UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2001
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: 0-24802
MONTEREY BAY BANCORP, INC.
(Exact Name Of Registrant As Specified In Its Charter)
DELAWARE 77-0381362
(State Or Other Jurisdiction Of (I.R.S. Employer Identification Number)
Incorporation Or Organization)
567 Auto Center Drive, Watsonville, California 95076
(Address Of Principal Executive Offices)(Zip Code)
(831) 768 - 4800
(Registrant's Telephone Number, Including Area Code)
WWW.MONTEREYBAYBANK.COM
(Registrant's Internet Site)
INFO@MONTEREYBAYBANK.COM
(Registrant's Electronic Mail Address)
Indicate by check mark whether the registrant (1) has filed all the 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
-------- --------
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date: 3,452,764 shares of common
stock, par value $0.01 per share, were outstanding as of November 9, 2001.
1
MONTEREY BAY BANCORP, INC. AND SUBSIDIARY
INDEX
PAGE
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Statements Of Financial Condition (unaudited)
As Of September 30, 2001 And December 31, 2000 3 - 4
Condensed Consolidated Statements Of Operations (unaudited) For The
Three And Nine Months Ended September 30, 2001 And September 30, 2000 5 - 6
Condensed Consolidated Statement Of Stockholders' Equity (unaudited) For
The Nine Months Ended September 30, 2001 7
Condensed Consolidated Statements Of Cash Flows (unaudited) For The
Nine Months Ended September 30, 2001 And September 30, 2000 8 - 9
Notes To Condensed Consolidated Financial Statements (unaudited) 10 - 15
Item 2. Management's Discussion And Analysis Of Financial Condition
And Results Of Operations 16 - 47
Item 3. Quantitative And Qualitative Disclosure About Market Risk 47
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 48
Item 2. Changes In Securities 48
Item 3. Defaults Upon Senior Securities 48
Item 4. Submission Of Matters To A Vote Of Security Holders 48
Item 5. Other Information 48
Item 6. Exhibits And Reports On Form 8-K 48
(a) Exhibits
(b) Reports On Form 8-K
Signature Page 49
2
Item 1. Financial Statements
MONTEREY BAY BANCORP, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (UNAUDITED)
SEPTEMBER 30, 2001 AND DECEMBER 31, 2000
(Dollars In Thousands)
---------------------------------------------------------------------------------------------------------------------
September 30, December 31,
2001 2000
---- ----
ASSETS
Cash and cash equivalents $ 13,380 $ 25,159
Securities available for sale, at estimated fair value:
Investment securities (amortized cost of $7,704 and $7,696 at
September 30, 2001 and December 31, 2000, respectively) 7,204 7,360
Mortgage backed securities (amortized cost of $30,578 and $43,675
at September 30, 2001 and December 31, 2000, respectively) 30,971 42,950
Loans held for sale 407 --
Loans receivable held for investment (net of allowances for loan losses of
$6,387 at September 30, 2001 and $5,364 at December 31, 2000) 454,492 391,820
Investment in capital stock of the Federal Home Loan Bank, at cost 3,323 2,884
Accrued interest receivable 3,151 2,901
Premises and equipment, net 7,732 7,375
Core deposit intangibles, net 1,684 2,195
Real estate acquired via foreclosure, net -- --
Other assets 4,754 3,546
-------- --------
TOTAL ASSETS $527,098 $486,190
======== ========
See Notes to Condensed Consolidated Financial Statements
3
MONTEREY BAY BANCORP, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (UNAUDITED) (Continued)
SEPTEMBER 30, 2001 AND DECEMBER 31, 2000
(Dollars In Thousands)
---------------------------------------------------------------------------------------------------------------------
September 30, December 31,
2001 2000
---- ----
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
Non-interest bearing demand deposits $ 20,016 $ 17,065
Interest bearing NOW checking accounts 41,073 41,859
Savings deposits 19,472 16,503
Money market deposits 97,114 87,651
Certificates of deposit 250,942 244,710
-------- --------
Total deposits 428,617 407,788
-------- --------
FHLB advances and other borrowings 47,943 32,582
Accounts payable and other liabilities 1,826 1,983
-------- --------
Total liabilities 478,386 442,353
-------- --------
Commitments and contingencies
STOCKHOLDERS' EQUITY
Preferred stock, $0.01 par value, 2,000,000 shares authorized; none issued -- --
Common stock, $0.01 par value, 9,000,000 shares authorized;
4,492,085 issued at September 30, 2001 and December 31, 2000;
3,449,379 outstanding at September 30, 2001 and
3,321,210 outstanding at December 31, 2000 45 45
Additional paid-in capital 28,462 28,278
Retained earnings, substantially restricted 35,330 32,722
Unallocated ESOP shares (748) (920)
Treasury shares designated for compensation plans, at cost (25,283 shares
at September 30, 2001 and 35,079 shares at December 31, 2000) (243) (338)
Treasury stock, at cost (1,042,706 shares at September 30, 2001 and
1,170,875 shares at December 31, 2000) (14,071) (15,326)
Accumulated other comprehensive loss, net of taxes (63) (624)
-------- --------
Total stockholders' equity 48,712 43,837
-------- --------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $527,098 $486,190
======== ========
See Notes to Condensed Consolidated Financial Statements
4
MONTEREY BAY BANCORP, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2001 AND SEPTEMBER 30, 2000
(Dollars In Thousands, Except Per Share Amounts)
-------------------------------------------------------------------------------------------------------------------
FOR THE THREE MONTHS FOR THE NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
---------------------- ----------------------
2001 2000 2001 2000
---- ---- ---- ----
INTEREST AND DIVIDEND INCOME:
Loans receivable $ 9,084 $ 8,118 $ 26,753 $ 23,972
Mortgage backed securities 488 1,011 1,970 2,888
Investment securities and cash equivalents 186 385 741 1,116
-------- -------- -------- --------
Total interest income 9,758 9,514 29,464 27,976
-------- -------- -------- --------
INTEREST EXPENSE:
Deposit accounts 4,032 4,532 13,072 12,569
FHLB advances and other borrowings 711 583 1,852 1,961
-------- -------- -------- --------
Total interest expense 4,743 5,115 14,924 14,530
-------- -------- -------- --------
NET INTEREST INCOME BEFORE PROVISION
FOR LOAN LOSSES 5,015 4,399 14,540 13,446
PROVISION FOR LOAN LOSSES 275 650 1,075 1,675
-------- -------- -------- --------
NET INTEREST INCOME AFTER PROVISION
FOR LOAN LOSSES 4,740 3,749 13,465 11,771
-------- -------- -------- --------
NON-INTEREST INCOME:
Gain (loss) on sale of mortgage backed securities
and investment securities, net 156 -- 190 (77)
Commissions from sales of noninsured products 35 145 223 534
Customer service charges 401 356 1,282 949
Income from loan servicing 33 30 77 90
Gain on sale of loans 18 4 47 15
Other income 47 95 209 203
-------- -------- -------- --------
Total non-interest income 690 630 2,028 1,714
-------- -------- -------- --------
See Notes to Condensed Consolidated Financial Statements
5
MONTEREY BAY BANCORP, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED) (Continued)
THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2001 AND SEPTEMBER 30, 2000
(Dollars In Thousands, Except Per Share Amounts)
-------------------------------------------------------------------------------------------------------------------
FOR THE THREE MONTHS FOR THE NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
---------------------- ----------------------
2001 2000 2001 2000
---- ---- ---- ----
NON-INTEREST EXPENSE:
Compensation and employee benefits 1,739 1,904 5,052 4,991
Occupancy and equipment 440 329 1,222 960
Deposit insurance premiums 50 48 148 140
Data processing fees 133 271 746 837
Legal and accounting expenses 274 148 724 489
Supplies, postage, telephone, and office expenses 158 163 510 522
Advertising and promotion 84 84 141 283
Amortization of intangible assets 170 175 511 524
Consulting 31 15 336 118
Other expense 507 415 1,558 1,396
-------- -------- -------- --------
Total non-interest expense 3,586 3,552 10,948 10,260
-------- -------- -------- --------
INCOME BEFORE INCOME TAXES 1,844 827 4,545 3,225
PROVISION FOR INCOME TAXES 787 366 1,937 1,411
-------- -------- -------- --------
NET INCOME $ 1,057 $ 461 $ 2,608 $ 1,814
======== ======== ======== ========
EARNINGS PER SHARE:
BASIC EARNINGS PER SHARE $ 0.32 $ 0.15 $ 0.80 $ 0.58
======== ======== ======== ========
DILUTED EARNINGS PER SHARE $ 0.31 $ 0.15 $ 0.79 $ 0.58
======== ======== ======== ========
See Notes to Condensed Consolidated Financial Statements
6
MONTEREY BAY BANCORP, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
(UNAUDITED)
NINE MONTHS ENDED SEPTEMBER 30, 2001
(Dollars And Shares In Thousands)
------------------------------------------------------------------------------------------------------------------------
Treasury
Shares
Desig- Accum-
nated ulated
For Other
Addi- Unal- Com- Compre-
Common Stock tional located pen- hensive
------------ Paid-In Retained ESOP sation Treasury Income /
Shares Amount Capital Earnings Shares Plans Stock (Loss) Total
------ ------ ------- -------- ------ ----- ----- ------ -----
Balance at December 31, 2000 3,321 $ 45 $28,278 $ 32,722 $ (920) $ (338) $(15,326) $ (624) $ 43,837
Exercise of stock options 112 (10) 1,099 1,089
Director fees paid using treasury 16 31 156 187
stock
Amortization of stock compensation 163 172 95 430
Comprehensive income:
Net income 2,608 2,608
Other comprehensive income:
Change in net unrealized loss
on securities available for
sale, net of taxes of $471 673 673
Reclassification adjustment for
gains on securities available
for sale included in income,
net of taxes of ($78) (112) (112)
------
Other comprehensive income, 561
------
Total comprehensive income
3,169
------
------ ------ ------- -------- ------ ------ -------- ------ --------
Balance at September 30, 2001 3,449 $ 45 $28,462 $ 35,330 $ (748) $ (243) $(14,071) $ (63) $ 48,712
====== ====== ======= ======== ====== ====== ======== ====== ========
See Notes to Condensed Consolidated Financial Statements
7
MONTEREY BAY BANCORP, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
NINE MONTHS ENDED SEPTEMBER 30, 2001 AND SEPTEMBER 30, 2000
(Dollars In Thousands)
--------------------------------------------------------------------------------------------------------------------------
FOR THE NINE MONTHS
ENDED SEPTEMBER 30,
----------------------
2001 2000
---- ----
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 2,608 $ 1,814
Adjustments to reconcile net income to net cash provided by operating
activities:
Depreciation and amortization of premises and equipment 481 327
Amortization of intangible assets 511 524
Amortization of purchase premiums, net of accretion of purchase discounts 93 55
Amortization of deferred loan fees and costs, net (159) (211)
Provision for loan losses 1,075 1,675
Federal Home Loan Bank stock dividends (141) (166)
Gross ESOP expense before dividends received on unallocated shares 314 243
Compensation expense associated with stock compensation plans 110 215
(Gain) loss on sale of mortgage-backed and investment securities (190) 77
Gain on sale of loans (47) (15)
Gain on sale of fixed assets (8) --
Loss on sale of real estate acquired via foreclosure -- 5
Origination of loans held for sale (6,966) (1,927)
Proceeds from sales of loans held for sale 6,559 1,768
Increase in accrued interest receivable (250) (234)
(Increase) decrease in other assets (1,208) 51
(Decrease) increase in accounts payable and other liabilities (157) 1,295
Other, net (568) (1,031)
------- -------
Net cash provided by operating activities 2,057 4,465
------- -------
CASH FLOWS FROM INVESTING ACTIVITIES:
Net increase in loans held for investment (62,672) (21,482)
Proceeds from sales of investment securities available for sale -- 3,730
Purchases of mortgage backed securities available for sale (20,493) (23,482)
Principal repayments on mortgage backed securities 21,368 11,254
Proceeds from sales of mortgage backed securities available for sale 12,097 12,571
(Purchases) redemptions of FHLB stock, net (298) 543
Proceeds from the sale of fixed assets 13 --
Purchases of premises and equipment (1,062) (423)
------- -------
Net cash used in investing activities (51,047) (17,289)
------- -------
See Notes to Condensed Consolidated Financial Statements
8
MONTEREY BAY BANCORP, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) (Continued)
NINE MONTHS ENDED SEPTEMBER 30, 2001 AND SEPTEMBER 30, 2000
(Dollars In Thousands)
---------------------------------------------------------------------------------------------------------------
FOR THE NINE MONTHS
ENDED SEPTEMBER 30,
----------------------
2001 2000
---- ----
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase in deposits 20,829 30,649
Proceeds (repayments) from FHLB advances, net 15,000 (9,000)
(Repayments) proceeds of securities sold under agreements to repurchase, net -- (2,410)
Proceeds (repayments) of other borrowings, net 361 --
Cash dividends paid to stockholders -- (274)
Purchases of treasury stock -- (1,251)
Sales of treasury stock 1,021 150
Sales of treasury stock for stock compensation plans -- 216
------- -------
Net cash provided by financing activities 37,211 18,080
------- -------
NET (DECREASE) INCREASE IN CASH & CASH EQUIVALENTS (11,779) 5,256
CASH & CASH EQUIVALENTS AT BEGINNING OF PERIOD 25,159 12,833
------- -------
CASH & CASH EQUIVALENTS AT END OF PERIOD $13,380 $18,089
======= =======
SUPPLEMENTAL CASH FLOW DISCLOSURES:
Cash paid during the period for:
Interest on deposits and borrowings $ 14,872 $14,309
Income taxes $ 2,850 $ 2,410
SUPPLEMENTAL DISCLOSURES OF NON CASH
INVESTING AND FINANCING ACTIVITIES
Loans transferred from held for sale to held for investment, at market value $ 85 $ 202
See Notes to Condensed Consolidated Financial Statements
9
MONTEREY BAY BANCORP, INC. AND SUBSIDIARY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
--------------------------------------------------------------------------------
NOTE 1: Basis Of Presentation
The accompanying condensed consolidated unaudited financial statements
have been prepared in accordance with accounting principles generally accepted
in the United States of America ("GAAP") for interim financial information and
with the instructions to Form 10-Q and Article 10 of Regulation S-X.
Accordingly, they do not include all of the information and footnotes required
by GAAP for annual financial statements. In the opinion of management, all
necessary adjustments, consisting only of normal recurring adjustments,
necessary for a fair presentation have been included. The results of operations
for the three and nine month periods ended September 30, 2001 are not
necessarily indicative of the results that may be expected for the entire fiscal
year or any other interim period.
Monterey Bay Bancorp, Inc. ("MBBC") is the holding company for Monterey
Bay Bank ("Bank"). The Bank maintains a subsidiary, Portola Investment
Corporation ("Portola"). These three companies are referred to herein on a
consolidated basis as the "Company". The Company's headquarters are in
Watsonville, California. The Company offers a broad range of financial services
to both consumers and small businesses. All significant intercompany
transactions and balances have been eliminated.
