UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
Form 10-Q Amendment #1
(Mark One)
X QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 1995
Commission File No.: 0-11113
OR
___ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from ______________ to ____________
SANTA BARBARA BANCORP
(Exact Name of Registrant as Specified in its Charter)
California 95-3673456
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1021 Anacapa Street, Santa Barbara, California 93101
(Address of principal executive offices) (Zip Code)
(805) 564-6300
(Registrant's telephone number, including area code)
Not Applicable
Former name, former address and former fiscal year, if changed since
last report.
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act
of 1934 during the preceding 12 months (or for such shorter period that
the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days.
Yes X No
Common Stock - As of August 10, 1995, there were 5,106,036 shares of the
issuer's common stock outstanding.
THE PURPOSE OF THIS AMENDMENT IS TO CORRECT THE DISCLOSURE OF INFORMATION
IN TWO TABLES IN MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATION.
SANTA BARBARA BANCORP
JUNE 30, 1995 FORM 10-Q
TABLE OF CONTENTS
PART 1. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS All statements
unchanged from
original filing
Consolidated Balance Sheets
At June 30, 1995 and December 31, 1994
Consolidated Statements of Income
Three months ended June 30, 1995 and 1994
Six months ended June 30, 1995 and 1994
Consolidated Statements of Cash Flows
Six months ended June 30, 1995 and 1994
Item 2. Management's Discussion and Analysis
of Financial Condition and Results
of Operation Amended
PART 2. OTHER INFORMATION
Items 1 though 5 Not Applicable
Item 6 Unchanged from
original filing
SIGNATURE
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Net income for the second quarter of 1995 is lower than net income for the
same quarter of last year, and the year to date net income at June 30 is
also lower than for the first half of 1994. The reasons for this decrease
are explained in detail in various sections of this discussion, but in
brief, they include a narrower spread between interest income and interest
expense for core products, an increase in expenses incurred in the refund
anticipation loan program, and an increase in non-interest expense related
to the three major initiatives begun by the Company to regain its former
rate of growth in net income--entry into the Ventura County market,
enhanced credit support and administration, and additional sales and
investment management staff for the Trust and Investment Services Division.
Business
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 which has just become a member of the
Federal Reserve System. 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
Most of the Company's earnings arise from its functioning as a financial
intermediary. As such, it takes in funds from depositors and then either
loans the funds to borrowers or invests the funds in securities and other
instruments. It earns interest on the loans and securities and it pays
interest on the deposits. Net interest income is the difference in dollars
between the interest income earned and the interest expense paid. The net
interest margin is the ratio of net interest income to earning assets. This
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 as interest rates change. Average market interest rates increased
during most of 1994 as the Federal Reserve Board ("the Fed") raised short-
term rates in an effort to temper economic recovery. Short-term rates then
declined slightly through the second quarter of 1995 while long-term rates
declined more significantly. In comparing results for the second quarters
of 1995 and 1994, the major impacts for the Company of these changes in
market rates are increases in the average rates earned and paid on short-
term assets and liabilities and a decrease in unrealized loss in the
securities that are intended to be held to maturity. These impacts
illustrate the risks associated with changes in interest rates.
The primary risk is "market risk;" that is, the market value of financial
instruments (such as loans, securities, 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 would be higher
than that of a newly issued comparable security because the holder of the
older security would be earning interest at a higher rate than the current
market. The same principle applies to fixed rate certificates of deposit
and other liabilities. They 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 stated 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 if the proceeds from shorter-term deposits are used to purchase longer-
term assets or fund longer-term loans. Many savings and loan institutions
were hurt in the early 1980's by this kind of mismatch.
The Company controls mismatch risk by attempting to roughly match the
maturities and repricing opportunities of assets and liabilities. When this
matching is achieved, if the interest rates for a significantly large
proportion of the Company's loans or securities decrease, the Company
should be able to reprice an approximately equal amount of deposits or
other liabilities to lower interest rates within a short time. Similarly,
if interest rates paid on deposits increase, the Company should be able to
protect its interest rate margin through adjustments in the interest rates
earned on loans and 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 for each period and on a cumulative basis for each period. 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. However, the
assumptions underlying the assignment of the various classes of non-term
assets and liabilities are somewhat arbitrary in that the timing of the
repricing is often a function of competitive influences. For example, if
other financial institutions are increasing the rates offered depositors,
the Company may have no choice but to reprice sooner than it expected or
assumed in order to maintain market share.
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 would be little time to correct a mismatch that is
having an adverse impact on income. For example, if the Company had a
significant negative gap for the period--with liabilities maturing or
repricing within the next three months significantly exceeding assets
maturing or repricing in that period -- and 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. From quarter to quarter, the gap for the first period
varies between positive and negative. As of June 30, 1995, the gap for this
first period is a negative 4.01%, well within the target range. At the end
of 1994 and at the end the second quarter of 1994, the gaps were also
negative at 6.25% and 9.42% of assets, respectively. The change from a year
ago is due to a substantially greater liquidity at June 30, 1995 that was
held in short-term instruments like Federal Funds Sold and bankers'
acceptances. Transaction deposit balances are higher as well, but did not
increase as much as the assets.
The impact of negative gap in the first period is mitigated by the
similarly sized 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 to offset the negative impact of rising rates.
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 market interest rates change substantially, the rates paid on
these accounts may have to be repriced sooner than six months. There would
be a negative impact on earnings from an upward repricing of these
deposits. This impact would 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. In
the cumulative computation, the positive gaps in these periods offset the
negative gaps from the earlier periods.
