News Column

BANKGUAM HOLDING CO - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

August 12, 2014

The following discussion provides information about the results of operations, financial condition, liquidity, and capital resources of the Company and its wholly-owned subsidiary, the Bank. This information is intended to facilitate the understanding and assessment of significant changes and trends related to our financial condition and the results of operations. This discussion and analysis should be read in conjunction with our consolidated financial statements and the accompanying notes presented elsewhere in this Quarterly Report.



Overview

BankGuam Holding Company (the "Company") is a Guam corporation organized on October 29, 2010, to act as a holding company of Bank of Guam (the "Bank"), a 23-branch bank serving the communities in Guam, the Commonwealth of the Northern Mariana Islands (CNMI), the Federated States of Micronesia (FSM), the Republic of the Marshall Islands (RMI), the Republic of Palau (ROP), and San Francisco, California. On August 15, 2011, the Company acquired all of the outstanding common stock of the Bank in a holding company formation transaction. Other than holding the shares of the Bank, the Company conducts no significant activities, although it is authorized, with the prior approval of its principal regulator, the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"), to engage in a variety of activities related to the business of banking. Currently, substantially all of the Company's operations are conducted and substantially all of the assets are owned by the Bank, which accounts for substantially all of our consolidated assets and consolidated revenues, expenses and operating income. The Bank's headquarters is located in HagÅtÑa, Guam, and the Bank provides a variety of financial services to individuals, businesses and government entities through its branch network. The Bank's primary deposit products are demand deposits, savings and time certificates of deposit, and its primary lending products are consumer, commercial and real estate loans. The Bank also provides many other financial services to its customers.



Summary of Operating Results

The following table provides unaudited comparative information with respect to our results of operations for the three-month and six-month periods ended June 30, 2014 and 2013, respectively:

(unaudited) Three months ended June 30, Six months ended June 30, 2014 2013 % 2014 2013 % Amount Amount Change Amount Amount Change (dollars in thousands) Interest income $ 16,500$ 15,867 4.0 % $ 32,730$ 31,143 5.1 % Interest expense 1,210 1,105 9.5 % 2,384 2,530 -5.8 % Net interest income 15,290 14,762 3.6 % 30,346 28,613 6.1 % Provision for loan losses 900 (680 ) -232.4 % 1,800 295 510.2 % Net interest income after provision for loan losses 14,390 15,442 -6.8 % 28,546 28,318 0.8 % Total non-interest income 2,496 2,994 -16.6 % 4,964 6,014 -17.5 % Total non-interest expense 14,001 14,128 -0.9 % 27,622 27,336 1.0 % Net income before income taxes 2,885 4,308 -33.0 % 5,887 6,996 -15.9 % Provision for income taxes 838 1,294 -35.3 % 1,713 2,056 -16.7 % Net income $ 2,047$ 3,014 -32.1 % $ 4,174$ 4,940 -15.5 % Net income per common share Basic $ 0.23$ 0.34$ 0.47$ 0.56 Diluted $ 0.23$ 0.34$ 0.47$ 0.56 As the above table indicates, our net income increased in the three months ended June 30, 2014, as compared to the corresponding period in 2013. In the three months ended June 30, 2014, we recorded net income after taxes of $2.0 million, down $967 thousand (or 32.1%) as compared to the same period in 2013. These results were most significantly impacted by: (i) a provision for loan losses of $900 thousand in the second quarter of 2014 as compared to a negative provision of $680 thousand during the same period of 2013; and, (ii) lower non-interest income, which decreased by $498 thousand, primarily caused by a decrease of $243 thousand in net investment securities gains and a decrease of $168 thousand in income from cardholders. These negative effects were partially offset by (i) a $528 thousand increase in net interest income, composed of a $633 thousand increase in interest income attenuated by a $105 thousand increase in interest expense; (ii) a decrease in our provision for income taxes of $456 thousand; and, a reduction of $127 thousand in non-interest expense. This decrease in non-interest expense in the three months ended June 30, 2014, as compared to the same period in 2013, was largely attributed to: (i) a drop of $733 thousand in the other general operating expense category; (ii) an increase of $595 thousand in expenses associated with other real estate owned, from a negative $566 thousand a year earlier; (iii) a 29 -------------------------------------------------------------------------------- decrease in employee salaries and related benefit expenses, which declined by $230; and, (iv) a decrease of $109 thousand in occupancy expenses. These were only partially offset by an increase of furniture and equipment expense by $204 thousand and an increase of $128 thousand in insurance expense. During the first six months of 2014 our net income after taxes decreased to $4.2 million from $4.9 million during the corresponding period of 2013. This decrease of $766 thousand (or 15.5%) was primarily due to an increase in our provision for loan losses by $1.5 million, from $295 thousand to $1.8 million in the first half of 2014. The increase in our provision for loan losses during the first six months of 2014 was the result of a one-time decrease in provisions in the second quarter of 2013. The increase in provisions caused net interest income to rise by only $228 thousand during the first half of 2014 in comparison to the same period in 2013. In addition, non-interest income decreased by $1.1 million during the six months ended June 30, 2014, and non-interest expense increased by $286 thousand, or 1.0%. The reduction in non-interest income was primarily caused by a decrease of $576 thousand in income from cardholders, a decrease of $450 thousand in net investment securities gains and a decrease of $112 thousand in trustee fees, only partially offset by an increase of $111 thousand in service charges and fees. The factors reducing our net income were only partially offset by a decrease in our provision for income taxes of $434 thousand, but the decrease in net income was limited by an increase of $1.7 million in net interest income that resulted from an increase of $1.6 million in interest income and a decrease of $146 thousand in interest expense. The following table shows the decrease in our net interest margin and indicates the impact that the decrease in our operating results in the three months and six months ended June 30, 2014, had on our annualized returns on average assets and average equity during that period, as compared to the corresponding periods in 2013: Three months ended June 30, Six months ended June 30, 2014 2013 2014 2013 Net interest margin 4.35 % 4.89 % 4.49 % 4.77 % Return on average assets 0.23 % 0.93 % 0.24 % 0.77 % Return on average equity 3.46 % 12.70 % 3.58 % 10.39 % All three measures for the three months and the six months ending June 30, 2014, decreased from the same periods in 2013. The primary reason for the decrease in net interest margin is that our interest earning assets grew at a much higher rate (16.3% in the three months ended and 12.7% in the six months ended June 30, 2014, versus June 30, 2013) than our net interest income (3.6% in the three months ended and 6.1% in the six months ended June 30, 2014, versus June 30, 2013) and the yield on total interest earning assets decreased sharply (by 0.56% in the three months ended and by 0.35% in the six months ended June 30, 2014, versus June 30, 2013). The decreases in the returns on average assets and average equity were primarily due to the decrease in net income (by 32.1% in the three months ended and 15.5% in the six months ended June 30, 2014, versus June 30, 2013) which in turn was primarily caused by the one-time boost to income from the negative provision for loan losses during the second quarter of 2013. We also experienced a very rapid increase in average assets relative to the previous year's periods, by 14.3% in the three months ended and 11.3% in the six months ended June 30, 2014. Critical Accounting Policies The Company's significant accounting policies are set forth in Note 1 in the Notes to the Company's Annual Report on Form 10-K for 2013 filed with the SEC on March 17, 2014, and Note 2 of Item 1 in this report. Our unaudited condensed consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States of America ("GAAP") and general practices in the banking industry. Certain of those accounting policies are considered critical accounting policies because they require us to make assumptions and judgments regarding circumstances or trends that could affect the carrying values of our material assets, such as assumptions regarding economic conditions or trends that could impact our ability to fully collect our outstanding loans or ultimately realize the carrying values of certain of our other assets, such as securities that are available for sale. If adverse changes were to occur in the events, trends or other circumstances on which our assumptions or judgments have been based, or other unanticipated events were to happen that might affect our operating results, it could become necessary under GAAP for us to reduce the carrying values of the affected assets on our Statement of Condition. In addition, because reductions in the carrying values of assets are sometimes effectuated by or require charges to income, such reductions also may have the effect of reducing our income. The following is a brief description of the Company's current accounting policies involving significant valuation judgments:



Loans and Interest on Loans

Loan receivables that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at their outstanding unpaid principal balances, reduced by any charge-offs of specific valuation allowances and net of any deferred fees or costs on originated loans, or unamortized premiums or discounts on purchased loans. Loan origination fees and certain direct origination costs are capitalized and recognized as an adjustment in income over the life of the related loan. 30 -------------------------------------------------------------------------------- Loans on which the accrual of interest has been discontinued are designated as non-accruing loans. The accrual of interest on loans is discontinued when principal and/or interest is past due 90 days or more based on the contractual terms of the loan and/or when, in the opinion of management, there is a reasonable doubt as to collectability, unless such loans are well-collateralized and in the process of collection. When loans are placed in non-accrual status, all interest previously accrued but not collected is reversed as a charge against current period interest income. Subsequent payments received on such loans are generally applied as a reduction to the loan principal balance, unless the likelihood of further loss is remote whereby cash interest payments may be recorded during the time the loan is on non-accrual status. Interest accruals are resumed on such loans only when they are brought current with respect to interest and principal and when, in the judgment of management, all remaining principal and interest is estimated to be fully collectible, there has been at least six months of sustained repayment performance since the loan was placed on non-accrual, and/or management believes, based on current information, that such loan is no longer impaired. Management considers a loan to be impaired when, based on current information and events, it is probable that the Bank will be unable to collect all of the amounts due according to the contractual terms of the loan agreement. Measurement of impairment is based on the expected future cash flows of an impaired loan, which are discounted at the loan's original effective interest rate, or measured by reference to an observable market value, if one exists, or the fair value of the collateral for a collateral-dependent loan. The Bank performs direct write-downs of impaired loans with a charge to the allocated component of the allowance for loan losses, thereby reducing the allocated component of the allowance to zero at the end of each reporting period.



Allowance for Loan Losses

The Bank maintains its allowance for loan losses at a level which, in management's judgment, is adequate to absorb credit losses inherent in the loan portfolio as of the balance sheet date. The amount of the allowance is based on management's periodic evaluation of the collectability of the loan portfolio, including the nature and volume of the portfolio, credit concentrations, trends in historical loss experience, the level of certain classified and impaired loans, and economic conditions and the related impact on specific borrowers that may affect the borrower's ability to repay. The allowance is increased by provisions for loan losses, which are charged against net interest earnings, and reduced by charge-offs, net of recoveries. Changes in the allowance relating to impaired loans are charged or credited to the allowance for loan losses. Because of uncertainties in the estimation process, management's estimate of credit losses inherent in the loan portfolio and the related allowance may change.



Other Real Estate Owned

Real estate and other property acquired in full or partial settlement of loan obligations is referred to as other real estate owned ("OREO"). OREO is originally recorded in the Bank's unaudited condensed financial statements at the lower of the carrying amount of the loan or the fair value of the property, less any estimated costs to sell the underlying assets. When property is acquired through foreclosure or surrendered in lieu of foreclosure, the Bank measures the fair value of the property acquired against its recorded investment in the loan. If the fair value of the property at the time of acquisition is less than the recorded investment in the loan, the difference is charged to the allowance for loan losses. Any subsequent fluctuations in the fair value of the OREO are recorded against a valuation allowance for other real estate owned, established through a charge to non-interest expense. All related operating or maintenance costs are charged to non-interest expense as incurred. Any subsequent gains or losses on the sale of OREO are recorded in other income or expense as incurred. Investment Securities In accordance with U.S. GAAP, securities are classified in three categories and accounted for as follows: (i) securities that the Bank has the intent and ability to hold to maturity are classified as "held-to-maturity" and are measured at amortized cost; (ii) securities bought and held principally for the purpose of selling in the near term are classified as "trading" securities and are measured at fair value, with unrealized gains and losses reflected in earnings; and, (iii) securities not classified as either held-to-maturity or trading are classified as "available-for-sale" securities and are measured at fair value, with unrealized gains and losses, net of applicable taxes, reported as a separate component of stockholders' equity. Where available, the fair values of available-for-sale securities are based on quoted market prices. If quoted market prices are not available, fair values are estimated from the quoted prices of similar instruments or through the use of other observable data supporting a valuation model. Gains and losses on sales of investment securities are determined on the specific identification method. Premiums and discounts are amortized or accreted using the interest method over the expected lives of the related securities. The Bank does not hold securities for trading purposes.



Results of Operations

Net Interest Income

Net interest income, the primary component of the Bank's income, refers to the difference between the interest earned on loans, investment securities and other interest-earning assets, and the interest paid on deposits and other borrowed funds. Our interest income and interest expense are affected by a number of factors, some of which are outside of our control, including national and local 31 -------------------------------------------------------------------------------- economic conditions, the monetary policies of the Federal Reserve Board which affect interest rates, competition in the marketplace for loans and deposits, the demand for loans and the ability of borrowers to meet their payment obligations. Net interest income, when expressed as a percentage of average earning assets, is a banking organization's "net interest margin". The following table sets forth our interest income, interest expense and net interest income, and our annualized net interest margin for the three-month and six-month periods ended June 30, 2014 and 2013, respectively: Three months ended June 30, Six months ended June 30, 2014 2013 % 2014 2013 % (dollars in thousands) Amount Amount Change Amount Amount Change Interest income $ 16,500$ 15,867 3.99 % $ 32,730$ 31,143 5.10 % Interest expense 1,210 1,105 9.47 % 2,384 2,530 -5.75 % Net interest income $ 15,290$ 14,762 3.58 % $ 30,346$ 28,613 6.06 % Net interest margin 4.35 % 4.89 % -0.54 % 4.49 % 4.77 % -0.28 %



Net interest income decreased by 0.54% for the three months and by 0.28% for the six months ended June 30, 2014, as compared to the corresponding periods in 2013.

For the three months ended June 30, 2014, net interest income rose by $528 thousand as compared to the same period in 2013. Total interest income increased by $633 thousand, because of a $453 thousand decrease in interest earned on loans and an increase of $180 thousand in interest income from investment securities. The increase in net interest income was attenuated by the increase in total interest expense of $105 thousand, which was due to the decrease in interest rates paid on money market and savings accounts and on certificates of deposit. For the six months ended June 30, 2014, net interest income rose by $1.7 million as compared to the same period in 2013, with a $146 thousand decrease in total interest expense supplemented by a $1.6 million increase in total interest income. The increase in total interest income was principally because of the $1.6 million increase in interest income from loans, while the decrease in total interest expense was primarily due to the reduction of $80 thousand in interest paid on other borrowings when compared to the same period in 2013, as other borrowings were paid off in the second quarter of 2013. As indicated in the above table, our net interest margin for the three months ended June 30, 2014, was 4.35%, a decrease of 0.54% from the 4.89% margin during the second quarter of 2013. For the six months ended June 30, 2014, the net interest margin decreased by 0.28% to 4.49% as compared to the 4.77% margin in the corresponding six months in 2013. 32