Monterey Bay Bancorp, Inc. operates as a single business segment.
Consequently, no segment information is provided in this Form 10-Q.
These unaudited condensed consolidated financial statements and the
information under the heading "Item 2. Management's Discussion And Analysis Of
Financial Condition And Results Of Operations" and the information under the
heading "Item 3. Quantitative And Qualitative Disclosure About Market Risk" have
been prepared with presumption that users of this interim financial information
have read, or have access to, the most recent audited consolidated financial
statements and notes thereto of Monterey Bay Bancorp, Inc. for the fiscal year
ended December 31, 2000 included in the Company's Annual Report on Form 10-K for
the fiscal year ended December 31, 2000.
The preparation of the condensed consolidated financial statements of
Monterey Bay Bancorp, Inc. and subsidiary requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
the reported revenues and expenses for the periods covered. These estimates are
based on information available as of the date of the financial statements.
Therefore, actual results could significantly differ from those estimates.
10
MONTEREY BAY BANCORP, INC. AND SUBSIDIARY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)
--------------------------------------------------------------------------------
NOTE 2. Computation Of Earnings Per Share
All of the Company's net income has been available to common
stockholders during the periods covered in this Form 10-Q.
Basic earnings per share ("EPS") are computed by dividing net income by
the weighted average common shares outstanding for the period. Diluted earnings
per share reflect the potential dilution that could occur if options or other
contracts to issue common stock were exercised and converted into common stock.
There was no difference in the numerator, net income, used in the
calculation of basic earnings per share and diluted earnings per share. The
denominator used in the calculation of basic earnings per share and diluted
earnings per share for the three and nine month periods ended September 30, 2001
and 2000 is reconciled in the following table. The following table also presents
the calculation of the Company's Basic EPS and Diluted EPS for the periods
indicated.
For The Three Months For The Nine Months
Ended September 30, Ended September 30,
--------------------------- ---------------------------
(In Whole Dollars And Whole Shares)
2001 2000 2001 2000
---- ---- ---- ----
Net income $1,057,000 $461,000 $2,608,000 $1,814,000
========== ======== ========== ==========
Average shares issued 4,492,085 4,492,085 4,492,085 4,492,085
Less weighted average:
Uncommitted ESOP shares (121,289) (157,227) (130,273) (166,211)
Non-vested stock award shares (26,903) (58,378) (30,289) (67,236)
Treasury shares (1,050,040) (1,176,316) (1,070,491) (1,154,058)
----------- ----------- ----------- -----------
Sub-total (1,198,232) (1,391,921) (1,231,053) (1,387,505)
----------- ----------- ----------- -----------
Weighted average BASIC shares outstanding 3,293,853 3,100,164 3,261,032 3,104,580
Add dilutive effect of:
Stock options 90,591 3,635 58,499 5,599
Stock awards 1,112 --- 706 163
----------- ----------- ----------- -----------
Sub-total 91,703 3,635 59,205 5,762
----------- ----------- ----------- -----------
Weighted average DILUTED shares outstanding 3,385,556 3,103,799 3,320,237 3,110,342
========= ========= ========= =========
Earnings per share:
BASIC $ 0.32 $ 0.15 $ 0.80 $ 0.58
========= ========= ========= =========
DILUTED $ 0.31 $ 0.15 $ 0.79 $ 0.58
========= ========= ========= =========
11
MONTEREY BAY BANCORP, INC. AND SUBSIDIARY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)
--------------------------------------------------------------------------------
NOTE 3: Other Comprehensive Income
The Company's only source of other comprehensive income is derived from
unrealized gains and losses on the portfolios of investment and mortgage backed
securities classified as available for sale.
Reclassification adjustments for realized net gains (losses) included
in other comprehensive income for investment and mortgage backed securities
classified as available for sale for the three and six months ended June 30,
2001 and 2000 are summarized as follows:
Three Months Ended September 30, Nine Months Ended September 30,
---------------------------------- ----------------------------------
2001 2000 2001 2000
---- ---- ---- ----
(Dollars In Thousands)
Gross reclassification adjustment $ 156 $ -- $ 190 $ (77)
Tax (expense) benefit (64) -- (78) 32
----- ------ ------ ------
Reclassification adjustment, net of tax $ 92 $ -- $ 112 $ (45)
===== ====== ====== =======
A reconciliation of the net unrealized gain or loss on available for
sale securities recognized in other comprehensive income is as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------------- ---------------------------
2001 2000 2001 2000
---- ---- ---- ----
(Dollars In Thousands)
Holding gain arising during the period, net of tax $ 208 $ 334 $ 673 $ 27
Reclassification adjustment, net of tax (92) -- (112) 45
----- ----- ------ -----
Net unrealized gain recognized in
other comprehensive income $ 116 $ 334 $ 561 $ 72
===== ===== ====== =====
12
MONTEREY BAY BANCORP, INC. AND SUBSIDIARY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)
--------------------------------------------------------------------------------
NOTE 4: Stock Option Plans
The Company maintains the Amended 1995 Incentive Stock Option Plan and
the 1995 Stock Option Plan For Outside Directors. Under these plans, stock
options typically vest over a five year time period, although other vesting
periods are permitted under the Amended 1995 Incentive Stock Option Plan and
have been utilized by the Company from time to time. All outstanding stock
options under both of these plans vest upon a change in control of the Company.
The following tables summarize the combined status of these plans:
Stock Stock Average
Options Stock Options Exercise
Stock Stock Cumulatively Options Available Price Of
Options Options Vested And Cumulatively For Future Vested
Date Authorized Outstanding Outstanding Exercised Grants Options
---- ---------- ----------- ----------- --------- ------ -------
December 31, 2000 757,929 550,236 325,502 80,150 127,543 $9.76
March 31, 2001 757,929 468,687 248,799 171,699 117,543 $10.05
June 30, 2001 757,929 418,384 249,655 174,992 164,553 $10.05
September 30, 2001 757,929 384,006 222,840 192,376 181,547 $9.92
Activity during the three and nine months ended September 30, 2001 included:
Three Months Ended Nine Months Ended
September 30, 2001 September 30, 2001
------------------ ------------------
Granted 3,000 21,500
Canceled 19,994 75,504
Exercised 17,384 112,226
Vested -- 33,403
The exercise price of individual vested stock options ranged from a low
of $8.19 per share to a high of $16.60 per share as of September 30, 2001.
13
MONTEREY BAY BANCORP, INC. AND SUBSIDIARY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)
--------------------------------------------------------------------------------
NOTE 5: Stock Award Plans
The Company maintains the Performance Equity Program ("PEP") for
officers and employees. Awards under the PEP typically vest over a five year
time period, although from time to time the Company has utilized unallocated or
forfeited PEP shares for immediately vested stock grants in lieu of cash
compensation. It is the Company's intention to utilize some or all of the PEP
shares available at September 30, 2001 in lieu of cash compensation during the
remainder of 2001. Awards under the PEP are both time-based and
performance-based. All outstanding stock awards under the PEP vest in the event
of a change in control of the Company. The following table summarizes the status
of this plan:
Stock
Stock Awards
Stock Stock Awards Available
Awards Awards Cumulatively For Future
Date Authorized Outstanding Vested Grants
---- ---------- ----------- ------ ------
December 31, 2000 141,677 35,079 106,598 --
March 31, 2001 141,677 31,082 110,595 --
June 30, 2001 141,677 23,782 113,895 4,000
September 30, 2001 141,677 21,301 116,394 3,982
Activity during the three and nine months ended September 30, 2001
included:
Three Months Ended Nine Months Ended
September 30, 2001 September 30, 2001
------------------ ------------------
Granted 2,314 4,989
Canceled 2,296 8,971
Vested 2,499 9,796
14
MONTEREY BAY BANCORP, INC. AND SUBSIDIARY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)
--------------------------------------------------------------------------------
NOTE 6: Commitments & Contingencies
At September 30, 2001, commitments maintained by the Company included
firm commitments to originate $9.5 million in various types of loans, and
optional commitments to sell $0.6 million in fixed rate residential mortgages on
a servicing released basis. The Company maintained no firm commitments to
purchase loans or securities, to assume borrowings, or to sell securities at
September 30, 2001.
NOTE 7: Recent Accounting Pronouncements
In June 2001, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standard (SFAS) No. 141, "Business
Combinations", and SFAS No.142, "Goodwill and Other Intangible Assets". SFAS No.
141 requires that all business combinations initiated after June 30, 2001 be
accounted for under the purchase method of accounting and addresses the initial
recognition and measurement of goodwill and other intangible assets acquired in
a business combination. SFAS No. 142 addresses the initial recognition and
measurement of intangible assets acquired outside of a business combination
whether acquired individually or with a group of other assets. SFAS No. 142 also
addresses the recognition and measurement of goodwill and other intangibles
assets subsequent to their acquisition. SFAS No. 142 provides that intangible
assets with finite useful lives will be amortized and that goodwill and
intangible assets with indefinite lives will not be amortized, but will be
required to be tested at least annually for impairment. The Company is required
to adopt SFAS No. 142 beginning January 1, 2002. Early adoption is not
permitted. The Company does not expect the adoption of SFAS No. 142 to have a
material effect on its financial position, results of operations, or cash flows,
as the Company had no goodwill as of September 30, 2001 and as all of the
Company's intangible assets at September 30, 2001 were comprised of core deposit
intangibles that will continue to amortize.
In August 2001, the Financial Accounting Standards Board ("FASB")
approved for issuance Statement of Financial Accounting Standard (SFAS) No. 144,
"Accounting For The Impairment Or Disposal Of Long-Lived Assets" SFAS No. 144
supersedes SFAS No. 121, "Accounting For The Impairment Of Long-Lived Assets And
For Long-Lived Assets To Be Disposed Of" and the accounting and reporting
provisions of Accounting Principles Board ("APB") Opinion No. 30, "Reporting The
Results Of Operations - Reporting The Effects Of Disposal Of A Segment Of A
Business, And Extraordinary, Unusual and Infrequently Occurring Events And
Transactions". SFAS No. 144 unifies the accounting treatment for various types
of long-lived assets to be disposed of, and resolves implementation issues
related to SFAS No. 121. SFAS No. 144 is effective for financial statements
issued for fiscal years beginning after December 15, 2001, and interim periods
within those fiscal years. The Company will adopt SFAS No. 144 beginning January
1, 2002. The Company does not expect the adoption of SFAS No. 144 to have a
material effect on its financial position, results of operations, or cash flows,
as the Company had no long-lived assets that were impaired or that were to be
disposed of as of September 30, 2001.
NOTE 8: Reclassifications
Certain amounts in the December 31, 2000 and September 30, 2000
financial statements have been reclassified to conform to the September 30, 2001
financial statement presentation.
15
Item 2. Management's Discussion And Analysis Of Financial Condition And Results
Of Operations
Forward-looking Statements
Discussions of certain matters in this Report on Form 10-Q may
constitute forward-looking statements within the meaning of the Section 27A of
the Securities Act of 1933, as amended, and Section 21E of the Securities and
Exchange Act of 1934, as amended (the "Exchange Act"), and as such, may involve
risks and uncertainties. Forward-looking statements, which are based on certain
assumptions and describe future plans, strategies, and expectations, are
generally identifiable by the use of words or phrases such as "believe", "plan",
"expect", "intend", "anticipate", "estimate", "project", "forecast", "may
increase", "may fluctuate", "may improve" and similar expressions or future or
conditional verbs such as "will", "should", "would", and "could". These
forward-looking statements relate to, among other things, expectations of the
business environment in which Monterey Bay Bancorp, Inc. operates, projections
of future performance, potential future credit experience, perceived
opportunities in the market, and statements regarding the Company's mission and
vision. The Company's actual results, performance, and achievements may differ
materially from the results, performance, and achievements expressed or implied
in such forward-looking statements due to a wide range of factors. These factors
include, but are not limited to, changes in interest rates, general economic
conditions, the demand for the Company's products and services, accounting
principles or guidelines, legislative and regulatory changes, monetary and
fiscal policies of the US Government, US Treasury, and Federal Reserve, real
estate markets, competition in the financial services industry, attracting and
retaining key personnel, performance of new employees, regulatory actions,
changes in and utilization of new technologies, consumer and business response
to terrorist actions, and other risks detailed in the Company's reports filed
with the Securities and Exchange Commission ("SEC") from time to time, including
the Annual Report on Form 10-K for the fiscal year ended December 31, 2000.
These factors should be considered in evaluating the forward-looking statements,
and undue reliance should not be placed on such statements. The Company does not
undertake, and specifically disclaims any obligation, to update any
forward-looking statements to reflect occurrences or unanticipated events or
circumstances after the date of such statements.
General
Monterey Bay Bancorp, Inc. (referred to herein on an unconsolidated
basis as "MBBC" and on a consolidated basis as the "Company") is a unitary
savings and loan holding company incorporated in 1994 under the laws of the
state of Delaware. MBBC currently maintains a single subsidiary company,
Monterey Bay Bank (the "Bank"), a federally chartered savings & loan. MBBC was
organized as the holding company for the Bank in connection with the Bank's
conversion from the mutual to stock form of ownership in 1995.
At September 30, 2001, the Company had $527.1 million in total assets,
$454.9 million in net loans receivable, and $428.6 million in total deposits.
The Company is subject to regulation by the Office of Thrift Supervision ("OTS")
and the Federal Deposit Insurance Corporation ("FDIC"). The principal executive
offices of the Company and the Bank are located at 567 Auto Center Drive,
Watsonville, California, 95076, telephone number (831) 768 - 4800, facsimile
number (831) 722 - 6794. The Company may also be contacted via electronic mail
at: INFO@MONTEREYBAYBANK.COM. The Bank is a member of the Federal Home Loan Bank
of San Francisco ("FHLB") and its deposits are insured by the FDIC to the
maximum extent permitted by law. Additional information regarding the Company is
available at the www.montereybaybank.com Internet site. The Company's Internet
site is not part of this Form 10-Q.
The Company conducts business from eight branch offices, 11 automated
teller machines ("ATM's") including two stand-alone ATM's, and its
administrative facilities. In addition, the Company supports its customers
through bilingual (English / Spanish) 24 hour telephone banking, Internet
banking, electronic bill payment, and ATM access through an array of networks
including STAR, CIRRUS, and PLUS. Through its network of banking offices, the
Bank emphasizes personalized service focused upon two primary markets:
households and small businesses. The Bank offers a wide complement of lending
and deposit products.
16
The Bank also supports its customers by functioning as a federal tax
depository, selling and purchasing foreign banknotes, issuing debit cards,
providing domestic and international collection services, and supplying various
forms of electronic funds transfer. Through its wholly owned subsidiary, Portola
Investment Corporation ("Portola"), the Bank provides, on an agency basis,
mortgage life insurance, fire insurance, and a large selection of non-FDIC
insured investment products including fixed and variable annuities, mutual
funds, and individual securities.
