The following is management's discussion and analysis of the major factors that influenced our financial performance for the three months ended
March 31, 2014. This analysis should be read in conjunction with our 2013 Annual Report to Shareholders on Form 10-K, and with the unaudited financial statements and notes as set forth in this report. Forward-Looking Statements This Form 10-Q contains various forward-looking statements, usually containing the words "estimate," "project," "expect," "objective," "goal," or similar expressions and includes assumptions concerning Farmers & Merchants Bancorp's (together with its subsidiaries, the "Company" or "we") operations, future results, and prospects. These forward-looking statements are based upon current expectations and are subject to risks and uncertainties. In connection with the "safe-harbor" provisions of the Private Securities Litigation Reform Act of 1995, the Company provides the following cautionary statement identifying important factors which could cause the actual results of events to differ materially from those set forth in or implied by the forward-looking statements and related assumptions. Such factors include the following: (1) continuing economic sluggishness in the Central Valleyof California; (2) significant changes in interest rates and prepayment speeds; (3) credit risks of lending and investment activities; (4) changes in federal and state banking laws or regulations; (5) competitive pressure in the banking industry; (6) changes in governmental fiscal or monetary policies; (7) uncertainty regarding the economic outlook resulting from the continuing war on terrorism, as well as actions taken or to be taken by the U.S. or other governments as a result of further acts or threats of terrorism; and (8) other factors discussed in Item 1A. Risk Factors located in the Company's 2013 Annual Report on Form 10-K.
Readers are cautioned not to place undue reliance on these forward-looking statements which speak only as of the date hereof. The Company undertakes no obligation to update any forward-looking statements to reflect events or circumstances arising after the date on which they are made.
Farmers & Merchants Bancorp, or the Company, is a bank holding company formed
March 10, 1999. Its subsidiary, Farmers & Merchants Bank of Central California, or the Bank, is a Californiastate-chartered bank formed in 1916. The Bank serves its primary service area, the mid Central Valleyof California, through twenty-one full-service branches and two stand-alone ATM's. The service area includes Sacramento, San Joaquin, Stanislausand MercedCounties with branches in Sacramento, Elk Grove, Galt, Lodi, Stockton, Linden, Modesto, Turlock, Hilmar, and Merced. 34 -------------------------------------------------------------------------------- Table of Contents During 2013, the Company initiated efforts to broaden its geographic footprint by establishing loan production offices ("LPO") in Irvine, CAand Walnut Creek, CA. Both LPO's were opened in January 2014, and in March 2014the Irvine LPO was converted to a full-service branch. Experienced lending and equipment leasing professionals have been hired to staff these offices. The Company intends to convert the Walnut Creek LPO to a full-service branch in the near future. Both of these areas have strong local economies, and will help diversify some of the concentration risks that the Company now has to the Central Valleyand the agricultural industry. The Irvinelocation will also be the headquarters for the Company's equipment leasing activities. As a bank holding company, the Company is subject to regulation and examination by the Board of Governorsof the Federal Reserve System("FRB"). As a California, state-chartered, non-fed member bank, the Bank is subject to regulation and examination by the California Department of Business Oversight("DBO") and the Federal Deposit Insurance Corporation("FDIC").
At the present time, the Company's primary service area remains the mid Central Valley of
California, a region that can be significantly impacted by the seasonal needs of the agricultural industry. Accordingly, discussion of the Company's Financial Condition and Results of Operations is influenced by the seasonal banking needs of its agricultural customers (e.g., during the spring and summer customers draw down their deposit balances and increase loan borrowing to fund the purchase of equipment and planting of crops. Correspondingly, deposit balances are replenished and loans repaid in fall and winter as crops are harvested and sold). For the three months ended March 31, 2014, Farmers & Merchants Bancorp reported net income of $6,282,000, earnings per share of $8.08and return on average assets of 1.20%. Return on average shareholders' equity was 11.70% for the three months ended March 31, 2014. For the three months ended March 31, 2013, Farmers & Merchants Bancorp reported net income of $6,251,000, earnings per share of $8.04and return on average assets of 1.28%. Return on average shareholders' equity was 12.04% for the three months ended March 31, 2013. The primary reasons for the Company's improved earnings performance in the first quarter of 2014 as compared to the same period last year were: (1) an $876,000increase in net interest income; and (2) a $171,000decrease in the provision for income taxes. These positive impacts were partially offset by an $898,000decrease in non-interest income attributable to reduced securities gains and deposit service charges.
The following is a summary of the financial results for the three-month period ended
· Net income increased 0.5% to
· Earnings per share increased 0.5% to
· Total assets increased 7.9% to
· Total loans & leases increased 11.1% to
· Total deposits increased 7.3% to
35 -------------------------------------------------------------------------------- Table of Contents Results of Operations Net Interest Income / Net Interest Margin The tables on the following pages reflect the Company's average balance sheets and volume and rate analysis for the three month periods ended
March 31, 2014and 2013.
The average yields on earning assets and average rates paid on interest-bearing liabilities have been computed on an annualized basis for purposes of comparability with full year data. Average balance amounts for assets and liabilities are the computed average of daily balances.
