, respectively.
The following is a summary of related party loan activities for the years ended December 31, 2011 and 2010:
Deposits by officers and directors of the Company at December 31, 2011 and 2010 totaled approximately $9.8 million and $12.4 million, respectively.
(6)
Premises and Equipment
Premises and equipment are stated at cost less accumulated depreciation and amortization. The depreciation and amortization are computed on a straight line basis over the lesser of the lease term, or the estimated useful lives of the assets, generally three to ten years.
Premises and equipment at December 31, 2011 and 2010 are comprised of the following:
December 31,
Depreciation and amortization included in occupancy expense for the years ended December 31, 2011 and 2010 amounted to $371,000 and $357,000, respectively.
(7)
Deposits
The following table reflects the summary of deposit categories by dollar and percentage at December 31, 2011 and 2010:
At December 31, 2011, the Company had three certificates of deposits with the State of California Treasurer’s Office for a total of $34.0 million that represented 10.2% of total deposits. Each of these deposits are scheduled to mature in the first quarter of 2012. The Company intends to renew each of these deposits at maturity. However, given the current economic climate in the State of California, there can be no assurance that the State of California Treasurer’s Office will continue to maintain deposit accounts with the Company. At December 31, 2010, the Company had three certificate of deposit accounts with the State of California Treasurer’s Office for a total of $34.0 million that represented 13.2% of total deposits. The Company was required to pledge $37.4 million of agency mortgage backed securities at December 31, 2011 and 2010 in connection with these certificates of deposit.
At December 31, 2011, the Company had $3.4 million of Certificate of Deposit Accounts Registry Service (“CDARS”) reciprocal deposits, which represented 1.0% of total deposits. At December 31, 2010, the Company had $12.8 million of CDARS deposits, which represented 5.0% of total deposits.
The aggregate amount of certificates of deposit of $100,000 or more at December 31, 2011 and 2010 was $44.9 million and $57.6 million, respectively. At December 31, 2011, the maturity distribution of certificates of deposit of $100,000 or more, including deposit accounts with the State of California Treasurer’s Office and CDARS, was as follows: $37.6 million maturing in six months or less, $4.1 million maturing in six months to one year and $3.1 million maturing in more than one year.
The table below sets forth the range of interest rates, amount and remaining maturities of the certificates of deposit at December 31, 2011.
(8)
Other Borrowings
At December 31, 2011 and 2010, the Company had a borrowing/credit facility secured by a blanket lien on eligible loans at the FHLB of $53.7 million and $45.8 million, respectively. The Company had $25.0 million and $2.0 million of long-term borrowings outstanding under this borrowing/credit facility with the FHLB at December 31, 2011 and 2010, respectively. The Company had no overnight borrowings outstanding under this borrowing/credit facility at December 31, 2011 and 2010.
The following table summarizes the outstanding long-term borrowings under the borrowing/credit facility secured by a blanket lien on eligible loans at the FHLB at December 31, 2011 and 2010 (dollars in thousands):
At December 31, 2011 and 2010, the Company also had $27.0 million in Federal fund lines of credit available with other correspondent banks that could be used to disburse loan commitments and to satisfy demands for deposit withdrawals. Each of these lines of credit is subject to conditions that the Company may not be able to meet at the time when additional liquidity is needed. The Company did not have any borrowings outstanding under these lines of credit at December 31, 2011 or 2010. As of December 31, 2011, the Company had pledged $6.3 million of corporate notes in connection with these lines of credit.
(9)
Commitments and Contingencies
Commitments to Extend Credit
The Company is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve various levels and elements of credit and interest rate risk in excess of the amount recognized in the accompanying consolidated financial statements. The contract or notional amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments. The Company had $57.0 million and $60.6 million in commitments to extend credit to customers and $2.5 million and $2.1 million in standby/commercial letters of credit at December 31, 2011 and 2010, respectively. The Company also guarantees the outstanding balance on credit cards offered at the Company, but underwritten by another financial institution. The outstanding balances on these credit cards were $54,000 and $49,000 as of December 31, 2011 and 2010, respectively.
