Central Valley Community Bancorp
Annual Report 2012

Plain-text annual report

2012 Annual Report Strong. Solid. Unchanging Values. 1 For Our Community Our Commitment Remains Unchanged. Not only is Central Valley Community Bank focused on our customers, but on investing in the areas we serve throughout the San Joaquin Valley. Through the donation of time, expertise and financial support, Central Valley Community Bank donates to a wide variety of local charities, philanthropies and business organizations - from educational causes to disease research, the arts to the underprivileged. It is our belief that to have a thriving business, you must first take care of the communities you serve. That is a commitment you can count on to remain unchanged from Central Valley Community Bank for years to come. “ We believe when a bank’s core values reflect its local community values, special things happen. That’s why we remain true to our roots as a community bank and invest in our community not only with financial support, but also with the talents and energy of our people.” Daniel J. Doyle, President and Chief Executive Officer 2 COMMUNITY Boys & Girls Club of Tracy Buddhist Church of Stockton CenterStage Clovis Community Theatre Central California Society for Prevention of Cruelty to Animals Chowchilla Athletic Foundation Girls Softball Clovis Babe Ruth Association Clovis Rodeo Association Eastern Fresno County Historical Society East Fresno Kiwanis Club East Fresno Rotary Club Fresno Art Museum Fresno City & County Historical Society Fresno River Park Rotary Club Fresno Sunrise Rotary GRID Alternatives Central Valley Junior League of San Joaquin County Katey’s Kids, a Sebastian Foundation Kerman Cal Ripken Baseball League Kerman Community Services Organization Kerman Rotary Club Kerman Youth Senior Cheerleaders Knights of Columbus Lambda Theta Phi Lodi Tokay Rotary Club LOEL Center & Gardens Madera County Ag Boosters Merced Boosters Club Merced Rotary Club Modesto Sunrise Rotary Club New Beginnings for Merced County Animals North Modesto Kiwanis Club Oakhurst Sierra Sunrise Rotary Our Lady of Guadalupe Catholic Church Our Lady of Perpetual Help Church Rotary Club of Clovis Rotary Club of Fig Garden Rotary Club of Fresno Rotary Club of Merced Rotary Club of Sacramento San-Tran Lions Club Shaver Lake Lions Club Sequoia Council of the Boy Scouts of America Sierra Lions Club Sierra Mountain Little League Sierra Oaks Senior Center SKP Park of the Sierras, Inc. Spectrum Art Gallery Stockton Athletic Hall of Fame Stockton Sunrise Rotary Club The Rotary Foundation The Salvation Army Tracy Hills Growers and Vintners Association Tracy Sunrise Rotary United Way California Capital Region United Way of Fresno County United Way of Merced County United Way of San Joaquin County United Way of Stanislaus County Urshiah Adopt-A-Grandparent Valley Public Television Women’s Success Network Women’s Trade Club of Fresno County Yosemite Baseball Boosters CIVIC American Institute of Certified Public Accountants Association of Commercial Real Estate Business Organization of Old Town Clovis California Chamber of Commerce California Cotton Ginners Association Central Valley Business Incubator Central Valley SCORE Certified Financial Planner Board of Standards, Inc. Clovis Chamber of Commerce Coarsegold Chamber of Commerce Creative Fresno Eastern Madera County Chamber of Commerce Economic Development Corporation Fresno Area Crime Stoppers Fresno Area Hispanic Chamber of Commerce Fresno Association of REALTORS Fresno Business Council Fresno County Farm Bureau Fresno First Steps Home Fresno Regional Independent Business Alliance Greater Fresno Area Chamber of Commerce Greater Merced Chamber of Commerce Greater Stockton Chamber of Commerce Kerman Chamber of Commerce Kings County Farm Bureau Lodi Area Crime Stoppers Inc. Lodi Chamber of Commerce Madera Association of REALTORS Madera County Farm Bureau Madera District Chamber of Commerce Merced County Association of REALTORS Merced County Farm Bureau Merced County Chamber of Commerce Merced County Hispanic Chamber of Commerce Modesto Chamber of Commerce Oakhurst Community Park PBID Partners of Downtown Fresno Peace Officer Memorial Group of Stanislaus County Rancho Cordova Chamber of Commerce Sacramento Metro Chamber of Commerce San Joaquin County Farm Bureau San Joaquin River Parkway and Conservation Trust Shaver Lake Chamber of Commerce Sheriff ’s Foundation for Public Safety Sierra Women’s Service Club Stanislaus County Farm Bureau The Clovis Community Foundation Tracy Chamber of Commerce Tulare County Farm Bureau Yosemite Gateway Association of REALTORS BANKING INDUSTRY American Bankers Association Association for Financial Professionals Bankers’ Compliance Group California Association of Mortgage Professionals California Bankers Association Department of Consumer Affairs Dun & Bradstreet Credibility Corp Independent Community Bankers of America Institute of Certified Bankers National Association of Government Guaranteed Lenders National Notary Association Signature User Group Technical Round Table The Risk Management Association Western Payments Alliance “ The Bank’s 33-year commitment to the community runs deep and we take pride in our ability to support the special communities we’re proud to call home.” Daniel N. Cunningham, Founding Director and Chairman of the Board EDUCATION California State University, Fresno - Craig School of Business California State University, Fresno - Foundation California State University Fresno - Maddy Institute California State University, Fresno - University Business Center Cordova High School Doug McDonald Scholarship Foundation for Clovis Schools Fresno County 4-H Sponsoring Committee Fresno Pacific University Goldenrod Elementary School Junior Achievement Kerman 4-H Club Kerman High School Kerman Senior Advisory Board McFarlane-Coffman Agriculture Center Regents of the University of California San Joaquin College of Law Stagg High School Football St. Joachim’s Elementary School St. Mary’s High School The Big Fresno Fair Livestock Auction The Bulldog Foundation The Central California Autism Center Tracy High School University of the Pacific Vineyard Christian Middle School Yosemite Adult Education Program HEALTH & WELFARE Alzheimer’s Foundation of Central California American Heart Association American Cancer Society California Armenian Home California Medical Group Management Association Camarena Health Camp Sunshine Dreams Child Advocates of Placer County Children’s Hospital Central California Alegria Guild Children’s Hospital Central California Foundation Community Food Bank Community Medical Foundation Court Appointed Special Advocates of Fresno and Madera Counties Court Appointed Special Advocates of Stanislaus County CureSearch For Children’s Cancer Exceptional Parents Unlimited Family Healing Center Hinds Hospice KlaasKids Foundation Legal Information for Families Today Leukemia & Lymphoma Society Central California Chapter LifeSTEPS Lodi Adopt-A-Child Madera Community Hospital Foundation Marjaree Mason Center National Child Safety Council One-Eighty Teen Center Sacramento Medical Group Management Association San Joaquin Dental Society Spirit of Woman of California Stanislaus Medical Society Trauma Intervention Program Women’s Center of San Joaquin County 3 To Our Shareholders Building On Our Success In the midst of an economy filled with both challenges and signs of recovery, Central Valley Community Bank continues to demonstrate strength while being recognized once again for strong financial performance. Indeed, 2012 has proven to be another successful link in the Company’s long chain of steady growth and consistent earnings, as we achieved our highest earnings mark in 32 years of operation. The banking industry is regaining its financial strength with peer banks returning to profitability and in general, an improvement in asset quality. This is a positive sign for the economy and good news for our customers, communities and the banking industry as a whole. Our Best Earnings Ever In addition to our record earnings, net income increased 16.10%, primarily driven by increases in non-interest income, a decrease in non-interest expense and lower provision for credit losses. This, along with continued asset quality improvement, highlights the safety, security and financial strength of the Bank. While there are signs of modest economic improvement in our markets, interest income is still negatively impacted due to weak loan demand and aggressive pricing by large financial institutions. Meanwhile, we are seeing some increase in loan commitments, but reduced usage on lines of credit due to the economic uncertainty affecting our business borrowers and the profitability of many of our agriculture- related borrowers, which has reduced their need to borrow. However, the Bank has hired additional lending staff who bring experience and success to the Company in several of our markets and have allowed continued expansion for our agri-business portfolio with new customers as well as 4 diversification and growth on our loan commitment. But like many banks, the challenge still remains to find good loans at fair and reasonable pricing and qualified borrowers who have the desire to grow, expand and operate their businesses. While it is good to see the asset quality of loans improving, many banks still carry problem loans and hold high reserves for potential future loss. Regulators report that nearly 10% of all the banks in the country are considered “troubled” and almost 40% of the banks in California are under some form of regulatory orders. Fortunately, our Bank does not fall into this category. On the other side of the balance sheet, we do see continued growth of deposits, even though banks in general are paying record low interest rates. Unfortunately, there is low demand for ways to lend out these deposits and obtain better profit margins than buying securities. At the end of 2012, Congress allowed the Transaction Account Guarantee of 100% of FDIC deposit insurance to terminate. Therefore, we are working with our large deposit balance customers by offering other methods to meet their needs for the safety of their deposits. The strong performance of the Bank was again recognized as we achieved a Super Premier Performance ranking from The Findley Reports, the highest of the three performance tiers recognized by the firm. The Bank has been identified as one of the top performing banks in California over the last 30 years and was also recommended by Bauer Financial, Inc. with their highest “5-Star Superior” rating in 2012. A Solid Value For Shareholders Our stability was once again confirmed by Sandler O'Neill + Partners, L.P., who named the Company stock as one of their “Top Investment Ideas” for the second time in the past three years. The Company was given an “Outperform” rating by Raymond James & Associates where it is expected to appreciate and outperform the S&P 500 through June of 2014. The Board of Directors approved the adoption of a program to repurchase up to five percent of the Company’s outstanding shares of common stock, which was determined as the best use for a portion of our excess capital. In seeking additional opportunities to best use our capital and to provide value to our shareholders, the Board also decided to return cash to shareholders through a $0.05 per share quarterly cash dividend. Throughout the year, I had the opportunity to present the success of our Company at several investor conferences attended by investors from all over the United States. They were all very complimentary of our business practices and in particular, they noted that our Company excels at all of the important elements that impact their decision to invest. More Milestones Ahead For The Bank In December of 2012, the Company entered into a definitive merger agreement to acquire our South Valley neighbor, Visalia Community Bank, with three full-service offices in Visalia and one office in Exeter. Both Companies are in the process of filing the required documents and the merger remains subject to regulatory approvals and approval by Visalia Community Bank’s shareholders. Once completed in mid-2013, the merger is slated to bolster us over the $1 billion asset mark. That milestone is possible because of the steady direction we have followed for over three decades, the vision of our board, the leadership of our senior management and the day-to-day service provided to customers by each and every one of our dedicated employees. We believe that by expanding our presence in the South Valley and adding professional employees and loyal customers to our current structure, we will provide a long-term benefit to the growth and profitability of the Company. In addition, the opportunities of more efficiencies and expense reduction will provide improved financial performance that either bank could not have achieved independently. Further benefitting the Company, I continue in the second year of a three-year term on the Federal Reserve Bank of San Francisco’s Twelfth District Community Depository Institutions Advisory Council (CDIAC). This position allows insight and knowledge for a variety of economic and banking conditions, regulatory policies and payments issues. Continued Challenges For The Local Economy The Federal Reserve continues to hold interest rates at historical low levels for savings instruments and securities, which is forcing pressure on banks for earnings from net interest margin compression. Employment growth, as the key driver needed for an economic rebound, was still slow this year. The development and growth of our team is always a continued commitment and as part of our on-going belief in planning for future succession, we completed the first stage of our three-year Leadership Development Program with a team of key employees. Additional outside training continued for employees to stay up to speed in the ever-changing world of technology, cybercrime, new regulations and customer needs. In order to expand and retain existing relationships and cultivate new customers, the Bank launched an internal sales and service initiative program to focus on needs-based selling and developing key skills instrumental in driving stronger relationships with our customers. Added Convenience For Customers We remain committed to providing the highest standards of service, alongside the products and services that meet the unique needs of our personal and business customers. To further strengthen our customer relationships and provide sound financial advice to the community at large, the Bank has made a number of upgrades to enhance its presence in the digital landscape. We are proud to announce that the Bank now has a social media presence on Facebook and Twitter. Our shareholders, customers and the community can now follow us for financial tips, important identity protection information, local community events, timely Bank news and answers to thoughts, questions and concerns. Additionally, Business Health Club was launched on our website as an online resource center where business owners can easily find helpful education on popular topics, from how to protect businesses against cybercrimes, to accounting tips on how to keep a business running smoothly. A new mobile banking application was recently launched that allows customers to manage their money anytime and anywhere from a mobile device. And with Popmoney, customers can safely send or receive money electronically with this Person-to-Person payment service. Also, the Bank has completed the installation of new ATMs at all branch locations that include the new deposit automation feature and also the ability to convert text to voice for those visitors with a vision disability. One positive in the lingering economic landscape is that slow but improving trends are being seen in the communities we serve. We are hopeful that these trends will continue to grow throughout California’s vital San Joaquin Valley, albeit slower than past periods of economic recovery. New Regulations Bring Challenges There will continue to be pressure on bank earnings and the ability to reach historical levels of return due to new regulatory requirements for additional capital, the current interest rate environment and the reducing of free-market pricing from regulatory changes. Furthermore, there are additional costs to implement and monitor the new expanding regulations from Dodd-Frank and the Consumer Financial Protection Bureau. Looking Ahead To A Successful 2013 While 2012 saw Central Valley Community Bank achieve our highest earnings in 32 years of operation, we will not rest on these laurels. Our success does not just happen by chance. We are successful because we plan, set goals and have a strong team of individuals who care about the needs of our shareholders, customers, fellow teammates and communities. We have not only survived, but also thrived through one of the toughest economic climates in recent history. As we look ahead to 2013 and beyond, we will continue to focus on growing our brand and increasing our market share. We are thankful to our customers, employees and shareholders, whose loyalty we strive to earn each day. Daniel J. Doyle President and Chief Executive Officer Daniel N. Cunningham Chairman of the Board 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 5 Strong. Solid. Unchanging Values. A 33-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. In December 2012, Central Valley Community Bancorp entered into a definitive merger agreement to aquire Visalia Community Bank with three full-service offices in Visalia, and one in Exeter, which is expected to be completed during 2013. 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 over $890,000,000 as of December 31, 2012, Central Valley Community Bank has grown into a well-capitalized institution, 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. 6 Central Valley Community Bank distinguishes itself from other financial institutions through its 33-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. 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. For maximum convenience, Online Banking, Bill Pay, Mobile Banking, Popmoney (person-to-person payments), eStatements 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 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, the Bank 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 13 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. 