BMRC-2013.09.30-10Q

 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, 2013
 
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
 
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 (or for such shorter period that the registrant was required to file such reports), 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 has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
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. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b(2) of the Exchange Act.
         
 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, as defined in Rule 12b(2) of the Exchange Act.
Yes   o     No  x
 
As of October 31, 2013, there were 5,460,411 shares of common stock outstanding.



TABLE OF CONTENTS
 
 
 
 
PART I
 
 
 
ITEM 1.
 
 
 
 
 
 
 
 
 
 
 
ITEM 2.
 
 
 
ITEM 3.
 
 
 
ITEM 4.
 
 
 
PART II
 
 
 
ITEM 1.
 
 
 
ITEM 1A.
 
 
 
ITEM 2.
 
 
 
ITEM 3.
 
 
 
ITEM 4.
 
 
 
ITEM 5.
 
 
 
ITEM 6.
 
 
 




Page-2



PART I       FINANCIAL INFORMATION
 
ITEM 1.  Financial Statements
 
BANK OF MARIN BANCORP
CONSOLIDATED STATEMENTS OF CONDITION 
at September 30, 2013 and December 31, 2012
(in thousands, except share data; 2013 unaudited)
September 30, 2013

 
December 31, 2012

Assets
 

 
 
Cash and due from banks
$
99,358

 
$
28,349

Investment securities
 

 


Held-to-maturity, at amortized cost
130,085

 
139,452

Available-for-sale, at fair value (amortized cost $118,353 and $150,420 at September 30, 2013 and December 31, 2012, respectively)
119,340

 
153,962

Total investment securities
249,425

 
293,414

Loans, net of allowance for loan losses of $13,808 and $13,661 at September 30, 2013 and December 31, 2012, respectively
1,079,043

 
1,060,291

Bank premises and equipment, net
8,947

 
9,344

Interest receivable and other assets
46,830

 
43,351

Total assets
$
1,483,603

 
$
1,434,749

 
 
 
 
Liabilities and Stockholders' Equity
 

 
 

Liabilities
 

 
 

Deposits
 

 
 

Non-interest bearing
$
537,104

 
$
389,722

Interest bearing
 

 


Transaction accounts
76,221

 
169,647

Savings accounts
102,898

 
93,404

Money market accounts
437,247

 
443,742

CDARS® time accounts
1,474

 
15,718

Other time accounts
137,532

 
141,056

Total deposits
1,292,476

 
1,253,289

   Federal Home Loan Bank borrowings
15,000

 
15,000

 Interest payable and other liabilities
14,416

 
14,668

Total liabilities
1,321,892

 
1,282,957

 
 
 
 
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 - 5,462,061 and 5,389,210 at
    September 30, 2013 and December 31, 2012, respectively
60,982

 
58,573

Retained earnings
100,157

 
91,164

Accumulated other comprehensive income, net
572

 
2,055

Total stockholders' equity
161,711

 
151,792

Total liabilities and stockholders' equity
$
1,483,603

 
$
1,434,749


The accompanying notes are an integral part of these consolidated financial statements.

Page-3



BANK OF MARIN BANCORP
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
 
Three months ended
 
Nine months ended
(in thousands, except per share amounts; unaudited)
September 30, 2013
 
June 30, 2013
 
September 30, 2012
 
September 30, 2013
 
September 30, 2012
Interest income
 
 
 
 
 
 
 
 
 
Interest and fees on loans
$
13,049

 
$
13,366

 
$
14,117

 
$
40,050

 
$
44,769

Interest on investment securities


 


 


 
 

 
 

Securities of U.S. government agencies
553

 
585

 
731

 
1,763

 
2,515

Obligations of state and political subdivisions
524

 
437

 
382

 
1,599

 
1,224

Corporate debt securities and other
311

 
339

 
326

 
974

 
812

Interest due from banks and other
34

 
3

 
42

 
45

 
148

Total interest income
14,471

 
14,730

 
15,598

 
44,431

 
49,468

Interest expense
 

 
 

 
 

 
 

 
 

Interest on interest bearing transaction accounts
12

 
12

 
48

 
35

 
137

Interest on savings accounts
9

 
8

 
26

 
25

 
72

Interest on money market accounts
101

 
95

 
181

 
295

 
544

Interest on CDARS® time accounts
1

 
2

 
19

 
8

 
72

Interest on other time accounts
226

 
224

 
254

 
682

 
827

Interest on borrowed funds
80

 
84

 
153

 
243

 
417

Total interest expense
429

 
425

 
681

 
1,288

 
2,069

Net interest income
14,042

 
14,305

 
14,917

 
43,143

 
47,399

(Reversal of) provision for loan losses
(480
)
 
1,100

 
2,100

 
390

 
2,200

Net interest income after (reversal of) provision for loan losses
14,522

 
13,205

 
12,817

 
42,753

 
45,199

Non-interest income
 

 
 

 
 

 
 

 
 

Service charges on deposit accounts
509

 
515

 
528

 
1,545

 
1,601

Wealth Management and Trust Services
532

 
539

 
507

 
1,618

 
1,451

Debit card interchange fees
288

 
280

 
261

 
820

 
754

Merchant interchange fees
196

 
222

 
183

 
623

 
562

Earnings on Bank-owned life insurance
179

 
186

 
192

 
766

 
572

Loss on sale of securities
(35
)
 

 

 
(35
)
 
(34
)
Other income
284

 
202

 
130

 
666

 
390

Total non-interest income
1,953

 
1,944

 
1,801

 
6,003

 
5,296

Non-interest expense
 

 
 

 
 

 
 

 
 

Salaries and related benefits
5,389

 
5,430

 
5,211

 
16,117

 
16,129

Occupancy and equipment
1,040

 
1,052

 
1,089

 
3,165

 
3,132

Depreciation and amortization
343

 
353

 
339

 
1,032

 
1,021

Federal Deposit Insurance Corporation insurance
244

 
223

 
221

 
681

 
672

Data processing
612

 
696

 
596

 
1,857

 
1,862

Professional services
775

 
814

 
519

 
2,116

 
1,620

Other expense
1,704

 
1,851

 
1,617

 
5,253

 
4,676

Total non-interest expense
10,107

 
10,419

 
9,592

 
30,221

 
29,112

Income before provision for income taxes
6,368

 
4,730

 
5,026

 
18,535

 
21,383

Provision for income taxes
2,364

 
1,675

 
1,802

 
6,610

 
8,268

Net income
$
4,004

 
$
3,055

 
$
3,224

 
$
11,925

 
$
13,115

Net income per common share:
 

 
 

 
 

 
 
 
 
