Table of Contents
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(MARK ONE)
☒
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2019
OR
☐
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission file number 000‑23877
Heritage Commerce Corp
(Exact name of Registrant as Specified in its Charter)
California(State or Other Jurisdiction ofIncorporation or Organization)
77‑0469558(I.R.S. Employer Identification No.)
150 Almaden Boulevard, San Jose, California(Address of Principal Executive Offices)
95113(Zip Code)
(408) 947‑6900
(Registrant’s Telephone Number, Including Area Code)
N/A
(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)
Securities registered pursuant to Section 12(b) of the Act:
Title of each class:
Trading Symbol:
Name of each exchange on which registered:
Common Stock, No Par Value
HTBK
The NASDAQ Stock Market LLC
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES ☒ NO ☐
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S‑T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). YES ☒ NO ☐
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer ☐
Accelerated filer ☒
Non‑accelerated filer ☐
Smaller reporting company ☐
Emerging growth company ☐
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b‑2 of the Exchange Act). YES ☐ NO ☒
The Registrant had 59,200,262 shares of Common Stock outstanding on October 28, 2019.
HERITAGE COMMERCE CORP
QUARTERLY REPORT ON FORM 10‑Q
TABLE OF CONTENTS
Page No.
Cautionary Note on Forward‑Looking Statements
Part I. FINANCIAL INFORMATION
Item 1.
Consolidated Financial Statements (unaudited)
Consolidated Balance Sheets
Consolidated Statements of Income
Consolidated Statements of Comprehensive Income
Consolidated Statements of Changes in Shareholders’ Equity
Consolidated Statements of Cash Flows
Notes to Unaudited Consolidated Financial Statements
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
Item 4.
Controls and Procedures
PART II. OTHER INFORMATION
Legal Proceedings
Item 1A.
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
Defaults Upon Senior Securities
Mine Safety Disclosures
Item 5.
Other Information
Item 6.
Exhibits
SIGNATURES
2
Cautionary Note Regarding Forward‑Looking Statements
This Report on Form 10‑Q contains various statements that may constitute forward‑looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, Rule 175 promulgated thereunder, and Section 21E of the Securities Exchange Act of 1934, as amended, Rule 3b‑6 promulgated thereunder and are intended to be covered by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Any statements about our expectations, beliefs, plans, objectives, assumptions or future events or performance are not historical facts and may be forward‑looking. These forward‑looking statements often can be, but are not always, identified by the use of words such as “assume,” “expect,” “intend,” “plan,” “project,” “believe,” “estimate,” “predict,” “anticipate,” “may,” “might,” “should,” “could,” “goal,” “potential” and similar expressions. We base these forward‑looking statements on our current expectations and projections about future events, our assumptions regarding these events and our knowledge of facts at the time the statements are made. These statements include statements relating to our projected growth, anticipated future financial performance, and management’s long‑term performance goals, as well as statements relating to the anticipated effects on results of operations and financial condition.
These forward‑looking statements are subject to various risks and uncertainties that may be outside our control and our actual results could differ materially from our projected results. In addition, our past results of operations do not necessarily indicate our future results. The forward‑looking statements could be affected by many factors, including but not limited to:
·
current and future economic and market conditions in the United States generally or in the communities we serve, including the effects of declines in property values and overall slowdowns in economic growth should these events occur;
effects of and changes in trade, monetary and fiscal policies and laws, including the interest rate policies of the Federal Open Market Committee of the Federal Reserve Board;
our ability to anticipate interest rate changes and manage interest rate risk;
changes in inflation, interest rates, and market liquidity which may impact interest margins and impact funding sources;
volatility in credit and equity markets and its effect on the global economy;
our ability to effectively compete with other banks and financial services companies and the effects of competition in the financial services industry on our business;
our ability to achieve loan growth and attract deposits;
risks associated with concentrations in commercial and real estate related loans;
the relative strength or weakness of the commercial and real estate markets where our borrowers are located;
other than temporary impairment charges to our securities portfolio;
changes in the level of nonperforming assets and charge offs and other credit quality measures, and their impact on the adequacy of the Company’s allowance for loan losses and the Company’s provision for loan losses;
increased capital requirements for our continued growth or as imposed by banking regulators, which may require us to raise capital at a time when capital is not available on favorable terms if at all;
regulatory limits on Heritage Bank of Commerce’s ability to pay dividends to the holding company;
changes in our capital management policies, including those regarding business combinations, dividends, and share repurchases;
3
operational issues stemming from, and/or capital spending necessitated by, the potential need to adapt to industry changes in information technology systems, on which we are highly dependent;
our inability to attract, recruit, and retain qualified officers and other personnel could harm our ability to implement our strategic plan, impair our relationships with customers and adversely affect our business, and results of operations;
the potential increase in reserves and allowance for loan loss as a result of the transition to the current expected credit loss standard (“CECL”) established by the Financial Accounting Standards Board to account for future expected credit losses;
possible impairment of our goodwill and other intangible assets;
possible adjustment of the valuation of our deferred tax assets;
our ability to keep pace with technological changes, including our ability to identify and address cyber-security risks such as data security breaches, “denial of service” attacks, “hacking” and identity theft;
inability of our framework to manage risks associated with our business, including operational risk and credit risk;
risks of loss of funding of Small Business Administration or SBA loan programs, or changes in those programs;
compliance with governmental and regulatory requirements, including the Dodd-Frank Act and others relating to banking, consumer protection, securities , accounting and tax matters;
significant changes in applicable laws and regulations, including those concerning taxes, banking and securities;
effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board, the Financial Accounting Standards Board and other accounting standard setters;
costs and effects of legal and regulatory developments, including resolution of legal proceedings or regulatory or other governmental inquiries, and the results of regulatory examinations or reviews;
availability and competition for acquisition opportunities;
risks resulting from domestic terrorism;
risks of natural disasters (including fires and earthquakes) and other events (including pervasive power outages) beyond our control;
the expected cost savings, synergies and other financial benefits from the Presidio Bank acquisition completed on October 11, 2019 might not be realized within the expected time frames or at all; the actual merger-related costs for the transaction may be higher than estimated; and
our success in managing the risks involved in the foregoing factors.
Forward-looking statements speak only as of the date they are made. The Company does not undertake to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made or to reflect the occurrence of unanticipated events. You should consider any forward looking statements in light of this explanation, and we caution you about relying on forward-looking statements.
4
Part I—FINANCIAL INFORMATION
ITEM 1—CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
CONSOLIDATED BALANCE SHEETS (Unaudited)
September 30,
December 31,
2019
2018
(Dollars in thousands)
Assets
Cash and due from banks
$
48,121
30,273
Other investments and interest-bearing deposits in other financial institutions
367,662
134,295
Total cash and cash equivalents
415,783
164,568
Securities available-for-sale, at fair value
333,101
459,043
Securities held-to-maturity, at amortized cost (fair value of $343,129 at
September 30, 2019 and $366,175 at December 31, 2018)
342,033
377,198
Loans held-for-sale - SBA, at lower of cost or fair value, including deferred costs
3,571
2,649
Loans, net of deferred fees
1,875,387
1,886,405
Allowance for loan losses
(25,895)
(27,848)
Loans, net
1,849,492
1,858,557
Federal Home Loan Bank and Federal Reserve Bank stock and other investments, at cost
25,231
25,216
Company-owned life insurance
62,858
61,859
Premises and equipment, net
6,849
7,137
Goodwill
83,753
Other intangible assets
10,346
12,007
Accrued interest receivable and other assets
49,454
44,575
Total assets
3,182,471
3,096,562
Liabilities and Shareholders' Equity
Liabilities:
Deposits:
Demand, noninterest-bearing
1,094,953
1,021,582
Demand, interest-bearing
666,054
702,000
Savings and money market
761,471
754,277
Time deposits - under $250
53,560
58,661
Time deposits - $250 and over
95,543
86,114
CDARS - interest-bearing demand, money market and time deposits
17,409
14,898
Total deposits
2,688,990
2,637,532
Subordinated debt, net of issuance costs
39,507
39,369
Accrued interest payable and other liabilities
58,628
52,195
Total liabilities
2,787,125
2,729,096
Shareholders' equity:
Preferred stock, no par value; 10,000,000 shares authorized; none issued and outstanding
at September 30, 2019 and December 31, 2018
—
Common stock, no par value; 100,000,000 shares authorized at September 30, 2019 and
60,000,000 shares authorized at December 31, 2018; 43,509,406 shares issued
and outstanding at September 30, 2019 and 43,288,750 shares issued and
outstanding at December 31, 2018
302,983
300,844
Retained earnings
98,161
79,003
Accumulated other comprehensive loss
(5,798)
(12,381)
Total shareholders' equity
395,346
367,466
Total liabilities and shareholders' equity
See notes to unaudited consolidated financial statements
5
CONSOLIDATED STATEMENTS OF INCOME (Unaudited)
Three Months Ended
Nine Months Ended
(Dollars in thousands, except per share amounts)
Interest income:
Loans, including fees
27,264
28,632
81,321
77,271
Securities, taxable
3,504
3,483
12,149
11,112
Securities, exempt from Federal tax
530
555
1,624
1,675
Other investments, interest-bearing deposits
in other financial institutions and Federal funds sold
1,952
1,940
5,094
4,409
Total interest income
33,250
34,610
100,188
94,467
Interest expense:
Deposits
2,042
1,575
5,873
3,772
Subordinated debt
583
1,731
Other borrowings
1
Total interest expense
2,625
2,159
7,605
5,504
Net interest income before provision for loan losses
30,625
32,451
92,583
88,963
Provision (credit) for loan losses
(576)
(425)
(2,377)
7,279
Net interest income after provision for loan losses
31,201
32,876
94,960
81,684
Noninterest income:
Service charges and fees on deposit accounts
1,032
1,107
3,370
2,981
Increase in cash surrender value of life insurance
336
216
999
816
Gain on sales of securities
330
878
266
Gain on sales of SBA loans
156
236
331
551
Servicing income
139
163
480
533
Other
625
484
1,793
2,034
Total noninterest income
2,618
2,206
7,851
7,181
Noninterest expense:
Salaries and employee benefits
10,467
10,719
31,935
35,302
Occupancy and equipment
1,550
1,559
4,634
3,927
Professional fees
789
721
2,360
1,116
5,103
4,729
15,343
18,235
Total noninterest expense
17,909
17,728
54,272
58,580
Income before income taxes
15,910
17,354
48,539
30,285
Income tax expense
4,633
4,979
13,763
8,186
Net income
11,277
12,375
34,776
22,099
Earnings per common share:
Basic
Diluted
6
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)
Other comprehensive income:
Change in net unrealized holding (losses) gains on available-for-sale
securities and I/O strips
1,041
(1,880)
10,245
(11,009)
Deferred income taxes
(304)
545
(3,032)
3,192
Change in net unamortized unrealized gain on securities available-for-
sale that were reclassified to securities held-to-maturity
(13)
(11)
(52)
(33)
16
9
Reclassification adjustment for gains realized in income
(330)
(878)
(266)
98
260
79
Change in unrealized (losses) gains on securities and I/O strips, net of
deferred income taxes
496
(1,343)
6,559
(8,028)
Change in net pension and other benefit plan liability adjustment
11
51
34
152
(3)
(15)
(10)
(45)
Change in pension and other benefit plan liability, net of
8
36
24
107
Other comprehensive income (loss)
504
(1,307)
6,583
(7,921)
Total comprehensive income
11,781
11,068
41,359
14,178
7
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (Unaudited)
Accumulated
Total
Common Stock
Retained
Comprehensive
Shareholders’
Shares
Amount
Earnings
Loss
Equity
Balance, January 1, 2018
38,200,883
218,355
62,136
(9,252)
271,239
8,809
Other comprehensive loss
(5,704)
Amortization of restricted stock awards,
net of forfeitures and taxes
228
Cash dividend declared $0.11 per share
(4,206)
Stock option expense, net of forfeitures and taxes
176
Stock options exercised
68,906
449
Balance, March 31, 2018
38,269,789
219,208
66,739
(14,956)
270,991
915
(910)
Issuance of common shares to acquire
Tri-Valley Bank
1,889,613
30,725
United American Bank
2,826,032
47,280
Issuance of restricted stock awards, net
97,818
net of forfeitures
283
(4,743)
175
138,932
1,553
Balance, June 30, 2018
43,222,184
299,224
62,911
(15,866)
346,269
Forfeiture of restricted stock awards, net
(2,440)
303
(4,755)
184
51,932
497
Balance, September 30, 2018
43,271,676
300,208
70,531
(17,173)
353,566
Balance, January 1, 2019
43,288,750
12,146
Other comprehensive income
3,394
271
Cash dividend declared $0.12 per share
(5,196)
166
35,003
269
Balance, March 31, 2019
43,323,753
301,550
85,953
(8,987)
378,516
11,353
2,685
134,653
(5,201)
155
40,000
297
Balance, June 30, 2019
43,498,406
302,305
92,105
(6,302)
388,108
(6,000)
358
(5,221)
17,000
157
Balance, September 30, 2019
43,509,406
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
CASH FLOWS FROM OPERATING ACTIVITIES:
Adjustments to reconcile net income to net cash provided by operating activities:
Amortization of discounts and premiums on securities
1,821
3,093
(Gain) on sale of securities available-for-sale
(Gain) on sale of SBA loans
(331)
(551)
Proceeds from sale of SBA loans originated for sale
4,692
9,315
SBA loans originated for sale
(5,977)
(11,689)
(999)
(816)
Depreciation and amortization
598
566
Amortization of other intangible assets
1,661
1,336
Stock option expense, net
535
Amortization of restricted stock awards, net
932
814
Amortization of subordinated debt issuance costs
138
Effect of changes in:
1,863
(19)
(3,120)
1,723
Net cash provided by operating activities
33,283
33,558
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of securities available-for-sale
(15,193)
Purchase of securities held-to-maturity
(8,386)
(16,906)
Maturities/paydowns/calls of securities available-for-sale
36,956
44,832
Maturities/paydowns/calls of securities held-to-maturity
42,255
38,091
Proceeds from sales of securities available-for-sale
98,733
94,291
Net change in loans
12,136
20,215
Changes in Federal Home Loan Bank stock and other investments
(4,478)
Purchase of premises and equipment
(310)
(108)
Cash received in bank acquisition, net of cash paid
36,028
Net cash provided by investing activities
181,369
196,772
CASH FLOWS FROM FINANCING ACTIVITIES:
Net change in deposits
51,458
(154,318)
Exercise of stock options
723
2,499
Payment of cash dividends
(15,618)
(13,704)
Net cash provided by (used in) financing activities
36,563
(165,523)
Net increase in cash and cash equivalents
251,215
64,807
Cash and cash equivalents, beginning of period
316,222
Cash and cash equivalents, end of period
381,029
Supplemental disclosures of cash flow information:
Interest paid
6,693
4,728
Income taxes paid
13,620
8,671
Supplemental schedule of non-cash activity:
Recording of right to use assets in exchange for lease obligations
9,566
Transfer of loans held-for-sale to loan portfolio
694
Summary of assets acquired and liabilities assumed through acquisitions:
Cash and cash equivalents, net of cash paid
Securities avaiable-for-sale
63,723
Net loans
336,446
350
38,089
8,361
Other assets, net
14,736
(416,628)
(62)
Other liabilities
(3,038)
Common stock issued to acquire Tri-Valley Bank and United American Bank
78,005
10
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2019
(Unaudited)
1) Basis of Presentation
The unaudited consolidated financial statements of Heritage Commerce Corp (the “Company” or “HCC”) and its wholly owned subsidiary, Heritage Bank of Commerce (“HBC”), have been prepared pursuant to the rules and regulations for reporting on Form 10-Q. Accordingly, certain information and notes required by accounting principles generally accepted in the United States of America (“GAAP”) for annual financial statements are not included herein. The interim statements should be read in conjunction with the consolidated financial statements and notes that were included in the Company’s Form 10-K for the year ended December 31, 2018.
HBC is a commercial bank serving customers primarily located in Santa Clara, Alameda, Contra Costa, San Benito, and San Mateo counties of California. CSNK Working Capital Finance Corp. a California corporation, dba Bay View Funding (“Bay View Funding”) is a wholly owned subsidiary of HBC, and provides business-essential working capital factoring financing to various industries throughout the United States. No customer accounts for more than 10% of revenue for HBC or the Company. The Company reports its results for two segments: banking and factoring. The Company’s management uses segment results in its operating and strategic planning.
In management’s opinion, all adjustments necessary for a fair presentation of these consolidated financial statements have been included and are of a normal and recurring nature. All intercompany transactions and balances have been eliminated.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ significantly from these estimates.
The results for the three and nine months ended September 30, 2019 are not necessarily indicative of the results expected for any subsequent period or for the entire year ending December 31, 2019.
Business Combinations
The Company accounts for acquisitions of businesses using the acquisition method of accounting. Under the acquisition method, assets acquired and liabilities assumed are recorded at their estimated fair values at the date of acquisition. Management utilizes various valuation techniques including discounted cash flow analyses to determine these fair values. Any excess of the purchase price over amounts allocated to the acquired assets, including identifiable intangible assets, and liabilities assumed is recorded as goodwill.
Goodwill and Other Intangible Assets
Goodwill resulted from the acquisition of Tri-Valley Bank (“Tri-Valley”) on April 6, 2018 and United American Bank (“United American”) on May 4, 2018, and from acquisitions in prior years. Goodwill represents the excess of the purchase price over the fair value of acquired tangible assets and liabilities and identifiable intangible assets. Goodwill is assessed at least annually for impairment and any such impairment is recognized in the period identified.
Other intangible assets consist of core deposit intangible assets and a below market value lease intangible asset, arising from the United American and Tri-Valley acquisitions. They are initially measured at fair value and then are amortized over their estimated useful lives. The core deposit intangible assets from the acquisitions of United American and Tri-Valley are being amortized on an accelerated method over ten years. The below market value lease intangible assets are being amortized on the straight line method over three years for United American and eleven years for Tri-Valley.
Reclassifications
Certain reclassifications of prior year balances have been made to conform to the current year presentation. These reclassifications had no impact on the Company’s consolidated financial position, results of operations or net change in cash and cash equivalents.
Adoption of New Accounting Standards
In February 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2016-02, “Leases (Topic 842)”. The pronouncement affects all entities that are party to leasing agreements. The ASU requires a lessee to recognize assets and liabilities on the balance sheet for leases. The ASU permits a lessee to elect to opt out of recognizing lease assets and lease liabilities for short-term leases with a term of twelve months or less. The Company has made this short-term lease election. Lessee’s recognition, measurement, and presentation of income, expenses and cash flows arising from a lease remain similar to current GAAP. Lessee and lessors have additional quantitative and qualitative disclosures to help users better understand the amount, timing, and uncertainty of cash flows arising from leases. ASU No. 2016-02 is effective for fiscal years beginning after December 31, 2018, and interim periods within those fiscal years. Lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach.
In July 2018, the FASB issued ASU No. 2018-11, “Leases (Topic 842) - Targeted Improvements” to provide entities with relief from the costs of implementing certain aspects of the new leasing standard. Specifically, under the amendments in ASU No. 2018-11 entities may elect not to recast the comparative periods presented when transitioning to the new leasing standard, and lessors may elect not to separate lease and non-lease components when certain conditions are met. As the Company elected the transition option provided in ASU No. 2018-11, the modified retrospective approach was applied on January 1, 2019 (as opposed to January 1, 2017). The Company also elected certain practical expedients provided under ASU No. 2016-02 whereby we will not reassess (i) whether any expired or existing contracts are or contain leases, (ii) the lease classification for any expired or existing leases and (iii) initial direct costs for any existing leases. In December 2018, the FASB issued ASU No. 2018-20, “Leases (Topic 842): Narrow-Scope Improvements for Lessors,” which provides targeted improvements and clarification to guidance with FASB ASC Topic 842 specific to lessors. The amendments of ASU No. 2018-20 have the same effective date as ASU 2016-02 and may be applied either retrospectively or prospectively to all new and existing leases. The Company obtained a third-party software application which provides lease accounting under the guidelines of FASB ASC Topic 842.
