Document
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 June 30, 2018
 
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, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act.
         
Large accelerated filer o
 
     Accelerated filer x
Non-accelerated filer o
(Do not check if a smaller reporting company)
     Smaller reporting company o
Emerging growth company o
 
 
 
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.
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 July 31, 2018, there were 6,993,452 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 
June 30, 2018 and December 31, 2017
(in thousands, except share data; unaudited)
June 30, 2018

December 31, 2017

Assets
 

 
Cash and due from banks
$
83,855

$
203,545

Investment securities
 

 
Held-to-maturity, at amortized cost
170,652

151,032

Available-for-sale, at fair value
388,137

332,467

Total investment securities
558,789

483,499

Loans, net of allowance for loan losses of $15,813 and $15,767 at
June 30, 2018 and December 31, 2017, respectively
1,701,798

1,663,246

Bank premises and equipment, net
7,965

8,612

Goodwill
30,140

30,140

Core deposit intangible
6,032

6,492

Interest receivable and other assets
76,463

72,620

Total assets
$
2,465,042

$
2,468,154

 
 
 
Liabilities and Stockholders' Equity
 

 

Liabilities
 

 

Deposits
 

 

Non-interest bearing
$
1,057,745

$
1,014,103

Interest bearing
 

 
Transaction accounts
132,272

169,195

Savings accounts
179,187

178,473

Money market accounts
631,479

626,783

Time accounts
137,040

160,116

Total deposits
2,137,723

2,148,670

Subordinated debentures
5,802

5,739

Interest payable and other liabilities
17,319

16,720

Total liabilities
2,160,844

2,171,129

 
 
 
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 - 6,991,821 and 6,921,542 at
June 30, 2018 and December 31, 2017, respectively
146,195

143,967

Retained earnings
166,281

155,544

Accumulated other comprehensive loss, net of taxes
(8,278
)
(2,486
)
Total stockholders' equity
304,198

297,025

Total liabilities and stockholders' equity
$
2,465,042

$
2,468,154


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

Page-3



BANK OF MARIN BANCORP
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
 
Three months ended
 
Six months ended
(in thousands, except per share amounts; unaudited)
June 30, 2018
June 30, 2017
 
June 30, 2018
June 30, 2017
Interest income
 
 

 
 
 
Interest and fees on loans
$
19,624

$
16,423

 
$
38,511

$
32,272

Interest on investment securities
 
 
 
 
 

Securities of U.S. government agencies
2,860

1,534

 
5,335

3,052

Obligations of state and political subdivisions
604

553

 
1,242

1,121

Corporate debt securities and other
35

36

 
79

73

Interest on Federal funds sold and due from banks
285

157

 
688

217

Total interest income
23,408

18,703

 
45,855

36,735

Interest expense
 

 

 
 

 

Interest on interest-bearing transaction accounts
48

21

 
100

50

Interest on savings accounts
18

16

 
36

31

Interest on money market accounts
236

114

 
452

227

Interest on time accounts
140

139

 
296

285

Interest on Federal Home Loan Bank ("FHLB") and other borrowings
1


 
1


Interest on subordinated debentures
123

109

 
237

217

Total interest expense
566

399

 
1,122

810

Net interest income
22,842

18,304

 
44,733

35,925

Provision for loan losses


 


Net interest income after provision for loan losses
22,842

18,304

 
44,733

35,925

Non-interest income
 

 
 
 

 

Service charges on deposit accounts
455

447

 
932

899

Wealth Management and Trust Services
488

504

 
1,003

1,007

Debit card interchange fees
360

384

 
756

756

Merchant interchange fees
118

112

 
198

208

Earnings on bank-owned life insurance
230

210

 
458

419

Dividends on FHLB stock
192

176

 
388

408

Gains on investment securities, net
11

10

 
11

10

Other income
384

253

 
734

504

Total non-interest income
2,238

2,096

 
4,480

4,211

Non-interest expense
 

 
 
 

 

Salaries and related benefits
8,316

7,287

 
17,333

14,762

Occupancy and equipment
1,511

1,380

 
3,018

2,699

Depreciation and amortization
546

463

 
1,093

944

Federal Deposit Insurance Corporation insurance
191

162

 
382

323

Data processing
1,023

963

 
2,404

1,902

Professional services
810

522

 
2,109

1,044

Directors' expense
183

224

 
357

382

Information technology
264

186

 
533

384

Provision for losses on off-balance sheet commitments

(208
)
 

(43
)
Other expense
1,665

1,652

 
3,361

3,245

Total non-interest expense
14,509

12,631

 
30,590

25,642

Income before provision for income taxes
10,571

7,769

 
18,623

14,494

Provision for income taxes
2,680

2,583

 
4,343

4,760

Net income
$
7,891

$
5,186

 
$
14,280

$
9,734

Net income per common share:
 

 
 
 

 
Basic
$
1.14

$
0.85

 
$
2.06

$
1.60

Diluted
$
1.12

$
0.84

 
$
2.03

$
1.58

Weighted average shares:
 
 

 
 

 

Basic
6,944

6,110

 
6,929

6,101

Diluted
7,033

6,174

 
7,019

6,173

Dividends declared per common share
$
0.31

$
0.27

 
$
0.60

$
0.54

Comprehensive income:
 
 
 
 


Net income
$
7,891

$
5,186

 
$
14,280

$
9,734

Other comprehensive (loss) income




 




Change in net unrealized gain or loss on available-for-sale securities
(1,131
)
1,961

 
(7,301
)
3,635

Reclassification adjustment for gains on available-for-sale securities in net income
(11
)
(10
)
 
(11
)
(10
)
Net unrealized loss on securities transferred from available-for-sale to held-to-maturity
(278
)

 
(278
)

Amortization of net unrealized losses on securities transferred from available-for-sale to held-to-maturity
132

124

 
268

165

Subtotal
(1,288
)
2,075

 
(7,322
)
3,790

Deferred tax (benefit) expense
(384
)
892

 
(2,168
)
1,596

Other comprehensive (loss) income, net of tax
(904
)
1,183

 
(5,154
)
2,194

Comprehensive income
$
6,987

$
6,369

 
$
9,126

$
11,928

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

Page-4



BANK OF MARIN BANCORP
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
for the year ended December 31, 2017 and the six months ended June 30, 2018
(in thousands, except share data; unaudited)
Common Stock
Retained
Earnings

Accumulated Other
Comprehensive Loss ("AOCI"),
Net of Taxes

 Total

Shares

Amount

Balance at December 31, 2016
6,127,314

$
87,392

$
146,464

$
(3,293
)
$
230,563

Net income


15,976


15,976

Other comprehensive income



807

807

Stock options exercised, net of shares surrendered for cashless exercises and tax withholdings
9,266

