UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
(Mark One)
X QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 1994 Commission File No.: 0-11113
OR
___ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ______________ to ____________
SANTA BARBARA BANCORP
(Exact Name of Registrant as Specified in its Charter)
California 95-3673456
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1021 Anacapa Street, Santa Barbara, California 93101
(Address of principal executive offices) (Zip Code)
(805) 564-6300
(Registrant's telephone number, including area code)
Not Applicable
Former name, former address and former fiscal year, if changed since last
report.
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.
Yes [X] No [ ]
Common Stock As of May 12, 1994, there were 5,100,788 shares of the
issuer's common stock outstanding.
<PAGE>
<TABLE>
SANTA BARBARA BANCORP & SUBSIDIARIES
Consolidated Balance Sheets (Unaudited)
(dollars in thousands except per share amount)
<CAPTION>
March 31, 1994 December 31, 1993
<S> <C> <C>
Assets:
Cash and due from banks 38,167 50,946
Federal funds sold 15,000 0
Cash and cash equivalents 53,167 50,946
Securities:
Held-to-maturity 273,484 194,474
Available-for-sale 187,041 189,044
Bankers' acceptances 4,986 63,614
Loans, net of allowance of $14,251 at
March 31, 1994 and $10,067 at
December 31, 1993 455,249 454,163
Premises and equipment, net (Note 6) 6,917 6,657
Accrued interest receivable 7,286 7,228
Other assets 13,345 13,017
Total assets 1,001,475 979,143
Liabilities:
Deposits:
Demand deposits 115,252 114,557
NOW deposit accounts 137,988 127,296
Money Market deposit accounts 250,002 247,772
Savings deposits 148,526 148,719
Time deposits of $100,000 or more 77,744 83,380
Other time deposits 143,888 144,529
Total deposits 873,400 866,253
Securities sold under agreements
to repurchase and Federal funds purchased 31,058 20,155
Other borrowed funds 1,000 1,172
Accrued interest payable and other liabilities 8,183 5,572
Total liabilities 913,641 893,152
Shareholders' equity (Notes 3 & 8):
Common stock (no par value; $1.00 per share stated value;
20,000,000 authorized; 5,065,742 outstanding at
March 31, 1994 and 5,064,517 at December 31, 1993) 5,066 5,065
Surplus 38,578 38,557
Unrealized gain (loss) on securities available for sale (101) 683
Retained earnings 44,291 41,686
Total shareholders' equity 87,834 85,991
Total liabilities and shareholders' equity 1,001,475 979,143
<FN>
See accompanying notes to consolidated condensed financial statements.
</TABLE>
<PAGE>
<TABLE>
SANTA BARBARA BANCORP & SUBSIDIARIES
Consolidated Statements of Income (Unaudited)
(dollars in thousands except per share amounts)
For the Three Months Ended March 31,
<CAPTION>
1994 1993
<S> <C> <C>
Interest income:
Interest and fees on loans 14,106 11,618
Interest on securities 5,906 5,891
Interest on Federal funds sold 38 135
Interest on bankers' acceptances 275 117
Total interest income 20,325 17,761
Interest expense:
Interest on deposits:
NOW accounts 312 403
Money Market accounts 1,605 1,464
Savings deposits 828 1,047
Time deposits of $100,000 or more 598 872
Other time deposits 1,663 1,845
Interest on securities sold under agreements
to repurchase and Federal funds purchased 192 207
Interest on other borrowed funds 19 16
Total interest expense 5,217 5,854
Net interest income 15,108 11,907
Provision for loan losses 4,282 2,775
Net interest income after provision
for loan losses 10,826 9,132
Other income:
Service charges on deposits 724 701
Trust fees 1,781 1,717
Other service charges, commissions and fees, net 791 822
Securities losses (Note 4) 0 (47)
Other income 145 182
Total other income 3,441 3,375
Other expense:
Salaries and benefits 5,449 5,014
Net occupancy expense 787 694
Equipment expense 488 370
Net cost (gain) from operating other real estate (650) 150
Other expense 3,096 2,711
Total other expense 9,170 8,939
Income before income taxes and cumulative
effect of accounting change 5,097 3,568
Applicable income taxes 1,580 888
Net income before cumulative effect
of accounting change 3,517 2,680
Cumulative effect of accounting change (Note 9) 0 619
Net income 3,517 3,299
Earnings per share before cumulative
effect of accounting change 0.69 0.52
Cumulative effect of accounting change (Note 9) 0.00 0.12
Earnings per share (Note 2) 0.69 0.64
<FN>
See accompanying notes to consolidated condensed financial statements.
</TABLE>
<TABLE>
SANTA BARBARA BANCORP & SUBSIDIARIES
Consolidated Statements of Cash Flows (Unaudited)
(dollars in thousands)
<CAPTION>
For the Three Months Ended March 31,
1994 1993
<S> <C> <C>
Cash flows from operating activities:
Net Income 3,517 3,299
Adjustments to reconcile net income to net cash
provided by operations:
Depreciation and amortization 328 220
Provision for loan losses 4,282 2,775
Benefit for deferred income taxes (2,112) (550)
Net amortization of investment securities
discounts and premiums (487) (1,019)
Net change in deferred loan origination and
extension fees and costs 111 2
Decrease (increase) in accrued interest receivable (58) 828
Decrease in accrued interest payable (8) (56)
Decrease (increase) in income receivable 49 (182)
Increase in income taxes payable 3,390 250
Increase in prepaid expenses (143) (1,595)
Decrease in accrued expenses (903) (1,714)
Other operating activities (402) 363
Net cash provided by operating activities 7,564 2,621
Cash flows from investing activities:
Proceeds from sale of
securities and bankers' acceptances 0 19,882
Proceeds from call or maturity of
securities and bankers' acceptances 129,077 37,195
Purchase of securities (148,306) (173)
Net increase in loans made to customers (5,479) (9,894)
Disposition of property from defaulted loans 2,970 512
Purchase or investment in premises and equipment (593) (588)
Net cash provided by (used in)
investing activities (22,331) 46,934
Cash flows from financing activities:
Net increase (decrease) in deposits 7,147 (21,773)
Net increase in borrowings with
maturities of 90 days or less 10,731 1,748
Proceeds from issuance of common stock 22 216
Dividends paid (912) (831)
Net cash provided by (used in) financing activities 16,988 (20,640)
Net increase in cash and cash equivalents 2,221 28,915
Cash and cash equivalents at beginning of period 50,946 44,059
Cash and cash equivalents at end of period 53,167 72,974
Supplemental disclosure:
Cash paid during the three months ended:
Interest 5,225 5,910
Income taxes 302 570
<FN>
See accompanying notes to consolidated condensed financial statements
</TABLE>
<PAGE>
Santa Barbara Bancorp and Subsidiaries
Notes to Consolidated Financial Statements
March 31, 1994
(Unaudited)
1. Principles of Consolidation
The consolidated financial statements include the parent holding company,
Santa Barbara Bancorp ("Company"), and its wholly owned subsidiaries,
Santa Barbara Bank & Trust ("Bank") and SBBT Service Corporation ("Service
Corp."). Material intercompany balances and transactions have been
eliminated.
2. Earnings Per Share
Net earnings per common and common equivalent share are computed based on
the weighted average number of shares outstanding during the period. There
are no common stock equivalents that cause dilution in earnings per share
in excess of 3 percent. For the three-month periods ended March 31, 1994
and 1993, the weighted average shares outstanding are as follows:
Three-Month Periods
Ended March 31,
1994 1993
Weighted average
shares outstanding 5,065,462 5,190,198
3. Basis of Presentation
The accompanying unaudited consolidated financial statements have been
prepared in a condensed format, and therefore do not include all of the
information and footnotes required by generally accepted accounting
principles for complete financial statements. In the opinion of
Management, all adjustments (consisting only of normal recurring accruals)
considered necessary for a fair presentation have been reflected in the
financial statements. Notwithstanding this, the results of operations for
the three months ended March 31, 1994, are not necessarily indicative of
the results to be expected for the full year. Certain amounts reported for
1993 have been reclassified to be consistent with the reporting for 1994.
For the purposes of reporting cash flows, cash and cash equivalents
include cash and due from banks and Federal funds sold.
4. Securities
In May 1993, the Financial Accounting Standards Board ("FASB") issued a
pronouncement that changed the accounting for some of the securities held
by the Company. The pronouncement, Statement of Financial Accounting
Standards No. 115, Accounting for Certain Investments in Debt and Equity
Securities, ("SFAS 115") was implemented by the Company as of December 31,
1993. Implementation of the pronouncement required that the Company's
securities be classified as either "held-to-maturity" or "available-for-
sale." Only those securities for which the Company has the ability and
positive intent to hold to maturity may be classified as held-to-maturity.
Securities which meet these critieria are accounted for at amortized
historical cost. This means that the security is carried at its purchase
price adjusted for the amortization of any premium or discount
irrespective of later changes in its market value prior to maturity.
Excluded from this category are securities which might be sold for
liquidity purposes, sold in response to interest rate changes, or sold to
restructure the maturities of the portfolio to better match deposit
maturities or complement the maturity characteristics of the loan
portfolio. Securities subject to sale for such reasons are considered
available-for-sale.
Classification as available-for-sale is required for many of the Company's
securities because they might be sold due to changes in interest rates or
liquidity needs. These securities are reported in financial statements at
fair value rather than at amortized cost. The after-tax effect of
unrealized gains or losses is reported as a separate component of
shareholders' equity. In accordance with the provisions of SFAS 115,
changes in the unrealized gains or losses will be shown as increases or
decreases in this component of equity, but are not reported as gains or
losses in the statements of income of the Company.
SFAS also provides for those securities which are purchased for later sale
at a higher price to be classified as "trading securities." The Company
does not purchase any securities for this purpose.
Book and market values of securities are as follows:
<TABLE>
<CAPTION>
(in thousands) Gross Gross Estimated
Amortized Unrealized Unrealized Market
Cost Gains Losses Value
<S> <C> <C> <C> <C>
March 31, 1994:
Held-to-maturity:
U.S. Treasury obligations 185,642 1,331 (4,417) 182,556
U.S. Agency obligations 9,795 0 (386) 9,409
State and municipal securities 78,047 12,980 (274) 90,753
273,484 14,311 (5,077) 282,718
Available-for-sale:
U.S. Treasury obligations 151,197 359 (529) 151,027
U.S. Agency obligations 36,015 2 (3) 36,014
187,212 361 (532) 187,041
460,696 14,672 (5,609) 469,759
December 31, 1993:
Held-to-maturity:
U.S. Treasury obligations 106,491 2,594 (512) 108,573
U.S. Agency obligations 9,786 0 (11) 9,775
State and municipal securities 78,197 18,644 0 96,841
194,474 21,238 (523) 215,189
Available-for-sale:
U.S. Treasury obligations 181,865 1,182 (17) 183,030
U.S. Agency obligations 6,015 0 (1) 6,014
187,880 1,182 (18) 189,044
382,354 22,420 (541) 404,233
</TABLE>
The Company does not expect to realize any significant amount of the
unrealized gains shown above for several reasons. First, the state and
municipal securities in the above table have irreplaceable tax-free
characteristics, which outweigh the benefit of selling them in order to
realize the gains that would result from their sale. Second, as indicated
above, the Company intends to hold to maturity the U. S. Treasury
securities that are classified as held-to-maturity. Third, while the
Company's investment policy provides for the sale of certain "available-
for-sale" taxable securities when the market value falls below the book
value, in most situations the policy requires holding securities that have
unrealized gains because they are earning rates of interest above what
would be available from current investment alternatives.
