<PAGE> 1
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
(Mark One)
X QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 1994
OR
___ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ______________ to ____________
Commission File No.: 0-11113
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 October 28, 1994, there were 5,124,513 shares of the
issuer's common stock outstanding.
<PAGE> 2
PART 1
FINANCIAL INFORMATION
SANTA BARBARA BANCORP & SUBSIDIARIES
Consolidated Balance Sheets (Unaudited)
(dollars in thousands except per share amount)
<TABLE>
<CAPTION>
September 30, December
Assets: 1994 1993
<S> <C> <C>
Cash and due from banks $ 49,809 $ 50,946
Federal funds sold 10,000 0
Cash and cash equivalents 59,809 50,946
Securities (Note 4):
Held-to-maturity 299,740 194,474
Available-for-sale 112,894 189,044
Bankers' acceptances 55,959 63,614
Loans, net of allowance of $12,562 at
September 30, 1994 and $10,067 at
December 31, 1993 (Note 5) 467,618 454,163
Premises and equipment, net (Note 6) 7,337 6,657
Accrued interest receivable 6,983 7,228
Other assets (Note 7) 32,249 13,017
Total assets $ 1,042,589 $ 979,143
Liabilities:
Deposits:
Demand deposits $ 126,250 $ 114,557
NOW deposit accounts 127,303 127,296
Money Market deposit accounts 337,499 247,772
Savings deposits 124,014 148,719
Time deposits of $100,000 or more 69,016 83,380
Other time deposits 139,599 144,529
Total deposits 923,681 866,253
Securities sold under agreements
to repurchase and Federal
funds purchased 19,965 20,155
Other borrowed funds 1,000 1,172
Accrued interest payable
and other liabilities 6,150 5,572
Total liabilities 950,796 893,152
Shareholders' equity (Notes 3 & 8)
Common stock (no par value; $1.00 per
share stated value; 20,000,000
authorized; 5,116,357 outstanding
at September 30, 1994 and 5,064,517
at December 31, 1993) 5,116 5,065
Surplus 39,483 38,557
Unrealized gain (loss) on securities
available for sale (1,219) 683
Retained earnings 48,413 41,686
Total shareholders' equity 91,793 85,991
Total liabilities and
shareholders' equity $ 1,042,589 $ 979,143
<FN>
See accompanying notes to consolidated condensed financial statements.
</TABLE>
<PAGE> 3
SANTA BARBARA BANCORP & SUBSIDIARIES
Consolidated Statements of Income (Unaudited)
(dollars in thousands except per share amounts
<TABLE>
<CAPTION>
For the For the
Nine-Month Three-Month
Periods Ended Periods Ended
September 30, September 30,
1994 1993 1994 1993
<S>
Interest income: <C> <C> <C> <C>
Interest and fees on loans $35,595 $32,818 $10,825 $10,421
Interest on taxable securities 14,284 12,809 4,852 4,249
Interest on tax-exempt securities 5,267 4,947 1,844 1,629
Interest on Federal funds sold 374 632 249 270
Interest on bankers' acceptances 626 251 339 134
Total interest income 56,146 51,457 18,109 16,703
Interest expense:
Interest on deposits:
NOW accounts 940 1,124 316 349
Money Market accounts 6,801 4,558 2,976 1,621
Savings deposits 2,366 2,939 737 936
Time deposits of
$100,000 or more 1,758 2,280 597 653
Other time deposits 5,136 5,441 1,762 1,767
Interest on securities sold
under agreements to repurchase
and Federal funds purchased 674 555 246 157
Interest on other borrowed funds 71 29 23 7
Total interest expense 17,746 16,926 6,657 5,490
Net interest income 38,400 34,531 11,452 11,213
Provision for loan losses 5,757 4,800 750 950
Net interest income after
provision for loan losses 32,643 29,731 10,702 10,263
Other income:
Service charges on deposits 2,222 2,112 752 709
Trust fees 4,839 4,883 1,548 1,682
Other service charges,
commissions and fees, net 3,064 2,781 1,023 1,043
Securities losses (Note 4) (1,027) (47) (414) 0
Other income 414 608 121 236
Total other income 9,512 10,337 3,030 3,670
Other expense:
Salaries and benefits 16,271 14,844 5,295 4,968
Net occupancy expense 2,578 2,173 935 792
Equipment expense 1,613 1,278 614 488
Net cost (gain) from operating
other real estate (597) 1,315 (17) 523
Other expense 9,106 8,133 2,867 2,672
Total other expense 28,971 27,743 9,694 9,443
Income before income taxes
and cumulative effect
of accounting change 13,184 12,325 4,038 4,490
Applicable income taxes 3,494 3,265 1,042 1,272
Net income before cumulative effect
of accounting change 9,690 9,060 2,996 3,218
Cumulative effect of
accounting change (Note 9) 0 619 0 0
Net income $ 9,690 $ 9,679 $ 2,996 $ 3,218
Earnings per share before
cumulative effect of
accounting change $ 1.90 $ 1.74 $ 0.59 $ 0.62
Cumulative effect of
accounting change (Note 9) 0.00 0.12 0.00 0.00
Earnings per share (Note 2) $ 1.90 $ 1.86 $ 0.59 $ 0.62
<FN>
See accompanying notes to consolidated condensed financial statements.
</TABLE>
<PAGE> 4
SANTA BARBARA BANCORP & SUBSIDIARIES
Consolidated Statements of Cash Flows (Unaudited)
(dollars in thousands)
<TABLE>
<CAPTION>
For the Nine Months
Ended September 30,
<S> <C> <C>
1994 1993
Cash flows from operating activities:
Net Income $ 9,690 $ 9,679
Adjustments to reconcile net income to
net cash provided by operations:
Depreciation and amortization 1,130 793
Provision for loan losses 5,757 4,800
Benefit for deferred income taxes (1,044) (1,062)
Net amortization of investment securities
discounts and premiums (4,211) (2,272)
Net change in deferred loan origination and
extension fees and costs 552 113
Decrease in accrued
interest receivable 245 825
Increase (decrease) in accrued
interest payable 150 (101)
Increase in income receivable (600) (972)
Decrease in income taxes payable (229) (303)
Decrease (increase) in prepaid expenses 383 (300)
Increase (decrease) in accrued expenses 484 (1,455)
Other operating activities 86 2,520
Net cash provided by operating activities 12,393 12,265
Cash flows from investing activities:
Proceeds from sale of
securities and bankers' acceptances 91,569 19,882
Proceeds from call or maturity of
securities and bankers' acceptances 199,972 88,529
Purchase of securities and bankers' acceptances (331,592) (95,564)
Net (increase) decrease in loans
made to customers (19,788) 5,591
Disposition of property from defaulted loans 3,024 4,375
Purchase or investment in premises
and equipment (1,822) (2,003)
Net cash provided by (used in)
investing activities (58,637) 20,810
Cash flows from financing activities:
Net increase (decrease) in deposits 57,428 (4,315)
Net decrease in borrowings with
maturities of 90 days or less (190) (4,237)
Proceeds from issuance of common stock 722 492
Payments to retire common stock 0 (9)
Dividends paid (2,853) (2,600)
Net cash provided by (used in) 55,107 (10,669)
financing activities
Net increase in cash and 8,863 22,406
cash equivalents
Cash and cash equivalents at beginning of period 50,946 44,059
Cash and cash equivalents at end of period $ 59,809 $ 66,465
Supplemental disclosure:
Cash paid during the nine months ended:
Interest $ 17,596 $ 17,027
Income taxes $ 4,882 $ 3,380
<FN>
See accompanying notes to consolidated condensed financial statements.
