2011 Annual Report Banking Your Way 1 To Our Shareholders Daniel J. Doyle President, CEO and Director Central Valley Community Bancorp Central Valley Community Bank Daniel N. Cunningham Director, Quinn Group, Inc. Founding Director and Chairman of the Board Central Valley Community Bancorp Promising Signs, Proven Strength From slow job growth to national debt levels to consumer confidence, there are abundant reminders that our Valley, state and nation are not yet through this difficult economic period. Even so, there is reason to be encouraged as Central Valley Community Bank continues to outperform its peers in all of the key financial and regulatory categories and has remained profitable every quarter during these difficult economic times. While the demand for loans remains a challenge, the Bank remains well-positioned for growth and stability with increased deposits and improved asset quality. In fact, 2011 represented the second highest earnings year in the history of the Company. The year also proved to be eventful in terms of expense-related activity, including the relocation of the Modesto office and the launch of enhanced electronic banking platforms for both business and personal customers. The Bank also paid-off TARP funding, redeemed warrants and completed funding for the Small Business Lending Fund. Where does the Bank stand among its peers? Quite admirably - when comparing key performance categories. The Bank’s performance sets a solid foundation for moving forward, with an established baseline that looks promising for 2012 and beyond. A Year Of Near-Record Earnings The Company demonstrated its commitment to strong financial performance and shareholder value, achieving its second-highest earnings mark in 31 years for the full 2011 year. While net income showed significant improvement over 2010, it fell short of our goals, but still exceeded most of our peers. Just as important was the continued improvement in asset quality with reductions in non-accrual loans and no OREO at year end. While slight economic improvement is being seen overall in the markets we serve, average loans decreased compared to 2010 due to deleveraging, the continued reluctance of businesses to expand by adding more debt and the reduction in non-performing and classified loans. Deposits showed positive growth while achieving a favorable mix in non-interest bearing deposits, continuing to reduce our overall 2 cost of funds. The expansion of new offices and the addition of new team members in recent years have helped the Bank achieve this organic growth in both deposits and customer relationships. Net income for the year increased 97.53%, primarily driven by lower provision for credit losses, decreases in non-interest expense and increases in non-interest income. The increase was partially offset by decreases in net interest income in 2011 compared to 2010. The Bank’s non-interest income for 2011 was aided by several extraordinary income items that we will not see in 2012. Additionally, the Bank will be negatively impacted by new regulations affecting overdraft services. Also worth noting is the funding received by the Bank through the Treasury Department’s Small Business Lending Fund. This fund, established as part of the Small Business Jobs Act signed into law by President Obama, encourages community banks to increase their lending to small businesses in order to help those companies expand their operations and create new jobs. The proceeds were used to repay the TARP preferred shares. Overall, 2011 will be remembered as a year in which the Bank built reserves and increased capital. Our growing capital enhanced the safe, solid base for expanding the Bank’s presence in California’s Central Valley and better serving our customers and communities. Strong Shareholder Value Central Valley Community Bank continues to offer excellent value to our shareholders as a safe, solid institution with strong performance, a sterling reputation and a long history of investing in our communities. Sandler O'Neill + Partners, L.P. named the Company stock among their “Top Investment Ideas” in both 2010 and 2011. Of course, the trading of the Company’s stock is directly affected by the status of the overall financial sector in the market and the liquidity of the stock. A Busy Year For The Bank Like many of the past 31 years, 2011 was an active period for the Bank and our executive team, who actively advocate on behalf of the Bank to educate our employees and customers about the evolving complexities of the financial industry and economy. As Bank President and CEO, To Our Shareholders Daniel J. Doyle President, CEO and Director Central Valley Community Bancorp Central Valley Community Bank Daniel N. Cunningham Director, Quinn Group, Inc. Founding Director and Chairman of the Board Central Valley Community Bancorp Promising Signs, Proven Strength From slow job growth to national debt levels to consumer confidence, there are abundant reminders that our Valley, state and nation are not yet through this difficult economic period. Even so, there is reason to be encouraged as Central Valley Community Bank continues to outperform its peers in all of the key financial and regulatory categories and has remained profitable every quarter during these difficult economic times. While the demand for loans remains a challenge, the Bank remains well-positioned for growth and stability with increased deposits and improved asset quality. In fact, 2011 represented the second highest earnings year in the history of the Company. The year also proved to be eventful in terms of expense-related activity, including the relocation of the Modesto office and the launch of enhanced electronic banking platforms for both business and personal customers. The Bank also paid-off TARP funding, redeemed warrants and completed funding for the Small Business Lending Fund. Where does the Bank stand among its peers? Quite admirably - when comparing key performance categories. The Bank’s performance sets a solid foundation for moving forward, with an established baseline that looks promising for 2012 and beyond. A Year Of Near-Record Earnings The Company demonstrated its commitment to strong financial performance and shareholder value, achieving its second-highest earnings mark in 31 years for the full 2011 year. While net income showed significant improvement over 2010, it fell short of our goals, but still exceeded most of our peers. Just as important was the continued improvement in asset quality with reductions in non-accrual loans and no OREO at year end. While slight economic improvement is being seen overall in the markets we serve, average loans decreased compared to 2010 due to deleveraging, the continued reluctance of businesses to expand by adding more debt and the reduction in non-performing and classified loans. Deposits showed positive growth while achieving a favorable mix in non-interest bearing deposits, continuing to reduce our overall cost of funds. The expansion of new offices and the addition of new team members in recent years have helped the Bank achieve this organic growth in both deposits and customer relationships. The Bank’s non-interest income for 2011 was aided by several extraordinary income items that we will not see in 2012. Additionally, the Bank will be negatively impacted by new regulations affecting overdraft services. Also worth noting is the funding received by the Bank through the Treasury Department’s Small Business Lending Fund. This fund, established as part of the Small Business Jobs Act signed into law by President Obama, encourages community banks to increase their lending to small businesses in order to help those companies expand their operations and create new jobs. The proceeds were used to repay the TARP preferred shares. Overall, 2011 will be remembered as a year in which the Bank built reserves and increased capital. Our growing capital enhanced the safe, solid base for expanding the Bank’s presence in California’s Central Valley and better serving our customers and communities. Strong Shareholder Value Central Valley Community Bank continues to offer excellent value to our shareholders as a safe, solid institution with strong performance, a sterling reputation and a long history of investing in our communities. Sandler O'Neill + Partners, L.P. named the Company stock among their “Top Investment Ideas” in both 2010 and 2011. Of course, the trading of the Company’s stock is directly affected by the status of the overall financial sector in the market and the liquidity of the stock. A Busy Year For The Bank Like many of the past 31 years, 2011 was an active period for the Bank and our executive team, who actively advocate on behalf of the Bank to educate our employees and customers about the evolving complexities of the financial industry and economy. As Bank President and CEO, I am invested in financial advocacy as well, and, as an example, began a three-year appointed term in 2011on the Federal Reserve Bank of San Francisco’s Twelfth District Community Depository Institutions Advisory Council (CDIAC). I am honored to share my expertise with this council that advises on a variety of economic and banking conditions, regulatory policies and payments issues. Industry-Wide Changes For Banking The media in 2011 spent a great deal of time focusing on the “Occupy” movement as it related to banks, specifically large banks. While the movement initially concentrated on the wealthy 1% compared to the remaining 99% of the population, its focus dissipated into many different agendas. On a more somber note, the Bank lost a trusted and dedicated team member, Vice President, Controller Rona Melkus, who passed away unexpectedly in 2011. She left an indelible impact and a positive legacy for all to cherish, and will be greatly missed. The year also saw our continued commitment to branch expansion, as the Modesto office moved to a larger new location that will better meet the growing needs of existing customers and allow the expansion of services to others in the area. What seems to have been lost in this movement is the role of banks in the nation’s free enterprise system and how banks create value for the communities they serve. In the case of Central Valley Community Bank, we create jobs, provide loans to grow businesses, help people meet their financial objectives, and pay a fair portion of the Company’s profit in taxes, among other benefits to our community and nation. Additionally, the Bank supports nonprofit organizations that work to improve our region’s quality of life and many of our employees perform volunteer work and provide their expertise in helping nonprofit boards. In 2011, the Bank received recognition for being the most active lender in the SBA 504 loan program by the Cen Cal Business Finance Group, the ninth time in the past twelve years. The Bank’s success in the program has attributed to loans responsible for over $49.9 million in project costs and the creation of an estimated 450 jobs since 1999. The financial industry is experiencing other changes in the form of increased federal regulations, such as the Dodd Frank legislation which will create nearly 300 new regulations and increase the cost of operation for all banks. These new compliance requirements will continue to place pressure on non-interest income and non-interest expense. Net income for the year increased 97.53%, primarily driven by lower provision for credit losses, decreases in non-interest expense and increases in non-interest income. The increase was partially offset by decreases in net interest income in 2011 compared to 2010. In addition, Central Valley Community Bank was the only community bank recognized by Fresno Magazine’s “Best of Fresno” contest in the category “Best Local Bank or Credit Union”, based on votes submitted by community members. Continuing our annual tradition, the Bank hosted free document shredding events for customers and community members to dispose of unwanted documents safely and securely. These tax-time events were offered at 15 of the Bank’s offices and demonstrate its commitment to customer security and education. As we continue striving to serve the needs of individual and commercial customers as efficiently and effectively as possible, the Bank instituted some changes to our product and service lineup in 2011. For example, we enabled our small business customers to successfully migrate from Online Banking to our new Cash Management platform. In addition, we launched our new Personal Online Banking and Bill Pay services that offer customers advantages such as security enhancements and eStatements. Also in 2011, the Bank prepared for the rollout of new ATMs, scheduled to be installed in 2012. The new machines will offer text-to-voice conversion for vision-impaired customers and a convenient new deposit automation feature, among other enhancements. Local Economy Remains Challenged The Bank remains committed to serving the financial needs of our customers, even though the Central Valley’s economy remains difficult. There are signs of improvement, however, in such areas as agriculture, food processing and transportation, as well as some renewed vibrancy in manufacturing. While the Federal Reserve intends to hold rates low through 2014 to help stimulate the economy, we expect the Central Valley will continue to experience soft loan demand in 2012, even with borrowing rates at historic low levels. A Forecast For Success In 2012 And Beyond While we believe 2012 will bring many of the same economic challenges we saw in 2011, the Bank’s senior management team is working hard to develop our long-term vision, fine-tune our strategic goals and identify short-term tactics needed to maintain our present levels of profitability and stability. We expect added pressure on net interest income and margin due to low loan demand and the Federal Reserve holding rates at historic low levels. However, improving asset quality and strong liquidity, bolstered by high levels of capital, provide for a very strong balance sheet and keep the Company well-positioned for growth. As the Bank continues to add new products and services in 2012 to provide our customers with competitive, valuable tools for meeting their banking needs, we expect to maintain our long track record of strength, security and satisfying relationships – the values that have guided us for over 31 years, and which will continue to make Central Valley Community Bank an asset to our customers, employees and shareholders. Daniel J. Doyle President and Chief Executive Officer Daniel N. Cunningham Chairman of the Board 3 Strong. Solid. Unchanging Values. A 32-Year Tradition Of Strong & Secure Banking Central Valley Community Bancorp (the “Company”) was established on November 15, 2000, as the holding company for Central Valley Community Bank (CVCB) and is registered as a bank holding company with the Board of Governors of the Federal Reserve System. The Company currently conducts no operations other than through its ownership of the Bank. The common stock of the Company trades on the NASDAQ stock exchange under the symbol CVCY. A Strong History Of Steady Growth Central Valley Community Bank, founded in 1979 as Clovis Community Bank, is a California State chartered bank with deposit accounts insured by the Federal Deposit Insurance Corporation (FDIC). The Bank commenced operations on January 10, 1980, in Clovis, California, with 12 professional bankers and beginning assets of $2,000,000. Currently, CVCB operates 17 full-service offices in Clovis, Fresno, Kerman, Lodi, Madera, Merced, Modesto, Oakhurst, Prather, Sacramento, Stockton and Tracy, plus Commercial, Real Estate, SBA and Agribusiness Lending Departments. Investment services are provided by Investment Centers of America, and Central Valley Community Insurance Services, LLC, provides financial and insurance solutions for businesses and individuals. Now with over 230 employees and assets of nearly $850,000,000 as of December 31, 2011, Central Valley Community Bank has grown into a well-capitalized institu- tion, with a proven track record of financial strength, security and stability. Yet despite the Bank’s growth, it has remained true to its original “roots” – a commitment to its core values of integrity, trustworthiness, caring, loyalty, leadership and teamwork. Central Valley Community Bank distinguishes itself from other financial institutions through its 32-year track record of strength, security, client advocacy and the unchanged values that have guided the Bank since its opening. The Bank’s unique brand of personalized service has expanded as the operation has strategically grown throughout the San Joaquin Valley. Guided by a hands-on Board of Directors and a seasoned senior management team, CVCB continues to focus on personalized service and customer and employee satisfaction. The Bank has remained committed to the ongoing addition and retention of high-quality employees, as evidenced by participating and being honored twice by the Business Journal as one of the top four “Best Companies To Work For” in Central California’s six-county region in the large-sized business category. This temporary unlimited coverage is in addition to, and separate from, the coverage of at least $250,000 available to depositors under the FDIC’s general deposit insurance rules. For maximum convenience, Online Banking, Bill Pay and a full range of Cash Management and Remote Deposit services are available at www.cvcb.com. In addition, ATMs are available at most CVCB offices, BankLine provides 24-hour telephone banking, and extended days and banking hours are offered at select CVCB offices. Success Built On “Relationship Banking” Central Valley Community Bank has built a reputation for superior banking service by offering personalized “relationship banking” for businesses, professionals and individuals. Serving the business community has always been a primary focus for CVCB, which continues to expand its commercial banking team to serve even more customers. The Bank’s experienced banking professionals live and work in the local community, and have a deep understanding of the marketplace. As a result, CVCB has remained an active business lender and is proud to be ranked number one SBA 504 Lender for Fresno, Kings and Madera counties for 9 of the past 12 years. Offering a wide range of lending products, CVCB is committed to helping businesses thrive even in the toughest economic times. The Bank is committed to increasing and enhancing its products and services, while emphasizing needs-based consulting within the branch environment. Serving both new and long-time customers continues to be an important factor in the Bank’s growth, as demonstrated in ongoing customer referrals. Dependable values and security have always been important to America’s banking customers, and CVCB is well-positioned to provide them, with an ongoing emphasis on privacy, safety and convenience. Leadership Fully Invested In The Community The Bank is focused not only on individual customers, but also on investing in the communities it serves. Each year, the Bank donates time, expertise and financial support to a wide variety of local charities and philanthropies. Additionally, the Bank’s management currently serves in over 80 different civic and philanthropic organizations in the Valley. This includes President and CEO, Dan Doyle, who currently serves on the Federal Reserve Bank of San Francisco’s Twelfth District Community Depository Institutions Advisory Council, and is a Past Chairman of the Board for the California Bankers Association, among many other organizations. Unparalleled Protection, Unbeatable Convenience Central Valley Community Bank maintains state-of-the-art data processing and information systems, and offers a complete line of competitive business and personal deposit and loan products. Through FDIC insurance, customer deposits for all insurable accounts are protected up to $250,000. All funds in “noninterest-bearing transaction accounts” and Interest on Lawyers Trust Accounts are insured in full by the FDIC through December 31, 2012. A Proud Past, A Promising Future Thanks to the vision of Central Valley Community Bancorp, as well as the leadership of its Board of Directors, CVCB has grown steadily and sensibly over the past 32 years, keeping pace with the needs of its customers and the communities it serves. All while retaining the local leadership and values that formed the Bank’s firm foundation. Central Valley Community Bank. Strong. Solid. Unchanging Values. 4 Board Of Directors Daniel J. Doyle President and CEO Central Valley Community Bancorp, Central Valley Community Bank Pictured in Central Valley Community Bank’s Clovis Main office Sidney B. Cox Owner Cox Communications Pictured in the Donor Appreciation Room of Children’s Hospital Central California in which he has served as a Trustee and volunteer for over 26 years, and headed the campaign to build the new hospital Steven D. McDonald Secretary of the Board President McDonald Properties, Inc. Pictured at a replica of the flume used in the 1800’s to transport lumber to Clovis from Shaver Lake, planned for future display at the Central Sierra Historical Museum William S. Smittcamp President/Owner Wawona Frozen Foods Pictured in a Wawona Frozen Foods peach orchard Daniel N. Cunningham Chairman of the Board Director, Quinn Group, Inc. Pictured in Central Valley Community Bank’s Clovis Main office Edwin S. Darden, Jr. Principal Darden Architects, Inc. Pictured at State Center Community College, Madera Center, architecturally designed by Darden Architects, Inc. Louis C. McMurray President Charles McMurray Co. Pictured at Charles McMurray Company Joseph B. Weirick Investments Pictured in his Meadow Lakes Apple Company orchard Not Pictured: Wanda Rogers, Director Emeritus and Founding President, Rogers Helicopters, Inc. 5 Our Team, Meeting Your Needs. Officers Holding Company and Bank Officers: Daniel J. Doyle President and Chief Executive Officer David A. Kinross Senior Vice President, Chief Financial Officer Thomas L. Sommer Senior Vice President, Credit Administrator Bank Officers: Gary D. Quisenberry Senior Vice President, Commercial and Business Banking Lydia E. Shaw Senior Vice President, Retail and Consumer Banking Shelle Abbott Vice President, Branch Manager Evey Amado Vice President, Cash Management Officer Susan Armstrong Vice President, Branch Manager Jacquie Ashjian Vice President, Credit Officer Patrick Carman Vice President, Senior Credit Officer Cyndi Carmichael Vice President, Compliance Officer Vicki Casares Vice President, Branch Manager Cathy Chatoian Vice President, Cash Management Manager Jenhi Ciapponi Vice President, Commercial Loan Officer 6 Terry Crawford Vice President, Agricultural Lending Group Manager Shawn Kruitbosch Vice President, Credit Review Officer Tom Crawley Vice President, Commercial Loan Officer Marci Madsen Vice President, Human Resources Director Shannon Reinard Vice President, Branch Manager Steve Romeo Vice President, Private Banking Officer John Royal Vice President, Commercial Loan Officer Elizabeth Salas Vice President, Small Business Development Officer Karen Smith Vice President, Branch Manager Ryan Streeter Vice President, Commercial Loan Officer Theodore Thome Vice President, Commercial Loan Officer Ramina Ushana Vice President, Branch Manager Doug Van den Enden Vice President, Commercial Loan Officer Robert Walker Vice President, Commercial Loan Officer Jeannine Welton Vice President, Branch Manager Brad Majors Vice President, Branch Manager Gina Manley Vice President, Branch Manager Don Mendenhall Vice President, Commercial Loan Officer Sheryl Michael Vice President, Branch Manager Heather Mills Vice President, Private Banking Officer Autumn Muller-Carrillo Vice President, Branch Manager Rosie Nunes Vice President, Small Business Development Officer Linda Ogata Vice President, Commercial Loan Officer Frank Oliver Vice President, Commercial Loan Officer Jean Ornelas Vice President, Real Estate Construction Loan Officer Jennette Williams Vice President, Commercial Loan Officer Jeff Pace Vice President, Real Estate Department Manager Carol Worstein Vice President, Branch Manager Wendy Parlavecchio Vice President, Real Estate Loan Officer Marti Pearson-Silva Vice President, Loan Servicing Manager Independent Auditors Crowe Horwath LLP, Sacramento, CA Counsel Downey Brand LLP, Sacramento, CA Dawn Crusinberry Vice President, Controller Stan Davis Vice President, Small Business/Consumer Underwriting Department Manager Daniel Demmers Vice President, Information Services Manager Ken Dodderer Vice President, Commercial Loan Officer Bob Elledge Vice President, Commercial Loan Officer Steve Freeland Vice President, Asset Credit Officer Mark Gay Vice President, Private Banking Officer Rod Geist Vice President, Branch Manager Teresa Gilio Vice President, Central Operations Manager Tim Harris Vice President, Private Banking Manager Charles Jones Vice President, Branch Manager Bernie Kraus Vice President, Commercial Loan Officer Mari Kroigaard Vice President, SBA Department Manager Mission Statement As A Full Service Bank, We Are Committed To: Providing a full range of financial services desired by our customers, while providing superior customer service delivered in a highly professional and personal manner. Exceptional Employees Each year Central Valley Community Bank’s top-performing employees are recognized in the Circle of Excellence, and from that group, the best are designated to the Circle of Elite. The 2011 Circle of Elite included: Patrick Carman Vice President, Senior Credit Officer Maintaining a positive work environment and investing in each individual to “be the best they can be.” Dawn Crusinberry Vice President, Controller Contributing to the quality of life in the communities we serve. Continuing to maximize shareholder value. Being the “Bank of Choice” for customers and employees! Core Values Leadership Integrity Loyalty Caring Teamwork Trustworthiness Ken Dodderer Vice President, Commercial Loan Officer Linda Miller Central Operations Representative Rosie Nunes Vice President, Small Business Development Officer Sonia Parso Assistant Vice President, Customer Service Manager Le-Ann Ruiz Executive Administrative Assistant Angela Shelton Wire Transfer/Electronic Payment Processor San Joaquin County Advisory Board Members of the advisory board for the San Joaquin County region include: Sidney Alegre Judith Buethe Mary Ghio Phil Katzakian George Liepart Clark Mizuno Rick Paulsen Russell Ray Penny van der Meer Central Valley Community Bank Senior Management Pictured Below From Left: David Kinross, Thomas Sommer, Daniel Doyle, Lydia Shaw and Gary Quisenberry 7 Central Valley Community Bancorp Trend Analysis 0 8 2 , 6 $ 9 3 1 , 5 $ 8 8 5 , 2 $ 7 0 0 2 8 0 0 2 9 0 0 2 9 7 2 , 3 $ 0 1 0 2 7 7 4 , 6 $ 1 1 0 2 9 9 . 0 $ 9 7 . 0 $ 8 0 0 2 8 2 . 0 $ 9 0 0 2 1 3 . 0 $ 0 1 0 2 7 0 0 2 Net Income (In Thousands) Diluted Earnings Per Share 3 6 . 0 $ 1 1 0 2 9 8 7 , 7 7 6 $ 3 6 2 , 2 3 6 $ 6 6 1 , 6 3 6 $ , 1 9 6 7 1 4 $ 7 0 0 2 5 8 2 , 5 4 4 $ 8 0 0 2 9 0 0 2 0 1 0 2 1 1 0 2 8 5 4 , 2 8 4 $ , 0 4 3 5 5 4 $ , 1 9 2 8 2 4 $ 9 0 0 , 7 6 3 $ , 9 5 4 1 3 3 $ 7 0 0 2 8 0 0 2 9 0 0 2 0 1 0 2 1 1 0 2 Average Total Loans (In Thousands) Average Total Deposits (In Thousands) % 3 1 . 2 1 7 0 0 2 % 2 8 . 8 8 0 0 2 % 6 2 . 6 1 1 0 2 % 0 1 . 3 9 0 0 2 % 1 4 . 3 0 1 0 2 8 7 1 , 0 0 8 $ 2 5 8 , 8 5 7 $ 9 0 5 , 2 5 7 $ 9 8 7 , 1 4 5 $ 9 8 7 , 1 4 5 $ 8 0 0 2 9 0 0 2 0 1 0 2 1 1 0 2 1 2 3 , 7 7 4 $ 7 0 0 2 Return on Shareholders’ Equity Average Total Assets (In Thousands) 8 Central Valley Community Bancorp Comparative Stock Price Performance Total Return Performance Index Value 12-31-06 12-31-07 12-31-08 12-31-09 12-31-10 12-31-11 100.00 100.00 100.00 98.43 78.51 75.06 65.18 57.02 42.48 82.89 46.25 38.27 105.14 54.57 38.81 100.75 Russell 2000 Bank Index 48.42 SNL NASDAQ Bank Index 37.44 Central Valley Community Bancorp of potential future stock price performance. Source: SNL Financial LC 9 Consolidated Balance Sheets December 31, 2011 and 2010 (In thousands, except per share amounts) ASSETS Cash and due from banks Interest-earning deposits in other banks Federal funds sold Total cash and cash equivalents Available-for-sale investment securities (Amortized cost of $321,405 at December 31, 2011 and $189,682 at December 31, 2010) Loans, less allowance for credit losses of $11,396 at December 31, 2011 and $11,014 at December 31, 2010 Bank premises and equipment, net Other real estate owned Bank owned life insurance Federal Home Loan Bank stock Goodwill Core deposit intangibles Accrued interest receivable and other assets Total assets LIABILITIES AND SHAREHOLDERS’ EQUITY Deposits: Non-interest bearing Interest bearing Total deposits Short-term borrowings Long-term debt Junior subordinated deferrable interest debentures Accrued interest payable and other liabilities Total liabilities Commitments and contingencies (Note 12) Shareholders’ equity: Preferred stock, no par value, $1,000 per share liquidation preference; 10,000,000 shares authorized, Series A, no par value, issued and outstanding: none at December 31, 2011 and 7,000 shares at December 31, 2010 Preferred stock, no par value, $1,000 per share liquidation preference; 10,000,000 shares authorized, Series C, no par value, issued and outstanding: 7,000 shares at December 31, 2011 and none at December 31, 2010 Common stock, no par value; 80,000,000 shares authorized; issued and outstanding: 9,547,816 at December 31, 2011 and 9,109,154 at December 31, 2010 Non-voting common stock, 1,000,000 shares authorized; issued and outstanding: none at December 31, 2011 and 258,862 at December 31, 2010 Retained earnings Accumulated other comprehensive income, net of tax Total shareholders’ equity $ $ $ 2011 2010 $ 19,409 24,467 928 44,804 328,413 415,999 5,872 - 11,655 2,893 23,577 783 15,027 11,357 89,042 600 100,999 191,325 420,583 5,843 1,325 11,390 3,050 23,577 1,198 18,304 849,023 $ 777,594 $ 208,025 504,961 712,986 - 4,000 5,155 19,400 741,541 - 7,000 40,552 - 55,806 4,124 107,482 173,867 476,628 650,495 10,000 4,000 5,155 10,553 680,203 6,864 - 38,428 1,317 49,815 967 97,391 Total liabilities and shareholders’ equity $ 849,023 $ 777,594 The accompanying notes are an integral part of these consolidated financial statements. 10 10 Consolidated Statements of Income For the Years Ended December 31, 2011, 2010, and 2009 (In thousands, except per share amounts) 2011 2010 2009 INTEREST INCOME: Interest and fees on loans Interest on deposits in other banks Interest on Federal funds sold Interest and dividends on investment securities: Taxable Exempt from Federal income taxes Total interest income INTEREST EXPENSE: Interest on deposits Interest on junior subordinated deferrable interest debentures Other Total interest expense Net interest income before provision for credit losses PROVISION FOR CREDIT LOSSES Net interest income after provision for credit losses NON-INTEREST INCOME: Service charges Appreciation in cash surrender value of bank owned life insurance Loan placement fees Gain on disposal of other real estate owned Net realized gains (losses) on sales and calls of investment securities Other-than-temporary impairment loss: Total impairment loss Loss recognized in other comprehensive income Net impairment loss recognized in earnings Federal Home Loan Bank dividends Other income Total non-interest income NON-INTEREST EXPENSES: Salaries and employee benefits Occupancy and equipment Regulatory assessments Data processing expense Advertising Audit and accounting fees Legal fees Other real estate owned Amortization of core deposit intangibles Loss on sale of assets Other expense Total non-interest expenses Income before provision for (benefit from) income taxes PROVISION FOR (BENEFIT FROM) INCOME TAXES Net income Net income Preferred stock dividends and accretion Net income available to common shareholders Basic earnings per common share Diluted earnings per common share $ $ $ $ $ $ 26,098 187 2 4,548 3,464 34,299 2,662 100 180 2,942 31,357 1,050 30,307 2,903 382 274 615 298 (31) - (31) 9 1,826 6,276 15,762 3,795 845 1,178 735 491 335 15 414 5 4,670 28,245 8,338 1,861 6,477 6,477 486 5,991 0.63 0.63 $ $ $ $ $ $ 27,390 110 2 5,472 3,039 36,013 3,713 102 468 4,283 31,730 3,800 27,930 3,225 392 300 176 (191) (1,587) - (1,587) 11 1,395 3,721 14,871 3,867 1,191 1,197 669 496 495 1,071 414 10 4,460 28,741 2,910 (369) 3,279 3,279 395 2,884 0.31 0.31 $ $ $ $ $ $ The accompanying notes are an integral part of these consolidated financial statements. 29,920 8 48 7,701 3,057 40,734 5,867 129 631 6,627 34,107 10,514 23,593 3,509 391 231 - 766 (300) - (300) 7 1,246 5,850 13,926 3,812 1,604 1,316 722 503 330 479 414 55 4,370 27,531 1,912 (676) 2,588 2,588 365 2,223 0.29 0.28 11 11 Consolidated Statements of Changes in Shareholders’ Equity For the Years Ended December 31, 2011, 2010, and 2009 (In thousands, except share and per share amounts) Series A Preferred Stock Series B Series C Common Stock Shares Amount Shares Amount Shares Amount Shares Amount Retained Earnings Accumulated Other Comprehensive Total Income (Loss) Shareholders’ Comprehensive Equity (Net of Taxes) Income Total Balance, January 1, 2009 Comprehensive income: Net income Other comprehensive income, net of tax: Net change in unrealized gain (loss) on available-for-sale investment securities Total comprehensive income Issuance of preferred stock Series A, net of discount Issuance of preferred stock Series B, net of issuance cost Issuance of common stock, net of issuance costs Issuance of common stock warrants Stock-based compensation expense Stock options exercised and related tax benefit Preferred stock dividends and accretion Balance, December 31, 2009 7,000 Comprehensive income: Net income Other comprehensive income, net of tax: Net change in unrealized gain (loss) on available-for-sale investment securities Total comprehensive income Conversion of preferred stock Series, B to common stock - non-voting Stock-based compensation expense Stock options exercised and related tax benefit Preferred stock dividends and accretion - - - - - - Balance, December 31, 2010 7,000 Comprehensive income: Net income Other comprehensive income, net of tax: Net change in unrealized gain (loss) on available-for-sale investment securities Total comprehensive income Stock-based compensation expense Issuance of preferred stock Series C Redemption of preferred stock Series A Repurchase and retirement of common stock warrants Stock options exercised and related tax benefit Preferred stock dividends and accretion Balance, December 31, 2011 - $ - - - - - 7,000 6,775 - - - - - - - - - - - - - - - 44 6,819 - - - - - 45 6,864 - - - - (7,000) (7,000) - - - - $ - - 136 - - $ - - - - - - - 1,359 1,317 - - - - - - - - - - 1,359 1,317 - - - - (1,359) (1,317) - - - - - - - - - - - - - $ - - - - - - - - - - - - - - $ - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - 7,000 7,000 - - - - - - - - 7,642,280 $ 30,479 $ 44,708 $ 188 $ 75,375 - - - - - - - - 1,264,952 6,441 - - 42,522 - 225 284 182 - 2,588 - 2,588 $ 2,588 - - - - - - - (365) (1,643) (1,643) (1,643) $ 945 - - - - - - - 6,775 1,317 6,441 225 284 182 (321) 8,949,754 37,611 46,931 (1,455) 91,223 - - - - 258,862 1,317 - 159,400 - 239 578 - 3,279 - 3,279 $ 3,279 - - - - (395) 2,422 2,422 2,422 $ 5,701 - - - - - 239 578 (350) 9,368,016 39,745 49,815 967 97,391 - - - - - - 179,800 - - - 196 - - (185) 796 - 6,477 - 6,477 $ 6,477 - - - - - - (486) 3,157 3,157 3,157 $ 9,634 - - - - - - 196 7,000 (7,000) (185) 796 (350) 7,000 $ 7,000 9,547,816 $ 40,552 $ 55,806 $ 4,124 $ 107,482 The accompanying notes are an integral part of these consolidated financial statements. 