The amendments of ASU No. 2016-02 and subsequently issued ASUs, which provided additional guidance and clarifications to various aspects of FASB ASC Topic 842, became effective for the Company on January 1, 2019. At September 30, 2019, the Company reported increased assets and liabilities of $7.1 million on its consolidated balance sheet as a result of recognizing right-of-use assets and lease liabilities related to non-cancellable operating lease agreements for office space. The adoption of this guidance did not have a material impact to its Consolidated Statetements of Income or Cash Flows. See Note 17 – Leases for more information.
In March 2017, the FASB issued ASU 2017-08, Premium Amortization on Purchased Callable Debt Securities. This update shortens the amortization period of certain callable debt securities held at a premium to the earliest call date. The amendments in this update were effective for the Company on January 1, 2019. The amendments are applied on a modified retrospective basis through a cumulative-effect adjustment to retained earnings as of the beginning of the period of adoption and the Company is required to provide change in accounting principle disclosures. The Company adopted the new guidance on January 1, 2019, and there was no material impact to the financial statements and no cumulative adjustments were made.
Newly Issued, but not yet Effective Accounting Standards
In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments – Credit Losses: Measurement of Credit Losses on Financial Instruments. The standard is the final guidance on the new current expected credit loss (“CECL”) model. The amendments in this update replace the incurred loss impairment methodology in current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to estimate future credit loss estimates. As CECL encompasses all financial assets carried at
12
amortized cost, the requirement that reserves be established based on an organization’s reasonable and supportable estimate of expected credit losses extends to held-to-maturity debt securities. The guidance allows for a modified retrospective approach with a cumulative effect adjustment to the balance sheet upon adoption (charge to retained earnings instead of the income statement). The new guidance is effective for public business entities for fiscal years, and interim periods within those years, beginning after December 15, 2019. Early application is permitted for fiscal years beginning after December 15, 2018. The Company has established a company-wide, cross-functional governance structure, which oversees overall strategy for implementation of CECL. We have evaluated various loss methodologies to determine their correlation to our various loan categories historical performance, and we have completed the data validation. The Company is focused on completing model validation, refining assumptions and continued review of the models. The Company also continues to focus on researching and resolving interpretive accounting issues in the ASU, contemplating various related accounting policies, developing processes and related controls and considering various reporting disclosures. The magnitude of the change in the Company’s allowance for loan losses at the adoption date will depend upon the nature and characteristics of the portfolio at the adoption date, as well as macroeconomic conditions and forecasts at that time.
In January 2017, the FASB issued accounting standards ASU No. 2017-04, Simplifying the Test for Goodwill Impairment. The provisions of the update eliminate the existing second step of the goodwill impairment test which provides for the allocation of reporting unit fair value among existing assets and liabilities, with the net remaining amount representing the implied fair value of goodwill. In replacement of the existing goodwill impairment rule, the update will provide that impairment should be recognized as the excess of any of the reporting unit’s goodwill over the fair value of the reporting unit. Under the provisions of this update, the amount of the impairment is limited to the carrying value of the reporting unit’s goodwill. For public business entities that are SEC filers, the amendments of the update will become effective in fiscal years beginning after December 15, 2019. Management does not expect the requirements of this update to have a material impact on the Company’s financial position, results of operations or cash flows.
2) Shareholders’ Equity and Earnings Per Share
Basic earnings per common share is computed by dividing net income by the weighted average common shares outstanding. Diluted earnings per share reflect potential dilution from outstanding stock options using the treasury stock method. There were 826,036 and 512,261 stock options for the three months ended September 30, 2019 and 2018, and 826,036 and 505,686 for the nine months ended September 30, 2019 and 2018, respectively, considered to be antidilutive and excluded from the computation of diluted earnings per share. A reconciliation of these factors used in computing basic and diluted earnings per common share is as follows:
Weighted average common shares outstanding for basic
earnings per common share
43,258,983
43,230,016
43,189,710
41,132,043
Dilutive potential common shares
537,921
501,354
538,375
551,001
Shares used in computing diluted earnings per common share
43,796,904
43,731,370
43,728,085
41,683,044
Basic earnings per share
0.26
0.29
0.81
0.54
Diluted earnings per share
0.28
0.80
0.53
13
3) Accumulated Other Comprehensive Income (Loss) (“AOCI”)
The following table reflects the changes in AOCI by component for the periods indicated:
Three Months Ended September 30, 2019 and 2018
Unamortized
Unrealized
Gain on
Gains (Losses) on
Available-
for-Sale
Defined
Securities
Benefit
Reclassified
Pension
and I/O
to Held-to-
Plan
Strips(1)
Maturity
Items
Beginning balance July 1, 2019, net of taxes
1,083
317
(7,702)
Other comprehensive income (loss) before reclassification,
net of taxes
737
(8)
729
Amounts reclassified from other comprehensive income (loss),
(232)
(9)
(225)
Net current period other comprehensive income (loss),
505
Ending balance September 30, 2019, net of taxes
1,588
308
(7,694)
Beginning balance July 1, 2018, net of taxes
(7,031)
359
(9,194)
Other comprehensive (loss) before reclassification,
(1,335)
(4)
(1,339)
40
32
Ending balance September 30, 2018, net of taxes
(8,366)
351
(9,158)
(1)
This AOCI component is included in the computation of net periodic benefit cost (see Note 9—Benefit Plans) and includes split-dollar life insurance benefit plan.
14
Nine Months Ended September 30, 2019 and 2018
Strips
Beginning balance January 1, 2019, net of taxes
(5,007)
344
(7,718)
7,213
(22)
7,191
(618)
(36)
46
(608)
6,595
Beginning balance January 1, 2018, net of taxes
(362)
375
(9,265)
(7,817)
(7,830)
(187)
(24)
120
(91)
(8,004)
15
Amounts Reclassified from
AOCI(1)
Affected Line Item Where
Details About AOCI Components
Net Income is Presented
Unrealized gains on available-for-sale securities
and I/O strips
(98)
232
Net of tax
Amortization of unrealized gain on securities available-
for-sale that were reclassified to securities
held-to-maturity
Interest income on taxable securities
Amortization of defined benefit pension plan items (1)
Prior transition obligation
Actuarial losses
(46)
(73)
(57)
Other noninterest expense
17
Income tax benefit
(16)
(40)
Total reclassification for the period
225
(32)
(260)
(79)
618
187
Amortization of unrealized gain on securities
available-for-sale that were reclassified to securities
52
33
73
48
(138)
(219)
(65)
(171)
19
(120)
Total reclassification from AOCI for the period
608
91
4) Securities
The amortized cost and estimated fair value of securities at September 30, 2019 and December 31, 2018 were as follows:
Gross
Estimated
Amortized
Fair
Cost
Gains
(Losses)
Value
Securities available-for-sale:
Agency mortgage-backed securities
212,759
588
(605)
212,742
U.S. Treasury
118,684
120,359
331,443
2,263
Securities held-to-maturity:
259,312
870
(1,175)
259,007
Municipals - exempt from Federal tax
82,721
1,403
(2)
84,122
2,273
(1,177)
343,129
December 31, 2018
311,523
(8,767)
302,854
147,823
930
148,753
U.S. Government sponsored entities
7,433
7,436
466,779
(8,768)
291,241
59
(9,153)
282,147
85,957
312
(2,241)
84,028
371
(11,394)
366,175
Securities with unrealized losses at September 30, 2019 and December 31, 2018, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position are as follows:
Less Than 12 Months
12 Months or More
25,073
(50)
84,313
(555)
109,386
38,850
(118)
104,510
(1,057)
143,360
1,012
39,862
144,372
3,868
(21)
281,082
(8,746)
284,950
3,974
7,842
288,924
16,088
(103)
255,917
(9,050)
272,005
5,019
(27)
57,301
(2,214)
62,320
21,107
(130)
313,218
(11,264)
334,325
There were no holdings of securities of any one issuer, other than the U.S. Government and its sponsored entities, in an amount greater than 10% of shareholders’ equity. At September 30, 2019, the Company held 451 securities (133 available-for-sale and 318 held‑to‑maturity), of which 100 had fair values below amortized cost. At September 30, 2019, there were $84,313,000 of agency mortgage-back securities available-for-sale, and $104,510,000 of agency mortgage-backed securities held-to-maturity, carried with an unrealized loss for 12 months or more. The total unrealized loss for securities 12 months or more was $1,612,000 at September 30, 2019. The unrealized losses were due to higher interest rates. The issuers are of high credit quality and all principal amounts are expected to be paid when securities mature. The fair value is expected to recover as the securities approach their maturity date and/or market rates decline. The Company does not believe that it is more likely than not that the Company will be required to sell a security in an unrealized loss position prior to recovery in value. The Company does not consider these securities to be other than temporarily impaired at September 30, 2019.
The proceeds from sales of securities and the resulting gains and losses were as follows for the periods indicated:
Proceeds
38,855
Gross gains
363
971
1,243
Gross losses
(93)
(977)
The amortized cost and estimated fair values of securities as of September 30, 2019 are shown by contractual maturity below. The expected maturities will differ from contractual maturities if borrowers have the right to call or pre‑pay obligations with or without call or pre‑payment penalties. Securities not due at a single maturity date are shown separately.
Available-for-sale
Fair Value
Due after 3 months through one year
29,722
29,947
Due after one through five years
88,962
90,412
18
Held-to-maturity
Due 3 months or less
360
361
654
659
5,968
6,123
Due after five through ten years
28,057
28,625
Due after ten years
47,682
48,354
Securities with amortized cost of $32,309,000 and $36,229,000 as of September 30, 2019 and December 31, 2018 were pledged to secure public deposits and for other purposes as required or permitted by law or contract.
5) Loans
Loans were as follows for the periods indicated:
Loans held-for-investment:
Commercial
528,060
597,763
Real estate:
CRE
1,080,235
994,067
Land and construction
96,610
122,358
Home equity
111,610
109,112
Residential mortgages
47,276
50,979
Consumer
11,701
12,453
Loans
1,875,492
1,886,732
Deferred loan fees, net
(105)
(327)
At September 30, 2019, total net loans included in the table above include $25,396,000, $91,818,000 and $150,149,000, of the loans acquired in the Focus Business Bank (“Focus”), Tri-Valley, and United American acquisitions that were not purchased credit impaired loans, respectively. At December 31, 2018, total net loans included in the table above include $36,958,000, $111,952,000 and $181,453,000, of the loans acquired in the Focus, Tri-Valley, and United American acquisitions, respectively, that were not purchased credit impaired loans.
Changes in the allowance for loan losses were as follows for the periods indicated:
Three Months Ended September 30, 2019
Real Estate
Beginning of period balance
15,234
11,307
90
26,631
Charge-offs
(315)
(318)
Recoveries
115
43
158
Net (charge-offs) recoveries
(200)
(160)
(378)
(207)
End of period balance
14,656
11,143
96
25,895
Three Months Ended September 30, 2018
17,522
9,020
122
26,664
(719)
(25)
(744)
1,897
1,931
1,178
1,187
(1,427)
1,022
(20)
17,273
10,076
77
27,426
Nine Months Ended September 30, 2019
17,061
10,671
116
27,848
(617)
(620)
917
127
1,044
300
424
(2,705)
345
(17)
Nine Months Ended September 30, 2018
10,608
8,950
100
19,658
(1,835)
(1,860)
2,229
2,349
394
489
Provision for loan losses
6,271
1,006
The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment, based on the impairment method at the following period‑ends:
Allowance for loan losses:
Ending allowance balance attributable to loans:
Individually evaluated for impairment
6,971
305
7,276
Collectively evaluated for impairment
7,685
10,838
18,619
Total allowance balance
Loans:
9,029
5,465
14,494
519,031
1,330,266
1,860,998
Total loan balance
1,335,731
20
6,944
10,117
20,904
9,495
5,645
15,140
588,268
1,270,871
1,871,592
1,276,516
The following table presents loans held-for-investment individually evaluated for impairment by class of loans as of September 30, 2019 and December 31, 2018. The recorded investment included in the following table represents loan principal net of any partial charge-offs recognized on the loans. The unpaid principal balance represents the recorded balance prior to any partial charge-offs. The recorded investment in consumer loans collateralized by residential real estate property that are in process of foreclosure according to local requirements of the applicable jurisdiction are not material as of the periods indicated:
Allowance
Unpaid
for Loan
Principal
Recorded
Losses
Balance
Investment
Allocated
With no related allowance recorded:
1,414
1,849
Home Equity
Total with no related allowance recorded
1,785
7,494
With an allowance recorded:
7,615
7,646
Total with an allowance recorded
12,709
The following tables present interest recognized and cash‑basis interest earned on impaired loans for the periods indicated:
Land and
Home
Construction
Average of impaired loans during the period
8,699
6,768
377
15,844
Interest income during impairment
Cash-basis interest recognized
21
19,638
5,720
572
25,930
8,857
460
16,085
11,056
3,110
30
472
14,668
Nonperforming loans include both smaller dollar balance homogenous loans that are collectively evaluated for impairment and individually classified loans. Nonperforming loans were as follows at period‑end:
Nonaccrual loans - held-for-investment
13,638
23,342
13,699
Restructured and loans over 90 days past due and still accruing
609
1,373
1,188
Total nonperforming loans
14,247
24,715
14,887
Other restructured loans
247
334
253
Total impaired loans
25,049
The following table presents the nonperforming loans by class for the periods indicated:
Restructured
and Loans
over 90 Days
Past Due
and Still
Nonaccrual
Accruing
8,397
385
8,782
8,279
963
9,242
147
224
326
22
The following tables present the aging of past due loans by class for the periods indicated:
30 - 59
60 - 89
90 Days or
Days
Greater
Loans Not
2,536
1,419
7,543
11,498
516,562
562
5,656
1,074,579
111,463
11,687
3,259
12,637
17,315
1,858,177
5,698
1,916
1,258
8,872
588,891
12,452
5,699
8,873
1,877,859
Past due loans 30 days or greater totaled $17,315,000 and $8,873,000 at September 30, 2019 and December 31, 2018, respectively, of which $12,425,000 and $430,000 were on nonaccrual, respectively. At September 30, 2019, there were also $1,213,000 of loans less than 30 days past due included in nonaccrual loans held-for-investment. At December 31, 2018, there were also $13,269,000 loans less than 30 days past due included in nonaccrual loans held-for-investment. Management’s classification of a loan as “nonaccrual” is an indication that there is reasonable doubt as to the full recovery of principal or interest on the loan. At that point, the Company stops accruing interest income, and reverses any uncollected interest that had been accrued as income. The Company begins recognizing interest income only as cash interest payments are received and it has been determined the collection of all outstanding principal is not in doubt. The loans may or may not be collateralized, and collection efforts are pursued.
Credit Quality Indicators
Concentrations of credit risk arise when a number of customers are engaged in similar business activities, or activities in the same geographic region, or have similar features that would cause their ability to meet contractual obligations to be similarly affected by changes in economic conditions. The Company’s loan portfolio is concentrated in commercial (primarily manufacturing, wholesale, and service) and real estate lending, with the remaining balance in consumer loans. While no specific industry concentration is considered significant, the Company’s lending operations are located in the Company’s market areas that are dependent on the technology and real estate industries and their supporting companies. Thus, the Company’s borrowers could be adversely impacted by a downturn in these sectors of the economy which could reduce the demand for loans and adversely impact the borrowers’ ability to repay their loans.
The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. The Company analyzes loans individually by classifying the loans as to credit risk. This analysis is performed on a quarterly basis. Nonclassified loans generally include those
23
loans that are expected to be repaid in accordance with contractual loans terms. Classified loans are those loans that are assigned a substandard, substandard-nonaccrual, or doubtful risk rating using the following definitions:
Substandard. Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well‑defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.
Substandard‑Nonaccrual. Loans classified as substandard‑nonaccrual are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any, and it is probable that the Company will not receive payment of the full contractual principal and interest. Loans so classified have a well‑defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected. In addition, the Company no longer accrues interest on the loan because of the underlying weaknesses.
Doubtful. Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.
Loss. Loans classified as loss are considered uncollectable or of so little value that their continuance as assets is not warranted. This classification does not necessarily mean that a loan has no recovery or salvage value; but rather, there is much doubt about whether, how much, or when the recovery would occur. Loans classified as loss are immediately charged off against the allowance for loan losses. Therefore, there is no balance to report as of September 30, 2019 and December 31, 2018.
The following table provides a summary of the loan portfolio by loan type and credit quality classification at period end:
Nonclassified
Classified
515,769
12,291
584,845
12,918
1,073,989
6,246
985,193
8,874
109,922
1,688
107,495
1,617
1,855,267
20,225
1,863,323
23,409
Classified loans were $ 20,225,000, or 0.64% of total assets, at September 30, 2019, compared to $30,546,000, or 0.95% of total assets, at September 30, 2018 and $23,409,000, or 0.76% of total assets, at December 31, 2018. The decrease in classified assets at September 30, 2019, compared to December 31, 2018, was primarily due to the payoff of classified loans.
The book balance of troubled debt restructurings at September 30, 2019 was $503,000, which included $6,000 of nonaccrual loans and $497,000 of accruing loans. The book balance of troubled debt restructurings at December 31, 2018 was $649,000, which included $36,000 of nonaccrual loans and $613,000 of accruing loans. Approximately $7,000 and $38,000 of specific reserves were established with respect to these loans as of September 30, 2019 and December 31, 2018, respectively.
The following table presents loans by class modified as troubled debt restructurings for the periods indicated:
During the Nine Months Ended
Pre-modification
Post-modification
Number
Outstanding
of
Troubled Debt Restructurings:
Contracts
September 30, 2018
159
384
During the three and nine months ended September 30, 2019, there were no new loans modified as troubled debt restructurings in which the amount of principal or accrued interest owed from the borrower was forgiven or which resulted in a charge-off or change to the allowance for loan losses.
A loan is considered to be in payment default when it is 30 days contractually past due under the modified terms. There were no defaults on troubled debt restructurings, within twelve months following the modification, during the three and nine months ended September 30, 2019 and 2018.
A loan that is a troubled debt restructuring on nonaccrual status may return to accruing status after a period of at least six months of consecutive payments in accordance with the modified terms.
6) Business Combinations
The Company completed the acquisition of Presidio Bank of San Francisco, CA, effective October 11, 2019. See Note 19 – Subsequent Events.
On April 6, 2018, the Company completed its acquisition of Tri-Valley for a transaction value of $32,320,000. At closing the Company issued 1,889,613 shares of the Company’s common stock with an aggregate market value of $30,725,000 on the date of closing. The number of shares issued was based on a fixed exchange ratio of 0.0489 of a share of the Company’s common stock for each outstanding share of Tri-Valley common stock. In addition, at closing the Company paid cash to the holder of a stock warrant and holders of outstanding stock options and related fees and fractional shares totaling $1,595,000. Tri-Valley’s results of operations have been included in the Company’s results of operations beginning April 7, 2018.
On May 4, 2018, the Company completed its acquisition of United American for a transaction value of $56,417,000. At closing the Company issued 2,826,032 shares of the Company’s common stock with an aggregate market value of $47,280,000 on the date of closing. The number of shares issued was based on a fixed exchange ratio of 2.1644 of a share of the Company’s common stock for each outstanding share of United American common stock and each common stock equivalent underlying the United American Series D Preferred Stock and Series E Preferred Stock. The shareholders of the United American Series A Preferred Stock and Series B Preferred Stock received $1,000 cash for each share totaling $8,700,000 and $435,000, respectively. In addition, the Company paid $2,000 in cash for fractional shares, for total cash consideration of $9,137,000. United American’s results of operations have been included in the Company’s results of operations beginning May 5, 2018.
The mergers provided the opportunity to combine three independent business banking franchises with similar philosophies and cultures into a combined $3.2 billion business bank based in San Jose, California. The pooling of the
25
three banks’ resources and knowledge enhanced the Company’s capabilities, operational efficiencies, and community outreach. The Company also believes the combined bank is much better positioned to meet the needs of the Company’s customers, shareholders and the community. The one time pre-tax severance, retention, acquisition and integration costs totaled $199,000 and $9,028,000 for the three months and nine months ended September 30, 2018, respectively.
The acquisitions were accounted for under the acquisition method of accounting. The fair value of net assets acquired includes fair value adjustments to certain receivables of which some were considered impaired and some were not considered impaired as of the acquisition date. The fair value adjustments were determined using discounted contractual cash flows, adjusted for expected losses and prepayments, where appropriate. The receivables that were not considered impaired at the acquisition date were not subject to the guidance relating to purchased credit impaired loans, which have shown evidence of credit deterioration since origination. There were no PCI loans at September 30, 2019 and December 31, 2018.