Basic
$
0.74

 
$
0.56

 
$
0.60

 
$
2.20

 
$
2.46

Diluted
$
0.72

 
$
0.55

 
$
0.59

 
$
2.16

 
$
2.41

Weighted average shares used to compute net income per common share:


 
 
 
 

 
 
 
 
Basic
5,433

 
5,419

 
5,344

 
5,414

 
5,335

Diluted
5,538

 
5,509

 
5,455

 
5,511

 
5,433

Dividends declared per common share
$
0.18

 
$
0.18

 
$
0.18

 
$
0.54

 
$
0.52

Comprehensive income:
 
 
 
 
 
 


 


Net income
$
4,004

 
$
3,055

 
$
3,224

 
$
11,925

 
$
13,115

Other comprehensive (loss) income


 
 
 


 


 


Change in net unrealized gain on available-for-sale securities
(621
)
 
(1,666
)
 
747

 
(2,591
)
 
736

     Reclassification adjustment for loss on sale of
     securities included in net income
35

 

 

 
35

 
34

          Net change in unrealized gain on available-for-sale
          securities, before tax
(586
)
 
(1,666
)
 
747

 
(2,556
)
 
770

Deferred tax (benefit) expense
(246
)
 
(700
)
 
314

 
(1,073
)
 
324

Other comprehensive (loss) income, net of tax
(340
)
 
(966
)
 
433

 
(1,483
)
 
446

Comprehensive income
$
3,664

 
$
2,089

 
$
3,657

 
$
10,442

 
$
13,561


The accompanying notes are an integral part of these consolidated financial statements.

Page-4



BANK OF MARIN BANCORP
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
for the year ended December 31, 2012 and the nine months ended September 30, 2013

(dollars in thousands; 2013 unaudited )
 
Common Stock
 
Retained
Earnings

 
Accumulated Other
Comprehensive Income,
Net of Taxes

 
 Total

Shares

 
Amount

 
 
 
Balance at December 31, 2011
 
5,336,927

 
$
56,854

 
$
77,098

 
$
1,599

 
$
135,551

Net income
 

 

 
17,817

 

 
17,817

Other comprehensive income
 

 

 

 
456

 
456

Stock options exercised
 
37,563

 
1,041

 

 

 
1,041

Excess tax benefit - stock-based compensation
 

 
42

 

 

 
42

Stock issued under employee stock purchase plan
 
700

 
25

 

 

 
25

Restricted stock granted
 
9,030

 

 

 

 

Restricted stock forfeited / cancelled
 
(380
)
 

 

 

 

Stock-based compensation - stock options
 

 
206

 

 

 
206

Stock-based compensation - restricted stock
 

 
202

 

 

 
202

Cash dividends paid on common stock
 

 

 
(3,751
)
 

 
(3,751
)
Stock purchased by directors under director stock plan
 
100

 
4

 

 

 
4

Stock issued in payment of director fees
 
5,270

 
199

 

 

 
199

Balance at December 31, 2012
 
5,389,210

 
$
58,573

 
$
91,164

 
$
2,055

 
$
151,792

Net income
 

 

 
11,925

 

 
11,925

Other comprehensive loss
 

 

 

 
(1,483
)
 
(1,483
)
Stock options exercised
 
56,850

 
1,736

 

 

 
1,736

Excess tax benefit - stock-based compensation
 

 
108

 

 

 
108

Stock issued under employee stock purchase plan
 
720

 
28

 

 

 
28

Restricted stock granted
 
12,010

 

 

 

 

Restricted stock forfeited / cancelled
 
(2,508
)
 

 

 

 

Stock-based compensation - stock options
 

 
139

 

 

 
139

Stock-based compensation - restricted stock
 

 
170

 

 

 
170

Cash dividends paid on common stock
 

 

 
(2,932
)
 

 
(2,932
)
Stock purchased by directors under director stock plan
 
160

 
6

 

 

 
6

Stock issued in payment of director fees
 
5,619

 
222

 

 

 
222

Balance at September 30, 2013
 
5,462,061

 
$
60,982

 
$
100,157

 
$
572

 
$
161,711


The accompanying notes are an integral part of these consolidated financial statements.

Page-5



BANK OF MARIN BANCORP
CONSOLIDATED STATEMENTS OF CASH FLOWS
for the nine months ended September 30, 2013 and 2012
(in thousands, unaudited)
September 30, 2013

 
September 30, 2012

Cash Flows from Operating Activities:
 
 
 
Net income
$
11,925

 
$
13,115

Adjustments to reconcile net income to net cash provided  by operating activities:
 

 
 

Provision for loan losses
390

 
2,200

Compensation expense--common stock for director fees
166

 
155

Stock-based compensation expense
309

 
307

Excess tax benefits from exercised stock options
(86
)
 
(40
)
Amortization of investment security premiums, net of accretion of discounts
2,401

 
1,619

Accretion of discount on acquired loans
(1,137
)
 
(1,965
)
Decrease in deferred loan origination fees, net
(662
)

(895
)
Loss on sale of investment securities
35


34

Depreciation and amortization
1,032

 
1,021

Loss on disposal of premise and equipment

 
11

(Gain) loss on sale of repossessed assets
(43
)
 
14

Earnings on bank owned life insurance policies
(766
)
 
(572
)
Net change in operating assets and liabilities:
 

 
 

Interest receivable
408

 
(267
)
Interest payable
(32
)
 
(142
)
Deferred rent and other rent-related expenses
50

 
257

Other assets
(2,276
)
 
798

Other liabilities
2,926

 
(1,623
)
Total adjustments
2,715

 
912

Net cash provided by operating activities
14,640

 
14,027

Cash Flows from Investing Activities:
 

 
 

Purchase of securities held-to-maturity

 
(40,639
)
Purchase of securities available-for-sale

 
(55,679
)
Proceeds from sale of securities available-for-sale
2,220

 
2,186

Proceeds from paydowns/maturity of securities held-to-maturity
7,815

 
5,068

Proceeds from paydowns/maturity of securities available-for-sale
28,963

 
41,663

Loans originated and principal collected, net
(20,375
)
 
17,301

Purchase of bank owned life insurance policies

 
(364
)
Purchase of premises and equipment
(635
)
 
(523
)
Proceeds from sale of repossessed assets
270

 
41

Net cash provided by (used in) investing activities
18,258

 
(30,946
)
Cash Flows from Financing Activities:
 

 
 

Net increase in deposits
39,187

 
55,901

Proceeds from stock options exercised
1,736

 
433

Repayment of subordinated debenture

 
(5,000
)
Repayment of Federal Home Loan Bank borrowings

 
(20,000
)
Cash dividends paid on common stock
(2,932
)
 
(2,784
)
Stock issued under employee and director stock purchase plans
34

 
24

Excess tax benefits from exercised stock options
86

 
40

Net cash provided by financing activities
38,111

 
28,614

Net increase in cash and cash equivalents
71,009

 
11,695

Cash and cash equivalents at beginning of period
28,349

 
129,743

Cash and cash equivalents at end of period
$
99,358

 
$
141,438

Supplemental disclosure of cash flow information:
 
 
 
Cash paid for interest
$
1,320

 
$
2,212

Cash paid for income taxes
$
7,889

 
$
8,541

Supplemental disclosure of non-cash investing and financing activities:
 

 
 

Change in unrealized gain on available-for-sale securities
$
(2,556
)

$
770

Loans transferred to repossessed assets
$

 
$
65

Stock issued in payment of director fees
$
222

 
$
199


The accompanying notes are an integral part of these consolidated financial statements.

