U.S. SECURITIES AND EXCHANGE COMMISSION

Washington, D. C.  20549

FORM 10-Q

 

Commission File Number   001-15955

 

CoBiz Inc.

(Exact name of registrant as specified in its charter)

 

(303)  293-2265

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes     x                       No     o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act).

Large Accelerated Filer        o        Accelerated Filer        x        Non-accelerated Filer        o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes    o                     No    x

There were 23,865,595 shares of the registrant’s Common Stock, $0.01 par value per share, outstanding as of April 23, 2007.

PART I.  FINANCIAL INFORMATION

Item 1.		Financial Statements
Item 2.		Management’s Discussion and Analysis of Financial
		Condition and Results of Operations
Item 3.		Quantitative and Qualitative Disclosures about Market Risk
Item 4.		Controls and Procedures
PART II. OTHER INFORMATION
Item 6.		Exhibits
SIGNATURES

 

Item 1.  Financial Statements

CoBiz Inc.

Consolidated Balance Sheets

March 31, 2007 and December 31, 2006

(unaudited)

 

		March 31,			December 31,
		2007			2006
		(dollars in thousands)
Assets
Cash and due from banks		$	57,440		$	38,976
Investments:
Investment securities available for sale (cost of $405,778 and $425,006, respectively)		404,351			422,573
Investment securities held to maturity (fair value of $689 and $725, respectively)		686			722
Other investments		15,756			15,599
Total investments		420,793			438,894
Loans, net		1,550,875			1,526,589
Goodwill		39,836			39,557
Intangible assets, net		2,464			2,583
Bank owned life insurance		25,688			25,581
Premises and equipment, net		8,581			9,033
Accrued interest receivable		9,987			9,747
Deferred income taxes		7,567			7,654
Other		14,077			13,809
TOTAL ASSETS		$	2,137,308		$	2,112,423
Liabilities
Deposits
Demand		$	443,303		$	450,244
NOW and money market		562,594			566,849
Savings		12,191			10,740
Certificates of deposits		468,897			448,504
Total Deposits		1,486,985			1,476,337
Securities sold under agreements to repurchase		257,855			227,617
Other short-term borrowings		111,318			152,200
Accrued interest and other liabilities		19,065			21,428
Junior subordinated debentures		72,166			72,166
TOTAL LIABILITIES		1,947,389			1,949,748
Shareholders’ Equity
Cumulative preferred, $.01 par value; 2,000,000 shares authorized; None outstanding Common, $.01 par value; 50,000,000 shares authorized; 23,864,745 and 22,700,890 issued and outstanding, respectively		239			227
Additional paid-in capital		96,509			74,560
Retained earnings		94,827			90,502
Accumulated other comprehensive loss, net of income tax of $(1,014) and $(1,601), respectively		(1,656		)	(2,614		)
Total shareholders’ equity		$	189,919		$	162,675
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY		$	2,137,308		$	2,112,423

 

See Notes to Consolidated Financial Statements

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CoBiz Inc.

Consolidated Statements of Income and Comprehensive Income

(unaudited)

 

		Three months ended March 31,
		2007			2006
		(dollars in thousands)
INTEREST INCOME:
Interest and fees on loans		$	30,946		$	25,703
Interest and dividends on investment securities:
Taxable securities		5,043			4,715
Nontaxable securities		49			58
Dividends on securities		203			165
Federal funds sold and other		116			81
Total interest income		36,357			30,722
INTEREST EXPENSE:
Interest on deposits		9,424			6,523
Interest on short-term borrowings		4,523			4,099
Interest on junior subordinated debentures		1,395			1,241
Total interest expense		15,342			11,863
NET INTEREST INCOME BEFORE PROVISION
FOR LOAN LOSSES		21,015			18,859
Provision for loan losses		—			400
NET INTEREST INCOME AFTER PROVISION
FOR LOAN LOSSES		21,015			18,459
NONINTEREST INCOME:
Service charges		684			708
Trust and advisory fees		1,152			982
Insurance income		2,630			2,797
Investment banking income		1,423			1,147
Other income		743			706
Total noninterest income		6,632			6,340
NONINTEREST EXPENSE:
Salaries and employee benefits		12,446			11,157
Occupancy expenses, premises and equipment		2,830			2,712
Amortization of intangibles		119			120
Other		2,990			2,617
Total noninterest expense		18,385			16,606
INCOME BEFORE INCOME TAXES		9,262			8,193
Provision for income taxes		3,379			2,913
NET INCOME		$	5,883		$	5,280
UNREALIZED APPRECIATION (DEPRECIATION) ON INVESTMENT SECURITIES AVAILABLE FOR SALE AND DERIVATIVE INSTRUMENTS , net of tax		958			(1,167		)
COMPREHENSIVE INCOME		$	6,841		$	4,113
EARNINGS PER SHARE:
Basic		$	0.25		$	0.24
Diluted		$	0.24		$	0.23
DIVIDENDS PER SHARE		$	0.06		$	0.05

 

See Notes to Consolidated Financial Statements

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CoBiz Inc.