Goodwill of $13,819,000 arising from the Tri-Valley acquisition and $24,270,000 from the United American acquisition is largely attributable to synergies and cost savings resulting from combining the operations of the companies. As these transactions were structured as a tax-free exchange, the goodwill will not be deductible for tax purposes. As of April 6, 2019 and May 4, 2019 the Company finalized its valuation of all assets acquired and liabilities assumed in its acquisition of Tri-Valley and United American, respectively, resulting in no material changes to acquisition accounting adjustments.
7) Goodwill and Other Intangible Assets
At September 30, 2019, the carrying value of goodwill was $83,753,000, which included $13,044,000 of goodwill related to its acquisition of Bay View Funding, $32,620,000 from its acquisition of Focus, $13,819,000 from its acquisition of Tri-Valley and $24,270,000 from its acquisition of United American.
Goodwill impairment exists when a reporting unit’s carrying value exceeds its fair value, which is determined through a qualitative assessment whether it is more likely than not that the fair value of equity of the reporting unit exceeds the carrying value (“Step Zero”). If the qualitative assessment indicates it is more likely than not that the fair value of equity of a reporting unit is less than book value, then a quantitative two-step impairment test is required. Step 1 includes the determination of the carrying value of the Company’s single reporting unit, including the existing goodwill and intangible assets, and estimating the fair value of the reporting unit. If the carrying amount of a reporting unit exceeds its fair value, the Company is required to perform a second step to the impairment test. Step 2 requires that the implied fair value of the reporting unit goodwill be compared to the carrying amount of that goodwill. If the carrying amount of the reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss shall be recognized in an amount equal to that excess.
The Company completed its annual goodwill impairment analysis as of November 30, 2018 with the assistance of an independent valuation firm. No events or circumstances since the November 30, 2018 annual impairment test were noted that would indicate it was more likely than not a goodwill impairment exists.
Other Intangible Assets
Other intangible assets acquired in the acquisition of United American in May 2018 included a core deposit intangible asset of $5,723,000, amortized on an accelerated method over its estimated useful life of 10 years, and a below market value lease intangible asset of $660,000, amortized over its estimated useful life of 3 years. Accumulated amortization of the core deposit intangible and below market lease was $1,530,000 and $756,000 at September 30, 2019 and December 31, 2018, respectively.
Other intangible assets acquired in the acquisition of Tri-Valley in April 2018 include a core deposit intangible asset of $1,768,000, amortized on an accelerated method over its estimated useful life of 10 years, and a below market value lease intangible asset of $210,000, amortized over its estimated useful life of 11 years. Accumulated amortization of the core deposit intangible and below market lease was $416,000 and $222,000 at September 30, 2019 and December 31, 2018, respectively.
26
The core deposit intangible asset acquired in the acquisition of Focus in August 2015 was $6,285,000. This asset is amortized on an accelerated method over its estimated useful life of 10 years. Accumulated amortization of this intangible asset was $3,320,000 and $2,770,000 at September 30, 2019 and December 31, 2018, respectively.
Other intangible assets acquired in the acquisition of Bay View Funding in November 2014 included a below market value lease intangible assets of $109,000, a non-compete agreement intangible asset of $250,000, and a customer relationship and brokered relationship intangible assets of $1,900,000, amortized over the 10 year estimated useful lives. Accumulated amortization of the customer relationship and brokered relationship intangible assets was $933,000 and $791,000 at September 30, 2019 and December 31, 2018, respectively.
Estimated amortization expense for 2019, the next five years and thereafter is as follows:
United
Bay View Funding
American
Tri-Valley
Focus
Customer &
Core
Below
Brokered
Deposit
Market
Relationship
Amortization
Year
Intangible
Lease
Expense
777
255
240
734
190
2,214
2020
665
235
208
716
2,032
2021
602
596
1,590
2022
553
167
502
1,430
2023
521
420
1,307
2024
499
346
1,174
Thereafter
1,520
451
88
201
2,260
5,137
490
1,560
196
3,515
1,109
Impairment testing of the intangible assets is performed at the individual asset level. Impairment exists if the carrying amount of the asset is not recoverable and exceeds its fair value at the date of the impairment test. For intangible assets, estimates of expected future cash flows (cash inflows less cash outflows) that are directly associated with an intangible asset are used to determine the fair value of that asset. Management makes certain estimates and assumptions in determining the expected future cash flows from core deposit and customer relationship intangibles including account attrition, expected lives, discount rates, interest rates, servicing costs and other factors. Significant changes in these estimates and assumptions could adversely impact the valuation of these intangible assets. If an impairment loss exists, the carrying amount of the intangible asset is adjusted to a new cost basis. The new cost basis is then amortized over the remaining useful life of the asset. Based on its assessment, management concluded that there was no impairment of intangible assets at September 30, 2019 and December 31, 2018.
8) Income Taxes
Some items of income and expense are recognized in one year for tax purposes, and another when applying generally accepted accounting principles, which leads to timing differences between the Company’s actual current tax liability and the amount accrued for this liability based on book income. These temporary differences comprise the “deferred” portion of the Company’s tax expense or benefit, which is accumulated on the Company’s books as a deferred tax asset or deferred tax liability until such time as they reverse.
Under generally accepted accounting principles, a valuation allowance is required if it is “more likely than not” that a deferred tax asset will not be realized. The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning management’s evaluation of both positive and negative evidence, including forecasts of future income, cumulative losses, applicable tax planning strategies, and assessments of current and future economic and business conditions.
The Company had net deferred tax assets of $21,699,000, and $27,089,000, at September 30, 2019 and December 31, 2018, respectively. After consideration of the matters in the preceding paragraph, the Company determined that it is more likely than not that the net deferred tax assets at September 30, 2019 and December 31, 2018 will be fully realized in future years.
27
The following table reflects the carrying amounts of the low income housing investments included in accrued interest receivable and other assets, and the future commitments included in accrued interest payable and other liabilities for the periods indicated:
Low income housing investments
3,035
3,172
Future commitments
273
The Company expects $14,000 of the future commitments to be paid in 2019, $14,000 in 2020, and $245,000 in 2021 through 2023.
For tax purposes, the Company had low income housing tax credits of $106,000 for the three months ended September 30, 2019 and September 30, 2018, and low income housing investment expense of $106,000 and $117,000, respectively. For tax purposes, the Company had low income housing tax credits of $319,000, for the nine months ended September 30, 2019 and September 30, 2018, and low income housing investment expense of $317,000 and $351,000, respectively. The Company recognized low income housing investment expense as a component of income tax expense.
9) Benefit Plans
Supplemental Retirement Plan
The Company has a supplemental retirement plan (the “Plan”) covering some current and some former key employees and directors. The Plan is a nonqualified defined benefit plan. Benefits are unsecured as there are no Plan assets. The following table presents the amount of periodic cost recognized for the periods indicated:
Components of net periodic benefit cost:
Service cost
55
62
165
186
Interest cost
264
237
792
711
Amortization of net actuarial loss
219
Net periodic benefit cost
365
372
1,095
The components of net periodic benefit cost other than the service cost component are included in the line item “other noninterest expense” in the Consolidated Statements of Income.
Split‑Dollar Life Insurance Benefit Plan
The Company maintains life insurance policies for some current and some former directors and officers that are subject to split‑dollar life insurance agreements. The following table sets forth the funded status of the split‑dollar life insurance benefits for the periods indicated:
Change in projected benefit obligation:
Projected benefit obligation at beginning of year
6,903
6,711
209
227
Actuarial loss (gain)
(35)
Projected benefit obligation at end of period
7,112
28
Net actuarial loss
2,713
2,573
1,081
1,149
3,794
3,722
Amortization of prior transition obligation
(48)
69
56
170
45
136
10) Fair Value
Accounting guidance establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:
Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.
Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities in active markets; quoted prices for identical assets or liabilities in markets that are not active; or other inputs that are observable or can be corroborated by observable market data (for example, interest rates and yield curves observable at commonly quoted intervals, prepayment speeds, credit risks, and default rates).
Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.
Financial Assets and Liabilities Measured on a Recurring Basis
The fair values of securities available-for sale-are determined by obtaining quoted prices on nationally recognized securities exchanges (Level 1 inputs) or matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities, but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs).
29
The fair value of interest‑only (“I/O”) strip receivable assets is based on a valuation model used by a third party. The Company is able to compare the valuation model inputs and results to widely available published industry data for reasonableness (Level 2 inputs).
Fair Value Measurements Using
Significant
Quoted Prices in
Active Markets for
Observable
Unobservable
Identical Assets
Inputs
(Level 1)
(Level 2)
(Level 3)
Assets at September 30, 2019
Available-for-sale securities:
I/O strip receivables
541
Assets at December 31, 2018
568
There were no transfers between Level 1 and Level 2 during the period for assets measured at fair value on a recurring basis.
Assets and Liabilities Measured on a Non‑Recurring Basis
The fair value of impaired loans with specific allocations of the allowance for loan losses is generally based on recent real estate appraisals. The appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.
Foreclosed assets are valued at the time the loan is foreclosed upon and the asset is transferred to foreclosed assets. The fair value is based primarily on third party appraisals, less costs to sell. The appraisals may utilize a single valuation approach or a combination of approaches including the comparable sales and income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are typically significant and result in a Level 3 classification of the inputs for determining fair value.
Impaired loans - held-for-investment:
644
4,789
5,433
702
The following table shows the detail of the impaired loans held-for-investment and the impaired loans held‑for‑investment carried at fair value for the periods indicated:
Impaired loans held-for-investment:
Book value of impaired loans held-for-investment carried at fair value
Book value of impaired loans held-for-investment carried at cost
Total impaired loans held-for-investment
Impaired loans held-for-investment carried at fair value:
Specific valuation allowance
(7,276)
(6,944)
Impaired loans held-for-investment carried at fair value, net
Impaired loans held‑for‑investment which are measured primarily for impairment using the fair value of the collateral were $14,494,000 at September 30, 2019. In addition, these loans had a specific valuation allowance of $7,276,000 at September 30, 2019. Impaired loans held‑for‑investment totaling $12,709,000 at September 30, 2019, were carried at fair value as a result of partial charge‑offs and specific valuation allowances at period‑end. The remaining $1,785,000 of impaired loans were carried at cost at September 30, 2019, as the fair value of the collateral exceeded the cost basis of each respective loan. Partial charge‑offs and changes in specific valuation allowances during the first nine months of 2019 on impaired loans held‑for‑investment carried at fair value at September 30, 2019 resulted in an additional provision for loan losses of $399,000.
At September 30, 2019, there were no foreclosed assets.
Impaired loans held‑for‑investment were $15,140,000 at December 31, 2018. In addition, these loans had a specific valuation allowance of $6,944,000 at December 31, 2018. Impaired loans held‑for‑investment totaling $7,646,000 at December 31, 2018 were carried at fair value as a result of partial charge‑offs and specific valuation allowances at year‑end. The remaining $7,494,000 of impaired loans were carried at cost at December 31, 2018, as the fair value of the collateral exceeded the cost basis of each respective loan. Partial charge‑offs and changes in specific valuation allowances during 2018 on impaired loans held‑for‑investment carried at fair value at December 31, 2018 resulted in an additional provision for loan losses of $7,042,000.
31
At December 31, 2018, there were no foreclosed assets.
The following table presents quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a non‑recurring basis at the periods indicated:
Valuation
Range
Techniques
(Weighted Average)
Market Approach
Discount adjustment for differences between comparable sales
Less than 1%
0% to 1%
The Company obtains third party appraisals on its impaired loans held-for-investment and foreclosed assets to determine fair value. Generally, the third party appraisals apply the “market approach,” which is a valuation technique that uses prices and other relevant information generated by market transactions involving identical or comparable (that is, similar) assets, liabilities, or a group of assets and liabilities, such as a business. Adjustments are then made based on the type of property, age of appraisal, current status of property and other related factors to estimate the current value of collateral.
The carrying amounts and estimated fair values of financial instruments at September 30, 2019 are as follows:
Estimated Fair Value
Carrying
Amounts
Assets:
Cash and cash equivalents
Securities available-for-sale
Securities held-to-maturity
Loans (including loans held-for-sale), net
1,853,063
1,856,933
1,860,504
FHLB stock, FRB stock, and other
investments
Accrued interest receivable
8,588
615
1,969
6,004
I/O strips receivables
Time deposits
151,040
151,561
Other deposits
2,537,950
40,407
Accrued interest payable
1,271
The carrying amounts and estimated fair values of the Company’s financial instruments at December 31, 2018:
310,290
1,861,206
1,826,654
1,829,303
9,577
597
2,274
6,706
147,560
147,916
2,489,972
38,969
In accordance with our adoption of ASU 2016-01 in 2018, the methods utilized to measure the fair value of financial instruments at September 30, 2019 and December 31, 2018 represent an approximation of exit price, however, an actual exit price may differ.
11) Equity Plan
The Company maintained an Amended and Restated 2004 Equity Plan (the “2004 Plan”) for directors, officers, and key employees. The 2004 Plan was terminated on May 23, 2013. On May 23, 2013, the Company’s shareholders approved the 2013 Equity Incentive Plan (the “2013 Plan”). On May 25, 2017, the shareholders approved an amendment to the Heritage Commerce Corp 2013 Equity Incentive Plan to increase the number of shares available from 1,750,000 to 3,000,000 shares. The equity plans provide for the grant of incentive and nonqualified stock options and restricted stock. The equity plans provide that the option price for both incentive and nonqualified stock options will be determined by the Board of Directors at no less than the fair value at the date of grant. Options granted vest on a schedule determined by the Board of Directors at the time of grant. Generally options vest over four years. All options expire no later than ten years from the date of grant. Restricted stock is subject to time vesting. For the nine months ended September 30, 2019, the Company granted 299,500 shares of nonqualified stock options and 134,653 shares of restricted stock. There were 756,903 shares available for the issuance of equity awards under the 2013 Plan as of September 30, 2019.
Stock option activity under the equity plans is as follows:
Weighted
Average
Remaining
Aggregate
Exercise
Contractual
Intrinsic
Total Stock Options
of Shares
Price
Life (Years)
Outstanding at January 1, 2019
1,570,603
10.76
Granted
299,500
12.16
Exercised
(92,003)
7.86
Forfeited or expired
(22,550)
15.70
Outstanding at September 30, 2019
1,755,550
11.09
6.51
3,371,810
Vested or expected to vest
1,650,217
3,169,501
Exercisable at September 30, 2019
1,147,730
5.29
3,319,623
Information related to the equity plans for the periods indicated:
Intrinsic value of options exercised
444,251
1,767,884
Cash received from option exercise
723,397
2,499,481
Tax benefit realized from option exercises
44,244
513,901
Weighted average fair value of options granted
1.91
3.07
As of September 30, 2019, there was $1,424,000 of total unrecognized compensation cost related to nonvested stock options granted under the equity plans. That cost is expected to be recognized over a weighted‑average period of approximately 2.82 years.
The fair value of each option grant is estimated on the date of grant using the Black Scholes option pricing model that uses the assumptions noted in the following table, including the weighted average assumptions for the option grants for the periods indicated:
Expected life in months(1)
72
Volatility(1)
%
Weighted average risk-free interest rate(2)
2.23
2.87
Expected dividends(3)
3.95
2.62
The expected life of employee stock options represents the weighted average period the stock options are expected to remain outstanding based on historical experience. Volatility is based on the historical volatility of the stock price over the same period of the expected life of the option.
Based on the U.S. Treasury constant maturity interest rate with a term consistent with the expected life of the option granted.
Each grant’s dividend yield is calculated by annualizing the most recent quarterly cash dividend and dividing that amount by the market price of the Company’s common stock as of the grant date
Restricted stock activity under the equity plans is as follows:
Average Grant
Date Fair
Total Restricted Stock Award
Nonvested shares at January 1, 2019
193,298
11.04
Vested
(82,498)
12.37
17.11
Nonvested shares at September 30, 2019
239,453
11.23
As of September 30, 2019, there was $2,692,000 of total unrecognized compensation cost related to nonvested restricted stock awards granted under the equity plans. The cost is expected to be recognized over a weighted‑average period of approximately 2.29 years.
12) Subordinated Debt
On May 26, 2017, the Company completed an underwritten public offering of $40,000,000 aggregate principal amount of its fixed-to-floating rate subordinated notes (“Subordinated Debt”) due June 1, 2027. The Subordinated Debt initially bears a fixed interest rate of 5.25% per year. Commencing on June 1, 2022, the interest rate on the Subordinated Debt resets quarterly to the three-month LIBOR rate plus a spread of 336.5 basis points, payable quarterly in arrears. Interest on the Subordinated Debt is payable semi-annually on June 1st and December 1st of each year through June 1, 2022 and quarterly thereafter on March 1st, June 1st, September 1st and December 1st of each year through the maturity date or early redemption date. The Company, at its option, may redeem the Subordinated Debt, in whole or in part, on any interest payment date on or after June 1, 2022 without a premium. It is anticipated that the LIBOR index will be phased out by the end of 2021 and the Secured Overnight Financing Rate (“SOFR”) has been recommended as an alternative to LIBOR.
13) Capital Requirements
The Company and its subsidiary bank are subject to various regulatory capital requirements administered by the banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory—and possibly additional discretionary—actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements and operations. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and HBC must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off balance sheet items as calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. There are no conditions or events since September 30, 2019, that management believes have changed the categorization of the Company or HBC as “well-capitalized.”
As of January 1, 2015, HCC and HBC along with other community banking organizations became subject to new capital requirements and certain provisions of the new rules were phased in from 2015 through 2019. The Federal Banking regulators approved the new rules to implement the revised capital adequacy standards of the Basel Committee on Banking Supervision, commonly called Basel III, and addressed relevant provisions of The Dodd Frank Wall Street Reform and Consumer Protection Act of 2010, as amended. The new capital rules established a “capital conservation buffer,” which must consist entirely of common equity Tier 1 capital. The capital conservation buffer is 2.5% of risk-weighted assets. The Company and HBC must maintain a capital conservation buffer above the minimum risk-based capital requirements in order to avoid certain limitations on capital distributions, stock repurchases and discretionary bonus payments to executive officers. The Company’s consolidated capital ratios and the Bank’s capital ratios exceeded the regulatory guidelines for a well-capitalized financial institution under the Basel III regulatory requirements at September 30, 2019.
Quantitative measures established by regulation to help ensure capital adequacy require the Company and HBC to maintain minimum amounts and ratios (set forth in the tables below) of total, Tier 1 capital, and common equity Tier 1 capital (as defined in the regulations) to risk weighted assets (as defined), and of Tier 1 capital to average assets (as defined). Management believes that, as of September 30, 2019 and December 31, 2018, the Company and HBC met all capital adequacy guidelines to which they were subject.
The Company’s consolidated capital amounts and ratios are presented in the following table, together with capital adequacy requirements, under the Basel III regulatory requirements as of September 30, 2019 and December 31, 2018.
35
Required For
Capital
Adequacy
Purposes
Actual
Under Basel III
Ratio
Ratio (1)
As of September 30, 2019
Total Capital
16.2
238,455
10.5
(to risk-weighted assets)
Tier 1 Capital
301,444
13.3
193,035
8.5
Common Equity Tier 1 Capital
158,970
7.0
10.0
120,086
4.0
(to average assets)
Includes 2.5% capital conservation buffer, effective January 1, 2019, except the Tier 1 Capital to average assets ratio.
As of December 31, 2018
344,597
15.0
227,514
9.875
276,675
12.0
181,435
7.875
146,876
6.375
8.9
124,726
4.000
Includes 1.875% capital conservation buffer, effective January 1, 2018 except the Tier 1 Capital to average assets ratio.
HBC’s actual capital amounts and ratios are presented in the following table, together with capital adequacy requirements, under the Basel III regulatory requirements as of September 30, 2019, and December 31, 2018.
To Be Well-Capitalized
Under Basel III PCA Regulatory
Requirements
346,087
15.2
226,966
238,314
319,572
14.1
181,573
8.0
192,921
147,528
6.5
158,876
10.6
150,040
5.0
120,032
322,283
14.0
230,275
227,397
293,730
12.8
184,220
181,342
149,679
146,800
9.4
155,832
124,666
Includes 1.875% capital conservation buffer, effective January 1, 2018, except the Tier 1 Capital to average assets ratio.