Page-6



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
Introductory Explanation
 
References in this report to “Bancorp” mean the Bank of Marin Bancorp as the parent holding company for Bank of Marin, the wholly-owned subsidiary (the “Bank”). References to “we,” “our,” “us” mean Bancorp and the Bank that are consolidated for financial reporting purposes.
 
Note 1:  Basis of Presentation
 
The consolidated financial statements include the accounts of Bancorp and its only wholly-owned bank subsidiary, the Bank. 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 our financial position, results of operations, changes in stockholders' equity and cash flows. All adjustments are of a normal, recurring nature. Management has evaluated subsequent events through the date of filing, and has determined that there are no subsequent events that require recognition or disclosure except the pending NorCal Community Bancorp ("NorCal") acquisition as discussed in Note 3.
 
Certain information and footnote disclosures presented in the annual consolidated 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 our 2012 Annual Report on Form 10-K.  The results of operations for the three months and nine months ended September 30, 2013 are not necessarily indicative of the operating results for the full year.
 
The following table shows: 1) weighted average basic shares, 2) potential common shares related to stock options, unvested restricted stock and stock warrant, and 3) weighted average diluted shares. Basic earnings per share (“EPS”) are calculated by dividing net income by the weighted average number of common shares outstanding during each period, excluding unvested restricted stock. Diluted EPS are calculated using the weighted average diluted shares. The number of potential common shares included in quarterly diluted EPS is computed using the average market prices during the three months included in the reporting period under the treasury stock method. The number of potential common shares included in year-to-date diluted EPS is a year-to-date weighted average of potential common shares included in each quarterly diluted EPS computation. We have two forms of outstanding common stock: common stock and unvested restricted stock awards. Holders of restricted stock awards receive non-forfeitable dividends at the same rate as common shareholders and they both share equally in undistributed earnings.
 
Three months ended
 
Nine months ended
(in thousands; except per share data; unaudited)
September 30,
2013
June 30,
2013
September 30,
2012
 
September 30,
2013
September 30,
2012
Weighted average basic shares outstanding
5,433

5,419

5,344

 
5,414

5,335

Add: Potential common shares related to stock options
46

39

55

 
43

48

Potential common shares related to unvested restricted stock
4

2

9

 
4

6

Potential common shares related to the warrant
55

49

47

 
50

44

Weighted average diluted shares outstanding
5,538

5,509

5,455

 
5,511

5,433

 
 
 
 
 
 
 
Net income
$
4,004

$
3,055

$
3,224

 
$
11,925

$
13,115

Basic EPS
$
0.74

$
0.56

$
0.60

 
$
2.20

$
2.46

Diluted EPS
$
0.72

$
0.55

$
0.59

 
$
2.16

$
2.41

 
 
 
 
 




Weighted average anti-dilutive shares not included in the calculation of diluted EPS
51

60

41

 
48

33


Page-7



Note 2: Recently Issued Accounting Standards
 
In December 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2011-11 Balance Sheet (Topic 210) Disclosures about Offsetting Assets and Liabilities. The ASU enhances disclosures in order to improve the comparability of offsetting (netting) assets and liabilities reported in accordance with U.S. generally accepted accounting principles (“GAAP”) and International Financial Reporting Standards (“IFRS”) by requiring entities to disclose both gross information and net information about both instruments and transactions eligible for offset in the statements of condition and instruments and transactions subject to an agreement similar to a master netting arrangement.

In January 2013, the FASB issued ASU No. 2013-01 Balance Sheet (Topic 210) Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities, which clarifies that ordinary trade receivables and receivables are not in the scope of ASU 2011-11. It further clarifies that the scope of ASU No. 2011-11 applies to derivatives, repurchase agreements and reverse purchase agreements, and securities borrowing and securities lending transactions that are either offset in accordance with specific criteria contained in FASB Accounting Standards Codification® or subject to a master netting arrangement or similar agreement. Both ASU 2011-11 and ASU 2013-01 are effective for annual periods beginning on or after January 1, 2013, and interim periods within those annual periods. We adopted these ASUs in the first quarter of 2013.

In February 2013, the FASB issued ASU No. 2013-02, Comprehensive Income (Topic 220) Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income. The ASU requires entities to present separately by component reclassifications out of accumulated other comprehensive income. An entity is required to disclose in the notes of the financial statements or parenthetically on the face of the financial statements the effect of significant items reclassified out of accumulated other comprehensive income on the respective line items of net income, but only if the item reclassified is required under U.S. GAAP to be reclassified to net income in its entirety. ASU 2013-02 is effective for fiscal years, and interim periods beginning on or after December 15, 2012 for public entities. We adopted this ASU in the first quarter of 2013.

In February 2013, the FASB issued ASU No. 2013-04, Liabilities (Topic 405) Obligations Resulting from Joint and Several Liability Arrangements for Which the Total Amount of the Obligation is Fixed at the Reporting Date. The ASU requires an entity to measure obligations resulting from joint and several liability arrangements for which the total amount of the obligation is fixed at the reporting date. Entities are required to record the amount the entity agreed to pay on the basis of its arrangement among its co-obligors and any additional amount the reporting entity expects to pay on behalf of its co-obligors at the reporting date. Examples of obligations within the scope of this guidance include debt arrangements, other contractual obligations, settled litigation and judicial rulings. ASU 2013-04 is effective retrospectively to all periods presented for fiscal years and interim periods beginning after December 15, 2013 for public entities. We do not expect this ASU to have a significant impact on our financial condition or results of operations.