Consolidated Statements of Cash Flows

(unaudited)

 

		Three months ended March 31,
		2007			2006
		(dollars in thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income		$	5,883		$	5,280
Adjustments to reconcile net income to net cash provided by operating activities:
Net amortization on investment securities		42			401
Depreciation and amortization		963			996
Amortization of net loan fees		(575		)	(702		)
Provision for loan and credit losses		222			400
Stock-based compensation		280			302
Federal Home Loan Bank stock dividend		(157		)	(119		)
Deferred income taxes		(384		)	(691		)
Excess tax benefits from stock-based compensation		(562		)	(164		)
Increase in cash surrender value of bank owned life insurance		(241		)	(228		)
Supplemental Executive Retirement Plan		124			101
Other operating activities, net		(21		)	17
Changes in operating assets and liabilities
Accrued interest receivable		(240		)	(706		)
Other assets		1,008			136
Accrued interest and other liabilities		(1,757		)	(59		)
Net cash provided by operating activities		4,585			4,964
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of other investments		(1,095		)	(3,062		)
Purchase of investment securities available for sale		(50,868		)	(53,885		)
Maturities of investment securities held to maturity		36			64
Maturities of investment securities available for sale		70,015			28,575
Net cash paid in earn-outs		(438		)	—
Loan originations and repayments, net		(23,711		)	(55,607		)
Purchase of premises and equipment		(476		)	(576		)
Proceeds from sale of premises and equipment		91			19
Repayment of other investments		63			—
Net cash used in investing activities		(6,383		)	(84,472		)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net (decrease) increase in demand, NOW, money market, and savings accounts		(9,745		)	67,480
Net increase in certificates of deposits		20,393			25,923
Net decrease in short term borrowings		(40,882		)	(31,100		)
Net increase in securities sold under agreements to repurchase		30,238			21,821
Proceeds from issuance of stock and stock option exercises		21,119			1,019
Dividends paid on common stock		(1,423		)	(1,118		)
Excess tax benefit on stock option exercises		562			164
Net cash provided by financing activities		20,262			84,189
NET INCREASE IN CASH AND CASH EQUIVALENTS		18,464			4,681
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD		38,976			50,701
CASH AND CASH EQUIVALENTS, END OF PERIOD		$	57,440		$	55,382

 

See notes to consolidated financial statements

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CoBiz Inc. and Subsidiaries

Notes to Consolidated Condensed Financial Statements

(unaudited)

1.                                            Consolidated Condensed Financial Statements

The accompanying unaudited consolidated condensed financial statements of CoBiz Inc. (“Parent”), and its wholly owned subsidiaries:  CoBiz ACMG, Inc.; CoBiz Bank (“Bank”); CoBiz Insurance, Inc.; Colorado Business Leasing, Inc. (“Leasing”); CoBiz GMB, Inc.; GMB Equity Partners; and Financial Designs Ltd. (“FDL”), 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 full-service business bank with eleven Colorado locations, including eight in the Denver metropolitan area, two locations in Boulder and one in Edwards, just west of Vail, as well as seven Arizona locations, all of which are in the Phoenix metropolitan area. CoBiz ACMG, Inc. provides investment management services to institutions and individuals through its subsidiary Alexander Capital Management Group, LLC (“ACMG”). FDL provides wealth transfer, employee benefits consulting, insurance brokerage and related administrative support to employers. CoBiz Insurance, Inc. provides commercial and personal property and casualty insurance brokerage, as well as risk management consulting services to small and medium-sized businesses and individuals. CoBiz GMB, Inc. provides investment banking services to middle-market companies through its wholly owned subsidiary, Green Manning & Bunch, Ltd. (“GMB”).

All significant intercompany accounts and transactions have been eliminated. These financial statements and notes thereto should be read in conjunction with, and are qualified in their entirety by, our Annual Report on Form 10-K for the year ended December 31, 2006, as filed with the Securities and Exchange Commission (“SEC”).

The consolidated condensed 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 months ended March 31, 2007 are not necessarily indicative of the results that may be expected for the full year ending December 31, 2007. Reclassifications within the segment disclosure have been made to prior balances to conform to the current year presentation.

2.                                            Recent Accounting Pronouncements

On January 1, 2007, the Company adopted Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standard (“SFAS”) No. 155, Accounting for Certain Hybrid Financial Instrument-an amendment of SFAS No. 133 and SFAS No.140 (“SFAS 155”). This statement permits fair value re-measurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation. It establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation. In addition, SFAS 155 clarifies

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which interest-only strips and principal-only strips are not subject to the requirements of SFAS 133. It also clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives. SFAS 155 amends SFAS 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. The adoption of SFAS 155 did not have an impact on the consolidated financial statements.

On January 1, 2007, the Company adopted SFAS No. 156, Accounting for Servicing of Financial Assets – an amendment of FASB Statement No. 140 (“SFAS 156”). SFAS 156 requires an entity to recognize a servicing asset or servicing liability each time it undertakes an obligation to service a financial asset by entering into certain servicing contracts. The Statement also requires all separately recognized servicing assets and servicing liabilities to be initially measured at fair value, if practicable. SFAS 156 permits an entity to choose between the amortization and fair value methods for subsequent measurements. At initial adoption, the Statement permits a one-time reclassification of available for sale securities to trading securities by entities with recognized servicing rights. SFAS 156 also requires separate presentation of servicing assets and servicing liabilities subsequently measured at fair value in the statement of financial position and additional disclosures for all separately recognized servicing assets and servicing liabilities. The adoption of SFAS 156 did not have an impact on the consolidated financial statements.

On January 1, 2007, the Company adopted Emerging Issues Task Force (“EITF”) 06-5, Accounting for Purchases of Life Insurance – Determining the Amount That Could be Realized in Accordance with FASB Technical Bulletin No. 85-4, Accounting for Purchases of Life Insurance (“EITF 06-5”). EITF 06-5, addresses various issues in determining the amount that could be realized under an insurance contract. Upon adoption, the Company recorded a cumulative effect adjustment of approximately $134,000 that was charged to retained earnings to reduce the amount that can be realized on insurance contracts.

On January 1, 2007, the Company adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes – an Interpretation of SFAS No. 109 (“FIN 48”). FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. The adoption FIN 48 did not have a material impact on the consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those years. The provisions of this Statement will be applied prospectively as of the beginning of the fiscal year in which the Statement is initially applied, except in certain circumstances that will be applied retrospectively. The Company is evaluating the impact, if any, SFAS 157 will have on its consolidated financial statements.

