10-Q/A 1 a08-5894_210qa.htm 10-Q/A

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 


 

FORM 10-Q/A

(Amendment No. 1)

 


 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended June 30, 2007
 

OR

 

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                 to

 

Commission file number 000-23877

 

Heritage Commerce Corp
(Exact name of Registrant as Specified in its Charter)

 

California

 

77-0469558

  (State or Other Jurisdiction of Incorporation or Organization)

 

(I.R.S. Employer Identification Number)

 

150 Almaden Boulevard
San Jose, California    95113

(Address of Principal Executive Offices including Zip Code)

 

(408) 947-6900
(Registrant’s Telephone Number, Including Area Code)

 

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 reports), and (2) has been subject to such filing requirements for the past 90 days.
YES
x                  NO o

 

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.
(Check one):    Large accelerated filer
o                          Accelerated filer x                             Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
YES
o   NO x

 

The Registrant had 13,375,163 shares of Common Stock outstanding on July 25, 2007.

 

 

 



 

Heritage Commerce Corp and Subsidiaries

Quarterly Report on Form 10-Q/A
Table of Contents

 

 

Page No.

 

 

Explanatory Note

2

 

 

PART I. FINANCIAL INFORMATION

 

 

 

 

 

Item 1. Consolidated Financial Statements (unaudited):

3

 

 

Consolidated Balance Sheets

3

 

 

Consolidated Income Statements

4

 

 

Consolidated Statement of Changes in Shareholders’ Equity

5

 

 

Consolidated Statements of Cash Flows

6

 

 

Notes to Consolidated Financial Statements

7

 

 

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

18

 

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

44

 

 

Item 4. Controls and Procedures

44

 

 

 

 

PART II. OTHER INFORMATION

 

 

 

Item 1.    Legal Proceedings

45

 

 

Item 1A. Risk Factors

45

 

 

Item 2.    Unregistered Sales of Equity Securities and Use of Proceeds

45

 

 

Item 3.    Defaults Upon Senior Securities

46

 

 

Item 4.    Submission of Matters to a Vote of Security Holders

46

 

 

Item 5.    Other Information

47

 

 

Item 6.    Exhibits

47

 

 

SIGNATURES

47

 

 

EXHIBIT INDEX

48

 

 

1



 

EXPLANATORY NOTE

 

Heritage Commerce Corp is filing this Amendment No. 1 to its Quarterly Report on Form 10-Q for the quarter ended June 30, 2007, to reflect the restatement of Heritage Commerce Corp’s Consolidated Balance Sheets and Consolidated Statements of Cash Flows, as discussed in Note 9 of the Notes to the Consolidated Financial Statements contained in Part I, Item 1. Except for Part I, Item 1, and related changes to conform Management’s Discussion and Analysis of Financial Condition and Results of Operations in Part I, Item 2 to the restated financial statements, no other information in the Form 10-Q for the quarter ended June 30, 2007 is being amended by this Amendment No. 1. This Amendment No. 1 continues to speak as of the date of the original filing of the Form 10-Q and Heritage Commerce Corp has not updated the disclosure in the Amendment to speak as of any later date.

 

 

2


 


 

Part I — FINANCIAL INFORMATION

 

ITEM 1 — CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

Heritage Commerce Corp

Consolidated Balance Sheets (Unaudited)

 

 

 

June 30,

 

December 31,

 

 

 

2007

 

2006

 

 

 

(As Restated

 

(As Restated

 

 

 

See Note 9)

 

See Note 9)

 

 

 

(Dollars in thousands)

 

Assets

 

 

 

 

 

Cash and due from banks

 

$

45,881

 

$

34,285

 

Federal funds sold

 

57,810

 

15,100

 

Total cash and cash equivalents

 

103,691

 

49,385

 

Securities available-for-sale, at fair value

 

169,498

 

172,298

 

Loans held for sale, at lower of cost or market

 

20,018

 

33,752

 

Loans, net of deferred origination costs

 

925,744

 

709,236

 

Allowance for loan losses

 

(11,104

)

(9,279

)

Loans, net

 

914,640

 

699,957

 

 

 

 

 

 

 

Federal Home Loan Bank and Federal Reserve Bank stock, at cost

 

6,334

 

6,113

 

Company owned life insurance

 

37,900

 

36,174

 

Premises and equipment, net

 

9,186

 

2,539

 

Goodwill

 

43,172

 

 

Core deposit intangible asset

 

5,031

 

 

Accrued interest receivable and other assets

 

37,461

 

36,920

 

Total assets

 

$

1,346,931

 

$

1,037,138

 

 

 

 

 

 

 

Liabilities and Shareholders’ Equity

 

 

 

 

 

Liabilities:

 

 

 

 

 

Deposits

 

 

 

 

 

Demand, noninterest bearing

 

$

266,404

 

$

231,841

 

Demand, interest bearing

 

162,003

 

133,413

 

Savings and money market

 

448,528

 

307,266

 

Time deposits, under $100

 

33,735

 

31,097

 

Time deposits, $100 and over

 

143,544

 

111,017

 

Brokered deposits, $100 and over

 

65,439

 

31,959

 

Total deposits

 

1,119,653

 

846,593

 

Notes payable to subsidiary grantor trusts

 

23,702

 

23,702

 

Securities sold under agreement to repurchase

 

10,900

 

21,800

 

Accrued interest payable and other liabilities

 

22,522

 

22,223

 

Total liabilities

 

1,176,777

 

914,318

 

 

 

 

 

 

 

Shareholders’ equity:

 

 

 

 

 

Preferred stock, no par value; 10,000,000 shares authorized; none outstanding

 

 

 

Common Stock, no par value; 30,000,000 shares authorized; shares outstanding: 13,375,163 at June 30, 2007 and 11,656,943 at December 31, 2006

 

103,498

 

62,363

 

Retained earnings

 

69,102

 

62,452

 

Accumulated other comprehensive loss

 

(2,446

)

(1,995

)

Total shareholders’ equity

 

170,154

 

122,820

 

Total liabilities and shareholders’ equity

 

$

1,346,931

 

$

1,037,138

 

 

See notes to consolidated financial statements

 

3



 

Heritage Commerce Corp

Consolidated Income Statements (Unaudited)

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

June 30,

 

June 30,

 

 

 

2007

 

2006

 

2007

 

2006

 

 

 

(Dollars in thousands, except per share data)

 

Interest income:

 

 

 

 

 

 

 

 

 

Loans, including fees

 

$

15,589

 

$

15,344

 

$

30,259

 

$

30,065

 

Securities, taxable

 

1,940

 

1,932

 

3,848

 

3,678

 

Securities, non-taxable

 

42

 

45

 

86

 

91

 

Interest bearing deposits in other financial institutions

 

40

 

42

 

73

 

60

 

Federal funds sold

 

706

 

1,029

 

1,285

 

1,758

 

Total interest income

 

18,317

 

18,392

 

35,551

 

35,652

 

 

 

 

 

 

 

 

 

 

 

Interest expense:

 

 

 

 

 

 

 

 

 

Deposits

 

5,221

 

5,033

 

10,006

 

9,352

 

Notes payable to subsidiary grantor trusts

 

583

 

575

 

1,164

 

1,137

 

Repurchase agreements and other

 

120

 

158

 

257

 

346

 

Total interest expense

 

5,924

 

5,766

 

11,427

 

10,835

 

Net interest income

 

12,393

 

12,626

 

24,124

 

24,817

 

Provision for loan losses

 

 

(114

)

(236

)

(603

)

Net interest income after provision for loan losses

 

12,393

 

12,740

 

24,360

 

25,420

 

 

 

 

 

 

 

 

 

 

 

Noninterest income:

 

 

 

 

 

 

 

 

 

Gain on sale of loans

 

695

 

842

 

1,706

 

2,339

 

Servicing income

 

534

 

441

 

1,050

 

909

 

Increase in cash surrender value of life insurance

 

353

 

360

 

697

 

707

 

Service charges and fees on deposit accounts

 

336

 

327

 

610

 

654

 

Other

 

344

 

287

 

713

 

542

 

Total noninterest income

 

2,262

 

2,257

 

4,776

 

5,151

 

 

 

 

 

 

 

 

 

 

 

Noninterest expense:

 

 

 

 

 

 

 

 

 

Salaries and employee benefits

 

4,685

 

4,653

 

9,573

 

9,762

 

Occupancy

 

770

 

774

 

1,535

 

1,551

 

Professional fees

 

401

 

334

 

738

 

847

 

Advertising and promotion

 

390

 

347

 

602

 

557

 

Client services

 

247

 

242

 

476

 

542

 

Data processing

 

197

 

161

 

401

 

342

 

Low income housing investment losses and writedowns

 

118

 

213

 

355

 

477

 

Furniture and equipment

 

119

 

148

 

229

 

257

 

Intangible amortization

 

18

 

 

18

 

 

Other

 

1,555

 

1,620

 

2,873

 

2,918

 

Total noninterest expense

 

8,500

 

8,492

 

16,800

 

17,253

 

Income before income taxes

 

6,155

 

6,505

 

12,336

 

13,318

 

Income tax expense

 

2,140

 

2,316

 

4,288

 

4,753

 

Net income

 

$

4,015

 

$

4,189

 

$

8,048

 

$

8,565

 

 

 

 

 

 

 

 

 

 

 

Earnings per share:

 

 

 

 

 

 

 

 

 

Basic

 

$

0.34

 

$

0.35

 

$

0.69

 

$

0.72

 

Diluted

 

$

0.33

 

$

0.35

 

$

0.68

 

$

0.71

 

 

See notes to consolidated financial statements

 

4



 

Heritage Commerce Corp

Consolidated Statements of Changes in Shareholders’ Equity (Unaudited)

Six Months Ended June 30, 2007 and 2006

 

 

 

 

 

 

 

 

 

Accumulated Other 

 

Total 

 

 

 

 

 

Common Stock

 

Retained

 

Comprehensive

 

Shareholders’

 

Comprehensive

 

 

 

Shares

 

Amount

 

Earnings

 

Loss

 

Equity

 

Income

 

 

 

(Dollars in thousands, except share data)

 

Balance, January 1, 2006

 

11,807,649

 

$

66,799

 

$

47,539

 

$

(2,721

)

111,617

 

 

 

Net Income

 

 

 

8,565

 

 

8,565

 

$

8,565

 

Net change in unrealized gain/loss on securities available-for-sale and I/O strips, net of reclassification adjustment and deferred income taxes

 

 

 

 

(1,143

)

(1,143

)

(1,143

)

Decrease in minimum pension liability, net of deferred income taxes

 

 

 

 

183

 

183

 

183

 

Total comprehensive income

 

 

 

 

 

 

 

 

 

 

 

$

7,605

 

Amortization of restricted stock award

 

 

76

 

 

 

76

 

 

 

Cash dividend declared on common stock, $.10 per share

 

 

 

(1,182

)

 

(1,182

)

 

 

Common stock repurchased

 

(72,000

)

(1,676

)

 

 

(1,676

)

 

 

Stock option expense

 

 

335

 

 

 

335

 

 

 

Stock options exercised

 

84,914

 

1,192

 

 

 

1,192

 

 

 

Balance, June 30, 2006

 

11,820,563

 

$

66,726

 

$

54,922

 

$

(3,681

)

$

117,967

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, January 1, 2007

 

11,656,943

 

$

62,363

 

$

62,452

 

$

(1,995

)

$

122,820

 

 

 

Net Income

 

 

 

8,048

 

 

8,048

 

$

8,048

 

Net change in unrealized gain/loss on securities available-for-sale and I/O strips, net of reclassification adjustment and deferred income taxes

 

 

 

 

(482

)

(482

)

(482

)

Decrease in minimum pension liability, net of deferred income taxes

 

 

 

 

31

 

31

 

31

 

Total comprehensive income

 

 

 

 

 

 

 

 

 

 

 

$

7,597

 

Issuance of 1,732,298 shares to acquire Diablo Valley Bank

 

1,732,298

 

41,397

 

 

 

41,397

 

 

 

Amortization of restricted stock award

 

 

76

 

 

 

76

 

 

 

Cash dividend declared on common stock, $.12 per share

 

 

 

(1,398

)

 

(1,398

)

 

 

Common stock repurchased

 

(60,200

)

(1,497

)

 

 

(1,497

)

 

 

Stock option expense

 

 

483

 

 

 

483

 

 

 

Stock options exercised

 

46,122

 

676

 

 

 

676

 

 

 

Balance, June 30, 2007

 

13,375,163

 

$

103,498

 

$

69,102

 

$

(2,446

)

$

170,154

 

 

 

 

See notes to consolidated financial statements

 

5



 

Heritage Commerce Corp

Consolidated Statements of Cash Flows (Unaudited)

 

 

 

Six Months Ended

 

 

 

June 30,

 

 

 

2007

 

2006

 

 

 

(As Restated

 

(As Restated

 

 

 

See Note 9)

 

See Note 9)

 

 

 

(Dollars in thousands)

 

CASH FLOWS FROM OPERATING ACTIVITIES:

 

 

 

 

 

Net income

 

$

8,048

 

$

8,565

 

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

 

 

 

 

 

Depreciation and amortization

 

307

 

343

 

Provision for loan losses

 

(236

)

(603

)

Stock option expense

 

483

 

335

 

Amortization of core deposit intangible

 

18

 

 

Amortization of restricted stock award

 

76

 

76

 

Amortization (accretion) of discounts and premiums on securities

 

51

 

(436

)

Gain on sale of Capital Group loan portfolio

 

 

(671

)

Gain on sale of SBA loans

 

(1,706

)

(1,668

)

Proceeds from sales of SBA loans held for sale

 

32,997

 

31,441

 

Change in SBA loans held for sale

 

(17,506

)

(26,157

)

Increase in cash surrender value of life insurance

 

(697

)

(707

)

Effect of changes in:

 

 

 

 

 

Accrued interest receivable and other assets

 

2,539

 

4,234

 

Accrued interest payable and other liabilities

 

(1,411

)

1,640

 

Net cash provided by operating activities

 

22,963

 

16,392

 

 

 

 

 

 

 

CASH FLOWS FROM INVESTING ACTIVITIES:

 

 

 

 

 

Net increase in loans

 

(11,312

)

(21,360

)

Proceeds from sale of Capital Group loan portfolio

 

 

30,047

 

Net decrease in Capital Group loan portfolio prior to sale

 

 

2,681

 

Purchases of securities available-for-sale

 

(9,322

)

(49,098

)

Maturities/paydowns/calls of securities available-for-sale

 

23,536

 

54,786

 

Purchase of premises and equipment

 

(107

)

(208

)

Redempton (purchase) of other investments

 

496

 

(124

)

Cash received in bank acquisition, net of cash paid

 

16,757

 

 

Net cash provided by investing activities

 

20,048

 

16,724

 

 

 

 

 

 

 

CASH FLOWS FROM FINANCING ACTIVITIES:

 

 

 

 

 

Net change in deposits

 

24,414

 

(31,272

)

Payment of other liability

 

 

(1,348

)

Exercise of stock options

 

676

 

1,192

 

Common stock repurchased

 

(1,497

)

(1,676

)

Payment of dividends

 

(1,398

)

(1,182

)

Net decrease in securities sold under agreement to repurchase

 

(10,900

)

(10,900

)

Net cash provided by (used in) financing activities

 

11,295

 

(45,186

)

Net increase (decrease) in cash and cash equivalents

 

54,306

 

(12,070

)

Cash and cash equivalents, beginning of period

 

49,385

 

98,460

 

Cash and cash equivalents, end of period

 

$

103,691

 

$

86,390

 

 

 

 

 

 

 

Supplemental disclosures of cash flow information:

 

 

 

 

 

Cash paid during the period for:

 

 

 

 

 

Interest

 

$

11,302

 

$

10,833

 

Income taxes

 

$

2,287

 

$

 

Supplemental schedule of non-cash investing and financing activities:

 

 

 

 

 

Loans transferred to foreclosed assets

 

$

487

 

$

 

Transfer of portfolio loans to loans held for sale

 

$

972

 

$

 

Transfer of loans held for sale to loan portfolio

 

$

921

 

$

530

 

Summary of assets acquired, and liabilities assumed through acquisition:

 

 

 

 

 

Cash and cash equivalents

 

$

41,807

 

$

 

Securities available-for-sale

 

$

12,214

 

$

 

Net loans

 

$

203,673

 

$

 

Goodwill and other intangible asset

 

$

48,221

 

$

 

Premises and equipment

 

$

6,847

 

$

 

Corporate owned life insurance

 

$

1,025

 

$

 

Federal Home Loan Bank Stock

 

$

717

 

 

 

Other assets, net

 

$

2,301

 

$

 

Deposits

 

$

(248,646

)

$

 

Other liabilities

 

$

(1,712

)

$

 

Common stock issued to acquire Diablo Valley Bank

 

$

41,397

 

$

 

 

See notes to consolidated financial statements

 

6


 


 

HERITAGE COMMERCE CORP
Notes to Consolidated Financial Statements

June 30, 2007
(Unaudited)

 

1)             Basis of Presentation

 

The unaudited consolidated financial statements of Heritage Commerce Corp (the “Company”) and its wholly owned subsidiary, Heritage Bank of Commerce (“HBC”), have been prepared pursuant to the rules and regulations for reporting on Form 10-Q.  Accordingly, certain information and notes required by accounting principles generally accepted in the United States of America (“GAAP”) for annual financial statements are not included herein.  The interim statements should be read in conjunction with the consolidated financial statements and notes that were included in the Company’s Form 10-K/A (Amendment No. 2) for the year ended December 31, 2006.  The Company has also established the following unconsolidated subsidiary grantor trusts: Heritage Capital Trust I; Heritage Statutory Trust I; Heritage Statutory Trust II; and Heritage Commerce Corp Statutory Trust III which are Delaware Statutory business trusts formed for the exclusive purpose of issuing and selling trust preferred securities.

