form10q.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549
 
FORM 10-Q
 
(Mark One)
 
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
 
For the quarterly period ended September 30, 2008
 
OR
 
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
 
For the transition period from __________________ to __________________
 
 Commission File Number 001-33572
 
Bank of Marin Bancorp
(Exact name of Registrant as specified in its charter)
 
 
California
20-8859754
(State or other jurisdiction of incorporation)
(IRS Employer Identification No.)
 
 
504 Redwood Blvd., Suite 100, Novato, CA
94947
(Address of principal executive office)
(Zip Code)
 
Registrant’s telephone number, including area code:  (415) 763-4520
 
Not Applicable
 
(Former name or former address, if changes since last report)
 
 
Indicate by check mark whether the registrant (1) has filed all reports to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days.  Yes  x No  o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.
 
Large accelerated filer o
Accelerated filer x
Non-accelerated filer o
Smaller reporting company o
 
Indicate by check mark if the registrant is a shell company, in Rule 12b(2) of the Exchange Act.
Yes    o           No x
 
As of October 31, 2008 there were 5,144,822 shares of common stock outstanding.
 


 
Page - 1

 
 
BANK OF MARIN BANCORP
 
Explanatory Note
 
Bank of Marin Bancorp is the successor registrant to Bank of Marin pursuant to an 8-K filed with the SEC on June 29, 2007.
 
On July 1, 2007 (the “Effective Date”), a bank holding company reorganization was completed whereby Bank of Marin Bancorp became the parent holding company for Bank of Marin.  On the Effective Date, each outstanding share of Bank of Marin common stock was converted into one share of Bank of Marin Bancorp common stock and Bank of Marin became a wholly-owned subsidiary of the holding company.  Bancorp assumed the ticker symbol BMRC, which was formerly used by Bank of Marin. Prior to the Effective Date, Bank of Marin filed reports and proxy statements with the Federal Deposit Insurance Corporation (“FDIC”) pursuant to Sections 12 of the Securities Exchange Act of 1934 (the “’34 Act”).
 
The financial statements and discussion thereof contained in this report for periods subsequent to the reorganization relate to consolidated Bank of Marin Bancorp.  Periods prior to the reorganization relate to Bank of Marin only.  The information is comparable as the sole subsidiary of Bank of Marin Bancorp is the Bank of Marin.
 
This report refers to previous filings made by Bank of Marin with the FDIC pursuant to the ’34 Act.   Copies of these filings are available by requesting them in writing or by phone from:
 
Corporate Secretary
Bank of Marin
504 Redwood Blvd., Suite 100
Novato, CA 94947
415-763-4523
 
Copies of such filings are also available on Bancorp’s website at www.bankofmarin.com. This website address is for information only and is not intended to be an active link, or to incorporate any website information into this document.
 
 
Page - 2

 
 
BANK OF MARIN BANCORP
 
 
 
TABLE OF CONTENTS
 
 
PART  I
FINANCIAL INFORMATION
 
     
Item 1
Financial Statements
 
 
4
 
5
 
7
 
8
 
9
     
Item 2
17
     
Item 3
32
     
Item 4
33
     
PART II
OTHER INFORMATION
 
     
Item 1
33
     
Item 1A
33
     
Item 2
34
     
Item 3
34
     
Item 4
34
     
Item 5
34
     
Item 6
34
     
36
     
37
 
 
BANK OF MARIN BANCORP
 
CONSOLIDATED STATEMENTS OF CONDITION
at September 30, 2008 and December 31, 2007
 
(in thousands, except share amounts - 2008 unaudited)
 
September 30, 2008
   
December 31, 2007
 
             
Assets
           
Cash and due from banks
  $ 20,464     $ 28,765  
Federal funds sold
    ---       47,500  
Cash and cash equivalents
    20,464       76,265  
                 
Investment securities
               
Held to maturity, at amortized cost
    20,542       13,182  
Available for sale (at fair market value, amortized cost $73,405at September 30, 2008 and $87,450 at December 31, 2007)
    73,348       86,989  
Total investment securities
    93,890       100,171  
                 
Loans, net of allowance for losses of $9,271 at September 30, 2008 and $7,575 at December 31, 2007
    829,736       717,303  
Bank premises and equipment, net
    8,558       7,821  
Interest receivable and other assets
    32,091       32,341  
                 
Total assets
  $ 984,739     $ 933,901  
                 
Liabilities and Stockholders' Equity
               
                 
Liabilities
               
Deposits
               
Non-interest bearing
  $ 215,307     $ 220,272  
Interest bearing
               
Transaction accounts
    80,723       110,174  
Savings and money market
    449,303       421,255  
CDARS® reciprocal time
    16,776       ---  
Other time
    87,119       82,941  
Total deposits
    849,228       834,642  
                 
Federal funds purchased and Federal Home Loan Bank borrowings
    28,600       ---  
Subordinated debenture
    5,000       5,000  
Interest payable and other liabilities
    7,238       6,485  
                 
Total liabilities
    890,066       846,127  
                 
Stockholders' Equity
               
Preferred stock, no par value
               
Authorized - 5,000,000 shares; none issued
    ---       ---  
Common stock, no par value
               
Authorized - 15,000,000 shares
               
Issued and outstanding - 5,136,267 shares at September 30, 2008 and 5,122,971 at December 31, 2007
    50,527       51,059  
Retained earnings
    44,179       36,983  
Accumulated other comprehensive loss, net
    (33 )     (268 )
                 
Total stockholders' equity
    94,673       87,774  
                 
Total liabilities and stockholders' equity
  $ 984,739     $ 933,901  
 
The accompanying notes are an integral part of these consolidated financial statements.
 
 
BANK OF MARIN BANCORP
 
CONSOLIDATED STATEMENTS OF OPERATIONS
for the nine months ended September 30, 2008  and September 30, 2007
 
(in thousands, except per share amounts - unaudited)
 
September 30, 2008
   
September 30, 2007
 
             
Interest income
           
Interest and fees on loans held in portfolio
  $ 40,545     $ 39,006  
Interest on auto loans held for sale
    ---       2,062  
Interest on investment securities
               
U.S. Treasury securities
    ---       8  
Securities of U.S. Government agencies
    2,641       2,714  
Obligations of state and political subdivisions (tax exempt)
    531       358  
Corporate debt securities and other
    258       336  
Interest on Federal funds sold
    138       1,657  
Total interest income
    44,113       46,141  
                 
Interest expense
               
Interest on interest bearing transaction accounts
    277       225  
Interest on savings and money market deposits
    5,607       11,052  
Interest on CDARS® reciprocal time deposits
    55       ---  
Interest on other time deposits
    1,962       2,628  
Interest on borrowed funds
    702       973  
Total interest expense
    8,603       14,878  
                 
Net interest income
    35,510       31,263  
Provision for loan losses
    2,810       340  
Net interest income after provision for loan losses
    32,700       30,923  
                 
Non-interest income
               
Service charges on deposit accounts
    1,253       894  
Wealth Management Services
    976       904  
Net gain on indirect auto and Visa portfolios
    ---       1,097  
Net gain on redemption of shares in Visa, Inc.
    457       ---  
Other income
    1,489       1,592  
Total non-interest income
    4,175       4,487  
                 
Non-interest expense
               
Salaries and related benefits
    12,372       12,064  
Occupancy and equipment
    2,363       2,155  
Depreciation and amortization
    996       929  
Data processing
    1,355       1,254  
Professional services
    1,161       1,239  
Other expense
    3,336       3,004  
Total non-interest expense
    21,583       20,645  
                 
Income before provision for income taxes
    15,292       14,765  
                 
Provision for income taxes
    5,935       5,699  
Net income
  $ 9,357     $ 9,066  
                 
Net income per common share:
               
Basic
  $ 1.82     $ 1.74  
Diluted
  $ 1.79     $ 1.70  
                 
Weighted average shares used to compute net income per common share:
               
Basic
    5,135       5,197  
Diluted
    5,224       5,347  
                 
Dividends declared per common share
  $ 0.42     $ 0.38  
 
The accompanying notes are an integral part of these consolidated financial statements.
 
