UNITED STATES SECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
(Mark One)
For the quarterly period ended June 30, 2004 or
For the transition period from _____________ to _____________
Commission File Number: 000-50245
NARA BANCORP, INC.
(213) 639-1700
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No o
As of July 31, 2004, there were 23,208,838 outstanding shares of the issuer’s Common Stock, $0.001 par value.
Table of Contents
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PART I
FINANCIAL INFORMATION
Item 1. Financial Statements
NARA BANCORP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION(Unaudited)
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See notes to condensed consolidated financial statements
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CONDENSED CONSOLIDATED STATEMENTS OF INCOME
For the three and six months ended June 30, 2004 and 2003(Unaudited)
See accompanying notes to condensed consolidated financial statements
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CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
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Notes to unaudited Consolidated Financial Statements
1. Nara Bancorp, Inc.
Nara Bancorp, Inc. (“Nara Bancorp”, on a parent-only basis, and “we” or “our” on a consolidated basis), incorporated under the laws of the State of Delaware in 2000, is a bank holding company, headquartered in Los Angeles, California, offering a full range of commercial banking and consumer financial services through its wholly owned subsidiary, Nara Bank, N.A., a national bank (“Nara Bank”) with branches in California and New York as well as Loan Production Offices in California, Washington, Colorado, Georgia, Illinois, New Jersey, and Virginia.
2. Basis of Presentation
Our condensed consolidated financial statements included herein have been prepared without an audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures, normally included in consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America, have been condensed or omitted pursuant to such SEC rules and regulations.
The condensed consolidated financial statements include the accounts of Nara Bancorp and its wholly owned subsidiaries, principally Nara Bank, N. A. (the “Bank”). All intercompany transactions and balances have been eliminated in consolidation.
Nara Bancorp also has five special-purpose subsidiaries that were formed for capital-raising transactions: Nara Capital Trust I, Nara Statutory Trust II, Nara Capital Trust III, Nara Statutory Trust IV, and Nara Statutory Trust V. With the adoption of FASB Interpretation No. 46 (“FIN 46”) Nara Bancorp deconsolidated the five grantor trusts as of December 31, 2003. As a result, the junior subordinated debentures issued by Bancorp to the grantor trusts, totaling $39.3 million, are reflected in our consolidated balance sheet in the liabilities section at June 30, 2004 and December 31, 2003, under the caption as “junior subordinated debentures.” We also recorded $2.1 million in other assets in the consolidated statement of financial condition at June 30, 2004 and December 31, 2003 for the common capital securities issued by the issuer trusts.
We also believe that we have made all adjustments necessary to fairly present our financial position and the results of our operations for the interim period ended June 30, 2004. Certain reclassifications have been made to prior period figures in order to conform to the June 30, 2004 presentation. The results of operations for the interim period are not necessarily indicative of results for the full year.
These condensed consolidated financial statements should be read along with the audited consolidated financial statements and accompanying notes included in our 2003 Annual Report on Form 10-K/A.
3. Stock-Based Compensation
Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation, encourages, but does not require, companies to record compensation cost for stock-based employees compensation plans at fair value. We have elected to continue to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion (“APB”) No. 25, Accounting for Stock Issued to Employees, and related interpretations. Accordingly, compensation cost for stock options is measured as the excess, if any, of the fair value of our stock at the date of grant over the grant price.
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We have adopted the disclosure only provisions of SFAS No. 123. Had compensation cost for our stock-based compensation plans been determined based on the fair value at the grant date for awards consistent with the provisions of SFAS No. 123, our net income would have been reduced to the pro forma amounts as follows:
No options were granted during the second quarter of 2004. The weighted-average fair value of options granted during the second quarter of 2003 was $4.81. The fair value of options granted under our stock option plans during the second quarter of 2003 was estimated on the date of grant using the Black-Scholes option-pricing model, with the following weighted-average assumptions used: 0.5% dividends yield, volatility of 35.10% with risk-free interest rate of 2.3% and expected lives of three to five years. The weighted-average fair value of options granted during the six months of 2004 was $12.46. The fair value of options granted under our stock option plans during the first six months of 2004 was estimated on the date of grant using the Black-Scholes option-pricing model, with the following weighted-average assumptions used: 0.67% dividend yield, volatility of 38.68%, risk-free interest rate of 3.5% and expected lives of six years.
4. Dividends
On May 17, 2004, we declared a $0.0275 per share cash dividend paid on July 14, 2004 to stockholders of record at the close of business on June 30, 2004. On March 11, 2004, we declared a $0.025 per share cash dividend paid on April 12, 2004 to stockholders of record at the close of business on March 31, 2004.
5. Stock Splits
On May 17, 2004, Nara Bancorp announced that its Board of Directors approved a two-for-one stock split of its common stock, effected in the form of a 100% stock dividend, which was distributed on June 15, 2004 to stockholders of record on close of business on May 31, 2004. The effect of this dividend is that stockholders received one additional share of Nara Bancorp common stock for each share owned. All share and per share information have been restated to reflect the stock split.
6. Earnings Per Share (“EPS”)
Basic EPS excludes dilution and is computed by dividing net income by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted to common stock that would then share in our earnings.
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The following table shows how we computed basic and diluted EPS for the periods ended June 30, 2004 and 2003.
For the six months ended June 30,
For the three months ended June 30,
7. SBA
Certain Small Business Administration (“SBA”) loans that we have the intent to sell prior to maturity have been designated as held for sale at origination and are recorded at the lower of cost or market value on an aggregate basis. A valuation allowance is established if the aggregate market value of such loans is lower than their cost and operations are charged or credited for valuation adjustments. A portion of the premium on sale of SBA loans is recognized as gain on sale of loans at the time of the sale. The remaining portion of the premium (relating to the portion of the loan retained) is deferred and amortized over the remaining life of the loan as an adjustment to yield. Servicing assets are recognized when loans are sold with servicing retained. Servicing assets are recorded based on the present value of the contractually specified servicing fee, net of servicing costs, over the estimated life of the loan, using a discount rate based on the related note rate, plus 1 to 2%. Servicing assets are amortized in proportion to and over the period of estimated future net servicing income.
We periodically evaluate servicing assets for impairment. At June 30, 2004, the fair value of servicing assets was determined using a weighted-average discount rate of 6.8% and a prepayment speed of 11.5%. At December 31, 2003, the fair value of servicing assets was determined using a weighted-average discount rate of 6.9% and a prepayment speed of 11.4%. For purposes of measuring impairment, servicing assets are stratified by
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loan type. An impairment is recognized if the carrying value of servicing assets exceeds the fair value of the stratum. The fair values of servicing assets exceeded the carrying amounts and were $3,784,000 and $3,376,000 at June 30, 2004 and December 31, 2003, respectively.
An interest-only strip is recorded based on the present value of the excess of the total future income from serviced loans over the contractually specified servicing fee, calculated using the same assumptions as used to value the related servicing assets. Such interest-only strip is accounted for at estimated fair value, with unrealized gain or loss, net of tax, recorded as a component of accumulated other comprehensive income (loss).
8. Goodwill and Other Intangible Assets
In July 2001, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 141 requires that the purchase method of accounting be used for all business combinations completed after June 30, 2001 and also specifies the types of acquired intangible assets that are required to be recognized and reported separately from goodwill and those acquired intangible assets that are required to be included in goodwill. SFAS No. 142 requires that goodwill no longer be amortized, but instead be tested for impairment at least annually. Additionally, SFAS No. 142 requires recognized intangible assets to be amortized over their respective estimated useful lives and reviewed for impairment. We adopted SFAS No. 142 on January 1, 2002.
