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CUNB > SEC Filings for CUNB > Form 10-K on 13-Mar-2014All Recent SEC Filings

Show all filings for CU BANCORP

Form 10-K for CU BANCORP


13-Mar-2014

Annual Report


ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

GENERAL

Management's discussion and analysis of financial condition and results of operations is intended to provide a better understanding of the significant changes in trends relating to the Company's financial condition, results of operation, liquidity and interest rate sensitivity. The following discussion and analysis should be read in conjunction with the audited financial statements at Item 9 herein including the notes thereto. This section should also be read in conjunction with the disclosure regarding "Forward Looking Statements" set forth in Item 1 Business - Forward Looking Statements, as well as the discussion set forth in "Item 1 Business".

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with generally accepted accounting principles accepted in the United States ("GAAP"). The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities at the date of our financial statements. Actual results may differ from these estimates under different assumptions or conditions.

Various elements of our accounting policies, by their nature, are inherently subject to estimation techniques, valuation assumptions, and other subjective assessments. We have identified several accounting policies that, due to judgments, estimates, and assumptions inherent in those policies, are essential to an understanding of our consolidated financial statements. These policies relate to the methodologies that determine our allowance for loan loss, the valuation of impaired loans, the classification and valuation of investment securities, accounting for and valuation of derivatives and hedging activities, accounting for business combinations, evaluation of goodwill for impairment, and accounting for income taxes.

We believe that our most critical accounting policies upon which our financial condition depends, and which involve the most complex or subjective decisions or assessment, are as follows:

Allowance for Loan Loss

We maintain an allowance for loan loss ("Allowance") to provide for probable losses in the loan portfolio. Additions to the Allowance are made by charges to operating expense in the form of a provision for loan losses. All loans that are judged to be uncollectible will be charged against the Allowance while any recoveries would be credited to the Allowance. We have instituted loan policies and procedures which enable us to adequately evaluate, analyze and monitor risk factors associated with our loan portfolio. These policies and procedures enable us to assess risk factors prior to granting new loans and to continually monitor the risk levels in the loan portfolio. We conduct a critical evaluation of the loan portfolio and the level of the Allowance quarterly. We have instituted loan policies to adequately evaluate and analyze risk factors associated with our loan portfolio and to enable us to assess such risk factors prior to granting new loans and to assess the sufficiency of the allowance. This evaluation includes an assessment of the following factors: the results of any internal and external loan reviews and any regulatory examination, changes in management or lending policies and underwriting standards, levels of past due loans, loan loss experience, estimated probable loss exposure on each impaired credit, concentrations of credit, value of collateral and any known impairment in the borrowers' ability to repay, and current economic conditions. For a more thorough description of the Company's evaluation see "Allowance for Loan Loss" in the Financial Condition discussion that follows. In July of 2012, the Company acquired $278 million of loans from the acquisition of PC Bancorp. In December of 2010, the Company acquired $87 million of loans from the acquisition of COSB. These loans were initially accounted for at fair value, and as a result were written down to their fair value which includes a credit loss factor on each of the specific loans. As a result, there was no Allowance assigned to these loans. The balance of these loans acquired through acquisitions, at December 31, 2013, was $227 million.


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Investment Securities

The Company currently classifies its investment securities under the available-for-sale classification. Under the available-for-sale classification, securities can be sold in response to certain conditions, such as changes in interest rates, changes in the credit quality of the securities, when the credit quality of a security does not conform with current investment policy guidelines, fluctuations in deposit levels or loan demand or need to restructure the portfolio to better match the maturity or interest rate characteristics of liabilities with assets. Securities classified as available-for-sale are accounted for at their current fair value rather than amortized cost. Unrealized gains or losses are excluded from net income and reported as a separate component of accumulated other comprehensive income (loss) included in shareholders' equity.