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 33 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. Daniel J. Doyle President and CEO Central Valley Community Bancorp, Central Valley Community Bank Daniel N. Cunningham Chairman of the Board Director, Quinn Group, Inc. Sidney B. Cox Owner Cox Communications Board Of Directors Edwin S. Darden, Jr. Architect Darden Architects, Inc. Steven D. McDonald Secretary of the Board President McDonald Properties, Inc. Louis C. McMurray President Charles McMurray Co. William S. Smittcamp President/Owner Wawona Frozen Foods Joseph B. Weirick Investments Not Pictured: Wanda Rogers, Director Emeritus and Founding President, Rogers Helicopters, Inc. 7 Our Team, Meeting Your Needs. Vicki Casares Vice President, Branch Manager Cathy Chatoian Vice President, Cash Management Manager Jenhi Ciapponi Vice President, Commercial Loan Officer Terry Crawford Vice President, Agricultural Lending Group Manager Tom Crawley Vice President, Commercial Loan Officer Dawn Crusinberry Vice President, Controller Craig Dadian Vice President, Business Development Officer Stan Davis Vice President, Small Business/Consumer Underwriting Department Manager Daniel Demmers Vice President, Information Services Manager Bob Elledge Vice President, Commercial Loan Officer Steve Freeland Vice President, Asset Credit Officer Officers Holding Company & 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, Small Business 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 8 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 Linda Hischier Vice President, Commercial Loan Officer Denise Jereb Vice President, Compliance Manager Charles Jones Vice President, Branch Manager Bernie Kraus Vice President, Commercial Loan Officer Marci Madsen Vice President, Human Resources Director Brad Majors Vice President, Branch Manager Constantine Makayed Vice President, Credit Review Officer 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 Leslee Minas Vice President, Branch Manager 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 Jeff Pace Vice President, Real Estate Department Manager Wendy Parlavecchio Vice President, Real Estate Loan Officer Shannon Reinard Vice President, Branch Manager Steve Romeo Vice President, Private Banking Officer Elizabeth Salas Vice President, Small Business Development Officer Irene Samano Vice President, Loan Servicing Manager Karen Smith Vice President, Branch Manager Mark Smith Vice President, Commercial Loan Officer Theodore Thome Vice President, Commercial Loan Officer Ramina Ushana Vice President, Branch Manager Robert Walker Vice President, Commercial Loan Officer Jeannine Welton Vice President, Branch Manager Jennette Williams Vice President, Commercial Loan Officer Carol Worstein Vice President, Branch Manager Independent Auditors Crowe Horwath LLP, Sacramento, CA Counsel Downey Brand LLP, Sacramento, CA 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 2012 Circle of Elite included: Diana Alvarado Financial Service Representative Maintaining a positive work environment and investing in each individual to “be the best they can be.” Pilar Alvarado Information Services Analyst 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 Trisha Barba Compliance Specialist Ashley Brannan Small Business, Consumer Loan Underwriter Rod Geist Vice President, Branch Manager, Team Leader Bryan Mimura Financial Service Representative Theodore Thome Vice President, Commercial Loan Officer, Team Leader Elaine Wiens Human Resources Assistant 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 9 Trend Analysis Central Valley Community Bancorp 0 2 5 , 7 $ 7 7 4 , 6 $ 9 7 2 , 3 $ 0 1 0 2 8 8 5 , 2 $ 9 0 0 2 1 1 0 2 2 1 0 2 9 7 . 0 $ 3 6 . 0 $ 1 1 0 2 8 0 0 2 8 2 . 0 $ 9 0 0 2 1 3 . 0 $ 0 1 0 2 Net Income (In Thousands) Diluted Earnings Per Share 8 5 4 , 2 8 4 $ 0 4 3 , 5 5 4 $ 1 9 2 , 8 2 4 $ 0 4 0 , 5 0 4 $ 9 8 7 , 7 7 6 $ 3 6 2 , 2 3 6 $ 6 6 1 , 6 3 6 $ 5 7 . 0 $ 2 1 0 2 1 0 6 , 9 1 7 $ 9 3 1 , 5 $ 8 0 0 2 9 0 0 , 7 6 3 $ 5 8 2 , 5 4 4 $ 8 0 0 2 9 0 0 2 0 1 0 2 1 1 0 2 2 1 0 2 8 0 0 2 9 0 0 2 0 1 0 2 1 1 0 2 2 1 0 2 Average Total Loans (In Thousands) Average Total Deposits (In Thousands) , 8 7 0 3 5 8 $ , 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 2 1 0 2 % 2 8 . 8 8 0 0 2 % 6 2 . 6 1 1 0 2 % 6 5 . 6 2 1 0 2 % 0 1 3 . 9 0 0 2 % 1 4 3 . 0 1 0 2 10 Return on Shareholders’ Equity Average Total Assets (In Thousands) Comparative Stock Price Performance Central Valley Community Bancorp Total Return Performance Index Value 12-31-07 12-31-08 12-31-09 12-31-10 12-31-11 12-31-12 100.00 100.00 100.00 72.62 66.21 56.58 84.20 58.91 50.98 106.82 102.36 69.51 51.71 61.67 49.88 119.09 Russell 2000 73.51 SNL NASDAQ Bank Index 71.68 Central Valley Community Bancorp stock price performance. Source: SNL Financial LC of potential future 11 $ $ $ Consolidated Balance Sheets December 31, 2012 and 2011 (In thousands, except 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 $381,074 at December 31, 2012 and $321,405 at December 31, 2011) Loans, less allowance for credit losses of $10,133 at December 31, 2012 and $11,396 at December 31, 2011 Bank premises and equipment, net 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 C, issued and outstanding: 7,000 shares at December 31, 2012 and December 31, 2011 Common stock, no par value; 80,000,000 shares authorized; issued and outstanding: 9,558,746 at December 31, 2012 and 9,547,816 at December 31, 2011 Retained earnings Accumulated other comprehensive income, net of tax Total shareholders’ equity 2012 2011 $ 22,405 30,123 428 52,956 393,965 385,185 6,252 12,163 3,850 23,577 583 11,697 19,409 24,467 928 44,804 328,413 415,999 5,872 11,655 2,893 23,577 783 15,027 890,228 $ 849,023 $ 240,169 511,263 751,432 4,000 - 5,155 11,976 772,563 7,000 40,583 62,496 7,586 117,665 208,025 504,961 712,986 - 4,000 5,155 19,400 741,541 7,000 40,552 55,806 4,124 107,482 849,023 Total liabilities and shareholders’ equity $ 890,228 $ The accompanying notes are an integral part of these consolidated financial statements. 12 12 Consolidated Statements of Income For the Years Ended December 31, 2012, 2011, and 2010 (In thousands, except per share amounts) 2012 2011 2010 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 gain (loss) on sale of assets 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 Merger expenses Other real estate owned Amortization of core deposit intangibles 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 Cash dividends per common share $ $ $ $ $ $ $ 23,913 108 2 3,289 4,508 31,820 1,630 107 146 1,883 29,937 700 29,237 2,774 391 631 12 4 1,639 - - - 36 1,755 7,242 15,597 3,578 652 1,125 558 514 185 284 78 200 4,503 27,274 9,205 1,685 7,520 7,520 350 7,170 0.75 0.75 0.05 $ $ $ $ $ $ $ 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 (5) 298 (31) - (31) 9 1,826 6,271 15,762 3,795 845 1,178 735 491 335 - 15 414 4,670 28,240 8,338 1,861 6,477 6,477 486 5,991 0.63 0.63 - $ $ $ $ $ $ $ The accompanying notes are an integral part of these consolidated financial statements. 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 (10) (191) (1,587) - (1,587) 11 1,395 3,711 14,871 3,867 1,191 1,197 669 496 495 - 1,071 414 4,460 28,731 2,910 (369) 3,279 3,279 395 2,884 0.31 0.31 - 13 13 Consolidated Statements of Comprehensive Income For the Years Ended December 31, 2012, 2011, and 2010 (In thousands) NET INCOME OTHER COMPREHENSIVE INCOME: Unrealized gains on securities: Unrealized holding gains Less: reclassification for net gains (losses) included in net income Other comprehensive income, before tax Tax expense related to items of other comprehensive income Total other comprehensive income Comprehensive income $ $ 2012 2011 2010 7,520 $ 6,477 $ 3,279 7,522 1,639 5,883 (2,421) 3,462 10,982 $ 5,632 267 5,365 (2,208) 3,157 9,634 $ 2,290 (1,778) 4,068 (1,646) 2,422 5,701 The accompanying notes are an integral part of these consolidated financial statements. 14 14 Consolidated Statements of Changes in Shareholders’ Equity For the Years Ended December 31, 2012, 2011, and 2010 (In thousands, except share amounts) Series A Preferred Stock Series B Series C Common Stock Shares Amount Shares Amount Shares Amount Shares Amount Balance, January 1, 2010 Net income 7,000 $ - 6,819 - 1,359 $ - Net change in unrealized gain on available-for-sale investment securities Conversion of preferred stock Series B, non-voting Stock-based compensation expense Stock options exercised and related tax benefit Preferred stock dividends and accretion Balance, December 31, 2010 Net income Net change in unrealized gain on available-for-sale investment securities Issuance of preferred stock Series C Redemption of preferred stock Series A Repurchase and retirement of common stock warrants Stock-based compensation expense Stock options exercised and related tax benefit Preferred stock dividends and accretion Balance, December 31, 2011 Net income Net change in unrealized gain on available-for-sale investment securities Stock-based compensation expense Cash dividend payment ($0.05 per common share) Repurchase and retirement of common stock Stock options exercised and related tax benefit Preferred stock dividends - - - - - 7,000 - - - (7,000) - - - - - - - - - - - - Balance, December 31, 2012 - $ - - - - 45 6,864 - - - (7,000) - - - 136 - - - - - - - - - - (1,359) - - - - - - - - - - - - - - - - - - - - - $ 1,317 - - (1,317) - - - - - - - - - - - - - - - - - - - - - 8,949,754 $ 37,611 $ - $ - - - - - - - - - - - - - - - - - - 7,000 - - 7,000 - - - 258,862 - 159,400 - 9,368,016 - - - - - - - - - - - - - - 179,800 - - - 1,317 239 578 - 39,745 - - - - (185) 196 796 - - - - (395) 49,815 6,477 - - - - - - (486) 7,000 - 7,000 - 9,547,816 - 40,552 - 55,806 7,520 - - - - - - - - - - - - - - - (58,100) 69,030 - - 108 - (488) 411 - - - (480) - - (350) Accumulated Other Total Retained Comprehensive Shareholders’ Earnings Income (Loss) Equity 46,931 $ 3,279 (1,455) $ - 91,223 3,279 - 2,422 2,422 - - - - 967 - 3,157 - - - - - - 4,124 - 3,462 - - - - - - 239 578 (350) 97,391 6,477 3,157 7,000 (7,000) (185) 196 796 (350) 107,482 7,520 3,462 108 (480) (488) 411 (350) 7,000 $ 7,000 9,558,746 $ 40,583 $ 62,496 $ 7,586 $ 117,665 The accompanying notes are an integral part of these consolidated financial statements. 15 15 Consolidated Statements of Cash Flows For the Years Ended December 31, 2012, 2011, and 2010 (In thousands) CASH FLOWS FROM OPERATING ACTIVITIES: Net income Adjustments to reconcile net income to net cash provided by operating activities: Net (decrease) increase in deferred loan fees Depreciation Accretion Amortization Stock-based compensation Excess 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 (gain) 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 in prepaid FDIC Assessments Net (decrease) increase 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 Proceeds from sales or calls of available-for-sale investment securities Proceeds from maturity and principal repayment of available-for-sale investment securities Net decrease in loans Proceeds from sale of other real estate owned Purchases of premises and equipment Purchases of bank owned life insurance FHLB stock (purchased) 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 Repayments of short-term borrowings to Federal Home Loan Bank Purchase and retirement of common stock Proceeds from exercise of stock options Repurchase of common stock warrant Excess tax benefit from exercise of stock options Cash dividend payments on common stock Cash dividend payments on preferred stock Net cash provided by financing activities Increase (decrease) 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 2012 2011 2010 $ 7,520 $ 6,477 $ (311) 972 (713) 7,549 108 (26) 700 - (1,639) (4) (12) - (391) - (19) 513 (7,425) 440 7,262 (194,583) 39,119 90,798 28,089 2,349 (1,353) (116) (957) - 5 (36,649) 53,265 (14,819) - (488) 385 - 26 (480) (350) 37,539 8,152 44,804 52,956 1,939 1,193 - 2,337 - - 88 $ $ $ $ $ $ $ $ 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 $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 3,279 107 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 The accompanying notes are an integral part of these consolidated financial statements. 16 16 Notes to Consolidated Financial Statements 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Investment Securities - Investments are classified into the following categories: 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. 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, Kerman, Lodi, Madera, Merced, Modesto, Oakhurst, Prather, Sacramento, Stockton, and Tracy, 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’s unlimited deposit insurance coverage on non-interest bearing transaction accounts mandated by the Dodd-Frank Act ended December 31, 2012. This coverage replaced the unlimited coverage under the Transaction Account Guarantee Program (‘‘TAG’’) and was confined to non-interest bearing accounts. Although the temporary coverage excluded interest-bearing NOW accounts, it did include interest on Lawyers Trust Accounts (IOLTAs). Beginning January 1, 2013, depositors’ accounts at an insured depository institution, including all non-interest bearing transactions accounts, will be insured by the FDIC up to the standard maximum deposit insurance amount of $250,000 for each deposit insurance ownership category. 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. 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 not 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 U.S. generally accepted accounting principles 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. • 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 years ended December 31, 2012 and December 31, 2011, there were no transfers between categories. At December 31, 2012 and 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, for debt securities, 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 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 on 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. 17 17 Notes to Consolidated Financial Statements 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) 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. 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. For all loan classes, 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 a 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. For all portfolio segments, 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 16 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 18 18 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, 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 2012. 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 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 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. 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 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. Past due receivables indicate the borrower’s capacity to repay their obligations may be deteriorating. 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. Notes to Consolidated Financial Statements 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Real Estate: Owner Occupied - Real estate collateral secured by commercial or professional properties with repayment arising from the owner’s business cash flows. 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 production loans secured by real estate 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 affecting 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 flows to service debt obligations. Other Real Estate - Primarily loans secured by agricultural real estate for development and production of permanent plantings that 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 the liquidity of the 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 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 include 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. Bank Owned Life Insurance - The Company has purchased life insurance policies on certain key executives. Company owned life insurance is recorded at the amount that can be realized under the insurance contract at the balance sheet date, which is the cash surrender value adjusted for other charges or other amounts due that are probable at settlement. 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, 2012 and 2011 was $23,577,000 consisting of $14,643,000 and $8,934,000 representing the excess of the cost of Service 1st Bancorp 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. The Company has selected September 30 as the date to perform the annual impairment test. Management assessed qualitative factors including performance trends and noted no factors indicating goodwill impairment. 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 2012, so goodwill was not required to be retested. Intangible Assets - The intangible assets at December 31, 2012 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, 2012 was $583,000, net of $2,317,000 in accumulated amortization expense. The carrying value at December 31, 2011 was $783,000, net of $2,117,000 in 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 19 19 Notes to Consolidated Financial Statements 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) useful lives was required. Management performed an annual impairment test on core deposit intangibles as of September 30, 2012 and determined no impairment was necessary. Amortization expense recognized was $200,000 for 2012 and $414,000 for 2011 and 2010. The estimated aggregate amortization expense for each of the three succeeding fiscal years is estimated to be $200,000 for 2013 and 2014, and $183,000 for 2015. 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. Income tax expense represents the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities. 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 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) plan expense is the amount of employer matching contributions. Profit sharing plan expense is the amount of employer contributions. Contributions to the profit sharing plan are determined at the discretion of the Board of Directors. Deferred compensation and supplemental retirement plan expense is allocated 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. Restrictions on Cash - Cash on hand or on deposit with the Federal Reserve Bank was required to meet regulatory reserve and clearing requirements. 20 20 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-Merton 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 award. 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, 2012, 2011, and 2010 were $26,000, $116,000, and $28,000, respectively. Dividend Restriction - Banking regulations require maintaining certain capital levels and may limit the dividends paid by the Bank to the Company or by the Company to shareholders. 