UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
FORM 10-Q
 
 
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2019
OR
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                     to                    
Commission file number 0-30777
 
PACIFIC MERCANTILE BANCORP
(Exact name of Registrant as specified in its charter)
 
California
 
33-0898238
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
 
 
949 South Coast Drive, Suite 300, Costa Mesa, California
 
92626
(Address of principal executive offices)
 
(Zip Code)
(714) 438-2500
(Registrant’s telephone number, including area code)
 
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports); and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).    Yes  x    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See definitions of “large accelerated filer,” “accelerated filer,” “non-accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer
 
o
  
Accelerated filer
 
x
Non-accelerated filer
 
o
  
Smaller reporting company
 
x
 
 
 
 
Emerging growth company
 
o
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o

1


Indicate by check mark whether the registrant is a shell company (as defined in Securities Exchange Act Rule 12b-2). Yes  ¨    No  x
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
Trading Symbol(s)
Name of each exchange on which registered
Common Stock, without par value
"PMBC"
Nasdaq Global Select Market
As of October 31, 2019, there were 22,037,971 shares of Common Stock and 1,467,155 shares of Non-Voting Common Stock outstanding.
 

2


PACIFIC MERCANTILE BANCORP
QUARTERLY REPORT ON FORM 10Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2019
TABLE OF CONTENTS
 
 
Page No.
 
 
 
 
4
 
 
 
 
4
 
 
 
 
5
 
 
 
 
6
 
 
 
 
7
 
 
 
 
9
 
 
 
 
10
 
 
 
40
 
 
 
63
 
 
 
63
 
 
 
 
 
 
 
64
 
 
 
64
 
 
 
65
 
 
 
66


3




PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(Dollars in thousands)
(Unaudited)
 
September 30, 2019
 
December 31, 2018
ASSETS
 
 
 
Cash and due from banks
$
19,425

 
$
13,250

Interest bearing deposits with financial institutions
191,431

 
174,468

Cash and cash equivalents
210,856

 
187,718

Interest-bearing time deposits with financial institutions
2,420

 
2,420

Federal Reserve Bank of San Francisco and Federal Home Loan Bank Stock, at cost
7,910

 
8,822

Securities available for sale, at fair value
24,973

 
31,231

Loans (net of allowances of $12,086 and $13,506, respectively)
1,153,217

 
1,083,240

Other real estate owned

 
1,173

Accrued interest receivable
4,121

 
4,003

Premises and equipment, net
1,090

 
1,039

Net deferred tax assets
7,844

 
10,935

Other assets
26,280

 
18,757

Total assets
$
1,438,711

 
$
1,349,338

LIABILITIES AND SHAREHOLDERS’ EQUITY
 
 
 
Deposits:
 
 
 
Noninterest-bearing
$
425,596

 
$
340,406

Interest-bearing
787,500

 
795,596

Total deposits
1,213,096

 
1,136,002

Borrowings
40,000

 
40,000

Accrued interest payable
384

 
361

Other liabilities
19,670

 
14,074

Junior subordinated debentures
17,527

 
17,527

Total liabilities
1,290,677

 
1,207,964

Commitments and contingencies (Note 11)

 

Shareholders’ equity:
 
 
 
Preferred stock, no par value, 2,000,000 shares authorized:
 
 
 
Series A Non-Voting Preferred Stock, no par value, 0 and 1,467,155 shares authorized at September 30, 2019 and December 31, 2018, respectively; 0 and 1,467,155 shares issued and outstanding at September 30, 2019 and December 31, 2018, respectively

 
8,480

Common stock, no par value, 85,000,000 shares of common stock and 2,000,000 shares of non-voting common stock authorized; 23,520,776 and 21,916,195 shares issued and outstanding at September 30, 2019 and December 31, 2018, respectively
152,883

 
143,466

Accumulated deficit
(4,395
)
 
(9,428
)
Accumulated other comprehensive loss
(454
)
 
(1,144
)
Total shareholders’ equity
148,034

 
141,374

Total liabilities and shareholders’ equity
$
1,438,711

 
$
1,349,338

The accompanying notes are an integral part of these consolidated financial statements.

4


PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Dollars in thousands, except for per share data)
(Unaudited)
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2019
 
2018
 
2019
 
2018
Interest income:
 
 
 
 
 
 
 
Loans, including fees
$
15,046

 
$
13,898

 
$
44,152

 
$
42,731

Securities available for sale and stock
257

 
265

 
808

 
801

Interest-bearing deposits with financial institutions
1,464

 
1,055

 
4,439

 
2,615

Total interest income
16,767

 
15,218

 
49,399

 
46,147

Interest expense:
 
 
 
 
 
 
 
Deposits
3,628

 
3,171

 
11,005

 
8,731

Borrowings
396

 
358

 
1,382

 
1,095

Total interest expense
4,024

 
3,529

 
12,387

 
9,826

Net interest income
12,743

 
11,689

 
37,012

 
36,321

Provision for loan and lease losses
2,100

 

 
5,400

 

Net interest income after provision for loan and lease losses
10,643

 
11,689

 
31,612

 
36,321

Noninterest income
 
 
 
 
 
 
 
Service fees on deposits and other banking services
463

 
382

 
1,303

 
1,176

Net gain on sale of securities available for sale

 

 

 
48

Net gain on sale of Small Business Administration loans
265

 

 
866

 

Net loss on sale of other assets
(6
)
 

 
(42
)
 
(4
)
Other noninterest income
620

 
733

 
2,092

 
2,086

Total noninterest income
1,342

 
1,115

 
4,219

 
3,306

Noninterest expense
 
 
 
 
 
 
 
Salaries and employee benefits
6,070

 
5,809

 
17,247

 
17,885

Occupancy
639

 
591

 
1,913

 
1,799

Equipment and depreciation
460

 
438

 
1,401

 
1,341

Data processing
574

 
412

 
1,618

 
1,184

FDIC expense
165

 
189

 
522

 
738

FDIC rebate
(189
)
 

 
(189
)
 

Other real estate owned expense, net

 
(16
)
 
69

 
(8
)
Professional fees
1,118

 
655

 
3,104

 
2,041

Business development
197

 
257

 
634

 
755

Loan related expense
122

 
181

 
429

 
534

Insurance
58

 
62

 
180

 
187

Other operating expense
483

 
424

 
1,460

 
1,378

Total noninterest expense
9,697

 
9,002

 
28,388

 
27,834

Income before income taxes
2,288

 
3,802

 
7,443

 
11,793

Income tax provision (benefit)
658

 
(98
)
 
2,204

 
(11,183
)
Net income allocable to common shareholders
$
1,630

 
$
3,900

 
$
5,239

 
$
22,976

Basic income per common share:
 
 
 
 
 
 
 
Net income allocable to common shareholders
$
0.07

 
$
0.17

 
$
0.22

 
$
0.98

Diluted income per common share:
 
 
 
 
 
 
 
Net income allocable to common shareholders
$
0.07

 
$
0.17

 
$
0.22

 
$
0.98

Weighted average number of common shares outstanding:
 
 
 
 
 
 
 
Basic
23,355,639

 
22,995,574

 
22,605,608

 
23,121,083

Diluted
23,656,570

 
23,598,267

 
23,605,390

 
23,535,408

The accompanying notes are an integral part of these consolidated financial statements.

5


PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(Dollars in thousands)
(Unaudited)
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2019
 
2018
 
2019
 
2018
Net income
$
1,630

 
$
3,900

 
$
5,239

 
$
22,976

Other comprehensive income (loss), net of tax:
 
 
 
 
 
 
 
Change in unrealized holding gain (loss) on securities available for sale
50

 
(105
)
 
690

 
(493
)
Less: Reclassification adjustment for change in accounting principle

 

 

 
(97
)
Less: Reclassification adjustment for net gains included in net income

 

 

 
48

Net unrealized holding gain (loss) on securities available for sale
50

 
(105
)
 
690

 
(444
)
Total comprehensive income
$
1,680

 
$
3,795

 
$
5,929

 
$
22,532

The accompanying notes are an integral part of these consolidated financial statements.


6


PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(Shares and dollars in thousands)
(Unaudited)
For the Three and Nine Months Ended September 30, 2019

  
Series A Non-Voting
Preferred stock
 
Common stock
 
Retained
earnings
(accumulated
deficit)
 
Accumulated
other
comprehensive
income (loss)
 
Total
Number
of shares
 
Amount
 
Number
of shares
 
Amount
 
Balance at December 31, 2018
1,467

 
$
8,480

 
21,916

 
$
143,466

 
$
(9,428
)
 
$
(1,144
)
 
$
141,374

Implementation of ASU 2016-02

 

 

 

 
(207
)
 

 
(207
)
Issuance of restricted stock, net

 

 
102

 

 

 

 

Common stock based compensation expense

 

 

 
200

 

 

 
200

Net income

 

 

 

 
882

 

 
882

Other comprehensive income

 

 

 

 

 
367

 
367

Balance at March 31, 2019
1,467

 
$
8,480

 
22,018

 
$
143,666

 
$
(8,753
)
 
$
(777
)
 
$
142,616

Issuance of restricted stock, net

 

 
15

 

 

 

 

Exchange Series A Non-Voting Preferred Stock to Series A Non-Voting Common Stock
(1,467
)
 
(8,480
)
 
1,467

 
8,480

 

 

 

Common stock based compensation expense

 

 

 
219

 

 

 
219

Common stock options exercised

 

 
15

 
80

 

 

 
80

Net income

 

 

 

 
2,728

 

 
2,728

Other comprehensive income

 

 

 

 

 
273

 
273

Balance at June 30, 2019

 

 
23,515

 
152,445

 
(6,025
)
 
(504
)
 
145,916

Issuance of restricted stock, net

 

 
3

 

 

 

 

Exchange Series A Non-Voting Preferred Stock to Series A Non-Voting Common Stock

 

 

 

 

 

 

Common stock based compensation expense

 

 

 
416

 

 

 
416

Common stock options exercised

 

 
3

 
22

 

 

 
22

Net income

 

 

 

 
1,630

 

 
1,630

Other comprehensive income

 

 

 

 

 
50

 
50

Balance at September 30, 2019

 

 
23,521

 
$
152,883

 
$
(4,395
)
 
$
(454
)
 
$
148,034



The accompanying notes are an integral part of these consolidated financial statements.














7





PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(Shares and dollars in thousands)
(Unaudited)
For the Three and Nine Months Ended September 30, 2018


  
Series A Non-Voting
Preferred stock
 
Common stock
 
Retained
earnings
(accumulated
deficit)
 
Accumulated
other
comprehensive
income (loss)
 
Total
Number
of shares
 
Amount
 
Number
of shares
 
Amount
 
Balance at December 31, 2017

 
$

 
23,233

 
$
150,689

 
$
(36,670
)
 
$
(1,143
)
 
$
112,876

Implementation of ASU 2016-01

 

 

 

 
(97
)
 

 
(97
)
Issuance of restricted stock, net

 

 
72

 

 

 

 

Common stock based compensation expense

 

 

 
179

 

 

 
179

Common stock options exercised

 

 
8

 
28

 

 

 
28

Net income

 

 

 

 
3,707

 

 
3,707

Other comprehensive loss

 

 

 

 

 
(298
)
 
(298
)
Balance at March 31, 2018

 
$

 
23,313

 
$
150,896

 
$
(33,060
)
 
$
(1,441
)
 
$
116,395

Issuance of common stock

 

 

 

 

 

 

Issuance of restricted stock, net

 

 
(2
)
 

 

 

 

Common stock based compensation expense

 

 

 
237

 

 

 
237

Common stock options exercised

 

 
67

 
345



 

 
345

Net income

 

 

 

 
15,369

 

 
15,369

Other comprehensive income

 

 

 

 

 
(41
)
 
(41
)
Balance at June 30, 2018

 

 
23,378

 
151,478

 
(17,691
)
 
(1,482
)
 
132,305

Exchange of common stock for Series A Non-Voting Preferred Stock
1,467

 
8,480

 
(1,467
)
 
(8,480
)
 

 

 

Issuance of restricted stock, net

 

 
7

 

 

 

 

Common stock based compensation expense

 

 

 
233

 

 

 
233

Common stock options exercised

 

 

 
(12
)
 

 

 
(12
)
Net income

 

 

 

 
3,900

 

 
3,900

Other comprehensive income
 
 
 
 
 
 
 
 
 
 
(105
)
 
(105
)
Balance at September 30, 2018
1,467

 
8,480

 
21,918

 
143,219

 
(13,791
)
 
(1,587
)
 
136,321



The accompanying notes are an integral part of these consolidated financial statements.


8


PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
(Unaudited)
 
Nine Months Ended September 30,
 
2019
 
2018
Cash Flows From Operating Activities:
 
 
 
Net income
$
5,239

 
$
22,976

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
311

 
300

Provision for loan and lease losses
5,400

 

Amortization of premium on securities
113

 
141

Net gain on sale of securities available for sale

 
(48
)
Net amortization of deferred fees and unearned income on loans
464

 
23

Net loss (gain) on sales of other real estate owned
66

 
(29
)
Net loss on sale of other assets
42

 
4

Net gain on sale of small business administration loans
(866
)
 

Small business administration loan originations
(10,118
)
 

Proceeds from sale of small business administration loans
11,090

 

Stock-based compensation expense
835

 
649

Other

 
59

Changes in operating assets and liabilities:
 
 
 
Net increase in accrued interest receivable
(118
)
 
(369
)
Net decrease in other assets
5,180

 
1,542

Net (increase) decrease in deferred taxes
2,802

 
(11,183
)
Net decrease (increase) in income taxes receivable
662

 
(53
)
Net increase in accrued interest payable
23

 
7

Net decrease in other liabilities
(7,273
)
 
(2,894
)
Net cash provided by operating activities
13,852

 
11,125

Cash Flows From Investing Activities:
 
 
 
Net decrease in interest-bearing time deposits with financial institutions

 
500

Maturities of and principal payments received on securities available for sale and other stock
7,125

 
4,694

Purchase of securities available for sale and other stock

 
(3,211
)
Proceeds from sale of securities available for sale and other stock
912

 
6,883

Purchase of other investments
(876
)
 
(175
)
Proceeds from sale of other real estate owned
1,107

 
827

Net increase in loans
(76,009
)
 
(19,800
)
Purchases of premises and equipment
(261
)
 
(346
)
Proceeds from sale of other assets
55

 
32

Net cash used in investing activities
(67,947
)
 
(10,596
)
Cash Flows From Financing Activities:
 
 
 
Net increase (decrease) in deposits
77,094

 
(22,298
)
Proceeds from borrowings
60,000

 
41,000

Payments of borrowings
(60,000
)
 
(41,727
)
Proceeds from exercise of common stock options
102

 
361

Net cash provided by (used in) financing activities
77,196

 
(22,664
)
Net increase (decrease) in cash and cash equivalents
23,101

 
(22,135
)
Cash and Cash Equivalents, beginning of period
187,718

 
198,208

Cash and Cash Equivalents, end of period
$
210,819

 
$
176,073

Supplementary Cash Flow Information:
 
 
 
Cash paid for interest on deposits and other borrowings
$
12,364

 
$
9,819

Cash paid for income taxes
$

 
$
59

Non-Cash Investing Activities:
 
 
 
Transfer of loans into other assets
$
161

 
$
15

Transfer of loans into other real estate owned
$

 
$
1,346

Impact of change in accounting principle
$

 
$
97

Assumption of debt upon foreclosure of property
$

 
$
727

Right-of-use assets obtained in exchange for new operating lease liabilities
$
12,625

 
$

 The accompanying notes are an integral part of these consolidated financial statements.

9



1. Nature of Business
Organization
Pacific Mercantile Bancorp (“PMBC”) is a bank holding company which, through its wholly owned subsidiary, Pacific Mercantile Bank (the “Bank”), is engaged in the commercial banking business in Southern California. PMBC is registered as a one bank holding company under the United States Bank Holding Company Act of 1956, as amended, and, as such, is regulated by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”) and the Federal Reserve Bank of San Francisco (“FRBSF”) under delegated authority from the Federal Reserve Board. Substantially all of our operations are conducted and substantially all of our assets are owned by the Bank, which accounts for substantially all of our consolidated revenues, expenses, and income. The Bank provides a full range of banking services to middle-market businesses and professionals primarily in Orange, Los Angeles, San Bernardino and San Diego counties in Southern California and is subject to competition from, among other things, other banks and financial institutions and from financial services organizations conducting operations in those same markets. The Bank is chartered by the California Department of Business Oversight under the Division of Financial Institutions and is a member of the FRBSF. In addition, the deposit accounts of the Bank’s customers are insured by the Federal Deposit Insurance Corporation (“FDIC”) up to the maximum amount allowed by law. PM Asset Resolution, Inc. (“PMAR”) was a wholly owned subsidiary of PMBC, which existed for the purpose of purchasing certain non-performing loans and other real estate from the Bank and thereafter collecting on or disposing of those assets. PMAR was dissolved and all remaining capital was returned to PMBC during the third quarter of 2018.
PMBC, the Bank and PMAR are sometimes referred to, together, on a consolidated basis, in this report as the “Company” or as “we”, “us” or “our”.


10


2. Significant Accounting Policies
Except as discussed below, our accounting policies are described in Note 2, Significant Accounting Policies of our audited consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2018 (“Form 10-K”).
Interim Consolidated Financial Statements Basis of Presentation
Our interim consolidated financial statements are prepared in accordance with generally accepted accounting principles in effect in the United States (“GAAP”) for interim financial information pursuant to rules and regulations of the U.S. Securities and Exchange Commission (the “SEC”), including instructions to Form 10-Q and Article 10 of Regulation S-X, on a basis consistent with prior periods. Our financial statements reflect all adjustments that are, in the opinion of management, necessary to present a fair statement of the results for the interim periods presented. The interim results are not necessarily indicative of operating results for the full year. The interim information should be read in conjunction with our audited consolidated financial statements in our Form 10-K.
Use of Estimates
The preparation of the financial statements in conformity with GAAP requires us to make certain estimates and assumptions that could affect the reported amounts of certain of our assets, liabilities, and contingencies at the date of the financial statements and the reported amounts of our revenues and expenses during the reporting periods. For the fiscal periods covered by this report, those estimates related primarily to our determinations of the allowance for loan and lease losses (“ALLL”), the fair values of securities available for sale, and the determination of the valuation allowance pertaining to deferred tax assets. If circumstances or financial trends on which those estimates were based were to change in the future or there were to occur any currently unanticipated events affecting the amounts of those estimates, our future financial position or results of operations could differ, possibly materially, from those expected at the current time.
Principles of Consolidation
Our consolidated financial statements for the three and nine months ended September 30, 2019 and 2018 include the accounts of PMBC, the Bank and PMAR; PMAR was liquidated during the third quarter of 2018. All significant intercompany balances and transactions were eliminated in consolidation. 
Recent Accounting Pronouncements
In February 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-02, “Leases (Topic 842),” which requires lessees to recognize the following for all leases (with the exception of short-term leases) at the commencement date: a lease liability measured on a discounted basis and a right-of-use asset a specified asset for the lease term. The new standard establishes a right-of-use model (ROU) that requires a lessee to recognize a ROU asset and lease liability on the balance sheet for all leases with a term longer than 12 months. Leases will be classified as finance or operating, with classification affecting the pattern and classification of expense recognition in the income statement. Under the new guidance, lessor accounting is largely unchanged and the accounting for sale and leaseback transactions were simplified. We elected most of the new standard’s available transition practical expedients. The new standard had a material effect on our financial statements. While we continue to assess all of the effects of adoption, we currently believe the most significant effects relate to (1) the recognition of new ROU assets and lease liabilities on our balance sheet for our office and equipment operating leases; and (2) providing significant new disclosures about our leasing activities. The new standard also provides practical expedients for an entity’s ongoing accounting. We have elected the short-term lease recognition exemption for all leases that qualify. This means, for those leases that qualify, we did not recognize ROU assets or lease liabilities, and this includes not recognizing ROU assets or lease liabilities for existing short-term leases of those assets in transition. In July 2018, the FASB issued ASU 2018-11, “Leases (Topic 842): Targeted Improvements,” which provides an additional transition method upon adoption of ASU 2016-02. The guidance allows an entity to apply the new leases standard at the adoption date and recognize a cumulative-effect adjustment to beginning retained earnings in the period of adoption. In March 2019, the FASB issued ASU 2019-01, “Leases (Topic 842): Codification Improvements,” which provides additional guidance for fair value of the underlying asset by lessors that are not manufacturers or dealers, requires lessors that are banking institutions to present all "principal payments received under leases" within investing activities, and exempts both lessees and lessors from having to provide certain interim disclosures in the fiscal year in which a company adopts the new leases standard. On adoption of these accounting standards, we recognized additional operating liabilities of $11.1 million, with corresponding ROU assets of the same or less amount based on the present value of the remaining minimum rental payments under current leasing standards for existing operating leases. We recorded a $207 thousand adjustment to our beginning retained earnings. This guidance is effective for interim and annual periods beginning after December 15, 2018. Early adoption is permitted. We adopted this guidance on January 1, 2019.

