Filed with the SEC from Mar 21 to Mar 27:
Pacific Mercantile Bancorp (PMBC)
Clinton Group said it now owns 1,690,438 shares (9.3%) after it bought 119,480 shares from March 12 through March 20 at prices in a range from $5.68 to $6.27 apiece.
Pacific Mercantile Bancorp is a California corporation that owns 100% of the stock of Pacific Mercantile Bank, a California state chartered commercial bank (which, for convenience, will sometimes be referred to in this report as the â€śBankâ€ť). The capital stock of the Bank is our principal asset and substantially all of our business operations are conducted by the Bank which, as a result, accounts for substantially all of our revenues, expenses and income. As the owner of a commercial bank, Pacific Mercantile Bancorp is registered as a bank holding company under the Bank Holding Company Act of 1956, as amended (the â€śBank Holding Company Actâ€ť) and, as such, our operations are regulated by the Board of Governors of the Federal Reserve System (the â€śFederal Reserve Boardâ€ť). See â€śSupervision and Regulationâ€ť below in this Report. For ease of reference, we will sometimes use the terms â€śCompany,â€ť â€śweâ€ť or â€śusâ€ť in this Report to refer to Pacific Mercantile Bancorp on a consolidated basis and â€śPM Bancorpâ€ť or the â€śBancorpâ€ť to refer to Pacific Mercantile Bancorp on a â€śstand-aloneâ€ť or unconsolidated basis.
The Bank, which is headquartered in Orange County, California, approximately 40 miles south of Los Angeles, conducts a commercial banking business in Orange, Los Angeles, San Bernardino and San Diego counties in Southern California. The Bank is also a member of the Federal Reserve System and its deposits are insured, to the maximum extent permitted by law, by the Federal Deposit Insurance Corporation (commonly known as the â€śFDICâ€ť).
At December 31, 2012, our total assets, net loans (which exclude loans held for sale) and total deposits were $1.054 billion, $719 million and $845 million, respectively. Additionally, as of that date a total of approximately 7,700 deposit accounts were being maintained at the Bank by our customers, of which approximately 38% were business customers. Currently we operate seven full service commercial banking offices (which we refer to as â€śfinancial centersâ€ť) and an online banking branch at www.pmbank.com. Due to the Bankâ€™s online presence, the Bank has customers who are located in 49 states and the District of Columbia, although the vast majority of our customers reside or are located in Southern California.
The Bank commenced business in March 1999, with the opening of its first financial center, located in Newport Beach, California, and in April 1999 it launched its online banking site, at www.pmbank.com, where our customers are able to conduct many of their business and personal banking transactions, more conveniently and less expensively, with us, 24 hours a day, 7 days a week. Between August 1999 and July 2005, we opened six additional financial centers as part of an expansion of our banking franchise into Los Angeles, San Diego and San Bernardino counties in Southern California. Set forth below is information regarding our current financial centers.
According to data published by the FDIC, at December 31, 2012 there were approximately 119 commercial banks operating with banking offices located in the counties of Los Angeles, Orange, San Diego, Riverside and San Bernardino in Southern California. Of those commercial banks, 14 had assets in excess of $2 billion; 79 had assets under $500 million (which are often referred to as â€ścommunity banksâ€ť); 14 had assets between $500 million and $1 billion, and 10, including our Bank, had assets ranging between $1 billion and $2 billion. As a result, we believe that we are well-positioned to achieve further growth in Southern California.
Our Business Strategy
Our growth and expansion are the result of our adherence to a business plan which was created by our founders, who include both experienced banking professionals and individuals who came out of the computer industry. That business plan is to build and grow a banking organization that offers its customers the best attributes of a community bank, which are personalized and responsive service, while taking advantage of advances in computer technology to reduce costs and at the same time extend the geographic coverage of our banking franchise, initially within Southern California, by opening additional financial centers and benefiting from opportunities that may arise in the future to acquire other banks.
In furtherance of that strategy:
We offer at our financial centers and at our interactive online banking website, a broad selection of financial products and services that address, in particular, the banking needs of business customers and professional firms, including services that are typically available only from larger banks in our market areas.
We provide a level of convenience and access to banking services that we believe are not typically available from the community banks with which we compete, made possible by the combination of our full service financial centers and the online banking capabilities coupled with personal services we offer our customers.
We have built a technology and systems infrastructure that we believe will support the growth and further expansion of our banking franchise in Southern California.
We continue to review and analyze additional opportunities to further enhance our profitability such as a return in 2010 to business of originating single family mortgage loans that qualify for resale into the secondary mortgage market.
We plan to continue to focus our services and offer products primarily to small to mid-size businesses in order to achieve internal growth of our banking franchise. We believe this focus will enable us to grow our loans and other earning assets and increase our core deposits (consisting of non-interest bearing demand, and lower cost savings and money market deposits), with the goal of increasing our net interest margins and improving our profitability. We also believe that, with our technology systems in place, we have the capability to significantly increase the volume of banking transactions without having to incur the cost or disruption of a major computer enhancement program.
Our Commercial Banking Operations
We seek to meet the banking needs of small and moderate size businesses, professional firms and individuals by providing our customers with:
A broad range of loan and deposit products and banking and financial services, more typically offered by larger banks, in order to gain a competitive advantage over independent or community banks that do not provide the same range or breadth of services that we are able to provide to our customers;
A high level of personal service and responsiveness, more typical of independent and community banks, which we believe gives us a competitive advantage over large out-of-state and other large multi-regional banks that are unable, or unwilling, due to the expense involved, to provide that same level of personal service to this segment of the banking market; and
The added flexibility, convenience and efficiency of conducting banking transactions with us over the Internet, which we believe further differentiates us from many of the community banks with which we compete and enables us to reduce the costs of providing services to our customers.
Deposits are a bankâ€™s principal source of funds for making loans and acquiring other interest earning assets. Additionally, the interest expense that a bank must incur to attract and maintain deposits has a significant impact on its operating results. A bankâ€™s interest expense, in turn, will be determined in large measure by the types of deposits that it offers to and is able to attract from its customers. Generally, banks seek to attract â€ścore depositsâ€ť which consist of demand deposits that bear no interest and low cost interest-bearing checking, savings and money market deposits. By comparison, time deposits (also sometimes referred to as â€ścertificates of depositâ€ť), including those in denominations of $100,000 or more, usually bear much higher interest rates and are more interest-rate sensitive and volatile than core deposits. A bank that is not able to attract significant amounts of core deposits must rely on more expensive time deposits or alternative sources of cash, such as Federal Home Loan Bank borrowings, to fund interest-earning assets, which means that its costs of funds are likely to be higher and, as a result, its net interest margin is likely to be lower than a bank with higher proportion of core deposits. See â€śMANAGEMENTâ€™S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS â€” Results of Operations- Net Interest Income â€ť in Item 7 of this report.
We offer our customers a number of different loan products, including commercial loans and credit lines, accounts receivable and inventory financing, SBA guaranteed business loans, commercial real estate, residential mortgage loans, and consumer loans.
The commercial loans we offer generally include short-term secured and unsecured business and commercial loans with maturities ranging from 12 to 24 months, accounts receivable financing for terms of up to 18 months, equipment and automobile term loans and leases which generally amortize over a period of up to 7 years, and SBA guaranteed business loans with terms of up to 10 years. The interest rates on these loans generally are adjustable and usually are indexed to The Wall Street Journalâ€™s prime rate and will vary based on market conditions and commensurate to the credit risk. However, since 2003 it generally has been our practice to establish an interest rate floor on a best effort basis on our commercial loans. In order to mitigate the risk of borrower default, we generally require collateral to support the credit or, in the case of loans made to businesses, personal guarantees from their owners, or both. In addition, all such loans must have well-defined primary and secondary sources of repayment. Generally, lines of credit are granted for no more than a 12-month period.
Commercial loans, including accounts receivable financing, generally are made to businesses that have been in operation for at least three years. To qualify for such loans, prospective borrowers generally must have debt-to-net worth ratios not exceeding 4-to-1, operating cash flow sufficient to demonstrate the ability to pay obligations as they become due, and good payment histories as evidenced by credit reports.
We also offer asset-based lending products, which involve a higher degree of risk because they generally are made to businesses that are growing rapidly, but cannot internally fund their growth without borrowings. These loans are collateralized primarily by the borrowerâ€™s accounts receivable and inventory. We control our risk by generally requiring loan-to-value ratios of not more than 80% and by closely and regularly monitoring the amount and value of the collateral in order to maintain that ratio.
Commercial loan growth is important to the growth and profitability of our banking franchise because, although not required to do so, commercial loan borrowers often establish noninterest-bearing (demand) and interest-bearing transaction deposit accounts and banking services relationships with us. Those deposit accounts help us to reduce our overall cost of funds and those banking services relationships provide us with a source of non-interest income.