We tested goodwill for impairment as of December 31, 2003, noting no impairment in recorded goodwill of $1.9 million. No conditions indicated any impairment as of June 30, 2004. There were no changes in goodwill for the three and six months ended June 30, 2004 and 2003.
We also tested intangible assets for impairment as of December 31, 2003, noting no impairment. We will continue to amortize intangible assets, representing core deposit intangibles, over their original estimated useful lives of seven years. There were no additions to core deposits intangibles during the three and six months ended June 30, 2004 and 2003.
As of June 30, 2004, intangible assets subject to amortization include core deposit intangibles of $4,439,659 (net of $1,165,247 accumulated amortization) and servicing assets of $ 3,068,200. Amortization expenses for such intangible assets were $324,544 and $651,128 for the three and six months ended June 30, 2004, respectively. Estimated amortization expense for intangible assets for the remainder of 2004 and the five succeeding fiscal years follows:
9. Recent Accounting Pronouncements
In January 2003, the FASB issued Interpretation No. 46 — “Consolidation of Variable Interest Entities” (“FIN 46”). In December 2003, the FASB revised FIN 46 and codified certain FASB Staff Positions previously issued for FIN 46 (“FIN 46R). The objective of FIN 46 as originally issued, and as revised by FIN 46R, was to improve financial reporting by companies involved with variable interest entities. Prior to the effectiveness of FIN 46, we generally included another entity in our consolidated financial statements only if we controlled the entity through voting interests. FIN 46 changed that standard by requiring a variable interest entity to be consolidated if we were subject to a majority of the risk of loss from the variable interest entity’s activities or entitled to receive a majority of the entity’s residual returns or both.
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The consolidation requirements of FIN 46 applied immediately to variable interest entities created after January 31, 2003. The consolidation requirements applied to older entities in the first fiscal year or interim period beginning after June 15, 2003. The provisions of FIN 46R are required to be adopted prior to the first reporting period that ends after March 15, 2004. The adoption of FIN 46 and FIN46R did not have a significant impact on our financial position, results of operations, or cash flows.
In December 2003, the Accounting Standards Executive Committee of the AICPA issued Statement of Position No. 03-3 (“SOP 03-3”), Accounting for Certain Loans or Debt Securities Acquired in a Transfer. SOP 03-3 addresses the accounting for differences between the contractual cash flows and the cash flows expected to be collected from purchased loans or debt securities if those differences are attributable, in part, to credit quality. SOP 03-3 requires purchased loans and debt securities to be recorded initially at fair value based on the present value of the cash flows expected to be collected with no carryover of any valuation allowance previously recognized by the seller. Interest income should be recognized based on the effective yield from the cash flows expected to be collected. To the extent that the purchased loans or debt securities experience subsequent deterioration in credit quality, a valuation allowance would be established for any additional cash flows that are not expected to be received. However, if more cash flows subsequently are expected to be received than originally estimated, the effective yield would be adjusted on a prospective basis. SOP 03-3 will be effective for loans and debt securities acquired after December 31, 2004. Although we anticipate that the implementation of SOP 03-3 will require significant loan system and operational changes to track credit related losses on loans purchased starting in 2005, we do not expect to have a significant effect on the consolidated financial statements.
In March 2004, the Emerging Issues Task Force (EITF) reached consensus on the guidance provided in EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments(EITF 03-1) as applicable to debt and equity securities that are within the scope of SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities and equity securities that are accounted for using the cost method specified in Accounting Policy Board Opinion No. 18 The Equity Method of Accounting for Investments in Common Stock. An investment is impaired if the fair value of the investment is less than its cost. EITF 03-1 outlines that an impairment would be considered other-than-temporary unless: a) the investor has the ability and intent to hold an investment for a reasonable period of time sufficient for the recovery of the fair value up to (or beyond) the cost of the investment, and b) evidence indicating that the cost of the investment is recoverable within a reasonable period of time outweighs evidence to the contrary. Although not presumptive, a pattern of selling investments prior to the forecasted recovery of fair value may call into question the investor’s intent. In addition, the severity and duration of the impairment should also be considered in determining whether the impairment is other-than-temporary. This new guidance for determining whether impairment is other-than-temporary is effective for reporting periods beginning after June 15, 2004. Adoption of this standard may cause us to recognize impairment losses in the consolidated statements of income which would not have been recognized under the current guidance or to recognize such losses in earlier periods, especially those due to increases in interest rates. Since fluctuations in the fair value for available-for-sale securities are already recorded in accumulated other comprehensive Income, adoption of this standard is not expected to have a significant impact on stockholders’ equity.
10. Commitments and Contingencies
We are a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit, standby letters of credit, and commercial letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated statements of financial condition. Our exposure to credit loss in the event of nonperformance by the other party to commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. We use the same credit policies in making commitments and conditional obligations as we do for extending loan facilities to customers. We evaluate each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary upon extension of credit, is based on our credit evaluation of the counterparty. Collateral held varies but may include accounts receivable; inventory; property, plant, and equipment; and income-producing properties.
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Commitments at June 30, 2004 are summarized as follows:
In the normal course of business, we are involved in various legal claims. We have reviewed all legal claims against us with counsel and have taken into consideration the views of such counsel as to the outcome of the claims. In our opinion, the final disposition of all such claims will not have a material adverse effect on our financial position and results of operations.
11. Derivative Financial Instruments and Hedging Activities
As part of our asset and liability management strategy, we may engage in derivative financial instruments, such as interest rate swaps, with the overall goal of minimizing the impact of interest rate fluctuations on our net interest margin. During the second and fourth quarters of 2002, we entered into various interest rate swap agreements as summarized in the table below. Our objective for the interest rate swaps is to manage asset and liability positions in connection with our overall strategy of minimizing the impact of interest rate fluctuations on our interest rate margin. As part of our overall risk management, our Asset Liability Committee monitors and measures the interest rate risk and the sensitivity of our assets and liabilities to interest rate changes, including the impact of the interest rate swaps.
Under the swap agreements, we receive a fixed rate and pay a variable rate based on H.15 Prime. The swaps qualify as cash flow hedges under SFAS No. 133,Accounting for Derivative Instruments and Hedging Activities, as amended and interpreted, and are designated as hedges of the variability of cash flows we receive from certain of our Prime-indexed loans. In accordance with SFAS No. 133, these interest rate swap agreements are measured at fair value and reported as assets or liabilities on the consolidated statement of financial condition. The portion of the change in the fair value of the interest rate swaps that is deemed effective in hedging the cash flows of the designated assets are recorded in accumulated other comprehensive income (“OCI”), net of tax and reclassified into interest income when such cash flows occur in the future. Any ineffectiveness resulting from the hedges is recorded as a gain or loss in the consolidated statement of income as a part of non-interest income. As of June 30, 2004, the amounts in accumulated OCI associated with these cash flows totaled a loss of $686,084 (net of tax of $457,390), of which $105,447 is expected to be reclassified into interest income within the next 12 months. As of June 30, 2004, the maximum length of time over which we are hedging our exposure to the variability of future cash flow is approximately 8.5 years.
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Interest rate swap information at June 30, 2004 is summarized as follows:
1. Loss included in the consolidated statement of income for the six months ended June 30, 2004, representing hedge ineffectiveness. Hedge ineffectiveness was ($1,025,756), $280,067 and $427,924 for the three months ended June 30, 2004 and 2003 and six months ended June 30, 2003, respectively
2. Prime rate is based on Federal Reserve statistical release H.15
During the second quarter of 2004 and 2003, interest income received from swap counterparties were $904,945 and $816,472, respectively. During the first six months of 2004 and 2003, interest income received from swap counterparties were $1.8 million and $1.6 million, respectively. At June 30, 2004 and 2003, we pledged as collateral to the interest rate swap counterparties agency securities with a book value of $2.0 million and real estate loans of $5.9 million.