11


In June 2016, the FASB issued ASU 2016-13, “Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments,” which requires the measurement of all expected credit losses for financial assets held at the reporting date, based on historical experience, current conditions, and reasonable and supportable forecasts. Financial institutions will now use forward-looking information to better inform their credit loss estimates. Additionally, the ASU amends the accounting guidance for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration. In October 2019, the FASB confirmed that it will be moving forward with finalizing its proposal to defer the effective date for this guidance for smaller reporting companies from the interim and annual periods beginning after December 15, 2020 to the interim and annual periods beginning after December 15, 2022. For this effective date deferral to take effect, the FASB must issue the final ASU which we expect to be issued in mid-November. Early adoption is permitted for interim and annual periods beginning after December 15, 2018. Upon issuance of the final ASU, we plan to adopt this guidance on January 1, 2023 and expect that it will have a material impact on the determination of our ALLL. We are unable to estimate the expected impact to the ALLL upon adoption due to various factors, primarily the fine tuning of our qualitative assumptions used within our preliminary model, uncertainty regarding economic conditions and the size and mix of our loan portfolio at the time of adoption, which could impact our historical loss factors. We are currently working with our existing ALLL software provider on further developing the model to perform the ALLL calculations upon adoption and we believe that we currently have in place the internal team capable of handling this implementation.
In August 2018, the FASB issued ASU 2018-13, “Fair Value Measurement (Topic 820): Disclosure Framework — Changes to the Disclosure Requirements for Fair Value Measurement,” which amends the disclosure requirements related to fair value. The guidance removes disclosure related to transfers between Level 1 and Level 2 of the fair value hierarchy, the timing of these transfers and the valuation processes for Level 3 fair value measurements. Additional disclosures required as a result of adoption of this ASU will include the change in Level 3 unrealized gains and losses included in other comprehensive income and the range and weighted average of significant observable inputs used to develop Level 3 fair value measurements. This guidance is effective for interim and annual periods beginning after December 15, 2019. Early adoption is permitted. An entity is permitted to early adopt any removed or modified disclosures upon issuance of ASU 2018-13 and delay adoption of the additional disclosure requirements until their effective date. We are currently evaluating this guidance to determine the date of adoption and impact on the Company.


12


3. Fair Value Measurements
Under FASB Accounting Standards Codification (“ASC”) 820-10, we group assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:
Level 1
Valuation is based upon quoted prices for identical instruments traded in active markets.
 
 
Level 2
Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.
 
 
Level 3
Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.
Risks with Fair Value Measurements
Fair value estimates are made at a discrete point in time based on relevant market information and other information about the financial instruments. Because no active market exists for a significant portion of our financial instruments, fair value estimates are based in large part on judgments we make primarily regarding current economic conditions, risk characteristics of various financial instruments, prepayment rates, and future expected loss experience. These estimates are subjective in nature and invariably involve some inherent uncertainties. Additionally, the occurrence of unexpected events or changes in circumstances can occur that could require us to make changes to our assumptions and which, in turn, could significantly affect and require us to make changes to our previous estimates of fair value.
In addition, the fair value estimates are based on existing on and off-balance sheet financial instruments without attempting to estimate the value of existing and anticipated future customer relationships and the value of assets and liabilities that are not considered financial instruments, such as premises and equipment and other real estate owned (“OREO”).
Measurement Methodology
Cash and Cash Equivalents. The fair value of cash and cash equivalents approximates its carrying value.
Interest-Bearing Deposits with Financial Institutions. The fair values of interest-bearing deposits maturing within one year approximate their carrying values.
FHLB and FRBSF Stock. The Bank is a member of the Federal Home Loan Bank of San Francisco (“FHLB”) and the FRBSF. As members, we are required to own stock of the FHLB and the FRBSF, the amount of which is based primarily on the level of our borrowings from those institutions. We also have the right to acquire additional shares of stock in either or both of the FHLB and the FRBSF. During the three and nine months ended September 30, 2019, we purchased no FHLB or FRBSF stock. No shares of FHLB stock or FRBSF stock were called during the three and nine months ended September 30, 2019. The fair values of the FHLB and FRBSF stock are equal to their respective carrying amounts, are classified as restricted securities and are periodically evaluated for impairment based on our assessment of the ultimate recoverability of our investments in that stock. Any cash or stock dividends paid to us on such stock are reported as income.
Investment Securities Available for Sale. Fair value measurement for our investment securities available for sale is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 investment securities include those traded on an active exchange, such as the New York Stock Exchange, and U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets. Level 2 investment securities include mortgage-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities. Securities classified as Level 3 include asset-backed securities in less liquid markets.
Equity Investments Without Readily Determinable Fair Value. Equity investments without readily determinable fair value are accounted for under the measurement alternative method of accounting. These investments are measured at cost, less any impairment, plus or minus any changes resulting from observable price changes in orderly transactions for an identical or similar investment of the same issuer. Any cash or stock dividends paid to us on such investments are reported as noninterest income.
Impaired Loans. Loans measured for impairment are measured at an observable market price (if available), or the fair value of the loan’s collateral (if the loan is collateral dependent). The fair value of an impaired loan may be estimated using one of several methods, including collateral value, market value of similar debt, liquidation value and discounted cash flows. Those

13


impaired loans not requiring a specific loan loss reserve represent loans for which the fair value of the expected repayments or collateral exceeds the recorded investments in such loans. When the fair value of the collateral is based on an observable market price or a current appraised value, we record the impaired loan at Level 2. When an appraised value is not available or we determine that the fair value of the collateral is further impaired below the appraised value and there is no observable market price, we record the impaired loan at Level 3.
Loans. The fair value for loans with variable interest rates less a credit discount is the carrying amount. The fair value of fixed rate loans is derived by calculating the present value of expected future cash flows discounted at the loan’s original interest rate by the various homogeneous categories of loans. All loans have been adjusted to reflect changes in credit risk and represent the exit price of the loans. Changes are not recorded directly as an adjustment to current earnings or comprehensive income, but rather as an adjustment component in determining the overall adequacy of the loan loss reserve.
Other Real Estate Owned. OREO is reported at its net realizable value (fair value less estimated costs to sell) at the time any real estate collateral is acquired by the Bank in satisfaction of a loan. Subsequently, OREO is carried at the lower of carrying value or fair value less estimated costs to sell. Fair value is determined based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or a current appraised value, we record the foreclosed asset at Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, we record the foreclosed asset at Level 3.
Other Foreclosed Assets. Other foreclosed assets are reported at their net realizable value (fair value less estimated costs to sell) at the time any collateral other than real estate is acquired by the Bank in satisfaction of a loan. Subsequently, other foreclosed assets are carried at the lower of carrying value or fair value less estimated costs to sell. Fair value is determined based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or a current appraised value, we record the foreclosed asset at Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, we record the foreclosed asset at Level 3.

Deposits. Deposits are carried at historical cost. The carrying amounts of deposits from savings and money market accounts are deemed to approximate fair value as they either have no stated maturities or short-term maturities. Certificates of deposit are estimated utilizing discounted cash flow techniques. The interest rates applied are rates currently being offered for similar certificates of deposit.
Borrowings. The fair value of borrowings is the carrying amount for those borrowings that mature on a daily basis. The fair value of term borrowings is derived by calculating the discounted value of future cash flows expected to be paid out by the Company. We classify our borrowings in Level 2 of the fair value hierarchy.
Junior Subordinated Debentures. The fair value of the junior subordinated debentures is based on quoted market prices of the underlying securities. These securities are variable rate in nature and repriced quarterly. We classify our junior subordinated debentures in Level 2 of the fair value hierarchy.
Commitments to Extend Credit and Standby Letters of Credit. The fair value of commitments to extend credit and standby letters of credit are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing.
Interest Receivable and Interest Payable. The carrying amounts of our accrued interest receivable and accrued interest payable are deemed to approximate fair value.
Assets Recorded at Fair Value on a Recurring Basis
The following tables show the recorded amounts of assets and liabilities measured at fair value on a recurring basis at September 30, 2019 and December 31, 2018:

14


 
At September 30, 2019
(Dollars in thousands)
Total
 
Level 1
 
Level 2
 
Level 3
Assets at Fair Value:
 
 
 
 
 
 
 
Debt securities available for sale
 
 
 
 
 
 
 
U.S. Treasury securities
$

 
$

 
$

 
$

Commercial mortgage backed securities issued by U.S. Agencies
4,424

 

 
4,424

 

Residential mortgage backed securities issued by U.S. agencies
20,549

 

 
20,549

 

Total debt securities available for sale at fair value
$
24,973

 
$

 
$
24,973

 
$

 
 
At December 31, 2018
(Dollars in thousands)
Total
 
Level 1
 
Level 2
 
Level 3
Assets at Fair Value:
 
 
 
 
 
 
 
Debt securities available for sale
 
 
 
 
 
 
 
U.S. Treasury securities
$
2,980

 
$

 
$
2,980

 
$

Commercial mortgage backed securities issued by U.S. Agencies
4,534

 

 
4,534

 

Residential mortgage backed securities issued by U.S. agencies
23,717

 

 
23,717

 

Total debt securities available for sale
31,231

 

 
31,231

 

Assets Recorded at Fair Value on a Nonrecurring Basis
We may be required, from time to time, to measure certain assets at fair value on a nonrecurring basis in accordance with GAAP. These nonrecurring fair value adjustments typically involve application of the lower of cost or market accounting or write-downs of individual assets. Information regarding assets measured at fair value on a nonrecurring basis is set forth in the table below.
 
At September 30, 2019
 
At December 31, 2018
(Dollars in thousands)
Total
 
Level 1
 
Level 2
 
Level 3
 
Total
 
Level 1
 
Level 2
 
Level 3
Assets at Fair Value:
 
 
 
Impaired loans
$
13,209

 
$

 
$

 
$
13,209

 
$
4,226

 
$

 
$

 
$
4,226

Other foreclosed assets
138

 

 
138

 

 
91

 

 
91

 

Other real estate owned

 

 

 

 
1,173

 

 
1,173

 

Total
$
13,347

 
$

 
$
138

 
$
13,209

 
$
5,490

 
$

 
$
1,264

 
$
4,226

 
Significant Unobservable Inputs and Valuation Techniques of Level 3 Fair Value Measurements
For our fair value measurements classified in Level 3 of the fair value hierarchy as of September 30, 2019, a summary of the significant unobservable inputs and valuation techniques is as follows:
 
Fair Value Measurement as of September 30, 2019
 
Valuation Techniques(2)
 
Unobservable Inputs(2)
 
Range
 
Weighted Average
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
Assets
 
 
 
 
 
 
 
 
 
Impaired loans
$
13,209

 
Third-Party Pricing
 
Discounted cash flow
 
N/A (1)
 
N/A (1)
 
(1)
As part of our process, we obtain appraisals for our various properties included within impaired loans which primarily rely upon market comparisons. These market comparisons support our assumption that the carrying value of the respective loans either requires or does not require additional impairment.
(2)
As of September 30, 2019, there has been no change to our valuation techniques or the types of unobservable inputs used in the calculation of fair value from December 31, 2018.

15


Fair Value Measurements for Other Financial Instruments
The table below provides estimated fair values and related carrying amounts of our financial instruments as of September 30, 2019 and December 31, 2018, excluding financial assets and liabilities which are recorded at fair value on a recurring basis.
 
Estimated Fair Value
At September 30, 2019
 
At December 31, 2018
Carrying Value
 
Total
 
Level 1
 
Level 2
 
Level 3
 
Carrying Value
 
Total
 
Level 1
 
Level 2
 
Level 3
 
(Dollars in thousands)
Financial assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
210,856

 
$
210,856

 
$
210,856

 
$

 
$

 
$
187,718

 
$
187,718

 
187,718

 

 

Interest-bearing deposits with financial institutions
2,420

 
2,420

 
2,420

 

 

 
2,420

 
2,420

 
2,420

 

 

Federal Reserve Bank of San Francisco and Federal Home Loan Bank stock
7,910

 
7,910

 
7,910

 

 

 
8,822

 
8,822

 
8,822

 

 

Loans, net
1,153,217

 
1,152,647

 

 

 
1,152,647

 
1,083,240

 
1,066,147

 

 

 
1,066,147

Accrued interest receivable
4,121

 
4,121

 
4,121

 

 

 
4,003

 
4,003

 
4,003

 

 

Financial liabilities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Noninterest bearing deposits
425,596

 
425,596

 
425,596

 

 

 
340,406

 
340,406

 
340,406

 

 

Interest-bearing deposits
787,500

 
788,762

 

 
788,762

 

 
795,596

 
794,321

 

 
794,321

 

Borrowings
40,000

 
40,004

 

 
40,004

 

 
40,000

 
39,976

 

 
39,976

 

Junior subordinated debentures
17,527

 
17,527

 

 
17,527

 

 
17,527

 
17,527

 

 
17,527

 

Accrued interest payable
384

 
384

 
384

 

 

 
361

 
361

 
361

 

 



16


4. Investments
Securities Available For Sale, at Fair Value
The following table sets forth the major components of securities available for sale and compares the amortized costs and estimated fair market values of, and the gross unrealized gains and losses on, these securities at September 30, 2019 and December 31, 2018:
(Dollars in thousands)
September 30, 2019
 
December 31, 2018
Amortized
Cost
 
Gross Unrealized
 
Estimated
Fair Value
 
Amortized
Cost
 
Gross Unrealized
 
Estimated
Fair Value
Gain
 
Loss
 
Gain
 
Loss
 
Securities Available for Sale
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. Treasury securities
$

 
$

 
$

 
$

 
$
2,999

 
$

 
$
(19
)
 
$
2,980

Commercial mortgage backed securities issued by U.S. Agencies(1)
4,247

 
177

 

 
4,424

 
4,495

 
40

 
(1
)
 
4,534

Residential mortgage backed securities issued by U.S. Agencies(2)
20,749

 
7

 
(207
)
 
20,549

 
24,739

 
1

 
(1,023
)
 
23,717

Total
$
24,996

 
$
184

 
$
(207
)
 
$
24,973

 
$
32,233

 
$
41

 
$
(1,043
)
 
$
31,231

 
 
(1)
Secured by first liens on commercial apartment building mortgages.
(2)
Secured by closed-end first liens on 1-4 family residential mortgages.

At September 30, 2019 and December 31, 2018, U.S. agency residential mortgage backed securities with an aggregate fair market value of $9.8 million and $18.2 million, respectively, were pledged to secure repurchase agreements, local agency deposits and treasury, tax and loan accounts.
The amortized cost and estimated fair values of securities available for sale at September 30, 2019 and December 31, 2018 are shown in the tables below by contractual maturities taking into consideration historical prepayments based on the prior twelve months of principal payments. Expected maturities will differ from contractual maturities and historical prepayments, particularly with respect to collateralized mortgage obligations, primarily because prepayment rates are affected by changes in conditions in the interest rate market and, therefore, future prepayment rates may differ from historical prepayment rates.
 
At September 30, 2019 Maturing in
(Dollars in thousands)
One year
or less
 
Over one
year through
five years
 
Over five
years through
ten years
 
Over ten
Years
 
Total
Securities available for sale, amortized cost
$
4,853

 
$
12,500

 
$
6,493

 
$
1,150

 
$
24,996

Securities available for sale, estimated fair value
4,810

 
12,422

 
6,548

 
1,193

 
24,973

Weighted average yield
1.52
%
 
1.62
%
 
2.16
%
 
3.06
%
 
1.81
%
 
At December 31, 2018 Maturing in
(Dollars in thousands)
One year
or less
 
Over one
year through
five years
 
Over five
years through
ten years
 
Over ten
Years
 
Total
Securities available for sale, amortized cost
$
7,874

 
$
13,466

 
$
9,971

 
$
922

 
$
32,233

Securities available for sale, estimated fair value
7,663

 
12,934

 
9,710

 
924

 
31,231

Weighted average yield
1.46
%
 
1.62
%
 
2.22
%
 
3.13
%
 
1.81
%
We purchased no securities available for sale during the three and nine months ended September 30, 2019. We purchased $2.5 million of securities available for sale during the three and nine months ended September 30, 2018. During the nine months ended September 30, 2018, we had sales proceeds of $2.1 million on the sale of debt securities available for sale, with a gain of $53 thousand, and sales proceeds of $4.8 million on the sale of our equity securities, with a loss of $5 thousand. We had no sales of securities available for sale during the three months ended September 30, 2018 or the three and nine months ended September 30, 2019.
The tables below indicate, as of September 30, 2019 and December 31, 2018, the gross unrealized losses and fair values of our investments, aggregated by investment category, and length of time that the individual securities have been in a continuous unrealized loss position.

17


 
Securities with Unrealized Loss at September 30, 2019
 
Less than 12 months
 
12 months or more
 
Total
(Dollars in thousands)
Fair Value
 
Unrealized
Loss
 
Fair Value
 
Unrealized
Loss
 
Fair Value
 
Unrealized
Loss
U.S. Treasury securities
$

 
$

 
$

 
$

 
$

 
$

Commercial mortgage backed securities issued by U.S. Agencies

 

 

 

 

 

Residential mortgage backed securities issued by U.S. Agencies

 

 
18,323

 
(207
)
 
18,323

 
(207
)
Total
$

 
$

 
$
18,323

 
$
(207
)
 
$
18,323

 
$
(207
)
  
Securities with Unrealized Loss at December 31, 2018
 
Less than 12 months
 
12 months or more
 
Total
(Dollars in thousands)
Fair Value
 
Unrealized
Loss
 
Fair Value
 
Unrealized
Loss
 
Fair Value
 
Unrealized
Loss
U.S. Treasury securities
$

 
$

 
$
2,980

 
$
(19
)
 
$
2,980

 
$
(19
)
Commercial mortgage backed securities issued by U.S. Agencies
999

 
(1
)
 

 

 
999

 
(1
)
Residential mortgage backed securities issued by U.S. Agencies
361

 
(3
)
 
23,299

 
(1,020
)
 
23,660

 
(1,023
)
Total
$
1,360

 
$
(4
)
 
$
26,279

 
$
(1,039
)
 
$
27,639

 
$
(1,043
)
We regularly monitor investments for significant declines in fair value. We have determined that declines in the fair values of these investments below their respective amortized costs, as set forth in the tables above, are temporary because (i) those declines were due to interest rate changes and not to a deterioration in the creditworthiness of the issuers of those investment securities, and (ii) we have the ability to hold those securities until there is a recovery in their values or until their maturity.
We recognize other-than-temporary impairments (“OTTI”) to our available-for-sale debt securities in accordance with FASB ASC 320-10. When there are credit losses associated with, but we have no intention to sell, an impaired debt security, and it is more likely than not that we will not have to sell the security before recovery of its cost basis, we will separate the amount of impairment, or OTTI, between the amount that is credit-related and the amount that is related to non-credit factors. Credit-related impairments are recognized in our consolidated statements of operations. Any non-credit-related impairments are recognized and reflected in other comprehensive income in our consolidated statements of financial condition.
Through the impairment assessment process, we determined that there were no available-for-sale debt securities that were other-than-temporarily impaired at September 30, 2019. We recorded no impairment credit losses on available-for-sale debt securities in our consolidated statements of operations for the three and nine months ended September 30, 2019 and 2018.
We have made a determination that the remainder of our securities with respect to which there were unrealized losses as of September 30, 2019 are not other-than-temporarily impaired, because we have concluded that we have the ability to continue to hold those securities until their respective fair market values increase above their respective amortized costs or, if necessary, until their respective maturities. In reaching that conclusion we considered a number of factors and other information, which included: (i) the significance of each such security, (ii) the amount of the unrealized losses attributable to each such security, (iii) our liquidity position, (iv) the impact that retention of those securities could have on our capital position and (v) our evaluation of the expected future performance of these securities (based on the criteria discussed above).
Equity Investments Without Readily Determinable Fair Value
As of September 30, 2019, we had three investments in private companies and limited partnerships without a readily determinable fair value. As of September 30, 2019, we owned less than 3% of the total investment in each such company or partnership. Under ASU 2016-01, we elected to measure these equity investments using the measurement alternative, which requires that these investments are measured at cost, less any impairment, plus or minus any changes resulting from observable price changes in orderly transactions for an identical or similar investment of the same issuer. During the three and nine months ended September 30, 2019, these investments were not impaired and there were no observable price changes. As a result, the balance shown below as of September 30, 2019 represents the cost of the investments and is included within other assets on the consolidated statements of financial condition. Prior to the adoption of ASU 2016-01, these investments were accounted for under the cost method of accounting and included within other assets on the consolidated statements of financial condition. During the three and nine months ended September 30, 2019, we had zero and $876 thousand, respectively, of capital contributions to these investments. We had $34 thousand and $175 thousand, respectively, of capital contributions to these investments during the three