 

HBC is a commercial bank serving customers located in Santa Clara, Alameda, and Contra Costa counties of California.  No customer accounts for more than 10 percent of revenue for HBC or the Company.  Management evaluates the Company’s performance as a whole and does not allocate resources based on the performance of different lending or transaction activities.  Accordingly, the Company and its subsidiary operate as one business segment.

 

In the Company’s opinion, all adjustments necessary for a fair presentation of these consolidated financial statements have been included and are of a normal and recurring nature.  All intercompany transactions and balances have been eliminated.

 

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods.  Actual results could differ significantly from these estimates.

 

Certain amounts reported in previous consolidated financial statements have been reclassified to conform to the 2007 presentation.

 

The results for the three and six months ended June 30, 2007 are not necessarily indicative of the results expected for any subsequent period or for the entire year ending December 31, 2007.

 

Adoption of New Accounting Standards

 

In February, 2006, FASB issued Statement 155, Accounting for Certain Hybrid Instruments. This standard amended the guidance in Statement 133, Accounting for Derivative Instruments and Hedging Activities, and Statement 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. Statement 155 permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation and clarifies which interest-only and principal-only strips are not subject to the requirements of Statement 133.  Statement 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. The adoption of this standard did not have a material impact on the Company’s financial statements.

 

In March, 2006, FASB issued Statement 156, Accounting for Servicing of Financial Assets - An Amendment of FASB Statement No. 140. This standard amends the guidance in Statement 140, with respect to the accounting for separately recognized servicing assets and servicing liabilities.   Among other requirements, Statement 156 requires an entity to recognize a servicing asset or servicing liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract in certain situations, including a transfer of loans with servicing retained that meets the requirements for sale accounting.  Statement 156 is effective as of the beginning of an

 

7



 

entity’s first fiscal year that begins after September 15, 2006.  The adoption of this standard did not have a material impact on the Company’s financial statements.

 

In June 2006, FASB issued FASB Interpretation (“FIN”) 48, Accounting for Uncertainty in Income Taxes. This Interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with Statement 109, Accounting for Income Taxes. This Interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. This Interpretation is effective for fiscal years beginning after December 15, 2006.

 

The Company adopted FIN 48 as of January 1, 2007.  Under FIN 48, a tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur.  The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination.  For tax positions not meeting the “more likely than not” test, no tax benefit is recorded. The adoption of this standard did not have a material impact on the Company’s financial statements.

 

The Company and its subsidiaries are subject to U.S. federal income tax as well as income tax of the State of California.  The Company is no longer subject to examination by taxing authorities for years before 2003.  The Company does not expect the total amount of unrecognized tax benefits to significantly increase in the next twelve months.

 

The Company recognizes interest and/or penalties related to income tax matters in income tax expense. The Company did not have any amounts accrued for interest and penalties at June 30, 2007.

 

In September 2006, the FASB Emerging Issues Task Force finalized Issue No. 06-5, Accounting for Purchases of Life Insurance - Determining the Amount That Could Be Realized in Accordance with FASB Technical Bulletin No. 85-4 (Accounting for Purchases of Life Insurance). This issue requires that a policyholder consider contractual terms of a life insurance policy in determining the amount that could be realized under the insurance contract.  It also requires that if the contract provides for a greater surrender value if all individual policies in a group are surrendered at the same time, that the surrender value be determined based on the assumption that policies will be surrendered on an individual basis.  Lastly, the issue discusses whether the cash surrender value should be discounted when the policyholder is contractually limited in its ability to surrender a policy.  This issue is effective for fiscal years beginning after December 15, 2006.  The adoption of this issue did not have a material impact on the financial statements.

 

Newly Issued but not yet Effective Accounting Standards

 

In September 2006, the FASB Emerging Issues Task Force finalized Issue No. 06-4, Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements.  This issue requires that a liability be recorded during the service period when a split-dollar life insurance agreement continues after participants’ employment or retirement.  The required accrued liability will be based on either the post-employment benefit cost for the continuing life insurance or based on the future death benefit depending on the contractual terms of the underlying agreement.  This issue is effective for fiscal years beginning after December 15, 2007.  Adoption of EITF Issue 06-4 is not expected to have a material effect on the Company’s financial statements.  In 2005, the Company began recognizing the cost of continuing life insurance coverage under split-dollar arrangements.  The recorded liability for split-dollar life insurance coverage was $1,277,000 and $1,113,000 at June 30, 2007 and 2006, respectively.

 

In September 2006, FASB issued Statement 157, Fair Value Measurements. This Statement defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. This Statement applies under other accounting pronouncements that require or permit fair value measurements,

 

8



 

FASB having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The adoption of this standard is not expected to have a material impact on the Company’s financial statements.

 

In February 2007, FASB issued Statement 159, The Fair Value Option for Financial Assets and Financial Liabilities. This statement provides companies with an option to report selected financial assets and liabilities at fair value.  The Standard’s objective is to reduce both complexity in accounting for financial instruments and the volatility in earnings caused by measuring related assets and liabilities differently.  The standard requires companies to provide additional information that will help investors and other users of financial statements to more easily understand the effect of the company’s choice to use fair value on its earnings. It also requires entities to display the fair value of those assets and liabilities for which the company has chosen to use fair value on the face of the balance sheet.  Statement 159 does not eliminate disclosure requirements included in other accounting standards, including requirements for disclosures about fair value measurements included in Statements 157, Fair Value Measurements, and 107, Disclosures about Fair Value of Financial Instruments.    This Statement is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. The Company has not completed its evaluation of Statement 159’s potential effects on its financial statements.

 

2)             Securities Available-for-Sale

 

The following table shows the gross unrealized losses and fair value of the Company’s securities with unrealized losses aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at June 30, 2007:

 

 

 

Less Than 12 Months

 

12 Months or More

 

Total

 

 

 

Fair

 

Unrealized

 

Fair

 

Unrealized

 

Fair

 

Unrealized

 

 

 

Value

 

Losses

 

Value

 

Losses

 

Value

 

Losses

 

 

 

(Dollars in thousands)

 

U.S. Treasury

 

$

4,895

 

$

6

 

$

 

$

 

$

4,895

 

$

6

 

U.S. Government Agencies

 

28,738

 

47

 

23,573

 

179

 

52,311

 

226

 

Mortgage-Backed

 

21,816

 

506

 

63,904

 

3,296

 

85,720

 

3,802

 

Municipals - Tax Exempt

 

 

 

6,877

 

112

 

6,877

 

112

 

Collateralized Mortgage Obligations

 

 

 

2,994

 

144

 

2,994

 

144

 

Total

 

$

55,449

 

$

559

 

$

97,348

 

$

3,731

 

$

152,797

 

$

4,290

 

 

As of June 30, 2007, the Company held 103 securities, of which 81 had fair values below amortized cost.  Fifty-four securities have been carried with an unrealized loss for over 12 months. Unrealized losses were primarily due to higher interest rates.  No security sustained a downgrade in credit rating.  The issuers are of high credit quality and all principal amounts are expected to be paid when securities mature. The fair value is expected to recover as the securities approach their maturity date and/or market rates decline.  Because the Company has the ability and intent to hold these securities until a recovery of fair value, which may be maturity, the Company does not consider these securities to be other-than-temporarily impaired at June 30, 2007.

 

Securities classified as U.S. Government Agencies as of June 30, 2007 and December 31, 2006 were issued by the Federal National Mortgage Association, Federal Home Loan Mortgage Corporation, and the Federal Home Loan Bank.

 

The securities portfolio of the Company is also used as collateral to meet requirements imposed as a condition of deposit by some depositors such as political subdivisions (public funds) bankruptcy trustees and other contractual

 

9



 

obligations such as repurchase agreements.  Securities with fair value of $46,365,000 and $57,909,000 as of June 30, 2007 and 2006 were pledged to secure public and certain other deposits as required by law or contract and other contractual obligations.  A portion of these deposits can only be secured by U.S. Treasury securities.  The Company has not used interest rate swaps or other derivative instruments to hedge fixed rate loans or to otherwise mitigate interest rate risk.

 

3)             Stock-Based Compensation

 

The Company has a stock option plan (the “Plan”) for directors, officers, and key employees. The Plan provides for the grant of incentive and non-qualified stock options. The Plan provides that the option price for both incentive and non-qualified stock options will be determined by the Board of Directors at no less than the fair value at the date of grant. Options granted vest on a schedule determined by the Board of Directors at the time of grant. Generally, options vest over four years. All options expire no later than ten years from the date of grant. As of June 30, 2007, there are 244,308 shares available for future grants under the Plan.  Option activity under the Plan is as follows:

 

 

 

 

 

 

 

Weighted
Average

 

 

 

 

 

 

 

Weighted

 

Remaining

 

Aggregate

 

 

 

Number

 

Average

 

Contractual

 

Intrinsic

 

Total Stock Options

 

of Shares

 

Exercise Price

 

Life

 

Value

 

Options Outstanding at January 1, 2007

 

752,983

 

$

16.56

 

 

 

 

 

Granted

 

194,500

 

$

24.01

 

 

 

 

 

Exercised

 

(46,122

)

$

8.81

 

 

 

 

 

Forfeited or expired

 

(23,323

)

$

20.93

 

 

 

 

 

Options Outstanding at June 30, 2007

 

878,038

 

$

18.50

 

7.5

 

$

4,635,000

 

Exercisable at June 30, 2007

 

433,373

 

$

14.41

 

6.0

 

$

4,026,000

 

 

Information related to the stock option plan during the six months ended June 30, 2007 and 2006 follows:

 

 

 

2007

 

2006

 

Intrinsic value of options exercised

 

$

715,000

 

$

1,188,000

 

Cash received from option exercise

 

$

406,000

 

$

785,000

 

Tax benefit realized from option exercises

 

$

270,000

 

$

407,000

 

Weighted average fair value of options granted

 

$

6.74

 

$

7.63

 

 

As of June 30, 2007, there was approximately $3,216,000 of total unrecognized compensation cost related to nonvested share-based compensation arrangements granted under the Company’s stock plan.  That cost is expected to be recognized over a weighted-average period of approximately 2.5 years.

 

10



 

The following table presents the assumptions used to estimate the fair value of options granted during the three months periods ending June 30, 2007 and 2006, respectively:

 

 

 

2007

 

2006

 

Expected life in months (1)

 

72

 

84

 

Volatility (1)

 

21

%

22

%

Risk-free interest rate (2)

 

4.68

%

4.87

%

Expected dividends (3)

 

1.00

%

0.87

%


(1)                Estimate based on historical experience.  Volatility is based on the historical volatility of the stock over the most recent period that is generally commensurate with the expected life of the option.

 

(2)                Based on the U.S. Treasury constant maturity interest rate with a term consistent with the expected life of the options granted.

 

(3)                The Company began paying cash dividends on common stock in 2006.  Each grant’s dividend yield is calculated by annualizing the most recent quarterly cash dividend and dividing that amount by the market price of the Company’s common stock as of the grant date.

 

The Company estimates the impact of forfeitures based on the Company’s historical experience with previously granted stock options in determining stock option expense.  The Company issues new shares of common stock to satisfy stock option exercises.

 

The Company awarded 51,000 restricted shares of common stock to Walter T. Kaczmarek, President and Chief Executive Officer of the Company, pursuant to the terms of a Restricted Stock Agreement dated March 17, 2005.  The grant price was $18.15.  Under the terms of the Restricted Stock Agreement, the restricted shares will vest 25% per year at the end of years three, four, five and six, provided Mr. Kaczmarek is still with the Company.  Compensation cost associated with the restricted stock issued is measured based on the market price of the stock at the grant date and is expensed on a straight-line basis over the service period.  Restricted stock compensation expense for the three and six months ended June 30, 2007 and 2006 were $38,000 and $76,000, respectively.

 

4)             Earnings Per Share

 

Basic earnings per share is computed by dividing net income by the weighted average common shares outstanding.  Diluted earnings per share reflects potential dilution from outstanding stock options, using the treasury stock method.  There were 337,174 and 92,174 stock options for three months ended June 30, 2007 and 2006 and 279,381 and 90,096 for six months ended June 30, 2007 and 2006, respectively, considered to be antidilutive and excluded from the computation of diluted earnings per share.  For each of the periods presented, net income is the same for basic and diluted earnings per share.  Reconciliation of weighted average shares used in computing basic and diluted earnings per share is as follows:

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

June 30,

 

June 30,

 

 

 

2007

 

2006

 

2007

 

2006

 

Weighted average common shares outstanding - used in computing basic earnings per share

 

11,798,627

 

11,835,202

 

11,700,374

 

11,828,510

 

Dilutive effect of stock options outstanding, using the treasury stock method

 

187,608

 

195,844

 

198,605

 

202,751

 

Shares used in computing diluted earnings per share

 

11,986,235

 

12,031,046

 

11,898,979

 

12,031,261

 

 

11



 

5)             Comprehensive Income

 

Comprehensive income includes net income and other comprehensive income, which represents the changes in net assets during the period from non-owner sources. The Company’s sources of other comprehensive income are unrealized gains and losses on securities available-for-sale and I/O strips, which are treated like available-for-sale securities, and the liability related to the Company’s supplemental retirement plan.  The items in other comprehensive income are presented net of deferred income tax effects. Reclassification adjustments result from gains or losses on securities that were realized and included in net income of the current period that also had been included in other comprehensive income as unrealized gains and losses.  The Company’s comprehensive income was as follows:

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

June 30,

 

June 30,

 

 

 

2007

 

2006

 

2007

 

2006

 

 

 

(Dollars in thousands)

 

Net Income

 

$

4,015

 

$

4,189

 

$

8,048

 

$

8,565

 

Other comprehensive income (loss):

 

 

 

 

 

 

 

 

 

Unrealized gains (losses) on available-for-sale of securities and I/O strips during the period

 

(1,293

)

(784

)

(830

)

(1,833

)

Deferred income tax

 

543

 

329

 

348

 

690

 

Net unrealized gains (losses) on available-for-sale securities and I/O strips, net of deferred income tax

 

(750

)

(455

)

(482

)

(1,143

)

 

 

 

 

 

 

 

 

 

 

Pension liability adjustment during the period

 

26

 

36

 

53

 

316

 

Deferred income tax

 

(11

)

(15

)

(22

)

(133

)

Pension liability adjustment, net of deferred income tax

 

15

 

21

 

31

 

183

 

Other comprehensive income (loss)

 

(735

)

(434

)

(451

)

(960

)

Comprehensive income

 

$

3,280

 

$

3,755

 

$

7,597

 

$

7,605

 

 

6)             Supplemental Retirement Plan

 

The Company has a supplemental retirement plan covering current and former key executives and directors (“Plan”).  The Plan is a nonqualified defined benefit plan.  Benefits are unsecured as there are no Plan assets.  The following table presents the amount of periodic cost recognized for the three months ended June 30, 2007 and 2006:

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

June 30,

 

June 30,

 

 

 

2007

 

2006

 

2007

 

2006

 

 

 

(Dollars in thousands)

 

Components of net periodic benefits cost

 

 

 

 

 

 

 

 

 

Service cost

 

$

184

 

$

200

 

$

368

 

$

400

 

Interest cost

 

155

 

138

 

310

 

276

 

Prior service cost

 

9

 

9

 

18

 

18

 

Amortization of loss

 

17

 

36

 

34

 

72

 

Net periodic cost

 

$

365

 

$

383

 

$

730

 

$

766

 

 

12



 

7)    Commitments and Contingencies

 

Financial Instruments with Off-Balance Sheet Risk

 

HBC is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its clients. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk, in excess of the amounts recognized in the balance sheets.

 

Heritage Bank of Commerce’s exposure to credit loss in the event of non-performance of the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. HBC uses the same credit policies in making commitments and conditional obligations as it does for loans. Credit risk is the possibility that a loss may occur because a party to a transaction fails to perform according to the terms of the contract. HBC controls the credit risk of these transactions through credit approvals, limits, and monitoring procedures. Management does not anticipate any significant losses as a result of these transactions.

