UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

FORM 10-K

Annual Report Pursuant to Section 13 or 15(d)

of the Securities Exchange Act of 1934

 

For the fiscal year ended December 31, 2011

 

Commission file number: 000-33063

 

 

 

SIERRA BANCORP

(Exact name of registrant as specified in its charter)

 

California 33-0937517
(State of incorporation) (I.R.S. Employer Identification Number)

 

86 North Main Street, Porterville, California 93257
(Address of principal executive offices) (Zip Code)

  

(559) 782-4900

Registrant’s telephone number, including area code

 

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class Name of each exchange on which registered
Common Stock, No Par Value The NASDAQ Stock Market LLC (NASDAQ Global Select Market)

 

Securities registered pursuant to Section 12(g) of the Act: None

 

 

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

£ Yes R No

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

£ Yes R No

 

Indicate by check mark whether the registrant (1) has filed all reports required 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.

R Yes £ No

 

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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

R Yes £ No

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. £

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.

Large accelerated filer £ Accelerated filer R
Non-accelerated filer £ (Do not check if a smaller reporting company) Smaller reporting company £

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).

£ Yes R No

 

As of June 30, 2011, the last business day of the registrant’s most recently completed second fiscal quarter, the aggregate market value of the voting stock held by non-affiliates of the registrant was approximately $120 million, based on the closing price reported to the registrant on that date of $11.32 per share. Shares of Common Stock held by each officer and director and each person or control group owning more than ten percent of the outstanding Common Stock have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

 

The number of shares of common stock of the registrant outstanding as of January 31, 2012 was 14,101,609.

 

Documents Incorporated by Reference: Portions of the definitive proxy statement for the 2012 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission pursuant to SEC Regulation 14A are incorporated by reference in Part III, Items 10-14.

 

 

 
 

 

TABLE OF CONTENTS

 

 

   
ITEM PAGE
   
PART I 1
   
Item 1. Business 1
   
Item 1A. Risk Factors 15
   
Item 1B. Unresolved Staff Comments 24
   
Item 2. Properties 24
   
Item 3. Legal Proceedings 25
   
Item 4. Reserved 25
   
PART II 25
   
Item 5. Market for Registrant’s Common Equity, Related Shareholder Matters and  
Issuer Purchases of Equity Securities 25
   
Item 6. Selected Financial Data 27
   
Item 7. Management’s Discussion and Analysis of Financial Condition  
and Results of  Operations 29
   
Item 7A.  Quantitative and Qualitative Disclosures about Market Risk 60
   
Item 8. Financial Statements and Supplementary Data 61
   
Item 9. Changes in and Disagreements with Accountants on  
Accounting and Financial Disclosure 118
   
Item 9A. Controls and Procedures 118
   
Item 9B. Other Information 121
   
PART III 121
   
Item 10. Directors, Executive Officers and Corporate Governance 121
   
Item 11. Executive Compensation 121
   
Item 12. Security Ownership of Certain Beneficial Owners and Management  
and Related Shareholder Matters 121
   
Item 13.  Certain Relationships and Related Transactions and Director Independence 122
   
Item 14.  Principal Accounting Fees and Services 122
   
PART IV 123
   
Item 15.  Exhibits and Financial Statement Schedules 123
   
SIGNATURES 125

 

 
 

PART I

 

Item 1. Business

 

General

 

The Company

 

Sierra Bancorp (the “Company”), headquartered in Porterville, California, is a California corporation registered as a bank holding company under the Bank Holding Company Act of 1956, as amended. The Company was incorporated in November 2000 and acquired all of the outstanding shares of Bank of the Sierra (the “Bank”) in August 2001. The Company’s principal subsidiary is the Bank, and the Company exists primarily for the purpose of holding the stock of the Bank and of such other subsidiaries it may acquire or establish. The Company’s main source of revenue is dividends paid by the Bank. The expenditures of the Company, including but not limited to the cost of servicing debt, audit costs, shareholder expenses, and the payment of dividends to shareholders, if and when declared by our Board of Directors, are paid from cash on hand at the holding company, as might be supplemented from time to time with dividends remitted to the Company by the Bank.

 

At the present time, the Company’s only other direct subsidiaries are Sierra Statutory Trust II and Sierra Capital Trust III, which were formed in March 2004 and June 2006, respectively, solely to facilitate the issuance of capital trust pass-through securities (“TRUPS”). Pursuant to the Financial Accounting Standards Board’s (FASB’s) standard on the consolidation of variable interest entities, these trusts are not reflected on a consolidated basis in the financial statements of the Company. References herein to the “Company” include Sierra Bancorp and its consolidated subsidiary, the Bank, unless the context indicates otherwise.

 

At December 31, 2011, the Company had consolidated assets of $1.335 billion, gross loans of $759 million, deposits of $1.086 billion and shareholders’ equity of $169 million. The Company’s liabilities include $31 million in debt obligations due to Sierra Statutory Trust II and Sierra Capital Trust III, related to TRUPS issued by those entities.

 

The Bank

 

The Bank is a California state-chartered bank headquartered in Porterville, California, that offers a full range of retail and commercial banking services to communities in the central and southern sections of the San Joaquin Valley. Our branch footprint stretches from Fresno on the north to Bakersfield on the south, and on the southern end extends east through the Tehachapi plateau and into the northwestern tip of the Mojave Desert. The Bank was incorporated in September 1977 and opened for business in January 1978, and in the ensuing years has grown to be the largest independent bank headquartered in the South San Joaquin Valley. Our growth has primarily been organic, but includes the acquisition of Sierra National Bank in 2000.

 

Our primary products and services are related to the business of lending money and accepting deposits. The Bank’s lending activities include real estate, commercial (including small business), agricultural, and consumer loans. The bulk of our real estate loans are secured by commercial or professional office properties which are predominantly owner-occupied. We also employ real estate lending specialists who are responsible for a complete line of construction loans for residential and commercial development, permanent mortgage loans, land acquisition and development loans, and multifamily credit facilities. Secondary market services are provided through the Bank’s affiliations with Freddie Mac, Fannie Mae and various non-governmental programs. As of December 31, 2011, the percentage of our total loan and lease portfolio for each of the principal areas in which we directed our lending activities was as follows: (i) loans secured by real estate (76.2%); (ii) commercial and industrial loans (including SBA loans) (15.8%); (iii) consumer loans (4.8%); (iv) direct finance leases (0.9%); and (v) agricultural production loans (2.3%). Real estate loans and related activities generated total revenue of $36.1 million in 2011 and $40.8 million in 2010. Interest, fees, and loan sale income on real-estate secured loans totaled approximately 49% of our total interest and other income for 2011 and 50% in 2010.

 

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In addition to loans, we offer a wide range of deposit products for individuals and businesses including checking accounts, savings accounts, money market demand accounts, time deposits, retirement accounts, and sweep accounts. The Bank’s deposit accounts are insured by the Federal Deposit Insurance Corporation (FDIC) up to maximum insurable amounts. We have also been in the Certificate of Deposit Account Registry Service (CDARS) network since its inception, and through CDARS are able to offer full FDIC insurance coverage to depositors with balances of up to $50 million. We attract deposits from throughout our market area with direct-mail campaigns, a customer-oriented product mix, competitive pricing, convenient locations, drive-through banking, and a multitude of alternative delivery channels, and we strive to retain our deposit customers by providing a consistently high level of service. At December 31, 2011 we had 90,400 deposit accounts totaling $1.086 billion, compared to 85,400 deposit accounts totaling $1.052 billion at December 31, 2010.

 

To provide non-deposit investment options we have a strategic alliance with Investment Centers of America, Inc. of Bismarck, North Dakota (“ICA”). Through this arrangement, registered and licensed representatives of ICA provide our customers with convenient access to annuities, insurance products, mutual funds, and a full range of investment products. They conduct business from offices located in our Porterville, Visalia, Tulare, Fresno, Bakersfield and Tehachapi branches.

 

We currently operate 25 full service branch offices throughout our geographic footprint. The Bank’s newest branches opened for business in Selma in February 2011 and Farmersville in March 2010. In January 2011 we closed our first branch ever, in Bakersfield on California Avenue, due to lease issues. The locations of the Bank’s current offices are:

 

Porterville:

Administrative Headquarters

86 North Main Street

Main Office

90 North Main Street

West Olive Branch

1498 West Olive Avenue

       
Bakersfield:

Bakersfield Ming Office

8500 Ming Avenue

Bakersfield Riverlakes Office

4060 Coffee Road

Bakersfield East Hills Office

2501 Mt. Vernon Avenue

       
California City:

California City Office

8031 California City Blvd.

   
       
Clovis:

Clovis Office

1710 Clovis Avenue

   
       
Delano:

Delano Office

1126 Main Street

   
       
Dinuba:

Dinuba Office

401 East Tulare Street

   
       
Exeter:

Exeter Office

1103 West Visalia Road

   
       
Farmersville:

Farmersville Office

400 West Visalia Road

   
       
Fresno:

Fresno Shaw Office

636 East Shaw Avenue

Fresno Herndon Office

7029 N. Ingram Avenue

Fresno Sunnyside Office

5775 E. Kings Canyon Rd.

       
Hanford:

Hanford Office

427 West Lacey Boulevard

   
       
Lindsay:

Lindsay Office

142 South Mirage Avenue

   
       
Reedley:

Reedley Office

1095 W. Manning Street

   
       
Selma:

Selma Office

2446 McCall Avenue

   
       
Tehachapi:

Tehachapi Downtown Office

224 West “F” Street

Tehachapi Old Town Office

21000 Mission Street

 
       
Three Rivers:

Three Rivers Office

40884 Sierra Drive

   
       
Tulare:

Tulare Office

246 East Tulare Avenue

Tulare Prosperity Office

1430 E Prosperity Avenue

 
       
Visalia:

Visalia Mooney Office

2515 South Mooney Blvd.

Visalia Downtown Office

128 East Main Street

 

 

 

 

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In addition to the full-service branch offices listed above, the Bank has an agricultural credit division and an SBA lending unit with staff located at our corporate headquarters. We also have ATM’s at all branch locations, and offsite ATM’s at six different non-branch locations. Furthermore, the Bank is a member of the Allpoint network, which provides our customers with surcharge-free access to over 35,000 ATMs across the nation, and our customers have access to electronic point-of-sale payment alternatives nationwide via the Pulse EFT network. To ensure that account access preferences are addressed for all of our customers, we operate an internet branch which provides the ability to open deposit accounts and submit certain loan applications online, offer an online banking option with bill-pay and mobile banking capabilities, maintain a customer service center that is accessible by toll-free telephone during business hours, and provide an automated telephone banking system that is accessible 24 hours a day, seven days a week. We offer a multitude of other banking products and services to complement and support our lending and deposit products, including remote deposit capture and automated payroll services for business customers.

 

We have not engaged in any material research activities related to the development of new products or services during the last two fiscal years. However, our officers and employees are continually searching for ways to increase public convenience, enhance public access to the electronic payments system, and enable us to improve our competitive position. The cost to the Bank for these development, operations, and marketing activities cannot be calculated with any degree of certainty.

 

We hold no patents or licenses (other than licenses required by appropriate bank regulatory agencies), franchises, or concessions. Our business has a modest seasonal component due to the heavy agricultural orientation of the Central Valley. As our branches in more metropolitan areas such as Fresno and Bakersfield have expanded, however, we have become less reliant on the agriculture-related base. We are not dependent on a single customer or group of related customers for a material portion of our core deposits, nor is a material portion of our loans concentrated within a single industry or group of related industries. Our efforts to comply with government and regulatory mandates on consumer protection and privacy, anti-terrorism, and other initiatives have resulted in significant ongoing expense to the Bank, including staffing additions and costs associated with compliance-related software. However, as far as can be determined there has been no material effect upon our capital expenditures, earnings, or competitive position as a result of environmental regulation at the Federal, state, or local level.

 

Recent Accounting Pronouncements

 

Information on recent accounting pronouncements is contained in Note 2 to the consolidated financial statements.

 

Competition

 

The banking business in California in general, and specifically in many of our market areas, is highly competitive with respect to virtually all products and services. The industry continues to consolidate, particularly with the relatively large number of FDIC-assisted takeovers of failed banks and other acquisitions of troubled banks in recent years. There are also many unregulated companies competing for business in our markets with financial products targeted at highly profitable customer segments. Many of these competitors are able to compete across geographic boundaries, and provide customers with meaningful alternatives to nearly all significant banking services and products. These competitive trends are likely to continue.

 

With respect to commercial bank competitors, the business is dominated by a relatively small number of major banks that operate a large number of offices within our geographic footprint. Based on June 30, 2011 FDIC market share data for the combined four counties within which the Company operates, namely Tulare, Kern, Fresno, and Kings counties, the largest portion of deposits belongs to Bank of America (21.8%), followed closely by Wells Fargo (19.7%). The next highest deposit market share drops down to 6.24% for Union Bank, and the four institutions after that, including Bank of the Sierra, all have market share percentages tightly grouped between 5% and 6%. Bank of the Sierra ranks seventh on the 2011 market share list with 5.2% of total deposits in the referenced four-county area. In Tulare County, however, where the Bank was originally formed, we rank first for total number of branch locations (12, including our online branch), and second for deposit market share with 19.9% of total deposits, just slightly below Bank of America’s 20.2%. The larger banks noted above have, among other advantages, the ability to finance wide-ranging advertising campaigns and to allocate their resources to regions of highest yield and demand. They can also offer certain services that we do not offer directly but may offer indirectly through correspondent institutions. By virtue of their greater total capitalization, these banks also have substantially higher lending limits than we do. For customers whose needs exceed our legal lending limit, we typically arrange for the sale, or “participation,” of some of the balances to financial institutions that are not within our geographic footprint.

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In addition to other banks, our competitors include savings institutions, credit unions, and numerous non-banking institutions such as finance companies, leasing companies, insurance companies, brokerage firms, asset management groups, mortgage banking firms and internet-based companies. Technological innovations have lowered traditional barriers of entry and enabled many of these companies to offer services that previously were considered traditional banking products, and we have witnessed increased competition from specialized companies, including those that circumvent the banking system by facilitating payments via the internet, wireless devices, prepaid cards, or other means.

 

Strong competition for deposits and loans among financial institutions and non-banks alike affects interest rates and other terms on which financial products are offered to customers. Mergers between financial institutions have placed additional pressure on other banks within the industry to remain competitive by streamlining operations, reducing expenses, and increasing revenues. Competition is also impacted by federal and state interstate banking laws enacted in the mid-1990’s, which permit banking organizations to expand into other states. The relatively large California market has been particularly attractive to out-of-state institutions. The Financial Modernization Act, enacted in 2000, made it possible for full affiliations to occur between banks and securities firms, insurance companies, and other financial companies, which further intensified competitive conditions.

 

For years we have countered rising competition by offering a broad array of products, with accommodative policies that allow flexibility in structure and term that cannot always be matched by our competitors. We also offer our customers community-oriented, personalized service, and rely on local promotional activity and personal contacts by our officers, directors, employees, and shareholders. This approach appears to be well-received by the populace of the San Joaquin Valley, who appreciate a high-touch, customer-oriented environment in which to conduct their financial transactions. As noted above, layered onto our traditional personal-contact banking philosophy are technology-driven initiatives that improve customer access and convenience.

 

Employees

 

As of December 31, 2011 the Company had 309 full-time and 93 part-time employees. On a full time equivalent basis staffing stood at 383 at December 31, 2011, down from 390 at December 31, 2010.

 

Regulation and Supervision

 

Banks and bank holding companies are heavily regulated by federal and state laws and regulations. Most banking regulations are intended primarily for the protection of depositors and the deposit insurance fund and not for the benefit of shareholders. The following is a summary of certain statutes, regulations and regulatory guidance affecting the Company and the Bank. This summary is not intended to be a complete explanation of such statutes, regulations and guidance and their effects on the Company and the Bank and is qualified in its entirety by such statutes, regulations and guidance, all of which are subject to change in the future.

 

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Regulation of the Company Generally

 

The Company’s stock is traded on the NASDAQ Global Select Market under the symbol BSRR, and as such the Company is subject to NASDAQ rules and regulations including those related to corporate governance. The Company is also subject to the periodic reporting requirements of Section 13 of the Securities Exchange Act of 1934 (the “Exchange Act”) which requires the Company to file annual, quarterly and other current reports with the Securities and Exchange Commission (the “SEC”). The Company is subject to additional regulations including, but not limited to, the proxy and tender offer rules promulgated by the SEC under Sections 13 and 14 of the Exchange Act; the reporting requirements of directors, executive officers and principal shareholders regarding transactions in the Company’s common stock, and short swing profits rules promulgated by the SEC, under Section 16 of the Exchange Act; and certain additional reporting requirements for principal shareholders of the Company promulgated by the SEC under Section 13 of the Exchange Act. As a publicly traded company which had more than $75 million in public float as of June 30, 2011, the Company is classified as an “accelerated filer” for purposes of its Exchange Act filing requirements. In addition to accelerated time frames for filing SEC periodic reports, this also means that the Company is subject to the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 with regard to documenting, testing, and attesting to internal controls over financial reporting.

 

The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956 and is registered as such with the Federal Reserve Board. A bank holding company is required to file with the Federal Reserve annual reports and other information regarding its business operations and those of its subsidiaries. It is also subject to periodic examination by the Federal Reserve and is required to obtain Federal Reserve approval before acquiring, directly or indirectly, ownership of the voting shares of any bank if, after such acquisition, it would directly or indirectly own or control more than 5% of the voting stock of that bank, unless it already owns a majority of the voting stock of that bank.

 

The Federal Reserve Board has determined by regulation certain activities in which a bank holding company may or may not conduct business. A bank holding company must engage, with certain exceptions, in the business of banking or managing or controlling banks or furnishing services to or performing services for its subsidiary banks. The principal exceptions to these prohibitions involve non-bank activities identified by statute, by Federal Reserve regulation, or by Federal Reserve order as activities so closely related to the business of banking or of managing or controlling banks as to be a proper incident thereto, including securities brokerage services, investment advisory services, fiduciary services, and management advisory and data processing services, among others. A bank holding company that also qualifies as and elects to become a “financial holding company” may engage in a broader range of activities that are financial in nature (and complementary to such activities), specifically non-bank activities identified by the Gramm-Leach-Bliley Act of 1999 or by Federal Reserve and Treasury regulation as financial in nature or incidental to a financial activity. Activities that are defined as financial in nature include securities underwriting, dealing, and market making, sponsoring mutual funds and investment companies, engaging in insurance underwriting and agency activities, and making merchant banking investments in non-financial companies. To become and remain a financial holding company, a bank holding company and its subsidiary banks must be well capitalized, well managed, and, except in limited circumstances, have at least a satisfactory rating under the Community Reinvestment Act. The Company has no current intention of becoming a financial holding company, but may do so at some point in the future if deemed appropriate in view of opportunities or circumstances at the time.

 

The Company and the Bank are deemed to be affiliates of each other within the meaning set forth in the Federal Reserve Act and are subject to Sections 23A and 23B of the Federal Reserve Act. The Federal Reserve Board has also issued Regulation W, which codifies prior regulations under Sections 23A and 23B of the Federal Reserve Act and related interpretative guidance with respect to affiliate transactions. This means, for example, that there are limitations on loans by the Bank to affiliates, and that all affiliate transactions must satisfy certain limitations and otherwise be on terms and conditions at least as favorable to the Bank as would be available for non-affiliates. In addition, we must comply with the Federal Reserve Act and Regulation O issued by the Federal Reserve Board, which require that loans and extensions of credit to our executive officers, directors and principal shareholders, or any company controlled by any such persons, shall, among other conditions, be made on substantially the same terms and follow credit-underwriting procedures no less stringent than those prevailing at the time for comparable transactions with non-insiders.

 

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Regulations and policies of the Federal Reserve Board require a bank holding company to serve as a source of financial and managerial strength to its subsidiary banks. It is the Federal Reserve Board’s policy that a bank holding company should stand ready to use available resources to provide adequate capital funds to a subsidiary bank during periods of financial stress or adversity and should maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting a subsidiary bank. Under certain conditions, the Federal Reserve Board may conclude that certain actions of a bank holding company, such as a payment of a cash dividend, would constitute an unsafe and unsound banking practice. The Federal Reserve Board also has the authority to regulate the debt of bank holding companies, including the authority to impose interest rate ceilings and reserve requirements on such debt. Under certain circumstances, the Federal Reserve Board may require a bank holding company to file written notice and obtain its approval prior to purchasing or redeeming its equity securities, unless certain conditions are met.