18


and nine months ended September 30, 2018. As of September 30, 2019 and December 31, 2018, our equity investments without readily determinable fair value were as follows:
 
September 30, 2019
 
December 31, 2018
 
(Dollars in thousands)
Equity investments without readily determinable fair value
$
2,117

 
$
1,240



19


5. Loans and Allowance for Loan and Lease Losses
The loan portfolio consisted of the following at:
 
September 30, 2019
 
December 31, 2018
(Dollars in thousands)
Amount
 
Percent
 
Amount
 
Percent
Commercial loans
$
434,249

 
37.4
%
 
$
444,441

 
40.7
%
Commercial real estate loans – owner occupied
216,848

 
18.7
%
 
211,645

 
19.3
%
Commercial real estate loans – all other
220,170

 
19.0
%
 
226,441

 
20.7
%
Residential mortgage loans – multi-family
173,275

 
14.9
%
 
97,173

 
8.9
%
Residential mortgage loans – single family
18,720

 
1.6
%
 
21,176

 
1.9
%
Construction and land development loans
6,110

 
0.5
%
 
38,496

 
3.5
%
Consumer loans
91,198

 
7.9
%
 
54,514

 
5.0
%
Gross loans
1,160,570

 
100.0
%
 
1,093,886

 
100.0
%
Deferred fee (income) costs, net
4,733

 
 
 
2,860

 
 
Allowance for loan and lease losses
(12,086
)
 
 
 
(13,506
)
 
 
Loans, net
$
1,153,217

 
 
 
$
1,083,240

 
 
At September 30, 2019 and December 31, 2018, real estate loans of approximately $436 million and $807 million, respectively, were pledged to secure borrowings obtained from the FHLB and to support our unfunded borrowing capacity. At September 30, 2019 and December 31, 2018, commercial and consumer loans of $267 million and $51 million, respectively, were pledged to secure borrowings from the FRB to support our unfunded borrowing capacity. During the three and nine months ended September 30, 2019, we sold $3.0 million and $10.1 million, respectively, of Small Business Administration (SBA) loans at a premium. During the nine months ended September 30, 2018, we sold $15.1 million of commercial real estate loans - all other at par value. No loans were sold during the three months ended September 30, 2018. During the three and nine months ended September 30, 2019, we purchased loans totaling $81.0 million and $123.1 million, respectively, of which $81.0 million were multi-family mortgage loans and $39.9 million were consumer loans. We purchased no loans during the three and nine months ended September 30, 2018.
Allowance for Loan and Lease Losses
The ALLL represents our estimate of credit losses in our loan and lease portfolio that are probable and estimable at the balance sheet date. We employ economic models that are based on bank regulatory guidelines, industry standards and our own historical loan loss experience, as well as a number of more subjective qualitative factors, to determine both the sufficiency of the ALLL and the amount of the provisions that are required to increase or replenish the ALLL.
 
The ALLL is first determined by (i) analyzing all classified loans (graded as “Substandard” or “Doubtful” under our internal asset quality grading parameters) on nonaccrual status for loss exposure and (ii) establishing specific reserves as needed. ASC 310-10 defines loan impairment as the existence of uncertainty concerning collection of all principal and interest in accordance with the contractual terms of a loan. For collateral dependent loans, impairment is typically measured by comparing the loan amount to the fair value of collateral, less estimated costs to sell, with any “shortfall” amount charged off. Other methods can be used in estimating impairment, including market price and the present value of expected future cash flows discounted at the loan’s original interest rate. We are an active lender with the U.S. Small Business Administration and collection of a percentage of the loan balance of many of the loans originated is guaranteed.  The ALLL reserves are calculated against the non-guaranteed loan balances. 
On a quarterly basis, we utilize a classification based loan loss migration model as well as review individual loans in determining the adequacy of the ALLL for homogenous pools of loans that are not subject to specific reserve allocations. Our loss migration analysis utilizes a series of nineteen staggered 16-quarter migration periods of loan loss history and industry loss factors to determine historical losses by classification category for each loan type, except certain consumer loans (automobile, mortgage and credit cards). We then apply these calculated loss factors, together with qualitative factors based on external economic conditions and trends and internal assessments, to the outstanding loan balances in each homogenous group of loans, and then, using our internal asset quality grading parameters, we grade the loans as “Pass,” “Special Mention,” “Substandard” or “Doubtful”. We analyze impaired loans individually. This grading is based on the credit classifications of assets as prescribed by government regulations and industry standards and is separated into the following groups:
Pass: Loans classified as pass include current loans performing in accordance with contractual terms, installment/consumer loans that are not individually risk rated, and loans which exhibit certain risk factors that require greater than usual monitoring by management.

20


Special Mention: Loans classified as special mention, while generally not delinquent, have potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or in the Bank’s credit position at some future date.
Substandard: Loans classified as substandard have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. There is a distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.
Doubtful: Loans classified as doubtful have all the weaknesses inherent in a substandard loan, and may also be at delinquency status and have defined weaknesses based on currently existing facts, conditions and values making collection or liquidation in full highly questionable and improbable.
Set forth below is a summary of the activity in the ALLL, by portfolio type, during the three and nine months ended September 30, 2019 and 2018:
(Dollars in thousands)
Commercial
 
Real  Estate
 
Construction and Land
Development
 
Consumer 
and Single
Family
Mortgages
 
Unallocated
 
Total
ALLL in the three months ended September 30, 2019:
 
 
 
 
 
 
 
 
 
 
 
Balance at beginning of period
$
6,809

 
$
2,790

 
$
119

 
$
1,756

 
$

 
$
11,474

Charge offs
(1,549
)
 

 

 
(2
)
 

 
(1,551
)
Recoveries
58

 

 

 
5

 

 
63

Provision
2,202

 
(45
)
 
(36
)
 
(21
)
 

 
2,100

Balance at end of period
$
7,520

 
$
2,745

 
$
83

 
$
1,738

 
$

 
$
12,086

ALLL in the nine months ended September 30, 2019:
 
 
 
 
 
 
 
 
 
 
 
Balance at beginning of period
$
8,071

 
$
3,643

 
$
426

 
$
1,290

 
$
76

 
$
13,506

Charge offs
(7,337
)
 

 

 
(39
)
 

 
(7,376
)
Recoveries
541

 

 

 
15

 

 
556

Provision
6,245

 
(898
)
 
(343
)
 
472

 
(76
)
 
5,400

Balance at end of period
$
7,520

 
$
2,745

 
$
83

 
$
1,738

 
$

 
$
12,086

ALLL in the three months ended September 30, 2018:
 
 
 
 
 
 
 
 
 
 
 
Balance at beginning of period
$
7,493

 
$
2,953

 
$
327

 
$
1,578

 
$
1,018

 
$
13,369

Charge offs
(416
)
 

 

 
(3
)
 

 
(419
)
Recoveries
448

 
60

 

 
5

 

 
513

Provision
(229
)
 
664

 
81

 
(21
)
 
(495
)
 

Balance at end of period
$
7,296

 
$
3,677

 
$
408

 
$
1,559

 
$
523

 
$
13,463

ALLL in the nine months ended September 30, 2018:
 
 
 
 
 
 
 
 
 
 
 
Balance at beginning of period
$
9,155

 
$
2,906

 
$
650

 
$
1,043

 
$
442

 
$
14,196

Charge offs
(1,840
)
 

 

 
(3
)
 

 
(1,843
)
Recoveries
1,009

 
60

 

 
41

 

 
1,110

Provision
(1,028
)
 
711

 
(242
)
 
478

 
81

 

Balance at end of period
$
7,296

 
$
3,677

 
$
408

 
$
1,559

 
$
523

 
$
13,463


21


Set forth below is information regarding loan balances and the related ALLL, by portfolio type, as of September 30, 2019 and December 31, 2018.
(Dollars in thousands)
Commercial
 
Real  Estate
 
Construction and Land
Development
 
Consumer 
and Single
Family
Mortgages
 
Unallocated
 
Total
ALLL balance at September 30, 2019 related to:
 
 
 
 
 
 
 
 
 
 
 
Loans individually evaluated for impairment
$

 
$

 
$

 
$

 
$

 
$

Loans collectively evaluated for impairment
7,520

 
2,745

 
83

 
1,738

 

 
12,086

Total
$
7,520

 
$
2,745

 
$
83

 
$
1,738

 
$

 
$
12,086

Loans balance at September 30, 2019 related to:
 
 
 
 
 
 
 
 
 
 
 
Loans individually evaluated for impairment
$
6,796

 
$
6,266

 
$

 
$

 
$

 
$
13,062

Loans collectively evaluated for impairment
427,453

 
604,027

 
6,110

 
109,918

 

 
1,147,508

Total
$
434,249

 
$
610,293

 
$
6,110

 
$
109,918

 
$

 
$
1,160,570

ALLL balance at December 31, 2018 related to:
 
 
 
 
 
 
 
 
 
 
 
Loans individually evaluated for impairment
$

 
$

 
$

 
$

 
$

 
$

Loans collectively evaluated for impairment
8,071

 
3,643

 
426

 
1,290

 
76

 
13,506

Total
$
8,071

 
$
3,643

 
$
426

 
$
1,290

 
$
76

 
$
13,506

Loans balance at December 31, 2018 related to:
 
 
 
 
 
 
 
 
 
 
 
Loans individually evaluated for impairment
$
3,352

 
$
831

 
$

 
$
43

 
$

 
$
4,226

Loans collectively evaluated for impairment
441,089

 
534,428

 
38,496

 
75,647

 

 
1,089,660

Total
$
444,441

 
$
535,259

 
$
38,496

 
$
75,690

 
$

 
$
1,093,886


Credit Quality
The amounts of nonperforming assets and delinquencies that occur within our loan portfolio factor into our evaluation of the adequacy of the ALLL.
The following table provides a summary of the delinquency status of loans by portfolio type at September 30, 2019 and December 31, 2018:

22


(Dollars in thousands)
30-59 Days Past Due
 
60-89 Days Past Due
 
90 Days and Greater
 
Total Past Due
 
Current
 
Total Loans Outstanding
 
Loans >90 Days and Accruing
At September 30, 2019
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial loans
$
3,478

 
$
12

 
$
82

 
$
3,572

 
$
430,677

 
$
434,249

 
$

Commercial real estate loans – owner-occupied

 

 

 

 
216,848

 
216,848

 

Commercial real estate loans – all other

 

 

 

 
220,170

 
220,170

 

Residential mortgage loans – multi-family

 

 

 

 
173,275

 
173,275

 

Residential mortgage loans – single family

 

 

 

 
18,720

 
18,720

 

Construction and land development loans
4,267

 

 

 
4,267

 
1,843

 
6,110

 

Consumer loans
68

 
2

 
4

 
74

 
91,124

 
91,198

 

Total
$
7,813

 
$
14

 
$
86

 
$
7,913

 
$
1,152,657

 
$
1,160,570

 
$

At December 31, 2018
 
Commercial loans
$

 
$
3,705

 
$
4,273

 
$
7,978

 
$
436,463

 
$
444,441

 
$
1,278

Commercial real estate loans – owner-occupied

 
831

 

 
831

 
210,814

 
211,645

 

Commercial real estate loans – all other

 

 

 

 
226,441

 
226,441

 

Residential mortgage loans – multi-family

 

 

 

 
97,173

 
97,173

 

Residential mortgage loans – single family

 

 

 

 
21,176

 
21,176

 

Construction and land development loans

 

 

 

 
38,496

 
38,496

 

Consumer loans
13

 

 

 
13

 
54,501

 
54,514

 

Total
$
13

 
$
4,536

 
$
4,273

 
$
8,822

 
$
1,085,064

 
$
1,093,886

 
$
1,278

Generally, the accrual of interest on a loan is discontinued when principal or interest payments become more than 90 days past due, unless we believe that the loan is adequately collateralized and it is in the process of collection. There were no loans 90 days or more past due and still accruing interest at September 30, 2019. There were $1.3 million of loans 90 days or more past due and still accruing interest at December 31, 2018. In certain instances, when a loan is placed on nonaccrual status, previously accrued but unpaid interest is reversed against current income. Subsequent collections of cash are applied as principal reductions when received (referred to as full nonaccrual basis of accounting), except when the ultimate collectability of principal is probable, in which case such payments are applied to accrued and unpaid interest, which is credited to income (referred to as nonaccrual cash basis of accounting). Nonaccrual loans may be restored to accrual status when principal and interest become current and full repayment becomes expected.
The following table provides information with respect to loans on nonaccrual status, by portfolio type, as of September 30, 2019 and December 31, 2018:
 
September 30, 2019
 
December 31, 2018
 
(Dollars in thousands)
Nonaccrual loans:
 
 
 
Commercial loans
$
6,849

 
$
3,352

Commercial real estate loans – owner occupied
6,266

 
831

Consumer
94

 
43

Total(1)
$
13,209

 
$
4,226

 
(1)    Nonaccrual loans may include loans that are currently considered performing loans.

23


 We classify our loan portfolio using internal asset quality ratings. The following table provides a summary of loans by portfolio type and our internal asset quality ratings as of September 30, 2019 and December 31, 2018:
 
September 30, 2019
 
December 31, 2018
 
(Dollars in thousands)
Pass:
 
 
 
Commercial loans
$
382,003

 
$
428,287

Commercial real estate loans – owner occupied
206,192

 
205,914

Commercial real estate loans – all other
220,170

 
226,441

Residential mortgage loans – multi family
173,275

 
97,173

Residential mortgage loans – single family
18,720

 
21,176

Construction and land development loans
6,110

 
38,496

Consumer loans
91,102

 
54,415

Total pass loans
$
1,097,572

 
$
1,071,902

Special Mention:
 
 
 
Commercial loans
$
26,721

 
$
10,411

Commercial real estate loans – owner occupied
4,390

 
4,900

Total special mention loans
$
31,111

 
$
15,311

Substandard:
 
 
 
Commercial loans
$
24,448

 
$
5,743

Commercial real estate loans – owner occupied
6,266

 
831

Consumer loans
96

 
99

Total substandard loans
$
30,810

 
$
6,673

Doubtful:
 
 
 
Commercial loans
$
1,077

 
$

Total doubtful loans
$
1,077

 
$

Total Loans:
$
1,160,570

 
$
1,093,886

Impaired Loans
A loan generally is classified as impaired when, in our opinion, principal or interest is not likely to be collected in accordance with the contractual terms of the loan agreement. We measure for impairments on a loan-by-loan basis, using either the present value of expected future cash flows discounted at the loan’s effective interest rate, or the fair value of the collateral if the loan is collateral dependent.
The following table sets forth information regarding impaired loans, at September 30, 2019 and December 31, 2018:
 
September 30, 2019
 
December 31, 2018
 
(Dollars in thousands)
Impaired loans:
 
Nonaccruing loans
$
13,209

 
$
4,226

Nonaccruing restructured loans(1)

 

Accruing restructured loans(1)(2)

 

Total impaired loans
$
13,209

 
$
4,226

Impaired loans less than 90 days delinquent and included in total impaired loans
$
13,205

 
$
1,232

 
(1)
As of September 30, 2019 and December 31, 2018, we had no restructured loans.
(2)
See “Troubled Debt Restructurings” below for a description of accruing restructured loans at September 30, 2019 and December 31, 2018.

24


The table below contains additional information with respect to impaired loans, by portfolio type, as of September 30, 2019 and December 31, 2018:
 
September 30, 2019
 
December 31, 2018
 
Recorded Investment
 
Unpaid Principal Balance
 
Related Allowance (1)
 
Recorded Investment
 
Unpaid Principal Balance
 
Related Allowance (1)
 
(Dollars in thousands)
No allowance recorded:
 
 
 
 
 
 
 
 
 
 
 
Commercial loans
$
6,849

 
$
8,427

 
$

 
$
3,352

 
$
4,516

 
$

Commercial real estate loans – owner occupied
6,266

 
6,395

 

 
831

 
925

 

Consumer loans
94

 
127

 

 
43

 
65

 

Total
13,209

 
14,949

 

 
4,226

 
5,506

 

With allowance recorded:
 
 
 
 
 
 
 
 
 
 
 
Total

 

 

 

 

 

Total
 
 
 
 
 
 
 
 
 
 
 
Commercial loans
$
6,849

 
$
8,427

 
$

 
$
3,352

 
$
4,516

 
$

Commercial real estate loans – owner occupied
6,266

 
6,395

 

 
831

 
925

 

Consumer loans
94

 
127

 

 
43

 
65

 

Total
13,209

 
14,949

 

 
4,226

 
5,506

 

 
(1)
When the discounted cash flows, collateral value or market price equals or exceeds the recorded investment in the loan, then specific reserves are not required to be set aside for the loan within the ALLL. This typically occurs when the impaired loans have been partially charged-off and/or there have been interest payments received and applied to the balance of the principal outstanding.
 
At September 30, 2019 and December 31, 2018, there were $13.2 million and $4.2 million, respectively, of impaired loans for which no specific reserves had been allocated because these loans, in our judgment, were sufficiently collateralized. Of the impaired loans at September 30, 2019 for which no specific reserves were allocated, $0.8 million had been deemed impaired in the prior year.
Average balances and interest income recognized on impaired loans, by portfolio type, for the three and nine months ended September 30, 2019 and 2018 were as follows:
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2019
 
2018
 
2019
 
2018
 
Average Balance
 
Interest Income Recognized
 
Average Balance
 
Interest Income Recognized
 
Average Balance
 
Interest Income Recognized
 
Average Balance
 
Interest Income Recognized
 
(Dollars in thousands)
No allowance recorded:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial loans
$
3,658

 
$
190

 
$
4,700

 
$
39

 
$
2,786

 
$
394

 
$
4,256

 
$
101

Commercial real estate loans – owner occupied
3,524

 
118

 
856

 

 
2,171

 
237

 
871

 

Commercial real estate loans – all other

 

 

 

 

 

 
762

 

Residential mortgage loans – single family

 

 

 

 

 

 
43

 

Consumer loans
95

 

 
48

 

 
68

 
2

 
51

 

Total
7,277

 
308

 
5,604

 
39

 
5,025

 
633

 
5,983

 
101

With allowance recorded:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial loans

 

 

 

 

 

 
209

 

Total

 

 

 

 

 

 
209

 

Total
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial loans
3,658

 
190

 
4,700

 
39

 
2,786

 
394

 
4,465

 
101

Commercial real estate loans – owner occupied
3,524

 
118

 
856

 

 
2,171

 
237

 
871

 

Commercial real estate loans – all other

 

 

 

 

 

 
762

 

Residential mortgage loans – single family

 

 

 

 

 

 
43

 

Consumer loans
95

 

 
48

 

 
68

 
2

 
51

 

Total
$
7,277

 
$
308

 
$
5,604

 
$
39

 
$
5,025

 
$
633

 
$
6,192

 
$
101

The interest that would have been earned had the impaired loans remained current in accordance with their original terms was $50 thousand and $131 thousand during the three months ended September 30, 2019 and 2018, respectively, and $54 thousand and $293 thousand during the nine months ended September 30, 2019 and 2018, respectively.

25


Troubled Debt Restructurings (“TDRs”)
Pursuant to the FASB's ASU No. 2011-2, A Creditor’s Determination of whether a Restructuring is a Troubled Debt Restructuring, the Bank's TDRs totaled $0 at both September 30, 2019 and December 31, 2018. TDRs consist of loans to which modifications have been made for the purpose of alleviating temporary impairments of the borrower's financial condition and cash flows. Those modifications have come in the form of changes in amortization terms, reductions in interest rates, interest only payments and, in limited cases, concessions to outstanding loan balances. The modifications are made as part of workout plans we enter into with the borrower that are designed to provide a bridge for the borrower’s cash flow shortfalls in the near term. If a borrower works through the near term issues, then in most cases, the original contractual terms of the borrower’s loan will be reinstated.
There were no loans restructured as TDRs during the three and nine months ended September 30, 2019 or 2018.


