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| PMBC > SEC Filings for PMBC > Form 10-Q on 7-Nov-2008 | All Recent SEC Filings |
7-Nov-2008
Quarterly Report
Introduction
Pacific Mercantile Bancorp is a bank holding company that owns all of the stock of Pacific Mercantile Bank (the "Bank"), which is a commercial bank that provides a full range of banking services to small and medium-size businesses and to professionals and the general public in Orange, Los Angeles, San Bernardino and San Diego counties, in Southern California. Substantially all of our operations are conducted and substantially all of our assets are owned by the Bank, which accounts for substantially all of our consolidated revenues, expenses and operating income,
The following discussion presents information about our consolidated results of operations for the three and nine month periods ended September 30, 2008 and 2007 and our consolidated financial condition, liquidity and capital resources at September 30, 2008 and should be read in conjunction with our interim consolidated financial statements and the notes thereto included elsewhere in this Report.
Forward-Looking Information
Statements contained in this Report that are not historical facts or that discuss our expectations, beliefs or views regarding our future operations or future financial performance, or financial or other trends in our business, constitute "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. Often, they include the words "believe," "expect," "anticipate," "intend," "plan," "estimate," "project," or words of similar meaning, or future or conditional verbs such as "will," "would," "should," "could," or "may." The information contained in such forward-looking statements is based on current information and assumptions about future events over which we do not have control and our business is subject to a number of risks and uncertainties that could cause our financial condition or actual operating results in the future to differ significantly from our expected financial condition or operating results that are set forth in those statements. Certain of those risks and uncertainties are summarized below, in this Item 2 (under the caption "Risks that could Affect our Future Financial Performance") and in Item 1A (entitled "Risk Factors") in Part II of this report and those, as well as other, risks are discussed in detail in Item 1A in our Annual Report on Form 10-K for our fiscal year ended December 31, 2007. Readers of this report are urged to read the discussion of those risks below and the information contained in Item 1A of our 2007 10-K.
Due to those risks and uncertainties, readers are cautioned not to place undue reliance on the forward-looking statements contained in this Report, which speak only as of the date of this Report, or to make predictions about future performance based solely on historical financial performance. We also disclaim any obligation to update forward-looking statements contained in this Report or in our 2007 10-K or any other prior filings with Securities and Exchange Commission.
Overview of Operating Results in the Three and Nine Months Ended September 30, 2008
The following table sets forth information regarding the interest income that we generated, the interest expense that we incurred, our net interest income, noninterest income, noninterest expense, and our net income and net income per share for the three and nine months ended September 30, 2008 and 2007.
Three Months Ended September 30, Nine Months Ended September 30,
2008 2007 Percent 2008 2007 Percent
Amounts Amounts Change Amounts Amounts Change
(Unaudited)
(Dollars in thousands, except per share data)
Interest income $ 15,230 $ 18,057 (15.7 )% $ 46,262 $ 53,109 (12.9 )%
Interest expense 8,246 9,964 (17.2 )% 25,879 29,399 (12.0 )%
Net interest income $ 6,984 $ 8,093 (13.7 )% $ 20,383 $ 23,710 (14.0 )%
Provision for loan losses $ 1,625 $ 300 441.7 % $ 5,441 $ 925 488.2 %
Net interest income after
provision for loan losses $ 5,359 $ 7,793 (31.2 )% $ 14,942 $ 22,785 (34.4 )%
Noninterest income $ 704 $ 369 90.8 % $ 2,589 $ 1,036 149.9 %
Noninterest expense $ 5,566 $ 5,864 (5.1 )% $ 16,955 $ 16,357 3.7 %
Income before income tax $ 497 $ 2,298 (78.4 )% $ 576 $ 7,464 (92.3 )%
Net income $ 354 $ 1,431 (75.3 )% $ 525 $ 4,568 (88.5 )%
Net income per diluted share $ 0.03 $ 0.13 (76.9 )% $ 0.05 $ 0.42 (88.1 )%
Weighted average number of
diluted shares 10,479,280 10,905,721 (3.9 )% 10,595,249 10,867,763 (2.5 )%
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As the table above indicates, we generated net income of $354,000, or $0.03 per diluted share, in the three months ended September 30, 2008, as compared to net income of $1.4 million, or $0.13 per diluted share in the same three months of 2007. In the nine months ended September 30, 2008, we generated net income of $525,000, or $0.05 per diluted share, as compared to $4.6 million, or $0.42 per diluted share, in the same nine months of 2007.