 

Commitments to extend credit as of June 30, 2007 and December 31, 2006 were as follows:

 

 

 

June 30,

 

December 31,

 

 

 

2007

 

2006

 

 

 

(Dollars in thousands)

 

Commitments to extend credit

 

$

436,650

 

$

310,200

 

Standby letters of credit

 

12,154

 

12,020

 

 

 

$

448,804

 

$

322,220

 

 

Generally, commitments to extend credit as of June 30, 2007 are at variable rates, typically based on the prime rate (with a margin). Commitments generally expire within one year.

 

Commitments to extend credit are agreements to lend to a client as long as there is no violation of conditions established in the contract. Commitments generally have fixed expiration dates or other termination clauses. Since some of the commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements. HBC evaluates each client’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by HBC upon the extension of credit, is based on management’s credit evaluation of the borrower. Collateral held varies but may include cash, marketable securities, accounts receivable, inventory, property, plant and equipment, income-producing commercial properties, and/or residential properties. Fair value of these instruments is not material.

 

Standby letters of credit are written with conditional commitments issued by HBC to guarantee the performance of a client to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to clients.

 

8)    Acquisition

 

The Company completed its acquisition of Diablo Valley Bank on June 20, 2007.  The transaction was valued at approximately $65 million, including payments for cancellation of options for Diablo Valley Bank common stock.  The merger consideration consisted of approximately $24 million in cash and the issuance of 1,732,298 shares of the Company’s common stock in exchange for all outstanding Diablo Valley Bank shares and stock options.  Prior to closing, Diablo Valley Bank redeemed all of its outstanding Series A Preferred Stock for an aggregate of approximately $6.7 million in cash (including dividend payments).  The unaudited consolidated financial statements of the Company for the three and six months ended June 30, 2007 include preliminary purchase accounting adjustments to record the assets and liabilities of Diablo Valley Bank at their estimated fair values.  The purchase accounting adjustments are subject to further refinement as more information becomes available.

 

13



 

The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition.  The Company is in the process of finalizing the purchase accounting for the acquisition.

 

Cash and cash equivalents

 

$

41,807

 

Securities available-for-sale

 

12,214

 

Net loans

 

203,673

 

Goodwill

 

43,172

 

Core deposit intangible asset

 

5,049

 

Premises and equipment

 

6,847

 

Corporate owned life insurance

 

1,025

 

Federal Home Loan Bank Stock

 

717

 

Other assets, net

 

2,301

 

Total assets acquired

 

316,805

 

 

 

 

 

Deposits

 

(248,646

)

Other liabilities

 

(1,712

)

Total liabilities

 

(250,358

)

Net assets acquired

 

$

66,447

 

 

The Company’s cost to acquire Diablo Valley Bank is summarized as follows:

 

Cash paid to Diablo Valley Bank common shareholders and stock option holders

 

$

24,000

 

Common stock issued to Diablo Valley Bank shareholders

 

41,397

 

Total consideration

 

65,397

 

Professional fees and other acquisition costs

 

1,050

 

Net assets acquired

 

$

66,447

 

 

The results of operations of Diablo Valley Bank for the ten day period starting on June 21, 2007 to June 30, 2007 are included in the income statement of the combined entity. Diablo Valley Bank was acquired by the Company for several reasons.  Diablo Valley Bank was a profitable and fast growing bank in a geographic area where the Company wanted to expand.  Diablo Valley Bank had experienced staff and the acquisition also enhanced the Company’s position in the East Bay area in the cities of Danville and Pleasanton. The Company believes it can achieve significant cost savings from merging Diablo Valley Bank into Heritage Bank of Commerce.

 

The following table presents pro forma information for the periods ended June 30 as if the acquisition had occurred at the beginning of the period presented.  The pro forma financial information is not necessarily indicative of the results of operations as they would have been had the transaction been effected on the assumed date and is not intended to be a projection of future results.

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

June 30,

 

June 30,

 

 

 

2007

 

2006

 

2007

 

2006

 

 

 

(Dollars in thousands, except per share data)

 

Net interest income

 

$

14,651

 

$

14,724

 

$

28,778

 

$

28,875

 

Net income

 

$

4,486

 

$

4,347

 

$

8,845

 

$

8,895

 

Net income per share - basic

 

$

0.34

 

$

0.32

 

$

0.66

 

$

0.66

 

Net income per share - diluted

 

$

0.33

 

$

0.32

 

$

0.65

 

$

0.65

 

 

14



 

9)    Restatement

 

On December 6, 2007, Heritage Commerce Corp management recommended to the Audit Committee of the Company’s Board of Directors and the Audit Committee agreed that the Company’s consolidated balance sheets for the years ended December 31, 2006 and 2005, and consolidated statements of cash flows for the years ended December  31, 2006, 2005, and 2004, and for the quarters ended March 31, 2007, June 30, 2007 and September 30, 2007 should be restated and the previously issued consolidated financial statements and any related reports from its independent registered public accounting firms should no longer be relied upon. The restatement does not change the Company’s revenues, net income, earnings per share, total assets, liabilities, shareholders’ equity, regulatory capital, or the net change in cash and cash equivalents for any of the periods reported.

 

In this Amendment No. 1 to our Form 10-Q for the quarter ended June 30, 2007, we are restating our consolidated balance sheets as of June 30, 2007 and December 31, 2006, and consolidated statements of cash flows for the six months ended June 30, 2007 and 2006.

 

The financial statements are being restated as a result of the following accounting errors:

 

·      The Company transferred its Capital Group loan portfolio of approximately $32 million from commercial loans to loans held for sale at December 31, 2005. In the first quarter of 2006, the Company sold the Capital Group loan portfolio for a gain of $671,000.  The gain was included in the “Gain on sale of loans” category in the 2006 Consolidated Statement of Cash Flows.  However, the $30,047,000 of proceeds from the Capital Group loan portfolio sale were incorrectly included in “Proceeds from sales of loans held for sale” under operating activities on the Consolidated Statement of Cash Flows in the Form 10-K for the year ended December 31, 2006 instead of investing activities. Since the Capital Group loan portfolio was not specifically acquired for resale, the proceeds from its sale, as well as the net decrease in the portfolio between December 31, 2005 and the sale date, should have been reported as investing activities to comply with the guidance in Statement of Financial Accounting Standards No. 102, “Statement of Cash Flows—Exemption of Certain Enterprises and Classification of Cash Flows from Certain Securities Acquired for Resale.”  This error has been corrected in this Amendment No. 1 to the Form 10-Q for the quarter ended June 30, 2007 by reporting the Capital Group loan portfolio sale proceeds, as well as the net reduction of the portfolio prior to its sale, as cash flows from investing activities in 2006, with an offsetting change in cash flows from operating activities.

 

·      The line items called “Originations of loans held for sale” and “Maturities of loans held for sale” on the consolidated statements of cash flows were overstated for all periods presented. However, the overstatements of these two amounts largely offset each other.  These matters are discussed in more detail as follows:

 

“Originations of loans held for sale” in our Consolidated Statements of Cash Flows consisted of the gross amount (not just the guaranteed portion) of government guaranteed loans that were funded during the respective periods.  These loans are guaranteed, typically to the extent of 75% to 85% of the respective loan balance, by the United States Small Business Administration or the U.S. Department of Agriculture.  We typically refer to such loans partially guaranteed by the U.S. Government as “SBA loans.”

 

In 2006, the amount reported as “Maturities of loans held for sale” included $2,681,000 of net principal reductions in the Capital Group loan portfolio that occurred prior to sale.  The rest of the amounts reported as “Maturities of loans held for sale” represented the remaining change in the guaranteed portion of loans held for sale during the period (after gains on sale, sale proceeds, and the gross amount of new loan originations), including any transfers (such as when a loan was no longer eligible for sale because it became 30 days or more delinquent or because we received notice of a forthcoming payoff).

 

On our consolidated balance sheet as of December 31, 2005, loans held for sale consisted of the Capital Group loan portfolio and the guaranteed portion of SBA loans that were eligible for sale.  At other year-ends and quarter-ends, including December 31, 2006, loans held for sale consisted of the guaranteed portion of SBA loans that were eligible for sale.

 

15



 

SBA loans include construction loans, term loans secured by inventory and equipment, and lines of credit.  Construction loans typically have multiple disbursements.  Loans secured by inventory and equipment also may have multiple disbursements, such as when different pieces of equipment or inventory are purchased from different vendors at different times.  SBA loans are not eligible for sale until they are fully disbursed.  Loans can be held for a number of months before they are sold.  During such holding period, principal reductions can be made by the borrowers and some loans are paid off, such as through refinancing by another lender.

 

·      In our consolidated financial statements for all the reported periods, the determination to sell all SBA loans was made at the time of loan origination. All of the SBA loans were initially recorded in the portfolio (not held for sale), and then reclassified to Loans Held for Sale during the month they met the eligibility criteria for a saleable SBA loan.  To be eligible for sale, an SBA loan must be (a) fully funded; (b) not 30 days or more delinquent or in non accrual or charge off status; and (c) not subject to a notice of payoff from the borrower or another lender, such as through a refinancing.  We believed it was reasonable to hold loans in portfolio until they were eligible for sale.  However, after reviewing the guidance in Statement of Position 01-6 “Accounting by Certain Entities (Including Entities with Trade Receivables) That Lend to or Finance the Activities of Others”, management determined that we will restate our financial statements to report SBA loans held for sale at the time of origination, regardless of when the loans satisfy all of the sale eligibility criteria.

 

Held-for-sale loans may be classified back to the Company’s loan portfolio if they no longer meet the sale eligibility criteria.  Loans could be classified as held-for-sale for a number of months depending on loan production and market conditions.  In the restated financial statements, such transfers are separately disclosed in our Consolidated Statements of Cash Flows as a non cash investing activity.

 

The restatement affects the amounts reported as “Loans held for sale, at lower of cost or market” and “Loans, net of deferred costs” in the consolidated balance sheets as of June 30, 2007 and December 31, 2006, but it has no impact on total assets, liabilities or shareholders’ equity.  The restatement also affects the totals on the consolidated statements of cash flows for the six months ended June 30, 2007 and 2006 for operating and investing activities, but has no impact on the net increase (decrease) in cash and cash equivalents for any period. The restatement does not change the Company’s consolidated statements of income and consolidated statements of changes in stockholders’ equity for any period.

 

·      Two loans totaling $972,000 were transferred from the portfolio to loans held for sale in the first quarter of 2007. These loans were transferred from held for sale to portfolio upon the receipt of payoff notification in 2006. When the payoffs did not materialize, the loans were transferred back to held for sale in the first quarter of the 2007.

 

16



 

Restatements on the consolidated balance sheets as of June 30, 2007 and December 31, 2006 are as follows:

 

June 30, 2007

 

As Previously
Reported

 

As Restated

 

Adjustments

 

 

 

(Dollars in thousands)

 

Loans held for sale, at lower of cost or market

 

$

6,095

 

$

20,018

 

$

13,923

 

 

 

 

 

 

 

 

 

Loans, net of deferred costs

 

$

939,667

 

$

925,744

 

$

(13,923

)

Allowance for loan losses

 

(11,104

)

(11,104

)

 

Loans, net

 

$

928,563

 

$

914,640

 

$

(13,923

)

 

 

 

 

 

 

 

 

December 31, 2006

 

As Previously
Reported

 

As Restated

 

Adjustments

 

 

 

(Dollars in thousands)

 

Loans held for sale, at lower of cost or market

 

$

17,234

 

$

33,752

 

$

16,518

 

 

 

 

 

 

 

 

 

Loans, net of deferred costs

 

$

725,754

 

$

709,236

 

$

(16,518

)

Allowance for loan losses

 

(9,279

)

(9,279

)

 

Loans, net

 

$

716,475

 

$

699,957

 

$

(16,518

)

 

Restatements on the consolidated statements of cash flows for the six months ended June 30, 2007 and 2006 are as follows:

 

June 30, 2007

 

As Previously
Reported

 

As Restated

 

Adjustments

 

 

 

(Dollars in thousands)

 

CASH FLOWS FROM OPERATING ACTIVITIES:

 

 

 

 

 

 

 

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

 

 

 

 

 

 

 

Change in SBA loans held for sale

 

$

12,845

 

$

(17,506

)

$

(30,351

)

Proceeds from sales of SBA loans held for sale

 

$

 

$

32,997

 

$

32,997

 

Net cash provided by operating activities

 

$

20,317

 

$

22,963

 

$

2,646

 

 

 

 

 

 

 

 

 

CASH FLOWS FROM INVESTING ACTIVITIES:

 

 

 

 

 

 

 

Net change in loans

 

$

(8,666

)

$

(11,312

)

$

(2,646

)

Net cash provided by investing activities

 

$

22,694

 

$

20,048

 

$

(2,646

)

 

 

 

 

 

 

 

 

Supplemental schedule of non-cash investing activity:

 

 

 

 

 

 

 

Transfer of portfolio loans to loans held for sale

 

$

 

$

972

 

$

972

 

Transfer of loans held for sale to portfolio loans

 

$

 

$

921

 

$

921

 

 

17



 

June 30, 2006

 

As Previously
Reported

 

As Restated

 

Adjustments

 

 

 

(Dollars in thousands)

 

CASH FLOWS FROM OPERATING ACTIVITIES:

 

 

 

 

 

 

 

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

 

 

 

 

 

 

 

Gain on sale of Capital Group loan portfolio

 

$

 

$

(671

)

$

(671

)

Gain on sale of SBA loans

 

$

 

$

(1,668

)

$

(1,668

)

Gain on sale of loans

 

$

(2,339

)

$

 

$

2,339

 

Proceeds from sales of SBA loans held for sale

 

$

 

$

31,441

 

$

31,441

 

Change in loans held for sale

 

$

42,161

 

 

(42,161

)

Change in SBA loans held for sale

 

$

 

$

(26,157

)

$

(26,157

)

Net cash provided by operating activities

 

$

53,269

 

$

16,392

 

$

(36,877

)

 

 

 

 

 

 

 

 

CASH FLOWS FROM INVESTING ACTIVITIES:

 

 

 

 

 

 

 

Net increase in loans

 

$

(25,509

)

$

(21,360

)

$

4,149

 

Proceeds from sale of Capital Group loan portfolio

 

$

 

$

30,047

 

$

30,047

 

Net decrease in Capital Group loan portfolio prior to sale

 

$

 

$

2,681

 

$

2,681

 

Net cash provided by investing activities

 

$

(20,153

)

$

16,724

 

$

36,877

 

 

 

 

 

 

 

 

 

Supplemental schedule of non-cash investing activity:

 

 

 

 

 

 

 

Transfer of loans held for sale to portfolio loans

 

$

 

$

530

 

$

530

 

 

ITEM 2 — MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The following discussion and analysis gives effect to the restatement discussed in Note 9 to the restated financial statements.

 

Discussions of certain matters in this Report on Form 10-Q/A may constitute forward looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and as such, may involve risks and uncertainties. Forward-looking statements, which are based on certain assumptions and describe future plans, strategies, and expectations, are generally identifiable by the use of words such as “believe”, “expect”, “intend”, “anticipate”, “estimate”, “project”, “assume”, “plan”, “predict”, “forecast” or similar expressions. These forward-looking statements relate to, among other things, expectations of the business environment in which the Company operates, projections of future performance, potential future performance, potential future credit experience, perceived opportunities in the market, and statements regarding the Company’s mission and vision. The Company’s actual results, performance, and achievements may differ materially from the results, performance, and achievements expressed or implied in such forward-looking statements due to a wide range of factors. These factors include, but are not limited to, consummation of the acquisition of Diablo Valley Bank and the successful integration of its business, customers, employees and operations with the Company, changes in interest rates, reducing interest margins or increasing interest rate risk, general economic conditions nationally or, in the State of California, legislative and regulatory changes adversely affecting the business in which the Company operates, monetary and fiscal policies of the US Government, real estate valuations, the availability of sources of liquidity at a reasonable cost, competition in the financial services industry, and other risks. All of the Company’s operations and most of its customers are located in California.  In addition, acts and threats of terrorism or the impact of military conflicts have increased the

 

18



 

uncertainty related to the national and California economic outlook and could have an effect on the future operations of the Company or its customers, including borrowers. See “Item 1A — Risk Factors” in this Report on Form 10-Q/A and in Item 1-A- Risk Factors” in our Annual Report Amendment No. 2 on Form 10-K/A for the Year ended December 31, 2006 for further discussions of factors that could cause actual result to differ from forward looking statements. The Company does not undertake, and specifically disclaims any obligation, to update any forward-looking statements to reflect occurrences or unanticipated events or circumstances after the date of such statements.