26


6. Leases
We have historically entered into a number of lease arrangements under which we are the lessee.  Specifically, all of our physical locations are subject to operating leases.  In addition, we have elected the short-term lease practical expedient related to operating leases. 
Two of our office leases, including our corporate headquarters, include multiple optional renewal periods.  To the extent we conclude that it is reasonably certain that a renewal option will be exercised, that renewal period is then included in the lease term, and the related payments are reflected in the ROU asset and lease liability.  Generally, we consider any additional renewal periods to be reasonably certain of being exercised. 
All of our leases include fixed rental payments.  We commonly enter into leases under which the lease payments increase at pre-determined dates.  While the majority of our leases are gross leases, we also have a number of leases in which we make separate payments to the lessor based on the lessor’s property and casualty insurance costs and the property taxes assessed on the property, as well as a portion of the common area maintenance associated with the property. 
During the three and nine months ended September 30, 2019, we recognized rent expense associated with our leases as follows:
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2019
 
2019
Lease cost
(Dollars in thousands)
Finance lease cost:
 
 
 
Operating lease cost
585

 
$
1,688

Short-term lease cost(1)
29

 
119

Total lease cost
$
614

 
$
1,807

 
 
 
 
Weighted-average remaining lease term—operating leases (in years)


 
5.61

 
(1)    Includes leases that are less than 12 months and equipment leases that are accounted for on a cash basis.
Because we generally do not have access to the rate implicit in the lease, we utilize our borrowing rate with the FHLB as the discount rate.  The weighted average discount rate associated with operating leases as of September 30, 2019 is 1.57%.
Supplemental balance sheet information related to leases was as follows:
 
Financial Statement Classification
 
September 30, 2019
 
 
 
(Dollars in thousands)
Operating right-of-use assets
Other assets
 
$
12,029

Operating lease liabilities
Other liabilities
 
$
12,869

During the nine months ended September 30, 2019, we had the following cash and non-cash activities associated with our leases:
 
Nine Months Ended September 30,
 
2019
 
(Dollars in thousands)
Cash paid for amounts included in the measurement of lease liabilities

Operating cash flows from operating leases (fixed payments)
$
1,688

 
 
Non-cash activities:
 
Right-of-use assets obtained in exchange for new operating lease liabilities
$
12,625

As a result of the Bank’s renewal of the lease of its headquarters, the ROU asset increased from $9.9 million at June 30, 2019 to 12.6 million at September 30, 2019.

27


Maturities of operating lease liabilities as of September 30, 2019 are as follows:
(Dollars in thousands)
 
For the years ending December 31,
 
Remainder of 2019
562

2020
2,289

2021
2,359

2022
2,440

2023
2,522

2024 and beyond
3,565

Total
13,737

Less: Imputed interest
868

Total Lease liabilities
12,869


28


7. Income Taxes
For the three and nine months ended September 30, 2019, we had income tax expense of $0.7 million and $2.2 million, respectively, as a result of our operating income. Accounting rules specify that management must evaluate the deferred tax asset on a recurring basis to determine whether enough positive evidence exists to determine whether it is more-likely-than-not that the deferred tax asset will be available to offset or reduce future taxes. The tax code allows net operating losses incurred prior to December 31, 2017 to be carried forward for 20 years from the date of the loss, and based on its evaluation, management believes that the Company will be able to realize the deferred tax asset within the period that our net operating losses may be carried forward. Due to the hierarchy of evidence that the accounting rules specify, management determined that there continued to be enough positive evidence to support no valuation allowance on our deferred tax asset at September 30, 2019. Significant positive evidence included our three-year cumulative income position, continued improvement in asset quality, and the expectation that we will continue to have positive earnings based on twelve trailing quarters of positive income and our forecast. Negative evidence included our accumulated deficit.
For the three and nine months ended September 30, 2018, we had an income tax benefit of $98 thousand and $11.2 million, respectively, as a result of our net income during the third quarter of 2018 and the release of our full valuation allowance of $11.1 million on our net deferred tax asset during the second quarter of 2018. During the three months ended September 30, 2018, management determined that there continued to be enough positive evidence to support no valuation allowance on our deferred tax asset. For the three months ended June 30, 2018, management evaluated the positive and negative evidence and determined that the valuation allowance that was previously established on the balance of our deferred tax asset was no longer required and released the entire $11.1 million. During the three months ended September 30, 2018, management determined that there continued to be enough positive evidence to support no valuation allowance on our deferred tax asset. Based on this evaluation, management believed that the Company would be able to realize the deferred tax asset within the period that our operating losses may be carried forward. Significant positive evidence included our three-year cumulative income position, continued improvement in asset quality, and the expectation that we will continue to have positive earnings based on eight trailing quarters of positive income and our forecast. Negative evidence at September 30, 2018 included our accumulated deficit.
We file income tax returns with the U.S. federal government and the State of California. As of September 30, 2019, we were subject to examination by the Internal Revenue Service with respect to our U.S. federal tax returns for the 2015 to 2017 tax years and the Franchise Tax Board for California state income tax returns for the 2014 to 2017 tax years. Net operating losses on our U.S. federal and California state income tax returns may be carried forward up to 20 years. As of September 30, 2019, we do not have any unrecognized tax benefits.
Our policy is to recognize interest and penalties accrued on any unrecognized tax benefits as a component of tax expense. We did not have any accrued interest or penalties associated with any unrecognized tax benefits, and no interest expense was recognized during the three and nine months ended September 30, 2019 and 2018.

29


8. Stock-Based Employee Compensation Plans
In May 2010, our shareholders approved the adoption of our 2010 Equity Incentive Plan, which was amended at the Annual Shareholders meeting held in May 2013 (the “2010 Incentive Plan”), and which superseded our shareholder-approved 2008 and 2004 Equity Incentive Plans (the “Previously Approved Plans”). Options to purchase a total of 6,003 shares of our common stock granted under the Previously Approved Plans were outstanding at September 30, 2019. As of September 30, 2019, there were options to purchase a total of 832,673 shares of our common stock and 137,692 shares of our unvested restricted stock grants under the 2010 Incentive Plan.
In May 2019, our shareholders approved the adoption of our 2019 Equity Incentive Plan (the “2019 Incentive Plan”), which authorized and set aside a total of 2,000,000 shares of our common stock for issuance on the exercise of stock options or the grant of restricted stock or other equity incentives to our officers, and other key employees and directors. Since approval of the 2019 Incentive Plan, no additional awards will be issued under the 2010 Incentive Plan, although awards outstanding under the 2010 Incentive Plan will remain outstanding and will continue to be governed by the terms of the 2010 Incentive Plan and any applicable award agreements. Under the terms of the 2019 Incentive Plan, any forfeited options or unvested restricted stock grants that had been issued under the Previously Approved Plans or the 2010 Incentive Plan will not be available for future equity incentive grants. As of September 30, 2019, there were outstanding options to purchase a total of 250,000 shares of our common stock, 100,000 shares of our unvested restricted stock units, and 2,656 shares of our unvested restricted stock grants under the 2019 Incentive Plan. As of September 30, 2019, there remain 1,493,360 shares available for future grants under the 2019 Incentive Plan.
A stock option entitles the recipient to purchase shares of our common stock at a price per share that may not be less than 100% of the fair market value of the Company’s shares on the date the option is granted. Restricted shares may be granted at such purchase prices and on such other terms, including restrictions and Company repurchase or reacquisition rights, as are fixed by the Compensation Committee at the time rights to purchase such restricted shares are granted. Stock Appreciation Rights (“SARs”) entitle the recipient to receive a cash payment in an amount equal to the difference between the fair market value of the Company’s shares on the date of vesting and a “base price” (which, in most cases, will be equal to the fair market value of the Company’s shares on the date the SAR is granted), subject to the right of the Company to make such payment in shares of its common stock at their then fair market value. Stock units may be payable in cash or shares of common stock, or a combination of the two. A stock unit is a bookkeeping entry representing the equivalent of one common share. Options, restricted shares, SARs and stock units may vest in installments over various periods generally ranging up to five years, subject to the recipient’s continued employment or service or the achievement of specified performance goals, as determined by the Compensation Committee at the time it grants or awards the options, the restricted shares, the SARs or the stock units. Stock options, SARs and stock units may be granted for terms of up to 10 years after the date of grant, but will terminate sooner upon or shortly after a termination of service occurring prior to the expiration of the term of the option, SAR or stock unit. The Company will become entitled to repurchase any unvested restricted shares, at the same price that was paid for the shares by the recipient, or to cancel those shares in the event of a termination of employment or service of the holder of such shares or if any performance goals specified in the award are not satisfied. To date, the Company has not granted any SARs.
Under FASB ASC 718-10, we are required to recognize, in our financial statements, the fair value of the options, restricted shares, SARs and stock units that we grant as compensation cost over their respective service periods. The fair values of the options that were outstanding at September 30, 2019 were estimated as of their respective dates of grant using the Black-Scholes option-pricing model. The Company has also granted restricted stock and stock units for the benefit of its employees and directors. These restricted shares vest over a period ranging from three to five years for employees and one year for directors while the stock units vest over a period of one to five years. The recipients of restricted shares have the right to vote all shares subject to such grant and receive all dividends with respect to such shares whether or not the shares have vested. The recipients of stock units have no rights of a stockholder. The recipients do not pay any cash consideration for the shares or stock units.
Stock Options
The table below summarizes the weighted average assumptions used to determine the fair values of the options granted during the following periods:
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
Assumptions with respect to:
2019
 
2018(1)
 
2019
 
2018
Expected volatility
27
%
 
%
 
27
%
 
30
%
Risk-free interest rate
1.35
%
 
%
 
1.35
%
 
2.69
%
Expected dividends
%
 
%
 
%
 
%
Expected term (years)
5.1

 
0.0

 
5.1

 
5.8

Weighted average fair value of options granted during period
$
1.97

 
$

 
$
1.97

 
$
2.81


30


 
(1)    No stock options were granted during the three months ended September 30, 2018.
The following table summarizes the stock option activity under the Company’s equity incentive plans during the nine months ended September 30, 2019 and 2018, respectively.
 
Number of
Shares
 
Weighted-
Average
Exercise
Price
Per Share
 
Number of
Shares
 
Weighted-
Average
Exercise
Price
Per Share
 
2019
 
2018
Outstanding – January 1,
864,330

 
$
6.86

 
792,577

 
$
6.41

Granted
250,000

 
7.33

 
154,011

 
8.20

Exercised
(18,250
)
 
5.57

 
(75,108
)
 
4.95

Forfeited/Canceled
(7,404
)
 
8.15

 
(7,150
)
 
6.47

Outstanding – September 30,
1,088,676

 
6.98

 
864,330

 
6.86

Options Exercisable – September 30,
720,402

 
$
6.68

 
588,233

 
$
6.49

Options Vested – September 30,
720,402

 
$
6.68

 
588,233

 
$
6.49

Options to purchase 3,250 and 0 shares of our common stock were exercised during the three months ended September 30, 2019 and 2018, respectively, and 18,250 and 75,108 during the nine months ended September 30, 2019 and 2018, respectively. The aggregate intrinsic value of options exercised during the three months ended September 30, 2019 and 2018 was $3 thousand and zero, respectively, and $41 thousand and $356 thousand during the nine months ended September 30, 2019 and 2018, respectively. The fair value of options that vested during the three months ended September 30, 2019 and 2018 was $8 thousand and $8 thousand, respectively, and $420 thousand and $358 thousand during the nine months ended September 30, 2019 and 2018, respectively.
The following table provides additional information regarding the vested and unvested options that were outstanding at September 30, 2019.
Options Outstanding as of September 30, 2019
 
Options Exercisable
as of September 30, 2019
(1)
Exercise Price
Vested
 
Unvested
 
Weighted
Average
Exercise
Price Per Share
 
Weighted
Average
Remaining
Contractual
Life (Years)
 
Shares
 
Weighted
Average
Exercise Price Per Share
$2.97 – $3.99
18,003

 

 
$
3.48

 
1.70
 
18,003

 
$
3.48

$4.00 – $5.99
16,000

 

 
4.34

 
1.55
 
16,000

 
4.34

$6.00– $6.99
477,937

 
13,800

 
6.61

 
4.74
 
477,937

 
6.60

$7.00– $7.99
161,129

 
250,000

 
7.23

 
8.44
 
161,129

 
7.08

$8.00-$8.40
47,333

 
104,474

 
8.19

 
8.38
 
47,333

 
8.17

 
720,402

 
368,274

 
$
6.98

 
6.55
 
720,402

 
$
6.68

 
(1)
The weighted average remaining contractual life of the options that were exercisable as of September 30, 2019 was 5.08 years.
The aggregate intrinsic value of options that were outstanding and exercisable at September 30, 2019 and December 31, 2018 was $628 thousand and $388 thousand, respectively.
 
A summary of the status of the unvested options outstanding as of September 30, 2019 and 2018, and changes in the weighted average grant date fair values of the unvested options during the nine months ended September 30, 2019 and 2018, are set forth in the following table.

31


 
For the nine months ended September 30,
 
2019
 
2018
 
Number of
Shares Subject
to Options
 
Weighted
Average
Grant Date
Fair Value Per Share
 
Number of
Shares Subject
to Options
 
Weighted
Average
Grant Date
Fair Value Per Share
Unvested at the beginning of the period
275,457

 
$
2.79

 
255,348

 
$
2.80

Granted
250,000

 
1.97

 
154,011

 
2.81

Vested
(150,439
)
 
2.79

 
(123,361
)
 
2.83

Forfeited/Canceled
(6,744
)
 
2.83

 
(7,150
)
 
2.66

Unvested at the end of the period
368,274

 
2.23

 
278,848

 
2.79

At September 30, 2019, the weighted average period over which nonvested awards were expected to be recognized was 3.91 years.
Restricted Stock
The following table summarizes the activity related to restricted stock granted, vested and forfeited under our equity incentive plans during the nine months ended September 30, 2019 and 2018.
 
For the nine months ended September 30,
 
2019
 
2018
 
Number of Shares
 
Average Grant Date Fair Value Per Share
 
Number of Shares
 
Average Grant Date Fair Value Per Share
Outstanding at the beginning of the period
115,031

 
$
8.04

 
103,508

 
$
7.33

Granted
126,552

 
8.58

 
82,217

 
8.33

Vested
(93,859
)
 
8.07

 
(62,564
)
 
7.26

Forfeited
(7,376
)
 
8.77

 
(4,690
)
 
7.55

Outstanding at the end of the period
140,348

 
$
8.47

 
118,471

 
$
8.06


Stock Units
The following table summarizes the activity related to stock units granted, vested and forfeited under our equity incentive plans during the nine months ended September 30, 2019 and 2018.
 
For the nine months ended September 30,
 
2019
 
2018
 
Number of Shares
 
Average Grant Date Fair Value Per Share
 
Number of Shares
 
Average Grant Date Fair Value Per Share
Outstanding at the beginning of the period


$

 

 
$

Granted
100,000


7.33

 

 

Vested



 

 

Forfeited



 

 

Outstanding at the end of the period
100,000


$
7.33

 

 
$







32


Compensation Expense
We expect that the compensation expense that will be recognized during the periods presented below in respect of stock options, restricted stock, and stock units outstanding at September 30, 2019, will be as follows:
 
Estimated Stock Based Compensation Expense Stock Options
 
Estimated Stock Based Compensation Expense Restricted Stock
 
Estimated Stock Based Compensation Expense Stock Units
 
Estimated Stock Based Compensation Expense Total
(Dollars in thousands)
 
 
 
 
 
 
 
For the years ending December 31,
 
 
 
 
 
 
 
Remainder of 2019
$
60

 
$
121

 
$
62

 
$
243

2020
246

 
383

 
244

 
873

2021
139

 
276

 
244

 
659

2022
114

 
91

 
164

 
369

2023 and beyond
167

 
47

 

 
214

 
$
726

 
$
918

 
$
714

 
$
2,358

The aggregate amounts of stock based compensation expense recognized in our consolidated statements of operations for the three months ended September 30, 2019 and 2018 were $293 thousand and $166 thousand, respectively, in each case net of taxes, and $589 thousand and $458 thousand for the nine months ended September 30, 2019 and 2018, respectively, in each case net of taxes.


33


9. Earnings Per Share (“EPS”)
Basic EPS excludes dilution and is computed by dividing net income or loss allocable to common shareholders by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if stock options or other contracts to issue common stock were exercised or converted into common stock that would then share in our earnings.

The following table shows how we computed basic and diluted EPS for the three and nine months ended September 30, 2019 and 2018. 
(In thousands, except per share data)
For the Three Months Ended September 30,
 
For the Nine Months Ended September 30,
2019
 
2018
 
2019
 
2018
Basic EPS:
 
 
 
 
 
 
 
Net income
$
1,630

 
$
3,900

 
$
5,239

 
$
22,976

Less dividends on preferred stock

 

 

 

Less dividends on common stock

 

 

 

Less dividends on unvested shares

 

 

 

Net income allocable to common shareholders
$
1,630

 
$
3,900

 
$
5,239

 
$
22,976

Less earnings allocated to participating securities
11

 
64

 
196

 
203

Earnings allocated to common shareholders
$
1,619

 
$
3,836

 
$
5,043

 
$
22,773

Weighted average common shares outstanding
23,356

 
22,996

 
22,606

 
23,121

Basic earnings per common share
$
0.07

 
$
0.17

 
$
0.22

 
$
0.98

Diluted EPS:
 
 
 
 
 
 
 
Earnings allocated to common shareholders
$
1,630

 
$
3,900

 
$
5,239

 
$
22,976

Weighted average common shares outstanding
23,356

 
22,996

 
22,606

 
23,121

Add dilutive effects of restricted stock grants
163

 
115

 
157

 
115

Add dilutive effects for assumed conversion of Series A preferred stock

 
271

 
720

 
91

Add dilutive effect for stock options
138

 
216

 
122

 
208

Weighted average diluted common shares outstanding
23,657

 
23,598

 
23,605

 
23,535

Diluted earnings per common share
$
0.07

 
$
0.17

 
$
0.22

 
$
0.98

 
(1)
The basic and diluted earnings per share amounts for the three and nine months ended September 30, 2019 and 2018 are the same under both the Treasury Stock Method and the Two-Class Method as prescribed in FASB ASC 260-10, Earnings Per Share.
The weighted average shares that have an antidilutive effect in the calculation of diluted net income per share and have been excluded from the computations above were as follows:
 
For the Three Months Ended September 30,
 
For the Nine Months Ended September 30,
 
2019
 
2018
 
2019
 
2018
Stock options(1)
257,636

 
140,985

 
208,997

 
128,711

 
(1)
Represents stock options that were excluded from the computation of diluted earnings per common share for the three and nine months ended September 30, 2019 and 2018 as a result of the shares being “out-of-the-money.”


34


10. Shareholders’ Equity
Accumulated Other Comprehensive Income (Loss), net
Accumulated other comprehensive income (loss), net as of September 30, 2019 and December 31, 2018 was as follows:
 
Unrealized Gain (Loss) on Securities Available-for-Sale, net of tax
 
Accumulated Other Comprehensive Income (Loss), Net
 
(Dollars in thousands)
Ending balance as of December 31, 2017
$
(1,143
)
 
$
(1,143
)
Other comprehensive income before reclassifications, net of tax of $142 thousand
(50
)
 
(50
)
Amounts reclassified from accumulated other comprehensive loss(1)
49

 
49

Other comprehensive loss, net of tax of $142 thousand
(1
)
 
(1
)
Ending balance as of December 31, 2018
$
(1,144
)
 
$
(1,144
)
Other comprehensive income before reclassifications, net of tax of $289 thousand
690

 
690

Amounts reclassified from accumulated other comprehensive loss

 

Other comprehensive income, net of tax of $289 thousand
690

 
690

Ending balance as of September 30, 2019
$
(454
)
 
$
(454
)
 
(1)
This balance consists of the $48 thousand net gain on sale of available for sale debt securities included in our consolidated statement of operations offset by $97 thousand included in our consolidated statement of shareholders' equity as an adjustment to our beginning retained earnings.