 
BANK OF MARIN BANCORP
 
CONSOLIDATED STATEMENTS OF OPERATIONS
for the three months ended September 30, 2008, June 30, 2008 and September 30, 2007
 
(in thousands, except per share amounts - unaudited
 
September 30, 2008
   
June 30, 2008
   
September 30, 2007
 
                   
Interest income
                 
Interest and fees on loans held in portfolio
  $ 13,833     $ 13,400     $ 13,283  
Interest on investment securities
                       
Securities of U.S. Government agencies
    892       882       1,063  
Obligations of state and political subdivisions (tax exempt)
    187       183       129  
Corporate debt securities and other
    91       78       115  
Interest on Federal funds sold
    25       1       1,240  
Total interest income
    15,028       14,544       15,830  
                         
Interest expense
                       
Interest on interest bearing transaction accounts
    93       96       74  
Interest on savings and money market deposits
    1,833       1,583       3,882  
Interest on CDARS® reciprocal time deposits
    50       4       ---  
Interest on other time deposits
    562       650       877  
Interest on borrowed funds
    179       302       209  
Total interest expense
    2,717       2,635       5,042  
                         
Net interest income
    12,311       11,909       10,788  
Provision for loan losses
    1,685       510       200  
Net interest income after provision for loan losses
    10,626       11,399       10,588  
                         
Non-interest income
                       
Service charges on deposit accounts
    417       430       325  
Wealth Management Services
    330       310       331  
Net gain on Visa portfolio
    ---       ---       387  
Other income
    447       539       543  
Total non-interest income
    1,194       1,279       1,586  
                         
Non-interest expense
                       
Salaries and related benefits
    4,179       4,035       3,938  
Occupancy and equipment
    802       793       716  
Depreciation and amortization
    351       327       318  
Data processing
    480       430       411  
Professional services
    336       419       536  
Other expense
    1,294       1,136       1,007  
Total non-interest expense
    7,442       7,140       6,926  
                         
Income before provision for income taxes
    4,378       5,538       5,248  
                         
Provision for income taxes
    1,683       2,152       2,059  
Net income
  $ 2,695     $ 3,386     $ 3,189  
                         
Net income per common share:
                       
Basic
  $ 0.53     $ 0.66     $ 0.62  
Diluted
  $ 0.52     $ 0.65     $ 0.60  
                         
Weighted average shares used to compute net income per common share:
                       
Basic
    5,130       5,139       5,172  
Diluted
    5,209       5,226       5,301  
                         
Dividends declared per common share
  $ 0.14     $ 0.14     $ 0.13  
 
The accompanying notes are an integral part of these consolidated financial statements.
 
 
BANK OF MARIN BANCORP
 
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
for the year ended December 31, 2007 and the nine months ended September 30, 2008
 
                     
Accumulated Other Comprehensive
       
   
Common Stock
   
Retained
   
Loss,
       
(dollar amounts in thousands - 2008 unaudited)
 
Shares
   
Amount
   
Earnings
   
Net of Taxes
   
Total
 
Balance at December 31, 2006
    5,366,416     $ 61,355     $ 28,760     $ (590 )   $ 89,525  
Cumulative-effect adjustment of adoption of SFAS No.159
    ---       ---       (1,452 )     ---       (1,452 )
Comprehensive income:
                                       
Net income
    ---       ---       12,324       ---       12,324  
Other comprehensive income
                                       
Net change in unrealized loss on available for sale securities (net of tax liability of $234)
    ---       ---       ---       322       322  
Comprehensive income
    ---       ---       12,324       322       12,646  
Stock options exercised
    112,496       1,620       ---       ---       1,620  
Excess tax benefit - stock-based compensation
    ---       729       ---       ---       729  
Stock repurchased, including commission costs
    (365,823 )     (13,483 )     ---       ---       (13,483 )
Stock issued under employee stock purchase plan
    292       8       ---       ---       8  
Stock-based compensation - stock options
    ---       502                       502  
Cash dividends paid
    ---       ---       (2,649 )     ---       (2,649 )
Stock issued in payment of director fees
    9,590       328       ---       ---       328  
Balance at December 31, 2007
    5,122,971     $ 51,059     $ 36,983     $ (268 )   $ 87,774  
Comprehensive income:
                                       
Net income
    ---       ---       9,357       ---       9,357  
Other comprehensive income
                                       
Net change in unrealized loss on available for sale securities (net of tax liability of $170)
    ---       ---       ---       235       235  
Comprehensive income
    ---       ---       9,357       235       9,592  
Stock options exercised
    85,066       1,262       ---       ---       1,262  
Excess tax benefit - stock-based compensation
    ---       128       ---       ---       128  
Stock repurchased, including commission costs
    (88,316 )     (2,526 )     ---       ---       (2,526 )
Stock issued under employee stock purchase plan
    954       26       ---       ---       26  
Stock-based compensation - stock options
    ---       316       ---       ---       316  
Restricted stock granted
    6,700       ---       ---       ---       ---  
Stock-based compensation - restricted stock
    ---       15       ---       ---       15  
Cash dividends paid
    ---       ---       (2,161 )     ---       (2,161 )
Stock issued in payment of director fees
    8,892       247       ---       ---       247  
Balance at September 30, 2008
    5,136,267     $ 50,527     $ 44,179     $ (33 )   $ 94,673  
 
The accompanying notes are an integral part of these consolidated financial statements.
 
 
BANK OF MARIN BANCORP
 
CONSOLIDATED STATEMENTS OF CASH FLOWS
for nine months ended September 30, 2008 and 2007
 
(in thousands, unaudited)
 
September 30, 2008
   
September 30, 2007
 
             
Cash Flows from Operating Activities:
           
Net income
  $ 9,357     $ 9,066  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Provision for loan losses
    2,810       340  
Compensation paid and payable in common stock
    195       193  
Stock-based compensation expense
    331       379  
Excess tax benefits from exercised stock options
    (128 )     (534 )
Amortization and accretion of investment security premiums, net
    186       142  
Loss on sale of investment securities
    2       ---  
Depreciation and amortization
    996       929  
Net gain on indirect auto and Visa portfolios
    ---       (1,097 )
Net gain on redemption of shares in Visa, Inc.
    (457 )     ---  
Loss on disposal of premises and equipment
    14       ---  
Net change in operating assets and liabilities:
               
Interest receivable
    106       139  
Interest payable
    57       125  
Deferred rent and other rent-related expenses
    105       83  
Other assets
    2,194       707  
Other liabilities
    988       2,454  
Total adjustments
    7,399       3,860  
Net cash provided by operating activities
    16,756       12,926  
                 
Cash Flows from Investing Activities:
               
Purchase of securities held-to-maturity
    (9,584 )     (2,056 )
Purchase of securities available-for-sale
    (42,607 )     (24,445 )
Proceeds from sale of securities
    21,489       ---  
Proceeds from paydowns/maturity of:
               
Securities held-to-maturity
    1,125       2,590  
Securities available-for-sale
    36,531       15,024  
Proceeds from sale of  indirect auto and Visa portfolios
    ---       78,599  
Loans originated and principal collected, net
    (115,460 )     (47,334 )
Purchase of bank owned life insurance policies
    (2,219 )     ---  
Additions to premises and equipment
    (1,747 )     (502 )
Net cash (used in) provided by investing activities
    (112,472 )     21,876  
                 
Cash Flows from Financing Activities:
               
Net increase in deposits
    14,586       72,717  
Proceeds from stock options exercised
    1,262       1,614  
Net increase (decrease) in Federal funds purchased and Federal Home Loan Bank borrowings
    28,600       (24,100 )
Common stock repurchased
    (2,526 )     (11,931 )
Dividends paid in cash
    (2,161 )     (1,977 )
Stock issued under employee stock purchase plan
    26       3  
Excess tax benefits from exercised stock options
    128       534  
Net cash provided by financing activities
    39,915       36,860  
                 
Net (decrease) increase in cash and cash equivalents
    (55,801 )     71,662  
Cash and cash equivalents at beginning of period
    76,265       38,783  
                 
Cash and cash equivalents at end of period
  $ 20,464     $ 110,445  
 
Non-Cash Transactions: The nine months ended September 30, 2007 reflected a cumulative-effect adjustment of the adoption of SFAS No. 159, which included non-cash decreases to net loans of $2.5 million and retained earnings of $1.5 million, and a non-cash increase to other assets of $1.0 million.
 