12. Business Segments
Our management utilizes an internal reporting system to measure the performance of our various operating segments. We have identified three principal operating segments for the purposes of management reporting: banking operation, trade finance (“TFS”), and small business administration (“SBA”). Information related to our remaining centralized functions and eliminations of intersegment amounts have been aggregated and included in banking operation. Although all three operating segments offer financial products and services, they are managed separately based on each segment’s strategic focus. The banking operation segment focuses primarily on commercial and consumer lending and deposit operations throughout our branch network. The TFS segment focuses primarily on allowing our import/export customers to handle their international transactions. Trade finance products include the issuance and collection of letters of credit, international collection, and import/export financing. The SBA segment provides our customers with the U.S. SBA guaranteed lending program.
Operating segment results are based on our internal management reporting process, which reflects assignments and allocations of capital, certain operating and administrative costs and the provision for loan losses. Non-interest income and non-interest expense, including depreciation and amortization, directly attributable to a segment are assigned to that business. We allocate indirect costs, including overhead expense, to the various segments based on several factors, including, but not limited to, full-time equivalent employees, loan volume and deposit volume. We allocate the provision for loan losses based on the origination of new loans for the period. We evaluate the overall performance based on profit or loss from operations before income taxes excluding nonrecurring gains and losses. Future changes in our management structure or reporting methodologies may result in changes to the measurement of operating segment results.
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The following tables present the operating results and other key financial measures for the individual operating segments for the three and six months ended June 30, 2004 and 2003.
For the Six Months Ended June 30(Dollars in thousands)
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For the Three Months Ended June 30(Dollars in thousands)
13. Other Comprehensive Income
The following table shows the reclassification of other comprehensive income for the six months ended June 30, 2004 and 2003.
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14. Other Than Temporary Impairment
For the six months ended June 30, 2004, we recorded pretax impairment charges of $1.8 million on floating rate agency preferred stocks as a result of decline in market value due to the interest rate environment.
15. Subsequent Event
On July 27, 2004, Nara Bank and Interchange Bank, a subsidiary of Interchange Financial Services Corporation, agreed to terminate the Purchase and Assumption Agreement entered into on March 9, 2004 without consummating the proposed purchase of a branch of Interchange Bank by Nara as contemplated by such agreement.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following is management’s discussion and analysis of the major factors that influenced our consolidated results of operations and financial condition for the three and six months periods ended June 30, 2004 and June 30, 2003. This analysis should be read in conjunction with our Annual Report on Form 10-K/A for the year ended December 31, 2003 and with the unaudited consolidated financial statements and notes set forth in this report.
GENERAL
Selected Financial Data
The following table sets forth certain selected financial data concerning the periods indicated:
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* Includes the loans held for sale
Forward-Looking Information
Certain matters discussed in this report may constitute forward-looking statements under Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. There can be no assurance that the results described or implied in such forward-looking statements will, in fact, be achieved and actual results, performance, and achievements could differ materially because our business involves inherent risks and uncertainties. Risks and uncertainties include possible future deteriorating economic conditions in our areas of operation; interest rate risk associated with volatile interest rates and related asset-liability matching risk; liquidity risks; risk of significant non-earning assets, and net credit losses that could occur, particularly in times of weak economic conditions or times of rising interest rates; risks of available for sale securities declining significantly in value as interest rates rise; and regulatory risks associated with the variety of current and future regulations which we are subject to. For additional information concerning these factors, see “Item 1. Business - Factors That May Affect Business or the Value of Our Stock” contained in our Annual Report on Form 10-K/A for the year ended December 31, 2003.
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Critical Accounting Policies
The preparation of the condensed consolidated financial statements in accordance with accounting principles generally accepted in the United States of America requires management to make a number of judgments, estimates and assumptions that affect the reported amount of assets, liabilities, income and expenses in our consolidated financial statements and accompanying notes. We believe that the judgments, estimates and assumptions used in the preparation of our consolidated financial statements are appropriate given the factual circumstances as of June 30, 2004.
Various elements of our accounting policies, by their nature, are inherently subject to estimation techniques, valuation assumptions and other subjective assessments. In particular, we have identified six accounting policies that, due to judgments, estimates and assumptions inherent in those policies, are critical to an understanding of our consolidated financial statements. These policies relate to the classification and valuation of investment securities, the methodologies that determine our allowance for loan losses, the treatment of non-accrual loans, the valuation of properties acquired through foreclosure, the valuation of retained interests and mortgage servicing assets related to the sales of Small Business Administration loans, and the valuation of derivative instruments. In each area, we have identified the variables most important in the estimation process. We have used the best information available to make the estimations necessary to value the related assets and liabilities. Actual performance that differs from our estimates and future changes in the key variables could change future valuations and impact net income.
Our significant accounting principles are described in greater detail in our 2003 Annual Report on Form 10-K/A in the “Critical Accounting Policies” section of Management’s Discussion and Analysis and in Note 1 to the Consolidated Financial Statements—“Significant Accounting Policies” which are essential to understanding Management’s Discussion and Analysis of Results of Operations and Financial Condition. There has been no material modification to these policies during the quarter ended June 30, 2004
RESULTS OF OPERATIONS
Net income
Our net income for the three months ended June 30, 2004 was $4.5 million or $0.19 per diluted share compared to $3.4 million or $0.15 per diluted share for the same quarter of 2003, which represented an increase of $1.1 million or 32.4%. The increase resulted primarily from an increase in net interest income due to growth in our loan portfolio. The annualized return on average assets was 1.36% for the second quarter of 2004 compared to 1.31% for the same period of 2003. The annualized return on average equity was 19.26 % for the second quarter of 2004 compared to 19.33% for the same period of 2003. The resulting efficiency ratio was 54.94% for the three months ended June 30, 2004 compared with 57.38% for the same period of 2003.
Our net income for the six months ended June 30, 2004 was $8.7 million or $0.36 per diluted share compared to $6.7 million or $0.29 per diluted share for the same period of 2003, an increase of approximately $2.0 million or 29.9%. The increase resulted primarily from a growth in our loan portfolio, which in turn resulted in higher interest income, and from the sale of loans we originated offset by higher loan loss provisions and non-interest expense.
The annualized return on average assets was 1.34 % for the six months ended June 30, 2004 compared to 1.32% for the same period of 2003. The annualized return on average equity was 19.06% for the six months ended June 30, 2004 compared to 19.36% for the same period of 2003. The efficiency ratios were 55.82% for the six months ended June 30, 2004 compared with 56.77% for the corresponding period of the preceding year. This improvement was primarily due to the increase in net income while expenses grew at a slower rate.
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Net Interest Income and Net Interest Margin
Net Interest Income
The principal component of our earnings is net interest income, which is the difference between the interest and fees earned on loans, interest rate swaps and investments and the interest paid on deposits and borrowed funds. When net interest income is expressed as a percentage of average interest-earning assets, the result is the net interest margin. Net interest spread is the yield on average interest-earning assets less the cost of average interest-bearing deposits and borrowed funds. Net interest income is affected by changes in the volume of interest-earning assets and interest-bearing liabilities as well as by changes in yield earned on interest-earning assets and rates paid on interest-bearing liabilities.