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Average Balances

Distribution, Rate and Yield

The following table sets forth information regarding our average balance sheet, annualized yields on interest earning assets and interest rates on interest-bearing liabilities, the interest rate spread and the interest rate margin for the six month period ended June 30, 2014 and 2013: Three months ended June 30, 2014 2013 Average Interest Average Average Interest Average (dollars in thousands) balance earned/paid yield/rate balance earned/paid yield/rate Interest earning assets: Short term investments1 $ 137,673$ 74 0.22 % $ 93,156$ 74 0.32 % Investment securities2 374,515 1,450 1.55 % 302,331 1,270 1.68 % Loans3 893,510 14,976 6.70 % 812,932 14,523 7.15 % Total interest earning assets 1,405,698 16,500 4.70 % 1,208,419 15,867 5.25 % Non-interest earning assets 69,897 82,607 Total Assets $ 1,475,595$ 1,291,026 Interest-bearing liabilities: Interest-bearing checking accounts $ 147,502$ 42 0.11 % $ 122,353$ 35 0.11 % Money market and savings accounts 816,457 1,125 0.55 % 709,023 1,010 0.57 % Certificates of deposit 49,427 43 0.35 % 55,309 60 0.43 % Total interest-bearing liabilities 1,013,386 1,210 0.48 % 886,685 1,105 0.50 % Non-interest-bearing liabilities 365,315 309,417 Total Liabilities 1,378,701 1,196,102 Stockholders' equity 96,894 94,924 Total Liabilities and Stockholders' equity $ 1,475,595$ 1,291,026 Net interest income $ 15,290$ 14,762 Interest rate spread 4.22 % 4.75 % Net interest margin 4.35 % 4.89 % Six months ended June 30, 2014 2013 Average Interest Average Average Interest Average (dollars in thousands) balance earned/paid yield/rate balance earned/paid yield/rate Interest earning assets: Short term investments1 $ 124,581$ 118 0.19 % $ 100,180$ 133 0.27 % Investment securities2 341,738 2,698 1.58 % 307,912 2,639 1.71 % Loans3 884,591 29,915 6.76 % 790,609 28,371 7.18 % Total interest earning assets 1,350,910 32,731 4.85 % 1,198,701 31,143 5.20 % Non-interest earning assets 74,174 81,191 Total Assets $ 1,425,084$ 1,279,892 Interest-bearing liabilities: Interest-bearing checking accounts $ 138,687$ 77 0.11 % $ 119,404$ 103 0.17 % Money market and savings accounts 785,308 2,215 0.56 % 700,763 2,234 0.64 % Certificates of deposit 49,894 92 0.37 % 55,588 113 0.41 % Other borrowings - - 0.00 % 3,333 80 4.80 % Total interest-bearing liabilities 973,889 2,384 0.49 % 879,088 2,530 0.58 % Non-interest-bearing liabilities 355,409 305,667 Total Liabilities 1,329,298 1,184,755 Stockholders' equity 95,786 95,137 Total Liabilities and Stockholders' equity $ 1,425,084$ 1,279,892 Net interest income $ 30,346$ 28,613 Interest rate spread 4.36 % 4.62 % Net interest margin 4.49 % 4.77 %



(¹) Short term investments consist of federal funds sold and interest-bearing

deposits that we maintain with other financial institutions.

(2) Includes all investment securities in the Available-for-Sale and the

Held-to-Maturity classifications. 33



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(3) Loans include the average balance of non-accrual loans.

For the three months ended June 30, 2014, our total average earning assets increased by $197.3 million as compared to the same period in 2013, comprised of the $80.6 million increase in our average loan portfolio, the $72.2 million increase in our average investment securities portfolio and the $44.5 million increase in average short term investments. The overall growth in average earning assets was the result of sustained growth in our deposit base. In the same three month period ended June 30, 2014, average total interest-bearing liabilities increased by $126.7 million, largely attributed to the $107.4 million increase in average money market and savings deposits, coupled with the $25.1 million increase in average interest-bearing checking account balances. These were, however, partially offset by the $5.9 million decrease in average certificates of deposit as compared to the same period in 2013. Average non-interest-bearing liabilities, primarily in checking accounts, increased by $55.9 million during the period. For the six months ended June 30, 2014, our total average earning assets increased by $152.2 million as compared to the same period in 2013, comprised of the $94.0 million increase in our average loan portfolio, the $72.2 million increase in our average investment securities portfolio and the $24.4 million increase in average short term investments. The overall growth in average earning assets was the result of sustained growth in our deposit base, which grew by $187.9 million during the first half of 2014. In the same six month period ended June 30, 2014, average total interest-bearing liabilities increased by $94.8 million, largely attributed to the $84.5 million increase in average money market and savings deposits, coupled with the $19.3 million increase in average interest-bearing checking account balances. These were, however, partially offset by the $5.7 million decrease in average certificates of deposit and the $3.3 million decrease in average other borrowings as compared to the same period in 2013. Average non-interest-bearing liabilities, primarily in checking accounts, increased by $49.7 million during the period. Our net interest spread and net interest margin in the three months ended June 30, 2014, decreased by 0.53% and 0.54%, respectively, as compared to the same period in 2013. These decreases are primarily attributed to the 0.55% drop in our average yield on total interest earning assets, led by the 0.55% decline in our average loan yields, and only partially offset by the overall 0.02% decline in our average cost of funds. Our net interest spread and net interest margin in the six months ended June 30, 2014, decreased by 0.26% and 0.28%, respectively, as compared to the same period in 2013. These decreases are primarily attributed to the 0.35% drop in our yield on total interest earning assets, led by the 0.42% decline in our loan yields, and only partially offset by the overall 0.09% decline in our cost of funds.



Provision for Loan Losses

We maintain allowances to provide for possible loan losses that occur from time to time as an incidental part of the banking business. As more fully discussed in Note 5 of the notes to the accompanying unaudited condensed consolidated financial statements in Item 1 of this Quarterly Report Form 10-Q, an allowance for loan losses has been established by management in order to provide for those loans, which for a variety of reasons, may not be repaid in their entirety. The allowance is maintained at a level considered by management to be adequate to provide for probable losses during the holding period of the loan and is based on methodologies applied on a consistent basis with the prior year. Management's review of the adequacy of the allowance includes, among other things, loan growth, changes in the composition of the loan portfolio, an analysis of past loan loss experience and management's evaluation of the loan portfolio under current and expected economic conditions. The allowance for loan losses is based on estimates, and ultimate losses will vary from current estimates. The Bank recognizes that credit losses will be experienced and the risk of loss will vary with, among other things: general economic conditions; the type of loan being made; the creditworthiness of the borrower over the term of the loan; and, in the case of a collateralized loan, the quality and retention of value of the collateral for such loan. The allowance for loan losses represents the Bank's best estimate of the allowance necessary to provide for probable losses in the portfolio as of the balance sheet date. If management determines that it is necessary to increase the allowance for loan losses, a provision for loan losses is taken from current income and assigned to the allowance. For the three-month period ended June 30, 2014, the Bank's provision for loan losses was $900 thousand, an increase of $1.6 million from the one-time negative provision of $680 thousand during the corresponding period of 2013. Management believes that the provision for loan losses was sufficient to provide for the risk of loss inherent with the increase in the average loan portfolio by $80.6 million, from $812.9 million for the three months ended June 30, 2013, to $893.5 million for the three months ended June 30, 2014. By comparison, we recorded net loan charge-offs of $713 thousand for the three month period ended June 30, 2014, and the allowance for loan losses at June 30, 2014, stood at $12.6 million or 1.38% of total gross loans outstanding as of the balance sheet date. For the six-month period ended June 30, 2014, the Bank's provision for loan losses was $1.8 million, an increase of $1.5 million, or 510.2%, from the corresponding period of 2013. Management believes that the provision for loan losses was sufficient to provide for the risk of loss inherent with the increase in the average loan portfolio by $94.0 million, from $790.6 million for the six months ended June 30, 2013, to $884.6 million for the six months ended June 30, 2014. By comparison, we recorded net loan charge-offs of $1.2 34 -------------------------------------------------------------------------------- million for the six month period ended June 30, 2014. See "Analysis of Allowance for Loan Losses" in the Financial Condition Section of Management's Discussion and Analysis of Financial Condition and Results of Operations.