28



28

Stock issued under employee stock purchase plan
512

32



32

Stock issued under employee stock ownership plan ("ESOP")
29,547

1,850



1,850

Restricted stock granted
16,230





Stock-based compensation - stock options

529



529

Stock-based compensation - restricted stock

742



742

Cash dividends paid on common stock


(6,896
)

(6,896
)
Stock purchased by directors under director stock plan
531

35



35

Stock issued in payment of director fees
2,878

188



188

Stock and stock options issued to Bank of Napa shareholders (net of payment for fractional shares of $14 thousand)
735,264

53,171



53,171

Balance at December 31, 2017
6,921,542

$
143,967

$
155,544

$
(2,486
)
$
297,025

Net income
 
 
14,280

 
14,280

Other comprehensive loss
 
 
 
(5,154
)
(5,154
)
Reclassification of stranded tax effects in AOCI
 
 
638

(638
)

Stock options exercised, net of shares surrendered for cashless exercises and tax withholdings
50,075

534

 
 
534

Stock issued under employee stock purchase plan
265

19

 
 
19

Stock issued under ESOP
7,900

601

 
 
601

Restricted stock granted
18,520

 
 
 

Restricted stock surrendered for tax withholdings upon vesting
(658
)
(45
)
 
 
(45
)
Restricted stock forfeited / cancelled
(6,028
)
 
 
 

Stock-based compensation - stock options
 
442

 
 
442

Stock-based compensation - restricted stock
 
672

 
 
672

Cash dividends paid on common stock
 
 
(4,181
)
 
(4,181
)
Stock purchased by directors under director stock plan
260

18

 
 
18

Stock issued in payment of director fees
1,343

91

 
 
91

Stock repurchased, net of commissions
(1,398
)
(104
)
 
 
(104
)
Balance at June 30, 2018
6,991,821

146,195

166,281

(8,278
)
304,198


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

Page-5



BANK OF MARIN BANCORP
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the six months ended June 30, 2018 and 2017
(in thousands; unaudited)
June 30, 2018
 
June 30, 2017
Cash Flows from Operating Activities:
 
 
 
Net income
$
14,280

 
$
9,734

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

 
 

Reversal of losses on off-balance sheet commitments

 
(43
)
Noncash contribution expense to employee stock ownership plan
601

 

Noncash director compensation expense
146

 
106

Stock-based compensation expense
1,114

 
710

Amortization of core deposit intangible
460

 
236

Amortization of investment security premiums, net of accretion of discounts
1,496

 
1,496

Accretion of discount on acquired loans
(428
)
 
(498
)
Accretion of discount on subordinated debentures
63

 
80

Net change in deferred loan origination costs/fees
18

 
60

Gain on sale of investment securities
(11
)
 
(10
)
Depreciation and amortization
1,093

 
944

Gain on sale of repossessed assets

 
(1
)
Earnings on bank-owned life insurance policies
(458
)
 
(419
)
Net change in operating assets and liabilities:
 
 
 
Deferred rent and other rent-related expenses
(179
)
 
114

Interest receivable and other assets
(971
)
 
93

Interest payable and other liabilities
1,543

 
(389
)
Total adjustments
4,487

 
2,479

Net cash provided by operating activities
18,767

 
12,213

Cash Flows from Investing Activities:
 

 
 

Purchase of held-to-maturity securities
(1,989
)
 
(4,496
)
Purchase of available-for-sale securities
(121,269
)
 
(9,377
)
Proceeds from sale of available-for-sale securities
5,006

 
1,321

Proceeds from paydowns/maturities of held-to-maturity securities
9,615

 
14,601

Proceeds from paydowns/maturities of available-for-sale securities
24,540

 
15,385

Loans originated and principal collected, net
(38,835
)
 
(4,563
)
Purchase of premises and equipment
(446
)
 
(814
)
Proceeds from sale of other real estate owned or repossessed assets

 
170

Cash paid for low-income housing tax credit investment
(373
)
 
(628
)
Net cash (used in) provided by investing activities
(123,751
)
 
11,599

Cash Flows from Financing Activities:
 

 
 

Net (decrease) increase in deposits
(10,947
)
 
67,840

Proceeds from stock options exercised
585

 
88

Payment of tax withholdings for stock options exercised and vesting of restricted stock
(96
)
 
(60
)
Proceeds from stock issued under employee and director stock purchase plans
37

 
737

Stock repurchased, net of commissions
(104
)
 

Cash dividends paid on common stock
(4,181
)
 
(3,315
)
Net cash (used in) provided by financing activities
(14,706
)
 
65,290

Net (decrease) increase in cash and cash equivalents
(119,690
)
 
89,102

Cash and cash equivalents at beginning of period
203,545

 
48,804

Cash and cash equivalents at end of period
$
83,855

 
$
137,906

Supplemental disclosure of cash flow information:
 
 
 
Cash paid in interest
$
1,083

 
$
751

Cash paid in income taxes
$
2,000

 
$
4,620

Supplemental disclosure of noncash investing and financing activities:
 

 
 

Change in net unrealized gain or loss on available-for-sale securities
$
(7,301
)
 
$
3,635

Securities transferred from available-for-sale to held-to-maturity
$
27,422

 
$
128,965

Amortization of net unrealized loss on available-for-sale securities transferred to held-to-maturity
$
268

 
$
165

Stock issued to ESOP
$
601

 
$

Stock issued in payment of director fees
$
91

 
$
82


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

Page-6



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
 
Note 1:  Basis of Presentation
 
The consolidated financial statements include the accounts of Bank of Marin Bancorp (“Bancorp”), a bank holding company, and its wholly-owned bank subsidiary, Bank of Marin (the “Bank”), a California state-chartered commercial bank. References to “we,” “our,” “us” mean Bancorp and the Bank that are consolidated for financial reporting purposes. The accompanying unaudited consolidated interim financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission ("SEC"). Certain information and note disclosures normally included in annual financial statements prepared in accordance with U.S. generally accepted accounting principles ("GAAP") have been condensed or omitted pursuant to those rules and regulations. Although we believe that the disclosures are adequate and the information presented is not misleading, we suggest that these interim financial statements be read in conjunction with the annual financial statements and the notes thereto included in our 2017 Annual Report on Form 10-K.  In the opinion of Management, the unaudited consolidated financial statements reflect all adjustments, which are necessary for a fair presentation of the consolidated financial position, the results of operations, changes in comprehensive income, changes in stockholders’ equity, and cash flows for the periods presented. All material intercompany transactions have been eliminated. The results of these interim periods may not be indicative of the results for the full year or for any other period.

The NorCal Community Bancorp Trusts I and II, respectively (the "Trusts") were formed for the sole purpose of issuing trust preferred securities. Bancorp is not considered the primary beneficiary of the Trusts (variable interest entities), therefore the Trusts are not consolidated in our consolidated financial statements, but rather the subordinated debentures are shown as a liability on our consolidated statements of condition (See Note 6, Borrowings). Bancorp accounts for its investment in the securities of the Trusts under the equity method, which is included in interest receivable and other assets in the consolidated statements of condition.
 