Commercial Real Estate Loans
The majority of our commercial real estate loans are secured by first trust deeds on nonresidential real property. Loans secured by nonresidential real estate often involve loan balances to single borrowers or groups of related borrowers, and generally involve a greater risk of nonpayment than do mortgage loans secured by multi-family dwellings. Payments on these loans depend to a large degree on the results of operations and cash flows of the borrowers, which are generated from a wide variety of businesses and industries. As a result, repayment of these loans can be affected adversely by changes in the economy in general or by the real estate market more specifically. Accordingly, the nature of this type of loan makes it more difficult to monitor and evaluate. Consequently, we typically require personal guarantees from the owners of the businesses to which we make such loans.
Customers desiring to obtain commercial real estate loans are required to have good payment records with a debt coverage ratio generally of at least 1.25 to 1. In addition, we require adequate insurance on the properties securing those loans to protect the collateral value. These loans are generally adjustable rate loans with interest rates tied to a variety of independent indexes. However, in some instances, the interest rates on these loans are fixed for an initial five year period and then adjust thereafter based on an applicable index. These loans are generally written for terms of up to 10 years, with loan-to-value ratios of not more than 75% in the case of owner occupied properties and 65% on non-owner occupied properties.
Residential Mortgage Loans â€“ Multi-family
We make multi-family residential mortgage loans primarily in Southern California for terms up to 30 years. These loans generally are adjustable rate loans with interest rates tied to a variety of independent indexes; although in some cases these loans have fixed interest rates for an initial five-year period and adjust thereafter based on an applicable index. These loans generally have interest rate floors, payment caps, and prepayment penalties. The loans are underwritten based on a variety of borrower and property criteria. Borrower criteria include liquidity and cash flow analysis and credit history verifications. Property criteria generally include loan to value limits under 75% and debt coverage ratios of 1.20 to 1 or greater.
Real Estate Construction and Land Development Loans
To reduce our exposure to the deteriorating conditions in the real estate markets, in the fourth quarter of 2007, we began reducing the volume of single family residential and real estate construction loans that we were making, while at the same time increasing our commercial and business lending. Moreover, in 2010 we essentially ceased all real estate construction lending.
We offer a variety of loan and credit products to consumers including personal installment loans, lines of credit, credit cards, and to high net-worth individuals for estate planning based upon cash surrender value life insurance. We design these products to meet the needs of our customers, and some are made at fixed rates of interest and others at adjustable rates of interest. Consumer loans often entail greater risk than real estate mortgage loans, particularly in the case of consumer loans which are unsecured or are secured by rapidly depreciable assets, such as automobiles, that may not provide an adequate source of repayment in the event of a default by the consumer. Consumer loan collections are dependent on the borrowerâ€™s ongoing financial stability. Furthermore, in the event a consumer files for bankruptcy protection, the bankruptcy and insolvency laws may limit the amount which can be recovered on such loans. To qualify for a consumer loan a prospective borrower must have a good payment record and, typically, debt ratios of not more than 45%.
Consumer loans and credit products are important because consumers are a source of noninterest-bearing checking accounts and low cost savings deposits. Additionally, banking relationships with consumers tend to be stable and longer lasting than banking relationships with businesses, which tend to be more sensitive to price competition.
Business Banking Services
We offer various banking and financial services designed primarily for our business banking customers. Those services include:
Financial management tools and services that include multiple account control, account analysis, transaction security and verification, wire transfers, bill payment, payroll and lock box services, most of which are available at our Internet website, www.pmbank.com; and
Automated clearinghouse (ACH) origination services which enable businesses that charge for their services or products on a recurring monthly or other periodic basis, to obtain payment from their customers through an automatic, pre-authorized debit from their customersâ€™ bank accounts anywhere in the United States.
Convenience Banking Services
We also offer a number of services and products that make it more convenient to conduct banking transactions with us, such as online banking services, ATMs, night drop services, courier and armored car services that enable our business customers to order and receive cash without having to travel to our banking offices, and Remote Deposit Capture (PMB Xpress Deposit) which enables business customers to image checks they receive for electronic deposit at the Bank, thereby eliminating the need for customers to travel to our offices to deposit checks into their accounts.
Online Banking Services
Our customers can securely access our online bank at www.pmbank.com to:
Use financial cash management tools and services
View account balances and account history
Transfer funds between accounts
Pay bills and order wire transfers of funds
Transfer funds from credit lines to deposit accounts
Make loan payments
Print bank statements
Place stop payments
Purchase certificates of deposit
Our Mortgage Banking Business
During the second quarter of 2010, we commenced a new mortgage banking business to originate residential real estate mortgage loans that qualify for sale to third-party investors into the secondary mortgage markets. Residential mortgage loans consist of loans secured by single-family residential properties.
We offer a variety of mortgage loan products catering to the specific needs of home borrowers, including fixed rate and adjustable rate, conventional and government insured (Federal Housing Administration (FHA) and Veteran Affairs (VA)) mortgages with either 30-year or 15-year terms. We also offer jumbo loans that meet conventional underwriting criteria, except for the loan amounts which exceed Fannie Mae and Freddie Mac limits.
The mortgage loans we originate are generally secured by first liens on the underlying real properties. We do not originate mortgage loans defined as high cost by state or federal regulators or that do not comply with applicable agency or investor-specific underwriting guidelines. The majority of these residential mortgage loans are made to finance the purchase of, or to refinance existing loans on, owner-occupied homes, and are collateralized by real properties located in Southern California; however we also originate mortgage loans throughout California and in 17 other states. The mortgage lending business is subject to seasonality, and the overall demand for mortgage loans is driven largely by the applicable interest rates at any given time.
We handle mortgage loan processing, underwriting and closings at our headquarters offices in Costa Mesa, California, and we sell a majority of the mortgage loans to various investors in the secondary market, subject to certain indemnification obligations, which may require us to repurchase loans sold and repay the sales proceeds to investors under certain conditions. In addition, if a customer defaults on a mortgage payment shortly after the loan is originated, the investor may require us to repurchase the loan at the full amount paid by the investor. Mortgage loans which we do not sell into the secondary mortgage market are held for investment by us.
Our residential mortgage loan business initially focused on the origination of mortgage loans directly from consumers seeking to refinance existing mortgage loans or finance the purchase of residential real estate (the â€śdirect-to-consumer retail mortgage channelâ€ť). In the latter half of 2011, we expanded our mortgage banking operations to include the funding of residential mortgage loans originated by independent mortgage brokers (the â€śwholesale mortgage channelâ€ť). Largely due to the growth of our wholesale mortgage business, the volume of residential mortgage loans funded by us grew from approximately $370 million in 2011 to approximately $955 million in 2012 and our mortgage banking division grew from approximately 172 employees at December 31, 2011 to approximately 212 employees at December 31, 2012.
However, as previously reported, based on review of our mortgage banking operations in mid-2012, we decided to focus our residential mortgage banking business entirely on the direct-to-consumer retail mortgage channel and to exit the wholesale mortgage banking business. Consequently, we ceased accepting new mortgage submissions submitted to us after August 31, 2012, although we did continue to process and fund all mortgage broker-originated loans in process or originated on our before that date. This action was taken (i) to enable us to redeploy some of our capital resources that were committed to the wholesale mortgage business to our core commercial lending business in anticipation of a strengthening of the economy and ahead of an expected reduction in the demand for residential mortgage loans due to an eventual increase in prevailing mortgage interest rates, (ii) to reduce and control our staffing costs and operating expenses, which had grown significantly due primarily to the growth of our wholesale mortgage business, and (iii) to manage and limit the interest rate and other risks inherent in residential mortgage businesses, including risks posed by the increase in government regulation of the mortgage industry primarily as a result of the adoption and implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the â€śDodd-Frank Actâ€ť). See â€śâ€” Impact of Economic Conditions, Government Policies and Legislation on our Business â€ť below in this Item 1.
The full impact of our exit from the wholesale mortgage loan channel on our operating results is not reflected in our operating results during the four month period ended December 31, 2012, primarily because we continued to fund broker-originated loans that were in process or for which applications had been submitted to us prior to September 1, 2012. However, we expect that our exit from the wholesale mortgage channel will result in a reduction, which could be substantial, in our mortgage banking revenues in 2013, as compared to 2012, which could, in turn, result in a reduction in our net income in 2013. Nevertheless, in our view, the exit from the wholesale mortgage loan channel was prudent, because we believe that it will enable us to build a stronger foundation for achieving improved profitability in the future, reduce and control our operating costs and reduce and limit interest rate and other risks inherent in the mortgage business, in order to enhance the value of our banking franchise in the future. However, there is no assurance that these objectives will be achieved.