The accompanying notes are an integral part of these consolidated financial statements.
 
 
BANK OF MARIN BANCORP
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
Introductory Explanation
 
On July 1, 2007 (the “Effective Date”), a bank holding company reorganization was completed whereby Bank of Marin Bancorp (Bancorp) became the parent holding company for Bank of Marin ( the “Bank”), its sole and wholly-owned subsidiary.  On the Effective Date, in a tax-free exchange, each outstanding share of the Bank was converted into one share of Bancorp and the Bank became a wholly-owned subsidiary of the holding company. The information contained in the financial statements and accompanying footnotes for periods subsequent to the reorganization relate to consolidated Bank of Marin Bancorp. Periods prior to the reorganization relate to Bank of Marin only. The information is comparable for all periods as the sole subsidiary of Bancorp is the Bank.
 
 
Note 1:  Basis of Presentation
 
The consolidated financial statements include the accounts of Bancorp and its wholly-owned bank subsidiary. All material intercompany transactions have been eliminated. In the opinion of Management, the unaudited interim consolidated financial statements contain all adjustments necessary to present fairly the financial position, results of operations, changes in stockholders' equity and cash flows. All adjustments are of a normal, recurring nature.
 
Certain information and footnote disclosures presented in the annual financial statements are not included in the interim consolidated financial statements.  Accordingly, the accompanying unaudited interim consolidated financial statements should be read in conjunction with Bancorp’s 2007 Annual Report, which is incorporated by reference in Bancorp’s 2007 Annual Report on Form 10-K.  The results of operations for the nine months ended September 30, 2008 are not necessarily indicative of the operating results for the full year.
 
The following table shows weighted average basic shares, common stock equivalents related to stock options and nonvested restricted stock, and weighted average diluted shares used in calculating earnings per share.  Basic earnings per share are based upon the weighted average number of common shares outstanding (including vested restricted stock) during each period.  Diluted earnings per share incorporates the dilutive effect of common stock equivalents outstanding, including stock options and nonvested restricted stock, on an average basis during each period.
 
   
Three months ended
   
Nine months ended
 
(in thousands)
 
September 30, 2008
   
June 30, 2008
   
September 30, 2007
   
September 30, 2008
   
September 30, 2007
 
Weighted average basic shares outstanding
    5,130       5,139       5,172       5,135       5,197  
Add: Common stock equivalents related to stock options and nonvested restricted stock
    79       87       129       89       150  
Weighted average diluted shares outstanding
    5,209       5,226       5,301       5,224       5,347  
Anti-dilutive shares not included in the calculation of diluted earnings per share
    201       236       187       201       60  
                                         
Net income
  $ 2,695     $ 3,386     $ 3,189     $ 9,357     $ 9,066  
Earnings per share (basic)
  $ 0.53     $ 0.66     $ 0.62     $ 1.82     $ 1.74  
Earnings per share (diluted)
  $ 0.52     $ 0.65     $ 0.60     $ 1.79     $ 1.70  
 
 
Note 2: Recently Issued Accounting Standards
 
On October 10, 2008, the Financial Accounting Standards Board (FASB) issued FASB Staff Position (FSP) FAS 157-3,Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active.” The FSP clarifies the application of Statement of Financial Accounting Standards (SFAS) No. 157, “Fair Value Measurements”, in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. The FSP is effective upon issuance, including prior periods for which financial statements have not been issued. Revisions resulting from a change in the valuation technique or its application should be accounted for as a change in accounting estimate following the guidance in SFAS No. 154, “Accounting Changes and Error Corrections.” However, the disclosure provisions in SFAS No. 154 for a change in accounting estimate are not required for revisions resulting from a change in valuation technique or its application. Adoption of FSP FAS 157-3 did not have a significant impact on Bancorp’s financial condition or results of operations.
 
 
BANK OF MARIN BANCORP
 
On June 16, 2008, the FASB issued FSP on Emerging Issues Task Force (EITF) 03-6-1, “Determining Whether Instruments Granted in Share-Based Payment Transactions are Participating Securities” which states that when calculating basic earnings per share pursuant to the two-class method, all awards that contain rights to nonforfeitable dividends should be considered participating securities. The two-class method is an earnings allocation formula that determines earnings per share for each class of common stock and participating security according to dividends declared (or accumulated) and participation rights in undistributed earnings. Dividends or dividend equivalents actually paid on share-based payment awards not expected to vest should be excluded from the earnings allocation to avoid counting the dividends as both compensation cost and distributed earnings. Undistributed earnings should be allocated to all outstanding share-based payment awards, including those that are not expected to vest. FSP EITF 03-6-1 will be effective for Bancorp beginning January 1, 2009.  All prior-period earnings per share data presented will be adjusted retrospectively to conform to the provisions of FSP EITF 03-6-1. Early adoption is not permitted. Bancorp’s presentation, but not the amount, of earnings per share will be affected upon adoption of FSP EITF 03-6-1 due to Bancorp’s issuance of nonvested restricted common shares on May 1, 2008.  See Note 8 below for further discussion.
 
In May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles.”  SFAS No. 162 identifies the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements that are presented in conformity with generally accepted accounting principles in the United States. SFAS No. 162 is effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board (PCAOB) amendments to AU Section 411, The Meaning of “Present Fairly in Conformity With Generally Accepted Accounting Principles.” Bancorp expects that SFAS No. 162 will have no impact on its financial condition or results of operations.
 
On March 19, 2008, the FASB issued SFAS. No. 161, “Disclosures about Derivative Instruments and Hedging Activities-an Amendment of FASB Statement 133.” SFAS No. 161 enhances required disclosures regarding derivatives and hedging activities, including improved disclosures regarding how: (a) an entity uses derivative instruments, (b) derivative instruments and related hedged items are accounted for under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (SFAS No.133), and (c) derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows.  SFAS No. 161 is effective for fiscal years and interim periods beginning after November 15, 2008, with early application permitted.  As SFAS No. 161 is disclosure-related only, it is expected that SFAS No. 161 will have no impact on Bancorp’s financial condition or results of operations.
 
In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations. SFAS No. 141R establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any non-controlling interest in the acquiree. The statement also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of the financial statement to evaluate the nature and financial effects of the business combination. SFAS No. 141R is effective for financial statements issued for fiscal years beginning after December 15, 2008. Accordingly, any business combinations Bancorp engages in will be recorded and disclosed following existing generally accepted accounting principles until January 1, 2009. Bancorp expects SFAS No. 141R would have an impact on its consolidated financial statements when effective if it acquires another company, but the nature and magnitude of the specific effects will depend upon the nature, terms and size of the acquisitions Bancorp consummates after the effective date.
 
In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements,” which provides guidance for accounting and reporting of noncontrolling (minority) interests in consolidated financial statements. The statement is effective for fiscal years and interim periods within fiscal years beginning on or after December 15, 2008.  Bancorp does not hold minority interests in subsidiaries, therefore it is expected that SFAS No. 160 will have no impact on its financial condition or results of operations.
 
In June 2007, the FASB EITF reached a consensus on EITF Issue No. 06-11, "Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards." The EITF requires that the tax benefit related to dividends paid on restricted stock, which are expected to vest, be recorded as an increase to additional paid-in-capital. The EITF was effective for all tax benefits on dividends declared by Bancorp after January 1, 2008. At adoption, there was no impact on Bancorp's financial position or results of operations.
 
Page - 10

 
BANK OF MARIN BANCORP
 
Note 3:  Fair Value Measurement
 
The Bank performs fair market valuations on certain assets and liabilities as a result of the application of accounting guidelines that were in effect prior to the adoption of SFAS No. 157, “Fair Value Measurements.  The following table summarizes the Bank’s financial instruments that were measured at fair value on a recurring basis at September 30, 2008.
 
