SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-K

 

 

Commission file number: 000-32987

 

 

Common Stock, no par value

(Title of Class)

 

Shares outstanding as of February 29, 2004:   5,513,613

 

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 for the past 90 days.

Yes ý  No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrants knowledge, in the definitive proxy or information statements incorporated by reference in Part III of this form 10-K or any amendment to this Form 10-K. o

 

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

 

Aggregate market value of the Common Stock held by non-affiliates as of the last business day of the registrant’s most recently completed second fiscal quarter - June 30, 2003:     $74,240,456

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Certain portions of the Proxy Statement for the 2004 Meeting of		Part III, Items 10, 11, 12 and 13
Shareholders (to be filed with the commission under Regulation
14A within 120 days after the end of the registrant’s fiscal year and,
upon such filing, to be incorporated by reference into Part III).

 

 

UNITED SECURITY BANCSHARES

 

TABLE OF CONTENTS

 

 

PART I:
	Item 1 - Business
	Item 2 - Properties
	Item 3 - Legal Proceedings
	Item 4 - Submission of Matters to a Vote of Security Holders
PART II:
	Item 5 - Market for the Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities
	Item 6 - Selected Financial Data
	Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 7A - Quantitative and Qualitative Disclosure About Market Risk
	Item 8 - Financial Statements and Supplementary Data
	Item 9 - Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
	Item 9A – Controls and Procedures
PART III:
	Item 10 - Directors and Executive Officers of the Registrant
	Item 11 - Executive Compensation
	Item 12 - Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
	Item 13 - Certain Relationships and Related Transactions
	Item 14 – Principal Accounting Fees and Services
PART IV:
	Item 15 - Exhibits, Financial Statement Schedules, and Reports on Form 8-K

 

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PART 1

 

Certain matters discussed or incorporated by reference in this Annual Report of Form 10-K including, but not limited to, those described in “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations”, are forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially from those projected in the forward-looking statements. Such risks and uncertainties include, among others, (1) competitive pressure in the banking industry increases significantly; (2) changes in the interest rate environment reduces margins; (3) general economic conditions, either nationally or regionally, are less favorable than expected, resulting in, among other things, a deterioration in credit quality; (4) changes in the regulatory environment; (5) changes in business conditions and inflation; and (6) changes in securities markets. Therefore, the information set forth therein should be carefully considered when evaluating the business prospects of the Company.

 

Significant Developments

 

Proposed Merger

 

On December 11, 2003, United Security Bancshares announced that it has entered into a definitive Agreement and Plan of Reorganization and Merger with Taft National Bank pursuant to which Taft National Bank will merge into United Security Bancshares. Taft National Bank operates branch offices in Taft and Bakersfield serving small business and retail banking clients. As of September 30, 2003, Taft National Bank had total assets of $52 million and deposits of $47 million. Upon completion of the merger, Taft National Bank branches will operate as branches of United Security Bank, a wholly owned subsidiary of United Security Bancshares. (For further discussion, see Item 7. Management’s Discussion and Analysis of Financial Condition and Operations).

 

Item 1 - Business

 

General

 

United Security Bancshares (the “Company”) is a California corporation incorporated during March of 2001and is registered with the Board of Governors of the Federal Reserve System as a bank holding company under the Bank Holding Company Act of 1956, as amended. The Company’s stock is listed on NASDAQ under the symbol “UBFO”. United Security Bank (the “Bank”) is a wholly-owned bank subsidiary of the Company and was formed in 1987. United Security Bancshares Capital Trust I (the “Trust”) is also a wholly-owned subsidiary of the Company and was formed during June of 2001 as a Delaware business trust for the sole purpose of issuing Trust Preferred securities. At present, the Company does not engage in any material business activities other than ownership of the Bank. References to the Company are references to United Security Bancshares, Inc. (including the Bank), except for periods prior to June 12, 2001, in which case, references to the Company are references to the Bank.

 

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United Security Bank

 

On June 12, 2001, the Bank became the wholly owned subsidiary of United Security Bancshares, through a tax-free holding company reorganization, accounted for on a basis similar to the pooling of interest method. In the transaction, each share of Bank stock was exchanged for a share of Company stock on a one-to-one basis.

 

The Bank is a California state-chartered bank headquartered in Fresno, California. It is also a member of the Federal Reserve System (“Fed member”). The Bank originally commenced business on December 21, 1987 as a national bank and, during the fourth quarter of 1998, filed an application with the California State Banking Department and other regulatory authorities to become a state-chartered bank. The shareholders approved the conversion in January of 1999, and the Bank was granted approval to operate as a state-chartered bank on February 3, 1999. The Bank’s operations are currently subject to federal and state laws applicable to state-chartered, Fed member banks and its deposits are insured up to the applicable limits by the Federal Deposit Insurance Corporation (the “FDIC”). The Bank is also subject to the Federal Deposit Insurance Act and regulatory reporting requirements of the FDIC. As a state-chartered bank and a member of the Federal Reserve System, the Bank is subject to supervision and regular examinations by the Board of Governors of the Federal Reserve System (the “FRB”) and the California Department of Financial Institutions (the “DFI”). In addition, the Bank is required to file reports with the FRB and provide such additional information as the FRB may require.

 

Effective August 25, 1995, the Bank consummated a merger with Golden Oak Bank, a two branch California state chartered bank located in Oakhurst, California, with assets of approximately $45 million at the date of merger.  The merger was accounted for as a pooling of interests.

 

During February of 1997, the Bank completed the purchase of the deposits and certain assets of two branches of Wells Fargo Bank located in Caruthers and San Joaquin, both located in Fresno County. This brought the total branches operated at that time by the Bank to six and the total assets to approximately $190 million. The Bank paid a premium of approximately $1.2 million to purchase deposit accounts totaling approximately $33.4 million. The Bank also purchased cash balances as well as certain fixed assets of the branch operations.

 

During October of 1997, the Bank completed the purchase from Bank of America of two of its branches located in Firebaugh and Coalinga, both located in Fresno County. The acquisition brought the total branches operated by the Bank to eight at that time and the total assets to approximately $238 million. The premium paid by the Bank totaled approximately $3.0 million and the amount of deposits totaled approximately $44.4 million. The transaction included the receipt of cash balances of approximately $1.0 million and the purchase of premises and equipment totaling approximately $600,000.

 

USB Investment Trust Inc. was incorporated effective December 31, 2001 as a special purpose real estate investment trust (“REIT”) under Maryland law. The REIT is a subsidiary of the Bank and was funded with $133.0 million in real estate-secured loans contributed by the Bank. USB Investment Trust will give the Bank flexibility in raising capital, and will reduce the expenses associated with holding the assets contributed to USB Investment Trust. For further discussion of the REIT, refer to the overview section of Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

 

At December 31, 2003, the Company operated seven (7) bank branches and one (1) construction lending office; seven (7) in Fresno County and one (1) in Madera County. The Bank operates two branches (including its main office) and one construction lending office in Fresno and one branch each, in Oakhurst, Caruthers, San Joaquin, Firebaugh, and Coalinga. In addition, the Company and Bank have administrative headquarters at 1525 East Shaw Avenue, Fresno, California, 93710.

 

At December 31, 2003, the consolidated Company had approximately $506.6 million in total assets, $338.7 million in net loans, $440.0 million in deposits, and $45.0 million in shareholders’ equity.

 

The following discussion of the Company’s services should be read in conjunction with “MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.”

 

Bank Services

 

As a state-chartered commercial bank, United Security Bank offers a full range of commercial banking services primarily to the business and professional community and individuals located in Fresno and Madera Counties.

 

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The Bank offers a wide range of deposit instruments including personal and business checking accounts and savings accounts, interest-bearing negotiable order of withdrawal  (“NOW”) accounts, money market accounts and time certificates of deposit. Most of the Bank’s deposits are attracted from individuals and from small and medium-sized

business-related sources.

 

The Bank also engages in a full complement of lending activities, including real estate mortgage, commercial and industrial, real estate construction, as well as agricultural, lease financing, and consumer loans, with particular emphasis on short and medium-term obligations. The Bank’s loan portfolio is not concentrated in any one industry, although approximately 70% of the Bank’s loans are secured by real estate. A loan may be secured (in whole or in part) by real estate even though the purpose of the loan is not to facilitate the purchase or development of real estate. At December 31, 2003, the Bank had loans (net of unearned fees) outstanding of $344.8 million, which represented approximately 78% of the Bank’s total deposits and approximately 68% of its total assets.

 

Real estate mortgage loans are secured by deeds of trust primarily on commercial property. Repayment of real estate mortgage loans is generally from the cash flow of the borrower. Commercial and industrial loans have a high degree of industry diversification. Loans may be originated in the Company’s market area, or participated with other financial institutions outside the Company’s market area. A substantial portion of the commercial and industrial loans are secured by accounts receivable, inventory, leases or other collateral. The remainder are unsecured; however extensions of credit are predicated on the financial capacity of the borrower. Repayment of commercial loans is generally from the cash flow of the borrower. Real estate construction loans consist of loans to residential contractors, which are secured by single-family residential properties. All real estate loans have established equity requirements. Repayment of real estate construction loans is generally from long-term mortgages with other lending institutions. Agricultural loans are generally secured by land, equipment, inventory and receivables. Repayment of this loan category is from the cash flow of the borrower.

 

In the normal course of business, the Bank makes various loan commitments and incurs certain contingent liabilities. At December 31, 2003 and 2002, loan commitments of the Bank aggregated $140.3 million and $114.2 million, respectively. Of the $140.3 million in loan commitments outstanding at December 31, 2003, $110.3 million or 72% were on loans with maturities of one year or less. Due to the nature of the business of the Bank’s customers, there are no seasonal patterns or absolute predictability to the utilization of unused loan commitments; therefore the Bank is unable to forecast the extent to which these commitments will be exercised within the current year. The Bank does not believe that any such utilization will constitute a material liquidity demand.

 

In addition to the loan and deposit services discussed above, the Bank also offers a wide range of specialized services designed to attract and service the needs of commercial customers and account holders. These services include cashier’s checks, traveler’s checks, money orders, and foreign drafts. The Bank does not operate a trust department; however, it makes arrangements with its correspondent bank to offer trust services to its customers on request. Most of the Bank’s business originates within Fresno and Madera Counties. Neither the Bank’s business or liquidity is seasonal, and there has been no material effect upon the Bank’s capital expenditures, earnings or competitive position as a result of federal, state or local environmental regulation.

