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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, 2002
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)
(831) 722 - 6794
(Registrant's Facsimile Number, Including Area Code)
WWW.MONTEREYBAYBANK.COM
(Registrant's Internet Site)
[email protected]
(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: 3,449,756 shares of common
stock, par value $0.01 per share, were outstanding as of November 11, 2002.
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, 2002 And December 31, 2001 3-4
Condensed Consolidated Statements Of Income (unaudited) For
The Three And Nine Months Ended September 30, 2002 And
September 30, 2001 5-6
Condensed Consolidated Statement Of Stockholders' Equity
(unaudited) For The Nine Months Ended September 30, 2002 7
Condensed Consolidated Statements Of Cash Flows (unaudited)
For The Nine Months Ended September 30, 2002 And September
30, 2001 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 16-55
Item 3. Quantitative And Qualitative Disclosure About Market Risk 56
Item 4. Controls And Procedures 56
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 56
Item 2. Changes In Securities 56
Item 3. Defaults Upon Senior Securities 56
Item 4. Submission Of Matters To A Vote Of Security Holders 57
Item 5. Other Information 57
Item 6. Exhibits And Reports On Form 8-K 57
(a) Exhibits
(b) Reports On Form 8-K
Signature Page 58
Certifications Pursuant To Section 302 Of The Sarbanes-Oxley Act Of 2002 59-60
2
Item 1. Financial Statements
MONTEREY BAY BANCORP, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (UNAUDITED)
SEPTEMBER 30, 2002 AND DECEMBER 31, 2001
(Dollars In Thousands)
- ---------------------------------------------------------------------------------------------------------------------
September 30, December 31,
2002 2001
---- ----
ASSETS
Cash and cash equivalents $ 9,513 $ 13,079
Securities available for sale, at estimated fair value:
Investment securities (amortized cost of $7,716 and $7,707 at
September 30, 2002 and December 31, 2001, respectively) 7,060 7,300
Mortgage backed securities (amortized cost of $42,721 and $30,358 at
September 30, 2002 and December 31, 2001, respectively) 43,000 30,644
Loans held for sale, at lower of cost or market 170 713
Loans receivable held for investment (net of allowances for loan losses of
$7,742 at September 30, 2002 and $6,665 at December 31, 2001) 496,006 465,887
Investment in capital stock of the Federal Home Loan Bank, at cost 3,347 2,998
Accrued interest receivable 3,024 2,915
Premises and equipment, net 7,278 7,618
Core deposit intangibles, net 1,003 1,514
Other assets 5,029 4,723
-------- --------
TOTAL ASSETS $575,430 $537,391
======== ========
See Notes to Condensed Consolidated Financial Statements
3
MONTEREY BAY BANCORP, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (UNAUDITED) (Continued)
SEPTEMBER 30, 2002 AND DECEMBER 31, 2001
(Dollars In Thousands)
- ---------------------------------------------------------------------------------------------------------------------
September 30, December 31,
2002 2001
---- ----
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
Non-interest bearing demand deposits $ 24,898 $ 21,062
Interest bearing NOW checking accounts 43,561 42,557
Savings deposits 18,703 19,127
Money market deposits 119,398 105,828
Certificates of deposit 255,118 243,765
-------- --------
Total deposits 461,678 432,339
-------- --------
Advances from the Federal Home Loan Bank and other borrowings 57,654 53,800
Accounts payable and other liabilities 1,328 1,090
-------- --------
Total liabilities 520,660 487,229
-------- --------
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, 2002 and December 31, 2001;
3,480,756 outstanding at September 30, 2002 and
3,456,097 outstanding at December 31, 2001 45 45
Additional paid-in capital 29,108 28,584
Retained earnings, substantially restricted 40,493 36,473
Unallocated ESOP shares (518) (690)
Treasury shares designated for compensation plans, at cost (14,802 shares
at September 30, 2002 and 17,969 shares at December 31, 2001) (142) (173)
Treasury stock, at cost (1,011,329 shares at September 30, 2002 and
1,035,988 shares at December 31, 2001) (13,994) (14,006)
Accumulated other comprehensive loss, net of taxes (222) (71)
-------- --------
Total stockholders' equity 54,770 50,162
-------- --------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $575,430 $537,391
======== ========
See Notes to Condensed Consolidated Financial Statements
4
MONTEREY BAY BANCORP, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER 30, 2002 AND SEPTEMBER 30, 2001
(Dollars In Thousands, Except Per Share Amounts)
- ---------------------------------------------------------------------------------------------------------------------
FOR THE THREE MONTHS FOR THE NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
----------------------------- ---------------------------
2002 2001 2002 2001
------ ------ ------- -------
INTEREST AND DIVIDEND INCOME:
Loans receivable $8,549 $9,084 $25,298 $26,753
Mortgage backed securities 323 488 963 1,970
Investment securities and cash equivalents 107 186 364 741
------ ------ ------- -------
Total interest and dividend income 8,979 9,758 26,625 29,464
------ ------ ------- -------
INTEREST EXPENSE:
Deposit accounts 2,578 4,032 8,084 13,072
Advances from the FHLB and other borrowings 606 711 1,833 1,852
------ ------ ------- -------
Total interest expense 3,184 4,743 9,917 14,924
------ ------ ------- -------
NET INTEREST INCOME BEFORE PROVISION
FOR LOAN LOSSES 5,795 5,015 16,708 14,540
PROVISION FOR LOAN LOSSES 400 275 1,110 1,075
------ ------ ------- -------
NET INTEREST INCOME AFTER PROVISION
FOR LOAN LOSSES 5,395 4,740 15,598 13,465
------ ------ ------- -------
NON-INTEREST INCOME:
Customer service charges 387 401 1,130 1,282
(Loss) gain on sale of mortgage backed securities (8) 156 35 190
Commissions from sales of noninsured products 25 35 100 223
Gain on sale of loans 33 18 81 47
Income from loan servicing 18 33 47 77
Other income 35 47 112 209
------ ------ ------- -------
Total non-interest income 490 690 1,505 2,028
------ ------ ------- -------
See Notes to Condensed Consolidated Financial Statements
5
MONTEREY BAY BANCORP, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) (Continued)
NINE MONTHS ENDED SEPTEMBER 30, 2002 AND SEPTEMBER 30, 2001
(Dollars In Thousands, Except Per Share Amounts)
- ---------------------------------------------------------------------------------------------------------------------
FOR THE THREE MONTHS FOR THE NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
----------------------------- ---------------------------
2002 2001 2002 2001
------ ------ ------- -------
NON-INTEREST EXPENSE:
Compensation and employee benefits 1,960 1,739 5,697 5,052
Occupancy and equipment 444 440 1,277 1,222
Deposit insurance premiums 19 50 121 148
Data processing fees 146 133 423 746
Legal and accounting expenses 107 274 328 724
Supplies, postage, telephone, and office expenses 158 158 505 510
Advertising and promotion 52 86 214 143
Amortization of intangible assets 170 170 511 511
Consulting 16 31 59 336
Other expense 370 505 1,176 1,556
------ ------ ------- -------
Total non-interest expense 3,442 3,586 10,311 10,948
------ ------ ------- -------
INCOME BEFORE PROVISION FOR
INCOME TAXES 2,443 1,844 6,792 4,545
PROVISION FOR INCOME TAXES 977 787 2,772 1,937
------ ------ ------- -------
NET INCOME $1,466 $1,057 $ 4,020 $ 2,608
====== ====== ======= =======
EARNINGS PER SHARE:
BASIC EARNINGS PER SHARE $ 0.43 $ 0.32 $ 1.19 $ 0.80
====== ====== ======= =======
DILUTED EARNINGS PER SHARE $ 0.42 $ 0.31 $ 1.15 $ 0.79
====== ====== ======= =======
See Notes to Condensed Consolidated Financial Statements
6
MONTEREY BAY BANCORP, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
(UNAUDITED)
NINE MONTHS ENDED SEPTEMBER 30, 2002
(Dollars And Shares In Thousands)
- ----------------------------------------------------------------------------------------------------------------------------
Treasury
Shares
Desig-
nated Accum-
For ulated
Addi- Unal- Com- Other
Common Stock tional located pen- Compre-
------------ Paid-In Retained ESOP sation Treasury hensive
Shares Amount Capital Earnings Shares Plans Stock Loss Total
------ ------ -------- -------- ------- ------- -------- ------- --------
Balance at December 31, 2001 3,456 $ 45 $ 28,584 $ 36,473 $(690) $ (173) $(14,006) $ (71) $ 50,162
Purchase of treasury stock (30) (512) (512)
Exercise of stock options 47 153 450 603
Director fees paid using treasury 8 61 74 135
stock
Amortization of stock compensation 310 172 31 513
Comprehensive income:
Net income 4,020 4,020
Other comprehensive income
(loss):
Change in net unrealized loss
on securities available
for sale, net of
taxes of $(91) (131) (131)
Reclassification adjustment for
gains on securities available
for sale included in income,
net of taxes of ($15) (20) (20)
--------
Other comprehensive income
(loss), net
(151)
--------
Total comprehensive income
3,869
------ ------ -------- -------- ------- ------- -------- ------- --------
Balance at September 30, 2002 3,481 $ 45 $ 29,108 $ 40,493 $(518) $ (142) $(13,994) $(222) $ 54,770
====== ====== ======== ======== ======= ======= ========= ======= ========
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, 2002 AND SEPTEMBER 30, 2001
(Dollars In Thousands)
- -------------------------------------------------------------------------------------------------------------------------
FOR THE NINE MONTHS
ENDED SEPTEMBER 30,
---------------------
2002 2001
---- ----
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 4,020 $ 2,608
Adjustments to reconcile net income to net cash provided by operating
activities:
Depreciation and amortization of premises and equipment 542 481
Amortization of intangible assets 511 511
Amortization of purchase premiums, net of accretion of discounts 827 93
Amortization of deferred loan fees and costs, net (212) (159)
Provision for loan losses 1,110 1,075
Federal Home Loan Bank stock dividends (133) (141)
Gross ESOP expense before dividends received on unallocated shares 467 314
Compensation expense associated with stock compensation plans 65 110
Director retainer fees paid in stock 135 156
Gain on sale of mortgage backed securities (35) (190)
Gain on sale of loans held for sale (81) (47)
Loss (gain) on sale of fixed assets 14 (8)
Origination of loans held for sale (9,242) (6,966)
Proceeds from sales of loans held for sale 9,866 6,559
Increase in accrued interest receivable (109) (250)
Increase in other assets (306) (1,208)
Increase (decrease) in accounts payable and other liabilities 238 (157)
Other, net (875) (724)
------- -------
Net cash provided by operating activities 6,802 2,057
------- -------
CASH FLOWS FROM INVESTING ACTIVITIES:
Net increase in loans held for investment (30,119) (62,672)
Purchases of investment securities available for sale (4,854) --
Proceeds from maturities of investment securities available for sale 4,850 --
Purchases of mortgage backed securities available for sale (46,155) (20,493)
Principal repayments on mortgage backed securities available for sale 28,683 21,368
Proceeds from sales of mortgage backed securities available for sale 4,500 12,097
Purchases of Federal Home Loan Bank stock (216) (298)
Proceeds from the sale of premises and equipment -- 13
Purchases of premises and equipment (216) (1,062)
------- -------
Net cash used in investing activities (43,527) (51,047)
------- -------
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, 2002 AND SEPTEMBER 30, 2001
(Dollars In Thousands)
- ------------------------------------------------------------------------------------------------------------------------
FOR THE NINE MONTHS
ENDED SEPTEMBER 30,
---------------------
2002 2001
---- ----
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase in deposits 29,339 20,829
Proceeds (repayments) of Federal Home Loan Bank advances, net 3,700 15,000
Proceeds of other borrowings, net 154 361
Purchases of treasury stock (512) --
Sales of treasury stock for exercise of stock options 478 1,021
------- -------
Net cash provided by financing activities 33,159 37,211
------- -------
NET DECREASE IN CASH & CASH EQUIVALENTS (3,566) (11,779)
CASH & CASH EQUIVALENTS AT BEGINNING OF PERIOD 13,079 25,159
------- -------
CASH & CASH EQUIVALENTS AT END OF PERIOD $ 9,513 $13,380
======= =======
SUPPLEMENTAL CASH FLOW DISCLOSURES:
Cash paid during the period for:
Interest on deposits and borrowings $ 8,087 $14,872
Income taxes $ 2,500 $ 2,850
SUPPLEMENTAL DISCLOSURES OF NON CASH
INVESTING AND FINANCING ACTIVITIES
Loan transferred to held for investment, at market value -- $ 85
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, 2002 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 incorporated in the State of
Delaware and 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 businesses. All
significant inter-company 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 the 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, 2001 included in the Company's Annual Report on
Form 10-K for the fiscal year ended December 31, 2001.
