10-K 1 sevice_k07.txt 10-K UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2007 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from __________________to __________________ 000-50323 ------------------------ (Commission File Number) SERVICE 1ST BANCORP ------------------------------------------------------ (Exact name of registrant as specified in its charter) State of California 32-0061893 ------------------------------- ----------------------- (State or other jurisdiction of (IRS Employer incorporation or organization) Identification Number) 49 W. 10th Street, Tracy, California 95376 -------------------------------------------------- (Address of principal executive offices, Zip Code) Registrant's telephone number, including area code: (209) 830-6995 Securities registered pursuant to Section 12 (b) of the Act: None Securities registered pursuant to Section 12 (g) of the Act: Title of Each Class --------------------------- Common Stock (No Par Value) Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes [ ] No [X] Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes [ ] No [X] Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (Section 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. Large accelerated filer [ ] Accelerated filer [ ] Non-accelerated filer [ ] Smaller reporting company [X] (Do not check if a smaller reporting company) Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes [ ] No [X] State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant's most recently completed second fiscal quarter. $27,467,437. Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date. As of March 28, 2008, the registrant had 2,388,739 shares of its common stock outstanding. Documents incorporated by reference: The registrant's proxy statement for its 2008 Annual Meeting of Shareholders is incorporated herein by reference in Part III, Items 10 through 14. The Index to Exhibits is located at page 90. INDEX TO SERVICE 1ST BANCORP ANNUAL REPORT ON FORM 10-K FOR YEAR ENDED DECEMBER 31, 2007 Part I Page Item 1 Business 2 Item 1A Risk Factors 13 Item 1B Unresolved Staff Comments 16 Item 2 Properties 16 Item 3 Legal Proceedings 17 Item 4 Submission of Matters to a Vote of Security Holders 17 Part II Item 5 Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 17 Item 6 Selected Financial Data 20 Item 7 Management's Discussion and Analysis of Financial Condition and Results of Operations 21 Item 7A Quantitative and Qualitative Disclosures About Market Risk 42 Item 8 Financial Statements and Supplementary Data 45 Item 9 Changes In and Disagreements with Accountants on Accounting and Financial Disclosure 81 Item 9A Controls and Procedures 81 Item 9B Other Information 82 Part III Item 10 Directors, Executive Officers, and Corporate Governance 83 Item 11 Executive Compensation 83 Item 12 Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 83 Item 13 Certain Relationships and Related Transactions, and Director Independence 83 Item 14 Principal Accounting Fees and Services 83 Part IV Item 15 Exhibits and Financial Statement Schedules 83 Signatures 88 Exhibit Index 90 10.30 Employee Agreement dated November 16, 2007 for Thomas A. Vander Ploeg 91 23.1 Consent of Vavrinek, Trine, Day & Co., LLP 99 31.1 Certifications of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 100 31.2 Certifications of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 101 32.1 Certifications of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 102 PART I ITEM 1. BUSINESS CAUTIONARY STATEMENTS REGARDING FORWARD-LOOKING STATEMENTS Certain matters discussed or incorporated by reference in this Annual Report on Form 10-K including, but not limited to, matters described in "Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations," are "forward-looking statements" within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, Section 27A of the Securities Act of 1933, as amended, and subject to the safe- harbor provisions of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements may contain words related to future projections including, but not limited to, words such as "believe," "expect," "anticipate," "intend," "may," "will," "should," "could," "would," and variations of those words and similar words that are subject to risks, uncertainties and other factors that could cause actual results to differ materially from those projected. Factors that could cause or contribute to such differences include, but are not limited to, the following: (1) variances in the actual versus projected growth in assets; (2) return on assets; (3) loan and lease losses; (4) expenses; (5) changes in the interest rate environment including interest rates charged on loans, earned on securities investments and paid on deposits; (6) competition effects; (7) fee and other noninterest income earned; (8) general economic conditions nationally, regionally, and in the operating market areas of the Company and its subsidiaries; (9) changes in the regulatory environment; (10) changes in business conditions and inflation; (11) changes in securities markets; (12) data processing problems; (13) a decline in real estate values in the Company's operating market areas; (14) the effects of earthquakes, floods, fires and other natural disasters, (15) terrorism, the threat of terrorism or the impact of the current military conflict in Afghanistan and Iraq and the conduct of the war on terrorism by the United States and its allies, as well as other factors. These factors set forth under "Item 1a-Risk Factors" in this report and other cautionary statements and information set forth in this report should be carefully considered and understood as being applicable to all related forward-looking statements contained in this report, when evaluating the business prospects of the Company and its subsidiaries. Forward-looking statements are not guarantees of performance. By their nature, they involve risks, uncertainties and assumptions. The future results and shareholder values may differ significantly from those expressed in these forward-looking statements. You are cautioned not to put undue reliance on any forward-looking statement. Any such statement speaks only as of the date of this report, and in the case of any documents that may be incorporated by reference, as of the date of those documents. We do not undertake any obligation to update or release any revisions to any forward-looking statements, to report any new information, future event or other circumstances after the date of this report or to reflect the occurrence of unanticipated events, except as required by law. However, your attention is directed to any further disclosures made on related subjects in our subsequent reports filed with the Securities and Exchange Commission on Forms 10-K, 10-Q and 8-K. GENERAL DEVELOPMENT OF BUSINESS Service 1st Bancorp (the "Company") is a California corporation, incorporated on January 23, 2003 to act as a holding company for Service 1st Bank (the "Bank"). The Bank became a subsidiary of the Company effective June 26, 2003. The Bank is locally owned and operated and serves the individuals, small and medium-sized businesses, municipalities and professionals located in and adjacent to the cities of Stockton, Tracy, Lodi and adjacent communities in San Joaquin County. On July 7, 2006, the Company organized Charter Services Group, Inc., a California corporation ("Charter"), as a wholly-owned subsidiary. Charter was formed to provide consulting services primarily related to start-up (de novo) bank formations. Charter conducts its operations from its headquarters office located at 1901 W. Kettleman Lane, Suite 102, Lodi, California 95242. The Company's administrative office is located at 49 West 10th Street, Tracy, California 95376. The Bank conducts operations at offices located at 2800 West March Lane, Suite 120, Stockton, California 95219, 60 West 10th Street, Tracy, California 95376, and 1901 W. Kettleman Lane, Suite 100, Lodi, California 95242. These offices are open from 9:00 a.m. to 5:00 p.m., Monday through Thursday and from 9:00 a.m. to 6:00 p.m. on Friday. 2 The Bank offers a full range of commercial banking services including acceptance of demand, savings and time deposits, and the making of commercial, real estate (including residential mortgage, construction and land development), leases, and consumer loans. The Bank sells cashier's checks, traveler's checks and money orders. The Bank also offers night depository, notary services, telephone and wire transfers, and federal tax depository services. The Bank does not offer trust or international banking services, but will arrange for such services through a correspondent bank. The Bank's data processing operations are provided through an outside vendor, Fiserv Solutions, Inc., 20660 Bahama Street, Chatsworth, California 91311, which provides processing of the Bank's deposits, loans and financial accounting. The Bank obtains market penetration from the services referred to above and by the personal solicitation of the Bank's officers, directors and shareholders. The Bank's deposits are attracted primarily from individuals, small and medium-sized businesses, municipalities and professionals in its market area. The Bank's deposits are not received from a single depositor or group of affiliated depositors, the loss of any one of which would have a materially adverse effect on the business of the Bank, nor is a material portion of the Bank's deposits concentrated within a single industry or group of related industries. As of December 31, 2007 the Company's total assets were $231,075,943 compared to $227,220,390 in 2006. As of December 31, 2007, the Bank had total loans of $114,887,771 before deducting the allowance for loan losses of $1,558,050 and deferred fees of $160,557. Of the loan total, $23,029,593 were commercial loans, $45,002,196 were real estate loans, $29,541,045 were construction and land development loans, $4,713,710 were agriculture loans, $8,560,166 were leases, and $4,041,061 were consumer loans. Total deposits at December 31, 2007 were $202,405,646. Of the deposit total, $26,697,543 were non-interest-bearing demand deposits, $86,305,530 were interest-bearing demand, money market and savings deposits, and $89,402,573 were interest-bearing time deposits. During 2007, The Company conducted no significant activities other than holding the shares of its subsidiaries. However, it is authorized, with the prior approval of the Board of Governors of the Federal Reserve System ("The Board of Governors"), the Company's principal regulator, to engage in a variety of activities which are deemed closely related to the business of banking. The common stock of the Company is not listed on any exchange, but it is quoted on the OTC Bulletin Board under the symbol "SCVF." The principal source of the Company's revenues reflected as a percentage of total revenues are: (1) interest and fees on loans 64.9%; (2) interest on Federal Funds sold 1.6%; (3) interest on investments 28.0%; (4) gain on sale and servicing of loans .4%; (5) referral fees on loans 1.7%; (6) service charges and other fees 1.9%; (7) earnings on cash surrender value life insurance 1.0%; and (8) interest on certificates of deposit with other banks .5%. Employees The Company employed 41 people on a full-time equivalent basis as of December 31, 2007. Website Access Information regarding the Company, the Bank, and Charter may be obtained from the Company's website at www.service1stbank.com. Copies of the Company's annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and Section 16 reports by Company insiders, including exhibits and amendments thereto, are available free of charge on the Company's website as soon as they are published by the Securities and Exchange Commission through a link to the Edgar reporting system maintained by the Securities and Exchange Commission. To access Company filings, select "Go to Service 1st Bancorp" at the bottom of the Company website page, then select "Click here to view Service 1st Bancorp SEC Filings", followed by selecting "Continue to view SEC Filings" to view or download copies of reports including Form 10-K, 10-Q or 8-K, or select "Click here to view Section 16 Reports," followed by selecting "Continue to view Section 16 Reports," to view or download reports on Forms 3, 4 or 5 of insider transactions in Company securities. 3 SUPERVISION AND REGULATION General The common stock of the Company is subject to the registration requirements of the Securities Act of 1933, as amended, and the qualification requirements of the California Corporate Securities Law of 1968, as amended. The Company is also subject to the periodic reporting requirements of Section 13 of the Securities Exchange Act of 1934, as amended, which include, but are not limited to, annual, quarterly and other current reports with the Securities and Exchange Commission (the "SEC"). The Bank is licensed by the California Commissioner of Financial Institutions ("Commissioner"), its deposits are insured by the Federal Deposit Insurance Corporation ("FDIC") up to the applicable legal limits, and it has chosen not to become a member of the Federal Reserve System. Consequently, the Bank is subject to the supervision of, and is regularly examined by, the Commissioner and the FDIC. The supervision and regulation includes comprehensive reviews of all major aspects of the Bank's business and condition, including its capital ratios, allowance for possible loan losses and other factors. However, no inference should be drawn that such authorities have approved any such factors. The Company and the Bank are required to file reports with the Board of Governors, the Commissioner, and the FDIC and provide the additional information that the Board of Governors, Commissioner, and FDIC may require. The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended (the "Bank Holding Company Act"), and is registered as such with, and subject to the supervision of, the Board of Governors. The Company is required to obtain the approval of the Board of Governors before it may acquire all or substantially all of the assets of any bank, or ownership or control of the voting shares of any bank if, after giving effect to such acquisition of shares, the Company would own or control more than 5% of the voting shares of such bank. The Bank Holding Company Act prohibits the Company from acquiring any voting shares of, or interest in, all or substantially all of the assets of, a bank located outside the State of California unless such an acquisition is specifically authorized by the laws of the state in which such bank is located. Any such interstate acquisition is also subject to the California law that implemented certain provisions of prior Federal law. The Company, and any subsidiaries which it may acquire or organize, are deemed to be "affiliates" within the meaning of that term as defined in the Federal Reserve Act. This means, for example, that there are limitations (a) on loans by the Bank to affiliates, and (b) on investments by the Bank in affiliates' stock as collateral for loans to any borrower. The Company and its subsidiaries are also subject to certain restrictions with respect to engaging in the underwriting, public sale and distribution of securities. In addition, regulations of the Board of Governors under the Federal Reserve Act require that reserves be maintained by the Bank in conjunction with any liability of the Company under any obligation (promissory note, acknowledgement of advance, banker's acceptance or similar obligation) with a weighted average maturity of less than seven (7) years to the extent that the proceeds of such obligations are used for the purpose of supplying funds to the Bank for use in its banking business, or to maintain the availability of such funds. Capital Standards The Board of Governors and the FDIC have adopted risk-based capital guidelines for evaluating the capital adequacy of bank holding companies and banks. The guidelines are designed to make capital requirements sensitive to differences in risk profiles among banking organizations, to take into account off-balance sheet exposures and to aid in making the definition of bank capital uniform internationally. Under the guidelines, the Company and the Bank are required to maintain capital equal to at least 8.0% of its assets and commitments to extend credit, weighted by risk, of which at least 4.0% must consist primarily of common equity (including retained earnings) and the remainder may consist of subordinated debt, cumulative preferred stock, or a limited amount of loan loss reserves. 4 Assets, commitments to extend credit, and off-balance sheet items are categorized according to risk and certain assets considered to present less risk than others permit maintenance of capital at less than the 8% ratio. For example, most home mortgage loans are placed in a 50% risk category and therefore require maintenance of capital equal to 4% of those loans, while commercial loans are placed in a 100% risk category and therefore require maintenance of capital equal to 8% of those loans. Under the risk-based capital guidelines, assets reported on an institution's balance sheet and certain off-balance sheet items are assigned to risk categories, each of which has an assigned risk weight. Capital ratios are calculated by dividing the institution's qualifying capital by its period-end risk-weighted assets. The guidelines establish two categories of qualifying capital: Tier 1 capital (defined to include common shareholders' equity and non-cumulative perpetual preferred stock) and Tier 2 capital which includes, among other items, limited life (and in the case of banks, cumulative) preferred stock, mandatory convertible securities, subordinated debt and a limited amount of reserve for credit losses. Tier 2 capital may also include up to 45% of the pretax net unrealized gains on certain available-for-sale equity securities having readily determinable fair values (i.e. the excess, if any, of fair market value over the book value or historical cost of the investment security). The federal regulatory agencies reserve the right to exclude all or a portion of the unrealized gains upon a determination that the equity securities are not prudently valued. Unrealized gains and losses on other types of assets, such as bank premises and available-for-sale debt securities, are not included in Tier 2 capital, but may be taken into account in the evaluation of overall capital adequacy and net unrealized losses on available-for-sale equity securities will continue to be deducted from Tier 1 capital as a cushion against risk. Each institution is required to maintain a minimum risk-based capital ratio (including Tier 1 and Tier 2 capital) of 8%, of which at least half must be Tier 1 capital. A leverage capital standard was adopted as a supplement to the risk-weighted capital guidelines. Under the leverage capital standard, an institution is required to maintain a minimum ratio of Tier 1 capital to the sum of its quarterly average total assets and quarterly average reserve for loan losses, less intangible assets not included in Tier 1 capital. Period-end assets may be used in place of quarterly average total assets on a case-by-case basis. The Board of Governors and the FDIC have also adopted a minimum leverage ratio for bank holding companies as a supplement to the risk-weighted capital guidelines. The leverage ratio establishes a minimum Tier 1 ratio of 3% (Tier 1 capital to total assets) for the highest rated bank holding companies or those that have implemented the risk-based capital market risk measure. All other bank holding companies must maintain a minimum Tier 1 leverage ratio of 4% with higher leverage capital ratios required for bank holding companies that have significant financial and/or operational weakness, a high risk profile, or are undergoing or anticipating rapid growth. At December 31, 2007, the Company and the Bank were in compliance with the risk-weighted capital and leverage ratio guidelines. Prompt Corrective Action The Board of Governors and FDIC have adopted regulations implementing a system of prompt corrective action pursuant to Section 38 of the Federal Deposit Insurance Act and Section 131 of the FDIC Improvement Act of 1991 ("FDICIA"). The regulations establish five capital categories with the following characteristics: (1) "Well capitalized" - consisting of institutions with a total risk-based capital ratio of 10% or greater, a Tier 1 risk-based capital ratio of 6% or greater and a leverage ratio of 5% or greater, and the institution is not subject to an order, written agreement, capital directive or prompt corrective action directive; (2) "Adequately capitalized" - consisting of institutions with a total risk-based capital ratio of 8% or greater, a Tier 1 risk-based capital ratio of 4% or greater and a leverage ratio of 4% or greater, and the institution does not meet the definition of a "well capitalized" institution; (3) "Undercapitalized" - consisting of institutions with a total risk-based capital ratio less than 8%, a Tier 1 risk-based capital ratio of less than 4%, or a leverage ratio of less than 4%; (4) "Significantly undercapitalized" - consisting of institutions with a total risk-based capital ratio of less than 6%, a Tier 1 risk-based capital ratio of less than 3%, or a leverage ratio of less than 3%; (5) "Critically undercapitalized" - consisting of an institution with a ratio of tangible equity to total assets that is equal to or less than 2%. The regulations established procedures for classification of financial institutions within the capital categories, filing and reviewing capital restoration plans required under the regulations and procedures for issuance of directives by the appropriate regulatory agency, among other matters. The regulations impose restrictions upon all institutions to refrain from certain actions which would cause an institution to be classified within any one of the 5 three "undercapitalized" categories, such as declaration of dividends or other capital distributions or payment of management fees, if following the distribution or payment the institution would be classified within one of the "undercapitalized" categories. In addition, institutions which are classified in one of the three "undercapitalized" categories are subject to certain mandatory and discretionary supervisory actions. Mandatory supervisory actions include (1) increased monitoring and review by the appropriate federal banking agency; (2) implementation of a capital restoration plan; (3) total asset growth restrictions; and (4) limitations upon acquisitions, branch expansion, and new business activities without prior approval of the appropriate federal banking agency. Discretionary supervisory actions may include (1) requirements to augment capital; (2) restrictions upon affiliate transactions; (3) restrictions upon deposit gathering activities and interest rates paid; (4) replacement of senior executive officers and directors; (5) restrictions upon activities of the institution and its affiliates; (6) requiring divestiture or sale of the institution; and (7) any other supervisory action that the appropriate federal banking agency determines is necessary to further the purposes of the regulations. Further, the federal banking agencies may not accept a capital restoration plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution's capital. In addition, for a capital restoration plan to be acceptable, the depository institution's parent holding company must guarantee that the institution will comply with such capital restoration plan. The aggregate liability of the parent holding company under the guaranty is limited to the lesser of (i) an amount equal to 5 percent of the depository institution's total assets at the time it became undercapitalized, and (ii) the amount that is necessary (or would have been necessary) to bring the institution into compliance with all capital standards applicable with respect to such institution as of the time it fails to comply with the plan. If a depository institution fails to submit an acceptable plan, it is treated as if it were "significantly undercapitalized." FDICIA also restricts the solicitation and acceptance of and interest rates payable on brokered deposits by insured depository institutions that are not "well capitalized." An "undercapitalized" institution is not allowed to solicit deposits by offering rates of interest that are significantly higher than the prevailing rates of interest on insured deposits in the particular institution's normal market areas or in the market areas in which such deposits would otherwise be accepted. Any financial institution which is classified as "critically undercapitalized" must be placed in conservatorship or receivership within 90 days of such determination unless it is also determined that some other course of action would better serve the purposes of the regulations. Critically undercapitalized institutions are also prohibited from making (but not accruing) any payment of principal or interest on subordinated debt without prior regulatory approval and regulators must prohibit a critically undercapitalized institution from taking certain other actions without prior approval, including (1) entering into any material transaction other than in the usual course of business, including investment expansion, acquisition, sale of assets or other similar actions; (2) extending credit for any highly leveraged transaction; (3) amending articles or bylaws unless required to do so to comply with any law, regulation or order; (4) making any material change in accounting methods; (5) engaging in certain affiliate transactions; (6) paying excessive compensation or bonuses; and (7) paying interest on new or renewed liabilities at rates which would increase the weighted average costs of funds beyond prevailing rates in the institution's normal market areas. Additional Regulations Under the FDICIA, the federal financial institution agencies have adopted regulations which require institutions to establish and maintain comprehensive written real estate policies which address certain lending considerations, including loan-to-value limits, loan administrative policies, portfolio diversification standards, and documentation, approval and reporting requirements. The FDICIA further generally prohibits an insured state bank from engaging as a principal in any activity that is impermissible for a national bank, absent FDIC determination that the activity would not pose a significant risk to the Bank Insurance Fund, and that the bank is, and will continue to be, within applicable capital standards. The Federal Financial Institution Examination Counsel ("FFIEC") utilizes the Uniform Financial Institutions Rating System ("UFIRS") commonly referred to as "CAMELS" to classify and evaluate the soundness of financial institutions. Bank examiners use the CAMELS measurements to evaluate capital adequacy, asset quality, management, earnings, liquidity and sensitivity to market risk. Effective January 1, 2005, bank holding companies such as the Company were subject to evaluation and examination under a revised bank holding company rating system. The so-called BOPEC rating system implemented in 1979 was primarily focused on financial condition, consolidated capital and consolidated earnings. The rating system reflects the change toward analysis of risk 6 management (as reflected in bank examination under the CAMELS measurements), in addition to financial factors and the potential impact of nondepository subsidiaries upon depository institution subsidiaries. The federal financial institution agencies have established bases for analysis and standards for assessing a financial institution's capital adequacy in conjunction with the risk-based capital guidelines including analysis of interest rate risk, concentrations of credit risk, risk posed by non-traditional activities, and factors affecting overall safety and soundness. The safety and soundness standards for insured financial institutions include analysis of (1) internal controls, information systems and internal audit systems; (2) loan documentation; (3) credit underwriting; (4) interest rate exposure; (5) asset growth; (6) compensation, fees and benefits; and (7) excessive compensation for executive officers, directors or principal shareholders which could lead to material financial loss. If an agency determines that an institution fails to meet any standard, the agency may require the financial institution to submit to the agency an acceptable plan to achieve compliance with the standard. If the agency requires submission of a compliance plan and the institution fails to timely submit an acceptable plan or to implement an accepted plan, the agency must require the institution to correct the deficiency. The agencies may elect to initiate enforcement action in certain cases rather than rely on an existing plan particularly where failure to meet one or more of the standards could threaten the safe and sound operation of the institution. Community Reinvestment Act ("CRA") regulations evaluate banks' lending to low and moderate income individuals and businesses across a four-point scale from "outstanding" to "substantial noncompliance," and are a factor in regulatory review of applications to merge, establish new branches or form bank holding companies. In addition, any bank rated in "substantial noncompliance" with the CRA regulations may be subject to enforcement proceedings. The Bank currently has a rating of "satisfactory" for CRA compliance. Limitations on Dividends The Company's ability to pay cash dividends is subject to restrictions set forth in the California General Corporation Law. Funds for payment of any cash dividends by the Company would be obtained from its investments as well as dividends and/or management fees from its subsidiaries. The payment of cash dividends and/or management fees by the Bank is subject to restrictions set forth in the California Financial Code, as well as restrictions established by the FDIC. See Item 5. "Market for Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities" for more information regarding cash dividends. COMPETITION Competitive Data At June 30, 2007, based on the most recent "Data Book Summary of Deposits in FDIC Insured Commercial and Savings Banks" report at that date, the competing commercial and savings banks had 101 offices in the cities of Tracy, Stockton, and Lodi, California, where the Bank has three offices. Additionally, the Bank competes with thrifts and, to a lesser extent, credit unions, finance companies and other financial service providers for deposit and loan customers. Larger banks may have a competitive advantage because of higher lending limits and major advertising and marketing campaigns. They also perform services, such as trust services, international banking, discount brokerage and insurance services, which the Bank is not authorized nor prepared to offer currently. The Bank has made arrangements with its correspondent banks and with others to provide some of these services for its customers. For borrowers requiring loans in excess of the Bank's legal lending limits, the Bank has offered, and intends to offer in the future, such loans on a participating basis with its correspondent banks and with other community banks, retaining the portion of such loans which is within its lending limits. As of December 31, 2007, the Bank's aggregate legal lending limits to a single borrower and such borrower's related parties were $3,369,810 on an unsecured basis and $5,616,350 on a fully secured basis based on the Bank's regulatory capital and reserves of $22,465,401. The Bank's business is concentrated in its service area, which primarily encompasses San Joaquin County. The economy of the Bank's service area is dependent upon government, manufacturing, residential construction, tourism, retail sales, population growth and smaller service oriented businesses. 