At each reporting date, investment securities are assessed to determine whether there is an other-than-temporary impairment. If it is probable, based on current information, that we will be unable to collect all amounts due according to the contractual terms of a debt security not impaired at acquisition, an other-than-temporary impairment shall be considered to have occurred. If it's determined that an other-than-temporary impairment exists on a debt security, the Company then determines if (a) it intends to sell the security or (b) it is more likely than not that it will be required to sell the security before its anticipated recovery. If either of the conditions is met, the Company will recognize an other-than-temporary impairment in earnings equal to the difference between the security's fair value and its adjusted cost basis, the credit portion of the loss is required to be recognized in current earnings, while the non-credit portion of the loss is recorded as a separate component of shareholders' equity. If neither of the conditions is met, the Company determines (a) the amount of the impairment related to credit loss and (b) the amount of the impairment due to all other factors. The difference between the present value of the cash flows expected to be collected and the amortized cost basis is the credit loss. The credit loss portion of such impairment, if any, is the portion of the other-than-temporary impairments that is recognized in current earnings rather than as a separate component of shareholders, equity and is a reduction to the cost basis of the security. The portion of total impairment related to all other factors is included in accumulated other comprehensive income (loss). Significant judgment is required in this analysis that includes, but is not limited to assumptions regarding the collectability of principal and interest, future default rates, future prepayment speeds, the amount of current delinquencies that will result in defaults and the amount of eventual recoveries expected on these defaulted loans through the foreclosure process.

Realized gains and losses on sales of securities are recognized in earnings at the time of sale and are determined on a specific-identification basis. Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities. For mortgage-backed securities, the amortization or accretion is based on estimated lives of the securities. The lives of these securities can fluctuate based on the amount of prepayments received on the underlying collateral of the securities. The amount of prepayments varies from time to time based on the interest rate environment and the rate of turnover of mortgages. The Company's investment in the common stock of the FHLB, Pacific Coast Bankers Bank and The Independent Banker's Bank ("TIB") and the preferred stock of TIB is carried at cost and is included in other assets on the accompanying consolidated balance sheets.

Derivative Financial Instruments and Hedging Activities

All derivative instruments are recorded on the consolidated balance sheet at fair value. For derivatives designated as fair value hedges, changes in the fair value of the derivative and hedged item related to the hedged risk are recognized in earnings. ASC Topic 815, Derivatives and Hedging ("ASC 815"), establishes the accounting and reporting standards requiring that every derivative instrument (including certain derivative instruments embedded in other contracts) be recorded in the consolidated balance sheet as either an asset or liability measured at its fair value. ASC 815 requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Accounting for qualifying hedges allows a derivative's gains and losses to offset related results on the hedged item in the income statement, and requires that a company must formally document, designate and assess the effectiveness of transactions that receive hedge accounting.


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On the date a derivative contract is entered into, the Company will designate the derivative contract as either a fair value hedge (i.e. a hedge of the fair value of a recognized asset or liability), a cash flow hedge (i.e. a hedge of the variability of cash flows to be received or paid related to a recognized asset or liability), or a stand-alone derivative (i.e. an instrument with no hedging designation). For a derivative designated as a fair value hedge, the changes in the fair value of the derivative and of the hedged item attributable to the hedged risk are recognized in earnings. If the derivative is designated as a cash flow hedge, the effective portions of changes in the fair value of the derivative are recorded in accumulated other comprehensive income (loss) and are recognized in the income statement when the hedged item affects earnings. Changes in the fair value of derivatives that do not qualify for hedge accounting are reported currently in earnings, as other non-interest income.

The Company will discontinue hedge accounting prospectively when: it is determined that the derivative is no longer effective in offsetting change in the fair value of the hedged item, the derivative expires or is sold, is terminated or management determines that designation of the derivative as a hedging instrument is no longer appropriate. When hedge accounting is discontinued, the Company will continue to carry the derivative on the consolidated balance sheet at its fair value (if applicable), but will no longer adjust the hedged asset or liability for changes in fair value. The adjustments of the carrying amount of the hedged asset or liability will be accounted for in the same manner as other components of the carrying amount of that asset or liability, and the adjustments are amortized to interest income over the remaining life of the hedged item upon the termination of hedge accounting.

