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 March 31, 2023
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.)
224 Airport Parkway, San Jose, California(Address of Principal Executive Offices)
95110(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 60,970,338 shares of Common Stock outstanding on April 28, 2023.
HERITAGE COMMERCE CORP
QUARTERLY REPORT ON FORM 10-Q
TABLE OF CONTENTS
Page No.
Cautionary Note on Forward-Looking Statements
3
Part I. FINANCIAL INFORMATION
Item 1.
Consolidated Financial Statements (unaudited)
5
Consolidated Balance Sheets
Consolidated Statements of Income
6
Consolidated Statements of Comprehensive Income
7
Consolidated Statements of Changes in Shareholders’ Equity
8
Consolidated Statements of Cash Flows
9
Notes to Unaudited Consolidated Financial Statements
10
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
41
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
70
Item 4.
Controls and Procedures
PART II. OTHER INFORMATION
Legal Proceedings
Item 1A.
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
71
Defaults Upon Senior Securities
Mine Safety Disclosures
Item 5.
Other Information
Item 6.
Exhibits
72
SIGNATURES
73
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. Risks and uncertainties that could cause our financial performance to differ materially from our goals, plans, expectations and projections expressed in forward-looking statements include those set forth in our filings with the Securities and Exchange Commission (“SEC”), Item 1A of the Heritage Commerce Corp’s (“the Company”) Annual Report on Form 10-K for the year ended December 31, 2022, and including, but not limited to the following:
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
CONSOLIDATED BALANCE SHEETS
(Unaudited)
March 31,
December 31,
2023
2022
(Dollars in thousands)
Assets
Cash and due from banks
$
41,318
27,595
Other investments and interest-bearing deposits in other financial institutions
698,690
279,008
Total cash and cash equivalents
740,008
306,603
Securities available-for-sale, at fair value
491,751
489,596
Securities held-to-maturity, at amortized cost, net of allowance for credit losses of $14 at both March 31, 2023
and December 31, 2022 (fair value of $607,986 at March 31, 2023 and $614,452 at December 31, 2022)
698,231
714,990
Loans held-for-sale - SBA, at lower of cost or fair value, including deferred costs
2,792
2,456
Loans, net of deferred fees
3,261,915
3,298,550
Allowance for credit losses on loans
(47,273)
(47,512)
Loans, net
3,214,642
3,251,038
Federal Home Loan Bank ("FHLB"), Federal Reserve Bank ("FRB") stock and other investments, at cost
32,526
32,522
Company-owned life insurance
79,438
78,945
Premises and equipment, net
9,142
9,301
Goodwill
167,631
Other intangible assets
10,431
11,033
Accrued interest receivable and other assets
89,948
93,465
Total assets
5,536,540
5,157,580
Liabilities and Shareholders' Equity
Liabilities:
Deposits:
Demand, noninterest-bearing
1,469,081
1,736,722
Demand, interest-bearing
1,196,789
1,196,427
Savings and money market
1,264,567
1,285,444
Time deposits - under $250
37,884
32,445
Time deposits - $250 and over
172,070
108,192
ICS/CDARS - interest-bearing demand, money market and time deposits
304,147
30,374
Total deposits
4,444,538
4,389,604
Other short-term borrowings
300,000
—
Subordinated debt, net of issuance costs
39,387
39,350
Accrued interest payable and other liabilities
105,407
96,170
Total liabilities
4,889,332
4,525,124
Shareholders' equity:
Preferred stock, no par value; 10,000,000 shares authorized; none issued and outstanding
at March 31, 2023 and December 31, 2022
Common stock, no par value; 100,000,000 shares authorized;
60,948,607 shares issued and outstanding at March 31, 2023 and
60,852,723 shares issued and outstanding at December 31, 2022
504,135
502,923
Retained earnings
157,390
146,389
Accumulated other comprehensive loss
(14,317)
(16,856)
Total shareholders' equity
647,208
632,456
Total liabilities and shareholders' equity
See notes to consolidated financial statements (unaudited).
CONSOLIDATED STATEMENTS OF INCOME
Three Months Ended
(Dollars in thousands, except per share amounts)
Interest income:
Loans, including fees
44,112
35,101
Securities, taxable
7,056
3,444
Securities, exempt from Federal tax
247
297
Other investments, interest-bearing deposits
in other financial institutions and Federal funds sold
4,859
1,064
Total interest income
56,274
39,906
Interest expense:
Deposits
5,901
1,114
Short-term borrowings
578
Subordinated debt
537
571
Total interest expense
7,016
1,685
Net interest income before provision for credit losses on loans
49,258
38,221
Provision for (recapture of) credit losses on loans
32
(567)
Net interest income after provision for credit losses on loans
49,226
38,788
Noninterest income:
Service charges and fees on deposit accounts
1,743
612
Increase in cash surrender value of life insurance
493
480
Servicing income
131
106
Gain on sales of SBA loans
76
156
Termination fees
11
Gain on warrants
637
Other
312
469
Total noninterest income
2,766
2,460
Noninterest expense:
Salaries and employee benefits
14,809
13,821
Occupancy and equipment
2,400
2,437
Professional fees
1,399
1,080
6,793
5,914
Total noninterest expense
25,401
23,252
Income before income taxes
26,591
17,996
Income tax expense
7,674
5,130
Net income
18,917
12,866
Earnings per common share:
Basic
0.31
0.21
Diluted
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Other comprehensive income (loss):
Change in net unrealized holding gains (losses) on available-for-sale
securities and I/O strips
3,631
(4,405)
Deferred income taxes
(1,054)
1,277
Change in unrealized gains (losses) on securities and I/O strips, net of
deferred income taxes
2,577
(3,128)
Change in net pension and other benefit plan liability adjustment
(34)
104
(4)
Change in pension and other benefit plan liability, net of
(38)
Other comprehensive income (loss)
2,539
(3,058)
Total comprehensive income
21,456
9,808
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
Accumulated
Total
Common Stock
Retained
Comprehensive
Shareholders’
Shares
Amount
Earnings
Loss
Equity
Balance, January 1, 2022
60,339,837
497,695
111,329
(10,996)
598,028
Other comprehensive loss
Amortization of restricted stock awards,
net of forfeitures and taxes
518
Cash dividend declared $0.13 per share
(7,848)
Stock option expense, net of forfeitures and taxes
149
Stock options exercised
68,009
401
Balance March 31, 2022
60,407,846
498,763
116,347
(14,054)
601,056
Balance, January 1, 2023
60,852,723
Other comprehensive income
382
(7,916)
147
95,884
683
Balance March 31, 2023
60,948,607
CONSOLIDATED STATEMENTS OF CASH FLOWS
CASH FLOWS FROM OPERATING ACTIVITIES:
Adjustments to reconcile net income to net cash provided by operating activities:
Amortization of discounts and premiums on securities
(1,258)
675
Gain on sale of SBA loans
(76)
(156)
Proceeds from sale of SBA loans originated for sale
1,045
2,146
SBA loans originated for sale
(1,305)
(934)
(493)
(480)
Depreciation and amortization
272
283
Amortization of other intangible assets
602
659
Stock option expense, net
Amortization of restricted stock awards, net
Amortization of subordinated debt issuance costs
37
46
Effect of changes in:
(519)
7,053
12,175
(5,475)
Net cash provided by operating activities
29,958
16,783
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of securities available-for-sale
(21,656)
Purchase of securities held-to-maturity
(109,610)
Maturities/paydowns/calls of securities available-for-sale
3,014
8,099
Maturities/paydowns/calls of securities held-to-maturity
16,485
30,709
Net change in loans
36,364
63,807
Changes in FHLB stock and other investments
(5)
Purchase of premises and equipment
(113)
(224)
Net cash provided by (used in) investing activities
55,746
(28,880)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net change in deposits
54,934
(69,507)
Net change in short-term borrowings
Exercise of stock options
Payment of cash dividends
Net cash provided by (used in) financing activities
347,701
(76,954)
Net increase in cash and cash equivalents
433,405
(89,051)
Cash and cash equivalents, beginning of period
1,306,216
Cash and cash equivalents, end of period
1,217,165
Supplemental disclosures of cash flow information:
Interest paid
5,657
1,112
Income taxes paid (refunds), net
(654)
Supplemental schedule of non-cash activity:
Recording of right to use assets in exchange for lease obligations
384
Transfer of loans held-for-sale to loan portfolio
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2023
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 (the “Bank” or “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, 2022.
HBC is a commercial bank serving customers primarily located in Alameda, Contra Costa, Marin, San Benito, San Francisco, San Mateo, and Santa Clara 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 accordance with the accounting principles generally accepted in the United States (“U.S. GAAP”) requires management to make a number of judgments, estimates and assumptions that affect the reported amount of assets, liabilities, income and expense in the financial statements. Various elements of our accounting policies, by their nature, involve the application of highly sensitive and judgmental estimates and assumptions. Some of these policies and estimates relate to matters that are highly complex and contain inherent uncertainties. Material estimates that are particularly susceptible to significant change include the determination of the allowance for credit losses and any impairment of goodwill or intangible assets. It is possible that, in some instances, different estimates and assumptions could reasonably have been made and used by management, instead of those we applied, which might have produced different results that could have had a material effect on the financial statements.
The results for the three months ended March 31, 2023 are not necessarily indicative of the results expected for any subsequent period or for the entire year ending December 31, 2023.
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 March 2022, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2022-02 Financial Instruments – Credit Losses (Topic 326): Troubled Debt Restructurings and Vintage Disclosures, which 1) eliminates the accounting guidance for troubled debt restructurings ("TDRs") by creditors while enhancing the disclosure requirements for certain loan refinancings and restructurings by creditors when a borrower is experiencing financial difficulty; and 2) requires that an entity disclose current-period gross writeoffs by year of origination for financing receivables and net investments in leases. The Company adopted the guidance of ASU 2022-02 on January 1, 2023 and the amendments were applied prospectively. The adoption of this new guidance did not impact the financial position or results of operations.
Accounting Guidance Issued But Not Yet Adopted
In March 2020, the FASB issued ASU 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting. The ASU provides optional expedients and exceptions for applying GAAP to loan and lease agreements, derivative contracts, and other transactions affected by the anticipated transition away from London Inter-Bank Offered Rate (“LIBOR”) toward new interest rate benchmarks. For transactions that are modified because of reference rate reform and that meet certain scope guidance (i) modifications of loan agreements should be accounted for by prospectively adjusting the effective interest rate and the modification will be considered "minor" so that any existing unamortized origination fees/costs would carry forward and continue to be amortized and (ii) modifications of lease agreements should be accounted for as a continuation of the existing agreement with no reassessments of the lease classification and the discount rate or remeasurements of lease payments that otherwise would be required for modifications not accounted for as separate contracts. ASU 2020-04 also provides numerous optional expedients for derivative accounting. ASU 2020-04 is effective March 12, 2020 through December 31, 2024. An entity may elect to apply ASU 2020-04 for contract modifications as of January 1, 2020, or prospectively from a date within an interim period that includes or is subsequent to March 12, 2020, up to the date that the financial statements are available to be issued. Once elected for a Topic or an Industry Subtopic within the Codification, the amendments in this ASU must be applied prospectively for all eligible contract modifications for that Topic or Industry Subtopic. The Company does not expect any material impact on its consolidated financial statements since the Company has an insignificant number of financial instruments applicable to this ASU.
