Quarterly Report (10-q)

Date : 05/08/2019 @ 10:28PM
Source : Edgar (US Regulatory)
Stock : Bank of Marin Bancorp (BMRC)
Quote : 42.48  0.15 (0.35%) @ 9:00PM

Quarterly Report (10-q)

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 March 31, 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   001-33572

Bank of Marin Bancorp
(Exact name of Registrant as specified in its charter)
California   
 
20-8859754
(State or other jurisdiction of incorporation)  
 
(IRS Employer Identification No.)
 
 
 
504 Redwood Blvd., Suite 100, Novato, CA 
 
94947
(Address of principal executive office)
 
(Zip Code)
 
Registrant’s telephone number, including area code:   (415) 763-4520
 
Indicate by check mark whether the registrant (1) has filed all reports 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   o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted 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 and post such files).
Yes  x                    No  o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “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
(Do not check if a smaller reporting company)
     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  

Indicate by check mark if the registrant is a shell company, as defined in Rule 12b-2 of the Exchange Act.
Yes    o      No   x
 
As of April 30, 2019 , there were 13,748,436 shares of common stock outstanding.



TABLE OF CONTENTS
 
 
 
 
PART I
 
 
 
ITEM 1.
 
 
 
 
 
 
 
 
 
 
 
ITEM 2.
 
 
 
ITEM 3.
 
 
 
ITEM 4.
 
 
 
PART II
 
 
 
ITEM 1.
 
 
 
ITEM 1A.
 
 
 
ITEM 2.
 
 
 
ITEM 3.
 
 
 
ITEM 4.
 
 
 
ITEM 5.
 
 
 
ITEM 6.
 
 
 
 




Page-2



PART I       FINANCIAL INFORMATION
 
ITEM 1.  Financial Statements
 
BANK OF MARIN BANCORP
CONSOLIDATED   STATEMENTS OF   CONDITION  
March 31, 2019 and December 31, 2018
(in thousands, except share data; unaudited)
March 31, 2019

December 31, 2018

Assets
 

 
Cash and due from banks
$
51,639

$
34,221

Investment securities
 

 
Held-to-maturity, at amortized cost
152,845

157,206

Available-for-sale, at fair value
442,885

462,464

Total investment securities
595,730

619,670

Loans, net of allowance for loan losses of $15,817 and $15,821 at
March 31, 2019 and December 31, 2018, respectively
1,756,721

1,748,043

Bank premises and equipment, net
7,237

7,376

Goodwill
30,140

30,140

Core deposit intangible
5,349

5,571

Operating lease right-of-use assets
12,465


Interest receivable and other assets
74,795

75,871

Total assets
$
2,534,076

$
2,520,892

 
 
 
Liabilities and Stockholders' Equity
 

 

Liabilities
 

 

Deposits
 

 

Non-interest bearing
$
1,076,382

$
1,066,051

Interest bearing
 

 
Transaction accounts
130,001

133,403

Savings accounts
180,758

178,429

Money market accounts
680,806

679,775

Time accounts
110,682

117,182

Total deposits
2,178,629

2,174,840

Borrowings and other obligations
309

7,000

Subordinated debentures
2,657

2,640

Operating lease liabilities
14,349


Interest payable and other liabilities
17,468

20,005

Total liabilities
2,213,412

2,204,485

 
 
 
Stockholders' Equity
 

 

Preferred stock, no par value,
Authorized - 5,000,000 shares, none issued


Common stock, no par value,
Authorized - 30,000,000 shares;
Issued and outstanding - 13,786,808 and 13,844,353 at
March 31, 2019 and December 31, 2018, respectively
137,125

140,565

Retained earnings
184,793

179,944

Accumulated other comprehensive loss, net of taxes
(1,254
)
(4,102
)
Total stockholders' equity
320,664

316,407

Total liabilities and stockholders' equity
$
2,534,076

$
2,520,892


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

Page-3



BANK OF MARIN BANCORP
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
 
Three months ended
(in thousands, except per share amounts; unaudited)
March 31, 2019
March 31, 2018
Interest income
 
 

Interest and fees on loans
$
20,695

$
18,887

Interest on investment securities
4,097

3,157

Interest on federal funds sold and due from banks
139

403

Total interest income
24,931

22,447

Interest expense
 

 

Interest on interest-bearing transaction accounts
77

52

Interest on savings accounts
18

18

Interest on money market accounts
764

216

Interest on time accounts
119

156

Interest on borrowings and other obligations
47


Interest on subordinated debentures
60

114

Total interest expense
1,085

556

Net interest income
23,846

21,891

Provision for loan losses


Net interest income after provision for loan losses
23,846

21,891

Non-interest income
 

 
Service charges on deposit accounts
479

477

Wealth Management and Trust Services
438

515

Debit card interchange fees, net
380

396

Merchant interchange fees, net
87

80

(Cost of) earnings on bank-owned life insurance, net
(60
)
228

Dividends on FHLB stock
196

196

(Losses) gains on investment securities, net
(6
)

Other income
257

350

Total non-interest income
1,771

2,242

Non-interest expense
 

 
Salaries and related benefits
9,146

9,017

Occupancy and equipment
1,531

1,507

Depreciation and amortization
556

547

Federal Deposit Insurance Corporation insurance
179

191

Data processing
1,015

1,381

Professional services
586

1,299

Directors' expense
179

174

Information technology
259

269

Amortization of core deposit intangible
222

230

Provision for losses on off-balance sheet commitments
129


Other expense
1,726

1,466

Total non-interest expense
15,528

16,081

Income before provision for income taxes
10,089

8,052

Provision for income taxes
2,610

1,663

Net income
$
7,479

$
6,389

Net income per common share: 1
 

 
Basic
$
0.54

$
0.46

Diluted
$
0.54

$
0.46

Weighted average shares: 1
 
 

Basic
13,737

13,827

Diluted
13,924

14,011

Comprehensive income:
 
 
Net income
$
7,479

$
6,389

Other comprehensive income (loss)




Change in net unrealized gain or loss on available-for-sale securities
3,939

(6,170
)
Reclassification adjustment for losses on available-for-sale securities in net income
6


Amortization of net unrealized losses on securities transferred from available-for-sale to held-to-maturity
101

136

Subtotal
4,046

(6,034
)
Deferred tax expense (benefit)
1,198

(1,784
)
Other comprehensive income (loss), net of tax
2,848

(4,250
)
Comprehensive income
$
10,327

$
2,139

1 Share and per share data have been adjusted to reflect the two -for-one stock split effective November 27, 2018.
The accompanying notes are an integral part of these consolidated financial statements (unaudited).