<TABLE>
Table 1- Interest Rate Sensitivity
<CAPTION>
As of June 30, 1995 After three After six After one Noninterest
(in thousands) Within months months year but bearing or
three but within but within within After five nonrepricing
months six months one year five years years items Total
<S> <C> <C> <C> <C> <C> <C> <C>
Assets:
Loans 308,965 90,688 41,414 60,711 26,083 10,134 537,995
Cash and due from banks -- -- -- -- -- 58,482 58,482
Securities:
Held-to-maturity 5,016 5,385 30,886 234,510 48,536 -- 324,333
Available-for-sale 10,000 3,978 19,806 6,162 -- -- 38,946
Bankers' acceptances 29,722 -- -- -- -- -- 29,722
Other assets -- -- -- -- -- 18,783 18,783
Total assets 413,703 100,051 92,106 300,383 74,619 87,399 1,068,261
Liabilities and shareholders' equity:
Borrowed funds:
Repurchase agreements and
Federal funds purchased 33,239 -- -- -- -- -- 33,239
Other borrowings 1,210 -- -- -- -- -- 1,210
Interest-bearing deposits:
Savings and interest-bearing
transaction accounts 355,696 -- 230,115 -- -- -- 585,811
Time deposits 64,644 39,146 46,911 62,795 459 -- 215,720
Demand deposits -- -- -- -- -- 128,846 128,846
Other liabilities -- -- -- -- -- 5,825 5,825
Net shareholders' equity -- -- -- -- -- 97,610 97,610
Total liabilities and
shareholders' equity 456,554 39,146 277,026 62,795 459 232,281 1,068,261
Interest rate-
sensitivity gap (42,851) 60,905 (184,920) 237,588 74,160 (144,882)
Gap as a percentage of
total assets (4.01%) 5.70% (17.31%) 22.24% 6.94% (13.56%)
Cumulative interest
rate-sensitivity gap (42,851) 18,054 (166,866) 70,722 144,882
Cumulative gap as a
percentage of total assets (4.01%) 1.69% (15.62%) 6.62% 13.56%
<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>
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 fourth quarter of 1992. 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 second
quarter of 1995 was unusual in that average assets and deposits were lower
than in the first quarter of the year. However, assets and deposits were
both higher at June 30, 1995 than at March 31, 1995 (assets by $40.7
million and deposits by $32.8 million), suggesting that the third quarter's
averages will be higher.
(In the printed copy of this filing there appears here a chart showing a
gradual rise in deposits and earning assets with variation as described in
the text)
Earning assets consist of the various assets on which the Company earns
interest income. The Company was earning interest on 94.5% of its assets
during the first half of 1995. This compares with an average of 84.9% for
all FDIC-Insured Commercial Banks and 88.9% for the Company's Southern
California peers for the first quarter of 1995.[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) most loans are structured to have interest payable 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 which allow it to put the cash to use more
quickly[2]. At the Company's current size, these steps have resulted in
about $99.9 million more assets earning interest during the first half of
the year than would be the case if the Company's ratio were similar to its
FDIC peers. The additional earnings from these assets are somewhat offset
by higher lease expense, additional equipment costs, and occasional losses
taken on quick sales of foreclosed property, but on balance Management
believes that these steps give the Company an earnings advantage.
Deposits and Related Interest Expense
While occasionally there are slight decreases in average deposits from one
quarter to the next, the overall trend is one of growth. This orderly
growth has been planned by Management and can be sustained because of the
strong capital position and earnings record of the Company. The overall
deposit base for financial institutions in the Company's Santa Barbara
market area has declined from $4.5 billion in 1989 to $3.2 billion in 1994.
During this time the Company has increased its market share from 14.1% in
1989 to 29.4% in 1994. The increases have come by maintaining competitive
deposit rates, through the introduction of new deposit products, and by
successfully encouraging former customers of failed or merged financial
institutions to become customers of the Company.
Table 2 presents the average balances for the major deposit categories and
the yields of interest-bearing deposit accounts for the last six quarters
(dollars in millions). As shown both in the preceding chart and in Table 2,
average deposits for the second quarter of 1995 have increased 2.3% from
average deposits a year ago, but are lower than in the first quarter of the
year. Management has identified two reasons for this decrease. It is partly
a function of declining interest rates leading customers to place funds
with non-financial institutions and therefore the Company must counter a
continuing decline in the deposit base available to all banks in the area.
The second reason is the practical difficulty of one institution continuing
to expand market share in the local area when it already has almost 30% of
that market. This second reason was a major factor in the decision to open
the Ventura County offices.
Administered rate deposit accounts are those products which the institution
can reprice at its choice based on competitive pressure and need for funds.
This contrasts with deposits the rate for which are set by contract for a
term or are tied to an external index like certificates of deposit. 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 second quarter of 1994, the primary growth in deposits during the last
four quarters came in the interest-bearing transaction accounts
("NOW/MMDA").
During 1994, as market interest rates were rising, most banks, including
the Company, raised interest rates paid on their administered rate
transaction accounts only minimally, but by late 1994, competitive
pressures required increases in the rates paid on all deposit types.
However, since 1990, the Company has offered a money market account,
"Personal Money Master," the rate for which was tied to the 3-month
Treasury bill. With the increases in short-term rates and a bonus rate
offered during the second quarter of 1994 for customers bringing in new
deposits from other financial institutions, this product became very
popular. The monthly average balance of these accounts had increased $110.4
million or 152% from December 1993 to October 1994. In November 1994 the
Company changed the account to an administered rate account and lowered the
rate. The account still remains attractive and the average balance has
remained at the October 1994 level of about $180-190 million.