In July 2013, the FASB issued ASU No. 2013-10, Derivatives and Hedging (Topic 815) Inclusion of the Fed Funds Effective Swap Rate (or Overnight Index Swap Rate) as a Benchmark Interest Rate for Hedging Accounting Purposes.
The ASU provides for the inclusion of the Fed Funds Effective Swap Rate or also referred to as the Overnight Index Swap Rate ("OIS") as a U.S. benchmark interest rate for hedge accounting purposes, in addition to direct Treasury obligations of the U.S. government ("UST") and London Interbank Offered Rate ("LIBOR"). The ASU is a result of the financial crisis in 2008, as the exposure to and the demand for hedging the Fund Funds rate have increased significantly. ASU 2013-10 is effective prospectively for qualifying new or re-designated hedging relationships entered into on or after July 17, 2013. We do not expect this ASU to have a significant impact on our financial condition or results of operations.

In July 2013, the FASB issued ASU No. 2013-11, Income Taxes (Topic 740) Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists. The ASU requires that an unrecognized tax benefit, or a portion of an unrecognized tax benefit, should be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward except as follows. To the extent that a net operating loss carryforward, a similar tax loss, or a tax credit carryforward is not available at the reporting date to settle any additional income taxes that would result from the disallowance of a tax position, or the tax law does not require the entity to use, and the entity does not intend to use, the deferred tax asset for such purposes, then the unrecognized tax benefit should be presented as a liability.
ASU 2013-11 is effective prospectively for fiscal years, and interim periods beginning after December 15, 2013 for public entities. We do not expect this ASU to have a significant impact on our financial condition or results of operations.


Page-8


Note 3: Acquisition

On July 1, 2013, we entered into a definitive agreement to acquire NorCal Community Bancorp, parent company of Bank of Alameda. Bank of Alameda has four branch offices serving Alameda, Emeryville, and Oakland, and had assets of $271.5 million, total deposits of $237.2 million, and total loans of $177.3 million as of September 30, 2013. We have received all the necessary regulatory approvals. Additionally, NorCal shareholders gave their approval on October 17, 2013. The transaction is expected to close in the fourth quarter of 2013.

For more information concerning the transaction, please see the S-4 filed by Bancorp with the Securities and Exchange Commission ("SEC") on August 23, 2013, and the 8-K Reports filed with the SEC on July 1 and July 5, 2013. For other important factors regarding the NorCal acquisition, please see the Forward Looking Statements and Risk Factors sections of the Form 10-Q for the quarter ended June 30, 2013.

Note 4:  Fair Value of Assets and Liabilities
 
Fair Value Hierarchy and Fair Value Measurement
 
We group our assets and liabilities that are measured at fair value in three levels within the fair value hierarchy, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:
 
Level 1: Valuations are based on quoted prices in active markets for identical assets or liabilities. Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these products does not involve a significant degree of judgment.
 
Level 2: Valuations are based on quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active and model-based valuations for which all significant assumptions are observable or can be corroborated by observable market data.
 
Level 3: Valuations are based on unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Values are determined using pricing models and discounted cash flow models and include management judgment and estimation which may be significant.


Page-9



 
The following table summarizes our assets and liabilities that were required to be recorded at fair value on a recurring basis.
 
(in thousands)  
Description of Financial Instruments
Carrying Value

 
Quoted Prices in Active Markets for Identical Assets (Level 1)

 
Significant Other Observable Inputs (Level 2)

 
Significant Unobservable Inputs (Level 3)

At September 30, 2013 (unaudited):
 
 
 
 
 
 
 
Securities available-for-sale:
 
 
 
 
 
 
 
Mortgage-backed securities and collateralized mortgage obligations issued by U.S. government-sponsored agencies
$
85,108

 
$

 
$
85,108

 
$

Debentures of government-sponsored agencies
$
18,954

 
$

 
$
18,954

 
$

Privately-issued collateralized mortgage obligations
$
15,278

 
$

 
$
15,278

 
$

Derivative financial assets (interest rate contracts)
$
646

 
$

 
$
646

 
$

Derivative financial liabilities (interest rate contracts)
$
3,085

 
$

 
$
3,085

 
$

At December 31, 2012:
 

 
 
 
 

 
 

Securities available-for-sale:
 

 
 
 
 

 
 

Mortgage-backed securities and collateralized mortgage obligations issued by U.S. government-sponsored agencies
$
111,797

 
$

 
$
111,797

 
$

Debentures of government-sponsored agencies
$
20,589

 
$

 
$
20,589

 
$

Privately-issued collateralized mortgage obligations
$
21,576

 
$

 
$
21,576

 
$

Derivative financial assets (interest rate contracts)
$
1

 
$

 
$
1

 
$

Derivative financial liabilities (interest rate contracts)
$
5,240

 
$

 
$
5,240

 
$

 
Securities available-for-sale are recorded at fair value on a recurring basis. 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, we obtain 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/ask prices, dealer-quoted prices, interest rates, benchmark yield curves, prepayment speeds, probability of default, loss severity and credit spreads (Level 2).   Level 2 securities include U.S. agencies or government sponsored agencies' debt securities, mortgage-backed securities, government agency-issued and privately-issued collateralized mortgage obligations. As of September 30, 2013 and December 31, 2012, there are no securities that are considered Level 1 or Level 3 securities.
 
On a recurring basis, derivative financial instruments are recorded at fair value, which 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 our 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 LIBOR cash rates (for the very short term), quoted prices for LIBOR futures contracts, observable market prices for LIBOR swap rates, and one-month and three-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 the 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 our potential credit risk to counterparties.  We have used the spread between the Standard & Poors BBB rated U.S. Bank

Page-10



Composite rate and LIBOR with the maturity term corresponding to the duration of the swaps to calculate this credit-risk-related discount of future cash flows.
 
Certain financial assets may be measured at fair value on a non-recurring basis. These assets are subject to fair value adjustments that result from the application of the lower of cost or fair value accounting or write-downs of individual assets, such as other real estate owned. 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) or the current net realizable value of the underlying collateral securing the loan, if the loan is collateral dependent (Level 3).  Net realizable value of the underlying collateral is the fair value of the collateral less estimated selling costs and any prior liens. Appraisals, recent comparable sales, offers and listing prices are factored in when valuing the collateral. We review and verify the qualifications and licenses of  the certified general appraisers used for appraising commercial properties or certified residential appraisers for residential properties. Real estate appraisals may utilize a combination of approaches including replacement cost, sales comparison and the income approach. Comparable sales and income data are analyzed by the appraisers and adjusted to reflect differences between them and the subject property such as type, leasing status and physical condition. When the appraisals are received, Management reviews the assumptions and methodology utilized in the appraisal, as well as the overall resulting value in conjunction with independent data sources such as recent market data and industry-wide statistics. We generally use a 6% discount for selling costs which is applied to all properties, regardless of size. Appraised values may be adjusted to reflect changes in market conditions that have occurred subsequent to the appraisal date, or for revised estimates regarding the timing or cost of the property sale. These adjustments are based on qualitative judgments made by management on a case-by-case basis. There have been no significant changes in the valuation techniques during the periods ended September 30, 2013.