Page-4



BANK OF MARIN BANCORP
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
For the three months ended March 31, 2019 and 2018
(in thousands, except share data; unaudited)
Common Stock
Retained
Earnings

Accumulated Other
Comprehensive Income (Loss) ("AOCI"),
Net of Taxes

 Total

Shares 1

Amount

 
Three months ended March 31, 2019
Balance at January 1, 2019
13,844,353

$
140,565

$
179,944

$
(4,102
)
$
316,407

Net income


7,479


7,479

Other comprehensive income



2,848

2,848

Stock options exercised, net of shares surrendered for cashless exercises and tax withholdings
28,142

259



259

Stock issued under employee stock purchase plan
377

15



15

Stock issued under employee stock ownership plan ("ESOP")
8,000

313



313

Restricted stock granted
29,110





Restricted stock surrendered for tax withholdings upon vesting
(4,820
)
(202
)


(202
)
Restricted stock forfeited / cancelled
(7,393
)




Stock-based compensation - stock options

284



284

Stock-based compensation - restricted stock

569



569

Cash dividends paid on common stock ($0.19 per share)


(2,630
)

(2,630
)
Stock purchased by directors under director stock plan
199

8



8

Stock issued in payment of director fees
2,744

114



114

Stock repurchased, net of commissions
(113,904
)
(4,800
)


(4,800
)
Balance at March 31, 2019
13,786,808

$
137,125

$
184,793

$
(1,254
)
$
320,664

 
Three months ended March 31, 2018
Balance at January 1, 2018
13,843,084

$
143,967

$
155,544

$
(2,486
)
$
297,025

Net income


6,389


6,389

Other comprehensive loss



(4,250
)
(4,250
)
Reclassification of stranded tax effects in AOCI


638

(638
)

Stock options exercised, net of shares surrendered for cashless exercises and tax withholdings
95,574

453



453

Stock issued under employee stock purchase plan
304

10



10

Restricted stock granted
37,040





Restricted stock surrendered for tax withholdings upon vesting
(802
)
(28
)


(28
)
Restricted stock forfeited / cancelled
(8,154
)




Stock-based compensation - stock options

316



316

Stock-based compensation - restricted stock

455



455

Cash dividends paid on common stock ($0.145 per share 1 )


(2,015
)

(2,015
)
Stock purchased by directors under director stock plan
520

18



18

Stock issued in payment of director fees
2,686

91



91

Balance at March 31, 2018
13,970,252

$
145,282

$
160,556

$
(7,374
)
$
298,464

1 Share and per share data have been adjusted to reflect the two -for-one stock split effective November 27, 2018.

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



Page-5



BANK OF MARIN BANCORP
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the three months ended March 31, 2019 and 2018
(in thousands; unaudited)
March 31, 2019
 
March 31, 2018
Cash Flows from Operating Activities:
 
 
 
Net income
$
7,479

 
$
6,389

Adjustments to reconcile net income to net cash provided by operating activities:
 

 
 

Provision for losses on off-balance sheet commitments
129

 

Noncash contribution expense to employee stock ownership plan
313

 

Noncash director compensation expense
75

 
67

Stock-based compensation expense
853

 
771

Amortization of core deposit intangible
222

 
230

Amortization of investment security premiums, net of accretion of discounts
485

 
762

Accretion of discount on acquired loans
(101
)
 
(211
)
Accretion of discount on subordinated debentures
17

 
33

Net change in deferred loan origination costs/fees
(49
)
 
(110
)
Loss on sale of investment securities
6

 

Depreciation and amortization
556

 
547

Cost of (earnings on) bank-owned life insurance policies
60

 
(228
)
Net change in operating assets and liabilities:
 
 
 
Interest receivable and other assets
1,641

 
(2,339
)
Interest payable and other liabilities
(1,157
)
 
3,288

Total adjustments
3,050

 
2,810

Net cash provided by operating activities
10,529

 
9,199

Cash Flows from Investing Activities:
 

 
 

Purchase of held-to-maturity securities

 
(1,989
)
Purchase of available-for-sale securities
(11,282
)
 
(109,693
)
Proceeds from sale of available-for-sale securities
4,229

 

Proceeds from paydowns/maturities of held-to-maturity securities
4,276

 
3,917

Proceeds from paydowns/maturities of available-for-sale securities
30,271

 
11,572

Loans originated and principal collected, net
(8,166
)
 
7,022

Purchase of bank-owned life insurance policies
(1,892
)
 

Purchase of premises and equipment
(67
)
 
(232
)
Cash paid for low-income housing tax credit investment
(38
)
 
(356
)
Net cash provided by (used in) investing activities
17,331

 
(89,759
)
Cash Flows from Financing Activities:
 

 
 

Net increase in deposits
3,789

 
37,924

Proceeds from stock options exercised
259

 
504

Payment of tax withholdings for stock options exercised and vesting of restricted stock
(202
)
 
(79
)
Proceeds from stock issued under employee and director stock purchase plans
23

 
28

Stock repurchased, net of commissions
(4,640
)
 

Repayment of Federal Home Loan Bank borrowings
(7,000
)
 

Repayment of finance lease obligations
(41
)
 

Cash dividends paid on common stock
(2,630
)
 
(2,015
)
Net cash (used in) provided by financing activities
(10,442
)
 
36,362

Net increase (decrease) in cash, cash equivalents and restricted cash
17,418

 
(44,198
)
Cash, cash equivalents and restricted cash at beginning of period
34,221

 
203,545

Cash, cash equivalents and restricted cash at end of period
$
51,639

 
$
159,347

Supplemental disclosure of cash flow information:
 
 
 
Cash paid in interest
$
1,066

 
$
543

Supplemental disclosure of noncash investing and financing activities:
 

 
 

Change in net unrealized gain or loss on available-for-sale securities
$
3,939

 
$
(6,170
)
Amortization of net unrealized loss on available-for-sale securities transferred to held-to-maturity
$
101

 
$
136

Right-of-use assets obtained in exchange for operating lease liabilities
$
266

 
$

Reclassification of deferred rent and unamortized lease incentives from other liabilities to operating lease right-of-use assets
$
1,967

 
$

Subscription in low-income housing tax credit investment
$

 
$
(3,000
)
Stock issued to ESOP
$
313

 
$

Stock issued in payment of director fees
$
114

 
$
91

Repurchase of stock not yet settled
$
160

 
$

Restricted cash:
 
 
 
Federal Reserve Bank reserve balance requirements included in cash and due from banks
$
10,932

 
$
18,183

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

Page-6



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
 
Note 1:  Basis of Presentation
 
The consolidated financial statements include the accounts of Bank of Marin Bancorp (“Bancorp”), a bank holding company, and its wholly-owned bank subsidiary, Bank of Marin (the “Bank”), a California state-chartered commercial bank. References to “we,” “our,” “us” mean Bancorp and the Bank that are consolidated for financial reporting purposes. The accompanying unaudited consolidated interim financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission ("SEC"). Certain information and note disclosures normally included in annual financial statements prepared in accordance with U.S. generally accepted accounting principles ("GAAP") have been condensed or omitted pursuant to those rules and regulations. Although we believe that the disclosures are adequate and the information presented is not misleading, we suggest that these interim financial statements be read in conjunction with the annual financial statements and the notes thereto included in our 2018 Annual Report on Form 10-K.  In the opinion of Management, the unaudited consolidated financial statements reflect all adjustments, which are necessary for a fair presentation of the consolidated financial position, the results of operations, changes in comprehensive income, changes in stockholders’ equity, and cash flows for the periods presented. All material intercompany transactions have been eliminated. The results of these interim periods may not be indicative of the results for the full year or for any other period.