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities – Including an amendment of FASB Statement No. 115 (“SFAS 159”). SFAS 159 permits entities to choose to measure certain financial assets and liabilities at fair value at specified election dates. For financial instruments elected to be accounted for at fair value, an entity will report the unrealized gains and losses in earnings. This Statement is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. The effect of the first remeasurement to fair value is to

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be recognized as a cumulative-effect adjustment to the opening balance of retained earnings. The Company is evaluating the impact, if any, SFAS 159 will have on its consolidated financial statements.

In September 2006, the EITF reached a consensus on EITF 06-4, Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements (“EITF 06-4”). The consensus, which has been ratified by the Financial Accounting Standards Board, requires companies to recognize an obligation for the future post-retirement benefits provided to employees in the form of death benefits to be paid to their beneficiaries through split-dollar policies carried in Bank-Owned Life Insurance (“BOLI”). EITF 06-4 is effective for fiscal periods beginning after December 15, 2007. The effects of applying EITF 06-4 are to be recognized through either (a) a change in accounting principle through a cumulative-effect adjustment to retained earnings as of the beginning of the year of adoption, or (b) a change in accounting principle through retrospective application to all prior periods. The Company is currently evaluating the impact EITF 04-6 will have on its consolidated financial statements, as the Company has issued endorsement split-dollar life insurance arrangements.

3.                                            Earnings per Common Share

The weighted average shares outstanding used in the calculation of basic and diluted earnings per share are as follows:

		Three months ended
		March 31,
		2007		2006
Weighted average shares outstanding - basic earnings per share		23,513,264		22,377,579
Effect of dilutive securities		691,938		832,017
Weighted average shares outstanding -   diluted earnings per share		24,205,202		23,209,596

 

For the three months ended March 31, 2007 and 2006, 416,159 and 318,198 options, respectively, were excluded from the earnings per share computation solely because their effect was anti-dilutive. On January 24, 2007, the Company issued 975,000 shares of common stock at a public offering price of $20.90, net of offering costs of $101,000.

4.                                            Comprehensive Income

Comprehensive income is the total of (1) net income plus (2) all other changes in net assets arising from nonowner sources, which are referred to as other comprehensive income. Presented below are the changes in other comprehensive income for the periods indicated.

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		Three months ended March 31,
		2007			2006
		(dollars in thousands)
Other comprehensive items:
Unrealized gain (loss) on available for sale securities net of reclassification to operations of $(39) and $0		$	1,006		$	(1,422	)
Unrealized gain (loss) on derivative securities, net of reclassification to operations of $(457) and $(376)		539			(461		)
Tax (expense) benefit related to items of other comprehensive income		(587		)	716
Other comprehensive income (loss), net of tax		$	958		$	(1,167	)

 

5.                                            Goodwill and Intangible Assets

A summary of goodwill, adjustments to goodwill and total assets by operating segment as of March 31, 2007, is noted below. The increase in goodwill is related to the 2006 FDL earn-out which was paid in the first quarter of 2007.   The payment consisted of 19,501 shares of CoBiz common stock and $0.4 million in cash.

											Total
		Goodwill									assets
		December 31,			Acquisitions and			March 31,			March 31,
		2006			adjustments			2007			2007
		(dollars in thousands)
Commercial banking		$	15,128		$	97		$	15,225		$	2,099,211
Investment banking services		5,279			—			5,279			7,520
Investment advisory and trust		4,217			—			4,217			5,950
Insurance		14,933			182			15,115			22,317
Corporate support and other		—			—			—			2,310
Total		$	39,557		$	279		$	39,836		$	2,137,308

 

As of December 31, 2006, and March 31, 2007, the Company’s intangible assets and related accumulated amortization consisted of the following:

		Customer			Employment and
		contracts, lists			non-solicitation
		and relationships			agreements			Total
		(dollars in thousands)
December 31, 2006		$	2,556		$	27		$	2,583
Amortization		116			3			119
March 31, 2007		$	2,440		$	24		$	2,464

 

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The Company recorded amortization expense of $119,000 during the three months ended March 31, 2007, compared to $120,000 in the same period of 2006. Amortization expense on intangible assets for each of the five succeeding years (excluding $351,000 to be recognized for the remaining nine months of fiscal 2007) is estimated as (in thousands):

2008		$	413
2009		364
2010		363
2011		360
2012		360

 

6.                                            Derivatives

A summary of the outstanding derivatives at March 31, 2007, is as follows:

		March 31,
		2007						2006
					Estimated						Estimated
		Notional			fair value			Notional			fair value
		(dollars in thousands)
Asset/liability management hedges:
Cash flow hedges - interest rate swap		$	110,000		$	(1,397	)	$	150,000		$	(3,280	)
Customer accomodation derivatives:
Interest rate swaps		$	20,390		$	(519	)	$	1,060		$	48
Reverse interest rate swaps		20,390			519			1,060			(48		)

 

7.                                            Junior Subordinated Debentures

A summary of the outstanding junior subordinated debentures at March 31, 2007 is as follows:

		Interest Rate		Junior Subordinated  Debentures			Maturity Date		Earliest Call Date
				(dollars in thousands)
CoBiz Statutory Trust I		3-month LIBOR + 2.95%		$	20,619		09/17/2033		09/17/2008
CoBiz Capital Trust II		3-month LIBOR + 2.60%		$	30,928		07/23/2034		07/23/2009
CoBiz Capital Trust III		3-month LIBOR + 1.45%		$	20,619		09/30/2035		09/30/2010

 

8.             Share-Based Compensation Plans

During the first three months of 2007 and 2006, the Company recognized compensation expense, net of estimated forfeitures, of $280,000 and $302,000 for stock-based compensation awards for which the requisite service was rendered in the period and had the following effect on net income, earnings per share and cash flows:

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		Increase/(decrease)
		(dollars in thousands, except per share amounts)
For three months ending March 31,		2007			2006
Income before income taxes		$	(280	)	$	(302	)
Net income		(226		)	(246		)
Earnings per share - basic		(0.01		)	(0.01		)
Earnings per share - diluted		(0.01		)	(0.01		)
Cash used by operating activities		(562		)	(164		)
Cash provided by financing activities (tax benefit)		562			164

 

The Company currently uses the Black-Scholes model to estimate the fair value of stock options using various interest, dividend, volatility and expected life assumptions. Grant date fair value for stock awards is determined by the closing market price of the stock on grant date.