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 years’ financial statements were reclassified to conform to the current presentation. Reclassifications had no effect on prior years’ net income or shareholders’ equity. Recent Accounting Pronouncements 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, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (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 International Accounting Standards Board (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 IFRS. The amendments to the FASB Accounting Standards Codification (Codification) in this ASU are to be applied prospectively. The additional disclosures are presented in Note 2: Fair Value Measurements. These new disclosure requirements were adopted by the Company in the first quarter of 2012, and did not have a material 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 (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 shareholders’ equity. The amendments to the Codification in the ASU do not change the items that must be reported in other comprehensive income or when Notes to Consolidated Financial Statements 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) The estimated carrying and fair values of the Company’s financial instruments an item of other comprehensive income must be reclassified to net income. The Company adopted this standard on January 1, 2012. The Company elected to present comprehensive income as a separate Statement of Comprehensive Income. Adoption of the standard did not have a material impact on the Company’s financial position, results of operations or cash flows. In February 2013, the FASB issued ASU 2013-02, Comprehensive Income (‘‘Topic 220’’) - Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income (‘‘ASU 13-02’’). This ASU requires an entity to provide information about the amounts reclassified out of accumulated other comprehensive income by component. In addition, an entity is required to present, either on the face of the statement where net income is presented or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income but only if the amount reclassified is required under GAAP to be reclassified to net income in its entirety in the same reporting period. For other amounts that are not required under GAAP to be reclassified in their entirety to net income, an entity is required to cross-reference to other disclosures required under GAAP that provide additional detail about those amounts. ASU 13-02 is effective prospectively for annual and interim periods beginning after December 15, 2012. The adoption of this ASU did not have a material impact on the Company’s financial position, results of operations, or cash flows. 2. FAIR VALUE MEASUREMENTS Fair Value Hierarchy Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. In accordance with applicable guidance, the Company groups its assets and liabilities measured at fair value in 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. are as follows: 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 Junior subordinated deferrable interest debentures Accrued interest payable Carrying Amount December 31, 2012 Fair Value Level 1 Level 2 Level 3 Total (In thousands) $ 22,405 $ 22,405 $ - $ - $ 22,405 30,123 428 30,123 428 - - - - 30,123 428 393,965 385,185 7,948 - 386,017 - - 388,834 393,965 388,834 3,850 N/A N/A N/A N/A 4,267 22 2,395 1,850 4,267 751,432 4,000 614,556 - 137,401 4,016 - - 751,957 4,016 5,155 174 - - - 2,990 2,990 149 25 174 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: December 31, 2011 Carrying Amount Fair Value (In thousands) $ 19,409 $ 19,409 24,467 928 328,413 418,084 N/A 3,953 24,467 928 328,413 415,999 2,893 3,953 Deposits Long-term borrowings Junior subordinated deferrable interest debentures Accrued interest payable 712,986 4,000 5,155 230 719,673 4,146 2,706 230 21 21 Notes to Consolidated Financial Statements 2. FAIR VALUE MEASUREMENTS (Continued) 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 methods and assumptions used to estimate fair values are described as follows: (a) Cash and Cash Equivalents - The carrying amounts of cash and due from banks, interest-earning deposits in other banks, and Federal funds sold approximate fair values and are classified as Level 1. (b) Available-for-Sale Investment Securities - Available-for-sale investment 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 classified in Level 2 are based on quoted market prices for similar securities in active markets. For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows or other market indicators. (c) Loans - Fair values of loans are estimated as follows: For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values resulting in a Level 3 classification. Fair values for other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level 3 classification. Impaired loans are initially valued at the lower of cost or fair value. Impaired loans carried at fair value generally receive specific allocations of the allowance for loan losses. For collateral dependent loans, fair value is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. Non-real estate collateral may be valued using an appraisal, net book value per the borrower’s financial statements, or aging reports, adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation, and management’s expertise and knowledge of the client and client’s business, resulting in a Level 3 fair value classification. Impaired loans are evaluated on a quarterly basis for additional impairment and adjusted accordingly. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price. (d) FHLB Stock - It is not practicable to determine the fair value of FHLB stock due to restrictions placed on its transferability. (e) Deposits - Fair value of demand deposit, savings, and money market accounts are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amount) resulting resulting in a Level 1 classification. Fair value for fixed and variable 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 resulting in a Level 2 classification. (f) Short-Term Borrowings - The carrying amounts of federal funds purchased, borrowings under repurchase agreements, and other short-term borrowings, generally maturing within ninety days, approximate their fair values resulting in a Level 2 classification. 22 22 (g) Other Borrowings - The fair values of the Company’s long-term borrowings are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 2 classification. The fair values of the Company’s Subordinated Debentures are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 3 classification. (h) Accrued Interest Receivable/Payable - The fair value of accrued interest receivable and payable is based on the fair value hierarchy of the related asset or liability. (i) Off-Balance Sheet Instruments - Fair values for off-balance sheet, credit-related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. The fair value of commitments is not material. 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 non-recurring basis as of December 31, 2012: 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 agencies $ Obligations of states and political subdivisions U.S. Government sponsored entities and agencies collateralized by residential mortgage obligations Private label residential mortgage backed securities Other equity securities Total assets measured at fair value on a recurring basis Fair Value Level 1 Level 2 Level 3 9,454 $ - $ 9,454 $ 161,678 208,510 - - 161,678 208,510 6,375 7,948 - 7,948 6,375 - - - - - - - $ 393,965 $ 7,948 $ 386,017 $ 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 in active markets. For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows or other market indicators. 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, 2012, no transfers between levels occurred. There were no Level 3 assets measured at fair value on a recurring basis at December 31, 2012. Also there were no liabilities measured at fair value on a recurring basis at December 31, 2012. Non-recurring Basis The Company may be required, from time to time, to measure certain assets and liabilities at fair value on a non-recurring basis. These include assets and Notes to Consolidated Financial Statements 2. FAIR VALUE MEASUREMENTS (Continued) liabilities that are measured at the lower of cost or fair value that were recognized at fair value which was below cost at December 31, 2012. Description Impaired loans: Real estate: Owner occupied Real estate-construction and other land loans Total real estate Consumer: Equity loans and lines of credit Total consumer Total impaired loans Total assets measured at fair value on a non-recurring basis $ $ Fair Value Level 1 Level 2 Level 3 $ 194 $ - $ - $ 194 4,863 5,057 233 233 - - - - - - - - 4,863 5,057 233 233 5,290 $ - $ - $ 5,290 5,290 $ - $ - $ 5,290 At the time a loan is considered impaired, it is valued at the lower of cost or fair value. Impaired loans carried at fair value generally receive specific allocations of the allowance for loan losses. For collateral dependent loans, fair value is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. Non-real estate collateral may be valued using an appraisal, net book value per the borrower’s financial statements, or aging reports, adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation, and management’s expertise and knowledge of the client and client’s business, resulting in a Level 3 fair value classification. The fair value of impaired loans is based on the fair value of the collateral. Impaired loans 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. Impaired loans evaluated under the discounted cash flow method are excluded from the table above. The discounted cash flow method as prescribed by topic 310 is not a fair value measurement since the discount rate utilized is the loan’s effective interest rate which is not a market rate. There were no changes in valuation techniques used during the year ended December 31, 2012. Appraisals for collateral-dependent impaired loans are performed by certified general appraisers (for commercial properties) or certified residential appraisers (for residential properties) whose qualifications and licenses have been reviewed and verified by the Company. Once received, the assumptions and approaches utilized in the appraisal as well as the overall resulting fair value is compared with independent data sources such as recent market data or industry-wide statistics. Impaired loans that are measured for impairment using the fair value of the collateral for collateral dependent loans, had a principal balance of $5,386,000 with a valuation allowance of $96,000 at December 31, 2012, resulting in an additional provision for loan losses of $19,000 for the year ended December 31, 2012. 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 securities Debt Securities: U.S. Government agencies $ Obligations of states and political subdivisions U.S. Government sponsored entities and agencies collateralized by residential mortgage obligations Private label residential mortgage backed securities Other equity securities Total assets measured at fair value on a recurring basis Fair Value Level 1 Level 2 Level 3 149 $ - $ 149 $ 108,431 204,544 - - 108,431 204,544 7,398 7,891 - 7,891 7,398 - - - - - - - $ 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 in active markets. For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows or other market indicators. There were no Level 3 assets measured at fair value on a recurring basis at December 31, 2011. Also there were no liabilities measured at fair value on a recurring basis at December 31, 2011. 23 23 Notes to Consolidated Financial Statements 2. FAIR VALUE MEASUREMENTS (Continued) 3. INVESTMENT SECURITIES Non-recurring Basis The Company may be required, from time to time, to measure certain assets and liabilities at fair value on a non-recurring basis. These include assets and liabilities 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). The fair value of the available-for-sale investment portfolio reflected an unrealized gain of $12,891,000 at December 31, 2012 compared to an unrealized gain of $7,008,000 at December 31, 2011. The unrealized gain recorded is net of $5,305,000 and $2,884,000 in tax liabilities as accumulated other comprehensive income within shareholders’ equity at December 31, 2012 and 2011, respectively. The following table sets forth the carrying values and estimated fair values of our investment securities portfolio at the dates indicated (in thousands): Description Impaired loans: Commercial: Fair Value Level 1 Level 2 Level 3 Commercial and industrial $ 2,312 $ - $ - $ 2,312 Total commercial Real estate: Owner occupied Real estate-construction and other land loans Commercial real estate 2,312 873 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 - - - - - - - - - - - - - - - - - - 2,312 873 8,782 1,487 11,142 2,003 51 2,054 15,508 Total assets measured at fair value on a non-recurring basis $ 15,508 $ - $ - $ 15,508 For collateral dependent loans, fair value is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. Non-real estate collateral may be valued using an appraisal, net book value per the borrower’s financial statements, or aging reports, adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation, and management’s expertise and knowledge of the client and client’s business, resulting in a Level 3 fair value classification. The fair value of impaired loans is based on the fair value of the collateral. Impaired loans 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 year ended December 31, 2011. Collateral dependent impaired loans with a carrying value of $19,876,000 were written down to their fair value of $15,508,000 resulting in an impairment charge of $4,368,000. The valuation allowance represents specific allocations for the allowance for credit losses for impaired loans. There were no liabilities measured at fair value on a non-recurring basis at December 31, 2011. December 31, 2012 Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value Available-for-Sale Securities Debt Securities: U.S. Government agencies Obligations of states and political subdivisions U.S. Government sponsored entities and agencies collateralized by residential mortgage obligations Private label residential mortgage backed securities Other equity securities $ 9,443 $ 34 $ (23) $ 9,454 151,312 10,751 (385) 161,678 206,465 3,152 (1,107) 208,510 6,258 7,596 323 352 (206) - 6,375 7,948 $ 381,074 $ 14,612 $ (1,721) $ 393,965 December 31, 2011 Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value Available-for-Sale Securities Debt Securities: U.S. Government agencies Obligations of states and political subdivisions U.S. Government sponsored entities and agencies collateralized by residential mortgage obligations Private label residential mortgage backed securities 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 24 24 Notes to Consolidated Financial Statements 3. INVESTMENT SECURITIES (Continued) Investment securities with unrealized losses at December 31, 2012 and 2011 are summarized and classified according to the duration of the loss period as follows (in thousands): December 31, 2012 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: U.S. Government agencies Obligations of states and political subdivisions U.S. Government sponsored entities and agencies collateralized by residential mortgage obligations Private label residential mortgage backed securities $ 3,590 $ (23) $ - $ - $ 3,590 $ (23) 30,572 (385) - - 30,572 (385) 76,764 (809) 18,024 (298) 94,788 (1,107) - - 2,886 (206) 2,886 (206) $ 110,926 $ (1,217) $ 20,910 $ (504) $ 131,836 $ (1,721) 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 sponsored entities and agencies collateralized by residential mortgage obligations Private label residential mortgage backed securities $ 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) 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. 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, 2012, 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, 2012, and identified those that had an unrealized loss for at least a consecutive 12 month period, which had an unrealized loss at December 31, 2012 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 December 2012 to provide independent valuation and OTTI analysis of the 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, 2012. 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 Agencies - At December 31, 2012, the Company held four U.S. Government agency securities of which two were in a loss position for less than 12 months and none 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 U.S. Government Agencies 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, 2012. Obligations of States and Political Subdivisions - At December 31, 2012, the Company held 196 obligations of states and political subdivision securities of which 21 were in a loss position for less than 12 months and none 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, 25 25 Notes to Consolidated Financial Statements 3. INVESTMENT SECURITIES (Continued) 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, 2012. U.S. Government Sponsored Entities and Agencies Collateralized by Residential Mortgage Obligations - At December 31, 2012, the Company held 200 U.S. Government sponsored entity and agency securities collateralized by residential mortgage obligation securities of which 50 were in a loss position for less than 12 months and 21 in a loss position for more than 12 months. The unrealized losses on the Company’s investments in U.S. Government sponsored entity and agencies collateralized by residential mortgage obligations were caused by interest rate changes. The contractual cash flows of those investments are guaranteed or supported by an agency or sponsored entity 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, 2012. Private Label Residential Mortgage Backed Securities - At December 31, 2012, the Company had a total of 23 PLRMBS with a remaining principal balance of $6,258,000 and a net unrealized gain of approximately $117,000. 17 of these securities account for $323,000 of the unrealized gains at December 31, 2012, offset by six of these securities with losses totaling $206,000. Seven of these PLRMBS with a remaining principal balance of $4,806,000 had credit ratings below investment grade. The Company continues to perform extensive analyses on these securities as well as all whole loan CMOs. No credit related OTTI charges related to PLRMBS were recorded during the year ended December 31, 2012. PLRMBS as of December 31, 2012 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 Gain (Loss) $ 1,866 $ 638 285 1,673 65 235 44 1,798 $ 625 252 1,826 50 159 68 $ 4,806 $ 4,778 $ (68) (13) (33) 153 (15) (76) 24 (28) Rating D D D D C D Caa2 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 % 11.58 15.38 16.96 13.48 12.55 8.28 13.00 22.40 11.21 12.54 17.30 12.40 8.85 6.12 51.00 65.59 62.99 48.50 65.50 50.64 67.33 97.25 100.73 101.38 95.00 97.24 97.46 86.39 - - (0.72) (0.66) 2.70 - - 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. 