 

Competition and Market Share

 

The banking business in California generally, and in the market area served by the Company specifically, is highly competitive with respect to both loans and deposits. The Company competes for loans and deposits with other commercial banks, savings and loan associations, finance companies, money market funds, credit unions and other financial institutions, including a number that are substantially larger than the Company. Deregulation of the banking industry, increased competition from non-bank entities for the cash balances of individuals and businesses, and continuing developments in the computer and communications industries have had, and most likely will continue to have, a significant impact on the Company’s competitive position. With the enactment of interstate banking legislation in California, bank holding companies headquartered outside of California may enter the California market and provide further competition for the Company. Additionally, with the Gramm-Leach-Bliley Act of 1999, traditional competitive barriers between insurance companies, securities underwriters, and commercial banks have been eased, allowing a greater number of financial intermediaries to offer a wider assortment of financial services. Many of the major commercial banks operating in the Company’s market areas offer certain services such as trust and international banking services, which the Company does not offer directly. In addition, banks with larger capitalization have larger lending limits and are thereby able to serve larger customers.

 

The Company’s primary market area is located in Fresno and Madera Counties, in which approximately 27 FDIC-insured financial institutions compete for business. The following table sets forth information regarding deposit market share and ranking by county as of June 30, 2003, which is the most current information available.

 

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		Rank		Share
Fresno County		6		5.64	%
Madera County		6		5.70	%
Total of Fresno and Madera Counties		7		5.65	%

 

Supervision and Regulation

 

The Company

 

The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended (the “BHC Act”), and is registered as such with the FRB. A bank holding company is required to file with the FRB annual reports and other information regarding its business operations and those of its subsidiaries and is also subject to examination by the FRB.

 

The BHC Act requires, among other things, prior approval before acquiring, directly or indirectly, ownership or control of any voting shares of any bank, if after such acquisition it would directly or indirectly own or control more than 5% of the voting stock of that bank, unless it already owns a majority of the voting stock of that bank. The BHC Act also provides that the FRB shall not approve any acquisition that would result in or further the creation of a monopoly, or the effect of which may be substantially to lessen competition, unless the anticompetitive effects of the proposed transaction are clearly outweighed by the probable effect in meeting the convenience and needs of the community served.

 

Furthermore, under the BHC Act, a bank holding company is, with limited exceptions, prohibited from (i) acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company which is not a bank or (ii) engaging in any activity other than managing or controlling banks. With the prior approval of the FRB, however, a bank holding company may own shares of a company engaged in activities which the FRB has determined to be so closely related to banking or managing or controlling banks as to be proper incident thereto.

 

The BHC Act requires a bank holding company to serve as a source of financial and managerial strength to its subsidiary banks. It is the FRB’s policy that a bank holding company should stand ready to use available resources to provide adequate capital funds to subsidiary banks during periods of financial stress and should maintain the financial flexibility and capital raising capacity to obtain additional resources for assisting a subsidiary bank. Under certain conditions, the FRB may conclude that certain actions of a bank holding company, such as payment of cash dividends, would constitute unsafe and unsound banking practices because they violate the FRB’s “source of strength” doctrine.

 

A bank holding company and its subsidiaries are prohibited from certain tie-in arrangements in connection with any extension of credit, sale or lease of property or furnishing of services. For example, with certain exceptions, a bank may not condition an extension of credit on a promise by its customer to obtain other services by it, its holding company or other subsidiaries, or on a promise by its customer not to obtain services from a competitor. In addition, federal law imposes certain restrictions between the Company and its subsidiaries, including the Bank. As an affiliate of the Bank, the Company is subject, with certain exceptions, to provisions of federal law imposing limitations on, and requiring collateral for, extensions of credit by the Bank to its affiliates.

 

In 1999 the Gramm-Leach-Bliley Act (the “GLBA”) was enacted. The GLBA became effective in March of 2000 and is a financial services modernization law that, among other things, facilitates broad new affiliations among securities firms, insurance companies and bank holding companies by repealing the 66-year old provisions of the Glass-Steagall Act. The GLBA allows the formation of financial holding companies (“FHC’s”), which are bank holding companies with substantially expanded powers. A bank holding company must acquire the approval of the FRB to become a FHC. Under these expanded powers, affiliations may occur between bank holding companies, securities firms and insurance companies, subject to a blend of umbrella supervision and regulation of the newly formed consolidated entity by the Federal Reserve, oversight of the FHC’s bank and thrift subsidiaries by their primary federal and state banking regulators and financial regulation of the FHC’s nonbank subsidiaries by their respective specialized regulators. The Company has not applied to become a FHC.

 

The Company is subject to the periodic reporting requirements of the Securities Exchange Act of 1934, as amended, which include but are not limited to the filing of annual, quarterly and other current reports with the SEC.

 

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The Bank

 

The Bank as a state-chartered bank, is subject to regulation, supervision and regular examination by the California Department of Financial Institutions. In addition, The Bank is also a member of the Federal Reserve System and, as such, is subject to applicable provisions of the Federal Reserve Act and regulations issued thereunder and, is subject to regulation, supervision and regular examination by the Board of Governors. The Bank is subject to California law, insofar as they are not preempted by federal banking law. Deposits of the Bank are insured by the FDIC in an amount up to $100,000 per customer, and, as such, the Bank is subject to the regulations of the FDIC and the Federal Deposit Insurance Act. As a consequence of the extensive regulation of commercial banking activities in California and the United States, the Bank’s business is particularly susceptible to changes in California and federal legislation and regulation, which may have the effect of increasing the cost of doing business, limiting permissible activities or increasing competition.

 

Various other requirements and restrictions under the laws of the United States and the State of California affect the operations of the Bank. Federal and California statutes and regulations relate to many aspects of the Bank’s operations, including capital requirements and disclosure requirements to depositors and borrowers, requirements to maintain reserves against deposits, limitations on interest rates payable on deposits, loans, investments, and restrictions on borrowings and on payment of dividends. The DFI regulates the number and location of branch offices of a state-chartered bank, and may permit a bank to maintain branches only to the extent allowable under state law for state banks. California law presently permits a bank to locate a branch in any locality in the state. Additionally, California law exempts banks from California usury laws.

 

Effect of Governmental Policies and Recent Legislation

 

Banking has traditionally been a business that depends on rate differentials. In general, the difference between the interest rate paid by the Company on its deposits and other borrowings and the interest rate received on loans extended to its customers and securities held in the Company’s portfolio comprise the major portion of the Company’s earnings. These rates are highly sensitive to many factors which are beyond the control of the Company. Accordingly, the earnings and growth of the Company are subject to the influence of domestic and foreign economic conditions, including, but not limited to, inflation, recession and unemployment.

 

The earnings and growth of the Company are affected not only by general economic conditions, both domestic and foreign, but also by the monetary and fiscal policies of the United States government and its agencies, particularly the Federal Reserve Board (“FRB”).  The FRB implements national monetary policies (with objectives such as to curb inflation and combat recession) by its open market operations in United States Government securities, by adjusting the required level of reserves for financial institutions subject to reserve requirements, and by varying the discount rates applicable to borrowing by banks which are members of the Federal Reserve System.  The actions of the FRB in these areas influence the growth of bank loans, investments and deposits and also affect interest rates charged on loans and paid on deposits.  The nature and impact that future changes in fiscal or monetary policies or economic controls may have on the Company’s business and earnings cannot be predicted.  In addition, adverse economic conditions could make a higher provision for loan losses a prudent course and could cause higher loan charge-offs, thus adversely affecting the Company’s net income.

 

From time to time, legislation is enacted which has the effect of increasing the cost of doing business, limiting or expanding permissible activities or affecting the competitive balance between banks and other financial institutions. Proposals to change the laws and regulations governing the operations and taxation of banks and other financial institutions are frequently made in Congress, in the California legislature and before various bank regulatory agencies. The likelihood of any major change and the impact such change may have on the Company is impossible to predict. Certain of the potentially significant changes which have been enacted recently and other which are currently under consideration by Congress or various regulatory agencies or professional agencies are discussed below.

 

Recent Legislation and Other Changes

 

During July 2002, President Bush signed into law the Sarbanes-Oxley Act of 2002.  The purpose of the Sarbanes-Oxley Act is to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes.

 

The Sarbanes-Oxley Act amends the Securities Exchange Act of 1934 to prohibit a registered public accounting firm from performing specified nonaudit services contemporaneously with a mandatory audit.  The Sarbanes-Oxley Act also vests the audit committee of an issuer with responsibility for the appointment, compensation, and oversight of any registered public accounting firm employed to perform audit services.  It requires each committee member to be a member of the board of directors of the issuer, and to be otherwise

 

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independent.  The Sarbanes-Oxley Act further requires the chief executive officer and chief financial officer of an issuer to make certain certifications as to each annual or quarterly report filed with the SEC.

 

In addition, the Sarbanes-Oxley Act requires officers to forfeit certain bonuses and profits under certain circumstances.  Specifically, if an issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer as a result of misconduct with any financial reporting requirement under the securities laws, the chief executive officer and chief financial officer of the issuer shall be required to reimburse the issuer for (1) any bonus or other incentive-based or equity-based compensation received by that person from the issuer during the 12-month period following the first public issuance or filing with the SEC of the financial document embodying such financial reporting requirement; and (2) any profits realized from the sale of securities of the issuer during that 12-month period.

 

The Sarbanes-Oxley Act also instructs the SEC to require by rule:

 

•        disclosure of all material off-balance sheet transactions and relationships that may have a material effect upon the financial status of an issuer; and

•        the presentation of pro forma financial information in a manner that is not misleading, and which is reconcilable with the financial condition of the issuer under generally accepted accounting principles.

 

The Sarbanes-Oxley Act also prohibits insider transactions in the company’s stock during lock out periods of the company’s pension plans, and any profits on such insider transactions are to be disgorged.  In addition, there is a prohibition of company loans to its executives, except in certain circumstances.  The Sarbanes-Oxley Act also provides for mandated internal control report and assessment with the annual report and an attestation and a report on such report by the company’s auditor.  The SEC is also required to issue a code of ethics for senior financial officers of the company.  Further, the Sarbanes-Oxley Act adds a criminal penalty of fines and imprisonment of up to 10 years for securities fraud.

 

The FRB on October 31, 2002 approved a final Regulation W that comprehensively implements sections 23A and 23B of the Federal Reserve Act.  Sections 23A and 23B and Regulation W restrict loans by a depository institution to its affiliates, asset purchases by a depository institution from its affiliates, and other transactions between a depository institution and its affiliates.  Regulation W unifies in one public document the Board’s interpretations of sections 23A and 23B.  Regulation W will have an effective date of April 1, 2003.