The following table shows: 1) weighted average basic shares, 2) potentially dilutive weighted average common shares related to stock options and unvested restricted stock awards, 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 awards. Diluted EPS are calculated using the weighted average number of potentially dilutive common shares. The number of potentially dilutive common shares included in the 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 potentially dilutive common shares included in year-to-date diluted EPS is a year-to-date weighted average of potentially dilutive common shares included in each quarterly diluted EPS computation. In computing diluted EPS, we exclude anti-dilutive shares such as options whose exercise prices exceed the current common stock price, as they would not reduce EPS under the treasury method. We have two forms of outstanding common stock: common stock and unvested restricted stock awards. Holders of unvested restricted stock awards receive non-forfeitable dividends at the same rate as common shareholders and they both share equally in undistributed earnings. Under the two-class method, the difference in EPS is nominal for these participating securities.
 
Three months ended
 
Six months ended
(in thousands, except per share data)
June 30, 2018
June 30, 2017
 
June 30, 2018
June 30, 2017
Weighted average basic shares outstanding
6,944

6,110

 
6,929

6,101

Potentially dilutive common shares related to:
 
 
 
 
 
Stock options
74

52

 
74

57

Unvested restricted stock awards
15

12

 
16

15

Weighted average diluted shares outstanding
7,033

6,174

 
7,019

6,173

Net income
$
7,891

$
5,186

 
$
14,280

$
9,734

Basic EPS
$
1.14

$
0.85

 
$
2.06

$
1.60

Diluted EPS
$
1.12

$
0.84

 
$
2.03

$
1.58

Weighted average anti-dilutive shares not included in the calculation of diluted EPS
30

33

 
35

23


Page-7



Note 2: Recently Adopted and Issued Accounting Standards

Accounting Standards Adopted in 2018

In May 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2014-09, Revenue from Contracts with Customers (Topic 606). The core principle of this ASU (and all subsequent updates) is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services. This ASU establishes a five-step model that must be used to recognize revenue that requires the entity to identify the contract with a customer, identify the performance obligations in the contract, determine the transaction price, allocate the transaction price to the performance obligations in the contract, and recognize revenue when (or as) the entity satisfies the performance obligation. The ASU does not apply to the majority of our revenue, including revenue associated with financial instruments, such as loans and investment securities, and certain non-interest income, such as earnings on bank-owned life insurance, dividends on Federal Home Loan Bank ("FHLB") stock, gains or losses on sales of investment securities, and deposit overdraft charges. The standard allowed the use of either the full retrospective or modified retrospective transition method. We elected to apply the modified retrospective transition method to incomplete contracts as of the initial date of application on January 1, 2018. The adoption of the new standards did not have a material impact on our financial condition or results of operations as revenue recognition under the new standards did not change significantly from our current practice of recognizing the in-scope non-interest income. In addition, we did not retroactively revise prior period amounts or record a cumulative adjustment to retained earnings upon adoption. We considered the nature, amount, timing, and uncertainty of revenue from contracts with customers and determined that significant revenue streams are sufficiently disaggregated in the consolidated statements of comprehensive income.

Descriptions of our significant revenue-generating transactions that are within the scope of the new revenue recognition standards, which are presented in the consolidated statements of comprehensive income as components of non-interest income, are as follows:

Wealth Management & Trust ("WM&T") fees - WM&T services include, but are not limited to: customized investment advisory and management; administrative services such as bill pay and tax reporting; trust administration, estate settlement, custody and fiduciary services. Performance obligations for investment advisory and management services are generally satisfied over time. Revenue is recognized monthly according to a tiered fee schedule based on the client's month-end market value of assets under our management. WM&T does not earn revenue based on performance or incentives. Costs associated with WM&T revenue-generating activities, such as payments to sub-advisors, are recorded separately as part of professional service expenses when incurred.

Deposit account service charges - Service charges on deposit accounts consist of monthly maintenance fees, business account analysis fees, business online banking fees, check order charges, and other deposit account-related fees. Performance obligations for monthly maintenance fees and account analysis fees are satisfied, and the related revenue recognized, when we complete our performance obligation each month. Performance obligations related to transaction-based services (such as check orders) are satisfied, and the related revenue recognized, at a point in time when completed, except for business accounts subject to analysis where the transaction-based fees are part of the monthly account analysis fees.

Debit card interchange fees - We issue debit cards to our consumer and small business customers that allow them to purchase goods and services from merchants in person, online, or via mobile devices using funds held in their demand deposit accounts held with us. Debit cards issued to our customers are part of global electronic payment networks (such as Visa) who pass a portion of the merchant interchange fees to debit card-issuing member banks like us when our customers make purchases through their networks. Performance obligations for debit card services are satisfied and revenue is recognized daily as the payment networks process transactions. Because we act in an agent capacity, we determined that network costs previously recorded as a component of non-interest expense should be netted with interchange fees recorded in non-interest income. Network costs were immaterial for the six months ended June 30, 2018 and 2017.

In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. The amendments in this ASU make improvements to accounting standards related to financial instruments, including the following:


Page-8



Requires equity investments, except for those accounted for under the equity method of accounting or those that result in consolidation of the investee, to be measured at fair value with changes in fair value recognized in net income. However, an entity may choose to measure equity investments that do not have readily determinable fair values at cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer.
Simplifies the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment. When impairment exists, an entity is required to measure the investment at fair value.
Eliminates the requirement to disclose the method(s) and significant assumptions used to estimate the fair value required under current standards for financial instruments measured at amortized cost on the consolidated balance sheet.
Requires public companies to use the exit price notion when measuring and disclosing the fair value of financial instruments.
Requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset (i.e., securities or loans and receivables) on the balance sheet or the accompanying notes to the financial statements.
Clarifies that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in combination with the entity's other deferred tax assets.

We adopted the requirements of this ASU effective January 1, 2018, which did not have a material impact on our financial condition and results of operations. The fair value of our loans held for investment, which is recorded at amortized cost, now incorporates the exit price notion reflecting factors such as a liquidity premium. See Note 3, Fair Value of Assets and Liabilities.
 
In August 2016, the FASB issued ASU No. 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments. This ASU provides guidance on how to present and classify eight specific cash flow topics in the statement of cash flows. The ASU is effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. The amendments should be applied using a retrospective transition method to each period presented, if practical. We adopted the requirements of this ASU effective January 1, 2018, which did not impact our financial condition, results of operations, or related financial statement disclosures for the periods presented.

In January 2017, the FASB issued ASU No. 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business. The amendments are intended to help companies evaluate whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses and provide a more robust framework to use in determining when a set of assets and activities is a business. The amendments should be applied prospectively and are effective for annual periods after December 31, 2017, including interim periods within those periods. We adopted the amendments effective January 1, 2018, which did not impact our financial condition, results of operations, or related financial statement disclosures in the first quarter of 2018.

