UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

ý Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

for the quarterly period ended September 30, 2004.

 

Or

 

o Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

for the transition period from                                                       to                                                       

 

Commission File Number 000-50266

 

TRINITY CAPITAL CORPORATION

(Exact name of registrant as specified in its charter)

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes ý No o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934).  Yes ý No o

 

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: 6,732,888 shares of common stock, no par value, outstanding as of October 15, 2004.

 

 

TRINITY CAPITAL CORPORATION AND SUBSIDIARIES

 

	PART I. FINANCIAL INFORMATION
Item 1.	Financial Statements
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosures About Market Risk
Item 4.	Controls and Procedures
	PART II. OTHER INFORMATION
Item 1.	Legal Proceedings
Item 2.	Changes in securities and use of proceeds and issuer purchases of equity securities
Item 3.	Defaults upon senior securities
Item 4.	Submission of matters to a vote of securities holders
Item 5.	Other information
Item 6.	Exhibits
	SIGNATURES
	CERTIFICATIONS

 

1

 

PART I – FINANCIAL INFORMATION

Item 1.  Financial Statements

TRINITY CAPITAL CORPORATION & SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

September 30, 2004 and December 31, 2003

(Amounts in thousands, except share data)

(Unaudited)

 

		September 30, 2004			December 31, 2003
ASSETS
Cash and due from banks		$	48,964		$	42,104
Interest bearing deposits with banks		43			967
Federal funds sold and securities purchased under resell agreements		40			40
Cash and cash equivalents		49,047			43,111
Investment securities available for sale		49,512			95,088
Investment securities held to maturity, at amortized cost (fair value of $68,630 at September 30, 2004 and $75,179 at December 31, 2003)		68,020			73,717
Other investments		7,255			6,161
Loans (net of allowance for loan losses of $8,554 at September 30, 2004 and $7,368 at December 31, 2003)		839,375			733,155
Loans held for sale		10,667			9,511
Premises and equipment, net		25,593			18,939
Accrued interest receivable		6,371			6,497
Mortgage servicing rights, net		8,446			7,792
Other real estate owned		6,728			7,383
Other assets		3,630			5,396
Total assets		$	1,074,644		$	1,006,750
LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities
Deposits:
Noninterest bearing		$	62,911		$	60,191
Interest bearing		805,772			776,004
Total deposits		868,683			836,195
Short-term borrowings		40,600			9,402
Long-term borrowings		61,883			67,398
Junior subordinated debt owed to unconsolidated trusts		22,682			16,496
Borrowings made by Employee Stock Ownership Plan (ESOP) to outside parties		1,686			2,157
Accrued interest payable		2,494			2,797
Other liabilities		3,879			6,247
Total liabilities		1,001,907			940,692
Stock owned by Employee Stock Ownership Plan (ESOP) participants; 638,115 and 653,381 shares at September 30, 2004 and December 31, 2003, respectively, at fair value; net of unearned ESOP shares of 99,748 shares and 126,194 shares at September 30, 2004 and December 31, 2003, respectively, at historical cost		17,582			18,256
Commitments, contingencies and credit risk (note 7)
Stockholders’ Equity
Common stock, no par, authorized 20,000,000 shares; issued 6,856,800 shares, outstanding 6,731,318 and 6,701,478 at September 30, 2004 and December 31, 2003, respectively		6,836			6,836
Additional paid-in capital		1,110			545
Retained earnings		47,844			40,845
Accumulated other comprehensive (loss) income		(31		)	135
Total stockholders’ equity before treasury stock		55,759			48,361
Treasury stock, at cost, 25,734 shares and 29,128 shares at September 30, 2004 and December 31, 2003, respectively, at historical cost		(604		)	(559		)
Total stockholders’ equity		55,155			47,802
Total liabilities and stockholders’ equity		$	1,074,644		$	1,006,750

 

The accompanying notes are an integral part of these unaudited consolidated financial statements.

 

2

 

TRINITY CAPITAL CORPORATION & SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

For the Three and Nine Months Ended September 30, 2004 and 2003

(Amounts in thousands except share and per share data)

(Unaudited)

 

		Three Months Ended						Nine Months Ended
		September 30, 2004			September 30, 2003			September 30, 2004			September 30, 2003
Interest income:
Loans, including fees		$	12,760		$	12,563		$	36,654		$	37,419
Investment securities:
Taxable		761			831			2,443			2,570
Nontaxable		150			144			471			370
Federal funds sold		—			1			—			3
Other interest bearing deposits		55			99			124			232
Investment in unconsolidated trusts		15			17			42			43
Total interest income		13,741			13,655			39,734			40,637
Interest expense:
Deposits		3,178			3,686			9,108			12,089
Short-term borrowings		51			—			146			2
Long-term borrowings		572			614			1,770			1,372
Junior subordinated debt owed to unconsolidated trusts		503			457			1,414			1,334
Total interest expense		4,304			4,757			12,438			14,797
Net interest income		9,437			8,898			27,296			25,840
Provision for loan losses		450			600			1,650			1,800
Net interest income after provision for loan losses		8,987			8,298			25,646			24,040
Other income:
Mortgage loan servicing fees		592			594			1,751			1,634
Loan and other fees		590			465			1,829			1,291
Service charges on deposits		377			332			1,047			960
Gain on sale of loans		374			3,148			2,373			9,871
Gain on sale of securities		—			—			272			—
Other operating income		164			483			692			1,331
		2,097			5,022			7,964			15,087
Other expenses:
Salaries and employee benefits		3,725			3,984			11,433			11,201
Occupancy		660			407			1,728			1,313
Data processing		508			426			1,442			1,075
Marketing		433			318			983			982
Amortization and valuation of mortgage servicing rights		1,230			(2,486		)	1,120			375
Supplies		202			252			583			682
Other		1,051			1,097			3,499			3,843
		7,809			3,998			20,788			19,471
Income before income taxes		3,275			9,322			12,822			19,656
Income taxes		1,147			3,515			4,885			7,495
Net income		$	2,128		$	5,807		$	7,937		$	12,161
Basic earnings per common share		$	0.32		$	0.87		$	1.18		$	1.82
Diluted earnings per common share		$	0.31		$	0.86		$	1.16		$	1.81

 

The accompanying notes are an integral part of these unaudited consolidated financial statements.