Non-Interest Income

The table below represents the major components of non-interest income and the changes therein for the three- and six-month periods ended June 30, 2014, as compared to the same periods in 2013. Three months ended June 30, Six months ended June 30, (dollars in 2014 2013 Amount Percent 2014 2013 Amount Percent thousands) amount amount change change amount amount change change Service charges and fees $ 1,247$ 1,236$ 11 0.9 % $ 2,356$ 2,245$ 111 4.9 % Investment securities gains, net - 243 (243 ) -100.0 % - 450 (450 ) -100.0 % Income from merchant services 487 434 53 12.2 % 1,016 967 49 5.1 % Income from cardholders 2 170 (168 ) -98.6 % 109 685 (576 ) -84.1 % Wire transfer fees 184 173 11 6.4 % 352 336 16 4.8 % Trustee fees 99 144 (45 ) -31.0 % 152 264 (112 ) -42.4 % Other income 476 594 (118 ) -19.9 % 978 1,067 (89 ) -8.3 % Total non-interest income $ 2,496$ 2,994$ (498 ) -16.6 % $ 4,964



$ 6,014$ (1,050 ) -17.5 %

For the three months ended June 30, 2014, non-interest income totaled $2.5 million, which represented a decrease of $498 thousand as compared to the same period in 2013. The decrease is attributed to the $243 thousand decrease in our net investment securities gains, coupled with the $168 thousand decrease in income from cardholders and the $118 thousand decrease in other income. The decrease in net investment securities gains was the result of stable to modestly rising yields in markets for the securities we transacted, the decrease in cardholder income was due to higher processing fees associated with incorporating the VISA® brand on the Bank's debit cards, and the decrease in other income resulted primarily from a change in electronic payment system fees. These were partially offset by the $53 thousand increase in income from merchant services in the ordinary course of business. For the six months ended June 30, 2014, there was a $1.1 million decrease in total non-interest income from the same period in 2013 that was primarily due to a $576 thousand decrease in our income from cardholders, as explained above, the $450 thousand decrease in net investment securities gains, and the $112 thousand reduction in our income from trustee fees. The decrease in our net investment securities gains was the result of elevated gains on the sale of securities to replenish the Bank's overnight liquidity, reduce the weighted average life of the portfolio and to convert 20% risk-weighted fixed rate securities to 0% risk-weighted variable rate securities during the first six months of 2013, gains that were not repeated during the first six months of 2014. The decrease in trustee fees was caused by falling fee income from the issuance of new municipal bonds for which the Bank is trustee, as well as other reductions in fees in the normal course of business. These decreases were only partially offset by a $111 thousand increase in service charges and fees from various bank products. Non-interest Expense



The table below represents the major components of non-interest expense and the changes for the three- and six-month periods ended June 30, 2014 and 2013.

Three months ended June 30, Six months ended June 30, (dollars in 2014 2013 Amount Percent 2014 2013 Amount Percent thousands) amount amount change change amount amount change change Salaries and employee benefits $ 6,654$ 6,884$ (230 ) -3.35 % $ 13,171$ 12,397$ 774 6.24 % Occupancy 1,691 1,800 (109 ) -6.08 % 3,363 3,373 (10 ) -0.29 % Furniture and equipment 1,587 1,383 204 14.78 % 3,118 3,022 96 3.17 % Contract services 508 380 128 33.68 % 876 710 166 23.42 % Insurance 421 423 (2 ) -0.36 % 840 838 2 0.19 % Professional services 294 337 (43 ) -12.79 % 767 668 99 14.85 % Telecommunications 358 355 3 0.71 % 723 737 (14 ) -1.84 % Federal Deposit Insurance Corporation assessment 299 274 25 9.14 % 555 550 5 0.84 % Stationery & supplies 239 199 40 20.32 % 437 382 55 14.44 % Education 175 181 (6 ) -3.41 % 300 415 (115 ) -27.64 % Other Real Estate Owned 30 172 (143 ) -82.89 % 35 1,076 (1,041 ) -96.72 % General, administrative and other 1,745 1,740 5 0.31 % 3,437 3,168 269 8.49 % Total non-interest expenses $ 14,001$ 14,128$ (127 ) -0.90 % $ 27,622$ 27,336$ 286 1.05 % 35

-------------------------------------------------------------------------------- For the three months ended June 30, 2014, non-interest expense totaled $14.0 million, which represented a $127 thousand decrease as compared to the same period in 2013. The $127 thousand decrease is largely attributed to the $230 thousand decrease in salaries and employee benefits, the $143 thousand decrease in the expenses associated with other real estate owned (OREO), and the $109 thousand decrease in occupancy expense. The decrease in salaries and employee benefits was primarily due to adjustments in our accruals. The $143 thousand drop in OREO expense was due to a write-down on a commercial real estate loan in the second quarter of 2013 that did not recur in 2014, and the decrease in occupancy expense resulted from the reduction in electrical power consumption based upon conservation measures. The decreases in these and other classifications were partially offset by the $204 thousand increase in furniture and equipment expense that resulted from higher costs of computer equipment maintenance contracts and depreciation, and the $128 thousand increase in contract services was incurred to place additional guards in Bank branches in Guam. During the six months ended June 30, 2014, total non-interest expense increased by $286 thousand from the year-earlier period. Salaries and employee benefits expense increased by $774 thousand, general, administrative and other expense increased by $269 thousand, and contract services expense increased by $166 thousand. The increase in salaries and employee benefits expense was due to annual merit increases for our employees as well as a slight increase in the number of personnel. General, administrative and other expense increased in the normal course of business. The increase in contract services expense resulted from placing additional security guards in the Bank's Guam branches. These increases were partially offset by a $1.0 million decrease in OREO expense, and a reduction of $115 thousand in education expense. OREO expense fell because of non-recurring write-down of a commercial real estate loan during the first half of 2013, and the reduction of education expense resulted from the one-time cost of implementing a new on-line training system.



Income Tax Expense

For the three months ended June 30, 2014, the Bank recorded income tax expenses of $837.7 thousand. This compares to the $1.3 million in income tax expenses recorded for the corresponding period in 2013, and is $456 thousand lower as the result of the decrease of $1.4 million in net income before taxes as compared to the same period in 2013. For the six months ended June 30, 2014, income tax expenses of $1.7 million were $343 thousand lower than the $2.1 million paid in the first two quarters of 2013 because of the $1.1 million decrease in net income before taxes. Financial Condition Assets As of June 30, 2014, total assets were $1.5 billion, an increase of 15.3% from the $1.28 billion at December 31, 2013. This $196.2 million increase is largely attributed to the $197.6 million increase in our interest earning assets portfolio, which was led by the $122.3 million increase in our available-for-sale investment securities portfolio, the $43.7 million increase in interest-earning deposits with financial institutions (which includes interest-earning balances we maintained at the Federal Reserve Bank of San Francisco and balances that we maintain as deposits in a commercial bank to meet the regulatory requirements of the State of California), and the $41.1 million increase in our net loan portfolio, supplemented by the $2.3 million increase in other assets. These were partially offset by a $9.4 million decrease in our held-to-maturity investment securities portfolio and a $3.9 million decrease in cash and cash due from other banks.



Interest-Earning Assets

The following table sets forth the composition of our interest-earning assets at June 30, 2014, as compared to December 31, 2013:

June 30, December 31, (dollars in thousands) 2014 2013 Variance Interest-earning deposits with financial institutions $ 108,527$ 64,841 $



43,686

Federal Funds sold 5,000 5,000



-

Federal Home Loan Bank stock, at cost 2,097 2,098 (1 ) Investment securities available for sale 305,125 182,832 122,293 Investment securities held to maturity 79,544 88,989 (9,445 ) Loans (net of allowances of $12,645 and $11,675 and deferred fees of $2,472 and $2,213) 901,997 860,883 41,114 Total interest-earning assets $ 1,402,290$ 1,204,643$ 197,647 36



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Loans

Commercial & industrial loans are loans to businesses to finance capital purchases and improvements, or to provide cash flow for operations. Commercial mortgage loans include loans secured by real property for purposes such as the purchase or improvement of real property, wherein repayment is derived from the income generated by the real property or from business operations. Residential mortgage loans are loans to finance the purchase, improvement, or refinance of real property secured by 1-4 family units. Consumer loans are loans to individuals to finance personal needs and are either closed- or open-ended loans. Automobile loans and credit cards fall under the consumer loans category. The bulk of the other consumer loans is typically an unsecured extensions of credit. A summary of the balances of loans at June 30, 2014, and December 31, 2013, follows: June 30, 2014 December 31, 2013 Amount Percent Amount Percent (Dollars in thousands) Commercial Commercial & industrial $ 197,824 21.6 % $ 183,364 21.0 % Commercial mortgage 391,877 42.7 % 380,454 43.4 % Commercial construction 11,696 1.3 % 697 0.1 % Total commercial 601,397 65.6 % 564,515 64.5 % Consumer Residential mortgage 147,360 16.1 % 152,757 17.5 % Home equity 1,037 0.1 % 1,039 0.1 % Automobile 13,412 1.5 % 7,269 0.8 % Other consumer loans1 153,908 16.8 % 149,593 17.1 % Total consumer 315,717 34.4 % 310,658 35.5 % Gross loans 917,114 100.0 % 875,173 100.0 %

