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UNITED STATES SECURITIES AND EXCHANGE COMMISSION 

Washington, D.C. 20549 

 

FORM 10-Q 

 

 

  

 

 (Former name, former address and former fiscal year, if changed since last report) 

 

 

There were 40,336,527 shares of the registrant’s Common Stock, $0.01 par value per share, outstanding at October 24, 2013. 

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Part I.  Financial Information 

Item 1.  Condensed Consolidated Financial Statements (unaudited) 

 

CoBiz Financial Inc. and Subsidiaries 

Condensed Consolidated Balance Sheets (unaudited) 

At September 30, 2013 and December 31, 2012 

 

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CoBiz Financial Inc. and Subsidiaries 

Condensed Consolidated Statements of Operations (unaudited)

For the three and nine months ended September 30, 2013 and 2012 

 

 

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CoBiz Financial Inc. and Subsidiaries 

Condensed Consolidated Statements of Comprehensive Income (unaudited)

For the three and nine months ended September 30, 2013 and 2012 

 

 

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CoBiz Financial Inc. and Subsidiaries 

Condensed Consolidated Statements of Cash Flows (unaudited) 

For the nine months ended September 30, 2013 and 2012 

 

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CoBiz Financial Inc. and Subsidiaries 

Notes to Condensed Consolidated Financial Statements (unaudited) 

 

1. Nature of Operations and Significant Accounting Policies

 

The accompanying unaudited Condensed Consolidated Financial Statements of CoBiz Financial Inc. (Parent), and its subsidiaries:  CoBiz Bank (Bank); CoBiz Insurance, Inc.; CoBiz Insurance - Employee Benefits Inc. (CEB); CoBiz GMB, Inc.; and CoBiz IM, Inc. (CoBiz IM); all collectively referred to as the “Company” or “CoBiz,” conform to accounting principles generally accepted in the United States of America for interim financial information and prevailing practices within the banking industry. The Bank operates in its Colorado market areas under the name Colorado Business Bank (CBB) and in its Arizona market areas under the name Arizona Business Bank (ABB). 

 

The Bank is a commercial banking institution with eight locations in the Denver metropolitan area; one in Boulder; one near Vail; and six in the Phoenix metropolitan area.  As a state chartered bank, deposits are insured by the Bank Insurance Fund of the Federal Deposit Insurance Corporation (FDIC) and the Bank is subject to supervision, regulation and examination by the Federal Reserve, Colorado Division of Banking and the FDIC. Pursuant to such regulations, the Bank is subject to special restrictions, supervisory requirements and potential enforcement actions. CoBiz Insurance, Inc. provides commercial and personal property and casualty (P&C) insurance brokerage.  CEB provides employee benefits consulting to small- and medium-sized business. CoBiz GMB, Inc. provides investment banking services to middle-market companies through its wholly-owned subsidiary, Green Manning & Bunch, Ltd. (GMB). CoBiz IM provides investment management services to institutions and individuals through its subsidiary, CoBiz Investment Management, LLC (CIM).  

 

The following is a summary of certain of the Company’s significant accounting and reporting policies.

 

Basis of Presentation —These financial statements and notes thereto should be read in conjunction with, and are qualified in their entirety by, the Company’s Annual Report on Form 10-K for the year ended December 31, 2012, as filed with the U.S. Securities and Exchange Commission (SEC). 

 

The Condensed Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the instructions to Form 10-Q. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting only of normally recurring accruals) considered necessary for a fair presentation have been included.  Operating results for the three and nine months ended September 30, 2013, are not necessarily indicative of the results that may be expected for the full year ending December 31, 2013. 

 

The consolidated financial statements include entities in which the Parent has a controlling financial interest.  These entities include; the Bank; CoBiz Insurance, Inc.; CEB; CoBiz GMB, Inc.; and CoBiz IM. Intercompany balances and transactions are eliminated in consolidation.  The Company determines whether it has a controlling financial interest in an entity by first evaluating whether the entity is a voting interest entity or a variable interest entity (VIE).

 

The voting interest model is used when the equity investment is sufficient to absorb the expected losses and the equity investment has all of the characteristics of a controlling financial interest. Under the voting interest model, the party with the controlling voting interest consolidates the legal entity.  The VIE model is used when any of the following conditions exist: the equity investment at risk is not sufficient to finance the entity’s activities without additional subordinated financial support; the holders of the equity investment do not have a controlling voting interest; or the holders of the equity investment are not obligated to absorb the expected losses or residual returns of the legal entity. An enterprise is considered to have a controlling financial interest of a VIE if it has both the power to direct the activities that most significantly impact economic performance and the obligation to absorb losses, or receive benefits, that are significant to the VIE. An enterprise that has a controlling financial interest is considered the primary beneficiary and must consolidate the VIE. 

 

Certain reclassifications have been made to prior years’ consolidated financial statements and related notes to conform to current year presentation including the effects of discontinued operations.

 

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Cash and Cash Equivalents — The Company considers all liquid investments with original maturities of three months or less to be cash equivalents. Cash and cash equivalents include amounts that the Company is required to maintain at the Federal Reserve Bank of Kansas City to meet certain regulatory reserve balance requirements. The following table shows supplemental disclosures of certain cash and noncash items:

 

 

Investments — The Company classifies its investment securities as held to maturity, available for sale or trading, according to management’s intent.  

 

Available for sale securities consist of residential mortgage-backed securities (MBS), bonds, notes and debentures (including corporate debt and trust preferred securities (TPS)) not classified as held to maturity securities and are reported at fair value as determined by quoted market prices. Unrealized holding gains and losses, net of tax, are reported as a net amount in AOCI until realized.  

 

Investment securities held to maturity consist of MBS, bonds, notes and debentures for which the Company has the positive intent and ability to hold to maturity and are reported at cost, adjusted for amortization or accretion of premiums and discounts.

 

Premiums and discounts, adjusted for prepayments as applicable, are recognized in interest income.  Other than temporary declines in the fair value of individual investment securities held to maturity and available for sale are charged against earnings. Gains and losses on disposal of investment securities are determined using the specific‑identification method.   

 

Other-than-temporary-impairment (OTTI) on debt securities is separated between the amount that is credit related (credit loss component) and the amount due to all other factors.  The credit loss component is recognized in earnings and is the difference between a security’s amortized cost basis and the discounted present value of expected future cash flows. The amount due to all other factors is recognized in other comprehensive income (OCI).

 

Bank Stocks — Federal Home Loan Bank of Topeka (FHLB), Federal Reserve Bank and other correspondent bank stocks are accounted for under the cost method.   

 

Loans held for investment— Loans that the Company has the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at their outstanding principal balance adjusted for any charge-offs, the allowance for loan losses, deferred fees and costs on originated loans, and unamortized premiums or discounts on purchased loans. Interest is accrued and credited to income daily based on the principal balance outstanding. The accrual of interest income is generally discontinued when a loan becomes 90 days past due as to principal and interest. When a loan is designated as nonaccrual, the current period’s accrued interest receivable is charged against current earnings while any portions relating to prior periods are charged against the allowance for loan losses. Interest payments received on nonaccrual loans are generally applied to the principal balance of the loan. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured and there has been demonstrated performance in accordance with contractual terms.  The Company may elect to continue the accrual of interest when the loan is in the process of collection and the realizable value of collateral is sufficient to cover the principal balance and accrued interest.

 

Loans Held For Sale — Loans held for sale include loans the Company has demonstrated the ability and intent to sell.  Loans held for sale are primarily nonperforming loans.  Loans held for sale are carried at the lower of cost or fair value and are evaluated on a loan-by-loan basis. 

  

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Impaired loans — Impaired loans, with the exception of groups of smaller-balance homogenous loans that are collectively evaluated for impairment, are defined as loans for which, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays of less than 90 days and monthly payment shortfalls of less than 10% of the contractual payment on a consumer loan generally are not classified as impaired if the Company ultimately expects to recover its full investment. The Company determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis by the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price or the fair value of the collateral if the loan is collateral dependent. Loans that are deemed to be impaired are evaluated in accordance with Accounting Standards Codification (ASC) Topic 310-10-35, Receivables – Subsequent Measurement (ASC 310) and ASC Topic 450-20, Loss Contingencies (ASC 450).

 

Included in impaired loans are troubled debt restructurings.  A troubled debt restructuring is a formal restructure of a loan where the Company, for economic or legal reasons related to the borrower’s financial difficulties, grants a concession to the borrower. The concessions may be granted in various forms, including but not limited to reduction in the stated interest rate, reduction in the loan balance or accrued interest, or extension of the maturity date.  Troubled debt restructurings are evaluated in accordance with ASC Topic 310-10-40, Troubled Debt Restructurings by Creditors. Interest payments on impaired loans are typically applied to principal unless collectability of principal is reasonably assured. Loans that have been modified in a formal restructuring are typically returned to accrual status when there has been a sustained period of performance (generally six months) under the modified terms, the borrower has shown the ability and willingness to repay and the Company expects to collect all amounts due under the modified terms. 

 

Loan Origination Fees and Costs — Loan fees and certain costs of originating loans are deferred and the net amount is amortized over the contractual life of the related loans in accordance with ASC Topic 310-20, Nonrefundable Fees and Other Costs. 

 

Allowance for Loan Losses — The allowance for loan losses (ALL) is established as losses are estimated to have occurred through a provision for loan losses charged against earnings. Loan losses are charged against the allowance when management believes the uncollectability of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. 

 

The ALL is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as new information becomes available. 

 

Allowance for Credit Losses — The allowance for credit losses is established as losses are estimated to have occurred through a provision for credit losses charged to earnings. The allowance for credit losses represents management’s recognition of a separate reserve for off-balance sheet loan commitments and letters of credit. While the allowance for loan losses is recorded as a contra-asset to the loan portfolio on the Condensed Consolidated Balance Sheets, the allowance for credit losses is recorded under the caption “Accrued interest and other liabilities”. Although the allowances are presented separately on the balance sheets, any losses incurred from credit losses would be reported as a charge-off in the allowance for loan losses, as any loss would be recorded after the off-balance sheet commitment had been funded.

 

Derivative Instruments — Derivative financial instruments are accounted for at fair value. The Company utilizes interest rate swaps to hedge a portion of its exposure to interest rate changes. These instruments are accounted for as cash flow hedges, as defined by ASC Topic 815, Derivatives and Hedging (ASC 815). The net cash flows from these hedges are classified in operating activities within the Condensed Consolidated Statements of Cash Flows with the hedged items. The Company also uses interest rate swaps to hedge against adverse changes in fair value on fixed-rate loans. These instruments are accounted for as fair value hedges in accordance with ASC 815. The Company also has a derivative program that offers interest-rate caps, floors, swaps and collars to customers of the Bank. The fair value amounts recognized for derivative instruments and the fair value amounts recognized for the right to reclaim or obligation to return cash collateral are offset when represented under a master netting arrangement. 

 

Fair Value Measurements —  The Company measures financial assets, financial liabilities, nonfinancial assets and nonfinancial liabilities pursuant to ASC Topic 820, Fair Value Measurements and Disclosures (ASC 820).  ASC 820

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defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements.

 

Income From Discontinued Operations, Net of Income Taxes —  Income from discontinued operations, net of income taxes for the three and nine months ended September 30, 2013 and 2012 include the results of the wealth transfer business and trust.  During the fourth quarter of 2012, the Company made the decision to close its trust department and sell its wealth transfer business.  Both of these divisions were within the Wealth Management segment.