 

3

 

TRINITY CAPITAL CORPORATION & SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

For the Nine Months Ended September 30, 2004 and 2003

(Amounts in thousands)

(Unaudited)

 

		Nine Months Ended
		September 30, 2004			September 30, 2003
Cash Flows From Operating Activities
Net income		$	7,937		$	12,162
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization		1,627			1,428
Net amortization of:
Mortgage servicing rights		2,016			678
Premiums and discounts on investment securities		1,055			1,072
Junior subordinated debt owed to unconsolidated trusts issuance costs		15			14
Provision for loan losses		1,650			1,800
Recovery of mortgage servicing rights		(896		)	(303		)
Gain on sale of available for sale securities		(272		)	—
Federal Home Loan Bank (FHLB) stock dividends received		(67		)	(63		)
Gain on sale of loans		(2,373		)	(9,871		)
Loss on disposal of other real estate owned		148			41
Write-down of value of other real estate owned		61			580
Decrease (increase) in other assets		1,877			663
(Decrease) increase in other liabilities		(518		)	1,228
Tax benefit recognized for exercise of stock options		53			—
Release of Employee Stock Ownership Plan (ESOP) shares		950			530
Net cash provided by operating activities before originations and gross sales of loans		13,263			9,959
Gross sales of loans held for sale		178,432			520,705
Origination of loans held for sale		(178,989		)	(464,763		)
Net cash provided by operating activities		12,706			65,901
Cash Flows From Investing Activities
Proceeds from maturities and paydowns of investment securities available for sale		44,760			13,120
Proceeds from maturities and paydowns of investment securities held to maturity		5,166			7,430
Proceeds from sale of investment securities, available for sale		28,388			—
Purchase of investment securities available for sale		(28,095		)	(35,553		)
Purchase of investment securities held to maturity		—			(10,374		)
Purchase of investment securities other		(1,327		)	(1,797		)
Proceeds from sale of other real estate owned		2,604			3,206
Loans funded, net of repayments		(110,028		)	(52,233		)
Purchases of premises and equipment		(8,281		)	(2,057		)
Net cash provided by (used in) investing activities		(66,513		)	(78,258		)
Cash Flows From Financing Activities
Net increase in demand deposits, NOW accounts and savings accounts		40,815			87,849
Net (decrease) increase in time deposits		(8,327		)	22,303
Proceeds from issuances of short-term borrowings		481,700			51,194
Proceeds from issuances of long-term borrowings		—			40,000
Repayment of short-term borrowings		(450,502		)	(51,194		)
Repayment of long-term borrowings		(5,515		)	(5,294		)
Repayment of ESOP debt		(471		)	(531		)
Proceeds from issuance of trust preferred securities		6,186			—
Purchase of treasury stock		(117		)	—
Issuance of common stock for stock option plan		72			—
Dividend payments		(4,098		)	(3,823		)
Net cash provided by financing activities		59,743			140,504
Net increase in cash and cash equivalents		5,936			128,147
Cash and cash equivalents:
Beginning of year		43,111			40,979
End of period		$	49,047		$	169,126
Supplemental Disclosures of Cash Flow Information
Cash payments for:
Interest		$	12,741		$	13,492
Income taxes		2,562			8,676
Non-cash investing and financing activities:
Transfers from loans to other real estate owned		2,158			2,872
Change in unrealized gain on investment securities, net of taxes		(166		)	(275		)

 

The accompanying notes are an integral part of these unaudited consolidated financial statements.

 

4

 

TRINITY CAPITAL CORPORATION & SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

Note 1.  Basis of Presentation

 

The accompanying unaudited consolidated financial statements include the consolidated balances and results of operations of Trinity Capital Corporation (“Trinity” or the “Company”) and its wholly owned subsidiaries: Los Alamos National Bank (the “Bank”) and Title Guaranty & Insurance Company (“Title Guaranty”), collectively referred to as the “Company.”  Trinity Capital Trust I (“Trust I”), Trinity Capital Trust II (“Trust II”) and Trinity Capital Trust III (“Trust III”), collectively referred to as the “Trusts”, which are also wholly owned subsidiaries of Trinity, are not consolidated in these financial statements.  The business activities of the Company consist solely of the operations of its wholly owned subsidiaries.  All significant intercompany balances and transactions have been eliminated in consolidation.  In the opinion of management, all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of the financial position, results of operations and cash flows for the interim periods have been made.  The results of operations for the three and nine months ended September 30, 2004 are not necessarily indicative of the results to be expected for the entire fiscal year.

 

The unaudited interim consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America and industry practice.  Certain information in footnote disclosure normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America and industry practice has been condensed or omitted pursuant to rules and regulations of the Securities and Exchange Commission.  These financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s December 31, 2003 audited financial statements filed on Form 10-K.

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions which affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements, as well as the reported amounts of income and expenses during the reported periods.  Actual results could differ from those estimates.