A summary of changes in option awards for the three months ended March 31, 2007, is as follows:

				Weighted
				average
				exercise
		Shares		price
Outstanding at December 31,2006		2,137,626		$	12.84
Granted		71,500		20.98
Exercised		157,622		7.93
Forfeited		7,508		17.98
Outstanding at March 31, 2007		2,043,996		$	13.49
Exercisable at March 31, 2007		1,420,796		$	10.69

 

The weighted average grant date fair value of options granted during the period was $5.21. The weighted average remaining term for outstanding options at March 31, 2007, was 4.9 years and unrecognized expense of $2,256,000 is expected to be recognized over a weighted average period of 2.1 years.

During the period ending March 31, 2007, the Company issued 2,000 shares with five-year vesting as stock awards with weighted average grant date fair value of $21.07. As of March 31, 2007, unrecognized expense associated with the stock awards is $41,000 and expected to be recognized over a weighted average period of 4.9 years. The Company had not issued any similar stock awards prior to those awarded in the current period.

9.             Segments

The Company’s principal areas of activity consist of commercial banking, investment banking services, investment advisory and trust, insurance, and corporate support and other.

The Company’s commercial banking consists of the activities of CBB and ABB. CBB is a full-service business bank with eleven Colorado locations, including eight in the Denver metropolitan area, two locations in Boulder and one in Edwards, just west of Vail. ABB is based in Phoenix, Arizona and has seven locations in the Phoenix metropolitan area. Prior to 2007, the Company disclosed CBB and ABB as separate reportable segments. In the first quarter of 2007, in conjunction with the implementation of a new internal income and expense allocation model, the two geographic areas were combined into one

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commercial banking segment. All prior period disclosures have been adjusted to conform to the new presentation.

The investment banking services segment consists of the operations of GMB, which provides middle-market companies with merger and acquisition advisory services, institutional private placements of debt and equity, and other strategic financial advisory services.

The investment advisory and trust segment consists of the operations of ACMG and CoBiz Trust (formerly CoBiz Private Asset Management). ACMG is an SEC-registered investment management firm that manages stock and bond portfolios for individuals and institutions. CoBiz Trust offers wealth management and investment advisory services, fiduciary (trust) services, and estate administration services.

The insurance segment includes the activities of FDL and CoBiz Insurance, Inc. FDL provides employee benefits consulting and brokerage, wealth transfer planning and preservation for high-net-worth individuals, and executive benefits and compensation planning. FDL represents individuals and companies in the acquisition of institutionally priced life insurance products to meet wealth transfer and business needs. Employee benefit services include assisting companies in creating and managing benefit programs such as medical, dental, vision, 401(k), disability, life and cafeteria plans. CoBiz Insurance, Inc. provides commercial and personal property and casualty insurance brokerage, as well as risk management consulting services to individuals and small and medium-sized businesses. The majority of the revenue for both FDL and CoBiz Insurance, Inc. is derived from insurance product sales and referrals, and are paid by third-party insurance carriers. Insurance commissions are normally calculated as a percentage of the premium paid by our clients to the insurance carrier, and are paid to us by the insurance carrier for distributing and servicing their insurance products.

Corporate support and other consists of activities that are not directly attributable to the other reportable segments. Included in this category are primarily the activities of the Leasing and Parent companies.

The financial information for each business segment reflects that information which is specifically identifiable or which is allocated based on an internal allocation method. Results of operations and selected financial information by operating segment are as follows (in thousands):

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For the Quarter ended March 31, 2007

					Investment			Investment						Corporate
		Commercial			banking			advisory						support and
		banking			services			and trust			Insurance			other			Consolidated
Income Statement
Total interest income		$	36,277		$	39		$	—		$	1		$	40		$	36,357
Total interest expense		13,948			—			—			2			1,392			15,342
Net interest income		22,329			39			—			(1		)	(1,352		)	21,015
Provision for loan losses		29			—			—			—			(29		)	—
Net interest income after provision for loan losses		22,300			39			—			(1		)	(1,323		)	21,015
Noninterest income		1,426			1,423			1,152			2,630			1			6,632
Noninterest expense and minority interest		6,470			1,520			1,000			2,458			6,937			18,385
Income before income taxes		17,256			(58		)	152			171			(8,259		)	9,262
Provision for income taxes		6,329			(19		)	51			78			(3,060		)	3,379
Net income before management fees and overhead allocations		$	10,927		$	(39	)	$	101		$	93		$	(5,199	)	$	5,883
Management fees and overhead allocations, net of tax		3,743			44			57			105			(3,949		)	—
Net income		$	7,184		$	(83	)	$	44		$	(12	)	$	(1,250	)	$	5,883

 

At March 31, 2007

 

Balance Sheet
Total assets		$	2,099,211		$	7,520		$	5,950		$	22,317		$	2,310		$	2,137,308
Total gross loans and leases		1,568,737			—			—			—			—			1,568,737
Total deposits & customer repurchase agreements		1,743,596			—			1,244			—			—			1,744,840

 

For the Quarter ended March 31, 2006

 