</TABLE>
<PAGE> 5
Santa Barbara Bancorp and Subsidiaries
Notes to Consolidated Financial Statements
September 30, 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. The decrease in the weighted average
number of shares from the 1993 to the 1994 periods is due to the
retirement of shares disclosed in Note 8. For the nine- and three-month
periods ended September 30, 1994 and 1993, the weighted average shares
outstanding were as follows:
Nine-Month Periods Three-Month Periods
Ended September 30, Ended September 30,
1994 1993 1994 1993
Weighted average
shares outstanding 5,089,466 5,199,608 5,108,987 5,208,945
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. However, the results of
operations for the nine months ended September 30, 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 criteria 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 the
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 115 also provides that those securities which the purchaser hopes
later to be able to sell for a higher price 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) Amor- Gross Un- Gross Un- Estimated
tized realized realized Market
Cost Gains Losses Value
<S> <C> <C> <C> <C>
September 30, 1994:
Held-to-maturity:
U.S. Treasury obligations $195,247 $ 0 $ (8,657) $186,590
U.S. Agency obligations 14,620 0 (750) 13,870
State and municipal
securities 89,873 11,019 0 100,892
Total Held-to-Maturity 299,740 11,019 (9,407) 301,352
Available-for-sale:
U.S. Treasury obligations 73,694 0 (443) 73,251
U.S. Agency obligations 41,026 0 (1,383) 39,643
Total Available for Sale 114,720 0 (1,826) 112,894
Total $414,460 $11,019 $(11,233) $414,246
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
Total Held-to-Maturity 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
Total Available for Sale 187,880 1,182 (18) 189,044
Total $382,354 $22,420 $ (541) $404,233
</TABLE>
The Company does not expect to realize any significant amount of the
unrealized gains shown above for two reasons. First, the state and
municipal securities in the above table have irreplaceable tax-free
characteristics, which outweigh the benefit of selling them in order to
realize the gains that would result from their sale. Second, the
Company's investment policy, in most instances, requires holding
securities that have unrealized gains because they are earning rates of
interest above what would be available from current investment
alternatives. The Company does not expect to realize any of the
unrealized losses related to the securities in the held-to-maturity
portfolio, because it is the Company's intent to hold them to maturity
at which time the par value will be received. Losses may be realized on
securities in the available-for-sale portfolio.
The book value and estimated market value of debt securities by
contractual maturity are shown above. Expected maturities may differ
from contractual maturities because certain issuers may have the right
to call or prepay obligations with or without call or prepayment
penalties.
<TABLE>
<CAPTION>
($ in thousands)
Held-to- Available-
Maturity for-Sale Total
<S> <C> <C> <C>
September 30, 1994:
Amortized cost:
In one year or less $ 11,714 $ 59,880 $ 71,594
After one year through five years 230,345 54,840 285,185
After five years through ten years 36,854 0 36,854
After ten years 20,827 0 20,827
$299,740 $114,720 $414,460
Estimated market value:
In one year or less $ 12,131 $ 59,851 $ 71,982
After one year through five years 223,168 53,043 276,211
After five years through ten years 45,378 0 45,378
After ten years 20,675 0 20,675
$301,352 $112,894 $414,246
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>
5. Loans
The balances in the various loan categories are as follows:
<TABLE>
<CAPTION>
(in thousands) September 30, December 31,
1994 1993
<S> <C> <C>
Real estate:
Residential $ 96,499 $ 54,395
Non-residential 136,691 123,534
Construction 27,418 41,030
Commercial loans 151,032 168,227
Home equity loans 32,345 36,219
Consumer loans 27,353 27,331
Municipal tax-exempt obligations 7,862 11,888
Other loans 980 1,606
Total loans $480,180 $464,230
</TABLE>
The loan balances at September 30, 1994 and December 31, 1993, are net
of approximately $1,853,000 and $1,301,000 respectively, in loan fees
and origination costs deferred under the provisions of Statement of
Financial Accounting Standards No. 91.
Statements of changes in allowance for loan losses (in thousands):
<TABLE>
<CAPTION>
(in thousands of $)
Periods Ended September 30, 1994
Nine-Month Three-Month
<S> <C> <C>
Balance, beginning of period 10,067 11,298
Provision for loan losses 5,757 750
Loan losses charged to allowance (4,026) (42)
Loan recoveries credited to allowance 764 556
Balance, September 30, 1994 12,562 12,562
</TABLE>
Included in loan losses charged to the allowance and loan recoveries
credited to allowance are $3,030,000 and $369,000, respectively, that
relate to the Company's tax refund anticipation loan program. The
losses occurred only in the second quarter of the year.
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 $431 and
$302 for the three-month periods ended September 30, 1994 and 1993,
respectively, and $1,130 and $793 for the nine-month periods ended
September 30, 1994 and 1993, respectively. The table below shows the
balances by major category of fixed assets:
<TABLE>
<CAPTION>
(in thousands) September 30, 1994
Accumulated Net Book
Cost Depreciation Value
<S> <C> <C> <C>
Land and buildings $ 5,787 $ 2,742 $ 3,045
Leasehold improvements 4,943 3,382 1,561
Furniture and equipment 10,893 8,162 2,731
Total $ 21,623 $ 14,286 $ 7,337
<CAPTION>
December 31, 1993
Accumulated Net Book
Cost Depreciation Value
<S> <C> <C> <C>
Land and buildings $ 5,613 $ 2,717 $ 2,896
Leasehold improvements 4,383 3,203 1,180
Furniture and equipment 10,004 7,423 2,581
Total $ 20,000 $ 13,343 $ 6,657
</TABLE>
7. Other Assets
The Company sold several securities on September 30, 1994. The
settlement date was October 3, 1994, and therefore the proceeds were not
received until that date. Included among other assets at September 30,
1994 is a receivable from the broker for $18.9 million.