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, 2002
and 2001 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)
2002 2001 2002 2001
---------- ---------- ---------- ----------
Net income $1,466,000 $1,057,000 $4,020,000 $2,608,000
========== ========== ========== ==========
Average shares issued 4,492,085 4,492,085 4,492,085 4,492,085
Less weighted average:
Uncommitted ESOP shares (85,352) (121,289) (94,336) (130,273)
Non-vested stock award shares (15,166) (26,903) (16,238) (30,289)
Treasury shares (1,007,045) (1,050,040) (1,011,979) (1,070,491)
---------- ---------- ---------- ----------
Sub-total (1,107,563) (1,198,232) (1,122,553) (1,231,053)
---------- ---------- ---------- ----------
Weighted average BASIC shares outstanding 3,384,522 3,293,853 3,369,532 3,261,032
Add dilutive effect of:
Stock options 123,253 90,591 123,577 58,499
Stock awards 1,343 1,112 1,419
---------- ---------- ---------- ----------
706
Sub-total 124,596 91,703 124,996 59,205
---------- ---------- ---------- ----------
Weighted average DILUTED shares outstanding 3,509,118 3,385,556 3,494,528 3,320,237
========== ========== ========== ==========
Earnings per share:
BASIC $ 0.43 $ 0.32 $ 1.19 $ 0.80
========== ========== ========== ==========
DILUTED $ 0.42 $ 0.31 $ 1.15 $ 0.79
========== ========== ========== ==========
11
MONTEREY BAY BANCORP, INC. AND SUBSIDIARY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)
- --------------------------------------------------------------------------------
NOTE 3: Other Comprehensive Income
The Company's only current 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 included in other
comprehensive income for investment and mortgage backed securities classified as
available for sale for the three and nine month periods ended September 30, 2002
and 2001 are summarized as follows:
Three Months Ended September 30, Nine Months Ended September 30,
---------------------------------- ----------------------------------
2002 2001 2002 2001
---- ---- ---- ----
(Dollars In Thousands)
Gross reclassification adjustment $ (8) $ 156 $ 35 $ 190
Tax benefit (expense) 3 (64) (15) (78)
----- ----- ----- ------
Reclassification adjustment, net of tax $ (5) $ 92 $ 20 $ 112
====== ===== ===== ======
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,
--------------------------- ---------------------------
2002 2001 2002 2001
---- ---- ---- ----
(Dollars In Thousands)
Holding (loss) gain arising during the period, net $ (208) $ 208 $ (131) $ 673
of tax
Reclassification adjustment, net of tax 5 (92) (20) (112)
------ ----- ------ ------
Net unrealized (loss) gain recognized in
other comprehensive income $ (203) $ 116 $ (151) $ 561
======= ===== ======= ======
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 in certain instances. 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, 2001 757,929 425,104 255,224 195,761 137,064 $ 10.88
March 31, 2002 757,929 390,999 238,390 225,566 141,364 $ 11.07
June 30, 2002 757,929 386,174 249,915 230,391 141,364 $ 11.06
September 30, 2002 757,929 371,866 238,182 242,724 143,339 $ 11.00
Activity during the three and nine months ended September 30, 2002 included:
Three Months Ended Nine Months Ended
September 30, 2002 September 30, 2002
------------------ ------------------
Granted 4,500 10,000
Canceled 6,475 16,275
Exercised 12,333 46,963
Vested 600 29,921
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, 2002.
13
MONTEREY BAY BANCORP, INC. AND SUBSIDIARY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)
- --------------------------------------------------------------------------------
NOTE 5: Stock Award Plan
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 in certain instances the Company has utilized unallocated
or forfeited PEP shares for immediately vested stock grants in lieu of cash
compensation. 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. Compensation expense related to the PEP for the nine
months ended September 30, 2002 and 2001 was $65 thousand and $110 thousand. The
following table summarizes the status of this plan:
Stock Stock
Awards Stock Awards
Stock Outstanding Awards Available
Awards And Not Cumulatively For Future
Date Authorized Vested Vested Grants
- ---- ---------- ------ ------ ------
December 31, 2001 141,677 17,969 123,708 --
March 31, 2002 141,677 16,486 125,191 --
June 30, 2002 141,677 15,436 126,241 --
September 30, 2002 141,677 14,802 126,875 --
Activity during the three and nine months ended September 30, 2002
included:
Three Months Ended Nine Months Ended
September 30, 2002 September 30, 2002
------------------ ------------------
Granted 450 450
Canceled 450 450
Vested 634 3,167
14
MONTEREY BAY BANCORP, INC. AND SUBSIDIARY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)
- --------------------------------------------------------------------------------
NOTE 6: Commitments & Contingencies
At September 30, 2002, commitments maintained by the Company included
firm commitments to originate $25.9 million in various types of loans, a firm
commitment to purchase a $1.0 million commercial real estate loan, and optional
commitments to sell $3.6 million in fixed rate residential mortgages on a
servicing released basis. The Company maintained no firm commitments to purchase
securities, to assume borrowings, or to sell securities at September 30, 2002.
NOTE 7: Recent Accounting Pronouncements
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities", which addresses accounting for
restructuring and similar costs. SFAS No. 146 supersedes previous accounting
guidance, principally Emerging Issues Task Force Issue No. 94-3. The Company
will adopt the provisions of SFAS No. 146 for restructuring activities initiated
after December 31, 2002. SFAS No. 146 requires that the liability for costs
associated with an exit or disposal activity be recognized when the liability is
incurred. Under Issue 94-3, a liability for an exit cost was recognized at the
date of the Company's commitment to an exit plan. SFAS No. 146 also establishes
that the liability should initially be measured and recorded at fair value.
Accordingly, SFAS No. 146 may affect the timing of recognizing future
restructuring costs as well as the amounts recognized.
NOTE 8: Reclassifications
Certain amounts in the December 31, 2001 and September 30, 2001
financial statements have been reclassified to conform to the September 30, 2002
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, opportunities
and expectations regarding technologies, anticipated performance or
contributions from new and existing employees, projections of future
performance, potential future credit experience, possible changes in laws and
regulations, potential risks and benefits arising from the implementation of the
Company's strategic and tactical plans, perceived opportunities in the market,
potential actions of significant stockholders and investment banking firms, 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 news events or economic
trends, 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, 2001. 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.
Availability Of Information
This Report on Form 10-Q is available free of charge at the following
Internet sites:
o www.sec.gov
o www.montereybaybank.com
Monterey Bay Bancorp, Inc. makes available free of charge through its
Internet site its Annual Report on Form 10-K, quarterly reports on Form 10-Q,
current reports on Form 8-K, and all amendments to those reports as soon as
reasonably practicable after such material is electronically filed with or
furnished to the Securities & Exchange Commission ("SEC").
Additional corporate information regarding Monterey Bay Bancorp, Inc.
and Monterey Bay Bank is also available at the www.montereybaybank.com Internet
site. This Internet site is not a part of this Report on Form 10-Q.
16
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, 2002, the Company had $575.4 million in total assets,
$496.2 million in net loans receivable, and $461.7 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: [email protected]. 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.
The Company conducts business from eight full service branch offices in
its primary market area in Central California, one loan production office in Los
Angeles, 11 automated teller machines ("ATM's") including two stand-alone ATM's,
and its administrative facilities in Watsonville, California. In addition, the
Company supports its customers through bilingual (English / Spanish) 24 hour
telephone banking, Internet banking, electronic bill payment, remote deposit
capability, bank by mail, and ATM access through an array of networks including
STAR, CIRRUS, and PLUS. Through its network of banking offices, the Bank
emphasizes personalized service in assisting individuals, families, community
organizations, and businesses in attaining their financial objectives. The Bank
offers a wide complement of lending and deposit products.
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, term, universal, and whole life 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 typically
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.
Critical Accounting Policies
The Company's financial statements are prepared in accordance with
accounting principles generally accepted in the United States of America
("GAAP"). The Company's significant accounting policies are presented in Note 1
to the Consolidated Financial Statements contained in the Company's 2001 Annual
Report on Form 10-K. The Company follows accounting policies typical to the
community commercial banking industry and in compliance with various regulations
and guidelines as established by the Financial Accounting Standards Board
("FASB") and the Bank's primary federal regulator, the OTS.
17
The Company's most significant management accounting estimate is the
appropriate level for the allowance for loan losses. The Company follows a
methodology for calculating the appropriate level for the allowance for loan
losses. However, various factors, many of which are beyond the control of the
Company, could lead to significant revisions in the amount of allowance for loan
losses in future periods, with a corresponding impact upon the results of
operations. In addition, the calculation of the allowance for loan losses is by
nature inexact, as the allowance represents Management's best estimate of the
loan losses inherent in the Company's credit portfolios at the reporting date.
These loan losses will occur in the future, and as such cannot be determined
with absolute certainty at the reporting date. Please see also "Asset Quality /
Credit Profile - Allowance For Loan Losses".
Other estimates that the Company utilizes in its accounting include the
expected useful lives of depreciable assets, such as buildings, building
improvements, equipment, and furniture. The useful lives of various technology
related hardware and software can be subject to change due to advances in
technology and the general adoption of new standards for technology or
interfaces among computer or telecommunication systems.
The Company applies Accounting Principles Board ("APB") Opinion No. 25
and related interpretations in accounting for stock options. Under APB No. 25,
compensation cost for stock options is measured as the excess, if any, of the
fair market value of the Company's stock at the date of grant over the amount
the employee or director must pay to acquire the stock. Because the Company's
stock option Plans provide for the issuance of options at a price of no less
than the fair market value at the date of grant, no compensation cost is
required to be recognized for the Plans.
Had compensation costs for the stock option Plans been determined based
upon the fair value at the date of grant consistent with SFAS No. 123,
"Accounting For Stock Based Compensation", the Company's net income and earnings
per share would have been reduced. The amount of the reduction for the fiscal
years 1999 through 2001 is disclosed in Note 18 to the Consolidated Financial
Statements contained in the 2001 Annual Report on Form 10-K, based upon the
assumptions listed therein.
GAAP itself may change over time, impacting the reporting of the
Company's financial activity. Although the economic substance of the Company's
transactions would not change, alterations in GAAP could affect the timing or
manner of accounting or reporting.
Recent Developments
Recent regulatory, financial industry, and other developments have
included the following:
o On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Act of
2002. This new legislation addresses accounting oversight and corporate
governance. The new law creates a five member oversight board appointed by
the Securities & Exchange Commission ("SEC") that will set standards for
accountants and have investigative and disciplinary powers. The new
legislation prohibits accounting firms from providing various types of
consulting services to public attest clients and requires accounting firms
to rotate partners among public client assignments every five years. The
new legislation also increases penalties for financial crimes, requires
expanded disclosure of corporate operations and internal controls, enhances
controls on and reporting of insider trading, expands the SEC's budget, and
places statutory separations between investment bankers and analysts.
Various aspects of the new legislation are dependent upon subsequent
rulemaking by the SEC. Management is currently evaluating what impacts the
new legislation will have upon the Company, including a likely increase in
certain outside professional costs. The Company currently utilizes its
external attestation auditor only for audit services and other closely
related services, and assistance with the preparation of income tax
returns.
o Federal legislation reforming the bankruptcy code remains in conference
between the House of Representatives and the Senate. This legislation,
depending upon its final form, if any, could potentially assist the Bank in
collecting certain credits.
18
o The Federal Reserve is pursuing modifications in its discount window
program to encourage borrowings from financial institutions. These changes
are projected to favorably impact the liquidity of financial institutions,
including the Bank.
o Congress continues to debate lifting restrictions on the payment of
interest on business checking accounts and easing restrictions on the
number of certain transactions for MMDA accounts at insured depository
institutions. The potential payment of interest on sterile reserves at the
Federal Reserve banks is also being considered. Depending on the nature of
such changes eventually approved, if any, there could be various favorable
and / or unfavorable impacts upon the Company.
o The new capital plan of the FHLB-San Francisco was approved by the Federal
Housing Finance Board on June 12, 2002. The FHLB-SF has not yet established
an implementation date for the new capital plan, with such implementation
required by June 2005. The Bank will receive at least 240 days' written
notice of the implementation date. The new capital plan incorporates a
single class of stock and requires each member to own stock in amount equal
to the greater of: a) a membership stock requirement, or b) an activity
based stock requirement. The new capital stock is redeemable on five years'
written notice, subject to certain conditions. The Company does not believe
that the initial implementation of the FHLB-SF new capital plan as most
recently communicated by the FHLB-SF will have a material impact upon the
Company's financial condition, cash flows, or results of operations.
However, latitude for the FHLB-SF included within the new capital plan
could result in the Bank's being required to purchase as much as 50%
additional capital stock or sell as much as 50% of its proposed capital
stock requirement at the discretion of the FHLB-SF.
o A possible increase in (e.g. from $100,000 to $130,000 per depositor, or
special limits for retirement accounts) or broadening of (e.g. higher
limits for public agency deposits) federal deposit insurance coverage,
which may be 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.
o The FDIC has scheduled a meeting in November 2002 to determine whether to
implement higher federal deposit insurance premium rates in 2003. This
evaluation has been spurred by a decline in the BIF reserve ratio to near
the 1.25% statutory minimum. An increase in premium rates, depending upon
how implemented, could adversely affect the Company's results of
operations.
o The US House of Representatives is considering a regulatory relief bill for
the financial services industry. Similar legislative action has not
proceeded in the Senate.
o The State of California is facing a significant budget deficit. The
potential imposition of new fees or taxes or higher tax rates by the State
of California could impact the Company's business and earnings. The
possible suspension, curtailment, or elimination of various State programs
could also affect the Company. The Company is unable to predict what, if
any, actions might be taken by the State of California and the possible
impact of those actions upon the Company's consolidated financial condition
or results of operations.
o The State of California legislature approved and the governor signed in
September 2002 new tax laws that impact the utilization of net operating
losses and conform bank bad debt deductions to federal tax law, with a
transition provision for 2002. The Company has no net operating loss
carryovers, and the transition provision associated with the State
treatment of bad debt deductions provided a one time benefit to the
Company, but will also accelerate the payment (but not impact the amount)
of certain tax obligations.
19
Strategic Plan
The Company's strategic plan envisions transforming the Bank from a 77
year old savings & loan into a community focused commercial bank serving the
financial needs of individuals, families, organizations, and businesses. The
strategic plan incorporates a greater amount of income property, construction,
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 high performing 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 multiple factors, many of which are outside the Company's control, including
the strength of the California and national economies, competition, regulatory
and legislative changes, and trends in real estate values. The State of
California budget deficit could also unfavorably impact the Company and / or
slow its strategic transformation. The strategy being pursued by the Company
also presents various types of tactical implementation risks. The Bank is under
no immediate pressure to pursue a change in charter at this time, as its
Qualified Thrift Lender ("QTL") ratio was 71.0% at September 30, 2002, compared
to a minimum requirement of 65.0% to retain its federal thrift charter.
Overview Of Business Activity
During the third quarter and first nine months of 2002, the Company
continued the implementation of its strategic plan. The Bank focuses on building
longstanding customer relationships, investing the time and energy to get to
know customers well and understand their financial objectives. Another key
aspect of the transformation strategy is a significant increase in the community
involvement and contributions made by the Bank, its Directors, and its
employees. These efforts are facilitated by the Bank's Director of Community
Relations. The Company seeks to differentiate itself from its competition
through various means, particularly by providing a superior level of customer
service.