2) 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 1,303,068 and 1,048,267 weighted average stock options outstanding for the three months ended March 31, 2023 and 2022, 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
60,908,221
60,393,883
Dilutive potential common shares
359,851
527,952
Shares used in computing diluted earnings per common share
61,268,072
60,921,835
Basic earnings per share
Diluted earnings per share
3) Accumulated Other Comprehensive Income (Loss) (“AOCI”)
The following table reflects the changes in AOCI by component for the periods indicated:
Three Months Ended March 31, 2023 and 2022
Unrealized
Gains (Losses) on
Available-
Defined
for-Sale
Benefit
Securities
Pension
and I/O
Plan
Strips
Items(1)
Beginning balance January 1, 2023, net of taxes
(11,394)
(5,462)
Other comprehensive income (loss) before reclassification,
net of taxes
(14)
2,563
Amounts reclassified from other comprehensive income (loss),
(24)
Net current period other comprehensive income (loss),
Ending balance March 31, 2023, net of taxes
(8,817)
(5,500)
Beginning balance January 1, 2022, net of taxes
2,153
(13,149)
(3)
(3,131)
Ending balance March 31, 2022, net of taxes
(975)
(13,079)
Amounts Reclassified from
AOCI
Affected Line Item Where
Details About AOCI Components
Net Income is Presented
Amortization of defined benefit pension plan items (1)
Prior transition obligation and actuarial losses (2)
47
Prior service cost and actuarial losses (3)
(13)
(114)
34
(103)
Other noninterest expense
(10)
30
Income tax benefit
24
(73)
Net of tax
Total reclassification from AOCI for the period
12
4) Securities
The amortized cost and estimated fair value of securities were as follows for the periods indicated:
Gross
Allowance
Estimated
Amortized
for Credit
Fair
Cost
Gains
(Losses)
Losses
Value
Securities available-for-sale:
U.S. Treasury
430,413
(7,510)
422,903
Agency mortgage-backed securities
73,817
(4,969)
68,848
504,230
(12,479)
Unrecognized
Securities held-to-maturity:
663,481
(90,344)
573,519
Municipals - exempt from Federal tax
34,764
18
(315)
34,467
698,245
400
(90,659)
607,986
December 31, 2022
428,797
(10,323)
418,474
76,916
(5,794)
71,122
505,713
(16,117)
677,381
235
(99,977)
577,639
37,623
(819)
36,813
715,004
244
(100,796)
614,452
Securities with unrealized losses aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position are as follows for the periods indicated:
Less Than 12 Months
12 Months or More
387,065
(6,596)
30,886
(914)
417,951
3,586
(122)
65,262
(4,847)
390,651
(6,718)
96,148
(5,761)
486,799
17,765
(319)
543,522
(90,025)
561,287
Municipals — exempt from Federal tax
14,130
(160)
5,532
(155)
19,662
31,895
(479)
549,054
(90,180)
580,949
13
136,264
(12,866)
429,257
(87,111)
565,521
31,007
167,271
(13,685)
596,528
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 March 31, 2023, the Company held 455 securities (173 available-for-sale and 282 held-to-maturity), of which 404 had fair value below amortized cost. The unrealized losses were due to higher interest rates in comparison to when the securities were purchased. 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 have credit-related losses at March 31, 2023.
The amortized cost and estimated fair values of securities as of March 31, 2023 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 three months through one year
66,001
65,614
Due after one through five years
364,412
357,289
Held-to-maturity
Due three months or less
9,813
5,020
5,022
4,029
3,981
Due after five through ten years
15,907
15,651
Securities with amortized cost of $1,075,800,000 and $66,272,000 as of March 31, 2023 and December 31, 2022 were pledged to secure public deposits and for other purposes as required or permitted by law or contract.
14
The table below presents a roll-forward by major security type for the three months ended March 31, 2023 of the allowance for credit losses on debt securities held-to-maturity held at period end:
Municipals
Beginning balance January 1, 2023
Provision for credit losses
Ending balance March 31, 2023
For the three months ended March 31, 2023, the allowance for credit losses on the Company’s held-to-maturity municipal investment securities portfolio remained at $14,000. The bond ratings for the Company’s municipal investment securities at March 31, 2023 were consistent with the ratings at December 31, 2022.
5) Loans and Allowance for Credit Losses on Loans
On January 1, 2020, the Company adopted the current expected credit loss (“CECL”) model under ASU 2016-13 (Topic 326) using the modified retrospective approach. The allowance for credit losses on loans is an estimate of the current expected credit losses in the loan portfolio. Loans are charged-off against the allowance when management determines that a loan balance has become uncollectible. Subsequent recoveries, if any, are credited to the allowance for credit losses on loans.
Management’s methodology for estimating the allowance balance consists of several key elements, which include pooling loans with similar characteristics into segments and using a discounted cash flow calculation to estimate losses. The discounted cash flow model inputs include loan level cash flow estimates for each loan segment based on peer and bank historic loss correlations with certain economic factors. Management uses a four quarter forecast of each economic factor that is used for each loan segment and the economic factors are assumed to revert to the historic mean over an eight quarter period after the forecast period. The economic factors management has selected include the California unemployment rate, California gross domestic product, California home price index, and a national CRE value index. These factors are evaluated and updated as economic conditions change. Additionally, management uses qualitative adjustments to the discounted cash flow quantitative loss estimates in certain cases when management has assessed an adjustment is necessary. These qualitative adjustments are applied by pooled loan segment and have been made for increased risk due to loan quality trends, collateral risk, or other risks management determines are not adequately captured in the discounted cash flow loss estimation. Specific allowances on individually evaluated loans are combined to the allowance on pools of loans with similar risk characteristics to derive to total allowance for credit losses on loans.
Management has also considered other qualitative risks such as collateral values, concentrations of credit risk (geographic, large borrower, and industry), economic conditions, changes in underwriting standards, experience and depth of lending staff, trends in delinquencies, and the level of criticized loans to address asset-specific risks and current conditions that were not fully considered by the macroeconomic variables driving the quantitative estimate.
The allowance for credit losses on loans was calculated by pooling loans of similar credit risk characteristics and credit monitoring procedures. The loan portfolio is classified into eight segments of loans - commercial, commercial real estate – owner occupied, commercial real estate – non-owner occupied, land and construction, home equity, multifamily, residential mortgages and consumer and other.
The risk characteristics of each loan portfolio segment are as follows:
Commercial
Commercial loans primarily rely on the identified cash flows of the borrower for repayment and secondarily on the underlying collateral provided by the borrower. However, the cash flows of the borrowers may not be as expected and the collateral securing these loans may fluctuate in value. Most commercial loans are secured by the assets being financed or other business assets such as accounts receivable, inventory or equipment and may incorporate a personal guarantee; however, some loans may be unsecured. Included in commercial loans are $565,000 of Small Business Administration (“SBA”) Paycheck Protection Program (“PPP”) loans and $69,424,000 of Bay View Funding factored receivables at March 31, 2023, compared to $1,166,000 and $79,263,000, respectively, at December 31, 2022.
15
Commercial Real Estate (“CRE”)
CRE loans rely primarily on the cash flows of the properties securing the loan and secondarily on the value of the property that is securing the loan. CRE loans comprise two segments differentiated by owner occupied CRE and non-owner CRE. Owner occupied CRE loans are secured by commercial properties that are at least 50% occupied by the borrower or borrower affiliate. Non-owner occupied CRE loans are secured by commercial properties that are less than 50% occupied by the borrower or borrower affiliate. CRE loans may be adversely affected by conditions in the real estate markets or in the general economy.
Land and Construction
Land and construction loans are generally based on estimates of costs and value associated with the complete project. Construction loans usually involve the disbursement of funds with repayment substantially dependent on the success of the completion of the project. Sources of repayment for these loans may be permanent loans from HBC or other lenders, or proceeds from the sales of the completed project. These loans are monitored by on-site inspections and are considered to have higher risk than other real estate loans due to the final repayment dependent on numerous factors including general economic conditions.
Home Equity
Home equity loans are secured by 1-4 family residences that are generally owner occupied. Repayment of these loans depends primarily on the personal income of the borrower and secondarily on the value of the property securing the loan which can be impacted by changes in economic conditions such as the unemployment rate and property values. These loans are generally revolving lines of credit.
Multifamily
Multifamily loans are loans on residential properties with five or more units. These loans rely primarily on the cash flows of the properties securing the loan for repayment and secondarily on the value of the properties securing the loan. The cash flows of these borrowers can fluctuate along with the values of the underlying property depending on general economic conditions.
Residential Mortgages
Residential mortgage loans are secured by 1-4 family residences which are generally owner-occupied. Repayment of these loans depends primarily on the personal income of the borrower and secondarily on the value of the property securing the loan which can be impacted by changes in economic conditions such as the unemployment rate and property values. These are generally term loans and are acquired.
Consumer and Other
Consumer and other loans are secured by personal property or are unsecured and rely primarily on the income of the borrower for repayment and secondarily on the collateral value for secured loans. Borrower income and collateral values can vary depending on economic conditions.
16
Loan Distribution
Loans by portfolio segment and the allowance for credit losses on loans were as follows for the periods indicated:
Loans held-for-investment:
506,602
533,915
Real estate:
CRE - owner occupied
603,298
614,663
CRE - non-owner occupied
1,083,852
1,066,368
Land and construction
166,408
163,577
Home equity
124,481
120,724
231,242
244,882
Residential mortgages
528,639
537,905
Consumer and other
17,905
17,033
Loans
3,262,427
3,299,067
Deferred loan fees, net
(512)
(517)
Changes in the allowance for credit losses on loans were as follows for the periods indicated:
Three Months Ended March 31, 2023
CRE
Owner
Non-owner
Land &
Home
Multi-
Residential
Consumer
Occupied
Construction
Family
Mortgage
and Other
Beginning of period balance
6,617
5,751
22,135
2,941
666
3,366
5,907
129
47,512
Charge-offs
(134)
(246)
(380)
Recoveries
80
25
109
Net (charge-offs) recoveries
(54)
(221)
(271)
(29)
(302)
542
243
1,026
(1,711)
28
End of period balance
6,534
5,453
22,677
3,176
688
4,392
4,196
157
47,273
Three Months Ended March 31, 2022
8,414
7,954
17,125
1,831
864
2,796
4,132
174
43,290
(16)
54
81
Net recoveries
38
65
(1,651)
(1,560)
2,288
175
(166)
(252)
625
(26)
6,801
6,397
19,413
2,006
722
2,544
4,757
148
42,788
17
The following tables present the amortized cost basis of nonperforming loans and loans past due over 90 days and still accruing at the periods indicated:
Restructured
Nonaccrual
and Loans
with no Specific
with Specific
over 90 Days
Allowance for
Past Due
Credit
and Still
Accruing
291
394
123
808
CRE - Owner Occupied
1,336
96
387
1,459
2,240
318
324
349
991
CRE - Non-Owner Occupied
98
416
2,425
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
Current
7,756
2,239
436
496,171
1,121
602,177
1,082,516
124,385
6,431
1,649
8,080
520,559
15,404
3,888
1,772
21,064
3,241,363
7,236
2,519
703
10,458
523,457
252
614,411
1,065,032
120,626
4,202
720
4,922
532,983
11,690
3,337
2,039
17,066
3,282,001
Past due loans 30 days or greater totaled $21,064,000 and $17,066,000 at March 31, 2023 and December 31, 2022, respectively, of which $410,000 and $479,000 were on nonaccrual, at March 31, 2023 and December 31, 2022, respectively. At March 31, 2023, there were also $371,000 of loans less than 30 days past due included in nonaccrual loans held-for-investment. At December 31, 2022, there were also $261,000 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.