Size of Board
Our bylaws currently provide that the authorized number of directors shall not be less than five or more than nine with the exact number of directors, within that range, to be fixed from time to time by resolution of the Board of Directors. The authorized number of directors is currently fixed at eight and the Board is currently composed of eight directors. The Board has nominated the nine candidates named below for election to the Board of Directors at the upcoming Annual Meeting. As a result, if those nine nominees are elected at the Annual Meeting, the authorized number of directors will be increased to nine.
As discussed below, the Board of Directors is asking shareholders to approve a bylaw amendment at the Annual Meeting to increase the minimum and maximum authorized number of directors to seven and thirteen, respectively. If our shareholders approve that bylaw amendment, then, the Board expects to increase the authorized number of directors to 12 and appoint three new members to the Board after they are determined to qualify to serve under bank regulatory requirements. See â€śAPPROVAL OF BYLAW AMENDMENT TO INCREASE THE AUTHORIZED NUMBER OF DIRECTORS TO A MINIMUM OF 7 AND A MAXIMUM OF 13 DIRECTORS (Proposal No. 2)â€ť below.
Our Board of Directors has nominated the nine individuals named below for election to the Board for a term of one year ending at the 2013 Annual Meeting of Shareholders and until their successors are elected and qualify to serve. Each of those nominees has consented to serve as a director, if elected at the upcoming Annual Meeting. Eight of the nine nominees are currently serving as directors and seven of the nine nominees were elected to the Board at the 2011 Annual Meeting held in May 2011. Mr. Strauss was elected to the Board in November 2011 by unanimous vote of the incumbent directors.
The other nominee that was not elected to the Board at last yearâ€™s annual meeting, is Mr. Neil Kornswiet, who is, however, and since 2010 has been a member of the Bankâ€™s Board of Directors. If Mr. Kornswiet is elected as a director of the Company at the upcoming Annual Meeting, his service as a director will commence on the later of (i) the date of the Annual Meeting or (ii) the date on which the Company receives notice from its principal banking regulator that Mr. Kornswiet has qualified to serve as a director under applicable bank regulatory standards. The Company has no reason to believe Mr. Kornswiet will not so qualify. However, if the required regulatory notice has not been received by the date of the Annual Meeting, then, the authorized number of directors will remain at eight and the Board will increase the authorized number of directors to nine, and Mr. Kornswietâ€™s term of office as a director will commence, when that regulatory notice is received.
Name of Nominee Age Director Since
George H. Wells 77 1999 (1)
Raymond E. Dellerba 64 1999 (1)
George L. Argyros 75 2010
Warren T. Finley 80 1999 (1)
Neil B. Kornswiet 55 â€” (2)
Andrew Phillips 54 2010
Daniel A. Strauss 26 2011
John Thomas, M.D. 61 1999 (1)
Gary M. Williams 59 2007
(1) The Bank was organized and commenced its operations, and each of these individuals became directors of the Bank, in 1999. The Company was organized in 2000 to become the holding company for the Bank, at which time each of these individuals also became directors of the Company.
(2) Although Mr. Kornswiet has not previously served on the Companyâ€™s Board of Directors, he currently is and since July 2010 has been a director of the Bank.
Vote Required and Recommendation of the Board of Directors
Unless otherwise instructed, the persons who are named as the proxy holders on the enclosed proxy card intend to vote the proxies received by them for the election of all nine of these nominees. If, prior to the Meeting, any nominee of the Board of Directors becomes unavailable to serve as a director, the proxy holders will vote the proxies received by them for the election of any substitute nominee selected by the Board of Directors. The Company has no reason to believe that any of the nominees will become unable to serve.
Under California law, the nine nominees receiving the highest number of votes cast in the election of Directors will be elected to serve as Directors of the Company for the ensuing year. As a result, although shares that are voted â€świthheldâ€ť will be counted, they will have no effect on the outcome of the election.
If any record shareholder gives notice at the Annual Meeting of his or her intention to cumulate votes in the election of Directors, the proxy holders will have the discretion to allocate and cast the votes represented by each of the proxies they hold among the above-named nominees for whom authority to vote has not been withheld, in such proportions as the proxy holders deem appropriate in order to elect as many of the nominees named above as is possible.
THE BOARD OF DIRECTORS RECOMMENDS A VOTE â€ś FOR â€ť THE ELECTION OF EACH OF THE NOMINEES NAMED ABOVE.
Set forth below is information relating to the principal occupations, recent business experience and qualifications of each of the nominees selected by the Board of Directors for election to the Companyâ€™s Board of Directors at the Annual Meeting.
George H. Wells has served as the Chairman of the Board and a Director of the Company and the Bank since the respective dates of their inception. Mr. Wells is a private investor. Mr. Wells was a founding director of Eldorado Bank in 1972, which was also based in Orange County, California, and served as Chairman of the Board of Directors of that bank and of its parent holding company, Eldorado Bancorp, from 1979 to 1997, when Eldorado Bank was sold. Prior to becoming a private investor, Mr. Wells held various executive positions, including Chairman, President, Treasurer and Chief Financial Officer, with Technology Marketing Incorporated, a publicly traded computer development services and software company. Mr. Wells brings extensive banking experience to the Board by reason of his many years of service as an outside Chairman and a director of Eldorado Bancorp and of the Company and the Bank. He also is familiar with and well known in the Orange County business community, which represents a significant market for us. In addition, he was the founder and served as a Chief Executive Officer and Chief Financial Officer of a public company and, as a result, is familiar with risk management and financial reporting issues, which qualifies him to serve as a member of the Board and the Companyâ€™s Audit Committee.
Raymond E. Dellerba has been the President, Chief Executive Officer and a Director of the Company and the Bank since the respective dates of their inception, in 1999 and 2000. Mr. Dellerba also served as the President, Chief Operating Officer and a director of Eldorado Bank, and Executive Vice President and a director of its parent holding company, Eldorado Bancorp, from February 1993 to 1997. Mr. Dellerba has more than 30 years of experience as a banking executive, primarily in Southern California and is familiar not only with the Orange County, but also the Los Angeles County, banking and financial services markets, which represent the Bankâ€™s two largest markets. As a result, Mr. Dellerba brings extensive leadership and community banking experience to our Board. In addition, as the Chief Executive Officer of the Company and the Bank, he provides valuable insight and guidance on the issues of corporate strategy and risk management.
George L. Argyros has been a member of the Board of Directors since April 2010. Mr. Argyros is, and for more than the last five years has been, the Chairman and Chief Executive Officer of Arnel & Affiliates, a diversified investment company. He was the U.S. Ambassador to Spain and Andorra from 2001 to 2004. He currently serves as a director of First American Corporation, one of the largest title insurance companies in the United States, and DST Systems, Inc., a provider of sophisticated information processing, computer software services and business solutions to the financial services, communications and healthcare industries. As a result of his extensive experience as a real estate developer and investor in numerous public and private companies, Mr. Argyros provides us with insight into ways in which we can improve the services we provide to many of our loan and deposit customers and with respect to risks associated with real estate lending.
Warren T. Finley has served as a Director of the Company and the Bank since the respective dates of their inception in 1999 and 2000. Mr. Finley has been engaged in the private practice of law in Orange County for over 50 years. Mr. Finley also served as a director and a member of the audit committee of Eldorado Bank and its parent holding company, Eldorado Bancorp, from 1972 to 1997. As a result, Mr. Finley has extensive community banking experience in Orange County, which is one of our significant markets. Prior to becoming a lawyer, Mr. Finley was a certified public accountant and was employed as an accountant at Price Waterhouse & Co. As a result of his accounting experience, Mr. Finley is familiar with financial reporting requirements and financial issues, making him an effective member of Audit Committee, of which he is the Chairman.
Neil B. Kornswiet is and since July 2010 has been the President of the Mortgage Division and a member of the Board of Directors of the Bank. Mr. Kornswiet has over 20 years experience in residential real estate lending, servicing and finance. Prior to joining the Bank, Mr. Kornswiet was a Managing Director of UBS Investment Bank with responsibility for mortgage loan servicing and mortgage loan origination in the United States. He previously founded and served as the Chief Executive Officer of nationwide mortgage lenders Peopleâ€™s Choice Home Loan, Inc. and One Stop Mortgage, Inc. Mr. Kornswiet also served as President of nationwide mortgage loan origination and servicing companies Aames Financial Corporation and Quality Mortgage. Mr. Kornswiet is licensed to practice law in California and New York. Mr. Kornswietâ€™s extensive knowledge of the mortgage banking business will be valuable to the other directors in enhancing their understanding of and in making strategic decisions with respect to the Companyâ€™s mortgage banking business, which is becoming increasingly important to the Companyâ€™s overall financial performance.