Key accomplishments during the third quarter of 2002 included:
o record quarterly net income of $1.47 million and diluted earnings per share
of $0.42
o improving the Company's return on average assets to 1.03% and return on
average equity to 10.73%, from 0.80% and 8.76%, respectively, during the
same quarter the prior year
o the attainment of record levels of total assets, loans, deposits, and
stockholders' equity at September 30, 2002
o significant progress in shifting the composition of the loan portfolio
o net interest income rose versus the same period during the prior year, due
to both a larger average balance sheet fueled by increased deposits and
loans and due to expanded spreads resulting from the planned change in
balance sheet composition
o a further improvement in the Company's efficiency ratio, to 54.77% for the
three months ended September 30, 2002
o continued maintenance of favorable credit quality as measured by net
charge-offs, with a decline in non-accrual loans from June 30, 2002 to
September 30, 2002
o increased local commercial banking business
o expanded local community and financial benefits arising from the Company's
participation in the State of California Enterprise Zone program
o the Bank's visibility and relationships with community leaders and business
associations continued to strengthen, as evidenced by the Bank's being
nominated for "Business Of The Year" by a local Chamber of Commerce
20
The Company has realized certain operating efficiencies from the new
technology environment implemented and better optimized over the past 18 months.
Additionally, the favorable credit quality experienced during the first nine
months of 2002 allowed the Company to avoid significant operating costs for
collections and foreclosures. The Company's commitment to quality customer
service was exemplified during the third quarter and early fourth quarter of
2002, when telecommunications network upgrades were implemented to speed
transaction processing for both deposits and new account openings.
Stockholder Value
The Company has continued its strong focus on enhancing stockholder
value during 2002. Tangible book value per share increased from $14.08 at
December 31, 2001 to $15.45 at September 30, 2002. Coverage of the Company by a
second equity analyst was obtained during the second quarter, and Management is
pursuing coverage by a third equity analyst to begin during the fourth quarter
of 2002. The Company has also added additional market makers in the past year to
facilitate the liquidity of its common stock. Subject to the terms of its stock
repurchase plan, the Company has accelerated the pace of its stock repurchases
during the third and fourth quarters of 2002.
Effective November 1, 2002, the Company's Directors will be paid under
a revised Director fee program. The new program provides for all Director
compensation of any type, other than travel reimbursement, to be paid
exclusively in Company common stock. In addition, base retainer fees were
reduced, with new fees implemented based upon meeting attendance and the number
of Board committees served. In adopting the new Director fee plan, the Board
sought to even more closely align their compensation with stockholder interests
by making Director compensation more performance and activity based. Total
annual costs under the new Director fee plan are projected to be close to those
associated with the prior program that was primarily focused upon flat retainer
fees.
The Company's executive Management has volunteered to accept a portion
of their 2002 cash incentive compensation in Company common stock, repeating
elections made in prior years.
The Company's Directors and Officers have continued to be net
purchasers of the Company's common stock during 2002. For example, in October
2002, the Company's Chief Executive Officer and Chief Financial Officer
purchased an additional 1,000 and 300 shares, respectively, on the open market,
adding to their investment in the Company.
A significant number of the Bank's employees have an ownership interest
in the Company, through one or more of the following:
o direct stock purchases
o the Employee Stock Ownership Plan ("ESOP")
o incentive stock options
o stock grant awards
o stock purchased with funds contributed by employees to the Bank's 401(k)
Plan
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. The Company maintains an active relationship with its
investment banker in monitoring potential opportunities to augment stockholder
value. The Company selected as its investment banker a firm that specializes in
financial institutions.
21
Holding Company Bylaw Changes
At its October 2002 meeting, the MBBC Board of Directors approved two
changes to the bylaws of the holding company. The retirement date for Directors
was modified from no later than December 31 of the year in which they attain an
age of 72 to no later than December 31 of the year in which they attain an age
of 73. In addition, the total Company stock ownership requirement for Directors
was increased, subject to certain conditions, from 1,000 shares to 5,000 shares.
McKenzie Moss, Chairman of the Board, is currently 72 years old. The amended and
restated bylaws, effective October 24, 2002, are attached to this Form 10-Q as
an Exhibit.
Changes In Financial Condition From December 31, 2001 To September 30, 2002
Total assets increased $38.0 million (7.1%) from $537.4 million at
December 31, 2001 to a record $575.4 million at September 30, 2002.
Cash & cash equivalents decreased from $13.1 million at December 31,
2001 to $9.5 million at September 30, 2002 due to the Company using cash & cash
equivalents to fund expansions in the security and loan portfolios.
Securities
At September 30, 2002, the Company owned no corporate bonds issued by
WorldCom, Enron, or any other companies primarily engaged in the
telecommunications, technology, or energy industries.
Investment securities available for sale were little changed during the
first nine months of 2002, totaling $7.3 million at December 31, 2001 and $7.1
million at September 30, 2002. At both these dates, the Company's investment
security portfolio was identically composed of two floating rate corporate trust
preferred bonds rated "A" and "A-" by Standard & Poors at September 30, 2002.
These corporate trust preferred securities are issued by large US financial
institutions. The slight decrease in balance during 2002 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.
The average balance of investment securities during the first nine
months of 2002 was increased by the purchase of Agency debentures which had been
called for redemption by the issuer. The Company acquired these bonds, which
typically have a remaining term of ten to fourteen days, as a higher yielding
alternative to federal funds sold, repurchase agreements, and other short term
investments. The Company owned no Agency debentures at September 30, 2002.
Mortgage backed securities available for sale increased from $30.6
million at December 31, 2001 to $43.0 million at September 30, 2002. The Company
continued to purchase relatively low duration Agency collateralized mortgage
obligations ("CMO's") during the third quarter of 2002 to serve as collateral
for certain deposits and to invest available liquidity. The low duration was
targeted in conjunction with the Company's asset / liability management program
and in order to provide cash flows in subsequent periods to fund anticipated
loan production.
During the first quarter of 2002, the Company sold a somewhat higher
duration private label CMO with $2.7 million in par value in conjunction with
its interest rate risk management program. In early July 2002, the Company sold
an Agency CMO with $2.0 million in par value to further moderate its net
liability sensitivity (see Interest Rate Risk Management And Exposure). The vast
majority of the Company's mortgage backed securities at September 30, 2002 were
relatively low duration bonds, and all of the Company's mortgage backed
securities at September 30, 2002 passed the Federal Financial Institutions
Examination Council ("FFIEC") test for volatility. 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.
22
Loans
Loans held for sale totaled $170 thousand at September 30, 2002, down
from $713 thousand at December 31, 2001. The Company sells most of its long
term, fixed rate residential mortgage production into the secondary market on a
servicing released basis, and purchases more interest rate sensitive loans as
part of its interest rate risk management program. All loans held for sale at
September 30, 2002 were matched with optional commitments to deliver such loans
into the secondary market.
Loans held for investment, net, increased from $465.9 million at
December 31, 2001 to a record $496.0 million at September 30, 2002. The increase
resulted from a combination of strong internal loan originations and from
purchases of, or participations in, individual income property and construction
loans from correspondent banks. The Company follows its customary underwriting
policies in evaluating loan purchases and participations.
Relatively high loan payoff volumes stemming from the low interest rate
environment restrained the rate of loan portfolio growth during 2002.
The Company opened its Los Angeles loan production office during the
first quarter of 2002. This office concentrates on relationship based lending to
local real estate investors and developers, with a particular emphasis on income
property and construction lending. The Los Angeles loan production office ended
the third quarter of 2002 with a significant loan pipeline, fueled by the local
market knowledge of the Company's lending staff and by the relative strength of
the economy and real estate markets in southern California.
Total net loans as a percentage of total assets were 86.2% at September
30, 2002, down slightly from 86.8% at December 31, 2001. The Company has
targeted increasing this ratio to 90.0% as part of its strategy of supporting
its interest margin, fostering economic activity in its local communities, and
effectively utilizing the Bank's capital.
The loan portfolio product mix shifted during the first nine months of
2002 in conformity with the Company's strategic plan. Residential one to four
unit loans declined from 42.3% of gross loans at December 31, 2001 to 35.5% of
gross loans at September 30, 2002. In contrast, commercial real estate loans
rose from 22.6% to 23.9%, construction loans increased from 7.9% to 10.2%, land
loans increased from 2.5% to 4.1%, commercial loans rose from 1.8% to 3.1%, and
consumer loans (primarily home equity lines of credit) increased from 1.4% to
1.9%. This change in loan mix was facilitated by the commercial business
relationship officers the Company hired over the past year and by the new Los
Angeles loan production office. To the extent economic and competitive
conditions permit, the Company plans to continue decreasing the percentage of
its loan portfolio allocated to residential mortgages in favor of other
generally higher yielding and more interest rate sensitive types of loans.
Management anticipates for the fourth quarter of 2002:
o a significant volume of new loans, as the Company intends to more
extensively meet the credit needs of its customers and local communities
o historically high prepayment rates for mortgages and mortgage related
securities, fueled by the record level of refinance activity occurring,
which in turn has been supported by historically low interest rates
o residential mortgages comprising a smaller percentage of total gross loans
Despite the Company's concluding the third quarter of 2002 with a significant
loan pipeline, Management is uncertain regarding the projected size of the loan
portfolio at the end of 2002, as prepayments during October 2002 were
historically high at $18.5 million, and could continue at historically high
levels in the current low interest rate environment. Other factors, including
many outside the control of the Company, could affect the realization of the
above expectations.
23
The Company's commercial banking group continued to produce increased
business during the first nine months of 2002. Commercial business loans
outstanding increased from $8.8 million at December 31, 2001 to $16.7 million at
September 30, 2002. This group has also generated applications for commercial
real estate mortgages and construction loans in 2002, in addition to acquiring
new deposits. The commercial lending pipeline at September 30, 2002 pointed
toward the continued gradual expansion of commercial banking customer
relationships during the fourth quarter of 2002.
During the third quarter of 2002, the Company introduced "remote
deposit" services to its business and high net worth individual accounts. Via
this new service, the Bank's customers can make deposits to their Monterey Bay
Bank checking account at any branch of a correspondent bank with over 4,900
banking locations in 23 states. Remote deposit services were implemented to
offer improved convenience and assist the Bank in competing with larger
financial institutions with more extensive branch networks. Management plans to
utilize this new service to continue expanding deposits by commercial banking
group customers, which totaled $8.5 million at September 30, 2002.
Additional information regarding loan portfolio composition is
presented in the following table:
(Dollars In Thousands) September 30, December 31,
2002 2001
---- ----
Held for investment:
Loans secured by real estate:
Residential one to four unit $187,484 $204,829
Multifamily five or more units 112,407 103,854
Commercial and industrial 126,606 109,988
Construction 54,207 38,522
Land 21,598 11,924
-------- --------
Sub-total loans secured by real estate 502,302 469,117
Other loans:
Home equity lines of credit 9,574 6,608
Loans secured by deposits 215 202
Consumer lines of credit, unsecured 155 170
Commercial term loans 5,130 3,163
Commercial lines of credit 11,520 5,680
-------- --------
Sub-total other loans 26,594 15,823
Sub-total gross loans held for investment 528,896 484,940
(Less) / Plus:
Undisbursed construction loan funds (24,935) (12,621)
Unamortized purchase premiums, net of purchase discounts 568 435
Deferred loan fees and costs, net (781) (202)
Allowance for loan losses (7,742) (6,665)
-------- --------
Loans receivable held for investment, net $496,006 $465,887
======== ========
Held for sale:
Residential one to four unit $ 170 $ 713
======== ========
FHLB Stock
The Company's investment in the capital stock of the FHLB-SF increased
from $3.0 million at December 31, 2001 to $3.3 million at September 30, 2002 due
to stock dividends and the required purchase of additional stock as a result of
the growth in the Bank's balance sheet.
24
Premises and Equipment
Premises and equipment, net, decreased from $7.6 million at December
31, 2001 to $7.3 million at September 30, 2002, as periodic depreciation and
amortization exceeded new purchases. Because the Company acquired significant
new hardware and software during 2001 in support of the new core processing
system, fixed asset acquisitions in 2002 have been and are expected to continue
to be moderate. This expectation could, however, change in the event the Company
is successful in opening a de novo branch or acquiring a branch from another
financial institution. Fixed asset requirements for the new Los Angeles loan
production office were not significant.
Core Deposit Intangibles
Core deposit intangibles, net, declined from $1.5 million at December
31, 2001 to $1.0 million at September 30, 2002 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.
Deposits
Deposits increased from $432.3 million at December 31, 2001 to a record
$461.7 million at September 30, 2002. This increase primarily resulted from:
o The Bank's issuance of its first brokered certificate of deposit ("CD"),
for $20.0 million, during the second quarter of 2002.
o A $9.0 million increase in deposits from the State of California time
deposit program during 2002. The State places funds with California banks
as a vehicle for encouraging employment and economic growth.
The Bank issued the $20.0 million one year CD on an uncollateralized
basis through one of the country's largest investment banks / securities dealers
at an all-in cost of LIBOR plus 12 basis points. The brokered CD was issued in
order to provide funding for anticipated loan production in the second and third
quarters of 2002. While the Company does not intend to become a significant
issuer of brokered CD's, Management took advantage of the opportunity due to:
o the Company's projected need for funding
o the efficiency of one relatively large issuance
o the attractiveness of the pricing
o the Company's loan to deposit ratio approaching 110%
o the one year term integrating effectively with the Company's asset /
liability management program
The Company continues to pursue increases in transaction account
balances as a fundamental component of its strategic plan. Excluding the impact
of the aggregate $29.0 million increase in brokered and State certificates of
deposit, transaction accounts increased from 43.6% of total deposits at December
31, 2001 to 47.7% of total deposits at September 30, 2002. This shift in mix
contributed to the Company's reducing its weighted average cost of deposits from
2.41% during the second quarter of 2002 to 2.26% during the third quarter of
2002. This 15 basis point reduction in deposit cost was attained despite the
historically low level of interest rates and therefore the Company's limited
ability to decrease interest rates on many deposit products that are currently
priced between zero and one percent.