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 Ending balance $ 783 $ Years ended December 31, 2012 2011 (In thousands) $ 783 $ 1,387 - - - 31 - (635) 783 Proceeds and gross realized gains (losses) on investment securities for the years ended December 31, 2012, 2011, and 2010 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 Years Ended December 31, 2012 2011 2010 (In thousands) $ $ $ 39,119 2,121 (482) $ $ $ 44,700 1,119 (821) $ $ $ 19,594 296 (487) The Company did not have any held-to-maturity securities during the years ended December 31, 2012 or 2011. The following tables provide a roll forward for the years ended December 31, 2012 and 2011 of investment securities credit losses recorded in earnings. The beginning balance represents the credit loss component for which OTTI occurred 26 26 Notes to Consolidated Financial Statements 3. INVESTMENT SECURITIES (Continued) 4. LOANS The amortized cost and estimated fair value of investment securities at December 31, 2012 and 2011 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. December 31, 2012 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 U.S. Government sponsored entities and agencies collateralized by residential mortgage obligations Private label residential mortgage backed securities Other equity securities 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 U.S. Government sponsored entities and agencies collateralized by residential mortgage obligations Private label residential mortgage backed securities Other equity securities Total Amortized Cost $ 150 10,355 20,256 120,551 Estimated Fair Value $ 151 11,250 22,176 128,101 151,312 161,678 9,443 9,454 206,465 208,510 6,258 7,596 6,375 7,948 $ 381,074 $ 393,965 Amortized Cost $ 569 8,705 20,553 71,352 Estimated Fair Value $ 574 9,480 22,179 76,347 101,179 108,580 - - 204,222 204,544 8,408 7,596 7,398 7,891 $ 321,405 $ 328,413 Investment securities with amortized costs totaling $81,245,000 and $102,527,000 and fair values totaling $89,343,000 and $109,119,000 were pledged as collateral for borrowing arrangements, public funds and for other purposes at December 31, 2012 and 2011, respectively. Outstanding loans are summarized as follows (in thousands): December 31, % of Total December 31, % of Total 2012 loans 2011 loans $ 77,956 19.7% $ 78,089 18.3% 26,599 6.7% 29,958 7.0% Loan Type Commercial: Commercial and industrial Agricultural land and production Total commercial 104,555 26.4% 108,047 Real estate: Owner occupied Real estate construction and other land loans Commercial real estate Agricultural real estate Other real estate 114,444 28.9% 113,183 33,199 53,797 28,400 8,098 8.4% 13.6% 7.2% 2.0% 33,047 62,523 42,596 7,892 25.3% 26.4% 7.7% 14.6% 9.9% 1.8% Total real estate 237,938 60.1% 259,241 60.4% Consumer: Equity loans and lines of credit Consumer and installment Total consumer Deferred loan fees, net Total gross loans Allowance for credit losses 10.9% 2.6% 13.5% 42,932 10,346 53,278 (453) 51,106 9,765 60,871 (764) 12.0% 2.3% 14.3% 395,318 100.0% 427,395 100.0% (10,133) (11,396) Total loans $ 385,185 $ 415,999 At December 31, 2012 and 2011, loans originated under Small Business Administration (SBA) programs totaling $5,586,000 and $6,421,000, respectively, were included in the real estate and commercial categories. Approximately $90,601,000 in loans were pledged under a blanket lien as collateral to the FHLB for the Bank’s remaining borrowing capacity of $129,034,000 as of December 31, 2012. The Bank’s credit limit varies according to the amount and composition of the investment and loan portfolios pledged as collateral. Salaries and employee benefits totaling $754,000, $229,000, and $305,000 have been deferred as loan origination costs for the years ended December 31, 2012, 2011, and 2010, respectively. 27 27 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, 2012 2011 2010 (In thousands) $ $ 11,396 700 (2,850) 887 11,014 1,050 (1,532) 864 $ 10,200 3,800 (4,122) 1,136 $ 10,133 $ 11,396 $ 11,014 The following table shows the summary of activities for the allowance for credit losses as of and for the years ended December 31, 2012 and 2011 by portfolio segment (in thousands): Allowance for credit losses: Beginning balance, January 1, 2012 Provision charged to operations Losses charged to allowance Recoveries Ending balance, December 31, 2012 Allowance for credit losses: Beginning balance, January 1, 2011 Provision charged to operations Losses charged to allowance Recoveries Ending balance, December 31, 2011 Commercial Real Estate Consumer Unallocated Total $ $ $ $ $ $ $ 2,266 18 (123) 515 2,676 2,437 (177) (280) 286 $ $ $ 7,155 643 (1,966) 45 5,877 5,836 1,403 (312) 228 $ $ $ 1,836 139 (761) 327 1,541 2,503 (77) (940) 350 $ $ $ 139 (100) - - 39 238 (99) - - 11,396 700 (2,850) 887 10,133 11,014 1,050 (1,532) 864 2,266 $ 7,155 $ 1,836 $ 139 $ 11,396 The following is a summary of the allowance for credit losses by impairment methodology and portfolio segment as of December 31, 2012 and December 31, 2011 (in thousands): Allowance for credit losses: Ending balance, December 31, 2012 Ending balance: individually evaluated for impairment Ending balance: collectively evaluated for impairment Ending balance, December 31, 2011 Ending balance: individually evaluated for impairment Ending balance: collectively evaluated for impairment Commercial Real Estate Consumer Unallocated Total $ $ $ $ $ $ 2,676 40 2,636 2,266 231 2,035 $ $ $ $ $ $ 5,877 465 5,412 7,155 3,764 3,391 $ $ $ $ $ $ 1,541 5 1,536 1,836 373 1,463 $ $ $ $ $ $ 39 - 39 139 - 139 $ $ $ $ $ $ 10,133 510 9,623 11,396 4,368 7,028 28 28 Notes to Consolidated Financial Statements 5. ALLOWANCE FOR CREDIT LOSSES (Continued) The following table shows the ending balances of loans as of December 31, 2012 and December 31, 2011 by portfolio segment and by impairment methodology (in thousands): Commercial Real Estate Consumer Total Loans: Ending balance, December 31, 2012 Ending balance: individually evaluated for impairment Ending balance: collectively evaluated for impairment Loans: Ending balance, December 31, 2011 Ending balance: individually evaluated for impairment Ending balance: collectively evaluated for impairment $ $ $ $ $ $ 104,555 2,405 102,150 108,047 3,857 104,190 $ $ $ $ $ $ 237,938 12,868 225,070 259,241 17,359 241,882 $ $ $ $ $ $ 53,278 1,832 51,446 60,871 2,428 58,443 The following table shows the loan portfolio by class allocated by management’s internal risk ratings at December 31, 2012 (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 $ 71,125 26,599 $ $ 824 - 6,007 - $ 107,281 18,517 44,880 26,883 8,098 40,527 10,259 1,831 3,377 3,952 1,517 - 258 77 5,332 11,305 4,965 - - 2,147 10 Total $ 354,169 $ 11,836 $ 29,766 $ - - - - - - - - - - $ $ $ $ $ $ $ 395,771 17,105 378,666 428,159 23,644 404,515 Total 77,956 26,599 114,444 33,199 53,797 28,400 8,098 42,932 10,346 $ 395,771 The following table shows the loan portfolio by class allocated by management’s internally assigned risk grade ratings at December 31, 2011 (in thousands): Pass Special Mention Substandard Doubtful Total 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 $ 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 Total $ 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 29 29 Current Total Loans Recorded Investment > 90 Days Accruing Non-accrual Notes to Consolidated Financial Statements 5. ALLOWANCE FOR CREDIT LOSSES (Continued) The following table shows an aging analysis of the loan portfolio by class and the time past due at December 31, 2012 (in thousands): 30-59 Days Past Due 60-89 Days Past Due Greater Than 90 Days Past Due 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 Total $ $ - - - - - - - - 27 27 $ $ - - 213 - - - - - - $ 213 $ - - - - - - - - - - Total Past Due $ - - $ 77,956 $ 77,956 $ 26,599 26,599 213 114,231 114,444 - - - - - 27 33,199 53,797 28,400 8,098 42,932 10,319 33,199 53,797 28,400 8,098 42,932 10,346 $ 240 $ 395,531 $ 395,771 $ The following table shows an aging analysis of the loan portfolio by class and the time past due at December 31, 2011 (in thousands): 30-59 Days Past Due 60-89 Days Past Due Greater Than 90 Days Past Due Total Past Due Current Total Loans Recorded Investment > 90 Days Accruing 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 Total $ 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 $ 30 30 - - - - - - - - - - - - - - - - - - - - $ - - 1,575 6,288 - - - 1,832 - $ 9,695 Non-accrual $ 267 - 1,372 6,823 3,544 - - 2,354 74 $ 14,434 Notes to Consolidated Financial Statements 5. ALLOWANCE FOR CREDIT LOSSES (Continued) The following table shows information related to impaired loans by class at December 31, 2011 (in thousands): The following table shows information related to impaired loans by class at December 31, 2012 (in thousands): Recorded Investment Unpaid Principal Balance Related Allowance 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 1,352 - - - 1,352 1,523 - 1,523 2,875 2,405 - 2,405 1,575 9,941 - - - 1,888 - - - 1,888 1,834 - 1,834 3,722 2,405 - 2,405 1,733 10,875 - - - 11,516 12,608 309 - 309 323 - 323 Total with an allowance recorded 14,230 15,336 Total $ 17,105 $ 19,058 $ - - - - - - - - - - - - - 40 - 40 165 300 - - - 465 5 - 5 510 510 Recorded Investment Unpaid Principal Balance Related Allowance 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 $ - 2,160 $ - 2,140 2,160 231 243 1,532 1,801 - - 3,564 - - - 1,906 1,801 - - 3,950 - - - Total with no related allowance recorded 5,704 6,110 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 1,717 - 1,717 1,718 - 1,718 1,141 1,216 10,911 1,743 - - 11,490 1,743 - - 13,795 14,449 2,354 74 2,428 2,581 74 2,655 - - - - - - - - - - - - - 231 - 231 268 2,130 1,366 - - 3,764 350 23 373 Total with an allowance recorded 17,940 18,822 4,368 Total $ 23,644 $ 24,932 $ 4,368 The recorded investment in loans excludes accrued interest receivable and net The recorded investment in loans excludes accrued interest receivable and net loan origination fees, due to immateriality. loan origination fees, due to immateriality. 31 31 Notes to Consolidated Financial Statements 5. ALLOWANCE FOR CREDIT LOSSES (Continued) The following presents by class, information related to the average recorded investment and interest income recognized on impaired loans for the years ended December 31, 2012 and 2011 (in thousands): 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 Year Ended December 31, 2012 Year Ended December 31, 2011 Average Recorded Investment Interest Income Recognized Average Recorded Investment Interest Income Recognized $ $ 952 - 952 1,053 4,933 301 - - 6,287 1,561 6 1,567 9,486 1,581 - 1,581 633 6,490 145 - - 7,268 600 37 637 $ - - - - - - - - - - - - - 226 - 226 - - 375 - - - 375 - - - $ 544 - 544 1,100 1,690 1,591 - - 4,381 357 - 357 5,282 505 - 505 1,193 6,544 849 - - 8,586 1,640 101 1,741 9,486 601 10,832 $ 18,972 $ 601 $ 16,114 $ - - - - - - - - - - - - - 181 - 181 - - 230 - - - 230 - - - 411 411 Foregone interest on nonaccrual loans totaled $693,000, $954,000, and $1,228,000 for the years ended December 31, 2012, 2011, and 2010, respectively. Troubled Debt Restructurings: As of December 31, 2012 and 2011, the Company has a recorded investment in troubled debt restructurings of $16,655,000 and $19,811,000, respectively. The Company has allocated $487,000 and $3,217,000 of specific reserves for those loans at December 31, 2012 and 2011, respectively. The Company has committed to lend additional amounts totaling up to $700,000 as of December 31, 2012 to customers with outstanding loans that are classified as troubled debt restructurings. For the years ending December 31, 2012 and 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 periods, there were no troubled debt restructurings in which the amount of principal or accrued interest owed from the borrower were forgiven. 32 32 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, 2012 (in thousands): Troubled Debt Restructurings: Real Estate: Real Estate - Owner occupied Consumer: Equity loans and line of credit Total Pre- Modification Outstanding Recorded Investment (1) Number of Loans Principal Modification Post Modification Outstanding Recorded Investment (2) Outstanding Recorded Investment 1 1 2 $ $ 425 $ 75 500 - - - $ $ 425 $ 75 500 $ 415 72 487 (1) Amounts represent the recorded investment in loans before recognizing effects of the TDR, if any. (2) Balance outstanding after principal modification, if any borrower reduction to recorded investment. 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 Consumer and installment Total consumer Total Pre- Modification Outstanding Recorded Investment (1) Number of Loans Principal Modification Post Modification Outstanding Recorded Investment (2) 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 2,791 2,791 1,019 10,911 1,110 13,040 1,648 - 1,648 $ 18,638 $ 17,479 (1) Amounts represent the recorded investment in loans before recognizing effects of the TDR, if any. (2) Balance outstanding after principal modification, if any borrower reduction to recorded investment. A loan is considered to be in payment default once it is 90 days contractually past due under the modified terms. There was one default on troubled debt restructurings within twelve months following the modification during the year ended December 31, 2012. The recorded investment in the one default is zero at December 31, 2012. The troubled debt restructurings described above resulted in an increase to the specific reserves added to the allowance for credit losses of $152,000 during the year ending December 31, 2012 compared to $1,471,000 in specific reserves added to the allowance for credit losses during the year ending December 31, 2011. The commercial real estate restructured debt outstanding at December 31, 2011 was charged off and transferred to other real estate owned the first quarter of 2012. The property has subsequently been sold. Only one other restructured debt outstanding at December 31, 2011 reported above under real estate owner occupied was charged off during 2012. 33 33 Notes to Consolidated Financial Statements 6. BANK PREMISES AND EQUIPMENT 8. DEPOSITS Bank premises and equipment consisted of the following: Interest-bearing deposits consisted of the following: Land Buildings and improvements Furniture, fixtures and equipment Leasehold improvements Less accumulated depreciation and amortization December 31, 2012 2011 (In thousands) $ $ 838 3,362 8,351 3,804 838 3,354 7,813 3,599 16,355 15,604 (10,103) (9,732) $ 6,252 $ 5,872 Savings Money market NOW accounts Time, $100,000 or more Time, under $100,000 December 31, 2012 2011 (In thousands) $ $ 39,573 173,486 161,328 91,880 44,996 31,267 181,731 140,268 102,577 49,118 $ 511,263 $ 504,961 Aggregate annual maturities of time deposits are as follows (in thousands): Depreciation and amortization included in occupancy and equipment expense totaled $972,000, $1,212,000 and $1,262,000 for the years ended December 31, 2012, 2011, and 2010, respectively. 7. OTHER REAL ESTATE OWNED The Company had no other real estate owned (OREO) at December 31, 2012 and 2011. The table below provides a summary of the change in other real estate owned (OREO) balances for the years ended December 31, 2012 and 2011. Years Ending December 31, 2013 2014 2015 2016 2017 Thereafter $ 109,004 8,572 6,887 1,505 10,908 - $ 136,876 Balance, Beginning of year Additions Dispositions Write-downs Net gain on disposition Balance, End of year December 31, 2012 2011 (In thousands) $ $ $ - 2,337 (2,349) - 12 - $ 1,325 532 (2,472) - 615 - As of December 31, 2012 the Bank had no OREO properties. In 2012, the Bank foreclosed on six properties with net realizable values totaling $2,337,000 and sold them for a net gain of $12,000. Two of the properties the Bank foreclosed on were mini storage facilities which were collateralized by real estate with net realizable values totaling $2,098,000. The Company realized losses of $6,000 on the sale of the properties. The Bank received income of $90,000 during 2012 from operations of the storage facilities. As of December 31, 2011 the Bank had no OREO properties. In 2011, the Bank foreclosed on three properties collateralized by real estate. During the year ended December 31, 2011, the remaining 12 units of the medical office condominium projects held at the end of 2010 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. Interest expense recognized on interest-bearing deposits consisted of the following: Savings Money market NOW accounts Time certificates of deposit Years Ended December 31, 2012 2011 2010 (In thousands) 47 $ 692 321 1,602 32 392 270 936 $ 52 1,035 447 2,179 1,630 $ 2,662 $ 3,713 $ $ 9. BORROWING ARRANGEMENTS Federal Home Loan Bank Advances - Advances from the Federal Home Loan Bank (FHLB) of San Francisco consisted of the following (dollars in thousands): December 31, 2012 Amount $ $ 4,000 4,000 (4,000) - December 31, 2011 Amount $ $ 4,000 4,000 - 4,000 Rate 3.59% Maturity Date February 12, 2013 Less short-term portion Long-term debt FHLB advances are secured by investment securities with amortized costs totaling $4,016,000 and $15,272,000 and market values totaling $4,225,000 and $15,683,000 at December 31, 2012 and 2011, 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, 2012 and 2011, the Company had no Federal funds purchased. 34 34 Notes to Consolidated Financial Statements 9. BORROWING ARRANGEMENTS (Continued) Lines of Credit - The Bank had unsecured lines of credit with its correspondent banks which, in the aggregate, amounted to $40,000,000 at December 31, 2012 and $44,000,000 at December 31, 2011, at interest rates which vary with market conditions. The Bank also had a line of credit in the amount of $127,000 and $551,000 with the Federal Reserve Bank of San Francisco at December 31, 2012 and 2011, respectively which bears interest at the prevailing discount rate collateralized by investment securities with amortized costs totaling $115,000 and $542,000 and market values totaling $129,000 and $562,000, respectively. At December 31, 2012 and 2011, 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, 2012, 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, 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 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, 2012, the rate was 1.94%. Interest expense recognized by the Company for the years ended December 31, 2012, 2011, and 2010 was $107,000, $100,000 and $102,000, respectively. 11. INCOME TAXES The provision for (benefit from) income taxes for the years ended December 31, 2012, 2011, and 2010 consisted of the following: 2012 Current Deferred Provision for income taxes 2011 Current Deferred Provision for income taxes 2010 Current Deferred Benefit from income taxes Federal State Total (In thousands) $ $ $ $ $ $ 1,196 249 1,445 686 893 1,579 1,472 (1,677) (205) $ $ $ $ $ $ 49 191 240 (95) 377 282 496 (660) (164) $ $ $ $ $ $ 1,245 440 1,685 591 1,270 1,861 1,968 (2,337) (369) 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. The balance of the allowance as of December 31, 2012, was $110,000. 35 35 Notes to Consolidated Financial Statements 11. INCOME TAXES (Continued) Deferred tax assets (liabilities) consisted of the following: $ 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 than temporary impairment Loan and investment impairment State Enterprise Zone credit carry-forward State capital loss carry-forward Alternative minimum tax credit State taxes Other Partnership income December 31, 2012 2011 (In thousands) $ 4,170 3,832 521 862 184 253 282 352 783 110 1,025 20 7 77 4,690 3,660 1,188 909 416 231 282 352 522 114 530 58 - 74 Total deferred tax assets Valuation allowance Net deferred tax asset after valuation allowance 12,478 (110) 13,026 (114) 12,368 12,912 Deferred tax liabilities: Finance leases Unrealized gain on available-for-sale investment securities Core deposit intangible FHLB stock Loan origination costs Total deferred tax liabilities (2,548) (5,305) (240) (241) (256) (8,590) (2,650) (2,884) (322) (241) (176) (6,273) Net deferred tax assets $ 3,778 $ 6,639 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, 2012, 2011, and 2010 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 2012 2011 2010 34.0 % 34.0 % 34.0 % 2.8 % 3.6 % (3.7)% (16.7)% (1.4)% (1.4)% 0.5 % 0.5 % (14.0)% (1.6)% (1.6)% 0.5 % 1.4 % (34.7)% (4.6)% (5.4)% (1.3)% 3.0 % Effective tax rate 18.3 % 22.3 % (12.7)% At December 31, 2012, the Company had Federal and California net operating loss (‘‘NOL’’) carry-forwards of approximately $1,110,000 and $2,003,000, 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. 