7 Based upon the most recent "Data Book Summary of Deposits in FDIC Insured Commercial and Savings Banks" report dated June 30, 2007, there were 123 operating commercial and savings bank offices in San Joaquin County with total deposits of $7,467,375,000. The Bank held a total of $191,813,000 in deposits, representing approximately 2.57% of total commercial and savings banks deposits in San Joaquin County as of June 30, 2007. At June 30, 2006, the Bank held approximately 2.20% of the deposits in the County. In 1996, pursuant to Congressional mandate, the FDIC reduced bank deposit insurance assessment rates to a range from $0 to $0.27 per $100 of deposits, dependent upon a bank's risk. In 2005, Congress adopted the Federal Deposit Insurance Reform Act of 2005 (the "Reform Act"), which had the effect of merging the Bank Insurance Fund and the Savings Association Insurance Fund into a new Deposit Insurance Fund ("DIF"). The FDIC released final regulations under the Reform Act on November 2, 2006 that established a revised risk-based deposit insurance assessment rate system for members of the DIF to insure, among other matters, that there will be sufficient assessment income for repayment of DIF obligations and to further refine the differentiation of risk profiles among institutions as a basis for assessments. Under the new assessment rate system, the FDIC set the assessment rates that became effective January 1, 2007 for most institutions from $0.05 to $0.07 per $100 of insured deposits and established a Designated Reserve Ratio ("DRR") for the DIF during 2007 of 1.25% of insured deposits. The new assessment rate system consolidates the nine categories of the prior assessment system into four categories (Risk Categories I, II, III and IV) and three Supervisory Groups (A, B and C) based upon an institution's capital levels and supervisory ratings. Risk Category I includes all well capitalized institutions with the highest supervisory ratings. Risk Category II includes adequately capitalized institutions that are assigned to Supervisory Groups A and B. Risk Category III includes all undercapitalized institutions that are assigned to Supervisory Groups A and B and institutions assigned to Supervisory Group C that are not undercapitalized, but have a low supervisory rating. Risk Category IV includes all undercapitalized institutions that are assigned to Supervisory Group C. Based upon the current risk-based assessment rate schedule, Service 1st Bank's current capital ratios and levels of deposits, Service 1st Bank does not anticipate a significant increase in operating expenses due to the assessment rate applicable to it during 2008 compared to 2007. General Competitive Factors In order to compete with the major financial institutions in their primary service areas, the Bank uses to the fullest extent possible the flexibility which is accorded by its community bank status. This includes an emphasis on specialized services, local promotional activity, and personal contacts by its respective officers, directors and employees. The Bank also seeks to provide special services and programs for individuals in its primary service area who are employed in the agricultural, professional and business fields, such as loans for equipment, furniture, tools of the trade or expansion of practices or businesses. In the event there are customers whose loan demands exceed their respective lending limits, the Bank seeks to arrange for such loans on a participation basis with other financial institutions. The Bank also assists those customers requiring services not offered by the Bank to obtain such services from correspondent banks. Commercial banks compete with savings and loan associations, credit unions, other financial institutions and other entities for funds. For instance, yields on corporate and government debt securities and other commercial paper affect the ability of commercial banks to attract and hold deposits. Commercial banks also compete for loans with savings and loan associations, credit unions, consumer finance companies, mortgage companies and other lending institutions. Banking is a business that depends on interest rate differentials. In general, the difference between the interest rate paid by a bank to obtain their deposits and other borrowings and the interest rate received by a bank on loans extended to customers and on securities held in a bank's portfolio comprise the major portion of a bank's earnings. The interest rate differentials of a bank, and therefore its earnings, are affected not only by general economic conditions, both domestic and foreign, but also by the monetary and fiscal policies of the United States as set by statutes and as implemented by federal agencies, particularly the Federal Reserve Board. The Federal Reserve Board can and does implement national 8 monetary policy, such as seeking to curb inflation and combat recession, by its open market operations in United States government securities, adjustments in the amount of interest free reserves that banks and other financial institutions are required to maintain, and adjustments to the discount rates applicable to borrowing by banks from the Federal Reserve Board. These activities influence the growth of bank loans, investments and deposits and also affect interest rates charged on loans and paid on deposits. The nature and timing of any future changes in monetary policies and their impact on the Company and the Bank is not predictable. Impact of Legislative and Regulatory Proposals Since 1996, California law implementing certain provisions of prior federal law has (1) permitted interstate merger transactions; (2) prohibited interstate branching through the acquisition of a branch business unit located in California without acquisition of the whole business unit of the California bank; and (3) prohibited interstate branching through de novo establishment of California branch offices. Initial entry into California by an out-of-state institution must be accomplished by acquisition of or merger with an existing whole bank which has been in existence for at least five years. The federal financial institution agencies, especially the Office of the Comptroller of the Currency ("OCC") and the Board of Governors, have taken steps to increase the types of activities in which national banks and bank holding companies can engage, and to make it easier to engage in such activities. The OCC has issued regulations permitting national banks to engage in a wider range of activities through subsidiaries. "Eligible institutions" (those national banks that are well capitalized, have a high overall rating and a satisfactory CRA rating, and are not subject to an enforcement order) may engage in activities related to banking through operating subsidiaries subject to an expedited application process. In addition, a national bank may apply to the OCC to engage in an activity through a subsidiary in which the Bank itself may not engage. In 1999, the Gramm-Leach-Bliley Act (the "GLB Act") was signed into law. The GLB Act eliminates most of the remaining depression-era "firewalls" between banks, securities firms and insurance companies which was established by The Banking Act of 1933, also known as the Glass-Steagall Act ("Glass-Steagall"). Glass-Steagall sought to insulate banks as depository institutions from the perceived risks of securities dealing and underwriting, and related activities. The GLB Act repealed Section 20 of Glass-Steagall which prohibited banks from affiliating with securities firms. Bank holding companies that can qualify as "financial holding companies" can now acquire securities firms or create them as subsidiaries, and securities firms can now acquire banks or start banking activities through a financial holding company. The GLB Act includes provisions which permit national banks to conduct financial activities through a subsidiary that are permissible for a national bank to engage in directly, as well as certain activities authorized by statute, or that are financial in nature or incidental to financial activities to the same extent as permitted to a "financial holding company" or its affiliates. This liberalization of United States banking and financial services regulation applies both to domestic institutions and foreign institutions conducting business in the United States. Consequently, the common ownership of banks, securities firms and insurance firms is now possible, as is the conduct of commercial banking, merchant banking, investment management, securities underwriting and insurance within a single financial institution using a "financial holding company" structure authorized by the GLB Act. Prior to the GLB Act, significant restrictions existed on the affiliation of banks with securities firms and on the direct conduct by banks of securities dealing and underwriting and related securities activities. Banks were also (with minor exceptions) prohibited from engaging in insurance activities or affiliating with insurers. The GLB Act removed these restrictions and substantially eliminated the prohibitions under the Bank Holding Company Act on affiliations between banks and insurance companies. Bank holding companies which qualify as financial holding companies can now insure, guarantee, or indemnify against loss, harm, damage, illness, disability, or death; issue annuities; and act as a principal, agent, or broker regarding such insurance services. In order for a commercial bank to affiliate with a securities firm or an insurance company pursuant to the GLB Act, its bank holding company must qualify as a financial holding company. A bank holding company will qualify if (1) its banking subsidiaries are "well capitalized" and "well managed" and (2) it files with the Board of Governors a certification to such effect and a declaration that it elects to become a financial holding company. The amendment of the Bank Holding Company Act now permits financial holding companies to engage in activities, and acquire companies engaged in activities, that are 9 financial in nature or incidental to such financial activities. Financial holding companies are also permitted to engage in activities that are complementary to financial activities if the Board of Governors determines that the activity does not pose a substantial risk to the safety or soundness of depository institutions or the financial system in general. These standards expand upon the list of activities "closely related to banking" which have to date, defined the permissible activities of bank holding companies under the Bank Holding Company Act. One further effect of the GLB Act is to require that federal financial institution and securities regulatory agencies prescribe regulations to implement the policy that financial institutions must respect the privacy of their customers and protect the security and confidentiality of customers' non-public personal information. These regulations require, in general, that financial institutions (1) may not disclose non-public personal information of customers to non-affiliated third parties without notice to their customers, who must have the opportunity to direct that such information not be disclosed; (2) may not disclose customer account numbers except to consumer reporting agencies; and (3) must give prior disclosure of their privacy policies before establishing new customer relationships. Neither the Company nor the Bank have determined whether or when they may seek to acquire and exercise powers or activities under the GLB Act, and the extent to which competition will change among financial institutions affected by the GLB Act has not yet become clear. On October 26, 2001, President Bush signed the USA Patriot Act (the "Patriot Act"), which includes provisions pertaining to domestic security, surveillance procedures, border protection, and terrorism laws to be administered by the Secretary of the Treasury. Title III of the Patriot Act entitled, "International Money Laundering Abatement and Anti-Terrorist Financing Act of 2001" includes amendments to the Bank Secrecy Act which expand the responsibilities of financial institutions in regard to anti-money laundering activities with particular emphasis upon international money laundering and terrorism financing activities through designated correspondent and private banking accounts. Effective December 25, 2001, Section 313(a) of the Patriot Act prohibits any insured financial institution such as Service 1st Bank, from providing correspondent accounts to foreign banks which do not have a physical presence in any country (designated as "shell banks"), subject to certain exceptions for regulated affiliates of foreign banks. Section 313(a) also requires financial institutions to take reasonable steps to ensure that foreign bank correspondent accounts are not being used to indirectly provide banking services to foreign shell banks, and Section 319(b) requires financial institutions to maintain records of the owners and agent for service of process of any such foreign banks with whom correspondent accounts have been established. Effective July 23, 2002, Section 312 of the Patriot Act created a requirement for special due diligence for correspondent accounts and private banking accounts. Under Section 312, each financial institution that establishes, maintains, administers, or manages a private banking account or a correspondent account in the United States for a non-United States person, including a foreign individual visiting the United States, or a representative of a non-United States person shall establish appropriate, specific, and, where necessary, enhanced, due diligence policies, procedures, and controls that are reasonably designed to detect and record instances of money laundering through those accounts. The Patriot Act contains various provisions in addition to Sections 313(a) and 312 that affect the operations of financial institutions by encouraging cooperation among financial institutions, regulatory authorities and law enforcement authorities with respect to individuals, entities and organizations engaged in, or reasonably suspected of engaging in, terrorist acts or money laundering activities. The Company and Service 1st Bank are not currently aware of any account relationships between Service 1st Bank and any foreign bank or other person or entity as described above under Sections 313(a) or 312 of the Patriot Act. Certain surveillance provisions of the Patriot Act were scheduled to expire on December 31, 2005, and actions to restrict the use of the Patriot Act surveillance provisions were filed by the ACLU and other organizations. On March 9, 2006, after temporary extensions of the Patriot Act, President Bush signed the "USA Patriot Improvement and Reauthorization Act of 2005" and the "USA Patriot Act Additional Reauthorizing Amendments Act of 2006," which reauthorized all expiring provisions of the Patriot Act by making permanent 14 of the 16 provisions and imposed a four-year expiration date on December 31, 2009 on the other two provisions related to "roving surveillance" and production of business records. 10 The effects which the Patriot Act and any additional legislation enacted by Congress may have upon financial institutions is uncertain; however, such legislation could increase compliance costs and thereby potentially may have an adverse effect upon the Company's results of operations. On July 30, 2002, President George W. Bush signed into law the Sarbanes-Oxley Act of 2002 (the "Act") which responds to recent issues in corporate governance and accountability. Among other matters, key provisions of the Act and rules promulgated by the SEC pursuant to the Act include the following: o Expanded oversight of the accounting profession by creating a new independent public company oversight board to be monitored by the SEC. o Revised rules on auditor independence to restrict the nature of non-audit services provided to audit clients and to require such services to be pre-approved by the audit committee. o Improved corporate responsibility through mandatory listing standards relating to audit committees, certifications of periodic reports by the CEO and CFO and making issuer interference with an audit a crime. o Enhanced financial disclosures, including periodic reviews for largest issuers and real time disclosure of material company information. o Enhanced criminal penalties for a broad array of white collar crimes and increases in the statute of limitations for securities fraud lawsuits. o Disclosure of whether a company has adopted a code of ethics that applies to the company's principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions, and disclosure of any amendments or waivers to such code of ethics. o Disclosure of whether a company's audit committee of its board of directors has a member of the audit committee who qualifies as an "audit committee financial expert." o A prohibition on insider trading during pension plan black-out periods. o Disclosure of off-balance sheet transactions. o A prohibition on personal loans to directors and officers. o Conditions on the use of non-GAAP (generally accepted accounting principles) financial measures. o Standards on professional conduct for attorneys requiring attorneys having an attorney-client relationship with a company, among other matters, to report "up the ladder" to the audit committee, another board committee or the entire board of directors certain material violations. o Expedited filing requirements for Form 4 reports of changes in beneficial ownership of securities reducing the filing deadline to within 2 business days of the date a transaction triggers an obligation to report. o Accelerated filing requirements for Forms 10-K and 10-Q by public companies which qualify as "accelerated filers" to a phased-in reduction of the filing deadline for Form 10-K reports and Form 10-Q reports. o Disclosure concerning website access to reports on Forms 10-K, 10-Q and 8-K, and any amendments to those reports, by "accelerated filers" as soon as reasonably practicable after such reports and material are filed with or furnished to the Securities and Exchange Commission. o Rules requiring national securities exchanges and national securities associations to prohibit the listing of any security whose issuer does not meet audit committee standards established pursuant to the Act. The Company's securities are not currently listed on the Nasdaq Stock Market and trading activity is reported on the OTC Bulletin Board. Consequently, the Company is not currently required to comply with Nasdaq listing standards in addition to the rules promulgated by the SEC pursuant to the Act. However, if the Company lists its common stock for trading on the Nasdaq Stock Market in the future, the Company would be required to comply with the Nasdaq listing rules in effect at that time, which may include additional standards related to (i) director independence, (ii) executive session meetings of the board, (iii) requirements for audit, nominating and compensation committee charters, membership qualifications and procedures, (iv) shareholder approval of equity compensation arrangements, and (v) code of conduct requirements that comply with the code of ethics under the Act. 11 The effect of the Act upon the Company is uncertain; however, the Company has incurred and it is anticipated that it will continue to incur increased costs to comply with the Act and the rules and regulations promulgated pursuant to the Act by the SEC, Nasdaq and other regulatory agencies having jurisdiction over the Company or the issuance and listing of its securities. The Company does not currently anticipate, however, that compliance with the Act and such rules and regulations will have a material adverse effect upon its financial position or results of its operations or its cash flows. Effective January 1, 2003, the California Corporate Disclosure Act (the "CCD Act") required publicly traded corporations incorporated or qualified to do business in California to disclose information about their past history, auditors, directors and officers. Effective September 28, 2004, the CCD Act, as currently in effect and codified at California Corporations Code Section 1502.1, requires the Company to file with the California Secretary of State and disclose within 150 days after the end of its fiscal year certain information including the following: o The name of the a company's independent auditor and a description of services, if any, performed for a company during the previous two fiscal years and the period from the end of the most recent fiscal year to the date of filing; o The annual compensation paid to each director and the five most highly compensated non-director executive officers (including the CEO) during the most recent fiscal year, including all plan and non-plan compensation for all services rendered to a company as specified in Item 402 of Regulation S-K such as grants, awards or issuance of stock, stock options and similar equity-based compensation; o A description of any loans made to a director at a "preferential" loan rate during the company's two most recent fiscal years, including the amount and terms of the loans; o Whether any bankruptcy was filed by a company or any of its directors or executive officers within the previous 10 years; o Whether any director or executive officer of a company has been convicted of fraud during the previous 10 years; and o A description of any material pending legal proceedings other than ordinary routine litigation as specified in Item 103 of Regulation S-K and a description of such litigation where the company was found legally liable by a final judgment or order. The Company does not currently anticipate that compliance with the CCD Act will have a material adverse effect upon its financial position or results of its operations or its cash flows. The Check Clearing for the 21st Century Act (commonly referred to as "Check 21") was signed into law in 2003 and became effective on October 28, 2004. The law facilitates check truncation by creating a new negotiable instrument called a "substitute check" which permits banks to truncate original checks, to process check information electronically and to deliver "substitute checks" to banks that want to continue receiving paper checks. Check 21 is intended to reduce the dependence of the check payment system on physical transportation networks (which can be disrupted by terrorist attacks of the type which occurred on September 11, 2001) and to streamline the collection and return process. The law does not require banks to accept checks in electronic form nor does it require banks to use the new authority granted by the Act to create "substitute checks." The Company does not currently anticipate that compliance with the Act will have a material effect upon its financial position or results of its operations or its cash flows. The Board of Governors, the FDIC, the other federal financial institution regulatory agencies, and the Federal Trade Commission issued a joint press release on October 31, 2007 and final rules and guidelines effective January 1, 2008, subject to mandatory compliance as of November 1, 2008, implementing sections 114 and 315 of the Fair and Accurate Credit Transactions Act of 2003 to require financial institutions and other creditors to develop and implement a written identity theft prevention program. The program must include reasonable policies and procedures for detecting, preventing, and mitigating identity theft in connection with certain new and existing covered accounts. Covered accounts are defined as (i) an account primarily for personal, family, or household purposes (i.e., consumer accounts), or (ii) any other account for which there is a reasonably foreseeable risk to customers or the safety and soundness of the financial institution or creditor from identity theft. The program must be appropriate to the size and complexity of the financial institution or creditor and the nature and scope of its activities and should be designed to: 12 o identify relevant patterns, practices, and specific forms of activity that are "red flags" of possible identity theft and incorporate those red flags into the program; o detect the occurrence of red flags incorporated into the program; o respond appropriately to any red flags that are detected to prevent and mitigate identity theft; and o ensure that the program is updated periodically to reflect changes in risks to customers or to the safety and soundness of the financial institution or creditor from identity theft. The regulations include guidelines that each financial institution must consider and, to the extent appropriate, include in its program and steps that must be taken to administer the program including (i) obtaining approval of the program by the board of directors or a committee of the board, (ii) ensuring oversight of the development, implementation and administration of the program, (iii) training staff, and (iv) overseeing service provider arrangements. The guidelines contemplate that existing fraud prevention procedures may be incorporated into the program. Certain legislative and regulatory proposals that could affect the Company, the Bank and the banking business in general are periodically introduced before the United States Congress, the California State Legislature and Federal and state government agencies. It is not known to what extent, if any, legislative proposals will be enacted and what effect such legislation would have on the structure, regulation and competitive relationships of financial institutions. In addition to legislative changes, the various Federal and state financial institution regulatory agencies frequently propose rules and regulations to implement and enforce already existing legislation. It cannot be predicted whether or in what form any such rules or regulations will be enacted or the effect that such regulations may have on the Company and the Bank. It is likely, however, that such legislation and regulation could subject the Company and the Bank to increased regulation, disclosure and reporting requirements, competition, and costs of doing business. Item 1A. Risk Factors. The Company and its subsidiary, Service 1st Bank, conduct business in an environment that includes certain risks described below which could have a material adverse effect on the Company's business, results of operations, financial condition, future prospects and stock price. You are also referred to the matters described under the heading "Cautionary Statements Regarding Forward-Looking Statements," in Part I, Item 1 and Part II, Item 7 of this report on Form 10-K for additional information regarding factors that may affect the Company's business. o Service 1st Bancorp's business is subject to interest rate risk and variations in interest rates may negatively affect its financial performance. Changes in the interest rate environment may reduce the Company's net interest income. It is expected that the Company will continue to realize income from the differential or "spread" between the interest earned on loans, securities and other interest-earning assets, and interest paid on deposits, borrowings and other interest-bearing liabilities. Net interest spreads are affected by the difference between the maturities and repricing characteristics of interest-earning assets and interest-bearing liabilities. In addition, loan volume and yields are affected by market interest rates on loans, and rising interest rates generally are associated with a lower volume of loan originations. We cannot assure you that we can minimize the Company's interest rate risk. In addition, an increase in the general level of interest rates may adversely affect the ability of certain borrowers to pay the interest on and principal of their obligations. Accordingly, changes in levels of market interest rates could materially and adversely affect the Company's net interest spread, asset quality, loan origination volume and overall profitability. o Governmental monetary policies affect the Company's business and are beyond the control of the Company. The business of banking is affected significantly by the fiscal and monetary policies of the federal government and its agencies. Such policies are beyond the control of the Company. The Company is particularly affected by the policies established by the Board of Governors in relation to the supply of money and credit in the United States. The instruments of monetary policy available to the Board of Governors can be used in varying degrees and 13 combinations to directly affect the availability of bank loans and deposits, as well as the interest rates charged on loans and paid on deposits, and this can and does have a material effect on the Company's business, results of operations and financial condition. o Service 1st Bancorp's subsidiary, Service 1st Bank, faces strong competition from banks, financial service companies and other companies that offer banking services, which can hurt Service 1st Bancorp's business. The Company's subsidiary, Service 1st Bank, conducts banking operations principally in Northern California. Increased competition in Service 1st Bank's market may result in reduced loans and deposits. Ultimately, it may not be able to compete successfully against current and future competitors. Many competitors offer the banking services that are offered by Service 1st Bank in its service area. These competitors include national and super-regional banks, finance companies, investment banking and brokerage firms, credit unions, government-assisted farm credit programs, other community banks and technology-oriented financial institutions offering online services. In particular, Service 1st Bank's competitors include several major financial companies whose greater resources may afford them a marketplace advantage by enabling them to maintain numerous banking locations and mount extensive promotional and advertising campaigns. Additionally, banks and other financial institutions with larger capitalization and financial intermediaries not subject to bank regulatory restrictions have larger lending limits and are thereby able to serve the credit needs of larger customers. Areas of competition include interest rates for loans and deposits, efforts to obtain deposits, and range and quality of products and services provided, including new technology-driven products and services. Technological innovation continues to contribute to greater competition in domestic and international financial services markets as technological advances, such as Internet-based banking services that cross traditional geographic bounds, enable more companies to provide financial services. If Service 1st Bank is unable to attract and retain banking customers, it may be unable to continue its loan growth and level of deposits, which may adversely affect its and the Company's results of operations, financial condition and future prospects. o Worsening economic conditions in Northern California could adversely affect the Company's business. The Company conducts business operations principally in Northern California. As a result, the Company's financial condition, results of operations and cash flows are subject to changes in the economic conditions in Northern California. The Company's business results are dependent in large part upon the business activity, population, income levels, deposits and real estate activity in Northern California, and adverse economic conditions could have adverse effects upon the Company. The State of California is currently experiencing significant budgetary and fiscal difficulties. The Company can provide no assurance that conditions in the California economy will not deteriorate or that such deterioration will not adversely affect the Company. A deterioration in economic conditions locally, regionally or nationally, including the economic impact of terrorist activities within and outside California could result in an economic downturn in Northern California and trigger the following consequences, any of which could adversely affect the Company's business: o loan delinquencies and defaults may increase; o problem assets and foreclosures may increase; o demand for the Company's products and services may decline; o low cost or non-interest bearing deposits may decrease; and o collateral for loans may decline in value, in turn reducing customers' borrowing power, and reducing the value of assets and collateral as sources of repayment of existing loans. o The Company has a concentration risk in real estate related loans. At December 31, 2007, approximately 64.9% of the Company's loan and lease portfolio consisted of real estate related loans. The majority of the Company's real property collateral is located in its operating markets in Northern California. A substantial decline in real estate values in the Company's primary market areas could occur as a result of worsening economic conditions, or other events including natural disasters such as earthquakes, fires, and floods. Such a decline in values could have an adverse impact on the Company by limiting repayment of defaulted loans through sale of the real estate collateral and by likely increasing the number of defaulted loans to the extent that the financial condition of its borrowers is adversely affected by such a 14 decline in values. At December 31, 2007, residential construction loans, including land acquisition and development, totaled $17 million or 14.84% of the Company's total loan portfolio. This was comprised of 1.47% owner-occupied and 13.37% speculative construction and land loans. Construction, land acquisition and development lending involve additional risks because funds are advanced on the security of the project, which is of uncertain value prior to its completion. Because of the uncertainties inherent in estimating construction costs, as well as the market value of the completed project and the effects of governmental regulation on real property, it is relatively difficult to evaluate accurately the total funds required to complete a project and the related loan-to-value ratio. As a result, speculative construction loans often involve the disbursement of substantial funds with repayment dependent, in part, on the completion of the project and the ability of the borrower to sell the property, rather than the ability of the borrower or the guarantor to repay the principal and interest. If our appraisal of the value of the completed project proves to be overstated, we may have inadequate security for the repayment of the loan upon completion of construction of the project. If we are forced to foreclose on a project prior to or at completion due to a default, there can be no assurance that we will be able to recover all of the unpaid balance of, and accrued interest on, the loan, a well as related foreclosure and holding costs. In addition, we may be