(Dollars in thousands)
Description of Financial Instruments
 
September 30, 2008
   
Quoted Prices in Active Markets for Identical Assets
(Level 1)
   
Significant Other Observable Inputs
(Level 2)
   
Significant Unobservable Inputs
(Level 3)
 
                         
                         
Securities available for sale
  $ 73,348     $ ---     $ 73,348     $ ---  
Derivative financial assets
    48               48       ---  
Total Assets
  $ 73,396     $ ---     $ 73,396     $ ---  
                                 
Derivative financial liabilities
  $ 902     $ ---     $ 902     $ ---  
 
 
When available, quoted market prices (Level 1) are used to determine the fair value of securities available for sale. If quoted market prices are not available, management obtains pricing information from a reputable third-party service provider, who may utilize valuation techniques that use current market-based or independently sourced parameters, such as bid prices, dealer-quoted prices, interest rates, benchmark yield curves, prepayment speeds, and credit spreads (Level 2).  Level 1 securities include those traded on active markets, including U.S. Treasury securities.  Level 2 securities include U.S. agencies’ securities, mortgage-backed securities and corporate collateralized mortgage obligations. Changes in fair market value are recorded in other comprehensive income.
 
The fair value of derivative financial instruments is based on the income approach using observable Level 2 market inputs, reflecting market expectations of future interest rates as of the measurement date.  Standard valuation techniques are used to calculate the present value of the future expected cash flows assuming an orderly transaction.  Valuation adjustments may be made to reflect both the Bank’s own credit risk and the counterparties’ credit quality in determining the fair value of the derivatives. Level 2 inputs for the valuations are limited to observable market prices for London Interbank Offered Rate (LIBOR) cash rates (for the very short term), quoted prices for LIBOR futures contracts (two years and less), observable market prices for LIBOR swap rates (at commonly quoted intervals from two years to beyond the derivative’s maturity), and 1-month and 3-month LIBOR basis spreads at commonly quoted intervals.  Mid-market pricing of the inputs is used as a practical expedient in the fair value measurements.  Key inputs for interest rate valuations are used to project spot rates at resets specified by each swap, as well as to discount those future cash flows to present value at measurement date.  When the value of any collateral placed with counterparties is less than the interest rate derivative liability, the interest rate liability position is further discounted to reflect the potential credit risk to counterparties.  The Bank has used the spread over LIBOR on the Federal Home Loan Bank San Francisco (FHLB) fixed-rate credit advance with the duration corresponding to the swaps' to calculate this credit-risk related discount of future cash flows.
 
The interest rate swaps are carried on the balance sheet at their fair value in other assets (when the fair value is positive) or in other liabilities (when the fair value is negative) and offset in other non-interest income.
 
Certain financial assets may be measured at fair value on a nonrecurring basis. For example, when a loan is identified as impaired, it is reported at the lower of cost or fair value, measured based on the loan's observable market price (Level 1), the present value of expected future cash flows discounted at the loan’s original effective interest rate (Level 2), or the fair value of the underlying collateral securing the loan if the loan is collateral dependent (Level 3). The value of impaired loans, which totaled $823 thousand at September 30, 2008, were primarily based on the appraised value of the collateral (Level 3).
 
Page - 11

 
BANK OF MARIN BANCORP
 
Note 4:  Investment Securities
 
The Bank's investment securities portfolio at September 30, 2008 consists primarily of U.S. government agency securities, including mortgage-backed securities (MBS) and collateralized mortgage obligations (CMOs) issued or guaranteed by Federal National Mortgage Association (FNMA), Federal Home Loan Mortgage Corporation (FHLMC), or Government National Mortgage Association (GNMA). The Bank’s portfolio also includes obligations of state and political subdivisions, debentures issued by government-sponsored agencies including FHLB, Federal Farm Credit Bank and FNMA, as well as corporate CMOs, as reflected in the table below.
 
   
September 30, 2008
   
December 31, 2007
 
(Dollars in thousands)
 
Amortized Cost
   
Market Value
   
Amortized Cost
   
Market Value
 
Held to maturity
                       
Obligations of state and political subdivisions
  $ 20,542     $ 19,627     $ 13,182     $ 13,238  
Total held to maturity
    20,542       19,627       13,182       13,238  
                                 
Available for sale
                               
Securities of U. S. government agencies:
                               
MBS pass-through securities issued by FNMA and FHLMC
    8,206       8,123       8,715       8,475  
CMOs issued by FNMA and FHLMC
    41,224       41,442       39,122       38,870  
CMOs issued by GNMA
    5,257       5,356       4,575       4,619  
Debentures of government sponsored agencies
    17,000       16,723       22,551       22,551  
Corporate CMOs
    1,718       1,704       2,487       2,474  
Corporate debt securities and other
    ---       ---       10,000       10,000  
Total available for sale
    73,405       73,348       87,450       86,989  
 
 
The Bank generally invests in mortgage-backed securities with borrowers having strong credit scores and/or collateral compositions reflecting low loan-to-value ratios. Investment securities carried at $25.8 million and $20.7 million were pledged at September 30, 2008 and December 31, 2007, respectively.
 
Note 5:  Allowance for Loan Losses and Non-accrual Loans
 
The allowance for loan losses is maintained at levels considered adequate by management to provide for probable loan losses inherent in the portfolio. The allowance is based on management's assessment of various factors affecting the loan portfolio, including problem loans, economic conditions and loan loss experience, and an overall evaluation of the quality of the underlying collateral.
 
Activity in the allowance for loan losses follows:
 
   
Three months ended
   
Nine months ended
 
(in thousands - unaudited)
 
September 30, 2008
   
June 30, 2008
   
September 30, 2007
   
September 30, 2008
   
September 30, 2007
 
Beginning balance
  $ 8,555     $ 8,199     $ 7,053     $ 7,575     $ 8,023  
Cumulative-effect adjustment of adoption of SFAS No. 159
    ---       ---       ---       ---       (1,048 )
Provision for loan loss charged to expense
    1,685       510       200       2,810       340  
Loans charged off
    (970 )     (156 )     (33 )     (1,128 )     (111 )
Loan loss recoveries
    1       2       7       14       23  
Ending balance
  $ 9,271     $ 8,555     $ 7,227     $ 9,271     $ 7,227  
                                         
Total loans held in portfolio at end of period, before deducting allowance for loan losses
  $ 839,007     $ 799,510     $ 685,975     $ 839,007     $ 685,975  
                                         
Ratio of allowance for loan losses to loans held in portfolio
    1.11 %     1.07 %     1.05 %     1.11 %     1.05 %
Non-accrual loans at period end
  $ 823     $ 236     $ 150     $ 823     $ 150  
 
At September 30, 2008, the Bank had six non-accrual loans totaling $823 thousand.  At December 31, 2007 the Bank had one non-accrual loan totaling $144 thousand.  At September 30, 2007, the Bank had two non-accrual loans amounting to $150 thousand. Impaired loan balances at each period-end approximated the balance of nonaccrual loans, with an allocated allowance of $47 thousand, $49 thousand, and zero at September 30, 2008, June 30, 2008, and September 30, 2007, respectively.  At September 30, 2008, there were no commitments to extend credit on impaired loans.
 
Page - 12

 
BANK OF MARIN BANCORP
 
The gross interest income that would have been recorded had non-accrual loans been current totaled $37 thousand, $6 thousand, and $3 thousand in the quarters ended September 30, 2008, June 30, 2008 and September 30, 2007, respectively.  The amount of foregone interest income on nonaccrual loans was $49 thousand and $8 thousand for the nine-month periods ended September 30, 2008 and 2007, respectively.  The Bank recognized interest income of $12 thousand and $5 thousand for cash payments received during the nine-month periods ended September 30, 2008 and 2007, respectively.
 