<TABLE>
<CAPTION>
Table 2 AVERAGE DEPOSITS AND RATES
1994 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
<S> <C> <C> <C> <C> <C> <C> <C> <C>
NOW/MMDA $371.2 2.09% $407.0 2.50% $446.5 2.93% $481.0 3.25%
Savings 149.4 2.25 142.9 2.25 130.4 2.24 118.7 2.23
Time deposits 100+ 72.3 3.35 63.2 3.57 61.0 3.88 58.4 4.13
Other time deposits 155.1 4.35 153.7 4.47 151.0 4.63 145.1 4.90
Total interest-bearing
deposits 748.0 2.72% 766.8 2.95% 788.9 3.21% 803.2 3.46%
Non-interest-bearing 117.5 118.6 119.1 123.0
Total deposits $865.5 $885.4 $908.0 $926.2
</TABLE>
<TABLE>
<CAPTION>
1995 1st Quarter 2nd Quarter
<S> <C> <C> <C> <C>
NOW/MMDA $480.1 3.58% $470.5 3.67%
Savings 108.6 2.39 100.7 2.38
Time deposits 100+ 53.8 4.58 56.7 5.10
Other time deposits 144.9 5.24 151.6 5.50
Total interest-bearing
deposits 787.4 3.79% 779.5 3.96%
Non-interest-bearing 135.5 126.3
Total deposits $922.9 $905.8
</TABLE>
As shown in Table 2, there has been some growth in non-interest bearing
demand accounts as well during the last year. Approximately $11.1 million
of the average balance for demand deposits in the first quarter of 1994 and
$15.6 in the first quarter of 1995 relates to outstanding checks from the
tax refund anticipation loan program. Adjusting for these amounts indicates
that there has been a real growth of about $7.7 million or 6.5% from the
second quarter of 1994 to the second quarter of 1995.
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 money
market rates because financial institutions do not change deposit rates
with each small increase or decrease in short-term rates. This trailing
characteristic is stronger with time deposits. With these accounts, even
when new offering rates are established, the average rates paid during the
quarter are a blend of the rates paid on individual accounts. Only new
accounts and those which mature and consequently reprice during the quarter
will bear the new rate. It is therefore consistent with expectations that
the average rate on the time deposits less than $100,000 would increase to
a lesser degree between the second quarter of 1994 and the second quarter
of 1995 than the NOW/MMDA transaction accounts.
Generally, the Company offers higher rates on certificates of deposit in
amounts over $100,000 than for lesser amounts. It would be expected,
therefore, 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 2, however, this is not the case. There are three
primary reasons for this.
First, as indicated in the next section of this discussion, loan demand has
been low during the recession in the California economy. With less need for
funds to lend, the Company has been reluctant to encourage large deposits
that are not the result of stable customer relationships, because the
spread is narrow between the cost of these funds and the earnings on their
uses. Therefore the premium offered on these large deposits has been small.
Second, the time deposits of $100,000 and over generally have shorter
maturities than the smaller certificates. Therefore, they reprice more
frequently. In a declining interest rate environment, that means that their
average rate paid will decline faster, and in a rising rate environment
they will rise faster. While the average rate paid on the smaller time
deposits has remained greater than on the larger deposits over the last
four quarters, the difference has contracted from 90 basis points to 40
basis points reflecting the general trend of increasing rates. Third, there
has been an increase in the proportion of IRA accounts among the under
$100,000 time deposits. The Company pays a higher rate on these accounts.
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 3 shows the changes in the end-of-period (EOP) and average loan
portfolio balances and taxable equivalent income and yields[3] over the
last seven quarters (dollars in millions).
<TABLE>
<CAPTION>
Table 3 LOAN BALANCES AND YIELDS
EOP Average Interest Average
Quarter Ended Outstanding Outstanding and Fees Yield
<S> <C> <C> <C> <C>
December 1993 464.2 457.7 10.4 9.00%
March 1994 469.5 488.6 14.2 11.73%
June 1994 464.9 465.6 10.8 9.24%
September 1994 480.2 474.1 10.9 9.15%
December 1994 499.4 486.3 11.3 9.25%
March 1995 534.9 525.5 15.1 11.58%
June 1995 541.0 537.8 12.5 9.31%
</TABLE>
Change in Average Loan Balances
The Company has increased its residential real estate loans by $54 million
or 70% in the last year. Most of this increase is in adjustable rate
mortgages ("ARMS") that have initial "teaser" rates. As the teaser rate
periods expire and with current rates higher than when most of these loans
were made, the yield should increase. Applicants for these loans are
qualified based on the fully-indexed rate. The Company sells almost all of
its long-term, fixed rate, 1-4 family residential loans when they are
originated. This is done in order to manage market and interest rate risks
and liquidity.
The first quarters of both 1994 and 1995 show the impact of the tax refund
anticipation loans ("RAL's") that the Company makes. The RAL's are extended
to taxpayers who have filed their returns with the IRS electronically and
do not want to wait for the IRS to send them their refund check. 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.
Through April of 1994, the Company had lent $230 million to 150,000
taxpayers. The outstanding loans averaged $29.5 million for the first
quarter of 1994 and there were $13.9 million outstanding at March 31, 1994.
Eliminating these loans from the above table would show average loans of
other types for the first quarter of 1994 of $459.1 million, just slightly
higher than for the fourth quarter of 1993 when no RAL's were outstanding.
Only $5.4 million of the average balance for the second quarter of 1994 in
the table above relates to RAL's.