 

Note 2.  Comprehensive Income

 

Comprehensive income includes net income, as well as the change in net unrealized gain on investment securities available for sale, net of tax.  Comprehensive income was $2.3 million and $5.5 million for the three month periods ended September 30, 2004 and 2003, respectively, and $7.8 million and $11.9 million for the nine month periods ended September 30, 2004 and 2003, respectively.

 

Note 3.  Earnings Per Share Data

 

The following table sets forth the computation of basic and diluted earnings per share for the periods indicated:

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2004			2003			2004			2003
		(Unaudited; in thousands, except share and per share data)
Net income		$	2,128		$	5,807		$	7,937		$	12,161
Weighted average common shares issued		6,856,800			6,856,800			6,856,800			6,856,800
LESS: Weighted average treasury stock shares		(25,734		)	(29,128		)	(27,951		)	(29,128		)
LESS: Weighted average unearned Employee Stock Ownership Plan (ESOP) stock shares		(99,748		)	(144,565		)	(101,582		)	(148,250		)
Weighted average common shares outstanding, net		6,731,318			6,683,107			6,727,267			6,679,422
Basic earnings per common share		$	0.32		$	0.87		$	1.18		$	1.82
Weighted average dilutive shares from stock option plan		108,718			31,134			111,035			31,134
Weighted average common shares outstanding including dilutive shares		6,840,036			6,714,241			6,838,302			6,710,556
Diluted earnings per common share		$	0.31		$	0.86		$	1.16		$	1.81

 

5

 

Note 4.  Recent Accounting Pronouncements and Regulatory Developments

 

In December 2003 the Financial Accounting Standards Board (the “FASB”) revised Statement of Financial Accounting Standards (“SFAS”) No. 132, “Employers’ Disclosures about Pensions and Other Postretirement Benefits.”  The provisions of this statement do not change the measurement and recognition provisions of previous statements, but adds disclosures about retirement plan assets, employer obligations, key assumptions in these measurements and the measurement date(s) used to determine pensions and other postretirement benefit measurements that make up at least the majority of plan assets and benefit obligations.  These provisions are effective for annual and interim financial statements for periods beginning after December 15, 2003.  The adoption of this statement as of January 1, 2004 did not have a material impact on the Company’s financial statements.

 

In December 2003, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants (the “AcSEC”) issued Statement of Position (“SOP”) 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer. The SOP is effective for loans acquired in fiscal years beginning after December 15, 2004, with early adoption encouraged. A certain transition provision applies for certain aspects of loans currently within the scope of Practice Bulletin 6, Amortization of Discounts on Certain Acquired Loans. The SOP addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor’s initial investment in loans or debt securities (loans) acquired in a transfer if those differences are attributable, at least in part, to credit quality. It includes loans acquired in business combinations and applies to all nongovernmental entities, including not-for-profit organizations. The SOP does not apply to loans originated by the entity.  Adoption of this SOP is not expected to have a material impact on the Company’s financial statements.

 

In March, 2004 the Securities and Exchange Commission (the “SEC”) issued Staff Accounting Bulletin (“SAB”) 105, “Application of Accounting Principles to Loan Commitments.”  This SAB summarizes the views of the SEC regarding the application of generally accepted accounting principles to loan commitments accounted for as derivative instruments.  Under this SAB, banks will no longer be able to record interest rate lock commitments (IRLCs) as assets, but only record any liabilities resulting from these IRLCs.  Through March 31, 2004, the Company followed industry practice in recording these IRLCs as assets or liabilities, depending on the net position the Company had on these IRLCs.  As of April 1, 2004, the Company has adopted this SAB.  This did not have a material effect on the Company’s financial statements.

 

On March 31, 2004, the Financial Accounting Standards Board ratified the consensus of its Emerging Issues Task Force (EITF) Issue 03-01 regarding the recognition and measurement of other-than-temporary impairments of unrealized losses on available for sale debt and equity securities.  On September 30, 2004, the FASB staff issued a Staff Position that delayed the effective date for the measurement and recognition guidance in EITF Issue 03-01.  The delay did not suspend the requirement to recognize other-than-temporary impairments as required by existing authoritative literature.  Adoption of further provisions when they are effective is not expected to have a material impact on the Company’s financial statements.

 

On May 6, 2004, the Board of Governors of the Federal Reserve System issued a Notice of Proposed Rulemaking in which it proposed to allow the continued inclusion of trust preferred securities in the tier 1 capital of bank holding companies, subject to stricter standards.  The Federal Reserve is proposing to limit the aggregate amount of a bank holding company’s cumulative perpetual preferred stock, trust preferred securities and other minority interests to 25% of the company’s core capital elements, net of goodwill.  Current regulations do not require the deduction of goodwill.  The proposal also provides that amounts of qualifying trust preferred securities and certain minority interests in excess of the 25% limit may be included in tier 2 capital but would be limited, together with subordinated debt and limited-life preferred stock, to 50% of tier 1 capital.  The proposal provides a three-year transition period for bank holding companies to meet these quantitative limitations.  At this time, this proposed rule, if adopted, will have no material effect on the Company.

 

On June 17, 2004, the SEC issued a Proposed Rule in which it described the parameters under which banks may sell securities to their customers without having to register as broker-dealers with the SEC in accordance with Title II of the Gramm-Leach-Bliley Act of 1999.  The proposal, which is designated as Regulation B, clarifies, among other things: (i) the limitations on the amount that unregistered bank employees may be compensated for making referrals in connection with a third-party brokerage arrangement; (ii) the manner by which banks may be compensated for effecting securities transactions for its customers in a fiduciary capacity; and (iii) the extent to which banks may engage in certain securities transactions as a custodian.  At this time, it appears as though this proposed regulation, if adopted, will have no material effect on the Company’s activities or financial results.