In May 2017, the FASB issued ASU No. 2017-09, Compensation - Stock Compensation (Topic 718): Scope of Modification Accounting. This ASU applies to entities that change the terms or conditions of a share-based payment award. The FASB adopted this ASU to provide clarity in what constitutes a modification and to reduce diversity in practice in applying Topic 718. In order for a change to a share-based arrangement to not require Topic 718 modification accounting treatment, all of the following must be met: no change in fair value, no change in vesting conditions and no change in the balance sheet classification of the modified award. The ASU is effective for fiscal years beginning after December 15, 2017, including interim periods within those periods. Early adoption is permitted, including adoption in an interim period. The amendments should be applied prospectively to an award modified on or after the adoption date. We adopted the requirements of this ASU effective January 1, 2018, which did not impact our financial condition, results of operation, or related financial statement disclosures.

In August 2017, the FASB issued ASU No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities. This amendment changes both the designation and measurement guidance for qualifying hedging relationships and the presentation of hedge results. It is intended to more closely align hedge accounting with companies' risk management strategies, simplify the application of hedge accounting and increase transparency as to the scope and results of hedging programs. The ASU is effective for fiscal years beginning after

Page-9



December 15, 2018, and interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. We early-adopted the amendments of this ASU in the second quarter of 2018, and elected to perform hedge effectiveness assessments using a qualitative approach instead of quantitative regression analysis going forward. The adoption of this ASU had an immaterial impact to our financial results. The amendments also require additional disclosures, which are included in Note 9, Derivative Financial Instruments and Hedging Activities.

In February 2018, the FASB issued ASU No. 2018-02, Income Statement - Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. This amendment helps organizations address certain stranded income tax effects in accumulated other comprehensive income (AOCI) resulting from the enactment of the Tax Cuts and Jobs Act of 2017. The ASU requires financial statement preparers to disclose a description of the accounting policy for releasing income tax effects from AOCI, whether or not they elect to reclassify the stranded income tax effects from the Tax Cuts and Jobs Act of 2017, and information about the other income tax effects that are reclassified. The amendments are effective for all organizations for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Early adoption is permitted. The amendments in this ASU should be applied in either the period of adoption or retrospectively to each period (or periods) in which the effect of the change in the U.S. federal corporate tax rate in the Tax Cuts and Jobs Act of 2017 is recognized. We early adopted this ASU in the first quarter of 2018. See Note 7, Stockholders' Equity.

Accounting Standards Not Yet Effective

In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842). The amendments in this ASU intend to increase transparency and comparability among organizations by recognizing an asset, which represents the right to use the asset for the lease term, and a lease liability, which is a lessee's obligation to make lease payments measured on a discounted basis. This ASU generally applies to leasing arrangements exceeding a twelve-month term. ASU 2016-02 is effective for annual periods, including interim periods within those annual periods beginning after December 15, 2018 and requires a modified retrospective method of adoption. In July 2018, the FASB issued ASU No. 2018-10, Codification Improvements to Topic 842, Leases, which provides various corrections and clarifications to ASU 2016-02. Early application of the amendments is permitted. We intend to adopt this ASU during the first quarter of 2019, as required. We completed an inventory of our lease agreements and continue to evaluate potential accounting software solutions that will aid in the transition to the new leasing guidance. As of June 30, 2018, our undiscounted operating lease obligations that were off-balance sheet totaled $16.5 million (See Note 8, Commitments and Contingencies). Upon adoption of this ASU, the present values of leases currently classified as operating leases will be recognized as lease assets and liabilities on our consolidated balance sheets. Additional disclosures of key information about our leasing arrangements will also be required. We do not expect that the ASU will have a material impact on our capital ratios or return on average assets when adopted and we are currently evaluating the effect that the ASU will have on other components of our financial condition and results of operations.

In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. Under the new guidance, entities will be required to present financial assets at the net amount expected to be collected. The measurement of expected credit losses will be based on historical experience, current conditions and reasonable and supportable forecasts that affect the collectability of a credit over its remaining life. In addition, the ASU amends the accounting for expected credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration. ASU 2016-13 is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is permitted for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. We have formed an internal Current Expected Credit Loss ("CECL") committee and are working with our third party vendor to determine the appropriate methodologies and resources to utilize in preparation for transition to the new accounting standards. The impact of this ASU on our financial condition and results of operations is not known at this time.

In June 2018, the FASB issued ASU No. 2018-07, Compensation - Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting. This update simplifies the accounting for share-based payment transactions for acquiring goods and services from nonemployees, applying some of the same requirements as employee share-based payment transactions. The ASU will not affect the accounting for share-based payment awards to nonemployee directors, which will continue to be treated as employee share-based transactions under the current standards. ASU 2018-07 is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption is permitted. We do not expect that the ASU will have a material impact on our financial condition or results of operations, as it is not our practice to issue stock-based awards to pay for goods and services from nonemployees, other than nonemployee directors.

Page-10




Note 3:  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 unadjusted quoted prices in active markets for identical assets or liabilities.
 
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 may include significant Management judgment and estimation.

Transfers between levels of the fair value hierarchy are recognized through our monthly and/or quarterly valuation process in the reporting period during which the event or circumstances that caused the transfer occurred. 

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)

Measurement Categories: Changes in Fair Value Recorded In1
June 30, 2018
 

 
 

 

 
Securities available-for-sale:
 
 
 
 
 
Mortgage-backed securities and collateralized mortgage obligations issued by U.S. government agencies
$
240,794

$

$
240,794

$

OCI
SBA-backed securities
23,954


23,954


OCI
Debentures of government sponsored agencies
32,139


32,139


OCI
Privately-issued collateralized mortgage obligations
435


435


OCI
Obligations of state and political subdivisions
87,788


87,788


OCI
Corporate bonds
3,027


3,027


OCI
Derivative financial assets (interest rate contracts)
327


327


NI
Derivative financial liabilities (interest rate contracts)
276


276


NI
December 31, 2017
 

 
 

 

 
Securities available-for-sale:
 

 
 

 

 
Mortgage-backed securities and collateralized mortgage obligations issued by U.S. government agencies
$
188,061

$

$
188,061

$

OCI
SBA-backed securities
25,982


25,817

165

OCI
Debentures of government sponsored agencies
12,938


12,938


OCI
Privately-issued collateralized mortgage obligations
1,431


1,431


OCI
Obligations of state and political subdivisions
97,491


97,491


OCI
Corporate bonds
6,564


6,564


OCI
Derivative financial assets (interest rate contracts)
74


74


NI
Derivative financial liabilities (interest rate contracts)
740


740


NI
 1 Other comprehensive income ("OCI") or net income ("NI").