35


11. Commitments and Contingencies
Commitments
To meet the financing needs of our customers in the normal course of business, we are a party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated financial statements. At September 30, 2019 and December 31, 2018, we were committed to fund certain loans including letters of credit amounting to approximately $286 million and $302 million, respectively. The contractual amounts of a credit-related financial instrument, such as a commitment to extend credit, a credit-card arrangement or a letter of credit, represent the amount of potential accounting loss should the commitment be fully drawn upon, the customer were to default, and the value of any existing collateral securing the customer’s payment obligation becomes worthless. The loss reserve for unfunded loan commitments was $350 thousand at both September 30, 2019 and December 31, 2018.
As a result, we use the same credit policies in making commitments to extend credit and conditional obligations as we do for on-balance sheet instruments. Commitments generally have fixed expiration dates; however, since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. We evaluate each customer’s creditworthiness on a case-by-case basis, using the same credit underwriting standards that are employed in making commercial loans. The amount of collateral obtained, if any, upon an extension of credit is based on our evaluation of the creditworthiness of the customer. Collateral held varies, but may include accounts receivable, inventory, property, plant and equipment, residential real estate and income-producing commercial properties.
Borrowings
At September 30, 2019 and December 31, 2018, our borrowings and contractual obligations consisted of the following:
(Dollars in thousands)
September 30, 2019
 
December 31, 2018
FHLB advances—short-term
$
40,000

 
$
40,000

FHLB advances—long-term

 

Total
$
40,000

 
$
40,000


The table below sets forth the amounts of, the interest rates we pay on, and the maturity dates of these FHLB borrowings. These borrowings had a weighted-average annualized interest rate of 2.17% for the nine months ended September 30, 2019.
Principal Amounts
 
Interest Rate
 
Maturity Dates
(Dollars in thousands)
10,000

 
2.52
%
 
November 29, 2019
10,000

 
2.19
%
 
December 26, 2019
10,000

 
2.00
%
 
December 30, 2019
10,000

 
1.97
%
 
March 30, 2020
At September 30, 2019, $436 million of loans were pledged to support our FHLB borrowings and our unfunded borrowing capacity. As of September 30, 2019, we had unused borrowing capacity of $273 million with the FHLB. The highest amount of borrowings outstanding at any month-end during the three months ended September 30, 2019 was $40 million. At September 30, 2019 and December 31, 2018, commercial and consumer loans of $257 million and $51 million, respectively, were pledged to secure borrowings from the FRB to support our unfunded borrowing capacity of $183 million.
As of December 31, 2018, we had $40.0 million of outstanding short-term borrowings and no outstanding long-term borrowings that we had obtained from the FHLB. These borrowings had a weighted-average annualized interest rate of 2.54% for the year ended December 31, 2018. As of December 31, 2018, we had unused borrowing capacity of $365 million with the FHLB. The highest amount of borrowings outstanding at any month-end during the year ended December 31, 2018 was $40.9 million.
Litigation, Claims and Assessments
We are a defendant in or a party to a number of legal actions or proceedings that arise in the ordinary course of business. In some of these actions and proceedings, claims for monetary damages are asserted against us.
In accordance with applicable accounting guidance, we establish an accrued liability for lawsuits or other legal proceedings when they present loss contingencies that are both probable and estimable. We estimate any potential loss based upon currently available information and significant judgments and a variety of assumptions, and known and unknown uncertainties. Moreover, the facts and circumstances on which such estimates are based will change over time. Therefore, the amount of any losses we

36


might incur in any lawsuits or other legal proceedings may exceed amounts which we had accrued based on our estimates and those estimates do not represent the maximum loss exposure that we may have in connection with any lawsuits or other legal proceedings.
In December 2016, following an ongoing review related to alleged discriminatory practices within our discontinued mortgage banking business, we received notice that the U.S. Department of Justice (“DOJ”) had authorized a potential enforcement action against the Bank. During the year ended December 31, 2018, we settled this matter with the DOJ for $1.0 million, which we have fully accrued and funded as of September 30, 2019.
Based on our evaluation of the remaining lawsuits and other proceedings that were pending against us as of September 30, 2019, the outcomes in those suits or other proceedings are not expected to have, either individually or in the aggregate, a material adverse effect on our consolidated financial position, results of operations or cash flows. However, in light of the inherent uncertainties involved, some of which are beyond our control, and the very large or indeterminate damages often sought in such legal actions or proceedings, an adverse outcome in one or more of these suits or proceedings could be material to our results of operations or cash flows for any particular reporting period.


37


12. Business Segment Information
We have one reportable business segment, commercial banking. The commercial banking segment provides middle-market businesses, professional firms and individuals with a diversified range of products and services such as various types of deposit accounts, various types of commercial and consumer loans, cash management services, and online banking services.
Since our operating segment derives all of its revenues from interest and noninterest income and interest expense constitutes its most significant expense, this segment is reported below using net interest income (interest income less interest expense) and noninterest income (primarily net gains on sales of small business administration loans and fee income). We do not allocate general and administrative expenses or income taxes to our operating segment.
The following table sets forth information regarding the net interest income and noninterest income for our commercial banking segment for the three and nine months ended September 30, 2019 and 2018.
(Dollars in thousands)
Commercial
 
Other(1)
 
Total
Net interest income for the three months ended September 30,
 
 
 
 
 
2019
$
12,960

 
$
(217
)
 
$
12,743

2018
$
11,876

 
$
(187
)
 
$
11,689

Noninterest income for the three months ended September 30,
 
 
 
 
 
2019
$
1,335

 
$
7

 
$
1,342

2018
$
1,109

 
$
6

 
$
1,115

Net interest income for the nine months ended September 30,
 
2019
$
37,692

 
$
(680
)
 
$
37,012

2018
$
35,325

 
$
996

 
$
36,321

Noninterest income for the nine months ended September 30,
 
 
 
 
 
2019
$
4,198

 
$
21

 
$
4,219

2018
$
3,288

 
$
18

 
$
3,306

Segment Assets at:
 
 
 
 
 
September 30, 2019
$
1,437,734

 
$
977

 
$
1,438,711

December 31, 2018
$
1,349,097

 
$
241

 
$
1,349,338

 
(1)
Represents net interest income and noninterest income for PMAR and PMBC.

38


13. Regulatory Capital
Under federal banking regulations that apply to all United States-based bank holding companies over $3 billion in total assets and all federally insured banks, the Bank (on a stand-alone basis) must meet specific capital adequacy requirements that, for the most part, involve quantitative measures, primarily in terms of the ratios of their capital to their assets, liabilities, and certain off-balance sheet items, calculated under regulatory accounting practices. The Company (on a consolidated basis) is below the reporting threshold of $3 billion in total assets and therefore is not subject to the same capital adequacy requirements. Under those regulations, each federally insured bank is determined by its primary federal bank regulatory agency to come within one of the following capital adequacy categories on the basis of its capital ratios:
well-capitalized
adequately capitalized
undercapitalized
significantly undercapitalized; or
critically undercapitalized
Certain qualitative assessments also are made by a banking institution’s primary federal regulatory agency that could lead the agency to determine that the banking institution should be assigned to a lower capital category than the one indicated by the quantitative measures used to assess the institution’s capital adequacy. At each successive lower capital category, a banking institution is subject to greater operating restrictions and increased regulatory supervision by its federal bank regulatory agency.
The following table sets forth the capital and capital ratios of the Bank (on a stand-alone basis) at September 30, 2019, as compared to the regulatory requirements applicable to it.
 
 
 
 
 
 
Applicable Federal Regulatory Requirement
 
 
 
For Capital
Adequacy Purposes
 
To be Categorized As
Well-Capitalized
 
Amount
 
Ratio
 
Amount
 
Ratio
 
Amount
 
Ratio
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
Total Capital to Risk Weighted Assets
168,838

 
13.2
%
 
123,694

 
At least 8.625
 
$
127,979

 
At least 10.0
 
 
 
 
 
 
 
 
 
 
 
 
Common Equity Tier 1 Capital to Risk Weighted Assets
156,402

 
12.2
%
 
65,589

 
At least 5.125
 
$
83,186

 
At least 6.5
 
 
 
 
 
 
 
 
 
 
 
 
Tier 1 Capital to Risk Weighted Assets
156,402

 
12.2
%
 
84,786

 
At least 6.625
 
$
102,383

 
At least 8.0
 
 
 
 
 
 
 
 
 
 
 
 
Tier 1 Capital to Average Assets
156,402

 
10.9
%
 
57,366

 
At least 4.0
 
$
71,707

 
At least 5.0
In early July 2013, the Federal Reserve Board and the FDIC issued final rules implementing the Basel III regulatory capital framework and related Dodd-Frank Wall Street Reform and Consumer Protection Act changes. The rules revise minimum capital requirements and adjust prompt correct action thresholds.  The final rules revise the regulatory capital elements, add a new common equity Tier 1 capital ratio, increase the minimum Tier 1 capital ratio requirement, and implement a new capital conservation buffer. The rules also permit certain banking organizations to retain, through a one-time election, the existing treatment for accumulated other comprehensive income. The final rules took effect for community banks on January 1, 2015, subject to a transition period for certain parts of the rules. At September 30, 2019, the Bank (on a stand-alone basis) continued to qualify as a well-capitalized institution under the capital adequacy guidelines described above.
On September 17, 2019, the FDIC finalized a rule that introduces an optional simplified measure of capital adequacy for qualifying community banking organizations (i.e., the community bank leverage ratio (CBLR) framework), as required by the Economic Growth, Regulatory Relief and Consumer Protection Act. The CBLR framework is designed to reduce burden by removing the requirements for calculating and reporting risk-based capital ratios for qualifying community banking organizations that opt into the framework. In order to qualify for the CBLR framework, a community banking organization must have a tier 1 leverage ratio of greater than 9.0%, less than $10 billion in total consolidated assets, and limited amounts of off-balance-sheet exposures and trading assets and liabilities. A qualifying community banking organization that opts into the CBLR framework and meets all requirements under the framework will be considered to have met the well-capitalized ratio requirements under the Prompt Corrective Action regulations and will not be required to report or calculate risk-based capital. The CBLR framework will be available for banks to use in their March 31, 2020, Call Report. The Company has not yet determined if it will opt into the CBLR framework for the Bank.

39


ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Forward Looking Statements
Statements contained in this Quarterly Report on Form 10-Q (this “Report”) that are not historical facts or that discuss our expectations, beliefs or views regarding our future operations or future financial performance, or financial or other trends in our business or in the markets in which we operate, constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. Often, they include words such as “believe,” “expect,” “anticipate,” “intend,” “plan,” “estimate,” “project,” “forecast,” or words of similar meaning, or future or conditional verbs such as “will,” “would,” “should,” “could,” or “may.” The information contained in such forward-looking statements is based on current information available to us and on assumptions that we make about future economic and market conditions and other events over which we do not have control. In addition, our business and the markets in which we operate are subject to a number of risks and uncertainties. Such risks and uncertainties, and the occurrence of events in the future or changes in circumstances that had not been anticipated, could cause our financial condition or actual operating results in the future to differ materially from our expected financial condition or operating results that are set forth in the forward-looking statements contained in this Report and could, therefore, also affect the price performance of our shares.
In addition to the risk of incurring loan losses and provision for loan losses, which is an inherent risk of the banking business, these risks and uncertainties include, but are not limited to, the following: the risk that the credit quality of our borrowers declines; potential declines in the value of the collateral for secured loans; the risk that steps we have taken to strengthen our overall credit administration are not effective; the risk of a downturn in the United States economy, and domestic or international economic conditions, which could cause us to incur additional loan losses and adversely affect our results of operations in the future; the risk that our interest margins and, therefore, our net interest income will be adversely affected by changes in prevailing interest rates; the risk of increases in our nonperforming assets, in which event we would face the prospect of further loan charge-offs and write-downs of assets; the risk that we will not be able to manage our interest rate risks effectively, in which event our operating results could be harmed; the prospect of changes in government regulation of banking and other financial services organizations, which could impact our costs of doing business and restrict our ability to take advantage of business and growth opportunities; the risk that our efforts to develop a robust commercial banking platform may not succeed; and the risk that we may be unable to realize our expected level of increasing deposit inflows. Readers of this Report are encouraged to review the additional information regarding these and other risks and uncertainties to which our business is subject that is contained in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2018 (the “2018 Form 10-K”) that we filed with the Securities and Exchange Commission (“SEC”) on March 11, 2019, as such information may be updated from time to time in subsequent Quarterly Reports on Form 10-Q that we file with the SEC. We urge you to read those risk factors in conjunction with your review of the following discussion and analysis of our results of operations for the three and nine months ended, and our financial condition at, September 30, 2019.
Due to the risks and uncertainties we face, readers are cautioned not to place undue reliance on the forward-looking statements contained in this Report, which speak only as of the date of this Report, or to make predictions about future performance based solely on historical financial performance. We also disclaim any obligation to update forward-looking statements contained in this Report as a result of new information, future events or otherwise, except as may otherwise be required by law.

Overview
The following discussion presents information about our consolidated results of operations, financial condition, liquidity and capital resources and should be read in conjunction with our consolidated financial statements and the notes thereto included in Item 1 above of this Report.
Our principal operating subsidiary is Pacific Mercantile Bank (the “Bank”), which is a California state chartered bank. The Bank accounts for substantially all of our consolidated revenues, expenses and income and our consolidated assets and liabilities. Accordingly, the following discussion focuses primarily on the Bank’s results of operations and financial condition.
As of September 30, 2019, our total assets, net loans and total deposits were $1.4 billion, $1.2 billion and $1.2 billion, respectively.
The Bank, which is headquartered in Orange County, California, approximately 40 miles south of Los Angeles, conducts a commercial banking business in Orange, Los Angeles, San Bernardino and San Diego counties in Southern California. The Bank is also a member of the Federal Reserve System and its deposits are insured, to the maximum extent permitted by law, by the
Federal Deposit Insurance Corporation (the “FDIC”). For the nine months ended September 30, 2019 and 2018, we operated as one reportable segment, Commercial Banking.
Unless the context otherwise requires, the “Company,” “we,” “our,” “ours,” and “us” refer to Pacific Mercantile Bancorp and its consolidated subsidiaries.

40


Results of Operations
Operating Results for the Three and Nine Months Ended September 30, 2019 and 2018     
Our operating results for the three and nine months ended September 30, 2019, compared to the same period in September 30, 2018, were as follows:
 
Three Months Ended September 30,
 
2019 vs. 2018
% Change
 
Nine Months Ended September 30,
 
2019 vs. 2018
% Change
 
2019
 
2018
 
 
2019
 
2018
 
 
(Dollars in thousands)
Interest income
$
16,767

 
$
15,218

 
10.2
 %
 
$
49,399

 
$
46,147

 
7.0
 %
Interest expense
4,024

 
3,529

 
14.0
 %
 
12,387

 
9,826

 
26.1
 %
Provision for loan and lease losses
2,100

 

 
 N/A

 
5,400

 

 
100.0
 %
Non-interest income
1,342

 
1,115

 
20.4
 %
 
4,219

 
3,306

 
27.6
 %
Non-interest expense
9,697

 
9,002

 
7.7
 %
 
28,388

 
27,834

 
2.0
 %
Income tax expense
658

 
(98
)
 
100.0
 %
 
2,204

 
(11,183
)
 
(119.7
)%
Net income
1,630

 
3,900

 
(58.2
)%
 
5,239

 
22,976

 
(77.2
)%
Interest Income
Three Months Ended September 30, 2019 and 2018
Total interest income increased 10.2% to $16.8 million for the three months ended September 30, 2019 from $15.2 million for the three months ended September 30, 2018. This was primarily due to an increase in interest earned on loans and short-term investments as a result of higher average balances and an increase in the average yield during the three months ended September 30, 2019 as compared to the same prior year period. During the three months ended September 30, 2019 and 2018, interest income on loans was $15.0 million and $13.9 million, respectively, yielding 5.44% and 5.25% on average loan balances of $1.10 billion and $1.05 billion, respectively. The increase in average loan yields is primarily attributable to the Board of Governors of the Federal Reserve System ("Federal Reserve Board") raising short-term interest rates by 100 basis points during the year ended December 31, 2018, which was partially offset by rate cuts of 50 basis points during the three months ended September 30, 2019.
During the three months ended September 30, 2019 and 2018, interest income from our securities available-for-sale and stock was $257 thousand and $265 thousand, respectively, yielding 2.90% and 2.74% on average balances of $35.1 million and $38.4 million, respectively. The average securities balances decreased as a result of the maturities of, and payments on, securities available-for-sale, partially offset by the purchase of $2.5 million in available-for-sale securities during 2018. Interest income from our short-term investments, including our Federal Funds sold and interest-bearing deposits, was $1.47 million and $1.06 million for the three months ended September 30, 2019 and 2018, respectively, yielding 2.21% and 1.99% on average balances of $263.2 million and $209.8 million, respectively. The increase in interest income from our short-term investments was primarily attributable to a higher average balance during the three months ended September 30, 2019 as compared to the three months ended September 30, 2018, and an increase in the average yield during the same period. The increase in average yields is attributable to the Federal Reserve Board raising short-term interest rates by 100 basis points during the year ended December 31, 2018, which was partially offset by rate cuts of 50 basis points during the three months ended September 30, 2019. As a result, total interest income on investments increased for the three months ended September 30, 2019 as compared to the three months ended September 30, 2018.
Nine Months Ended September 30, 2019 and 2018
Total interest income increased 7.0% to $49.4 million for the nine months ended September 30, 2019 from $46.1 million for the nine months ended September 30, 2018. This was primarily due to an increase in interest income on short-term investments during the nine months ended September 30, 2019 as compared to the same prior year period. During the nine months ended September 30, 2019 and 2018, interest income on loans was $44.2 million and $42.7 million, respectively, yielding 5.46% and 5.35% on average loan balances of $1.08 billion and $1.07 billion, respectively. The increase in average loan yields is primarily attributable to (“Federal Reserve Board”) raising short-term interest rates by 100 basis points during the year ended December 31, 2018, partially offset by the recovery of $1.6 million in interest income on two loan relationships that had been on nonaccrual status but were paid off during the nine months ended September 30, 2018.
During the nine months ended September 30, 2019 and 2018, interest income from our securities available-for-sale and stock was $808 thousand and $801 thousand, respectively, yielding 2.92% and 2.68% on average balances of $37.0 million and $40.0 million, respectively. Interest income from our short-term investments, including our Federal Funds sold and interest-bearing deposits, was $4.4 million and $2.6 million for the nine months ended September 30, 2019 and 2018, respectively, yielding 2.35% and 1.80% on average balances of $253.1 million and $194.3 million, respectively. The increase in interest income from

41


our short-term investments was primarily attributable to an increase in the average balance of investments and an increase in average yield resulting from higher interest rates set by the Federal Reserve Board during the nine months ended September 30, 2019 as compared to the nine months ended September 30, 2018. As a result, total interest income on investments increased for the nine months ended September 30, 2019 as compared to the nine months ended September 30, 2018.

Interest Expense
Three Months Ended September 30, 2019 and 2018
Total interest expense increased 14.0% for the three months ended September 30, 2019 compared to the three months ended September 30, 2018. The increase was primarily due to an increase in our cost of funds from 1.68% at September 30, 2018 to 1.88% at September 30, 2019 and an increase in the average balance of interest-bearing liabilities from $833.1 million at September 30, 2018 to $850.2 million at September 30, 2019, which consisted of deposits, borrowings and junior subordinated debentures. Our cost of funds increased as a result of the actions of the Federal Reserve Board to raise short-term interest rates by 100 basis points throughout the year 2018. The increase in our average balance of interest-bearing liabilities is primarily the result of higher deposits due to new client acquisition, our decision to increase the rate of interest paid on our non-maturing interest bearing deposits and our certificates of deposit resulting from the rising interest rate environment, and an increase in our Federal Home Loan Bank (“FHLB”) borrowings. Interest expense on our certificates of deposit for the three months ended September 30, 2019 and 2018 was $1.6 million and $1.3 million, respectively, with a cost of funds of 2.39% and 1.75% on average balances of $259.8 million and $299.3 million, respectively.
Nine Months Ended September 30, 2019 and 2018
Total interest expense increased 26.1% for the nine months ended September 30, 2019 compared to the nine months ended September 30, 2018. The increase was primarily due to an increase in our cost of funds from 1.54% at September 30, 2018 to 1.89% at September 30, 2019 and an increase in the average balance of interest-bearing liabilities from $851.7 million at September 30, 2018 to $874.0 million at September 30, 2019, which consisted of deposits, borrowings and junior subordinated debentures. Our cost of funds increased as a result of the actions of the Federal Reserve Board to raise short-term interest rates by 100 basis points over the course of the year 2018. The increase in our average balance of interest-bearing liabilities is primarily the result of higher deposits due to new client acquisition, our decision to increase the rate of interest paid on our non-maturing interest bearing deposits and our certificates of deposit resulting from the rising interest rate environment, and an increase in our FHLB borrowings. Interest expense on our certificates of deposit for the nine months ended September 30, 2019 and 2018 was $4.4 million and $4.1 million, respectively, with a cost of funds of 2.21% and 1.65% on average balances of $264.6 million and $327.9 million, respectively.
Net Interest Margin
One of the principal determinants of a bank’s income is its net interest income, which is the difference between (i) the interest that a bank earns on loans, investment securities and other interest earning assets, on the one hand, and (ii) its interest expense, which consists primarily of the interest it must pay to attract and retain deposits and the interest that it pays on borrowings and other interest-bearing liabilities, on the other hand. As a general rule, all other things being equal, the greater the difference or “spread” between the amount of our interest income and the amount of our interest expense, the greater will be our net income; whereas, a decline in that difference or “spread” will generally result in a decline in our net income.
A bank’s interest income and interest expense are affected by a number of factors, some of which are outside of its control, including national and local economic conditions and the monetary policies of the Federal Reserve Board which affect interest rates, competition in the market place for loans and deposits, the demand for loans and the ability of borrowers to meet their loan payment obligations. Net interest income, when expressed as a percentage of total average interest earning assets, is a banking organization’s “net interest margin.”
The following table sets forth information regarding our average balances, yields on interest earning assets, interest expense on interest-bearing liabilities, the interest rate spread and the interest rate margin for the three and nine months ended September 30, 2019 and 2018. Average balances are calculated based on average daily balances.