 

Regulation of the Bank Generally

 

As a California state-chartered bank whose accounts are insured by the FDIC up to the maximum limits allowable by law, the Bank is subject to regulation, supervision and regular examination by the California Department of Financial Institutions (the “DFI”) and the FDIC. In addition, while the Bank is not a member of the Federal Reserve System, the Bank is subject to certain regulations of the Federal Reserve Board. The regulations of these agencies govern most aspects of the Bank’s business, including the making of periodic reports by the Bank, and the Bank’s activities relating to dividends, investments, loans, borrowings, capital requirements, certain check-clearing activities, branching, mergers and acquisitions, reserves against deposits and numerous other areas. Supervision, legal action and examination by the FDIC are generally intended to protect depositors and are not intended for the protection of shareholders.

 

The earnings and growth of the Bank are largely dependent on our ability to maintain a favorable differential, or “spread,” between our yield on interest-earning assets and the average rate paid on our deposits and other interest-bearing liabilities. As a result, the Bank’s performance is influenced by general economic conditions, both domestic and foreign, the monetary and fiscal policies of the federal government, and the policies of the regulatory agencies, particularly the Federal Reserve Board. The Federal Reserve Board implements national monetary policies (such as, for example, seeking to curb inflation and combat recession) by its open-market operations in United States government securities, by adjusting the required level of reserves for financial institutions subject to its reserve requirements, and by varying the discount rate applicable to borrowings by banks that participate in the Federal Reserve System. The actions of the Federal Reserve Board in these areas influence the growth of bank loans, investments and deposits and also affect interest rates on loans and deposits. The nature and impact of any future changes in monetary policies cannot be predicted with any degree of certainty.

 

Capital Adequacy Requirements

 

The Company and the Bank are subject to the regulations of the Federal Reserve Board and the FDIC, respectively, governing capital adequacy. Each of the federal regulators has established risk-based and leverage capital guidelines for the banks and/or bank holding companies it regulates, which set total capital requirements and define capital in terms of “core capital elements,” or Tier 1 capital; and “supplemental capital elements,” or Tier 2 capital. Tier 1 capital is generally defined as the sum of the core capital elements less goodwill and certain other deductions, including the unrealized net gains or losses (after tax adjustments) on available-for-sale investment securities, and disallowed deferred tax assets. The following items are defined as core capital elements: (i) common shareholders’ equity; (ii) qualifying non-cumulative perpetual preferred stock and related surplus (and, in the case of holding companies, senior perpetual preferred stock issued to the U.S. Treasury Department pursuant to the Troubled Asset Relief Program); (iii) minority interests in the equity accounts of consolidated subsidiaries; and (iv) qualifying trust preferred securities up to a specified limit as discussed below. Supplementary capital elements include: (i) allowance for loan and lease losses (but not more than 1.25% of an institution’s risk-weighted assets); (ii) perpetual preferred stock and related surplus not qualifying as core capital; (iii) hybrid capital instruments, perpetual debt and mandatory convertible debt instruments; and, (iv) term subordinated debt and intermediate-term preferred stock and related surplus. The maximum amount of supplemental capital elements which qualify as Tier 2 capital is limited to 100% of Tier 1 capital.

 

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In March 2005, the Federal Reserve Board adopted a final rule allowing bank holding companies to continue to include trust preferred securities in their Tier 1 capital. The amount that can be included is limited to 25% of core capital elements, net of goodwill less any associated deferred tax liability. As of December 31, 2011, TRUPS made up approximately 16% of the Company’s Tier 1 capital. In addition, since the Company had less than $15 billion in assets when its TRUPS were issued, under the Dodd-Frank Act the Company can continue to include those TRUPS in Tier 1 capital to the extent permitted by FRB guidelines. See “Dodd-Frank Wall Street Reform and Consumer Protection Act” below.

 

The minimum required ratio of qualifying total capital to total risk-weighted assets is 8% (“Total Risk-Based Capital Ratio”), at least one-half of which must be in the form of Tier 1 capital, and the minimum required ratio of Tier 1 capital to total risk-weighted assets is 4% (“Tier 1 Risk-Based Capital Ratio”). Risk-based capital ratios are calculated to provide a measure of capital relative to the degree of risk associated with a financial institution’s operations for transactions reported on the balance sheet as assets, and transactions, such as letters of credit and recourse arrangements, which are recorded as off-balance sheet items. Under risk-based capital guidelines, the nominal dollar amounts of assets and credit-equivalent amounts of off-balance sheet items are multiplied by one of several risk adjustment percentages, which range from 0% for assets with low credit risk, such as cash on hand and certain U.S. Treasury securities, to 100% for assets with relatively high credit risk, such as unsecured loans. As of December 31, 2011 and 2010, Bank-only Total Risk-Based Capital Ratios were 20.89% and 19.31%, respectively, and the Bank’s Tier 1 Risk-Based Capital Ratios were 19.63% and 18.04%, respectively. As of December 31, 2011 and 2010, the consolidated Company’s Total Risk-Based Capital Ratios were 21.72% and 20.33%, respectively, and its Tier 1 Risk-Based Capital Ratios were 20.46% and 19.06%, respectively.

 

The FDIC and the Federal Reserve Board have also established guidelines for a financial institution’s leverage ratio, defined as Tier 1 capital to adjusted total assets. Banks and bank holding companies that have received the highest rating of the five categories used by regulators to rate banks and are not anticipating or experiencing any significant growth must maintain a leverage ratio of at least 3%. All other institutions are typically required to maintain a leverage ratio of at least 4% to 5%; however, federal regulations also provide that financial institutions must maintain capital levels commensurate with the level of risk to which they are exposed, including the volume and severity of problem loans, and federal regulators may set higher capital requirements when an institution’s particular circumstances warrant. Bank-only leverage ratios were 13.53% and 13.07% on December 31, 2011 and 2010, respectively. As of December 31, 2011 and 2010, the consolidated Company’s leverage ratios were 14.11% and 13.84%, respectively.

 

Risk-based capital requirements also take into account concentrations of credit involving collateral or loan type, and the risks of “non-traditional” activities (those that have not customarily been part of the banking business). The regulations require institutions with high or inordinate levels of risk to operate with higher minimum capital standards, and authorize the regulators to review an institution’s management of such risks in assessing an institution’s capital adequacy. Additionally, the regulatory Statements of Policy on risk-based capital include exposure to interest rate risk as a factor that the regulators will consider in evaluating a financial institution’s capital adequacy, although interest rate risk does not impact the calculation of an institution’s risk-based capital ratios. Interest rate risk is the exposure of a bank’s current and future earnings and equity capital to adverse movement in interest rates. While interest rate risk is inherent in a financial institution’s role as a financial intermediary, it introduces volatility to the institution’s earnings and economic value.

 

For more information on the Company’s capital, see Part II, Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operation – Capital Resources. Risk-based capital ratio requirements are discussed in greater detail in the following section.

 

Prompt Corrective Action Provisions

 

Federal law requires each federal banking agency to take prompt corrective action to resolve the problems of insured financial institutions, including but not limited to those that fall below one or more prescribed minimum capital ratios. The federal banking agencies have by regulation defined the following five capital categories: “well capitalized” (Total Risk-Based Capital Ratio of 10%; Tier 1 Risk-Based Capital Ratio of 6%; and Leverage Ratio of 5%); “adequately capitalized” (Total Risk-Based Capital Ratio of 8%; Tier 1 Risk-Based Capital Ratio of 4%; and Leverage Ratio of 4%, or 3% if the institution receives the highest rating from its primary regulator); “undercapitalized” (Total Risk-Based Capital Ratio of less than 8%; Tier 1 Risk-Based Capital Ratio of less than 4%; or Leverage Ratio of less than 4%, or 3% if the institution receives the highest rating from its primary regulator); “significantly undercapitalized” (Total Risk-Based Capital Ratio of less than 6%; Tier 1 Risk-Based Capital Ratio of less than 3%; or Leverage Ratio less than 3%); and “critically undercapitalized” (tangible equity to total assets less than 2%). As of December 31, 2011 and 2010, both the Company and the Bank were deemed to be well capitalized for regulatory capital purposes. A bank may be treated as though it were in the next lower capital category if, after notice and the opportunity for a hearing, the appropriate federal agency finds an unsafe or unsound condition or practice so warrants, but no bank may be treated as “critically undercapitalized” unless its actual capital ratio warrants such treatment.

 

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At each successively lower capital category, an insured bank is subject to increased restrictions on its operations. For example, a bank is generally prohibited from paying management fees to any controlling persons or from making capital distributions if to do so would make the bank “undercapitalized.” Asset growth and branching restrictions apply to undercapitalized banks, which are required to submit written capital restoration plans meeting specified requirements (including a guarantee by the parent holding company, if any). “Significantly undercapitalized” banks are subject to broad regulatory authority, including among other things, capital directives, forced mergers, restrictions on the rates of interest they may pay on deposits, restrictions on asset growth and activities, and prohibitions on paying bonuses or increasing compensation to senior executive officers without FDIC approval. Even more severe restrictions apply to “critically undercapitalized” banks. Most importantly, except under limited circumstances, not later than 90 days after an insured bank becomes critically undercapitalized the appropriate federal banking agency is required to appoint a conservator or receiver for the bank.

 

In addition to measures taken under the prompt corrective action provisions, insured banks may be subject to potential actions by the federal regulators for unsafe or unsound practices in conducting their businesses or for violations of any law, rule, regulation or any condition imposed in writing by the agency or any written agreement with the agency. Enforcement actions may include the issuance of cease and desist orders, termination of insurance of deposits (in the case of a bank), the imposition of civil money penalties, the issuance of directives to increase capital, formal and informal agreements, or removal and prohibition orders against “institution-affiliated” parties.

 

Safety and Soundness Standards

 

The federal banking agencies have also adopted guidelines establishing safety and soundness standards for all insured depository institutions. Those guidelines relate to internal controls, information systems, internal audit systems, loan underwriting and documentation, compensation and interest rate exposure. In general, the standards are designed to assist the federal banking agencies in identifying and addressing problems at insured depository institutions before capital becomes impaired. If an institution fails to meet the requisite standards, the appropriate federal banking agency may require the institution to submit a compliance plan and could institute enforcement proceedings if an acceptable compliance plan is not submitted or adhered to.

 

The Dodd-Frank Wall Street Reform and Consumer Protection Act

 

The Dodd-Frank Wall Street Reform and Consumer Protection Act financial reform legislation (“Dodd-Frank”) significantly revised and expanded the rulemaking, supervisory, and enforcement authority of the federal bank regulatory agencies. Dodd-Frank impacts many aspects of the financial industry and, in many cases, will impact larger and smaller financial institutions and community banks differently over time. Many of the following key provisions of Dodd-Frank affecting the financial industry are now either effective or are in the proposed rule or implementation stage:

 

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Dodd-Frank also contains a number of additional provisions which should not directly impact the Company, such as the prohibition against charter conversions for troubled institutions; the elimination of the Office of Thrift Supervision and the transfer of oversight of thrift institutions and their holding companies to the Office of the Comptroller of the Currency or the FDIC and the Federal Reserve; the termination of investments by the U.S. Treasury under the Troubled Asset Relief Program; the creation of a Financial Services Oversight Counsel to identify emerging systemic risks and improve interagency cooperation; and the establishment of enhanced prudential standards for risk-based capital, leverage limits, stress testing, liquidity, risk management, and concentration/credit exposure limits for institutions with total consolidated assets of $50 billion or more. However, some of these provisions could have an indirect impact due to their influence on the industry generally.

 

Because many of the regulations related to Dodd-Frank have not yet been issued or fully implemented, the statute’s effect on the financial services industry in general, and on the Company in particular, is uncertain at this time. However, it is expected that certain provisions of Dodd-Frank may significantly impact our operations and compliance costs, such as changes in FDIC assessments, the permitted payment of interest on demand deposits, and projected enhanced consumer compliance requirements. Our management is actively reviewing the provisions of Dodd-Frank and assessing its probable impact on our business, financial condition, and results of operations. Some of the rules and regulations promulgated or yet to be promulgated under Dodd-Frank will apply directly only to institutions much larger than ours, but could indirectly impact smaller banks, either due to competitive influences or because certain required practices for larger institutions may subsequently become expected “best practices” for smaller institutions. We generally anticipate that changes required by Dodd-Frank will impact our profitability and business practices to some extent, and that we may be required to devote even more management attention and resources to evaluate and make any changes necessary to comply with new statutory and regulatory requirements.

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Deposit Insurance

 

The Bank’s deposits are insured under the Federal Deposit Insurance Act, up to the maximum applicable limits by the Deposit Insurance Fund (“DIF”) of the FDIC and are subject to deposit insurance assessments to maintain the DIF. In October 2010, the FDIC adopted a revised restoration plan to ensure that the DIF’s designated reserve ratio reaches 1.35% of insured deposits by September 30, 2020, the deadline mandated by the Dodd-Frank Act. However, financial institutions like Bank of the Sierra with assets of less than $10 billion are exempted from the cost of this increase. In addition, because of lower expected losses over the next five years and the additional time provided by Dodd-Frank to meet the minimum DRR, the FDIC eliminated the uniform 3 basis point increase in assessment rates that was previously scheduled to go into effect on January 1, 2011. Furthermore, the restoration plan proposed an increase in the DRR to 2% of estimated insured deposits as a long-term goal for the fund. The FDIC also proposed future assessment rate reductions in lieu of dividends, when the DRR reaches 1.5% or greater.

 

As noted above, the Dodd-Frank Act provided for a permanent increase in FDIC deposit insurance per depositor from $100,000 to $250,000 retroactive to January 1, 2008, and extended unlimited deposit insurance coverage for non-interest bearing transaction accounts through December 31, 2012. Furthermore, the FDIC redefined its deposit insurance premium assessment base from an institution’s total domestic deposits to its total assets less tangible equity, effective in the second quarter of 2011. The changes to the assessment base necessitated changes to assessment rates, which also became effective April 1, 2011. The revised assessment rates are lower than prior rates, but the assessment base is larger and approximately the same amount of assessment revenue will be collected by the FDIC as under the previous structure.

 

To help address liquidity issues created by potential timing differences between the collection of premiums and charges against the DIF, in November 2009 the FDIC adopted a final rule to require insured institutions to prepay, on December 31, 2009, their estimated quarterly risk-based deposit insurance assessments for the fourth quarter of 2009, and for all of 2010, 2011 and 2012. Our prepaid assessment, a non-earning asset, was $2.7 million as of December 31, 2011. Until such time as our prepaid FDIC assessment is fully utilized, our accounting offset for FDIC assessment expense is the prepaid account rather than cash.

 

We are generally unable to control the amount of premiums that we are required to pay for FDIC insurance. If there are additional bank or financial institution failures or if the FDIC otherwise determines, we may be required to pay even higher FDIC premiums than the recent levels. Any future increases in FDIC insurance premiums may have a material and adverse effect on our earnings and could have a material adverse effect on the value of, or market for, our common stock.

 

In addition to DIF assessments, banks must pay quarterly assessments that are applied to the retirement of Financing Corporation bonds issued in the 1980’s to assist in the recovery of the savings and loan industry. The assessment amount fluctuates, but is currently 0.66 basis points of insured deposits. These assessments will continue until the Financing Corporation bonds mature in 2019.

 

Community Reinvestment Act

 

The Bank is subject to certain requirements and reporting obligations involving Community Reinvestment Act (“CRA”) activities. The CRA generally requires federal banking agencies to evaluate the record of a financial institution in meeting the credit needs of its local communities, including low and moderate income neighborhoods. The CRA further requires the agencies to consider a financial institution’s efforts in meeting its community credit needs when evaluating applications for, among other things, domestic branches, mergers or acquisitions, or the formation of holding companies. In measuring a bank’s compliance with its CRA obligations, the regulators utilize a performance-based evaluation system under which CRA ratings are determined by the bank’s actual lending, service, and investment performance, rather than on the extent to which the institution conducts needs assessments, documents community outreach activities or complies with other procedural requirements. In connection with its assessment of CRA performance, the FDIC assigns a rating of “outstanding,” “satisfactory,” “needs to improve” or “substantial noncompliance.” The Bank was last examined for CRA compliance in late 2010, and received a “satisfactory” CRA Assessment Rating as a result of that exam.

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Privacy and Data Security

 

The Gramm-Leach-Bliley Act, also known as the Financial Modernization Act of 1999 (the “Financial Modernization Act”), imposed requirements on financial institutions with respect to consumer privacy. Financial institutions, however, are required to comply with state law if it is more protective of consumer privacy than the Financial Modernization Act. The Financial Modernization Act generally prohibits disclosure of consumer information to non-affiliated third parties unless the consumer has been given the opportunity to object and has not objected to such disclosure. The statute also directed federal regulators, including the Federal Reserve and the FDIC, to prescribe standards for the security of consumer information, and requires financial institutions to disclose their privacy policies to consumers annually.

 

Overdrafts

 

The Electronic Funds Transfer Act, as implemented by the Federal Reserve's Regulation E (which was updated effective January 2010 with an mandatory compliance date of July 1, 2010), governs transfers initiated through automated teller machines (ATMs), point-of-sale terminals, and other electronic banking services. Regulation E prohibits financial institutions from assessing an overdraft fee for paying (ATM) and one-time point-of-sale debit card transactions, unless the customer affirmatively opts in to the overdraft service for those types of transactions. The opt-in provision establishes requirements for clear disclosure of fees and terms of overdraft services for ATM and one-time debit card transactions. The rule does not apply to other types of transactions, such as check, automated clearinghouse (ACH) and recurring debit card transactions.

 

Additionally, in November 2010, the FDIC issued its Overdraft Guidance on automated overdraft service programs to ensure that a bank mitigates the risks associated with offering automated overdraft payment programs and complies with all consumer protection laws and regulations. The procedural changes and fee adjustments necessitated by these regulatory changes resulted in decreased overdraft income in 2011 and could have a further adverse impact on the Company’s non-interest income in the future.

 

Predatory Lending

 

The term “predatory lending,” much like the terms “safety and soundness” and “unfair and deceptive practices,” is far-reaching and covers a potentially broad range of behavior. As such, it does not lend itself to a concise or a comprehensive definition. But typically predatory lending involves at least one, and perhaps all three, of the following elements: making unaffordable loans based on the assets of the borrower rather than on the borrower’s ability to repay an obligation, or asset-based lending; inducing a borrower to refinance a loan repeatedly in order to charge high points and fees each time the loan is refinanced, or loan flipping; and engaging in fraud or deception to conceal the true nature of the loan obligation from an unsuspecting or unsophisticated borrower.

 

Federal Reserve Board regulations aimed at curbing such lending significantly widened the pool of high-cost home-secured loans covered by the Home Ownership and Equity Protection Act of 1994, a federal law that requires extra disclosures and consumer protections to borrowers. In addition, the regulation bars loan flipping by the same lender or loan servicer within a year. Lenders also will be presumed to have violated the law which says loans shouldn’t be made to people unable to repay them, unless they document that the borrower has the ability to repay. Lenders that violate the rules face cancellation of loans and penalties equal to the finance charges paid. The Company does not engage in predatory lending and thus does not expect these rules and potential state action in this area to have any impact on its financial condition or results of operations.

 

Consumer Financial Protection and Other Consumer Laws and Regulations

 

Dodd-Frank created the Consumer Financial Protection Bureau ("CFPB") as a new and independent unit within the Federal Reserve System. With certain exceptions, the CFPB has authority to regulate any person or entity that engages in offering or providing a “consumer financial product or service” and has rulemaking, examination, and enforcement powers over financial institutions. With respect to primary examination and enforcement authority of financial entities, however, the CFPB's authority is limited to institutions with assets of $10 billion or more. Existing regulators retain this authority over institutions with assets of $10 billion or less, such as the Bank.

 

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The powers of the CFPB currently include:

The CFPB officially commenced operations on July 21, 2011 and engaged in several activities throughout the remainder of the year including (i) investigating consumer complaints about credit cards and mortgages, (ii) launching a supervision program, (iii) conducting research for and developing mandatory financial product disclosures, and (iv) engaging in consumer financial protection rulemaking.

 

Some uncertainty has arisen related to confidential treatment and privilege and the CFPB's ability to require reports from financial institutions. Banks currently have express legal protection that gives them the confidence and legal certainty to provide confidential “privileged” documents at the request of the federal banking agencies, and the current law provides that a bank does not “waive” confidentiality and risk disclosure of the information to an outside party, potentially involved in litigation with the bank, by providing the information to its regulator. The CFPB does not have the same express statutory protections relating to privilege that the other banking agencies are given. The full extent of the CFPB’s authority and potential impact on the Bank is unclear at this time, but the Bank continues to monitor the CFPB’s activities on an ongoing basis.