Page-11



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 obligations of state and political subdivisions, U.S. agencies or government-sponsored agencies' debt securities, mortgage-backed securities, government agency-issued, privately-issued collateralized mortgage obligations, and corporate bonds. As of June 30, 2018 and December 31, 2017, there were no Level 1 securities. As of December 31, 2017, we had one Level 3 available-for-sale U.S. government agency obligation, which was paid off during the second quarter of 2018.

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 other-than-temporary impairment, and we did not record any write-downs during the six months ended June 30, 2018 or June 30, 2017.
 
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 risk 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") and Overnight Index Swap ("OIS") rates (for the very short term), quoted prices for LIBOR futures contracts, observable market prices for LIBOR and OIS 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.  We project spot rates at reset days specified by each swap contract to determine future cash flows, then discount to present value using either LIBOR or OIS curves depending on whether the swap positions are fully collateralized as of the measurement date.  When the value of any collateral placed with counterparties is less than the interest rate derivative liability, a credit valuation adjustment ("CVA") is applied to reflect the credit risk we pose to counterparties.  We have used the spread between the Standard & Poor's BBB rated U.S. Bank Composite rate and LIBOR for the closest maturity term corresponding to the duration of the swaps to derive the CVA. A similar credit risk adjustment, correlated to the credit standing of the counterparty, is made when collateral posted by the counterparty does not fully cover their liability to the Bank. For further discussion on our methodology in valuing our derivative financial instruments, refer to Note 9, Derivative Financial Instruments and Hedging Activities.

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 impaired loans that are collateral dependent and other real estate owned ("OREO"). As of June 30, 2018 and December 31, 2017, we did not carry any assets measured at fair value on a non-recurring basis.
 
 
 
 
 


Page-12



Disclosures about Fair Value of Financial Instruments
 
The following table summarizes fair value estimates for financial instruments as of June 30, 2018 and December 31, 2017, 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. Further, we have not disclosed the fair value of financial instruments specifically excluded from disclosure requirements such as bank-owned life insurance policies ("BOLI") and non-maturity deposit liabilities. Additionally, we hold shares of FHLB stock and Visa Inc. Class B common stock at cost. These shares are restricted from resale, except among member banks, and their values are discussed in Note 4, Investment Securities.
 
June 30, 2018
 
December 31, 2017
(in thousands)
Carrying Amounts

Fair Value

Fair Value Hierarchy
 
Carrying Amounts

Fair Value

Fair Value Hierarchy
Financial assets (recorded at amortized cost)
 
 
 
 
 
 
Cash and cash equivalents
$
83,855

$
83,855

Level 1
 
$
203,545

$
203,545

Level 1
Investment securities held-to-maturity
170,652

166,127

Level 2
 
151,032

151,032

Level 2
Loans, net
1,701,798

1,666,409

Level 3
 
1,663,246

1,650,198

Level 3
Interest receivable
7,814

7,814

Level 2
 
7,501

7,501

Level 2
Financial liabilities (recorded at amortized cost)
 

 
 
 
 

 
Time deposits
137,040

136,023

Level 2
 
160,116

159,540

Level 2
Subordinated debentures
5,802

6,988

Level 3
 
5,739

5,118

Level 3
Interest payable
167

167

Level 2
 
191

191

Level 2

Commitments - The value of unrecognized financial instruments is estimated based on the fee income associated with the commitments which, in the absence of credit exposure, is considered to approximate their settlement value. The fair value of commitment fees was not material at June 30, 2018 and December 31, 2017.

Note 4:  Investment Securities
 
Our investment securities portfolio consists of obligations of state and political subdivisions, corporate bonds, U.S. government agency securities, including residential and commercial mortgage-backed securities (“MBS”) and collateralized mortgage obligations (“CMOs”) issued or guaranteed by Federal National Mortgage Association ("FNMA"), Federal Home Loan Mortgage Corporation ("FHLMC"), Small Business Administration ("SBA"), or Government National Mortgage Association ("GNMA"), debentures issued by government-sponsored agencies such as FNMA, Federal Farm Credit Bureau, FHLB and FHLMC, and privately issued CMOs, as reflected in the following table.

Page-13



 
June 30, 2018
 
December 31, 2017
 
Amortized
Fair
Gross Unrealized
 
Amortized
Fair
Gross Unrealized
(in thousands)
Cost
Value
Gains
(Losses)
 
Cost
Value
Gains
(Losses)
Held-to-maturity:
 
 
 
 
 
 
 
 
 
Securities of U.S. government agencies:
 
 
 
 
 
 
 
 
 
MBS pass-through securities issued by FHLMC and FNMA
$
94,203

$
90,824

$

$
(3,379
)

$
100,376

$
100,096

$
234

$
(514
)
SBA-backed securities
8,882

8,743


(139
)
 




  CMOs issued by FNMA
11,881

11,766


(115
)
 




     CMOs issued by FHLMC
34,668

33,591


(1,077
)
 
31,010

30,938

2

(74
)
CMOs issued by GNMA
3,730

3,713


(17
)
 




Obligations of state and
political subdivisions
17,288

17,490

235

(33
)
 
19,646

19,998

383

(31
)
Total held-to-maturity
170,652

166,127

235

(4,760
)

151,032

151,032

619

(619
)
Available-for-sale:
 
 
 
 
 
 
 
 
 
Securities of U.S. government agencies:
 
 
 
 
 
 
 
 
 
MBS pass-through securities issued by FHLMC and FNMA
90,082

87,590

17

(2,509
)

65,559

65,262

126

(423
)
SBA-backed securities
24,620

23,954


(666
)
 
25,979

25,982

58

(55
)
CMOs issued by FNMA
21,026

20,571

7

(462
)

35,340

35,125

33

(248
)
CMOs issued by FHLMC
123,359

120,411

1

(2,949
)

70,514

69,889

3

(628
)
CMOs issued by GNMA
12,641

12,222

2

(421
)

17,953

17,785

26

(194
)
Debentures of government- sponsored agencies
32,395

32,139


(256
)

12,940

12,938

3

(5
)
Privately issued CMOs
431

435

4



1,432

1,431

1

(2
)
Obligations of state and
political subdivisions
89,699

87,788

77

(1,988
)

98,027

97,491

298

(834
)
  Corporate bonds
3,015

3,027

24

(12
)

6,541

6,564

26

(3
)
Total available-for-sale
397,268

388,137

132

(9,263
)

334,285

332,467

574

(2,392
)
Total investment securities
$
567,920

$
554,264

$
367

$
(14,023
)

$
485,317

$
483,499

$
1,193

$
(3,011
)

The amortized cost and fair value of investment debt securities by contractual maturity at June 30, 2018 and December 31, 2017 are shown in the following table. Expected maturities may differ from contractual maturities if the issuers of the securities have the right to call or prepay obligations with or without call or prepayment penalties.
 