 

EXECUTIVE SUMMARY

 

This summary is intended to identify the most important matters on which management focuses when it evaluates the financial condition and performance of the Company.  When evaluating financial condition and performance, management looks at certain key metrics and measures.  The Company’s evaluation includes an analysis including comparisons with peer group financial institutions and with its own performance objectives established in the internal planning process.

 

The primary activity of the Company is commercial banking.  The Company’s operations are located entirely in the southern and eastern regions of the general San Francisco Bay area of California in the counties of Santa Clara, Alameda and Contra Costa.  The largest city in this area is San Jose and the Company’s market includes the headquarters of a number of technology based companies in the region known commonly as Silicon Valley.  The Company’s customers are primarily closely held businesses and professionals.

 

The merger with Diablo Valley Bank was completed on June 20, 2007 for approximately $65 million payable in approximately $24 million in cash and 1,732,298 shares of the Company’s common stock. The unaudited consolidated financial statements of the Company for the three and six months ended June 30, 2007 include preliminary purchase accounting adjustments to record the assets and liabilities of Diablo Valley Bank at their estimated fair values.  The Company recorded goodwill in connection with the transaction of $43,172,000 and a core deposit intangible asset of $5,049,000. The 10 day period from the closing date to June 30, 2007 did not result in a material effect on the Company’s revenues and expenses, net interest margin, or net income.

 

Performance Overview

 

For the three months and six months ended June 30, 2007, consolidated net income was $4.0 million and $8.0 million, compared to $4.2 million and $8.6 million for the three and six months ended June 30, 2006, a decrease of 4% and 6%, respectively.  Earnings per diluted share were $.33 and $.68 for the three and six months ended June 30, 2007, compared to $.35 and $.71 for the three and six months ended June 30, 2006, a decrease of 6% and 4%, respectively. The Company’s return on average assets and return on average equity for the three months ended June 30, 2007 were 1.50% and 12.17%, compared to 1.50% and 14.35%, for the same period in 2006, respectively.  Returns on average assets and average equity for the first six months of 2006 were 1.53% and 12.63%, compared to 1.55% and 14.93% for the first six months of 2006, respectively.

 

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

 

·                  Net interest income decreased 2% to $12.4 million for the three months ended June 30, 2007, compared to $12.7 million for the three months ended June 30, 2006 and decreased 3% for the six months ended June 30, 2007 compared to 2006, primarily due to a decrease in average interest earning assets.

 

·                  Noninterest income remained at $2.3 million for the three months ended June 30, 2007, compared to the three months ended June 30, 2006.  Year-to-date noninterest income decreased 7% for the six months ended June 30, 2007 from 2006, primarily due to a decrease of 27% in 2007 in gain on sale of loans, or $633,000, compared to 2006.  The six month period in 2006 also benefited from a $671,000 nonrecurring gain on the sale of the Capital Group loan portfolio in the first quarter of 2006.

 

·                  The efficiency ratio was 58.00% and 58.13% for the three and six months ended June 30, 2007, compared to 57.06% and 57.57% for the three and six months ended June 30, 2006, respectively.

 

19



 

·                  No provision for loan losses was recorded in the second quarter of 2007, compared to a reverse provision for loan losses of $114,000 in the second quarter of 2006.  The year-to-date reverse provision for loan losses was $236,000 in 2007, compared to a reverse provision of $603,000 a year ago.  The reverse provision in 2007 was due to continued improvement in credit quality, excluding the loans acquired in the Diablo Valley Bank merger.

 

·                  Nonperforming assets at June 30, 2007 increased to $6.3 million, or 290%, from June 30, 2006 levels.  Nonperforming assets increased by $2.0 million, or 46%, compared to December 31, 2006.  Approximately $3.7 million of the nonperforming assets were acquired in the Diablo Valley Bank merger.

 

Deposits

 

Growth in deposits is an important metric management uses to measure market share.  The Company’s depositors are primarily located in its primary market area.  Depending on loan demand and other funding requirements, the Company occasionally obtains deposits from wholesale sources including deposit brokers.  The Company had $65 million in brokered deposits at June 30, 2007.  The Company also seeks deposits from title insurance companies and real estate exchange facilitators.  The Company has a policy to monitor all deposits that may be sensitive to interest rate changes to help assure that liquidity risk does not become excessive due to concentrations.  As a result of the merger with Diablo Valley Bank, deposits increased $257 million.

 

Lending

 

Our lending business originates primarily through our branch offices.  The economy in our primary service area has continued to stabilize in 2007.  Commercial loans increased for the period ended June 30, 2007 from June 30, 2006, primarily from increased loan demand reflecting the improving economy in our primary service area.  Commercial real estate mortgage loans increased for the period ended June 30, 2007 from June 30, 2006, primarily due to general improvements in commercial income property markets.  We will continue to use and improve existing products to expand market share at current locations.  As a result of the merger with Diablo Valley Bank, loans increased $214 million.

 

Net Interest Income

 

The management of interest income and interest expense is fundamental to the performance of the Company.  Net interest income, the difference between interest income and interest expense, is the largest component of the Company’s total revenue.  Management closely monitors both net interest income and the net interest margin (net interest income divided by average earning assets).

 

Increases in short-term interest rates contributed to growth in net interest income since the interest rate earned on a majority of the Company’s loan portfolio adjusts with the prime rate.  Approximately 76% of the Company’s loan portfolio is indexed to the prime rate.  The Federal Open Market Committee (“FOMC”) increased short term rates in one quarter percent increments in January, March, May, and June of 2006.  The prime rate increased from 7.25% in January of 2006 to 8.25% in June of 2006.  The prime rate has remained at 8.25% since June of 2006. The improvement in net interest margin in the second quarter of 2007 from a year ago is largely attributable to the FOMC action.  Because of its focus on commercial lending to closely held businesses, the Company continues to have a high percentage of floating rate loans and other assets.  Given the current volume, mix and repricing characteristics of our interest-bearing liabilities and interest-earning assets, we believe our interest rate spread is expected to increase slightly in a rising rate environment, and decrease slightly in a declining interest rate scenario.

 

The Company, through its asset and liability policies and practices, seeks to maximize net interest income without exposing the Company to an excessive level of interest rate risk.  Interest rate risk is managed by monitoring the pricing, maturity and repricing options of all classes of interest bearing assets and liabilities.

 

20



 

Management of Credit Risk

 

Because of its focus on business banking, loans to single borrowing entities are often larger than would be found in a more consumer oriented bank with many smaller, more homogenous loans.  The average size of its relationships makes the Company more susceptible to larger losses.  As a result of this concentration of larger risks, the Company has maintained an allowance for loan losses which is substantially higher than would be indicated by its actual historic loss experience.

 

Noninterest Income

 

While net interest income remains the largest single component of total revenues, noninterest income is an important component.  A significant percentage of the Company’s noninterest income is associated with its SBA lending activity, either as gains on the sale of loans sold in the secondary market or servicing income from loans sold with servicing retained. However, beginning in the third quarter of 2007, the Company decided to change its strategy regarding its SBA loan business.  The Company will retain most new SBA production in lieu of selling it.  As a result, the Company expects its noninterest income will be lower in the second half of 2007, compared to the second half of 2006.

 

Risks associated with the continuation of this level of noninterest income from SBA lending include the possibility that the federal government will eliminate or change SBA programs in a manner that becomes less attractive to the Company or to SBA borrowers.  Further, change in the secondary market for SBA loans could reduce gains on sale.  Higher than expected prepayments of SBA loans on which the Company has retained servicing could reduce the carrying value of the associated servicing asset and interest only strip.

 

Noninterest Expense

 

Management considers the control of operating expenses to be a critical element of the Company’s performance.  Over the last three years, the Company has undertaken several initiatives to reduce its noninterest expense and improve its efficiency.  These initiatives included a reduction in staff and the consolidation of operations under the common Heritage Bank brand and restructuring each department.  Management monitors progress in reducing noninterest expense through review of the Company’s efficiency ratio.  The Company’s efficiency ratio was 58.00% in the second quarter of 2007, compared with 57.06% in the second quarter of 2006, and 58.13% for the six months ended June 30, 2007, compared to 57.57% in 2006.

 

Capital Management and Share Repurchases

 

Heritage Commerce Corp and Heritage Bank of Commerce meet the regulatory definition of “well capitalized” at June 30, 2007.  As part of its asset and liability process, the Company continually assesses its capital position to take into consideration growth, expected earnings, risk profile and potential corporate activities that it may choose to pursue.  On July 26, 2007, the Board of Directors authorized the repurchase of up to an additional $30 million of common stock over the next two years.

 

RESULTS OF OPERATIONS

 

The Company earns income from two primary sources. The first is net interest income, which is interest income generated by earning assets less interest expense on interest-bearing liabilities.  The second is noninterest income, which primarily consists of gains from the sale of loans, loan servicing fees, and customer service charges and fees as well as non-customer sources such as Company-owned life insurance. The majority of the Company’s noninterest expenses are operating costs that relate to providing a full range of banking services to our customers.

 

Net Interest Income and Net Interest Margin

 

Net interest income is the largest component of the Company’s total revenue.  Net interest income is the difference

 

21



 

between the interest and fees earned on loans and investments and interest expense on deposits and other liabilities.  Net interest income depends on two factors: (1) the volume or balance of earning assets compared to the volume or balance of interest bearing deposits and liabilities, and (2) the interest rate earned on those interest earning assets compared with the interest rate on those interest bearing assets and liabilities.  Net interest margin is net interest income expressed as a percentage of average earning assets.  To maintain its net interest margin, the Company must manage the relationship between interest earned and paid.

 

The following table presents the average amounts outstanding for the major categories of the Company’s balance sheet, the average interest rates earned or paid thereon, and the resulting net interest margin on average interest earning assets for the periods indicated.  Average balances are based on daily averages.

 

Average Balance, Rate and Yield

 

 

 

For the Three Months Ended

 

 

 

June 30,

 

 

 

2007

 

2006

 

 

 

 

 

Interest

 

Average

 

 

 

Interest

 

Average

 

 

 

Average

 

Income /

 

Yield /

 

Average

 

Income /

 

Yield /

 

 

 

Balance

 

Expense

 

Rate

 

Balance

 

Expense

 

Rate

 

 

 

(Dollars in thousands)

 

Assets:

 

 

 

 

 

 

 

 

 

 

 

 

 

Loans, gross

 

$

743,160

 

$

15,589

 

8.41

%

$

735,311

 

$

15,344

 

8.37

%

Securities

 

171,896

 

1,982

 

4.62

%

195,743

 

1,977

 

4.05

%

Interest bearing deposits in other financial institutions

 

3,243

 

40

 

4.95

%

2,728

 

42

 

6.18

%

Federal funds sold

 

53,717

 

706

 

5.27

%

83,508

 

1,029

 

4.94

%

Total interest earning assets

 

972,016

 

$

18,317

 

7.56

%

1,017,290

 

$

18,392

 

7.25

%

Cash and due from banks

 

33,305

 

 

 

 

 

36,224

 

 

 

 

 

Premises and equipment, net

 

3,111

 

 

 

 

 

2,393

 

 

 

 

 

Other assets

 

66,839

 

 

 

 

 

64,201

 

 

 

 

 

Total assets

 

$

1,075,271

 

 

 

 

 

$

1,120,108

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Liabilities and shareholders' equity:

 

 

 

 

 

 

 

 

 

 

 

 

 

Deposits:

 

 

 

 

 

 

 

 

 

 

 

 

 

Demand, interest bearing

 

$

141,230

 

$

780

 

2.22

%

$

148,635

 

$

830

 

2.24

%

Savings and money market

 

328,580

 

2,456

 

3.00

%

373,697

 

2,698

 

2.90

%

Time deposits, under $100

 

30,872

 

301

 

3.91

%

32,264

 

251

 

3.12

%

Time deposits, $100 and over

 

102,284

 

1,067

 

4.18

%

111,024

 

929

 

3.36

%

Brokered time deposits, $100 and over

 

53,698

 

617

 

4.61

%

34,489

 

325

 

3.78

%

Notes payable to subsidiary grantor trusts

 

23,702

 

583

 

9.87

%

23,702

 

575

 

9.73

%

Securities sold under agreement to repurchase

 

16,407

 

120

 

2.93

%

25,722

 

158

 

2.46

%

Total interest bearing liabilities

 

696,773

 

$

5,924

 

3.41

%

749,533

 

$

5,766

 

3.09

%

Demand, noninterest bearing

 

223,415

 

 

 

 

 

228,891

 

 

 

 

 

Other liabilities

 

22,736

 

 

 

 

 

24,558

 

 

 

 

 

Total liabilities

 

942,924

 

 

 

 

 

1,002,982

 

 

 

 

 

Shareholders' equity

 

132,347

 

 

 

 

 

117,126

 

 

 

 

 

Total liabilities and shareholders' equity

 

$

1,075,271

 

 

 

 

 

$

1,120,108

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net interest income / margin

 

 

 

$

12,393

 

5.11

%

 

 

$

12,626

 

4.98

%

 

Note: Yields and amounts earned on loans include loan fees of $0 and $165,000 for the three month periods ended June 30, 2007 and 2006, respectively.  Nonaccrual loans are included in the average balance calculation above.

 

22



 

 

 

For the Six Months Ended

 

 

 

June 30,

 

 

 

2007

 

2006

 

 

 

 

 

Interest

 

Average

 

 

 

Interest

 

Average

 

 

 

Average

 

Income /

 

Yield /

 

Average

 

Income /

 

Yield /

 

 

 

Balance

 

Expense

 

Rate

 

Balance

 

Expense

 

Rate

 

 

 

(Dollars in thousands)

 

Assets:

 

 

 

 

 

 

 

 

 

 

 

 

 

Loans, gross

 

$

731,255

 

$

30,259

 

8.34

%

$

737,840

 

$

30,065

 

8.22

%

Securities

 

172,603

 

3,934

 

4.60

%

198,394

 

3,769

 

3.83

%

Interest bearing deposits in other financial institutions

 

2,936

 

73

 

5.01

%

2,783

 

60

 

4.35

%

Federal funds sold

 

49,080

 

1,285

 

5.28

%

74,583

 

1,758

 

4.75

%

Total interest earning assets

 

955,874

 

$

35,551

 

7.50

%

1,013,600

 

$

35,652

 

7.09

%

Cash and due from banks

 

34,311

 

 

 

 

 

36,588

 

 

 

 

 

Premises and equipment, net

 

2,807

 

 

 

 

 

2,435

 

 

 

 

 

Other assets

 

64,691

 

 

 

 

 

64,570

 

 

 

 

 

Total assets

 

$

1,057,683

 

 

 

 

 

$

1,117,193

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Liabilities and shareholders' equity:

 

 

 

 

 

 

 

 

 

 

 

 

 

Deposits:

 

 

 

 

 

 

 

 

 

 

 

 

 

Demand, interest bearing

 

$

138,876

 

$

1,545

 

2.24

%

$

153,288

 

$

1,668

 

2.19

%

Savings and money market

 

323,549

 

4,740

 

2.95

%

360,983

 

4,779

 

2.67

%

Time deposits, under $100

 

30,929

 

590

 

3.85

%

33,232

 

497

 

3.02

%

Time deposits, $100 and over

 

101,741

 

2,079

 

4.12

%

109,656

 

1,750

 

3.22

%

Brokered time deposits, $100 and over

 

47,600

 

1,052

 

4.46

%

35,265

 

658

 

3.76

%

Notes payable to subsidiary grantor trusts

 

23,702

 

1,164

 

9.90

%

23,702

 

1,137

 

9.67

%

Securities sold under agreement to repurchase

 

19,015

 

257

 

2.73

%

29,119

 

346

 

2.40

%

Total interest bearing liabilities

 

685,412

 

$

11,427

 

3.36

%

745,245

 

$

10,835

 

2.93

%

Demand, noninterest bearing

 

220,727

 

 

 

 

 

232,072

 

 

 

 

 

Other liabilities

 

23,035

 

 

 

 

 

24,171

 

 

 

 

 

Total liabilities

 

929,174

 

 

 

 

 

1,001,488

 

 

 

 

 

Shareholders' equity

 

128,509

 

 

 

 

 

115,705

 

 

 

 

 

Total liabilities and shareholders' equity

 

$

1,057,683

 

 

 

 

 

$

1,117,193

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net interest income / margin

 

 

 

$

24,124

 

5.09

%

 

 

$

24,817

 

4.94

%

 

Note: Yields and amounts earned on loans include loan fees of $0 and $426,000 for the three month periods ended June 30, 2007 and 2006, respectively.  Nonaccrual loans are included in the average balance calculation above.