42


 
Three Months Ended September 30,
 
2019
 
2018
 
Average
Balance
 
Interest
Earned/
Paid
 
Average
Yield/
Rate
 
Average
Balance
 
Interest
Earned/
Paid
 
Average
Yield/
Rate
 
(Dollars in thousands)
Interest-earning assets
 
 
 
 
 
 
 
 
 
 
 
Short-term investments(1)
$
263,219

 
$
1,465

 
2.21
%
 
$
209,805

 
$
1,055

 
1.99
%
Securities available for sale and stock(2)
35,105

 
257

 
2.90
%
 
38,409

 
265

 
2.74
%
Loans(3)
1,097,646

 
15,045

 
5.44
%
 
1,050,264

 
13,898

 
5.25
%
Total interest-earning assets
1,395,970

 
16,767

 
4.77
%
 
1,298,478

 
15,218

 
4.65
%
Noninterest-earning assets
 
 
 
 
 
 
 
 
 
 
 
Cash and due from banks
16,551

 
 
 
 
 
14,711

 
 
 
 
All other assets
25,295

 
 
 
 
 
17,459

 
 
 
 
Total assets
$
1,437,816

 
 
 
 
 
$
1,330,648

 
 
 
 
Interest-bearing liabilities:
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing checking accounts
$
111,614

 
$
163

 
0.58
%
 
$
66,799

 
$
86

 
0.51
%
Money market and savings accounts
432,397

 
1,904

 
1.75
%
 
421,562

 
1,764

 
1.66
%
Certificates of deposit
259,830

 
1,562

 
2.39
%
 
299,305

 
1,321

 
1.75
%
Other borrowings
28,804

 
177

 
2.44
%
 
27,935

 
138

 
1.96
%
Junior subordinated debentures
17,527

 
218

 
4.93
%
 
17,527

 
220

 
4.98
%
Total interest bearing liabilities
850,172

 
4,024

 
1.88
%
 
833,128

 
3,529

 
1.68
%
Noninterest bearing liabilities
 
 
 
 
 
 
 
 
 
 
 
Demand deposits
421,524

 
 
 
 
 
353,635

 
 
 
 
Accrued expenses and other liabilities
17,739

 
 
 
 
 
9,292

 
 
 
 
Shareholders equity
148,381

 
 
 
 
 
134,593

 
 
 
 
Total liabilities and shareholders equity
$
1,437,816

 
 
 
 
 
$
1,330,648

 
 
 
 
Net interest income
 
 
$
12,743

 
 
 
 
 
$
11,689

 
 
Net interest income/spread
 
 
 
 
2.89
%
 
 
 
 
 
2.97
%
Net interest margin
 
 
 
 
3.62
%
 
 
 
 
 
3.57
%
 
(1)
Short-term investments consist of Federal Funds sold and interest bearing deposits that we maintain at other financial institutions.
(2)
Stock consists of FHLB stock and FRBSF stock.
(3)
Loans include the average balance of nonaccrual loans.

43


 
Nine Months Ended September 30,
 
2019
 
2018
 
Average
Balance
 
Interest
Earned/
Paid
 
Average
Yield/
Rate
 
Average
Balance
 
Interest
Earned/
Paid
 
Average
Yield/
Rate
 
(Dollars in thousands)
Interest-earning assets
 
 
 
 
 
 
 
 
 
 
 
Short-term investments(1)
$
253,058

 
$
4,439

 
2.35
%
 
$
194,302

 
$
2,615

 
1.80
%
Securities available for sale and stock(2)
37,047

 
808

 
2.92
%
 
39,987

 
801

 
2.68
%
Loans(3)
1,080,278

 
44,152

 
5.46
%
 
1,067,399

 
42,731

 
5.35
%
Total interest-earning assets
1,370,383

 
49,399

 
4.82
%
 
1,301,688

 
46,147

 
4.74
%
Noninterest-earning assets
 
 
 
 
 
 
 
 
 
 
 
Cash and due from banks
15,741

 
 
 
 
 
15,717

 
 
 
 
All other assets
26,845

 
 
 
 
 
12,547

 
 
 
 
Total assets
$
1,412,969

 
 
 
 
 
$
1,329,952

 
 
 
 
Interest-bearing liabilities:
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing checking accounts
$
105,265

 
$
505

 
0.64
%
 
$
69,363

 
$
263

 
0.51
%
Money market and savings accounts
450,342

 
6,123

 
1.82
%
 
401,993

 
4,418

 
1.47
%
Certificates of deposit
264,557

 
4,377

 
2.21
%
 
327,873

 
4,050

 
1.65
%
Other borrowings
36,300

 
698

 
2.57
%
 
34,932

 
475

 
1.82
%
Junior subordinated debentures
17,527

 
684

 
5.22
%
 
17,527

 
620

 
4.73
%
Total interest bearing liabilities
873,991

 
12,387

 
1.89
%
 
851,688

 
9,826

 
1.54
%
Noninterest bearing liabilities
 
 
 
 
 
 
 
 
 
 
 
Demand deposits
374,713

 
 
 
 
 
344,090

 
 
 
 
Accrued expenses and other liabilities
18,837

 
 
 
 
 
10,230

 
 
 
 
Shareholders’ equity
145,428

 
 
 
 
 
123,944

 
 
 
 
Total liabilities and shareholders equity
$
1,412,969

 
 
 
 
 
$
1,329,952

 
 
 
 
Net interest income
 
 
$
37,012

 
 
 
 
 
$
36,321

 
 
Net interest income/spread
 
 
 
 
2.93
%
 
 
 
 
 
3.20
%
Net interest margin
 
 
 
 
3.61
%
 
 
 
 
 
3.73
%
 
 
 
 
 
 
 
 
 
 
 
 
 
(1)
Short-term investments consist of Federal Funds sold and interest bearing deposits that we maintain at other financial institutions.
(2)
Stock consists of FHLB stock and FRBSF stock.
(3)
Loans include the average balance of nonaccrual loans.

The following table sets forth changes in interest income, including loan fees, and interest paid in the three and nine months ended September 30, 2019 and 2018 and the extent to which those changes were attributable to changes in (i) the volumes of or the rates of interest earned on interest-earning assets and (ii) the volumes of or the rates of interest paid on our interest-bearing liabilities.
 

44


 
Three Months Ended September 30, 2019 Compared to
Three Months Ended September 30, 2018 Increase (Decrease) due to Changes in
 
Nine Months Ended September 30, 2019 Compared to
Nine Months Ended September 30, 2018 Increase (Decrease) due to Changes in
 
Volume
 
Rates
 
Total Increase
(Decrease)
 
Volume
 
Rates
 
Total
Increase
(Decrease)
 
(Dollars in thousands)
Interest income
 
 
 
 
 
 
 
 
 
 
 
Short-term investments(1)
$
290

 
$
120

 
$
410

 
$
911

 
$
913

 
$
1,824

Securities available for sale and stock(2)
(24
)
 
16

 
(8
)
 
(61
)
 
68

 
7

Loans
639

 
508

 
1,147

 
520

 
901

 
1,421

Total earning assets
905

 
644

 
1,549

 
1,370

 
1,882

 
3,252

Interest expense
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing checking accounts
64

 
13

 
77

 
160

 
82

 
242

Money market and savings accounts
46

 
94

 
140

 
574

 
1,132

 
1,706

Certificates of deposit
(191
)
 
432

 
241

 
(878
)
 
1,204

 
326

Borrowings
4

 
35

 
39

 
19

 
204

 
223

Junior subordinated debentures

 
(2
)
 
(2
)
 


 
64

 
64

Total interest-bearing liabilities
(77
)
 
572

 
495

 
(125
)
 
2,686

 
2,561

Net interest income
$
982

 
$
72

 
$
1,054

 
$
1,495

 
$
(804
)
 
$
691

 
(1)
Short-term investments consist of Federal Funds sold and interest bearing deposits that we maintain at other financial institutions.
(2)
Stock consists of FHLB stock and FRBSF stock.
Provision for Loan and Lease Losses
We maintain reserves to provide for loan losses that occur in the ordinary course of the banking business. When it is determined that the payment in full of a loan has become unlikely, the carrying value of the loan is reduced (“written down”) to what management believes is its realizable value or, if it is determined that a loan no longer has any realizable value, the carrying value of the loan is written off in its entirety (a loan “charge-off”). Loan charge-offs and write-downs are charged against our allowance for loan and lease losses (“ALLL”). The amount of the ALLL is increased periodically to replenish the ALLL after it has been reduced due to loan write-downs or charge-offs. The ALLL also is increased or decreased periodically to reflect increases or decreases in the volume of outstanding loans and to take account of changes in the risk of probable loan losses due to financial performance of borrowers, the value of collateral securing non-performing loans or changing economic conditions. Increases in the ALLL are made through a “provision for loan and lease losses” that is recorded as an expense in the statement of operations. Increases in the ALLL are also recognized through the recovery of charged-off loans which are added back to the ALLL. As such, recoveries are a direct offset for a provision for loan and lease losses that would otherwise be needed to replenish or increase the ALLL.
We employ economic models and data that conform to bank regulatory guidelines and reflect sound industry practices as well as our own historical loan loss experience to determine the sufficiency of the ALLL and any provisions needed to increase or replenish the ALLL. Those determinations involve judgments and assumptions about current economic conditions and external events that can impact the ability of borrowers to meet their loan obligations. However, the duration and impact of these factors cannot be determined with any certainty. As such, unanticipated changes in economic or market conditions, bank regulatory guidelines or the sound practices that are used to determine the sufficiency of the ALLL, could require us to record additional, and possibly significant, provisions to increase the ALLL. This would have the effect of reducing reportable income or, in the most extreme circumstance, creating a reportable loss. In addition, the Federal Reserve Bank and the California Department of Business Oversight (“CDBO”), as an integral part of their regulatory oversight, periodically review the adequacy of our ALLL. These agencies may require us to make additional provisions for perceived potential loan losses, over and above the provisions that we have already made, the effect of which would be to reduce our income or increase any losses we might incur.
We recorded a provision for loan and lease losses of $2.1 million and $5.4 million, respectively, during the three and nine months ended September 30, 2019, as a result of $5.7 million in total charge offs in the first quarter of 2019, which primarily related to one credit relationship, $1.5 million in total total charge-offs in the third quarter of 2019, which primarily related to one credit relationship, partially offset by a change in the mix of our loan portfolio. We recorded no provision for loan and lease losses during the three and nine months ended September 30, 2018 due primarily to the slight decrease in our loan portfolio for these periods.

45


See “—Financial Condition—Nonperforming Assets and Allowance for Loan and Lease Losses” below in this Item 2 for additional information regarding the ALLL.
Noninterest Income
The following table identifies the components of and the percentage changes in noninterest income during the three and nine months ended September 30, 2019 and 2018: 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
Amount
 
Amount
 
Percentage
Change
 
Amount
 
Amount
 
Percentage
Change
 
2019
 
2018
 
2019 vs. 2018
 
2019
 
2018
 
2019 vs. 2018
 
(Dollars in thousands)
Service fees on deposits and other banking services
$
463

 
$
382

 
21.2
 %
 
$
1,303

 
$
1,176

 
10.8
 %
Net gain on sale of securities available for sale

 

 
 %
 

 
48

 
(100.0
)%
Net loss on sale of other assets
(6
)
 

 
(100.0
)%
 
(42
)
 
(4
)
 
950.0
 %
Net gain on sale of Small Business Administration loans
265

 

 
100.0
 %
 
866

 

 
100.0
 %
Other noninterest income
620

 
733

 
(15.4
)%
 
2,092

 
2,086

 
0.3
 %
Total noninterest income
$
1,342

 
$
1,115

 
20.4
 %
 
$
4,219

 
$
3,306

 
27.6
 %
Three Months Ended September 30, 2019 and 2018
Noninterest income increased by $227 thousand, or 20.4%, for the three months ended September 30, 2019 as compared to the three months ended September 30, 2018, primarily as a result of:
An increase of $265 thousand gain on sale of SBA loans and an increase of $81 thousand in service fees, partially offset by
A decrease of $113 thousand of other noninterest income during the third quarter of 2019 as compared to the same quarter of 2018.
Nine Months Ended September 30, 2019 and 2018
Noninterest income increased $913 thousand, or 27.6%, for the nine months ended September 30, 2019 as compared to the nine months ended September 30, 2018, primarily as a result of:
An increase of $866 thousand in gain on sale of SBA loans during the nine months ended September 30, 2019 as compared to the same period in 2018; and
An increase of $127 thousand in deposit related fees, credit card fees and loan service fees during the nine months ended September 30, 2019 as compared to the same period in 2018; partially offset by
A gain of $48 thousand on the sale of securities available for sale during the nine months ended September 30, 2018 that did not occur in the same period in 2019.










46



Noninterest Expense
The following table sets forth the principal components and the amounts of, and the percentage changes in, noninterest expense during the three and nine months ended September 30, 2019 and 2018.
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2019
 
2018
 
2019 vs. 2018
 
2019
 
2018
 
2019 vs. 2018
 
Amount
 
Amount
 
Percent Change
 
Amount
 
Amount
 
Percent Change
 
(Dollars in thousands)
Salaries and employee benefits
$
6,070

 
$
5,809

 
4.5
 %
 
$
17,247

 
$
17,885

 
(3.6
)%
Occupancy
639

 
591

 
8.1
 %
 
1,913

 
1,799

 
6.3
 %
Equipment and depreciation
460

 
438

 
5.0
 %
 
1,401

 
1,341

 
4.5
 %
Data processing
574

 
412

 
39.3
 %
 
1,618

 
1,184

 
36.7
 %
FDIC expense
165

 
189

 
(12.7
)%
 
522

 
738

 
(29.3
)%
FDIC rebate
(189
)
 

 
(100.0
)%
 
(189
)
 

 
(100.0
)%
Other real estate owned expense, net

 
(16
)
 
100.0
 %
 
69

 
(8
)
 
100.0
 %
Professional fees
1,118

 
655

 
70.7
 %
 
3,104

 
2,041

 
52.1
 %
Business development
197

 
257

 
(23.3
)%
 
634

 
755

 
(16.0
)%
Loan related expense
122

 
181

 
(32.6
)%
 
429

 
534

 
(19.7
)%
Insurance
58

 
62

 
(6.5
)%
 
180

 
187

 
(3.7
)%
Other operating expenses (1)
483

 
424

 
13.9
 %
 
1,460

 
1,378

 
6.0
 %
Total noninterest expense
$
9,697

 
$
9,002

 
7.7
 %
 
$
28,388

 
$
27,834

 
2.0
 %
 
(1)
Other operating expenses primarily consist of telephone, investor relations, promotional, regulatory expenses, and correspondent bank fees.
Three Months Ended September 30, 2019 and 2018
Noninterest expense increased $695 thousand, or 7.7%, for the three months ended September 30, 2019 as compared to the three months ended September 30, 2018, primarily as a result of:
An increase of $463 thousand in our professional fees primarily related to higher legal fees during the third quarter of 2019 compared to the recovery of legal fees attributable to the payoff of a loan relationship during the third quarter of 2018 that was previously on nonaccrual status; and
An increase of $162 thousand in our data processing fees primarily related to a higher credit card and deposit volume in the third quarter of 2019; and
An increase of $261 thousand in salaries and employee benefits primarily related to the acceleration of equity awards of a former executive; partially offset by
A decrease of $24 thousand in our FDIC insurance expenses as the result of a lower rate and rebate; and
A decrease in various expense accounts related to the normal course of operating, including expenses related to loan production and business development during the three months ended September 30, 2019 as compared to the three months ended September 30, 2018.

Nine Months Ended September 30, 2019 and 2018
Noninterest expense increased $554 thousand, or 2.0%, for the nine months ended September 30, 2019 as compared to the nine months ended September 30, 2018, primarily as a result of:
An increase of $1.06 million in our professional fees primarily related to higher legal fees in 2019 and the recovery of legal fees attributable to the payoff of a loan relationship in 2018 that was previously on nonaccrual status; and
An increase of $174 thousand in occupancy and equipment expense related to building and equipment maintenance; and
An increase $434 thousand in data processing fees primarily related to a higher credit card and deposit volume; partially offset by
A decrease of $638 thousand in salaries and employee benefits primarily related to a decrease in employee benefits and incentive compensation partially offset by the acceleration of equity awards of a former executive; and
A decrease of $216 thousand in our FDIC insurance expenses as the result of a lower rate and rebate; and

47


A decrease in various expense accounts related to the normal course of operating, including expenses related to loan production and business development.
Provision for Income Tax    
For the three and nine months ended September 30, 2019, we had income tax expense of $658 thousand and $2.2 million, respectively, as a result of our operating income. Accounting rules specify that management must evaluate the deferred tax asset on a recurring basis to determine whether enough positive evidence exists to determine whether it is more-likely-than-not that the deferred tax asset will be available to offset or reduce future taxes. The tax code allows net operating losses incurred prior to December 31, 2017 to be carried forward for 20 years from the date of the loss, and based on its evaluation, management believes that the Company will be able to realize the deferred tax asset within the period that our net operating losses may be carried forward. Due to the hierarchy of evidence that the accounting rules specify, management determined that there continued to be enough positive evidence to support no valuation allowance on our deferred tax asset at September 30, 2019. Significant positive evidence included our three-year cumulative income position, and the expectation that we will continue to have positive earnings based on twelve trailing quarters of positive income and our forecast. Negative evidence included our accumulated deficit.
For the three and nine months ended September 30, 2018, we had an income tax benefit of $98 thousand and $11.2 million, respectively, as a result of our net income during the third quarter of 2018 and the release of our full valuation allowance of $11.1 million on our net deferred tax asset during the second quarter of 2018. During the three months ended June 30, 2018, management evaluated the positive and negative evidence and determined that the valuation allowance that was previously established on the balance of our deferred tax asset was no longer required and released the entire $11.1 million. During the three months ended September 30, 2018, our taxable income was higher than previously estimated when calculating the value of our deferred tax asset in the second quarter, which resulted in further taxable benefit for the third quarter of 2018.


48


Financial Condition
Assets
Our total assets increased by $89 million at September 30, 2019 compared to December 31, 2018. The following table sets forth the composition of our interest earning assets at:
 
September 30, 2019
 
December 31, 2018
 
(Dollars in thousands)
Interest-bearing deposits with financial institutions (1)
$
191,431

 
$
174,468

Interest-bearing time deposits with financial institutions
2,420

 
2,420

Federal Reserve Bank of San Francisco and Federal Home Loan Bank Stock, at cost
7,910

 
8,822

Securities available for sale, at fair value
24,973

 
31,231

Loans (net of allowances of $12,086 and $13,506, respectively)
1,153,217

 
1,083,240

 
(1)
Includes interest-earning balances maintained at the FRBSF.
Investment Portfolio
Securities Available for Sale. Securities that we intend to hold for an indefinite period of time, but which may be sold in response to changes in liquidity needs, in interest rates, or in prepayment risks or other similar factors, are classified as “securities available for sale”. Such securities are recorded on our balance sheet at their respective fair values and increases or decreases in those values are recorded as unrealized gains or losses, respectively, and are reported as other comprehensive income (loss) on our accompanying consolidated statements of financial condition, rather than included in or deducted from our earnings.
The following is a summary of the major components of securities available for sale and a comparison of the amortized cost, estimated fair values and the gross unrealized gains and losses attributable to those securities, as of September 30, 2019 and December 31, 2018:
(Dollars in thousands)
Amortized Cost
 
Gross
Unrealized Gain
 
Gross
Unrealized Loss
 
Estimated
Fair Value
Securities available for sale at September 30, 2019:
 
 
 
 
 
 
 
U.S. Treasury securities
$

 
$

 
$

 
$

Commercial mortgage backed securities issued by U.S. Agencies
4,247

 
177

 

 
4,424

Residential mortgage backed securities issued by U.S. Agencies
20,749

 
7

 
(207
)
 
20,549

Total securities available for sale
$
24,996

 
$
184

 
$
(207
)
 
$
24,973

Securities available for sale at December 31, 2018:
 
 
 
 
 
 
 
U.S. Treasury securities
$
2,999

 
$

 
$
(19
)
 
$
2,980

Commercial mortgage backed securities issued by U.S. Agencies
4,495

 
40

 
(1
)
 
4,534

Residential mortgage backed securities issued by U.S. Agencies
24,739

 
1

 
(1,023
)
 
23,717

Total securities available for sale
$
32,233

 
$
41

 
$
(1,043
)
 
$
31,231

The amortized cost of securities available for sale at September 30, 2019 is shown in the table below by contractual maturities taking into consideration historical prepayments based on the prior twelve months of principal payments. Expected maturities will differ from contractual maturities and historical prepayments, particularly with respect to collateralized mortgage obligations, if any, primarily because prepayment rates are affected by changes in conditions in the interest rate market and, therefore, future prepayment rates may differ from historical prepayment rates.