12 12 Consolidated Statements of Cash Flows For the Years Ended December 31, 2011, 2010, and 2009 (In thousands) 2011 2010 2009 $ 6,477 $ 3,279 $ 2,588 CASH FLOWS FROM OPERATING ACTIVITIES: Net income Adjustments to reconcile net income to net cash provided by operating activities: Net increase in deferred loan fees Depreciation Accretion Amortization Stock-based compensation Tax benefit from exercise of stock options Provision for credit losses Net other than temporary impairment losses on investment securities Net realized (gains) losses on sales and calls of available-for-sale investment securities Net realized losses on sales of held-to-maturity investment securities Net loss on sale and disposal of equipment Net gain on sale of other real estate owned Write down of other real estate owned and other property Increase in bank owned life insurance, net of expenses Net gain on bank owned life insurance Net (increase) decrease in accrued interest receivable and other assets Net decrease (increase) in prepaid FDIC Assessments Net increase (decrease) in accrued interest payable and other liabilities Provision (benefit) for deferred income taxes Net cash provided by operating activities CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of available-for-sale investment securities Purchases of held-to-maturity investment securities Proceeds from sales or calls of available-for-sale investment securities Proceeds from calls of held-to-maturity investment securities Proceeds from maturity and principal repayment of available-for-sale investment securities Proceeds from principal repayments of held-to-maturity investment securities Net decrease in loans Proceeds from sale of other real estate owned Purchases of premises and equipment FHLB stock redeemed Proceeds from bank owned life insurance Proceeds from sale of premises and equipment Net cash (used in) provided by investing activities CASH FLOWS FROM FINANCING ACTIVITIES: Net increase in demand, interest-bearing and savings deposits Net decrease in time deposits Proceeds from issuance of Series A preferred stock and warrants Net proceeds from issuance of Series B preferred stock Net proceeds from issuance of common stock Proceeds from long-term borrowings from Federal Home Loan Bank Repayments of long-term borrowings to Federal Home Loan Bank Repayments of borrowings from other financial institutions Proceeds from exercise of stock options Repurchase of common stock warrant Tax benefit from exercise of stock options Cash dividend payments on preferred stock Net cash provided by financing activities (Decrease) increase in cash and cash equivalents CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR CASH AND CASH EQUIVALENTS AT END OF YEAR SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Cash paid during the year for: Interest Income taxes Non-cash investing and financing activities: Redemption of preferred stock Series A and issuance of preferred stock Series C Transfer of loans to other real estate owned Assumption of other real estate owned liabilities Transfer of loans to other assets Accrued preferred stock dividends $ $ $ $ $ $ $ $ The accompanying notes are an integral part of these consolidated financial statements 266 1,212 (715) 3,590 196 (116) 1,050 31 (298) - 5 (615) - (204) (85) (700) 705 8,515 1,270 20,584 (214,569) - 44,700 - 35,951 - 2,815 2,472 (1,246) 157 146 - (129,574) 87,928 (25,437) - - - - (10,000) - 680 (185) 116 (307) 52,795 (56,195) 100,999 44,804 3,186 826 7,000 244 288 209 88 $ $ $ $ $ $ $ $ 107 1,262 (983) 2,014 239 (28) 3,800 1,587 191 - 10 (66) 638 (392) - 3,281 981 594 (2,337) 14,177 (39,985) - 19,594 - 28,058 - 21,214 4,203 (595) 90 - 5 32,584 33,877 (23,548) - - - - (5,000) - 550 - 28 (349) 5,558 52,319 48,680 100,999 4,485 301 - 3,467 - - 45 $ $ $ $ $ $ $ $ 174 1,367 (1,796) 414 284 (7) 10,514 300 (942) 176 55 - 356 (190) - (1,106) (3,740) (2,259) 788 6,976 (82,178) (410) 40,407 1,474 32,877 2,793 14,379 - (991) - 430 - 8,781 16,415 (11,306) 7,000 1,317 6,441 10,000 (10,000) (6,367) 175 - 7 (277) 13,405 29,162 19,518 48,680 6,983 690 - 3,921 - - 44 13 13 Notes to Consolidated Financial Statements 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES General - Central Valley Community Bancorp (the ‘‘Company’’) was incorporated on February 7, 2000 and subsequently obtained approval from the Board of Governors of the Federal Reserve System to be a bank holding company in connection with its acquisition of Central Valley Community Bank (the ‘‘Bank’’). The Company became the sole shareholder of the Bank on November 15, 2000 in a statutory merger, pursuant to which each outstanding share of the Bank’s common stock was exchanged for one share of common stock of the Company. The Bank of Madera County (BMC) was merged with and into the Bank on January 1, 2005. The transaction was a combination of cash and stock and was accounted for under the purchase method of accounting. BMC had two branches in Madera County which continue to be operated by the Bank. Service 1st Bancorp (Service 1st) and Service 1st Bank (S1 Bank) were merged with and into the Company and the Bank, respectively, on November 13, 2008. The transaction was a combination of cash and stock and was accounted for under the purchase method of accounting. Accordingly, the operating results of the Company only include the operations of Service 1st subsequent to the acquisition. Service 1st Bank had three branches in Tracy, Stockton and Lodi, California, which continue to be operated by the Bank. Service 1st Capital Trust I (the ‘‘Trust’’) is a business trust formed by Service 1st for the sole purpose of issuing trust preferred securities. The Company succeeded to all the rights and obligations of Service 1st in connection with the acquisition of Service 1st. The Trust is a wholly-owned subsidiary of the Company. The Bank operates 17 full service offices in Clovis, Fresno, west and northeast Fresno County, Madera County, Tracy, Stockton, Lodi, Merced, Modesto, and Sacramento, California. The Bank’s primary source of revenue is providing loans to customers who are predominately small and middle-market businesses and individuals. The deposits of the Bank are insured by the Federal Deposit Insurance Corporation (FDIC) up to applicable legal limits. The FDIC implemented unlimited deposit insurance coverage on non-interest bearing transaction accounts beginning December 31, 2010, and ending December 31, 2012, as mandated by the Dodd-Frank Act. This coverage replaces the unlimited coverage under the Transaction Account Guarantee Program. Coverage under this program is confined to non-interest bearing accounts and does not cover interest-bearing NOW accounts but does include Interest on Lawyers Trust Accounts (IOLTAs). Coverage on all other accounts including interest bearing NOW accounts is limited to $250,000 beginning January 1, 2011. The accounting and reporting policies of Central Valley Community Bancorp and Subsidiary conform with accounting principles generally accepted in the United States of America and prevailing practices within the banking industry. Management has determined that because all of the banking products and services offered by the Company are available in each branch of the Bank, all branches are located within the same economic environment and management does not allocate resources based on the performance of different lending or transaction activities, it is appropriate to aggregate the Bank branches and report them as a single operating segment. No customer accounts for more than 10 percent of revenues for the Company or the Bank. Certain reclassifications have been made to prior years’ balances to conform to classifications used in 2011. Reclassifications had no affect on prior year net income or shareholders’ equity. Principles of Consolidation - The consolidated financial statements include the accounts of the Company and the consolidated accounts of its wholly-owned subsidiary, the Bank. For financial reporting purposes, Service 1st Capital Trust I, is a wholly-owned subsidiary acquired in the merger of Service 1st Bancorp and formed for the exclusive purpose of issuing trust preferred securities. The Company is considered the primary beneficiary of this trust (variable interest entity), therefore the trust is not consolidated in the Company’s financial statements, but rather the subordinated debentures are shown as a liability on the Company’s consolidated financial statements. The Company’s investment in the common stock of the Trust is included in accrued interest receivable and other assets on the consolidated balance sheet. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates. The allowance for credit losses, deferred taxes assets and fair values of financial instruments are estimates which are particularly subject to change. Cash and Cash Equivalents - For the purpose of the statement of cash flows, cash, due from banks with maturities less than 90 days, and Federal funds sold are considered to be cash equivalents. Generally, Federal funds are sold for one-day periods. Net cash flows are reported for customer loan and deposit transactions, interest bearing deposits in other financial institutions, and federal funds purchased. Investment Securities - Investments are classified into the following categories: • Available-for-sale securities, reported at fair value, with unrealized gains and losses excluded from earnings and reported, net of taxes, as accumulated other comprehensive income (loss) within shareholders’ equity. • Held-to-maturity securities, which management has the positive intent and ability to hold to maturity, reported at amortized cost, adjusted for the accretion of discounts and amortization of premiums. Management determines the appropriate classification of its investments at the time of purchase and may only change the classification in certain limited circumstances. All transfers between categories are accounted for at fair value. For the year ended December 31, 2011, there were no transfers between categories. During 2010, management transferred one CMO security totaling $3,078,000 from Level 3 to Level 2 and other equity securities totaling $7,588,000 from Level 3 to Level 1. The transfers occurred to correct misclassification errors in prior periods. At December 31, 2011, the Company had no held-to-maturity securities. Gains or losses on the sale of investment securities are computed on the specific identification method. Interest earned on investment securities is reported in interest income, net of applicable adjustments for accretion of discounts and amortization of premiums. Premiums and discounts on securities are amortized or accreted on the level yield method without anticipating prepayments, except for mortgage backed securities where prepayments are anticipated. An investment security is impaired when its carrying value is greater than its fair value. Investment securities that are impaired are evaluated on at least a quarterly basis and more frequently when economic or market conditions warrant such an evaluation to determine whether such a decline in their fair value is other than temporary. Management utilizes criteria such as the magnitude and duration of the decline and the intent and ability of the Company to retain its investment in the securities for a period of time sufficient to allow for an anticipated recovery in fair value, in addition to the reasons underlying the decline, to determine whether the loss in value is other than temporary. The term ‘‘other than temporary’’ is not intended to indicate that the decline is permanent, but indicates that the prospects for a near-term recovery of value is not necessarily favorable, or that there is a lack of evidence to support a realizable value equal to or greater than the carrying value of the investment. Once a decline in value is determined to be other than temporary, and management does not intend to sell the security or it is more likely than not that the Company will not be required to sell the security before recovery, only the portion of the impairment loss representing credit exposure is recognized as a charge to earnings, with the balance recognized as a charge to other comprehensive income. If management intends to sell the security or it is more likely than not that the Company will be required to sell the security before recovering its forecasted cost, the entire impairment loss is recognized as a charge to earnings. Loans - For all loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are stated at principal balances outstanding net of deferred loan fees and costs, and the allowance for credit losses. Interest is accrued daily based upon outstanding loan balances. However, for all loans when, in the opinion of management, loans are considered impaired and the future collectibility of interest and principal is in serious doubt, a loan is placed on nonaccrual status and the accrual of interest income is suspended. Any loan 90 days or more delinquent is automatically placed on nonaccrual status. Any interest accrued but unpaid is charged against income. Payments received are applied to reduce principal to ensure collection. Subsequent payments on these loans, or payments received on nonaccrual loans for which the ultimate 14 14 Notes to Consolidated Financial Statements 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) collectibility of principal is not in doubt, are applied first to principal until fully collected and then to interest. Interest income on mortgage and commercial loans is discontinued at the time the loan is 90 days delinquent unless the loan is well-secured and in process of collection. Consumer and credit card loans are typically charged off no later than 90 days past due. Past due status is based on the contractual terms of the loan. In all cases, loans are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is considered doubtful. Nonaccrual loans and loans past due 90 days still on accrual include both smaller balance homogeneous loans that are individually evaluated for impairment. A loan is moved to non-accrual status in accordance with the Company’s policy, typically after 90 days of non-payment. A loan placed in non-accrual status may be restored to accrual status when principal and interest are no longer past due and unpaid, or the loan otherwise becomes both well secured and in the process of collection. When a loan is brought current the Company must also have a reasonable assurance that the obligor has the ability to meet all contractual obligations in the future, that the loan will be repaid within a reasonable period of time, and that a minimum of six months of satisfactory repayment performance has occurred. Substantially all loan origination fees, commitment fees, direct loan origination costs and purchase premiums and discounts on loans are deferred and recognized as an adjustment of yield, and amortized to interest income over the contractual term of the loan. The unamortized balance of deferred fees and costs is reported as a component of net loans. Purchased Loans - The Company may acquire loans through a business combination or a purchase for which differences may exist between the contractual cash flows and the cash flows expected to be collected due, at least in part, to credit quality. When the Company acquires such loans, the yield that may be accreted (accretable yield) is limited to the excess of the Company’s estimate of undiscounted cash flows expected to be collected over the Company’s initial investment in the loan. The excess of contractual cash flows over cash flows expected to be collected may not be recognized as an adjustment to yield, loss, or a valuation allowance. Subsequent increases in cash flows expected to be collected generally are recognized prospectively through adjustment of the loan’s yield over its remaining life. Decreases in cash flows expected to be collected are recognized as an impairment. The Company does not ‘‘carry over’’ or create a valuation allowance in the initial accounting for loans acquired under these circumstances. Allowance for Credit Losses - The allowance for credit losses is an estimate of probable credit losses inherent in the Company’s loan portfolio that have been incurred as of the balance-sheet date. The allowance is established through a provision for credit losses which is charged to expense. Additions to the allowance are expected to maintain the adequacy of the total allowance after credit losses and loan growth. Credit exposures determined to be uncollectible are charged against the allowance. Cash received on previously charged off amounts is recorded as a recovery to the allowance. The overall allowance consists of two primary components, specific reserves related to impaired loans and general reserves for inherent losses related to loans that are not impaired. A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due, including principal and interest, according to the contractual terms of the original agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Loans determined to be impaired are individually evaluated for impairment. When a loan is impaired, the Company measures impairment based on the present value of expected future cash flows discounted at the loan’s effective interest rate, except that as a practical expedient, it may measure impairment based on a loan’s observable market price, or the fair value of the collateral if the loan is collateral dependent. A loan is collateral dependent if the repayment of the loan is expected to be provided solely by the underlying collateral. A restructuring of a debt constitutes a troubled debt restructuring (TDR) if the Company for economic or legal reasons related to the debtor’s financial difficulties grants a concession to the debtor that it would not otherwise consider. Restructured workout loans typically present an elevated level of credit risk as the borrowers are not able to perform according to the original contractual terms. Loans that are reported as TDRs are considered impaired and measured for impairment as described above. For TDRs that subsequently default, the Company determines the amount of reserve in accordance with the accounting policy for the allowance for credit losses. The determination of the general reserve for loans that are not impaired is based on estimates made by management, including but not limited to, consideration of historical losses by portfolio segment over the most recent eight quarters, internal asset classifications, and qualitative factors including economic trends in the Company’s service areas, industry experience and trends, geographic concentrations, estimated collateral values, the Company’s underwriting policies, the character of the loan portfolio, and probable losses inherent in the portfolio taken as a whole. The Company maintains a separate allowance for each portfolio segment. These portfolio segments include commercial, real estate, and consumer loans. The relative significance of risk considerations vary by portfolio segment. For commercial and real estate loans, the primary risk consideration is a borrower’s ability to generate sufficient cash flows to repay their loan. Secondary considerations include the creditworthiness of guarantors and the valuation of collateral. In addition to the creditworthiness of a borrower, the type and location of real estate collateral is an important risk factor for real estate loans. The primary risk considerations for consumer loans are a borrower’s personal cash flow and liquidity, as well as collateral value. The allowance for credit losses attributable to each portfolio segment, which includes both impaired loans and loans that are not impaired, is combined to determine the Company’s overall allowance, which is included on the consolidated balance sheet. The Company assigns a risk rating to all loans, except pools of homogeneous loans, and periodically performs detailed reviews of all such loans over a certain threshold to identify credit risks and to assess the overall collectibility of the portfolio. The most recent review of risk rating was completed in December 2011. These risk ratings are also subject to examination by independent specialists engaged by the Company and the Company’s regulators. During these internal reviews, management monitors and analyzes the financial condition of borrowers and guarantors, trends in the industries in which borrowers operate and the fair values of collateral securing these loans. These credit quality indicators are used to assign a risk rating to each individual loan. The risk ratings can be grouped into five major categories, defined as follows: Pass - A pass loan is a strong credit with no existing or known potential weaknesses deserving of management’s close attention. Special Mention - A special mention loan has potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or in the Company’s credit position at some future date. Special Mention loans are not adversely classified and do not expose the Company to sufficient risk to warrant adverse classification. Substandard - A substandard loan is not adequately protected by the current sound worth and paying capacity of the borrower or the value of the collateral pledged, if any. Loans classified as substandard have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. Well defined weaknesses include a project’s lack of marketability, inadequate cash flow or collateral support, failure to complete construction on time or the project’s failure to fulfill economic expectations. They are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected. Doubtful - Loans classified doubtful have all the weaknesses inherent in those classified as substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently known facts, conditions and values, highly questionable and improbable. The possibility of loss is extremely high, but because of certain important and reasonably specific pending factors, which may work to the advantage and strengthening of the asset, its classification as an estimated loss is deferred until its more exact status may be determined. Pending factors include proposed merger, acquisition, or liquidation 15 15 Notes to Consolidated Financial Statements 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) procedures, capital injection, perfecting liens on additional collateral, and refinancing plans. Doubtful classification is considered temporary and short term. Loss - Loans classified as loss are considered uncollectible and charged off immediately. The general reserve component of the allowance for loan losses also consists of reserve factors that are based on management’s assessment of the following for each portfolio segment: (1) inherent credit risk, (2) historical losses and (3) other qualitative factors. Inherent credit risk and qualitative reserve factors are inherently subjective and are driven by the repayment risk associated with each class of loans described below. Commercial: Commercial and industrial - Commercial and industrial loans generally possess a lower inherent risk of loss than real estate portfolio segments as these loans are generally underwritten to existing cash flows of operating businesses. Debt coverage is provided by business cash flows and economic trends influenced by unemployment rates and other key economic indicators are closely correlated to the credit quality of these loans. Agricultural land and production - Loans secured by crop production and livestock are especially vulnerable to two risk factors that are largely outside the control of Company and borrowers: commodity prices and weather conditions. Real Estate: Owner Occupied - Real estate collateral secured by commercial or professional properties with repayment arising from the owner’s business cash flow. To meet this classification, the owner’s operation must occupy no less than 50% of the real estate held. Financial profitability and capacity to meet the cyclical nature of the industry and related real estate market over a significant timeframe is essential. Real estate construction and other land loans - Land and construction loans generally possess a higher inherent risk of loss than other real estate portfolio segments. A major risk arises from the necessity to complete projects within specified cost and time lines. Trends in the construction industry significantly impact the credit quality of these loans, as demand drives construction activity. In addition, trends in real estate values significantly impact the credit quality of these loans, as property values determine the economic viability of construction projects. Agricultural real estate - Agricultural real estate loans generally possess a higher inherent risk of loss caused by changes in concentration of permanent plantings, government subsidies, and the value of the U.S. dollar effecting the export of commodities. Commercial real estate - Commercial real estate loans generally possess a higher inherent risk of loss than other real estate portfolio segments, except land and construction loans. Adverse economic developments or an overbuilt market impact commercial real estate projects and may result in troubled loans. Trends in vacancy rates of commercial properties impact the credit quality of these loans. High vacancy rates reduce operating revenues and the ability for properties to produce sufficient cash flow to service debt obligations. Other Real Estate - Primarily Loans secured by agricultural real estate for development and production of permanent plantings have not reached maximum yields. Also real estate loans where agricultural vertical integration exists in packing and shipping of commodities. Risk is primarily based on liquidity of borrower to sustain payment during the development period. In addition weather conditions and commodity prices within obligor’s existing agricultural production may affect repayment. Consumer: Equity loans and lines of credit - The degree of risk in residential real estate lending depends primarily on the loan amount in relation to collateral value, the interest rate and the borrower’s ability to repay in an orderly fashion. These loans generally possess a lower inherent risk of loss than other real estate portfolio segments. Economic trends determined by unemployment rates and other key 16 16 economic indicators are closely correlated to the credit quality of these loans. Weak economic trends indicate that the borrowers’ capacity to repay their obligations may be deteriorating. Consumer and installment - An installment loan portfolio is usually comprised of a large number of small loans scheduled to be amortized over a specific period. Most installment loans are made directly for consumer purchases, but business loans granted for the purchase of heavy equipment or industrial vehicles may also be included. Consumer loans included credit card and other open ended unsecured consumer receivables. Credit card receivables and open ended unsecured receivables generally have a higher rate of default than all other portfolio segments and are also impacted by weak economic conditions and trends. Credit card receivables and open ended unsecured receivables in homogeneous loan portfolio segments are not evaluated for specific impairment. Although management believes the allowance to be adequate, ultimate losses may vary from its estimates. At least quarterly, the Board of Directors reviews the adequacy of the allowance, including consideration of the relative risks in the portfolio, current economic conditions and other factors. If the Board of Directors and management determine that changes are warranted based on those reviews, the allowance is adjusted. In addition, the Company’s primary regulators, the FDIC and California Department of Financial Institutions, as an integral part of their examination process, review the adequacy of the allowance. These regulatory agencies may require additions to the allowance based on their judgment about information available at the time of their examinations. Bank Premises and Equipment - Land is carried at cost. Bank premises and equipment are carried at cost less accumulated depreciation. Depreciation is determined using the straight-line method over the estimated useful lives of the related assets. The useful lives of Bank premises are estimated to be between twenty and forty years. The useful lives of improvements to Bank premises, furniture, fixtures and equipment are estimated to be three to ten years. Leasehold improvements are amortized over the life of the asset or the term of the related lease, whichever is shorter. When assets are sold or otherwise disposed of, the cost and related accumulated depreciation 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. The Bank evaluates premises and equipment for financial impairment as events or changes in circumstances indicate that the carrying amount of such assets may not be fully recoverable. Federal Home Loan Bank (FHLB) Stock - The Bank is a member of the FHLB system. Members are required to own a certain amount of stock based on the level of borrowings and other factors, and may invest in additional amounts. FHLB stock is carried at cost, classified as a restricted security, and periodically evaluated for impairment based on ultimate recovery of par value. Both cash and stock dividends are reported as income. Other Real Estate Owned - Other real estate owned (OREO) is comprised of property acquired through foreclosure proceedings or acceptance of deeds-in-lieu of foreclosure. Losses recognized at the time of acquiring property in full or partial satisfaction of debt are charged against the allowance for credit losses. OREO is initially recorded at fair value less estimated disposition costs. Fair value of OREO is generally based on an independent appraisal of the property. Subsequent to initial measurement, OREO is carried at the lower of the recorded investment or fair value less disposition costs. If fair value declines subsequent to foreclosure, a valuation allowance is recorded through noninterest expense. Revenues and expenses associated with OREO are reported as a component of noninterest expense when incurred. Goodwill - Business combinations involving the Bank’s acquisition of the equity interests or net assets of another enterprise give rise to goodwill. Total goodwill at December 31, 2011 was $23,577,000 consisting of $14,643,000 and $8,934,000 representing the excess of the cost of Service 1st Bank and Bank of Madera County, respectively, over the net of the amounts assigned to assets acquired and liabilities assumed in the transactions accounted for under the purchase method of accounting. The value of goodwill is ultimately derived from the Bank’s ability to generate net earnings after the acquisitions and is not deductible for tax purposes. A decline in net earnings could be indicative of a decline in the fair value of goodwill and result in impairment. For that reason, goodwill is assessed at least annually for impairment. Notes to Consolidated Financial Statements 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) In 2011, Accounting Standards Update (ASU) 2011-08 was issued that provided additional guidance on the determination of whether an impairment of goodwill has occurred, including the introduction of a qualitative review of factors that might indicate that a goodwill impairment has occurred. ASU 2011-08 is effective for our 2012 reporting year; however, the Company early adopted this standard as of September 30, 2011. The Company performed our annual impairment test in the third quarter of 2011 utilizing the qualitative factors cited in the ASU. Management believes that factors cited in the ASU are sufficient and comprehensive and as such, no further factors need to be assessed at this time. Based on the analysis performed by management, there were no indications that the Company’s goodwill was impaired at September 30, 2011. Goodwill is also tested for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of the Company below its carrying amount. No such events or circumstances arose during the fourth quarter of 2011, so goodwill was not required to be retested. Intangible Assets - The intangible assets at December 31, 2011 represent the estimated fair value of the core deposit relationships acquired in the acquisition of Service 1st Bank in 2008 of $1,400,000 and the 2005 acquisition of Bank of Madera County of $1,500,000. Core deposit intangibles are being amortized using the straight-line method over an estimated life of seven years from the date of acquisition. The carrying value of intangible assets at December 31, 2011 was $783,000, net of $2,117,000 in accumulated amortization expense. The carrying value at December 31, 2010 was $1,198,000, net of $1,702,000 accumulated amortization expense. Management evaluates the remaining useful lives quarterly to determine whether events or circumstances warrant a revision to the remaining periods of amortization. Based on the evaluation, no changes to the remaining useful lives was required. Management performed an annual impairment test on core deposit intangibles as of September 30, 2011 and determined no impairment was necessary. Amortization expense recognized was $414,000 for 2011, 2010, and 2009. Income Taxes - The Company files its income taxes on a consolidated basis with its Subsidiary. The allocation of income tax expense (benefit) represents each entity’s proportionate share of the consolidated provision for (benefit from) income taxes. Deferred tax assets and liabilities are recognized for the tax consequences of temporary differences between the reported amounts of assets and liabilities and their tax bases. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. On the balance sheet, net deferred tax assets are included in accrued interest receivable and other assets. The determination of the amount of deferred income tax assets which are more likely than not to be realized is primarily dependent on projections of future earnings, which are subject to uncertainty and estimates that may change given economic conditions and other factors. The realization of deferred income tax assets is assessed and a valuation allowance is recorded if it is ‘‘more likely than not’’ that all or a portion of the deferred tax assets will not be realized. ‘‘More likely than not’’ is defined as greater than a 50% chance. All available evidence, both positive and negative is considered to determine whether, based on the weight of that evidence, a valuation allowance is needed. Accounting for Uncertainty in Income Taxes - The Company uses a comprehensive model for recognizing, measuring, presenting and disclosing in the financial statements tax positions taken or expected to be taken on a tax return. A tax position is recognized as a benefit only if it is more likely than not that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the more likely than not test, no tax benefit is recorded. Interest expense and penalties associated with unrecognized tax benefits, if any, are classified as income tax expense in the consolidated statement of income. Retirement Plans - Employee 401(k) and profit sharing plan expense is the amount of matching contributions. Deferred compensation and supplemental retirement plan expense allocates the benefits over years of service. Earnings Per Common Share - Basic earnings per common share (EPS), which excludes dilution, is computed by dividing income available to common shareholders (net income after deducting dividends on preferred stock and accretion of discount) by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock, such as stock options or warrants, result in the issuance of common stock which shares in the earnings of the Company. All data with respect to computing earnings per share is retroactively adjusted to reflect stock dividends and splits and the treasury stock method is applied to determine the dilutive effect of stock options in computing diluted EPS. Comprehensive Income - Comprehensive income consists of net income and other comprehensive income. Other comprehensive income includes unrealized gains and losses on securities available for sale which are also recognized as separate components of equity. Loss Contingencies - Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Management does not believe there are such matters that will have a material effect on the financial statements. Share-Based Compensation - Compensation cost is recognized for stock options and restricted stock awards issued to employees, based on the fair value of these awards at the date of grant. A Black-Scholes model is utilized to estimate the fair value of stock options, while the market price of the Company’s common stock at the date of grant is used for restricted stock awards. Compensation cost is recognized over the required service period, generally defined as the vesting period. For awards with graded vesting, compensation cost is recognized on a straight-line basis over the requisite service period for the entire awards. The cash flows from the tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options (excess tax benefits) are classified as cash flows from financing activity in the statement of cash flows. Excess tax benefits for the years ended December 31, 2011, 2010, and 2009 were $116,000, $28,000, and $7,000, respectively. Fair Value of Financial Instruments - Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in Note 2. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect these estimates. Reclassifications - Some items in the prior year financial statements were reclassified to conform to the current presentation. Reclassifications had no effect on prior year net income or shareholders’ equity. Recent Accounting Pronouncements Determination of Whether a Restructuring is a Troubled Debt Restructuring In April 2011, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2011-02, A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring. This ASU provides for a more consistent application of the accounting guidance for troubled debt restructurings (TDRs). This ASU clarified guidance on a creditor’s evaluation of whether it has granted a concession to a borrower, and clarified guidance to determine if a borrower is experiencing financial difficulties. This ASU also finalized the disclosures required in a creditor’s financial statements related to TDRs. The new provisions of this standard became effective on July 1, 2011. As a result of adopting ASU 2011-02, management reassessed all restructurings that occurred on or after January 1, 2011 and identified six loans totaling $15,293,000 that were not previously identified as TDRs which now qualify as TDRs under the guidance of ASU 2011-02. The identification of the $15,293,000 of TDRs resulted in an increase to the specific reserves added to the allowance for credit losses of $1,471,000 at December 31, 2011. 17 17 Notes to Consolidated Financial Statements 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) 2. FAIR VALUE MEASUREMENTS Impact of New Financial Accounting Standards Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs In May 2011, FASB issued ASU 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. This ASU represents the converged guidance of the FASB and the IASB (the Boards) on fair value measurement. The collective efforts of the Boards and their staffs, reflected in ASU 2011-04, have resulted in common requirements for measuring fair value and for disclosing information about fair value measurements, including a consistent meaning of the term ‘‘fair value.’’ The Boards have concluded the common requirements will result in greater comparability of fair value measurements presented and disclosed in financial statements prepared in accordance with U.S. GAAP and IFRSs. The amendments to the FASB Accounting Standards Codification� (Codification) in this ASU are to be applied prospectively. The amendments are effective during interim and annual periods beginning after December 15, 2011. Early application is not permitted. Management does not believe the adoption of this ASU will have a significant impact on the Company’s financial position, results of operations or cash flows. Presentation of Comprehensive Income In June 2011, FASB issued ASU 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income. This ASU amends the FASB Accounting Standards Codification TM (Codification) to allow an entity the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both choices, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. ASU 2011-05 eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders’ equity. The amendments to the Codification in the ASU do not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. In October 2011, FASB decided that the specific requirement to present items that are reclassified from other comprehensive income to net income alongside their respective components of net income and other comprehensive income will be deferred. Therefore, those requirements will not be effective for fiscal years and interim periods with those years beginning after December 15, 2011. The remaining provisions of ASU 2011-05 should be applied retrospectively. The amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. Early adoption is permitted. Management does not believe the adoption of this ASU will have a significant impact on the Company’s financial position, results of operations or cash flows. Intangibles - Goodwill and Other Topics The FASB has issued ASU 2011-08, Intangibles - Goodwill and Other (Topic 350): Testing Goodwill for Impairment. ASU 2011-08 is intended to simplify how entities, both public and nonpublic, test goodwill for impairment. ASU 2011-08 permits an entity to first assess qualitative factors to determine whether it is ‘‘more likely than not’’ that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test described in Topic 350, Intangibles - Goodwill and Other. The more-likely-than-not threshold is defined as having a likelihood of more than 50%. ASU 2011-08 is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. The Company has elected to early-adopt the provisions of ASU 2011-08 and apply the provisions to management’s annual evaluation of the Company’s Goodwill as of September 30, 2011. The impact of adoption was not material to the Company’s financial position, results of operations or cash flows. 18 18 The estimated carrying and fair values of the Company’s financial instruments are as follows: December 31, 2011 December 31, 2010 Carrying Amount Fair Value Carrying Amount Fair Value (In thousands) $ 19,409 $ 19,409 $ 11,357 $ 11,357 24,467 928 24,467 928 89,042 600 89,042 600 328,413 415,999 328,413 418,084 191,325 420,583 191,325 405,876 2,893 3,953 N/A 3,953 3,050 3,467 N/A 3,467 $ 712,986 $ 719,673 $ 650,495 $ 651,668 10,000 4,256 10,000 4,000 - 4,146 - 4,000 5,155 230 2,706 230 5,155 475 2,320 475 Financial assets: Cash and due from banks Interest-earning deposits in other banks Federal funds sold Available-for-sale investment securities Loans, net Federal Home Loan Bank stock Accrued interest receivable Financial liabilities: Deposits Short-term borrowings Long-term debt Junior subordinated deferrable interest debentures Accrued interest payable These estimates do not reflect any premium or discount that could result from offering the Company’s entire holdings of a particular financial instrument for sale at one time, nor do they attempt to estimate the value of anticipated future business related to the instruments. In addition, the tax ramifications related to the realization of unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in any of these estimates. These estimates are made at a specific point in time based on relevant market data and information about the financial instruments. Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on judgments regarding current economic conditions, risk characteristics of various financial instruments and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the fair values presented. The following methods and assumptions were used to estimate the fair value of financial instruments. For cash and due from banks, interest-earning deposits in other banks, Federal funds sold, variable-rate loans, accrued interest receivable and payable, demand deposits and short-term borrowings, the carrying amount is estimated to be fair value. It was not practicable to determine the fair value of Federal Home Loan Bank (FHLB) stock due to restrictions placed on its transferability. For investment securities, fair values are based on quoted market prices, quoted market prices for similar securities and indications of value provided by brokers. The fair values for fixed-rate loans are estimated using discounted cash flow analyses, using interest rates currently being offered at each reporting date for loans with similar terms to borrowers of comparable creditworthiness. Fair values for fixed-rate certificates of deposit are estimated using discounted cash flow analyses using interest rates offered at each reporting date by the Company for certificates with similar remaining maturities. The fair value of long-term debt and subordinated debentures was determined based on the current market for like-kind instruments of a similar maturity and structure. The fair values of commitments are estimated using the fees currently charged to enter into similar agreements and are not significant and, therefore, not included in the above table. Notes to Consolidated Financial Statements 2. FAIR VALUE MEASUREMENTS (Continued) Fair Value Hierarchy In accordance with applicable accounting guidance, the Company groups its assets and liabilities measured at fair value into three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. Valuations within these levels are based upon: Level 1 - Quoted market prices (unadjusted) for identical instruments traded in active exchange markets that the Company has the ability to access as of the measurement date. Level 2 - Quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable or can be corroborated by observable market data. Level 3 - Model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect the Company’s estimates of assumptions that market participants would use on pricing the asset or liability. Valuation techniques include management judgment and estimation which may be significant. Management monitors the availability of observable market data to assess the appropriate classification of financial instruments within the fair value hierarchy. Changes in economic conditions or model-based valuation techniques may require the transfer of financial instruments from one fair value level to another. In such instances, we report the transfer at the beginning of the reporting period. Management evaluates the significance of transfers between levels based upon the nature of the financial instrument and size of the transfer relative to total assets, total liabilities or total earnings. During the year ended December 31, 2011, no transfers between levels occurred. Assets Recorded at Fair Value The following tables present information about the Company’s assets and liabilities measured at fair value on a recurring and nonrecurring basis as of December 31, 2011: Recurring Basis The Company is required or permitted to record the following assets at fair value on a recurring basis under other accounting pronouncements (in thousands). Description Available-for-sale investment securities Debt Securities: U.S. Government sponsored entities and agencies Obligations of states and political subdivisions U.S. Government agencies collateralized by mortgage obligations Other collateralized mortgage obligations Other equity securities Total assets and liabilities measured at fair value Fair Value Level 1 Level 2 Level 3 $ 149 $ - $ 149 $ 108,431 200,839 11,103 7,891 - - - 7,891 108,431 200,839 11,103 - $ 328,413 $ 7,891 $ 320,522 $ - - - - - - Securities in Level 1 are mutual funds and fair values are based on quoted market prices for identical instruments traded in active markets. Fair values for available-for-sale investment securities in Level 2 are based on quoted market prices for similar securities. The balance of Level 3 assets measured at fair value on a recurring basis was zero for the year ended December 31, 2011. There were no transfers between Levels 1, 2 or 3 for the year ended December 31, 2011. There were no liabilities measured at fair value on a recurring basis at December 31, 2011. Non-recurring Basis The Company may be required, from time to time, to measure certain assets at fair value on a non-recurring basis. These include assets that are measured at the lower of cost or fair value that were recognized at fair value which was below cost at December 31, 2011 (in thousands). Description Impaired loans: Commercial: Commercial and industrial Fair Value Level 1 Level 2 Level 3 Total Gains (Losses) in the Year $ 2,312 $ - $ - $ 2,312 $ (271) Total commercial 2,312 Real estate: Owner occupied Real estate- construction and other land loans Commercial real estate 873 8,782 1,487 Total real estate 11,142 Consumer: Equity loans and lines of credit Consumer and installment Total consumer 2,003 51 2,054 Total impaired loans 15,508 - - - - - - - - - - - - - - - - - - 2,312 (271) 873 (65) 8,782 1,487 (996) (1,366) 11,142 (2,427) 2,003 51 2,054 4 (23) (19) 15,508 (2,717) Total assets and liabilities measured at fair value on a non-recurring basis $ 15,508 $ - $ - $ 15,508 $ (2,717) The fair value of impaired loans and other real estate owned is based on the fair value of the collateral for all collateral dependent loans and for other impaired loans is estimated using a discounted cash flow model. Impaired loans and other real estate owned were determined to be collateral dependent and categorized as Level 3 due to ongoing real estate market conditions resulting in inactive market data, which in turn required the use of unobservable inputs and assumptions in fair value measurements. There were no changes in valuation techniques used during the years ended December 31, 2011 and 2010. In accordance with the provisions of ASC 360-10, impaired loans with a carrying value of $19,876,000 were written down to their fair value of $15,508,000. The valuation allowance represents specific allocations for the allowance for credit losses for impaired loans. 19 19 Notes to Consolidated Financial Statements 2. FAIR VALUE MEASUREMENTS (Continued) The following tables present information about the Company’s assets and liabilities measured at fair value on a recurring and nonrecurring basis as of December 31, 2010: Recurring Basis The Company is required or permitted to record the following assets at fair value on a recurring basis under other accounting pronouncements (in thousands). Description Available-for-sale securities Debt Securities: U.S. Government sponsored entities and agencies Obligations of states and political subdivisions U.S. Government agencies collateralized by mortgage obligations Other collateralized mortgage obligations Corporate debt securities Other equity securities Total assets and liabilities measured at fair value Fair Value Level 1 Level 2 Level 3 $ 195 $ 75,090 90,077 17,838 504 7,661 - $ - - - - 7,661 195 $ 75,090 90,077 17,838 504 - $ 191,365 $ 7,661 $ 183,704 $ Securities in Level 1 are mutual funds and fair values are based on quoted market prices for identical instruments traded in active markets. Fair values for available-for-sale investment securities in Level 2 are based on quoted market prices for similar securities. The changes in Level 3 assets and liabilities measured at fair value on a recurring basis are summarized as follows for the year ended December 31, 2010 (in thousands). Balance, beginning of year Net income Other comprehensive income Purchases, sales, and principal payments Transfers into Level 3 Transfers out of Level 3 Balance, end of year Available-for-sale securities Other collateralized mortgage obligations Corporate debt securities Other equity securities Total assets and liabilities measured at fair value $ $ 5,724 $ 785 7,588 14,097 $ 13 $ 235 - 248 $ 93 $ - - 93 $ (2,752) $ (1,020) - (3,772) $ - $ - - - $ (3,078) $ - (7,588) (10,666) $ - - - - - - - - - - - 20 20 Notes to Consolidated Financial Statements 2. FAIR VALUE MEASUREMENTS (Continued) 3. INVESTMENT SECURITIES Gains and losses (realized and unrealized) included in earnings (or changes in net assets) for the year ended December 31, 2010 totaled $248,000 and were included in non-interest income. During 2010, management transferred one CMO security totaling $3,078,000 from Level 3 to Level 2 and other equity securities totaling $7,588,000 from Level 3 to Level 1. The transfers occurred to correct immaterial misclassification errors in prior periods. Non-recurring Basis The Company may be required, from time to time, to measure certain assets at fair value on a non-recurring basis. These include assets that are measured at the lower of cost or fair value that were recognized at fair value which was below cost at December 31, 2010 (in thousands). Description Impaired loans: Commercial and industrial Total commercial Real estate: Owner occupied Real estate- construction and other land loans Commercial real estate Total real estate Consumer Equity loans and lines of credit Total consumer Total Impaired Other real estate owned Other repossessed assets Total assets and liabilities measured at fair value on a non-recurring basis Fair Value Level 1 Level 2 Level 3 Total Losses in the Year $ 838 $ - $ - $ 838 $ (208) 838 1,016 4,773 679 6,468 2,007 2,007 9,313 1,325 98 - - - - - - - - 838 1,016 (208) (261) 4,773 679 (1,170) (47) 6,468 (1,478) 2,007 2,007 9,313 1,325 98 (460) (460) (2,146) (309) - - - - - - - - - $ 10,736 $ - $ - $ 10,736 $ (2,455) The fair value of impaired loans included above and other real estate owned is based on the fair value of the collateral. Impaired loans and other real estate owned were determined to be collateral dependent and categorized as Level 3 due to ongoing real estate market conditions resulting in inactive market data, which in turn required the use of unobservable inputs and assumptions in fair value measurements. In accordance with the provision of ASC 360-10, impaired loans with a carrying value of $11,437,000 were written down to their fair value of $9,313,000 resulting in an impairment charge of $2,124,000. The valuation allowance represents specific allocation for the allowance for credit loans for impaired loans. The fair value of other real estate owned is based on property appraisals at the time of transfer and as appropriate thereafter, less estimated costs to sell. Other real estate owned is periodically reviewed to determine whether the property continues to be carried at lower of it’s recorded book value or estimated fair value, net of estimated selling costs. In 2010, other real estate properties were written down $309,000 to their estimated fair values of $1,325,000. In 2010, other repossessed assets were recorded at their estimated realizable value of $98,000. The investment portfolio consists primarily of U.S. Government sponsored entities and agencies, mortgage backed securities, and obligations of states and political subdivisions all of which are classified as available-for-sale. As of December 31, 2011, $109,119,000 was held as collateral for borrowing arrangements, public funds, and for other purposes. The fair value of the available-for-sale investment portfolio reflected an unrealized gain of $7,008,000 at December 31, 2011 compared to an unrealized gain of $1,643,000 at December 31, 2010. The following table sets forth the carrying values and estimated fair values of our investment securities portfolio at the dates indicated (in thousands): December 31, 2011 Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value Available-for-Sale Securities Debt Securities: U.S. Government sponsored entities and agencies Obligations of states and political subdivisions U.S. Government agencies collateralized by mortgage obligations Other collateralized mortgage obligations Other equity securities $ 149 $ - $ - $ 149 101,030 7,732 (331) 108,431 204,222 1,402 (1,080) 204,544 8,408 7,596 245 295 (1,255) - 7,398 7,891 $ 321,405 $ 9,674 $ (2,666) $ 328,413 December 31, 2010 Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value Available-for-Sale Securities Debt Securities: U.S. Government sponsored entities and agencies Obligations of states and political subdivisions U.S. Government agencies collateralized by mortgage obligations Other collateralized mortgage obligations Corporate debt securities Other equity securities $ 190 $ 5 $ - $ 195 74,598 1,884 (1,432) 75,050 88,105 2,092 (120) 90,077 18,661 500 7,628 506 4 33 (1,329) 17,838 - - 504 7,661 $ 189,682 $ 4,524 $ (2,881) $ 191,325 21 21 Notes to Consolidated Financial Statements 3. INVESTMENT SECURITIES (Continued) Investment securities with unrealized losses at December 31, 2011 and 2010 are summarized and classified according to the duration of the loss period as follows (in thousands): December 31, 2011 Less than 12 Months 12 Months or More Total Fair Value Unrealized Losses Fair Value Unrealized Losses Fair Value Unrealized Losses Available-for-Sale Securities Debt Securities: Obligations of states and political subdivisions U.S. Government agencies collateralized by mortgage obligations Other collateralized mortgage obligations $ 1,194 $ (20) $ 2,598 $ (311) $ 3,792 $ (331) 105,902 (1,080) - - 105,902 (1,080) 32 (1) 4,917 (1,254) 4,949 (1,255) $ 107,128 $ (1,101) $ 7,515 $ (1,565) $ 114,643 $ (2,666) December 31, 2010 Less than 12 Months 12 Months or More Total Fair Value Unrealized Losses Fair Value Unrealized Losses Fair Value Unrealized Losses Available-for-Sale Securities Debt Securities: Obligations of states and political subdivisions U.S. Government agencies collateralized by mortgage obligations Other collateralized mortgage obligations $ 24,782 $ (904) $ 3,168 $ (528) $ 27,950 $ (1,432) 9,131 (120) - - 9,131 (120) 286 (2) 10,136 (1,327) 10,422 (1,329) $ 34,199 $ (1,026) $ 13,304 $ (1,855) $ 47,503 $ (2,881) We periodically evaluate each investment security for other-than-temporary impairment, relying primarily on industry analyst reports, observation of market conditions and interest rate fluctuations. As of December 31, 2011, the Company performed an analysis of the investment portfolio to determine whether any of the investments held in the portfolio had an other-than-temporary impairment (OTTI). Under ASC 320-10, the portion of the impairment that is attributable to a shortage in the present value of expected future cash flows relative to the amortized cost should be recorded as a current period charge to earnings. The discount rate in this analysis is the original yield expected at time of purchase. As of December 31, 2011, the Company performed an analysis of the investment portfolio to determine whether any of the investments held in the portfolio had an other-than-temporary impairment (OTTI). Management evaluated all available-for-sale investment securities with an unrealized loss at December 31, 2011, and identified those that had an unrealized loss for at least a consecutive 12 month period, which had an unrealized loss at December 31, 2011 greater than 10% of the recorded book value on that date, or which had an unrealized loss of more than $10,000. Management also analyzed any securities that may have been down graded by credit rating agencies. Management retained the services of a third party in November 2011 to provide independent valuation and OTTI analysis of private label residential mortgage backed securities (PLRMBS). 22 22 For those bonds that met the evaluation criteria management obtained and reviewed the most recently published national credit ratings for those bonds. For those bonds that were municipal debt securities with an investment grade rating by the rating agencies, management also evaluated the financial condition of the municipality and any applicable municipal bond insurance provider and concluded that no credit related impairment existed. The evaluation for PLRMBS also includes estimating projected cash flows that the Company is likely to collect based on an assessment of all available information about the applicable security on an individual basis, the structure of the security, and certain assumptions, such as the remaining payment terms for the security, prepayment speeds, default rates, loss severity on the collateral supporting the security based on underlying loan-level borrower and loan characteristics, expected housing price changes, and interest rate assumptions, to determine whether the Company will recover the entire amortized cost basis of the security. In performing a detailed cash flow analysis, the Company identified the most likely estimate of the cash flows expected to be collected. If this estimate results in a present value of expected cash flows (discounted at the security’s original yield at time of purchase) that is less than the amortized cost basis of the security, an OTTI is considered to have occurred. To assess whether it expects to recover the entire amortized cost basis of its PLRMBS, the Company performed a cash flow analysis for all of its PLRMBS as of December 31, 2011. In performing the cash flow analysis for each security, the Company uses a third-party model. The model considers borrower characteristics and the particular attributes of the loans underlying the Company’s securities, in conjunction with assumptions about future changes in home prices and other assumptions, to project prepayments, default rates, and loss severities. The month-by-month projections of future loan performance are allocated to the various security classes in each securitization structure in accordance with the structure’s prescribed cash flow and loss allocation rules. When the credit enhancement for the senior securities in a securitization is derived from the presence of subordinated securities, losses are allocated first to the subordinated securities until their principal balance is reduced to zero. The projected cash flows are based on a number of assumptions and expectations, and the results of these models can vary significantly with changes in assumptions and expectations. The scenario of cash flows determined based on the model approach described above reflects a best-estimate scenario. At each quarter end, the Company compares the present value of the cash flows expected to be collected on its PLRMBS to the amortized cost basis of the securities to determine whether a credit loss exists. The unrealized losses associated with PLRMBS are primarily driven by higher projected collateral losses, wider credit spreads, and changes in interest rates. The Company assesses for credit impairment using a discounted cash flow model. The key assumptions include default rates, severities, discount rates and prepayment rates. Losses are estimated to a security by forecasting the underlying mortgage loans in each transaction. The forecasted loan performance is used to project cash flows to the various tranches in the structure. Based upon management’s assessment of the expected credit losses of the security given the performance of the underlying collateral compared with our credit enhancement (which occurs as a result of credit loss protection provided by subordinated tranches), the Company expects to recover the entire amortized cost basis of these securities, with the exception of certain securities for which OTTI was previously recorded. U.S. Government Sponsored Entities and Agencies - At December 31, 2011, the Company held one U.S. Government sponsored entities and agencies security and it was not in a loss position. Obligations of States and Political Subdivisions - At December 31, 2011, the Company held 178 obligations of states and political subdivision securities of which two were in a loss position for less than 12 months and four were in a loss position and have been in a loss position for 12 months or more. The unrealized losses on the Company’s investments in obligations of states and political subdivision securities were caused by interest rate changes. Because the decline in market value is attributable to changes in interest rates and not credit quality, and because the Company does not intend to sell, and it is more likely than not that it will not be required to sell those investments until a recovery of fair value, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at December 31, 2011. Notes to Consolidated Financial Statements 3. INVESTMENT SECURITIES (Continued) U.S. Government Agencies Collateralized by Mortgage Obligations - At December 31, 2011, the Company held 183 U.S. Government agency securities collateralized by mortgage obligation securities of which 54 were in a loss position for less than 12 months. The unrealized losses on the Company’s investments in U.S. government agencies collateralized by mortgage obligations were caused by interest rate changes. The contractual cash flows of those investments are guaranteed by an agency of the U.S. government. Accordingly, it is expected that the securities would not be settled at a price less than the amortized cost of the Company’s investment. Because the decline in market value is attributable to changes in interest rates and not credit quality, and because the Company does not intend to sell, and it is more likely than not that it will not be required to sell those investments until a recovery of fair value, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at December 31, 2011. Other Collateralized Mortgage Obligations - At December 31, 2011, the Company had a total of 27 PLRMBS with a remaining principal balance of $8,408,000 and a net unrealized loss of approximately $1,010,000. Eight of these securities account for $1,255,000 of the unrealized loss at December 31, 2011 offset by 19 of these securities with gains totaling $245,000. Seven of these PLRMBS with a remaining principal balance of $6,224,000 had credit ratings below investment grade. The Company continues to perform extensive analyses on these securities as well as all whole loan CMOs. Several of these investment securities continue to demonstrate cash flows and credit support as expected and the expected cash flows of the security discounted at the security’s original yield at time of purchase are greater than the book value of the security, therefore management does not consider these securities to be other than temporarily impaired. No credit related OTTI charges related to PLRMBS were recorded during the year ended December 31, 2011. Other Equity Securities - At December 31, 2011, the Company had a total of two mutual fund equity investments, one of which had been in an unrealized loss position for more than 12 months. Based on management’s evaluation of the nature of the decline in net asset value on this mutual fund, the Company recorded an OTTI charge of $31,000 during the year ended December 31, 2011. Investment securities as of December 31, 2011 with credit ratings below investment grade are summarized in the table below (dollars in thousands): Description PHHAM CWALT 1 CWALT 2 FHAMS BAALT ABFS CONHE Book Value Market Value Unrealized Loss $ 2,400 $ 781 367 2,179 141 302 54 1,931 $ 583 217 1,831 123 231 72 (469) (198) (150) (348) (18) (71) 18 $ 6,224 $ 4,988 $ (1,236) Rating D C C D CCC D B3 Agency Fitch Fitch Fitch Fitch Fitch S&P Moody’s 12 Month Historical Prepayment Rates % Projected CDR Rates % Projected Severity Rates % Original Purchase Price % Current Credit Enhancement % 11.06 10.11 9.07 10.7 7.66 4.7 - 8.64 6.40 7.30 10.36 4.79 13.00 1.00 51 63 66 48 56 80 60 97.25 100.73 101.38 95 97.24 97.46 86.39 - 3.02 0.98 - 4.7 - - All securities in the above table are private label residential collateralized In 2009, one security was transferred from held-to-maturity to mortgage obligations. Net unrealized gains on available-for-sale investment securities totaling $7,008,000 and $1,643,000 are recorded net of $2,884,000 and $676,000 in tax liabilities as accumulated other comprehensive income within shareholders’ equity at December 31, 2011 and 2010, respectively. available-for-sale at its fair value based on management’s intent to sell, and subsequent to the transfer, a $300,000 charge to earnings was recorded as OTTI expense. There were no sales or transfers of held-to-maturity investment securities for the years ended December 31, 2011 or 2010. The Company did not have any held-to-maturity securities at December 31, 2011 or 2010. Proceeds and gross realized gains (losses) on investment securities for the years The following tables provide a roll forward for the years ended December 31, ended December 31, 2011, 2010 and 2009 are shown below. Available-for-Sale Securities Proceeds from sales or calls Gross realized gains from sales or calls Gross realized losses from sales or calls Held-to-Maturity Proceeds from sales or calls Gross realized losses from sales or calls Years Ended December 31, 2011 2010 2009 (In thousands) 44,700 1,119 (821) $ $ $ 19,594 296 (487) $ $ $ 40,407 1,438 (496) Years Ended December 31, 2011 2010 2009 (In thousands) - - $ $ - - $ $ 1,474 (176) $ $ $ $ $ 2011 and 2010 of investment securities credit losses recorded in earnings. The beginning balance represents the credit loss component for which OTTI occurred on debt securities in prior periods. Additions represent the first time a debt security was credit impaired or when subsequent credit impairments have occurred on securities for which OTTI credit losses have been previously recognized. (In thousands) Beginning balance Amounts related to credit loss for which an OTTI charge was not previously recognized Increases to the amount related to credit loss for which OTTI was previously recognized Realized losses for securities sold For the years ended December 31, December 31, 2011 2010 $ 1,387 $ 31 - (635) 300 1,587 - (500) Ending balance $ 783 $ 1,387 23 23 Notes to Consolidated Financial Statements 3. INVESTMENT SECURITIES (Continued) 4. LOANS The amortized cost and estimated fair value of investment securities at December 31, 2011 and 2010 by contractual maturity are shown below (in thousands). 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. Outstanding loans are summarized as follows: Loan Type December 31, % of Total December 31, % of Total 2011 loans 2010 loans (Dollars in thousands) Commercial: Commercial and industrial Agricultural land and production Total $ 78,089 18.3% $ 81,318 18.8% 29,958 7.0% 20,604 4.8% commercial 108,047 25.3% 101,922 Real estate: Owner occupied Real estate construction and other land loans Commercial real estate Agricultural real estate Other real estate 113,183 26.4% 111,888 33,047 62,523 42,596 7,892 7.7% 14.6% 9.9% 1.8% 32,038 63,627 44,397 8,103 Total real estate 259,241 60.4% 260,053 Consumer: Equity loans and lines of credit Consumer and installment Total consumer Deferred loan fees, net Total gross loans Allowance for credit losses 12.0% 2.3% 14.3% 51,106 9,765 60,871 (764) 58,860 11,261 70,121 (499) 427,395 100.0% 431,597 100.0% (11,396) (11,014) 23.6% 25.9% 7.4% 14.7% 10.3% 1.9% 60.2% 13.6% 2.6% 16.2% Total loans $ 415,999 $ 420,583 At December 31, 2011 and 2010, loans originated under Small Business Administration (SBA) programs totaling $6,421,000 and $7,932,000, respectively, were included in the real estate and commercial categories. Salaries and employee benefits totaling $229,000, $305,000, and $229,000 have been deferred as loan origination costs for the years ended December 31, 2011, 2010, and 2009, respectively. December 31, 2011 Within one year After one year through five years After five years through ten years After ten years Investment securities not due at a single maturity date: U.S. Government agencies collateralized by mortgage obligations Other collateralized mortgage obligations Other equity securities December 31, 2010 Within one year After one year through five years After five years through ten years After ten years Investment securities not due at a single maturity date: U.S. Government agencies collateralized by mortgage obligations Other collateralized mortgage obligations Other equity securities Amortized Cost $ 569 8,705 20,553 71,352 Estimated Fair Value $ 574 9,480 22,179 76,347 101,179 108,580 204,222 8,408 7,596 200,839 11,103 7,891 $ 321,405 $ 328,413 Amortized Cost Estimated Fair Value $ 500 6,350 18,274 50,164 75,288 88,105 18,661 7,628 $ 504 6,819 18,664 49,762 75,749 90,077 17,838 7,661 Total $ 189,682 $ 191,325 Investment securities with amortized costs totaling $102,527,000 and $127,293,000 and fair values totaling $109,119,000 and $129,968,000 were pledged to secure public deposits, other contractual obligations and short-term borrowings at December 31, 2011 and 2010, respectively. 