25
Key trends and results within the deposit portfolio during the first
nine months of 2002 included:
o Non-interest bearing demand deposits increased from $21.1 million at
December 31, 2001 to $24.9 million at September 30, 2002. This rise was
supported by balances maintained by commercial banking customers and the
Company's targeting demand deposit balances as part of its sales management
program.
o Interest bearing NOW checking account balances increased from $42.6 million
at December 31, 2001 to $43.6 million at September 30, 2002. The Company
has pursued new consumer checking accounts throughout 2002, with a special
promotion during October providing new checking account customers with the
opportunity to earn a bonus yield on a new three year CD placed on combined
statement with the new checking account. During the first nine months of
2002, the Company experienced particularly aggressive advertising and price
competition for consumer NOW deposits from one large national thrift. This
thrift paid interest rates far above market and significantly in excess of
the federal funds rate. 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 decreased from $19.1 million at December 31, 2001 to $18.7
million at September 30, 2002. While the Company continues to offer
traditional statement savings products, its sales focus has instead
concentrated on checking and money market accounts due to the greater
features and flexibility offered.
o Money market deposits increased from $105.8 million at December 31, 2001 to
$119.4 million at September 30, 2002. Money market deposit balances during
the first nine months of 2002 were positively impacted by Bank advertising
and sales programs, and by certain customers waiting to commit funds to
certificates of deposit given the historically low interest rate
environment. In addition, during the first nine months of 2002, the Company
offered interest rates on its Money Market Plus product that were in excess
of many money market mutual funds and money market accounts offered through
securities firms. The Bank's sales staff was trained to highlight this
differential, and to explain the many attractive attributes of the Money
Market Plus product, including:
A. access via telephone banking, Internet banking, ATM's, bank by mail,
check writing, and in-branch service
B. extensively tiered interest rates, whereby earnings on the account
increase as each successively higher balance tier is attained
C. FDIC insurance to the maximum amount permitted by law
D. combined statement with other Bank products
E. automatic transfers and direct deposit
o Certificate of deposit balances excluding the $20.0 million brokered CD and
the $9.0 million rise in time deposits from the State of California
decreased from $243.8 million at December 31, 2001 to $226.1 million at
September 30, 2002. This decline in part resulted from certain customers
delaying committing funds to fixed term, fixed rate certificates of deposit
due to the historically low interest rate environment and from significant
price competition from two large thrifts, one local credit union, and
several non-traditional competitors. Price competition from banks
specializing in credit card lending has also been significant during 2002,
as certain customers needing a given level of nominal interest income have
pursued national avenues for their CD funds due to the historically low
interest rate environment. During the first nine months of 2002, the
Company priced its longer term (18 to 60 months) CD's attractively as part
of its asset / liability management program and to encourage the
development of longer term customer relationships. In addition, the Company
has conducted various print advertising campaigns for 24 to 36 month CD's
during 2002. These campaigns attracted new customers, with whom the
Company's employees discussed the establishment of a more complete banking
relationship.
26
Management is, however, not satisfied with the volume of deposit
acquisition achieved by its eight full service retail branches during the first
nine months of 2002, particularly in light of general deposit inflows into the
banking system from investors leaving the equity markets. Management responded
to this performance by:
o designing new relationship oriented deposit products, as detailed below
o recruiting a Branch Sales Manager during the second quarter of 2002, whose
primary responsibility is to implement and manage an improved sales culture
throughout the branch network
o adjusting branch staff compensation to provide for an increased incentive
opportunity based upon deposit growth and quality customer service
Increasing the percentage of total deposits comprised of checking,
savings, and money market accounts 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 expanding
business relationships and cross-selling other products and services to
customers, and are typically less interest rate sensitive than many other
funding sources. The Company plans to introduce a new suite of transaction
account products during the fourth quarter of 2002 and the first quarter of
2003. These new products will focus on two key characteristics:
o providing customer choice and options
o promoting relationship banking
For example, the new consumer checking account products will facilitate
the customer's selection of how they wish to avoid periodic service charges and
how to earn more interest based upon their individual financial profile. Many of
the new accounts provide benefits such as free services, eliminated periodic
service charges, or higher rates of interest for building a relationship with
the Bank through multiple deposit products and combined statements. The new
products also further encourage businesses to bank with the Company, as the
principals can obtain preferred personal pricing while the business benefits
from new products and services. The Company plans to coordinate the introduction
of these new deposit products with marketing and promotion activities.
The Company plans to introduce two new money market accounts in the
latter part of the fourth quarter of 2002: Investors Money Market and Business
Money Market. Investors Money Market is a highly tiered product targeted to
attract funds from money market mutual funds and brokerage firms. Business Money
Market is a product designed specifically for the Bank's local commercial
customers seeking an attractive return on liquid funds while also enjoying the
many attractive attributes provided by the Bank, including Internet banking,
global ATM access, 24 hour bilingual telephone banking, and, above all, superior
customer service by local bankers familiar with their business.
The Company's ratio of loans to deposits was 107.47% at September 30,
2002, down slightly from December 31, 2001. In light of this ratio, the Company
has implemented the following strategic and tactical actions during the first
nine months of 2002:
o modified staff incentive programs to more strongly focus on expanding
deposit relationships
o directed a higher percentage of the advertising and promotion budget to
deposit generation
o accepted a brokered deposit and established a new deposit broker
relationship
o acquired additional deposits through the State of California time deposit
program
o implemented "remote deposit" services for businesses (including those
introduced to the Company through the Los Angeles loan production office)
and individuals maintaining relatively higher deposit balances
27
In addition, due to the Company's objective of effectively leveraging
its capital position through lending, the Company is exploring various strategic
and tactical alternatives for further increasing its funding base, including:
o pursuing opportunities for additional branch locations, either de novo or
acquisition of existing branches from other financial institutions
o introducing new deposit products and related services, as discussed above
o increased business lending with associated compensating customer deposit
balances
o relationship loan pricing for income property owners maintaining operating
accounts with the Company
Early in the fourth quarter of 2002, Management initiated discussions
to negotiate the lease of commercial retail space for a de novo branch in the
Company's primary market area. However, no assurance can be provided that the
Company will be successful in securing the site and adding this de novo branch
to its current network.
Despite Management's lack of satisfaction with the deposit generation
stemming from its eight full service branches, during the first nine months of
2002, the Company has not, however, pursued the offering of deposit rates
substantially above market in order to avoid:
o attracting highly volatile funds
o placing pressure on the net interest margin
o decreasing focus on its relationship banking approach and commitment to
providing superior customer service
Borrowings
Borrowings increased from $53.8 million at December 31, 2001 to $57.7
million at September 30, 2002. The increase was associated with funding the rise
in the loan and security portfolios. The $57.7 million balance at September 30,
2002 included $53.6 million in term FHLB advances and a $3.7 million overnight
FHLB advance. All of the Company's FHLB advances at September 30, 2002 were
fixed rate, fixed term or overnight borrowings without call or put option
features. The Company has $8.0 million in term FHLB advances with a weighted
average interest rate of 2.33% scheduled to mature during the fourth quarter of
2002. Management plans to roll over this debt for the terms that best integrate
with the Company's objectives for interest rate risk management.
Stockholders' Equity
Total stockholders' equity increased from $50.2 million at December 31,
2001 to a record $54.8 million at September 30, 2002. Factors contributing to
the increase included:
o $4.0 million in 2002 year to date net income
o continued amortization of deferred stock compensation, including both ESOP
and PEP shares
o the ongoing payment of Director retainer fees with Company common stock
o the exercise of 46,963 vested stock options, generating $603 thousand in
additional stockholders' equity
28
The above factors more than offset the impact of:
o the repurchase of 30,000 shares of the Company's common stock
o depreciation in the portfolio of securities classified as available for
sale
Repurchases of the Company's common stock under the current
authorization during 2002 are summarized as follows:
Number Of Shares Price Range Of
Quarter In 2002 Repurchased Repurchases
- --------------------- --------------------- ----------------
First 5,000 $16.25
Second -- --
Third 25,000 $17.10 - $17.36
Fourth [1] 31,000 $18.15
------ ------
Total / Average 61,000 $17.62
====== ======
- -----------------------------------------
[1] Through November 11, 2002
At November 11, 2002, there were 53,035 remaining shares authorized for
repurchase under the Company's current repurchase program.
The Company did not declare or pay any cash dividends during the first
nine months of 2002. The Board of Directors continues to believe that
alternative uses for the Company's capital, at this time, are more attractive
than the payment of a cash dividend.
Tangible book value per share increased from $14.08 at December 31,
2001 to $15.45 at September 30, 2002. The amount of increase in tangible book
value per share during the fourth quarter of 2002 may be favorably impacted by:
o the impact on additional paid-in capital of the Company's higher stock
price as reflected in the accounting for the ESOP
o the effect of utilizing deferred stock compensation in lieu of certain cash
incentive compensation
o the adoption of a new Director fee plan effective November 1, 2002, whereby
all Director compensation, except for travel reimbursement, will be paid in
Company common stock, with the number of shares earned by each Director
dependent upon the quantity of meetings attended and Board committees
served
29
Interest Rate Risk Management And Exposure
The table below presents an overview of the interest rate environment
during the 21 months ended September 30, 2002. The 12 MTA 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 (1) 12/31/00 3/31/01 6/30/01 9/30/01 12/31/01 3/31/02 6/30/02 9/30/02
- ---------------- -------- ------- ------- ------- -------- ------- ------- -------
3 month Treasury bill 5.89% 4.28% 3.65% 2.37% 1.72% 1.78% 1.68% 1.55%
6 month Treasury bill 5.70% 4.13% 3.64% 2.35% 1.79% 2.10% 1.74% 1.50%
2 year Treasury note 5.09% 4.18% 4.24% 2.85% 3.02% 3.72% 2.81% 1.68%
5 year Treasury note 4.97% 4.56% 4.95% 3.80% 4.30% 4.84% 4.03% 2.56%
10 year Treasury note 5.11% 4.92% 5.41% 4.59% 5.05% 5.40% 4.80% 3.59%
Target federal funds 6.50% 5.00% 3.75% 3.00% 1.75% 1.75% 1.75% 1.75%
Prime rate 9.50% 8.00% 6.75% 6.00% 4.75% 4.75% 4.75% 4.75%
3 month LIBOR 6.40% 4.88% 3.84% 2.59% 1.88% 2.03% 1.86% 1.79%
12 month LIBOR 6.00% 4.67% 4.18% 2.64% 2.44% 3.00% 2.29% 1.73%
1 Year CMT (2) 5.60% 4.30% 3.58% 2.82% 2.22% 2.57% 2.20% 1.72%
12 MTA (2) 6.11% 5.71% 5.10% 4.40% 3.48% 2.91% 2.55% 2.18%
COFI (2) 5.62% 5.20% 4.50% 3.97% 3.07% 2.65% 2.85% 2.76%
- -----------------------------------------------
(1) Indices / rates are spot values unless otherwise noted.
(2) These indices / rates are monthly averages.
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.
The Company has recently maintained a relatively balanced, though
slightly net liability sensitive, 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 almost the same, though slightly more,
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, beginning in early 2001, the Federal
Reserve commenced decreasing its benchmark interest rates in response to the
slowing national economy, increases in unemployment, falling equity values, weak
manufacturing activity, and other negative or unfavorable economic trends or
statistics. By the end of 2001, the Federal Reserve had cut interest rates 11
times for a total of 475 basis points, representing one of the largest and
fastest series of rate decreases ever experienced in the United States. The
Federal Reserve continued cutting interest rates throughout 2001 in part in
response to the onset of the first national economic recession in many years. In
addition to cutting interest rates, the Federal Reserve also fostered
significant expansion in the money supply, with a particular increase following
the events of September 11, 2001.
30
The eleven rate cuts in 2001 led to nominal levels of interest rates
that were the lowest in decades, with the target federal funds rate decreasing
to 1.75%. The Prime Rate followed the target federal funds rate down in 2001,
while the COFI and 12 MTA indices lagged the more responsive Treasury and LIBOR
rates throughout 2001. The low nominal level of interest rates in effect in the
latter part of 2001 and in the first nine months of 2002 presented a particular
challenge to the Company, as the rates on its NOW and Savings deposit accounts
were already at low levels by mid 2001 and could not be decreased to the same
extent as declines in many capital markets interest rates. The Company addressed
this issue through its asset / liability management program, whereby decisions
regarding pricing, promotion, and incentives are integrated with tactical
transactions to moderate the Company's exposure to changes in interest rates.
Various interest rates increased in the first quarter of 2002 when the
capital markets assumed that the Federal Reserve would not continue decreasing
its benchmark interest rates. In addition, concerns about the impact of interest
rates staying at such low levels for an extended period of time began to raise
worries about potential future inflation, leading to a rise in longer term
interest rates. At the end of the first quarter of 2002, many economists were
predicting a relatively strong recovery from the US recession and were
forecasting increases of 100 basis points or more in the target federal funds
rate by the end of the year. In March 2002, the Dow Jones Industrial Average had
recovered the losses that occurred in September 2001, with the Index again
closing over 10,500. By the end of the first quarter, the Treasury curve had
become significantly steeper, with the differential between federal funds and
the 2 year Treasury Note at 197 basis points. Steep yield curves are generally
beneficial for financial institutions, including the Bank, as greater income is
derived from short term maturity mismatches and as customer demand often shifts
toward adjustable mortgages due to the rate differential between adjustable and
fixed rate loans.