Effective January 1, 2007, the Bank elected the early-adoption provisions of SFAS No. 159, which permits entities to choose to measure eligible financial instruments at fair value at specified election dates. Upon adoption, the Bank selected the fair value option for the indirect auto loan portfolio, which was subsequently sold on June 5, 2007. In conjunction with the adoption of SFAS No. 159, the allowance for loan losses was reduced by $1.0 million in the first quarter of 2007, which is reflected in the table above.
 
Note 6: CDARS® Reciprocal Deposits
 
Late in the first quarter of 2008, the Bank began to offer the CDARS® deposit product, short for Certificate of Deposit Account Registry Service. Through CDARS®, the Bank may accept deposits in excess of the FDIC insured maximum from a depositor and place the deposits through a network to other member banks in increments of less than the FDIC insured maximum to provide the depositor full FDIC insurance coverage.  Where the Bank receives an equal dollar amount of deposits from other member banks in exchange for the deposits the Bank places into the network, the Bank records these as CDARS® reciprocal deposits.  At September 30, 2008, CDARS® reciprocal deposits totaled $16.8 million.
 
Note 7: Borrowings
 
As of September 30, 2008 and December 31, 2007, the Bank had lines of credit with the FHLB totaling $170.7 million and $184.8 million, respectively. At September 30, 2008 overnight borrowings totaled $13.6 million with the FHLB under the line of credit.  At December 31, 2007, the Bank had no outstanding borrowings with FHLB, correspondent banks, or the Federal Reserve. The interest rate for overnight borrowings is determined daily.
 
On February 5, 2008, the Bank entered into a ten-year borrowing agreement under the same FHLB line of credit for $15.0 million at a fixed rate of 2.07%. Interest-only payments are required every three months until maturity. Although the entire principal is due on February 5, 2018, the FHLB has the unconditional right to accelerate the due date on February 5, 2009 and every three months thereafter (the “put” dates). If the FHLB exercises its right to accelerate the due date, the FHLB will offer replacement funding at the current market rate, subject to certain conditions. The Bank must comply with the put date, but is not required to accept replacement funding.
 
At September 30, 2008, $142.1 million was remaining as available for borrowing from the FHLB under a formula based on eligible collateral. The FHLB overnight borrowing and the FHLB line of credit are secured by certain assets, including a portfolio of loans, investment securities, cash and cash equivalents under a blanket lien. On September 30, 2008, the pledged loans totaled $341.4 million.
 
Additional borrowing capacity includes lines of credit with correspondent banks totaling $65.0 million and a line of credit with the Federal Reserve Bank totaling $3.0 million to borrow overnight. There were no borrowings under these credit facilities on September 30, 2008.
 
Note 8:  Stockholders' Equity
 
Effective January 1, 2007, the Bank elected early adoption of SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” Upon adoption, the Bank selected the fair value option for its indirect auto loan portfolio, which was subsequently sold on June 5, 2007. Upon the adoption of SFAS No. 159 for its indirect auto loan portfolio, the Bank recorded a cumulative-effect adjustment as a charge to retained earnings totaling $1.5 million effective January 1, 2007.
 
On July 1, 2007 (the “Effective Date”), the bank holding company reorganization was completed and the Bank repurchased a total of 24,399 common shares of the Bank for $876 thousand from six stockholders who dissented to the exchange of these shares for Bancorp common stock. Also, on the Effective Date, after the repurchase, each remaining outstanding share of the Bank was converted into one share of Bank of Marin Bancorp and the Bank became a wholly-owned subsidiary of the holding company.
 
Page - 13

 
BANK OF MARIN BANCORP
 
The California Department of Financial Institutions (DFI) and the FDIC approved  a $15 million, twelve-month share repurchase program in October 2006.Under this program, the Bank repurchased 115,625 shares in the fourth quarter of 2006 at an average price of $34.26 per share, plus commissions, for a total cost of $4.0 million and 289,692 shares in the first quarter of 2007 at an average price of $38.10 per share, plus commissions, for a total cost of $11.0 million, at which time the program was completed.
 
In November 2007, Bancorp’s Board of Directors approved an additional plan to repurchase up to $5 million of common shares of Bancorp.  No regulatory approval was required for this repurchase plan as Bancorp was exempted under the provisions of Regulation Y of the Federal Reserve Board. In the fourth quarter of 2007, Bancorp repurchased a total of 51,732 shares at an average price of $29.96 per share, plus commissions, for a total cost of $1.5 million.  During the first nine months of 2008, Bancorp repurchased 88,316 shares at an average price of $28.55, plus commissions, for a total cost of $2.5 million. In September 2008, the repurchases under the plan were discontinued to preserve capital during a time of extreme economic turbulence.
 
The Bank executed the repurchase transactions pursuant to the Securities and Exchange Commission’s Rule 10b-18.  All shares repurchased under both programs were made in open market transactions and were part of publicly announced repurchase programs.
 
A summary of cash dividends paid to stockholders, which are recorded as a reduction of retained earnings, is presented below.
 
 
   
Three months ended
   
Nine months ended
 
(in thousands except per share data - unaudited)
 
September 30, 2008
   
June 30, 2008
   
September 30, 2007
   
September 30, 2008
   
September 30, 2007
 
Cash dividends
  $ 719     $ 722     $ 672     $ 2,161     $ 1,977  
Cash dividends per share
  $ 0.14     $ 0.14     $ 0.13     $ 0.42     $ 0.38  
 
Under SFAS No. 123R, “Share-Based Payment,” which was implemented in January 2006, the fair value of stock options on the grant date is recorded as a stock-based compensation expense in the income statement over the requisite service period with a corresponding increase in common stock.  In addition, the Bank records excess tax benefits on the exercise of non-qualified stock options, disqualifying disposition of incentive stock options or vesting of restricted stock as an addition to common stock with a corresponding decrease in current taxes payable.
 
Stock-based compensation also includes compensation expense related to the issuance of nonvested restricted common shares pursuant to the 2007 Equity Plan.  On May 1, 2008 employees were granted 6,700 restricted common shares of Bancorp, which vest twenty percent on each anniversary of the grant for five years.  The grant-date fair value of the restricted common shares, which is equal to its intrinsic value, is recorded as compensation expense over the requisite service period with a corresponding increase in common stock. Any excess tax benefit on the vesting of these shares will be also recorded as increase in common stock and a corresponding decrease in current taxes payable. The holders of the nonvested restricted common shares are entitled to dividends on the same per-share ratio as the holders of common stock. Dividends paid on the portion of share-based awards not expected to vest are also included in stock-based compensation expense. Tax benefits on dividends paid on the portion of share-based awards expected to vest are recorded as increase to common stock with a corresponding decrease in current taxes payable.
 
Stock-based compensation and excess tax benefits on exercised options are shown below.
 
   
Three months ended
   
Nine months ended
 
(in thousands - unaudited)
 
September 30, 2008
   
June 30, 2008
   
September 30, 2007
   
September 30, 2008
   
September 30, 2007
 
Stock-based compensation
  $ 103     $ 108     $ 124     $ 331     $ 379  
Excess(Deficient) tax benefits on exercised options
  $ 69     $ (22 )   $ 4     $ 128     $ 728  
 
Page - 14

 
BANK OF MARIN BANCORP
 
Note 9:  Financial Instruments with Off-Balance Sheet Risk
 
The Bank makes commitments to extend credit in the normal course of business to meet the financing needs of its customers.  These financial instruments include commitments to extend credit in the form of loans or through standby letters of credit.  Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Standby letters of credit issued by the Bank guarantee the performance of a customer to a third party.  Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  Since many of the commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements.
 
The Bank is exposed to credit loss in the contract amount of the commitment in the event of nonperformance by the borrower. The Bank uses the same credit policies in making commitments as it does for on-balance-sheet instruments and evaluates each customer's creditworthiness on a case-by-case basis.  The amount of collateral obtained, if deemed necessary by the Bank, is based on management's credit evaluation of the borrower.  Collateral held varies, but may include accounts receivable, inventory, property, plant and equipment, and real estate property.
 