required to fund additional amounts to complete the project and may have to hold the property for an unspecified period of time. The adverse effects of the foregoing matters upon the Company's real estate portfolio could necessitate a material increase in the provision for loan and lease losses which could adversely affect the Company's results of operations, financial condition, and future prospects. o Service 1st Bancorp is subject to extensive regulation, which could adversely affect its business. The Company's operations are subject to extensive regulation by state and local governmental authorities and are subject to various laws and judicial and administrative decisions imposing requirements and restrictions on part or all of its operations. The Company believes that it is in substantial compliance in all material respects with laws, rules and regulations applicable to the conduct of its business. Because the Company's business is highly regulated, the laws, rules and regulations applicable to it are subject to regular modification and change. There can be no assurance that these laws, rules and regulations, or any other laws, rules or regulations, will not be adopted in the future, which could make compliance much more difficult or expensive, restrict the Company's ability to originate, broker or sell loans, further limit or restrict the amount of commissions, interest or other charges earned on loans originated or sold by the Company, or otherwise adversely affect the Company's results of operations, financial condition, or future prospects. o Service 1st Bancorp's allowance for loan and lease losses may not be adequate to cover actual losses. Like all financial institutions, Service 1st Bancorp's subsidiary, Service 1st Bank, maintains an allowance for loan and lease losses to provide for loan defaults and non-performance, but its allowance for loan and lease losses may not be adequate to cover actual loan and lease losses. In addition, future provisions for loan and lease losses could materially and adversely affect Service 1st Bank's and therefore the Company's operating results. Service 1st Bank's allowance for loan and lease losses is based on prior experience, as well as an evaluation of the risks in the current portfolio. The amount of future losses is susceptible to changes in economic, operating and other conditions, including changes in interest rates that may be beyond Service 1st Bank's control, and these losses may exceed current estimates. Federal regulatory agencies, as an integral part of their examination process, review Service 1st Bank's loans and leases and allowance for loan and lease losses. Although we believe that Service 1st Bank's allowance for loan and lease losses is adequate to cover current losses, we cannot assure you that it will not further increase the allowance for loan and lease losses or that regulators will not require it to increase this allowance. Either of these occurrences could materially and adversely affect the Company's earnings. o Service 1st Bancorp's and Service 1st Bank's operations are dependent upon key personnel. The future prospects of the Company will be highly dependent on its directors, executive officers and other key personnel. The success of the Company will, to some extent, depend on the continued service of its directors and continued employment of the executive officers, in addition to the Company's ability to attract and retain experienced banking professionals to serve the Company and the Bank in other key positions. The unexpected loss of the services of any of these individuals could have a detrimental effect on the Company and Service 1st Bank. 15 o Technology implementation problems or computer system failures could adversely affect Service 1st Bancorp and Service 1st Bank. The Company's future prospects will be highly dependent on the ability of Service 1st Bank to implement changes in technology that affect the delivery of banking services such as the increased demand for computer access to bank accounts and the availability to perform banking transactions electronically. The Bank's ability to compete will depend upon it ability to continue to adapt technology on a timely and cost-effective basis to meet such demands. In addition, the business and operations of the Company and the Bank will be susceptible to adverse effects from computer failures, communication and energy disruption, and the activities of unethical individuals with the technological ability to cause disruptions or failures of the Bank's data processing system. o Information security breach or other technology difficulties could adversely affect Service 1st Bancorp and Service 1st Bank. The Company and the Bank cannot be certain that implementation of safeguards will eliminate the risk of vulnerability to technological difficulties or failures or ensure the absence of a breach of information security. The Bank will rely on the services of various vendors who provide data processing and communication services to the banking industry. Nonetheless, if information security is compromised or other technology difficulties or failures occur, information may be lost or misappropriated, services and operations may be interrupted and the Company and Bank could be exposed to claims from its customers as a result. The occurrence of any of these events could adversely affect the Company's results of operations, financial condition, prospects, and stock price. ITEM 1B. UNRESOLVED STAFF COMMENTS None. ITEM 2. PROPERTIES The Company's administrative office consists of approximately 1,800 square feet on the ground floor of a one story building located in downtown Tracy and is leased from May 1, 2005 through April 30, 2010. There are no options to renew this lease. The current monthly lease rate is $3,004 subject to a 4% adjustment on each anniversary of the commencement of the lease. The Bank conducts operations at offices located at 2800 West March Lane, Suite 120, Stockton, California 95219, 60 West 10th Street, Tracy, California 95376, and 1901 W. Kettleman Lane, Suite 100, Lodi, California 95242. The Bank's Stockton office consists of approximately 4,715 square feet on the ground floor of an office building located adjacent to Interstate Highway 5 and is leased from October 1, 2002 to September 30, 2009. There are two five-year options to extend the lease term. The current monthly lease rate is $10,938, subject to a 3% annual adjustment. The monthly rate during the extended term will be the fair market rental value of the premises at the commencement of the extended term. The Bank's Tracy office consists of approximately 7,500 square feet of space on the ground floor and second floor of a two-story building located in downtown Tracy. The original lease from February 15, 2000 to February 28, 2007, with two five-year options has been extended by the exercise of the first five-year option to extend the lease term to February 28, 2012. The current monthly lease rate is $9,000, subject to increase as specified in the lease option exercise letter dated September 12, 2006. The Bank's Lodi office consists of approximately 9,580 square feet on the first floor of a two story office building and is leased from January 1, 2006 through December 31, 2015. There are two five year options to extend the lease. The monthly rental is $21,027, subject to a 3% annual adjustment. The monthly rate during the extended term will be adjusted at the commencement of each extension to the fair market rental value for comparable buildings in San Joaquin County at the time of such extension. The Bank subleased 2,170 square feet to a third party at $4,779.40 per month. The Bank has also subleased 910 square feet to the Company's subsidiary, Charter Services Group, Inc. at a monthly rental of $2,010. 16 Charter conducts is operations at an office located at 1901 W. Kettleman Lane, Suite 102, Lodi, California 95242. The office consists of approximately 910 square feet. The lease agreement is on a month-to-month basis with the Bank. Management believes that the facilities are appropriate and adequate for the operation of the business as it is currently structured. The foregoing lease descriptions are qualified in their entirety by reference to the lease agreements listed in Item 15 as exhibits to this Annual Report on Form 10-K. ITEM 3. LEGAL PROCEEDINGS The Bank is not a party to any pending legal or administrative proceedings other than ordinary routine litigation incidental to the Bank's business involving the Bank or any of its property, and no such proceedings are known to be contemplated. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of 2007. PART II ITEM 5. MARKET FOR COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES Market Information There is limited trading in and no established public trading market for the Company's common stock. The Company's common stock is not listed on any exchange and is not quoted by The Nasdaq Stock Market. The Company's common stock is quoted on the OTC Bulletin Board under the symbol "SVCF." The quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not represent actual transactions. Total shares and prices per share have been adjusted retroactively to reflect a three-for-two stock split payable on September 29, 2005. As of March 28, 2008, there were 2,388,739 shares of the Company's common stock outstanding. The Company's common stock was registered under Section 12(g) of the Securities Exchange Act of 1934, by the filing of the Company's registration statement on Form 8-A with the SEC on June 26, 2003. Pershing LLC and Wells Fargo Van Kasper have facilitated trades in the Company's common stock. The high and low bid quotations for the Company's common stock for each full quarterly period of the Company's operations for the last two years is listed in the chart shown below. Calendar Year High Low ------------- ----------- ----------- 2007 First Quarter $ 20.42 $ 18.00 Second Quarter $ 18.00 $ 14.00 Third Quarter $ 14.75 $ 10.75 Fourth Quarter $ 13.15 $ 7.00 2006 First Quarter $ 23.00 $ 15.25 Second Quarter $ 18.00 $ 17.00 Third Quarter $ 27.00 $ 17.65 Fourth Quarter $ 22.00 $ 19.25 The high and low bid quotations for the Company's common stock were $6.75 and $7.00 as of March 28, 2008. 17 Holders At March 28, 2008, there were approximately 833 shareholders of the Company's common stock. There are no other classes of equity shares of the Company outstanding. Dividends The Company's shareholders are entitled to receive dividends when and as declared by its Board of Directors, out of funds legally available therefore, subject to the restrictions set forth in the California General Corporation Law (the "Corporation Law"). The Corporation Law provides that a corporation may make a distribution to its shareholders if the corporation's retained earnings equal at least the amount of the proposed distribution. The Corporation Law further provides that, in the event that sufficient retained earnings are not available for the proposed distribution, a corporation may nevertheless make a distribution to its shareholders if it meets two conditions, which generally stated are as follows: (1) the corporation's assets equal at least 1-1/4 times its liabilities; and (2) the corporation's current assets equal at least its current liabilities or, if the average of the corporation's earnings before taxes on income and before interest expenses for the two preceding fiscal years was less than the average of the corporation's interest expenses for such fiscal years, then the corporation's current assets must equal at least 1-1/4 times its current liabilities. Funds for payment of any cash dividends by the Company would be obtained from its investments as well as dividends and/or management fees from the Bank. The payment of cash dividends by the Bank is subject to restrictions set forth in the California Financial Code (the "Financial Code") which may include obtaining the consent of the California Commissioner of Financial Institutions (the "Commissioner") under certain circumstances described below. The Financial Code provides that a bank may not make a cash distribution to its shareholders in excess of the lesser of (a) the bank's retained earnings; or (b) the bank's net income for its last three fiscal years, less the amount of any distributions made by the bank or by any majority-owned subsidiary of the bank to the shareholders of the bank during such period. However, a bank may, with the approval of the Commissioner, make a distribution to its shareholders in an amount not exceeding the greater of (a) its retained earnings; (b) its net income for its last fiscal year; or (c) its net income for its current fiscal year. In the event that the Commissioner determines that the shareholders' equity of a bank is inadequate or that the making of a distribution by the bank would be unsafe or unsound, the Commissioner may order the bank to refrain from making a proposed distribution. The FDIC may also restrict the payment of dividends if such payment would be deemed unsafe or unsound or if after the payment of such dividends, a bank would be included in one of the "undercapitalized" categories for capital adequacy purposes pursuant to the Federal Deposit Insurance Corporation Improvement Act of 1991. Additionally, while the Board of Governors has no general restriction with respect to the payment of cash dividends by an adequately capitalized bank to its parent holding company, the Board of Governors might, under certain circumstances, place restrictions on the ability of a particular bank to pay dividends based upon peer group averages and the performance and maturity of the particular bank, or object to management fees on the basis that such fees cannot be supported by the value of the services rendered or are not the result of an arm's length transaction. To date, the Company has not paid a cash dividend and presently does not intend to pay cash dividends in the foreseeable future. The Company declared a five percent stock dividend in February 2004 payable in April 2004. Payment of dividends in the future will be determined by the Board of Directors after consideration of various factors including the profitability and capital adequacy of the Company and the Bank. Stock Repurchases The Company did not repurchase shares of its common stock during the fourth quarter of the year ended December 31, 2007, and has not repurchased shares of its common stock at any time since its incorporation. 18 PERFORMANCE GRAPH The following graph compares the performance of Service 1st Bancorp's common shares to the Nasdaq Stock Market Total Return Index and the Nasdaq Bank Stock Index during the last five years. The graph shows the value of $100 invested in Service 1st Bancorp common stock and both indices on December 31, 2002 and the change in the value of Service 1st Bancorp's common shares compared to the indices as of the end of each year. The graph assumes the reinvestment of all dividends. Historical stock price performance is not necessarily indicative of future stock price performance. SERVICE 1ST BANCORP [GRAPHIC CHART OMITTED]
Year Ending -------------------------------------------------------------------------------- Index 12/31/02 12/31/03 12/31/04 12/31/05 12/31/06 12/31/07 --------------------------------------------------------------------------------------------------------- Service 1st Bancorp 100 152.44 162.67 267.71 303.15 124.41 NASDAQ Composite 100 150.01 162.90 165.13 180.85 198.59 NASDAQ Bank 100 129.93 144.21 137.97 153.16 119.36
19 ITEM 6. SELECTED FINANCIAL DATA BUSINESS ORGANIZATION Service 1st Bancorp (the "Company") is a California corporation and was incorporated on January 23, 2004 to act as a holding company for Service 1st Bank (the "Bank"). The Bank became a subsidiary of the Company effective June 26, 2004. As of December 31, 2007, the Company maintained its administrative office in Tracy, San Joaquin County and the Bank operated three full-service offices in the cities of Stockton, Tracy, and Lodi in San Joaquin County, The Bank offers a full range of commercial banking services to individuals, small and medium sized businesses, municipalities and professionals in San Joaquin County and the surrounding communities. The Company also has a wholly-owned subsidiary, Charter Services Group, Inc., which provides consulting services to start-up (de novo) banks. The following analysis is designed to enhance the reader's understanding of the Company's financial condition and the results of its operations as reported in the Financial Statements included in this Annual Report. Reference should be made to the financial statements and notes thereto for additional detailed information. All per share data has been retroactively restated to reflect stock dividends and stock splits.
SELECTED FINANCIAL DATA 2007 2006 2005 ------------- ------------- ------------- Interest Income $ 14,906,522 $ 12,723,496 $ 8,479,233 Interest Expense 8,000,166 5,772,931 2,853,899 ------------- ------------- ------------- Net interest Income 6,906,356 6,950,565 5,625,334 Provision for loan loss 935,000 300,000 165,000 ------------- ------------- ------------- Net Interest Income After Provision for Loan Losses 5,971,356 6,650,565 5,460,334 Non-interest Income 888,995 806,295 686,843 Non-interest Expense 6,879,522 6,310,574 4,579,562 ------------- ------------- ------------- Income (loss) before Provision for Taxes (19,171) 1,146,286 1,567,615 Tax Expense (Credit) (356,194) 299,165 144,996 ------------- ------------- ------------- Net Income $ 337,023 $ 847,121 $ 1,422,619 ============= ============= ============= Net Income Per Share - Basic $ .14 $ .35 $ .60 Net Income Per Share - Diluted $ .14 $ .33 $ .56 Return on Average Assets .15% .44% .90% Return on Average Equity 1.95% 5.37% 9.42% Average Equity to Average Assets 7.69% 8.16% 9.53% Average Loans to Average Deposits 60.18% 62.75% 52.21% Total Assets as of December 31, $ 231,075,943 $ 227,220,390 $ 169,329,270 Total Deposits as of December 31, $ 202,405,646 $ 199,955,091 $ 151,141,667 Net Interest Margin 3.25% 3.82% 3.88%
20 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CAUTIONARY STATEMENTS REGARDING FORWARD-LOOKING STATEMENTS Certain matters discussed or incorporated by reference in this Annual Report on Form 10-K including, but not limited to, matters described in "Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations," are "forward-looking statements" within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, Section 27A of the Securities Act of 1933, as amended, and subject to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements may contain words related to future projections including, but not limited to, words such as "believe," "expect," "anticipate," "intend," "may," "will," "should," "could," "would," and variations of those words and similar words that are subject to risks, uncertainties and other factors that could cause actual results to differ materially from those projected. Factors that could cause or contribute to such differences include, but are not limited to, the following: (1) variances in the actual versus projected growth in assets; (2) return on assets; (3) loan and lease losses; (4) expenses; (5) changes in the interest rate environment including interest rates charged on loans, earned on securities investments and paid on deposits; (6) competition effects; (7) fee and other noninterest income earned; (8) general economic conditions nationally, regionally, and in the operating market areas of the Company and its subsidiaries; (9) changes in the regulatory environment; (10) changes in business conditions and inflation; (11) changes in securities markets; (12) data processing problems; (13) a decline in real estate values in the Company's operating market areas; (14) the effects of earthquakes, floods, fires and other natural disasters, (15) terrorism, the threat of terrorism or the impact of the current military conflict in Afghanistan and Iraq and the conduct of the war on terrorism by the United States and its allies, as well as other factors. These factors set forth under "Item 1a-Risk Factors" in this report and other cautionary statements and information set forth in this report should be carefully considered and understood as being applicable to all related forward-looking statements contained in this report, when evaluating the business prospects of the Company and its subsidiaries. Forward-looking statements are not guarantees of performance. By their nature, they involve risks, uncertainties and assumptions. The future results and shareholder values may differ significantly from those expressed in these forward-looking statements. You are cautioned not to put undue reliance on any forward-looking statement. Any such statement speaks only as of the date of this report, and in the case of any documents that may be incorporated by reference, as of the date of those documents. We do not undertake any obligation to update or release any revisions to any forward-looking statements, to report any new information, future event or other circumstances after the date of this report or to reflect the occurrence of unanticipated events, except as required by law. However, your attention is directed to any further disclosures made on related subjects in our subsequent reports filed with the Securities and Exchange Commission on Forms 10-K, 10-Q and 8-K. 21 EARNINGS OVERVIEW For the year ended December 31, 2007, the Company reported net income of $337,023 or $0.14 basic and $0.14 diluted earnings per share, compared with the net of income of $847,121 or $0.35 basic and $0.33 diluted earnings per share for the year ended December 31, 2006 and $1,422,619 or $0.60 basic and $0.56 diluted earnings per share for the year ended December 31, 2005. The decline in net income for 2007 resulted primarily from an increase in the allowance for loan loss and an increase in salary expense. The decline in net income from 2005 to 2006 resulted primarily from an increase in salary expense, occupancy expense, advertising, and promotional expense. The increase in salary expense from 2005 to 2006 included $121,810 for stock-based compensation. There was no stock-based compensation expense for 2005. NET INTEREST INCOME AND NET INTEREST MARGIN Net interest income refers to the difference between the interest paid on deposits and borrowings, and the interest earned on loans and investments. It is the primary component of the net earnings of a financial institution. The primary factors to consider in analyzing the net interest income are the composition and volume of earning assets and interest bearing liabilities, the amount of noninterest bearing liabilities and nonaccrual loans, and changes in market interest rates. Beginning in July 2004 and continuing through June 2006, actions by the Federal Reserve Board to raise interest rates resulted in the prime rate being raised from 4.00% to 8.25%. Beginning on September 18, 2007 the Federal Reserve changed its policy and started dropping interest rates. The prime rate declined from 8.25% on September 18, 2007 to 7.25% on December 11, 2007. Historically, the largest source of income for banks is that which is created by net interest income. Even though the Federal Reserve began to reduce rates in September 2007, the competition for deposits caused interest rates on interest-bearing liabilities to increase from 3.91% for 2006 to 4.43% for 2007. The yield on interest-earning assets increased from 6.98% during 2006 to 7.02% during 2007. Net interest income before provision for loan losses for 2007 was $6,906,356 compared to $6,950,565 in 2006. The average rate earned on interest earning assets increased from 6.98% in 2006 to 7.02% in 2007. Interest income in 2007 was $14,906,522 or $2,183,026 greater than the $12,723,496 in 2006. The growth in average interest bearing liabilities was $32,691,144. Interest expense for 2007 was $8,000,166 or $2,227,235 greater than the $5,772,931 in 2006. Net interest income before provision for loan losses for 2006 was $6,950,565 representing an increase of $1,325,231 or 23.56% from $5,625,334 in 2005. The increase in net interest income for 2006 was primarily attributable to an increase of $37,194,858 in average interest-earning assets from 2005 to 2006. The average rate earned on interest earning assets increased from 5.85% in 2005 to 6.98% in 2006. Interest income in 2006 was $12,723,496 or $4,244,263 greater than the $8,479,233 in 2005. The growth in average interest bearing liabilities was $33,517,489. Interest expense for 2006 was $5,772,931 or $2,919,032 greater than the $2,853,899 in 2005. 22 The following tables set forth average balance sheet information, interest income and expense, average yields and rates, and net interest income and margin for the years ended December 31, 2007, 2006 and 2005.
December 31, 2007 December 31, 2006 ------------------------------------------- ------------------------------------------ Average Average Average Income/ Yield or Average Income/ Yield or Balance (4) Expense Rate Paid Balance (4) Expense Rate Paid ------------------------------------------- ------------------------------------------ Interest-earning assets: Interest-bearing deposits $ 1,438,011 $ 71,627 4.98% $ 1,469,855 $ 81,322 5.53% Investment securities, taxable 64,535,592 3,414,206 5.29% 56,510,601 2,609,668 4.62% Investment securities, non-taxable 23,561,350 975,926 4.14% 15,279,119 549,852 3.60% Federal funds sold 4,972,951 250,587 5.04% 4,863,038 247,675 5.09% Loans (1) (2) 117,744,381 10,194,176 8.66% 104,063,315 9,234,979 8.87% ------------- ------------- ------------- ------------- Total interest-earning assets 212,252,285 14,906,522 7.02% 182,185,928 12,723,496 6.98% ------------- ------------- Allowance for loan losses (1,479,968) (1,260,870) Cash and due from banks 4,229,357 3,692,527 Bank premises and equipment 1,367,153 1,051,835 Accrued interest receivable 1,316,236 956,572 Other assets 6,718,547 6,844,281 ------------- ------------- Total assets $ 224,403,610 $ 193,470,273 ============= ============= Interest-bearing liabilities: Demand deposits $ 57,736,501 2,446,946 4.24% $ 63,060,814 2,199,856 3.49% Savings & money market accounts 28,722,251 845,277 2.94% 21,266,677 588,396 2.77% Time deposits 84,239,592 4,110,771 4.88% 52,683,301 2,374,854 4.51% Other borrowings 9,769,185 597,172 6.11% 10,765,593 609,825 5.66% ------------- ------------- ------------- ------------- Total interest-bearing liabilities 180,467,529 8,000,166 4.43% 147,776,385 5,772,931 3.91% ------------- ------------- Non-interest bearing demand deposits 24,940,284 28,776,610 Other liabilities 1,729,218 1,148,399 ------------- ------------- Total liabilities 207,137,031 177,701,394 Shareholders' equity 17,266,579 15,768,879 ------------- ------------- Total liabilities and shareholders' equity $ 224,403,610 $ 193,470,273 ============= ============= Net interest income $ 6,906,356 $ 6,950,565 ============= ============= Net interest margin on average interest earning assets (3) 3.25% 3.82%
1. Average loan balances include average deferred loan fees of $178,983 and $261,631 for the years ending December 31, 2007 and 2006, respectively. 2. Interest on loans includes fees of $190,955 and $248,683 for the years ending December 31, 2007 and 2006, respectively. 3. Net interest margin is computed by dividing net interest income by total average earning assets. 4. All average balances have been computed using daily balances. 23
December 31, 2005 -------------------------------------------- Average Average Income/ Yield or Balance (4) Expense Rate Paid -------------------------------------------- Interest-earning assets: Interest-bearing deposits $ 2,624,303 $ 73,952 2.82% Investment securities, taxable 58,180,384 2,271,855 3.90% Investment securities, non-taxable 3,982,007 149,133 3.75% Federal funds sold 6,225,953 188,098 3.02% Loans (1) (2) 73,978,423 5,796,195 7.83% ------------- ------------- Total interest-earning assets 144,991,070 8,479,233 5.85% ------------- Allowance for loan losses (1,070,293) Cash and due from banks 8,283,607 Bank premises and equipment 631,980 Accrued interest receivable 641,492 Other assets 4,929,952 ------------- Total assets $ 158,407,808 ============= Interest-bearing liabilities: Demand deposits $ 68,382,714 1,519,486 2.22% Savings & money market accounts 15,745,131 200,799 1.28% Time deposits 29,852,230 1,122,522 3.76% Other borrowings 278,821 11,092 3.98% ------------- ------------- Total interest-bearing liabilities 114,258,896 2,853,899 2.50% ------------- Non-interest bearing demand deposits 27,703,879 Other liabilities 1,341,828 ------------- Total liabilities 143, 304,603 Shareholders' equity 15,103,205 ------------- equity $ 158,407,808 ============= Net interest income $ 5,625,334 ============= Net interest margin on average interest earning assets (3) 3.88%
1. Average loan balances include average deferred loan fees of $277,103 for the year ended December 31, 2005. 2. Interest on loans includes fees of $193,744 for the year ended December 31, 2005. 3. Net interest margin is computed by dividing net interest income by total average earning assets. 4. All average balances have been computed using daily balances. 24
Rate/Volume Analysis 2007 over 2006 2006 over 2005 Increase (decrease) due to change in: Increase (decrease) due to change in: ----------------------------------------- ----------------------------------------- Volume (1)(3) Rate (2)(3) Total Volume (1)(3) Rate (2)(3) Total ----------------------------------------- ----------------------------------------- Increase (Decrease) in: Interest income: Interest-bearing deposits in banks $ (1,737) $ (7,958) $ (9,695) $ (42,365) $ 49,735 $ 7,370 Investment securities, taxable 397,920 406,618 804,538 616,636 (9,486) 607,150 Investment securities, non-taxable 505,226 140,341 645,567 (67,119) 404,933 337,814 Taxable equivalent adjustment (171,777) (47,716) (219,493) (209,657) 3,225 (206,432) Federal funds sold 5,454 (2,542) 2,912 (48,010) 107,587 59,577 Loans 1,185,096 (225,899) 959,197 2,589,473 849,311 3,438,784 ----------- ----------- ----------- ----------- ----------- ----------- Total 1,920,182 262,844 2,183,026 2,838,958 1,405,305 4,244,263 Interest Expense: Demand, interest-bearing (196,802) 443,892 247,090 (126,404) 806,775 680,371 Savings 218,051 38,830 256,881 89,884 297,712 387,596 Time 1,526,870 209,047 1,735,917 993,881 258,451 1,252,332 Borrowings (59,081) 46,428 (12,653) 592,070 6,663 598,733 ----------- ----------- ----------- ----------- ----------- ----------- Total 1,489,038 738,197 2,227,235 1,549,431 1,369,601 2,919,032 ----------- ----------- ----------- ----------- ----------- ----------- Increase (Decrease) in Net interest income $ 431,144 $ (475,353) $ (44,209) $ 1,289,527 $ 35,704 $ 1,325,231 =========== =========== =========== =========== =========== ===========
1. Average balances of all categories in each period were included in the volume computations. 2. Average yields and rates in each period were used in rate computations. 3. Any change attributable to changes in both volume and rate which cannot be segregated has been allocated based on the absolute value of each. 25 OTHER INCOME Total other income was $888,995 for 2007, $806,295 for 2006, and $686,843 for 2005. During 2007, service charges and fees increased from $275,863 in 2006 to $304,281 in 2007. During 2006, service charges and fees decreased from $323,980 in 2005 to $275,863 in 2006. The increase in service charges, fees, and other income for 2007 was primarily from consulting fees from the Company's subsidiary, Charter Services Group, Inc. ("Charter") of $110,000. There were no fees earned from Charter in 2006 and 2005. During 2002, the Bank established a Small Business Administration ("SBA") Department. The Government guarantees a portion of each SBA loan. The guaranteed portion of each SBA loan can be sold in the secondary market and the Bank receives a premium on these sales and servicing revenue. Gains on sales and servicing of the guaranteed portion of SBA loans during 2007 were $56,655 compared to $102,845 in 2006 and $187,902 in 2005. The decline in gains on SBA loan sales was due to the loss of the Bank's SBA loan officer and the Company does not anticipate any growth in this category until a new officer fills that position. The Bank offers loans on single family homes and commercial mortgage loans through third party lenders. The Bank receives fees for packaging loans for third party lenders. These loans are then funded by and become assets of the third party lenders. The fees received on such loans were $265,409 for 2007 compared to $275,661 in 2006 and $45,285 for 2005. There was no comparable income from loan packaging of commercial mortgage loans during 2005. The Company purchased key-man life insurance policies on several of its officers. The proceeds received from these policies will fund retirement benefits for executive officers of the Company and the Bank. The earnings on the cash surrender value of life insurance were $159,837 during 2007 compared to $153,725 during 2006 and $123,485 during 2005. Gains/losses on the sale of investment securities consisted of a loss of $7,187 for the year ended December 31, 2007, a loss of $1,799 for the year ended December 31, 2006, and a gain of $6,191 for the year ended December 31, 2005. The major components of other expenses for the years ended December 31, 2007, 2006, and 2005 are listed in the table below.