Most interest rates reversed course and declined during the second and
third quarters of 2002. Among the factors leading to this reduction in interest
rates were:
o the "crisis of confidence" stemming from the restatement of financial
information by Enron, WorldCom, and other large companies
o the broad decline in equity indices during the second and third quarters of
2002, with certain investors seeking relative safe harbor in US government
and Agency fixed income investments
o companies being slow to rehire despite growth in gross domestic product,
contributing to the term "jobless recovery"
o ongoing tensions in the Middle East and continued discussion of a potential
US invasion of Iraq encouraging "flight to quality" investments by certain
capital markets participants
o increasing discussion of new rounds of rate cuts by the Federal Reserve in
the latter half of 2002, facilitated by low measured inflation and a lack
of inflationary pressures stemming from higher rates of unemployment and
continuing jobless claims, low capacity utilization at factories, and a
general lack of pricing power reinforced by high levels of global
competition
o uncertainty regarding control of both houses of Congress following the
November 2002 elections leading certain investors and companies to avoid
committing to significant new investments
The Treasury yield curve was flatter at September 30, 2002 than three, six, and
nine months earlier, with the differential between federal funds and the 2 year
Treasury Note declining from a positive 197 basis points at March 31, 2002 to a
negative 7 basis points at September 30, 2002. The negative 7 basis point spread
was one of many capital market indicators at the end of the third quarter of
2002 that pointed toward additional rate reductions by the Federal Reserve. In
an unusual announcement, the Federal Open Market Committee ("FOMC") communicated
that two Federal Reserve governors dissented from the majority opinion at the
September 24, 2002 meeting and voted for a rate cut at that time. On November 6,
2002, the FOMC voted to reduce the target federal funds rate by 50 basis points
to 1.25%.
31
Management is uncertain regarding the potential impacts of interest
rates being at low levels not seen in many decades, and thus never experienced
by the modern economy and capital markets. For example, with the target federal
funds rate at 1.25%, many money market mutual funds will be paying rates of less
than 1.00%, possibly encouraging some consumers to shift funds into federally
insured deposit accounts or pursue other, and perhaps less traditional,
investment alternatives.
The divergence of the COFI index in the above table from other capital
markets interest rates may have been in part caused by the payment of deposit
rates significantly above market by two very large thrifts with operations in
the 11th Federal Home Loan Bank District - the largest component of which is
California.
The analytical results of the Company's interest rate risk modeling
have been empirically validated over the past several years, as the Company's
interest margin has remained stable or expanded during periods of both rising
and falling general market interest rates. The expansion in interest margin over
the past several years has been significantly impacted by the implementation of
the Company's strategic plan, in addition to being influenced by the interest
rate environment.
The Company plans 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 2002,
the Company continued to sell the vast majority of its long term, fixed rate
residential loan production into the secondary market on a servicing released
basis. The low interest rate environment contributed to continued prepayments on
the Company's existing portfolios of residential fixed rate mortgages held for
investment and higher duration mortgage backed securities classified as
available for sale.
Mortgage backed security purchases during the first nine months of 2002
were primarily low duration CMO's with limited extension risk and above market
coupon rates. The Company also sold one relatively higher duration CMO during
the first quarter of 2002 and its one remaining volatile, support tranche CMO in
the third quarter of 2002. Loan purchases during the first nine months of 2002
were generally either adjustable rate or fixed rate for a short period of time,
then converting to adjustable rate ("hybrid mortgages"). During the past year,
the Company has periodically prepaid and extended certain FHLB advances in order
to increase the duration of its funding and therefore moderate its net liability
sensitivity. Effective July 1, 2002, the Company was no longer originating
mortgages tied to the 11th District COFI Index due to concerns regarding the
capacity of a small number of large thrifts to dominate this Index. In addition,
in July 2002, the Company commenced offering two year fixed rate hybrid loans
that adjust every six months thereafter as a means of differentiating itself in
the market and increasing the interest rate sensitivity of its asset portfolio.
The Company has also increased the average remaining term of its certificate of
deposit portfolio from 228 days at December 31, 2001 to 303 days at September
30, 2002 through continued marketing of intermediate to longer term accounts.
The aforementioned and other tactical and strategic actions were
conducted as part of the interest rate risk management program in general, and
specifically to prepare the Company for what Management believes is a likely
eventual return to an increasing interest rate environment commencing some time
in 2003. In other words, Management believes it unlikely that interest rates
will remain at historically low levels, with negative real federal funds, for an
extended period of time. Management has recently considered shifting the
Company's interest rate risk profile to very slightly net asset sensitive at
some point in the next several quarters in preparation for a return to an
increasing interest rate environment.
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.
32
Liquidity
Liquidity is actively managed to ensure sufficient funds are available
to meet ongoing needs of both the Company and the Bank. 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, 2002, the Company had $9.5 million in cash and cash
equivalents, available borrowing capacity in excess of $180.0 million at the
FHLB-SF, $2.9 million in unpledged securities, and a significant volume of
residential mortgages that could be securitized, liquidated, or used in
collateralized borrowings in order to meet future liquidity requirements.
The State of California is the Bank's largest single depositor, with
$28.0 million in certificates of deposit placed in the Bank as of September 30,
2002. Should the State of California not renew these certificates of deposit
upon maturity, replacement funding would likely be more costly. The maturity
dates for the State of California certificates of deposit are staggered to avoid
a concentration of repricing and funding risk. The Bank's second largest
depositor is a $20.0 million brokered CD that matures in May 2003. The Asset /
Liability Management Committee ("ALCO") of the Bank is planning how to best
address the future maturity of that funding, from both liquidity and repricing
perspectives.
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, 2002, the Bank
maintained $34.5 million in unsecured federal funds lines of credit from five
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 four investment banking firms as an additional source of liquidity. The
Bank intends to add the ability to issue DTC certificates of deposit through an
additional firm during the fourth quarter of 2002 in order to further increase
its available liquidity and to obtain even more competitive pricing.
At September 30, 2002, MBBC on a stand alone basis had cash & cash
equivalents of $4.4 million. In addition, MBBC had no outstanding balance on a
$3.0 million committed revolving line of credit. This line of credit is
scheduled to mature at the end of 2002. The Company is currently pursuing a
renewal of, and possible increase in, this credit facility.
33
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
As of September 30, 2002, the most recent notification from the OTS
categorized the Bank as "well capitalized". There are no conditions or events
since that notification that Management believes have changed the Bank's
category. 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, 2002 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 $ 49,221 8.57% $ 49,221 11.76% $ 54,480 13.01%
Well capitalized requirement 28,718 5.00% 25,122 6.00% 41,869 10.00%
-------- ----- -------- ----- -------- -----
Excess $ 20,503 3.57% $ 24,099 5.76% $ 12,611 3.01%
======== ===== ======== ===== ======== =====
Adjusted assets (1) $574,356 $418,693 $418,693
======== ======== ========
- -------------------------------------
(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.
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).
34
The following table summarizes these regulatory capital requirements
for the Bank. As indicated in the table, the Bank's capital levels at September
30, 2002 exceeded all three of the currently applicable minimum regulatory
capital requirements.
Percent Of
Adjusted
(Dollars In Thousands) Total
Amount Assets
------ ------
Tangible Capital
Regulatory capital $49,221 8.57%
Minimum required 8,615 1.50%
------- ----
Excess $40,606 7.07%
======= ====
Core Capital
Regulatory capital $49,221 8.57%
Minimum required 22,974 4.00%
------- ----
Excess $26,247 4.57%
======= ====
Percent Of
Risk-
weighted
Amount Assets
------ ------
Risk-based Capital
Regulatory capital $54,480 13.01%
Minimum required 33,495 8.00%
------- ----
Excess $20,985 5.01%
======= ====
At September 30, 2002, 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, 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.
35
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, 2002 December 31, 2001
------------------ -----------------
Outstanding Balances Before Valuation Reserves
Non-accrual loans $ 3,554 $ 2,252
Loans 90 or more days delinquent and accruing interest -- --
Restructured loans in compliance with modified terms -- --
------- -------
Total gross non-performing loans 3,554 2,252
Investment in foreclosed real estate before valuation reserves -- --
Repossessed consumer assets -- --
------- -------
Total gross non-performing assets $ 3,554 $ 2,252
======= =======
Gross non-accrual loans to total loans 0.72% 0.48%
Gross non-performing loans to total loans 0.72% 0.48%
Gross non-performing assets to total assets 0.62% 0.42%
Allowance for loan losses $7,742 $6,665
Allowance for loan losses to non-performing loans 217.84% 295.96%
Valuation allowances for foreclosed real estate $ -- $ --
Non-accrual loans at September 30, 2002 are detailed in the following
table:
(Dollars In Thousands) Number Principal Balance
Of Outstanding At
Category Of Loan Loans September 30, 2002
- ---------------- ----- ------------------
Residential mortgage one to four units 2 $ 1,148
Commercial & industrial real estate 1 2,277
Land 1 129
- -------
Total 4 $ 3,554
= =======
Non-accrual loans increased from $2.3 million at December 31, 2001 to
$3.6 million at September 30, 2002 primarily due to the placement of a $2.3
million commercial real estate mortgage on non-accrual status. This credit is a
participation loan where the Bank is not the lead financial institution. The
loan is secured by a first deed of trust on a hotel / resort located within the
Company's primary market area and by a first deed of trust on a residential lot
located in California. The borrowers are directly personally indebted. The hotel
/ resort is a relatively new development that has experienced limited cash flow.
The hotel / resort was also adversely impacted by the decline in tourism and
travel following the events of September 11, 2001 and the national economic
recession.
36
At September 30, 2002, the Company maintained a $475 thousand specific
reserve for this hotel / resort loan, based upon estimated net proceeds
following foreclosure and sale. This specific reserve was decreased from $754
thousand at June 30, 2002 due to payments received from the borrowers during the
third quarter, the borrowers providing additional real estate collateral (the
first deed of trust on the residential lot), and the Company's receipt of
updated valuation and financial information regarding the hotel / resort.
Although the loan was current in its payments at September 30, 2002, the Company
maintained the loan on non-accrual status at September 30, 2002 due to concern
about the future net cash flow of the hotel / resort following the peak summer
season, particularly in light of the status of the economy, the tourism
industry, and the outlook for business travel activity. These factors also
create particular volatility in the market value of the hotel / resort.
Non-accrual loans at September 30, 2002 also included:
o An $846 thousand residential mortgage secured by a first deed of trust. The
borrowers have declared bankruptcy. There are significant junior mortgages
from other lenders secured by the subject collateral. The Company is
currently pursuing approval from the bankruptcy court to proceed with
foreclosure.
o A residential mortgage with a balance of $303 thousand that is associated
with a chronically late paying borrower.
o A $129 thousand loan secured by a first deed of trust on residential land.
This loan has matured. The Company has conducted a recent site visit and is
currently pursuing foreclosure.
The Company does not anticipate recording a loss on any of the above
three non-accrual loans due to the estimated value of the underlying real estate
collateral. All non-accrual loans at September 30, 2002 were secured by real
estate. The Company had no foreclosed real estate at September 30, 2002.
Criticized And Classified Assets
The following table presents information concerning the Company's
criticized ("OAEM") and classified ("substandard" and lower) assets. The
category "OAEM" refers to "Other Assets Especially Mentioned", or those assets
that present indications of potential future credit deterioration.
(Dollars In Thousands) OAEM Substandard Doubtful Loss Total
---- ----------- -------- ---- -----
December 31, 2001 $ 6,207 $ 5,098 $ -- $ -- $11,305
March 31, 2002 $ 3,296 $ 4,386 $ -- $ 754 $ 8,436
June 30, 2002 $ 6,230 $ 4,819 $ -- $ 754 $11,803
September 30, 2002 $ 6,234 $ 5,022 $ -- $ 475 $11,731
Classified assets as a percent of stockholders' equity decreased
slightly from 10.2% at December 31, 2001 to 10.0% at September 30, 2002.
37
The amounts classified as "Loss" in the prior table are associated with
the specific reserve for the $2.3 million commercial real estate mortgage
secured by a hotel / resort located in the Company's primary market area, as
described above under "Non-performing Assets". The remainder of this $2.3
million loan is classified as substandard. September 30, 2002 substandard assets
in the above table also include:
o The Company's other non-accrual loans as described above under
"Non-performing Assets".
o An $836 thousand commercial real estate mortgage secured by a first deed of
trust. The borrower fully reinstated this loan during the third quarter of
2002 and paid in full all delinquent property taxes. This loan is well
secured by the value of the real property, and there is a significant
junior mortgage from another lender secured by the subject collateral.
o A total of $419 thousand in commercial loans to a corporation that
experienced a slowdown in sales during the first half of 2002, in part due
to staff turnover. The slowdown in sales contributed to loan covenant
violations. The loans were current in their payments at September 30, 2002.
The Company is presently working with the borrowers to pay down the
outstanding debt. The Company has obtained real estate collateral to secure
a portion of the debt.
o A total of $334 thousand in commercial loans to a corporation whose sole
stockholder has declared personal bankruptcy. These loans were current in
their payments as of September 30, 2002 and the borrower has indicated his
intent to continue making payments per the terms of the loans.
o A total of $298 thousand in commercial loans to a corporation that
experienced a slowdown in sales during the first half of 2002, resulting in
loan covenant violations. The loans were current in their payments at
September 30, 2002, and the borrowers have been cooperative. Recent sales
have improved. The loans are secured by business assets and real estate.
Criticized loans at September 30, 2002 included:
o A $1.7 million residential mortgage in the Company's primary market area
where the borrowers have repeatedly failed to make timely payments. This
loan was current in its payments as of early November 2002.
o A $1.3 million mortgage, current in its payments at September 30, 2002,
secured by a motel located in the Silicon Valley area of the San Francisco
Bay Area. The motel's cash flow has been unfavorably impacted by the
economic difficulties being experienced in the technology industry and by a
reduction in business travel in general.
o A $981 thousand mortgage secured by an apartment complex in the Silicon
Valley area. This loan was current in its payments at September 30, 2002;
however, rents in the subject area have been adversely affected by the
economic difficulties in the technology industry.
o A $561 thousand commercial loan to a business in the Company's primary
market area that participates in the telecommunications industry. This loan
is secured by business assets and a deed of trust on residential real
estate, and was current in its payments at September 30, 2002. At September
30, 2002, the borrower was in the process of refinancing certain
residential real estate with the intention of using the net proceeds from
such refinancing to pay off the Company's commercial loan.
o A total of $299 thousand in commercial loans to a winery. The winery
experienced some financial difficulty during 2002, resulting in sporadic
late payments. The loans were fully current in early November 2002 and the
borrowers have been cooperative. The loans are secured by real estate.
At the present time, the Company does not anticipate recording a loss
on any of the above detailed criticized loans due to borrower cooperation and /
or the estimated fair value of the associated collateral.