Business Combinations

The Company has a number of fair value adjustments recorded within the consolidated financial statements at December 31, 2013 that were created from the business combinations with COSB and PC Bancorp on December 31, 2010 and July 31, 2012, respectively. These fair value adjustments include the Company's goodwill, fair value adjustments on loans, core deposit intangible assets, other intangible assets, fair value adjustments to acquired lease obligations, fair value adjustments to high rate certificates of deposit and fair value adjustments on derivatives. The assets and liabilities acquired through acquisition have been accounted for at fair value as of the date of the acquisition. The goodwill that was recorded on the transactions represented the excess of the purchase price over the fair value of net assets acquired. If the consideration paid would have been less than the fair value of the net assets acquired, the Company would have recorded a bargain purchase gain. Goodwill is not amortized and is reviewed for impairment on October 1st of each year. If an event occurs or circumstances change that results in the Company's fair value declining to below its book value, the Company would perform an impairment analysis at that time.

Based on the Company's 2013 goodwill impairment analysis, no impairment to goodwill appears to have occurred. The Company is a sole reporting unit for evaluation of goodwill. The Company was trading above its book value by approximately 48% based on its stock price as of October 1, 2013. We believe the estimated fair value of the Company is above its carrying value at December 31, 2013.

The core deposit intangibles on non-maturing deposits, which represent the intangible value of depositor relationships resulting from deposit liabilities assumed through acquisition, are being amortized over the projected useful lives of the deposits. The weighted remaining life of the core deposit intangible is estimated at approximately 4 years at December 31, 2013. Core deposit intangibles are reviewed for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable.

Purchased Credit Impaired Loans ("PCI") loans are acquired loans with evidence of deterioration of credit quality since origination and it is probable at the acquisition date, that the Company will not be able to collect all contractually required amounts. When the timing and/or amounts of expected cash flows on such loans are not reasonably estimable, no interest is accreted and the loan is reported as a non-accrual loan; otherwise, if the timing and amounts of expected cash flows for PCI loans are reasonably estimable, then interest is accreted and the loans are reported as accruing loans. The non-accretable difference represents the difference between the


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undiscounted contractual cash flows and the undiscounted expected cash flows, and also reflects the estimated credit losses in the acquired loan portfolio at the acquisition date and can fluctuate due to changes in expected cash flows during the life of the PCI loans. For non-PCI loans, loan fair value adjustments consist of an interest rate premium or discount on each individual loan and are amortized to loan interest income based on the effective yield method over the remaining life of the loans.

Income Taxes

Deferred income tax assets and liabilities are computed using the asset and liability method, which recognizes a liability or asset representing the tax effects, based on current tax law, of future deductible or taxable amounts attributable to events that have been recognized in the financial statements. A valuation allowance may be established to the extent necessary to reduce the deferred tax asset to the level at which it is "more likely than not" that the tax assets or benefits will be realized. Realization of tax benefits depends on having sufficient taxable income, available tax loss carrybacks or credits, the reversing of taxable temporary differences and/or tax planning strategies within the reversal period and that current legislative tax law allows for the realization of those tax benefits. The Company maintains a relatively small valuation allowance related to a state tax loss carryforward that the Company acquired from the PC Bancorp acquisition. The valuation allowance is based on management's estimation that it is more likely than not that the state tax loss carryforward at December 31, 2013 will not be fully realized.

RESULTS OF OPERATIONS

The Company's increase in total assets over the last eight years is due to the Company's execution of its primary business model focusing on businesses, non-profits, entrepreneurs, professionals and investors, supplemented by the acquisition of PC Bancorp in July of 2012 and COSB in December of 2010. The Company is organized and operated as a single reporting segment, principally engaged in commercial business banking. At December 31, 2013, the Company conducted its lending and deposit operations through eight branch offices, located in the counties of Los Angeles, Ventura and Orange in Southern California. The financial statements, as they appear in this document, represent the grouping of revenue and expense items as they are presented to executive management for use in strategically directing the Company's operations. The Company's growth in loans and deposit liabilities during 2013 was the direct result of successfully executing its growth strategies by maintaining existing customer relationships in addition to adding new customer relationships. The increase in the customer base is a result of establishing new customer relationships from referrals from Board members, current customers, and the local communities the Company actively supports. In addition, the Company targets potential customers whose current bank may be unable to provide the same level of customer support that the customer has come to desire.

Operations Performance Summary for 2013 and 2012

The Company recorded net income of $9.8 million (or $0.93 and $0.90 per common share on a basic and diluted basis, respectively for the year ended December 31, 2013), compared to net income of $1.7 million (or $0.21 per common share on a basic and diluted basis) for the year ended December 31, 2012. This represented an $8.1 million or 466.6% increase over the prior year. The following describes the changes in the major components of the Company's net income for the year ended December 31, 2013 compared to net income for the year ended December 31, 2012.