<TABLE>
<CAPTION>
(in thousands)
Held-to- Available-
Maturity for-Sale Total
<S> <C> <C> <C>
March 31, 1994:
Amortized cost:
In one year or less 3,602 109,448 113,050
After one year through five years 223,709 76,736 300,445
After five years through ten years 35,568 1,028 36,596
After ten years 10,605 0 10,605
273,484 187,212 460,696
Estimated market value:
In one year or less 3,722 109,699 113,421
After one year through five years 223,384 76,312 299,696
After five years through ten years 44,594 1,030 45,624
After ten years 11,018 0 11,018
282,718 187,041 469,759
December 31, 1993:
Amortized cost:
In one year or less 4,504 144,965 149,469
After one year through five years 137,139 41,886 179,025
After five years through ten years 36,463 1,029 37,492
After ten years 16,368 0 16,368
194,474 187,880 382,354
Estimated market value:
In one year or less 4,694 145,650 150,344
After one year through five years 141,799 42,364 184,163
After five years through ten years 48,229 1,030 49,259
After ten years 20,467 0 20,467
215,189 189,044 404,233
</TABLE>
The book value and estimated market value of debt securities by
contractual maturity are shown above. Expected maturities may differ from
contractual maturities because certain issuers may have the right to call
or prepay obligations with or without call or prepayment penalties.
5. Loans
The balances in the various loan categories are as follows:
<TABLE>
<CAPTION>
(in thousands) March 31, 1994 December 31, 1993
<S> <C> <C>
Real estate:
Residential 54,428 54,395
Non-residential 124,357 123,534
Construction 40,080 41,030
Commercial loans 164,578 168,227
Home equity loans 34,486 36,219
Consumer loans 40,679 27,331
Municipal tax-exempt obligations 9,292 11,888
Other loans 1,600 1,606
Total loans 469,500 464,230
</TABLE>
The loan balances at March 31, 1994 and December 31, 1993, are net of
approximately $1,412,000 and $1,301,000 respectively, in loan fees and
origination costs deferred under the provisions of Statement of Financial
Accounting Standards No. 91.
Statement of changes in allowance for loan losses (in thousands):
Balance, December 31, 1993 10,067
Provision for loan losses 4,282
Loan losses charged to allowance (237)
Loan recoveries credited to allowance 139
Balance, March 31, 1994 14,251
6. Premises and Equipment
Premises and equipment are stated at cost less accumulated depreciation
and amortization. Depreciation is charged to income over the estimated
useful lives of the assets generally by the use of an accelerated method
in the early years, switching to the straight line method in later years.
Leasehold improvements are amortized over the terms of the related lease
or the estimated useful lives of the improvements, whichever is shorter.
Depreciation expense (in thousands) was $328 and $220 for the three-month
periods ended March 31, 1994 and 1993, respectively. The table below shows
the balances by major category of fixed assets:
<TABLE>
<CAPTION>
(in thousands) March 31, 1994 December 31, 1993
Accumulated Net Book Accumulated Net Book
Cost Depreciation Value Cost Depreciation Value
<S> <C> <C> <C> <C> <C> <C>
Land and buildings 5,915 2,760 3,155 5,613 2,717 2,896
Leasehold improvements 4,392 3,259 1,133 4,383 3,203 1,180
Furniture and equipment 10,273 7,644 2,629 10,004 7,423 2,581
Total 20,580 13,663 6,917 20,000 13,343 6,657
</TABLE>
7. Property from Defaulted Loans Included in Other Assets
Property from defaulted loans is included within other assets on the
balance sheets. As of March 31, 1994, and December 31, 1993, the Company
had $1.4 million and $3.5 million in property from defaulted loans,
respectively. Property from defaulted loans is carried at the lower of the
outstanding balance of the related loan or the estimate of the market
value of the assets less disposal costs.
8. Shareholders' Equity
On October 1, 1993, the Company made to its shareholders an Offer to
Purchase for cash up to 250,000 shares of its common stock at $21.00 per
share. The offer expired November 19, 1993. Approximately 155,000 shares
were tendered by shareholders and purchased by the Company.
9. Accounting Changes
As of the beginning of 1993, the Company implemented Statement of
Financial Accounting Standards No. 109, Accounting for Income Taxes ("SFAS
109"). This statement required a change in the method by which the Company
computes its income tax expense. With the adoption of this new standard, a
one time gain of $619,500 relating to prior years was realized. This gain
is shown as a cumulative effect of accounting change in the consolidated
statement of income for the three month period ended March 31, 1993.
The implementation of SFAS 115 is discussed in Note 4 above.
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Summary
Net income for the first quarter of 1994 is higher than net income for
both the same quarter of last year and the immediately preceding quarter.
The Company has grown 4.9% in average total assets and 4.7% in average
total deposits compared to the first quarter of 1993. This growth occurred
while many other financial institutions were losing deposits, some
intentionally as a method of managing their capital ratios.
The first quarter of 1994 saw a reversal of the trend of declining
interest rates. Over the last several years the interest rates for most
financial instruments had been steadily declining. For the Company, this
had meant that the proceeds from maturing investments were reinvested at
lower rates and term deposits renewed by customers were renewed at lower
rates. In February, the Federal Reserve Board ("the Fed") raised short
term interest rates in what was assumed to be a signal that they were
prepared to slow the growth rate in the economy. Aside from being able to
reinvest the funds from some maturing securities at higher rates than
would otherwise have been the case, the Company felt little impact from
this rise. The Company did not raise its base lending rate until after the
Fed raised short-term rates a second time in late March. Deposit rates
have only begun to increase subsequent to the end of the quarter. The Fed
has raised rates again in the second quarter of 1994 and Management
expects that the impact of the new rate environment will be felt more
substantially from the second quarter through the end of the year.
The Company is a bank holding company. While the Company has a few
operations of its own, these are not significant in comparison to those of
its major subsidiary, Santa Barbara Bank and Trust (the "Bank"). The Bank
is a state-chartered commercial bank. It offers a full range of retail and
commercial banking services. These include commercial, real estate, and
consumer loans, a wide variety of deposit products, and full trust
services. The Company's second subsidiary is SBBT Service Corporation
("ServiceCorp"). ServiceCorp provides correspondent banking services such
as check processing, internal auditing, and courier service to other
financial institutions on the Central Coast of California. All references
to "the Company" below apply to the Company and its subsidiaries.
Interest Rate Sensitivity
The Company functions as a financial intermediary, that is, it takes in
funds from depositors and then either loans the funds to borrowers or
invests the funds in securities and other instruments. Net interest income
is the difference between the interest income earned on loans and
investments and the interest expense paid on deposits and is expressed in
dollars. Net interest margin is the ratio of net interest income to
earning assets. This ratio allows the Company to monitor the spread
between interest income and interest expense from month to month and year
to year irrespective of the growth of the Company. If the Company is able
to maintain the same percentage spread between interest income and
interest expense as the Company grows, the amount of net interest income
will increase.
Because the Company must maintain its net interest margin to remain
profitable, the effects of changes in interest rates on the net interest
margin are very important. Stated another way, with so many of its assets
earning interest and so many of its liabilities requiring interest to be
paid, the Company is subject to risks related to changing interest rates.
The primary risk is "market risk;" that is, the market value of loans,
investments, and deposits will increase or decrease with changes in market
interest rates. If the Company invests funds in a fixed-rate long-term
security and interest rates subsequently rise, the security is worth less
than a comparable security just issued because it pays less interest than
the newly issued security. If the security had to be sold, the Company
would have to recognize a loss. The opposite is true when interest rates
decline, namely, the market value of the security is higher than that of a
newly issued comparable security. Therefore, the exposure to loss from
market risk is from rising interest rates.
This exposure to "market risk" is managed by lessening the amount of fixed
rate assets (loans or securities that earn interest at a rate fixed when
the funds are lent or the security purchased) and by keeping maturities
short. The Company underwrites the largest proportion of its loans with
variable interest rates and has generally maintained the taxable portion
of its securities portfolios heavily weighted towards securities with
maturities of less than two years. However, these means of avoiding market
risk must be balanced against the consideration that shorter term
securities generally earn less interest income than longer term
instruments. If the Company were to make only variable loans and only
purchase securities with very short maturities, its net interest margin
would decline significantly.
The Company is also exposed to "interest rate risk." This is the risk that
interest rate changes may not be equally reflected in the rates of
interest earned and paid. This would occur because of differences in the
contractual terms of the assets and liabilities held. An obvious example
of this kind of difference is when a financial institution primarily holds
longer-term assets but has shorter-term deposits. Many savings and loan
institutions were hurt in the early 1980's by this kind of mismatch. They
held large portfolios of long-term fixed rate loans with rates of 5-9%
that had been made in the 1960's and 1970's when deposit rates were
regulated at 4% or less. In the early 1980's, with deregulation of
deposits and inflation, deposit rates soared above 15%.
The Company controls interest rate risk by matching the maturities and
repricing opportunities of assets and liabilities. When this matching is
properly carried out, it should ensure that if the interest rates for a
significantly large proportion of the Company's loans or securities
decrease, the Company should be able to reprice an approximately equal
amount of deposits or other liabilities to lower interest rates within a
short time. Similarly, if interest rates paid on deposits increase, the
Company should be able to protect its interest rate margin through
adjustments in the interest rates earned on loans or securities. This
matching is accomplished by managing the terms and conditions of the
products that are offered to depositors and borrowers and by purchasing
securities with the right maturity or repricing characteristics to fill in
mismatches.
One of the means by which the Company monitors the extent to which the
maturities or repricing opportunities of the major categories of assets
and liabilities are matched is an analysis such as that shown in Table 1.
This analysis is sometimes called a "gap" report, because it shows the gap
between assets and liabilities repricing or maturing in each of a number
of periods. The gap is stated in both dollars and as a percentage of total
assets. As a percentage of assets, the Company's target is to be no more
than 10% plus or minus in any of the three periods within one year, with
the emphasis on the first two periods.
Many of the categories of assets and liabilities on the balance sheet do
not have specific maturities. The Company assigns these pools of funds to
a likely repricing period. The assumptions underlying the assignment of
the various classes of non-term assets and liabilities are somewhat
arbitrary, however, in that the timing of the repricing is primarily a
function of competitive influences, i.e. whether other financial
institutions are changing their rates.
The first period shown in the report covers assets and liabilities that
mature or reprice within the next three months. This is the most critical
period because there would be little time to correct a mismatch if it is
having an adverse impact on income. For example, if the Company had a
significant negative gap for the period--with liabilities maturing or
repricing within the next three months significantly exceeding assets
maturing or repricing in that period by a margin above the 10% target--and
interest rates rose suddenly, the Company would have to wait for up to
three months before enough assets could be repriced to offset the higher
interest expense on the liabilities. As of March 31, 1994, the Company was
well within its target range for this first period and is quite well
matched.
While the Company is also well within its target range in the next period,
"After three months but within six," there is a larger negative gap for
the third period, "After six months but within one year." This mismatch is
caused by the large amounts of transaction deposit accounts that the
Company assumes will not be repriced sooner than six months. If interest
rates continue to rise over the next six months to a year, there will be
some negative impact from the repricing of these deposits. This impact
will be partially offset by the fact that, in an environment of rising
interest rates, short-term assets tend to reprice more often and to a
greater degree than the short-term liabilities.
The periods of over one year are the least critical because more steps can
be taken to mitigate the adverse effects of any interest rate changes. The
Company does attempt to loosely match its long-term municipal portfolio
with long-term IRA certificates of deposit, but most of the other assets
that have scheduled maturities in this period are highly liquid Treasury
Notes that would be sold if interest rates rise, thereby achieving a
repricing. These sales in a rising interest rate environment would involve
some losses, but they are minimized by the Company's investment policy as
explained below.