24 24 Notes to Consolidated Financial Statements 5. ALLOWANCE FOR CREDIT LOSSES Changes in the allowance for credit losses were as follows: Balance, beginning of year Provision charged to operations Losses charged to allowance Recoveries Balance, end of year Years Ended December 31, 2011 2010 2009 (In thousands) $ $ 11,014 1,050 (1,532) 864 $ 10,200 3,800 (4,122) 1,136 7,223 10,514 (7,926) 389 $ 11,396 $ 11,014 $ 10,200 The following table shows the allocation of the allowance for loan losses as of and for the year ended December 31, 2011 by class of loan and by impairment methodology (in thousands): Allowance for credit losses: Beginning balance Provision charged to operations Losses charged to allowance Recoveries Balance, end of year Ending balance: individually evaluated for impairment Ending balance: collectively evaluated for impairment Loans: Balance, end of year Ending balance: individually evaluated for impairment Ending balance: collectively evaluated for impairment Commercial Real Estate Consumer Unallocated Total $ $ $ $ $ $ $ 2,437 (177) (280) 286 2,266 231 2,035 108,047 3,857 104,190 $ $ $ $ $ $ $ 5,836 1,403 (312) 228 7,155 3,764 3,391 259,241 17,359 241,882 $ $ $ $ $ $ $ 2,503 (77) (940) 350 1,836 373 1,463 60,871 2,428 58,443 $ $ $ $ $ $ $ 238 (99) - - 139 - 139 - - - $ $ $ $ $ $ $ 11,014 1,050 (1,532) 864 11,396 4,368 7,028 428,159 23,644 404,515 The following table shows the allocation of the allowance for loan losses at December 31, 2010 by class of loan and by impairment methodology (in thousands): Allowance for credit losses: Balance, end of year Ending balance: individually evaluated for impairment Ending balance: collectively evaluated for impairment Loans: Balance, end of year Ending balance: individually evaluated for impairment Ending balance: collectively evaluated for impairment Commercial Real Estate Consumer Unallocated Total $ $ $ $ $ $ 2,437 227 2,210 101,922 1,475 100,447 $ $ $ $ $ $ 5,836 1,477 4,359 260,053 13,432 246,621 $ $ $ $ $ $ 2,503 420 2,083 70,121 3,654 66,467 $ $ $ $ $ $ 238 - 238 - - - $ $ $ $ $ $ 11,014 2,124 8,890 432,096 18,561 413,535 25 25 Notes to Consolidated Financial Statements 5. ALLOWANCE FOR CREDIT LOSSES (Continued) The following table shows the loan portfolio allocated by management’s internally assigned risk grade ratings at December 31, 2011 (in thousands): Commercial: Commercial and industrial Agricultural land and production Real Estate: Owner occupied Real estate construction and other land loans Commercial real estate Agricultural real estate Other real estate Consumer: Equity loans and lines of credit Consumer and installment Pass Special Mention Substandard Doubtful Total $ 70,093 29,958 $ 105,308 15,717 47,323 40,808 7,672 46,939 9,570 2,595 - 3,125 4,056 5,035 1,788 220 1,047 105 $ 5,401 - $ 4,750 13,274 10,165 - - 3,120 90 $ 373,388 $ 17,971 $ 36,800 $ - - - - - - - - - - $ 78,089 29,958 113,183 33,047 62,523 42,596 7,892 51,106 9,765 $ 428,159 The following table shows the loan portfolio allocated by management’s internally assigned risk grade ratings at December 31, 2010 (in thousands): Commercial: Commercial and industrial Agricultural land and production Real Estate: Owner occupied Real estate construction and other land loans Commercial real estate Agricultural real estate Other real estate Consumer: Equity loans and lines of credit Consumer and installment Pass Special Mention Substandard Doubtful Total $ 70,877 19,511 $ 100,278 10,286 49,294 39,791 8,103 52,004 11,126 3,827 - 6,336 6,330 3,118 1,903 - 1,900 - $ 6,614 1,093 $ 5,274 15,422 11,215 2,703 - 4,956 135 $ 361,270 $ 23,414 $ 47,412 $ - - - - - - - - - - $ 81,318 20,604 111,888 32,038 63,627 44,397 8,103 58,860 11,261 $ 432,096 The following table shows an aging analysis of the loan portfolio by the time past due at December 31, 2011 (amounts in thousands): 30-59 Days Past Due 60-89 Days Past Due Greater Than 90 Days (nonaccrual) Total Past Due Current Total Loans Recorded Investment > 90 Days Accruing Non-accrual Commercial: Commercial and industrial Agricultural land and production Real estate: Owner occupied Real estate construction and other land loans Commercial real estate Agricultural real estate Other real estate Consumer: Equity loans and lines of credit Consumer and installment $ 57 $ - - 1,532 - - - 123 29 $ 1,741 $ - - - - - - - - 74 74 $ 236 $ 293 $ 77,796 $ 78,089 $ - 122 - 3,544 - - 97 - - 122 1,532 3,544 - - 220 103 29,958 29,958 113,061 113,183 31,515 58,979 42,596 7,892 50,886 9,662 33,047 62,523 42,596 7,892 51,106 9,765 $ 3,999 $ 5,814 $ 422,345 $ 428,159 $ - - - - - - - - - - - $ 267 - 1,372 6,823 3,544 - - 2,354 74 $ 14,434 26 26 Notes to Consolidated Financial Statements 5. ALLOWANCE FOR CREDIT LOSSES (Continued) The following table shows an aging analysis of the loan portfolio by the time past due at December 31, 2010 (amounts in thousands): Commercial: Commercial and industrial Agricultural land and production Real estate: Owner occupied Real estate construction and other land loans Commercial real estate Agricultural real estate Other real estate Consumer: Equity loans and lines of credit Consumer and installment 30-59 Days Past Due 60-89 Days Past Due $ 164 $ - 863 - 2,316 - - - 78 $ 3,421 $ - - - - - - - - - - Greater Than 90 Days (nonaccrual) $ - - - 5,634 726 - - 180 - Total Past Due Current Total Loans Recorded Investment > 90 Days Accruing $ 164 $ 81,154 $ 81,318 $ - 863 5,634 3,042 - - 180 78 20,604 20,604 111,025 111,888 26,404 60,585 44,397 8,103 58,680 11,183 32,038 63,627 44,397 8,103 58,860 11,261 $ 6,540 $ 9,961 $ 422,135 $ 432,096 $ Non-accrual $ 2,355 - 3,777 7,827 1,828 - 2,286 - 488 $ 18,561 - - - - - - - - - - - 27 27 Notes to Consolidated Financial Statements 5. ALLOWANCE FOR CREDIT LOSSES (Continued) The following table shows information related to impaired loans at and for the year ended December 31, 2011 (amounts in thousands): Recorded Investment Unpaid Principal Balance Related Allowance Average Recorded Investment Interest Income Recognized With no related allowance recorded: Commercial: Commercial and industrial Agricultural land and production Total commercial Real estate: Owner occupied Real estate construction and other land loans Commercial real estate Agricultural real estate Other real estate Total real estate Consumer: Equity loans and lines of credit Consumer and installment Total consumer $ $ 2,140 - 2,140 231 1,532 1,801 - - 3,564 - - - $ 2,160 - 2,160 243 1,906 1,801 - - 3,950 - - - Total with no related allowance recorded 5,704 6,110 $ - - - - - - - - - - - - - $ 1,090 - 1,090 59 1,378 251 - - 1,688 - - - 2,778 669 - 669 1,057 5,985 277 - - 7,319 1,419 74 1,493 9,481 - - - - - - - - - - - - - 181 - 181 - 230 - - - 230 - - - 411 411 1,717 - 1,717 1,141 10,911 1,743 - - 13,795 2,354 74 2,428 1,718 - 1,718 1,216 11,490 1,743 - - 14,449 2,581 74 2,655 231 - 231 268 2,130 1,366 - - 3,764 350 23 373 17,940 18,822 4,368 $ 23,644 $ 24,932 $ 4,368 $ 12,259 $ With an allowance recorded: Commercial: Commercial and industrial Agricultural land and production Total commercial Real estate: Owner occupied Real estate construction and other land loans Commercial real estate Agricultural real estate Other real estate Total real estate Consumer: Equity loans and lines of credit Consumer and installment Total consumer Total with an allowance recorded Total 28 28 Notes to Consolidated Financial Statements 5. ALLOWANCE FOR CREDIT LOSSES (Continued) The following table shows information related to impaired loans at and for the year ended December 31, 2010 (amounts in thousands): Recorded Investment Unpaid Principal Balance Related Allowance Average Recorded Investment Interest Income Recognized With no related allowance recorded: Commercial: Commercial and industrial Agricultural land and production Total commercial Real estate: Owner occupied Real estate construction and other land loans Commercial real estate Agricultural real estate Other real estate Total real estate Consumer: Equity loans and lines of credit Consumer and installment Total consumer Total with no related allowance recorded With an allowance recorded: Commercial: Commercial and industrial Agricultural land and production Total commercial Real estate: Owner occupied Real estate construction and other land loans Commercial real estate Agricultural real estate Other real estate Total real estate Consumer: Equity loans and lines of credit Consumer and installment Total consumer Total with an allowance recorded Total $ $ 410 - 410 1,775 1,885 1,828 - - 5,488 1,228 - 1,228 7,126 1,065 - 1,065 1,276 5,942 726 - - 7,944 2,426 - 2,426 $ 435 - 435 2,147 2,056 1,834 - - 6,037 1,245 - 1,245 7,717 1,140 - 1,140 1,284 6,290 824 - - 8,398 2,459 - 2,459 $ - - - - - - - - - - - - - 227 - 227 260 1,170 47 - - 1,477 420 - 420 $ 495 - 495 1,115 2,667 1,521 - - 5,303 649 - 649 6,447 1,575 - 1,575 1,672 5,995 243 - - 7,910 1,628 91 1,719 11,435 11,997 2,124 11,204 $ 18,561 $ 19,714 $ 2,124 $ 17,651 $ - - - - - - - - - - - - - - - - - - - - - - - - - - - - The recorded investment in loans excludes accrued interest receivable and loan origination fees, net due to immateriality. For purposes of this disclosure, the unpaid principal balance is not reduced for net charge-offs. Nonaccrual loans totaled $14,434,000 and $18,561,000 at December 31, 2011 and 2010, respectively. Foregone interest on nonaccrual loans totaled $954,000, $1,228,000, and $852,000 for the years ended December 31, 2011, 2010, and 2009, respectively. There were no accruing loans past due 90 days or more at December 31, 2011 or 2010. Included in the impaired and nonaccrual loans above at December 31, 2011 are 11 loans considered troubled debt restructurings totaling $19,811,000. Troubled Debt Restructurings: The Company has allocated $3,217,000 of specific reserves to customers whose loan terms have been modified in troubled debt restructurings as of December 31, 2011. The Company has committed to lend additional amounts totaling up to $302,000 as of December 31, 2011 to customers with outstanding loans that are classified as troubled debt restructurings. During the year ending December 31, 2011 the terms of certain loans were modified as troubled debt restructurings. The modification of the terms of such loans included one or a combination of the following: a reduction of the stated interest rate of the loan or an extension of the maturity date at a stated rate of interest lower than the current market rate for new debt with similar risk. During the same period, there were no troubled debt restructurings in which the amount of principal or accrued interest owed from the borrower were forgiven. Modifications involving a reduction of the stated interest rate occurred on one loan which will mature the first quarter of 2012. Modifications involving an extension of the maturity date were for periods ranging from one month to three years. 29 29 Notes to Consolidated Financial Statements 5. ALLOWANCE FOR CREDIT LOSSES (Continued) The following table presents loans by class modified as troubled debt restructurings that occurred during the year ended December 31, 2011 (in thousands): Troubled Debt Restructurings: Commercial: Commercial and Industrial Total commercial Real Estate: Owner occupied Real estate-construction and other land loans Commercial real estate Total real estate Consumer: Equity loans and line of credit Total Consumer Pre- Modification Outstanding Recorded Investment (1) Number of Loans Principal Modification (2) Post- Modification Outstanding Recorded Investment (3) Outstanding Recorded Investment 2 2 1 3 1 5 1 1 8 $ 3,089 $ 3,089 1,074 11,094 1,110 13,278 2,271 2,271 $ 18,638 $ - - - - - - - - $ 3,089 $ 3,089 1,074 11,094 1,110 13,278 2,271 2,271 $ 18,638 $ 2,791 2,791 1,019 10,911 1,110 13,040 1,648 1,648 17,479 (1) Amounts represent the recorded investment in loans before recognizing effects of the TDR, if any. (2) Principal Modification includes principal forgiveness at the time of modification, contingent principal forgiveness granted over the life of the loan based on borrower performance, and principal that has been legally separated and deferred to the end of the loan, with zero percent contractual interest rate. (3) Balance outstanding after principal modification, if any borrower reduction to recorded investment. The following table presents loans by class modified as troubled debt Depreciation and amortization included in occupancy and equipment expense restructurings for which there was a payment default within 12 months following the modification during the year ended December 31, 2011 (in thousands): totaled $1,212,000, $1,262,000 and $1,367,000 for the years ended December 31, 2011, 2010, and 2009, respectively. Troubled Debt Restructurings That Subsequently Defaulted Real Estate: Commercial real estate Number of Loans Recorded Investment 1 $ 1,110 A loan is considered to be in payment default once it is 90 days contractually past due under the modified terms. The troubled debt restructurings described above resulted in an increase to the specific reserves added to the allowance for credit losses of $1,471,000 and resulted in no charge offs during the year ended December 31, 2011. 6. BANK PREMISES AND EQUIPMENT Bank premises and equipment consisted of the following: December 31, 2011 2010 (In thousands) $ $ 838 3,354 7,813 3,599 580 3,091 7,263 3,569 15,604 14,503 (9,732) (8,660) $ 5,872 $ 5,843 Land Buildings and improvements Furniture, fixtures and equipment Leasehold improvements Less accumulated depreciation and amortization 30 30 7. OTHER REAL ESTATE OWNED The Company had no other real estate owned (OREO) at December 31, 2011. At December 31, 2010 the Company had $1,325,000 invested in properties acquired through foreclosure. The properties are described in the following paragraph. These properties are carried at their fair value. Fair value is based on recently obtained third-party appraisals or recent offers on like properties. The table below provides a summary of the change in other real estate owned (OREO) balances for the years ended December 31, 2011 and 2010. Balance, Beginning of year Additions Dispositions Write-downs Net gain on disposition Balance, End of year Year Ended Year Ended December 31, December 31, 2011 2010 (In thousands) $ $ 1,325 $ 532 (2,472) - 615 2,832 3,467 (4,449) (591) 66 - $ 1,325 As of December 31, 2011 the Bank had no OREO properties. In 2011, the Bank foreclosed on three other loans collateralized by real estate with net realizable values totaling $527,000. During the year ended December 31, 2011, the remaining 12 units of the medical office condominium project along with the three other properties were sold. Proceeds from OREO sales totaled $2,472,000 during 2011. The Company realized a $615,000 net recovery from the sale of all units. Notes to Consolidated Financial Statements 7. OTHER REAL ESTATE OWNED (Continued) 9. BORROWING ARRANGEMENTS As of December 31, 2010, OREO consisted of two properties. The Bank was a participant with an independent bank in a loan collateralized by 24 units of a medical office condominium project. On April 30, 2010, the lead bank foreclosed on the loan and the Bank recorded the property as OREO at a net realizable value of $1,656,000 for their portion of the loan. Net realizable value was based on a third-party appraisal using a discounted as-is bulk value of the 24 units. As of December 31, 2010, 12 of the 24 units were sold. Sales proceeds totaled $911,000. At December 31, 2010 the recorded investment in this property was $745,000. On May 28, 2010, the Bank foreclosed on a loan collateralized by a property containing a gas station, convenience store and restaurant. The Company recorded the property at a net realizable value of $889,000 based on a third-party appraisal. Subsequent to foreclosure, the Company recorded a valuation allowance of $309,000 to reduce the value to an estimated realizable value of $580,000. In 2010, the Bank foreclosed on three other loans collateralized by real estate with net realizable values totaling $923,000. The properties were all sold in 2010. During the year ended December 31, 2010, the Company realized a $176,000 net recovery from the sale of one property and realized losses on the sale of two other properties totaling $109,000. The Company sold the third property for its carrying value. Thus, the Company realized a $66,000 net recovery from the sale of all property. 8. DEPOSITS Interest-bearing deposits consisted of the following: Savings Money market NOW accounts Time, $100,000 or more Time, under $100,000 December 31, 2011 2010 (In thousands) $ 31,267 181,731 140,268 102,577 49,118 $ 27,678 157,345 114,473 119,503 57,629 $ 504,961 $ 476,628 Aggregate annual maturities of time deposits are as follows (in thousands): Years Ending December 31, 2012 2013 2014 2015 2016 Thereafter $ 140,169 6,282 2,365 1,322 1,556 1 $ 151,695 Interest expense recognized on interest-bearing deposits consisted of the following: Savings Money market NOW accounts Time certificates of deposit Years Ended December 31, 2011 2010 2009 (In thousands) 52 $ 1,035 447 2,179 $ 47 692 321 1,602 49 1,262 722 3,834 2,662 $ 3,713 $ 5,867 $ $ Federal Home Loan Bank Advances - Advances from the Federal Home Loan Bank (FHLB) of San Francisco at December 31, 2011 and 2010 consisted of the following: December 31, 2011 Amount $ - - 4,000 4,000 - December 31, 2010 Amount $ 5,000 5,000 4,000 14,000 (10,000) Rate 3.00% 3.10% 3.59% Maturity Date February 7, 2011 February 14, 2011 February 12, 2013 Less short-term portion $ 4,000 $ 4,000 Long-term debt FHLB advances are secured by investment securities with amortized costs totaling $15,272,000 and $31,918,000 and market values totaling $15,683,000 and $33,214,000 at December 31, 2011 and 2010, respectively. The Bank’s credit limit varies according to the amount and composition of the investment and loan portfolios pledged as collateral. As of December 31, 2011 and 2010, the Company had no Federal funds purchased. Lines of Credit - The Bank had unsecured lines of credit with its correspondent banks which, in the aggregate, amounted to $44,000,000 at December 31, 2011 and $39,000,000 at December 31, 2010, at interest rates which vary with market conditions. The Bank also had a line of credit in the amount of $551,000 and $1,321,000 with the Federal Reserve Bank of San Francisco at December 31, 2011 and 2010, respectively which bears interest at the prevailing discount rate collateralized by investment securities with amortized costs totaling $542,000 and $1,322,000 and market values totaling $562,000 and $1,354,000, respectively. At December 31, 2011 and 2010, the Bank had no outstanding short-term borrowings under these lines of credit. 10. JUNIOR SUBORDINATED DEFERRABLE INTEREST DEBENTURES Service 1st Capital Trust I is a Delaware business trust formed by Service 1st. The Company succeeded to all of the rights and obligations of Service 1st in connection with the merger with Service 1st as of November 12, 2008. The Trust was formed on August 17, 2006 for the sole purpose of issuing trust preferred securities fully and unconditionally guaranteed by Service 1st. Under applicable regulatory guidance, the amount of trust preferred securities that is eligible as Tier 1 capital is limited to 25% of the Company’s Tier 1 capital on a pro forma basis. At December 31, 2011, all of the trust preferred securities that have been issued qualify as Tier 1 capital. The trust preferred securities mature on October 7, 2036, are redeemable at the Company’s option beginning after five years, and require quarterly distributions by the Trust to the holder of the trust preferred securities at a variable interest rate which will adjust quarterly to equal the three month LIBOR plus 1.60%. The Trust used the proceeds from the sale of the trust preferred securities to purchase approximately $5,155,000 in aggregate principal amount of Service 1st’s junior subordinated notes (the Notes). The Notes bear interest at the same variable interest rate during the same quarterly periods as the trust preferred securities. The Notes are redeemable by the Company on any January 7, April 7, July 7, or October 7 on or after October 7, 2011 or at any time within 90 days following the occurrence of certain events, such as: (i) a change in the regulatory capital treatment of the Notes (ii) in the event the Trust is deemed an investment company or (iii) upon the occurrence of certain adverse tax events. In each such case, the Company may redeem the Notes for their aggregate principal amount, plus any accrued but unpaid interest. The Notes may be declared immediately due and payable at the election of the trustee or holders of 25% of the aggregate principal amount of outstanding Notes in the event that the Company defaults in the payment of any interest following the nonpayment of any such interest for 20 or more consecutive quarterly periods. 31 31 Notes to Consolidated Financial Statements JUNIOR SUBORDINATED DEFERRABLE INTEREST DEBENTURES 10. (Continued) Deferred tax assets (liabilities) consisted of the following: Holders of the trust preferred securities are entitled to a cumulative cash distribution on the liquidation amount of $1,000 per security. For each January 7, April 7, July 7 or October 7 of each year, the rate will be adjusted to equal the three month LIBOR plus 1.60%. As of December 31, 2011, the rate was 2.00%. Interest expense recognized by the Company for the years ended December 31, 2011, 2010 and 2009 was $100,000, $102,000 and $129,000, respectively. 11. INCOME TAXES The provision for (benefit from) income taxes for the years ended December 31, 2011, 2010, and 2009 consisted of the following: Federal State Total (In thousands) 2011 Current Deferred Provision for income taxes 2010 Current Deferred Benefit from income taxes 2009 Current Deferred Benefit from income taxes $ $ $ $ $ $ 686 893 1,579 1,472 (1,677) (205) (1,374) 804 (570) $ $ $ $ $ $ (95) 377 282 496 (660) (164) (90) (16) (106) $ $ $ $ $ $ 591 1,270 1,861 1,968 (2,337) The determination of the amount of deferred income tax assets which are more likely than not to be realized is primarily dependent on projections of future earnings, which are subject to uncertainty and estimates that may change given economic conditions and other factors. The realization of deferred income tax assets is assessed and a valuation allowance is recorded if it is more likely than not that all or a portion of the deferred tax asset will not be realized. More likely than not is defined as greater than a 50% chance. All available evidence, both positive and negative is considered to determine whether, based on the weight of the evidence, a valuation allowance is needed. Based on management’s analysis as of December 31, 2011, the Company established a deferred tax valuation allowance in the amount of $114,000 for California capital loss carryforwards. 32 32 $ Deferred tax assets: Allowance for credit losses Deferred compensation Net operating loss carryover from acquisition Bank premises and equipment Mark to market adjustment Other deferred taxes Other then temporary impairment Other real estate Loan and investment impairment State Enterprise Zone credit carry-forward State capital loss carry-forward Alternative minimum tax credit State taxes Other reserves Partnership income Total deferred tax assets Valuation allowance Net deferred tax asset after valuation allowance (369) Deferred tax liabilities: Finance leases Unrealized gain on available-for-sale (1,464) 788 (676) investment securities Core deposit intangible FHLB stock Loan origination costs Total deferred tax liabilities December 31, 2011 2010 (In thousands) $ 4,690 3,660 1,188 909 416 231 282 - 352 522 114 530 58 - 74 4,370 3,445 1,959 907 551 682 653 566 383 343 120 138 144 10 39 13,026 (114) 14,310 - 12,912 14,310 (2,650) (2,884) (322) (241) (176) (6,273) (2,581) (676) (493) (254) (189) (4,193) Net deferred tax assets $ 6,639 $ 10,117 The provision for income taxes differs from amounts computed by applying the statutory Federal income tax rates to operating income before income taxes. The significant items comprising these differences for the years ended December 31, 2011, 2010, and 2009 consisted of the following: Federal income tax, at statutory rate State taxes, net of Federal tax benefit Tax exempt investment security income, net Bank owned life insurance, net Solar credits Change in uncertain tax positions Other 2011 2010 2009 34.0 % 34.0 % 34.0 % 3.6 % (3.7)% (3.7)% (14.0)% (1.6)% (1.6)% 0.5 % 1.4 % (34.7)% (4.6)% (5.4)% (1.3)% 3.0 % (52.4)% (6.9)% (15.7)% 7.7 % 1.7 % Effective tax rate 22.3 % (12.7)% (35.3)% At December 31, 2011, the Company had Federal and California net operating loss (‘‘NOL’’) carry-forwards of approximately $5,794,000 and $5,949,000, respectively from the Service 1st acquisition, subject to an Internal Revenue Code (IRC) Sec. 382 annual limitation of $1,133,000. Management expects to fully utilize the Service 1st Federal and California NOL carry-forward. The Federal NOL will begin to expire in 2028. California suspended utilization of NOLs for 2009, 2010 and 2011 tax years for taxpayers with business income in excess of $500,000. The California NOL will begin to expire in 2019. Notes to Consolidated Financial Statements 11. INCOME TAXES (Continued) The Company and its Subsidiary file income tax returns in the U.S. federal and California jurisdictions. The Company conducts all of its business activities in the State of California. As of December 31, 2011, the Company had one state income tax examination in process. The outcome of the examination is not settled. There are currently no pending U.S. federal or local income tax examinations by those taxing authorities. The Company is no longer subject to the examination by U.S. federal taxing authorities for the years ended before December 31, 2008 and by the state and local taxing authorities for the years ended before December 31, 2007. A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows (in thousands): Balance at January 1, 2011 Additions based on tax positions related to the current year Reductions for tax positions of prior years Balance at December 31, 2011 $ $ 211 57 (13) 255 Of this total, $255,000 represents the amount of unrecognized tax benefits that, if recognized, would favorably affect the effective income tax rate in future periods. The Company does not expect the total amount of unrecognized tax benefits to significantly increase or decrease in the next twelve months. During the years ended December 31, 2011 and 2010, the Company did not recognize any interest and penalties related to uncertain tax positions. In 2009, the Company recognized $32,000 of interest related to the pending state tax examination and no penalties related to uncertain tax positions. 12. COMMITMENTS AND CONTINGENCIES Leases - The Bank leases certain of its branch facilities and administrative offices under noncancelable operating leases. Rental expense included in occupancy and equipment and other expenses totaled $1,982,000, $1,922,000 and $1,796,000 for the years ended December 31, 2011, 2010, and 2009, respectively. Future minimum lease payments on noncancelable operating leases are as follows (in thousands): Years Ending December 31, 2012 2013 2014 2015 2016 Thereafter $ 1,899 1,892 1,920 1,746 5,506 674 $ 13,637 Federal Reserve Requirements - Banks are required to maintain reserves with the Federal Reserve Bank equal to a percentage of their reservable deposits. The amount of such reserve balances required at December 31, 2011 was $25,000. Correspondent Banking Agreements - The Bank maintains funds on deposit with other federally insured financial institutions under correspondent banking agreements. The Bank had no uninsured deposits at December 31, 2011. Financial Instruments With Off-Balance-Sheet Risk - The Bank is a party to financial instruments with off-balance-sheet risk in the normal course of business in order to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments consist of commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized on the balance sheet. The Bank’s exposure to credit loss in the event of nonperformance by the other party for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and standby letters of credit as it does for loans included on the balance sheet. The following financial instruments represent off-balance-sheet credit risk: Commitments to extend credit Standby letters of credit December 31, 2011 2010 (In thousands) $ $ 128,585 420 $ $ 123,311 369 Commitments to extend credit consist primarily of unfunded commercial loan commitments and revolving lines of credit, single-family residential equity lines of credit and commercial real estate construction loans. Construction loans are established under standard underwriting guidelines and policies and are secured by deeds of trust, with disbursements made over the course of construction. Commercial revolving lines of credit have a high degree of industry diversification. 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 without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Standby letters of credit are generally secured and are issued by the Bank to guarantee the performance of a customer to a third party. The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending loans to customers. The fair value of the liability related to these standby letters of credit, which represents the fees received for issuing the guarantees, was not significant at December 31, 2011 and 2010. The Company recognizes these fees as revenue over the term of the commitment or when the commitment is used. At December 31, 2011, commercial loan commitments represent approximately 50% of total commitments and are generally secured by collateral other than real estate or unsecured. Real estate loan commitments represent 39% of total commitments and are generally secured by property with a loan-to-value ratio not to exceed 80%. Consumer loan commitments represent the remaining 11% of total commitments and are generally unsecured. In addition, the majority of the Bank’s loan commitments have variable interest rates. Concentrations of Credit Risk - At December 31, 2011, in management’s judgment, a concentration of loans existed in commercial loans and real-estate- related loans, representing approximately 97.7% of total loans of which 25.3% were commercial and 72.4% were real-estate-related. At December 31, 2010, in management’s judgment, a concentration of loans existed in commercial loans and real-estate-related loans, representing approximately 97.4% of total loans of which 23.6% were commercial and 73.8% were real-estate-related. Management believes the loans within these concentrations have no more than the typical risks of collectibility. However, in light of the current economic environment, additional declines in the performance of the economy in general or a continued decline in real estate values in the Company’s primary market area, in particular, could have an adverse impact on collectibility, increase the level of real-estate-related nonperforming loans, or have other adverse effects which alone or in the aggregate could have a material adverse effect on the financial condition, results of operations and cash flows of the Company. Contingencies - The Company is subject to legal proceedings and claims which arise in the ordinary course of business. In the opinion of management, the amount of ultimate liability with respect to such actions will not materially affect the consolidated financial position or consolidated results of operations of the Company. 33 33 Notes to Consolidated Financial Statements 13. SHAREHOLDERS’ EQUITY Regulatory Capital - The Company and the Bank are subject to certain regulatory capital requirements administered by the Board of Governors of the Federal Reserve System and the FDIC. Failure to meet these minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company’s consolidated financial statements. Under capital adequacy guidelines, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. These quantitative measures are established by regulation and require that minimum amounts and ratios of total and Tier 1 capital to risk-weighted assets and of Tier 1 capital to average assets be maintained. Capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. The Bank is also subject to additional capital guidelines under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the following table. The most recent notification from the FDIC categorized the Bank as well capitalized under these guidelines. There are no conditions or events since that notification that management believes have changed the Bank’s category. Management believes that the Company and the Bank met all their capital adequacy requirements as of December 31, 2011 and 2010. There are no conditions or events since those notifications that management believes have changed those categories. Tier 1 Leverage Ratio Central Valley Community Bancorp and Subsidiary Minimum regulatory requirement Central Valley Community Bank Minimum requirement for ‘‘Well-Capitalized’’ institution Minimum regulatory requirement Tier 1 Risk-Based Capital Ratio Central Valley Community Bancorp and Subsidiary Minimum regulatory requirement Central Valley Community Bank Minimum requirement for ‘‘Well-Capitalized’’ institution Minimum regulatory requirement Total Risk-Based Capital Ratio Central Valley Community Bancorp and Subsidiary Minimum regulatory requirement Central Valley Community Bank Minimum requirement for ‘‘Well-Capitalized’’ institution Minimum regulatory requirement December 31, 2011 December 31, 2010 Amount Ratio Amount Ratio (Dollars in thousands) $ 82,571 $ 32,612 $ 81,599 10.13% $ 70,669 4.00% $ 29,832 10.01% $ 69,457 $ 40,743 $ 32,594 5.00% $ 37,264 4.00% $ 29,811 9.48% 4.00% 9.32% 5.00% 4.00% $ 82,571 $ 20,383 $ 81,599 16.20% $ 70,669 4.00% $ 19,965 16.02% $ 69,457 14.16% 4.00% 13.92% $ 30,554 $ 20,369 6.00% $ 29,929 4.00% $ 19,953 6.00% 4.00% $ 89,136 $ 40,767 $ 88,159 17.49% $ 76,982 8.00% $ 39,931 17.31% $ 75,766 15.42% 8.00% 15.19% $ 50,923 $ 40,738 10.00% $ 49,881 8.00% $ 39,905 10.00% 8.00% Dividends - No dividends on common shares were declared in 2011, 2010, or 2009. The Company’s primary source of income with which to pay cash dividends are dividends from the Bank. The California Financial Code restricts the total amount of dividends payable by a bank at any time without obtaining the prior approval of the California Department of Financial Institutions to the lesser of (1) the bank’s retained earnings or (2) the bank’s net income for its last three fiscal years, less distributions made to shareholders during the same three-year period. At December 31, 2011, retained earnings of $13,382,000 were free of such restrictions. Stock Purchase Agreements - On December 23, 2009, the Company entered into Stock Purchase Agreements (Agreements) with a limited number of accredited investors (collectively, the ‘‘Purchasers’’) to sell to the Purchasers a total of 1,264,952 shares of common stock, (Common Stock) at $5.25 per share and 1,359 shares of non-voting Series B Convertible Adjustable Rate Non-Cumulative Perpetual Preferred Stock (Series B Preferred Stock) at $1,000 per share, for an aggregate gross purchase price of $8,000,000 (the ‘‘Offering’’) offset by issuance costs totaling $242,000. The Offering closed on December 23, 2009, and the Company issued an aggregate of 1,264,952 shares of its Common Stock and an aggregate of 1,359 shares of its Preferred Stock upon its receipt of consideration in cash. The Series B Preferred Stock was eligible to receive a semi-annual non-cumulative preferred dividend with an initial annualized coupon of 10%, payable at the end of the first six months the shares are outstanding. The annual dividend rate would have increased to 15% for the second six month period and 20% for each six month period thereafter. Dividends may not be paid on any other class or series of the Company’s stock unless dividends are currently paid on the Preferred Stock in any period. In May 2010, the shareholders of the Company approved an amendment to the Company’s governing instruments to create a series of non-voting common stock. In June 2010, the Company exercised its option to require the Purchasers to exchange 1,359 shares of Series B Preferred Stock for 258,862 shares of non-voting common stock. In August, 2011, the Company agreed to exchange of 258,862 shares of the Company’s non-voting common stock to 258,862 shares of the Company’s voting common stock. The issuance of voting common stock was conducted in a privately negotiated transaction exempt from registration pursuant to Sections 3(a)(9) and 4(2) of the Securities Act of 1933, as amended. Capital Purchase Program - Small Business Lending Fund - On August 18, 2011, the Company entered into a Securities Purchase Agreement with the Small Business Lending Fund of the United States Department of the Treasury (the ‘‘Treasury’’), under which the Company issued 7,000 shares of Senior Non-Cumulative Perpetual Preferred Stock, Series C (the ‘‘Preferred Shares’’) to the Treasury for an aggregate purchase price of $7,000,000. Simultaneously, the Company agreed with Treasury under a Letter Agreement to redeem, for an aggregate price of $7,000,000, the 7,000 shares of the Company’s Series A Fixed Rate Cumulative Preferred Stock (‘‘Series A Stock’’)originally issued pursuant to the Treasury’s Capital Purchase Program (‘‘CPP’’) in 2009.The redemption of the Series A Stock resulted in an acceleration of the remaining discount booked at the time of the CPP transaction. In connection with the repurchase of the Series A Stock, the Company also notified the Treasury of the Company’s intent to repurchase the warrant (the ‘‘Warrant’’) to purchase 79,037 shares of the Company’s common stock that was originally issued to Treasury in connection with the CPP transaction. On September 28, 2011, the Company completed the repurchase of the Warrant for total consideration of $185,000. The Preferred Shares will qualify as Tier 1 capital and will pay non-cumulative dividends at an initial rate of 5% per annum. The dividend rate may vary, but not exceed 5%, with any reductions in interest rate to be calculated by reference to increases over a baseline amount in the Company’s small business lending activities. The Preferred Stock may be redeemed by the Company, or by Treasury in the event that it is statutorily prevented from continuing to hold the Preferred Stock. The Preferred Stock was issued in a private placement exempt from registration pursuant to Section 4(2) of the Securities Act of 1933, as amended. The Series C Preferred Stock is non-voting, other than class voting rights on (i) any authorization or issuance of shares ranking senior to the Series C Preferred Stock, (ii) any amendment to the rights of the Series C Preferred Stock, or (iii) any merger, exchange or similar transaction which would adversely affect the rights of the Series C Preferred Stock. If dividends on the Series C Preferred Stock are not paid in full for six dividend periods, whether or not consecutive, the holders of the Series C Preferred Stock will have the right to elect 2 directors. The right to elect directors will end when full dividends have been paid for four consecutive dividend periods. The Company has paid all scheduled dividend payments as of December 31, 2011. 