38
Impaired Loans
At September 30, 2002, the Company had total gross impaired loans,
before specific reserves, of $3.6 million, constituting four credits. Specific
reserves on these $3.6 million in impaired loans totaled $475 thousand. This
compares to total gross impaired loans of $2.3 million, with no specific
reserves, at December 31, 2001. 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, 2002, accrued interest on impaired loans was zero and
interest of $132 thousand was received in cash. The average balance of impaired
loans during the three and nine months ended September 30, 2002 was $4.7 million
and $4.0 million, respectively. If all non-accrual loans had been performing in
accordance with their original loan terms, the Company would have recorded
interest income of $201 thousand during the nine months ended September 30,
2002, instead of interest income actually recognized, based on cash payments, of
$132 thousand.
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 that 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. For example, the Company increased
the formula allowance for commercial business loans during the third quarter of
2002 in response to reports of weaker sales by a number of borrowers across
several industries, as described above under "Criticized And Classified Assets".
The formula allowance at September 30, 2002 was $6.8 million, compared to $6.0
million at December 31, 2001.
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". The
Company had $475 thousand in specific allowance at September 30, 2002, compared
to none at December 31, 2001.
39
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, 2002 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
The unallocated allowance at September 30, 2002 was $509 thousand, compared to
$668 thousand at December 31, 2001.
The following table presents activity in the Company's allowance for
loan losses during the nine months ended September 30, 2002 and September 30,
2001:
Nine Months Ended September 30,
-----------------------------------------
2002 2001
---- ----
Allowance For Loan Losses (Dollars In Thousands)
- -------------------------
Balance at beginning of year $ 6,665 $ 5,364
Charge-offs:
Consumer lines of credit (10) (2)
Commercial term loans (30) --
Commercial lines of credit -- (50)
-- ------- -------
Total charge-offs (40) (52)
Recoveries:
Consumer lines of credit 4 --
Commercial lines of credit 3 --
-- ------- -------
Total recoveries 7 --
Provision for loan losses 1,110 1,075
-- ------- -------
Balance at September 30 $ 7,742 $ 6,387
======= =======
Annualized ratio of net charge-offs during the period to average
loans receivable, net, outstanding during the period 0.01% 0.02%
40
Additional ratios applicable to the allowance for loan losses include:
September 30, 2002 December 31, 2001
------------------ -----------------
Allowance for loan losses as a percent of non-performing loans 217.84% 295.96%
Allowance for loan losses as a percent of gross loans
receivable net of undisbursed loan funds and
unamortized yield adjustments 1.54% 1.41%
Allowance for loan losses as a percent of classified assets 140.84% 130.74%
The $509 thousand in unallocated allowance at September 30, 2002
reflected the Company's consideration of the following factors, as well as the
more general factors listed above in conjunction with the definition of the
unallocated allowance:
o The adverse impacts of the weak technology and telecommunications
industries 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 telecommunications,
technology, and technology related businesses. Recent reports indicate a
rise in office vacancy rates and a decline in rental rates for office space
in multiple markets within the greater San Francisco Bay Area. Based on
Management estimates, this impact could be in the range of $100 thousand to
$1.1 million.
o Recent reports of selected areas of soft or declining apartment rents in
Northern California resulting from reduced employment, weakness in the
technology and telecommunications industries, and a strong home purchase
market. The soft or declining rents could lead to decreased multifamily
property values. Based on Management estimates, this impact could be in the
range of $100 thousand to $900 thousand.
As subsequently discussed (see "Provision For Loan Losses"), the
Company recorded similar provisions for loan losses during the first nine months
of 2002 versus the same period in the prior year. The primary factors impacting
the Company's reserve requirements, and resulting provision for loan losses,
however, varied between the first nine months of 2002 and the first nine months
of 2001, as highlighted in the following table:
First Nine Months Of 2002 First Nine Months Of 2001
- ------------------------------------------------------ ---------------------------------------------------
1) Change in loan portfolio product mix 1) National economic recession
2) Growth in loan portfolio 2) Growth in loan portfolio
3) Impact of weak economic recovery upon 3) Portfolio of residential mortgages with less
commercial business credits favorable credit profile than typically
pursued by the Company (paid down to
$3.3 million at September 30, 2002,
4) Establishment of $475 thousand specific with no credit losses)
reserve for $2.3 million hotel / resort loan
4) Uncertain impacts from the events of
5) Origination of relatively larger loans in September 11, 2001, particularly in regards to
conjunction with change in product mix and business travel and tourism
opening of the Los Angeles loan production
office in 2002 5) "Business Express" commercial portfolio
(discontinued product in 2002)
6) State of California budget deficit
6) Recapture of $600 thousand specific reserve
7) State of California energy crisis
41
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, purchase, and participation of income property
real estate loans
o expanding the construction loan portfolio
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, construction, and income property
loans present greater risks than residential real estate loans, and therefore
should be accompanied by suitably higher levels of reserves.
Comparison Of Operating Results For The Three Months And Nine Months
Ended September 30, 2002 and September 30, 2001
General
During the third quarter of 2002, the Company reported net income $1.47
million, equivalent to $0.42 diluted earnings per share, compared to net income
of $1.06 million, or $0.31 diluted earnings per share, for the same period in
2001. Net income during the quarter ended June 30, 2002 (the immediately
preceding quarter) was $1.35 million, equivalent to $0.38 diluted earnings per
share. The Company's diluted earnings per share have increased for six
consecutive quarters.
For the nine months ended September 30, 2002, net income was $4.02
million, equivalent to $1.15 diluted earnings per share. This compares to net
income of $2.61 million, or $0.79 diluted earnings per share, for the first nine
months of 2001. The 54.1% increase in net income for the first nine months of
2002 compared to the same period in 2001 primarily resulted from three key
factors:
o the continued implementation of the Company's strategic plan to transform
the Bank into a community commercial bank serving the financial needs of
individuals, families, local community organizations, and businesses
o a $2.2 million rise in net interest income resulting from a combination of
increased spreads and larger average balances of interest earning assets
and liabilities
o during the nine months of 2001, the Company incurred pre-tax operating
costs of $447 thousand for the conversion of the core data processing
system and $284 thousand for legal expenses associated with the arbitration
of claims by a former executive
The third quarter of 2002 earnings were the highest of any quarter in
the Company's history. Annualized return on average stockholders' equity
improved from 8.76% during the third quarter of 2001 to 10.73% during the third
quarter of 2002.
42
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 nine quarters. Market interest rates have varied considerably during this
time period, generally falling throughout 2001, with certain interest rates
rising in the first quarter of 2002 and then falling in the second and third
quarters of 2002. In addition, the slope of the Treasury curve shifted from
inverted at the beginning of 2001, to flatter by the end of the first quarter of
2001, to positively sloped by mid 2001. From mid 2001 to March 31, 2002, the
Treasury curve generally became progressively more steeply sloped (i.e. a
greater differential between short term and longer term interest rates). During
the second and third quarters of 2002, the Treasury curve flattened.
Financial institutions, including the Bank, 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. In addition, steep yield curves often lead to increased customer
demand for adjustable rate mortgages due to the rate differential to long term,
fixed rate mortgages.
As a result of the interest rate environment over the past 21 months,
yields and rates for most assets and liabilities were substantially lower in the
first nine months and third quarter of 2002 compared to the same periods in
2001.
Net Interest Income
Net interest income increased from $5.0 million and $14.5 million
during the third quarter and first nine months of 2001, respectively, to $5.8
million and $16.7 million during the same periods in 2002 due to both expanded
spreads and greater average balances of interest earning assets and liabilities.
The Company's ratio of net interest income to average total assets was 4.07% for
the third quarter of 2002, up from 3.79% during the same period in 2001. This
ratio similarly increased from 3.80% during the first nine months of 2001 to
4.01% during the same period in 2002. The increased spreads in 2002 in part
stemmed from the Company's continued implementation of its strategic plan.
The spread derived from investing the Company's demand deposit balances
and capital was lower in the first nine months of 2002 than the same period in
2001 due to the significantly lower general interest rate environment. However,
net interest income during the first nine months of 2002 benefited from lifetime
rate floors on certain loans and prepayment penalties received on certain income
property loans that were paid off.
Other factors influencing net interest income during the third quarter
and first nine months of 2002 compared to the same periods in 2001 included:
o Average net loans as a percentage of average total assets improved from
85.5% and 83.0% during the third quarter and first nine months of 2001 to
86.0% and 86.0% during the same periods in 2002. Because loans constitute
the Company's highest yielding type of asset, this change in asset mix
favorably affected net interest income.
o Average transaction account (NOW, savings, and MMDA) deposits as a
percentage of average total assets increased from 28.5% and 29.2% during
the third quarter and first nine months of 2001 to 31.3% and 31.3% during
the same periods in 2002. Because transaction accounts represent relatively
low cost funding for the Company, this change in funding mix favorably
impacted net interest income.
43
o Average demand deposits as a percentage of average total assets increased
from 3.8% and 3.6% during the third quarter and first nine months of 2001
to 4.1% and 4.0% during the same periods in 2002. In addition, average
stockholders' equity as a percentage of average total assets increased from
9.1% and 9.1% during the third quarter and first nine months of 2001 to
9.6% and 9.5% during the same periods in 2002. Increases in interest free
funding sources favorably impact the Company's spreads.
o The ratio of interest earning assets to interest bearing liabilities
increased slightly from 1.10 and 1.09 during the third quarter and first
nine months of 2001 to 1.11 and 1.11 during the same periods in 2002.
Increases in this ratio favorably impact average spreads, as this indicates
that the Company is earning interest income on a relatively larger base of
assets versus the quantity of liabilities upon which it is paying interest.
The Company regularly endeavors to allocate as much of its assets as
operationally practicable to interest earning alternatives.
The Company's ratio of net interest income to average interest earning
assets rose from 4.18% during the second quarter of 2002 to a record 4.27%
during the third quarter of 2002. Approximately 3 basis points of this increase
resulted from a reduction in earned, but uncollected and unrecorded, interest
income on non-accrual loans, which declined from $109 thousand at June 30, 2002
to $69 thousand at September 30, 2002. During the third quarter of 2002, the
Company had several loans that were on non-accrual status at June 30, 2002 fully
reinstate. The majority of the $69 thousand earned, but uncollected and
unrecorded, interest income at September 30, 2002 was associated with a single
residential mortgage with a principal balance of $846 thousand, as described in
more detail under "Non-performing Assets".
The Company plans to further increase its net interest margin by
continuing the transformation into a community commercial bank, increasing the
percentage of total assets constituted by loans, decreasing the percentage of
the loan portfolio comprised of residential mortgages, and increasing the
percentage of the deposit portfolio composed of transaction accounts. 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.
44
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, 2002 and 2001.
Three Months Ended September 30, 2002 Three Months Ended September 30, 2001
---------------------------------------- ----------------------------------------
(Dollars In Thousands) Average Average Average Average
Balance Interest Rate Balance Interest Rate
------- -------- ---- ------- -------- ----
Assets
Interest earning assets:
Cash equivalents (1) $ 1,621 $ 6 1.48% $ 6,035 $ 50 3.31%
Investment securities 7,265 52 2.86% 7,404 93 5.02%
Mortgage backed securities (2) 40,806 323 3.17% 32,883 488 5.94%
Loans receivable, net (3) 489,713 8,549 6.98% 453,030 9,084 8.02%
FHLB stock 3,323 49 5.90% 3,259 43 5.28%
-------- -------- -------- --------
Total interest earning assets 542,728 8,979 6.62% 502,611 9,758 7.77%
-------- --------
Non-interest earnings assets 26,466 27,353
-------- --------
Total assets $569,194 $529,964
======== ========
Liabilities & Equity
Interest bearing liabilities:
NOW accounts $ 44,318 39 0.35% $ 40,907 77 0.75%
Savings accounts 18,731 26 0.56% 19,694 51 1.04%
Money market accounts 115,357 621 2.15% 90,186 807 3.58%
Certificates of deposit 254,003 1,892 2.98% 252,369 3,097 4.91%
-------- -------- -------- --------
Total interest-bearing deposits 432,409 2,578 2.38% 403,156 4,032 4.00%
FHLB advances 56,557 603 4.26% 55,365 708 5.12%
Other borrowings (4) 319 3 3.76% 356 3 3.37%
-------- -------- -------- --------
Total interest-bearing liabilities 489,285 3,184 2.60% 458,877 4,743 4.13%
-------- --------
Demand deposit accounts 23,365 20,067
Other non-interest bearing liabilities 1,893 2,752
-------- --------
Total liabilities 514,543 481,696
Stockholders' equity 54,651 48,268
-------- --------
Total liabilities & equity $569,194 $529,964
======== ========
Net interest income $ 5,795 $ 5,015
======== ========
Interest rate spread (5) 4.02% 3.64%
Net interest earning assets 53,443 43,734
Net interest margin (6) 4.27% 3.99%
Net interest income /
average total assets 4.07% 3.79%
Interest earnings assets /
Interest bearing liabilities 1.11 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 and collateralized mortgage
obligations.
(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 $96,000 and
$45,000 in 2002 and 2001, respectively.
(4) Includes federal funds purchased, securities sold under agreements to
repurchase, and borrowings drawn on MBBC's line of credit.
(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.
45
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, 2002 and 2001.