 

During the fourth quarter of 2012, the Company entered into a transition agreement with another local bank to transfer the fiduciary and custodial accounts of its trust department.  The Company did not receive any compensation for the transfer of its trust customers and the disposed assets and liabilities of the trust department were not material.  On December 31, 2012, the Company completed the sale of certain assets and liabilities, including all rights to the customer lists of the wealth transfer business. 

 

Operating results associated with the trust and wealth transfer divisions for the three and nine months ended September 30, 2013 and 2012 are shown in the following table.

 

 

 

 

 

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2. Earnings per Common Share and Dividends Declared per Common Share 

 

Earnings per common share is calculated based on the two-class method prescribed in ASC 260, Earnings per Share.  The two-class method is an allocation of undistributed earnings to common stock and securities that participate in dividends with common stock.  The Company’s restricted stock awards are considered participating securities since the recipients receive non-forfeitable dividends on unvested awards.  The impact of participating securities is included in common shareholder basic earnings per share for the three and nine months ended September 30, 2013 and 2012. Earnings per common share from discontinued operations was not material in the presented periods and have been excluded from the following table.  Income allocated to common shares and weighted average shares outstanding used in the calculation of basic and diluted earnings per share are as follows: 

 

 

 

 

Dividends on the Senior Non-Cumulative Perpetual Preferred Stock, “Series C Preferred Stock” began accruing at 5.0% when issued in conjunction with the Company’s participation in the Small Business Lending Fund program (SBLF) during 2011.  The dividend rate can fluctuate between 1% and 5% depending on the change in the level of Qualified Small Business Lending (QSBL).  The average dividend rate for the three and nine months ended September 30, 2013 was 1.00% and 1.87%, respectively, compared to an average rate of 5.00% for the prior year periods.  Preferred stock dividends for the three and nine months ended September 30, 2013 were $0.1 million and $0.8 million, respectively, and $0.7 million and $2.2 million for the respective prior year periods, as noted in the table above. Based on QSBL through September 30, 2013, the Series C Preferred Stock dividend rate will be fixed at 1.00% through December 31, 2015.  Beginning in 2016, the applicable dividend rate increases to 9.0%.

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3. Investments 

 

The amortized cost and fair values of investment securities are summarized as follows: 

 

 

 

 

Proceeds from the sale of investments and the gain (loss) recognized on securities sold or called are summarized as follows:

 

 

 

The amortized cost and fair value of investments in debt securities at September 30, 2013, by contractual maturity are shown below.  Expected maturities can differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without penalties. 

 

 

 

 

Investment securities with an approximate fair value of $117.6 million and $141.1 million were pledged to secure public deposits of $139.5 million and $106.9 million at September 30, 2013 and December 31, 2012, respectively.  Securities sold under agreements to repurchase of $164.2 million and $127.9 million at September 30, 2013 and December 31, 2012, respectively, consisted primarily of MBS with an estimated fair value of $183.3 million and $143.2 million, respectively.     

 

Changes in interest rates and market liquidity may cause adverse fluctuations in the market price of securities resulting in temporary unrealized losses.  In reviewing the realizable value of its securities in a loss position, the Company considered the following factors: (1) the length of time and extent to which the market had been less than cost; (2) the financial condition and near-term prospects of the issuer; (3) investment downgrades by rating agencies; and (4) whether it is more likely than not that the Company will have to sell the security before a recovery in value.  When it is probable that the

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Company will be unable to collect all amounts due according to the contractual terms of the security, and the fair value of the investment security is less than its amortized cost, an other-than-temporary impairment is recognized in earnings.  

 

For debt securities that are considered other-than temporarily impaired and that the Company does not intend to sell and will not be required to sell prior to recovery of the amortized cost basis, an OTTI is recognized.  OTTI is separated into the amount that is credit related (credit loss component) and the amount due to all other factors.  The credit loss component is recognized in earnings and is the difference between a security’s amortized cost basis and the discounted present value of expected future cash flows.  The amount due to all other factors is recognized in OCI.   

 

There were 48 and 19 securities in the tables below at September 30, 2013 and December 31, 2012, respectively, in an unrealized loss position.  

 

 

 

 

 

 

The credit component of OTTI recognized in earnings is presented as an addition in two parts based upon whether the current period is the first time the debt security was credit impaired or if it is additional credit impairment.  The credit loss component is reduced if the Company sells, intends to sell or believes it will be required to sell previously credit impaired debt securities.  Additionally, the credit loss component is reduced if the Company receives cash flows in excess of what it expected to receive over the remaining life of the credit impaired debt security or when the security matures.   

 

During the three and nine months ended September 30, 2013, the Company did not have any credit impaired securities.  The following table presents a roll-forward of the credit loss component of OTTI on debt securities recognized in earnings during the three and nine months ended September 30, 2012.

 

 

 

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Other investments at September 30, 2013 and December 31, 2012, consist of the following: 

 

 

Bank stocks consist primarily of stock in the FHLB which is part of the Federal Home Loan Bank System.  The purpose of the FHLB investment relates to maintenance of a borrowing base with the FHLB.  FHLB stock holdings are largely dependent upon the Company’s liquidity position.  To the extent the need for wholesale funding increases or decreases, the Company may purchase additional or sell excess FHLB stock, respectively.  The Company evaluates impairment in this investment based on the ultimate recoverability of the par value and at September 30, 2013, did not consider the investment to be other-than-temporarily impaired. 

   

4. Loans 

 

The following disclosure reports the Company’s loan portfolio segments and classes.  Segments are groupings of similar loans at a level which the Company has adopted systematic methods of documentation for determining its allowance for loan and credit losses. Classes are a disaggregation of the portfolio segments.  The Company’s loan portfolio segments are: 

 

 

 

 

 

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The loan portfolio segments at September 30, 2013 and December 31, 2012 were as follows: 

 

 

The Company uses qualifying loans as collateral for advances and a line of credit from the FHLB.  The FHLB line of credit, which did not have a balance outstanding at September 30, 2013, was collateralized by loans of $771.5 million with a lending value of $456.2 million.   

 

The Company maintains a loan review program independent of the lending function that is designed to reduce and control risk in lending. It includes the continuous monitoring of lending activities with respect to underwriting and processing new loans, preventing insider abuse and timely follow-up and corrective action for loans showing signs of deterioration in quality.  The Company also has a systematic process to evaluate individual loans and pools of loans within our loan portfolio. The Company maintains a loan grading system whereby each loan is assigned a grade between 1 and 8, with 1 representing the highest quality credit, 7 representing a nonaccrual loan where collection or liquidation in full is highly questionable and improbable, and 8 representing a loss that has been or will be charged-off.  Grades are assigned based upon the degree of risk associated with repayment of a loan in the normal course of business pursuant to the original terms.  Loans that are graded 5 or better are categorized as non-classified credits while loans graded 6 or worse are categorized as classified credits.  Loan grade changes are evaluated on a monthly basis.  Loans above a certain dollar amount that are adversely graded are reported to the Special Assets Group Manager and the Chief Credit Officer along with current financial information, a collateral analysis and an action plan.   

  

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The loan portfolio showing total non-classified and classified balances by loan class at September 30, 2013 and December 31, 2012 is summarized below: 

 

 

 

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Transactions in the allowance for loan losses by segment for the three and nine months ended September 30, 2013 and 2012 are summarized below: 

 

 

 

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The Company estimates the ALL in accordance with ASC 310 for purposes of evaluating loan impairment on a loan-by-loan basis and ASC 450 for purposes of collectively evaluating loan impairment by grouping loans with common risk characteristics (i.e. risk classification, past-due status, type of loan, and collateral).  The ALL is comprised of the following components: 

 

 

For collateral dependent loans that have been specifically identified as impaired, the Company measures fair value based on third-party appraisals, adjusted for estimated costs to sell the property.  Upon impairment, the Company will obtain a new appraisal if one had not been previously obtained in the last 6-12 months.  For credits over $2.0 million, the Company engages an additional third-party appraiser to review the appraisal.  For credits under $2.0 million, the Company’s internal appraisal department reviews the appraisal.  All appraisals are reviewed for reasonableness based on recent sales transactions that may have occurred subsequent to or right at the time of the appraisal.  Based on this analysis the appraised value may be adjusted downward if there is evidence that the appraised value may not be indicative of fair value.  Each appraisal is updated on an annual basis, either through a new appraisal or through the Company’s comprehensive internal review process. 

 

Values are reviewed and monitored internally and fair value is re-assessed at least quarterly or more frequently when events or circumstances occur that indicate a change in fair value.  It has been the Company’s experience that appraisals quickly become outdated due to the volatile real estate environment.  As such, fair value based on property appraisals may be adjusted to reflect estimated declines in the fair value of properties since the time the last appraisal was performed.   

 

 

 

Troubled debt restructurings have a direct impact on the allowance to the extent a loss has been recognized in relation to the loan modified.  This is consistent with the Company’s consideration of Migration in determining general reserves. 

 

The aforementioned factors enable management to recognize environmental conditions contributing to incurred losses in the portfolio, which have not yet manifested in Migration.  Due to current and recent adverse economic conditions resulting in increased loan loss levels for the Company, management relies more heavily on actual empirical charge-off history.  Management believes Migration history adequately captures a great percentage of probable incurred losses within the portfolio.

 

In addition to the allocated reserve for graded loans, a portion of the allowance is determined by segmenting the portfolio into product groupings with similar risk characteristics.  Part of the segmentation involves assigning increased reserve factors to those lending activities deemed higher-risk such as leverage-financings, unsecured loans, certain loans lacking personal guarantees, and land acquisition and development loans.     

 

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In assessing the reasonableness of management’s assumptions, consideration is given to select peer ratios, industry standards and directional consistency of the ALL.  Ratio analysis highlights divergent trends in the relationship of the ALL to nonaccrual loans, to total loans and to historical charge-offs.  Although these comparisons can be helpful as a supplement to assess reasonableness of management assumptions, they are not, by themselves, sufficient basis for determining the adequacy of the ALL.  While management utilizes its best judgment and information available, the ultimate adequacy of the allowance is dependent upon a variety of factors beyond the Company’s control, including the performance of our loan portfolio, the economy, changes in interest rates and the view of the regulatory authorities toward loan classifications. 

 

The following table summarizes loans held for investment and the allowance for loan and credit losses on the basis of the impairment method:  

 

 

 

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Information on impaired loans at September 30, 2013 and December 31, 2012 is reported in the following tables:

 

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Interest income of $0.6 million and $1.5 million recognized on impaired loans during the three and nine months September 30, 2013, respectively, represents primarily interest earned on troubled debt restructurings that meet the definition of an impaired loan pursuant to ASU 310-10-35-16 and are subject to disclosure requirement under ASU 310-10-50-15.  During the three and nine months ended September 30, 2012, interest income on impaired loans of $0.5 million and $1.4 million was recognized, respectively.     

   

The table below summarizes transactions as it relates to troubled debt restructurings during the nine months ended September 30, 2013:  

 

 

 

The below table provides information regarding troubled debt restructurings that occurred during the three and nine months ended September 30, 2013 and 2012.  Pre-modification outstanding recorded investment reflects the Company’s recorded investment immediately before the modification.  Post-modification outstanding recorded investment represents the Company’s recorded investment at the end of the reporting period.  The table below does not include loans restructured and paid-off during the periods presented.

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Troubled debt restructurings during the three and nine months ended September 30, 2013 resulted primarily from the extension of repayment terms and interest rate reductions.  The Company had no charge-offs in conjunction with loans restructured during the three and nine months ended September 30, 2013.  The Company recognized charge-offs of $0.1 million and $0.3 million in conjunction with loans restructured during the three and nine months ended September 30, 2012, respectively.  