Property from defaulted loans is included within other assets on the
balance sheets. As of September 30, 1994, and December 31, 1993, the
Company had $1.4 million and $3.5 million, respectively, in property
from defaulted loans. 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 an Offer to Purchase for cash up to
250,000 shares of its common stock at $21.00 per share to its
shareholders. The offer expired November 19, 1993. Approximately
155,000 shares were tendered by shareholders and purchased by the
Company at a cost of $3.3 million.
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 nine month
periods ended September 30, 1993.
The implementation of SFAS 115 is discussed in Note 4 above.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Summary
Net income for the third quarter of 1994 is lower than net income for
the same quarter of last year, primarily due to losses realized on the
sale of securities as explained in the section below titled "Losses on
Securities Sales." The Company has grown 6.9% in average total assets
and 6.6% in average total deposits compared to the third quarter of
1993.
Interest rates continued to rise in the third quarter of 1994, extending
the reversal of the trend of declining interest rates that had prevailed
over the last several years. For the Company, this means that the
proceeds from maturing investments were reinvested at higher rates as
were term deposits renewed by customers at higher rates. Since February
the Federal Reserve Board ("the FRB") has raised short term interest
rates several times. With the exception of its impact on the market
value of the Company's securities, the effect of the increased interest
rates has not yet been significant. The Company did not raise its base
lending rate until after the second increase that occurred in late
March. The Company began to raise some of its deposit rates during the
second quarter of 1994. There is some indication that rates will be
raised again, possibly after the election in November. Further
increases are likely to have more impact as pressure grows to increase
deposit rates further.
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. The ratio is useful in allowing 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's
assets. 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 Company must be prepared to address the risks of adverse
effects or risks from changes in interest rates.
The primary risk is "market risk;" that is, the market value of loans,
investments, and deposits that have rates of interest fixed for some
term 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; that is, the market value of the older security is higher
than that of a newly issued comparable security. Fixed rate
certificates of deposit and other liabilities represent a less costly
obligation relative to the current market when interest rates rise and a
more costly obligation when interest rates decline. However, most
interest-bearing liabilities have a shorter maturity than interest-
earning assets and so there is less fluctuation in market value from
changes in interest rates. Therefore, the exposure to loss from market
risk is primarily from rising interest rates.
This exposure to "market risk" is managed by limiting 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. It has generally maintained the
taxable portion of its securities portfolios heavily weighted towards
securities with maturities of less than three years. However, these
methods of avoiding market risk must be balanced against the
consideration that shorter term securities generally earn less interest
income than longer term instruments. Therefore, the Company makes some
fixed rate loans and purchases some longer-term securities, because if
it 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 "mismatch risk." This is the risk that
interest rate changes may not be equally reflected in the rates of
interest earned and paid 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 holds mostly 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%, causing them to
have to pay more on deposits than they earned on their assets.
The Company controls mismatch risk by attempting to roughly match the
maturities and repricing opportunities of assets and liabilities. If
this matching is properly carried out, when 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 either of the first
two periods.
Many of the categories of assets and liabilities on the balance sheet do
not have specific maturities. For the purposes of this table, 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.
<TABLE>
Table 1 -- INTEREST RATE SENSITIVITY
<CAPTION>
After three After six After one Non-interest
As of September 30, 1994 Within months months year but bearing or
(in thousands of $) 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 301,854 62,131 30,898 64,947 21,238 (888)
480,180
Cash and due from banks 0 0 0 0 0 49,809
49,809
Federal funds 10,000 0 0 0 0 0
10,000
Securities:
Held-to-maturity 2,005 529 9,180 230,345 57,681 0
299,740
Available for sale 29,886 15,005 14,960 53,043 0 0
112,894
Bankers' acceptances 0 55,959 0 0 0
55,959
Other assets 0 0 0 0 0 34,007
34,007
Total assets 343,745 133,624 55,038 348,335 78,919 82,928
1,042,589
Liabilities and
shareholders' equity:
Borrowed funds:
Repurchase agreements and
Federal funds purchased 19,965 0 0 0 0 0
19,965
Other borrowings 1,000 0 0 0 0 0
1,000
Interest-bearing deposits:
Savings and interest-bearing
transaction accounts 349,949 0 238,867 0 0 0
588,816
Time deposits 77,836 31,109 35,799 63,380 491 0
208,615
Demand deposits 0 0 0 0 0 126,250
126,250
Other liabilities 0 0 0 0 0 6,150
6,150
Net shareholders' equity 0 0 0 0 0 91,793
91,793
Total liabilities and
shareholders' equity 448,750 31,109 274,666 63,380 491 224,193
1,042,589
Interest rate-
sensitivity gap (105,005)102,515 (219,628) 284,955 78,428 (141,265)
Gap as a percentage of
total assets -10.07% 9.83% -21.07% 27.33% 7.52% -13.55%
Cumulative interest
rate-sensitivity gap (105,005) (2,490) (222,118) 62,837 141,265
Cumulative amount as a
percentage of total assets -10.07% -0.24% -21.30% 6.03% 13.55%
<FN>
Note: Net deferred loan fees, overdrafts, and the reserve for loan loss are
included in the above table as non-interest bearing or non-repricing items.
</TABLE>
The first period shown in the gap report covers assets and liabilities
that mature or reprice within the next three months. This is the most
critical period because there is little time to correct a mismatch that
is having an adverse impact on income. Currently, the Company has a
significant negative gap for the first period--liabilities maturing or
repricing within the next three months exceed assets maturing or
repricing in that period by a margin slightly above the 10% upper limit
of its target range. If interest rates rose suddenly, the Company would
have to wait for more than three months before an equal amount of assets
could be repriced to offset the higher interest expense on the
liabilities. Management has elected temporarily to take the risk from
this mismatch in order to provide funding for the tax refund
anticipation loan ("RAL") program. A significant amount of funds is
needed in late January and early February. Rather than borrow all of
these funds or sell higher yielding securities prior to their maturity,
the Company has purchased $56 million bankers' acceptances and $15
million U.S. Treasury securities with maturities in those months.