Net interest income for the year ended December 31, 2013 increased by $13.1 million, to $48.8 million, an increase of 36.6% from 2012 primarily due to both the acquisition of PC Bancorp and the growth of the Company's organic loan portfolio, with an increase in interest income of $13.4 million partially offset by an increase in interest expense of $282,000. The increase in interest income, which increased 35.6% to $50.8 million from $37.5 million, was the direct result of the growth of the Company's average interest earning assets by $248 million to $1,231 million in 2013. Contributing to the increase in interest income during 2013, was a


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change in the mix of the Company's average earnings assets, with loans increasing from 61.7% of interest earning assets to 71.4%, an increase of 9.7% during 2013. The overall yield of the Company's interest earning assets increased from 3.82% during 2012 to 4.13% during 2013, an increase of 31 basis points. Also during 2013, the Company had the positive impact on the full year 2013 earnings from the July 31, 2012 acquisition of PC Bancorp.

The Company's net interest margin increased by 33 basis points from 3.63% in 2012 to 3.96% in 2013. This increase in the 2013 net interest margin was positively impacted by $4.9 million related to the amortization of the fair value discounts related to loans acquired from the COSB and PC Bancorp acquisitions. Included in the $4.9 million was approximately $2.2 million in amortization of fair value discounts earned on early loan payoffs of acquired loans. The amortization of the fair value discounts of the acquired loans of $4.9 million positively impacted the overall 2013 net interest margin by approximately 40 basis points, while the $2.2 million in amortization of the fair value discount on early loan payoffs positively impacting the 2013 net interet margin by approximately 18 basis points. This compares with the year ending December 31, 2012, where the net interest margin was positively impacted by 4 basis points from $451,000 of amortization of the fair value discount earned from the early payoff of two COSB loans.

The increase in interest expense in 2013 by $282,000, a 15.7% increase to $2.1 million from $1.8 million in the prior year, was the result of the increase in the average outstanding interest bearing liabilities of $130.0 million or 28.2% to $591 million in 2013. Partially offsetting this increase was a decrease in the rate paid on interest bearing liabilities from 0.39% in 2012 to 0.35% in 2013. A slight impact to the average rate paid in 2013 occurred as a result of the change in the estimated average life of the subordinated debentures that were acquired from the PC Bancorp acquisition. The estimated life for the amortization of the fair value adjustment on the subordinated debentures was increased during 2013, which reduced interest expense on these instruments, which lowered the overall rate from 8.54% in 2012 to 5.11% in 2013. The overall cost of funds (from all funding sources including non-interest bearing deposits) remained relatively flat at 0.18% for 2013 compared to 0.19% for 2012. The increase in interest expense was primarily the result of the growth in interest bearing deposits and the subordinated debentures acquired from the acquisition of PC Bancorp. The growth in interest bearing deposits which included organic deposit growth in 2013 over 2012 as well as deposits acquired from the acquisition of PC Bancorp in 2012. Average interest bearing deposits increased by $126 million, to $558 million, with an overall rate of 0.27% for 2013. The growth in average interest bearing deposits during 2013 was from both organic growth, as well as from the acquisition of PC Bancorp.

The increases in the earning assets and interest bearing liabilities of the Company result from the Company's ability to execute its marketing and customer growth strategies, including continued support from the Company's founders, shareholders and directors, the hiring of additional relationship managers during both 2012 and 2013, the acquisition of PC Bancorp in 2012 and the continued development of new customers.