Net interest income is the amount by which the interest and fees on loans & leases and other interest earning assets exceed the interest paid on interest bearing sources of funds. For the purpose of analysis, the interest earned on tax-exempt investments and municipal loans is adjusted to an amount comparable to interest subject to normal income taxes. This adjustment is referred to as "taxable equivalent" and is noted wherever applicable. The Volume and Rate Analysis of Net Interest Income summarizes the changes in interest income and interest expense based on changes in average asset and liability balances (volume) and changes in average rates (rate). For each category of interest-earning assets and interest-bearing liabilities, information is provided with respect to changes attributable to: (1) changes in volume (change in volume multiplied by initial rate); (2) changes in rate (change in rate multiplied by initial volume); and (3) changes in rate/volume (allocated in proportion to the respective volume and rate components). The Company's earning assets and rate sensitive liabilities are subject to repricing at different times, which exposes the Company to income fluctuations when interest rates change. In order to minimize income fluctuations, the Company attempts to match asset and liability maturities. However, some maturity mismatch is inherent in the asset and liability mix. See "Item 3. Quantitative and Qualitative Disclosures about Market Risk - Interest Rate Risk." 36 -------------------------------------------------------------------------------- Table of Contents Farmers & Merchants Bancorp Year-to-Date Average Balances and Interest Rates (Interest and Rates on a Taxable Equivalent Basis) (in thousands) Three Months Ended March 31, Three Months Ended March 31, 2014 2013 Annualized Annualized Assets Balance Interest Yield/Rate Balance Interest Yield/Rate Interest Bearing Deposits With Banks
$ 102,142 $ 640.25 % $ 70,206 $ 440.25 % Investment Securities Government Agency& Government-Sponsored Entities 21,369 55 1.03 % 29,835 71 0.95 % Obligations of States and Political Subdivisions - Non-Taxable 64,329 916 5.70 % 71,114 1,011 5.69 % Mortgage Backed Securities 324,507 1,907 2.35 % 366,810 1,891 2.06 % Other 53,964 153 1.13 % 48,637 144 1.18 % Total Investment % Securities 464,169 3,031 2.61 % 516,396 3,117 2.41 Loans & Leases Real Estate 935,838 11,519 4.99 % 840,253 11,154 5.38 % Home Equity Line & Loans 34,829 475 5.53 % 40,556 455 4.55 % Agricultural 214,141 2,141 4.05 % 187,871 1,969 4.25 % Commercial 159,021 1,884 4.80 % 144,532 1,777 4.99 % Consumer 6,258 71 4.60 % 4,733 87 7.45 % Other 70 1 5.79 % 232 3 5.24 % Leases 14,867 180 4.91 % - - 0.00 % Total Loans & Leases 1,365,024 16,271 4.83 % 1,218,177 15,445 5.14 % Total Earning Assets 1,931,335 $ 19,3664.07 % 1,804,779 $ 18,6064.18 % Unrealized Gain (Loss) on Securities Available-for-Sale (1,975 ) 10,623 Allowance for Credit Losses (34,270 ) (34,253 ) Cash and Due From Banks 32,604 33,086 All Other Assets 161,930 146,547 Total Assets $ 2,089,624 $ 1,960,782Liabilities & Shareholders' Equity Interest Bearing Deposits Transaction $ 290,018 $ 330.05 % $ 253,157 $ 290.05 % Savings and Money Market 619,852 240 0.16 % 577,270 244 0.17 % Time Deposits 426,462 327 0.31 % 455,171 410 0.37 % Total Interest Bearing % Deposits 1,336,332 600 0.18 % 1,285,598 683 0.22 Federal Home Loan Bank % Advances 5 - 0.00 % 87 - 0.00 Subordinated Debentures 10,310 80 3.10 % 10,310 81 3.19 % Total Interest Bearing % Liabilities 1,346,647 $ 6800.20 % 1,295,995 $ 7640.24 Interest Rate Spread 3.86 % 3.94 % Demand Deposits (Non-Interest Bearing) 482,603 421,845 All Other Liabilities 45,600 35,220 Total Liabilities 1,874,850 1,753,060 Shareholders' Equity 214,774 207,722 Total Liabilities & Shareholders' Equity $ 2,089,624 $ 1,960,782Impact of Non-Interest Bearing Deposits and Other Liabilities 0.06 % 0.07 % Net Interest Income and Margin on Total Earning Assets 18,686 3.92 % 17,842 4.01 % Tax Equivalent Adjustment (319 ) (351 ) Net Interest Income $ 18,3673.86 % $ 17,4913.93 % Notes: Yields on municipal securities have been calculated on a fully taxable equivalent basis. Loan interest income includes fee income and unearned discount in the amount of $956,000and $774,000for the quarters ended March 31, 2014and 2013, respectively. Yields on securities available-for-sale are based on historical cost. 37 -------------------------------------------------------------------------------- Table of Contents Farmers & Merchants Bancorp Volume and Rate Analysis of Net Interest Revenue (Interest and Rates on a Taxable Equivalent Basis) (in thousands) Three Months Ended Mar. 31, 2014 compared to Mar. 31, 2013 Interest Earning Assets Volume Rate Net Chg. Interest Bearing Deposits With Banks $ 20 $ - $ 20 Investment SecuritiesGovernment Agency & Government-Sponsored Entities (22 ) 6 (16 )
Obligations of States and Political Subdivisions - Non-Taxable
(97 ) 2 (95 ) Mortgage Backed Securities (232 ) 248 16 Other 15 (6 ) 9 Total Investment Securities (336 ) 250 (86 ) Loans & Leases Real Estate 1,226 (861 ) 365 Home Equity Line & Loans (70 ) 90 20 Agricultural 268 (96 ) 172 Commercial 175 (68 ) 107 Consumer 24 (40 ) (16 ) Other (2 ) - (2 ) Leases 180 - 180 Total Loans & Leases 1,801 (975 ) 826 Total Earning Assets 1,485 (725 ) 760 Interest Bearing Liabilities Interest Bearing Deposits Transaction 4 - 4 Savings and Money Market 18 (22 ) (4 ) Time Deposits (25 ) (58 ) (83 ) Total Interest Bearing Deposits (3 ) (80 ) (83 ) Other Borrowed Funds - - - Subordinated Debentures - (1 ) (1 ) Total Interest Bearing Liabilities (3 ) (81 ) (84 ) Total Change $ 1,488
$ (644 ) $ 844
Notes: Rate/volume variance is allocated based on the percentage relationship of changes in volume and changes in rate to the total "net change." The above figures have been rounded to the nearest whole number.
38 -------------------------------------------------------------------------------- Table of Contents Net interest income increased
$876,000or 5.0% to $18.4 millionduring the first quarter of 2014 compared to $17.5 millionfor the first quarter of 2013. On a fully tax equivalent basis, net interest income increased 4.7% and totaled $18.7 millionat March 31, 2014, compared to $17.8 millionat March 31, 2013. As more fully discussed below, the increase in net interest income was primarily due to a $126.6 millionincrease in average earning assets. Net interest income on a taxable equivalent basis, expressed as a percentage of average total earning assets, is referred to as the net interest margin. For the quarter ended March 31, 2014, the Company's net interest margin was 3.92% compared to 4.01% for the quarter ended March 31, 2013. This decrease in net interest margin was due primarily to a decline in earning asset yields that exceeded a corresponding drop in funding costs. Average loans & leases totaled $1.4 billionfor the quarter ended March 31, 2014; an increase of $146.8 millioncompared to the average balance for the quarter ended March 31, 2013. Loans & leases increased from 67.5% of average earning assets at March 31, 2013to 70.7% at March 31, 2014. As a result of the continuing impact of the sustained low rate environment since late 2008, the annualized yield on the Company's loan portfolio declined to 4.83% for the quarter ended March 31, 2014, compared to 5.14% for the quarter ended March 31, 2013. Overall, the positive impact on interest revenue from the increase in loan & lease balances was only partially offset by the negative impact of a decline in yields resulting in interest revenue from loans & leases increasing 5.4% to $16.3 millionfor quarter ended March 31, 2014. The Company has been experiencing aggressive competitor pricing for loans & leases to which it may need to continue to respond in order to retain key customers. This could place even greater negative pressure on future loan & lease yields and net interest margin. The investment portfolio is the other main component of the Company's earning assets. Since the risk factor for investments is typically lower than that of loans or leases, the yield earned on investments is generally less than that of loans & leases. Average investment securities totaled $464.2 millionfor the quarter ended March 31, 2014; a decrease of $52.2 millioncompared to the average balance for the quarter ended March 31, 2013. Tax equivalent interest income on securities decreased $86,000to $3.0 millionfor the quarter ended March 31, 2014, compared to $3.1 millionfor the quarter ended March 31, 2013. The average investment portfolio yield, on a tax equivalent (TE) basis, was 2.61% for the quarter ended March 31, 2014, compared to 2.41% for the quarter ended March 31, 2013. This increase in yield occurred primarily as a result of the Company's sale of $28.2 millionof lower yielding Mortgage Backed Securitiesin September 2013. See "Financial Condition - Investment Securities" for a discussion of the Company's investment strategy in 2014. Net interest income on the Schedule of Year-to-Date Average Balances and Interest Rates is shown on a tax equivalent basis, which is higher than net interest income as reflected on the Consolidated Statement of Income because of adjustments that relate to income on securities that are exempt from federal income taxes. Interest bearing deposits with banks and overnight investments in Federal Funds Sold are