 

The Bank is already subject to a variety of statutes and regulations designed to protect consumers, including the Fair Credit Reporting Act, Equal Credit Opportunity Act, and Truth-in-Lending Act. Interest and other charges collected or contracted for by the Bank are also subject to state usury laws and certain other federal laws concerning interest rates. The Bank’s loan operations are also subject to federal laws and regulations applicable to credit transactions. Together, these laws and regulations include provisions that:

The Bank’s deposit operations are also subject to laws and regulations that:

In November 2009, the Board of Governors of the Federal Reserve System promulgated a rule entitled “Electronic Fund Transfers”, with a mandatory compliance date of July 1, 2010. The rule, which applies to all FDIC-regulated institutions, prohibits financial institutions from assessing an overdraft fee for paying automated teller machine (ATM) and one-time point-of-sale debit card transactions, unless the customer affirmatively opts in to the overdraft service for those types of transactions. The opt-in provision establishes requirements for clear disclosure of fees and terms of overdraft services for ATM and one-time debit card transactions. The rule does not apply to other types of transactions, such as check, automated clearinghouse (ACH) and recurring debit card transactions.

 

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The Emergency Economic Stabilization Act of 2008 and the Troubled Asset Relief Program

 

In response to the market turmoil and financial crises affecting the overall banking system and financial markets in the United States, the Emergency Economic Stabilization Act of 2008 (“EESA”) was enacted in October 2008. In February 2009, the American Recovery and Reinvestment Act of 2009 (the “Stimulus Bill”) was enacted, which among other things augmented certain provisions of the EESA. Under the EESA, the Treasury Department has authority to purchase up to $700 billion in mortgage loans, mortgage-related securities and certain other financial instruments, including debt and equity securities issued by financial institutions in the Troubled Asset Relief Program (the “TARP”). The purpose of the TARP was to restore confidence and stability to the U.S. banking system and to encourage financial institutions to increase lending to customers and to each other.

 

The Treasury Department allocated $250 billion in TARP-authorized funds to the TARP Capital Purchase Program, which was developed to purchase senior preferred stock from qualifying financial institutions in order to strengthen their capital and liquidity positions and encourage them to increase lending to creditworthy borrowers. Qualifying financial institutions could be approved to issue preferred stock to the Treasury Department in amounts not less than 1% of their risk-weighted assets and not more than the lesser of $25 billion or 3% of risk-weighted assets. After evaluating the strategic advantages and operating restrictions inherent in issuing preferred shares to the U.S. government, Sierra Bancorp elected not to participate in the capital purchase element of TARP.

 

The EESA also established a Temporary Liquidity Guarantee Program (“TLGP”) that gave the FDIC the ability to provide a guarantee for newly-issued senior unsecured debt and non-interest bearing transaction deposit accounts at eligible insured institutions. The Company is currently participating in the transaction account guarantee program. This program was initially scheduled to continue through December 31, 2010, but the Dodd-Frank Act extended full deposit insurance coverage for non-interest bearing transaction accounts through December 31, 2012, and all financial institutions are required to participate in this extended guarantee program. For non-interest bearing transaction deposit accounts, a 10 basis point annual FDIC insurance premium surcharge was applied to deposit amounts in excess of $250,000 through December 31, 2009, and a risk-based surcharge of between 15 and 25 basis points was applied beginning January 1, 2010.

 

Interstate Banking and Branching

 

The Riegle Neal Interstate Banking and Branching Efficiency Act of 1994 (the “Interstate Banking Act”) regulates the interstate activities of banks and bank holding companies and establishes a framework for nationwide interstate banking and branching. Since 1995, adequately capitalized and managed bank holding companies have been permitted to acquire banks located in any state, subject to two exceptions: first, any state may still prohibit bank holding companies from acquiring a bank which is less than five years old; and second, no interstate acquisition can be consummated by a bank holding company if the acquirer would control more than 10% of the deposits held by insured depository institutions nationwide or 30% or more of the deposits held by insured depository institutions in any state in which the target bank has branches. In 1995, California enacted legislation to implement important provisions of the Interstate Banking Act and to repeal California’s previous interstate banking laws, which were largely preempted by the Interstate Banking Act. A bank may establish and operate de novo branches in any state in which the bank does not maintain a branch if that state has enacted legislation to expressly permit all out-of-state banks to establish branches in that state. However, California law expressly prohibits an out-of-state bank which does not already have a California branch office from (i) purchasing a branch office of a California bank (as opposed to purchasing the entire bank) and thereby establishing a California branch office, or (ii) establishing a de novo branch in California. It appears that the Interstate Banking Act and related California laws have contributed to the accelerated consolidation of the banking industry and increased competition, with many large out-of-state banks having entered the California market as a result of this legislation.

 

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USA Patriot Act of 2001

 

The impact of the USA Patriot Act of 2001 (the “Patriot Act”) on financial institutions of all kinds has been significant and wide ranging. The Patriot Act substantially enhanced existing anti-money laundering and financial transparency laws, and required appropriate regulatory authorities to adopt rules that promote cooperation among financial institutions, regulators, and law enforcement entities in identifying parties that may be involved in terrorism or money laundering. Under the Patriot Act, financial institutions are subject to prohibitions regarding specified financial transactions and account relationships, as well as enhanced due diligence and “know your customer” standards in their dealings with foreign financial institutions and foreign customers. The Patriot Act also requires all financial institutions to establish anti-money laundering programs. The Bank expanded its Bank Secrecy Act Compliance Department and intensified due diligence procedures concerning the opening of new accounts to fulfill the anti-money laundering requirements of the Patriot Act, and also implemented systems and procedures to identify suspicious banking activity and report any such activity to the Financial Crimes Enforcement Network.

 

Sarbanes-Oxley Act of 2002

 

The Company is subject to the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”) which addresses, among other issues, corporate governance, auditing and accounting, executive compensation, and enhanced and timely disclosure of corporate information. Among other things, Sarbanes-Oxley mandates chief executive and chief financial officer certifications of periodic financial reports, additional financial disclosures concerning off-balance sheet items, and accelerated share transaction reporting for executive officers, directors and 10% shareholders. In addition, Sarbanes-Oxley increased penalties for non-compliance with the Exchange Act. SEC rules promulgated pursuant to Sarbanes-Oxley impose obligations and restrictions on auditors and audit committees intended to enhance their independence from management, and include extensive additional disclosure, corporate governance and other related rules.

 

Commercial Real Estate Lending Concentrations

 

In December 2006, the federal bank regulatory agencies released Guidance on Concentrations in Commercial Real Estate (“CRE”) Lending, Sound Risk Management Practices (the “Guidance”). The Guidance, which was issued in response to the agencies’ concern that rising CRE concentrations might expose institutions to unanticipated earnings and capital volatility in the event of adverse changes in the commercial real estate market, reinforced existing regulations and guidelines for real estate lending and loan portfolio management. Highlights of the Guidance include the following:

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The Bank believes that the Guidance is applicable to it, as it has a relatively high level concentration in CRE loans. The Bank and its board of directors have discussed the Guidance and believe that the Bank’s underwriting policies, management information systems, independent credit administration process, and monitoring of real estate loan concentrations are sufficient to address the Guidance.

 

Allowance for Loan and Lease Losses

 

In December 2006, the federal bank regulatory agencies released an Interagency Policy Statement on the Allowance for Loan and Lease Losses (“ALLL”), which revises and replaces the banking agencies’ 1993 policy statement on the ALLL. The revised statement was issued to ensure consistency with generally accepted accounting principles (GAAP) and more recent supervisory guidance, and it extended the scope to include credit unions. Highlights of the revised statement include the following:

Other Pending and Proposed Legislation

 

Other legislative and regulatory initiatives which could affect the Company, the Bank and the banking industry in general are pending, and additional initiatives may be proposed or introduced before the United States Congress, the California legislature and other governmental bodies in the future. Such proposals, if enacted, may further alter the structure, regulation and competitive relationship among financial institutions, and may subject the Bank to increased regulation, disclosure and reporting requirements. In addition, the various banking regulatory agencies often adopt new rules and regulations to implement and enforce existing legislation. It cannot be predicted whether, or in what form, any such legislation or regulations may be enacted or the extent to which the business of the Company or the Bank would be affected thereby.

 

Item 1A. RISK FACTORS

 

You should carefully consider the following risk factors and all other information contained in this Annual Report before making investment decisions concerning the Company’s common stock. The risks and uncertainties described below are not the only ones the Company faces. Additional risks and uncertainties not presently known to the Company or that the Company currently believes are immaterial may also adversely impact the Company’s business. If any of the events described in the following risk factors occur, the Company’s business, results of operations and financial condition could be materially adversely affected. In addition, the trading price of the Company’s common stock could decline due to any of the events described in these risks.

 

Risks Relating to the Bank and to the Business of Banking in General

Our business has been and may continue to be adversely affected by volatile conditions in the financial markets and unfavorable economic conditions generally. From December 2007 through June 2009, the U.S. economy was in recession. Business activity across a wide range of industries and regions in the U.S. was greatly reduced, and remains at subdued or recessionary levels in many parts of the Country. The financial markets and the financial services industry in particular suffered unprecedented disruption, causing a number of institutions to fail or to require government intervention to avoid failure.

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As a result of these financial and economic crises, many lending institutions, including our company, have experienced significant declines in the performance of their loans, particularly construction, development and land loans, and unsecured commercial and consumer loans. Our total nonperforming assets stood at $71.5 million at December 31, 2011, relative to $66.6 million at December 31, 2010 and $72.6 million at December 31, 2009, representing 9.23%, 8.07%, and 7.98% of total gross loans and foreclosed assets at December 31, 2011, 2010 and 2009, respectively.

The California economy has been particularly hard hit, and the economic decline has been a major factor leading to the significant increase in the Company’s nonperforming assets and loan charge-offs since the end of 2007. Unemployment levels have always been relatively high in the San Joaquin Valley and in Tulare County, which is our geographic center and the base of our agriculturally oriented communities, but recessionary conditions pushed the unemployment rate to exceptionally high levels in recent years. The unemployment rate for Tulare County reached a high of 19.1% during the current economic cycle, in March of 2010. It was 16.2% in December 2011, down slightly from 17.7% in December 2010 and 17.1% in December 2009, but still well above the 11.1% aggregate unemployment rate for California as of December 2011.

Although there are indications of improving economic conditions nationally, certain sectors, such as real estate, remain weak and unemployment remains high, especially in our local markets. The state government, most local governments, and many businesses are still experiencing difficulties due to lower consumer spending and the lack of liquidity in the credit markets. In addition, the values of the real estate collateral supporting many commercial loans and home mortgages have declined and may continue to decline. Further negative market developments may also continue to adversely affect consumer confidence levels and payment patterns, which could cause delinquencies and default rates to remain at high levels.

If business and economic conditions do not improve generally or in the principal markets in which we do business, the prolonged economic weakness could have one or more of the following adverse effects on our business:

·a continued lack of demand for loans, or other products and services offered by us;
·a continued decline in the value of our loans or other assets secured by residential or commercial real estate;
·a decrease in deposit balances due to increased pressure on the liquidity of our customers;
·an impairment of our investment securities; or
·an increase in the number of borrowers who become delinquent, file for protection under bankruptcy laws or default on their loans or other obligations to us, which in turn could result in a higher level of nonperforming assets, net charge-offs and provision for credit losses, which would reduce our earnings.

 

Challenges in the agricultural industry could have an adverse effect on our customers and their ability to make payments to us. While the Company’s current relatively high level of nonperforming assets is comprised mainly of other real estate owned and loans secured by land, lots, and commercial/residential real estate, one of the additions to non-accrual loans during the fourth quarter of 2011 was a sizeable agricultural-related real estate loan. In previous years, difficulties experienced by the agricultural industry in our market areas were the primary driver behind high levels of nonperforming assets. This is due to the fact that a considerable portion of our total loan portfolio consists of loans to borrowers either directly or indirectly involved in the agricultural industry. A great number of our borrowers may not be individually directly involved in agriculture, but many of the jobs in the San Joaquin Valley are ancillary to the regular production, processing, marketing and sales of agricultural commodities.

The markets for agricultural products can be adversely impacted by increased supply from overseas competition, a drop in consumer demand, and numerous other factors. The ripple effect of any resulting drop in commodity prices can depress land prices, lower borrower income, and decrease collateral values. Weather patterns are also of critical importance to row crop, tree fruit, and citrus production. A degenerative cycle of weather has the potential to adversely affect agricultural industries as well as consumer purchasing power, and could lead to further unemployment throughout the San Joaquin Valley. Another potential looming issue that could have a major impact on the agricultural industry involves water distribution rights. If the amount of water available to agriculture becomes increasingly scarce due to drought and/or diversion to other uses, farmers may not be able to continue to produce agricultural products at a reasonable profit, which has the potential to force many out of business. Such conditions have affected and may continue to adversely affect our borrowers and, by extension, our business, and if general agricultural conditions decline our level of nonperforming assets could increase.

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Concentrations of real estate loans could subject us to increased risks in the event of a prolonged real estate recession or natural disaster. Our loan portfolio is heavily concentrated in real estate loans, particularly commercial real estate. At December 31, 2011, 76% of our loan portfolio consisted of loans secured by real estate. Balances secured by commercial buildings and construction and development loans represented 57% of all real estate loans, while loans secured by residential properties accounted for 33%, and loans secured by farmland were 10% of real estate loans. The Company’s $71.5 million balance of nonperforming assets at December 31, 2011 included $15.4 million in foreclosed assets, primarily other real estate owned (OREO) consisting of vacant land, lots, and residential properties. Nonperforming loans totaling $56.1 million comprised the remainder of the nonperforming assets, and $46.1 million of that balance was in nonperforming real estate loans.

The Central Valley residential real estate market experienced significant deflation in property values during 2008 and 2009, with little change from recessionary lows in 2010 and 2011, and foreclosures have occurred at relatively high rates since the beginning of the recession. If residential real estate values slide further, and/or if this weakness further impacts commercial real estate values, the Company’s nonperforming assets could increase from current levels. Such an increase could have a material adverse effect on our financial condition and results of operations by reducing our income, increasing our expenses, and leaving less cash available for lending and other activities. As noted above, the primary collateral for many of our loans consists of commercial real estate properties, and continued deterioration in the real estate market in the areas the Company serves would likely reduce the value of the collateral for many of our loans and could negatively impact the repayment ability of many of our borrowers. It might also reduce further the amount of loans the Company makes to businesses in the construction and real estate industry, which could negatively impact our organic growth prospects. Similarly, the occurrence of a natural disaster like those California has experienced in the past, including earthquakes, brush fires, and flooding, could impair the value of the collateral we hold for real estate secured loans and negatively impact our results of operations.

In addition, banking regulators now give commercial real estate loans extremely close scrutiny due to risks relating to the cyclical nature of the real estate market, and related risks for lenders with high concentrations of such loans. The regulators have required banks with relatively high levels of CRE loans to implement enhanced underwriting standards, internal controls, risk management policies and portfolio stress testing, which has resulted in higher allowances for possible loan losses. Expectations for higher capital levels have also materialized. Any increase in our allowance for loan losses would adversely affect our net income, and any requirement that we maintain higher capital levels could adversely impact financial performance measures such as earnings per share.

Our concentrations of commercial real estate, construction and land development, and commercial and industrial loans expose us to increased lending risks. Commercial real estate, construction and land development, and commercial and industrial loans and leases, including agricultural production loans but not including SBA loans, comprised approximately 60% of our total loan portfolio as of December 31, 2011, and expose the Company to a greater risk of loss than residential real estate and consumer loans, which comprised a smaller percentage of the total loan portfolio. Commercial real estate and land development loans typically involve larger loan balances to single borrowers or groups of related borrowers compared to residential loans. Consequently, an adverse development with respect to one commercial loan or one credit relationship exposes us to a significantly greater risk of loss compared to an adverse development with respect to one residential mortgage loan.

Repayment of our commercial loans is often dependent on the cash flows of the borrower, which may be unpredictable, and the collateral securing these loans may fluctuate in value. At December 31, 2011, we had $123 million or 16% of total loans in commercial loans and leases, including agricultural production loans but not including SBA loans. Commercial lending involves risks that are different from those associated with residential and commercial real estate lending. Real estate lending is generally considered to be collateral based lending with loan amounts based on predetermined loan to collateral values and liquidation of the underlying real estate collateral being viewed as the primary source of repayment in the event of borrower default. Our commercial loans are primarily made based on the cash flow of the borrower and secondarily on any underlying collateral provided by the borrower. The borrower’s cash flow may be unpredictable, and collateral securing these loans may fluctuate in value. Although commercial loans are often collateralized by equipment, inventory, accounts receivable, or other business assets, the liquidation of collateral in the event of default is often an insufficient source of repayment because accounts receivable may be uncollectible and inventories may be obsolete or of limited use, among other things. Accordingly, the repayment of commercial loans depends primarily on the cash flow and credit worthiness of the borrower and secondarily on the underlying collateral provided by the borrower.

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Nonperforming assets take significant time to resolve and adversely affect our results of operations and financial condition. Our nonperforming assets adversely affect our net income in various ways. Until economic and market conditions improve, we expect that our nonperforming loans will continue at relatively high levels, which will negatively impact earnings and could have a substantial adverse impact if conditions deteriorate further. We do not record interest income on non-accrual loans, thereby adversely affecting our level of interest income. Additionally, our non-interest expense has increased due to the costs of reappraising adversely classified assets, write-downs on foreclosed assets subsequent to reappraisals reflecting lower values, operating costs related to foreclosed assets, legal and other costs associated with loan collections, and various other expenses that would not typically be incurred in a normal operating environment. Furthermore, when we receive collateral through foreclosures and similar proceedings, we are required to record the collateral at its fair market value less estimated selling costs, which may result in write-downs or losses. An increase in the level of nonperforming assets also increases our risk profile and may impact the capital levels our regulators believe is appropriate in light of such risks. We utilize various techniques such as loan sales, workouts and restructurings to manage our problem assets. Decreases in the value of these problem assets, the underlying collateral, or in the borrowers’ performance or financial condition, could adversely affect our business, results of operations and financial condition. In addition, the resolution of nonperforming assets requires a significant commitment of time from management and staff, which can be detrimental to performance of their other responsibilities. There can be no assurance that we will avoid further increases in nonperforming loans in the future.

We may experience loan and lease losses in excess of our allowance for such losses. We endeavor to limit the risk that borrowers might fail to repay; nevertheless, losses can and do occur. We maintain an allowance for estimated loan and lease losses in our accounting records, based on estimates of:

·historical experience with our loans;
·evaluation of economic conditions;
·regular reviews of the quality, mix and size of the overall loan portfolio;
·a detailed cash flow analysis for nonperforming loans;
·regular reviews of delinquencies; and
·the quality of the collateral underlying our loans.

 

We maintain our allowance for loan and lease losses at a level that we believe is adequate to absorb specifically identified probable losses as well as any other losses inherent in our loan portfolio at a given date. While we strive to carefully monitor credit quality and to identify loans that may become nonperforming, at any given time there are loans in the portfolio that could result in losses but that have not been identified as nonperforming or potential problem loans. We cannot be sure that we will be able to identify deteriorating loans before they become nonperforming assets, or that we will be able to limit losses on those loans that have been identified. Changes in economic, operating and other conditions which are beyond our control, including interest rate fluctuations, deteriorating values in underlying collateral (most of which consists of real estate), and changes in the financial condition of borrowers, may cause our estimate of probable losses or actual loan losses to exceed our current allowance. In addition, the FDIC and the DFI, as part of their supervisory functions, periodically review our allowance for loan and lease losses. Such agencies may require us to increase our provision for loan and lease losses or to recognize further losses, based on their judgment, which may be different from that of our management. Any such increase in the allowance required by the FDIC or the DFI could also hurt our business.

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Our use of appraisals in deciding whether to make a loan on or secured by real property does not ensure the value of the real property collateral. In considering whether to make a loan secured by real property, we generally require an appraisal of the property. However, an appraisal is only an estimate of the value of the property at the time the appraisal is made, and an error in fact or judgment could adversely affect the reliability of an appraisal. In addition, events occurring after the initial appraisal may cause the value of the real estate to decrease. As a result of any of these factors the value of collateral backing a loan may be less than supposed, and if a default occurs we may not recover the outstanding balance of the loan.

Our expenses could increase as a result of increases in FDIC insurance premiums. The FDIC, absent extraordinary circumstances, must establish and implement a plan to restore the deposit insurance reserve ratio to 1.35% of estimated insured deposits or the comparable percentage of the assessment base at any time the reserve ratio falls below 1.35%. Bank failures during the current economic cycle depleted the deposit insurance fund balance, which was in a negative position from the end of 2009 until the second quarter of 2011. The balance had increased to only $7.8 billion with a resulting reserve ratio of 0.12% at September 30, 2011. The FDIC currently has until September 30, 2020 to bring the reserve ratio back to the statutory minimum. As noted above under “Regulation and Supervision – Deposit Insurance”, the FDIC has implemented a restoration plan that adopted a new assessment base and established new assessment rates starting with the second quarter of 2011. The FDIC also imposed a special assessment in 2009 and required the prepayment of three years of FDIC insurance premiums at the end of 2009. The prepayments were designed to help address liquidity issues created by potential timing differences between the collection of premiums and charges against the DIF, but it is generally expected that assessment rates will remain relatively high in the near term due to the significant cost of bank failures and the relatively large number of troubled banks. Any further significant premium increases or special assessments could have a material adverse effect on our financial condition and results of operations.