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, and 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 loans that are expected to be repaid in accordance with their contractual loan terms. Loans categorized as special mention have potential weaknesses that may, if not checked or corrected, weaken the credit or inadequately protect the Company’s position at some future date. These loans pose elevated risk, but their weaknesses do not yet justify a substandard classification. Classified loans are those loans that are assigned a substandard, substandard-nonaccrual, or doubtful risk rating using the following definitions:
Special Mention. A Special Mention asset has potential weaknesses that deserve management's close attention. If left uncorrected, these potential weaknesses may result in a deterioration of the repayment prospects for the asset or in the credit position at some future date. Special Mention assets are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification.
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 will 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.
19
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 credit losses on loans. Therefore, there is no balance to report as of March 31, 2023 and December 31, 2022.
Loans may be reviewed at any time throughout a loan’s duration. If new information is provided, a new risk assessment may be performed if warranted.
The following tables present term loans amortized cost by vintage and loan grade classification, and revolving loans amortized cost by loan grade classification at March 31, 2023 and December 31, 2022. The loan grade classifications are based on the Bank’s internal loan grading methodology. Loan grade categories for doubtful and loss rated loans are not included on the tables below as there are no loans with those grades at March 31, 2023 and December 31, 2022. The vintage year represents the period the loan was originated or in the case of renewed loans, the period last renewed. The amortized balance is the loan balance less any purchase discounts, plus any loan purchase premiums. The loan categories are based on the loan segmentation in the Company's CECL reserve methodology based on loan purpose and type.
20
Revolving
Term Loans Amortized Cost Basis by Originated Period as of March 31, 2023
2018 and
03/31/2023
12/31/2022
12/31/2021
12/31/2020
12/31/2019
Prior
Basis
Commercial:
Pass
87,216
36,758
32,068
21,972
16,738
29,376
260,606
484,734
Special Mention
2,020
1,418
524
-
917
1,260
4,494
10,633
Substandard
321
620
274
4,370
4,961
10,550
Substandard-Nonaccrual
236
300
685
89,240
38,497
33,448
17,929
35,306
270,210
CRE - Owner Occupied:
2,381
87,418
118,376
74,459
59,368
241,040
12,216
595,258
1,588
1,230
853
2,250
5,921
990
2,119
3,371
89,006
119,606
75,312
60,489
243,298
CRE - Non-Owner Occupied:
30,477
239,675
270,999
29,747
99,910
398,297
3,416
1,072,521
3,354
7,841
136
7,977
409,492
3,552
Land and construction:
16,276
64,546
56,324
23,113
6,149
Home equity:
116
119,343
119,459
4,640
144
142
286
260
124,125
Multifamily:
2,977
41,892
57,255
5,493
42,919
78,199
215
228,950
2,292
80,491
Residential mortgage:
1,200
197,922
281,025
1,060
6,736
34,132
522,075
723
1,052
1,994
3,769
1,873
922
2,795
283,621
7,788
37,048
Consumer and other:
386
2,202
15,230
17,828
77
87
Total loans
143,541
671,924
821,436
156,697
235,184
808,097
425,548
Risk Grades:
140,527
668,597
816,057
155,844
231,820
783,362
411,026
3,207,233
3,006
2,554
1,969
8,858
9,134
28,394
994
2,493
1,395
15,577
5,239
26,019
332
781
Grand Total
21
Term Loans Amortized Cost Basis by Originated Period as of December 31, 2022
2021
2020
2019
2018
Prior Periods
102,969
36,752
24,406
19,272
12,089
21,127
293,546
510,161
3,408
192
1,123
6,031
5,551
17,365
145
102
5,496
5,747
279
330
33
642
106,381
38,091
24,598
20,540
12,419
27,293
304,593
92,689
116,266
75,007
59,887
58,180
194,584
8,758
605,371
2,033
867
1,120
4,410
8,430
660
193
862
118,959
75,874
61,007
58,373
199,003
239,556
278,051
31,848
101,854
63,905
337,048
3,245
1,055,507
4,883
5,978
347,909
62,241
72,847
22,459
6,030
44
117,950
117,994
2,346
188
120,438
42,111
69,824
4,871
42,412
15,356
66,380
180
241,134
657
771
2,320
3,748
5,528
43,183
68,700
191,907
296,270
1,068
6,788
2,724
33,290
532,047
1,058
1,482
2,387
4,927
931
7,846
4,206
36,608
389
1,364
1,283
13,647
16,696
82
249
337
95
13,896
735,274
874,235
161,375
240,466
155,623
680,984
451,110
731,862
870,023
159,659
236,243
153,618
653,756
437,326
3,242,487
3,175
1,716
4,078
20,031
8,146
42,036
7,164
5,638
13,804
377
740
22
The following table presents the gross charge-offs by class of loans and year of origination for the three months ended March 31, 2023:
Gross Charge-offs by Originated Period as of March 31, 2023
49
85
134
246
380
The amortized cost basis of collateral-dependent loans by business assets was $394,000 and $324,000 at March 31, 2023 and December 31, 2022, respectfully.
When management determines that foreclosures are probable, expected credit losses for collateral-dependent loans are based on the fair value of the collateral at the reporting date, adjusted for selling costs as appropriate. For loans for which foreclosure is not probable, but for which repayment is expected to be provided substantially through the operation or sale of the collateral and the borrower is experiencing financial difficulty, management has elected the practical expedient under ASC 326 to estimate expected credit losses based on the fair value of collateral, adjusted for selling costs as appropriate. The class of loan represents the primary collateral type associated with the loan. Significant quarter over quarter changes are reflective of changes in nonaccrual status and not necessarily associated with credit quality indicators like appraisal value.
Loan Modifications
Occasionally, the Company modifies loans to borrowers experiencing financial difficulty by providing principal forgiveness, term extension, payment delay, or interest reduction. When principal forgiveness is provided, the amount of forgiveness is charged-off against the allowance for credit losses.
In some cases, the Company provides multiple types of concessions on one loan. Typically, one type of concession, such as a term extension, is granted initially. If the borrower continues to experience financial difficulty, another concession, such as principal forgiveness, may be granted. For the loans included in the “combination” columns below, multiple types of modifications have been made on the same loan within the current reporting period. The combination is at least two of the following: a term extension, principal forgiveness, payment delay, and/or interest rate reduction.
The following table presents the amortized cost basis of loans at March 31, 2023 that were both experiencing financial difficulty and modified during the quarter ended March 31, 2023, by segment and type of modification. The percentage of the amortized cost basis of the loans that were modified to borrowers experiencing financial difficulty as compared to the amortized cost basis of each class of financing receivable is also presented below.
Combination
Term
Extension
Interest
and
Class of
Principal
Payment
Rate
Interest Rate
Financing
Forgiveness
Delay
Reduction
Receivables
88
36
0.03
%
The Company has committed to lend no additional amounts to the borrowers included in the previous table.
23
The Company closely monitors the performance of the loans that are modified to borrowers experiencing financial difficulty to understand the effectiveness of its modification efforts. The following table presents the performance of such loans that have been modified in the last quarter ended March 31, 2023, and there were no payment defaults for loans modified in the quarter ended March 31, 2023.
42
The following table presents the financial effect of the loan modification presented above to borrowers experiencing financial difficulty for the quarter ended March 31, 2023:
Weighted
Average
(Months)
There were no payment defaults for loans modified for the quarter ended March 31, 2023.
Upon the Company’s determination that a modified loan (or portion of a loan) has subsequently been deemed uncollectible, the loan (or portion of the loan) is written off. Therefore, the amortized cost basis of the loan is reduced by the uncollectible amount and the allowance for credit losses is adjusted by the same amount.
6) Goodwill and Other Intangible Assets
At March 31, 2023, the carrying value of goodwill was $167,631,000, which included $13,044,000 of goodwill related to its acquisition of Bay View Funding, $32,619,000 from its acquisition of Focus Business Bank, $13,819,000 from its acquisition of Tri-Valley Bank, $24,271,000 from its acquisition of United American Bank and $83,878,000 from its acquisition of Presidio Bank.
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 impairment test is required. The quantitative assessment identifies if a reporting unit fair value is less than its carrying value. If it is, then the Company will recognize goodwill impairment equal to the difference between the carrying amount of the reporting unit and its fair value, not to exceed the carrying amount of goodwill.
The Company completed its annual goodwill impairment analysis as of November 30, 2022 with the assistance of an independent valuation firm. The goodwill related to the acquisition of Bay View Funding was tested separately for impairment under this analysis. No events or circumstances since the November 30, 2022 annual impairment test were noted that would indicate it was more likely than not that a goodwill impairment exists, for either the Company’s banking or factoring reporting units.
The following table summarizes the carrying amount of goodwill by segment for the periods indicated:
Banking
154,587
Factoring
13,044
Total Goodwill
Other Intangible Assets
The Company’s intangible assets are summarized as follows for the periods indicated:
Carrying
Amortization
Core deposit intangibles
25,023
(14,984)
10,039
Customer relationship and brokered relationship intangibles
1,900
(1,598)
302
Below market leases
110
(20)
90
27,033
(16,602)
(14,429)
10,594
(1,551)
(16,000)
As of March 31, 2023, the estimated amortization expense for future periods is as follows:
Customer &
Below/
Core
Brokered
(Above)
Deposit
Relationship
Market
Year
Intangible
Lease
Expense
2023 remaining
1,662
143
(2)
1,803
2024
2,023
159
2,187
2025
1,795
1,813
2026
1,512
1,530
2027
1,438
1,456
2028
999
1,017
2029
610
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 March 31, 2023 and December 31, 2022.
7) 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 $29,841,000 and $32,176,000, at March 31, 2023 and December 31, 2022, 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 March 31, 2023 and December 31, 2022 will be fully realized in future years.
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
3,290
3,537
Future commitments
521
523
The Company expects $27,000 of the future commitments to be paid in 2023, and $494,000 in 2024 through 2026.
For tax purposes, the Company had low income housing tax credits of $180,000 for the three months ended March 31, 2023, and $210,000 for the three months ended March 31, 2022, and low income housing investment expense of $186,000 and $211,000, respectively. The Company recognized low income housing investment expense as a component of income tax expense.