The Subordinated Debt, net of unamortized issuance costs, totaled $39,507,000 at September 30, 2019, and qualifies as Tier 2 capital for the Company under the guidelines established by the Federal Reserve Bank.
At a Special Meeting of Shareholders on August 27, 2019, the Company’s shareholders approved an amendment to the Company’s articles of incorporation to increase the number of authorized shares of common stock from 60,000,000 to 100,000,000 shares of common stock.
Under California General Corporation Law, the holders of common stock are entitled to receive dividends when and as declared by the Board of Directors, out of funds legally available. The California Financial Code provides that a state licensed bank may not make a cash distribution to its shareholders in excess of the lesser of the following: (i) the bank’s retained earnings; or (ii) the bank’s net income for its last three fiscal years, less the amount of any distributions made by the bank to its shareholders during such period. However, a bank, with the prior approval of the Commissioner of the California Department of Business Oversight—Division of Financial Institutions (“DBO”) may make a distribution to its shareholders of an amount not to exceed the greater of (i) a bank’s retained earnings; (ii) its net income for its last fiscal year; or (iii) its net income for the current fiscal year. Also with the prior approval of the Commissioner of the DBO and the shareholders of the bank, the bank may make a distribution to its shareholders, as a reduction in capital of the bank. In the event that the Commissioner determines that the shareholders’ equity of a bank is inadequate or that the making of a distribution by a bank would be unsafe or unsound, the Commissioner may order a bank to refrain from making such a proposed distribution. As of September 30, 2019, HBC would not be required to obtain regulatory approval, and the amount available for cash dividends is $27,636,000. Similar restrictions applied to the amount and sum of loan advances and other transfers of funds from HBC to the parent company. During the third, second and first quarter of 2019, HBC distributed to HCC dividends of $5,000,000, $5,500,000 and $5,000,000, respectively, for a total of $15,500,000 for the nine months of 2019.
14) Loss Contingencies
The Company is involved in certain legal actions arising from normal business activities. Management, based upon the advice of legal counsel, believes the ultimate resolution of all pending legal actions will not have a material effect on the financial statements of the Company.
15) Revenue Recognition
On January 1, 2018, the Company adopted ASU No. 2014-09 (Topic 606) and all subsequent ASUs that modified Topic 606. Topic 606 does not apply to revenue associated with financial instruments, including revenue from loans and securities. In addition, certain noninterest income streams such as fees associated with mortgage servicing rights, financial guarantees, gain on sale of securities, bank-owned life insurance, gain on sales of SBA loans, and certain credit card fees are also not in scope of the new guidance. Topic 606 is applicable to noninterest revenue streams such as
37
deposit related fees, interchange fees, and merchant income. However, the recognition of these revenue streams did not change significantly upon adoption of Topic 606. Substantially all of the Company’s revenue is generated from contracts with customers. The following noninterest income revenue streams are in-scope of Topic 606:
Service charges and fees on deposit accounts consist of account analysis fees (i.e., net fees earned on analyzed business and public checking accounts), monthly service fees, check orders, and other deposit account related fees. We sometimes charge customers fees that are not specifically related to the customer accessing its funds, such as account maintenance or dormancy fees. The amount of deposit fees assessed varies based on a number of factors, such as the type of customer and account, the quantity of transactions, and the size of the deposit balance. We charge, and in some circumstances do not charge, fees to earn additional revenue and influence certain customer behavior. An example would be where we do not charge a monthly service fee, or do not charge for certain transactions, for customers that have a high deposit balance. Deposit fees are considered either transactional in nature (such as wire transfers, nonsufficient fund fees, and stop payment orders) or non-transactional (such as account maintenance and dormancy fees). These fees are recognized as earned or as transactions occur and services are provided. Check orders and other deposit account related fees are largely transactional based and, therefore, the Company’s performance obligation is satisfied, and related revenue recognized, at a point in time. Payment for service charges on deposit accounts is primarily received immediately or in the following month through a direct charge to customers’ accounts.
The following presents noninterest income, segregated by revenue streams in-scope and out-of-scope of Topic 606, for the periods indicated:
Noninterest Income In-scope of Topic 606:
Noninterest Income Out-of-scope of Topic 606
1,586
1,099
4,481
4,200
16) Noninterest Expense
The following table sets forth the various components of the Company’s noninterest expense for the periods indicated:
10,536
31,726
2,038
Merger-related costs (1)
661
199
1,201
9,028
Software subscriptions
601
1,746
1,747
Amortization of intangible assets
554
631
Insurance expense
479
430
1,354
1,236
Data processing
454
525
1,865
1,501
Recovery of legal fees (2)
(922)
2,354
2,572
7,516
6,963
38
Severance and retention expense of $183,000 and $3,576,000 for first three months and first nine months of 2018 is included in the “Salaries and employee benefits” category in the Consolidated Statements of Income. Other acquisition and integration costs of $661,000 and $16,000 for the third quarter of 2019 and the third quarter of 2018, respectively, is included in the “Other noninterest expense” category in the Consolidated Statements of Income. Other acquisition and integration costs of $1,201,000 and $5,452,000 for the first nine months of 2019 and the first nine months of 2018, respectively, is included in the “Other noninterest expense” category in the Consolidated Statements of Income.
Included in Professional fees for the nine months ended September 30, 2018 in the Consolidated Statements of Income.
17) Leases
On January 1, 2019, the Company adopted ASU No. 2016-02, Leases (Topic 842). Under the new guidance, the Company recognizes the following for all leases, at the commencement date: (1) a lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis; and (2) a right-of-use (“ROU”) asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. The Company is impacted as a lessee of the offices and real estate used for operations. The Company's lease agreements include options to renew at the Company's option. No lease extensions are reasonably certain to be exercised, therefore it was not considered in the calculation of the ROU asset and lease liability. As of September 30, 2019, operating lease ROU assets, included in other assets, and lease liabilities, included in other liabilities, totaled $7,089,000.
The following table presents the quantitative information for the Company’s leases:
Operating Lease Cost (Cost resulting from lease payments)
1,035
Operating Lease - Operating Cash Flows (Fixed Payments)
1,040
Operating Lease - ROU assets
7,089
Operating Lease - Liabilities
Weighted Average Lease Term - Operating Leases
3.59 years
Weighted Average Discount Rate - Operating Leases
The following maturity analysis shows the undiscounted cash flows due on the Company’s operating lease abilities:
1,024
2,353
1,565
1,306
769
784
Total undiscounted cash flows
7,801
Discount on cash flows
(712)
Total lease liability
In June of 2019, the Company entered in to a lease agreement for 54,910 square feet of office space in San Jose, California, commencing on February 1, 2020. The Company intends to move its Bay View Funding office during the first quarter of 2020, and move the main office of HBC during the second quarter of 2020, to this new location.
39
18) Business Segment Information
The following presents the Company’s operating segments. The Company operates through two business segments: Banking segment and Factoring segment. Transactions between segments consist primarily of borrowed funds. Intersegment interest expense is allocated to the Factoring segment based on the Company’s prime rate and funding costs. The provision for loan loss is allocated based on the segment’s allowance for loan loss determination which considers the effects of charge-offs. Noninterest income and expense directly attributable to a segment are assigned to it. Taxes are paid on a consolidated basis and allocated for segment purposes. The Factoring segment includes only factoring originated by Bay View Funding.
Banking(1)
Factoring
Consolidated
Interest income
30,371
2,879
Intersegment interest allocations
(303)
Net interest income
28,049
2,576
(1,019)
443
Net interest income after provision
29,068
2,133
Noninterest income
2,488
130
Noninterest expense (2)
16,204
1,705
Intersegment expense allocations
125
(125)
15,477
433
Income tax (benefit) expense
4,505
128
10,972
3,119,367
63,104
1,831,172
44,215
70,709
13,044
30,425
4,185
(601)
28,867
3,584
(671)
246
29,538
3,338
2,011
195
16,045
1,683
172
(172)
15,676
1,678
4,483
11,193
1,182
3,107,897
85,013
3,192,910
1,828,379
71,008
1,899,387
70,708
83,752
Includes the holding company’s results of operations
The banking segment’s noninterest expense includes merger-related costs of $661,000 and $199,000, for the third quarter of 2019 and the third quarter of 2018, respectively
91,388
8,800
909
(909)
84,692
7,891
(2,655)
278
87,347
7,613
7,361
49,189
5,083
378
45,897
2,642
12,982
781
32,915
1,861
83,781
10,686
1,304
(1,304)
79,581
9,382
6,958
321
72,623
9,061
6,628
53,813
4,767
574
(574)
26,012
4,273
6,923
1,263
19,089
3,010
The banking segment’s noninterest expense includes merger-related costs of $1,201,000 and $9,028,000, for the first nine months of 2019 and the first nine months of 2018, respectively
19) Subsequent Events
The Company completed its previously announced merger of its wholly-owned bank subsidiary Heritage Bank of Commerce with Presidio Bank (“Presidio”) effective October 11, 2019. The merger, which was first announced on May 16, 2019, was concluded following receipt of approval from both the Company’s and Presidio shareholders and all required regulatory approvals. Presidio’s results of operations from October 12, 2019 through December 31, 2019 will be reflected in the Company’s results of operations in the fourth quarter of 2019.
Presidio was a full-service California state-chartered commercial bank headquartered in San Francisco with branches in Palo Alto, San Francisco, San Mateo, San Rafael, and Walnut Creek, California.
41
At September 30, 2019, Presidio had approximately $877.4 million in assets, $692.9 million in net loans and $754.5 million in deposits.
The transactions will be accounted for using the acquisition method of accounting which requires, among other things, that the assets acquired and liabilities assumed be recognized at their fair values as of the acquisition dates. The acquisition related disclosures required by the accounting guidance cannot be made at this time as the initial accounting for the business transactions has not been completed.
On October 24, 2019, the Company announced that its Board of Directors declared a $0.12 per share quarterly cash dividend to holders of common stock. The dividend will be paid on November 19, 2019 to shareholders of record on November 5, 2019.
42
ITEM 2—MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion provides information about the results of operations, financial condition, liquidity, and capital resources of Heritage Commerce Corp (the “Company” or “HCC”), its wholly‑owned subsidiary, Heritage Bank of Commerce (“HBC”), and HBC’s wholly‑owned subsidiary, CSNK Working Capital Finance Corp., a California Corporation, dba Bay View Funding (“Bay View Funding”). This information is intended to facilitate the understanding and assessment of significant changes and trends related to our financial condition and the results of operations. This discussion and analysis should be read in conjunction with our consolidated financial statements and the accompanying notes presented elsewhere in this report. Unless we state otherwise or the context indicates otherwise, references to the “Company,” “Heritage,” “we,” “us,” and “our,” in this Report on Form 10‑Q refer to Heritage Commerce Corp and its subsidiaries.
CRITICAL ACCOUNTING POLICIES
Critical accounting policies are discussed in our Form 10‑K for the year ended December 31, 2018. There are no changes to these policies as of September 30, 2019.
EXECUTIVE SUMMARY
This summary is intended to identify the most important matters on which management focuses when it evaluates the financial condition and performance of the Company. When evaluating financial condition and performance, management looks at certain key metrics and measures. The Company’s evaluation includes comparisons with peer group financial institutions and its own performance objectives established in the internal planning process.
The primary activity of the Company is commercial banking. The Company’s operations are located entirely in the general San Francisco Bay Area of California in the counties of Santa Clara, Alameda, Contra Costa, San Mateo, and San Benito. The largest city in this area is San Jose and the Company’s market includes the headquarters of a number of technology based companies in the region known commonly as Silicon Valley. The Company’s customers are primarily closely held businesses and professionals.
Performance Overview
For the three months ended September 30, 2019, net income was $11.3 million, or $0.26 per average diluted common share, compared to $12.4 million, or $0.28 per average diluted common share, for the three months ended September 30, 2018. The Company’s annualized return on average tangible assets was 1.49% and annualized return on average tangible equity was 15.08% for the three months ended September 30, 2019, compared to 1.54% and 19.36%, respectively, for the three months ended September 30, 2018.
For the nine months ended September 30, 2019, net income was $34.8 million, or $0.80 per average diluted common share, compared to $22.1 million, or $0.53 per average diluted common share, for the nine months ended September 30, 2018. The Company’s annualized return on average tangible assets was 1.55% and annualized return on average tangible equity was 16.26% for the nine months ended September 30, 2019, compared to 1.01% and 12.33%, respectively, for the nine months ended September 30, 2018.
Earnings for the third quarter of 2019, and the first nine months of 2019, were reduced by merger-related costs of $661,000, and $1.2 million, respectively, related to the merger with Presidio Bank (“Presidio”) completed on October 11, 2019. Earnings for the third quarter of 2018 and for the first nine months of 2018, were reduced by merger-related costs of $199,000 and $9.0 million, respectively, for the acquisitions of Tri-Valley Bank (“Tri-Valley”) and United American Bank (“United American”) which were completed on April 6, 2018 and May 4, 2018, respectively.
Presidio Bank Merger
The Company completed its previously announced merger of its wholly-owned bank subsidiary Heritage Bank of Commerce with Presidio effective October 11, 2019. The merger, which was first announced on May 16, 2019, was concluded following receipt of approval from both the Company’s and Presidio shareholders and all required regulatory
approvals. Presidio’s results of operations from October 12, 2019 through December 31, 2019 will be reflected in the Company’s results of operations in the fourth quarter of 2019.
Tri-Valley Bank and United American Bank Mergers
The Company completed the merger of its wholly-owned bank subsidiary Heritage Bank of Commerce with Tri-Valley Bank effective as of the close on April 6, 2018. Tri-Valley’s results of operations were included in the Company’s results of operations beginning April 7, 2018.
Tri-Valley was a full-service California state-chartered commercial bank with branches in San Ramon and Livermore, California and served businesses and individuals primarily in Contra Costa and Alameda counties in Northern California. The Company closed the San Ramon office on July 13, 2018.
The Company completed the merger of its wholly-owned bank subsidiary Heritage Bank of Commerce with United American effective as of the close on May 4, 2018. United American’s results of operations were included in the Company’s results of operations beginning May 5, 2018.
United American was a full-service commercial bank located in San Mateo County with full-service branches located in San Mateo, Redwood City and Half Moon Bay, California and serviced businesses, professionals and individuals. The Company closed the Half Moon Bay office on August 10, 2018.
Factoring Activities - Bay View Funding
Based in Santa Clara, California, Bay View Funding provides business-essential working capital factoring financing to various industries throughout the United States. The following table reflects selected financial information for Bay View Funding for the periods indicated:
Total factored receivables
Average factored receivables
For the three months ended
47,614
69,740
For the nine months ended
47,271
57,096
Total full time equivalent employees
Third Quarter 2019 Highlights
The following are important factors that impacted the Company’s results of operations:
Net interest income, before provision for loan losses, decreased (6%) to $30.6 million for the third quarter of 2019, compared to $32.5 million for the third quarter of 2018. For the first nine months of 2019, net interest income increased 4% to $92.6 million, compared to $89.0 million for the first nine months of 2018.
For the third quarter of 2019, the fully tax equivalent (“FTE”) net interest margin contracted 12 basis points to 4.24% from 4.36% for the third quarter of 2018, primarily due to a decline in the average balance of loans, and a higher cost of deposits.
For the first nine months of 2019, the net interest margin expanded 6 basis points to 4.33%, compared to 4.27% for the first nine months of 2018, primarily due to a higher average balance of loans and securities, the impact of increases in the yields on loans, investment securities, and overnight funds, and an increase in
44
the accretion of the loan purchase discount into loan interest income from the acquisitions, partially offset by an increase in the cost of deposits, and a decrease in the average balance of Bay View Funding’s factored receivables.
The average yield on the loan portfolio decreased to 5.83% for the third quarter of 2019, compared to 5.92% for the third quarter of 2018, primarily due to a decrease in the average balance of Bay View Funding’s factored receivables. The average yield on the Company’s legacy loan portfolio (excluding the purchased residential loans, purchased commercial real estate (“CRE”) loans, factored receivables portfolio, and accretion of the loan purchase discount from the acquisitions) increased 10 basis points for the third quarter of 2019, compared to the third quarter of 2018.
The average yield on the loan portfolio increased to 5.90% for the first nine months of 2019, compared to 5.82% for the first nine months of 2018, primarily due to increases in the prime rate, and an increase in the accretion of the loan purchase discount into loan interest income from the acquisitions. The yield on the Company’s legacy loan portfolio (excluding the purchased residential loans, purchased CRE loans, factored receivables portfolio, and accretion of the loan purchase discount from the acquisitions) increased 21 basis points for the first nine months of 2019, compared to the first nine months of 2018.
The accretion of the loan purchase discount into loan interest income from the acquisitions was $471,000 for the third quarter of 2019 compared to $506,000 for the third quarter of 2018. The accretion of the loan purchase discount into loan interest income from the acquisitions was $1.3 million for the first nine months of 2019, compared to $1.2 million for the first nine months of 2018.
The total purchase discount on loans from Focus Business Bank (“Focus”) loan portfolio was $5.4 million on the acquisition date of August 20, 2015, of which $437,000 remains outstanding as of September 30, 2019. The total purchase discount on loans from Tri-Valley loan portfolio was $2.6 million on the acquisition date of April 6, 2018, of which $1.8 million remains outstanding as of September 30, 2019. The total purchase discount on loans from United American loan portfolio was $4.7 million on the acquisition date of May 4, 2018, of which $2.9 million remains outstanding as of September 30, 2019.
There was a $576,000 credit to the provision for loan losses for the third quarter of 2019, compared to a $425,000 credit to the provision for loan losses for the third quarter of 2018. For the nine months ended September 30, 2019, there was a $2.4 million credit to the provision for loan losses, compared to a $7.3 million provision for loan losses for the nine months ended September 30, 2018. The higher provision for loan losses for first nine months of 2018 included a $7.0 million specific reserve for a lending relationship that was placed on nonaccrual during the second quarter of 2018.
Total noninterest income increased to $2.6 million for the third quarter of 2019, compared to $2.2 million for the third quarter of 2018, primarily due to a $330,000 net gain on sales of securities for the third quarter of 2019.
For the nine months ended September 30, 2019, noninterest income increased to $7.9 million, compared to $7.2 million for the nine months ended September 30, 2018. The increase in noninterest income for the first nine months of 2019, was primarily due to higher service charges and fees on deposit accounts, and a higher gain on sales of securities for the first nine months of 2019, partially offset by lower gain on sales of Small Business Administration (“SBA”) loans for the first nine months of 2019, and proceeds from a legal settlement in the first nine months of 2018.
The Company received $1.3 million in proceeds from a legal settlement during the second quarter of 2018, of which $377,000 was recorded in other noninterest income, and $922,000 was credited to professional fees for recaptured legal fees previously paid by the Company.
Total noninterest expense for the third quarter of 2019 increased to $17.9 million, compared to $17.7 million for the third quarter of 2018, primarily due to higher merger-related costs for the third quarter of 2019. Noninterest expense for the third quarter of 2019 included $661,000 of merger-related costs for the Presidio acquisition, compared to $199,000 of merger-related costs for the third quarter of 2018 for the Tri-Valley and United American acquisitions.
Noninterest expense for the nine months ended September 30, 2019 decreased to $54.3 million, compared to $58.6 million for the nine months ended September 30, 2018, primarily due to lower merger-related costs, partially offset by higher professional fees. Noninterest expense for the nine months ended September 30, 2019 included $1.2 million of merger-related costs for the Presidio acquisition, compared to $9.0 million of merger-related costs for the nine months ended September 30, 2018 for the Tri-Valley and United American acquisitions. Professional fees for the nine months ended September 30, 2018 included a recovery of $922,000 from a legal settlement.
The efficiency ratio for the third quarter of 2019 was 53.87%, compared to 51.15% for the third quarter of 2018. The efficiency ratio for the nine months ended September 30, 2019 was 54.04%, compared to 60.93% for the nine months ended September 30, 2018.