June 30, 2018
 
December 31, 2017
 
Held-to-Maturity
 
Available-for-Sale
 
Held-to-Maturity
 
Available-for-Sale
(in thousands)
Amortized Cost
Fair Value
 
Amortized Cost
Fair Value
 
Amortized Cost
Fair Value
 
Amortized Cost
Fair Value
Within one year
$
2,859

$
2,882

 
$
8,272

$
8,263

 
$
2,151

$
2,172

 
$
10,268

$
10,272

After one but within five years
13,063

13,147

 
79,662

78,514

 
15,577

15,791

 
71,576

71,237

After five years through ten years
63,321

61,350

 
216,584

210,650

 
54,641

54,554

 
129,723

128,954

After ten years
91,409

88,748

 
92,750

90,710

 
78,663

78,515

 
122,718

122,004

Total
$
170,652

$
166,127

 
$
397,268

$
388,137

 
$
151,032

$
151,032

 
$
334,285

$
332,467


Sales of investment securities and gross gains and losses are shown in the following table.
 
Three months ended
 
Six months ended
(in thousands)
June 30, 2018
 
June 30, 2017
 
June 30, 2018
 
June 30, 2017
Available-for-sale:
 
 
 
 
 
 
 
Sales proceeds
$
5,006

 
$
1,321

 
$
5,006

 
$
1,321

Gross realized gains
27

 
13

 
27

 
13

Gross realized losses
(16
)
 
(3
)
 
(16
)
 
(3
)


Page-14



Pledged investment securities are shown in the following table.
(in thousands)
June 30, 2018
December 31, 2017
Pledged to the State of California:
 
 
   Secure public deposits in compliance with the Local Agency Security Program
$
103,097

$
107,829

   Collateral for trust deposits
749

761

      Total investment securities pledged to the State of California
$
103,846

$
108,590

Collateral for Wealth Management and Trust Services checking account
$
2,014

$
2,026


As part of our ongoing review of our investment securities portfolio, we reassessed the classification of certain securities issued by government sponsored agencies. During 2018 and 2017, we transferred $27.4 million and $129.0 million, respectively, of these securities from available-for-sale to held-to-maturity at fair value. We intend and have the ability to hold these securities to maturity. The net unrealized pre-tax loss of $278 thousand and $3.0 million, at the respective transfer dates, remained in accumulated other comprehensive income and are amortized over the remaining lives of the securities. Amortization of the net unrealized pre-tax losses totaled $268 thousand and $165 thousand for the six months ended June 30, 2018 and 2017, respectively.

Other-Than-Temporarily Impaired ("OTTI") Debt Securities
 
We have evaluated the credit of our investment securities and their issuers and/or insurers. Based on our evaluation, Management has determined that no investment security in our investment portfolio is other-than-temporarily impaired as of June 30, 2018. 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 June 30, 2018 before recovery of the amortized cost basis.
 
There were 266 and 198 investment securities in unrealized loss positions at June 30, 2018 and December 31, 2017, respectively. Those securities are summarized and classified according to the duration of the loss period in the following tables:
June 30, 2018
< 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:
 
 
 
 
 
 
 
 
MBS pass-through securities issued by FHLMC and FNMA
$
22,100

$
(830
)
 
$
68,724

$
(2,549
)
 
$
90,824

$
(3,379
)
SBA-backed securities

8,742

(139
)
 


 
$
8,742

$
(139
)
CMOs issued by FNMA
11,766

(115
)
 


 
11,766

(115
)
CMOs issued by FHLMC
19,798

(564
)
 
13,793

(513
)
 
33,591

(1,077
)
CMOs issued by GNMA


 
3,713

(17
)
 
3,713

(17
)
Obligations of state and political subdivisions
3,816

(33
)
 


 
3,816

(33
)
Total held-to-maturity
66,222

(1,681
)
 
86,230

(3,079
)
 
152,452

(4,760
)
Available-for-sale:
 
 
 
 
 
 
 
 
MBS pass-through securities issued by FHLMC and FNMA
68,906

(1,843
)
 
17,713

(666
)
 
86,619

(2,509
)
SBA-backed securities

23,954

(666
)
 


 
23,954

(666
)
CMOs issued by FNMA
15,687

(321
)
 
4,642

(141
)
 
20,329

(462
)
CMOs issued by FHLMC
115,370

(2,949
)
 


 
115,370

(2,949
)
CMOs issued by GNMA
11,297

(419
)
 
603

(2
)
 
11,900

(421
)
Debentures of government- sponsored agencies
32,139

(256
)
 


 
32,139

(256
)
Privately issued CMOs


 


 


Obligations of state and political subdivisions
57,217

(835
)
 
18,832

(1,153
)
 
76,049

(1,988
)
Corporate bonds
1,522

(12
)
 


 
1,522

(12
)
Total available-for-sale
326,092

(7,301
)
 
41,790

(1,962
)
 
367,882

(9,263
)
Total temporarily impaired securities
$
392,314

$
(8,982
)
 
$
128,020

$
(5,041
)
 
$
520,334

$
(14,023
)

Page-15



December 31, 2017
< 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 and political subdivisions
$
3,648

$
(31
)
 
$

$

 
$
3,648

$
(31
)
MBS pass-through securities issued by FHLMC and FNMA
16,337

(143
)
 
46,845

(371
)
 
63,182

(514
)
CMOs issued by FHLMC
11,066

(31
)
 
13,824

(43
)
 
24,890

(74
)
Total held-to-maturity
31,051

(205
)
 
60,669

(414
)
 
91,720

(619
)
Available-for-sale:




 




 




MBS pass-through securities issued by FHLMC and FNMA
32,189

(121
)
 
15,325

(302
)
 
47,514

(423
)
SBA-backed securities
11,028

(53
)
 
165

(2
)
 
11,193

(55
)
CMOs issued by FNMA
26,401

(171
)
 
5,440

(77
)
 
31,841

(248
)
CMOs issued by FHLMC
69,276

(628
)
 


 
69,276

(628
)
CMOs issued by GNMA
14,230

(194
)
 


 
14,230

(194
)
Debentures of government- sponsored agencies
2,984

(5
)
 


 
2,984

(5
)
   Privately issued CMO's
1,310

(2
)
 


 
1,310

(2
)
Obligations of state and political subdivisions
52,197

(288
)
 
19,548

(546
)
 
71,745

(834
)
Corporate bonds
3,060

(3
)
 


 
3,060

(3
)
Total available-for-sale
212,675

(1,465
)
 
40,478

(927
)
 
253,153

(2,392
)
Total temporarily impaired securities
$
243,726

$
(1,670
)
 
$
101,147

$
(1,341
)
 
$
344,873

$
(3,011
)

As of June 30, 2018, sixty-four investment securities in our portfolio had been in a continuous loss position for twelve months or more. They consisted of five CMOs issued by FHLMC, three CMOs issued by FNMA, two CMOs issued by GNMA, twenty-two agency MBS securities and thirty-two obligations of U.S. state and political subdivisions securities. We have evaluated the securities and believe that the decline in fair value is primarily driven by factors other than credit. It is probable that we will be able to collect all amounts due according to the contractual terms and no other-than-temporary impairment exists on these securities. The debenture of government-sponsored agency security is supported by the U.S. Federal Government, which protects us from credit losses. Based upon our assessment of the credit fundamentals, we concluded that these securities were not other-than-temporarily impaired at June 30, 2018.