The NorCal Community Bancorp Trusts I and II, respectively (the "Trusts") were formed for the sole purpose of issuing trust preferred securities. Bancorp is not considered the primary beneficiary of the Trusts (variable interest entities), therefore the Trusts are not consolidated in our consolidated financial statements, but rather the subordinated debentures are shown as a liability on our consolidated statements of condition. Bancorp's investment in the securities of the Trusts is accounted for under the equity method and is included in interest receivable and other assets on the consolidated statements of condition. Refer to Note 6, Borrowings, for detail on the early redemption on October 7, 2018 of one subordinated debenture due to NorCal Community Bancorp Trust I.
 
The following table shows: 1) weighted average basic shares, 2) potentially dilutive weighted average common shares related to stock options and unvested restricted stock awards, and 3) weighted average diluted shares. Basic earnings per share (“EPS”) are calculated by dividing net income by the weighted average number of common shares outstanding during each period, excluding unvested restricted stock awards. Diluted EPS are calculated using the weighted average number of potentially dilutive common shares. The number of potentially dilutive common shares included in the quarterly diluted EPS is computed using the average market prices during the three months included in the reporting period under the treasury stock method. The number of potentially dilutive common shares included in year-to-date diluted EPS is a year-to-date weighted average of potentially dilutive common shares included in each quarterly diluted EPS computation. In computing diluted EPS, we exclude anti-dilutive shares such as options whose exercise prices exceed the current common stock price, as they would not reduce EPS under the treasury method. We have two forms of outstanding common stock: common stock and unvested restricted stock awards. Holders of unvested restricted stock awards receive non-forfeitable dividends at the same rate as common shareholders and they both share equally in undistributed earnings. Under the two-class method, the difference in EPS is nominal for these participating securities.
 
Three months ended
(in thousands, except per share data) 1
March 31, 2019
March 31, 2018
Weighted average basic shares outstanding
13,737

13,827

Potentially dilutive common shares related to:
 
 
Stock options
155

150

Unvested restricted stock awards
32

34

Weighted average diluted shares outstanding
13,924

14,011

Net income
$
7,479

$
6,389

Basic EPS
$
0.54

$
0.46

Diluted EPS
$
0.54

$
0.46

Weighted average anti-dilutive shares not included in the calculation of diluted EPS
20

63

1 Share and per share data have been adjusted to reflect the two -for-one stock split effective November 27, 2018.

Page-7



Note 2: Recently Adopted and Issued Accounting Standards

Accounting Standards Adopted in 2019

In February 2016, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2016-02, Leases (Topic 842) (the "new lease accounting standard"). The amendments in this ASU intend to increase transparency and comparability among organizations by recognizing an operating lease or finance lease right-of-use asset for the lease term, and a lease liability, which is a lessee's obligation to make lease payments, recorded based on discounting future lease payments under the lease terms. This ASU generally applies to leasing arrangements exceeding a twelve-month term. ASU 2016-02 is effective for annual periods, including interim periods within those annual periods beginning after December 15, 2018 and requires a modified retrospective method of adoption. In July 2018, the FASB issued two amendments to ASU 2016-02: ASU No. 2018-10, Codification Improvements to Topic 842, Leases , which provided various corrections and clarifications to ASU 2016-02; and ASU No. 2018-11, Leases (Topic 842): Targeted Improvements , which permitted optional transition methods and provided lessors with a practical expedient for separating lease and non-lease components of a lease. The ASU allowed entities to apply either a modified retrospective approach at the beginning of the earliest period presented or at the beginning of the period of adoption through a cumulative-effect adjustment to retained earnings, which we adopted.

As a result of the adoption of the ASU on January 1, 2019, we recorded operating and finance lease right-of-use assets totaling $13.4 million , net of deferred rent and unaccreted lease incentives, operating and finance lease liabilities totaling $15.4 million , and no cumulative-effect adjustments to retained earnings. Under the standard's transition guidance, we elected the package of practical expedients, which allowed us to carry forward existing lease classifications and did not require us to reassess initial direct costs for any existing leases. In addition, we elected the hindsight practical expedient when determining the lease term (i.e., considering whether we are reasonably certain to exercise options to extend or terminate the lease). We made accounting policy elections not to separate non-lease components from lease components and to exclude short-term leases (i.e., lease term of 12 months or less at the commencement date) from right-of-use assets and lease liabilities for all lease classifications. See Note 8, Commitments and Contingencies for further information.

In June 2018, the FASB issued ASU No. 2018-07, Compensation - Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting . This update simplifies the accounting for share-based payment transactions for acquiring goods and services from nonemployees, applying some of the same requirements as employee share-based payment transactions. The ASU will not affect the accounting for share-based payment awards to nonemployee directors, which will continue to be treated as employee share-based transactions under the current standards. ASU 2018-07 is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption is permitted. We adopted the requirements of this ASU effective January 1, 2019, which did not impact our financial condition or results of operations, as it is not our practice to issue stock-based awards to pay for goods and services from nonemployees, other than nonemployee directors.

In October 2018, the FASB issued ASU No. 2018-16, Derivatives and Hedging (Topic 815): Inclusion of the Secured Overnight Financing Rate (SOFR) Overnight Index Swap (OIS) Rate as a Benchmark Interest Rate for Hedge Accounting Purposes . This update adds an alternative fifth permissible U.S. benchmark rate to be used for hedge accounting purposes. As we have already adopted the amendments in ASU 2017-12, which changed both the designation and measurement guidance for qualifying hedging relationships, the amendments in ASU 2018-16 are effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. The amendments should be adopted on a prospective basis for qualifying new or re-designated hedging relationships entered into on or after the date of adoption. Early adoption is permitted in any interim period upon issuance of this ASU if an entity already has adopted ASU 2017-12. We adopted this ASU effective January 1, 2019, which did not impact our financial condition or results of operations.
Accounting Standards Not Yet Effective
In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments . The standard will replace today's "incurred loss" model with a "current expected credit loss" ("CECL") model. The CECL model will apply to estimated credit losses on loans receivable, held-to-maturity debt securities, unfunded loan commitments, and certain other financial assets measured at amortized cost. The CECL model is based on lifetime expected losses, rather than incurred losses, and requires the recognition of credit loss expense in the consolidated statement of income and a related allowance for credit losses on the consolidated statement of condition at the time of origination or purchase of a loan receivable or held-to-maturity debt

Page-8



security. Likewise, subsequent changes in this estimate are recorded through credit loss expense and related allowance. The CECL model requires the use of not only relevant historical experience and current conditions, but reasonable and supportable forecasts of future events and circumstances, incorporating a broad range of information in developing credit loss estimates, which could result in significant changes to both the timing and amount of credit loss expense and allowance. Under ASU 2016-13, available-for-sale debt securities are evaluated for impairment if fair value is less than amortized cost. Estimated credit losses are recorded through a credit loss expense and an allowance, rather than a write-down of the investment. Changes in fair value that are not credit-related will continue to be recorded in other comprehensive income. The ASU also expands the disclosure requirements regarding assumptions, models, and methods for estimating the allowance for loan losses. In addition, entities will need to disclose the amortized cost balance for each class of financial asset by credit quality indicator, disaggregated by the year of origination. ASU 2016-13 is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is permitted for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Entities will apply a modified retrospective approach through a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is effective. While we believe the change from an incurred loss model to a CECL model has the potential to increase the allowance for loan losses at the adoption date, we cannot reasonably quantify the impact of the adoption of the amendments to our financial condition or results of operations at this time due to the complexity and extensive changes from these amendments. We have formed an internal CECL committee and are working with our third-party vendor to determine the appropriate methodologies and resources to utilize in preparation for transition to the new accounting standards, including but not limited to the use of certain tools to forecast future economic conditions and identify loan loss drivers that affect the cash flows of our loans over their lifetime. We expect to begin parallel testing and quantifying the estimated impact of the adoption during the second quarter of 2019.