The income tax expense for the third quarter of 2019 was $4.6 million, compared to $5.0 million for the third quarter of 2018. The effective tax rate for the third quarter of 2019 was 29.1%, compared to 28.7% for the third quarter of 2018. Income tax expense for the nine months ended September 30, 2019 was $13.8 million, compared to $8.2 million for the nine months ended September 30, 2018. The effective tax rate for the nine months ended September 30, 2019 was 28.4%, compared to 27.0% for the nine months ended September 30, 2018.
The following are important factors in understanding our current financial condition and liquidity position:
Cash, other investments and interest‑bearing deposits in other financial institutions and securities available‑for‑sale, at fair value, increased 7% to $748.9 million at September 30, 2019, from $700.1 million at September 30, 2018, and increased 20% from $623.6 million at December 31, 2018.
At September 30, 2019, securities held‑to‑maturity, at amortized cost, totaled $342.0 million, compared to $375.7 million at September 30, 2018, and $377.2 million at December 31, 2018.
Loans, excluding loans held-for-sale, decreased $24.0 million, or (1%), to $1.88 billion at September 30, 2019, compared to $1.90 billion at September 30, 2018, primarily due to a decline of $72.5 million in commercial loans (“C&I”), $34.9 million in land and construction loans, $5.0 million in home equity loans, $4.8 million in purchased residential mortgages, and $3.8 million in purchased CRE loans, partially offset by an increase of $95.5 million in CRE loans. Loans, excluding loans held-for-sale, decreased $11.0 million, or (1%), to $1.88 billion at September 30, 2019, compared to $1.89 billion December 31, 2018.
Nonperforming assets (“NPAs”) were $14.2 million, or 0.45% of total assets, at September 30, 2019, compared to $24.7 million, or 0.77% of total assets, at September 30, 2018, and $14.9 million, or 0.48% of total assets, at December 31, 2018.
A large lending relationship was placed on nonaccrual during the second quarter of 2018. At September 30, 2019, the recorded investment of this lending relationship decreased to $10.8 million, and the Company had a $6.0 million specific loan loss reserve allocated for this lending relationship, compared to a recorded investment of $21.8 million, and a $7.0 million specific loan loss reserve allocated for this lending relationship at September 30, 2018, and a recorded investment of $12.0 million, and a $6.7 million specific loan loss reserve allocated for this lending relationship at December 31, 2018, as a result of loan paydowns.
Classified assets decreased to $20.2 million, or 0.64% of total assets, at September 30, 2019, compared to $30.5 million, or 0.95% of total assets, at September 30, 2018, and $23.4 million, 0.76% of total assets, at December 31, 2018, primarily due to the payoff of classified loans. There were no foreclosed assets at September 30, 2019, September 30, 2018, and December 31, 2018.
Net charge-offs totaled $160,000 for the third quarter of 2019, compared to net recoveries of $1.2 million for the third quarter of 2018, and net recoveries of $280,000 for the fourth quarter of 2018.
The allowance for loan losses (“ALLL”) at September 30, 2019 was $25.9 million, or 1.38% of total loans, representing 181.76% of total nonperforming loans. The allowance for loan losses at September 30, 2018 was $27.4 million, or 1.44% of total loans, representing 110.97% of total nonperforming loans. The
allowance for loan losses at December 31, 2018 was $27.8 million, or 1.48% of total loans, representing 187.06% of total nonperforming loans.
Total deposits decreased $56.3 million, or (2%), to $2.69 billion at September 30, 2019, compared to $2.75 billion at September 30, 2018. Total deposits increased $51.5 million or 2% from $2.64 billion at December 31, 2018.
Deposits, excluding all time deposits and CDARS deposits, decreased $58.3 million, or (2%), to $2.52 billion at September 30, 2019, compared to $2.58 billion at September 30, 2018. Deposits, excluding all time deposits and CDARS deposits, at September 30, 2019 increased $44.6 million, or 2% compared to $2.48 billion at December 31, 2018.
The ratio of noncore funding (which consists of time deposits of $250,000 and over, CDARS deposits, brokered deposits, securities under an agreement to repurchase, subordinated debt, and short‑term borrowings) to total assets was 4.79% at September 30, 2019, compared to 4.25% at September 30, 2018 and 4.53% at December 31, 2018.
The loan to deposit ratio was 69.74% at September 30, 2019, compared to 69.19% at September 30, 2018, and 71.52% at December 31, 2018.
The Company’s consolidated capital ratios exceeded regulatory guidelines and the Bank’s capital ratios exceeded the regulatory guidelines for a well‑capitalized financial institution under the Basel III regulatory requirements at September 30, 2019.
Well-capitalized
Heritage
Financial Institution
Basel III Minimum
Commerce
Bank of
Basel III PCA Regulatory
Regulatory
Capital Ratios
Corp
Guidelines
Requirement(1)
Total Risk-Based
Tier 1 Risk-Based
Common Equity Tier 1 Risk-based
Leverage
Fully phased in Basel III requirements for both HCC and HBC include a 2.5% capital conservation buffer, except the leverage ratio.
The composition and cost of the Company’s deposit base are important in analyzing the Company’s net interest margin and balance sheet liquidity characteristics. The Company’s depositors are generally located in its primary market area. Depending on loan demand and other funding requirements, the Company also obtains deposits from wholesale sources including deposit brokers. HBC is a member of the Certificate of Deposit Account Registry Service (“CDARS”) program. The CDARS program allows customers with deposits in excess of FDIC insured limits to obtain coverage on time deposits through a network of banks within the CDARS program. The Company has a policy to monitor all deposits that may be sensitive to interest rate changes to help assure that liquidity risk does not become excessive due to concentrations.
Total deposits decreased $56.3 million, or (2%), to $2.69 billion at September 30, 2019, compared to $2.75 billion at September 30, 2018. Total deposits increased $51.5 million or 2% from $2.64 billion at December 31, 2018. Deposits, excluding all time deposits and CDARS deposits, decreased $58.3 million, or (2%), to $2.52 billion at September 30, 2019, compared to $2.58 billion at September 30, 2018. Deposits, excluding all time deposits and CDARS deposits, at September 30, 2019 increased $44.6 million, or 2% compared to $2.48 billion at December 31, 2018.
47
Liquidity
Our liquidity position refers to our ability to maintain cash flows sufficient to fund operations and to meet obligations and other commitments in a timely fashion. The Company manages liquidity to be able to meet unexpected sudden changes in levels of its assets or deposit liabilities without maintaining excessive amounts of balance sheet liquidity. Excess balance sheet liquidity can negatively impact the Company’s interest margin. At September 30, 2019, we had $415.8 million in cash and cash equivalents and approximately $716.5 million in available borrowing capacity from various sources including the Federal Home Loan Bank (“FHLB”), the Federal Reserve Bank of San Francisco (“FRB”), Federal funds facilities with several financial institutions, and line of credit with a correspondent bank. The Company also had $643.1 million at fair value in unpledged securities available at September 30, 2019. Our loan to deposit ratio was 69.74% at September 30, 2019, compared to 69.19% at September 30, 2018, and 71.52% at December 31, 2018.
Lending
Our lending business originates principally through our branch offices located in our primary markets. In addition, Bay View Funding provides factoring financing throughout the United States. Total loans, excluding loans held-for-sale, decreased $24.0 million, or (1%), to $1.88 billion at September 30, 2019, compared to $1.90 billion at September 30, 2018, primarily due to a decline of $72.5 million in C&I loans, $34.9 million in land and construction loans, $5.0 million in home equity loans, $4.8 million in purchased residential mortgages, and $3.8 million in purchased CRE loans, partially offset by an increase of $95.5 million in CRE loans. Loans, excluding loans held-for-sale, decreased $11.0 million, or (1%), to $1.88 billion at September 30, 2019, compared to $1.89 billion December 31, 2018. The loan portfolio remains well-diversified with C&I loans accounting for 28% of the loan portfolio at September 30, 2019, which included $44.2 million of factored receivables. CRE loans accounted for 58% of the total loan portfolio, of which 38% were occupied by businesses that own them. Land and construction loans accounted for 5% of total loans, consumer and home equity loans accounted for 7% of total loans, and residential mortgage loans accounted for the remaining 2% of total loans at September 30, 2019.
Net Interest Income
The management of interest income and expense is fundamental to the performance of the Company. Net interest income, the difference between interest income and interest expense, is the largest component of the Company’s total revenue. Management closely monitors both total net interest income and the net interest margin (net interest income divided by average earning assets). Net interest income, before provision for loan losses, decreased (6%) to $30.6 million for the third quarter of 2019, compared to $32.5 million for the third quarter of 2018. For the first nine months of 2019, net interest income increased 4% to $92.6 million, compared to $89.0 million for the first nine months of 2018, primarily due to the impact of the increase in loans and deposits from the Tri-Valley and United American acquisitions.
The Company through its asset and liability policies and practices seeks to maximize net interest income without exposing the Company to an excessive level of interest rate risk. Interest rate risk is managed by monitoring the pricing, maturity and repricing options of all classes of interest‑bearing assets and liabilities. This is discussed in more detail under “Liquidity and Asset/Liability Management.” In addition, we believe there are measures and initiatives we can take to improve the net interest margin, including increasing loan rates, adding floors on floating rate loans, reducing nonperforming assets, managing deposit interest rates, and reducing higher cost deposits.
The net interest margin is also adversely impacted by the reversal of interest on nonaccrual loans and the reinvestment of loan payoffs into lower yielding investment securities and other short‑term investments.
Management of Credit Risk
We continue to identify, quantify, and manage our problem loans. Early identification of problem loans and potential future losses helps enable us to resolve credit issues with potentially less risk and ultimate losses. We maintain an allowance for loan losses in an amount that we believe is adequate to absorb probable incurred losses in the portfolio. While we strive to carefully manage and monitor credit quality and to identify loans that may be deteriorating, circumstances can change at any time for loans included in the portfolio that may result in future losses, that as of the date of the financial statements have not yet been identified as potential problem loans. Through established credit practices, we adjust the allowance for loan losses accordingly. However, because future events are uncertain, there may be loans that will deteriorate, some of which could occur in an accelerated time‑frame. As a result, future additions to the
allowance for loan losses may be necessary. Because the loan portfolio contains a number of commercial loans, commercial real estate, construction and land development loans with relatively large balances, deterioration in the credit quality of one or more of these loans may require a significant increase to the allowance for loan losses. Future additions to the allowance may also be required based on changes in the financial condition of borrowers. Additionally, Federal and state banking regulators, as an integral part of their supervisory function, periodically review our allowance for loan losses. These regulatory agencies may require us to recognize further loan loss provisions or charge‑offs based upon their judgments, which may be different from ours. Any increase in the allowance for loan losses would have an adverse effect, which may be material, on our financial condition and results of operation. Further discussion of the management of credit risk appears under “Provision for Loan Losses” and “Allowance for Loan Losses.”
In June 2016, the FASB issued new guidance on measurement of credit losses on financial instruments, which is the final guidance on the new current expected credit loss (“CECL”) model. The new guidance will replace the incurred loss impairment methodology in current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to estimate future credit loss estimates. Early application is permitted for fiscal years beginning after December 15, 2018. The Company has established a company-wide, cross-functional governance structure, which oversees overall strategy for implementation of CECL. We have evaluated various loss methodologies to determine their correlation to our various loan categories historical performance, and we have completed the data validation. The Company is focused on completing model validation, refining assumptions and continued review of the models. The Company also continues to focus on researching and resolving interpretive accounting issues in the ASU, contemplating various related accounting policies, developing processes and related controls and considering various reporting disclosures. The magnitude of the change in the Company’s allowance for loan losses at the adoption date will depend upon the nature and characteristics of the portfolio at the adoption date, as well as macroeconomic conditions and forecasts at that time. Further discussion of the adoption of CECL appears in Note 1 – Basis of Presentation – Newly Issued, but not yet Effective Accounting Standards in the financial statements in this Form 10-Q.
Noninterest Income
While net interest income remains the largest single component of total revenues, noninterest income is an important component. A portion of the Company’s noninterest income is associated with its SBA lending activity, consisting of gains on the sale of loans sold in the secondary market and servicing income from loans sold with servicing retained. Other sources of noninterest income include loan servicing fees, service charges and fees, cash surrender value from company owned life insurance policies, and gains on the sale of securities.
Noninterest Expense
Management considers the control of operating expenses to be a critical element of the Company’s performance. Total noninterest expense for the third quarter of 2019 increased to $17.9 million, compared to $17.7 million for the third quarter of 2018, primarily due to higher merger-related costs for the third quarter of 2019. Noninterest expense for the nine months ended September 30, 2019 decreased to $54.3 million, compared to $58.6 million for the nine months ended September 30, 2018, primarily due to lower merger-related costs, partially offset by higher professional fees. Professional fees for the nine months ended September 30, 2018 included a recovery of $922,000 from a legal settlement.
The following table presents the merger-related costs for the periods indicated:
For the Three Months Ended
For the Nine Months Ended
183
3,576
5,452
Total merger-related costs
Noninterest expense, excluding merger-related costs, totaled $17.2 million for the third quarter of 2019, compared to $17.5 million for the third quarter of 2018. Noninterest expense, excluding merger-related costs, increased to $53.1 million for the nine months ended September 30, 2019, compared to $49.6 million for the nine months ended September 30, 2018, primarily due to a full nine months of additional staff and other operating expenses related to the Tri-Valley and United American acquisitions in the second quarter of 2018.
49
Capital Management
As part of its asset and liability management process, the Company continually assesses its capital position to take into consideration growth, expected earnings, risk profile and potential corporate activities that it may choose to pursue.
RESULTS OF OPERATIONS
The Company earns income from two primary sources. The first is net interest income, which is interest income generated by earning assets less interest expense on interest‑bearing liabilities. The second is noninterest income, which primarily consists of gains on the sale of loans, loan servicing fees, customer service charges and fees, the increase in cash surrender value of life insurance, and gains on the sale of securities. The majority of the Company’s noninterest expenses are operating costs that relate to providing a full range of banking and lending services to our customers.
Net Interest Income and Net Interest Margin
The level of net interest income depends on several factors in combination, including yields on earning assets, the cost of interest‑bearing liabilities, the relative volumes of earning assets and interest‑bearing liabilities, and the mix of products which comprise the Company’s earning assets, deposits, and other interest‑bearing liabilities. To maintain its net interest margin the Company must manage the relationship between interest earned and paid.
The following Distribution, Rate and Yield table presents the average amounts outstanding for the major categories of the Company’s balance sheet, the average interest rates earned or paid thereon, and the resulting net interest margin on average interest earning assets for the periods indicated. Average balances are based on daily averages.
50
Distribution, Rate and Yield
Interest
Income /
Yield /
Rate
Loans, gross (1)(2)
1,855,840
5.83
1,918,791
5.92
Securities — taxable
2.21
624,352
Securities — exempt from Federal tax (3)
83,403
3.19
87,410
2.50
335,373
2.29
Total interest earning assets
2,878,590
33,391
4.60
2,965,926
34,757
4.65
37,615
40,704
6,933
7,320
Goodwill and other intangible assets
94,441
96,436
Other assets
85,464
82,753
3,103,043
3,193,139
Liabilities and shareholders’ equity:
1,041,712
1,071,638
670,203
571
0.34
682,694
0.32
737,484
1,073
0.58
823,762
761
0.37
Time deposits — under $100
18,549
0.49
23,699
0.39
Time deposits — $100 and over
127,314
373
1.16
131,262
0.72
CDARS — interest-bearing demand, money
market and time deposits
16,990
0.05
15,971
0.07
Total interest-bearing deposits
1,570,540
0.52
1,677,388
2,612,252
0.31
2,749,026
0.23
39,477
5.86
39,292
Short-term borrowings
151
133
2.98
Total interest-bearing liabilities
1,610,168
0.65
1,716,813
0.50
Total interest-bearing liabilities and demand,
noninterest-bearing / cost of funds
2,651,880
2,788,451
60,077
54,717
2,711,957
2,843,168
Shareholders’ equity
391,086
349,971
Total liabilities and shareholders’ equity
Net interest income / margin
30,766
4.24
32,598
4.36
Less tax equivalent adjustment
(141)
(147)
Includes loans held‑for‑sale. Nonaccrual loans are included in average balance.
Yield amounts earned on loans include fees and costs. The accretion of net deferred loan fees into loan interest income was $189,000 for the third quarter of 2019, compared to $73,000 for the third quarter of 2018.
Reflects the fully tax equivalent adjustment for Federal tax-exempt income based on a 21%.
1,842,870
5.90
1,776,546
77,272
5.82
692,369
2.35
662,274
2.24
Securities — exempt from Federal tax
84,882
2,057
3.24
87,990
2,120
3.22
249,473
2.73
271,757
4,408
2.17
2,869,594
100,621
4.69
2,798,567
94,912
4.53
37,293
37,890
7,024
7,330
94,976
77,777
85,312
82,666
3,094,199
3,004,230
1,022,654
1,003,590
686,144
1,801
0.35
651,445
1,319
0.27
744,333
3,015
769,448
1,823
19,392
66
0.46
21,235
58
126,732
986
1.04
131,436
564
0.57
14,151
16,086
1,590,752
1,589,650
2,613,406
0.30
2,593,240
0.19
39,414
5.87
39,246
1.11
76
1.76
1,630,286
0.62
1,628,972
0.45
2,652,940
0.38
2,632,562
60,340
54,204
2,713,280
2,686,766
380,919
317,464
93,016
4.33
89,408
4.27
(433)
(445)
Yield amounts earned on loans include fees and costs. The accretion of net deferred loan fees into loan interest income was $490,000 for the nine months ended September 30, 2019, compared to $322,000 for the nine months ended September 30, 2018.
Volume and Rate Variances
The Volume and Rate Variances table below sets forth the dollar difference in interest earned and paid for each major category of interest‑earning assets and interest‑bearing liabilities for the noted periods, and the amount of such change attributable to changes in average balances (volume) or changes in average interest rates. Volume variances are equal to the increase or decrease in the average balance times the prior period rate, and rate variances are equal to the increase or decrease in the average rate times the prior period average balance. Variances attributable to both rate and volume changes are equal to the change in rate times the change in average balance and are included below in the average volume column.
Three Months Ended September 30,
2019 vs. 2018
Increase (Decrease)
Due to Change in:
Net
Volume
Change
Income from the interest earning assets:
Loans, gross
(932)
(436)
(1,368)
(5)
Securities — exempt from Federal tax (1)
(31)
(161)
173
Total interest income on interest-earning assets
(1,099)
(267)
(1,366)
Expense from the interest-bearing liabilities:
(14)
(131)
(6)
CDARS — interest-bearing demand, money market
and time deposits
Total interest expense on interest-bearing liabilities
(159)
466
(940)
(892)
(1,832)
(1,826)
53
Nine Months Ended September 30,
2,924
1,125
4,049
508
529
1,037
(75)
(63)
(455)
1,141
686
2,902
2,807
5,709
386
482
1,285
1,192
(7)
458
422
2,134
2,101
2,935
673
3,608
3,620
The Company’s net interest margin (FTE), expressed as a percentage of average earning assets, contracted 12 basis points to 4.24% for the third quarter of 2019, from 4.36% for the third quarter of 2018, primarily due to a decline in the average balance of loans, and a higher cost of deposits.
For the first nine months of 2019, the net interest margin expanded 6 basis points to 4.33%, compared to 4.27% for the first nine months of 2018, primarily due to a higher average balance of loans and securities, the impact of increases in the yields on loans, investment securities, and overnight funds, and an increase in the accretion of the loan purchase discount into loan interest income from the acquisitions, partially offset by an increase in the cost of deposits, and a decrease in the average balance of Bay View Funding’s factored receivables.
The average yield on the loan portfolio decreased to 5.83% for the third quarter of 2019, compared to 5.92% for the third quarter of 2018, primarily due to decrease in the average balance of Bay View Funding’s factored receivables. The average yield on the Company’s legacy loan portfolio (excluding the purchased residential loans, purchased CRE loans, factored receivables portfolio, and accretion of the loan purchase discount from the acquisitions) increased 10 basis points for the third quarter of 2019, compared to the third quarter of 2018.
The average yield on the loan portfolio increased to 5.90% for the first nine months of 2019, compared to 5.82% for the first nine months of 2018, primarily due to increases in the prime rate, and an increase in the accretion of the loan purchase discount into loan interest income from the acquisitions. The yield on the Company’s legacy loan portfolio (excluding the purchased residential loans, purchased CRE loans, factored receivables portfolio, and accretion of the loan purchase discount from the acquisitions) increased 21 basis points for the first nine months of 2019 compared to the first nine months of 2018.
