Bank of Marin Bancorp
Annual Report 2007

Plain-text annual report

Growing with our Strengths S e r v iC e · C o m m u n i t y · r e l a t i o n S h i p S 2 0 0 7 a n n u a l r e p o r t Bank of Marin has Been coMMitted to strengthening our local coMMunities since our inception. our principles of co MM u n i t y i n vo lv eMe n t a n d e x t r a - ordinary personal service have Been ongoing, while at the saMe tiMe we have successfully grown and expanded our products and services. B a n k o f Ma r i n B a n c o r p Legendary Service Bank of Marin places great value on our employees, realizing our success as a community bank is largely due to our dedicated staff that consistently surpasses customers’ expectations. Phyllis Cope is the epitome of a Bank of Marin employee. With her positive, friendly outlook and “can do” attitude she goes the extra mile for her customers. She’s even been known to chase the FedEx deliveryman down the street in high heels to make sure loan documents got to her customer on time. Phyllis has also been nominated numerous times for the Bank of Marin “legendary service” award. This award is given from one co-worker to another in recognition of going “above and beyond” their normal job responsibilities to provide legendary service. What makes Phyllis different from most bankers is that “no” is not in her vocabulary. She always finds the answer to a problem. Whether it’s meeting a customer after hours, person- ally filling out paperwork that a client normally would, or hand delivering travelers checks to a bank customer just in time for an overseas trip, she always delivers. Inevitably, her customers also become her friends. Phyllis is involved in numerous Novato community organiza- tions, including the Novato Rotary and Chamber of Commerce, where she is one of the original founders of the Women in Business group, Novato Youth Center, Novato Human Needs, the local schools and Novato Community Hospital. Phyllis intertwines her job at Bank of Marin with her love of the community and the busi- nesses and people who live there. She and her husband, former Novato Mayor Bill Cope, have lived in Novato for 24 years. phyllis cope, Vice President, Private Banker, Novato Office b a n k o f m a r i n b a n c o r p · 1 · Community Commitment Bank of Marin is proud to contribute to over 300 local nonprofit groups, plus local chambers of commerce, schools, and service organiza- tions with particular focus on youth and education, health and humanities, the arts, and the environment. Joan Capurro manages Bank of Marin’s community contributions, reviews hundreds of requests, and ultimately contributes on behalf of the Bank to over 300 nonprofit organizations a year. She also recruits and coordinates the volunteer efforts of Bank of Marin employees while volunteering hundreds of hours a year herself. An active and tireless volunteer in the com- munity, who has a deep commitment to helping others, Capurro serves on numerous nonprofit boards, chairs many committees, and serves as a community resource to countless charitable organizations. Her advice has proven invaluable to nonprofits that sometimes do not have the resources to support a large staff. Through Joan’s leadership, Bank of Marin has been named one of the “Top Corporate Philanthropists” in the greater Bay Area by the San Francisco Business Journal for the past five years. The past two years we were one of just ten Bay Area companies to receive the Levi Strauss Community Commitment Award, which recognizes companies that give more than 1% of pretax profit to charities. Bank of Marin established the Spirit of Marin Awards in 1993, which honors others who give back to the community. This popular county-wide event recognizes and celebrates the volunteer efforts of local businesses and individuals each year chosen by the Marin County Chambers of Commerce. The Spirit of Marin award was inspired by the life of Dr. Jim Dawson, a Bank of Marin organizer and director, whose philosophy of life was to give fully back to his community. Joan capurro, Senior Vice President, Director Community Relations, San Rafael Office b a n k o f m a r i n b a n c o r p · 2 · Day in anD Day out bank of marin employees strive to leaD by ex ample in the communities where we live anD work. our employees anD Direc tors c o n t r i b u t e o v e r 7, 0 0 0 vo l u n t e e r hours a year. our loan portfolio is co n c e n t r at e D i n o u r co mmu n i t i e s, which in turn strengthens our local economy. truly, bank of marin is com- mit teD to supporting our communit y in many ways. b a n k o f m a r i n b a n c o r p · 3 · bank of marin is known for its expe- rienceD team of bankers who consis - tently surpass client expectations in D e l i v e r i n g pe r s o n a l i z e D f i n a n c i a l services. our managers specialize in prov i Di n g c r e at i v e fi n a n c i a l so lu - tions, quick turnarounD, flexibilit y, anD ongoing gui Dance for our busi- ness customers. b a n k o f m a r i n b a n c o r p · 4 · Building Relationships We strive to build long-term valued rela- tionships based on trust and respect with our customers and shareholders, among the community, and within the Bank. Dan’s twenty-four years of exceptional banking experience com- bined with his outgoing, friendly manner and energetic approach as Regional Manager have helped him build highly successful busi- ness partnerships. His focus is to be fully immersed in the community while developing genuine customer relationships. He specializes in matching customers’ financial needs with appropriate solutions while providing expertise in business consultation, real estate lend- ing, asset management, and commercial lending. In fact, Dan’s keen sense of business knowledge has helped pro- pel Bank of Marin into the market leader as the number one business bank in Marin County. That’s because Dan, like many other Bank of Marin bankers, is an expert at resolving financial issues for his customers. It takes an understanding and knowl- edge of local businesses, experience with commercial lend- ing, responsiveness, and creativity. Like all of our managers, Dan can be found at numerous Chamber, Rotary and Lions Club functions, plus volunteering at community and nonprofit events. His nonprofit focus includes advocating for affordable housing for seniors as Vice President of Rotary Housing, guiding the Center for Attitudinal Healing as past President of the Board, and leading Christ Church in Sausalito as Senior Warden. Dan rheiner, Senior Vice President, Southern Marin Regional Manager, Sausalito Office b a n k o f m a r i n b a n c o r p · 5 · To Our Fellow Shareholders: Throughout the challenging year of 2007, Bank of Marin stayed true to its mission of serving local businesses, individuals, and communities with integrity and sound decision making. We are pleased with another successful year of solid performance. We continue to act as a dedicated business We actively managed our balance sheet partner to our customers, providing knowl- by taking advantage of several oppor- edgeable advice, creativity, and extraordi- tunities in 20 07. The sale of nary service. Our ongoing efforts throughout two underperforming asset the year moved us to a leadership position as categories—the indirec t the number one business bank in Marin auto and the Visa credit County. We will continue to focus on long- card portfolios—provided term sustainable growth in core deposits and nearly $ 8 0 million for loans, new products, and focused bank-wide funding higher yielding business strategies. relationship loans. We initiated a $5 million com- Bank of Marin had excellent deposit growth mon stock repurchase and liquidity in 2007. This combination allowed plan, reflecting the confi- us to realize a lower average cost of funds dence that senior man- than most of our competitors. Our loan port- agement and the Board folio grew substantially, with a diversified mix of Directors have in the of commercial, construction, commercial real Bank’s future. Additionally, estate, personal, home equity, and Tenants- Bank of Marin Bancorp was in-Common loans. Bank of Marin does not formed in July with Bank of offer traditional residential mortgage loans, Marin as its wholly-owned and we have never been in the subprime loan subsidiary, allowing us addi- business. Our focus on relationship banking tional strategic flexibility. has us growing at a strong pace while main- taining excellent credit quality. Joel sklar, mD, Chairman of the Board b a n k o f m a r i n b a n c o r p · 6 · Our new San Francisco commercial loan pro- one of the “Top Corporate Philanthropists duction office opened mid-year, and we have in the Bay Area” by the San Francisco rapidly established new lending relationships Business Times. in the City and Marin. The downtown Mill Valley branch is under construction and As we move into 2008, we believe our Bank is expected to open in late spring of 2008. We well positioned to successfully serve our continue to actively pursue new opportuni- shareholders, employees, and the commu- ties within our footprint that will enhance nity. We are proud of the progress we made our number one position in the busi- in 2007, and we look forward with great opti- ness market while we extend our mism to 2008 and beyond. high level of service to a greater number of customers. Sincerely, Bank of Marin’s dedicated employees worked diligently in 2007, resulting in several accomplishments and recog- nitions. After a year of con- certed effort from our Marin based staff, we were certi- fied as a Marin County Green Business. We were named by the North Bay Business Journal as one of the top “Best Places to Work in the North Bay.” russell a. colombo President and Chief Executive Officer And for the fourth consecu- Joel sklar, mD tive year, we were honored as Chairman of the Board russell a. colombo, President and Chief Executive Officer b a n k o f m a r i n b a n c o r p · 7 · Directors & Officers Bank of Marin’s directors and employees are represented on over 135 different boards in Marin and Sonoma counties, including, but not limited to, the North Bay Leadership Council, American Red Cross, Marin YMCA, Buckelew Programs, Center for Attitudinal Healing, Novato Human Needs, Image for Success, Marin County School Volunteers, Hanna Boys Center, Petaluma People Services, and Petaluma Ecumenical Properties. B oa r d o f d i r e c t o r s James D. Kirsner Business Consultant Judith O’Connell Allen J. Dietrich Stroeh Community Volunteer Partner, CSW/Stuber-Stroeh J. Patrick Hunt Joel Sklar, MD Partner, Hunt Investments Partner, Cardiology Assoc. of Marin Engineering Group Robert Heller and San Francisco, Chairman, Bank Former Governor, Federal Reserve of Marin & Bank of Marin Bancorp Board and former President and CEO, Visa USA Jan Yanehiro Owner, Media and Marketing Strategic Planning William H. McDevitt, Jr. President, McDevitt & McDevitt Construction Corp. James E. Deitz President, Marin Business Services Stuart Lum President, Pacific Mortgage Investors Russell A. Colombo President and Chief Executive Officer Joseph D. Martino Retired Banker Brian M. Sobel Partner, Sobel Communications Bank of Marin & Bank of Marin Bancorp Norma J. Howard Business Consultant e x e c u t i v e o f f i c e r s pictured from left to right Peter Pelham Nancy Rinaldi Boatright Executive Vice President and Senior Vice President and Branch Executive Corporate Secretary Russell A. Colombo Christina J. Cook President and Chief Executive Officer Executive Vice President and Kevin K. Coonan Executive Vice President and Chief Credit Officer Chief Financial Officer Michael E. Besselievre Executive Vice President and Chief Information Officer b a n k o f m a r i n b a n c o r p · 8 · r e l l e H n a D y b y h p a r g o t o h P m o c . s r o n n o c - n a r r u c . w w w / . c n I , s r o n n o C & n a r r u C y b d e n g i s e D Committed to Your Business and Our Community At Bank of Marin, we always go the extra mile. We respond quickly to our customer’s needs and work hard to provide creative and flexible financing solutions. Bank of Marin’s customer service is simply superior. b u s i n e s s s e r v i c e s We offer a variety of innovative financial services tailored to any size business. · Business Internet Banking · ACH Origination & Management · Remote Deposit · Positive Pay · Zero Balance & Sweep Accounts · Business Credit Cards & ATM Cards · Credit Card Processing · Courier Services co m m e r c i a l l oa n s Our experienced commercial lenders respond quickly to individual situations to provide flexible and creative financing. · Commercial Loans & Lines of Credit · Construction Loans · Commercial Real Estate Loans · Equipment Loans · Asset Based Loans b u s i n e s s co n s u ltat i o n Our dedicated Bank of Marin team acts as knowledgeable trusted financial partners who help analyze customers’ financial goals and provide appropriate guidance and resources. We’re able to blend the resources of a large financial organization with the responsiveness of a local bank. Bank of Marin’s experienced, professional bankers work as business consultants and can offer assistance on business growth and expansion, internal fraud protection, and business succession. This annual report is printed on 100% post-consumer recycled fiber. Corporate information t r a n s f e r ag e n t a n d r e g i s t r a r Registrar and Transfer Company 10 Commerce Drive Cranford, NJ 07016-3506 (800) 368-5948 www.rtco.com i n d e p e n d e n t au d i t o r s Moss Adams LLP Stockton, CA l e g a l co u n s e l Reitner Stuart & Moore San Luis Obispo, CA n a s daq s y m b o l BMRC a n n ua l m e e t i n g 6:00 p.m., May 13, 2008 10 Avenue of the Flags San Rafael, CA 94903 p e r i o d i c r e p o r t s The Company’s annual report for 2007 on Form 10-K, which is required to be filed with the SEC, is available to any shareholder without charge. The report may be obtained by written request to Corporate Secretary, Bank of Marin Bancorp, P.O. Box 2039, Novato, CA 94948. It is available in the Investor Relations section of the Company’s website at www.bankofmarin.com. f o r wa r d - l o o k i n g s tat e m e n t s This discussion of financial results includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of 1934. The Company’s actual results may differ materially from these projected results. Forward-looking statements are based on managements current expectations regarding issues that may impact the Company’s earnings in future periods. A number of factors, many of which are beyond the Company’s control, could cause future results to vary materially from current management expectations. Such factors include, but are not lim- ited to, general economic conditions, changes in interest rates, deposit flows, real estate values and competition; changes in accounting principles, poli- cies or guidelines; changes in legisla- tion or regulation; and other economic, competitive, governmental, regulatory and technological factors affecting the Company’s operations, pricing, prod- ucts and services, and other important factors detailed in various FDIC and SEC filings made periodically by the Company. The Company does not undertake any obligation to update forward-looking statements to reflect n e w c i r c u m s t a n c e s o r e v e n t s o r otherwise. a d m i n i s t r at i v e h e a d q u a r t e r s 504 Redwood Boulevard, Novato, CA 94947 (415) 763-4520 s a n f r a n c i s c o 235 Pine Street, San Francisco, CA 94104 (415) 403-5580 s a u s a l i t o 3 Harbor Drive, Sausalito, CA 94965 (415) 289-8710 m i l l v a l l e y 23 Reed Boulevard, Mill Valley, CA 94941 (415) 381-2265 19 Sunnyside Avenue, Mill Valley 94941 (415) 380-4665 c o r t e m a d e r a 50 Madera Boulevard, Corte Madera, CA 94925 (415) 927-2265 s a n r a f a e l 999 Andersen Drive, San Rafael, CA 94901 (415) 259-0365 1101 Fourth Street, San Rafael, CA 94901 (415) 485-2265 4460 Redwood Highway, San Rafael, CA 94903 (415) 472-2265 n o v at o 368 Ignacio Boulevard, Novato, CA 94949 (415) 884-2265 1450 Grant Avenue, Novato, CA 94945 (415) 899-7338 p e ta l u m a 799 Baywood Drive, Petaluma, CA 94954 (707) 781-2210 8 4th Street, Petaluma, CA 94952 (707) 781-1810 1371 N. McDowell Boulevard, Petaluma, CA 94954 (707) 658-4210 w w w . b a n k o f m a r i n . C o m 2 0 0 7 A N N U A L R E P O R T B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T Financial Performance *Restated for all stock dividends and stock splits. PAGE 2 – SELECTED FINANCIAL DATA / PAGE 3 – BUSINESS OF THE BANK / PAGE 4 – MANAGEMENT’S DISCUSSION AND ANALYSIS / PAGE 8 – RESULTS OF OPERATIONS / PAGE 15 – FINANCIAL CONDITION / PAGE 25 – REPORT OF INDEPENDENT AUDITORS / PAGE 26 – MANAGEMENT REPORT TO STOCKHOLDERS / PAGE 27 – FINANCIAL STATEMENTS / PAGE 31 – NOTES TO FINANCIAL STATEMENTS / PAGE 52 – STOCK PRICE PERFORMANCE · 1 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T Selected Financial Data At or for the Year Ended December 31, (dollars in thousands, except per share data) AT D E C E M B E R 3 1 Total assets Total loans Total deposits Total stockholders’ equity Equity-to-asset ratio F O R Y E A R E N D E D D E C E M B E R 3 1 Net interest income Provision for possible loan losses Non-interest income Non-interest expense Net income Net income per share (diluted)* Cash dividend payout ratio 2007 2006 2005 2004 2003 ’06/’07 $ 933,901 $ 876,578 $ 840,449 $ 737,094 $ 642,607 719,778 686,661 576,957 450,881 736,697 721,172 645,079 584,116 55,577 724,878 834,642 87,774 78,221 89,525 65,608 9.4% 10.2% 9.3% 8.9% 8.6% $ 42,742 $ 41,733 $ 39,442 $ 32,237 $ 27,656 686 2,960 17,817 7,473 1.44 1,541 3,708 22,498 11,737 2.12 934 3,643 19,620 9,518 1.76 20.1% 1,266 3,972 25,891 11,883 2.11 20.8% 685 5,718 27,673 12,324 2.31 21.4% 8.4% 0% % change 6.5% 0.7 13.3 (2.0) 2.4% (45.9) 44.0 6.9 3.7 9.5 *Restated for all stock dividends and stock splits. On July 1, 2007, Bank of Marin Bancorp became the parent holding company for Bank of Marin. Financial informa- tion prior to July 1, 2007 pertains to Bank of Marin. Subsequent to that date, the information pertains to Bank of Marin Bancorp. The information is comparable for all periods as the sole subsidiary of Bank of Marin Bancorp is Bank of Marin. D I V I D E N D I N F O R M AT I O N , S T O C K P R I C E A N D M A R K E T P L A C E D E S I G N AT I O N In April 2006 and April 2005, the Board of Directors declared 5% stock dividends. In April 2004, the Board of Directors declared a 3-for-2 stock split. The table below presents cash dividends per share in the last four fiscal years. Q1 Q2 Q3 Q4 2007 $0.12 $0.13 $0.13 $0.13 2006 $0.10 $0.12 $0.12 $0.12 2005 -- -- $0.10 $0.10 2004 -- $0.40 -- -- During 2007, there were 4,139 reported trades at prices ranging from a high of $39.49 to a low of $27.00. In 2006 there were 2,961 trades ranging from a high of $37.00 to a low of $30.00. Bank of Marin Bancorp common stock trades on the NASDAQ Capital Market under the symbol BMRC. There were approximately 700 holders of record of the Bank of Marin Bancorp’s common stock as of February 20, 2008. · 2 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T Business of the Bank GGEENNEERRAALL On July 1, 2007 (the "Effective Date"), a bank holding company reorganization was completed whereby Bank of Marin Bancorp ("Bancorp") became the parent holding company for Bank of Marin (the "Bank"), its sole subsidiary. On the Effective Date, a tax-free exchange was completed whereby each outstanding share of Bank of Marin common stock was converted into one share of Bank of Marin Bancorp common stock and Bank of Marin became a wholly-owned subsidiary of the holding company. Bancorp assumed the ticker symbol BMRC, which was formerly used by Bank of Marin. Prior to the Effective Date, Bank of Marin filed reports and proxy statements with the Federal Deposit Insurance Corporation ("FDIC") pursuant to Sections 12 of the Securities Exchange Act of 1934 (the "1934 Act"). Upon formation of the holding company, Bancorp became subject to regulation under the Bank Holding Company Act of 1956, as amended, which subjects Bancorp to Federal Reserve Board reporting and examination requirements. Bank of Marin was incor- porated in August 1989, received its charter from the California Superintendent of Banks (now the California Department of Financial Institutions) and commenced operations in January 1990. The Bank is an insured bank under the Federal Deposit Insurance Act. MMAARRKKEETT AARREEAA AANNDD CCUUSSTTOOMMEERR BBAASSEE The Bank's primary market area reaches from southern Sonoma County south to San Francisco and lies between the Pacific Ocean on the west and San Pablo Bay to the east. The Bank's customer base is made up of business and personal banking relationships from the communities near the branch office locations. LLOOAANNSS The Bank offers a broad range of commercial and retail lending programs that includes commercial loans, construction financing, consumer loans, and home equity loans and lines of credit. Through a third party vendor, the Bank also offers a proprietary Visa credit card combined with a rewards program to its cus- tomers, as well as a Business Visa program for business and pro- fessional customers. For reporting purposes the lending programs are consolidated into the general categories of commercial loans, real estate loans and installment loans. At December 31, 2007, these broad categories totaled $724.9 million, and accounted for approximately 17%, 78% and 5%, respectively, of the loan portfo- lio. Of the real estate loans, 46% are non-owner occupied com- mercial real estate loans, 23% are owner occupied commercial real estate loans, 17% are construction loans, 8% are personal real estate loans and 6% are home equity loans. The interest rates on commercial loans are either fixed or tied to the Wall Street Journal prevailing prime rate and change as rate changes are reported. The loan portfolio is fairly evenly split between the two interest rate types. Commercial lines of credit generally have terms of one to two years. Commercial term loans generally have terms of three to five years. Loans secured by real property include commercial real estate loans, consumer loans, lines of credit and construction financing. Commercial real estate loans are generally written for ten years with fixed rates for the first 5 years, which are then adjusted based on an indexed spread for the remaining 5 years. Consumer real estate secured loans include equity lines of credit and installment loans for various consumer purposes. Generally, equity lines are for a term of ten years or less and are secured by first or second deeds of trust on residential properties and bear interest at a float- ing rate tied to the Wall Street Journal prevailing prime rate. Usually, home equity installment loans are for a term of 15 years or less and have a fixed rate of interest. The Bank offers construction financing to developers of single- family and multi-family residences and commercial real estate properties. Construction loans are typically repaid through perma- nent financing by the Bank or from other financial institutions. Usually these loans have terms of twelve to eighteen months, have fixed rates of interest or floating rates tied to the Wall Street Journal prevailing prime rate, and are secured by deeds of trust. DDEEPPOOSSIITTSS The Bank offers a variety of checking and savings accounts, and a number of time deposit alternatives, including interest bearing and non-interest bearing personal and business checking accounts and time certificates of deposit. The Bank also offers remote deposit capture and direct deposit of payroll, social security and pension checks. A valet pick-up service is available to the Bank's professional and business clients. Bank of Marin's ATM system is linked into the STAR, PLUS and NYCE networks, and the Bank offers a proprietary Visa debit card. The Bank offers its depositors 24-hour access to their accounts by telephone and to both con- sumer and business accounts through its internet banking prod- ucts. Bank of Marin attracts deposits from individuals, merchants, small to medium sized businesses and professionals who live and/or work in its market areas. Approximate 88% of the Bank's deposits come from Marin and southern Sonoma counties. Approximately 62% of the Bank's deposits are from businesses and 38% are from individuals. · 3 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T WWEEAALLTTHH MMAANNAAGGEEMMEENNTT SSEERRVVIICCEESS The Bank offers Wealth Management Services which include cus- tomized investment portfolio management, financial planning, trust administration, estate settlement and custody services. The Bank also offers 401(k) plan services to small and medium busi- nesses through a third party vendor. PPRRIIVVAATTEE BBAANNKKIINNGG In February 2007 the Bank introduced branch-based private bank- ing to select customers as a natural extension of the Bank's serv- ices. The Bank's Private Banking includes deposit services, loans, investment management, trust administration, financial planning and advice on charitable giving. Management’s Discussion and Analysis The following discussion of financial condition and results of oper- ations for each of the years in the three-year period ended December 31, 2007 should be read in conjunction with Bancorp's financial statements and related notes thereto, included in this Annual Report. Average balances, including balances used in cal- culating certain financial ratios, are generally comprised of aver- age daily balances. Earnings per share and book value per share amounts in 2005 have been restated to reflect the 5% stock dividend declared in April 2006. HHOOLLDDIINNGG CCOOMMPPAANNYY On May 8, 2007 Bank of Marin shareholders approved the forma- tion of a bank holding company. On July 1, 2007, the holding company, Bank of Marin Bancorp, acquired Bank of Marin as its wholly owned subsidiary. The holding company is expected to provide flexibility in meeting the financing needs of the Bank and in responding to evolving changes in the banking and financial services industries. See Note 1 of the Notes to Financial Statements. SSHHAARREE RREEPPUURRCCHHAASSEE PPRROOGGRRAAMMSS In October 2006, Bank of Marin received approval from the California Department of