 

In December of 2001 and January of 2002, the Office of the Comptroller of the Currency, FRB and the FDIC adopted final rules governing the regulatory capital treatment of equity investments in nonfinancial companies held by banks, bank holding companies and financial holding companies.  The final rules became effective on April 1, 2002.  The new capital requirements apply symmetrically to equity investments made by banks and their holding companies in nonfinancial companies under the legal authorities specified in the final rules.  Among others, these include the merchant banking authority granted by the Gramm-Leach-Bliley Act and the authority to invest in small business investment companies (“SBICs”) granted by the Small Business Investment Act.  Covered equity investments will be subject to a series of marginal Tier 1 capital charges, with the size of the charge increasing as the organization’s level of concentration in equity investments increases.  The highest marginal charge specified in the final rules requires a 25 percent deduction from Tier 1 capital for covered investments that aggregate more than 25 percent of an organization’s Tier 1 capital.  Equity investments through SBICs will be exempt from the new charges to the extent such investments, in the aggregate, do not exceed 15 percent of the banking organization’s Tier 1 capital.  The new charges would not apply to individual investments made by banking organizations prior to March 13, 2000.  Grandfathered investments made by state banks under section 24(f) of the Federal Deposit Insurance Act also are exempted from coverage.

 

The terrorist attacks in September 2001, have impacted the financial services industry and led to federal legislation that attempts to address certain issues involving financial institutions.  On October 26, 2001, President Bush signed into law the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001.

 

Part of the USA Patriot Act is the International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001 (“IMLA”).  IMLA authorizes the Secretary of the Treasury, in consultation with the heads of other government agencies, to adopt special measures applicable to banks, bank holding companies, and/or other financial institutions.  These measures may include enhanced recordkeeping and reporting requirements for certain financial transactions that are of primary money laundering concern, due diligence requirements concerning the beneficial ownership of certain types of accounts, and restrictions or prohibitions on certain types of accounts with foreign financial institutions.

 

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Among its other provisions, IMLA requires each financial institution to: (i) establish an anti-money laundering program; (ii) establish due diligence policies, procedures and controls with respect to its private banking accounts and correspondent banking accounts involving foreign individuals and certain foreign banks; and (iii) avoid establishing, maintaining, administering, or managing correspondent accounts in the United States for, or on behalf of, a foreign bank that does not have a physical presence in any country.  In addition, IMLA contains a provision encouraging cooperation among financial institutions, regulatory authorities and law enforcement authorities with respect to individuals, entities and organizations engaged in, or reasonably suspected of engaging in, terrorist acts or money laundering activities.  IMLA expands the circumstances under which funds in a bank account may be forfeited and requires covered financial institutions to respond under certain circumstances to requests for information from federal banking agencies within 120 hours.  IMLA also amends the Bank Holding Company Act and the Bank Merger Act to require the federal banking agencies to consider the effectiveness of a financial institution’s anti-money laundering activities when reviewing an application under these acts.

 

IMLA became effective July 23, 2002.  Additional regulations are to be adopted during 2002 to implement minimum standards to verify customer identity, to encourage cooperation among financial institutions, federal banking agencies, and law enforcement authorities regarding possible money laundering or terrorist activities, to prohibit the anonymous use of “concentration accounts,” and to require all covered financial institutions to have in place a Bank Secrecy Act compliance program.

 

The Federal Reserve Board and the Secretary of the Treasury in January 2001 jointly adopted a final rule governing merchant banking investments made by financial holding companies.  The rule implements provisions of the Gramm-Leach-Bliley Act discussed below that permit financial holding companies to make investments as part of a bona fide securities underwriting or merchant or investment banking activity.  The rule provides that a financial holding company may not, without Federal Reserve Board approval, directly or indirectly acquire any additional shares, assets or ownership interests or make any additional capital contribution to any company the shares, assets or ownership interests of which are held by the financial holding company subject to the rule if the aggregate carrying value of all merchant banking investments held by the financial holding company exceeds:

 

•             30 percent of the Tier 1 capital of the financial holding company, or

 

•             after excluding interests in private equity funds, 20 percent of the Tier 1 capital of the financial holding company.

 

A separate final rule will establish the capital charge of merchant banking investments for the financial holding company.

 

The American Homeownership and Economic Opportunity Act of 2000 was enacted in late 2000 and provides for certain regulatory and financial relief to depository institutions.  With respect to savings and loan associations, the Home Owners’ Loan Act was amended to:

 

•             repeal the savings association liquidity requirements, and

 

•             permit a savings and loan holding company with prior approval to acquire more than 5% of the voting shares of a nonsubsidiary savings association or nonsubsidiary savings and loan holding company.

 

•             With respect to national banks, the Banking Act of 1933 was amended to allow a national bank to:

 

•             specifically reorganize into a bank holding company structure or merge with subsidiaries and nonbank affiliates;

 

•             have more than 25 directors as may be allowed by the Comptroller;

 

•             have director terms of up to three years;

 

•             have a classified board; and

 

•             allow the repurchase of stock to prevent loss upon a previously contracted debt without having to dispose of it within a period of six months.

 

In addition, federal banking law was amended to authorize the Comptroller to waive the citizenship requirement for a minority of the directors on national bank boards and to repeal the 20% surplus requirement for national banks.  As to depository institutions, in general, the federal banking agencies are to develop a system for the electronic filing and dissemination of depository institution call reports.

 

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The Gramm-Leach-Bliley Act (“GLBA”) was enacted in late 1999.  GLBA, among other things, repeals the Glass-Steagall Act.  The Glass-Steagall Act enacted in the depression era prohibited banks from affiliating with securities firms.  In addition, GLBA allows for a new type of bank holding company under the Bank Holding Company Act.  The new bank holding company will be allowed to engage in insurance and securities underwriting, merchant banking and insurance company portfolio investment activities.  Currently, bank holding companies are strictly limited in the amount of insurance and securities underwriting activities in which they may engage.

 

GLBA also allows bank holding company companies to engage in any activity considered “financial” in nature or incidental to such financial activities.  Under the existing Bank Holding Company Act, incidental activities are limited to those that are “banking” in nature or incidental to such banking activities.

 

Financial activities include, as well as lending, providing insurance as an agent, broker or as principal, issuing annuities, underwriting, and dealing in or making a market in securities.  All insurance activities that are to be conducted must be conducted in compliance with applicable state laws.  In connection with insurance sales the United States Supreme Court case of Barnett Bank of Marion County N.A. v. Nelson, 116 S. Ct. 1103 (1996) is followed by GLBA, and GLBA further provides that “no state may, by statute, regulation, order, interpretation, or other action, prevent or significantly interfere with the ability of an insured depository institution, or a subsidiary or affiliate thereof, to engage, directly or indirectly, either by itself or in conjunction with a subsidiary, affiliate, or any other party, in any insurance sales, solicitation, or cross-marketing activity.”

 

The Community Reinvestment Act provisions in GLBA require that any new bank holding company that is formed meet the conditions that all of the company’s insured depository institutions are well capitalized and well managed or received at least a satisfactory rating in the most recent Community Reinvestment Act examination.

 

Other key aspects of GLBA include the following:

 

•             streamlining bank holding company supervision by defining the roles of the Federal Reserve and other federal and state regulators;

 

•             prohibiting FDIC assistance to affiliates and subsidiaries of banks and thrifts;

 

•             allowing a national bank that is well capitalized and well managed to establish new operating subsidiaries that may engage in financial activities other than insurance underwriting, merchant banking, insurance company portfolio investments, real estate development and real estate investment, so long as the aggregate assets of all financial subsidiaries do not exceed 45% of the parent’s assets or $50 billion, whichever is less;

 

•             permitting national banks to underwrite municipal bonds;

 

•             providing that securities activities conducted by a bank subsidiary will be subject to regulation by the Securities and Exchange Commission;

 

•             providing that insurance activities conducted by a bank subsidiary will be subject to regulation by the applicable state insurance authority;

 

•             replacing broker-dealer exemptions allowed to banks with limited exemptions;

 

•             providing that de novo unitary thrift holding company applications received by the Office of Thrift Supervision after May 4, 1999 shall not be approved;

 

•             providing that existing unitary thrift holding companies may only be sold to financial companies;

 

•             adopting new privacy provisions which allow customers to “opt out” of sharing nonpublic personal information with nonaffiliated third parties subject to certain exceptions;

 

•             requiring that ATM’s which impose a fee on noncustomers to disclose on the ATM screen the amount of the fee prior to a transaction becoming irrevocable on the ATM;

 

10

 

•             providing regulatory relief to smaller banks with less than $250 million in total assets with respect to the frequency of CRA examinations.  The time between examinations may be as long as five years for small banks and savings and loans; and

 

•             requiring plain language for federal banking agency regulations.

 

It is impossible to predict what effect the enactment of certain of the above-mentioned legislation will have on the Company.  Moreover, it is likely that other bills affecting the business of banks may be introduced in the future by the United States Congress or California legislature.

 

Employees

 

At December 31, 2003, the Company employed 88 persons on a full-time equivalent basis. The Company believes its employee relations are excellent.

 

Available Information

 

The Company files period reports and other reports as required to the Securities and Exchange Commission (SEC), including Forms 10K, 10Q, 8-K, and Form 4. The public may read and copy any of the material the Company files with the SEC at the SEC’s Public Reference Room located at 450 Fifth Street, N.W., Washington, D.C. 20459. The phone number for the SEC’s Public Reference Room is 1-800-SEC-0330. The Company is an electronic filer and the SEC maintains an Internet site (http://www.sec.gov) that contains reports, proxy and information statements, and other information that the Company files electronically. Certain information including financial reports and press releases may be obtained from the Company’s website at <http://www.unitedsecuritybank.com>.

 

Item 2 - Properties

 

The Company’s Main bank branch is located at 2151 West Shaw Avenue, Fresno, California. The Company owns the building and leases the land under a sublease dated December 1, 1986 between Central Bank and USB. The current sublessor under the master ground lease is Bank of the West, which acquired the position through the purchase of Central Bank. The lessor under the ground lease (Master Lease) is Thomas F. Hinds. The lease expires on December 31, 2015 and the Company has options to extend the term for four (4) ten-year periods and one seven (7) year period.

 

The Company occupies the banking premises of approximately 3,600 square feet for its East Shaw branch at 1041 E. Shaw Avenue, Fresno, California, under a lease extension expiring February 28, 2004 with additional extensions to August 31, 2011.

 

The Company owns the Oakhurst bank branch located at the Old Mill Village Shopping Center, 40074 Highway 49, Oakhurst, California, which was completed during April of 1999. The Company had originally maintained two branches in the Oakhurst area, and at this time consolidated its two Oakhurst branches into the new facility. The current facility, which consists of approximately 5,000 square feet, will be leased for a term of 15 years with two five-year options to extend the lease term.