Securities held-to-maturity may be written down to fair value (determined using the same techniques discussed above for securities available-for-sale) as a result of an other-than-temporary impairment, if any.
 
The following table presents the carrying value of financial instruments that were measured at fair value on a nonrecurring basis and that were still held in the statements of condition at each respective period end, by level within the fair value hierarchy as of September 30, 2013 and December 31, 2012.

 
(in thousands)
Description of Financial Instruments
Carrying Value1

 
Quoted Prices in Active Markets for Identical Assets
(Level 1)

 
Significant Other Observable Inputs
(Level 2)

 
Significant Unobservable Inputs 
(Level 3) 1

 
At September 30, 2013 (unaudited):
 
 
 

 
 

 
 

 
Impaired loans carried at fair value:


 


 


 


 
Commercial real estate, investor
$
2,786

 
$

 
$

 
$
2,786

 
Construction
3,971

 

 

 
3,971

 
Home equity
45

 

 

 
45

 
Installment and other consumer
143

 

 

 
143

 
Total
$
6,945

 
$

 
$

 
$
6,945

 
 
 
 
 
 
 
 
 
 
At December 31, 2012:
 

 
 

 
 

 
 

 
Impaired loans carried at fair value:
 
 
 
 
 
 


 
Commercial and industrial
$
51

 
$

 
$

 
$
51

 
Commercial real estate, investor
2,941

 

 

 
2,941

 
Construction
1,722

 

 

 
1,722

 
Home equity
107

 

 

 
107

 
Other residential
594

 

 

 
594

 
Installment and other consumer
159

 

 

 
159

 
Total
$
5,574

 
$

 
$

 
$
5,574

 

1 Represents collateral-dependent loan principal balances that had been generally written down to the values of the underlying collateral, net of specific valuation allowances of $1.5 million and $729 thousand at September 30, 2013 and December 31, 2012, respectively. The carrying value of loans fully charged-off, which includes unsecured lines of credit, overdrafts and all other loans, is zero.

Page-11



 


Disclosures about Fair Value of Financial Instruments
 
The table below is a summary of fair value estimates for financial instruments as of September 30, 2013 and December 31, 2012, excluding financial instruments recorded at fair value on a recurring basis (summarized in the first table in this note). The carrying amounts in the following table are recorded in the consolidated statements of condition under the indicated captions. We have excluded non-financial assets and non-financial liabilities defined by the Codification (ASC 820-10-15-1A), such as Bank premises and equipment, deferred taxes and other liabilities.  In addition, we have not disclosed the fair value of financial instruments specifically excluded from disclosure requirements of the Financial Instruments Topic of the Codification (ASC 825-10-50-8), such as Bank-owned life insurance policies.
 
 
September 30, 2013
 
December 31, 2012
(in thousands; 2013 unaudited)
Carrying Amounts

Fair Value

Fair Value Hierarchy
 
Carrying Amounts

Fair Value

Fair Value Hierarchy
Financial assets
 
 
 
 
 
 
 
Cash and cash equivalents
$
99,358

$
99,358

Level 1
 
$
28,349

$
28,349

Level 1
Investment securities held-to-maturity
130,085

131,567

Level 2
 
139,452

142,231

Level 2
Loans, net
1,079,043

1,097,619

Level 3
 
1,060,291

1,111,355

Level 3
Interest receivable
4,665

4,665

Level 2
 
5,073

5,073

Level 2
Financial liabilities
 

 

 
 
 

 

 
Deposits
1,292,476

1,293,741

Level 2
 
1,253,289

1,254,713

Level 2
Federal Home Loan Bank borrowings
15,000

15,715

Level 2
 
15,000

15,989

Level 2
Interest payable
193

193

Level 2
 
225

225

Level 2

Following is a description of methods and assumptions used to estimate the fair value of each class of financial instrument not recorded at fair value but required for disclosure purposes:
 
Cash and Cash Equivalents - The carrying amounts of cash and cash equivalents approximate their fair value because of the short-term nature of these instruments.
 
Held-to-maturity Securities - Held-to-maturity securities, which generally consist of obligations of state and political subdivisions and corporate bonds, are recorded at their amortized cost. Their fair value for disclosure purposes is determined using methodologies similar to those described above for available-for-sale securities using Level 2 inputs. If Level 2 inputs are not available, we may utilize pricing models that incorporate unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities (Level 3).  As of September 30, 2013 and December 31, 2012, we did not hold any securities whose fair value was measured using significant unobservable inputs.
 
Loans - The fair value of loans with variable interest rates approximates their current carrying value, because their rates are regularly adjusted to current market rates. The fair value of fixed rate loans or variable loans at negotiated interest rate floors or ceilings with remaining maturities in excess of one year is estimated by discounting the future cash flows using current market rates at which similar loans would be made to borrowers with similar credit worthiness and similar remaining maturities. The allowance for loan losses (“ALLL”) is considered to be a reasonable estimate of loan discount due to credit risks.
 
Interest Receivable and Payable - The interest receivable and payable balances approximate their fair value due to the short-term nature of their settlement dates.

Deposits - The fair value of non-interest bearing deposits, interest bearing transaction accounts, savings accounts and money market accounts is the amount payable on demand at the reporting date. The fair value of time deposits is estimated by discounting the future cash flows using current rates offered for deposits of similar remaining maturities.

Page-12



 
Federal Home Loan Bank Borrowings - The fair value is estimated by discounting the future cash flows using current rates offered by the Federal Home Loan Bank of San Francisco ("FHLB") for similar credit advances corresponding to the remaining duration of our fixed-rate credit advances.
 

Commitments - Loan commitments and standby letters of credit generate ongoing fees, which are recognized over the term of the commitment period. In situations where the borrower's credit quality has declined, we record a reserve for these off-balance sheet commitments. Given the uncertainty in the likelihood and timing of a commitment being drawn upon, a reasonable estimate of the fair value of these commitments is the carrying value of the related unamortized loan fees plus the reserve, which is not material.
 