49


 
September 30, 2019 Maturing in
 
One year or less
 
Over one year through five years
 
Over five years through ten years
 
Over ten years
 
Total
(Dollars in thousands)
Amortized Cost
 
Weighted
Average
Yield
 
Amortized Cost
 
Weighted
Average
Yield
 
Amortized Cost
 
Weighted
Average
Yield
 
Amortized Cost
 
Weighted
Average
Yield
 
Amortized Cost
 
Weighted
Average
Yield
Securities available for sale:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial mortgage backed securities issued by U.S. Agencies
204

 
2.92
%
 
753

 
2.91
%
 
2,214

 
3.13
%
 
1,077

 
3.01
%
 
4,248

 
3.05
%
Residential mortgage-backed securities issued by U.S. Agencies
4,649

 
1.46
%
 
11,748

 
1.54
%
 
4,279

 
1.66
%
 
73

 
3.73
%
 
20,749

 
1.55
%
Total securities available for sale
$
4,853

 
1.52
%
 
$
12,501

 
1.62
%
 
$
6,493

 
2.16
%
 
$
1,150

 
3.06
%
 
$
24,997

 
1.81
%

Loans
The following table sets forth the composition, by loan category, of our loan portfolio at September 30, 2019 and December 31, 2018:
 
September 30, 2019
 
December 31, 2018
 
Amount
 
Percent
 
Amount
 
Percent
 
(Dollars in thousands)
Commercial loans
$
434,249

 
37.4
%
 
$
444,441

 
40.7
%
Commercial real estate loans – owner occupied
216,848

 
18.7
%
 
211,645

 
19.3
%
Commercial real estate loans – all other
220,170

 
19.0
%
 
226,441

 
20.7
%
Residential mortgage loans – multi-family
173,275

 
14.9
%
 
97,173

 
8.9
%
Residential mortgage loans – single family
18,720

 
1.6
%
 
21,176

 
1.9
%
Construction and land development loans
6,110

 
0.5
%
 
38,496

 
3.5
%
Consumer loans
91,198

 
7.9
%
 
54,514

 
5.0
%
Total loans
1,160,570

 
100.0
%
 
1,093,886

 
100.0
%
Deferred loan origination costs, net
4,733

 
 
 
2,860

 
 
Allowance for loan and lease losses
(12,086
)
 
 
 
(13,506
)
 
 
Loans, net
$
1,153,217

 
 
 
$
1,083,240

 
 
Commercial loans are loans to businesses to finance capital purchases or improvements, or to provide cash flow for operations. Commercial real estate and residential mortgage loans are loans secured by trust deeds on real properties, including commercial properties and single family and multi-family residences. Construction loans are interim loans to finance specific construction projects. Land development loans are loans secured by non-arable bare land. Consumer loans include installment loans to consumers.
The following table sets forth the maturity distribution of our loan portfolio (excluding single and multi-family residential mortgage loans and consumer loans) at September 30, 2019:
 
September 30, 2019
 
One Year
or Less
 
Over One
Year
Through
Five Years
 
Over Five
Years
 
Total
 
(Dollars in thousands)
Real estate loans(1)
 
 
 
 
 
 
 
Floating rate
$
32,639

 
$
30,175

 
$
108,936

 
$
171,750

Fixed rate
15,844

 
69,052

 
186,482

 
271,378

Commercial loans
 
 
 
 
 
 
 
Floating rate
103,550

 
170,995

 
38,167

 
312,712

Fixed rate
21,223

 
69,906

 
30,408

 
121,537

Total
$
173,256

 
$
340,128

 
$
363,993

 
$
877,377


50


 
(1)
Does not include mortgage loans on single or multi-family residences or consumer loans, which totaled $192.0 million and $91.2 million, respectively, at September 30, 2019.
Nonperforming Assets and Allowance for Loan and Lease Losses
Nonperforming Assets. Nonperforming loans consist of (i) loans on nonaccrual status which are loans on which the accrual of interest has been discontinued and include restructured loans when there has not been a history of past performance on debt service in accordance with the contractual terms of the restructured loans, and (ii) loans 90 days or more past due and still accruing interest. Nonperforming assets are comprised of non-performing loans and other real estate owned (“OREO”), which consists of real properties that we have acquired by or in lieu of foreclosure and which we intend to offer for sale.
Loans are placed on nonaccrual status when, in our opinion, the full timely collection of principal or interest is in doubt. Generally, the accrual of interest is discontinued when principal or interest payments become more than 90 days past due, unless we believe the loan is adequately collateralized and the loan is in the process of collection. However, in certain instances, we may place a particular loan on nonaccrual status earlier, depending upon the individual circumstances involved in that loan’s delinquency. When a loan is placed on nonaccrual status, previously accrued but unpaid interest is reversed against current income. Subsequent collections of unpaid amounts on such a loan are applied to reduce principal when received, except when the ultimate collectability of principal is probable, in which case such payments are applied to interest and are credited to income. Nonaccrual loans may be restored to accrual status if and when principal and interest become current and full repayment is expected. Interest income is recognized on the accrual basis for impaired loans which, based on our nonaccrual policy, do not require nonaccrual treatment.
The following table sets forth information regarding our nonperforming assets, as well as information regarding restructured loans, at September 30, 2019 and December 31, 2018:
 
At September 30, 2019
 
At December 31, 2018
 
(Dollars in thousands)
Nonaccrual loans:
 
 
 
Commercial loans
$
6,849

 
$
3,352

Commercial real estate
6,266

 
831

Residential real estate

 

Consumer
94

 
43

Total nonaccrual loans
$
13,209

 
$
4,226

Other real estate owned (OREO):
 
 
 
Commercial loans
$

 
$
1,173

Total other real estate owned
$

 
$
1,173

Loans past due 90 days and still accruing interest:
 
 
 
Commercial loans
$

 
$
1,278

Total loans past due 90 days and still accruing interest
$

 
$
1,278

Other nonperforming assets:
 
 
 
Other foreclosed assets
138

 
91

Total nonperforming assets
$
13,347

 
$
6,768

Restructured loans(1):
 
 
 
Accruing loans
$

 
$

Nonaccruing loans (included in nonaccrual loans above)

 

Total restructured loans
$

 
$

 
(1)
As of September 30, 2019 and December 31, 2018, we had no restructured loans.
As the table above indicates, total nonperforming assets increased by approximately $6.6 million, or 97%, to $13.3 million as of September 30, 2019 from $6.8 million as of December 31, 2018. The increase in our nonaccrual loans resulted primarily from addition of three new loan relationships totaling $19.9 million, partially offset by $3.4 million of payoffs or paydowns on our nonaccrual loans, charge-offs of $7.3 million, and the transfer to other assets of $161 thousand during the nine months ended September 30, 2019. The decrease in our OREO balance from December 31, 2018 resulted from the sale during the first quarter of 2019 of the single property owned by the Bank.
Information Regarding Impaired Loans. At September 30, 2019, loans deemed impaired totaled $13.2 million as compared to $4.2 million at December 31, 2018. We had an average investment in impaired loans of $5.0 million for the nine months ended September 30, 2019, as compared to $5.6 million for the nine months ended September 30, 2018. The interest that would have

51


been earned during the nine months ended September 30, 2019 had the nonaccruing impaired loans remained current in accordance with their original terms was approximately $54 thousand.
The following table sets forth the amount of impaired loans to which a portion of the ALLL has been specifically allocated, and the aggregate amount so allocated, in accordance with Accounting Standards Codification 310-10, and the amount of the ALLL and the amount of impaired loans for which no such allocations were made, in each case at September 30, 2019 and December 31, 2018:
 
September 30, 2019
 
December 31, 2018
 
Loans
 
Reserves for
Loan Losses
 
% of
Reserves to
Loans
 
Loans
 
Reserves for
Loan Losses
 
% of
Reserves to
Loans
 
(Dollars in thousands)
Impaired loans with specific reserves
$

 
$

 
%
 
$

 
$

 
%
Impaired loans without specific reserves
13,209

 

 

 
4,226

 

 

Total impaired loans
$
13,209

 
$

 
%
 
$
4,226

 
$

 
%
The $9.0 million increase in impaired loans to $13.2 million at September 30, 2019 from $4.2 million at December 31, 2018 was primarily attributable to $19.9 million in additions to impaired loans during the period, partially offset by $3.4 million in principal payments, $161 thousand transferred to other assets, and $7.3 million charged-off during the nine months ended September 30, 2019. Based on an internal analysis, using the current estimated fair values of the collateral or the discounted present values of the future estimated cash flows of the impaired loans, we concluded that, at September 30, 2019, no specific reserves were required on our impaired loans and that all impaired loans were well secured and adequately collateralized.
Allowance for Loan and Lease Losses. The ALLL totaled $12.1 million, representing 1.04% of loans outstanding, at September 30, 2019, as compared to $13.5 million, or 1.23% of loans outstanding, at December 31, 2018.
The adequacy of the ALLL is determined through periodic evaluations of the loan portfolio and other factors that can reasonably be expected to affect the ability of borrowers to meet their loan obligations. Those factors are inherently subjective as the process for determining the adequacy of the ALLL involves some significant estimates and assumptions about such matters such as (i) economic conditions and trends and the amounts and timing of expected future cash flows of borrowers which can affect their ability to meet their loan obligations to us, (ii) the fair value of the collateral securing non-performing loans, (iii) estimates of losses that we may incur on non-performing loans, which are determined on the basis of historical loss experience and industry loss factors and bank regulatory guidelines, which are subject to change, and (iv) various qualitative factors. Since those factors are subject to changes in economic and other conditions and changes in regulatory guidelines or other circumstances over which we have no control, the amount of the ALLL may prove to be insufficient to cover all of the loan losses we might incur in the future. In such an event, it may become necessary for us to increase the ALLL from time to time to maintain its adequacy. Such increases are effectuated by means of a charge to income, referred to as the “provision for loan and lease losses”, in our statements of our operations. See “—Results of OperationsProvision for Loan and Lease Losses, above in this Item 2.
The amount of the ALLL is first determined by assigning reserve ratios for all loans. All nonaccrual loans and other loans classified as “Special Mention,” “Substandard” or “Doubtful” (“classified loans” or “classification categories”) and not fully collateralized are then assigned specific reserves within the ALLL, with greater reserve allocations made to loans deemed to be of a higher risk. These ratios are determined based on prior loss history and industry guidelines and loss factors, by type of loan, adjusted for current economic factors and current economic trends. Refer to Note 5, Loans and Allowance for Loan and Lease Losses, in Item 1 for definitions related to our internal asset quality indicators stated above.
On a quarterly basis, we utilize a classification based loan loss migration model as well as review individual loans in determining the adequacy of the ALLL. Our loss migration analysis tracks a certain number of quarters of loan loss history and industry loss factors to determine historical losses by classification category for each loan type, except certain consumer loans (automobile, mortgage and credit cards), which are analyzed as homogeneous loan pools. These calculated loss factors are then applied to outstanding loan balances. We analyze impaired loans individually.
In determining whether and the extent to which we will make adjustments to our loan loss migration model for purposes of determining the ALLL, we also consider a number of qualitative factors that can affect the performance and the collectability of the loans in our loan portfolio. Such qualitative factors include:
The effects of changes that we may make in our loan policies or underwriting standards on the quality of the loans and the risks in our loan portfolios;

52


Trends and changes in local, regional and national economic conditions, as well as changes in industry specific conditions, and any other reasonably foreseeable events that could affect the performance or the collectability of the loans in our loan portfolios;
Material changes that may occur in the mix or in the volume of the loans in our loan portfolios that could alter, whether positively or negatively, the risk profile of those portfolios;
Changes in management or loan personnel or other circumstances that could, either positively or negatively, impact the application of our loan underwriting standards, the monitoring of nonperforming loans or our loan collection efforts; and
External factors that, in addition to economic conditions, can affect the ability of borrowers to meet their loan obligations, such as fires, earthquakes and terrorist attacks.
Determining the effects that these qualitative factors may have on the performance of each category of loans in our loan portfolio requires numerous judgments, assumptions and estimates about conditions, trends and events which may subsequently prove to have been incorrect due to circumstances outside of our control. Moreover, the effects of qualitative factors such as these on the performance of our loan portfolios are often difficult to quantify. As a result, we may sustain loan losses in any particular period that are sizable in relation to the ALLL or that may even exceed the ALLL.
Set forth below is information regarding loan balances and the related ALLL, by portfolio type, for the nine months ended September 30, 2019 and 2018.
(Dollars in thousands)
Commercial
 
Real  Estate
 
Construction and land
Development
 
Consumer 
and Single
Family
Mortgages
 
Unallocated
 
Total
ALLL for the nine months ended September 30, 2019:
 
 
 
 
 
 
 
 
 
 
 
Balance at beginning of year
$
8,071

 
$
3,643

 
$
426

 
$
1,290

 
$
76

 
$
13,506

Charge-offs
(7,337
)
 

 

 
(39
)
 

 
(7,376
)
Recoveries
541

 

 

 
15

 

 
556

Provision
6,245

 
(898
)
 
(343
)
 
472

 
(76
)
 
5,400

Balance at September 30, 2019
$
7,520

 
$
2,745

 
$
83

 
$
1,738

 
$

 
$
12,086

Allowance for loan and lease losses as a percentage of average total loans
 
 
 
 
 
 
 
 
 
 
1.12
%
Allowance for loan and lease losses as a percentage of total outstanding loans
 
 
 
 
 
 
 
 
 
 
1.04
%
Ratio of net charge-offs to average loans outstanding (annualized)
 
 
 
 
 
 
 
 
 
 
2.33
%
ALLL for the nine months ended September 30, 2018:
 
 
 
 
 
 
 
 
 
 
 
Balance at beginning of year
$
9,155

 
$
2,906

 
$
650

 
$
1,043

 
$
442

 
$
14,196

Charge-offs
(1,840
)
 

 

 
(3
)
 

 
(1,843
)
Recoveries
1,009

 
60

 

 
41

 

 
1,110

Provision
(1,028
)
 
711

 
(242
)
 
478

 
81

 

Balance at September 30, 2018
$
7,296

 
$
3,677

 
$
408

 
$
1,559

 
$
523

 
$
13,463

Allowance for loan and lease losses as a percentage of average total loans
 
 
 
 
 
 
 
 
 
 
1.26
%
Allowance for loan and lease losses as a percentage of total outstanding loans
 
 
 
 
 
 
 
 
 
 
1.25
%
Ratio of net charge-offs to average loans outstanding (annualized)
 
 
 
 
 
 
 
 
 
 
0.09
%
The ALLL decreased $1.3 million from September 30, 2018 to September 30, 2019 primarily as a result of charge-offs exceeding recoveries, partially offset by a change in the mix of our loan portfolio, during the twelve months ended September 30, 2019. The reserve for loan losses may include an unallocated amount based upon our judgment as to possible credit losses inherent in the loan portfolio that may not have been captured by historical loss experience, qualitative factors, or specific evaluations of impaired loans. Unallocated reserves may be adjusted for factors including, but not limited to, unexpected or unusual events, volatile market and economic conditions, effects of changes or seasoning in methodologies, regulatory guidance and recommendations, or other factors that may impact borrower operating conditions and loss expectations. Management’s judgment

53


as to unallocated reserves is determined in the context of, but separate from, the historical loss trends and qualitative factors described above. The unallocated reserve for loan losses was zero at September 30, 2019 and $76 thousand at December 31, 2018.
We classify our loan portfolios using asset quality ratings. The credit quality table in Note 5, Loans and Allowance for Loan and Lease Losses above in Item 1, provides a summary of loans by portfolio type and asset quality ratings as of September 30, 2019 and December 31, 2018. Loans totaled approximately $1.2 billion at September 30, 2019, an increase of $66.7 million from $1.1 billion at December 31, 2018. The disaggregation of the loan portfolio by risk rating in the credit quality table located in Note 5 reflects the following changes that occurred between December 31, 2018 and September 30, 2019:
Loans rated “Pass” totaled $1.1 billion, an increase of $25.7 million from $1.1 billion at December 31, 2018. The increase was primarily attributable to downgrades to “Special Mention”, and “Substandard” of $35.6 million and $16.7 million, respectively, and paydowns of principal payments, partially offset by new loan growth.
Loans rated “Special Mention” totaled $31.1 million, an increase of $15.8 million from $15.3 million at December 31, 2018. The increase was primarily the result of $35.6 million downgraded from “Pass” and line increases on existing loans of $5.1 million, partially offset by upgrades to "Pass" of $2.9 million, downgrades to "Substandard" of $17.7 million, and $4.3 million of payoffs and principal payments.
Loans rated “Substandard” totaled $30.8 million, an increase of $24.1 million from $6.7 million at December 31, 2018. This increase was primarily the result of $16.7 million downgraded from “Pass” and $16.2 million downgraded from "Special Mention", partially offset by $5.9 million in principal payments, charge offs of $1.7 million, and $161 thousand transfer to other assets. The loans downgraded from the "Pass" rating had been rated "Watch", a rating within our "Pass" rating that receives more oversight and attention by management.
Loans rated "Doubtful" totaled $1.1 million, an increase of $1.1 million from zero at December 31, 2018. This increase was primarily the result of $1.1 million downgraded from "Special Mention".
Our loss migration analysis currently utilizes a series of nineteen staggered 16-quarter migration periods. As a result, for purposes of determining applicable loss factors at September 30, 2019, our migration analysis covered the period from March 31, 2014 to September 30, 2018. We believe this was consistent with and reasonably reflects current economic conditions, portfolio trends and the risks that were inherent in our loan portfolio at September 30, 2019.
The table below sets forth loan delinquencies, by quarter, for the five preceding quarters ended September 30, 2019.
 
September 30, 2019
 
June 30, 2019
 
March 31, 2019
 
December 31, 2018
 
September 30, 2018
Loans Delinquent:
(Dollars in thousands)
90 days or more:
 
 
 
 
 
 
 
 
 
Commercial loans
$
82

 
$

 
$

 
$
4,273

 
$
2,669

Consumer loans
4

 
 
 
 
 
 
 
 
 
86

 

 

 
4,273

 
2,669

30-89 days:
 
 
 
 
 
 
 
 
 
Commercial loans
3,490

 
5,334

 
351

 
3,705

 
6,357

Commercial real estate

 

 
807

 
831

 
4,720

Construction and land development
4,267

 

 

 

 

Consumer loans
70

 

 

 
13

 

 
7,827

 
5,334

 
1,158

 
4,549

 
11,077

Total Past Due(1)(2):
$
7,913

 
$
5,334

 
$
1,158

 
$
8,822

 
$
13,746

 
(1)
Past due balances include nonaccrual loans.
(2)
No loans 90 days or more past due at June 30, 2019 or March 31, 2019.
As the above table indicates, total past due loans decreased by $0.9 million, to $7.9 million at September 30, 2019 from $8.8 million at December 31, 2018. Loans past due 90 days or more decreased by $4.2 million, to $86 thousand at September 30, 2019, from $4.3 million at December 31, 2018 primarily resulting from $4.2 million of payoffs.