2007 2006 2005 ---------- ---------- ---------- Other expenses: Salaries & employee benefits $3,935,912 $3,564,721 $2,701,793 Occupancy expense 649,247 641,177 329,017 Equipment expense 345,107 237,866 185,313 Data Processing and other professional services 603,000 625,216 504,024 Office supplies and equipment 222,450 178,813 155,880 Loan department expense 53,552 191,203 105,734 Advertising and promotion 225,162 270,766 139,902 Directors fees and expenses 210,360 196,230 93,852 FDIC & State assessments 141,350 61,876 82,956 Other operating expenses 493,382 342,706 281,091 ---------- ---------- ---------- Total other expenses $6,879,522 $6,310,574 $4,579,562 ========== ========== ========== Other expenses as a percentage of average assets 3.06% 3.26% 2.89%
Salaries and Employee Benefits Salaries and employee benefits expense for 2007 was $3,935,912, an increase of $371,191 from $3,564,721 in 2006. The primary increase in salaries and employee benefits was from additional staff required to service the anticipated growth in the Company. The total salary and employee benefits expense for the Lodi branch office in 2006 was approximately $350,000. Salaries and employee benefits expense for 2005 was $2,701,793. The increase from 2005 to 2006 was due to the opening of a new branch office in Lodi and the establishment of a new subsidiary, Charter Services Group, Inc. There were no comparable 26 expenses in 2005 for Charter or the Lodi branch. Prior to 2006, the Company was not required to expense stock-based compensation on its statement of income. During 2007 and 2006, the Company recognized $75,322 and $121,810, respectively, for stock-based compensation expense on incentive stock options that had been granted to certain employees. Occupancy Expense Occupancy expense was $649,247 in 2007, $641,177 in 2006 and $329,017 in 2005. The increase in expense from 2005 to 2006 was primarily related to the expense for the new Lodi branch office. The occupancy expense for the Lodi branch office was $258,957 for 2006. There was no occupancy expense for Lodi in 2005. Equipment Expense Equipment expense in 2007 was $345,107 compared to $237,866 in 2006 and $185,313 in 2005. The increase in equipment expense was primarily related to an increase in depreciation expense which increased from $147,981 in 2006 to $202,724 in 2007. The increased depreciation expense was incurred to replace obsolescent equipment. The amortization of maintenance contracts associated with the new equipment caused total maintenance expense to increase from $62,254 in 2006 to $112,177 in 2007. Data Processing and Other Professional Services Data processing and other professional services for 2007 were $603,000 compared to $625,216 in 2006 and $504,024 in 2005. The increase in expense from 2005 to 2006 was primarily related to services provided by consultants. During 2006, the Company incurred costs to assist it with the preparation of a disaster recovery procedures manual. The Company also paid approximately $50,000 to a recruitment agency to find new employees. Office Supplies and Equipment Office supplies and equipment expenses were $222,450 in 2007 compared to $178,813 in 2006 and $155,880 for 2005. The increase in expense was related to the anticipated expansion of the Bank and the printing costs associated with the change in the Bank's logo. Loan Department Expense Loan department expense for 2007 was $53,552 compared to $191,203 for 2006 and $105,734 for 2005. The provision for the reserve for loan losses on undisbursed loans was $(22,000) for 2007 compared to $12,000 for 2006 and $10,000 for 2005. During 2007, it was determined that the Company's reserves for undisbursed loans could be reduced by $22,000. There have been no losses on undisbursed loans in prior years. The Bank has sold the guaranteed portion on certain loans to other third parties but continues to service these loans. The loan servicing expense was $50,794 in 2007 compared to $160,373 in 2006 and $68,436 in 2005. The increase in loan servicing expense for 2006 is related to the early payoff of loans that the Company was servicing. When the Company sells loans but retains the servicing, the Company amortizes the loan servicing fees over the estimated life of the loan. If the loan pays off early, the remaining unamortized servicing asset is expensed. During 2006, several loans paid off early. Advertising and Promotion Expense Advertising and promotion expense in 2007 was $225,162 compared to $270,766 in 2006 and $139,902 in 2005. The increases in expense for 2007 and 2006 compared to 2005 was related to promoting the growth of the Bank. Directors Fees and Expenses The Company does not pay director fees to employee directors. Director fees and expenses for 2007 were $210,360 compared to $196,230 in 2006 and $93,852 in 2005. The primary increase in director expense from 2005 to 2006 was from $77,640 associated with stock-based compensation expense for options granted to directors. Prior to 2006, the Company was not required to reflect a 27 cost related to stock options granted to directors on its income statement. Beginning in 2006, the Company was required to reflect this cost on its income statement in accordance with SFAS No. 123R. FDIC and State Assessments FDIC and California Department of Financial Institutions assessments were $141,350 in 2007 compared to $61,876 in 2006 and $82,956 in 2005. During 2007, the FDIC imposed a large increase in rates that all banks were required to pay to the FDIC. Other Operating Expense Other operating expenses in 2007 were $493,382 compared to $342,706 in 2006 and $281,091 in 2005. The increase is related to the growth of the Company. The Bank belongs to the Certificate of Deposit Account Registry Service(R) (CDARS) network. The Bank can provide its customers with $50,000,000 in FDIC insurance coverage on certificates of deposit accounts. Through the CDARS network, the Bank places its customers with other banks throughout the country and receives reciprocal deposits from other bank's customers. The Bank pays a fee for placing these reciprocal deposits through the CDARS network. The CDARS expense for 2007 was $159,170 compared to $58,525 in 2006 and $48,001 in 2005. The average balance of CDARS deposits during 2007 was $54,448,389 compared to $19,948,093 in 2006. Provision for Income Taxes The Company has a large portfolio of municipal investment securities. These securities are substantially tax free for federal income tax purposes. As a result of the benefits associated with these securities, the Company has a tax benefit of $356,194 for 2007 compared to the tax expense of $299,165 in 2006 and $144,996 in 2005. Provision and Allowance for Loan Losses The allowance for loan losses is established through a provision for loan losses charged to expense. Loans are charged against the allowance for loan losses when management believes that the collectibility of the principal is unlikely. The allowance is an amount that management believes will be adequate to absorb losses inherent in existing loans and commitments to extend credit, based on evaluations of collectibility and prior loss experience of loans and commitments to extend credit. The evaluations take into consideration such factors as changes in the nature and volume of the portfolio, overall portfolio quality, loan concentration, specific problem loans, commitments, and current economic conditions that may affect the borrowers' ability to pay. The allowance for loan losses is maintained at a level that is considered adequate to provide for the loan losses inherent in the Company's loans. The provision for loan losses was $935,000 in 2007, $300,000 in 2006 and $165,000 in 2005. During 2007, the Company charged off $806,000 of a $2,420,000 real estate loan located in Clements, California reducing the loan balance to $1,614,000. After the loan was written down, The Company increased its provision for loan loss to maintain an adequate reserve for other possible loan losses. 28 Summary of Loan Loss Experience The following table summarizes the changes in the allowance for loan losses arising from loans charged-off, recoveries on loans previously charged-off, and additions to the allowance which have been charged to operating expenses and certain ratios relating to the allowance for loan losses.
For the Year Ended December 31, ------------------------------------------------ 2007 2006 2005 ------------- ------------- ------------- Outstanding Loans: Average for the Year $ 117,744,381 $ 104,063,315 $ 73,978,423 End of the Year $ 114,887,771 $ 115,171,711 $ 83,964,728 Allowance For Loan Losses: Balance at Beginning of Year $ 1,429,050 $ 1,123,494 $ 963,000 Actual Charge-Offs: Commercial -- -- 4,506 Consumer -- -- -- Real Estate 806,000 -- -- ------------- ------------- ------------- Total Charge-Offs 806,000 -- 4,506 Less Recoveries: Commercial -- -- -- Consumer 5,556 -- Real Estate -- -- -- ------------- ------------- ------------- Total Recoveries -- 5,556 -- ------------- ------------- ------------- Net Loans Charged-Off (Recovered) 806,000 (5,556) 4,506 Provision for Loan Losses 935,000 300,000 165,000 ------------- ------------- ------------- Balance at End of Year $ 1,558,050 $ 1,429,050 $ 1,123,494 ============= ============= ============= Ratios: Net Loans Charged-Off (Recovered) to Average Loans .68% (.01%) .01% Allowance for Loan Losses to Total Loans 1.36% 1.24% 1.34% Net Loans Charged-Off (Recovered) to Beginning Allowance for Loan Losses 56.40% (.49%) .47% Net Loans Charged-Off (Recovered) to Provision for Loan Losses 86.20% (1.85%) 2.73% Allowance for Loan Losses to Nonperforming Loans 77.67% 328.41% 363.29%
Management believes that the allowance for loan losses is adequate. Quarterly detailed reviews are performed to identify the risks inherent in the loan portfolio, assess the overall quality of the loan portfolio and to determine the adequacy of the allowance for loan losses and the related provision for loan losses to be charged to expense. These systematic reviews follow the methodology set forth by the Interagency Policy Statements on the Allowance for Loan and Lease Losses dated December 13, 2006, the update of Accounting for Loan and Lease Losses dated March, 2004, and the Interagency Policy Statements on Allowance for Loan and Lease Losses Methodologies for Banks and Savings Institutions dated July 6, 2001. The following table summarizes the allocation of the allowance for loan losses by loan type for the years indicated and the percent of loans in each category to total loans (dollar amounts in thousands):
2007 2006 2005 --------------------------------- ------------------- ------------------- ------------------- Loan category Amount Percent Amount Percent Amount Percent --------------------------------- -------- -------- -------- -------- -------- -------- Construction and land development $ 530 34.01% $ 310 29.74% $ 459 40.88% Real estate 446 28.63% 445 37.68% 312 27.78% Commercial 300 19.26% 438 20.34% 315 28.05% Agriculture 35 2.25% 35 3.72% 10 .89% Consumer 160 10.27% 108 1.06% 27 2.40% Leases 87 5.58% 93 7.46% -- -- -------- -------- -------- -------- -------- -------- Total gross loans $ 1,558 100.00% $ 1,429 100.00% $ 1,123 100.00% ======== ======== ======== ======== ======== ========
29 The Company's current policy is to cease accruing interest when a loan becomes 90 days past due as to principal or interest, when the full timely collection of interest or principal becomes uncertain or when a portion of the principal balance has been charged off, unless the loan is well secured and in the process of collection. When a loan is placed on nonaccrual status, the accrued and uncollected interest receivable is reversed and the loan is accounted for on the cash or cost recovery method thereafter, until qualifying for return to accrual status. Generally, a loan may be returned to accrual status when all delinquent interest and principal become current in accordance with the terms of the loan agreement or when the loan is both well secured and in the process of collection. NONPERFORMING ASSETS The following table provides information with respect to the components of our nonperforming assets at the dates indicated (dollars in thousands):
December 31, ------------------------------------- 2007 2006 2005 ---------- ---------- ---------- Loans 90 Days Past Due and Still Accruing $ -- $ -- $ 255 Nonaccrual Loans 2,006 435 54 ---------- ---------- ---------- Total Nonperforming Loans 2,006 435 309 Other Real Estate Owned -- -- -- ---------- ---------- ---------- Total Nonperforming Assets $ 2,006 $ 435 $ 309 ========== ========== ========== Non performing Loans as a Percentage of Total Loans 1.75% .38% .37% Allowance for Loan Loss as a Percentage of Nonperforming Loans 77.67% 328.41% 363.29% Nonperforming Assets as a Percentage of Total Assets .87% .19% .18%
Nonaccrual loans are generally past due 90 days or are loans as to which the principal may not be collectible. Loans past due 90 days will continue to accrue interest only when the loan is both well secured and in the process of collection. There were $2,006,029 in nonperforming loans held by the Bank at December 31, 2007. One of the loans in the amount of $352,542 is guaranteed by the Small Business Administration for $264,407. The Bank does not currently anticipate that there will be any significant losses associated with these nonperforming loans. The Bank subsequently foreclosed on a real estate loan of $1,614,000 during the first quarter of 2008. BALANCE SHEET ANALYSIS Total assets of the Company at December 31, 2007 were $231,075,943 compared to $227,220,390 in 2006 and $169,329,270 in 2005, representing an increase of 1.70% and 34.2%, respectively. The growth of the Company in 2007 slowed as a result of a worsening economy and a slow down in new real estate construction. The growth in 2006 over 2005 was primarily from the opening of a new branch in Lodi. Investment Securities Other earning assets are comprised of Federal Funds sold (funds loaned on a short-term basis to other banks), investment securities, mutual funds, commercial paper, and short-term interest bearing deposits at other financial institutions. These assets are maintained for short-term liquidity needs of the Company, collateralization of public deposits, and diversification of the earning asset mix. Investment securities increased to $95,995,684 at December 31, 2007 compared to $86,143,722 at December 31, 2006 and to $68,809,971 at December 31, 2005. This represents an increase of $9,851,962 or 11.4% for 2007 as compared to 2006. The increase in investments is available for liquidity and pledging purposes. 30 The tables below reflect the composition of investment securities, amortized cost, unrealized gains and losses and estimated fair values as of December 31, 2007.
Gross Gross Estimated Amortized Unrealized Unrealized Fair Average Cost Gains Losses Value Yields ------------ ------------ ------------ ---------------------------- Available-for-Sale Securities: U.S. Government Agencies $ 35,211,652 $ 83,394 $ (53,615) $ 35,241,431 5.20% State and Political Subdivisions 23,520,119 24,390 (249,204) 23,295,305 4.15% Asset-Backed Securities 7,173,180 1,274 (77,244) 7,097,210 5.15% Mortgage-Backed Securities 14,368,973 47,170 (128,003) 14,288,140 4.66% Agency Preferred Stock 2,530,000 -- (13,767) 2,516,233 7.40% Short-Term Mutual Funds 500,000 -- (4,111) 495,889 5.21% ------------ ------------ ------------ ------------ $ 83,303,924 $ 156,228 $ (525,944) $ 82,934,208 4.91% ============ ============ ============ ============ Held-to-Maturity Securities: U.S. Government Agencies $ 3,875,767 $ 353 $ (96,834) $ 3,779,286 6.51% State and Political Subdivisions 5,123,990 18,549 (383,769) 4,758,770 4.46% Corporate 3,898,115 14,070 (83,352) 3,828,833 10.46% Mortgage-Backed Securities 163,604 3,202 (6) 166,800 6.02% ------------ ------------ ------------ ------------ $ 13,061,476 $ 36,174 $ (563,961) $ 12,533,689 6.99% ============ ============ ============ ============
The following table sets forth the total gross unrealized losses and estimated fair values of investment securities with continuous losses less than twelve months, those with continuous losses for twelve months or more, and total losses as of December 31, 2007 (dollar amounts in thousands).
Less than Twelve Months Twelve Months or More Total --------------------------- ---------------------------- ---------------------------- Gross Estimated Gross Estimated Gross Estimated Unrealized Fair Unrealized Fair Unrealized Fair Losses Value Losses Value Losses Value ------------ ------------ ------------ ------------ ------------ ------------ US Government Agencies $ (78) $ 7,863 $ (73) $ 9,462 $ (151) $ 17,325 State and Political Subdivisions (475) 14,975 (158) 6,025 (633) 21,000 Preferred Stock (14) 486 -- -- (14) 486 Asset-Backed Securities (11) 2,798 (66) 4,662 (77) 7,460 Mortgage-Backed Securities (4) 972 (124) 8,466 (128) 9,438 Short-Term Mutual Funds (4) 496 -- -- (4) 496 Corporate (83) 2,185 -- -- (83) 2,185 ------------ ------------ ------------ ------------ ------------ ------------ $ (669) $ 29,775 $ (421) $ 28,615 $ (1,090) $ 58,390 ============ ============ ============ ============ ============ ============
31 As of December 31, 2007, the Company had 278 investment securities with an estimated fair value decline of .93% from the Company's amortized cost. Management evaluates investment securities for other than temporary impairment taking into consideration the extent and length of time the fair value has been less than cost, the financial condition of the issuer, and whether the Company has the intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery in fair value. As of December 31, 2007, no declines in fair value are deemed to be other than temporary. The scheduled maturities of securities available-for-sale and held-to-maturity as of December 31, 2007 are shown below. Actual maturities may differ from contractual maturities because borrowers have the right to call or prepay obligations with or without call or prepayment penalties.
Available-for-Sale Held-to-Maturity --------------------------------------- -------------------------------------- Weighted Weighted Amortized Fair Average Amortized Fair Average Cost Value Yields (1) Cost Value Yields (1) ----------- ----------- ---------- ----------- ----------- ---------- Due in one year or less $ 3,967,362 $ 3,946,364 3.79% $ -- $ -- N/A After one year to five years 7,715,875 7,699,821 4.91% -- -- N/A After five years to ten years 15,697,581 15,730,936 5.36% 1,000,000 1,013,710 8.75% After ten years 38,524,133 38,256,825 5.76% 11,897,872 11,353,179 7.72% Mortgage-backed securities 14,368,973 14,288,140 4.66% 163,604 166,800 6.01% Preferred stock 2,530,000 2,516,233 7.40% -- -- N/A Short-term mutual fund 500,000 495,889 5.21% -- -- N/A ----------- ----------- ----------- ----------- $83,303,924 $82,934,208 5.37% $13,061,476 $12,533,689 7.78% =========== =========== =========== ===========
(1) Weighted average yields for municipal securities have been adjusted to reflect their tax equivalent yields. Listed below are the amortized cost and fair value of the securities owned by the Company, which exceed ten percent of shareholders' equity. Amortized Cost Fair Value ----------- ----------- Federal National Mortgage Association $22,979,620 $23,000,325 Federal Home Loan Mortgage Corporation $15,161,337 $15,018,342 Federal Home Loan Bank $14,347,803 $14,326,203 Government National Mortgage Association $ 2,161,237 $ 2,157,485 32 The tables below reflect the composition of investment securities, amortized cost, unrealized gains and losses and estimated fair values as of December 31, 2006.
Gross Gross Estimated Amortized Unrealized Unrealized Fair Average Cost Gains Losses Value Yields ------------ ------------ ------------ -------------------------- Available-for-Sale Securities: U.S. Government Agencies $ 39,415,380 $ 63,385 $ (294,940) $ 39,183,825 4.97% State and Political Subdivisions 19,522,737 38,074 (74,787) 19,486,024 3.92% Asset-Backed Securities 7,280,691 3,946 (133,943) 7,150,694 4.90% Mortgage-Backed Securities 15,138,808 12,460 (314,084) 14,837,184 4.41% Short-Term Mutual Funds 500,000 -- -- 500,000 5.38% ------------ ------------ ------------ ------------ $ 81,857,616 $ 117,865 $ (817,754) $ 81,157,727 4.61% ============ ============ ============ ============ Held-to-Maturity Securities: U.S. Government Agencies $ 2,468,485 $ -- $ (17,659) $ 2,450,826 6.44% State and Political Subdivisions 2,313,410 119,689 (12,909) 2,420,190 4.58% Asset-Backed Securities 14,526 -- -- 14,526 6.30% Mortgage-Backed Securities 189,574 2,567 (57) 192,084 5.79% ------------ ------------ ------------ ------------ $ 4,985,995 $ 122,256 $ (30,625) $ 5,077,626 5.55% ============ ============ ============ ============
The following sets forth the total gross unrealized losses and estimated fair values of investment securities with continuous losses less than twelve months, those with continuous losses for twelve months or more, and total losses as of December 31, 2006 (dollar amounts in thousands).
Less than Twelve Months Twelve Months or More Total --------------------------- --------------------------- --------------------------- Gross Estimated Gross Estimated Gross Estimated Unrealized Fair Unrealized Fair Unrealized Fair Losses Value Losses Value Losses Value ------------ ------------ ------------ ------------ ------------ ------------ US Government Agencies $ (32) $ 8,951 $ (281) $ 19,219 $ (313) $ 28,170 State and Political Subdivisions (46) 6,518 (40) 5,635 (86) 12,153 Asset-Backed Securities (1) 451 (133) 6,497 (134) 6,665 Mortgage-Backed Securities (1) 168 (314) 12,580 (315) 13,031 ------------ ------------ ------------ ------------ ------------ ------------ $ (80) $ 16,088 $ (768) $ 43,931 $ (848) $ 60,019 ============ ============ ============ ============ ============ ============
As of December 31, 2007, the Company had 278 investment securities with an estimated fair value decline of .93% from the Company's amortized cost. Management evaluates investment securities for other than temporary impairment taking into consideration the extent and length of time the fair value has been less than cost, the financial condition of the issuer, and whether the Company has the intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery in fair value. As of December 31, 2007, no declines in value are deemed to be other than temporary. 33 Loans A significant portion of the Company's assets consists of the loan portfolio. Gross loans were $114,887,771 in 2007, $115,171,711 in 2006 and $83,964,728 at December 31, 2005. Approximately 74.6% of the gross loans at December 31, 2007 are adjustable rate loans. Nearly all of the adjustable rate loans are tied to the prime rate. To mitigate the negative effect on earnings from declining interest rates, the Bank included interest rate floors on some of its loans. Once the interest rate on a loan reaches the interest rate floor, the interest rate cannot decline further. The interest rate floors helped to protect net income from declining interest rates, but also creates a lag in the repricing of certain loans as interest rates rise. The table below summarizes the composition of the loan portfolio as of December 31, 2007, 2006, and 2005.
2007 2006 2005 Loan category Amount Percent Amount Percent Amount Percent --------------------------------- ------------- --------- ------------- --------- ------------- --------- Construction and land development $ 29,541,045 25.71% $ 34,248,157 29.74% $ 27,787,719 33.09% Real estate 45,004,402 39.18% 43,396,795 37.68% 33,672,659 40.11% Commercial 23,027,387 20.04% 23,421,351 20.34% 18,109,304 21.57% Leases 8,560,166 7.45% 8,591,815 7.46% -- -- Agriculture 4,713,710 4.10% 4,288,022 3.72% 1,964,690 2.34% Consumer 4,041,061 3.52% 1,225,571 1.06% 2,430,356 2.89% ------------- --------- ------------- --------- ------------- --------- Total gross loans 114,887,771 100.00% 115,171,711 100.00% 83,964,728 100.00% Deferred loan fees and discounts (160,557) (234,487) (308,102) Reserve for possible loan losses (1,558,050) (1,429,050) (1,123,494) ------------- ------------- ------------- Total net loans $ 113,169,164 $ 113,508,174 $ 82,533,132 ============= ============= ============= The table below summarizes the approximate maturities and sensitivity to changes in interest rates for the loans at December 31, 2007. After One Year Due Within But Within After Loan category One Year Five Years Five Years Total --------------------------------- ------------ ------------ ------------ ------------ Construction and land development $ 25,936,817 $ 2,903,107 $ 701,122 $ 29,541,046 Real estate 12,487,825 22,117,178 10,397,192 45,002,195 Commercial 13,232,822 6,494,042 3,302,729 23,029,593 Leases -- 2,588,166 5,972,000 8,560,166 Agriculture 3,634,656 976,287 102,767 4,713,710 Consumer 3,705,141 310,033 25,887 4,041,061 ------------ ------------ ------------ ------------ Total gross loans $ 58,997,261 $ 35,388,813 $ 20,501,697 $114,887,771 ============ ============ ============ ============ Interest rate provision ----------------------- Predetermined rates $ 6,013,534 $ 13,947,663 $ 9,175,017 $ 29,136,214 Floating or adjustable rates 52,983,727 21,441,150 11,326,680 85,751,557 ------------ ------------ ------------ ------------ $ 58,997,261 $ 35,388,813 $ 20,501,697 $114,887,771 ============ ============ ============ ============
34 Risk Elements The Company assesses and manages credit risk on an ongoing basis through stringent credit review and approval policies, extensive internal monitoring and established formal lending policies. Additionally, the Company contracts with an outside source to periodically review the existing loan portfolio. Management believes its ability to identify and assess risk and return characteristics of the loan portfolio is critical for profitability and growth. Management strives to continue the historically low level of credit losses by continuing its emphasis on credit quality in the loan approval process, active credit administration and regular monitoring. Management has implemented a loan review and grading system that functions to continually assess the credit risk inherent in the loan portfolio. In extending credit and commitments to borrowers, the Company generally requires collateral and/or guarantees as security. The repayment of such loans is expected to come from cash flows or from proceeds from the sale of selected assets of the borrowers. The Company's requirement for collateral and/or guarantees is determined on a case-by-case basis in connection with management's evaluation of the creditworthiness of the borrower. Collateral held varies but may include accounts receivable, inventory, personal property, plant and equipment, income-producing properties, residences and other real property. California's economy has not been as robust as in prior years. Construction loans and other real estate secured loans comprise approximately 64.9% of total loans outstanding, which management believes represents a concentration in the loan portfolio. Although management believes such loans have no more than the normal risk of collectibility, a substantial decline in the economy in general, or a decline in real estate values in the Company's primary operating market areas in particular, could have an adverse impact on the collectibility of such loans. In addition, such an occurrence could result in an increase in loan losses and an increase in the provision for loan losses which could adversely affect the Company's future prospects, results of operations, overall profitability and the market price of the Company's common stock. Management believes that its lending policies and underwriting standards will tend to minimize losses in an economic downturn; however, there is no assurance that losses will not occur under such circumstances. The Company's loan policies and underwriting standards include, but are not limited to, the following: (1) maintaining a thorough understanding of the Company's service area and limiting investments outside this area; (2) maintaining a thorough understanding of borrowers' knowledge and capacity in their field of expertise; (3) basing real estate construction loan approval not only on the prospects for sale of the project, but also within the original projected time period; and (4) maintaining conforming and prudent loan to value and loan to cost ratios based on independent outside appraisals and ongoing inspection and analysis by the Company's construction lending officers. In addition, the Company strives to diversify the risk inherent in the construction portfolio by avoiding concentrations to individual borrowers and on any one category of loans. Subprime loans generally refer to adjustable rate residential mortgages made to higher-risk borrowers with lower credit and/or income histories. Such subprime loans coupled with declines in housing prices have led to an increase in default rates resulting in many instances of increased foreclosure rates as the adjustable interest rates reset to higher levels. The Company does not originate and does not have any "subprime" loans or investments on its books at December 31, 2007; however, the effects of subprime loan defaults, foreclosures and declining housing prices has contributed to the worsening economic conditions affecting the real estate markets generally in areas where the Company conducts its business. The continuing effect of such circumstances may adversely affect the value of the Company's loan portfolio requiring further reserves against loss and thereby adversely affect the Company's results of operations, financial condition, prospects and stock price. Nonaccrual Loans, Loans Past Due 90 Days and OREO Management generally places loans on nonaccrual status when they become 90 days past due, unless the loan is well secured and in the process of collection. Loans are charged off when, in the opinion of management, collection appears unlikely. Total nonaccrual loans and loans more than 90 days past due at December 31, 2007 were $2,006,029, $435,147 at December 31, 2006 and $309,256 at December 31, 2005. The increase from 2006 to 2007 was primarily from one real estate loan secured by a tract of 15 developed lots. 35 At December 31, 2007, there were loans totaling $2,006,029 that were considered impaired. There were no loans that were considered troubled debt restructurings. Management is not aware of any potential problem loans, which were accruing and current at December 31, 2007, where serious doubt exists as to the ability of the borrower to comply with the present repayment terms. There was no other real estate owned at December 31, 2007, 2006 and 2005. Off-Balance Sheet Arrangements and Contractual Obligations The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business in order to meet the financing needs of its customers and to reduce its exposure to fluctuations in interest rates. These financial instruments consist of commitments to extend credit and letters of credit and involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized on the balance sheet. The Company's exposure to credit loss in the event of nonperformance by the other party for commitments to extend credit and letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and letters of credit as it does for loans included on the consolidated balance sheet. The following financial instruments represent off-balance-sheet credit risk (dollars in thousands):
December 31, ------------------------------------------ 2007 2006 2005 ------------ ------------ ------------ Commitments to extend credit: Revolving lines of credit secured by 1-4 family residences $ 4,653 $ 4,580 $ 4,442 Commercial real estate, construction and land development commitments secured by real estate 8,984 17,321 16,475 Other commitments: Commercial loans 15,489 9,587 7,943 Agricultural loans 4,591 3,774 1,939 Unsecured consumer lines of credit 2,775 4,103 2,501 ------------ ------------ ------------ Total $ 36,492 $ 39,365 $ 33,300 ============ ============ ============ Letters of Credit $ 1,547 $ 1,242 $ 1,596 ============ ============ ============
As of December 31, 2007, commitments to extend credit and letters of credit were the only financial instruments with off-balance sheet risk. The Company has not entered into any contracts for financial derivative instruments such as futures, swaps, options or similar instruments. Real estate commitments are generally secured by property with a loan-to-value ratio of 65% to 80%. In addition, the majority of the Company's commitments have variable interest rates. Certain financial institutions have elected to use special purpose vehicles ("SPV") to dispose of problem assets. The SPV is typically a subsidiary company with an asset and liability structure and legal status that makes its obligations secure even if the parent corporation goes bankrupt. Under certain circumstances, these financial institutions may exclude the problem assets from their reported impaired and non-performing assets. The Company does not use those vehicles or any other structures to dispose of problem assets. 36 Contractual Obligations The Company leases certain facilities at which it conducts its operations. Future minimum lease commitments under non-cancelable operating leases as of December 31, 2007 are listed in the table below. 2008 470,247 2009 450,422 2010 332,797 2011 339,595 2012 300,536 Thereafter 888,563 ------------ Total $ 2,782,160 ============ Deposits Deposits represent the Company's principal source of funds for loans and investments. Deposits are primarily generated from local businesses, government agencies and individuals. Total deposits were $202,405,646 at December 31, 2007 compared to $199,955,091 at December 31, 2006 and $151,141,667 at December 31, 2005. This represents an increase of $245,055 or 1.2% at December 31, 2007. Average non-interest bearing demand deposits increased from $28,776,610 at December 31, 2006 to $24,940,284 at December 31, 2007. Total average balances of money market accounts at December 31, 2007 were $25,568,491 compared to $17,871,116 at December 31, 2006 and $12,316,407 at December 31, 2005. Average balances of certificates of deposit increased from $52,683,301 at December 31, 2006 to $84,239,592 at December 31, 2007. The table below reflects the composition of the deposits including average balance and the average rate paid for the years ended December 31, 2007, 2006 and 2005.