There were two hundred one investment securities in our portfolio that had been in temporary loss positions for less than twelve months as of June 30, 2018, and their temporary loss positions mainly arose from changes in interest rates since purchase. They consisted of eleven SBA-backed securities, eight debentures of a U.S. government-sponsored agency, ninety-eight obligations of U.S. state and political subdivisions, thirty-six MBS securities, forty-six CMOs issued by government-sponsored agencies, and three corporate bonds. Securities of government-sponsored agencies are supported by the U.S. Federal Government, which protects us from credit losses. Other temporarily impaired securities are deemed creditworthy after internal analysis of the issuers' latest financial information and credit enhancement. Additionally, all are rated as investment grade by at least one major rating agency. As a result of this impairment analysis, we concluded that these securities were not other-than-temporarily impaired at June 30, 2018.

Non-Marketable Securities

As a member of the FHLB, we are required to maintain a minimum investment in FHLB capital stock determined by the Board of Directors of the FHLB. The minimum investment requirements can increase in the event we increase our total asset size or borrowings with the FHLB. Shares cannot be purchased or sold except between the FHLB and its members at the $100 per share par value. We held $11.1 million of FHLB stock recorded at cost in other assets in the consolidated statements of condition at both June 30, 2018 and December 31, 2017. The carrying amounts of these investments are reasonable estimates of fair value because the securities are restricted to member banks and they do not have a readily determinable market value. Management does not believe that the FHLB stock is other-than-temporarily-impaired, due to FHLB's current financial condition. On July 26, 2018, FHLB announced a cash

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dividend to be distributed in mid-August 2018 at an annualized dividend rate of 7.00%. Cash dividends paid on FHLB capital stock are recorded as non-interest income.

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. Because of the restriction, these shares are not considered available-for-sale and are not carried at fair value. When converting this Class B common stock to Class A common stock based on the conversion rate of 1.6298 as of June 30, 2018 and 1.6483 as of December 31, 2017, and the closing stock price of Class A shares, the value of our shares of Class B common stock would have been $3.7 million and $3.2 million at June 30, 2018 and December 31, 2017, respectively. The conversion rate is subject to further reduction upon the final settlement of the covered litigation against Visa Inc. and its member banks. As such, the fair value of these Class B shares can differ significantly from their if-converted values. For further information, refer to Note 8, Commitments and Contingencies.

We invest in low-income housing tax credit funds as a limited partner, which totaled $4.9 million and $2.1 million recorded in other assets as of June 30, 2018 and December 31, 2017, respectively. In the first six months of 2018, we recognized $282 thousand of low-income housing tax credits and other tax benefits, net of $237 thousand of amortization expense of low-income housing tax credit investment, as a component of income tax expense. As of June 30, 2018, our unfunded commitments for these low-income housing tax credit funds totaled $3.2 million. We did not recognize any impairment losses on these low-income housing tax credit investments during the six months ended June 30, 2018 or 2017, as the value of the future tax benefits exceeds the carrying value of the investments.

Note 5:  Loans and Allowance for Loan Losses

Credit Quality of Loans
 
The following table shows outstanding loans by class and payment aging as of June 30, 2018 and December 31, 2017.
Loan Aging Analysis by Loan Class
(in thousands)
Commercial and industrial

Commercial real estate, owner-occupied

Commercial real estate, investor

Construction

Home equity

Other residential 1

Installment and other consumer

Total

June 30, 2018
 

 

 

 

 

 

 

 

 30-59 days past due
$

$

$

$

$
77

$

$
11

$
88

 60-89 days past due








 90 days or more past due








Total past due




77


11

88

Current
241,994

317,587

839,667

57,015

125,954

108,829

26,477

1,717,523

Total loans 3
$
241,994

$
317,587

$
839,667

$
57,015

$
126,031

$
108,829

$
26,488

$
1,717,611

Non-accrual loans 2
$

$

$

$

$
385

$

$

$
385

December 31, 2017
 

 

 

 

 

 

 

 

 30-59 days past due
$

$

$

$

$
99

$
255

$
330

$
684

 60-89 days past due
1,340







1,340

 90 days or more past due




307



307

Total past due
1,340




406

255

330

2,331

Current
234,495

300,963

822,984

63,828

132,061

95,271

27,080

1,676,682

Total loans 3
$
235,835

$
300,963

$
822,984

$
63,828

$
132,467

$
95,526

$
27,410

$
1,679,013

Non-accrual loans 2
$

$

$

$

$
406

$

$

$
406

1 Our residential loan portfolio does not include sub-prime loans, nor is it our 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 One purchased credit impaired ("PCI") loan with an unpaid balance of $6 thousand and no carrying value was not accreting interest at June 30, 2018. Three PCI loans with unpaid balances totaling $131 thousand and no carrying values were not accreting interest at December 31, 2017. Amounts exclude accreting PCI loans totaling $2.1 million at both June 30, 2018 and December 31, 2017 as we have a reasonable expectation about future cash flows to be collected and we continue to recognize accretable yield on these loans in interest income. There were no accruing loans past due more than ninety days at June 30, 2018 or December 31, 2017.
3 Amounts include net deferred loan origination costs of $800 thousand and $818 thousand at June 30, 2018 and December 31, 2017, respectively. Amounts are also net of unaccreted purchase discounts on non-PCI loans of $956 thousand and $1.2 million at June 30, 2018 and December 31, 2017, respectively.

We generally make commercial loans to established small and mid-sized businesses to provide financing for their growth and working capital needs, equipment purchases and acquisitions.  Management examines historical, current, and projected cash flows to determine the ability of the borrower to repay obligations as agreed. Commercial loans

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are made based primarily on the identified cash flows of the borrower and secondarily on the underlying collateral and guarantor support. 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 and inventory, and typically include personal guarantees. We target stable businesses with guarantors who provide additional sources of repayment and have proven to be resilient in periods of economic stress.
 
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. Underwriting standards for commercial real estate loans include, but are not limited to, debt coverage and loan-to-value ratios. Furthermore, the owners of the properties guarantee substantially all of our commercial real estate loans.  Conditions in the real estate markets or in the general economy may adversely affect our commercial real estate loans. In the event of a vacancy, we expect guarantors to carry the loans until they find a replacement tenant.  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.