The Company's revenues are primarily derived from interest on its loan
and mortgage backed securities portfolios, interest and dividends on its
investment securities, and fee income associated with the provision of various
customer services. Interest paid on deposits and borrowings constitutes the
Company's largest type of expense. The Company's primary sources of funds are
deposits, principal and interest payments on its asset portfolios, and various
sources of wholesale borrowings including FHLB advances and securities sold
under agreements to repurchase. The Company's most significant operating
expenditures are its staffing expenses and the costs associated with maintaining
its branch network. During the nine months ended September 30, 2001, the Company
incurred non-recurring operating costs associated with the March 2001 conversion
of its primary data processing systems of approximately $447 thousand; in
addition to the approximately $108 thousand of similar costs incurred in the
fourth quarter of 2000.
Recent Developments
Recent regulatory and financial industry developments have included the
following:
o Federal legislation reforming the bankruptcy code remains stalled in
Congress. This legislation, depending upon its final form, if any, could
potentially assist the Bank in collecting on certain credits.
o California Governor Davis signed two "predatory lending" bills in October
2001. These bills are intended to curb certain practices associated with
home mortgage loans where the rates and fees exceed specified thresholds.
The new law applies to loans applied for on or after July 1, 2002. The
Company does not anticipate a material impact from these bills, as the
Company's lending practices are within the safe harbor limits of the
legislation. In addition, it is still uncertain whether federal law
applicable to the Bank preempts these new California laws.
o Congress has continued debating various federal "predatory lending" bills.
These bills contain a wide variety of content, including restrictions on
loan points and fees, prepayment penalties, credit life insurance, and
balloon payments. The Company is unable to predict what legislation, if
any, may eventually be passed and what impact such legislation might have
upon the Company. The Company is currently subject to the Home Ownership
and Equity Protection Act and Regulation Z that govern certain lending
practices and in general do not adversely impact or restrain the Company,
as the Company does not conduct "sub-prime" lending.
o Both Congress and the California State Legislature are continuing to
discuss various pieces of "privacy" related legislation, with some
consideration that new federal laws might be specifically drafted to
preempt state privacy laws. Among topics under consideration is the
potential requirement for explicit "opt-in" documentation from customers to
permit information sharing. Depending upon the content of any final new
privacy laws, if any, the Company could experience increased operating
costs.
o New capital and membership rules for the Federal Home Loan Bank ("FHLB")
System continue to be drafted, with implementation anticipated during late
2001. The FHLB-San Francisco has circulated a draft capital plan. The
Company does not believe that this draft plan would materially impact the
Bank's balance of FHLB capital stock owned. The Federal Housing Finance
Board is analyzing the potential to ease restrictions on membership in more
than one Federal Home Loan Bank. The easing of these restrictions, if any,
depending upon their nature, could present a range of impacts upon the
individual Federal Home Loan Banks, including the FHLB-San Francisco.
o A possible increase in (e.g. from $100,000 to $200,000 per depositor, or
special limits for retirement accounts) or broadening of (e.g. all public
agency deposits) federal deposit insurance coverage, perhaps combined with
a new formula for FDIC insurance premiums, is under evaluation at the FDIC
and in Congress. Congress also continues to discuss the potential merger of
the Bank Insurance Fund ("BIF") and Savings Association Insurance Fund
("SAIF") of the FDIC.
17
State of California Energy Crisis
Various factors including the opening of new power plants, moderate
weather, the national economic slowdown, and energy conservation contributed to
the State of California's being able to meet electricity demand during the
summer of 2001 with only minimal disruption. While the peak summer demand season
is now over, longer term aspects of the California energy crisis remain,
including uncertainty regarding the settlement of the various financial
components of the crisis. These financial components include a potential adverse
impact on the State of California's general fund, the determination of which
energy customers will bear what cost burdens, and the resolution of the
financial status of the two largest utilities in the State.
The Company includes an analysis of borrowers' exposure to energy
availability and prices as part of its underwriting process for new loans and
its periodic credit review procedures for existing loans. Through September 30,
2001, the Company experienced no credit losses directly associated with the
California energy crisis.
The Company is also exposed to the California energy crisis via the
State's maintenance of $16.0 million in time deposits with the Bank as of
September 30, 2001. Should the State need to withdraw such deposits, replacement
funding for the Bank would likely be more expensive.
The Company recently completed the installation of a new and larger
natural gas powered electricity generator at its administrative headquarters
building. The new generator produces sufficient electricity to power the entire
building and all associated equipment, including the Company's primary data
processing servers. This new generator replaces a smaller unit that the Company
plans to relocate to its backup data processing "hot site", thereby providing
additional disaster recovery capability.
Events Of September 11, 2001
The Company experienced only limited and indirect impact from the
events of September 11, 2001. Sales of non-FDIC insured investment products were
suspended for a week following the actions, and then remained slow through the
end of the third quarter. A significant market maker in the Company's
NASDAQ-traded common stock that also provided equity analyst coverage was
headquartered in the World Trade Center and was more directly impacted. To help
maintain the liquidity in its stock, the Company is seeking other market makers
and intends to work with the impacted market maker as that firm rebuilds.
During the third quarter of 2001, the Company had conversations with an
investment banking firm aimed at having the firm commence providing equity
analyst coverage on the Company. This investment banking firm, however, was also
headquartered in the World Trade Center and was directly impacted by the events
of September 11, 2001.
In light of the above, the Company is uncertain when it will again be
covered by one or more equity analysts. The market liquidity in the Company's
common stock may also be impacted for a period of time due to more limited
market making by investment banking firms.
18
Overview Of Business Activity
During the third quarter of 2001, the Company continued the
implementation of its strategic plan of transforming the Bank into a community
focused commercial bank serving the financial needs of consumers and businesses
throughout the Greater Monterey Bay Area. Key accomplishments during the third
quarter of 2001 included the hiring of two experienced commercial banking
relationship managers, the continued implementation of technologies
complementary to the new core processing system installed in March 2001, and the
attainment of record levels of total assets, loans, deposits, and stockholders'
equity at September 30, 2001. In addition, the $1.1 million in earnings during
the third quarter of 2001 was the highest of any quarter in the Company's
history.
Significant events during the three and nine months ended September 30,
2001 also included:
1. The Company's ratio of net loans to total assets increased from 80.6% at
December 31, 2000 to 86.3% at September 30, 2001, in conjunction with the
Company's strategy of supporting its interest margin, fostering economic
activity in its local communities, and effectively utilizing the Bank's
capital.
2. The Company has enhanced its employee mix during 2001 through the addition
of experienced professional and commercial bankers. These new employees
were hired to advance the Company's sales to doctors, accountants,
attorneys, and other professionals, and local businesses, while also
providing improved service to the Bank's retail customers.
3. The Company continues to maintain favorable credit quality, with just $957
thousand in non-accrual loans at September 30, 2001 and $52 thousand in net
charge-offs during 2001. The Company views this favorable credit profile as
particularly important heading into a period of economic slowdown, likely
recession, and increasing unemployment - factors that are historically
associated with an increase in loan delinquencies.
4. The Board of Directors reduced its size to ten following two retirements,
thereby decreasing ongoing non-interest expense. In addition, the Directors
have actively purchased the Company's shares on the open market and
continue to receive their retainer fees exclusively in Company common
stock.
5. The Company's ratio of net interest income to average total assets was
constant for the first nine months of 2001 versus the same period in the
prior year despite significant fluctuation in capital market interest
rates, highlighting the effect of the Company's interest rate risk
management program.
6. The Bank supplemented its primary marketing campaign of 2001, centered
about the theme "Monterey Bay Bank. Expect More. Get The Best.", with local
radio ads that focused on attracting business customers interested in being
served by local professionals using a relationship banking approach. The
Bank also continued its significant increase in employee involvement in and
contributions to community development groups, coordinated by the Bank's
Director of Community Relations.
7. The Company continued its focus on stockholder value, increasing its
tangible book value per share from $12.54 at December 31, 2000 to $13.63 at
September 30, 2001. In addition, during the third quarter of 2001, several
members of the Bank's senior management team elected to receive shares of
Company common stock in lieu of cash in conjunction with pay raises. The
Company intends to continue pursuing opportunities to utilize stock based
compensation in lieu of cash compensation as a means of aligning employee
interests with improvements in stockholder value.
The Board of Directors and management have targeted the transformation
strategy into a community focused commercial bank based on their belief that
this approach presents the best current opportunity to enhance long term
stockholder value.
19
During 2001, the Company also achieved progress in addressing two
historical issues that have consumed significant resources:
A. The Special Residential Loan Pool, originally $40.0 million at its purchase
in 1998, (see "Special Residential Loan Pool") comprised of residential
mortgages with a lower credit quality than typically accepted by the Bank,
paid down to $6.3 million by October 20, 2001, compared with $16.5 million
outstanding at December 31, 2000, with the seller / servicer for the pool
continuing to meet its obligation to absorb all credit losses.
B. The Company concluded binding arbitration during the fourth quarter of 2001
to address claims by the former President and Chief Operating Officer
regarding payments due under his employment contracts. This issue has
required significant management time and has generated $284 thousand in
legal costs over the past nine months. The arbitrator's final decision
required the Company to make total payments of approximately $40 thousand
less than the Company accrued for settlement of the former executive's
claims in the third quarter of 2000, when the matter commenced. The Company
will record the recapture of the $40 thousand excess accrual in the fourth
quarter of 2001. This recapture will, however, be offset by the final legal
costs for the arbitration, resulting in no material impact upon earnings
for the fourth quarter of 2001.
The Company's strategic plan envisions a greater amount of income
property and business lending funded with a higher percentage of transaction
deposit accounts. The strategic plan also includes improvements in the Company's
efficiency ratio and return on stockholders' equity, two key measures of
financial performance where the Company has lagged peer institutions. However,
the pace of the Company's conversion from a savings & loan into a locally
focused community bank will be impacted in coming quarters by the national
economic slowdown, levels of consumer and business confidence, the interest rate
environment, the levels of unemployment and loan delinquencies, and the impact
of additional, if any, terrorist actions upon the local and state business
environment, including real estate values. The combination of historically low
interest rates and a weak economic environment may adversely impact the
Company's ability to maintain the size of its loan portfolio, as customers
refinance their mortgages into products not retained on the Company's balance
sheet and if the demand for new loans decreases. The Bank is under no immediate
pressure to pursue a change in charter at this time, as its Qualified Thrift
Lender ("QTL") ratio was 74.1% at September 30, 2001, compared to a minimum
requirement of 65.0% to retain its federal thrift charter.
Changes In Financial Condition From December 31, 2000 To September 30, 2001
Total assets increased $40.9 million, or 8.4%, from $486.2 million at
December 31, 2000 to a record $527.1 million at September 30, 2001. The rise in
assets was centered in loans and was funded with:
o reductions in cash & cash equivalents and mortgage backed securities
o increased deposits and borrowings
o an expansion in stockholders' equity
Cash & cash equivalents decreased from $25.2 million at December 31,
2000 to $13.4 million at September 30, 2001. The Company maintained a higher
than usual balance of cash & cash equivalents at the end of 2000 in part due to
loan prepayments occurring late in the year and the Company's not reinvesting
those proceeds into longer term assets before year end 2000.
Investment securities available for sale were little changed during the
first nine months of 2001, totaling $7.4 million at December 31, 2000 and $7.2
million at September 30, 2001. At both December 31, 2000 and September 30, 2001,
the Company's investment security portfolio was identically composed of two
floating rate corporate trust preferred bonds rated "A-" or better by Standards
& Poors. The decrease in balance during 2001 resulted from the mark to market
adjustment for available for sale securities, which reflects increased credit
spreads and reduced demand for long term corporate bonds repricing based upon
three month LIBOR through the year.
20
Mortgage backed securities available for sale decreased from $43.0
million at December 31, 2000 to $31.0 million at September 30, 2001, as the
Company redirected cash flows from sales, prepayments, and scheduled payments
into the expansion of the loan portfolio. Prepayments on mortgage backed
securities have been significant during 2001 due to a combination of the
historically low interest rate environment and the payoff and / or pay down of
various collateralized mortgage obligations ("CMO's"), particularly planned
amortization classes ("PAC's") that the Company had purchased over the past year
in anticipation of the funding requirements for expanded lending in 2001 in
conjunction with the implementation of the strategic plan.
During the third quarter of 2001, the Company sold two higher duration,
non-accelerated security ("NAS") class, private label CMO's totaling $9.3
million in par value in conjunction with its interest rate risk management
program and to generate additional funds for lending. At September 30, 2001, all
but $5.4 million of the Company's mortgage backed security portfolio was
comprised of Agency securities. The Bank utilizes Agency securities as
collateral for various deposit programs. The $5.4 million in non-Agency mortgage
backed securities at September 30, 2001 were all rated AAA.
The vast majority of the Company's mortgage backed securities at
September 30, 2001 were relatively low duration bonds. The Company's management
believes that allocating asset duration to new loans versus securities
facilitates better community support and derives a higher yield for the same
level of exposure to future increases in general market interest rates.
Loans held for sale increased from none at December 31, 2000 to $407
thousand at September 30, 2001. The Company's pace of mortgage banking activity
has accelerated in 2001 in conjunction with the Federal Reserve's nine interest
rate cuts through October 2001 and declines in mortgage rates from their levels
of one year ago, generating borrower impetus to refinance. The Company sells
most of its long term, fixed rate residential mortgage production into the
secondary market on a servicing released basis. All loans held for sale at
September 30, 2001 were matched with optional commitments to deliver such loans
into the secondary market. The Company sells its long term, fixed rate
residential mortgages and purchases more interest rate sensitive loans as part
of its interest rate risk management program.
Loans held for investment, net, increased from $391.8 million at
December 31, 2000 to a record $454.5 million at September 30, 2001. The increase
resulted from a combination of strong internal loan originations and from pool
purchases of various types of California real estate loans. The Company follows
its customary underwriting policies in evaluating loan pools.
The Company's total loan pipeline was lower at September 30, 2001
versus June 30, 2001. This stemmed from multiple factors, including:
o the Company's decision not to aggressively price intermediate term (e.g. 5
years fixed, then adjustable) hybrid residential mortgages in a
historically low interest rate environment
o the Company's determining not to match broker rebate payments offered by
certain large, national residential loan originators for wholesale
mortgages
o the Company's having open positions for non-residential loan relationship
managers
o the national slowdown in economic activity
The commercial lending pipeline, however, was larger at September 30, 2001 than
at June 30, 2001, reflecting the impact of the new commercial banking
relationship managers. Commercial business loans totaled $6.9 million at
September 30, 2001, or 1.3% of total assets, up from $6.1 million or 1.2% of
total assets at June 30, 2001 and up from $3.1 million or 0.6% of total assets
at December 31, 2000.