Financial Institutions (DFI) and the Federal Deposit Insurance Corporation (FDIC) to buy back up to 10%, or approximately 545,884 of the Bank's 5,458,838 then-out- standing shares, not to exceed $15 million. The repurchase pro- gram allowed the Bank to purchase common shares for a period of approximately twelve months from the approval date in the open market or in privately negotiated transactions. In 2006 the Bank repurchased 115,625 shares at prices ranging from $32.43 to $36.25 for a total cost of $4.0 million. In 2007 through February 28, the Bank purchased an additional 289,692 shares at prices ranging from $36.05 to $39.10 for a total cost of $11.0 million, thereby concluding this share repurchase program. In November 2007 Bancorp's Board of Directors approved an additional plan to repurchase common shares of Bancorp up to $5 million. No regulatory approval was required for this repurchase plan as Bancorp was exempted under the provisions of Regulation Y of the Federal Reserve Board. In November and December 2007, Bancorp repurchased a total of 51,732 shares at an average price of $29.96 for a total cost of $1.5 million. In 2008 through January 31, Bancorp purchased an additional 5,100 shares at an average price of $28.75 for a total cost of $147 thousand. For discussion of stock dividends and share repurchases, see Note 9 of the Notes to Financial Statements. FFOORRWWAARRDD--LLOOOOKKIINNGG SSTTAATTEEMMEENNTTSS This discussion of financial results includes forward-looking state- ments within the meaning of Section 27A of the Securities Act of 1933, as amended, (the "1933 Act") and Section 21E of the Securities Exchange Act of 1934, as amended, (the "1934 Act"). Those sections of the 1933 Act and 1934 Act provide a "safe har- bor" for forward-looking statements to encourage companies to provide prospective information about their financial performance so long as they provide meaningful, cautionary statements identi- fying important factors that could cause actual results to differ sig- nificantly from projected results. Bancorp's forward-looking statements include descriptions of plans or objectives of management for future operations, products or services, and forecasts of its revenues, earnings or other meas- ures of economic performance. Forward-looking statements can be identified by the fact that they do not relate strictly to histori- cal or current facts. They often include the words "believe," "expect," "intend," "estimate" or words of similar meaning, or future or conditional verbs such as "will," "would," "should," "could" or "may." · 4 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T Forward-looking statements are based on management's current expectations regarding economic, legislative, and regulatory issues that may impact Bancorp's earnings in future periods. A number of factors - many of which are beyond management's con- trol - could cause future results to vary materially from current management expectations. Such factors include, but are not limit- ed to, general economic conditions, changes in interest rates, deposit flows, real estate values and competition; changes in accounting principles, policies or guidelines; changes in legisla- tion or regulation; and other economic, competitive, governmen- tal, regulatory and technological factors affecting Bancorp's oper- ations, pricing, products and services. These and other important factors are detailed in the Risk Factors section of Bancorp's 2007 Form 10-K as filed with the SEC, copies of which are available from Bancorp at no charge. Forward-looking statements speak only as of the date they are made. Bancorp does not undertake to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made or to reflect the occurrence of unanticipated events. loans, an allowance factor for pools of credits, and allowances for changing environmental factors (e.g., portfolio trends, concentra- tion of credit, growth, economic factors). Allowances for identified problem loans are based on specific analysis of individual credits. Loss estimation factors for loan pools are based on analysis of local economic factors applicable to each loan pool. Due to the Bank's minimal historic losses, loss estimation factors are based only in part on the previous historical loss experience for each pool. Allowances for changing environmental factors are manage- ment's best estimate of the probable impact these changes have had on the loan portfolio as a whole. Share-Based Payment On January 1, 2006, the Bank adopted the provisions of Statement of Financial Accounting Standard ("SFAS") No.123R, "Share-Based Payment," which requires that all share-based pay- ments, including stock-options, be recognized as an expense in the income statement based on the grant-date fair value of the award with a corresponding increase to common stock. CCRRIITTIICCAALL AACCCCOOUUNNTTIINNGG PPOOLLIICCIIEESS Management considers three accounting policies to be critical: the Allowance for Loan Losses, Share-Based Payment and Fair Value Option for Financial Assets and Liabilities. Allowance for Loan Losses Management has considered the accounting principles upon which Bank of Marin Bancorp's financial reporting depends and has determined the allowance for loan losses to be the most criti- cal accounting policy. The allowance for loan losses is discussed in further detail beginning on page 20 of this Annual Report. The Bank formally assesses the adequacy of the allowance for loan losses on a quarterly basis. Determination of the adequacy is based on ongoing assessments of the probable risk in the out- standing loan portfolio. These assessments include the periodic re-grading of loans based on changes in their individual credit characteristics including delinquency, seasoning, recent financial performance of the borrower, economic factors, changes in the interest rate environment, and other factors as warranted. Loans are initially graded when originated. They are reviewed as they are renewed, when there is a new loan to the same borrower and/or when identified facts demonstrate heightened risk of default. Review of larger problem loans occurs at least quarterly. Confirmation of the quality of the grading process is obtained by independent credit reviews conducted by consultants specifically hired for this purpose and by various bank regulatory agencies. The Bank's method for assessing the appropriateness of the allowance includes specific allowances for identified problem For additional discussion of the impact of SFAS No.123R, see Notes 1, 9, and 10 of the Notes to Financial Statements. Fair Value Option for Financial Assets and Financial Liabilities and Fair Value Measurements Effective January 1, 2007, Bank of Marin elected early adoption of 159, "The Fair Value Option for Financial Assets and Financial Liabilities" and SFAS No. 157,"Fair Value Measurements." Upon adoption of SFAS No. 159, the Bank selected the fair value option for its indirect auto loan portfolio. The changes in fair value of the selected financial instruments after the initial adoption at each bal- ance sheet date were recorded through earnings prior to the sale of the portfolio on June 5, 2007. The Bank determined fair value at January 1, 2007 and March 31, 2007 based on certain criteria including weighted average interest rate, remaining term and FICO credit score. The expected cash flows were discounted using Treasury rates and a spread above the Treasury rate was applied based on recent sales of similar assets. The assumptions represent management's best estimates, but these estimates involve inher- ent uncertainties and the application of management's judgment. As a result, if other assumptions had been used, the Bank's record- ed unrealized gain in the first quarter of 2007 could have been materially different from that reflected in these financial state- ments. As a result of the Bank's fair value measurement election for the auto loan portfolio, the Bank recorded a cumulative-effect adjust- ment of $1.5 million, net of tax, as a reduction of retained earnings as of January 1, 2007. In addition, $190 thousand and $520 thou- · 5 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T sand of pre-tax net gains were recorded in the Bank's second and first quarter earnings, respectively (2 cents and 6 cents per diluted share, respectively, on an after-tax basis), representing the change in fair value of such instruments during those periods after giving effect to the cumulative-effect adjustment. For Additional discussion of the impact of the Adoption of SFAS No. 157 and 159, see Note 15 of the Notes to Financial Statements. RREECCEENNTTLLYY IISSSSUUEEDD AACCCCOOUUNNTTIINNGG SSTTAANNDDAARRDDSS In December 2007, the FASB issued SFAS No. 141 (revised 2007), "Business Combinations". SFAS No. 141R establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any non-controlling interest in the acquiree. The statement also provides guidance for recog- nizing and measuring the goodwill acquired in the business com- bination and determines what information to disclose to enable users of the financial statement to evaluate the nature and finan- cial effects of the business combination. SFAS No. 141R is effec- tive for financial statements issued for fiscal years beginning after December 15, 2008. Accordingly, any business combinations Bancorp engages in will be recorded and disclosed following existing generally accepted accounting principles until January 1, 2009. Bancorp expects SFAS No. 141R would have an impact on its consolidated financial statements when effective if it acquires another company, but the nature and magnitude of the specific effects will depend upon the nature, terms and size of the acqui- sitions Bancorp consummates after the effective date. the FASB issued SFAS No. 160, In December 2007, "Noncontrolling Interests in Consolidated Financial Statements," which provides guidance for accounting and reporting of noncon- trolling (minority) interests in consolidated financial statements. The statement is effective for fiscal years and interim periods with- in fiscal years beginning on or after December 15, 2008. Bancorp does not hold minority interests in subsidiaries, therefore it is expected that SFAS No. 160 will have no impact on its financial condition or results of operations. In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements," which clarifies the definition of fair value, describes methods used to appropriately measure fair value in accordance with generally accepted accounting principles and expands fair value disclosure requirements. This statement applies whenever other accounting pronouncements require or permit fair value measurements and is effective for fiscal years beginning after November 15, 2007, with early adoption allowed effective January 1, 2007 in conjunction with the early adoption of SFAS No. 159. The adoption of SFAS No. 157 effective January 1, 2007 did not impact financial position or results of operations. On February 15, 2007, the FASB released SFAS No. 159, which permits entities to choose to measure eligible financial instru- ments at fair value at specified election dates. Under SFAS No. 159 an entity records unrealized gains and losses in earnings on items for which the fair value option has been elected at each sub- sequent reporting date. The objective is to mitigate volatility in reported earnings without having to apply complex hedge accounting provisions. The provisions of SFAS No. 159 are effec- tive for fiscal years ending on or after November 15, 2007, with early adoption allowed effective January 1, 2007. Effective January 1, 2007, the Bank elected early adoption of SFAS No. 159. Upon adoption, the Bank selected the fair value option for its indirect auto loan portfolio, which was subsequently sold on June 5, 2007. For further information on the financial effect of SFAS No. 159 see, Note 15 of the Notes to Financial Statements. In July 2006, the FASB issued Interpretation (FIN) No. 48, "Accounting for Uncertainty in Income Taxes - An Interpretation of FASB Statement No. 109," which clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with FASB Statement No. 109, "Accounting for Income Taxes." FIN 48 establishes a "more-likely- than-not" recognition threshold that must be met before a tax benefit can be recognized in the financial statements. For tax posi- tions that meet the more-likely-than-not threshold, an enterprise may recognize only the largest amount of tax benefit that is greater than fifty percent likely of being realized upon ultimate settlement with the taxing authority. The cumulative effect of applying the provisions of FIN 48 would be recognized as an adjustment to the beginning balance of retained earnings. FIN 48 was adopted January 1, 2007 and has not had a material impact on financial condition or results of operations. In September 2006, the Emerging Issues Task Force (EITF) reached a final consensus on Issue No. 064-4 (EITF 06-4), "Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements." EITF 06- 4 requires employers to recognize a liability for future benefits pro- vided through endorsement split-dollar life insurance arrange- ments that extend into postretirement periods in accordance with SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions or APB Opinion No. 12, Omnibus Opinion-1967." The provisions of EITF 06-4 become effective on January 1, 2008 and are to be applied as a change in accounting · 6 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T principle either through a cumulative-effect adjustment to retained earnings or other components of equity or net assets in the statement of financial position as of the beginning of the year of adoption, or through retrospective application to all prior peri- ods. The Bank's split-dollar life insurance benefits are limited to the employee's active service period. Therefore it is expected that EITF 06-4 will have no impact on financial condition or results of operations. In September 2006, the FASB issued SFAS No. 158, "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements Nos. 87, 88, 106 and 132(R)." SFAS No. 158 requires employers to recognize the under- funded or over-funded status of a defined benefit postretirement plan as an asset or liability in its statement of financial position and to recognize changes in the funded status in the year in which the changes occur through accumulated other comprehensive income. Additionally, SFAS No. 158 requires employers to meas- ure the funded status of a plan as of the date of its year-end state- ment of financial position. The new reporting requirements and related new footnote disclosure rules of SFAS No. 158 are effec- tive for fiscal years ending after December 15, 2006. The new measurement date requirement applies for fiscal years ending after December 15, 2008. As the Bank has no pension or other post-retirement benefit plans, it is expected that SFAS No. 158 will have no impact on financial condition or results of operations. EEXXEECCUUTTIIVVEE SSUUMMMMAARRYY The majority of Bancorp's and the Bank's assets and liabilities are monetary. As a result, movement of interest rates plays a large part in the risk to earnings. In 2006, the Bank's earnings were impacted by interest rate com- pression in which its deposit rates rose rapidly while loan rates remained flat. The rise in deposit rates stemmed primarily from local market competition while loan rates reflected general eco- nomic conditions in which the interest yield curve was flat. A more normal yield curve slopes upward giving a premium to longer term assets, such as term loans. 2007 was a year of rapid change. In the first half of the year, com- petition for funds in the Bank's service area continued to put upward pressure on deposit rates while economic factors resulted in relatively flat loan rates. As a result of a management decision, the Bank sold its less profitable indirect auto loan portfolio. The Bank also sold its Visa portfolio to a third party vendor who can provide a more flexible product while retaining the Bank's brand- ing on the Visa card. Proceeds from these sales markedly improved the Bank's liquidity, which lessened pressure to com- pete on deposit pricing and provided funds for more profitable lending activity. Beginning in August through the end of 2007, in response to sudden turmoil in the housing market and concerns over a possible recession, the Federal Reserve lowered its Federal funds rate (the rate at which banks may borrow from each other) by 100 basis points, resulting in lower offered deposit rates by the Bank, which positively affected the interest margin, along with the reinvestment of loan sale proceeds into higher-yielding relation- ship loans. Although variable rate loans adjusted downward with the decline in the Prime rate, the yield on fixed rate loans, which comprise about half of the loan portfolio, remain relatively unchanged. These changes resulted in a significant improvement to the net interest margin in the fourth quarter of 2007. In January 2008, the Federal Reserve continued dropping target rates by another 125 basis points, and management expects rate cuts to continue. This will result in loans repricing downward. Potentially the largest factor to affect the Bank's net interest mar- gin in 2008 could be the level to which the Bank is responsive to competitive deposit pricing in its market, which will be influenced by the Bank's liquidity level. Bancorp's serving area has been somewhat insulated from the recent turmoil in the residential housing market due to the upscale nature of its market and relatively stable housing prices due to lim- ited area for housing expansion. Bancorp itself has not been impacted by defaults on sub-prime mortgages. Bancorp holds no sub-prime mortgage loans nor does it invest in mortgage-backed securities collateralized by sub-prime loans. A relatively small por- tion of the loan portfolio (6.2%) is comprised of residential loans, which primarily relate to "tenancy in common" loans made to highly qualified applicants at a maximum loan to value of 80%. This product has shown resiliency in the recently volatile residen- tial housing market. An additional 4.7% of the loan portfolio is comprised of home equity loans and lines of credit, at a maximum loan to value of 80%, in which historical delinquencies have been minimal. Credit quality remains very strong with only $144 thou- sand in non-accrual loans at December 31, 2007. Through two share repurchase programs in 2006 and 2007, man- agement has used excess capital to enhance earnings per share. Shares totaling 341,424 were repurchased in 2007 for $12.6 mil- lion and shares totaling 115,625 were repurchased in 2006 for $4.0 million under the repurchase programs. Management is constantly alert for opportunities to offset the impact of interest rate compression on earnings including offering new fee income services and expansion of the franchise. The deci- sion to create a bank holding company was made in order to pro- · 7 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T vide additional flexibility in meeting financing needs, to facilitate acquisition of other banks and move into other financial services. In May of 2007, a loan production office was opened in San Francisco to help drive commercial loan and core deposit growth. Bancorp has received regulatory approval to open a second branch in Mill Valley which is scheduled to open in the second quarter of 2008. Banking is a highly regulated industry. Management continually monitors the Bank's compliance with regulatory requirements including capital adequacy and liquidity. Upon formation of the bank holding company, Bank of Marin Bancorp became subject to regulation under the Bank Holding Company Act of 1956, as amended which subjects Bancorp to Federal Reserve Board reporting and examination requirements. As a California state- chartered insured bank, the Bank remains subject to regulation and periodic examination by the California Department of Financial Insurance Institutions and the Federal Deposit Corporation. RREESSUULLTTSS OOFF OOPPEERRAATTIIOONNSS Overview Highlights of Bancorp's results are presented in the following table: As of and for the 12 months ended December 31, (Dollars in thousands, except per share data) 2007 For the period: Net income Net income per share* $ 12,324 2006 2005 $ 11,883 $ 11,737 Basic Diluted Return on average equity Return on average assets Cash dividend payout ratio Efficiency ratio At period end: $ 2.38 $ 2.31 14.44% 1.38% 21.43% 57.10% $ 2.21 $ 2.11 13.83% 1.38% 20.81% 56.65% $ 2.28 $ 2.12 16.15% 1.46% 8.37% 52.14% Book value per share* Total assets Total loans Total deposits Loan-to-deposit ratio $ 17.13 $ 933,901 $ 724,878 $ 834,642 $ 16.68 $ 876,578 $ 719,778 $ 736,697 $ 15.02 $ 840,449 $ 686,661 $ 721,172 86.85% 97.70% 95.21% * These per-share amounts have been adjusted for all stock splits and dividends. The 2007 financial performance for Bancorp produced growth in loans and deposits, with net income increasing $441 thousand from the prior year. Net income for 2007 was $12.3 million or $2.31 per share (diluted) compared with $11.9 million or $2.11 per share (diluted) in 2006. Net income for 2007 includes pre-tax non- recurring net gains of $710 thousand related to the second-quar- ter sale of the $76 million indirect auto loan portfolio and pre-tax non-recurring gains of $387 thousand from the third-quarter sale of the Bank's $1.5 million Visa portfolio. The 2007 net income also includes a pre-tax non-recurring charge of $242 thousand record- ed in the fourth quarter for the potential obligation to Visa Inc. in connection with certain litigation indemnifications provided to Visa Inc. by Visa member banks. Net income for 2006 includes $610 thousand of one-time prior-period tax benefits, including interest on enterprise zone loans for 2002 through 2005. Total deposits reached $834.6 million at December 31, 2007, an increase of $97.9 million or 13.3% from the prior year. Despite heightened competition for deposits among banks in general and community banks in particular, the Bank's market share of total Marin County deposits increased from 8.95% to 9.50% for the six- month period from December 2006 to June 2007 (the latest date for which the information is available). Total gross loans finished the year at $724.9 million compared to $719.8 million in 2006, representing an increase of $5.1 million or 0.7%. Excluding the indirect auto portfolio, which was sold in the second quarter of 2007, loans increased 14.1% over 2006. The Bank's loan quality remains strong, with non-performing loans of $144 thousand at December 31, 2007, $49 thousand at December 31, 2006 and zero at December 31, 2005. In 2007, the Bank pro- vided $685 thousand to the allowance for loan losses, and net charge-offs were $85 thousand. Approximately $89 thousand of recoveries on indirect auto loans were recorded in other income during 2007 subsequent to recording these loans at their fair value. This compares to a provision of $1.3 million and net charge- offs of $358 thousand in 2006. At year-end 2007 and 2006, the allowance for loan losses as a percentage of total loans was 1.05% and 1.11%, respectively. Assets of Bancorp totaled $933.9 million at December 31, 2007, an increase of $57.3 million or 6.5% from December 31, 2006. Bancorp's return on average assets (ROA) remains unchanged from year ended 2006 to 2007 whereas the return on average equity (ROE) increased for the same period. ROE increased 61 basis points, primarily due to common share repurchases and an increase in net income of $441 thousand from the prior year. In 2007 Bancorp's ROA and ROE were, respectively, 1.38% and 14.44% compared to 1.38% and 13.83% in 2006. Net interest income reached $42.7 million, an increase of $1.0 mil- lion or 2.4% over 2006. The interest income component of net interest income was up 6.1% to $61.8 million, and is the result of both growth in interest-earning assets and higher asset yields in · 8 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T most categories. Total interest expense of $19.1 million in 2007 was up from 2006 by $2.5 million, or 15.2%, mainly attributable to higher rates paid on deposits, primarily money market accounts. from $1.0 million in 2006, to $1.3 million in 2007. WMS revenue grew to $1.2 million, an increase of $162 thousand, and other income finished the year at $2.1 million compared to $1.9 million in the prior year. Non-interest income is comprised of service charges on deposit accounts, Wealth Management Services (WMS) revenue and other income, including non-recurring gains previously discussed. In 2007, total non-interest income totaled $5.7 million, which is an increase of $1.7 million or 44.0% over 2006. Excluding non-recur- ring items, non- interest income in 2007 grew $649 thousand, or 16.3% over 2006. Service charges on deposit accounts increased Non-interest expenses increased from $25.9 million in 2006 to $27.7 million in 2007, an increase of $1.8 million or 6.9%. The overall efficiency of Bancorp changed from 56.65% in 2006 to 57.10% in 2007. These changes reflected expenses associated with the one-time costs for the formation of the holding company, higher FDIC insurance premiums, and the hiring of new personnel. Summary of Quarterly Results of Operations Table 1 sets forth the quarterly results of operations for 2007 and 2006. TTaabbllee 11 SSuummmmaarriizzeedd SSttaatteemmeenntt ooff OOppeerraattiioonnss 2007 Quarters Ended 2006 Quarters Ended (Dollars in thousands) Interest income Interest expense Net interest income Provision for loan losses Dec. 31 June 30 Sept. 30 Mar.31 $ 15,700 $ 15,830 $ 15,439 $ 14,872 $ 15,290 $ 14,875 $ 14,302 $ 13,844 3,473 10,371 260 4,221 11,479 345 4,961 10,478 75 5,042 10,788 200 4,725 10,565 477 4,457 10,418 287 3,923 10,379 242 4,875 9,997 65 Sept. 30 June 30 Dec. 31 Mar. 31 Net interest income after provision for loan losses Non-interest income Non-interest expense 11,134 1,231 7,028 Income before provision for income taxes 5,337 2,079 $ 3,258 Provision for income taxes Net income Net income per common share* 10,588 1,586 6,926 5,248 2,059 $ 3,189 10,403 1,393 7,030 4,766 1,863 $ 2,903 9,932 1,508 6,689 4,751 1,777 $ 2,974 