additional earning assets available to the Company. Interest bearing deposits with banks consisted of FRB deposits. Deposits with the FRB earn interest at the Fed Funds rate, which has been 0.25% since December 2008. Average interest bearing deposits with banks for the quarter ended March 31, 2014, was $102.1 million, a decrease of $31.9 millioncompared to the average balance for the quarter ended March 31, 2013. Interest income on interest bearing deposits with banks for the quarter ended March 31, 2014, increased $20,000to $64,000compared to the quarter ended March 31, 2013. Average interest-bearing liabilities increased $50.7 millionor 3.9% during the first quarter of 2014. Of that increase: (1) interest-bearing transaction deposits increased $36.9 million; (2) savings and money market deposits increased $42.6 million; (3) time deposits decreased $28.7 million; (4) Federal Home Loan Bank("FHLB") Advances decreased $82,000(see "Financial Condition - Federal Home Loan Bank Advancesand Federal Reserve Bank Borrowings"); and (5) subordinated debt remained unchanged (see "Financial Condition - Subordinated Debentures"). Total interest expense on interest bearing deposits was $600,000for the first quarter of 2014 as compared to $683,000 millionfor the first quarter of 2013. The average rate paid on interest-bearing deposits was 0.18% for the first quarter of 2014 compared to 0.22% for the first quarter of 2013. The Company anticipates that this decline in deposit rates, if any, will be much more modest through the remainder of 2014. 39 -------------------------------------------------------------------------------- Table of Contents Provision and Allowance for Credit Losses As a financial institution that assumes lending and credit risks as a principal element of its business, credit losses will be experienced in the normal course of business. The Company has established credit management policies and procedures that govern both the approval of new loans & leases and the monitoring of the existing portfolio. The Company manages and controls credit risk through comprehensive underwriting and approval standards, dollar limits on loans & leases to one borrower, and by restricting loans & leases made primarily to its principal market area where management believes it is best able to assess the applicable risk. Additionally, management has established guidelines to ensure the diversification of the Company's credit portfolio such that even within key portfolio sectors such as real estate or agriculture, the portfolio is diversified across factors such as location, building type, crop type, etc. See "Item 7A. Quantitative and Qualitative Disclosures About Market Risk - Credit Risk." Management reports regularly to the Board of Directors regarding trends and conditions in the loan & lease portfolio and regularly conducts credit reviews of individual loans & leases. Loans & leases that are performing but have shown some signs of weakness are subject to more stringent reporting and oversight. Allowance for Credit Losses The allowance for credit losses is an estimate of probable incurred credit losses inherent in the Company's loan & lease portfolio 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 & lease 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 three primary components, specific reserves related to impaired loans & leases, general reserves for inherent losses related to loans & leases that are not impaired and an unallocated component that takes into account the imprecision in estimating and allocating allowance balances associated with macro factors. A loan or lease 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. Loans & leases determined to be impaired are individually evaluated for impairment. When a loan or lease is impaired, the Company measures impairment based on the present value of expected future cash flows discounted at the loan or lease's effective interest rate, except that as a practical expedient, it may measure impairment based on a loan or lease's observable market price, or the fair value of the collateral if the loan or lease is collateral dependent. A loan or lease is collateral dependent if the repayment of the loan or lease is expected to be provided solely by the underlying collateral. A restructuring of a loan or lease constitutes a troubled debt restructuring ("TDR") under ASC 310-40, 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 loans or leases typically present an elevated level of credit risk as the borrowers are not able to perform according to the original contractual terms. If the restructured loan or lease was current on all payments at the time of restructure and management reasonably expects the borrower will continue to perform after the restructure, management may keep the loan or lease on accrual. Loans & leases that are on nonaccrual status at the time they become TDR, remain on nonaccrual status until the borrower demonstrates a sustained period of performance, which the Company generally believes to be six consecutive months of payments, or equivalent. A loan or lease can be removed from TDR status if it was restructured at a market rate in a prior calendar year and is currently in compliance with its modified terms. However, these loans or leases continue to be classified as impaired and are individually evaluated for impairment. The determination of the general reserve for loans or leases that are collectively evaluated for impairment is based on estimates made by management, to include, but not limited to, consideration of historical losses by portfolio segment, internal asset classifications, and qualitative factors to include 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 & lease portfolio, and probable losses inherent in the portfolio taken as a whole. 40 -------------------------------------------------------------------------------- Table of Contents The Company maintains a separate allowance for each portfolio segment (loan & lease type). These portfolio segments include: (1) commercial real estate; (2) agricultural real estate; (3) real estate construction (including land and development loans); (4) residential 1st mortgages; (5) home equity lines and loans; (6) agricultural; (7) commercial; (8) consumer & other; and (9) equipment leases. See "Financial Condition - Loans & Leases" for examples of loans & leases made by the Company. The allowance for credit losses attributable to each portfolio segment, which includes both impaired loans & leases and loans & leases 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 & leases and periodically performs detailed reviews of all such loans & leases over a certain threshold to identify credit risks and to assess the overall collectability of the portfolio. A credit grade is established at inception for smaller balance loans, such as consumer and residential real estate, and then updated only when the loan becomes contractually delinquent or when the borrower requests a modification. 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 & leases. These credit quality indicators are used to assign a risk rating to each individual loan & lease. These risk ratings are also subject to examination by independent specialists engaged by the Company. The risk ratings can be grouped into five major categories, defined as follows:
Pass - A pass loan or lease is a strong credit with no existing or known potential weaknesses deserving of management's close attention.
Special Mention - A special mention loan or lease 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 lease or in the Company's credit position at some future date. Special Mention loans & leases are not adversely classified and do not expose the Company to sufficient risk to warrant adverse classification. Substandard - A substandard loan or lease is not adequately protected by the current financial condition and paying capacity of the borrower or the value of the collateral pledged, if any. Loans or leases 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 or leases 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, based on currently known facts, conditions and values, highly questionable or improbable.
Loss - Loans or leases classified as loss are considered uncollectible. Once a loan or lease becomes delinquent and repayment becomes questionable, the Company will address collateral shortfalls with the borrower and attempt to obtain additional collateral. If this is not forthcoming and payment in full is unlikely, the Bank will estimate its probable loss and immediately charge-off some or all of the balance. The general reserve component of the allowance for credit 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. These reserve factors are inherently subjective and are driven by the repayment risk associated with each portfolio segment described below: Commercial Real Estate - Commercial real estate mortgage loans generally possess a higher inherent risk of loss than other real estate portfolio segments, except land and construction loans. Adverse economic developments or an overbuilt market impact commercial real estate projects and may result in troubled loans. Trends in vacancy rates of commercial properties impact the credit quality of these loans. High vacancy rates reduce operating revenues and the ability for properties to produce sufficient cash flow to service debt obligations.