The Company had intended to significantly expand the program for the 1995
tax season, but several changes in IRS procedures prevented this. In prior
years the IRS provided confirmation before the Company advanced funds that
the taxpayer identification was valid, that there were no liens by the IRS
against the refund, and that the refund would be sent to the Company
instead of the taxpayer to repay the loan. This confirmation was
discontinued for the 1995 tax season. The IRS also placed a moratorium on
payment of that portion of refunds which was related to the Earned Income
Credit ("EIC"). Many of the taxpayers filing electronically are low income
families who do so to receive the EIC. Without confirmation, and with
significant uncertainty regarding whether the IRS would reimburse the
Company for loans related to EIC, the Company restricted loans only to
those taxpayers who met certain credit standards, and restricted the amount
that it would lend only to the non-EIC related portion of any refund claim.
Through April of 1995, the Company had lent just over $75.5 million to
about 75,600 taxpayers. Eliminating the average balance of these loans
($11.6 million) from the above table would show average loans of other
types for the first quarter of 1995 of $513.9 million, continuing a steady
increase in the average balance since the second quarter of 1994.
Interest and Fees Earned and the Effect of Changing Interest Rates
Interest rates on most consumer loans are fixed at the time funds are
advanced. The average yields on these loans significantly lag market rates
as rates rise because the Company only has the opportunity to increase
yields as new loans are made. However, in a declining interest rate
environment, these loans tend to track market rates more closely because
they may be prepaid if the current market rate for any specific type of
loan declines sufficiently below the contractual rate on the original loan
to warrant the customer refinancing.
The rates on most commercial and construction loans vary with an external
index like the national prime rate or the Cost of Funds Index ("COFI") for
the 11th District of the Federal Home Loan Bank, or are set by reference to
the Company's base lending rate. This rate is established by the Company by
reference to the national prime adjusting for local lending and deposit
price conditions. The loans that are tied to prime or to the Company's base
lending rate adjust immediately to a change in those rates while the loans
tied to COFI usually adjust every six months or less. Therefore, variable
rate loans tend to follow market rates more closely.
The yields shown in Table 3 for the first quarters of 1994 and 1995 are
significantly affected by the fees earned in the RAL program which is
reported as interest income. Average yields for the two quarters without
the effect of RAL's were 8.67% and 9.27%, respectively.
Fees earned on the RAL's were increased in 1995 to cover the greater credit
risk and the additional expenses associated with credit checks on taxpayers
which had not been necessary in previous years. However, the lower level of
activity resulted in $3.2 million in fees from RAL's in the first quarter
of 1995 compared to $4.7 million in fees in 1994. As described in the
section below titled "Other Operating Income," $1.5 million in other fees
related to the RAL program were earned during the first quarter.
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) June 30, June 30,
1995 1994
Credit lines with unused balances $123.2 $119.7
Undisbursed loans $12.0 $11.4
Other loan or letter of credit commitments $54.2 $39.9
The increase in commitments is attributed to some improvement in local
economic activity and to the Company's entry into the Ventura County market
area. The majority of the commitments are for one year or less. The
majority of the credit lines and commitments may be withdrawn by the
Company subject to applicable legal requirements. With the exception of the
undisbursed loans, the Company does not anticipate that a majority of the
above commitments will be used by customers.
The Company has established maximum loan amount to collateral value ratios
for construction and development loans ranging from 65% for raw land to 85%
1-4 family residential, but in practice lower ratios are used for most
loans. There are no specific loan to value ratios for other commercial,
industrial, agricultural loans not secured by real estate. The adequacy of
the collateral is established based on the individual borrower and purpose
of the loan. Consumer loans may have maximum ratios based on loan amount,
the nature of the collateral, and other factors.
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
this general allowance is based on the size of the loan portfolio, his-
torical 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. In addition, Statement of Accounting Standards No.
114, Accounting by Creditors for Impairment of a Loan requires the
establishment of a valuation allowance for impaired loans as described in
Note 5 to the financial statements.
Table 4 shows the amounts of non-current loans and non-performing assets
for the Company at the end of the second quarter of 1995, 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. Also included in the table in
boldface is comparable data[4] regarding the Company's Southern California
peers for the three earlier quarters.
One large relationship consisting of a number of individual loans was
recognized as impaired and placed on non-accrual status during the first
quarter of 1995. This relationship accounts for $4.0 million of the $9.1
million in non-accrual loans as of June 30, 1995. The relationship is made
up of a number of loans. The Company has charged-off portions of these
loans it deems uncollectible.
<TABLE>
<CAPTION>
Table 4 ASSET QUALITY
June 30, March 31, December 31 June 30,
1995 1995 1994 1994
Company Company Company Company
<S> <C> <C> <C> <C>
Loans delinquent
90 days or more $5,111 $1,671 $1,290 $1,064
Non-accrual loans 9,143 10,651 6,326 4,380
Total non-current loans 14,254 12,322 7,616 5,444
Foreclosed real estate 1,113 681 856 1,602
Total non-performing assets $15,367 $13,003 $8,472 $7,046
</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> <C>
Coverage ratio of
allowance for loan
losses to non-current
loans and leases 78% 133% 95% 170% 99% 252% 98%
Ratio of non-current loans
to total loans and leases 2.64% 2.30% 3.76% 1.52% 3.54% 1.20% 3.75%
Ratio of non-performing
assets to average
total assets 1.44% 1.25% 3.28% 0.81% 3.16% 0.72% 3.25%
</TABLE>
Management is concerned by the trend of increasing other non-current loans.