We may not be able to continue to attract and retain banking customers, and our efforts to compete may reduce our profitability. Competition in the banking industry in the markets we serve may limit our ability to continue to attract and retain banking customers. The banking business in our current and intended future market areas is highly competitive with respect to virtually all products and services. In California generally, and in our service areas specifically, branches of major banks dominate the commercial banking industry. Such banks have substantially greater lending limits than we have, offer certain services we cannot offer directly, and often operate with economies of scale that result in relatively low operating costs on a per loan or per asset basis. We also compete with numerous financial and quasi-financial institutions for deposits and loans, including providers of financial services over the internet. New technology and other changes are allowing parties to effectuate financial transactions that previously required the involvement of banks. For example, consumers can maintain funds in brokerage accounts or mutual funds that would have historically been held as bank deposits. Consumers can also complete transactions such as paying bills and transferring funds directly without the assistance of banks. The process of eliminating banks as intermediaries, known as “disintermediation,” could result in the loss of fee income, as well as the loss of customer deposits and the related income generated from those deposits. The loss of these revenue streams and access to lower cost deposits as a source of funds could have a material adverse effect on our financial condition and results of operations.

In addition, with the increase in bank failures, customers are increasingly concerned about the extent to which their deposits are insured by the FDIC. Customers may withdraw deposits in an effort to ensure that the amount they have on deposit with their bank is fully insured. Decreases in deposits may adversely affect our funding costs and net income. Ultimately, competition can and does increase our cost of funds, reduce loan yields and drive down our net interest margin, thereby reducing profitability. It can also make it more difficult for us to continue to increase the size of our loan portfolio and deposit base, and could cause us to rely more heavily on wholesale borrowings, which are generally more expensive than deposits.

If we are not able to successfully keep pace with technological changes affecting the industry, our business could be hurt. The financial services industry is constantly undergoing technological change, with the frequent introduction of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better service clients and reduce costs. Our future success depends, in part, upon our ability to respond to the needs of our clients by using technology to provide desired products and services and create additional efficiencies within our operations. Some of our competitors have substantially greater resources to invest in technological improvements. We may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our clients. Failure to successfully keep pace with technological change in the financial services industry could have a material adverse impact on our business and, in turn, on our financial condition and results of operations.

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If our information systems were to experience a system failure or a breach in security, our business and reputation could suffer. We rely heavily on communications and information systems to conduct our business. The computer systems and network infrastructure we use could be vulnerable to unforeseen problems. Our operations are dependent upon our ability to minimize service disruptions by protecting our computer equipment, systems, and network infrastructure from physical damage due to fire, power loss, telecommunications failure or a similar catastrophic event. In addition, we must be able to protect against unauthorized system breaches that could jeopardize the security of customer information and other proprietary data. We have protective measures in place to prevent or limit the effect of the failure, interruption or security breach of our information systems and will continue to implement security technology and monitor and update operational procedures to prevent such damage. However, if such failures, interruptions or security breaches were to occur, they could result in damage to our reputation, a loss of customers, increased regulatory scrutiny, or possible exposure to financial liability, any of which could have a material adverse effect on our financial condition and results of operations.

We are subject to a variety of operational risks, including reputational risk, legal risk and compliance risk, and the risk of fraud or theft by employees or outsiders, which may adversely affect our business and results of operations. We are exposed to many types of operational risks, including reputational risk, legal and compliance risk, the risk of fraud or theft by employees or outsiders, and unauthorized transactions by employees or operational errors, including clerical or record-keeping errors or those resulting from faulty or disabled computer or telecommunications systems.

If personal, non-public, confidential or proprietary information of customers in our possession were to be mishandled or misused, we could suffer significant regulatory consequences, reputational damage and financial loss. Such mishandling or misuse could occur, for example, if information were erroneously provided to parties who are not permitted to have the information, either by fault of our systems, employees, or counterparties, or where such information is intercepted or otherwise inappropriately taken by third parties.

Because the nature of the financial services business involves a high volume of transactions, certain errors may be repeated or compounded before they are discovered and successfully rectified. Our necessary dependence upon automated systems to record and process transactions and our large transaction volume may further increase the risk that technical flaws or employee tampering or manipulation of those systems could result in losses that are difficult to detect. We also may be subject to disruptions of our operating systems arising from events that are wholly or partially beyond our control (for example, computer viruses or electrical or telecommunications outages, or natural disasters, disease pandemics or other damage to property or physical assets) which may give rise to disruption of service to customers and to financial loss or liability. We are further exposed to the risk that our external vendors may be unable to fulfill their contractual obligations (or will be subject to the same risk of fraud or operational errors by their respective employees as we are) and to the risk that we (or our vendors’) business continuity and data security systems prove to be inadequate. The occurrence of any of these risks could result in a diminished ability to operate our business (for example, by requiring us to expend significant resources to correct the defect), as well as potential liability to clients, reputational damage and regulatory intervention, which could adversely affect our business, financial condition and results of operations, perhaps materially.

Recently enacted and potential further financial regulatory reforms could have a significant impact on our business, financial condition and results of operations. The Dodd-Frank Wall Street Reform and Consumer Protection Act was enacted in July 2010. Dodd-Frank is expected to have a broad impact on the financial services industry, including significant regulatory and compliance changes. Many of the requirements called for in Dodd-Frank will be implemented over time and most will be subject to implementing regulations over the course of several years. Given the uncertainty associated with the manner in which the provisions of Dodd-Frank will be implemented by the various regulatory agencies and through regulations, the full extent of the impact these requirements will have on our operations is unclear. The changes resulting from Dodd-Frank may impact the profitability of business activities, require changes to certain business practices, impose more stringent capital, liquidity and leverage requirements or otherwise adversely affect our business. In particular, the potential impact of Dodd-Frank on our operations and activities, both currently and prospectively, include, among others:

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·an increase in the cost of operations due to greater regulatory oversight, supervision and examination of banks and bank holding companies, and higher deposit insurance premiums;
·the limitation of our ability to expand consumer product and service offerings due to anticipated stricter consumer protection laws and regulations;
·a material negative impact on our cost of funds when market interest rates increase, if pursuant to the authorization for financial institutions to pay interest on business checking accounts we decide to offer such a product on a broad scale for competitive reasons;
·a potential reduction in fee income, due to limits on interchange fees applicable to larger institutions which could ultimately lead to a competitive-driven reduction in the fees we charge;
·a potential increase in competition due to the elimination of remaining barriers to de novo interstate branching; and
·the limitation of our ability to raise new capital through the use of trust preferred securities, as any new issuances of these securities are not includible as Tier 1 capital.

 

Further, we may be required to invest significant management attention and resources to evaluate and make any changes necessary to comply with new statutory and regulatory requirements under the Dodd-Frank Act, which may negatively impact results of operations and financial condition.

Additionally, we cannot predict whether there will be additional laws or reforms that would affect the U.S. financial system or financial institutions, when such changes may be adopted, how such changes may be interpreted and enforced or how such changes may affect us. However, the costs of complying with any additional laws or regulations could have a material adverse effect on our financial condition and results of operations.

We may be adversely affected by the soundness of other financial institutions. Our ability to engage in routine funding transactions could be adversely affected by the actions and liquidity of other financial institutions. Financial institutions are often interconnected as a result of trading, clearing, counterparty, or other business relationships. We have exposure to many different industries and counterparties, and routinely execute transactions with counterparties in the financial services industry, including commercial banks, brokers and dealers, investment banks, and other institutional clients. Many of these transactions expose us to credit risk in the event of a default by a counterparty or client. In addition, that credit risk may be exacerbated when collateral held by us cannot be liquidated at prices sufficient to recover the full amount of the credit or derivative exposure due to us. Any such losses could adversely affect our business, financial condition or results of operations.

Changes in interest rates could adversely affect our profitability, business and prospects. Banking companies’ earnings depend largely on the relationship between the cost of funds, primarily deposits and borrowings, and the yield on earning assets, such as loans and investment securities. That relationship, known as the interest rate spread, is subject to fluctuation and is affected by the monetary policies of the Federal Reserve Board and the international interest rate environment, as well as by economic, regulatory and competitive factors which influence interest rates, the volume and mix of interest earning assets and interest bearing liabilities, and the level of nonperforming assets. Many of these factors are beyond our control. We are subject to interest rate risk to the degree that our interest bearing liabilities re-price or mature more slowly or more rapidly or on a different basis than our interest earning assets. For example, if the rate of interest we pay on interest-bearing deposits, borrowings, and other liabilities increases more than the rate of interest we receive on loans, securities, and other interest-earning assets, our net interest income and therefore our earnings could be adversely affected. Our earnings could also be adversely affected if the rates on our loans and other investments fall more quickly than those on our deposits and other liabilities.

In addition, fluctuations in interest rates can affect the demand of customers for products and services, and an increase in the general level of interest rates may adversely affect the ability of certain borrowers to make variable-rate loan payments as they adjust upward. Accordingly, changes in market interest rates could materially and adversely affect our net interest spread, asset quality, loan origination volume, business, financial condition, results of operations, and cash flows.

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We depend on our executive officers and key personnel to implement our business strategy and could be harmed by the loss of their services. We believe that our continued growth and success depends in large part upon the skills of our management team and other key personnel. The competition for qualified personnel in the financial services industry is intense, and the loss of key personnel or an inability to continue to attract, retain or motivate key personnel could adversely affect our business. If we are not able to retain our existing key personnel or attract additional qualified personnel, our business operations would be hurt. None of our executive officers have employment agreements.

The value of securities in our investment securities portfolio may be negatively affected by continued disruptions in securities markets. The market for some of the investment securities held in our portfolio has experienced volatility and disruption for the last several years. These market conditions may have a detrimental effect on the value of our securities, such as reduced valuations because of the perception of heightened credit risks or due to illiquid markets for certain securities. There can be no assurance that the declines in market value associated with these disruptions will not result in other-than-temporary impairments of these assets, which would lead to accounting charges that could have a material adverse effect on our results of operations and capital levels.

We are exposed to risk of environmental liabilities with respect to properties to which we obtain title. Approximately 76% of our loan portfolio at December 31, 2011 was secured by real estate. In the normal course of business, we may foreclose and take title to real estate, and could be subject to environmental liabilities with respect to these properties. We may be held liable to a governmental entity or to third parties for property damage, personal injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination, or may be required to investigate or clean up hazardous or toxic substances, or chemical releases at a property. The costs associated with investigation or remediation activities could be substantial. In addition, if we are the owner or former owner of a contaminated site, we may be subject to common law claims by third parties based on damages and costs resulting from environmental contamination emanating from the property. These costs and claims could adversely affect our business and prospects.

The recent repeal of federal prohibitions on payment of interest on demand deposits could increase our interest expense. All federal prohibitions on the ability of financial institutions to pay interest on demand deposit accounts were repealed as part of the Dodd-Frank Act. As a result, beginning on July 21, 2011, financial institutions were allowed to offer interest on demand deposits to compete for clients. Because of the current low interest rate environment, the rates offered by competing financial institutions have not posed a competitive threat to our business. However, in the event of rising interest rates or irrational competition, our interest expense will increase and our net interest margin will decrease if we actively market an interest-bearing demand deposit account to attract additional customers or retain current customers, which could have a material adverse effect on our business, financial condition and results of operations.

Risks Related to our Common Stock

The price of our common stock may fluctuate significantly, and this may make it difficult for you to sell shares of common stock at times or at prices you find attractive. The trading price of our common stock may fluctuate widely as a result of a number of factors, many of which are outside our control. In addition, the stock market is subject to fluctuations in share prices and trading volumes that affect the market prices of the shares of many companies. These broad market fluctuations could adversely affect the market price of our common stock. Among the factors that could affect our common stock price in the future are:

·actual or anticipated fluctuations in our reported operating results and financial condition;
·changes in revenue or earnings estimates or publication of research reports and recommendations by financial analysts;
·failure to meet analysts’ revenue or earnings estimates;
·speculation in the press or investment community;
·strategic actions by us or our competitors, such as acquisitions or restructurings;

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·acquisitions of other banks or financial institutions, through FDIC-assisted transactions or otherwise;
·actions by shareholders;
·fluctuations in the stock price, trading volumes, and operating results of our competitors;
·general market conditions and, in particular, market conditions for the financial services industry;
·fluctuations in the stock prices and/or operating results of our competitors;
·proposed or adopted regulatory changes or developments;
·formal regulatory action against us;
·anticipated or pending investigations, proceedings, or litigation that involve or affect us; and
·domestic and international economic factors unrelated to our performance.

 

The stock market and, in particular, the market for financial institution stocks, has experienced significant volatility in recent years. As a result, the market price of our common stock has been, and could continue to be, volatile. In addition, the trading volume in our common stock may fluctuate more than usual and cause significant price variations to occur. The trading price of the shares of our common stock also depends on many other factors which may change from time to time, including, without limitation, our financial condition, performance, creditworthiness and prospects, future sales of our equity or equity related securities, and other factors identified elsewhere in this report. The capital and credit markets have been experiencing volatility and disruption for several years, at times reaching unprecedented levels. In some cases, the markets have produced downward pressure on stock prices and credit availability for certain issuers without regard to the issuers’ underlying financial strength.

We may pursue additional capital in the future, which may not be available on acceptable terms or at all, could dilute the holders of our outstanding common stock, and may adversely affect the market price of our common stock. Our ability to raise additional capital, if needed, will depend on, among other things, conditions in the capital markets at the time, which are outside of our control, and our financial performance. We cannot provide any assurance that such capital will be available to us on acceptable terms or at all. Any such capital raising alternatives could dilute the holders of our outstanding common stock, and may adversely affect the market price of our common stock and our performance measures such as earnings per share.

The Company relies heavily on the payment of dividends from the Bank. Other than $5.4 million in cash available at the holding company level at December 31, 2011, the Company’s ability to meet debt service requirements and to pay dividends depends on the Bank’s ability to pay dividends to the Company, as it has no other source of significant income. However, the Bank is subject to regulations limiting the amount of dividends it may pay. For example, the payment of dividends by the Bank is affected by the requirement to maintain adequate capital pursuant to the capital adequacy guidelines issued by the Federal Deposit Insurance Corporation. All banks and bank holding companies are required to maintain a minimum ratio of qualifying total capital to total risk-weighted assets of 8%, at least one-half of which must be in the form of Tier 1 capital, and a ratio of Tier 1 capital to average adjusted assets of 4%. If (i) any of these required ratios are increased; (ii) the total risk-weighted assets of the Bank increase significantly; and/or (iii) the Bank’s income declines significantly, the Bank’s Board of Directors may decide or be required to retain a greater portion of the Bank’s earnings to achieve and maintain the required capital or asset ratios. This will reduce the amount of funds available for the payment of dividends by the Bank to the Company. Further, in some cases, one or more of the Bank’s regulators could prohibit the Bank from paying dividends if, in their view, such payments would constitute unsafe or unsound banking practices. The Bank’s ability to pay dividends to the Company is also limited by the California Financial Code. Whether dividends are paid and their frequency and amount will also depend on the financial condition and performance of the Bank, and the discretion of the Bank’s Board of Directors. Information concerning the Company’s dividend policy and historical dividend practices is set forth below under “Dividend Policy.” However, no assurance can be given that our future performance will justify the payment of dividends in any particular year.

You may not be able to sell your shares at the times and in the amounts you want if the trading market for our stock is not active. Although our stock has been listed on NASDAQ for many years, trading in our stock does not consistently occur in high volumes and cannot always be characterized as an active trading market. The limited trading market for our common stock may exaggerate fluctuations in the value of our common stock, leading to price volatility in excess of that which would occur in a more active trading market. Future sales of substantial amounts of common stock in the public market, or the perception that such sales may occur, could also adversely affect the prevailing market price of our common stock.

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Your investment may be diluted because of the ability of management to offer stock to others and stock options. The shares of our common stock do not have preemptive rights. This means that you may not be entitled to buy additional shares if shares are offered to others in the future. We are authorized to issue 24,000,000 shares of common stock, and as of December 31, 2011 we had 14,101,609 shares of our common stock outstanding. Except for certain limitations imposed by NASDAQ, nothing restricts management’s ability to offer additional shares of stock for fair value to others in the future. Any issuances of common stock would dilute our shareholders’ ownership interests and may dilute the per share book value of our common stock. In addition, when our directors, executive officers and key employees exercise any of their stock options, your ownership in the Company will be diluted. As of December 31, 2011, there were outstanding options to purchase an aggregate of 810,020 shares of our common stock with an average exercise price of $14.97 per share. At the same date there were an additional 871,920 shares available for grant under our 2007 Stock Incentive Plan.

Shares of our preferred stock issued in the future could have dilutive and other effects on our common stock. Our Articles of Incorporation authorize us to issue 10,000,000 shares of preferred stock, none of which is presently outstanding. Although our Board of Directors has no present intent to authorize the issuance of shares of preferred stock, such shares could be authorized in the future. If such shares of preferred stock are made convertible into shares of common stock, there could be a dilutive effect on the shares of common stock then outstanding. In addition, shares of preferred stock may be provided a preference over holders of common stock upon our liquidation or with respect to the payment of dividends, in respect of voting rights or in the redemption of our common stock. The rights, preferences, privileges and restrictions applicable to any series or preferred stock would be determined by resolution of our Board of Directors.

The holders of our debentures have rights that are senior to those of our shareholders. In 2004 we issued $15,464,000 of junior subordinated debt securities due March 17, 2034 and in 2006 we issued an additional $15,464,000 of junior subordinated debt securities due September 23, 2036 in order to raise additional regulatory capital. These junior subordinated debt securities are senior to the shares of our common stock. As a result, we must make interest payments on the debentures before any dividends can be paid on our common stock, and in the event of our bankruptcy, dissolution or liquidation, the holders of the debt securities must be paid in full before any distributions may be made to the holders of our common stock. In addition, we have the right to defer interest payments on the junior subordinated debt securities for up to five years, during which time no dividends may be paid to holders of our common stock. In the event that the Bank is unable to pay dividends to us, then we may be unable to pay the amounts due to the holders of the junior subordinated debt securities and, thus, we would be unable to declare and pay any dividends on our common stock.

Provisions in our articles of incorporation could delay or prevent changes in control of our corporation or our management. Our articles of incorporation contain provisions for staggered terms of office for members of the board of directors; no cumulative voting in the election of directors; and the requirement that our board of directors consider the potential social and economic effects on our employees, depositors, customers and the communities we serve as well as certain other factors, when evaluating a possible tender offer, merger or other acquisition of the Company. These provisions make it more difficult for another company to acquire us, which could cause our shareholders to lose an opportunity to be paid a premium for their shares in an acquisition transaction, and reduce the current and future market price of our common stock.

 

ITEM 1B. UNRESOLVED STAFF COMMENTS

 

Not applicable.

 

Item 2. Properties

 

The Company’s administrative headquarters is located at 86 North Main Street, Porterville, California, in a 37,000 square feet, three-story office building of which the Company is sole occupant. The Company purchased this office building in December 2011 in a cash transaction, from parties unrelated to the Company. The Company’s main office is located at 90 N. Main Street, Porterville, California, adjacent to its administrative headquarters, and it consists of a one-story brick building that sits upon unencumbered property owned by the Company. The Company also owns unencumbered property on which 14 of its other offices are located, namely the following branches: Porterville West Olive, Bakersfield Ming, California City, Dinuba, Exeter, Farmersville, Fresno Shaw, Hanford, Lindsay, Tehachapi Downtown, Tehachapi Old Town, Three Rivers, Tulare, and Visalia Mooney. The remaining branches are all leased from unrelated parties. In addition, the Company operates a technology center in Porterville which consists of approximately 12,000 square feet in a freestanding single-story building that is leased from unrelated parties, and the Bank has eight remote ATM locations leased from unrelated parties. While limited branch expansion is planned over the course of the next few years, management believes that existing back office facilities are adequate to accommodate the Company’s operations for the immediately foreseeable future.

 

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Item 3. Legal Proceedings

 

From time to time, the Company is a party to claims and legal proceedings arising in the ordinary course of business. After taking into consideration information furnished by counsel to the Company as to the current status of these claims or proceedings to which the Company is a party, management is of the opinion that the ultimate aggregate liability represented thereby, if any, will not have a material adverse affect on the financial condition of the Company.