Lease Commitments
The Company leases office premises under three operating leases that will expire in May 2012, June 2014 and November 2017, respectively. Rental expense, which is included in occupancy expense and is reduced for any sublease income earned during the period, was $542,000 and $459,000 for the years ended December 31, 2011 and 2010, respectively. Sublease income earned during the years ended December 31, 2011 and 2010 were $106,000 and $97,000, respectively.
The projected minimum rental payments under the term of the leases at December 31, 2011 are as follows (in thousands):
Litigation
The Company from time to time is party to lawsuits, which arise out of the normal course of business. At December 31, 2011 and 2010, the Company did not have any litigation that management believes will have a material impact on the Consolidated Balance Sheets or Consolidated Statements of Operations.
Restricted Stock
The following table sets forth the Company’s future restricted stock expense, net of estimated forfeitures (in thousands):
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Stock Repurchase Program
In August 2010, the Company’s Board of Directors (the “Board”) authorized the purchase of up to $2.0 million of the Company’s common stock, which was announced by press release and Current Report on Form 8-K on August 16, 2010. Under this stock repurchase program, the Company has been acquiring its common stock in the open market from time to time beginning in August 2010. The shares repurchased by the Company under this stock repurchase program are held as treasury stock. As of December 31, 2011, the Company had repurchased 490,324 shares in the open market at a cost ranging from $3.35 to $4.02 per share in connection with this program. During the year ended December 31, 2011, the Company repurchased 383,182 shares in the open market at a cost ranging from $3.38 to $4.02 per share in connection with this program. This stock repurchase program may be modified, suspended or terminated by the Board at any time without notice.
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Fair Value Measurements
The following tables present information about the Company’s assets and liabilities measured at fair value on a recurring and non-recurring basis as of December 31, 2011 and 2010, and indicate the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.
Assets Measured on a Recurring Basis
Assets measured at fair value on a recurring basis are summarized below:
AFS securities - Level 2 fair values for investment securities are based on inputs other than quoted prices that are observable, either directly or indirectly. The Company obtains quoted prices through third party brokers. There were no transfers into or out of Level 2 measurements during the years ended December 31, 2011 and 2010.
As of December 31, 2011 and December 31, 2010, the Level 2 fair value of the Company’s residential mortgage-backed securities was $120.8 million and $54.5 million, respectively. These securities consist entirely of agency mortgage-backed securities issued by the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC). The underlying loans for these securities are residential mortgages that were primarily originated beginning in the year of 2003 through the current period. These loans are geographically dispersed throughout the United States. At December 31, 2011 and December 31, 2010, the weighted average rate and weighed average life of these securities were 2.60% and 3.74%, respectively, and 3.57 years and 3.51 years, respectively.
The valuation for investment securities utilizing Level 2 inputs were primarily determined by quotes received from an independent pricing service using matrix pricing, which is a mathematical technique widely used in the industry to value securities without relying exclusively on quoted market prices for the specific securities, but rather by relying on the securities’ relationship to other benchmark quoted securities.
Assets Measured on a Non-Recurring Basis
Assets measured at fair value on a non-recurring basis are summarized below:
Impaired loans - Loans are considered impaired when, based upon current information and events, it is probable that the Company will be unable to collect all principal and interest amounts due according to the original contractual terms of the loan agreement on a timely basis. The Company evaluates impairment on a loan-by-loan basis. Once a loan is determined to be impaired, the impairment is measured based on the present value of the expected future cash flows discounted at the loan’s effective interest rate or by using the loan’s most recent market value or the fair value of the collateral if the loan is collateral dependent. The fair value of impaired loans using discounted cash flows is determined using estimates of expected future cash flows which requires significant judgment from management that could not be corroborated by observable market data. The fair value of impaired loans that are collateral dependent is determined using various valuation techniques which are not readily observable in the market place, including consideration of appraised values and other pertinent real estate market data. The Company recorded net charge-offs of $274,000 on impaired loans at December 31, 2011, compared to net charge-offs of $3.0 million during the same period last year.
Other real estate owned - OREO represents real estate acquired through or in lieu of foreclosure. OREO is held for sale and is initially recorded at fair value less estimated costs of disposition at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of cost or estimated fair value less costs of disposition. The fair value of OREO is determined using various valuation techniques which are not readily observable in the market place, including consideration of appraised values and other pertinent real estate market data.