8) 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
48
Interest cost
216
Amortization of net actuarial loss
114
Net periodic benefit cost
385
417
26
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 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
7,060
9,244
91
Actuarial loss
(2,430)
Projected benefit obligation at end of period
7,151
Net actuarial loss
2,371
2,301
Prior transition obligation
768
790
3,139
3,091
Amortization of prior transition obligation and actuarial losses
(47)
(11)
62
51
9) 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
27
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).
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
Balance
(Level 1)
(Level 2)
(Level 3)
Assets at March 31, 2023
Available-for-sale securities:
I/O strip receivables
Assets at December 31, 2022
152
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 collateral dependent loans individually evaluated with specific allocations of the allowance for credit losses on loans 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. There were no material collateral dependent loans carried at fair value on a non-recurring basis at March 31, 2023 or December 31, 2022.
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. At March 31, 2023 and December 31, 2022, there were no foreclosed assets on the balance sheet.
The carrying amounts and estimated fair values of financial instruments at March 31, 2023 are as follows:
Estimated Fair Value
Amounts
Assets:
Cash and cash equivalents
Securities available-for-sale
Securities held-to-maturity
Loans (including loans held-for-sale)
3,264,707
(1)
3,058,697
3,061,489
FHLB stock, FRB stock, and other
investments
Accrued interest receivable
16,117
1,745
2,502
11,870
I/O strips receivables
Time deposits
214,443
216,579
Other deposits
4,230,095
Borrowings on FHLB and FRB
lines of credit
32,787
Accrued interest payable
1,921
(1) Before allowance for credit losses on loans of $47,273,000.
The carrying amounts and estimated fair values of the Company’s financial instruments at December 31, 2022:
3,301,006
3,080,485
3,082,941
15,047
1,328
1,836
11,883
143,958
144,702
4,245,646
36,025
600
(1) Before allowance for credit losses on loans of $47,512,000.
29
10) 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 21, 2020, the shareholders approved an amendment to the Heritage Commerce Corp 2013 Equity Incentive Plan to increase the number of shares available from 3,000,000 to 5,000,000 shares. The equity plans provide for the grant of incentive and nonqualified stock options, restricted stock, and restricted stock units. 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. The 2013 Plan will terminate at the 2023 Annual Shareholders Meeting to be held May 25, 2023. The Company intends to propose a new 2023 Equity Incentive Plan at the 2023 Annual Shareholders Meeting. For the three months ended March 31, 2023, the Company granted no nonqualified stock options and or shares of restricted stock. There were 1,498,474 shares available for the issuance of equity awards under the 2013 Plan as of March 31, 2023.
Stock option activity under the equity plans is as follows:
Remaining
Aggregate
Number
Exercise
Contractual
Intrinsic
Total Stock Options
of Shares
Price
Life (Years)
Outstanding at January 1, 2023
2,527,173
10.44
Exercised
7.12
Forfeited or expired
(23,728)
13.62
Outstanding at March 31, 2023
2,407,561
10.54
5.38
1,356,635
Vested or expected to vest
2,263,107
1,275,237
Exercisable at March 31, 2023
1,858,557
4.46
Information related to the equity plans for the periods indicated:
Intrinsic value of options exercised
466,308
415,117
Cash received from option exercise
682,825
401,136
Tax benefit (expense) realized from option exercises
3,969
31,971
As of March 31, 2023, there was $1,141,000 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 2.50 years.
Restricted stock activity under the equity plans is as follows:
Average Grant
Date Fair
Total Restricted Stock Award
Nonvested shares at January 1, 2023
253,491
11.05
Vested
Nonvested shares at March 31, 2023
As of March 31, 2023, there was $1,500,000 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 1.84 years.
11) Borrowing Arrangements
Federal Home Loan Bank Borrowings, Federal Reserve Bank Borrowings, and Available Lines of Credit
HBC maintains a collateralized line of credit with the FHLB of San Francisco. Under this line, the Company can borrow from the FHLB on a short-term (typically overnight) or long-term (over one year) basis. HBC had $653,005,000 of loans and $377,513,000 of securities pledged to the FHLB as collateral on an available line of credit of $789,909,000 at March 31, 2023, of which $150,000,000 was outstanding. The Bank repaid in full the $150,000,000 outstanding on April 20, 2023. HBC had no overnight borrowings from the FHLB at December 31, 2022.
HBC can also borrow from the FRB discount window. HBC had $1,622,220,000 of loans and securities pledged to the FRB as collateral on an available line of credit of $1,231,874,000 at March 31, 2023, of which $150,000,000 was outstanding. The Bank repaid in full the $150,000,000 outstanding on April 20, 2023. There were no outstanding balances at December 31, 2022.
At March 31, 2023, HBC had Federal funds purchased arrangements available of $80,000,000. There were no Federal funds purchased outstanding at March 31, 2023 and December 31, 2022.
The Company has a $20,000,000 million line of credit with a correspondent bank, of which none was outstanding at March 31, 2023 and December 31, 2022.
HBC may also utilize securities sold under repurchase agreements to manage its liquidity position. There were no securities sold under agreements to repurchase at March 31, 2023, March 31, 2022, and December 31, 2022.
Subordinated Debt
On May 11, 2022, the Company completed a private placement offering of $40,000,000 aggregate principal amount of its 5.00% fixed-to-floating rate subordinated notes due May 15, 2032 (“Sub Debt due 2032”). The Company used the net proceeds of the Sub Debt due 2032 for general corporate purposes, including the repayment on June 1, 2022 of the Company’s $40,000,000 aggregate principal amount of 5.25% fixed-to-floating rate subordinated notes due June 1, 2027 (“Sub Debt due 2027”). The Sub Debt due 2032, net of unamortized issuance costs of $613,000, totaled $39,387,000 at March 31, 2023, and qualifies as Tier 2 capital for the Company under the guidelines established by the Federal Reserve Bank
On May 26, 2017, the Company completed an underwritten public offering of $40,000,000 aggregate principal amount of its Sub Debt due 2027. The Sub Debt due 2027 had a fixed interest rate of 5.25% per year through June 1, 2022. On June 1, 2022, the Company completed the redemption of all of its outstanding $40,000,000 of Sub Debt due 2027, prior to resetting to a floating rate. The Sub Debt due 2027 was redeemed pursuant to the terms of the Subordinated Indenture, as supplemented by the First Supplemental Indenture, each dated as of May 26, 2017, between the Company and Wilmington Trust, National Association, as Trustee, at the redemption price of 100% of its principal amount.
12) 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.
The Company’s consolidated capital ratios and the HBC’s capital ratios exceeded the regulatory guidelines for a well-capitalized financial institution under the Basel III regulatory requirements at March 31, 2023. There are no conditions or events since March 31, 2023, that management believes have changed the categorization of the Company or HBC as “well-capitalized.”
31
As permitted by the interim final rule issued on March 27, 2020 by our federal regulatory agency, we elected the option to delay the estimated impact of the adoption of the CECL Standard in our regulatory capital for two years. This two-year delay is in addition to the three-year transition period the agency had already made available. The adoption delayed the effects of CECL on our regulatory capital through the end of 2021. The effects are being phased-in over a three-year period from January 1, 2022 through December 31, 2024, with 75% recognized in 2022, 50% recognized in 2023, and 25% recognized in 2024. Under the interim final rule, the amount of adjustments to regulatory capital deferred until the phase-in period includes both the initial impact of adoption of the CECL Standard at January 1, 2020 and 25% of subsequent changes in our allowance for credit losses during each quarter of the two-year period ending December 31, 2021.
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 March 31, 2023 and December 31, 2022, 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 for the periods indicated:
Required For
Capital
Adequacy
Purposes
Actual
Under Basel III
Ratio
Ratio (1)
As of March 31, 2023
Total Capital
567,562
15.3
389,554
10.5
(to risk-weighted assets)
Tier 1 Capital
485,738
13.1
315,353
8.5
Common Equity Tier 1 Capital
259,703
7.0
9.6
202,798
4.0
(to average assets)
As of December 31, 2022
554,810
14.8
393,461
475,609
12.7
318,516
262,307
9.2
207,852
HBC’s actual capital amounts and ratios are presented in the following table, together with capital adequacy requirements, under the Basel III regulatory requirements for the periods indicated:
To Be Well-Capitalized
Under Basel III PCA Regulatory
Requirements
545,172
14.7
371,242
10.0
389,804
502,735
13.5
296,993
8.0
315,555
241,307
6.5
259,869
9.9
253,402
5.0
202,722
532,576
14.2
374,572
393,301
492,725
13.2
299,658
318,387
243,472
262,201
9.5
259,740
207,792
The Subordinated Debt, net of unamortized issuance costs, totaled $39,387,000 at March 31, 2023, and qualifies as Tier 2 capital for the Company under the guidelines established by the Federal Reserve Bank.
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 Financial Protection and Innovation (“DFPI”) 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 DFPI 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 March 31, 2023, HBC would not be required to obtain regulatory approval, and the amount available for cash dividends is $58,084,000. HBC distributed to HCC dividends of $8,000,000, during the first quarter of 2023.
13) Commitments and Loss Contingencies
Loss Contingencies
Within the ordinary course of our business, we are subject to private lawsuits, government audits, administrative proceedings and other claims. A number of these claims may exist at any given time, and some of the claims may be pled as class actions. We could be affected by adverse publicity and litigation costs resulting from such allegations, regardless of whether they are valid or whether we are legally determined to be liable. A summary of proceedings outstanding at March 31, 2023 follows:
D.C. Solar Related:
Employee Related:
The Company makes a provision for a liability relating to legal matters when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. These provisions are reviewed at least quarterly and adjusted to reflect the impacts of negotiations, estimated settlements, legal rulings, advice of legal counsel and other information and events pertaining to a particular matter. The outcomes of legal proceedings and other contingencies are, however, inherently unpredictable and subject to significant uncertainties. As a result, the Company is not able to reasonably estimate the amount or range of possible losses, including losses that could arise as a result of application of non-monetary remedies, with respect to the contingencies it faces, and the Company’s estimates may not prove to be accurate.
35
At this time, we believe that the amount of reasonably possible losses resulting from final disposition of any pending lawsuits, audits, proceedings and claims will not have a material adverse effect individually or in the aggregate on our financial position, results of operations or liquidity. It is possible, however, that our future results of operations for a particular quarter or fiscal year could be impacted by changes in circumstances relating to lawsuits, proceedings or claims. Legal costs related to such claims are expensed as incurred.
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 $1,088,698,000 at March 31, 2023, and $1,134,619,000 at December 31, 2022. Unused commitments represented 33% outstanding gross loans at March 31, 2023, and 34% at December 31, 2022.
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
Variable
Unused lines of credit and commitments
to make loans
78,955
996,210
1,075,165
87,348
1,036,847
1,124,195
Standby letters of credit
4,850
8,683
13,533
1,565
8,859
10,424
83,805
1,004,893
1,088,698
88,913
1,045,706
1,134,619
For the three months ended March 31, 2023, there was an decrease of $2,000 to the allowance for credit losses on the Company’s off-balance sheet credit exposures. The decrease in the allowance for credit losses for off-balance sheet credit exposures in the first three months of 2023 was driven by lower loan commitments. The allowance for credit losses on the Company’s off-balance sheet credit exposures was $818,000 at March 31, 2023 and $820,000 at December 31, 2022.