Nine Months Ended September 30, 2002 Nine Months Ended September 30, 2001
---------------------------------------- ----------------------------------------
(Dollars In Thousands) Average Average Average Average
Balance Interest Rate Balance Interest Rate
------- -------- ---- ------- -------- ----
Assets
Interest earning assets:
Cash equivalents (1) $ 3,912 $ 51 1.74% $ 8,123 $ 277 4.55%
Investment securities 7,441 162 2.90% 7,356 338 6.13%
Mortgage backed securities (2) 36,454 963 3.52% 41,644 1,970 6.31%
Loans receivable, net (3) 477,609 25,298 7.06% 423,124 26,753 8.43%
FHLB stock 3,196 151 6.30% 3,051 126 5.51%
--------- ------ --------- ------
Total interest earning assets 528,612 26,625 6.72% 483,298 29,464 8.13%
------ ------
Non-interest earnings assets 26,714 26,748
--------- ---------
Total assets $ 555,326 $ 510,046
========= =========
Liabilities & Equity
Interest bearing liabilities:
NOW accounts $ 43,530 123 0.38% $ 40,811 317 1.04%
Savings accounts 18,752 78 0.55% 19,318 187 1.29%
Money market accounts 111,316 1,813 2.17% 88,859 2,764 4.15%
Certificates of deposit 248,448 6,070 3.26% 246,996 9,804 5.29%
--------- ------ --------- ------
Total interest-bearing deposits 422,046 8,084 2.55% 395,984 13,072 4.40%
FHLB advances 55,959 1,823 4.34% 46,538 1,834 5.25%
Other borrowings (4) 303 10 4.40% 214 18 11.21%
--------- ------ --------- ------
Total interest-bearing liabilities 478,308 9,917 2.76% 442,736 14,924 4.49%
------ ------
Demand deposit accounts 22,260 18,561
Other non-interest bearing
liabilities 1,738 2,427
--------- --------
Total liabilities 502,306 463,724
Stockholders' equity 53,020 46,322
--------- --------
Total liabilities & equity $ 555,326 $ 510,046
========= =========
Net interest income $16,708 $ 14,540
======= ========
Interest rate spread (5) 3.96% 3.64%
Net interest earning assets 50,304 40,562
Net interest margin (6) 4.21% 4.01%
Net interest income /
average total assets 4.01% 3.80%
Interest earnings assets /
Interest bearing liabilities 1.11 1.09
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 and collateralized mortgage
obligations.
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 $212,000 and
$159,000 in 2002 and 2001, respectively.
4) Includes federal funds purchased, securities sold under agreements to
repurchase, and borrowings drawn on MBBC's line of credit.
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.
46
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, 2002
Compared To
Three Months Ended September 30, 2001
----------------------------------------------------------------------
Volume
(Dollars In Thousands) Volume Rate / Rate Net
------ ---- ------ ---
Interest-earning assets
Cash equivalents $ (37) $ (28) $ 21 $ (44)
Investment securities (2) (40) 1 (41)
Mortgage backed securities 118 (228) (55) (165)
Loans receivable, net 735 (1,175) (95) (535)
FHLB Stock 1 5 0 6
------ ------ ------ ------
Total interest-earning assets 815 (1,466) (128) (779)
------ ------ ------ ------
Interest-bearing liabilities
NOW Accounts 6 (41) (3) (38)
Savings accounts (2) (24) 1 (25)
Money market accounts 225 (322) (89) (186)
Certificates of deposit 20 (1,217) (8) (1,205)
------ ------ ------ ------
Total interest-bearing deposits 249 (1,604) (99) (1,454)
FHLB advances 15 (118) (2) (105)
Other borrowings 0 0 0 0
------ ------ ------ ------
Total interest-bearing liabilities 264 (1,722) (101) (1,559)
------ ------ ------ ------
Increase in net interest income $ 551 $ 256 $ (27) $ 780
====== ====== ======= ======
47
Nine Months Ended September 30, 2002
Compared To
Nine Months Ended September 30, 2001
----------------------------------------------------------------------
Volume
(Dollars In Thousands) Volume Rate / Rate Net
------ ---- ------ ---
Interest-earning assets
Cash equivalents $ (144) $ (171) $ 89 $ (226)
Investment securities 4 (178) (2) (176)
Mortgage backed securities (246) (871) 110 (1,007)
Loans receivable, net 3,445 (4,341) (559) (1,455)
FHLB Stock 6 18 1 25
------- ------ ----- --------
Total interest-earning assets 3,065 (5,543) (361) (2,839)
------- ------ ----- --------
Interest-bearing liabilities
NOW Accounts 21 (202) (13) (194)
Savings accounts (5) (107) 3 (109)
Money market accounts 699 (1,317) (333) (951)
Certificates of deposit 58 (3,769) (23) (3,734)
------- ------ ----- --------
Total interest-bearing deposits 773 (5,395) (366) (4,988)
FHLB advances 371 (318) (64) (11)
Other borrowings 7 (11) (4) (8)
------- ------ ----- --------
Total interest-bearing liabilities 1,151 (5,724) (434) (5,007)
------- ------ ----- --------
Increase in net interest income $ 1,914 $ 181 $ 73 $ 2,168
======= ====== ===== ========
Interest Income
Interest income decreased from $9.8 million and $29.5 million during
the three and nine months ended September 30, 2001 to $9.0 million and $26.6
million during the same periods in 2002. This decrease was primarily due to the
much lower interest rate environment present in 2002. The effect of lower
general market interest rates more than offset the impact of an 8.0% rise in
average interest earning assets from the third quarter of 2001 to the third
quarter of 2002 and a shift in asset mix towards loans, coincident with the
Company's strategic plan of better supporting its local communities with the
delivery of credit.
Interest income on loans decreased from $9.1 million and $26.8 million
during the three and nine months ended September 30, 2001 to $8.5 million and
$25.3 million during the same periods in 2002. The effect of lower interest
rates more than offset the impact of 8.1% and 12.9% rises in average net loan
balances outstanding from the three and nine months ended September 30, 2001 to
the three and nine months ended September 30, 2002. 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 purchases from
correspondent banks, and loan participations; with the latter primarily sourced
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.
48
Interest income on cash equivalents decreased from $50 thousand and
$277 thousand for the three and nine months ended September 30, 2001 to $6
thousand and $51 thousand for the same period in 2002. This decline was due to:
o lower average rates resulting from the interest rate cuts implemented by
the Federal Reserve in 2001
o lower average volumes stemming from:
A. the Company's redeploying funds from cash equivalents into loans as a
result of the demand for credit
B. the Company's purchasing short term investment securities (called
Agency debentures) during the first quarter of 2002 in lieu of
investing in cash equivalents
Interest income on investment securities declined from $93 thousand and
$338 thousand during the three and nine months ended September 30, 2001 to $52
thousand and $162 thousand during the same periods in 2002. The reduced interest
income resulted from lower yields on variable rate corporate trust preferred
securities that reprice quarterly based upon 3 month LIBOR, which was
significantly lower in the first nine months of 2002 than during the same period
in 2001. This impact was only partially offset by interest income earned on
short term Agency debentures purchased during the first quarter of 2002 as a
vehicle for investing short term excess liquidity.
Interest income on mortgage backed securities fell from $488 thousand
and $2.0 million during the three and nine months ended September 30, 2001 to
$323 thousand and $963 thousand during the same periods in 2002. These decreases
were primarily caused by reductions in average rates. Average volumes were lower
for the nine month comparative period, but higher for the three month
comparative period. 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 2001, which adjusted downward in rate in
conjunction with the decline in interest rates during 2001 and 2002. The
Company's effective yield on mortgage backed securities during the third quarter
of 2002 was unfavorably impacted by the Company's purchasing short term, above
market coupon CMO's in conjunction with its interest rate risk management
program. When residential mortgage prepayment speeds accelerated during the
third quarter of 2002, the Company's effective yield on CMO's was negatively
impacted by faster amortization of the purchase premium.
Dividend income on FHLB stock increased from $43 thousand and $126
thousand during the three and nine months ended September 30, 2001 to $49
thousand and $151 thousand during the same periods in 2002. Greater average
balances of FHLB stock stemming from the expansion in the Bank's balance sheet
contributed to these increases. In addition, the FHLB-SF declared a particularly
high fourth quarter 2001 dividend rate of 5.99% during the first quarter of
2002. This rate was above that accrued by the Company in 2001, and therefore
increased the Company's reported yield on FHLB stock during 2002.
Interest Expense
Interest expense decreased from $4.7 million and $14.9 million during
the three and nine months ended September 30, 2001 to $3.2 million and $9.9
million during the same periods in 2002, as the effect of the lower interest
rate environment more than offset the impact of increases in average interest
bearing liabilities.
49
Interest expense on deposits decreased from $4.0 million and $13.1
million during the three and nine months ended September 30, 2001 to $2.6
million and $8.1 million during the same periods in 2002. 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 and a shift in
the composition of the deposit portfolio. Relatively higher cost certificates of
deposit decreased from 59.6% of average total deposits during the third quarter
of 2001 to 55.7% during the third quarter of 2002 despite the Company's issuing
a $20.0 million brokered certificate of deposit during May 2002. Relatively
lower cost transaction deposit accounts experienced a complementary increase,
with money market deposits experiencing a significant rise from 21.3% to 25.3%
of average total deposits during the same time periods. This change in deposit
mix is a fundamental component of the Company's strategic plan.
At September 30, 2002, the Company's weighted average nominal cost of
deposits was 2.15%, down from 2.87% at December 31, 2001. The Company paid an
average rate of just 0.35% on its NOW deposits and 0.56% on its savings deposits
during the third quarter of 2002, highlighting the limited ability of the
Company to further reduce the cost of this funding should general market
interest rates decline in future periods. At September 30, 2002, $56.1 million
in certificates of deposit with a weighted average nominal rate of 2.58% were
scheduled to mature in the next quarter. This figure included $6.0 million in
State of California deposits. At September 30, 2002, the longest term permitted
by the State under its time deposit program was six months.
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, 8, and 19 months, augmented by ongoing sales and periodic
print advertising of longer term certificates of deposit. For example, the
Company conducted two rounds of print advertising throughout its primary market
area in the second quarter of 2002 promoting 24 month and 30 month certificates
of deposit. Three year certificates of deposit were extensively advertised
during the early part of the fourth quarter of 2002. At September 30, 2002, the
weighted average cost of the certificate of deposit portfolio was 2.81%, down
from 3.14% at June 30, 2002.
During the fourth quarter of 2002, the Company plans to continue
promoting money market accounts, including new consumer and business MMDA
products, intermediate to longer term certificates of deposit, and business
checking accounts. The Company's deposit products are highly tiered, encouraging
greater account balances in order to earn higher rates of interest. Customer
accounts are 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
commercial credit facilities.
Interest expense on FHLB advances and other borrowings decreased from
$711 thousand during the three months ended September 30, 2001 to $606 thousand
during the same period in 2002 due to the effect of lower average rates more
than offsetting a slight increase in average balances. Interest expense on FHLB
advances and other borrowings was little changed for the first nine months of
2002 compared to the same period during the prior year, as the impact of greater
average balances negated the effect of lower average rates. The Company had
higher levels of borrowings outstanding in the first nine months of 2002 than
the same period in 2001 due to borrowings being utilized to fund some of the
growth in the loan portfolio.
The Company's average interest rate on other borrowings was inflated
during 2001 and 2002 as a result of the amortization of loan fees (discount on a
liability) on MBBC's $3.0 million revolving line of credit combined with a lack
of draws (outstanding balances) on the line.
50
Provision For Loan Losses
The Company recorded provisions for loan losses totaling $400 thousand
and $1.1 million during the three and nine months ended September 30, 2002,
compared to $275 thousand and $1.1 million during the same periods in 2001. The
Company determines its periodic provision for loan losses based upon its
analysis of loan loss reserve adequacy. Net charge-offs during the first nine
months of 2002 were $33 thousand (of which less than $1 thousand occurred in the
third quarter), versus $52 thousand during the first nine months of 2001. The
Company's ratio of loan loss reserves to loans outstanding increased from 1.41%
at December 31, 2001 to 1.54% at September 30, 2002, while the nominal amount of
the loan loss reserve rose from $6.7 million at December 31, 2001 to $7.7
million at September 30, 2002.
Factors contributing to the provision for loan losses during the first
nine months of 2002 included:
o the establishment of a specific reserve of $475 thousand associated with a
$2.3 million commercial real estate mortgage secured by a hotel / resort
described above under "Non-performing Assets"
o the expansion in the loan portfolio
o the addition of a large volume of new credits to the loan portfolio
o the origination of relatively larger loans by the Los Angeles loan
production office
o the stage of the economic and credit cycles, with Management's belief that
California typically lags national economic trends
o the change in loan portfolio mix, particularly the reduced concentration of
relatively lower risk residential mortgages
o the Company's updating its formula general reserve factors during 2002 to
reflect current information regarding real estate valuations, business
conditions, rental and vacancy rates for various types of income property,
and other factors in estimating the amount of loss inherent in the loan
portfolio at September 30, 2002
o year to date net charge-offs
Because the $2.3 million commercial real estate mortgage secured by a hotel /
resort was already classified as substandard at December 31, 2001, the
incremental loan loss reserves associated with this loan at September 30, 2002
were less than the $475 thousand specific reserve.
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. Commercial lines of credit
and term loans to businesses also typically present a greater level of credit
risk than residential mortgages.
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,
construction, and commercial business lending. This change in portfolio mix is
anticipated to continue to be accelerated by the Los Angeles loan production
office, which concentrates on construction and income property lending. The Los
Angeles loan production office presents the Company with the opportunity to
better geographically diversify its real estate loan portfolio, such that the
Company becomes less exposed to a downturn in real estate values, economic
weakness, or a natural disaster in any one local real estate market. The Company
does not, however, pursue lending outside the State of California, but does
occasionally make real estate loans secured by property in other states as an
accommodation to existing customers.
51
Non-interest Income
Non-interest income totaled $490 thousand and $1.5 million during the
three and nine months ended September 30, 2002, down from $690 thousand and $2.0
million during the same periods in 2001.
Customer service charge income was $387 thousand and $1.1 million
during the three and nine months ended September 30, 2002, down from $401
thousand and $1.3 million during the same periods in 2001. In conjunction with
the conversion to the new core data processing system in March 2001, the Company
implemented a revamped consumer checking product line and an associated revised
fee and service charge schedule. These changes contributed to the closing of
certain lower balance, recurring overdraft, and / or higher transaction volume
consumer checking accounts beginning in the second quarter of 2001, as such
accounts began incurring increased service charges. The closure of these
accounts contributed to the reduced levels of customer service charge income,
but also decreased certain operating costs for the Company. In addition, certain
uncollected funds fees charged in 2001 were eliminated by the beginning of 2002
due to competitive factors.
Commissions from the sale of non-FDIC insured investment products were
$25 thousand and $100 thousand during the three and nine months ended September
30, 2002, down from $35 thousand and $223 thousand during the same periods in
2001. This decrease was primarily due to vacancies in positions for licensed
investment sales representatives and the general state of the capital markets in
the first nine months of 2002. The Company expects revenue from these operations
to remain constrained during the fourth quarter of 2002.