In August 2018, the FASB issued ASU No. 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement . The amendments in this ASU remove, modify, and add disclosure requirements for the fair value reporting of assets and liabilities. The modifications and additions relate to Level 3 fair value measurements at the end of the reporting period. ASU 2018-13 is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Entities should disclose and describe the range and weighted-average of significant observable inputs used to develop Level 3 fair value measurements prospectively. Early adoption is permitted. Entities making this election are permitted to early adopt the eliminated or modified disclosure requirements and delay the adoption of all the new disclosure requirements until the ASU's effective date. As the ASU’s requirements only relate to disclosures, the amendments will not impact our financial condition or results of operations.

In August 2018, the FASB issued ASU No. 2018-15, Intangibles - Goodwill and Other - Internal-Use Software (Subtopic 350-40): Customer's Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract . This standard aligns the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software, regardless of whether they convey a license to the hosted software. The accounting for the service element of a hosting arrangement that is a service contract is not affected by this ASU. The amendments are effective for public business entities for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. An entity has the option to apply amendments in the ASU either retrospectively or prospectively to all implementation costs incurred after the date of adoption. Early adoption is permitted, including adoption in an interim period. We do not expect that the ASU will have a material impact on our financial condition or results of operations.
In March 2019, the FASB issued ASU No. 2019-01, Leases (Topic 842): Codification Improvements . This ASU addresses two lessor implementation issues and clarifies that lessees and lessors are exempt from certain interim disclosure requirements associated with adopting ASU 2016-02. The amendments related to the lessor implementation issues are effective for public business entities for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. Early application is permitted. As the ASU's amendments applicable to us only relate to disclosures, the adoption of ASU 2019-01 will not impact our financial condition or results of operations.
Note 3:  Fair Value of Assets and Liabilities
 
Fair Value Hierarchy and Fair Value Measurement
 
We group our assets and liabilities that are measured at fair value in three levels within the fair value hierarchy, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value.

Page-9



These levels are:
 
Level 1: Valuations are based on unadjusted quoted prices in active markets for identical assets or liabilities.
 
Level 2: Valuations are based on quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active and model-based valuations for which all significant assumptions are observable or can be corroborated by observable market data.
 
Level 3: Valuations are based on unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Values are determined using pricing models and discounted cash flow models and may include significant Management judgment and estimation.

Transfers between levels of the fair value hierarchy are recognized through our monthly and/or quarterly valuation process in the reporting period during which the event or circumstances that caused the transfer occurred. No such transfers occurred during the first three months of 2019 or 2018.

The following table summarizes our assets and liabilities that were required to be recorded at fair value on a recurring basis.
(in thousands)  
Description of Financial Instruments
Carrying Value

Quoted Prices in Active Markets for Identical Assets (Level 1)

Significant Other Observable Inputs
(Level 2)

Significant Unobservable Inputs 
(Level 3)

Measurement Categories: Changes in Fair Value Recorded In 1
March 31, 2019
 

 
 

 

 
Securities available-for-sale:
 
 
 
 
 
Mortgage-backed securities and collateralized mortgage obligations issued by U.S. government agencies
$
278,726

$

$
278,726

$

OCI
SBA-backed securities
48,798


48,798


OCI
Debentures of government sponsored agencies
38,245


38,245


OCI
Privately-issued collateralized mortgage obligations
252


252


OCI
Obligations of state and political subdivisions
74,855


74,855


OCI
Corporate bonds
2,009


2,009


OCI
Derivative financial assets (interest rate contracts)
60


60


NI
Derivative financial liabilities (interest rate contracts)
631


631


NI
December 31, 2018
 

 
 

 

 
Securities available-for-sale:
 

 
 

 

 
Mortgage-backed securities and collateralized mortgage obligations issued by U.S. government agencies
$
278,403

$

$
278,403

$

OCI
SBA-backed securities
50,781


50,781


OCI
Debentures of government sponsored agencies
53,018


53,018


OCI
Privately-issued collateralized mortgage obligations
297


297


OCI
Obligations of state and political subdivisions
77,960


77,960


OCI
Corporate bonds
2,005


2,005


OCI
Derivative financial assets (interest rate contracts)
161


161


NI
Derivative financial liabilities (interest rate contracts)
375


375


NI
 1 Other comprehensive income ("OCI") or net income ("NI").

Securities available-for-sale are recorded at fair value on a recurring basis. When available, quoted market prices (Level 1) are used to determine the fair value of securities available-for-sale. If quoted market prices are not available, we obtain pricing information from a reputable third-party service provider, who may utilize valuation techniques that use current market-based or independently sourced parameters, such as bid/ask prices, dealer-quoted prices, interest rates, benchmark yield curves, prepayment speeds, probability of default, loss severity and credit spreads (Level 2).   Level 2 securities include obligations of state and political subdivisions, U.S. agencies or government-sponsored

Page-10



agencies' debt securities, mortgage-backed securities, government agency-issued, privately-issued collateralized mortgage obligations, and corporate bonds. As of March 31, 2019 and December 31, 2018 , there were no Level 1 or Level 3 securities.

Securities held-to-maturity may be written down to fair value (determined using the same techniques discussed above for securities available-for-sale) as a result of other-than-temporary impairment, and we did not record any write-downs during the three months ended March 31, 2019 or March 31, 2018 .
 
On a recurring basis, derivative financial instruments are recorded at fair value, which is based on the income approach using observable Level 2 market inputs, reflecting market expectations of future interest rates as of the measurement date.  Standard valuation techniques are used to calculate the present value of the future expected cash flows assuming an orderly transaction.  Valuation adjustments may be made to reflect both our own credit risk and the counterparties’ credit risk in determining the fair value of the derivatives. Level 2 inputs for the valuations are limited to observable market prices for London Interbank Offered Rate ("LIBOR") and Overnight Index Swap ("OIS") rates (for the very short term), quoted prices for LIBOR futures contracts, observable market prices for LIBOR and OIS swap rates, and one-month and three-month LIBOR basis spreads at commonly quoted intervals.  Mid-market pricing of the inputs is used as a practical expedient in the fair value measurements.  We project spot rates at reset days specified by each swap contract to determine future cash flows, then discount to present value using either LIBOR or OIS curves depending on whether the swap positions are fully collateralized as of the measurement date.  When the value of any collateral placed with counterparties is less than the interest rate derivative liability, a credit valuation adjustment ("CVA") is applied to reflect the credit risk we pose to counterparties.  We have used the spread between the Standard & Poor's BBB rated U.S. Bank Composite rate and LIBOR for the closest maturity term corresponding to the duration of the swaps to derive the CVA. A similar credit risk adjustment, correlated to the credit standing of the counterparty, is made when collateral posted by the counterparty does not fully cover their liability to us. For further discussion on our methodology in valuing our derivative financial instruments, refer to Note 9, Derivative Financial Instruments and Hedging Activities.