Andrew M. Phillips has been a director of the Company and the Bank since April 2010. Mr. Phillips is the founder and President of CardFlex, Inc. Mr. Phillips also has owned and operated several payment-processing companies, including CheckRite, a check recovery franchise, Integrated Transaction Services, a full-service processing independent sales organization that specialized in electronic benefits transfers, and Payment Resources International, one of the pioneers in the rapidly expanding field of Internet payment systems. His technological expertise has enabled him to develop some of the financial services industryâ€™s leading processing technologies, including Transaction Centralâ„˘, a Web-based credit card and an ACH (Automated Clearing House) terminal that features all the functionality of an electronic countertop terminal. As a result, Mr. Phillips brings a wealth of knowledge regarding payment processing services, which are valuable to us in understanding and meeting the needs of our business customers for such services. Mr. Phillips serves as a member of the Board of Directors of the Orange County chapter of the Alzheimerâ€™s Association.
Daniel A. Strauss has been a director of the Company since November 15, 2011. Mr. Strauss is, and since 2010 has been, a Senior Vice President of Clinton Group, Inc. (â€śClintonâ€ť), where he serves as a Senior Strategist on its private and public equity investment team. In that position, Mr. Strauss is responsible for evaluating and effectuating equity financing transactions across a range of industries, including the banking and financial services industries. From 2008 to 2010, Mr. Strauss was employed as an Associate in the private equity investment group at Angelo, Gordon & Co. Prior to joining that firm, Mr. Strauss was an investment banking analyst in the mergers and acquisitions group of Houlihan Lokey. Mr. Strauss holds a Bachelors of Science degree in Finance and International Business from the Stern School of Business at New York University. Mr. Strauss brings to the Board extensive knowledge with respect to the structuring of equity financings and the evaluation of bank acquisition opportunities. Mr. Strauss was appointed to the Board, pursuant to an agreement entered into by the Company with SBAV in connection with its purchase of $7.5 million of the Companyâ€™s Series B Shares in August 2011.
John Thomas, M.D. has served as a Director of the Company and the Bank since the respective dates of their inception. Dr. Thomas is a licensed physician who is, and for more than the past 17 years has been, engaged in the private practice of medicine, specializing in Radiation Oncology. He also serves as, and for over 10 years has been, the Medical Director of the Red Bluff Cancer Center, which he founded and has grown into a leading provider of specialty medical services. He is a Diplomate and Fellow of the American Board of Radiology and a Fellow of the American College of Radiation Oncology, and serves as a member of its Standards Committee. He brings his managerial experience, gained from founding, managing and growing his Cancer Center, which has enabled him to provide valuable insights about how we can better serve our smaller business customers, which include medical practices and medical service providers.
Gary M. Williams has been a member of the Companyâ€™s Board of Directors since July 2007. He also has been a member of the Bankâ€™s Board of Directors since February 2007. Mr. Williams is, and since 1992 has been, one of the co-owners and the CEO of Garcher Enterprises Inc., which owns the area franchise rights for all Mail Boxes Etc. locations and UPS stores in Los Angeles, Orange and San Diego Counties in California, overseeing a total 257 stores in that three-county area. From 1987 until 1992, Mr. Williams was the President of Mail Boxes Coast to Coast, a publicly traded company that owned the Mail Boxes Etc. area franchise rights for New York City and Queens, and for Nassau and Suffolk Counties, in New York. As a result, Mr. Williams has extensive leadership and managerial experience which enables him to provide valuable insights into how to manage risk in a business environment. As a franchisor, moreover, he has developed extensive knowledge about the operations and financial needs of smaller businesses and that knowledge has been particularly valuable to us in growing our SBA loan business.
There are no family relationships among any of the officers or directors of the Company.
MANAGEMENT DISCUSSION FROM LATEST 10K
Forward Looking Statements
The following discussion contains statements (which are commonly referred to as â€śforward looking statementsâ€ť) which discuss our beliefs or expectations about (i) our future financial performance and future financial condition and (ii) operating trends in our markets and in economic conditions generally. The consequences of those operating trends on our business and the realization of our expected future financial results, as discussed in those forward looking statements, are subject to a number of risks and uncertainties, including those described above in Item 1A of this Report under the caption â€śRISK FACTORS.â€ť Due to those risks and uncertainties, our future financial performance may differ, possibly significantly, from the performance that is currently expected as set forth in the forward looking statements. As a result, you should not place undue reliance on those forward looking statements. We disclaim any obligation to update or revise any of the forward looking statements, whether as a result of new information, future events or otherwise, except as may be required by applicable law or NASDAQ rules.
The following discussion presents information about our consolidated results of operations, financial condition, liquidity and capital resources and should be read in conjunction with our consolidated financial statements and the notes thereto included in Item 8 of this Report.
Our principal operating subsidiary is Pacific Mercantile Bank (the â€śBankâ€ť), which is a California state chartered bank and a member of the Federal Reserve System. The Bank accounts for substantially all of our consolidated revenues, expenses and income and our consolidated assets and liabilities. Accordingly, the following discussion focuses primarily on the Bankâ€™s results of operations and financial condition.
Net Income and Income per Diluted Share . Notwithstanding that increase in pre-tax income, net income declined by 17.0% to approximately $9.7 million in the year ended December 31, 2012 from $11.6 million in the year ended December 31, 2011. That decrease was attributable to a $3.5 million reduction in income tax benefits to $3.0 million in 2012 from $6.4 million in 2011. Income per diluted share of common stock was $0.55 for 2012, as compared to $0.98 per diluted share in 2011, due not only to the lower income tax benefits in 2012, but also a 56% increase in the weighted average shares outstanding in 2012, as compared to 2011, due to primarily to our sale, in a private placement, of a total of 4,201,278 shares of our common stock in April 2012 at a price of $6.26 per share in cash.
The increase in pre-tax income in 2012 was primarily attributable to a combination of factors, the most important of which were the following:
Increase in Noninterest Income. In 2012, noninterest income increased by $20.3 million, or 246.3%, as compared to 2011, which was primarily attributable to a $19.2 million, or 316.1%, increase in mortgage banking revenue and a $1.7 million, or 424.2%, increase in net gains from sales of securities held for sale. The increase in mortgage banking revenue was due primarily to the growth of our wholesale mortgage business which funded, and sold into the secondary mortgage market, residential mortgage loans originated for us by outside mortgage brokers. As previously reported and for the reasons discussed below, we exited the wholesale mortgage business by ceasing to accept mortgage loan applications from outside brokers effective August 31, 2012, while continuing our direct-to-consumer retail mortgage business in which we originate mortgage loans directly from consumers. As a result, we expect to report a significant decline in our mortgage banking revenues in 2013 when compared to 2012.
Modest Increase in Net Interest Income . Net interest income increased by $80,000, or 0.2%, in 2012 due to a nearly $2.6 million, or 23.0%, decrease in interest expense that resulted primarily from (i) decreases in market rates of interest, which led to reductions in the rates of interest we paid on deposits and borrowings, and (ii) a change in the mix of our deposits to a higher proportion of non-interest bearing demand deposits. That decrease in interest expense more than offset a $2.5 million, or 5.6%, decline in interest income, which was primarily attributable to (i) a $1.7 million decline in interest earned on securities available for sale and (ii) an $808,000 decline in interest and fee income on loans, primarily reflecting the impact of declines in market rates of interest on the yields we earned on such securities and on our loans in 2012 and, to a lesser extent, a decline in the average volume of such securities outstanding during 2012.
Increase in Noninterest Expense. Noninterest expense increased by $16.1 million, or 34.4%, in 2012, as compared to 2011. That increase was primarily attributable to increases of $9.0 million, $3.3 million, $1.9 million, and $1.6 million in compensation expense, expenses incurred in connection with other real estate owned (â€śOREOâ€ť), mortgage-loan related expenses and other operating expenses, respectively, in 2012 as compared to 2011. The increase in compensation expense was primarily attributable to an increase in mortgage banking personnel employed during 2012, as compared to 2011 and, to a much lesser extent, the addition of loan officers primarily for our SBA and entertainment industry lending businesses.
Increase in Provision for Loan Losses. The provision we made for loan losses increased by nearly $2.8 million, or 334.1%, in 2012, as compared to 2011 when we recorded an $833,000 reduction in the provision. That increase was primarily attributable to $1.7 million of write-downs of the carrying values of $5.3 million of loans to market, upon the transfer of those loans from held for investment to loans held for sale. Since the write-downs were charged against the allowance for loan losses, we increased the provision for loan losses to offset those charges to the allowance.
Income Tax Benefit . In 2012 we recorded a non-cash income tax benefit of $3.0 million as a result of a $4.6 million reduction we made in the valuation allowance that we had established against our deferred tax
asset by means of non-cash charges to income tax expense in previous years. By comparison, in 2011 we recorded a non-cash income tax benefit of $6.4 million as a result of a $7.0 million reduction in that same valuation allowance.