Net interest income before provision for loan losses was $14.0 million for the three months ended June 30, 2004, an increase of $3.0 million, or 27.3% from net interest income of $11.0 million for the same quarter of 2003. This increase was primarily due to an increase in average earning assets, which increased $273.1 million or 28.3% to $1,237.5 million for the second quarter of 2004 from $964.4 million for the same quarter of 2003.
Interest income for the second quarter of 2004 was $18.2 million, which represented an increase of $3.1 million or 20.5% over interest income of $15.1 million for the same quarter of 2003. The increase was the net result of a $4.8 million increase in interest income due to an increase in volume of average interest-earning assets (volume change) off-set by a $1.7 million decrease in interest income due to a decline in the yield earned on those average interest-earning assets (rate change). Interest expense for the second quarter of 2004 was $4.2 million, an increase of $100,000 or 2.4% over interest expense of $4.1 million for the same quarter of 2003. The increase was the net result of a $1.1 million increase in interest expense due to an increase in volume of average interest-bearing liabilities (volume change) offset by a $957,000 decrease in interest expense due to a decline in the rates paid on interest-bearing liabilities (rate change).
Net interest income before provision for loan losses was $27.4 million for the six months ended June 30, 2004, which represented an increase of $6.5 million or 31.1% from net interest income of $20.9 million for the same period of 2003. The increase was the primarily due to an increase in average earning assets. Average earning assets increased $261.0 million or 27.7% to $1,204.3 million for the six months ended June 30, 2004, from $943.3 million for the same period of 2003.
Interest income for the six months ended June 30, 2004 was $35.5 million, an increase of $6.5 million or 22.4% over interest income of $29.0 million for the same period of 2003. The increase was the net result of a $9.2 million increase in interest income due to an increase in volume of average interest-earning assets (volume change) off-set by a $2.7 million decrease in interest income due to a decline in the yield earned on those average interest-earning assets (rate change). Interest expense for the six months ended June 30, 2004 was $8.1 million, which represented a decrease of $42,000 or 0.5% over interest expense of $8.2 million for the same period of 2003. The increase was the net result of a $2.0 million increase in interest expense due to an increase in volume of average interest-bearing liabilities (volume change) offset by a $2.1 million decrease in interest expense due to a decline in the rates paid on interest-bearing liabilities (rate change).
Net Interest Margin
The yield on average interest-earning assets decreased to 5.89% for the second quarter of 2004 compared with 6.27% for the same quarter of 2003. The decrease was primarily due to a decrease in market interest rates for our loans, including a 25 basis point reduction by Federal Reserve Board in the prime rate between these periods. The average cost of interest-bearing liabilities decreased to 1.85 % for the second quarter of 2004 from 2.30% for the same quarter of 2003. The decrease was also due to a decrease in market rates for deposits. The net interest margin was 4.54% for the second quarter of 2004 compared with 4.57% for the same quarter of 2003.
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Despite the rate cut we managed to maintain the interest margin above 4.50% by successfully managing the interest-bearing liabilities.
The yield on average interest-earning assets decreased by 27 basis points to 5.89% for the six months ended June 30, 2004 compared with 6.16% for the six months ended June 30, 2003. The average cost of interest-bearing liabilities decreased by 51 basis points to 1.86% for the six months ended June 30, 2004 from 2.37% for the six months ended June 30, 2003. These decreases were mainly due to a 25 basis point reduction in the prime rate in June of 2003. The net interest margin was 4.54% for the six months ended June 30, 2004 compared with 4.43% for the same period of 2003. Interest bearing liabilities fully repriced and stabilized over those periods.
The following table presents our condensed consolidated average balance sheet information, together with interest rates earned and paid on the various sources and uses of funds for the three and six months periods indicated:
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The following table illustrates the changes in our interest income, interest expenses, amount attributable to variations in interest rates, and volumes for the periods indicated. The variances attributable to simultaneous volume and rate changes have been allocated to the change s due to volume and the changes due to rate categories in proportion to the relationship of the absolute dollar amount attributable solely to the change in volume and to the change in rate.
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Provision for Loan Losses
The provision for loan losses reflects our judgment of the current period cost associated with credit risk inherent in our loan portfolio. The loan loss provision for each period is dependent upon many factors, including loan growth, net charge-offs, changes in the composition of the loan portfolio, delinquencies, assessments by management, third parties’ and regulators’ examination of the quality of the loan portfolio, the value of the underlying collateral on problem loans and the general economic conditions in our market areas. Specifically, the provision for loan losses represents the amount charged against current period earnings to achieve an allowance for loan losses that, in our judgment, is adequate to absorb losses inherent in our loan portfolio. Periodic fluctuations in the provision for loan losses result from management’s assessment of the adequacy of the allowance for loan losses; however, actual loan losses may vary from current estimates.
We recorded a $1.3 million in provision for loan losses in the second quarter of 2004 compared to $1.1 million in the same quarter of 2003. For the six months ended June 30, 2004, we recorded $2.8 million in provision for loan losses compared to $2.4 million for the six months ended June 30, 2003. These increases reflect the results of our review and analysis of the loan portfolio and the adequacy of our existing allowance for loan losses in light of the growth experienced in our loan portfolio. We believe that the allowance is sufficient for the known and inherent losses at June 30, 2004. Refer to Allowance and Provision for Loan Losses section for further discussion.
Non-interest Income
Non-interest income includes revenues earned from sources other than interest income. It is primarily comprised of service charges and fees on deposits accounts, fees received from letter of credit operations, gain or losses on interest rate swaps and gains on sale of SBA loans and investment securities.
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Non-interest income for the second quarter of 2004 was $5.4 million compared to $4.9 million for the same quarter of 2003, an increase of $0.5 million, or 10.9%, primarily as a result of an increase in gain on sale of loans, offset by a loss in interest rate swaps. Gain on sale of SBA loans increased $904,000 or 108.0% to $1.7 million for the second quarter of 2004 from $837,000 for the same quarter of 2003. During the second quarter of 2004 we originated $47.6 million in SBA loans and sold $32.2 million. During the second quarter of 2004 we recognized a loss of $1.0 million from the valuation of interest rate swap transactions, which represented the ineffective portion of swaps that related to cash flow hedge, compared to a gain of $280,000 for the same quarter of 2003. Ineffectiveness in cash flow hedge occurs when the cumulative gain or loss on the derivative hedging instrument exceeds the cumulative change in the expected future cash flows on the hedge transaction due to changes in market interest rates. Such gain or loss is recognized as non-interest income or loss.
Non-interest income for the six months ended June 30, 2004 was $11.3 million compared to $9.7 million for the same period of 2003, which represented an increase of $1.6 million or 16.3%, primarily as a result of increase in service charges on deposits and gains on sale of loans. Service charges on deposits increased $461,000 or 12.8% to $4.1 million for the six months ended June 30, 2004 from $3.6 million for the same period of 2003. This increase is primarily due to an increase in number of accounts from acquisitions as well as from existing branches. Gain on sale of SBA loans for the first six months of 2004 was $2.7 million, increased $642,000 million or 31.5% from $2.0 million for the same period of 2003. We originated $64.6 million in SBA loans and sold $43.4 million during the first six months of 2004. During the same period of 2003, we originated $40.5 million and sold $28.4 million. We recognized a loss of $306,000 from the interest rate swap transactions during the first six months of 2004, compared to a gain of $428,000 during the same period of 2003.