Two specific steps have been taken to reverse the trend of increase in non-
current loans. First, Management has strengthened the credit review,
analysis, and administrative functions by hiring additional professional
staff. Second, Management has established a Special Assets Committee to
give increased attention to the larger problem loans. The new staff and the
committee are aggressively pursuing collection plans or acknowledging
uncollectibility and charging-off the loans ($3.2 million in the second
quarter of 1995). However, several quarters may be needed before there is a
significant decrease in the ratio of non-current loans to total loans.
The June 30, 1995 balance of non-current loans does not equate directly
with future charge-offs, because most of these loans are secured by
collateral. Nonetheless, according to Management, it is probable that some
portion of such loans will have to be charged off and that other loans will
become delinquent. Based on its review of the loan portfolio, Management
considers the current amount of the reserve adequate. As reviews are
completed each period and additional information becomes available,
Management will provide for additional allowance to address new possible
losses identified.
The following table classifies nonperforming loans (both 90+ days delin-
quent and nonaccrual) and other potential problem loans by loan category for
June 30, 1995 (amounts in thousands).
Nonperforming Loans
90+ days Potential
Delinquent Problem
Still Accruing Nonaccrual Loans
Loans secured by real estate:
Construction and
land development 0 0 0
Agricultural 0 0 0
Home equity lines 0 588 55
1-4 family 0 2,737 1,019
Multi-family 0 954 0
Non-residential, non-farm 930 3,318 6,296
Commercial and industrial 4,177 1,510 13,243
Checking overdraft lines 1 0 0
Other consumer loans 0 36 293
Refund anticipation loans 0 0 1,187
Other 3 0 0
Total 5,111 9,143 22,093
The following table provides the allocation of the allowance for the above
nonperforming and potential problem loans by classification as of
June 30, 1995 (amounts in thousands).
Doubtful 3,342
Substandard 3,998
Special Mention 977
The total of the above numbers is less than the total allowance because
some of the allowance is allocated to loans which are not regarded as
potential problem loans, and some is not allocated but instead is provided
for potential losses in any classification that have not yet been
identified.
Securities and Related Interest Income
Generally accepted accounting principles require 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, for securities that will be held to maturity, 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," consists of the securities that are
available for sale and 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. The Company has no
securities which would be classified as trading securities.
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.
In general, the Company uses available funds to purchase for the two
portfolios according to the following priorities. Taxable securities,
usually U. S. Government obligations with maturities of one year to three
years, are 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 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 two to five
years, may be purchased for the earnings portfolio.
The Effects of Interest Rates on the Composition of the Investment
Portfolio
Table 5 presents the combined securities portfolios, showing the average
outstanding balances (dollars in millions) and the yields for the last six
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>
<CAPTION>
Table 5 AVERAGE BALANCES OF SECURITIES AND INTEREST YIELD
1994 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
<S> <C> <C> <C> <C> <C> <C> <C> <C>
U.S. Treasury $305.4 5.28% $355.6 5.30% $309.4 5.38% $259.5 5.55%
U.S. Agency 20.8 4.61 45.9 4.55 55.8 4.71 55.7 4.78
Tax-Exempt 78.0 13.49 79.9 13.44 86.8 13.14 90.0 13.49
Total $404.2 6.83% $481.4 6.58% $452.0 6.79% $405.2 7.21%
</TABLE>
<TABLE>
<CAPTION>
1995 1st Quarter 2nd Quarter
<S> <C> <C> <C> <C>
U.S. Treasury $236.7 5.63% $226.8 5.60%
U.S. Agency 55.6 4.86 54.8 5.25
Tax-Exempt 87.6 12.99 84.0 12.69
Total $379.9 7.22% $365.6 7.18%
</TABLE>
The Company's 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. When interest rates are rising, short
maturity investments are preferred. This is because principal is better
protected from market risk 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.
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 last year's increases in
market rates is seen as a very gradual increase in the average rates of
taxable securities through the first quarter of 1995, with the decline in
rates in 1995 beginning to appear in the yield for the second quarter.
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"). 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 yield on these
securities is gradually declining as older, higher-earning securities
mature or are called by the issuers.
Certain issues of municipal securities may still be purchased with the tax
advantages that were 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
or credit insurance by a third party. 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 received from the
issuer upon maturity).
Included with the balances shown for U.S. Agency securities that are being
held to maturity are four structured notes with a combined book value of
$34.2 million. They are a type of security known as step bonds. They were
issued at an initial rate and had one or more call dates. If not called,
the interest rate steps up to a higher level. None of the notes purchased
have been called and two have reached their final steps at 4.50% and 6.61%.
The other two have three remaining steps with call dates each 6 months. The
first has a current rate of 4.65% with future rates of 5.15%, 6.15%, and
7.15% if not called. The second has a current rate of 4.50% with future
rates of 5.00%, 6.00%, and 7.00% if not called. Only the interest rate on
these notes is contingent, all principal is paid at maturity unless at a
sooner call date. There is no circumstance under which the interest rates
will decline. The current interest rate for notes of comparable maturity
with no call or step provisions is slightly above the current rates so
there are small unrealized losses for these notes.
Unrealized Gains and Losses
As explained in "Interest Rate Sensitivity" above, fixed rate securities
are subject to market risk from changes in interest rates. Footnote 4 to
the financial statements shows the impact of the decline in longer-term
interest rates that occurred during the first half of 1995. While there
were no maturities or purchases of U.S. Treasury securities in the earnings
or held-to-maturity portfolio during the first half of 1995, the market
value increased by $10.6 million while the book value increased only
$215,000 from the accretion of discount. The market value of the municipal
securities (of which there were several purchases and calls) also increased
in market value from 109% of book value to 115%.