14) 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 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 Company currently accounts for sales of foreclosed assets in accordance with Topic 360-20. In most cases the Company will seek to engage a real estate agent for the sale of foreclosed assets immediately upon foreclosure. However, in some cases, where there is clear demand for the property in question, the Company may elect to allow for a marketing period of no more than six months to attempt a direct sale of the property. We generally recognize the sale, and any associated gain or loss, of a real estate property when control of the property transfers. Any gains or losses from the sale are recorded to noninterest income/expense.
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:
Total noninterest income in-scope of Topic 606
Noninterest Income Out-of-scope of Topic 606
1,023
1,848
15) Noninterest Expense
The following table sets forth the various components of the Company’s noninterest expense for the periods indicated:
Insurance expense
1,520
1,043
Amortization of intangible assets
Data processing
774
651
3,897
3,561
16) Leases
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 March 31, 2023, operating lease ROU assets, included in other assets, and lease liabilities, included in other liabilities, totaled $32,123,000.
The following table presents the quantitative information for the Company’s leases for the periods indicated:
Operating Lease Cost (Cost resulting from lease payments)
1,701
1,620
Operating Lease - Operating Cash Flows (Fixed Payments)
1,645
1,210
Operating Lease - ROU assets
32,123
33,669
Operating Lease - Liabilities
Weighted Average Lease Term - Operating Leases
6.44 years
7.19 years
Weighted Average Discount Rate - Operating Leases
4.54%
4.49%
The following maturity analysis shows the undiscounted cash flows due on the Company’s operating lease liabilities as of March 31, 2023:
4,750
6,063
5,523
4,974
4,804
Thereafter
11,189
Total undiscounted cash flows
37,303
Discount on cash flows
(5,180)
Total lease liability
17) 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 credit losses on loans 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)
Consolidated
Interest income
52,273
4,001
Intersegment interest allocations
705
(705)
Net interest income
45,962
3,296
(112)
Net interest income after provision
45,818
Noninterest income
2,682
84
Noninterest expense
23,728
1,673
Intersegment expense allocations
(174)
24,946
7,188
486
17,758
1,159
5,453,352
83,188
3,192,491
69,424
(1) Includes the holding company’s results of operations
39
37,113
2,793
237
(237)
35,665
2,556
Provision (recapture) for credit losses on loans
(539)
(28)
36,204
2,584
2,398
21,767
1,485
16,949
1,047
4,821
309
12,128
738
5,352,709
74,689
5,427,398
2,962,823
61,241
3,024,064
18) Subsequent Events
On April 27, 2023, the Company announced that its Board of Directors declared a $0.13 per share quarterly cash dividend to holders of common stock. The dividend will be payable on May 25, 2023, to shareholders of record at the close of the business day on May 11, 2023.
40
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” or the “Bank”), 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, 2022. There have been no changes in the Company's application of critical accounting policies since December 31, 2022, except for the adoption the following new accounting standard:
The Company adopted the guidance of Financial Accounting Standards Board (“FASB”) Accounting Standards Update (“ASU”) No. 2022-02 Financial Instruments – Credit Losses (Topic 326): Troubled Debt Restructurings and Vintage Disclosures on January 1, 2023, which 1) eliminates the accounting guidance for troubled debt restructurings ("TDRs") by creditors while enhancing the disclosure requirements for certain loan refinancings and restructurings by creditors when a borrower is experiencing financial difficulty; and 2) requires that an entity disclose current-period gross writeoffs by year of origination for financing receivables and net investments in leases. The adoption of the new guidance did not have a material impact the consolidated financial statements. The adoption of this ASU is further discussed “Note 1 – Basis of Presentation – Adoption of New Accounting Standard and Note 5 – Loans and Allowance for Credit Losses on Loans.”
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 Alameda, Contra Costa, Marin, San Benito, San Francisco, San Mateo, and Santa Clara. The Company’s market includes the cities of Oakland, San Francisco and San Jose and 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 March 31, 2023, net income was $18.9 million, or $0.31 per average diluted common share, compared to $12.9 million, or $0.21 per average diluted common share, for the three months ended March 31, 2022. The Company’s annualized return on average tangible assets was 1.52% and annualized return on average tangible common equity was 16.71% for the three months ended March 31, 2023, compared to 0.99% and 12.47%, respectively, for the three months ended March 31, 2022.
Factoring Activities - Bay View Funding
Based in San Jose, 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 at period-end
Average factored receivables:
For the three months ended
77,754
57,761
Total full time equivalent employees at period-end
First Quarter 2023 Highlights
The following are important factors that impacted the Company’s results of operations:
The following are important factors in understanding our current financial condition and liquidity position:
Outstanding
Available
Lines of Credit
Unpledged investment securities (at fair value)
122,483
Off-balance sheet deposits
132,987
Excess funds at the FRB
695,400
FRB discount window
1,231,874
150,000
(1)
1,081,874
FHLB Advances
789,909
639,909
Federal funds purchase arrangements
80,000
Holding company line of credit
20,000
3,072,653
2,772,653
43
Well-capitalized
Heritage
Financial Institution
Basel III Minimum
Commerce
Bank of
Basel III PCA Regulatory
Regulatory
Capital Ratios
Corp
Guidelines
Requirement(1)
Tier 1 Leverage
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 the 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 and amounts 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.
45
Distribution, Rate and Yield
March 31, 2022
Income /
Yield /
Loans, gross (1)(2)
3,277,525
5.46
3,028,589
4.70
Securities — taxable
1,161,021
2.46
781,689
1.79
Securities — exempt from Federal tax (3)
36,012
313
3.52
44,871
376
3.40
420,451
4.69
1,238,702
0.35
Total interest earning assets
4,895,009
56,340
4.67
5,093,851
39,985
3.18
37,563
37,630
9,269
9,605
Goodwill and other intangible assets
178,443
181,065
Other assets
115,222
121,089
5,235,506
5,443,240
Liabilities and shareholders’ equity:
1,667,260
1,857,164
1,217,731
1,476
0.49
1,279,989
459
0.15
1,285,173
3,489
1.10
1,394,734
543
0.16
Time deposits — under $100
12,280
0.33
13,235
Time deposits — $100 and over
163,047
845
2.10
119,082
0.36
ICS/CDARS — interest-bearing demand, money
market and time deposits
70,461
0.47
32,932
1
0.01
Total interest-bearing deposits
2,748,692
0.87
2,839,972
4,415,952
0.54
4,697,136
0.10
46,677
5.02
0.00
39,363
5.53
39,951
5.80
Total interest-bearing liabilities
2,834,732
1.00
2,879,952
0.24
Total interest-bearing liabilities and demand,
noninterest-bearing / cost of funds
4,501,992
0.63
4,737,116
0.14
Other liabilities
95,917
106,769
4,597,909
4,843,885
Shareholders’ equity
637,597
599,355
Total liabilities and shareholders’ equity
Net interest income / margin
49,324
4.09
38,300
3.05
Less tax equivalent adjustment
(66)
(79)
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 March 31,
2023 vs. 2022
Increase (Decrease)
Due to Change in:
Net
Volume
Change
Income from the interest earning assets:
Loans, gross
3,338
5,673
9,011
2,314
1,298
3,612
Securities — exempt from Federal tax (1)
(63)
(9,466)
13,261
3,795
Total interest income on interest-earning assets
(3,890)
20,245
16,355
Expense from the interest-bearing liabilities:
(71)
1,088
(294)
3,240
2,946
228
511
739
CDARS — interest-bearing demand, money market
and time deposits
(8)
Total interest expense on interest-bearing liabilities
475
4,856
5,331
(4,365)
15,389
11,024
11,037
Net interest income, before provision for credit losses on loans, increased 29% to $49.3 million for the first quarter of 2023, compared to $38.2 million for the first quarter of 2022. The FTE net interest margin increased 104 basis points to 4.09% for the first quarter of 2023, from 3.05% for the first quarter of 2022, primarily due to increases in the prime rate and the rate of overnight funds, and a shift in the mix of earning assets into higher yielding loans and investment securities, partially offset by lower interest and fees PPP loans, lower prepayment fees, a decrease in the accretion of the loan purchase discount into interest income from acquired loans, a higher cost of funds, and an increase in short-term borrowings.
Net interest income, before provision for credit losses on loans, decreased (5%) to $49.3 million for the first quarter of 2023, compared to $51.7 million for the fourth quarter of 2022. The FTE net interest margin decreased (1) basis point to 4.09% for the first quarter of 2023 from 4.10% for the fourth quarter of 2022, primarily due to a higher cost of funds, a decrease in the average balances of noninterest bearing demand deposits, and an increase in short-term borrowings, partially offset by increases in the prime rate and higher average yields on overnight funds, and an increase in the accretion of the loan purchase discount into interest income from acquired loans.
The following tables present the average balance of loans outstanding, interest income, and the average yield for the periods indicated:
For the Quarter Ended
Income
Yield
Loans, core bank
2,680,849
34,827
5.27
2,483,708
26,097
4.26
Prepayment fees
138
0.02
510
0.08
PPP loans
832
0.97
60,264
146
0.98
PPP fees, net
8.77
1,346
9.06
Asset-based lending
27,550
627
9.23
69,617
950
Bay View Funding factored receivables
77,755
20.87
19.61
Purchased residential mortgages
487,780
3,857
3.21
355,626
2,428
2.77
Purchased commercial real estate ("CRE") loans
7,119
120
6.84
8,514
3.67
Loan fair value mark / accretion
(4,360)
522
(6,901)
754
0.12
Total loans (includes loans held-for-sale)
The average yield on the total loan portfolio increased to 5.46% for the first quarter of 2023, compared to 4.70% for the first quarter of 2022, primarily due to increases in the prime rate, partially offset by lower interest and fees on PPP loans, lower prepayment fees, a decrease in the accretion of the loan purchase discount into interest income from acquired loans, and higher average balances of lower yielding purchased residential mortgages.
2,654,311
33,594
1,255
0.95
7.90
35,519
756
8.44
71,789
3,696
20.43
485,149
3,842
3.14
Purchased CRE loans
7,307
4.34
(4,774)
0.06
3,250,556
42,501
5.19
The average yield on the total loan portfolio increased to 5.46% for the first quarter of 2023, compared to 5.19% for the fourth quarter of 2022, primarily due to increases in the prime rate, and an increase in the accretion of the loan purchase discount into interest income from acquired loans.
In aggregate, the remaining net purchase discount on total loans acquired was $4.1 million at March 31, 2023.
The following table presents the average balance of deposits and interest-bearing liabilities, interest expense, and the average rate for the periods indicated:
1,851,003
1,164,378
945
0.32
1,424,964
1,694
Time deposits - under $100
12,157
0.23
Time deposits - $100 and over
120,246
268
0.88
ICS/CDARS - interest-bearing demand, money market
27,785
2,749,530
2,915
0.42
4,600,533
0.25
39,326
538
5.43
2,788,880
3,453
4,639,883
0.30
The average cost of total deposits increased to 0.54% for the first quarter of 2023, compared to 0.25% for the fourth quarter of 2022. The average cost of funds increased to 0.63% for the first quarter of 2023, compared to 0.30% for the fourth quarter of 2022. The average cost of deposits was 0.10% and the average cost of funds was 0.14% for the first quarter of 2022.