The breakdown of changes in our non-interest income by category is illustrated below:
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Non-interest Expense
Non-interest expense for the second quarter of 2004 was $10.7 million compared to $9.1 million for the same quarter of 2003, an increase of $1.6 million or 17.5%, primarily due to increases in occupancy, advertising and professional fees. Occupancy expense for the second quarter of 2004 increased $261,000 or 24.7% to $1.3 million from $1.1 million for the same quarter of 2003. This increase is primarily due to the acquisition and opening of new branches in addition to the general increases to the existing building leases. Adverting and marketing expenses for the second quarter of 2004 increased $166,000 or 51.2% to $490,000 from $324,000 for the same quarter of 2003. These increases were due to our continued efforts to serve and market to our customers and community through financial supports and events. Professional fees for the second quarter of 2004 also increased $309,000 or 67.6% to $766,000 from $457,000 for the same quarter of 2003. This increase was due to an increase in SBA referral fees from higher SBA volumes and an increase in other professional fees.
Non-interest expense for the six months ended June 30, 2004 was $21.6 million compared to $17.4 million for the same period of 2003, an increase of $4.2 million or 24.2%, primarily due to the recognition of other than temporary impairment charges of $1.8 million in U.S. Agency Preferred Stock and the increases in occupancy expense and professional fees. During the first half of 2004 we recorded pretax impairment charges of $1.8 million on floating rate agency preferred stocks as a result of decline in market value due to the interest rate environment. Excluding this impairment charge, non-interest expense for the six months ended June 30, 2004 was $19.8 million, an increase of $2.4 million of 13.8% from the corresponding period of 2003. Occupancy expenses increased $476,000 or 22.6% to $2.6 million for the first six months of 2004 from $2.1 million for the corresponding period of 2003. This increase was due to the acquisition and opening of branches in additional to general increases in leases. Professional fees also increased $408,000 or 44.8% to $1.3 million for the first six months of 2004 from $910,000 for the corresponding period of 2003. This increase was due to the increases in SBA referral fees and other professional fees.
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The breakdown of changes in our non-interest expense is illustrated below:
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Provision for Income Taxes
The provision for income taxes was $2.9 million and $2.3 million on income before taxes of $7.5 million and $5.7 million for the three months ended June 30, 2004 and 2003, respectively. The effective tax rate for the quarter ended June 30, 2004 was 39.1% compared with 39.9% for the quarter ended June 30, 2003.
The provision for income taxes was $5.6 million and $4.2 million on income before taxes of $14.3 million and $10.8 million for the six months ended June 30, 2004 and 2003, respectively. The effective tax rate for the six months ended June 30, 2003 was 39.1% compared with 38.9% for the six months ended June 30, 2003.
Financial Condition
At June 30, 2004, our total assets were $1,398.0 million, an increase of $138.0 million or 11.0% from $1,260.0 million at December 31, 2003. The growth was primarily due to increases in our loans funded by growth in deposits.
Investment Securities Portfolio
We classify our securities as held-to-maturity or available-for-sale under SFAS No.115. Those securities that we have the ability and intent to hold to maturity are classified as “held-to-maturity securities”. All other securities are classified as “available-for-sale”. We did not own any trading securities at June 30, 2004 and December 31, 2003. Securities that are held to maturity are stated at cost, adjusted for amortization of premiums and accretion of discounts. Securities that are available for sale are stated at fair value. The securities we currently hold are government-sponsored agency bonds, corporate bonds, collateralized mortgage obligations, U.S. government agency preferred stocks, and municipal bonds.
As of June 30, 2004, we had $2.0 million in held-to-maturity securities and $124.8 million in available-for-sale securities compared to $2.0 million and $126.4 million, respectively at December 31, 2003. The total net unrealized loss on the available-for sale securities at June 30, 2004 was $3.2 million compared to net unrealized loss of $1.5 million at December 31, 2003. During the first six months of 2004 we purchased a total of $32.4 million in securities which we classified as available-for-sale and sold $11.9 million and recognized total gross gains of $408,223.
Securities with an amortized cost of $5.2 million were pledged to secure public deposits and for other purposes as required or permitted by law at June 30, 2004. Securities with an amortized cost of $26.6 million and $70.6 million were pledged to FHLB of San Francisco and State of California Treasurer’s Office, respectively, at June 30, 2004.
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The following table summarizes the book value, market value and distribution of our investment securities portfolio as of dates indicated:
Investment Portfolio
Investment Maturities and Repricing Schedule
The amortized cost by contractual maturity at June 30, 2004 are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
The unrealized losses were created due to what we believe is a temporary condition, mainly fluctuations in interest rates and do not reflect a deterioration of credit quality of the issuers. At June 30, 2004, there were no securities which had unrealized losses for 12 months or more. For the three and six months ended June 30, 2004, we did not have any sales of investment securities resulting in realized losses. For investments in an unrealized loss position at June 30, 2004, we have the intent and ability to hold these investments until the full recovery. During
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the first six months of 2004, as a result of an other than temporary decline in market value due to changes in interest rates, impairment charges of $1.8 million were recognized for floating rate agency preferred stocks.
The following table shows our investments’ gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at June 30, 2004.
Loan Portfolio
We carry all loans (except for certain SBA loans held-for-sale) at face amount, less payments collected, net of deferred loan origination fees and the allowance for loan losses. SBA loans held-for-sale are carried at the lower of cost or market. Interest on all loans is accrued daily. Once a loan is placed on non-accrual status, accrual of interest is discontinued and previously accrued interest is reversed. Loans are placed on a non-accrual status when principal and interest on a loan is past due 90 days or more, unless a loan is both well secured and in process of collection.
As of June 30,2004, our gross loans (net of unearned fees), including loans held for sale, increased by $104.1 million or 10.4% to $1,105.4 million from $1,001.3 million at December 31, 2003. The commercial loans, which include domestic commercial, international trade finance, SBA loans, and equipment leasing, at June 30, 2004 increased by $35.8 million or 9.8 % to $400.0 million from $364.2 million at December 31, 2003. Real estate and construction loans increased by $67.2 million or 11.7% to $643.0 million from $575.9 million at December 31, 2003. There has been a continued high demand for real estate loans during the past six months.
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The following table illustrates our loan portfolio by amount and percentage of gross loans in each major loan category at the dates indicated:
We normally do not extend lines of credit and make loan commitments to business customers for periods in excess of one year. We use the same credit policies in making commitments and conditional obligations as we do for extending loan facilities to our customers. We perform annual reviews of such commitments prior to the renewal. The following table shows our loan commitments and letters of credit outstanding at the dates indicated:
At June 30, 2004, our nonperforming assets (nonaccrual loans, loans 90 days or more past due and still accruing interest, restructured loans, and other real estate owned) were $5.2 million, a decrease from $5.6 million at December 31, 2003. As of June 30, 2004 restructured loans that are current totaled $359,000. Nonperforming assets to total assets was 0.37% and 0.44% at June 30, 2003 and December 31, 2003, respectively. At June 30, 2004, nonperforming loans were $4.9 million, a decrease from $5.1 million in nonperforming loans at December 31, 2003. Of the $4.9 million in nonperforming loans, $4.0 million are fully secured by commercial real estate. At June 30, 2004, nonperforming loans to total gross loans was 0.44% compared to 0.51% at December 31, 2003.
The following table illustrates the composition of our nonperforming assets as of the dates indicated.
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Allowance for Loan Losses
We maintain an allowance for credit losses to absorb losses inherent in our loan portfolio. The allowance is based on our regular quarterly assessments of the probable estimated losses inherent in the loan portfolio. Our methodologies for measuring the appropriate level of the allowance includes: (1) the Migration Analysis; (2) the Reasonableness Test; (3) the Specific Allocation Method.