Without the RAL program, maturities would be more evenly spread out. It
is therefore likely that more securities would maturing within three
months and the gap in the first period likely would be lower.
A second main reason for the negative position in the first time period
is the rapid growth of the money market deposits that are tied to U.S.
Treasury bills mentioned in the section below. As of November 15, these
accounts will no longer be tied to the rates paid on U.S. Treasury
bills. The Company will instead administer the rate offered in the same
manner it administers the rates on most other accounts. Should interest
rates rise rapidly, it will then not be bound to raise the rates on
these accounts. With an administered rate, the balances in these
accounts will no longer automatically be placed in the "Within Three
Month" time period. Instead, the Company will place them in the
maturity range in which it is likely that their rate would be changed.
The impact of negative gap in the first period is mitigated by the
positive gap in the second period, "After three months but within six."
If there were a negative gap in the second period as well as the first,
then it would be even longer before sufficient assets could be repriced.
The larger negative gap for the third period, "After six months but
within one year" is caused by the large amounts of transaction deposit
accounts that the Company at present assumes will not be repriced sooner
than six months. If interest rates continue to rise, the rates paid on
these accounts may have to be repriced sooner than that, and there would
be a negative impact on earnings 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 many
of the other assets that have scheduled maturities in this period are
highly liquid U.S. 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.
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 for the last several
years are 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. Again 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, less
costly, short-term funding sources which smaller banks cannot
efficiently utilize.
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%
May, 1994 7.25% 8.25%
August, 1994 7.75% 8.75%
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 third quarter of 1994. One column is for the
balance of average total assets and the other is 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 94.3% of its
assets during the first three quarters of 1994. This compares with an
average of 85.2% for all FDIC-Insured Commercial Banks and 87.6% for the
Company's Southern California peers for the second quarter of 1994.[1]
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 (which are non-earning assets) are not built up; (2)
the Company avoids tying up funds that could be earning interest by
leasing most of its facilities under long-term contracts 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 allow it to put the cash to use more quickly. At
the Company's current size, these steps have resulted in about $92.1
million more assets earning interest than would be the case if the
Company's ratio were similar to its peers. If these extra assets were
earning at the average rate earned on U.S. Treasury and Agency
securities held by the Company during the first three quarters of 1994,
they would add about $4.3 million in additional pre-tax income for this
period.
Deposits and Related Interest Expense
Table 3 presents the average balances for the major deposit categories
and the yields of interest-bearing deposit accounts for the last seven
quarters (dollars in millions). As shown both in the preceding chart
and in Table 3, average deposits have continued to grow. Average total
deposits for the third quarter of 1994 increased 6.0% from average
deposits a year ago.
<TABLE>
<CAPTION>
Table 3 -- AVERAGE DEPOSITS AND RATES
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
</TABLE>
<TABLE>
<CAPTION>
Year 1994
<S> <C> <C> <C> <C> <C> <C>
NOW/MMDA 371.2 2.09% 407.0 2.50% 446.5 2.93%
Savings 149.4 2.25 142.9 2.25 130.4 2.24
Time deposits 100+ 72.3 3.35 63.2 3.57 61.0 3.88
Other time 155.1 4.35 153.7 4.47 151.0 4.63
Total interest-
bearing deposits 748.0 2.72% 766.8 2.95% 788.9 3.21%
Non-interest-bearing 117.5 118.6 119.1
Total deposits 865.5 885.4 908.0
</TABLE>
While occasionally there are slight decreases in average total 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 competitive deposit rates. The
increases in average total deposits 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 third quarter of 1993, the growth in
deposits during the last four quarters came in the transaction accounts,
both interest-bearing and non-interest bearing. The Company offers a
money market account, "Personal Money Master," the rate for which has
been tied to the 3-month U.S. Treasury bill. With the recent increases
in short-term rates and a bonus rate offered during the second quarter
for customers bringing in new deposits from other financial
institutions, this product has become very popular. The monthly average
balance of these accounts has increased $100.8 million or 144% from
September 1993 to September 1994. Most of the reduction in the average
balance for savings from the second to the third quarter relates to
migration from savings to the Personal Money Master account.
As shown in Table 3, there has been some growth in non-interest bearing
demand accounts as well during the last year. There has been an
increase of approximately $19.5 million of the increase in average
balance of non-interest bearing deposits compared to the same quarter a
year ago, an increase of 19.6%.
The Company 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 unless the depository institution is prepared to
continue to offer very high interest rates to keep the deposits.
Therefore, the Company has taken specific steps to discourage even
unsolicited out-of-territory deposits in the $100,000 range and above.
Interest Rates Paid
The average rates that are paid on deposits generally trail behind
market rates. This is especially the case with time deposits because
the average rates are a blend of the rates paid on individual accounts
which do not change until maturity. The effect of increases in rates
offered on new or renewing time accounts is now apparent in the yields
shown in Table 3 for the third quarter of 1994 compared with those paid
in earlier quarters.
The Company has not yet raised rates paid on its NOW and standard MMDA
accounts, but, as noted above, the rates on the Personal Money Master
have increased with the rates on the 3-month Treasury bill. The rate
paid increased from 3.06% at the beginning of the year to 4.91% by
September 30, 1994. With an average balance of $170.8 million for the
third quarter, this increase has substantially impacted the average rate
on the combined total of interest-bearing transaction accounts
(NOW/MMDA).
Generally, the Company offers higher rates on certificates of deposit in
amounts over $100,000 than for lesser amounts and one would 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 seven
quarters. There are two 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, because the spread between the
cost of these funds and the earnings on their uses are small. Second,
most of the IRA accounts are 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 accounts 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[2] over the
last eight quarters (dollars in millions).
<TABLE>
Table 4 LOAN BALANCES AND YIELDS
(in millions of $)
<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
June 1994 464.9 465.6 10.76 9.24
September 1994 480.2 474.1 10.90 9.15
</TABLE>
Change in Average Loan Balances
For the first time in several years, the third quarter of 1994 brought a
substantive (not related to the RAL program) increase in average loan
balances. Most of this was due to a major promotion for residential real
estate loans that began in the second quarter of 1994. As shown in note
5 to the accompanying financial statements, residential real estate
loans increased from $54.4 million to $96.5 million from the end of 1993
to September 30, 1994. 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. Therefore
the increase is primarily in adjustable rate notes. Most of these notes
have initial lower "teaser" rates, which is why the average yield has
not shown any increase. As these loans age beyond their initial periods,
yields should increase.
Loans under the RAL program 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. The Company earns a fixed fee
per loan for advancing the funds. Because of the April 15 tax filing
date, 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
I.R.S.