<TABLE>
<CAPTION>
Table 1 INTEREST RATE SENSITIVITY After three After six After one Non-interest
As of March 31, 1994 Within months months year but bearing or
(in thousands) three but within but within within After five non-repricing
months six one year five years items Total
<S> <C> <C> <C> <C> <C> <C> <C>
Assets:
Loans 323,912 48,100 28,231 52,988 15,968 301 469,500
Cash and due from banks 0 0 0 0 0 38,167 38,167
Federal Funds 15,000 0 0 0 0 0 15,000
Securities:
Held-to-maturity 0 1,050 2,552 223,709 46,173 0 273,484
Available-for-sale 25,056 40,037 44,606 76,312 1,030 0 187,041
Bankers' acceptances 4,986 0 0 0 0 0 4,986
Other assets 0 0 0 0 0 13,297 13,297
Total assets 368,954 89,187 75,389 353,009 63,171 51,765 1,001,475
Liabilities and shareholders' equity:
Borrowed funds:
Repurchase agreements and
Federal funds purchased 31,058 0 0 0 0 0 31,058
Other borrowings 1,000 0 0 0 0 0 1,000
Interest-bearing deposits:
Savings and interest-bearing
transaction accounts 284,280 0 252,236 0 0 0 536,516
Time deposits 80,841 49,441 34,096 55,084 2,170 0 221,632
Demand deposits 0 0 0 0 0 115,252 115,252
Other liabilities 0 0 0 0 0 8,183 8,183
Shareholders' equity 0 0 0 0 0 87,834 87,834
Total liabilities and
shareholders' equity 397,179 49,441 286,332 55,084 2,170 211,269 1,001,475
Interest rate-
sensitivity gap (28,225) 39,746 (210,943) 297,925 61,001 (159,504)
Gap as a percentage of
total assets (2.82%) 3.97% (21.06%) 29.75% 6.09% (15.93%)
Cumulative interest
rate-sensitivity gap (28,225) 11,521 (199,422) 98,503 159,504
<FN>
Note: Net deferred loan fees, overdrafts, and the allowance for loan
losses are included in the above table as non-interest bearing or non-
repricing items.
</TABLE>
As noted above, interest rates recently have been rising after a prolonged
decline. The most widely watched short-term interest rate is probably the
money center banks' prime lending rate. Publicly announced changes for the
money center banks and the Company beginning with a rate of 10% at the
beginning of 1990, are as shown in the table below. As with a number of
community banks, the Company uses a "base lending rate" from which it sets
the rates charged to individual customers. This base lending rate is set
by the Company with reference to the local market conditions as well as
the money center banks' prime lending rate. Also like other community
banks, the Company trailed the decreases in the prime lending rate of the
money center banks. This departure from national prime is a recognition
that money center banks have access to different short-term funding
sources which smaller banks cannot efficiently utilize.
While the Company's base lending rate had not changed for 20 months,
changes in other rates have nonetheless occurred and have had important
effects on the Company. The specific effects on this quarter and those
which might be anticipated in the future are discussed in various sections
of this analysis.
Table 2--LENDING RATES
Prime Lending Base Lending
Rate for Typical Rate for Santa
Money Center Bank Barbara Bancorp
January, 1990 10.00% 10.00%
January, 1991 9.50% 10.00%
February, 1991 9.00% 9.50%
May, 1991 8.50% 9.00%
September, 1991 8.00% 8.50%
November, 1991 7.50% 8.00%
December, 1991 6.50% 7.50%
July, 1992 6.00% 7.00%
March, 1994 6.25% 7.25%
April, 1994 6.75% 7.75%
Total Assets and Earning Assets
Because significant deposits are sometimes received at the end of a
quarter and are quickly withdrawn, especially at year-end, the overall
trend in the Company's growth is better shown by the use of average
balances for the quarters. The chart below shows the growth in average
total assets and deposits since the last quarter of 1991. For the Company,
changes in assets are primarily related to changes in deposit levels, so
these have been included in the chart. Dollar amounts are in millions. The
chart exemplifies the normal pattern of asset and deposit growth for the
Company--relatively steady increases with first quarter deposits sometimes
less than the fourth quarter of the prior year.
(A chart is placed here in the printed copy of this filing. The chart is a
column graph with two columns for each quarter from the fourth quarter of
1991 to the first quarter of 1994. One column is for the balance of
average total assets and the other for average deposits. The columns show
a steady upward trend with some variability as described in the paragraph
above.)
Earning assets consist of the various assets on which the Company earns
interest income. The Company was earning interest on 94.2% of its assets
during the first quarter of 1994. This compares with an average of 85.4%
for all FDIC-Insured Commercial Banks and 87.7% for the Company's Southern
California peers for the fourth quarter of 1993.<F1> Having more of its
assets earning interest helps the Company to maintain its high level of
profitability. The Company has achieved this higher percentage by several
means: (1) loans are structured to have interest payable in most cases
each month so that large amounts of accrued interest receivable are not
built up; (2) the Company has long-term leases on most of its facilities
rather than owning them; (3) the Company has aggressively disposed of real
estate obtained as the result of foreclosure; and (4) the Company has
developed systems for clearing checks faster than those used by most banks
of comparable size that allows it to put the cash to use more quickly. At
the Company's current size, these steps have resulted in about $88.1
million more assets earning interest than would be the case if the
Company's ratio were similar to its peers. If it is assumed that these
extra assets would be earning at the average rate earned on U. S. Treasury
and Agency securities held by the Company during the first quarter, this
has resulted in about $1.1 million in additional pre-tax income for the
first quarter of 1994.
Deposits and Related Interest Expense
As shown both in the preceding chart and in Table 3 below, average
deposits have continued to grow. Average total deposits for the first
quarter of 1994 increased 4.7% from average deposits a year ago.
Growth in Average Deposit Balances
Table 3 presents the average balances for the major deposit categories and
the yields of interest-bearing deposit accounts for the last five quarters
(dollars in millions).
<TABLE>
Table--AVERAGE DEPOSITS AND RATES
<CAPTION>
1993 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
<S> <C> <C> <C> <C> <C> <C> <C> <C>
NOW/MMDA 323.2 2.34% 340.0 2.18% 364.3 2.15% 377.3 2.10%
Savings 153.5 2.77 152.3 2.52 154.5 2.41 154.6 2.24
Time deposits 100+ 93.1 3.80 83.4 3.63 75.7 3.42 73.8 3.38
Other time 160.5 4.66 160.5 4.57 157.5 4.45 156.1 4.38
Total interest-bearing
deposits 730.3 3.13% 736.2 2.93% 752.0 2.81% 761.8 2.72%
Non-interest-bearing 96.4 99.0 99.6 106.4
Total deposits 826.7 835.2 851.6 868.2
<CAPTION>
1994 1st Quarter
<S> <C> <C>
NOW/MMDA 371.2 2.09%
Savings 149.4 2.25
Time deposits 100+ 72.3 3.35
Other time 155.1 4.35
Total interest-bearing
deposits 748.0 2.72%
Non-interest-bearing 117.5
Total deposits 865.5
</TABLE>
While occasionally there are slight decreases in average deposits from one
quarter to the next, the overall trend is one of growth. This orderly
growth has been planned by Management and can be sustained because of the
strong capital position and earnings record of the Company. These factors
have allowed the Company to increase its market share of local deposits by
maintaining quite competitive deposit rates. The increases have come
through the introduction of new deposit products and successfully
encouraging former customers of failed or merged financial institutions to
become customers of the Company.
The growth trends of the individual types of deposits, are primarily
impacted by the relative rates of interest offered by the Company and the
customers' perceptions of the direction of future interest rate changes.
Compared with the first quarter of 1993, the growth in deposits during the
last four quarters came in the interest-bearing transaction accounts.
During 1993, as market interest rates were declining, most banks,
including the Company, did not lower interest rates paid on their
transaction accounts as much as they had on the certificates of deposit.
Therefore, with less of an interest rate differential to encourage them to
purchase term certificates, and a common view that it would be better to
remain liquid in preparation for what had been considered an inevitable
rise in interest rates, new customers generally placed their deposits in
non-term accounts. If not placed in transaction accounts, funds from
maturing CD's have often been taken by customers to outside mutual funds
or brokerage accounts.
As shown in Table 3, there has been some growth in non-interest bearing
demand accounts during the last year. However, approximately $10.0 million
of the average balance for the first quarter relates to outstanding checks
from the refund anticipation loan program. Without this account, which
will have an average balance of less than a million dollars in the second
quarter of 1994, the average balance for non-interest bearing demand
deposits would still have shown about 11.5% growth in the last year.
Without this account, the average balance for all deposits for the quarter
would have increased 3.5% from the first quarter of last year instead of
4.7%, and would have declined by 1.5% from the fourth quarter of 1993, a
decline comparable to the 1.0% decline in the average balance from the
fourth quarter of 1992 to the first quarter of 1993.
Banks that are insured by the Bank Insurance Fund of the FDIC are required
to notify that agency 30 days in advance if they plan to increase their
assets 7.5% or more over any three-month period through the solicitation,
in any combination, of fully insured brokered deposits, fully insured out-
of-territory deposits, or secured borrowings, including repurchase
agreements. This requirement applies to the Bank, the principal subsidiary
of the Company. While the Company does forecast continued asset growth, it
is not expected that the growth will exceed 7.5% in any one quarter. In
addition, the Bank currently does not solicit and does not intend in the
future to solicit any brokered deposits or out-of-territory deposits.
Because these types of accounts are highly volatile, they present major
problems in liquidity management to a depository institution unless it is
prepared to continue to offer very high interest rates to keep the
deposits. Therefore, the Bank has taken specific steps to discourage even
unsolicited out-of-territory deposits in the $100,000 range and above.
While the Bank does offer repurchase agreements, the average balance has
remained stable over the last several quarters.
Interest Rates Paid
The interest rates paid on deposits in the first quarter of 1994 were
virtually identical with the rates paid in the last quarter of 1993, but
lower than the rates paid a year ago. This is because average deposit
rates generally lag market rates. During the latter part of the first
quarter of 1994 and the early part of the second quarter, the Company
increased some of its rates on certificates of deposit, so it would be
expected that the average rates will show an increase in the second
quarter, depending on the number of new certificates and maturing
certificates that are renewed at the higher rates. Savings, money market
and NOW account rates have not yet been increased.
Generally, the Company offers higher rates on certificates of deposit in
amounts over $100,000 than for amounts and therefore one would normally
expect that the average rate paid on these large time deposits would be
higher than the average rate paid on time deposits with smaller balances.
As may be noted in Table 3, this has not been the case during the last
five quarters. There are three primary reasons for this.
First, as indicated in the next section of this discussion, there has been
a much lower demand for loans over the last two years because of the
sluggish economy. This factor, together with what are still relatively low
rates currently available from short-term securities, has made the Company
reluctant to encourage large deposits that are not the result of stable
customer relationships. Therefore, the interest rate premium on time
deposits over $100,000 for some maturities is now only 1/20 of 1%. This
compares with a premium of 1/4 of 1% three years ago and 3/4 of 1% six
years ago. Second, the time deposits of $100,000 and over generally have
shorter maturities than the smaller certificates. Therefore, they reprice
more frequently. In a declining interest rate environment, that means that
their average rate paid will decline faster. Third, there has been an
increase in the proportion of IRA accounts among the under $100,000 time
deposits. The Company pays a higher rate on these accounts and they tend
to have longer terms. Therefore, some are still paying quite high rates
set several years ago. These factors have served to maintain a higher
average rate paid on the smaller time deposits relative to the average
rate paid on larger deposits.
Loans and Related Interest Income
Table 4 shows the changes in the end-of-period (EOP) and average loan
portfolio balances and taxable equivalent income and yields <F2> over the
last six quarters (dollars in millions).