10,088 1,037 6,471 4,654 1,427 $ 3,227 10,131 996 6,585 4,542 1,437 $ 3,105 10,137 997 6,593 4,541 1,900 $ 2,641 10,111 942 6,242 4,811 1,901 $ 2,910 Basic Diluted $ 0.63 $ 0.62 $ 0.62 $ 0.60 $ 0.56 $ 0.54 $ 0.57 $ 0.55 $ 0.59 $ 0.57 $ 0.57 $ 0.55 $ 0.50 $ 0.47 $ 0.56 $ 0.52 * These per-share amounts have been adjusted for all stock splits and dividends. Net Interest Income Net interest income is the difference between the interest earned on loans, investments and other interest-earning assets and the interest expense on deposits and other interest-bearing liabilities. Net interest income is impacted by changes in general market interest rates and by changes in the amounts and composition of interest earning assets and interest bearing liabilities. The table below indicates net interest income, net interest margin, and net interest rate spread for each period presented. Net interest mar- gin is expressed as net interest income divided by average earn- ing assets. Net interest rate spread is the difference between the average rate earned on total interest-earning assets and the aver- age rate incurred on total interest-bearing liabilities. Both of these measures are reported on a taxable-equivalent basis. Net interest margin is the higher of the two because it reflects interest income earned on assets funded with non-interest bearing sources of funds, which include demand deposits and stockholders' equity. Table 2, Distribution of Average Statements of Condition and Analysis of Net Interest Income, compares interest income and interest earning assets with interest expense and interest bearing liabilities for the three years 2007, 2006 and 2005. The table also indicates net interest income, net interest margin and net interest rate spread for each year. · 9 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T TTaabbllee 22 DDiissttrriibbuuttiioonn ooff AAvveerraaggee SSttaatteemmeennttss ooff CCoonnddiittiioonn aanndd AAnnaallyyssiiss ooff NNeett IInntteerreesstt IInnccoommee (Dollars in thousands) Assets Federal funds sold and other short-term investments Investment securities U.S. Treasury securities U.S. Government agencies Other Municipal bonds Loans and banker's acceptances (2) Total interest-earning assets Cash and due from banks Bank premises and equipment, net Interest receivable and other assets, net Total assets Liabilities and Stockholders' Equity 2007 Interest Income/ Expense (1) Average Balance Yield/ Rate(1) Average Balance 2006 Interest Income/ Expense (1) Yield/ Rate (1) Average Balance 2005 Interest Income/ Expense(1) Yield/ Rate (1) $ 42,584 $ 2,209 5.19% $ 4,503 $ 226 5.01% $ 4,343 $ 156 3.58% 315 75,775 11,110 13,067 703,087 845,938 24,364 8,185 16,301 $ 894,788 8 3,759 656 641 54,730 62,003 2.43 4.96 5.92 4.91 7.78 7.33 3,086 84,185 5,830 14,955 701,732 814,291 28,322 6,343 13,307 $ 862,263 76 3,707 297 758 53,447 58,511 2.45 4.40 5.10 5.07 7.62 7.18 7,082 73,212 8,701 21,838 640,694 755,870 32,407 4,229 10,989 $ 803,495 155 2,930 448 1,141 44,988 49,818 2.19 4.00 5.14 5.23 7.02 6.60 Interest-bearing transaction accounts Savings and money market accounts Time accounts Purchased funds Borrowed funds $ 76,673 414,592 86,268 16,097 5,000 598,630 204,146 6,648 85,364 Total liabilities and stockholders’ equity $ 894,788 Demand accounts Interest payable and other liabilities Stockholders' equity Total interest-bearing liabilities $ 301 14,161 3,465 765 407 19,099 $ 293 10,979 3,837 1,078 391 16,578 0.39% $ 75,336 358,027 3.42 104,205 4.02 23,008 4.76 5,000 8.14 565,576 3.19 205,512 5,262 85,913 $ 862,263 0.39% $ 70,710 333,165 3.07 116,302 3.68 16,074 4.68 5,000 7.82 541,251 2.93 185,873 3,676 72,695 $ 803,495 $ 276 5,530 3,396 543 298 10,043 0.39% 1.66 2.92 3.38 5.97 1.86 Net interest income Net interest margin Net interest rate spread $ 42,904 $ 41,933 $ 39,775 5.07% 4.14% 5.15% 4.25% 5.26% 4.74% (1) Yields and interest income are presented on a taxable-equivalent basis using the Federal statutory rate of 35 percent for 2007 and 2006 and 34 percent for 2005. (2) Average balances on loans outstanding include non-performing loans, if any. The amortized portion of net loan origination fees (costs) is included in interest income on loans, representing an adjustment to the yield. The tax-equivalent net interest margin declined to 5.07% in 2007 compared to 5.15% in 2006, and declined in 2006 from 5.26% in 2005. During the two year period beginning in 2006, the tax- equivalent net interest margin was impacted by a higher cost of funds driven by competition for deposits only partially offset by higher yields on interest-earning assets. In 2006, the margin was also impacted by increased levels of overnight borrowings to sup- port loan growth. Competition for deposits eased somewhat in the second half of 2007 as liquidity improved from the sale of the Bank's $76 million indirect auto portfolio. Initially the proceeds were invested in Federal funds and other short-term investments yielding approximately the same overall return as the sold portfo- lio. In the second half of 2007, the funds were reinvested in high- er-yielding relationship loans. The drop of 100 basis points in the Federal funds borrowing rate in the latter part of 2007 resulted in lower offered rates on deposits, favorably impacting the net inter- est margin. Total average interest earning assets increased $31.6 million, or 3.9% in 2007 over 2006 and $58.4 million in 2006 over 2005. The composition of average interest-earning assets shifted in 2007 compared to 2006 and 2005, primarily reflecting the sale of the indirect auto loan portfolio and the subsequent investment of the proceeds. · 10 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T Due to a rise in average market interest rates on the largest com- ponents of earning assets, which are loans and agency securities, the average yield on interest earning assets increased 15 basis points in 2007 over 2006 and 58 basis points in 2006 over 2005. The yield on the loan portfolio, which comprised 83.1% and 86.2% of average earning assets in 2007 and 2006, respectively, increased 16 basis points in 2007 from 2006 and increased 60 basis points in 2006 over 2005. The increase in 2007 loan yields reflects loan originations at higher yields, the paydown of loans at lower yields and the write-down to fair value and subsequent sale of the lower-yielding indirect auto portfolio. The increase in the yield on loans in 2006 over 2005 is primarily attributable to the increasing interest-rate environment at the time, partially offset by the effect of competitive pressures on rates. The yield on the portfolio of agency securities which comprised 9.0% and 10.3% of average earning assets in 2007 and 2006, respectively, increased 56 basis points in 2007 over 2006 and 40 basis points in 2006 over 2005. Agency securities generally have shorter lives than other securities in the portfolio and will mature or be called more quickly. The increase in yield on agency securi- ties in 2007 over 2006 primarily relates to maturities and pay- downs of securities at lower yields and purchases of securities at higher yields. The yield on agency securities improved in 2006 over 2005 primarily due to the purchases of higher-yielding secu- rities in a rising rate environment. The yield on other securities increased 82 basis points in 2007 over 2006 and decreased 4 basis points in 2006 over 2005. Other securities consist of corporate debt securities, FHLB stock, on which dividends are paid at vary- ing rates, collateralized mortgage obligations and corporate bonds. The yield on other securities increased in 2007 over 2006 due to the addition of high-yielding corporate debt securities. The yield on municipal bond securities declined 16 basis points in both 2007 over 2006 and 2006 over 2005 due to maturities of higher yielding bonds. Market rates are in part based on the Federal Reserve Open Market Committee target Federal funds interest rate (the interest rate banks charge each other for short-term borrowings). The change in the Federal funds sold and purchased rates is the result of target rate changes implemented by the Federal Reserve. In 2007 there was a 100 basis point decrease in the Federal funds target rate between September and December. In 2006, a 100 basis point increase occurred over the first half of the year. The yield on Federal funds sold and other short-term investments increased 29 basis points in 2007 over 2006 and 143 basis points in 2006 over 2005, reflecting the average rates in those periods. The average balance of interest-bearing liabilities increased $33.1 million, or 5.8% in 2007 and $24.3 million, or 4.5% in 2006. In 2007, an increase in savings and money market accounts, partial- ly due to higher offered rates, was partially offset by the decline in time accounts and purchased funds. In 2006, an increase in sav- ings and money market accounts and purchased funds was partial- ly offset by the decline in time accounts. The rate on interest bearing liabilities increased 26 basis points in 2007 over 2006 and 107 basis points in 2006 over 2005. The over- all cost of liabilities is affected by offered rates and the mix of deposits and liabilities. In 2007, the rate on savings and money market accounts increased 35 basis points over 2006 and the rate on time deposits increased 34 basis points. In 2006 the increases to savings and money market accounts totaled 141 basis points and increases to time deposits totaled 76 basis points. In 2007, demand deposits, on which no interest is paid, decreased to 26.1% of average deposits, down from 27.7% in 2006. This shift increased the overall cost of funds. Savings and money market accounts increased to 53.0% of average deposits in 2007 up from 48.2% in 2006, while time deposits decreased to 11.0% of aver- age deposits from 14.0% in the same period. Interest bearing transaction accounts were 9.8% and 10.1% of average deposits in 2007 and 2006, respectively. Average purchased funds in 2007 decreased $6.9 million over 2006 and increased $6.9 million in 2006 over 2005. The decrease in 2007 related to paydowns using the proceeds generated by the sale of the indirect auto portfolio. The increase in 2006 over 2005 related to the support of loan growth. The rate on purchased funds increased 8 basis points in 2007 over 2006 and 130 basis points in 2006 over 2005, reflecting the changes in the Federal funds target rate. Interest rate changes can create fluctuations in the net interest margin due to an imbalance in the timing of repricing or maturity of assets or liabilities. Interest rate risk exposure is managed with the goal of minimizing the impact of interest rate volatility on the net interest margin. The net interest margin may decline slightly if rates fall due to the high level of Federal funds sold at year-end as a result of a $53.0 million short-term deposit placed with the Bank in late December 2007. With a lower level of Federal funds, as would be expected in 2008, the net interest margin could increase slightly in the short term as deposits reprice downward and loan repricing lags. If rates rise, generally net interest income would rise; however, net interest income may decline slightly if non- maturity deposit rates become sensitive to competition. · 11 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T Table 3, Analysis of Changes in Net Interest Income, separates the change in net interest income into two components: (1) volume - change caused by increases or decreases in the average asset and liability balances outstanding, and (2) yield/rate - changes in aver- age yields on earning assets and average rates for interest bear- ing liabilities. Table 3 shows the impact on income of balance sheet changes and the changes in market interest rate levels which occurred during 2007 and 2006. The chart indicates that for 2007 and 2006, the increase in interest income was evenly impacted by rate and volume. The increase in interest expense was more attributable to rate increases than vol- ume increases in both years. TTaabbllee 33 AAnnaallyyssiiss ooff CChhaannggeess iinn NNeett IInntteerreesstt IInnccoommee (Dollars in thousands) Assets Federal funds sold Investment securities U. S. Treasury securities U. S. government agencies Other Municipal bonds Loans and bankers’ acceptances Total interest-earning assets Liabilities Interest-bearing transaction accounts Savings and money market accounts Time accounts Purchased funds Borrowed funds Total interest-bearing liabilities Net Interest Income * Variances due to changes in both yield/rate and volume (mix) are allocated to yield/rate. 2007 compared to 2006 2006 compared to 2005 Volume Yield/ Rate* Total Volume Yield/ Rate* Total $ 1,975 $ 8 $ 1,983 $ 6 $ 64 $ 70 (67) (391) 305 (102) 103 1,823 5 1,849 (700) (330) --- 824 $ 999 (1) 443 54 (15) 1,180 1,669 3 1,333 328 17 16 1,697 $ (28) (68) 52 359 (117) 1,283 3,492 8 3,182 (372) (313) 16 2,521 $ 971 (147) 465 (147) (357) 4,479 4,299 68 312 (4) (26) 3,980 4,394 (79) 777 (151) (383) 8,459 8,693 18 441 (379) 282 --- 362 $ 3,937 (1) 5,008 820 253 93 6,173 $ (1,779) 17 5,449 441 535 93 6,535 $ 2,158 Provision for Loan Losses The Bank formally assesses the adequacy of the allowance on a quarterly basis. The Bank provides as an expense an amount to bring the allowance for loan losses to a level to provide adequate coverage for probable loan losses. The adequacy of the allowance for loan losses is evaluated based on several factors, including growth of the loan portfolio, analysis of probable losses in the portfolio and recent loss experience. Actual losses on loans are charged against the allowance, and the allowance is increased through the provision charged to expense. For further discussion, see sections captioned "Critical Accounting Policies and "Allowance for Loan Losses." The Bank's provision for loan losses in 2007 was $685 thousand versus $1.3 million for 2006 and $1.5 million in 2005. The provi- sion for loan losses declined in 2007 compared to 2006 reflecting the amount deemed necessary to maintain the allowance at a level considered adequate to provide for probable losses inherent in the portfolio, and also reflected the absence of the indirect auto portfolio subsequent to its sale, which previously accounted for a significant portion of the total charge-offs for the Bank. Net charge-offs for 2007 totaled $85 thousand compared with $358 thousand in 2006 and $536 thousand in 2005. The decline in net charge-offs in 2007 from 2006 is the result of the absence of charge-offs and recoveries on the indirect auto portfolio, which was accounted for at fair value in accordance with SFAS No. 159 beginning January 1, 2007 and was sold during the quarter ended June 30, 2007. Approximately $89 thousand of recoveries on indi- rect auto loans were recorded in other income during 2007 subse- quent to recording these loans at their fair value. · 12 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T Table 4, Non-performing Assets at December 31, shows that there was one non-performing asset at December 31, 2007, one non- performing asset at December 31, 2006 and no non-performing assets at the prior three year ends. TTaabbllee 44 NNoonn--ppeerrffoorrmmiinngg AAsssseettss aatt DDeecceemmbbeerr 3311 (Dollars in thousands) Non accrual loans Accruing loans past due 90 days or more Other real estate owned Total non-performing assets 2007 $144 --- --- $144 2006 $ 49 --- --- $ 49 2005 $ --- --- --- $ 0 2004 $ --- --- --- $ 0 2003 $ --- --- --- $ 0 The Bank's policy is to place loans on non-accrual status when management believes that there is serious doubt as to the collec- tion of principal or interest, or when they become contractually past due by 90 days or more with respect to principal or interest, except for loans that are both well secured and in the process of collection. When loans are placed on non-accrual status, any accrued but uncollected interest is reversed from current income. TTaabbllee 55 SSiiggnniiffiiccaanntt CCoommppoonneennttss ooff NNoonn--iinntteerreesstt IInnccoommee Non-interest Income Non-interest income includes service charges on deposit accounts, Wealth Management Services (WMS) income and other income. Non-interest income grew to $5.7 million in 2007, up from $4.0 million in 2006 and $3.7 million in 2005. (Dollars in thousands) 2007 Service charges on deposit accounts $ 1,251 Wealth Management Services 1,229 Net gain on indirect auto and Visa portfolios Other non-interest income Earnings on Bank owned life insurance Customer banking fees and other charges Other income Total other non-interest income 1,097 577 536 1,028 2,141 $ 5,718 Total non-interest income Year ended December 31, 2006 $ 1,007 1,067 2005 $ 1,044 958 2007 compared to 2006 Percent Increase (Decrease) 24.2% 15.2% Amount Increase (Decrease) $ 244 162 2006 compared to 2005 Amount Increase (Decrease) $ (37) 109 Percent Increase (Decrease) (3.5)% 11.4% --- --- 1,097 100.0% --- --- 505 442 72 14.3% 63 14.3% 506 887 1,898 $ 3,972 483 781 1,706 $ 3,708 30 141 243 $ 1,746 5.9% 15.9% 12.8% 44.0% 23 106 192 $ 264 4.8% 13.6% 11.3% 7.1% The adoption of SFAS No. 159 and the subsequent sale of the indirect auto loan portfolio generated a pre-tax net gain in 2007 of $710 thousand and the sale of the Visa portfolio generated a pre-tax net gain of $387 thousand, resulting in total net gains of $1.1 million. Excluding these gains, non-interest income increased $649 thousand or 16.3% in 2007 over 2006. Service charges on deposits in 2007 increased by $244 thousand. This increase is primarily attributable to an increase effective April 1, 2007, in the fees the Bank charges for checks drawn against insufficient funds as well as reduced earnings credits provided to certain customer accounts. WMS revenue increased $162 thou- sand over the prior year. This increase is primarily the result of growth in assets under management and market appreciation of assets. The increase in "other" income in 2007 of $243 thousand is primarily due to an increase in Bank owned life insurance (due to additional investment of $1.2 million in September 2006 and a gradually increasing yield), and higher miscellaneous income (which included $89 thousand of indirect auto loan recoveries sub- sequent to recording these loans at their fair value). The increase in "other" income in 2006 reflects fees from a program introduced in 2006 for first mortgages through a third-party vendor, higher miscellaneous income and cash management fees. · 13 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T Non-interest Expense Table 6, Significant Components of Non-interest Expense, summa- rizes the amounts and changes in dollars and percentages. In 2007 non-interest expense increased 6.9%. In 2006, non-interest expense increased 15.1%. The Bank's efficiency ratio (the ratio of non-interest expense divided by the sum of non-interest income and net interest income) increased to 57.10% in 2007 from 56.65% in 2006 and from 52.14% in 2005. TTaabbllee 66 SSiiggnniiffiiccaanntt CCoommppoonneennttss ooff NNoonn--iinntteerreesstt EExxppeennssee (Dollars in thousands) Salaries and related benefits Occupancy and equipment Depreciation & amortization Data processing fees Professional services Other non-interest expense Advertising Director expense Other expense Total other non-interest expense Total non-interest expense 2007 $ 15,900 2,871 1,246 1,657 1,681 297 395 3,626 4,318 $ 27,673 2007 compared to 2006 2006 compared to 2005 Year ended December 31, 2006 $ 15,490 2,624 998 1,537 1,269 387 495 3,091 3,973 $ 25,891 2005 $ 13,819 2,074 846 1,330 809 427 415 2,778 3,620 $ 22,498 Amount Increase (Decrease) $ 410 247 248 120 412 (90) (100) 535 345 $ 1,782 Percent Increase (Decrease) 2.6% 9.4% 24.8% 7.8% 32.5% (23.3)% (20.2)% 17.3% 8.7% 6.9% Amount Increase (Decrease) $ 1,671 550 152 207 460 (40) 80 313 353 $ 3,393 Percent Increase (Decrease) 12.1% 26.5% 18.0% 15.6% 56.9% (9.4)% 19.3% 11.3% 9.8% 15.1% In 2007, salaries and benefits costs increased by $410 thousand or 2.6%. This increase is due to normal annual salary increases, par- tially offset by a slight decrease in net full-time equivalent (FTE) employees to 190, down from 194 at year-end 2006. In 2007 there were expenses of $854 thousand for the Bank's Employee Stock Ownership and Savings Plan (ESOP), and $1.1 million for staff and officer incentive bonus plans. In comparing 2006 with 2005, salaries and benefits costs increased by $1.7 million or 12.1%, pri- marily due to a higher number of FTE, regular salary adjustments, as well as $555 thousand of expenses recorded in connection with the implementation of SFAS No. 123R, partially offset by lower incentive bonuses. In 2006 there were expenses of $900 thousand for the ESOP, and $1.1 million for staff and officer incentive bonus plans. The increases in 2007 in occupancy and equipment costs of $247 thousand are largely due to a full year's expense related to the lease of a new facility housing the Bank's loan production, opera- tions and administrative personnel, the addition of a new loan office lease, and annual rent increases in the branch facilities. The increases in 2006 in occupancy and equipment costs of $550 thou- sand, are largely due to the lease of the new facility housing the Bank's loan production, operations and administrative personnel in July 2006 and the addition of a new branch lease in April of 2006, as well as annual rent increases. 2007 reflects expenses associated with the remodeling of the Bank's Northgate branch, a full year of amortization of the new facility housing the Bank's loan production, operations and admin- istrative personnel as well as expenses associated with the opening of a new loan office. The increase in depreciation of $152 thousand in 2006 over 2005 reflects expenses associated with the amortization of leasehold improvements, furniture and equipment in the Bank's new administrative, operations and loan production facility as well as expenses associated with the two branches opened in the first quarter of 2006 and late in the third quarter of 2005. In 2007 data processing costs increased $120 thousand or 7.8% due to the contractually stipulated price increases that are part of the Bank's long-term agreement with its data processing provider and also due to costs associated with regulatory compliance and the implementation of new products and services. In 2006, data processing costs increased $207 thousand or 15.6%. This increase was largely attributable to the contractually stipulated price increases that are part of the Bank's long-term agreement with its data processing provider, the increased use of internet banking and bill pay by the Bank's customers, and one-time expenses in 2006 relating to the move to the Bank's new administrative facility. The increase in depreciation and amortization of $248 thousand in In 2007 professional services increased $412 thousand or 32.5% from 2006. This increase reflected higher legal and accounting · 14 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T expenses, primarily associated with the implementation of the holding company as well as a full year of a consulting agreement that commenced in July of 2006. In 2006 professional services increased $460 thousand or 56.9% which reflected higher execu- tive recruiting and accounting expenses as well as six months of the consulting agreement that commenced in July of 2006. Other non-interest expenses of $4.3 million represent a $345 thousand or 8.7% increase over 2006. In 2007, other non-interest expense includes a pre-tax non-recurring charge of $242 thousand recorded in the fourth quarter for the potential obligation to Visa U.S.A. in connection with certain litigation indemnifications pro- vided to Visa U.S.A. by Visa member banks. The change also includes increases in FDIC insurance and information technology costs, partially offset by decreases in other losses, director expens- es, and advertising. In November 2006, the FDIC issued a final rule, effective January 1, 2007 that created a new deposit insur- ance premium system for banks. The new assessment system results in annual assessments to the Bank of 5 to 7 basis points per $100 of insured deposits. In 2006, other non-interest expense increased $353 thousand, or 9.8%, over 2005. The change includes a $105 thousand loss on lease, moving expenses relating to the Bank's new facility, other regulatory costs, special events, loss on disposal of assets relating to the move, partially offset by a decline in advertising and other processing costs. Provision for Income Taxes Bancorp reported a provision for income taxes of $7.8 million, $6.7 million, and $7.4 million for the years 2007, 2006 and 2005, respectively. The effective tax rates were 38.7%, 35.9% and 38.6% at December 31, 2007, 2006 and 2005, respectively. These provi- sions reflect accruals for taxes at the applicable rates for Federal income and California franchise taxes based upon reported pre- tax income, and adjusted for the effects of all permanent differ- ences between income for tax and financial reporting purposes (such as earnings on qualified municipal securities and certain life insurance products). Therefore, there are normal fluctuations in the effective rate from period to period based on the relationship of net permanent differences to income before tax. The majority of the reduction in the provision for income taxes from 2005 to 2006 pertains to one-time prior-period tax benefits, including interest on enterprise zone loans for 2002 through 2005. The Bank has not been subject to an alternative minimum tax (AMT). See Note 12 of the Notes to Financial Statements for additional dis- cussion of Provision for Income Taxes. Short-period Federal and California tax returns will be filed for the Bank for the period ending July 1, 2007. Thereafter, consolidated returns will be filed for Bancorp and the Bank. Bancorp and the Bank have entered into a tax allocation agreement which provides that income taxes shall be allocated between the parties on a sep- arate entity basis. The intent of this agreement is that each mem- ber of the consolidated group will incur no greater tax liability than it would have incurred on a stand-alone basis. FFIINNAANNCCIIAALL CCOONNDDIITTIIOONN Investment Securities The Bank maintains an investment