 

6

 

Note 5.  Short Term Borrowings

 

The Company had Federal Home Loan Bank advances with maturities of less than one year of $40.6 million as of September 30, 2004.  As of December 31, 2003, the Company had Federal Home Loan Bank advances with maturities of less than one year of $5.0 million and federal funds purchased from other financial institutions of $4.4 million.  As of September 30, 2004, the advances had fixed interest rates ranging from 1.96% to 2.16%.

 

Note 6.  Long Term Borrowings

 

The Company had Federal Home Loan Bank advances with maturity dates greater than one year of $61.9 million and $67.4 million as of September 30, 2004 and December 31, 2003, respectively.  As of September 30, 2004, the advances have fixed interest rates ranging from 3.22% to 6.34%.

 

Note 7.  Junior Subordinated Debt Owed to Unconsolidated Trusts

 

The following table presents details on the junior subordinated debt owed to unconsolidated trusts as of September 30, 2004:

 

		Trust I			Trust II			Trust III
		(Dollars in thousands)
Date of issue		March 23, 2000			November 28, 2001			May 11, 2004
Amount of trust preferred securities issued		$	10,000		$	6,000		$	6,000
Rate on trust preferred securities		10.875		%	9.95		%	3.88% (variable		)
Maturity		March 8, 2030			December 8, 2031			September 8, 2034
Date of first redemption		March 8, 2010			December 8, 2006			September 8, 2009
Common equity securities issued		$	310		$	186		$	186
Junior subordinated deferrable interest debentures owed		$	10,310		$	6,186		$	6,186
Rate on junior subordinated deferrable interest debentures		10.875		%	9.95		%	4.49% (variable		)

 

On the dates of issue indicated above, the Trusts, being Delaware statutory business trusts, issued trust preferred securities (the “trust preferred securities”) in the amount and at the rate indicated above.  These securities represent preferred beneficial interests in the assets of the Trusts.  The trust preferred securities will mature on the dates indicated, and are redeemable in whole or in part at the option of the Company at any time after the date of first redemption indicated above, with the approval of the Federal Reserve Board and in whole at any time upon the occurrence of certain events affecting their tax or regulatory capital treatment.  The Trusts also issued common equity securities to Trinity in the amounts indicated above.  The Trusts used the proceeds of the offering of the trust preferred securities to purchase junior subordin ated deferrable interest debentures (the debentures) issued by the Company, which have terms substantially similar to the trust preferred securities.  The Company has the right to defer payments of interest on the debentures at any time or from time to time for a period of up to ten consecutive semi-annual periods with respect to each interest payment deferred.  Under the terms of the debentures, in the event that under certain circumstances there is an event of default under the debentures or the Company has elected to defer interest on the debentures, the Company may not, with certain exceptions, declare or pay any dividends or distributions on its capital stock or purchase or acquire any of its capital stock.  The Company used the majority of the proceeds from the sale of the debentures to add to Tier 1 capital in order to support its growth.

 

Trinity owns all of the outstanding common stock of the Trusts.  The Trusts are considered variable interest entities (VIEs) under Financial Accounting Standards Board Interpretation (FIN) No. 46, “Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51”, as revised.  Prior to FIN 46, VIEs were generally consolidated by an enterprise when the enterprise had a controlling financial interest through ownership of a majority of voting interest in the entity.  Under FIN 46, a VIE should be consolidated by its primary beneficiary.  The Company implemented FIN 46 during the fourth quarter of 2003.  Because Trinity is not the primary beneficiary of the Trusts, the financial statements of the Trusts are no longer included in the consolidated financial statements of t he Company.  The Company’s prior financial statements have been reclassified to de-consolidate the Company’s investment in the Trusts.

 

7

 

The trust preferred securities are currently included in the Tier 1 capital of Trinity for regulatory capital purposes.  However, because the Trusts are no longer a part of the Company’s financial statements, the Federal Reserve Board may in the future disallow inclusion of the trust preferred securities in Tier 1 capital for regulatory capital purposes.  The most recent proposed rule issued by the Board of the Federal Reserve System indicated that it will continue to recognize these trust preferred securities as Tier 1 capital (see discussion in Note 4, “Recent Accounting Pronouncements and Regulatory Developments”.)  However, there can be no assurance that the Federal Reserve Board will continue to permit institutions to include trust preferred securities in Tier I capital for regulatory capital purposes.  As of September 30, 2004, assuming the Company was not permitted to include the $22 million in trust preferred securities issued by the Trusts in its Tier 1 capital, the Company would still exceed the regulatory required minimums for capital adequacy purposes.  If the trust preferred securities were no longer permitted to be included in Tier 1 capital, the Company would also be permitted to redeem the capital securities without penalty.

 

Payments of distributions on the trust preferred securities and payments on redemption of the trust preferred securities are guaranteed by the Company on a limited basis.  The Company also entered into an agreement as to expenses and liabilities with the Trusts pursuant to which it agreed, on a subordinated basis, to pay any co sts, expenses or liabilities of the Trusts other than those arising under the trust preferred securities.  The obligations of the Company under the junior subordinated debentures, the related indenture, the trust agreement establishing the Trusts, the guarantee and the agreement as to expenses and liabilities, in the aggregate, constitute a full and unconditional guarantee by the Company of the Trusts’ obligations under the trust preferred securities.