21
The Company reversed its long term loan portfolio diversification away
from residential mortgages during the first nine months of 2001, in part due to
management's concerns about the near term status of the California economy in
general and construction lending in particular. Residential mortgages comprised
44.6% of gross loans at September 30, 2001, up from 37.8% at December 31, 2000.
In contrast, construction loans declined from 13.9% of gross loans at December
31, 2000 to 9.1% of gross loans at September 30, 2001. In addition, land loans
declined from 3.8% of gross loans at December 31, 2000 to 2.3% of gross loans at
September 30, 2001.
During the fourth quarter of 2001, the Company intends to continue
pursuing its long term shift in loan mix toward income property lending, with a
particular focus on mortgages secured by multifamily buildings and various types
of commercial real estate that is other than single-use.
Multifamily loans increased from $76.7 million at December 31, 2000 to
$86.0 million at September 30, 2001. Cash flows for apartment buildings in many
parts of California have been somewhat insulated from the slowing economy by a
combination of lower debt service due to declining interest rates and stable to
greater revenue stemming from limited unit construction compared to increases in
population. The Company initiated a direct mail program soliciting the refinance
of other lenders' multifamily loans early in the fourth quarter and intends to
pursue the purchase of multifamily loans on the secondary market during the
remainder of 2001.
The Company also plans to pursue increased lending to businesses, with
an initial focus on lending to local companies, many of which have been
depositors at the Bank for several years. The Company also intends to increase
its lending to professionals (e.g. accountants, doctors, attorneys) in the
Greater Monterey Bay Area in coming quarters.
Additional information regarding loan portfolio composition is
presented in the following table:
(Dollars In Thousands) September 30, December 31,
2001 2000
--------- ---------
Held for investment:
Loans secured by real estate:
Residential one to four unit $ 212,309 $ 160,155
Multifamily five or more units 85,960 76,727
Commercial and industrial 110,735 102,322
Construction 43,199 59,052
Land 11,039 16,310
--------- ---------
Sub-total loans secured by real estate 463,242 414,566
Other loans:
Home equity lines of credit 6,208 5,631
Loans secured by deposits 212 494
Consumer lines of credit, unsecured 169 175
Business term loans 2,279 1,641
Business lines of credit 4,599 1,438
--------- ---------
Sub-total other loans 13,467 9,379
Sub-total gross loans held for investment 476,709 423,945
(Less) / Plus:
Undisbursed construction loan funds (15,955) (26,580)
Unamortized purchase premiums, net of purchase discounts 230 21
Deferred loan fees and costs, net (105) (202)
Allowance for estimated loan losses (6,387) (5,364)
--------- ---------
Loans receivable held for investment, net $ 454,492 $ 391,820
========= =========
Held for sale:
Residential one to four unit $ 407 $ --
========= =========
22
The Company's investment in the capital stock of the FHLB-SF increased
from $2.9 million at December 31, 2000 to $3.3 million at September 30, 2001due
to a combination of stock dividends received and stock purchases in conjunction
with expanded borrowing. A mandatory October stock redemption by the FHLB-SF is
anticipated to result in a decline in the Company's investment position during
the fourth quarter of 2001.
Premises and equipment, net, increased from $7.4 million at December
31, 2000 to $7.7 million at September 30, 2001 primarily due to hardware and
software purchases in support of the new core processing system.
Core deposit intangibles, net, declined by $511 thousand during the
first nine months of 2001 in conjunction with periodic amortization. Under OTS
regulations, intangible assets, including core deposit premiums, reduce
regulatory capital, resulting in lower regulatory capital ratios than would
otherwise be the case.
Total deposits increased from $407.8 million at December 31, 2000 to a
record $428.6 million at September 30, 2001. Key trends within the deposit
portfolio included:
o Non-interest bearing demand deposits increased from $17.1 million at
December 31, 2000 to $20.0 million at September 30, 2001. This rise was
supported by balances maintained by new commercial business customers, as
the Bank often requires a certain amount of compensating balances in
conjunction with a commercial credit facility. The Company has also
targeted attracting DDA balances as part of its sales management program.
This increase was also supported by the Bank's issuing checks on its own
account following the computer systems conversion. Outstanding checks drawn
on the Bank's own account are accounted for as demand deposits.
o Interest bearing NOW checking account balances decreased from $41.9 million
at December 31, 2000 to $41.1 million at September 30, 2001. During 2001,
the Company has experienced particularly aggressive advertising and price
competition for NOW deposits from two large thrifts. These two large
thrifts have at times paid, and extensively marketed, interest rates 100
basis points or more in excess of federal funds on consumer NOW accounts,
particularly on accounts with higher balances. The Company has been
reluctant to match these prices, and has instead focused on competing based
upon service, convenience, flexible access (e.g. bilingual telephone
banking, Internet banking, ATM access, debit card, and in-branch service),
and overall business relationships.
o Savings deposits increased from $16.5 million at December 31, 2000 to $19.5
million at September 30, 2001. This increase was primarily due to the
re-categorization of approximately $4.2 million in balances from money
market accounts to savings accounts in conjunction with the computer
systems conversion. By the end of the first quarter of 2001, the Company
eliminated its passbook based deposit accounts in favor of statement based
accounts that integrate effectively with global ATM networks, debit cards,
Internet banking, and telephone access. Management also believes that
statement based deposit products present a lower likelihood of operating
losses and provide a more regular opportunity for customer communication
and marketing.
o Money market deposits increased from $87.7 million at December 31, 2000 to
$97.1 million at September 30, 2001, with most of the growth occurring in
the third quarter when the Company advertised its tiered Money Market Plus
account and conducted an internal sales campaign. The Money Market Plus
product pays interest rates competitive with money market mutual funds for
higher balance accounts, plus provides flexible access through Internet
banking, telephone banking, ATM's, and in-branch service. Money market
deposit balances during the third quarter of 2001 were also bolstered by a
$5.0 million deposit from a single customer.
o Certificate of deposit balances increased from $244.7 million at December
31, 2000 to $250.9 million at September 30, 2001, with a slight decrease in
balances during the third quarter of 2001. The Company redesigned its
certificate of deposit products during the first quarter of 2001, providing
the opportunity for customers to earn higher interest rates by increasing
their balances, expanding their relationship with the Bank, and / or
incrementally extending the term of their accounts. During most of 2001,
the Company has priced its longer term (18 to 60 months) certificates of
deposit attractively as part of its asset / liability management program
and to encourage the development of longer term customer relationships.
23
Transaction accounts increased from 40.0% of total deposits at December
31, 2000 to 41.5% of total deposits at September 30, 2001. Continuing this
change in deposit mix is integral to the Company's strategic plan, as
transaction accounts provide for a lower cost of funds versus most other funding
sources, generate fee income, furnish opportunities for cross-selling other
products and services to customers, and are typically less interest rate
sensitive than many other funding sources. The Company continues to focus its
advertising, marketing, product development, and sales efforts on attracting new
deposit transaction accounts, including those from businesses. The Company is
currently testing Internet banking for commercial business customers, with a
planned introduction early in 2002. The Company is also developing an internal
sweep product for businesses, whereby checking balances in excess of certain
thresholds can be transferred into a higher yielding money market account.
With the aforementioned focus on transaction accounts, the Company does
not anticipate significantly expanding the certificate of deposit portfolio in
coming quarters. This expectation is reinforced by the offering of certificate
of deposit interest rates significantly in excess of wholesale funding costs for
similar terms by several large thrift institutions during the third and early
fourth quarters of 2001. The Company has been reluctant to match such pricing,
with a willingness to substitute an increase in FHLB advances or other wholesale
funding in lieu of retaining relatively high cost retail certificates of deposit
should additional funding be required.
The Company's ratio of loans to deposits increased from 96.08% at
December 31, 2000 to 106.13% at September 30, 2001, as the strong loan growth
eclipsed the expansion in deposits. In light of this ratio, the Company is
exploring various strategic alternatives for increasing its funding base,
including:
o new sites for traditional stand-alone branches
o expanded provision of courier services to businesses
o increased business lending with associated compensating customer deposit
balances
o relationship loan pricing for income property owners maintaining operating
accounts with the Company
Borrowings increased from $32.6 million at December 31, 2000 to $47.9
million at September 30, 2001. The Company has acquired additional FHLB advances
during 2001 to provide funding for the expansion in the loan portfolio. All of
the Company's FHLB advances at September 30, 2001 were fixed rate, bullet
(non-amortizing), without embedded options, such as granting the FHLB the
ability to call the borrowing prior to maturity. Should cash inflows from
mortgage prepayments or other sources during the fourth quarter of 2001 exceed
the Company's requirements, $10.0 million in FHLB advances maturing during the
first quarter of 2001 may be prepaid. The Company prepaid a $5.0 million FHLB
advance during the third quarter of 2001.
Total stockholders' equity increased from $43.8 million at December 31,
2000 to $48.7 million at September 30, 2001. Factors contributing to the
increase included:
o $2.6 million in 2001 year to date net income
o continued amortization of deferred stock compensation, including the
issuance of certain compensation plan shares in lieu of cash compensation
o the payment of Director retainer fees with Company common stock
o the exercise of 112 thousand vested stock options by former employees and
Directors, generating $1.1 million in additional stockholders' equity
o $561 thousand in other comprehensive income, net, stemming from the
appreciation in the portfolios of securities classified as available for
sale, which in turn resulted from the decline in general market interest
rates during 2001
The Company plans to continue utilizing stock based compensation in
lieu of cash compensation for certain payments during the remainder of 2001. The
Company has not conducted any share repurchases during 2001. The Company's
tangible book value per share increased from $12.54 at December 31, 2000 to
$13.63 at September 30, 2001.
24
Interest Rate Risk Management And Exposure
The table below presents an overview of the interest rate environment
during the 21 months ended September 30, 2001. The 12MAT and 11th District Cost
Of Funds Index ("COFI") are by nature lagging indices that trail changes in more
responsive interest rate indices such as those associated with the Treasury or
LIBOR markets.
Index/ Rate 12/31/99 3/31/00 6/30/00 9/30/00 12/31/00 3/31/01 6/30/01 9/30/01
----------- -------- ------- ------- ------- -------- ------- ------- -------
3 month Treasury bill 5.31% 5.87% 5.85% 6.20% 5.89% 4.28% 3.65% 2.37%
6 month Treasury bill 5.73% 6.14% 6.22% 6.27% 5.70% 4.13% 3.64% 2.35%
2 year Treasury note 6.24% 6.47% 6.36% 5.97% 5.09% 4.18% 4.24% 2.85%
5 year Treasury note 6.34% 6.31% 6.18% 5.85% 4.97% 4.56% 4.95% 3.80%
10 year Treasury note 6.44% 6.00% 6.03% 5.80% 5.11% 4.92% 5.41% 4.59%
30 year Treasury bond 6.48% 5.83% 5.90% 5.88% 5.46% 5.44% 5.76% 5.42%
1 year LIBOR 6.50% 6.94% 7.18% 6.80% 6.00% 4.67% 4.18% 2.64%
Target federal funds 5.50% 6.00% 6.50% 6.50% 6.50% 5.00% 3.75% 3.00%
Prime rate 8.50% 9.00% 9.50% 9.50% 9.50% 8.00% 6.75% 6.00%
12MAT 5.08% 5.46% 5.79% 6.04% 6.11% 5.71% 5.10% 4.40%
COFI 4.85% 5.00% 5.36% 5.55% 5.62% 5.20% 4.50% 3.97%
In an effort to limit the Company's exposure to interest rate changes,
management monitors and evaluates interest rate risk on a regular basis,
including participation in the OTS Net Portfolio Value Model and associated
regulatory reporting. Management believes that interest rate risk and credit
risk compose the two greatest financial exposures faced by the Company in the
normal course of its business. The Company is not directly exposed to risks
associated with commodity prices or fluctuations in foreign currency values.
In the past year, the Company has maintained a relatively balanced
exposure to changes in general market interest rates as measured by potential
prospective changes in net portfolio value, also referred to as market value of
portfolio equity. These potential prospective changes in net portfolio value are
calculated based upon immediate, sustained, and parallel shifts in the term
structure of interest rates, often referred to as the "yield curve". In other
words, these calculations highlight that the fair value of the Company's assets
exhibits about the same volatility as does its liabilities. However, in addition
to the overall direction of general market interest rates, changes in relative
rates (i.e. the slope of the term structure of interest rates) and relative
credit spreads also impact net portfolio value and the Company's profitability.
As highlighted in the above table, over the past 21 months, general
market interest rates first increased rapidly in early 2000, reached a plateau
approximately during the third quarter of 2000, and then fell rapidly throughout
the first nine months of 2001. The Federal Reserve cut its benchmark interest
rates a total of nine times in 2001 through October 2, 2001, for a total
decrease of 400 basis points. This decline represented a historically rapid and
aggressive set of actions by the Federal Reserve, as it sought to reinvigorate
the national economy.
Throughout the volatile 21 month time period covered in the above
table, the impact of changing rates on the Company's interest margin was
moderate, providing empirical support for the financial modeling previously
described.
During 2001, the Company has sought to maintain its relatively balanced
interest rate risk profile by avoiding adding significant volumes of long term,
fixed rate assets to the balance sheet. Long term, fixed rate assets are
relatively more challenging to match fund, and therefore can expose the Company
to interest rate risk in rising interest rate environments. During the first
nine months of 2001, the Company continued to sell the majority of its long
term, fixed rate residential loan production into the secondary market on a
servicing released basis. Mortgage backed security purchases were primarily
either short term, fixed rate or longer maturity, but floating rate. Loan pool
purchases were generally either adjustable rate or seasoned hybrid mortgages, as
defined below.
25
The steeper yield curve present in mid-2001 combined with the lagging
nature of the COFI and 12MAT indices to encourage more mortgage borrowers to
select the Company's hybrid "3/1" and "5/1" loan programs versus long term,
fixed rate loans or traditional adjustable rate mortgages. The hybrid programs
provide initial fixed rates for three or five years, after which time the
mortgages adjust their rates semi-annually at a margin over the One Year
Treasury Constant Maturities Index. The Company has thus added a significant
volume of hybrid loans to its balance sheet in 2001. However, by the end of the
third quarter of 2001, the historically low level of interest rates led most of
the Company's residential loan borrowers to pursue long term, fixed rate
mortgages, with diminished interest in hybrid loans and negligible interest in
traditional adjustable rate mortgages.
The Company's assets thus became, in aggregate, slightly less interest
rate sensitive than its liabilities in mid 2001, which favorably impacted net
interest income as market interest rates continued to decline. Anticipated
increases in asset prepayment speeds and the continued implementation of the
Company's strategic plan, as discussed below, is expected to return the Company
to a more nearly balanced interest rate risk profile over the next several
quarters.
The strategic plan of transforming the Bank into a community focused
financial services provider by nature presents a lower interest rate risk
profile than historically experienced by the Bank when the balance sheet was
highly concentrated in residential mortgages (including long term, fixed rate),
which present greater embedded optionality than many other types of loans.