 

The Company leases the Caruthers bank branch located at 13356 South Henderson, Caruthers, California, which consists of approximately 5,000 square feet of floor space. The branch was acquired from Wells Fargo Bank in February 1997 under a lease which expires January 19, 2006 with extensions to January 19, 2021.

 

The Company previously leased the San Joaquin bank branch, which was also acquired from Wells Fargo Bank during February of 1997. During 1999, the Company completed the construction of new facilities at 21574 Manning Avenue, San Joaquin, California and the branch operations were moved to that locality during November 1999.  The new bank branch is approximately 2,500 square feet and is owned by the Company.

 

The Company owns the Firebaugh bank branch located at 1067 O Street, Firebaugh, California which was purchased from Bank of America during October 1997 for a total consideration of $211,500. The premises are comprised of approximately 4,666 of interior floor space situated on land totaling approximately one-third of an acre.

 

The Company owns the Coalinga bank branch located at 145 East Durian, Coalinga, California which also purchased from Bank of America during October 1997. The total price paid for the premises was $268,000 which purchased 6,184 square feet of interior floor space situated on approximately 0.45 acres.

 

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The Company owns its administrative headquarters located at 1525 East Shaw Avenue, Fresno, California. The building consists of approximately 10,000 square feet of interior floor space and was purchased from Security Mutual Life Insurance Company during December of 1997.

 

Item 3 - Legal Proceedings

 

From time to time, the Company is party to claims and legal proceedings arising in the ordinary course of business. At this time, the management of the Company is not aware of any material pending litigation proceedings to which it is a party or has recently been party to, which will have a material adverse effect on the financial condition or results of operations of the Company.

 

Item 4 - Submission of Matters to a Vote of Security Holders

 

No matters were submitted to a vote of shareholders during the fourth quarter of 2003.

 

PART II

 

Item 5 - Market for the Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities

 

Trading History

 

The Company became a NASDAQ National Market listed company on May 31, 2001. The Company’s common stock was previously quoted on the OTCBB (over-the-counter bulletin board), a quotation service for securities not listed or traded on NASDAQ or a national securities exchange. Volumes traded are shown below.

 

The Company currently has four market makers for its common stock. These include, The Seidler Companies, Hoeffer & Arnett, Sandler O’Neill & Partners, and Hill Thompson, Magid & Company. The Company is aware of two other securities dealers: Smith Barney and Dean Witter Reynolds Inc., which periodically act as brokers in the Company’s stock.

 

The following table sets forth the high and low closing sales prices by quarter for the Company’s common stock, for the years ended December 31, 2003 and 2002.

 

 

At January 31, 2004, there were approximately 644 record holders of common stock of the Company. This does not reflect the number of persons or entities who hold their stock in nominee or street name through various brokerage firms.

 

Dividends

 

The Company’s shareholders are entitled to cash dividends when and as declared by the Company’s Board of Directors out of funds legally available therefore. Dividends paid to shareholders by the Company are subject to restrictions set forth in California General Corporation Law, which provides that a corporation may make a distribution to its shareholders if retained earnings immediately prior to the dividend payout are at least equal the amount of the proposed distribution. As a bank holding company without significant assets

 

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other than its equity position in the Bank, the Company’s ability to pay dividends to its shareholders depends primarily upon dividends it receives from the Bank. Such dividends paid by the Bank to the Company are subject to certain limitations. See “Management’s Discussion and Analysis of Financial and Results of Operations – Regulatory Matters”.

 

The Company paid cash dividends to shareholders of  $ 0.13 per share on January 22, 2003, and $0.145 per share on April 23, 2003, July 23, 2003 and October 22, 2002. During the previous year, the Company paid cash dividends of  $ 0.115 per share on January 23, 2002, and $0.13 per share on April 24, 2002, July 24, 2002 and October 23, 2002.

 

The amount and payment of dividends by the Company to shareholders are set by the Company’s Board of Directors with numerous factors involved including the Company’s earnings, financial condition and the need for capital for expanded growth and general economic conditions. No assurance can be given that cash or stock dividends will be paid in the future.

 

Securities Authorized for Issuance under Equity Compensation Plans

 

The following table sets forth securities authorized for issuance under equity compensation plans as for December 31, 2003.

 

 

A complete description of the above plans is included in Note 10 of the Company’s Financial Statements in Item 8 of this Annual Report on Form 10K, and is hereby incorporated by reference.

 

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Purchases of Equity Securities by Affiliates and Associated Purchasers

 

 

On August 30, 2001 the Company announced that its Board of Directors approved a plan to repurchase, as conditions warrant, up to 280,000 shares of the Company’s common stock on the open market or in privately negotiated transactions. The duration of the program was open-ended and the timing of purchases was dependent on market conditions. A total of 215,423 shares had been repurchased under that plan as of December 31, 2003, at a total cost of $3.7 million.

 

Then, on February 25, 2004 the Company announced another stock repurchase plan under which the Board of Directors approved a plan to repurchase, as conditions warrant, up to 276,500 shares of the Company’s common stock on the open market or in privately negotiated transactions. As with the first plan, the duration of the new program is open-ended and the timing of purchases will depend on market conditions.

 

Concurrent with the approval of the new repurchase plan, the Board terminated the 2001 repurchase plan and canceled the remaining 64,577 shares yet to be purchased under the earlier plan.

 

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Item 6 - Selected Financial Data

 

The following table sets forth certain selected financial data for the Bank for each of the years in the five-year periods ended December 31, 2003 and should be read in conjunction with the more detailed information and financial statements contained elsewhere herein (in thousands except per share data and ratios).

 

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Overview

 

Certain matters discussed or incorporated by reference in this Annual Report on Form 10-K are forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially from those projected in the forward-looking statements. Such risks and uncertainties include, but are not limited to, those described in Management’s Discussion and Analysis of Financial Condition and Results of Operations. Therefore, the information set forth therein should be carefully considered when evaluating the business prospects of the Company.

 

The Company

 

On June 12, 2001, the United Security Bank (the “Bank”) became the wholly owned subsidiary of United Security Bancshares (the “Company”) through a tax free holding company reorganization, accounted for on a basis similar to the pooling of interest method. In the transaction, each share of Bank stock was exchanged for a share of Company stock on a one-to-one basis. No additional equity was issued as part of this transaction. In the following discussion, references to the Bank are references to United Security Bank. References to the Company are references to United Security Bancshares (including the Bank), except for periods prior to June 12, 2001, in which case, references to the Company are references to the Bank.

 

On June 28, 2001, United Security Bancshares Capital Trust I (the “Trust”) was formed as a Delaware business trust for the sole purpose of issuing Trust Preferred securities. On July 16, 2001, the Trust completed the issuance of $15 million in Trust Preferred securities, and concurrently, the Trust used the proceeds from that offering to purchase Junior Subordinated Debentures of the Company. The Company contributed $13.7 million of the $14.5 million in net proceeds received from the Trust to the Bank to increase its regulatory capital and used the rest for the Company’s business.

 

The Company currently has seven banking branches and one construction lending office, which provide financial services in Fresno and Madera counties. As a community-oriented bank, the Company continues to seek ways to better meet its customers’ needs for financial services, and to expand its business opportunities in today’s ever-changing financial services environment. The Company’s strategy is to be a better low-cost provider of services to its customer base while enlarging its market area and corresponding customer base to further its ability to provide those services.

 

On December 11, 2003, United Security Bancshares announced that it has entered into a definitive Agreement and Plan of Reorganization and Merger with Taft National Bank pursuant to which Taft National Bank will merge into United Security Bancshares. Taft National Bank operates branch offices in Taft and Bakersfield serving small business and retail banking clients. As of September 30, 2003, Taft National Bank had total assets of $52 million and deposits of $47 million. Upon completion of the merger, Taft National Bank branches will operate as branches of United Security Bank, a wholly owned subsidiary of United Security Bancshares.

 

In the merger, United Security Bancshares (“USB”) will issue shares of its stock in a tax-free exchange for all of the Taft National Bank shares. The value of the merger will vary depending on the market price of USB stock at the time of the merger closing. The

 

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merger, which will be accounted for as a purchase transaction, is expected to be completed late in the first quarter or early in the second quarter of 2004. The merger is subject to certain conditions, including the approval of the shareholders of Taft National Bank and regulatory approval. Upon consummation of the merger, former Taft National Bank shareholders will own approximately 4.2% of United Security Bancshares outstanding shares.

 

Effective December 31, 2001, United Security Bank formed a subsidiary Real Estate Investment Trust (“REIT”) through which preferred stock was offered to private investors, to raise capital for the bank in accordance with the laws and regulations in effect at the time. The principal business purpose of the REIT was to provide an efficient and economical means to raise capital. The REIT also provided state tax benefits beginning in 2002. On December 31, 2003 the California Franchise Tax Board (FTB) announced certain tax transactions related to real estate investment trusts (REITs) and regulated investment companies (RICs) will be disallowed pursuant to Senate Bill 614 and Assembly Bill 1601, which were signed into law in the 4th quarter of 2003.

 

As a result, the Company reversed related net state tax benefits recorded in the first three quarters of 2003 and took no such benefit in the 4th quarter. The Company has recorded no state liability for 2002. United Security Bancshares and its financial advisors believe that the Company’s position has merit and the Company will pursue its tax claims and defend its use of these entities and transactions. The Company cannot predict at this time what the ultimate outcome will be.

 

Trends Affecting Results of Operations and Financial Position

 

The Company’s overall operations are impacted by a number of factors, including not only interest rates and margin spreads, which impact results of operations, but also the composition of the Company’s balance sheet. One of the primary strategic goals of the Company is to maintain a mix of assets that will generate a reasonable rate of return without undue risk, and to finance those assets with a low-cost and stable source of funds. Liquidity and capital resources must also be considered in the planning process to mitigate risk and allow for growth.

 

The following table summarizes the year-to-date averages of the components of interest-bearing assets as a percentage of total interest bearing assets, and the components of interest-bearing liabilities as a percentage of total interest-bearing liabilities:

 

 

The Company has modified its business plan over the past several years to better position itself for strategic growth in the future, while reducing potential risk levels. This is in response to the relative size and complexity of the Company, as well as economic and other market factors that may affect future operations and anticipated growth.