The following table provides a breakdown of the allowance for loan losses by category at June 30, 2004 and December 31, 2003:
Allocation of Allowance for Loan Losses
(Dollars in thousands)
The adequacy of the allowance is determined by management based upon an evaluation and review of the loan portfolio, consideration of historical loan loss experience, current economic conditions, changes in the composition of the loan portfolio, analysis of collateral values and other pertinent factors.
The Migration Analysis is a formula method based on our actual historical net charge-off experience for each loan type pools and a loan risk grade (Pass; net of cash secured loans, Special Mention, Substandard, Doubtful).
Central to the migration analysis is our credit risk rating system. Both internal, contracted external, and regulatory credit reviews are used to determine and validate loan risk grades. Our credit review system takes into consideration factors such as: borrower’s background and experience; historical and current financial condition; credit history and payment performance; industry and the economy; type, market value, volatility of the market value of collateral, and our lien position; and the financial strength of the guarantors
To calculate our various loan factors, we use twelve-quarter rolling average of historical losses detailing charge-offs, recoveries, and loan type pool balances to determine the estimated credit losses for non-classified and classified loans. Also, in order to reflect the impact of recent events more heavily, the twelve-quarter rolling average has been weighted. The most recent four quarters have been assigned a 40% weighted average while the next four quarters have been assigned a 33% weighted average and the last four quarters have been assigned a 27% weighted average.
The resulting migration risk factors, or our established minimum risk factor for loan type pools that have no historical loss, whichever is greater, for each loan type pool is used to calculate our General Reserve. We have established a minimum risk factor for each loan grade Pass (0.40% — 1.00%), Special Mention (3.0%), Substandard (10.0% — 15.0%), Doubtful (50.0%), and Loss (100.0%).
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Additionally, in order to systematically quantify the credit risk impact of trends and changes within the loan portfolio, we subjectively, make adjustments to the Migration Analysis within established parameters. Our parameters for making adjustments are established under a Credit Risk Matrix that provides seven possible scenarios for each of the factors below. The matrix allows for three positive/decrease (Major, Moderate, and Minor), three negative/increase (Major, Moderate, and Minor), and one neutral credit risk scenarios within each factor for each loan type pool. Generally, the factors are considered to have no impact (neutral) to our migration ratios. However, if information exists to warrant adjustment to the Migration Analysis, we make the changes in accordance with the established parameters supported by narrative and/or statistical analysis. Our Credit Risk Matrix and the seven possible scenarios enable us to adjust the Migration Analysis as much as 50 basis points in either direction (positive or negative) for each loan type pool.
The Reasonableness Test is based on a national historical loss experience for each loan graded Special Mention, Substandard, Doubtful, and Loss; and an established minimum for loans graded Pass. The reserve factors applied under this method are: 1.0% for loans graded Pass; 5.0% for loans graded Special Mention; 15.0% for loans graded Substandard; 50.0% for loans graded Doubtful; and 100% for loans graded Loss. This method is not intended to substitute or override the Bank’s other methodologies, but rather is used for comparative purposes.
Under the Specific Allocation method, management establishes specific allowances for loans where management has identified significant conditions or circumstances related to a credit that are believed to indicate the probability that a loss may be incurred. The specific allowance amount is determined by a method prescribed by the Statement of Financial Accounting Standards (SFAS) No. 114, Accounting by Creditors for Impairment of a Loan. Our actual historical repayment experience and the borrower’s cash flow, together with an individual analysis of the collateral held on a loan, is taken into account in determining the allocated portion of the required Allowance under this method. As estimations and assumptions change, based on the most recent information available for a credit, the amount of the required specific allowance for a credit will increase or decrease.
We consider a loan as impaired when it is probable that it will be unable to collect all amounts due (principal and interest) according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment
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delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed.
For commercial, real estate and certain consumer loans, we base the measurement of loan impairment on the present value of the expected future cash flows, discounted at the loan’s effective interest rate or on the fair value of the loan’s collateral if the loan is collateral dependent. We evaluate installment loans for impairment on a collective basis, because these loans are smaller balance, homogeneous loans. Impairment losses are included in the allowance for loan losses through a charge to provision for loan losses. Upon disposition of an impaired loan, any related allowance is charged off to the allowance for loan losses.
Executive management reviews these conditions quarterly in discussion with our senior credit officers. To the extent that any of these conditions is evidenced by a specifically identifiable problem credit or portfolio segment as of the evaluation date, management’s estimate of the effect of such conditions may be reflected as a specific allowance, applicable to such credit or portfolio segment. Where any of these conditions is not evidenced by a specifically identifiable problem credit or portfolio segment as of the evaluation date, management’s evaluation of the probable loss related to such condition is reflected in the unallocated allowance.
The allowance for loan losses was $14.3 million at June 30, 2004, compared to $10.4 million at June 30, 2003. We recorded a provision of $2.8 million during the six months ended June 30, 2004, mainly due to an increase in our loan portfolio and classified loans. Average gross loans (net of unearned) increased $220.6 million or 26.3% to $1,059.7 million for the six months ended June 30, 2004, compared to $216.3 million increase for the same period of 2004. During the first six months of 2004, we charged off $1.4 million and recovered $456,000. The allowance for loan losses was 1.29% of gross loans at June 30, 2003, compared to 1.24% at June 30, 2003. The total classified loans at June 30, 2004 were $9.2 million, compared to $5.8 million at June 30, 2003.
We believe the level of allowance as of June 30, 2004 is adequate to absorb the estimated losses from any known or inherent risks in the loan portfolio and the loan growth for the quarter. However, no assurance can be given that economic conditions which adversely affect our service areas or other circumstances will not be reflected in increased provisions or loan losses in the future.
The following table shows the provisions made for loan losses, the amount of loans charged off, the recoveries on loans previously charged off together with the balance in the allowance for possible loan losses at the beginning and end of each period, the amount of average and total loans outstanding, and other pertinent ratios as of the dates and for the periods indicated:
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Deposits and Other Borrowings
Deposits. Deposits are our primary source of funds to use in our lending and investment activities. At June 30, 2004, our deposits increased by $159.3 million or 15.0% to $1,220.6 million from $1,061.4 million at December 31, 2003. Demand deposits totaled $333.6 million at June 30, 2004, an increase of $8.1 million or 2.5% from $325.6 million at December 31, 2003. Time deposits over $100,000 totaled $373.0 million, an increase of $24.4 million or 7.0% from $348.6 million at December 31, 2003. Other interest-bearing demand deposits, including money market and super now accounts, totaled $295.7 million, an increase of $161.6 million or 120.5% from $134.1 million at December 31, 2003. The growth in deposits was the result of our continued marketing efforts throughout all three regions as well as the direct result of several newly opened branches, such as Wilshire, Diamond Bar and Rowland Height branches.
At June 30, 2004, 27.3% of the total deposits were non-interest bearing demand deposits, 37.8% were time deposits, 10.7% were savings accounts, and 24.2% were interest bearing demand deposits. By comparison, at December 31, 2003, 30.7% of the total deposits were non-interest bearing demand deposits, 41.8% were time deposits, 14.8% were savings accounts, and 12.7% were interest bearing demand deposits. The increase in interest bearing demand deposits at June 30, 2004 was primarily due to bank-wide deposit campaign on new money market product we launched during the second quarter of 2004 to support the loan growth.
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At June 30, 2004, we had a total of $77.5 million in time deposits issued through brokers and $60.0 million in time deposits from the State of California Treasurer’s Office. The deposits from the State of California Treasurer’s Office were collateralized with our securities with an amortized cost of $70.6 million. The detail of those deposits is shown on the table below.