The Company significantly expanded the program for the 1994 tax season.
As of the end of the tax season for 1994, the Company had lent just over
$230 million to 150,000 taxpayers. The average loan was for $1,536 and
was outstanding about 12 days. The balance of outstanding loans
averaged $29.5 million for the first quarter of 1994 and there were
$13.9 million in loans outstanding at March 31, 1994. Eliminating these
loans from the above table would show average loans for the first
quarter of 1994 of $459.1 million, just slightly higher than for the
fourth quarter of 1993. Only $5.4 million of the average balance for
the second quarter in the table above relates to RAL's, and there were
no such loans included in the period-end balance because, as described
below, the remaining loans were delinquent and had been charged-off.
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 subsequent quarters 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 and will not 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 (COFI) 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.
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 may be prepaid if the current market rate for any
specific type of loan declines sufficiently below the contractual rate
on the loan to warrant refinancing. Therefore, it would be expected
that average yields on the portfolio would follow increases or decreases
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.
(in millions) September 30, December
31,
1994 1993
Credit lines with unused balances $120.6 $116.3
Undisbursed loans $10.5 $10.9
Other loan or letter of credit commitments $34.3 $23.7
The increase of $10.6 million in other loan commitments is related to
real estate transactions. 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,
because in many instances, the customers' use is based on the occurrence
of uncertain events.
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 fully 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, including 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 generally less over the last
three years than in the previous several years due to a slower economy.
There have been more charge-offs for the same reason, and Management has
not used the declining loan volume as a reason for decreasing the
allowance for loan losses.
Table 5 shows the amounts of non-current loans and non-performing assets
for the Company at the end of the third quarter of 1994, at the end of
the prior two quarters and at the end of the same quarter a year ago.
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. While not yet available
for the quarter ended September 30, 1994, peer data is shown for the
ratios for the other quarters.
<TABLE>
Table 5 ASSET QUALITY
($ in thousands)
<CAPTION>
September 30, June 30 March 31, September 30,
1994 1994 1994 1993
Company Company Company Company
<S> <C> <C> <C> <C>
Loans delinquent
90 days or more 1,379 1,064 348 685
Non-accrual loans 3,328 4,380 5,308 2,370
Total non-current loans 4,707 5,444 5,656 3,055
Foreclosed real estate 1,397 1,602 1,423 14,542
Total non-performing assets 6,104 7,046 7,079 17,597
</TABLE>
<TABLE>
<CAPTION>
So. Cal So. Cal So. Cal
Peer Peer Peer
Company Company Group Company Group Company Group
<S> <C> <C> <C> <C> <C> <C>
Coverage ratio of allowance
for loan losses to non-
current loans and leases 207% 252% 97% 252% 83% 300% 72%
Ratio of non-current loans
to total loans and leases 1.17% 1.20% 3.87% 0.86% 4.89% 0.80% 5.13%
Ratio of non-performing
assets to average total assets 0.70% 0.71% 3.58% 0.75% 3.81% 1.82% 4.51%
</TABLE>
Non-performing assets always represent a concern to the Company.
However, as shown in the ratios above, compared with its Southern
California Peers[4], the Company's non-current loans represent a much
lower percentage of its total loans than they do for its peers, non-
performing assets are less than a fifth the amount of the average peer,
and the Company has set aside more than twice as much in its allowance
to cover problems than has the average peer bank.
Charge-offs have been higher in 1994 than historical levels because of
the RAL program. Because these RAL's are made to customers all over the
country who have no other relationship with the Company, the loss rate
is fairly high. In 1993, there were net charge-offs of about $588,000
(initial charge-offs at June 30, 1993 of $650,000 with subsequent
recoveries of $62,000). The higher loss rate was nonetheless more than
covered by the fees charged by the program in 1993 (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.
The Company followed the same process in 1994 as it did in 1993 by
charging-off all outstanding RAL's at June 30. The total was $3,030,000
with subsequent recoveries of $369,000 by September 30. The Company
expects to receive additional recoveries after this date as it did in
1993. The initial charge-off ratio in 1993 was 1.44%, with a final
ratio after recoveries of 1.31%. The amount charged off at June 30,
1994 represents 1.32% of the total loans that had been made. Recoveries
through September 30, 1994 give a ratio of 1.15%. Any further recoveries
will reduce this ratio. The better position for 1994 reflects
improvements in screening preparers and borrowers for 1994. These
losses plus the operating expense are more than covered by the fees
earned in 1994 of $4.8 million.
Management continues to closely monitor the condition of the remainder
of the loan portfolio.
The amount of non-current loans shown for the Company as of September
30, 1994, does not equate directly with future charge-offs. Most of
these loans are well secured by collateral. Nonetheless, Management
still considers it prudent to increase the allowance for loan losses
through generous quarterly provisions (bad debt expense). The Company
provided $4.3 million in the first quarter of 1994, including $2.9
million for the RAL's, compared to a total of $2.8 million for the
comparable period of 1993. Another $725,000 was added in the second
quarter of 1994, including $132,000 for the RAL's, and $750,000 was
added in the third quarter. This results in an allowance that is 2.62%
of loans outstanding. The average for all FDIC insured banks of
comparable size is 1.79%[5], and the average for the Company's Southern
California peers is 3.12%. 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 the lower ratio is justified
because the Company's coverage ratio of allowance to non-current loans
is two and a half times that of its peers. This is the case because the
Company has a much lower proportion of non-current loans than its peers
(1.17% vs. 4.89%). Management expects that the Company's credit
quality ratios should continue to be substantially more favorable than
those of the average peer bank.
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 were 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 for later sale,
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.
However, 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 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, the Company will 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
seven 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 the amount that 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 7.80%
1994
U.S. Treasury 305.4 5.28% 355.6 5.30% 309.4 5.38%
U.S. Agency 20.8 4.61 45.9 4.55 55.8 4.71
Tax-Exempt 78.0 13.49 79.9 13.44 86.8 13.14
Total 404.2 6.83% 481.4 6.58% 452.0 6.79%
</TABLE>
The Company's investment practice has been to shorten the average
maturity of its investments while interest rates are rising, and to
lengthen the average maturity as rates are declining. This practice 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 more closely follow market
rates since the Company is buying new securities more frequently to
replace maturing securities. When rates are declining, longer
maturities are preferable because their purchase tends to "lock-in"
higher rates. When there is no sustained movement up or down, the funds
from maturing securities are usually sold as Federal funds until a clear
direction is established. Generally, "longer maturities" has meant
purchases of securities with maturities of three or five years. The
two-year securities are generally purchased in $10 million increments,
while the three and five-year securities are purchased in $5 million and
$2 million increments, respectively.
