-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, EI/175rf7qXVa4NzYX43MR7zAU0zFypeNRrWGlEEzf43k2vqvFILu1U8PtMUFpT5 j8wYrPfYoTdMWWcd793/Aw== 0000912057-96-004327.txt : 19960312 0000912057-96-004327.hdr.sgml : 19960312 ACCESSION NUMBER: 0000912057-96-004327 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 8 CONFORMED PERIOD OF REPORT: 19951231 FILED AS OF DATE: 19960311 SROS: AMEX FILER: COMPANY DATA: COMPANY CONFORMED NAME: REDWOOD EMPIRE BANCORP CENTRAL INDEX KEY: 0000840007 STANDARD INDUSTRIAL CLASSIFICATION: STATE COMMERCIAL BANKS [6022] IRS NUMBER: 680166366 STATE OF INCORPORATION: CA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 001-10868 FILM NUMBER: 96533656 BUSINESS ADDRESS: STREET 1: 111 SANTA ROSA AVENUE CITY: SANTA ROSA STATE: CA ZIP: 95402 BUSINESS PHONE: 7075459611 MAIL ADDRESS: CITY: 111 SANTA ROSA AVENU STATE: CA ZIP: 95404-4905 10-K 1 FORM 10-K SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K [ X ] Annual report under Section 13 or 15(d) of the Securities Exchange Act of 1934 (FEE REQUIRED) For the fiscal year ended December 31, 1995 or [ ] Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 (NO FEE REQUIRED) For the transition period from: to Commission file number: 0-19231 REDWOOD EMPIRE BANCORP ------------------------------------------------------------ (Exact number of Registrant as specified in its charter) California 68-0166366 ---------------------------- ------------------- (State or other jurisdiction of (IRS Employer incorporation or organization) Identification No.) 111 Santa Rosa Avenue, Santa Rosa, California 95404-4905 ---------------------------------------------- ---------- (Address of principal executive officers) (Zip Code) Registrant's telephone number, including area code: (707) 545-9611 Securities registered pursuant to Section 12(b) of the Act: NAME OF EACH EXCHANGE TITLE OF EACH CLASS ON WHICH REGISTERED ------------------------- ----------------------- Common Stock American Stock Exchange 7.80% Noncumulative Convertible American Stock Exchange Perpetual Preferred Stock, Series A Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark whether the Registrant (1) has filed all reports required to be filed under 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 the filing requirements for the past 90 days. Yes X No --- --- The aggregate market value of the Registrant's common stock held by non-affiliates on March 1, 1996 (based on the closing sale price of the Common Stock on the American Stock Exchange on such date) was $16,740,441. As of March 1, 1996 there were outstanding 2,679,227 shares of the Registrant's common stock. DOCUMENTS INCORPORATED BY REFERENCE 1. Annual Report to Shareholders (see Part II, Items 5, 6, 7, and 8; and Part IV, Item 14). 2. Definitive Proxy Statement (see Part III, Items 10, 11, and 12). 1 TABLE OF CONTENTS ----------------- Page ---- PART I Item 1. Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Item 2. Properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . .24 Item 3. Legal Proceedings. . . . . . . . . . . . . . . . . . . . . . . . . 24 Item 4. Submission of Matters to A Vote of Securities Holders. . . . . . . 24 PART II Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 Item 6. Selected Financial Data. . . . . . . . . . . . . . . . . . . . . . 25 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. . . . . . . . . . . . . . . . . . . . . . . 25 Item 8. Financial Statements and Supplementary Data. . . . . . . . . . . . 26 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure . . . . . . . . . . . . . . 26 PART III Item 10. Directors and Executive Officers of the Registrant . . . . . . . . 26 Item 11. Executive Compensation . . . . . . . . . . . . . . . . . . . . . . 26 Item 12. Security Ownership of Certain Beneficial Owners and Management . . 26 Item 13. Certain Relationships and Related Transactions . . . . . . . . . . 27 PART IV Item 14. Exhibits, Financial Statements, Schedules and Reports on Form 8-K. 27 2 PART I ITEM 1. BUSINESS Redwood Empire Bancorp ("Redwood," and with its subsidiaries, the "Company") is a financial institution holding company headquartered in Santa Rosa, California, and operating in Northern and Central California through two principal subsidiaries: National Bank of the Redwoods, a national bank ("NBR"), and Allied Bank, F.S.B., a federal savings bank ("Allied"). (a) GENERAL DEVELOPMENT OF BUSINESS. Redwood is a California corporation, headquartered in Santa Rosa, California. Its wholly-owned subsidiaries are NBR, a national bank which was chartered in 1985, and Allied, a federal savings bank which was chartered in 1986. In addition, NBR has two wholly-owned subsidiaries, NBR Mortgage Company, Inc. and Redwood Empire Datacorp. Redwood was created by NBR in August 1988, in order to become a bank holding company through the acquisition of all of NBR's outstanding shares. That transaction was consummated in January 1989. Redwood acquired Allied in September 1990, through a tax-free reorganization in which Redwood exchanged shares of its stock for all of the outstanding shares of Allied. The acquisition of Allied was accounted for as a pooling of interests for financial reporting purposes. On October 31, 1992, Lake Savings and Loan Association, a one-branch California chartered savings and loan based in Lakeport, California ("Lake"), was purchased for approximately $2,300,000 in cash, and merged into Allied. At the time of its acquisition Lake had total assets of approximately $41 million. The acquisition was accounted for as a purchase. On November 4, 1994, Codding Bank, a multiple-branch California chartered bank based in Rohnert Park, California ("Codding"), was purchased for $7,028,000 in cash, including merger related expenses, and merged into NBR. At the merger date, the fair value of the assets acquired totalled approximately $42 million. (See Item 8 "FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA NOTE C OF NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS OF REDWOOD EMPIRE BANCORP.") The acquisition was accounted for as a purchase. (b) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS. During the year ended December 31, 1995, the Company operated in two principal industry segments: commercial banking and mortgage banking. Commercial banking activities include all other services provided by the Company, including portfolio lending, the origination for sale and servicing of Small Business Administration loans, various deposit programs and numerous fee-based services. The Company's mortgage banking activities relate principally to the origination for sale, servicing of loans sold to investors, and sale and purchase of mortgage loans and servicing rights. 3 The Company's principal business lines, commercial banking and residential mortgage banking, attempt to counterbalance the effects on the Company of interest rate shifts. When interest rates decline, the Company anticipates greater mortgage lending activity through mortgage refinancings and home purchases. As business activity increases, the Company's commercial banking business has the potential to increase interest margins and to expand its commercial lending portfolio. See Item 8 "FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA NOTE Q OF NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS OF REDWOOD EMPIRE BANCORP." (c) NARRATIVE DESCRIPTION OF BUSINESS. The Company's principal targeted mortgage banking areas are Northern and Central California, Oregon and Washington State. These areas are served by four offices, all of which provide retail and wholesale lending. The Company's targeted commercial banking market area includes the California counties north of San Francisco. The Company provides these banking services through six additional retail branches. At December 31, 1995, the Company's total assets were $558 million. Commercial banking loans are generally extended to professionals and to businesses with annual revenues of less than $10 million. Commercial loans are primarily for working capital, asset acquisition, or commercial real estate. The Company, a Preferred Lender under the Small Business Administration loan program, makes loans, a portion of which are guaranteed by the Small Business Administration ("SBA"), and sells the guaranteed portions of such loans into the secondary market. The Company also finances construction loans to residential home builders generally operating in Sonoma and Mendocino Counties. The Company offers consumer loans and commercial construction loans, as well as various deposit programs and numerous fee-based services. During 1995, the Company's commercial banking operations generated revenues of approximately $47.9 million and operating profits of approximately $7.6 million, as compared to operating revenues and profits of approximately $32.6 million and $6.9 million in 1994 and $24.9 million and $4.2 million in 1993. 4 The Company's mortgage banking business originates one-to-four unit residential first mortgage loans. Such residential mortgage loans are predominantly conforming loans; that is, such loans are underwritten using standards set by Fannie Mae or Freddie Mac. Such conforming mortgage loans are readily saleable to Fannie Mae or Freddie Mac, or into the national secondary mortgage market. A combination of declining mortgage rates during 1992 and 1993, as well as the Company's increased penetration of the Northern and Central California mortgage market, produced significant growth in the Company's mortgage banking operations during 1992 and 1993. During 1994, however, increases in interest rates sharply curtailed refinancing activity and the residential mortgage market shifted towards adjustable rate mortgages. As a result, the Company's mortgage banking loan originations declined sharply in 1994, as compared to rapid increases in origination volumes in 1992 and 1993. During 1995, the Company's mortgage banking originations totalled approximately $840 million, a 22% decrease from 1994 originations of approximately $1.1 billion. The 1994 originations represented a decrease of 45% over the Company's $1.9 billion of originations for 1993. In addition, the Company's origination of fixed rate loans increased in 1995 to approximately 84% of originations as opposed to 67% in 1994 and 91% in 1993. In 1995, the Company's mortgage banking operations generated revenues of $16,089,000 as compared to $16,269,000 in 1994 and $21,537,000 in 1993. In 1995 the Company's mortgage operations generated an operating profit of $138,000 compared to an operating loss of $9,821,000 in 1994 and an operating profit of $4,484,000 in 1993. (See Item 7 "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" and Item 8 "FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - NOTE Q OF NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS OF REDWOOD EMPIRE BANCORP".) In addition to its lending activities, the Company has purchased mortgage loan servicing rights from other institutions to augment and diversify its income sources. Based on market conditions, the Company either retains or sells the servicing on mortgage loans sold to institutional investors. At December 31, 1995 the Company's mortgage loan servicing portfolio aggregated approximately $1.0 billion, an increase of approximately 9% from the size of the portfolio as of December 31, 1994. The Company is also approved to offer various other specialized products. It is an approved Fannie Mae/Freddie Mac lender/servicer, a principal bank for VISA/Mastercard, and an approved lender of the Federal Housing, Veterans and Farmers Home Administrations. The primary sources of funds for the Company's lending programs are local deposits, proceeds from loan sales, loan payments, and other borrowings by its subsidiaries. The Company attracts deposits primarily from local businesses, professionals and retail customers. These deposits are periodically supplemented through insured certificates of deposit obtained directly by the Company from other financial institutions located throughout the United States. The Company generally does not purchase deposits through deposit brokers and had no brokered deposits at December 31, 1995. In addition to deposits, the Company obtains other borrowed funds through its membership in the Federal Home Loan Bank of San Francisco (the "FHLB") and its retention of treasury tax and loan funds at the Federal Reserve Bank of San Francisco. The Company is regulated by various government agencies, with the primary regulators being the Board of Governors of the Federal Reserve System (the "FRB"), the Office of Thrift Supervision (the "OTS"), the Office of the Comptroller of the Currency (the "OCC"), and the Federal Deposit Insurance Corporation (the "FDIC"). 5 The Company and its subsidiaries had 353 full-time-equivalent employees at December 31, 1995. Redwood's headquarters are located at 111 Santa Rosa Avenue, Santa Rosa, California 95404-4905, and its telephone number is (707) 545-9611. PRIMARY MARKET AREA The Company's deposit market area is Sonoma, Mendocino and Lake Counties, California. In addition, Allied has wholesale mortgage loan production offices in San Jose, San Ramon, Fresno, Santa Rosa, and Sacramento, California and Portland, Oregon, which primarily originate loans referred by independent mortgage brokers. The borrowers serviced through these offices may be located throughout Northern California and the loans are generally sold into the secondary market. Sonoma, Mendocino and Lake Counties have benefited from migration of population and businesses into the area, as well as growth in established firms and industries. These counties have generally exceeded the growth in population and economic activity of California as a whole. INVESTMENT PORTFOLIO The Company classifies its investment securities as held to maturity or available for sale. The Company's intent is to hold all securities held to maturity until maturity and management believes that the Company has the ability to do so. Securities available for sale may be sold to implement the Company's asset/liability management strategies and in response to changes in interest rates, prepayment rates and similar factors. The following table summarizes the maturities of the Company's debt securities at their book value and their weighted average yields at December 31, 1995. Yields on tax-exempt securities have been computed on a tax-equivalent basis. At December 31, 1995, the total market value of the securities described below was $40,074,000.
After One Through After Five Within One Year Five Years Years Total ----------------- ----------------- ----------------- ----------------- Amount Yield Amount Yield Amount Yield Amount Yield ----------------- ----------------- ----------------- ----------------- (dollars in thousands) U.S. Government and agencies $ 7,966 5.85% $ 10,507 6.54% $ 11,981 6.17% $ 30,454 6.22% Other bonds 2,035 5.08 4,985 5.83 2,600 7.30 9,620 6.07 -------- -------- -------- -------- Total $ 10,001 5.70% $ 15,492 6.31% $ 14,581 6.37% $ 40,074 6.18 % -------- -------- -------- -------- -------- -------- -------- --------
6 The following table summarizes the book value of the Company's investment securities held on the dates indicated:
December 31, 1995 1994 1993 ------------------------------------ (in thousands) U.S. Government and agencies $37,436 $31,910 $19,553 Other bonds and mortgage-backed securities 2.638 2,093 2,326 FHLB and FRB Stock 3,890 8,063 8,063 ------------------------------------ Total $43,964 $42,066 $29,942 ------------------------------------ ------------------------------------
DEPOSIT STRUCTURE The Company primarily attracts deposits from local businesses and professionals, as well as through retail certificates of deposits, savings and checking accounts. In addition to the Company's local depository offices, it attracts certificates of deposit, primarily from financial institutions throughout the nation, by publishing rates in national publications. These certificates of deposit have often been attracted at interest rates below local market retail deposit rates. The national deposit market is utilized to supplement funding for the Company's mortgage banking activities and other liquidity needs. There can be no assurance that this funding practice will continue to provide deposits at attractive rates, or that applicable federal regulations will not limit the Company's ability to attract deposits in this manner. The Company generally does not purchase brokered deposits and had no brokered deposits at December 31, 1995. The following chart sets forth the distribution of the Company's average daily deposits for the periods indicated.
Year Ended December 31, 1995 1994 1993 ------------------ ------------------ ------------------ Amount Rate Amount Rate Amount Rate ------------------ ------------------ ------------------ (dollars in thousands) Transaction accounts: Interest bearing (1) $116,316 3.75% $114,266 3.22% $107,557 3.18% Noninterest bearing 51,946 --- 44,283 --- 37,026 --- Time 304,396 6.03 233,896 4.81 169,212 4.80
(1) Includes savings deposits, money market savings deposits, money market demand deposits, and interest-bearing demand deposits. 7 The Company's time deposits of $100,000 or more had the following schedule of maturities at December 31, 1995:
Amount ---------------- (in thousands) Remaining Maturity: Three months or less $49,769 Over three months to six months 21,351 Over six months to 12 months 28,080 Over 12 months 40,779 ---------------- Total $139,979 ---------------- ----------------
Time deposits of $100,000 or more are generally from the Company's institutional and business and professional customer base. The potential impact on the Company's liquidity from the withdrawal of these deposits is considered in the Company's asset and liability management policies, which attempt to anticipate adequate liquidity needs through its management of investments, federal funds sold, loan sales, or by generating additional deposits. OTHER BORROWINGS At December 31, 1995, the Company had FHLB short-term borrowings of $23,000,000 with a weighted average interest rate of 6.24%, collateralized by Allied's loan portfolio. Remaining available credit at December 31, 1995 was $57,000,000 reflecting approximately 25% of Allied's assets at December 31, 1995. Advances are made on a short-term basis with a rolling maturity date and are typically repaid within a 30-day period. On occasion, a borrowing is made on a fixed maturity basis. In such instances, maturities do not extend beyond one year. The highest amount of FHLB borrowings outstanding for a month-end during the year was $112,150,000 at January 31, 1995. The average balance of borrowings from the FHLB was $46,600,000, with a weighted average rate of 6.56% during the year ended December 31, 1995. REGULATION AND SUPERVISION Federal Securities Laws. Redwood is subject to various federal securities laws, including the Securities Act of 1933 (the "1933 Act") and the Securities Exchange Act of 1934 (the "1934 Act"). The 1933 Act regulates the distribution or public offering of securities, while the 1934 Act regulates trading in securities that are already issued and outstanding. Both Acts provide civil and criminal penalties for misrepresentations and omissions in connection with the sale of securities, and the 1934 Act also prohibits market manipulation and insider trading. 8 Redwood files annual, quarterly, and current reports with the Securities and Exchange Commission (the "SEC"). In addition, Redwood's directors, executive officers, and 5% or greater shareholders, and certain of the senior officers of Redwood's subsidiaries are subject to further reporting requirements under the 1934 Act, including obligations to submit to the SEC reports of beneficial ownership of Redwood's securities. THE EFFECT OF GOVERNMENTAL POLICIES AND REGULATIONS ON THE COMPANY. The Company's overall earnings and growth, as well as that of NBR and Allied individually, are affected not only by local market area factors and general economic conditions, but also by government monetary and fiscal policies. For example, the Board of Governors of the Federal Reserve System (the "FRB") influences the supply of money through its open market operations in U.S. Government securities, as well as by adjustments to the discount rates applicable to borrowings by depository institutions and others. Such actions influence the growth of loans, investments and deposits and also affect interest rates charged on loans and paid on deposits. The nature and impact of future changes in such policies on the Company's business and earnings cannot be predicted. Beginning with the enactment of the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (the "FIRREA"), and following with Federal Deposit Insurance Corporation Improvement Act of 1991 (the "FDICIA"), numerous regulatory requirements have been placed on the banking and thrift industries in the recent past, and additional changes have been and are being proposed. As a consequence of the extensive regulation of commercial and mortgage banking and thrift activities in the United States, the business of the Company is particularly susceptible to being affected by enactment of federal and state legislation which may have the effect of increasing or decreasing the cost of doing business, modifying permissible activities, or enhancing the competitive position of other financial institutions. Any change in applicable laws or regulations could have a material adverse effect on the business and prospects of the Company. BANK HOLDING COMPANY REGULATION. Because of its ownership of NBR, Redwood is a bank holding company subject to the Bank Holding Company Act of 1956, as amended (the "BHCA"). Redwood reports to, registers with, and may be examined by, the FRB, which also has the authority to examine Redwood's subsidiaries. The FRB, which has significant supervisory and regulatory authority over Redwood and its affiliates, requires Redwood to maintain certain levels of capital. See "CAPITAL STANDARDS," below. The FRB also has the authority to take enforcement action against any bank holding company that commits any unsafe or unsound practice, or violates certain laws, regulations, or conditions imposed in writing by the FRB. See "PROMPT CORRECTIVE ACTION AND OTHER ENFORCEMENT MECHANISMS," below. Under the BHCA, a company generally must obtain the prior approval of the FRB before it exercises a controlling influence over, or acquires directly or indirectly, more than 25% of the voting shares or substantially all of the assets of any bank or bank holding company. Thus, Redwood may be required to obtain the prior approval of the FRB before it or its subsidiaries may acquire, merge or consolidate with any bank or bank holding company; any company seeking to acquire or merge with Redwood also would be required to obtain the FRB's approval. 9 Redwood is generally prohibited under the BHCA from acquiring ownership or control of more than 5% of the voting shares of any company that is not a bank or bank holding company and from engaging directly or indirectly in activities other than banking, managing banks, or providing services to affiliates of the holding company. A bank holding company, with the approval of the FRB, may engage, or acquire the voting shares of companies engaged, in activities that the FRB has determined to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. A bank holding company must demonstrate that the benefits to the public of the proposed activity will outweigh the possible adverse effects associated with such activity. The FRB generally prohibits a bank holding company from declaring or paying a cash dividend which would impose undue pressure on the capital of subsidiary banks or would be funded only through borrowing or other arrangements that might adversely affect a bank holding company's financial position. The FRB's policy is that a bank holding company is expected to act as a source of financial strength to its financial institution subsidiaries, and to commit resources to support such subsidiaries even at the expense of any of its non-bank subsidiaries, if necessary. Transactions between Redwood and its subsidiaries are subject to a number of other restrictions. FRB policies forbid the payment by bank subsidiaries of management fees which are unreasonable in amount or exceed the fair market value of the services rendered (or, if no market exists, actual costs plus a reasonable profit). Additionally, a bank holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with the extension of credit, sale or lease of property, or furnishing of services. Subject to certain limitations, depository institution subsidiaries of bank holding companies may extend credit to, invest in the securities of, purchase assets from, or issue a guarantee, acceptance, or letter of credit on behalf of, an affiliate, provided that the aggregate of such transactions with affiliates may not exceed 10% of the capital stock and surplus of the institution, and the aggregate of such transactions with all affiliates may not exceed 20% of the capital stock and surplus of such institution. Redwood may only borrow from depository institution subsidiaries if the loan is secured by marketable obligations with a value of a designated amount in excess of the loan. Further, Redwood may not sell a low-quality asset to a depository institution subsidiary. BANK REGULATION AND SUPERVISION. As a national bank, NBR is regulated, supervised and regularly examined by the Office of the Comptroller of the Currency (the "OCC"). Deposit accounts at NBR are insured by the Bank Insurance Fund (the "BIF"), as administered by the Federal Deposit Insurance Corporation (the "FDIC"), to the maximum amount permitted by law. NBR is also subject to applicable provisions of California law, insofar as such provisions are not in conflict with or preempted by federal banking law. The OCC or the FDIC regulate or monitor virtually all areas of NBR's operations, including security devices and procedures, adequacy of capitalization and loss reserves, loans, investments, borrowings, deposits, mergers, payment of dividends, establishment of branches, interest rates chargeable on loans or payable on deposits, establishment of branches, mergers, reorganizations, and the like. NBR is required by the OCC to prepare quarterly reports on its financial condition and to conduct an annual audit of its affairs in compliance with minimum standards and procedures prescribed by the OCC. 10 Under FDICIA, all insured institutions must undergo regular on-site examination by their appropriate federal banking agency, which in the case of NBR is the OCC. The cost of these examinations may be assessed against the institution. Insured institutions are also required to submit annual reports to the FDIC and their principal regulatory agency. FDICIA also requires the federal regulatory agencies to prescribe, by regulation, standards for all insured depository institutions and their holding companies relating, among other things, to (a) internal controls, including internal information and audit systems, (b) loan documentation, (c) credit underwriting, (d) interest rate risk exposure, and (e) asset quality. National banks and their holding companies which have undergone a change in control within two years, or which are deemed by the FRB or the OCC to be troubled institutions must give the FRB or the OCC, respectively, thirty days' prior notice of the appointment of any senior executive officer or director. Within the thirty days the FRB or the OCC, as the case may be, may approve or disapprove any such appointment. THRIFT HOLDING COMPANY REGULATION. Because it controls Allied, which is a federal savings bank, Redwood is also a savings and loan holding company within the meaning of the Home Owners' Loan Act (the "HOLA"). As such, Redwood reports to and is regulated, examined and supervised by the Office of Thrift Supervision (the "OTS"). As a savings and loan holding company, Redwood is required to file with the OTS an annual report and such additional information as the OTS may require pursuant to the HOLA. The OTS may also conduct examinations of Redwood and its subsidiaries. Under the HOLA, Redwood is required to obtain the prior approval of the OTS before it can acquire direct or indirect control over the business or substantially all of the assets of another savings and loan or savings and loan holding company; however acquisition of 5% or less of such an institution's voting shares does not require the approval of the OTS. In considering such a transaction, the OTS will consider not only the financial and managerial resources of the prospective acquiror, but also the insurance risk posed by such a transaction to the Savings Association Insurance Fund. THRIFT REGULATION AND SUPERVISION. As a federal savings bank, Allied is federally-chartered and subject to regulation, examination and general supervision of its operations by the OTS. Savings institutions and their directors, officers or employees failing to conform to OTS regulations, policies, and directives may be sanctioned for noncompliance. The consent of the OTS is required prior to any major corporate reorganization involving Allied. The OTS requires an annual audit of all savings institutions by independent accountants and, in connection with its own periodic examinations, may revalue assets, based upon appraisals, and require establishment of specific reserves based upon such revaluation. Deposit accounts with Allied are insured by the Savings Association Insurance Fund ("SAIF") as administered by the FDIC to the maximum amount permitted by law. As a member of the Federal Home Loan Bank System, Allied may obtain collateralized advances from the FHLB for certain purposes at favorable rates. 11 In 1993 the OTS amended its qualified thrift lender ("QTL") regulations to require that at least 65% of the association's portfolio assets consist of certain types of housing related investments for at least nine out of every twelve consecutive months. Associations which fail the QTL test lose their right to long-term Federal Home Loan Bank ("FHLB") advances and must either limit their new activities and new branches to those permitted to a national bank or convert to a bank charter. In addition, the OTS may limit or restrict activities of a savings and loan holding company which it determines create a serious risk for subsidiary savings associations. As of December 31, 1995, Allied qualified as a QTL, substantially exceeding the QTL test. CAPITAL STANDARDS. The FRB, the OCC, the OTS, and other federal banking agencies have risk based capital adequacy guidelines intended to provide a measure of capital adequacy that reflects the degree of risk associated with a banking organization's operations for both transactions reported on the balance sheet as assets and transactions, such as letters of credit and recourse arrangements, which are reported as off balance sheet items. Under these guidelines, nominal dollar amounts of assets and credit equivalent amounts of off balance sheet items are multiplied by one of several risk adjustment percentages, which range from 0% for assets with low credit risk, such as certain U.S. government securities, to 100% for assets with relatively higher credit risk, such as business loans. A banking organization's risk based capital ratios are obtained by dividing its qualifying capital by its total risk-adjusted assets and off balance sheet items. The regulators measure risk-adjusted assets and off balance sheet items against both total qualifying capital (the sum of Tier 1 capital and limited amounts of Tier 2 capital) and Tier 1 capital. Tier 1 capital consists of common stock, retained earnings, noncumulative perpetual preferred stock and minority interests in certain subsidiaries, less most other intangible assets. Tier 2 capital may consist of a limited amount of the allowance for possible loan and lease losses and certain other instruments with some characteristics of equity. The inclusion of elements of Tier 2 capital is subject to certain other requirements and limitations imposed by the federal banking agencies. Since December 31, 1992, the federal banking agencies have required a minimum ratio of qualifying total capital to risk- adjusted assets and off balance sheet items of 8%, and a minimum ratio of Tier 1 capital to risk-adjusted assets and off balance sheet items of 4%. In addition to the risk-based guidelines, federal banking regulators require banking organizations to maintain a minimum amount of Tier 1 capital to average total assets, referred to as the leverage ratio. For a banking organization rated in the highest of the five categories used by regulators to rate banking organizations, the minimum leverage ratio of Tier 1 capital to average total assets is 3%. It is improbable, however, that an institution with a 3% leverage ratio would receive the highest rating by the regulators since a strong capital position is a significant part of the regulators' rating. For all banking organizations not rated in the highest category, the minimum leverage ratio is at least 100 to 200 basis points above the 3% minimum. Thus, the effective minimum leverage ratio, for all practical purposes, is at least 4% or 5%. In addition to these uniform risk-based capital guidelines and leverage ratios that apply across the industry, the regulators have the discretion to set individual minimum capital requirements for specific institutions at rates significantly above the minimum guidelines and ratios. 12 Savings associations (such as Allied) are also required to maintain minimum tangible capital (generally the same as Tier 1 capital) of 1.5% of adjusted total assets. Allied also has a minimum core capital ratio of 4% where core capital is defined as Tier 1 capital to total assets. Allied had tangible and core capital ratios of 6.26% as of December 31, 1995. During 1994, the OTS issued a final rule regarding the types and amounts of intangible assets that may be included in a savings association's capital for purposes of complying with the minimum capital ratios. Under this rule, purchased mortgage servicing rights ("PMSR's") and purchased credit card relationships ("PCCR's") may be included in a savings association's regulatory capital but may not exceed, in the aggregate, 50% of core capital, while PCCR's alone may not exceed 25% of core capital. Savings associations may include in tangible capital the same dollar amounts of PMSR's that they include in core capital. As required by FDICIA, the OTS has added an interest rate risk component to its risk-based capital rules. Under the new regulation, for which no effective date has been set, any thrift institution regulated by the OTS deemed to have an "above-normal" level of interest rate exposure will be required to deduct an interest rate risk ("IRR") component from its total capital when determining its compliance with the risk based capital requirements. An "above normal" level of interest rate risk exposure is a projected decline in the association's net portfolio value of assets and liabilities that is greater than 2% of assets resulting from a projected two percentage point swing in interest rates. The IRR component will equal one-half of the difference between the institution's measured interest rate exposure and the level of exposure deemed "normal." Financial institutions subject to these regulations, including Allied but not NBR or Redwood, are required to file IRR-related data with the OTC, which the OTC will use to calculate, on a quarterly basis, the institutions' interest rate risk and IRR components. The IRR component to be deducted from capital is the lowest of the IRR components so calculated for the previous three quarters (commencing with the quarter ended September 30, 1994). At present, neither the FRB nor the OCC has adopted an IRR-related amendment to its risk-based capital rules, although it is anticipated that both agencies will publish new proposed regulations for comment during 1996. The following tables present the capital ratios for the Company, NBR and Allied compared to the standards for well-capitalized depository institutions, as of December 31, 1995.