Certain financial assets may be measured at fair value on a non-recurring basis. These assets are subject to fair value adjustments that result from the application of the lower of cost or fair value accounting or write-downs of individual assets, such as impaired loans that are collateral dependent and other real estate owned ("OREO"). As of March 31, 2019 and December 31, 2018 , we did not carry any assets measured at fair value on a non-recurring basis.
 
 
 
 
 
 
Disclosures about Fair Value of Financial Instruments
 
The table below is a summary of fair value estimates for financial instruments as of March 31, 2019 and December 31, 2018 , excluding financial instruments recorded at fair value on a recurring basis (summarized in the first table in this note). The carrying amounts in the following table are recorded in the consolidated statements of condition under the indicated captions. Further, we have not disclosed the fair value of financial instruments specifically excluded from disclosure requirements such as bank-owned life insurance policies ("BOLI") and non-maturity deposit liabilities. Additionally, we hold shares of FHLB stock and Visa Inc. Class B common stock, both recorded at cost, as there was no impairment or changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer as of March 31, 2019 and December 31, 2018 . The values are discussed in Note 4, Investment Securities.
 
March 31, 2019
 
December 31, 2018
(in thousands)
Carrying Amounts

Fair Value

Fair Value Hierarchy
 
Carrying Amounts

Fair Value

Fair Value Hierarchy
Financial assets (recorded at amortized cost)
 
 
 
 
 
 
Cash and cash equivalents
$
51,639

$
51,639

Level 1
 
$
34,221

$
34,221

Level 1
Investment securities held-to-maturity
152,845

151,254

Level 2
 
157,206

153,894

Level 2
Loans, net
1,756,721

1,739,432

Level 3
 
1,748,043

1,700,971

Level 3
Interest receivable
7,852

7,852

Level 2
 
8,292

8,292

Level 2
Financial liabilities (recorded at amortized cost)
 

 
 
 
 

 
Time deposits
110,682

109,741

Level 2
 
117,182

116,584

Level 2
Subordinated debentures
2,657

3,307

Level 3
 
2,640

3,268

Level 3
Interest payable
105

105

Level 2
 
104

104

Level 2


Page-11



Commitments - The value of unrecognized financial instruments is estimated based on the fee income associated with the commitments which, in the absence of credit exposure, is considered to approximate their settlement value. The fair value of commitment fees was not material as of March 31, 2019 or December 31, 2018 .

Note 4:  Investment Securities
 
Our investment securities portfolio consists of obligations of state and political subdivisions, U.S. corporations, U.S. federal government agencies such as Government National Mortgage Association ("GNMA") and Small Business Administration ("SBA"), U.S. government-sponsored enterprise securities ("GSEs"), such as Federal National Mortgage Association ("FNMA"), Federal Home Loan Mortgage Corporation ("FHLMC"), Federal Farm Credit Banks Funding Corporation and FHLB. We also invest in residential and commercial mortgage-backed securities (“MBS”/"CMBS") and collateralized mortgage obligations (“CMOs”) issued or guaranteed by the GSEs, and privately issued CMOs, as reflected in the following table:
 
March 31, 2019
 
December 31, 2018
 
Amortized
Fair
Gross Unrealized
 
Amortized
Fair
Gross Unrealized
(in thousands)
Cost
Value
Gains
(Losses)
 
Cost
Value
Gains
(Losses)
Held-to-maturity:
 
 
 
 
 
 
 
 
 
Securities of U.S. government-sponsored enterprises:
 
 
 
 
 
 
 
 
 
MBS pass-through securities issued by FHLMC and FNMA
$
86,117

$
84,588

$
44

$
(1,573
)

$
88,606

$
85,804

$
7

$
(2,809
)
SBA-backed securities
8,403

8,483

80


 
8,720

8,757

37


CMOs issued by FNMA
11,166

11,165


(1
)
 
11,447

11,327


(120
)
CMOs issued by FHLMC
33,375

33,148

65

(292
)
 
33,583

33,021

8

(570
)
CMOs issued by GNMA
3,746

3,733


(13
)
 
3,739

3,769

30


Obligations of state and
political subdivisions
10,038

10,137

111

(12
)
 
11,111

11,216

128

(23
)
Total held-to-maturity
152,845

151,254

300

(1,891
)

157,206

153,894

210

(3,522
)
Available-for-sale:
 
 
 
 
 
 
 
 
 
Securities of U.S. government-sponsored enterprises:
 
 
 
 
 
 
 
 
 
MBS pass-through securities issued by FHLMC and FNMA
91,714

91,771

617

(560
)

95,339

94,467

358

(1,230
)
SBA-backed securities
48,441

48,798

582

(225
)
 
50,722

50,781

465

(406
)
CMOs issued by FNMA
27,192

27,037

127

(282
)

28,275

28,079

134

(330
)
CMOs issued by FHLMC
145,917

146,237

1,112

(792
)

145,979

144,836

454

(1,597
)
CMOs issued by GNMA
13,983

13,681


(302
)

11,294

11,021

1

(274
)
Debentures of government- sponsored agencies
37,984

38,245

344

(83
)

52,956

53,018

185

(123
)
Privately issued CMOs
251

252

1



295

297

2


Obligations of state and
political subdivisions
74,902

74,855

477

(524
)

79,046

77,960

134

(1,220
)
Corporate bonds
2,002

2,009

12

(5
)

2,004

2,005

15

(14
)
Total available-for-sale
442,386

442,885

3,272

(2,773
)

465,910

462,464

1,748

(5,194
)
Total investment securities
$
595,231

$
594,139

$
3,572

$
(4,664
)

$
623,116

$
616,358

$
1,958

$
(8,716
)

The amortized cost a nd fair value of investment debt securities by contractual maturity at March 31, 2019 and December 31, 2018 are shown in the following table below. Expected maturities may differ from contractual maturities if the issuers of the securities have the right to call or prepay obligations with or without call or prepayment penalties.
 
March 31, 2019
 
December 31, 2018
 
Held-to-Maturity
 
Available-for-Sale
 
Held-to-Maturity
 
Available-for-Sale
(in thousands)
Amortized Cost
Fair Value
 
Amortized Cost
Fair Value
 
Amortized Cost
Fair Value
 
Amortized Cost
Fair Value
Within one year
$
6,949

$
6,945

 
$
9,104

$
9,058

 
$
6,194

$
6,182

 
$
9,863

$
9,795

After one but within five years
3,649

3,664

 
71,592

71,425

 
5,481

5,492

 
84,871

84,435

After five years through ten years
58,337

58,048

 
243,869

244,875

 
59,231

58,120

 
252,274

250,055

After ten years
83,910

82,597

 
117,821

117,527

 
86,300

84,100

 
118,902

118,179

Total
$
152,845

$
151,254

 
$
442,386

$
442,885

 
$
157,206

$
153,894

 
$
465,910

$
462,464


Page-12




Sales of investment securities and gross gains and losses are shown in the following table.
 