Overview of Changes in Financial Condition in 2012
Decrease in the Allowance for Loan Losses . We decreased the allowance for loan losses to $10.9 million, or 1.49% of loans outstanding at December 31, 2012, from $15.6 million, or 2.37% of loans outstanding at December 31, 2011. That decrease was primarily attributable to transfers during 2012 of $14 million and $11 million in loans classified as special mention and substandard, respectively, to â€śpassâ€ť as the borrowers were able to bring their payments current on those loans.
Change in Mix of Deposits to a Greater Proportion of Lower Costs Deposits . During 2012, as a percentage of total deposits, the volume of non-interest bearing and lower cost deposits increased to 43.1% and the volume of higher-costs certificates of deposits declined to 56.9%, from 40.9% and 59.1%, respectively, at December 31, 2011. The average rate of interest we paid on certificates of deposits in 2012 decreased to 1.22% from 1.62% in 2011. The combination of this change in mix of deposits and this decrease in interest rates contributed to the decline in our interest expense during fiscal 2012.
Increase in Shareholderâ€™s Equity and Improvements in Capital Ratios. Shareholdersâ€™ equity at December 31, 2012 totaled $122.5 million, an increase of $35.9 million, or 41.5%, from $86.6 million at December 31, 2011. That increase was primarily attributable to the $9.7 million in net income we earned in 2012 and the sale of $26.3 million of shares of our common stock, at a price of $6.26 per share, in April 2012 to Carpenter Community Bancfund, L.P. and Carpenter Community Bancfund-A, L.P. (the â€śCarpenter Fundsâ€ť). As a result, the consolidated book value of our common stock increased to $6.75 per share at December 31, 2012 from $6.26 per share at December 31, 2011. Due to this increase in shareholderâ€™s equity, the ratio of our consolidated total capital-to-risk weighted assets (which is the principal federal regulatory measure of the financial strength of banking institutions) increased to 16.3% at December 31, 2012, from 13.4% at December 31, 2011. As a result, at December 31, 2012 we continued to exceed the highest of the capital standards that are applicable to bank holding companies under federal banking regulations.
Outlook for 2013
Expected Decline in Mortgage Banking Revenues . As discussed above, effective August 31, 2012 we exited the wholesale residential mortgage business. As a result, our Mortgage Banking Division is currently engaged in the direct-to-consumer retail mortgage business in which we originate mortgage loans directly from consumers seeking to refinance existing mortgage loans or finance the purchase of residential real estate. The decision to exit the wholesale mortgage business was made to enable us (i) to redeploy some of our capital resources, which had been committed to the wholesale mortgage business, to our core commercial lending business, (ii) to reduce and control our staffing costs and operating expenses, which had grown significantly to a large extent as a result of the growth of the wholesale mortgage business, and (iii) to manage and limit interest rate and other risks inherent in a wholesale mortgage business.
Accordingly, we have begun to refocus the resources that had been devoted to the wholesale mortgage business to initiatives to grow our commercial lending business and our retail mortgage business. However, as a result of our exit from wholesale residential mortgage business, we expect that mortgage banking revenue in 2013 will be significantly lower than in 2012.
Actions to Improve the Quality and Performance of the Bankâ€™s Loan Portfolio and Strengthen its Financial Condition . In February 2013, we entered into a Stock Purchase Agreement to sell up to $15 million of additional shares of common stock, at a price of $6.75 per share in cash, to the Carpenter Funds. If that sale of shares is consummated, we intend to use the net proceeds to capitalize a new wholly-owned asset management subsidiary, which will use those proceeds to fund the purchase of nonperforming loans and OREO from the Bank and thereafter manage and dispose of those loans and OREO. The purpose of these transactions is to significantly reduce the Bankâ€™s nonperforming assets in order to improve the Bankâ€™s financial condition and reduce the costs it has been incurring in managing and disposing of those assets in order to improve the Bankâ€™s results of operation. If these initiatives prove to be successful, we believe that such success will move the Bank closer to a relaxation of some of the regulatory restrictions under which it has been operating since August 2010 and which, therefore, could enable us to focus more resources on growing our banking franchise.
The sale of the shares of common stock to the Carpenter Funds also will strengthen the Companyâ€™s financial condition by increasing its capital and capital ratios. However, the Bankâ€™s sale of non-performing assets to the Companyâ€™s new asset management subsidiary will not result in changes in or improvements to the Companyâ€™s consolidated financial condition or operating results, because those non-performing assets will remain on the Companyâ€™s consolidated balance sheet and the costs of managing and disposing of those assets, and any losses that may be recognized on their sale, will continue to be reflected in the Companyâ€™s consolidated operating results and cash flows until the sales or dispositions of those assets have been completed.
Critical Accounting Policies
Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States (â€śGAAPâ€ť) and regulatory accounting practices in the banking industry. Certain of those accounting policies are considered critical accounting policies, because they require us to make estimates and assumptions regarding circumstances or trends that could materially affect the value of those assets, such as economic conditions that could impact our ability to fully collect our loans or ultimately realize the carrying value of certain of our other assets. Those estimates and assumptions are made based on current information available to us regarding those economic conditions or trends or other circumstances. If changes were to occur in the events, trends or other circumstances on which our estimates or assumptions were based, or other unanticipated events were to occur that might affect our operations, we may be required under GAAP to adjust our earlier estimates and to reduce the carrying values of the affected assets on our balance sheet, generally by means of charges against income, which could also affect our results of operations in the fiscal periods when those charges are recognized.
Our critical accounting policies relate to the determinations of our allowance for loan losses, the fair values of securities available for sale and the realizability, and hence the valuation, of our deferred tax asset.
Allowance for Loan Losses. Like virtually all banks and other financial institutions, we follow the practice of maintaining an allowance to provide for possible loan losses that occur from time to time as an incidental part of the banking business. The accounting policies and practices we follow in determining the sufficiency of that allowance (which is commonly referred to as the â€śallowance for loan lossesâ€ť or the â€śALLâ€ť), require us to make judgments and assumptions about economic and market conditions and trends that can affect the ability of our borrowers to meet their loan payment obligations to us. In making those judgments, we use historical loss factors, adjusted for current economic and market conditions, other economic indicators and applicable bank regulatory guidelines, to determine losses inherent in our loan portfolio and the sufficiency of our allowance for loan losses. If unanticipated changes were to occur in those conditions or trends, or the financial condition of borrowers was to deteriorate, actual loan losses could be greater than those that had previously been predicted. In such events, or if there were changes to the loss factors or regulatory guidelines on which we had based our determinations regarding the sufficiency of the ALL, it could become necessary for us to increase the ALL by means of a charge to income referred to in our financial statements as the â€śprovision for loan losses.â€ť Such an increase would reduce the carrying value of the loans on our balance sheet and the provisions made for loan losses to increase that ALL would reduce our income in the period when it is determined that the increase was necessary. During the fourth quarter of 2008, federal bank regulatory agencies adopted new and more stringent guidelines and methodologies for identifying losses in bank loan portfolios and determining the sufficiency of loan loss reserves, as a result of the worsening of the economic recession and the prospects that conditions would not soon improve. We have been applying those new guidelines and methodologies since the fourth quarter of 2008. See the discussion in the subsections entitled â€śâ€” Provision for Loan Losses â€ť and â€śâ€” Allowance for Loan Losses and Nonperforming Loans â€ť below in this Item 7.
Fair Value of Securities Available for Sale. Under applicable accounting principles, we are required to recognize any unrealized loss on the securities we hold for sale. An unrealized loss occurs when the fair value of a security held for sale declines below its amortized cost as recorded on our balance sheet. As a result, we make determinations, on a quarterly basis, of the fair values of the securities held for sale in order to determine if there are any unrealized losses in those securities. When there is an active market for such a security, the determination of its fair value is based on market prices. If there is no active trading market, but such securities do trade from time to time, we rely primarily on quotes we obtain from third party vendors and securities brokers to determine the fair values of those securities. However, quotes are not always available for some securities and, in those instances, we make those fair value determinations on the basis of a variety of industry standard pricing methodologies, such as discounted cash flow analyses, matrix pricing, and option adjusted spread models, as well as fundamental analysis of the creditworthiness of the obligors under those securities. These methodologies require us to make various assumptions relating to such matters as future prepayment speeds, yield, duration, Federal Reserve Board monetary policies and the supply and demand for the individual securities. Consequently, if changes were to occur in market or other conditions or the circumstances on which our earlier assumptions or judgments were based, it could become necessary for us to reduce the fair values of such securities, which would result in charges to accumulated other comprehensive income (loss) on our balance sheet. Moreover, if we conclude that reductions in the fair values of any securities are other than temporary, it would be necessary for us to recognize an impairment loss to noninterest income in our statement of operations.