Well- Minimum Actual Capitalized Requirement ----------------------------------------- COMPANY Leverage 5.14% 5.00% 4.00% Tier 1 risk-based 7.24 6.00 4.00 Total risk-based 11.68 10.00 8.00 NBR Leverage 7.47 5.00 4.00 Tier 1 risk-based 9.41 6.00 4.00 Total risk-based 12.19 10.00 8.00 ALLIED Core 6.26 5.00 4.00 Tier 1 risk-based 9.22 6.00 4.00 Total risk-based 10.47 10.00 8.00
13 PROMPT CORRECTIVE ACTION AND OTHER ENFORCEMENT MECHANISMS. FDICIA requires each federal banking agency to take prompt corrective action to resolve the problems of insured depository institutions, including but not limited to those that fall below one or more prescribed minimum capital ratios. The law required each federal banking agency to promulgate regulations defining the following five categories in which an insured depository institution will be placed, based on the level of its capital ratios: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. In September 1992, the federal banking agencies issued uniform final regulations implementing the prompt corrective action provisions of FDICIA. An insured depository institution generally will be classified in the following categories based on capital measures indicated below: "WELL-CAPITALIZED" Total risk-based capital of 10% or more; Tier 1 risk-based ratio capital of 6% or more; and Leverage ratio of 5% or more. "ADEQUATELY CAPITALIZED" Total risk-based capital of at least 8%; Tier 1 risk-based capital of at least 4%; and Leverage ratio of at least 4%. "UNDERCAPITALIZED" Total risk-based capital less than 8%; Tier 1 risk-based capital less than 4%; or Leverage ratio less than 4%. "SIGNIFICANTLY UNDERCAPITALIZED" Total risk-based capital less than 6%; Tier 1 risk-based capital less than 3%; or Leverage ratio less than 3%. "CRITICALLY UNDERCAPITALIZED" Tangible equity to total assets less than 2%. An institution that, based upon its capital levels, is classified as well capitalized, adequately capitalized or undercapitalized may be treated as though it were in the next lower capital category if the appropriate federal banking agency, after notice and opportunity for hearing, determines that an unsafe or unsound condition or an unsafe or unsound practice warrants such treatment. At each successive lower capital category, an insured depository institution is subject to more restrictions. The federal banking agencies, however, may not treat an institution as "critically undercapitalized" unless its capital ratio actually warrants such treatment. 14 If an insured depository institution is undercapitalized, it will be closely monitored by the appropriate federal banking agency. Undercapitalized institutions must submit an acceptable capital restoration plan with a guarantee of performance issued by the holding company. An undercapitalized depository institution generally will not be able to acquire other banks or thrifts, establish additional branches, or engage in any new lines of business unless consistent with its capital plan. A "significantly undercapitalized" institution will be subject to additional restrictions on its affiliate transactions, the interest rates paid by the institution on its deposits, asset growth, the compensation of its senior executive officers, and other activities deemed to pose excessive risk to the institution. Regulators may also order a significantly undercapitalized institution to hold elections for new directors, terminate any director or senior executive officer employed for more than 180 days prior to the time the institution became significantly undercapitalized, or hire qualified senior executive officers approved by the regulators. Further restrictions and sanctions are required to be imposed on insured depository institutions that are "critically undercapitalized." The most important additional measure is that the appropriate federal banking agency is required to either appoint a receiver for the institution within 90 days or obtain the concurrence of the FDIC in another form of action. In addition to measures taken under the prompt corrective action provisions, commercial banking organizations may be subject to potential enforcement actions by the federal regulators for unsafe or unsound practices in conducting their businesses or for violations of any law, rule, regulation or any condition imposed in writing by the agency or any written agreement with the agency. Enforcement actions may include the imposition of a conservator or receiver, the issuance of a cease-and-desist order that can be judicially enforced, the termination of insurance of deposits (in the case of a depository institution), the imposition of civil money penalties, the issuance of directives to increase capital, the issuance of formal and informal agreements, the issuance of removal and prohibition orders against institution-affiliated parties and the enforcement of such actions through injunctions or restraining orders based upon a prima facie showing by the agency that such relief is appropriate. Additionally, a holding company's inability to serve as a source of strength to its subsidiary banking organizations could serve as an additional basis for a regulatory action against the holding company. SAFETY AND SOUNDNESS STANDARDS. FDICIA also implemented certain specific restrictions on transactions and required the regulators to adopt overall safety and soundness standards for depository institutions related to internal control, loan underwriting and documentation, and asset growth. Among other things, FDICIA limits the interest rates paid on deposits by undercapitalized institutions, the use of brokered deposits and the aggregate extensions of credit by a depository institution to an executive officer, director, principal stockholder or related interest, and reduces deposit insurance coverage for deposits offered by undercapitalized institutions for deposits by certain employee benefits accounts. In addition to the statutory limitations, FDICIA requires the federal banking agencies to prescribe, by regulation, standards for all insured depository institutions for such things as classified loans and asset growth. In July 1992, the federal banking agencies issued a joint advance notice of proposed rule making requesting public comment on the safety and soundness standards. Although final regulations are required by law to be issued by August 1, 1993 and to become effective no later than December 1, 1993, final regulations have not yet been issued. 15 In December 1992, the federal banking agencies issued final regulations prescribing uniform guidelines for real estate lending. The regulations, which became effective on March 19, 1993, require insured depository institutions to adopt written policies establishing standards, consistent with such guidelines, for extensions of credit secured by real estate. The policies must address loan portfolio management, underwriting standards and loan to value limits that do not exceed the supervisory limits prescribed by the regulations. RESTRICTIONS ON DIVIDENDS AND OTHER DISTRIBUTIONS. The power of the board of directors of an insured depository institution to declare a cash dividend or other distribution with respect to capital is subject to statutory and regulatory restrictions which limit the amount available for such distribution depending upon the earnings, financial condition and cash needs of the institution, as well as general business conditions. FDICIA prohibits insured depository institutions from paying management fees to any controlling persons or, with certain limited exceptions, making capital distributions, including dividends, if, after such transaction, the institution would be undercapitalized. The payment of dividends by a national bank is further restricted by additional provisions of federal law, which prohibit a national bank from declaring a dividend on its shares of common stock unless its surplus fund exceeds the amount of its common capital (total outstanding common shares times the par value per share). Additionally, if losses have at any time been sustained equal to or exceeding a bank's undivided profits then on hand, no dividend shall be paid. Moreover, even if a bank's surplus exceeded its common capital and its undivided profits exceed its losses, the approval of the OCC is required for the payment of dividends if the total of all dividends declared by a national bank in any calendar year would exceed the total of its net profits of that year combined with its retained net profits of the two preceding years, less any required transfers to surplus or a fund for the retirement of any preferred stock. A national bank must consider other business factors in determining the payment of dividends. The payment of dividends by NBR is governed by NBR's ability to maintain minimum required capital levels and an adequate allowance for loan losses. Regulators also have the authority to prohibit a depository institution from engaging in business practices which are considered to be unsafe or unsound, possibly including payment of dividends or other payments under certain circumstances even if such payments are not expressly prohibited by statute. As of December 31, 1995, NBR had the ability to dividend $4,328,000 to Redwood without prior regulatory approval. 16 Federal savings banks, such as Allied, which meet the minimum capital requirements described above (see "CAPITAL STANDARDS," above) may distribute as dividends up to 100% of their current net income plus an amount that would reduce by one-half its surplus capital ratio at the beginning of the calendar year. A federal savings bank which equals or exceeds current minimum capital requirements may distribute up to 75% of its net income for the most recent four quarters, depending upon its level of compliance with its risk-based capital requirements. A federal savings bank not meeting minimum capital requirements may not make any capital distribution without the prior written approval of the OTS. In any event, the OTS must be given 30-days' advance written notice of all proposed capital distributions by federal savings banks. Upon application, the OTS may, in its discretion, allow capital distributions in excess of those permitted by its regulations. In addition to the foregoing restrictions, in 1990 Redwood entered into a Capital Maintenance/Dividend Agreement (the "Capital Maintenance Agreement") with the OTS as a condition to its acquisition of Allied. Under the terms of the Capital Maintenance Agreement, Redwood may not accept from Allied, or cause Allied to pay, any dividend (1) without the prior written approval of the OTS if, and as long as, Allied's capital falls or remains below the applicable minimum capital requirements of the OTS, (2) if Allied's capital is below the current capital requirements of the OTS, or (3) if payment of the dividend would cause Allied's capital to fall below the current capital requirements of the OTS. In addition, the Capital Maintenance Agreement prohibits Allied from paying dividends in excess of its cumulative net income for the prior eight quarters, less cumulative dividends paid during that period, without prior OTS approval, even when Allied's capital exceeds its capital requirements. As of December 31, 1995, Allied had the ability to dividend $2,329,000 to Redwood. PREMIUMS FOR DEPOSIT INSURANCE AND ASSESSMENTS FOR EXAMINATIONS. FDICIA established several mechanisms to increase funds to protect deposits insured by the BIF administered by the FDIC. The FDIC is authorized to borrow up to $30 billion from the U.S. Treasury; borrow from the Federal Financing Bank up to 90% of the fair market value of assets of institutions acquired by the FDIC as receiver; and borrow from depository institutions that are members of the BIF. Any borrowings not repaid by asset sales are to be repaid through insurance premiums assessed to member institutions. Such premiums must be sufficient to repay any borrowed funds within 15 years and provide insurance fund reserves of $1.25 for each $100 of insured deposits. The result of these provisions is that the assessment rate on deposits of BIF members could increase in the future. FDICIA also provides authority for special assessments against insured deposits. No assurance can be given at this time as to what the future level of premiums will be. 17 As required by FDICIA, the FDIC adopted a transitional risk-based assessment system for deposit insurance premiums which became effective January 1, 1993. Under this system, depository institutions are charged anywhere from 23 cents to 31 cents for every $100 in insured domestic deposits, based on such institutions' capital levels and supervisory subgroup assignment. The FDIC has adopted a permanent risk-based assessment system scheduled to take effect on January 1, 1994, which incorporates the same basic rate structure. The limited changes adopted by the FDIC are those it proposed in December 1992. These amendments clarify the basis on which supervisory subgroup assignments are made by the FDIC, eliminate from the assessment classification review procedure the specific reference to an "informal hearing," provide for the assignment of new institutions to the "well capitalized" assessment group, clarify that an institution is to make timely adjustments as appropriate, clarify the basis, and report data, on which capital group assignments are made for insured branches of foreign banks, and expressly address the treatment of certain lifeline accounts for which special assessment treatment is given. FDICIA prohibits assessment rates from falling below the current annual assessment rate of 23 cents per $100 of eligible deposits if the FDIC has outstanding borrowings from the United States Treasury Department or the 1.25% designated reserve ratio has not been met. During 1995, the FDIC announced that the BIF had reached its mandated reserve level, reducing insurance premiums on BIF-insured deposits, and subsequently announcing that deposit insurance premiums on BIF-insured deposits would be reduced at December 31, 1995. The SAIF fund has not yet met its mandated reserve level. As a result, deposit insurance premiums attributable to BIF deposits are less than those attributable to SAIF deposits. There are numerous regulatory proposals before Congress to address the deposit insurance premium differential between BIF- and SAIF-insured deposits. The most recent plans consist of one-time insurance premium charges attributable to SAIF-insured deposits sufficient to bring the SAIF up to its mandated reserve level, with a corresponding and immediate reduction in SAIF premiums thereafter. Based on 87 basis points on Allied's deposits at March 31, 1995, the resulting after-tax charge to the Company would be approximately $1,670,000. As both the timing and final form of any proposed regulations remain uncertain, no adjustments to the Company's financial statements have been recorded at December 31, 1995. FDICIA requires all insured depository institutions to undergo a full-scope, on-site examination by their primary federal banking regulator at least once every 12 months. The cost of examinations of insured depository institutions and any affiliates may be assessed by the appropriate federal banking agency against each institution or affiliate as it deems necessary or appropriate. RECENTLY ENACTED AND PROPOSED LEGISLATION. The United States Department of the Treasury has issued a proposal to consolidate the federal bank regulatory agencies. Under this proposal, the supervisory and regulatory oversight authority of the FDIC, the FRB, the OCC, and the OTS would be transferred to a new independent federal banking agency, although the FRB would continue to carry out monetary and fiscal policy, discount window operations, and payments system functions and the FDIC would continue to have oversight over the deposit insurance funds. The Treasury Department may seek to introduce a bill in Congress providing for such consolidation during 1995; however the proposal has already been opposed by, among others, certain industry groups and the FRB, which has suggested a competing consolidation plan which would preserve its regulatory oversight authority. At the present time, due to the preliminary nature of the proposals the Company cannot determine what, if any, effect such a consolidation of regulatory agencies would have on its operations. 18 In September of 1994 the Riegle Community Development and Regulatory Improvement Act (the "Riegle Act") and the Riegle-Neal Interstate Banking and Branching Efficiency Act (the "Riegle-Neal Act") became law. The Riegle Act is intended to reduce much of the federal red tape with which financial institutions have had to contend, providing about fifty different kinds of specific relief. Among other things, the Riegle Act requires the federal regulatory agencies to set up regulatory appeals systems and an ombudsman system, streamlines the examination process, simplifies the audit requirements for CAMEL 1 or 2 rated institutions with less than $5 billion in assets, requires the regulatory agencies to take into account the size and activities of financial institutions in issuing certain risk-related capital rules, streamlines the application process for bank holding company activities, and simplifies certain Truth-in-Lending rules. The Riegle Act also provides for new consumer protections with respect to certain high cost home mortgages, amends securities, banking, pension, and tax laws to encourage securitization of small business loans and the development of a secondary market for pools of such loans, and permits lenders to participate in capital access programs designed to encourage lenders to make loans to small and medium sized businesses. The Riegle-Neal Act allows adequately capitalized and managed bank holding companies, with the approval of the FRB, to acquire control of, or to acquire all or substantially all of the assets of, banks in any State, commencing in September of 1995. States are permitted, however, to pass legislation either providing for earlier approval of such mergers or prohibiting interstate mergers entirely. California had already adopted legislation permitting interstate mergers. Additionally, the Riegle-Neal Act permits the federal bank regulatory agencies to approve merger transactions between insured banks having different home states, without regard to the laws of either of the States involved, unless between September 1994 and June 1, 1997 one of the involved States has enacted a law prohibiting expressly prohibiting merger transactions involving out-of-state banks. Bills are regularly introduced in the United States Congress which contain wide-ranging proposals for altering the structures, regulations, and competitive relationships of the nation's financial institutions. It cannot be predicted whether or in what form any proposed legislation will be adopted, or the extent to which the business of the Company may be affected by such legislation. ACCOUNTING PRONOUNCEMENTS The Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 123 "Accounting for Stock-Based Compensation" in October 1995, which the Company is required to adopt in 1996. SFAS No. 123 establishes accounting and disclosure requirements using a fair value-based method of accounting for stock-based employee compensation plans. Under SFAS No. 123, the Company may either adopt the new fair value-based accounting method or continue the intrinsic value-based method and provide pro forma disclosures of net income and earnings per share as if the accounting provisions of SFAS No. 123 had been adopted. The Company plans to adopt only the disclosure requirements of SFAS No. 123; therefore such adoption will have no effect on the Company's consolidated net earnings or cash flows. 19 FASB issued SFAS No. 122 "Accounting for Mortgage Servicing Rights," an amendment of SFAS No. 65 in May 1995. SFAS No. 122 requires a mortgage banking enterprise that purchases or originates mortgage loans with a definitive plan to sell or securitize those loans and retain the mortgage servicing rights to allocate the cost of the mortgage loans based on the relative fair values of the mortgage loans and mortgage servicing rights at the date of purchase or origination. Prior to SFAS No. 122, originated mortgage servicing rights were not recognized for financial statement purposes with the entire cost of the mortgage loan being allocated to the loan. The Company early adopted SFAS No. 122 on January 1, 1995 as permitted. The effect of adoption on the 1995 statement of operations was to increase gain on sale of loans by $1,830,000 and net income by $857,000 ($.27 per fully-diluted share). SFAS No. 122 prohibited the restatement of results for prior years. In May 1993, the FASB issued SFAS No. 115 "Accounting for Certain Investments in Debt and Equity Securities. The Company adopted SFAS No. 115 at December 31, 1993 and, accordingly, has classified its investment securities as held to maturity or available for sale. Securities held to maturity are carried at cost adjusted by the accretion of discounts and amortization of premiums. The Company has the ability and intent to hold these investment securities to maturity. Securities available for sale may be sold to implement the Company's asset/liability management strategies and in response to changes in interest rates, prepayment rates and similar factors. These securities are recorded at market value and unrealized gains or losses, net of income taxes, are included in shareholders' equity. Gain or loss on sale of investment securities is based on the specific identification method. During 1995, the FASB issued a Special Report, "A Guide to Implementation of Statement 115 on Accounting for Certain Investments in Debt and Equity Securities". The Special Report provided a one-time opportunity to reassess the appropriateness of its designations of securities subject to the accounting and reporting requirements of Statement 115, without calling into questions the intent to hold other debt securities to maturity in the future. In accordance with the Special Report, in December 1995, the Company transferred $20,709,000 in U.S. Government obligations with an unrealized gain of $145,000 from held-to-maturity to available-for-sale. On January 1, 1995, the Company adopted SFAS No. 114 "Accounting by Creditors for Impairment of a Loan" and SFAS No. 118, "Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosure." These statements address the accounting and reporting by creditors for impairment of certain loans. In general, a loan is impaired when, based upon current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. These statements are applicable to all loans, uncollateralized as well as collateralized, except loans that are measured at the lower of cost or fair value. Impairment is measured based on the present value of expected future cash flows discounted at the loan's effective interest rate, except that as a practical expedient, the Company measures impairment based on a loan's observable market price or the fair value of the collateral if the loan is collateral dependent. Loans are measured for impairment as part of the Company's normal internal asset review process. The effect of adopting SFAS 114 was not material to the Company's 1995 balance sheet or statement of operations. 20 COMPETITION The Company competes for deposits and loans principally with major commercial banks, other independent banks, savings and loan associations, savings banks, thrift and loan associations, credit unions, mortgage companies, insurance companies and other lending institutions. Among the advantages of the larger of these institutions are their ability to make larger loans, finance extensive advertising campaigns, access international money markets and to generally allocate their investment assets to regions of highest yield and demand. Major commercial banks, savings and loans in California, and certain national mortgage companies operating in the Company's primary market area dominate the commercial banking and mortgage banking industries with large branch systems and loan production offices operating over a wide geographical area. In order to compete with the other financial institutions in its primary market area, the Company relies principally upon local directors and employees, extended hours and quick turnaround on loan requests. The Company's promotional activities emphasize the advantages of dealing with a locally-owned and headquartered institution attuned to the particular needs of the community. For customers whose loan demands exceed the Company's lending limit, the Company attempts to arrange for such loans on a participation basis with its correspondent banks. (d) FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES. Not applicable. CERTAIN IMPORTANT CONSIDERATIONS FOR INVESTORS MORTGAGE BANKING ACTIVITY. The Company is substantially dependent upon mortgage banking activity, which can fluctuate significantly, in both volume and profitability, with changes in interest rate movements. During 1992 and 1993, the Company experienced a significant increase in mortgage banking activity as a result of an increase in refinancing activity caused by declining interest rates. During 1994, however, increases in interest rates curtailed refinancing activity and the mortgage market shifted toward adjustable-rate mortgages used to purchase homes. As a result, mortgage banking loan originations declined sharply during 1994, compared to rapid increases in origination volumes during 1993 and 1992. Although the Company's mortgage banking originations were down in 1995, the volume began to increase in the last half of 1995. The following is a table of mortgage banking revenues and operating profits for the last three years.
Year Ended December 31, 1995 1994 1993 ----------------------------------- (in thousands) Revenue $16,089 $16,269 $21,537 Operating profit (loss) $138 ($9,821) $4,484
21 The Company seeks to minimize its interest rate by monitoring its exposure to potential losses from shifts in interest rates on a daily basis and hedging that exposure through the use of various financial instruments, including derivatives. These investments include both written and purchased put and call options and forward commitments to sell mortgage loans and mortgage-backed securities to investors. The Company uses software developed by an independent party to evaluate its daily hedging position and the potential impact of various changes in interest rates. Interest rate fluctuations, however, can leave the Company unable to adjust its hedging position in a timely manner, and could have a material adverse effect on the Company's results of operations. INTEREST RATE RISK. The Company's profitability may be adversely affected by rapid changes in interest rates. The Company is substantially dependent on mortgage banking activity, which can fluctuate significantly with interest rate movements. The Company's ability to manage its net interest margin depends on the volume of commercial loans compared to residential mortgage loans. Additionally, the volume of adjustable rate mortgage loans ("ARMs") compared to fixed rate mortgage loans can impact the net interest margin. ARMs can be originated with initial rates at or below the cost of funding the loans and reduce the net interest margin while the loans are held until the loans reprice. A decline in net interest margin can result from fixed rate loans in a rising rate environment as the Company's cost of funding loans rises. In a declining rate environment, refinancing of fixed rate loans can inhibit an increase in the net interest margin. CONCENTRATION OF LENDING ACTIVITIES. Concentration of the Company's lending activities in the real estate sector, including construction loans could have the effect of intensifying the impact on the Company of adverse changes in the real estate market in the Company's lending areas. At December 31, 1995, approximately 82% of the Company's loans were secured by real estate, of which 22% were secured by commercial real estate, including small office buildings, owner-user office/warehouses, mixed-use residential and commercial properties and retail properties. Substantially all of the properties that secure the Company's present loans are located within Northern and Central California. The ability of the Company to continue to originate mortgage loans may be impaired by adverse changes in local or regional economic conditions, adverse changes in the real estate market, increasing interest rates, or acts of nature (including earthquakes, which may cause uninsured damage and other loss of value to real estate that secures the Company's loans. Due to the concentration of the Company's real estate collateral, such events could have a significant adverse impact on the value of such collateral or the Company's earnings. 22 DIVIDENDS. Beginning with the fourth quarter of 1992, Redwood paid a quarterly dividend on its Common Stock each quarter until the fourth quarter of 1994, when the payment of Common Stock dividends was suspended indefinitely by the Board of Directors. There can be no assurance that such dividend payments will be resumed in the future. Federal regulatory agencies have the authority to prohibit the payment of dividends by NBR and Allied to Redwood if a finding is made that such payment would constitute an unsafe or unsound practice, or if NBR or Allied became undercapitalized. If NBR or Allied are restricted from paying dividends, Redwood could be unable to pay dividends on either its Common or its Preferred Stock. In addition, the payment of dividends by Redwood is limited by California law and subject to the discretion of the Board of Directors of Redwood. No assurance can be given as to the ability of the Company's subsidiaries to pay dividends to Redwood, the ability of Redwood to continue or resume paying dividends in accordance with prior practice or at all, or the determination by the Board of Directors that payment of any such dividend will be appropriate under the circumstances. Under applicable law and regulations, at December 31, 1995, Allied and NBR were able to pay up to $4,531,000 and $4,328,000 in additional dividends to Redwood. See "REGULATION AND SUPERVISION -- RESTRICTIONS ON DIVIDENDS AND OTHER DISTRIBUTIONS," above. GOVERNMENT REGULATION. Redwood and its subsidiaries are subject to extensive federal and state governmental supervision, regulation and control, and future legislation and government policy could adversely affect the financial industry. Although the full impact of such legislation and regulation cannot be predicted, future changes may alter the structure of and competitive relationship among financial institutions. See "REGULATION AND SUPERVISION," above. COMPETITION FROM OTHER FINANCIAL INSTITUTIONS. The Company competes for deposits and loans principally with major commercial banks, other independent banks, savings and loan associations, savings banks, thrift and loan associations, credit unions, mortgage companies, insurance companies and other lending institutions. With respect to deposits, additional significant competition arises from corporate and governmental debt securities, as well as money market mutual funds. The Company also depends for its origination of mortgage loans on independent mortgage brokers who are not contractually obligated to do business with the Company and are regularly solicited by the Company's competitors. Aggressive policies of such competitors have in the past resulted, and may in the future result, in a decrease in the Company's volume of mortgage loan originations and/or a decrease in the profitability of such originations, especially during periods of declining mortgage loan origination volumes. Several of the nation's largest savings and loan associations and commercial banks have a significant number of branch offices in the areas in which the Company conducts operations. Among the advantages possessed by the larger of these institutions are their ability to make larger loans, finance extensive advertising campaigns, access international money markets and generally allocate their investment assets to regions of highest yield and demand. See "COMPETITION," above. RISKS INVOLVED IN ACQUISITION STRATEGY. The Company has grown in significant part through acquisitions of financial institutions, including savings and loan companies and banks. The Company intends to continue its policy of reviewing such opportunities as they present themselves, and to make further acquisitions as strategically appropriate. Such acquisitions, including the recent merger of Codding bank with and into NBR, involve risks of adversely changing the Company's results of operations, unforeseen liabilities or asset quality problems of the acquired entity, and unanticipated conditions not within the Company's control, including among others adverse personnel relations, loss of customers because of change of identity, and deterioration in local economic conditions. 