36 36 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, 2012, 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, 2009 and by the state and local taxing authorities for the years ended before December 31, 2008. A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows (in thousands): Balance at January 1, 2012 Additions based on tax positions related to the current year Reductions for tax positions of prior years Balance at December 31, 2012 $ $ 255 61 - 316 This 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, 2012, 2011, and 2010, the Company did not recognize any interest and 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 $1,947,000, $1,982,000 and $1,922,000 for the years ended December 31, 2012, 2011, and 2010, respectively. Future minimum lease payments on noncancelable operating leases are as follows (in thousands): Years Ending December 31, 2013 2014 2015 2016 2017 Thereafter $ 1,941 1,897 1,719 1,272 883 3,870 $ 11,582 Federal Reserve Requirements - Banks are required to maintain reserves with the Federal Reserve Bank equal to a percentage of their reservable deposits. The Bank had no reserve balances required at December 31, 2012. 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, 2012. 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. Notes to Consolidated Financial Statements 12. COMMITMENTS AND CONTINGENCIES (Continued) The following financial instruments represent off-balance-sheet credit risk: Commitments to extend credit Standby letters of credit December 31, 2012 2011 (In thousands) $ $ 162,261 590 $ $ 128,585 420 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 financial obligation or 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, 2012 and 2011. The Company recognizes these fees as revenue over the term of the commitment or when the commitment is used. At December 31, 2012, commercial loan commitments represent 59% of total commitments and are generally secured by collateral other than real estate or unsecured. Real estate loan commitments represent 31% 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 10% of total commitments and are generally unsecured. In addition, the majority of the Bank’s loan commitments have variable interest rates. At December 31, 2012, the balance of a contingent allocation for probable loan loss experience on unfunded obligations was $110,000. The contingent allocation for probable loan loss experience on unfunded obligations is calculated by management using an appropriate, systematic, and consistently applied process. While related to credit losses, this allocation is not a part of the ALLL and is considered separately as a liability for accounting and regulatory reporting purposes. There was no contingent allocation recorded at December 31, 2011. Concentrations of Credit Risk - At December 31, 2012, 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 26.4% were commercial and 71.0% were real-estate-related. 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. 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. 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 considers capital requirements as part of its strategic planning process. The strategic plan calls for continuing increases in assets and liabilities, and if the capital required to support such increases is in excess of retained earnings, the Company may be required to go the capital markets. 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 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 including acquisition opportunities. Management believes that the Company and the Bank met all their capital adequacy requirements as of December 31, 2012 and 2011. There are no conditions or events since those notifications that management believes have changed those categories. 37 37 Notes to Consolidated Financial Statements 13. SHAREHOLDERS’ EQUITY (Continued) 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, 2012 December 31, 2011 Amount Ratio Amount Ratio (Dollars in thousands) $ 90,866 $ 34,418 $ 87,911 10.56% $ 82,571 4.00% $ 32,612 10.22% $ 81,599 10.13% 4.00% 10.01% $ 42,994 $ 34,395 5.00% $ 40,743 4.00% $ 32,594 5.00% 4.00% $ 90,866 $ 19,926 $ 87,911 18.24% $ 82,571 4.00% $ 20,383 17.67% $ 81,599 16.20% 4.00% 16.02% $ 29,848 $ 19,899 6.00% $ 30,554 4.00% $ 20,369 6.00% 4.00% $ 97,299 $ 39,853 $ 94,336 19.53% $ 89,136 8.00% $ 40,767 18.96% $ 88,159 17.49% 8.00% 17.31% $ 49,747 $ 39,798 10.00% $ 50,923 8.00% $ 40,738 10.00% 8.00% Dividends - During 2012, the Bank declared and paid cash dividends to the Company in the amount of $3,000,000, in connection with stock repurchase agreements and cash dividends approved by the Company’s Board of Directors. The Bank would not pay any dividend that would cause it to be deemed not ‘‘well capitalized’’ under applicable banking laws and regulations. On October 17, 2012, the Board of Directors declared a $480,000 or $0.05 per common share cash dividend to shareholders of record at the close of business on November 15, 2012 which was paid on November 30, 2012. No dividends on common shares were declared in 2011 or 2010. 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, 2012, retained earnings of $15,504,000 were free of such restrictions. Share Repurchase Plan - On August 15, 2012, the Board of Directors of the Company approved the adoption of a program to effect repurchases of the Company’s common stock. Under the program, the Company was to repurchase up to five percent of the Company’s outstanding shares of common stock, or approximately 479,850 shares based on the shares outstanding as of August 15, 2012, for the period beginning on August 15, 2012 and ending February 15, 2013. During 2012, the Company repurchased and retired a total of 58,100 shares at an average price of $8.41 for a total cost of $488,000. The stock repurchase program was suspended after the Company entered into a Reorganization Agreement and Plan of Merger (the Merger Agreement) with Visalia Community Bank on December 19, 2012. 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 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 qualify as Tier 1 capital and 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 Shares may be redeemed by the Company or by Treasury in the event that it is statutorily prevented from continuing to hold the Preferred Shares. The Preferred Shares are non-voting, other than class voting rights on (i) any authorization or issuance of shares ranking senior to the Preferred Shares, (ii) any amendment to the rights of the Preferred Shares, or (iii) any merger, exchange or similar transaction which would adversely affect the rights of the Preferred Shares. If dividends on the Preferred Shares are not paid in full for six dividend periods, whether or not consecutive, the holders of the Preferred Shares 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, 2012. 38 38 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, 2012 2011 2010 (In thousands, except share and per share amounts) Basic Earnings Per Common Share: Net income Less: Preferred stock dividends and accretion $ 7,520 $ 6,477 $ 3,279 (350) (486) (395) $ 7,170 $ 5,991 $ 2,884 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 $ $ 9,587,784 9,522,066 9,209,858 0.75 $ 0.63 $ 0.31 7,520 $ 6,477 $ 3,279 (350) (486) (395) 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 $ 7,170 $ 5,991 $ 2,884 9,587,784 9,522,066 9,209,858 28,629 16,596 80,813 9,616,413 9,538,662 9,290,671 Net income per diluted common share $ 0.75 $ 0.63 $ 0.31 Outstanding options and warrants of 352,319, 436,619, and 531,996 were not factored into the calculation of dilutive stock options at December 31, 2012, 2011, and 2010, respectively, because they were anti-dilutive. 14. SHARE-BASED COMPENSATION On December 31, 2012, 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 317,799 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 181,490 shares reserved for issuance for options already granted to employees and 292,960 remain reserved for future grants as of December 31, 2012. 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. In 2012, options to purchase 92,150 shares of common stock were granted from the 2005 Plan at exercise prices between $8.02 and $8.75. No options to purchase shares of the Company’s common stock were granted 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. 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, dividend yields, 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 and dividend yields. In addition to these assumptions, management makes estates regarding pre-vesting forfeitures that will impact total compensation expense recognized under the plans. The fair value of each option is estimated on the date of grant using the following assumptions: Dividend yield Expected volatility Risk-free interest rate Expected option term 2012 0.00% 42% 0.71% 6.5 years For the years ended December 31, 2012, 2011, and 2010, the compensation cost recognized for share based compensation was $108,000, $196,000, and $239,000, respectively. The recognized tax benefit for share based compensation expense was $16,000, $36,000, and $42,000 for 2012, 2011, and 2010, respectively. 39 39 Notes to Consolidated Financial Statements 14. SHARE-BASED COMPENSATION (Continued) A summary of the combined activity of the Plans for the year ended December 31, 2012 follows: Weighted Average Exercise Price Weighted Average Remaining Contractual Term (Years) Shares Aggregate Intrinsic Value (Dollars in thousands, except per share amounts) 511,019 92,150 $ (69,030) $ (34,850) $ 8.03 5.59 9.91 499,289 $ 8.78 4.61 $ 284 491,705 $ 8.80 4.55 $ 358,279 $ 9.40 2.91 $ 186 181 Options outstanding at January 1, 2012 Options granted Options exercised Options forfeited Options outstanding at December 31, 2012 Options vested or expected to vest at December 31, 2012 Options exercisable at December 31, 2012 Information related to the stock option plan during each year follows: 2012 2011 2010 (In thousands, except per share amounts) Weighted-average per share grant-date fair value of options granted Intrinsic value of options exercised Cash received from options exercised Excess tax benefit realized for option exercises $ $ $ $ 3.40 93 385 26 $ $ $ $ - 417 680 116 $ $ $ $ 2.58 349 550 28 As of December 31, 2012, there was $374,000 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 1.98 years. The total fair value of options vested was $140,000 and $123,000 for the years ended December 31,2012 and 2011, 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 (3.32% at December 31, 2012). At December 31, 2012 and 2011, the total net deferrals included in accrued interest payable and other liabilities were $1,978,000 and $2,297,000, 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 $3,308,000 and $3,205,000 and at December 31, 2012 and 2011, respectively. Income recognized on these policies, net of related expenses, for the years ended December 31, 2012, 2011, and 2010, was $103,000, $98,000, and $100,000, 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, 2012, 2011, and 2010, totaled $658,000, $341,000, and $450,000, respectively. Accrued compensation payable under the salary continuation plans totaled $4,339,000 and $3,764,000 at December 31, 2012 and 2011, respectively. In connection with these plans, the Bank purchased single premium life insurance policies with cash surrender values totaling $4,659,000 and $4,393,000 at December 31, 2012 and 2011, respectively. Income recognized on these policies, net of related expense, for the years ended December 31, 2012, 2011, and 2010 totaled $150,000, $144,000, and $152,000, 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, 2012 and 2011, the total amount of the liability was $1,807,000 and $1,694,000, respectively. Expense recognized by the Bank in 2012, 2011 and 2010 associated with these plans was $184,000, $98,000, and $95,000, 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 $4,196,000, and $4,057,000 at December 31, 2012 and 2011, respectively. Income recognized on these policies, net of related expenses, for the years ended December 31, 2012, 2011, and 2010, was $150,000, $140,000, and $140,000, respectively. The current annual tax-free interest rate on all life insurance policies is 5.17%. 15. EMPLOYEE BENEFITS 16. LOANS TO RELATED PARTIES 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 $210,000 and $150,000 to the profit sharing plan in 2012 and 2011, respectively. The Bank did not contribute to the profit sharing plan in 2010. 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, 2012, 2011, and 2010, 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, 2012, 2011, and 2010, the Bank made matching contributions totaling $388,000, $352,000, and $336,000, respectively. 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): Balance, January 1, 2012 Disbursements Amounts repaid Balance, December 31, 2012 Undisbursed commitments to related parties, December 31, 2012 $ $ $ 919 380 (583) 716 464 40 40 Notes to Consolidated Financial Statements 17. PARENT ONLY CONDENSED FINANCIAL STATEMENTS CONDENSED BALANCE SHEETS December 31, 2012 and 2011 (In thousands) ASSETS Cash and cash equivalents Investment in Bank subsidiary Other assets Total assets LIABILITIES AND SHAREHOLDERS’ EQUITY Liabilities: Junior subordinated debentures due to subsidiary grantor trust Other liabilities Total liabilities Shareholders’ equity: $ $ 5,155 375 5,530 5,155 197 5,352 7,000 40,552 55,806 4,124 Preferred stock, Series C Common stock Retained earnings Accumulated other comprehensive income, net of tax 7,000 40,583 62,496 7,586 Total shareholders’ equity 117,665 107,482 Total liabilities and shareholders’ equity $ 123,195 $ 112,834 CONDENSED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME For the Years Ended December 31, 2012, 2011, and 2010 (In thousands) 2012 2011 2010 2012 2011 $ 2,807 119,812 576 $ 969 111,357 508 $ 123,195 $ 112,834 Income: Dividends declared by Subsidiary - eliminated in consolidation $ Other income Total income $ 3,000 3 3,003 $ - 3 3 Expenses: Interest on junior subordinated deferrable interest debentures Professional fees Other expenses Total expenses Income (loss) before equity in undistributed net income of Subsidiary Equity in undistributed net income of Subsidiary Income before income tax benefit Benefit from income taxes Net income Preferred stock dividend and accretion of discount Income available to common shareholders Comprehensive income 107 140 587 834 2,169 4,993 7,162 358 7,520 350 100 148 352 600 (597) 6,854 6,257 220 6,477 486 $ $ 7,170 10,982 $ $ 5,991 9,634 $ $ - 3 3 102 147 329 578 (575) 3,657 3,082 197 3,279 395 2,884 5,701 41 41 2012 2011 2010 $ 7,520 $ 6,477 $ 3,279 (4,993) 108 (26) (28) 179 (15) 2,745 (480) (350) (488) 385 - 26 (907) 1,838 969 2,807 109 - $ $ $ (6,854) 196 (116) (50) (23) (36) (406) - (307) - 680 (185) 116 304 (102) 1,071 969 98 7,000 $ $ $ (3,657) 239 (28) 170 23 (43) (17) - (349) - 550 - 28 229 212 859 1,071 101 - $ $ $ Notes to Consolidated Financial Statements 17. PARENT ONLY CONDENSED FINANCIAL STATEMENTS (Continued) CONDENSED STATEMENTS OF CASH FLOWS For the Years Ended December 31, 2012, 2011, and 2010 (In thousands) Cash flows from operating activities: Net income Adjustments to reconcile net income to net cash provided by (used in) 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 increase (decrease) in other liabilities Benefit for deferred income taxes Net cash provided by (used in) operating activities Cash flows from financing activities: Cash dividend payments on common stock Cash dividend payments on preferred stock Share repurchase and retirement Proceeds from exercise of stock options Warrant purchase Tax benefit from exercise of stock options Net cash (used in) provided by financing activities Increase (decrease) 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 18. PENDING ACQUISITION On December 19, 2012, the Company and Visalia Community Bank, headquartered in Visalia, California, entered into a Reorganization Agreement and Plan of Merger (the Merger Agreement). Under the terms of the agreement, Visalia Community Bank with four branches in Visalia and one branch in Exeter, will merge with the Company’s subsidiary. The transaction is subject to customary closing conditions, including regulatory approvals and approval by Visalia Community Bank’s shareholders. The Company and Visalia Community Bank boards of directors have unanimously approved the transaction, which is expected to close in the second quarter of 2013. The transaction is initially valued at approximately $22.1 million or $52.00 per share to Visalia Community Bank shareholders. The purchase price is to be paid half in cash and half in Company common stock. Based on a value of $8.75 per share of Company common stock, using the 30-day volume weighted average trading price at the time when the principal terms of the agreement were being established, in the aggregate approximately 1.263 million shares of Company common stock would be issued and $11,050,000 would be paid in cash. As a result, Visalia Community Bank shareholders would be entitled to receive approximately $26.00 and 2.97 shares of Company common stock per share. The total purchase price is subject to adjustments and closing conditions, including potential adjustments if the volume weighted average trading price of Company common shares rises or falls beyond certain levels prior to closing. 42 42 Report of Independent Registered Public Accounting Firm The Shareholders and Board of Directors Central Valley Community Bancorp and Subsidiary Fresno, California We have audited the accompanying consolidated balance sheets of Central Valley Community Bancorp and subsidiary (the ‘‘Company’’) as of December 31, 2012 and 2011, and the related consolidated statements of income, comprehensive income, changes in shareholders’ equity, and cash flows for the years 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 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 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 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 financial position of the Company as of December 31, 2012 and 2011, and the results of its operations and its cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles. Sacramento, California March 20, 2013 43 43 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 statements of income, comprehensive income, changes in shareholders’ equity and cash flows of Central Valley Community Bancorp and subsidiary (the ‘‘Company’’) for the year ended December 31, 2010. 