Composition of Deposits 2007 2006 2005 -------------------------- -------------------------- -------------------------- Deposits Average Average Average Average Average Average Balance Rate Balance Rate Balance Rate ------------ ---------- ------------ ---------- ------------ ---------- Non-interest bearing demand $ 24,940,284 0.00% $ 28,776,610 0.00% $ 27,703,879 0.00% Interest bearing demand 57,736,501 4.24% 63,060,814 3.49% 68,382,714 2.22% Money market deposit accounts 25,568,491 3.20% 17,871,116 3.15% 12,316,407 1.47% Savings accounts 3,153,760 .86% 3,395,561 .74% 3,428,724 0.57% Certificates of deposit 84,239,592 4.88% 52,683,301 4.51% 29,852,230 3.76% ------------ ------------ ------------ $195,638,625 3.78% $165,787,402 3.12% $141,683,954 2.01% ============ ============ ============
37 The maturities of time certificates of deposit of $100,000 or more at December 31, 2007 are summarized as follows: December 31, 2007 --------------- Three months or less $ 10,915,891 Over three months through six months 2,452,275 Over six months through twelve months 3,167,410 Over one year through three years 536,981 Over three years 2,548,331 --------------- Total $ 19,620,888 =============== 38 CAPITAL RESOURCES The Company's total shareholders' equity was $17,648,014 at December 31, 2007 compared to $16,966,834 at December 31, 2006 and $15,574,101 as of December 31, 2005. The increase in shareholders' equity was primarily from the current year's net income of $337,023 and a reduction in the accumulated other comprehensive income net of tax of $195,149, and an increase in additional paid in capital of $149,008. The Company's capital resources include shareholders' equity plus junior subordinated debt securities (trust preferred securities) and the allowance for loan losses for regulatory purposes, subject to limitations. See Note 7 of the financial statements in Item 8 for information regarding junior subordinated debt securities. The Company and the Bank are subject to regulations issued by the Board of Governors of the Federal Reserve System and the FDIC which require maintenance of a certain level of capital. Under the regulations, capital requirements are based upon the composition of an institution's asset base and the risk factors assigned to those assets. The guidelines characterize an institution's capital as being "Tier 1" capital (defined to be principally shareholders' equity less intangible assets) and "Tier 2" capital (defined to be principally the allowance for loan losses, limited to one and one-fourth percent of gross risk-weighted assets). The guidelines require the Company and the Bank to maintain a risk-based capital target ratio of 8%, one-half or more of which should be in the form of Tier 1 capital. See the discussion of capital standards and prompt corrective action at pages 4 through 6 for more information regarding capital resources. 39 The table below reflects the capital and leverage ratios of the Company and the Bank as of December 31, 2007, 2006 and 2005.
Actual For capital adequacy To be well-capitalized under purposes prompt corrective action provisions ------------------------- ------------------------- ------------------------- Amount Ratio Amount Ratio Amount Ratio ------------ ---------- ------------ ---------- ------------ ---------- As of December 31, 2007: Company: Total capital (to risk weighted assets) $ 24,574 14.7% $ 13,334 8.0% N/A N/A Tier 1 capital (to risk weighted assets) $ 23,016 13.8% $ 6,667 4.0% N/A N/A Tier 1 capital (to average assets) $ 23,016 9.8% $ 9,422 4.0% N/A N/A Bank: Total capital (to risk weighted assets) $ 22,423 13.5% $ 13,334 8.0% $ 16,668 10.0% Tier 1 capital (to risk weighted assets) $ 20,825 12.5% $ 6,667 4.0% $ 10,001 6.0% Tier 1 capital (to average assets) $ 20,825 8.9% $ 9,375 4.0% $ 11,719 5.0% As of December 31, 2006: Company: Total capital (to risk weighted assets) $ 23,956 15.3% $ 12,510 8.0% N/A N/A Tier 1 capital (to risk weighted assets) $ 22,527 14.4% $ 6,255 4.0% N/A N/A Tier 1 capital (to average assets) $ 22,527 10.4% $ 8,673 4.0% N/A N/A Bank: Total capital (to risk weighted assets) $ 21,519 13.8% $ 12,510 8.0% $ 15,637 10.0% Tier 1 capital (to risk weighted assets) $ 20,028 12.8% $ 6,255 4.0% $ 9,382 6.0% Tier 1 capital (to average assets) $ 20,028 9.3% $ 8,593 4.0% $ 10,741 5.0% As of December 31, 2005: Company: Total capital (to risk weighted assets) $ 17,404 15.1% $ 9,224 8.0% N/A N/A Tier 1 capital (to risk weighted assets) $ 16,281 14.1% $ 4,612 4.0% N/A N/A Tier 1 capital (to average assets) $ 16,281 9.8% $ 6,683 4.0% N/A N/A Bank: Total capital (to risk weighted assets) $ 16,304 14.1% $ 9,224 8.0% $ 11,530 10.0% Tier 1 capital (to risk weighted assets) $ 15,181 13.2% $ 4,612 4.0% $ 6,918 6.0% Tier 1 capital (to average assets) $ 15,181 9.1% $ 6,644 4.0% $ 8,304 5.0%
LIQUIDITY Liquidity management refers to the Company's ability to provide funds on an ongoing basis to meet fluctuations in deposit levels as well as the credit needs and requirements of its customers. Both assets and liabilities contribute to the Company's liquidity position. Federal Funds lines, short-term investments and securities, and loan repayments contribute to liquidity, along with deposit increases, while loan funding and deposit withdrawals decrease liquidity. Commitments to fund loans and letters of credit at December 31, 2007 were approximately $38,038,672. Such loans relate primarily to real estate construction loans and revolving lines of credit and other commercial loans. The Company's sources of liquidity consist of its available-for-sale securities, cash and due from banks, overnight funds sold, mutual funds, and short-term borrowing lines. At December 31, 2007, the net ratio of available liquidity not pledged for collateral and other purposes to deposits and other short-term borrowings was 17.7% in 2007 compared to 17.1 % in 2006 and 31.4 % in 2005. The ratio of gross loans to deposits, another key liquidity ratio, was 56.8% at year-end 2007 compared to 57.6% at year-end 2006 and 54.0% at year-end 2005. The Bank has unused borrowing lines from correspondent banks totaling $41,310,000 and an additional available borrowing line with the Federal Home Loan Bank of San Francisco totaling $16,332,796. 40 INFLATION The impact of inflation on a financial institution differs significantly from that exerted on manufacturing, or other commercial concerns, primarily because its assets and liabilities are largely monetary. In general, inflation primarily affects the Company indirectly through its effect on market rates of interest, and thus the ability of the Company to attract loan customers. Inflation affects the growth of total assets by increasing the level of loan demand, and potentially adversely affects the Company's capital adequacy because loan growth in inflationary periods can increase at rates higher than the rate that capital grows through retention of earnings which the Company may generate in the future. In addition to its effects on interest rates, inflation directly affects the Company by increasing operating expenses of the Company. The effects of inflation were not material to the Company's results of operations during the years ended December 31, 2007, 2006 and 2005. CRITICAL ACCOUNTING POLICIES Use of Estimates in the Preparation of Financial Statements The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires the Bank's management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Note 1 to the Financial Statements describes the significant accounting policies used in the preparation of the financial statements. A critical accounting policy is defined as one that is both material to the presentation of the Company's financial statements and requires management to make difficult, subjective or complex judgments that could have a material effect on the Company's financial condition and results of operations. Management believes that the matters described below are critical accounting policies. Allowance for Loan Losses The allowance for loan losses is established through a provision for loan losses charged to expenses. Loans are charged against the allowance for loan losses when management believes that the collectibility of the principal is unlikely. The allowance is an amount that management believes will be adequate to absorb losses inherent in existing loans and commitments to extend credit, based on evaluations of collectibility and prior loss experience of loans and commitments to extend credit. The evaluations take into consideration such factors as changes in the nature and volume of the portfolio, overall portfolio quality, loan concentration, specific problem loans, commitments, and current economic conditions that may affect the borrowers' ability to pay. Stock-Based Compensation The Company previously accounted for its stock-based compensation under the recognition and measurement principles of Accounting Principles Board ("APB") Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. Because the Company's 2000 Stock Option Plan provides for the issuance of options at a price of no less than the fair market value at the date of the grant, no compensation expense was recognized in the financial statements unless the options were modified after the grant date. In December 2004, the Financial Accounting Standards Board issued Statement Number 123 (revised 2004) ("FAS 123 (R)"), Share-Based Payments. FAS 123 (R) requires all entities to recognize compensation expense in an amount equal to the fair value of share-based payments such as stock options granted to employees. The Company adopted FAS 123 (R) on a modified prospective method, beginning on January 1, 2006. Under this method, the Company is required to record compensation expense (as previous awards continue to vest) for the unvested portion of previously granted awards that remain outstanding at the date of adoption. As a result of adopting Statement 123 (R) on January 1, 2006, the Company's income before benefit for income taxes and net income for the year ended December 31, 2007 was $149,009 and $118,797 lower, respectively, than if it had continued to account for share-based compensation under APB Opinion No. 25. Diluted earnings per share and basic earnings per share for the year ended December 31, 2007 would have increased $0.05 had the Company continued to account for share-based compensation under APB Opinion No. 25. The Company's income before provision for income taxes and net income for the year ended December 31, 2006, was $199,260 and $167,277 lower, respectively, than if it had continued to account for share-based compensation under APB Opinion No. 25. Diluted earnings per share and basic earnings per share for the year ended December 31, 2006 would have increased $0.04 and $0.03, respectively, had the Company continued to account for share-based compensation under APB Opinion No. 25. 41 The fair value of each option is estimated on the date of grant and amortized over the service period using an option pricing model. Critical assumptions that affect the estimated fair value of each option include expected stock price volatility, dividend yields, option life and the risk-free interest rate. Financial Assets and Liabilities The Company has adopted SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." The Statement provides accounting and reporting standards for transfers and servicing of financial assets and extinguishments of liabilities. Under this Statement, after a transfer of financial assets, an entity recognizes the financial and servicing assets it controls and liabilities it has incurred, derecognizes financial assets when control has been surrendered, and derecognizes liabilities when extinguished. To calculate the gain (loss) on sale of loans, the Company's investment in the loan is allocated among the retained portion of the loan, the servicing retained, the interest-only strip and the sold portion of the loan, based on the relative fair market value of each portion. The gain (loss) on the sold portion of the loan is recognized at the time of sale based on the difference between the sale proceeds and the allocated investment. As a result of the relative fair value allocation, the carrying value of the retained portion is discounted, with the discount accreted to interest income over the life of the loan. That portion of the excess servicing fees that represent contractually specified servicing fees (contractual servicing) are reflected as a servicing asset which is amortized over an estimated life using a method approximating the level yield method. In the event future prepayments exceed management's estimates and future expected cash flows are inadequate to cover the unamortized servicing asset, additional amortization would be recognized. The portion of excess servicing fees in excess of the contractual servicing fees is reflected as interest-only strips receivable, which are classified as interest-only strips receivable available for sale and are carried at fair value. Income Taxes The Company recognizes deferred tax assets and liabilities based on differences between the financial reporting and tax bases of assets and liabilities using the enacted tax rates and laws that are expected to be in effect when the differences are expected to be recognized. The Company provides a valuation allowance for deferred tax assets when it does not consider recognition of such assets to be more likely than not. OTHER MATTERS Effects of Terrorism The terrorist actions on September 11, 2001 and thereafter and the military conflicts in Afghanistan, Iraq and elsewhere have had significant adverse effects upon the United States economy. Whether the terrorist activities in the future and the actions of the United States and its allies in combating terrorism on a worldwide basis will adversely impact the Company and the extent of such impact is uncertain. Such economic deterioration could adversely affect the Company's future results of operations by, among other matters, reducing the demand for loans and other products and services offered by the Company, increasing nonperforming loans and the amounts reserved for loan and lease losses, and causing a decline in the Company's stock price. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. The types of market risk exposures generally faced in the banking industry include interest rate risk, liquidity risk, equity price risk, foreign currency risk, and commodity price risk. Due to the nature of our operations, foreign currency and commodity price risk are not significant to us. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity for a discussion of our liquidity risk. Our interest rate risk and equity market price risk are described below. 42 Interest Rate Risk The Company manages its interest rate risk within an overall asset and liability management framework that includes attention to credit risk, liquidity risk, and capital structure. A principal objective of asset/liability management is to manage the sensitivity of net interest income to changing interest rates. Asset and liability management activity is governed by a policy reviewed and approved annually by the Board of Directors. The Board of Directors has delegated the administration of this policy to the Funds Management Committee, a committee of the Board of Directors, which is comprised of senior executive management, and four independent directors. Two common measures used to monitor interest rate risk are economic value interest rate sensitivity and forecasted net interest income rate sensitivity. Economic Value Interest Rate Sensitivity Interest rate sensitivity is computed by estimating percentage changes in the economic value of our equity over a range of potential yield curve shocks. Economic value sensitivity is defined as the economic value of our assets less the economic value of our liabilities plus or minus the economic value of off-balance sheet items. The economic value of each asset, liability and off-balance sheet item is its discounted present value of expected cash flows. Discount rates are based on implied forward market rates of interest, adjusted for assumed shock scenario interest rate changes. The following table shows our projected percentage change in economic value sensitivity for parallel yield curve shocks as of the dates indicated relative to the value if wholesale market rates follow implied forward rates. Projected change in economic value -------------------------- December 31, December 31, Change in interest rates 2007 2006 ---------------------------- ------------ ----------- 100 basis point rise -23.4% -15.6% 100 basis point decline 6.68% 5.2% The economic value of portfolio equity sensitivity from December 31, 2006 to December 31, 2007 has shifted due to changes in wholesale rates, a change in the composition of customer loans, leases, investments, and deposits, and shortened wholesale borrowing maturities. Forecasted Net Interest Income Interest Rate Sensitivity The impact of interest rate changes on the next 12 months' net interest income is measured using income simulation. The various products in our balance sheet are modeled to simulate their income (and cash flow) behavior in relation to interest rate movements. Income for the next 12 months is calculated using the implied forward curve and for immediate and sustained yield curve shocks. The income simulation model includes various assumptions about the repricing behavior for each product and new business volumes and pricing behaviors. Many of our assets are floating rate loans, which would subsequently reprice in response to changes in market interest rates with the repricing being the same extent as the change in the underlying contracted index. Our Liquid Gold account deposit products are assumed to reprice gradually in response to wholesale rate changes. The following table shows our projected percentage change in 12 month net interest income as a consequence of parallel yield curve shocks from the implied forward curve: Projected change in net interest income -------------------------- December 31, December 31, Change in interest rates 2007 2006 ---------------------------- ------------ ----------- 100 basis point rise 2.15% 4.32% 100 basis point decline .55% 1.12% 43 Net interest income sensitivity from December 31, 2006 to December 31, 2007 evolved from a slightly asset-sensitive position to a relatively neutral position. Equity Market Price Risk The actively traded equity stocks owned at December 31,2007 were comprised of $2,530,000 of preferred stock in Federal Home Loan Bank and Federal National Mortgage Association. The market value of these preferred stocks was $2,516,233 at December 31, 2007. The only other stocks owned are 9,586 shares of FHLB of San Francisco and 400 shares of Pacific Coast Bankers' Bank. These stocks are not actively traded on any exchange, but their market value exceeds their cost. 44 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO FINANCIAL STATEMENTS Page ---- Report of Independent Registered Public Accounting Firm 46 Consolidated Balance Sheets 47 Consolidated Statements of Income 48 Consolidated Statement of Shareholders' Equity 49 Consolidated Statements of Cash Flows 50 Notes to Financial Statements 51 Schedules have been omitted since the required information is not present in amounts sufficient to require submission of the schedule or because the information required is included in the Financial Statements or notes thereto. 45 [GRAPHIC OMITTED] Vavrinek, Trine, Day & Co., LLP vtd Certified Public Accountants & Consultants REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Board of Directors and Shareholders Service 1st Bancorp We have audited the accompanying consolidated balance sheets of Service 1st Bancorp and Subsidiaries as of December 31, 2007 and 2006, and the related consolidated statements of income, shareholders' equity, and cash flows for the each of the years in the three year period ended December 31, 2007. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Service 1st Bancorp and Subsidiaries as of December 31, 2007 and 2006, and the results of its operations and cash flows for each of the years in the three year period ended December 31, 2007 in conformity with accounting principles generally accepted in the United States of America. /s/ Vavrinek, Trine, Day & Co., LLP Pleasanton, California March 28, 2008 46
SERVICE 1ST BANCORP AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, 2007 and 2006 ASSETS 2007 2006 ------------- ------------- Cash and due from banks $ 6,636,751 $ 6,543,416 Federal funds sold 4,652,900 10,616,902 ------------- ------------- Cash and cash equivalents 11,289,651 17,160,318 Certificates of deposit with other banks 486,488 1,500,000 Investment securities available for sale 82,934,208 81,157,727 Investment securities held to maturity 13,061,476 4,985,995 Loans, net 113,169,164 113,508,174 Bank premises and equipment, net 1,308,720 1,388,980 Cash surrender value of life insurance 3,698,239 3,566,696 Accrued interest receivable 1,505,244 1,461,602 Other assets 3,622,753 2,490,898 ------------- ------------- $ 231,075,943 $ 227,220,390 ============= ============= LIABILITIES AND SHAREHOLDERS' EQUITY Deposits: Noninterest-bearing demand $ 26,697,543 $ 33,848,426 Money market, NOW and savings 86,305,530 94,662,249 Time deposits under $100,000 69,781,685 48,409,724 Time deposits $100,000 and over 19,620,888 23,034,692 ------------- ------------- Total deposits 202,405,646 199,955,091 Junior subordinated debt securities 5,155,000 5,155,000 Other borrowings 4,000,000 4,000,000 Accrued interest and other liabilities 1,867,283 1,143,465 ------------- ------------- Total liabilities 213,427,929 210,253,556 Commitments and contingencies - Notes 5 and 9 -- -- Shareholders' equity: Preferred stock, no par value, 10,000,000 shares authorized, none issued or outstanding -- -- Common stock, no par value, 30,000,000 shares authorized; issued and outstanding, 2,388,739 shares at December 31, 2007 and issued and outstanding, 2,386,239 shares at December 31, 2006 16,023,738 16,023,738 Additional paid in capital 356,152 207,144 Retained earnings 1,484,090 1,147,067 Accumulated other comprehensive income, net of tax (215,966) (411,115) ------------- ------------- Total shareholders' equity 17,648,014 16,966,834 ------------- ------------- $ 231,075,943 $ 227,220,390 ============= =============
The accompanying notes are an integral part of these consolidated statements. 47
SERVICE 1ST BANCORP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME For the years ended December 31, 2007, 2006 and 2005 2007 2006 2005 ------------ ------------ ------------ Interest income: Interest and fees on loans $ 10,194,176 $ 9,234,979 $ 5,796,195 Interest on investment securities 4,390,132 3,159,520 2,420,988 Interest on federal funds sold 250,587 247,675 188,098 Other interest income 71,627 81,322 73,952 ------------ ------------ ------------ 14,906,522 12,723,496 8,479,233 Interest expense: Interest expense on deposits 7,402,994 5,163,106 2,842,807 Other interest expense 597,172 609,825 11,092 ------------ ------------ ------------ 8,000,166 5,772,931 2,853,899 ------------ ------------ ------------ Net interest income 6,906,356 6,950,565 5,625,334 Provision for loan losses 935,000 300,000 165,000 ------------ ------------ ------------ Net interest income after provision for loan losses 5,971,356 6,650,565 5,460,334 Other income: Service charges, fees and other income 304,281 275,863 323,980 (Loss) Gain on the sale of investment securities (7,187) (1,799) 6,191 Gain on sale and servicing of loans 56,655 102,845 187,902 Referral fees on mortgage loans 265,409 275,661 45,285 Earnings on cash surrender value life insurance 159,837 153,725 123,485 Consulting fees 110,000 -- -- ------------ ------------ ------------ 888,995 806,295 686,843 Other expenses: Salaries and employee benefits 3,935,912 3,564,721 2,701,793 Occupancy expense 649,247 641,177 329,017 Equipment expense 345,107 237,866 185,313 Data processing and other professional services 603,000 625,216 504,024 Office supplies and equipment 222,450 178,813 155,880 Loan department expense 53,552 191,203 105,734 Advertising and promotion 225,162 270,766 139,902 Directors fees and expenses 210,360 196,230 93,852 FDIC and state assessments 141,350 61,876 82,956 Other operating expenses 493,382 342,706 281,091 ------------ ------------ ------------ 6,879,522 6,310,574 4,579,562 ------------ ------------ ------------ Net income before income taxes (19,171) 1,146,286 1,567,615 Income taxes (benefit) (356,194) 299,165 144,996 ------------ ------------ ------------ Net income $ 337,023 $ 847,121 $ 1,422,619 ============ ============ ============ Net income per share - basic $ 0.14 $ 0.35 $ 0.60 ============ ============ ============ Net income per share - diluted $ 0.14 $ 0.33 $ 0.56 ============ ============ ============
The accompanying notes are an integral part of these consolidated statements. 48
SERVICE 1ST BANCORP AND SUBSIDIARIES CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY For the years ended December 31, 2007, 2006 and 2005 Accumulated Common Stock Additional Retained Other Total ------------------------- Paid In Comprehensive Earnings Comprehensive Shareholders' Shares Amount Capital Income (Deficit) Income Equity ------------------------------------------------------------------- ---------- ------------ ----------- ----------- ---------- ---------- ---------- ------------ Balance at January 1, 2005 1,541,664 15,425,042 -- (1,117,844) (205,527) 14,101,671 Common stock sold, net of costs of $11,086 49,273 567,871 567,871 Three for two stock split including cash for fractional shares 795,302 (4,829) (4,829) Comprehensive Income: Net income $ 1,422,619 1,422,619 1,422,619 Unrealized losses on securities net of taxes of $357,867 (509,594) (509,594) (509,594) Reclassification adjustment for gains included in net income, net of tax of $2,554 (3,637) (3,637) (3,637) ------------ Comprehensive Income $ 909,388 ============ ----------- ----------- ---------- ---------- ---------- ------------ Balance at December 31, 2005 2,386,239 15,992,913 -- 299,946 (718,758) 15,574,101 Stock options exercised 2,500 30,825 30,825 Surplus from options expense 207,144 207,144 Comprehensive Income: Net income $ 847,121 847,121 847,121 Unrealized gains on securities net of taxes of $217,194 308,699 308,699 308,699 Reclassification adjustment for gains included in net income, net of tax of $743 (1,056) (1,056) (1,056) ------------ Comprehensive Income $ 1,154,764 ============ ----------- ----------- ---------- ---------- ---------- ------------ Balance at December 31, 2006 2,388,739 $16,023,738 $ 207,144 $1,147,067 $ (411,115) $ 16,966,834 Surplus from options expense 149,008 149,008 Comprehensive Income: Net income $ 337,023 337,023 337,023 Unrealized gains on securities net of taxes of $135,135 199,368 199,368 199,368 Reclassification adjustment for gains included in net income, net of tax of $2,968 (4,219) (4,219) (4,219) ------------ Comprehensive Income $ 532,172 ============ ----------- ----------- ---------- ---------- ---------- ------------ Balance at December 31, 2007 2,388,739 $16,023,738 $ 356,152 $1,484,090 $ (215,966) $ 17,648,014 =========== =========== ========== ========== ========== ============
The accompanying notes are an integral part of these consolidated statements. 49
SERVICE 1ST BANCORP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS For the years ended December 31, 2007, 2006 and 2005 2007 2006 2005 ------------ ------------ ------------ Cash flows from operating activities: Net income $ 337,023 $ 847,121 $ 1,422,619 Adjustments to reconcile net income to net cash Provided by operating activities: Provision for loan losses 935,000 300,000 165,000 Depreciation and amortization 276,749 206,950 168,002 Deferred income tax expense (credit) 168,000 (70,000) (212,000) Loss (Gain) on sale of securities 7,187 1,799 (6,191) Options expense 149,008 199,450 -- Gain on sale of loans (6,737) (20,023) (67,226) Loans originated for sale (63,750) (221,621) (887,997) Proceeds from loans sales 70,487 241,644 955,223 Amortization and accretion on securities (98,305) 221,191 310,400 Earnings on cash surrender value life insurance, net (131,543) (130,546) (104,842) (Increase) decrease in accrued interest (43,642) (503,601) (418,476) Decrease/(Increase) in other assets (1,434,379) 246,091 (680,512) (Decrease)/Increase in accrued interest and other liabilities 723,818 (432,343) 621,119 ------------ ------------ ------------ 888,916 886,112 1,265,119 Net cash provided by operating activities Cash flows from investing activities: Purchases of securities available for sale (35,915,181) (30,332,660) (34,617,974) Proceeds from sales of securities available for sale 6,743,578 3,497,638 1,396,477 Proceeds from maturities and calls of securities available for sale 27,508,532 13,328,771 15,919,158 Purchases of securities held to maturity (8,835,032) (3,615,234) (619,838) Proceeds from maturities and calls of securities held to maturity 857,891 107,688 250,286 Proceeds from sale of securities held to maturity 209,041 -- -- Increase in loans (595,990) (31,275,042) (14,375,784) Purchase of certificates of deposit at other banks 1,013,512 (506,280) (648,720) Purchase of bank owned life insurance -- -- (1,000,000) Purchases of premises and equipment (196,489) (924,480) (212,660) ------------ ------------ ------------ Net cash used by investing activities (9,210,138) (49,719,599) (33,909,055) Cash flows from financing activities: Net increase in demand, interest-bearing deposits, and savings (15,507,602) 52,061,138 16,302,368 Net increase in time deposits 17,958,157 (3,247,714) 12,730,717 Cash paid for fractional shares -- -- (4,829) Proceeds from sale of common stock, net of costs -- -- 567,871 Stock options exercised -- 30,825 -- Increase in junior subordinated debt -- 5,155,000 -- Net increase in other borrowings -- 2,970,000 1,030,000 ------------ ------------ ------------ Net cash from financing activities 2,450,555 56,929,249 30,626,127 Net increase (decrease) in cash and cash equivalents (5,870,667) 8,135,762 (2,017,809) Cash and cash equivalents at beginning of year 17,160,318 9,024,556 11,042,365 ------------ ------------ ------------ Cash and cash equivalents at end of year $ 11,289,651 $ 17,160,318 $ 9,024,556 ============ ============ ============ Supplemental disclosures of cash flow information: Interest $ 8,012,547 $ 5,633,334 $ 2,735,722 Income taxes $ 30,000 $ 534,281 $ 325,000