Because securities generally have a fixed rate of interest to maturity,
the average interest rate earned in the portfolio lags market rates in
the same way as rates paid on term deposits. The impact of the recent
increases in market rates is just beginning to be seen in the average
rates of taxable securities. The sustained general downward trend in
interest rates during the preceding several years resulted in the
Company having to reinvest maturing funds and new funds at progressively
lower rates. Even with the large amount of maturities in recent
quarters ($50 million in U. S. Treasury securities matured in the fourth
quarter of 1993, $70 million matured in the first quarter of 1994, $25
million matured in the second quarter of 1994, and $40 million in the
third quarter of 1994), the proceeds generally had to be reinvested at
rates lower than applied to the maturing security. The effect of this
on the average yield of taxable securities is obvious in Table 6 by
comparing the average rates earned on the taxable securities in the
first and second quarters of 1994 with the rates for the same quarters
in 1993--the rates earned in the 1994 quarters are significantly lower
than the rates earned in the same quarters of 1993. Only in the third
quarter of 1994 are the rates on newly purchased securities higher than
the rates on the securities they are replacing. The impact of this is
seen in the increase in the average rate earned on securities in the
third quarter compared with the second quarter of 1994.
Investments in most tax-exempt securities became less advantageous after
1986 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 require 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 enough to trigger the Alternative Minimum Tax; otherwise 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 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
tend to sell other securities that are not below the current market. In
periods of rising interest rates, this can cause an institution to
accumulate 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
or to call date if their market value has declined to a certain trigger
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. Limiting how
much decline in market value is allowed to occur before securities are
sold maintains the liquidity of the securities in the liquidity
portfolio. It also recognizes 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. In addition, selling depreciated
securities generates an immediate tax loss while holding the depreciated
security delays the realization of the benefit of the loss for taxes.
Management occasionally makes exceptions to this policy, but the policy
expresses Management's preferred course of action. Generally,
exceptions are made when there are indications that the decline in price
may be temporary. One such indication might be very light trading
activity.
Market rates of U.S. Treasury securities have increased significantly
since the FRB began raising short-term rates in February. As market
rates rose, Management followed the policy of selling securities to
follow the market up. As rates rose further, the Company reinvested at
higher rates, improving future income. With rates continuing to rise,
however, the value of a number of these recent purchases again fell
below the trigger point and were sold. This accounts for the losses in
the second and third quarters of 1994. The Company's resolve to hold to
this policy is always tested in periods of rising market rates because
of the losses that can result from following this policy, but the three
reasons given above for it are important to remember: it protects the
liquidity of the portfolio, it allows the Company to reinvest the funds
at higher rates and carry those higher yields forward, and it allows for
the immediate realization of the tax benefit on the losses.
There is always some variation in the market rates for U.S. Treasury
securities. Under the investment policy described above, short-term
reversals in a downward general trend can trigger sales of securities
recently purchased, and such sales accounted for the losses in the
quarters ended December of 1992 and March of 1993. 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 seldom will be gains from sales
of securities. Table 7 shows the net amounts of losses from the sale of
securities for the last eight 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
June 1994 (613)
September 1994 (414)
To date in October 1994, no more losses have been realized.
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 eight 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 3.20
June 1994 8.7 3.95
September 1994 22.1 4.47
When interest rates are rising, the Company can benefit by keeping
larger amounts in Federal funds because the excess funds earn interest
which reprices daily. 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, even
though rates were rising.
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 eight 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 - -
September 1993 16.0 3.34
December 1993 60.8 3.32
March 1994 33.7 3.31
June 1994 1.4 3.35
September 1994 25.3 5.32
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 RAL program. When these matured, they were
not immediately replaced, which is why there were no outstanding amounts
in the second quarter of that year. 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 a single $5 million acceptance at March 31, 1994.
The Company began again to purchase acceptances in the third quarter to
fund the 1995 RAL program.
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 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 eight 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
June 1994 30.5 3.50 3.0
September 1994 26.3 4.05 2.5
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. Table 11
shows trust income over the last eight 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
June 1994 1,510
September 1994 1,548
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 and
$81,000 of the fees earned in the first and second quarters of 1994,
respectively, 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 the completion of
probate that the fee is established by the court. After adjustment for
these seasonal and non-recurring items and short-term fluctuations of
price levels in the stock and bond markets, there is a general flat
trend in trust income. Increased fees from new customers bringing
additional trust assets to the Company have been offset by stable or
lower prices in the securities markets. The Company has taken steps to
increase trust income over the next several years by initiating a plan
to sell mutual funds and annuities.
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, 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.
Categories of non-interest operating income other than trust fees are
shown in Table 12 for the last eight quarters (in thousands).
Table 12--OTHER INCOME
Service Other 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
June 1994 746 1,249 149
September 1994 752 1,023 121
The amounts for the first quarter of 1994 are lower than usual 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 was 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 customer use of their
cards. Approximately $134,000 of the $1,043,000 in Other Service
Charges, Commissions and 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 of the credit card portfolio. 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. An increase in
these fees accounts for much of the increase in fees for the second
quarter. Management anticipates that total Other Service Charges,
Commissions and Fees will average around $1,050,000 per quarter 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. These were 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
has done substantially fewer refinancings in the first and second
quarters of 1994. Gains attributable to the subsequent sale of these
notes totaled approximately $75,000, $38,000, and $11,000 for the first,
second, and third quarters of 1994, respectively, compared with
approximately $196,000 in the fourth quarter of 1993. With rates at
higher levels, it would be expected that refinancing activity will
remain less than in 1993.
Staff Expense
Although staff size varies some quarter-to-quarter, the Company has
closely monitored the growth in staff size. Over the last two years, the
increase in the average number of employees has been limited to about
5.4% (about 24 employees) while average assets of the Company increased
about 9.9% and the market value of trust assets under administration
increased substantially. Merit increases have averaged 5% or less over
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
and payroll taxes, and (3) workers' compensation insurance. The
significant 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 amount. This amount is made up of
income before tax and before the contribution, adjusted to add back the
provision for loan loss and to 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 previously had been. The Company had been accruing
for these contributions during the first three quarters of 1993 at the
1992 rate and therefore needed to adjust the accrual in the fourth
quarter. For the first two quarters of 1994, the Company accrued for
these contributions at a higher rate, with the belief 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. Moreover, 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 eight
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
June 1994 4,281 1,246
September 1994 4,090 1,205
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.