Deferred fee (income) costs, net (2,472 ) (2,213 ) Allowance for loan losses (12,645 ) (12,077 ) Loans, net $ 901,997$ 860,883



1 Comprised of other revolving credit, installment loans, and overdrafts.

At June 30, 2014, total gross loans increased by $41.9 million, to $917.1 million, from $875.2 million at December 31, 2013. The increase in loans was largely attributed to a $36.9 million increase in commercial loans to $601.4 million at June 30, 2014, from $564.5 million at December 31, 2013. The increase in commercial loans was due to the $14.5 million growth in the commercial & industrial loan portfolio, supplemented by the $11.4 million increase in commercial mortgage loans and the $11.0 million increase in commercial construction loans. The increases in commercial loans were primarily due to new loan bookings in Guam and in the California region. There was a $5.1 million increase in consumer loans to $315.7 million at June 30, 2014, up from $310.7 million at December 31, 2013. The increases in consumer loans were due to the $6.1 million increase in automobile loans derived from new dealer loan bookings and $4.3 million rise in other consumer loans, which include revolving credit, installment loans and overdrafts. These were offset by decrease of $5.4 million in residential mortgages. The residential mortgages on our books decreased largely because of principal pay downs, payoffs, and refinancings with the Federal Home Loan Mortgage Corporation in reaction to favorable interest rates.



At June 30, 2014, loans outstanding were comprised of approximately 66.57% variable rate loans and 33.43% fixed rate loans.

Since it first opened in 1972, the Bank has expanded its operations and its branch network, first in Guam, then in the other islands of our region and in San Francisco. In the interests of enhancing performance and stability through market and industry diversification, the Bank has increased its focus on growth in the California region in recent years, adding personnel with experience and expertise in the San Francisco area. The following table provides figures for loans in the Bank's administrative regions for the years ending December 31, 2011, 2012 and 2013, and the six months ended June 30, 2014: At December 31, At June 30, 2011 2012 2013 2014 Guam $ 530,959$ 498,728$ 550,380$ 579,645 Commonwealth of the Northern Mariana Islands $ 71,190$ 65,703$ 66,252$ 65,057 The Freely Associated States of Micronesia * $ 38,742$ 40,618$ 41,030$ 41,299 California $ 87,307$ 143,783$ 203,221$ 215,996 Total $ 728,198$ 748,832$ 860,883$ 901,997 37



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* The Freely Associated States are comprised of the Federated States of

Micronesia (Chuuk, Kosrae, Pohnpei and Yap), the Republic of Palau and the

Republic of the Marshall Islands.

As the table indicates, the Bank's total loans, net of deferred fees and the allowance for loan losses, increased by 4.8% during the first six months of 2014, and by a cumulative 18.2% in 2012 and 2013. By way of comparison, loans in the California region increased by 6.3% during the first six months of this year, and by a cumulative 132.8% in 2012 and 2013. While the Bank's overall loan portfolio continues to grow, nearly one-third of that growth has been in the California region for the six months ended June 30, 2014, and by 87.4% in the two years ended December 31, 2013, providing support for the expansion of the Bank.



Interest Earning Deposits and Investment Securities

In the current interest rate environment and in order to maintain sufficient liquidity in the ordinary course of business, the Bank maintained $108.1 million in interest earning deposits with financial institutions at June 30, 2014, an increase of $43.7 million, or 67.8%, from the $64.4 million in such deposits at December 31, 2013. This increase was primarily in our Federal Reserve account. From December 31, 2013, to June 30, 2014, the Bank's investment portfolio increased by $112.8 million, or 41.2%, from $273.9 million to $386.8 million. During the six months ended June 30, 2014, pay downs in the portfolio averaged $23.5 million, and in March, May and June, $16.0 million in securities were called. Replenishment of the portfolio averaged $24.4 million during the six months, but with the June 30, 2014, revaluation of the available for sale portfolio, previously unrealized losses swung to an unrealized gain position with a net effect of a $2.6 million increase in value. The investment portfolio expansion was comprised of a $122.3 million increase in available for sale securities, which rose by 66.9%, from $182.8 million to $305.1 million, partially offset by a $9.4 million decrease in held to maturity securities, which declined by 10.6%, from $89.0 million to $79.5 million. The combined increase in interest earning deposits with financial institutions and investment securities was $197.6 million, absorbing the increase of $187.9 million in total deposits during the first six months of 2014.



Non-Performing Loans and Other Non-Performing Assets

Non-performing loans consist of (i) loans on non-accrual status because we have ceased accruing interest on these loans; (ii) loans 90 days or more past due and still accruing interest; and, (iii) restructured loans. Other non-performing assets consist of real estate properties (OREO) that have been acquired through foreclosure or similar means and which management intends to offer for sale. Loans are placed on non-accrual status when, in the opinion of management, the full and timely collection of principal or interest is in doubt. Generally, the accrual of interest is discontinued when principal or interest payment becomes 90 days past due, unless the loan is adequately collateralized and the loan is in the process of collection. When a loan is placed in non-accrual status, accrued but unpaid interest is reversed against current income. Subsequently, when payments are received on such loans, the amounts are applied to reduce principal, except when the ultimate collectability of principal is probable, in which case accrued loans may be restored to accrual status when principal and interest becomes current and full repayment is expected. Interest income is recognized on an accrual basis for impaired loans not meeting the non-accrual criteria. 38



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The following table contains information regarding our non-performing assets as well as restructured loans as of June 30, 2014, and December 31, 2013.

(dollars in thousands) June 30, 2014 December 31, 2013 Non-accrual loans: Commercial & industrial $ 504 $ 343 Commercial mortgage 6,464 6,344 Residential mortgage 7,866 6,351 Home equity 71 62 Other consumer 133 195 Total nonaccrual loans: $ 15,038$ 13,295 Loans past due 90 days and still accruing: Commercial & industrial $ 111 $ 23 Commercial mortgage 605 - Residential mortgage 837 45 Automobile - 13 Other consumer 1,035 826 Total loans past due 90 days and still accruing $ 2,588 $



907

Total non-performing loans 17,626



14,202

Other real estate owned (OREO): Commercial real estate $ 2,999 $ 2,923 Residential real estate 1,485 1,687 Total other real estate owned $ 4,484 $ 4,610 Other non-performing assets: Total other nonperforming assets - - Total nonperforming assets $ 22,110$ 18,812 Restructured loans: Accruing loans $ 5,273 $ 3,552 Non-accruing loans (included in nonaccrual loans above) 6,894 5,554 Total restructured loans $ 12,167 $ 9,106 The above table indicates that non-performing loans increased by $3.4 million during the six months ended June 30, 2014, which resulted from the increase in non-accrual loans by $1.7 million to $15.0 million, up from $13.3 million at December 31, 2013, and the increase of $1.7 million in total loans past due by 90 days or more and still accruing interest, from $907 thousand to $2.6 million during the same period. This increase is largely attributed to the $1.5 million increase in nonaccruing residential mortgages, supplemented by the increase of past due but still accruing loans of $792 thousand in residential mortgages, $605 thousand in commercial mortgages, and $209 thousand in other consumer loans. At June 30, 2014, the Bank's largest non-performing loans consist of two commercial loan relationships in the amount of $4.8 million, located in Guam. The two loan relationships are secured by real estate. The Guam loans were placed on non-accrual due to deficiencies in their cash flow to service the monthly loan payments and meet operating expenses. At this time, management believes that the allowance for loan losses is adequate to cover these loans; however, should property values deteriorate, additional write-downs or additional provisions may be necessary.