 

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The following table presents troubled loans restructured within the past 12 months with a payment default during the nine months ended September 30, 2012.  There were no such loans in 2013. 

 

At September 30, 2013 and December 31, 2012 there were $1.8 million and $0.1 million in outstanding commitments on restructured loans, respectively.      

 

The Company’s nonaccrual loans by class at September 30, 2013 and December 31, 2012 are reported in the following table: 

 

 

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The following table summarizes the aging of the Company’s loan portfolio at September 30, 2013.  There were no loans 90 days or more past due and accruing at September 30, 2013.   Recorded investment in loans 90 days or more past due and accruing was immaterial at December 31, 2012. 

 

 

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5. Long-Term Debt

 

Outstanding subordinated debentures and notes payable at September 30, 2013 and December 31, 2012, is summarized as follows:

 

 

During the third and fourth quarter of 2008, the Company completed a private placement of $21.0 million of Subordinated Unsecured Promissory Notes (the Notes).  The Notes had a fixed annual interest rate of 9.00%, paid interest quarterly, and could be prepaid at par without penalty at any time on or after the fifth anniversary of the initial issue date.  The Notes qualified as Tier 2 capital for regulatory capital purposes.  Certain employees and directors of the Company participated in the private placement.  At December 31, 2012 there were $3.5 million in Notes owed to related parties.

 

On August 18, 2013, the Company fully redeemed the Notes for $21.3 million of principal and accrued interest.  Related party Note holders were paid $3.5 million for principal and accrued interest.  The Company continues to maintain its well-capitalized status following the redemption.  See Note 10 to the Condensed Consolidated Financial Statements for presentation of the Company’s current regulatory capital position.

 

6. Derivatives 

 

ASC 815 contains the authoritative guidance on accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and hedging activities. As required by ASC 815, the Company records all derivatives on the consolidated balance sheets at fair value.   

 

The Company is exposed to certain risks arising from both its business operations and economic conditions.  The Company principally manages its exposures to a wide variety of business and operational risks through management of its core business activities. The Company manages economic risks, including interest rate, liquidity and credit risk, primarily by managing the amount, sources, and duration of its assets and liabilities and the use of derivative financial instruments.  Specifically, the Company enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and unknown cash amounts, the value of which are determined by interest rates.  The Company’s derivative financial instruments are used to manage differences in the amount, timing, and duration of the Company’s known or expected cash receipts and its known or expected cash payments principally related to certain variable-rate loan assets and variable-rate borrowings.  The Company also enters into derivative financial instruments to protect against adverse changes in fair value on fixed-rate loans. 

 

The Company’s objective in using derivatives is to minimize the impact of interest rate fluctuations on the Company’s interest expense. To accomplish this objective, the Company uses interest-rate swaps as part of its cash flow hedging strategy.  The Company also offers an interest-rate hedge program that includes derivative products such as swaps, caps, floors and collars to assist its customers in managing their interest-rate risk profile. In order to eliminate the interest-rate risk associated with offering these products, the Company enters into derivative contracts with third parties to offset the customer contracts.  These customer accommodation interest rate swap contracts are not designated as hedging instruments.

 

The Company has agreements with its derivative counterparties that contain a provision where if the Company defaults on any of its indebtedness, including default where repayment of the indebtedness has not been accelerated by the lender, then the Company could also be declared in default on its derivative obligations.  Also, the Company has agreements with certain of its derivative counterparties that contain a provision where if the Bank fails to maintain its status as a well or adequately capitalized institution, then the counterparty could terminate the derivative positions and the Company would be required to settle its obligations under the agreements.  

 

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At September 30, 2013, the fair value of derivatives in a net liability position, including accrued interest but excluding any adjustment for nonperformance risk, related to these agreements was $9.8 million. The Company has minimum collateral posting thresholds with certain of its derivative counterparties and has posted collateral of $20.1 million against its obligations under these agreements.  At September 30, 2013, the Company was not in default with any of its debt or capitalization covenants.

 

The table below presents the fair value of the Company’s derivative financial instruments as well as the classification within the Condensed Consolidated Balance Sheets. 

 

 

The tables below include information required by ASU No. 2011-11 Disclosures about Offsetting Assets and Liabilities, about derivative instruments that are offset in accordance with ASC 815-10-45 or subject to an enforceable master netting arrangement.  Accrued interest is included as part of gross amounts of recognized assets and liabilities in the table below. 

 

 

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Cash Flow Hedges of Interest Rate Risk — For hedges of the Company’s variable-rate loan assets, interest rate swaps designated as cash flow hedges involve the receipt of fixed-rate amounts from a counterparty in exchange for the Company making variable-rate payments over the life of the agreements without exchange of the underlying notional amount.  For hedges of the Company’s variable-rate borrowings, interest-rate swaps designated as cash flow hedges involve the receipt of variable-rate amounts from a counterparty in exchange for the Company making fixed-rate payments.  The Company has executed a series of interest-rate swap transactions in order to fix the effective interest rate for payments due on its junior subordinated debentures with the objective of reducing the Company’s exposure to adverse changes in cash flows relating to payments on its LIBOR-based floating rate debt.  The swaps have contractual lives ranging between five and 14 years.  Select critical terms of the cash flow hedges are as follows:

 

Based on the Company’s ongoing assessments (including at inception of the hedging relationship), it is probable that there will be sufficient variable interest payments through the maturity date of the swaps. The Company also monitors the risk of counterparty default on an ongoing basis. The Company uses the “Hypothetical Derivative” method described in Statement 133 Implementation Issue No. G7, Cash Flow Hedges: Measuring the Ineffectiveness for a Cash Flow Hedge under Paragraph 30(b) When the Shortcut Method Is Not Applied, for both prospective and retrospective assessments of hedge effectiveness on a quarterly basis. The Company also uses this methodology to measure hedge ineffectiveness each period.  The effective portion of changes in the fair value of derivatives designated and that qualify as cash flow hedges is recorded in AOCI and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. These derivatives are used to hedge the variable cash inflows associated with existing pools of LIBOR-based loans, as well as variable cash outflows associated with its junior subordinated debentures.  The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings. The Company’s derivatives did not have any hedge ineffectiveness recognized in earnings during the three and nine months ended September 30, 2013 and 2012. 

 

Amounts reported in AOCI related to derivatives will be reclassified to interest income/expense as interest payments are received/made on the Company’s variable-rate assets/liabilities. During the next 12 months, the Company estimates that $2.2 million will be reclassified as an increase to interest expense and $0.2 million as an increase to interest income. 

 

The following table reports the beginning and ending balance of AOCI relating to derivatives designated as hedging transactions and the associated periodic change, net of reclassifications to earnings and the effect of income taxes for the periods shown.

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Fair Value Hedges of Fixed-Rate Assets —  The Company is exposed to changes in the fair value of certain of its fixed-rate assets due to changes in benchmark interest rates based on LIBOR.  The Company uses interest rate swaps to manage its exposure to changes in fair value on certain fixed rate loans.  Interest rate swaps designated as fair value hedges involve the receipt of variable rate payments from a counterparty in exchange for the Company’s fixed-rate payments over the life of the agreements without the exchange of the underlying notional amount.  The Company performs ongoing retrospective and prospective effectiveness assessments (including at inception) using a regression analysis to compare periodic changes in fair value of the swaps to periodic changes in fair value of the fixed rate loans attributable to changes in the benchmark interest rate.  At September 30, 2013, the Company had five interest rate swaps with a notional amount of $34.6 million used to hedge the change in the fair value of five commercial loans.  For derivatives that are designated and qualify as fair value hedges, the gain or loss on the derivative as well as the gain or loss on the hedged item attributable to the hedged risk are recognized in earnings.  The net amount recognized in noninterest expense during the three and nine months ended September 30, 2013, representing hedge ineffectiveness, was immaterial.

 

Non-designated Hedges — Derivatives not designated as hedges are not speculative and result from a service the Company provides to its customers.  The Company executes interest-rate swaps with commercial banking customers to facilitate their respective risk management strategies.  Those interest-rate swaps are simultaneously hedged by offsetting interest-rate swaps that the Company executes with a third party, such that the Company minimizes its net risk exposure resulting from such transactions.  As the interest-rate swaps associated with this program do not meet the strict hedge accounting requirements, changes in the fair value of both the customer swaps and the offsetting swaps are recognized directly in earnings.   At September 30, 2013, the Company had 116 interest-rate swaps with an aggregate notional amount of $295.9 million related to this program.  Gains and losses arising from changes in the fair value of these swaps are included in “Other income” in the accompanying Condensed Consolidated Statements of Operations and were immaterial for the three months ended September 30, 2013.  For the nine months ended September 30, 2013, gains were $0.4 million.  Gains and losses arising from changes in the fair value of these swaps for the three and nine months ended September 30, 2012 were immaterial.  

 

7. Employee Benefit and Stock Compensation Plans 

 

Stock Options and Awards - During the three and nine months ended September 30, 2013, the Company recognized compensation expense (net of estimated forfeitures) of $0.7  million and $2.2 million, respectively, compared to $0.5 million and $1.5 million in the relative prior year periods. Estimated forfeitures are periodically evaluated based on historical and expected forfeiture behavior.   

 

The following table summarizes changes in option awards during the nine months ended September 30, 2013. 

 

 

The weighted average grant date fair value of options granted during the nine months ended September 30, 2013 was $3.06 per share. 

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The following table summarizes changes in stock awards for the nine months ended September 30, 2013. 

 

 

At September 30, 2013, there was $3.9 million of total unrecognized compensation expense related to unvested share-based compensation arrangements granted under the Company’s equity incentive plans.  The cost is expected to be recognized over a weighted average period of 2.1 years.  

  

8. Segments 

 

The Company’s segments consist of Commercial Banking, Investment Banking, Wealth Management, Insurance and Corporate Support and Other.

 

The Wealth Management segment has historically included the operations of the trust department, CIM and CEB’s wealth transfer business line.  As discussed in Note 1, the Company exited the trust and wealth transfer business lines at December 31, 2012.

 

The financial information for each business segment reflects that information which is specifically identifiable or which is allocated based on an internal allocation method.  The following tables report the results of operations for the three and nine months ended September 30, 2013 and 2012 by operating segment.

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9. Fair Value Measurements 

 

ASC 820 emphasizes that fair value is a market-based measurement, not an entity-specific measurement.  Therefore, a fair value measurement should be determined based on the assumptions that market participants would use in pricing an asset or liability.  As a basis for considering market participant assumptions in fair value measurements, ASC 820 establishes a fair value hierarchy that distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity (observable inputs that are classified within Levels 1 and 2 of the hierarchy) and the reporting entity’s own assumptions about market participant assumptions (unobservable inputs classified within Level 3 of the hierarchy). 

 

 

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In instances where the determination of the fair value measurement is based on inputs from different levels of the fair value hierarchy, the level in the fair value hierarchy within which the entire fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.  The Company evaluates fair value measurement inputs on an ongoing basis in order to determine if there is a change of sufficient significance to warrant a transfer between levels.  For example, changes in market activity or the addition of new unobservable inputs could, in the Company’s judgment, cause a transfer to either a higher or lower level.  For the three and nine months ended September 30, 2013 there were no significant transfers between levels. 

 

A description of the valuation methodologies used for financial instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below. 