Agricultural Real Estateand Agricultural - Loans secured by crop production, livestock and related real estate are vulnerable to two risk factors that are largely outside the control of Company and borrowers: commodity prices and weather conditions. 41 -------------------------------------------------------------------------------- Table of Contents Real Estate Construction- Real Estate Constructionloans, including land 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. Commercial - Commercial loans generally possess a lower inherent risk of loss than real estate portfolio segments because these loans are generally underwritten to existing cash flows of operating businesses. Debt coverage is provided by business cash flows and economic trends influenced by unemployment rates and other key economic indicators are closely correlated to the credit quality of these loans. Residential 1st Mortgages and Home Equity Lines and Loans - 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, although this is not always true as evidenced by the weakness in residential real estate values over the past five years. 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 & Other - A consumer 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 for consumer purchases. 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. Leases - Equipment leases subject the Company, as Lessor, to both the credit risk of the Lessee and the residual value risk of the equipment. Credit risks are underwritten using the same credit criteria the Company would use when making an equipment term loan. Residual value risk is managed through the use of qualified, independent appraisers that establish the residual values the Company uses in structuring a lease. In addition, the Company's and Bank's regulators, including the FRB, DBO and FDIC, 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. Provision for Credit Losses Changes in the provision for credit losses between years are the result of management's evaluation, based upon information currently available, of the adequacy of the allowance for credit losses relative to factors such as the credit quality of the loan & lease portfolio, loan & lease growth, current credit losses, and the prevailing economic climate and its effect on borrowers' ability to repay loans & leases in accordance with the terms of the notes. The Central Valleyof Californiawas one of the hardest hit areas in the country during the recession. In many areas housing prices declined as much as 60% and unemployment reached 15% or more. Although the economy appears to have stabilized throughout most of the Central Valley, housing prices for the most part have not recovered significantly and unemployment levels remain well above those in other areas of the state and country. While, in management's opinion, the Company's levels of net charge-offs and non-performing assets as of March 31, 2014, compare very favorably to our peers at the present time, carefully managing credit risk remains a key focus of the Company. The state of Californiaexperienced drought conditions during much of 2013. Importantly, most of the Company's agricultural customers have access to their own ground water supplies and, therefore, are not as dependent on the delivery of surface water as growers in other parts of California. Although Management does not expect current conditions to have a material impact on credit quality during 2014, the lack of rain will have some adverse impact on our agricultural customers' operating costs, crop yields and crop quality. The longer the drought continues, the more significant this impact will become, particularly if ground water levels reach critical stage. 42 -------------------------------------------------------------------------------- Table of Contents The Company made no provision for credit losses during the first quarters of 2014 or 2013. Net recoveries during the first quarter of 2014 were $3,000compared to net recoveries of $38,000in the first quarter of 2013. See "Overview - Looking Forward: 2014 and Beyond", "Critical Accounting Policies and Estimates - Allowance for Credit Losses" and "Item 7A. Quantitative and Qualitative Disclosures About Market Risk-Credit Risk" located in the Company's 2013 Annual Report on Form 10-K. After reviewing all factors above, based upon information currently available, management concluded that the allowance for credit losses as of March 31, 2014, was adequate. Three Months Ended March 31, Allowance for Credit Losses (in thousands) 2014
Balance at Beginning of Period
Loans or Leases Charged Off (30 ) (35 ) Recoveries of Loans or Leases Previously Charged Off 33
Provision Charged to Expense - - Balance at End of Period
$ 34,277 $ 34,255
The table below breaks out current quarter activity by portfolio segment (in thousands):
Commercial Agricultural Real Estate Residential 1st Home Equity Consumer &
March 31, 2014Real Estate Real Estate Construction Mortgages Lines & Loans Agricultural Commercial Other Leases Unallocated Total Year-To-Date Allowance for Credit Losses: Beginning Balance- January 1, 2014 $ 5,178$ 3,576 $ 654 $ 1,108 $ 2,767 $ 12,205 $ 5,697 $ 176 $ 639 $ 2,274 $ 34,274Charge-Offs - - - (3 ) - - - (27 ) - - (30 ) Recoveries - - - - 12 1 5 15 - - 33 Provision 1,248 (189 ) 423 (5 ) (131 ) (2,605 ) 724 7 282 246 - Ending Balance- March 31, 2014 $ 6,426$ 3,387 $ 1,077 $ 1,100 $ 2,648 $ 9,601 $ 6,426 $ 171 $ 921 $ 2,520 $ 34,277The Allowance for Credit Losses at March 31, 2014remained nearly unchanged from December 31, 2013. However, the allowance allocated to the following categories of loans did change materially during the quarter:
· Commercial Real Estate allowance balances increased
a result of increased balances of loans risk rated special mention.
· Agricultural allowance balances decreased
of decreased loan balances. See "Management's Discussion and Analysis - Financial Condition - Classified Loans & Leases and Non-Performing Assets" for further discussion regarding these loan categories.
See "Note 3. Allowance for Credit Losses" for additional details regarding the provision and allowance for credit losses.
Non-Interest Income Non-interest income includes: (1) service charges and fees from deposit accounts; (2) net gains and losses from investment securities; (3) increases in the cash surrender value of bank owned life insurance; (4) debit card and ATM fees; (5) net gains and losses on non-qualified deferred compensation plans; and (6) fees from other miscellaneous business services. Overall, non-interest income decreased
$2.3 millionor 42.5% for the three months ended March 31, 2014, compared to the same period of 2013. This decrease was primarily due to: (1) a $166,000decrease in service charges on deposit accounts related to the Company's overdraft privilege service; (2) a $732,000decrease in net gain on sale of investment securities; (3) a $1.2 milliondecrease in the net gain on deferred compensation investments; and (4) a $209,000decrease in swap referral fee income. 43 -------------------------------------------------------------------------------- Table of Contents Balances in non-qualified deferred compensation plans may be invested in financial instruments whose market value fluctuates based upon trends in interest rates and stock prices. Although Generally Accepted Accounting Principles require these investment gains/losses be recorded in non-interest income, an offsetting entry is also required to be made to non-interest expense resulting in no effect on the Company's net income. Non-Interest Expense Non-interest expense for the Company includes expenses for: (1) salaries and employee benefits; (2) net gain on deferred compensation investment; (3) occupancy; (4) equipment; (5) ORE holding costs; (6) supplies; (7) legal fees; (8) professional services; (9) data processing; (10) marketing; (11) deposit insurance; and (12) other miscellaneous expenses. Overall, non-interest expense decreased $1.3 millionor 10.2% for the three months ended March 31, 2014, compared to the same period in 2013. This decrease was primarily comprised of: (1) a $1.2 milliondecrease in the net gain on deferred compensation investments; and (2) a $150,000decrease in legal fee expense. These decreases were partially offset by a $192,000increase in salaries and employee benefits primarily related to: (1) new staff added for the LPO's in Walnut Creekand Irvine; (2) bank-wide raises; and (3) increased medical insurance premiums. Balances in non-qualified deferred compensation plans may be invested in financial instruments whose market value fluctuates based upon trends in interest rates and stock prices. Although Generally Accepted Accounting Principles require these investment gains/losses be recorded in non-interest income, an offsetting entry is also required to be made to non-interest expense resulting in no effect on the Company's net income. Income Taxes The provision for income taxes decreased 4.5% to $3.6 millionfor the first quarter of 2014 compared to the first quarter of 2013. The effective tax rate for the first quarter of 2014 was 36.5% compared to 37.7% for the first quarter of 2013. The Company's effective tax rate fluctuates from quarter to quarter due primarily to changes in the mix of taxable and tax-exempt earning sources. The effective rates were lower than the statutory rate of 42% due primarily to benefits regarding the cash surrender value of life insurance; Californiaenterprise zone hiring tax credit; and tax-exempt interest income on municipal securities and loans. Current tax law causes the Company's current taxes payable to approximate or exceed the current provision for taxes on the income statement. Three provisions have had a significant effect on the Company's current income tax liability: (1) the restrictions on the deductibility of credit losses; (2) deductibility of retirement and other long-term employee benefits only when paid; and (3) the statutory deferral of deductibility of Californiafranchise taxes on the Company's federal return.