<TABLE>
Table 4 LOAN BALANCES AND YIELDS
<CAPTION>
EOP Average Interest Average
Quarter Ended Outstanding Outstanding and Fees Yield
<S> <C> <C> <C> <C> <C>
December 1992 477.2 474.9 10.98 9.19
March 1993 474.3 485.5 11.73 9.72
June 1993 472.1 477.6 10.91 9.12
September 1993 451.6 465.4 10.55 9.01
December 1993 464.2 457.7 10.36 9.00
March 1994 469.5 488.6 14.23 11.73
</TABLE>
Change in Average Loan Balances
Due to the slow-down in the economy, the loan portfolio balance began to
decline in the fourth quarter of 1990 and there have been decreases in the
average balance for the majority of the subsequent quarters. The first
quarters of both 1993 and 1994 show the impact of the tax refund
anticipation loans ("RAL's") that the Company makes. These loans are
described below. They averaged $29.5 million for the first quarter of 1994
and $5.3 million for the first quarter of 1993. There were $13.9 million
outstanding at March 31, 1994. Eliminating these loans from the above
table would show average loans for the first quarter of 1994 just slightly
higher than for the fourth quarter of 1993.
During 1993, for an unusually large amount of loans, the Company had to
foreclose on some collateral or recognize that the collateral was "in-
substance" foreclosed. In such cases the carrying amounts of the loans are
adjusted to the estimated market value of the collateral if lower than the
outstanding amount of the loan. This lower of cost or market is reported
among other assets rather than in the loan portfolio, causing some of the
decrease in the balances in the preceding table for 1993.
The Company sells almost all of its long-term, fixed rate, 1-4 family
residential loans when they are originated in order to manage market and
interest rate risks and liquidity. If interest rates continue to rise,
consumer demand for these loans may decline, especially if initially lower
"teaser" rates again become prevalent to entice borrowers to choose
adjustable rate notes. In such circumstances, the Company might retain a
larger percentage of the residential loans it originates.
The RAL's are extended to taxpayers who have filed their returns with the
IRS electronically and do not want to wait for the IRS to send them their
refund check. Almost all of the loans are made in the first quarter of the
year. In 1993, there was an average of $5.3 million outstanding during the
first quarter. The average loan was for about $1,100 and was outstanding
for 20 days before the Company received payment from the IRS. The Company
earned a fixed fee per loan for advancing the funds.
The Company signficantly expanded the program for the 1994 tax season. As
of the end of the first quarter of 1994, the Company had lent $225 million
to 145,000 taxpayers. The average loan was for $1,550 and was outstanding
about 12 days.
On September 29, 1993, the Company sold its portfolio of credit card
loans. Outstanding balances at the time of the sale were $7.7 million. The
Company continued to service the portfolio for the purchasing bank until
March 1994, but the outstanding balances were not shown as loans of the
Company, and the average balances of loans in the fourth quarter of 1993
and the first quarter of 1994 are lower because of the sale. The Company
will continue to issue credit cards, but it will not be responsible for
collections or losses from defaults, nor will it receive interest earned
on the outstanding balances.
Interest and Fees Earned and the Effect of Changing Interest Rates
A large proportion of the loan portfolio is made up of loans that have
variable rates that are tied to the Company's base lending rate or to the
cost of funds index for the 11th District of the Federal Home Loan Bank.
Approximately 90% of both the commercial loans and the real estate
construction loans are tied to the Company's base lending rate, and
approximately one quarter of the real estate mortgage loans are tied to
the 11th District Cost of Funds Index (COFI). The loans that are tied to
the Company's base lending rate adjust immediately to any change in that
rate while the loans tied to COFI usually adjust every six months or less.
The interest rates on the fixed rate loans do not change directly with the
base lending rate or any other index, but are subject to prepayment when
the current market rate for any specific type of loan has declined
sufficiently below the contractual rate on the loan to warrant
refinancing. Therefore, it would be expected that average yields on the
portfolio would follow declines in market interest rates with some lag,
and then catch up if rates remain stable for a period of time.
The yields shown in Table 4 for the first quarters of 1993 and 1994 are
significantly affected by the income from the RAL program. Average yields
for the two quarters without the effect of RAL's were 9.04% and 8.67%,
respectively.
Other Loan Information
In addition to the outstanding loans reported in the accompanying
financial statements, the Company has made certain commitments with
respect to the extension of credit to customers. Among these are credit
lines with unused balances of $116.9 million, undisbursed loans of $15.8
million, and other loan or letter of credit commitments of $37.2 million.
The corresponding figures for March 31, 1993 were $147.0 million, $16.0
million, and $32.3 million, respectively. Most of the decrease in the
unused balances of credit lines is due to the sale of the credit card
portfolio mentioned above. The decrease in undisbursed loans is due to the
decline in real estate construction activity. The majority of the
commitments are for one year or less. The majority of the credit lines and
commitments may be withdrawn by the Company subject to applicable legal
requirements. With the exception of the undisbursed loans, the Company
does not anticipate that a majority of the above commitments will be used
by customers.
The Company defers and amortizes loan fees collected and origination costs
incurred over the lives of the related loans. For each category of loans,
the net amount of the unamortized fees and costs are reported as a
reduction or addition to the balance reported. Because the fees are
generally less than the costs for commercial and consumer loans, the total
net deferred or unamortized amounts for these categories are additions to
the loan balances.
Allowance for Loan Losses and Credit Quality
The allowance for loan losses (sometimes called a "reserve") is provided
in recognition that not all loans will be totally paid according to their
contractual terms. The Company is required by regulation, generally
accepted accounting principles, and safe and sound banking practices to
maintain an allowance that is adequate to absorb losses that are inherent
in the loan portfolio, even those not yet identified. The adequacy of the
allowance is based on the size of the loan portfolio, historical trends of
charge-offs, and Management's estimates of future charge-offs. These
estimates are in turn based on the grading of individual loans and
Management's outlook for the local and national economies and how they
might affect borrowers.
The size of the loan portfolio has been declining over the last two years.
However, because this decline has been due to a slower economy that has
also led to more charge-offs, Management has not used this decline as a
reason to decrease the allowance.
While reflective of developments in the loan portfolio during the quarter,
it is assumed that net charge-offs for 1994 will be higher than the figure
that would result from annualizing the net charge-offs of $97,000 for the
first quarter of 1994. From the beginning of 1988 through 1992, the
Company's ratio of net charge-offs to average total loans and leases
averaged one quarter as much as that of the average FDIC bank and one
third that of its Southern California peers. However, in 1993 the
Company's ratio increased to 1.15% compared to 0.84% for all FDIC banks
and 1.51% for its Southern Califoria peers. In 1993, the Company charged
off a portion ($3.3 million) of one large loan to recognize the decline in
value of its real estate collateral before foreclosing on the property. In
addition, the RAL program generated significant net charge-offs of about
$588,000. Because these refund anticipation loans are made to customers
all over the country who have no other relationship with the Company, the
loss rate is fairly high, about 1.40%. The higher loss rate is nonetheless
more than covered by the fees charged by the program (about $1,048,000),
and the higher level of net charge-offs is considered to be part of the
cost of entering this line of business.
While the losses that will result from the expanded 1994 RAL program will
not be known until the end of the second quarter, the Company is
estimating they will total approximately $2.3 million. This represents
about 1.0% of loans made and reflects improvements in screening preparers
and borrowers for 1994. These losses plus the operating expense are more
than covered by the fees earned through quarter-end of $4.3 million.
Because these loans are less than 90 days old, none are included in the
non-current loan totals for March 31, 1994.
Management continues to closely monitor the condition of the remainder of
the loan portfolio. Table 5 shows the amounts of non-current loans and
non-performing assets for the Company at the end of the first quarter of
1994 and at the end of the fourth, third, and first quarters of 1993 in
thousands of dollars. Also shown is the coverage ratio of the allowance to
non-current loans, the ratio of non-current loans to total loans, and the
percentage of non-performing assets to average total assets.
Included in the table is comparable data <F3> regarding the Company's
Southern California peers at December 31, September 30 and March 31, 1993.
The Company's coverage ratio remains at almost three times that of its
average Southern California peer bank at December 31, 1993.
While non-current loans are always a cause of concern, the amount of these
loans shown for the Company as of March 31, 1994, does not equate directly
with future charge-offs. Most of these loans are well secured by
collateral. Nonetheless, Management still considered it prudent in 1993
and the first quarter of 1994 to continue to increase the allowance for
loan losses through generous quarterly provisions (bad debt expense). The
Company charged $4.3 million to the provision in the first quarter of
1994, compared to $2.8 million for the comparable period of 1993. This
results in an allowance that is 3.04% of loans outstanding. This ratio is
temporarily higher than the ratio the Company anticipates for the
remainder of the year, because of the extra provision recorded in the
first quarter to cover RAL losses that will be charged-off in the second
quarter. The average for all FDIC insured banks of comparable size is
2.46%, and the average for the Company's Southern California peers is
3.15%.<F4> Although the Company's ratio of allowance to total loans is
less than that of the average ratio for its Southern California peers,
Management believes that this is justified because the Company's coverage
ratio of allowance to non-current loans is almost three times that of its
peers since the Company has a much lower proportion of non-current loans
than its peers.
Management anticipates that over the next several quarters, until economic
recovery is established, net charge-offs may be larger than the historical
averages, and that, in any given quarter, delinquent loans may increase.
To mitigate the effects of this, Management intends to continue to review
the situation each quarter, and may continue to increase the amount of the
allowance even though the total average balance of the loan portfolio is
decreasing (after consideration of the increase in the average balance of
loans due to the RAL's). Management expects that the Company's credit
quality ratios should therefore continue to be substantially more
favorable than those of the average peer bank.
<TABLE>
Table--5 ASSET QUALITY
<CAPTION>
March 31, 1994 December 31, 1993 September 30, 1993 March 31, 1993
Company Company Company Company
<S> <C> <C> <C> <C>
Loans delinquent
90 days or more 348 862 685 533
Non-accrual loans 5,308 3,126 2,370 958
Total non-current loans 5,656 3,988 3,055 1,491
Foreclosed real estate 1,423 3,479 14,542 14,882
Total non-performing assets 7,079 7,467 17,597 16,373
<CAPTION>
So. Cal So. Cal So. Cal
Peer Peer Peer
Company Company Group Company Group Company Group
<S> <C> <C> <C> <C> <C> <C> <C>
Coverage ratio of allowance
for loan losses to non-current
loans and leases 252% 252% 87% 300% 72% 676% 80%
Ratio of non-current loans
to total loans and leases 1.20% 0.86% 4.37% 0.80% 5.13% 0.31% 4.43%
Ratio of non-performing
assets to average total assets 0.71% 0.75% 3.71% 1.82% 4.51% 1.74% 4.08%
</TABLE>
The Company's ratio of non-performing assets to average total assets
substantially decreased during the fourth quarter of 1993 because of sales
of foreclosed properties (at a gain of $600,000). There were additional
sales in the first quarter of 1994 (at a net gain of $907,000) but the
effect of these sales on the ratio was partially offset by additional
loans that needed to be placed in non-accrual status.
Securities and Related Interest Income
In 1993, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 115, Accounting for
Certain Investments in Debt and Equity Securities ("FASB 115"). This new
pronouncement requires that securities be classified in one of three
categories when they are purchased. The first category is that of "held-
to-maturity." The Company must have both the intent and the ability to
hold a security until its maturity date for it to be classified as such.