34 34 Notes to Consolidated Financial Statements 13. SHAREHOLDERS’ EQUITY (Continued) A reconciliation of the numerators and denominators of the basic and diluted earnings per common share computations is as follows: For the Years Ended December 31, 2011 2010 (In thousands, except share and per share amounts) 2009 Basic Earnings Per Common Share: Net income Less: Preferred stock dividends and accretion $ 6,477 $ 3,279 $ 2,588 (486) (395) (365) $ 5,991 $ 2,884 $ 2,223 9,522,066 9,209,858 7,685,789 $ $ $ $ 0.63 6,477 (486) $ $ 0.31 3,279 (395) 0.29 2,588 (365) $ 5,991 $ 2,884 $ 2,223 9,522,066 9,209,858 7,685,789 Income available to common shareholders Weighted average shares outstanding Net income per common share Diluted Earnings Per Common Share: Net income Less: Preferred stock dividends and accretion Income available to common shareholders Weighted average shares outstanding Effect of dilutive stock options and warrants Weighted average shares of common stock and common stock equivalents 9,538,662 9,290,671 7,803,764 Net income per diluted common share $ 0.63 $ 0.31 $ 0.28 Outstanding options and warrants of 436,619, 531,996, and 512,301 were not factored into the calculation of dilutive stock options at December 31, 2011, 2010, and 2009, respectively, because they were anti-dilutive. 14. SHARE-BASED COMPENSATION On December 31, 2011, the Company had two share-based compensation plans, which are described below. The Plans do not provide for the settlement of awards in cash and new shares are issued upon option exercise or restricted share grants. On November 15, 2000, the Company adopted, and subsequently amended on December 20, 2000, the Central Valley Community Bancorp 2000 Stock Option Plan (2000 Plan) for which 416,769 shares remain reserved for issuance for options already granted to employees and directors under incentive and nonstatutory agreements. The plan expired on November 15, 2010. Outstanding options under this plan are exercisable until their expiration, however, no new options will be granted under this plan. The plan required that the option price may not be less than the fair market value of the stock at the date the option was granted, and that the option price must be paid in full at the time it is exercised. The options under the plan expire on dates determined by the Board of Directors, but not later than 10 years from the date of grant. The vesting period was determined by the Board of Directors and was generally over five years. In May 2005, the Company adopted the Central Valley Community Bancorp 2005 Omnibus Incentive Plan (2005 Plan). The plan provides for awards in the form of incentive stock options, non-statutory stock options, stock appreciation rights, and restricted stock. The plan also allows for performance awards that may be in the form of cash or shares of the Company, including restricted stock. The maximum number of shares that can be issued with respect to all awards under the plan is 476,000. Currently under the 2005 Plan, there are 94,250 shares reserved for issuance for options already granted to employees and 381,750 remain reserved for future grants as of December 31, 2011. The 2005 plan requires that the exercise price may not be less than the fair market value of the stock at the date the option is granted, and that the option price must be paid in full at the time it is exercised. The options and awards under the plan expire on dates determined by the Board of Directors, but not later than 10 years from the date of grant. The vesting period for the options and option related stock appreciation rights is determined by the Board of Directors and is generally over five years. No options to purchase shares of the Company’s common stock were issued during the year ending December 31, 2011 from any of the company’s stock based compensation plans. In 2010, options to purchase 15,200 shares of the Company’s common stock were granted from the 2000 Plan at an exercise price of $5.76 and options to purchase 67,800 shares of common stock were granted from the 2005 Plan at exercise prices between $5.30 and $5.76. In 2009, options to purchase 13,500 shares of the Company’s common stock were granted at exercise prices of between $5.06 and $6.40 from the 2005 Plan. All options were granted with an exercise price equal to the market value on the grant date. The Company bases the fair value of the options previously granted on the date of grant using a Black-Scholes-Merton option pricing model that uses assumptions based on expected option life, the level of estimated forfeitures, expected stock volatility and the risk-free interest rate. Stock volatility is based on the historical volatility of the Company’s stock. The risk-free rate is based on the U.S. Treasury yield curve and the expected term of the options. Historical data is used to determine the expected term of its stock options. The fair value of each option is estimated on the date of grant using the Dividend yield Expected volatility Risk-free interest rate Expected option term 2010 2009 0.00% 40% - 44% 1.47% - 2.43% 6.5 years 0.10% 31% - 38% 1.52% - 1.87% 6.5 years For the years ended December 31, 2011, 2010, and 2009, the compensation cost recognized for share based compensation was $196,000, $239,000, and $284,000, respectively. The recognized tax benefit for share based compensation expense was $36,000, $42,000, and $44,000 for 2011, 2010, and 2009, respectively. 35 35 16,596 80,813 117,975 following assumptions. Notes to Consolidated Financial Statements 14. SHARE-BASED COMPENSATION (Continued) A summary of the combined activity of the Plans for the years ended December 31, 2011, 2010, and 2009 follows: Weighted Average Exercise Price Weighted Average Remaining Contractual Term (Years) Aggregate Intrinsic Value Number of Stock Options Outstanding (Dollars in thousands, except per share amounts) 823,881 13,500 $ (42,522) $ (4,925) $ 5.21 4.11 8.10 789,934 $ 6.70 3.29 $ 668 757,726 $ 6.60 4.46 $ 668 679,507 $ 6.46 2.65 $ 668 789,934 83,000 $ (159,400) $ (6,405) $ 5.75 3.45 8.59 707,129 $ 7.31 3.78 $ 350 687,832 $ 7.34 6.04 $ 350 568,891 $ 7.62 4.34 $ 350 707,129 (179,800) $ (16,310) $ 3.78 6.93 511,019 $ 8.56 3.92 $ 12 494,692 $ 8.64 5.44 $ 422,375 $ 9.11 3.08 $ 12 10 Options outstanding at January 1, 2009 Options granted Options exercised Options canceled Options outstanding at December 31, 2009 Options vested or expected to vest at December 31, 2009 Options exercisable at December 31, 2009 Options outstanding at January 1, 2010 Options granted Options exercised Options canceled Options outstanding at December 31, 2010 Options vested or expected to vest at December 31, 2010 Options exercisable at December 31, 2010 Options outstanding at January 1, 2011 Options exercised Options canceled Options outstanding at December 31, 2011 Options vested or expected to vest at December 31, 2011 Options exercisable at December 31, 2011 The weighted-average grant-date fair value of options granted during 2010, and 2009 was $2.58, and $1.33, respectively. There were no options granted in 2011. The total intrinsic value of options exercised in the years ended December 31, 2011, 2010, and 2009 was $417,000, $349,000, and $51,000, respectively. Cash received from options exercised for the years ended December 31, 2011, 2010, and 2009 was $680,000, $550,000, and $175,000, respectively. The tax benefit realized for the tax deductions from options exercised totaled $116,000, $28,000, and $7,000 for the years ended December 31, 2011, 2010, and 2009, respectively. 36 36 As of December 31, 2011, there was $197,000 of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under all Plans. The cost is expected to be recognized over a weighted average period of 2.85 years. The total fair value of options vested was $123,000 and $260,000 for the years ended December 31, 2011 and 2010, respectively. 15. EMPLOYEE BENEFITS 401(k) and Profit Sharing Plan - The Bank has established a 401(k) and profit sharing plan. The 401(k) plan covers substantially all employees who have completed a six-month period in which they are credited with at least 1,000 hours of service. Participants in the profit sharing plan are eligible to receive employer contributions after completion of two years of service. Bank contributions to the profit sharing plan are determined at the discretion of the Board of Directors. Participants are automatically vested 100% in all employer contributions. The Bank contributed $150,000 to the profit sharing plan in 2011. The Bank did not contribute to the profit sharing plan in 2010 or 2009. Additionally, the Bank may elect to make a matching contribution to the participants’ 401(k) plan accounts. The amount to be contributed is announced by the Bank at the beginning of the plan year. For the years ended December 31, 2011, 2010, and 2009, the Bank made a 100% matching contribution on all deferred amounts up to 3% of eligible compensation and a 50% matching contribution on all deferred amounts above 3% to a maximum of 5%. For the years ended December 31, 2011, 2010, and 2009, the Bank made matching contributions totaling $352,000, $336,000, and $301,000, respectively. Deferred Compensation Plan - The Bank has a nonqualified Deferred Compensation Plan which provides directors with an unfunded, deferred compensation program. Under the plan, eligible participants may elect to defer some or all of their current compensation or director fees. Deferred amounts earn interest at an annual rate determined by the Board of Directors (5.25% at December 31, 2011). At December 31, 2011 and 2010, the total net deferrals included in accrued interest payable and other liabilities were $2,297,000 and $2,151,000, respectively. In connection with the implementation of the above plan, single premium universal life insurance policies on the life of each participant were purchased by the Bank, which is beneficiary and owner of the policies. The cash surrender value of the policies totaled $3,205,000, $3,106,000 and $3,006,000 at December 31, 2011, 2010, and 2009, respectively. Income recognized on these policies, net of related expenses, for the years ended December 31, 2011, 2010, and 2009 was $98,000, $100,000, and $97,000, respectively. Salary Continuation Plans - The Board of Directors approved salary continuation plans for certain key executives during 2002 and subsequently amended the plans in 2006. Under these plans, the Bank is obligated to provide the executives with annual benefits for fifteen years after retirement. These benefits are substantially equivalent to those available under split-dollar life insurance policies purchased by the Bank on the life of the executives. The expense recognized under these plans for the years ended December 31, 2011, 2010, and 2009 totaled $341,000, $450,000, and $407,000, respectively. Accrued compensation payable under the salary continuation plan totaled $3,764,000, $3,574,000 and $3,201,000 at December 31, 2011, 2010, and 2009, respectively In connection with these plans, the Bank purchased single premium life insurance policies with cash surrender values totaling $4,393,000, $4,366,000 and $4,214,000 at December 31, 2011, 2010, and 2009, respectively. Income recognized on these policies, net of related expense, for the years ended December 31, 2011, 2010, and 2009 totaled $144,000, $152,000, and $155,000, respectively. In connection with the acquisition of Service 1st Bank, the Bank assumed a liability for the estimated present value of future benefits payable to former key executives of Service 1st. The liability relates to change in control benefits associated with Service 1st’s salary continuation plans. The benefits are payable to the individuals when they reach retirement age. At December 31, 2011 and 2010, the total amount of the liability was $1,694,000 and $1,636,000, respectively. Expense recognized by the Bank in 2011, 2010 and 2009 associated with these plans was $98,000, $95,000 and $22,000, respectively. These benefits are substantially equivalent to those available under split-dollar life insurance policies acquired. These single premium life insurance policies had cash surrender values totaling $4,057,000, $3,918,000 and $3,778,000 at December 31, 2011, 2010, and 2009, respectively. Income recognized on these policies, net of related Notes to Consolidated Financial Statements 15. EMPLOYEE BENEFITS (Continued) 18. PARENT ONLY CONDENSED FINANCIAL STATEMENTS expenses, for the year ended December 31, 2011, 2010, and 2009 was $140,000, $140,000 and $139,000, respectively. The current annual tax-free interest rate on all life insurance policies is CONDENSED BALANCE SHEETS December 31, 2011 and 2010 (In thousands) 5.22%. 16. LOANS TO RELATED PARTIES During the normal course of business, the Bank enters into loans with related parties, including executive officers and directors. The following is a summary of the aggregate activity involving related party borrowers (in thousands): ASSETS Cash and cash equivalents Investment in Bank subsidiary Other assets Total assets 2011 2010 $ 969 111,357 508 $ 1,071 101,346 305 $ 112,834 $ 102,722 Balance, January 1, 2011 Disbursements Amounts repaid Balance, December 31, 2011 Undisbursed commitments to related parties, December 31, 2011 17. COMPREHENSIVE INCOME $ $ $ 809 410 (300) 919 1,391 LIABILITIES AND SHAREHOLDERS’ EQUITY Liabilities: Junior subordinated debentures due to subsidiary grantor trust Other liabilities Total liabilities Shareholders’ equity: $ $ 5,155 197 5,352 Comprehensive income is a more inclusive financial reporting methodology that includes disclosure of other comprehensive income (loss) that historically has not been recognized in the calculation of net income. The Company’s only source of other comprehensive income (loss) is unrealized gains and losses on the Company’s available-for-sale investment securities. Total comprehensive income and the components of accumulated other comprehensive income (loss) are presented in the consolidated statement of changes in shareholders’ equity. At December 31, 2011, 2010, and 2009, the Company held securities classified as available-for-sale which had net unrealized gains or losses as follows: Preferred stock, Series A Preferred stock, Series B Preferred stock, Series C Common stock Retained earnings Accumulated other comprehensive income, net of taxes - - 7,000 40,552 55,806 4,124 Total shareholders’ equity 107,482 97,391 Total liabilities and shareholders’ equity $ 112,834 $ 102,722 5,155 176 5,331 6,864 1,317 - 38,428 49,815 967 Before Tax Tax (Expense) Benefit (In thousands) After Tax CONDENSED STATEMENTS OF INCOME For the Years Ended December 31, 2011, 2010, and 2009 (In thousands) For the Year Ended December 31, 2011 Other comprehensive income: Unrealized holding gains Less reclassification adjustment for net gains included in net income Total other comprehensive income $ 5,632 $ (2,318) $ 3,314 267 (110) 157 $ 5,365 $ (2,208) $ 3,157 For the Year Ended December 31, 2010 Other comprehensive income: Unrealized holding gains Less reclassification adjustment for net losses included in net income Total other comprehensive income $ 2,290 $ (927) $ 1,363 (1,778) 719 (1,059) $ 4,068 $ (1,646) $ 2,422 For the Year Ended December 31, 2009 Other comprehensive loss: Unrealized holding losses Less reclassification adjustment for net gains included in net income $ (1,971) $ 788 $ (1,183) 767 (307) 460 Total other comprehensive loss $ (2,738) $ 1,095 $ (1,643) Income: Other income Total income Expenses: Interest on junior subordinated deferrable interest debentures Professional fees Other expenses Total expenses Loss before equity in undistributed net income of Subsidiary Equity in undistributed net income of Subsidiary, net of distributions Income before income tax benefit Benefit from income taxes Net income Preferred stock dividend and accretion of discount Income available to common shareholders 2011 2010 2009 $ $ 3 3 $ 3 3 100 148 352 600 102 147 329 578 13 13 129 30 295 454 (597) (575) (441) 6,854 3,657 2,871 6,257 220 6,477 486 3,082 197 3,279 395 2,430 158 2,588 365 $ 5,991 $ 2,884 $ 2,223 37 37 Notes to Consolidated Financial Statements 18. PARENT ONLY CONDENSED FINANCIAL STATEMENTS (Continued) CONDENSED STATEMENTS OF CASH FLOWS For the Years Ended December 31, 2011, 2010, and 2009 (In thousands) Cash flows from operating activities: Net income Adjustments to reconcile net income to net cash (used in) provided by operating activities: Undistributed net income of subsidiary, net of distributions Stock-based compensation Tax benefit from exercise of stock options Net (increase) decrease in other assets Net (decrease) increase in other liabilities Provision for deferred income taxes Net cash (used in) provided by operating activities Cash flows used in investing activities: Investment in subsidiary Cash flows from financing activities: Net proceeds from issuance of common stock Proceeds from issuance of Series A preferred stock and warrants Proceeds from issuance of Series B preferred stock Cash dividend payments Proceeds from exercise of stock options Warrant purchase Tax benefit from exercise of stock options Net cash provided in financing activities (Decrease) increase in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year Cash paid during the year for interest Non-Cash Investing and Financing Activities: Redemption of preferred stock Series A and issuance of preferred stock Series C Accrued Preferred Stock Dividend 2011 2010 2009 $ 6,477 $ 3,279 $ 2,588 (6,854) 196 (116) (50) (23) (36) (406) - - - - (307) 680 (185) 116 304 (102) 1,071 969 98 7,000 88 $ $ $ $ (3,657) 239 (28) 170 23 (43) (17) - - - - (349) 550 - 28 229 212 859 1,071 101 - 45 $ $ $ $ (2,871) 284 (7) 1,765 (140) 68 1,687 (16,578) 6,441 7,000 1,317 (277) 175 - 7 14,663 (228) 1,087 859 182 - 44 $ $ $ $ 38 38 Report of Independent Registered Public Accounting Firm The Shareholders and Board of Directors Central Valley Community Bancorp and Subsidiary We have audited the accompanying consolidated balance sheet of Central Valley Community Bancorp and subsidiary (the ‘‘Company’’) as of December 31, 2011, and the related consolidated statements of income, changes in shareholders’ equity, and cash flows for the year then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. 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 principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Central Valley Community Bancorp and subsidiary as of December 31, 2011, and the results of their operations and their cash flows for the year then ended, in conformity with U.S. generally accepted accounting principles. Sacramento, California March 21, 2012 39 39 Report of Independent Registered Public Accounting Firm The Shareholders and Board of Directors Central Valley Community Bancorp and Subsidiary We have audited the accompanying consolidated balance sheet of Central Valley Community Bancorp and subsidiary (the ‘‘Company’’) as of December 31, 2010 and the related consolidated statements of income, changes in shareholders’ equity and cash flows for the years ended December 31, 2010 and 2009. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements 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 audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Central Valley Community Bancorp and subsidiary as of December 31, 2010 and the consolidated results of their operations and their cash flows for the years ended December 31, 2010 and 2009, in conformity with U.S. generally accepted accounting principles. Sacramento, California March 16, 2011 40 40 Selected Consolidated Financial Data Statements of Income Total interest income Total interest expense Net interest income before provision for credit losses Provision for credit losses Net interest income after provision for credit losses Non-interest income Non-interest expenses Income before (benefit from) provision for income taxes (Benefit from) provision for income taxes Net income Preferred stock dividends and accretion of discount Net income available to common shareholders Basic earnings per share Diluted earnings per share Cash dividends declared per common share Balances at end of year: Investment securities, Federal funds sold and deposits in other banks Net loans Total deposits Total assets Shareholders’ equity Earning assets Average balances: Investment securities, Federal funds sold and deposits in other banks Net loans Total deposits Total assets Shareholders’ equity Earning assets Years Ended December 31, (In thousands, except per share amounts) 2011 2010 2009 2008 2007 $ 34,299 $ 2,942 36,013 $ 4,283 40,734 $ 6,627 31,845 $ 7,278 31,357 1,050 30,307 6,276 36,583 28,245 8,338 1,861 6,477 486 31,730 3,800 27,930 3,721 31,651 28,741 2,910 (369) 3,279 395 34,107 10,514 23,593 5,850 29,443 27,531 1,912 (676) 2,588 365 24,567 1,290 23,277 5,190 28,467 20,976 7,491 2,352 5,139 - 5,991 $ 2,884 $ 2,223 $ 5,139 $ 0.63 $ 0.31 $ 0.29 $ 0.83 $ 0.63 $ 0.31 $ 0.28 $ 0.79 $ - $ - $ - $ 0.10 $ December 31, (In Thousands) 32,566 8,058 24,508 480 24,028 4,518 28,546 19,099 9,447 3,167 6,280 - 6,280 1.05 0.99 0.10 2011 2010 2009 2008 2007 353,808 $ 415,999 712,986 849,023 107,482 777,088 280,967 $ 420,583 650,495 777,594 97,391 713,971 232,142 $ 449,007 640,167 765,488 91,223 696,914 194,215 $ 477,015 635,058 752,713 75,375 681,280 98,909 337,241 402,562 483,685 54,194 441,825 299,935 $ 417,273 677,789 800,178 103,386 715,862 231,761 $ 444,418 636,166 758,852 96,174 672,804 199,425 $ 473,850 632,263 752,509 83,400 671,906 125,932 $ 362,333 445,285 541,789 58,251 492,414 103,253 327,665 417,691 477,321 51,754 436,564 $ $ $ $ $ $ Data from 2008 reflects the partial year impact of the acquisition of Service 1st Bancorp and its subsidiary, Service 1st Bank. Supplementary Financial Information Net interest income Provision for credit losses Net interest income after provision for credit losses Total non-interest income Total non-interest expense (Benefit from) Provision for income taxes Net income Net income available to common shareholders Basic earnings per share Diluted earnings per share Unaudited Quarterly Statement of Operations Data (Dollars in thousands, except per share data) Q4 2011 Q3 2011 Q2 2011 Q1 2011 Q4 2010 Q3 2010 Q2 2010 Q1 2010 $ $ $ $ $ 8,016 $ 300 7,949 $ 400 7,794 $ 250 7,598 $ 100 7,641 $ 900 8,173 $ 1,300 7,930 $ 1,000 7,716 1,336 6,803 541 7,549 1,595 7,222 514 7,544 1,597 7,067 301 7,498 1,748 7,153 505 1,708 $ 1,408 $ 1,773 $ 1,588 $ 1,622 $ 1,206 $ 1,674 $ 1,489 $ 0.17 $ 0.17 $ 0.13 $ 0.13 $ 0.18 $ 0.18 $ 0.16 $ 0.16 $ 6,741 347 6,986 (517) 619 $ 520 $ 0.06 $ 0.06 $ 6,873 1,293 7,409 (107) 864 $ 766 $ 0.08 $ 0.08 $ 6,930 747 7,142 31 504 $ 405 $ 0.04 $ 0.04 $ 7,986 600 7,386 1,334 7,204 224 1,292 1,193 0.13 0.13 41 41 Management’s Discussion and Analysis of Financial Condition and Results of Operations MANAGEMENT’S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION. Management’s discussion and analysis should be read in conjunction with the Company’s audited Consolidated Financial Statements, including the Notes thereto, in Item 8 of this Annual Report. Certain matters discussed in this report constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All statements contained herein that are not historical facts, such as statements regarding the Company’s current business strategy and the Company’s plans for future development and operations, are based upon current expectations. These statements are forward-looking in nature and involve a number of risks and uncertainties. Such risks and uncertainties include, but are not limited to (1) significant increases in competitive pressure in the banking industry; (2) the impact of changes in interest rates, a decline in economic conditions at the international, national or local level on the Company’s results of operations, the Company’s ability to continue its internal growth at historical rates, the Company’s ability to maintain its net interest margin, and the quality of the Company’s earning assets; (3) changes in the regulatory environment; (4) fluctuations in the real estate market; (5) changes in business conditions and inflation; (6) changes in securities markets (7) risks associated with acquisitions, relating to difficulty in integrating combined operations and related negative impact on earnings, and incurrence of substantial expenses. Therefore, the information set forth in such forward-looking statements should be carefully considered when evaluating the business prospects of the Company. When the Company uses in this Annual Report the words ‘‘anticipate,’’ ‘‘estimate,’’ ‘‘expect,’’ ‘‘project,’’ ‘‘intend,’’ ‘‘commit,’’ ‘‘believe’’ and similar expressions, the Company intends to identify forward-looking statements. Such statements are not guarantees of performance and are subject to certain risks, uncertainties and assumptions, including those described in this Annual Report. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those anticipated, estimated, expected, projected, intended, committed or believed. The future results and shareholder values of the Company may differ materially from those expressed in these forward-looking statements. Many of the factors that will determine these results and values are beyond the Company’s ability to control or predict. For those statements, the Company claims the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. See also the discussion of risk factors in Item 1A, ‘‘Risk Factors’’ in the Company’s December 31, 2011 Form 10-K. INTRODUCTION Central Valley Community Bancorp (NASDAQ: CVCY) (the Company) was incorporated on February 7, 2000. The formation of the holding company offered the Company more flexibility in meeting the long-term needs of customers, shareholders, and the communities it serves. The Company currently has one bank subsidiary, Central Valley Community Bank (the Bank) and one business trust subsidiary, Service 1st Capital Trust 1. The Bank of Madera County (BMC) was merged with and into the Bank on January 1, 2005. BMC had two branches in Madera County which continue to be operated by the Bank. After the close of business on November 12, 2008, Service 1st Bancorp (Service 1st) was merged with and into the Company, and Service 1st Bank was merged with and into the Bank. Service 1st Bank had three branches in Stockton, Tracy, and Lodi which continue to be operated by the Bank. Service 1st Capital Trust 1 (the Trust) is a business trust formed for the purpose of issuing trust preferred securities. The Company succeeded to all the rights and obligations of Service 1st in connection with the acquisition of Service 1st. The Trust is a subsidiary of the Company. The Company’s market area includes the central valley area from Sacramento, California to Bakersfield, California. During 2011, we focused on asset quality and capital adequacy due to the uncertainty created by the economy. We also focused on assuring that competitive products and services were made available to our clients while adjusting to the many new laws and regulations that affect the banking industry. In 2011, the Company relocated the existing Modesto branch, a full service office, to a more desirable location. In 2009, we opened a new full service office in Merced, California and relocated our Oakhurst office to a new smaller facility in a more desirable location. During 2008 the Company acquired Service 1st Bancorp and its banking subsidiary adding three strategically located branches and we relocated our Herndon and Fowler branch from an in-store location to a new larger facility. During 2007, we relocated our Kerman branch to a new larger facility. During 2006, the Bank opened two full service retail offices in Fresno, one in the downtown area and one in the Sunnyside area of Fresno. In 2006, the Company consolidated its administrative offices into a single location in Fresno and opened a limited service branch there. The Bank now operates 17 full-service offices. The Bank has a Real Estate Division, an Agribusiness Center and an SBA Lending Division in Fresno. All real estate related transactions are conducted and processed through the Real Estate Division, including interim construction loans for single family residences and commercial buildings. We offer permanent single family residential loans through our mortgage broker services. ECONOMIC CONDITIONS The economy in California’s Central Valley has been negatively impacted by the recession that began in 2007 and the related real estate market and the slowdown in residential construction. The recession has impacted most industries in our market area. During the past three years, housing values throughout the nation and especially in the Central Valley have decreased dramatically, which in turn has negatively affected the personal net worth of much of the population in our service area. Housing in the Central Valley continues to be relatively more affordable than the major metropolitan areas in California. Agriculture and agricultural related businesses remain a critical part of the Central Valley’s economy. The Valley’s agricultural production is widely diversified, producing nuts, vegetables, fruit, cattle, dairy products, and cotton. The continued future success of agriculture related businesses is highly dependent on the availability of water and is subject to fluctuation in worldwide commodity prices and demand. OVERVIEW Diluted earnings per share (EPS) for the year ended December 31, 2011 was $0.63 compared to $0.31 and $0.28 for the years ended December 31, 2010, and 2009, respectively. Net income for 2011 was $6,477,000 compared to $3,279,000 and $2,588,000 for the years ended December 31, 2011, 2010 and 2009, respectively. The increase in net income and EPS was primarily driven by lower provision for credit losses, decreases in non-interest expense and increases in non-interest income, partially offset by decreases in net interest income in 2011 compared to 2010. Total assets at December 31, 2011 were $849,023,000 compared to $777,594,000 at December 31, 2010. Return on average equity for 2011 was 6.26% compared to 3.41% and 3.10% for 2010 and 2009, respectively. Return on average assets for 2011 was 0.81% compared to 0.43% and 0.34% for 2010 and 2009, respectively. Total equity was $107,482,000 at December 31, 2011 compared to $97,391,000 at December 31, 2010. The increase in assets and equity in 2011 compared to 2010 is due to an increase in deposits and increases in other comprehensive income and retained earnings and the exercise of stock options. Average total loans decreased $27,049,000 or 5.94% to $428,291,000 in 2011 compared to $455,340,000 in 2010. In 2011, we recorded a provision for credit losses of $1,050,000 compared to $3,800,000 in 2010 and $10,514,000 in 2009. The Company had nonperforming assets totaling $14,434,000 at December 31, 2011. Nonperforming assets included nonaccrual loans totaling $14,434,000. At December 31, 2010 nonperforming assets totaled $19,984,000 consisting of $18,561,000 in nonaccrual loans, other real estate owned of $1,325,000 and $98,000 in other assets. Net charge-offs for 2011 were $668,000 compared to $2,986,000 for 2010 and $7,537,000 for 2009. Refer to ‘‘Asset Quality’’ below for further information. 42 42 Management’s Discussion and Analysis of Financial Condition and Results of Operations OVERVIEW (Continued) Key Factors in Evaluating Financial Condition and Operating Performance As a publicly traded community bank holding company, we focus on several key factors including: • Return to our stockholders; • Return on average assets; • Development of core earnings, including net interest income and non-interest income; • Asset quality; • Asset growth; • Capital adequacy; • Operating efficiency; and • Liquidity. Return to Our Stockholders Our return to our stockholders is measured in a ratio that measures the return on average equity (ROE). Our ROE was 6.26% for the year ended 2011 compared to 3.41% and 3.10% for the years ended 2010 and 2009, respectively. In 2011, compared to 2010 we experienced an increase in net income and an increase in capital due to increases in retained earnings, other comprehensive income, and the exercise of stock options. Our net income for the year ended December 31, 2011 increased $3,198,000 compared to 2010 and increased $691,000 for 2010 compared to 2009. During 2011 net income increased primarily due to a decrease in the provision for credit losses, decreases in non-interest expense and increases in non-interest income, partially offset by decreases in net interest income in 2011 compared to 2010. Net interest income decreased because of decreases in loan and investment income, partially offset by decreases in interest expense on deposits. Non-interest income increased due to an Other-Than-Temporary-Impairment (OTTI) charge of $31,000 in 2011, compared to $1,587,000 in 2010, an increase in net realized gains on sales and calls of investment securities of $489,000, a $142,000 gain related to the final distribution of the Service 1st escrow account, an $85,000 gain related to the collection of life insurance proceeds, and an increase in gain of other real estate owned of $439,000. Non-interest expenses decreased in 2011 compared to 2010 primarily due to decrease in OREO expenses of $1,056,000, legal fees of $160,000, and regulatory assessment of $346,000, partially offset by increases in salaries and employee benefits of $891,000. During 2011, our net interest margin (NIM) decreased 32 basis points compared to 2010. Basic EPS was $0.63 for 2011 compared to $0.31 and $0.29 for 2010 and 2009, respectively. Diluted EPS was $0.63 for 2011 compared to $0.31 and $0.28 for 2010 and 2009, respectively. The increase in EPS in 2011 was due primarily to the increase in net income. Return on Average Assets Our return on average assets (ROA) is a ratio that measures our performance compared with other banks and bank holding companies. Our ROA for the year ended 2011 was 0.81% compared to 0.43% and 0.34% for the years ended December 31, 2010 and 2009, respectively. The 2011 increase in ROA is due to the increase in net income, notwithstanding an increase in average assets. Annualized ROA for our peer group was 0.37% at December 31, 2011. Peer group information from SNL Financial data includes bank holding companies in central California with assets from $300M to $950M that are not subchapter S corporations. Development of Core Earnings Over the past several years, we have focused on not only our net income, but improving the consistency of our core earnings in order to create more predictable future earnings and reduce the effect of changes in our operating environment on our net income. Specifically, we have focused on net interest income through a variety of processes, including increases in average interest- earning assets through loan generation and retention. We minimized the effects of the recent interest rate decline on our net interest margin by focusing on core deposits and managing the cost of funds. Our net interest margin (fully tax equivalent basis) was 4.63% for the year ended December 31, 2011, compared to 4.95% and 5.31% for the years ended December 31, 2010 and 2009, respectively. The decrease in net interest margin compared to 2010 is principally due to a decrease in our yield on earning assets which was greater than the decrease in our cost of funds. In comparing the two periods, the effective yield on total earning assets decreased 55 basis points, while the cost of total interest- bearing liabilities decreased 27 basis points and the cost of total deposits decreased 19 basis points. Our cost of total deposits in 2011 was 0.39% compared to 0.58% for the same period in 2010 and 0.93% for the year ended December 31, 2009. Our net interest income before provision for credit losses decreased $373,000 or 1.18% to $31,357,000 for the year ended 2011 compared to $31,730,000 and $34,107,000 for the years ended 2010 and 2009, respectively. Our non-interest income is generally made up of service charges and fees on deposit accounts, fee income from loan placements, appreciation in cash surrender value of bank owned life insurance, and net gains from sales and calls of investment securities. Non-interest income in 2011 increased $2,555,000 or 68.66% to $6,276,000 compared to $3,721,000 in 2010 and $5,850,000 in 2009. Customer service charges decreased $322,000 or 9.98% to $2,903,000 in 2011 compared to $3,225,000 and $3,509,000 in 2010 and 2009, respectively. Further detail on non-interest income is provided below. Asset Quality For all banks and bank holding companies, asset quality has a significant impact on the overall financial condition and results of operations. Asset quality is measured in terms of percentage of total loans and total assets, and is a key element in estimating the future earnings of a company. Total nonperforming assets were $14,434,000 and $19,984,000 at December 31, 2011 and 2010, respectively. Nonperforming assets included nonaccrual loans totaling $14,434,000 or 3.38% of gross loans as of December 31, 2011 and $18,561,000 or 4.30% of gross loans as of December 31, 2010. Management maintains certain loans that have been brought current by the borrower (less than 30 days delinquent) on nonaccrual status until such time as management has determined that the loans are likely to remain current in future periods. Asset Growth As revenues from both net interest income and non-interest income are a function of asset size, the continued growth in assets has a direct impact in increasing net income and therefore ROE and ROA. The majority of our assets are loans and investment securities, and the majority of our liabilities are deposits, and therefore the ability to generate deposits as a funding source for loans and investments is fundamental to our asset growth. Total assets increased 9.19% during 2011 to $849,023,000 as of December 31, 2011 from $777,594,000 as of December 31, 2010. Total gross loans decreased 0.97% to $427,395,000 as of December 31, 2011, compared to $431,597,000 at December 31, 2010. Total investment securities and Federal funds sold increased 71.60% to $329,341,000 as of December 31, 2011 compared to $191,925,000 as of December 31, 2010. Total deposits increased 9.61% to $712,986,000 as of December 31, 2011 compared to $650,495,000 as of December 31, 2010. Our loan to deposit ratio at December 31, 2011 was 59.94% compared to 66.35% at December 31, 2010. The loan to deposit ratio of our peers was 74.42% at December 31, 2011. Capital Adequacy At December 31, 2011, we had a total capital to risk-weighted assets ratio of 17.49%, a Tier 1 risk-based capital ratio of 16.20% and a leverage ratio of 10.13%. At December 31, 2010, we had a total capital to risk-weighted assets ratio of 15.42%, a Tier 1 risk-based capital ratio of 14.16% and a leverage ratio of 9.48%. At December 31, 2011, on a stand-alone basis, the Bank had a total risk-based capital ratio of 17.31%, a Tier 1 risk based capital ratio of 16.02% and a leverage ratio of 10.01%. At December 31, 2010, the Bank had a total risk-based capital ratio of 15.19%, Tier 1 risk-based capital of 13.92% and a leverage ratio of 9.32%. The improvement in 2011 is due to an increase in risk adjusted capital while risk weighted assets decreased. Note 13 of the audited Consolidated Financial Statements provides more detailed information concerning the Company’s capital amounts and ratios. 