This section discusses material changes in the Company's balance sheet at
March 31, 2014, as compared to December 31, 2013and to March 31, 2013. As previously discussed (see "Overview") the Company's financial condition can be influenced by the seasonal banking needs of its agricultural customers. Investment Securitiesand Federal Funds Sold The investment portfolio provides the Company with an income alternative to loans & leases. The debt securities in the Company's investment portfolio have historically been comprised primarily of: (1) mortgage-backed securities issued by federal government-sponsored entities; (2) debt securities issued by government agencies and government-sponsored entities; and (3) investment grade bank-qualified municipal bonds. However, during 2013, the Company began to selectively add investment grade corporate securities (floating rate and fixed rate with maturities less than 5 years) to the portfolio in order to obtain yields that exceed government agency securities of equivalent maturity without subjecting the Company to the interest rate risk associated with mortgage-backed securities. 44 -------------------------------------------------------------------------------- Table of Contents The Company's investment portfolio at March 31, 2014was $465.4 millioncompared to $473.1 millionat the end of 2013, a decrease of $7.7 millionor 1.6%. At March 31, 2013, the investment portfolio totaled $583.3 million. The mix of the investment portfolio has changed over the past three to five years. To protect against future increases in market interest rates, while at the same time generating some reasonable level of current yields, the Company has invested most of its available funds in either shorter term government agency & government-sponsored entity securities and shorter term (10, 15, and 20 year) mortgage-backed securities. Beginning in late May 2013rates on 10-year treasuries began to increase from under 2% to a peak of just below 3% in early September 2013, then dropped to around 2.65% at September 30, 2013, and over the past six months have settled into a trading range of 2.60% - 2.90%. As a result of these overall increases in rates, the market value of the Company's security portfolio has declined. . In late September 2013, the Company took advantage of the pull back in rates to sell $28.2 millionof 20-year mortgage-backed securities for a loss of $1.1 million.
The Company's total investment portfolio currently represents 21.9% of the Company's total assets as compared to 22.8% at
March 31, 2014the Company held $62.9 millionof municipal investments, of which $48.9 millionwere bank-qualified municipal bonds, all classified as held-to-maturity. The financial problems experienced by certain municipalities over the past five years, along with the financial stresses exhibited by some of the large monoline bond insurers, has increased the overall risk associated with bank-qualified municipal bonds. This situation caused the Company not to purchase any municipal bonds between late 2006 and year-end 2011. However, during the first quarter of 2012 the Company began investing in bank-qualified municipals that were rated AA or better. As of March 31, 2014ninety-three percent of the Company's bank-qualified municipal bond portfolio is rated at either the issue or issuer level, and all of these ratings are "investment grade." Additionally, in order to comply with Section 939A of the Dodd-Frank Act, the Company performs its own credit analysis on new purchases of municipal bonds and corporate securities. The Company monitors the status of the approximately seven percent ( $3.6 million) of the portfolio that is not rated and at the current time does not believe any of them to be exhibiting financial problems that could result in a loss in any individual security. Not included in the investment portfolio are interest bearing deposits with banks and overnight investments in Federal Funds Sold. Interest bearing deposits with banks consisted of FRB deposits. The FRB currently pays interest on the deposits that banks maintain in their FRB accounts, whereas historically banks had to sell these Federal Funds to other banks in order to earn interest. Since balances at the FRB are effectively risk free, the Company elected to maintain its excess cash at the FRB. Interest bearing deposits with banks totaled $134.7 millionat March 31, 2014, $42.7 millionat December 31, 2013and $12.8 millionat March 31, 2013. The Company classifies its investments as held-to-maturity, trading, or available-for-sale. Securities are classified as held-to-maturity and are carried at amortized cost when the Company has the intent and ability to hold the securities to maturity. Trading securities are securities acquired for short-term appreciation and are carried at fair value, with unrealized gains and losses recorded in non-interest income. As of March 31, 2014, December 31, 2013and March 31, 2013, there were no securities in the trading portfolio. Securities classified as available-for-sale include securities, which may be sold to effectively manage interest rate risk exposure, prepayment risk, satisfy liquidity demands and other factors. These securities are reported at fair value with aggregate, unrealized gains or losses excluded from income and included as a separate component of shareholders' equity, net of related income taxes. Loans & Leases Loans & leases can be categorized by borrowing purpose and use of funds. Common examples of loans & leases made by the Company include: Commercial and Agricultural Real Estate- These are loans secured by farmland, commercial real estate, multifamily residential properties, and other non-farm, non-residential properties within our market area. Commercial mortgage term loans can be made if the property is either income producing or scheduled to become income producing based upon acceptable pre-leasing, and the income will be the Bank's primary source of repayment for the loan. Loans are made both on owner occupied and investor properties; generally do not exceed 15 years (and may have pricing adjustments on a shorter timeframe); have debt service coverage ratios of 1.00 or better with a target of greater than 1.20; and fixed rates that are most often tied to treasury indices with an appropriate spread based on the amount of perceived risk in the loan. 45 -------------------------------------------------------------------------------- Table of Contents Real Estate Construction- These are loans for development and construction (the Company generally requires the borrower to fund the land acquisition) and are secured by commercial or residential real estate. These loans are generally made only to experienced local developers with whom the Bank has a successful track record; for projects in our service area; with Loan To Value (LTV) below 75%; and where the property can be developed and sold within 2 years. Commercial construction loans are made only when there is a written take-out commitment from the Bank or an acceptable financial institution or government agency. Most acquisition, development and construction loans are tied to the prime rate with an appropriate spread based on the amount of perceived risk in the loan. Residential 1st Mortgages - These are loans primarily made on owner occupied residences; generally underwritten to income and LTV guidelines similar to those used by FNMA and FHLMC; however, we will make loans on rural residential properties up to 20 acres. Most residential loans have terms from ten to twenty years and carry fixed rates priced off of treasury rates. The Company has always underwritten mortgage loans based upon traditional underwriting criteria and does not make loans that are known in the industry as "subprime," "no or low doc," or "stated income." Home Equity Lines and Loans - These are loans made to individuals for home improvements and other personal needs. Generally, amounts do not exceed $250,000; Combined Loan To Value (CLTV) does not exceed 80%; FICO scores are at or above 670; Total Debt Ratios do not exceed 43%; and in some situations the Company is in a 1st lien position. Agricultural - These are loans and lines of credit made to farmers to finance agricultural production. Lines of credit are extended to finance the seasonal needs of farmers during peak growing periods; are usually established for periods no longer than 12 to 24 months; are often secured by general filing liens on livestock, crops, crop proceeds and equipment; and are most often tied to the prime rate with an appropriate spread based on the amount of perceived risk in the loan. Term loans are primarily made for the financing of equipment, expansion or modernization of a processing plant, or orchard/vineyard