Securities classified as held-to-maturity are carried on the balance sheet
at their amortized historical cost. That is, they are carried at their
purchase price adjusted for the amortization of premium or accretion of
discount. If debt securities are purchased with the intent of later
selling them for a gain, the securities are classified as "trading
assets." Assets held in a trading account are required to be carried on
the balance sheet at their current market value. Changes in the market
value of the securities are recognized in the income statement for each
period in which they occur as unrealized gain or loss. Securities that do
not meet the criteria for either of these categories, e.g. securities
which might be sold to meet liquidity requirements or to effect a better
asset/liability maturity matching, are classified as "available-for-sale."
They are carried on the balance sheet at market value like trading
securities, but unlike trading securities, changes in their market value
are not recognized in the income statement for the period. Instead, the
unrealized gain or loss (net of tax effect) is reported as a separate
component of equity. Changes in the market value are reported as changes
to this component.
The Company has created two separate portfolios of securities. The first
portfolio is the "Earnings Portfolio." This portfolio includes all of the
tax-exempt municipal securities and most of the longer term taxable
securities. The second portfolio, the "Liquidity Portfolio," is be made up
almost entirely of the shorter term taxable securities. The Company
specifies the portfolio into which each security will be classified at the
time of purchase.
Securities purchased for the earnings portfolio will not be sold for
liquidity purposes or because their fair value has increased or decreased
because of interest rate changes. They could be sold if concerns arise
about the ability of the issuer to repay them or if tax laws change in
such a way that any tax-exempt characteristics are reduced or eliminated.
Under the provisions of FASB 115, contemplation of sale for these reasons
does not require classification as available-for-sale. The accounting for
these securities will therefore continue to be based on amortized
historical cost.
In general, it will be the practice of the Company to purchase for the two
portfolios according to the following priorities. Taxable securities,
usually U.S. Government obligations with maturities of two years to five
years, will be purchased for the liquidity portfolio. The size of the
liquidity portfolio will vary based on loan demand, deposit growth, and
the scheduled maturities of other securities. To the extent that estimated
liquidity needs are met, tax-exempt municipals that meet credit quality
standards will be purchased for the earnings portfolio up to an amount
that does not trigger the Alternative Minimum Tax described below in
"Income Taxes." Lastly, taxable securities, generally U. S. Government
obligations with maturities of five years or longer, may be purchased for
the earnings portfolio.
The Effects of Interest Rates on the Composition of the Investment
Portfolio
Table 6 presents the combined securities portfolios, showing the average
outstanding balances (dollars in millions) and the yields for the last
five quarters. The yield on tax-exempt state and municipal securities has
been computed on a taxable equivalent basis. Computation using this basis
increases income for these securities in the table over the amount accrued
and reported in the accompanying financial statements. The tax-exempt
income is increased to that amount which, were it fully taxable, would
yield the same income after tax as what is reported in the financial
statements. The computation assumes a combined Federal and State tax rate
of approximately 41%.
<TABLE>
Table 6 AVERAGE BALANCES OF SECURITIES AND INTEREST YIELD
<CAPTION>
1993 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
<S> <C> <C> <C> <C> <C> <C> <C> <C>
U.S. Treasury 297.0 5.83% 296.4 5.79% 293.1 5.68% 294.2 5.53%
U.S. Agency 0.0 0.00 1.2 3.62 5.5 3.80 15.1 4.34
Tax-Exempt 75.5 13.30 76.2 13.29 77.5 13.21 77.6 13.09
Total 372.5 7.34% 373.8 7.32% 376.1 7.21% 386.9 7.00%
<CAPTION>
1994 1st Quarter
<S> <C> <C>
U.S. Treasury 305.4 5.28%
U.S. Agency 20.8 4.61
Tax-Exempt 78.0 13.20
Total 404.2 6.77%
</TABLE>
The Company's investment practice has been to shorten the average maturity
of its investments while interest rates are rising, and lengthen the
average maturity as rates are declining, and this is expected to continue
within the two portfolios. When interest rates are rising, short maturity
investments are preferred because principal is better protected and
average interest yields closely follow market rates since the Company is
buying new securities more frequently to replace those maturing. When
rates are declining, longer maturities are preferable because their
purchase tends to "lock-in" higher rates. Generally, "longer maturities"
has meant purchases in the two-to-five year range. The two-year securities
are generally purchased in $10 million increments, and the three and five-
year securities in $5 million and $2 million increments, respectively.
Because of the sustained general downward trend in interest rates during
the last several years, the Company's investment policy called for
continued purchases of securities so long as immediate liquidity needs
could be met. The effect on the average yield of securities from the
reinvestment of maturing securities at progressively lower rates is shown
in Table 6 as $50 million in U. S. Treasury securities matured in the
fourth quarter of 1993 and $70 million matured in the first quarter of
1994. The effect is especially apparent by comparing the 6.77% overall
yield for the first quarter of 1994 with the 7.34% overall yield for the
same quarter a year earlier.
Investments in most tax-exempt securities became less advantageous because
of the effect of certain provisions of the Tax Reform Act of 1986 ("TRA").
Those provisions did not affect securities purchased before the passage of
the act which make up the majority of the Company's tax-exempt securities.
There is still more than a sufficient differential between the taxable
equivalent yields on these securities and yields on taxable securities to
justify holding them to maturity. The average maturity is approximately
eight years.
Certain issues of municipal securities may still be purchased with the tax
advantages available before TRA. Such securities, because they can only be
issued in very limited amounts, are generally issued only by small
municipalities, and the Company must do a careful credit evaluation of the
issuer. In reviewing securities for possible purchase, Management must
also ascertain that the securities have desirable maturity
characteristics, and that the amount of tax-exempt income they generate
will not be so great as to trigger the Alternative Minimum Tax or the tax
advantage will be lost. Apart from a few small issues that have met the
Company's criteria for purchase, the increase in the average balance of
tax exempt securities is due to the accretion of discount (the periodic
recognition as interest income of the difference between the purchase cost
and the par value that will be paid upon maturity).
Losses on Securities Sales
When interest rates rise, the market value of a fixed rate security
declines; the market value increases when rates decline. The decline in
market value occurs because investors will pay less for a security that
earns interest at a rate less than that which is available on a newly
issued comparable security. Correspondingly, in a declining interest rate
environment, an investor will pay more for an older security that pays
interest at a higher rate than the latest issues of comparable maturity.
Banks have found that they are reluctant to sell a security if the
increase in interest rates is such that the loss resulting from the sale
of the security would have a significantly negative impact on earnings. In
such cases, the holder of the security should no longer consider the
security to be available for liquidity, even if there may be an active
market for the security, because the earnings penalty upon sale is too
great. Instead, banks sell other securities that are not below the current
market. In periods of rising interest rates, this can cause an institution
to end up with large unrealized losses in its portfolios. This phenomenon
was in large part the impetus for the FASB to develop and regulators to
support the classification of most non-trading securities as available-
for-sale with balance sheet reporting at market value.
The Company's policy calls for it to sell those securities in its
liquidity portfolio which have more than a year remaining until maturity
if their market value has declined to a certain point. That point is
reached when their yield to maturity based on their current market value
is 25 basis points (1/4 of 1%) more than the yield to maturity based on
their original purchase price. By limiting how much decline in market
value is allowed to occur before securities are sold, this provision is
designed to maintain the liquidity of the securities in the liquidity
portfolio. It also recognitizes that the difference in market value
between an older security with a lower rate and a newer security with an
interest rate at or near market approximates the present value of the
higher future earnings that would be available if the Company were to sell
the lower yielding security and invest in the more recent issue. In other
words, when interest rates move higher and a security declines in value,
the holder can either recognize the loss immediately through sale and make
it up in higher future earnings, or the holder can refrain from
immediately recognizing the loss but earn less on its funds until the
maturity of the security. While Management occasionally makes exceptions
to this provision, the policy expresses its preference for the former
course of action.
Even while generally trending down during the last several years, there is
always some variation in the market rates for Treasury securities. Under
the investment policy described above, short-term reversals in the general
trend can trigger sales of securities recently purchased, accounting for
the losses. When rates are generally flat, few or no sales are triggered.
Because the Company follows the practice of holding securities that have a
market value above cost and selling securities when the value has declined
to a certain point, it is expected that there will seldom be gains from
sales of securities. Table 7 shows the net amounts of losses from the sale
of securities for the last six quarters (dollars in thousands).
Table 7--LOSSES ON SECURITIES SALES
Quarter Ended Losses
December 1992 (103)
March 1993 (47)
June 1993 0
September 1993 0
December 1993 0
March 1994 0
Rates have increased subsequent to March 31, 1994 to trigger some sales
with consequent losses.
Federal Funds Sold
Cash in excess of the amount needed to fund loans, invest in securities,
or cover deposit withdrawals, is sold to other institutions as Federal
funds. The sales are only overnight. Excess cash expected to be available
for longer periods is generally invested in U.S. Treasury securities or
bankers' acceptances if the available returns are acceptable. The amount
of Federal funds sold during the quarter is therefore an indication of
Management's estimation during the quarter of immediate cash needs and
relative yields of alternative investment vehicles.
Table 8 illustrates the average funds sold position of the Company and the
average yields over the last six quarters (dollars in millions).
Table 8--AVERAGE BALANCE OF FUNDS SOLD AND YIELDS
Average Average
Quarter Ended Outstanding Yield
December 1992 2.3 2.90%
March 1993 18.2 3.02
June 1993 31.3 2.91
September 1993 36.1 2.96
December 1993 21.8 2.97
March 1994 4.9 3.31
When interest rates are rising, keeping larger amounts in Federal funds
benefits the Company because its excess funds earn interest at the market
rate. When rates are declining, the Company generally decreases the amount
of funds sold and instead purchases Treasury securities and/or bankers'
acceptances. When rates are stable, the balance of Federal funds is
determined more by available liquidity than by policy concerns. In the
third and fourth quarters of 1993, excess funds that might otherwise have
been sold as Federal funds were instead invested in short term U. S.
Treasury securities and bankers' acceptances maturing in the first quarter
of 1994 to provide funding for the RAL program. In the first quarter of
1994, virtually all available funds were used to support the program,
leaving few funds for sale.
Bankers' Acceptances
The Company has used bankers' acceptances as an alternative to 6-month
U.S. Treasury securities when pledging requirements are otherwise met and
sufficient spreads to U.S. Treasury obligations exist. The acceptances of
only the highest quality institutions are utilized. Table 9 discloses the
average balances and yields of bankers' acceptances for the last six
quarters (dollars in millions).
Table 9--AVERAGE BALANCE OF BANKERS' ACCEPTANCES AND YIELDS
Average Average
Quarter Ended Outstanding Yield
December 1992 14.3 3.53%
March 1993 13.4 3.52
June 1993 0.0 0.00
September 1993 16.0 3.34
December 1993 60.8 3.32
March 1994 33.7 3.31
About $35 million in bankers' acceptances were purchased in the fourth
quarter of 1992 to mature in the first quarter of 1993 to provide funding
for the Company's refund anticipation loan program. When these matured,
they were not immediately replaced. However, the Company recognized the
need to provide a significant amount of funds in the first quarter of 1994
for the planned expansion of the RAL program. With rates on acceptances
comparing favorably to shorter-term U. S. Treasury securities, significant
purchases were made beginning late in the third quarter of 1993. When they
matured, the proceeds were used as planned to fund the RAL program. As the
RAL's were repaid, the funds were used to purchase securities with longer
maturities, thereby reducing the Company's holdings to one $5 million
acceptance at March 31, 1994.
Other Borrowings and Related Interest Expense
Other borrowings consist of securities sold under agreements to
repurchase, Federal funds purchased (usually only from other local banks
as an accommodation to them), Treasury Tax and Loan demand notes, and
borrowings from the Federal Reserve Bank ("FRB"). Because the average
total short-term component represents a very small portion of the
Company's source of funds (less than 5%) and shows little variation in
total, all of the short-term items have been combined for the the
following table. Interest rates on these short-term borrowings change over
time, generally in the same direction as interest rates on deposits.