 

Available for sale securities – At September 30, 2013, the Company holds, as part of its investment portfolio, available for sale securities reported at fair value consisting of MBS, municipal securities, corporate debt securities and TPS.  The fair value of the majority of MBS and municipal securities are determined using widely accepted valuation techniques including matrix pricing and broker-quote based applications.  Inputs include benchmark yields, reported trades, issuer spreads, prepayment speeds and other relevant items.  As a result, the Company has determined that these valuations fall within Level 2 of the fair value hierarchy. The Company’s TPS are recorded at fair value based on unadjusted quoted market prices for identical securities in an active market.  The majority of the TPS are actively traded in the market and as a result, the Company has determined that the valuation of these securities falls within Level 1 of the fair value hierarchy.  The Company also holds certain TPS and corporate debt securities for which unadjusted market prices are not available or the markets are not active and are therefore classified as Level 2.  For these securities, broker-dealer quotes, valuations based on similar but not identical securities or the most recent market trade (which may not be current), are used.  The Company holds other single-issuer TPS for which the fair value is determined using broker-dealer quotes and is classified as a Level 3 due to the illiquid nature of this type of security.

 

Derivative financial instruments – The Company uses interest-rate swaps as part of its cash flow strategy to manage its interest-rate risk.  The valuation of these instruments is determined using widely accepted valuation techniques as discussed further below.  The fair values of interest-rate swaps are determined using the market standard methodology of netting the discounted future fixed cash receipts (or payments) and the discounted expected variable cash payments (or receipts).  The variable cash payments (or receipts) are based on an expectation of future interest rates (forward curves) derived from observable market interest rate curves.   

 

Pursuant to guidance in ASC 820, credit valuation adjustments are incorporated into the valuation to appropriately reflect both the Company’s own nonperformance risk and the respective counterparty’s nonperformance risk in the fair value measurements.  In adjusting the fair value of its derivative contracts for the effect of nonperformance risk, the Company has considered the impact of netting and any applicable credit enhancements, such as collateral postings and thresholds. The Company has made an accounting policy election to measure the credit risk of its derivative financial instruments that are subject to master netting agreements on a net basis by counterparty portfolio.  

 

The Company uses Level 2 and Level 3 inputs to determine the valuation of its derivatives portfolio.  The valuation of derivative instruments is determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs (Level 2 inputs), including interest rate curves and implied volatilities. The estimates of fair value are made using a standardized methodology that nets the discounted expected future cash receipts and cash payments (based on observable market inputs). Level 3 inputs include the credit valuation adjustments which use estimates of current credit spreads to evaluate the likelihood of default by the Company and its counterparties.  At September 30, 2013 and December 31, 2012, the Company assessed the impact of the Level 3 inputs on the overall derivative valuations in terms of the significance of the credit valuation adjustments in basis points and as a percentage of the overall derivative portfolio valuation and the overall notional value.  The Company’s assessment determined that credit valuation adjustments were not significant to the overall valuation of the portfolio.  In addition, the significance of the credit value adjustments and overall derivative portfolio to the Company’s financial statements was considered.  As a result of the insignificance of the credit value adjustments to the derivative portfolio valuations and the Company’s financial statements, the Company classified the derivative valuations in their entirety in Level 2.  

 

Impaired loans – Certain collateral-dependent impaired loans are reported at the fair value of the underlying collateral.  Impairment is measured based on the fair value of the collateral, which is typically derived from appraisals that take into consideration prices in observed transactions involving similar assets and similar locations.  Each appraisal is updated on an annual basis, either through a new appraisal or through the Company’s comprehensive internal review process. Appraised values are reviewed and monitored internally and fair value is assessed at least quarterly or more frequently

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when circumstances occur that indicate a change in fair value has occurred.  The Company classified impaired loans as Level 3.  

 

The following tables present the Company’s assets and liabilities measured at fair value on a recurring basis at September 30, 2013 and December 31, 2012, aggregated by the level in the fair value hierarchy within which those measurements fall.

 

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A reconciliation of the beginning and ending balances of assets measured at fair value, on a recurring basis, using Level 3 inputs follows:

 

Fair value is used on a nonrecurring basis to evaluate certain financial assets and financial liabilities in specific circumstances.  The following table presents the Company’s assets measured at fair value on a nonrecurring basis at the dates specified in the following table, aggregated by the level in the fair value hierarchy within which those measurements fall. 

 

 

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During the three and nine months ended September 30, 2013, the Company recorded a $0.4 million provision for loan loss reversal and a $1.1 million loan loss provision on impaired loans, respectively.  For the three and nine months ended September 30, 2013 the Company recorded net recoveries and charge-offs of $0.1 million and $0.8 million, respectively, on impaired loans, respectively.  

 

Fair value is also used on a nonrecurring basis for nonfinancial assets and nonfinancial liabilities such as foreclosed assets, other real estate owned, intangible assets, nonfinancial assets and liabilities evaluated in a goodwill impairment analysis and other nonfinancial assets measured at fair value for purposes of assessing impairment.  A description of the valuation methodologies used for nonfinancial assets measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below.    

 

Other real estate owned (OREO) – OREO represents real property taken by the Company either through foreclosure or through a deed in lieu thereof from the borrower.  The fair value of OREO is based on property appraisals adjusted at management’s discretion to reflect a further decline in the fair value of properties since the time the appraisal analysis was performed.  It has been the Company’s experience that appraisals quickly become outdated due to the volatile real estate environment.  Therefore, the inputs used to determine the fair value of OREO fall within Level 3. The Company may include within OREO other repossessed assets received as partial satisfaction of a loan.  Other repossessed assets are not material and do not typically have readily determinable market values and are considered Level 3 inputs. 

 

The following tables present the Company’s nonfinancial assets measured at fair value on a nonrecurring basis at September 30, 2013 and December 31, 2012, aggregated by the level in the fair value hierarchy within which those measurements fall. 

 

In accordance with ASC 310, the fair value of OREO recorded as an asset is reduced by estimated selling costs.  The following table is a reconciliation of the fair value measurement of OREO disclosed pursuant to ASC 820 to the amount recorded on the Condensed Consolidated Balance Sheets:

 

Valuation adjustments on OREO and additional gains or losses at the time OREO is sold are recognized in current earnings under the caption “Loss on securities, other assets and other real estate owned.”  Below is a summary of OREO transactions during the nine months ended September 30, 2013:

 

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The following table provides information describing the valuation processes used to determine recurring and nonrecurring fair value measurements categorized within Level 3 of the fair value hierarchy.

 

 

 

 

 

The following table includes the estimated fair value of the Company’s financial instruments. The methodologies for estimating the fair value of financial assets and financial liabilities measured at fair value on a recurring and nonrecurring basis are discussed above.  The methodologies for estimating the fair value for other financial assets and financial liabilities are discussed below.  The estimated fair value amounts have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is required to interpret market data in order to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts at September 30, 2013 and December 31, 2012.  

 

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The fair value estimation methodologies utilized by the Company for financial instruments and the classification level within the fair value hierarchy that those instruments fall are summarized as follows: 

  

Cash and cash equivalents — The carrying amount of cash and cash equivalents is a reasonable estimate of fair value which is classified as Level 2. 

  

Restricted cash — The carrying amount of restricted cash is a reasonable estimate of fair value which is classified as Level 2. 

 

Other investments — Included in this category are the Company’s investment in the FHLB and other equity method investments.  Due to restrictions on transferability, it is not practical to estimate fair value on the FHLB investment which is reported at carrying value.  The fair value of other equity method investments approximates fair value and is classified as Level 2.   

  

Loans — The fair value of loans is estimated by discounting future contractual cash flows using estimated market rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.  In computing the estimate of fair value for all loans, the estimated cash flows and/or carrying value have been reduced by specific and general reserves for loan losses. The fair value of loans is classified as Level 3 within the fair value hierarchy. 

  

Accrued interest receivable/payable — The fair value of accrued interest receivable/payable approximates the carrying amount due to the short-term nature of these amounts and is classified in the same hierarchy level as the underlying assets/liabilities. 

  

Deposits — The fair value of certificates of deposit is estimated by discounting the expected life using an index of the LIBOR swap curve.  Non-maturity deposits are reflected at their carrying value for purposes of estimating fair value. The fair value of all deposits is classified as Level 2. 

  

Short-term borrowings — The estimated fair value of short-term borrowings approximates their carrying value, due to their short-term nature and is classified as Level 2. 

  

Securities sold under agreements to repurchase — Estimated fair value is based on discounting cash flows for comparable instruments and is classified as Level 2. 

  

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Junior subordinated debentures — The estimated fair value of junior subordinated debentures approximates their carrying value, due to the variable interest rate paid on the debentures and is classified as Level 2. 

 

Subordinated notes payable — The estimated fair value of subordinated notes payable is based on discounting cash flows for comparable instruments and is classified as Level 3. 

  

Commitments to extend credit and standby letters of credit — The Company’s off-balance sheet commitments are funded at current market rates at the date they are drawn upon. It is management’s opinion that the fair value of these commitments would approximate their carrying value, if drawn upon, and are classified as Level 3. 

  

The fair value estimates presented herein are based on pertinent information available to management at September 30, 2013 and December 31, 2012. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since that date and, therefore, current estimates of fair value may differ significantly from the amounts presented herein.

  

10. Regulatory Matters 

 

The following table shows capital amounts, ratios and regulatory thresholds at September 30, 2013:   

 

 

 

 

 

 

(1) The ratios for the well-capitalized requirement are only applicable to the Bank.  However, the Company manages its capital position as if the requirement applies to the consolidated entity and has presented the ratios as if they also applied to the Company. 

 

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 11.  Supplemental Financial Data 

 

Other income and Other expense as shown in the Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2013 and 2012 is detailed in the following schedules to the extent the components exceed one percent of the aggregate of total interest income and other income. 

 

 

 

 

 

 

 

 

 

Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

This discussion should be read in conjunction with our Condensed Consolidated Financial Statements and notes thereto included in this Form 10-Q. Certain terms used in this discussion are defined in the notes to these financial statements. For a description of our accounting policies, see Note 1 of the Notes to Consolidated Financial Statements included in our Form 10-K for the year ended December 31, 2012. For a discussion of the segments included in our principal activities, see Note 8 of the Notes to the Condensed Consolidated Financial Statements.

 

Executive Summary

 

CoBiz Financial Inc. is a $2.8 billion financial holding company offering a broad array of financial service products to its target market of professionals, small and medium-sized businesses, and high-net-worth individuals primarily in Arizona and Colorado. Our operating segments include: Commercial Banking, Investment Banking, Wealth Management and Insurance.

 

Earnings are derived primarily from our net interest income, which is interest income less interest expense, and our noninterest income earned from fee-based business lines and banking service fees, offset by noninterest expense. As the majority of our assets are interest-earning and our liabilities are interest-bearing, changes in interest rates impact our net interest margin, the largest component of our operating revenue (defined as net interest income plus noninterest income). We manage our interest-earning assets and interest-bearing liabilities to reduce the impact of interest rate changes on our operating results. We also have focused on reducing our dependency on the net interest margin by increasing our noninterest income from complementary financial service activities including investment banking, wealth management and insurance brokerage.

 

Industry Overview

 

At the September 2013 meeting, the Federal Open Market Committee (FOMC) kept the target range for federal funds rate at 0-25 basis points.  The FOMC noted that while some indicators of labor market conditions have shown improvement, the unemployment rate remains elevated.  The FOMC currently anticipates that the low range of the target federal funds rate will remain appropriate for as long as the unemployment rate is above 6.5% and inflation is projected to be no more than a half percentage point above the Committee’s 2% goal. The FOMC also stated that the downside risks to the

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outlook of the economy and the labor market have diminished since last fall, while at the same time economic activity and labor market conditions have improved.  However, the FOMC decided to continue purchasing additional agency mortgage backed and longer-term Treasury securities at a combined pace of $85 billion each month.  This is intended to keep downward pressure on longer-term interest rates, support mortgage markets and help make broader financial conditions more accommodative.  The FOMC intends to await more evidence that economic activity and labor market improvements will be sustained before adjusting the pace of its purchases. 