Serving the financial needs of local businesses is by nature asset sensitive, as
primarily variable rate commercial loans are in part funded with demand deposit
balances. Growth in the Company's business banking thus helps offset some of the
interest rate risk (net liability sensitivity) typically present in mortgage
lending.
The Company is concerned about the possible impacts of the historically
low interest rate environment present in early November, 2001. With interest
rates at such low nominal levels, the Company could experience margin
compression since rates on various types of deposit accounts are either zero or
near-zero, and thus no longer provide an opportunity to reduce the Company's
cost of funding. In addition, historically low interest rates could spur a
sufficiently large refinancing wave that could present the Company with excess
liquidity at a time when reinvestment options would be relatively unattractive.
Liquidity
Liquidity is actively managed to ensure sufficient funds are available
to meet ongoing needs of both the Company in general and the Bank in particular.
Liquidity management includes projections of future sources and uses of funds to
ensure the availability of sufficient liquid reserves to provide for
unanticipated circumstances. The Company's primary sources of funds are customer
deposits, principal and interest payments on loans and securities, FHLB advances
and other borrowings, and, to a lesser extent, proceeds from sales of loans and
securities. While maturities and scheduled amortization of loans and securities
are predictable sources of funds, deposit flows and prepayments on mortgage
related assets are significantly influenced by general market interest rates,
economic conditions, and competition.
OTS regulations require that the Bank maintain a safe and sound level
of liquidity at all times. Management believes that having a surplus of
available liquidity at all times is prudent and fundamental to effective Bank
management.
At September 30, 2001, the Company had $13.4 million in cash and cash
equivalents, untapped borrowing capacity in excess of $115.0 million at the
FHLB-SF, and a significant volume of residential mortgages that could be
securitized, liquidated, or used in collateralized borrowings in order to meet
future liquidity requirements. During the third quarter of 2001, the Bank
pledged additional loan collateral to the FHLB-SF and enrolled in the FHLB's
specific loan pledging program in order to increase its borrowing capacity.
MBBC and the Bank have each entered into several Master Repurchase
Agreements to permit securities sold under agreements to repurchase transactions
with a number of counterparties. In addition, at September 30, 2001, the Bank
maintained $25.5 million in unsecured federal funds lines of credit from four
correspondent financial institutions. However, there can be no assurance that
funds from these lines of credit will be available at all times, or that the
lines will be maintained in future periods. The Bank is able to issue wholesale
"DTC" certificates of deposit through two large, national investment banking
firms as an additional source of liquidity.
26
At September 30, 2001, MBBC on a stand alone basis had cash & cash
equivalents of $4.2 million. In addition, MBBC had no outstanding balance on a
$2.0 million revolving line of credit. The loan agreement for this line of
credit contains certain restrictions on the use of borrowed funds, including a
prohibition for such funds to be used to repurchase Company common stock. The
Company intends to seek an increase in this line of credit before the end of
2001 in order to enhance MBBC's available liquidity.
Due to additional capital requirements implemented by the OTS for the
Bank in conjunction with the Special Residential Loan Pool, the Bank is
currently limited, but not prohibited, in its ability to pay dividends to MBBC.
Capital Resources And Regulatory Capital Compliance
Federal banking regulatory agencies maintain a system providing for
regulatory sanctions against financial institutions that are not adequately
capitalized. The severity of these sanctions increases to the extent that an
institution's capital falls further below the adequately capitalized thresholds.
OTS Prompt Corrective Action ("PCA") regulations require specific capital ratios
for five separate capital categories as set forth below:
Core Capital Core Capital Total Capital
To Adjusted To To
Total Assets Risk-weighted Risk-weighted
(Leverage Ratio) Assets Assets
---------------- ------ ------
Well capitalized 5% or above 6% or above 10% or above
Adequately capitalized 4% or above 4% or above 8% or above
Undercapitalized Under 4% Under 4% Under 8%
Significantly undercapitalized Under 3% Under 3% Under 6%
Critically undercapitalized Ratio of tangible equity to adjusted total assets of 2% or less
The following table summarizes the capital ratios required for an
institution to be considered well capitalized and the Bank's regulatory capital
at September 30, 2001 as compared to such ratios.
Core Capital Core Capital To Total Capital To
To Adjusted Risk-weighted Risk-weighted
(Dollars In Thousands) Total Assets Assets Assets
----------------------- ----------------------- -----------------------
Balance Percent Balance Percent Balance Percent
------- ------- ------- ------- ------- -------
Bank regulatory capital $42,629 8.12% $42,629 11.44% $47,307 12.70%
Well capitalized requirement 26,253 5.00% 22,353 6.00% 37,255 10.00%
------ ----- ------ ----- ------ ------
Excess $16,376 3.12% $20,276 5.44% $10,052 2.70%
======= ===== ======= ===== ======= =====
Adjusted assets (1) $525,060 $372,552 $372,552
======== ======== ========
------------------------------------- -----------
(1) The above line for "adjusted assets" refers to the term "adjusted total
assets" as defined in 12 C.F.R. Section 567.1(a) for purposes of core capital
requirements, and refers to the term "risk-weighted assets" as defined in C.F.R.
Section 567.1(bb) for purposes of risk-based capital requirements.
The Bank has been informed by the OTS that it is to maintain its
regulatory capital ratios at levels no less than those in effect at December 31,
1999 until further notice (see "Special Residential Loan Pool"). The following
table demonstrates the Bank's compliance with this institution-specific
regulatory capital requirement.
September 30, 2001 December 31, 1999
------------------ -----------------
Core capital to adjusted total assets 8.12% 7.11%
Core capital to risk-weighted assets 11.44% 9.58%
Total capital to risk-weighted assets 12.70% 10.56%
27
Other OTS capital regulations require the Bank to maintain: (a)
tangible capital of at least 1.5% of adjusted total assets (as defined in the
regulations), (b) core capital of at least 4.0% of adjusted total assets (as
defined in the regulations) (unless the Bank has been assigned the highest
composite rating under the Uniform Financial Institutions Rating System, in
which case 3.00%), and (c) total capital of at least 8.0% of risk-weighted
assets (as defined in the regulations).
The following table summarizes these regulatory capital requirements
for the Bank. As indicated in the table, the Bank's capital levels at September
30, 2001 exceeded all three of the currently applicable minimum regulatory
capital requirements.
Percent Of
Adjusted
(Dollars In Thousands) Total
Amount Assets
------ ------
Tangible Capital
Regulatory capital $42,629 8.12%
Minimum required 7,876 1.50%
------- -----
Excess $34,753 6.62%
======= =====
Core Capital
Regulatory capital $42,629 8.12%
Minimum required 21,002 4.00%
------- -----
Excess $21,627 4.12%
======= =====
Percent Of
Risk-
weighted
Amount Assets
------ ------
Risk-based Capital
Regulatory capital $47,307 12.70%
Minimum required 29,804 8.00%
------- -----
Excess $17,503 4.70%
======= =====
At September 30, 2001, the Bank's regulatory capital levels exceeded
the thresholds required to be classified as a "well capitalized" institution.
The Bank's regulatory capital ratios detailed above do not reflect the
additional capital (and assets) maintained by MBBC. Management believes that,
under current regulations and institution-specific requirements, the Bank will
continue to meet its minimum capital requirements. However, events beyond the
control of the Bank, such as changing interest rates or a downturn in the
economy or real estate markets in the areas where the Bank has most of its
loans, could adversely affect future earnings and, consequently, the ability of
the Bank to meet its future minimum regulatory capital requirements.
28
Asset Quality / Credit Profile
Non-performing Assets
The following table sets forth information regarding non-performing
assets at the dates indicated.
(Dollars In Thousands) September 30, 2001 December 31, 2000
------------------ -----------------
Outstanding Balances Before Valuation Reserves
Non-accrual loans $ 957 $ 4,666
Loans 90 or more days delinquent and accruing interest -- --
Restructured loans in compliance with modified terms -- 75
------ -------
Total gross non-performing loans 957 4,741
Investment in foreclosed real estate before valuation reserves -- --
Repossessed consumer assets -- --
------ -------
Total gross non-performing assets $ 957 $ 4,741
====== =======
Gross non-accrual loans to total loans 0.21% 1.17%
Gross non-performing loans to total loans 0.21% 1.19%
Gross non-performing assets to total assets 0.18% 0.98%
Allowance for loan losses $6,387 $5,364
Allowance for loan losses to non-performing loans 667.40% 113.14%
Valuation allowances for foreclosed real estate $ -- $ --
Non-accrual loans at September 30, 2001 are detailed in the following
table:
(Dollars In Thousands) Number Principal Balance
Of Outstanding At
Category Of Loan Loans September 30, 2001
---------------- ----- ------------------
Residential one to four unit mortgage 4 $ 875
Business line of credit 2 43
Business term loan 2 38
Consumer line of credit 1 1
- ------
Total 9 $ 957
= ======
In April 2001, the Bank collected in full on a $544 thousand commercial
& industrial real estate mortgage and a $2.85 million commercial real estate
construction loan that were on non-accrual status and classified as substandard.
Both loans were located in the Bank's primary market area. The commercial
construction loan had a $600 thousand specific reserve. In conjunction with both
payoffs, the Bank received all principal, interest, fees, and expense
reimbursements due.
29
Criticized And Classified Assets
The following table presents information concerning the Company's
inventory of criticized ("OAEM") and classified ("substandard" and lower)
assets. The category "OAEM" refers to "Other Assets Especially Mentioned", or
those assets which present indications of potential future credit deterioration.
(Dollars In Thousands) OAEM Substandard Doubtful Loss Total
---- ----------- -------- ---- -----
December 31, 2000 $ 2,283 $ 6,323 $ -- $ 600 $ 9,206
March 31, 2001 $ 5,182 $ 4,897 $ -- $ 600 $10,679
June 30, 2001 $ 5,100 $ 4,048 $ -- $ -- $ 9,148
September 30, 2001 $ 5,369 $ 3,539 $ -- $ -- $ 8,908
Classified assets as a percent of stockholders' equity decreased from
15.8% at December 31, 2000 to 7.3% at September 30, 2001.
The September 30, 2001 substandard assets in the above table include a
$2.3 million "mini-perm" mortgage loan participation maturing in 2004 secured by
a beach resort in the Company's primary business area. The resort has
experienced lower occupancy than forecast, contributing to a reduced cash flow
and inadequate debt service coverage. The borrowers have continued to timely
make all loan payments, and no delinquency was experienced through September 30,
2001. The Company downgraded this loan from OAEM during the second quarter of
2001 because of the cash flow inadequacy and concerns that a potential
additional slowdown in economic activity might further reduce occupancy or
realized average room rates. The Company intends to continue closely monitoring
this loan.
The September 30, 2001 OAEM assets in the above table include a $2.4
million construction loan participation for the development of a residential
project in the Coachella Valley in southern California. The borrowers were
current in their payments at September 30, 2001. However, slower than
anticipated sales of homes and lots within the development led to the credit's
being identified as "OAEM". This loan matures late in the fourth quarter of
2001, and the Company has requested payoff in full at that time.
Impaired Loans
At September 30, 2001, the Company had total gross impaired loans,
before specific reserves, of $957 thousand, constituting 9 credits. This
compares to total gross impaired loans of $5.3 million at December 31, 2000.
Interest is accrued on impaired loans on a monthly basis except for those loans
that are 90 or more days delinquent or those loans which are less than 90 days
delinquent but where management has identified concerns regarding the collection
of the credit. For the nine months ended September 30, 2001, accrued interest on
impaired loans was zero and interest of $61 thousand was received in cash. If
all non-accrual loans had been performing in accordance with their original loan
terms, the Company would have recorded interest income of $83 thousand during
the nine months ended September 30, 2001, instead of interest income actually
recognized, based on cash payments, of $61 thousand.
Hotel / Motel Loans
At September 30, 2001, the Company had 21 real estate loans outstanding
that are secured by hotel / motel properties. The aggregate outstanding balance
for these loans at September 30, 2001 was $32.7 million. Various reports have
indicated that travel industry businesses such as hotels / motels have been
particularly adversely impacted since the events of September 11, 2001. The
Company intends to augment its normal credit monitoring for these loans. In
addition, depending upon the information resulting from such increased
monitoring, the Company may alter its loan loss reserve factor for these credits
in the fourth quarter of 2001 to more accurately reflect the inherent loss in
this portfolio. The potential credit deterioration of this portfolio could
therefore impact the levels of future provisions for loan losses.
30
Special Residential Loan Pool
During 1998, the Bank purchased a $40.0 million residential mortgage
pool comprised of loans secured by homes throughout the nation (but with a
concentration in California) that presented a borrower credit profile and / or a
loan to value ratio outside of (less favorable than) the Bank's normal
underwriting criteria. To mitigate its credit risk for this portfolio, the Bank
obtained at purchase a scheduled principal / scheduled interest loan servicing
agreement from the seller. Further, this agreement also contains a guaranty by
the seller to absorb any principal losses on the portfolio in exchange for the
seller's retention of a portion of the loans' yield through loan servicing fees.
In obtaining these credit enhancements, the Bank functionally aggregated the
credit risk for this loan pool into a single borrower credit risk to the seller
/ servicer of the loans. The Bank was subsequently informed by the OTS that
structuring the purchase in this manner made the transaction an "extension of
credit" by the Bank to the seller, which, by virtue of its size, violated the
OTS' "Loans To One Borrower" regulation. The Bank continues to report to the OTS
in this regard on a monthly basis.
At September 30, 2001, the outstanding principal balance of this
mortgage loan pool was $6.8 million, comprised of 59 mortgages, with $554
thousand received during October, 2001 (normal monthly remittance cycle) based
upon prepayments and scheduled principal for September, 2001. At December 31,
2000, the outstanding principal balance of this mortgage loan pool was $16.5
million. The loans in this mortgage pool bear interest rates significantly in
excess of current market rates for similar new loans extended to borrowers with
moderate or better credit profiles. This rate differential contributed to the
level of prepayments realized on the portfolio during 2001.
Through the October 20, 2001 regularly scheduled remittance date, the
seller performed per the loan servicing agreement, making scheduled principal
and interest payments to the Bank while also absorbing all credit losses on the
loan portfolio. At September 30, 2001, the Company categorized all loans within
this mortgage pool as performing based upon the continued payment performance of
the seller.
As of the October 20, 2001 remittance and reporting date for activity
through September 30, the mortgage pool included three foreclosed properties.
The seller continued to advance scheduled interest and principal payments to the
Company for these three mortgages, totaling $503 thousand in loan principal
balance.
Despite the performance of the seller, however, the Company has
allocated certain reserves to this mortgage pool at September 30, 2001 due to
concerns regarding the potential losses by the seller in honoring the guaranty,
the present delinquency profile of the pool, and the differential between loan
principal balances and current appraisals for foreclosed loans and loans in the
process of foreclosure.