development; have maturities from five to seven years; and fixed rates that are most often tied to treasury indices with an appropriate spread based on the amount of perceived risk in the loan. Commercial - These are loans and lines of credit to businesses that are sole proprietorships, partnerships, LLC'sand corporations. Lines of credit are extended to finance the seasonal working capital needs of customers during peak business periods; are usually established for periods no longer than 12 to 24 months; are often secured by general filing liens on accounts receivable, inventory and equipment; and are most often tied to the prime rate with an appropriate spread based on the amount of perceived risk in the loan. Term loans are primarily made for the financing of equipment, expansion or modernization of a plant or purchase of a business; have maturities from five to seven years; and fixed rates that are most often tied to treasury indices with an appropriate spread based on the amount of perceived risk in the loan. Consumer - These are loans to individuals for personal use, and primarily include loans to purchase automobiles or recreational vehicles, and unsecured lines of credit. The Company has a very minimal consumer loan portfolio, and loans are primarily made as an accommodation to deposit customers. Leases -These are leases to businesses or individuals, for the purpose of financing the acquisition of equipment. They can be either "finance leases" where the lessee retains the tax benefits of ownership but obtains 100% financing on their equipment purchases; or "true tax leases" where the Company, as lessor, places reliance on equipment residual value and in doing so obtains the tax benefits of ownership. Leases typically have a maturity of three to ten years, and fixed rates that are most often tied to treasury indices with an appropriate spread based on the amount of perceived risk. Credit risks are underwritten using the same credit criteria the Company would use when making an equipment term loan. Residual value risk is managed through the use of qualified, independent appraisers that establish the residual values the Company uses in structuring a lease. 46 -------------------------------------------------------------------------------- Table of Contents Each loan or lease type involves risks specific to the: (1) borrower; (2) collateral; and (3) loan & lease structure. See "Results of Operations - Provision and Allowance for Credit Losses" for a more detailed discussion of risks by loan & lease type. The Company's current underwriting policies and standards are designed to mitigate the risks involved in each loan & lease type. The Company's policies require that loans & leases are approved only to those borrowers exhibiting a clear source of repayment and the ability to service existing and proposed debt. The Company's underwriting procedures for all loan & lease types require careful consideration of the borrower, the borrower's financial condition, the borrower's management capability, the borrower's industry, and the economic environment affecting the loan or lease. Most loans & leases made by the Company are secured, but collateral is the secondary or tertiary source of repayment; cash flow is our primary source of repayment. The quality and liquidity of collateral are important and must be confirmed before the loan is made. In order to be responsive to borrower needs, the Company prices loans & leases: (1) on both a fixed rate and adjustable rate basis; (2) over different terms; and (3) based upon different rate indices; as long as these structures are consistent with the Company's interest rate risk management policies and procedures (see Item 3. Quantitative and Qualitative Disclosures About Market Risk-Interest Rate Risk). The Company's loan & lease portfolio at March 31, 2014totaled $1.36 billion, an increase of $136.3 millionor 11.1% over March 31, 2013. This increase has occurred despite what has been a difficult economic environment combined with a very competitive pricing environment, and is a result of the Company's intensified business development efforts directed toward credit-qualified borrowers. No assurances can be made that this growth in the loan & lease portfolio will continue until the economy in the Central Valleyof Californiaimproves.
Loans & leases at
The following table sets forth the distribution of the loan & lease portfolio by type and percent as of the periods indicated.
Loan & Lease Portfolio March 31, 2014 December 31, 2013 March 31, 2013 (in thousands) $ % $ % $ % Commercial Real Estate
$ 406,49529.8 % $ 411,03729.5 % $ 363,38429.5 % Agricultural Real Estate 326,112 23.9 % 328,264 23.6 % 318,823 25.9 % Real Estate Construction 55,751 4.1 % 41,092 3.0 % 32,681 2.7 % Residential 1st Mortgages 156,094 11.4 % 151,292 10.9 % 145,419 11.8 % Home Equity Lines and Loans 34,289 2.5 % 35,477 2.5 % 40,141 3.3 % Agricultural 209,228 15.3 % 256,414 18.4 % 181,725 14.8 % Commercial 155,802 11.4 % 150,398 10.8 % 142,115 11.6 % Consumer & Other 4,721 0.3 % 5,052 0.4 % 4,898 0.4 % Leases 18,168 1.3 % 12,733 0.9 % - 0.0 % Total Gross Loans & Leases 1,366,660 100.0 % 1,391,759 100.0 % 1,229,186 100.0 % Less: Unearned Income 3,630 3,523 2,491 Subtotal 1,363,030 1,388,236 1,226,695 Less: Allowance for Credit Losses 34,277 34,274 34,255 Net Loans & Leases $ 1,328,753 $ 1,353,962 $ 1,192,440Classified Loans & Leases and Non-Performing Assets All loans & leases are assigned a credit risk grade using grading standards developed by bank regulatory agencies. See "Results of Operations - Provision and Allowance for Credit Losses" for more detail on risk grades. The Company utilizes the services of a third-party independent loan review firm to perform evaluations of individual loans & leases and review the credit risk grades the Company places on loans & leases. Loans & leases that are judged to exhibit a higher risk profile are referred to as "classified loans & leases," and these loans & leases receive increased management attention. As of March 31, 2014, classified loans totaled $4.1 millioncompared to $5.8 millionat December 31, 2013and $22.2 millionat March 31, 2013. 47 -------------------------------------------------------------------------------- Table of Contents Classified loans & leases with higher levels of credit risk can be further designated as "impaired" loans & leases. A loan or lease 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. See "Results of Operations - Provision and Allowance for Credit Losses" for further details. Impaired loans & leases consist of: (1) non-accrual loans & leases; and/or (2) restructured loans & leases that are still performing (i.e., accruing interest). Non-Accrual Loans & leases - Accrual of interest on loans & leases is generally discontinued when a loan or lease becomes contractually past due by 90 days or more with respect to interest or principal. When loans & leases are 90 days past due, but in management's judgment are well secured and in the process of collection, they may not be classified as non-accrual. When a loan or lease is placed on non-accrual status, all interest previously accrued but not collected is reversed. Income on such loans & leases is then recognized only to the extent that cash is received and where the future collection of principal is probable. As of March 31, 2014non-accrual loans & leases totaled $3.1 million. At December 31, 2013and March 31, 2013, non-accrual loans totaled $2.6 millionand $9.5 million, respectively. The decrease in non-accrual loans & leases was primarily a result of workouts with problem credit related to the dairy industry. Restructured Loans & Leases - A restructuring of a loan or lease constitutes a troubled debt restructuring ("TDR") under ASC 310-40, 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 loans or leases typically present an elevated level of credit risk as the borrowers are not able to perform according to the original contractual terms. If the restructured loan or lease was current on all payments at the time of restructure and management reasonably expects the borrower will continue to perform after the restructure, management may keep the loan or lease on accrual. Loans & leases that are on nonaccrual status at the time they become TDR loans, remain on nonaccrual status until the borrower demonstrates a sustained period of performance, which the Company generally believes to be six consecutive months of payments, or equivalent. A loan or lease can be removed from TDR status if it was restructured at a market rate in a prior calendar year and is currently in compliance with its modified terms. However, these loans or leases continue to be classified as impaired and are individually evaluated for impairment.