Three months ended
(in thousands)
March 31, 2019
 
March 31, 2018
Available-for-sale:
 
 
 
Sales proceeds
$
4,229

 
$

Gross realized gains
3

 

Gross realized losses
(9
)
 


Pledged investment securities are shown in the following table.
(in thousands)
March 31, 2019
December 31, 2018
Pledged to the State of California:
 
 
Secure public deposits in compliance with the Local Agency Security Program
$
114,335

$
125,696

Collateral for trust deposits
729

734

Total investment securities pledged to the State of California
$
115,064

$
126,430

Collateral for Wealth Management and Trust Services checking account
$
1,995

$
2,000


Other-Than-Temporarily Impaired ("OTTI") Debt Securities
 
There were 175 and 229 securities in unrealized loss positions at March 31, 2019 and December 31, 2018 , respectively. Those securities are summarized and classified according to the duration of the loss period in the tables below:
March 31, 2019
< 12 continuous months
 
≥ 12 continuous months
 
Total securities
 in a loss position
(in thousands)
Fair value
Unrealized loss
 
Fair value
Unrealized loss
 
Fair value
Unrealized loss
Held-to-maturity:
 
 
 
 
 
 
 
 
MBS pass-through securities issued by FHLMC and FNMA
$
2,663

$
(39
)
 
$
70,078

$
(1,534
)
 
$
72,741

$
(1,573
)
CMOs issued by FNMA


 
11,165

(1
)
 
11,165

(1
)
CMOs issued by FHLMC


 
19,113

(292
)
 
19,113

(292
)
CMOs issued by GNMA
3,733

(13
)
 


 
3,733

(13
)
Obligations of state and political subdivisions


 
3,554

(12
)
 
3,554

(12
)
Total held-to-maturity
6,396

(52
)
 
103,910

(1,839
)
 
110,306

(1,891
)
Available-for-sale:
 
 
 
 
 
 
 
 
MBS pass-through securities issued by FHLMC and FNMA


 
51,734

(560
)
 
51,734

(560
)
SBA-backed securities
12,253

(123
)
 
14,799

(102
)
 
27,052

(225
)
CMOs issued by FNMA


 
17,786

(282
)
 
17,786

(282
)
CMOs issued by FHLMC
4,187

(3
)
 
72,861

(789
)
 
77,048

(792
)
CMOs issued by GNMA
3,529

(4
)
 
10,127

(298
)
 
13,656

(302
)
Debentures of government- sponsored agencies


 
11,385

(83
)
 
11,385

(83
)
Obligations of state and political subdivisions
1,044

(4
)
 
38,308

(520
)
 
39,352

(524
)
Corporate bonds


 
1,008

(5
)
 
1,008

(5
)
Total available-for-sale
21,013

(134
)
 
218,008

(2,639
)
 
239,021

(2,773
)
Total temporarily impaired securities
$
27,409

$
(186
)
 
$
321,918

$
(4,478
)
 
$
349,327

$
(4,664
)

Page-13



December 31, 2018
< 12 continuous months
 
≥ 12 continuous months
 
Total securities
 in a loss position
(in thousands)
Fair value
Unrealized loss
 
Fair value
Unrealized loss
 
Fair value
Unrealized loss
Held-to-maturity:
 
 
 
 
 
 
 
 
MBS pass-through securities issued by FHLMC and FNMA
$
198

$
(9
)
 
$
83,990

$
(2,800
)
 
$
84,188

$
(2,809
)
CMOs issued by FNMA


 
11,327

(120
)
 
11,327

(120
)
CMOs issued by FHLMC
2,880

(3
)
 
28,171

(567
)
 
31,051

(570
)
Obligations of state and political subdivisions


 
3,565

(23
)
 
3,565

(23
)
Total held-to-maturity
3,078

(12
)
 
127,053

(3,510
)
 
130,131

(3,522
)
Available-for-sale:




 




 




MBS pass-through securities issued by FHLMC and FNMA
19,971

(128
)
 
50,077

(1,102
)
 
70,048

(1,230
)
SBA-backed securities
13,175

(122
)
 
20,123

(284
)
 
33,298

(406
)
CMOs issued by FNMA
2,345

(8
)
 
16,138

(322
)
 
18,483

(330
)
CMOs issued by FHLMC
24,094

(330
)
 
74,243

(1,267
)
 
98,337

(1,597
)
CMOs issued by GNMA
1,666

(7
)
 
9,112

(267
)
 
10,778

(274
)
Debentures of government- sponsored agencies
4,992

(8
)
 
11,349

(115
)
 
16,341

(123
)
Obligations of state and political subdivisions
15,290

(54
)
 
52,804

(1,166
)
 
68,094

(1,220
)
Corporate Bonds


 
1,004

(14
)
 
1,004

(14
)
Total available-for-sale
81,533

(657
)
 
234,850

(4,537
)
 
316,383

(5,194
)
Total temporarily impaired securities
$
84,611

$
(669
)
 
$
361,903

$
(8,047
)
 
$
446,514

$
(8,716
)

As of March 31, 2019 , the investment portfolio included 154 investment securities that had been in a continuous loss position for twelve months or more and 21 investment securities that had been in a loss position for less than twelve months.

Securities issued by government-sponsored agencies, such as FNMA and FHLMC, usually have implicit credit support by the U.S. federal government. However, since 2008, FNMA and FHLMC have been under government conservatorship and, therefore, contractual cash flows for these investments carry explicit guarantees by the U.S. federal government. Securities issued by the SBA and GNMA have explicit credit guarantees by the U.S. federal government, which protects us from credit losses on the contractual cash flows of the securities.
Other temporarily impaired securities, including obligations of state and political subdivisions and corporate bonds, were deemed credit worthy after our internal analyses of the issuers’ latest financial information, credit ratings by major credit agencies, and/or credit enhancements. Based on our comprehensive analyses, we determined that the decline in the fair values of these securities was primarily driven by factors other than credit, such as changes in market interest rates and liquidity spreads subsequent to purchase. At March 31, 2019 , Management determined that it did not intend to sell investment securities with unrealized losses, and it is more likely than not that we will not be required to sell any of the securities with unrealized losses before recovery of their amortized cost. Therefore, we do not consider these investment securities to be other-than-temporarily impaired at March 31, 2019 .
Non-Marketable Securities

As a member of the FHLB, we are required to maintain a minimum investment in FHLB capital stock determined by the Board of Directors of the FHLB. The minimum investment requirements can increase in the event we increase our total asset size or borrowings with the FHLB. Shares cannot be purchased or sold except between the FHLB and its members at the $100 per share par value. We held $11.1 million of FHLB stock included in other assets on the consolidated statements of condition at both March 31, 2019 and December 31, 2018 . The carrying amounts of these investments are reasonable estimates of fair value because the securities are restricted to member banks and they do not have a readily determinable market value. Based on our analysis of FHLB's financial condition and certain qualitative factors, we determined that the FHLB stock was not impaired at March 31, 2019 and December 31, 2018 . On April 25, 2019, FHLB announced a cash dividend for the first quarter of 2019 at an annualized dividend rate of

Page-14



7.00% to be distributed in mid-May 2019. Cash dividends paid on FHLB capital stock are recorded as non-interest income.