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Estimated Fair Value Information
The fair value of a financial instrument is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is best determined based upon quoted market prices. However, in many cases, there are no quoted market prices for the Company’s various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. 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 the Company could realize in a current market exchange.
The methods and assumptions used to estimate the fair value of each class of financial instruments for which it is practicable to estimate the value are explained below.
Cash and cash equivalents
The carrying amounts are considered to be their estimated fair values because of the short-term maturity of these instruments which includes Federal funds sold and interest-earning deposits at other financial institutions.
Investment securities
AFS investment securities are carried at fair value, which are based on quoted prices of exact or similar securities, or on inputs that are observable, either directly or indirectly. The Company obtains quoted prices through third party brokers.
FRB and FHLB stock
For FRB and FHLB stock, the carrying amount is equal to the par value at which the stock may be sold back to FRB or FHLB, which approximates fair value.
Loans, net
For loans, the fair value is estimated using market quotes for similar assets or the present value of future cash flows, discounted using the current rate at which similar loans would be made to borrowers with similar credit ratings and for the same maturities and giving consideration to estimated prepayment risk and credit risk.
Impaired loans are measured for impairment based on the present value of expected future cash flows discounted at the loan's effective interest rate, except that as a practical expedient, the Company may measure impairment based on a loan's observable market price, or the fair value of the collateral (net of estimated costs to sell) if the loan is collateral dependent.
Off-balance sheet credit-related instruments
The fair values of commitments, which include standby letters of credit and commercial letters of credit, are based upon fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. The related fees are not considered material to the Company’s financial statements as a whole and the fair market value of the Company’s off-balance sheet credit-related instruments cannot be readily determined.
Deposits
For demand deposits, the carrying amount approximates fair value. The fair values of interest bearing checking, savings, and money market deposits are estimated by discounting future cash flows using the interest rates currently offered for deposits of similar products. The fair values of the certificates of deposit are estimated by discounting future cash flows based on the rates currently offered for certificates of deposit with similar interest rates and remaining maturities.
Other borrowings
The fair values of long term FHLB advances are estimated based on the rates currently offered by the FHLB for advances with similar interest rates and remaining maturities.
Accrued interest
The estimated fair value for both accrued interest receivable and accrued interest payable are considered to be equivalent to the carrying amounts.
Summary
The estimated fair value and carrying amounts of the financial instruments at December 31, 2011 and 2010 are as follows:
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Non-Interest Income
The following table summarizes the information regarding non-interest income for the years ended December 31, 2011 and 2010, respectively:
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Other Operating Expenses
The following table summarizes the information regarding other operating expenses for the years ended December 31, 2011, and 2010, respectively:
Years ended December 31,
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Stock-Based Compensation
The Company grants restricted stock awards to directors and employees under the Equity Incentive Plan. Restricted stock awards are considered fixed awards as the number of shares and fair value is known at the date of grant and the fair value at the grant date is amortized over the requisite service period. On May 15, 2011, the Company granted 104,500 restricted stock awards to employees with various vesting periods as follows: 50% or 52,250 awards that vest in three years, 25% or 26,125 awards that vest in four years, and 25% or 26,125 awards that vest in five years. On November 17, 2011, the Company granted 60,000 restricted stock awards to employees with various vesting periods as follows: 50% or 30,000 awards that vest in three years, 25% or 15,000 awards that vest in four years, and 25% or 15,000 awards that vest in five years. On November 17, 2011, the Company granted 42,104 restricted stock awards to directors with graded vesting over 3 years.
Non-cash stock compensation expense recognized in the Consolidated Statement of Operations related to the restricted stock awards, net of estimated forfeitures, was $420,000 in 2011 and $507,000 in 2010. The fair value of restricted stock awards that vested during the year was $319,000 and $533,000 for the years ended December 31, 2011 and 2010, respectively.
The following table reflects the activities related to restricted stock awards outstanding for the years ended December 31, 2011 and 2010, respectively.
The Company recognizes compensation expense for stock options by amortizing the fair value at the grant date over the service, or vesting period.