 

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

 

23



 

Volume and Rate Variances

 

 

 

Three Months Ended June 30,

 

 

 

2007 vs. 2006

 

 

 

Increase (Decrease) Due to Change In:

 

 

 

Average

 

Average

 

Net

 

 

 

Volume

 

Rate

 

Change

 

 

 

(Dollars in thousands)

 

Income from the interest earning assets:

 

 

 

 

 

 

 

Loans, gross

 

$

171

 

$

74

 

$

245

 

Securities

 

(273

)

278

 

5

 

Interest bearing deposits in other financial institutions

 

6

 

(8

)

(2

)

Federal funds sold

 

(391

)

68

 

(323

)

Total interest income from interest earnings assets

 

$

(487

)

$

412

 

$

(75

)

 

 

 

 

 

 

 

 

Expense from the interest bearing liabilities:

 

 

 

 

 

 

 

Demand, interest bearing

 

$

(43

)

$

(7

)

$

(50

)

Savings and money market

 

(339

)

97

 

(242

)

Time deposits, under $100

 

(14

)

64

 

50

 

Time deposits, $100 and over

 

(90

)

228

 

138

 

Brokered time deposits, $100 and over

 

221

 

71

 

292

 

Notes payable to subsidiary grantor trusts

 

 

8

 

8

 

Securities sold under agreement to repurchase

 

(68

)

30

 

(38

)

Total interest expense on interest bearing liabilities

 

$

(333

)

$

491

 

$

158

 

Net interest income

 

$

(154

)

$

(79

)

$

(233

)

 

 

 

 

 

 

 

 

 

 

Six Months Ended June 30,

 

 

 

2007 vs. 2006

 

 

 

Increase (Decrease) Due to Change In:

 

 

 

Average

 

Average

 

Net

 

 

 

Volume

 

Rate

 

Change

 

 

 

(Dollars in thousands)

 

Income from the interest earning assets:

 

 

 

 

 

 

 

Loans, gross

 

$

(256

)

$

450

 

$

194

 

Securities

 

(592

)

757

 

165

 

Interest bearing deposits in other financial institutions

 

4

 

9

 

13

 

Federal funds sold

 

(668

)

195

 

(473

)

Total interest income on interest earning assets

 

$

(1,512

)

$

1,411

 

$

(101

)

 

 

 

 

 

 

 

 

Expense from the interest bearing liabilities:

 

 

 

 

 

 

 

Demand, interest bearing

 

$

(158

)

$

35

 

$

(123

)

Savings and money market

 

(541

)

502

 

(39

)

Time deposits, under $100

 

(44

)

137

 

93

 

Time deposits, $100 and over

 

(161

)

490

 

329

 

Brokered time deposits, $100 and over

 

272

 

122

 

394

 

Notes payable to subsidiary grantor trusts

 

 

27

 

27

 

Securities sold under agreement to repurchase

 

(137

)

48

 

(89

)

Total interest expense on interest bearing liabilities

 

$

(769

)

$

1,361

 

$

592

 

Net interest income

 

$

(743

)

$

50

 

$

(693

)

 

24



 

Net interest income decreased $233,000 and $693,000 for the three and six months ended June 30, 2007 from 2006.  The decrease was primarily due to decrease in interest earning assets partially offset by the increase in short-term interest rates since a substantial portion of the Company’s earning assets are variable-rate loans that re-price when the Company’s prime lending rate is changed, while a large base of core deposits that are generally slower to re-price.

 

Provision for Loan Losses

 

Credit risk is inherent in the business of making loans. The Company maintains an allowance for loan losses through charges to earnings, which are shown in the income statement as the provision for loan losses. Specifically identifiable and quantifiable losses are immediately charged off against the allowance. The loan loss provision is determined by conducting a monthly evaluation of the adequacy of the Company’s allowance for loan losses, and charging the shortfall, if any, to the current month’s expense. A credit provision for loan losses is recorded if the allowance would otherwise be more than warranted because of a significant decrease in impaired loans or total loans or material net recoveries during a quarter.  This has the effect of creating variability in the amount and frequency of charges to the Company’s earnings.  The loan loss provision and level of allowance for each period is dependent upon many factors, including loan growth, net charge-offs, changes in the composition of the loan portfolio, delinquencies, management’s assessment of the quality of the loan portfolio, the valuation of problem loans and the general economic conditions in the Company’s market area.

 

The Company had no provision for loan losses for the three months ended June 30, 2007 and a reverse provision for loan losses of $236,000 six months ended June 30, 2007.  The Company had a reverse provision for loan losses of $114,000 and $603,000 for the three and six months ended June 30, 2006, respectively.   See additional discussion under the caption “Allowance for Loan Losses.”

 

Noninterest Income

 

The following table sets forth the various components of the Company’s noninterest income for the periods indicated:

 

 

 

For the Three Months Ended

 

Increase (decrease)

 

 

 

June 30,

 

2007 versus 2006

 

 

 

2007

 

2006

 

Amount

 

Percent

 

 

 

(Dollars in thousands)

 

Gain on sale of SBA loans

 

$

695

 

$

842

 

$

(147

)

-17

%

Servicing income

 

534

 

441

 

93

 

21

%

Increase in cash surrender value of life insurance

 

353

 

360

 

(7

)

-2

%

Service charges and fees on deposit accounts

 

336

 

327

 

9

 

3

%

Other

 

344

 

287

 

57

 

20

%

Total noninterest income

 

$

2,262

 

$

2,257

 

$

5

 

0

%

 

25



 

 

 

For the Six Months Ended

 

Increase (decrease)

 

 

 

June 30,

 

2007 versus 2006

 

 

 

2007

 

2006

 

Amount

 

Percent

 

 

 

(Dollars in thousands)

 

Gain on sale of SBA loans

 

$

1,706

 

$

1,668

 

$

38

 

2

%

Gain on sale of Capital Group loan portfolio

 

0

 

671

 

(671

)

-100

%

Servicing income

 

1,050

 

909

 

141

 

16

%

Increase in cash surrender value of life insurance

 

697

 

707

 

(10

)

-1

%

Service charges and fees on deposit accounts

 

610

 

654

 

(44

)

-7

%

Other

 

713

 

542

 

171

 

32

%

Total noninterest income

 

$

4,776

 

$

5,151

 

$

(375

)

-7

%

 

For the three months and six months ended June 30, 2007, noninterest income was $2.3 and $4.8 million compared to $2.3 million and $5.2 million for the three and six months ended June 30, 2006, respectively.  The year-to-date decrease was primarily due to a decrease in gain on sale of loans of $633,000.  There was a $671,000 nonrecurring gain on the sale of the Capital Group loan portfolio in the first quarter of 2006.

 

Noninterest income is primarily comprised of the gain on sale of SBA and other guaranteed loans, SBA loan-servicing income, and increase in cash surrender value of the Company owned life insurance.  To date in 2007, and in prior fiscal years, the Company had an ongoing program of originating SBA loans and selling the government guaranteed portion in the secondary market, while retaining the servicing of the whole loans. Beginning in the third quarter of 2007, the Company decided to change its strategy regarding its SBA loan business. The Company will retain most new SBA production in lieu of selling it.  As a result, the Company expects its noninterest income will be lower in the second half of 2007 compared to the second half of 2006.

 

Gains or losses on SBA loans held for sale are recognized upon completion of the sale, and are based on the difference between the net sales proceeds and the relative fair value of the guaranteed portion of the loan sold compared to the relative fair value of the unguaranteed portion.  The servicing assets that result from the sale of SBA loans, with servicing rights retained, are amortized over the lives of the loans using a method approximating the interest method.

 

Gain on sales of SBA and other guaranteed loans contributed $0.7 million and $1.7 million, during the second quarter and the first six months of 2007, compared to $0.8 million and $1.7 million, during the second quarter and the first six months of 2006, respectively.  The Company sold its Capital Group loan portfolio, which consisted primarily of “factoring” type loans, during the first quarter of 2006, resulting in a gain on sale of $0.7 million.  In the second quarter 2007, the increase in cash surrender value of the Company owned life insurance was approximately the same as 2006.  The decrease in deposit service charges and fees on deposit accounts was primarily because higher interest rates applied to collected balances created a waiver of (or credit against) service charges for many business customers.

 

26



 

Noninterest Expense

 

The following table sets forth the various components of the Company’s noninterest expense for the periods indicated:

 

 

 

For the Three Months Ended

 

Increase (decrease)

 

 

 

June 30,

 

2007 versus 2006

 

 

 

2007

 

2006

 

Amount

 

Percent

 

 

 

(Dollars in thousands)

 

Salaries and employee benefits

 

$

4,685

 

$

4,653

 

$

32

 

1

%

Occupancy

 

770

 

774

 

(4

)

-1

%

Professional fees

 

401

 

334

 

67

 

20

%

Advertising and promotion

 

390

 

347

 

43

 

12

%

Client services

 

247

 

242

 

5

 

2

%

Data processing

 

197

 

161

 

36

 

22

%

Low income housing investment losses and writedowns

 

118

 

213

 

(95

)

-45

%

Furniture and equipment

 

119

 

148

 

(29

)

-20

%

Intangible amortization

 

18

 

 

18

 

N/A

 

Other

 

1,555

 

1,620

 

(65

)

-4

%

Total noninterest expense

 

$

8,500

 

$

8,492

 

$

8

 

0

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

For the Six Months Ended

 

Increase (decrease)

 

 

 

June 30,

 

2007 versus 2006

 

 

 

2007

 

2006

 

Amount

 

Percent

 

 

 

(Dollars in thousands)

 

Salaries and employee benefits

 

$

9,573

 

$

9,762

 

$

(189

)

-2

%

Occupancy

 

1,535

 

1,551

 

(16

)

-1

%

Professional fees

 

738

 

847

 

(109

)

-13

%

Advertising and promotion

 

602

 

557

 

45

 

8

%

Client services

 

476

 

542

 

(66

)

-12

%

Data processing

 

401

 

342

 

59

 

17

%

Low income housing investment losses and writedowns

 

355

 

477

 

(122

)

-26

%

Furniture and equipment

 

229

 

257

 

(28

)

-11

%

Intangible amortization

 

18

 

 

18

 

N/A

 

Other

 

2,873

 

2,918

 

(45

)

-2

%

Total noninterest expense

 

$

16,800

 

$

17,253

 

$

(453

)

-3

%

 

27



 

The following table indicates the percentage of noninterest expense in each category:

 

 

 

For The Three Months Ended June 30,

 

 

 

 

 

Percent

 

 

 

Percent

 

 

 

2007

 

of Total

 

2006

 

of Total

 

 

 

(Dollars in thousands)

 

Salaries and employee benefits

 

$

4,685

 

55

%

$

4,653

 

55

%

Occupancy

 

770

 

9

%

774

 

9

%

Professional fees

 

401

 

5

%

334

 

4

%

Advertising and promotion

 

390

 

5

%

347

 

4

%

Client services

 

247

 

3

%

242

 

3

%

Data processing

 

197

 

2

%

161

 

3

%

Low income housing investment losses and writedowns

 

118

 

1

%

213

 

3

%

Furniture and equipment

 

119

 

1

%

148

 

2

%

Intangible amortization

 

18

 

0

%

 

0

%

Other

 

1,555

 

19

%

1,620

 

19

%

Total noninterest expense

 

$

8,500

 

100

%

$

8,492

 

100

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

For The Six Months Ended June 30,

 

 

 

 

 

Percent

 

 

 

Percent

 

 

 

2007

 

of Total

 

2006

 

of Total

 

 

 

(Dollars in thousands)

 

Salaries and employee benefits

 

$

9,573

 

57

%

$

9,762

 

57

%

Occupancy

 

1,535

 

9

%

1,551

 

9

%

Professional fees

 

738

 

4

%

847

 

5

%

Advertising and promotion

 

602

 

4

%

557

 

3

%

Client services

 

476

 

3

%

542

 

3

%

Data processing

 

401

 

2

%

342

 

3

%

Low income housing investment losses and writedowns

 

355

 

2

%

477

 

3

%

Furniture and equipment

 

229

 

1

%

257

 

1

%

Intangible amortization

 

18

 

0

%

 

0

%

Other

 

2,873

 

17

%

2,918

 

17

%

Total noninterest expense

 

$

16,800

 

100

%

$

17,253

 

100

%

 

For the three months ended June 30, 2007, noninterest expense remained at $8.5 million compared to 2006 but decreased 3% for the six months ended June 30, 2007 from a year ago.  The efficiency ratio was 58.00% and 58.13% for the three and six months ended June 30, 2007, compared to 57.06% and 57.57% for the three and six months ended June 30, 2006.

 

Salaries and employee benefits, the single largest component of noninterest expenses increased $32,000 but decreased $189,000 for the three and six months ended June 30, 2007, respectively, from the same period in 2006.  Salaries and employee benefits as a percentage of total noninterest expense remained fairly constant at 55% and 57% for the three and six months ended June 30, 2007 and 2006.

 

Occupancy decreased $4,000 and $16,000 for the three and six months ended June 30, 2007 from same period in 2006.  The decrease was primarily a result of lower premises repairs expense and premises insurance expense for the three and six months ended June 30, 2007. Occupancy cost as a percentage of total noninterest expense remained fairly constant at 9% for the three and six months ended June 30, 2007 and 2006.

 

Professional fees increased $67,000 for the three months ended June 30, 2007 but decreased $109,000 for the six months ended June 30, 2007 from the same period in 2006.  The decrease was primarily attributable to decreases in audit expenses.

 

28



 

Advertising and promotion costs increased $43,000 and $45,000, respectively, for the three and six months ended June 30, 2007 from the same period in 2006.  The increase was primarily attributable to certain new sponsorships and promotions in 2007.

 

Client services increased $5,000 for the three months ended June 30, 2007 but decreased $66,000 for the six months ended June 30, 2007 from the same period in 2006. The decrease was primarily attributable to the decrease in service fees charged to the Company from third party vendors who have certain deposit accounts.  Client services as a percentage of total noninterest expense remained constant at 3% for the three months ended March 31, 2007 and 2006.

 

Data processing expense increased $36,000 and $59,000, respectively, for the three and six months ended June 30, 2007 from the same period in 2006.  The increase was primarily attributable to a higher volume of data processing.

 

Low income housing investment losses and writedowns decreased $95,000 and $122,000, respectively, for the three and six months ended June 30, 2007 from the same period in 2006.  The decrease was primarily attributable to the lower amortization expense from two funds due to adjustments from prior year.  Low income housing investment losses and writedowns as a percentage of total expense decreased to 1% and 2% for the three and six months ended June 30, 2007 from 3% for the three and six months ended June 30, 2006.

 

Furniture and equipment expense decreased $29,000 and $28,000, respectively, for the three and six months ended June 30, 2007 from the same period in 2006.  The decrease was primarily attributable to lower depreciation on furniture and equipment.

 

Other noninterest expenses decreased $65,000 and $45,000, respectively, for the three and six months ended June 30, 2007 from the same period in 2006. Other noninterest expense as a percentage of total noninterest expense remained at 19% and 17%, respectively, for the three and six months ended June 30, 2007 and 2006.

 

Income Tax Expense

 

Income tax expense for the three and six months ended June 30, 2007 was $2.1 million and $4.3 million, respectively, as compared to $2.3 million and $4.8 million for the same periods in the prior year. The following table shows the effective income tax rate for each period indicated.

 

 

 

For the Three Months Ended

 

For the Six Months Ended

 

 

 

June 30,

 

June 30,

 

 

 

2007

 

2006

 

2007

 

2006

 

Effective income tax rate

 

34.8

%

35.6

%

34.8

%

35.7

%

 

The difference in the effective tax rate compared to the combined federal and state statutory tax rate of 42% is primarily the result of the Company’s investment in life insurance policies whose earnings are not subject to taxes, tax credits related to investments in low income housing and investments in tax-free municipal securities.  The effective tax rate in the first half of 2007 is lower compared to the first half of 2006 because pre-tax income decreased while benefits from tax advantaged investments did not.

 

FINANCIAL CONDITION

 

As of June 30, 2007, total assets were $1.35 billion, compared to $1.09 billion as of June 30, 2006.   Total securities were $169 million as of June 30, 2007, a decrease of 11% from $191 million as of June 30, 2006.  The total loan portfolio was $926 million, an increase of $224 million or 32%, compared to June 30, 2006.  Total deposits were $1.12 billion as of June 30, 2007, compared to $908 million as of June 30, 2006.