54
The cost of total deposits was 0.31% for the third quarter of 2019, compared to 0.23% for the third quarter of 2018. The cost of total deposits was 0.30% for the first nine months of 2019, compared to 0.19% for the first nine months of 2018.
Net interest income, before the provision for loan losses, decreased (6%) to $30.6 million for the third quarter of 2019, compared to $32.5 million for the third quarter of 2018. Net interest income increased 4% to $92.6 million for the nine months ended September 30, 2019, compared to $89.0 million for the nine months ended September 30, 2018, primarily due to the impact of the increase in loans and deposits from the Tri-Valley and United American acquisitions.
Provision for Loan Losses
Credit risk is inherent in the business of making loans. The Company establishes an allowance for loan losses through charges to earnings, which are presented in the statements of income as the provision for loan losses. Specifically identifiable and quantifiable known losses are promptly charged off against the allowance. The provision for loan losses is determined by conducting a quarterly evaluation of the adequacy of the Company’s allowance for loan losses and charging the shortfall or excess, if any, to the current quarter’s expense. This has the effect of creating variability in the amount and frequency of charges to the Company’s earnings. The provision for loan losses and level of allowance for each period are dependent upon many factors, including loan growth, net charge‑offs, changes in the composition of the loan portfolio, delinquencies, management’s assessment of the quality of the loan portfolio, the valuation of problem loans and the general economic conditions in the Company’s market area.
There was a $576,000 credit to the provision for loan losses for the third quarter of 2019, compared to a $425,000 credit to the provision for loan losses for the third quarter of 2018. For the nine months ended September 30, 2019, there was a $2.4 million credit to the provision for loan losses compared to a $7.3 million provision for loan losses for the nine months ended September 30, 2018. The higher provision for loan losses for the first nine months of 2018 included a $7.0 million specific reserve for a lending relationship that was placed on nonaccrual during the second quarter of 2018. Provisions for loan losses are charged to operations to bring the allowance for loan losses to a level deemed appropriate by the Company based on the factors discussed under “Allowance for Loan Losses.”
The allowance for loan losses totaled $25.9 million, or 1.38% of total loans at September 30, 2019, compared to $27.4 million, or 1.44% of total loans at September 30, 2018, and $27.8 million, or 1.48% of total loans at December 31, 2018. The allowance for loan losses to total nonperforming loans was 181.76% at September 30, 2019, compared to 110.97% at September 30, 2018, and 187.06% at December 31, 2018. Net charge-offs totaled $160,000 for the third quarter of 2019, compared to net recoveries of $1.2 million for the third quarter of 2018, and net recoveries of $280,000 for the fourth quarter of 2018.
The following table sets forth the various components of the Company’s noninterest income for the periods indicated:
Increase
(decrease)
2019 versus 2018
Percent
(80)
(34)
141
412
389
612
230
(220)
(53)
(241)
(12)
670
Total noninterest income increased to $2.6 million for the third quarter of 2019, compared to $2.2 million for the third quarter of 2018, primarily due to a $330,000 gain on sales of securities for the third quarter of 2019. For the nine months ended September 30, 2019, noninterest income increased to $7.9 million, compared to $7.2 million for the nine months ended September 30, 2018. The increase in noninterest income for the first nine months of 2019, was primarily due to higher service charges and fees on deposit accounts, and a higher gain on sales of securities for the first nine months of 2019, partially offset by lower gain on sales of SBA loans for the first nine months of 2019, and proceeds from a legal settlement in the first nine months of 2018.
Historically, a portion of the Company’s noninterest income has been associated with its SBA lending activity, as gains on the sale of loans sold in the secondary market and servicing income from loans sold with servicing rights retained. For the third quarter ended September 30, 2019, SBA loan sales resulted in a $156,000 gain, compared to a $236,000 gain on sales of SBA loans for the third quarter ended September 30, 2018. For the nine months ended September 30, 2019, SBA loan sales resulted in a $331,000 gain, compared to a $551,000 gain on sale of SBA loans for the nine months ended September 30, 2018.
The servicing assets that result from the sales of SBA loans with servicing retained are amortized over the expected term of the loans using a method approximating the interest method. Servicing income generally declines as the respective loans are repaid.
The following table indicates the percentage of noninterest expense in each category for the periods indicated:
(Decrease)
(69)
68
462
(77)
(71)
(218)
181
Severance and retention expense of $183,000 for the third quarter of 2018 is included in the “Salaries and employee benefits” category in the Consolidated Statements of Income. Other acquisition and integration costs of $661,000 and $16,000 for the third quarter of 2019 and the third quarter of 2018, respectively, is included in the “Other noninterest expense” category in the Consolidated Statements of Income.
707
322
(7,827)
(87)
325
118
364
922
(100)
(4,308)
Severance and retention expense of $3.6 million for the first nine months of 2018 is included in the “Salaries and employee benefits” category in the Consolidated Statements of Income. Other acquisition and integration costs of $1.2 million and $5.4 million for the first nine months of 2019 and the first nine months of 2018, respectively, is included in the “Other noninterest expense” category in the Consolidated Statements of Income.
Included in professional fees for the nine months ended September 30, 2018 in the Consolidated Statements of Income
Noninterest Expense by Category
Percent of
57
of Total
Included in professional fees in the Consolidated Statements of Income
Total noninterest expense for the third quarter of 2019 increased to $17.9 million, compared to $17.7 million for the third quarter of 2018, primarily due to higher merger related costs for the third quarter of 2019, partially offset by lower FDIC assessments. Noninterest expense for the third quarter of 2019 included total merger-related costs of $661,000 for the Presidio acquisition (all included in other noninterest expense), compared to total merger-related costs of $199,000 for the third quarter of 2018 for the Tri-Valley and United American acquisitions. The merger-related costs of $199,000 for the third quarter of 2018 consisted of $183,000 included in salaries and employee benefits expense and $16,000 included in other noninterest expense. There were no FDIC assessments for the third quarter of 2019, compared to FDIC assessments of $263,000 for the third quarter of 2018.
Noninterest expense for the nine months ended September 30, 2019 decreased to $54.3 million, compared to $58.6 million for the nine months ended September 30, 2018, primarily due to lower merger-related costs, and FDIC assessments, partially offset by higher professional fees. Noninterest expense for the nine months ended September 30, 2019 included total merger-related costs of $1.2 million for the Presidio acquisition (all included in other noninterest expense), compared to total merger-related costs of $9.0 million for the nine months ended September 30, 2018 for the Tri-Valley and United American acquisitions. The merger-related costs of $9.0 million for the nine months ended September 30, 2018 consisted of $3.6 million included in salaries and employee benefits and $5.4 million in other noninterest expense. Professional fees for the nine months ended September 30, 2018 included a recovery of $922,000 from a legal settlement. FDIC assessments were $446,000 for the nine months ended September 30, 2019, compared to FDIC assessments of $710,000 for the nine months ended September 30, 2018. Full time equivalent employees were 308, 296, and 302 at September 30, 2019, September 30, 2018, and December 31, 2018, respectively
Income Tax Expense
The Company computes its provision for income taxes on a quarterly basis. The effective tax rate is determined by applying the Company’s statutory income tax rates to pre‑tax book income as adjusted for permanent differences between pre‑tax book income and actual taxable income. These permanent differences include, but are not limited to, increases in the cash surrender value of life insurance policies, interest on tax‑exempt securities, certain expenses that are not allowed as tax deductions, and tax credits.
The following table shows the Company’s effective income tax rates for the periods indicated:
Effective income tax rate
29.1
28.7
28.4
27.0
The Company’s income tax expense for the third quarter of 2019 was $4.6 million, compared $5.0 million for the third quarter of 2018. Income tax expense for the nine months ended September 30, 2019 was $13.8 million, compared to $8.2 million for the nine months ended September 30, 2018.
Some items of income and expense are recognized in one year for tax purposes, and another when applying generally accepted accounting principles, which leads to timing differences between the Company’s actual tax liability, and the amount accrued for this liability based on book income. These temporary differences comprise the “deferred” portion of the Company’s tax expense or benefit, which is accumulated on the Company’s books as a deferred tax asset or deferred tax liability until such time as they reverse.
Realization of the Company’s deferred tax assets is primarily dependent upon the Company generating sufficient future taxable income to obtain benefit from the reversal of net deductible temporary differences and the utilization of tax credit carryforwards and the net operating loss carryforwards for Federal and state income tax purposes. The amount of deferred tax assets considered realizable is subject to adjustment in future periods based on estimates of future taxable income. Under generally accepted accounting principles a valuation allowance is required to be recognized if it is “more likely than not” that the deferred tax assets will not be realized. The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning management’s evaluation of both positive and negative evidence, including forecasts of future income, cumulative losses, applicable tax planning strategies, and assessments of current and future economic and business conditions.
The Company had net deferred tax assets of $21.7 million at September 30, 2019, $28.1 million at September 30, 2018, and $27.1 million at December 31, 2018. After consideration of the matters in the preceding paragraph, the Company determined that it is more likely than not that the net deferred tax assets at September 30, 2019, September 30, 2018, and December 31, 2018 will be fully realized in future years.
Business Segment Information
The following presents the Company’s operating segments. Transactions between segments consist primarily of borrowed funds. Intersegment interest expense is allocated to the Factoring segment based on the Company’s prime rate and funding costs. The provision for loan loss is allocated based on the segment’s allowance for loan loss determination which considers the effects of charge‑offs. Noninterest income and expense directly attributable to a segment are assigned to it. Taxes are paid on a consolidated basis and allocated for segment purposes. The Factoring segment includes only factoring originated by Bay View Funding.
The banking segment’s noninterest expense includes merger-related costs of $661,000 for the third quarter of 2019
The banking segment’s noninterest expense includes merger-related costs of $199,000 for the third quarter of 2018
60
The banking segment’s noninterest expense includes merger-related costs of $1.2 million for the first nine months of 2019
The banking segment’s noninterest expense includes merger-related costs of $9.0 million for the first nine months of 2018
61
Banking. Our banking segment’s net income was $11.0 million for the three months ended September 30, 2019, compared to $11.2 million for the three months ended September 30, 2018. Our banking segment’s net income was $32.9 million for the nine months ended September 30, 2019, compared to $19.1 million for the nine months ended September 30, 2018. The banking segment’s earnings for the third quarter of 2019, and for the first nine months of 2019 were reduced by merger-related costs of $661,000, and $1.2 million, respectively, for the merger with Presidio completed on October 11, 2019. Earnings for the third quarter of 2018 and for the first nine months of 2018 were reduced by merger-related costs of $199,000 and $9.0 million, respectively, for the acquisitions of Tri-Valley completed on April 6, 2018, and United American completed on May 4, 2018. The decrease in net interest income for the third quarter of 2019, compared to the third quarter of 2018, was primarily due to a decrease in the average balance of loans, and an increase in the cost of deposits. The increase in net interest income for the nine months ended September 30, 2019, compared to the nine months ended September 30, 2018, was primarily due to the impact of the increase in loans and deposits from the Tri-Valley and United American acquisitions and the positive impact of rising interest rates, partially offset by an increase in the cost of deposits. The decrease in the provision for loan losses for first nine months of 2019, compared to the first nine months of 2018, was primarily due to the $7.0 million specific reserve for a lending relationship that was placed on nonaccrual during the second quarter of 2018. Noninterest income increased to $2.5 million for the third quarter of 2019, from $2.0 million for the third quarter of 2018, primarily due to a higher gain on sales of securities for the third quarter of 2019. The increase in noninterest income for the first nine months of 2019, compared to the first nine months of 2018, was primarily due to higher service charges and fees on deposit accounts, and a higher gain on sales of securities for the first nine months of 2019, partially offset by lower gain on sales of SBA loans for the first nine months of 2019, and proceeds from a legal settlement in the first nine months of 2018. The increase in noninterest expense for the third quarter of 2019, compared to the third quarter of 2018, was primarily due to higher merger-related costs for the third quarter of 2019. Noninterest expense for the nine months ended September 30, 2019 decreased to $49.2 million, compared to $53.8 million for the nine months ended September 30, 2018, primarily due to lower merger-related costs, partially offset by higher professional fees. Professional fees for the nine months ended September 30, 2018 included a recovery of $922,000 from a legal settlement.
Factoring. Bay View Funding’s primary business operation is purchasing and collecting factored receivables. Factored receivables are receivables that have been transferred by the originating organization and typically have not been subject to previous collection efforts. In a factoring transaction Bay View Funding directly purchases the receivables generated by its clients at a discount to their face value. The transactions are structured to provide the clients with immediate working capital when there is a mismatch between payments to the client for a good and service and the payment of operating costs incurred to provide such good or service. The average life of the factored receivables was 37 days for the nine months ended September 30, 2019, compared to 35 days for the nine months ended September 30, 2018. Net interest income for the three months and nine months ended September 30, 2019, decreased from the comparable periods in 2018, primarily due to a decrease in the average balance of factored receivables outstanding.
FINANCIAL CONDITION
At September 30, 2019, total assets remained relatively flat at $3.18 billion, compared to $3.19 billion at September 30, 2018, and increased from $3.10 billion at December 31, 2018.
Securities available‑for‑sale, at fair value, were $333.1 million at September 30, 2019, an increase of 4% from $319.1 million at September 30, 2018, and a decrease of (27%) from $459.0 million at December 31, 2018. Securities held‑to‑maturity, at amortized cost, were $342.0 million at September 30, 2019, a decrease of (9%) from $375.7 million at September 30, 2018, and a decrease of (9%) from $377.2 million at December 31, 2018. Loans, excluding loans held-for-sale, decreased $24.0 million, or (1%), to $1.88 billion at September 30, 2019, compared to $1.90 billion at September 30, 2018, primarily due to a decline of $72.5 million in C&I, $34.9 million in land and construction loans, $5.0 million in home equity loans, $4.8 million in purchased residential mortgages, and $3.8 million in purchased CRE loans, partially offset by an increase of $95.5 million in CRE loans. Loans, excluding loans held-for-sale, decreased $11.0 million, or (1%), to $1.88 billion at September 30, 2019, compared to $1.89 billion December 31, 2018.
Securities Portfolio
The following table reflects the balances for each category of securities at the dates indicated:
Securities available-for-sale (at fair value):
311,665
7,406
319,071
Securities held-to-maturity (at amortized cost):
288,594
Municipals — exempt from Federal tax
87,138
375,732
The following table summarizes the weighted average life and weighted average yields of securities at September 30, 2019:
Weighted Average Life
After One and
After Five and
Within One
Within Five
Within Ten
After Ten
Year or Less
Years
Yield
210,300
2,442
2.83
300,712
2.44
216,437
6,038
36,837
Municipals — exempt from Federal tax (1)
16,966
62,517
1,748
1,490
278,954
7,786
38,327
Reflects tax equivalent adjustment for Federal tax exempt income based on a 21% tax rate.
The securities portfolio is the second largest component of the Company’s interest‑earning assets, and the structure and composition of this portfolio is important to an analysis of the financial condition of the Company. The portfolio serves the following purposes: (i) it provides a source of pledged assets for securing certain deposits and borrowed funds, as may be required by law or by specific agreement with a depositor or lender; (ii) it provides liquidity to even out cash flows from the loan and deposit activities of customers; (iii) it can be used as an interest rate risk management tool, since it provides a large base of assets, the maturity and interest rate characteristics of which can be changed more readily than the loan portfolio to better match changes in the deposit base and other funding sources of the Company; and (iv) it is an alternative interest‑earning use of funds when loan demand is weak or when deposits grow more rapidly than loans.
The Company’s portfolio may include: (i) U.S. Treasury securities and U.S. Government sponsored entities’ debt securities for liquidity and pledging; (ii) mortgage‑backed securities, which in many instances can also be used for pledging, and which generally enhance the yield of the portfolio; (iii) municipal obligations, which provide tax free income and limited pledging potential; (iv) single entity issue trust preferred securities, which generally enhance the yield on the portfolio; (v) corporate bonds, which also enhance the yield on the portfolio; (vi) money market mutual funds; (vii) certificates of deposit; (viii) commercial paper; (ix) bankers acceptances; (x) repurchase agreements; (xi) collateralized mortgage obligations; and (xii) asset-backed securities.
The Company classifies its securities as either available‑for‑sale or held‑to‑maturity at the time of purchase. Accounting guidance requires available‑for‑sale securities to be marked to fair value with an offset to accumulated other
63
comprehensive income (loss), a component of shareholders’ equity. Monthly adjustments are made to reflect changes in the fair value of the Company’s available‑for‑sale securities.
The investment securities available-for-sale portfolio, at fair value, totaled $333.1 million at September 30, 2019, compared to $319.1 million at September 30, 2018, and $459.0 million at December 31, 2018. At September 30, 2019, the Company’s securities available-for-sale portfolio comprised $212.7 million of agency mortgage-backed securities (all issued by U.S. Government sponsored entities), and $120.4 million of U.S. Treasury. The pre-tax unrealized gain on securities available-for-sale at September 30, 2019 was $1.7 million, compared to a pre-tax unrealized loss on securities available-for-sale of ($12.7) million at September 30, 2018, and a pre-tax unrealized loss on securities available-for-sale of ($7.7) million at December 31, 2018. All other factors remaining the same, when market interest rates are rising, the Company will experience a lower unrealized gain (or a higher unrealized loss) on the securities portfolio.
During the third quarter of 2019, the Company sold $38.9 million of securities available-for-sale for a net gain of $330,000. The securities sold consisted of $18.6 million of agency mortgage-backed securities, $20.3 million of U.S. Treasury securities. For the nine months ended, the Company sold $98.7 million of securities available-for-sale for a net gain of $878,000. The securities sold consisted of $60.8 million of agency mortgage-backed securities, $30.5 million of U.S. Treasury securities, and $7.4 million of U.S. Government sponsored entities debt securities.
At September 30, 2019, investment securities held‑to‑maturity, at amortized cost, totaled $342.0 million, a decrease of (9%) from $375.7 million at September 30, 2018, and a decrease of (9%) from $377.2 million at December 31, 2018. At September 30, 2019, the Company’s securities held-to-maturity portfolio was comprised of $259.3 million of agency mortgage-backed securities, and $82.7 million of tax-exempt municipal bonds. During the third quarter of 2019, the Company purchased $8.4 million of agency-mortgage backed securities held-to-maturity, with a weighted average book yield of 2.60% and a weighted average duration of 5.72 years.
The Company has not used interest rate swaps or other derivative instruments to hedge fixed rate loans or securities.
The Company’s loans represent the largest portion of invested assets, substantially greater than the securities portfolio or any other asset category, and the quality and diversification of the loan portfolio is an important consideration when reviewing the Company’s financial condition. Gross loans, excluding loans held‑for‑sale, represented 59% of total assets at both September 30, 2019 and September 30, 2018, and represented 61% at December 31, 2018. The ratio of loans to deposits was 69.74% at September 30, 2019, compared to 69.19% at September 30, 2018, and 71.52% at December 31, 2018.
Loan Distribution
The Loan Distribution table that follows sets forth the Company’s gross loans, excluding loans held‑for‑sale, outstanding and the percentage distribution in each category at the dates indicated:
% to Total
600,594
988,491
131,548
116,657
52,441
9,932
Total Loans
1,899,663
(276)
(27,426)
1,871,961
The Company’s loan portfolio is concentrated in commercial loans, (primarily manufacturing, wholesale, and services oriented entities), and commercial real estate, with the remaining balance in land development and construction,
64
home equity, purchased residential mortgages, and consumer loans. The Company does not have any concentrations by industry or group of industries in its loan portfolio, however, 71% of its gross loans were secured by real property at September 30, 2019, compared to 68% at September 30, 2018 and 67% at December 31, 2018. While no specific industry concentration is considered significant, the Company’s bank lending operations are substantially located in areas that are dependent on the technology and real estate industries and their supporting companies.
The Company has established concentration limits in its loan portfolio for commercial real estate loans, commercial loans, construction loans and unsecured lending, among others. All loan types are within established limits. The Company uses underwriting guidelines to assess the borrower’s historical cash flow to determine debt service, and we further stress test the debt service under higher interest rate scenarios. Financial and performance covenants are used in commercial lending to allow the Company to react to a borrower’s deteriorating financial condition should that occur.