The contract amount of loan commitments and standby letters of credit not reflected on the statement of condition was $251.2 million at September 30, 2008 at rates ranging from 3.73% to 10.25%.  This amount included $128.7 million under commercial lines of credit (these commitments are contingent upon customers maintaining specific credit standards), $74.0 million under revolving home equity lines, $37.4 million under undisbursed construction loans, $4.0 million under standby letters of credit, and the remaining $7.1 million under personal and other lines of credit. The Bank has set aside an allowance for losses in the amount of $502 thousand for these commitments, which is recorded in "interest payable and other liabilities."
 
Note 10:  Derivative Financial Instruments and Hedging Activities
 
The Bank has entered into interest-rate swap agreements, primarily as an asset/liability management strategy, in order to mitigate the changes in the fair value of the hedged long-term fixed-rate loans or firm commitments to enter into long-term fixed-rate loans caused by changes in interest rates.  Such hedges allow the Bank to offer long-term fixed rate loans to customers without assuming the interest rate risk of a long-term asset by swapping the Bank's fixed-rate interest stream for a floating-rate interest stream, generally benchmarked to the one-month U.S. dollar LIBOR index, thus protecting the Bank against an adverse effect on the net interest margin due to fluctuating interest rates.
 
The interest rate swap agreements are generally structured at inception to mirror all of the provisions of the hedged loan agreements. These interest rate swaps, designated and qualified as fair value hedges, are carried on the balance sheet at their fair value in other assets (when the fair value is positive) or in other liabilities (when the fair value is negative). One of the Bank’s interest rate swap agreements qualifies for short-cut hedge accounting treatment in accordance with SFAS 133. The change in fair value of the swap using the short-cut accounting treatment is recorded in other non-interest income, while the change in fair value of swaps using non-short cut accounting is recorded in interest income.  The unrealized gain or loss in market value of the hedged fixed-rate loan is recorded as an adjustment to the hedged loan and offset in other non-interest income (for short-cut accounting treatment) or interest income (for non-short cut accounting treatment).
 
During the third quarter of 2007, a forward swap was designated to offset the change in fair value of a loan originated during the period. The fair value of the related yield maintenance agreement totaling $69 thousand at the date of designation, recorded in other assets, is being amortized to interest income using the effective yield method over the life of the loan.
 
The Bank’s credit exposure, if any, on interest rate swaps is limited to the net favorable value (net of any collateral pledged) and interest payments of all swaps by each counterparty. Conversely, when the interest rate swaps are in liability position exceeding certain threshold, the Bank may be required to post collateral to the counterparties.  Collateral levels are monitored and adjusted on a regular basis for changes in interest rate swap values. The Bank’s securities totaling $3.0 million were held as collateral by one of the counterparties for derivative liabilities at September 30, 2008.
 
Page - 15

 
BANK OF MARIN BANCORP
 
As of September 30, 2008, the Bank had three interest rate swap agreements, which are scheduled to mature in September 2018, June 2020 and June 2022.  Information on the Bank’s derivatives follows:
 
 
   
Derivatives designated as fair value hedge under SFAS 133
 
   
Interest rate swaps
             
(in thousands)
 
Shortcut Accounting Treatment
   
Non-shortcut Accounting Treatment
   
Yield Maintenance Agreement
   
Total
 
At September 30, 2008:
                       
Notional or contractual amount
  $ 6,933     $ 11,168     $ ---     $ 18,101  
Credit risk amount (1)
    ---       ---       ---       ---  
Estimated fair value
    (160 )     (742 )     48       (854 )
Blance sheet location
 
Other liabilites
   
Other liabilites
   
Other assets
         
                                 
At December 31, 2007:
                               
Notional or contractual amount
  $ 7,201     $ 8,134     $ ---     $ 15,335  
Credit risk amount (1)
    ---       ---       ---       ---  
Estimated fair value
    (44 )     (603 )     62       (585 )
Blance sheet location
 
Other liabilites
   
Other liabilites
   
Other assets
         
 
   
Three months ended
   
Nine months ended
 
   
September 30, 2008
   
June 30, 2008
   
September 30, 2007
   
September 30, 2008
   
September 30, 2007
 
Interest rate swap designated as fair value hedge
                             
(Shortcut Accounting Treatment):
                             
Weighted average pay rate
    4.59 %     4.59 %     4.59 %     4.59 %     4.59 %
Weighted average receive rate
    2.47 %     2.68 %     5.47 %     2.96 %     5.37 %
                                         
Interest rate swaps designated as fair value hedge
                                       
(Non-shortcut Accounting Treatment):
                                       
Weighted average pay rate
    5.44 %     5.54 %     5.54 %     5.51 %     5.54 %
Weighted average receive rate
    2.47 %     2.67 %     5.44 %     2.94 %     5.41 %
                                         
Yield maintenance agreement
                                       
Weighted average receive rate (2)
    5.15 %     5.15 %     5.15 %     5.15 %     5.15 %
                                         
                                         
Gain (loss) on designated interest rate swaps recognized in income
  $ (231 )   $ 665     $ (500 )   $ (255 )   $ (16 )
Increase (decrease) in value of hedged loans and yield maintenance agreement qualifying as derivatives recognized in income
    181       (667 )     491       203       6  
Net loss on derivatives used to hedge loans recorded in income
  $ (50 )   $ (2 )   $ (9 )   $ (52 )   $ (10 )
 
1  Credit risk represents the amount of unrealized gain included in derivative assets which is subject to counterparty credit risk. It reflects the effect of master netting agreements and includes credit risk on  virtual derivatives.
2  Tax equivalent yield equals 8.43%, 8.44%, and 8.26% for three months ended Spetember 30, 2008, June 30, 2008, and September 30, 2007, respectively; 8.43% and 8.26% for the nine months ended September 30, 2008 and 2007, respectively.
 
 
Note 11: Transactions with Visa Inc.
 
As a member bank of Visa Inc., the Bank holds 16,939 shares of Visa Inc. Class B common stock at a zero cost basis.  In connection with Visa Inc.’s initial public offering (IPO) on March 19, 2008, the Bank recognized a $457 thousand gain on the mandatory redemption of 10,677 shares of Class B common stock representing the difference between the cash proceeds received and the zero carrying basis of the stock redeemed. The remaining shares owned by the Bank cannot be converted into Class A (voting) shares until the later of March 25, 2011 or the final resolution of the covered litigation described below.
 
The Bank recorded a liability of $242 thousand in the fourth quarter of 2007 to cover its potential indemnification obligations to Visa, Inc. The obligations arose in connection with the Bank’s proportionate share of certain litigation indemnifications provided to Visa U.S.A. by its member banks prior to Visa U.S.A.’s merger into Visa Inc. In March of 2008, the Bank reversed this liability because, subsequent to Visa Inc.’s IPO, Visa, Inc. established an escrow account from which it planned to pay any potential settlements.
 
On October 27, 2008 Visa Inc. announced a settlement with one of the litigants, Discover Card, for $1.9 billion, of which $1.7 billion is the responsibility of member banks.  As of the settlement date, the escrow account was underfunded by $1.1 billion. The Bank’s proportionate share of the shortfall is $75 thousand. Visa Inc. expects to further fund the escrow account in the fourth quarter of 2008 to cover the settlement through a reduction in the conversion factor of Class B shares held by member banks that are available for conversion to Class A as allowed by the “Retrospective Responsibility Plan” outlined in the Form S-1 filed by Visa Inc. on November 9, 2007. The Bank expects that its liability will be fully covered by the additional escrow funding, with no cash payment required by the Bank.
 
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BANK OF MARIN BANCORP
 
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
In the following pages, Management discusses its analysis of the financial condition and results of operations for the third quarter of 2008 compared to the third quarter of 2007 and to the prior quarter (second quarter of 2008). This discussion should be read in conjunction with the related financial statements and with the audited financial statements and accompanying notes included in the Bank of Marin Bancorp’s 2007 Annual Report.  Average balances, including balances used in calculating certain financial ratios, are generally comprised of average daily balances.
 