Fair Value of Financial Instruments Financial Accounting Standards Boardâ€”Accounting Standards Codification FASB ASC 820-10-35 defines fair value, establishes a framework for measuring fair value and outlines a fair value hierarchy based on the inputs to valuation techniques used to measure fair value. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (also referred to as an exit price). Fair value measurements are categorized into a three-level hierarchy based on the extent to which the measurement relies on observable market inputs in measuring fair value. Level 1, which is the highest priority in the fair value hierarchy, is based on unadjusted quoted prices in active markets for identical assets or liabilities. Level 2 is based on observable market-based inputs, other than quoted prices, in active markets for identical assets or liabilities. Level 3, which is the lowest priority in the fair value hierarchy, is based on unobservable inputs. Assets and liabilities are classified within this hierarchy in their entirety based on the lowest level of any input that is significant to the fair value measurement.
The use of fair value to measure our financial instruments is fundamental to our financial statements and is a critical accounting estimate because a substantial portion of our mortgage banking assets and liabilities are recorded at estimated fair value. Financial instruments classified as Level 3 are generally based on unobservable inputs, and the process to determine fair value is generally more subjective and involves a high degree of management judgment and assumptions. These assumptions may have a significant effect on our estimates of fair value, and the use of different assumptions, as well as changes in market conditions and interest rates, could have a material effect on our results of operations or financial condition.
Mortgage loans held-for-sale â€” We elected to carry our mortgage loans held-for-sale originated or acquired from the mortgage lending operation at fair value. Fair value is based on quoted market prices, where available, prices for other traded mortgage loans with similar characteristics, and purchase commitments and bid information received from market participants.
Mortgage servicing rights â€” We elected to carry all of our mortgage servicing rights arising from the mortgage loan origination operation at fair value. The fair value of mortgage servicing rights is based upon market prices for similar instruments and a discounted cash flow model. The valuation model incorporates assumptions that market participants would use in estimating the fair value of servicing. These assumptions include estimates of prepayment speeds, discount rate, cost to service, escrow account earnings, contractual servicing fee income, prepayment and late fees, among other considerations.
Derivative financial instrumentsâ€”We utilize certain derivative instruments in the ordinary course of our business to manage our exposure to changes in interest rates. These derivative instruments include forward sales of mortgage-backed securities (TBA MBS) and interest rate lock commitments (IRLCs) issued to borrowers in connection with single family mortgage loan originations. We recognize all derivative instruments at fair value. The estimated fair value of IRLCs are based on underlying loan types with similar characteristics using the TBA MBS market, which is actively quoted and easily validated through external sources. The data inputs used in this valuation include, but are not limited to, loan type, underlying loan amount, note rate, loan program, and expected sale date of the loan, adjusted for current market conditions. These valuations are adjusted at the loan level to consider the servicing release premium and loan pricing adjustments specific to each loan. For all IRLCs, the base value is then adjusted for the anticipated pull-through rate. The fair value of the forward sales of mortgage-backed securities is based on the actively quoted TBA MBS market using observable inputs related to characteristics of the underlying MBS stratified by product, coupon and settlement date.
Utilization and Valuation of Deferred Income Tax Benefits . We record as a â€śdeferred tax assetâ€ť on our balance sheet an amount equal to the tax credit and tax loss carryforwards and tax deductions (â€śtax benefitsâ€ť) that we believe will be available to us to offset or reduce income taxes in future periods. Under applicable federal and state income tax laws and regulations, in most cases such tax benefits will expire, if they cannot be used, within specified periods of time. Accordingly, the ability to fully use our deferred tax asset to reduce income taxes in the future depends on the amount of taxable income that we generate during those time periods. At least once each year, or more frequently, if circumstances warrant, we make estimates of future taxable income that we believe we are likely to generate during those future periods. If we conclude, on the basis of those estimates and the amount of the tax benefits available to us, that it is more likely, than not, that we will be able to fully utilize those tax benefits prior to their expiration, we recognize the deferred tax asset in full on our balance sheet. On the other hand, if we conclude, instead, that it has become more likely, than not, that we will be unable to utilize those tax benefits in full prior to their expiration, then, we would establish, or increase any existing, reserves (commonly referred to as a â€śvaluation allowanceâ€ť) to reduce the deferred tax asset on our balance sheet to the amount with respect to which we believe it is still more likely, than not, that we will be able to use to offset or reduce taxes in the future. The establishment of or an increase in that valuation allowance is implemented by recognizing a non-cash charge that would have the effect of increasing the provision, or reducing any credit, for income taxes that we would otherwise have recorded in our statements of operations. The determination of whether and the extent to which we will be able to utilize our deferred tax asset involves significant judgments and assumptions that are subject to period to period changes as a result of changes in tax laws, changes in market or economic conditions that could affect our operating results or variances between our actual operating results and the operating results that we had projected for any such period, as well as other factors.
We conducted an assessment of the realizability of our deferred tax asset as of June 30, 2010. Based on that assessment and due, in part, to continued weakness in the economy and financial markets, we concluded that it had become more likely, than not, that we would be unable to utilize our remaining tax benefits comprising our deferred tax asset prior to their expiration. Therefore, we recorded a valuation allowance against our net deferred tax asset in the amount of $10.7 million by means of a $9.0 million non-cash charge to income tax expense in the quarter ended June 30, 2010. The provision for income taxes we recorded in our statement of operations of nearly $9.0 million for the year ended December 31, 2010 was primarily attributable to that charge.
We conducted another assessment of the realizability of our deferred tax asset in the fourth quarter of 2011, due to a strengthening of economic conditions, an improvement in the quality of our loan portfolio, as reflected in declines in loan losses and loan delinquencies, and the earnings we generated from operations during 2011. Based on that assessment, we determined that it had become more likely, than not, that we would be able to use approximately $7.0 million of the income tax benefits comprising our deferred tax asset to offset or reduce taxes in future years. As a result we reduced, by a corresponding amount, the valuation allowance that we had established in previous years against our deferred tax asset by recording a non-cash income tax benefit for 2011 in the amount of $6.4 million.
At June 30, 2012 we conducted another assessment of the realizability of our deferred tax asset and due to a continued strengthening of economic conditions, a further improvement in the performance of our loan portfolio, and the earnings we were generating from our operations, we determined that it had become more likely than not that we would be able to use approximately $13.8 million of the income tax benefits comprising our deferred tax asset to offset or reduce taxes in future years. As a result, in the second quarter of 2012 we reduced the valuation allowance that we had previously established against our deferred tax asset, as a result of which we recognized a non-cash tax benefit of $3.0 million for the year ended December 31, 2012.
Results of Operations
Net Interest Income
One of the principal determinants of a bankâ€™s income is its net interest income, which is the difference between (i) the interest that a bank earns on loans, investment securities and other interest earning assets, on the one hand, and (ii) its interest expense, which consists primarily of the interest it must pay to attract and retain deposits and the interest that it pays on borrowings and other interest-bearing liabilities, on the other hand. A bankâ€™s interest income and interest expense, in turn, are affected by a number of factors, some of which are outside of its control, including national and local economic conditions and the monetary policies of the Federal Reserve Board which affect interest rates, the demand for loans by prospective borrowers, the competition among banks and other lending institutions for loans and deposits and the ability of borrowers to meet their loan payment obligations. Net interest income, when expressed as a percentage of total average interest earning assets, is a banking organizationâ€™s â€śnet interest margin.â€ť
Fiscal 2012 Compared to Fiscal 2011. In fiscal 2012, our net interest income increased by $80,000, or 0.2%, to $33.3 million, from $33.2 million in fiscal 2011. Interest income decreased by $2.5 million, or 5.6%, to $41.8 million in 2012 from $44.3 million in 2011. That decrease was offset by a $2.6 million, or 23.0%, decrease in interest expense, to $8.5 million in 2012 from $11.1 million in 2011. The decrease in interest income was primarily due to further reductions by the Federal Reserve Board in interest rates and, to a lesser extent, a decrease in the volume of securities held for sale during 2012, which had the effect of reducing the yields that we were able to realize on our interest-earning assets to 4.94% in 2012 from 5.45% in 2011. The decrease in interest expense, which had the effect of reducing the average rate of interest that we paid on our interest-bearing liabilities to 1.11% in 2012 from 1.43% in 2011, was attributable primarily to continued reductions in market rates of interest and, to a lesser extent, an increase in noninterest bearing demand deposits and a reduction in time certificates of deposit on which we pay higher rates of interest than on our core deposits.
Due to the decline in our interest income in 2012, our net interest margin for fiscal 2012 decreased to 3.29% from 3.41% in fiscal 2011.