Provision for Credit Losses on Loans
Credit risk is inherent in the business of making loans. The Company establishes an allowance for credit losses on loans through charges to earnings, which are presented in the statements of income as the provision for credit losses on loans. Specifically identifiable and quantifiable known losses are promptly charged off against the allowance. The provision for credit losses on loans is determined by conducting a quarterly evaluation of the adequacy of the Company’s allowance for credit losses on loans 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 credit losses on loans 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. The provision for credit losses on loans and level of allowance for each period are also dependent on forecast data for the state of California including GDP and unemployment rate projections.
During the first quarter of 2023, there was a provision for credit losses on loans of $32,000, compared to a ($567,000) recapture of provision for credit losses on loans for the first quarter of 2022. Provisions for credit losses on loans are charged to operations to bring the allowance for credit losses on loans to a level deemed appropriate by the Company based on the factors discussed under “Credit Quality and Allowance for Credit Losses on Loans.”
Noninterest Income
Increase
(decrease)
2023 versus 2022
Percent
1,131
185
(80)
(51)
(637)
(100)
(157)
(33)
306
Total noninterest income increased 12% to $2.8 million for the first quarter of 2023, compared to $2.5 million for the first quarter of 2022, primarily due to higher service charges and fees on deposit accounts.
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 first quarter of 2023, SBA loan sales resulted in a $76,000 gain, compared to a $156,000 gain on sales of SBA loans for the first quarter of 2022.
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.
Noninterest Expense
The following table sets forth the various components of the Company’s noninterest expense:
(Decrease)
988
(37)
477
319
(57)
(9)
336
2,149
50
The following table indicates the percentage of noninterest expense in each category for the periods indicated:
Percent of
58
59
100
Total noninterest expense for the first quarter of 2023 increased to $25.4 million, compared to $23.3 million for the first quarter of 2022, primarily due to higher payroll taxes and employee benefits, higher professional fees, and higher insurance and information technology related expenses included in other noninterest expense during the first quarter of 2023.
Full time equivalent employees was 339 at March 31, 2023, compared to 325 at March 31, 2022, and 340 and at December 31, 2022.
Income Tax Expense
The Company computes its provision for income taxes on a monthly 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
28.9
28.5
The Company’s Federal and state income tax expense for the first quarter of 2023 was $7.7 million, compared to $5.1 million for the first quarter of 2022.
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 $29.8 million at March 31, 2023, $28.1 million at March 31, 2022, and $32.2 million at December 31, 2022. 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 March 31, 2023, March 31, 2022, and December 31, 2022 will be fully realized in future years.
FINANCIAL CONDITION
At March 31, 2023, total assets increased 2% to $5.537 billion, compared to $5.427 billion at March 31, 2022, and increased 7% from $5.158 billion at December 31, 2022.
Securities available-for-sale, at fair value, were $491.8 million at March 31, 2023, an increase of 342% from $111.2 million at March 31, 2022, and remained relatively flat from $489.6 million at December 31, 2022. Securities held-to-maturity, at amortized cost, were $698.2 million at March 31, 2023, a decrease of (5%) from $736.8 million at March 31, 2022, and a decrease of (2%) from $715.0 million at December 31, 2022.
Loans, excluding loans held-for-sale, increased $237.9 million, or 8%, to $3.262 billion at March 31, 2023, compared to $3.024 billion at March 31, 2022, and decreased ($36.6) million, or (1%), from $3.299 billion at December 31, 2022. Loans, excluding loans held-for-sale, PPP loans and residential mortgages, increased $136.5 million, or 5%, to $2.733 billion at March 31, 2023, compared to $2.596 billion at March 31, 2022, and decreased ($26.8) million, or (1%), from $2.760 billion at December 31, 2022.
Total deposits decreased ($245.4) million, or (5%), to $4.445 billion at March 31, 2023, compared to $4.690 billion at March 31, 2022, and increased $54.9 million, or 1%, from $4.390 billion at December 31, 2022.
Securities Portfolio
The following table reflects the balances for each category of securities at the dates indicated:
Securities available-for-sale (at fair value):
21,564
89,653
111,217
Securities held-to-maturity (at amortized cost):
696,161
40,701
736,862
52
The following table summarizes the weighted average life and weighted average yields of securities at March 31, 2023:
Weighted Average Life
After One and
After Five and
Within One
Within Five
Within Ten
After Ten
Year or Less
Years
2.94
99
2.31
55,211
2.50
13,538
2.64
2.53
65,713
412,500
2.88
2.98
68,333
2.19
512,143
83,005
1.99
Municipals — exempt from Federal tax (1)
14,828
3.69
3.15
3.50
3.54
72,362
2.24
528,050
1.84
2.06
The securities 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 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.
53
The following table shows the pre-tax unrealized (loss) gain on securities available-for-sale and securities held-to-maturity and the allowance for credit losses for the periods indicated:
Securities available-for-sale pre-tax unrealized (loss):
(93)
(1,406)
(1,499)
Securities held-to-maturity pre-tax unrealized (loss) gain:
(89,962)
(46,226)
(99,742)
(297)
(810)
(90,259)
(46,078)
(100,552)
Allowance for credit losses on municipal securities
(39)
The pre-tax unrealized loss on securities available-for-sale was ($12.5) million, or ($8.9) million net of taxes, which was 1% of total shareholders’ equity at March 31, 2023. The pre-tax unrealized loss on securities held-to-maturity at March 31, 2023 was ($90.3) million, or ($64.5) million net of taxes, which was 10% of total shareholders’ equity at March 31, 2023. The unrealized losses in both the available-for-sale and held-to-maturity portfolios were due to higher interest rates at March 31, 2023 compared to when the securities were purchased. The issuers are of high credit quality and all principal amounts are expected to be repaid when the securities mature. The fair value is expected to recover as the securities approach their maturity date and/or interest rates decline.
The average life of the total securities available-for-sale portfolio was 1.88 years and the modified duration was 1.76 years at March 31, 2023. The average life of the total securities held-to-maturity portfolio was 6.95 years and the modified duration was 5.70 years at March 31, 2023. The average life of the total investment securities portfolio was 4.82 years and the modified duration was 4.04 years at March 31, 2023.
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 March 31, 2023, represented 56% at March 31, 2022 and 64% at December 31, 2022. The loan to deposit ratio was 73.39% at March 31, 2023, compared to 64.48% at March 31, 2022, and 75.14% at December 31, 2022.
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
506,037
568,053
532,749
PPP loans (1)
565
0
37,393
1,166
597,542
928,220
153,323
111,609
221,767
391,171
17,110
Total Loans
3,026,188
(2,124)
(42,788)
2,981,276
The Company’s loan portfolio is concentrated in commercial loans, (primarily manufacturing, wholesale, and services oriented entities), and CRE, with the remaining balance in land development and construction, 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, 83% of its gross loans were secured by real property at both March 31, 2023 and December 31, 2022, compared to 79% at March 31, 2022. 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 CRE loans, commercial loans, construction loans and unsecured lending, among others. 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 three months ended March 31, 2023 and 2022, loans were sold resulting in a gain on sales of SBA loans of $76,000 and $156,000, 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 39 days for the first three months of 2023, compared to 38 days for the first three months of 2022. The balance of the
55
purchased receivables was $69.4 million at March 31, 2023, compared to $61.2 million at March 31, 2022, and $79.3 million at December 31, 2022.
The commercial loan portfolio, excluding PPP loans, decreased ($62.0) million, or (11%), to $506.0 million at March 31, 2023, from $568.1 million at March 31, 2022, and decreased ($26.7) million, or (5%), from $532.7 million at December 31, 2022. Commercial and industrial (“C&I”) line usage was 31% at both March 31, 2023 and March 31, 2022, compared to 29% at December 31, 2022. In addition, the Company had $565,000 in PPP loans at March 31, 2023, compared to $37.4 million at March 31, 2022, and $1.2 million at December 31, 2022.
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 owner-occupied loan portfolio increased $5.8 million, or 1%, to $603.3 million at March 31, 2023, from $597.5 million at March 31, 2022, and decreased ($11.4) million, or (2%), from $614.7 million at December 31, 2022. CRE non-owner occupied loans increased $155.6 million, or 17%, to $1.084 billion at March 31, 2023, compared to $928.2 million at March 31, 2022, and increased $17.5 million, or 2%, from $1.066 billion at December 31, 2022. At March 31, 2023, 36% of the CRE loan portfolio was secured by owner-occupied real estate, compared to 39% at March 31, 2022, and 37% at December 31, 2022.
The average loan size for all CRE loans was $1.6 million, and the average loan size for office CRE loans was also $1.6 million. The Company has personal guaranties on 90% of its CRE portfolio, while 10% are unguaranteed. A substantial portion of the unguaranteed CRE loans were made to credit-worthy non-profit organizations. Office exposure in the CRE portfolio totaled $383 million, including 30 loans totaling approximately $70 million, in San Jose, 19 loans totaling approximately $28 million, in San Francisco, and 5 loans totaling approximately $10 million, in Oakland, at March 31, 2023. Of the $383 million of CRE loans with office exposure, approximately $29 million, or 8%, are situated in the Bay Area downtown business districts of San Jose and San Francisco, with an average loan size of $2.2 million.
At March 31, 2023, the weighted average loan-to-value and debt-service coverage for the entire non-owner occupied office portfolio were 43.2% and 2.09 times, respectively. For the ten non-owner occupied office loans in the City of San Francisco at March 31, 2023, the weighted average loan-to-value and debt-service coverage were 28.5% and 3.41 times, respectively. The average vacancy level for the San Francisco CRE loans was 5.8%, of which the vast majority are single-tenant small spaces in office buildings situated outside of downtown.
The Company’s land and construction loans are primarily to finance the development and 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 increased $13.1 million, or 9%, to $166.4 million at March 31, 2023, compared to $153.3 million at March 31, 2022, and increased $2.8 million, or 2%, from $163.6 million at December 31, 2022.
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 increased $12.9 million, or 12%, to $124.5 million at March 31, 2023, compared to $111.6 million at March 31, 2022, and increased $3.8 million, or 3%, from $120.7 million at December 31, 2022.
Multifamily loans increased $9.5 million, or 4%, to $231.2 million, at March 31, 2023, compared to $221.7 million at March 31, 2022, and decreased ($13.7) million, or (6%), from $244.9 million at December 31, 2022.
From time to time the Company has purchased single family residential mortgage loans. Purchases of residential loans have been an attractive alternative for replacing mortgage-backed security paydowns in the investment securities
56
portfolio. Residential mortgage loans increased $137.5 million, or 35%, to $528.6 million at March 31, 2023, compared to $391.2 million at March 31, 2022, and decreased ($9.3) million, or (2%) from $537.9 million at December 31, 2022.