 

Item 4. RESERVED

 

PART II

 

Item 5. Market for REGISTRANT’S Common Equity, Related Shareholder Matters AND ISSUER PURCHASES OF EQUITY SECURITIES

 

(a) Market Information

 

Sierra Bancorp’s Common Stock trades on the NASDAQ Global Select Market under the symbol BSRR, and the CUSIP number for our stock is #82620P102. Trading in the Common Stock of the Company has not consistently occurred in high volumes, and such trading activity cannot always be characterized as constituting an active trading market. The following table summarizes trades of the Company’s Common Stock, setting forth the approximate high and low sales prices and volume of trading for the periods indicated, based upon information provided by public sources.

 

  Sale Price of the Company’s Approximate
Calendar Common Stock (per share) Trading Volume
Quarter Ended High Low In Shares
March 31, 2010 $13.73 $7.18 1,898,909
June 30, 2010 $14.12 $11.49 1,871,420
September 30, 2010 $12.50 $10.81 1,605,491
December 31, 2010 $13.10 $10.06 1,916,775
March 31, 2011 $11.20 $10.38 1,444,602
June 30, 2011 $11.73 $10.58 1,233,723
September 30, 2011 $11.70 $8.47 1,499,721
December 31, 2011 $11.49 $8.51 1,744,827

 

(b) Holders

 

As of February 7, 2012 there were approximately 4,176 shareholders of the Company’s Common Stock. Per our stock transfer agent there were 577 registered holders of record, and per Broadridge, an investor communication company, there were approximately 3,599 beneficial holders with shares being held under a street name on that date, including “objecting beneficial owners” whose names and addresses are unavailable.

 

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(c) Dividends

 

The Company paid cash dividends totaling $3.4 million, or $0.24 per share in 2011, and $2.9 million, or $0.24 per share in 2010, representing 43% of annual net earnings for dividends paid in 2011 and 40% in 2010. The Company’s general dividend policy is to pay cash dividends within the range of typical peer payout ratios, provided that such payments do not adversely affect the Company’s financial condition and are not overly restrictive to its growth capacity. While many of our peers have elected to suspend dividend payments, at least temporarily, the Company’s Board has concluded that a certain level of dividend should be maintained as long as our core operating performance remains adequate and policy or regulatory restrictions do not preclude such payments. That said, in an effort to conserve capital in an uncertain environment and maintain a rational dividend payout ratio, our quarterly per-share dividend was reduced in 2009 and lowered again in 2010. While we maintained a consistent level of quarterly dividends in 2011, no assurance can be given that our financial performance in any given year will justify the continued payment of a cash dividend. As a bank holding company that currently has no significant assets other than its equity interest in the Bank, the Company’s ability to declare dividends depends primarily upon current levels of cash on hand, as supplemented by dividends it might receive from the Bank. The Bank’s dividend practices in turn depend upon the Bank’s earnings, financial position, current and anticipated capital requirements, and other factors deemed relevant by the Bank’s Board of Directors at that time. The power of the Bank’s Board of Directors to declare cash dividends is also subject to statutory and regulatory restrictions. Under California banking law, the Bank may declare dividends in an amount not exceeding the lesser of its retained earnings or its net income for the last three years (reduced by dividends paid during such period) or, with the prior approval of the California Commissioner of Financial Institutions, in an amount not exceeding the greatest of (i) the retained earnings of the Bank, (ii) the net income of the Bank for its last fiscal year, or (iii) the net income of the Bank for its current fiscal year. The payment of any cash dividends by the Bank will depend not only upon the Bank’s earnings during a specified period, but also on the Bank meeting certain regulatory capital requirements.

 

The Company’s ability to pay dividends is also limited by state corporation law. The California General Corporation Law allows a California corporation to pay dividends if the company’s retained earnings equal at least the amount of the proposed dividend. If a California corporation does not have sufficient retained earnings available for the proposed dividend, it may still pay a dividend to its shareholders if immediately after the dividend the sum of the company’s assets (exclusive of goodwill and deferred charges) would be at least equal to 125% of its liabilities (not including deferred taxes, deferred income and other deferred liabilities) and the current assets of the company would be at least equal to its current liabilities, or, if the average of its earnings before taxes on income and before interest expense for the two preceding fiscal years was less than the average of its interest expense for the two preceding fiscal years, at least equal to 125% of its current liabilities. In addition, during any period in which the Company has deferred payment of interest otherwise due and payable on its subordinated debt securities, it may not make any dividends or distributions with respect to its capital stock (see “Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations – Capital Resources”).

 

(d) Securities Authorized for Issuance under Equity Compensation Plans

 

The following table provides information as of December 31, 2011, with respect to options outstanding and available under our 2007 Stock Incentive Plan and the now-terminated 1998 Stock Option Plan, which are our only equity compensation plans other than an employee benefit plan meeting the qualification requirements of Section 401(a) of the Internal Revenue Code:

 

Plan Category

Number of Securities

to be Issued Upon Exercise

of Outstanding Options

Weighted-Average Exercise Price of

Outstanding Options

Number of Securities Remaining Available

for Future Issuance

Equity compensation plans

approved by security holders

810,020 $14.97 871,920

 

 

(e) Performance Graph

 

The following is a five-year performance graph comparing the total cumulative shareholder return on the Company’s common stock to the cumulative total returns of the NASDAQ Composite Index (a broad equity market index), the SNL Bank Index, and the SNL $1 billion to $5 billion (asset size) Bank Index (the latter two qualifying as peer bank indices), assuming a $100 investment on December 31, 2006 and reinvestment of dividends:

 

 

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       Period Ending     
Index  12/31/06   12/31/07   12/31/08   12/31/09   12/31/10   12/31/11 
Sierra Bancorp   100.00    86.76    75.61    28.49    40.91    34.31 
NASDAQ Composite   100.00    110.66    66.42    96.54    114.06    113.16 
SNL Bank $1B-$5B   100.00    72.84    60.42    43.31    49.09    44.77 
SNL Bank   100.00    77.71    44.34    43.88    49.17    38.08 

 

Source : SNL Financial LC, Charlottesville, VA

 

 

(f) Stock Repurchases

 

The Company has a non-expiring stock repurchase program that became effective July 1, 2003, under which all share repurchases are executed in accordance with SEC Rule 10b-18. Of the aggregate 1,250,000 shares authorized for repurchase since the effective date of the plan, there were 100,669 shares remaining available for repurchase as of December 31, 2011. There were no stock repurchases during the fourth quarter of 2011.

 

 

Item 6. Selected Financial Data

 

The following table presents selected historical financial information concerning the Company, which should be read in conjunction with our audited consolidated financial statements, including the related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” included elsewhere herein. The selected financial data as of December 31, 2011 and 2010, and for each of the years in the three year period ended December 31, 2011, is derived from our audited consolidated financial statements and related notes which are included in this Annual Report. The selected financial data presented for earlier years is derived from our audited financial statements which are not included in this Annual Report. Throughout this Annual Report, information is for the consolidated Company unless otherwise stated.

 

27
 

 

                     
Selected Financial Data                    
(Dollars in thousands, except per share data)                    
   As of and for the years ended December 31, 
                     
Income Statement Summary   2011    2010    2009    2008    2007 
Interest income  $58,614   $63,831   $70,146   $77,938   $87,816 
Interest expense  $5,657   $7,649   $12,177   $21,329   $31,435 
Net interest income before provision for                         
loan losses  $52,957   $56,182   $57,969   $56,609   $56,381 
Provision for loan losses  $12,000   $16,680   $21,574   $19,456   $3,252 
Non-interest income  $14,646   $17,861   $17,279   $15,987   $14,635 
Non-interest expense  $47,259   $50,234   $44,138   $35,859   $35,981 
Income before provision for income taxes  $8,344   $7,129   $9,536   $17,281   $31,783 
Provision for income taxes  $564   $(234)  $608   $3,868   $10,761 
Net Income  $7,780   $7,363   $8,928   $13,413   $21,022 
                          
Balance Sheet Summary                         
Total loans, net  $740,929   $783,601   $859,875   $929,629   $909,312 
Allowance for loan losses  $(17,283)  $(21,138)  $(23,715)  $(15,094)  $(12,276)
Securities available for sale  $406,471   $331,730   $278,168   $243,413   $184,917 
Cash and due from banks  $63,036   $42,435   $66,234   $46,010   $44,022 
Federal funds sold  $-   $210   $-   $5,500   $- 
Foreclosed Assets  $15,364   $20,691   $25,654   $7,127   $556 
Premises and equipment, net  $20,721   $20,190   $20,069   $19,280   $18,255 
Total Interest-Earning assets  $1,185,647   $1,137,805   $1,194,700   $1,200,603   $1,109,600 
Total Assets  $1,335,405   $1,286,571   $1,335,549   $1,326,292   $1,233,735 
Total Interest-Bearing liabilities  $852,308   $860,944   $953,156   $974,177   $874,393 
Total Deposits  $1,086,268   $1,052,274   $1,125,432   $1,061,498   $850,147 
Total Liabilities  $1,166,841   $1,126,974   $1,201,069   $1,219,492   $1,134,271 
Total Shareholders' Equity  $168,564   $159,597   $134,480   $106,800   $99,464 
Per Share Data                         
Net Income Per Basic Share   0.55    0.61    0.86    1.40    2.17 
Net Income Per Diluted Share   0.55    0.60    0.86    1.37    2.09 
Book Value   11.95    11.42    11.57    11.04    10.39 
Cash Dividends   0.24    0.24    0.40    0.68    0.62 
Weighted Average Common Shares Outstanding Basic   14,036,667    12,109,717    10,343,502    9,607,184    9,700,048 
Weighted Average Common Shares Outstanding Diluted   14,085,201    12,192,345    10,415,084    9,779,657    10,044,915 
Key Operating Ratios:                         
Performance Ratios:                         
Return on Average Equity (1)   4.73%   5.16%   7.56%   12.86%   22.28%
Return on Average Assets (2)   0.59%   0.56%   0.68%   1.05%   1.74%
Net Interest Spread (tax-equivalent) (3)   4.41%   4.72%   4.74%   4.52%   4.45%
Net Interest Margin (tax-equivalent)   4.59%   4.90%   5.00%   4.98%   5.28%
Dividend Payout Ratio (4)   43.29%   39.86%   46.76%   48.73%   28.64%
Equity to Assets Ratio (5)   12.37%   10.82%   9.03%   8.12%   7.79%
Efficiency Ratio (tax-equivalent)   67.67%   66.64%   57.69%   48.73%   49.36%
Net Loans to Total Deposits at Period End   68.21%   74.47%   76.40%   87.58%   106.96%
Asset Quality Ratios:                         
Non-Performing Loans to Total Loans   7.39%   5.70%   5.31%   3.15%   0.98%
Non-Performing Assets to Total Loans and                         
Other Real Estate Owned   9.23%   8.07%   7.98%   3.87%   1.04%
Net Charge-offs (recoveries) to Average Loans   2.06%   2.26%   1.40%   1.79%   0.28%
Allowance for Loan Losses to                         
Net Loans at Period End   2.33%   2.70%   2.76%   1.62%   1.35%
Allowance for Loan Losses to Non-Performing Loans   30.80%   46.00%   50.49%   50.67%   135.62%
Capital Ratios:                         
Tier 1 Capital to Adjusted Total Assets   14.11%   13.84%   11.91%   9.92%   10.22%
Tier 1 Capital to Total Risk-weighted Assets   20.46%   19.06%   15.41%   12.34%   12.11%
Total Capital to Total Risk-weighted Assets   21.72%   20.33%   16.67%   13.59%   13.33%

(1) Net income divided by average shareholders' equity              
(2) Net income divided by average total assets              
(3) Represents the average rate earned on interest-earning assets less the average rate paid on interest-bearing liabilities
(4) Total dividends paid divided by net income              
(5) Average equity divided by average total assets              

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

This discussion presents Management’s analysis of the financial condition of the Company as of December 31, 2011 and December 31, 2010, and the results of operations for each of the years in the three-year period ended December 31, 2011. The discussion should be read in conjunction with the Consolidated Financial Statements of the Company and the Notes related thereto presented elsewhere in this Form 10-K Annual Report (see Item 8 below).

 

Statements contained in this report or incorporated by reference that are not purely historical are forward looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 as amended, including the Company’s expectations, intentions, beliefs, or strategies regarding the future. All forward-looking statements concerning economic conditions, growth rates, income, expenses, or other values which are included in this document are based on information available to the Company on the date noted, and the Company assumes no obligation to update any such forward-looking statements. It is important to note that the Company’s actual results could materially differ from those in such forward-looking statements. Risk factors that could cause actual results to differ materially from those in forward-looking statements include but are not limited to those outlined previously in Item 1A.

 

Critical Accounting Policies

 

The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States. The financial information and disclosures contained within those statements are significantly impacted by Management’s estimates and judgments, which are based on historical experience and various other assumptions that are believed to be reasonable under current circumstances. Actual results may differ from those estimates under divergent conditions.

 

Critical accounting policies are those that involve the most complex and subjective decisions and assessments, and have the greatest potential impact on the Company’s stated results of operations. In Management’s opinion, the Company’s critical accounting policies deal with the following areas: the establishment of the Company’s allowance for loan losses, as explained in detail in Note 2 to the consolidated financial statements and in the “Provision for Loan Losses” and “Allowance for Loan and Lease Losses” sections of this discussion and analysis; the valuation of impaired loans and foreclosed assets, as discussed in Note 2 to the consolidated financial statements; income taxes and deferred tax assets and liabilities, especially with regard to the ability of the Company to recover deferred tax assets as discussed in the “Provision for Income Taxes” and “Other Assets” sections of this discussion and analysis; goodwill, which is evaluated annually for impairment based on the fair value of the Company and for which it has been determined that no impairment exists, as discussed in Note 2 to the consolidated financial statements and in the “Other Assets” section of this discussion and analysis; and equity-based compensation, which is discussed in greater detail in Note 2 to the consolidated financial statements contained herein. Critical accounting areas are evaluated on an ongoing basis to ensure that the Company’s financial statements incorporate the most recent expectations with regard to these areas.

 

Summary of Performance

 

There are signs of improvement in the national economy and in certain regions of California, but the economy in our market areas remains under considerable stress. In fact, recessionary conditions have led to higher credit costs, declining loan balances, and associated earnings pressures at the Company for the past four years. Industry-wide regulatory pressures on certain components of non-interest income have exacerbated the negative impact of economic conditions on our financial performance. The Company recognized net income of $7.780 million in 2011 relative to $7.363 million in 2010, representing the first year-over-year increase in net income since 2007 but still well below levels achieved in pre-recession years. Net income per diluted share was $0.55 for 2011, as compared to $0.60 in 2010 and $0.86 in 2009. The Company’s return on average assets was 0.59% and return on average equity was 4.73% in 2011, as compared to 0.56% and 5.16%, respectively in 2010, and 0.68% and 7.56%, respectively for 2009.

 

The following are major factors impacting the Company’s results of operations in recent years:

 

29
 

  

·Net interest income declined by $3.225 million, or 6%, in 2011 relative to 2010, and reflects a decrease of $1.787 million, or 3%, in 2010 relative to 2009. The decline in 2011 is the result of a 31 basis point net interest margin decline partially offset by a $12 million increase in average interest-earning assets, while the decline in 2010 is due to a 10 basis point slide in our net interest margin and an $11 million drop in the average balance of interest-earning assets. Our net interest margin has been negatively impacted in recent years by a shift from average loan balances into lower-yielding investment balances, higher average balances for non-accruing loans and other non-earning assets, lower loan yields resulting from increased competition for quality loans, and a relatively high level of interest reversals on loans placed on non-accrual status.

 

·Our provision for loan losses was $12.000 million in 2011, which is lower than in the three prior years but still much higher than in pre-recession years. Our loan loss provision was $16.680 million in 2010 and $21.574 million in 2009. In 2011 and 2010, the loan loss provision was utilized to establish specific reserves for impaired loans that migrated into impaired status, replenish reserves subsequent to loan charge-offs, and build general reserves for performing loans due to higher historical loss factors. The principal reason for the relatively high loan loss provision in 2009 was a rising level of impaired loans requiring greater specific reserves.

 

·Non-interest income declined by $3.215 million, or 18%, in 2011 relative to 2010, but increased by $582,000, or 3%, in 2010 over 2009. A lower level of gains on the sale of investments, an other-than-temporary impairment charge recorded on equity investment securities, and a sizeable drop in overdraft fee income were the primary contributors to the decline in 2011, although those negative factors were partially offset by a lower net loss on the sale of OREO. For 2010, a higher level of losses on the sale of OREO and a lower level of deposit service charges had an unfavorable impact on the level of non-interest income relative to the prior year, but these negatives were more than offset by an increase in gains on the sale of investment securities, a higher level of check card interchange fees, and a lower level of pass-through losses on our low-income housing tax credit investments.

 

·Operating expense declined by $2.975 million, or 6%, in 2011 relative to 2010, but increased by $6.096 million, or 14%, in 2010 relative to 2009. The decline in 2011 is mainly due to a lower level of OREO write-downs and OREO operating expense, as well as lower FDIC assessments. The majority of the increase in 2010 was in OREO write-downs, OREO operating expense and compensation expense, which were partially offset by a drop in FDIC costs.

 

·The Company had a tax provision of $564,000, or 7% of pre-tax income in 2011, but we experienced a negative income tax provision in 2010. The higher tax accrual in 2011 is primarily the result of a drop in tax-exempt BOLI income, and an increase in taxable income relative to the Company’s available tax credits. The negative provision in 2010 was the result of a high level of tax credits relative to our tax liability. Tax credits include those related to investments in low-income housing tax credit funds, as well as enterprise zone credits.

 

The Company’s assets totaled $1.335 billion at December 31, 2011, relative to total assets of $1.287 billion at December 31, 2010. Total liabilities were $1.167 billion at the end of 2011 compared to $1.127 billion at the end of 2010, and we had shareholders’ equity totaling $169 million at December 31, 2011 relative to $160 million at December 31, 2010. The following summarizes key balance sheet changes during 2011:

 

·Total assets increased by $49 million, or 4%. Investment securities, fed funds sold, cash, and balances due from banks were up by a combined $95 million, or 25%, but that growth was partly offset by a drop of $42 million, or 5%, in net loan balances, and foreclosed assets were also reduced by a net $5 million, or 26%, in 2011. Runoff in the normal course of business, prepayments, transfers to OREO, and charge-offs have reduced loan balances in recent periods, and weak loan demand from quality borrowers and aggressive competition have hindered the Company’s ability to counteract that contraction.

 

·Our allowance for loan and lease losses was $17.3 million as of December 31, 2011, which represents a drop of $3.9 million relative to the balance at December 31, 2010. This contra-asset account is increased by the amount of the loan loss provision, and decreased by the amount of net loan charge-offs. We experienced net charge-offs totaling $15.855 million in 2011. Since a sizeable portion of those charge-offs were against reserves that had been established in prior periods for specifically-identified losses on certain impaired loans, net charge-offs exceeded the $12.000 million provision for loan losses in 2011 and the allowance declined. Our allowance also fell to 2.28% of total loans at December 31, 2011 from 2.62% at December 31, 2010.

 

30
 

 

 

·Nonperforming assets ended 2011 with a balance of $71 million, an increase of $5 million, or 7%, for the year but still well below the peak balance of $80 million reported at September 30, 2009. The balance of non-performing assets had been trending down for most of 2011, but ultimately increased due to some large additions to non-accruing loans in the fourth quarter. The net increase for the year is comprised of a $10 million increase in loans on non-accrual status, partially offset by a $5 million reduction in foreclosed assets. Nonperforming assets also increased as a percentage of total loans plus OREO, to 9.23% at December 31, 2011 from 8.07% at December 31, 2010.

 

·Total deposits increased by $34 million, or 3%, during 2011, and non-maturity deposits were up $57 million, or 8%, for the year. Non-maturity deposits increased due in part to aggressive deposit acquisition programs and an intensified focus on business relationships. Total deposits did not increase to the same extent as non-maturity deposits primarily because we have not aggressively pursued the renewal of certain time deposits managed by our Treasury Department.

 

·Total shareholders’ equity increased by $9 million, or 6%, during the year. Our capital ratios continued their upward trend during 2011, as well, and as of December 31, 2011 our consolidated total risk-based capital ratio was 21.72%, our Tier 1 risk-based capital ratio was 20.46%, and our Tier 1 leverage ratio was 14.11%.

 

Results of Operations

 

The Company earns income from two primary sources. The first is net interest income, which is interest income generated by earning assets less interest expense on deposits and other borrowed money. The second is non-interest income, which primarily consists of customer service charges and fees but also comes from non-customer sources such as bank-owned life insurance. The majority of the Company’s non-interest expenses are operating costs that relate to providing a full range of banking services to our customers.