 

Labor markets have improved in 2013 with the national unemployment rate decreasing to 7.3% in August, down from respective averages of 8.1% and 8.9% in 2012 and 2011 and the lowest level since November 2008.  Between August 2012 and August 2013, Colorado and Arizona were two of the states noted as having statistically significant employment increases at 2.5% and 2.0%, respectively. 

 

In the second quarter of 2013, FDIC insured commercial banks and savings institutions reported combined earnings of $42.2 billion, 23% higher than the second quarter of 2012.  This was the 16th consecutive quarter that earnings registered a year-over-year increase.  However, the average Return on Assets (ROA) of 1.17% for the second quarter of 2013 remains below the average ROA of 1.27% for the industry between 2000-2006. Earnings for the industry continue to be restrained by a diminishing net interest income.  Net interest income for the industry fell for the third consecutive quarter and for the fourth time in the past five quarters.  Higher noninterest income and lower noninterest expense helped improve earnings on a year-over-year basis.   

 

On July 2, 2013, one year after issuing notices of proposed rulemaking, the Federal Reserve Board approved a final rule to implement the Basel III regulatory capital reforms and certain changes required by the Dodd-Frank Wall Street Reform and Consumer Protection Act.  The FDIC and the Office of the Comptroller of the Currency subsequently approved the final rule on July 9, 2013.  The rule becomes effective for large banks subject to the advanced approaches risk-based capital rules on January 1, 2014.  Non-advanced approaches banks will implement the final rule beginning January 1, 2015, the implementation date for the Company.  The final rule minimizes the impact on smaller, less complex financial institutions.  Key highlights of the final rule for non-advanced approaches banks such as the Company include:

 

 

 

 

Financial and Operational Highlights

 

As discussed in Note 1 to the Condensed Consolidated Financial Statements, the Company sold its wealth transfer division that focused on high-end life insurance and closed its trust department during the fourth quarter of 2012.  The results of operations related to these areas have been reported as discontinued operations.  The prior period disclosures in the following section of this report have been adjusted to conform to the new presentation.  Noted below are some of the Company’s significant financial performance measures and operational results for the first nine months of 2013:

 

 

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Critical Accounting Policies

 

The Company’s discussion and analysis of its financial condition and results of operations are based upon the Company’s Condensed Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the instructions to Form 10-Q. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. In making those critical accounting estimates, we are required to make assumptions about matters that may be highly uncertain at the time of the estimate. Different estimates we could reasonably have used, or changes in the assumptions that could occur, could have a material effect on our financial condition or results of operations. In addition to the discussion on fair value measurements and deferred taxes below, a description of our critical accounting policies was provided in the Management’s Discussion and Analysis of Financial Condition and Results of Operations section of our Annual Report on Form 10-K for the year ended December 31, 2012.

 

Fair Value Measurements.  The Company measures or monitors certain assets and liabilities on a fair value basis in accordance with GAAP.  ASC 820 emphasizes that fair value is a market-based measurement, not an entity-specific measurement.  Therefore, a fair value measurement should be determined based on the assumptions that market participants would use in pricing an asset or liability.  As a basis for considering market participant assumptions in fair value measurements, ASC 820 establishes a fair value hierarchy that distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity (observable inputs that are classified within Levels 1 and 2 of the hierarchy) and the reporting entity’s own assumptions about market participant assumptions (unobservable inputs classified within Level 3 of the hierarchy). Fair value may be used on a recurring basis for certain assets and liabilities such as available for sale securities and derivatives in which fair value is the primary basis of accounting.  Similarly, fair value may be used on a nonrecurring basis to evaluate certain assets or liabilities such as impaired loans and other real estate owned (OREO).  Depending on the nature of the asset or liability, the Company uses various valuation techniques and assumptions in accordance with ASC 820 to determine the instrument’s fair value.  At September 30, 2013 there were $568.5 million or 20.0% of total assets recorded at fair value on a recurring basis consisting of $560.8 million in available for sale securities and $7.8 million in derivative instruments.  At September 30, 2013, $11.2 million or 0.4% of total liabilities represents liabilities recorded at fair value on a recurring basis, consisting of derivative liabilities. Assets recorded at fair value on a nonrecurring basis at September 30, 2013, consist of impaired loans totaling $13.5 million or 0.5% of total assets.

 

At September 30, 2013, the Company holds, as part of its investment portfolio, available for sale securities reported at fair value consisting of MBS, government agencies, municipal securities, and corporate debt securities.  The fair value of the majority of these securities is determined using widely accepted valuation techniques, including matrix pricing and broker-quote based applications, considered Level 2 inputs.  The Company also holds TPS, the majority of which are recorded at fair value based on quoted market prices, considered by the Company Level 1 inputs.  Certain TPS are valued using broker-dealer quotes, which are considered by the Company an unobservable input (Level 3), totaled $1.0 million at September 30, 2013.  Investments incorporating Level 3 inputs as part of their valuation represent less than 0.1% of total assets at the report date.

 

The Company uses interest-rate swaps as part of its cash flow strategy to manage its interest-rate risk.  The valuation of these instruments is determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative. To comply with the provisions of ASC 820, credit valuation adjustments are incorporated into the valuation to appropriately reflect both the Company’s own nonperformance risk and the respective counterparty’s nonperformance risk in the fair value measurements.  Although the Company has determined that the majority of the inputs used to value its derivatives fall within Level 2 of the fair value hierarchy, the credit valuation

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adjustments associated with its derivatives utilize Level 3 inputs (i.e. estimates of current credit spreads to evaluate the likelihood of default by itself and its counterparties).  However, at September 30, 2013 and December 31, 2012, the Company concluded that the impact of the credit valuation adjustments on the overall valuation of its derivative positions is not significant.  Therefore, the Company has determined that its derivative valuations in their entirety are classified in Level 2 of the fair value hierarchy.

 

Certain collateral-dependent impaired loans are reported at the fair value of the underlying collateral.  Impairment is measured based on the fair value of the collateral, which is typically derived from appraisals taking into consideration prices in observed transactions involving similar assets and similar locations, in accordance with GAAP.

 

OREO and repossessed assets represents real property taken by the Bank either through foreclosure or through a deed in lieu thereof from the borrower.  At the time of foreclosure, OREO is measured at fair value, less selling costs, which becomes its new costs basis.  Subsequent to acquisition, OREO is carried at the lower of cost or fair value, less selling costs.  Fair values are based on property appraisals, generally considered a Level 2 input by the Company.  However, where the Company has adjusted an appraisal valuation downward due to its expectation of market conditions, the adjusted value is considered a Level 3 input.

 

Deferred Tax Assets.  At September 30, 2013, the Company has recorded net deferred tax assets of $26.6 million which relate to expected future deductions arising in large part from the allowance for loan losses.  Since there is no absolute assurance that these assets will be realized, the Company evaluates its ability to carryback losses, its tax planning strategies and forecasts of future earnings to determine the need for a valuation allowance on these assets.  If current available information raises doubt as to the realization of the deferred tax assets, a valuation allowance may be established.  The Company did not have a valuation allowance at September 30, 2013 or December 31, 2012.

 

 

 

Financial Condition

 

Total assets at September 30, 2013 were $2.81 billion, increasing $154.3 million or 5.82% from $2.65 billion at December 31, 2012.  Assets consist primarily of loans net of allowance for losses and investment securities, accounting for 92% of total assets.  Total liabilities at September 30, 2013, were $2.54 billion, increasing $138.4 million or 5.8% from $2.40 billion at December 31, 2012.  Liabilities consist primarily of deposits and securities sold under agreements to repurchase, comprising 96% of total liabilities.  Shareholder’s equity at September 30, 2013 was $272.9 million, increasing $15.9 million or 6.2% from $257.1 million at December 31, 2012.  The following paragraphs discuss changes in the relative mix of certain assets and liability classes and reasons for such changes.

 

Investments.  The Company manages its investment portfolio to provide interest income and to meet the collateral requirements for public deposits, customer repurchases and wholesale borrowings. Investments account for 20.8% of total assets at September 30, 2013, compared to 21.5% at December 31, 2012. 

 

The investment portfolio is primarily comprised of MBS explicitly (GNMA) and implicitly (FNMA and FHLMC) backed by the U.S. Government. The portfolio does not include any securities exposed to sub-prime mortgage loans. The investment portfolio also includes single-issuer TPS and corporate debt securities. The corporate debt securities portfolio is mainly comprised of six Fortune 100 issuers.  Over eighty percent of the corporate debt securities portfolio is investment grade. None of the issuing institutions are in default, nor have interest payments on the TPS been deferred.

 

The net unrealized gain on available for sale securities decreased $9.4 million to $7.5 million at September 30, 2013 from $16.8 million at December 31, 2012, as a result of an increase in interest rates during 2013.    The Company did not recognize any OTTI in earnings during the three and nine months ended September 30, 2013.

 

 

Loans.  Gross loans held for investment increased by $122.4 million to $2.05 billion at September 30, 2013, from $1.93 billion at December 31, 2012. During the nine months ended September 30, 2013, the Company advanced $363.8 million

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in new credit relationships and an additional $257.3 million on existing lines.  Offsetting credit extensions were primarily Paydowns and maturities of $495.5 million and gross charge-offs of $3.2 million.

 

 

The commercial and consumer loan segments drove loan growth during the first nine months of 2013.  Commercial loans increased $86.0 million or 12% while consumer lending, primarily jumbo mortgages, increased $30.6 million or 20% since the beginning of 2013.  

 

The allowance for loan losses decreased $5.1 million during the nine months ended September 30, 2013, through net charge-offs of $0.8 million and release of net excess reserves of $4.2 million.  The reduction in the allowance for loan losses even as lending grows is the result of continued credit quality improvement across all loan segments.  See the Provision and Allowance for Loan and Credit Losses section and Note 4 to the Condensed Consolidated Financial Statements for additional discussion.

 

Deferred Income Taxes.  Net deferred income tax assets decreased $5.0 million to $26.6 million at September 30, 2013, from $31.6 million at December 31, 2012. The decrease was primarily related to the tax effect of the following events during the first nine months of 2013:  decline in the allowance for loan and credit losses ($1.9 million); settlement of bonus, stock, and deferred compensation obligations ($2.0 million); and valuation changes in the derivatives portfolio ($1.6 million).  Offsetting these items was a net change in other items ($0.5 million).

 

Other Real Estate Owned.  OREO decreased $3.6 million to $7.0 million at September 30, 2013, from $10.6 million at December 31, 2012.  During the nine months ended September 30, 2013, the Company received proceeds of $5.2 million on the sale of five Colorado and two Arizona properties.  Gains recognized on OREO were $1.4 million during the first nine months of 2013.  At September 30, 2013, $1.1 million of OREO was in Arizona and $5.9 million was in Colorado.

 

Other Assets. Other assets were $22.9 million at September 30, 2013, down $10.0 million from December 31, 2012.  The decrease related primarily to repayment by the FDIC of the Company’s prepaid assessment ($1.0 million), release of restricted cash held with a correspondent bank ($4.5 million), decrease in the fair market value of derivatives assets ($2.3 million) and decreases in fees receivable ($1.9 million).