These declines in net income were primarily attributable to (i) decreases of $1.1 million and $3.3 million in net interest income, and (ii) increases of $1.3 million and $4.5 million in the provisions made for loan losses, in the three and nine month periods ended September 30, 2008, respectively.
The decreases in net interest income and net income were primarily attributable to:
• Declines in interest income of $2.8 million, or 15.7%, and $6.8 million, or 12.9%, respectively, in the three and nine month periods ended September 30, 2008, as a result of:
• reductions of 325 basis points in interest rates by the Federal Reserve Board from September 30, 2007 to September 30, 2008 in response to the economic downturn, which led to decreases in prevailing interest rates that adversely affected the yields on our loans and other interest-earning assets and more than offset (i) declines in interest expense, consisting principally of interest paid on deposits, as a result of those same decreases in prevailing market rates of interest and (ii) the positive effect on interest income of increases in the volume of loans we made during these periods;
• increases, of $8.7 million and $12.3 million, in the three and nine months ended September 30, 2008, in non-performing loans on which we ceased accruing interest income, that we attribute primarily to the worsening of economic conditions in the United States which made it more difficult for borrowers to meet their loan payment obligations; and
• increases, both as a percentage of total deposits and in absolute dollars, in time deposits, which bear higher rates of interest than other types of deposits, in order to offset decreases in lower cost core deposits, as customers increased withdrawals of those deposits to fund their cash needs and to purchase, what they believed were more secure, U.S. Treasury securities, as a result of worsening economic conditions and the credit crisis.
• Increases that we made in the provisions for loan losses, in both the three and nine months ended September 30, 2008, in order to increase our loan loss reserve at September 30, 2008 to $8.4 million, or 1.00% of the total loans then outstanding, from $6.1 million, or 0.79% of total loans outstanding at December 31, 2007, primarily due to an increase in non-performing loans and other non-performing assets to $26.2 million at September 30, 2008 from $8.4 million at December 31, 2007, which we attribute to the worsening of economic conditions.
Partially offsetting the declines in net interest income in both the three and nine months ended September 30, 2008, were increases in non-interest income of $335,000, or 91%, and $1.6 million, or 150%, respectively, due to gains recognized on sales of securities held for sale and increases in fees and service charges on deposit account transactions.
The following table indicates the impact of the decreases in our net interest income and the declines in earnings in the three and nine months ended September 30, 2008 have had on our net interest margin and certain other financial performance ratios:
Three Months Ended Nine Months Ended
September 30, September 30,
2008 2007 2008 2007
(Unaudited) (Unaudited)
Net interest margin (1) (2) 2.56 % 2.94 % 2.52 % 2.97 %
Return on average assets (1) 0.13 % 0.51 % 0.06 % 0.56 %
Return on average shareholders' equity (1) 1.51 % 6.13 % 0.74 % 6.71 %
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(1) Annualized.
(2) Net interest income expressed as a percentage of total average interest earning assets.
To reduce our exposure to the worsening conditions in the real estate market, since the fourth quarter of 2007 we have reduced the volume of single family residential and real estate construction loans, while increasing the volume of commercial and business loans, in our loan portfolio. As a result, as of September 30, 2008, single family residential and real estate construction loans accounted for 12.0% of the loans in our loan portfolio, as compared to 15.5% at September 30, 2007.
We believe that these reductions in the volume of such real estate related loans, together with our actions in charging off non-performing loans and increasing the loan loss reserve, have improved the quality of our loan portfolio and, at the same time, has enhanced our ability to absorb additional loan losses that are inherent in our loan portfolio.