There have been no options granted, exercised or cancelled under the 2004 Founder Stock Option Plan for the years ended December 31, 2011 or 2010. The remaining contractual life of the 2004 Founder Stock Options outstanding was 2.15 and 3.15 years at December 31, 2011 and 2010, respectively. All options under the 2004 Founder Stock Option Plan were exercisable at December 31, 2011 and 2010. The weighted average exercise price of the 133,700 shares outstanding under the 2004 Founder Stock Option Plan is $5.00.
There have been no options granted, exercised or cancelled under the Director and Employee Stock Option Plan for the years ended December 31, 2011 or 2010. The remaining contractual life of the Director and Employee Stock Options outstanding was 2.64 and 3.64 years at December 31, 2011 and 2010, respectively. All options under the Directors and Employee Stock Option Plan were exercisable at December 31, 2011 and 2010. At December 31, 2011 and 2010, the weighted average exercise price of the 1,045,673 shares outstanding under the Director and Employee Stock Option Plan was $6.05.
The following tables detail the amount of shares authorized and available under all stock plans as of December 31, 2011:
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Income Taxes
The income tax provision consists of the following for the years ended December 31, 2011 and 2010:
During the year ended December 31, 2011, the Company recorded a tax expense of approximately $71,000, primarily related to amounts due for California State taxes. The taxes owed in connection with pre-tax earnings would have typically been entirely offset by the Company’s net operating loss carryforwards, however, the State temporarily suspended the use of these carryforwards for the year ended December 31, 2011, and, as a result, the Company has recorded a tax liability for that period. Going forward, the Company does not anticipate owing any substantial taxes for Federal or State purposes, until the Company’s net operating losses are fully utilized. During the year ended December 31, 2010, the Company did not record an income tax provision.
A reconciliation of the amounts computed by applying the federal statutory rate of 34% for 2011 and 2010 to the loss before income tax provision and the effective tax rate are as follows:
The major components of the net deferred tax assets and liabilities at December 31, 2011 and 2010 are as follows:
A valuation allowance is required if it is “more likely than not” that a deferred tax asset will not be realized. The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning management’s evaluation of both positive and negative evidence, including historic financial performance, the forecasts of future income, existence of feasible tax planning strategies, length of statutory carryforward periods, and assessments of the current and future economic and business conditions. Management evaluates the positive and negative evidence and determines the realizability of the deferred tax asset on a quarterly basis.
During the year ended December 31, 2009, we established a full valuation allowance against the Company’s deferred tax assets after we determined that it is “more likely than not” that the Company will not be able to realize the benefit of the deferred tax asset. During the years ended December 31, 2011 and 2010, management reassessed the continuing need for this valuation allowance and determined that as of December 31, 2011 and 2010, it was appropriate to maintain a full valuation allowance against the Company’s deferred tax assets. Management reached this conclusion as a result of the Company’s cumulative losses since inception, and the near term economic climate in which the Company operates. Management will continue to evaluate the potential realizability of the deferred tax assets and will continue to maintain a valuation allowance to the extent it is determined that it is more likely than not that these assets will not be realized.
At December 31, 2011 and 2010, the Company maintained a deferred tax liability of $1.1 million and $586,000, respectively, in connection with net unrealized gains on investment securities, and is included in Accrued Interest and Other Liabilities within the accompanying Consolidated Balance Sheets. We did not utilize this deferred tax liability to reduce our tax valuation allowance due to the fact that we do not currently intend to dispose of these investments and realize the associated gains.
As of December 31, 2011, the Company had federal and state net operating loss carryforwards of approximately $8.1 million and $10.6 million, respectively. As of December 31, 2010, the Company had federal and state net operating loss carryforwards of approximately $8.7 million and $11.2 million, respectively. For federal tax purposes, the Company’s NOL carryforwards expire beginning in 2024, and for California tax purposes, the Company’s NOL carryforwards expire beginning in 2018.