Note 5:  Investment Securities
 
Our investment securities portfolio consists of obligations of state and political subdivisions, corporate bonds, 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"), debentures issued by government-sponsored agencies such as FNMA and FHLMC, as well as privately issued CMOs, as reflected in the table below:
 
 
 
 
 
 
 
 
 
 
 
September 30, 2013
 
December 31, 2012
 
Amortized

Fair

Gross Unrealized
 
Amortized

Fair

Gross Unrealized
(in thousands; 2013 unaudited)
Cost

Value

Gains

(Losses)

 
Cost

Value

Gains

(Losses)

Held-to-maturity
 
 
 
 
 
 
 
 
 
  Obligations of state and
  political subdivisions
$
87,867

$
89,057

$
1,935

$
(745
)
 
$
96,922

$
99,350

$
2,855

$
(427
)
  Corporate bonds
42,218

42,510

382

(90
)
 
42,530
42,881
458

(107
)
Total held-to-maturity
130,085
131,567
2,317
(835
)
 
139,452
142,231
3,313
(534
)
 
 
 
 
 
 
 
 
 
 
Available-for-sale
 
 
 
 
 
 
 
 
 
Securities of U. S. government agencies:
 
 
 
 
 
 
 
 
MBS pass-through securities issued by FNMA and FHLMC
46,553

46,763

725

(515
)
 
52,042
53,713
1,711
(40
)
CMOs issued by FNMA
1,342

1,416

74


 
4,447
4,550
105
(2
)
CMOs issued by FHLMC
8,940

9,084

166

(22
)

13,527
13,778
251

CMOs issued by GNMA
27,133

27,845

745

(33
)

38,871
39,756
886
(1
)
Debentures of government- sponsored agencies
19,365

18,954

130

(541
)
 
20,462
20,589
228
(101
)
Privately-issued CMOs
15,020

15,278

320

(62
)
 
21,071
21,576
595
(90
)
Total available-for-sale
118,353
119,340
2,160
(1,173
)
 
150,420

153,962

3,776

(234
)
 
 
 
 
 
 
 
 
 
 
Total investment securities
$
248,438

$
250,907

$
4,477

$
(2,008
)
 
$
289,872

$
296,193

$
7,089

$
(768
)
 
 
 
 
 
 
 
 
 
 
The amortized cost and fair value of investment debt securities by contractual maturity at September 30, 2013 are shown below. Expected maturities will differ from contractual maturities because the issuers of the securities may have the right to call or prepay obligations with or without call or prepayment penalties.

Page-13



 
 
September 30, 2013
 
Held-to-Maturity
 
Available-for-Sale
(in thousands; unaudited)
Amortized Cost

 
Fair Value

 
Amortized Cost

 
Fair Value

Within one year
$
8,331

 
$
8,340

 
$

 
$

After one year but within five years
92,671

 
93,521

 
27,536

 
27,791

After five years through ten years
26,094

 
26,779

 
18,132

 
17,528

After ten years
2,989

 
2,927

 
72,685

 
74,021

Total
$
130,085

 
$
131,567

 
$
118,353

 
$
119,340

 
We sold four available-for-sale securities in the first nine months of 2013 with proceeds of $2.2 million and a loss of $35 thousand. One available-for-sale security was sold in 2012 with proceeds of $2.2 million and a loss of $34 thousand.

Investment securities carried at $42.2 million and $47.7 million at September 30, 2013 and December 31, 2012, respectively, were pledged with the State of California: $41.5 million and $47.0 million to secure public deposits in compliance with the Local Agency Security Program at September 30, 2013 and December 31, 2012, respectively, and $729 thousand and $719 thousand to provide collateral for trust deposits at September 30, 2013 and December 31, 2012, respectively. In addition, investment securities carried at $1.1 million were pledged to collateralize an internal Wealth Management and Trust Services (“WMTS”) checking account at both September 30, 2013 and December 31, 2012.

Other-Than-Temporarily Impaired Debt Securities
 
We have evaluated the credit ratings of our investment securities and their issuer and/or insurers. Based on our evaluation, Management has determined that no investment security in our investment portfolio is other-than-temporarily impaired. In October 2013, we sold five securities amounting to $5.2 million in amortized cost as part of a portfolio review. Some of the positions were temporarily impaired and others were not, and the sales resulted in a net gain of approximately $8 thousand. We do not have the intent, and it is more likely than not that we will not have to sell the remaining securities temporarily impaired at September 30, 2013 before recovery of the cost basis.
 
Fifty-two and fifty-five investment securities were in unrealized loss positions at September 30, 2013 and December 31, 2012, respectively. They are summarized and classified according to the duration of the loss period as follows:
 

Page-14



September 30, 2013
 
< 12 continuous months
 
 
> 12 continuous months
 
 
Total Securities
 in a loss position
 
(In thousands; unaudited)
 
Fair value

 
Unrealized loss

 
Fair value

 
Unrealized loss

 
Fair value

 
Unrealized loss

Held-to-maturity
 
 
 
 
 
 
 
 
 
 
 
 
Obligations of state & political subdivisions
 
$
24,675

 
$
(711
)
 
2,551

 
(34
)
 
$
27,226

 
$
(745
)
Corporate bonds
 
10,002

 
(89
)
 
1,434

 
(1
)
 
11,436

 
(90
)
Total held-to-maturity
 
34,677

 
(800
)
 
3,985

 
(35
)
 
38,662

 
(835
)
Available-for-sale
 
 
 
 
 
 
 
 
 
 
 
 
MBS pass-through securities issued by FNMA and FHLMC
 
16,612

 
(515
)
 

 

 
16,612

 
(515
)
CMOs issued by FHLMC
 
2,716

 
(22
)
 

 

 
2,716

 
(22
)
CMOs issued by GNMA
 
4,190

 
(33
)
 

 

 
4,190

 
(33
)
Debentures of government- sponsored agencies
 
14,459

 
(541
)
 

 

 
14,459

 
(541
)
Privately issued CMOs
 
5,615

 
(61
)
 
167

 
(1
)
 
5,782

 
(62
)
Total available-for-sale
 
43,592

 
(1,172
)
 
167

 
(1
)
 
43,759

 
(1,173
)
Total temporarily impaired securities
 
$
78,269

 
$
(1,972
)
 
$
4,152

 
$
(36
)
 
$
82,421

 
$
(2,008
)
 
December 31, 2012
 
< 12 continuous months
 
 
> 12 continuous months
 
 
Total Securities
 in a loss position
(In thousands)
 
Fair value

 
Unrealized loss

 
Fair value

 
Unrealized loss

 
Fair value

 
Unrealized loss

Held-to-maturity
 
 
 
 
 
 
 
 
 
 
 
 
Obligations of state & political subdivisions
 
$
33,196

 
$
(427
)
 
$

 
$

 
$
33,196

 
$
(427
)
Corporate bonds
 
15,649

 
(107
)
 

 

 
15,649

 
(107
)
Total held-to-maturity
 
48,845

 
(534
)
 

 

 
48,845

 
(534
)
Available-for-sale
 
 
 
 
 
 
 
 
 
 
 
 
MBS pass-through securities issued by FNMA and FHLMC
 
3,569

 
(40)

 

 

 
3,569

 
(40)

CMOs issued by FNMA
 
3,185

 
(2)

 

 

 
3,185

 
(2)