Forward-Looking Statements
 
This discussion of financial results includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, (the "1933 Act") and Section 21E of the Securities Exchange Act of 1934, as amended, (the "1934 Act").  Those sections of the 1933 Act and 1934 Act provide a "safe harbor" for forward-looking statements to encourage companies to provide prospective information about their financial performance so long as they provide meaningful, cautionary statements identifying important factors that could cause actual results to differ significantly from projected results.
 
Bancorp’s forward-looking statements include descriptions of plans or objectives of management for future operations, products or services, and forecasts of its revenues, earnings or other measures of economic performance. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. They often include the words "believe," "expect," "intend," "estimate" or words of similar meaning, or future or conditional verbs such as "will," "would," "should," "could" or "may."
 
Forward-looking statements are based on management's current expectations regarding economic, legislative, and regulatory issues that may impact Bancorp’s earnings in future periods. A number of factors - many of which are beyond management’s control - could cause future results to vary materially from current management expectations. Such factors include, but are not limited to, general economic conditions, the current financial turmoil in the United States and abroad, changes in interest rates, deposit flows, real estate values and competition; changes in accounting principles, policies or guidelines; changes in legislation or regulation; and other economic, competitive, governmental, regulatory and technological factors affecting Bancorp’s operations, pricing, products and services. These and other important factors are detailed in the Risk Factors section of Bancorp’s 2007 Form 10-K as filed with the SEC, copies of which are available from Bancorp at no charge, and in the Risk Factors noted in Part II, Item 1A of this report . Forward-looking statements speak only as of the date they are made. Bancorp does not undertake to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made or to reflect the occurrence of unanticipated events.
 
Executive Summary
 
In 2007 and 2008, financial markets experienced significant disruptions beginning with dramatic declines in the housing market leading to increased foreclosures, declines in home values and increased unemployment which culminated in significantly reduced liquidity in financial markets. Banks and other financial institutions became reluctant to lend to clients and to other banks. The liquidity crisis has spread worldwide.
 
Recently, the federal government has announced various programs under the Emergency Economic Stabilization Act of 2008 (the Act) intended to inject liquidity and stabilize the financial industry. The Act includes the Treasury Capital Purchase Program (TCPP), Troubled Assets Relief Program (TARP), FDIC Temporary Liquidity Guarantee Program (TLGP) and the Money Market Investor Funding Facility. Bancorp is assessing the potential impact of its participation in the TCPP and TLGP but has not yet made a definitive decision as to whether it will participate.
 
It cannot be determined whether these recent steps taken by the federal government will result in significant improvement in financial and economic conditions affecting the banking industry. Despite the federal government's recent fiscal and monetary measures, if the U.S. economy were to remain in a recessionary condition for an extended period, this would present additional significant challenges for the U.S. banking and financial services industry, and inevitably, businesses of Bancorp.
 
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BANK OF MARIN BANCORP
 
While the banking industry continued to be impacted by the slowing U.S. economy and volatility in the financial markets, due to the strength of the market in which it operates, Bancorp continued to generate healthy loan growth, maintain stable deposits and increase efficiency. It maintains a strong capital base.  It’s sources of funding, including lines of credit with the FHLB and correspondent banks remain available.
 
Bancorp experienced loan growth of $114 million, an increase of 15.7%, in the first nine months of 2008, and experienced loan growth of $38.8 million, or 4.9% in the third quarter of 2008, with no significant changes to the mix of loans.  During the same period, deposits, exclusive of a $53 million short-term deposit placed with Bancorp over the 2007 year-end, increased $67 million, or 8.6%.
 
Bancorp recorded an increase in net income of $291 thousand, or 3.2% in the nine-month period ended September 30, 2008 compared to the same period in 2007 and a decrease of $494 thousand, or 15.5%, in the quarter ended September 30, 2008 compared to the same period last year. The results reflect increases in the provision for loan losses from $340 thousand in the nine months ended September 30, 2007 to $2.8 million in the nine months ended September 30, 2008 and from $200 thousand in the third quarter of 2007 to $1.7 million in the third quarter of 2008. The increases in the loan loss reserve reflect strong loan growth, an increased allocation for economic uncertainty, and increases to the specific reserve where needed.
 
Charge-offs in the first nine months of 2008 totaling $1.1 million and in the third quarter of 2008 totaling $969 thousand primarily relate to the charge-off of one unsecured commercial line of credit and one commercial term loan collateralized by a residence where the Bank holds the second deed of trust. The allowance for loan losses as a percentage of loans totaled 1.11% at September 30, 2008 compared to 1.05% a year ago. In addition, our allowance for loan losses is 11.3 times our non-performing loans at September 30, 2008.
 
Bancorp has not participated in subprime lending nor does it hold investment securities backed by subprime loans.  Bancorp does not hold common or preferred stock of either the Federal National Mortgage Association (Fannie Mae) or the Federal Home Loan Mortgage Corporation (Freddie Mac).
 
A combination of lower deposit and borrowing rates and a shift in interest-earning assets from Federal funds sold to higher-yielding loans contributed to expansion of the tax-equivalent net interest margin to 5.43% percent in the nine months ended September 30, 2008 compared to 5.00% in the nine months ended September 30, 2007.  Beginning in August 2007 and continuing through April 2008, the Federal Reserve lowered its target interest rate by 325 basis points, resulting in lower deposit rates offered by Bancorp.  Loan yields did not fall as dramatically since the yield on fixed-rate loans, which comprise over half of the loan portfolio, remained relatively unchanged.  During June 2007, Bancorp received proceeds of $76.7 million from sale of its indirect auto loan portfolio. Such proceeds were mainly invested in Federal funds sold during the second and third quarters of 2007, and were gradually reinvested in higher-yielding relationship loans.
 
In the third quarter of 2008, Bancorp experienced a decline in the tax-equivalent net interest margin to 5.35% from 5.52% in the second quarter, reflecting downward repricing on variable rate loans and new loans originated at lower market rates, partially offset by lower deposit rates in a declining rate environment. During the quarter, there were no changes in the Federal funds target rate. The repricing relates to rate re-sets at specified intervals and loans tied to indexes that may not move in tandem with the Federal funds rate. The effect of lower loan yields was partially offset by a decline in the cost of purchased funds during the period due to an injection of liquidity into the market by the Federal Reserve in later part of the third quarter.
 
The largest factors likely to affect Bancorp’s net interest margin in the remainder of 2008 will be the volume of loan demand and deposits, which will in turn influence Bancorp’s liquidity level, the Federal funds target rate, which is expected to decline during the remainder of 2008, as well as Bancorp’s responsiveness to competitive pricing on loans and deposits in its market.
 
Higher net interest income combined with modest growth in non-interest expenses have resulted in a marked improvement in efficiency.  The efficiency ratio improved 336 basis points in the nine-month period ended September 30, 2008 compared to the same period in 2007 and 86 basis points in the quarter ended September 30, 2008 compared to the same period last year.
 
In the first nine months of 2008, Bancorp recorded a non-recurring pre-tax gain of $457 thousand related to the mandatory redemption of shares in Visa, Inc. and the reversal of a $242 thousand pre-tax charge for the potential obligation to Visa Inc. in connection with certain indemnifications provided to Visa Inc. by Visa member banks. In the first nine months of 2007, Bancorp recorded a non-recurring pre-tax gain of $710 thousand on the sale of the indirect auto portfolio and a $387 pre-tax gain on the sale of the Visa card portfolio.
 
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BANK OF MARIN BANCORP
 
Bancorp has continued to expand its franchise with the opening of a new branch in downtown Mill Valley in June of 2008 and has secured a site for an additional branch in Greenbrae.
 
In November 2007, Bancorp initiated a stock repurchase plan to buy back up to $5 million of its common stock.  Bancorp purchased 88,316 shares during the first nine months of 2008 for $2.5 million, bringing the total amount purchased under this program to $4.1 million. In September 2008, Bancorp discontinued purchases under the program to preserve capital during a time of extreme economic turbulence. Bancorp has maintained a strong capital position, with total risk-based capital at September 30, 2008 of 11.6%, well over the ten percent regulatory minimum to be considered well-capitalized.
 