 

Issuance costs of $615 thousand related to the trust preferred securities were deferred and are being amortized over the period until mandatory redemption of the securities in March 2030, December 2031 and September 2034, respectively.  During the three months ended September 30, 2004 and 2003, respectively, $5 thousand and $4 thousand of these issuance costs were amortized.  During the nine months ended September 30, 2004 and 2003, respectively, $15 thousand and $14 thousand of these issuance costs were amortized.  Unamortized issuance costs were $544 thousand and $481 thousand at September 30, 2004 and December 31, 2003, respectively.

 

Dividends accrued and unpaid to securities holders totaled $282 thousand and $270 thousand on September 30, 2004 and 2003, respectively.

 

Note 8.  Commitments, Contingencies and Off-Balance Sheet Activities

 

Credit-related financial instruments:  The Company is a party to credit-related commitments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers.  These credit-related commitments include commitments to extend credit, standby letters of credit and commercial letters of credit.  Such credit-related commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets.

 

The Company’s exposure to credit loss is represented by the contractual amount of these credit-related commitments.  The Company follows the same credit policies in making credit-related commitments as it does for on-balance-sheet instruments.

 

At September 30, 2004 and December 31, 2003, the following credit-related commitments were outstanding whose contract amounts represent credit risk:

 

		Contract Amount
		September 30, 2004			December 31, 2003
		(In thousands)
Mortgage loans sold with recourse		—			$	17
Unfunded commitments under lines of credit		$	157,095		130,868
Commercial and standby letters of credit		23,850			27,522

 

Mortgage loans sold with recourse are loans sold to outside investors, with the Company retaining servicing and responsibility for collection in the event of a default.  For 2004 and 2003, no such defaults occurred or were expected to occur.

 

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Commitments generally have fixed expiration dates or other termination clauses and may require a payment of a fee.  The commitments for equity lines of credit may expire without being drawn upon.  Therefore, the total commitment amounts do not necessarily represent future cash requirements.  The amount of collateral obtained, if it is deemed necessary by the Company, is based on management’s credit evaluation of the customer.  Unfunded commitments under commercial lines of credit, revolving credit lines and overdraft protection agreements are commitments for possible future extensions of credit to existing customers.  Overdraft protection agreements are uncollateralized, but most other unfunded commitments have collateral.  These unfunded lines of credit usually do not contain a specified maturity date and may not necessarily be drawn upon to the total extent to which the Company is committed.

 

8

 

Commercial and standby letters of credit are conditional credit-related commitments issued by the Company to guarantee the performance of a customer to a third party.  Those letters of credit are primarily issued to support public and private borrowing arrangements.  Essentially all letters of credit issued have expiration dates within one year. The credit risk involved in issuing letters of credit is the same as that involved in extending loans to customers.  The Company generally holds collateral supporting those credit-related commitments, if deemed necessary. In the event the customer does not perform in accordance with the terms of the agreement with the third party, the Company would be required to fund the credit-related commitment.  The maximum potential amount of future payments the Company could be required to make is represented by the contractual amount shown in the summary above.  If the credit-related commitment is funded, the Company would be entitled to seek recovery from the customer.  At September 30, 2004 and December 31, 2003, no amounts have been recorded as liabilities for the Company’s potential obligations under these credit-related commitments.  The fair value of these credit-related commitments is approximately equal to the fees collected when granting these letters of credit.  These fees collected were $28 thousand and $30 thousand as of September 30, 2004 and December 31, 2003, respectively, and are included in “other liabilities” on the Company’s balance sheet.

 

Concentrations of credit risk:  The majority of the loans, commitments to extend credit, and standby letters of credit have been granted to customers in Los Alamos and surrounding communities.  Although the Company has a diversified loan portfolio, a substantial portion of its loans are made to businesses and individuals associated with, or employed by, Los Alamos National Laboratory (“the Laboratory”).  The ability of such borrowers to honor their contracts is predominately dependent upon the continued operation and funding of the Laboratory.  Investments in securities issued by states and political subdivisions involve governmental entities within the state of New Mexico.  The distribution of commitments to extend credit approximates the distribution of loans outstanding.  Standby letters of credit were granted primarily to commercial borrowers.

 

Contingencies:  In the normal course of business, the Company is involved in various legal proceedings.  In the opinion of management, after consulting with counsel, probable liabilities resulting from such proceedings would not have a material adverse effect on the Company’s consolidated financial statements.

 

Note 9.  Pro Forma Impact of Stock-Based Compensation Plans

 

As allowed under SFAS No. 123, Accounting for Stock-Based Compensation, the Company measures stock-based compensation cost in accordance with the methods prescribed in Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees.  As stock options are granted at fair value, there are no charges to earnings associated with stock options granted.  Accordingly, no compensation cost has been recognized for grants made to date.  Had compensation cost been determined based on the fair value method prescribed in FASB Statement No. 123, reported net income and earnings per common share would have been reduced to the pro forma amounts shown below (dollars in thousands, except earnings per share data):

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2004			2003			2004			2003
		(Unaudited; in thousands except per share data)
Net income as reported		$	2,128		$	5,807		$	7,937		$	12,161
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		28			27			85			81
Pro forma net income		$	2,100		$	5,780		$	7,852		$	12,080
Earnings per share:
Basic – as reported		$	0.32		$	0.87		$	1.18		$	1.82
Basic – pro forma		$	0.31		$	0.86		$	1.17		$	1.81
Diluted – as reported		$	0.31		$	0.86		$	1.16		$	1.81
Diluted – pro forma		$	0.31		$	0.86		$	1.15		$	1.80

 

9

 

Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

This discussion is intended to focus on certain financial information regarding the Company and the Bank and is written to provide the reader with a more thorough understanding of its financial statements. The following discussion and analysis of the Company’s financial position and results of operations should be read in conjunction with the information set forth in Item 3, Quantitative and Qualitative Disclosures about Market Risk and the annual audited consolidated financial statements filed on Form 10-K.