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 usually an indication of
Management's estimation during the quarter of immediate cash needs and
relative yields of alternative investment vehicles.
Table 6 illustrates the average funds sold position of the Company and the
average yields over the last seven quarters (dollars in millions).
Table 6--AVERAGE BALANCE OF FUNDS SOLD AND YIELDS
Average Average
Quarter Ended Outstanding Yield
December 1993 $21.8 2.97%
March 1994 4.9 3.20
June 1994 8.7 3.95
September 1994 22.1 4.47
December 1994 30.8 5.13
March 1995 23.8 5.69
June 1995 38.5 6.01
When interest rates are rising, the Company can benefit by keeping larger
amounts in Federal funds because these excess funds then earn interest that
is repriced 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 recent years, excess funds that might otherwise have been sold
as Federal funds were instead invested in short-term U. S. Treasury
securities and bankers' acceptances that would mature in the first quarter
of the year 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.
In the first two quarters of 1995, with the RAL program requiring less
funds, the balance in Federal funds sold was higher than the same quarter a
year ago. Because of the very flat Treasury yield curve during the second
quarter of 1995, rates paid on Federal Funds sold were frequently higher
than the rates available on securities with less than two years maturity.
Consequently, Management chose to sell more funds than usual. With the drop
in rates by the Federal Reserve Bank in early July, the average yield for
the third quarter is expected to be about 25 basis points less than in the
second.
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 7 discloses the
average balances and yields of bankers' acceptances for the last seven
quarters (dollars in millions).
Table 7--AVERAGE BALANCE OF BANKERS' ACCEPTANCES AND YIELDS
Average Average
Quarter Ended Outstanding Yield
December 1993 $60.8 3.32%
March 1994 33.7 3.31
June 1994 1.4 3.35
September 1994 25.3 5.32
December 1994 4.4 5.38
March 1995 55.7 5.97
June 1995 41.6 6.44
After the RAL program expanded in the Spring of 1993, Management recognized
that it would have to begin during the third quarter to purchase securities
or bankers' acceptances that would mature during the first quarter of the
following year. 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. Expecting a further expansion of
the program in 1995, Management again purchased bankers' acceptances in the
third and fourth quarters of 1994 to mature in early 1995. With the
reduction in loans in the RAL program in 1995, some of the maturities were
not needed for the intended purpose and were reinvested in bankers'
acceptances in anticipation of funding the loans that would be arising out
of the opening of the Ventura offices.
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 8 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 seven quarters.
Table 8--OTHER BORROWINGS
Average Average Percentage of
Quarter Ended Outstanding Rate Average Total Assets
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
December 1994 18.3 4.63 1.8
March 1995 16.3 5.47 1.6
June 1995 28.1 5.69 2.7
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. Table 9 shows trust income over the last seven
quarters (in thousands).
Table 9--TRUST INCOME
Quarter Ended Trust Income
December 1993 $1,706
March 1994 1,781
June 1994 1,510
September 1994 1,548
December 1994 1,611
March 1995 1,765
June 1995 1,590
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 $236,000 of the fees
earned in the first quarter of 1995 and $179,000 and $81,000 of the fees
earned in the first and second quarters of 1994, 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, trust income
has remained relatively stable during the quarters shown.
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 for merchants, escrow fees, and a number of other
fees charged for special services provided to customers. Categories of non-
interest operating income other than trust fees are shown in Table 10 for
the last seven quarters (in thousands).
Table 10--OTHER INCOME Other Service
Service Charges Charges,
on Deposit Commissions Other
Quarter Ended Accounts & Fees Income
December 1993 $ 713 $1,012 $334
March 1994 724 791 145
June 1994 746 1,249 149
September 1994 752 1,023 121
December 1994 961 1,013 152
March 1995 1,044 2,468 78
June 1995 1,072 1,143 113
In the fourth quarter of 1994 the Company revised its schedule to increase
most fees . The effect of the change is seen in the increase in the amount
of service charges on deposit accounts in that quarter and the first two
quarters of 1995.
The large increase in other service charges, commissions and fees for the
first quarter of 1995 is due to $1.5 million of fees received for the
electronic transfer of tax refunds. As explained in the section above
titled "Loans and Related Interest Income," the Company did not advance
funds under the RAL program to as large a number of potential borrowers as
it had expected because of the changes in the IRS procedures. Nonetheless,
the Company was able to assist these taxpayers by transferring funds to
them faster than the standard IRS check writing process. The Company
received the refund from the IRS and then transferred it directly to the
taxpayer's checking account or authorized the tax preparer to write a check
that the taxpayer could pick up immediately.
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 1993 when interest rates were low, the
Company originated a significant number of refinancings that it immediately
sold to other financial institutions or insurance companies. This was
especially true in the fourth quarter of 1993 as approximately $196,000 in
gains were recognized. The larger amount 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. As interest rates rose in 1994,
the Company did fewer refinancings, accounting for the smaller amount of
other income.
Staff Expense
The Company closely monitors staff size and over the last several years has
managed to limit the increase in the average number of employees to less
than the rate of increase in the average assets of the Company and rate of
increase in the market value of trust assets under administration.
Table 11--STAFF EXPENSE
Salary and Profit Sharing and
Quarter Ended Other Compensation Other Employee Benefits
December 1993 $4,010 $ 787
March 1994 4,096 1,353
June 1994 4,281 1,246
September 1994 4,090 1,205
December 1994 3,834 1,045
March 1995 4,780 1,405
June 1995 4,422 1,015
Staff expense increased in the first quarter of 1995 for several reasons.