Table 10 indicates the average balances that are outstanding (dollars in
millions) and the rates and the proportion of total assets funded by the
short-term component over the last six quarters.
Table 10--OTHER BORROWINGS
Average Average Percentage of
Quarter Ended Outstanding Rate Average Total Assets
December 1992 39.2 3.02% 4.1%
March 1993 30.7 2.94 3.3
June 1993 27.4 2.89 2.9
September 1993 23.0 2.83 2.4
December 1993 29.1 2.88 2.9
March 1994 28.8 2.97 2.9
Other Operating Income
Trust fees are the largest component of other operating income. Management
fees on trust accounts are generally based on the market value of assets
under administration. As the number of customers and the size of
portfolios have grown, the fees have increased. These fees are recorded
when probates close. Table 11 shows trust income over the last six
quarters (in thousands).
Table 11--TRUST INCOME
Quarter Ended Trust Income
December 1992 1,491
March 1993 1,717
June 1993 1,484
September 1993 1,682
December 1993 1,706
March 1994 1,781
Trust customers are charged for the preparation of the fiduciary tax
returns. The preparation generally occurs in the first and/or second
quarter of the year. This accounts for approximately $179,000 of the fees
earned in the first quarter of 1994 and $226,000 and $32,000 of the fees
earned in the first and second quarters of 1993, respectively. Other
variation is caused by the recognition of probate fees when the work is
completed rather than accrued as the work is done, because it is only upon
completion that the fee is established by the court. After adjustment for
these seasonal and non-recurring items, there is a general increasing
trend in trust income. New customers bringing additional trust assets to
the Company and higher prices in the stock and bond markets have caused
the market value of assets to increase substantially over the last several
years.
Other categories of non-interest income include various service charges,
fees, and miscellaneous income. Included within "Other Service Charges,
Commissions & Fees" in the following table are service fees arising from
credit card processing, escrow fees, and a number of other fees charged
for special services provided to customers. The quarterly amounts for some
of these fees tend to vary based on the local economy. For instance, in
1993, a slower real estate market resulted in lower escrow fees.
Similarly, credit card spending had been down for several quarters, so
less fees were earned for processing. There was an increased volume of
drafts submitted during the third quarter of 1993, accounting for about
$70,000 of the increase over the prior quarter.
Categories of non-interest operating income other than trust fees are
shown in Table 12 for the last six quarters (in thousands).
Table 12--OTHER INCOME
Other Service
Service Charges Charges,
on Deposit Commissions Other
Quarter Ended Accounts & Fees Income
December 1992 682 929 278
March 1993 701 822 182
June 1993 702 916 190
September 1993 709 1,043 236
December 1993 713 1,012 334
March 1994 724 791 145
The amounts for the first quarter of 1994 are lower than for previous
quarters for several reasons. In addition to interest earned on
outstanding credit card balances, which up to the time of the sale of the
credit card portfolio at the end of the third quarter of 1993 were
reported with other interest income, there are also other fees related to
credit card processing. When a merchant deposits credit card charges with
a bank, the merchant is charged a fee. The bank with which a merchant
deposits credit card charges earns a portion of that fee, and the bank
that issued the card earns a portion of the fee. Prior to the sale of the
credit card portfolio, the Company earned fees for the use of their cards
by its customers. Approximately $134,000 of the $1,043,000 in Charges,
Commissions & Fees for the third quarter of 1993 were fees of this type.
These fees have not been earned after the third quarter of 1993 because of
the sale. By the terms of the sales agreement with the purchaser of the
portfolio, some fees will be earned from the purchasing bank based on the
number of cards outstanding and purchases by these cardholders, but these
fees are less than what was earned when the Company owned the portfolio.
These fees were approximately $55,000 for the first quarter of 1994. The
Company continues to earn the portion of the fees related to the merchant,
because the merchant processing activity was not sold. Management
anticipates that total other service charges, commissions and fees will
average around $900,000 over the next few quarters.
Included in other income are gains or losses on sales of loans. When the
Company collects fees on loans that it originates, it must defer them and
recognize them as interest income over the term of the loan. If the loan
is sold before maturity, any unamortized fees are recognized as gains on
sale rather than interest income. In the fourth quarters of 1992 and 1993,
the Company originated a significant number of fixed rate mortgages, many
of them refinancings, that it immediately sold to other financial
institutions or insurance companies. The larger-than-usual balance of
refinancings in the fourth quarter of 1993 appeared to be related to
consumers' fears that rates were starting to rise and that this would be
their last chance to "lock in" lower rates. The Company did many fewer
refinancings in the first quarter of 1994. Gains recognized because of the
susbsequent sale of these notes totaled approximately $75,000 compared
with approximately $196,000 in the fourth quarter of 1993. If rates
continue to rise, it would be expected that refinancings will remain at a
lower level.
Staff Expense
The Company has closely monitored staff size and in the last two years has
managed to hold the increase in the average number of employees to about
4.4% (about 15 employees) while average assets increased about 10% and the
market value of trust assets under administration increased by 35%. With
the rate of inflation running very low, merit increases have averaged 5%
or less the last two years.
The amounts shown for Profit Sharing and Other Employee Benefits include
(1) the Company's contribution to profit sharing plans and retiree health
benefits, (2) the Company's portion of health insurance premiums, payroll
taxes, and (3) workers' compensation insurance. The signficant decrease in
this expense from the third quarter of 1993 to the fourth quarter of 1993
and the significant increase for the first quarter of 1994 are due to
several factors. The first factor relates to the Company's contributions
to the profit sharing and retiree health plans. These contributions are
determined by a formula that results in a contribution equal to 10% of a
base figure made up of income before tax and before the contribution
adjusted to add back loan loss provision and subtract actual charge-offs.
Because actual net charge-offs were a higher percentage of the provision
in 1993 (72%) than they had been in prior years, the base was lower
relative to net income than it had been. The Company had been accruing
during the first three quarters of 1993 at the 1992 rate and so needed to
adjust the amount in the fourth quarter. In the first quarter of 1994, the
Company accrued for these contributions at a higher rate, in accordance
with the projection that net charge-offs will not be as great in 1994 as
in 1993.
The second factor relates to payroll taxes. An estimated amount for
officer bonuses is accrued as salary expense during the year because the
bonuses are based on the financial performance for that year. However, the
Company is not liable for the payroll taxes until the bonuses are paid in
the first quarter of the following year. Therefore the payroll taxes
relating to the bonuses for the prior year are all charged as expense in
the first quarter of the current year, accounting for a portion
(approximately $76,000) of the increase from the fourth quarter of 1993 to
the first quarter of 1994. Related to this is the fact that payroll tax
expense is normally lower in the fourth quarter of each year because the
salaries of the higher paid employees have passed the payroll tax ceilings
by the fourth quarter. On just a slightly higher salary level, payroll
taxes were about $127,000 more in the first quarter of 1994 than the
fourth quarter of 1993.
Table 13 shows the amounts of staff expense incurred over the last six
quarters (in thousands).
Table 13--STAFF EXPENSE
Salary and Profit Sharing and
Quarter Ended Other Compensation Other Employee Benefits
December 1992 3,577 1,110
March 1993 3,709 1,305
June 1993 3,785 1,077
September 1993 3,828 1,140
December 1993 4,010 787
March 1994 4,096 1,353
As discussed above in "Loans and Related Interest Income," the accounting
standard relating to loan fees and origination costs requires that salary
expenditures related to originating loans not be immediately recognized as
expenses, but instead be deferred and then amortized over the life of the
loan as a reduction of interest and fee income for the loan portfolio.
Compensation actually paid to employees in each of the above listed
periods is thus higher than shown by an amount ranging from $125,000 to
$275,000, depending on the number of loans originated during that quarter.
Other Operating Expenses
The Company has made a serious effort to contain non-interest expense. A
way of measuring this is by computing an operating efficiency ratio. This
ratio is the amount of non-interest expense (including salaries and
benefits as well as the other operating expenses discussed in this
section) divided by the sum of net interest income and non-interest
income. The provision for loan loss and the effect of gains or losses from
sales of securities are omitted from the computation. The Company's
operating efficiency ratio for the year 1993 was 62.0%. This means that it
cost the Company sixty-two cents to earn a dollar of income. This compares
with a ratio of 65.5% for all FDIC banks of $100 million to $1 billion in
asset size for 1993. For the year of 1993, the Company's lower ratio meant
$2.1 million less operating expense was incurred than the FDIC peer ratio
would indicate was incurred at the average peer bank of comparable size.
The Company's operating efficiency ratio for the first quarter of 1994 is
49.4%, but that number is significantly impacted by the large amount of
RAL fees and the gains on the sale of OREO that will not occur during the
remainder of the year. The Company is working to bring the ratio below 60%
for the year 1994.
Table 14 shows other operating expenses over the last six quarters
(dollars in thousands).
Table 14--OTHER OPERATING EXPENSE
Occupancy Expense Furniture & Other
Quarter Ended Bank Premises Equipment Expense
December 1992 728 370 3,018
March 1993 694 370 2,711
June 1993 686 420 2,749
September 1993 792 488 2,672
December 1993 817 539 3,459
March 1994 787 488 3,096
The Company leases rather than owns most of its premises. Many of the
leases provide for annual rent adjustments. The Company leased additional
office space during 1993 to provide more efficient operating areas.
Equipment expense fluctuates over time as rental needs change, maintenance
is performed, and equipment is purchased. Much of the additional expense
in the last two quarters in this category relates to upgrades of computer
equipment as the Company looks to automation to handle more tasks.
Other expense was higher than usual in the fourth quarter of 1992 in part
because the Company made a $200,000 charitable contribution. This
contribution was made to a charitable corporation that distributes the
money to other charitable organizations at the Company's instruction. This
gift, which would have been made in any event over the next year, was made
in 1992 to reduce taxes.
Included in other expense is the premium cost paid for FDIC insurance. The
FDIC has converted to a graduated rate for the premium based on the
soundness of the bank. The annual rate ranges from $0.23 to $0.30 per
hundred. On the basis of its "well-capitalized" position, the Company's
rate is $0.23 per hundred dollars of deposits.
Other expense for the fourth quarter of 1993 was higher than usual due to
the same kind of year-end charitable donation as was made in 1992 and due
to extra marketing expense incurred for the Company's new advertising
program. Table 15 details the components of other expense in the
accompanying income statements (in thousands).
Table 15--OTHER EXPENSE
Three-Month Periods
Ended March 31
1994 1993
FDIC and State assessments 520 459
Insurance 64 74
Professional services 196 272
RAL processing fees 323 0
Supplies and sundries 148 147
Postage and freight 176 168
Marketing 136 235
Bankcard processing 418 383
Other 1,115 973
Total 3,096 2,711
The net cost (gain) from other real estate owned ("OREO") is not included
in the table above because it appears on a separate line in the statements
of income. When the Company forecloses on the real estate collateral
securing delinquent loans, it must record these assets at the lower of
their fair value (market value less estimated costs of disposal) or the
outstanding amount of the loan. If the fair value is less than the
outstanding amount of the loan, the difference is charged to the allowance
for loan loss at the time of foreclosure. Costs incurred to maintain or
operate the properties are charged to expense as they are incurred. If the
fair value of the property declines below the original estimate, the
carrying amount of the property is written-down to the new estimate of
fair value and the decrease is also charged to this expense category. If
the property is sold at an amount higher than the estimated fair value, a
gain is realized that is credited to this category.