 

After experiencing significant growth during 2001 and 2002, the Company reduced overall asset growth in 2003 while focusing efforts on strengthening the balance sheet to improve asset quality and enhance liquidity. During 2003, loan growth was curtailed in out-of-market-area participations, and certain liabilities including FHLB borrowings totaling $35 million, were paid off. As a result, loans declined during 2003 by approximately $3.3 million and excess funds obtained from deposit growth were used to pay down borrowings or were invested in short-term overnight investments to enhance liquidity.

 

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The Company continues to emphasize relationship banking and core deposit growth. As local economies began to improve during 2003, the Company focused greater attention on its market area of Fresno and Madera Counties. While overall loans increased $9.4 million between December 31, 2001 and December 31, 2003, the level of loan participations declined by more than $36.7 million during that two-year period. In addition, the Company also concentrated its resources during 2003 on asset improvement and developing a business culture that will enable the Company to better compete and expand in its market area. In the future, the Company will continue to emphasize its core lending strengths of commercial real estate and construction lending, as well as small business financing.

 

Deposit growth totaled $16.5 million during 2003, as compared to $55.3 million during 2002. During those two years, steady increases were experienced in demand and savings deposits, which include NOW and money market accounts, savings accounts, and noninterest-bearing checking accounts. Growth in these deposit categories has been consistent during 2002 and 2003 as the Company continues to emphasize core deposit growth as part of it s relationship banking strategy. Growth in demand and savings deposits included increases in the total number of accounts during 2002 and 2003, as well as the average balances in certain categories such as money market accounts. Increases in demand and savings deposits were experienced in all branches during 2003, although approximately 54% of the growth was achieved in the immediate Fresno area. The Company will continue to emphasize these deposit categories throughout its market area during 2004 and beyond.

 

Growth in time deposits has fluctuated over the past several years, as the Company has been able to control the level of these deposits to some degree with pricing strategies. Time deposits, including brokered and other out-of-market deposits were allowed to grow during 2002 as the funds were needed for loan growth, but then allowed to run-off as they matured during 2003 as the need for such deposits diminished. The Company will continue to use pricing strategies to control the overall level of time deposits as part of its growth and liquidity planning process.

 

The Company will continue to evaluate its business plan as economic and market factors change in its market area. Growth and increased market share will be of primary importance during 2004 as the Company opens a new branch in Downtown Fresno, and completes the merger with Taft National Bank in Kern County, California.

 

Results of Operations

 

For the year ended December 31, 2003, the Company reported net income of $7.7 million or $1.41 per share ($1.40 diluted) as compared to $6.8 million or $1.27 per share ($1.25 diluted) for the year ended December 31, 2002, and $6.2 million or $1.14 per share ($1.11 diluted) for the year ended December 31, 2001. Net income for 2003 increased  $873,000 from the previous year primarily as the result of increased volumes in earning assets combined with a substantial decrease in the cost of interest-bearing liabilities, which was reflected in an increase in the Company’s net margin.

 

The Company’s return on average assets was 1.51% for the year ended December 31, 2003 as compared to 1.37% and 1.55% for the same twelve-month periods of 2002 and 2001, respectively. The Company’s return on average equity was 17.80% for the year ended December 31, 2003 as compared to 17.64% and 17.25% for the same twelve-month periods of 2002 and 2001, respectively.

 

Net Interest Income

 

Net interest income, the most significant component of earnings, is the difference between the interest and fees received on earning assets and the interest paid on interest-bearing liabilities. Earning assets consist primarily of loans, and to a lesser extent, investments in securities issued by federal, state and local authorities, and corporations, as well as interest-bearing deposits and overnight funds with other financial institutions. These earning assets are funded by a combination of interest-bearing and noninterest-bearing liabilities, primarily customer deposits and short-term and long-term borrowings. Net interest income before provision for credit losses totaled $19.7 million for the year ended December 31, 2003 as compared to $17.2 million for the year ended December 31, 2002. This represents an increase of $2.5 million or 14.3% between the years ended December 31, 2002 and 2003, as compared to an increase of $548,000 or 3.3% between 2001 and 2002. The increase in net interest income between 2002 and 2003 is primarily the result of substantial growth in net average earning assets, combined with a decline in average interest-bearing liabilities, which more than offset the decline in average market rates of interest between those two twelve-month periods. Average interest-bearing liabilities declined during 2003 as the result of reductions in the other borrowings, which were not renewed as they matured. This was part of the Company’s strategic plan to slow asset growth to allow reengineering of the Company’s infrastructure to better prepare for growth in the future. This included reducing the total amounts of loan participations outside of the Company’s market area and to focus on reducing the amount of nonperforming assets. For further discussion on changes in assets and liabilities, refer to the section entitled “Financial Condition”. The increase in net interest income between 2001 and 2002 is primarily the result of substantial growth in net

 

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average earning assets and liabilities, which more than offset the decline in average market rates of interest between those two twelve-month periods.

 

Table 1. – Distribution of Average Assets, Liabilities and Shareholders’ Equity:

Interest rates and interest differentials

Years Ended December 31, 2003, 2002, and 2001

 

		2003								2002								2001
(Dollars in thousands)		Average Balance			Interest			Yield/ Rate		Average Balance			Interest			Yield/ Rate		Average Balance			Interest			Yield/ Rate
Assets:
Interest-earning assets:
Loans (1)		$	353,562		$	23,134		6.54	%	$	347,192		$	24,521		7.06	%	$	297,653		$	26,412		8.87	%
Investment Securities – taxable		90,608			3,169			3.50	%	84,904			3,617			4.26	%	55,285			3,218			5.82	%
Investment Securities – nontaxable (2)		2,613			132			5.05	%	2,889			139			4.81	%	3,357			155			4.62	%
Interest on deposits in other banks		8,496			345			4.06	%	3,048			138			4.53	%	0			0			0.00	%
Federal funds sold and reverse repos		13,714			147			1.07	%	18,322			301			1.64	%	7,766			278			3.58	%
Total interest-earning assets		468,993			$	26,927		5.74	%	456,355			$	28,716		6.29	%	364,061			$	30,063		8.26	%
Allowance for possible loan losses		(5,375		)						(5,372		)						(4,114		)
Noninterest-bearing assets:
Cash and due from banks		18,449								17,728								14,154
Premises and equipment, net		3,960								2,839								3,265
Accrued interest receivable		2,226								2,891								3,352
Other real estate owned		4,348								9,186								4,179
Other assets		17,690								15,580								13,863
Total average assets		$	510,291							$	499,207							$	398,760
Liabilities and Shareholders’ Equity:
Interest-bearing liabilities:
NOW accounts		$	30,840		$	146		0.47	%	$	27,275		$	208		0.76	%	$	24,382		$	360		1.48	%
Money market accounts		75,111			1,103			1.47	%	60,573			1,131			1.87	%	47,440			1,604			3.38	%
Savings accounts		23,705			124			0.52	%	20,106			165			0.82	%	18,337			322			1.76	%
Time deposits		216,127			4,563			2.11	%	221,387			7,686			3.47	%	169,720			8,917			5.25	%
Other borrowings		13,206			540			4.09	%	33,476			1,427			4.26	%	33,752			1,667			4.94	%
Trust Preferred securities		15,000			784			5.23	%	15,000			899			5.99	%	6,945			541			7.79	%
Total interest-bearing liabilities		373,989			$	7,260		1.94	%	377,817			$	11,516		3.05	%	300,576			$	13,411		4.46	%
Noninterest-bearing liabilities:
Noninterest-bearing checking		89,713								79,974								59,389
Accrued interest payable		756								1,141								1,388
Other liabilities		2,539								1,544								1,504
Total average liabilities		466,997								460,476								362,857
Total average shareholders’ equity		43,294								38,731								35,903
Total average liabilities and Shareholders’ equity		$	510,291							$	499,207							$	398,760
Interest income as a percentage of average earning assets								5.74	%							6.29	%							8.26	%
Interest expense as a percentage of average earning assets								1.55	%							2.52	%							3.68	%
Net interest margin								4.19	%							3.77	%							4.58	%

 

(1) Loan amounts include nonaccrual loans, but the related interest income has been included only if collected for the period prior to the loan being placed on a nonaccrual basis. Loan interest income includes loan fees of approximately $1,889,000, $1,352,000, and $1,468,000 for the years ended December 31, 2003, 2002, and 2001, respectively.

 

(2) Applicable nontaxable securities yields have not been calculated on a tax-equivalent basis because they are not material to the Company’s results of operations.

 

As summarized in Table 2, the increase in net interest income between the two twelve-month periods ended December 31, 2003 and 2002 is comprised of a decrease in total interest income of approximately $1.8 million, which was more than offset by a decrease in total interest expense of approximately $4.3 million. The Bank’s net interest margin, as shown in Table 1, increased to 4.19% at

 

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December 31, 2003 from 3.77% at December 31, 2002, an increase of 42 basis points (100 basis points = 1%) between the two periods. Contrarily, the net margin reported during 2002 represents a decrease of 81 basis points from the 4.58% net margin realized by the Company during 2001. While assets have grown over the past three years and the balance sheet mix has changed, interest rate movements over those three years have played a significant role in net interest income trends.  Market rates of interest decreased significantly between the years ended December 31, 2000 and 2001, and then rates remained stable throughout much of 2002 and 2003. During 2002 and 2003, the Company’s liabilities continued to reprice. The prime rate, for example (the rate to which most of the Company’s floating-rate loans are tied), increased by 100 basis points during 2000, but declined by an unprecedented 475 basis points between December 31, 2000 and December 31, 2001, then only decreased 50 basis points during the fourth quarter of 2002, and another 25 basis points during June 2003. As a result of the Federal Reserve’s actions, the prime rate averaged 4.12% for the year ended December 31, 2003 as compared to 4.63% and 6.93% for the years ended December 31, 2002 and 2001, respectively.

 

Both the Company’s net interest income and net interest margin are affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities, referred to as “volume change.” Both are also affected by changes in yields on interest-earning assets and rates paid on interest-bearing liabilities, referred to as “rate change”. The following table sets forth the changes in interest income and interest expense for each major category of interest-earning asset and interest-bearing liability, and the amount of change attributable to volume and rate changes for the years indicated. Changes in interest income and expense, which are not attributable specifically to either rate or volume, are allocated proportionately between the two variances based on the absolute dollar amounts of the change in each.

 

Table 2.  Rate and Volume Analysis

 

 

Total interest income decreased approximately $1.8 million or 6.2% for the year ended December 31, 2003 as compared to the previous year.  The change is attributable primarily to an increase in the overall volume of earning assets, which was more than offset by a decrease in market rates of interest. Earning asset growth was mainly in loans, which are traditionally the Company’s highest earning asset and, to a smaller degree, in investment securities and interest-bearing deposits. On average, loan growth totaled nearly $6.4 million or 1.8% during 2003. The Company continues to maintain a high percentage of loans in its earning asset mix with loans averaging 75.4% of total earning assets for the year ended December 31, 2003, as compared to 76.1% and 81.8% for the years ended December 31, 2002 and 2001, respectively.