 

Deposits.  Total deposits increased  $139.9 million to $2.27 billion at September 30, 2013 from $2.13 billion at December 31, 2012.  Noninterest-bearing deposits drove the total deposit increase growing $130.8 million or 15% year to date. Noninterest-bearing deposits have accounted for more than 40% of total deposits since the third quarter of 2012 and were 43.6% at September 30, 2013.   At the end of 2012, Dodd-Frank unlimited insurance for noninterest-bearing transaction accounts expired and as a result funds deposited in noninterest-bearing deposit accounts no longer receive unlimited deposit insurance coverage by the FDIC.  All depositors’ accounts, including all noninterest-bearing transaction accounts will be insured by the standard maximum deposit insurance amount of $250,000.  In response to the expiration of the unlimited FDIC insurance, the Company began offering a new deposit product in 2013 similar to CDARS  (discussed below) that provides  a way for customers to obtain full FDIC coverage on transaction accounts through a reciprocal deposit network.  While the Company does not believe there will be a significant outflow of deposits due to the expiration of unlimited FDIC insurance, if this were to occur, the Company’s liquidity and results of operations may be negatively impacted.

 

The Company views its reciprocal Certificate of Deposit Account Registry Service® (CDARS) accounts as customer-related accounts.  The CDARS program is provided through a third party and designed to provide full FDIC insurance on deposit amounts larger than the stated maximum by exchanging or reciprocating larger depository relationships with other member banks. Depositor funds are broken into smaller amounts and placed with other banks that are members of the

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network. Each member bank issues CDs in amounts under $250,000, so the entire deposit is eligible for FDIC insurance. CDARS are technically brokered deposits, however, the Company considers the reciprocal deposits placed through the CDARS program as core funding due to the customer relationship that generated the transaction and does not report the balances as brokered sources in its internal or external financial reports.

 

 

Securities Sold Under Agreements to Repurchase.  Securities sold under agreement to repurchase (Customer Repos) are transacted with customers as a way to enhance our customers’ interest-earning ability.  The Company does not consider Customer Repos to be a wholesale funding source, but rather an additional treasury management service provided to our customer base. Our customer repos are based on an overnight investment sweep that can fluctuate based on our customers’ operating account balances. Customer repos increased 28% during the first nine months 2013.

 

Other Short-Term Borrowings.  Other short-term borrowings normally consist of federal funds purchased and overnight and term borrowings from the FHLB.  Short-term borrowings are used as part of our liquidity management strategy and fluctuate based on the Company’s cash position. The Company’s wholesale funding needs are largely dependent on core deposit levels which can be volatile in uncertain economic conditions and sensitive to competitive pricing. A decline in deposits and growth in the loan portfolio increases the Company’s need for wholesale borrowings.  At September 30, 2013 and December 31, 2012, the Company had no short-term borrowings outstanding.  If the Company is unable to retain deposits or maintain deposit balances at a level sufficient to fund asset growth, the composition of interest-bearing liabilities may shift toward additional wholesale funds, which historically bear a higher interest cost than core deposits.

Accrued Interest and Other Liabilities.  Accrued interest and other liabilities decreased $16.8 million from the end of 2012 to $29.5 million at September 30, 2013.  The decrease is attributed to lower income tax accruals ($1.5 million), bonus and deferred compensation items ($3.8 million), a decrease in the fair market value of derivative liabilities ($8.2 million) and a decrease in other liabilities ($3.3 million).

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Results of Operations

 

Overview

 

The following table presents the Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2013 and 2012.

 

 

Annualized ROA for the three and nine months ended September 30, 2013 increased to 1.02% compared to 1.00% and 0.92% in the comparable prior year periods.  Annualized return on average shareholders’ equity for the three and nine months ended September 30, 2013 was 10.34% and 10.25%, respectively, compared to 10.23% and 9.56% in the comparable prior year periods.  Improvement in both earnings metrics is attributable to the negative provision for loan losses, and an increase in contributions by fee-based business lines.  Noninterest income as a percentage of operating revenue increased to 24.15% and 24.21% for the three and nine months ended September 30, 2013, respectively, compared to 21.59% and 22.08% in the comparable prior year periods.  The Company’s efficiency ratio was 75.10% and 74.00% for the three and nine months ended September 30, 2013, respectively, compared to 75.28% and 75.46% in the comparable prior year periods.

 

Net Interest Income.  The largest component of our net income is our net interest income.  Net interest income is the difference between interest income, principally from loans and investment securities, and interest expense, principally on customer deposits and borrowings. Changes in net interest income result from changes in volume, net interest spread and net interest margin. Volume refers to the average dollar levels of interest-earning assets and interest-bearing liabilities. Net interest spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities. Net interest margin refers to net interest income divided by average interest-earning assets and is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities.

 

As the majority of our assets are interest-earning and our liabilities are interest-bearing, changes in interest rates may impact our net interest margin. The FOMC uses the federal funds rate, which is the interest rate used by banks to lend to each other, to influence interest rates and the national economy. Changes in the fed funds rate have a direct correlation to changes in the prime rate, the underlying index for most of the variable-rate loans issued by the Company.  The FOMC has held the target federal funds rate at a range of 0-25 basis points since December 2008. 

 

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The following table sets forth the average amounts outstanding for each category of interest-earning assets and interest-bearing liabilities, the interest earned or paid on such amounts on a taxable equivalent basis, and the average rate earned or paid for the three and nine months ended September 30, 2013 and 2012.

 

 

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(1)Interest earned has been adjusted to reflect tax exempt assets on a fully tax-equivalent basis.

(2)Loan fees included in interest income are not material.  Nonaccrual loans are included with average loans outstanding.

(3)Yields have been adjusted to reflect a tax-equivalent basis where applicable.

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Net interest income on a taxable equivalent basis for the three and nine months ended September 30, 2013 rose 5.7% and 2.0%, respectively, compared to the prior year periods.  Average interest-earning assets for the three and nine months ended September 30, 2013 increased $211.9 million and $201.2 million to $2.58 billion and $2.51 billion, respectively. Growth in interest-earning assets was driven primarily by a $258.7 million and $266.1 million increase in average net loans during the three and nine months ended September 30, 2013, respectively.  The positive effect of interest-earning asset growth on the net interest margin was offset by lower yields due to the current low interest rate environment.  The tax-equivalent net interest margin dropped to 3.87% and 3.89% during the three and nine months ended September 30, 2013, respectively, from 4.00% and 4.14% in the comparable prior year periods.  During the three and nine months ended September 30, 2013, average yields on interest-earning assets decreased 23 basis points and 33 basis points, respectively, from the comparable prior year periods.

 

Including noninterest-bearing deposits, the Company’s overall deposit interest cost decreased to 21 basis points and 23 basis points for the three and nine months ended September 30, 2013, respectively, down from 31 basis points and 33 basis points in the comparable prior year periods.  Average rates on total interest-bearing liabilities for the three and nine months ended September 30, 2013 decreased 20 basis points and 16 basis points to 0.66% and 0.72%, respectively, driven primarily by lower rates on NOW and money market deposits and CDs.

 

The following table presents noninterest income for the three and nine months ended September 30, 2013 and 2012.

 

 

Service Charges. Service charges primarily consist of fees earned from our treasury management services.  Customers are given the option to pay for these services in cash or by offsetting the fees for these services against an earnings credit that is given for maintaining noninterest-bearing deposits.  Service charges grew in the current quarter compared to a year ago due to growth in the average balance of deposit accounts using our treasury management services.

 

Investment Advisory Income.  Investment advisory income increased $0.1 million and $0.6 million during the three and nine months ended September 30, 2013 compared to the prior year periods.  Fees earned are generally based on a percentage of the assets under management (AUM) and market volatility has a direct impact on earnings.  Average AUM for the first nine months of 2013 grew approximately 5.5% compared to the first nine months of 2012 and totaled $789.7 million at September 30, 2013.

 

Insurance Income.  Insurance income is derived from two main areas: benefits consulting and P&C.  Revenue from benefits consulting and P&C are recurring revenue sources as policies and contracts generally renew or rewrite on an annual or more frequent basis.  Insurance revenue for the three and nine months ended September 30, 2013 increased $0.5 million and $1.2 million, respectively, compared to the prior year periods on higher income from both areas.  Benefits consulting contributed 48% of total insurance income and P&C contributed 52% in the nine months ended September 30, 2013, unchanged from the same period in 2012.

 

Investment Banking Income.  Investment banking income includes retainer fees which are recognized over the expected term of the engagement and success fees which are recognized when the transaction is completed and collectability of fees is reasonably assured. Investment banking income is transactional by nature and will fluctuate based on the number of clients engaged and transactions successfully closed. During the three and nine months ended September 30, 2013, investment banking revenues increased $0.4 million and $0.9 million compared to the prior year periods due to an increase in the number of deal closings and active engagements.

 

Other Income.  Other income is comprised of increases in the cash surrender value of bank-owned life insurance, earnings on equity method investments, swap fees, merchant charges, bankcard fees, wire transfer fees, foreign

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exchange fees and safe deposit income.  Other income for the three and nine months ended September 30, 2013 increased $0.2 million and decreased $0.3 million, respectively, from the comparable prior year periods.  

 

The following table presents noninterest expense for the three and nine months ended September 30, 2013 and 2012.

 

 

nm = not meaningful

 

Salaries and Employee Benefits.  Salaries and employee benefit expense increased 16.9% or $2.4 million and 7.3% or $3.1 million for the three and nine months ended September 30, 2013, respectively. The increase relates to annual cost of living and merit increases effective in the second quarter of 2013, an increase in variable compensation due to an increase in fee-based income, an increase in incentive compensation, and higher medical expenses.  The Company had 510 full-time equivalent employees at September 30, 2013, up from 502 a year earlier. 

 

Share-based Compensation. The Company uses share-based compensation to recruit new employees and reward and retain existing employees.  Share-based compensation increased during the three and nine months ended September 30, 2013 compared to the prior year periods due to the issuance of restricted stock during the first quarter of 2013 coupled with an increase in the grant-date fair value of awards.  The Company recognizes compensation costs for the grant-date fair value of awards issued to employees and expects to continue using share-based compensation in the future.

 

Occupancy Costs.  Occupancy costs consist primarily of rent, depreciation, utilities, property taxes and insurance.  Occupancy costs remained relatively stable during the three and nine months ended September 30, 2013, with year to date expense decreasing $0.3 million or 3% compared to the prior year period due to lower rent, common area and utilities expense.

 

FDIC and Other Assessments.  FDIC and other assessments consist of premiums paid by the Company that are required for all FDIC-insured institutions and Colorado chartered banks.  The assessments are based on statutory and risk classification factors.  FDIC and other assessments were stable compared to prior year periods.

 

OREO and Loan Workout Costs.  Carrying costs and workout expenses of nonperforming loans and OREO decreased $0.4 million and $1.4 million during the three and nine months ended September 30, 2013, respectively, compared to the corresponding prior year periods.  These costs are directly related to the level of nonperforming assets and have declined due to the reduction in nonperforming assets.  Nonperforming assets were $25.5 million and $34.3 million at September 30, 2013 and 2012, respectively, a reduction of 26%.

 

Net OTTI on Securities Recognized in Earnings.  Net OTTI losses on securities represent credit losses recognized on available for sale securities.  OTTI recognized during the three and nine months ended September 30, 2012 related solely to private-label MBS that were credit impaired and were sold in 2012.

 

(Gain) Loss on Securities, Other Assets, and OREO. (Gain) and loss on securities, other assets and OREO is summarized in the following table.

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Gains and losses on available for sale securities are recognized upon the sale or call of a security.  Gains and losses on OREO are recognized upon sale or due to valuation changes on OREO held at the balance sheet date.

 

Other Operating Expenses.  Other operating expenses consist primarily of business development expenses (meals, entertainment and travel), charitable donations, professional services (auditing, legal, marketing and courier).  Other operating expenses for the three and nine months ended September 30, 2013 increased due to higher business development and marketing expense and service contracts compared to the prior year periods.