The negative amount in the income statement for this expense category for
the first quarter of 1994 reflects approximately $907,000 in net gains
arising out of sales less approximately $257,000 in operating expenses and
writedowns. The gains arose from the sale of the final four units of a
condominium project on which the Company foreclosed in 1993. The Company
had made a very conservative estimate of the market value of these units
at the time of foreclosure because of the slow pace of sales of the units
before foreclosure. With the local residential real estate market showing
increased strength, and with some initial sales to show buyers that the
prices were not going to be cut further, the Company was able to sell the
units at prices higher than the conservative estimate. Some gains from
sale were also recognized in the final quarter of 1993.
As disclosed in Note 7 to the financial statements, the Company has $1.4
million in OREO as of March 31, 1994. This compares with $14.9 million as
of a year earlier. While further gains on sale are not expected, with a
much smaller balance of OREO being held, Management anticipates that this
expense will continue to trend lower. However, there are properties which
are now collateral for (1) loans which are in non-accrual status, or (2)
loans that are currently performing but about which there is some question
that the borrower will be able to continue to service the debt according
to the terms of the note. This may necessitate additional foreclosures
during the next several quarters, with a corresponding increase in this
expense.
Accounting Standard Changes
The provisions and impact of FASB 115 are discussed above in "Investment
Policies and the Volume of Turnover in the Portfolio."
Impaired Loans
As explained in "Allowance for Loan Losses," generally accepted accounting
principles have required the Company to provide an allowance that is
adequate to absorb losses that are inherent in the loan portfolio. Banks
and other financial institutions have determined the adequacy of this
allowance based on the eventual collectibility of principal and interest
without regard to the timing of the payments. According to the FASB, this
does not recognize that there is an economic loss from a delay in payments
even if all outstanding balances are eventually collected.
To recognize this loss and to eliminate differences in the manner in which
various types of financial institutions account for troubled loans, in May
1993, the FASB issued Statement of Financial Accounting Standards No. 114,
Accounting by Creditors for Impairment of a Loan ("SFAS 114"). This
pronouncement, which must be implemented by the Company in 1995, provides
that a loan is "impaired, when, based on current information and events,
it is probable that a creditor will be unable to collect all amounts due
according to the contractual terms of the loan agreement." The impairment
is to be measured by the creditor based on the present value of its best
estimate of future cash flows discounted at the loan's effective interest
rate. Estimates are to be based on reasonable and supportable assumptions
and projections. Alternatively, the creditor may measure impairment by
means of an observable market price. If foreclosure of the collateral is
probable, the statement requires that the Company measure impairment at
the fair value of the collateral. For any difference between the
outstanding balance of the loan and its fair value after recognition of
the impairment, a valuation allowance is to be established through a
charge to the provision for loan loss.
Each month, as part of its review of the adequacy of the allowance, the
Management allocates portions of the allowance to individual loans that
have been identified as troubled. The allocation is based on its estimates
of losses that might be realized and to all other loans based on
historical trends, recent credit gradings, and estimates of the impact of
economic factors on borrowers in general. After this allocation is
completed, any remaining amount in the allowance would be unallocated. The
Company has followed the practice of maintaining a generous unallocated
allowance to provide for unforeseen circumstances. While the Company has
not taken the loss from delayed payments into account in estimating the
amount of the allowance that should be provided, Management believes that,
when the pronouncement is implemented, the unallocated amount should be
sufficient to absorb any additional losses that need to be recognized with
no need for significant additions to the allowance.
Stock-based Compensation
Generally accepted accounting principles currently require that employee
compensation expense be recognized if stock options are granted to
employees that permit them to purchase stock at a price less than the
market price of the stock at the time of the grant. If the exercise price
is at or above the market price at the time of the grant, no compensation
expense is recognized because it has been regarded as uncertain whether
the employee would realize any benefit from the grant. The Company has
three stock option plans, the details of which are described in the notes
to the financial statements in the 1993 annual report. The plans provide
for options to be granted at the market price. Under the SEC's proxy
disclosure rules, all public registrants are required to disclose in their
proxy materials an estimate of the market value of stock options granted
to executive officers, but there is no provision for recognition in the
financial statements.
In June, 1993, the FASB issued an exposure draft for a new pronouncement
that would eventually require the Company to recognize employee
compensation expense for all stock options. The amount of expense would be
computed using a mathematical model that considers such factors as the
exercise price, the current market price, the length of the option period,
and the price volatility of the stock. The model is intended to compute
the probabilities for various amounts by which, during the term of the
option, the market price of the stock will exceed the exercise price. The
provisions of the exposure draft would require footnote disclosure of the
expense but not recognition in the financial statements for the years 1994
through 1996. Recognition in the financial statements would begin in 1997.
The FASB received a large number of comment letters on the exposure draft,
and the reaction has been so strong that different bills have been
introduced in Congress which would, alternatively, require or forbid
recognition of compensation expense for the granting of stock options by
public registrants. The FASB has indicated that they are considering the
objections and suggestions that were made before issuing a final
statement.
Management has not attempted to estimate the eventual impact on net income
or earnings per share should this pronouncement be adopted as proposed.
Consultants were engaged to compute the fair value information necessary
for the proxy material. While a model similar to the one suggested by the
FASB is required by the SEC, it is not easy to estimate the fair value of
options granted to all officers from the fair value of options granted to
the executive officers. A critical component in the computation of the
fair value under these models is the term of the option and the terms of
the options granted to executive officers are longer than for those
granted to other employees. Because of the complexity of the computation,
Management does not consider it cost effective to incur the expense of
computing the possible effect of a proposal the final provisions of which
are still uncertain.
Should the proposal be adopted, and the expense prove to be significant,
the Board of Directors will decide whether to continue to grant options
under the plans.
Liquidity
Sufficient liquidity is necessary to handle fluctuations in deposit
levels, to provide for customers' credit needs, and to take advantage of
investment opportunities as they are presented. Sufficient liquidity is a
function of (1) having cash or cash equivalents on hand or on deposit at
the FRB adequate to meet unexpected immediate demands and (2) balancing
near-term and long-term cash inflows and outflows to meet such demands
over future periods.
FRB regulations require banks to maintain a certain amount of funds on
deposit ("deposit reserves") at the FRB for liquidity. Except in periods
of extended declines in interest rates when the investment policy calls
for additional purchases of investment securities, the Company also
maintains a balance of Federal funds sold which are available for
liquidity needs with one day's notice. During the first quarter of 1994,
with the large liquidity needs associated with the RAL program, the
Company purchased Federal funds from other banks or borrowed from the FRB.
There were no significant problems with this approach, and the Company
always had an abundance of Treasury notes in its liquidity portfolio that
could be sold to provide immediate liquidity if required by the situation.
The timing of inflows and outflows to provide for liquidity over longer
periods is done by making adjustments to the mix of assets and liabilities
so that maturities are matched. These adjustments are accomplished through
changes in terms and relative pricing of different products. The timing of
liquidity sources and demands is well matched when there is approximately
the same amount of short-term liquid assets as volatile, large
liabilities, and the maturities of the remaining long-term assets are
relatively spread out. Of those assets generally held by the Company, the
short-term liquid assets consist of Federal funds sold and debt securities
with a remaining maturity of less than one year. Because of its investment
policy of selling taxable securities before any loss becomes too great to
materially affect liquidity, and because there is an active market for
Treasury securities, the Company considers its Treasury securities with a
remaining maturity of under 2 years to be short-term liquid assets for
this purpose. The volatile, large liabilities are time deposits over
$100,000, public time deposits, Federal funds purchased, repurchase
agreements, and other borrowed funds. While balances held in demand and
passbook accounts are immediately available to depositors, they are
generally the result of stable business or customer relationships with
inflows and outflows usually in balance over relatively short periods of
time. Therefore, for the purposes of this analysis, they are not
considered volatile.
A way of computing liquidity using this concept of matching maturities,
and one used by bank regulators, is to divide the difference between the
short-term, liquid assets and the volatile, large liabilities by the sum
of the loans and long-term investments, or:
Short-term, Liquid Assets - Volatile, Large Liabilities
- - ------------------------------------------------------- = Liquidity Ratio
Net Loans and Long-term Investments
As of March 31, 1994, the difference between short-term, liquid assets and
volatile, large liabilities, the "liquidity amount," was a positive $67
million and the liquidity ratio was 8.93%, using the balances (in
thousands) in Table 16.
<TABLE>
Table 16--LIQUIDITY COMPUTATION COMPONENTS
<CAPTION>
Net Loans and Long-term
Short-term, Liquid Assets Volatile, Large Liabilities Investments
<S> <C> <S> <C> <S> <C>
Federal funds 15,000 Time deposits 100+ 77,744 Net loans 455,249
Fixed rate debt Repurchase agreements Long-term
with maturity and Federal funds securities 302,979
less than 1 year 113,300 purchased 31,058
Treasury securities with Other borrowed funds 1,000
1-2 year maturities 44,246
Bankers' acceptances 4,986
Total 177,532 Total 109,802 Total 758,228
</TABLE>
The Company's liquidity ratio indicates that all of the Company's
volatile, large liabilities are matched against short-term liquid assets,
with an excess of liquid assets. Since the first quarter of 1993, the end-
of-quarter ratio has been as high as 36.35% at September 30, 1993. The
current liquidity amount is just above the range that the Company is
trying to maintain--from positive $50 million to negative $25 million. Too
high a liquidity amount or ratio results in reduced earnings because the
short-term, liquid assets generally have lower interest rates. However,
immediately investing the excess in longer-term securities would subject
the Company to substantial interest rate risk and limit its ability to
respond when loan demand picks up as the economy recovers, so no specific
steps are being taken at present to reduce liquidity.
Securities from both the liquidity and earnings portfolios are included in
the balances for short-term liquid assets in Table 16. The inclusion of
securities from the earnings portfolio is not predicated on their possible
sale, but rather on the recognition that Management will be including the
proceeds that will be received at maturity in liquidity planning.
Capital Resources
Table 17 presents a comparison of several important amounts and ratios for
the first quarters of 1994 and 1993 (dollars in thousands).
<TABLE>
<CAPTION>
Table 17--CAPITAL RATIOS 1st Quarter 1st Quarter
1994 1993 Change
<S> <C> <C> <C>
Amounts:
Net Income 3,517 3,299 218
Average Total Assets 989,683 943,341 46,342
Average Equity 88,263 80,023 8,240
Ratios:
Equity Capital to
Total Assets (Period-end) 8.77% 8.62% 0.15%
Annualized Return on Average Assets 1.42% 1.40% 0.02%
Annualized Return on Average Equity 15.94% 16.49% (0.55%)
</TABLE>
Earnings are the largest source of capital for the Company. Management
expects that over the next few quarters operating earnings will continue
at about the same level as during the first quarter of 1994 on an
annualized basis. However, it is virtually certain that there will be some
variation quarter by quarter. Areas of uncertainty relate to asset
quality, loan demand, and the continued ability to respond to interest
rate changes.
A substantial increase in charge-offs would require the Company to record
a larger provision for loan loss to restore the allowance to an adequate
level, and this would negatively impact earnings. If loan demand
increases, the Company will be able to reinvest proceeds from maturing
investments at higher rates, which would positively impact earnings. Since
March 31, 1994, increasing interest rates have caused some losses from
sales of securities as explained in the section above titled "Securities
and Related Interest Income." If interest rates on investments continue to
rise over the next few quarters, additional losses will need to be taken
in order to keep the securities in the liquidity portfolio liquid and
earning at close to the market rate. Most financial institutions have not
raised their deposit rates significantly. If market rates continue to
increase, deposit rate increases will be necessary to hold market share.