 

Special Note Concerning Forward-Looking Statements

 

This Form 10-Q contains, and future oral and written statements of the Company may contain, forward-looking statements, within the meaning of such term in the Private Securities Litigation Reform Act of 1995, with respect to the financial condition, results of operations, plans, objectives, future performance and business of the Company. Forward-looking statements, which may be based upon beliefs, expectations and assumptions of our management and on information currently available to management, are generally identifiable by the use of words such as “believe,” “expect,” “anticipate,” “plan,” “intend,” “estimate,” “may,” “will,” “would,” “could,” “should” or other similar expressions. Additionally, all statements in this document, including forward-looking statements, speak only as of the date they are made, and we undertake no obligation to update any statement in light of new information or future events.

 

Our ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on our operations and future prospects include, but are not limited to, the following:

 

•                                          The strength of the United States economy in general and the strength of the local economies in which we conduct our operations which may be less favorable than expected and may result in, among other things, a deterioration in the credit quality and value of our assets.

 

•                                          The economic impact of any future terrorist threats or attacks, and the response of the United States to any such threats and attacks.

 

•                                          The effects of, and changes in, federal, state and local laws, regulations and policies affecting banking, securities, insurance and monetary and financial matters.

 

•                                          The effects of changes in interest rates (including the effects of changes in the rate of prepayments of the Company’s assets) and the policies of the Board of Governors of the Federal Reserve System.

 

•                                          Our ability to compete with other financial institutions as effectively as we currently intend due to increases in competitive pressures in the financial services sector.

 

•                                          Our inability to obtain new customers and to retain existing customers.

 

•                                          The timely development and acceptance of products and services, including products and services offered through alternative delivery channels such as the Internet.

 

•                                          Technological changes implemented by us and by other parties, including third party vendors, which may be more difficult or more expensive than anticipated or which may have unforeseen consequences to us and its customers.

 

•                                          Our ability to develop and maintain secure and reliable electronic systems.

 

•                                          Our ability to retain key executives and employees and the difficulty that we may experience in replacing key executives and employees in an effective manner.

 

•                                          Consumer spending and saving habits which may change in a manner that affects our business adversely.

 

•                                          Business combinations and the integration of acquired businesses which may be more difficult or expensive than expected.

 

•                                          The costs, effects and outcomes of existing or future litigation.

 

10

 

•                                          Changes in accounting policies and practices, as may be adopted by state and federal regulatory agencies and the Financial Accounting Standards Board.

 

•                                          Our ability to manage the risks associated with the foregoing as well as anticipated.

 

These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Additional information concerning the Company and our business, including other factors that could materially affect our financial results, will be included in our filings with the Securities and Exchange Commission.

 

Critical Accounting Policies

 

Allowance for Loan Losses:  Management believes the allowance for loan losses accounting policy is critical to the portrayal and understanding of our financial condition and results of operations.  As such, selection and application of this “critical accounting policy” involves judgments, estimates, and uncertainties that are susceptible to change.  In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of materially different financial condition or results of operations is a reasonable likelihood.

 

The allowance for loan losses is maintained at an amount that management believes will be adequate to absorb probable losses on existing loans, based on an evaluation of the collectibility of loans and prior loss experience.  This evaluation also takes into consideration such factors as changes in the nature and volume of the loan portfolio, the value of underlying collateral, overall portfolio quality, review of specific problem loans and current economic conditions that may affect the borrower’s ability to pay.  While management uses the best information available to make its evaluation, future adjustments to the allowance may be necessary if there are significant changes in these factors.  In addition, as an integral part of their examination process regulatory agencies periodically review our allowance for loan losses and may require us to make additions to the allowance based on their evaluation of information available at the time of their examinations.

 

We maintain our allowance for loan losses at a level that management believes will be adequate to absorb probable losses on existing loans based on an evaluation of the collectibility of loans and prior loss experience.  Three methods are used to evaluate the adequacy of the allowance for loan losses: (1) historical loss experience, based on loss experience by quality classification in the previous twelve calendar quarters; (2) specific identification, based upon management’s assessment of loans and the probability that a charge off will occur in the upcoming quarter; and (3) loan concentrations, based on current or expected economic factors in the geographic and industry sectors where management believes we may eventually experience some loan losses.

 

Mortgage Servicing Right (MSR) Assets:  Servicing residential mortgage loans for third-party investors represents a significant business activity of the Bank.  As of September 30, 2004, mortgage loans serviced for others totaled $910.2 million.  The MSRs on these loans totaled $8.4 million as of September 30, 2004.  The expected and actual rates of mortgage loan prepayments are the most significant factors driving the value of MSRs.  Increases in mortgage loan prepayments reduce estimated future net servicing cash flows because the life of the underlying loan is reduced.  In determining the initial value of the MSRs, mortgage interest rates, which are used to determine prepayment rates and discount rates, are held constant over the estimated life of the portfolio.  Fair values of the MSRs are provided by an independent third-party broker of MSRs on a monthly basis.  The values given by the broker are based upon current market conditions and assumptions, which incorporate the expected life of the loans, estimated costs to service the loans, servicing fees to be received and other factors.  MSRs are carried at the lower of the initial capitalized amount, net of accumulated amortization, or fair value.