 

For the year ended December 31, 2002, total interest income decreased approximately $1.3 million or 4.5% as compared to the year ended December 31, 2001.  As with 2003, this decrease is also attributable to an increase in the overall volume of earning assets, which was more than offset by a decrease in market rates of interest between 2001 and 2002. Earning asset growth was mainly in loans, which are traditionally the Company’s highest earning asset and, to a smaller degree, in investment securities, interest-bearing deposits and federal funds sold. On average, loan growth totaled nearly $49.5 million or 16.6% during 2002.

 

Total interest expense decreased approximately $4.3 million or 37.0% for the year ended December 31, 2003 as compared to the year ended December 31, 2002. As with the previous year, the decrease between these two periods is primarily the result of a substantial

 

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decrease in the average rates paid on all interest-bearing categories, which was combined with a decrease in average balances of time deposits and other borrowings during the year. Average time deposit balances decreased $5.3 million and average balances on other borrowings decreased $20.3 million during 2003, and the average rate paid on time deposits and other borrowings declined 136 and 17 basis points, respectively, when compared to the year ended December 31, 2001. All other interest bearing-liability categories experienced increases in average volumes during 2003, which were more than offset by the average rates paid on those liabilities.

 

For the year ended December 31, 2002, total interest expense of $11.5 million represents a decrease of approximately $1.9 million or 14.1% as compared to the year ended December 31, 2001. The decrease between these two periods is primarily the result of a substantial decrease in the average rates paid on all interest-bearing categories, which more than offset the $77.2 million total increase in average balances during the year. Rate declines were the result of general declines in market rates of interest over that period. While average time deposit balances increased $51.7 million during 2002, the total cost of those time deposits declined $1.2 million and the average rate paid declined 178 basis points, when compared to the year ended December 31, 2001. All other interest bearing-liability categories experienced increases in average volumes during 2002, while realizing declines in interest expense and the average rates paid on those liabilities.

 

Provision for Credit Losses

 

Provisions for credit losses and the amount added to the allowance for credit losses is determined on the basis of management’s continuous credit review of the loan portfolio, consideration of past loan loss experience, current and future economic conditions, and other pertinent factors. Such factors consider the allowance for credit losses to be adequate when it covers estimated losses inherent in the loan portfolio. Based on the condition of the loan portfolio, management believes the allowance is sufficient to cover risk elements in the loan portfolio. For the year ended December 31, 2003 the provision to the allowance for credit losses amounted to $1.7 million as compared to $2.0 and $1.7 million for the years ended December 31, 2002 and 2001, respectively. The provision made during the fourth quarter of 2003 totaled $841,000, or approximately 49.1% of the total provision made during 2003, while the provision made during the fourth quarter of 2002 totaled $744,000, or approximately 39.4% of the total provision made during that year. The additional provisions made during the fourth quarters of 2003 and 2002 were in response to increased levels of nonperforming loans. Specifically, additional provisions for credit losses taken during the fourth quarter of 2003 are primarily the result of a nonperforming lease portfolio totaling approximately $5.5 million. For further discussion, see “Asset quality and allowance for credit losses” included in the financial condition section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations. The additional provisions made during the fourth quarters of 2003 and 2002 were in response to increased levels of nonperforming loans. For further discussion, see the “Asset Quality and Allowance for Credit Losses” section of this financial review. The amount provided to the allowance for credit losses during 2003 brought the allowance to 1.76% of net outstanding loan balances at December 31, 2003, as compared to 1.59% of net outstanding loan balances at December 31, 2002, and 1.33% at December 31, 2001.

 

Noninterest Income

 

The following table summarizes significant components of noninterest income for the years indicted and the net changes between those years:

 

Noninterest income consists primarily of fees and commissions earned on services that are provided to the Company’s banking customers and, to a lesser extent, gains on sales of Company assets and other miscellaneous income. Noninterest income for the year ended December 31, 2003 increased $900,000 when compared to the previous year, and increased  $1.2 million when compared to the year ended December 31, 2001. Shared appreciation income on commercial real estate increased $1.5 million between the two years ended December 31, 2003 and 2002, and was a major contributing factor to the overall increase in noninterest income during 2003.

 

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Shared appreciation income results from agreements between the Company and the borrower on certain construction loans where the Company agrees to receive interest on the loan at maturity rather than monthly and the borrower agrees to share in the profits of the project. The profit is determined by the appraised value of the completed project and subsequent refinancing or sale of the project. Due to the difficulty in calculating future values, shared appreciation income is recognized when received. Customer service fees declined by $106,000 during the year ended December 31, 2003, which is attributable to modest declines in checking service charges and overdraft fee income. Gain on sale of interest-bearing deposits in other banks totaled $186,000 during 2003, and resulted from the sale of investment CD’s. In addition, and in contrast to previous years, losses on sales of securities were experienced during 2003 as securities were called prior to maturity.

 

Total noninterest income for the year ended December 31, 2002 increased $1.1 million or 25.5% when compared to the year ended December 31, 2001. Increases in customer service fees accounted for $809,000 or 74.2% of the total increase in noninterest income between those two periods. Increases in customer service fees were attributable to growth in ATM fee income, as well as checking service charges and overdraft charges. The Company has not only increased its number of ATM’s, but has also experienced an increase in transaction volume over the past several years. Gains from sales of available-for-sale securities accounted for $485,000 of the total noninterest income for the year ended December 31, 2002. Increases of $339,000 in other noninterest income were largely comprised of OREO income, and dividends paid from the Company’s equity investment in a title company.

 

Noninterest Expense

 

The following table sets forth the components of total noninterest expense in dollars and as a percentage of average earning assets for the years ended December 31, 2003, 2002 and 2001:

 

		2003					2002					2001
(Dollars in thousands)		Amount			% of Average Earning Assets		Amount			% of Average Earning Assets		Amount			% of Average Earning Assets
Salaries and employee benefits		$	5,089		1.09	%	$	4,895		1.07	%	$	4,525		1.24	%
Occupancy expense		1,658			0.35	%	1,730			0.38	%	1,731			0.48	%
Data processing		515			0.11	%	553			0.12	%	544			0.15	%
Professional fees		991			0.21	%	965			0.21	%	591			0.15	%
Directors fees		184			0.04	%	201			0.04	%	202			0.06	%
Amortization of intangibles		353			0.08	%	360			0.08	%	360			0.10	%
Correspondent bank service charges		281			0.06	%	289			0.06	%	218			0.06	%
Writedowns on OREO		403			0.09	%	132			0.03	%	19			0.01	%
Other		2,381			0.51	%	1,735			0.38	%	1,628			0.45	%
Total		$	11,855		2.53	%	$	10,860		2.38	%	$	9,818		2.70	%

 

Noninterest expense, excluding provision for credit losses and income tax expense, totaled $11.9 million for the year ended December 31, 2003 as compared to $10.9 million and $9.8 million for the years ended December 31, 2002 and 2001, respectively. These figures represent an increase of $1.0 million or 9.2% between the years ended December 31, 2003 and 2002 and an increase of $1.0 million or 10.6% between the years ended December 31, 2002 and 2001. Expense increases between the three years presented are associated primarily with normal, anticipated growth of the Company. As a percentage of average earning assets, total noninterest expense has only experienced minor changes over the past three years as the Company has controlled overhead expenses while experiencing profitable growth. Noninterest expense amounted to 2.53% of average earning assets for the year ended December 31, 2002 as compared to 2.38% at December 31, 2002 and 2.70% at December 31, 2001.

 

Increases in salaries and employee benefits over the three years presented were the result of additional staff to support the Company’s strategic long-term growth objectives, as well as normal wage and benefit increases combined with increased medical insurance costs incurred. Professional fees increased over the three years presented as the result of additional legal expenses associated with impaired loans, increased audit fees, and the formation of the Bank’s subsidiary REIT during 2002. Increases in other noninterest expense over the three years presented are associated with normal business growth and, include a number of items such as telephone, postage, insurance, and armored car expenses. Increases in other noninterest expense during 2003 included an additional $164,000 in expenses to maintain OREO properties.

 

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Financial Condition

 

Total assets decreased by $12.7 million or 2.5% during the year to $506.6 million at December 31, 2003, down from $519.3 million at the end of the same period last year, but up from the balance of $450.9 million at December 31, 2001. The asset decline experienced during 2003 was primarily the result of a decrease in funding sources. Maturing securities were utilized to fund loan growth and growth in federal funds sold, as well as the overall decline in liabilities, thus enhancing the Company’s overall liquidity position. During the year ended December 31, 2003, net loans decreased $4.3 million, investment securities decreased $20.8 million, while federal funds sold and interest-bearing deposits in other banks increased $9.1 million. Total deposits of $444.4 million at December 31, 2003 increased $16.5 million or 3.9% from the balance reported at December 31, 2002, and increased $71.8 million or 19.5% from the balance of $368.7 million reported at December 31, 2001.

 

Earning assets averaged approximately $469.0 million during the year ended December 31, 2003, as compared to $456.4 million and $364.1 million for the years ended December 31 2002 and 2001, respectively. Average interest-bearing liabilities decreased to  $374.0 million for the year ended December 31, 2003, as compared to $377.8 million for the year ended December 31, 2002, but increased compared to $300.6 million for the year ended December 31, 2001.

 

Loans

 

The Company’s primary business is that of acquiring deposits and making loans, with the loan portfolio representing the largest and most important component of its earning assets. Loans totaled $345.7 million at December 31, 2003, a decrease of $3.4 million or 1.0% when compared to the balance of $349.1 million at December 31, 2002, but an increase of $9.4 million or 2.8% when compared to the balance of $336.3 million reported at December 31, 2001.  Average loans totaled $353.6 million, $347.2 million, and $297.7 million for the years ended December 31, 2003, 2002 and 2001, respectively. During 2003 average loans increased 1.8% when compared to the year ended December 31, 2002 and increased 18.8% compared to the year ended December 31, 2001.

 

The following table sets forth the amounts of loans outstanding by category and the category percentages as of the year-end dates indicated:

 

 

Loans declined during 2003 as part of the Company’s plan to slow overall asset growth and better position itself for sustained and stable growth in the future. During this time loan participations in other market areas were curtailed and the Company began to focus more on its market area of Fresno and Madera Counties as local economies began to improve. Total loan participations declined from $79.5 million at December 31, 2001 to $63.8 million and $42.7 million at December 31, 2002 and 2003, respectively. As a result, commercial and industrial, real estate mortgage, and construction loans showed only minor changes between December 31, 2002 and December 31, 2003. In addition, the company concentrated its resources on asset improvement and developing a business culture that will enable the Company to better compete in its market area. In the future, the Company will continue to focus on its core lending emphasis of commercial real estate and construction lending, as well as small business financing.