23 Management believes that the Company's potential growth in earnings will depend in part on the successful development of future acquisition prospects. Candidates for such future acquisitions may not prove to be available on terms the Company believes to be favorable, however. Furthermore, state and Federal regulatory agencies have the power to block, delay, or adversely condition such acquisitions in the future, depending on the financial condition of Redwood, its subsidiaries, and its potential acquisition targets. In pursuing its acquisition strategy the Company must compete with a variety of individuals and institutions, including major regional bank holding companies, for suitable acquisition candidates. Such competition could affect the Company's ability to make acquisitions, increase the price the Company may be forced to pay for certain acquisitions in the future, and increase the Company's costs in analyzing and negotiating such potential transactions. STRATEGIC EVALUATION OF ALLIED. In an effort to increase shareholder value the Board of Directors is currently evaluating strategic options relating to Allied. These options include a sale or partial sale of Allied or a merger of Allied into NBR. The ultimate resolution of this evaluation process and actions stemming therefrom, if any, cannot currently be determined. ITEM 2. PROPERTIES The Company owns and leases certain premises and equipment used in the normal course of business. There are no contingent rental payments and the Company has three sublease arrangements. Total rental expenses under all leases, including premises, totaled $2,172,000, $2,336,000 and $1,533,000, in 1995, 1994 and 1993. The expiration dates of the leases vary, with the last such lease expiring during 2009. The Company enters into leases for premises and equipment as the Company expands its business. The Company maintains insurance coverage on its premises, leaseholds and equipment, including business interruption and record reconstruction coverage. Management believes that there are no premises occupied that could not be relocated with minimal impact. ITEM 3. LEGAL PROCEEDINGS There are no material legal proceedings pending against the Company to which the Company is a party or to which any of its properties is subject, except ordinary routine litigation incidental to the businesses of the Company. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS No matters were submitted to a vote of the Company's shareholders during the fourth quarter of 1995. 24 PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Redwood's Common Stock is publicly traded on the American Stock Exchange. Market information for Redwood's Common Stock for the two most recent fiscal years can be found under the heading "Quarterly Results" of the 1995 Annual Report to Shareholders, and is by this reference incorporated herein. As of March 1, 1996 there were 693 shareholders of record of Redwood's Common Stock. Redwood declared quarterly cash dividends on its Common Stock at the rate of $0.03 per share for the fourth quarter of 1992 and the first three quarters of 1993. In the fourth quarter of 1993, the Common Stock dividend was increased to $0.035 per share, and it remained at that level through the first three quarters of 1994. The Common Stock dividend was suspended during the fourth quarter of 1994. See Item 8 "FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA -- NOTE P OF NOTES TO CONSOLIDATED FINANCIAL STATEMENTS OF REDWOOD EMPIRE BANCORP," below. Dividends from NBR and Allied are a primary source of cash for Redwood. There are regulatory limitations on cash dividends that may be paid by NBR and Allied to Redwood which could limit Redwood's ability to pay dividends. Federal regulatory agencies have the authority to prohibit the payment of dividends by NBR and Allied if a finding is made that such payment would constitute an unsafe or unsound practice, or if NBR or Allied became critically undercapitalized. Redwood is not subject to any prohibitions or limitations imposed on its ability to pay dividends by any regulatory agency, although it has entered into a Capital Maintenance/Dividend Agreement with the OTS with respect to the payment of dividends by Allied. See Item 1(c) "NARRATIVE DESCRIPTION OF BUSINESS -- RESTRICTIONS ON DIVIDENDS AND OTHER DISTRIBUTIONS," above. ITEM 6. SELECTED FINANCIAL DATA The information required by this Item can be found in the Company's 1995 Annual Report to Shareholders under the heading "Summary of Consolidated Financial Data and Performance Ratios", and is by this reference incorporated herein. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required by this Item can be found in the Company's 1995 Annual Report to Shareholders, and is by this reference incorporated herein. 25 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements appear, together with the Notes thereto and the independent auditors' report of Deloitte & Touche LLP dated January 24, 1996 thereon, in the Company's 1995 Annual Report to Shareholders, and are by this reference incorporated herein. Supplementary data for each full quarter within the years ended December 31, 1995 and 1993, can be found in the Company's 1995 Annual Report to Shareholders under the heading "Quarterly Results", and is by this reference incorporated herein. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this Item can be found in Redwood's definitive Proxy Statement pursuant to Regulation 14A under the Securities Exchange Act of 1934, and is by this reference incorporated herein. ITEM 11. EXECUTIVE COMPENSATION The information required by this Item can be found in Redwood's definitive Proxy Statement pursuant to Regulation 14A under the Securities Exchange Act of 1934, and is by this reference incorporated herein. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item can be found in Redwood's definitive Proxy Statement pursuant to Regulation 14A under the Securities Exchange Act of 1934, and is by this reference incorporated herein. 26 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (a) TRANSACTIONS WITH MANAGEMENT AND OTHERS. NBR leases 34,000 square feet of office space for its main office from 137 Group, a partnership that includes as a minority partner NBR director Richard Colombini. The lease calls for payments of $62,455 per month plus annual rental increases through November 1999. Total lease payments in 1995, 1994, and 1993 for this location were $851,000, $839,000 and $753,000, respectively. (b) CERTAIN BUSINESS RELATIONSHIPS. Except as disclosed elsewhere in this Item, management is not aware of any business relationships required to be disclosed hereunder. (c) INDEBTEDNESS OF MANAGEMENT. Some of the Company's directors and executive officers and their immediate families, as well as the companies with which they are associated, are customers of or have had banking transactions with the Company in the ordinary course of the Company's business, and the Company expects to have banking transactions with such persons in the future. In management's opinion, all such loans and commitments to lend were made in the ordinary course of business, in compliance with applicable laws, on substantially the same terms, including interest rates and collateral, as those prevailing for comparable transactions with other persons of similar credit worthiness and, in the opinion of management, did not involve more than a normal risk of collectibility or present other unfavorable features. The Company has a strong policy regarding review of the adequacy and fairness to the Company of loans to its directors and officers. At December 31, 1995, there were no outstanding balances under extensions of credit to directors and executive officers of the Company and companies with which directors are associated. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES AND REPORTS ON FORM 8-K. (a) 1. FINANCIAL STATEMENTS. The following consolidated financial statements of Redwood and its subsidiaries, and independent auditors' report included in the Annual Report of Redwood to its shareholders for the years ended December 31, 1995, 1994 and 1993, are incorporated herein by reference. Independent Auditors' Report Consolidated Financial Statements of Redwood Empire Bancorp Consolidated Statements of Operations Consolidated Balance Sheets Consolidated Statements of Shareholders' Equity Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements 27 2. FINANCIAL STATEMENT SCHEDULES. All financial statement schedules have been omitted, as inapplicable. 3. EXHIBITS. The following documents are included or incorporated by reference in this Annual Report on Form 10-K. Exhibits marked with an asterisk (*) represent management contracts or compensatory plans or arrangements. EXHIBIT NUMBER DESCRIPTION ------- ----------- 2.1 Acquisition and Merger Agreement between National Bank of the Redwoods and Codding Bank, dated June 21, 1994, including Exhibits A and B thereto, filed as Exhibit 2.1 to the Registrant's Current Report on Form 8-K dated June 21, 1994, and by this reference incorporated herein. 2.2 Amendment No. 1 to Acquisition and Merger Agreement between National Bank of the Redwoods and Codding Bank, dated September 21, 1994, filed as Exhibit 2.1 to the Registrant's Current Report on Form 8-K dated September 21, 1994, and by this reference incorporated herein. 3. Amended and restated By-Laws of the Registrant, filed as Exhibit 3 to the Registrant's 1994 Annual Report on Form 10-K and by this reference incorporated herein. 4.1 Form of Indenture (including form of Notes) between the Registrant and the Bank of New York, as Trustee, relating to the issuance of 8.50% Subordinated Notes due 2004, filed as Exhibit 4.1 to the Registrant's Registration Statement on Form S-2 dated December 13, 1993 (Registration No. 33-71324), and by this reference incorporated herein. 4.2 Certificate of Determination of the Rights, Preferences, Privileges and Restrictions of the Registrant's 7.80% Noncumulative Convertible Perpetual Preferred Stock, Series A, filed as Exhibit 4.1 to the Registrant's Registration Statement on Form S-2 dated February 16, 1993 (Registration No. 33-56962), and by this reference incorporated herein. 10.1* Severance Compensation Agreement between Allied Savings Bank, F.S.B. and Terance O'Mahoney, filed as Exhibit 10.1 to the Registrant's 1990 Annual Report on Form 10-K and by this reference incorporated herein. 28 10.2* Amendment No. 1 to Severance Compensation Agreement between Allied Savings Bank, F.S.B. and Terance O'Mahoney dated as of January 1, 1993, filed as Exhibit 10.2 to the Registrant's 1992 Annual Report on Form 10-K and by this reference incorporated herein. 10.3* Employment Agreement between Allied Savings Bank, F.S.B. and Martin B. McCormick, dated as of July 1, 1990, filed as Exhibit 10.5 to the Registrant's 1992 Annual Report on Form 10-K and by this reference incorporated herein. 10.4* Amendment No. 1 to Employment Agreement between Allied Savings Bank, F.S.B. and Martin B. McCormick, dated as of January 1, 1993, filed as Exhibit 10.6 to the Registrant's 1992 Annual Report on Form 10-K and by this reference incorporated herein. 10.5* Employment Agreement between National Bank of the Redwoods and Patrick W. Kilkenny, dated as of January 1, 1994, filed as Exhibit 10.7 to the Registrant's 1993 Annual Report on Form 10-K and by this reference incorporated herein. 10.6 Lease, dated August 30, 1988, between National Bank of the Redwoods and 137 Group, a general partnership, filed as Exhibit 10.1 to the Registrant's 1989 Annual Report on Form 10-K, and by this reference incorporated herein. 10.7 Lease, Dated April 18, 1990, between Allied Savings Bank, F.S.B. and Stony Point West, General Partnership, filed as Exhibit 10.2 to the Registrant's 1990 Annual Report on Form 10-K, and by this reference incorporated herein. 10.8* The Registrant's 401 (k) Profit Sharing Plan, filed as Exhibit 28.1 to the Registrant's Registration Statement on Form S-8 dated June 12, 1990 (Registration No. 33-35377), and by this reference incorporated herein. 10.9* The Allied Savings Bank, F.S.B. 1986 Stock Option Plan, filed as Exhibit 28.1 to the Registrant's Registration Statement on Form S-8 dated June 28, 1991 (Registration No. 33-41503), and by this reference incorporated herein. 10.10* The National Bank of the Redwoods Stock Option Plan, filed as Exhibit 28.1 to the Registrant's Post-Effective Amendment No. 1 to Registration Statement on Form S-4 dated March 27, 1989 (Registration No. 33-24642), and by this reference incorporated herein. 10.11* The Registrant's Amended and Restated 1991 Stock Option Plan, filed as Exhibit 4.1 to the Registrant's Registration Statement on Form S-8 filed on July 8, 1992 (Registration No. 33-49372), and by this reference incorporated herein. 10.12* The Registrant's Performance Incentive Bonus Plan, filed as Exhibit 10.13 to the Registrant's 1992 Annual Report on Form 10-K, and by this reference incorporated herein. 29 10.13 The Registrant's Dividend Reinvestment and Stock Purchase Plan, filed as Exhibit 10.14 to the Registrant's 1992 Annual Report on Form 10-K, and by this reference incorporated herein. 10.14* The Registrant's Phantom Stock Plan, filed as Exhibit 10.16 to the Registrant's 1993 Annual Report on Form 10-K, and by this reference incorporated herein. 10.15* Phantom Stock Agreement between the Registrant and John H. Downey, Jr., dated as of January 1, 1994, filed as Exhibit 10.17 to the Registrant's 1993 Annual Report on Form 10-K, and by this reference incorporated herein. 10.16* The Registrant's Executive Salary Continuation Plan, filed as Exhibit 10.9 to the Registrant's Registration Statement on Form S-2 dated December 13, 1993 (Registration No. 33-71324), and by this reference incorporated herein. 10.17* Director Retirement Plan, filed as Exhibit 10.10 to the Registrant's Registration Statement on Form S-2 dated December 13, 1993 (Registration No. 33-71324), and by this reference incorporated herein. 10.18* Chairman Retirement Agreement, dated November 30, 1993, between the Registrant and John H. Downey, Jr., filed as Exhibit 10.11 to the Registrant's Registration Statement on Form S-2 dated December 13, 1993 (Registration No. 33-71324), and by this reference incorporated herein. 10.19* Lease, dated December 23, 1993 between Allied Bank, F.S.B. and Santa Rosa Corporate Center Associates II, filed as Exhibit 10.21 to the Registrant's 1994 Annual Report on Form 10-K, and by this reference incorporated herein. 11. Statement re Computation of Per Share Earnings. 12.1 Statement re Computation of Ratio of Earnings to Fixed Charges. 12.2 Statement re Computation of Ratio of Earnings to Fixed Charges and Preferred Dividends. 13. Annual Report to Security Holders. 21. Subsidiaries of the Registrant. 24. Consent of Deloitte & Touche LLP. (b) REPORTS ON FORM 8-K. The Company filed the following Current Reports on Form 8-K during the last quarter of 1995: 1. On October 31, 1995 reporting the declaration of a quarterly dividend of 19.5 cents per share on the Registrant's 7.80% Noncumulative Convertible Perpetual Preferred Stock. 30 2. On October 30, 1995 reporting the earnings for the quarter ended September 30, 1995. (c) EXHIBITS. See Item 14(a)3 and the Index to Exhibits. (d) EXCLUDED FINANCIAL STATEMENTS Not applicable. 31 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. REDWOOD EMPIRE BANCORP By: /S/ JOHN H. DOWNEY, JR. Dated: March 5, 1996 ----------------------- John H. Downey, Jr. Chairman of the Board And By: /S/ PATRICK W. KILKENNY Dated: March 6, 1996 ----------------------- Patrick W. Kilkenny President and Chief Executive Officer (Principal Executive Officer) And By: /S/ JAMES E. BECKWITH Dated: March 6, 1996 ----------------------- James E. Beckwith Senior Vice President and Chief Financial Officer (Principal Financial Officer) And By: /S/ GALE D. BRIDGEMAN Dated: March 5, 1996 ----------------------- Gale D. Bridgeman Vice President and Controller (Principal Accounting Officer) 32 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 and in the capacities and on the date indicated. /S/ ORLANDO J. ANTONINI Dated: March 11, 1996 - ----------------------------- Orlando J. Antonini, Director /S/ HASKELL E. BOYETT Dated: March 5, 1996 - ----------------------------- Haskell E. Boyett, Director /S/ JOHN H. DOWNEY, JR. Dated: March 5, 1996 - ----------------------------- John H. Downey, Jr., Director and Chairman of the Board /S/ PATRICK W. KILKENNY Dated: March 6, 1996 - ----------------------------- Patrick W. Kilkenny, Director /S/ JOHN R. OLSEN Dated: March 5, 1996 - ----------------------------- John R. Olsen, Director /S/ WILLIAM B. STEVENSON Dated: March 5, 1996 - ----------------------------- William B. Stevenson, Director /S/ TOM D. WHITAKER Dated: March 5, 1996 - ----------------------------- Tom D. Whitaker, Director and Vice Chairman of the Board 33 INDEX TO EXHIBITS Exhibit Number Description - ------- ----------- 11. Statement re Computation of Per Share Earnings. 12.1 Statement re Computation of Ratio of Earnings to Fixed Charges. 12.2 Statement re Computation of Ratio of Earnings to Fixed Charges and Preferred Dividends. 13. Annual Report to security holders. 21. Subsidiaries of the Registrant. 24. Consent of Deloitte & Touche LLP. 34 EX-11 2 EXHIBIT 11 Exhibit 11 Redwood Empire Bancorp EARNINGS PER COMMON SHARE Earnings per common and common equivalent shares are computed by dividing net income applicable to common stock by the total of the average number of common shares outstanding and the additional dilutive effect of stock options outstanding during the respective period. The calculations give effect to the 3 percent stock dividends declared in 1993 and 1992. The dilutive effect of stock options is computed using the average market price of the common stock for the period for primary earnings per share. Earnings per common share, assuming full dilution, are computed by dividing net income by the average number of common shares outstanding during the period, the dilutive effect of the Convertible Preferred Stock assuming conversion at the time it was issued, and the additional dilutive effect of stock options outstanding during the period. The dilutive effect of outstanding stock options is computed using the greater of the closing market price or the average market price of the common stock for the period. Earnings per common share have been computed based on the following:
Year Ended December 31, 1995 1994 1993 --------------------------------- (in thousands) Net income (loss) $3,313 ($3,035) $4,564 Dividends on preferred stock 336 448 432 -------- -------- -------- Net income (loss) applicable to common stock $2,977 ($3,483) $4,132 -------- -------- -------- -------- -------- -------- Average number of common shares outstanding 2,671 2,649 2,480 Average number of common and common equivalent shares outstanding 2,680 2,649 2,679 Average number of common shares outstanding - assuming full dilution 3,179 2,649 3,171 Earnings per common and common equivalent share: Primary net income (loss) per share $1.11 ($1.31) $1.54 Fully diluted net income (loss) per share 1.04 (1.31) 1.44
EX-12.1 3 EXHIBIT 12.1 Exhibit 12.1 REDWOOD EMPIRE BANCORP AND SUBSIDIARIES COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES (in thousands, except ratios)
Year Ended December 31 1995 ---------------- EXCLUDING INTEREST ON DEPOSITS Net income $3,313 Tax provision 2,359 Fixed charges: Other interest expense 4,941 ------- Earnings before taxes and fixed charges $10,613 ------- ------- Ratio of earnings to fixed charges 2.15 ------- ------- INCLUDING INTEREST ON DEPOSITS Fixed charges, per above $4,941 Interest on deposits 22,730 ------- Total fixed charges and interest on deposits $27,671 ------- ------- Earnings before taxes and fixed charges, per above $10,613 Interest on deposits 22,730 ------- Total earnings before taxes, fixed charges and interest on deposits $33,343 ------- ------- Ratio of earnings to fixed charges 1.20 ------- ------- Surplus $5,672 ------- ------- The 1995 earnings are adequate to cover fixed charges by the amount noted above.
EX-12.2 4 EXHIBIT 12.2 Exhibit 12.2 REDWOOD EMPIRE BANCORP AND SUBSIDIARIES COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES AND PREFERRED STOCK DIVIDEND REQUIREMENT (in thousands, except ratios)
Year Ended December 31 1995 ----------- EXCLUDING INTEREST ON DEPOSITS Net income $3,313 Tax provision 2,359 Other interest expense 4,941 ------- Earnings before taxes and fixed charges $10,613 ------- ------- Fixed charges per above $4,941 Preferred stock dividends 336 ------- Fixed charges including preferred stock dividends $5,277 ------- ------- Ratio of earnings to fixed charges and preferred stock dividend requirements 2.01 ------- ------- INCLUDING INTEREST ON DEPOSITS Fixed charges, including preferred stock dividends $5,277 Interest on deposits 22,730 ------- Total fixed charges and interest on deposits $28,007 ------- ------- Earnings before taxes and fixed charges, per above $10,613 Interest on deposits 22,730 ------- Total earnings before taxes, fixed charges and interest on deposits $33,343 ------- ------- Ratio of earnings to fixed charges 1.19 ------- ------- Surplus $5,336 ------- -------
The 1995 earnings are adequate to cover fixed charges by the amount noted above. EX-13 5 EXHIBIT 13 1995 ANNUAL REPORT [REDWOOD EMPIRE BANCORP IN SCRIPT] [4 PHOTO MONTAGE OF REDWOOD TREE PARTS] [REDWOOD EMPIRE BANCORP LOGO] [REDWOOD EMPIRE BANCORP LOGO] [REDWOOD EMPIRE BANCORP IN SCRIPT] Redwood Empire Bancorp and its consolidated subsidiaries provide diverse financial products and services. Redwood's commercial bank subsidiary, National Bank of the Redwoods, offers financial services primarily to business and professionals in the North Coast counties of California. Redwood's subsidiary, Allied Bank, F.S.B., conducts mortgage banking activities throughout Northern and Central California and Oregon. Redwood's business plan includes the development of fee-based products and services which will provide insulation to the Company's results from changes in interest rates. Redwood's stock is listed and traded on the American Stock Exchange under the symbol "REB." Note: All per share information set forth in this Annual Report has been adjusted as appropriate to reflect 3% stock dividends paid in January 1994, 1993, 1992 and 1991. DEAR SHAREHOLDERS We are pleased to report significant improvement in the consolidated financial condition and consolidated results of operations of Redwood Empire Bancorp as of and for the year ended December 31, 1995. The successful development and implementation of our turnaround strategy relating to our Allied Bank subsidiary along with a favorable external environment provided for a dramatic rebound in several key measurements of financial performance and strength of the Company. For the year ended December 31, 1995 the Company recorded net income of $3,313,000 or $1.04 per share as compared to a net loss of $3,035,000 or $1.31 per share in 1994. The Company's capital ratios were also improved. The consolidated leverage ratio, which is a key regulatory capital adequacy measure, improved from 4.08% as of December 31, 1994 to 5.14% as of December 31, 1995 or a 26% increase. As of December 31, 1995 the Company and its subsidiaries maintained capital in excess of what is deemed by Federal Banking Regulators as "well capitalized". Total assets of the Company, which ballooned to $630,652,000 as of December 31, 1994, were reduced to $557,910,000 as of December 31, 1995. As most of you are aware, Redwood Empire Bancorp entered 1995 faced with significant challenges. Allied Bank, F.S.B., the Company's mortgage banking arm and wholly owned subsidiary, through balance sheet growth and geographic expansion in 1994, created a higher than normal level of interest rate risk, capital adequacy concerns and unprofitable operations for both Allied and the Company. [Graph of Fully Diluted Earnings per share 91-95] 1991 1992 1993 1994 1995 Fully Diluted Earnings per share $0.91 $1.10 $1.44 ($1.31) $1.04 The Company's management and Board of Directors met these challenges by the development of a 1995 Allied business plan which called for asset reduction, expense control, capital improvement and revenue diversification. Through a 1 series of asset sales which disposed of all of Allied's held for sale COFI loan position, Allied's total assets were reduced from $413,789,000 as of December 31, 1994 to $318,996,000 as of December 31, 1995. Allied's overhead, which amounted to $20,315,000 in the year ended December 31, 1994, was reduced to $15,638,000 in 1995 through the implementation of a cost reduction program. With the development of Allied Diversified Credit, the savings bank's non-agency lending arm, and increased construction lending, Allied was able to diversify its revenue sources. All these efforts were aided by a much improved interest rate environment. This improvement is best evidenced by an improvement in the long bond rate which was 7.89% of December 31, 1994 as compared to 6.03% as of December 31, 1995. As a result of this improvement, Allied's mortgage loan originations in the second half of 1995 amounted to $660 million as compared to $338 million in the same period in 1994. This interest rate trend certainly bodes well for Allied in 1996 as our January mortgage loan originations amounted to $141 million as compared to $16 million in January of 1995. As a result of the above factors, Allied recorded net income of $2,202,000 for the year ended December 31, 1995 as compared to a net loss of $3,116,000 in 1994. Allied's capital ratios, as evidenced by its core capital ratio, improved from 4.27% as of December 31, 1994 to 6.26% as of December 31, 1995. Its interest rate risk is now within regulatory guidelines, as measured by the Office of Thrift Supervision. The company is pleased with Allied's turnaround performance. During 1995 the Company embarked on an extensive strategic review of the operations of Allied. As a result of this review, your Board of Directors has initiated a process to evaluate various strategic options of the Company relating to Allied. These options may include a sale, or partial sale of Allied, or merging Allied into National Bank of the Redwoods. At the time of this letter no determination has been made with respect to this evaluation process. [Graph of Capital Ratios] Capital Ratios 1994 1995 Total Capital to Risk-weighted Assets 10.75% 11.68% Tier 1 Capital to Risk-weighted Assets 6.55% 7.24% Leverage Ratio 4.08% 5.14% We are pleased to announce that National Bank of the Redwoods enjoyed another record year in 1995. Net income for the Bank was $2,332,000 in 1995 as compared to $1,816,000 in 1994. Total assets of the Bank amounted to $238,791,000 at December 31, 1995 as compared to $215,553,000 one year ago. The increase in net income for the Bank was the result of an increase in the Bank's net interest income and growth in fee-based products and services. Growth 2 of the Bank in 1995 was principally due to in-market deposit growth of the Bank. As financial institutions are evaluated on their local market share and level of core deposits, we are very pleased with the progress National Bank of the Redwoods has made in these areas in 1995. The Company will continue to focus on building National Bank of the Redwoods' penetration of the commercial banking market in northern California through internal growth and acquisitions. [Graph of High, Low, Close Stock Price]
Quarter 1994 Quarter 1995 1 2 3 4 1 2 3 4 STOCK PRICE PERFORMANCE HIGH $14.63 $13.88 $13.38 $10.50 $7.25 $9.25 $10.13 $9.38 LOW 11.75 12.25 10.50 7.00 5.75 6.38 7.25 7.50 CLOSE 13.25 13.25 10.50 7.13 6.75 8.50 8.88 8.00
In October 1995 the Company announced the promotion of Patrick Kilkenny as Chief Executive Officer. Mr. Kilkenny now serves as the Company's and National Bank of the Redwoods' Chief Executive Officer. Mr. Kilkenny brings significant financial institution expertise to the consolidated entity and its particularly adept in product development and strategic planning. [Graph of Return on Common Equity] Return on common Equity 17.39% (13.22%) 12.39% As we enter into 1996, we wish to reconfirm our Company's mission statement to our shareholders. Our mission statement, which drives each and every business decision made at your Company is simply to "increase shareholder value." We believe this focus has, and will continue to set us apart from other community-based financial institutions. We look forward to fulfilling this mission statement in 1996. /s/ John H. Downey, Jr. John H. Downey, Jr. Chairman of the Board 3 CORPORATE PROFILE Redwood Empire Bancorp is a financial institution holding company headquartered in Santa Rosa, California, and operating in California, Oregon and Washington. Its wholly-owned subsidiaries are National Bank of the Redwoods ("NBR"), chartered in 1985, and Allied Bank, F.S.B., ("Allied"), chartered in 1986. The Company's business strategy involves two principal business activities, commercial banking and mortgage banking, which are conducted through NBR and Allied, respectively. NBR provides its commercial banking services through five retail branches located in Sonoma County, California and one retail branch located in Mendocino County, California. Loan services at NBR are generally extended to professionals and to businesses with annual revenues of less than $10 million. Commercial loans are primarily for working capital, asset acquisition and commercial real estate. NBR generates noninterest income through merchant draft processing by virtue of its status as a Principal Bank of Visa/MasterCard. As a Preferred Lender under the Small Business Administration ("SBA") Loan Guarantee Program, NBR generates noninterest income through premiums received on the sale of the guaranteed portions of SBA loans and the resulting on-going servicing income on its SBA portfolio. In addition, NBR offers its customers cash management services through internally-developed proprietary software. The Company's strategy with respect to NBR is to increase NBR's penetration of the commercial banking market in Northern California's coastal counties through internal growth and acquisitions and to develop or enhance fee-based products and services. In November 1994, NBR acquired Codding Bank, a California- chartered bank headquartered in Sonoma County, California. In connection with the acquisition, NBR added two branches and approximately $42 million in assets. In October, 1994 NBR also opened a new branch in Mendocino County, California. The Company's mortgage banking business is conducted entirely through Allied. The savings bank originates one-to-four family residential mortgage loans which predominately conform to the underwriting standards set by Fannie Mae or Freddie Mac. LOAN PORTFOLIO DECEMBER 31, 1995 Residential real estate mortgage 39% Commercial real estate mortgage 15% Commercial 15% Real estate construction 16% Installment and other 1% Mortgage loans held for sale 14% Allied also originates mortgage loans through its Allied Diversified Credit division that do not comply with all standards established by governmental agencies. All mortgage loan originations are packaged and sold into the secondary market. Allied sells substantially all the servicing rights on the mortgage loans it sells and from time to time may purchase mortgage loan servicing rights from other companies, thereby generating ongoing servicing fees. In addition, Allied originates construction loans for its portfolio. 4 SUMMARY OF CONSOLIDATED FINANCIAL DATA AND PERFORMANCE RATIOS
At or for the Year ended December 31, 1995 1994 1993 1992 1991 - -------------------------------------------------------------------------------------------------------------------------- (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) STATEMENTS OF OPERATIONS: Total interest income $ 47,374 $ 38,005 $ 27,465 $ 21,459 $ 21,351 Net interest income 19,703 17,339 14,980 11,087 9,483 Provision for loan losses 1,590 1,095 1,679 2,272 1,866 Other operating income 16,575 10,885 19,177 12,327 7,692 Net income (loss) 3,313 (3,035) 4,564 2,609 1,810 Net income (loss) available to common equity 2,977 (3,483) 4,132 2,609 1,810 - -------------------------------------------------------------------------------------------------------------------------- BALANCE SHEETS: Total assets $ 557,910 $ 630,652 $ 471,674 $ 326,730 $ 235,161 Total loans 368,224 384,569 210,257 185,366 144,896 Mortgage loans held for sale 62,620 138,003 168,619 68,186 41,511 Allowance for loan losses 5,037 5,787 5,209 4,320 2,441 Total deposits 458,393 469,008 351,775 295,100 207,129 Shareholders' equity 31,585 28,194 31,576 22,251 16,013 - -------------------------------------------------------------------------------------------------------------------------- PERFORMANCE RATIOS: Return on average assets .57% (.56%) 1.21% .97% .82% Return on average common equity 12.39 (13.22) 17.39 13.80 12.03 Common dividend payout ratio N/A 7.70 2.76 Average equity to average assets 5.13 5.88 7.56 7.01 6.82 Leverage ratio 5.14 4.08 6.99 6.88 6.70 Tier 1 risk-based capital ratio 7.24 6.55 10.72 10.50 9.29 Total risk-based capital ratio 11.68 10.75 16.04 11.76 10.54 Net interest margin 3.63 3.40 4.20 4.48 4.70 Other operating expense to net interest income and other operating income 79.98 113.46 72.06 70.51 70.42 Average earning assets to average total assets 93.49 93.39 94.32 91.93 91.29 Nonperforming assets to total assets 1.28 1.34 1.72 1.94 1.63 Net loan charge-offs to average loans .60 .40 .40 .53 .57 Allowance for loan losses to total loans 1.37 1.50 2.48 2.33 1.68 Allowance for loan losses to nonperforming loans 101.88 104.97 122.65 104.15 100.04 - -------------------------------------------------------------------------------------------------------------------------- SHARE DATA: Common shares outstanding (000) 2,679 2,663 2,598 2,470 1,823 Book value per common share $ 9.64 $ 8.43 $ 9.94 $ 9.01 $ 8.78 Primary earnings (loss) per share 1.11 (1.31) 1.54 1.11 .91 Fully diluted earnings (loss) per share 1.04 (1.31) 1.44 1.10 .91 Cash dividend per common share .105 .125 .03 - -------------------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------------------