54


Loans 30-89 days past due increased by $3.3 million to $7.8 million at September 30, 2019 from $4.5 million at December 31, 2018 primarily attributable to $4.5 million of payoffs and $13 thousand paid current, offset by the addition of $7.8 million in commercial loans.
Deposits
Average Balances of and Average Interest Rates Paid on Deposits
Set forth below are the average amounts of, and the average rates paid on, deposits for the nine months ended September 30, 2019 and year ended December 31, 2018:
 
Nine Months Ended September 30, 2019
 
Year Ended December 31, 2018
 
Average
Balance
 
Average
Rate
 
Average
Balance
 
Average
Rate
 
(Dollars in thousands)
Noninterest bearing demand deposits
$
374,713

 

 
$
348,923

 

Interest-bearing checking accounts
105,265

 
0.64
%
 
69,841

 
0.52
%
Money market and savings deposits
450,342

 
1.82
%
 
412,366

 
1.54
%
Time deposits(1)
264,557

 
2.21
%
 
315,189

 
1.70
%
Total deposits
$
1,194,877

 
1.23
%
 
$
1,146,319

 
1.05
%
 
 
(1)
Comprised of time certificates of deposit in denominations of less than and more than $100,000.
Deposit Totals
Deposits totaled $1.2 billion at September 30, 2019 as compared to $1.1 billion at December 31, 2018. The following table provides information regarding the mix of our deposits at September 30, 2019 and December 31, 2018:
 
At September 30, 2019
 
At December 31, 2018
 
Amounts
 
% of Total Deposits
 
Amounts
 
% of Total Deposits
 
(Dollars in thousands)
Deposits
 
 
 
 
 
 
 
Noninterest bearing demand deposits
$
425,596

 
35.2
%
 
$
340,406

 
30.0
%
Savings and other interest-bearing transaction deposits
525,132

 
43.3
%
 
524,499

 
46.2
%
Time deposits(1)
262,368

 
21.6
%
 
271,097

 
23.9
%
Total deposits
$
1,213,096

 
100.0
%
 
$
1,136,002

 
100.0
%
 
 
(1)
Comprised of time certificates of deposit in denominations of less than and more than $100,000.
Certificates of deposit in denominations of $100,000 or more, on which we pay higher rates of interest than on other deposits, aggregated $237.9 million, or 19.6%, of total deposits at September 30, 2019, as compared to $244.2 million, or 21.5%, of total deposits at December 31, 2018.
Set forth below is a maturity schedule of domestic time certificates of deposit outstanding at September 30, 2019 and December 31, 2018:
 
September 30, 2019
 
December 31, 2018
Maturities
Certificates of
Deposit Under
$ 100,000
 
Certificates of
Deposit $100,000
or more
 
Certificates of
Deposit Under
$100,000
 
Certificates of
Deposit $100,000
or more
 
(Dollars in thousands)
Three months or less
$
4,407

 
$
35,761

 
$
7,074

 
$
60,802

Over three and through six months
6,882

 
47,166

 
5,162

 
64,020

Over six and through twelve months
8,174

 
86,668

 
9,936

 
80,212

Over twelve months
4,993

 
68,317

 
4,710

 
39,181

Total
$
24,456

 
$
237,912

 
$
26,882

 
$
244,215


55


Other Assets and Other Liabilities
In February 2016, the FASB issued ASU 2016-02, “Leases (Topic 842),” which requires lessees to recognize the following for all leases (with the exception of short-term leases) at the commencement date: a lease liability measured on a discounted basis and a right-of-use asset a specified asset for the lease term. The new standard establishes a right-of-use model (ROU) that requires a lessee to recognize a ROU asset and lease liability on the balance sheet for all leases with a term longer than 12 months. The new standard had a material effect on our financial statements related to the recognition of new ROU assets and lease liabilities on our balance sheet for our office operating leases.
During the nine months ended September 30, 2019, we recognized additional operating liabilities of $12.6 million, with corresponding ROU assets of the same amount based on the present value of the remaining minimum rental payments under current leasing standards for existing operating leases. We recorded a $207 thousand adjustment to our beginning retained earnings. Refer to the Note 1, Significant Accounting Policies and Note 6, Leases above in Item 1 for further detail.


56


Liquidity
We actively manage our liquidity needs to ensure that sufficient funds are available to meet our needs for cash, including to fund new loans and deposit withdrawals by our customers. We project the future sources and uses of funds and maintain liquid funds for unanticipated events. Our primary sources of cash include cash we have on deposit at other financial institutions, payments from borrowers on their loans, proceeds from sales or maturities of securities held for sale, sales of residential mortgage loans, increases in deposits and increases in borrowings principally from the FHLB. The primary uses of cash include funding new loans and making advances on existing lines of credit, purchasing investments, including securities available for sale, funding new residential mortgage loans, funding deposit withdrawals and paying operating expenses. We maintain funds in overnight Federal Funds sold and other short-term investments to provide for short-term liquidity needs. We also have obtained credit lines from the FHLB and other financial institutions to meet any additional liquidity requirements we might have. See “—Contractual ObligationsBorrowings” below for additional information related to our borrowings from the FHLB.
Our liquid assets, which included cash and due from banks, Federal Funds sold, interest earning deposits that we maintain with financial institutions and unpledged securities available for sale (excluding FRBSF and FHLB stock) totaled $218.0 million, which represented 15% of total assets, at September 30, 2019. We believe that our cash and cash equivalent resources, together with available borrowings under our credit facilities, will be sufficient to meet normal operating requirements for at least the next twelve months, including to enable us to meet any increase in deposit withdrawals that might occur in the foreseeable future.
Cash Flow Provided by Operating Activities. During the nine months ended September 30, 2019, operating activities provided net cash of $13.9 million, primarily attributable to our net income of $5.2 million and a $5.4 million non-cash adjustment related to our provision for loan and lease losses. During the nine months ended September 30, 2018, operating activities provided net cash of $11.1 million, primarily attributable to our net income of $23.0 million, partially offset by a non-cash recognition of $11.1 million in our deferred tax asset, which resulted from the full release of our valuation allowance.
Cash Flow Used in Investing Activities. During the nine months ended September 30, 2019, investing activities used net cash of $67.9 million, primarily attributable to a $76.0 million increase in loans, offset by $7.1 million of cash provided from maturities of and principal payments on securities available for sale and other stock and $1.1 million of cash provided from the sale of other real estate owned. During the nine months ended September 30, 2018, investing activities used net cash of $10.6 million, primarily attributable to a $19.8 million increase in loans and $3.2 million of cash from maturities of and principal payments on securities available for sale and other stock.
Cash Flow Provided by (Used in) Financing Activities. During the nine months ended September 30, 2019, financing activities provided net cash of $77.2 million, consisting of a $77.1 million increase in our deposits, which was primarily the result of new client acquisition, which has resulted in relationships with growing operating companies that are attracting capital investment. During the nine months ended September 30, 2018, financing activities used net cash of $22.7 million which consisted primarily of a $22.3 million decrease in our deposits.
Ratio of Loans to Deposits. The relationship between gross loans and total deposits can provide a useful measure of a bank’s liquidity. Since repayment of loans tends to be less predictable than the maturity of investments and other liquid resources, the higher the loan-to-deposit ratio the less liquid are our assets. On the other hand, since we realize greater yields on loans than we do on investments, a lower loan-to-deposit ratio can adversely affect interest income and earnings. As a result, our goal is to achieve a loan-to-deposit ratio that appropriately balances the requirements of liquidity and the need to generate a fair return on our assets. At September 30, 2019 and December 31, 2018, the loan-to-deposit ratio was 96% and 96%, respectively.
Capital Resources
Regulatory Capital Requirements Applicable to Banking Institutions
Under federal banking regulations that apply to all United States-based bank holding companies over $3 billion in total assets and all federally insured banks, the Bank (on a stand-alone basis) must meet specific capital adequacy requirements that, for the most part, involve quantitative measures, primarily in terms of the ratios of their capital to their assets, liabilities, and certain off-balance sheet items, calculated under regulatory accounting practices. The Company (on a consolidated basis) is below the reporting threshold of $3 billion in total assets and therefore is not subject to the same capital adequacy requirements. Under those regulations, each federally insured bank is determined by its primary federal bank regulatory agency to come within one of the following capital adequacy categories on the basis of its capital ratios:
well-capitalized
adequately capitalized
undercapitalized
significantly undercapitalized; or
critically undercapitalized

57


Certain qualitative assessments also are made by a banking institution’s primary federal regulatory agency that could lead the agency to determine that the banking institution should be assigned to a lower capital category than the one indicated by the quantitative measures used to assess the institution’s capital adequacy. At each successive lower capital category, a banking institution is subject to greater operating restrictions and increased regulatory supervision by its federal bank regulatory agency.
The following table sets forth the capital and capital ratios of the Bank (on a stand-alone basis) at September 30, 2019, as compared to the regulatory requirements applicable to it.
 
 
 
 
 
 
Applicable Federal Regulatory Requirement
 
 
 
For Capital
Adequacy Purposes
 
To be Categorized As
Well-Capitalized
 
Amount
 
Ratio
 
Amount
 
Ratio
 
Amount
 
Ratio
 
(Dollars in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
Total Capital to Risk Weighted Assets
168,838

 
13.2
%
 
123,694

 
At least 8.625
 
$
127,979

 
At least 10.0
 
 
 
 
 
 
 
 
 
 
 
 
Common Equity Tier 1 Capital to Risk Weighted Assets
156,402

 
12.2
%
 
65,589

 
At least 5.125
 
$
83,186

 
At least 6.5
 
 
 
 
 
 
 
 
 
 
 
 
Tier 1 Capital to Risk Weighted Assets
156,402

 
12.2
%
 
84,786

 
At least 6.625
 
$
102,383

 
At least 8.0
 
 
 
 
 
 
 
 
 
 
 
 
Tier 1 Capital to Average Assets
156,402

 
10.9
%
 
57,366

 
At least 4.0
 
$
71,707

 
At least 5.0
As the above table indicates, at September 30, 2019, the Bank (on a stand-alone basis) qualified as a “well-capitalized” institution under federally mandated capital standards and federally established prompt corrective action regulations. Since September 30, 2019, there have been no events or circumstances known to us which have changed or which are expected to result in a change in the Bank’s classifications as a well-capitalized institution.
In early July 2013, the Federal Reserve Board and the FDIC issued final rules implementing the Basel III regulatory capital framework and related Dodd-Frank Wall Street Reform and Consumer Protection Act changes.  The rules revise minimum capital requirements and adjust prompt corrective action thresholds.  The final rules revise the regulatory capital elements, add a new common equity Tier 1 capital ratio, increase the minimum Tier 1 capital ratio requirement, and implement a new capital conservation buffer.  The rules also permit certain banking organizations to retain, through a one-time election, the existing treatment for accumulated other comprehensive income.  The final rules took effect for community banks on January 1, 2015, subject to a transition period for certain parts of the rules.  At September 30, 2019, the Bank (on a stand-alone basis) continued to qualify as a well-capitalized institution under the capital adequacy guidelines described above.
On September 17, 2019, the FDIC finalized a rule that introduces an optional simplified measure of capital adequacy for qualifying community banking organizations (i.e., the community bank leverage ratio (CBLR) framework), as required by the Economic Growth, Regulatory Relief and Consumer Protection Act. The CBLR framework is designed to reduce burden by removing the requirements for calculating and reporting risk-based capital ratios for qualifying community banking organizations that opt into the framework. In order to qualify for the CBLR framework, a community banking organization must have a tier 1 leverage ratio of greater than 9.0%, less than $10 billion in total consolidated assets, and limited amounts of off-balance-sheet exposures and trading assets and liabilities. A qualifying community banking organization that opts into the CBLR framework and meets all requirements under the framework will be considered to have met the well-capitalized ratio requirements under the Prompt Corrective Action regulations and will not be required to report or calculate risk-based capital. The CBLR framework will be available for banks to use in their March 31, 2020, Call Report. The Company has not yet determined if it will opt into the CBLR framework for the Bank.
Dividend Policy and Share Repurchase Programs
It is, and since the beginning of 2009 it has been, the policy of the Boards of Directors of the Company and the Bank to preserve cash to enhance our capital positions and the Bank’s liquidity. In addition, we have agreed that the Bank will not, without the FRB and the CDBO’s prior written approval, pay any dividends to Bancorp. Accordingly, we do not expect to pay dividends or make share repurchases for the foreseeable future.
The principal source of cash available to a bank holding company consists of cash dividends from its bank subsidiaries. There are currently several restrictions on the Bank’s ability to pay us cash dividends. Government regulations, including the laws of the State of California, as they pertain to the payment of cash dividends by California state-chartered banks, limits the amount

58


of funds that the Bank is permitted to dividend to us. Further, Section 23(a) of the Federal Reserve Act limits the amounts that a bank may loan to its bank holding company to an aggregate of no more than 10% of the bank subsidiary’s capital surplus and retained earnings and requires that such loans be secured by specified assets of the bank holding company. We have committed to obtaining approval from the FRB and the CDBO prior to Bancorp paying any dividends, or making any distributions representing interest, principal or other sums on subordinated debentures or trust preferred securities. There can be no assurance that our regulators will approve such payments or dividends in the future. Refer to “Supervision and Regulation” in Item 1 of our 2018 Form 10-K and Note 14, Shareholders’ Equity in the notes to our consolidated financial statements on our 2018 Form 10-K for more detail regarding the regulatory restrictions on our and the Bank’s ability to pay dividends. In addition, we currently have sufficient cash on hand to meet our cash obligations. As a result, we do not expect that these restrictions will impact our ability to meet our cash obligations.


59


Off-Balance Sheet Arrangements
Loan Commitments and Standby Letters of Credit. To meet the financing needs of our customers in the normal course of business, we are a party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit. At September 30, 2019 and December 31, 2018, we were committed to fund certain loans including letters of credit amounting to approximately $286 million and $302 million, respectively.
Commitments to extend credit and standby letters of credit generally have fixed expiration dates or other termination clauses and the customer may be required to pay a fee and meet other conditions in order to draw on those commitments or standby letters of credit. We expect, based on historical experience, that many of the commitments will expire without being drawn upon and, therefore, the total commitment amounts do not necessarily represent future cash requirements.
To varying degrees, commitments to extend credit involve elements of credit and interest rate risk for us that are in excess of the amounts recognized in our balance sheets. Our maximum exposure to credit loss in the event of nonperformance by the customers to whom such commitments are made could potentially be equal to the amount of those commitments. As a result, before making such a commitment to a customer, we evaluate the customer’s creditworthiness using the same underwriting standards that we would apply if we were approving loans to the customer. In addition, we often require the customer to secure its payment obligations for amounts drawn on such commitments with collateral such as accounts receivable, inventory, property, plant and equipment, income-producing commercial properties, residential properties and properties under construction. As a consequence, our exposure to credit and interest rate risk on such commitments is not different in character or amount than risks inherent in the outstanding loans in our loan portfolio.
Standby letters of credit are conditional commitments issued by the Bank to guarantee a payment obligation of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan commitments to customers.
Contractual Obligations
Borrowings. At September 30, 2019 and December 31, 2018, our borrowings consisted of the following:
(Dollars in thousands)
September 30, 2019
 
December 31, 2018
FHLB advances—short-term
$
40,000

 
$
40,000

FHLB advances—long-term

 

Total
$
40,000

 
$
40,000


The table below sets forth the amounts of, the interest rates we pay on, and the maturity dates of these FHLB borrowings. These borrowings had a weighted-average annualized interest rate of 2.17% for the three months ended September 30, 2019.
Principal Amounts
 
Interest Rate
 
Maturity Dates
(Dollars in thousands)
10,000

 
2.52
%
 
November 29, 2019
10,000

 
2.19
%
 
December 26, 2019
10,000

 
2.00
%
 
December 30, 2019
10,000

 
1.97
%
 
March 30, 2020
At September 30, 2019, $436 million of loans were pledged to support our unfunded borrowing capacity. At September 30, 2019, we had unused borrowing capacity of $273 million with the FHLB. The highest amount of borrowings outstanding at any month-end during the three months ended September 30, 2019 was $40.0 million from the FHLB. The highest amount of borrowings outstanding at any month end in 2018 consisted of $40.9 million of borrowings from the FHLB. At September 30, 2019 and December 31, 2018, commercial and consumer loans of $257 million and $51 million, respectively, were pledged to secure borrowings from the FRB to support our unfunded borrowing capacity of $183 million.
Junior Subordinated Debentures. Pursuant to rulings of the Federal Reserve Board, bank holding companies were permitted to issue long term subordinated debt instruments that, subject to certain conditions, would qualify as and, therefore, augment capital for regulatory purposes. At September 30, 2019, we had outstanding approximately $17.5 million principal amount of Debentures, of which $17.0 million would qualify as additional Tier 1 capital for regulatory purposes as of September 30, 2019 if we were to surpass the reporting threshold of $3 billion in total assets.

60


Set forth below is certain information regarding the Debentures:
Original Issue Dates
Principal Amount
 
Interest Rates
 
Maturity Dates(1)
September 2002
$
7,217

 
LIBOR plus 3.40%
 
September 2032
October 2004
10,310

 
LIBOR plus 2.00%
 
October 2034
Total
$
17,527

 
 
 
 
 
 
(1)
Subject to the receipt of prior regulatory approval, we may redeem the Debentures, in whole or in part, without premium or penalty, at any time prior to maturity.
These Debentures require quarterly interest payments, which are used to make quarterly distributions required to be paid on the corresponding trust preferred securities. Subject to certain conditions, we have the right, at our discretion, to defer those interest payments, and the corresponding distributions on the trust preferred securities, for up to five years. Exercise of this deferral right does not constitute a default of our obligations to pay the interest on the Debentures or the corresponding distributions that are payable on the trust preferred securities. We have committed to obtaining approval from the FRB and the CDBO prior to making any distributions representing interest, principal or other sums on subordinated debentures or trust preferred securities. Refer to “Supervision and Regulation” in Item 1 of our 2018 Form 10-K for further detail. As of September 30, 2019, we were current on all interest payments. There can be no assurance that our regulators will approve such payments in the future.

61


Critical Accounting Policies
Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States (“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 value of our material assets, such as, for example, assumptions regarding economic conditions or trends that could impact our ability to fully collect our loans or ultimately realize the carrying value of certain of our other assets, such as securities available for sale and our deferred tax asset. Those assumptions and judgments are based on current information available to us regarding those economic conditions or trends or other circumstances. If adverse changes were to occur in the conditions, trends or other events on which our assumptions or judgments had been based, then under GAAP it could become necessary for us to reduce the carrying values of any affected assets on our balance sheet. In addition, because reductions in the carrying value of assets are sometimes effectuated by or require charges to income, such reductions also may have the effect of reducing our income.
There have been no significant changes during the nine months ended September 30, 2019 to the items that we disclosed as our critical accounting policies and estimates in Critical Accounting Policies within Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our 2018 Form 10-K.


62


ITEM 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
As an accelerated filer subject to the smaller reporting company disclosure requirements we are not required to provide the information required by this item.

ITEM 4.     CONTROLS AND PROCEDURES

Disclosure Controls and Procedures
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports under the Exchange Act, is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, our management recognized that any system of controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, as ours are designed to do, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
As required by SEC rules, an evaluation was performed under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer of the effectiveness, as of September 30, 2019, of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act). Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of September 30, 2019, the Company’s disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed in the reports that we file under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.
Internal Control Over Financial Reporting
There were no changes in our internal control over financial reporting during the three months ended September 30, 2019 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

63


PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS
We are subject to legal actions that arise from time to time in the ordinary course of our business. Currently, neither we nor any of our subsidiaries is a party to, and none of our or our subsidiaries’ property is the subject of, any material legal proceeding.

ITEM 1A. RISK FACTORS
There have been no material changes in our assessment of our risk factors from those set forth in our 2018 Form 10-K.


64


ITEM 6. EXHIBITS
Exhibit No.
 
Description of Exhibit
 
 
 
 
10.1
 

 
 
 
10.2
 
 
 
 
 
 
 
31.1
 
 
 
31.2
 
 
 
 
32.1**
 
 
 
32.2**
 
 
 
 
Exhibit 101.INS
 
XBRL Instance Document
 
 
Exhibit 101.SCH
 
XBRL Taxonomy Extension Schema Document
 
 
Exhibit 101.CAL
 
XBRL Taxonomy Extension Calculation Linkbase Document
 
 
Exhibit 101.DEF
 
XBRL Taxonomy Extension Definition Linkbase Document
 
 
Exhibit 101.LAB
 
XBRL Taxonomy Extension Labels Linkbase Document
 
 
Exhibit 101.PRE
 
XBRL Taxonomy Extension Presentation Linkbase Document

** Furnished herewith.

65


SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on November 1, 2019.
 
PACIFIC MERCANTILE BANCORP
 
 
By:
 
/s/ BRADFORD R. DINSMORE
 
 
Bradford R. Dinsmore
 
 
President and Chief Executive Officer
 
 
(Principal Executive Officer)
PACIFIC MERCANTILE BANCORP
 
 
By:
 
/s/ CURT A. CHRISTIANSSEN
 
 
Curt A. Christianssen
 
 
Chief Financial Officer
 
 
(Principal Financial Officer)


66
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