43 43 Management’s Discussion and Analysis of Financial Condition and Results of Operations OVERVIEW (Continued) Operating Efficiency Operating efficiency is the measure of how efficiently earnings before taxes are generated as a percentage of revenue. A lower ratio represents greater efficiency. The Company’s efficiency ratio (operating expenses, excluding amortization of intangibles and foreclosed property expense, divided by net interest income plus non-interest income, excluding net gains and losses from sale of securities) was 75.67% for 2011 compared to 73.53% for 2010 and 67.31% for 2009. The decline in the efficiency ratio in 2011 and 2010 is due to an increase in operating expenses and a decrease in net interest income. The efficiency ratio in 2009 improved as compared to 2008 due to an increase in net interest income and non-interest income. The Company’s net interest income before provision for credit losses plus non-interest income increased 6.15% to $37,633,000 in 2011 compared to $35,451,000 in 2010 and $39,957,000 in 2009, while operating expenses decreased 1.73% in 2011. Operating expenses increased 4.40% in 2010, and 31.25% in 2009. Liquidity Liquidity management involves our ability to meet cash flow requirements arising from fluctuations in deposit levels and demands of daily operations, which include providing for customers’ credit needs, funding of securities purchases, and ongoing repayment of borrowings. Our liquidity is actively managed on a daily basis and reviewed periodically by our management and Directors’ Asset/Liability Committee. This process is intended to ensure the maintenance of sufficient funds to meet our needs, including adequate cash flow for off-balance sheet commitments. Our primary sources of liquidity are derived from financing activities which include the acceptance of customer and, to a lesser extent, broker deposits, Federal funds facilities and advances from the Federal Home Loan Bank of San Francisco. We have available unsecured lines of credit with correspondent banks totaling approximately $44,000,000 and secured borrowing lines of approximately $125,122,000 with the Federal Home Loan Bank. These funding sources are augmented by collection of principal and interest on loans, the routine maturities and pay downs of securities from our investment securities portfolio, the stability of our core deposits, and the ability to sell investment securities. Primary uses of funds include origination and purchases of loans, withdrawals of and interest payments on deposits, purchases of investment securities, and payment of operating expenses. We had liquid assets (cash and due from banks, interest-earning deposits in other banks, Federal funds sold and available-for-sale securities) totaling $373,217,000 or 43.96% of total assets at December 31, 2011 and $292,324,000 or 37.59% of total assets as of December 31, 2010. RESULTS OF OPERATIONS NET INCOME Net income was $6,477,000 in 2011 compared to $3,279,000 and $2,588,000 in 2010 and 2009, respectively. Basic earnings per share was $0.63, $0.31, and $0.29 for 2011, 2010, and 2009, respectively. Diluted earnings per share was $0.63, $0.31, and $0.28 for 2011, 2010 and 2009, respectively. ROE was 6.26% for 2011 compared to 3.41% for 2010 and 3.10% for 2009. ROA for 2011 was 0.81% compared to 0.43% for 2010 and 0.34% for 2009. The increase in net income for 2011 compared to 2010 can be attributed to the decrease in the provision for credit losses and an increase in non-interest income, partially offset by decrease in interest income and increase in provision from income taxes. The decrease in net interest income for 2010 compared to 2009 was due primarily to the 36 basis point reduction in the net interest margin. INTEREST INCOME AND EXPENSE Net interest income is the most significant component of our income from operations. Net interest income (the interest rate spread) is the difference between the gross interest and fees earned on the loan and investment portfolios and the interest paid on deposits and other borrowings. Net interest income depends on the volume of and interest rate earned on interest-earning assets and the volume of and interest rate paid on interest-bearing liabilities. 44 44 Management’s Discussion and Analysis of Financial Condition and Results of Operations INTEREST INCOME AND EXPENSE (Continued) The following table sets forth a summary of average balances with corresponding interest income and interest expense as well as average yield and cost information for the periods presented. Average balances are derived from daily balances, and nonaccrual loans are not included as interest-earning assets for purposes of this table. Year Ended December 31, 2011 Year Ended December 31, 2010 Year Ended December 31, 2009 Average Balance Interest Income/ Expense Average Interest Rate Average Balance Interest Income/ Expense Average Interest Rate Average Balance Interest Income/ Expense Average Interest Rate SCHEDULE OF AVERAGE BALANCES AND AVERAGE YIELDS AND RATES (Dollars in thousands) ASSETS Interest-earning deposits in other banks Securities Taxable securities Non-taxable securities (1) Total investment securities Federal funds sold Total securities Loans (2) (3) Federal Home Loan Bank stock $ 73,016 $ 150,559 75,665 226,224 695 299,935 412,969 2,958 187 4,548 5,248 9,796 2 9,985 26,098 9 Total interest-earning assets 715,862 $ 36,092 Allowance for credit losses Nonaccrual loans Other real estate owned Cash and due from banks Bank premises and equipment Other non-earning assets Total average assets LIABILITIES AND SHAREHOLDERS’ EQUITY Interest-bearing liabilities: Savings and NOW accounts Money market accounts Time certificates of deposit, under $100,000 Time certificates of deposit, $100,000 and over Total interest-bearing deposits Other borrowed funds $ $ (11,018) 15,322 217 17,977 5,788 56,030 800,178 154,765 $ 174,049 70,111 96,620 495,545 10,265 Total interest-bearing liabilities 505,810 $ Non-interest bearing demand deposits Other liabilities Shareholders’ equity 182,244 8,738 103,386 Total average liabilities and shareholders’ equity $ 800,178 368 692 688 914 2,662 280 2,942 0.26% $ 42,047 $ 0.26% $ 3,008 $ 3.02% 6.94% 4.33% 0.29% 3.33% 6.32% 0.30% 5.04% 0.24% 0.40% 0.98% 0.95% 0.54% 2.73% 0.58% 124,163 64,838 189,001 713 231,761 437,959 3,084 110 5,472 4,605 10,077 2 10,189 27,390 11 672,804 $ 37,590 $ $ (10,922) 17,381 2,972 16,479 6,089 54,049 758,852 142,350 $ 157,761 69,066 114,043 483,220 19,634 502,854 $ 152,946 6,878 96,174 498 1,036 866 1,313 3,713 570 4,283 4.41% 7.10% 5.33% 0.28% 4.40% 6.25% 0.36% 5.59% 0.35% 0.66% 1.25% 1.15% 0.77% 2.90% 0.85% 114,465 64,325 178,790 17,627 199,425 469,341 3,140 8 7,701 4,632 12,333 48 12,389 29,920 7 671,906 $ 42,316 $ $ (8,608) 13,117 2,553 17,401 6,629 49,511 752,509 131,818 $ 136,104 90,614 120,579 479,115 29,987 509,102 $ 153,148 6,859 83,400 771 1,262 1,922 1,912 5,867 760 6,627 0.27% 6.73% 7.20% 6.90% 0.27% 6.21% 6.37% 0.22% 6.30% 0.58% 0.93% 2.12% 1.59% 1.22% 2.53% 1.30% $ 758,852 $ 752,509 Interest income and rate earned on average earning assets Interest expense and interest cost related to average interest- bearing liabilities Net interest income and net interest margin (4) $ 36,092 5.04% $ 37,590 5.59% $ 42,316 6.30% 2,942 0.58% 4,283 0.85% 6,627 1.30% $ 33,150 4.63% $ 33,307 4.95% $ 35,689 5.31% (1) Calculated on a fully tax equivalent basis, which includes Federal tax benefits relating to income earned on municipal bonds totaling $1,784, $1,566, and $1,575 in 2011, 2010, and 2009, respectively. (2) Loan interest income includes loan fees of $399 in 2011, $460 in 2010, and $544 in 2009. (3) Average loans do not include nonaccrual loans. (4) Net interest margin is computed by dividing net interest income by total average interest-earning assets. Interest and fee income from loans decreased $1,292,000 or 4.72% in 2011 compared to 2010. Interest and fee income decreased $2,530,000 or 8.46% in 2010 compared to 2009. The decrease in 2011 is attributable to a decrease in average total loans outstanding combined with a 7 basis point decrease in the yield on loans. The decrease in 2010 is attributable to a decrease in average total loans outstanding and a 12 basis point decrease in yield on loans in 2010 compared to 2009. Average total loans for 2011 decreased $27,049,000 to $428,291,000 compared to $455,340,000 for 2010 and $482,458,000 for 2009. The yield on loans for 2011 was 6.32% compared to 6.25% and 6.37% for 2010 and 2009, respectively. 45 45 Management’s Discussion and Analysis of Financial Condition and Results of Operations INTEREST INCOME AND EXPENSE (Continued) Interest income from total investments, (total investments include investment securities, Federal funds sold, interest-bearing deposits in other banks, and other securities) not on a fully tax equivalent basis, decreased $422,000 or 4.89% in 2011 compared to 2010 primarily due to a $68,174,000 increase in the average balance to $299,935,000 in 2011 compared to $231,761,000 in 2010, coupled with a decrease in yield on investments of 107 basis points. In 2010, total investment income decreased $2,191,000 or 20.26% from 2009 primarily due to a 16.21% increase in the average balances of these investments and a 181 basis point increase in the yields earned. Average total investments for 2010 were $231,761,000 compared to $199,425,000 for 2009. A significant portion of the investment portfolio is mortgage-backed securities (MBS) and collateralized mortgage obligations (CMOs). At December 31, 2011, we held $211,942,000 or 64.54% of the total market value of the investment portfolio in MBS and CMOs with an average yield of 2.90%. We invest in Collateralized Mortgage Obligations (CMO) and Mortgage Backed Securities, (MBS) as part of the overall strategy to increase our net interest margin. CMOs and MBS by their nature react to changes in interest rates. In a normal declining rate environment, prepayments from MBS and CMOs would be expected to increase and the expected life of the investment would be expected to shorten. Conversely, if interest rates increase, prepayments normally would be expected to decline and the average life of the MBS and CMOs would be expected to extend. However, in the current economic environment, prepayments may not behave according to historical norms. Premium amortization and discount accretion of these investments affects our net interest income. Our management monitors the prepayment speed of these investments and adjusts premium amortization and discount accretion based on several factors. These factors include the type of investment, the investment structure, interest rates, interest rates on new mortgage loans, expectation of interest rate changes, current economic conditions, the level of principal remaining on the bond, the bond coupon rate, the bond origination date, and volume of available bonds in market. The calculation of premium amortization and discount accretion is by nature inexact, and represents management’s best estimate of principal pay downs inherent in the total investment portfolio. The net of tax effect value of the change in market value of the available-for-sale investment portfolio was a gain of $4,124,000 and is reflected in the Company’s equity. At December 31, 2011, the average life of the investment portfolio was five years and the market value reflected a pre-tax gain of $7,008,000. Management reviews market value declines on individual investment securities to determine whether they represent other-than-temporary impairment (OTTI) and recorded a $31,000 OTTI loss for the year ended December 31, 2011. Future deterioration in the market values of our investment securities may require the Company to recognize additional OTTI losses. A component of the Company’s strategic plan has been to use its investment portfolio to offset, in part, its interest rate risk relating to variable rate loans. Measured at December 31, 2011, an immediate rate increase of 200 basis points would result in an estimated decrease in the market value of the investment portfolio by approximately $26,725,000. Conversely, with an immediate rate decrease of 200 basis points, the estimated increase in the market value of the investment portfolio would be $32,215,000. The modeling environment assumes management would take no action during an immediate shock of 200 basis points. The likelihood of immediate changes of 200 basis points is contrary to expectation, as evidenced by the historical changes in interest rates that occurred in 2007 and 2008, which were in 25, 50 and 75 basis point increments. However, the Company uses those increments to measure its interest rate risk in accordance with regulatory requirements and to measure the possible future risk in the investment portfolio. For further discussion of the Company’s market risk, refer to Quantitative and Qualitative Disclosures about Market Risk. Management’s review of all investments before purchase includes an analysis of how the security will perform under several interest rate scenarios to monitor whether investments are consistent with our investment policy. The policy addresses issues of average life, duration, and concentration guidelines, prohibited investments, impairment, and prohibited practices. Total interest income in 2011 decrease $1,714,000 to $34,299,000 compared to $36,013,000 in 2010 and $40,734,000 in 2009. The decrease was due to the 55 basis point decrease in the tax equivalent yield on average interest earning assets and a change in the mix of interest earning assets. The yield on interest earning assets decreased to 5.04% for the year ended December 31, 2011 from 5.59% for the year ended December 31, 2010. Average interest earning assets increased to $715,862,000 for the year ended December 31, 2011 compared to $672,804,000 for the year ended December 31, 2010. Average interest-earning deposits in other banks increased $30,969,000 comparing 2011 to 2010. Average yield on these deposits was 0.26%. Average investments increased $37,223,000 but the tax equivalent yield on average investments decreased 100 basis points. Average loans decreased $27,049,000 and the yield on average loans decreased 7 basis points. The decrease in total interest income in 2010 was due to the 71 basis point decrease in the tax equivalent yield on average interest earning assets and a change in the mix of interest earning assets. The yield on interest-earning assets decreased to 5.59% for the year ended December 31, 2010 from 6.30% for the year ended December 31, 2009. Average interest-earning assets increased to $672,804,000 for the year ended December 31, 2010 compared to $671,906,000 for the year ended December 31, 2009. Interest expense on deposits in 2011 decreased $1,051,000 or 28.31% to $2,662,000 compared to $3,713,000 in 2010 and $5,867,000 in 2009. The decrease in interest expense in 2011 compared to 2010 was primarily due to the repricing of interest-bearing deposits which decreased 23 basis points to 0.54% in 2011 from 0.77% in 2010. This decrease was partially offset by a $12,325,000 or 2.55% increase in average interest-bearing deposits. The decrease in interest expense in 2010 compared to 2009 was due to repricing of interest-bearing deposits, which decreased 45 basis points to 0.77% in 2010 from1.22% in 2009, as a result of the decreases in the Federal funds interest rate. Average interest- bearing deposits were $495,545,000 for 2011 compared to $483,220,000 and $479,115,000 for 2010 and 2009, respectively. The increases in average interest- bearing deposits in 2010 and 2009 were the result of our own organic growth. Average other borrowings decreased to $10,265,000 with an effective rate of 2.73% for 2011 compared to $19,634,000 with an effective rate of 2.90% for 2010. In 2009, the average other borrowings were $29,987,000 with an effective rate of 2.53%. Included in other borrowings are the junior subordinated deferrable interest debentures acquired from Service 1st, advances on lines of credit and advances from the Federal Home Loan Bank (FHLB). The FHLB advances are fixed rate short-term and long-term borrowings. Advances were utilized as part of a leveraged strategy in the first quarter of 2008 to purchase investment securities. The effective rate of the FHLB advances was 3.59% for 2011 and 3.20% for 2010 and 3.08% for 2009. The cost of all of our interest-bearing liabilities decreased 27 basis points to 0.58% for 2011 compared to 0.85% for 2010 and 1.30% for 2009. The cost of total deposits decreased to 0.39% for the year ended December 31, 2011 compared to 0.58% and 0.93% for the years ended December 31, 2010 and 2009, respectively. Average demand deposits increased 19.16% to $182,244,000 in 2011 compared to $152,946,000 for 2010 and $153,148,000 for 2009. The ratio of non-interest demand deposits to total deposits increased to 26.89% for 2011 compared to 24.04% and 24.22% for 2010 and 2009, respectively. NET INTEREST INCOME BEFORE PROVISION FOR CREDIT LOSSES Net interest income before provision for credit losses for 2011 decreased $373,000 or 1.18% to $31,357,000 compared to $31,730,000 for 2010 and $34,107,000 for 2009. The decrease in 2011 was due to the 32 basis point decrease in our net interest margin (NIM). Yield on interest earning assets decreased 55 basis points while the effective rate on interest bearing liabilities only decreased 27 basis points. The change in the mix of average interest earning assets also affected NIM. Interest-earning deposits in other banks and investment securities, which tend to have lower effective yields, increased while higher yielding loans decreased as previously discussed. Net interest income before provision for credit losses decreased $2,377,000 in 2010 compared to 2009 mainly due to the 36 basis point decrease in our net interest margin (NIM). Average interest-earning assets were $715,862,000 for the year ended December 31, 2011 with a net interest margin (NIM) of 4.63% compared to $672,804,000 with a NIM of 4.95% in 2010, and $671,906,000 with a NIM of 5.31% in 2009. For a discussion of the repricing of our assets and liabilities, refer to Quantitative and Qualitative Disclosure about Market Risk. PROVISION FOR CREDIT LOSSES We provide for probable credit losses by a charge to operating income based upon the composition of the loan portfolio, delinquency levels, losses and nonperforming assets, economic and environmental conditions and other factors which, in management’s judgment, deserve recognition in estimating credit losses. 46 46 Management’s Discussion and Analysis of Financial Condition and Results of Operations PROVISION FOR CREDIT LOSSES (Continued) Loans are charged off when they are considered uncollectible or of such little value that continuance as an active earning bank asset is not warranted. The establishment of an adequate credit allowance is based on both an accurate risk rating system and loan portfolio management tools. The Board has established initial responsibility for the accuracy of credit risk grades with the individual credit officer. The grading is then submitted to the Chief Credit Administrator (CCA), who reviews the grades for accuracy and gives final approval. The CCA is not involved in loan originations. The risk grading and reserve allocation is analyzed quarterly by the CCA and the Board and at least annually by a third party credit reviewer and by various regulatory agencies. Quarterly, the CCA sets the specific reserve for all adversely risk-graded credits. This process includes the utilization of loan delinquency reports, classified asset reports, and portfolio concentration reports to assist in accurately assessing credit risk and establishing appropriate reserves. Reserves are also allocated to credits that are not impaired. The allowance for credit losses is reviewed at least quarterly by the Board’s Audit/Compliance Committee and by the Board of Directors. Reserves are allocated to loan portfolio categories using percentages which are based on both historical risk elements such as delinquencies and losses and predictive risk elements such as economic, competitive and environmental factors. We have adopted the specific reserve approach to allocate reserves to each impaired asset for the purpose of estimating potential loss exposure. Although the allowance for credit losses is allocated to various portfolio categories, it is general in nature and available for the loan portfolio in its entirety. Additions may be required based on the results of independent loan portfolio examinations, regulatory agency examinations, or our own internal review process. Additions are also required when, in management’s judgment, the allowance does not properly reflect the portfolio’s probable loss exposure. The allocation of the allowance for credit losses is set forth below: Loan Type (Dollars in thousands) Commercial: December 31, % of Total December 31, % of Total 2011 Loans 2010 Loans Commercial and industrial Agricultural land and production $ 1,924 342 18.3% $ 7.0% 2,229 208 18.8% 4.8% Real estate: Owner occupied Real estate construction and other land loans Commercial real estate Agricultural real estate Other real estate Total real estate Consumer: Equity loans and lines of credit Consumer and installment Unallocated reserves 1,578 26.4% 1,978 25.9% 2,954 2,043 489 91 7.7% 14.6% 9.9% 1.8% 1,791 1,387 466 214 7.4% 14.7% 10.3% 1.9% 7,155 60.4% 5,836 60.2% 1,419 417 139 12.0% 2.3% 1,975 528 238 13.6% 2.6% Total allowance for credit losses $ 11,396 $ 11,014 Loans are charged to the allowance for credit losses when the loans are deemed uncollectible. It is the policy of management to make additions to the allowance so that it remains adequate to cover all probable loan charge-offs that exist in the portfolio at that time. In 2010 enhanced methodology enabled us to assign qualitative and quantitative factors (Q factors) to each loan category resulting in a decrease in unallocated reserves. Q factors include reserves held for the effects of lending policies, economic trends, and portfolio trends along with other dynamics which may cause additional stress to the portfolio. Managing credits identified through the risk evaluation methodology includes developing a business strategy with the customer to mitigate our potential losses. Management continues to monitor these credits with a view to identifying as early as possible when, and to what extent, additional provisions may be necessary. The provisions for credit losses in 2011, 2010 and 2009 were $1,050,000, $3,800,000, and $10,514,000, respectively. These provisions are primarily the result of our assessment of the overall adequacy of the allowance for credit losses considering a number of factors as discussed in the ‘‘Allowance for Credit Losses’’ section below. During the year ended December 31, 2011, the Company had net charge offs totaling 668,000 compared to 2,986,000 and 7,537,000 for the same periods in 2010 and 2009, respectively. The decrease in provision for credit losses in 2011 compared to 2010 resulted from a decrease in the level of outstanding loans and a decrease in net charge offs. The net charge off ratio, which reflects net charge-offs to average loans, was 0.16%, 0.66% and 1.56% for 2011, 2010, and 2009, respectively. Nonperforming loans were $14,434,000 and $18,561,000 at December 31, 2011 and 2010, respectively. Nonperforming loans as a percentage of total loans were 3.38% at December 31, 2011 compared to 4.30% at December 31, 2010. There was no other real estate owned at December 31, 2011 compared to $1,325,000 net of a valuation allowance of $309,000 at December 31, 2010 and $2,832,000 net of a valuation allowance of $356,000 in 2009. Losses in the real estate segments of the loan portfolio in 2011 decreased compared to 2010. With real estate appraised values reflecting lower levels, additions to the reserves were required. We had loans past due, not including non accrual loans, totaling $1,741,000 at December 31, 2011 compared to $3,421,000 at December 31, 2010. Losses in the loan portfolio and non-accruing balances remain elevated relative to historical periods and an increase in the level of charge-offs and the number and dollar volume of past due and nonperforming loans may result in further provisions to the allowance for credit losses. We believe the significant economic downturn that has continued throughout 2011 has had a considerable impact on the ability of certain borrowers to satisfy their obligations, resulting in loan downgrades and corresponding increases in credit loss provisions. Additionally, we estimate the impact certain economic factors will have on various credits within the portfolio. Negative economic trends contributed substantially to increases in the required allowance to cover probable losses in the loan portfolio resulting in additional provisions. We anticipate weakness in economic conditions on national, state and local levels to continue. Continued economic pressures may negatively impact the financial condition of borrowers to whom the Company has extended credit and as a result we may be required to make further significant provisions to the allowance for credit losses in the future. We have been and will continue to be proactive in looking for signs of deterioration within the loan portfolio in an effort to manage credit quality and work with borrowers where possible to mitigate any further losses. As of December 31, 2011, we believe, based on all current and available information, the allowance for credit losses is adequate to absorb current estimable losses within the loan portfolio. However, no assurance can be given that we may not sustain charge-offs which are in excess of the allowance in any given period. Refer to ‘‘Allowance for Credit Losses’’ below for further information. NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES Net interest income, after the provision for credit losses of $1,050,000 in 2011, $3,800,000 in 2010, and $10,514,000 in 2009, was $30,307,000 for 2011 compared to $27,930,000 and $23,593,000 for 2010 and 2009, respectively. NON-INTEREST INCOME Non-interest income is comprised of customer service charges, gains on sales and calls of investment securities, income from appreciation in cash surrender value of bank owned life insurance, loan placement fees, Federal Home Loan Bank dividends, and other income. Non-interest income was $6,276,000 in 2011 compared to $3,721,000 and $5,850,000 in 2010 and 2009, respectively. The $2,555,000 or 68.66% increase in non-interest income was due to increases in gains on sales and calls of investment securities, a gain on disposal of other real estate owned, and a decrease in other-than-temporary impairment write down on certain investment securities. The $2,129,000 decrease in non-interest income comparing 2010 to 2009 was due to decreases in gains on sales and calls of investment securities, an other-than-temporary impairment write down on certain investment securities, and a decrease in customer service charges. Customer service charges decreased $322,000 to $2,903,000 in 2011 compared to $3,225,000 in 2010 and $3,509,000 in 2009. The decrease from 2011 to 2010 and 2010 to 2009 is mainly due to decreases in overdraft fee income. During the year ended December 31, 2011, we realized net gain on sales and calls of investment securities of $298,000 from sales and calls of securities. In 47 47 Management’s Discussion and Analysis of Financial Condition and Results of Operations The Company bases the fair value of the options previously granted on the date of grant using a Black-Scholes Merton option pricing model that uses assumptions based on expected option life, the level of estimated forfeitures, expected stock volatility and the risk-free interest rate. Stock volatility is based on the historical volatility of the Company’s stock. The risk-free rate is based on the U.S. Treasury yield curve and the expected term of the options. The expected term of the options represents the period that the Company’s options are expected to be outstanding. For the years ended December 31, 2011, 2010 and 2009, the compensation cost recognized for share based compensation was $196,000, $239,000 and $284,000, respectively. As of December 31, 2011, there was $197,000 of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the two plans. The cost is expected to be recognized over a weighted average period of 2.5 years. See Notes 1 and 14 to the audited Consolidated Financial Statements for more detail. In 2010, options to purchase 15,200 shares of the Company’s common stock were granted from the 2000 Plan at an exercise price of $5.76 and options to purchase 67,800 shares of common stock were granted from the 2005 Plan at exercise prices between $5.30 and $5.76. In 2009, options to purchase 13,500 shares of the Company’s common stock were granted at exercise prices of between $5.06 and $6.40 from the 2005 Plan. All options were granted with an exercise price equal to the market value on the grant date. Occupancy and equipment expense decreased $72,000 or 1.86% to $3,795,000 in 2011 compared to $3,867,000 in 2010 and $3,812,000 in 2009. The increase in 2010 can be principally attributed to the expansion of our Modesto loan production office to a full service office and the relocation of our Merced and Oakhurst offices to larger facilities. Regulatory assessments decreased $346,000 or 29.05% to $845,000 in 2011 compared to $1,191,000 and $1,604,000 in 2010 and 2009, respectively. The FDIC finalized a new assessment system which took effect the third quarter of 2011. That final rule changed the assessment base from domestic deposits to average assets minus average tangible equity. There was no special assessment in 2010 which is the main reason for the decrease comparing 2010 to 2009. The FDIC imposed Special Assessment of $343,000 that was effective during the second quarter of 2009. Data processing expenses were $1,178,000 in 2011 compared to $1,197,000 in 2010 and $1,316,000 in 2009. The $19,000 or 1.59% decrease in 2011, and the $119,000 decrease in 2010 compared to 2009 is a result of a reduction in terms of our core processing contract. Legal fees decreased $160,000 or 32.32% to $335,000 for the year ended December 31, 2011 compared to $495,000 and $330,000 in 2010 and 2009, respectively. The higher legal fees in increases in 2010 and 2009 are primarily due to issues related to nonperforming assets and other loan related legal expenses. Total other real estate owned (OREO) expenses decreased $1,056,000 or 98.60% to $15,000 for the year ended December 31, 2011 compared to $1,071,000 for the same period in 2010. OREO expenses in 2010 were primarily the result of the write downs of several OREO properties to their estimated fair value resulting in a valuation expense totaling $591,000. Carrying costs and property taxes totaled $371,000 related to the OREO portfolio and we realized a $109,000 loss on disposition of OREO property for the year ended December 31, 2010. Amortization of core deposit intangibles was $414,000 for the years ended December 31, 2011, 2010 and 2009. Other non-interest expenses increased $210,000 or 4.71% to $4,670,000 in 2011 compared to $4,460,000 in 2010 and $4,370,000 in 2009. NON-INTEREST INCOME (Continued) 2010 we realized a net loss of $191,000 compared to a net gain of $766,000 in 2009 from sales and calls of securities. In 2009, investment securities that had been marked to market when we acquired Service 1st were subsequently called at par value resulting in gains. For the year ended December 31, 2011, we realized a $31,000 other-than-temporary impairment write down on certain investment securities. See Footnote 3 to the audited Consolidated Financial Statements for more detail. Income from the appreciation in cash surrender value of bank owned life insurance (BOLI) totaled $382,000 in 2011 compared to $392,000 and $391,000 in 2010 and 2009, respectively. The Bank’s salary continuation and deferred compensation plans and the related BOLI are used as a retention tool for directors and key executives of the Bank. We earn loan placement fees from the brokerage of single-family residential mortgage loans provided for the convenience of our customers. Loan placement fees decreased $26,000 in 2011 to $274,000 compared to $300,000 in 2010 and $231,000 in 2009. Fees were higher in 2011 and 2010, compared to 2009, as refinancing and new mortgage activity increased due to the historically low mortgage rates, a decline in housing values and first time home buyer tax incentives. The Bank holds stock from the Federal Home Loan Bank in relationship with its borrowing capacity and generally receives quarterly dividends. As of December 31, 2011 we held $2,893,000 in FHLB stock compared to $3,050,000 at December 31, 2010. Dividends in 2011 decreased to $9,000 compared to $11,000 in 2010 and $7,000 in 2009. Other income increased to $1,826,000 in 2011 compared to $1,395,000 and $1,246,000 in 2010 and 2009, respectively. The period-to-period increases in 2011 compared to 2010 and 2009 were due to an increase in electronic funds transfer fee income, a $142,000 gain related to the final distribution of the Service 1st escrow account, and an $85,000 gain related to the collection of life insurance proceeds. NON-INTEREST EXPENSES Salaries and employee benefits, occupancy, regulatory assessments, data processing expenses, and professional services are the major categories of non-interest expenses. Non-interest expenses decreased $496,000 or 1.73% to $28,245,000 in 2011 compared to $28,741,000 in 2010, which was an increase of $1,210,000 in 2010 compared to $27,531,000 in 2009. Our efficiency ratio, measured as the percentage of non-interest expenses (exclusive of amortization of core deposit intangibles and other real estate owned expenses) to net interest income before provision for credit losses plus non-interest income (exclusive of realized gains or losses on sale and calls of investments) was 75.67% for 2011 compared to 73.53% for 2010 and 67.31% for 2009. The decline in the efficiency ratio in 2011 resulted from an increase in operating expense and a decrease in net interest income. Our efficiency ratio deteriorated in 2010 compared to 2009 due to a 112.77% decrease in net interest income plus non-interest income. Salaries and employee benefits increased 891,000 or 5.99% to $15,762,000 in 2011 compared to $14,871,000 in 2010 and $13,926,000 in 2009. The increase in salaries and employee benefits for the 2011 period can be attributed to normal cost increases. Full time equivalents were 210 at December 31, 2011 compared to 217 at December 31, 2010. The increase in salaries and employee benefits in 2010 compared to 2009 can be attributed to the addition of personnel in connection with the expansion of offices in Modesto and Merced and other new positions along with normal cost increases. At December 31, 2011 we had two share based compensation plans under which compensation expense is recognized based on the estimated fair value of the awards at the date of the grant. The Central Valley Community Bancorp 2000 Stock Option Plan (2000 Plan) for which 416,769 shares remain reserved for issuance for options already granted under incentive and nonstatutory agreements. This plan expired in November 2010 and no new options will be granted under this plan. The Central Valley Community Bancorp 2005 Omnibus Incentive Plan (2005 Plan) provides for awards in the form of incentive stock options, non-statutory stock options, stock appreciation rights, and restricted stock. Currently under the 2005 Plan, there are 94,250 shares reserved for issuance for options already granted to employees and directors. 