					Investment			Investment						Corporate
		Commercial			banking			advisory						support and
		banking			services			and trust			Insurance			other			Consolidated
Income Statement
Total interest income		$	30,665		$	8		$	5		$	6		$	38		$	30,722
Total interest expense		10,627			—			—			—			1,236			11,863
Net interest income		20,038			8			5			6			(1,198		)	18,859
Provision for loan losses		436			—			—			—			(36		)	400
Net interest income after provision for loan losses		19,602			8			5			6			(1,162		)	18,459
Noninterest income		1,349			1,147			982			2,797			65			6,340
Noninterest expense and minority interest		5,284			863			822			2,546			7,091			16,606
Income before income taxes		15,667			292			165			257			(8,188		)	8,193
Provision for income taxes		5,675			111			64			102			(3,039		)	2,913
Net income before management fees and overhead allocations		$	9,992		$	181		$	101		$	155		$	(5,149	)	$	5,280
Management fees and overhead allocations, net of tax		3,962			42			48			84			(4,136		)	—
Net income		$	6,030		$	139		$	53		$	71		$	(1,013	)	$	5,280

 

At March 31, 2006

 

Balance Sheet
Total assets		$	1,986,915		$	6,989		$	5,557		$	20,827		$	3,921		$	2,024,209
Total gross loans and leases		1,388,360			—			—			—			33			1,388,393
Total deposits & customer repurchase agreements		1,657,957			—			945			—			—			1,658,902

 

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

This discussion should be read in conjunction with our 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 Notes to Consolidated Financial Statements included in our Form 10-K for the year ended December 31, 2006. For a discussion of the segments included in our principal activities, see Note 9 to these financial statements.

Executive Summary

The Company is a financial holding company that offers a broad array of financial service products to its target market of small and medium-sized businesses and high-net-worth individuals. Our operating

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segments include our commercial banking franchise, Colorado Business Bank and Arizona Business Bank; investment banking services; investment advisory and trust services; and insurance services.

Earnings are derived primarily from our net interest income, which is interest income less interest expense, and our noninterest income earned from our 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 (which is 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 have also focused on reducing our dependency on our net interest margin by increasing our noninterest income.

Our Company has focused on developing an organization with personnel, management systems and products that will allow us to compete effectively and position us for growth. The cost of this process relative to our size has been high. In addition, we have operated with excess capacity during the start-up phases of various projects. As a result, relatively high levels of noninterest expense have adversely affected our earnings over the past several years. Salaries and employee benefits comprised most of this overhead category. However, we believe that our compensation levels have allowed us to recruit and retain a highly qualified management team capable of implementing our business strategies. We believe our compensation policies, which include the granting of options to purchase common stock to many employees and the offering of an employee stock purchase plan, have highly motivated our employees and enhanced our ability to maintain customer loyalty and generate earnings.

Financial Highlights

·                  Net income for the three months ended March 31, 2007, was $5.9 million compared to $5.3 million for the same period in 2006. Diluted earnings per share for the three months ended March 31, 2007, were $0.24, compared to $0.23 for the same period in 2006.

·                  The net interest margin expanded 14 basis points to 4.38% for the three months ended March 31, 2007, compared to 4.24% for the same period in 2006.

·                  During the fourth quarter of 2006, the Company began the process of selling additional common stock through a secondary offering that subsequently closed on January 24, 2007. The Company sold 975,000 shares of common stock at a public offering price of $20.90. The proceeds will primarily be used to support the growth of the Bank, as well as general corporate purposes.

·                  The Company’s commercial bank segment contributed $0.29 per diluted share for the first three months in 2007, as compared to $0.26 per diluted share for the same period in 2006. For the same periods, the net contribution for the rest of the company decreased $0.02 per share, mainly due to the volatility inherent in our fee-based business lines.

·                  Gross loans increased 6.4% on an annualized basis from December 31, 2006.

·                  Deposits and customer repurchase agreements increased 9.7% on an annualized basis from December 31, 2006.

·                  Asset quality, while still strong when compared to our peers, worsened slightly with non-performing assets as a percentage of total assets at 0.20%, compared to 0.06% at December 31, 2006.

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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 consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. 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 are 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. A description of our critical accounting policies was provided in the Management’s Discussion and Analysis of Financial Condition and Results of Operation section of our Annual Report on Form 10-K for the year ended December 31, 2006. There have been no changes in our critical accounting policies and no other significant changes to the assumptions and estimates related to them.

Financial Condition

Total assets increased by $24.9 million to $2.14 billion as of March 31, 2007, from $2.11 billion as of December 31, 2006. The increase in total assets is primarily due to growth in net loans which were largely funded by proceeds from paydowns and maturities in the investment securities portfolio.

Investments. Total investments decreased $18.1 million to $420.8 million, from $438.9 million as of December 31, 2006. The decrease in investments was largely due to paydowns and maturities of available-for-sale mortgage-backed securities of $70.0 million, offset by $50.9 million in purchases of primarily short-term government agency debentures.

Loans. Gross loans increased by $24.3 million to $1.57 billion as of March 31, 2007, from $1.54 billion at December 31, 2006. The increase in loans is primarily due to growth in our real estate mortgage portfolio with approximately 74.0% of the growth in that portfolio coming from the Arizona market.

		March 31, 2007					December 31, 2006					March 31, 2006
					% of					% of					% of
		Amount			Portfolio		Amount			Portfolio		Amount			Portfolio
		(dollars in thousands)
LOANS
Commercial		$	480,339		31.0	%	$	482,309		31.6	%	$	421,223		30.7	%
Real Estate - mortgage		727,109			46.9	%	698,951			45.8	%	702,018			51.2	%
Real Estate - construction		291,971			18.8	%	292,952			19.2	%	194,102			14.2	%
Consumer		56,014			3.6	%	57,990			3.8	%	58,750			4.3	%
Other		13,304			0.9	%	12,258			0.8	%	12,300			0.9	%
Gross loans		1,568,737			101.2	%	1,544,460			101.2	%	1,388,393			101.2	%
Less allowance for loan losses		(17,862		)	(1.2	)%	(17,871		)	(1.2	)%	(16,721		)	(1.2	)%
Net loans		$	1,550,875		100.0	%	$	1,526,589		100.0	%	$	1,371,672		100.0	%

 

Goodwill. Goodwill increased by $0.3 million to $39.8 million as of March 31, 2007, from $39.5 million as of December 31, 2006. The increase was due to additional purchase price consideration paid to the former owners of Financial Designs, Ltd. under the terms of an earn-out agreement for the year-ended December 31, 2006.