securities portfolio to provide liquidity and earnings on funds that have not been loaned. Management determines the maturities and the types of securities to be purchased based on the need for liquidity to fund loans and the desire to attain a high investment yield. Table 7 shows the makeup of the securities portfolio at December 31, 2007 and 2006. · 15 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T December 31, 2007 December 31, 2006 Principal Amount Book Value (2) Market Value Average Yield Principal Amount Book Value (2) Market Value Average Yield $ 1,010 4,990 3,340 3,550 12,890 --- --- --- --- --- 12,890 --- --- --- --- --- 17,386 44,010 4,623 8,573 74,592 --- 2,483 --- --- 2,483 $ 1,010 5,165 3,391 3,616 13,182 --- --- --- --- --- 13,182 --- --- --- --- --- 17,388 44,285 4,575 8,715 74,963 --- 2,487 --- --- 2,487 $ 1,017 5,200 3,470 3,551 13,238 --- --- --- --- --- 13,238 --- --- --- --- --- 17,376 44,045 4,619 8,475 74,515 --- 2,474 --- --- 2,474 10,000 --- --- --- 10,000 87,075 10,000 10,000 --- --- --- --- --- --- 10,000 10,000 86,989 87,450 $99,965 $100,632 $ 100,227 4.81% $ 1,810 4,585 3.34 3,150 3.94 3,210 3.44 12,755 3.64 --- --- --- --- --- 3.64 --- --- --- --- --- 4.76 4.93 5.58 5.41 4.99 --- 5.38 --- --- 5.38 1,000 --- --- --- 1,000 13,755 2,500 --- --- --- 2,500 8,024 42,377 13,113 5,803 69,317 2,165 737 --- 1,072 3,974 $ 1,814 4,761 3,271 3,317 13,163 996 --- --- --- 996 14,159 2,511 --- --- --- 2,511 8,023 42,558 13,277 5,884 69,742 2,165 741 --- 1,072 3,978 $ 1,820 4,747 3,311 3,238 13,116 1,008 --- --- --- 1,008 14,124 2,504 --- --- --- 2,504 7,938 41,963 13,095 5,782 68,778 2,128 737 --- 1,067 3,932 --- --- --- --- --- 75,791 --- 5.60 --- --- --- --- --- --- --- 5.60 5.07 75,214 4.88% $ 89,546 $ 90,390 $ 89,338 --- --- --- --- --- 76,231 4.76% 3.54 3.79 3.34 3.73 7.57 --- --- --- 7.57 4.01 2.38 --- --- --- 2.38 3.06 4.59 5.04 3.92 4.44 5.25 5.92 --- 5.13 5.34 --- --- --- --- --- 4.42 4.36% TTaabbllee 77 IInnvveessttmmeenntt SSeeccuurriittiieess Type and Maturity Grouping (Dollars in thousands) Held to maturity State and municipal (1) Due within 1 year Due after 1 but within 5 years Due after 5 but within 10 years Due after 10 years Total Corporate debt securities and other Due within 1 year Due after 1 but within 5 years Due after 5 but within 10 years Due after 10 years Total Total held to maturity Available for sale U. S. Treasury Due within 1 year Due after 1 but within 5 years Due after 5 but within 10 years Due after 10 years Total U. S. government agencies Due within 1 year Due after 1 but within 5 years Due after 5 but within 10 years Due after 10 years Total Corporate CMOs Due within 1 year Due after 1 but within 5 years Due after 5 but within 10 years Due after 10 years Total Corporate debt securities and other Due within 1 year Due after 1 but within 5 years Due after 5 but within 10 years Due after 10 years Total Total available for sale Total (1) Interest income and yields on tax-exempt securities are not presented on a tax-equivalent basis. Maturities for securities are based on expected versus contractual maturities. (2) Book value reflects cost, adjusted for accumulated amortization and accretion. No securities are less than investment grade. · 16 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T The Bank's investment securities portfolio, consisting primarily of U.S. government agencies, state and municipal securities, corpo- rate debt securities and corporate collateralized mortgage obliga- tions (CMO's), increased $10.8 million or 12.1% in 2007. U.S. gov- ernment agency securities made up 74.4% of the portfolio and increased by $5.7 million. Corporate debt securities made up 10.0% of the portfolio. Corporate collateralized mortgage obliga- tion securities made up 2.5% of the portfolio and decreased by $1.5 million, while state and municipal securities increased by $19 thousand and represented 13.1% of the portfolio. The weighted average maturity of the portfolio at December 31, 2007 was approximately fifty-one months. Total mortgage backed securities in the portfolio at December 31, 2007 were $54.4 million which consisted of $8.4 million pass- through securities issued by FNMA and FHLMC (Federal Home Loan Mortgage Corporation), $43.5 million other mortgage backed securities issued or guaranteed by FNMA, FHLMC, or GNMA, and $2.5 million of collateralized mortgage obligations issued by corporations. See Note 2 of the Notes to Financial Statements for more information on investment securities. Loans Although loans other than indirect auto loans increased $89.2 mil- lion, loans overall only increased by $5.5 million from December 31, 2006 to December 31, 2007 due to the sale of the indirect auto portfolio. In the first quarter of 2007, the Bank elected to TTaabbllee 88 LLooaannss OOuuttssttaannddiinngg bbyy TTyyppee aatt DDeecceemmbbeerr 3311 adopt the SFAS No. 159 and record its indirect auto portfolio at fair value. In connection with this event, an unrealized loss of $3.5 million was recorded as a reduction of loans, and the allowance for loan losses was reduced by $1.0 million. These changes were recorded, net of tax, as a reduction to retained earnings. Commercial loans increased by $6.9 million in 2007 compared to 2006, and real estate loans increased by $78.0 million in the same period. The increase in commercial loan totals resulted from a targeted emphasis on commercial and industrial lending, specifi- cally asset-based lines of credit, as well as the opening of the San Francisco loan production office. Commercial real estate loans increased due to ongoing demand complemented by opportuni- ties that surfaced as a result of the Bank's active involvement in its trade area. The Bank seeks to maintain a loan portfolio that is well balanced in terms of borrowers, collateral and maturities. Approximately 84% and 75% of the Bank's outstanding loans are secured by real estate at December 31, 2007 and 2006, respectively. Of the real estate loans, 46% are non-owner occupied commercial real estate loans, 23% are owner occupied commercial real estate loans, 17% are construction loans, 8% are personal real estate loans and 6% are home equity loans. The Bank's commercial real estate loan portfolio is weighted towards term loans for which the primary source of repayment is cash flow from net operating income of the real estate property. Table 8 shows an analysis of loans by type. (in thousands) Commercial loans Real estate Commercial Construction Residential Installment Indirect Auto loans Other installment Total loans Less Allowance for loan losses Net loans 2007 $124,336 2006 $117,391 2005 $144,510 2004 $120,006 2003 $105,847 389,741 97,153 78,860 --- 34,788 724,878 7,575 $ 717,303 311,692 116,790 58,912 84,141 30,852 719,778 8,023 $711,755 282,564 112,116 36,304 77,612 33,555 686,661 7,115 $679,546 250,326 81,549 30,692 68,769 25,615 576,957 6,110 $570,847 196,703 44,471 28,052 49,617 26,191 450,881 5,458 $445,423 · 17 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T Table 9 shows a slightly more even split between fixed rate and variable rate loans within the portfolio in 2007 when compared to 2006. In 2007, the Bank's fixed rate loans were 50.8% of the port- folio, and the variable portion was 49.2%. The large majority of the variable rate loans are tied to independent indices (such as the TTaabbllee 99 LLooaann PPoorrttffoolliioo MMaattuurriittyy DDiissttrriibbuuttiioonn aanndd IInntteerreesstt RRaattee SSeennssiittiivviittyy Wall Street Journal prime rate or the Treasury Constant Maturities). Substantially all loans with an original term of more than five years have provisions for the fixed rates to reset, or convert to a variable rate, after one, three or five years. December 31, 2007 December 31, 2006 Fixed Variable Fixed Variable (In thousands) Due within 1 year Due after 1 but within 5 years Due after 5 years Total Percentage Rate Rate Total $ 60,885 $ 110,827 $ 171,712 111,150 92,687 $ 203,837 196,011 153,318 $ 349,329 $ 368,046 $ 356,832 $ 724,878 49.23% 100.00% 50.77% Rate Rate Percent Total 23.7% $ 80,688 $ 113,872 $ 194,560 28.1% 136,569 86,862 223,431 48.2% 165,562 136,225 301,787 100.0% $ 382,819 $ 336,959 $ 719,778 46.80% 100.00% 53.20% Percent 27.0% 31.0% 42.0% 100.0% Note: The "Due within 1 year" data includes demand loans, overdrafts and past due loans. Allowance for Loan Losses Credit risk is inherent in the business of lending. As a result, the Bank maintains an allowance for loan losses to absorb losses inherent in the Bank's loan portfolio. This is maintained through periodic charges to earnings. These charges are shown in the Statement of Operations as provision for loan losses. All specifi- cally identifiable and quantifiable losses are immediately charged off against the allowance. The balance of the Bank's allowance for loan losses is an estimate of the remaining losses inherent in the portfolio. The allowance for loan losses as a percent of total loans at December 31, 2007 was 1.05% versus 1.11% at the end of 2006. At December 31, 2005, the allowance for loan losses as a percent of total loans was 1.04%. Based on the current conditions of the loan portfolio, management believes that the $7.6 million allowance for loan losses at December 31, 2007 is adequate to absorb losses inherent in the Bank's loan portfolio. No assurance can be given, however, that adverse economic conditions or other circumstances will not result in increased losses in the portfolio. Table 10 shows the activity in the allowance for loan losses for each of the years in the five-year period ended December 31, 2007. At December 31, 2007, the Bank had one non-accrual loan of $144 thousand. At December 31, 2006, the Bank had one non- accrual loan of $49 thousand. With the adoption of SFAS No. 159, the indirect auto loan portfo- lio was recorded at fair value. As a result, an unrealized loss of $3.5 million was recorded as a reduction of loans, and the allowance for loan losses was reduced by $1.0 million, which is reflected in the table below. See Note 15 of the Notes to Financial Statements for additional information. · 18 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T TTaabbllee 1100 AAlllloowwaannccee ffoorr LLooaann LLoosssseess aatt DDeecceemmbbeerr 3311 (Dollars in thousands) Beginning balance Cumulative-effect adjustment of adoption of SFAS No. 159 Provision charged to expense Loans charged off Commercial Construction Real estate Installment Total charged off Loan loss recoveries Commercial Construction Real estate Installment Total recoveries Net loans charged off Ending balance 2007 $ 8,023 (1,048) 685 --- --- --- (115) (115) --- --- --- 30 30 (85) $ 7,575 2006 $ 7,115 --- 1,266 (172 ) --- --- (424 ) (596 ) 35 --- --- 203 238 (358) $ 8,023 2005 $ 6,110 --- 1,541 (362) --- --- (402) (764) 6 --- --- 222 228 (536) $ 7,115 2004 $ 5,458 2003 $ 5,035 --- 934 (6) --- --- (421) (427) 1 --- --- 144 145 (282) $ 6,110 --- 685 (146) --- --- (230 ) (376 ) 14 --- --- 100 114 (262) $ 5,458 Total loans outstanding at end of year, before deducting allowance for loan losses $ 724,878 $ 719,778 $ 686,661 $ 576,957 $ 450,881 Average total loans outstanding during year Ratio of allowance for loan losses to total loans at end of year $ 703,087 $ 701,732 $ 640,694 $ 514,299 $ 434,908 1.05% 1.11% 1.04% 1.06% 1.21% The Components of the Allowance for Loan Losses As stated previously in "Critical Accounting Policies," the overall allowance consists of a specific allowance, an allowance factor, and an allowance for changing environmental factors. The first component, the specific allowance, results from the analysis of identified problem credits and the evaluation of sources of including collateral, as applicable. Through repayment management's ongoing loan grading process, individual loans are identified that have conditions that indicate the borrower may be unable to pay all amounts due under the contractual terms. These loans are evaluated individually by management and specified allowances for loan losses are established where applicable. The second component, the allowance factor, is an estimate of the probable inherent losses across the major loan categories in the Bank's loan portfolio. This analysis is based on loan grades by pool and current general economic and business conditions. Confirmation of the quality of the Bank's grading process is obtained by independent reviews conducted by consultants specifically hired for this purpose and by various bank regulatory agencies. This analysis covers the Bank's entire loan portfolio but excludes any loans that were analyzed individually for specific allowances as discussed above. The total amount allocated for this component is determined by applying loss estimation factors to outstanding loans. There are limitations to any credit risk grading process. The num- ber of loans makes it impractical to review every loan every quar- ter. Therefore, it is possible that some currently performing loans not recently graded will not be as strong as their last grading and an insufficient portion of the allowance will have been allocated to them. Grading and loan review often must be done without know- ing whether all relevant facts are at hand. Troubled borrowers may deliberately or inadvertently omit important information from reports or conversations with lending officers regarding their financial condition and the diminished strength of repayment sources. The third component of the allowance for credit losses is an economic component that is not allocated to specific loans or groups of loans, but rather is intended to absorb losses caused by portfolio trends, concentration of credit, growth, and economic trends. · 19 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T At December 31, 2007, the allowance for loan losses was $7.6 mil- lion consisting of a specific allowance of zero, an allowance factor of $6.0 million, and an economic allowance of $1.6 million. At December 31, 2006, the allowance for loan losses was $8.0 million consisting of a specific allowance of zero, an allowance factor of $6.3 million, and an economic allowance of $1.7 million. Table 11 shows the allocation of the allowance by loan type as well as the percentage of total loans in each of the same loan types. TTaabbllee 1111 AAllllooccaattiioonn ooff AAlllloowwaannccee ffoorr LLooaann LLoosssseess December 31, 2007 December 31, 2006 December 31, 2005 December 31, 2004 December 31, 2003 (Dollars in thousands) Commercial Construction Real Estate Installment Total allowance for loan losses Total percent Allowance balance allocation $ 1,989 1,659 3,292 635 $ 7,575 Loans as percent of total loans Allowance balance allocation 17.2% $1,923 1,995 13.4 2,533 64.6 1,572 4.8 Loans as percent of total loans Allowance balance allocation 16.3% $ 2,510 1,764 16.2 1,435 51.5 1,406 16.0 Loans as percent of total loans Allowance balance allocation 21.1% $ 2,320 1,315 16.3 1,260 46.4 1,215 16.2 Loans as percent of total loans Allowance balance allocation 20.8% $ 2,288 14.1 734 1,319 48.7 1,117 16.4 Loans as percent of total loans 23.4% 9.8 44.2 22.6 $ 8,023 $ 7,115 $ 6,110 $ 5,458 100.0% 100.0% 100.0% 100.0% 100.0% Deposits Deposits increased by $97.9 million at December 31, 2007, as compared to December 31, 2006. The 2007 year-end deposit bal- ance includes a $53.0 million short-term deposit placed with the Bank in December. Deposits are used to fund the Bank's interest earning assets. The Bank does not accept brokered deposits and has only a nominal amount of public funds. Tables 12 and 13 show the relative composition of the Bank's average deposits for the years 2007, 2006 and 2005, and the maturity groupings for the Bank's time deposits of $100,000 or more. TTaabbllee 1122 DDiissttrriibbuuttiioonn ooff AAvveerraaggee DDeeppoossiittss (Dollars in thousands) Demand Interest checking Savings Money market Time deposits Less than $100,000 $100,000 or more Total time deposits Total Average Deposits 2007 Year ended December 31, 2006 2005 Amount $ 204,147 76,673 43,754 370,837 37,417 48,851 86,268 $ 781,679 Percent 26.1% 9.8 5.6 47.5 Amount $ 205,512 75,336 58,881 299,146 4.8 6.2 11.0 100.0% 40,732 63,473 104,205 $ 743,080 Percent 27.7% 10.1 7.9 40.3 Amount $ 185,873 70,710 79,482 253,683 5.5 8.5 14.0 100.0% 39,683 76,619 116,302 $ 706,050 Percent 26.3% 10.0 11.3 35.9 5.6 10.9 16.5 100.0% Note: Refer to Table 2 for the average amount of and the average rate paid on each deposit category. TTaabbllee 1133 MMaattuurriittiieess ooff TTiimmee DDeeppoossiittss ooff $$110000,,000000 oorr mmoorree aatt DDeecceemmbbeerr 3311 (Dollars in thousands) Three months or less Over three months through six months Over six months through twelve months Over twelve months Total 2007 $ 19,431 10,638 13,164 7,437 $ 50,670 December 31, 2006 $ 19,041 12,063 15,023 7,912 $ 54,039 2005 $ 47,155 7,249 16,729 20,795 $ 91,928 · 20 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T Commitments The following is a summary of the Bank's contractual commitments as of December 31, 2007. TTaabbllee 1144 CCoonnttrraaccttuuaall OObblliiggaattiioonnss aatt DDeecceemmbbeerr 3311 (Dollars in thousands) Operating leases Subordinated debt Total <1 year $ 2,175 --- $ 2,175 1-3 years $ 3,853 --- $ 3,853 Payments due by period 4-5 years $ 2,666 --- $ 2,666 >5 years $ 11,139 5,000 $ 16,139 Total $ 19,833 5,000 $ 24,833 The contract amount of loan commitments not reflected on the Statement of Condition was $224.5 million at December 31, 2007, and $218.8 million at December 31, 2006. that enable the Bank to borrow funds as needed. The Bank's Asset/Liability Management Committee is responsible for estab- lishing and monitoring the Bank's liquidity targets and strategies. As permitted or required under California law and to the maxi- mum extent allowable under that law, Bancorp has certain obliga- tions to indemnify its current and former officers and directors for certain events or occurrences while the officer or director is, or was serving, at Bancorp's request in such capacity. These indemnifica- tion obligations are valid as long as the director or officer acted in good faith and in a manner the person reasonably believed to be in or not opposed to the best interests of the corporation, and, with respect to any criminal action or proceeding, had no reason- able cause to believe his or her conduct was unlawful. The maxi- mum potential amount of future payments Bancorp could be required to make under these indemnification obligations is unlim- ited; however, Bancorp has a director and officer insurance policy that mitigates Bancorp's exposure and enables Bancorp to recov- er a portion of any future amounts paid. Bancorp believes the esti- mated fair value of these indemnification obligations is minimal. Capital Adequacy As discussed in Note 16 of the Notes to Financial Statements, the Bank's capital ratios are above regulatory guidelines to be consid- ered "well capitalized" and Bancorp's ratios exceed the required minimum ratios for capital adequacy purposes. The Bank's total risk based capital ratio decreased from 12.56% at December 31, 2006, to 11.61% at December 31, 2007. The decline in the risk based capital ratio is due primarily to share repurchases under approved stock repurchase programs. Bancorp's total risk based capital ratio at December 31, 2007 was 12.06%. See Notes 9 and 16 of the Notes to Financial Statements. Liquidity The goal of liquidity management is to provide adequate funds to meet both loan demands and unexpected deposit withdrawals. This goal is accomplished by maintaining an appropriate level of liquid assets, and formal lines of credit with correspondent banks Bank management regularly adjusts its investments in liquid assets based upon its assessment of expected loan demand, expected deposit flows, yields available on interest-earning securities and the objectives of the Bank's asset/liability management program. The Bank obtains funds from the repayment and maturity of loans as well as deposit inflows, investment security maturities and pay- downs, Federal funds purchased, FHLB advances, and other bor- rowings. In the year ended December 31, 2007, an additional source of liquidity was the sale of the indirect auto portfolio. The Bank's primary uses of funds are the origination of loans, the pur- chase of investment securities, maturing CDs, demand deposit withdrawals, repayment of borrowings and dividends to common shareholders. The Bank must retain and attract new deposits, which depends upon the variety and effectiveness of its customer account prod- ucts, service and convenience, and rates paid to customers. Any decline in retail deposit funding would adversely impact the Bank's liquidity. Bank management anticipates that Federal funds purchased and FHLB advances will continue to be important sources of funding in the future, and management expects there to be adequate collateral for such funding requirements. A decline in Bancorp's or the Bank's credit rating would adversely affect the Bank's ability to borrow and/or the related borrowing costs, thus impacting the Bank's liquidity. As presented in the accompanying consolidated statements of cash flows, the sources of liquidity vary between periods. Consolidated cash and cash equivalents at December 31, 2007 and December 31, 2006 totaled $76.3 million and $38.8 million, respectively. The primary sources of funds during the year ended December 31, 2007 were $100.0 million in the sale of securities available for sale, a $97.9 million increase in deposits (including a · 21 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T $53.0 million short-term deposit placed with the Bank in December 2007), $78.6 million from the sale of the indirect auto and Visa portfolios and $27.4 million from paydowns and maturi- ties of securities. The primary uses of funds were $135.8 million in investment securities purchases, $86.2 million in loan originations (net of principal collections), $39.4 million payoff of Federal funds purchased and FHLB advances and $13.5 million in repurchases of common stock. At December 31, 2007, the Bank's cash and cash equivalents, Federal funds sold and unpledged assets maturing within one year totaled $104.0 million. The remainder of the unpledged securities portfolio of $51.0 million provides additional liquidity. At year-end 2006, the Bank's cash, Federal funds sold and unpledged securi- ties maturing within one year totaled $51.5 million. The remain- der of the unpledged securities portfolio of $57.5 million at December 31, 2006 provided additional liquidity. Taken together, these liquid assets equaled 16.6% and 12.4% of the Bank's assets at December 31, 2007 and 2006 respectively. The increase in liq- uid assets as a percent of total assets at December 31, 2007 is pri- marily related to a short-term deposit placed with the Bank at the end of December 2007. The Bank anticipates that cash and cash equivalents on hand and its sources of funds will provide adequate liquidity for its operat- ing, investing and financing needs and its regulatory liquidity requirements for the foreseeable future. Management monitors the Bank's liquidity position daily, balancing loan fundings/pay- ments with changes in deposit activity and overnight investments. The Bank's emphasis on local deposits combined with its 9.3% equity capital base, provides a very stable funding base. In addi- tion to cash and cash equivalents, the Bank has substantial addi- tional borrowing capacity including unsecured lines of credit total- ing $65.0 million with correspondent banks and a $3.7 million line of credit with the Federal Reserve Bank to borrow overnight, which were not drawn upon at December 31, 2007. The Bank is a mem- ber of the Federal Home Loan Bank of San Francisco (FHLB) and has a line of credit (secured under terms of a blanket collateral agreement by a pledge of loans) for advances of $184.8 million, which was unused as of December 31, 2007, at an interest rate that is determined daily. Borrowings under the line are limited to eligible collateral. As of December 31, 2007, the Bank had undisbursed loan commit- ments of $224.5 million, including $118.4 million under commer- cial lines of credit (these commitments are contingent upon cus- tomers maintaining specific credit standards), $59.6 million under revolving home equity lines, and $35.2 million under undisbursed construction loans. These commitments, to the extent used, are expected to be funded through current liquidity, repayment of existing loans and normal deposit growth. Over the next twelve months $69.3 million of time deposits will mature. The Bank expects these funds to be replaced with new time or savings accounts. The primary source of funds for Bancorp is dividends from the Bank. The primary uses of funds are shareholder dividends, stock repurchases and ordinary operating expenses. Management anticipates that there will be sufficient earnings at the Bank level to provide dividends to Bancorp to meet its funding requirements for the foreseeable future. Market Risk Management Bancorp's most significant form of market risk is interest rate risk. The risk is inherent in its deposit and lending activities. Bancorp's management together with the Asset Liability Management Committee (ALCO), which is comprised of certain directors of the Bank, has sought to manage rate sensitivity and maturities of assets and liabilities to minimize the exposure of its earnings and capital to changes in interest rates. Additionally, interest rate risk exposure is managed with the goal of minimizing the impact of interest rate volatility on its net interest margin. Activities in asset and liability management include, but are not limited to, lending, accepting deposits and investing in securities. Interest rate risk is the primary market risk associated with asset and liability management. Sensitivity of net interest income (NII) and Capital to interest rate changes results from differences in the maturity, or repricing, of asset and liability portfolios. To mitigate interest rate risk, the structure of the Statement of Condition is managed with the objective of correlating the movements of inter- est rates on loans and investments with those of deposits. The asset and liability policy sets limits on the acceptable amount of