CMOs issued by GNMA
 
1,550

 
(1)

 

 

 
1,550

 
(1)

Debentures of government- sponsored agencies
 
9,899

 
(101)

 

 

 
9,899

 
(101)

Privately issued CMOs
 
4,214

 
(89)

 
203

 
(1)

 
4,417

 
(90)

Total available-for-sale
 
22,417
 
(233)
 
203

 
(1)

 
22,620
 
(234)
Total temporarily impaired securities
 
$
71,262

 
$
(767
)
 
$
203

 
$
(1
)
 
$
71,465

 
$
(768
)
 
Forty-eight securities in our portfolio were in a temporary loss position for less than twelve months as of September 30, 2013. We determine that the strengths of GNMA and FNMA through guarantee or support from the U.S. Federal Government are sufficient to protect us from credit losses. The other temporarily impaired securities are deemed credit worthy after our periodic impairment analysis and are all rated as investment grade by at least one major rating agency. We also monitor the financial information of the issuers of obligations of U.S. states and political subdivisions. As a result of this impairment analysis, we concluded that these securities were not other-than-temporarily impaired at September 30, 2013.

Page-15




As of September 30, 2013, there were two obligations of state and political subdivisions bonds, one corporate bond and one CMO privately issued by a financial institution (with no guarantee from government sponsored agencies) in a continuous loss position for more than twelve months. We believe the decline in fair value is primarily driven by factors other than credit from our review of the issuer's financial information and it is probable that we will be able to collect all amounts due according to the contractual terms and that no other-than-temporary impairment exists. The two obligations of state and political subdivisions bonds and the corporate bond were rated as investment grade by at least one of the rating agencies. The CMO issued by a financial institution is collateralized by residential mortgages with low loan-to-value ratios and delinquency ratios and may be prepaid at par prior to maturity. We reviewed the loans collateralizing the security, credit scores of the borrowers, historical default rates and loss severities. Based upon our assessment of expected credit losses of the security given the performance of the underlying collateral and the credit enhancements, we concluded that the security was not other-than-temporarily impaired at September 30, 2013. In addition, the security was rated as investment grade by both Moody's and S&P.

Securities Carried at Cost
 
As a member of the FHLB, we are required to maintain a minimum investment in the FHLB capital stock determined by the Board of Directors of the FHLB. The minimum investment requirements can also increase in the event we need to increase our borrowing capacity with the FHLB. Shares cannot be purchased or sold except between the FHLB and its members at its $100 per share par value. We held $6.5 million and $6.0 million of FHLB stock recorded at cost in other assets on the consolidated statements of condition at September 30, 2013, and December 31, 2012, respectively. On October 29, 2013, the FHLB declared a cash dividend for the third quarter of 2013 at an annualized dividend rate of 5.65%. Management does not believe that the FHLB stock is other-than-temporarily-impaired, as we expect to be able to redeem this stock at cost.

As a member bank of Visa U.S.A., we hold 16,939 shares of Visa Inc. Class B common stock with a carrying value of zero, which is equal to our cost basis. These shares are restricted from resale until their conversion into Class A (voting) shares upon the termination of Visa Inc.'s covered litigation escrow account. As a result of the restriction, these shares are not considered available-for-sale and are not carried at fair value. Upon conversion of this Class B common stock at a conversion rate of 0.4206 to Class A common stock, the value would be $1.4 million and $1.1 million at September 30, 2013 and December 31, 2012, respectively. The conversion rate is subject to further reduction upon the final settlement of the covered litigation against Visa Inc. and its member banks. See Note 9 herein.


Page-16



Note 6:  Loans and Allowance for Loan Losses
 
Credit Quality of Loans
 
Outstanding loans by class and payment aging as of September 30, 2013 and December 31, 2012 are as follows:
 
Loan Aging Analysis by Class as of September 30, 2013 and December 31, 2012
(dollars in thousands; 2013 unaudited)
Commercial and industrial

 
Commercial real estate, owner-occupied

 
Commercial real estate, investor

 
Construction

 
Home equity

 
Other residential 1

 
Installment and other consumer

 
Total

September 30, 2013
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 30-59 days past due
$
5

 
$

 
$

 
$
1,720

 
$

 
$

 
$
246

 
$
1,971

 60-89 days past due

 

 

 

 
240

 

 
2

 
242

Greater than 90 days past due (non-accrual) 2
1,229

 
1,403

 
5,832

 
7,045

 
359

 
1,117

 
311

 
17,296

Total past due
1,234

 
1,403

 
5,832

 
8,765

 
599

 
1,117

 
559

 
19,509

Current
167,606

 
204,770

 
541,505

 
16,228

 
85,605

 
42,455

 
15,173

 
1,073,342

Total loans 3
$
168,840

 
$
206,173

 
$
547,337

 
$
24,993

 
$
86,204

 
$
43,572

 
$
15,732

 
$
1,092,851

Non-accrual loans to total loans
0.7
%
 
0.7
%
 
1.1
%
 
28.2
%
 
0.4
%
 
2.6
%
 
2.0
%
 
1.6
%
December 31, 2012
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 30-59 days past due
$
29

 
$

 
$

 
$

 
$
294

 
$
167

 
$
98

 
$
588

 60-89 days past due

 

 

 

 

 

 

 

Greater than 90 days past due (non-accrual) 2
4,893

 
1,403

 
6,843

 
2,239

 
545

 
1,196

 
533

 
17,652

Total past due
4,922

 
1,403

 
6,843

 
2,239

 
839

 
1,363

 
631

 
18,240

Current
171,509

 
195,003

 
502,163

 
28,426

 
92,398

 
48,069

 
18,144

 
1,055,712

Total loans 3
$
176,431

 
$
196,406

 
$
509,006

 
$
30,665

 
$
93,237

 
$
49,432

 
$
18,775

 
$
1,073,952

Non-accrual loans to total loans
2.8
%
 
0.7
%
 
1.3
%
 
7.3
%
 
0.6
%
 
2.4
%
 
2.8
%
 
1.6
%
1 Our residential loan portfolio includes no sub-prime loans, nor is it our normal practice to underwrite loans commonly referred to as "Alt-A mortgages", the characteristics of which are loans lacking full documentation, borrowers having low FICO scores or higher loan-to-value ratios.

2 Amounts include $1.4 million and $1.6 million of Purchased Credit Impaired ("PCI") loans that have stopped accreting interest at September 30, 2013 and December 31, 2012, respectively, and exclude accreting PCI loans of $2.2 million and $3.0 million at September 30, 2013 and December 31, 2012, respectively, as their accretable yield interest recognition is independent from the underlying contractual loan delinquency status. There were no accruing loans past due more than ninety days at September 30, 2013 or December 31, 2012.