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 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 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 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 consolidated results of operations and cash flows of Central Valley Community Bancorp and subsidiary for the year ended December 31, 2010, in conformity with U.S. generally accepted accounting principles. Sacramento, California March 16, 2011 44 44 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 provision for (benefit from) income taxes Provision for (benefit from) 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) 2012 2011 2010 2009 2008 $ 31,820 $ 1,883 34,299 $ 2,942 36,013 $ 4,283 40,734 $ 6,627 29,937 700 29,237 7,242 27,274 9,205 1,685 7,520 350 31,357 1,050 30,307 6,271 28,240 8,338 1,861 6,477 486 31,730 3,800 27,930 3,711 28,731 2,910 (369) 3,279 395 34,107 10,514 23,593 5,850 27,531 1,912 (676) 2,588 365 7,170 $ 0.75 $ 5,991 $ 0.63 $ 2,884 $ 0.31 $ 2,223 $ 0.29 $ 0.75 $ 0.63 $ 0.31 $ 0.28 $ 0.05 $ - $ - $ - $ December 31, (In Thousands) 31,845 7,278 24,567 1,290 23,277 5,190 20,976 7,491 2,352 5,139 - 5,139 0.83 0.79 0.10 2012 2011 2010 2009 2008 424,516 $ 385,185 751,432 890,228 117,665 801,098 353,808 $ 415,999 712,986 849,023 107,482 762,654 280,967 $ 420,583 650,495 777,594 97,391 695,410 232,142 $ 449,007 640,167 765,488 91,223 677,955 194,215 477,015 635,058 752,713 75,375 665,530 368,818 $ 394,675 719,601 853,078 114,561 766,937 299,935 $ 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 $ $ $ $ $ $ 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 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 2012 Q3 2012 Q2 2012 Q1 2012 Q4 2011 Q3 2011 Q2 2011 Q1 2011 $ $ $ $ $ 7,189 $ 200 7,572 $ - 7,510 $ 100 7,666 $ 400 8,016 $ 300 7,949 $ 400 7,794 $ 250 6,989 1,829 6,983 193 7,572 2,284 6,655 745 7,410 1,471 6,718 454 7,266 1,658 6,918 293 7,716 1,336 6,803 541 7,549 1,595 7,222 514 7,544 1,597 7,067 301 1,642 $ 2,456 $ 1,709 $ 1,713 $ 1,708 $ 1,408 $ 1,773 $ 1,554 $ 2,369 $ 1,622 $ 1,625 $ 1,622 $ 1,206 $ 1,674 $ 0.16 $ 0.16 $ 0.25 $ 0.25 $ 0.17 $ 0.17 $ 0.17 $ 0.17 $ 0.17 $ 0.17 $ 0.13 $ 0.13 $ 0.18 $ 0.18 $ 7,598 100 7,498 1,748 7,153 505 1,588 1,489 0.16 0.16 45 45 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.’’ 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 2012, 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 December 2012, the Company and Visalia Community Bank, headquartered in Visalia, California, entered into a Reorganization Agreement and Plan of Merger (the Merger Agreement). Under the terms of the agreement, Visalia Community Bank, with four branches in Visalia and one branch in Exeter, will merge with Central Valley Community Bancorp’s subsidiary, Central Valley Community Bank (the Merger). The transaction is subject to customary closing conditions, including regulatory approvals and approval by Visalia Community Bank’s shareholders. The Central Valley Community Bancorp and Visalia Community Bank boards of directors have unanimously approved the transaction, which is expected to close in the second quarter of 2013. 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. 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. Since 2007, 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, 2012 was $0.75 compared to $0.63 and $0.31 for the years ended December 31, 2011 and 2010, respectively. Net income for 2012 was $7,520,000 compared to $6,477,000 and $3,279,000 for the years ended December 31, 2012, 2011, and 2010, respectively. The increase in net income and EPS was primarily driven by lower provision for credit losses, decrease in non-interest expense and increase in non-interest income, partially offset by decreases in net interest income in 2012 compared to 2011. Total assets at December 31, 2012 were $890,228,000 compared to $849,023,000 at December 31, 2011. Return on average equity for 2012 was 6.56% compared to 6.26% and 3.41% for 2011 and 2010, respectively. Return on average assets for 2012 was 0.88% compared to 0.81% and 0.43% for 2011 and 2010, respectively. Total equity was $117,665,000 at December 31, 2012 compared to $107,482,000 at December 31, 2011. The increase in assets and equity in 2012 compared to 2011 is due to an increase in deposits and increases in other comprehensive income and retained earnings. Average total loans decreased $23,251,000 or 5.43% to $405,040,000 in 2012 compared to $428,291,000 in 2011. In 2012, we recorded a provision for credit losses of $700,000 compared to $1,050,000 in 2011 and $3,800,000 in 2010. The Company had nonperforming assets totaling $9,695,000 at December 31, 2012. Nonperforming assets included nonaccrual loans totaling $9,695,000. At December 31, 2011, nonperforming assets totaled $14,434,000 consisting of $14,434,000 in nonaccrual loans. Net charge-offs for 2012 were $1,963,000 compared to $668,000 for 2011 and $2,986,000 for 2010. Refer to ‘‘Asset Quality’’ below for further information. 46 46 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 shareholders; • Return on average assets; • Development of revenue streams, including net interest income and non-interest income; • Asset quality; • Asset growth; • Capital adequacy; • Operating efficiency; and • Liquidity. Return to Our Shareholders Our return to our shareholders is measured in a ratio that measures the return on average equity (ROE). Our ROE was 6.56% for the year ended 2012 compared to 6.26% and 3.41% for the years ended 2011 and 2010, respectively. In 2012, compared to 2011 we experienced an increase in net income and an increase in capital due to increases in retained earnings and other comprehensive income. Our net income for the year ended December 31, 2012 increased $1,043,000 compared to 2011 and increased $3,198,000 for 2011 compared to 2010. During 2012, net income increased due to decreases in non-interest expenses, increases in non-interest income, a decrease in the provision for credit losses and a decrease in tax expense, partially offset by decreases in net interest income in 2012 compared to 2011. 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 a net realized gain on sale of investment securities of $1,639,000 in 2012, compared to $298,000 in 2011 and an increase in loan placement fees of $357,000, partially offset by a decrease of $603,000 in gains on the sale of other real estate owned, and a $129,000 decrease in service charge income. Non-interest expenses decreased in 2012 compared to 2011 primarily due to decreases in amortization of core deposit intangibles of $214,000, salary and employee benefit expenses of $165,000, legal fees of $150,000, occupancy and equipment expenses of $217,000, regulatory assessments of $193,000, and advertising fees of $177,000, partially offset by increase in merger-related expenses of $284,000 and other real estate owned expenses of $63,000. During 2012, our net interest margin (NIM) decreased 42 basis points compared to 2011. Basic EPS was $0.75 for 2012 compared to $0.63 and $0.31 for 2011 and 2010, respectively. Diluted EPS was $0.75 for 2012 compared to $0.63 and $0.31 for 2011 and 2010, respectively. The increase in EPS in 2012 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 2012 was 0.88% compared to 0.81% and 0.43% for the years ended December 31, 2011 and 2010, respectively. The 2012 increase in ROA is due to the increase in net income, notwithstanding an increase in average assets. Annualized ROA for our peer group was 0.87% at September 30, 2012. 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 Revenue Streams 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 4.21% for the year ended December 31, 2012, compared to 4.63% and 4.95% for the years ended December 31, 2011 and 2010, respectively. The decrease in net interest margin compared to 2011 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 58 basis points, while the cost of total interest- bearing liabilities decreased 21 basis points and the cost of total deposits decreased 16 basis points. Our cost of total deposits in 2012 was 0.23% compared to 0.39% for the same period in 2011 and 0.58% for the year ended December 31, 2010. Our net interest income before provision for credit losses decreased $1,420,000 or 4.53% to $29,937,000 for the year ended 2012 compared to $31,357,000 and $31,730,000 for the years ended 2011 and 2010, 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 2012 increased $971,000 or 15.48% to $7,242,000 compared to $6,271,000 in 2011 and $3,711,000 in 2010. The increase resulted primarily from an increase in net realized gains on sales and calls of investment securities and an increase in loan placement fees compared to the comparable 2011 period, partially offset by a decrease in gain on sale of other real estate owned and a decrease in service charge income. The net gain realized on sales and calls of investment securities was the result of a partial restructuring of the investment portfolio designed to improve the future performance of the portfolio. Customer service charges decreased $129,000 or 4.44% to $2,774,000 in 2012 compared to $2,903,000 and $3,225,000 in 2011 and 2010, 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 $9,695,000 and $14,434,000 at December 31, 2012 and 2011, respectively. Nonperforming assets totaled 2.45% of gross loans as of December 31, 2012 and 3.38% of gross loans as of December 31, 2011. The Company had no other real estate owned at December 31, 2012 and 2011. 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 4.85% during 2012 to $890,228,000 as of December 31, 2012 from $849,023,000 as of December 31, 2011. Total gross loans decreased 7.51% to $395,318,000 as of December 31, 2012, compared to $427,395,000 at December 31, 2011. Total investment securities and Federal funds sold increased 19.75% to $394,393,000 as of December 31, 2012 compared to $329,341,000 as of December 31, 2011. Total deposits increased 5.39% to $751,432,000 as of December 31, 2012 compared to $712,986,000 as of December 31, 2011. Our loan to deposit ratio at December 31, 2012 was 52.61% compared to 59.94% at December 31, 2011. The loan to deposit ratio of our peers was 70.66% at September 30, 2012. Over the past several years, we have focused on not only our net income, but Capital Adequacy improving the consistency of our revenue streams 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 At December 31, 2012, we had a total capital to risk-weighted assets ratio of 19.53%, a Tier 1 risk-based capital ratio of 18.24% and a leverage ratio of 10.56%. At December 31, 2011, we had a total capital to risk-weighted assets 47 47 Management’s Discussion and Analysis of Financial Condition and Results of Operations OVERVIEW (Continued) ratio of 17.49%, a Tier 1 risk-based capital ratio of 16.20% and a leverage ratio of 10.13%. At December 31, 2012, on a stand-alone basis, the Bank had a total risk-based capital ratio of 18.96%, a Tier 1 risk based capital ratio of 17.67% and a leverage ratio of 10.22%. At December 31, 2011, the Bank had a total risk-based capital ratio of 17.31%, Tier 1 risk-based capital of 16.02% and a leverage ratio of 10.01%. The improvement in 2012 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. 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 75.99% for 2012 compared to 75.67% for 2011 and 73.55% for 2010. The decline in the efficiency ratio in 2012 is due to a decrease in net interest income that is greater than the decrease in operating expenses. The decline in the efficiency ratio in 2011 compared to 2010 is due to an increase in operating expenses and a decrease in net interest income. The efficiency ratio in 2010 declined as compared to 2009 due to a decrease in net interest income and non-interest income. The Company’s net interest income before provision for credit losses plus non-interest income decreased 1.19% to $37,179,000 in 2012 compared to $37,628,000 in 2011 and $35,441,000 in 2010, while operating expenses decreased 3.42% in 2012 and 1.71% in 2011. Operating expenses increased 4.36% in 2010. 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 $40,000,000 and secured borrowing lines of approximately $133,034,000 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 $446,921,000 or 50.20% of total assets at December 31, 2012 and $373,217,000 or 43.96% of total assets as of December 31, 2011. RESULTS OF OPERATIONS NET INCOME Net income was $7,520,000 in 2012 compared to $6,477,000 and $3,279,000 in 2011 and 2010, respectively. Basic earnings per share was $0.75, $0.63, and $0.31 for 2012, 2011, and 2010, respectively. Diluted earnings per share was $0.75, $0.63, and $0.31 for 2012, 2011, and 2010, respectively. ROE was 6.56% for 2012 compared to 6.26% for 2011 and 3.41% for 2010. ROA for 2012 was 0.88% compared to 0.81% for 2011 and 0.43% for 2010. The increase in net income for 2012 compared to 2011 can be attributed to the decrease in the provision for credit losses, an increase in non interest income, and a decrease in provision for income taxes, partially offset by decrease in interest income. The decrease in net interest income for 2012 compared to 2011 was due primarily to the 42 basis point reduction in the net interest margin. 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 an increase in provision from income taxes. 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. 48 48 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, 2012 Year Ended December 31, 2011 Year Ended December 31, 2010 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 and interest-earning deposits Loans (2) (3) Federal Home Loan Bank stock $ 36,836 $ 218,325 113,039 331,364 618 368,818 394,575 3,544 108 3,289 6,830 10,119 2 10,229 23,913 36 Total interest-earning assets 766,937 $ 34,178 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 $ $ (10,365) 10,465 919 19,525 6,217 59,380 853,078 177,205 $ 178,734 59,838 86,295 502,072 9,156 Total interest-bearing liabilities 511,228 $ Non-interest bearing demand deposits Other liabilities Shareholders’ equity 217,529 9,760 114,561 Total average liabilities and shareholders’ equity $ 853,078 302 392 466 470 1,630 253 1,883 0.29% $ 73,016 $ 0.26% $ 42,047 $ 1.51% 6.04% 3.05% 0.30% 2.77% 6.06% 1.02% 4.46% 0.17% 0.22% 0.78% 0.54% 0.32% 2.76% 0.37% 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 9 715,862 $ 36,092 $ $ (11,018) 15,322 217 17,977 5,788 56,030 800,178 154,765 $ 174,049 70,111 96,620 495,545 10,265 505,810 $ 182,244 8,738 103,386 368 692 688 914 2,662 280 2,942 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 0.26% 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% $ 800,178 $ 758,852 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) $ 34,178 4.46% $ 36,092 5.04% $ 37,590 5.59% 1,883 0.37% 2,942 0.58% 4,283 0.85% $ 32,295 4.21% $ 33,150 4.63% $ 33,307 4.95% (1) Calculated on a fully tax equivalent basis, which includes Federal tax benefits relating to income earned on municipal bonds totaling $2,322, $1,784, and $1,566 in 2012, 2011, and 2010, respectively. (2) Loan interest income includes loan fees of $646 in 2012, $399 in 2011, and $460 in 2010. (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. 49 49 Management’s Discussion and Analysis of Financial Condition and Results of Operations INTEREST INCOME AND EXPENSE (Continued) Interest and fee income from loans decreased $2,185,000 or 8.37% in 2012 compared to 2011. Interest and fee income decreased $1,292,000 or 4.72% in 2011 compared to 2010. The decrease in 2012 is attributable to a decrease in average total loans outstanding combined with a 26 basis point decrease in the yield on loans. The decrease in 2011 is attributable to a decrease in average total loans outstanding and a 7 basis point decrease in yield on loans compared to 2010. Average total loans for 2012 decreased $23,251,000 to $405,040,000 compared to $428,291,000 for 2011 and $455,340,000 for 2010. The yield on loans for 2012 was 6.06% compared to 6.32% and 6.25% for 2011 and 2010, respectively. Interest income from total investments on a non tax-equivalent basis, (total investments include investment securities, Federal funds sold, interest-bearing deposits in other banks, and other securities), decreased $294,000 or 3.58% in 2012 compared to 2011. The yield on average investments decreased 56 basis points to 2.77% for the year ended December 31, 2012 from 3.33% for the year ended December 31, 2011. The increase of the investment portfolio balance at significantly reduced yields contributed to the decreases in net interest income and net interest margin. Average total investments increased $68,883,000 to $368,818,000 in 2012 compared to $299,935,000 in 2011. In 2011, total investment income decreased $422,000 or 4.89% 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, for 2010, coupled with a decrease in yield on investments of 107 basis points. A significant portion of the investment portfolio is mortgage-backed securities (MBS) and collateralized mortgage obligations (CMOs). At December 31, 2012, we held $214,885,000 or 54.54% of the total market value of the investment portfolio in MBS and CMOs with an average yield of 1.41%. 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 $7,586,000 and is reflected in the Company’s equity. At December 31, 2012, the average life of the investment portfolio was 5.48 years and the market value reflected a pre-tax gain of $12,891,000. Management reviews market value declines on individual investment securities to determine whether they represent other-than-temporary impairment (OTTI) and for the year ended December 31, 2012, no OTTI was recorded, compared to 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, 2012, an immediate rate increase of 200 basis points would result in an estimated decrease in the market value of the investment portfolio by approximately $20,730,000. Conversely, with an immediate rate decrease of 200 basis points, the estimated increase in the market value of the investment portfolio would be $19,082,000. 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 2012 decreased $2,479,000 to $31,820,000 compared to $34,299,000 in 2011 and $36,013,000 in 2010. The decrease was due to the 58 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 4.46% for the year ended December 31, 2012 from 5.04% for the year ended December 31, 2011. Average interest earning assets increased to $766,937,000 for the year ended December 31, 2012 compared to $715,862,000 for the year ended December 31, 2011. Average interest-earning deposits in other banks decreased $36,180,000 comparing 2012 to 2011. Average yield on these deposits was 0.29%. Average investments increased $68,883,000 but the tax equivalent yield on average investment securities decreased 56 basis points. Average total loans decreased $23,251,000 and the yield on average loans decreased 26 basis points. The decrease in total interest income in 2011 was due to the 55 basis point decrease in the tax equivalent yield on average interest earning asset 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. Interest expense on deposits in 2012 decreased $1,032,000 or 38.77% to $1,630,000 compared to $2,662,000 in 2011 and $3,713,000 in 2010. The decrease in interest expense in 2012 compared to 2011 was primarily due to the repricing of interest-bearing deposits which decreased 22 basis points to 0.32% in 2012 from 0.54% in 2011. The decrease in interest expense in 2011 compared to 2010 was due to repricing of interest-bearing deposits, which decreased 23 basis points to 0.54% in 2011 from 0.77% in 2010. Average interest-bearing deposits were $502,072,000 for 2012 compared to $495,545,000 and $483,220,000 for 2011 and 2010, respectively. The increases in average interest- bearing deposits in 2011 and 2010 were the result of our own organic growth. Average other borrowings decreased to $9,156,000 with an effective rate of 2.76% for 2012 compared to $10,265,000 with an effective rate of 2.73% for 2011. In 2010, the average other borrowings were $19,634,000 with an effective rate of 2.90%. 