The Company’s commercial loans are made for working capital, financing the purchase of equipment or for other business purposes. Commercial loans include loans with maturities ranging from thirty days to one year and “term loans” with maturities normally ranging from one to five years. Short‑term business loans are generally intended to finance current transactions and typically provide for periodic principal payments, with interest payable monthly. Term loans normally provide for floating interest rates, with monthly payments of both principal and interest.
The Company is an active participant in the SBA and U.S. Department of Agriculture guaranteed lending programs, and has been approved by the SBA as a lender under the Preferred Lender Program. The Company regularly makes such guaranteed loans (collectively referred to as “SBA loans”). The guaranteed portion of these loans is typically sold in the secondary market depending on market conditions. When the guaranteed portion of an SBA loan is sold the Company retains the servicing rights for the sold portion. During the third quarter and nine months ended September 30, 2019, loans were sold resulting in a gain on sales of SBA loans of $156,000, and $331,000, respectively.
The Company’s factoring receivables are from the operations of Bay View Funding whose primary business is purchasing and collecting factored receivables. Factored receivables are receivables that have been transferred by the originating organization and typically have not been subject to previous collection efforts. These receivables are acquired from a variety of companies, including but not limited to service providers, transportation companies, manufacturers, distributors, wholesalers, apparel companies, advertisers, and temporary staffing companies. The portfolio of factored receivables is included in the Company’s commercial loan portfolio. The average life of the factored receivables was 37 days for the first nine months of 2019, compared to 35 days for the first nine months of 2018. The balance of the purchased receivables was $44.2 million at September 30, 2019, compared to $71.0 million at September 30, 2018 and $53.6 million at December 31, 2018.
The commercial loan portfolio decreased $72.5 million, or (12%), to $528.1 million at September 30, 2019 from $600.6 million at September 30, 2018 and decreased $69.7 million, or (12%), from $597.8 million at December 31, 2018. C&I line usage was 35% at September 30, 2019, compared to 36% at both September 30, 2018 and December 31, 2018.
The Company’s CRE loans consist primarily of loans based on the borrower’s cash flow and are secured by deeds of trust on commercial property to provide a secondary source of repayment. The Company generally restricts real estate term loans to no more than 75% of the property’s appraised value or the purchase price of the property depending on the type of property and its utilization. The Company offers both fixed and floating rate loans. Maturities for CRE loans are generally between five and ten years (with amortization ranging from fifteen to twenty five years and a balloon payment due at maturity), however, SBA and certain other real estate loans that can be sold in the secondary market may be granted for longer maturities.
The CRE loan portfolio increased $91.7 million, or 9%, to $1.08 billion at September 30, 2019, compared to $988.5 million at September 30, 2018, and increased $86.2 million, or 9%, from $994.1 million at December 31, 2018. At September 30, 2019, there was 38% of the CRE loan portfolio secured by owner-occupied real estate.
The Company’s land and construction loans are primarily to finance the development/construction of commercial and single family residential properties. The Company utilizes underwriting guidelines to assess the likelihood of repayment from sources such as sale of the property or availability of permanent mortgage financing prior to making the construction loan. Construction loans are provided only in our market area, and the Company has extensive controls for the disbursement process. Land and construction loans decreased $34.9 million, or (27%), to $96.6 million at
65
September 30, 2019, compared to $131.5 million at September 30, 2018, and decreased $25.7 million, or (21%), from $122.3 million at December 31, 2018.
The Company makes home equity lines of credit available to its existing customers. Home equity lines of credit are underwritten initially with a maximum 75% loan to value ratio. Home equity lines of credit decreased $5.0 million, or (4%), to $111.6 million at September 30, 2019, compared to $116.6 million at September 30, 2018, and increased $2.5 million, or 2%, from $109.1 million at December 31, 2018.
Residential mortgage loans decreased $5.1 million, or (10%), to $47.3 million at September 30, 2019, compared to $52.4 million at September 30, 2018, and decreased $3.7 million, or (7%) from $51.0 million at December 31, 2018.
Additionally, the Company makes consumer loans for the purpose of financing automobiles, various types of consumer goods, and other personal purposes. Consumer loans generally provide for the monthly payment of principal and interest. Most of the Company’s consumer loans are secured by the personal property being purchased or, in the instances of home equity loans or lines, real property.
With certain exceptions, state chartered banks are permitted to make extensions of credit to any one borrowing entity up to 15% of the bank’s capital and reserves for unsecured loans and up to 25% of the bank’s capital and reserves for secured loans. For HBC, these lending limits were $65.9 million and $109.8 million at September 30, 2019, respectively.
Loan Maturities
The following table presents the maturity distribution of the Company’s loans (excluding loans held‑for‑sale) as of September 30, 2019. The table shows the distribution of such loans between those loans with predetermined (fixed) interest rates and those with variable (floating) interest rates. Floating rates generally fluctuate with changes in the prime rate as reflected in the Western Edition of The Wall Street Journal. As of September 30, 2019, approximately 46% of the Company’s loan portfolio consisted of floating interest rate loans.
Over One
Due in
Year But
One Year
Less than
Over
or Less
Five Years
406,771
99,384
21,905
142,741
456,074
481,420
94,911
1,699
103,903
3,928
3,779
444
11,246
35,586
11,163
538
759,933
572,869
542,690
Loans with variable interest rates
668,505
137,347
60,573
866,425
Loans with fixed interest rates
91,428
435,522
482,117
1,009,067
Loan Servicing
As of September 30, 2019 and 2018, $87.2 million and $113.1 million, respectively, in SBA loans were serviced by the Company for others. Activity for loan servicing rights was as follows:
677
1,065
871
Additions
84
75
160
(121)
(170)
(355)
(554)
591
979
Loan servicing rights are included in accrued interest receivable and other assets on the unaudited consolidated balance sheets and reported net of amortization. There was no valuation allowance as of September 30, 2019 and 2018, as the fair value of the assets was greater than the carrying value.
Activity for the I/O strip receivable was as follows:
919
968
Unrealized holding loss
(56)
863
Credit Quality
Financial institutions generally have a certain level of exposure to credit quality risk, and could potentially receive less than a full return of principal and interest if a debtor becomes unable or unwilling to repay. Since loans are the most significant assets of the Company and generate the largest portion of its revenues, the Company’s management of credit quality risk is focused primarily on loan quality. Banks have generally suffered their most severe earnings declines as a result of customers’ inability to generate sufficient cash flow to service their debts and/or downturns in national and regional economies and declines in overall asset values including real estate. In addition, certain debt securities that the Company may purchase have the potential of declining in value if the obligor’s financial capacity to repay deteriorates.
The Company’s policies and procedures identify market segments, set goals for portfolio growth or contraction, and establish limits on industry and geographic credit concentrations. In addition, these policies establish the Company’s underwriting standards and the methods of monitoring ongoing credit quality. The Company’s internal credit risk controls are centered in underwriting practices, credit granting procedures, training, risk management techniques, and familiarity with loan customers as well as the relative diversity and geographic concentration of our loan portfolio.
The Company’s credit risk may also be affected by external factors such as the level of interest rates, employment, general economic conditions, real estate values, and trends in particular industries or geographic markets. As an independent community bank serving a specific geographic area, the Company must contend with the unpredictable changes in the general California market and, particularly, primary local markets. The Company’s asset quality has suffered in the past from the impact of national and regional economic recessions, consumer bankruptcies, and depressed real estate values.
Nonperforming assets are comprised of the following: loans for which the Company is no longer accruing interest; restructured loans which have been current under six months; loans 90 days or more past due and still accruing interest (although they are generally placed on nonaccrual when they become 90 days past due, unless they are both well‑secured and in the process of collection); and foreclosed assets. Past due loans 30 days or greater totaled $17.3 million and $8.9 million at September 30, 2019 and December 31, 2018, respectively, of which $12.4 million and $430,000 were on nonaccrual, respectively. At September 30, 2019, there were also $1.2 million loans less than 30 days
67
past due included in nonaccrual loans held‑for‑investment. At December 31, 2018, there were also $13.3 million loans less than 30 days past due included in nonaccrual loans held‑for‑investment.
Management’s classification of a loan as “nonaccrual” is an indication that there is reasonable doubt as to the full recovery of principal or interest on the loan. At that point, the Company stops accruing interest income, and reverses any uncollected interest that had been accrued as income. The Company begins recognizing interest income only as cash interest payments are received and it has been determined the collection of all outstanding principal is not in doubt. The loans may or may not be collateralized, and collection efforts are pursued. Loans may be restructured by management when a borrower has experienced some change in financial status causing an inability to meet the original repayment terms and where the Company believes the borrower will eventually overcome those circumstances and make full restitution. Foreclosed assets consist of properties acquired by foreclosure or similar means that management is offering or will offer for sale.
The following table summarizes the Company’s nonperforming assets at the dates indicated:
Nonaccrual loans — held-for-investment
Restructured and loans 90 days past due and
still accruing
Foreclosed assets
Total nonperforming assets
Nonperforming assets as a percentage of loans
plus foreclosed assets
0.76
1.30
0.79
Nonperforming assets as a percentage of total assets
0.77
0.48
Nonperforming assets were $14.2 million, or 0.45% of total assets, at September 30, 2019, compared to $24.7 million, or 0.77% of total assets, at September 30, 2018, and $14.9 million, or 0.48% of total assets, at December 31, 2018.
A large lending relationship was placed on nonaccrual during the second quarter of 2018. At September 30, 2019, the recorded investment of this lending relationship decreased to $10.8 million, and the Company had a $6.0 million specific loan loss allocated for this lending relationship, compared to a recorded investment of $21.8 million and a $7.0 million specific loan loss reserve allocated for this lending relationship at September 30, 2018, and a recorded investment of $12.0 million, and a $6.7 million specific loan loss reserve allocated for this lending relationship at December 31, 2018, as a result of loan paydowns.
The following table presents nonperforming loans by class at the dates indicated:
Loans with a well‑defined weakness, which are characterized by the distinct possibility that the Company will sustain a loss if the deficiencies are not corrected, are categorized as “classified.” Classified loans include all loans considered as substandard, substandard‑nonaccrual, and doubtful and may result from problems specific to a borrower’s business or from economic downturns that affect the borrower’s ability to repay or that cause a decline in the value of the
underlying collateral (particularly real estate). Loans held‑for‑sale are carried at the lower of cost or estimated fair value, and are not allocated an allowance for loan losses.
The following table provides a summary of the loan portfolio by loan type and credit quality classification at the dates indicated:
577,325
23,269
982,852
5,639
115,019
1,638
1,869,117
30,546
Classified loans decreased to $20.2 million, or 0.64% of total assets, at September 30, 2019, compared to $30.5 million, or 0.95% of total assets, at September 30, 2018 and $23.4 million, or 0.76% of total assets at December 31, 2018, primarily due to the payoff of classified loans.
In order to determine whether a borrower is experiencing financial difficulty, an evaluation is performed of the probability that the borrower will be in payment default on any of its debt in the foreseeable future without the modification. This evaluation is performed in accordance with the Company’s underwriting policy.
The following provides a rollforward of troubled debt restructurings (“TDRs”):
Performing
Nonperforming
TDRs
Balance at January 1, 2019
613
649
Principal repayments
(37)
(155)
Balance at September 30, 2019
503
Balance at January 1, 2018
309
Balance at September 30, 2018
676
Allowance for Loan Losses
The allowance for loan losses is an estimate of probable incurred losses in the loan portfolio. Loans are charged‑off against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance for loan losses. Management’s methodology for estimating the allowance balance consists of several key elements, which include specific allowances on individual impaired loans and the formula driven allowances on pools of loans with similar risk characteristics. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged‑off.
Specific allowances are established for impaired loans. Management considers a loan to be impaired when it is probable that the Company will be unable to collect all amounts due according to the original contractual terms of the loan agreement, including scheduled interest payments. Loans for which the terms have been modified with a concession granted, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and classified as impaired. When a loan is considered to be impaired, the amount of impairment is measured based on the fair
value of the collateral less costs to sell if the loan is collateral dependent, or on the present value of expected future cash flows or values that are observable in the secondary market. If the measure of the impaired loans is less than the investment in the loan, the deficiency will be charged‑off against the allowance for loan losses if the amount is a confirmed loss, or, alternatively, a specific allocation within the allowance will be established. Loans that are considered impaired are specifically excluded from the formula portion of the allowance for loan losses analysis.
The estimated loss factors for pools of loans that are not impaired are based on determining the probability of default and loss given default for loans within each segment of the portfolio, adjusted for significant factors that, in management’s judgment, affect collectability as of the evaluation date. The Company’s historical delinquency experience and loss experience are utilized to determine the probability of default and loss given default for segments of the portfolio where the Company has experienced losses in the past. For segments of the portfolio where the Company has no significant prior loss experience, the Company uses quantifiable observable industry data to determine the probability of default and loss given default.
The following provides a summary of the risks associated with various segments of the Company’s loan portfolio, which are factors management regularly considers when evaluating the adequacy of the allowance:
Commercial loans consist primarily of commercial and industrial loans (business lines of credit), and other commercial purpose loans. Repayment of commercial and industrial loans is generally provided from the cash flows of the related business to which the loan was made. Adverse changes in economic conditions may result in a decline in business activity, which may impact a borrower’s ability to continue to make scheduled payments. The factored receivables at Bay View Funding are included in the Company’s commercial loan portfolio; however, they are evaluated for risk primarily based on the agings of the receivables. Faster turning receivables imply less risk and therefore warrant a lower associated allowance. Should the overall aging for the portfolio increase, this structure will by formula increase the allowance to reflect the increasing risk. Should the portfolio turn more quickly, it would reduce the associated allowance to reflect the reducing risk.
Real estate loans consist primarily of loans secured by commercial and residential real estate. Also included in this segment are land and construction loans and home equity lines of credit secured by real estate. As the majority of this segment is comprised of commercial real estate loans, risks associated with this segment lay primarily within these loan types. Adverse economic conditions may result in a decline in business activity and increased vacancy rates for commercial properties. These factors, in conjunction with a decline in real estate prices, may expose the Company to the potential for losses if a borrower cannot continue to service the loan with operating revenues, and the value of the property has declined to a level such that it no longer fully covers the Company’s recorded investment in the loan.
Consumer loans consist primarily of a large number of small loans and lines of credit. The majority of installment loans are made for consumer and business purchases. Weakened economic conditions may result in an increased level of delinquencies within this segment, as economic pressures may impact the capacity of such borrowers to repay their obligations.
As a result of the matters mentioned above, changes in the financial condition of individual borrowers, economic conditions, historical loss experience and the condition of the various markets in which collateral may be sold may all affect the required level of the allowance for loan losses and the associated provision for loan losses.
It is the policy of management to maintain the allowance for loan losses at a level adequate for risks inherent in the loan portfolio. On an ongoing basis, we have engaged an outside firm to perform independent credit reviews of our loan portfolio. The Federal Reserve Board and the California Department of Business Oversight—Division of Financial Institutions also review the allowance for loan losses as an integral part of the examination process. Based on information currently available, management believes that the allowance for loan losses is adequate. However, the loan portfolio can be adversely affected if California economic conditions and the real estate market in the Company’s market area were to weaken. Also, any weakness of a prolonged nature in the technology industry would have a negative impact on the local market. The effect of such events, although uncertain at this time, could result in an increase in the level of nonperforming loans and increased loan losses, which could adversely affect the Company’s future growth and profitability. No assurance of the ultimate level of credit losses can be given with any certainty.
70
The following tables summarize the Company’s loan loss experience, as well as provisions and charges to the allowance for loan losses and certain pertinent ratios for the periods indicated:
The following table provides a summary of the allocation of the allowance for loan losses by class at the dates indicated. The allocation presented should not be interpreted as an indication that charges to the allowance for loan losses will be incurred in these amounts or proportions, or that the portion of the allowance allocated to each category represents the total amount available for charge‑offs that may occur within these classes.
71
Allocation of Allowance for Loan Losses
of Loans
in each
category
to total
loans
7,682
6,053
6,737
1,658
1,987
2,008
1,826
1,609
243
210
The allowance for loan losses totaled $25.9 million, or 1.38% of total loans at September 30, 2019, compared to $27.4 million, or 1.44% of total loans at September 30, 2018, and $27.8 million, or 1.48% of total loans at December 31, 2018. The allowance for loan losses was 181.76% of nonperforming loans at September 30, 2019, compared to 110.97% of nonperforming loans at September 30, 2018, and 187.06% of nonperforming loans at December 31, 2018. The Company had net charge-offs of $160,000, or 0.03% of average loans, for the third quarter of 2019, compared to net recoveries of $1.2 million, or (0.24%) of average loans, for the third quarter of 2018, and net recoveries $280,000, or (0.06%) of average loans, for the fourth quarter of 2018.
The allowance for loan losses related to the commercial portfolio decreased $2.4 million, at September 30, 2019 from December 31, 2018, largely due to the reduction of a specific loan loss reserve allocated for a single large lending relationship that was placed on nonaccrual during the second quarter of 2018, and the payoff of nonperforming loans. The allowance for loan losses related to the real estate portfolio increased $473,000 at September 30, 2019 from December 31, 2018, primarily due to an increase in CRE loans.
Leases
On January 1, 2019, the Company adopted Accounting Standards Update (“ASU”) No. 2016-02, Leases (Topic 842). Under the new guidance, the Company recognizes the following for all leases, at the commencement date: (1) a lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis; and (2) a right-of-use (“ROU”) asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. While the new standard impacts lessors and lessees, the Company is impacted as a lessee of the offices and real estate used for operations. The Company's lease agreements include options to renew at the Company's discretion. The extensions are not reasonably certain to be exercised, therefore it was not considered in the calculation of the ROU asset and lease liability. Total assets and total liabilities were $7.1 million on its consolidated statement of financial condition at September 30, 2019, as a result of recognizing right-of-use assets, included in other assets, and lease liabilities, included in other liabilities, related to non-cancelable operating lease agreements for office space.
Goodwill represents the excess of the purchase price over the fair value of acquired tangible assets and liabilities and identifiable intangible assets. The fair values of assets acquired and liabilities assumed are subject to adjustment during the first twelve months after the acquisition date if additional information becomes available to indicate a more accurate or appropriate value for an asset or liability. Total goodwill was $83.7 million at both September 30, 2019 and December 31, 2018, which consisted of $13.0 million related to the Bay View Funding acquisition, $32.6 million related to the Focus acquisition, $13.8 million related to the Tri-Valley acquisition, and $24.3 million related to the United American acquisition.
On April 6, 2018, the Company completed its acquisition of Tri-Valley for a transaction value of $32.3 million. At closing the Company issued 1,889,613 shares of the Company’s common stock with an aggregate market value of $30.7 million on the date of closing. The number of shares issued was based on a fixed exchange ratio of 0.0489 of a share of the Company’s common stock for each outstanding share of Tri-Valley common stock. In addition, at closing the Company paid cash to the holder of a stock warrant and holders of outstanding stock options and related fees and fractional shares totaling $1.6 million. The Company recorded goodwill of $13.8 million for the Tri-Valley acquisition.
On May 4, 2018, the Company completed its acquisition of United American for a transaction value of $56.4 million. At closing the Company issued 2,826,032 shares of the Company’s common stock with an aggregate market value of $47.3 million on the date of closing. The number of shares issued was based on a fixed exchange ratio of 2.1644 of a share of the Company’s common stock for each outstanding share of United American common stock and each common stock equivalent underlying the United American Series D Preferred Stock and Series E Preferred Stock. The shareholders of the United American Series A Preferred Stock and the Series B Preferred Stock received $1,000 cash for each share totaling $8.7 million and $435,000, respectively. In addition, the Company paid $2,000 in cash for fractional shares, for total cash consideration of $9.1 million. The Company recorded goodwill of $24.3 million for the United American acquisition.