First, the Company began hiring staff for the three Ventura offices that
have been opened. They were hired with enough lead time before the openings
to provide training and familiarization with the Company. Second, as
mentioned above, the Company has hired a number of new staff in the areas
of lending and credit administration and in loan review to more closely
monitor credit quality. Thirdly, staff has been added in the Trust and
Investment Services Division to sell and manage several new products
offered in this area. Lastly, all officers have their annual salary review
in the first quarter with merit increases effective on March 1. These
increases averaged 4% this year.
Salary and other compensation decreased in the second quarter of 1995. The
Board of Directors has established an incentive bonus plan for officers.
The amount of the pool from which bonuses are paid is set based on net
income. The bonuses are paid in the following year, but are accrued in the
year to which they relate. The amount accrued is based on projected net
income for the year. Management's 1995 mid-year revised forecast projects
net income at an amount less than originally projected and the accrual
amount was therefore reduced during the second quarter.
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 amount for the
fourth quarter of 1993 was unusually low. The Company's contributions for
the profit sharing and retiree health benefit plans are determined by a
formula that results in a contribution equal to 10% of a base figure made
up of income before tax and before the contribution, adjusted to add back
the provision for loan loss and to subtract actual charge-offs. The Company
begins each year accruing an amount based on its forecast of the base
figure. 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 with the assumption of a more normal ratio of actual net charge-offs
to provision and therefore needed to adjust the accrual in the fourth
quarter. In 1994 and 1995, the Company adjusted its accrual in the second
quarter of each year as the base figure proved lower than originally
forecast.
The second factor explaining the increase in profit sharing and other
employee benefits in the first quarter of 1995 relates to payroll taxes.
While bonus expense is accrued as salary expense during the year to which
it relates, 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 $57,000) of the increase from the fourth quarter of 1994 to
the first quarter of 1995. 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.
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
Table 12 shows other operating expenses over the last seven quarters (in
thousands).
Table 12--OTHER OPERATING EXPENSE
Occupancy Expense Furniture & Other
Quarter Ended Bank Premises Equipment Expense
December 1993 $ 817 $539 $3,459
March 1994 787 488 3,096
June 1994 855 511 3,144
September 1994 935 614 2,867
December 1994 950 634 3,745
March 1995 1,011 645 4,198
June 1995 1,003 640 3,611
Other operating expenses have increased in the first quarter of 1995.
Occupancy expenses have increased as a result of the new Ventura County
offices. The Company leases rather than owns most of its premises. Many of
the leases provide for annual rent adjustments. Equipment expense
fluctuates over time as rental needs change, maintenance is performed, and
equipment is purchased, and this category has also been impacted by the
opening of the new offices.
Table 13 shows a detailed comparison for the major expense items in other
expense for the first quarters of 1994 and 1995.
Table 13-OTHER EXPENSE
Six-Month Periods Three-Month Periods
Ended June 30 Ended June 30
1995 1994 1995 1994
FDIC and State assessments $1,038 $1,040 $ 510 $ 520
Professional services 385 362 200 166
RAL processing and incentive fees 100 323 (150) --
Supplies and sundries 311 300 143 152
Postage and freight 365 318 145 142
Marketing 804 489 637 353
Bankcard processing 708 799 360 381
Credit bureau 493 28 50 17
Telephone and wire expense 479 174 170 86
Charities and contributions 216 128 74 65
Software expense 415 359 212 184
Operating losses 219 8 18 11
Other 2,275 1,910 1,242 1,067
Total $7,808 $6,238 $3,611 $3,144
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 particular institution. The annual rate has ranged from
$0.23 to $0.30 per hundred dollars of deposits. On the basis of its "well-
capitalized" position, the Company's rate has been $0.23 per hundred. As
deposits increased, this expense increased as well. The FDIC recently
announced that it would decrease the rates paid by well-capitalized banks
to $0.04 per hundred dollars. The effective date of this change and the
amount of the premium that will be refunded to the Company is not yet
determined. Management assumes that the Company will be charged at the
$0.04 per hundred dollar rate and estimates that the change will reduce
expense for the whole 1995 by at least $1 million compared to what it would
have been at the current rate.
A number of these expense categories have increased due to the Ventura
County expansion. These include marketing, telephone and wire, and
charities and contributions. The increase in credit bureau expense is
almost wholly related to the extra credit checks for the RAL program
necessitated by the IRS changes noted above. Substantial telephone expense
was incurred in the RAL program to answer questions from applicants for
loans regarding the changes made by the IRS and why the Company would act
as a transferor only. Telephone expense also increased because of a new
business rate schedule implemented by the Company's local telephone vendor.
The RAL related expenses will be less for subsequent quarters of the year,
but expenses related to the new offices will continue.
The Company became aware in the first quarter of 1995 that it may have some
responsibility for a large loss suffered by one of its customers because of
the failure of a Company employee to question the actions of one of the
customer's employees. The Company has accrued an an estimate ($150,000) of
the amount it is likely to have to reimburse the customer. It is included
in other operating losses.
RAL processing and incentive fees are paid to tax preparers and filers
based on the volume of loans and the collectibility of the loans made
through them. As of March 31, 1995, the Company had estimated that it would
be obligated for $250,000 in such payments. With the reduced volume and the
lower collectibility, the Company estimated it would be obligated for only
$100,000, and a portion of the earlier estimate was reversed.