 

Provision for Income Taxes.  Effective income tax rates for the three and nine months ended September 30, 2013, were 29% and 32%, respectively, compared to 36% and 35% for the respective prior year periods.  During the three and nine months ended September 30, 2013, the Company made return-to-provision adjustments and derecognized estimated penalties and interest related to uncertain tax positions settled during the period.  These adjustments reduced tax expense by $0.4 million and $0.5 million for the respective periods.  Income from tax-exempt loans, investments and BOLI are the primary activities impacting the effective tax rate. 

 

 

 

Provision and Allowance for Loan and Credit Losses

 

The following table presents the provision for loan and credit losses for the three and nine months ended September 30, 2013 and 2012:

 

 

The improvement in credit quality over the prior year, as reflected by a decrease in classified loans and charge-offs, has resulted in negative loan and credit loss provisions.     

 

All loans are continually monitored to identify potential problems with repayment and collateral deficiency.  Classified loans decreased $32.5 million to $48.7 million at September 30, 2013 from December 31, 2012.  At September 30, 2013, the allowance for loan and credit losses decreased to 2.04% of total loans from 2.43% at December 31, 2012, and 2.57% a year earlier primarily due to growth in the loan portfolio coupled with improved asset quality.  The ratio of allowance for loan and credit losses to nonperforming loans decreased to 225.87% at September 30, 2013 from 237.75% at December 31, 2012 and was comparable to the 225.00% a year earlier.  Though management believes the current allowance provides adequate coverage of potential problems in the loan portfolio as whole, negative economic trends could adversely affect future earnings and asset quality.

 

The allowance for loan losses represents management’s recognition of the risks of extending credit and its evaluation of the quality of the loan portfolio. The allowance is maintained to provide for probable losses related to specifically identified loans and for losses inherent in the loan portfolio that have been incurred as of the balance sheet date. The allowance is based on various factors affecting the loan portfolio, including a review of problem loans, business conditions, historical loss experience, evaluation of the quality of the underlying collateral, and holding and disposal costs. The allowance is increased by additional charges to operating income and reduced by loans charged off, net of recoveries.  During the three and nine months ended September 30, 2013, the Company had $0.1 million net recoveries and $0.8 million in net charge-offs, respectively.  During the three and nine months ended September 30, 2012, the Company had $2.2 million net recoveries and $4.8 million net charge-offs, respectively.   

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Nonperforming Assets

 

Nonperforming assets consist of nonaccrual loans, past due loans, repossessed assets and OREO.  The following table presents information regarding nonperforming assets as of the dates indicated:

 

 

Nonperforming assets decreased  $4.8 million or 15.9% at September 30, 2013, from December 31, 2012 and decreased $8.8 million or 25.7% from the comparable prior year period.  The decrease in nonperforming assets from the end of 2012 is attributed to a decline in nonperforming A&D loans and OREO.  Approximately 45% or $11.6 million of nonperforming assets at September 30, 2013 were concentrated in Colorado, while the remaining 55% or $13.9 million were in Arizona.  Nonperforming loans represent 73% of total nonperforming assets with the remaining 27% comprised of OREO and repossessed assets.  Nonperforming loans of $18.5 million are concentrated primarily within the real estate – mortgage (68%), land A&D (12%), and commercial (18%) loan segments.  OREO decreased $3.6 million and $6.7 million from December 31, 2012 and September 30, 2012, respectively, primarily as a result of the overall improvement in asset quality and OREO sales.  The Company foreclosed on two properties in 2012 and two additional properties during the first nine months of 2013, but sold 18 properties in 2012 and seven in 2013.  The Company has dedicated significant resources to the workout and resolution of nonaccrual loans and OREO and continues to closely monitor the financial condition of its clients.

   

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Segment Results

 

Certain financial metrics and discussion of the results for the three and nine months ended September 30, 2013 and 2012, of each operating segment, are presented below.

 

 

Net income for the Commercial Banking segment during the three and nine months ended September 30, 2013 was largely stable compared to the prior year periods.  Both periods in 2013 benefited from a higher net interest income that was offset by a lower negative loan loss provision and higher noninterest expense. 

 

Net interest income for the three and nine months ended September 30, 2013 increased $0.9 million and $0.6 million, respectively, compared to the prior year periods.  The effect on net interest income from loan volume increases in the current quarter and year-to-date periods compared to a year earlier was offset by volume declines in the investment securities portfolio coupled with a decrease in the average earning yield.

 

The commercial banking segment continues to benefit from negative provision for loan losses due to the overall improvement in asset quality metrics.  However, pressure on the net interest margin from the low rate environment continues to hinder the positive effects of the growing loan portfolio.

 

 

Net loss for the Investment Banking segment for the three and nine months ended September 30, 2013 improved compared to the prior year periods due to higher revenue on closed transactions and retainer fees.  Expense for the current quarter and year-to-date periods was higher due to higher variable compensation expense tied to the revenue increase.

 

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At December 31, 2012, the Company sold substantially all assets comprising the wealth transfer business, a component of Wealth Management.  Additionally, the Company transitioned its trust and custodial services business to an unaffiliated third party, effectively exiting that business line at the end of the year.  Together, the wealth transfer and trust businesses constitute discontinued operations and the results of those operations are reported separately from the continuing operations of the segment. 

 

Net income for the Wealth Management segment improved $0.3 million and $1.0 million for the three and nine months ended September 30, 2013, respectively, compared to the prior year periods.  Improved results are attributed to revenue growth as the segment has grown AUM and reduced expenses through streamlining front and back office operations.

 

Investment advisory revenues comprise the majority of noninterest income.  Revenues are generally earned as a percentage of AUM and can fluctuate with movement in the equity markets. Discretionary AUM at September 30, 2013, was $789.7 million, and average AUM for the nine months ended September 30, 2013, increased $40.1 million or 5.5% compared to the prior year period average.

 

 

Net income in the Insurance segment for the three and nine months ended September 30, 2013 increased $0.3 million compared to the prior year periods. Revenue in the current quarter increased 19% compared to the prior year periods, driven equally by increases in employee benefits and P&C revenue growth.  Revenues for the nine months ended September 30, 2013, increased 17%, primarily due to employee benefits.  Year-to-date, expense increased due to variable compensation which is directly related to revenues.

 

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The Corporate Support and Other segment is composed of activities of the Parent; non-production, back-office support operations; and eliminating transactions in consolidation.  Non-production, back-office operations include human resources, accounting and finance, information technology, and loan and deposit operations.  The Company has a process for allocating these support operations back to the production lines based on an internal allocation methodology that is updated annually.

 

The primary component of net interest expense for the segment is interest expense related to the Company’s long-term debt.  Provision for loan loss relates to a nonperforming loan portfolio the Parent owns. This portfolio has steadily decreased since the 2009 purchase due to loan repayments and collateral sales.  In addition, asset quality improvement within the portfolio has contributed to the decline in the provision for loan losses.

 

Net loss for the three months ended September 30, 2013, was stable compared to the prior year period due to a reduction in interest expense associated with the redemption $21.0 million notes payable during the current quarter offset by higher expense attributed to salaries and benefits.  Noninterest expense includes salaries and benefits of employees of the Parent and support functions as well as the nonemployee overhead operating costs not directly associated with another segment. Net loss for the nine months ended September 30, 2013, decreased $1.9 million compared to the prior year period primarily due to gains recognized on the sale of OREO and lower loan workout expense.

 

 

 

Contractual Obligations and Commitments

 

Summarized below are the Company’s contractual obligations (excluding deposit liabilities) to make future payments at September 30, 2013:

 

 

 

(1)Interest on these obligations has been excluded due to the short-term nature of the instruments.

 

(2)Principal repayment of the junior subordinated debentures is assumed to be at the contractual maturity, currently beyond five years.  Interest on the junior subordinated debentures is calculated at the fixed rate associated with the applicable hedging instrument through the instrument maturity date and is reported in the "due within" categories during which the interest expense is expected to be incurred.  Interest payments on junior subordinated debentures after maturity of the related fixed interest rate swap hedges are variable and no estimate of those payments has been included in the preceding table.  The weighted average variable rate applicable to the junior subordinated debentures as of the date of this report is 2.63% and ranges from 1.7% to 3.2%.

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(3)Series C Preferred Stock issued to U.S. Department of Treasury in September 2011 includes dividends payable at 1%, the rate in effect at September 30, 2013.  The preferred shares are shown in the table as being due in the “After three but within five years” category which assumes $57.4 million of preferred stock will be redeemed in the year prior to the contractual dividend rate step up to 9% effective 4.5 years after issuance.

 

The contractual amount of the Company’s financial instruments with off-balance sheet risk at September 30, 2013, is presented below, classified by the type of commitment and the term within which the commitment expires:

 

 

 

The Company is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the liquidity, credit enhancement and financing needs of its customers.  These financial instruments include legally binding commitments to extend credit and standby letters of credit and involve, to varying degrees, elements of credit and interest-rate risk in excess of the amount recognized in the consolidated balance sheet.  Credit risk is the principal risk associated with these instruments.  The contractual amounts of these instruments represent the amount of credit risk should the instruments be fully drawn upon and the customer defaults.

 

To control the credit risk associated with entering into commitments and issuing letters of credit, the Company uses the same credit quality, collateral policies, and monitoring controls in making commitments and letters of credit as it does with its lending activities.  The Company evaluates each customer’s credit worthiness on a case-by-case basis.  The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation.

 

Legally binding commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  Since many of the commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Standby letters of credit obligate the Company to meet certain financial obligations of its customers if, under the contractual terms of the agreement, the customers are unable to do so. The financial standby letters of credit issued by the Company are irrevocable.  Payment is only guaranteed under these letters of credit upon the borrower’s failure to perform its obligations to the beneficiary.

 

Approximately $50.2 million of total loan commitments at September 30, 2013 represent commitments to extend credit at fixed rates of interest, which exposes the Company to some degree of interest-rate risk.

 

The Company has also entered into interest-rate swap agreements under which it is required to either receive cash or pay cash to counterparty depending on changes in interest rates.  The interest-rate swaps are carried at fair value on the Condensed Consolidated Balance Sheets with the fair value representing the net present value of expected future cash receipts or payments based on market interest rates as of the balance sheet date. The fair value of interest-rate swaps recorded on the balance sheet at September 30, 2013 do not represent the actual amounts that will ultimately be received or paid under the contracts since the fair value is based on estimated future interest rates and are therefore excluded from the table above.

 

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Liquidity and Capital Resources

 

Liquidity refers to the Company’s ability to generate adequate amounts of cash to meet financial obligations to its customers and shareholders in order to fund loans, to respond to deposit outflows and to cover operating expenses.  Maintaining a level of liquid funds through asset/liability management seeks to ensure that these needs are met at a reasonable cost.  Liquidity is essential to compensate for fluctuations in the balance sheet and provide funds for growth and normal operating expenditures.  Sources of funds include customer deposits, scheduled amortization of loans, loan prepayments, scheduled maturities of investments and cash flows from MBS.  Liquidity needs may also be met by deposit growth, converting assets into cash, raising funds in the brokered CD market or borrowing using lines of credit with correspondent banks, the FHLB or the FRB.  Longer-term liquidity needs may be met by selling securities available for sale or raising additional capital.  