48 48 Management’s Discussion and Analysis of Financial Condition and Results of Operations NON-INTEREST EXPENSES (Continued) The following table describes significant components of other non-interest expense as a percentage of average assets. For the years ended December 31, 2011 2010 2009 Other Expense % Average Assets Other Expense % Average Assets Other Expense % Average Assets ‘‘Warrant’’) to purchase 79,037 shares of the Company’s common stock that was originally issued to Treasury in connection with the CPP transaction. On September 28, 2011, the Company completed the repurchase of the Warrant for total consideration of $185,000. We accrued preferred stock dividends to the Treasury and accretion of the issuance discount in the amount of $486,000 and $395,000 during the years ended December 31, 2011 and 2010, respectively. FINANCIAL CONDITION SUMMARY OF CHANGES IN CONSOLIDATED BALANCE SHEETS (Dollars in thousands) December 31, 2011 compared to December 31, 2010 ATM/debit card expenses Consulting License and maintenance $ contracts Stationery/supplies Telephone Amortization of software Director fees and related expenses Postage Donations Education/training Operating losses General insurance Appraisal fees Other Total other non-interest expense 369 340 324 245 236 232 219 198 154 160 125 125 112 1,831 0.05% $ 0.04% 0.04% 0.03% 0.03% 0.03% 0.03% 0.02% 0.02% 0.02% 0.02% 0.02% 0.01% 0.23% 354 212 275 271 305 195 209 218 148 139 44 130 165 1,795 0.05% $ 0.03% 0.04% 0.04% 0.04% 0.03% 0.03% 0.03% 0.02% 0.02% 0.01% 0.02% 0.02% 0.24% 419 454 251 271 272 194 205 233 99 85 47 144 125 1,571 0.06% 0.06% 0.03% 0.04% 0.04% 0.03% 0.03% 0.03% 0.01% 0.01% 0.01% 0.02% 0.02% 0.21% $ 4,670 0.58% $ 4,460 0.59% $ 4,370 0.58% For the year ended December 31, 2011, the $128,000 increase in consulting was related to assistance various financial and tax planning projects. License and maintenance contract expense increased in 2011 as a result of annual increases on various contracts in addition to new contracts for new products, services and software put in place during 2010. In 2010, the $40,000 increase in appraisal fees was related to nonperforming assets and updating appraisals for certain loans collateralized by real estate. Education and training expenses increased $54,000 mainly due to the implementation of a management training program. In 2009 the $262,000 increase in consulting expenses was related to assistance with renegotiating our core processor contracts. The $120,000 increase in appraisal fees is primarily due to issues related to nonperforming assets and other loan related expenses. The increase in various other expenses was principally due to the addition of the Service 1st offices and the new Oakhurst and Merced offices. PROVISION FOR INCOME TAXES Our effective income tax rate was 22.32% for 2011 compared to (12.68%) for 2010 and (35.36%) for 2009. The Company reported an income tax provision of $1,861,000 for the year ended December 31, 2011, compared to a benefit totaling $369,000 and $676,000 for the years ended December 31, 2010 and 2009, respectively. The increase in the effective tax rate in 2011 compared to 2010 was a result of an increase in net income before tax. PREFERRED STOCK DIVIDENDS AND ACCRETION On August 18, 2011, the Company entered into a Securities Purchase Agreement with the Small Business Lending Fund of the United States Department of the Treasury (the ‘‘Treasury’’), under which the Company issued 7,000 shares of Senior Non-Cumulative Perpetual Preferred Stock, Series C (the ‘‘Preferred Shares’’) to the Treasury for an aggregate purchase price of $7,000,000. Simultaneously, the Company agreed with Treasury under a Letter Agreement to redeem, for an aggregate price of $7,000,000, the 7,000 shares of the Company’s Series A Fixed Rate Cumulative Preferred Stock (‘‘Series A Stock’’)originally issued pursuant to the Treasury’s Capital Purchase Program (‘‘CPP’’) in 2009. The redemption of the Series A Stock resulted in an acceleration of the remaining discount booked at the time of the CPP transaction. In connection with the repurchase of the Series A Stock, the Company also notified the Treasury of the Company’s intent to repurchase the warrant (the As of December 31, 2011, total assets were $849,023,000 an increase of 9.19%, or $71,429,000 compared to $777,594,000 as of December 31, 2010. Total gross loans decreased 0.97%, or $4,202,000 to $427,395,000 as of December 31, 2011 compared to $431,597,000 as of December 31, 2010. Total investment portfolio increased 71.65% to $328,413,000. Total deposits increased 9.61%, or $62,491,000 to $712,986,000 as of December 31, 2011 compared to $650,495,000 as of December 31, 2010. Shareholders’ equity increased 10.36%, or $10,091,000, to $107,482,000 as of December 31, 2011 compared to $97,391,000 as of December 31, 2010. FAIR VALUE The Company measures the fair values of its financial instruments utilizing a hierarchical disclosure framework associated with the level of observable pricing scenarios utilized in measuring financial instruments at fair value. The degree of judgment utilized in measuring the fair value of financial instruments generally correlates to the level of the observable pricing scenario. Financial instruments with readily available active quoted prices or for which fair value can be measured from actively quoted prices generally will have a higher degree of observable pricing and a lesser degree of judgment utilized in measuring fair value. Conversely, financial instruments rarely traded or not quoted will generally have little or no observable pricing and a higher degree of judgment utilized in measuring fair value. Observable pricing scenarios are impacted by a number of factors, including the type of financial instrument, whether the financial instrument is new to the market and not yet established and the characteristics specific to the transaction. See Note 2 of the audited Consolidated Financial Statements for additional information about the level of pricing transparency associated with financial instruments carried at fair value. INVESTMENTS Our investment portfolio consists primarily of agency securities, mortgage backed securities, municipal securities, collateralized mortgage obligations, corporate debt securities, and overnight investments in the Federal funds market and are classified at the date of acquisition as available for sale or held to maturity. As of December 31, 2011, investment securities with a fair value of $109,119,000, or 33.23% of our investment securities portfolio, were held as collateral for public funds, short and long-term borrowings, treasury, tax, and for other purposes. Our investment policies are established by the Board of Directors and implemented by our Investment/Asset Liability Committee. They are designed primarily to provide and maintain liquidity, to enable us to meet our pledging requirements for public money and borrowing arrangements, to generate a favorable return on investments without incurring undue interest rate and credit risk, and to complement our lending activities. The level of our investment portfolio is generally considered higher than our peers due primarily to a comparatively low loan to deposit ratio. Our loan to deposit ratio at December 31, 2011 was 59.94% compared to 66.35% at December 31, 2010. The loan to deposit ratio of our peers was 74.42% at December 31, 2011. The total investment portfolio, including Federal funds sold, increased 71.60% or $137,416,000 to $328,413,000 at December 31, 2011 from $191,325,000 at December 31, 2010 primarily due to purchases of securities. The market value of the portfolio reflected an unrealized gain of $7,008,000 at December 31, 2011 compared to $1,643,000 at December 31, 2010. 49 49 Management’s Discussion and Analysis of Financial Condition and Results of Operations The unrealized losses associated with PLRMBS are primarily driven by higher projected collateral losses, wider credit spreads, and changes in interest rates. The Company assesses for credit impairment using a discounted cash flow model. The key assumptions include default rates, severities, discount rates and prepayment rates. Losses are estimated to a security by forecasting the underlying mortgage loans in each transaction. The forecasted loan performance is used to project cash flows to the various tranches in the structure. Based upon management’s assessment of the expected credit losses of the security given the performance of the underlying collateral compared with our credit enhancement (which occurs as a result of credit loss protection provided by subordinated tranches), the Company expects to recover the entire amortized cost basis of these securities, with the exception of certain securities for which OTTI was previously recorded. At December 31, 2011, the Company had a total of 27 PLRMBS with a remaining principal balance of $8,408,000 and a net unrealized loss of approximately $1,010,000. Eight of these securities account for $1,255,000 of the unrealized loss at December 31, 2011 offset by 19 of these securities with gains totaling $245,000. Seven of these PLRMBS with a remaining principal balance of $6,224,000 had credit ratings below investment grade. The Company continues to perform extensive analyses on these securities as well as all whole loan CMOs. Several of these investment securities continue to demonstrate cash flows and credit support as expected and the expected cash flows of the security discounted at the security’s original yield at time of purchase are greater than the book value of the security, therefore management does not consider these securities to be other than temporarily impaired. No credit related OTTI charges related to PLRMBS were recorded during the year ended December 31, 2011. See Note 3 to the audited Consolidated Financial Statements for carrying values and estimated fair values of our investment securities portfolio. INVESTMENTS (Continued) We periodically evaluate each investment security for other-than-temporary impairment, relying primarily on industry analyst reports, observation of market conditions and interest rate fluctuations. As of December 31, 2011, the Company performed an analysis of the investment portfolio to determine whether any of the investments held in the portfolio had an other-than-temporary impairment (OTTI). Under ASC 320-10, the portion of the impairment that is attributable to a shortage in the present value of expected future cash flows relative to the amortized cost should be recorded as a current period charge to earnings. The discount rate in this analysis is the original yield expected at time of purchase. As of December 31, 2011, the Company performed an analysis of the investment portfolio to determine whether any of the investments held in the portfolio had an other-than-temporary impairment (OTTI). Management evaluated all available-for-sale investment securities with an unrealized loss at December 31, 2011, and identified those that had an unrealized loss for at least a consecutive 12 month period, which had an unrealized loss at December 31, 2011 greater than 10% of the recorded book value on that date, or which had an unrealized loss of more than $10,000. Management also analyzed any securities that may have been down graded by credit rating agencies. Management retained the services of a third party in November 2011 to provide independent valuation and OTTI analysis of private label residential mortgage backed securities (PLRMBS). For those bonds that met the evaluation criteria management obtained and reviewed the most recently published national credit ratings for those bonds. For those bonds that were municipal debt securities with an investment grade rating by the rating agencies, management also evaluated the financial condition of the municipality and any applicable municipal bond insurance provider and concluded that no credit related impairment existed. The evaluation for PLRMBS also includes estimating projected cash flows that the Company is likely to collect based on an assessment of all available information about the applicable security on an individual basis, the structure of the security, and certain assumptions, such as the remaining payment terms for the security, prepayment speeds, default rates, loss severity on the collateral supporting the security based on underlying loan-level borrower and loan characteristics, expected housing price changes, and interest rate assumptions, to determine whether the Company will recover the entire amortized cost basis of the security. In performing a detailed cash flow analysis, the Company identified the most likely estimate of the cash flows expected to be collected. If this estimate results in a present value of expected cash flows (discounted at the security’s original yield at time of purchase) that is less than the amortized cost basis of the security, an OTTI is considered to have occurred. To assess whether it expects to recover the entire amortized cost basis of its PLRMBS, the Company performed a cash flow analysis for all of its PLRMBS as of December 31, 2011. In performing the cash flow analysis for each security, the Company uses a third-party model. The model considers borrower characteristics and the particular attributes of the loans underlying the Company’s securities, in conjunction with assumptions about future changes in home prices and other assumptions, to project prepayments, default rates, and loss severities. The month-by-month projections of future loan performance are allocated to the various security classes in each securitization structure in accordance with the structure’s prescribed cash flow and loss allocation rules. When the credit enhancement for the senior securities in a securitization is derived from the presence of subordinated securities, losses are allocated first to the subordinated securities until their principal balance is reduced to zero. The projected cash flows are based on a number of assumptions and expectations, and the results of these models can vary significantly with changes in assumptions and expectations. The scenario of cash flows determined based on the model approach described above reflects a best-estimate scenario. At each quarter end, the Company compares the present value of the cash flows expected to be collected on its PLRMBS to the amortized cost basis of the securities to determine whether a credit loss exists. 50 50 Management’s Discussion and Analysis of Financial Condition and Results of Operations LOANS Total gross loans decreased to $427,395,000 as of December 31, 2011 compared to $431,597,000 as of December 31, 2010. The following table sets forth information concerning the composition of our loan portfolio as of and for the years ended December 31, 2011, 2010, 2009, 2008, and 2007. Loan Type (Dollars in thousands) Commercial: 2011 2010 2009 2008 2007 Amount % of Total loans Amount % of Total loans Amount % of Total loans Amount % of Total loans Amount % of Total loans Commercial and industrial Agricultural land and production $ 78,089 29,958 18.3% $ 7.0% 81,318 20,604 18.8% $ 4.8% 93,282 13,903 20.3% $ 3.0% 109,664 20,406 22.6% $ 4.2% Total commercial 108,047 25.3% 101,922 23.6% 107,185 23.3% 130,070 26.8% 71,416 17,584 89,000 20.9% 5.2% 26.1% Real estate: Owner occupied Real estate-construction and other land loans Agricultural real estate Commercial real estate Other real estate Total real estate Consumer: Equity loans and lines of credit Consumer and installment Total consumer Deferred loan fees, net Total gross loans 113,183 26.4% 111,888 25.9% 106,606 23.2% 113,414 23.4% 76,808 22.5% 33,047 62,523 42,596 7,892 259,241 51,106 9,765 60,871 (764) 7.7% 14.6% 9.9% 1.8% 60.4% 12.0% 2.3% 14.3% 32,038 63,627 44,397 8,103 260,053 58,860 11,261 70,121 (499) 7.4% 14.7% 10.3% 1.9% 60.2% 13.6% 2.6% 16.2% 51,633 71,420 38,759 4,610 273,028 65,353 14,033 79,386 (392) 11.2% 15.6% 8.4% 1.0% 59.4% 14.2% 3.1% 17.3% 57,923 64,358 32,136 2,926 270,757 63,828 19,801 83,629 (218) 12.0% 13.3% 6.6% 0.6% 55.9% 13.2% 4.1% 17.3% 48,593 43,334 26,796 1,772 197,303 46,575 8,838 55,413 (588) 14.2% 12.7% 7.9% 0.5% 57.8% 13.7% 2.4% 16.1% 427,395 100.0% 431,597 100.0% 459,207 100.0% 484,238 100.0% 341,128 100.0% Allowance for credit losses (11,396) (11,014) (10,200) (7,223) (3,887) Total loans $ 415,999 $ 420,583 $ 449,007 $ 477,015 $ 337,241 At December 31, 2011, in management’s judgment, a concentration of loans existed in commercial loans and real-estate-related loans, representing approximately 97.7% of total loans of which 25.3% were commercial and 72.4% were real-estate-related. This level of concentration is consistent with the 97.4% at December 31, 2010. Although we believe the loans within this concentration have no more than the normal risk of collectibility, a substantial further decline in the performance of the economy in general or a further decline in real estate values in our primary market areas, in particular, could have an adverse impact on collectibility, increase the level of real estate-related nonperforming loans, or have other adverse effects which alone or in the aggregate could have a material adverse effect on our business, financial condition, results of operations and cash flows. The Company was not involved in any sub-prime mortgage lending activities at December 31, 2011 and 2010. We believe that our commercial real estate loan underwriting policies and practices result in prudent extensions of credit, but recognize that our lending activities result in relatively high reported commercial real estate lending levels. Commercial real estate loans include certain loans which represent low to moderate risk and certain loans with higher risks. Nonperforming Assets - Nonperforming assets consist of nonperforming loans, other real estate owned (OREO), and repossessed assets. Nonperforming loans are those loans which have (i) been placed on nonaccrual status, (ii) been subject to troubled debt restructuring, (iii) been classified as doubtful under our asset classification system, or (iv) become contractually past due 90 days or more with respect to principal or interest and have not been restructured or otherwise placed on nonaccrual status. A loan is classified as nonaccrual when 1) it is maintained on a cash basis because of deterioration in the financial condition of the borrower, 2) payment in full of principal or interest under the original contractual terms is not expected, or 3) principal or interest has been in default for a period of 90 days or more unless the asset is both well secured and in the process of collection. At December 31, 2011, nonperforming assets totaled $14,434,000 compared to $19,984,000 at December 31, 2010. In 2011, nonperforming assets included nonaccrual loans totaling $14,434,000 and no OREO or repossessed assets. Nonperforming assets in 2010 consisted of $18,561,000 in nonaccrual loans, OREO of $1,325,000 and repossessed assets of $98,000. At December 31, 2011, we had six loans considered troubled debt restructurings totaling $10,601,000, which are included in nonaccrual loans compared to twelve restructured loans totaling $10,655,000 at December 31, 2010. We have no outstanding commitments to lend additional funds to any of these borrowers. A summary of nonaccrual, restructured, and past due loans at December 31, 2011 and 2010 is set forth below. The Company had no loans past due more than 90 days and still accruing interest at December 31, 2011 and 2010. Management is not aware of any potential problem loans, which were current and accruing at December 31, 2011, where serious doubt exists as to the ability of the borrower to comply with the present repayment terms. Management can give no assurance that nonaccrual and other nonperforming loans will not increase in the future. 51 51 Management’s Discussion and Analysis of Financial Condition and Results of Operations LOANS (Continued) Composition of Nonaccrual, Past Due and Restructured Loans (Dollars in thousands) Nonaccrual Loans Commercial and industrial Owner occupied Real estate construction and other land loans Commercial real estate Equity loans and line of credit Consumer and installment Restructured loans (non-accruing) Commercial and industrial Owner occupied Real estate construction and other land loans Commercial real estate Other real estate Equity loans and line of credit Total nonaccrual Accruing loans past due 90 days or more Total nonperforming loans Nonperforming loans to total loans Ratio of nonperforming loans to allowance for credit losses Loans considered to be impaired Related allowance for credit losses on impaired loans December 31, 2011 December 31, 2010 December 31, 2009 December 31, 2008 December 31, 2007 $ $ $ $ $ 267 353 - 2,434 705 74 - 1,019 6,823 1,110 - 1,649 14,434 - $ 377 1,407 5,634 - 488 1,978 2,370 2,193 1,828 2,286 - 18,561 - $ 2,868 2,218 7,691 965 301 348 28 2,282 2,214 - - 44 18,959 - $ 907 1,644 4,839 6,296 280 81 - 1,108 595 - - - 15,750 - 14,434 $ 18,561 $ 18,959 $ 15,750 $ 3.38% 126.66% 23,644 4,368 $ $ 4.30% 168.52% 18,561 2,124 $ $ 4.13% 185.87% 18,959 752 $ $ 3.25% 218.05% 15,750 125 $ $ 27 - - - - 152 - - - - - - 179 - 179 0.05% 4.61% 179 - We measure our impaired loans by using the fair value of the collateral if the loan is collateral dependent and the present value of the expected future cash flows discounted at the loan’s effective interest rate if the loan is not collateral dependent. As of December 31, 2011 and 2010, we had impaired loans totaling $23,644,000 and $18,561,000, respectively. For collateral dependent loans secured by real estate, we obtain external appraisals which are updated at least annually to determine the fair value of the collateral, and we record an immediate charge off for the difference between the book value of the loan and the appraised value of collateral. We perform quarterly internal reviews on substandard loans. We place loans on nonaccrual status and classify them as impaired when it becomes probable that we will not receive interest and principal under the original contractual terms, or when loans are delinquent 90 days or more unless the loan is both well secured and in the process of collection. Management maintains certain loans that have been brought current by the borrower (less than 30 days delinquent) on nonaccrual status until such time as management has determined that the loans are likely to remain current in future periods. Foregone interest on nonaccrual loans totaled $954,0000 for the year ended December 31, 2011 of which $769,000 was attributable to troubled debt restructurings. Foregone interest on nonaccrual loans totaled $1,228,000 and $852,000 for the years ended December 31, 2010 and 2009, respectively of which $376,000 and $404,000 was attributable to troubled debt restructurings, respectively. The following table provides a reconciliation of the change in non-accrual loans for the year ended December 31, 2011. (Dollars in thousands) Non-accrual loans: Commercial and industrial Real estate Equity loans and lines of credit Consumer Restructured loans (non-accruing): Commercial and industrial Real estate Real estate construction and land development Equity loans and lines of credit Consumer Balances December 31, 2010 Additions to Nonaccrual Loans Net Pay Downs Transfer to Foreclosed Collateral - OREO Returns to Accrual Status Charge Offs Balances December 31, 2011 $ $ 196 1,407 669 - 1,279 4,198 7,827 2,985 - 370 3,293 758 74 - 1,211 - - 82 $ $ (113) (958) (249) - $ - - (244) - (430) (3,280) (718) (1,336) (1) - - - - - $ - (929) - - (849) - - - - $ (186) (26) (229) - - - (286) - (81) 267 2,787 705 74 - 2,129 6,823 1,649 - Total non-accrual $ 18,561 $ 5,788 $ (7,085) $ (244) $ (1,778) $ (808) $ 14,434 52 52 Management’s Discussion and Analysis of Financial Condition and Results of Operations LOANS (Continued) The following table provides a summary of the annual change in the OREO balance: (Dollars in thousands) Balance, Beginning of year Additions Dispositions Write-downs Net gain on disposition Balance, End of year Years Ended December 31, 2011 2010 $ 1,325 532 (2,472) - 615 $ 2,832 3,467 (4,449) (591) 66 $ - $ 1,325 OREO represents real property taken either through foreclosure or through a deed in lieu thereof from the borrower. OREO is carried at the lesser of cost or fair market value, less selling costs. As of December 31, 2011 the Company had no OREO properties. At December 31, 2010 the Company had $1,325,000 invested in properties acquired through foreclosure. The Bank was party to a lawsuit filed by Regent Hotel, LLC against First Bank (Lead Bank), as the lead bank in a loan participation, and East West Bank and Service 1st Bank, which was acquired by the Bank on November 13, 2008, were participating in the loan. In 2009, the Lead Bank purchased the Bank’s participating interest in the Regent Hotel loan at a discount and indemnified the Bank against any further actions pursuant to the lawsuit. Included in the merger consideration paid by the Company to acquire Service 1st was $3,500,000 which was placed into an escrow fund to protect the Company and the Bank from all losses and liabilities that related to the loan participation and/or the Regent Litigation. Consequent to the Lead Bank buying the Bank’s position, in 2009 the Bank collected $1,046,000 from the escrow fund to cover the portion of the loan that was not recovered, accrued and unpaid interest and other costs. In 2010, settlement agreements between all parties were signed and the bankruptcy court approved the settlement. The settlement was finalized in 2011. In accordance with the escrow agreement, once the litigation was completely satisfied and after reimbursing the Bank for any legal and escrow costs, the escrow fund was terminated and the remaining balance was disbursed for payment to former Service 1st shareholders. At December 31, 2011, $309,520 remained unclaimed. Allowance for Credit Losses - We have established a methodology for the determination of the allowance for credit losses. The methodology is set forth in a formal policy and takes into consideration the need for an overall allowance for credit losses as well as specific allowances that are tied to individual loans. Our methodology for assessing the appropriateness of the allowance consists of several key elements, which include the formula allowance and a specific allowance for identified problem loans. In originating loans, we recognize that losses will be experienced and that the risk of loss will vary with, among other things, the type of loan being made, the creditworthiness of the borrower over the term of the loan, general economic conditions and, in the case of a secured loan, the quality of the collateral securing the loan. The allowance is increased by provisions charged against earnings and reduced by net loan charge offs. Loans are charged off when they are deemed to be uncollectible, or partially charged off when portions of a loan are deemed to be uncollectible. Recoveries are recorded only when cash payments are received. The allowance for credit losses is maintained to cover probable losses inherent in the loan portfolio. The responsibility for the review of our assets and the determination of the adequacy lies with management and our Audit Committee. They delegate the authority to the Chief Credit Administrator (CCA) to determine the loss reserve ratio for each type of asset and review, at least quarterly, the adequacy of the allowance based on an evaluation of the portfolio, past experience, prevailing market conditions, amount of government guarantees, concentration in loan types, and other relevant factors. The allowance for credit losses is an estimate of the losses that may be sustained in our loan and lease portfolio. The allowance is based on principles of accounting: (1) ASC 310-10 which requires that losses be accrued when they are probable of occurring and can be reasonably estimated and (2) ASC 450-20 which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance. Credit Administration adheres to an internal asset review system and loss allowance methodology designed to provide for timely recognition of problem assets and adequate valuation allowances to cover expected asset losses. The Bank’s asset monitoring process includes the use of asset classifications to segregate the assets, largely loans and real estate, into various risk categories. The Bank uses the various asset classifications as a means of measuring risk and determining the adequacy of valuation allowances by using a nine-grade system to classify assets. All credit facilities exceeding 90 days of delinquency require classification. The following table sets forth information regarding our allowance for credit losses at the dates and for the periods indicated: (Dollars in thousands) Balance, beginning of year Provision charged to operations Losses charged to allowance Recoveries Balance, end of year Years Ended December 31, 2011 2010 $ $ 11,014 1,050 (1,532) 864 10,200 3,800 (4,122) 1,136 $ 11,396 $ 11,014 Allowance for credit losses to total loans 2.67% 2.55% As of December 31, 2011 the balance in the allowance for credit losses was $11,396,000 compared to $11,014,000 as of December 31, 2010. The increase was due to net charge offs during 2011 being less than the amount of the provision for credit losses. Net charge offs totaled $668,000 while the provision for credit losses was $1,050,000. The balance of commitments to extend credit on undisbursed construction and other loans and letters of credit was $129,005,000 as of December 31, 2011 compared to $123,680,000 as of December 31, 2010. Risks and uncertainties exist in all lending transactions, and our management and Directors’ Loan Committee have established reserve levels based on economic uncertainties and other risks that exist as of each reporting period. As of December 31, 2011 the allowance for credit losses was 2.67% of total gross loans compared to 2.55% as of December 31, 2010. During 2011 there were no major changes in loan concentrations that significantly affected the allowance for credit losses. During the year ended December 31, 2010 the Company enhanced the process for estimating the allowance for credit losses. The modification did not have a significant impact on the amount of the allowance for credit losses in total nor did it have a material impact on the allocation of the allowance within loan categories. In 2011 the enhanced methodology enabled us to assign qualitative and quantitative factors (Q factors) to each loan category resulting in a decrease in unallocated reserves. Q factors include reserves held for the effects of lending policies, economic trends, and portfolio trends along with other dynamics which may cause additional stress to the portfolio. Assumptions regarding the collateral value of various under performing loans may affect the level and allocation of the allowance for credit losses in future periods. The allowance may also be affected by trends in the amount of charge offs experienced or expected trends within different loan portfolios. Of the losses charged to the allowance in 2011 and 2010 of $1,532,000 and $4,122,000, the portion related to overdraft losses on transaction deposit accounts totaled $71,000 and $96,000, respectively. Nonperforming loans totaled $14,434,000 as of December 31, 2011, and $18,561,000 as of December 31, 2010. The allowance for credit losses as a percentage of nonperforming loans was 78.95% and 59.34% as of December 31, 2011 and 2010, respectively. Management believes the allowance at December 31, 2011 is adequate based upon its ongoing analysis of the loan portfolio, historical loss trends and other factors. However, no assurance can be given that the Company may not sustain charge-offs which are in excess of the allowance in any given period. 