The accompanying notes are an integral part of these consolidated statements. 50 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2007, 2006 and 2005 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES A summary of the significant accounting policies applied in the preparation of the accompanying financial statements follows: Principles of Consolidation --------------------------- The financial statements include the accounts of Service 1st Bancorp and its subsidiaries, Service 1st Bank ("the Bank") and Charter Services Group, Inc. ("Charter"), collectively referred to herein as the "Company". All significant intercompany transactions have been eliminated. Nature of operations -------------------- The Company has been organized as a single operating segment and operates full-service branch offices in Stockton, Tracy, and Lodi, California. The Company's primary source of revenue is providing loans to customers, who are predominately small and middle-market businesses and individuals. Use of estimates ---------------- In preparing financial statements in conformity with accounting principles generally accepted in the United States of America, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and revenues and expenses during the reporting period. Actual results could differ from those estimates. Cash and cash equivalents ------------------------- For purposes of the statement of cash flows, the Company considers cash, due from banks, certificates of deposit with maturities of three months or less and federal funds sold to be cash equivalents. Securities available for sale ----------------------------- Available-for-sale securities consist of bonds, notes, short-term mutual funds, commercial paper and debentures not classified as trading securities or held-to-maturity securities. These securities are carried at estimated fair value with unrealized holding gains and losses, net of tax, reported as a separate component of stockholders' equity, accumulated other comprehensive income, until realized. Gains and losses on the sale of available-for-sale securities are determined using the specific identification method. The amortization of premiums and accretion of discounts are recognized as adjustments to interest income over the period to maturity. Investment Securities --------------------- Bonds, notes, and debentures for which the Company has the positive intent and ability to hold to maturity are reported at cost, adjusted for premiums and discounts that are recognized in interest income using the interest method over the period to maturity. Declines in the fair value of individual held-to-maturity and available-for-sale securities below their cost that are other-than-temporary result in write-downs of the individual securities to their fair value. The related write-downs are included in earnings as realized losses. In estimating other-than-temporary impairment losses, management considers the length of time and the extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and the intent and ability of the Bank to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. 51 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 31, 2007, 2006 and 2005 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - CONTINUED Loans ----- Loans receivable that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at their outstanding unpaid principal balances reduced by any charge-offs or specific valuation accounts and net of any deferred fees or costs on originated loans, or unamortized premiums or discounts on purchased loans. Loan origination fees and certain direct origination costs are capitalized and recognized as an adjustment of the yield of the related loan. Deferred loan origination fee income and direct loan origination costs are amortized to interest income over the life of the loan using the interest method. Interest on loans is accrued to income daily based upon the outstanding principal balances. Loans for which the accrual of interest has been discontinued are designated as nonaccrual loans. Accrual of interest on such loans is discontinued when there exists a reasonable doubt as to the full and timely collection of either principal or interest or when principal or interest is past due 90 days, based on the contractual terms of the loan. Income on such loans is then only recognized to the extent that cash is received and where the future collection of principal is probable. Accrual of interest is resumed only when principal and interest are brought fully current and when such loans are considered to be collectible as to both principal and interest. For impairment recognized in accordance with Financial Accounting Standards Board ("FASB") Statement of Financial Accounting Standards ("SFAS") No. 114, "Accounting by Creditors for Impairment of a Loan", as amended by SFAS No. 118, the entire change in the present value of expected cash flows is reported as either provision for credit losses in the same manner in which impairment initially was recognized, or as a reduction in the amount of provision for credit losses that otherwise would be reported. Loans Held for Sale ------------------- Mortgage loans and SBA loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated market value in the aggregate. Net unrealized losses are recognized through a valuation allowance by charges to income. The only loans originated by the Company for sale in the secondary market are government guaranteed loans such as SBA loans. The Bank retains the unguaranteed portion of the loan on its books and intends to hold that portion of the loan to maturity. Historically, the Bank sold most of the guaranteed portion of the SBA loans in the secondary market thereby receiving premiums and service fees. The Bank does have SBA loans wherein the guaranteed portion, totaling $382,816 has not been sold. It is the Bank's intention to retain the guaranteed portion of these loans; however, they could be sold at a later date. 52 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 31, 2007, 2006 and 2005 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - CONTINUED The Company has adopted SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities". The Statement provides accounting and reporting standards for transfers and servicing of financial assets and extinguishments of liabilities. Under this Statement, after a transfer of financial assets, an entity recognizes the financial and servicing assets it controls and liabilities it has incurred, derecognizes financial assets when control has been surrendered, and derecognizes liabilities when extinguished. To calculate the gain (loss) on sale of loans, the Company's investment in the loan is allocated among the retained portion of the loan, the servicing retained, the interest-only strip and the sold portion of the loan, based on the relative fair market value of each portion. The gain (loss) on the sold portion of the loan is recognized at the time of sale based on the difference between the sale proceeds and the allocated investment. Servicing Rights - Servicing rights are recognized separately when they are acquired through sale of loans. For sales of SBA loans prior to January 1, 2007, a portion of the cost of the loan was allocated to the servicing right based on relative fair values. The Company adopted SFAS No. 156, Accounting for Servicing of Financial Assets, on January 1, 2007, for sales of SBA loans beginning in 2007. Servicing rights are initially recorded at fair value with the income statement effect recorded in gain on sale of loans. Fair value is based on a valuation model that calculates the present value of estimated future cash flows from the servicing assets. The valuation model uses assumptions that market participants would use in estimating cash flows from servicing assets, such as the cost to service, discount rates and prepayment speeds. The Company compares the valuation model inputs and results to published industry data in order to validate the model results and assumptions. All classes of servicing assets are subsequently measured using the amortization method which requires servicing rights to be amortized into non-interest income in proportion to, and over the period of, the estimated future net servicing income of the underlying loans. Servicing assets are evaluated for impairment based upon the fair value of the rights as compared to the carrying amount. Impairment is determined by stratifying rights into groupings based on predominant risk characteristics, such as interest rate, loan type and investor type. For purposes of measuring impairment, the Company has identified each servicing asset with the underlying loan being serviced. A valuation allowance is recorded where the fair value is below the carrying amount of the asset. If the Company later determines that all or a portion of the impairment no longer exists for a particular grouping, a reduction of the allowance may be recorded as an increase to income. The fair values of servicing rights are subject to significant fluctuations as a result of changes in estimated and actual prepayment speeds and changes in the discount rates. Servicing fee income which is reported on the income statement as servicing income is recorded for fees earned for servicing loans. The fees are based on a contractual percentage of the outstanding principal and recorded as income when earned. The amortization of servicing rights and changes in the valuation allowance are netted against loan servicing income. Allowance for loan losses ------------------------- The allowance for loan losses is established through a provision for loan losses charged to expenses. Loans are charged against the allowance for loan losses when management believes that the collectibility of the principal in unlikely. The allowance is an amount that management believes will be adequate to absorb losses inherent in existing loans and commitments to extend credit, based on evaluations of collectibility and prior loss experience of loans and commitments to extend credit. The evaluations take into consideration such factors as changes in the nature and volume of the portfolio, overall portfolio quality, loan concentration, specific problem loans, commitments, and current economic conditions that may affect the borrowers' ability to pay. 53 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 31, 2007, 2006 and 2005 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - CONTINUED Premises and equipment ---------------------- Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are provided for in amounts sufficient to relate the cost of depreciable assets to operations over their estimated service lives using the straight-line basis. The estimated lives used in determining depreciation are: Equipment 3 - 5 years Furniture and fixtures 5 - 7 years Leasehold improvements 5 - 15 years Leasehold improvements are amortized over the lesser of the useful life of the asset or the term of the lease. The straight-line method of depreciation is followed for all assets for financial reporting purposes, but accelerated methods are used for tax purposes. Deferred income taxes have been provided for the resulting temporary differences. Advertising Costs ----------------- The Company expenses the costs of advertising in the year incurred. Income taxes ------------ The Company recognizes deferred tax assets and liabilities based on differences between the financial reporting and tax bases of assets and liabilities using the enacted tax rates and laws that are expected to be in effect when the differences are expected to be covered. The Company provides a valuation allowance for deferred tax assets for which it does not consider realization of such assets to be more likely than not. On January 1, 2007, the Bank adopted Financial Accounting Standards Board ("FASB") Interpretation No. 48, Accounting for Uncertainty in Income Taxes ("FIN 48"). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. FIN 48 prescribes a recognition threshold and measurement standard for the financial statement recognition and measurement of an income tax position taken or expected to be taken in a tax return. In addition, FIN 48 provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. The provisions of FIN 48 have been applied to all tax positions of the Bank as of January 1, 2007. Only tax positions that met the more-likely-than-not recognition threshold on January 1, 2007 were recognized or continue to be recognized upon adoption. The Bank previously recognized income tax positions based on management's estimate of whether it was reasonably possible that a liability has been incurred for unrecognized income tax benefits by applying FASB Statement No. 5, Accounting for Contingencies. The adoption of FIN 48 did not have a material impact on the Bank's financial position, results of operations or cash flows. The adoption of FIN 48 made no impact on the balance of retained earnings as of January 1, 2007. Interest expense associated with unrecognized tax benefits is classified as income tax expense in the statement of income. Penalties associated with unrecognized tax benefits are classified as income tax expense in the statement of income. 54 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 31, 2007, 2006 and 2005 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - CONTINUED Earnings per share (EPS) ------------------------ Basic EPS excludes dilution and is computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if options or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity. Weighted average shares outstanding used in the computation of basic earning per share were 2,388,739, 2,386,739 and 2,381,219 in 2007, 2006 and 2005, respectively. Weighted average shares outstanding used in the computation of diluted earning per share were 2,486,050, 2,568,990 and 2,531,586 in 2007, 2006 and 2005, respectively. Comprehensive income -------------------- Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting Comprehensive Income," requires the disclosure of comprehensive income and its components. Included in accumulated other comprehensive income at December 31, 2007 is unrealized loss on investment securities available for sale of $369,716, less taxes of $153,750. Included in accumulated other comprehensive income at December 31, 2006 is unrealized loss on investment securities available for sale of $699,889, less taxes of $288,774. Included in accumulated other comprehensive income at December 31, 2005 is unrealized loss on investment securities available for sale of $1,223,626, less taxes of $504,868. Financial instruments --------------------- In the ordinary course of business, the Company has entered into off-balance sheet financial instruments consisting of commitments to extend credit, commercial letters of credit, and standby letters of credit as described in Note 9. Such financial instruments are recorded in the financial statements when they are funded or related fees are incurred or received. Fair values of financial instruments ------------------------------------ SFAS No. 107 specifies the disclosure of the estimated fair value of financial instruments. The Company's estimated fair value amounts have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is required to develop the estimates of fair value. Accordingly, the estimates are not necessarily indicative of the amounts the Company could have realized in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since the balance sheet date and, therefore, current estimates of fair value may differ significantly from the amounts presented in the accompanying Notes. 55 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 31, 2007, 2006 and 2005 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - CONTINUED Reclassifications ----------------- Certain reclassifications were made to prior years' presentations to conform to the current year. These reclassifications are of a normal recurring nature. Stock-based compensation ------------------------ Effective January 1, 2006, the Company adopted the provisions of SFAS No. 123R Share Based Payment (SFAS No. 123R) under the modified prospective method. Accordingly, compensation expense for stock options is measured at the grant-date fair value and amortized over the requisite service period of the award. The impact of adopting SFAS No. 123R is discussed in Note 12. Prior to the adoption of SFAS No. 123R, the Bank measured compensation expense for its employee stock-based compensation plans using the intrinsic value method prescribed by APB Opinion No. 25. The Bank applied the disclosure provisions of SFAS No. 123 as amended by SFAS No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure as if the fair-value-based method had been applied in measuring compensation expense. Under APB Opinion No. 25, when the exercise price of the Company's employee stock options was equal to the market price of the underlying stock on the date of the grant, no compensation expense was recognized. The following table illustrates the effect on net income after taxes and net income per common share as if the Bank had applied the fair value recognition provisions of SFAS No. 123 to stock-based compensation during the year ended December 31, 2005. 2005 ------------ Net Income: As Reported $ 1,422,619 Stock-Based Compensation using the Intrinsic Value Method -- Stock-Based Compensation that would have been reported using the Fair Value Method of SFAS 123 (119,000) ------------ Pro Forma $ 1,303,619 ============ Net income per share - basic As reported $ .60 Pro forma $ .55 Net income per share - diluted As reported $ .56 Pro forma $ .52 56 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 31, 2007, 2006 and 2005 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - CONTINUED The fair value of each option was estimated on the date of the grant using an option-pricing model with the following assumptions: 2007 2006 2005 ---------------------------------------- Expected volatility 52.34% 55.58% 45.52% Expected dividends None None None Expected term 4 years 7 years 7 years Risk-free rate 4.68% 4.77% 4.21% Recently issued accounting pronouncements ----------------------------------------- In May 2005, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 154, "Accounting Changes and Error Corrections" (SFAS No. 154). SFAS No. 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes, unless impracticable, retrospective application as the required method for reporting a change in accounting principle in the absence of explicit transition requirements specific to the newly adopted accounting principle. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The adoption of SFAS No. 154, effective January 1, 2006, did not have a material impact on our financial position or operating results. In February 2006, the Financial Accounting standards Board (FASB) released Statement of Financial Accounting Standard (SFAS) No. 155, "Accounting for Certain Hybrid Financial Instruments" (SFAS No. 155). SFAS No. 155 is an amendment of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," and SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities." SFAS No. 155 establishes, among other items, the accounting for certain derivative instruments embedded within other types of financial instruments; and eliminates a restriction on the passive derivative instruments that a qualifying special-purpose entity may hold. Effective for the Company for January 1, 2007, SFAS No. 155 did not have any impact on our financial position, results of operations or cash flows. In March 2006, the FASB released SFAS No. 156, "Accounting for Servicing of Financial Assets," an amendment of SFAS Statement No. 140, (SFAS No. 156). SFAS No. 156 amends SFAS No. 140 to require that all separately recognized servicing assets and liabilities in accordance with SFAS No. 140 be initially measured at fair value, if practicable. Furthermore, this standard permits, but does not require fair value measurement for separately recognized servicing assets and liabilities in subsequent reporting periods. SFAS No. 156 is also effective for the Company beginning January 1, 2007; however, the standard did not have any impact on the Company's financial position, results of operations or cash flows. In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurement" a standard that provides enhanced guidance for using fair value to measure assets and liabilities. The standard also responds to investors' requests for expanded information about the extent to which companies' measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. The standard applies whenever other standards require (or permit) assets or liabilities to be measured at fair value. Under the standard, fair value refers to the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the market in which the reporting entity transacts. The standard clarifies that fair value should be based on the assumptions market participants would use when pricing the asset or liability. In support of this principle, the standard establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. The fair 57 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 31, 2007, 2006 and 2005 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - CONTINUED value hierarchy gives the highest priority to quoted prices in active markets and the lowest priority to unobservable data, for example, the reporting entity's own data. Under the standard, fair value measurements would be separately disclosed by level within the fair value hierarchy. We will adopt SFAS No. 157 on January 1, 2008, and we do not expect the adoption of SFAS No. 157 to have a material impact on our financial condition or operating results. In September 2006, the FASB issued SFAS No. 158 "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans," which will require employers to fully recognize the obligations associated with single-employer defined benefit pension, retiree healthcare and other postretirement plans in their financial statements. The standard will make it easier for investors, employees, retirees and others to understand and assess an employer's financial position and its ability to fulfill the obligations under its benefit plans. Specifically, SFAS No. 158 requires an employer to (a) recognize in its balance sheet an asset for a plan's over funded status or a liability for a plan's under funded status; (b) measure a plan's assets and its obligations that determine its funded status as of the end of the employer's fiscal year (with limited exceptions); and (c) recognize changes in the funded status of a defined benefit postretirement plan in the year in which the changes occur. Those changes will be reported in comprehensive income of a business entity. The adoption of SFAS No. 158 did not have a material impact on our financial condition or operating results. The requirement to recognize the funded status of a benefit plan and the disclosure requirements are effective as of December 31, 2006. In February 2007, the FASB issued SFAS No. 159 "The Fair Value Option for Financial Assets and Financial Liabilities", which provides companies with an option to report selected financial assets and liabilities at fair value. This statement requires companies to display on the face of the balance sheet the fair value of those assets and liabilities for which they have chosen to use fair value. This standard also requires companies to provide additional information that will help investors and other users of financial statements to easily understand the effect on earnings of a company's choice to use fair value. SFAS No. 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. This statement is effective as of our fiscal year beginning January 1, 2008. We are currently evaluating the potential impact this statement will have on our statements of financial condition and operating results. NOTE 2 - CASH AND DUE FROM BANKS Cash and due from banks includes balances with the Federal Reserve and other correspondent banks. The Company is required to maintain specified reserves by the Federal Reserve Bank. The average reserve requirements are based on a percentage of the Company's deposit liabilities. In addition, the Federal Reserve requires the Company to maintain a certain minimum balance at all times. The Company maintains amounts due from banks, which exceed federally insured limits. The Company has not experienced any losses in such accounts. 58 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 31, 2007, 2006 and 2005 NOTE 3 - SECURITIES The amortized cost and estimated fair values of securities as of December 31, 2007 are as follows:
Gross Gross Estimated Amortized Unrealized Unrealized Fair Cost Gains Losses Value ------------ ------------ ------------ ------------ Available-for-Sale Securities: U.S. Government Agencies $ 35,211,652 $ 83,394 $ (53,615) $ 35,241,431 State and political subdivisions 23,520,119 24,390 (249,204) 23,295,305 Asset backed-securities 7,173,180 1,274 (77,244) 7,097,210 Mortgage backed-securities 14,368,973 47,170 (128,003) 14,288,140 Agency preferred stock 2,530,000 -- (13,767) 2,516,233 Short-term mutual funds 500,000 -- (4,111) 495,889 ------------ ------------ ------------ ------------ $ 83,303,924 $ 156,228 $ (525,944) $ 82,934,208 ============ ============ ============ ============ Held-to-Maturity Securities: U.S. Government Agencies $ 3,875,767 $ 353 $ (96,834) $ 3,779,286 State and political subdivisions 5,123,990 18,549 (383,769) 4,758,770 Asset backed-securities 3,898,115 14,070 (83,352) 3,828,833 Mortgage backed-securities 163,604 3,202 (6) 166,800 ------------ ------------ ------------ ------------ $ 13,061,476 $ 36,174 $ (563,961) $ 12,533,689 ============ ============ ============ ============
59 The following sets forth the total gross unrealized losses and estimated fair values of investment securities with continuous losses less than twelve months, those with continuous losses for twelve months or more and total losses (dollar amounts in thousands):
Less than Twelve Months Twelve Months or More Total ---------------------------- ---------------------------- ---------------------------- Gross Estimated Gross Estimated Gross Estimated Unrealized Fair Unrealized Fair Unrealized Fair Losses Value Losses Value Losses Value ------------ ------------ ------------ ------------ ------------ ------------ US Government Agencies $ (78) $ 7,863 $ (73) $ 9,462 $ (151) $ 17,325 State and Political Subdivisions (475) 14,975 (158) 6,025 (633) 21,000 Preferred stock (14) 486 -- -- (14) 486 Asset-Backed Securities (11) 2,798 (66) 4,662 (77) 7,460 Mortgage-Backed Securities (4) 972 (124) 8,466 (128) 9,438 Short-term mutual funds (4) 496 -- -- (4) 496 Corporate (83) 2,185 -- -- (83) 2,185 ------------ ------------ ------------ ------------ ------------ ------------ $ (669) $ 29,775 $ (421) $ 28,615 $ (1,090) $ 58,390 ============ ============ ============ ============ ============ ============
60 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 31, 2007, 2006 and 2005 NOTE 3 - SECURITIES - CONTINUED As of December 31, 2007, the Company had 278 investment securities where estimated fair value had declined .93% from the Company's amortized cost. Management evaluates investment securities for other-than-temporary impairment taking into consideration the extent and length of time the fair value has been less than cost, the financial condition of the issuer and whether the Company has the intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery in fair value. As of December 31, 2007, no declines in value are deemed to be other-than-temporary. The scheduled maturities of securities as of December 31, 2007 are shown below. Actual maturities may differ from contractual maturities because borrowers have the right to call or prepay obligations with or without call or prepayment penalties.