 

29



 

Securities Portfolio

 

The following table reflects the amortized cost and fair market values for each category of securities at the dates indicated:

 

Investment Portfolio

 

 

 

June 30,

 

December 31,

 

 

 

2007

 

2006

 

2006

 

 

 

(Dollars in thousands)

 

Securities available-for-sale (at fair value)

 

 

 

 

 

 

 

U.S. Treasury

 

$

4,895

 

$

5,904

 

$

5,963

 

U.S. Government Agencies

 

62,281

 

75,767

 

59,396

 

Mortgage-Backed

 

86,349

 

90,224

 

90,186

 

Municipals - Taxable

 

997

 

 

 

Municipals - Tax Exempt

 

6,877

 

8,083

 

8,142

 

Collateralized Mortgage Obligations

 

8,099

 

11,493

 

8,611

 

Total available-for-sale

 

$

169,498

 

$

191,471

 

$

172,298

 

 

The following table summarizes the amounts and distribution of the Company’s securities and the weighted average yields at June 30, 2007:

 

 

 

June 30, 2007

 

 

 

Maturity

 

 

 

 

 

 

 

After One and

 

After Five and

 

 

 

 

 

 

 

 

 

 

 

Within One Year

 

Within Five Years

 

Within TenYears

 

After Ten Years

 

Total

 

 

 

Amount

 

Yield

 

Amount

 

Yield

 

Amount

 

Yield

 

Amount

 

Yield

 

Amount

 

Yield

 

 

 

(Dollars in thousands)

 

Securities available-for-sale:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

U.S. Treasury

 

$

 

 

$

4,895

 

4.84

%

$

 

 

$

 

 

$

4,895

 

4.84

%

U.S. Government Agencies

 

38,125

 

4.90

%

24,156

 

4.82

%

 

 

 

 

62,281

 

4.87

%

Mortgage Backed

 

 

 

1,872

 

3.46

%

6,458

 

4.44

%

78,019

 

4.49

%

86,349

 

4.46

%

Municipals - Taxable

 

997

 

3.03

%

 

 

 

 

 

 

997

 

3.03

%

Municipals - Tax Exempt

 

3,313

 

2.93

%

3,564

 

3.15

%

 

 

 

 

6,877

 

3.04

%

Collateralized Mortgage Obligations

 

 

 

 

 

5,105

 

5.61

%

2,994

 

3.16

%

8,099

 

4.70

%

Total available-for-sale

 

$

42,435

 

4.70

%

$

34,487

 

4.58

%

$

11,563

 

4.96

%

$

81,013

 

4.44

%

$

169,498

 

4.57

%

 

The investment securities portfolio is the second largest component of the Company’s interest earning assets, and the structure and composition of this portfolio is important to any analysis of the financial condition of the Company.  The investment portfolio serves the following purposes:  (i) it can be readily reduced in size to provide liquidity for loan balance increases or deposit balance decreases; (ii) it provides a source of pledged assets for securing certain deposits and borrowed funds, as may be required by law or by specific agreement with a depositor or lender; (iii) it can be used as an interest rate risk management tool, since it provides a large base of assets, the maturity and interest rate characteristics of which can be changed more readily than the loan portfolio to better match changes in the deposit base and other funding sources of the Company; (iv) it is an alternative interest-earning

 

30


 


 

use of funds when loan demand is weak or when deposits grow more rapidly than loans; and (v) it can enhance the Company’s tax position by providing partially tax exempt income.

 

The Company classifies all of its securities as “Available-for-Sale”.  Accounting rules also allow for trading or “Held-to-Maturity” classifications, but the Company has no securities that would be classified as such.  Even though management currently has the intent and the ability to hold the Company’s securities for the foreseeable future, they are all currently classified as available-for-sale to allow flexibility with regard to the active management of the Company’s investment portfolio.  FASB Statement 115 requires available-for-sale securities to be marked to market with an offset to accumulate other comprehensive income, a component of shareholders’ equity.  Monthly adjustments are made to reflect changes in the market value of the Company’s available-for-sale securities.

 

The Company’s investment portfolio is currently composed primarily of:  (i) U.S. Treasury and Government Agency issues for liquidity and pledging; (ii) mortgage-backed securities, which in many instances can also be used for pledging, and which generally enhance the yield of the portfolio; (iii) municipal obligations, which provide tax free income and limited pledging potential; and (iv) collateralized mortgage obligations, which generally enhance the yield of the portfolio. The amortized cost of securities pledged as collateral for repurchase agreements, public deposits and for other purposes as required or permitted by law was $46 million and $58 million at June 30, 2007 and 2006, respectively.

 

Except for obligations of U.S. government agencies, no securities of a single issuer exceeded 10% of shareholders’ equity at June 30, 2007.  The Company has not used interest rate swaps or other derivative instruments to hedge fixed rate loans or to otherwise mitigate interest rate risk.

 

In the second quarter of 2007, the investment portfolio declined by $22 million, or 11%, and decreased to 13% of total assets at June 30, 2007 from 17% at June 30, 2006.  U.S. Treasury and U.S. Agency securities decreased to 40% of the portfolio at June 30, 2007 from 43% at June 30, 2006.  The decrease was primarily due to maturities of U.S. Government Agency securities.  Municipal securities, mortgage-backed securities and collateralized mortgage obligations remained fairly constant in the portfolio in the second quarter of 2007 compared to the second quarter of 2006.  The Company invests in securities with the available cash based on market conditions and the Company’s cash flow.

 

Loans

 

The Company’s loans represent the largest portion of invested assets, substantially greater than the securities portfolio or any other asset category, and the quality and diversification of the loan portfolio is an important consideration when reviewing the Company’s financial condition.

 

Gross loans (including loans held for sale) represented 70% of total assets at June 30, 2007, as compared to 68% at June 30, 2006.  The ratio of loans to deposits increased to 83% at June 30, 2007 from 77% at June 30, 2006.  Demand for loans remains relatively sound in many areas within the Company’s markets and competition continues to intensify.  To help ensure that we remain competitive, we make every effort to be flexible and creative in our approach to structure loans.

 

The Loan Distribution table that follows sets forth the Company’s gross loans outstanding and the percentage distribution in each category at the dates indicated.

 

31



 

Loan Distribution

 

 

 

June 30, 2007

 

June 30, 2007

 

December 31, 2006

 

 

 

(Dollars in thousands)

 

Commercial

 

$

344,172

 

37

%

$

260,936

 

37

%

$

284,093

 

40

%

Real estate - mortgage

 

330,422

 

36

%

242,125

 

35

%

239,041

 

34

%

Real estate - land and construction

 

203,457

 

22

%

149,168

 

21

%

143,834

 

20

%

Home equity

 

42,474

 

5

%

46,690

 

7

%

38,976

 

6

%

Consumer

 

4,715

 

1

%

1,389

 

0

%

2,422

 

0

%

Total loans

 

925,240

 

100

%

700,308

 

100

%

708,366

 

100

%

Deferred loan costs

 

504

 

 

 

1,184

 

 

 

870

 

 

 

Allowance for loan losses

 

(11,104

)

 

 

(9,098

)

 

 

(9,279

)

 

 

Loans, net

 

$

914,640

 

 

 

$

692,394

 

 

 

$

699,957

 

 

 

 

Total loans (excluding loans held of sale) were $925 million at June 30, 2007, compared to $700 million at June 30, 2006.  The Company’s allowance for loan losses was $11.1 million, or 1.20% of total loans, at June 30, 2007, as compared to $9.1 million, or 1.30% of total loans, at June 30, 2006.  As of June 30, 2007 and 2006, the Company had $5.8 million and $1.6 million, respectively, in nonperforming loans.

 

The Company’s loan portfolio is concentrated in commercial loans, primarily manufacturing, wholesale, and services, and real estate, with the balance in land development and construction, home equity and consumer loans. The increase in the Company’s loan portfolio in the second quarter of 2007 from 2006 is primarily due to the completed merger with Diablo Valley Bank adding $214 million to the Company’s loan portfolio.  The Company does not have any concentrations by industry or group of industries in its loan portfolio; however, approximately 62% of its loans were secured by real property as of June 30, 2007 and 2006. While no specific industry concentration is considered significant, the Company’s lending operations are located in areas that are dependent on the technology and real estate industries and their supporting companies.

 

The Company’s commercial loans are made for working capital, financing the purchase of equipment or for other business purposes. Such loans include loans with maturities ranging from thirty days to one year and “term loans,” with maturities normally ranging from one to five years. Short-term business loans are generally intended to finance current transactions and typically provide for periodic principal payments, with interest payable monthly. Term loans normally provide for floating interest rates, with monthly payments of both principal and interest.

 

The Company is an active participant in the Small Business Administration (“SBA”) and U.S. Department of Agriculture guaranteed lending programs, and has been approved by the SBA as a lender under the Preferred Lender Program. The Company regularly makes SBA-guaranteed loans.  To date and in prior years, the Company sold the guaranteed portion of these loans in the secondary market depending on market conditions. Through June 30, 2007, SBA loans were classified as held for sale upon origination.  In the event of the sale of the guaranteed portion of an SBA loan, the Company retained the servicing rights for the sold portion. Beginning in the third quarter of 2007, the Company decided to change its strategy regarding its SBA loan business. The Company will retain most new SBA production in lieu of selling it.  As a result, the Company expects its noninterest income will be lower in the second half of 2007 compared to the second half of 2006.  However, the amount of loans outstanding will reflect an increase attributed to retained SBA loans and the Company will benefit from the yield earned on the loans.

 

As of June 30, 2007, real estate mortgage loans of $329 million consisted of adjustable and fixed rate loans secured by commercial property, and loans secured by first mortgages on 1-4 family residential properties of $0.9 million. Home equity lines of credit are secured by junior deeds of trust on 1-4 family residential properties totaling $43 million.  Properties securing the real estate mortgage loans are primarily located in the Company’s market area.  While no specific industry concentration is considered significant, the Company’s lending operations are located in market areas that are dependent on the technology and real estate industries and their supporting companies. Real estate values in portions of Santa Clara County and neighboring San Mateo County are among the highest in the

 

32



 

country at the present time. The Company’s borrowers could be adversely impacted by a downturn in these sectors of the economy, which could reduce the demand for loans and adversely impact the borrowers’ ability to repay their loans.

 

The Company’s real estate term loans consist primarily of loans made based on the borrower’s cash flow and are secured by deeds of trust on commercial and residential property to provide a secondary source of repayment. The Company generally restricts real estate term loans to no more than 80% of the property’s appraised value or the purchase price of the property, depending on the type of property and its utilization. The Company offers both fixed and floating rate loans. Maturities on such loans are generally between five and ten years (with amortization ranging from fifteen to twenty-five years and a balloon payment due at maturity); however, SBA and certain other real estate loans that are easily sold in the secondary market may be granted for longer maturities.

 

The Company’s real estate land and construction loans are primarily short term interim loans to finance the construction of commercial and single family residential properties.  The Company utilizes underwriting guidelines to assess the likelihood of repayment from sources such as sale of the property or permanent mortgage financing prior to making the construction loan.

 

The Company makes consumer loans for the purpose of financing automobiles, various types of consumer goods, and other personal purposes. Additionally, the Company makes home equity lines of credit available to its clientele. Consumer loans generally provide for the monthly payment of principal and interest. Most of the Company’s consumer loans are secured by the personal property being purchased or, in the instances of home equity loans or lines, real property.

 

With certain exceptions, state chartered banks are permitted to make extensions of credit to any one borrowing entity up to 15% of the bank’s capital and reserves for unsecured loans and up to 25% of the bank’s capital and reserves for secured loans.  For Heritage Bank of Commerce (“HBC”), these lending limits were $30 million and $50 million at June 30, 2007.

 

Loan Maturities

 

The following table presents the maturity distribution of the Company’s loans as of June 30, 2007. The table shows the distribution of such loans between those loans with predetermined (fixed) interest rates and those with variable (floating) interest rates. Floating rates generally fluctuate with changes in the prime rate as reflected in the western edition of The Wall Street Journal. As of June 30, 2007, approximately 76% of the Company’s loan portfolio consisted of floating interest rate loans.

 

33



 

Loan Maturities

 

 

 

 

 

Over One

 

 

 

 

 

 

 

Due in

 

Year But

 

 

 

 

 

 

 

One Year

 

Less than

 

Over

 

 

 

 

 

or Less

 

Five Years

 

Five Years

 

Total

 

 

 

(Dollars in thousands)

 

Commercial

 

$

297,113

 

$

34,018

 

$

13,041

 

$

344,172

 

Real estate - mortgage

 

128,309

 

117,613

 

84,500

 

330,422

 

Real estate - land and construction

 

200,812

 

73

 

2,572

 

203,457

 

Home equity

 

42,474

 

 

 

42,474

 

Consumer

 

3,155

 

1,560

 

 

4,715

 

Total loans

 

$

671,863

 

$

153,264

 

$

100,113

 

$

925,240

 

 

 

 

 

 

 

 

 

 

 

Loans with variable interest rates

 

$

633,052

 

$

60,502

 

$

6,346

 

$

699,900

 

Loans with fixed interest rates

 

38,811

 

92,762

 

93,767

 

225,340

 

Total loans

 

$

671,863

 

$

153,264

 

$

100,113

 

$

925,240

 

 

 

Loan Servicing

 

As of June 30, 2007 and 2006, $197 million and $182 million, respectively, in SBA and U.S. Department of Agriculture loans were serviced by the Company for others.

 

Activity for loan servicing rights was as follows:

 

 

 

For the Three Months Ended

 

For the Six Months Ended

 

 

 

June 30,

 

June 30,

 

 

 

2007

 

2006

 

2007

 

2006

 

 

 

(Dollars in thousands)

 

Beginning of period balance

 

$

2,190

 

$

2,161

 

$

2,154

 

$

2,171

 

Additions

 

217

 

309

 

534

 

598

 

Amortization

 

(269

)

(309

)

(550

)

(608

)

End of period balance

 

$

2,138

 

$

2,161

 

$

2,138

 

$

2,161

 

 

Loan servicing rights and I/O strips are included in Accrued Interest and Other Assets on the balance sheet and are reported net of amortization. There was no valuation allowance for servicing rights as of June 30, 2007 and 2006, as the fair market value of the assets was greater than the carrying value.

 

Activity for I/O strip receivables was as follows:

 

 

 

For the Three Months Ended

 

For the Six Months Ended

 

 

 

June 30,

 

June 30,

 

 

 

2007

 

2006

 

2007

 

2006

 

 

 

(Dollars in thousands)

 

Beginning of period balance

 

$

2,190

 

$

2,161

 

$

2,154

 

$

2,171

 

Additions

 

217

 

309

 

534

 

598

 

Amortization

 

(269

)

(309

)

(550

)

(608

)

End of period balance

 

$

2,138

 

$

2,161

 

$

2,138

 

$

2,161

 

 

34



 

Nonperforming Assets

 

Financial institutions generally have a certain level of exposure to asset quality risk, and could potentially receive less than a full return of principal and interest if a debtor becomes unable or unwilling to repay.  Since loans are the most significant assets of the Company and generate the largest portion of its revenues, the Company’s management of asset quality risk is focused primarily on loan quality.  Banks have generally suffered their most severe earnings declines as a result of customers’ inability to generate sufficient cash flow to service their debts, or as a result of the downturns in national and regional economies which have brought about declines in overall property values.  In addition, certain debt securities that the Company may purchase have the potential of declining in value if the obligor’s financial capacity to repay deteriorates.

 

To help minimize credit quality concerns, we have established a sound approach to credit that includes well-defined goals and objectives and well-documented credit policies and procedures.  The policies and procedures identify market segments, set goals for portfolio growth or contraction, and establish limits on industry and geographic credit concentrations.  In addition, these policies establish the Company’s underwriting standards and the methods of monitoring ongoing credit quality.  The Company’s internal credit risk controls are centered in underwriting practices, credit granting procedures, training, risk management techniques, and familiarity with loan and lease customers as well as the relative diversity and geographic concentration of our loan portfolio.

 

The Company’s credit risk may also be affected by external factors such as the level of interest rates, employment, general economic conditions, real estate values, and trends in particular industries or geographic markets.  As a multi-community independent bank serving a specific geographic area, the Company must contend with the unpredictable changes of both the general California and, particularly, primary local markets.  The Company’s asset quality has suffered in the past from the impact of national and regional economic recessions, consumer bankruptcies, and depressed real estate values.

 

Nonperforming assets are comprised of the following: Loans for which the Company is no longer accruing interest; loans 90 days or more past due and still accruing interest (although they are generally placed on nonaccrual when they become 90 days past due unless they are both well secured and in the process of collection); loans restructured where the terms of repayment have been renegotiated, resulting in a deferral of interest or principal; and other real estate owned (“OREO”).  Management’s classification of a loan as “nonaccrual” is an indication that there is reasonable doubt as to the full recovery of principal or interest on the loan.  At that point, the Company stops accruing interest income, reverses any uncollected interest that had been accrued as income, and begins recognizing interest income only as cash interest payments are received as long as the collection of all outstanding principal is not in doubt.  The loans may or may not be collateralized, and collection efforts are continuously pursued.  Loans may be restructured by management when a borrower has experienced some change in financial status causing an inability to meet the original repayment terms and where the Company believes the borrower will eventually overcome those circumstances and make full restitution.  OREO consists of properties acquired by foreclosure or similar means that management is offering or will offer for sale.