No uncertain tax positions were identified as of December 31, 2011 and 2010, and the Company had no tax reserve for uncertain tax positions at December 31, 2011 and December 31, 2010. The Company does not anticipate providing a reserve for uncertain tax positions in the next twelve months. Furthermore, the Company has elected to record interest accrued and penalties related to unrecognized tax benefits in tax expense. At December 31, 2011 and 2010, the Company did not have an accrual for interest and/or penalties associated with uncertain tax positions.
The Company files income tax returns in the U.S. federal and California jurisdictions. With few exceptions, the Company is not subject to U.S. federal, state, local, or non-U.S. income tax examinations by tax authorities for years before 2007.
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Employee Benefit Plan
The Company has a 401(k) plan for all employees and permits voluntary contributions of their salaries on a pre-tax basis, subject to statutory and Internal Revenue Service guidelines. The contributions to the 401(k) plan are invested at the directions of the participants. The Company matches 100% of the employee’s contribution up to the first 3% of the employee’s salary and 50% of the employee’s contribution up to the next 2% of the employee’s salary. The Company’s expense relating to the contributions made to the 401(k) plan for the benefit of the employees for the years ended December 31, 2011 and 2010 was $131,000 and $135,000, respectively.
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Regulatory Matters
Capital
Bancshares and the Bank are subject to the various regulatory capital requirements administered by federal banking agencies. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, Bancshares and the Bank must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. 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 financial statements of the Company.
Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulation) to risk-weighted assets (as defined) and of Tier 1 capital (as defined) to average assets (as defined). Management believes that as of December 31, 2011 and 2010, the Company and the Bank met all capital adequacy requirements to which they are subject.
At December 31, 2011, the most recent notification from the OCC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well-capitalized, the Bank must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios. There are no conditions or events since the notification that management believes have changed the Bank’s category.
The Company’s and the Bank’s capital ratios as of December 31, 2011 and 2010 are presented in the table below:
Dividends
In the ordinary course of business, Bancshares is dependent upon dividends from the Bank to provide funds for the payment of dividends to shareholders and to provide for other cash requirements. Banking regulations may limit the amount of dividends that may be paid. Approval by regulatory authorities is required if the effect of dividends declared would cause the regulatory capital of the Bank to fall below specified minimum levels. Approval is also required if dividends declared exceed the net profits for that year combined with the retained net profits for the preceding two years. Currently, the Bank is prohibited from paying dividends to Bancshares until such time as the accumulated deficit is eliminated.
To date, Bancshares has not paid any cash dividends. Payment of stock or cash dividends in the future will depend upon earnings and financial condition and other factors deemed relevant by Bancshares’ Board of Directors, as well as Bancshares’ legal ability to pay dividends. Accordingly, no assurance can be given that any cash dividends will be declared in the foreseeable future.
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Parent Company Only Condensed Financial Information
The condensed financial statements of 1st Century Bancshares, Inc. as of and for the years ended December 31, 2011 and 2010 are presented below:
Condensed Balance Sheets
Condensed Statements of Operations
Condensed Statements of Cash Flows
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and
Stockholders of 1st Century Bancshares, Inc.
We have audited the accompanying consolidated balance sheets of 1st Century Bancshares, Inc. as of December 31, 2011, and the related consolidated statements of operations, changes in stockholders’ equity and comprehensive income (loss), and cash flows for the year then ended. 1st Century Bancshares, Inc.’s management is responsible for these consolidated financial statements. Our responsibility is to express an opinion on these consolidated financial statements 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 the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of 1st Century Bancshares, Inc. as of December 31, 2011, and the results of its operations and its cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America.
/s/ Crowe Horwath LLP
Sacramento, California
March 6, 2012
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and
Stockholders of 1st Century Bancshares, Inc.
We have audited the accompanying consolidated balance sheet of 1st Century Bancshares, Inc. as of December 31, 2010, and the related consolidated statements of operations, changes in stockholders’ equity and comprehensive income (loss), and cash flows for the year then ended. 1st Century Bancshares, Inc.’s management is responsible for these consolidated financial statements. Our responsibility is to express an opinion on these consolidated financial statements 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 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, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of 1st Century Bancshares, Inc. as of December 31, 2010, and the results of its operations and its cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America.
/s/ Perry-Smith LLP
Sacramento, California
March 15, 2011