 

Loan volume continues to be greatest in what has historically been the Bank’s primary lending emphasis: commercial, real estate mortgage, and construction lending. The only loan growth experienced during 2003 occurred in real estate construction and lease financing loans, which increased by $3.0 million or 3.1%, and $949,000 or 8.2%, respectively, during the year. Modest decreases were experienced in all other loan categories during 2003. Much of the loan growth experienced during 2002 occurred in commercial and industrial loans, which increased by $15.0 million or 14.7% during that year. At December 31, 2003, approximately 77% of commercial and industrial loans have floating rates and, although some may be secured by real estate, many are secured by accounts receivable, inventory, and other business assets. Construction loans continues to be a significant focus for the Company and increased $3.0 million or 3.1% during 2003, increased $2.3 million or 2.4% during 2002, and increased $31.7 million or 52.0% during 2001.

 

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Construction loans are generally short-term, floating-rate obligations, which consist of both residential and commercial projects.  Agricultural loans consisting of mostly short-term, floating rate loans for crop financing, decreased $1.7 million or 10.2% between December 31, 2002 and December 31, 2003, while installment loans decreased $1.2 million or 15.3% during that same period. Since 2000, the Company has done lease financing, with growth of $1.0 million or 8.2% experienced during 2003, as compared to $1.4 million or 14.5% and $7.0 million or 215.8% during the years ended December 31, 2002 and 2001, respectively.

 

The real estate mortgage loan portfolio totaling $96.4 million at December 31, 2003 consists of commercial real estate, residential mortgages, and home equity loans. Commercial real estate is the core of this segment of the portfolio, with balances of $86.1 million, $82.6 million, and $83.3 million at December 31, 2003, 2002, and 2001, respectively. Commercial real estate loans are generally a mix of short to medium-term, fixed and floating rate instruments and, are mainly tied to commercial income and multi-family residential properties. The Company does not currently offer residential mortgage loans and, as a result, that portion of the portfolio generally has declined over time with balances of  $5.2 million, $7.8 million, and $13.4 million at December 31, 2003, 2002 and 2001, respectively. The Company purchased a portfolio of fixed-rate jumbo mortgages during 2001, which accounted for $8.7 million of the outstanding mortgage loans at December 31, 2001. With substantial prepayments experienced during 2002, that jumbo mortgage portfolio declined during the year to a balance of $1.9 million at December 31, 2002. The Company began offering short to medium-term, fixed-rate, home equity loans early in 1997 and during the last three years balances have declined moderately, with $5.0 million at December 31, 2003, $10.0 million at December 31, 2002, and $14.8 million at December 31, 2001.

 

The following table sets forth the maturities of the Bank’s loan portfolio at December 31, 2003. Amounts presented are shown by maturity dates rather than repricing periods:

 

 

The average yield on loans was 6.54% for the year ended December 31, 2003, representing a decrease of 52 basis points when compared to the year ended December 31, 2002 and was a result of a general decline in average market rates of interest between those two periods.  For the year ended December 31, 2002, the overall average yield on the loan portfolio was 7.06%, representing a decrease of 181 basis points when compared to 8.87% for the same twelve-month period of 2001 and again was a result of a significant decrease in average market rates of interest during 2002. The Bank’s loan portfolio is generally comprised of short-term or floating rate loans and is therefore susceptible to fluctuations in market rates of interest. At December 31, 2003, 2002 and 2001, approximately 66.5%, 68.7% and 65.2% of the Bank’s loan portfolio consisted of floating rate instruments, with the majority of those tied to the prime rate.

 

The following table sets forth the contractual maturities of the Bank’s fixed and floating rate loans at December 31, 2003. Amounts presented are shown by maturity dates rather than repricing periods, and do not consider renewals or prepayments of loans:

 

 

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Securities

 

Following is a comparison of the amortized cost and approximate fair value of available-for-sale and held-to-maturity securities for the three years indicated:

 

 

 

Included in other debt securities at December 31, 2003 is a short-term government securities mutual fund totaling $7.9 million, a commercial asset-backed trust totaling $5.6 million, and Trust Preferred securities pools totaling $8.4 million. Included in other debt securities at December 31, 2002 is a short-term government securities mutual fund totaling $10.0 million, a money market mutual fund totaling $23.0 million, and a Trust Preferred securities pool totaling $3.1 million.  The commercial asset-backed trust consists of fixed and floating rate commercial and multifamily mortgage loans. The short-term government securities mutual fund invests in debt securities issued or guaranteed by the U.S. Government, its agencies or instrumentalities, with a maximum duration equal to that of a 3-year U.S. Treasury Note.

 

Realized gains on securities available-for-sale totaled $11,000 during 2003, $509,000 during 2002, and $769,000 during 2001. Realized losses on securities available-for-sale totaled $69,000 during 2003 and $24,000 during 2002. There were no realized losses for such securities during 2001.

 

Investment securities decreased $20.82 million between December 2002 and December 2003, as maturing securities were utilized to fund borrowing runoff. Excess funds were temporarily invested in overnight funds to enhance the Company’s liquidity position. The decrease in securities during 2003 was primarily in other investment securities, and included the sale of a short-term money market mutual fund with Janus Investments totaling $23.0 million.

 

Investment securities increased $41.2 million between December 2001 and December 2002, as deposits and borrowings grew faster than loans, and excess funds were utilized to enhance the Company’s liquidity position. The increase was divided almost evenly between U.S. Government-sponsored agencies and other investment securities. Included in the increase in other investment securities was a short-term money market mutual fund with Janus Investments totaling $23.0 million, which can be liquidated as needed for loan growth or deposit runoff.

 

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The contractual maturities of investment securities as well as yields based on amortized cost of those securities at December 31, 2003 are shown below.  Actual maturities may differ from contractual maturities because issuers have the right to call or prepay obligations with or without call or prepayment penalties.

 

 

(1) Weighted average yields are not computed on a tax equivalent basis

 

At December 31, 2003 and 2002, available-for-sale securities with an amortized cost of approximately $61.3 million and $65.0 million, respectively (fair value of $61.7 million and $66.7 million, respectively) were pledged as collateral for public funds, FHLB borrowings, and treasury tax and loan balances.

 

Deposits

 

The Bank attracts commercial deposits primarily from local businesses and professionals, as well as retail checking accounts, savings accounts and time deposits. Total deposits increased $16.5 million or 3.9% during the year to a balance of $440.4 million at December 31, 2003 and increased $55.3 million or 15.0% between December 31, 2001 and December 31, 2002. Core deposits, consisting of all deposits other than time deposits of $100,000 or more and brokered deposits, continue to provide the foundation for the Bank’s principal sources of funding and liquidity. These core deposits amounted to 70.1%, 69.4% and 65.5% of the total deposit portfolio at December 31, 2003, 2002 and 2001, respectively.

 

The following table sets forth the year-end amounts of deposits by category for the years indicated, and the dollar change in each category during the year:

 

 

The Company’s continues to emphasize core deposits as part of its relationship banking strategy. As a result, deposits continue to grow in the Company’s deposit categories of NOW and money market accounts, savings accounts, as well as noninterest-bearing checking accounts. Substantial increases have been experienced in these deposit categories during 2002 and 2003 as the result of both an increase in the total number of accounts as well as an increase in the average balance per account, particularly in money market accounts. With market rates of interest at historical lows, money market accounts, with their tiered interest-rate features, have become increasingly attractive to depositors. During 2003 total NOW, money market accounts, and noninterest-bearing checking accounts increased in all branches, with about 54% of that increase taking place in the immediate Fresno area.

 

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Deposit accounts of $100,000 or more, for NOW and money market accounts, as well as noninterest-bearing checking accounts, increased approximately $33.7 million between December 31, 2001 and December 31, 2002, and increased $21.1 million between December 31, 2001 and December 31, 2002. On average, total NOW, money market accounts, and noninterest-bearing checking accounts of $100,000 or more increased $27.3 million during 2003 and increased $29.0 million during 2002.

 

As mentioned previously, growth in time deposits has fluctuated over the past several years, as the Company has been able to control the level of these deposits to some degree with pricing strategies. Time deposits, including brokered and other out-of-market deposits were allowed to grow during 2002 as the funds were needed for loan growth, but then allowed to run-off as they matured during 2003 as the need for such deposits diminished. The Company will continue to use pricing strategies to control the overall level of time deposits as part of its growth and liquidity planning process.

 

During the year ended December 31, 2003, increases were experienced in all deposit categories, except in time deposits, with the majority of the increase being in interest-bearing checking accounts. During the year ended December 31, 2002, increases were experienced in all deposit categories, with substantial increases in time deposits, as well as interest-bearing and noninterest-bearing checking accounts. Much of the increase in time deposits over the years presented has been the result of wholesale and brokered deposits, as well as time deposits from the State of California. The Company has utilized brokered deposits over the past several years to enhance its deposit growth, with brokered deposits totaling $27.1 million, $26.3 million and $51.3 million at December 31, 2003, 2002 and 2001, respectively. In addition, the Company has been able to obtain time deposits from the State of California, which totaled $40.0 million, $40.0 million, and $30.0 million at December 31, 2003, 2002 and 2001, respectively. The time deposits of the State of California are collateralized by pledged securities in the Company’s investment portfolio.

 

The Company’s deposit base consists of two major components represented by noninterest-bearing (demand) deposits and interest-bearing deposits. Interest-bearing deposits consist of time certificates, NOW and money market accounts and savings deposits. Total interest-bearing deposits increased $10.9 million or 3.2% between December 31, 2002 and December 31, 2003, while noninterest-bearing deposits increased $5.6 million or 6.3% between the same two periods presented. Between December 31, 2001 and December 31, 2002, total interest-bearing deposits increased $38.7 million or 13.1%, while noninterest-bearing deposits increased $16.6 million or 22.9%.