Analysis of Allowance for Loan Losses

The allowance for loans losses was $12.6 million and 1.38% of outstanding gross loans as of June 30, 2014, as compared to $12.1 million, also 1.38% of outstanding gross loans at December 31, 2013. This increase in the amount of the allowance was proportional to the $41.9 million growth of our loan portfolio.



Management maintains an allowance for loan losses to absorb estimated credit losses associated with the loan portfolio. The adequacy of the allowance is determined by management through ongoing quarterly loan quality assessments.

Management assesses the estimated credit losses inherent in the non-classified and classified portions of our loan portfolio by considering a number of factors or elements including:



- Management's evaluation of the collectability of the loan portfolio;

39



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- Credit concentrations;

- Historical loss experience in the loan portfolio;

- Levels of and trending in delinquency, classified assets, non -performing

and impaired loans;

- Effects of changes in underwriting standards and other changes in lending

policies, procedures and practices;

- Experience, ability, and depth of lending management and other relevant staff;

- Local, regional, and national trends and conditions including industry-specific conditions;



- Effect of changes in credit concentration; and

- External factors such as competition, legal and regulatory conditions, as well as typhoon and other natural disasters. Management calculates the allowance for the classified loan portfolio, non-classified loans and a homogeneous pool of loans based on an appropriate percentage loss factor that is calculated based on the above noted factors and trends. Management normally writes down impaired loans after determining the loans' credit and collateral fair value. Our analysis of the adequacy of the allowance incorporates the provisions made for our non-classified loans, classified loans, and homogeneous pool of loans. While management believes it uses the best information available for calculating the allowance, the results of operations could be significantly affected if circumstances differ substantially from the assumptions used in determining the allowance. The current qualitative and quantitative factors used to calculate the allowance are inherently subjective. The estimates and assumptions are subject to changes in economic and regulatory guidelines, and other circumstances over which management has no control. The allowance may prove in the future to be insufficient to cover all of the losses the Bank may incur and it may be necessary to increase the allowance from time to time as a result of monitoring the adequacy of the allowance for loan losses. 40



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The following table summarizes the changes in our allowance for loan losses. Residential Commercial Mortgages Consumer Total (Dollars in thousands) Six Months Ended June 30, 2014 Allowance for loan losses: Balance at beginning of period $ 5,987$ 922$ 5,168$ 12,077 Charge-offs (266 ) (58 ) (1,793 ) (2,117 ) Recoveries 167 15 703 885 Provision 302 130 1,368 1,800 Balance at end of period $ 6,190$ 1,009$ 5,446$ 12,645 Three Months Ended June 30, 2014 Allowance for loan losses: Balance at beginning of quarter $ 6,249$ 695$ 5,514$ 12,458 Charge-offs (107 ) (39 ) (1,001 ) (1,147 ) Recoveries 12 12 410 434 Provision 36 341 523 900 Balance at end of quarter $ 6,190$ 1,009$ 5,446$ 12,645 Allowance balance at end of quarter related to: Loans individually evaluated for impairment $ - $ - $ - $ - Loans collectively evaluated for impairment $ 6,190$ 1,009 $



5,446 $ 12,645

Loan balances at end of quarter: Loans individually evaluated for impairment $ 12,998$ 8,800$ 133$ 21,931 Loans collectively evaluated for impairment 588,399 139,597 167,187 895,183 Ending Balance $ 601,397$ 148,397$ 167,320$ 917,114 Year Ended December 31, 2013 Allowance for loan losses: Balance at beginning of year $ 6,251$ 1,453$ 4,524$ 12,228 Charge-offs (470 ) (168 ) (3,422 ) (4,060 ) Recoveries 116 143 1,555 1,814 Provision 90 (506 ) 2,511 2,095 Balance at end of year $ 5,987$ 922$ 5,168$ 12,077 Allowance balance at end of year related to: Loans individually evaluated for impairment $ - $ - $ - $ - Loans collectively evaluated for impairment $ 5,987$ 922 $



5,168 $ 12,077

Loan balances at end of year: Loans individually evaluated for impairment $ 10,239$ 6,412$ 195$ 16,846 Loans collectively evaluated for impairment 554,276 147,384 156,667 858,327 Ending Balance $ 564,515$ 153,796$ 156,862$ 875,173



Total Cash and Cash Equivalents

Total cash and cash equivalents were $136.3 million and $96.6 million at June 30, 2014, and December 31, 2013, respectively. This balance, which is comprised of cash and due from bank balances, federal funds sold and unrestricted interest-bearing deposits that we maintain at other financial institutions (including the Federal Reserve Bank of San Francisco) will vary depending on daily cash settlement activities, the amount of highly liquid assets needed based on known events such as the repayment of borrowings and funding of loans, and actual cash on hand in the Bank's branches. The increase of $39.7 million in the balance during the period partially absorbed the increase of $187.9 million in total deposits and the increase of $4.2 million in other liabilities. 41



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The following table sets forth the composition of our cash and cash equivalent balances at June 30, 2014, and December 31, 2013:

June 30, December 31, Variance to (dollars in thousands) 2014 2013 December 31 Cash and due from banks $ 23,195$ 27,142$ (3,947 ) Federal funds sold 5,000 5,000 - Interest-bearing deposits with financial institutions 108,127 64,441



43,686

Total cash and cash equivalents $ 136,321$ 96,583$ 39,738Investment Securities The subsidiary Bank manages its securities portfolio to provide a source of both liquidity and earnings. The Bank has an Asset/Liability Committee (ALCO) that develops current investment policies based on the Bank's operating needs and market circumstances. The Bank's investment policy is formally reviewed and approved annually by the Board of Directors, and the Asset/Liability Committee is responsible for reporting and monitoring compliance with the investment policy. Investment portfolio reports are provided to the Board of Directors on a monthly basis, two inside Board members sit on the Committee, and an additional inside Board member attends the meeting along with three outside Board members quarterly. At June 30, 2014, the carrying value of the investment securities portfolio totaled $384.7 million, which represents a $112.8 million increase from the portfolio balance of $271.8 million at December 31, 2013. The table below sets forth the composition of our investment securities portfolio at June 30, 2014, and December 31, 2013:



The amortized cost and fair value of investment securities, with gross unrealized gains and losses, follows:

June 30, 2014 Gross Gross Amortized Unrealized Unrealized Cost Gains Losses Fair Value Securities Available-for-Sale U.S. government agency and sponsored enterprise (GSE) debt securities $ 79,295$ 111$ (12 )$ 79,394 U.S. government agency pool securities 50,989 103 (722 ) 50,369 U.S. government agency or GSE mortgage-backed securities 174,600 1,355 (593 ) 175,362 Total $ 304,884$ 1,569$ (1,327 )$ 305,125 Securities Held-to-Maturity U.S. government agency and sponsored enterprise (GSE) debt securities $ 28,035$ 534 $ - $ 28,569 U.S. government agency pool securities 1,294 25 (7 ) 1,312 U.S. government agency or GSE mortgage-backed securities 50,215 1,238 (87 ) 51,366 Total $ 79,544$ 1,797$ (94 )$ 81,247 42

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December 31, 2013 Gross Gross Amortized Unrealized Unrealized Cost Gains Losses Fair Value Securities Available-for-Sale U.S. government agency pool securities $ 54,733$ 122$ (563 )$ 54,292 U.S. government agency or GSE mortgage-backed securities 130,411 112 (1,983 ) 128,540 Total $ 185,144$ 234$ (2,546 )$ 182,832 Securities Held-to-Maturity U.S. government agency and sponsored enterprise (GSE) debt securities $ 32,824 $ - $ (515 )$ 32,309 U.S. government agency pool securities 1,641 24 (12 ) 1,653 U.S. government agency or GSE mortgage-backed securities 54,524 920 (586 ) 54,858 Total $ 88,989$ 944$ (1,113 )$ 88,820 At June 30, 2014, and December 31, 2013, investment securities with a carrying value of $185.7 million and $170.5 million, respectively, were pledged to secure various government deposits and other public requirements.