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 2012 and 2011 and 3.20% for 2010. The cost of all of our interest-bearing liabilities decreased 21 basis points to 0.37% for 2012 compared to 0.58% for 2011 and 0.85% for 2010. The cost of total deposits decreased to 0.23% for the year ended December 31, 2012 compared to 0.39% and 0.58% for the years ended December 31, 2011 and 2010, respectively. Average demand deposits increased 19.36% to $217,529,000 in 2012 compared to $182,244,000 for 2011 and $152,946,000 for 2010. The ratio of non-interest demand deposits to total deposits increased to 30.23% for 2012 compared to 26.89% and 24.04% for 2011 and 2010, respectively. NET INTEREST INCOME BEFORE PROVISION FOR CREDIT LOSSES Net interest income before provision for credit losses for 2012 decreased $1,420,000 or 4.53% to $29,937,000 compared to $31,357,000 for 2011 and $31,730,000 for 2010. The decrease in 2012 was due to the 42 basis point decrease in our net interest margin (NIM). Yield on interest earning assets decreased 58 basis points while the effective rate on interest bearing liabilities only decreased 21 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 $373,000 in 2011 compared to 2010 mainly due to the 32 basis point decrease in our net interest margin (NIM). Average 50 50 Management’s Discussion and Analysis of Financial Condition and Results of Operations NET INTEREST INCOME BEFORE PROVISION FOR CREDIT LOSSES (Continued) interest-earning assets were $766,937,000 for the year ended December 31, 2012 with a net interest margin (NIM) of 4.21% compared to $715,862,000 with a NIM of 4.63% in 2011, and $672,804,000 with a NIM of 4.95% in 2010. 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. 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 2012 Loans 2011 Loans Commercial and industrial Agricultural land and production $ 2,071 605 19.7% $ 6.7% 1,924 342 18.3% 7.0% 2,153 28.9% 1,578 26.4% 1,035 1,886 646 157 8.4% 13.6% 7.2% 2.0% 2,954 2,043 489 91 7.7% 14.6% 9.9% 1.8% 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 exist in the portfolio at that time. We assign qualitative and quantitative factors (Q factors) to each loan category. 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 2012, 2011, and 2010 were $700,000, $1,050,000, and $3,800,000, 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, 2012, the Company had net charge offs totaling $1,963,000 compared to $668,000 and $2,986,000 for the same periods in 2011 and 2010, respectively. The decrease in provision for credit losses in 2012 compared to 2011 resulted from a decrease in the level of outstanding loans and nonperforming loans. The net charge off ratio, which reflects net charge-offs to average loans, was 0.48%, 0.16% and 0.66% for 2012, 2011, and 2010, respectively. The 2012 charge offs consisted primarily of one real estate loan. The charged off loans were previously identified and adequately reserved for as of December 31, 2011. Nonperforming loans were $9,695,000 and $14,434,000 at December 31, 2012 and 2011, respectively. Nonperforming loans as a percentage of total loans were 2.45% at December 31, 2012 compared to 3.38% at December 31, 2011. There was no other real estate owned at December 31, 2012 and December 31, 2011 compared to $1,325,000 net of a valuation allowance of $309,000 at December 31, 2010. Losses in the real estate segments of the loan portfolio in 2012 increased compared to 2011. 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 $27,000 at December 31, 2012 compared to $1,741,000 at December 31, 2011. 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 2012 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, 2012, we believe, based on all current and available information, the allowance for credit losses is adequate to absorb probable incurred 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. 5,877 60.1% 7,155 60.4% NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES 1,158 383 39 10.9% 2.6% 1,419 417 139 12.0% 2.3% Net interest income, after the provision for credit losses of $700,000 in 2012, $1,050,000 in 2011, and $3,800,000 in 2010, was $29,237,000 for 2012 compared to $30,307,000 and $27,930,000 for 2011 and 2010, respectively. Total allowance for credit losses $ 10,133 $ 11,396 NON-INTEREST INCOME 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 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 $7,242,000 in 2012 51 51 Management’s Discussion and Analysis of Financial Condition and Results of Operations NON-INTEREST INCOME (Continued) compared to $6,271,000 and $3,711,000 in 2011 and 2010, respectively. The $971,000 or 15.48% increase in non-interest income was due to increases in gains on sales and calls of investment securities, and an increase in loan placement fees, partially offset by a decrease in gains on sales of other real estate owned and a decrease in service charges. The $2,560,000 or 68.98% increase in non-interest income comparing 2011 to 2010 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. Customer service charges decreased $129,000 to $2,774,000 in 2012 compared to $2,903,000 in 2011 and $3,225,000 in 2010. The decrease in 2012 from 2011, and in 2011 from 2010 is mainly due to decreases in overdraft fee income. During the year ended December 31, 2012, we realized net gain on sales and calls of investment securities of $1,639,000 resulting primarily from the partial restructuring of the investment portfolio designed to improve the future performance of the portfolio. In 2011, we realized a net gain of $298,000 compared to a net loss of $191,000 in 2010 from sales and calls of securities. 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 $391,000 in 2012 compared to $382,000 and $392,000 in 2011 and 2010, 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 increased $357,000 in 2012 to $631,000 compared to $274,000 in 2011 and $300,000 in 2010. Fees were higher in 2012 compared to 2011 and 2010, 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, 2012, we held $3,850,000 in FHLB stock compared to $2,893,000 at December 31, 2011. Dividends in 2012 increased to $36,000 compared to $9,000 in 2011 and $11,000 in 2010. Other income decreased to $1,755,000 in 2012 compared to $1,826,000 and $1,395,000 in 2011 and 2010, respectively. The period-to-period decrease in 2012 compared to 2011 was primarily due to 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 realized in 2011 offset by increases in electronic funds transfer fee income and non-customer check cashing fees. NON-INTEREST EXPENSES Salaries and employee benefits, occupancy and equipment, regulatory assessments, data processing expenses, and professional services (consisting of audit, accounting and legal fees) are the major categories of non-interest expenses. Non-interest expenses decreased $966,000 or 3.42% to $27,274,000 in 2012 compared to $28,240,000 in 2011, compared to $28,731,000 in 2010, which was a decrease of $491,000 in 2011. 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 75.99% for 2012 compared to 75.67% for 2011 and 73.55% for 2010. The decline in the efficiency ratio in 2012 is due to a decrease in net interest income that is greater than the decrease in operating expenses. The decline in the efficiency ratio in 2011 compared to 2010 is due to an increase in operating expenses and a decrease in net interest income. Salaries and employee benefits decreased $165,000 or 1.05% to $15,597,000 in 2012 compared to $15,762,000 in 2011 and $14,871,000 in 2010. Full time equivalents were 208 at December 31, 2012 compared to 211 at December 31, 2011. At December 31, 2012, 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 317,799 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 181,490 shares reserved for issuance for options already granted to employees and directors. 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, 2012, 2011, and 2010, the compensation cost recognized for share based compensation was $108,000, $196,000 and $239,000, respectively. As of December 31, 2012, there was $374,000 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 1.98 years. See Notes 1 and 14 to the audited Consolidated Financial Statements for more detail. In 2012, options to purchase 92,150 shares of common stock were granted from the 2005 Plan at exercise prices between $8.02 and $8.75. No options to purchase shares of the Company’s common stock were issued during the year ending December 31, 2011. 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. All options were granted with an exercise price equal to the market value on the grant date. Occupancy and equipment expense decreased $217,000 or 5.72% to $3,578,000 in 2012 compared to $3,795,000 in 2011 and $3,867,000 in 2010. Relocation of one branch resulted in lower rent expenses in 2012, as compared to same period in 2011. Fully depreciated assets resulted in lower depreciation expenses in 2012, as compared to 2011. The company made no changes in depreciation expense methodology. Regulatory assessments decreased $193,000 or 22.84% to $652,000 in 2012 compared to $845,000 and $1,191,000 in 2011 and 2010, respectively. The FDIC finalized a new assessment system which took effect the third quarter of 2011. The final rule changed the assessment base from domestic deposits to average assets minus average tangible equity. Data processing expenses were $1,125,000 in 2012 compared to $1,178,000 in 2011 and $1,197,000 in 2010. The $53,000 or 4.50% decrease in 2012, and the $19,000 decrease in 2011 compared to 2010 are a result of a reduction in terms of our core processing contract. Legal fees decreased $150,000 or 44.78% to $185,000 for the year ended December 31, 2012 compared to $335,000 and $495,000 in 2011 and 2010, respectively. The higher legal fees in 2011 and 2010 are primarily due to issues related to nonperforming assets and other loan related legal expenses. Total other real estate owned (OREO) expenses increased $63,000 or 420.00% to $78,000 for the year ended December 31, 2012 compared to $15,000 and $1,071,000 in 2011 and 2010. The increase in OREO expenses was primarily due to new OREO properties added and subsequently sold in 2012. 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 $200,000 for 2012 and $414,000 for 2011 and 2010. Other non-interest expenses increased $167,000 or 3.58% to $4,503,000 in 2012 compared to $4,670,000 in 2011 and $4,460,000 in 2010. 52 52 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. We accrued preferred stock dividends to the Treasury and accretion of the issuance discount in the amount of $350,000 and $486,000 during the years ended December 31, 2012 and 2011, respectively. For the years ended December 31, 2012 2011 2010 Other Expense % Average Assets Other Expense % Average Assets Other Expense % Average Assets (Dollars in thousands) $ 369 0.04% $ 369 0.05% $ 354 0.05% 362 270 221 215 196 183 169 162 155 148 120 85 77 1,771 0.04% 0.03% 0.03% 0.03% 0.02% 0.02% 0.02% 0.02% 0.02% 0.02% 0.01% 0.01% 0.01% 0.21% 324 247 245 219 232 198 236 340 160 154 125 125 112 1,584 0.04% 0.03% 0.03% 0.03% 0.03% 0.02% 0.03% 0.04% 0.02% 0.02% 0.02% 0.02% 0.01% 0.20% 275 119 271 209 195 218 305 212 139 148 130 44 165 1,676 0.04% 0.02% 0.04% 0.03% 0.03% 0.03% 0.04% 0.03% 0.02% 0.02% 0.02% 0.01% 0.02% 0.22% $ 4,503 0.53% $ 4,670 0.58% $ 4,460 0.59% ATM/debit card expenses License and maintenance contracts Internet banking expense Stationery/supplies Director fees and related expenses Amortization of software Postage Telephone Consulting Education/training Donations General insurance Operating losses Appraisal fees Other Total other non-interest expense For the year ended December 31, 2012, the $178,000 decrease in consulting was related to various financial and tax planning projects assistance in 2011. License and maintenance contract expense increased in 2012 as a result of annual increases on various contracts in addition to new contracts for new products, services and software put in place during 2011. In 2012, the $35,000 decrease in appraisal fees resulted due to fewer appraisals paid for by the bank. PROVISION FOR INCOME TAXES Our effective income tax rate was 18.31% for 2012 compared to 22.32% for 2011 and (12.68)% for 2010. The Company reported an income tax provision of $1,685,000 and $1,861,000 for the years ended December 31, 2012 and 2011, compared to a benefit totaling $369,000 for the year ended December 31, 2010. The decrease in the effective tax rate in 2012 compared to 2011 is due primarily to federal tax deductions for tax free municipal bond income, solar tax credits, the state tax deduction for loans in designated enterprise zones in California, and state hiring tax credits. 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 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. FINANCIAL CONDITION SUMMARY OF CHANGES IN CONSOLIDATED BALANCE SHEETS December 31, 2012 compared to December 31, 2011. Total assets were $890,228,000 as of December 31, 2012, compared to $849,023,000 as of December 31, 2011, an increase of 4.85% or $41,205,000. Total gross loans were $395,318,000 as of December 31, 2012, compared to $427,395,000 as of December 31, 2011, a decrease of $32,077,000 or 7.51%. The total investment portfolio (including Federal funds sold and interest-earning deposits in other banks) increased 19.98% or $70,708,000 to $424,516,000. Total deposits increased 5.39% or $38,446,000 to $751,432,000 as of December 31, 2012, compared to $712,986,000 as of December 31, 2011. Shareholders’ equity increased $10,183,000 or 9.47% to $117,665,000 as of December 31, 2012, compared to $107,482,000 as of December 31, 2011, due to net income included in retained earnings and an increase in other comprehensive income. Accrued interest payable and other liabilities were $11,976,000 as of December 31, 2012, compared to $19,400,000 as of December 31, 2011, a decrease of $7,424,000. 2011 other liabilities included an accrual of $7,749,000 for investment securities with a trade date before and a settlement date after December 31, 2011. FAIR VALUE The Company measures the fair values of its financial instruments utilizing a hierarchical 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 actively 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 Notes to 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 U.S. Government sponsored entities and agencies collateralized by residential mortgage backed obligations and obligations of states and political subdivision securities and are classified at the date of acquisition as available for sale or held to maturity. As of December 31, 2012, investment securities with a fair value of $89,343,000, or 22.68% 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, 2012 was 52.61% compared to 59.94% at December 31, 2011. The loan to deposit ratio of our peers was 70.66% at September 30, 2012. The total investment portfolio, including Federal funds sold and interest-earning deposits in other banks, increased 19.98% or $70,708,000 to $424,516,000 at December 31, 2012, from $353,808,000 at December 31, 2011. The market value of the portfolio reflected an unrealized gain of 53 53 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, 2012, the Company had a total of 23 PLRMBS with a remaining principal balance of $6,258,000 and a net unrealized loss of approximately $117,000. Six of these securities account for $206,000 of the unrealized loss at December 31, 2012 offset by 17 of these securities with gains totaling $323,000. Seven of these PLRMBS with a remaining principal balance of $4,806,000 had credit ratings below investment grade. The Company continues to perform extensive analyses on these securities as well as all whole loan CMOs. No credit related OTTI charges related to PLRMBS were recorded during the year ended December 31, 2012. See Note 3 to the audited Consolidated Financial Statements for carrying values and estimated fair values of our investment securities portfolio. INVESTMENTS (Continued) $12,891,000 at December 31, 2012, compared to $7,008,000 at December 31, 2011. 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. 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, 2012, 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, 2012, and identified those that had an unrealized loss for at least a consecutive 12 month period, which had an unrealized loss at December 31, 2012 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 December 2012 to provide independent valuation and OTTI analysis of the 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, 2012. 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. 54 54 Management’s Discussion and Analysis of Financial Condition and Results of Operations LOANS Total gross loans decreased $32,077,000 or 7.51% to $395,318,000 as of December 31, 2012, compared to $427,395,000 as of December 31, 2011. The following table sets forth information concerning the composition of our loan portfolio as of and for the years ended December 31, 2012, 2011, 2010, 2009, and 2008. Loan Type (Dollars in thousands) Commercial: 2012 2011 2010 2009 2008 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 $ 77,956 26,599 19.7% $ 6.7% 78,089 29,958 18.3% $ 7.0% 81,318 20,604 18.8% $ 4.8% 93,282 13,903 20.3% $ 3.0% Total commercial 104,555 26.4% 108,047 25.3% 101,922 23.6% 107,185 23.3% 109,664 20,406 130,070 22.6% 4.2% 26.8% 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 114,444 28.9% 113,183 26.4% 111,888 25.9% 106,606 23.2% 113,414 23.4% 33,199 53,797 28,400 8,098 237,938 42,932 10,346 53,278 (453) 8.4% 13.6% 7.2% 2.0% 60.1% 10.9% 2.6% 13.5% 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% 395,318 100.0% 427,395 100.0% 431,597 100.0% 459,207 100.0% 484,238 100.0% Allowance for credit losses (10,133) (11,396) (11,014) (10,200) (7,223) Total loans $ 385,185 $ 415,999 $ 420,583 $ 449,007 $ 477,015 At December 31, 2012, in management’s judgment, a concentration of loans At December 31, 2012, total nonperforming assets totaled $9,695,000, or existed in commercial loans and real-estate-related loans, representing approximately 97.4% of total loans of which 26.4% were commercial and 71.0% were real-estate-related. This level of concentration is consistent with 97.7% at December 31, 2011. 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, 2012 and 2011. 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. The Board of Directors review and approve concentration limits and exceptions to limitations of concentration are reported to the Board of Directors at least quarterly. Nonperforming Assets - Nonperforming assets consist of loans past due 90 days or more that are still accruing interest, loans on nonaccrual status, and foreclosed property classified as Other Real Estate Owned (OREO). We measure all loans placed on nonaccrual status for impairment based on the fair value of the underlying collateral or the net present value of the expected cash flows. 1.09% of total assets, compared to $14,434,000, or 1.70% of total assets at December 31, 2011. Total nonperforming assets at December 31, 2012, included nonaccrual loans totaling $9,695,000 and no OREO or repossessed assets. Nonperforming assets at December 31, 2011 consisted of $14,434,000 in nonaccrual loans and no OREO or repossessed assets. At December 31, 2012, we had seven loans considered troubled debt restructurings (‘‘TDRs’’) totaling $9,245,000 which are included in nonaccrual loans compared to six TDRs totaling $10,601,000 at December 31, 2011. 