The Federal Reserve Board sets minimum capital guidelines for U.S. banks
and bank holding companies based on the relative risk of the various types
of assets. The guidelines require banks to have capital equivalent to at
least 8% of risk adjusted assets. As of March 31, 1994, the Company's
risk-based capital ratio is 18.74%. The previous guidelines that required
primary capital to exceed 5.5% of total assets have been replaced with new
"Leverage Capital Requirements." According to these requirements, the
Company must maintain shareholders' equity of at least 4% to 5% of total
assets. As of March 31, 1994, shareholders' equity is 8.77% of total
assets, reflecting that the Company currently has ample capital to support
both the additional growth in deposits that is expected, and the higher
level of dividends declared by the Board of Directors.
On October 1, 1993, the Company mailed an Offer to Purchase Shares to all
shareholders. The Offer provided for the Company to purchase up to 250,000
shares that might be tendered by shareholders for a net price of $21 per
share. This number represented almost 4.8% of then outstanding shares. At
the option of the Company, an additional 2% of outstanding shares could
have been purchased. The offer expired November 19, 1993 with 155,000
shares tendered by shareholders.
The purposes of the Offer were: (1) to provide an opportunity to
shareholders who had had problems selling their stock to do so in a timely
and orderly manner at a fair price; (2) to increase the return on equity
and earnings per share for remaining shareholders; (3) to permit the
Bank's Employee Stock Ownership Plan to sell shares back to the Company to
provide funds for the diversification of investments required by Federal
law; and, (4) to reduce the number of shares outstanding in anticipation
of issuance of new shares pursuant to the exercise of employee stock
options.
No other significant commitments or reductions of capital are anticipated.
As explained in Note 4 to the financial statements, effective December 31,
1993 with the adoption of FASB 115 the Company is reporting a new
component of capital in the balance sheet representing the after-tax
effect of the unrealized gains or losses on securities that are available
for sale. With the increase in interest rates during the first quarter,
the net unrealized gain at December 31, 1993 has become a net unrealized
loss. The $101,000 net unrealized loss is an insignificant amount relative
to the Company's total capital of almost $88 million. With the policy to
set stop loss orders on the securities in its liquidity portfolio,
Management does not anticipate a situation in which this account will
represent a material reduction in capital.
Regulation
The Company is strongly impacted by regulation. The Company and its
subsidiaries may engage only in lines of business that have been approved
by their respective regulators, and cannot open or close offices without
their approval. Disclosure of the terms and conditions of loans made to
customers and deposits accepted from customers are both heavily regulated
as to content. By the provisions of the Community Reinvestment Act
("CRA"), the Bank is required to make significant efforts to ensure that
access to banking services is available to the whole community. The Bank's
CRA compliance was examined by the FDIC in the fourth quarter of 1992, and
the Bank was given the highest rating of "Outstanding." As a bank holding
company, the Company is primarily regulated by the FRB. The Bank is
primarily regulated by the FDIC and the California State Department of
Banking. As a non-bank subsidiary of the Company, ServiceCorp is regulated
by the FRB. Each of the regulatory agencies conducts periodic examinations
of the Company and/or its subsidiaries to ascertain their compliance with
regulations.
The FRB may take action against bank holding companies and the FDIC
against banks should they fail to maintain adequate capital. This action
has usually taken the form of restrictions on the payment of dividends to
shareholders, requirements to obtain more capital from investors, and
restrictions on operations. The Company has received no indication that
either banking agency is in any way contemplating any such action with
respect to the Company or the Bank, and given the strong capital position
of both the Bank and the Company, Management expects no such action.
The following text contains footnotes to Management's Discussion and
Analysis
of Financial Condition and Results of Operation
<F1> The Company primarily uses two published sources of information to
obtain performance ratios of its peers. The FDIC Quarterly Banking
Profile, Fourth Quarter, 1993, published by the FDIC Division of Research
and Statistics, provides information about all FDIC insured banks and
certain subsets based on size and geographical location. Geographically,
the Company is included in a subset that includes 12 Western states plus
the Pacific Islands. To obtain information more specific to California,
the Company uses The Western Bank Monitor, published by Montgomery
Securities. This publication provides performance statistics for "leading
independent banks" in 13 Western states, and further distinguishes a
Southern California subset, in which the Company is included. Both of
these publications are based on quarter-end information provided by banks.
It takes about 1-2 months to process the information, so the published
data is always one quarter behind the Company's information. For this
quarter, the peer information is for the year 1993. All peer information
in this discussion and analysis is reported in or has been derived from
information reported in one of these two publications.
<F2> As required by applicable regulations, tax-exempt non-security
obligations of municipal governments are reported as part of the loan
portfolio. These totaled approximately $9.3 million as of March 31, 1994.
The average yields presented above give consideration to the tax-exempt
status of the interest received on these obligations by the use of a
taxable equivalent yield assuming a combined Federal and State tax rate of
approximately 41%. (While not tax exempt for the State of California, the
State taxes paid on this Federal-exempt income is deductible for Federal
tax purposes.) Without consideration for this status, interest earned on
loans for the first quarter of 1994 would be $14.1 million as shown in the
accompanying financial statements and the average yield would be 11.66%.
There would also be corresponding reductions for the other quarters shown
in the table above. The computation of the taxable equivalent yield is
explained in the section below titled "Investment Securities and Related
Interest Income."
<F3> Reported in Western Bank Monitor, Fourth Quarter, 1993.
<F4> Reported in or derived from information reported in The FDIC
Quarterly Banking Profile and the Western Bank Monitor, Fourth Quarter
1993.
Graphic Appendix:
A column chart appears after the first paragraph of the section of
Management's Discussion and Analysis of Financial Condition and Results of
Operations entitled "Total Assets and Earning Assets" and is described at
that location.
PART II
OTHER INFORMATION
Item 1. Legal Proceedings
Not applicable.
Item 2. Changes in Securities
Not applicable.
Item 3. Defaults Upon Senior Securities
Not applicable.
Item 4. Submission of Matters to a Vote of Security Holders
(a) The Company's annual meeting of shareholders was held on April
26, 1994. Proxies were solicited by the Company's Management pursuant to
Regulation 14 under the Securities Exchange Act of 1934.
(b) There was no solicitation in opposition to Management's nominees
for directorships as listed in the proxy statement, and all of such
nominees were elected pursuant to the vote of shareholders. The directors
elected to one year terms were:
Donald M. Anderson Anthony Guntermann
Frank H. Barranco Dale Hanst
Edward E. Birch Harry B. Powell
B. Paul Blasingame David W. Spainhour
Richard M. Davis
There are no other directors whose term of office as a director continued
after the shareholders' meeting.
Arthur Andersen & Co. were selected as the Company's independent public
accountants for 1994.
Item 5. Other Information:
Not applicable.
Item 6. Exhibits and Reports on Form 8-K
No reports were filed on Form 8-K
Exhibit Index:
Sequential
Exhibit Number Item Description Page Number
10 Material Contracts:
10.1 Compensation Plans
and Agreements:
10.1.10 First Amendment to 34
Incentive and Investment
Salary Savings Plan
11 Computation of Per 36
Share Earnings
<PAGE>
EXHIBIT 10.1.10
FIRST AMENDMENT
TO
SANTA BARBARA BANK & TRUST
INCENTIVE & INVESTMENT AND SALARY SAVINGS PLAN
THIS FIRST AMENDMENT (the "First Amendment") is made and
entered into, effective on the dates set forth below, by and
between SANTA BARBARA BANK & TRUST, a California corporation
("Employer"), and SANTA BARBARA BANK & TRUST, a California
corporation ("Trustee"), with reference to the following facts:
RECITALS:
A. The Employer sponsors the Santa Barbara Bank & Trust
Incentive & Investment and Salary Savings Plan (the "Plan"),
pursuant to that certain Plan document executed December 31, 1991
(the "Plan Document").
B. The Trustee serves as the Trustee of the trust estab-
lished under the Plan.
C. The Employer and the Trustee desire to execute this
First Amendment in order to modify the amount of the Employer's
matching contribution under the Plan.
AGREEMENT:
NOW, THEREFORE, the parties hereto, intending to be legally
bound, do hereby agree as follows:
1. AMENDMENT TO SECTION 4.1(b)
Section 4.1(b) of the Plan Document is hereby amended in its
entirety to read as follows:
"(b) On behalf of each Participant who is eligible to
share in matching contributions for the Plan Year, a
matching contribution equal to the sum of (i) one-hundred
percent (100%) of that portion of the Participant's
Deferred Compensation up to three percent (3.0%) of the
Participant's Compensation, plus (ii) fifty percent (50%)
of that portion of the Participant's Deferred Compensa-
tion in excess of three percent (3.0%) of Compensation
and up to six percent (6.0%) of Compensation; provided,
in no event shall the amount of the matching contribution
under this Section 4.1(b) on behalf of any Participant in
any Plan Year exceed four and one-half percent (4.5%) of
the Participant's Compensation for the Plan Year. The
aggregate matching contribution under this Section 4.1(b)
shall be deemed to be an Employer Non-Elective Contribu-
tion.
2. MISCELLANEOUS
2.1 Ratification. Except as expressly modified by this
First Amendment, the Plan Document is hereby ratified and confirmed
and remains in full force and effect.
2.2 Effective Date. The Effective Date of this First
Amendment shall be January 1, 1994.
IN WITNESS WHEREOF, the parties hereto have executed this
First Amendment, effective on the date set forth above.
"EMPLOYER:" "TRUSTEE:"
SANTA BARBARA BANK & TRUST, a SANTA BARBARA BANK & TRUST, a
California corporation California Corporation
By By
Name: Jay D. Smith Name: Janice Kroekel
Title: Senior Vice President Title: Assistant Vice President
April 27, 1994 April 27, 1994
Date Date
<PAGE>
<TABLE>
EXHIBIT 11
SANTA BARBARA BANCORP & SUBSIDIARIES
COMPUTATION OF PER SHARE EARNINGS
<CAPTION>
For the Three-Month Periods Ended
March 31,
1994 1993
Primary Fully Diluted Primary Fully
Diluted
<S> <C> <C> <C> <C>
Weighted Average Shares Outstanding 5,065,462 5,065,462 5,190,198 5,190,198
Weighted Average Options Outstanding 537,456 537,456 472,530 472,530
Anti-dilution adjustment (1) 0 0 (165,652) (165,495)
Adjusted Options Outstanding 537,456 537,456 306,878 307,035
Equivalent Buyback Shares (2) (426,339) (381,895) (260,060) (257,669)
Total Equivalent Shares 111,117 155,561 46,818 49,366
Adjustment for Non-Qualified Tax Benefit (3) (45,558) (63,780) (19,195) (20,255)
Weighted Average Equivalent Shares Outstanding 65,559 91,781 27,623 29,111
Weighted Average Shares for Computation 5,131,021 5,157,243 5,217,821 5,219,309
Fair Market Value (4) 22.39 25.00 19.06 19.25
Net Income 3,517,155 3,517,155 3,299,277 3,299,277
Per Share Earnings 0.69 0.68 0.63 0.63
<FN>
(1)Options with exercise prices above fair market value are excluded
because of their anti-dilutive effect.
(2)The number of shares that could be purchased at fair market value from
the proceeds were the adjusted options outstanding to be exercised.
(3)The Company receives a tax benefit when non-qualified options are
exercised equal to its tax rate times the difference between the market
value at the time of exercise and the exercise price. The benefit is
assumed available for purchase of additional outstanding shares.
(4)Fair market value for the computation is defined as the average market
price during the period for primary dilution, and the greater of that
average or the end of period market price for full dilution.
</TABLE>
SIGNATURES
Pursuant to the Securities Exchange Act of 1934, the Company has duly
caused this report to be signed on its behalf by the undersigned thereunto
duly authorized:
SANTA BARBARA BANCORP
DATE: May 12, 1994 /s/ Kent M. Vining
Senior Vice President
Chief Financial Officer
DATE: May 12, 1994 /s/ Donald Lafler
Vice President
Principal Accounting Officer