MANAGEMENT DISCUSSION FOR LATEST QUARTER
Statements contained in this Report that are not historical facts or that discuss our expectations, beliefs or views regarding our future operations or future financial performance, or financial or other trends in our business or in the markets in which we operate, constitute â€śforward-looking statementsâ€ť within the meaning of Section 27A of the Securities Act of 1933, as amended (the â€śSecurities Actâ€ť), and Section 21E of the Securities Exchange Act of 1934, as amended (the â€śExchange Actâ€ť). Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. Often, they include words such as â€śbelieve,â€ť â€śexpect,â€ť â€śanticipate,â€ť â€śintend,â€ť â€śplan,â€ť â€śestimate,â€ť â€śproject,â€ť â€śforecastâ€ť or words of similar meaning, or future or conditional verbs such as â€świll,â€ť â€śwould,â€ť â€śshould,â€ť â€ścould,â€ť or â€śmay.â€ť The information contained in such forward-looking statements is based on current information and on assumptions that we make about future events over which we do not have control. In addition, our business and the markets in which we operate are subject to a number of risks and uncertainties. Such risks and uncertainties, and the occurrence of events in the future or changes in circumstances that had not been anticipated, could cause our financial condition or actual operating results in the future to differ significantly from our expected financial condition or operating results that are set forth in the forward-looking statements contained in this Report and could, therefore, also affect the price performance of our shares.
Many of those risks and uncertainties are discussed in Item 1A Part I, entitled â€śRisk Factors,â€ť in our Annual Report on Form 10-K for the year ended December 31, 2011 (the â€ś2011 10-Kâ€ť) that we filed with the SEC on February 27, 2012. Additional risk factors are discussed in Item 1A of Part II in our Quarterly Reports on Form 10-Q for the quarters ended March 31, 2012 and June 30, 2012, which we filed with the SEC on May 7, 2012 and August 14, 2012, respectively. We urge you to read those risk factors in conjunction with your review of the following discussion and analysis of our results of operations for the three and nine months ended, and our financial condition at, September 30, 2012.
Due to the risks and uncertainties we face, readers are cautioned not to place undue reliance on the forward-looking statements contained in this Report, which speak only as of the date of this Report, or to make predictions about future performance based solely on historical financial performance. We also disclaim any obligation to update forward-looking statements contained in this Report, except as may otherwise be required by law or NASDAQ rules.
Results of Operations in the Three Months Ended September 30, 2012.
As the above table indicates, net income in this yearâ€™s third quarter increased by $2.5 million, or 294%, to $3.4 million, from $852,000 in the same three months of 2011, notwithstanding a $2.2 million increase in income taxes in this year third quarter. At the same time, income per diluted share of common stock increased by 200% to $0.18 for the three months ended September 30, 2012, from $0.06 per diluted share of common stock for the same three months of 2011, notwithstanding a 56% increase in the weighted average number of diluted shares of common stock outstanding in this yearâ€™s third quarter over the same quarter of 2011. These increases were primarily attributable to an increase in net interest income of $1.1 million, or 13.2%, to $9.3 million, and an increase in mortgage banking revenues of $7.8 million, or 543%, to $9.2 million, in each case as compared to the same three months of 2011. These increases in net interest income and mortgage banking revenues more than offset a $3.6 million, or 37%, increase in noninterest expense, to $13.4 million in the three months ended September 30, 2012 from $9.8 million in the same three months of 2011.
Results of Operation for the Nine Months Ended September 30, 2012 . Net income for the nine months ended September 30, 2012 increased by $6.7 million, or 179%, to $10.5 million, from $3.8 million in the same nine months of 2011. Income per diluted share for the nine months ended September 30, 2012 increased by 85% to $0.61, from $0.33 for the same nine months of 2011, notwithstanding a 57% increase in the weighted average number of diluted shares of common stock outstanding during the first nine months of 2012 over the same nine months of 2011. Those increases were primarily attributable to an increase of $18.6 million, or 517%, in mortgage banking revenues to $22.1 million, and an increase of $1.7 million, or 424%, in net gains on sales of securities, to $2.1 million, in the nine months ended September 30, 2012, in each case as compared to the same nine months of 2011. Those increases more than offset a nearly $2.0 million increase in the provision made for loan losses, and an increase of $12.7 million, or 47.6%, in non-interest expense, in each case as compared to the same nine months of 2011.
Information regarding the changes in our net interest income, the provisions made for loan losses, our mortgage banking revenues and our non-interest expense in the three and nine months ended September 30, 2012, as compared to the same respective periods of 2011, is set forth under the caption â€śâ€”Results of Operationsâ€ť below.
Outlook for the Fourth Quarter of 2012 . As is discussed above, the increases in our net income in both the third quarter and nine months ended September 30, 2012 were largely attributable to increases in our mortgage banking revenues. Those increases were attributable primarily to substantial increases, in each of those periods, in the volume of mortgage loans that we originated directly from consumers (our â€śretail mortgage businessâ€ť) and in the volume of mortgage loans originated for us by independent mortgage brokers (our â€śwholesale mortgage businessâ€ť), in each case as compared to the quarter and nine months ended September 30, 2011. As previously reported, we made a decision to exit the wholesale mortgage business effective August 31, 2012. As we disclosed, that decision was made in order (i) to redeploy capital resources committed to our wholesale mortgage lending business to our core commercial lending business, (ii) to reduce our staffing and other operating costs and, thereby, improve the efficiency and profitability of our mortgage banking operations and (iii) to manage and limit the interest rate risk and some of the other risks that are inherent in wholesale mortgage businesses.
Although we ceased accepting mortgage loan applications from outside mortgage brokers submitted to us after August 31, 2012, we continued to fund mortgage loans in process or originated on or before that date and, as a result, that cessation of wholesale mortgage loan originations did not materially affect the volume of mortgage loans that we funded or sold into the secondary mortgage market during the third quarter of 2012. However, we anticipate that, as a result of our exist from the wholesale mortgage business, commencing with the fourth quarter of 2012 there will be a significant decline in mortgage loan originations and mortgage banking revenues as compared to the first three quarters of 2012. It is too early to predict the extent of that decline or its effect on our results of operations in this yearâ€™s fourth quarter.
Critical Accounting Policies
Introduction. Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States (â€śGAAPâ€ť) and general practices in the banking industry. Certain of those accounting policies are considered critical accounting policies, because they require us to make assumptions and judgments regarding circumstances or trends that could affect the carrying values of our material assets, such as, for example, assumptions regarding economic conditions or trends that could impact our ability to fully collect our loans or ultimately realize the carrying values of certain of our other assets, such as securities available for sale and our deferred tax assets. Those assumptions and judgments are necessarily based on current information available to us regarding those economic conditions or trends or other circumstances. If adverse changes were to occur in the events, trends or other circumstances on which our assumptions or judgments had been based, or other unanticipated events were to happen that might affect our operating results, under GAAP it could become necessary for us to reduce the carrying values of the affected assets on our balance sheet. In addition, because reductions in the carrying value of assets are sometime effectuated by or require charges to income, such reductions also may have the effect of reducing our income.
Our critical accounting policies consist of the accounting policies and practices we follow in determining (i) the sufficiency of the allowance we establish for loan losses; (ii) the fair values of our investment securities that we hold for sale, and (iii) the amount of our deferred tax asset, consisting primarily of tax loss carryforwards and tax credits that we believe will be able to use to offset income taxes in future periods. There were no significant changes in the Companyâ€™s critical accounting policies or their application during the nine months ended September 30, 2012, as compared to our critical accounting policies in effect as of December 31, 2011. Information regarding our critical accounting policies in effect as of December 31, 2011 is contained in the sections captioned â€śCritical Accounting Policiesâ€ť and â€śAllowance for Loan Lossesâ€ť in Item 7, entitled â€śManagementâ€™s Discussion and Analysis of Financial Condition and Results of Operationsâ€ť contained in our 2011 10-K which we filed with the SEC on February 27, 2012 and readers of this report are urged to read those sections of that 10-K.
Results of Operations
Net Interest Income
One of the principal determinants of a bankâ€™s income is its net interest income, which is the difference between (i) the interest that a bank earns on loans, investment securities and other interest-earning assets, on the one hand, and (ii) its interest expense, which consists primarily of the interest it must pay to attract and retain deposits and the interest that it pays on borrowings and other interest-bearing liabilities, on the other hand. As a general rule, all other things being equal, the greater the difference or â€śspreadâ€ť between the amount of our interest income and the amount of our interest expense, the greater will be our net income; whereas, a decline in that difference or â€śspreadâ€ť will generally result in a decline in our net income.