Other Real Estate - Loans where the collateral has been repossessed are classified as other real estate ("ORE") or, if the collateral is personal property, the loan is classified as other assets on the Company's financial statements.
The following table sets forth the amount of the Company's non-performing loans & leases (defined as non-accrual loans & leases plus accruing loans & leases past due 90 days or more) and ORE as of the dates indicated. Non-Performing Assets (in thousands) March 31, 2014 Dec. 31, 2013 March 31, 2013 Non-Performing Loans & Leases $ 3,133 $ 2,596 $ 9,478 Other Real Estate 3,294 4,611 4,743 Total Non-Performing Assets $ 6,427 $
Non-Performing Loans & Leases as a % of Total Loans & Leases 0.23 % 0.19 % 0.77 % Restructured Loans & Leases (Performing) $ 3,956 $
4,649 $ 1,427
Although management believes that non-performing loans & leases are generally well-secured and that potential losses are provided for in the Company's allowance for credit losses, there can be no assurance that future deterioration in economic conditions and/or collateral values will not result in future credit losses. Specific reserves of
$1.0 million, $983,000, and $1.3 millionhave been established for non-performing loans & leases at March 31, 2014, December 31, 2013and March 31, 2013, respectively. 48 -------------------------------------------------------------------------------- Table of Contents Foregone interest income on non-accrual loans & leases which would have been recognized during the period, if all such loans & leases had been current in accordance with their original terms, totaled $13,000for the three months ended March 31, 2014, $30,500for the year ended December 31, 2013, and $219,000for the three months ended March 31, 2013. The Company reported $3.3 millionof ORE at March 31, 2014, $4.6 millionat December 31, 2013, and $4.7 millionat March 31, 2013. The March 31, 2014value is net of a $3.7 millionreserve for ORE valuation allowance. The December 31, 2013and March 31, 2013values are both net of a $4.1 millionreserve for ORE valuation allowance. Except for those classified and non-performing loans & leases discussed above, the Company's management is not aware of any loans or leases as of March 31, 2014, for which known financial problems of the borrower would cause serious doubts as to the ability of these borrowers to materially comply with their present loan repayment terms or lease payments, or any known events that would result in the loan or lease being designated as non-performing at some future date. However, the Central Valleywas one of the hardest hit areas in the country during the recession. In many areas housing prices declined as much as 60% and unemployment reached 15% or more. Although the economy appears to have stabilized throughout most of the Central Valley, housing prices for the most part have not recovered significantly and unemployment levels remain well above those in other areas of the state and country. See "PartI, Item 1A. Risk Factors" in the Company's 2013 Annual Report on Form 10-K.
One of the key sources of funds to support earning assets is the generation of deposits from the Company's customer base. The ability to grow the customer base and subsequently deposits is a significant element in the performance of the Company. The Company's deposit balances at
March 31, 2014have increased $125.4 millionor 7.3% compared to March 31, 2013. In addition to the Company's ongoing business development activities for deposits, the following factors positively impacted year-over-year deposit growth: (1) the Federal government's decision to permanently increase FDICdeposit insurance limits from $100,000to $250,000per depositor; and (2) the Company's strong financial results and position and F&M Bank's reputation as one of the most safe and sound banks in its market territory. The Company expects that, at some point, deposit customers may begin to diversify how they invest their money (e.g., move funds back into the stock market or other investments) and this could impact future deposit growth. Although total deposits have increased 7.3% since March 31, 2013, the Company's focus has been on increasing low cost transaction and savings accounts, which have grown at a much faster pace:
· Demand and interest-bearing transaction accounts increased
· Savings and money market accounts have increased
March 31, 2013.
· Time deposit accounts have decreased
2013. This decline was the continuing result of an explicit pricing strategy
adopted by the Company beginning in 2009 based upon the recognition that market
CD rates were greater than the yields that the Company could obtain reinvesting
these funds in short-term government agency & government-sponsored entity
securities or overnight Fed Funds. Beginning in 2009, management carefully
reviewed time deposit customers and reduced our deposit rates to customers that
did not also have transaction, money market, and/or savings balances with us
(i.e., depositors who were not "relationship customers"). Given the Company's
strong deposit growth in transaction, savings and money market accounts, this
time deposit decline has not presented any liquidity issues and it has significantly enhanced the Company's net interest margin and earnings. The Company's deposit balances at
March 31, 2014have increased $32.9 millionor 1.8% compared to December 31, 2013. Savings and money market deposits increased 8.5% or $49.8 millionwhile demand and interest-bearing transaction accounts decreased by $10.8 millionor 1.4% and time deposit accounts decreased by $6.1 millionor 1.4%. Deposit trends in the first half of the year can be impacted by the seasonal needs of our agricultural customers. 49 -------------------------------------------------------------------------------- Table of Contents Federal Home Loan Bank Advancesand Federal Reserve Bank Borrowings Lines of credit with the Federal Reserve Bankand the Federal Home Loan Bankare other key sources of funds to support earning assets See "Item 3. Quantitative and Qualitative Disclosures About Market Risk and Liquidity Risk." These sources of funds are also used to manage the Company's interest rate risk exposure, and as opportunities arise, to borrow and invest the proceeds at a positive spread through the investment portfolio. There were no FHLB Advances at March 31, 2014, December 31, 2013, and March 31, 2013. There were no amounts outstanding on the Company's line of credit with the FRB as of March 31, 2014.