Other intangible assets were $10.3 million at September 30, 2019, compared to $12.0 million at December 31, 2018. A customer relationship and brokered relationship intangible assets arising from the acquisition of Bay View Funding were $997,000 at September 30, 2019 and $1.1 million December 31, 2018, net of accumulated amortization. The core deposit intangible assets arising from the acquisition of Focus was $3.0 million at September 30, 2019 and $3.5 million at December 31, 2018, net of accumulated amortization. The core deposit intangible and below market lease intangible assets arising from the Tri-Valley acquisition were $1.6 million at September 30, 2019 and $1.8 million at December 31, 2018, net of accumulated amortization. The core deposit intangible and below market lease intangible assets arising from the United American acquisition were $4.9 million at September 30, 2019 and $5.6 million at December 31, 2018, net of accumulated amortization.
The composition and cost of the Company’s deposit base are important components in analyzing the Company’s net interest margin and balance sheet liquidity characteristics, both of which are discussed in greater detail in other sections herein. The Company’s liquidity is impacted by the volatility of deposits from the propensity of that money to leave the institution for rate‑related or other reasons. Deposits can be adversely affected if economic conditions weaken in California, and the Company’s market area in particular. Potentially, the most volatile deposits in a financial institution are jumbo certificates of deposit, meaning time deposits with balances that equal or exceed $250,000, as customers with balances of that magnitude are typically more rate‑sensitive than customers with smaller balances.
The following table summarizes the distribution of deposits and the percentage of distribution in each category of deposits for the periods indicated:
1,081,846
670,624
828,297
Time deposits — under $250
68,194
Time deposits — $250 and over
84,763
CDARS — interest-bearing demand,
money market and time deposits
11,575
2,745,299
The Company obtains deposits from a cross‑section of the communities it serves. The Company’s business is not generally seasonal in nature. Public funds were less than 1% of deposits and September 30, 2019 and at December 31, 2018.
At September 30, 2019, the $17.4 million CDARS deposits comprised $13.0 million of interest-bearing demand deposits, $2.5 million of money market accounts and $1.9 million of time deposits. At September 30, 2018, the $11.6 million CDARS deposits comprised $7.3 of million of interest-bearing demand deposits, $1.4 million of money market accounts and $2.9 million of time deposits. At December 31, 2018, the $14.9 million CDARS deposits comprised $8.7 million of interest-bearing demand deposits, $3.4 million of money market accounts and $2.8 million of time deposits.
The following table indicates the contractual maturity schedule of the Company’s time deposits of $250,000 and over, and all CDARS time deposits as of September 30, 2019:
% of Total
Three months or less
46,961
Over three months through six months
17,877
Over six months through twelve months
26,982
Over twelve months
5,660
97,480
The Company focuses primarily on providing and servicing business deposit accounts that are frequently over $250,000 in average balance per account. As a result, certain types of business clients that the Company serves typically carry average deposits in excess of $250,000. The account activity for some account types and client types necessitates appropriate liquidity management practices by the Company to help ensure its ability to fund deposit withdrawals.
Return on Equity and Assets
The following table indicates the ratios for return on average assets and average equity, and average equity to average assets for the periods indicated:
Return on average assets
1.44
1.54
1.50
0.98
Return on average tangible assets
1.49
1.59
1.55
1.01
Return on average equity
11.44
14.03
12.21
9.31
Return on average tangible equity
15.08
19.36
16.26
12.33
Average equity to average assets ratio
12.60
10.96
12.31
10.57
Off‑Balance Sheet Arrangements
In the normal course of business the Company makes commitments to extend credit to its customers as long as there are no violations of any conditions established in the contractual arrangements. These commitments are obligations that represent a potential credit risk to the Company, but are not reflected on the Company’s consolidated balance sheets. Total unused commitments to extend credit were $753.1 million at September 30, 2019, compared to $721.0 million at September 30, 2018, and $740.4 million at December 31, 2018. Unused commitments represented 40% outstanding gross loans at September 30, 2019, 38% at September 30, 2018, and 39% at December 31, 2018.
74
The effect on the Company’s revenues, expenses, cash flows and liquidity from the unused portion of the commitments to provide credit cannot be reasonably predicted because there is no certainty that lines of credit and letters of credit will ever be fully utilized. The following table presents the Company’s commitments to extend credit for the periods indicated:
Fixed Rate
Variable Rate
Unused lines of credit and commitments
to make loans
148,011
589,479
737,490
120,286
584,141
704,427
130,871
593,839
724,710
Standby letters of credit
2,244
13,344
15,588
4,125
12,468
16,593
2,770
12,899
15,669
150,255
602,823
753,078
124,411
596,609
721,020
133,641
606,738
740,379
Liquidity and Asset/Liability Management
Liquidity refers to the Company’s ability to maintain cash flows sufficient to fund operations and to meet obligations and other commitments in a timely and cost effective fashion. At various times the Company requires funds to meet short‑term cash requirements brought about by loan growth or deposit outflows, the purchase of assets, or liability repayments. An integral part of the Company’s ability to manage its liquidity position appropriately is the Company’s large base of core deposits, which are generated by offering traditional banking services in its service area and which have historically been a stable source of funds. To manage liquidity needs cash inflows must be properly timed to coincide with anticipated outflows or sufficient liquidity resources must be available to meet varying demands. The Company manages liquidity to be able to meet unexpected sudden changes in levels of its assets or deposit liabilities without maintaining excessive amounts of balance sheet liquidity. Excess balance sheet liquidity can negatively impact the Company’s interest margin. In order to meet short‑term liquidity needs the Company utilizes overnight Federal funds purchase arrangements and other borrowing arrangements with correspondent banks, solicits brokered deposits if cost effective deposits are not available from local sources, and maintains collateralized lines of credit with the FHLB and FRB. In addition, the Company can raise cash for temporary needs by selling securities under agreements to repurchase and selling securities available‑for‑sale.
One of the measures of liquidity is our loan to deposit ratio. Our loan to deposit ratio was 69.74% at September 30, 2019, compared to 69.19% at September 30, 2018, and 71.52% at December 31, 2018.
FHLB and FRB Borrowings and Available Lines of Credit
HBC has off‑balance sheet liquidity in the form of Federal funds purchase arrangements with correspondent banks, including the FHLB and FRB. HBC can borrow from the FHLB on a short‑term (typically overnight) or long‑term (over one year) basis. HBC had no overnight borrowings from the FHLB at September 30, 2019, September 30, 2018, and December 31, 2018. HBC had $274.9 million of loans pledged to the FHLB as collateral on an available line of credit of $227.6 million at September 30, 2019, none of which was outstanding.
HBC can also borrow from the FRB’s discount window. HBC had $746.8 million of loans pledged to the FRB as collateral on an available line of credit of $403.9 million at September 30, 2019, none of which was outstanding.
At September 30, 2019, HBC had Federal funds purchase arrangements available of $80.0 million. There were no Federal funds purchased outstanding at September 30, 2019, September 30, 2018, and December 31, 2018.
The Company has a $5.0 million line of credit with a correspondent bank, of which none was outstanding at September 30, 2019.
HBC may also utilize securities sold under repurchase agreements to manage its liquidity position. There were no securities sold under agreements to repurchase at September 30, 2019, September 30, 2018, and December 31, 2018.
Subordinated Debt
On May 26, 2017, the Company completed an underwritten public offering of $40,000,000 aggregate principal amount of its fixed-to-floating rate subordinated notes (“Subordinated Debt”) due June 1, 2027. The Subordinated Debt initially bears a fixed interest rate of 5.25% per year. Commencing on June 1, 2022, the interest rate on the Subordinated
Debt resets quarterly to the three-month LIBOR rate plus a spread of 336.5 basis points, payable quarterly in arrears. Interest on the Subordinated Debt is payable semi-annually on June 1st and December 1st of each year through June 1, 2022 and quarterly thereafter on March 1st, June 1st, September 1st and December 1st of each year through the maturity date or early redemption date. The Company, at its option, may redeem the Subordinated Debt, in whole or in part, on any interest payment date on or after June 1, 2022 without a premium. It is anticipated that the LIBOR index will be phased out by the end of 2021 and the Secured Overnight Financing Rate (“SOFR”) has been recommended as an alternative to LIBOR.
Capital Resources
The Company uses a variety of measures to evaluate capital adequacy. Management reviews various capital measurements on a regular basis and takes appropriate action to ensure that such measurements are within established internal and external guidelines. The external guidelines, which are issued by the Federal Reserve and the FDIC, establish a risk‑adjusted ratio relating capital to different categories of assets and off‑balance sheet exposures.
The following table summarizes risk‑based capital, risk‑weighted assets, and risk‑based capital ratios of the consolidated Company under the Basel III requirements for the periods indicated:
Capital components:
Common equity Tier 1 capital
266,654
Additional Tier 1 capital
Tier 2 Capital
66,022
67,498
67,922
Total risk-based capital
334,152
Risk-weighted assets
2,270,997
2,318,713
2,303,941
Average assets for capital purposes
3,002,149
3,100,135
3,118,150
Capital ratios:
14.4
Tier 1 risk-based capital
11.5
Common equity Tier 1 risk-based capital
Leverage(1)
8.6
The following table summarizes risk based capital, risk-weighted assets, and risk-based capital ratios of HBC under the Basel III requirements for the periods indicated:
282,460
26,515
28,176
28,553
310,636
2,269,658
2,316,959
2,302,751
3,000,792
3,098,391
3,116,645
13.4
12.2
9.1
Tier 1 capital divided by quarterly average assets (excluding intangible assets and disallowed deferred tax assets).
The following table presents the applicable well‑capitalized regulatory guidelines and the standards for minimum capital adequacy requirements under Basel III and the regulatory guidelines for a “well–capitalized” financial institution under Prompt Corrective Action (“PCA”):
Financial
Minimum
Institution PCA
Includes 2.5% capital conservation buffer, except the leverage capital ratio.
The Basel III capital rules introduce a new “capital conservation buffer,” for banking organizations to maintain a common equity Tier 1 ratio more than 2.5% above these minimum risk‑weighted asset ratios. The capital conservation buffer is designed to absorb losses during periods of economic stress. Banking institutions with a ratio of common equity Tier 1 to risk‑weighted assets above the minimum but below the capital conservation buffer will face constraints on dividends, equity repurchases and compensation based on the amount of the shortfall.
At September 30, 2019, the Company’s consolidated capital ratio exceeded regulatory guidelines and HBC’s capital ratios exceed the highest regulatory capital requirement of “well‑capitalized” under Basel III prompt corrective action provisions. Quantitative measures established by regulation to help ensure capital adequacy require the Company and HBC to maintain minimum amounts and ratios of total risk‑based capital, Tier 1 capital, and common equity Tier 1 (as defined in the regulations) to risk‑weighted assets (as defined), and of Tier 1 capital to average assets (as defined). Management believes that, as of September 30, 2019, September 30, 2018, and December 31, 2018, the Company and HBC met all capital adequacy guidelines to which they were subject. There are no conditions or events since September 30, 2019, that management believes have changed the categorization of the Company or HBC as well‑capitalized.
At September 30, 2019, the Company had total shareholders’ equity of $395.3 million, compared to $353.6 million at September 30, 2018, and $367.5 million at December 31, 2018. At September 30, 2019, total shareholders’ equity included $303.0 million in common stock, $98.1 million in retained earnings, and ($5.8) million of accumulated other comprehensive loss. The book value per share was $9.09 at September 30, 2019, compared to $8.17 at September 30, 2018, and $8.49 at December 31, 2018. The tangible book value per share was $6.92 at September 30, 2019, compared to $5.94 at September 30, 2018, and $6.28 at December 31, 2018.
The following table reflects the components of accumulated other comprehensive loss, net of taxes, for the periods indicated:
ACCUMULATED OTHER COMPREHENSIVE LOSS
(in $000's, unaudited)
Unrealized gain (loss) on securities available-for-sale
1,202
(8,980)
(5,412)
Remaining unamortized unrealized gain on securities
available-for-sale transferred to held-to-maturity
306
343
Split dollar insurance contracts liability
(3,794)
(3,740)
(3,722)
Supplemental executive retirement plan liability
(3,898)
(5,417)
(3,995)
Unrealized gain on interest-only strip from SBA loans
614
405
Total accumulated other comprehensive loss
Market Risk
Market risk is the risk of loss of future earnings, fair values, or future cash flows that may result from changes in the price of a financial instrument. The value of a financial instrument may change as a result of changes in interest rates, foreign currency exchange rates, commodity prices, equity prices and other market changes that affect market risk sensitive instruments. Market risk is attributed to all market risk sensitive financial instruments, including securities, loans, deposits and borrowings, as well as the Company’s role as a financial intermediary in customer‑related transactions. The objective of market risk management is to avoid excessive exposure of the Company’s earnings and equity to loss and to reduce the volatility inherent in certain financial instruments.
Interest Rate Management
Market risk arises from changes in interest rates, exchange rates, commodity prices and equity prices. The Company’s market risk exposure is primarily that of interest rate risk, and it has established policies and procedures to monitor and limit earnings and balance sheet exposure to changes in interest rates. The Company does not engage in the trading of financial instruments, nor does the Company have exposure to currency exchange rates.
The principal objective of interest rate risk management (often referred to as “asset/liability management”) is to manage the financial components of the Company in a manner that will optimize the risk/reward equation for earnings and capital in relation to changing interest rates. The Company’s exposure to market risk is reviewed on a regular basis by the Management’s Asset/Liability Committee and the Director’s Finance and Investment Committee. Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximizing income. Management realizes certain risks are inherent, and that the goal is to identify and manage the risks. Management uses two methodologies to manage interest rate risk: (i) a standard GAP analysis; and (ii) an interest rate shock simulation model.
The planning of asset and liability maturities is an integral part of the management of an institution’s net interest margin. To the extent maturities of assets and liabilities do not match in a changing interest rate environment, the net interest margin may change over time. Even with perfectly matched repricing of assets and liabilities, risks remain in the form of prepayment of loans or securities or in the form of delays in the adjustment of rates of interest applying to either earning assets with floating rates or to interest‑bearing liabilities.
Interest rate changes do not affect all categories of assets and liabilities equally or at the same time. Varying interest rate environments can create unexpected changes in prepayment levels of assets and liabilities, which may have a significant effect on the net interest margin and are not reflected in the interest sensitivity analysis table. Because of these
78
factors, an interest sensitivity GAP report may not provide a complete assessment of the exposure to changes in interest rates.
The Company uses modeling software for asset/liability management in order to simulate the effects of potential interest rate changes on the Company’s net interest margin, and to calculate the estimated fair values of the Company’s financial instruments under different interest rate scenarios. The program imports current balances, interest rates, maturity dates and repricing information for individual financial instruments, and incorporates assumptions on the characteristics of embedded options along with pricing and duration for new volumes to project the effects of a given interest rate change on the Company’s interest income and interest expense. Rate scenarios consisting of key rate and yield curve projections are run against the Company’s investment, loan, deposit and borrowed funds’ portfolios. These rate projections can be shocked (an immediate and parallel change in all base rates, up or down) and ramped (an incremental increase or decrease in rates over a specified time period), based on current trends and econometric models or stable economic conditions (unchanged from current actual levels).
The following table sets forth the estimated changes in the Company’s annual net interest income that would result from the designated instantaneous parallel shift in interest rates noted, as of September 30, 2019. Computations of prospective effects of hypothetical interest rate changes are based on numerous assumptions including relative levels of market interest rates, loan prepayments and deposit decay, and should not be relied upon as indicative of actual results.
Increase/(Decrease) in
Estimated Net
Interest Income
Change in Interest Rates (basis points)
+400
28,723
24.3
+300
21,674
18.3
+200
14,555
12.3
+100
7,283
6.2
0
−100
(10,709)
(9.1)
−200
(23,573)
(19.9)
This data does not reflect any actions that we may undertake in response to changes in interest rates such as changes in rates paid on certain deposit accounts based on local competitive factors, which could reduce the actual impact on net interest income.
As with any method of gauging interest rate risk, there are certain shortcomings inherent to the methodology noted above. The model assumes interest rate changes are instantaneous parallel shifts in the yield curve. In reality, rate changes are rarely instantaneous. The use of the simplifying assumption that short‑term and long‑term rates change by the same degree may also misstate historic rate patterns, which rarely show parallel yield curve shifts. Further, the model assumes that certain assets and liabilities of similar maturity or period to repricing will react in the same way to changes in rates. In reality, certain types of financial instruments may react in advance of changes in market rates, while the reaction of other types of financial instruments may lag behind the change in general market rates. Additionally, the methodology noted above does not reflect the full impact of annual and lifetime restrictions on changes in rates for certain assets, such as adjustable rate loans. When interest rates change, actual loan prepayments and actual early withdrawals from certificates may deviate significantly from the assumptions used in the model. Finally, this methodology does not measure or reflect the impact that higher rates may have on adjustable‑rate loan clients’ ability to service their debt. All of these factors are considered in monitoring the Company’s exposure to interest rate risk.
ITEM 3—QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The information concerning quantitative and qualitative disclosure or market risk called for by Item 305 of Regulation S‑K is included as part of Item 2 above.
ITEM 4—CONTROLS AND PROCEDURES
Disclosure Control and Procedures
The Company has carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of September 30, 2019. As defined in Rule 13a‑15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), disclosure controls and procedures are controls and procedures designed to reasonably assure that information required to be disclosed in our reports filed or submitted under the Exchange Act are recorded, processed, summarized and reported on a timely basis. Disclosure controls are also designed to reasonably assure that such information is accumulated and communicated to our management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. Based upon their evaluation, our Chief Executive Officer and Chief Financial Officer concluded the Company’s disclosure controls were effective at September 30, 2019, the period covered by this report on Form 10‑Q.
During the three and nine months ended September 30, 2019, there were no changes in our internal controls over financial reporting that materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.
Part II—OTHER INFORMATION
ITEM 1—LEGAL PROCEEDINGS
ITEM 1A—RISK FACTORS
In addition to the other information set forth in this Report, you should carefully consider the other factors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10‑K for the year ended December 31, 2018, which could materially affect our business, financial condition and/or operating results. There were no material changes from risk factors previously disclosed in our 2018 Annual Report on Form 10‑K. The risk factors identified are in addition to those contained in any other cautionary statements, written or oral, which may be or otherwise addressed in connection with a forward‑looking statement or contained in any of our subsequent filings with the Securities and Exchange Commission.
ITEM 2—UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None
ITEM 3—DEFAULTS UPON SENIOR SECURITIES
ITEM 4—MINE SAFETY DISCLOSURES
ITEM 5—OTHER INFORMATION
80
ITEM 6—EXHIBITS
Exhibit
Description
3.1
Heritage Commerce Corp Restated Articles of Incorporation, (incorporated by reference to Exhibit 3.1 to the Registrant’s Annual Report on Form 10‑K filed on March 16, 2009)
3.2
Certificate of Amendment of Articles of Incorporation of Heritage Commerce Corp as filed with the California Secretary of State on June 1, 2010 (incorporated by reference to Exhibit 3.2 to the Registrant’s Registration Statement on Form S‑1 filed July 23, 2010).
3.3
Certificate of Amendment of Articles of Incorporation of Heritage Commerce Corp as filed with the Secretary of State on September 9, 2019
3.4
Heritage Commerce Corp Bylaws, as amended (incorporated by reference to the Registrant’s Current Report on Form 8‑K filed on June 28, 2013)
31.1
Certification of Registrant’s Chief Executive Officer Pursuant To Section 302 of the Sarbanes‑Oxley Act of 2002
31.2
Certification of Registrant’s Chief Financial Officer Pursuant To Section 302 of the Sarbanes‑Oxley Act of 2002
32.1
Certification of Registrant’s Chief Executive Officer Pursuant To 18 U.S.C. Section 1350
32.2
Certification of Registrant’s Chief Financial Officer Pursuant To 18 U.S.C. Section 1350
101.INS
XBRL Instance Document, filed herewith
101.SCH
XBRL Taxonomy Extension Schema Document, filed herewith
101.CAL
XBRL Taxonomy Extension Calculation Linkbase Document, filed herewith
101.DEF
XBRL Taxonomy Extension Definition Linkbase Document, filed herewith
101.LAB
XBRL Taxonomy Extension Label Linkbase Document, filed herewith
101.PRE
XBRL Taxonomy Extension Presentation Linkbase Document, filed herewith
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Heritage Commerce Corp (Registrant)
Date: November 7, 2019
/s/ KEITH A. WILTON
Keith A. Wilton
Chief Executive Officer
/s/ Lawrence D. mcgovern
Lawrence D. McGovern
Chief Financial Officer
81