The Company continues to monitor the financial performance and
condition of the seller on a monthly basis. The earnings and capital of the
seller have experienced favorable results during 2001, supported by the strong
mortgage refinance market. In addition, the Company analyzes the payment
performance and credit profile of the remaining outstanding loans on a monthly
basis.
During the first quarter of 2000, the Bank was informed by the OTS
that:
1. all loans associated with this loan pool would be required to be assigned
to the 100% risk based capital category in calculating regulatory capital
ratios that incorporate risk weighted assets
2. the Bank's regulatory capital position at December 31, 1999 and thereafter
must reflect the above requirement
3. until further notice, the Bank's regulatory capital ratios were required to
be maintained at levels no lower than the levels at December 31, 1999
Because remaining a "well capitalized" financial institution is
integral to the Bank's business strategy and due to the Bank's current
regulatory capital position, management does not foresee that the aforementioned
requirements will have a material adverse impact upon the Company in 2001.
31
Allowance For Loan Losses
The allowance for loan losses is established through a provision for
loan losses based on management's evaluation of the risks inherent in the loan
portfolio, including unused commitments to provide financing. In determining
levels of risk, management considers a variety of factors, including, but not
limited to, asset classifications, economic trends, industry experience and
trends, geographic concentrations, estimated collateral values, historical loan
loss experience, and the Company's underwriting policies. The allowance for loan
losses is maintained at an amount management considers adequate to cover losses
in loans receivable which are deemed probable and estimable. While management
uses the best information available to make these estimates, future adjustments
to allowances may be necessary due to economic, operating, regulatory, and other
conditions that may be beyond the Company's control. In addition, various
regulatory agencies, as an integral part of their examination process,
periodically review the Bank's allowance for loan losses. Such agencies may
require the Bank to recognize additions to the allowance based on judgements
different from those of management.
The allowance for loan losses is comprised of three primary types of
allowances:
1. Formula Allowance
Formula allowances are based upon loan loss factors that reflect
management's estimate of the inherent loss in various segments of
or pools within the loan portfolio. The loss factor is multiplied
by the portfolio segment (e.g. multifamily permanent mortgages)
balance (or credit commitment, as applicable) to derive the
formula allowance amount. The loss factors are updated
periodically by the Company to reflect current information that
has an effect on the amount of loss inherent in each segment.
2. Specific Allowance
Specific allowances are established in cases where management has
identified significant conditions or circumstances related to an
individually impaired credit. In other words, these allowances are
specific to the loss inherent in a particular loan. The amount for
a specific allowance is calculated in accordance with SFAS No.
114, "Accounting By Creditors For Impairment Of A Loan".
3. Unallocated Allowance
The Company maintains an unallocated loan loss allowance that is
based upon management's evaluation of conditions that are not
directly measured in the determination of the formula and specific
allowances. The evaluation of inherent loss with respect to these
conditions is subject to a higher degree of uncertainty because
they are not identified with specific problem credits or
historical performance of loan portfolio segments. The conditions
evaluated in connection with the unallocated allowance at
September 30, 2001 included the following, which existed at the
balance sheet date:
o General business and economic conditions affecting the
Company's key lending areas
o Real estate values in California
o Loan volumes and concentrations
o Seasoning of the loan portfolio
o Status of the current business cycle
o Specific industry or market conditions within portfolio
segments
32
The following table presents activity in the Company's allowance for
loan losses during the nine months ended September 30, 2001 and September 30,
2000:
Nine Months Ended September 30,
-----------------------------------------
2001 2000
---- ----
Allowance For Loan Losses (Dollars In Thousands)
-------------------------
Balance at beginning of year $ 5,364 $ 3,502
Charge-offs:
Residential one to four unit real estate loans -- (371)
Consumer lines of credit (2) --
Business lines of credit (50) --
------- -------
Total charge-offs (52) (371)
Recoveries -- --
Provision for loan losses 1,075 1,675
------- -------
Balance at September 30 $ 6,387 $ 4,806
======= =======
Annualized ratio of net charge-offs during the period to average
loans receivable, net, outstanding during the period 0.02% 0.13%
Additional ratios applicable to the allowance for loan losses include:
September 30, 2001 December 31, 2000
------------------ -----------------
Allowance for loan losses as a percent of non-performing loans 667.40% 113.14%
Allowance for loan losses as a percent of gross loans receivable net of
undisbursed loan funds and unamortized yield
Adjustments 1.38% 1.35%
Allowance for loan losses as a percent of classified assets 180.47% 77.48%
33
At September 30, 2001, the allowance for loan losses was comprised of
$5.2 million in formula allowance, zero specific allowance, and $1.2 million in
unallocated allowance. The $5.2 million in formula allowance included amounts
for the Special Residential Loan Pool as described elsewhere in this report. The
$1.2 million in unallocated allowance reflected the Company's consideration of
the following factors, as well as more general factors including the shrinking
economy, increased layoffs and unemployment, and consumer and business reactions
to the events of September 11, 2001:
o The recent adverse effects of a decline in tourism impacting the
hospitality industry that is a significant component of the economies in
Santa Cruz and Monterey counties, which could be in the range of $100
thousand to $500 thousand.
o The adverse impacts of the weakening technology industry upon commercial
real estate values. The Company's primary lending area is near the Silicon
Valley area of the San Francisco Bay Area, which has been impacted by the
slump in various technology and technology related businesses. This impact
could be in the range of $275 thousand to $550 thousand.
o Slowing housing activity could lead to increased losses associated with
construction lending, particularly for homes being built on a speculative
or non-pre-sold basis. At September 30, 2001, the Company had gross credit
commitments of $18.3 million for speculative construction of homes. This
impact could be in the range of $100 thousand to $400 thousand.
o The charge-off in 2001 of $50 thousand in loans from the Company's
portfolio of "Business Express" loans may indicate the need to increase the
Company's loss factors for this portfolio. These loans have a maximum
credit limit of $25 thousand and were targeted to very small local
businesses. These borrowers may be particularly impacted by the shrinking
economy due to their often more limited financial resources. At September
30, 2001, the Company had $536 thousand in Business Express loans
outstanding. The inherent loss in this portfolio could exceed the formula
allowance by a range of $25 thousand to $100 thousand.
As subsequently discussed (see "Provision For Loan Losses"), the lower
provision for loan losses recorded during the first nine months of 2001 versus
the same period in the prior year resulted from multiple factors, including
lower net charge-offs, the recapture of a $600 thousand specific reserve during
the second quarter of 2001, and changes in the volume and mix of the loan
portfolio.
Management anticipates that should the Company accomplish its strategic
plan and be successful in:
o generating further growth in loans receivable held for investment
o emphasizing the origination and purchase of income property real estate
loans
o continuing expansion of commercial business lending
future provisions will result and the ratio of the allowance for loan losses to
loans outstanding will increase. Experience across the financial services
industry indicates that commercial business and income property loans present
greater risks than residential real estate loans, and therefore should be
accompanied by suitably higher levels of reserves.
34
Comparison Of Operating Results For The Three Months And Nine Months
Ended September 30, 2001 and September 30, 2000
General
During the third quarter of 2001, the Company reported net income of
$1.1 million, equivalent to $0.31 diluted earnings per share. This compares to
net income of $461 thousand, or $0.15 diluted earnings per share, for the same
period in 2000. Net income during the quarter ended June 30, 2001 (the
immediately preceding quarter) was $949 thousand, equivalent to $0.29 diluted
earnings per share.
For the nine months ended September 30, 2001, net income was $2.6
million, equivalent to $0.79 diluted earnings per share. This compares to net
income of $1.8 million, or $0.58 diluted earnings per share, for the first nine
months of 2000.
The Company realized some of the financial benefits from its
transformation strategy during the first nine months of 2001. Net interest
income rose, primarily due to a larger average balance sheet fueled by increased
deposits and loans. Customer service charge income expanded, assisted by the new
fee & service charge schedule and financial product revisions implemented with
the new core processing system in March 2001. In addition, the Company began
realizing certain operating efficiencies from the new technology environment
following the systems conversion. The Company maintained favorable credit
quality during 2001, thus avoiding significant operating costs for collections
and foreclosures. Net income during the first half of 2001 was impacted by
(pre-tax) operating costs for the conversion of the Company's core data
processing system ($447 thousand) and legal expenses associated with the
arbitration of claims by a former executive ($284 thousand).
Interest Rate Environment
The table presented above under "Interest Rate Risk Management And
Exposure" furnishes an overview of the interest rate environment during the most
recent seven quarters. Market interest rates have varied considerably during
this time period. In early 2000, the Federal Reserve continued increasing its
target federal funds rate (commenced in 1999), expressing concern about the
rapid pace of economic expansion, the booming equity markets (particularly
NASDAQ), and the combination of very low unemployment, spot labor shortages, and
increased compensation costs which presented the potential for a rise in
inflation. During the second half of 2000, many capital markets interest rates
(e.g. LIBOR and Treasuries) began declining in response to falling equity
markets and slowing economic growth. The Federal Reserve did not commence
cutting its benchmark interest rates until the first week of 2001. The Federal
Reserve then cut the target federal funds rate a total of 400 basis points over
nine separate occasions through early October, 2001, taking the target federal
funds rate from 6.50% on January 2, 2001 to 2.50% on October 2, 2001. By early
November, 2001, various Wall Street firms were forecasting the federal funds
rate as low as 1.50% over the coming months. The Company cannot, however,
forecast the future direction, levels, or term structures of interest rates.
The year 2001 began with an inverted Treasury curve, highlighting a
traditionally difficult interest rate environment for financial institutions,
including the Bank. Financial institutions generally benefit from a positively
sloped term structure of interest rates, whereby higher duration assets may be
funded at a favorable spread with shorter term liabilities, and whereby fixed
rate assets appreciate in market price as they move nearer to maturity. By the
end of the first quarter of 2001, the Treasury curve from three months through
two years was relatively flat. Following additional interest rate cuts by the
Federal Reserve during the second quarter of 2001, the Treasury curve became
steeper, with short term Treasury rates falling and long term Treasury rates
rising between March 31 and June 30, 2001. During the third quarter of 2001,
additional interest rate cuts led to the steepest yield curve in the past two
years. During the summer of 2001, the Company took advantage of the steeper term
structure of interest rates by funding certain hybrid residential loans (i.e.
fixed for 3 - 5 years, then floating) with lower duration liabilities.
35
Net Interest Income
Net interest income increased from $4.4 million and $13.4 million
during the third quarter and first nine months of 2000, respectively, to $5.0
million and $14.5 million during the same periods in 2001 primarily due to
greater average balances of interest earning assets and liabilities. The
Company's ratio of net interest income to average total assets was 3.79% and
3.80% for the three and nine months ended June 30, 2001, compared to 3.67% and
3.80% during the same periods in 2000. The Company's margins were impacted in
2001 by a shift in loan mix toward residential mortgages. Margins were also
hampered during the early part of 2001 by the Company's offering higher than
normal relative retail deposit pricing to facilitate customer retention
following the core systems conversion. In addition, during the second and third
quarters of 2001, the Company experienced difficulty decreasing its NOW and
Savings deposit rates at the same pace as the declines in indices utilized for
adjustable rate loans, as the NOW and Savings rates were already at low nominal
levels.
Other factors influencing net interest income during the first three
and nine months of 2001 compared to the same periods of 2000 included:
o During the first half of 2000, the Company benefited from locking in a
significant volume of funding during the fourth quarter of 1999 and early
2000 in a rising interest rate environment.
o The FHLB-SF paid particularly high dividend rates on its capital stock
during the first half of 2000 in conjunction with its capital management
program.
o The Company increased the size of its balance sheet early in 2001 in
anticipation of a declining interest rate environment, funding new short to
intermediate term assets with low duration borrowings. This favorably
impacted net interest income.
o Average net loans as a percentage of average total assets improved from
79.5% during the first nine months of 2000 to 83.0% during the first nine
months of 2001. Because loans constitute by far the Company's highest
yielding type of asset, this change in asset mix favorably affected net
interest income.
o The Company maintained higher levels of non-interest earning correspondent
bank account balances than usual during March 2001 as a liquidity cushion
to address any potential operational or financial settlement issues arising
following the implementation of the new computer system. The Company
repeated this positioning following the events of September 11, 2001. At
both times, this excess liquidity, which unfavorably impacted the Company's
margins, was not required.
o During 2001, the Bank has not been able to decrease its weighted average
cost of deposits as rapidly as declines in indices used for adjustable rate
loans such as Prime, CMT, 12MAT, and COFI. The Bank's weighted average cost
of deposits declined from 4.72% at December 31, 2000 to 3.46% at September
30, 2001. In contrast, the Prime Rate declined 350 basis points, COFI
decreased 165 basis points, 12MAT decreased 171 basis points, and the 1
Year CMT Index fell 283 basis points over the same time period.
During the fourth quarter of 2001, the Company plans to address the above issues
that unfavorably impact net interest income by continuing to the transformation
into a community commercial bank and repositioning the asset and liability
mixes. However, no assurance can be provided that the Company will be successful
in this regard, as interest rates and new business activity are influenced by
many factors beyond the control of the Company, such as actions by the Federal
Reserve and competition.
36
The following table presents the average annualized rate earned upon
each major category of interest earning assets, the average annualized rate paid
for each major category of interest bearing liabilities, and the resulting net
interest spread, net interest margin, and average interest margin on total
assets for the three months ended September 30, 2001 and 2000.
Three Months Ended September 30, 2001 Three Months Ended September 30, 2000
---------------------------------------- ----------------------------------------
(Dollars In Thousands) Average Average Average Average
Balance Interest Rate Balance Interest Rate
------- -------- ---- ------- -------- ----
Assets
------
Interest earning assets:
Cash equivalents (1) $ 6,035 $ 50 3.31% $ 11,303 $ 187 6.58%
Investment securities 7,404 93 5.02% 7,471 150 8.03%
Mortgage backed securities (2) 32,883 488 5.94% 58,392 1,011 6.93%
Loans receivable, net (3) 453,030 9,084 8.02% 379,048 8,118 8.57%
FHLB stock 3,259 43 5.28% 2,869 48 6.66%
--------- ------ -------- ------
Total interest earning assets 502,611 9,758 7.77% 459,083 9,514 8.29%
------ ------
Non-interest earnings assets 27,353 20,344
--------- ---------
Total assets $ 529,964 $ 479,427
========= =========
Liabilities & Equity
--------------------
Interest bearing liabilities:
NOW accounts $ 40,907 77 0.75% $ 37,419 137 1.46%
Savings accounts 19,694 51 1.04% 15,885 64 1.60%
Money market accounts 90,186 807 3.58% 91,749 1,088 4.72%
Certificates of deposit 252,369 3,097 4.91% 233,497 3,243 5.53%
--------- ------ -------- ------
Total interest-bearing deposits 403,156 4,032 4.00% 378,550 4,532 4.76%
FHLB advances 55,365 708 5.12% 40,675 583 5.70%
Other borrowings (4) 356 3 3.37% 11 -- 6.73%
--------- ------ -------- ------
Total interest-bearing liabilities 458,877 4,743 4.13% 419,236 5,115 4.85%
------ ------
Demand deposit accounts 20,067 16,642
Other non-interest bearing liabilities 2,752 3,001
-------- ---------
Total liabilities 481,696 438,879
Stockholders' equity 48,268 40,548
--------- ---------
Total liabilities & equity $ 529,964 $ 479,427
========= =========
Net interest income $5,015 $ 4,339
====== =======
Interest rate spread (5) 3.64% 3.44%
Net interest earning assets 43,734 39,847
Net interest margin (6) 3.99% 3.83%
Net interest income /
average total assets 3.79% 3.67%
Interest earnings assets /
interest bearing liabilities 1.10 1.10
Average balances in the above table were calculated using average daily figures.