 

On a year-to-date average, the Company experienced an increase of $26.2 million or 6.4% in total deposits between the years ended December 31, 2002 and December 31, 2003. Between these two periods, average interest-bearing deposits increased $16.4 million or 5.0%, while total noninterest-bearing checking increased $9.7 million or 12.2% on a year-to-date average basis. On average, the Company experienced increases in all deposit categories between the years ended December 31, 2002 and December 31, 2003, except time deposits, which decreased $5.3 million on average during 2003. On a year-to-date average basis, total deposits increased $90.0 million or 28.2% between the years ended December 31, 2001 and December 31, 2002.  Of that total, interest-bearing deposits increased by $69.5 million or 26.7%, while noninterest-bearing deposits increased $20.6 million or 34.7% during 2002. The most significant increases experienced in average deposits during 2002 were in time deposits, money market accounts, and noninterest bearing accounts.

 

The following table sets forth the average deposits and average rates paid on those deposits for the years ended December 31, 2003, 2002 and 2001:

 

 

(1) Included at December 31, 2003, are $126.1 million in time certificates of deposit of  $100,000 or more, of which $65.7 million matures in three months or less, $13.1 million matures in 3 to 6 months, $29.1 million matures in 6 to 12 months, and $18.2 million matures in more than 12 months.

 

Short-term Borrowings

 

The Company has the ability to obtain borrowed funds consisting of federal funds purchased, securities sold under agreements to repurchase (“repurchase agreements”) and Federal Home Loan Bank (“FHLB”) advances as alternatives to retail deposit funds. The

 

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Company has established collateralized and uncollateralized lines of credit with several correspondent banks, as well as a securities dealer, for the purpose of obtaining borrowed funds as needed. The Company may continue to borrow funds in the future as part of its asset/liability strategy, and may use these funds to acquire certain other assets as deemed appropriate by management for investment purposes and to better utilize the capital resources of the Bank. Federal funds purchased represent temporary overnight borrowings from correspondent banks and are generally unsecured. Repurchase agreements are collateralized by mortgage backed securities and securities of U.S. Government agencies, and generally have maturities of one to six months, but may have longer maturities if deemed appropriate as part of the Company’s asset/liability management strategy. FHLB advances are collateralized by the Company’s stock in the FHLB, securities, and certain qualifying mortgage loans. In addition, the Company has the ability to obtain borrowings from the Federal Reserve Bank of San Francisco, which would be collateralized by certain pledged loans in the Company’s loan portfolio. The lines of credit are subject to periodic review of the Company’s financial statements by the grantors of the credit lines. Lines of credit may be modified or revoked at any time if the grantors feel there are adverse trends in the Company’s financial position.

 

The Company had collateralized and uncollateralized lines of credit aggregating $130.6 million and $157.5 million, as well as FHLB lines of credit totaling $31.8 million and $36.7 million at December 31, 2003 and 2002, respectively. These lines of credit generally have interest rates tied to the Federal Funds rate or are indexed to short-term U.S. Treasury rates or LIBOR.

 

The table below provides further detail of the Company’s federal funds purchased, repurchase agreements and FHLB advances for the years ended December 31, 2003, 2002 and 2001:

 

 

Asset Quality and Allowance for Credit Losses

 

Lending money is the Company’s principal business activity, and ensuring appropriate evaluation, diversification, and control of credit risks is a primary management responsibility. Implicit in lending activities is the fact that losses will be experienced and that the amount of such losses will vary from time to time, depending on the risk characteristics of the loan portfolio as affected by local economic conditions and the financial experience of borrowers.

 

The allowance for credit losses is maintained at a level deemed appropriate by management to provide for known and inherent risks in existing loans and commitments to extend credit. The adequacy of the allowance for credit losses is based upon management’s continuing assessment of various factors affecting the collectibility of loans and commitments to extend credit; including current economic conditions, past credit experience, collateral, and concentrations of credit. There is no precise method of predicting specific losses or amounts which may ultimately be charged off on particular segments of the loan portfolio. The collectibility of a loan is subjective to some degree, but must relate to the borrower’s financial condition, cash flow, quality of the borrower’s management expertise, collateral and guarantees, and the state of the local economy. When determining the adequacy of the allowance for credit losses, the Company follows, in accordance with GAAP, the guidelines set forth in the Interagency Policy Statement on the Allowance for Loan and Lease Losses (“Statement”) issued jointly by banking regulators during July 2001. The Statement outlines characteristics that should be used in segmentation of the loan portfolio for purposes of the analysis including risk classification, past due status, type of loan, industry or collateral. It also outlines factors to consider when adjusting the loss factors for various segments of the loan

 

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portfolio. Securities and Exchange Commission Staff Accounting Bulletin No. 102 was also released at this time which represents the SEC staff’s view relating to methodologies and supporting documentation for the Allowance for Loan and Lease Losses that should be observed by all public companies in complying with the federal securities laws and the Commission’s interpretations.  It is also generally consistent with the guidance published by the banking regulators.

 

The Company segments the loan and lease portfolio into eleven (11) segments, primarily by loan class and type, that have homogeneity and commonality of purpose and terms for analysis under SFAS No. 5. Those loans which are determined to be impaired under SFAS No. 114 are not subject to the general reserve analysis under SFAS No. 5, and evaluated individually for specific impairment. The eleven segments of the Company’s loan portfolio are as follows (subtotals are provided as needed to allow the reader to reconcile the amounts to the Company’s loan classification reported elsewhere in these financial statements):

 

 

The Company’s methodology for assessing the adequacy of the allowance for credit losses consists of several key elements, which include:

 

• the formula allowance,

• specific allowances for problem graded loans (“classified loans”)

• and the unallocated allowance

 

In addition, the allowance analysis also incorporates the results of measuring impaired loans as provided in:

 

• Statement of Financial Accounting Standards (“SFAS”) No. 114, “Accounting by Creditors for Impairment of a Loan”  and

• SFAS 118, “Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosures.”

 

The formula allowance is calculated by applying loss factors to outstanding loans and certain unfunded loan commitments. Loss factors are based on the Company’s historical loss experience and on the internal risk grade of those loans and, may be adjusted for significant factors that, in management’s judgment, affect the collectibility of the portfolio as of the evaluation date. Factors that may affect collectibility of the loan portfolio include:

 

•                  Levels of, and trends in delinquencies and nonaccrual loans;

•                  Trends in volumes and term of loans;

•                  Effects of any changes in lending policies and procedures including those for underwriting, collection, charge-off, and recovery;

•                  Experience, ability, and depth of lending management and staff;

 

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•                  National and local economic trends and conditions and;

•                  Concentrations of credit that might affect loss experience across one or more components of the portfolio, including high-balance loan concentrations and participations.

 

Management determines the loss factors for problem-graded loans (substandard, doubtful, and loss), special mention loans, and pass graded loans, based on a loss migration model. The migration analysis incorporates loan losses over the past twelve quarters (three years) and loss factors are adjusted to recognize and quantify the loss exposure from changes in market conditions and trends in the Company’s loan portfolio. For purposes of this analysis, loans are grouped by internal risk classifications, which are “pass”, “special mention”, “substandard”, “doubtful”, and “loss”. Certain loans are homogenous in nature and are therefore pooled by risk grade. These homogenous loans include consumer installment and home equity loans. Special mention loans are currently performing but are potentially weak, as the borrower has begun to exhibit deteriorating trends, which if not corrected, could jeopardize repayment of the loan and result in further downgrade. Substandard loans have well-defined weaknesses which, if not corrected, could jeopardize the full satisfaction of the debt. A loan classified as “doubtful” has critical weaknesses that make full collection of the obligation improbable. Classified loans, as defined by the Company, include loans categorized as substandard, doubtful, and loss.

 

Loan participations are reviewed for allowance adequacy under the same guidelines as other loans in the Company’s portfolio, with an additional participation factor added, if required, for specific risks associated with participations. In general, participations are subject to certain thresholds set by the Company, and are reviewed for geographic location as well as the well-being of the underlying agent bank.

 

The formula allowance includes reserves for certain off-balance sheet risks including letters of credit, unfunded loan commitments, and lines of credit. Reserves for undisbursed commitments are generally formula allocations based on the Company’s historical loss experience and other loss factors, rather than specific loss contingencies. The reserves for these off-balance sheet commitments are included in the Company’s allowance for credit losses, rather than a separate liability on the balance sheet because the reserve amounts are considered to be immaterial in relation to total liabilities. At December 31, 2003, 2002 and 2001 the formula reserve allocated to undisbursed commitments totaled $399,000, $224,000 and $181,000, respectively.

 

Specific allowances are established based on management’s periodic evaluation of loss exposure inherent in classified loans, impaired loans, and other loans in which management believes there is a probability that a loss has been incurred in excess of the amount determined by the application of the formula allowance. Specific allowance amounts include those calculated under SFAS No. 114. Under SFAS No. 114, specific allowances are determined based on the collateralized value of the underlying properties, the net present value of the anticipated cash flows, or the market value of the underlying assets. Under SFAS No. 5, specific allowances, where required, are determined on the basis of additional risks involved with individual loans that may be in excess of risk factors associated with the loan portfolio as a whole. The specific allowance is different from the formula allowance in that the specific allowance is determined on a loan-by-loan basis based on risk factors directly related to a particular loan, as opposed to the formula allowance which is determined for a pool of loans with similar characteristics, based on past historical trends and other risk factors which may be relevant on an ongoing basis.

 

The unallocated portion of the allowance is the result of both expected and unanticipated changes in various conditions that are not directly measured in the determination of the formula and specific allowances. The conditions may include, but are not limited to, general economic and business conditions affecting the key lending areas of the Company, credit quality trends, collateral values, loan volumes and concentrations, and other business conditions.

 

The Company’s methodology includes features that are intended to reduce the difference between estimated and actual losses. The specific allowance portion of the analysis is designed to be self-correcting by taking into account the current loan loss experience based on that portion of the portfolio. By analyzing the probable estimated losses inherent in the loan portfolio on a quarterly basis, management is able to adjust specific and inherent loss estimates using the most recent information available. In performing the periodic migration analysis, management believes that historical loss factors used in the computation of the formula allowance need to be adjusted to reflect current changes in market conditions and trends in the Company’s loan portfolio. There are a number of other factors which are reviewed when determining adjustments in the historical loss factors. They include 1) trends in delinquent and nonaccrual loans, 2) trends in loan volume and terms, 3) effects of changes in lending policies, 4) concentrations of credit, 5) competition, 6) national and local economic trends and conditions, 7) experience of lending staff, 8) loan review and Board of Directors oversight, 9) high balance loan concentration, and 10) other business conditions. The ninth factor above for high balance loan concentration was added during 2002, and as a result, the impact to the allowance for credit losses for the inclusion of that factor amounted to approximately $183,000 and $132,000 for 2003 and 2002, respectively. Other than the added factor just mentioned, there were no changes in estimation methods or assumptions during 2003 that affected the methodology for assessing the overall adequacy of the allowance for credit losses.

 

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