The amortized cost and fair value of investment securities by contractual maturity at June 30, 2014, and December 31, 2013, follows:

June 30, 2014 Available for Sale Held to Maturity Amortized Cost Fair Value Amortized Cost Fair Value Due within one year $ - $ - $ 2 $ 2 Due after one but within five years 83,946 84,141 1,130 1,194 Due after five but within ten years 71,249 71,626 50,261 51,568 Due after ten years 149,689 149,358 28,151 28,483 Total $ 304,884$ 305,125$ 79,544$ 81,247 December 31, 2013 Available for Sale Held to Maturity Amortized Cost Fair Value Amortized Cost Fair Value Due within one year $ - $ - $ 37 $ 38 Due after one but within five years 5,084 5,196 565 600 Due after five but within ten years 39,155 38,923 57,154 57,153 Due after ten years 140,905 138,713 31,233 31,029 Total $ 185,144$ 182,832$ 88,989$ 88,820 43



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Temporarily Impaired Securities

The following table shows the gross unrealized losses and fair value of investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and the length of time that individual securities have been in a continuous unrealized loss position at June 30, 2014, and December 31, 2013.

June 30, 2014 Less Than Twelve Months More Than Twelve Months Total Unrealized Unrealized Unrealized Loss Fair Value Loss Fair Value Loss Fair Value Securities Available for Sale U.S. government agency and sponsored enterprise (GSE) debt securities $ (12 )$ 9,983 $ - $ - $ (12 )$ 9,983 U.S. government agency pool securities (39 ) 6,877 (683 ) 38,496 (722 ) 45,373 U.S. government agency or GSE mortgage-backed securities - - (593 ) 51,636 (593 ) 51,636 Total $ (51 )$ 16,860$ (1,276 )$ 90,132$ (1,327 )$ 106,992 Securities Held to Maturity U.S. government agency and sponsored enterprise (GSE) debt securities $ - $ - $ - $ - $ - $ - U.S. government agency pool securities (4 ) 162 (3 ) 132 (7 ) 294 U.S. government agency or GSE mortgage-backed securities - - (87 ) 18,014 (87 ) 18,014 Total $ (4 )$ 162$ (90 )$ 18,146$ (94 )$ 18,308 December 31, 2013 Less Than Twelve Months More Than Twelve Months Total Unrealized Unrealized Unrealized Loss Fair Value Loss Fair Value Loss Fair Value Securities Available for Sale U.S. government agency pool securities $ (505 )$ 42,298$ (58 )$ 4,843$ (563 )$ 47,141 U.S. government agency or GSE mortgage-backed securities (1,957 ) 108,637 (26 ) 5,606 (1,983 ) 114,243 Total $ (2,462 )$ 150,935$ (84 )$ 10,449$ (2,546 )$ 161,384 Securities Held to Maturity U.S. government agency and sponsored enterprise (GSE) debt securities $ (515 )$ 32,309 $ - $ - $ (515 )$ 32,309 U.S. government agency pool securities (8 ) 304 (4 ) 284 (12 ) 588 U.S. government agency or GSE mortgage-backed securities (586 ) 18,770 - - (586 ) 18,770 Total $ (1,109 )$ 51,383$ (4 )$ 284



$ (1,113 )$ 51,667

The Company does not believe that any of the investment securities that were in an unrealized loss position as of June 30, 2014, which comprised a total of 39 securities, were other-than-temporarily impaired. Specifically, the 39 securities are comprised of the following: 18 Small Business Administration (SBA) Pool securities, 14 mortgage-backed securities issued by the Government National Mortgage Association (GNMA), 3 mortgage-backed securities issued by the Federal National Mortgage Association (FNMA), 2 mortgage-backed securities issued by the Federal Home Loan Mortgage Corporation (FHLMC), and 2 U.S. Government agency bonds issued by the Federal Home Loan Bank (FHLB). Total gross unrealized losses were primarily attributable to changes in interest rates, relative to when the investment securities were purchased, and not due to changes in the credit quality of the investment securities. The Company does not intend to sell the investment securities that were in an unrealized loss position and it is not likely that the Company will be required to sell the investment securities before recovery of their amortized cost bases, which may be at maturity. 44



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Deposits

At June 30, 2014, total deposits increased by $187.9 million to $1.37 billion as compared to $1.18 billion in total deposits at December 31, 2013. Interest-bearing deposits increased by $147.5 million to $1.0 billion at June 30, 2014, up from $862.0 million at December 31, 2013, while non-interest bearing deposits increased by $40.4 million to $361.8 million at June 30, 2014, up from $321.4 million at December 31, 2013. The 15.9% increase in total deposits was primarily due to improvements in general economic conditions and competitive factors, as well as the withdrawal of one financial institution from the depository services industry in Guam. In addition, there was a total deposit of $60 million in two bid bonds associated with the prospective licensing of a casino in the CNMI, but half of that amount will be refunded to the unsuccessful bidder.



The following table sets forth the composition of our interest-bearing deposit portfolio with the average balances and average interest rates for the six months ending June 30, 2014, and June 30, 2013, respectively:

Six months ending June 30, 2014 June 30, 2013 Average Average Average Average (dollars in thousands) balance rate balance rate Interest-bearing deposits: Interest-bearing checking accounts $ 147,502 0.11 % $ 119,404 0.17 % Money market and savings accounts 816,457 0.55 % 700,763 0.64 % Certificates of deposit 49,427 0.35 % 55,588 0.41 % Total interest-bearing deposits $ 1,013,386 0.24 % $ 875,755 0.56 % As mentioned earlier, the Bank has expanded its operations and its branch network since it first opened in 1972, first in Guam, then in the other islands of our region and in San Francisco. As time has passed and the Bank has gathered market share in each of the islands. In recent years, in order to diversify its geographic market, the Bank has increased its focus on growth in the California region. The following table provides figures for deposits in the Bank's administrative regions for the years ending December 31, 2011, 2012 and 2013, and the six months ended June 30, 2014: At December 31, At June 30, 2011 2012 2013 2014 Guam $ 629,206$ 640,893$ 645,056$ 825,605 Commonwealth of the Northern Mariana Islands $ 161,918$ 180,220$ 207,402$ 232,305 The Freely Associated States of Micronesia * $ 193,485$ 212,722$ 254,900$ 256,756 California $ 53,730$ 68,705$ 76,087$ 56,677 Total $ 1,038,339$ 1,102,540$ 1,183,445$ 1,371,343



* The Freely Associated States are comprised of the Federated States of

Micronesia (Chuuk, Kosrae, Pohnpei and Yap), the Republic of Palau and the

Republic of the Marshall Islands.

During the first six months of 2014, deposits increased by a total of $187.9 million, of which $180.5 million, or 96.1%, was in the Bank's Guam branches. Deposits in our CNMI branches increased by $24.9 million and increased in our Freely Associated States branches by $1.9 million. Overall, the Bank's deposit base increased by 15.9% during the first six months of 2014, and by 14.0% from December 31, 2011 to December 31, 2013. In comparison, deposits decreased in the California region by 25.5% in the six months ended June 30, 2014, after increasing by a cumulative 41.6% during 2012 and 2013. The reduction in California region deposits during the first six months of this year was principally due to a decrease in the interest rate paid on savings accounts. Prior to the change in the savings interest rate, the continuing growth of the California region's deposit base had substantially supplemented the growth of the other administrative regions and of the whole Bank to the point where growth in assets significantly outpaced the overall growth in the Bank's capital.



Borrowed Funds

The Bank has a variety of sources from which it may obtain secondary funding. These sources include, among others, the Federal Reserve Bank of San Francisco, the Federal Home Loan Bank-Seattle, and credit lines established with our correspondent banks. Borrowings are obtained for a variety of reasons which include, but are not limited to, funding loan growth, the purchase of investments in the absence of core deposits, and to provide additional liquidity to meet the demands of depositors.



At June 30, 2014, and at December 31, 2013, the Bank had no short-term borrowings.