5 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW Redwood Empire Bancorp ("Redwood" and with its subsidiaries, the "Company") is a financial institution holding company headquartered in Santa Rosa, California. The Company's business strategy involves two principal business activities, commercial banking and mortgage banking which are conducted through its two principal subsidiaries, National Bank of the Redwoods, a national bank ("NBR"), and Allied Bank, F.S.B., a federal savings bank ("Allied"). Commercial banking activities include portfolio lending, including construction loans, the origination for sale and servicing of Small Business Administration ("SBA") loans, various deposit programs and numerous fee-based services. Mortgage banking activities relate principally to the origination of mortgage loans for sale, servicing of mortgage loans sold to investors, and sale and purchase of mortgage loans and servicing rights. The Company derives its income from three principal sources: (1) net interest income, which is the difference between the interest income it receives on interest-earning assets and the interest expense it pays on interest-bearing liabilities; (2) mortgage banking operations, which involve the origination for sale and sale of real estate secured loans, the sale of mortgage loan servicing rights, and mortgage loan servicing fee income on loans serviced; and (3) fee income, which includes fees earned on deposit services, income from SBA lending, electronic-based cash management services and merchant sales draft processing. In an effort to increase shareholder value the Board of Directors is currently evaluating strategic options relating to Allied. These options include a sale or partial sale of Allied or a merger of Allied into NBR. The ultimate resolution of this evaluation process and actions stemming therefrom, if any, cannot currently be determined. The following analysis of the Company's financial condition and results of operations should be read in conjunction with the Consolidated Financial Statements of Redwood Empire Bancorp, related notes thereto, and other information presented elsewhere in this Annual Report. Average balances, including such balances used in calculating financial and performance ratios, are generally a blend of daily averages for NBR and for Allied, which management believes are representative of the operations of the Company. ACQUISITIONS On November 4, 1994, NBR acquired Codding Bank, a California-chartered bank headquartered in Rohnert Park, California ("Codding"). The purchase price of Codding totalled $7,028,000 in cash, including merger related expenses. At the merger date, the fair value of Codding's assets totalled approximately $42,048,000, including loans of approximately $28,294,000 and investment securities of approximately $7,935,000 and the fair value of liabilities assumed was approximately $43,224,000, including deposits of $42,817,000. The Company recorded goodwill of $1,176,000 which is being amortized over 15 years on a straight-line basis. The Company's consolidated financial statements include the results of Codding beginning October 31, 1994. RESULTS OF OPERATIONS The Company's financial results in 1995 improved significantly from the prior year due primarily to improvements in net interest income, improved mortgage banking operations, increased other fee income and reduced corporate overhead. The Company reported net income of $3,313,000, or $1.04 per fully-diluted common share for 1995. In 1994, the Company reported a net loss of $3,035,000 (a loss of $1.31 per fully-diluted share). The Company's net income in 1993 was $4,564,000 ($1.44 per fully-diluted share). Return on average assets for the year ended December 31, 1995 was .57%, as compared to (.56%) and 1.21% for the years ended December 31, 1994 and 1993. Return on average common equity was 12.39% for the year ended December 31, 1995, as compared to (13.22%) and 17.39% for the years ended December 31, 1994 and 1993. The Company's mortgage banking operations accounted for approximately $138,000 or 2% of total operating profit in 1995, compared to an operating loss of $9,821,000 in 1994. In 1993, mortgage banking accounted for approximately $4,484,000 or 51% of the Company's operating profit. The improved performance in 1995 in mortgage banking operations was attributable to a favorable interest rate environment, increased production of fixed rate loans and reduced noninterest expense. The decrease in 1994 when compared to 1993 was primarily due to the decreased gain on sale of loans recorded in 1994, restructuring charges associated with the closing of several production offices and the increased overhead attributable to the mortgage banking segment prior to the restructuring. See Note Q to the Consolidated Financial Statements for a description of operating income and for additional information relating to the Company's two principal business lines. NET INTEREST INCOME. For 1995, the Company's net interest income increased by $2,364,000, to $19,703,000, as compared to $17,339,000 in 1994. Net interest income was $14,980,000 in 1993. This represents an annual increase of approximately 14% in 1995 and 16% in 1994. The increase in 1995 when compared to 1994 is primarily atributable to an increase in construction lending and to afull year impact of the Codding acquistion. The increase in 1994 when compared to 1993 was in part due to the Codding acquisition and an increase in residential mortgage and construction loans. The following table presents for the years indicated the distribution of consolidated average assets, liabilities and shareholders' equity, as well as the total dollar amounts of interest income from average earning assets and the resultant yields, and the dollar amounts of interest expense and average interest-bearing liabilities, expressed both in dollars and in rates. Nonaccrual loans are included in the calculation of the average balances of loans, and interest not accrued is excluded. 6
1995 1994 1993 AVERAGE YIELD/ Average Yield/ Average Yield/ BALANCE INTEREST RATE Balance Interest Rate Balance Interest Rate - ----------------------------------------------------------------------------------------------------------------------------------- (dollars in thousands) ASSETS: Portfolio loans $390,664 $ 38,052 9.74% $287,257 $ 26,057 9.07% $197,858 $ 18,941 9.57% Mortgage loans held for sale 71,395 4,417 6.19 163,495 9,397 5.75 113,961 6,768 5.94 Investment securities 49,044 3,187 6.50 30,235 1,381 4.57 20,890 1,040 4.98 Federal funds sold 27,777 1,581 5.69 25,140 1,006 4.00 19,048 592 3.11 Interest-bearing deposits due from financial institutions 3,467 137 3.95 3,661 164 4.48 4,862 124 2.55 - ----------------------------------------------------------------------------------------------------------------------------------- Total earning assets 542,347 47,374 8.73 509,788 38,005 7.46 356,619 27,465 7.70 - ----------------------------------------------------------------------------------------------------------------------------------- Other assets 43,758 41,463 26,181 Less allowance for loan losses (6,023) (5,353) (4,706) - ----------------------------------------------------------------------------------------------------------------------------------- Total average assets $580,082 $545,898 $378,094 - ----------------------------------------------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------------------------------------------- LIABILITIES AND SHAREHOLDERS' EQUITY: Transaction accounts $116,316 4,367 3.75 $114,266 3,679 3.22 $107,557 3,423 3.18 Time deposits 304,396 18,363 6.03 233,896 11,239 4.81 169,212 8,122 4.80 Other borrowings 71,593 4,941 6.90 105,009 5,748 5.47 28,413 940 3.31 - ----------------------------------------------------------------------------------------------------------------------------------- Total interest-bearing liabilities 492,305 27,671 5.62 453,171 20,666 4.56 305,182 12,485 4.09 Demand deposits 51,946 44,283 37,026 Other liabilities 6,054 16,339 7,289 Shareholders' equity 29,777 32,105 28,597 - ----------------------------------------------------------------------------------------------------------------------------------- Total average liabilities and shareholders' equity $580,082 $545,898 $378,094 Net interest spread 3.11 2.90 3.61 Net interest income and net interest margin $19,703 3.63 $17,339 3.40 $14,980 4.20 - ----------------------------------------------------------------------------------------------------------------------------------- - -----------------------------------------------------------------------------------------------------------------------------------
The Company's average earning assets for 1995 increased approximately 6%, or $32,559,000, to $542,347,000, as compared to $509,788,000 for 1994. Average earning assets increased approximately 43% in 1994 as compared to 1993. The growth in average earning assets for 1995, as well as in 1994 and 1993, was derived principally from portfolio loans, which increased 36% for 1995 and 45% for 1994. Portfolio loans are the Company's highest yielding category of earning assets. In addition, the average balance of investment securities increased approximately 62% to $49,044,000 in 1995 as compared to $30,235,000 in 1994. The following table sets forth changes in interest income and interest expense for each major category of earning asset and interest-bearing liability, and the amount of change attributable to volume and rate changes for the years indicated. Changes not solely attributable to rate or volume have been allocated to rate. 7
1995 Over 1994 1994 Over 1993 Volume Rate Total Volume Rate Total - ---------------------------------------------------------------------------------------------------------------------------------- (in thousands) INCREASE (DECREASE) IN INTEREST INCOME: Portfolio loans (1), (2) $9,379 $ 2,616 $11,995 $8,555 $(1,439) $7,116 Mortgage loans held for sale (5,296) 316 (4,980) 2,942 (313) 2,629 Investment securities 860 946 1,806 465 (124) 341 Federal funds sold 105 470 575 189 225 414 Interest-earning deposits with other institutions (9) (18) (27) (31) 71 40 - ---------------------------------------------------------------------------------------------------------------------------------- Total increase (decrease) 5,039 4,330 9,369 12,120 (1,580) 10,540 - ---------------------------------------------------------------------------------------------------------------------------------- INCREASE (DECREASE) IN INTEREST EXPENSE: Interest-bearing transaction accounts 66 622 688 213 43 256 Time deposits 3,391 3,733 7,124 3,105 12 3,117 Other borrowings (1,829) 1,022 (807) 2,534 2,274 4,808 - ---------------------------------------------------------------------------------------------------------------------------------- Total increase 1,628 5,377 7,005 5,852 2,329 8,181 - ---------------------------------------------------------------------------------------------------------------------------------- Increase (decrease) in net interest income $3,411 $(1,047) $2,364 $6,268 $(3,909) $2,359 - ---------------------------------------------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------------------------------------------
(1) Does not include interest income which would have been earned on nonaccrual loans had such loans performed in accordance with their terms. (2) Loan fees of $2,112,000, $1,611,000, and $479,000 are included in interest income for 1995, 1994 and 1993. The net interest margin increased to 3.63% for the year ended December 31, 1995, as compared to 3.40% and 4.20% for the years ended December 31, 1994 and 1993. The increase in net interest margin in 1995 was primarily due to increased yield on earning assets, substantially offset by increased liability costs. The yield on earning assets increased to 8.73% in 1995 compared to 7.46% in 1994 and 7.70% in 1993. The increase in 1995 was due to the seasoning of adjustable-rate mortgage loans in the portfolio as many of these loans were originated in 1994 with "teaser" rates which reset to market in 1995. In addition, in 1995 the Company increased its high-yielding construction loan portfolio from $33.3 million as of December 31, 1994 to $69.5 million as of December 31, 1995. The decline in yield on earning assets in 1994 was principally attributable to the practice of originating adjustable rate mortgage loans with teaser rates. (See "Loan Portfolio" and "Mortgage Banking".) The effective rates on interest-bearing liabilities increased to 5.62% for 1995, as compared to 4.56% for 1994 and 4.09% for 1993. The increase in 1995 was due primarily to an increase in high-cost time deposits and FHLB advances to fund mortgage loan growth. The increase in 1994 when compared to 1993 is generally attributable to a higher rate environment and the use of high-cost FHLB advances and time deposits to fund mortgage loan growth. PROVISION FOR LOAN LOSSES. Annual fluctuations in the provision for loan losses result from management's regular assessment of the adequacy of the allowance for loan losses. The provision for loan losses was $1,590,000 for the year ended December 31, 1995, which represents an increase of $495,000 or 45% from 1994. In 1994, the provision for loan losses of $1,095,000 represented a 35% decline from $1,679,000 in 1993. See "Asset Quality". OTHER OPERATING INCOME. Other operating income increased 52%, or $5,690,000, to $16,575,000, for 1995, as compared to $10,885,000 for 1994. The Company's other operating income for 1994 represented a decrease of $8,292,000 or 43% from the $19,177,000 it received during 1993. The following table sets forth the sources of other operating income for the years ended December 31, 1995, 1994 and 1993.
Year Ended December 31, 1995 1994 1993 - ------------------------------------------------------------------------------- (IN THOUSANDS) Service charges on deposit accounts $ 1,148 $ 1,009 $ 1,085 Merchant draft processing, net 1,505 1,168 697 Loan servicing income 1,625 1,943 981 Net realized gains (losses) on sale of investment securities available for sale 386 (24) 242 Gain on sale of loans and loan servicing 10,195 5,448 15,637 Other income 1,716 1,341 535 - ------------------------------------------------------------------------------- $ 16,575 $ 10,885 $ 19,177 - -------------------------------------------------------------------------------
The primary cause of the increase in the Company's other operating income was the increased gain on sale of loans and loan servicing of $4,747,000 in 1995 over 1994. As a result of an improved interest rate environment and higher demand, in the first half of 1995 the Company was able to sell its $110 million of COFI-based mortgage loans held for sale whose carrying amount had been adjusted at December 31, 1994 by a $5,534,000 valuation allowance. As a result, the Company recorded a gain of approximately $2,300,000 in 1995 associated with the disposition of these loans. In addition, due to a much-improved interest rate environment, the Company's origination of fixed rate loans increased in 1995 to approximately 84% of the total originations, as opposed to 67% in 1994 and 91% in 1993. 8 Loan servicing revenues decreased to $1,625,000 for the year ended December 31, 1995, compared to $1,943,000 and $981,000 in 1994 and 1993. Future loan servicing income will be dependent on prepayments of loans held in the Company's servicing portfolio, the volume of additional loans added to this portfolio and any future bulk servicing sales. See "Mortgage Banking" and Note B of Notes to Consolidated Financial Statements. Other income increased $375,000 to $1,716,000 in 1995 from $1,341,000 in 1994 and $535,000 in 1993 primarily due to merchant draft processing performed by NBR. The Company took advantage of the interest rate environment and relief under SFAS No. 115 and sold securities in 1995 for a gain of $386,000. Securities gains of $242,000 were recorded in 1993 compared to losses of $24,000 recorded in 1994. See Note E of Notes to Consolidated Financial Statements. OTHER OPERATING EXPENSE. In 1995 other operating expense decreased $3,007,000 or 9% as a direct result of the Company's cost-cutting measures enacted in the last half of 1994 and the first half of 1995. In 1994 the increase in other expense of $7,408,000 or 30% when compared to 1993 related primarily to the Company's mortgage banking operations and related staffing additions and a restructuring charge recorded in 1994 (described below) attributable to those mortgage banking operations. Excluding the restructuring charge recorded in 1994 and recovery recorded in 1995, other operating expenses decreased $1,142,000 or 4% over 1994 and increased 20% or $4,999,000 over 1993. Salary and employee benefits expense and occupancy and equipment increased each period. Salary and employee benefits expense for 1995 increased $221,000, or 2%, to $14,368,000, as compared to $14,147,000 for 1994. This compared with a 13% increase during 1994 over the 1993 salary and employee benefits expense of $12,533,000. The increases during 1995 and 1994 were due to the salaries and benefits resulting from higher full-time-equivalent staff levels, payments under the Company's management bonus plan in 1993 and general salary and benefit increases. The Company's full-time-equivalent staff levels were 353, 336 and 373 at December 31, 1995, 1994 and 1993, respectively. There were no payments made under the management bonus plan in 1995 or 1994. Occupancy and equipment expense was $5,544,000 for 1995, an increase of 10%, or $519,000, over 1994 occupancy and equipment expense of $5,025,000. This increase was primarily attributable to the addition of three branch offices by NBR in late 1994 and annual lease payment increases. The Company's 1994 occupancy expense represented a 55% increase over its 1993 level of $3,237,000 due to the opening of several loan production offices by Allied and the addition of the NBR branch offices. During the third and fourth quarters of 1994, the Company implemented major cost reduction programs in response to declining origination volumes in the Company's mortgage banking business and recorded a restructuring charge of $815,000 in the third quarter and $1,594,000 in the fourth quarter. The restructuring entailed closing wholesale mortgage production offices in Fresno, San Diego, San Ramon and Windsor, California, Phoenix, Arizona and Seattle, Washington. The charge also includes the effects of consolidation of leased space in the Sacramento and Santa Rosa, California offices and termination of related employees. The restructuring charge consisted of: Severance expenses for 125 employees $ 374,000 Writeoff of the estimated present value of discontinued leases 1,683,000 Writeoff of leasehold improvements, furniture and fixtures 352,000 - --------------------------------------------------------------------- $2,409,000 - --------------------------------------------------------------------- - --------------------------------------------------------------------- In 1995, the Company was able to sublease three properties allowing a recovery of $456,000 related to leases discontinued in 1994. At December 31, 1995, $619,000 of the restructuring charge remained in other liabilities, substantially all of which is related to the future minimum lease payments associated with the closed facilities. The Company is continuing to seek sublease tenants for many of these closed facilities and an additional portion of the restructuring charge may be reversed in future periods if the Company is successful in entering into such arrangements. For further discussion, see "Mortgage Banking." The following table describes the components of other operating expense for the years ended December 31, 1995, 1994 and 1993.
Year Ended December 31, 1995 1994 1993 - ------------------------------------------------------------------------------- (IN THOUSANDS) Professional fees $2,187 $2,065 $1,803 Regulatory expense and insurance 1,716 1,345 1,038 Postage and office supplies 1,224 1,013 1,295 Shareholder expenses and Director fees 486 950 700 Advertising 481 919 531 Telephone 778 782 535 Electronic data processing 1,022 775 606 Net costs of other real estate owned 163 609 131 Other 1,503 1,984 2,206 - ------------------------------------------------------------------------------- $9,560 $10,442 $8,845 - ------------------------------------------------------------------------------- - -------------------------------------------------------------------------------
Other expenses were $9,560,000 during 1995, a decrease of $882,000, or 8%, over 1994 expenses of $10,442,000. This decrease was due to decreased mortgage banking related advertising and telephone costs and decreased OREO expenses partially offset by higher regulatory and insurance expenses. Other expenses increased 18% in 1994 from $8,845,000 in 1993, primarily due to the significant increase in the Company's general operating expenses directly attributable to the growth of the Company's mortgage banking operations. 9 INCOME TAXES. The Company's effective tax rate was 41.6% in 1995 and 42.0% in 1993 and a benefit of 38.0% in 1994. The benefit recorded in 1994 was limited due to the absence of carrybacks and limitation on carryforwards for California tax purposes. LOAN PORTFOLIO The Company concentrates its lending activities in three principal areas: real estate mortgage loans (residential and commercial loans), real estate construction loans and commercial loans. At December 31, 1995, these three categories accounted for approximately 63%, 19% and 17%, respectively, of the Company's loan portfolio. The interest rates charged for the loans made by the Company vary with the degree of risk, the size and maturity of the loans, the borrowers' depository relationships with the Company and prevailing money market rates indicative of the Company's cost of funds. Concentration of the Company's lending activities in the real estate sector could have the effect of intensifying the impact on the Company of adverse changes in the real estate market in the Company's lending areas. The ability of the Company to continue to originate mortgage loans may be impaired by adverse changes in local or regional economic conditions, adverse changes in the real estate market, increasing interest rates, or acts of nature (including earthquakes, which may cause uninsured damage and other loss of value to real estate that secures the Company's loans). Due to the concentration of the Company's real estate collateral, such events could have a significant adverse impact on the value of such collateral or the Company's earnings. The following table sets forth the amounts of loans outstanding by category as of the dates indicated. There were no concentrations of loans exceeding 10% of total loans which are not otherwise disclosed as a category of loans in the table below.
December 31, 1995 1994 1993 1992 1991 (IN THOUSANDS) - -------------------------------------------------------------------------------------------------------------------- Residential real estate mortgage $168,022 $222,822 $102,254 $ 83,273 $ 33,936 Commercial real estate mortgage 65,655 61,347 35,909 25,051 20,942 Commercial 63,975 64,807 49,556 48,147 53,288 Real estate construction 69,504 33,348 21,476 20,598 25,803 Installment and other 4,103 5,063 3,033 9,804 12,223 Less deferred fees (3,035) (2,818) (1,971) (1,507) (1,296) - -------------------------------------------------------------------------------------------------------------------- Total loans 368,224 384,569 210,257 185,366 144,896 Less allowance for loan losses (5,037) (5,787) (5,209) (4,320) (2,441) - -------------------------------------------------------------------------------------------------------------------- Net loans $363,187 $378,782 $205,048 $181,046 $142,455 - -------------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------------
REAL ESTATE MORTGAGE LOANS. As of December 31, 1995, the Company's residential mortgage loans totalled $168,022,000, or 45%, of its total loans. These loans were predominantly originated in Sonoma and Mendocino Counties. The decrease in residential real estate loans is due primarily to loan sales of $35.9 million during the second quarter of 1995. The sale was executed to restructure Allied's balance sheet and consequently improve Allied's capital ratios and reduce its interest rate risk. In addition, in the third quarter of 1995, the Company swapped $22.1 million of adjustable rate loans with Fannie Mae for a mortgage-backed security which had a coupon rate of 7.295% and was scheduled to mature in 2025; this security, which was classified as available for sale, was sold prior to December 31, 1995, with settlement due from broker in January 1996. The increase in residential mortgage loans in 1994 was directly attributable to Allied's desire to increase its earning asset base. The increase in residential mortgage loans in 1993 was primarily a result of a high level of refinancing activity within Allied's primary service market. As a result of the Company's acquisition of Lake on October 31, 1992, the Company's residential real estate mortgage loan portfolio increased by approximately $25 million during the fourth quarter of 1992. These loans were originated by Lake, prior to its acquisition, throughout the greater San Francisco Bay Area. The remaining increase in the Company's residential real estate mortgage loan portfolio resulted from loans originated by the Company. At December 31, 1995, $44 million, or 26%, of the Company's residential real estate mortgage loans were fixed-rate mortgage loans having original terms ranging from one to 30 years, with the majority having terms of five years or less. Another $107 million, or 64%, were held as adjustable-rate mortgages, substantially all of which adjust semi-annually, based on the Eleventh District Cost-of-Funds Index published monthly by the FHLB. The balance of these loans, $17 million, or 10%, consisted of multifamily loans, second mortgage loans and loans on improved single-family lots. The majority of the Company's residential mortgage loans have been underwritten for the Company's portfolio and do not necessarily meet standard underwriting criteria for sale in the secondary market. Approximately 81% of the total amount outstanding had principal balances that were less than $300,000. The Company's residential real estate mortgage loans predominately have loan-to-value ratios of 80% or less, using current loan balances and appraised values as of the time of origination. The Company's general policy is not to exceed an 80% loan-to-value ratio on residential mortgage loans without mortgage insurance. The Company generally does not make portfolio loans on a negative amortization basis. As of December 31, 1995, the Company had outstanding $65,655,000 in commercial mortgage loans, which constituted 18% of total loans. These loans were primarily secured by owner-occupied commercial properties and have 5- to 15-year maturities based upon 25- to 30-year amortization periods. Loan to appraised values are generally 75% or 10 less, using appraised values at the time of loan origination, and the loans are predominantly for owner-occupied small office buildings or office/warehouses. The Company originates commercial mortgage loans that are guaranteed by the SBA up to 70% to 90% of the balance. The SBA guaranteed portion of such loans are sold into the secondary market with the unguaranteed principal balance retained. The aggregate retained unguaranteed principal balance of such loans was $11.4 million at December 31, 1995. Approximately 67% of the total amount outstanding of commercial mortgage loans had principal balances that were less than $250,000. The Company also originates residential mortgage loans for sale. See "Mortgage Banking." REAL ESTATE CONSTRUCTION LOANS. Real estate construction loans are primarily for residential housing. The primary market focus is toward individual borrowers and small residential and commercial projects. The economic viability of the project and the borrower's past development record and creditworthiness are primary considerations in the loan underwriting decision. The Company had $69,504,000 in construction loans outstanding at December 31, 1995, comprising 19% of its total loans. These loans were almost entirely located in Sonoma and Mendocino Counties. Approximately $73 million of these loans consisted of 178 single-family individual-borrower construction loans, and the remaining loans included 69 subdivision projects, 66 land development projects and eight commercial projects. At December 31, 1995, the largest single-family construction loan commitment was $875,000, and the average commitment was less than $365,000. The largest commitment for a subdivision project was $2.9 million, and the average subdivision commitment was less than $524,000. The average commercial project involved a loan of approximately $811,000. Construction loans are funded on a line-item, percentage of completion basis. As the builder completes various line items (foundation, framing, electrical, etc.) of the project, or portions of those line items, the work is reviewed by one of several independent inspectors hired by the Company. Upon approval from the inspector, the Company funds the draw request according to the percentage completion of the line items that have been approved. The Company rotates inspectors during construction to insure independent review. Actual funding checks must be signed by an officer of the Company, and that officer must also initial the line-item worksheet used to support the draw request. In addition, senior management routinely inspects the various construction projects, all of which are located in the Company's lending area. Commercial real estate mortgage and construction lending contains potential risks which are not inherent in other types of commercial loans. These potential risks include declines in market values of underlying real property collateral and, with respect to construction lending, delays or cost overruns which could expose the Company to loss. In addition, risks in commercial real estate lending include declines in commercial real estate values, general economic conditions surrounding the commercial real estate properties, and vacancy rates. A decline in the general economic conditions or real estate values within the Company's market area could have a negative impact on the performance of the loan portfolio or value of the collateral. Because the Company lends primarily within its market area, the real property collateral for its loans is similarly concentrated, rather than diversified over a broader geographic area. The Company could therefore be adversely affected by a decline in real estate values in its primary market area even if real estate values elsewhere in California remained stable or increased. COMMERCIAL LOANS. Commercial loans consist primarily of short-term financing for businesses and professionals located in Sonoma and Mendocino Counties. At December 31, 1995, these loans totalled $63,975,000, or 17%, of the Company's total loans. The commercial loans are diversified as to industries and types of businesses, with no material industry concentrations. Commercial loan borrowers generally have deposit relationships with the Company. The commercial loans can be unsecured or secured by various assets, including equipment, receivables, deposits and other assets. Commercial loans may be secured by commercial or residential property; however they are not classified as mortgage loans since these loans are not typically taken out for the purpose of acquiring real estate and the loans are short-term. In these cases, the mortgage collateral is often taken as additional collateral. As of December 31, 1995, the size of individual commercial loans varied widely, with 99% having principal balances less than $350,000. At December 31, 1995, the Company had 41 commercial borrowers whose aggregate individual liability exceeded $1,000,000. LOAN COMMIMENTS. In the normal course of business, there are various commitments outstanding to extend credit that are not reflected in the financial statements. Annual review of the commercial credit lines and ongoing monitoring of outstanding balances reduces the risk of loss associated with these commitments. As of December 31, 1995, the Company had outstanding $82,518,000 in unfunded mortgage loan commitments, $69,493,000 in undisbursed loan commitments and $1,372,000 in standby letters of credit. The Company's undisbursed commercial loan commitments represented primarily business lines of credit. The undisbursed construction commitments represented undisbursed funding on construction projects in process. The mortgage loan commitments represented approved but unfunded mortgage loans with the Company's mortgage banking business. MORTGAGE BANKING The Company is substantially dependent upon mortgage banking activity, which can fluctuate significantly, in both volume and profitability, with changes in interest rates. During 1992 and 1993, the Company experienced a significant increase in mortgage banking activity as a result of an increase in refinancing activity caused by declining interest rates. During 1994, increases in interest rates sharply curtailed refinancing activity and the Company began to emphasize the origination of adjustable-rate mortgages for home purchases. Rates again began to decline in late 1995. For 1995, mortgage banking loan originations totaled $840 million, or $233 million less than the $1,073 million originated in 1994. 1994 mortgage loan originations were $876 million less than the $1.949 billion originated in 1993. The mix of these originations has shifted from approximately 91% fixed rate loans vs. 9% adjustable rate loans in 1993 to approximately 67% fixed rate loans vs. 33% adjustable rate loans for 1994, and again back to 84% fixed, 16% variable for 1995. The secondary market for adjustable-rate mortgages is different than it is for fixed-rate mortgages, as the buyers of such adjustable rate loans 11 are often portfolio lenders rather than mortgage loan dealers who typically securitize whole loans. Also, the "teaser" rates that may be in effect for the first three to six months on many adjustable-rate mortgages are often set at below-market interest rates. As a result, the Company's cost of funds to carry such loans before they are sold into the secondary market can exceed the yields received on them, which reduces the Company's net interest margin. In addition, the Company's adjustable-rate loans based on the Federal Home Loan Bank's Eleventh District cost of funds index ("COFI"), which is a slower-moving index than an index based on U.S. Treasury rates and therefore prices for such loans are lower in a rising rate environment. The following table represents the Company's residential mortgage banking origination and sale activity for the years indicated.