In addition, as of September 30, 2008, the ratio of the Bank's total capital-to-risk weighted assets, which is the principal federal regulatory measure of the financial strength of banking institutions, was 11.2%, which exceeded the federal regulatory capital ratio required for the Bank to qualify as a "well-capitalized" banking institution, which is the highest of the capital standards established under federal banking regulations.
Critical Accounting Policies
Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States ("GAAP") and general practices in the banking industry. Certain of those accounting policies are considered critical accounting policies, because they require us to make estimates and assumptions regarding circumstances or trends that could affect the value of those assets, such as, for example, assumptions regarding economic conditions or trends that could impact our ability to fully collect our loans or ultimately realize the carrying value of certain of our other assets. Those estimates and assumptions are made based on current information available to us regarding those economic conditions or trends or other circumstances. If changes were to occur in the events, trends or other circumstances on which our estimates or assumptions were based, or other unanticipated events were to happen that might affect our operating results, under GAAP it could become necessary to reduce the carrying values of the affected assets on our balance sheet. In addition, because reductions in the carrying value of assets are sometime effectuated by or require charges to income, such reductions also may have the effect of reducing our income.
Our critical accounting policies relate to the determination of our allowance for loan losses, the fair value of securities available for sale and the valuation of deferred tax assets.
Allowance for Loan Losses. The failure of borrowers to repay their loans is an inherent risk of the banking business. Therefore, like virtually all banks and other lending institutions, we follow the practice of maintaining reserves (often referred to as an allowance) against which we charge losses on the loans we make (the "allowance for loan losses"). The accounting policies and practices we follow in determining the sufficiency of that allowance require us to make judgments and assumptions about economic and market conditions and trends that can affect the ability of our borrowers to meet their loan payment obligations to us. Accordingly, we use historical loss factors, adjusted for current economic market conditions and other economic indicators, to estimate the potential losses inherent in our loan portfolio and assess the sufficiency of our allowance for loan losses. If unanticipated
changes were to occur in those conditions or trends, such as those that occurred during the first nine months of 2008, actual loan losses could be greater than those predicted by those loss factors and our prior assessments of economic conditions and trends. In such an event, it could be necessary for us to increase the allowance for loan losses by means of a charge to income referred to in our financial statements as the "provision for loan losses." Such an increase would reduce the carrying value of the loans on our balance sheet, and the additional provision for loan losses taken to increase that allowance would reduce our income in the period when it is determined that an increase in the allowance for loan losses is necessary. See the discussion in the subsections entitled "Results of Operations-Provision for Loan Losses" and "Financial Condition-Allowance for Loan Losses and Nonperforming Loans" below.
Fair Value of Securities Available for Sale. Securities available for sale are those that we intend to hold for an indefinite period of time, but which we may sell in response to changes in liquidity needs, changes in interest rates, changes in prepayment risks or other similar factors. Such securities are recorded at fair value. Any unrealized gains and losses are reported as "Other Comprehensive Income (Loss)" rather than included in or deducted from earnings. We determine the fair value of those securities (as opposed to securities which we intend to hold to maturity) by obtaining price quotations from third party vendors and securities brokers. When such quotations are not available, a reasonable fair value is determined by using a variety of industry standard pricing methodologies including, but not limited to, discounted cash flow analysis, matrix pricing, option adjusted spread models, as well as fundamental analysis. These pricing methodologies require us to make various assumptions relating to such matters as future prepayment speeds, yield, duration, monetary policy and demand and supply for the individual securities. Consequently, if changes were to occur in the market or other conditions on which those assumptions were based, it could become necessary for us to make adjustments to the fair values of those securities, which would have the effect of changing our accumulated other comprehensive gain (loss) in our consolidated statements of financial condition.