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, 2012 and 2011 is set forth below. The Company had no loans past due more than 90 days and still accruing interest at December 31, 2012 and 2011. Management is not aware of any potential problem loans, which were current and accruing at December 31, 2012, 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. 55 55 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, 2012 December 31, 2011 December 31, 2010 December 31, 2009 December 31, 2008 $ $ $ $ - 213 - - 237 - - 1,362 6,288 - - 1,595 9,695 - 9,695 2.45% 95.68% 17,105 510 $ $ $ $ $ 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 - 14,434 $ 18,561 $ 18,959 $ 3.38% 126.66% 23,644 4,368 $ $ 4.30% 168.52% 18,561 2,124 $ $ 4.13% 185.87% 18,959 752 $ $ 907 1,644 4,839 6,296 280 81 - 1,108 595 - - - 15,750 - 15,750 3.25% 218.05% 15,750 125 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, 2012 and 2011, we had impaired loans totaling $17,105,000 and $23,644,000, 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 less selling costs value of the 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 $693,000 for the year ended December 31, 2012 of which $669,000 was attributable to troubled debt restructurings. Foregone interest on nonaccrual loans totaled $954,000 and $1,228,000 for the years ended December 31, 2011 and 2010, respectively of which $769,000 and $376,000 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, 2012. (Dollars in thousands) Non-accrual loans: Commercial and industrial Real estate Equity loans and lines of credit Consumer Restructured loans (non-accruing): Real estate Real estate construction and land development Equity loans and lines of credit Consumer Balances December 31, 2011 Additions to Nonaccrual Loans Net Pay Downs Transfer to Foreclosed Collateral - OREO Returns to Accrual Status Charge Offs Balances December 31, 2012 $ $ 267 2,787 705 74 2,129 6,823 1,649 - $ 4 294 79 73 425 - 75 - (32) (312) (472) (4) (82) (535) (129) - $ $ (155) (2,175) - - (7) - - - - - - - - - - - - $ $ (84) (381) (75) (143) (1,103) - - - $ (1,786) $ - 213 237 - 1,362 6,288 1,595 - 9,695 Total non-accrual $ 14,434 $ 950 $ (1,566) $ (2,337) $ 56 56 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, 2012 2011 $ - 2,337 (2,349) - 12 $ 1,325 532 (2,472) - 615 $ - $ - 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, 2012 and 2011, the Company had no OREO properties. Allowance for Credit Losses - We have established a methodology for the determination of provisions for credit losses made up of general and specific allocations. 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. The allowance for credit losses is an estimate of probable credit losses inherent in the Company’s loan portfolio as of the balance-sheet date. The 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. 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, 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. Each quarter management assesses which period of time is most appropriate when factoring in historical loan losses into the general reserve calculation. From time to time, this look back period changes in order to be reflective of management’s expectations which are driven by a number of factors including economic data, the relevance of past periods’ losses to the current period and the estimated point in the credit cycle that we are in. During the quarter ended September 30, 2012, management determined that the most recent 16 quarters was an appropriate look back period based on several factors including the current global economic uncertainty and various national and local economic indicators. The impact to the general reserve, as a result of moving from a 12 quarter rolling average to a 16 quarter rolling average, did not have a material impact on the level of allowance required, but it did ensure that the significant loss years for the Bank that began in 2009 would continue to be factored into the general reserve analysis. We utilize actual loss history as a starting point for the general reserve beginning with January 1, 2009. We believe this period is an appropriate look back period given the significant charge-offs incurred during this credit cycle. Our methodology for assessing the appropriateness of the allowance consists of several key elements, which include the formula allowance (general reserve) and a specific allowance for identified impaired 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 generally recorded only when cash payments are received. The allowance for credit losses is maintained to cover probable incurred 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 to 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 probable incurred losses in our loan and lease portfolio as of the balance sheet date. The allowance is based on principles of accounting: (1) ASC 450-20 which requires losses to be accrued for on loans when they are probable of occurring and can be reasonably estimated and (2) ASC 310-10 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 and are placed on nonaccrual. 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, 2012 2011 $ $ 11,396 700 (2,850) 887 11,014 1,050 (1,532) 864 $ 10,133 $ 11,396 Allowance for credit losses to total loans 2.56% 2.67% As of December 31, 2012, the balance in the allowance for credit losses was $10,133,000 compared to $11,396,000 as of December 31, 2011. The decrease was due to net charge offs during the year ended December 31, 2012 being greater than the amount of the provision for credit losses. Net charge offs totaled $1,963,000 while the provision for credit losses was $700,000. Loans charged off in 2012 were fully reserved at December 31, 2011. The balance of commitments to extend credit on undisbursed construction and other loans and letters of credit was $162,851,000 as of December 31, 2012, compared to $129,005,000 as of December 31, 2011. At December 31, 2012, the balance of a contingent allocation for probable loan loss experience on unfunded obligations was $110,000. The contingent allocation for probable loan loss experience on unfunded obligations is calculated by management using appropriate, systematic, and consistently applied process. While related to credit losses, this allocation is not a part of ALLL and is considered separately as a liability for accounting and regulatory reporting purposes. Risks and uncertainties exist in all lending transactions and our management and Audit Committee have established reserve levels based on economic uncertainties and other risks that exist as of each reporting period. As of December 31, 2012, the allowance for credit losses was 2.56% of total gross loans compared to 2.67% as of December 31, 2011. During the year ended December 31, 2012, there were no major changes in loan concentrations that significantly affected the allowance for credit losses. During the period ended December 31, 2012, the Company enhanced the process for estimating the allowance for credit losses related to impaired loans through inclusion of the use of the net present value method on certain credits where sufficient payment history exists and future payments can be reasonably projected based on a global borrower cash flow analysis in addition to collateral dependent analysis. 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, enhanced methodology enabled us to assign qualitative and environmental factors (Q factors) to each loan category. Q factors include reserves held for the effects of lending policies, economic trends, and portfolio trends along with other dynamics which may cause 57 57 Management’s Discussion and Analysis of Financial Condition and Results of Operations LOANS (Continued) 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. Non-performing loans totaled $9,695,000 as of December 31, 2012, and $14,434,000 as of December 31, 2011. The allowance for credit losses as a percentage of nonperforming loans was 104.52% and 78.95% as of December 31, 2012 and December 31, 2011, respectively. Management believes the allowance at December 31, 2012 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. GOODWILL AND INTANGIBLE ASSETS Business combinations involving the Company’s acquisition of the equity interests or net assets of another enterprise give rise to goodwill. Total goodwill at December 31, 2012, was $23,577,000 consisting of $14,643,000 and $8,934,000 representing the excess of the cost of Service 1st 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 significant 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. Management performed our annual impairment test in the third quarter of 2012 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 management’s analysis performed, no impairment was required. The intangible assets represent the estimated fair value of the core deposit relationships acquired in the acquisition of Service 1st 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 (which approximates the effective interest method) over an estimated life of seven years from the date of acquisition. The carrying value of intangible assets at December 31, 2012 was $583,000, net of $2,317,000 in accumulated amortization expense. The carrying value at December 31, 2011 was $783,000, net of $2,117,000 accumulated amortization expense. We evaluate 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 in 2012. Amortization expense recognized was $200,000 and $414,000 for the years ended December 31, 2012 and 2011. The core deposit intangible for the 2005 acquisition of Bank of Madera County was fully amortized as of December 31, 2011. DEPOSITS AND BORROWINGS The Bank’s deposits are insured by the Federal Deposit Insurance Corporation (FDIC) up to applicable legal limits. The FDIC’s unlimited deposit insurance coverage on non-interest bearing transaction accounts mandated by the Dodd-Frank Act ended December 31, 2012. This coverage replaced the unlimited coverage under the Transaction Account Guarantee Program (‘‘TAG’’) and was confined to non-interest bearing accounts. Although the temporary coverage excluded interest-bearing NOW accounts, it did include interest on Lawyers Trust Accounts (IOLTAs). Beginning January 1, 2013, all of a depositors’ accounts at an insured depository institution, including all non-interest bearing transactions accounts, will be insured by the FDIC up to the standard maximum deposit insurance amount of ($250,000) for each deposit insurance ownership category. Total deposits increased $38,446,000 or 5.39% to $751,432,000 as of December 31, 2012, compared to $712,986,000 as of December 31, 2011. Interest-bearing deposits increased $6,302,000 or 1.25% to $511,263,000 as of December 31, 2012, compared to $504,961,000 as of December 31, 2011. Non-interest bearing deposits increased $32,144,000 or 15.45% to $240,169,000 as of December 31, 2012, compared to $208,025,000 as of December 31, 2011. Average non-interest bearing deposits to average total deposits was 30.23% for the year ended December 31, 2012 compared to 26.89% for the same period in 2011. Our total market share of deposits in Fresno, Madera, and San Joaquin counties was 3.58% in 2012 compared to 3.39% in 2011 based on FDIC deposit market share information published as of June 2012. The composition of the deposits and average interest rates paid at December 31, 2012 and December 31, 2011 is summarized in the table below. (Dollars in thousands) 2012 Deposits Rate 2011 Deposits Rate December 31, Total Effective December 31, Total Effective % of % of NOW accounts MMA accounts Time deposits Savings deposits $ 161,328 173,486 136,876 39,573 21.4% 0.19% $ 23.1% 0.22% 18.2% 0.64% 5.3% 0.09% 140,268 181,731 151,695 31,267 19.6% 0.26% 25.5% 0.40% 21.3% 0.96% 4.4% 0.16% Total interest-bearing Non-interest bearing 511,263 240,169 68.0% 0.32% 32.0% 504,961 208,025 70.8% 0.54% 29.2% Total deposits $ 751,432 100.0% $ 712,986 100.0% There were $4,000,000 short term borrowings as of December 31, 2012, compared to none as of December 31, 2011. Short-term borrowings of $4,000,000 at December 31, 2012 represent FHLB advances with a weighted average interest of 3.59% and weighted average maturity of 0.1 years. Long-term FHLB borrowings at December 31, 2011 were $4,000,000. There were no long-term FHLB borrowings outstanding at December 31, 2012. 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. 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, 2012, 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, 2012, the rate was 1.94%. Interest expense recognized by the Company for the years ended December 31, 2012, 2011, and 2010 was $107,000, $100,000 and $102,000, respectively. 58 58 Management’s Discussion and Analysis of Financial Condition and Results of Operations 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. 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 shareholders’ equity was $117,665,000 as of December 31, 2012, compared to $107,482,000 as of December 31, 2011. The increase in shareholders’ equity is the result of increase in retained earnings from net income of $7,520,000, an increase in unrealized gain on the available-for-sale investment securities of $3,462,000, exercise of stock options, including the related tax benefit of $411,000, and the effect of share based compensation expense of $108,000 offset by the repurchases of the Company’s common stock of $488,000, preferred stock dividends of $350,000, and common stock cash dividends of $480,000. 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. On August 15, 2012, the Board of Directors of the Company approved the adoption of a program to effect repurchases of the Company’s common stock. Under the program, the Company was to repurchase up to five percent of the Company’s outstanding shares of common stock, or approximately 479,850 shares based on the shares outstanding as of August 15, 2012, for the period beginning on August 15, 2012, and ending February 15, 2013. During 2012, the Company repurchased and retired a total of 58,100 shares at an average price of $8.41 for a total cost of $488,000. The stock repurchase program was suspended after the Company entered into a Reorganization Agreement and Plan of Merger (the Merger Agreement) with Visalia Community Bank on December 19, 2012. During 2012, the Bank declared and paid cash dividends to the Company of $3,000,000, in connection with stock repurchase agreements and cash dividends approved by the Company’s Board of Directors. During 2011 and 2010, 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. On October 17, 2012, the Board of Directors declared a $0.05 per common share cash dividend to shareholders of record at the close of business on November 15, 2012 which was paid on November 30, 2012. No dividends on common shares were declared in 2011 or 2010. 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 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 including acquisition opportunities. The following table presents the Company’s and the Bank’s Regulatory capital ratios as of December 31, 2012 and December 31, 2011. 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, 2012 December 31, 2011 Amount Ratio Amount Ratio (Dollars in thousands) $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 90,866 34,418 87,911 42,994 34,395 90,866 19,926 87,911 29,848 19,899 97,299 39,853 94,336 49,747 39,798 10.56% $ 4.00% $ 10.22% $ 82,571 32,612 81,599 5.00% $ 4.00% $ 40,743 32,594 18.24% $ 4.00% $ 17.67% $ 82,571 20,383 81,599 6.00% $ 4.00% $ 30,554 20,369 19.53% $ 8.00% $ 18.96% $ 89,136 40,767 88,159 10.00% $ 8.00% $ 50,923 40,738 10.13% 4.00% 10.01% 5.00% 4.00% 16.20% 4.00% 16.02% 6.00% 4.00% 17.49% 8.00% 17.31% 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 59 59 Management’s Discussion and Analysis of Financial Condition and Results of Operations CAPITAL RESOURCES (Continued) OFF-BALANCE SHEET ITEMS 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 $53,000 and $1,427,000 at December 31, 2012 and 2011, 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 (FHLB). 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, 2012, the Company had unpledged securities totaling $304,622,000 available as a secondary source of liquidity and total cash and cash equivalents of $52,956,000. Cash and cash equivalents at December 31, 2012 increased 18.19% compared to December 31, 2011. 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. As a means of augmenting our liquidity, we have established Federal funds lines with various correspondent banks. At December 31, 2012, our available borrowing capacity includes approximately $40,000,000 in Federal funds lines with our correspondent banks and $129,034,000 in unused FHLB advances. At December 31, 2012, 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, 2012 and 2011: 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, 2012 2011 $ $ $ $ $ $ $ $ $ $ 40,000 $ - $ 44,000 - 133,034 $ 4,000 $ 94,368 $ 94,809 $ 125,122 4,000 112,926 114,214 127 $ - $ 115 $ 129 $ 551 - 542 562 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. 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 $162,851,000 as of December 31, 2012 compared to $129,005,000 as of December 31, 2011. 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. Use of 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. 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 may differ from these estimates under different assumptions. The allowance for credit losses, deferred taxes assets and fair values of financial instruments are estimates which are particularly subject to change. 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 60 60 Management’s Discussion and Analysis of Financial Condition and Results of Operations CRITICAL ACCOUNTING POLICIES (Continued) 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. Amortization of Premiums/Discount Accretion on Investments 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 by nature inexact, and represents management’s best estimate of the grant date fair value of the share based payments. See Note 14 to the audited Consolidated Financial Statements in this Annual Report. 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, 2012, 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. 61 61 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 18, 2013, the Company had approximately 799 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, 2011 June 30, 2011 September 30, 2011 December 31, 2011 March 31, 2012 June 30, 2012 September 30, 2012 December 31, 2012 $ $ Sales Prices for the Company’s Common Stock High 6.19 6.95 6.90 6.25 7.25 7.75 8.50 9.25 Low 5.61 6.19 5.20 5.25 5.25 6.77 6.90 7.74 The Company paid a $0.05 per common share cash dividend in 2012. The Company did not pay a cash dividend in 2011. 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 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) 616-8935 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 by calling 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. 62 Notes 63 Notes 64 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 

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