change to NII and Capital in changing interest rate environments. The Bank uses simulation models to forecast NII and Capital. Exposure to interest rate risk is reviewed at least quarterly by the ALCO and the Board of Directors. They utilize interest rate sensi- tivity simulation models as a tool for achieving these objectives and for developing ways in which to improve profitability. A sim- plified statement of condition is prepared on a quarterly basis as a starting point, using as inputs, actual loans, investments and deposits. If potential changes to net equity value and net interest income resulting from hypothetical interest changes are not with- in the limits established by the Board of Directors, management may adjust the asset and liability mix to bring interest rate risk within approved limits. · 22 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T In the simulation of NII and Capital under various interest rate sce- narios, the simplified statement of condition is processed against at least six interest rate change scenarios. In addition to a flat rate scenario, which assumes interest rates are unchanged, the six sce- narios include three 100 basis point increases and three 100 basis point decreases. Each of these scenarios assumes that the change in interest rates is immediate and interest rates remain at the new levels. Table 15 summarizes the effect on NII and Capital due to chang- ing interest rates as measured against the flat rate scenario. TTaabbllee 1155 EEffffeecctt ooff IInntteerreesstt RRaattee CChhaannggee oonn NNeett IInntteerreesstt IInnccoommee aanndd CCaappiittaall Changes in Interest Rates (in basis points) up 300 up 200 up 100 unchanged down 100 down 200 down 300 Estimated change in NII (as percent of NII) at December 31, Estimated change in capital (as percent of capital) at December 31, 2007 1.0% 0.6% 0.3% --- (1.0)% (2.1)% (3.6)% 2006 (9.0)% (5.9)% (3.0)% --- (0.5)% (1.9)% (3.0)% 2007 0.5% 0.3% 0.2% --- (0.5)% (1.1)% (1.9)% 2006 (4.3)% (2.8)% (1.4)% --- (0.2)% (0.9)% (1.4)% The above table estimates the impact of interest rate changes. The estimated changes are within the Bank's policy guidelines established by ALCO. The table indicates that the Bank is slightly asset sensitive in a declining rate environment. This situation reflects the relatively high level of Fed funds sold at December 31, 2007 which reprice immediately when rates decline. The sensitivi- ty will mitigate somewhat as Federal funds sold decline. In 2006, it was estimated that in 2007, the Bank would be somewhat liabil- ity sensitive when rates rose, and slightly asset sensitive when rates declined. This was driven, in great part, by assumptions made as to how the Bank would respond to competitive pressures in the marketplace under various interest rate scenarios. As with any simulation model or other method of measuring inter- est rate risk, certain limitations are inherent in the process. For example, although certain of the Bank's assets and liabilities may have similar maturities or repricing time frames, they may react dif- ferently to changes in market interest rates. In addition, the changes in interest rates on certain categories of either the Bank's assets or liabilities may precede or lag changes in market interest rates. Also, the actual rates and timing of prepayments on loans and investment securities could vary significantly from the assumptions used in the various scenarios. Further, changes in US Treasury rates accompanied by a change in the shape of the yield curve could produce different results from those presented in the table. Accordingly, the results presented should not be relied upon as indicative of actual results in the event of changing market inter- est rates. Interest rate sensitivity is a function of the repricing characteristics of the Bank's assets and liabilities. One aspect is the time frame within which the interest earning assets and interest bearing liabil- ities are subject to change in interest rates at repricing or maturi- ty. An analysis of the repricing time frames is called a "gap" analy- sis because it shows the gap between the amounts of assets and liabilities repricing in each of several periods of time. Another aspect is the relative magnitude of the repricing for each catego- ry of interest earning asset and interest bearing liability given var- ious changes in market rates. Gap analysis gives no indication of the relative magnitude of repricing. Interest rate sensitivity man- agement focuses on the maturity of assets and liabilities and their repricing during periods of change in market rates. Interest rate sensitivity gaps are calculated as the difference between the amounts of assets and liabilities that are subject to repricing dur- ing various time periods. Table 16 shows the Bank's repricing gaps as of December 31, 2007. Due to the limitations of gap analysis, as described above, the Bank does not generally use it in managing interest rate risk. Instead the Bank relies on the more sophisticated simulation model described above as its primary tool in measuring and man- aging interest rate risk. · 23 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T TTaabbllee 1166 IInntteerreesstt RRaattee SSeennssiittiivviittyy (Dollars in thousands) At December 31, 2007 Interest Earning Assets Funds sold Investment securities Loans Total Interest Bearing Liabilities Transaction and savings deposits Other borrowings Time deposits less than $100,000 Time deposits $100,000 or more Total Demand Deposits Sensitivity for period Sensitivity – cumulative 1-30 Days 31-90 Days 91-180 Days 181-365 Days Over one year Total $ 47,500 20,003 179,293 246,796 531,429 --- 3,286 11,409 546,124 --- --- 4,989 8,134 13,123 --- 5,000 7,316 8,129 20,445 --- (299,328) $ (299,328) (7,322) $ (306,650) --- 1,648 16,651 18,299 --- 1,746 47,872 49,618 --- --- 8,113 10,532 18,645 --- (346) $ (306,996) --- --- 7,637 12,886 20,523 --- 29,095 $ (277,901) --- 71,785 472,928 544,713 --- --- 5,919 7,714 13,633 220,272 310,808 $ 32,907 $ 47,500 100,171 724,878 872,549 531,429 5,000 32,271 50,670 619,370 220,272 32,907 Deferred Compensation Obligations The Bank maintains a nonqualified, unfunded deferred compensa- tion plan for certain key management personnel. Under this plan, participating employees may defer compensation, which will enti- tle them to receive certain payments upon retirement, death, or disability. The plan provides for payments for up to fifteen years commencing upon retirement and reduced benefits upon early retirement, disability, or termination of employment. The partici- pating employee may elect to receive payments over periods not to exceed fifteen years. At December 31, 2007, the Bank's aggre- gate payment obligations under this plan totaled $2.2 million. Off Balance Sheet Arrangements The Bank makes commitments to extend credit in the normal course of business to meet the financing needs of its customers. For additional information, see Note 17 of the Notes to Financial Statements. Borrowings Short-term borrowings consist primarily of Federal funds pur- chased and borrowings from the FHLB of San Francisco. Federal Home Loan Bank Borrowings At December 31, 2007, the Bank had no overnight borrowings with the FHLB compared to $29.4 million at December 31, 2006. Based on a blanket collateral agreement by a pledge of loans, at December 31, 2007 the FHLB line provided for maxi- mum borrowings of approximately $184.8 million. Federal Funds Purchased from Correspondent Banks The Bank has available unsecured lines of credit totaling $65.0 million for Federal funds transactions with correspondent banks. At December 31, 2007, no Federal funds were purchased by the Bank. Federal Reserve Line of Credit The Bank also has available a line of credit with the Federal Reserve Bank totaling $3.7 million at December 31, 2007, secured by an agency security. Subordinated Debt On June 17, 2004, the Bank issued a 15-year, $5 million subor- dinated debenture through a pooled trust preferred program. The interest rate on the debentures is paid quarterly at the three-month LIBOR plus 2.48%. The debenture is subordinated to the claims of depositors and other creditors of the Bank. The principal is due on June 17, 2019. · 24 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T Report of Independent Registered Public Accounting Firm To the Board of Directors and Shareholders of Bank of Marin Bancorp We have audited the accompanying consolidated statements of condition of Bank of Marin Bancorp and subsidiary, (Bancorp) as of December 31, 2007 and 2006 and the related consolidated state- ments of operations, changes in stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 2007. We have also audited Bank of Marin Bancorp's internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Bank of Marin Bancorp's management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on these financial statements and an opinion on the effec- tiveness of the Bancorp's internal control over financial reporting based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial state- ments are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting prin- ciples used and significant estimates made by management, as well as evaluating the overall financial statement presentation. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and eval- uating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinion. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliabili- ty of financial reporting and the preparation of financial state- ments for external purposes in accordance with generally accept- ed accounting principles. A company's internal control over finan- cial reporting includes those policies and procedures that (1) per- tain to the maintenance of records that, in reasonable detail, accu- rately and fairly reflect the transactions and dispositions of assets of the company; (2) provide reasonable assurance that transac- tions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of manage- ment and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unautho- rized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projec- tions of any evaluation of the effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Bank of Marin Bancorp as of December 31, 2007 and 2006 and the results of their operations and cash flows for each of the three years in the three-year period ended December 31, 2007 in con- formity with accounting principles generally accepted in the United States of America. Also, in our opinion Bank of Marin Bancorp maintained, in all material respects, effective internal con- trol over financial reporting as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the COSO. As discussed in Note 1 to the financial statements, effective January 1, 2006, Bancorp changed its method of accounting for share-based payment arrangements to conform to Statement of Financial Accounting Standard No. 123(R), Share-Based Payments. As discussed in Note 15 to the consolidated financial statements, effective January 1, 2007, Bancorp adopted the provisions of SFAS No. 157, Fair Value Measurements and SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. Stockton, California March 12, 2008 · 25 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T 504 Redwood Blvd Novato, CA 94949 March 12, 2008 To the Shareholders: Management Report Regarding Internal Control and Compliance with Designated Laws and Regulations Management of the Bank of Marin Bancorp ("Bancorp") is respon- sible for preparing the Bancorp's annual financial statements. Management is also responsible for establishing and maintaining internal control over financial reporting presented in conformity with both generally accepted accounting principles and regulato- ry reporting. Bancorp's internal control contains monitoring mech- anisms, and actions are taken to correct deficiencies identified. There are inherent limitations in the effectiveness of any internal control, including the possibility of human error and the circum- vention or overriding of controls. Accordingly, even effective inter- nal control can provide only reasonable assurance with respect to financial statement preparation. Further, because of changes in conditions, the effectiveness of internal control may vary over time. Management assessed Bancorp's internal control over financial reporting presented in conformity with both generally accepted accounting principles and regulatory reporting requirements as of December 31, 2007. The assessment was based on criteria for effective internal control over financial reporting described in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, Management believes that, as of December 31, 2007, Bancorp maintained effective internal control over finan- cial reporting presented in conformity with both generally accept- ed accounting principles and regulatory reporting requirements. Management also believes that there was satisfactory compliance during 2007 with the designated laws and regulations. Russell A. Colombo, President and Chief Executive Officer Christina J. Cook, EVP and Chief Financial Officer · 26 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T Consolidated Statement of Condition at December 31, 2007 and December 31, 2006 (in thousands, except share data) AASSSSEETTSS Cash and due from banks Federal funds sold Cash and cash equivalents Investment securities Held to maturity, at amortized cost Available for sale (at fair market value, amortized cost $87,450 at 12/31/07 and $76,231 at 12/31/06) Total investment securities Loans, net of allowance for loan losses of $7,575 at 12/31/07 and $8,023 at 12/31/06 Bank premises and equipment, net Interest receivable and other assets December 31, 2007 December 31, 2006 $ 28,765 47,500 76,265 13,182 86,989 100,171 717,303 7,821 32,341 $ 37,283 1,500 38,783 14,159 75,214 89,373 711,755 8,446 28,221 TTOOTTAALL AASSSSEETTSS $ 933,901 $ 876,578 LLIIAABBIILLIITTIIEESS AANNDD SSTTOOCCKKHHOOLLDDEERRSS’’ EEQQUUIITTYY LLIIAABBIILLIITTIIEESS Deposits Non-interest bearing Interest bearing Transaction accounts Savings and money market Time Total deposits Federal funds purchased and Federal Home Loan Bank borrowings Subordinated debenture Interest payable and other liabilities TTOOTTAALL LLIIAABBIILLIITTIIEESS SSTTOOCCKKHHOOLLDDEERRSS’’ EEQQUUIITTYY Common stock, no par value Authorized – 15,000,000 shares Issued and outstanding – 5,122,971 shares at 12/31/07 and 5,366,416 at 12/31/06 Retained earnings Accumulated other comprehensive loss, net TTOOTTAALL SSTTOOCCKKHHOOLLDDEERRSS’’ EEQQUUIITTYY $ 220,272 $ 206,201 110,174 421,255 82,941 834,642 --- 5,000 6,485 846,127 51,059 36,983 (268) 87,774 75,993 365,850 88,653 736,697 39,400 5,000 5,956 787,053 61,355 28,760 (590) 89,525 TTOOTTAALL LLIIAABBIILLIITTIIEESS AANNDD SSTTOOCCKKHHOOLLDDEERRSS’’ EEQQUUIITTYY $ 933,901 $ 876,578 The accompanying notes are an integral part of these consolidated financial statements. · 27 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T Consolidated Statement of Operations for the fiscal years ended December 31, 2007, December 31, 2006 and December 31, 2005 (in thousands, except per share amounts) December 31, 2007 December 31, 2006 December 31, 2005 IINNTTEERREESSTT IINNCCOOMMEE Interest and fees on loans held in portfolio Interest on auto loans held for sale Interest on investment securities $ 52,668 2,062 $ 53,447 --- $ 44,988 --- U.S. Treasury securities Securities of U.S. Government agencies Obligations of state and political subdivisions (tax exempt) Corporate debt securities and other Interest on Federal funds sold Total interest income IINNTTEERREESSTT EEXXPPEENNSSEE Interest on interest bearing transaction accounts Interest on savings and money market deposits Interest on time deposits Interest on borrowed funds Total interest expense Net interest income Provision for loan losses Net interest income after provision for loan losses NNOONN--IINNTTEERREESSTT IINNCCOOMMEE Service charges on deposit accounts Wealth Management Services Net gain on indirect auto and Visa portfolios Other income Total non-interest income NNOONN--IINNTTEERREESSTT EEXXPPEENNSSEE Salaries and related benefits Occupancy and equipment Depreciation and amortization Data processing Professional services Other expense Total non-interest expense Income before provision for income taxes Provision for income taxes Net income Net income per common share:* Basic Diluted 8 3,759 479 656 2,209 61,841 301 14,161 3,465 1,172 19,099 42,742 685 42,057 1,251 1,229 1,097 2,141 5,718 15,900 2,871 1,246 1,657 1,681 4,318 27,673 20,102 76 3,707 558 297 226 58,311 293 10,979 3,837 1,469 16,578 41,733 1,266 40,467 1,007 1,067 --- 1,898 3,972 15,490 2,624 998 1,537 1,269 3,973 25,891 18,548 155 2,930 808 448 156 49,485 276 5,530 3,396 841 10,043 39,442 1,541 37,901 1,044 958 --- 1,706 3,708 13,819 2,074 846 1,330 809 3,620 22,498 19,111 7,778 $ 12,324 $ 2.38 $ 2.31 6,665 $ 11,883 7,374 $ 11,737 $ 2.21 $ 2.11 5,385 5,639 $ 0.46 $ 2.28 $ 2.12 5,164 5,516 $ 0.20 Weighted average shares used to compute net income per common share:* Basic Diluted Dividends declared per common share 5,187 5,330 $ 0.51 * 2005 was restated for the 5% stock dividend declared in April 2006. The accompanying notes are an integral part of these consolidated financial statements. · 28 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T Consolidated Statement of Changes in Stockholders’ Equity for the years ended December 31, 2005, December 31, 2006 and December 31, 2007 (dollar amounts in thousands) Balance at December 31, 2004 Comprehensive income: Net income Other comprehensive income Net change in unrealized loss on available for sale securities (net of tax benefit of $381) Comprehensive income Stock options exercised Tax benefit from exercised stock options Stock issued on 5% stock dividend declared on April 14 Cash dividends paid Stock issued in payment of director fees Balance at December 31, 2005 Comprehensive income: Net income Other comprehensive income Net change in unrealized loss on available for sale securities (net of tax liability of $128) Comprehensive income Stock options exercised Tax benefit from exercised stock options Stock repurchased, including commission costs Stock-based compensation Stock issued on 5% dividend declared on April 13 Cash dividends paid Stock issued in payment of director fees Balance at December 31, 2006 Cumulative-effect adjustment of adoption of SFAS No.159 Comprehensive income: Net income Other comprehensive income Net change in unrealized loss on available for sale securities (net of tax liability of $234) Comprehensive income Stock options exercised Tax benefit from exercised stock options Stock repurchased, including commission costs Stock issued under employee stock purchase plan Stock-based compensation Cash dividends paid Stock issued in payment of director fees Balance at December 31, 2007 Common Stock Shares 4,609,685 Amount $ 40,208 Retained Earnings $ 25,640 Accumulated Other Comprehensive (Loss), Net of Taxes $ (240) Total $ 65,608 --- --- 11,737 11,737 --- --- 106,709 --- 233,025 --- 10,829 4,960,248 --- --- 1,351 680 8,340 --- 378 $ 50,957 --- 11,737 --- (8,357) (990) --- $ 28,030 (526) (526) --- --- --- --- $ (766) (526) 11,211 1,351 680 (17) (990) 378 $ 78,221 --- --- 11,883 --- 11,883 --- --- 258,207 --- (115,625) --- 250,658 --- 12,928 5,366,416 --- --- --- 3,307 1,394 (3,968) 555 8,678 --- 432 $ 61,355 --- --- 11,883 --- --- --- --- (8,705) (2,448) --- $ 28,760 (1,452) 176 176 --- --- --- --- --- --- --- $ (590) --- 176 12,059 3,307 1,394 (3,968) 555 (27) (2,448) 432 $ 89,525 (1,452) --- --- 12,324 --- 12,324 --- --- 112,496 --- (365,823) 292 --- --- 9,590 5,122,971 --- --- 1,620 729 (13,483) 8 502 --- 328 $ 51,059 --- 12,324 --- --- --- --- 322 322 --- --- --- --- (2,649) --- $ 36,983 --- --- $ (268) 322 12,646 1,620 729 (13,483) 8 502 (2,649) 328 $ 87,774 The accompanying notes are an integral part of these consolidated financial statements. · 29 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T Consolidated Statement of Cash Flows for the fiscal years ended December 31, 2007, December 31, 2006 and December 31, 2005 (in thousands) CCAASSHH FFLLOOWWSS FFRROOMM OOPPEERRAATTIINNGG AACCTTIIVVIITTIIEESS:: Net income Adjustments to reconcile net income to net cash provided by operating activities: December 31, 2007 December 31, 2006 December 31, 2005 $ 12,324 $ 11,883 $ 11,737 Provision for loan losses Compensation payable in common stock Stock-based compensation expense Excess tax benefits from exercised stock options Amortization and accretion of investment security premiums, net Depreciation and amortization Net gain on indirect auto and Visa portfolios Net loss on disposition and sale of furniture and equipment Net change in operating assets and liabilities: Interest receivable Interest payable Deferred rent and other rent-related expenses Other assets Other liabilities Total adjustments Net cash provided by operating activities CCAASSHH FFLLOOWWSS FFRROOMM IINNVVEESSTTIINNGG AACCTTIIVVIITTIIEESS:: Purchase of securities held-to-maturity Purchase of securities available-for-sale Proceeds from paydowns/maturity of: Securities held-to-maturity Securities available-for-sale Proceeds from sale of securities Proceeds from sale of indirect auto and Visa loans Loans originated and principal collected, net Purchase of bank owned life insurance policies Proceeds from disposition of assets Additions to premises and equipment Net cash used in investing activities CCAASSHH FFLLOOWWSS FFRROOMM FFIINNAANNCCIINNGG AACCTTIIVVIITTIIEESS:: Net increase in deposits Proceeds from stock options exercised Net (decrease) increase in Federal Funds purchased and Federal Home Loan Bank borrowings Common stock repurchased Dividends paid in cash Stock issued under employee stock purchase plan Cash paid for fractional shares Excess tax benefits from exercised stock options Net cash provided by financing activities Net increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of period Cash and cash equivalents at end of period Supplemental disclosure of cash flow information: Cash paid for interest Cash paid for income taxes 685 258 502 (535) 150 1,246 (1,097) --- 106 (1) 108 (3,412) 1,221 (769) 11,555 (2,056) (135,767) 2,925 24,505 100,000 78,599 (86,234) --- --- (621) (18,649) 97,945 1,620 (39,400) (13,483) (2,649) 8 --- 535 44,576 37,482 38,783 $ 76,265 $ 19,101 $ 6,295 1,266 465 555 (1,394) 487 998 --- 50 (257) 292 164 (1,870) 1,060 1,816 13,699 (1,087) (10,471) 8,663 22,011 --- --- (33,475) (1,159) 12 (3,855) (19,361) 15,525 3,307 8,400 (3,968) (2,448) --- (27) 1,394 22,183 16,521 22,262 $ 38,783 $ 16,285 $ 6,075 1,541 410 --- --- 821 846 --- --- (621) 89 --- (2,762) 1,709 2,033 13,770 (1,205) (33,630) 15,915 19,511 992 --- (110,240) (698) --- (1,969) (111,324) 76,093 2,031 13,200 --- (990) --- (17) --- 90,317 (7,237) 29,499 $ 22,262 $ 9,911 $ 7,400 Non-Cash Transactions: The fiscal year ended December 31, 2007 reflected a cumulative-effect adjustment of the adoption of SFAS No. 159, which included non-cash decreas- es to net loans of $2.5 million and retained earnings of $1.5 million, and a non-cash increase to other assets of $1.0 million. The fiscal year ended December 31, 2006 includ- ed non-cash increases to both fixed assets and other liabilities representing tenant improvements paid for by the landlord for the Bank's administrative facility totaling $617 thousand. This amount is amortized over the fifteen-year term of the lease. The accompanying notes are an integral part of these financial statements. · 30 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T Notes to Financial Statements INTRODUCTORY EXPLANATION · · · On July 1, 2007 (the "Effective Date"), a bank holding company reorganization was completed whereby Bank of Marin Bancorp (Bancorp) became the parent holding company for Bank of Marin ( the "Bank"), its sole subsidiary. On the Effective Date, a tax-free exchange was completed whereby each outstanding share of the Bank was converted into one share of Bank of Marin Bancorp and the Bank became a wholly-owned subsidiary of the holding com- pany. The information contained in the financial statements and accompanying footnotes for periods subsequent to the reorgani- zation relate to consolidated Bank of Marin Bancorp. Periods prior to the reorganization relate to Bank of Marin only. The information is comparable for all periods as the sole subsidiary of Bancorp is the Bank. The consolidated financial statements include the accounts of Bancorp and its wholly-owned bank subsidiary. All material inter- company transactions have been eliminated. In the opinion of Management, the consolidated financial statements contain all adjustments necessary to present fairly the financial position, results of operations, changes in stockholders' equity and cash flows. All adjustments are of a normal, recurring nature. NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES · · · Nature of Operations: Bancorp, through its sole subsidiary, Bank of Marin (a California state-chartered bank), provides a wide range of financial services to customers, who are predominantly profes- sionals, small and middle-market businesses, and individuals who work and/or reside in Marin and southern Sonoma counties. The Bank operates eight branches in Marin County and three in south- ern Sonoma County, as well as a loan production office in San Francisco. The accounting and reporting policies of Bancorp and Bank conform with generally accepted accounting principles and general practice within the banking industry. A summary of the more significant policies follows. Investment Securities are classified as "held to maturity," "trading securities" or "available for sale." Investments classified as held to maturity are those that the Bank has the ability and intent to hold until maturity and are reported at cost, adjusted for the amor- tization or accretion of premiums or discounts. Investments clas- sified as trading securities are reported at fair value, with unreal- ized gains and losses included in earnings. Investments classified as available for sale are reported at fair value, with unrealized gains and losses, net of related tax, if any, reported as a separate component of comprehensive income and included