Year Ended December 31, 1995 1994 1993 - ----------------------------------------------------------------------- (IN MILLIONS) Mortgage banking loan originations $ 840 $1,073 $1,949 Increase (decrease) from prior period (22%) (45%) 99% Mortgage banking loan sales $ 887 $1,048 $1,859 Increase (decrease) from prior period (15%) (44%) 105% Mortgage banking revenue $ 16 $ 16 $ 22
Due to the rapid rise in general interest rates in 1994, the demand for adjustable rate loans tied to COFI was weakened. In addition, the Company did not maintain an effective hedge against these adjustable rate loans because a good correlation between a COFI loan and a contrived hedge is difficult to achieve. Accordingly, the Company was required to record an unrealized loss of $5,534,000 on mortgage loans held for sale to account for the decline in market value of loans held for sale which was principally comprised of COFI loans. This charge is included in gain on sale of loans in the consolidated statement of operations. In response to the marketability problems associated with COFI loans, the Company curtailed production of such loans in the fourth quarter of 1994. In the beginning of 1994, the Company's mortgage banking segment, in response to declining mortgage loan production volume in its Northern California market, initiated a plan to open loan production offices in Portland, Oregon, Seattle, Washington and Phoenix, Arizona as well as expanding into other California cities. Mortgage loan production volume from most of these new offices did not cover the related overhead, and with the prospect of continued losses, the Company decided to close the new offices. See "Results of Operations - Other Operating Expense" for further information on the restructuring. All of the Company's mortgage loans held for sale meet certain investor underwriting criteria regarding loan-to-value ratios, maturities, yields and related documentation. The majority of the loans sold by the Company have been sold to either Fannie Mae or Freddie Mac. These loans must conform to established Freddie Mac/Fannie Mae underwriting criteria, including a maximum dollar limit, maturities that vary from five to 30 years, loan-to-value ratios of 80% or less (90% or less with mortgage insurance), adequate borrower liquidity, and the ability of the borrower to service the mortgage debt (and all other debt) out of income. Loans sold to other investors, such as savings and loans, insurance companies and other conduits, usually are for dollar amounts in excess of the Freddie Mac/Fannie Mae limit, but otherwise generally meet standard Freddie Mac/Fannie Mae underwriting criteria. As part of its mortgage banking activities, the Company enters into forward commitments to sell mortgage loans, either in the form of mortgage-backed securities ("MBS") or as whole loans. These commitments may be optional or mandatory. Under optional commitments, a commitment fee is paid and the Company carries no risk in excess of the loss of such fee in the event that the Company is unable to deliver sufficient mortgage loans to fulfill the commitment. Mandatory commitments may entail possible financial risk to the Company if it is unable to deliver mortgage loans in sufficient quantity or at sufficient rates to meet the terms of the commitments. In order to minimize the risk that a change in interest rates will result in a decrease in the value of the Company's current mortgage loan inventory or its commitments to purchase or originate mortgage loans ("committed pipeline"), the Company enters into hedging transactions. The Company's hedging policies generally require that its inventory of mortgage loans held for sale and the maximum portion of its committed pipeline that may close be hedged with forward sales of MBS or options to buy or sell mortgage-backed or U.S. Treasury securities. As such, the Company is not exposed to significant risk nor will it derive any significant benefit from changes in interest rates on the price of the mortgage loan inventory net of gains or losses of associated hedge positions. The correlation between the price performance of the hedge instruments and the inventory being hedged is very high due to the similarity of the asset and the related hedge instrument. The Company is exposed to interest- rate risk to the extent that the portion of loans from the committed pipeline that actually closes at the committed price is less than the portion expected to close in the event of a decline in rates, and in the event such decline in closings is not covered by forward contracts and options to purchase MBS needed to replace the loans in process that do not close at their committed price. The Company determines the portion of its committed pipeline that it will hedge based on numerous factors, including the composition of the Company's committed pipeline, the portion of such committed pipeline likely to close, the timing of such closings and the current interest rate environment. The following lists the notional amounts of the various hedging instruments outstanding at December 31, 1995 and the date through which exercise dates extend: 12
Exercise Dates Notional Amount Extend Through - ------------------------------------------------------------------------------- (IN THOUSANDS) Forward contracts to sell MBS $ 12,770 February 1996 Purchased put options- MBS 30,000 April 1996 U.S. Treasury 80,000 March 1996 Purchased call options- U.S. Treasury 25,000 March 1996 Written call options- MBS 80,000 February 1996 Written put options- U.S. Treasury 20,000 March 1996 - ------------------------------------------------------------------------------ - ------------------------------------------------------------------------------
MORTGAGE LOAN SERVICING. Mortgage loan servicing includes the collection and remittance of loan payments, accounting for principal and interest, holding escrow (impound) funds for payment of taxes and insurance, making inspections of the mortgage premises when required, collection of past due amounts from delinquent mortgagors, supervision of foreclosures in the event of unremedied defaults, and general administration of the loans, either for the Company or for the investors to whom the loans have been sold. The amounts of impound payments held by the Company for others totalled $2,809,000, $2,407,000, and $1,721,000 on December 31, 1995, 1994 and 1993, respectively. Servicers of loans sold to Freddie Mac or Fannie Mae generally receive a loan servicing fee of at least .25% per annum on the declining principal balance of the loans being serviced, but the actual fee can be higher depending upon the coupon rate of the loans being serviced and the actual pass-through rate paid to the investor. Servicing fees for other investors can vary according to market conditions at the time the loan is sold. In general, the value of the Company's loan servicing portfolio may be adversely affected by declining mortgage interest rates and increasing loan prepayments. Income generated from the portfolio may also decline in such an environment. In a low interest rate environment, the rate at which mortgage loans are prepaid tends to increase as borrowers refinance their loans. A high level of prepayments for an extended period of time could have an adverse effect on the value of the Company's PMSR pools, the level of the Company's outstanding loan portfolio, and the size of its mortgage loan servicing portfolio. Additionally, the Company's decision to sell servicing rights, and the timing of such sales, may affect the Company's earnings on a quarter-to-quarter basis. Certain factors, including demand and prepayment, delinquency and foreclosure rates, could have an adverse effect on the Company's ability to sell servicing rights and the value of those rights. In a rising interest rate environment, prepayments of loans decrease and the value of the Company's loan servicing portfolio will decline at a slower rate. The following table sets forth the dollar amounts of the Company's mortgage loan servicing portfolio at the dates indicated, the portion of the Company's loan servicing portfolio resulting from loan originations and purchases and the carrying value as a percentage of loans serviced.
Year Ended December 31, 1995 1994 1993 - ------------------------------------------------------------------------------- (IN THOUSANDS) Loans originated by the Company and sold $ 266,712 $ 92,230 $ 888,289 Loans underlying purchased mortgage servicing rights 772,626 863,426 198,540 - ------------------------------------------------------------------------------- Total $1,039,338 $ 955,656 $1,086,829 - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- Purchased and originated mortgage servicing rights $ 5,970 $ 6,270 $ 1,439 Purchased and originated mortgage servicing rights as a percentage of loans serviced .57% .66% .13% - ------------------------------------------------------------------------------- - -------------------------------------------------------------------------------
Since 1989, the Company has sold most of its mortgage banking loans on a servicing released basis. Servicing on the loans sold to Freddie Mac and Fannie Mae was sold to third parties, and servicing on the other mortgage banking loans was sold, with the loans, to the investors. During the second half of 1993, the Company retained the servicing rights on a greater portion of the mortgage banking loans which it originated. Management may from time to time determine to sell the Company's mortgage loans on a servicing released basis based on market conditions. The Company sells loan servicing rights to offset the cost of originating mortgage loans. The amount of loan servicing rights sold annually by the Company may vary because of market fluctuations in the pricing of loan servicing rights, and the amount of gain upon sale of servicing rights may vary significantly from period to period. In 1995 and 1994, the Company sold a portion of its originated servicing rights on a bulk basis for gains of $149,000 and $10,150,000; no bulk servicing sales occurred in 1993. The Company also purchases mortgage servicing rights ("PMSR") in order to better utilize its servicing capabilities and to take advantage of market prices which management believed to be favorable. The amounts the Company pays for the rights to service loans are carried on the Company's statement of financial condition as intangible assets and are amortized in proportion to, and over the estimated life of, the related pools of mortgage loans using a method approximating the interest method. The Company's carrying values of purchased mortgage servicing rights, and the amortization thereon, are evaluated quarterly, by portfolios, and such carrying values are adjusted for indicated impairments based on management's best estimate of the remaining cash flows. Such estimates may vary from the actual remaining cash flows due to unanticipated prepayments of the underlying mortgage loans and increases in servicing costs. The Company's carrying values of purchased mortgage servicing rights do not purport to represent the amount that would be realizable by a sale of these assets in the open market. The prepayment rates of the Company's PMSR pools ranged between 7% and 33% during 1995 and between 22% and 42% during 1994. The Company's PMSR amortization, including valuation adjustments, totalled $1,877,000 for 1995, $1,024,000 for 1994, and $1,105,000 for 1993. The amortized values of the Company's PMSR pools were $4,494,000, $6,270,000, and $1,439,000 at December 31, 1995, 1994 and 1993, respectively. 13 The Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 122 "Accounting for Mortgage Servicing Rights," an amendment of SFAS No. 65 in May 1995. SFAS No. 122 requires a mortgage banking enterprise that purchases or originates mortgage loans with a definitive plan to sell or securitize those loans and retain the mortgage servicing rights to allocate the cost of the mortgage loans based on the relative fair values of the mortgage loans and mortgage servicing rights at the date of purchase or origination. Prior to SFAS No. 122, originated mortgage servicing rights were not recognized for financial statement purposes with the entire cost of the mortgage loan being allocated to the loan. The Company early adopted SFAS No. 122 on January 1, 1995 as permitted. The effect of adoption on the 1995 statement of operations was to increase gain on sale of loans by $1,830,000 and net income by $857,000 ($.27 per fully-diluted share). SFAS No. 122 prohibited the restatement of results for prior years. Originated mortgage servicing rights of $1,476,000 arising in 1995 are included in mortgage servicing rights on the balance sheet at December 31, 1995. ASSET QUALITY The Company attempts to minimize credit risk through its underwriting and credit review policies. The Company conducts its own internal credit review processes and, in addition, contracts with an independent loan reviewer who performs monthly reviews of new loans and potential problem loans that meet predetermined parameters. The Boards of Directors of both Allied and NBR have internal asset review committees which review the asset quality of new and problem loans on a monthly basis and report their findings to their full Boards. In management's opinion, this loan review system facilitates the early identification of potential problem loans. The performance of the Company's loan portfolio is evaluated regularly by management. The Company places a loan on nonaccrual status when one of the following events occurs: any installment of principal or interest is 90 days or more past due (unless, in management's opinion, the loan is well secured and in the process of collection); management determines the ultimate collection of principal of or interest on a loan to be unlikely; or the terms of a loan have been renegotiated to less than market rates due to a serious weakening of the borrower's financial condition. With respect to the Company's policy of placing loans 90 days or more past due on nonaccrual status unless the loan is well secured and in the process of collection, a loan is considered to be in the process of collection if, based on a probable specific event, it is expected that the loan will be repaid or brought current. Generally, this collection period would not exceed 30 days. When a loan is placed on nonaccrual status, the Company's general policy is to reverse and charge against current income previously accrued but unpaid interest. Interest income on such loans is subsequently recognized only to the extent that cash is received and future collection of principal is deemed by management to be probable. Where the collectibility of the principal of or interest on a loan is considered to be doubtful by management, it is placed on nonaccrual status prior to becoming 90 days delinquent. On January 1, 1995, the Company adopted SFAS No. 114 "Accounting by Creditors for Impairment of a Loan" and SFAS No. 118, "Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosure." These statements address the accounting and reporting by creditors for impairment of certain loans. In general, a loan is impaired when, based upon current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. These statements are applicable to all loans, uncollateralized as well as collateralized, except loans that are measured at the lower of cost or fair value. Impairment is measured based on the present value of expected future cash flows discounted at the loan's effective interest rate, except that as a practical expedient, the Company measures impairment based on a loan's observable market price or the fair value of the collateral if the loan is collateral dependent. Loans are measured for impairment as part of the Company's normal internal asset review process. The effect of adopting SFAS 114 was not material to the Company's 1995 balance sheet or statement of operations. Interest income is recognized on impaired loans in a manner similar to that of all loans. It is the Company's policy to place loans that are delinquent 90 days or more as to principal or interest on nonaccrual status unless secured and in the process of collection, and to reverse from current income accrued but uncollected interest. Cash payments subsequently received on nonaccrual loans are recognized as income only where the future collection of principal is considered by management to be probable. At December 31, 1995 the Company's total recorded investment in impaired loans was $5,202,000 of which $3,515,000 relates to the recorded investment for which there is a related allowance for credit losses of $425,000 determined in accordance with these statements and $1,687,000 relates to the amount of that recorded investment for which there is no related allowance for credit losses determined in accordance with these statements. The average recorded investment in impaired loans during the year ended December 31, 1995 was $5,196,000. The related amount of interest income recognized during the period that such loans were impaired was $187,000. No interest income was recognized using a cash-basis method of accounting during the period that the loans were impaired. Interest due but excluded from interest income on loans placed on nonaccrual status was $485,000, $236,000 and $193,000 for the years ended December 31, 1995, 1994 and 1993. Interest income received on nonaccrual loans was $554,000, $166,000 and $43,000 for the years ended December 31, 1995, 1994 and 1993. The following table sets forth the amount of the Company's nonperforming assets as of the dates indicated. 14
December 31, 1995 1994 1993 1992 1991 - ------------------------------------------------------------------------------------------------------------------------ (IN THOUSANDS) Nonaccrual loans $4,201 $2,314 $3,964 $4,133 $2,049 Accruing loans past due 90 days or more 92 2,767 131 15 391 Restructured loans (in compliance with modified terms) 651 432 152 - ------------------------------------------------------------------------------------------------------------------------ Total nonperforming loans 4,944 5,513 4,247 4,148 2,440 Other real estate owned 963 1,814 3,633 2,184 1,397 Other assets owned 1,249 1,133 250 - ------------------------------------------------------------------------------------------------------------------------ Total nonperforming assets $7,156 $8,460 $8,130 $6,332 $3,837 - ------------------------------------------------------------------------------------------------------------------------ - ------------------------------------------------------------------------------------------------------------------------ Nonperforming loans to total loans 1.34% 1.43% 2.02% 2.24% 1.68% Nonperforming assets to total assets 1.28 1.34 1.72 1.94 1.63 Allowance for loan losses to nonperforming assets 70.39 68.40 64.07 68.22 63.62 Allowance for loan losses to nonperforming loans 101.88 104.97 122.65 104.15 100.04 - ------------------------------------------------------------------------------------------------------------------------ - ------------------------------------------------------------------------------------------------------------------------
Nonperforming assets were $7,156,000, or 1.28% of total assets, as of December 31, 1995, compared to $8,460,000, or 1.34% of total assets, as of December 31, 1994. Nonperforming loans totaled $4,944,000 at December 31, 1995, consisting of $2,361,000 that were secured by residential real estate, $167,000 secured by commercial real estate and the remaining $2,416,000 were either unsecured or collateralized by various business assets, other than real estate. Other real estate owned totaled $963,000 at December 31, 1995, consisting of $344,000 in commercial real estate properties and $619,000 in residential properties. Other assets owned were contract receivable rights and repossessed personal property valued at $1,249,000. Although the volume of nonperforming assets will depend on the future economic environment, management of the Company has identified approximately $2.7 million in potential nonperforming loans, in addition to the above mentioned assets, as to which it has serious doubts as to the ability of the borrowers to comply with the present repayment terms and which may become nonperforming assets, based on known information about possible credit problems of the borrower. The following table provides certain information for the years indicated with respect to the Company's allowance for loan losses as well as charge-off and recovery activity. 15
Year Ended December 31, 1995 1994 1993 1992 1991 - ------------------------------------------------------------------------------------------------------------------- (in thousands) Balance at beginning of period $5,787 $5,209 $4,320 $2,441 $1,367 - ------------------------------------------------------------------------------------------------------------------- CHARGE-OFFS: Residential real estate mortgage: 304 434 334 324 42 Commercial real estate mortgage 14 57 55 34 295 Commercial 1,985 593 347 473 404 Real estate construction 32 51 23 Installment and other 147 86 91 79 60 - ------------------------------------------------------------------------------------------------------------------- Total charge-offs 2,450 1,202 827 961 824 - ------------------------------------------------------------------------------------------------------------------- RECOVERIES: Residential real estate mortgage 25 39 12 Commercial real estate mortgage 3 25 Commercial 84 8 101 32 Installment and other 1 1 3 - ------------------------------------------------------------------------------------------------------------------- Total recoveries 110 51 37 104 32 - ------------------------------------------------------------------------------------------------------------------- Net charge-offs 2,340 1,151 790 857 792 Reserves acquired from Lake 464 Reserves acquired from Codding 634 Provision for loan losses 1,590 1,095 1,679 2,272 1,866 - ------------------------------------------------------------------------------------------------------------------- Balance at end of period $5,037 $5,787 $5,209 $4,320 $2,441 - ------------------------------------------------------------------------------------------------------------------- - ------------------------------------------------------------------------------------------------------------------- Net charge-offs during the year to average loans .60% .40% .40% .53% .57% Allowance for loan losses to total loans 1.37 1.50 2.48 2.33 1.68 Allowance for loan losses to nonperforming loans 101.88 104.97 122.65 104.15 100.04 - ------------------------------------------------------------------------------------------------------------------- - -------------------------------------------------------------------------------------------------------------------
Net charge-offs increased to $2,340,000 in 1995 primarily due to $1,446,000 in charge-offs related primarily to three separate borrowers. The allowance for loan losses is established through charges to earnings in the form of the provision for loan losses. Loan losses are charged to, and recoveries are credited to, the allowance for loan losses. The provision for loan losses is determined after considering various factors such as loan loss experience, current economic conditions, maturity of the portfolio, size of the portfolio, industry concentrations, borrower credit history, the existing allowance for loan losses, independent loan reviews, current charges and recoveries to the allowance for loan losses, and the overall quality of the portfolio, as determined by management, regulatory agencies, and independent credit review consultants retained by the Company. The adequacy of the Company's allowance for loan losses is based on specific and formula allocations to the Company's loan portfolio. Specific allocations of the allowance for loan losses are made to identified problem or potential problem loans. The specific allocations are increased or decreased through management's reevaluation of the status of the particular problem loans. Loans which do not receive a specific allocation receive an allowance allocation based on a formula, represented by a percentage factor based on underlying collateral, type of loan, historical charge-offs and general economic conditions, which is applied against the general portfolio segments. At December 31, 1995, 1994 and 1993, the allowance for loan losses was $5,037,000, $5,787,000 and $5,209,000, respectively, which represented 1.37%, 1.50%, and 2.48% of total loans for the respective years. The ratio of the allowance for loan losses to loans reflects the blended ratios of Redwood's two financial institution subsidiaries, Allied and NBR. It is the policy of management to make additions to the allowance for loan losses so that it remains adequate to cover anticipated charge-offs, and management believes that the allowance at December 31, 1995 is adequate. However, the determination of the amount of the allowance is judgmental and subject to economic conditions which cannot be predicted with certainty. Accordingly, the Company cannot predict whether charge-offs of loans in excess of the allowance may be required in future periods. The provision for loan losses reflects an accrual sufficient to cover projected probable charge-offs and the maintenance of the allowance at a level deemed adequate to absorb potential future losses. The table below sets forth the allocation of the allowance for loan losses by loan type as of the dates specified. The allocation of individual categories of loans includes amounts applicable to specifically identified as well as unidentified losses inherent in that segment of the loan portfolio and will necessarily change whenever management determines that the risk characteristics of the loan portfolio have changed. Management believes that any breakdown or allocation of the allowance for loan losses into loan categories lends an appearance of exactness which does not exist, in that the allowance is utilized as a single unallocated allowance available for all loans and undisbursed commitments. The allocation below should not be interpreted as an indication of the specific amounts or loan categories in which future charge-offs may occur. 16
December 31, 1995 1994 1993 1992 1991 - ----------------------------------------------------------------------------------------------------------------------------------- ALLOWANCE Allowance Allowance Allowance Allowance FOR % OF for % of for % of for % of for % of LOSSES LOANS Losses Loans Losses Loans Losses Loans Losses Loans - ----------------------------------------------------------------------------------------------------------------------------------- (DOLLARS IN THOUSANDS) Residential real estate mortgage $1,922 45% $2,231 57% $1,770 49% $ 1,346 45% $290 24% Commercial real estate mortgage 664 18 728 16 455 17 318 13 289 14 Commercial 1,082 17 1,441 17 1,488 23 1,294 26 1,051 36 Real estate construction 1,210 19 723 9 702 10 504 11 531 18 Installment and other 118 1 336 1 119 1 227 5 137 8 Unallocated 41 328 675 631 143 - ----------------------------------------------------------------------------------------------------------------------------------- Total $5,037 100% $5,787 100% $5,209 100% $ 4,320 100% $2,441 100% - ---------------------------------------------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------------------------------------------
ASSET/LIABILITY MANAGEMENT The fundamental objective of the Company's management of its assets and liabilities is to maximize the economic value of the Company while maintaining adequate liquidity and an exposure to interest rate risk deemed by management to be acceptable. Management believes an acceptable degree of exposure to interest rate risk results from the management of assets and liabilities through maturities, pricing and mix to attempt to neutralize the potential impact of changes in market interest rates. The principal sources of asset liquidity are federal funds sold and loans held for sale. Secondary sources of liquidity are loan repayments, investments available for sale, maturing investments, and investments that can be used as collateral for other borrowings. At December 31, 1995, the Company had $9,969,000 in federal funds sold and $62,620,000 in loans held for sale. Total investments were $43,964,000, of which $11,607,000 were pledged. Liability-based liquidity includes interest-bearing and noninterest bearing retail deposits, which are a relatively stable source of funds, time deposits from financial institutions throughout the United States, federal funds purchased, and other short-term and long-term borrowings, some of which are collateralized. The Company obtains collateralized FHLB advances solely through Allied. Management uses FHLB advances as part of its funding strategy because the rates paid for those advances are generally lower than the rates paid on deposits. FHLB advances must be collateralized by the pledging of qualified mortgage loans of Allied. Allied's FHLB borrowing limitation at December 31, 1995 was $80 million, which equaled approximately 25% of Allied's total assets at December 31, 1995, compared to $145 million, or 35% of Allied's total assets, at December 31, 1994. At December 31, 1995, Allied had $23,000,000 in FHLB advances outstanding, as compared to $97,150,000 at December 31, 1994. As an integral part of its funding strategy, the Company will consider alternatives to FHLB advances while seeking to increase its maximum borrowing limits from the FHLB as Allied's total assets increase from time to time. There is no assurance, however, that the Company will be able to continue to obtain additional increases in its FHLB borrowing authority, or that the rates paid on such advances will be advantageous in the future. If additional increases are not obtained, the Company's cost of funds could increase, as the Company may be required to raise interest rates offered on deposit programs in order to retain deposits in both the retail and wholesale markets to fund its mortgage banking operations. Time deposits from other financial institutions totalled $47.9 million, or 10% of total deposits, at December 31, 1995, a decrease of $34.7 million from the $82.6 million recorded at December 31, 1994, which amounted to 18% of total deposits at that time. These deposits are used to supplement liquidity when the Company determines that deposits from local sources would be more expensive. The Company is able to retain such deposits at favorable rates when desired. The volume of these deposits are dependent on anticipated mortgage origination volumes. The following table sets forth, as of December 31, 1995, the distribution of repricing opportunities for the Company's earning assets and interest-bearing liabilities, the interest rate sensitivity gap, the cumulative interest rate sensitivity gap, the interest rate sensitivity gap ratio (i.e., earning assets divided by interest-bearing liabilities) and the cumulative interest rate sensitivity gap ratio. 17
After Three After Six After One Within Months But Months But Year But Three Within Within Within After Months Six Months One Year Five Years Five Years Total - ---------------------------------------------------------------------------------------------------------------------------------- (IN THOUSANDS) Earning assets: Federal funds sold $ 9,969 $ 9,969 Investment securities and other 10,468 $ 3,014 $ 13,903 $ 6,041 $ 10,538 43,964 Mortgage loans held for sale 62,620 62,620 Loans 154,373 78,442 66,358 38,051 31,000 368,224 - ---------------------------------------------------------------------------------------------------------------------------------- Total earning assets 237,430 81,456 80,261 44,092 41,538 484,777 - ---------------------------------------------------------------------------------------------------------------------------------- Interest-bearing liabilities: Interest-bearing transaction accounts 129,436 129,436 Time deposits 97,301 54,869 57,300 53,885 263,355 Other borrowings 47,871 47,871 Subordinated notes 12,000 12,000 - ---------------------------------------------------------------------------------------------------------------------------------- Total interest-bearing liabilities 274,608 54,869 57,300 53,885 12,000 452,662 - ---------------------------------------------------------------------------------------------------------------------------------- Interest rate sensitivity gap $ (37,178) $ 26,587 $ 22,961 $ (9,793) $ 29,538 $ 32,115 - ---------------------------------------------------------------------------------------------------------------------------------- Cumulative interest rate sensitivity gap $ (37,178) $(10,591) $ 12,370 $ 2,577 $ 32,115 - ---------------------------------------------------------------------------------------------------------------------------------- Interest rate sensitivity gap ratio .86 1.48 1.40 .82 3.46 Cumulative interest rate sensitivity gap ratio .86 .97 1.03 1.01 1.07 - ---------------------------------------------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------------------------------------------
The Company's gap position is substantially dependent upon the volume of mortgage loans held for sale and held in the portfolio. These loans generally have maturities greater than five years; however, mortgage loans held for sale are generally sold within 5 to 60 days of funding and therefore are classified in the above table as repricing within three months. The Company enters into commitments to sell such loans on a forward basis, usually within 30 to 60 days. The amount of loans held for sale and the amount of forward commitments can fluctuate significantly from period to period. Additionally, interest-bearing transaction accounts, which consist of money market, demand and savings deposit accounts, are classified as repricing within three months. Some of these deposits may be repriced at management's option, and therefore a decision not to reprice such deposits could significantly alter the Company's gap position. Management expects that, in a declining rate environment, the Company's net interest margin would be expected to decline, and, in an increasing rate environment, the Company's net interest margin would tend to increase. The Company has experienced greater mortgage lending activity through mortgage refinancings and financing new home purchases as rates declined, and may increase its net interest margins in an increasing rate environment if more traditional commercial bank lending becomes a higher percentage of the overall earning assets mix. There can be no assurance, however, that under such circumstances the Company will experience the described relationships to declining or increasing interest rates. In 1994, the net interest margin decreased due to higher funding costs associated with mortgage originations. This was coupled with teaser rates on new fundings, the flattened yield curve and the increase in funding from FHLB advances rather than deposits, all of which caused the net interest margin to decline. The following table shows the maturity distribution of the Company's commercial and real estate construction loans outstanding as of December 31, 1995, which, based on remaining scheduled repayments of principal, were due within the periods indicated.
After One Within Through After One Year Five Years Five Years Total - ---------------------------------------------------------------------------------------------------- (IN THOUSANDS) Commercial $28,467 $26,586 $8,922 $ 63,975 Real estate construction 66,096 3,408 69,504 - ---------------------------------------------------------------------------------------------------- Total $94,563 $29,994 $8,922 $133,479 - ---------------------------------------------------------------------------------------------------- - ---------------------------------------------------------------------------------------------------- Loans with fixed interest rates $37,171 $ 9,472 $3,817 $ 50,460 Loans with variable interest rates 57,392 20,522 5,105 83,019 - ---------------------------------------------------------------------------------------------------- Total $94,563 $29,994 $8,922 $133,479 - ---------------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------------
18 LIQUIDITY Liquidity management is monitored by Redwood, as well as by Allied and NBR. Redwood's operations generate debt service costs and administrative costs associated with regulatory reporting and overall planning, which may include acquisition or merger costs. Aside from accessing the capital markets, Redwood's primary source of liquidity is dividends from its financial institution subsidiaries, which amounted to $1,087,000 in 1995 and $600,000 for 1994. Redwood's subsidiaries did not pay dividends during 1993. It is Redwood's general policy to retain excess capital at its subsidiaries, maintaining Redwood's available capital at a level which Redwood's management believes to be consistent with the safety and soundness of the Company as a whole. As of December 31, 1995, Redwood held $1,623,000 in interest-bearing deposits at its subsidiaries and a $3,000,000 subordinated note issued by NBR. At December 31, 1995, NBR could pay additional dividends to the Company of approximately $4,328,000 without prior regulatory approval and Allied could pay additional dividends of approximately $2,329,000. Management believes that at December 31, 1995, the Company's liquidity position was adequate for the operations of Redwood and its subsidiaries for the forseeable future. In order to enhance the Company's liquidity position, Redwood suspended the payment of its quarterly dividend to common shareholders in the fourth quarter of 1994. In the prior three quarters of 1994, Redwood had declared dividends totaling $.105 per common share. CAPITAL A strong capital base is essential to the Company's continued ability to service the needs of its customers. Capital protects depositors and the deposit insurance fund from potential losses and is a source of funds for the substantial investments necessary for the Company to remain competitive. In addition, adequate capital and earnings enable the Company to gain access to the capital markets to supplement its internal growth of capital. Capital is generated internally primarily through earnings retention. In 1993, the Company issued 575,000 shares of 7.80% Noncumulative Convertible Perpetual Preferred Stock, Series A. The preferred stock is convertible, at the option of the holder, into .8674 shares of common stock for each share of preferred stock. The preferred stock may be redeemed after February 15, 1996, at the option of the Company, at redemption prices which range from $10.55 at February 15, 1996 to $10.00 after February 14, 2003. The preferred stock has a liquidation preference of $10.00. At the end of 1993, Redwood issued $12 million in long-term debt which qualifies as supplemental capital under government capital regulations. The debt issued was at an interest rate of 8.5% and matures in January 2004. See Notes N and O to the Consolidated Financial Statements. The Company and each of its principal subsidiaries are required to maintain minimum capital ratios defined by various federal government regulatory agencies. The FRB, the OCC and the OTS have each established capital guidelines, which include minimum capital requirements. The regulations impose three sets of standards: a "risk-based", "leverage" and "tangible" capital standard. Under the risk-based capital standard, assets reported on an institution's balance sheet and certain off-balance sheet items are assigned to risk categories, each of which is assigned a risk weight. This standard characterizes an institution's capital as being "Tier 1" capital (defined as principally comprising shareholders' equity and noncumulative preferred stock) and "Tier 2" capital (defined as principally comprising the allowance for loan losses and subordinated debt). At December 31, 1993, 1994 and 1995, the Company and its subsidiaries were required to maintain a total risk-based capital ratio of 8%, including a Tier 1 capital ratio of at least 4%. Under the leverage capital standard, an institution must maintain a specified minimum ratio of Tier 1 capital to total assets, with the minimum ratio ranging from 4% to 6%. The minimum core capital ratio for Allied is 4% and is based on period end assets while the leverage ratio for the Company and NBR is based on average assets for the quarter. Allied is subject to a minimum tangible capital ratio of 1.5% of adjusted total assets. It is anticipated that Allied will be subject to an OTS regulation issued in August, 1993 that added an interest rate risk component to the risk- based capital requirements of thrifts. The original effective date was to be December 31, 1993 and the regulation has been postponed several times. The effective date has now been postponed indefinitely until the OTS evaluates the effectiveness of its appeals process. Under the proposed regulation, those thrifts that have an above normal interest rate risk exposure must take a deduction from the total capital available to meet their risk-based capital requirement. This deduction will be equal to one-half of the difference between the thrift's actual measured exposure and the normal level of exposure. The actual deduction taken at any quarter end is equal to the lowest amount calculated for the three quarters prior to the reporting date. A thrift's actual measured interest risk is expressed as the change that occurs in its net portfolio value ("NPV") as a result of an immediate 200 basis point increase or decrease in interest rates (whichever results in the lower NPV) divided by the estimated economic value of its assets, as calculated in accordance with OTS instructions. An above normal decline in NPV is one that exceeds 2% of the estimated economic value of its assets. NBR and Allied maintain insurance on its customer deposits with the Federal Deposit Insurance Corporation ("FDIC"). The FDIC manages the Bank Insurance Fund ("BIF"), which insures deposits of commercial banks such as NBR, and the Savings Association Insurance Fund ("SAIF"), which insures deposits of savings associations such as Allied. FDICIA mandated that the two funds maintain reserves at 1.25% of their respective federally insured deposits. During 1995, the FDIC announced that the BIF had reached its mandated reserve level, reducing insurance premiums on BIF-insured deposits, and subsequently announcing that deposit insurance premiums on BIF-insured deposits would be reduced at December 31, 1995. The SAIF fund has not yet met its mandated reserve level. As a result, deposit insurance premiums attributable to BIF deposits are less than those attributable to SAIF deposits. There are numerous regulatory proposals before Congress to address the deposit insurance premium differential between BIF- and SAIF-insured deposits. The most recent plans consist of one-time insurance premium charges attributable to SAIF- insured deposits sufficient to 19 bring the SAIF up to its mandated reserve level, with a corresponding and immediate reduction in SAIF premiums thereafter. Based on 87 basis points on Allied's deposits at March 31, 1995, the resulting after-tax charge to the Company would be approximately $1,670,000. As both the timing and final form of any proposed regulations remain uncertain, no adjustments to the Company's financial statements have been recorded at December 31, 1995. The table below shows the capital ratios for the Company and its subsidiaries at December 31, 1995.