Loan interest income for the year ending December 31, 2013 increased by $13.9 million, or 40.7% to $48.2 million, compared to the $34.3 million in 2012. This increase was attributable to an increase in the average outstanding loan balances during 2013 by $273 million, or 45.0%, over average outstanding loans from 2012. The increase in the average outstanding loans balances during 2013 added $15.3 million to loan interest income, as average loan balances increased to $879 million, a 45% increase over 2012. A significant portion of this increase is attributable to the merger of PC Bancorp. At December 31, 2012, the Company's loan portfolio was $855 million and by December 31, 2013 the loan portfolio had increased to $933 million, an increase of $78 million, or 9%. Partially offsetting the increase in interest income from the growth in loan balances was a decrease in the overall yield on loans from 5.65% in 2012 to 5.49% in 2013, a 16 basis point decline. The decline in the yield earned on average loan balances of 16 basis points between the two periods, reducing loan interest income by $1.4 million. During the year ending December 31, 2013, loan interest income was positively impacted by $4.9 million related to the amortization of the fair value adjustments related to loans acquired from both the COSB and PC Bancorp acquisitions. Included in this amortization was approximately $2.2 in amortization of fair value discounts earned on early loan payoffs of acquired loans. The amortization of the fair


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value adjustments related to the acquired loans of $4.9 million positively impacted the overall 2013 loan yield by 56 basis points, with the $2.2 million in amortization of the fair value adjustments on early loan payoffs positively impacting the 2013 loan yield by 25 basis points during 2013. This compares with the year ending December 31 2012, where loan interest income was positively impacted by $451,000 of amortization of the fair value discount earned from the early payoffs of two COSB loans. The Company's loan yield for both the years ending December 31, 2013 and 2012, would have been lower had it not been for these early payoffs. During 2013, 2012 and 2011, the prime rate remained unchanged at 3.25%. The Company had several loans on non-accrual during both 2013 and 2012, which negatively impacted loan interest income during both years, although not materially.

Interest on interest bearing deposits in other financial institutions (which includes interest income on certificates of deposit in other financial institutions) decreased by $75,000, to $732,000, a 9% decline for the year ended December 31, 2013, compared to $807,000 in 2012. This decrease was primarily attributed to a decrease of $20 million in average balances during 2013, with the average balances decreasing from $265 million in 2012 to $245 million during 2013. Interest income was also impacted slightly from a decrease in the rate earned on these short term investments. The yield earned decreased from 0.30% in 2012 to 0.29%, a decrease of 1 basis point between these two years. The decrease in the average balance of $19.6 million resulted in a decline of $52,000 in interest income, and the decline of 1 basis point resulted in a reduction of $23,000 in interest income for the year ending December 31, 2013 compared to 2012. The average balance decrease was the result of the Company reducing its liquidity during a portion of 2013 compared to 2012. This decrease in the yield was a direct result of maintaining larger balances with the Federal Reserve in 2013 compared to 2012, with balances at the Federal Reserve earning 0.25% compared to higher yields being earned in certificates of deposit in other financial institutions. Additionally, the average rate paid on certificates of deposit in other financial institutions has declined over the past two years. The Company had $27 million in certificates of deposit in other financial institutions at December 31, 2012 compared to $60 million at December 31, 2013. The increase in bank certificates was a direct result of the Company electing to reinvest a portion of its excess liquidity maintained with the Federal Reserve into certificates of deposits that mature within one year or less.

Interest income on investment securities declined by $508,000 to $1.9 million, a 20.9% decline for the year ended December 31, 2013 compared to 2012. This decrease was primarily attributable to a significant decline in the overall yield in the Company's securities portfolio. The yield on the Company's investment securities declined from 2.16% for the year ending December 31, 2012 to 1.79% for the year ending December 31, 2013, a decline of 37 basis points, and reduced investment interest income by $396,000 for 2013 compared to 2012. Also impacting the decline was the decline in the average balance in the investment securities portfolio, with a decrease of $5.1 million during 2013 compared to 2012. The decrease in the average balance of the Company's investment securities was the result of investment securities runoff exceeding the purchase and reinvestment of additional investment securities during 2013, this decrease resulted in a decrease of $112,000 in interest income. The decline in the overall yield between 2013 and 2012, was the result of the loss of higher yielding securities due to the runoff of principal balances on the higher yielding mortgage backed securities portfolio and the sale of the private issue CMO's. The reinvestments of funds in new securities between these periods were at substantially lower rates than the yield on securities that were running off between these periods. Also impacting the investment securities yield was the addition of $44.4 million of securities on July 31, 2012 from the PC Bancorp acquisition. The overall yield of the PC Bancorp securities was approximately 1.78% at July 31, 2012, after the fair value adjustment, which negatively . . .

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