Loan servicing income totaled $18 thousand and $47 thousand during the
three and nine months ended September 30, 2002, compared to $33 thousand and $77
thousand during the same periods in 2001. 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, and purchases more interest rate
sensitive loans as part of its interest rate risk management program. Additions
to loans serviced for others during 2002 have thus been limited to loan
participations sold to correspondent banks. As a result, the portfolio of loans
serviced for others is declining as loans pay off. At September 30, 2002, the
Company serviced $38.3 million in various types of loans for other investors,
compared to $42.6 million at December 31, 2001. The Company maintained loan
servicing assets of $39 thousand at September 30, 2002, and is thus limited in
its exposure of loan servicing income to the accelerated loan prepayment speeds
now occurring as a result of the low interest rate environment and high volume
of residential mortgage refinance activity.
Gains on the sale of loans were $33 thousand during the third quarter
of 2002, up from $18 thousand during the third quarter of 2001. For the first
nine months of 2002, gains on the sale of loans totaled $81 thousand, a 72.3%
increase from the $47 thousand recorded during the first nine months of 2001.
The Company anticipates continued favorable results from its mortgage banking
operations during the fourth quarter of 2002, stimulated by the availability of
thirty and fifteen year fixed rate residential mortgages at rates below 6.25%
and 5.75%, respectively, at the beginning of the quarter.
The Company recorded a loss of $8 thousand on the sale of an Agency
collateralized mortgage obligation ("CMO") during the third quarter of 2002,
compared to realizing a gain of $156 thousand on the sale of two non-Agency
CMO's during the third quarter of 2001. The recent sale was conducted in
conjunction with the Company's asset / liability management program. Gains on
sale of mortgage backed securities were $35 thousand during the first nine
months of 2002, compared to $190 thousand during the same period in 2001.
Although many of the Company's mortgage backed securities appreciated in fair
value during the first nine months of 2002 due to the decline in most capital
markets interest rates, the Company retained the securities as a means of
generating net interest income.
52
Other income declined from $47 thousand and $209 thousand during the
three and nine months ended September 30, 2001 to $35 thousand and $112 thousand
during the same periods in 2002. Various factors contributed to this decline,
including:
o the collection of a $25 thousand fee in the second quarter of 2001 in
conjunction with the workout of a troubled loan
o the Company's earning $39 thousand more in fees in the first nine months of
2001 versus the same period in 2002 associated with the (discontinued)
issuance of Bank official checks drawn on a third party
o the Company's collecting $3 thousand less in rent from sub-leased space in
its branches and administrative buildings during the first nine months of
2002 versus the same period in 2001, as certain rent increases were
insufficient to offset the loss of two tenants
The Company's strategic plan incorporates non-interest income
representing a greater percentage of total revenue. The Company's efforts in
this regard during the third quarter of 2002 included an employee incentive
campaign to provide debit cards to existing customers, highlighting the many
attractive benefits of paying for purchases with a debit card rather than a
check. The Company intends to pursue increased non-interest income in future
periods through:
o further increases in the portfolio of deposit transaction accounts
o the continued sale of consumer Internet banking with electronic bill
payment
o the expanded sale of Internet banking and cash management services for
businesses
o the continued marketing of debit cards
o the recent introduction of trade and standby letter of credit services for
business customers in conjunction with a correspondent bank
However, no assurance can be provided regarding the amount of or trends in the
Company's future levels and composition of non-interest income.
Non-interest Expense
Non-interest expense totaled $3.4 million and $10.3 million during the
three and nine months ended September 30, 2002, comparing favorably to $3.6
million and $10.9 million during the same periods in 2001. Factors contributing
to the lower expenses included the Company's incurring significant costs in the
first nine months of 2001 associated with its data processing conversion ($447
thousand) and the arbitration of claims by a former executive ($284 thousand).
The data processing conversion costs included de-conversion charges from the
Company's external service bureau, travel and training costs for employees to
assist with the implementation of the new system, printing and postage for
additional customer mailings, and consultant fees.
53
Compensation and employee benefits costs were higher in the three and
nine months ended September 30, 2002 than during the same periods the prior year
due to:
o compensation costs associated with the Los Angeles loan production office
which opened during the first quarter of 2002
o other staff additions and changes in support of the Company's strategic
plan, particularly in the Company's commercial banking, income property
lending, and information technology functions
o higher costs for the Bank's Employee Stock Ownership Plan due to the
greater average market price of the Company's common stock; associated
expenses were $467 thousand for the first nine months of 2002 compared to
$314 thousand for the first nine months of 2001
o higher costs for payroll taxes on a greater compensation base
o increased expenses for worker's compensation insurance, which is a general
problem faced by businesses in the State of California
Deposit insurance premiums decreased from $50 thousand and $148
thousand for the three and nine months ended September 30, 2001 to $19 thousand
and $121 thousand during the same periods in 2002, despite the expansion in the
Company's deposit portfolio. The decline resulted from an adjustment in the
Company's insurance premium rate effective July 1, 2002. The lower insurance
premium rate will also favorably impact deposit insurance expenses during the
fourth quarter of 2002.
Legal and accounting expenses declined from $274 thousand and $724
thousand during the three and nine months ended September 30, 2001 to $107
thousand and $328 thousand during the same periods in 2002 primarily due to the
aforementioned arbitration in 2001 and due to the Company's utilizing more cost
effective providers for certain professional services in 2002.
Advertising and promotion costs totaled $52 thousand during the third
quarter of 2002, down from $86 thousand during the same period during the prior
year. The Company limited its print and broadcast advertising during the third
quarter of 2002 in light of the challenges of advertising for deposits with
interest rates at historic low levels. Advertising and promotion costs totaled
$214 thousand during the first nine months of 2002, up from $143 thousand during
the same period the prior year. These costs were unusually low in the first half
of 2001, as the Company postponed certain advertising and promotional activities
due to the implementation of the new computer systems environment. In
conjunction with the Company's strategic plan and as an alternative to print and
broadcast media, the Company's employees and Directors enhanced the Bank's
visibility during 2002 by their extensive participation in a significant number
of community events and organizations. As just one example, the Bank's employees
logged over 150 volunteer hours during the month of September participating in
various community events, the majority of which were fundraisers to support
local non-profit organizations in the Bank's primary market area.
Consulting expenses declined from $31 thousand and $336 thousand during
the three and nine months ended September 30, 2001 to $16 thousand and $59
thousand during the same periods in 2002. In 2001, the Company hired several
consultants to assist with the core systems conversion and the implementation of
complementary technology following the conversion.
The Company's efficiency ratio during the third quarter of 2002 was
54.77%, comparing favorably to 62.86% during the third quarter of 2001 and
improving from 56.12% during the second quarter of 2002 (the immediately
preceding quarter). Despite this progress, the Company's efficiency ratio is
still above those of high performing peer financial institutions. The expansion
in the Company's interest margin has been a significant factor in the
improvement in the efficiency ratio during the past year.
54
The Company continues to restructure its operations both to better
utilize new technology and improve efficiency. A major upgrade of the Company's
core banking system is planned for the fourth quarter of 2002. The Company also
continues to evaluate new vendors for various products and services, seeking
more cost effective business relationships. In 2002, the Company altered the
manner in which its facilities management is conducted to provide for better
expense control. By mid 2002, the Company implemented revised practices for
check ordering and printing, leading to cost savings. In the third quarter of
2002, the Company completed the transition to a higher quality and lower cost
cellular phone service and streamlined certain electronic transaction
processing. In upcoming quarters, the Company plans to obtain better pricing for
certain correspondent banking services, reconfigure its item processing
operations, and improve the cost effectiveness of its Internet banking program.
Through these and other initiatives, the Company continues to target progress in
improving its efficiency ratio.
However, the Company's progress in improving its efficiency ratio in
the next several quarters may be tempered by the up front costs associated with
the hiring of additional experienced commercial bankers in order to speed the
implementation of the strategic plan. In addition, should the Company open a de
novo branch in order to improve its coverage of its local market area, attract
additional deposits and new customers, build franchise value, and reduce the
loan to deposit ratio, such would likely unfavorably impact the efficiency
ratio, as new branches typically generate negative incremental contributions in
the first year of operation. Moreover, the Company is subject to certain third
party pricing increases for health insurance and worker's compensation
insurance, which are common issues for many businesses in the State of
California.
In light of the above and because of the uncertain impacts of
competition, the regulatory environment, and other factors over which the
Company has no control, Management cannot predict the Company's efficiency ratio
in future periods.
Income Taxes
Income tax expense increased in 2002 versus 2001 due to greater pre-tax
income. The Company's effective book income tax rate was 40.8% for the first
nine months of 2002, down from 42.6% for the first nine months of 2001 due to:
o certain non-deductible expenses and other adjustments to taxable income
representing a smaller percentage of the increased amount of book pre-tax
income
o the Company's filing for additional State income tax credits in 2002 under
the Enterprise Zone program
In addition, net income during the third quarter of 2002 was increased by $32
thousand associated with a non-recurring reduction in the Company's provision
for income taxes resulting from a change in California tax law. This one time
reduction contributed to the Company's reporting an effective book income tax
rate of 40.0% for the third quarter of 2002, compared to the Company's effective
book income tax rate of 40.8% for the first nine months of 2002.
55
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, 2001. There has been no significant change in these
disclosures since the filing of that document.
Item 4. Controls And Procedures
(a) The Company maintains disclosure controls and procedures that are designed
to ensure that information required to be disclosed in the Company's
reports in compliance with the Securities Exchange Act of 1934, as amended
("Exchange Act"), is recorded, processed, summarized, and reported within
the time periods specified in the Securities and Exchange Commission's
("SEC") rules and forms, and that such information is accumulated and
communicated to the Company's Management, including its Chief Executive
Officer and Chief Financial Officer, as appropriate, to allow timely
decisions regarding required disclosure based closely on the definition of
"disclosure controls and procedures" in Rule 13a-14(c) promulgated under
the Exchange Act. Within 90 days prior to the date of this report, the
Company carried out an evaluation, under the supervision and with the
participation of the Company's Management, including the Company's Chief
Executive Officer and the Company's Chief Financial Officer, of the
effectiveness of the design and operation of the Company's disclosure
controls and procedures. Based on the foregoing, the Company's Chief
Executive Officer and Chief Financial Officer concluded that the Company's
disclosure controls and procedures were effective.
(b) There have been no significant changes in the Company's internal controls
or in other factors that could significantly affect the internal controls
subsequent to the date of the evaluation referenced in paragraph (a) above.
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.
56
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, 2002.
Item 5. Other Information
None.
Item 6. Exhibits And Reports On Form 8-K
A. Exhibits
10.23 Monterey Bay Bancorp, Inc. Form Of Indemnification
Agreement Between The Company And All Directors Plus
The Chief Financial Officer
10.24 Monterey Bay Bank Form Of Indemnification Agreement
Between The Company And All Directors Plus The Chief
Financial Officer
10.25 Amended And Restated Bylaws Of Monterey Bay Bancorp,
Inc.
99.1 Chief Executive Officer Certification Pursuant To 18
U.S.C. Section 1350
99.2 Chief Financial Officer Certification Pursuant To 18
U.S.C. Section 1350
B. Reports On Form 8-K
The Company has recently filed the following Current Reports
on Form 8-K:
1. Form 8-K dated September 9, 2002. This Current Report
reported:
o an expansion in the number of Company
Directors from nine to ten
o the appointment of a new Director for
Monterey Bay Bancorp, Inc. and its
subsidiary, Monterey Bay Bank
o third quarter 2002 share repurchases by the
Company
o increased Insider ownership of the Company
2. Form 8-K dated October 21, 2002. This Current Report
reported the Company's financial and operating
results for the three month and nine month periods
ending September 30, 2002.
57
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 12, 2002 By: /s/ C. Edward Holden
--------------------
C. Edward Holden
Chief Executive Officer
President
Vice Chairman Of The Board Of Directors
Date: November 12, 2002 By: /s/ Mark R. Andino
------------------
Mark R. Andino
Chief Financial Officer
Treasurer
(Principal Financial & Accounting Officer)
58
Certification of the Principal Executive Officer
(Section 302 of the Sarbanes-Oxley Act of 2002)
I, C. Edward Holden, Chief Executive Officer and President, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Monterey Bay Bancorp,
Inc.;
2. Based on my knowledge, this quarterly report does not contain and untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure
that material information relating to the registrant,
including its consolidated subsidiaries, is made known to us
by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to
the filing date of this quarterly report (the "Evaluation
Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based
on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of the registrant's board of directors (or persons performing the
equivalent function):
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the
registrant's ability to record, process, summarize and report
financial data and have identified for the registrant's
auditors and any material weakness in internal controls; and
b) any fraud, whether or not material, that involves management
or other employees who have a significant role in the
registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and material
weaknesses.
Date: November 12, 2002
By: /s/ C. Edward Holden
--------------------
C. Edward Holden
Chief Executive Officer
President
Vice Chairman
59
Certification of the Principal Financial Officer
(Section 302 of the Sarbanes-Oxley Act of 2002)
I, Mark R. Andino, Chief Financial Officer and Treasurer, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Monterey Bay Bancorp,
Inc.;
2. Based on my knowledge, this quarterly report does not contain and untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a. designed such disclosure controls and procedures to ensure
that material information relating to the registrant,
including its consolidated subsidiaries, is made known to us
by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b. evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to
the filing date of this quarterly report (the "Evaluation
Date"); and
c. presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based
on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of the registrant's board of directors (or persons performing the
equivalent function):
a. all significant deficiencies in the design or operation of
internal controls which could adversely affect the
registrant's ability to record, process, summarize and report
financial data and have identified for the registrant's
auditors and any material weakness in internal controls; and
b. any fraud, whether or not material, that involves management
or other employees who have a significant role in the
registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and material
weaknesses.
Date: November 12, 2002
By: /s/ Mark R. Andino
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Mark R. Andino
Chief Financial Officer
Treasurer
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