 

Net Interest Income and Net Interest Margin

 

Net interest income was $52.957 million in 2011, compared to $56.182 million in 2010 and $57.969 million in 2009. This represents declines of 6% in 2011 and 3% in 2010. The level of net interest income depends on several factors in combination, including growth in earning assets and interest-bearing liabilities, yields on earning assets, the cost of interest-bearing liabilities, the relative volumes of earning assets and interest-bearing liabilities, and the mix of products which comprise the Company’s earning assets, deposits, and other borrowed money. Net interest income can also be impacted by the reversal of interest for loans placed on non-accrual, and by the recovery of interest on loans that have been on non-accrual and are either sold or returned to accrual status.

 

The following Distribution, Rate and Yield table shows, for each of the past three years, the average balance for each principal balance sheet category, and the amount of interest income or interest expense associated with that category. This table also shows the calculated yields on each major component of the Company’s investment and loan portfolio, the average rates paid on each key segment of the Company’s interest-bearing liabilities, and our net interest margin.

 

31
 

 

 

                       
                       

 

Distribution, Rate & Yield  Year Ended December 31, 
(dollars in thousands, except per share data)  2011   2010   2009 
   Average   Income/   Average   Average   Income/   Average   Average   Income/   Average 
Assets  Balance(1)   Expense   Rate/Yield(2)   Balance(1)    Expense   Rate/Yield(2)   Balance(1)    Expense   Rate/Yield(2) 
Investments:                                             
Federal funds sold/Due from time  $25,930   $68    0.26%  $14,066   $40    0.28%  $10,620   $86    0.81%
Taxable   319,635    8,732    2.73%   239,926    8,016    3.34%   187,212    8,234    4.40%
Non-taxable   73,108    2,834    5.96%   68,858    2,709    6.05%   61,274    2,476    6.22%
Equity   1,508    21    1.39%   1,473    9    0.61%   1,598    66    4.13%
         Total Investments   420,181    11,655    3.14%   324,323    10,774    3.77%   260,704    10,862    4.68%
Loans and Leases:(3)                                             
Agricultural   13,847    648    4.68%   10,137    517    5.10%   12,409    631    5.09%
Commercial   104,293    6,224    5.97%   115,188    6,882    5.97%   141,190    8,217    5.82%
Real Estate   553,063    35,970    6.50%   612,001    40,669    6.65%   647,099    44,294    6.85%
Consumer   39,928    3,731    9.34%   50,522    4,377    8.66%   61,726    5,265    8.53%
Direct Financing Leases   6,723    386    5.74%   10,835    612    5.65%   14,835    877    5.91%
Other   50,047    -    0.00%   52,609    -    0.00%   49,067    -    0.00%
         Total Loans and Leases   767,901    46,959    6.12%   851,292    53,057    6.23%   926,326    59,284    6.40%
Total Interest Earning Assets (4)   1,188,082    58,614    5.06%   1,175,615    63,831    5.55%   1,187,030    70,146    6.02%
Other Earning Assets   7,735              8,984              9,361           
Non-Earning Assets   133,733              134,552              111,560           
  Total Assets  $1,329,550             $1,319,151             $1,307,951           
                                              
Liabilities and Shareholders' Equity                                             
Interest Bearing Deposits:                                             
Demand Deposits  $24,707   $137    0.55%  $-   $-    0.00%  $-   $-    0.00%
NOW   179,253    860    0.48%   178,345    1,682    0.94%   116,112    569    0.49%
Savings Accounts   85,568    203    0.24%   70,367    174    0.25%   61,377    167    0.27%
Money Market   132,208    506    0.38%   162,619    914    0.56%   156,110    1,886    1.21%
CDAR's   36,335    199    0.55%   70,661    621    0.88%   137,025    2,204    1.61%
Certificates of Deposit<$100,000   142,753    1,001    0.70%   162,418    1,283    0.79%   121,644    1,843    1.52%
Certificates of Deposit>$100,000   204,185    1,223    0.60%   194,220    1,237    0.64%   203,091    2,136    1.05%
Brokered Deposits   12,986    176    1.36%   10,885    210    1.93%   61,886    1,235    2.00%
         Total Interest Bearing Deposits   817,995    4,305    0.53%   849,515    6,121    0.72%   857,245    10,040    1.17%
Borrowed Funds:                                             
Federal Funds Purchased   4    -    0.19%   3    -    0.32%   295    1    0.34%
Repurchase Agreements   2,371    16    0.67%   -    -    0.00%   14,909    35    0.23%
Short Term Borrowings   5,637    39    0.69%   16,044    190    1.18%   20,140    389    1.93%
Long Term Borrowings   15,000    569    3.79%   16,041    604    3.77%   22,000    798    3.63%
TRUPS   30,928    728    2.35%   30,928    734    2.37%   30,928    914    2.96%
         Total Borrowed Funds   53,940    1,352    2.51%   63,016    1,528    2.42%   88,272    2,137    2.42%
         Total Interest Bearing Liabilities   871,935    5,657    0.65%   912,531    7,649    0.84%   945,517    12,177    1.29%
Non-interest Bearing Demand Deposits   276,363              246,949              229,974           
Other Liabilities   16,744              16,917              14,301           
Shareholders' Equity   164,508              142,754              118,159           
  Total Liabilities and Shareholders' Equity  $1,329,550             $1,319,151             $1,307,951           
                                              
Interest Income/Interest Earning Assets             5.06%             5.55%             6.02%
Interest Expense/Interest Earning Assets             0.48%             0.65%             1.02%
Net Interest Income and Margin(5)       $52,957    4.59%       $56,182    4.90%       $57,969    5.00%

 

(1)Average balances are obtained from the best available daily or monthly data and are net of deferred fees and related direct costs.
(2)Yields and net interest margin have been computed on a tax equivalent basis.
(3)Loans are gross of the allowance for possible loan losses. Net loan fees have been included in the calculation of interest income. Net loan Fees were $(635,719), $(491,045), and $(109,217) for the years ended December 31, 2011, 2010, and 2009 respectively. 
(4)Non-accrual loans have been included in total loans for purposes of total interest earning assets.
(5)Represents net interest income as a percentage of average interest-earning assets (tax-equivalent).

 

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The Volume and Rate Variances table below sets forth the dollar difference in interest earned or paid for each major category of interest-earning assets and interest-bearing liabilities between the noted periods, and the amount of such change attributable to changes in average balances (volume) or changes in average interest rates. Volume variances are equal to the increase or decrease in average balance multiplied by prior period rates, and rate variances are equal to the increase or decrease in rate times prior period average balances. Variances attributable to both rate and volume changes are calculated by multiplying the change in rate by the change in average balance, and have been allocated to the rate variance.

 

Volume & Rate Variances  Years Ended December 31, 
                         
(dollars in thousands)  2011 over 2010   2010 over 2009 
    Increase(decrease) due to    Increase(decrease) due to 
Assets:  Volume   Rate   Net   Volume   Rate   Net 
Investments:                              
Federal funds sold / Due from time  $34   $(6)  $28   $28   $(74)  $(46)
Taxable   2,663    (1,947)   716    2,318    (2,536)   (218)
Non-taxable(1)   167    (42)   125    306    (73)   233 
Equity   -    12    12    (5)   (52)   (57)
         Total Investments   2,864    (1,983)   881    2,647    (2,735)   (88)
                               
Loans and Leases:                              
Agricultural   189    (58)   131    (116)   2    (114)
Commercial   (651)   (7)   (658)   (1,513)   178    (1,335)
Real Estate   (3,917)   (782)   (4,699)   (2,402)   (1,223)   (3,625)
Consumer   (918)   272    (646)   (956)   68    (888)
Direct Financing Leases   (232)   6    (226)   (236)   (29)   (265)
Other   -    -    -    -    -    - 
         Total Loans and Leases   (5,529)   (569)   (6,098)   (5,223)   (1,004)   (6,227)
         Total Interest Earning Assets  $(2,665)  $(2,552)  $(5,217)  $(2,576)  $(3,739)  $(6,315)
                               
Liabilities                              
Interest Bearing Deposits:                              
Demand  $-   $137   $137   $-   $-   $- 
NOW   9    (831)   (822)   305    808    1,113 
Savings Accounts   38    (9)   29    24    (17)   7 
Money Market   (171)   (237)   (408)   79    (1,051)   (972)
CDAR's   (302)   (120)   (422)   (1,067)   (516)   (1,583)
Certificates of Deposit < $100,000   (155)   (127)   (282)   618    (1,178)   (560)
Certificates of Deposit > $100,000   63    (77)   (14)   (93)   (806)   (899)
Brokered Deposits   41    (75)   (34)   (1,018)   (7)   (1,025)
          Total Interest Bearing Deposits   (477)   (1,339)   (1,816)   (1,153)   (2,766)   (3,919)
Borrowed Funds:                              
Federal Funds Purchased   -    -    -    (1)   -    (1)
Repurchase Agreements   -    16    16    (35)   -    (35)
Short Term Borrowings   (123)   (28)   (151)   (79)   (120)   (199)
Long Term Borrowings   (39)   4    (35)   (216)   22    (194)
TRUPS   -    (6)   (6)   -    (180)   (180)
          Total Borrowed Funds   (162)   (14)   (176)   (331)   (278)   (609)
          Total Interest Bearing Liabilities   (639)   (1,353)   (1,992)   (1,484)   (3,044)   (4,528)
          Net Interest Income  $(2,026)  $(1,199)  $(3,225)  $(1,092)  $(695)  $(1,787)
                               

 

(1) Yields on tax exempt income have not been computed on a tax equivalent basis
                               

 

 

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As shown above, the volume variance for 2011 relative to 2010 was negative $2.026 million, despite the fact that average interest-earning assets were $12 million higher. The negative volume variance was primarily the result of an unfavorable shift in average earning asset balances. We experienced an $83 million drop in average loans due to declining balances of relatively high-yielding real estate, commercial and consumer loans, and there was a corresponding increase of $96 million in the average balance of investments, including a $12 million increase in overnight fed funds sold and short-term interest-earning deposits in other banks which have yields that are significantly lower than average loan yields. Unfavorable changes in average asset balances were partially countered by positive swings in average liability and equity balances. We experienced movement out of time deposits and wholesale borrowings into lower-cost non-maturity deposits for the comparative years, including a $29 million increase in the average balance of non-interest bearing demand deposits. A $22 million increase in average equity, resulting from our registered direct offering in October 2010 and the addition of net income, also helped reduced our reliance on interest-bearing liabilities and thus helped limit the magnitude of the negative volume variance.

 

The impact of interest rate changes on net interest income was also negative for 2011 over 2010, with an unfavorable rate variance of $1.199 million. There hasn’t been a significant change in market interest rates during the past year, but our weighted average yield on interest-earning assets was 49 basis points lower due primarily to the addition of investment securities in a relatively low-rate environment. Also impacting our yield on earning assets were lower real estate and agricultural loan yields, which declined 15 basis points and 42 basis points, respectively, due to increased competition for quality loans. In contrast to the large drop in our yield on average earning assets, our weighted average cost of interest-bearing liabilities was only 19 basis points lower due primarily to the re-pricing of time deposits at maturity, a drop in the cost of NOW accounts coincidental with runoff in our online-only account balances, and an improving deposit mix. The unfavorable rate variance is magnified by our sizeable net interest position, which is measured as the amount by which the balance of interest-earning assets exceeds interest-bearing liabilities. Our average net interest position was $263 million for 2010, the base period for the rate variance calculation, meaning that the yield decrease for interest-earning assets was applied to a much higher balance than the rate decrease for interest-bearing liabilities and had a greater impact on net interest income. Helping offset the negative factors impacting the Company’s rate variance were a $41 million reduction in average interest-bearing liabilities facilitated by increases in average non-interest bearing demand deposits and average equity, and a $3 million drop in the average balance of nonperforming loans. Furthermore, net interest reversals were only $189,000 in 2011 as compared to $566,000 in 2010.

 

The Company’s net interest margin, which is tax-equivalent net interest income as a percentage of average interest-earning assets, is affected by the same factors discussed above relative to rate and volume variances. Our net interest margin was 4.59% in 2011, a decline of 31 basis points relative to 2010. The principle negative factors impacting our net interest margin in 2011 were a shift from average loan balances into lower-yielding investment balances, and lower loan yields resulting from increased competition for quality loans. Having a favorable effect on our net interest margin were a shift in average balances from higher-cost liabilities into lower-cost non-maturity deposits, a reduced reliance on interest-bearing liabilities, and a drop in average non-accruing loan balances. We expect that our net interest margin could continue to experience slight contraction due to heightened competitive pressures on loan yields, and that effect will be exacerbated if the negative trends in outstanding loan balances and nonperforming loans are not reversed.

 

For 2010 relative to 2009, net interest income declined due to the fact that average interest-earning assets were $11 million lower and our net interest margin fell by 10 basis points. The principal negative pressures on our net interest margin in 2010 came from a $418,000 increase in net interest reversals and an unfavorable shift in average asset balances. Having a positive impact for the 2010 over 2009 comparison were increases of $25 million in average equity and $17 million in average non-interest bearing demand deposit balances, which reduced our reliance on interest-bearing liabilities.

 

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Provision for Loan and Lease Losses

 

Credit risk is inherent in the business of making loans. The Company sets aside an allowance for loan and lease losses, a contra-asset account, through periodic charges to earnings which are reflected in the income statement as the provision for loan and lease losses. These charges are in amounts sufficient to achieve an allowance for loan and lease losses that, in management’s judgment, is adequate to absorb probable loan losses related to specifically-identified impaired loans, as well as probable incurred loan losses in the remaining loan portfolio. Specifically identifiable and quantifiable losses are immediately charged off against the allowance. The loan loss provision is also impacted by the level of loan charge-offs, since charge-offs affect historical loss factors used in determining general reserves in the allowance and could necessitate reserve replenishment. Net loans charged off in 2011 totaled $15.855 million, relative to $19.257 million in 2010 and $12.953 million in 2009. Charge-offs were higher in 2011 and 2010, because reserves that had been established in previous periods for specifically-identified losses on certain impaired loans were determined to be uncollectible and written off. The Company’s policies for monitoring the adequacy of the allowance and determining loan amounts that should be charged off, and other detailed information with regard to changes in the allowance, are discussed below under “Allowance for Loan and Lease Losses.” The process utilized to establish an appropriate allowance for loan and lease losses can result in a high degree of variability in the Company’s loan loss provision, and consequently in our net earnings.

 

Despite a relatively high level of charge-offs, the Company’s loan loss provision was reduced by $4.680 million, or 28%, in 2011 relative to 2010, and was also reduced by $4.894 million, or 23%, in 2010 relative to 2009, since many of the charge-offs in 2011 and 2010 were against reserves that were already reflected in the allowance at the beginning of those respective years, as noted above. Our loan loss provision in 2011 and 2010 was primarily utilized to provide specific reserves for loans that migrated into impaired status, build general reserves for performing loans due to higher historical loss factors, and replenish reserves subsequent to loan charge-offs. The principal reason for the relatively high loan loss provision in 2009 was a rising level of impaired loans requiring greater specific reserves. The severity of economic challenges has contributed to much higher provisions for the past four years than recorded in prior periods of strong economic growth, due to the negative impact of recessionary conditions on many of our borrowers and the resulting credit challenges in our loan portfolio.

 

Non-interest Revenue and Operating Expense

 

The following table sets forth the major components of the Company’s non-interest revenue and operating expense, along with relevant ratios, for the years indicated:

 

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Non-Interest Revenue/Expense                        
(Dollars in thousands)            
             
    2011    % of Total    2010    % of Total    2009    % of Total 
NON-INTEREST REVENUE                              
Service charges on deposit accounts  $9,543    65.16%  $11,212    62.77%  $11,552    66.86%
Credit card fees   411    2.81%   391    2.19%   417    2.41%
Checkcard fees   2,519    17.20%   2,261    12.66%   1,782    10.31%
Other service charges and fees   2,054    14.02%   2,260    12.65%   2,198    12.72%
Bank owned life insurance income   934    6.38%   1,382    7.74%   1,561    9.03%
Gains on sales of loans   139    0.95%   105    0.59%   81    0.47%
Gain on sales  investment securities   1,660    11.33%   2,643    14.80%   1,099    6.36%
Other-than-temporary impairment                              
    losses on equity securities   (1,370)   -9.36%   -    0.00%   -    0.00%
(Loss) on tax credit investment   (885)   -6.04%   (808)   -4.52%   (1,443)   -8.35%
Other   (359)   -2.45%   (1,585)   -8.88%   32    0.19%
     Total non-interest income   14,646    100.00%   17,861    100.00%   17,279    100.00%
As a % of average interest-earning assets         1.23%        1.52%        1.46%
                               
OTHER OPERATING EXPENSES                              
Salaries and employee benefits   20,669    43.74%   20,869    41.54%   18,963    42.96%
Occupancy costs                              
  Furniture and equipment   2,366    5.01%   2,406    4.79%   2,638    5.98%
  Premises   4,392    9.29%   4,634    9.23%   4,311    9.77%
Advertising and marketing costs   2,051    4.34%   1,979    3.94%   1,872    4.24%
Data processing costs   1,523    3.22%   1,737    3.46%   1,406    3.19%
Deposit services costs   2,516    5.32%   2,708    5.39%   2,188    4.96%
Loan services costs                              
    Loan processing   1,082    2.29%   765    1.52%   961    2.17%
    Other real estate owned   4,880    10.33%   6,168    12.28%   1,827    4.14%
Other operating costs                              
    Telephone and data communications   1,291    2.73%   1,156    2.30%   1,107    2.51%
    Postage and mail   576    1.22%   558    1.11%   501    1.13%
    Other   886    1.87%   1,059    2.11%   1,040    2.36%
Professional services costs                              
    Legal and accounting   1,719    3.64%   1,276    2.54%   1,537    3.48%
    Other professional services costs   2,222    4.70%   3,742    7.45%   4,585    10.39%
    Stationery and supply costs   705    1.49%   715    1.42%   675    1.53%
Sundry & tellers   381    0.81%   462    0.92%   527    1.19%
    Total other operating expense  $47,259    100.00%  $50,234    100.00%  $44,138    100.00%
As a % of average interest-earning assets         3.98%        4.27%        3.72%
Net non-interest income as a % of average interest-earning assets       -2.75%      -2.75%        -2.6 %
Efficiency ratio (tax-equivalent)        67.67%        66.64%        57.69%

 

 

  

The overhead efficiency ratio in the table above represents total operating expense divided by the sum of fully tax-equivalent net interest and non-interest income, with the provision for loan losses, investment gains and losses, and other extraordinary gains and losses excluded from the equation. Since total revenue declined by a proportionately greater amount than other operating expense in 2011 (excluding investment gains and other extraordinary items), our efficiency ratio increased by 103 basis points relative to 2010. Our efficiency ratio rose by 895 basis points in 2010 in comparison to 2009, due to a drop in revenue relative to a large increase in operating expense.

 

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The Company’s results reflect a decline of $3.215 million, or 18%, in non-interest income in 2011 relative to 2010, but an increase of $582,000, or 3%, for 2010 relative to 2009. While the primary reasons for these fluctuations are discussed in greater detail below, several items of a non-recurring nature have impacted non-interest income over the past few years. For 2011, those items include a $1.660 million gain on the sale of investment securities, a $1.370 million other-than-temporary impairment charge on equity investment securities, and $451,000 in net losses on the sale of OREO. In 2010, non-recurring items include $2.643 million in gains on investment securities, net losses on the disposition of foreclosed assets totaling $1.536 million, and $238,000 in losses incurred upon the disposition of equipment that was acquired subsequent to the termination of operating leases. In 2009, we had $1.099 million in gains on securities, $204,000 in losses on OREO sales, and a $66,000 recovery on a previously charged-off investment in a title insurance holding company. Total non-interest revenue was 1.23% of average earning assets in 2011, relative to 1.52% in 2010 and 1.46% in 2009.

 

The principal component of non-interest income, service charges on deposit accounts, fell by $1.669 million, or 15%, in 2011 over 2010. The drop was centered in overdraft income, with returned item and overdraft charges falling by $1.892 million, or 23%, primarily as the result of procedural changes and fee adjustments implemented pursuant to new consumer-focused legislation and updated regulatory guidelines on overdrafts. Partially offsetting the decline in overdraft income in 2011 were increases in fees recently implemented for higher risk deposit accounts, totaling $166,000 in the fourth quarter and $169,000 for the year in 2011. Deposit service charges declined by $340,000, or 3%, in 2010 relative to 2009, since the highest-impact portions of the aforementioned regulatory guidance and legislation became effective in the third and fourth quarters of 2010. The Company’s ratio of service charge income to average transaction account balances was 2.0% in 2011, down from 2.6% in 2010 and 3.3% in 2009.