Other Assets. Other assets is comprised of investments in limited partnership interests, accounts receivable, prepaid expenses and the fair value of derivative instruments.

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Changes in these assets during the three months ended March 31, 2007, did not materially fluctuate from the same period in 2006.

Deposits. Deposits increased by $10.6 million to $1.49 billion as of March 31, 2007, from $1.48 billion as of December 31, 2006. The net increase in deposits was driven primarily by increases in Certificates of Deposit (“CD”) under $100,000, which increased $13.5 million. Deposit growth since March 31, 2006, has largely been due to increases in Brokered CDs ($129.1 million as of March, 2007) which the Company uses as an alternative to other short-term borrowing and do not require the collateral commitment that other traditional sources may require, such as Federal Home Loan Bank (“FHLB”) advances. Core-deposit growth continues to be a challenge due to competition from other banks and financial service providers.  To address this challenge, the Company implemented a banker incentive plan based on 2007 deposit growth in the non-interest bearing portfolio.

		March 31, 2007					December 31, 2006					March 31, 2006
					% of					% of					% of
		Amount			Portfolio		Amount			Portfolio		Amount			Portfolio
		(dollars in thousands)
DEPOSITS AND CUSTOMER REPURCHASE AGREEMENTS
NOW and money market accounts		$	562,594		32.2	%	$	566,849		33.3	%	$	543,794		32.8	%
Savings		12,191			0.7	%	10,740			0.6	%	8,706			0.5	%
Certificates of deposits under $100,000		100,866			5.8	%	87,366			5.1	%	83,626			5.0	%
Certificates of deposits $100,000 and over		368,031			21.1	%	361,138			21.2	%	322,414			19.4	%
Total interest-bearing deposits		1,043,682			59.8	%	1,026,093			60.2	%	958,540			57.8	%
Noninterest-bearing demand deposits		443,303			25.4	%	450,244			26.4	%	461,815			27.8	%
Customer repurchase agreements		257,855			14.8	%	227,617			13.4	%	238,547			14.4	%
Total deposits and customer repurchase agreements		$	1,744,840		100.0	%	$	1,703,954		100.0	%	$	1,658,902		100.0	%

 

Securities Sold Under Agreements to Repurchase. Securities sold under agreements to repurchase increased $30.3 million to $257.9 million at March 31, 2007, from $227.6 million at December 31, 2006. Securities sold under agreement to repurchase are represented by two types, customer repurchase agreements and street repurchase agreements. Management does not consider customer repurchase agreements to be a wholesale funding source, but rather an additional treasury management service provided to our customer base. As of March 31, 2007 and December 31, 2006, all of our repurchase agreements were transacted on behalf of our customers. Our customer repurchase agreements are based on an overnight investment sweep that can fluctuate based on our customers’ operating account balances.

Other Short-Term Borrowings. Other short-term borrowings decreased $40.9 million to $111.3 million as of March 31, 2007, from $152.2 million at December 31, 2006. Other short-term borrowings consist of fed funds purchased, overnight and term borrowings from the FHLB, and short-term borrowings from the U.S. Treasury. Other short-term borrowings are used as part of our liquidity management strategy and can fluctuate based on the Company’s cash position. The Company’s wholesale funding needs are largely dependent on core deposit levels, which have proven to be more volatile due to increased competition and rising rates. If we are unable to maintain deposit balances at a level sufficient to fund our asset growth, our composition of interest-bearing liabilities will shift toward additional wholesale funds, which typically have a higher interest cost than our core deposits. Net proceeds from securities investment paydowns and the completed equity offering have been used to reduce short-term borrowings during the quarter. The Company has actively sought additional funding through the use of Brokered CDs which generally carry more favorable interest rates than those available in the overnight fed funds market or from the FHLB.

Accrued Interest and Other Liabilities. Accrued interest and other liabilities decreased $2.3 million to $19.1 million at March 31, 2007, from $21.4 million as of December 31, 2006. The decrease was

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primarily the result of the $5.2 million payout of 2006 year-end bonuses, earn-outs and compensation accrued as of December 31, 2006, offset by increases in accrued interest of $0.2 million, $3.3 million in income taxes payable and a $0.2 million addition to the reserve for letters of credit losses.

Results of Operations

Overview

The following table presents the condensed statements of income for the three months ended March 31, 2007 and 2006 (dollars in thousands):

		Quarter Ended March 31,
		2007			2006
INCOME STATEMENT DATA
Interest income		$	36,357		$	30,722
Interest expense		15,342			11,863
NET INTEREST INCOME BEFORE PROVISION		21,015			18,859
Provision for loan and credit losses		—			400
NET INTEREST INCOME AFTER PROVISION		21,015			18,459
Noninterest income		6,632			6,340
Noninterest expense		18,385			16,606
INCOME BEFORE INCOME TAXES		9,262			8,193
Provision for income taxes		3,379			2,913
NET INCOME		$	5,883		$	5,280

 

Annualized return on average assets for the three months ended March 31, 2007, was 1.13%, compared to 1.09% for the same period in 2006. Annualized return on average common shareholders’ equity for the three months ended March 31, 2007, was 13.19%, compared to 15.42% for the same period in 2006. The decrease in our return on average equity ratio is primarily the result of the common equity raise completed in January 2007 that increased equity by $19.3 million. The growth in equity is impacted not only by the equity raise, but also by the issuance of stock for option exercises and earn-out arrangements as well as fluctuations in the market values of our available for sale investments and cash flow hedges.

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. Rising short-term rates and the flattening of the yield curve has compressed interest rate spreads and dampened expansion of the net interest margin as our wholesale borrowing costs increase and our ability to raise lending rates is limited. The Federal Open Markets Committee (“FOMC”) uses the fed funds rate, which is the interest rate used by banks to lend to each other, to influence interest rates and the 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.