Available-for-Sale Held-to-Maturity --------------------------------------- --------------------------------------- Weighted Weighted Amortized Fair Average Amortized Fair Average Cost Value Yields (1) Cost Value Yields (1) ----------- ----------- ----------- ----------- ----------- ---------- Due in one year or less $ 3,967,362 $ 3,946,364 3.79% $ -- $ -- N/A After one year to five years 7,715,875 7,699,821 4.91% -- -- N/A After five years to ten years 15,697,581 15,730,936 5.36% 1,000,000 1,013,710 8.75% After ten years 38,524,133 38,256,825 5.76% 11,897,872 11,353,179 7.72% Mortgage-backed securities 14,368,973 14,288,140 4.66% 163,604 166,800 5.61% Preferred stock 2,530,000 2,516,233 7.40% -- -- N/A Short-term mutual fund 500,000 495,889 5.21% -- -- N/A ----------- ----------- ----------- ----------- $83,303,924 $82,934,208 5.37% $13,061,476 $12,533,689 7.78% =========== =========== =========== ===========
(1) Weighted average yields for municipal securities have been adjusted to reflect their tax equivalent yields. Proceeds from the sale of available-for-sale securities were $6,743,578, $3,497,638, and $1,396,477 for the years ended December 31, 2007, 2006, and 2005, respectively. Gross losses of $7,187 were realized on sales of securities during 2007, a loss of $1,799 in 2006 and a gain of $6,191 in 2005. Securities carried at approximately $42,672,000 and $63,146,000 at December 31, 2007 and 2006, respectively, were pledged to secure deposits of public funds and borrowing arrangements 61 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 31, 2007, 2006 and 2005 NOTE 3 - SECURITIES - CONTINUED The amortized cost and estimated fair values of securities as of December 31, 2006 are as follows:
Gross Gross Estimated Amortized Unrealized Unrealized Fair Cost Gains Losses Value ------------ ------------ ------------ ------------ Available-for-Sale Securities: U.S. Government Agencies $ 39,415,380 $ 63,385 $ (294,940) $ 39,183,825 State and political subdivisions 19,522,737 38,074 (74,787) 19,486,024 Asset backed-securities 7,280,691 3,946 (133,943) 7,150,694 Mortgage backed-securities 15,138,808 12,460 (314,084) 14,837,184 Short-term mutual funds 500,000 -- -- 500,000 ------------ ------------ ------------ ------------ $ 81,857,616 $ 117,865 $ (817,754) $ 81,157,727 ============ ============ ============ ============ Held-to-Maturity Securities: U.S. Government Agencies $ 2,468,485 $ -- $ (17,659) $ 2,450,826 State and political subdivisions 2,313,410 119,689 (12,909) 2,420,190 Asset backed-securities 14,526 -- -- 14,526 Mortgage backed-securities 189,574 2,567 (57) 192,084 ------------ ------------ ------------ ------------ $ 4,985,995 $ 122,256 $ (30,625) $ 5,077,626 ============ ============ ============ ============
Proceeds from the sale of available-for-sale securities were $3,497,638 for 2006. Gross losses of $1,799 were realized on sales of securities during 2006. The following sets forth the total gross unrealized losses and estimated fair values of investment securities with continuous losses less than twelve months, those with continuous losses for twelve months or more and total losses (dollar amounts in thousands):
Less than Twelve Months Twelve Months or More Total ---------------------------- ---------------------------- ---------------------------- Gross Estimated Gross Estimated Gross Estimated Unrealized Fair Unrealized Fair Unrealized Fair Losses Value Losses Value Losses Value ------------ ------------ ------------ ------------ ------------ ------------ US Government Agencies $ (32) $ 8,951 $ (281) $ 19,219 $ (313) $ 28,170 State and Political Subdivisions (46) 6,518 (40) 5,635 (86) 12,153 Asset-Backed Securities (1) 451 (133) 6,497 (134) 6,665 Mortgage-Backed Securities (1) 168 (314) 12,580 (315) 13,031 ------------ ------------ ------------ ------------ ------------ ------------ $ (80) $ 16,088 $ (768) $ 43,931 $ (848) $ 60,019 ============ ============ ============ ============ ============ ============
62 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 31, 2007, 2006 and 2005 NOTE 3 - SECURITIES - CONTINUED The Company evaluates investment securities for other-than-temporary impairment taking into consideration the extent and length of time the fair value has been less than cost, the financial condition of the issuer and whether the Company has the intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery in fair value. As of December 31, 2006, no declines are deemed to be other than temporary. NOTE 4 - LOANS The Company's customers are primarily located in San Joaquin County. At December 31, 2007, approximately 64.9% of the Company's loans are for real estate and construction and approximately 20.0% of the Company's loans are for general commercial uses including professional, retail and small businesses. Consumer loans make up approximately 3.5% of the loan portfolio, leases make up 7.5%, and agriculture loans making up the remaining 4.1%. Generally, real estate loans are collateralized by real property while commercial and other loans are collateralized by funds on deposit, business or personal assets. 63 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 31, 2007, 2006 and 2005 NOTE 4 - LOANS - CONTINUED Loans at December 31, 2007 and 2006 consisted of the following:
2007 2006 ------------- ------------- Construction and land development loans $ 29,541,045 $ 34,248,157 Real estate loans 45,002,196 43,396,795 Commercial loans 23,029,593 23,421,351 Leases 8,560,166 8,591,815 Agricultural loans 4,713,710 4,288,022 Consumer loans 4,041,061 1,225,571 ------------- ------------- 114,887,771 115,171,711 Deferred loan fees and costs, net (160,557) (234,487) Allowance for loan losses (1,558,050) (1,429,050) ------------- ------------- $ 113,169,164 $ 113,508,174 ============= =============
A summary of activity in the allowance for loan losses for the years ended December 31, 2007, 2006 and 2005 are as follows:
2007 2006 2005 ------------- ------------- ------------- Balance, beginning of year $ 1,429,050 $ 1,123,494 $ 963,000 Provision for loan losses 935,000 300,000 165,000 ------------- ------------- ------------- 2,364,050 1,423,494 1,128,000 Less net (charge-offs) recoveries (806,000) (5,556) 4,506 ------------- ------------- ------------- Balance, end of year $ 1,558,050 $ 1,429,050 $ 1,123,494 ============= ============= =============
64 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 31, 2007, 2006 and 2005 NOTE 4 - LOANS - CONTINUED The following is a summary of the investment in impaired loans, the related allowance for loan losses, and income recognized thereon and information pertaining to loans on nonaccrual and certain past due loans as of December 31:
2007 2006 2005 ---------- ---------- ---------- Recorded Investment in Impaired Loans $2,006,029 $ 435,147 $ 309,256 Related Allowance for Loan Losses $ 74,635 $ 90,720 $ 92,305 Average Recorded Investment in Impaired Loans $1,059,140 $ 210,246 $ 129,591 Interest Income Recognized for Cash Payments $ 12,425 $ -- -- Total Loan on Nonaccrual $2,006,029 $ 435,147 $ 54,020 Total Loans Past Due 90 Days or More and Still Accruing $ -- $ -- $ 255,237
Loans totaling approximately $51,145,000 have been pledged as collateral for Federal Home Loan Bank borrowing line. The Bank also originated mortgage and SBA loans and under its Section 7a program and has sold the guaranteed portions of most of the loans to institutional investors. Funding for the Section 7a program depends on annual appropriations by the U.S. Congress. At December 31, 2007, 2006, and 2005 the Bank was servicing approximately $10,155,328, $13,731,908, and $12,593,000 respectively, in loans previously sold. A summary of the changes in the related servicing assets and interest-only strips receivable are as follows:
Servicing Assets ------------------------------------ 2007 2006 2005 ---------- ---------- ---------- Balance at beginning of year $ 57,544 $ 121,258 $ 137,960 Increase from loan sales 1,242 3,996 15,677 Amortization charged to income (30,847) (67,710) (32,379) Change in valuation allowance -- -- -- ---------- ---------- ---------- Balance at end of year $ 27,939 $ 57,544 $ 121,258 ========== ========== ========== Interest-Only Strips Receivable ------------------------------------ 2007 2006 2005 ---------- ---------- ---------- Balance at beginning of year $ 51,757 $ 144,206 $ 180,262 Increase from loan sales 201 214 -- Amortization charged to income (19,948) (92,663) (36,056) Writedowns -- -- -- ---------- ---------- ---------- Balance at end of year $ 32,010 $ 51,757 $ 144,206 ========== ========== ==========
The estimated fair value of the servicing assets approximated the carrying amount at December 31, 2007, 2006, and 2005. Fair value is estimated by discounting estimated future cash flows from the servicing assets using discount rates that approximate current market rates over the expected lives of the loans being serviced. 65 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 31, 2007, 2006 and 2005 NOTE 4 - LOANS - CONTINUED Management has estimated the expected life of these loans to be approximately 25% to 30% of the remaining life at the time of sale. For purposes of measuring impairment, the Bank has identified each servicing asset with the underlying loan being serviced. A valuation allowance is recorded where the fair value is below the carrying amount of the asset. At December 31, 2007 and 2006, the Bank had no valuation allowances. The Bank may also receive a portion of subsequent interest collections on loans sold that exceed the contractual servicing fee. In that case the Bank records an interest-only strip based on the relative fair market value of it and the other components of the loan. At December 31, 2007 and 2006, the Bank had interest-only strips of $32,010 and $51,757, respectively, which approximates fair value. Fair value is estimated by discounting estimated future cash flows from the interest-only strips using assumptions similar to those used in valuing servicing assets. NOTE 5 - PREMISES AND EQUIPMENT Major classifications of premises and equipment are summarized as follows: 2007 2006 ------------ ------------ Leasehold improvements $ 1,057,723 $ 1,079,996 Furniture, fixtures and equipment 1,527,350 1,308,959 ------------ ------------ 2,585,073 2,388,955 Less accumulated depreciation and amortization (1,276,353) (999,974) ------------ ------------ $ 1,308,720 $ 1,388,980 ============ ============ Depreciation and amortization expense on premises and equipment was $276,749, $206,950 and $168,002 for the years ended December 31, 2007, 2006, and 2005, respectively. The Company leases its premises under noncancelable operating leases with initial terms expiring in 2012, 2009, 2015, and 2010. Certain of these contain renewal options with escalation clauses that provide for increased lease payments. The Company recognized rent expense, including common area costs and equipment rentals, of $464,201, 504,235, and $248,693 in 2007, 2006 and 2005, respectively. The future minimum commitments under these operating leases are as follows: 2008 470,247 2009 450,422 2010 332,797 2011 339,595 2012 300,536 Thereafter 888,563 ------------ Total $ 2,782,160 ============ 66 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 31, 2007, 2006 and 2005 NOTE 6 - TIME DEPOSITS Time deposits issued and their remaining maturities as of December 31, 2007 are as follows: 2008 $ 85,098,115 2009 920,088 2010 508,192 2011 61,648 2012 2,814,530 ------------ Total $ 89,402,573 ============ NOTE 7 - JUNIOR SUBORDINATED DEBT SECURITIES AND OTHER BORROWINGS On August 17, 2006, Service 1st Bancorp (the "Company") completed a private placement to an institutional investor of approximately $5 million of trust preferred securities, through a newly formed Delaware trust affiliate, Service 1st Capital Trust I (the "Trust"). The trust preferred securities mature on October 7, 2036, are redeemable at the Company's option beginning after five years, and require quarterly distributions by the Trust to the holder of the trust preferred securities at a variable interest rate which will adjust quarterly to equal the three month LIBOR plus 1.60%. The proceeds from the sale of the trust preferred securities were used by the Trust to purchase from the Company approximately $5,155,000 in aggregate principal amount of the Company's junior subordinated notes (the "Notes"). The Notes will bear interest at the same variable interest rate during the same quarterly periods as the trust preferred securities. The net proceeds to the Company from the sale of the Notes to the Trust will be used by the Company primarily to fund the growth of its bank subsidiary, Service 1st Bank, and for general corporate purposes. The Notes were issued pursuant to a Junior Subordinated Indenture (the "Indenture"), dated August 17, 2006, by and between the Company and Wells Fargo National Bank, National Association, as trustee. Like the trust preferred securities, the interest rate on the Notes will adjust quarterly to equal the three month LIBOR plus 1.60%. The interest payments by the Company will be used to pay the quarterly distributions payable by the Trust to the holder of the trust preferred securities. However, so long as no event of default, as described below, has occurred under the Notes, the Company may defer interest payments on the Notes (in which case the Trust will be entitled to defer distributions otherwise due on the trust preferred securities) for up to 20 consecutive quarters. The Notes are subordinated to the prior payment of any other indebtedness of the Company that by its terms is not similarly subordinated and will be recorded as a long-term liability on the Company's balance sheet. For regulatory purposes, the Notes will be treated as Tier 1 or Tier 2 capital under applicable regulations of the Federal Reserve Board, the Company's primary federal regulatory agency. The Notes mature on October 7, 2036, but may be redeemed at the Company's option on any January 7, April 7, July 7, or October 7 on or after October 7, 2011 or at any time within 90 days following the occurrence of certain events, such as: (i) a change in the regulatory capital treatment of the Notes (ii) in the event the Trust is deemed an investment company or (iii) upon the occurrence of certain adverse tax events. In each such case, the Company may redeem the Notes for their aggregate principal amount, plus any accrued but unpaid interest. 67 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 31, 2007, 2006 and 2005 NOTE 7 - JUNIOR SUBORDINATED DEBT SECURITIES AND OTHER BORROWINGS - CONTINUED The Notes may be declared immediately due and payable at the election of the trustee or holders of 25% of the aggregate principal amount of outstanding Notes in the event that the Company defaults in the payment of any interest following the nonpayment of any such interest for 20 or more consecutive quarterly periods. Also, the entire principal amount of the Notes and any premium and interest accrued becomes immediately due and payable without further action if (1) a court enters a decree or order for relief in respect of the Company in any involuntary case under any bankruptcy or similar law; (2) the Company commences a voluntary case under any bankruptcy or similar law, consents to the entry of an order for relief in an involuntary case under any such law or consents to the appointment of or taking possession by a receiver, liquidator or trustee of the Company or substantially all of its property; (3) the Company makes any general assignment for the benefit of creditors or fails generally to pay its debits as they become due; or (4) the Trust liquidates or winds up, other that as contemplated in the Indenture. Further, if the Company is no longer subject to the supervision and regulation of the Federal Reserve, the trustee or the holders of 15% of the aggregate principal amount of the outstanding Notes may declare the Notes immediately due and payable if (x) the Company defaults in the payment of any interest in such default continues unremedied for a period of thirty (30) days, except in the case of an election by the Company to defer payments of interest for up to 20 consecutive quarters (which deferral will not constitute a default and will not subject the Notes to acceleration); (y) the Company defaults in the payment of the principal amount of the Notes when due; or (z) the Company defaults in the performance of or breaches certain covenants in the Indenture, which default or breach which is not cured within 30 days after there has been given notice of such default or breach. The Company also has entered into a Guarantee Agreement pursuant to which it has agreed to guarantee the payment by the Trust of distributions on the trust preferred securities, and the payment of principal of the trust preferred securities when due, either at maturity or on redemption, but only if and to the extent that the Trust fails to pay distributions on or principal of the trust preferred securities after having received interest payments or principal payments on the Notes from the Company for the purpose of paying those distributions or the principal amount of the trust preferred securities. The Company has unsecured borrowing lines available with correspondent banks totaling $36,300,000 and secured borrowing lines totaling $5,000,000. Management uses these borrowing lines for short-term funding needs and usually repays the lines within a week. The interest rate charged on these lines is approximately the prevailing federal funds rate plus 20 to 100 basis points. In addition to the borrowing lines with the correspondent banks, the Company also has a secured borrowing line with the Federal Home Loan Bank of San Francisco ("the FHLB"). As of December 31, 2006, the Company had no outstanding borrowings from any of its correspondent banks, but did have a loan of $4,000,000 outstanding from the FHLB. This borrowing will mature on May 7, 2008 and has a fixed rate of interest at 5.21%. The Company had additional credit available with the FHLB of $16,332,796 at December 31, 2007. As of December 31, 2005, the Company had outstanding borrowings from correspondent banks of $1,030,000. There were no borrowings from correspondent banks at December 31, 2007 or 2006. 68 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 31, 2007, 2006 and 2005 NOTE 8 - INCOME TAXES Income taxes included in the consolidated statements of income consist of the following:
2007 2006 2005 ---------- ---------- ---------- Current: Federal $ (524,194) $ 223,288 $ 337,964 State -- 145,877 19,032 ---------- ---------- ---------- (524,194) 369,165 356,996 Deferred 168,000 (70,000) (212,000) ---------- ---------- ---------- $ (356,194) $ 299,165 $ 144,996 ========== ========== ==========
A comparison of the federal statutory income tax rates to the Company's effective income tax rates follow:
2007 2006 2005 ------------------------ ------------------------ ------------------------ Amount Rate Amount Rate Amount Rate ---------- ---------- ---------- ---------- ---------- ---------- Statutory federal tax $ (7,000) (34.0%) $ 390,000 34.0% $ 533,000 34.0% State franchise tax, net of federal benefit -- -- 82,000 7.0% 93,000 6.0% Reduction in valuation allowance -- -- -- -- (414,000) (27.0%) Nontaxable income (386,000) (2,035.0%) (232,000) (21.0%) (82,000) (5.0%) Other items, net 36,806 194.0% 59,165 6.0% 14,996 1.0% ---------- ---------- ---------- ---------- ---------- ---------- Actual tax expense (credit) $ (356,194) (1,875.0%) $ 299,165 26.0% $ 144,996 9.0% ========== ========== ========== ========== ========== ==========
69 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 31, 2007, 2006 and 2005 NOTE 8 - INCOME TAXES - CONTINUED Deferred income taxes reflect the effect of temporary differences between the tax basis of assets and liabilities and the reported amounts of those assets and liabilities for financial reporting purposes. Deferred income taxes also reflect the value of net operating losses and an offsetting valuation allowance. The Company's deferred tax assets, liabilities and corresponding valuation allowance consist of the following:
2007 2006 2005 ----------- ----------- ----------- Deferred tax assets: Allowance for loan losses $ 567,000 $ 550,000 $ 448,000 Net operating loss carryforward 249,000 -- -- Unrealized loss on investment securities 154,000 289,000 505,000 Deferred compensation 375,000 302,000 191,000 Other items 188,000 155,000 9,000 ----------- ----------- ----------- 1,533,000 1,296,000 1,153,000 Deferred tax liabilities: Deferred tax leases (770,000) (272,000) -- Deferred loan costs (129,000) (96,000) (102,000) Other items (63,000) (54,000) (69,000) ----------- ----------- ----------- (962,000) (422,000) (171,000) Total deferred income tax asset 571,000 874,000 982,000 Valuation allowance -- -- -- ----------- ----------- ----------- Net deferred income tax assets $ 571,000 $ 874,000 $ 982,000 =========== =========== ===========
Income tax returns for the years ended December 31, 2006, 2005 and 2004 are open to audit by the federal authorities and income tax returns for the years ended December 31, 2006, 2005, 2004 and 2003 are open to audit by California authorities. Unrecognized tax benefits are not expected to significantly increase or decrease within the next twelve months. NOTE 9 - FINANCIAL INSTRUMENTS The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit in the form of loans. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. The contract amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments. 70 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 31, 2007, 2006 and 2005 NOTE 9 - FINANCIAL INSTRUMENTS - CONTINUED The Company's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitment to extend credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. Financial instruments at December 31, whose contract amounts represent credit risk are as follows:
2007 2006 2005 ----------- ----------- ----------- Undisbursed loan commitments $36,491,788 $39,365,000 $33,301,000 Standby letters of credit 1,546,884 1,242,000 1,596,000 ----------- ----------- ----------- $38,038,672 $40,607,000 $34,897,000 =========== =========== ===========
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management's credit evaluation. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties. NOTE 10 - RELATED PARTY TRANSACTIONS In the ordinary course of business, the Company has granted loans to certain officers and directors and the companies with which they are associated. In the Company's opinion, all loan commitments to such parties are made on substantially the same terms including interest rates and collateral, as those prevailing at the time of comparable transactions with other persons. The following is a summary of the activity in these loans commitments:
2007 2006 2005 ----------- ----------- ----------- Balance at the beginning of the year $ 5,212,000 $ 3,530,000 $ 1,971,000 New loans and renewals 4,370,375 4,167,000 2,708,000 Repayments and renewals (2,331,407) (2,485,000) (1,149,000) ----------- ----------- ----------- Balance at the end of the year $ 7,250,843 $ 5,212,000 $ 3,530,000 =========== =========== ===========
Also in the ordinary course of business, certain officers and directors of the Company have deposits with the Bank. In the Bank's opinion, all deposit relationships with such parties are made on substantially the same terms including interest rates and maturities, as those prevailing at the time of comparable transactions with other persons. The balance of these deposits at December 31, 2007, 2006 and 2005 was approximately $4,789,000, $5,051,000 and $1,198,000, respectively. 71 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 31, 2007, 2006 and 2005 NOTE 11 - COMPANY SAVINGS PLAN In October 2001, the Company elected to establish a deferred compensation plan for those employees employed as of this date or for all employees who have completed at least 1,000 hours of service during a twelve consecutive month period. The employees may defer a portion of their compensation subject to certain limits based on federal tax laws. The Company may elect to make matching contributions to the plan. Matching contributions vest to the employee equally over a five-year period. For the year ended December 2007, the Company made a contribution of $85,200. For the year ended December 2006, the Company made a contribution of $34,417. For the year ended December 2005, the Company made a contribution of $20,254. NOTE 12 - STOCK OPTION PLAN On January 1, 2006, the Company adopted the provisions of SFAS No. 123R "Share Based Payment" (SFAS No. 123R) requiring the measurement and recognition of all share-based compensation under the fair value method. Prior to January 1, 2006, the Company accounted for share-based awards under APB No. 25. The Company adopted SFAS No. 123R using the modified prospective transition method, therefore, prior period results are not restated and do not reflect the recognition of share-based compensation. Under the modified prospective transition method, share-based compensation expense is recorded for all awards granted after the adoption date and for the unvested portion of previously granted awards outstanding on the adoption date. Compensation cost related to the unvested portion of previously granted awards is based on the grant-date fair value estimated in accordance with the original provisions of SFAS No. 123. Compensation cost for awards granted after the adoption date is based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123R. Total compensation costs recorded during the year ended December 31, 2007, amounted to $75,322 for employees and $73,687 for directors. The effect of implementing SFAS No. 123R reduced net income in 2007 by $118,797 or $.05 per share basic and $.05 per share fully diluted and reduced net income in 2006 by $167,277 or $.07 per share basic and $.06 per share fully diluted. During 1999, the Company's Board of Directors approved a fixed stock option plan under which incentive and non-qualified stock options may be granted to key, full-time salaried officers, employees and directors of the Company. The shares of stock initially subject to options authorized to be granted under the Plan consist of 252,000 shares of the authorized and unissued common stock of the Company. All options are granted at an exercise price equal to the fair market value of the shares on the date of grant and have an exercise period of not longer than ten years from the date of grant. The Plan was ratified by the shareholders at the Company's annual meeting in May 2001. These options vest equally over a three-year period. All of the unissued options in this plan were canceled with the adoption of the 2004 stock option plan. During 2004, the Company's Board of Directors approved a fixed stock option plan under which incentive and non-qualified stock options may be granted to key, full-time salaried officers, employees and directors of the Company. The shares of stock initially subject to options authorized to be granted under the Plan consist of 253,500 shares of the authorized and unissued common stock of the Company. All options are granted at an exercise price equal to the fair market value of the shares on the date of grant and have an exercise period of not longer than ten years from the date of grant. The Plan was ratified by the shareholders at the Company's annual meeting in May 2004. These options vest equally over a three-year period. 72 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 31, 2007, 2006 and 2005 NOTE 12 - STOCK OPTION PLAN - CONTINUED The fair value of each option award is estimated on the date of grant using the Black Scholes option pricing model. Expected volatility is based on historical volatility of the common stock. The Company uses historical data to estimate option exercise and forfeiture rates within the valuation model. The expected life of the options granted is derived from the award's vesting period and the award recipient's exercise history, if applicable, and represents the period of time that the options are expected to be outstanding. The risk-free rate for periods within the expected life of the option is based on the 7-year U.S. Treasury note rate at the time of the grant. The assumptions used for determining the fair value of the options granted during the year ended December 31, 2007, 2006, and 2005 are as follows: 2007 2006 2005 ----------------------------------------------- Expected volatility 52.34% 55.58% 45.52% Expected dividends None None None Expected term 4 years 7 years 7 years Risk-free rate 4.68% 4.77% 4.21% A summary of option activity of the Company's fixed stock option plan is presented below.
Weighted Aggregate Weighted average intrinsic average remaining value of exercise contractual term outstanding Shares price in years options ------------- ------------- ------------- ------------- Outstanding, January 1, 2007 419,113 $ 9.20 Exercised -- $ -- Forfeited (42,875) $ 12.79 Granted 30,000 $ 16.13 ------------- Outstanding, December 31, 2007 406,238 $ 9.41 4.60 $ (818,721) ============= Exercisable, December 31, 2007 328,738 $ 8.31 4.16 $ (300,887) ============= Weighted Weighted Average Average Exercise Number Remaining Exercise Price Outstanding Life Price ------------- ------------- ------------- ------------- $ 6.03 23,625 3.23 $ 6.03 $ 6.35 183,488 2.19 $ 6.35 $ 9.30 34,125 6.82 $ 9.30 $ 12.33 125,000 7.46 $ 12.33 $ 13.00 15,000 9.72 $ 13.00 $ 15.50 5,000 8.05 $ 15.50 $ 18.67 5,000 7.80 $ 18.67 $ 19.25 15,000 9.05 $ 19.25 ------------- 406,238 4.60 $ 9.41 =============
73 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 31, 2007, 2006 and 2005 NOTE 12 - STOCK OPTION PLAN - CONTINUED The weighted-average grant-date fair value of options granted during the year ended December 31, 2007 was $2.73. There were no options exercised in 2007. The total intrinsic value of options exercised during the year ended December 31, 2006, was $18,675. Cash received from options exercised under the Plan for the years ended December 31, 2006, was $30,825. The actual tax benefit realized for the tax deductions from options exercised was $7,694. As of December 31, 2007, there was $122,348 of total unrecognized compensation cost related to nonvested share-based compensation arrangements granted under the Plan. That cost is expected to be recognized over a weighted-average period of 1.35 years. NOTE 13 - DEFERRED COMPENSATION AGREEMENTS During 2004 and 2005, the Company entered into deferred compensation agreements with certain executive officers. Under these agreements, the Company is obligated to provide, upon retirement, annual benefit for the officers ranging from $40,000 to $133,000 for 15 years. The estimated present value of future benefits to be paid is being accrued over the period from the effective date of the agreements until the expected retirement dates of the participants. The expense incurred and amount accrued for this plan for the years ended December 31, 2007, 2006 and 2005 totaled $153,244, $229,505, and $217,554, respectively. The Company is a beneficiary of the life insurance policies that have been purchased as a method of financing the benefits under the agreements. NOTE 14 - RESTRICTION ON RETAINED EARNINGS With certain exceptions, a California corporation may pay a dividend to its shareholders in an amount equal to the lesser of total retained earnings or the sum of the prior three years net income after subtracting dividends paid, if any. NOTE 15 - REGULATORY MATTERS The Company (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory - and possibly additional discretionary - actions by regulators that, if undertaken, could have a direct material effect on the Company's and the Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of the Company's and Bank's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined). 74 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 31, 2007, 2006 and 2005 NOTE 15 - REGULATORY MATTERS - CONTINUED The Bank's primary federal regulator is the Federal Deposit Insurance Corporation (FDIC). As of December 31, 2007, the most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. There are no events or conditions since notification that management believes have changed the Bank's category. To be categorized as well capitalized the Bank must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the following table. The Company's and the Bank's actual capital amounts and ratios are presented in the following table (dollar amounts are in thousands).