 

The next line item under non-interest revenue is credit card fees, which consist primarily of credit card interchange fees. Despite the sale of all credit card balances in 2007, we still receive a portion of the interchange and interest from credit cards issued in our name. Credit card fees increased by $20,000, or 5%, in 2011 relative to 2010, due to an increase in consumer credit card usage, but these fees fell by $26,000, or 6%, in 2010 relative to 2009, due to a drop in usage in a difficult economic environment. Credit card fees were 3% of total non-interest income in 2011, up slightly from 2% in 2010 and 2009.

 

Check card fees, which represent interchange fees from electronic funds transactions (EFT), increased by $258,000, or 11%, in 2011 over 2010, and also increased by $479,000, or 27%, in 2010 relative to 2009. The increase is from fees earned on incremental cards issued in association with new retail deposit accounts, as well as increased usage per card. Check card fees have been increasing as a percentage of total non-interest revenue, and the rising popularity of point-of-sale transactions leads us to believe that this access channel will likely continue to grow in importance. The number of active check cards now in use by personal and business account holders at the Bank is approximately 47,000, up from about 45,000 at the end of 2010 and 40,000 at the end of 2009.

 

Other service charges and fees also constitute a large portion of non-interest income, with the principal components consisting of ATM fees from transactions not associated with deposit customers (also referred to as foreign ATM fees), currency order fees, other fees for merchant services, and operating lease income. This category is also where rental income on OREO properties is reflected. Other service charges, commissions, and fees declined by $206,000, or 9%, in 2011 over 2010, due to a drop of $397,000, or 70%, in leasing income resulting from declining operating lease balances, which was partially offset by increases in merchant fees and foreign ATM fees. There was a nominal increase in other service charges and fees in 2010 relative to 2009, due to increases in OREO rental income and merchant fees.

 

Bank-owned life insurance (BOLI) income declined by $448,000, or 32%, in 2011 relative to 2010, and was also down by $179,000, or 11%, in 2010 relative to 2009. These variances are primarily due to fluctuations in income on “separate account” BOLI related to deferred compensation plans. The Company owns and derives income from two basic types of BOLI: “general account” and “separate account.” At December 31, 2011, the Company had $34.9 million invested in single-premium general account BOLI, which includes a $5 million investment consummated at the end of the third quarter of 2011. Income from our general account BOLI is used to fund expenses associated with executive salary continuation plans, director retirement plans and other employee benefits. General account BOLI income is typically fairly consistent with interest credit rates that do not change frequently, but the purchase of BOLI at the end of September boosted general account BOLI income slightly in 2011. Moreover, the exchange of select general account policies in 2009 generated a one-time gain of approximately $72,000, which contributed to the overall decline in BOLI income in 2010 relative to 2009. In addition to general account BOLI, the Company had $2.7 million invested in separate account BOLI at December 31, 2011, the earnings on which help offset deferred compensation accruals for certain directors and senior officers. These deferred compensation accounts have returns pegged to participant-directed investment allocations, and are thus subject to gains or losses which often contribute to significant fluctuations in income from period to period. There was a loss on separate account BOLI totaling $92,000 in 2011 relative to a gain of $352,000 in 2010, for a total decline in separate account BOLI income of $444,000 for the comparative years. The comparison for 2010 relative to 2009 also reflects a drop of $111,000 in separate account BOLI income, since the gain in 2010 was lower than the gain of $463,000 in 2009. As noted, gains and losses on separate account BOLI are related to participant gains and losses on deferred compensation balances. Participant gains are accounted for as expense accruals which, combined with their associated tax effect, effectively offset income on separate account BOLI, while participant losses result in expense accrual reversals that effectively offset losses on separate account BOLI.

 

37
 

 

 

Gains on loan sales increased by $34,000 or 32%, in 2011 over 2010, and also reflect an increase of $24,000, or 30%, in 2010 over 2009. Despite the first quarter 2011 termination of our affiliation with PHH Mortgage, which had been our primary outlet for mortgage loan sales, gains on loan sales have increased due to a pickup in mortgage lending activity.

 

In 2011, 2010 and 2009, gains on the sale of investments totaled $1.660 million, $2.643 million and $1.099 million, respectively, representing significant additions to income. The realized gain in 2011 came from the sale of $43 million in select mortgage-backed securities, the proceeds of which were used to retire short-term debt and enable the non-renewal of certain higher-cost time deposits. The sale of these securities also helped us reduce potential volatility in our investment portfolio. In 2011, we also recorded a $1.370 million other-than-temporary impairment (OTTI) charge against equity investment securities, offsetting much of the income boost provided by the gain on the sale of investments. The referenced equity securities, comprised of investments in five different community-based financial institutions, were previously carried on the Company’s books at their market values with mark-to-market adjustments applied directly to equity, the standard accounting convention for available-for-sale securities. Since the equities had been in continuous unrealized loss positions since mid-2008 and the near-term prospect of price recovery was increasingly uncertain, the Company determined that it would be appropriate to take the OTTI charge in the fourth quarter of 2011 by marking those securities to their current carrying values as a loss through earnings. The investment gains in 2010 were taken pursuant to a portfolio restructuring in the third quarter that involved the sale of $64 million in mortgage-backed securities, with the proceeds reinvested in agency-issued mortgage-backed securities that have a slightly longer duration and slightly lower yield and lend themselves to more efficient portfolio management. For 2009, gains were taken on the sale of $30 million in mortgage-backed securities, with the proceeds reinvested in high-quality agency-issued mortgage-backed securities. The gain on investments in 2009 also includes small gains on bonds called prior to maturity, and a non-recurring $66,000 recovery on a previously charged-off investment in a title insurance holding company.

 

The next line item reflects pass-through losses associated with our partnership investments in low-income housing tax credit funds. These costs, which are accounted for as a reduction in revenue, increased by $77,000, or 10%, in 2011 over 2010, but declined by $635,000, or 44%, in 2010 relative to 2009. The annual fluctuations typically result from expense accrual adjustments made subsequent to the receipt of updated partnership financial statements.

 

Other non-interest income includes gains and losses on the disposition of real properties and other assets, and rental income generated by the Company’s alliance with Investment Centers of America (ICA). Other non-interest income improved by $1.226 million, or 77%, in 2011 over 2010, but declined by $1.617 million in 2010 relative to 2009. The large fluctuations are the result of changes in gains and losses on the sale of foreclosed assets. In 2011 we had a net loss of $451,000 on the sale of foreclosed assets, while the net loss was $1.536 million in 2010 and only $204,000 in 2009. A non-recurring $238,000 loss on the disposition of equipment acquired upon the termination of operating leases in 2010 was also a factor in the comparative results.

 

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Total operating expense (non-interest expense) was down by $2.975 million, or 6%, in 2011 relative to 2010, due primarily to a reduced level of OREO write-downs, a drop in OREO operating expense, and lower FDIC assessments. In contrast, non-interest expense was up by $6.096 million, or 14%, for 2010 over 2009, with the majority of the increase coming in OREO write-downs and compensation expense.

 

Non-interest expense includes the following significant non-recurring items, which net out to additional expense of $4.243 million in 2011, $5.120 million in 2010, and $1.857 million in 2009: OREO write-downs totaling $4.184 million in 2011, $5.045 million in 2010, and $1.265 million in 2009; vendor credits in the amount of $181,000 for prior-year overcharges on processing software, which were received in the first quarter of 2011; a non-recurring accrual of $240,000 in the fourth quarter of 2011, for potential expenses related to leases; a $75,000 legal settlement paid in 2010 on an operations-related issue; and, the payment of $592,000 in 2009 for an industry-wide special FDIC assessment. Total operating expense was 3.98% of average earning assets in 2011, relative to 4.27% in 2010 and 3.72% in 2009.

 

The largest component of operating expense, namely salaries and employee benefits, declined by $200,000, or 1%, in 2011 relative to 2010, but increased by $1.906 million, or 10%, in 2010 over 2009. The decline in 2011 was due to a lower level of deferred compensation accruals and a higher level of salaries deferred and amortized as an adjustment to loan yields, which were partially offset by an increase in expense accruals associated with stock options. Salaries deferred for amortization as an adjustment to loan yields, accounted for in accordance with FASB guidelines on the recognition and measurement of non-refundable fees and origination costs associated with lending activities, totaled $2.586 million in 2011, $2.376 million in 2010, and $2.554 million in 2009, with the fluctuations due to variability in loan origination activity. As noted above in our discussion of BOLI income, the accruals associated with employee deferred compensation plans are related to separate account BOLI income and losses, as are directors deferred compensation accruals that are included in “other professional services,” and the net income impact of all income/expense accruals related to deferred compensation is usually minimal. Gains on employee plans totaled only $17,000 in 2011, relative to gains of $206,000 in 2010 and $237,000 in 2009. The biggest contributing factor to the increase in salaries and employee benefits in 2010 over 2009 was our accrual for incentive compensation; no incentive compensation was accrued for 2009 because the Company’s net income did not reach the level necessary to trigger bonus payments. The increase in 2010 was also supplemented by a lower level of salaries deferred and amortized as an adjustment to loan yields. Adding to salaries and benefits in both 2011 and 2010 were normal annual salary adjustments, staffing costs associated with recently-opened branches, and strategic staff additions to help address credit issues and position the Company for future growth opportunities. For 2011, however, the branch closure in Bakersfield offset some of that impact. Salaries and benefits were 43.74% of total operating expense in 2011, relative to 41.54% in 2010 and 42.96% in 2009. The number of full-time equivalent staff employed by the Company was 383 at the end of 2011, 390 at the end of 2010, and 402 at the end of 2009.

 

Total rent and occupancy costs, including furniture and equipment expense, fell by $282,000, or 4%, in 2011 as compared to 2010, but increased by $91,000, or 1%, in 2010 relative to 2009. The largest impact for 2011 came from the January 2011 closure of a branch with a relatively costly lease, and lower maintenance/repair costs. For 2010 over 2009, declining depreciation expense and lower maintenance and repair costs for furniture and equipment were more than offset by higher premises costs resulting from our new branches, annual rental increases, and the rising cost of insurance and utilities.

 

Advertising and marketing costs were up by $72,000, or 4%, in 2011 over 2010, and by $107,000, or 6%, in 2010 compared to 2009. The increase in 2011 resulted from higher costs for television advertising and the expansion of our direct-mail marketing campaign for deposits. The increase in 2010 is mainly due to costs associated with implementing a debit rewards program and an increase in radio advertising.

 

Data processing costs reflect a drop of $214,000, or 12%, in 2011, but an increase of $331,000, or 24% in 2010. The difference for 2011 was due in large part to $181,000 in non-recurring vendor credits which were received in the first quarter of 2011 for prior-year overcharges on processing software, as well as lower internet banking costs. The increase in 2010 was centered in internet banking costs and software maintenance fees.

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Deposit services costs dropped by $192,000, or 7%, in 2011 relative to the prior year, but increased by $520,000, or 24%, in 2010 relative to 2009. The decline for 2011 was due primarily to lower costs associated with our online deposit products, net of an increase of $138,000 in debit card processing costs. The increase in 2010 was due to higher expenses for our online deposit products, ATM servicing, check card processing, and remote deposit capture.

 

Loan services costs, including expenses associated with foreclosed assets, credit card costs, and other loan processing costs, were reduced by $970,000, or 14%, in 2011 relative to 2010, but reflect an increase of $4.145 million, or 149%, in 2010 over 2009. Much of the variability in loan costs in recent years has been driven by write-downs on foreclosed assets (primarily OREO), which totaled $4.184 million in 2011 relative to $5.045 million in 2010 and $1.264 million in 2009, and foreclosed asset operating expenses (including property taxes), which totaled $695,000 in 2011 in comparison to $1.123 million in 2010 and $563,000 in 2009. As is evident in those numbers, the primary impact on the year-over-year decrease in total loan costs in 2011 came from declines of $861,000 in write-downs on foreclosed assets and $427,000 in OREO operating expense. Those favorable developments were partially offset by increases in costs associated with collections and appraisals, as well as the aforementioned non-recurring accrual of $240,000 for potential expenses on operating leases. For 2010, the year-over-year increase was due to a $3.781 million increase in write-downs on foreclosed assets and an increase of $560,000 in OREO operating expense.

 

The “other operating costs” category includes telecommunications expense, postage, and other miscellaneous costs, and reflects a slight decline in 2011 but an aggregate increase of $125,000, or 5%, in 2010. Telecommunications expense increased by $135,000, or 12%, in 2011, and by $49,000, or 4%, in 2010, with the relatively large increase in 2011 coming from costs associated with the addition and enhancement of data circuits. Postage expense increased by $18,000, or 3%, in 2011, and by $57,000, or 11%, in 2010, with the increase in 2010 resulting from additional mailings for newly-required regulatory compliance disclosures. Other miscellaneous costs fell by $174,000, or 16%, in 2011 due to lower depreciation on operating leases, but did not change materially in 2010.

 

Legal and accounting costs increased by $443,000, or 35%, in 2011 over 2010, but declined by $261,000, or 17%, in 2010 over 2009. For 2011, the increase was due primarily to higher legal costs for loan collections, and consulting costs which were necessitated by the numerous changes in regulatory expectations and the associated promulgation of new guidance on overdrafts, as referenced above. Legal and accounting costs were lower in 2010 mainly because of enhanced staffing in the collections area which enabled a reduction in lending-related legal expense, but also due to a reduction in expenses associated with compliance and operations reviews.

 

Other professional services costs include FDIC assessments and other regulatory costs, directors’ costs, certain insurance costs, and certain shareholder expenses. This category fell by $1.520 million, or 41%, in 2011 relative to 2010, and by $843,000, or 18%, in 2010 over 2009. The large year-over-year declines were centered on FDIC assessments, which totaled $1.314 in 2011, $2.214 million in 2010, and $3.155 million in 2009 (including the special FDIC assessment of $592,000). The reduced accrual in 2011 was due in large part to the FDIC’s implementation of a new rate structure in 2011, as well as the Company’s reduced risk profile. The 2011 variance in other professional service expense also reflects a $123,000 decline in director retirement plan accruals, and a $213,000 drop in deferred compensation accruals for the Company’s directors due to losses on directors’ deferred compensation plans in 2011 relative to gains in 2010. As with deferred compensation accruals for employees, directors’ deferred fee accruals are related to separate account BOLI income and losses, and the net income impact of all income/expense accruals related to deferred compensation is usually minimal.

 

Stationery and supply costs declined by $10,000 in 2011 due to operational efficiency enhancements implemented toward the end of 2011, but were up $40,000, or 6%, in 2010 primarily due to supplies purchased for recently-added branches. Sundry and teller costs fell by $81,000, or 18%, in 2011, and by $65,000, or 12%, in 2010. The decline in 2011 was due mainly to a non-recurring settlement of $75,000 paid to a deposit customer in the second quarter of 2010 for a fraud loss, while the drop in 2010 is from reductions in debit card losses due to enhanced anti-fraud efforts, and a lower level of other sundry losses that was achieved in spite of the aforementioned legal settlement.

 

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Income Taxes

 

The Company sets aside its provision for income taxes on a monthly basis. As indicated in Note 9 in the Notes to Consolidated Financial Statements, the amount of such provision is determined by applying the Company’s statutory income tax rates to pre-tax book income as adjusted for permanent differences between book income and actual taxable income. These permanent differences include, but are not limited to, tax-exempt interest income, increases in the cash surrender value of BOLI (BOLI income), California Enterprise Zone deductions, and certain book expenses that are not allowed as tax deductions. Tax-exempt interest income is generated primarily by the Company’s investments in state, county and municipal bonds, which provided $2.8 million in federal tax-exempt income in 2011, $2.7 million in 2010, and $2.5 million in 2009. Tax credits, including hiring tax credits as well as those stemming from our investments in low-income housing tax credit funds, are applied as a direct reduction to our tax liability for both book and tax purposes. The company had investments totaling $9.4 million in low-income housing tax credit funds as of December 31, 2011. These investments, which are included in other assets rather than in our investment portfolio, have generated substantial tax credits over the past few years, with about $1.6 million in credits available for the 2011 tax year and $1.7 million in tax credits utilized in 2010. The credits are dependent upon the occupancy level of the housing projects and income of the tenants, and cannot be projected with complete certainty. Furthermore, our capacity to utilize them will continue to depend on our ability to generate sufficient pre-tax income. Because we have not invested in additional tax credit funds for the past few years, the level of low-income housing tax credits available for future years will taper off until they are substantially utilized by the end of 2018. This means that even if taxable income stayed at the same level through 2018, our tax accrual rate would gradually increase.

 

Our tax provision of $564,000 resulted in a 7% tax accrual rate in 2011, while a negative income tax provision of $234,000 helped boost net income in 2010. The higher tax accrual in 2011 is primarily the result of a drop in tax-exempt BOLI income, and an increase in taxable income relative to the Company’s available tax credits. While our level of tax credits did not change materially relative to the prior year, our tax liability increased due to an increase in pre-tax income, as adjusted for the permanent differences noted above.

 

In addition to permanent differences, some income and expense items are recognized in different years for tax purposes than when applying generally accepted accounting principles, leading to timing differences between the Company’s actual tax liability and the amount accrued for this liability based on book income. These temporary differences comprise the “deferred” portion of the Company’s tax expense, which is accumulated on the Company’s books as a deferred tax asset or deferred tax liability until such time as it reverses. At the end of 2011, the Company had a net deferred tax asset of $11.7 million.

 

Financial Condition

 

Total assets of $1.335 billion at the end of 2011 reflect an increase of $49 million, or 4%, for the year, due primarily to growth in investments partially offset by declining loan balances. We experienced a drop in loan balances in 2010 and 2009, as well. In addition to loan growth challenges for the past few years, we have seen marked deterioration in asset quality as a result of the decline in the economy. Even though the regional economy appears to have stabilized, our market areas have not improved materially. Our borrowers are still experiencing the residual effects of lower consumer spending and economic activity, and our asset quality is still being negatively impacted. Despite growth challenges and relatively high levels of nonperforming assets we have a very strong capital position, due in part to our registered direct offering in 2010 and private placement in 2009, and positive net income throughout the recession. Furthermore, our liquidity position has significantly improved over the past couple of years due to strong growth in customer deposits and the runoff of a large volume of wholesale-sourced brokered deposits and other borrowings, as well as a drop in loan balances and substantial increase in unpledged investments. Our strong capital position and access to liquidity resources position us well to endure to the end of the current cycle and eventually return to previous levels of loan growth, although no assurance can be provided in that regard.

 

Significant changes in the relative size of balance sheet components in 2011 include net loans and leases, which fell to 55% of total assets at the end of 2011 from 61% at the end of 2010, and investment securities, which increased to 30% of total assets at the end of 2011 from 26% at the end of 2010. On the liability side, non-maturity deposits increased to 67% of total deposits at the end of 2011 from 63% at the end of 2010, while customer time deposits less than $100,000 dropped to 10% of total deposits at December 31, 2011 from 16% at December 31, 2010. The major components of the Company’s balance sheet are individually analyzed below, along with information on off-balance sheet activities and exposure.

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Loan and Lease Portfolio

 

The Company’s loan and lease portfolio represents the single largest portion of invested assets, substantially greater than the investment portfolio or any other asset category, and the quality and diversification of the loan and lease portfolio are important considerations when reviewing the Company’s financial condition. The Company is not involved with chemicals or toxins that might have an adverse effect on the environment, thus its primary exposure to environmental legislation is through its lending activities. The Company’s lending procedures include steps to identify and monitor this exposure in an effort to avoid any related loss or liability. The Selected Financial Data table in Item 6 above reflects the amount of loans and leases outstanding at December 31st for each year from 2007 through 2011, net of deferred fees and origination costs and the allowance for loan and lease losses. The Loan and Lease Distribution tables that follow set forth by loan type the Company’s gross loans and leases outstanding, and the percentage distribution in each category at the dates indicated. The first table provides the loan distribution for the past five years, with a level of detail consistent with 10-K disclosures in previous years. The second table provides the loan distribution as of the two most recent year-ends using the loan categories that have been disclosed in our recent quarterly reports, which include a greater level of detail for real estate loans than is available for the five-year disclosure. The gross balances shown include nonperforming loans by type, but do not reflect any deferred or unamortized loan origination, extension, or commitment fees, or deferred loan origination costs.