As a member bank of Visa U.S.A., we held 10,439 shares of Visa Inc. Class B common stock at March 31, 2019 and December 31, 2018 . These shares have a carrying value of zero and are restricted from resale to non-member banks of Visa U.S.A. until their conversion into Class A (voting) shares upon the termination of Visa Inc.'s Covered Litigation escrow account. Because of the restriction and the uncertainty on the conversion rate to Class A shares, these shares lack a readily determinable fair value. When converting this Class B common stock to Class A common stock based on the conversion rate of 1.6298 both as of March 31, 2019 and December 31, 2018 , and the closing stock price of Class A shares at those respective dates, the converted value of our shares of Class B common stock would have been $2.7 million and $2.2 million at March 31, 2019 and December 31, 2018 , respectively. The conversion rate is subject to further adjustment upon the final settlement of the covered litigation against Visa Inc. and its member banks. As such, the fair value of these Class B shares can differ significantly from their converted values. For further information, refer to Note 8, Commitments and Contingencies.

We invest in low-income housing tax credit funds as a limited partner, which totaled $4.5 million and $4.6 million recorded in other assets as of March 31, 2019 and December 31, 2018 , respectively. In the first three months of 2019, we recognized $154 thousand of low-income housing tax credits and other tax benefits, offset by $130 thousand of amortization expense of low-income housing tax credit investment, as a component of income tax expense. As of March 31, 2019 , our unfunded commitments for these low-income housing tax credit funds totaled $3.1 million . We did not recognize any impairment losses on these low-income housing tax credit investments during the first three months of 2019 or 2018, as the value of the future tax benefits exceeds the carrying value of the investments.

Note 5:  Loans and Allowance for Loan Losses

Credit Quality of Loans
 
The following table shows outstanding loans by class and payment aging as of March 31, 2019 and December 31, 2018 .
Loan Aging Analysis by Class
(in thousands)
Commercial and industrial

Commercial real estate, owner-occupied

Commercial real estate, investor

Construction

Home equity

Other residential

Installment and other consumer

Total

March 31, 2019
 

 

 

 

 

 

 

 

 30-59 days past due
$
320

$
1,584

$

$

$
517

$

$
102

$
2,523

 60-89 days past due




108



108

 90 days or more past due




84



84

Total past due
320

1,584



709


102

2,715

Current
237,326

309,004

878,494

72,271

123,803

117,558

31,367

1,769,823

Total loans 2
$
237,646

$
310,588

$
878,494

$
72,271

$
124,512

$
117,558

$
31,469

$
1,772,538

Non-accrual loans 1
$
309

$

$

$

$
346

$

$
64

$
719

December 31, 2018
 

 

 

 

 

 

 

 

 30-59 days past due
$
5

$

$
1,004

$

$

$

$
112

$
1,121

 60-89 days past due








 90 days or more past due








Total past due
5


1,004




112

1,121

Current
230,734

313,277

872,406

76,423

124,696

117,847

27,360

1,762,743

Total loans 2
$
230,739

$
313,277

$
873,410

$
76,423

$
124,696

$
117,847

$
27,472

$
1,763,864

Non-accrual loans 1
$
319

$

$

$

$
313

$

$
65

$
697

1 Includes no purchased credit impaired ("PCI") loans at March 31, 2019 and December 31, 2018 . Amounts exclude accreting PCI loans of $2.1 million at March 31, 2019 and December 31, 2018 as we have a reasonable expectation about future cash flows to be collected and we continue to recognize accretable yield on these loans in interest income. There were no accruing loans past due more than ninety days at March 31, 2019 or December 31, 2018 .
2 Amounts include net deferred loan origination costs of $684 thousand and $635 thousand at March 31, 2019 and December 31, 2018 , respectively. Amounts are also net of unaccreted purchase discounts on non-PCI loans of $666 thousand and $708 thousand at March 31, 2019 and December 31, 2018 , respectively.

We generally make commercial loans to established small and mid-sized businesses to provide financing for their growth and working capital needs, equipment purchases and acquisitions.  Management examines historical, current, and projected cash flows to determine the ability of the borrower to repay obligations as agreed. Commercial loans

Page-15



are made based primarily on the identified cash flows of the borrower and secondarily on the underlying collateral and guarantor support. The cash flows of borrowers, however, may not occur as expected, and the collateral securing these loans may fluctuate in value. Most commercial and industrial loans are secured by the assets being financed, such as accounts receivable and inventory, and typically include personal guarantees. We target stable businesses with guarantors who provide additional sources of repayment and have proven to be resilient in periods of economic stress.
 
Commercial real estate loans are subject to underwriting standards and processes similar to commercial loans discussed above. We underwrite these loans to be repaid from cash flow and to be supported by real property collateral. Underwriting standards for commercial real estate loans include, but are not limited to, debt coverage and loan-to-value ratios. Furthermore, substantially all of our loans are guaranteed by the owners of the properties. Conditions in the real estate markets or in the general economy may adversely affect our commercial real estate loans. In the event of a vacancy, we expect guarantors to carry the loans until they find a replacement tenant.  The owner's substantial equity investment provides a strong economic incentive to continue to support the commercial real estate projects. As such, we have generally experienced a relatively low level of loss and delinquencies in this portfolio.

Construction loans are generally made to developers and builders to finance construction, renovation and occasionally land acquisitions in anticipation of near-term development. Construction loan borrowers provide for interest reserves that are used for the payment of interest during the development and marketing periods. When a construction loan is placed on nonaccrual status before the depletion of the interest reserve, we apply the interest funded by the interest reserve against the loan's principal balance. These loans are underwritten after evaluation of the borrower's financial strength, reputation, prior track record, and independent appraisals. We monitor all construction projects to determine whether they are on schedule, completed as planned and in accordance with the approved construction budgets. Significant events can affect the construction industry, including: the inherent volatility of real estate markets and vulnerability to delays due to weather, change orders, inability to obtain construction permits, labor or material shortages, and price changes. Estimates of construction costs and value associated with the completed project may be inaccurate. Repayment of construction loans is largely dependent on the ultimate success of the project.
 
Consumer loans primarily consist of home equity lines of credit, other residential loans and floating homes, along with a small number of installment loans. Our other residential loans include tenancy-in-common fractional interest loans ("TIC") located almost entirely in San Francisco County. We originate consumer loans utilizing credit score information, debt-to-income ratio and loan-to-value ratio analysis. Diversification among consumer loan types, coupled with relatively small loan amounts that are spread across many individual borrowers, mitigates risk. We do not originate sub-prime residential mortgage loans, nor is it our practice to underwrite loans commonly referred to as "Alt-A mortgages," the characteristics of which are reduced documentation, borrowers with low FICO scores or collateral with high loan-to-value ratios.

We use a risk rating system to evaluate asset quality, and to identify and monitor credit risk in individual loans, and in the loan portfolio. Our definitions of “Special Mention” risk graded loans, or worse, are consistent with those used by the Federal Deposit Insurance Corporation ("FDIC").  Our internally assigned grades are as follows:
 
Pass and Watch : Loans to borrowers of acceptable or better credit quality. Borrowers in this category demonstrate fundamentally sound financial positions, repayment capacity, credit history, and management expertise.  Loans in this category must have an identifiable and stable source of repayment and meet the Bank’s policy regarding debt-service-coverage ratios.  These borrowers are capable of sustaining normal economic, market or operational setbacks without significant financial consequences.  Negative external industry factors are generally not present.  The loan may be secured, unsecured or supported by non-real estate collateral for which the value is more difficult to determine and/or marketability is more uncertain. This category also includes “Watch” loans, where the primary source of repayment has been delayed. “Watch” is intended to be a transitional grade, with either an upgrade or downgrade within a reasonable period.
 