 

The fair value of the MSRs is driven primarily by the effect current mortgage interest rates have on the likelihood borrowers will prepay the underlying mortgages by refinancing at a lower rate.  Accordingly, higher interest rates decrease the likelihood of repaym ent, extending the life of the MSRs and increasing the value of these assets.  Lower interest rates increase the likelihood of repayment, contracting the life of the MSRs and decreasing the value of these assets.  This can have a significant impact on our income.  In the three months ended September 30, 2004, we recognized an expense of $521 thousand due to the decrease in the values of these MSRs.  In the nine months ended September 30, 2004, we recognized income of $896 thousand due to the increase in the values of these MSRs.  For the year ending December 31, 2003, we recognized an expense of $754 thousand for these assets due to the decrease in the values of these MSRs over the year.  We can have no certainty on the direction and amount of interest rate changes looking forward, and therefore, we can have no certainty on the amount or direction of the change in valuation.

 

11

 

Overview

 

The Company’s earnings declined in the third quarter of 2004 over the second quarter of 2004, largely due to the impairment and amortization of mortgage servicing rights as interest rates decreased.  Mortgage loan refinance activity (and its associated income) was much lower in 2004 compared to 2003 (as expected), and the Company’s net income decreased 63.4% from the third quarter of 2003 to the third quarter of 2004, mainly due to this factor.  The Company’s balance sheet growth improved, growing 6.7% from December 31, 2003 to September 30, 2004.  There was also a shift from lower-yielding assets (investment securities) to higher-yielding assets (loans), increasing net interest margin on a fully tax-equivalent basis from 3.84% for the year ended December 31, 2003 to 3.87% for the nine months ended September 30, 2004.  The Company also increased its risk-based capital by issuing $6 million in trust preferred securities during this year, enabling us to continue to grow and remain well-capitalized.  Construction on the second office in Santa Fe was completed during this quarter, and it opened in August 2004.

 

Income Statement Analysis

 

Net Income-General.  Net income for the three months ended September 30, 2004 was $2.1 million, compared to $5.8 million for the same period of 2003.  Diluted earnings per share decreased by $0.55 to $0.31 for the three months ended September 30, 2004 from $0.86 for the same period of 2003.  This represented a decrease in earnings per share of 64.0%.  The decrease in net income was primarily the result of a decrease in gains on loans sold of $2.8 million due to the decline in mortgage loan refinancing activity (which management anticipated) and an increase in the impairment and amortization of mortgage servicing rights of $3.7 million.  The effect of these items, net of taxes, was a decline of $4.2 million in net income for the three months ended September 30, 2004 compared to the same period in 2003.

 

Net income for the nine months ended September 30, 2004 was $7.9 million, compared to $12.2 million for the same period of 2003.  Diluted earnings per share decreased by $0.65 to $1.16 for the nine months ended September 30, 2004 from $1.81 for the same period of 2003.  This represented a decrease in diluted earnings per share of 35.9%.  The decrease in net income was primarily the result of a decrease in gains on loans sold of $7.5 million due to the anticipated decline in mortgage loan refinancing activity.  The effect of this item, net of taxes, was a decline in net income of approximately $4.6 for the first nine months of 2004 compared to the same period in 2003.

 

The profitability of the Company’s operations depends primarily on its net interest income, which is the difference between total interest earned on interest earning assets and total interest paid on interest bearing liabilities. The Company’s net income is affected by its provision for loan losses as well as other income and other expenses. The provision for loan losses reflects the amount thought to be adequate to cover probable credit losses in the loan portfolio. Non-interest income or other income consists of mortgage loan servicing fees, loan and other fees, service charges on deposits, gain on sale of loans, gain on sale of securities and other operating income. Other expenses include salaries and employee benefits, occupancy expenses, data processing expenses, marketing, amortization and valuation of mortgage servicing rights, supplies expense and other expenses.

 

The amount of net interest income is affected by changes in the volume and mix of interest earning assets, the level of interest rates earned on those assets, the volume and mix of interest bearing liabilities, and the level of interest rates paid on those interest bearing liabilities. The provision for loan losses is dependent on changes in the loan portfolio and management’s assessment of the collectibility of the loan portfolio, as well as economic and market conditions. Other income and other expenses are impacted by growth of operations and growth in the number of accounts through both acquisitions and core banking business growth. Growth in operations affects other expenses as a result of additional employees, branch facilities and promotional marketing expense. Growth in the number of accounts affects other income including service fees as well as other expenses such as computer services, supplies, postage, telecommunications and other miscellaneous expenses.

 

12

 

Net Interest Income.  The following tables present, for the periods indicated, the total dollar amount of interest income from average interest earning assets and the resultant yields, as well as the interest expense on average interest bearing liabilities, and the resultant costs, expressed both in dollars and rates. Borrowings made by the Company’s Employee Stock Ownership Plan (“ESOP”) to outside parties are not included in this analysis, as the interest expense on this borrowing is born by the ESOP. Funding for the ESOP is recognized as part of compensation expense:

 