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The following tables set forth the average amounts outstanding for each category of interest-earning assets and interest-bearing liabilities, the interest earned or paid on such amounts, and the average rate earned or paid for the three months ended March 31, 2007 and 2006.

		For the quarter ended March 31,
					2007								2006
					Interest			Average					Interest			Average
		Average			earned			yield		Average			earned			yield
		Balance			or paid			or cost (1)		Balance			or paid			or cost (1)
		(dollars in thousands)
Assets
Federal funds sold and other		$	6,291		$	116		7.38	%	$	5,951		$	81		5.44	%
Investment securities (2)		414,251			5,324			5.14	%	459,843			4,973			4.33	%
Loans (2), (3)		1,557,779			31,068			7.98	%	1,366,088			25,792			7.55	%
Allowance for loan losses		(17,981		)						(17,221		)
Total interest earning assets		$	1,960,340		$	36,508		7.45	%	$	1,814,661		$	30,846		6.80	%
Noninterest-earning assets
Cash and due from banks		46,776								47,096
Other		108,806								99,526
Total assets		$	2,115,922							$	1,961,283
Liabilities and Shareholders’ Equity
Deposits
NOW and money market deposits		$	555,667		$	4,219		3.08	%	$	495,906		$	2,930		2.40	%
Savings deposits		11,101			43			1.57	%	8,538			14			0.67	%
Certificates of deposits
Under $100,000		94,433			1,080			4.64	%	80,157			712			3.60	%
$100,000 and over		335,684			4,082			4.93	%	303,337			2,867			3.83	%
Total Interest-bearing deposits		$	996,885		$	9,424		3.83	%	$	887,938		$	6,523		2.98	%
Other borrowings
Securities sold under agreements to repurchase and other short-term borrowings		412,230			4,523			4.39	%	427,415			4,099			3.84	%
Junior subordinated debentures		72,166			1,395			7.73	%	72,166			1,241			6.88	%
Total interest-bearing liabilities		$	1,481,281		$	15,342		4.18	%	$	1,387,519		$	11,863		3.45	%
Noninterest-bearing demand accounts		435,353								421,396
Total deposits and interest-bearing liabilities		1,916,634								1,808,915
Other noninterest-bearing liabilities		18,398								13,478
Total liabilities and preferred securities		1,935,032								1,822,393
Shareholders’ equity		180,890								138,890
Total liabilities and shareholders’ equity		$	2,115,922							$	1,961,283
Net interest income					$	21,166							$	18,983
Net interest spread								3.27	%							3.35	%
Net interest margin								4.38	%							4.24	%
Ratio of average interest-earning assets to average interest-bearing liabilities		132.34		%						130.78		%

 

(1)                                  Average yield or cost for the three months ended March 31, 2007 and 2006 has been annualized and is not necessarily indicative of results for the entire year.

(2)                                  Yields include adjustments for tax-exempt interest income based on the Company’s effective tax rate.

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

The increase in interest income on a tax-equivalent basis for the three months ended March 31, 2007, was primarily driven by an increase in the average volume of the loan portfolio and yield increases on the loan and investment portfolios. The volume of our interest-earning assets increased due to the growth in our average loan portfolio of $191.7 million for the three months ended March 31, 2007 over the same period in 2006, primarily driven by growth in real estate construction lending. The yield on interest-earning assets also contributed to the increase in interest income, as the average yield increased 65 basis points for the three months ended March 31, 2007.

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The increase in interest expense is attributed primarily to the rising interest rate environment and to a lesser extent the increased volume of interest-bearing liabilities. The rates on our deposit portfolio and wholesale funding sources are significantly impacted by changes in short-term rates, in addition to other economic factors. The average target federal funds rate was 5.25% for the three months ended March 31, 2007 compared to 4.42% for the same period in 2006. The increase in the average federal funds rate has increased our wholesale funding costs. The increase in interest expense from volume growth was relatively muted when comparing the first quarter of 2007 to the first quarter of 2006. The volume growth in interest-bearing liabilities for the quarter-ended March 31, 2007, was all in the deposit portfolio, which has a lower yield than wholesale borrowings. The Company also benefited from the common equity raise completed in January 2007 that allowed for a reduction in wholesale borrowings.

Our net interest income is driven almost exclusively by our core banking franchise. Future increases in net interest income will primarily come by increasing our loan and investment portfolios, offset by the cost of funds from growth in our deposit portfolio and other funding sources. We expect to continue augmenting the organic growth from our existing banks with the addition of new de novo banks in Arizona and Colorado as qualified bank presidents are identified.

Noninterest Income. The following table presents noninterest income for the three months ended March 31, 2007 and 2006:

		Quarter ended March 31,						Increase/(decrease)
		2007			2006			Amount			%
		(dollars in thousands)
NONINTEREST INCOME
Deposit service charges		$	684		$	708		$	(24	)	(3.4	)%
Other loan fees		184			172			12			7.0	%
Investment advisory and trust income		1,152			982			170			17.3	%
Insurance income		2,630			2,797			(167		)	(6.0	)%
Investment banking income		1,423			1,147			276			24.1	%
Other income		559			534			25			4.7	%
Total noninterest income		$	6,632		$	6,340		$	292		4.6	%

 

Noninterest income includes revenues earned from sources other than interest income. These sources include: service charges and fees on deposit accounts, letter of credit and ancillary loan fees, income from investment advisory and trust services, income from life insurance and wealth transfer products, benefits brokerage, property and casualty insurance, retainer and success fees from investment banking engagements, and increases in the cash surrender value of bank-owned life insurance.

We believe offering such complementary products as discussed below allows us to both broaden our relationships with existing customers and attract new customers to our core business. We believe the fees generated by these services will increase our noninterest income and reduce our dependency on net interest income. Noninterest income as a percentage of operating revenues was 24% for the three months ended March 31, 2007, compared to 25% for the same period in 2006. This level of noninterest income to operating revenues is consistent with the Company’s ongoing goal of diversifying our revenue and reducing our dependency on net interest income.