 

35



 

The following table provides information with respect to components of the Company’s non-performing assets at the dates indicated:

 

Nonperforming Assets

 

 

 

June 30,

 

December 31,

 

 

 

2007

 

2006

 

2006

 

 

 

(Dollars in thousands)

 

Nonaccrual loans

 

$

3,192

 

$

1,612

 

$

3,866

 

Loans 90 days past due and still accruing

 

2,604

 

 

451

 

Total nonperforming loans

 

5,796

 

1,612

 

4,317

 

Other real estate owned

 

487

 

 

 

Total nonperforming assets

 

$

6,283

 

$

1,612

 

$

4,317

 

 

 

 

 

 

 

 

 

Nonperforming assets as a percentage of loans plus other real estate owned

 

0.68

%

0.23

%

0.61

%

 

The balance of nonperforming assets increased to $6.3 million, or 0.47% of total assets, at June 30, 2007.  Nonperforming assets increased by $2.0 million, or 46%, compared to December 31, 2006.  The increase in 2007 was a result of the acquisition of Diablo Valley Bank.  Approximately $3.7 million of the nonperforming assets at June 30, 2007 was a result of the additions of the Diablo Valley Bank loans portfolio as a result of the merger.  Of the total nonperforming assets at June 30, 2007, so far $900,000 were paid off during the third quarter of 2007.

 

Allowance for Loan Losses

 

The allowance for loan losses is an estimate of the losses in our loan portfolio.  The allowance is based on two basic principles of accounting: (1) Statement of Financial Accounting Standards (“Statement”) No. 5 “Accounting for Contingencies,” which requires that losses be accrued when they are probable of occurring and estimable and (2) Statement No. 114, “Accounting by Creditors for Impairment of a Loan,” which requires that losses be accrued based on the differences between the impaired loan balance and value of collateral, if the loan is collateral dependent, or present value of future cash flows or values that are observable in the secondary market.

 

Management conducts a critical evaluation of the loan portfolio monthly. This evaluation includes periodic loan by loan review for certain loans to evaluate impairment, as well as detailed reviews of other loans (either individually or in pools) based on an assessment of the following factors: past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, collateral values, loan volumes and concentrations, size and complexity of the loans, recent loss experience in particular segments of the portfolio, bank regulatory examination and independent loan review results, and current economic conditions in the Company’s marketplace, in particular the state of the technology industry and the real estate market.   This process attempts to assess the risk of loss inherent in the portfolio by segregating loans into two categories for purposes of determining an appropriate level of the allowance: Loans graded “Pass through Special Mention” and those graded “Substandard.”

 

Loans are charged against the allowance when management believes that the uncollectibility of the loan balance is confirmed. The Company’s methodology for assessing the appropriateness of the allowance consists of several key elements, which include the formula allowance and specific allowances.

 

Specific allowances are established for impaired loans.  Management considers a loan to be impaired when it is probable that the Company will be unable to collect all amounts due according to the original contractual terms of the note agreement. When a loan is considered to be impaired, the amount of impairment is measured based on the fair value of the collateral if the loan is collateral dependent or on the present value of expected future cash flows.

 

36



 

The formula portion of the allowance is calculated by applying loss factors to pools of outstanding loans. Loss factors are based on the Company’s historical loss experience, adjusted for significant factors that, in management’s judgment, affect the collectibility of the portfolio as of the evaluation date. The adjustment factors for the formula allowance may include existing general economic and business conditions affecting the key lending areas of the Company, in particular the real estate market, credit quality trends, collateral values, loan volumes and concentrations, the technology industry and specific industry conditions within portfolio segments, recent loss experience in particular segments of the portfolio, duration of the current business cycle, and bank regulatory examination results. The evaluation of the inherent loss with respect to these conditions is subject to a higher degree of uncertainty.

 

Loans that demonstrate a weakness, for which there is a possibility of loss if the weakness is not corrected, are categorized as “classified.” Classified loans include all loans considered as substandard, doubtful, and loss and may result from problems specific to a borrower’s business or from economic downturns that affect the borrower’s ability to repay or that cause a decline in the value of the underlying collateral (particularly real estate).  The principal balance of classified loans, which consists of all loans internally graded as substandard, was $24 million and $16 million, respectively, at June 30, 2007 and 2006.  As of June 30, 2007, $4 million substandard loans were acquired from Diablo Valley Bank due to the merger.  Classified loans were $25 million at December 31, 2006.

 

In adjusting the historical loss factors applied to the respective segments of the loan portfolio, management considered the following factors:

 

·                  Levels and trends in delinquencies, non-accruals, charge offs and recoveries

·                  Trends in volume and loan terms

·                  Lending policy or procedural changes

·                  Experience, ability, and depth of lending management and staff

·                  National and local economic trends and conditions

·                  Concentrations of credit

 

There can be no assurance that the adverse impact of any of these conditions on the Company will not be in excess of the current level of estimated losses.

 

It is the policy of management to maintain the allowance for loan losses at a level adequate for risks inherent in the loan portfolio.  On an ongoing basis, we have engaged outside firms to independently assess our methodology and perform independent credit reviews of our loan portfolio.  The Company’s credit review consultants, the Federal Reserve Bank (“FRB”) and the California Department of Financial Institutions (“DFI”) also review the allowance for loan losses as an integral part of the examination process.  Based on information currently available, management believes that the loan loss allowance is adequate. However, the loan portfolio can be adversely affected if California economic conditions and the real estate market in the Company’s market area were to weaken. Also, any weakness of a prolonged nature in the technology industry would have a negative impact on the local market. The effect of such events, although uncertain at this time, could result in an increase in the level of nonperforming loans and increased loan losses, which could adversely affect the Company’s future growth and profitability. No assurance of the ultimate level of credit losses can be given with any certainty.

 

37


 


 

The following table summarizes the Company’s loan loss experience, as well as provisions and charges to the allowance for loan losses and certain pertinent ratios for the periods indicated:

 

Allowance for Loan Losses

 

 

 

For the Six Months Ended

 

For the Year Ended

 

 

 

June 30,

 

December 31,

 

 

 

2007

 

2006

 

2006

 

 

 

(Dollars in thousands)

 

Balance, beginning of period / year

 

$

9,279

 

$

10,224

 

$

10,224

 

Net charge-offs

 

(64

)

(523

)

(442

)

Provision for loan losses

 

(236

)

(603

)

(503

)

Allowance acquired in bank acquisition

 

2,125

 

 

 

Balance, end of period/ year

 

$

11,104

 

$

9,098

 

$

9,279

 

 

 

 

 

 

 

 

 

RATIOS:

 

 

 

 

 

 

 

Net charge-offs to average loans outstanding*

 

0.02

%

0.15

%

0.06

%

Allowance for loan losses to total loans*

 

1.20

%

1.30

%

1.31

%

Allowance for loan losses to nonperforming loans

 

192

%

564

%

215

%


* Average loans and total loans exclude loans held for sale

 

Net loans charged-off reflect the realization of losses in the portfolio that were recognized previously though provisions for loan losses.  Historical net loan charge-offs are not necessarily indicative of the amount of net charge-offs that the Company will realize in the future.

 

Deposits

 

The composition and cost of the Company’s deposit base are important components in analyzing the Company’s net interest margin and balance sheet liquidity characteristics, both of which are discussed in greater detail in other sections herein.  Our net interest margin is improved to the extent that growth in deposits can be concentrated in historically lower-cost deposits such as non-interest-bearing demand, NOW accounts, savings accounts and money market deposit accounts.  The Company’s liquidity is impacted by the volatility of deposits or other funding instruments, or, in other words, by the propensity of that money to leave the institution for rate-related or other reasons.  Potentially, the most volatile deposits in a financial institution are jumbo certificates of deposit, meaning time deposits with balances that equal or exceed $100,000, as customers with balances of that magnitude are typically more rate-sensitive than customers with smaller balances.

 

The following table summarizes the distribution of deposits:

 

Deposits

 

 

 

June 30, 2007

 

June 30, 2006

 

December 31, 2006

 

 

 

Balance

 

% to Total

 

Balance

 

% to Total

 

Balance

 

% to Total

 

 

 

(Dollars in thousands)

 

Demand, noninterest bearing

 

$

266,404

 

24

%

$

221,438

 

24

%

$

231,841

 

27

%

Demand, interest bearing

 

162,006

 

14

%

144,120

 

16

%

133,413

 

16

%

Savings and money market

 

448,525

 

40

%

366,892

 

40

%

307,266

 

36

%

Time deposits, under $100

 

33,735

 

3

%

31,476

 

4

%

31,097

 

4

%

Time deposits, $100 and over

 

143,544

 

13

%

110,513

 

12

%

111,017

 

13

%

Brokered deposits, $100 and over

 

65,439

 

6

%

34,048

 

4

%

31,959

 

4

%

Total deposits

 

$

1,119,653

 

100

%

$

908,487

 

100

%

$

846,593

 

100

%

 

38



 

Total deposits were $1,120 million at June 30, 2007 and $908 million at June 30, 2006.  The increases primarily reflect the completion of the merger with Diablo Valley Bank.  At June 30, 2007, compared to June 30, 2006, noninterest bearing demand deposits increased $45 million, or 20%; interest bearing demand deposits increased $18 million, or 12%; savings and money market deposits increased $82 million, or 22%; time deposits increased $35 million, or 25%; and brokered deposits increased $31 million, or 92%.

 

At June 30, 2007 and 2006, less than 1%, of deposits were from public sources and approximately 3% of deposits were from real estate exchange company, title company and escrow accounts.

 

The Company obtains deposits from a cross-section of the communities it serves. The Company’s business is not seasonal in nature. The Company had brokered deposits totaling $65 million, and $34 million at June 30, 2007 and 2006, respectively.  These brokered deposits generally mature within one to three years.  Brokered deposits are generally less desirable because of higher interest rates.  The Company is not dependent upon funds from sources outside the United States.

 

The following table indicates the maturity schedule of the Company’s time deposits of $100,000 or more as of June 30, 2007:

 

Deposit Maturity Distribution

 

 

 

Balance

 

% of Total

 

 

 

(Dollars in thousands)

 

Three months or less

 

$

90,590

 

43

%

Over three months through six months

 

52,998

 

25

%

Over six months through twelve months

 

35,515

 

17

%

Over twelve months

 

29,880

 

14

%

Total

 

$

208,983

 

100

%

 

The Company focuses primarily on providing and servicing business deposit accounts that are frequently over $100,000 in average balance per account.   The account activity for some account types and client types necessitates appropriate liquidity management practices by the Company to ensure its ability to fund deposit withdrawals.

 

Return on Equity and Assets

 

The following table indicates the ratios for return on average assets and average equity, dividend payout, and average equity to average assets for 2007 and 2006:

 

 

 

Three Months Ended

 

Six Months Ended

 

 

June 30,

 

June 30,

 

 

 

2007

 

2006

 

2007

 

2006

 

Return on average assets

 

1.50

%

1.50

%

1.53

%

1.55

%

Return on average equity

 

12.17

%

14.35

%

12.63

%

14.93

%

Dividend payout ratio

 

17.41

%

14.11

%

17.37

%

13.80

%

Average equity to average assets

 

12.31

%

10.46

%

12.15

%

10.36

%

 

Liquidity and Asset/Liability Management

 

Liquidity refers to the Company’s ability to maintain cash flows sufficient to fund operations, and to meet obligations and other commitments in a timely and cost-effective fashion.  At various times the Company requires funds to meet short-term cash requirements brought about by loan growth or deposit outflows, the purchase of assets, or liability repayments.  To manage liquidity needs properly, cash inflows must be timed to coincide with

 

39



 

anticipated outflows or sufficient liquidity resources must be available to meet varying demands.  The Company manages liquidity in such a fashion as to be able to meet unexpected sudden changes in levels of its assets or deposit liabilities without maintaining excessive amounts of balance sheet liquidity.  Excess balance sheet liquidity can negatively impact the interest margin.

 

An integral part of the Company’s ability to manage its liquidity position appropriately is the Company’s large base of core deposits, which are generated by offering traditional banking services in its service area and which have, historically, been a stable source of funds.  In addition to core deposits, the Company has the ability to raise deposits through various deposit brokers if required for liquidity purposes.  The Company’s loan to deposit ratio increased to 83% at June 30, 2007 from 77% at June 30, 2006.

 

To meet liquidity needs, the Company maintains a portion of its funds in cash deposits at other banks, in Federal funds sold and in securities available-for-sale.  The primary liquidity ratio is composed of net cash, non-pledged securities, and other marketable assets, divided by total deposits and short-term liabilities minus liabilities secured by investments or other marketable assets.  As of June 30, 2007, the Company’s primary liquidity ratio was 14.5%, comprised of $77 million in securities available for sale of maturities of up to five years, less $21 million of securities that were pledged to secure public and certain other deposits as required by law and contract, Federal funds sold of $58 million, and $46 million cash and due from banks, as a percentage of total unsecured deposits of $1.1 billion.

 

As of June 30, 2006, the Company’s primary liquidity ratio was 18.6%, comprised of $92 million in securities available-for-sale of maturities of up to five years, less $11 million of securities that were pledged to secure public and certain other deposits as required by law and contract, Federal funds sold of $47 million and $39 million in cash and due from banks, as a percentage of total unsecured deposits of $897 million.

 

The following table summarizes the Company’s borrowings under its Federal funds purchased and security repurchase arrangements for the periods indicated:

 

 

 

June 30,

 

 

 

2007

 

2006

 

 

 

(Dollars in thousands)

 

Average balance year-to-date

 

$

19,015

 

$

29,119

 

Average interest rate year-to-date

 

2.73

%

2.39

%

Maximum month-end balance during the quarter

 

$

15,100

 

$

21,800

 

Average rate at June 30

 

2.66

%

2.43

%

 

Capital Resources

 

At June 30, 2007, the Company had total shareholders’ equity of $170 million, which included $103 million in common stock and $67 million in retained earnings.

 

The Company paid cash dividends totaling $1.4 million, or $.12 per share, in the first half of 2007. The Company anticipates paying future dividends within the range of typical peer payout ratios provided, however, that no assurance can be given that earnings and/or growth expectations in any given year will justify the payment of such a dividend.

 

On July 26, 2007, the Board of Directors authorized the repurchase of up to $30 million of common stock through June 30, 2009.  Shares may be repurchased in open market purchases or in privately negotiated transactions as permitted under applicable rules and regulations.  The repurchase program may be modified, suspended or terminated by the Board of Directors at any time without notice.  The extent to which the Company repurchases its shares and the timing of such repurchases will depend upon market conditions and other corporate considerations.

 

40



 

The Company uses a variety of measures to evaluate capital adequacy. Management reviews various capital measurements on a regular basis and takes appropriate action to ensure that such measurements are within established internal and external guidelines. The external guidelines, which are issued by the Federal Reserve Board and the FDIC, establish a risk-adjusted ratio relating capital to different categories of assets and off-balance sheet exposures. There are two categories of capital under the Federal Reserve Board and FDIC guidelines: Tier 1 and Tier 2 Capital. Our Tier 1 Capital currently includes common shareholders’ equity and the proceeds from the issuance of trust preferred securities (trust preferred securities are counted only up to a maximum of 25% of Tier 1 capital), less goodwill and other intangible assets, and the unrealized net gains/losses (net of deferred income taxes) on securities available for sale and I/O Strips, which are carried at fair market value. Our Tier 2 Capital includes the allowances for loan losses and off balance sheet credit losses.

 

The following table summarizes risk-based capital, risk-weighted assets, and risk-based capital ratios of the Company:

 

 

 

June 30,

 

December 31,

 

 

 

 

 

 

2007

 

2006

 

2006

 

 

 

 

 

 

(Dollars in thousands)

 

 

 

 

Capital components:

 

 

 

 

 

 

 

 

 

 

Tier 1 Capital

 

$

147,161

 

$

142,938

 

$

147,600

 

 

 

 

Tier 2 Capital

 

11,897

 

9,493

 

9,756

 

 

 

 

Total risk-based capital

 

$

159,058

 

$

152,431

 

$

157,356

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Risk-weighted assets

 

$

1,087,972

 

$

852,540

 

$

855,715

 

 

 

 

Average assets for capital purposes

 

$

1,029,893

 

$

1,125,188

 

$

1,087,502

 

 

 

 

Capital ratios

 

 

 

 

 

 

 

 

Minimum Regulatory Requirements

 

Total risk-based capital

 

14.6

%

17.9

%

18.4

%

 

8.00

%

Tier 1 risk-based capital

 

13.5

%

16.8

%

17.3

%

 

4.00

%

Leverage (1)

 

14.3

%

12.7

%

13.6

%

 

4.00

%


(1)     Leverage ratio is equal to Tier 1 capital divided by quarterly average assets (excluding goodwill and other intangible assets).

 

The table above presents the capital ratios of the Company computed in accordance with applicable regulatory guidelines and compared to the standards for minimum capital adequacy requirements under the FDIC’s prompt corrective action authority as of June 30, 2007.

 

Since the Diablo Valley Bank acquisition occurred on June 20, 2007, the transaction did not have much effect on the quarterly average assets used in the leverage ratio calculation.  If period end total assets were the denominator instead of average assets, the leverage ratio would be 11.3% at June 30, 2007.