We generally make construction loans to developers and builders to finance construction, renovation and occasionally land acquisitions in anticipation of near-term development. These loans are underwritten after evaluation of the borrower's financial strength, reputation, prior track record, and independent appraisals. Significant events can affect the construction industry, including: the inherent volatility of real estate markets and vulnerability to delays due to weather, change orders, inability to obtain construction permits, labor or material shortages, and price changes. Estimates of construction costs and value associated with the completed 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 loans and floating homes, along with a small number of installment loans. Our other residential loans include tenancy-in-common fractional interest loans ("TIC") located almost entirely in San Francisco County. We originate consumer loans utilizing credit score information, debt-to-income ratio and loan-to-value ratio analysis. Diversification among consumer loan types, coupled with relatively small loan amounts that are spread across many individual borrowers, mitigates risk.

We use a risk rating system to evaluate asset quality, and to identify and monitor credit risk in individual loans, and in the loan portfolio. Our definitions of “Special Mention” risk graded loans, or worse, are consistent with those used by the Federal Deposit Insurance Corporation ("FDIC").  Our internally assigned grades are as follows:
 
Pass and Watch: 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 consequences.  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(s) 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. 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.

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We regularly review our credits for accuracy of risk grades whenever we receive new information. Borrowers are generally required to submit financial information at regular intervals. Typically, 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. In addition, investor commercial real estate borrowers are usually required to submit rent rolls or property income statements annually. We monitor construction loans monthly and review them on an ongoing basis. We review home equity and other consumer loans based on delinquency status. We also review loans graded “Watch” or worse, regardless of loan type, no less than quarterly.

The following table represents an analysis of the carrying amount in loans, net of deferred fees and costs and purchase premiums or discounts, by internally assigned risk grades, including PCI loans, at June 30, 2018 and December 31, 2017.
Credit Risk Profile by Internally Assigned Risk Grade
(in thousands)
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

June 30, 2018
 
 
 
 
 
 
 
 
 
Pass
$
224,707

$
299,469

$
836,634

$
54,324

$
124,103

$
108,829

$
26,389

$
2,140

$
1,676,595

Special Mention
14,842

8,904

2,232


1,121




27,099

Substandard
2,403

8,005


2,691

719


99


13,917

Total loans
$
241,952

$
316,378

$
838,866

$
57,015

$
125,943

$
108,829

$
26,488

$
2,140

$
1,717,611

December 31, 2017
 

 

 

 

 

 

 

 

 

Pass
$
214,636

$
281,104

$
818,570

$
60,859

$
130,558

$
95,526

$
27,287

$
1,325

$
1,629,865

Special Mention
9,318

9,284

1,850





790

21,242

Substandard
11,816

9,409

1,774

2,969

1,815


123


27,906

Total loans
$
235,770

$
299,797

$
822,194

$
63,828

$
132,373

$
95,526

$
27,410

$
2,115

$
1,679,013

 
Troubled Debt Restructuring
 
Our loan portfolio includes certain loans modified in a troubled debt restructuring (“TDR”), where we have granted economic concessions to borrowers experiencing financial difficulties. These concessions typically result from our loss mitigation activities and could include reductions in the interest rate, payment extensions, forgiveness of principal, forbearance or other actions. TDRs on non-accrual status at the time of restructure may be returned to accruing status after Management considers the borrower’s sustained repayment performance for a reasonable period, generally six months, and obtains reasonable assurance of repayment and performance.
 
We may remove a loan from TDR designation if it meets all of the following conditions:
The loan is subsequently refinanced or restructured at current market interest rates and the new terms are consistent with the treatment of creditworthy borrowers under regular underwriting standards;
The borrower is no longer considered to be in financial difficulty;
Performance on the loan is reasonably assured; and;
Existing loan did not have any forgiveness of principal or interest.

The same Management level that approved the upgrading of the loan classification must approve the removal of TDR status. During the six months ended June 30, 2018, one TIC loan with a recorded investment of $150 thousand was removed from TDR designation after meeting all of the conditions noted above. There were no loans removed from TDR designation during 2017.
 

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The following table summarizes the carrying amount of TDR loans by loan class as of June 30, 2018 and December 31, 2017.
(in thousands)
 
Recorded investment in Troubled Debt Restructurings 1
June 30, 2018

December 31, 2017

Commercial and industrial
$
1,917

$
2,165

Commercial real estate, owner-occupied
7,002

6,999

Commercial real estate, investor
1,844

2,171

Construction
2,691

2,969

Home equity
348

347

Other residential
988

1,148

Installment and other consumer
704

721

Total
$
15,494

$
16,520

1 There were no TDR loans on non-accrual status at June 30, 2018 and December 31, 2017.

The following table presents information for loans modified in a TDR during the presented periods, including the number of modified contracts, the recorded investment in the loans prior to modification, and the recorded investment in the loans at period end after being restructured. The table excludes fully charged-off TDR loans and loans modified in a TDR and subsequently paid-off during the years presented.
(dollars in thousands)
Number of Contracts Modified

Pre-Modification Outstanding Recorded Investment

Post-Modification Outstanding Recorded Investment

Post-Modification Outstanding Recorded Investment at Period End

TDRs during the three months ended June 30, 2018:
 
 
 

Commercial and industrial
2

$
254

$
245

$
235

TDRs during the three months ended June 30, 2017:
 

 

 



None

$

$

$

TDRs during the six months ended June 30, 2018:
 
 
 
 
Commercial and industrial
2

$
254

$
245

$
235

TDRs during the six months ended June 30, 2017:
 

 

 

 
Installment and consumer
1

$
50

$
50

$
49

The two loans that were modified during the six months ended June 30, 2018 were to the same borrower and included loan extensions and other changes in loan terms. The modification during the six months ended June 30, 2017 primarily involved an interest rate concession and other changes to loan terms. During the first six months of 2018 and 2017, there were no defaults on loans that had been modified in a TDR within the prior twelve-month period. We report defaulted TDRs based on a payment default definition of more than ninety days past due.

Impaired Loans

The following tables summarize information by class on impaired loans and their related allowances. Total impaired loans include non-accrual loans, accruing TDR loans and accreting PCI loans that have experienced post-acquisition declines in cash flows expected to be collected.

Page-20



(in thousands)
Commercial and industrial

Commercial real estate, owner-occupied

Commercial real estate, investor

Construction

Home equity

Other residential

Installment and other consumer

Total

June 30, 2018
 

 

 

 

 

 

 

Recorded investment in impaired loans:
 
 
 
 
 
 
With no specific allowance recorded
$
306

$

$

$
2,691

$
385

$
989

$
46

$
4,417

With a specific allowance recorded
1,611

7,002

1,844


347


658

11,462

Total recorded investment in impaired loans
$
1,917

$
7,002

$
1,844

$
2,691

$
732

$
989

$
704

$
15,879

Unpaid principal balance of impaired loans
$
1,905

$
6,993

$
1,837

$
2,688

$
729

$
987

$
703

$
15,842

Specific allowance
232

126

47


6


92

503

Average recorded investment in impaired loans during the quarter ended
June 30, 2018
2,092

7,005

1,849

2,833