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, the gain that is
realized is credited to this category.
The negative amount in the income statement for this expense category for
the first half of 1994 reflects approximately $907,000 in net gains arising
out of sales less approximately $327,000 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 had $1.1
million in OREO as of June 30, 1995. This compares with $856,000 million as
of a year earlier. With the small balance of OREO being held, Management
anticipates that OREO operating expense will continue to be relatively low.
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.
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 ("FRB") adequate to meet unexpected immediate demands, and (2)
balancing near-term and long-term cash inflows and outflows to meet such
demands over future periods.
Federal 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 at times during 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 the year, with the large liquidity needs associated
with the RAL program, the Company purchases Federal funds from other banks
or borrows 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 at least the same amount of short-term liquid assets as volatile,
large liabilities. It is also important that 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 from the liquidity portfolio 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
<TABLE>
<CAPTION>
Table 14--LIQUIDITY COMPUTATION COMPONENTS
(in thousands of $)
Short-term, Volatile, Net Loans and Long-
Liquid Assets: Large Liabilities: term Investments:
<S> <C> <S> <C> <S> <C>
Fixed rate debt Time deposits 100+ $ 71,028 Net loans $526,718
with maturity Repurchase agreements Long-term
less than 1 year $ 75,070 and Federal funds securities 256,206
Treasury securities purchased 33,239
with 1-2 year Other borrowed funds 1,210
maturities 32,003
Federal funds 60,000
Bankers'
acceptances 29,722
Total $196,795 Total $105,477 Total $782,924
</TABLE>
As of June 30, 1995, the difference between short-term, liquid assets and
volatile, large liabilities, the "liquidity amount," was a positive $91
million and the liquidity ratio was 11.52%, using the balances (in
thousands) in Table 14.
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. The current liquidity amount exceeds the range
that the Company is trying to maintain -- from positive $75 million to
negative $25 million. Too high a liquidity amount or ratio generally
results in reduced earnings because the short-term, liquid assets often
have lower interest rates. If liquidity is too low, earnings are reduced by
the cost to borrow funds or because of lost opportunities. Some purchases
of taxable securities are planned for the third quarter of 1995 but they
will have maturities less than two years and so will not reduce the
liquidity ratio. The Company is also making small purchases of municipal
securities for their tax advantages, but these are unlikely to be in an
amount that will significantly lower the liquidity ratio.
Securities from both the liquidity and earnings portfolios are included in
the balances for short-term liquid assets in Table 14. The inclusion of
securities from the earnings portfolio is not predicated on their possible
sale, but rather on the recognition that Management will be including the
proceeds that will be received at maturity in liquidity planning.
Capital Resources
Table 15 presents a comparison of several important amounts and ratios for
the second quarters of 1995 and 1994 (dollars in thousands).
Table 15-CAPITAL RATIOS 2nd Quarter 2nd Quarter
1995 1994 Change
Amounts:
Net Income $ 2,293 $ 3,177 $ (884)
Average Total Assets 1,038,595 1,011,108 27,487
Average Equity 97,749 89,155 8,594
Ratios:
Equity Capital to
Total Assets (Period-end) 9.14% 8.78% 0.36%
Annualized Return
on Average Assets 0.88% 1.26% (0.38%)
Annualized Return
on Average Equity 9.38% 14.25% (4.87%)
Earnings are the largest source of capital for the Company. For reasons
mentioned in various sections of this discussion, Management expects that
there will be more variation quarter by quarter in operating earnings.
Areas of uncertainty include asset quality, loan demand, RAL operations and
collections, and the Ventura County expansion.
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. Because of the
changes instituted by the IRS regarding RAL payments to the Company, the
amount of these loans not repaid to the Company is higher than originally
estimated. These changes have already increased operating costs over the
Company's original projections and additional charge-offs are likely in the
third quarter. There will be some additional initial expenses related to
Ventura that will be incurred in the second quarter as well as a full
quarter of operating expenses, but these should begin to be offset by
additional income as loans are made and deposits received.
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 June 30, 1995, the Company's risk-based capital
ratio was 18.37%. The Company must also maintain shareholders' equity of at
least 4% to 5% of unadjusted total assets. As of June 30, 1995,
shareholders' equity was 9.14% of total assets. The Company's ratios
reflect that it currently has ample capital to support the additional
growth in Ventura County.
No 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 last 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 has become a member bank of the Federal Reserve System and so is also
primarily regulated by the FRB. Because it retained its state charter it is
also regulated by 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.
[1]The Company primarily uses two published sources of information to
obtain performance ratios of its peers. The FDIC Quarterly Banking Profile,
First Quarter, 1995, 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 year-to-date information provided by banks each
quarter. It takes about 2-3 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 first quarter of 1995. 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]Checks deposited by its customers do not represent available funds on
which the Company can earn interest until they have been presented to the
bank on which they are drawn and the funds paid by it to the Company.
[3]As required by applicable regulations, tax-exempt non-security
obligations of municipal governments are reported as part of the loan
portfolio. These totaled approximately $7.7 million as of June 30, 1995.
The average yields presented in Table 3 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 second quarter of 1995 would be $12.4
million as shown in the accompanying financial statements and the average
yield would be 9.26%. 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."
[4]Reported in Western Bank Monitor, First Quarter, 1995.
The following table provides the allocation of the allowance for all
potential problem loans by classification as of June 30, 1995 (amounts
in thousands)
SIGNATURE
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: September 6, 1995 /s/ Donald Lafler
Donald Lafler
Vice President
Chief Financial Officer