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Liquidity

We actively manage our liquidity to ensure that sufficient funds are available to meet our needs for cash, including cash needed to fund new loans and to accommodate deposit withdrawals by our customers. We project future sources and uses of funds, and maintain additional liquid funds for unanticipated events. Our primary sources of cash include cash we have in deposits at other financial institutions, the repayment of loans, proceeds from the sale or maturity of investment securities, and increases in deposits. The primary uses of cash include funding new loans and making advances on existing lines of credit, purchasing investments, funding new residential mortgage loans, funding deposit withdrawals, and paying operating expenses. We maintain funds in overnight Federal Funds and other short-term investments to provide for short-term liquidity needs. We also have established, for contingency funding purposes, credit lines with the Federal Reserve Bank of San Francisco, the Federal Home Loan Bank-Seattle, and correspondent commercial banks in the U.S. At June 30, 2014, our liquid assets, which include cash and due from banks, federal funds sold, unrestricted interest-earning deposits with financial institutions, and available-for-sale investment securities, totaled $441.4 million, up $162.0 million from $279.4 million at December 31, 2013. This increase is comprised of the rise of $122.3 million in available-for-sale securities and the increase of $43.7 million in interest bearing deposits in banks, offset by the $3.9 million decrease in cash and due from banks. The level of liquidity at June 30, 2014, was deemed to be adequate to meet the Bank's needs even under the most severe conditions, as analyzed quarterly as a part of the Asset and Liability Committee's duties.



Contractual Obligations

The Bank utilizes facilities, equipment and land under various operating leases with terms, including renewal options, ranging from 1 to 99 years. Some of these leases include scheduled rent increases. The total amount of the rent is being debited to expense on the straight-line method over the lease terms in accordance with ASC Topic 840 "Leases". The Bank has recorded a deferred obligation of $790 thousand and $760 thousand as of June 30, 2014, and December 31, 2013, respectively, which has been included within other liabilities to reflect the excess of rent expense over cash paid on the leases.



At June 30, 2014, future lease commitments under the above non-cancelable operating leases were as follows:

Periods ending December 31, 2014 $ 1,171 2015 1,263 2016 1,067 2017 877 Thereafter 18,509 Total $ 22,888 The Bank leases certain facilities from two separate entities in which two of its directors have separate ownership interests. Lease payments made to these entities during the six months ended June 30, 2014, and the twelve months ended December 31, 2013, approximated $185 thousand and $370 thousand, respectively. Additionally, the Bank leases office space to third parties, with original lease terms ranging from 3 to 5 years with option periods ranging up to 15 years. At June 30, 2014, minimum future rents to be received under non-cancelable operating sublease agreements were $136.7, $40.3, $26.9 thousand for the periods ending December 2014, 2015 and 2016, respectively. A summary of rental activities for the six-month periods ended June 30, 2014 and 2013, is as follows: June 30, June 30, 2014 2013 Rent expense $ 1,211$ 1,166 Less: sublease rentals 137 133 Net rent expense $ 1,074$ 1,033



Off-Balance-Sheet Arrangements

The Bank is a party to credit related financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, standby letters of credit and commercial letters of credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount reflected in the consolidated financial statements. 46 -------------------------------------------------------------------------------- The Bank's exposure to credit loss, in the event of nonperformance by the other parties to financial instruments for loan commitments and letters of credit, is represented by the contractual amount of these instruments. The Bank follows essentially the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.



A summary of financial instruments with off-balance-sheet risk at June 30, 2014, and December 31, 2013 is as follows:

June 30, December 31, 2014 2013 Commitments to extend credit $ 158,517$ 121,618 Letters of credit: Standby letters of credit $ 51,561$ 47,543 Other letters of credit 3,678 2,582 Total $ 55,239$ 50,125 Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses, and may require payment of a fee. The commitments for certain lines of credit may expire without being drawn upon. Therefore, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if it is deemed necessary by the Bank upon the extension of credit, is based on management's credit evaluation of the customer. Commercial and standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party or the shipment of merchandise from a third party. Those letters of credit are primarily issued to support public and private borrowing arrangements. Almost all letters of credit issued have expiration dates within one year. The credit risk involved in issuing letters of credit is effectively the same as that involved in extending loan facilities to customers. The Bank generally holds collateral supporting those commitments. The Bank considers its standby letters of credit to be guarantees. At June 30, 2014, the maximum undiscounted future payments that the Bank could be required to make was $55.2 million. All of these arrangements mature within one year. The Bank generally has recourse to recover from the customer any amounts paid under these guarantees. Most of the guarantees are fully collateralized; however, several that are extended to the Bank's most creditworthy customers are unsecured. The Bank had not recorded any liabilities associated with these guarantees at June 30, 2014. Mortgage loans serviced for others are not included in the accompanying consolidated statements of condition. The unpaid principal balances of mortgage loans serviced for others were $211.9 million and $208.6 million at June 30, 2014, and December 31, 2013, respectively. On June 30, 2014, and December 31, 2013, the Bank recorded mortgage servicing rights at their fair value of $1.42 million and $1.35 million, respectively.



Capital Resources

The Bank is subject to various regulatory capital requirements administered by the United States federal banking agencies. Failure to meet 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 Bank's consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, 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. Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined) and of Tier 1 capital (as defined) to average assets (as defined). Management believes that, as of June 30, 2014, and December 31, 2013, the Bank met all capital adequacy requirements to which it is subject. 47

-------------------------------------------------------------------------------- As of June 30, 2014, the most recent notification from the Federal Deposit Insurance Corporation categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, an institution 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 the FDIC notification that management believes have changed the Bank's category. The Bank's actual capital amounts and ratios as of June 30, 2014, and December 31, 2013, are also presented in the table. To Be Well Capitalized For Capital Adequacy Under Prompt Corrective Actual Purposes Action Provisions Amount Ratio Amount Ratio Amount Ratio At June 30, 2014: Total capital (to Risk Weighted Assets) $ 111,072 12.03 % $ 73,855 8.00 % $ 92,319 10.00 % Tier 1 capital (to Risk Weighted Assets) $ 99,665 10.93 % $ 36,471 4.00 % $ 54,707 6.00 % Tier 1 capital (to Average Assets) $ 99,665 6.76 % $ 58,992 4.00 % $ 73,741 5.00 % At December 31, 2013: Total capital (to Risk Weighted Assets) $ 108,238 12.53 % $ 69,114 8.00 % $ 86,392 10.00 % Tier 1 capital (to Risk Weighted Assets) $ 97,563 11.43 % $ 34,130 4.00 % $ 51,195 6.00 % Tier 1 capital (to Average Assets) $ 97,563 7.60 % $ 51,320 4.00 % $ 64,151 5.00 %



Contingency Planning and Cybersecurity

The services provided by banks are crucial to the continuing performance of the economy, so it is very important that banks are able to conduct business as usual on an ongoing basis. In light of this, the Bank has developed a comprehensive business continuity plan to address whatever disruptions may directly affect customers or change internal processes, whether caused by man-made or natural events. Training in the plan components is conducted annually, and risk-based testing of the major processes and procedures within the Bank occur on a regular basis. In modern banking, technology has taken on an increasingly important role, and the Bank also has a disaster recovery plan, incorporated into the business continuity plan, that provides specific, detailed procedures for recovering quickly from any technology failure. The disaster recovery plan procedures are actively tested, and are also implemented from time to time. The recovery time objectives for all major technological processes range from two hours to 16 hours, enabling the Bank to maintain or resume operations with a minimum impact on its customers. As the results of testing are analyzed and as technology continues to advance, improvements are made in the Bank's processes and procedures as the plans evolve. The rapid advances in computing and telecommunications technology over the past several decades have brought with them increasingly sophisticated methods of delivering financial services through electronic channels. Along with these advances, though, have come risks regarding the integrity and privacy of data, and these risks apply to banking, perhaps more than any other industry, falling into the general classification of cybersecurity. The Bank has made substantial investments in multiple systems to ensure both the integrity of its data and the protection of the privacy of its customers' personal financial and identity information. While it is not possible for anyone to give an absolute guarantee that data will not be compromised, the Bank is confident that its systems provide a reasonable assurance that the financial and personal data that it holds are secure.


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Source: Edgar Glimpses


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