Utilization of Deferred Income Tax Benefits. The provision that we make for income taxes is based on, among other things, our ability to use certain income tax benefits available under state and federal income tax laws to reduce our income tax liability. As of September 30, 2008, the total of the unused income tax benefits (included in "Other Assets" in our consolidated balance sheet), available to reduce our income taxes in future periods was $7.9 million. Unless used, such tax benefits expire over time. Therefore, the realization of those benefits is dependent on our generating taxable income in the future in amounts sufficient to enable us to use those tax benefits prior to their expiration. We have made a judgment, based on historical experience and current and anticipated market and economic conditions and trends, that it is more likely than not that we will generate taxable income in future years sufficient to fully utilize those benefits before they expire. In the event that market or economic conditions or our results of operation were to change in a manner that would lead us to conclude that it would be less likely that those benefits could be fully utilized, it could become necessary for us to establish a valuation reserve to cover any potential loss of those tax benefits by increasing the provision we make for income taxes, which would have the effect of reducing our net income in the period when that valuation reserve is established.
Utilization of Current Income Tax Receivable. As of September 30, 2008 we had a current net income tax receivable of $874,000 generated by (i) a $734,000 receivable for 2007 income tax, and (ii) $140,000 of estimated overpayments of taxes for 2008.
Results of Operations
Net Interest Income
One of the principal determinants of a bank's income is net interest income,
which is the difference between (i) the interest that a bank earns on loans,
investment securities and other interest-earning assets, on the one hand, and
(ii) its interest expense, which consists primarily of the interest it must pay
to attract and retain deposits and the interest that it pays on borrowings and
other interest-bearing liabilities, on the other hand. As a general rule, all
other things being equal, the greater the difference between the amount of our
interest income and the amount of our interest expense, the greater will be our
income; whereas, a decline in that difference will generally result in a decline
in our net income. A bank's interest income and interest expense are, in turn,
affected by a number of factors, some of which are outside of its control,
including national and local economic conditions and the monetary policies of
the Federal Reserve Board which affect interest rates, the demand for loans, and
the ability of borrowers to meet their loan payment obligations. Net interest
income, when expressed as a percentage of total average interest earning assets,
is a banking organization's "net interest margin."
The following table sets forth our interest income, interest expense and net interest income (in thousands of dollars) and our net interest margin in the three and nine months ended September 30, 2008 and 2007, respectively:
Three Months Ended Nine Months Ended
September 30, September 30,
2008 2007 Percent 2008 2007 Percent
Amount Amount Change Amount Amount Change
(Unaudited) (Unaudited)
Interest income $ 15,230 $ 18,057 (15.7 )% $ 46,262 $ 53,109 (12.9 )%
Interest expense 8,246 9,964 (17.2 )% 25,879 29,399 (12.0 )%
Net interest income $ 6,984 $ 8,093 (13.7 )% $ 20,383 $ 23,710 (14.0 )%
Net interest margin 2.56 % 2.94 % 2.52 % 2.97 %
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As the table above indicates, our net interest income decreased by $1.1 million, or 14%, in the third quarter of 2008, and by $3.3 million, or 14%, in the nine months ended September 30, 2008, as compared to the same respective periods of 2007. Those decreases were primarily attributable to decreases in interest income of $2.8 million, or 16%, and $6.8 million, or 13%, respectively, in the three and nine month periods of 2008. Those decreases in interest income more than offset decreases in interest expense of $1.7 million, or 17%, and $3.5 million, or 12%, respectively, in the three and nine month periods ended September 30, 2008 over the respective corresponding periods of 2007.
The decreases in interest income in the three and nine months ended September 30, 2008, were due primarily (i) to a 325 basis points decline in prevailing market rates of interest, which we believe was primarily the result of reductions, commenced in September 2007, in the federal funds rate implemented by the Federal Reserve Board in response to the economic downturn, and (ii) increases in non-performing loans on which we ceased accruing interest income. Those decreases were partially offset by the positive effects on our interest income of increases, in the three and nine months ended September 30, 2008, of $70 million and $57 million, respectively, in average loans outstanding, which generate higher yields than other earning assets. We used lower-yielding federal funds and proceeds from the sale of securities available for sale, along with Federal Home Loan Bank (FHLB) borrowings, to fund those increases in loans.