Other Borrowings. Advances may be obtained from the FHLB of San Francisco to supplement our supply of lendable funds. Advances from the FHLB of San Francisco are typically secured by a pledge of mortgage loans and/or securities with a market value at least equal to outstanding advances plus investment in FHLB stocks. The following table shows our outstanding borrowings from FHLB at June 30, 2004. All FHLB advances carry fixed interest rates.
At June 30, 2004 and December 31, 2003, five wholly-owned subsidiary grantor trusts established by Nara Bancorp had issued $38 million of pooled Trust Preferred Securities (“trust preferred securities”). Trust preferred securities accrue and pay distributions periodically at specified annual rates as provided in the indentures. The trusts used the net proceeds from the offering to purchase a like amount of junior subordinated debentures (the “Debentures”) of the Nara Bancorp. The Debentures are the sole assets of the trusts. Nara Bancorp’s obligations under the junior subordinated debentures and related documents, taken together, constitute a full and unconditional guarantee by Nara Bancorp of the obligations of the trusts. The trust preferred securities are
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mandatorily redeemable upon the maturity of the Debentures, or upon earlier redemption as provided in the indentures. Nara Bancorp has the right to redeem the Debentures in whole (but not in part) on or after specific dates, at a redemption price specified in the indentures plus any accrued but unpaid interest to the redemption date.
The following table is a summary of trust preferred securities and debentures at June 30, 2004:
The Junior Subordinated Debentures are not redeemable prior to June 8, 2011 with respect to Nara Bancorp Capital Trust I, March 26, 2007 with respect to Nara Statutory Trust II, June 15, 2008 with respect to Nara Capital Trust III, January 7, 2009 with respect to Nara Statutory Trust IV, and December 17, 2008 with respect to Nara Statutory Trust V unless certain events have occurred. During March of 2004, $10 million of the total proceeds from the issuance of the Trust Preferred Securities were injected into Nara Bank as permanent capital.
With the adoption of FIN No. 46R, Nara Bancorp deconsolidated the five grantor trusts. As a result, the junior subordinated debentures issued by Nara Bancorp to the grantor trusts, totaling $39.3 million, are reflected in the consolidated balance sheet in the liabilities section at June 30, 2004 and December 31, 2003, under the caption “junior subordinated debentures.” We also recorded $2.1 million in other assets in the consolidated balance sheet at June 30, 2004 and December 31, 2003 for the common capital securities issued by the issuer trusts.
On July 2, 2003, the Federal Reserve Bank issued Supervisory Letter SR 03-13 clarifying that bank holding companies should continue to report trust preferred securities in accordance with current Federal Reserve Bank instructions which allows trust preferred securities to be counted in Tier 1 capital subject to certain limitations. The Federal Reserve has indicated it will review the implications of any accounting treatment changes and, if necessary or warranted, will provide appropriate guidance.
Off-Balance Sheet Activities And Contractual Obligations
We routinely engage in activities that involve, to varying degrees, elements of risk that are not reflected, in whole or in part, in the consolidated financial statements. These activities are part of our normal course of business and include traditional off-balance sheet credit-related financial instruments, interest rate swap contracts, operating leases and long-term debt.
Traditional off-balance sheet credit-related financial instruments are primarily commitments to extend credit and standby letters of credit. These activities could require us to make cash payments to third parties in the event certain specified future events have occurred. The contractual amounts represent the extent of our exposure in these off-balance sheet activities. However, since certain off-balance sheet commitments, particularly standby letters of credit, are expected to expire or be only partially used, the total amount of commitments does not
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necessarily represent future cash requirements. These activities are necessary to meet the financing needs of our customers.
We also entered into interest rate swap contracts where we are required to either receive cash from or pay cash to counter parties depending on changes in interest rates. We utilize interest rate swap contracts to help manage the risk of changing interest rates. Our accounting for interest rate swap contracts is discussed below under Item 3.
We do not anticipate that our current off-balance sheet activities will have a material impact on future results of operations and financial condition. Further information regarding our financial instruments with off-balance sheet risk can be found in Item 3– “Quantitative and Qualitative Disclosures of Market Risks”.
We continue to lease our banking facilities and equipment under non-cancelable operating leases with terms providing for fixed monthly payments over periods typically ranging from 2 to 30 years.
The following table shows our contractual obligation as of June 30, 2004.
Stockholders’ Equity and Regulatory Capital
In order to ensure adequate levels of capital, we conduct an ongoing assessment of projected sources and uses of capital in conjunction with projected increases in assets and levels of risk. We consider on an ongoing basis, among other things, cash generated from operations, access to capital from financial markets or the issuance of additional securities, including common stock or notes, to meet our capital needs. Total stockholders’ equity was $90.5 million at June 30, 2004. This represented an increase of $5.5 million or 6.5% over total stockholders’ equity of $85.0 million at December 31, 2003.
The federal banking agencies require a minimum ratio of qualifying total capital to risk-adjusted assets of 8% and a minimum ratio of Tier 1 capital to risk-adjusted assets of 4%. In addition to the risk-based guidelines, federal banking regulators require banking organizations to maintain a minimum amount of Tier 1 capital to total assets, referred to as the leverage ratio. For a banking organization rated in the highest of the five categories used by regulators to rate banking organizations, the minimum leverage ratio of Tier 1 capital to total assets must be 3%. In addition to these uniform risk-based capital guidelines and leverage ratios that apply across the industry, the regulators have the discretion to set individual minimum capital requirements for specific institutions at rates significantly above the minimum guidelines and ratios.
At June 30, 2004, Tier 1 capital, stockholders’ equity less intangible assets, plus proceeds from the Trust Preferred Securities, was $115.6 million. This represented an increase of $9.0 million or 8.4% over total Tier 1 capital of $106.6 million at December 31, 2003. This increase was due to a net income of $8.7 million reduced by the payments of cash dividends. At June 30, 2004, we had a ratio of total capital to total risk-weighted assets of 11.92% and a ratio of Tier 1 capital to total risk weighted assets of 9.83%. The Tier 1 leverage ratio was 8.69% at June 30, 2004.
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As of June 30, 2004, the Bank has met the criteria as a “well capitalized institution” under the regulating framework for prompt corrective action. The following table presents the amounts of our regulatory capital and capital ratios, compared to regulatory capital requirements for adequacy purposes as of June 30, 2004 and December 31, 2003.
Liquidity Management
Liquidity risk is the risk to earnings or capital resulting from our inability to fund assets when needed and liability obligations when they come due without incurring unacceptable losses. Liquidity risk includes the ability to manage unplanned decreases or changes in funding sources and to recognize or address changes in market conditions that affect our ability to liquidate assets quickly and with a minimum loss of value. Factors considered in liquidity risk management are stability of the deposit base, marketability of our assets, maturity and availability of pledgeable investments, and customer demand for credits.
In general, our sources of liquidity are derived from financing activities, which include the acceptance of customer and broker deposits, federal funds facilities, and advances from the Federal Home Loan Bank of San Francisco. These funding sources are augmented by payments of principal and interest on loans and the routine liquidation of securities from principal paydown, maturity and sales. Our primary uses of funds include withdrawal of and interest payments on deposits, originations of loans, purchases of investment securities, and payment of operating expenses.
We manage liquidity risk by controlling the level of federal funds and by maintaining lines with correspondent banks, the Federal Reserve Bank, and Federal Home Loan Bank of San Francisco. The sale of investment securities available-for-sale can also serve as a contingent source of funds. Increasing the deposit rates is considered a last resort in raising funds to increase liquidity.