Securities Sold Under Agreement to Repurchase Securities Sold Under Agreement to Repurchase are used as secured borrowing alternatives to FHLB Advances or FRB Borrowings.
In 2008, the Bank entered into medium term repurchase agreements with Citigroup totaling
$60 million. In 2012, the repurchase agreements with Citigroup were terminated resulting in an early termination fee totaling $1.7 million. The Bank had determined that it was appropriate to replace these relatively "high-cost" borrowings with short-term FHLB advances at substantially lower rates.
Subordinated Debentures On
December 17, 2003, the Company raised $10 millionthrough an offering of trust-preferred securities. See Note 13 located in "Item 8. Financial Statements and Supplementary Data." Although this amount is reflected as subordinated debt on the Company's balance sheet, under current regulatory guidelines, our trust preferred securities will continue to qualify as regulatory capital (See "Basel III Regulatory Capital Rules" for a discussion of the potential impact of proposed regulatory guidelines on this qualification). These securities accrue interest at a variable rate based upon 3-month LIBORplus 2.85%. Interest rates reset quarterly and were 3.08% as of March 31, 2014, 3.9% at December 31, 2013and 3.13% at March 31, 2013. The average rate paid for these securities for the first quarter of 2014 was 3.10% compared to 3.19% for the first quarter of 2013. Additionally, if the Company decided to defer interest on the subordinated debentures, the Company would be prohibited from paying cash dividends on the Company's common stock.
The Company relies primarily on capital generated through the retention of earnings to satisfy its capital requirements. The Company engages in an ongoing assessment of its capital needs in order to support business growth and to insure depositor protection. Shareholders' Equity totaled
$218.0 millionat March 31, 2014, $209.9 millionat December 31, 2013, and $209.8 millionat March 31, 2013. The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company's and the Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of the Company's and the Bank's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Company's and the Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. 50 -------------------------------------------------------------------------------- Table of Contents Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios set forth in the table below of Total and Tier 1 capital to risk-weighted assets and of Tier 1 capital to average assets (all terms as defined in the regulations). Management believes, as of March 31, 2014, that the Company and the Bank meet all capital adequacy requirements to which they are subject. In its most recent notification from the FDICthe Bank was categorized as "well capitalized" 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. There are no conditions or events since that notification that management believes have changed the institution's categories. To Be Well Capitalized Under Regulatory Capital Prompt Corrective (in thousands) Actual Requirements Action Provisions The Company: Amount Ratio Amount Ratio Amount Ratio As of March 31, 2014Total Capital to Risk $ 250,46114.46 % $ 138,5608.0 % N/A N/A Weighted Assets Tier 1 Capital to $ 228,65313.20 % $ 69,2804.0 % N/A N/A Risk Weighted Assets Tier 1 Capital to $ 228,65310.93 % $ 83,6674.0 % N/A N/A Average Assets To Be Well Capitalized Under Regulatory Capital Prompt Corrective (in thousands) Actual Requirements Action Provisions The Bank: Amount Ratio Amount Ratio Amount Ratio As of March 31, 2014Total Capital to Risk $ 250,39814.46 % $ 138,5338.0 % $ 173,16710.0 % Weighted Assets Tier 1 Capital to $ 228,59513.20 % $ 69,2674.0 % $ 103,9006.0 % Risk Weighted Assets Tier 1 Capital to $ 228,59510.93 % $ 83,6334.0 % $ 104,5425.0 % Average Assets As previously discussed (see "Subordinated Debentures"), in order to supplement its regulatory capital base, during December 2003the Company issued $10 millionof trust preferred securities. On March 1, 2005, the Federal Reserve Boardissued its final rule effective April 11, 2005, concerning the regulatory capital treatment of trust preferred securities ("TPS") by bank holding companies ("BHCs"). Under the final rule BHCs may include TPS in Tier 1 capital in an amount equal to 25% of the sum of core capital net of goodwill. Any portion of trust-preferred securities not qualifying as Tier 1 capital would qualify as Tier 2 capital subject to certain limitations. The Company has received notification from the Federal Reserve Bank of San Franciscothat all of the Company's trust preferred securities currently qualify as Tier 1 capital.
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.
In 1998, the Board approved the Company's first common stock repurchase program. This program has been extended and expanded several times since then, and most recently, on
September 11, 2012, the Board of Directors approved increasing the funds available for the Company's common stock repurchase program to $20 millionover the three-year period ending September 30, 2015. See "Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities" of the Company's 2013 Annual Report on Form 10-K for additional information. During 2013 and first quarter of 2014, the Company did not repurchase any shares under the Stock Repurchase Program. During 2012, the Company repurchased 1,542 shares under the Stock Repurchase Program at an average per share price of $373. The remaining dollar value of shares that may yet be purchased under the Company's Stock Repurchase Program is approximately $20 million. 51 -------------------------------------------------------------------------------- Table of Contents On August 5, 2008, the Board of Directors approved a Share Purchase Rights Plan (the "Rights Plan"), pursuant to which the Company entered into a Rights Agreement dated August 5, 2008, with Registrar and Transfer Companyas Rights Agent. See "Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities" of the Company's 2013 Annual Report on Form 10-K for further explanation. Basel III Regulatory Capital Rules On July 2, 2013, the FRB approved final rules and the FDICsubsequently adopted interim final rules that would substantially amend the regulatory risk-based capital rules applicable to the Company and the Bank. These rules would implement the Basel III regulatory capital reforms and changes required by the Dodd-Frank Act. The final rules include new minimum risk-based capital and leverage ratios, which would be phased in over time. The new minimum capital level requirements applicable to the Company and the Bank under the final rules will be: (i) a common equity Tier 1 capital ratio of 4.5% of risk weighted assets ("RWA"); (ii) a Tier 1 capital ratio of 6% of RWA; (iii) a total capital ratio of 8% of RWA; and (iv) a Tier 1 leverage ratio of 4% of total assets. The final rules also establish a "capital conservation buffer" of 2.5% above each of the new regulatory minimum capital ratios, which would result in the following minimum ratios: (i) a common equity Tier 1 capital ratio of 7.0% of RWA; (ii) a Tier 1 capital ratio of 8.5% of RWA, and (iii) a total capital ratio of 10.5% of RWA. An institution will be subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses if its capital level falls below the buffer amount. The final rules also implement other revisions to the current capital rules but, in general, those revisions are not as onerous as originally thought when the proposed rules were issued in June 2012. For instance, the Company's subordinated debentures will continue to qualify for Tier 1 under the rules. The Company believes that it is currently in compliance with all of these new capital requirements (as fully phased-in) and that they will not result in any restrictions on the Company's business activity. Critical Accounting Policies and Estimates This "Management's Discussion and Analysis of Financial Condition and Results of Operations," is based upon the Company's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. In preparing the Company's financial statements management makes estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. These judgments govern areas such as the allowance for credit losses, the fair value of financial instruments and accounting for income taxes.
For a full discussion of the Company's critical accounting policies and estimates see "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Company's 2013 Annual Report on Form 10-K.