 

                     
                     
Loan and Lease Distribution                    
(dollars in thousands)  As of December 31, 
   2011   2010   2009   2008   2007 
Agricultural  $17,078   $13,457   $9,865   $13,542   $13,103 
Commercial and Industrial   99,408    94,768    116,835    122,856    117,183 
Real Estate:                         
    Secured by Commercial/Professional Office                         
       Properties including construction and development   328,973    360,517    421,114    456,932    457,236 
    Secured by Residential Properties   188,117    200,156    188,750    189,849    187,267 
    Secured by Farmland   60,142    61,293    56,654    57,808    51,607 
    Held for Sale   1,354    914    376    552    - 
Total Real Estate   578,586    622,880    666,894    705,141    696,110 
Small Business Administration loans   21,006    18,616    18,626    19,463    20,366 
Consumer Loans   36,124    45,585    56,992    65,755    54,731 
Direct Financing Leases   6,743    10,234    15,394    19,883    23,140 
Total Loans and Leases  $758,945   $805,540   $884,606   $946,640   $924,633 
                          
Percentage of Total Loans and Leases                         
Agricultural   2.25%   1.67%   1.12%   1.42%   1.42%
Commercial and Industrial   13.10%   11.77%   13.21%   12.97%   12.67%
Real Estate:                         
    Secured by Commercial/Professional Office                         
       Properties including construction and development   43.35%   44.75%   47.60%   48.27%   49.45%
    Secured by Residential Properties   24.78%   24.85%   21.34%   20.06%   20.26%
    Secured by Farmland   7.92%   7.61%   6.40%   6.11%   5.58%
    Held for Sale   0.18%   0.11%   0.04%   0.06%   0.00%
Total Real Estate   76.23%   77.32%   75.38%   74.50%   75.29%
Small Business Administration loans   2.77%   2.31%   2.11%   2.06%   2.20%
Consumer Loans   4.76%   5.66%   6.44%   6.95%   5.92%
Direct Financing Leases   0.89%   1.27%   1.74%   2.10%   2.50%
    100.00%   100.00%   100.00%   100.00%   100.00%

 

 

 

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Loan and Lease Distribution        
(dollars in thousands)        
   As of December 31, 
   2011   2010 
Real Estate:          
1-4 family residential construction  $8,488   $13,866 
Other Construction/Land   40,060    52,047 
1-4 family - closed-end   106,307    105,459 
Equity Lines   66,497    70,783 
Multi-family residential   8,179    10,962 
Commercial RE- owner occupied   183,070    187,970 
Commercial RE- non-owner occupied   105,843    120,500 
Farmland   60,142    61,293 
Total Real Estate   578,586    622,880 
Agricultural products   17,078    13,457 
Commercial and Industrial   99,408    94,768 
Small Business Administration Loans   21,006    18,616 
Direct finance leases   6,743    10,234 
Consumer loans   36,124    45,585 
Total Loans and Leases  $758,945   $805,540 
Percentage of Total Loans and Leases          
Real Estate:          
1-4 family residential construction   1.12%   1.72%
Other Construction/land   5.28%   6.46%
1-4 family - closed-end   14.01%   13.09%
Equity Lines   8.76%   8.79%
Multi-family residential   1.08%   1.36%
Commercial RE- owner occupied   24.12%   23.33%
Commercial RE- non-owner occupied   13.94%   14.96%
Farmland   7.92%   7.61%
Total Real Estate   76.23%   77.32%
Agricultural products   2.25%   1.67%
Commercial and Industrial   13.10%   11.77%
Small Business Administration Loans   2.77%   2.31%
Direct finance leases   0.89%   1.27%
Consumer loans   4.76%   5.66%
    100.00%   100.00%
           
           

 

The Company’s gross loans and leases totaled $759 million at the end of December 2011, a drop of $47 million, or 6%, since December 31, 2010. Loan balances have been declining because of runoff in the normal course of business (including prepayments), transfers to OREO, and charge-offs. Furthermore, loan origination activity in our branches has been light due to weak demand from creditworthy borrowers, tightened credit criteria for real estate loans, heightened competition, and increased attention devoted to monitoring and managing current loan relationships. Management has made selective personnel changes and established branch objectives weighted toward high-quality loan growth, with a particular focus on commercial loans and agricultural loans, and we have seen a recent increase in the volume of potential loan deals reviewed. However, no assurance can be provided that loan balances will not continue to decline, especially in the near term.

 

Despite commercial loan charge-offs of over $3 million in 2011, commercial loans increased by about $5 million, or 5%, due to higher outstanding balances on mortgage warehouse lines, and SBA loan balances increased by over $2 million, or 13%. Agricultural production loans also show an increase of close to $4 million, or 27%, relative to their year-end 2010 balance, due to increased activity in the ag lending area. Total real estate loan balances, however, declined by $44 million, or 7%, in 2011. The largest drop within the real estate category was a $15 million decline in non-owner occupied commercial real estate loans, due in part to an $8.4 million non-accruing note that was written down to $7 million and then sold in the second quarter of 2011. We also experienced a decline of $12 million in “other construction/land” loans, and sizeable reductions in “1-4 family residential construction” loans, owner-occupied commercial real estate loans, equity lines, and multi-family residential loans. Loans secured by farmland declined slightly, but would have increased if not for the payoff of a $9 million loan that occurred when the borrower sold the underlying collateral. The net decline in real estate loan balances in 2011 includes charge-offs of about $11 million, and close to $7 million in balances transferred to OREO. We also experienced declines about $3 million, or 34%, in direct finance leases, and $9 million, or 21%, in consumer loans. Charge-offs account for about $3 million of the decline in consumer loans. With regard to loan composition, commercial loans, SBA loans and ag production loans increased slightly as a percentage of total loans in 2011, while real estate loans declined as a percentage of total loans, in a slight reversal of trends experienced in the previous few years. Consumer loans continued on their same trajectory, dropping once again as a percentage of total loans in 2011.

 

 

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Although not reflected in the loan totals above, the Company occasionally originates and sells, or participates out portions of, certain commercial real estate loans, agricultural or residential mortgage loans, and other loans to non-affiliated investors, and we currently provide servicing for some of those loans including a small number of SBA loans. The balance of loans serviced for others fell to less than $1 million at December 31, 2011 from $5 million at December 31, 2010, due primarily to our foreclosure on a real estate loan for which we had sold a participating interest.

 

Loan and Lease Maturities

 

The following table shows the maturity distribution for total loans and leases outstanding as of December 31, 2011, including non-accruing loans, grouped by remaining scheduled principal payments.

 

                             
Loans and Lease Maturity                        
(Dollars in thousands)                            
   As of December 31, 2011 
   Three months or less   Three months to twelve months   One to five years   Over five years   Total   Floating rate: due after one year   Fixed rate: due after one year 
Agricultural  $2,637   $9,486   $3,595   $1,360   $17,078   $2,862   $2,093 
Commercial and Industrial(1)   13,154    25,436    60,728    21,096    120,414    46,639    35,185 
Real Estate   26,829    23,023    127,533    401,201    578,586    205,789    322,944 
Consumer Loans   3,025    3,781    10,221    19,097    36,124    2,612    26,707 
Direct Financing Leases   714    651    2,788    2,590    6,743    -    5,378 
    Total  $46,359   $62,377   $204,865   $445,344   $758,945   $257,902   $392,307 
                                    

 

(1) Includes Small Business and Administration Loans 

 

 

  

For a comprehensive discussion of the Company’s liquidity position, re-pricing characteristics of the balance sheet, and sensitivity to changes in interest rates, see the “Liquidity and Market Risk” section.

 

Off-Balance Sheet Arrangements

 

In the normal course of business, the Company makes commitments to extend credit to its customers as long as there are no violations of conditions established in contractual arrangements. Total unused commitments to extend credit were $154 million at December 31, 2011, as compared to $142 million at December 31, 2010. These numbers include $31 million in home equity lines of credit at December 31, 2011, and $33 million at December 31, 2010. Unused commitments represented 20% of gross loans and leases outstanding at December 31, 2011 and 18% at December 31, 2010. The Company’s undrawn letters of credit totaled $20 million at December 31, 2011 and $17 million at December 31, 2010. The effect on the Company’s revenues, expenses, cash flows and liquidity from the unused portion of the commitments to provide credit cannot be reasonably predicted, because there is no certainty that lines of credit will ever be fully utilized. However, these off-balance sheet obligations represent potential credit risk to the Company, and a $160,000 reserve for unfunded commitments is reflected as a liability in our consolidated balance sheet at December 31, 2011. For more information regarding the Company’s off-balance sheet arrangements, see Note 11 to the consolidated financial statements in Item 8 herein.

 

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Contractual Obligations

 

At the end of 2011, the Company had contractual obligations for the following payments, by type and period due:

 

                     
                     
Contractual Obligations                    
(Dollars in thousands)                    
   Payments Due by Period 
    Total    Less Than 1
Year
    1-3 Years    3-5 Years    More Than 5 Years 
                
Long-term debt obligations  $45,928   $10,000   $5,000   $-   $30,928 
Operating lease obligations   9,626    1,068    2,010    1,602    4,946 
Other long-term obligations   353    142    -    -    211 
    Total  $55,907   $11,210   $7,010   $1,602   $36,085 
                          

 

 

Nonperforming Assets

 

Nonperforming assets are comprised of loans for which the Company is no longer accruing interest, and foreclosed assets, including mobile homes and other real estate owned. OREO consists of properties acquired by foreclosure or similar means, which the Company is offering or will offer for sale. Nonperforming loans and leases result when reasonable doubt exists with regard to the ability of the Company to collect all principal and interest on a loan or lease. At that point, we stop accruing interest on the loan or lease in question, and reverse any previously-recognized interest to the extent that it is uncollected or associated with interest-reserve loans. Any asset for which principal or interest has been in default for a period of 90 days or more is also placed on non-accrual status, even if interest is still being received, unless the asset is both well secured and in the process of collection. If the Bank grants a concession to a borrower in financial difficulty, the loan falls into the category of a troubled debt restructuring (TDR). TDR’s may be classified as either nonperforming or performing loans depending on their accrual status. The tables that follow present comparative data for the Company’s nonperforming assets and performing TDR’s. The first table provides those numbers for the past five years, with a level of detail consistent with 10-K disclosures in previous years. The second table provides nonperforming assets as of the two most recent year-ends using the loan categories that have been disclosed in our recent quarterly reports, which include a greater level of detail for nonperforming real estate loans than is available for the five-year disclosure.

 

 

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Nonperforming Assets and Performing TDR'S                    
(dollars in thousands)  As of December 31, 
   2011   2010   2009   2008   2007 
NON-ACCRUAL LOANS: (1)                         
Agricultural  $-   $-   $-   $-   $- 
Commercial and Industrial   3,778    2,005    3,559    771    75 
Real Estate                         
    Secured by Commercial/Professional Office                         
         Properties including construction and development   21,044    32,222    31,842    24,432    6,976 
    Secured by Residential Properties   18,182    6,270    5,652    2,918    666 
    Secured by Farmland   6,919    404    429    42    - 
         Subtotal Real Estate   46,145    38,896    37,923    27,392    7,642 
Small Business Administration Loans   3,452    3,440    3,683    862    1,174 
Consumer Loans   2,144    1,112    756    392    161 
Direct Financing Leases   591    501    1,053    369    - 
TOTAL NONPERFORMING LOANS   56,110    45,954    46,974    29,786    9,052 
                          
Foreclosed assets   15,364    20,691    25,654    7,127    556 
Total nonperforming assets  $71,474   $66,645   $72,628   $36,913   $9,608 
Performing loans classified as                         
troubled debt restructurings (TDR's)(2)  $36,058   $12,465   $28,024   $-   $- 
Nonperforming loans and leases as a %                         
of total gross loans and leases   7.39%   5.70%   5.31%   3.15%   0.98%
Nonperforming assets as a % of total gross                         
loans and leases and other real estate owned   9.23%   8.07%   7.98%   3.87%   1.04%
                          

 

(1)   The gross interest income that would have been recorded in the period ending December 31, 2011 if all non-accrual loans had been paying pursuant to their original terms was $4,353,000, which included $1,328,000 that was recorded and included in net income for the period.

 

(2)  Performing TDRs are not included in nonperforming loans above, nor are they included in the numerators used to calculate the ratios disclosed in this table.

                   

  

 

 

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Nonperforming Assets and Performing TDR'S
(dollars in thousands)

 

   As of December 31, 
NON-ACCRUAL LOANS: (1)  2011   2010 
Real Estate:          
1-4 family residential construction  $2,244   $4,057 
Other Construction/Land   4,083    6,185 
1-4 family - closed-end   7,605    4,894 
Equity Lines   1,309    1,239 
Multi-family residential   2,941    - 
Commercial RE- owner occupied   7,087    7,412 
Commercial RE- non-owner occupied   13,958    14,704 
Farmland   6,919    405 
Subtotal Real Estate   46,146    38,896 
Agricultural products   -    - 
Commercial and Industrial   3,778    2,005 
Small Business Administration Loans   3,452    3,440 
Direct finance leases   591    501 
Consumer loans   2,144    1,112 
TOTAL NONPERFORMING LOANS  $56,111   $45,954 
           
Foreclosed assets   15,364    20,691 
Total nonperforming assets  $71,475   $66,645 
Performing loans classified as          
troubled debt restructurings (TDR's) (1)  $36,058   $12,465 
Nonperforming loans and leases as a %          
of total gross loans and leases   7.39%   5.70%
Nonperforming assets as a % of total gross          
loans and leases and other real estate owned   9.23%   8.07%

 

(1) Performing TDRs are not included in nonperforming loans above, nor are they included in the numerators used to calculate the ratios disclosed in this table.

           

 

Nonperforming assets comprised only 1% of total loans and leases plus foreclosed assets at the end of 2007, but have escalated since then due to deterioration in economic conditions and the associated negative impact on our borrowers. After experiencing a year-over-year decline in 2010, total nonperforming assets increased by $4.8 million, or 7%, in 2011, increasing to 9.23% of gross loans and leases plus foreclosed assets at December 31, 2011 relative to 8.07% at December 31, 2010. Total nonperforming loans were up by $10.2 million, or 22%, in 2011, but foreclosed assets declined by $5.3 million, or 26%. The balance of nonperforming loans at December 31, 2011 includes $20.3 million in TDR’s and other loans that were paying as agreed under modified terms or forbearance agreements but were still classified as nonperforming. As shown in the table, we also had $36.1 million in loans classified as performing TDR’s for which we were still accruing interest at December 31, 2011, relative to a balance of $12.5 million at December 31, 2010. The $23.6 million increase in performing TDR’s is the result of elevated efforts to help ensure the ability of our borrowers to continue to service their debt. At the end of June 2011 the Company early-adopted ASU 2011-02, Receivables (Topic 310): A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring, which added only $552,000 to performing TDR’s at the time of adoption. Notes 2 and 4 in the Notes to Consolidated Financial Statements provide a more comprehensive disclosure of TDR balances and TDR activity within recent periods.

 

Non-accruing loan balances secured by real estate comprised $46.1 million of total nonperforming loans at December 31, 2011, and reflect a net increase of $7.2 million, or 19%, during the year due to three large additions during the fourth quarter: A $6.4 million dairy loan secured by farmland, a real estate relationship with $8.2 million in well-secured loans, and a $1.6 million loan on well-located rental properties that are generating cash flows and which we have subsequently acquired into OREO. Gross additions to nonperforming real estate loans totaled $43.2 million for 2011, with the largest additions coming in loans secured by commercial real estate and farmland. Partially offsetting the increase created by additional real estate loans being placed on non-accrual status during 2011 were net pay-downs on nonperforming real estate loans of $14.7 million, charge-offs totaling $10.7 million, $6.5 million in transfers to OREO, and the return to accrual status of $4.1 million in balances.

 

 

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Nonperforming commercial and SBA loans increased by a combined $1.8 million, or 33%, during 2011, ending the period at $7.2 million. Gross additions to nonperforming commercial and SBA loans totaled $7.6 million for 2011, but this was partly offset by net pay-downs of $1.8 million, the return to accrual status of $1.3 million in balances, and the charge-off of $2.7 million in nonperforming commercial loans. Nonperforming consumer loans, which are largely unsecured, increased by $1.0 million, or 93%, to a total of $2.1 million.

 

As noted above, foreclosed assets declined by $5.3 million, or 26%, during 2011. The balance of foreclosed assets at December 31, 2011 had an aggregate carrying value of $15.4 million, and was comprised of 66 properties classified as OREO and 5 mobile homes. Much of our OREO consists of vacant lots or land, but there are also 11 residential properties totaling $1.4 million, and four commercial buildings with a combined book balance of $1.9 million. At the end of 2010 foreclosed assets totaled $20.7 million, comprised of 79 properties in OREO and 17 mobile homes. All foreclosed assets are periodically evaluated and written down to their fair value less expected disposition costs, if lower than the then-current carrying value.

 

While we anticipate relatively slow progress with regard to the resolution of nonperforming assets, an action plan is in place for each of our non-accruing loans and foreclosed assets and they are all being actively managed. Collection efforts are continuously pursued for all nonperforming loans, but we cannot provide assurance that all will be resolved in a timely manner or that nonperforming balances will not increase further.

 

Allowance for Loan and Lease Losses

 

The allowance for loan and lease losses, a contra-asset account, is established through periodic charges to earnings which are reflected in the income statement as the provision for loan and lease losses, in a manner consistent with FASB’s guidance on loss contingencies and impaired loans and consistent with the guidance outlined in the 2006 Interagency Policy Statement on the Allowance for Loan and Lease Losses. Specifically identifiable and quantifiable loan losses are immediately charged off against the allowance, while recoveries are generally recorded only when cash payments are received subsequent to the charge off. The Company’s allowance for loan and lease losses is maintained at a level that is adequate to absorb specifically identified probable losses on impaired loans and probable incurred losses inherent in the remaining loan portfolio, after factoring in charge-offs taken against the allowance and recoveries credited back to the allowance. Fluctuations in credit quality, changes in economic conditions, or other factors could induce us to augment the allowance in the future, however, and no assurance can be given that the Company will not experience substantial losses relative to the size of the allowance. Note 2 in the Notes to Consolidated Financial Statements provides a more comprehensive discussion of the accounting guidance we conform to and the methodology we use to determine an appropriate allowance for loan and lease losses. At December 31, 2011, our allowance for loan and lease losses was $17.3 million, or 2.28% of gross loans and leases, an 18% decline from the $21.1 million allowance at December 31, 2010 which was 2.62% of gross loans and leases. The Company’s total allowance was 30.80% of nonperforming loans at December 31, 2011, relative to 46.00% at December 31, 2010. An allowance for potential losses inherent in unused commitments, totaling $160,000 at December 31, 2011, is included in other liabilities.

 

The table that follows summarizes the activity in the allowance for loan and lease losses for the periods indicated:

 

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Allowance for Loan and Lease Losses                    
(Dollars in thousands)                    
   As of and for the years ended December 31, 
Balances:  2011   2010   2009   2008   2007 
Average gross loans and leases outstanding during period  $767,901   $851,292   $926,326   $931,382   $903,046 
Gross loans and leases net of deferred fees and costs  $758,945   $805,540   $884,606   $946,640   $924,633 
                          
Allowance for Loan and Lease Losses:                         
Balance at beginning of period  $21,138   $23,715   $15,094   $12,276   $11,579 
Provision charged to expense   12,000    16,680    21,574    19,456    3,252 
Charge-offs                         
  Real Estate:                         
     1-4 family residential construction   1,389    1,706    536    1,375    148 
     Other Construction/Land   1,807    4,579    2,599    7,453    202 
     1-4 Family - closed-end   795    1,400    1,649    459    17 
     Equity Lines   1,776    596    695    608    357 
     Multi-family residential   -    97    -    -    - 
     Commercial RE- owner occupied   1,306    946    26    66    - 
     Commercial RE - non-owner occupied   3,027    1,358    -    -    - 
     Farmland   496    27    -    60    - 
TOTAL REAL ESTATE   10,596    10,709    5,505    10,021    724 
     Agricultural products   -    -    524    -    15 
     Commercial and Industrial   3,407    4,998    3,508    2,438    632 
     Small Business Administration Loans   148    293    143    558    34 
     Direct Finance Leases   82    646    97    255    - 
     Consumer Loans   2,754    3,691    4,622    3,936    2,134 
     Consumer Credit Cards   -    -    5    17    139 
   Total   16,987    20,337    14,404    17,225    3,678 
Recoveries                         
  Real Estate:                         
     1-4 family residential construction   133    25    270    32    - 
     Other Construction/Land   38    13    242    -    - 
     1-4 Family - closed-end   23    41    10    -    - 
     Equity Lines   4    41    2    3    28 
     Multi-family residential   -    -    -    -    49 
     Commercial RE- owner occupied   71    -    -    -    - 
     Commercial RE - non-owner occupied   148    -    -    -    - 
     Farmland   1    -    -    -    - 
TOTAL REAL ESTATE   418    120    524    35    77 
     Agricultural products   -    -    -    -    - 
     Commercial and Industrial   323    462    474    82    826 
     Small Business Administration Loans   71    63    75    154    36 
     Direct Finance Leases   57    159    103   <