 

At June 30, 2007 and 2006, and December 31, 2006, the Company’s capital met all minimum regulatory requirements.   As of June 30, 2007, management believes that HBC was considered “Well Capitalized” under the Prompt Corrective Action Provisions.

 

Market Risk

 

Market risk is the risk of loss to future earnings, to fair values, or to future cash flows that may result from changes in the price of a financial instrument. The value of a financial instrument may change as a result of changes in interest rates, foreign currency exchange rates, commodity prices, equity prices and other market changes that affect market risk sensitive instruments. Market risk is attributed to all market risk sensitive financial instruments,

 

41



 

including securities, loans, deposits and borrowings, as well as the Company’s role as a financial intermediary in customer-related transactions. The objective of market risk management is to avoid excessive exposure of the Company’s earnings and equity to loss and to reduce the volatility inherent in certain financial instruments.

 

Interest Rate Management

 

The Company’s market risk exposure is primarily that of interest rate risk, and it has established policies and procedures to monitor and limit earnings and balance sheet exposure to changes in interest rates. The Company does not engage in the trading of financial instruments, nor does the Company have exposure to currency exchange rates.

 

The principal objective of interest rate risk management (often referred to as “asset/liability management”) is to manage the financial components of the Company in a manner that will optimize the risk/reward equation for earnings and capital in relation to changing interest rates.  The Company’s exposure to market risk is reviewed on a regular basis by the Asset/Liability Committee (“ALCO”). Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximizing income. Management realizes certain risks are inherent, and that the goal is to identify and accept the risks. Management uses two methodologies to manage interest rate risk:  (i) a standard GAP analysis; and (ii) an interest rate shock simulation model.

 

The planning of asset and liability maturities is an integral part of the management of an institution’s net interest margin. To the extent maturities of assets and liabilities do not match in a changing interest rate environment; net interest margin may change over time. Even with perfectly matched repricing of assets and liabilities, risks remain in the form of prepayment of loans or securities or in the form of delays in the adjustment of rates of interest applying to either earning assets with floating rates or to interest bearing liabilities. The Company has generally been able to control its exposure to changing interest rates by maintaining primarily floating interest rate loans and a majority of its time certificates with relatively short maturities.

 

Interest rate changes do not affect all categories of assets and liabilities equally or at the same time. Varying interest rate environments can create unexpected changes in prepayment levels of assets and liabilities, which may have a significant effect on the net interest margin and are not reflected in the interest sensitivity analysis table. Because of these factors, an interest sensitivity gap report may not provide a complete assessment of the exposure to changes in interest rates.

 

The Company uses modeling software for asset/liability management to simulate the effects of potential interest rate changes on the Company’s net interest margin, and to calculate the estimated fair values of the Company’s financial instruments under different interest rate scenarios. The program imports current balances, interest rates, maturity dates and repricing information for individual financial instruments, and incorporates assumptions on the characteristics of embedded options along with pricing and duration for new volumes to project the effects of a given interest rate change on the Company’s interest income and interest expense. Rate scenarios consisting of key rate and yield curve projections are run against the Company’s investment, loan, deposit and borrowed funds portfolios.

 

The Company applies a market value (“MV”) methodology to gauge its interest rate risk exposure as derived from its simulation model. Generally, MV is the discounted present value of the difference between incoming cash flows on interest earning assets and other investments and outgoing cash flows on interest bearing liabilities and other liabilities. The application of the methodology attempts to quantify interest rate risk as the change in the MV which would result from a theoretical 200 basis point (1 basis point equals 0.01%) change in market interest rates. Both a 200 basis point increase and a 200 basis point decrease in market rates are considered.

 

At June 30, 2007, it was estimated that the Company’s MV would increase 12.0% in the event of a 200 basis point increase in market interest rates. The Company’s MV at the same date would decrease 17.5% in the event of a 200 basis point decrease in market interest rates.

 

42



 

Presented below, as of June 30, 2007 and 2006, is an analysis of the Company’s interest rate risk as measured by changes in MV for instantaneous and sustained parallel shifts of 200 basis points in market interest rates (excluding Diablo Valley Bank):

 

 

 

June 30, 2007

 

June 30, 2006

 

 

 

$ Change

 

% Change

 

Market Value as a % of

 

$ Change

 

% Change

 

Market Value as a % of

 

 

 

in Market

 

in Market

 

Present Value of Assets

 

in Market

 

in Market

 

Present Value of Assets

 

 

 

Value

 

Value

 

MV Ratio

 

Change (bp)

 

Value

 

Value

 

MV Ratio

 

Change (bp)

 

 

 

(Dollars in thousands)

 

Change in rates

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

+ 200 bp

 

$

27,048

 

12.0

%

23.74

%

254

 

$

31,109

 

15.4

%

21.70

%

288

 

0 bp

 

$

 

0.0

%

21.21

%

0

 

$

 

0.0

%

18.80

%

0

 

- 200 bp

 

$

(39,648

)

-17.5

%

17.49

%

(372

)

$

(44,467

)

-22.0

%

14.70

%

(412

)

 

Management believes that the MV methodology overcomes three shortcomings of the typical maturity gap methodology. First, it does not use arbitrary repricing intervals and accounts for all expected future cash flows. Second, because the MV method projects cash flows of each financial instrument under different interest rate environments, it can incorporate the effect of embedded options on an institution’s interest rate risk exposure. Third, it allows interest rates on different instruments to change by varying amounts in response to a change in market interest rates, resulting in more accurate estimates of cash flows.

 

However, as with any method of gauging interest rate risk, there are certain shortcomings inherent to the MV methodology. The model assumes interest rate changes are instantaneous parallel shifts in the yield curve. In reality, rate changes are rarely instantaneous. The use of the simplifying assumption that short-term and long-term rates change by the same degree may also misstate historic rate patterns, which rarely show parallel yield curve shifts. Further, the model assumes that certain assets and liabilities of similar maturity or period to repricing will react in the same way to changes in rates. In reality, certain types of financial instruments may react in advance of changes in market rates, while the reaction of other types of financial instruments may lag behind the change in general market rates. Additionally, the MV methodology does not reflect the full impact of annual and lifetime restrictions on changes in rates for certain assets, such as adjustable rate loans. When interest rates change, actual loan prepayments and actual early withdrawals from certificates may deviate significantly from the assumptions used in the model. Finally, this methodology does not measure or reflect the impact that higher rates may have on adjustable-rate loan clients’ ability to service their debt. All of these factors are considered in monitoring the Company’s exposure to interest rate risk.

 

CRITICAL ACCOUNTING POLICIES

 

General

 

The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”).  The financial information contained within our consolidated financial statements is, to a significant extent, based on approximate measures of the financial effects of transactions and events that have already occurred.  A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability.  In certain instances, we use a discount factor and prepayment assumptions to determine the present value of assets and liabilities. A change in the discount factor or prepayment speeds could increase or decrease the values of those assets and liabilities which would result in either a beneficial or adverse impact to our financial results. We use historical loss factors as one factor in determining the inherent loss that may be present in our loan portfolio.  Actual losses could differ significantly from the historical factors that we use.  The Company adopted Statement 123R on January 1, 2006, and elected the modified prospective method for expensing stock options, under which prior periods are not revised for comparative purposes.  Other estimates that we use are related to the expected useful lives of our depreciable assets.  In addition, GAAP itself may change from one previously acceptable method to another method, although the economics of our transactions would be the same.

 

43


 


 

Allowance for Loan Losses

 

The allowance for loan losses is an estimate of the losses in our loan portfolio.  Our accounting for estimated loan losses is discussed under the heading “Allowance for Loan Losses”.

 

Loan Sales and Servicing

 

The amounts of gains recorded on sales of loans and the initial recording of servicing assets and I/O strips are based on the estimated fair values of the respective components.  In recording the initial value of the servicing assets and the fair value of the I/O strips receivable, the Company uses estimates which are made on management’s expectations of future prepayment and discount rates.

 

Stock Based Compensation

 

We grant stock options to purchase our common stock to our employees and directors under the 2004 Plan.  We also granted our chief executive officer restricted stock when he joined the Company.  Additionally, we have outstanding options that were granted under an option plan from which we no longer make grants.  The benefits provided under all of these plans are subject to the provisions of FASB Statement 123(Revised), “Share-Based Payment,” which we adopted effective January 1, 2006.  We elected to use the modified prospective application in adopting Statement 123R and therefore have not restated results for prior periods.  The valuation provisions of Statement 123R apply to new awards and to awards that are outstanding on the adoption date and subsequently modified or cancelled.  Our results of operations for 2007 and 2006 were impacted by the recognition of non cash expense related to the fair value of our share-based compensation awards as discussed in Note 3 to the consolidated financial statements.

 

The determination of fair value of stock-based payment awards on the date of grant using the Black-Scholes model is affected by our stock price, as well as the input of other subjective assumptions.  These assumptions include, but are not limited to, the expected term of stock options and our expected stock price volatility over the term of the awards.  Our stock options have characteristics significantly different from those of traded options, and changes in the assumptions can materially affect the fair value estimates.

 

Statement 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.  If actual forfeitures vary from our estimates, we will recognize the difference in compensation expense in the period the actual forfeitures occur or when options vest.

 

ITEM 3 — QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

As a financial institution, the Company’s primary component of market risk is interest rate volatility. Fluctuations in interest rates will ultimately impact both the level of income and expense recorded on most of the Company’s assets and liabilities, and the market value of all interest-earning assets, other than those which have a short term to maturity. Based upon the nature of the Company’s operations, the Company is not subject to foreign exchange or commodity price risk. The Company has no market risk sensitive instruments held for trading purposes. As of June 30, 2007, the Company does not use interest rate derivatives to hedge its interest rate risk.

 

The information concerning quantitative and qualitative disclosure or market risk called for by Item 305 of Regulation S-K is included as part of Item above. See page 36.

 

ITEM 4 — CONTROLS AND PROCEDURES

 

Disclosure Control and Procedures

 

The Company has carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of June 30, 2007.  As defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), disclosure controls and

 

44



 

procedures are controls and procedures designed to reasonably assure that information required to be disclosed in our reports filed or submitted under the Exchange Act are recorded, processed, summarized and reported on a timely basis.  Disclosure controls are also designed to reasonably assure that such information is accumulated and communicated to our management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.  Based upon their evaluation, our Chief Executive Officer and Chief Financial Officer concluded the Company’s disclosure controls were effective as of June 30, 2007, the period covered by this report on Form 10Q/A.

 

During the six months ended June 30, 2007, there were no changes in our internal controls over financial reporting that materially affected, or are reasonably likely to affect, our internal controls over financial reporting.

 

Part II — OTHER INFORMATION

 

ITEM 1 — LEGAL PROCEEDINGS

 

The Company is involved in certain legal actions arising from normal business activities.  Management, based upon the advice of legal counsel, believes the ultimate resolution of all pending legal actions will not have a material effect on the financial statements of the Company.

 

ITEM 1A — RISK FACTORS

 

A description of the risk factors associated with our business is contained in Part I, Item 1A, “Risk Factors,” of our Annual Report Amendment No. 2 on Form 10-K/A for the fiscal year ended December 31, 2006 filed with the Securities and Exchange Commission.  These cautionary statements are to be used as a reference in connection with any forward-looking statements.  The factors, risks and uncertainties identified in these cautionary statements are in addition to those contained in any other cautionary statements, written or oral, which may be made or otherwise addressed in connection with a forward-looking statement or contained in any of our subsequent filings with the Securities and Exchange Commission.  There are no material changes in the  “Risk Factors” previously disclosed in the Annual Report Amendment No. 2 on Form 10-K/A for the year ended December 31, 2006.

 

ITEM 2 — UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

 

In February 2006, the Company’s Board of Directors authorized the purchase of up to $10 million of its common stock.  The share repurchase authorization expired on June 30, 2007.  On July 26, 2007, the Company’s Board of Directors authorized the purchase of up to an additional $30 million of its common stock over the next two years, which represents approximately 1.48 million shares, or 11% (based on the closing price of its shares on July 26, 2007).

 

The Company intends to finance the purchase using its available cash.  Shares may be repurchased by the Company in open market purchases or in privately negotiated transactions as permitted under applicable rules and regulations.  The repurchase program may be modified, suspended or terminated by the Board of Directors at any time without notice.  The extent to which the Company repurchases its shares and the timing of such repurchases will depend upon market conditions and other corporate considerations.

 

45



 

In the second quarter of 2007, repurchases of common stock are presented in the table below.

 

 

 

 

 

 

 

 

 

Approximate

 

 

 

 

 

 

 

Total Number of

 

Dollar of Shares That

 

 

 

 

 

 

 

Shares Purchased

 

May Yet Be

 

 

 

Total Number of

 

Price Paid

 

as Part of Publicly

 

Purchased

 

Settlement Date

 

Shares Purchased

 

Per Share

 

Announced Plans

 

Under the Plan

 

5/9/2007

 

5,000

 

$

24.15

 

5,000

 

$

1,079,018

 

5/10/2007

 

5,000

 

$

23.99

 

5,000

 

$

959,046

 

5/11/2007

 

5,000

 

$

23.80

 

5,000

 

$

840,057

 

5/14/2007

 

4,200

 

$

24.08

 

4,200

 

$

738,909

 

5/15/2007

 

6,000

 

$

23.99

 

6,000

 

$

594,942

 

 

 

25,200

 

 

 

25,200

 

 

 

 

 

ITEM 3 — DEFAULTS UPON SENIOR SECURITIES

 

None

 

ITEM 4 — SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

The Company held its 2007 Annual Meeting of Shareholders on May 24, 2007. There were 11,630,782 issued and outstanding shares of Company Common Stock on March 28, 2007, the record date for the 2007 Annual Meeting. Each of the shares voting at the meeting was entitled to one vote.

 

At the 2007 Annual Meeting, the following actions were taken:

 

Election of Directors

 

At the 2007 Annual Meeting, eleven directors of the Company were elected for one year term.  The following chart indicates the number of shares cast for each elected director:

 

Name of Director

 

Votes For

 

Votes Withheld

 

 

 

 

 

Frank G. Bisceglia

 

9,227,359

 

212,539

 

 

 

 

 

James R. Blair

 

9,196,126

 

243,772

 

 

 

 

 

Jack W. Conner

 

9,128,385

 

311,513

 

 

 

 

 

William J. Del Biaggio, Jr.

 

9,196,226

 

243,672

 

 

 

 

 

Walter T. Kaczmarek

 

9,196,266

 

243,672

 

 

 

 

 

Robert T. Moles

 

9,275,234

 

164,664

 

 

 

 

 

Louis (“Lon”) O. Normandin

 

9,136,785

 

303,113

 

 

 

 

 

Jack L. Peckham

 

9,161,744

 

278,154

 

 

 

 

 

Humphrey P. Polanen

 

9,078,905

 

360,993

 

 

 

 

 

Charles J. Toeniskoetter

 

9,300,193

 

139,705

 

 

 

 

 

Ranson W. Webster

 

9,275,234

 

164,664

 

46



 

ITEM 5 — OTHER INFORMATION

 

None

 

ITEM 6 — EXHIBITS

 

Exhibit

 

Description

 

 

 

31.1

 

Certification of Registrant’s Chief Executive Officer Pursuant To Section 302 of the Sarbanes-Oxley Act of 2002

 

 

 

31.2

 

Certification of Registrant’s Chief Financial Officer Pursuant To Section 302 of the Sarbanes-Oxley Act of 2002

 

 

 

32.1

 

Certification of Registrant’s Chief Executive Officer Pursuant To 18 U.S.C. Section 1350

 

 

 

32.2

 

Certification of Registrant’s Chief Financial Officer Pursuant To 18 U.S.C. Section 1350

 

 

SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

 

Heritage Commerce Corp

 

 

 

(Registrant)

 

 

 

 

 

February 22, 2008

/s/

Walter T. Kaczmarek

 

Date

 

Walter T. Kaczmarek

 

 

 

Chief Executive Officer

 

 

 

 

 

February 22, 2008

/s/

Lawrence D. McGovern

 

Date

 

Lawrence D. McGovern

 

 

 

Chief Financial Officer

 

 

47



 

EXHIBIT INDEX

 

Exhibit

 

Description

 

 

 

31.1

 

Certification of Registrant’s Chief Executive Officer Pursuant To Section 302 of the Sarbanes-Oxley Act of 2002

 

 

 

31.2

 

Certification of Registrant’s Chief Financial Officer Pursuant To Section 302 of the Sarbanes-Oxley Act of 2002

 

 

 

32.1

 

Certification of Registrant’s Chief Executive Officer Pursuant To 18 U.S.C. Section 1350

 

 

 

32.2

 

Certification of Registrant’s Chief Financial Officer Pursuant To 18 U.S.C. Section 1350

 

48