During the year ended December 31, 2022, the Company purchased single family residential mortgage loans totaling $185.4 million, tied to homes all located in California, with average principal balances of approximately $950,000.
Consumer and other loans increased $795,000, or 5%, to $17.9 million at March 31, 2023, compared to $17.1 million at March 31, 2022, and increased $872,000, or 5% from $17.0 million at December 31, 2022.
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 totaling 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 $106.5 million and $177.5 million at March 31, 2023, respectively.
Loan Maturities
The following table presents the maturity distribution of the Company’s loans (excluding loans held-for-sale) as of March 31, 2023. 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 March 31, 2023, approximately 31% 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
266,900
185,827
53,875
29,242
132,816
441,240
17,795
300,601
765,456
140,067
17,871
8,470
3,201
36,457
84,823
3,836
88,445
138,961
1,852
20,656
506,131
11,965
4,407
1,533
474,858
787,080
2,000,489
Loans with variable interest rates
409,059
286,346
312,341
1,007,746
Loans with fixed interest rates
65,799
500,734
1,688,148
2,254,681
57
Loan Servicing
As of March 31, 2023 and 2022, $61.7 million and $69.3 million, respectively, in SBA loans were serviced by the Company for others. Activity for loan servicing rights was as follows:
549
655
Additions
(45)
(87)
606
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 March 31, 2023 and 2022, as the fair value of the assets was greater than the carrying value.
Activity for the I/O strip receivable was as follows:
221
Unrealized holding loss
(7)
208
Credit Quality and Allowance for Credit Losses on Loans
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 $21.1 million and $17.1 million at March 31, 2023 and December 31, 2022, respectively, of which $410,000 and $479,000 were on nonaccrual. At March 31, 2023, there were also $371,000 loans less than 30 days past due included in
nonaccrual loans held-for-investment. At December 31, 2022, there were also $261,000 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 on all nonaccrual loans. 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
3,303
Restructured and loans 90 days past due and
still accruing
527
Total nonperforming loans
3,830
Foreclosed assets
Total nonperforming assets
Nonperforming assets as a percentage of loans
plus foreclosed assets
0.07
0.13
Nonperforming assets as a percentage of total assets
0.04
0.05
Nonperforming assets were $2.2 million, or 0.04% of total assets, at March 31, 2023, compared to $3.8 million, or 0.07% of total assets, at March 31, 2022, and $2.4 million, or 0.05% of total assets, at December 31, 2022.
The following table presents the amortized cost basis of nonperforming loans and loans past due over 90 days and still accruing at the periods indicated:
with no Special
with Special
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 amortized cost basis of collateral-dependent commercial loans collateralized by business assets totaled $394,000 and $324,000 at March 31, 2023 and December 31, 2022, respectively.
Classified loans decreased to $26.8 million, or 0.48% of total assets, at March 31, 2023, compared to $30.6 million, or 0.56% of total assets, at March 31, 2022, and $14.5 million, or 0.28% of total assets at December 31, 2022.
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 ACLL is calculated by using the current expected credit loss (“CECL”) methodology. The ACLL estimation process involves procedures to appropriately consider the unique characteristics of loan portfolio segments. These segments are further disaggregated into loan classes, the level at which credit risk is monitored. When computing the level of expected credit losses, credit loss assumptions are estimated using a model that categorizes loan pools based on loss history, delinquency status, and other credit trends and risk characteristics, including current conditions and reasonable and supportable forecasts about the future. Determining the appropriateness of the allowance is complex and requires judgment by management about the effect of matters that are inherently uncertain. In future periods, evaluations of the overall loan portfolio in light of the factors and forecasts then prevailing, may result in significant changes in the allowance and credit loss expense in those future periods.
The allowance level is influenced by loan volumes, loan risk rating migration or delinquency status, changes in historical loss experience, and other conditions influencing loss expectations, such as reasonable and supportable forecasts of economic conditions. The methodology for estimating the amount of expected credit losses reported in the allowance for credit losses has two basic components: first, an asset-specific component involving individual loans that do not share risk characteristics with other loans and the measurement of expected credit losses for such individual loans; and second, a pooled component for estimated expected credit losses for pools of loans that share similar risk characteristics.
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 credit losses on loans.
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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 primarily rely on the identified cash flows of the borrower for repayment and secondarily on the value of underlying collateral provided by the borrower. However, the cash flows of the borrowers may not be as expected and the collateral securing these loans may vary in value. Most commercial loans are secured by the assets being financed or on other business assets such as accounts receivable, inventory or equipment and may incorporate a personal guarantee; however, some loans may be unsecured. Included in commercial loans are $565,000 of PPP loans at March 31, 2023, $37.4 million at March 31, 2022, and $1.2 million at December 31, 2022. No allowance for credit losses has been recorded for PPP loans as they are fully guaranteed by the SBA at March 31, 2023, March 31, 2022, and December 31, 2022.
Home equity loans are secured by 1-4 family residences that are generally owner occupied. Repayment of these loans depends primarily on the personal income of the borrower and secondarily on the value of the property securing the loan which can be impacted by changes in economic conditions such as the unemployment rate and property values.
Residential mortgage loans are secured by 1-4 family residences which are generally owner-occupied. Repayment of these loans depends primarily on the personal income of the borrower and secondarily by the value of the property securing the loan which can be impacted by changes in economic conditions such as the unemployment rate and property values.
Consumer and other loans are secured by personal property or are unsecured and rely primarily on the income of the borrower for repayment and secondarily on the collateral value for secured loans. Borrower income and collateral value can vary dependent on economic conditions.
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Allocation of Allowance for Credit Losses on Loans
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 credit losses on loans and the associated provision for credit losses on loans.
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 Financial Protection and Innovation (“DFPI”) also review the allowance for credit losses on loans as an integral part of the examination process. Based on information currently available, management believes that the allowance for credit losses on loans 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 further. 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.
Mortgages
The decrease in the allowance for credit losses on loans to $47.3 million March 31, 2023, compared to $47.5 million December 31, 2022, was primarily attributed to a net decrease of $343,000 in the reserve for pooled loans, driven by a decrease in the loan portfolio, partially offset by a $104,000 increase in specific reserves for individually evaluated loans.
The following table provides a summary of the allocation of the allowance for credit losses on loans by class at the dates indicated. The allocation presented should not be interpreted as an indication that charges to the allowance for credit losses on loans 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.
of Loans
in each
category
to total
loans
The ACLL totaled $47.3 million, or 1.45% of total loans at March 31, 2023, compared to $42.8 million, or 1.41% of total loans at March 31, 2022, and $47.5 million, or 1.44% of total loans at December 31, 2022. The ACLL was 2,110% of nonperforming loans at March 31, 2023, compared to 1,117% of nonperforming loans at March 31, 2022, and 1,959% of nonperforming loans at December 31, 2022. The Company had net charge-offs of $271,000, or 0.03% of average loans, for the first quarter of 2023, compared to net recoveries of ($65,000) or (0.01%) of average loans, for the first quarter of 2022, and net recoveries of ($83,000), or (0.01%) of average loans for the fourth quarter of 2022. The total ACLL is sensitive to the forecasted economic factors management has selected in the calculation of the allowance, among other assumptions and inputs including qualitative factors. A forecast of a decline in California GDP, an increase in California unemployment rate, and declining California home and commercial real estate prices would result in an increase in the ACLL.
The following table shows the drivers of change in ACLL under CECL for first quarter of 2023:
ACLL at December 31, 2022
Portfolio changes during the first quarter of 2023
Qualitative and quantitative changes during the first
quarter of 2023 including changes in economic forecasts
ACLL at March 31, 2023
Leases
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'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 $32.1 million on its consolidated statement of financial condition at March 31, 2023, 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.
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.
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The following table summarizes the distribution of deposits and the percentage of distribution in each category of deposits for the periods indicated:
1,811,943
1,268,942
1,447,434
Time deposits — under $250
38,417
Time deposits — $250 and over
93,161
ICS/CDARS — interest-bearing demand,
money market and time deposits
30,008
4,689,905
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 at March 31, 2023, March 31, 2022, and December 31, 2022.
Total deposits decreased ($245.4) million, or (5%), to $4.445 billion at March 31, 2023, compared to $4.690 billion at March 31, 2022, and increased $54.9 million, or 1%, from $4.390 billion at December 31, 2022. Noninterest-bearing demand deposits decreased ($342.9) million, or (19%), to $1.469 billion at March 31, 2023, compared to $1.812 billion at March 31, 2022, and decreased ($267.6) million, or (15%), from $1.737 billion at December 31, 2022. Noninterest-bearing deposits shifted during the quarter to the Bank’s interest-bearing deposits, primarily due to the acceleration of recent rate hikes by the Federal Reserve Bank, prompting customers to seek higher yields. ICS/CDARS deposits increased $274.1 million, or 914%, to $304.1 million at March 31, 2023, compared to $30.0 million at March 31, 2022, and increased $273.7 million, or 901%, from $30.4 million at December 31, 2022, primarily due to bringing $128.0 million of off-balance sheet relationship-based client deposits onto the balance sheet, and an increase in client deposits during the first quarter of 2023.
Uninsured deposits represented approximately 57% of total deposits at March 31, 2023. The Company had 24,103 deposit accounts at March 31, 2023, with an average balance of $184,000. Deposits from the top 100 client relationships totaled $2.201 billion, representing 50% of total deposits, with an average account size of $445,000, representing 21% of the total number of accounts at March 31, 2023.
At March 31, 2023, the $304.1 million ICS/CDARS deposits comprised $241.3 million of interest-bearing demand deposits, $58.3 million of money market accounts and $4.5 million of time deposits. At March 31, 2022, the $30.0 million ICS/CDARS deposits comprised $22.9 million of interest-bearing demand deposits, $1.5 million of money market accounts and $5.6 million of time deposits. At December 31, 2022, the $30.4 million CDARS deposits comprised $26.0 million of interest-bearing demand deposits, $1.1 million of money market accounts and $3.3 million of time deposits.
The following table indicates the contractual maturity schedule of the Company’s uninsured time deposits in excess of $250,000 as of March 31, 2023:
% of Total
Three months or less
51,402
Over three months through six months
15,550
Over six months through twelve months
54,643
Over twelve months
4,225
125,820
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.
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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
1.47
0.96
Return on average tangible assets
1.52
0.99
Return on average equity
12.03
8.71
Return on average tangible common equity
16.71
12.47
Average equity to average assets ratio
12.18
11.01
Liquidity, Asset/Liability Management and Available Lines of Credit
The Company’s liquidity position supports its ability to maintain cash flows sufficient to fund operations, meet all of its financial obligations and commitments, and accommodate unexpected sudden changes in balances of loans and deposits in a timely manner. 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 repayment of liabilities. An integral part of the Company’s ability to manage its liquidity position appropriately is derived from its 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.
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. 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.
One of the measures of liquidity is the loan to deposit ratio. The loan to deposit ratio was 73.39% at March 31, 2023, compared to 64.48% at March 31, 2022, and 75.14% at December 31, 2022.