Company NBR Allied - ---------------------------------------------------------------------------- Total capital to risk based assets 11.68% 12.19% 10.47% Tier 1 capital to risk based assets 7.24 9.41 9.22 Leverage ratio 5.14 7.47 N/A Tangible ratio N/A N/A 6.26 - ---------------------------------------------------------------------------- - ----------------------------------------------------------------------------
In addition to these capital guidelines, the Federal Deposit Insurance Act of 1991 required each federal banking agency to implement a regulatory framework for prompt corrective actions for insured depository institutions that are not adequately capitalized. The Board of Governors of the Federal Reserve System, FDIC, OCC and OTS have adopted regulations which became effective on December 19, 1992, 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. The regulations establish five capital categories with the following characteristics:
Total Tier 1 Risk Based Risk Based Leverage Capital Ratio Capital Ratio Ratio - -------------------------------------------------------------------------- "WELL CAPITALIZED" - THE institution is not subject to an order, written agreement, capital directive or prompt corrective action directive at least 10% at least 6% at least 5% - ------------------------------------------------------------------------------- "ADEQUATELY CAPITALIZED" - the institution does not meet the definition of a well- capitalized institution at least 8% at least 4% at least 4% - ------------------------------------------------------------------------------- "UNDERCAPITALIZED" less than 8% less than 4% less than 4% - ------------------------------------------------------------------------------- "SIGNIFICANTLY UNDERCAPITALIZED" less than 6% less than 3% less than 3% - ------------------------------------------------------------------------------- "critically undercapitalized" - the institution has a ratio of tangible equity to total assets of 2% or less
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 of the three "undercapitalized" categories, such as the declaration of the 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) limitation 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 segment capital; (2) restriction 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 purpose of the regulations. Under the most stringent capital requirement, the Company has approximately $6,589,000 in excess capital before it becomes under-capitalized. Similarly, Allied has approximately $4,657,000 and NBR has $7,697,000 in excess capital. 20 QUARTERLY RESULTS
UNAUDITED QUARTERLY STATEMENTS OF OPERATIONS DATA (in thousands) Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 1994 1994 1994 1994 1995 1995 1995 1995 - ---------------------------------------------------------------------------------------------------------------------------------- Net interest income $ 3,656 $ 4,120 $ 4,449 $ 5,114 $ 4,612 $ 4,692 $ 4,823 $ 5,576 Provision for credit losses 245 270 291 289 300 370 385 535 Other operating income 5,468 4,984 1,931 (1,498) 4,433 4,121 3,525 4,496 Other operating expense 7,262 7,488 8,046 9,227 7,197 7,077 6,957 7,785 - ---------------------------------------------------------------------------------------------------------------------------------- Income (loss) before income taxes 1,617 1,346 (1,957) (5,900) 1,548 1,366 1,006 1,752 Provision (benefit) for income taxes 691 607 (992) (2,165) 637 604 391 727 Net income (loss) $ 926 $ 739 $ (965) $(3,735) $ 911 $ 762 $ 615 $1,025 - ---------------------------------------------------------------------------------------------------------------------------------- - ---------------------------------------------------------------------------------------------------------------------------------- Net income (loss) available for common stock $ 814 $ 627 $(1,077) $(3,847) $ 799 $ 650 $ 503 $1,025 Per share: Primary earnings (loss) $ .29 $ .22 $ ( .40) $ (1.45) $ .30 $ .24 $ .19 $ .38 Fully-diluted earnings (loss) .28 .22 (.40) (1.45) .29 .24 .19 .32 Common dividend .035 .035 .035 Common Stock Prices: High $14.63 $ 13.88 $ 13.38 $ 10.50 $ 7.25 $ 9.25 $ 10.13 $ 9.38 Low 11.75 12.25 10.50 7.00 5.75 6.38 7.25 7.50 Close 13.25 13.50 10.50 7.13 6.75 8.50 8.88 8.00 - ---------------------------------------------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------------------------------------------
Net income in the fourth quarter of 1995 increased $4,760,000 compared to the same quarter in 1994 primarily due to increased gains on sales of loans and securities partially offset by increased loan loss and income tax provisions. The net loss recorded in the fourth quarter of 1994 included a $5,534,000 valuation allowance on mortgage loans held for sale and a restructuring charge of $1,594,000. The results for the first quarter of 1995 were restated to reflect the adoption of SFAS No. 122 as of January 1, 1995, accounting for an additional $167,000 ($.05 per fully-diluted share) in the first quarter. 21 INDEPENDENT AUDITORS' REPORT To the Board of Directors and Shareholders of Redwood Empire Bancorp Santa Rosa, California We have audited the accompanying consolidated balance sheets of Redwood Empire Bancorp and subsidiaries (Company) as of December 31, 1995 and 1994 and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1995. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. 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, such consolidated financial statements present fairly, in all material respects, the financial position of Redwood Empire Bancorp and subsidiaries at December 31, 1995 and 1994, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1995, in conformity with generally accepted accounting principles. As discussed in Note B to the consolidated financial statements, the Company changed its method of accounting for originated mortgage servicing rights effective January 1, 1995 to conform with Statement of Financial Accounting Standards No. 122. DELOTTE TOUCHE LLP January 24, 1996 22 FINANCIAL STATEMENTS CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS EXCEPT PER SHARE DATA)
Year Ended December 31, 1995 1994 1993 - --------------------------------------------------------------------------------------- Interest income: Interest and fees on loans $42,469 $35,454 $25,709 Interest on investment securities 3,187 1,381 1,040 Interest on federal funds sold 1,581 1,006 592 Interest on time deposits due from financial institutions 137 164 124 - --------------------------------------------------------------------------------------- Total interest income 47,374 38,005 27,465 - --------------------------------------------------------------------------------------- Interest expense: Interest on deposits 22,730 14,918 11,545 Interest on other borrowings 3,841 4,617 931 Interest on subordinated notes 1,100 1,131 9 - --------------------------------------------------------------------------------------- Total interest expense 27,671 20,666 12,485 - --------------------------------------------------------------------------------------- Net interest income 19,703 17,339 14,980 Provision for loan losses 1,590 1,095 1,679 - --------------------------------------------------------------------------------------- Net interest income after provision for loan losses 18,113 16,244 13,301 - --------------------------------------------------------------------------------------- Other operating income: Service charges on deposit accounts 1,148 1,009 1,085 Merchant draft processing, net 1,505 1,168 697 Loan servicing income 1,625 1,943 981 Net realized gains (losses) on sale of investment securities available for sale 386 (24) 242 Gain on sale of loans and loan servicing 10,195 5,448 15,637 Other income 1,716 1,341 535 - --------------------------------------------------------------------------------------- Total other operating income 16,575 10,885 19,177 - --------------------------------------------------------------------------------------- Other operating expense: Salaries and employee benefits 14,368 14,147 12,533 Occupancy and equipment expense 5,544 5,025 3,237 Restructuring charge (456) 2,409 Other 9,560 10,442 8,845 - --------------------------------------------------------------------------------------- Total other operating expense 29,016 32,023 24,615 - --------------------------------------------------------------------------------------- Income (loss) before income taxes 5,672 (4,894) 7,863 Provision (benefit) for income taxes 2,359 (1,859) 3,299 - --------------------------------------------------------------------------------------- Net income (loss) 3,313 (3,035) 4,564 Dividends on preferred stock 336 448 432 - --------------------------------------------------------------------------------------- Net income (loss) available for common stockholders $ 2,977 $(3,483) $ 4,132 - --------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------- Earnings per common and common equivalent share: Primary net income (loss) per share $ 1.11 $ (1.31) $ 1.54 Fully diluted net income (loss) per share 1.04 (1.31) 1.44 Dividends per common share .105 .125 - --------------------------------------------------------------------------------------- - ---------------------------------------------------------------------------------------
See Notes to Consolidated Financial Statements. 23 CONSOLIDATED BALANCE SHEET
December 31, 1995 1994 - ------------------------------------------------------------------------------------------------ (IN THOUSANDS EXCEPT PER SHARE DATA) Assets: Cash and due from banks $ 24,312 $ 18,436 Federal funds sold 9,969 14,918 Due from broker 20,859 - ------------------------------------------------------------------------------------------------ Cash and cash equivalents 55,140 33,354 Interest bearing deposits due from financial institutions 417 512 Investment securities: Held to maturity, at cost (market value: 1995 - $6,528, 1994 - $18,973) 6,528 19,485 Available for sale, at market (cost: 1995 - $37,195, 1994 - $22,825) 37,436 22,581 - ------------------------------------------------------------------------------------------------ Total investment securities 43,964 42,066 Mortgage loans held for sale 62,620 138,003 Loans: Portfolio loans 368,224 384,569 Less allowance for loan losses (5,037) (5,787) - ------------------------------------------------------------------------------------------------ Net loans 363,187 378,782 Premises and equipment, net 6,561 8,146 Mortgage servicing rights, net 5,970 6,270 Other real estate owned 963 1,814 Cash surrender value of life insurance 4,363 4,179 Other assets and interest receivable 14,725 17,526 - ------------------------------------------------------------------------------------------------ Total Assets $557,910 $630,652 - ------------------------------------------------------------------------------------------------ - ------------------------------------------------------------------------------------------------ Liabilities and Shareholders' Equity: Deposits: Noninterest bearing demand deposits $ 65,602 $ 48,421 Interest bearing transaction accounts 129,436 120,855 Time deposits $100,000 and over 139,979 90,443 Other time deposits 123,376 209,289 - ------------------------------------------------------------------------------------------------ Total deposits 458,393 469,008 Other borrowings 47,871 112,075 Other liabilities and interest payable 8,061 9,375 Subordinated notes 12,000 12,000 - ------------------------------------------------------------------------------------------------ Total Liabilities 526,325 602,458 - ------------------------------------------------------------------------------------------------ Shareholders' Equity: Preferred stock, no par value; authorized 2,000,000 shares; issued and outstanding 575,000 shares; liquidation preference of $10.00 per share 5,750 5,750 Common stock, no par value; authorized 10,000,000 shares; issued and outstanding: 1995 - 2,679,227 shares, 1994 - 2,663,360 shares 18,728 18,609 Retained earnings 6,967 3,990 Unrealized gain (loss) on investment securities available for sale, net of income taxes (1995 - ($101); 1994 - $90) 140 (155) - ------------------------------------------------------------------------------------------------ Total Shareholders' Equity 31,585 28,194 - ------------------------------------------------------------------------------------------------ Total Liabilities and Shareholders' Equity $557,910 $630,652 - ------------------------------------------------------------------------------------------------ - ------------------------------------------------------------------------------------------------
See Notes to Consolidated Financial Statements 24 CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
Unrealized gain (loss) For the Years ended on investment December 31, 1995, 1994 and 1993 Preferred Common Retained securities available (IN THOUSANDS) Stock Stock Earnings for sale Total - --------------------------------------------------------------------------------------------------------------------- Balances, January 1, 1993 $ $ 16,846 $ 5,675 $ $ 22,521 Issuance of preferred stock 5,750 5,750 Stock options exercised 370 370 Stock dividend 903 (903) Cash dividends declared - preferred (432) (432) Cash dividends declared - common (318) (318) Preferred stock issuance costs (840) (840) Unrealized losses on investment securities available for sale, net of income taxes (39) (39) Net income 4,564 4,564 - --------------------------------------------------------------------------------------------------------------------- Balances, December 31, 1993 5,750 18,119 7,746 (39) 31,576 Stock options exercised 490 490 Cash dividends declared - preferred (448) (448) Cash dividends declared - common (273) (273) Change in unrealized losses on investment securities available for sale, net of income taxes (116) (116) Net loss (3,035) (3,035) - --------------------------------------------------------------------------------------------------------------------- Balances, December 31, 1994 5,750 18,609 3,990 (155) 28,194 Stock options exercised 119 119 Cash dividends declared - preferred (336) (336) Change in unrealized gains (losses) on investment securities available for sale, net of income taxes 295 295 Net income 3,313 3,313 - --------------------------------------------------------------------------------------------------------------------- Balances, December 31, 1995 $ 5,750 $ 18,728 $ 6,967 $ 140 $ 31,585 - --------------------------------------------------------------------------------------------------------------------- - ---------------------------------------------------------------------------------------------------------------------
See Notes to Consolidated Financial Statements. 25 CONSOLIDATED STATEMENTS OF CASH FLOWS
Year Ended December 31, 1995 1994 1993 - ----------------------------------------------------------------------------------------- (IN THOUSANDS) Cash flows from operating activities: Net income (loss) $ 3,313 $ (3,035) $ 4,564 - ----------------------------------------------------------------------------------------- Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation and amortization, net 2,559 268 1,138 Deferred taxes (709) 664 (116) Net realized losses (gains) on securities available for sale (386) 24 (242) Loans originated for sale (848,236) (1,089,567) (1,958,898) Proceeds from sale of loans held for sale 887,249 1,080,249 1,868,723 Gain on sale of loans and loan servicing (10,195) (5,448) (15,637) Provision for loan losses 1,590 1,095 1,679 Change in cash surrender value of life insurance (169) 513 (4,692) Change in other assets and interest receivable 2,658 (4,238) (6,241) Change in other liabilities and interest payable (829) 1,517 2,998 Noncash restructuring charge (456) 2,035 Other, net (1,936) 359 636 - ----------------------------------------------------------------------------------------- Total adjustments 31,140 (12,529) (110,652) - ----------------------------------------------------------------------------------------- Net cash provided by (used in) operating activities 34,453 (15,564) (106,088) - ----------------------------------------------------------------------------------------- Cash flows from investing activities: Acquisitions, net of cash acquired 5,318 Net increase in loans (30,602) (108,401) (27,877) Proceeds from sale of loans in portfolio 91,229 6,467 3,618 Purchases of investment securities available for sale (51,438) (16,712) Purchases of investment securities held to maturity (20,215) (9,286) (19,704) Sales of investment securities available for sale 31,481 4,177 4,393 Maturities of investment securities available for sale 21,000 9,100 Maturities of investment securities held to maturity 18,811 5,122 7,637 Premises and equipment, net (1,096) (4,654) (2,532) Purchase of mortgage servicing rights (101) (5,817) (730) Change in interest bearing deposits due from financial institutions 95 4,502 (3,718) Proceeds from sale of other real estate owned 3,328 2,372 2,064 - ----------------------------------------------------------------------------------------- Net cash provided by (used in) investing activities 62,492 (107,812) (36,849) - ----------------------------------------------------------------------------------------- Cash flows from financing activities: Change in noninterest bearing transaction accounts 17,181 (4,483) 11,210 Change in interest bearing transaction accounts 8,580 (5,879) 9,568 Change in time deposits (36,376) 84,778 35,897 Change in other borrowings (64,204) 41,739 64,087 Issuance of subordinated notes 12,000 Issuance of stock 108 425 6,120 Dividends paid (448) (810) (621) - ----------------------------------------------------------------------------------------- Net cash provided by (used in) financing activities (75,159) 115,770 138,261 - ----------------------------------------------------------------------------------------- Net change in cash and cash equivalents 21,786 (7,606) (4,676) Cash and cash equivalents at beginning of period 33,354 40,960 45,636 - ----------------------------------------------------------------------------------------- Cash and cash equivalents at end of period $ 55,140 $ 33,354 $ 40,960 - ----------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------- (Continued) 26 CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) Year Ended December 31, 1995 1994 1993 - ----------------------------------------------------------------------------------------- (IN THOUSANDS) Supplemental Disclosures: Cash paid during the period for: Income taxes $ 2,661 $ 582 $ 4,724 Interest expense 27,547 20,086 12,366 Noncash investing and financing activities: Transfer from loans to other real estate owned 2,434 1,853 3,075 Transfer from loans to other assets owned 1,344 Loans to facilitate sale of other real estate owned 485 910 Transfer from mortgage loans held for sale to loans 15,000 45,443 Transfer of investment securities from held to maturity to available for sale 20,709 Components of cash acquired in acquisitions: Fair value of assets, net of cash acquired $ 37,906 Liabilities assumed 43,224 - ----------------------------------------------------------------------------------------- Acquisitions, net of cash acquired $ 5,318 - ----------------------------------------------------------------------------------------- - -----------------------------------------------------------------------------------------
See Notes to Consolidated Financial Statements. 27 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE A - DESCRIPTION OF BUSINESS Redwood Empire Bancorp ("Redwood," and with its subsidiaries, the "Company") is a financial institution holding company headquartered in Santa Rosa, California, and operating in California, Oregon and Washington. Its wholly-owned subsidiaries are National Bank of the Redwoods("NBR"), a national bank chartered in 1985 and Allied Bank, F.S.B., ("Allied"), a federal savings bank chartered in 1986. The Company's business strategy involves two principal business activities, commercial banking and mortgage lending which are conducted through NBR and Allied, respectively. NBR provides its commercial banking services through five retail branches located in Sonoma County, California and one retail branch located in Mendocino County, California. Loan services at NBR are generally extended to professionals and to businesses with annual revenues of less than $10 million. Commercial loans are primarily for working capital, asset acquisition and commercial real estate. NBR generates noninterest income through merchant draft processing by virtue of its status as a Principal Bank of Visa/MasterCard. As a Preferred Lender under the Small Business Administration ("SBA") Loan Guarantee Program, NBR generates noninterest income through premiums received on the sale of the guaranteed portions of SBA loans and the resulting on-going servicing income on its SBA portfolio. In November 1994, NBR acquired Codding Bank, a California-chartered bank headquartered in Sonoma County, California. In connection with the acquisition, NBR added two branches and approximately $42 million in assets. In October, 1994 NBR also opened a new branch in Mendocino County, California. The Company's mortgage lending business is conducted entirely through Allied. Allied originates one-to-four family residential mortgage loans which predominantly conform to the underwriting standards set by Fannie Mae or Freddie Mac. Allied also originates mortgage loans through its Allied Diversified Credit division that do not comply with all standards established by Fannie Mae or Freddie Mac. Substantially all mortgage loan originations are packaged and sold into the secondary market. Allied sells substantially all the servicing rights on the mortgage loans it sells and from time to time may purchase mortgage loan servicing rights from other companies, thereby generating ongoing servicing fees. In addition, Allied originates construction loans for its portfolio. The Company's targeted commercial banking market area includes the California counties north of San Francisco. Allied's principal targeted mortgage banking territory includes Northern and Central California and Oregon and Washington State. These areas are served by four loan production offices located in Santa Rosa, San Jose and Sacramento, California and Portland, Oregon, all of which provide retail and wholesale lending. To fund its lending activities Allied maintains depository branches in Santa Rosa, Ukiah and Lakeport, California. In an effort to increase shareholder value the Board of Directors is currently evaluating strategic options relating to Allied. These options include a sale or partial sale of Allied or a merger of Allied into NBR. The ultimate resolution of this evaluation process and actions stemming therefrom, if any, cannot currently be determined. NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The accounting and reporting policies of the Company conform with generally accepted accounting principles and general practice within the banking industry. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. A summary of the more significant policies follows: BASIS OF PRESENTATION. The consolidated financial statements include the accounts of Redwood Empire Bancorp and its wholly-owned subsidiaries, National Bank of the Redwoods and Allied Bank, F.S.B. All material intercompany transactions and accounts have been eliminated. Certain reclassifications to the 1994 and 1993 financial statements were made to conform to the 1995 presentation. For the purpose of the statements of cash flows, cash and cash equivalents have been defined as cash, demand deposits with correspondent banks, cash items in transit, federal funds sold and amounts due from broker, which represents a mortgage-backed security traded but not settled, with original maturities of 90 days or less at date of acquisition. INVESTMENT SECURITIES. In May, 1993, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities". The Company adopted SFAS No. 115 at December 31, 1993 and, accordingly, has classified its investment securities as held to maturity or available for sale. Securities held to maturity are carried at cost adjusted by the accretion of discounts and amortization of premiums. The Company has the ability and intent to hold these investment securities to maturity. Securities available for sale may be sold to implement the Company's asset/liability management strategies and in response to changes in interest rates, prepayment rates and similar factors. Available for sale securities are recorded at market value and unrealized gains or losses, net of income taxes, are included in shareholders' equity. Gain or loss on sale of investment securities is based on the specific identification method. 28 LOANS AND THE ALLOWANCE FOR LOAN LOSSES. Loans are stated at the principal balance outstanding net of allowance for loan losses and deferred loan fees. Loan fees net of certain related direct costs to originate loans are deferred and amortized over the contractual life of the loan using a method approximating the interest method. Loan fees and direct costs related to the origination of loans held for sale are recognized as a component of gain or loss on sale of mortgage loans when the related loans are sold. The allowance for loan losses is maintained at a level considered adequate to provide for losses that can be reasonably anticipated and is based on management's continual evaluation of the economic climate and other factors related to the collectability of loan balances. The factors considered by management include growth and composition of the loan portfolio, overall portfolio quality, review of specific problem loans, historical loss rates and current economic conditions that may affect the borrower's ability to pay. The actual results could differ significantly from management's estimates. The allowance for loan losses is increased by provisions charged to operations and reduced by loan charge-offs net of recoveries. On January 1, 1995, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 114 "Accounting by Creditors for Impairment of a Loan" and SFAS No. 118, "Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosure." These statements address the accounting and reporting by creditors for impairment of certain loans. In general, a loan is impaired when, based upon current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. These statements are applicable to all loans, uncollateralized as well as collateralized, except loans that are measured at the lower of cost or fair value. Impairment is measured based on the present value of expected future cash flows discounted at the loan's effective interest rate, except that as a practical expedient, the Company measures impairment based on a loan's observable market price or the fair value of the collateral if the loan is collateral dependent. Loans are measured for impairment as part of the Company's normal internal asset review process. The effect of adopting SFAS 114 was not material to the Company's 1995 balance sheet or statement of operations. Interest income is recognized on impaired loans in a manner similar to that of all loans. It is the Company's policy to place loans that are delinquent 90 days or more as to principal or interest on nonaccrual status unless secured and in the process of collection, and to reverse from current income accrued but uncollected interest. Cash payments subsequently received on nonaccrual loans are recognized as income only where the future collection of principal is considered by management to be probable. The Company originates loans to customers under a Small Business Administration (SBA) program that generally provides for SBA guarantees of 70% to 85% of each loan. The Company generally sells the guaranteed portion of each loan to a third party and retains the unguaranteed portion in its own portfolio. A gain is recognized on these loans through collection on sale of a premium over the adjusted carrying value, through retention of an ongoing rate differential less a normal service fee (excess servicing fee) between the rate paid by the borrower to the Company and the rate paid by the Company to the purchaser, or both. To calculate the gain or loss on the sale, the Company's investment in an SBA loan is allocated among the retained portion of the loan, excess servicing retained and the sold portion of the loan, based on the relative fair market value of each portion. The gain on the sold portion of the loan is recognized. The excess servicing fees are reflected as an asset which is amortized over an estimated life using a method approximating the interest method; in the event future prepayments are significant and future expected cash flows are inadequate to cover the unamortized excess servicing asset, additional amortization would be recognized. SBA loans held for sale are carried at the lower of cost or estimated market value, determined on an aggregate basis. OTHER REAL ESTATE OWNED. Property acquired by the Company through foreclosure is recorded at the lower of estimated fair value less estimated selling costs (fair value) or cost at the date of foreclosure. At the time the property is acquired, if the fair value is less than the loan amounts outstanding, any difference is charged against the allowance for loan losses. After acquisition, valuations are periodically performed and, if the carrying value of the property exceeds the fair value, a valuation allowance is established by a charge to operations. Subsequent increases in the fair value may reduce or eliminate the allowance. Operating costs on foreclosed real estate are expensed as incurred. Costs incurred for physical improvements to foreclosed real estate are capitalized if the value is recoverable through future sale. MORTGAGE BANKING ACTIVITIES. The Company sells residential mortgage loans to a variety of secondary market investors, including Freddie Mac and Fannie Mae. Gains or losses on the sale of mortgage loans are recognized based on the difference between the selling price and the carrying value of the related mortgage loans sold. Mortgage loans held for sale are carried at the lower of cost or market value as determined by outstanding commitments from investors, indicators of value obtained by management from independent third parties, current investor yield requirements calculated on an aggregate loan basis and the market value of its hedging instruments. Valuation adjustments are charged against the gain or loss on sale of mortgage loans. In order to minimize the risk that a change in interest rates will result in a decrease in the value of the Company's current mortgage loan inventory or its commitments to purchase or originate mortgage loans ("committed pipeline"), the Company utilizes various financial instruments, including derivatives. These instruments involve, to varying degrees, elements of credit and interest-rate risk. All of the Company's derivative financial instruments are held or issued for purposes other than trading. 29 These instruments include forward sales of mortgage-backed securities ("MBS") and options to sell or buy mortgage-backed or U.S. treasury securities. Unrealized gains and losses resulting from changes in the market value of uncommitted mortgage loans and interest rate locks and open hedge positions are netted. Any net unrealized gain that results is deferred; any net unrealized loss that results is recognized currently. Hedging gains and losses realized before the hedged loans are sold are deferred. Unrealized or realized hedging losses are recognized currently if deferring such losses would result in mortgage loans held for sale and the interest rate locks being valued in excess of their estimated net realizable value. Option premiums paid for purchased put or call options are amortized on a straight-line basis over the life of the option. Premiums received on written call or put options are recognized when the option expires. Premiums paid or received are included in the carrying values of the related hedged items for purposes of determining lower of cost or market. Purchased mortgage servicing rights represent the cost of acquiring the right to service mortgage loans. Such amounts are amortized in proportion to, and over the period of, estimated net servicing income based on methods which approximate the interest method. The Company's carrying values of purchased mortgage servicing rights, and the amortization thereon, are evaluated quarterly, by portfolios, and such carrying values are adjusted for indicated impairments based on management's best estimate of the remaining cash flows. Such estimates may vary from the actual remaining cash flows due to unanticipated prepayments of the underlying mortgage loans and increases in servicing costs. The Company's carrying values of purchased mortgage servicing rights do not purport to represent the amount that would be realizable by a sale of these assets in the open market. The Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 122 "Accounting for Mortgage Servicing Rights," an amendment of SFAS No. 65 in May 1995. SFAS No. 122 requires a mortgage banking enterprise that purchases or originates mortgage loans with a definitive plan to sell or securitize those loans and retain the mortgage servicing rights to allocate the cost of the mortgage loans based on the relative fair values of the mortgage loans and mortgage servicing rights at the date of purchase or origination. Prior to SFAS No. 122, originated mortgage servicing rights were not recognized for financial statement purposes with the entire cost of the mortgage loan being allocated to the loan. The Company early adopted SFAS No. 122 on January 1, 1995 as permitted. The effect of adoption on the 1995 statement of operations was to increase gain on sale of loans by $1,830,000 and net income by $857,000 ($.27 per fully-diluted share). SFAS No. 122 prohibited the restatement of results for prior years. Mortgage servicing rights are amortized in proportion to and over the period of estimated net servicing income. The Company evaluates impairment of its mortgage servicing rights quarterly. Impairment is measured on a disaggregated basis using the state of origination as the predominant risk characteristic with respect to originated mortgage servicing rights. Impairment of purchased mortgage servicing rights is measured based on discrete acquisitions. Any impairment is calculated as the difference between fair value and amortized cost by stratum. Fair value is estimated on a loan by loan basis using market prices under comparable servicing sale contracts, when available or, using a cash flow model with current assumptions with respect to prepayments, servicing costs and other significant factors. Impairment is recognized through a valuation allowance by stratum. The Company is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit, standby letters of credit, forward contracts to sell mortgage-backed securities and options written. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the statement of financial position. The contract or notional amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments. The Company's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. The Company manages credit risk with respect to MBS, and options to sell or buy mortgage-backed or U.S. Treasury securities by entering into agreements with entities approved by senior management and the Board of Directors. These entities include Wall Street firms having primary dealer status. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. For forward contracts to sell mortgage-backed securities and options written, the contract or notional amounts do not represent exposure to credit loss. The Company controls the credit risk of its forward contracts through credit approvals, limits and monitoring procedures. Contract or notional amount - -------------------------------------------------------------------- Financial instruments whose contract amounts represent credit risk: Commitments to extend credit $152,011,000 Standby letters of credit 1,372,000 Financial instruments whose contract amounts exceed the amount of credit risk: Forward contracts 12,770,000 Options written 100,000,000 Loan commitments are typically contingent upon the borrower meeting certain financial and other covenants, and such commitments typically have fixed expiration dates and require payment of a fee. As many of these commitments are expected to expire without being drawn upon, the total commitments do not necessarily represent future cash 30 requirements. The Company evaluates each potential borrower and the necessary collateral on an individual basis. Collateral varies, but may include real property, bank deposits, debt securities, equity securities, or business assets. Standby letters of credit are conditional commitments written by the Company to guarantee the performance of a customer to a third party. These guarantees relate primarily to inventory purchases by the Company's commercial customers, and such guarantees are typically short-term. Credit risk is similar to that involved in extending loan commitments to customers and the Company accordingly uses evaluation and collateral requirements similar to those of loan commitments. Virtually all such commitments are collateralized. Forward contracts are contracts for delayed delivery of mortgage-backed securities in which the Company agrees to make delivery at a specified future date of a specified instrument, at a specified yield. Risks arise from the possible inability of counterparties to meet those terms of their contracts and from movements in interest rates. The Company's exposure to risk in the event of default by the counterparty is the difference between the contract price and the current market price. The Company enters into written call options for purposes of managing its interest rate exposure from mortgage banking activities. These options are contracts that allow the holder of the options to purchase a mortgage-backed security at a specified price and within a specified period of time from the seller, or writer, of the option. As a writer of options, the Company receives a premium at the outset and then bears the risk of an unfavorable change in the price of the financial instrument underlying the option. The Company believes its risk on written call options is substantially limited through the origination of mortgage loans that could be delivered in the event interest rates decrease and the holder exercises its option to buy. PREMISES AND EQUIPMENT. Premises and equipment consist of building, leasehold improvements, furniture and equipment and are stated at cost, less accumulated depreciation and amortization. Depreciation is computed using the straight-line method over the estimated useful lives for financial reporting purposes and an accelerated method for income tax reporting. Leasehold improvements are amortized over the terms of the lease or their estimated useful lives whichever is shorter. INCOME TAXES. The Company accounts for income taxes using an asset and liability approach, which requires the recognition of deferred tax assets and liabilities at tax rates in effect when these balances reverse. Future tax benefits attributable to temporary differences are recognized currently to the extent that realization of such benefits is more likely than not. These future tax benefits are measured by applying currently enacted tax rates. EARNINGS PER COMMON SHARE. Earnings per common and common equivalent shares are computed by dividing net income applicable to common stock by the total of the average number of common shares outstanding and the additional dilutive effect of stock options outstanding during the respective period. The calculations give effect to the 3 percent stock dividend declared in 1993. The dilutive effect of stock options is computed using the average market price of the common stock for the period for primary earnings per share. Earnings per common share, assuming full dilution, are computed by dividing net income by the average number of common shares outstanding during the period, the dilutive effect of the Convertible Preferred Stock assuming conversion at the time it was issued, and the additional dilutive effect of stock options outstanding during the period. The dilutive effect of outstanding stock options is computed using the greater of the closing market price or the average market price of the common stock for the period. Earnings per common share have been computed based on the following:
Year Ended December 31, 1995 1994 1993 - ------------------------------------------------------------------------ (IN THOUSANDS) Net income (loss) $3,313 ($3,035) $4,564 Dividends on preferred stock 336 448 432 - ------------------------------------------------------------------------- Net income (loss) applicable to common stock $2,977 ($3,483) $4,132 - ------------------------------------------------------------------------- - ------------------------------------------------------------------------- Average number of common shares outstanding 2,671 2,649 2,480 Average number of common and common equivalent shares outstanding 2,680 2,649 2,679 Average number of common shares outstanding assuming full dilution 3,179 2,649 3,171
NEW ACCOUNTING PRONOUNCEMENTS. The Company is required to adopt SFAS No. 123 "Accounting for Stock-Based Compensation" in 1996. SFAS No. 123 establishes accounting and disclosure requirements using a fair value-based method of accounting for stock-based employee compensation plans. Under SFAS No. 123, the Company may either adopt the new fair value-based accounting method or continue the intrinsic value-based method and provide pro forma disclosures of net income and earnings per share as if the accounting provisions of SFAS No. 123 had been adopted. The Company plans to adopt only the disclosure requirements of SFAS No. 123; therefore such adoption will have no effect on the Company's consolidated net earnings or cash flows. NOTE C - ACQUISITION On November 4, 1994, NBR acquired Codding Bank, a California-chartered bank headquartered in Rohnert Park, California ("Codding"). The amended acquisition agreement (the "Agreement") provided for a two-step merger transaction in which a wholly-owned non-bank subsidiary of NBR would first be merged into Codding, followed immediately thereafter by the merger of Codding into NBR, with NBR being the surviving entity. The transaction was structured as a 31 cash-for-stock merger, in which shareholders of Codding received $12.12 per share of Codding stock outstanding at the time of the acquisition. Holders of outstanding options to purchase shares of Codding stock received $12.12 per share covered by such options less the option exercise price per share. The transaction was accounted for as a purchase in accordance with Accounting Principles Board Opinion No. 16, "Business Combinations". Under this method of accounting, the purchase price is allocated to the respective assets acquired and liabilities assumed based on their estimated fair values, net of applicable income tax effects. The purchase price of Codding totalled $7,028,000 in cash, including merger related expenses. At the merger date, the fair value of the assets acquired totalled approximately $42,048,000, including loans of approximately $28,294,000 and investment securities of approximately $7,935,000 and the fair value of liabilities assumed was approximately $43,224,000, including deposits of $42,817,000. The Company recorded goodwill of $1,176,000 which is being amortized over 15 years on a straight-line basis. The Company's consolidated financial statements include the results of Codding beginning October 31, 1994. The following Unaudited Pro Forma Combined Summary of Operations presents a pro forma combined summary of operations of the Company and Codding for the years ended December 31, 1994 and 1993 and it is presented as if the merger had been effective on January 1, 1993. This pro forma combined historical summary of operations was adjusted for the amortization of purchase accounting adjustments. The Unaudited Pro Forma Combined Summary of Operations for the year ended December 31, 1993, combines the historical results of the Company and Codding for the year ended December 31, 1993, after giving effect to amortization of purchase accounting adjustments. The Unaudited Pro Forma Combined Summary of Operations data is intended for informational purposes only and is not necessarily indicative of the future results of operations of the Company, or the results of operations that would have actually occurred had the Codding merger been in effect for the periods presented. UNAUDITED PRO FORMA COMBINED SUMMARY OF OPERATIONS
Year ended December 31, 1994 1993 - ------------------------------------------------------------------------------- (IN THOUSANDS, EXCEPT PER SHARE DATA) Interest income $ 41,243 $ 30,809 Interest expense 21,682 13,763 - ------------------------------------------------------------------------------- Net interest income 19,561 17,046 Provision for loan losses 1,296 1,890 - ------------------------------------------------------------------------------- Net interest income after provision for loan losses 18,265 15,156 Other operating income 11,036 19,308 Other operating expense 34,015 26,736 - ------------------------------------------------------------------------------- Income (loss) before income taxes and accounting change (4,714) 7,728 Provision (benefit) for income taxes (1,780) 3,115 - ------------------------------------------------------------------------------- Income (loss) before accounting change (2,934) 4,613 Change in accounting for income taxes 20 Net income (loss) (2,934) 4,633 Dividends on preferred stock 448 432 - ------------------------------------------------------------------------------- Net income (loss) available for common stock $ (3,382) $ 4,201 - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- Primary earnings (loss) per share $ (1.28) $ 1.57 Fully diluted earnings (loss) per share (1.28) 1.46 Weighted average shares outstanding: Primary 2,649 2,679 Fully diluted 2,649 3,171
NOTE D - CASH AND DUE FROM BANKS The Company's subsidiaries are required to maintain average reserve balances with the Federal Reserve Bank. The required reserve balance included in cash and due from banks was approximately $3,307,000 and $2,439,000 at December 31, 1995 and 1994. 32 NOTE E - INVESTMENT SECURITIES An analysis of the investment security portfolio follows:
Gross Gross Amortized Unrealized Unrealized Market (IN THOUSANDS) Cost Gains Losses Value - --------------------------------------------------------------------------------------------------- DECEMBER 31, 1995: Held to maturity: Mortgage-backed and other securities $ 2,638 $ $ $ 2,638 - --------------------------------------------------------------------------------------------------- Total debt securities 2,638 2,638 FRB and FHLB stock 3,890 3,890 - --------------------------------------------------------------------------------------------------- Total held to maturity $ 6,528 $ $ $ 6,528 - --------------------------------------------------------------------------------------------------- Available for sale: U.S. Government obligations $ 37,195 $ 267 $ 26 $ 37,436 - --------------------------------------------------------------------------------------------------- Total available for sale $ 37,195 $ 267 $ 26 $ 37,436 - --------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------- DECEMBER 31, 1994: Held to maturity: U.S. Government obligations $ 9,329 $ $ 512 $ 8,817 Other securities 2,093 2,093 - --------------------------------------------------------------------------------------------------- Total debt securities 11,422 512 10,910 FRB and FHLB stock 8,063 8,063 - --------------------------------------------------------------------------------------------------- Total held to maturity $ 19,485 $ $ 512 $ 18,973 - --------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------- Available for sale: U.S. Government obligations $ 22,825 $ $ 244 $ 22,581 - --------------------------------------------------------------------------------------------------- Total available for sale $ 22,825 $ $ 244 $ 22,581 - --------------------------------------------------------------------------------------------------- - ---------------------------------------------------------------------------------------------------
Debt securities by contractual maturity at December 31, 1995, were due as follows:
Amortized Cost Market Value - ----------------------------------------------------------------------- (IN THOUSANDS) Held to maturity: One year or less $ 38 $ 38 After five years 2,600 2,600 - ----------------------------------------------------------------------- $ 2,638 $ 2,638 - ----------------------------------------------------------------------- - ----------------------------------------------------------------------- Available for sale: One year or less $ 9,968 $ 9,963 After one year through five years 15,349 15,492 After five years 11,878 11,981 - ----------------------------------------------------------------------- $ 37,195 $ 37,436 - ----------------------------------------------------------------------- - -----------------------------------------------------------------------
Proceeds from sales of investments in debt securities during 1995, 1994 and 1993 were $31,481,000, $4,177,000 and $4,393,000. These sales resulted in the realization of gross gains of $386,000 for 1995 and $242,000 for 1993 and gross losses of $24,000 for 1994. During 1995, the FASB issued a Special Report, "A Guide to Implementation of Statement 115 on Accounting for Certain Investments in Debt and Equity Securities". The Special Report provided the Company a one-time opportunity to reassess the appropriateness of its designations of securities subject to the accounting and reporting requirements of Statement 115, without calling into question the intent to hold other debt securities to maturity in the future. In accordance with the Special Report, in December 1995, the Company transferred $20,709,000 in U.S. Government obligations with an unrealized gain of $145,000 from held to maturity to available for sale. Securities carried at approximately $11,607,000 and $13,224,000 at December 31, 1995 and 1994 were pledged to secure public deposits, bankruptcy deposits, and treasury tax and loan borrowings. 33 NOTE F - MORTGAGE BANKING ACTIVITIES As part of its mortgage banking activities, the Company enters into forward commitments to sell mortgage loans, either in the form of mortgage-backed securities or as whole loans. These commitments may be optional or mandatory. Under optional commitments, a commitment fee is paid and the Company carries no risk in excess of the loss of such fee in the event that the Company is unable to deliver sufficient mortgage loans to fulfill the commitment. Mandatory commitments may entail possible financial risk to the Company if it is unable to deliver mortgage loans in sufficient quantity or at sufficient rates to meet the terms of the commitments. In order to minimize the risk that a change in interest rates will result in a decrease in the value of the Company's current mortgage loan inventory or its commitments to purchase or originate mortgage loans ("committed pipeline"), the Company enters into hedging transactions. The Company's hedging policies generally require that its inventory of mortgage loans held for sale and the maximum portion of its committed pipeline that may close be hedged with forward sales of MBS or options to buy or sell mortgage-backed or U.S. Treasury securities. As such, to the extent the Company hedges its committed pipeline, the Company is not exposed to significant interest rate risk nor will it derive any significant benefit from changes in interest rates on the price of the mortgage loan inventory net of gains or losses of associated hedge positions. The correlation between the price performance of the hedge instruments and the inventory being hedged is very high due to the similarity of the asset and the related hedge instrument. The Company is exposed to interest-rate risk to the extent that the portion of loans from the committed pipeline that actually closes at the committed price is less than the portion expected to close in the event of a decline in rates and, in the event such decline in closings is not covered by options to purchase MBS needed to replace the loans in process that do not close at their committed price. The Company determines the portion of its committed pipeline that it will hedge based on numerous factors, including the composition of the Company's committed pipeline, the portion of such committed pipeline likely to close, the timing of such closings and the current interest rate environment. The following lists the notional amounts of the various hedging instruments outstanding at December 31, 1995 and the date through which exercise dates extend:
Exercise Dates Notional Amount Extend Through - ------------------------------------------------------------------------ (IN THOUSANDS) Forward contracts to sell MBS $ 12,770 February 1996 Purchased put options: MBS 30,000 April 1996 U.S. Treasury 80,000 March 1996 Purchased call options - U.S. Treasury 25,000 March 1996 Written call options - MBS 80,000 February 1996 Written put options - U.S. Treasury 20,000 March 1996 - ------------------------------------------------------------------------ - ------------------------------------------------------------------------
The Company services mortgage loans and participating interests in mortgage loans owned by investors. The unpaid principal balances of mortgage loans serviced for others are as follows:
December 31, 1995 1994 - ----------------------------------------------------------------------- (in thousands) Mortgage loan portfolios serviced for: Freddie Mac $ 468,555 $ 510,604 Fannie Mae 411,707 376,455 Other investors 159,076 68,597 - ----------------------------------------------------------------------- $ 1,039,338 $ 955,656 - ----------------------------------------------------------------------- - -----------------------------------------------------------------------
At December 31, 1995 and 1994, the Company also serviced $19,900,000 and $236,000,000 in loans and participating interests in loans owned by investors, under subservicing agreements. Escrow funds held in trust for loans serviced for others were $2,809,000 and $2,407,000 at December 31, 1995 and 1994. 34 The following table provides a summary of the Company's purchased ("PMSR") and originated ("OMSR") mortgage servicing rights portfolio:
OMSR ---------------------------------------- States ------------------------ PMSR California Other Total - ------------------------------------------------- ---------------------------------------- (IN THOUSANDS) Balance, January 1, 1993 $ 1,814 $ $ $ Purchases 730 Amortization (813) Valuation adjustments (292) - ------------------------------------------------- ---------------------------------------- Balance, December 31, 1993 1,439 Purchases 5,855 Amortization (980) Valuation adjustments (44) - ------------------------------------------------- ---------------------------------------- Balance, December 31, 1994 6,270 Purchases 11 Originations 1,616 13 1,829 Amortization (1,787) (290) (38) (328) Valuation adjustments (22) (3) (25) - ------------------------------------------------- ---------------------------------------- Balance, December 31, 1995 $ 4,494 $ 1,304 $ 172 $ 1,476 - ------------------------------------------------- ---------------------------------------- - ------------------------------------------------- ----------------------------------------
NOTE G - LOANS AND THE ALLOWANCE FOR LOAN LOSSES The Company primarily makes residential real estate loans in California, Oregon and Washington and loans to individuals and small businesses primarily in Sonoma and Mendocino Counties, California. There are no major industry segments in the loan portfolio. Outstanding loans by type were:
December 31, 1995 1994 - ----------------------------------------------------------------- (IN THOUSANDS) Residential real estate mortgage $168,022 $222,822 Commercial real estate mortgage 65,655 61,347 Commercial 63,975 64,807 Real estate construction 69,504 33,348 Installment and other 4,103 5,063 Less deferred fees (3,035) (2,818) - ----------------------------------------------------------------- Total loans 368,224 384,569 Less allowance for loan losses (5,037) (5,787) - ----------------------------------------------------------------- Net loans $363,187 $378,782 - ----------------------------------------------------------------- - -----------------------------------------------------------------
A summary of the transactions in the allowance for loan losses follows:
1995 1994 1993 - -------------------------------------------------------------------------- (IN THOUSANDS) Balance, beginning of year $5,787 $5,209 $4,320 Allowance obtained through acquisition 634 Provision for loan losses 1,590 1,095 1,679 Loans charged off (2,450) (1,202) (827) Recoveries 110 51 37 - -------------------------------------------------------------------------- Balance, end of year $5,037 $5,787 $5,209 - -------------------------------------------------------------------------- - --------------------------------------------------------------------------
At December 31, 1995 the Company's total recorded investment in impaired loans (as defined by SFAS 114 and 118; see Note B) was $5,202,000 of which $3,515,000 relates to the recorded investment for which there is a related allowance for loan losses of $425,000 determined in accordance with these statements and $1,687,000 relates to the amount of that recorded investment for which there is no related allowance for loan losses determined in accordance with these statements. The average recorded investment in impaired loans during the year ended December 31, 1995 was $5,196,000. The related amount of interest income recognized during the period that such loans were impaired was $187,000. No interest income was recognized using a cash-basis method of accounting during the period that the loans were impaired. 35 As of December 31, 1995 and 1994 there were $4,201,000 and $2,314,000 of loans on which the accrual of interest had been discontinued. Interest due but excluded from interest income on these nonaccrual loans was $485,000, $236,000 and $193,000 for the years ended December 31, 1995, 1994 and 1993. Interest income received on nonaccrual loans was $554,000, $166,000 and $43,000 for the years ended December 31, 1995, 1994 and 1993. At December 31, 1995 and 1994, the Company had $92,000 and $2,767,000 in loans past due 90 days or more in interest or principal and still accruing interest. These loans were collateralized and in the process of collection. The Company originates SBA loans for sale to investors. A summary of the activity in SBA loans is as follows:
December, 31 1995 1994 1993 - ---------------------------------------------------------------------- (IN THOUSANDS) SBA guaranteed portion of loans originated $ 8,509 $ 9,448 $ 9,720 SBA loans sold 8,992 8,097 9,163 Premium received at sale 700 689 965 SBA guaranteed portion of loans serviced for others 36,203 31,833 24,714 - ---------------------------------------------------------------------- - ----------------------------------------------------------------------
The Company has loans receivable from executive officers, directors and related parties. No preference is given to these individuals as these transactions are made in the ordinary course of business at the Company's normal credit terms, including interest rates and collateralization. At December 31, 1994, these loans outstanding totalled $5,000; no balances were outstanding at December 31, 1995. NOTE H - PREMISES, EQUIPMENT AND LEASES A summary of premises and equipment is as follows:
December 31, 1995 1994 - --------------------------------------------------------------- (in thousands) Land $ 307 $ 307 Building and leasehold improvements 2,556 2,334 Furniture and equipment 10,917 10,944 - --------------------------------------------------------------- Total premises and equipment 13,780 13,585 Less accumulated depreciation and amortization 7,219 5,439 - --------------------------------------------------------------- Premises and equipment, net $ 6,561 $ 8,146 - --------------------------------------------------------------- - ---------------------------------------------------------------
Depreciation expense for the years ended December 31, 1995, 1994 and 1993 was $2,647,000, $2,022,000 and $1,078,000. The Company leases certain premises and equipment used in the normal course of business. There are no contingent rental payments and the Company has three subleased properties. Total rental expense under all leases, including premises, totalled $2,172,000, $2,336,000 and $1,533,000 in 1995, 1994 and 1993. Minimum future lease commitments are as follows: 1996 - $2,443,000; 1997 - $2,353,000; 1998 - $2,169,000; 1999 - $1,476,000; 2000 - $197,000 and thereafter - $951,000. Minimum future sublease receivables are as follows: 1996 - $85,000; 1997 - $79,000; and 1998 - $34,000. NBR leases 34,000 square feet of office space for its main office from a partnership that includes one director of a subsidiary as a minority partner. The lease calls for payments of $62,455 per month plus operating cost adjustments through November, 1999. Total lease payments for the years ended December 31, 1995, 1994 and 1993 were $851,000, $839,000 and $753,000. NOTE I - INCOME TAXES The provision (benefit) for income taxes consists of the following:
Year Ended December 31, 1995 1994 1993 - ---------------------------------------------------------------------- (IN THOUSANDS) Current: Federal $2,897 ($2,424) $2,502 State 171 (99) 913 - ---------------------------------------------------------------------- 3,068 (2,523) 3,415 - ---------------------------------------------------------------------- Deferred: Federal (1,191) 833 (68) State 482 (169) (48) - ---------------------------------------------------------------------- (709) 664 (116) - ---------------------------------------------------------------------- $2,359 ($1,859) $3,299 - ---------------------------------------------------------------------- - ----------------------------------------------------------------------
A reconciliation of the statutory income tax rate to the effective income tax rate of the Company is as follows:
1995 1994 1993 - ------------------------------------------------------------------- Income tax at federal statutory rate 35.0% 35.0% 35.0% State franchise tax, net of federal benefit 7.5 3.6 7.3 Other (.9) (.6) (.3) - ------------------------------------------------------------------- 41.6% 38.0% 42.0% - ------------------------------------------------------------------- - -------------------------------------------------------------------
Deferred income taxes reflect the tax effect of temporary differences existing between the financial statement basis and tax basis of the Company's assets and liabilities. Deferred tax benefits attributable to temporary differences are recognized to the extent that realization of such benefits is more likely than not. The Company believes it is more likely than not that the net deferred tax asset at December 31, 1995 will be utilized to reduce future taxable income. Accordingly, there is no valuation allowance associated with deferred tax assets at December 31, 1995. The tax effect of the principal temporary items creating the Company's deferred tax benefit included in other assets and interest receivable are: 36
December 31, 1995 1994 - ----------------------------------------------------------------- (IN THOUSANDS) Deferred tax assets: Allowance for loan losses $1,300 $1,834 Mortgage servicing rights 597 75 Interest foregone on nonaccrual loans 336 66 Restructuring costs 280 762 Accrued expenses not yet deductible 276 72 Depreciation 201 (78) - ------------------------------------------------------------------ Total deferred tax assets 2,990 2,731 - ------------------------------------------------------------------ Deferred tax liabilities: Deferred loan fees 935 1,036 Installment sale of servicing 676 FHLB stock dividends 326 221 Securities and loans marked to market for tax purposes 152 (479) Premium on loan sales 125 56 Unrealized gain (loss) on securities available for sale 101 (90) State taxes 19 205 Other real estate owned 5 (111) Other, net 53 461 - ----------------------------------------------------------------- Total deferred tax liabilities 1,716 1,975 - ----------------------------------------------------------------- Net deferred tax asset $1,274 $ 756 - ----------------------------------------------------------------- - -----------------------------------------------------------------
NOTE J - OTHER BORROWINGS Other borrowings consist of the following:
December 31, 1995 1994 - ------------------------------------------------------------------ (IN THOUSANDS) Advances from FHLB $ 23,000 $ 97,150 Warehouse credit line 10,477 Treasury, tax and loan note 1,463 2,869 Securities and loans sold under agreements to repurchase 21,355 608 Federal funds purchased 1,445 Capital leases 608 971 - ------------------------------------------------------------------ $ 47,871 $112,075 - ------------------------------------------------------------------
(a) ADVANCES FROM THE FHLB The Company has a line of credit for short-term purposes with the Federal Home Loan Bank (FHLB). There were $23,000,000 in advances drawn under this line of credit at December 31, 1995 at 6.24% with an overnight maturity. The average balance of FHLB advances was $46,600,000 for 1995 at an average interest rate of 6.56%. The highest month-end balance during the year was $112,150,000. All borrowings from the FHLB must be collateralized, and the Company has pledged approximately $85,430,000 of residential mortgage loans as of December 31, 1995, to the FHLB to secure any funds it may borrow. (b) WAREHOUSE CREDIT LINE The Company was eligible for a warehouse credit line in an amount of $50,000,000 at December 31, 1994, subject to adequate collateralization in the form of mortgage loans. (c) FEDERAL FUNDS PURCHASED, SECURITIES AND LOANS SOLD UNDER AGREEMENTS TO REPURCHASE AND TREASURY TAX AND LOAN NOTE The Company enters into various short-term borrowing agreements which include Treasury, Tax and Loan borrowings. These borrowings have maturities of one day and are collateralized by investments or loans. Federal Funds purchased had maturities of one day. Securities sold under agreements to repurchase have maturities ranging from January to March 1996 with one agreement having no predetermined maturity. Loans sold under agreements to repurchase had maturities of one day. The average balance of securities and loans sold under agreements to repurchase was $21,395,000 for 1995 at an average interest rate of 5.88%. The highest month-end balance during the year was $22,950,000. (d) CAPITAL LEASES The Company has $608,000 in capital leases at fixed rates from 2.73% to 4.50%. The leases mature through August, 1997, and are collateralized by specific fixed assets with a net carrying value of $376,000 at December 31, 1995. 37 NOTE K - GAINS ON SALE OF LOANS AND LOAN SERVICING The components of gains on sale of loans and loan servicing are as follows:
Year Ended December 31, 1995 1994 1993 - ---------------------------------------------------------------------- (IN THOUSANDS) Gain (loss) on sale of mortgage loans $ 9,091 $(5,391) $14,672 Gains on sale of SBA loans 955 689 965 Gains on bulk servicing sales 149 10,150 - ---------------------------------------------------------------------- $10,195 $ 5,448 $15,637 - ---------------------------------------------------------------------- - ----------------------------------------------------------------------
NOTE L - OTHER EXPENSES The major components of other expense are as follows:
Year Ended December 31, 1995 1994 1993 - ---------------------------------------------------------------------- (IN THOUSANDS) Professional fees $ 2,187 $ 2,065 $ 1,803 Regulatory expense and insurance 1,716 1,345 1,038 Postage and office supplies 1,224 1,013 1,295 Shareholder expenses and Director fees 486 950 700 Advertising 481 919 531 Telephone 778 782 535 Electronic data processing 1,022 775 606 Net costs of other real estate owned 163 609 131 Other 1,503 1,984 2,206 - ---------------------------------------------------------------------- $ 9,560 $10,442 $ 8,845 - ---------------------------------------------------------------------- - ----------------------------------------------------------------------
NOTE M - STOCK OPTIONS AND BENEFIT PLANS The Company has assumed stock options outstanding that were issued under stock option plans of its subsidiaries prior to their acquisitions and has adopted a stock option plan in 1991 which was amended in 1992. There are 541,000 shares available for options under the plans, with 400,000 shares granted but unexercised at December 31, 1995. Outstanding options for common stock at December 31, 1995, are exercisable at various dates through 2005. The following table summarizes option activity:
Number of Option Price Shares per Share - ------------------------------------------------------------------------- Balance at December 31, 1992 509,000 $ 4.80 - 10.44 Adjustment for stock dividends 15,000 Options granted 40,000 $ 9.25 Options exercised (52,000) $ 4.94 - $6.68 Options cancelled (3,000) $ 7.44 - ------------------------------------------------------------------------- Balance at December 31, 1993 509,000 $ 4.94 - 10.44 Options granted 55,000 $ 12.88 - 13.00 Options exercised (75,000) $ 4.94 - 8.24 Options cancelled (24,000) $ 6.68 - ------------------------------------------------------------------------- Balance at December 31, 1994 465,000 $ 4.94 - 13.00 Options granted 50,000 $ 8.25 Options exercised (16,000) $ 6.17 - 7.44 Options cancelled (99,000) $ 4.94 - 12.88 - ------------------------------------------------------------------------- Balance at December 31, 1995 400,000 $ 6.17 - 13.00 - ------------------------------------------------------------------------- - -------------------------------------------------------------------------
Senior management of the Company and its subsidiaries are eligible to participate in an incentive bonus plan. Incentive bonus plan expenses were $830,000 for 1993; there was no incentive bonus plan expense for 1994 or 1995. In 1991 the Company established a 401(K) savings plan for employees who have at least one year of continuous service. For 1994 and 1995, the Company contributions were based on a sliding scale where it matched 100% of the first $300 contributed by the employee, 75% of the next $400, 50% of the next $800 and 25% of the next $4,000 for a maximum contribution per employee of $2,000. For 1993, the Company contributed $.25 for each dollar contributed by the employee, up to a maximum of $1,000 per employee. Company contributions totalled $151,000, $186,000 and $43,000 in 1995, 1994 and 1993. In December 1993 the Company established a supplemental benefit plan (Plan) to provide death benefits and supplemental income payments during retirement for selected officers. The Plan is a nonqualified defined benefit plan and is unsecured and unfunded. Benefits under the Plan are fixed for each participant and are payable over a specific period following the participant's retirement or at such earlier date as termination or death occurs. Participants vest in the plan based on their years of service subsequent to being covered by the Plan. The Company has purchased insurance policies to fund its obligations under the Plan in the event a participant dies prior to retirement. The cash surrender value of such policies was $4,363,000 at December 31, 1995. Under this plan, the Company recognized expense of $221,000, $210,000 and $4,000 in 1995, 1994 and 1993. The aggregate projected benefit obligation of the Plan was approximately $308,000 and $143,000 at December 31, 1995 and 1994. A discount rate of 8.5% was used to determine the aggregate projected benefit obligation for both years. The aggregate vested benefit obligation was $191,000 at December 31, 1995. 38 NOTE N - SUBORDINATED DEBT AND PREFERRED STOCK In 1993, the Company issued $12,000,000 of 8.5% subordinated notes. The notes are due February 15, 2004 and qualify as capital for bank regulatory purposes (total capital). The notes are callable at par after January 15, 1997. Issuance costs of $735,000 are carried as a deferred asset and are amortized over the life of the notes as an adjustment to interest expense. In 1993, the Company issued 575,000 shares of 7.80% Noncumulative Convertible Perpetual Preferred Stock, Series A. The preferred stock is convertible, at the option of the holder, into .8674 shares of common stock for each share of preferred stock. The preferred stock may be redeemed after February 15, 1996, at the option of the Company, at redemption prices which range from $10.55 at February 15, 1996 to $10.00 after February 14, 2003. The preferred stock has a liquidation preference of $10.00. NOTE O - REGULATORY MATTERS One of the principal sources of cash for the Company are dividends from its subsidiary financial institutions. Total dividends which may be declared by the subsidiary financial institutions depend on the regulations which govern them. In addition, regulatory agencies can place dividend restrictions on the subsidiaries based on their evaluation of the financial condition of the subsidiaries. No restrictions are currently imposed by regulatory agencies on the subsidiaries other than the limitations found in the regulations which govern the respective subsidiaries. At December 31, 1995, NBR could pay additional dividends to the Company of approximately $4,328,000 without prior regulatory approval and Allied could pay additional dividends of approximately $2,329,000. The subsidiary financial institutions are subject to certain restrictions under the Federal Reserve Act, including restrictions on the extension of credit to affiliates. In particular, the subsidiaries are prohibited from lending to an affiliated company unless the loans are secured by specific types of collateral. Such secured loans and other advances from the subsidiaries are limited to 10 percent of the subsidiary's equity. No such advances were made during 1995. The Company and its subsidiaries are subject to various regulatory capital requirements administered by the federal banking agencies. In addition to these capital guidelines, the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) required each federal banking agency to implement a regulatory framework for prompt corrective actions for insured depository institutions that are not adequately capitalized. The Board of Governors of the Federal Reserve System, FDIC, OCC and OTS have adopted such a system which became effective on December 19, 1992. 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 financial statements. The regulations require the Company to meet specific capital adequacy guidelines that involve quantitative measures of the Company's assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The Company's capital classification is also subject to qualitative judgements by the regulators about components, risk weightings and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company to maintain a minimum leverage ratio of Tier 1 capital (as defined in the regulations) to adjusted assets (as defined), and minimum ratios of Tier 1 and total capital (as defined) to risk-weighted assets (as defined). To be considered adequately capitalized as defined under the regulatory framework for prompt corrective action, the Company must maintain a minimum leverage ratio of 4%, Tier 1 risk-based ratio of 4% and total risk-based ratio of 8%. In addition, Allied is subject to a minimum tangible capital ratio of 1.5%. The Company's and its subsidiaries' actual capital amounts and ratios are presented in the table below with the required amount of capital and excess over the required amount. 39
Actual Required Amount Amount Excess Actual % - ---------------------------------------------------------------------------------------------------- (DOLLARS IN THOUSANDS) At December 31, 1995: COMPANY Leverage Capital (to Average Assets) $29,723 $23,134 $ 6,589 5.14% Tier 1 Capital (to Risk-weighted Assets) 27,123 14,991 12,132 7.24 Total Capital (to Risk-weighted Assets) 43,780 29,981 13,799 11.68 NBR Leverage Capital (to Average Assets) 17,283 9,258 8,025 7.47 Tier 1 Capital (to Risk-weighted Assets) 17,283 7,349 9,934 9.41 Total Capital (to Risk-weighted Assets) 22,395 14,698 7,697 12.19 ALLIED Core Capital (to Total Assets) 19,955 12,752 7,203 6.26 Tier 1 Capital (to Risk-weighted Assets) 17,355 7,528 9,827 9.22 Total Capital (to Risk-weighted Assets) 19,713 15,056 4,657 10.47 Tangible Capital (to Total Assets) 19,955 4,782 15,173 6.26 - ---------------------------------------------------------------------------------------------------- - ---------------------------------------------------------------------------------------------------- At December 31, 1994: COMPANY Leverage Capital (to Average Assets) $26,673 $26,167 $ 506 4.08% Tier 1 Capital (to Risk-weighted Assets) 26,673 16,288 10,385 6.55 Total Capital (to Risk-weighted Assets) 43,772 32,577 11,195 10.75 NBR Leverage Capital (to Average Assets) 16,076 8,066 8,010 7.97 Tier 1 Capital (to Risk-weighted Assets) 16,076 6,865 9,211 9.37 Total Capital (to Risk-weighted Assets) 21,232 13,731 7,501 12.37 ALLIED Core Capital (to Total Assets) 17,664 16,511 1,153 4.27 Tier 1 Capital (to Risk-weighted Assets) 17,664 9,338 8,326 7.57 Total Capital (to Risk-weighted Assets) 19,900 18,677 1,223 8.52 Tangible Capital (to Total Assets) 17,664 6,199 11,465 4.27 - ---------------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------------
Management believes that as of December 31, 1995, the Company and its subsidiaries meet all capital requirements to which they are subject. Under the most stringent capital requirement, the Company has approximately $6,589,000 in excess capital before it becomes "undercapitalized" under the regulatory framework for prompt corrective action. Similarly, Allied has approximately $4,657,000 and NBR has $7,697,000 in excess capital. The prompt corrective action regulations impose restrictions upon all institutions to refrain from certain actions which would cause an institution to be classified as "undercapitalized", such as the declaration of the dividends or other capital distributions or payment of management fees, if following the distribution or payment the institution would be classified as "undercapitalized". In addition, institutions which are classified as "undercapitalized" are subject to certain mandatory and discretionary supervisory actions. NOTE P - DIVIDENDS The Company declared quarterly cash dividends at a rate of $.03 per common share for the fourth quarter of 1992 and the first three quarters of 1993. The cash dividend was increased to $.035 per common share in the fourth quarter of 1993 and remained at $.035 per share for the first three quarters of 1994. In December, 1994, the Company suspended its quarterly cash dividend on common shares. The Company declared cash dividends of $336,000, $448,000 and $432,000 on its preferred stock for the years ended December 31, 1995, 1994 and 1993. The Company declared a 3 percent stock dividend in 1993. The Company issued 75,000 common shares under this dividend. 40 NOTE Q - INDUSTRY SEGMENT DATA During the years ended December 31, 1995, 1994 and 1993, the Company operated in two principal industry segments: mortgage banking and commercial banking. The Company's mortgage banking activities relate to the origination for sale, servicing of sold mortgages and sale of residential mortgage loans. Commercial banking activities relate to the origination of commercial, real estate (including construction) and installment loans for the Company's portfolio and origination and sale of SBA loans. Commercial banking also includes other fee services. Revenue from mortgage banking activities is defined as interest income on mortgage loans held for sale and investments used to hedge or provide liquidity, gains on sale of loans and loan servicing and income from mortgage loan servicing activities. Revenue for commercial banking activities include interest income on loans and investments and service fee income. Operating profit for both segments excludes holding company expenses and income taxes. Identifiable assets are those assets that are used in the Company's operations in each industry segment. Corporate assets primarily consist of investments in subsidiaries. Substantially all mortgage loan sales are made to Freddie Mac and Fannie Mae. Capital expenditures and depreciation and amortization expenses are not material for the industry segments.
Year ending December, 31 1995 1993 1992 - -------------------------------------------------------------------- (IN THOUSANDS) REVENUE Mortgage banking $ 16,089 $ 16,269 $ 21,537 Commercial banking 47,860 32,621 24,858 - -------------------------------------------------------------------- Total $ 63,949 $ 48,890 $ 46,395 - -------------------------------------------------------------------- - -------------------------------------------------------------------- OPERATING PROFIT (LOSS) Mortgage banking $ 138 $ (9,821) $ 4,484 Commercial banking 7,639 6,881 4,242 - -------------------------------------------------------------------- Total operating profit (loss) 7,777 (2,940) 8,726 Corporate (2,105) (1,954) (863) - -------------------------------------------------------------------- Income (loss) before income taxes $ 5,672 $ (4,894) $ 7,863 - -------------------------------------------------------------------- - -------------------------------------------------------------------- IDENTIFIABLE ASSETS Mortgage banking $105,580 $168,461 $180,228 Commercial banking 450,486 459,444 290,229 Corporate 1,844 2,747 1,217 - -------------------------------------------------------------------- Total $557,910 $630,652 $471,674 - -------------------------------------------------------------------- - --------------------------------------------------------------------
NOTE R - FAIR VALUE OF FINANCIAL INSTRUMENTS Statement of Financial Accounting Standards No. 107, "Disclosures About Fair Value of Financial Instruments" requires that the Company disclose the fair value of financial instruments for which it is practicable to estimate that value. Although management uses its best judgment in assessing fair value, there are inherent weaknesses in any estimating technique that may be reflected in the fair values disclosed. The fair value estimates are made at a discrete point in time based on relevant market data, information about the financial instruments, and other factors. Estimates of fair value of instruments without quoted market prices are subjective in nature and involve various assumptions and estimates that are matters of judgment. Changes in the assumptions used could significantly affect these estimates. Fair value has not been adjusted to reflect changes in market conditions for the period subsequent to the valuation dates of December 31, 1995 and 1994 and therefore estimates presented herein are not necessarily indicative of amounts which could be realized in a current transaction. The following estimates and assumptions were used on December 31, 1995 and 1994 to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value. (a) CASH AND CASH EQUIVALENTS For cash and cash equivalents, the carrying amount is a reasonable estimate of fair value. (b) INTEREST-BEARING DEPOSITS DUE FROM FINANCIAL INSTITUTIONS The fair value of interest-bearing deposits held by the Company is based on the discounted cash flows through the date of maturity at market interest rates for similar maturities as of the valuation date. (c) INVESTMENTS Fair value equals quoted market price, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. For investments in unregistered mortgage-backed securities with recourse, fair value was estimated based on the expected future cash flows to be received adjusted for prepayments, foreclosures, losses and other significant factors impacting fair value. U.S. Government agency stock has no trading market but is required as part of membership, and therefore it is carried at cost. (d) LOANS HELD FOR SALE For uncommitted residential mortgages held for sale, fair value is estimated using indications of value obtained by management from independent third parties or quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics. Committed residential mortgage loans held for sale are valued based on actual commitment prices. Fair value of certain loans held for sale include the value of premiums associated with the sale of the related servicing rights in the instance that a commitment exists for the sale of such servicing at a predetermined rate. (e) LOANS RECEIVABLE To estimate fair value of loans held for investment, including commercial loans, mortgages and construction loans, each loan category is segmented by fixed and adjustable rate interest terms, by estimated credit risk, by maturity, and by performing and nonperforming categories. The fair value of performing loans is estimated by discounting 41 contractual cash flows using the current interest rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. Assumptions regarding credit risk, cash flow, and discount rates are judgmentally determined using available market information. The fair value of nonperforming loans and loans delinquent more than 30 days is estimated by discounting estimated future cash flows using current interest rates with an additional risk adjustment reflecting the individual characteristics of the loans. (f) INTEREST RECEIVABLE For interest receivable, the carrying amount is a reasonable estimate of fair value. (g) MORTGAGE SERVICING RIGHTS The fair value of mortgage servicing rights is estimated on a loan by loan basis using market prices under comparable servicing sale contracts, when available or, using a cash flow model with current assumptions with respect to prepayments, servicing costs and other significant factors. (h) DEPOSIT LIABILITIES Under SFAS No. 107, the fair value of deposits with no stated maturity, such as noninterest bearing demand deposits, savings and money market accounts, is equal to the amount payable on demand on December 31, 1995 and 1994. The fair value of time deposits, is based on the discounted value of contractual cash flows. The discount rate is based on rates currently offered for deposits of similar size and remaining maturities. (i) OTHER BORROWINGS AND SUBORDINATED NOTES The discounted value of contractual cash flows at market interest rates for debt with similar terms and remaining maturities are used to estimate the fair value of existing debt. (j) COMMITMENTS TO FUND MORTGAGE LOANS The fair value of commitments to fund fixed-rate mortgage loans represents the estimated gain (loss) to the Company of fully funding its commitments at current interest rates and selling the underlying loans in the secondary market. (k) COMMITMENTS TO FUND OTHER LOANS The fair value of commitments to fund other loans represents fees currently charged to enter into similar agreements with similar remaining maturities. (l) FORWARD CONTRACTS TO SELL MBS The fair value of forward contracts to sell MBS represents the difference between current rates for similar quantities and delivery dates of mortgage- backed securities as compared to the contractual rates. (m) PURCHASED AND WRITTEN OPTIONS Carrying value represents premiums paid or received. Fair values were obtained from third party dealers of such options. The estimated fair values of the Company's financial instruments are as follows: December 31
1995 1994 CARRYING FAIR Carrying Fair AMOUNT VALUE Amount Value - ------------------------------------------------------------------------------------------- (IN THOUSANDS) ASSETS: Cash and cash equivalents $ 55,140 $ 55,140 $ 33,354 $ 33,354 Interest-bearing deposits 417 417 512 512 Investments 43,964 43,964 42,066 41,554 Loans held for sale 62,620 64,251 138,003 138,003 Portfolio loans, net 363,187 366,046 378,782 377,159 Interest receivable 3,825 3,825 3,476 3,476 Mortgage servicing rights 5,970 7,446 6,270 9,982 LIABILITIES: Deposits 458,393 458,070 469,008 470,392 Other borrowings 47,871 45,438 112,075 112,075 Subordinated notes 12,000 12,300 12,000 11,160 UNRECOGNIZED FINANCIAL INSTRUMENTS: Commitments to fund mortgage loans 76 51 Commitments to fund other loans 349 353 Forward contracts to sell MBS (64) Purchased put options: MBS 217 84 U.S. Treasury 340 197 Purchased call options - U.S. Treasury 308 320 Written call options - MBS 261 464 Written put options - U.S. Treasury 204 170 - ------------------------------------------------------------------------------------------- - -------------------------------------------------------------------------------------------
42 NOTE S - RESTRUCTURING CHARGE During the third and fourth quarters of 1994, the Company implemented major cost reduction programs in response to declining origination volumes in the Company's mortgage banking business and recorded a restructuring charge of $815,000 in the third quarter and $1,594,000 in the fourth quarter. During 1995, the Company was able to sublease some of the properties noted below and recorded a recovery of $456,000. The restructuring entailed closing wholesale mortgage production offices in Fresno, San Diego, San Ramon and Windsor, California, Phoenix, Arizona and Seattle, Washington. The charge also includes the effects of consolidation of leased space in the Sacramento and Santa Rosa, California offices and termination of related employees. The restructuring charge consisted of:
1995 1994 - -------------------------------------------------------------- Severance expenses for 125 employees $ 374,000 Writeoff (recovery) of estimated present value of discontinued leases $(456,000) 1,683,000 Writeoff of leasehold improvements, furniture and fixtures 352,000 - -------------------------------------------------------------- $(456,000) $2,409,000 - -------------------------------------------------------------- - --------------------------------------------------------------
At December 31, 1995, $619,000 of the restructuring charge remained in other liabilities, substantially all of which is related to the future minimum lease payments associated with the closed facilities. The Company is actively seeking sublease tenants for many of these closed facilities and a portion of the restructuring charge may be reversed in future periods if the Company is successful in entering into such arrangements. NOTE T - COMMITMENTS AND CONTINGENCIES NBR and Allied maintain insurance on its customer deposits with the Federal Deposit Insurance Corporation ("FDIC"). The FDIC manages the Bank Insurance Fund ("BIF"), which insures deposits of commercial banks such as NBR, and the Savings Association Insurance Fund ("SAIF"), which insures deposits of savings associations such as Allied. FDICIA mandated that the two funds maintain reserves at 1.25% of their respective federally insured deposits. During 1995, the FDIC announced that the BIF had reached its mandated reserve level, reducing insurance premiums on BIF-insured deposits, and subsequently announcing that deposit insurance premiums on BIF-insured deposits would be reduced at December 31, 1995. The SAIF fund has not yet met its mandated reserve level. As a result, deposit insurance premiums attributable to BIF deposits are less than those attributable to SAIF deposits. There are numerous regulatory proposals before Congress to address the deposit insurance premium differential between BIF- and SAIF-insured deposits. The most recent plans consist of one-time insurance premium charges attributable to SAIF- insured deposits sufficient to bring the SAIF up to its mandated reserve level, with a corresponding and immediate reduction in SAIF premiums thereafter. Based on 87 basis points on Allied's deposits at March 31, 1995, the resulting after- tax charge to the Company would be approximately $1,670,000. As both the timing and final form of any proposed regulations remain uncertain, no adjustments to the Company's financial statements have been recorded at December 31, 1995. Certain lawsuits and claims arising in the ordinary course of business have been filed or are pending against the Company or its subsidiaries. Based upon information available to the company, its review of such lawsuits and claims and consultation with its counsel, the Company believes the liability relating to these actions, if any, would not have a material adverse effect on its financial position. NOTE U - CONDENSED FINANCIAL INFORMATION OF REDWOOD EMPIRE BANCORP (PARENT ONLY) BALANCE SHEETS
December 31, 1995 1994 - ------------------------------------------------------------------------ (IN THOUSANDS) ASSETS Cash $ 1,623 $ 626 Investment in subsidiaries 39,100 35,362 Capitalized issuance costs 735 815 Other assets 2,486 3,676 - ------------------------------------------------------------------------ Total assets $43,944 $40,479 - ------------------------------------------------------------------------ - ------------------------------------------------------------------------ LIABILITIES AND SHAREHOLDERS' EQUITY Accounts payable $ 359 $ 285 Subordinated notes 12,000 12,000 - ------------------------------------------------------------------------ Total liabilities 12,359 12,285 - ------------------------------------------------------------------------ SHAREHOLDERS' EQUITY: Preferred stock, authorized 2,000,000 shares; issued and outstanding 575,000 shares 5,750 5,750 Common stock, no par value: authorized 10,000,000 shares; issued and outstanding: 1995 - 2,679,227 shares; 1994 - 2,663,360 shares 18,728 18,609 Retained earnings 6,967 3,990 Unrealized gain (loss) on investment securities available for sale, net of taxes 140 (155) Total shareholders' equity 31,585 28,194 - ------------------------------------------------------------------------ Total liabilities and shareholders' equity $43,944 $40,479 - ------------------------------------------------------------------------ - ------------------------------------------------------------------------
43
STATEMENTS OF OPERATIONS Year Ended December 31, 1995 1994 1993 - ---------------------------------------------------------------------------------------------------- (IN THOUSANDS) Operating income: Management service fees $ 403 $ 61 $ 88 Dividends from subsidiaries 1,087 600 Interest income from subsidiaries 292 311 66 Other income 13 5 - ---------------------------------------------------------------------------------------------------- Total operating income 1,782 985 159 - ---------------------------------------------------------------------------------------------------- Expenses: Interest expense 1,100 1,131 5 Operating expenses 1,700 1,208 872 - ---------------------------------------------------------------------------------------------------- Total expenses 2,800 2,339 877 - ---------------------------------------------------------------------------------------------------- Loss before undistributed income of subsidiaries (1,018) (1,354) (718) Equity in undistributed income (loss) of subsidiaries 3,447 (1,900) 5,282 - ---------------------------------------------------------------------------------------------------- Income (loss) before income taxes 2,429 (3,254) 4,564 Income tax benefit (884) (219) - ---------------------------------------------------------------------------------------------------- Net income (loss) $ 3,313 $(3,035) $ 4,564 - ---------------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------------
STATEMENTS OF CASH FLOWS
Year Ended December 31, 1995 1994 1993 - ---------------------------------------------------------------------------------------------------- (IN THOUSANDS) Cash flows from operating activities: Net income (loss) $ 3,313 $(3,035) $ 4,564 - ---------------------------------------------------------------------------------------------------- Adjustments to reconcile net income (loss) to net cash provided by operating activities: Amortization and depreciation 10 5 9 Equity in undistributed net loss (income) of subsidiaries (3,447) 1,900 (5,282) Change in other assets 1,275 (300) (1,076) Change in other liabilities 186 225 (733) - ---------------------------------------------------------------------------------------------------- Total adjustments (1,976) 1,830 (7,082) - ---------------------------------------------------------------------------------------------------- Net cash provided by (used in) operating activities 1,337 (1,205) (2,518) - ---------------------------------------------------------------------------------------------------- Cash flows from investing activities: Investment in subsidiaries (6,000) (7,948) - ---------------------------------------------------------------------------------------------------- Net cash used in investing activities (6,000) (7,948) - ---------------------------------------------------------------------------------------------------- Cash flows from financing activities: Notes issued 12,000 Stock issuance 108 425 6,120 Cash dividends (448) (810) (621) - ---------------------------------------------------------------------------------------------------- Net cash provided by (used in) financing activities (340) (385) 17,499 - ---------------------------------------------------------------------------------------------------- Increase (decrease) in cash 997 (7,590) 7,033 Cash at beginning of year 626 8,216 1,183 - ---------------------------------------------------------------------------------------------------- Cash at end of year $ 1,623 $ 626 $ 8,216 - ---------------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------------
44 OTHER INFORMATION Redwood Empire Bancorp 111 Santa Rosa Avenue P.O. Box 402 Santa Rosa, CA 95402-0402 (707) 545-9611 American Stock Exchange Symbol "REB" SUBSIDIARY LOCATIONS National Bank of the Redwoods 111 Santa Rosa Avenue P.O. Box 402 Santa Rosa, CA 95402-0402 (707) 545-4800 Allied Bank, F.S.B. 2227 Capricorn Way Santa Rosa, CA 95407 (707) 524-5500 Redwood Empire Datacorp 111 Santa Rosa Avenue P.O. Box 402 Santa Rosa, CA 95402-0402 (707) 573-4800 DIRECTORS Redwood Empire Bancorp Orlando J. Antonini Business Consultant Haskell E. Boyett PG&E Division Manager, Retired John H. Downey Chairman of the Board Redwood Empire Bancorp Patrick W. Kilkenny President, Chief Executive Officer Redwood Empire Bancorp John R. Olsen Standard Insurance Company Investment Division, Retired William B. Stevenson Principal Financial Institutions Analysts & Consultants, Inc. Tom Whitaker President, Chief Executive Officer Motion Analysis Corporation EXECUTIVE OFFICERS Patrick W. Kilkenny President, Chief Executive Officer James E. Beckwith Chief Financial Officer SUBSIDIARY DIRECTORS National Bank of the Redwoods Orlando J. Antonini Haskell E. Boyett Richard I. Columbini John H. Downey Margie Handley Dennis E. Kelley Patrick W. Kilkenny John R. Olsen Patricia "Padi" Selwyn William B. Stevenson Tom Whitaker Allied Bank, F.S.B. Orlando J. Antonini Haskell E. Boyett John H. Downey Patrick W. Kilkenny Terance O'Mahoney John R. Olsen William B. Stevenson Tom Whitaker DIVIDEND DISBURSEMENT AGENT, REGISTRAR AND TRANSFER AGENT FOR COMMON AND PREFERRED STOCK Registered shareholders with questions about dividends, changes of address, lost certificates, or name changes should contact: Shareholder Relations First Interstate Bank of California 405 Montgomery Street San Francisco, CA 94104 Dividend Reinvestment and Stock Purchase Plan Shareholders may purchase additional shares of the Company's Common Stock conveniently and without fees or commissions through dividend reinvestment or direct cash payments. Further information may be obtained by writing to: First Interstate Bank of Califonia Dividend Reinvestment Department Box 60975 - Terminal Annex Los Angeles, CA 90060-60975 (800) 522-6645 FORM 10-K A copy of the Company's Annual Report on Form 10-K to be filed with the Securities and Exchange Commission will be furnished free of charge upon written request to: Shareholder Relations 111 Santa Rosa Avenue P.O. Box 402 Santa Rosa, CA 95402-0402 [REDWOOD EMPIRE BANCORP IN SCRIPT] [REDWOOD EMPIRE BANCORP LOGO] 111 Santa Rosa Avenue Santa Rosa, CA 95402-0402 707-545-9611 EX-21 6 EXHIBIT 21 Exhibit 21 REDWOOD EMPIRE BANCORP List of Subsidiaries The Company has the following subsidiaries, all of which are included in the Company's Consolidated Financial Statements: PERCENTAGE OF ORGANIZED VOTING SECURITES UNDER THE OWNED BY NAME LAWS OF IMMEDIATE PARENT - -------------------------------------------------------------------------------- Redwood Empire Bancorp California 100.00% Allied Bank, F.S.B. United States 100.00% Allied Diversified Credit (Inactive) California 100.00% National Bank of the Redwoods United States 100.00% NBR Mortgage and Investment Company California 100.00% Redwood Empire Datacorp California 100.00% EX-24 7 EXHIBIT 24 Exhibit 24 INDEPENDENT AUDITORS' CONSENT We consent to the incorporation by reference in Registration Statement No. 33- 49372 on Form S-8, Registration Statement No. 33-24642 on Form S-4, Registration Statement No. 33-41503 on Form S-8 and Registration Statement No. 33-61750 on From S-3 of Redwood Empire Bancorp of our report dated January 24, 1996 incorporated by reference in this Annual Report on Form 10-K of Redwood Empire Bancorp for the year ended December 31, 1995. Deloitte & Touche LLP March 11, 1996 EX-27 8 FINANCIAL DATA SCHEDULE
9 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE CONSOLIDATED BALANCE SHEETS AND CONSOLIDATED STATEMENTS OF OPERATIONS OF THE COMPANY'S FORM 10-K AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000 YEAR DEC-31-1995 JAN-01-1995 DEC-31-1995 24312 417 9969 0 37436 6528 6528 368224 5037 557910 458393 47871 8061 12000 0 5750 18728 140 557910 42469 3187 1718 47374 22730 27671 19703 1590 386 29016 5672 3313 0 0 3313 1.11 1.04 3.63 4201 92 651 2700 5787 2450 110 5037 4996 0 41 EXCLUDES MORTGAGE LOANS HELD FOR SALE
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