in stockhold- ers' equity until realized. For the majority of the Bank's securities, fair values are determined based upon quoted prices for similar securities. ket conditions and interest rate trends. A decline in the market value of any security below cost that is deemed other than tempo- rary results in a charge to earnings and the corresponding estab- lishment of a new cost basis for the security. Premiums and dis- counts are amortized or accreted over the life of the related secu- rity as an adjustment to yield using the effective interest method. Dividend and interest income are recognized when earned. Realized gains and losses for securities are included in earnings and are derived using the specific identification method for deter- mining the cost of securities sold. Loans are reported at the principal amount outstanding net of deferred fees and the allowance for loan losses. Interest income is accrued daily using the simple interest method. Loans are placed on non-accrual status when management believes that there is serious doubt as to the collection of principal or interest, or when they become contractually past due by 90 days or more with respect to principal or interest, except for loans that are both well secured and in the process of collection. When loans are placed on non-accrual status, any accrued but uncollected interest is reversed from current-period interest income and additional income is recorded only after the loan is brought current or after all principal has been collected. Loan origination and commitment fees, offset by certain direct loan origination costs, are deferred and amortized as yield adjustments over the contractual lives of the related loans. At each financial statement date, management assesses each investment to determine if impaired investments are temporarily impaired or if the impairment is other than temporary based upon the positive and negative evidence available. Evidence evaluated includes, but is not limited to, industry analyst reports, credit mar- Allowance for Loan Losses is based upon estimates of loan losses and is maintained at a level considered adequate to provide for probable losses inherent in the loan portfolio. The allowance is increased by provisions charged to expense and reduced by net · 31 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T charge-offs. In periodic evaluations of the adequacy of the allowance balance, Management considers the Bank's past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay, the esti- mated value of any underlying collateral, current economic condi- tions and other factors. The allowance for loan losses is based on estimates and ultimate losses may vary from current estimates. Management's method for assessing the appropriateness of the allowance includes specific allowances for identified problem loans, an allowance factor for pools of credits and allowances for changing environmental factors (e.g., portfolio trends, concentra- tion of credit, growth, economic factors, etc.). Allowances for identified problem loans are based on specific analysis of individ- ual credits. Loss estimation factors for loan pools are based on analysis of local economic factors applicable to each loan pool. Due to the Bank's minimal historic losses, loss estimation factors are based only in part on the previous historical loss experience for each pool. Allowances for changing environmental factors are management's best estimate of the probable impact these changes have had on the loan portfolio as a whole. Management considers a loan to be impaired when it is probable the Bank will be unable to collect all amounts due according to the contractual terms of the loan agreement. For loans determined to be impaired, the extent of the impairment is measured based on the present value of expected future cash flows discounted at the loan's original effective interest rate or based on the loan's observ- able market price or the fair value of the collateral, if the loan is collateral dependent. When the measure of the impaired loan is less than the recorded investment in the loan, the impairment is recorded through an allocation of the allowance for loan losses. ALCO reviews the adequacy of the allowance for loan losses at least quarterly, to include consideration of the relative risks in the portfolio and current economic conditions. The allowance is adjusted based on that review if, in the judgment of the ALCO and management, changes are warranted. Transfers of Financial Assets: The Bank has entered into certain participation agreements with other organizations. The Bank accounts for these transfers of financial assets as sales when con- trol over the assets has been surrendered. Control over trans- ferred assets is deemed to be surrendered when (1) the assets have been isolated from the Bank, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Bank does not maintain effective control over the transferred assets through either (a) an agreement to repurchase them before their maturity or (b) the ability to otherwise cause the holder to return specific assets. No gain or loss has been recognized by the Bank on the sale of these participation interests. Premises and Equipment consist of leasehold improvements, fur- niture, fixtures and equipment and are stated at cost, less accumu- lated depreciation and amortization, which are calculated on a straight-line basis over the estimated useful life of the property or the term of the lease (if less). Furniture and fixtures are depreciat- ed over 8 years and equipment is generally depreciated over 3 to 20 years. Leasehold improvements are amortized over the terms of the leases or their estimated useful lives, whichever is shorter. When assets are sold or otherwise disposed of, the cost and relat- ed accumulated depreciation or amortization are removed from the accounts and any resulting gain or loss is recognized in income for the period. The cost of maintenance and repairs is charged to expense as incurred. Employee Stock Ownership Plan (ESOP) and Related Debt: Bancorp accounts for shares acquired by its ESOP in accordance with the guidelines established by the American Institute of Certified Public Accountants Statement of Position 93-6, "Employers' Accounting for Employee Stock Ownership Plans." As Bancorp recognizes compensation cost for the ESOP, these funds become committed for the purchase of Bancorp common shares into the plan. To the extent that the fair value of Bancorp's ESOP shares committed to be released differ from the cost of those shares, the differential is charged or credited to equity. The ESOP may be externally leveraged and, as such, the ESOP debt is recorded as a liability and interest expense is recognized on such debt. The ESOP shares not yet committed to be released are accounted for as a reduction in stockholders' equity. Income Taxes reported in the financial statements are computed based on an asset and liability approach. Bancorp recognizes the amount of taxes payable or refundable for the current year, and deferred tax assets and liabilities for the future tax consequences that have been recognized in the financial statement or tax returns. The measurement of tax assets and liabilities is based on the provisions of enacted tax laws. Bancorp files consolidated fed- eral and combined state income tax returns. Cash and Cash Equivalents include cash, due from banks and Federal funds sold . At December 31, 2007, $851 thousand of cash and cash equivalents was pledged to collateralize interest rate swaps. Earnings per share are based upon the weighted average number of common shares outstanding during each year. The following table shows weighted average basic shares, potential common · 32 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T shares related to stock options, and weighted average diluted shares. Basic earnings per share are based upon the weighted average number of common shares outstanding during each period. Diluted earnings per share are based upon the weighted average number of common shares and potential common shares outstanding during each period. Earnings per share and share amounts for 2005 have been retroactively adjusted for the 5% stock dividend in 2006. (in thousands) Weighted average basic shares outstanding Add: Potential common shares related to stock options Weighted average diluted shares outstanding Anti-dilutive shares not included in the calculation of diluted earnings per share 2007 2006 2005 5,187 5,385 5,164 143 254 352 5,330 5,639 5,516 80 88 64 Net income Earnings per share (basic) Earnings per share (diluted) $ 12,324 $ 2.38 $ 2.31 11,883 $ 2.21 $ 2.11 11,737 $ 2.28 $ 2.12 Share-Based Compensation On January 1, 2006, the Bank adopt- ed the provisions of Statement of Financial Accounting Standard No. 123R (SFAS No. 123R) "Share-Based Payment," which requires that all share-based payments to employees, including stock options, be recognized as an expense in the income state- ment based on the grant date fair value of the award with a corre- sponding increase in common stock. The fair value, as defined in SFAS No.123R, is amortized over the implied service period, which is generally the vesting period. Prior to January 1, 2006, the Bank accounted for its share-based payments in accordance with APB Opinion No. 25, "Accounting for Stock Issued to Employees" under which no stock-based compensation was required to be rec- ognized in net income for options granted that had an exercise price equal to the market value of the underlying common stock on the date of grant. Under SFAS No. 123R, Bancorp determines fair value at grant date using the Black-Scholes pricing model that takes into account the stock price at the grant date, the exercise price, the expected life of the option, the volatility of the underlying stock, the expected dividend yield and the risk-free interest rate over the expected life of the option. The Black-Scholes option valuation model requires the input of highly subjective assumptions, including the expect- ed life of the stock based award and stock price volatility. The assumptions used represent management's best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if other assumptions had been used, the recorded stock-based compensation expense could have been materially different from that recorded in its financial statements. In addition, Bancorp is required to estimate the expected vesting period. If Bancorp's actual forfeiture rate is materially different from the estimate, the share-based compensa- tion expense could be materially different. Upon adoption of SFAS No. 123R on January 1, 2006, the Bank elected the disclosure provisions using the modified-prospective- transition method. Under that method, compensation cost recog- nized in 2006 includes a) compensation cost for all share-based option awards granted prior to, but not yet vested as of January 1, 2006 and b) compensation cost for all share-based option awards granted subsequent to January 1, 2006. The results for prior periods have not been restated. However, had compensation cost for the stock option plans been determined in accordance with SFAS No. 123R in 2005, the Bank's net income and earnings per share would have been reduced to the pro forma amounts in the following table: (in thousands except per share data) Net income as reported Stock-based compensation expense, net of taxes Pro forma net income Earnings per share* Year Ended December 31, 2005 $11,737 (833) $10,904 As reported (basic) As reported (diluted) Pro forma (basic) Pro forma (diluted) Weighted average fair value of options granted during the year* $2.28 $2.12 $2.11 $1.98 $11.06 * These numbers have been adjusted for the 5% stock dividend declared in April 2006. Derivative Financial Instruments and Hedging Activities Fair Value Hedges: Certain of the Bank's interest rate swap con- tracts that are designated as fair value hedges qualify for short-cut hedge accounting in accordance with SFAS No. 133 "Accounting for Derivative Instruments and Hedging Activities," as amended, as they are aligned to perfectly offset the change in the fair value of the designated fixed-rate loan. The interest rate swaps are car- ried on the balance sheet at their fair value in other assets (when the fair value is positive) or in other liabilities (when the fair value is negative) and offset in other non-interest income. As a result of interest rate fluctuations, the hedged fixed-rate loan will gain or lose market value. In this fair value hedging strategy, this unreal- ized gain or loss in market value will be recorded as an adjustment to the hedged loan and offset in other non-interest income. Under this scenario, the change in fair value of the interest rate swap per- · 33 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T fectly offsets the change in fair value of the loan, resulting in zero impact to net income. are included in non-interest income in the statement of opera- tions. The revenues of the community banking segment are reflected in all other income lines in the statement of operations. Certain of the Bank's interest rate swap contracts are designated as fair value hedges, whereby non-short cut accounting treatment is applied under SFAS No. 133. The interest rate swaps are close- ly aligned to offset the change in the fair value of the designated fixed-rate loan and are tested for effectiveness on a quarterly basis. The interest rate swaps are carried on the balance sheet at their fair value in other assets (when the fair value is positive) or in other liabilities (when the fair value is negative) and offset in inter- est income. In this fair value hedging strategy, the unrealized gain or loss due to changes in fair value of the hedged fixed-rate loan is recorded as an adjustment to the hedged loan and offset in interest income. Prior to loan funding, the yield maintenance agreement was carried on the balance sheet in other assets or other liabilities with the changes in fair value offset in interest income. The fair value of the yield maintenance agreement upon loan funding and simultaneous designation remains on the bal- ance sheet as an asset and is amortized using the effective yield method over the life of the resulting loan. The net effect of rec- ognizing the interest rate swap, the yield maintenance agreement and the changes in the fair value of the hedged loan on the bal- ance sheet as assets or liabilities is an insignificant amount of inef- fectiveness recognized in interest income. Non-designated Hedges: Both yield maintenance agreements with net settlement features that meet the definition of a deriva- tive and the undesignated interest rate swaps used to mitigate the agreement's change in value are recorded as assets or liabilities with offsetting gains and losses recorded directly to interest income. The Bank's forward swap was considered to be a non-des- ignated hedge prior to its designation in the third quarter of 2007. Comprehensive Income for Bancorp includes net income reported on the statement of operations and changes in the fair value of available for sale investments, net of related taxes, reported as a component of stockholders' equity. Segment Information The Bank's two operating segments include the traditional community banking activities provided through its eleven branches and its Wealth Management Services. The activ- ities of these two segments are monitored and reported by man- agement as separate operating segments. The accounting poli- cies of the segments are the same as those described in this note. The Bank evaluates segment performance based on total segment revenue and does not allocate expenses between the segments. Wealth Management Services revenues were $1,229 thousand in 2007, $1,067 thousand in 2006 and $958 thousand in 2005, which Reclassifications Certain amounts in prior years' financial state- ments have been reclassified to conform with the current presen- tation. These reclassifications have no effect on previously report- ed net income. Use of Estimates The preparation of financial statements in con- formity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contin- gent amounts of revenues and expenses during the reporting peri- od. Actual results could differ from those estimates. Recently Issued Accounting Standards In December 2007, the FASB issued SFAS No. 141 (revised 2007), "Business Combinations". SFAS No. 141R establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any non-controlling interest in the acquiree. The statement also provides guidance for recog- nizing and measuring the goodwill acquired in the business com- bination and determines what information to disclose to enable users of the financial statement to evaluate the nature and finan- cial effects of the business combination. SFAS No. 141R is effec- tive for financial statements issued for fiscal years beginning after December 15, 2008. Accordingly, any business combinations Bancorp engages in will be recorded and disclosed following existing generally accepted accounting principles until January 1, 2009. Bancorp expects SFAS No. 141R would have an impact on its consolidated financial statements when effective if it acquires another company, but the nature and magnitude of the specific effects will depend upon the nature, terms and size of the acqui- sitions Bancorp consummates after the effective date. the FASB In December 2007, issued SFAS No. 160, "Noncontrolling Interests in Consolidated Financial Statements," which provides guidance for accounting and reporting of noncon- trolling (minority) interests in consolidated financial statements. The statement is effective for fiscal years and interim periods with- in fiscal years beginning on or after December 15, 2008. Bancorp does not hold minority interests in subsidiaries, therefore it is expected that SFAS No. 160 will have no impact on its financial condition or results of operations. In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements," which clarifies the definition of fair value, · 34 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T describes methods used to appropriately measure fair value in accordance with generally accepted accounting principles and expands fair value disclosure requirements. This statement applies whenever other accounting pronouncements require or permit fair value measurements and is effective for fiscal years beginning after November 15, 2007, with early adoption allowed effective January 1, 2007 in conjunction with the early adoption of SFAS No. 159. The adoption of SFAS No. 157 effective January 1, 2007 did not impact financial position or results of operations. On February 15, 2007, the FASB released SFAS No. 159, which permits entities to choose to measure eligible financial instru- ments at fair value at specified election dates. Under SFAS No. 159 an entity records unrealized gains and losses in earnings on items for which the fair value option has been elected at each sub- sequent reporting date. The objective is to mitigate volatility in reported earnings without having to apply complex hedge accounting provisions. The provisions of SFAS No. 159 are effec- tive for fiscal years ending on or after November 15, 2007, with early adoption allowed effective January 1, 2007. Effective January 1, 2007, the Bank elected early adoption of SFAS No. 159. Upon adoption, the Bank selected the fair value option for its indirect auto loan portfolio, which was subsequently sold on June 5, 2007. For further information on the financial effect of SFAS No. 159 see Note 15. In July 2006, the FASB issued Interpretation (FIN) No. 48, "Accounting for Uncertainty in Income Taxes - An Interpretation of FASB Statement No. 109," which clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with FASB Statement No. 109, "Accounting for Income Taxes." FIN 48 establishes a "more-likely- than-not" recognition threshold that must be met before a tax benefit can be recognized in the financial statements. For tax posi- tions that meet the more-likely-than-not threshold, an enterprise may recognize only the largest amount of tax benefit that is greater than fifty percent likely of being realized upon ultimate settlement with the taxing authority. The cumulative effect of applying the provisions of FIN 48 would be recognized as an adjustment to the beginning balance of retained earnings. FIN 48 was adopted January 1, 2007 and has not had a material impact on financial condition or results of operations. In September 2006, the Emerging Issues Task Force (EITF) reached a final consensus on Issue No. 064-4 (EITF 06-4), "Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements." EITF 06- 4 requires employers to recognize a liability for future benefits pro- vided through endorsement split-dollar life insurance arrange- ments that extend into postretirement periods in accordance with SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions or APB Opinion No. 12, Omnibus Opinion-1967." The provisions of EITF 06-4 become effective on January 1, 2008 and are to be applied as a change in accounting principle either through a cumulative-effect adjustment to retained earnings or other components of equity or net assets in the statement of financial position as of the beginning of the year of adoption, or through retrospective application to all prior peri- ods. The Bank's split-dollar life insurance benefits are limited to the employee's active service period. Therefore it is expected that EITF 06-4 will have no impact on financial condition or results of operations. In September 2006, the FASB issued SFAS No. 158, "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements Nos. 87, 88, 106 and 132(R)." SFAS No. 158 requires employers to recognize the under- funded or over-funded status of a defined benefit postretirement plan as an asset or liability in its statement of financial position and to recognize changes in the funded status in the year in which the changes occur through accumulated other comprehensive income. Additionally, SFAS No. 158 requires employers to meas- ure the funded status of a plan as of the date of its year-end state- ment of financial position. The new reporting requirements and related new footnote disclosure rules of SFAS No. 158 are effec- tive for fiscal years ending after December 15, 2006. The new measurement date requirement applies for fiscal years ending after December 15, 2008. As the Bank has no pension or other post-retirement benefit plans, it is expected that SFAS No. 158 will have no impact on financial condition or results of operations. · 35 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T The amortized cost and fair market value of investment securities at December 31, 2007 and 2006 consisted of the following: NOTE 2: INVESTMENT SECURITIES · · · (In thousands) 22000077 HHEELLDD TTOO MMAATTUURRIITTYY Obligation of state & political subdivisions Corporate debt securities and other Total held to maturity 22000077 AAVVAAIILLAABBLLEE FFOORR SSAALLEE U. S. Treasury Securities Securities of U.S. Government Agencies Corporate CMOs Corporate debt securities and other Total available for sale Total 22000066 HHEELLDD TTOO MMAATTUURRIITTYY Obligation of state & political subdivisions Corporate debt securities and other Total held to maturity 22000066 AAVVAAIILLAABBLLEE FFOORR SSAALLEE U. S. Treasury Securities Securities of U.S. Government Agencies Corporate CMOs Corporate debt securities and other Total available for sale Total Amortized Cost $ 13,182 --- 13,182 --- 74,963 2,487 10,000 87,450 $ 100,632 $ 13,163 996 14,159 2,511 69,742 3,978 --- 76,231 $ 90,390 Gross Unrealized Gains Losses Fair Market Value $ 139 --- 139 --- 132 4 --- 136 $ 275 $ 67 12 79 --- 11 --- --- 11 $ 90 $ (83) --- (83) --- (580) (17) --- (597) $ (680) $ (114) --- (114) (7) (975) (46) --- (1,028) $ (1,142) $ 13,238 --- 13,238 --- 74,515 2,474 10,000 86,989 $ 100,227 $ 13,116 1,008 14,124 2,504 68,778 3,932 --- 75,214 $ 89,338 The amortized cost and estimated market value of investment securities at December 31, 2007 by contractual maturity are shown below. Expected maturities will differ from contractual maturities because the issuers of the securities may have the right to call or prepay obligations with or without call or prepayment penalties. (In thousands) Within one year After one but within five years After five years through ten After ten years Total Held to Maturity Available for Sale December 31, 2007 Amortized Cost $ 1,010 $ 5,165 $ 3,391 $ 3,616 $ 13,182 Fair Market Value $ 1,017 $ 5,200 $ 3,470 $ 3,551 $ 13,238 Amortized Cost $ 27,388 $ 46,772 $ 4,575 $ 8,715 $ 87,450 Fair Market Value $ 27,376 $ 46,519 $ 4,619 $ 8,475 $ 86,989 · 36 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T In the year ended December 31, 2007, $100.0 million in short- term available for sale securities were sold at no gain or loss as these securities were very short-term in nature, with an average hold period from seven to twenty-eight days. In the year ended December 31, 2006, no investment securities were sold and accordingly no gains or losses were recognized. During 2005, the Bank sold one security due to deterioration of the issuer's credit- worthiness. The proceeds from the sale totaled $992 thousand and resulted in a gain of $1 thousand. and $3.8 million to provide collateral for potential future borrow- ings to meet unusual short-term liquidity needs. At December 31, 2007, investment securities carried at $13.2 million were pledged with the State of California: $12.2 million to secure public deposits in compliance with the Local Agency Security Program and $1.0 million to provide collateral for trust deposits. In addi- tion, at December 31, 2007, investment securities carried at $2.3 million were pledged to collateralize an internal Wealth Management Services checking account. At December 31, 2007, investment securities carried at $5.2 mil- lion were pledged with the Federal Reserve Bank of San Francisco: $1.4 million to secure the Bank's Treasury, Tax and Loan account, Investment securities with unrealized losses at December 31, 2007 are summarized and classified according to the duration of the loss period as follows: DDEECCEEMMBBEERR 3311,, 22000077 (In thousands) Held-to-maturity Obligations of