53 53 Management’s Discussion and Analysis of Financial Condition and Results of Operations GOODWILL AND INTANGIBLE ASSETS Business combinations involving the Bank’s acquisition of the equity interests or net assets of another enterprise give rise to goodwill. Total goodwill at December 31, 2011 was $23,577,000 consisting of $14,643,000 and $8,934,000 representing the excess of the cost of Service 1st Bank and Bank of Madera County, respectively, over the net of the amounts assigned to assets acquired and liabilities assumed in the transactions accounted for under the purchase method of accounting. The value of goodwill is ultimately derived from the Bank’s ability to generate net earnings after the acquisitions and is not deductible for tax purposes. A decline in net earnings could be indicative of a decline in the fair value of goodwill and result in impairment. For that reason, goodwill is assessed at least annually for impairment. In 2011, ASU 2011-08 was issued that provided additional guidance on the determination of whether an impairment of goodwill has occurred, including the introduction of a qualitative review of factors that might indicate that a goodwill impairment has occurred. ASU 2011-08 is effective for our 2012 reporting year; however, the Company early adopted this standard as of September 30, 2011. The Company performed our annual impairment test in the third quarter of 2011 utilizing the qualitative factors cited in the ASU. Management believes that factors cited in the ASU are sufficient and comprehensive and as such, no further factors need to be assessed at this time. Based on the analysis performed by management, there were no indications that the Company’s goodwill was impaired at September 30, 2011. Goodwill is also tested for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of the Company below its carrying amount. No such events or circumstances arose during the fourth quarter of 2011, so goodwill was not required to be retested. The intangible assets at December 31, 2011 represent the estimated fair value of the core deposit relationships acquired in the acquisition of Service 1st Bank in 2008 of $1,400,000 and the 2005 acquisition of Bank of Madera County of $1,500,000. Core deposit intangibles are being amortized using the straight-line method over an estimated life of seven years from the date of acquisition. The carrying value of intangible assets at December 31, 2011 was $783,000, net of $2,117,000 in accumulated amortization expense. The carrying value at December 31, 2010 was $1,198,000, net of $1,702,000 accumulated amortization expense. Management evaluates the remaining useful lives quarterly to determine whether events or circumstances warrant a revision to the remaining periods of amortization. Based on the evaluation, no changes to the remaining useful lives was required. Management performed an annual impairment test on core deposit intangibles as of September 30, 2011 and determined no impairment was necessary. Amortization expense recognized was $414,000 for 2011, 2010, and 2009. DEPOSITS AND BORROWINGS. The Bank’s deposits are insured by the Federal Deposit Insurance Corporation (FDIC) up to applicable legal limits. The FDIC implemented unlimited deposit insurance coverage on non-interest bearing transaction accounts beginning December 31, 2010, and ending December 31, 2012, as mandated by the Dodd-Frank Act. Coverage under this program is confined to non-interest bearing accounts and does not cover interest-bearing NOW accounts but does include Interest on Lawyers Trust Accounts (IOLTAs). Coverage on all other accounts including interest bearing NOW accounts is limited to $250,000 beginning January 1, 2011. This coverage replaces the unlimited coverage under the Transaction Account Guarantee Program (TAGP). Total deposits increased $62,491,000 or 9.61% to $712,986,000 as of December 31, 2011 compared to $650,495,000 as of December 31, 2010. Interest-bearing deposits increased $28,333,000 or 5.94% to $504,961,000 as of December 31, 2011 compared to $476,628,000 as of December 31, 2010. Non-interest bearing deposits increased $34,158,000 or 19.65% to $208,025,000 as of December 31, 2011 compared to $173,867,000 as of December 31, 2010. Our total market share of deposits in Fresno, Madera, and San Joaquin counties was 3.39% in 2011 compared to 3.38% in 2010 based on FDIC deposit market share information published as of June 2011. The composition of the deposits and average interest rates paid at December 31, 2011 and 2010 is summarized in the table below. (Dollars in thousands) 2011 Deposits Rate 2010 Deposits Rate % of % of December 31, Total Effective December 31, Total Effective NOW accounts MMA accounts Time deposits Savings deposits $ 140,268 181,731 151,695 31,267 19.6% 0.26% $ 25.5% 0.40% 21.3% 0.96% 4.4% 0.16% 114,473 157,345 177,132 27,678 17.6% 0.38% 24.2% 0.66% 27.2% 1.19% 4.3% 0.20% Total interest-bearing Non-interest bearing 504,961 208,025 70.8% 0.54% 29.2% 476,628 173,867 73.3% 0.77% 26.7% Total deposits $ 712,986 100.0% $ 650,495 100.0% There were no short-term borrowings as of December 31, 2011, while they totaled $10,000,000 as of December 31, 2010. The short-term borrowings consisted of FHLB advances maturing within one month. We maintain a line of credit with the FHLB collateralized by government securities and loans. Refer to Liquidity section below for further discussion of FHLB advances. Total long-term debt as of December 31, 2011 and 2010 was $4,000,000 and consisted of FHLB advances with an interest rate of 3.59% maturing in 2013. The Company succeeded to all of the rights and obligations of Service 1st Capital Trust I, a Delaware business trust, in connection with the acquisition of Service 1st as of November 12, 2008. The Trust was formed on August 17, 2006 for the sole purpose of issuing trust preferred securities fully and unconditionally guaranteed by Service 1st. Under applicable regulatory guidance, the amount of trust preferred securities that is eligible as Tier 1 capital is limited to 25% of the Company’s Tier 1 capital on a pro forma basis. At December 31, 2011, all of the trust preferred securities that have been issued qualify as Tier 1 capital. The trust preferred securities mature on October 7, 2036, are redeemable at the Company’s option beginning after five years, and require quarterly distributions by the Trust to the holder of the trust preferred securities at a variable interest rate which will adjust quarterly to equal the three month LIBOR plus 1.60%. The Trust used the proceeds from the sale of the trust preferred securities to purchase approximately $5,155,000 in aggregate principal amount of Service 1st’s junior subordinated notes (the Notes). The Notes bear interest at the same variable interest rate during the same quarterly periods as the trust preferred securities. The Notes are redeemable by the Company on any January 7, April 7, July 7, or October 7 on or after October 7, 2012 or at any time within 90 days following the occurrence of certain events, such as: (i) a change in the regulatory capital treatment of the Notes (ii) in the event the Trust is deemed an investment company or (iii) upon the occurrence of certain adverse tax events. In each such case, the Company may redeem the Notes for their aggregate principal amount, plus any accrued but unpaid interest. The Notes may be declared immediately due and payable at the election of the trustee or holders of 25% of the aggregate principal amount of outstanding Notes in the event that the Company defaults in the payment of any interest following the nonpayment of any such interest for 20 or more consecutive quarterly periods. Holders of the trust preferred securities are entitled to a cumulative cash distribution on the liquidation amount of $1,000 per security. For each January 7, April 7, July 7 or October 7 of each year, the rate will be adjusted to equal the three month LIBOR plus 1.60%. As of December 31, 2011, the rate was 2.00%. Interest expense recognized by the Company for the years ended December 31, 2011, 2010 and 2009 was $100,000, $102,000 and $129,000, respectively. CAPITAL RESOURCES Capital serves as a source of funds and helps protect depositors and shareholders against potential losses. Historically, the primary source of capital for the Company has been internally generated capital through retained earnings. In addition to net income, capital increased in 2009 from the issuance of preferred stock and warrants under the Treasury Capital Purchase Program and preferred stock and common stock issued to accredited investors. In 2008, in addition to net income, capital increased from common stock issued for the acquisition of Service 1st Bancorp. 54 54 Management’s Discussion and Analysis of Financial Condition and Results of Operations CAPITAL RESOURCES (Continued) The Company has historically maintained substantial levels of capital. The assessment of capital adequacy is dependent on several factors including asset quality, earnings trends, liquidity and economic conditions. Maintenance of adequate capital levels is integral to providing stability to the Company. The Company needs to maintain substantial levels of regulatory capital to give it maximum flexibility in the changing regulatory environment and to respond to changes in the market and economic conditions. Our stockholders’ equity increased to $107,482,000 as of December 31, 2011 compared to $97,391,000 as of December 31, 2010. The increase in stockholder’s equity is a result of increase in retained earnings from net income of $6,477,000, increase in unrealized gain on the available-for-sale investment securities of $3,157,000, exercise of stock options and related tax benefits of $796,000, and the effect of share based compensation expense of $196,000, offset by preferred stock dividends and accretion of discount of $350,000 and repurchase and retirement of common stock warrants of $185,000. On August 18, 2011, the Company entered into a Securities Purchase Agreement with the Small Business Lending Fund of the United States Department of the Treasury (the ‘‘Treasury’’), under which the Company issued 7,000 shares of Senior Non-Cumulative Perpetual Preferred Stock, Series C (the ‘‘Preferred Shares’’) to the Treasury for an aggregate purchase price of $7,000,000. Simultaneously, the Company agreed with Treasury under a Letter Agreement to redeem, for an aggregate price of $7,000,000, the 7,000 shares of the Company’s Series A Fixed Rate Cumulative Preferred Stock (‘‘Series A Stock’’)originally issued pursuant to the Treasury’s Capital Purchase Program (‘‘CPP’’) in 2009. The redemption of the Series A Stock resulted in an acceleration of the remaining discount booked at the time of the CPP transaction. In connection with the repurchase of the Series A Stock, the Company also notified the Treasury of the Company’s intent to repurchase the warrant (the ‘‘Warrant’’) to purchase 79,037 shares of the Company’s common stock that was originally issued to Treasury in connection with the CPP transaction. On September 28, 2011, the Company completed the repurchase of the Warrant for total consideration of $185,000. See Note 13 to the audited Consolidated Financial Statements in this report for a more detailed discussion. On December 23, 2009, the Company entered into Stock Purchase Agreements (Agreements) with a limited number of accredited investors (collectively, the ‘‘Purchasers’’) to sell to the Purchasers a total of 1,264,952 shares of common stock, (Common Stock) at $5.25 per share and 1,359 shares of non-voting Series B Convertible Adjustable Rate Non-Cumulative Perpetual Preferred Stock (Series B Preferred Stock) at $1,000 per share, for an aggregate gross purchase price of $8,000,000 (the ‘‘Offering’’) offset by issuance costs totaling $242,000. The Offering closed on December 23, 2009, and the Company issued an aggregate of 1,264,952 shares of its Common Stock and an aggregate of 1,359 shares of its Preferred Stock upon its receipt of consideration in cash. The Series B Preferred Stock was eligible to receive a semi-annual non-cumulative preferred dividend with an initial annualized coupon of 10%, payable at the end of the first six months the shares are outstanding. The annual dividend rate would have increased to 15% for the second six month period and 20% for each six month period thereafter. Dividends may not be paid on any other class or series of the Company’s stock unless dividends are currently paid on the Preferred Stock in any period. In May 2010, the shareholders of the Company approved an amendment to the Company’s governing instruments to create a series of non-voting common stock. In June 2010, the Company exercised its option to require the Purchasers to exchange 1,359 shares of Series B Preferred Stock for 258,862 shares of non-voting common stock. In August 2011, the Company agreed to exchange of 258,862 shares of the Company’s non-voting common stock to 258,862 shares of the Company’s voting common stock. The issuance of voting common stock was conducted in a privately negotiated transaction exempt from registration pursuant to Sections 3(a)(9) and 4(2) of the Securities Act of 1933, as amended. See Note 13 to the audited Consolidated Financial Statements in this report for a more detailed discussion. During 2011, 2010 and 2009, the Bank did not pay any dividends to the Company. The Bank would not pay any dividend that would cause it to be deemed not ‘‘well capitalized’’ under applicable banking laws and regulations. Management considers capital requirements as part of its strategic planning process. The strategic plan calls for continuing increases in assets and liabilities, and the capital required may therefore be in excess of retained earnings. The ability to obtain capital is dependent upon the capital markets as well as our performance. Management regularly evaluates sources of capital and the timing required to meet its strategic objectives. The following table presents the Company’s and the Bank’s capital ratios as of December 31, 2011 and 2010: Tier 1 Leverage Ratio Central Valley Community Bancorp and Subsidiary Minimum regulatory requirement Central Valley Community Bank Minimum requirement for ‘‘Well-Capitalized’’ institution Minimum regulatory requirement Tier 1 Risk-Based Capital Ratio Central Valley Community Bancorp and Subsidiary Minimum regulatory requirement Central Valley Community Bank Minimum requirement for ‘‘Well-Capitalized’’ institution Minimum regulatory requirement Total Risk-Based Capital Ratio Central Valley Community Bancorp and Subsidiary Minimum regulatory requirement Central Valley Community Bank Minimum requirement for ‘‘Well-Capitalized’’ institution Minimum regulatory requirement December 31, 2011 December 31, 2010 Amount Ratio Amount Ratio (Dollars in thousands) $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 82,571 32,612 81,599 40,743 32,594 82,571 20,383 81,599 30,554 20,369 89,136 40,767 88,159 50,923 40,738 10.13% $ 4.00% $ 10.01% $ 70,669 29,832 69,457 5.00% $ 4.00% $ 37,264 29,811 16.20% $ 4.00% $ 16.02% $ 70,669 19,965 69,457 6.00% $ 4.00% $ 29,929 19,953 17.49% $ 8.00% $ 17.31% $ 76,982 39,931 75,766 10.00% $ 8.00% $ 49,881 39,905 9.48% 4.00% 9.32% 5.00% 4.00% 14.16% 4.00% 13.92% 6.00% 4.00% 15.42% 8.00% 15.19% 10.00% 8.00% We are required to deduct the disallowed portion of net deferred tax assets from Tier 1 capital in calculating our capital ratios. Generally, disallowed deferred tax assets that are dependent upon future taxable income are limited to the lesser of the amount of deferred tax assets that we expect to realize within one year, based on projected future taxable income, or 10% of the amount of our Tier 1 capital. Disallowed deferred tax assets deducted from Tier 1 capital were $1,427,000 and $5,981,000 at December 31, 2011 and 2010, respectively. LIQUIDITY Liquidity management involves our ability to meet cash flow requirements arising from fluctuations in deposit levels and demands of daily operations, which include funding of securities purchases, providing for customers’ credit needs and ongoing repayment of borrowings. Our liquidity is actively managed on a daily basis and reviewed periodically by our management and Director’s Asset/Liability Committees. This process is intended to ensure the maintenance of sufficient funds to meet our needs, including adequate cash flows for off-balance sheet commitments. Our primary sources of liquidity are derived from financing activities which include the acceptance of customer and, to a lesser extent, broker deposits, Federal funds facilities and advances from the Federal Home Loan Bank of San Francisco. These funding sources are augmented by payments of principal and interest on loans, the routine maturities and pay downs of securities from the securities portfolio, the stability of our core deposits and the ability to sell investment securities. As of December 31, 2011, the Company had unpledged securities totaling $219,294,000 available as a secondary source of liquidity and total cash and cash equivalents of $44,804,000. Cash and cash equivalents at December 31, 2011 decreased 55.64% compared to December 31, 2010. Primary uses of funds include withdrawal of and interest payments on deposits, origination and purchases of loans, purchases of investment securities, and payment of operating expenses. Due to the negative impact of the slow economic recovery, we have been cautiously managing our asset quality. Consequently, expanding our loan portfolio or finding adequate investments to utilize some of our excess liquidity has been difficult in the current economic environment. 55 55 Management’s Discussion and Analysis of Financial Condition and Results of Operations LIQUIDITY (Continued) Use of Estimates As a means of augmenting our liquidity, we have established Federal funds lines with various correspondent banks. At December 31, 2011 our available borrowing capacity includes approximately $44,000,000 in Federal funds lines with our correspondent banks and $125,122,000 in unused FHLB advances. At December 31, 2011, we were not aware of any information that was reasonably likely to have a material effect on our liquidity position. The following table reflects the Company’s credit lines, balances outstanding, and pledged collateral at December 31, 2011 and 2010: Credit Lines (In thousands) Unsecured Credit Lines (interest rate varies with market): Credit limit Balance outstanding Federal Home Loan Bank (interest rate at prevailing interest rate): Credit limit Balance outstanding Collateral pledged Fair value of collateral Federal Reserve Bank (interest rate at prevailing discount interest rate): Credit limit Balance outstanding Collateral pledged Fair value of collateral December 31, December 31, 2011 2010 $ $ $ $ $ $ $ $ $ $ 44,000 $ - $ 39,000 - 125,122 $ 4,000 $ 112,926 $ 114,214 $ 114,659 14,000 123,717 126,326 551 $ - $ 542 $ 562 $ 1,321 - 1,322 1,354 The liquidity of our parent company, Central Valley Community Bancorp, is primarily dependent on the payment of cash dividends by its subsidiary, Central Valley Community Bank, subject to limitations imposed by regulations. OFF-BALANCE SHEET ITEMS In the normal course of business, the Company is a party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit. Such financial instruments are recorded in the financial statements when they are funded or related fees are incurred or received. The balance of commitments to extend credit on undisbursed construction and other loans and letters of credit was $129,005,000 as of December 31, 2011 compared to $123,680,000 as of December 31, 2010. For a more detailed discussion of these financial instruments, see Note 12 to the audited Consolidated Financial Statements in this Annual Report. In the ordinary course of business, the Company is party to various operating leases. For a more detailed discussion of these financial instruments, see Note 12 to the audited Consolidated Financial Statements in this Annual Report. CRITICAL ACCOUNTING POLICIES The Securities and Exchange Commission (SEC) has issued disclosure guidance for ‘‘critical accounting policies.’’ The SEC defines ‘‘critical accounting policies’’ as those that require application of management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain and may change in future periods. Our accounting policies are integral to understanding the results reported. Our significant accounting policies are described in detail in Note 1 in the audited Consolidated Financial Statements. Not all of the significant accounting policies presented in Note 1 of the audited Consolidated Financial Statements in this Annual Report require management to make difficult, subjective or complex judgments or estimates. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amount of assets, liabilities, revenues and expenses. On an ongoing basis, management evaluates the estimates used. Estimates are based upon historical experience, current economic conditions and other factors that management considers reasonable under the circumstances. These estimates result in judgments regarding the carrying values of assets and liabilities when these values are not readily available from other sources, as well as assessing and identifying the accounting treatments of contingencies and commitments. Actual results may differ from these estimates under different assumptions. Accounting Principles Generally Accepted in the United States of America Our financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). We follow accounting policies typical to the commercial banking industry and in compliance with various regulation and guidelines as established by the Public Company Accounting Oversight Board (PCAOB), Financial Accounting Standards Board (FASB), the American Institute of Certified Public Accountants (AICPA), and the Bank’s primary federal regulator, the FDIC. The following is a brief description of our current accounting policies involving significant management judgments. Allowance for Credit Losses Our most significant management accounting estimate is the appropriate level for the allowance for credit losses. The allowance for credit losses is established to absorb known and inherent losses attributable to loans outstanding. The adequacy of the allowance is monitored on an on-going basis and is based on our management’s evaluation of numerous factors. These factors include the quality of the current loan portfolio, the trend in the loan portfolio’s risk ratings, current economic conditions, loan concentrations, loan growth rates, past-due and nonperforming trends, evaluation of specific loss estimates for all significant problem loans, historical charge-off and recovery experience and other pertinent information. See Note 1 to the audited Consolidated Financial Statements in this Annual Report for more detail regarding our allowance for credit losses. The calculation of the allowance for credit losses is by nature inexact, as the allowance represents our management’s best estimate of the probable losses inherent in our credit portfolios at the reporting date. These credit losses will occur in the future, and as such cannot be determined with absolute certainty at the reporting date. Impairment of Investment Securities Investment securities are impaired when the amortized cost exceeds fair value. Investment securities are evaluated for impairment on at least a quarterly basis and more frequently when economic or market conditions warrant such an evaluation to determine whether a decline in their value is other than temporary. Management utilizes criteria such as the magnitude and duration of the decline and the intent and ability of the Company to retain its investment in the securities for a period of time sufficient to allow for an anticipated recovery in fair value, in addition to the reasons underlying the decline, to determine whether the loss in value is other than temporary. The term ‘‘other than temporary’’ is not intended to indicate that the decline is permanent, but indicates that the prospects for a near-term recovery of value is not necessarily favorable, or that there is a lack of evidence to support a realizable value equal to or greater than the carrying value of the investment. Once a decline in value is determined to be other-than-temporary and we do not intend to sell the security or it is more likely than not that we will not be required to sell the security before recovery, only the portion of the impairment loss representing credit exposure is recognized as a charge to earnings, with the balance recognized as a charge to other comprehensive income. If management intends to sell the security or it is more likely than not that we will be required to sell the security before recovering its forecasted cost, the entire impairment loss is recognized as a charge to earnings. 56 56 Management’s Discussion and Analysis of Financial Condition and Results of Operations CRITICAL ACCOUNTING POLICIES (Continued) Amortization of Premiums/Discount Accretion on Investments by nature inexact, and represents management’s best estimate of the grant date fair value of the share based payments. See Note 1 to the audited Consolidated Financial Statements in this Annual Report. We invest in Collateralized Mortgage Obligations (CMO) and Mortgage Backed Securities, (MBS) as part of the overall strategy to increase our net interest margin. CMOs and MBS by their nature react to changes in interest rates. In a normal declining rate environment, prepayments from MBS and CMOs would be expected to increase and the expected life of the investment would be expected to shorten. Conversely, if interest rates increase, prepayments normally would be expected to decline and the average life of the MBS and CMOs would be expected to extend. However, in the current economic environment, prepayments may not behave according to historical norms. Premium amortization and discount accretion of these investments affects our net interest income. Our management monitors the prepayment speed of these investments and adjusts premium amortization and discount accretion based on several factors. These factors include the type of investment, the investment structure, interest rates, interest rates on new mortgage loans, expectation of interest rate changes, current economic conditions, the level of principal remaining on the bond, the bond coupon rate, the bond origination date, and volume of available bonds in market. The calculation of premium amortization and discount accretion is by nature inexact, and represents management’s best estimate of principal pay downs inherent in the total investment portfolio. Goodwill Business combinations involving the Company’s acquisition of the equity interests or net assets of another enterprise or the assumption of net liabilities in an acquisition of branches constituting a business may give rise to goodwill. Goodwill represents the excess of the cost of an acquired entity over the net of the amounts assigned to assets acquired and liabilities assumed in transactions accounted for under the purchase method of accounting. The value of goodwill is ultimately derived from the Company’s ability to generate net earnings after the acquisition. A decline in net earnings could be indicative of a decline in the fair value of goodwill and result in impairment. For that reason, goodwill is assessed for impairment at a reporting unit level at least annually or more often if an event occurs or circumstances change that would more likely than not reduce the fair value of the Company below its carrying amount. While the Company believes all assumptions utilized in its assessment of goodwill for impairment are reasonable and appropriate, changes could cause the Company to record impairment in the future. Share-Based Compensation The Company recognizes compensation expense in an amount equal to the fair value of all share-based payments which consist of stock options granted to directors and employees. The fair value of each option is estimated on the date of grant and amortized over the service period using a Black-Scholes-Merton based option valuation model that requires the use of assumptions to estimate the grant date fair value. The estimates are based on assumptions on the expected option life, the level of estimated forfeitures, expected stock volatility and the risk-free interest rate. The calculation of the fair value of share based payments is Accounting for Income Taxes The Company files its income taxes on a consolidated basis with its subsidiary. The allocation of income tax expense (benefit) represents each entity’s proportionate share of the consolidated provision for income taxes. Deferred tax assets and liabilities are recognized for the tax consequences of temporary differences between the reported amounts of assets and liabilities and their tax bases. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. On the balance sheet, net deferred tax assets are included in accrued interest receivable and other assets. The determination of the amount of deferred income tax assets which are more likely than not to be realized is primarily dependent on projections of future earnings, which are subject to uncertainty and estimates that may change given economic conditions and other factors. The realization of deferred income tax assets is assessed and a valuation allowance is recorded if is ‘‘more likely than not’’ that all or a portion of the deferred tax asset will not be realized. ‘‘More likely than not’’ is defined as greater than a 50% chance. All available evidence, both positive and negative is considered to determine whether, based on the weight of that evidence, a valuation allowance is needed. Only tax positions that meet the more-likely-than-not recognition threshold are recognized. The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, management believes it is more likely than not that the position will be sustained upon examination, including the resolution of appeals or litigation processes, if any. Tax positions taken are not offset or aggregated with other positions. Tax positions that meet the more-likely-than-not recognition threshold are measured as the largest amount of tax benefit that is more than 50 percent likely of being realized upon settlement with the applicable taxing authority. The portion of the benefits associated with tax positions taken that exceeds the amount measured as described above is reflected as a liability for unrecognized tax benefits in the accompanying balance sheet along with any associated interest and penalties that would be payable to the taxing authorities upon examination. Interest expense and penalties associated with unrecognized tax benefits are classified as income tax expense in the consolidated statement of income. INFLATION The impact of inflation on a financial institution differs significantly from that exerted on other industries primarily because the assets and liabilities of financial institutions consist largely of monetary items. However, financial institutions are affected by inflation in part through non-interest expenses, such as salaries and occupancy expenses, and to some extent by changes in interest rates. At December 31, 2011, we do not believe that inflation will have a material impact on our consolidated financial position or results of operations. However, if inflation concerns cause short term rates to rise in the near future, we may benefit by immediate repricing of a portion of our loan portfolio. Refer to Market Risk section for further discussion. 57 57 Stock Price Information The Company’s common stock is listed for trading on the NASDAQ Capital Market under the ticker symbol CVCY. As of March 19, 2012, the Company had approximately 763 shareholders of record. The following table shows the high and low sales prices for the common stock for each quarter as reported by NASDAQ. Quarter Ended March 31, 2010 June 30, 2010 September 30, 2010 December 31, 2010 March 31, 2011 June 30, 2011 September 30, 2011 December 31, 2011 Sales Prices for the Company’s Common Stock High $ 6.10 8.25 6.44 6.00 6.19 6.95 6.90 6.25 Low $ 5.34 5.13 5.40 5.25 5.61 6.19 5.20 5.25 The Company did not pay a cash dividend in 2011 or 2010. The Company’s primary source of income with which to pay cash dividends are dividends from the Bank. The Bank would not pay any dividend that would cause it to be deemed not “well capitalized” under applicable banking laws and regulations. See Note 13 in the audited Consolidated Financial Statements in Item 8 of this Annual Report. MARKET MAKERS Inquiries on Central Valley Community Bancorp stock can be made by calling any of the contacts listed below, or any licensed stockbroker. Troy Carlson Keefe Bruyette & Woods (212) 887-8901 Lisa Gallo Wedbush Morgan Securities (866) 491-7228 Richard Levenson Western Financial Corporation (800) 488-5990 Joey Warmenhoven McAdams Wright Ragen, Inc. (866) 662-0351 John Cavender Raymond James (415) 538-5725 Michael Hedri Fig Partners, LLC (212) 899-5217 Troy Norlander Crowell, Weedon & Co. (800) 288-2811 SHAREHOLDER INQUIRIES Inquiries regarding Central Valley Community Bancorp’s accounting, internal accounting controls or auditing concerns should be directed to Steven D. McDonald, chairman of the Board of Directors ’ Audit Committee, at steve.mcdonald@cvcb.com, anonymously at www.ethicspoint.com or call Ethics Point, Inc. at (866) 294-9588. General inquiries about the Company or the Bank should be directed to Cathy Ponte, Assistant Corporate Secretary at (800) 298 -1775. 58 Notes 59 Doing Our Part For A Stronger, More Satisfying Community. Central Valley Community Bank is highly visible in the areas we serve, and not just because of our office locations. You can see us in local philanthropies and in the lives of people touched by worthy causes… in our sponsorship of community events and in our support of vital projects and nonprofit organizations. We’re proud of the many ways in which we give back to our community, starting with the service we provide to those who entrust us with their financial security. We thank them – and you – for supporting the Bank that supports our community by giving our time, talents and resources to organizations like those listed here. Ag Lenders Society of California Alzheimer's Foundation of Central California American Cancer Society American Red Cross Big Brothers Big Sisters of Central California Biola Chamber of Commerce Boys & Girls Clubs of Fresno County Boys & Girls Club of Tracy Break The Barriers Buchanan High School Building Industry Association of the Delta Business Council Inc. Business Organization of Old Town Clovis California State University, Fresno Alumni Association California State University, Fresno Craig School of Business California State University, Fresno Foundation California State University, Fresno Maddy Institute California Wine Education Foundation Camp Sunshine Dreams Cen Cal Business Finance Group Central California Builders Exchange Central Valley Business Incubator Central Valley SCORE Charterhouse Center for Families Children’s Hospital Central California Children’s Hospital Central California Alegria Guild Clovis District Chamber of Commerce Clovis Drug Prevention Council Clovis Rodeo Association Coarsegold Chamber of Commerce Community Food Bank Community Medical Foundation Court Appointed Special Advocates of Fresno & Madera Counties Court Appointed Special Advocates of Merced County Create for the Westside Doug McDonald Scholarship Downtown Stockton Alliance East Fresno Kiwanis Club East Fresno Rotary Charity Foundation Easter Seals Central California Exceptional Parents Unlimited Family Healing Center Fig Garden Rotary Club Fresno Area Hispanic Chamber of Commerce Fresno Association of REALTORS Fresno Business Council Fresno Regional Independent Business Alliance Foundation for Clovis Schools Fresno Area Crime Stoppers Fresno Art Museum Fresno City & County Historical Society Fresno County 4 - H Club Fresno County Farm Bureau Fresno Sunrise Rotary Friends of the Oakhurst Branch Library Give Every Child A Chance Greater Fresno Area Chamber of Commerce Greater Madera Kiwanis Club Greater Merced Chamber of Commerce Greater Stockton Chamber of Commerce HandsOn Central California Hinds Hospice Hoover High School Hubbard-Baro Memorial Golf Tournament Japanese Amercian Citizens League Lodi Chapter Junior Achievement Junior Leadership Merced - Growing Merced Foundation Junior League of San Joaquin County Kerman 4-H Club Kerman Ag Expo Kerman Cal Ripken Baseball League Kerman Chamber of Commerce Kerman Christian School Kerman Community Services Organization Kerman Heat Softball Association Kerman High School Kerman Rotary Club Kerman Senior Advisory Board Lambda Theta Phi Latinas United Republican Women Federated LeTip of Stockton Leukemia & Lymphoma Society Central California Chapter LifeSTEPS Lodi Area Crime Stoppers Inc. Lodi Chamber of Commerce Lodi-Tokay Rotary Club Madera Chamber of Commerce Madera Community Hospital Foundation Make-A-Wish Foundation of Central California Marjaree Mason Center McHenry House Tracy Family Shelter Merced Boosters Club Merced County Association of Realtors Merced County Chamber of Commerce Merced County Hispanic Chamber of Commerce Micke Grove Zoological Society Modesto Chamber of Commerce National Child Safety Council New Jerusalem Elementary School North Modesto Kiwanis Club Oakhurst Area Chamber of Commerce Oakhurst Community Center Our Lady of Perpetual Help School Park of the Sierras PBID Partners of Downtown Fresno Pop Laval Foundation Rancho Cordova Chamber of Commerce Reading and Beyond 60 Rotary Club of Clovis Rotary Club of Fresno Rotary Club of Merced Sacramento Metro Chamber of Commerce San Joaquin College of Law San Joaquin Farm Bureau Federation San Joaquin Memorial High School San Joaquin River Parkway and Conservation Trust San Joaquin Tranquility Lions Club Sebastian Foundation Selma Chapter of the Triple X Fraternity Sequoia Council of the Boy Scouts of America Shaver Lake Chamber of Commerce Shaver Lake Lions Club Sherriff’s Foundation for Public Safety Sierra High School Sierra Lions Club Sierra Mountain Little League Soroptimist International of Kerman Soroptimist International of Madera Spirit of Women Stagg High School Stanislaus Medical Society St. Joachim’s Elementary School Stockton Athletic Hall of Fame Stockton Sunrise Rotary Club Sunnyside High School The Bulldog Foundation The Clovis Community Foundation The Fresno Bee – Newspapers In Education The Leadership Forum The Salvation Army Tracy Chamber of Commerce Tracy Hospital Foundation Tracy Sunrise Rotary Turning Point Pregnancy Care Center United Cerebral Palsy of Stanislaus and Tuolumne Counties United Way of Fresno County United Way of Merced County United Way of San Joaquin County United Way of Stanislaus County United Way of the Capital Region University of California, Merced University of the Pacific Urshiah Care Center Valley Public Television Vineyard Christian Middle School Women’s Center of San Joaquin County Yosemite High School BUSINESS LENDING Business Lending 7100 North Financial Drive, Suite 101 Fresno, CA 93720 (559) 298-1775 (800) 298-1775 Agribusiness 7100 North Financial Drive, Suite 101 Fresno, CA 93720 (559) 323-3493 Real Estate 7100 North Financial Drive, Suite 101 Fresno, CA 93720 (559) 323-3365 SBA Lending 8375 North Fresno Street Fresno, CA 93720 (559) 323-3384 www.cvcb.com Kerman 360 South Madera Avenue Kerman, CA 93630 (559) 842-2265 Lodi 1901 West Kettleman Lane, Suite 100 Lodi, CA 95242 (209) 333-5000 Madera 1919 Howard Road Madera, CA 93637 (559) 673-0395 Merced 3337 G Street, Suite B Merced, CA 95340 (209) 725-2820 Modesto 2020 Standiford Avenue, Suite H Modesto, CA 95350 (209) 576-1402 Oakhurst 40004 Highway 41, Suite 101 Oakhurst, CA 93644 (559) 642-2265 Prather 29430 Auberry Road Prather, CA 93651 (559) 855-4100 Sacramento 2339 Gold Meadow Way, Suite 100 Gold River, CA 95670 (916) 859-2550 Stockton 2800 West March Lane, Suite 120 Stockton, CA 95219 (209) 956-7800 Tracy 60 West 10th Street Tracy, CA 95376 (209) 830-6995 CLOVIS Clovis Main 600 Pollasky Avenue Clovis, CA 93612 (559) 323-3480 Herndon & Fowler 1795 Herndon Avenue, Suite 101 Clovis, CA 93611 (559) 323-2200 FRESNO Fig Garden Village 5180 North Palm, Suite 105 Fresno, CA 93704 (559) 221-2760 Financial Drive Corporate Office 7100 North Financial Drive, Suite 101 Fresno, CA 93720 (559) 298-1775 (800) 298-1775 Fresno Downtown 2404 Tulare Street Fresno, CA 93721 (559) 268-6806 River Park 8375 North Fresno Street Fresno, CA 93720 (559) 447-3350 Sunnyside 570 South Clovis Avenue, Suite 101 Fresno, CA 93727 (559) 323-3400