To be Actual For capital adequacy well-capitalized under purposes prompt corrective action provisions ----------------------- ----------------------- ----------------------- Amount Ratio Amount Ratio Amount Ratio ---------- ---------- ---------- --------- ---------- ---------- As of December 31, 2007: Company: Total capital (to risk weighted assets) $ 24,574 14.7% $ 13,334 8.0% N/A N/A Tier 1 capital (to risk weighted assets) $ 23,016 13.8% $ 6,667 4.0% N/A N/A Tier 1 capital (to average assets) $ 23,016 9.8% $ 9,422 4.0% N/A N/A Bank: Total capital (to risk weighted assets) $ 22,423 13.5% $ 13,334 8.0% $ 16,668 10.0% Tier 1 capital (to risk weighted assets) $ 20,825 12.5% $ 6,667 4.0% $ 10,001 6.0% Tier 1 capital (to average assets) $ 20,825 8.9% $ 9,375 4.0% $ 11,719 5.0% As of December 31, 2006: Company: Total capital (to risk weighted assets) $ 23,956 15.3% $ 12,510 8.0% N/A N/A Tier 1 capital (to risk weighted assets) $ 22,527 14.4% $ 6,255 4.0% N/A N/A Tier 1 capital (to average assets) $ 22,527 10.4% $ 8,673 4.0% N/A N/A Bank: Total capital (to risk weighted assets) $ 21,519 13.8% $ 12,510 8.0% $ 15,637 10.0% Tier 1 capital (to risk weighted assets) $ 20,028 12.8% $ 6,255 4.0% $ 9,382 6.0% Tier 1 capital (to average assets) $ 20,028 9.3% $ 8,593 4.0% $ 10,741 5.0% As of December 31, 2005: Company: Total capital (to risk weighted assets) $ 17,404 15.1% $ 9,224 8.0% N/A N/A Tier 1 capital (to risk weighted assets) $ 16,281 14.1% $ 4,612 4.0% N/A N/A Tier 1 capital (to average assets) $ 16,281 9.8% $ 6,683 4.0% N/A N/A Bank: Total capital (to risk weighted assets) $ 16,304 14.1% $ 9,224 8.0% $ 11,530 10.0% Tier 1 capital (to risk weighted assets) $ 15,181 13.2% $ 4,612 4.0% $ 6,918 6.0% Tier 1 capital (to average assets) $ 15,181 9.1% $ 6,644 4.0% $ 8,304 5.0%
75 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 31, 2007, 2006 and 2005 NOTE 16 - FAIR VALUE OF FINANCIAL INSTRUMENTS The fair value of a financial instrument is the amount at which the asset or obligation could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. Fair value estimates are made at a specific point in time based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the entire holdings of a particular financial instrument. Because no market value exists for a significant portion of the financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature, involve uncertainties and matters of judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates. Fair value estimates are based on financial instruments both on and off the balance sheet without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Additionally, tax consequences related to the realization of the unrealized gains and losses can have a potential effect on fair value estimates and have not been considered in many of the estimates. The following methods and assumptions were used to estimate the fair value of significant financial instruments: Financial Assets ---------------- The carrying amounts of cash, short-term investments, due from customers on acceptances, and Bank acceptances outstanding are considered to approximate fair value. Short-term investments include federal funds sold, securities purchased under agreements to resell, commercial paper and interest bearing deposits with Banks. The fair values of investment securities, including available-for-sale, are generally based on quoted market prices. The fair value of loans are estimated using a combination of techniques, including discounting estimated future cash flows and quoted market prices of similar instruments where available. Financial Liabilities --------------------- The carrying amounts of deposit liabilities payable on demand, commercial paper, and other borrowed funds are considered to approximate fair value. For fixed maturity deposits, fair value is estimated by discounting estimated future cash flows using currently offered rates for deposits of similar remaining maturities. The fair value of long-term debt is based on rates currently available to the Company for debt with similar terms and remaining maturities. Off-Balance Sheet Financial Instruments --------------------------------------- The fair value of commitments to extend credit and standby letters of credit is estimated using the fees currently charged to enter into similar agreements. The fair value of these financial instruments is not material. 76 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 31, 2007, 2006 and 2005 NOTE 16 - FAIR VALUE OF FINANCIAL INSTRUMENTS - CONTINUED The estimated fair value of financial instruments is summarized as follows: (dollar amounts in thousands)
December 31, --------------------------------------------------------------------------- 2007 2006 2005 ----------------------- ----------------------- ----------------------- Carrying Fair Carrying Fair Carrying Fair Value Value Value Value Value Value ---------- ---------- ---------- ---------- ---------- ---------- Financial Assets: Cash and due from banks $ 6,637 $ 6,637 $ 6,543 $ 6,543 $ 9,025 $ 9,025 Federal funds sold 4,653 4,653 10,617 10,617 -- -- Certificates of deposit 486,488 486,488 1,500 1,500 994 994 Investment securities 96,365 95,468 86,144 86,235 68,810 68,832 Loans, net 113,169 112,116 113,508 113,473 82,533 82,115 Cash surrender value of life insurance 3,698 3,698 3,567 3,567 3,436 3,436 Accrued interest receivable 1,505 1,505 1,462 1,462 958 958 Financial Liabilities: Deposits 202,406 200,522 199,955 199,895 151,142 154,165 Other borrowings 9,155 9,143 9,155 9,145 1,030 1,030 Accrued interest and other liabilities 1,867 1,867 1,143 1,143 1,584 1,584 Undisbursed loan commitments and letters of credit 38,039 38,039 40,607 40,607 34,897 34,897
NOTE 17 - FORMATION OF SERVICE 1ST BANCORP On June 26, 2003, Service 1st Bancorp acquired Service 1st Bank by issuing 1,155,105 shares of common stock in exchange for the surrender of all outstanding shares of the Bank's common stock. There was no cash involved in this transaction. The acquisition was accounted for like a pooling of interests and the consolidated financial statements contained herein have been restated to give full effect to this transaction. Service 1st Bancorp has no significant business activity other than its investment in Service 1st Bank and Charter Services Group, Inc. Accordingly, no separate financial information on the Company is provided. NOTE 18 - STOCK SPLIT On September 15, 2005, the Company declared a three-for-two stock split stock dividend to shareholders of record on September 29, 2005. The split was paid on October 18, 2005. Each shareholder entitled to the split received a stock certificate equal to 50% of the shares held by the shareholder rounded down to the nearest whole share with fractional shares paid in cash. All of the per share data in the financial statements were retroactively adjusted to reflect this three-for-two stock split. 77
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 31, 2007, 2006 and 2005 NOTE 19 - PARENT ONLY CONDENSED FINANCIAL STATEMENTS CONDENSED BALANCE SHEET December 31, 2007 and 2006 2007 2006 ------------ ------------ ASSETS Cash and due from banks $ 219,058 $ 64,007 Investment in subsidiaries 20,329,560 19,512,746 Other assets 2,350,756 2,624,248 ------------ ------------ Total assets $ 22,899,374 $ 22,201,001 ============ ============ LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities: Junior subordinated debt securities $ 5,155,000 $ 5,155,000 Other liabilities 96,360 79,167 ------------ ------------ Total liabilities 5,251,360 5,234,167 Shareholders' equity: Common stock 16,023,738 16,023,738 Additional paid in capital 356,152 207,144 Retained earnings 1,484,090 1,147,067 Accumulated other comprehensive income, net of taxes (215,966) (411,115) ------------ ------------ Total shareholders' equity 17,648,014 16,966,834 ------------ ------------ Total liabilities and shareholders' equity $ 22,899,374 $ 22,201,001 ============ ============
78
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 31, 2007, 2006 and 2005 NOTE 19 - PARENT ONLY CONDENSED FINANCIAL STATEMENTS - CONTINUED CONDENSED STATEMENT OF INCOME December 31, 2007, 2006 and 2005 2007 2006 2005 ----------- ----------- ----------- Income: Investment and interest income $ 64,938 $ 44,887 $ 35,523 ----------- ----------- ----------- Total income 64,938 44,887 35,523 Expenses: Salaries and employee benefits 386,637 698,148 391,926 Occupancy expenses 59,121 43,402 23,702 Director fees and expenses 73,185 79,320 -- Data processing and other professional expenses 40,615 77,095 40,742 Interest expenses 352,678 129,593 -- Other operating expenses 85,032 78,432 68,147 ----------- ----------- ----------- Total expenses 997,268 1,105,990 524,517 Loss before equity in undistributed income of subsidiaries (932,330) (1,061,103) (488,994) Equity in undistributed income of subsidiaries 905,088 1,520,501 1,683,627 ----------- ----------- ----------- Income (loss) before income taxes (27,242) 459,398 1,194,633 Income tax benefit 364,265 387,723 227,986 ----------- ----------- ----------- Net income $ 337,023 $ 847,121 $ 1,422,619 =========== =========== ===========
79 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 31, 2007, 2006 and 2005
NOTE 19 - PARENT ONLY CONDENSED FINANCIAL STATEMENTS - CONTINUED CONSOLIDATED STATEMENT OF CASH FLOWS December 31, 2007, 2006 and 2005 2007 2006 2005 ----------- ----------- ----------- Cash flows from operating activities: Net income $ 337,023 $ 847,121 $ 1,422,619 Adjustments to reconcile net income to net cash provided by operating activities: Undistributed earnings of subsidiaries (905,088) (1,520,501) (1,683,627) Depreciation 15,982 14,172 -- Stock option compensation expense 82,345 199,450 -- (Increase) decrease in other assets (392,840) (514,546) (245,051) Increase (decrease) in other liabilities 17,193 57,159 14,556 ----------- ----------- ----------- Net cash provided by operating activities (845,385) (917,145) (491,503) ----------- ----------- ----------- Cash flows from investing activities: (Increase) decrease in short-term investments 1,201,000 (1,100,000) 300,000 Increase in investment in subsidiaries (200,000) (3,200,000) (250,000) Purchase of equipment (564) (46,850) (33,624) ----------- ----------- ----------- Net cash used in investing activities 1,000,436 (4,346,850) 16,376 ----------- ----------- ----------- Cash flows from financing activities: Proceeds from sale of common stock, net of costs -- -- 567,871 Exercise of stock options, including tax benefit -- 30,825 -- Increase in junior subordinated debt -- 5,155,000 -- ----------- ----------- ----------- Net cash used in financing activities -- 5,185,825 567,871 ----------- ----------- ----------- Net increase (decrease) in cash and cash equivalents 155,051 (78,170) 92,744 Cash and cash equivalents at beginning of year $ 64,007 $ 142,177 $ 49,433 ----------- ----------- ----------- Cash and cash equivalents at end of year $ 219,058 $ 64,007 $ 142,177 =========== =========== ===========
80 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 9A. CONTROLS AND PROCEDURES Evaluation of Disclosure Controls and Procedures An evaluation of the Company's disclosure controls and procedures (as defined in the Securities Exchange Act of 1934 ("Exchange Act") Rules 13a-15(e) and 15d-15(e)) was carried out under the supervision and with the participation of the Company's Chief Executive Officer, Chief Financial Officer and other members of the Company's senior management as of the end of the period covered by this annual report on Form 10-K. The Company's Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures as in effect are effective in ensuring that the information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is (i) accumulated and communicated to the Company's management (including the Chief Executive Officer and Chief Financial Officer) to allow timely decisions regarding required disclosure, and (ii) recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. Changes in Internal Controls An evaluation of any changes in the Company's internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)), that occurred during the Company's fiscal quarter ended December 31, 2007, was carried out under the supervision and with the participation of the Company's Chief Executive Officer, Chief Financial Officer and other members of the Company's senior management. The Company's Chief Executive Officer and Chief Financial Officer concluded that no change identified in connection with such evaluation has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. Management's Report on Internal Controls Management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company (as defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended). The Company's management, including the Chief Executive Officer and Chief Financial Officer, has assessed the effectiveness of the Company's internal control over financial reporting as of December 31, 2007. In making this assessment, management used the criteria applicable to the Company as set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control--Integrated Framework. Based upon such assessment and criteria, management believes that, as of December 31, 2007, the Company's internal control over financial reporting was effective. This Annual Report does not include an attestation report of our independent registered public accounting firm regarding internal control over financial reporting. The Company is not currently required to engage and has not engaged its independent registered public accounting firm to provide an attestation report regarding the Company's internal controls over financial reporting pursuant to temporary rules of the Securities and Exchange Commission that permit us to provide only the above-described report by management. /s/ JOHN O. BROOKS /s/ROBERT E. BLOCH ----------------------- ----------------------- John O. Brooks Robert E. Bloch Chief Executive Officer Chief Financial Officer 81 ITEM 9B. OTHER INFORMATION None 82 PART III ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE; COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT The information required by Item 10 of Form 10-K is incorporated by reference to the information contained in the Company's Proxy Statement for the 2008 Annual Meeting of Shareholders which will be filed pursuant to Regulation 14A. ITEM 11. EXECUTIVE COMPENSATION The information required by Item 11 of Form 10-K is incorporated by reference to the information contained in the Company's Proxy Statement for the 2008 Annual Meeting of Shareholders which will be filed pursuant to Regulation 14A. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information required by Item 12 of Form 10-K is incorporated by reference to the information contained in the Company's Proxy Statement for the 2008 Annual Meeting of Shareholders which will be filed pursuant to Regulation 14A. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE The information required by Item 13 of Form 10-K is incorporated by reference to the information contained in the Company's Proxy Statement for the 2008 Annual Meeting of Shareholders which will be filed pursuant to Regulation 14A. ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES The information required by Item 14 of Form 10-K is incorporated by reference to the information contained in the Company's Proxy Statement for the 2008 Annual Meeting of Shareholders which will be filed pursuant to Regulation 14A. PART IV ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES (a) (1) Financial Statements. Listed and included in Part II, Item 8. -------------------- (2) Financial Statement Schedules ----------------------------- Not applicable. (3) Exhibits -------- (2.1) Plan of Reorganization and Merger Agreement (included in Annex A) incorporated by reference from the Registrant's Form S-4EF, Registration No. 333-104244, filed with the Securities and Exchange Commission on April 1, 2003. (3.1) Articles of Incorporation, as amended, incorporated by reference from the Registrant's Form 10-QSB for the quarter ended September 30, 2005, filed with the Securities and Exchange Commission on November 10, 2005. 83 (3.2) Bylaws, as amended incorporated by reference from the Registrant's Form 10-KSB for the year ended December 31, 2004, filed with the Securities and Exchange Commission on March 31, 2005. (4.1) Specimen form of certificate for Service 1st Bancorp common stock incorporated by reference from Registrant's Form 10-QSB for the quarterly period ended September 30, 2003, filed with the Securities and Exchange Commission on November 14, 2003. (10.1) Lease agreement dated May 3, 2002, related to 2800 West March Lane, Suite 120, Stockton, CA 95219 incorporated by reference from the Registrant's Form S-4EF, Registration No. 333-104244, filed with the Securities and Exchange Commission on April 1, 2003. (10.2) Lease agreement dated April 13, 1999 and amendment thereto dated June 17, 1999, related to 60 West 10th Street, Tracy, CA 95376, incorporated by reference from the Registrant's Form S-4EF, Registration No. 333-104244, filed with the Securities and Exchange Commission on April 1, 2003. (10.3)* 1999 Service 1st Bancorp Stock Option Plan, Amendment No. 1 thereto, and related forms of Incentive and Nonstatutory Stock Option Agreements entered into with executive officers and directors, incorporated by reference from the Registrant's Form S-8, Registration No. 333-107346, filed with the Securities and Exchange Commission on July 25, 2003. (10.4) Agreement dated July 27, 1999 with BancData Solutions, Inc. for service bureau and data processing services, incorporated by reference from the Registrant's Form S-4EF, Registration No. 333-104244, filed with the Securities and Exchange Commission on April 1, 2003. (10.5) Agreement with Financial Marketing Services dated February 1, 2000 incorporated by reference from the Registrant's Form S-4EF, Registration No. 333-104244, filed with the Securities and Exchange Commission on April 1, 2003. (10.6)* Service 1st Bank 401(k) Profit Sharing Plan and Trust Summary Plan Description, dated January 1, 2000, incorporated by reference from the Registrant's Form S-4EF, Registration No. 333-104244, filed with the Securities and Exchange Commission on April 1, 2003. (10.7)* John O. Brooks Salary Continuation Agreement dated September 10, 2003, incorporated by reference from the Registrant's Form 10-KSB for the year ended December 31, 2003, filed with the Securities and Exchange Commission on March 30, 2004. (10.8)* Bryan R. Hyzdu Salary Continuation Agreement dated September 10, 2003, incorporated by reference from the Registrant's Form 10-KSB for the year ended December 31, 2003, filed with the Securities and Exchange Commission on March 30, 2004. (10.9)* Robert E. Bloch Salary Continuation Agreement dated September 10, 2003, incorporated by reference from the Registrant's Form 10-KSB for the year ended December 31, 2003, filed with the Securities and Exchange Commission on March 30, 2004. 84 (10.10)* Patrick Carman Salary Continuation Agreement dated September 10, 2003, incorporated by reference from the Registrant's Form 10-KSB for the year ended December 31, 2003, filed with the Securities and Exchange Commission on March 30, 2004. (10.11)* 2004 Stock Option Plan and Forms of Incentive and Nonstatutory Stock Option Agreements, incorporated by reference from the Registrant's Form S-8, Registration No. 333-116818, filed with the Securities and Exchange Commission on June 24, 2004. (10.12)* John O. Brooks Employment Agreement dated July 15, 2004, incorporated by reference from the Registrant's Form 10-QSB, for the quarterly period ended September 30, 2004, filed with the Securities and Exchange Commission on November 15, 2004. (10.13)* Bryan R. Hyzdu Employment Agreement dated July 15, 2004, incorporated by reference from the Registrant's Form 10-QSB, for the quarterly period ended September 30, 2004, filed with the Securities and Exchange Commission on November 15, 2004. (10.14)* Robert E. Bloch Employment Agreement dated July 15, 2004, incorporated by reference from the Registrant's Form 10-QSB, for the quarterly period ended September 30, 2004, filed with the Securities and Exchange Commission on November 15, 2004. (10.15)* Patrick Carman Employment Agreement dated July 15, 2004, incorporated by reference from the Registrant's form 10-QSB, for the quarterly period ended September 30, 2004, filed with the Securities and Exchange Commission on November 15, 2004. (10.16)* Shannon Reinard Employment Agreement dated July 15, 2004, incorporated by reference from the Registrant's Form 10-QSB, for the quarterly period ended September 30, 2004, filed with the Securities and Exchange Commission on November 15, 2004. (10.17) Fiserv Solutions, Inc. Agreement dated October 7, 2004, for service bureau, data processing, and item processing, incorporated by reference from the Registrant's Form 10-KSB for the year ended December 31, 2004, filed with the Securities and Exchange Commission on March 31, 2005. (10.18) Lease agreement dated May 1, 2005, related to 49 W. 10th Street, Tracy, CA 95378 incorporated by reference from the Registrant's Form 10-QSB for the quarter ended September 30, 2005, filed with the Securities and Exchange Commission on November 10, 2005. (10.19) Lease agreement dated October 3, 2005, related to 1901 W. Kettleman Lane, Building A, Suite 1A and 1B, Lodi, CA 95242, incorporated by reference from the Registrant's form 10-QSB for the quarter ended September 30, 2005, filed with the Securities and Exchange Commission on November 10, 2005. (10.20)* Shannon Reinard Salary Continuation Agreement dated August 8, 2005, incorporated by reference from Registrant's Form 10-KSB for the year ended December 31, 2005, filed with the Securities and Exchange Commission on March 30, 2006. 85 (10.21)* Bryan R. Hyzdu First Amendment dated August 8, 2005 to Salary Continuation Agreement dated September 10, 2003, incorporated by reference from Registrant's Form 10-KSB for the year ended December 31, 2005, filed with the Securities and Exchange Commission on March 30, 2006. (10.22)* Bryan R. Hyzdu Second Amendment dated August 8, 2005 to Salary Continuation Agreement dated September 10, 2003, incorporated by reference from Registrant's Form 10-KSB for the year ended December 31, 2005, filed with the Securities and Exchange Commission on March 30, 2006. (10.23)* Patrick Carman First Amendment dated August 8, 2005 to Salary Continuation Agreement dated September 10, 2003, incorporated by reference from Registrant's Form 10-KSB for the year ended December 31, 2005, filed with the Securities and Exchange Commission on March 30, 2006. (10.24)* Patrick Carman Second Amendment dated August 8, 2005 to Salary Continuation Agreement dated September 10, 2003, incorporated by reference from Registrant's Form 10-KSB for the year ended December 31, 2005, filed with the Securities and Exchange Commission on March 30, 2006. (10.25)* Robert E. Bloch First Amendment dated August 8, 2005 to Salary Continuation Agreement dated September 10, 2003, incorporated by reference from Registrant's Form 10-KSB for the year ended December 31, 2005, filed with the Securities and Exchange Commission on March 30, 2006. (10.26)* Robert E. Bloch Second Amendment dated August 8, 2005 to Salary Continuation Agreement dated September 10, 2003, incorporated by reference from Registrant's Form 10-KSB for the year ended December 31, 2005, filed with the Securities and Exchange Commission on March 30, 2006. (10.27)* Director Emeritus Program approved by Board of Directors effective June 30, 2006, incorporated by reference from Registrant's Form 8-K, filed with the Securities and Exchange Commission on July 7, 2006. (10.28) Private placement to an institutional investor of approximately $5 million of trust preferred securities, incorporated by reference from Registrant's Form 8-K, filed with the Securities and Exchange Commission on August 23, 2006. (10.29) Lease option exercise letter dated September 12, 2006, related to 60 West 10th Street, Tracy, CA 95376, incorporated by reference from Registrant's Form 10-K for the year ended December 31, 2006, filed with the Securities and Exchange Commission on March 14, 2007. (10.30)* Thomas A. Vander Ploeg Employment Agreement dated November 16, 2007. (14.1) Code of Ethics, incorporated by reference from the Registrant's Form 10-K for the year ended December 31, 2003, filed with the Securities and Exchange Commission on March 30, 2004. (21.1) Registrant's only subsidiaries are Service 1st Bank and Charter Services Group, Inc. (23.1) Consent of Vavrinek, Tine, Day & Co., LLP (31.1) Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 86 (31.2) Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. (32.1) Certification of Service 1st Bancorp by its Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. *Denotes management compensatory plans or arrangements. 87 SIGNATURES Pursuant to the requirements of Section 13 or 15d) 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. SERVICE 1ST BANCORP Date: March 28, 2008 By: /s/ John O. Brooks ------------------------------------ John O. Brooks Chief Executive Officer (Principal Executive Officer) Date: March 28, 2008 By: /s/ Robert E. Bloch ------------------------------------ Robert E. Bloch Executive Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934 this report has been signed below by the following persons on behalf of the registrant in the capacities and on the dates indicated. Signature Title Date --------------------------- ------------------- ------------------ /s/ John O. Brooks Chairman March 28, 2008 --------------------------- John O. Brooks /s/ Eugene C. Gini Director March 28, 2008 --------------------------- Eugene C. Gini /s/ Bryan R. Hyzdu Director March 28, 2008 --------------------------- Bryan R. Hyzdu /s/ Susan Lenz Director March 28, 2008 --------------------------- Susan Lenz /s/ Robert D. Lawrence Director March 28, 2008 --------------------------- Robert D. Lawrence /s/ Frances C. Mizuno Director March 28, 2008 --------------------------- Frances C. Mizuno /s/ Richard R. Paulsen Director March 28, 2008 --------------------------- Richard R. Paulsen 88 /s/ Toni Marie Raymus Director March 28, 2008 --------------------------- Toni Marie Raymus /s/ Michael K. Repetto Director March 28, 2008 --------------------------- Michael K. Repetto /s/ Anthony F. Souza Director March 28, 2008 --------------------------- Anthony F. Souza /s/ Donald L. Walters Director March 28, 2008 --------------------------- Donald L. Walters /s/ Dean Andal Director March 28, 2008 --------------------------- Dean Andal 89 EXHIBIT INDEX Exhibit Sequential Number Description Page Number ------ --------------------------------------------------------- ----------- 10.30 Thomas A. Vander Ploeg Employment Agreement dated November 16, 2007 91 23.1 Consent of Vavrinek, Trine, Day & Co., LLP 99 31.1 Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 100 31.2 Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 101 32.1 Certification of Service 1st Bancorp by its Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 102 90