As a means of augmenting our liquidity, we have established federal funds lines with corresponding banks and Federal Home Loan Bank of San Francisco. At June 30, 2004, our borrowing capacity included $46.0 million in federal funds line facility from correspondent banks and $159.7 million in unused Federal Home Loan Bank of San Francisco advances. In addition to the lines, our liquid assets include cash and cash equivalents, federal funds sold and securities available for sale that are not pledged. The book value of the aggregate of these assets totaled $132.8 million at June 30, 2004 compared to $107.9 million at December 31, 2003. We believe our liquidity sources to be stable and adequate.
Because our primary sources and uses of funds are loans and deposits, the relationship between gross loans and total deposits provides a useful measure of our liquidity. Typically, higher the ratio of loans to deposits, the more we rely on our loan portfolio to provide for short-term liquidity needs. Because repayment of loans tends to be less predictable than the maturity of investments and other liquid resources, the higher the loan to deposit ratio, the less liquid are our assets. At June 30, 2004, our gross loan to deposit ratio was 90.5%.
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Item 3. Quantitative and qualitative disclosures about market risk
The objective of our asset and liability management activities is to improve our earnings by adjusting the type and mix of assets and liabilities to effectively address changing condition and risks. Through overall management of our balance sheet and by controlling various risks, we seek to optimize our financial returns within safe and sound parameters. Our operating strategies for attaining this objective include managing net interest margin through appropriate risk/return pricing of asset and liabilities and emphasizing growth in retail deposits, as a percentage of interest-bearing liabilities, to reduce our cost of funds. We also seek to improve earnings by controlling non-interest expense, and enhancing non-interest income. We also use risk management instruments to modify interest rate characteristic of certain assets and liabilities to hedge against our exposure to interest rate fluctuations, reducing the effects these fluctuations might have on associated cash flows or values. Finally, we perform internal analyses to measure, evaluate and monitor risk.
Interest Rate Risk
Interest rate risk is the most significant market risk impacting us. Market risk is the risk of loss to future earnings, to fair values, or to future cash flow that may result from changes in the price of a financial instrument. Interest rate risk occurs when interest rate sensitive assets and liabilities do not reprice simultaneously and in equal volume. A key objective of asset and liability management is to manage interest rate risk associated with changing asset and liability cash flows and values and market interest rate movements. The management of interest risk is governed by policies reviewed and approved annually by the Board of Directors. Our Board delegates responsibility for interest risk management to the Asset and Liability Management Committee (“ALCO”), which is composed of Nara Bank’s senior executives and other designated officers.
The fundamental objective of the ALCO is to manage our exposure to interest rate fluctuations while maintaining adequate levels of liquidity and capital. The ALCO meets regularly to monitor the interest rate risk, the sensitivity of our assets and liabilities to interest rate changes, the book and market values of assets and liabilities, the investment activities and the changes in the composition of the balance sheet. Our strategy has been to reduce the sensitivity of our earnings to interest rate fluctuations by more closely matching the effective maturities or repricing characteristics of our assets and liabilities. Certain assets and liabilities, however, may react in different degrees to changes in market interest rates. Furthermore, interest rates on certain types of assets and liabilities may fluctuate prior to the changes in market interest rates, while the rates on other types may lag . We consider the anticipated effects of these factors when implementing our interest rate risk management objectives.
Swaps
As part of our asset and liability management strategy, we may engage in derivative financial instruments, such as interest rate swaps, with the overall goal of minimizing the impact of interest rate fluctuations on our net interest margin. Interest rate swaps involve the exchange of fixed-rate and variable-rate interest payment obligations without the exchange of the underlying notional amounts. During 2002, we entered into eight different interest rate swap agreements as summarized in the table below.
Under the swap agreements, we receive a fixed rate and pay a variable rate based on H.15 Prime. The swaps qualify as cash flow hedges under SFAS No. 133,Accounting for Derivative Instruments and Hedging Activities, as amended, and are designated as hedges of the variability of cash flows we receive from certain of our Prime-indexed loans. In accordance with SFAS No. 133, these swap agreements are measured at fair value and reported as assets or liabilities on the consolidated statement of financial condition. The portion of the change in the fair value of the swaps that is deemed effective in hedging the cash flows of the designated assets are recorded in accumulated other comprehensive income (“OCI”) and reclassified into interest income when such cash flows occur in the future. Any ineffectiveness resulting from the hedges is recorded as a gain or loss in the consolidated statement of income as a part of non-interest income or loss. As of June 30, 2004, the amounts in
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accumulated OCI associated with these cash flows totaled a loss of $686,084 (net of tax of $457,390), of which $105,447 is expected to be reclassified into interest income within the next 12 months.
Information regarding our interest rate swaps information at June 30, 2004 is summarized as follows:
Interest Rate Sensitivity
Our monitoring activities related to managing interest rate risk include both interest rate sensitivity “gap” analysis and the use of a simulation model. While traditional gap analysis provides a simple picture of the interest rate risk embedded in the balance sheet, it provides only a static view of interest rate sensitivity at a specific point in time and does not measure the potential volatility in forecasted results relating to changes in market interest rates over time. Accordingly, we combine the use of gap analysis with the use of a simulation model, which provides a dynamic assessment of interest rate sensitivity.
The interest rate sensitivity gap is defined as the difference between the amount of interest-earning assets anticipated to reprice within a specific time period and the amount of interest-bearing liabilities anticipated to reprice within that same time period. A gap is considered positive when the amount of interest rate sensitive assets repricing within a specific time period exceeds the amount of interest-bearing liabilities repricing within that same time period. Positive cumulative gaps suggest that earnings will increase when interest rates rise. Negative cumulative gap suggest that earnings will increase when interest rates fall.
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The following table shows our gap position as of June 30, 2004
The simulation model discussed above also provides our ALCO with the ability to simulate our net interest income. In order to measure, at June 30, 2004, the sensitivity of our forecasted net interest income to changing interest rates, both a rising and falling interest scenario were projected and compared to a base market interest rate forecasts. One application of our simulation model measures the impact of market interest rate changes on the net present value of estimated cash flows from our assets and liabilities, defined as our market value of equity. This analysis assesses the changes in market values of interest rate sensitive financial instruments that would occur in response to an instantaneous and sustained increase in market interest rates.
At June 30, 2004, our net interest income and market value of equity exposed to these hypothetical changes in market interest rates are illustrated in the following table.
Item 4. Controls and Procedures
Our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are sufficiently effective to ensure that the information we are required to be disclosed in the reports we file under the Securities Exchange Act is gathered, analyzed and disclosed with adequate timeliness, accuracy and completeness, based on an evaluation of such controls and procedures conducted within 90 days prior to the date thereof.
There have been no significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of the evaluation referred to above.
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PART II
OTHER INFORMATION
Item 1. Legal Proceedings
Item 2. Changes in Securities and Use of Proceeds
Item 3. Defaults upon Senior Securities
None
Item 4. Submission of Matters to a vote of Security Holders
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Item 5. Other information
Item 6. Exhibits and Reports on Form 8-K
The exhibits listed on the accompanying index to exhibits are filed or incorporated by reference (as stated herein) as part of this Quarterly Report on Form 10-Q.
During the quarter ended June 30, 2004, Nara Bancorp filed the following Current Report on Form 8-K: (1) May 18, 2004 (announcing a two-for-one-stock split effected as a 100% stock dividend) and (2) April 28, 2004 (furnishing a press release regarding first quarter preliminary financial results.)
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SIGNATURES
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.
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INDEX TO EXHIBITS
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