Special Mention : Potential weaknesses that deserve close attention. If left uncorrected, those potential weaknesses may result in deterioration of the payment prospects for the asset. Special Mention assets do not present sufficient risk to warrant adverse classification.
 
Substandard : Inadequately protected by either the current sound worth and paying capacity of the obligor or the collateral pledged, if any. A Substandard asset has a well-defined weakness or weaknesses that jeopardize(s) the liquidation of the debt. Substandard assets are characterized by the distinct possibility that we will sustain some loss

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if such weaknesses or deficiencies are not corrected. Well-defined weaknesses include adverse trends or developments of the borrower’s financial condition, managerial weaknesses and/or significant collateral deficiencies.
 
Doubtful : Critical weaknesses that make collection or liquidation in full improbable. There may be specific pending events that work to strengthen the asset; however, the amount or timing of the loss may not be determinable. Pending events generally occur within one year of the asset being classified as Doubtful. Examples include: merger, acquisition, or liquidation; capital injection; guarantee; perfecting liens on additional collateral; and refinancing. Such loans are placed on non-accrual status and usually are collateral-dependent.

We regularly review our credits for accuracy of risk grades whenever we receive new information. Borrowers are generally required to submit financial information at regular intervals. Typically, commercial borrowers with lines of credit are required to submit financial information with reporting intervals ranging from monthly to annually depending on credit size, risk and complexity. In addition, investor commercial real estate borrowers are usually required to submit rent rolls or property income statements annually. We monitor construction loans monthly. We review home equity and other consumer loans based on delinquency. We also review loans graded “Watch” or worse, regardless of loan type, no less than quarterly.

The following table represents an analysis of the carrying amount in loans, net of deferred fees and costs and purchase premiums or discounts, by internally assigned risk grades, including PCI loans, at March 31, 2019 and December 31, 2018 .
Credit Risk Profile by Internally Assigned Risk Grade
(in thousands)
Commercial and industrial

Commercial real estate, owner-occupied

Commercial real estate, investor

Construction

Home equity

Other residential

Installment and other consumer

Purchased credit-impaired

Total

March 31, 2019
 
 
 
 
 
 
 
 
 
Pass
$
226,164

$
294,713

$
875,562

$
69,580

$
122,578

$
117,558

$
31,312

$
2,098

$
1,739,565

Special Mention
10,312

4,613

2,116


1,121




18,162

Substandard
1,144

10,086


2,691

733


157


14,811

Total loans
$
237,620

$
309,412

$
877,678

$
72,271

$
124,432

$
117,558

$
31,469

$
2,098

$
1,772,538

December 31, 2018
 

 

 

 

 

 

 

 

 

Pass
$
219,625

$
299,998

$
870,443

$
73,735

$
122,844

$
117,847

$
27,312

$
2,112

$
1,733,916

Special Mention
9,957

4,106

2,156


1,121




17,340

Substandard
1,126

7,986


2,688

648


160


12,608

Total loans
$
230,708

$
312,090

$
872,599

$
76,423

$
124,613

$
117,847

$
27,472

$
2,112

$
1,763,864

 
Troubled Debt Restructuring
 
Our loan portfolio includes certain loans modified in a troubled debt restructuring (“TDR”), where we have granted economic concessions to borrowers experiencing financial difficulties. These concessions typically result from our loss mitigation activities and could include reductions in the interest rate, payment extensions, forgiveness of principal, forbearance or other actions. TDRs on non-accrual status at the time of restructure may be returned to accruing status after Management considers the borrower’s sustained repayment performance for a reasonable period, generally six months, and obtains reasonable assurance of repayment and performance.
 
We may remove a loan from TDR designation if it meets all of the following conditions:
The loan is subsequently refinanced or restructured at current market interest rates and the new terms are consistent with the treatment of creditworthy borrowers under regular underwriting standards;
The borrower is no longer considered to be in financial difficulty;
Performance on the loan is reasonably assured; and
Existing loan did not have any forgiveness of principal or interest.

The same Management level that approved the loan classification upgrade must approve the removal of TDR status. There were no loans removed from TDR designation during 2019 . During the three months ended March 31, 2018 , one TIC loan with recorded investments totaling $150 thousand was removed from TDR designation after meeting all of the conditions above.


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The following table summarizes the carrying amount of TDR loans by loan class as of March 31, 2019 and December 31, 2018 .
(in thousands)
 
Recorded Investment in Troubled Debt Restructurings 1
March 31, 2019

December 31, 2018

Commercial and industrial
$
1,198

$
1,506

Commercial real estate, owner-occupied
7,001

6,993

Commercial real estate, investor
1,812

1,821

Construction
2,691

2,688

Home equity
251

251

Other residential
460

462

Installment and other consumer 2
675

685

Total
$
14,088

$
14,406

1 There were no acquired TDR loans as of March 31, 2019 or December 31, 2018 .
2 There were two TDR loans on non-accrual status with recorded investments totaling $64 thousand and $65 thousand at March 31, 2019 and December 31, 2018 , respectively.

The following table presents information for loans modified in a TDR during the presented periods, including the number of modified contracts, the recorded investment in the loans prior to modification, and the recorded investment in the loans at period end after being restructured. The table excludes fully charged-off TDR loans and loans modified in a TDR and subsequently paid-off during the years presented.
(dollars in thousands)
Number of Contracts Modified

Pre-Modification Outstanding Recorded Investment

Post-Modification Outstanding Recorded Investment

Post-Modification Outstanding Recorded Investment at Period End

TDRs during the three months ended March 31, 2019:
 
 
 

None

$

$

$

TDRs during the three months ended March 31, 2018:
 

 

 



None

$

$

$

 
 
 
 
 
During the first three months of 2019 and 2018, there were no defaults on loans that had been modified in a TDR within the prior twelve-month period. We report defaulted TDRs based on a payment default definition of more than ninety days past due.

Impaired Loans

The following tables summarize information by class on impaired loans and their related allowances. Total impaired loans include non-accrual loans, accruing TDR loans and accreting PCI loans that have experienced post-acquisition declines in cash flows expected to be collected.

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(in thousands)
Commercial and industrial

Commercial real estate, owner-occupied

Commercial real estate, investor

Construction

Home equity

Other residential

Installment and other consumer

Total

March 31, 2019
 

 

 

 

 

 

 

Recorded investment in impaired loans:
 
 
 
 
 
 
With no specific allowance recorded
$
328

$

$

$
2,691

$
346

$
460

$
109

$
3,934

With a specific allowance recorded
1,179

7,001

1,812


251


566

10,809

Total recorded investment in impaired loans
$
1,507

$
7,001

$
1,812

$
2,691

$
597

$
460

$
675

$
14,743

Unpaid principal balance of impaired loans
$
1,489

$
6,993

$
1,801

$
2,687

$
595

$
459

$
674

$
14,698

Specific allowance
424

161

47


5


67

704

Average recorded investment in impaired loans during the quarter ended March 31, 2019
1,666

6,997

1,816

2,690

580

461

680

14,890

Interest income recognized on impaired loans during the quarter ended March 31, 2019 1
22

66

20

42

4

5

6

165

Average recorded investment in impaired loans during the quarter ended March 31, 2018
2,216

7,003

2,012

2,972

746

1,070

717