Deposit Service Charges. Deposit service charges primarily consist of fees earned from our treasury management services where customers are billed for deposits on analysis.  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. Fees earned from treasury management

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services will fluctuate based on the number of customers using the services and from changes in U.S. Treasury rates which are used as a benchmark for the earnings credit rate.  Other miscellaneous deposit charges are transactional by nature and may not be consistent period-over-period.

Investment Advisory and Trust Income. Investment advisory and trust income for the three months ended March 31, 2007, increased from the same period in 2006 due to an increase in the overall assets under management. As of March 31, 2007, the Investment Advisory and Trust segment had a combined $666.6 million in discretionary assets under management, a 14% increase over March 31, 2006. In January 2007, the Company hired two business development officers to lead the Company’s trust function. The benefit from hiring these officers is already being realized, as total discretionary and non-discretionary assets under management for the trust division at the end of March 31, 2007, increased at an annualized rate of 17.4% during the first quarter.

Insurance Income. Insurance income is derived from three main areas: wealth transfer, benefits consulting, and property and casualty. The majority of fees earned on wealth transfer transactions are earned at the inception of the product offering in the form of commissions. As the fees on these products are transactional by nature, fee income can fluctuate from period-to-period based on the number of transactions that have been closed. Revenue from benefits consulting and property and casualty (“P&C”) is a more recurring revenue source. For the three months ended on March 31, 2007 and 2006, revenue earned from the Insurance segment is comprised of the following:

		Three months ended March 31,
		2007		2006
Wealth transfer and executive compensation		51.50	%	50.20	%
Benefits consulting		28.82	%	25.12	%
Property and casualty		16.73	%	21.92	%
Fee income		2.95	%	2.75	%
		100.00	%	100.00	%

 

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 collectibility 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. The increase in revenue for the first three months of 2007 compared to 2006 was due to higher average success fees in 2007, as well as a greater number of clients under retainer.

Other Income. Other income is comprised of increases in the cash surrender value of BOLI, earnings on equity method investments, merchant charges, bankcard fees, wire transfer fees, foreign exchange fees, and safe deposit income. Other income for the three months ended March 31, 2007 did not materially fluctuate from the same period in 2006.

Noninterest Expense.  The following table presents noninterest expense for the three months ended March 31, 2007 and 2006:

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		Quarter ended March 31,						Increase/(decrease)
		2007			2006			Amount			%
		(dollars in thousands)
NONINTEREST EXPENSES
Salaries and employee benefits		$	12,166		$	10,855		$	1,311		12.1	%
Stock based compensation expense		280			302			(22		)	(7.3	)%
Occupancy expenses, premises and equipment		2,830			2,712			118			4.4	%
Amortization of intangibles		119			120			(1		)	(0.8	)%
Other operating expenses		2,990			2,617			373			14.3	%
Total noninterest expenses		$	18,385		$	16,606		$	1,779		10.7	%

 

Salaries and Employee Benefits. Salaries and employee benefits for the three months ended March 31, 2007 have increased primarily due to the growth of our full-time equivalent employee base. The increase in salaries and employee benefits, which increased 12.1% from the first quarter of 2006, is due in part to higher staffing levels to accommodate our growth and annual merit increases awarded as of January 1, 2007, that averaged 4.38%. As of March 31, 2007, the Company employed 468 full-time-equivalent employees, compared to 444 a year earlier. The Company made significant progress in the recruitment of business development officers in the latter half of 2006, increasing compensation expense though the beneficial revenue impact has yet to be fully realized.

Stock-based Compensation. The Company adopted SFAS 123(R) on January 1, 2006, which requires us to recognize compensation costs for the grant-date fair value of awards issued after the adoption date and for the portion of awards for which the requisite service period had not previously been rendered. Prior to 2006, the Company applied the intrinsic value method of measuring compensation costs which did not trigger expense recognition in prior periods. The Company uses stock-based compensation to retain existing employees, recruit new employees and is considered an important part of overall compensation. The Company expects to continue using stock-based compensation in the future.

Occupancy Costs. Occupancy costs consist primarily of rent, depreciation, utilities, property taxes and insurance. Occupancy costs for the first three months of 2007 have remained relatively stable when compared to the same period in 2006, as the majority of our de novo locations were in place as of March 31, 2006. The slight increase is primarily due to depreciation from the expansion of existing locations, increases in common area management charges and increases in rent for leases that escalate periodically based on the Consumer Price Index.

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), regulatory assessments and provision expense for off-balance sheet commitments. The increase in other operating expenses for the three months ended March 31, 2007, over the same period in 2006 was primarily attributed to $0.2 million in provision for credit losses that was recorded for estimated letter of credit losses.

Provision and Allowance for Loan and Credit Losses

For the three months ending March 31, 2007 the Company recorded $0.2 million in combined provision for loan and credit losses, compared to $0.4 million for the same period in 2006. The allowance for loan and credit losses amounted to 1.19% of gross loans as of March 31, 2007, compared to 1.25% as of March 31, 2006. The Company continues to maintain a superior standing in the industry with just one-fifth of one percent of total assets in a non-performing status as of March 31, 2007. The Company’s

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credit quality measures are a reflection of management’s commitment to maintaining its high underwriting standards.

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.

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 consolidated balance sheet, the allowance for credit losses is recorded in Accrued Interest and Other Liabilities in the accompanying consolidated balance sheet. Although the allowances are presented separately on the balance sheet, any losses incurred from credit losses would be reported as a charge-off in the allowance for loan losses, since any loss would be recorded after the off-balance sheet commitment had been funded. Due to the relationship of these allowances, as extensions of credit underwritten through a comprehensive risk analysis, information on both the allowance for loan and credit losses positions is presented in the following table.

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