--------------------------------------------------------------------------------
(1) Includes federal funds sold, money market fund investments, banker's
acceptances, commercial paper, interest earning deposit accounts, and
securities purchased under agreements to resell.
(2) Includes mortgage backed securities, including CMO's, both available for
sale and held to maturity.
(3) In computing the average balance of loans receivable, non-accrual loans and
loans held for sale have been included. Amount is net of deferred loan
fees, premiums and discounts, and undisbursed loan funds. Interest income
on loans includes amortized loan fees and costs, net, of $45,000 and
$69,000 in 2001 and 2000, respectively.
(4) Includes federal funds purchased and securities sold under agreements to
repurchase.
(5) Interest rate spread represents the difference between the average rate on
interest earning assets and the average rate on interest bearing
liabilities.
(6) Net interest margin equals net interest income before provision for loan
losses divided by average interest earning assets.
37
The following table presents the average annualized rate earned upon
each major category of interest earning assets, the average annualized rate paid
for each major category of interest bearing liabilities, and the resulting net
interest spread, net interest margin, and average interest margin on total
assets for the nine months ended September 30, 2001 and 2000.
Nine Months Ended September 30, 2001 Nine Months Ended September 30, 2000
---------------------------------------- ----------------------------------------
(Dollars In Thousands) Average Average Average Average
Balance Interest Rate Balance Interest Rate
------- -------- ---- ------- -------- ----
Assets
------
Interest earning assets:
Cash equivalents (1) $ 8,123 $ 277 4.55% $ 8,733 $ 411 6.29%
Investment securities 7,356 338 6.13% 9,397 536 7.62%
Mortgage backed securities (2) 41,644 1,970 6.31% 55,052 2,888 6.99%
Loans receivable, net (3) 423,124 26,753 8.43% 375,140 23,972 8.52%
FHLB stock 3,051 126 5.51% 3,047 169 7.41%
--------- ------ ------- ------
Total interest earning assets 483,298 29,464 8.13% 451,369 27,976 8.26%
------ ------
Non-interest earnings assets 26,748 20,491
--------- ---------
Total assets $ 510,046 $ 471,860
========= =========
Liabilities & Equity
--------------------
Interest bearing liabilities:
NOW accounts $ 40,811 317 1.04% $ 34,781 399 1.53%
Savings accounts 19,318 187 1.29% 15,506 199 1.71%
Money market accounts 88,859 2,764 4.15% 87,747 2,986 4.55%
Certificates of deposit 246,996 9,804 5.29% 228,437 8,985 5.25%
--------- ------ ------- ------
Total interest-bearing deposits 395,984 13,072 4.40% 366,471 12,569 4.58%
FHLB advances 46,538 1,834 5.25% 45,392 1,950 5.74%
Other borrowings (4) 214 18 11.21% 225 11 6.53%
--------- ------ ------- ------
Total interest-bearing liabilities 442,736 14,924 4.49% 412,088 14,530 4.71%
------ ------
Demand deposit accounts 18,561 16,722
Other non-interest bearing liabilities 2,427 3,058
-------- ---------
Total liabilities 463,724 431,868
Stockholders' equity 46,322 39,992
--------- ---------
Total liabilities & equity $ 510,046 $ 471,860
========= =========
Net interest income $14,540 $13,446
======= =======
Interest rate spread (5) 3.64% 3.55%
Net interest earning assets 40,562 39,281
Net interest margin (6) 4.01% 3.97%
Net interest income /
average total assets 3.80% 3.80%
Interest earnings assets /
interest bearing liabilities 1.09 1.10
Average balances in the above table were calculated using average daily figures.
--------------------------------------------------------------------------------
(1) Includes federal funds sold, money market fund investments, banker's
acceptances, commercial paper, interest earning deposit accounts, and
securities purchased under agreements to resell.
(2) Includes mortgage backed securities, including CMO's, both available for
sale and held to maturity.
(3) In computing the average balance of loans receivable, non-accrual loans and
loans held for sale have been included. Amount is net of deferred loan
fees, premiums and discounts, and undisbursed loan funds. Interest income
on loans includes amortized loan fees and costs, net, of $159,000 and
$211,000 in 2001 and 2000, respectively.
(4) Includes federal funds purchased and securities sold under agreements to
repurchase.
(5) Interest rate spread represents the difference between the average rate on
interest earning assets and the average rate on interest bearing
liabilities.
(6) Net interest margin equals net interest income before provision for loan
losses divided by average interest earning assets.
38
Rate / Volume Analysis
The most significant impact upon the Company's net interest income
between periods is derived from the interaction of changes in the volumes of and
rates earned or paid on interest-earning assets and interest-bearing
liabilities. The following table utilizes the figures from the preceding table
to present a comparison of interest income and interest expense resulting from
changes in the volumes and the rates on average interest-earning assets and
average interest-bearing liabilities for the periods indicated. Changes in
interest income or interest expense attributable to volume changes are
calculated by multiplying the change in volume by the prior period average
interest rate. The changes in interest income or interest expense attributable
to interest rate changes are calculated by multiplying the change in interest
rate by the prior year period volume. The changes in interest income or interest
expense attributable to the combined impact of changes in volume and changes in
interest rate are calculated by multiplying the change in rate by the change in
volume.
Three Months Ended September 30, 2001
Compared To
Three Months Ended September 30, 2000
----------------------------------------------------------------------
Volume
(Dollars In Thousands) Volume Rate / Rate Net
------ ---- ------ ---
Interest-earning assets
Cash equivalents $ (87) $ (92) $ 42 $ (137)
Investment securities (1) (56) -- (57)
Mortgage backed securities (442) (144) 63 (523)
Loans receivable, net 1,584 (517) (101) 966
FHLB Stock 6 (10) (1) (5)
------ ------ ------ -------
Total interest-earning assets 1,060 (819) 3 244
------ ------ ------ -------
Interest-bearing liabilities
NOW Accounts 13 (67) (6) (60)
Savings accounts 15 (23) (5) (13)
Money market accounts (18) (261) (2) (281)
Certificates of deposit 261 (360) (47) (146)
------ ------ ------ -------
Total interest-bearing deposits 271 (711) (60) (500)
FHLB advances 211 (60) (26) 125
Other borrowings 6 -- (3) 3
------ ------ ------ -------
Total interest-bearing liabilities 488 (771) (89) (372)
------ ------ ------ -------
Increase in net interest income $ 572 $ (48) $ 92 $ 616
====== ====== ====== =======
39
Nine Months Ended September 30, 2001
Compared To
Nine Months Ended September 30, 2000
----------------------------------------------------------------------
Volume
(Dollars In Thousands) Volume Rate / Rate Net
------ ---- ------ ---
Interest-earning assets
Cash equivalents $ (29) $ (114) $ 9 $ (134)
Investment securities (117) (105) 24 (198)
Mortgage backed securities (703) (284) 69 (918)
Loans receivable, net 3,066 (253) (32) 2,781
FHLB Stock -- (43) -- (43)
------ ------ ------ -------
Total interest-earning assets 2,217 (799) 70 1,488
------ ------ ------ -------
Interest-bearing liabilities
NOW Accounts 69 (129) (22) (82)
Savings accounts 49 (49) (12) (12)
Money market accounts 38 (257) (3) (222)
Certificates of deposit 731 66 22 819
------ ------ ------ -------
Total interest-bearing deposits 887 (369) (15) 503
FHLB advances 49 (165) -- (116)
Other borrowings (1) 8 -- 7
------ ------ ------ -------
Total interest-bearing liabilities 935 (526) (15) 394
------ ------ ------ -------
Increase in net interest income $ 1,282 $ (273) $ 85 $ 1,094
====== ====== ====== =======
40
Interest Income
Interest income increased from $9.5 million and $28.0 million during
the three and nine months ended September 30, 2000 to $9.8 million and $29.5
million during the same periods in 2001. These increases were primarily due to:
o higher interest earning assets in 2001: 9.5% greater for the three months
ended September 30, 2001, and 7.1% greater for the nine months ended
September 30, 2001 versus the same periods in 2000
o a shift in asset mix towards relatively higher yielding loans versus
securities, coincident with the Company's strategic plan of better
supporting its local communities with the delivery of credit
The above factors more than offset the impact of a lower interest rate
environment during the first nine months of 2001 versus the same period in 2000.
Interest income on loans rose from $8.1 million and $24.0 million
during the three and nine months ended September 30, 2000 to $9.1 million and
$26.8 million during the same periods in 2001. This expansion in interest income
was due to greater average volumes, as average loan rates were lower in 2001
versus 2000 due to the lower interest rate environment. The greater volume
stemmed from the Company's strategic plan of increasing the percentage of the
balance sheet comprised of loans through internal originations, loan pool
purchases on the secondary market, and loan participations; with the latter
primarily through other California community banks. The Company plans to
increase total loans to approximately 90.0% of total assets over time.
Management believes stockholder value is maximized through the extension and
effective management of credit, versus leveraging the balance sheet through
securities transactions where the Company provides comparatively little added
economic value. Interest income on loans was supported during 2001 by various
loans (generally income property and construction) reaching lifetime rate
floors. In certain instances, however, the Company has negotiated a reduction in
lifetime rate floors with borrowers in order to maintain the lending
relationship.
Interest income on cash equivalents decreased from $187 thousand for
the three months ended September 30, 2000 to $50 thousand for the same period in
2001. This decline was due to lower average rates stemming from the interest
rate cuts implemented by the Federal Reserve in 2001, and due to lower average
volumes stemming from the Company's redeploying funds from cash equivalents into
loans as a result of the demand for credit. Interest income on cash equivalents
declined from $411 thousand during the nine months ended September 30, 2000 to
$277 thousand for the same period in 2001, primarily due to the lower interest
rate environment. The Company has recently been investing excess daily funds
balances in a money market mutual fund to take advantage of its lagging decline
in yield as the Federal Reserve has repeatedly cut short term interest rates.
Interest income on investment securities declined from $150 thousand
and $536 thousand during the three and nine months ended September 30, 2000 to
$93 thousand and $338 thousand during the same periods in 2001. The reduced
interest income resulted from lower average balances and lower average rates.
The Company maintained on average a smaller portfolio of variable rate corporate
trust preferred securities during 2001 versus 2000. In addition, the variable
rate corporate trust preferred securities reprice quarterly based upon 3 month
LIBOR, which was significantly lower in the first nine months of 2001 than
during the same period in 2000.
Interest income on mortgage backed securities fell from $1.0 million
and $2.9 million during the three and nine months ended September 30, 2000 to
$488 thousand and $2.0 million during the same periods in 2001. This decrease
was caused by reductions in average volume and average rates. Over the past
year, the Company has reduced the percentage of its balance sheet allocated to
securities in favor of increased lending. In addition, the mix of the Company's
mortgage backed securities has changed over the past two years, with an increase
in lower duration, high cash flow instruments and a reduction in higher
duration, lower cash flow securities in order to better support greater funding
requirements stemming from the Company's increased lending. The Company also
purchased additional adjustable rate mortgage backed securities during the first
quarter of 2001, which adjusted downward in rate in conjunction with the decline
in general capital market interest rates during 2001.
41
Interest income on FHLB stock decreased from $48 thousand and $169
thousand during the three and nine months ended September 30, 2000 to $43
thousand and $126 thousand during the same periods in 2001. This reduction in
interest income stemmed from lower effective earnings rates. The FHLB-SF paid
particularly high dividend rates during the first half of 2000 in conjunction
with their capital management program, and recent quarterly dividend rates have
tracked the decrease in short term market interest rates.
Interest Expense
Interest expense decreased from $5.1 million during the quarter ended
September 30, 2000 to $4.7 million during the quarter ended September 30, 2001,
as the effect of the lower interest rate environment more than offset the impact
of a rise in average interest bearing liabilities. Interest expense increased
from $14.5 million during the nine months ended September 30, 2000 to $14.9
million during the first nine months of 2001, as the impact of greater average
balances of interest bearing liabilities more than offset the effect of lower
average rates.
By the end of the third quarter of 2001, wholesale borrowing costs had
declined more rapidly than competitive pricing for retail certificates of
deposit, rendering FHLB advances and other wholesale funding alternatives
comparatively price attractive to the Company. However, the Company's
stockholder value is increased over the longer term by expanding its customer
relationships, leading to increased sales of fee based services and greater
local lending. Management anticipates a continuation of this situation during
the fourth quarter of 2001, where trade-offs between savings in short term
funding costs and investments in longer term customer relationships will be
considered.
Interest expense on deposits decreased from $4.5 million in the quarter
ended September 30, 2000 to $4.0 million during the quarter ended September 30,
2001. This decline was due to the effect of a significant decrease in average
interest rate more than offsetting the impact of a rise in average balances. The
large decrease in average rates resulted from the lower interest rate
environment in general, and the Company's ability to timely reprice its three
money market deposit products as interest rates declined in 2001 in particular.
While certain large banks and thrifts only adjust their deposit rates on a set
schedule (e.g. weekly), the Company often adjusts its deposit pricing several
times per week in response to changes in the capital markets, competitive
conditions, and / or the Company's need for funds. In a rapidly declining
interest rate environment such as has occurred in 2001, this timeliness provides
a financial benefit.
Interest expense on deposits rose from $12.6 million during the nine
months ended September 30, 2000 to $13.1 million during the same period in 2001.
This increase was due to the effect of greater average interest bearing deposit
balances more than offsetting the impact of lower average rates. The Company's
average cost of deposits did not benefit from a change in deposit mix when
comparing the first nine months of 2001 versus the same period in 2000, as the
Company's deposit mix between transaction accounts (in aggregate) and
certificates of deposit was relatively constant. The Company's strategic plan
envisions a shift in deposit mix toward transactions accounts. Factors impacting
the Company's progress in this regard during 2001 included the resources
committed to the core systems conversion, certain account closures stemming from
the revised fee schedule and product mix implemented with the new data
processing system, and by aggressive competition for checking and money market
accounts during 2001, particularly from two large thrifts that extensively
advertised above market annual percentage yields on selected NOW checking and
money market deposit accounts.