Holding Company
 
On May 8, 2007, Bank of Marin stockholders approved the formation of a bank holding company.  On July 1, 2007, the holding company, Bank of Marin Bancorp, acquired Bank of Marin as its wholly owned subsidiary. The holding company is expected to provide flexibility in meeting the financing needs of the Bank and in responding to evolving changes in the banking and financial services industries.
 
The financial statements and discussion thereof contained in this report for periods subsequent to the reorganization relate to consolidated Bank of Marin Bancorp.  Periods prior to the reorganization relate to Bank of Marin only.  The information is comparable as the sole subsidiary of Bank of Marin Bancorp is the Bank of Marin.
 
Critical Accounting Policies
 
Critical accounting policies are those that are both most important to the portrayal of Bancorp’s financial condition and results of operations and require management’s most difficult, subjective, or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Management has determined the following four accounting policies to be critical: Allowance for Loan Losses, Share-Based Payment, Accounting for Income Taxes and Fair Value Option for Financial Assets and Liabilities.
 
Allowance for Loan Losses
 
Allowance for loan losses is based upon estimates of loan losses and is maintained at a level considered adequate to provide for probable losses inherent in the outstanding loan portfolio. The allowance is increased by provisions charged to expense and reduced by net charge-offs.  In periodic evaluations of the adequacy of the allowance balance, management considers the Bank's past loan loss experience by type of credit, known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay, the estimated value of any underlying collateral, current economic conditions and other factors. The Bank formally assesses the adequacy of the allowance for loan losses on a quarterly basis. These assessments include the periodic re-grading of loans based on changes in their individual credit characteristics including delinquency, seasoning, recent financial performance of the borrower, economic factors, changes in the interest rate environment, and other factors as warranted. Loans are initially graded when originated. They are reviewed as they are renewed, when there is a new loan to the same borrower and/or when identified facts demonstrate heightened risk of default. Larger problem loans are monitored continuously and formal impairment analysis for the purpose of SFAS No. 114 occurs at least quarterly.
 
The Bank's method for assessing the appropriateness of the allowance includes specific allowances for identified problem loans, an allowance factor for categories of credits, and allowances for changing environmental factors (e.g., portfolio trends, concentration of credit, growth, economic factors). Allowances for identified problem loans are based on specific analysis of individual credits. Loss estimation factors for loan categories are based on analysis of local economic factors applicable to each loan categories. Allowances for changing environmental factors are management's best estimate of the probable impact these changes have had on the loan portfolio as a whole.
 
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BANK OF MARIN BANCORP
 
Share-Based Payment
 
On January 1, 2006, the Bank adopted the provisions of SFAS No.123R, “Share-Based Payment,” which requires that all share-based payments, including stock options and nonvested restricted common shares, be recognized as an expense in the income statement based on the grant-date fair value of the award with a corresponding increase to common stock.
 
The Bank determines the fair value of stock options at grant date using the Black-Scholes pricing model that takes into account the stock price at the grant date, the exercise price, the expected dividend yield, stock price volatility and the risk-free interest rate over the expected life of the option. The Black-Scholes model requires the input of highly subjective assumptions including the expected life of the stock-based award and stock price volatility.  The estimates used in the model involve inherent uncertainties and the application of management judgment.  As a result, if other assumptions had been used, the Bank’s recorded stock-based compensation expense could have been materially different from that reflected in these financial statements. The fair value of nonvested restricted common shares generally equals the stock price at grant date.  In addition, the Bank is required to estimate the expected forfeiture rate and only recognize expense for those share-based awards expected to vest.  If the Bank’s actual forfeiture rate is materially different from the estimate, the share-based compensation expense could be materially different.  For additional discussion of SFAS No.123R, see Note 6 of the Notes to Consolidated Financial Statements in this Form 10-Q.
 
Accounting for Income Taxes
 
Income taxes reported in the financial statements are computed based on an asset and liability approach in accordance with FASB Statement No. 109, “Accounting for Income Taxes.”(FASB No. 109). Bancorp recognizes the amount of taxes payable or refundable for the current year, and deferred tax assets and liabilities for the expected future tax consequences that have been recognized in the financial statements. Under this method, deferred tax assets and liabilities are determined based on the differences between the financial statements and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. Bancorp records net deferred tax assets to the extent it is more likely than not that they will be realized.  In evaluating Bancorp’s ability to recover the deferred tax assets, management considers all available positive and negative evidence, including scheduled reversals of deferred tax liabilities, projected future taxable income, tax planning strategies and recent financial operations.  In projecting future taxable income, management develops assumptions including the amount of future state and federal pretax operating income, the reversal of temporary differences, and the implementation of feasible and prudent tax planning strategies. These assumptions require significant judgment about the forecasts of future taxable income and are consistent with the plans and estimates being used to manage the underlying business. Bancorp files consolidated federal and combined state income tax returns.
 
Effective January 1, 2007, Bancorp adopted the provisions of FASB Interpretation (FIN) No. 48, “Accounting for Uncertainty in Income Taxes – An Interpretation of FASB Statement No. 109,” which clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB No. 109. FIN 48 establishes a “more-likely-than-not” recognition threshold that must be met before a tax benefit can be recognized in the financial statements. For tax positions that meet the more-likely-than-not threshold, an enterprise may recognize only the largest amount of tax benefit that is greater than fifty percent likely of being realized upon ultimate settlement with the taxing authority. Management believed that there were no tax positions that did not meet the more-likely-than-not recognition threshold; therefore, there were no adjustments to retained earnings as a consequence of adopting FIN No. 48 and no subsequent adjustments to the provision for income taxes related to FIN 48.  To the extent tax authorities disagree with these tax positions, the Bank’s and Bancorp’s effective tax rates could be materially affected in the period of settlement with the taxing authorities.
 
Fair Value Option for Financial Assets and Financial Liabilities and Fair Value Measurements
 
Effective January 1, 2007, the Bank elected early adoption of FASB Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” and FASB Statement No. 157, “Fair Value Measurementsand elected the fair value option for its indirect auto loan portfolio, which was subsequently sold. The changes in fair value of the portfolio after the initial adoption at each balance sheet date were recorded through earnings prior to the sale on June 5, 2007. The Bank determined fair value at January 1, 2007 and March 31, 2007 based on certain criteria including weighted average interest rate, remaining term and FICO credit score. The expected cash flows were discounted using Treasury rates and a spread above the Treasury rate was applied based on recent sales of similar assets. The assumptions represented management’s best estimates, but these estimates involved inherent uncertainties and the application of management’s judgment. As a result, if other assumptions had been used, the Bank’s recorded unrealized gain in the first quarter of 2007 could have been materially different from that reflected in these financial statements.
 
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BANK OF MARIN BANCORP
 
As a result of the Bank’s fair value measurement election for the auto loan portfolio, the Bank recorded a cumulative-effect adjustment of $1.5 million, net of tax, as a reduction of retained earnings as of January 1, 2007. In addition, $190 thousand and $520 thousand of pre-tax net gains were recorded in the Bank’s second and first quarter 2007 earnings, respectively (2 cents and 6 cents per diluted share, respectively,  on an after-tax basis), representing the change in fair value of such instruments during those periods after giving effect to the cumulative-effect adjustment.
 
The Bank has established and documented a process for determining fair value. For detailed information on the Bank’s use of fair valuation of financial instruments and our related valuation methodologies, see Note 3 of the Consolidated Financial Statements in this Form 10-Q.
 
RESULTS OF OPERATIONS
 
Overview
 
Highlights of the financial results are presented in the following table:
 
   
As of and for the three months ended
   
As of and for the nine months ended
 
(dollars in thousands except per share data)
 
September 30, 2008
   
June 30, 2008
   
September 30, 2007
   
September 30, 2008
   
September 30, 2007
 
For the period:
                             
Net income
  $ 2,695     $ 3,386     $ 3,189     $ 9,357     $ 9,066  
Net income per share
                                       
Basic
    0.53       0.66       0.62       1.82       1.74  
Diluted
    0.52       0.65       0.60       1.79       1.70  
Return on average equity
    11.37