		Three Months Ended September 30,
		2004								2003
		Average Balance			Interest			Yield/Rate		Average Balance			Interest			Yield/Rate
		(Dollars in thousands)
Interest Earning Assets:
Loans(1)(2)		$	819,202		$	12,760		6.20	%	$	724,764		$	12,563		6.88	%
Taxable investment securities		105,049			761			2.88		108,993			831			3.02
Investment securities exempt from federal income taxes(3)		19,936			227			4.53		14,775			220			5.91
Federal funds sold and securities purchased under resell agreements		40			—			1.11		560			1			0.71
Other interest bearing deposits		16,115			55			1.36		42,702			99			0.92
Investment in unconsolidated trust subsidiaries		682			15			8.75		496			17			13.60
Total interest earning assets		961,024			13,818			5.72		892,290			$	13,731		6.11
Non-interest earning assets		69,926								118,609
Total assets		$	1,030,950							$	1,010,899
Interest Bearing Liabilities:
Deposits:
NOW and money market deposit		$	114,304		$	312		1.09	%	$	201,199		$	498		0.98	%
Savings deposit		348,514			923			1.05		223,044			650			1.16
Time deposits		324,895			1,943			2.38		362,000			2,538			2.78
Short-term borrowings		10,153			51			2.00		174			—			2.28
Long-term borrowings		62,604			572			3.63		69,447			614			3.51
Junior subordinated debt owed to unconsolidated trusts		22,682			503			8.82		16,496			457			10.99
Total interest bearing liabilities		883,152			4,304			1.94		872,360			4,757			2.16
Demand deposits—non-interest bearing		51,771								60,575
Other non-interest bearing liabilities		23,808								12,917
Stockholders’ equity, including stock owned by ESOP		72,219								65,047
Total liabilities and stockholders equity		$	1,030,950							$	1,010,899
Net interest income/interest rate Spread(4)					$	9,514		3.78	%				$	8,974		3.94	%
Net interest margin on a fully tax equivalent basis(5)								3.94	%							3.99	%
Net interest margin(5)								3.91	%							3.96	%

 

(1)	Includes non-accrual loans of $3.4 million and $2.2 million for the three months ended September 30, 2004 and 2003, respectively.
(2)	Interest income includes loan origination fees of $896 thousand and $927 thousand for the three months ended September 30, 2004 and 2003, respectively.
(3)	Non-taxable investment income is presented on a fully tax equivalent basis, adjusting for federal and state exemption of interest income and certain other permanent income tax differences.
(4)	Interest rate spread represents the difference between the average yield on interest earning assets and the average cost of interest bearing liabilities and is presented on a fully tax equivalent basis.
(5)	Net interest margin represents net interest income as a percentage of average interest earning assets.

 

 

13

 

For the third quarter of 2004, net interest income on a fully tax equivalent basis increased $540 thousand (6.0%) to $9.5 million from $9.0 million for the third quarter of 2003.  The increase in net interest income resulted from a decrease in interest expense of $453 thousand (9.5%), while interest income on a fully tax equivalent basis increased $87 thousand (0.6%).  Interest expense decreased mainly due to a decrease in rate on interest bearing liabilities of 22 basis points, which accounted for a decrease in interest expense of $400 thousand.  Interest income on a fully tax equivalent basis increased due to a increase in average earning assets of $68.7 million (7.7%), which accounted for a increase in interest income on a fully tax equivalent basis of $1.5 million.  This was largely offset by an decrease in rate on earning assets of 39 basis points, which accounted for a decrease of $1.4 million in interest income on a fully tax equivalent basis.  The net interest margin expressed on a fully tax equivalent basis decreased 5 basis points to 3.94% for 2004 from 3.99% for 2003.

 

		Nine Months Ended September 30,
		2004								2003
		Average Balance			Interest			Yield/Rate		Average Balance			Interest			Yield/Rate
		(Dollars in thousands)
Interest Earning Assets:
Loans(1)(2)		$	790,113		$	36,654		6.20	%	$	748,981		$	37,419		6.68	%
Taxable investment securities		114,422			2,443			2.85		105,580			2,570			3.25
Investment securities exempt from federal income taxes(3)		20,586			734			4.76		13,181			573			5.81
Federal funds sold		40			—			0.89		546			3			0.73
Other interest bearing deposits		15,217			124			1.09		30,016			232			1.03
Investment in unconsolidated trust subsidiaries		593			42			9.46		496			43			11.59
Total interest earning assets		940,971			39,997			5.68		898,800			40,840			6.08
Non-interest earning assets		72,601								63,540
Total assets		$	1,013,572							$	962,340
Interest Bearing Liabilities:
Deposits:
NOW and money market deposit		$	140,836		$	966		0.92	%	$	193,014		$	1,835		1.25	%
Savings deposit		307,109			2,275			0.99		213,098			2,375			1.47
Time deposits		328,976			5,867			2.38		351,311			7,879			2.97
Short-term borrowings		11,108			146			1.76		290			2			1.07
Long-term borrowings		64,453			1,770			3.67		37,519			1,372			3.84
Junior subordinated debt owed to unconsolidated trusts		19,724			1,414			9.58		16,496			1,334			10.81
Total interest bearing liabilities		872,206			12,438			1.90		811,728			14,797			2.38
Demand deposits—non-interest bearing		51,970								59,341
Other non-interest bearing liabilities		19,755								4,274
Stockholders’ equity, including stock owned by ESOP		69,641								62,315
Total liabilities and stockholders equity		$	1,013,572							$	937,658
Net interest income/interest rate Spread(4)					$	27,559		3.77	%				$	26,043		3.70	%
Net interest margin on a fully tax equivalent basis(5)								3.91	%							3.87	%
Net interest margin(5)								3.87	%							3.84	%

 

(1)	Includes non-accrual loans of $3.3 million and $2.5 million for the nine months ended September 30, 2004 and 2003, respectively.
(2)	Interest income includes loan origination fees of $2.3 million and $2.7 million for the nine months ended September 30, 2004 and 2003, respectively.
(3)	Non-taxable investment income is presented on a fully tax equivalent basis, adjusting for federal and state exemption of interest income and certain other permanent income tax differences.
(4)	Interest rate spread represents the difference between the average yield on interest earning assets and the average cost of interest bearing liabilities and is presented on a fully tax equivalent basis.
(5)	Net interest margin represents net interest income as a percentage of average interest earning assets.

 

14