One method of measuring its success 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 nine months of 1994 is 59.2%,
but that number is impacted by the large amount of RAL fees and the
gains on the sale of OREO that occurred during the first quarter of
1994. These will not recur during the remainder of the year. The
Company is working to maintain the ratio below 60.0% for the year 1994.
The FDIC peer ratio for the first half of 1994 was 64.4%.
Table 14 shows other operating expenses over the last eight 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
June 1994 855 511 3,144
September 1994 935 614 2,867
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.
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 dollars of deposits. On the basis of its "well-capitalized"
position, the Company's rate is $0.23 per hundred. As deposits increase,
this expense increases proportionally.
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.
Other expense for the fourth quarter of 1993 was higher than usual due
to the same type 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 dollars).
<TABLE>
<CAPTION>
Table 15 OTHER EXPENSE
Nine-Month Periods Three-Month Periods
Ended September 30, Ended September 30,
1994 1993 1994 1993
<S> <C> <C> <C> <C>
FDIC and State assessments 1,560 1,443 520 505
Insurance 197 201 67 66
Professional services 497 574 135 152
RAL processing fees 348 0 25 0
Supplies and sundries 439 430 139 142
Postage and freight 452 454 134 135
Marketing 720 492 232 141
Bankcard processing 1,204 1,316 405 489
Other 3,689 3,223 1,210 1,042
Total 9,106 8,133 2,867 2,672
</TABLE>
Marketing expense is higher for the first nine months and for the third
quarter of 1994 compared to the comparable periods of 1993 primarily
because of a special promotion for residential real estate loans. As
part of its management of the interest rate risk inherent in holding
large amounts of fixed rate securities, the Company is attempting to
increase its portfolio of variable rate residential loans.
The net cost of other real estate owned ("OREO") is not included in the
preceding table 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 nine months of 1994 reflects approximately $888,000 in net
gains arising out of sales less approximately $291,000 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 demonstrate that the prices were not going to be reduced
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 September 30, 1994. This compares with $17.9
million as of a year earlier. With a much smaller balance of OREO being
held, Management anticipates that this OREO operating expense will
continue to trend lower. However, the Company has liens on properties
which are 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. These conditions may necessitate
additional foreclosures during the next several quarters, with a
corresponding increase in this expense.
Accounting Standard Changes
Impaired Loans
As explained in "Allowance for Loan Losses," generally accepted
accounting principles require 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 determination does not recognize the economic loss that
results 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,
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 an
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 for the years 1995 through 1996, but not
recognition in the financial statements. Recognition in the financial
statements would begin in 1997.
The FASB has 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 is
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 for options granted
to executive officers, 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, and the Company has not attempted to estimate
fair value. 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 a Federal Reserve Bank 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, or in
the first quarter when all available funds are used to fund the RAL's,
the Company also maintains a balance of Federal funds sold which are
available for liquidity needs with one day's notice. Because the
Company stays fairly fully invested, occasionally during the year, and
more frequently 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 are no
significant problems with this approach, and the Company always has an
abundance of Treasury notes in its liquidity portfolio that could be
sold to provide immediate liquidity if necessary.
The timing of inflows and outflows to provide for liquidity over longer
periods is achieved 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 method used by bank regulators to compute liquidity using this concept
of matching maturities 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, that is:
Short-term, Liquid Assets -
Volatile, Large Liabilities
----------------------------------------------- = Liquidity
Ratio
Net Loans and Long-term Investments
As of September 30, 1994, the difference between short-term, liquid
assets and volatile, large liabilities, the "liquidity amount," was a
positive $97 million and the liquidity ratio was 12.75%, using the
balances (in thousands of dollars) in Table 16.
<TABLE>
Table 16--LIQUIDITY COMPUTATION COMPONENTS
<CAPTION>
<S> <C> <C> <C> <C> <C>
Net Loans and Long-
Short-term, Liquid Assets: Volatile, Large Liabilities: term Investments:
Federal funds 10,000 Time deposits 100+ 69,016 Net loans 467,618
Fixed rate debt Repurchase agreements Long-term
with maturity and Federal funds securities 291,686
less than 1 year 71,565 purchased 19,965
Treasury securities with Other borrowed funds 1,000
1-2 year maturities 49,247
Bankers' acceptances 55,959
Total 186,771 Total 89,981 Total 759,304
</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 of $97 million is still above
the range that the Company is trying to maintain -- from positive $75
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, investing the excess in
longer-term securities would subject the Company to substantial market
risk and limit its ability to respond when loan demand increases as the
economy recovers. In addition, the Company has specifically purchased
securities with short-term maturities to provide funds for the RAL
program in early 1995. Therefore, 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. The amounts in Table 16 are also adjusted for $5 million in
taxable securities which had depreciated below the level at which they
would normally be sold, but which Management elected to hold until the
market showed more stability.
Capital Resources
Table 17 presents a comparison of several important amounts and ratios
for the third quarters of 1994 and 1993 (dollars in thousands).
<TABLE>
<CAPTION>
Three-Month Periods Ended
Table 17--CAPITAL RATIOS September 30,
(amounts in thousands of $) 1994 1993 Change
<S> <C> <C> <C>
Amounts:
Net Income 2,996 3,218 (222)
Average Total Assets 1,032,016 965,126 66,890
Average Equity 91,157 85,535 5,622
Ratios:
Equity Capital to
Total Assets (Period-end) 8.80% 8.96% -0.16%
Annualized Return
on Average Assets 1.16% 1.33% -0.17%
Annualized Return
on Average Equity 13.15% 15.05% -1.90%
</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 third 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. 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 FRB 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 September 30, 1994, the Company's risk-
based capital ratio is 18.86%. 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 September 30, 1994, shareholders' equity is 8.80%
of total assets, reflecting that the Company currently has ample capital
to support both the additional growth in deposits that is expected, and
the current level of dividends ($0.20 per share per quarter).
As explained in Note 4 to the financial statements, effective with the
adoption of FASB 115 on December 31, 1993 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 $1,219,000 net unrealized loss is not a
material amount relative to the Company's total capital of over $91
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.
The Company has received approval for the opening of a branch office in
Ventura, a community 25 miles from Santa Barbara. The Company is in the
process of preparing applications for two additional branch offices in
Oxnard and Camarillo, two other communities in Ventura County. It is
expected that retail office space will be leased and that there will not
be any significant commitment of capital. No other circumstances
requiring significant commitments or reductions of capital are
anticipated.