A bankâ€™s interest income and interest expense are, in turn, affected by a number of factors, some of which are outside of its control, including national and local economic conditions and the monetary policies of the Federal Reserve Board which affect interest rates, competition in the market place for loans and deposits, and the demand for loans and the ability of borrowers to meet their loan payment obligations. Net interest income, when expressed as a percentage of total average interest earning assets, is a banking organizationâ€™s â€śnet interest margin.â€ť
In the three months ended September 30, 2012, net interest income increased by $1.1 million, or 13.2%, due to a $430,000, or 3.9%, increase in interest income and a $648,000, or 23.5%, decrease in interest expense, in each case as compared to the same three months of 2011. The increase in interest income was primarily attributable to a nearly $1.6 million increase in the volume of loans outstanding (exclusive of loans held for sale), which more than offset declines in the volume of other interest earning assets and in the yields on interest earning assets, including loans, as a result of further declines in market rates of interest. The decrease in interest expense was primarily attributable to reductions in the rates of interest we were paying on time certificates of deposit, which also resulted, in declines in the volume of those deposits in the three months ended September 30, 2012 as compared to the same three months of 2011.
In the nine months ended September 30, 2012 our net interest income was essentially unchanged from our net interest income in the same nine months of 2011, as a $1.8 million decrease in interest income was offset by a nearly $1.9 million reduction in interest expense that was primarily due to reductions in the rates of interest we paid on, and a resulting decline in the volume of, time certificates of deposit.
As a result of the increase in net interest income in the three months ended September 30, 2012, our net interest margin increased by 19 basis points to 3.56% from 3.37% in the three ended September 30, 2011. In the nine months ended September 30, 2012 our net interest margin declined by 11 basis points, to 3.38% from 3.49% in the same nine months of 2011, due primarily to an increase in average earning assets.
Provision for Loan Losses
Like virtually all banks and other financial institutions, we follow the practice of maintaining reserves to provide for possible loan losses that occur in banking. When it is determined that the payment in full of a loan has become unlikely, the carrying value of the loan is reduced (â€śwritten downâ€ť) to what management believes is its realizable value or, if it is determined that a loan no longer has any realizable value, the carrying value of the loan is written off in its entirety (a loan â€ścharge-offâ€ť). Loan charge-offs and write-downs are charged against an allowance for loan losses (the â€śAllowance for Loan Lossesâ€ť or the â€śALLâ€ť) which, at September 30, 2012, totaled $14.6 million. The amount of the ALL is increased periodically to replenish the ALL after it has been reduced due to loan write-downs or charge-offs. The ALL also is increased or decreased periodically to reflect increases or decreases in the volume of outstanding loans, and to take account of changes in the risk of potential loan losses due to a deterioration or improvement in the condition of borrowers or in the value of properties securing nonâ€“performing loans or adverse changes or improvements in economic conditions. Increases in the ALL are made through a charge, recorded as an expense in the statement of income, referred to as the â€śprovision for loan losses.â€ť Recoveries of loans previously charged-off are added back to and, therefore, to that extent increase the ALL and reduce the amount of the provision for loan losses that might otherwise have had to be made to replenish or increase the ALL. See â€śâ€”Financial Conditionâ€”Nonperforming Loans and the Allowance for Loan Lossesâ€ť below in this Item 2 for additional information regarding the ALL.
We employ economic models that are based on bank regulatory guidelines, industry standards and our own historical loan loss experience, as well as a number of more subjective qualitative factors, to determine both the sufficiency of the ALL and the amount of the provisions that need to be made for potential loan losses. However, those determinations involve judgments and assumptions about trends in current economic conditions and other events that can affect the ability of borrowers to meet their loan obligations to us and a weighting among the quantitative and qualitative factors we consider in determining the amount of the ALL. Moreover, the duration and anticipated effects of prevailing economic conditions or trends can be uncertain and can be affected by number of risks and circumstances that are outside of our ability to control. See the discussion below in this Item 2 under the caption â€śFinancial Conditionâ€”Nonperforming Loans and the Allowance for Loan Lossesâ€ť. If changes in economic or market conditions or unexpected subsequent events or changes in circumstances were to occur, or if changes were made to bank regulatory guidelines or industry standards that are used to assess the sufficiency of the ALL, it could become necessary for us to record additional, and possibly significant, charges to increase the allowance for loan losses, which would have the effect of reducing our income or causing us to incur losses.
In addition, the FRB and the DFI, as an integral part of their examination processes, periodically review the adequacy of our ALL. These agencies may require us to make additional provisions for possible loan losses, over and above the provisions that we have already made, the effect of which would be to reduce our income or increase any losses we might incur.
At September 30, 2012, the ALL totaled $12.7 million, which was $2.9 million, or 19.0%, lower than at December 31, 2011. This decrease was principally due to net charge-offs of $2.5 million, partially offset by a $2.0 million provision that we made for loan losses in the nine months ended September 30, 2012. The ratio of the ALL to total loans outstanding as of September 30, 2012 was 1.83% compared to 2.37% as of December 31, 2011. Notwithstanding the decrease in the Allowance at September 30, 2012, based on the methodologies we use to assess asset quality, bank regulatory guidelines and our historical loan loss history, we determined that that the Allowance was adequate at September 30, 2012 to cover inherent losses in the loan portfolio.
As the table above indicates, the increase in noninterest income in the three months ended September 30, 2012, as compared to the same period in 2011, was primarily attributable to a $7.7 million, or 543%, increase in mortgage banking revenue. The increase in noninterest income in the nine months ended September 30, 2012, as compared to the same nine months in 2011, was primarily attributable to (i) a $18.5 million, or 517%, increase in mortgage banking revenue and (ii) a $2.1 million, or 424%, increase in net gains on sales of securities available for sale.
The increases in mortgage banking revenue in the three and nine months ended September 30, 2012 were primarily attributable to increases of approximately 257% and 218%, respectively, in the dollar volume of mortgage loan originations, as compared to same three and nine month periods of 2011. Those increases in mortgage loan originations were attributable primarily to the growth of our mortgage banking business, which resulted in the addition of mortgage loan personnel, an expansion of our network of outside mortgage brokers and the implementation of marketing and business development programs by the mortgage banking division.
As discussed above in the subsection of this Item 2, entitled â€śOverview of Operating Results in the Three and Nine Months Ended September 30, 2012â€” Outlook for the Fourth Quarter of 2012 â€ť, we decided to exit our wholesale mortgage loan business and ceased accepting new wholesale originated mortgage loan applications effective on August 31, 2012. Due to the volume of mortgage loan applications (both retail and wholesale) received or in process as of August 31, 2012, we do not believe that the exit from our wholesale mortgage business materially affected our mortgage banking revenues in this yearâ€™s third quarter. However, due to our exit from the wholesale mortgage business, we expect that there will be a significant decline in mortgage loan originations and mortgage banking revenues in this yearâ€™s fourth quarter as compared to the first three quarters of 2012.
The following table compares the amounts of the principal components of noninterest expense in the three and nine months ended September 30, 2012 and 2011.
The increases in noninterest expense in the three and nine months ended September 30, 2012 were due primarily to (i) the growth of our mortgage banking business, as we added mortgage personnel, and related support staff, and incurred higher marketing, business development and other costs to increase the volume of mortgage loan originations and (ii) $933,000 and $3.8 million of write downs in the carrying values of other real estate owned (â€śOREOâ€ť) to their respective fair values for the three and nine months ended September 30, 2012, respectively. Due primarily to our exit from the wholesale mortgage loan business at the end of August 2012, we expect mortgage banking related noninterest expense to decline in the fourth quarter of 2012.
A measure of our ability to control noninterest expense is our efficiency ratio, which is the ratio of noninterest expense to net revenue (net interest income plus noninterest income). As a general rule, a lower efficiency ratio indicates an ability to generate increased revenue without a commensurate increase in the staffing and equipment and third party services and, therefore, would be indicative of greater operational efficiencies. Due to the increase in noninterest income, largely attributable to the growth of our mortgage banking division, our efficiency ratio improved to 69.8% in the three months ended September 30, 2012 from 94.0% in the corresponding three month period of 2011, and to 77.8% in the nine months ended September 30, 2012 from 86.4% in the same nine months of 2011.
Provision for (Benefit from) Income Tax
For the three months ended September 30, 2012, we recorded a tax provision of $1.9 million as compared to a tax benefit of $225,000 for the same period in 2012.
For the nine months ended September 30, 2012 we recorded a tax benefit of $1.3 million as compared to a tax provision of $405,000 for the same period in 2011. During the nine months ended September 30, 2012 we released the remaining valuation allowance, in the amount of $5.0 million, which had been established against our deferred tax asset by means of charges to the provision for income taxes in prior years. The release of the valuation allowance was based on an assessment we made in the second quarter of 2012 that, due primarily to the taxable earnings we have been generating from operations since the quarter ended December 31 2010, it had become more likely than not that we would be able to use the income tax benefits comprising our deferred tax asset, in their entirety, to offset or reduce taxes in future periods.