The Company paid an average rate of just 0.75% on its NOW deposits and
1.04% on its savings deposits during the third quarter of 2001, highlighting the
limited ability of the Company to further reduce the cost of this funding should
general market interest rates continue to decline.
42
The rapidly declining interest rate environment experienced during 2001
contributed to "sticker shock" for certificate of deposit account holders with
maturing deposits. With renewal certificate of deposit interest rates down from
100 to 400 basis points below prior levels, many maturing CD holders,
particularly those dependent upon their interest income for day to day living
expenses, aggressively shopped for interest rates, causing the Bank to
selectively match high rate competitors in order to maintain customer
relationships and continue growing the deposit portfolio. In contrast, during
most of the first nine months of 2000, interest rates were generally increasing,
presenting less impetus for maturing certificate of deposit holders to
extensively shop for peak interest rates.
Over the past year, the Company has worked to more uniformly distribute
its certificate of deposit maturities by month in order to facilitate cash
management and avoid concentrated exposure to capital market events at any one
point in time. This objective has been accomplished through the use of "odd
term" certificates of deposit such as 7 and 8 months, augmented by ongoing sales
of longer term certificates of deposit. At September 30, 2001, the Company's
weighted average cost of its certificates of deposit portfolio was 4.59%, with
26.5% of the portfolio (by balance) scheduled to reprice during the fourth
quarter of 2001.
During the fourth quarter of 2001, the Company plans to continue
promoting its Money Market Plus account, Interest Checking Plus account, "40+"
NOW checking account, and business checking accounts. The consumer products
present attractive benefits to both customers and the Company. For example, all
three consumer transaction accounts are highly tiered, encouraging greater
account balances in order to earn higher rates of interest. These three products
are also accessible via bilingual telephone banking, Internet banking, global
ATM networks, mail, and in-branch service. The Company also intends to continue
pursuing compensating balances, typically demand deposit balances, for business
credit facilities.
At September 30, 2001, the Bank's weighted average nominal cost of
deposits was 3.46%, or 51 basis points below the COFI Index for the same date.
The Company utilizes a comparison of its cost of deposits and cost of funds to
COFI as one measure of relative performance. The Company's weighted average
nominal cost of deposits was 4.72% at December 31, 2000, or 90 basis points
below the COFI Index for the same date.
Interest expense on total borrowings increased from $583 thousand
during the three months ended September 30, 2000 to $711 thousand during the
three months ended September 30, 2001 due to the effect of greater average
balances more than offsetting the impact of lower average rates. The Company
utilized short term wholesale borrowings early in the third quarter of 2001 to
fund a surge in loan demand at the end of the summer. These short term
borrowings were repaid by the end of the third quarter of 2001, but affected the
average balance for the quarter.
Interest expense on total borrowings decreased from $2.0 million during
the first nine months of 2000 to $1.9 million during the same period in 2001 due
to the effect of lower average rates more than offsetting slightly higher
average balances. The Company has no FHLB advances scheduled to mature in the
fourth quarter of 2001, and $10.0MM in FHLB advances with a weighted average
rate of 5.13% scheduled to mature in the first quarter of 2002. The Company's
average interest rate on other borrowings was inflated during 2001 as a result
of the amortization of loan fees (discount on a liability) on MBBC's $2.0
million revolving line of credit combined with a lack of draws (outstanding
balances) on the line.
43
Provision For Loan Losses
The Company recorded a $275 thousand provision for loan losses during
the third quarter of 2001, down from $650 thousand during the third quarter of
2000. For the first nine months of 2001, provisions for loan losses totaled $1.1
million, down from $1.7 million during the first nine months of 2000. No
recoveries were realized during the first nine months of 2001, and charge-offs
during the period totaled $52 thousand. Net charge-offs during the first nine
months of 2000 were $371 thousand, associated with a residential mortgage
secured by a real property that suffered substantial earth movement. The
Company's ratio of loan loss reserves to loans outstanding increased slightly
from 1.35% at December 31, 2000 to 1.38% at September 30, 2001, while the
nominal amount of the loan loss reserve rose from $5.4 million at December 31,
2000 to $6.4 million at September 30, 2001. The Company remains concerned about
the negative impacts upon the amount of loss inherent in the loan portfolio at
September 30, 2001 arising from:
o the financial difficulties experienced by many technology related companies
in the Silicon Valley area adjacent to the Bank's primary market areas
o the impact of lower stock prices on consumer spending, liquidity, and
investment, with a particular concern regarding the effects on the demand
and pricing for real estate in the Bank's primary market areas
o the significant number of layoffs announced during 2001 by California
companies, with a related rise in the rate of unemployment in California
o the general decline in national economic output
Other factors contributing to the increased nominal and relative
reserves in 2001 versus 2000 included:
o the increasing concentration of the portfolio in relatively less seasoned
credits, because of the Company's growth rate in recent periods
o higher concentrations of credit exposure as a result of increased income
property lending, as these loans generally are larger than residential
mortgages
o the allocation of increased reserves during 2001 for the Special
Residential Loan Pool (see "Special Residential Loan Pool") based upon
recent loss rates by the seller / servicer on disposition of foreclosed
collateral
o the increase in the size of the loan portfolio
Commercial & industrial and multifamily real estate loans typically
present greater credit, concentration, and event risks than home mortgages,
thereby requiring proportionately greater reserve levels. Newer loans typically
present more credit exposure than seasoned loans with many years of prompt
payment experience and amortized principal balances.
The Company anticipates that its ratio of loan loss reserves to loans
outstanding will continue to increase in future periods to the extent that the
Company is successful in its strategic plan of increasing total loans while
expanding the proportion of the loan portfolio represented by income property
and commercial business lending. The Company's strategic plan also incorporates
expanded construction lending, although the Company has tightened its credit
requirements for such lending during 2001 in light of the trends within the
California economy.
44
Non-interest Income
Non-interest income totaled $690 thousand and $2.0 million during the
three and nine months ended September 30, 2001, comparing favorably to $630
thousand and $1.7 million during the same periods in 2000.
Service charge income rose from $356 thousand and $949 thousand during
the three and nine months ended September 30, 2000 to $401 thousand and $1.3
million during the same periods in 2001. This increase primarily resulted from
the revised fee and service charge schedule implemented with the new core
processing system in March, 2001. Following the computer systems conversion, the
Company increased its fee for checks drawn against insufficient funds ("NSF
Fees") from $17 to $20 per check. In addition, the revised fee and service
charge schedule established certain minimum balance requirements and maximum
free usage limits for certain deposit accounts.
The Company sold two non-Agency collateralized mortgage obligations
during the third quarter of 2001 for a pre-tax gain of $156 thousand. The sale
was made in conjunction with its asset / liability management program and to
provide additional liquidity for lending. No securities were sold during the
third quarter of 2000. For the first nine months of 2001, gains on the sale of
securities totaled $190 thousand, compared to a loss of $77 thousand during the
same period in 2000.
Loan servicing income totaled $33 thousand and $77 thousand during the
three and nine months ended September 30, 2001, compared to $30 thousand and $90
thousand during the same periods in 2000. The Company continues to sell the vast
majority of its long term, fixed rate residential loan production into the
secondary market on a servicing released basis. As a result, the portfolio of
loans serviced for others is declining as loans pay off. At September 30, 2001,
the Company serviced $47.0 million in various types of loans for other
investors, compared to $62.0 million at December 31, 2000.
Commissions from sale of non-FDIC insured investments totaled $35
thousand and $223 thousand during the three and nine months ended September 30,
2001, compared to $145 thousand and $534 thousand during the same periods in
2000. Less favorable general capital market conditions, the events of September
11, 2001, and investment staff turnover contributed to the lower revenues in
2001 versus 2000. The Company anticipates unfavorable comparisons for such
commissions during the fourth quarter of 2001, as capital market conditions
remain challenging and the Company seeks to fill its remaining vacant licensed
investment representative positions.
Gains on the sale of loans increased from $4 thousand and $15 thousand
during the three and nine months ended September 30, 2000 to $18 thousand and
$47 thousand during the same periods in 2001. The lower interest rate
environment in 2001 resulting from the rate cuts implemented by the Federal
Reserve has led to a strong residential loan refinance market, which in turn has
bolstered the Company's mortgage banking activity.
The Company's strategic plan incorporates non-interest income
representing a greater percentage of total revenue. The Company intends to
pursue increased non-interest income in future quarters through:
o seeking additional remote ATM sites
o further increases in the portfolio of deposit transaction accounts
o the continued sale of consumer Internet banking with electronic bill
payment
o the planned introduction of Internet banking and cash management services
for businesses
o the continued marketing of debit cards
However, no assurance can be provided regarding the amount of or trends in the
Company's future levels and composition of non-interest income.
45
Non-interest Expense
Non-interest expense totaled $3.6 million and $10.9 million for the
three and nine months ended September 30, 2001, compared to $3.6 million and
$10.3 million for the same periods in 2000. Total non-interest expense in 2001
has been increased by costs for the data processing conversion ($447 thousand)
and legal expenses associated with the arbitration of claims by a former
executive ($284 thousand). Costs for the data processing conversion included
deconversion fees to the prior service bureau, printing and postage costs for
additional customer communications, employee training and travel costs, and
consulting fees for technology professionals retained to assist with and speed
the implementation of the new system.
The Company's efficiency ratio during the third quarter of 2001 was
62.86%, comparing favorably to 66.08% during the third quarter of 2000, but
still above high performing peer financial institutions. The Company has
identified reducing the efficiency ratio as a key objective of its strategic
plan and an important component of executive incentive compensation.
During the first nine months of 2001, the Company adjusted its staffing
to advance the strategic plan. During 2001, the Bank has added additional
commercial business relationship managers and hired new professional bankers.
Staffing has also increased in the data processing function, coincident with the
Company's shifting from an external service bureau to in-house data processing.
Compensation and employee benefits expense during the third quarter of 2000
included a $250 thousand accrual for negotiation of a settlement with the former
President & Chief Operating Officer in conjunction with his employment
contracts. Compensation and employee benefits expense during the first nine
months of 2001 was inflated versus the same period in the prior year due to:
o $70 thousand in greater ESOP benefit expenses, which in turn resulted from
the Company's higher average stock price in 2001 versus 2000, as a fixed
number of shares are expensed each year
o $80 thousand in greater incentive bonus accrual due to the Company's
improved financial performance
The change in the Company's systems environment also impacted various
other operating expenses. Data processing fees were much lower in the third
quarter of 2001 than the same period in 2000, while equipment expense was higher
due to the added depreciation and amortization from the new hardware and
software installed in 2001. The Company's new client-server technology platform,
combined with the associated product redesign, has fostered various operating
efficiencies, including reduced costs for customer statements, certificate of
deposit maturity notices, and certain electronic transaction processing.
Supplies, postage, telephone, and office expenses were slightly lower
in the three and nine months ended September 30, 2001 than during the same
periods the prior year despite the non-recurring expenses for the core systems
conversion. In 2001, the Company is utilizing a lower cost supplies vendor,
accessed through the Internet, with next day delivery avoiding the need to
maintain local supplies inventories. In addition, most forms are now dynamically
created through the new core processing system, avoiding forms obsolescence,
shipping costs, and local inventory requirements.
Advertising and promotion costs were constant between the three months
ended September 30, 2001 and 2000, but significantly lower for the first nine
months of 2001 versus the same period the prior year. This stemmed from the
Company's awaiting the completion of the systems conversion and product redesign
prior to conducting extensive advertising in 2001. By mid-2001, the Bank had
commenced a significant local radio advertising campaign focused on building
customer relationships and centered about the theme "Monterey Bay Bank. Expect
More. Get The Best." During the third quarter of 2001, the Bank augmented its
radio advertising with commercials aimed at encouraging local businesses to try
Monterey Bay Bank. In addition, the Bank throughout 2001 has significantly
expanded the community involvement of its employees, under the direction of the
Director of Community Relations - a new position in 2001. During the third
quarter of 2001, the Company also ran multiple print advertisements focusing on
the benefits of its Money Market Plus account. The Company anticipates spending
more on advertising, promotion, and community outreach in coming quarters than
has been spent in prior periods.
46
Consulting expenses rose from $15 thousand and $118 thousand during the
three and nine months ended September 30, 2000 to $31 thousand and $336 thousand
during the same periods in 2001 primarily due to consultant services associated
with the core systems conversion and complementary software and hardware being
implemented post conversion.
The Company continues to restructure its operations both to better
utilize new technology and improve efficiency. The Company also continues to
evaluate new vendors for various products and services, seeking more cost
effective business relationships. By the end of 2001, the Company will change
the manner in which its facilities management is conducted to provide for better
expense control. The Company is also redesigning its incentive programs for 2002
to better integrate contributions to the achievement of the strategic plan with
incentive payments. Through these and other initiatives, the Company continues
to target progress in improving its efficiency ratio.
Income Taxes
Income tax expense increased in 2001 versus 2000 primarily due to
greater pre-tax income.
Item 3. Quantitative And Qualitative Disclosures About Market Risk
For a current discussion of the nature of market risk exposures, see
"Item 2. Management's Discussion And Analysis Of Financial Condition And Results
Of Operations - Interest Rate Risk Management And Exposure". Readers should also
refer to the quantitative and qualitative disclosures (consisting primarily of
interest rate risk) in the Company's Annual Report on Form 10-K for the fiscal
year ended December 31, 2000.
47
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
From time to time, the Company is party to claims and legal proceedings
in the ordinary course of business. Management believes that the
ultimate aggregate liability represented thereby, if any, will not have
a material adverse effect on the Company's consolidated financial
position or results of operations.
Item 2. Changes In Securities
None.
Item 3. Defaults Upon Senior Securities
Not applicable.
Item 4. Submission Of Matters To A Vote Of Security Holders
No matters were submitted to a vote of security holders during the
quarter ended September 30, 2001.
Item 5. Other Information
None.
Item 6. Exhibits And Reports On Form 8-K
A. Exhibits
None.
B. Reports On Form 8-K
The Company has recently filed the following Current Reports
on Form 8-K:
1. Form 8-K dated October 22, 2001. This Current Report
reported the Company's results for the three months
and nine months ended September 30, 2001, and the
continued binding arbitration proceeding with the
former President and Chief Operating Officer in
regards to amounts due under his employment
contracts.
2. Form 8-K dated November 7, 2001. This Current Report
reported the conclusion and results of the binding
arbitration process conducted to address claims by
the former President and Chief Operating Officer
regarding payments due under his employment
contracts. This matter will have no future material
impact on the Company's earnings or financial
condition.
48
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.
MONTEREY BAY BANCORP, INC.
(Registrant)
Date: November 13, 2001 By: /s/ C. Edward Holden
--------------------
C. Edward Holden
Chief Executive Officer
President
Vice Chairman Of The Board Of Directors
Date: November 13, 2001 By: /s/ Mark R. Andino
------------------
Mark R. Andino
Chief Financial Officer
Treasurer
(Principal Financial & Accounting Officer)
49