 

Liquidity management is the process by which the Company manages the continuing flow of funds necessary to meet its financial commitments on a timely basis and at a reasonable cost. The objective of liquidity management is to ensure the Company has the ability to satisfy the cash flow requirements of depositors and borrowers and to allow us to sustain our operations. These funding commitments include withdrawals by depositors, credit commitments to borrowers, shareholder dividends, debt payments, expenses of its operations and capital expenditures. Liquidity is monitored and closely managed by the Company’s Asset and Liability Committee (ALCO), a group of senior officers from the lending, deposit gathering, finance and treasury areas. ALCO’s primary responsibilities are to ensure the necessary level of funds are available for normal operations as well as maintain a contingency funding policy to ensure that liquidity stress events are quickly identified and management plans are in place to respond. This is accomplished through the use of policies which establish limits and require measurements to monitor liquidity trends, including management reporting that identifies the amounts and costs of all available funding sources.

 

The Company's current liquidity position is expected to be more than adequate to fund expected asset growth. Historically, our primary source of funds has been customer deposits.  Scheduled loan repayments are a relatively stable source of funds, while deposit inflows and unscheduled loan prepayments – which are influenced by fluctuations in the general level of interest rates, returns available on other investments, competition, economic conditions, and other factors – are less predictable. 

 

The Company’s average loan to core deposit ratio increased to 95.1% for the first nine months of 2013 from 89.1% during fiscal 2012. As the loan to deposit ratio has increased, the Company has also increased its level of wholesale borrowings that historically bear a higher cost than core deposits. At September 30, 2013 and December 31, 2012, the Company had no outstanding wholesale borrowings.  However, average wholesale borrowings were $60.2 million and $58.1 million during the three and nine months ended September 30, 2013, respectively, up from $39.4 million during fiscal 2012.

 

The Company uses various forms of short-term borrowings for cash management and liquidity purposes, regularly accessing its federal funds and FHLB lines to manage its daily cash position. At September 30, 2013, the Bank has approved federal funds purchase lines with seven correspondent banks with an aggregate credit line of $175.0 million.  The Bank also has a line of credit from the FHLB that is limited by the amount of eligible collateral available to secure it and the Company’s investment in FHLB stock.  Borrowings under the FHLB line are required to be secured by unpledged securities and qualifying loans. Borrowings may also be used on a longer-term basis to support expanded lending activities and to match the maturity or repricing intervals of assets.

 

Available funding through correspondent lines and the FHLB at September 30, 2013, totaled $587.9 million.  Available funding is comprised of $175.0 million through the unsecured federal fund lines and $412.9 million in secured FHLB borrowing capacity. The Company had $11.4 million in securities available to be pledged as collateral for additional FHLB borrowings at September 30, 2013.  Access to funding through correspondent lines is dependent upon the cash position of the correspondent banks and there may be times when certain lines are not available.  In addition, certain lines require a one day rest period after a specified number of consecutive days of accessing the lines. The Company believes it has sufficient borrowing capacity and diversity in correspondent banks to meet its needs. 

 

At the holding company level, our primary sources of funds are dividends paid from the Bank and fee-based subsidiaries, management fees assessed to the Bank and the fee-based business lines, proceeds from the issuance of common stock, and other capital markets activity.  The main use of this liquidity is the quarterly payment of dividends on our common and preferred stock, quarterly interest payments on the subordinated debentures and notes payable, payments for mergers and acquisitions activity, and payments for the salaries and benefits for the employees of the holding company.  The Company has $57.4 million in preferred stock issued pursuant to the SBLF program that increases to a 9% dividend rate in 2016 which it expects to redeem at or before the date the dividend rate increases.  In July 2013, the Federal Reserve Board’s final rule implementing changes to the regulatory capital framework contained provisions that would preserve the current capital treatment of TPS issued by bank holding companies with less than $15 billion in total assets.  The

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Company has $70.0 million of callable junior subordinated debentures related to the issuance of TPS at September 30, 2013.

 

The approval of the Colorado State Banking Board is required prior to the declaration of any dividend by the Bank if the total of all dividends declared by the Bank in any calendar year exceeds the total of its net profits for that year combined with the retained net profits for the preceding two years. In addition, the Federal Deposit Insurance Corporation Improvement Act of 1991 provides that the Bank cannot pay a dividend if it will cause the Bank to be “undercapitalized.”  At September 30, 2013, the Bank was not otherwise restricted in its ability to pay dividends to the holding company.  The Company’s ability to pay dividends on its common stock depends upon the availability of dividends from the Bank, earnings from its fee-based businesses, and upon the Company’s compliance with the capital adequacy guidelines of the Federal Reserve Board of Governors.  The holding company has a liquidity policy that requires the maintenance of at least 18 months of liquidity on the balance sheet based on projected cash usages, exclusive of dividends from the Bank.  At September 30, 2013, the holding company had a liquidity position that exceeds the policy limit and the Company believes it has the ability to continue paying dividends.

 

Net income from discontinued operations for the nine months ending September 30, 2013, was $0.2 million and reasonably approximates the cash flows of those operations which are not separately stated in the Company’s Condensed Consolidated Statements of Cash Flows. Discontinued operations are expected to have no impact on the Company’s ability to finance its continuing operations or meet its outstanding obligations. The Company believes overall liquidity will not be significantly impacted by discontinued operations.

 

At September 30, 2013, shareholders’ equity totaled $272.9 million, a $15.9 million increase from December 31, 2012,  primarily related to current period earnings of $20.3 million.  Also contributing to the increase was a $3.1 million increase in common surplus relating to stock-based compensation, sales of stock under the employee stock purchase plan and stock exercises as well as an increase of $2.7 million in AOCI associated with changes in the fair value of derivatives.  Offsetting these increases were common and preferred dividends of $4.4 million and a $5.8 million decline in AOCI related to the Company’s available for sale securities.

 

We anticipate that our cash and cash equivalents, expected cash flows from operations together with alternative sources of funding are sufficient to meet our anticipated cash requirements for working capital, loan originations, capital expenditures and other obligations for at least the next 12 months.  We continually monitor existing and alternative financing sources to support our capital and liquidity needs, including but not limited to, debt issuance, common stock issuance and deposit funding sources.  Based on our current financial condition and our results of operations, we believe the Company will be able to sustain its ability to raise adequate capital through one or more of these financing sources.

 

We are subject to minimum risk-based capital limitations as set forth by federal banking regulations at both the consolidated Company level and the Bank level. Under the risk-based capital guidelines, different categories of assets, including certain off-balance sheet items, such as loan commitments in excess of one year and letters of credit, are assigned different risk weights, based generally on the perceived credit risk of the asset. These risk weights are multiplied by corresponding asset balances to determine a “risk-weighted” asset base. For purposes of the risk-based capital guidelines, total capital is defined as the sum of “Tier 1” and “Tier 2” capital elements, with Tier 2 capital being limited to 100% of Tier 1 capital. Tier 1 capital includes, with certain restrictions, common shareholders’ equity, perpetual preferred stock and minority interests in consolidated subsidiaries. Tier 2 capital includes, with certain limitations, perpetual preferred stock not included in Tier 1 capital, certain maturing capital instruments, and the allowance for loan and credit losses. At September 30, 2013, the Bank was well-capitalized with a Tier 1 Capital ratio of 12.2% and Total Capital ratio of 13.4%. The minimum ratios to be considered well-capitalized under the risk-based capital standards are 6% and 10%, respectively. At the holding company level, the Company’s Tier 1 Capital ratio at September 30, 2013, was 14.5% and its Total Capital ratio 15.8%.  In order to comply with the regulatory capital constraints, the Company and its Board of Directors constantly monitor the capital level and its anticipated needs based on the Company’s growth. The Company has identified sources of additional capital that could be used if needed, and monitors the costs and benefits of these sources, which include both the public and private markets. 

 

In July 2013, the Federal Reserve Board finalized rules reforming the regulatory capital framework for banking institutions.  The U.S. banking regulatory agencies have implemented the reforms which are designed to ensure that banks maintain strong capital positions even in the event of severe economic downturns or unforeseen losses.  The rules for non-advanced approaches banks and financial institutions like the Company will increase both the quantity and quality of required capital beginning January 1, 2015, with full implementation by 2018.

 

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Effects of Inflation and Changing Prices

 

The primary impact of inflation on our operations is increased operating costs.  Unlike most retail or manufacturing companies, virtually all of the assets and liabilities of a financial institution such as the Bank are monetary in nature.  As a result, the impact of interest rates on a financial institution’s performance is generally greater than the impact of inflation.  Although interest rates do not necessarily move in the same direction, or to the same extent, as the prices of goods and services, increases in inflation generally have resulted in increased interest rates.  Over short periods of time, interest rates may not move in the same direction, or at the same magnitude, as inflation.

 

 

 

 

Forward Looking Statements

 

This report contains forward-looking statements that describe the Company’s future plans, strategies and expectations. All forward-looking statements are based on assumptions and involve risks and uncertainties, many of which are beyond our control and which may cause our actual results, performance or achievements to differ materially from the results, performance or achievements contemplated by the forward-looking statements. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. They often include words such as "believe," "expect," "anticipate," "intend," "plan," "estimate" or words of similar meaning, or future or conditional verbs such as "would," "could" or "may." Forward-looking statements speak only as of the date they are made.  Such risks and uncertainties include, among other things:

 

•Competitive pressures among depository and other financial institutions nationally and in our market areas may increase significantly.

•Adverse changes in the economy or business conditions, either nationally or in our market areas, could increase credit-related losses and expenses and/or limit growth.

•Increases in defaults by borrowers and other delinquencies could result in increases in our provision for losses on loans and related expenses.

•Our inability to manage growth effectively, including the successful expansion of our customer support, administrative infrastructure and internal management systems, could adversely affect our results of operations and prospects.

•Fluctuations in interest rates and market prices could reduce our net interest margin and asset valuations and increase our expenses.

•The consequences of continued bank acquisitions and mergers in our market areas, resulting in fewer but much larger and financially stronger competitors, could increase competition for financial services to our detriment.

•Our continued growth will depend in part on our ability to enter new markets successfully and capitalize on other growth opportunities.

•Changes in legislative or regulatory requirements applicable to us and our subsidiaries could increase costs, limit certain operations and adversely affect results of operations.

•Changes in tax requirements, including tax rate changes, new tax laws and revised tax law interpretations may increase our tax expense or adversely affect our customers' businesses.

•The risks identified under “Risk Factors” in Item 1A of our annual report on Form 10-K for the year ended December 31, 2012.

 

In light of these risks, uncertainties and assumptions, you should not place undue reliance on any forward-looking statements in this report. We undertake no obligation to publicly update or otherwise revise any forward-looking statements, whether as a result of new information, future events or otherwise.

 

 

 

Item 3.Quantitative and Qualitative Disclosures about Market Risk

 

At September 30, 2013, there have been no material changes in the quantitative and qualitative information about market risk provided pursuant to Item 305 of Regulation S-K as presented in our Form 10-K for the year ended December 31, 2012.

 

 

 

 

Item 4.  Controls and Procedures

 

Evaluation of Disclosure Controls and Procedures.  The Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and the Company’s Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures at September 30, 2013, the end of the period covered by this report (“Evaluation Date”), pursuant to Exchange Act Rule 13a-15(e).  Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective in timely alerting them to material

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information relating to the Company (including its consolidated subsidiaries) required to be included in the Company’s periodic SEC filings. 

 

Disclosure controls and procedures are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934, as amended (Exchange Act) is recorded, processed, summarized, and reported within the time periods specified in the SEC's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

 

Changes in Internal Control.   During the quarter that ended on the Evaluation Date, there were no changes in internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

 

 

 

 

 

PART II.  OTHER INFORMATION

 

   

 

 

Item 6.Exhibits 

 

 

 

 

 

 

SIGNATURES

 

In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

COBIZ FINANCIAL INC.

 

 

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