Regulation
The Company is closely regulated by Federal and State agencies. 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. The Company is
required by the provisions of the Community Reinvestment Act ("CRA") 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.
NOTES TO MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATION
[1] The Company primarily uses two published sources of information to
obtain performance ratios of its peers. The FDIC Quarterly Banking
Profile, Second Quarter, 1994, 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 within
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 second quarter of 1994. All peer information in
this discussion and analysis is reported in or has been derived from
information reported in one of these two publications.
[2] As required by applicable regulations, tax-exempt non-security
obligations of municipal governments are reported as part of the loan
portfolio. These totaled approximately $8.0 million as of September 30,
1994. The average yields presented in Table 4 give effect 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). If their tax-exempt status were
not taken into account, interest earned on loans for the third quarter
of 1994 would be $10.8 million as shown in the accompanying financial
statements and the average yield would be 9.13%. There would also be
corresponding reductions for the other quarters shown in the Table 4.
The computation of the taxable equivalent yield is explained in the
section below titled "Investment Securities and Related Interest
Income."
[3] Subsequent to this charge-off, the Company was able to realize
gains on the sales of the individual units of this property. These
gains are included as offsets to the net cost of operating other real
estate on the income statements of the Company for the year ended
December 31, 1993 and the nine months ended September 30, 1994.
[4] Reported in Western Bank Monitor, Second Quarter, 1994.
[5] Reported in or derived from information reported in The FDIC
Quarterly Banking Profile and the Western Bank Monitor, Second Quarter
1994.
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
Not applicable.
Item 5. Other Information:
Not applicable.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibit Index:
Sequential
Exhibit Number Item Description Page Number
11 Computation of Per 50
Share Earnings
27 Financial Data Schedule 51
(b) No reports were filed on Form 8-K
<PAGE> 50
<TABLE>
<CAPTION>
EXHIBIT 11
SANTA BARBARA BANCORP & SUBSIDIARIES
COMPUTATION OF PER SHARE EARNINGS
For the Nine-Month Periods Ended September 30,
1994 1993
Primary Fully Diluted Primary Fully Diluted
<S> <C> <C> <C> <C>
Weighted Average Shares Outstanding 5,089,466 5,089,466 5,199,608 5,199,608
Weighted Average Options Outstanding 509,805 509,805 527,083 527,083
Anti-dilution adjustment (1) (15,885) 0 (6,090) 0
Adjusted Options Outstanding 493,920 509,805 520,993 527,083
Equivalent Buyback Shares (2) (348,689) (323,763) (454,354) (431,277)
Total Equivalent Shares 145,231 186,042 66,639 95,806
Adjustment for Non-Qualified Tax Benefit (3) (59,545) (76,277) (27,322) (39,280)
Weighted Average Equivalent Shares Outstanding 85,686 109,765 39,317 56,526
Weighted Average Shares for Computation 5,175,152 5,199,231 5,238,925 5,256,134
Fair Market Value (4) 25.09 28.50 20.11 21.50
Net Income 9,689,975 9,689,975 9,678,585 9,678,585
Per Share Earnings 1.87 1.86 1.85 1.84
<CAPTION>
For the Three-Month Periods Ended September 30,
1994 1993
Primary Fully Diluted Primary Fully Diluted
<S> <C> <C> <C> <C>
Weighted Average Shares Outstanding 5,108,987 5,108,987 5,208,945 5,208,945
Weighted Average Options Outstanding 488,881 488,881 550,653 550,653
Anti-dilution adjustment (1) 0 0 (9,470) 0
Adjusted Options Outstanding 488,881 488,881 541,183 550,653
Equivalent Buyback Shares (2) (326,652) (312,062) (459,340) (453,242)
Total Equivalent Shares 162,229 176,819 81,843 97,411
Adjustment for Non-Qualified Tax Benefit (3) (66,514) (72,496) (33,556) (39,939)
Weighted Average Equivalent Shares Outstanding 95,715 104,323 48,287 57,472
Weighted Average Shares for Computation 5,204,702 5,213,310 5,257,232 5,266,417
Fair Market Value (4) 27.21 28.50 20.78 21.50
Net Income 2,996,051 2,996,051 3,218,285 3,218,285
Per Share Earnings 0.58 0.57 0.61 0.61
<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: November 3, 1994 /s/ Kent M. Vining
Kent M. Vining
Senior Vice President
Chief Financial Officer
DATE: November 3, 1994 /s/ Donald Lafler
Donald Lafler
Vice President
Principal Accounting Officer
<TABLE> <S> <C>
<ARTICLE> 9
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1994
<PERIOD-END> SEP-30-1994
<CASH> 49,809
<INT-BEARING-DEPOSITS> 0
<FED-FUNDS-SOLD> 10,000
<TRADING-ASSETS> 0
<INVESTMENTS-HELD-FOR-SALE> 112,894
<INVESTMENTS-CARRYING> 299,740
<INVESTMENTS-MARKET> 0
<LOANS> 480,180
<ALLOWANCE> 12,562
<TOTAL-ASSETS> 1,042,589
<DEPOSITS> 923,681
<SHORT-TERM> 20,965
<LIABILITIES-OTHER> 6,150
<LONG-TERM> 0
<COMMON> 5,116
0
0
<OTHER-SE> 86,677
<TOTAL-LIABILITIES-AND-EQUITY> 1,042,589
<INTEREST-LOAN> 35,595
<INTEREST-INVEST> 19,551
<INTEREST-OTHER> 1,000
<INTEREST-TOTAL> 56,146
<INTEREST-DEPOSIT> 17,001
<INTEREST-EXPENSE> 17,746
<INTEREST-INCOME-NET> 38,400
<LOAN-LOSSES> 5,757
<SECURITIES-GAINS> (1,027)
<EXPENSE-OTHER> 28,971
<INCOME-PRETAX> 13,184
<INCOME-PRE-EXTRAORDINARY> 13,184
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 9,690
<EPS-PRIMARY> 1.90
<EPS-DILUTED> 1.90
<YIELD-ACTUAL> 5.37
<LOANS-NON> 3,328
<LOANS-PAST> 1,379
<LOANS-TROUBLED> 0
<LOANS-PROBLEM> 35,002
<ALLOWANCE-OPEN> 10,067
<CHARGE-OFFS> 4,026
<RECOVERIES> 764
<ALLOWANCE-CLOSE> 12,562
<ALLOWANCE-DOMESTIC> 12,562
<ALLOWANCE-FOREIGN> 0
<ALLOWANCE-UNALLOCATED> 0
</TABLE>