state & political subdivisions Corporate debt securities and other Total held to maturity Available for sale U.S. Treasury Securities Securities of U. S. Government Agencies Corporate CMOs Corporate debt securities and other Total available for sale Total temporarily impaired securities DDEECCEEMMBBEERR 3311,, 22000066 (In thousands) Held-to-maturity Obligations of state & political subdivisions Corporate debt securities and other Total held to maturity 2,176 (6) 5,682 (108) Available for sale U.S. Treasury Securities Securities of U. S. Government Agencies Corporate CMOs Corporate debt securities and other Total available for sale Total temporarily impaired securities < 12 continuous months > 12 continuous months Fair value Unrealized loss Fair value Unrealized loss $ --- --- --- --- 2,855 --- --- 2,855 $ 2,855 $ --- --- --- --- (22) --- --- (22) $ (22) $ 4,461 --- 4,461 --- 39,144 1,994 --- 41,138 $ 45,599 $ (83) --- (83) --- (558) (17) --- (575) $ (658) < 12 continuous months > 12 continuous months Fair value Unrealized loss Fair value Unrealized loss $ 2,176 --- $ (6) --- $ 5,682 --- $ (108) --- --- 3,456 2,866 --- 6,322 $ 8,498 --- (43) (41) --- (84) $ (90) 2,504 61,589 1,067 --- 65,160 $ 70,842 (7) (932) (5) --- (944) $ (1,052) Management periodically evaluates each investment security in an unrealized loss position to determine if the impairment is temporary or other than temporary. Included are twenty-three securities at December 31, 2007 and forty-one securities at December 31, 2006, with fair values of $48.5 million and $79.3 million, respectively, and unrealized losses of $680 thousand and $1.1 million, respectively. Management has determined that no investment security is impaired due to credit quality and no investment security is other- than-temporarily impaired. This temporary impairment is attribut- able to general changes in short-term interest rates as measured by the U.S. Treasury yield curve. · 37 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T NOTE 3: LOANS · · · The majority of the Bank's loan activity is with customers located in California, primarily in the counties of Marin, San Francisco and southern Sonoma. Although the Bank has a diversified loan port- folio, a large portion of the loans are for commercial real estate, and many of the Bank's loans are secured by real estate in Marin, San Francisco and Sonoma Counties. Approximately 84% and 75% of the loans were secured by real estate at December 31, 2007 and 2006, respectively. Effective January 1, 2007, the Bank elected the early-adoption provisions of SFAS No. 159, which permits entities to choose to measure eligible financial instruments at fair value at specified election dates. Upon adoption, the Bank selected the fair value option for the indirect auto loan portfolio, which was subsequent- ly sold on June 5, 2007. See Note 15. Outstanding loans by type, net of deferred loan fees of $2.9 mil- lion and $2.8 million at December 31, 2007 and 2006, respective- ly, are as follows: (In thousands) Commercial loans Real estate 2007 $ 124,336 2006 $ 117,391 Commercial owner-occupied Commercial investor Construction Residential (a) 132,614 257,127 97,153 78,860 Installment Indirect auto loans Other installment Total loans Less Allowance for loan losses Net Loans --- 34,788 724,878 (7,575) $ 717,303 123,601 188,091 116,790 58,912 84,141 30,852 719,778 (8,023) $ 711,755 (a) The residential loan portfolio includes no sub-prime loans at December 31, 2007 and December 31, 2006. At December 31, 2007, the Bank had one non-accrual loan total- ing $144 thousand and at December 31, 2006, the Bank had one non-accrual loan totaling $49 thousand. Neither of these loans was past due greater than 90 days at December 31 of their respec- tive years. At December 31, 2007, the Bank's FHLB line of credit was secured under terms of a blanket collateral agreement by a pledge of cer- tain qualifying collateral, including loans. The Bank has, and expects to have in the future, banking transac- tions in the ordinary course of its business with directors, officers, principal stockholders and their associates. These transactions, including loans, are granted on substantially the same terms, including interest rates and collateral on loans, as those prevailing at the same time for comparable transactions with others. Likewise, these transactions do not involve more than the normal risk of collectability or present other unfavorable features. An analysis of net loans to related parties for the years ended December 31, 2007 and 2006 is as follows: (In thousands) Balance at beginning of year New loans to related parties Repayments Balance at end of year 2007 $ 3,394 4,811 (306) $ 7,899 2006 $ 4,627 2,821 (4,054) $ 3,394 The undisbursed commitment to related parties as of December 31, 2007, was $410 thousand. · 38 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T NOTE 4: ALLOWANCE FOR LOAN LOSSES · · · Activity in the allowance for loan losses for each of the three years ended December 31 follows: (In thousands) Beginning balance Cumulative-effect adjustment of adoption of SFAS No. 159 Provision for loan loss charged to expense Loans charged off Loan loss recoveries Ending balance 2007 $ 8,023 (1,048) 685 (115) 30 $ 7,575 2006 $ 7,115 --- 1,266 (596) 238 $ 8,023 2005 $ 6,110 --- 1,541 (764) 228 $ 7,115 Total loans outstanding at end of year, before deducting allowance for loan losses $ 724,878 $ 719,778 $ 686,661 Average total loans outstanding during the year $ 703,087 $ 701,438 $ 640,726 Ratio of allowance for loan losses to total loans at end of year 1.05% 1.11% 1.04% Loans classified as non-accrual amounted to $144 thousand at December 31, 2007 and $49 thousand at December 31, 2006. At December 31, 2005 no loans were classified as non-accrual. At December 31, 2007, the Bank had one impaired loan totaling $144 thousand. At December 31, 2006, the bank had one impaired loan totaling $49 thousand. At December 31, 2005 the Bank had no impaired loans. The average recorded investment in impaired loans was $104 thousand for the year ended December 31, 2007, $1.8 million for the year ended December 31, 2006 (pri- marily related to two loans, one of which paid off and one that was sold), and $214 thousand for the year ended December 31, 2005. There was no specific valuation allowance recorded against these loans. The gross interest income that would have been recorded had non-accrual loans been current totaled $11 thousand in the year ended December 31, 2007 and $223 thousand in the year ended December 31, 2006. For the year ended December 31, 2005 the amount of foregone interest due to non-accrual loans was not sig- nificant. Effective January 1, 2007, the Bank elected the early-adoption provisions of SFAS No. 159, which permits entities to choose to measure eligible financial instruments at fair value at specified election dates. Upon adoption, the Bank selected the fair value option for the indirect auto loan portfolio, which was subsequent- ly sold on June 5, 2007. In conjunction with the adoption of SFAS No. 159, the allowance for loan losses was reduced by $1.0 mil- lion, which is reflected in the table above. See Note 15. NOTE 5: BANK PREMISES AND EQUIPMENT · · · A summary of Bank premises and equipment at December 31 follows: (In thousands) Leasehold improvements Furniture and equipment Subtotal Accumulated depreciation and amortization Bank premises and equipment, net 2007 $ 9,501 8,617 18,118 2006 $ 9,260 8,245 17,505 (10,297) $ 7,821 (9,059) $ 8,446 The amount of depreciation and amortization was $1.2 million, $998 thousand and $846 thousand for the years ended December 31, 2007, 2006 and 2005, respectively. · 39 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T NOTE 6: BANK OWNED LIFE INSURANCE · · · The Bank has purchased life insurance policies on the lives of cer- tain officers of the Bank ($14.1 million cash surrender value at December 31, 2007 and $13.5 million cash surrender value at December 31, 2006) to finance employee benefit programs. The investment in the Bank owned life insurance (BOLI) policies are reported in "interest receivable and other assets" at the cash sur- render value of the policies. The cash surrender value includes both the Bank's original premiums invested in the life insurance policies and the accumulated accretion of policy income since inception of the policies. Income of $577 thousand in 2007 and $504 thousand in 2006 was recognized on the life insurance poli- cies and is reported in "other non-interest income." NOTE 7: DEPOSITS · · · Total time deposits were $82.9 million and $88.7 million at December 31, 2007 and 2006, respectively. Of these amounts, $50.7 million and $54.0 million represented time deposits greater than $100,000 at December 31, 2007 and 2006, respectively. Interest on time deposits was $3.5 million, $3.8 million and $3.4 million in 2007, 2006 and 2005, respectively. Scheduled maturi- ties of these deposits at December 31, 2007 follows: (In thousands) 2008 Scheduled maturities of time deposits $ 69,308 2009 $ 7,625 2010 $ 3,400 2011 $ 744 2012 $ 1,864 Thereafter --- Total $82,941 The Bank accepts deposits from shareholders, directors and employees in the normal course of business, and the terms are comparable to those with non-affiliated parties. NOTE 8: BORROWINGS · · · Purchased Funds – At December 31, 2007, the Bank had no overnight borrowings or other short-term debt compared to $29.4 million at December 31, 2006, which consisted of overnight bor- rowings from the Federal Home Loan Bank ("FHLB"). Short-term borrowing available to the Bank of $184.8 million consists of a line of credit for advances with FHLB secured under terms of a blanket collateral agreement by a pledge of loans. The Bank also has unsecured lines of credit totaling $65.0 million with correspondent banks for overnight borrowings. In general, interest rates on these lines approximate the Federal funds target rate. Federal Home Loan Bank Advance – During the third quarter of 2005, the Bank obtained a three-year fixed-rate advance with Federal Home Loan Bank for $10.0 million. Each month, the Bank paid an annualized fixed rate of interest of 4.23% on the three- year advance. Although the advance was due upon maturity in the third quarter of 2008, the Bank repaid the advance in full in December of 2007. Federal Reserve Line of Credit – The Bank also has available a line of credit with the Federal Reserve Bank of San Francisco totaling $3.7 million as of December 31, 2007. This line of credit is secured by an agency security. Subordinated Debt – On June 17, 2004 the Bank issued a 15-year, $5.0 million subordinated debenture through a pooled trust pre- ferred program, which matures on June 17, 2019. The Bank has the right to redeem the debenture, in whole or in part, at the redemption price at principal amounts in multiples of $1.0 million on any interest payment date on or after June 17, 2009. The inter- est rate on the debenture changes quarterly and is paid quarterly at the three-month LIBOR plus 2.48%. The rate at December 31, 2007 was 7.47%. The debenture is subordinated to the claims of depositors and other creditors of the Bank. · 40 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T Borrowings at December 31, 2007 and 2006 are summarized as follows: (In thousands) Overnight borrowings FHLB three-year advance Subordinated debenture Carry Value $ --- --- 5,000 2007 Average Balance $ 6,836 9,260 5,000 The maximum amount outstanding at any month end for overnight borrowings was $38.5 million and $39.0 million, during Average Rate 5.35% 4.23% 8.14% Carry Value $ 29,400 10,000 5,000 2007 and 2006, respectively. 2006 Average Balance $ 13,008 10,000 5,000 Average Rate 4.68% 4.23% 7.82% NOTE 9: STOCKHOLDERS’ EQUITY · · · On July 1, 2007, the Effective Date, the bank holding company reorganization was completed and the Bank repurchased a total of 24,399 common shares of the Bank for $876 thousand from six shareholders who dissented to the exchange of these shares for Bancorp common stock. Also, on the Effective Date, after the repurchase, each remaining outstanding share of the Bank was converted into one share of Bank of Marin Bancorp and the Bank became a wholly-owned subsidiary of the holding company. Upon the adoption of SFAS No. 159 for its indirect auto loan port- folio, the Bank recorded a cumulative-effect adjustment as a charge to retained earnings totaling $1.5 million effective January 1, 2007. See Note 15. In October 2006, the Bank received approval from the California Department of Financial Institutions (DFI) and the Federal Deposit Insurance Corporation (FDIC) to buy back up to 10%, or up to 545,884 of the Bank's 5,458,838 then-outstanding shares, not to exceed $15 million. The repurchase program allowed the Bank to purchase common shares for a period of twelve months from the approval date in the open market or in privately negotiated trans- actions. In 2006, the Bank purchased 115,625 shares at an average price of $34.26 per share for a total cost of $4.0 million. In the first quarter of 2007, the Bank purchased an additional 289,692 shares at an average price of $38.10 for a total cost of $11.0 million, thereby completing the share repurchase under the approved pro- gram. In November 2007 Bancorp's Board of Directors approved an additional plan to repurchase common shares of Bancorp up to $5 million. No regulatory approval was required for this repurchase plan as Bancorp was exempted under the provisions of Regulation Y of the Federal Reserve Board. In November and December 2007, Bancorp repurchased a total of 51,732 shares at an average price of $29.96 per share for a total cost of $1.5 million. The Bank executed the repurchase transactions pursuant to the Securities and Exchange Commission's Rule 10b-18. All shares repurchased under both programs were made in open market transactions and were part of publicly announced repurchase pro- grams. A quarterly cash dividend program was implemented in the third quarter of 2005. A summary of cash dividends paid to sharehold- ers, which are recorded as a reduction of retained earnings, is pre- sented below. (In thousands except per share data) Cash dividends Cash dividends per share Years Ended December 31 2007 $ 2,649 $ 0.51 2006 $ 2,448 $ 0.46 2005 $ 990 $ 0.20 Included in cash dividends in 2007 is $5 thousand paid to share- holders in connection with the redemption of all the preferred share purchase rights issued pursuant to the Bank's Rights Agreement of August 11, 2003. Each right entitled the registered holder to purchase from the Bank one one-hundredth of a share of Series A Junior Participating Preferred stock, no par value of Bank at a price of $125 per one one-hundredth of a preferred share, subject to adjustments. The redemption, in anticipation of the for- mation of a bank holding company, was effective June 14, 2007 at a redemption price of $0.001 per right. On that same day, Bank of Marin Bancorp's Board of Directors executed a Rights Agreement substantially similar to the Bank's agreement and has issued replacement rights to purchase shares of Bancorp under the new Rights Agreement to shareholders of record as of July 23, 2007. The Bank of Marin Bancorp Rights Agreement is designed to dis- courage takeovers that involve abusive tactics or do not provide fair value to shareholders. Under California State banking laws, payment of dividends is restricted to the lesser of retained earnings or the amount of undistributed net profits from the three most recent fiscal years. · 41 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T Under this restriction, approximately $12.4 million of the retained earnings balance was available for payment of dividends as of December 31, 2007. See Note 10 for further information on accounting for stock options and share-based payments. On April 13, 2006, and April 14, 2005, the Board of Directors declared 5% stock dividends. Cash was paid in lieu of issuing frac- tional shares. Earnings per share amounts and information with respect to stock options have been restated for all years present- ed to reflect the stock dividends. Stock-based compensation also includes compensation expense related to the Employee Stock Purchase Plan, which was imple- mented in the third quarter of 2007, whereby employees may pur- chase common shares of Bancorp at a five percent discount. The discount amount is recorded as compensation expense at the time of the purchase, with a corresponding increase in common stock. Under SFAS No. 123R which was implemented in January 2006, the fair value of stock options on the grant date is recorded as a compensation expense on the income statement over the service period with a corresponding increase in common stock. In addi- tion, the Bank records tax benefits on the exercise of non-qualified stock options and on the disqualifying disposition of incentive stock options, which are accounted for as an addition to common stock with a corresponding decrease in accrued taxes payable. Stock-based compensation and tax benefits on exercised options are shown below. Years Ended December 31 (In thousands) Stock-based compensation Tax benefits on exercised options 2007 $ 502 $ 729 2006 $ 555 $ 1,394 2005* $ --- $ 680 *Accounting for stock-based compensation in accordance with SFAS No. 123R, which requires share-based payments to be recorded as an expense, was implemented January 1, 2006. NOTE 10: STOCK OPTION AND PURCHASE PLANS · · · Effective July 1, 2007, Bank of Marin Bancorp adopted an Employee Stock Purchase Plan whereby employees of Bancorp and its subsidiary may purchase Bancorp common shares through payroll deductions of between one percent and fifteen percent of pay in each pay period. Shares are purchased quarterly at a five percent discount from the closing market price on the last day of the quarter. The plan calls for 200,000 common shares to be set aside for employee purchases. On January 1, 2006, the Bank adopted the provisions of Statement of Financial Accounting Standard No. 123R (SFAS No. 123R), "Share-Based Payment," which requires that all share- based payments to employees, including stock options, be recog- nized as an expense in the income statement based on the grant date fair value of the award with a corresponding increase in com- mon stock. The fair value, as defined in SFAS No. 123R, is amor- tized over the implied service period, which is generally the vest- ing period. As of May 8, 2007, the 2007 Equity Plan was approved by share- holders. The 2007 Equity Plan was subsequently adopted by Bank of Marin Bancorp as part of the holding company formation described in Note 1. Awards under the 2007 Equity Plan now relate to shares of common stock of Bank of Marin Bancorp. All new stock-based compensation awards from the approval date forward are granted through the 2007 Equity Plan. The 2007 Equity plan provides financial incentives for selected employees, advisors and non-employee directors. Terms of the plan provide for the issuance of up to 500,000 shares of common stock for these employees, advisors and non-employee directors. The Compensation Committee of the Board of Directors has the authority in its discretion to determine those employees, advisors and non-employee directors who will receive an award, the timing of awards, the vesting schedule for each award, the type of award to be granted, the number of shares of Bancorp stock to be sub- ject to each option and restricted stock award, and all other terms and conditions of any award. The Bank has two additional stock option plans, the 1999 Stock Option Plan and the 1989 Stock Option Plan for full-time, salaried officers and employees who have substantial responsibility for the successful operation of the Bank. Upon approval of the 1999 Stock Option Plan, no new awards were granted under the 1989 Stock Option Plan. Upon approval of the 2007 Equity Plan, no new awards were granted under the 1999 Stock Option Plan. Terms of the 1999 Stock Option Plan and the 1989 Stock Option Plan provided for the issuance of up to 1,115,629 and 975,189 shares, respectively, of common stock for these officers and employees. Terms of the 1999 Stock Option and the 1989 Stock Option plans also provided for the issuance of up to 190,965 and 192,113 shares, respectively, for non-employee directors. · 42 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T Stock options granted pursuant to the 1989 and 1999 Stock Option Plans were subsequently adopted by Bank of Marin Bancorp as part of the holding company formation described in Note 1. Stock options under these plans now relate to shares of common stock of Bank of Marin Bancorp. grant for five years. All officer and employee options expire ten years from the grant date. Options granted to non-employee directors vest 20% immediately and 20% on each anniversary of the grant for four years. Director options expire seven years from the grant date. Options are issued at the fair market value of the stock at the date of grant. Options to officers and employees granted prior to January 1, 2006, vested 20% immediately and 20% on each anniversary of the grant for four years. Options granted subse- quent to January 1, 2006, vested 20% on each anniversary of the A summary of activity for options for the years ended December 31, 2005, December 31, 2006 and December 31, 2007 is present- ed below. The amounts in 2005 have been restated to reflect the 5% stock dividend declared on April 13, 2006. Options outstanding at December 31, 2004 Granted Cancelled/forfeited Exercised Options outstanding at December 31, 2005 Exercisable (vested) at December 31, 2005 Options outstanding at December 31, 2005 Granted Cancelled/forfeited Exercised Options outstanding at December 31, 2006 Exercisable (vested) at December 31, 2006 Options outstanding at December 31, 2006 Granted Cancelled/forfeited Exercised Options outstanding at December 31, 2007 Exercisable (vested) at December 31, 2007 Number of Shares 802,179 96,732 (6,340) (115,015) 777,556 587,390 777,556 79,351 (49,335) (261,307) 546,265 383,842 546,265 54,551 (6,345) (112,496) 481,975 327,948 Weighted Average Exercise Price $ 14.38 32.87 24.89 11.75 16.99 $ 13.89 $ 16.99 33.30 25.18 12.65 20.69 $ 16.28 $ 20.69 34.87 30.17 14.40 23.64 $ 19.12 Aggregate Intrinsic Value (in thousands) Weighted Average Remaining Contractual Term (in years) --- --- --- $ 2,438 $ 12,025 $ 10,865 --- --- --- $ 5,340 $ 11,303 $ 6,249 --- --- --- $ 2,532 $ 3,593 $ 3,560 --- --- --- --- 5.41 4.47 --- --- --- --- 5.44 4.17 --- --- --- --- 5.47 4.23 As of December 31, 2007, there was $933 thousand of total unrec- ognized compensation expense related to non-vested stock options. This cost is expected to be recognized over a weighted average period of approximately 14.4 months. A summary of the options outstanding and exercisable by price range as of December 31, 2007 is presented in the following table: Range of Exercise Prices $10.01 – $15.00 $15.01 – $20.00 $20.01 – $25.00 $25.01 – $30.00 $30.01 – $35.00 $35.01 – $40.00 Outstanding as of 12/31/2007 159,047 49,708 11,107 56,303 158,002 47,808 481,975 Options Outstanding Remaining Contractual Life 2.5 3.7 5.1 6.3 7.6 9.2 Weighted Average Exercise Price $12.08 $16.99 $20.48 $26.53 $33.06 $35.20 Options Exercisable Shares 159,047 49,708 11,107 43,216 62,886 1,984 327,948 Weighted Average Exercise Price $12.08 $16.99 $20.48 $26.46 $32.83 $35.37 · 43 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T The following table summarizes share-based compensation expense under SFAS No. 123R for the years ended December 31, 2006 and December 31, 2007. Year Ended (In thousands except fair value data) Net income as reported Stock based compensation included in salaries and related benefits Tax benefit of share-based compensation included in provision for income taxes Share-based compensation net of tax Weighted-average fair value of options granted Weighted-average fair value of options vested December 31, 2007 $ 12,324 502 (83) $ 419 $ 7.46 $ 7.61 December 31, 2006 $ 11,833 555 (80) $ 475 $ 7.93 $ 9.30 Bancorp determines fair value at grant date using the Black- Scholes pricing model that takes into account the stock price at the grant date, the exercise price, the expected life of the option, the volatility of the underlying stock, the expected dividend yield and the risk-free interest rate over the expected life of the option. The weighted average assumptions used in the pricing model are (In thousands except fair value data) Risk-free interest rate Expected dividend yield Expected life in years Expected price volatility noted in the table below. The expected term of options granted is derived from historical data on employee exercise and post-vesting employment termination behavior. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of the grant. Expected volatility is based on the historical volatility of the common stock. December 31, 2007 4.64% 1.38% 7 Year Ended December 31, 2006 5.06% 1.37% 7 12.30% 12.53% December 31, 2005 4.38% 1.13% 9 22.87% For options granted prior to January 1, 2006, and valued in accor- dance with Statement of Financial Accounting Standard No. 123,"Accounting for Stock-Based Compensation," (SFAS No. 123), the Bank recognized option forfeitures as they occurred. For options granted after January 1, 2006, and valued in accor- dance with SFAS 123R, the fair value of the option is expensed on a straight-line basis over the vesting period. Forfeitures are esti- mated and expense is recognized only for those shares expected to vest. The estimated forfeiture rate, based on historical forfei- ture experience, was 7.5% in 2007. The Black-Scholes option valuation model requires the input of highly subjective assumptions, including the expected life of the stock based award and stock price volatility. The assumptions list- ed above represent management's best estimates, but these esti- mates involve inherent uncertainties and the application of man- agement judgment. As a result, if other assumptions had been used, the recorded stock-based compensation expense could have been materially different from that reflected in these financial statements. If the actual forfeiture rate is materially different from the estimate, the share-based compensation expense could be materially different. NOTE 11: BENEFIT PLANS · · · In 2003 the Bank established an Officer Deferred Compensation Plan that allows key executive officers designated by the Board of Directors of the Bank to defer up to 80% of their salary and 100% of their annual bonus. Amounts deferred earn interest at a rate set annually by the Board of Directors. The interest rate was set at 8.25% for 2007, 7.25% for 2006, and 7.25% for 2005. The Bank's deferred compensation obligation of $2.2 million and $1.8 million at December 31, 2007 and 2006, respectively, is included in "interest payable and other liabilities." The Bank also established a Split Dollar Plan and a Survivor Income Plan in 2003 for officers designated by the Board of Directors. Death benefits are provided under the specific terms of these plans. The Bank has purchased life insurance policies on the designated officers in connection with these plans. The expense recognized under this plan totaled $79 thousand, $67 thousand and $56 thousand for the years ended December 31, 2007, 2006 and 2005, respectively. The Bank's 401(k) Plan commenced in May 1990 and is available to all employees. Under this plan employees can defer up to 50% of their total compensation, up to the maximum amount allowed by the Internal Revenue Code. The Bank will match 50% of each participant's contribution up to a maximum match of $4 thousand · 44 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T annually. Employer contributions totaled $383 thousand, $409 thousand and $338 thousand for the years ended December 31, 2007, 2006 and 2005, respectively. In 1999 the 401(k) Plan was amended to include an employee stock ownership component and was renamed the Bank of Marin Employee Stock Ownership and Savings Plan (the "Plan".) Under the terms of the Plan, as amended, a portion of the Bank's profits, as determined by the Board of Directors, is contributed to the Plan each year either in common stock or in cash for the purchase of Bank of Marin Bancorp stock. For the years ended December 31, 2007, 2006 and 2005 the Bank contributed $854 thousand, $900 thousand and $889 thousand, respectively. Generally, cash divi- dends on Bancorp's stock held by the Plan are used to purchase additional shares in the open market. All shares of the Bancorp's stock held by the Plan are included in the calculations of basic and diluted earnings per share. Contributions to the Plan for both the matching contribution and for the purchase of Bank of Marin stock are included in "salaries and benefits." Employer contributions vest at a rate of 20% per year over a five-year period. NOTE 12: INCOME TAXES · · · The current and deferred components of the income tax provision for each of the three years ended December 31 are as follows: (In thousands) Current tax provision Federal State Total current Deferred tax (benefit)/liability Federal State Total deferred Total income tax provision 2007 2006 2005 $ 5,993 1,847 7,840 $ 5,800 1,514 7,314 $ 6,113 2,220 8,333 (128) 66 (62) $ 7,778 (494) (155) (649) $ 6,665 (769) (190) (959) $ 7,374 Income taxes recorded directly to comprehensive income are not included above. These income tax benefits or liabilities relating to changes in the unrealized gains and losses on available for sale securities amounted to $(234) thousand, $128 thousand and $381 thousand in 2007, 2006 and 2005, respectively. The following table shows the tax effect of the Bank's cumulative temporary differences as of December 31: (In thousands) Deferred tax assets: 2007 2006 Allowance for loan losses Depreciation State franchise tax Deferred compensation Net unrealized loss on securities available for sale Other $ 3,374 397 547 950 194 330 Deferred tax liabilities: Loan origination costs Other Net deferred tax asset (190) (146) $ 5,456 $ 3,557 366 541 797 428 145 (180) (26) $ 5,628 Based upon the level of historical taxable income and projections for further taxable income over the periods during which the deferred tax assets expect to be deductible, management believes it is more likely than not the Bank will realize the benefit of the deferred tax assets. The effective tax rate of the Bank for 2007, 2006 and 2005 differs from the current Federal statutory income tax rate as follows: Federal statutory income tax rate Increase (decrease) due to: California franchise tax, net of federal tax benefit Stock based compensation Tax exempt interest on municipal securities and loans Prior year tax adjustments Tax exempt earnings on bank owned life insurance Other permanent differences Effective Tax Rate 2007 35.0% 2006 35.0% 2005 35.0% 6.2 0.8 (1.6) (0.3) 6.1 1.1 (1.8) (3.3) 6.9 --- (1.6) --- (1.2) (0.2) 38.7% (1.1) (0.1) 35.9% (1.0) (0.7) 38.6% Bancorp files a consolidated return in the U.S. Federal tax jurisdic- tion and a combined report in the State of California tax jurisdic- tion. Prior to the formation of Bancorp in 2007, the Bank filed in the U.S. Federal and California jurisdictions on a stand-alone basis. None of the entities are subject to examination by taxing authorities for years before 2004 for U.S. Federal or for years before 2003 for California. Bancorp adopted the provisions of FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes, on January 1, 2007. No adjustments were identified for unrecognized tax ben- efits that required an adjustment to the January 1, 2007 beginning tax reserve. Bancorp had no tax reserve for uncertain tax positions · 45 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T at December 31, 2007. Bancorp does not anticipate providing a reserve for uncertain tax positions in the next twelve months. Bancorp has elected to record interest and penalties related to unrecognized tax benefits in tax expense. During the years ended December 31, 2007, 2006 and 2005, neither the Bank nor Bancorp had an accrual for interest and penalties associated with uncertain tax positions. NOTE 13: COMMITMENTS AND CONTINGENCIES · · · The Bank rents certain premises and equipment under long-term non-cancelable operating leases expiring at various dates through the year 2022. At December 31, 2007, the approximate minimum future commitments payable under non-cancelable contracts for leased premises are as follows: (In thousands) Operating leases 2008 $2,175 2009 $2,037 2010 $1,816 2011 $1,383 2012 $1,283 Thereafter $11,139 Total $19,833 Rent expense included in "occupancy" totaled $2.3 million, $2.0 million and $1.5 million in 2007, 2006 and 2005, respectively. from the initial public offering is expected to be set aside by Visa Inc. to cover this litigation on behalf of its member banks. Bancorp may be party to legal actions which arise from time to time as part of the normal course of its business. Bancorp believes, after consultation with legal counsel, that it has meritori- ous defenses in these actions, and that the liability, if any, will not have a material adverse effect on the financial position, results of operations, or cash flows of Bancorp. Bancorp is responsible for its proportionate share of certain litiga- tion indemnifications provided to Visa U.S.A. by its member banks in connection lawsuits related to anti-trust charges and inter- change fees. Bancorp recorded a liability of $242 thousand in the fourth quarter of 2007 to cover its potential liability. Bancorp expects to fully reverse this liability in 2008 upon the initial public offering of Visa Inc., which became the parent company of Visa U.S.A. during a restructuring in 2007. A portion of the proceeds As permitted or required under California law and to the maxi- mum extent allowable under that law, Bancorp has certain obliga- tions to indemnify its current and former officers and directors for certain events or occurrences while the officer or director is, or was serving, at Bancorp's request in such capacity. These indemnifica- tion obligations are valid as long as the director or officer acted in good faith and in a manner the person reasonably believed to be in or not opposed to the best interests of the corporation, and, with respect to any criminal action or proceeding, had no reason- able cause to believe his or her conduct was unlawful. The maxi- mum potential amount of future payments Bancorp could be required to make under these indemnification obligations is unlim- ited; however, Bancorp has a director and officer insurance policy that mitigates Bancorp's exposure and enables Bancorp to recov- er a portion of any future amounts paid. Bancorp believes the esti- mated fair value of these indemnification obligations is minimal. The carrying amounts and fair values of the Bank's financial instruments at December 31, 2007 and 2006 are presented below. NOTE 14: FAIR VALUE OF FINANCIAL INSTRUMENTS · · · (In thousands) Financial assets Cash and cash equivalents Investment securities Loans, net Accrued interest receivable Financial liabilities Deposits Federal funds purchased Federal Home Loan Bank borrowings Subordinated debenture Accrued interest payable 2007 2006 Fair Value Carrying Amounts Fair Value $ 76,265 100,227 718,184 4,085 835,151 --- --- 5,000 796 $ 38,783 89,373 711,755 4,191 736,697 29,400 10,000 5,000 797 $ 38,783 89,338 704,341 4,191 735,969 29,400 9,805 5,000 797 Carrying Amounts $ 76,265 100,171 717,303 4,085 834,642 --- --- 5,000 796 · 46 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T The following methods and assumptions were used to estimate the fair value of each class of financial instruments: Cash and Cash Equivalents – Cash and cash equivalents are val- ued at their carrying amounts because of the short-term nature of these instruments. Investment Securities – Investment securities are valued at the quoted market prices. See Note 2 for further analysis. Loans – Loans with variable interest rates are valued at the cur- rent carrying value, because these loans are regularly adjusted to market rates. The fair value of fixed rate loans with remain- ing maturities in excess of one year is estimated by discounting the future cash flows using current rates at which similar loans would be made to borrowers with similar credit ratings for the same remaining maturities. Accrued Interest Receivable and Payable – The accrued interest receivable and payable balance approximates its fair value. Deposits – The fair value of non-interest bearing deposits, inter- est bearing transaction accounts and savings accounts is the amount payable on demand at the reporting date. The fair value of time deposits is estimated by discounting the future cash flows using current rates offered for deposits of similar remaining maturities. Federal Funds Purchased – The balance represents its fair value due to the short-term nature of these borrowings. Federal Home Loan Bank Borrowings – The fair value is estimat- ed by discounting the future cash flows using current rates offered for similar borrowings. Subordinated Debenture – The balance represent its fair value as it has a variable interest rate. Commitments – The fair value of commitments represents the carrying amount of the related unamortized loan fees and is not material. NOTE 15: FAIR VALUE MEASUREMENTS · · · The Bank performs fair-market valuations on certain assets as a result of the application of accounting guidelines that were in effect prior to the adoption of SFAS No. 157. The following table summarizes the Bank's financial instruments that were measured at fair value on a recurring basis at December 31, 2007. (Dollars in thousands) Description of Financial Instruments Securities available for sale Derivative financial instruments (assets) Total assets Derivative financial instruments (liabilities) December 31, 2007 $ 86,989 62 $ 87,051 647 $ Quoted Prices in Active Markets for Identical Assets (Level 1) $ 86,989 --- $ 86,989 --- $ Significant Other Observable Inputs (Level 2) $ --- 62 $ 62 $ 647 Significant Unobservable Inputs (Level 3) $ --- --- $ --- $ --- Securities available for sale are valued based upon open-market quotes obtained from reputable third-party brokers. Market pric- ing is based upon specific CUSIP identification for each individual security. Changes in fair market value are recorded in other com- prehensive income. The fair value of derivative financial instruments is based on the present value of future expected cash flows. The variable rates and discount rates are derived from LIBOR cash and swap rates. LIBOR, rather than risk free rates, are used to adjust for the inher- ent credit risk associated with high quality counterparties. The fair value of derivative financial instruments is provided by a third party. Changes in fair market value are recorded in other non-inter- est income for fair value hedges using short-cut hedge accounting treatment and are recorded in interest income for fair value hedges not qualifying for short-cut hedge accounting treatment. Effective January 1, 2007, the Bank adopted SFAS No. 157, "Fair Value Measurements," concurrent with its early adoption of SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities." SFAS No. 157 clarifies the definition of fair value, describes methods used to appropriately measure fair value in accordance with generally accepted accounting principles and expands fair value disclosure requirements. This statement applies whenever other accounting pronouncements require or permit fair value measurements. SFAS No. 157 generally permits the meas- urement of selected eligible financial instruments at fair value on specified election dates. In conjunction with the Bank's decision to sell its indirect auto portfolio, on January 1, 2007 the Bank elected the fair value meas- urement option for its indirect auto loan portfolio under the early adoption provisions of SFAS No. 159. The sale of the indirect auto · 47 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T portfolio was concluded on June 5, 2007. The following table presents a computation of the net change to retained earnings at the initial adoption of SFAS No. 159 for the Bank's indirect auto loan portfolio. (Dollars in thousands) Assets Auto loans, net Pre-tax cumulative effect of adoption of the fair value option Increase in deferred tax asset Cumulative effect of adoption of the fair value option (charge to retained earnings) January 1, 2007 Prior to Adoption Net Gain (Loss) Upon Adoption January 1, 2007 After Adoption $ 83,327 $ 80,828 $ (2,499) (a) (2,499) 1,047 $ (1,452) (a) The $2.5 million loss on loans that was recorded as part of the cumulative-effect adjustment to retained earnings upon initial adoption of SFAS No. 159 is net of $1.0 million that was removed from the allowance for loan losses. NOTE 16: REGULATORY MATTERS · · · Bancorp and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regu- lators that, if undertaken, could have a material effect on Bancorp's consolidated financial statements. Under capital ade- quacy guidelines and the regulatory framework for prompt correc- tive action, Bancorp and the Bank must meet specific capital guidelines that involve quantitative measures of Bancorp's and the Bank's assets, liabilities, and certain off-balance sheet items as cal- culated under regulatory accounting practices. The capital amounts and the Bank's prompt corrective action classification are also subject to qualitative judgments by the regulators about com- ponents, risk weightings and other factors. Prompt corrective action provisions are not applicable to bank holding companies such as Bancorp. Quantitative measures established by regulation to ensure capital adequacy require Bancorp and the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital to risk weighted assets and of Tier 1 capital to quarterly average assets. Bancorp's and the Bank's capital adequacy ratios are presented in the following tables. Capital ratios are reviewed by Management on a regular basis to ensure that capital exceeds the prescribed regulatory minimums and is adequate to meet the Bank's antici- pated future needs. For all periods presented, the Bank's ratios exceed the regulatory definition of "well capitalized" under the regulatory framework for prompt corrective action and Bancorp's ratios exceed the required minimum ratios for capital adequacy purposes. CCAAPPIITTAALL RRAATTIIOOSS FFOORR TTHHEE BBAANNCCOORRPP:: (In thousands) Total Capital (to risk-weighted assets) Tier 1 Capital (to risk-weighted assets) Tier 1 Capital (to average assets) Actual Ratio Amount $101,066 $88,041 $88,041 Ratio 12.06% 10.51% 9.63% Amount >$67,015 >$33,508 >$36,588 Ratio for Capital Adequacy Purposes Ratio >8.0% >4.0% >4.0% CCAAPPIITTAALL RRAATTIIOOSS FFOORR TTHHEE BBAANNKK:: (In thousands) Actual Ratio Ratio for Capital Adequacy Purposes Ratio to be Well Capitalized Under Prompt Corrective Action Provisions As of December 31, 2007 Total Capital (to risk-weighted assets) $97,179 Tier 1 Capital (to risk-weighted assets) $84,155 $84,155 Tier 1 Capital (to average assets) Amount As of December 31, 2006 Total Capital (to risk-weighted assets) $103,576 Tier 1 Capital (to risk-weighted assets) $90,115 $90,115 Tier 1 Capital (to average assets) Ratio 11.61% 10.05% 9.20% 12.56% 10.93% 10.27% Amount >$66,983 >$33,491 >$36,587 >$65,969 >$32,984 >$35,113 Ratio >8.0% >4.0% >4.0% >8.0% >4.0% >4.0% Amount >$83,729 >$50,237 >$45,734 >$82,461 >$49,477 >$43,892 Ratio >10.0% >6.0% >5.0% >10.0% >6.0% >5.0% · 48 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T NOTE 17: FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK · · · The Bank makes commitments to extend credit in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend cred- it in the form of loans or through standby letters of credit. Commitments to extend credit are agreements to lend to a cus- tomer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire with- out being drawn upon, the total commitment amount does not necessarily represent future cash requirements. The Bank is exposed to credit loss in the contract amount of the commitment in the event of nonperformance by the borrower. The Bank uses the same credit policies in making commitments as it does for on-balance-sheet instruments and evaluates each cus- tomer's creditworthiness on a case-by-case basis. The amount of collateral obtained if deemed necessary by the Bank is based on management's credit evaluation of the borrower. Collateral held varies, but may include accounts receivable, inventory, property, plant and equipment, and real property. The contract amount of loan commitments not reflected on the statement of condition was $224.5 million at December 31, 2007 at rates ranging from 5.78% to 11.25%. This amount included $118.4 million under commercial lines of credit (these commit- ments are contingent upon customers maintaining specific credit standards), $59.6 million under revolving home equity lines and $35.2 million under undisbursed construction loans. The Bank has set aside an allowance for losses in the amount of $449 thousand for these commitments, which is recorded in "interest payable and other liabilities." Approximately 42% of the commitments expire in 2008 with approximately 58% expiring between 2009 and 2019. NOTE 18: DERIVATIVE FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES · · · The Bank has entered into interest-rate swaps, primarily as an asset/liability management strategy, in order to hedge the change in the fair value of both long-term fixed-rate loans and firm com- mitments to enter into long-term fixed-rate loans due to changes in interest rates. Such hedges allow the Bank to offer long-term fixed rate loans to customers without assuming the interest rate risk of a long-term asset by swapping the Bank's fixed-rate inter- est stream for a floating-rate interest stream tied to one-month LIBOR. Such modification of the interest characteristics of the loan protects the Bank against an adverse effect on earnings and the net interest margin due to fluctuating interest rates. During the third quarter of 2007, the Bank's forward swap was des- ignated to offset the change in fair value of a loan originated dur- ing the period. The fair value of the related yield maintenance agreement totaling $69 thousand at the date of designation is being amortized to interest income using the effective yield method over the life of the loan. · 49 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T (In thousands) Notional or contractual amount Credit risk amount (1) Estimated net fair value Fair Value Swap (Shortcut Accounting Treatment) $ 7,201 --- (44) At December 31, 2007 Fair Value Swap (Non-shortcut Accounting Treatment) $ 8,134 --- (603) Yield Maintenance Agreement --- --- 62 At December 31, 2006 Fair Value Swap (Shortcut Accounting Treatment) $ 7,513 220 220 Fair Value Swap (Non-shortcut Accounting Treatment $ 8,300 --- (295) (In thousands except fair value data) Fair Value Swap (Shortcut Accounting Treatment): Weighted average pay rate Weighted average receive rate Fair Value Swap (Non-Shortcut Accounting Treatment): Weighted average pay rate Weighted average receive rate Yield maintenance agreement Weighted average receive rate (2) (Loss) gain on designated and undesignated interest rate contracts Increase (decrease) in value of designated loans and yield maintenance agreement qualifying as derivatives Net loss on derivatives used to hedge loans recorded in income Year Ended December 31, 2007 December 31, 2006 4.59% 5.28% 5.54% 5.24% 5.15% $ (572) 551 $ (21) 4.59% 5.06% 5.54% 5.06% 5.15% $ (198) 198 $ --- (1) Credit risk represents the amount of unrealized gain included in derivative assets which is subject to counterparty credit risk. It reflects the effect of master netting agreements and includes credit risk on virtual derivatives. (2) Tax equivalent yield equals 8.26%. Ineffectiveness of ($21) thousand and zero was recorded in inter- est income during the twelve months ended December 31, 2007 and 2006, respectively. The full change in value of swaps was included in the assessment of hedge effectiveness. NOTE 19: CONDENSED BANK OF MARIN BANCORP UNCONSOLIDATED FINANCIAL STATEMENTS · · · Presented below is financial information for Bank of Marin Bancorp, holding company only, subsequent to its formation on July 1, 2007. See Note 1. CCOONNDDEENNSSEEDD UUNNCCOONNSSOOLLIIDDAATTEEDD SSTTAATTEEMMEENNTT OOFF CCOONNDDIITTIIOONN at December 31, 2007 (In thousands) AASSSSEETTSS Cash and due from Bank of Marin Investment in subsidiary Other assets Total assets LLIIAABBIILLIITTIIEESS AANNDD SSTTOOCCKKHHOOLLDDEERRSS'' EEQQUUIITTYY Accrued expenses payable Total liabilities Stockholders' equity TTOOTTAALL LLIIAABBIILLIITTIIEESS AANNDD SSTTOOCCKKHHOOLLDDEERRSS'' EEQQUUIITTYY $ 3,751 83,887 179 $ 87,817 $ 43 43 87,774 $ 87,817 · 50 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T CCOONNDDEENNSSEEDD UUNNCCOONNSSOOLLIIDDAATTEEDD SSTTAATTEEMMEENNTT OOFF OOPPEERRAATTIIOONNSS for the six months ended December 31, 2007 (In thousands) IINNCCOOMMEE Dividends from bank subsidiary Total income EEXXPPEENNSSEE Non-interest expense Total expense IINNCCOOMMEE BBEEFFOORREE IINNCCOOMMEE TTAAXXEESS AANNDD EEQQUUIITTYY IINN UUNNDDIISSTTRRIIBBUUTTEEDD NNEETT IINNCCOOMMEE OOFF SSUUBBSSIIDDIIAARRYY Income tax benefit Income before equity in undistributed net income of subsidiary Equity in undistributed net income of subsidiary NNEETT IINNCCOOMMEE $ 7,000 7,000 371 371 6,629 156 6,785 (338) $ 6,447 CCOONNDDEENNSSEEDD UUNNCCOONNSSOOLLIIDDAATTEEDD SSTTAATTEEMMEENNTT OOFF CCAASSHH FFLLOOWWSS for the six months ended December 31, 2007 (In thousands) CCAASSHH FFLLOOWWSS FFRROOMM OOPPEERRAATTIINNGG AACCTTIIVVIITTIIEESS:: Net income Adjustments to reconcile net income to net cash provided by operating activities: Equity in undistributed and distributed net income of subsidiary Net change in operating assets and liabilities Other assets Other liabilities Net cash used in operating activities CCAASSHH FFLLOOWWSS FFRROOMM IINNVVEESSTTIINNGG AACCTTIIVVIITTIIEESS:: Capital contribution to subsidiary Net cash used in investing activities CCAASSHH FFLLOOWWSS FFRROOMM FFIINNAANNCCIINNGG AACCTTIIVVIITTIIEESS:: Stock options exercised Dividends paid in cash Dividends received from subsidiary Stock repurchased Net cash provided by financing activities Net increase in cash and cash equivalents Cash and cash equivalents at beginning of period Cash and cash equivalents at end of period $ 6 ,447 (6,662) (179) 43 (351) (61) (61) 61 (1,345) 7,000 (1,553) 4,163 3,751 --- $ 3,751 Non-Cash Transactions: Upon formation of the holding company on July 1, 2007, Bank of Marin Bancorp exchanged one share of common stock for each share of common stock of the Bank of Marin. The investment in subsidiary account was created to reflect the total capital of the Bank of $84.2 million at that date, comprised of $53.0 million of common stock, $31.9 million of retained earnings, and $762 thousand of other comprehensive loss. EENNDD OOFF 22000077 AAUUDDIITTEEDD CCOONNSSOOLLIIDDAATTEEDD FFIINNAANNCCIIAALL SSTTAATTEEMMEENNTTSS · 51 · B A N K O F M A R I N B A N C O R P 2 0 0 7 A N N U A L R E P O R T Stock Price Performance The following graph, provided by Keefe, Bruyette, & Woods, Inc., shows a comparison of cumulative total shareholder return on ticker symbol BMRC common stock during the five fiscal years ended December 31, 2007 compared to Standard & Poors (S&P) 500 stock index and a peer group index of other financial institu- tions. The comparison assumes $100 was invested on December 31, 2002 in BMRC common stock and all of the dividends were reinvested. The chart indicates that BMRC common stock outper- formed both the S&P 500 stock index and its peer group index. Ticker symbol BMRC represents the common stock of Bank of Marin Bancorp subsequent to its formation on July 1, 2007 and represents the common stock of Bank of Marin for periods prior to the formation of the bank holding company. The sole subsidiary of Bank of Marin Bancorp is Bank of Marin. BMRC PEER GROUP S&P 500 INDEX 2002 100 100 100 2003 201 177 97 2004 283 208 106 2005 257 228 109 2006 286 242 124 2007 232 195 128 BMRC Peer Group includes: AMRB, FNRN, SBNK, EXSR, EPIK, BSRR, RBCB. Source: FactSet. · 52 · 501001502002503003502002200320042005200620070BMRCPEER GROUPS&P 500INDEXED PRICES (%)10020128325728623219512824212422810920810697177w w w . b a n k o f m a r i n . c o m 

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