The Company’s total liquidity and borrowing capacity was $3.073 billion, of which $2.773 billion was remaining available at March 31, 2023. The remaining available liquidity and borrowing capacity of $2.773 billion was 62% of total deposits and approximately 110% of estimated uninsured deposits of $2.532 billion at March 31, 2023. During the first quarter of 2023, the Bank increased its credit line availability from the FRB and the FHLB from $839.5 million at December 31, 2022 to $2.022 billion at March 31, 2023.
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 $653.0 million of loans and $377.5 million of securities pledged to the FHLB as collateral on an available line of credit of $789.9 million at March 31, 2023, of which $150 million was outstanding. The Bank repaid in full the $150.0 million outstanding on April 20, 2023. HBC had no overnight borrowings from the FHLB at March 31, 2022, and December 31, 2022.
HBC can also borrow from the FRB’s discount window. HBC had $1.622 billion of loans and securities pledged to the FRB as collateral on an available line of credit of $1.232 billion at March 31, 2023, of which $150.0 million was outstanding. The Bank repaid in full the $150.0 million outstanding on April 20, 2023. There were no outstanding balances at March 31, 2022 and December 31, 2022.
At March 31, 2023, HBC had Federal funds purchased arrangements available of $80.0 million. There were no Federal funds purchased outstanding at March 31, 2023, March 31, 2022, and December 31, 2022.
The Company has a $20.0 million line of credit with a correspondent bank, of which none was outstanding at March 31, 2023, March 31, 2022, and December 31, 2022.
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.
On May 11, 2022, the Company completed a private placement offering of $40.0 million aggregate principal amount of its 5.00% fixed-to-floating rate subordinated notes due May 15, 2032 (“Sub Debt due 2032”). The Company used the net proceeds of the Sub Debt due 2032 for general corporate purposes, including the repayment on June 1, 2022 of the Company’s $40.0 million aggregate principal amount of 5.25% fixed-to-floating rate subordinated notes due June 1, 2027 (“Sub Debt due 2027”). The Sub Debt due 2032, net of unamortized issuance costs of $613,000, totaled $39.4 million at March 31, 2023, and qualifies as Tier 2 capital for the Company under the guidelines established by the Federal Reserve Bank
On May 26, 2017, the Company completed an underwritten public offering of $40.0 million aggregate principal amount of its Sub Debt due 2027. The Sub Debt due 2027 had a fixed interest rate of 5.25% per year through June 1, 2022. On June 1, 2022, the Company completed the redemption of all of its outstanding $40.0 million of Sub Debt due 2027, prior to resetting to a floating rate. The Sub Debt due 2027 was redeemed pursuant to the terms of the Subordinated Indenture, as supplemented by the First Supplemental Indenture, each dated as of May 26, 2017, between the Company and Wilmington Trust, National Association, as Trustee, at the redemption price of 100% of its principal amount.
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
438,203
Additional Tier 1 capital
Tier 2 Capital
81,824
75,069
79,201
513,272
Risk-weighted assets
3,710,037
3,525,741
3,747,246
Average assets for capital purposes
5,069,944
5,256,141
5,196,294
Capital ratios:
14.6
12.4
Common equity Tier 1 Capital
Tier 1 Leverage(1)
8.3
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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:
456,267
42,437
35,082
39,851
491,349
3,712,417
3,524,365
3,745,725
5,068,039
5,254,169
5,194,802
13.9
12.9
8.7
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
The Basel III capital rules introduced a “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 March 31, 2023, 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 March 31, 2023, March 31, 2022, and December 31, 2022, the Company and HBC met all capital adequacy guidelines to which they were subject.
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At March 31, 2023, the Company had total shareholders’ equity of $647.2 million, compared to $601.1 million at March 31, 2022, and $632.5 million at December 31, 2022. At March 31, 2023, total shareholders’ equity included $504.1 million in common stock, $157.4 million in retained earnings, and ($14.3) million of accumulated other comprehensive loss. The book value per share was $10.62 at March 31, 2023, compared to $9.95 at March 31, 2022, and $10.39 at December 31, 2022. The tangible book value per share was $7.70 at March 31, 2023, compared to $6.96 at March 31, 2022, and $7.46 at December 31, 2022.
The following table reflects the components of accumulated other comprehensive loss, net of taxes, for the periods indicated:
Accumulated Other Comprehensive Loss
Unrealized loss on securities available-for-sale
(8,924)
(11,506)
(1,127)
Split dollar insurance contracts liability
(3,139)
(3,091)
(5,491)
Supplemental executive retirement plan liability
(2,361)
(2,371)
(7,588)
Unrealized gain on interest-only strip from SBA loans
107
112
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. 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 Management
The Company’s market risk exposure is primarily that of interest rate risk, and it has established policies and procedures to monitor and limit earnings and balance sheet exposure to changes in interest rates. The Company does not engage in the trading of financial instruments, nor does the Company have exposure to currency exchange rates.
The principal objective of interest rate risk management (often referred to as “asset/liability management”) is to manage the financial components of the Company in a manner that will optimize the risk/reward equation for earnings and capital in relation to changing interest rates. 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 factors, an interest sensitivity GAP report may not provide a complete assessment of the exposure to changes in interest rates.
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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). Critical assumptions in the Company’s interest rate risk model, like deposit beta assumptions, are reviewed and updated regularly to reflect current market conditions. The deposit beta assumptions were reviewed and increased as of March 31, 2023 for the upward shock scenarios.
The following table sets forth the estimated changes in the Company’s annual net interest income that would result from an instantaneous shift in interest rates from the base rate as of March 31, 2023:
Increase/(Decrease) in
Estimated Net
Interest Income(1)
Change in Interest Rates (basis points)
+400
14,603
7.1
+300
10,917
5.3
+200
7,254
3.5
+100
3,618
1.8
−100
(6,667)
(3.2)
−200
(19,823)
(9.6)
−300
(35,220)
(17.1)
−400
(50,409)
(24.4)
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.
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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 March 31, 2023. 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 March 31, 2023, the period covered by this report on Form 10-Q.
During the three months ended March 31, 2023, 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
We evaluate all claims and lawsuits with respect to their potential merits, our potential defenses and counterclaims, settlement or litigation potential and the expected effect on us. The outcome of any claims or litigation, regardless of the merits, is inherently uncertain. Any claims and other lawsuits, and the disposition of such claims and lawsuits, whether through settlement or litigation, could be time-consuming and expensive to resolve, divert our attention from executing our business plan, result in efforts to enjoin our activities, and lead to attempts by third parties to seek similar claims.
For more information regarding legal proceedings, see Note 13 “Commitments and Loss Contingencies” to the consolidated financial statements.
ITEM 1A—RISK FACTORS
The following discussion supplements the discussion of risk factors affecting us as set forth in Part I, Item 1A. Risk Factors, on pages 26-50, of our 2022 Annual Report on Form 10-K. The discussion of risk factors, as so supplemented, provides a description of some of the important risk factors that could affect our actual results and could cause our results to vary materially from those expressed in public statements or documents. However, other factors besides those included in the discussion of risk factors, as so supplemented, or discussed elsewhere in other of our reports filed with or furnished to the SEC could affect our business or results.
Adverse developments affecting the banking industry, and resulting media coverage, have eroded customer confidence in the banking system and could have a material effect on the Company’s operations and/or stock price.
The recent high-profile bank failures of Silicon Valley Bank, Signature Bank and First Republic have generated significant market volatility among publicly traded bank holding companies. These market developments have negatively impacted customer confidence in the safety and soundness in the financial services industry. As a result, customers may choose to maintain deposits with larger financial institutions or invest in higher yielding short-term fixed income securities, all of which could materially adversely impact our liquidity, cost of funding, loan funding capacity, net interest margin, capital, and results of operations. In connection with high-profile bank failures, uncertainty and concern has been, and may be in the future, compounded by advances in technology that increase the speed at which deposits can be moved, as well as the speed and reach of media attention, including social media, and its ability to disseminate concerns or
rumors, in each case potentially exacerbating liquidity concerns. While the Department of the Treasury, the Federal Reserve, and the Federal Deposit Insurance Corporation (“FDIC”) have made statements ensuring that depositors of recently failed banks would have access to their deposits, including uninsured deposit accounts, there is no guarantee that such actions will be successful in restoring customer confidence in the banking system.
In addition, the banking operating environment and public trading prices of banking institutions can be highly correlated, in particular during times of stress, which could adversely impact the trading prices of our common stock.
These recent events may also result in potentially adverse changes to laws or regulations governing banks and bank holding companies or result in the impositions of restrictions through supervisory or enforcement activities, including higher capital requirements, which could have a material impact on our business. The cost of resolving the recent bank failures may prompt the FDIC to increase its premiums above the recently increased levels or to issue additional special assessments.
Rising interest rates have decreased the value of a portion of the Company’s securities portfolio, and the Company would realize losses if it were required to sell such securities to meet liquidity needs.
As a result of inflationary pressures and the resulting rapid increases in interest rates over the last year, the fair value of our securities classified as available-for-sale has declined, resulting in unrealized losses embedded in accumulated other comprehensive loss as a part of shareholders’ equity. If the Company were required to sell such securities to meet liquidity needs, including in the event of deposit outflows or slower deposit growth, it may incur losses.
The loss of our deposit clients or substantial reduction of our deposit balances could force us to fund our business with more expensive and less stable funding sources.
As of March 31, 2023, deposits from our top 100 client relationships accounted for, in the aggregate, 50% of our total deposits. The deposits not insured by the FDIC (approximately $2.537 billion of uninsured deposits, or 57%, of our total deposits of $4.445 billion at March 31, 2023) could present a heightened risk of withdrawal, if such depositors materially decreased the volume of those deposits and it could reduce our liquidity. We have traditionally obtained funds through deposits for use in lending and investment activities. The interest rates stated for borrowings typically exceed the interest rates paid on deposits. Deposit outflows can occur for a number of reasons, including; clients may seek investments with higher yields, clients with uninsured deposits may seek greater financial security during prolonged periods of volatile and unstable market conditions. If a significant portion of our deposits were withdrawn, we may need to rely more heavily on more expensive borrowings and other sources of funding to fund our business and meet withdrawal demands, adversely affecting our net interest margin. The occurrence of any of these events could materially and adversely affect our business, results of operations and financial condition.
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
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 August 29, 2019 (incorporated by reference to Exhibit 3.3 to the Registrant’s Quarterly Report on Form 10-Q filed on November 11, 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 Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document
101.SCH
XBRL Taxonomy Extension Schema
101.CAL
XBRL Taxonomy Extension Calculation Linkbase
101.DEF
XBRL Taxonomy Extension Definition Linkbase
101.LAB
XBRL Taxonomy Extension Label Linkbase
101.PRE
XBRL Taxonomy Extension Presentation Linkbase
104.
The cover page from Heritage Commerce Corp's Quarterly Report on Form 10-Q for the quarter ended March 31, 2023, formatted in Inline XBRL
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: May 5, 2023
/s/ Robertson clay jones
Robertson Clay Jones
Chief Executive Officer
/s/ Lawrence D. mcgovern
Lawrence D. McGovern
Chief Financial Officer