3 Amounts were net of deferred loan fees of $107 thousand and $769 thousand at September 30, 2013 and December 31, 2012, respectively. Amounts were also net of unaccreted purchase discounts on non-PCI loans of $1.5 million and $2.1 million at September 30, 2013 and December 31, 2012, respectively.

Our commercial loans are generally made to established small to mid-sized businesses to provide financing for their working capital needs or acquisition of fixed assets.  Management examines historical, current, and projected cash flows to determine the ability of the borrower to repay obligations as agreed. Commercial loans are primarily made based on the identified cash flows of the borrower and secondarily on the underlying collateral. The cash flows of borrowers, however, may not occur as expected, and the collateral securing these loans may fluctuate in value. Most commercial and industrial loans are secured by the assets being financed, such as accounts receivable or inventory, and include a personal guarantee. Some short-term loans may be made on an unsecured basis. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers. We target stable local businesses with strong guarantors that have proven to be more resilient in periods of economic stress.  Typically, the strong guarantors provide an additional source of repayment for most of our credit extensions.
 
Commercial real estate loans are subject to underwriting standards and processes similar to commercial loans discussed above. We underwrite these loans to be repaid from cash flow and to be supported by real property collateral. Repayment of commercial real estate loans is largely dependent on the successful operation of the property securing the loan, or of the business conducted on the property securing the loan. Underwriting standards for commercial real estate loans include, but are not limited to, conservative debt coverage and loan-to-value ratios. Furthermore, substantially all of our loans are guaranteed by the owners of the properties.  Commercial real estate loans may be adversely affected by conditions in the real estate markets or in the general economy. In the event of a vacancy, strong guarantors have historically carried the loans until a replacement tenant can be found.  The owner's substantial equity investment provides a strong economic incentive to continue to support the commercial real estate projects. As such, we have generally experienced a relatively low level of loss and delinquencies in this portfolio.

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Construction loans are generally made to developers and builders to finance land acquisition as well as the subsequent construction. These loans are underwritten after evaluation of the borrower's financial strength, reputation, prior track record, and after obtaining independent appraisals. The construction industry can be impacted by major factors, including: the inherent volatility of real estate markets and vulnerability to delays due to weather, change orders, ability to obtain construction permits, labor or material shortages, and price hikes. Estimates of construction costs and value associated with the complete project may be inaccurate. Repayment of construction loans is largely dependent on the ultimate success of the project.
 
Consumer loans primarily consist of home equity lines of credit, other residential (tenancy-in-common, or “TIC”) loans, and other personal loans. We originate consumer loans utilizing credit score information, debt-to-income ratio and loan-to-value ratio analysis. To monitor and manage consumer loan risk, policies and procedures are developed and modified, as needed. This activity, coupled with relatively small loan amounts that are spread across many individual borrowers, mitigates risk. Additionally, trend reports are reviewed by Management on a regular basis. Underwriting standards for home equity lines of credit include, but are not limited to, a conservative loan-to-value ratio, the number of such loans a borrower can have at one time, and documentation requirements. Our underwriting of the other residential loans, mostly secured by TIC units in San Francisco, is cautious compared to traditional residential mortgages due to the unique ownership structure.  However, these borrowers tend to have more equity in their properties, which mitigates risk. Personal loans are nearly evenly split between mobile home loans and floating home loans along with a small number of installment loans.
 
We use a risk rating system to evaluate asset quality, and to identify and monitor credit risk in individual loans, and ultimately in the portfolio. Definitions of loans that are risk graded “Special Mention” or worse are consistent with those used by the Federal Deposit Insurance Corporation ("FDIC").  Our internally assigned grades are as follows:
 
Pass – Loans to borrowers of acceptable or better credit quality. Borrowers in this category demonstrate fundamentally sound financial positions, repayment capacity, credit history and management expertise.  Loans in this category must have an identifiable and stable source of repayment and meet the Bank’s policy regarding debt service coverage ratios.  These borrowers are capable of sustaining normal economic, market or operational setbacks without significant financial impacts.  Financial ratios and trends are acceptable.  Negative external industry factors are generally not present.  The loan may be secured, unsecured or supported by non-real estate collateral for which the value is more difficult to determine and/or marketability is more uncertain. This category also includes “Watch” loans, where the primary source of repayment has been delayed. “Watch” is intended to be a transitional grade, with either an upgrade or downgrade within a reasonable period.
 
Special Mention - Potential weaknesses that deserve close attention. If left uncorrected, those potential weaknesses may result in deterioration of the payment prospects for the asset. Special Mention assets do not present sufficient risk to warrant adverse classification.
 
Substandard - Inadequately protected by either the current sound worth and paying capacity of the obligor or the collateral pledged, if any. A Substandard asset has a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. Substandard assets are characterized by the distinct possibility that we will sustain some loss if such weaknesses or deficiencies are not corrected. Loss potential, while inherent in the aggregate substandard amount, does not necessarily exist in the individual assets classified Substandard. Well-defined weaknesses include adverse trends or developments of the borrower’s financial condition, managerial weaknesses and/or significant collateral deficiencies.
 
Doubtful - Critical weaknesses that make collection or liquidation in full improbable. There may be specific pending events that work to strengthen the asset, however, the amount or timing of the loss may not be determinable. Pending events generally occur within one year of the asset being classified as Doubtful. Examples include: merger, acquisition, or liquidation; capital injection; guarantee; perfecting liens on additional collateral; and refinancing. Such loans are placed on non-accrual status and usually are collateral-dependent.

We regularly review our credits for accuracy of risk grades whenever new information is received. Borrowers are required to submit financial information at regular intervals:

Generally, commercial borrowers with lines of credit are required to submit financial information with reporting intervals ranging from monthly to annually depending on credit size, risk and complexity.

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Investor commercial real estate borrowers with loans greater than $750 thousand are required to submit rent rolls or property income statements at least annually.
Construction loans are monitored monthly, and assessed on an ongoing basis.
Home equity and other consumer loans are assessed based on delinquency.
Loans graded “Watch” or more severe, regardless of loan type, are assessed no less than quarterly.

The following table represents our analysis of loans by internally assigned grades, including the PCI loans, at September 30, 2013 and December 31, 2012:

 
(in thousands; 2013 unaudited)
Commercial and industrial

 
Commercial real estate, owner-occupied

 
Commercial real estate, investor

 
Construction

 
Home equity

 
Other residential

 
Installment and other consumer

 
Purchased credit-impaired

 
Total

Credit Risk Profile by Internally Assigned Grade:
 
 
 
 
 
 
 
 
 
 
 
 
September 30, 2013
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Pass
$
148,974

 
$
183,754

 
$
529,573

 
$
16,669