The decreases in interest expense during the three and nine month periods ended September 30, 2008 were primarily attributable to the aforementioned decreases in prevailing market rates of interest, which enabled us to reduce interest rates on interest bearing deposits, partially offset by increases in the volume of interest-bearing deposits and a change in the mix of our deposits to a greater proportion of time deposits which bear higher rates of interest than other types of deposits. The increase in the proportion of time deposits was necessitated by a decrease in the volume of demand and savings and money market deposits, which we believe was due to (i) the worsening of economic conditions in the United States which has led consumers to make greater use of their savings to pay on-going expenses, (ii) downsizing by businesses which has led to reductions in balances in business transaction accounts and (iii) more recently, the loss in confidence by consumers and investors in banks, which led to a shift of funds out of banks to treasury securities.
Due primarily to the decline in prevailing market rates of interest, our net interest margin decreased by 38 basis points to 2.56% in the three months ended September 30, 2008, from 2.94% in the same period of 2007, and by 45 basis points to 2.52% in the nine months ended September 30, 2008, from 2.97% in the same nine months ended September 30, 2007. In the three months ended September 30, 2008, the yield on interest-earning assets declined to 5.61% from 6.57% in the same period of 2007, which more than offset a decline in the average interest rate paid on interest bearing liabilities to 3.90%, from 4.78% in the same three month period of 2007. Similarly, in the nine months ended September 30, 2008, the average rate of interest earned on average earning assets decreased to 5.73%, from 6.66% in the same nine month period of 2007, and was only partially offset by a decrease in the average interest rate paid on interest bearing deposits to 3.94%, from 4.57% in the same period of 2007. The decreases in net interest margin also reflect timing differences in the impact that the declines in market rates of interest have on our interest income and interest expense. Those declines resulted in automatic decreases in the interest rates on our adjustable rate loans, whereas the impact of those declines on the interest we paid on deposits has been more gradual primarily as a result of the maturity schedule of our time deposits.
Average Balances
Information Regarding Average Assets and Average Liabilities
The following table sets forth information regarding our average balance sheet,
yields on interest earning assets, interest expense on interest-bearing
liabilities, the interest rate spread and the interest rate margin for the three
months ended September 30, 2008 and 2007.
Three Months Ended September 30,
2008 2007
Interest Average Interest Average
Average Earned/ Yield/ Average Earned/ Yield/
Balance Paid Rate Balance Paid Rate
(Dollars in thousands)
(Unaudited)
Interest earning assets:
Short-term investments(1) $ 38,526 $ 179 1.85 % $ 109,456 $ 1,387 5.03 %
Securities available for sale and
stock(2) 228,814 2,595 4.51 % 237,731 2,718 4.54 %
Loans 813,514 12,456 6.09 % 743,916 13,952 7.44 %
Total earning assets 1,080,854 15,230 5.61 % 1,091,103 18,057 6.57 %
Noninterest earning assets 35,681 27,797
Total Assets $ 1,116,535 $ 1,118,900
Interest-bearing liabilities:
Interest-bearing checking accounts $ 20,100 27 0.54 % $ 23,568 42 0.71 %
Money market and savings accounts 117,818 511 1.72 % 160,558 1,455 3.60 %
Certificates of deposit 450,079 4,969 4.39 % 413,594 5,411 5.19 %
Other borrowings 239,835 2,499 4.15 % 209,951 2,624 4.96 %
Junior subordinated debentures 17,682 240 5.40 % 19,367 432 8.85 %
Total interest-bearing liabilities 845,514 8,246 3.90 % 827,038 9,964 4.78 %
Noninterest-bearing liabilities 178,177 199,371
Total Liabilities 1,023,691 1,026,409
Shareholders' equity 92,844 92,491
Total Liabilities and
Shareholders' Equity $ 1,116,535 $ 1,118,900
Net interest income $ 6,984 $ 8,093
Interest rate spread 1.71 % 1.79 %
Net interest margin 2.56 % 2.94 %
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(1) Short-term investments consist of federal funds sold and interest bearing deposits with financial institutions.
(2) Stock consists of Federal Home Loan Bank Stock and Federal Reserve Bank Stock.
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