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HERITAGE OAKS BANCORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) This Quarterly Report on Form 10-Q may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. You can find many but not all of these statements by looking for words such as "approximates," "believes," "expects," "anticipates," "estimates," "intends," "plans," "likely," "would," "could," "may" and other similar expressions in this Quarterly Report on Form 10-Q. The Company claims the protection of the safe harbor contained in the Private Securities Litigation Reform Act of 1995, as amended. The Company cautions investors that any forward-looking statements presented in this Quarterly Report on Form 10-Q, or those that the Company may make orally or in writing from time to time, are based on the Company's beliefs, and on assumptions made by, and information available to management at the time such statements are first made. The actual outcome will be affected by known and unknown risks, trends, uncertainties and factors that are beyond the Company's control or ability to predict. Although the Company believes that management's assumptions are reasonable, they are not guarantees of future performance and some will inevitably prove to be incorrect. As a result, the Company's actual future results can be expected to differ from management's expectations, and those differences may be material and adverse to the Company's business, results of operations and financial condition. Accordingly, investors should use caution in relying on forward-looking statements to anticipate future results or trends. Some of the risks and uncertainties that may cause the Company's actual results, performance or achievements to differ materially from those expressed herein include the following: uncertainty as to whether the financial crisis in the United States has fully been resolved, including continuing relative softness in the California real estate market, and the response of federal and state governments and our banking regulators thereto; a decline in general economic conditions in those areas in which the Company operates; changes in the Company's business strategy or development plans; the Company's ability to effectively integrate its merger with Mission Community Bancorp into its business; the threat and impact of cyber-attacks on our and our third party vendors information technology infrastructure; environmental conditions, including the prolonged drought in California, natural disasters such as earthquakes, landslides and wildfires, that may disrupt business, impede operations, or negatively impact the ability of certain borrowers to repay their loans and/or values of collateral securing loans; the possibility of an unfavorable ruling in a legal matter in which the Company is involved, and the potential impact that it may have on earnings, reputation, or the Company's operations; and the possibility that any expansionary activities will be impeded while the FDIC's and CA DBO's joint Consent Order remains outstanding, and that we will be unable to comply with the requirements set forth in the Consent Order, which could result in restrictions on our operations. Additional information on these risks and other factors that could affect operating results and financial condition are detailed in reports filed by the Company with the U.S. Securities and Exchange Commission, including the Company's Annual Report on Form 10-K for the year ended December 31, 2013, filed by the Company with the U.S. Securities and Exchange Commission on March 4, 2014. Forward looking statements speak only as of the date they are made, and the Company does not undertake to update forward looking statements to reflect circumstances or events that occur after the date the forward looking statements are made, whether as a result of new information, future developments or otherwise, and specifically disclaims any obligation to revise or update such forward looking statements for any reason, except as may be required by law. Heritage Oaks Bancorp | - 41 - -------------------------------------------------------------------------------- Table of Contents Executive Overview This overview of management's discussion and analysis highlights selected information in the financial results of the Company and may not contain all of the information that is important to you. For a more complete understanding of trends, commitments, uncertainties, liquidity, capital resources and critical accounting policies and estimates, you should carefully read this entire document. Each of these items could have an impact on the Company's consolidated financial condition and results of operations. Heritage Oaks Bancorp ("Bancorp") is a California corporation organized in 1994 to act as a holding company for Heritage Oaks Bank (the "Bank" and together with Bancorp hereinafter collectively referred to as the "Company"), a bank founded in 1983 that serves San Luis Obispo, Santa Barbara and Ventura counties. As of September 30, 2014, Heritage Oaks Bank operated two branch offices in Paso Robles, San Luis Obispo and Santa Maria, one branch office in Arroyo Grande, Atascadero, Cambria, Templeton, Morro Bay, and Santa Barbara, as well as loan production offices in Goleta and Ventura/Oxnard. The principal business of the Bank consists of attracting deposits from the general public and investing these funds primarily in commercial real estate ("CRE") and commercial business loans, loans secured by first mortgages on one-to-four single family residences, operating and real estate procurement loans for agricultural businesses, multi-family residential property loans and a variety of consumer loans. The Bank offers a variety of deposit accounts for both individuals and businesses with varying rates and terms, which generally include savings accounts, money market deposits, certificates of deposit and checking accounts. The Bank solicits deposits primarily in its market area, and in the past has accepted brokered deposits. The Bank also originates one-to-four family residential mortgages for sale in the secondary market. During the first quarter of 2014, the Bank received approval to sell home loans directly to Fannie Mae. The Bank also provides SBA loans, as a member of the SBA's Preferred Lender Program. Other than holding the shares of the Bank, Bancorp conducts no significant activities. As a bank holding company, Bancorp generally is prohibited from acquiring direct or indirect ownership or control of more than 5 percent of the voting shares of any company which is not a bank or bank holding company, or from engaging directly or indirectly in activities other than those of banking, managing or controlling banks, or providing services for its subsidiaries. The principal exceptions to these prohibitions involve certain non-bank activities which, by statute or regulation or order of the Federal Reserve Board, have been identified as activities closely related to the business of banking or managing or controlling banks. In October 2006, Bancorp formed Heritage Oaks Capital Trust II ("Trust II"). Trust II is a statutory business trust formed under the laws of the State of Delaware and is a wholly-owned, non-financial, non-consolidated subsidiary of Bancorp, the sole purpose of which is to issue trust preferred securities. In conjunction with our acquisition of Mission Community Bank (discussed below), Bancorp assumed two additional trusts: Mission Community Capital Trust I ("Trust III"), and Santa Lucia Bancorp (CA) Capital Trust ("Trust IV"), both of which are statutory business trusts formed under the laws of the State of Delaware, the sole purpose of which is to issue trust preferred securities. On February 28, 2014, the Company completed the acquisition of Mission Community Bancorp and its subsidiary Mission Community Bank (collectively "MISN"). The total value of the transaction was $69.0 million, which is comprised of cash of $8.7 million and 7,541,326 shares of Bancorp's common stock valued at $60.3 million, based on the $7.99 closing price of Bancorp's stock on February 28, 2014. The operating results of MISN beginning on March 1, 2014 are included in the Company's results for the first nine months of 2014 and are presented in Note 2. Business Combination, of the Condensed Consolidated Financial Statements filed in this Form 10-Q. The impact of the MISN acquisition to the Company's total loans and deposits was a 34% increase in total loans and 38% increase in total deposits as of February 28, 2014. Strategic Initiatives † Continue as a public company with a common stock that is quoted and traded on a national exchange. In addition to providing access to growth capital, we believe a "public currency" provides flexibility in structuring acquisitions and will allow us to attract and retain qualified management through equity-based compensation. † Expand our commercial and agribusiness loan portfolios to diversify both our customer base and maturities of the loan portfolio and to benefit from the low cost deposits associated with individual accounts and the professional, general business accounts connected to our commercial and agribusiness customers. The Bank successfully recruited and installed an agribusiness team in 2012 which contributed to a significant increase in the Bank's agribusiness lending presence in the Central Coast region of California. Heritage Oaks Bancorp | - 42 - -------------------------------------------------------------------------------- Table of Contents † Enhance the residential lending product mix and loan sale alternatives with Fannie Mae approval by originating qualified loans that are subsequently sold directly to Fannie Mae. † Invest in Infrastructure in order to have the ability to scale efficiently and effectively, in line with our long-term goal of creating a community banking franchise of $3.0 billion to $5.0 billion in total assets. During the month of July, 2014 the Company successfully integrated the operating platform of Mission Community Bank into our existing banking platform. As of October 31, 2014 we have consolidated all but one of the MISN branches into our existing branches and have sold all but one MISN branch building. We anticipate that both the branch consolidation and building sale will be completed by the end of 2014 and that substantially all of the costs of restructuring the Company's operations will be concluded. The comparability of the Company's operating results for the three months and nine months ended September 30, 2014 and 2013 is significantly impacted by the Company's acquisition of MISN on February 28, 2014. Financial Highlights The Company generated net income of $3.4 million or $0.10 per diluted common share, and $4.6 million or $0.14 per diluted common share for the three and nine months ended September 30, 2014, respectively as compared to net income available to common shareholders of $2.6 million or $0.10 per diluted common share and $8.3 million or $0.31 per diluted common share for the same periods a year earlier. Significant factors impacting the Company's net income during the third quarter and year to date through September 30, 2014 are discussed below: † Net interest income was $15.6 million, or 3.98% of average interest earning assets ("net interest margin"), for the third quarter of 2014 compared with $10.5 million, and a 4.04% net interest margin, for the same period in the prior year. Net interest income was $43.2 million, and net interest margin was 3.98% for the year to date through September 30, 2014 compared with $30.8 million, and a 4.07% net interest margin, for the same prior year period. Net interest income increased for the three and nine months ended September 30, 2014 as compared to the same periods in 2013 due primarily to the increase generated from MISN's loan and securities portfolios. We have continued to experience declining yields on our loan portfolio due to the historically low interest rate environment and increasing competition in our lending market; however, the impact of accretion from purchased MISN loans and the increase in average balances from our organic loan growth (exclusive of MISN) over the last two years has significantly offset the impact of declining loan yields on our net interest income when compared to the third quarter and year to date through September 30, 2013. We have actually experienced an increase in loan yields for the third quarter of 2014 as compared to the same prior year period, marking the first time that loan yields have increased as compared to the same prior year quarter in 2014. This increase can be attributed primarily to discount accretion on acquired loans. However, our loan yields are still lower, on a year to date basis, than they were in the prior year. We also have continued to experience compressed yields on our investment securities portfolio; however, securities' yields were essentially unchanged for the nine months ended September 30, 2014 when compared to the same prior year period, and are down only slightly for the third quarter of 2014 as compared to the prior year period, due to both the change in the composition of the securities portfolio, and a deceleration in prepayment speeds, which resulted in less premium amortization relative to the prior year. Heritage Oaks Bancorp | - 43 - -------------------------------------------------------------------------------- Table of Contents † Non-interest expense increased to $13.4 million for the three months and $43.4 million for the nine months ended September 30, 2014, from $8.6 million and $26.9 million, respectively, for the same periods a year earlier. The increase in non-interest expense for both the third quarter and year to date, 2014, as compared to the same prior year periods, was largely attributable to the addition of MISN's operating expenses and merger, restructure and integration related costs. We experienced quarterly and year to date increases in the following expense categories with the primary driver being attributable to the addition of MISN's operations: † salaries and benefits increases of $1.6 million and $3.6 million, respectively, † occupancy and equipment expense increases of $0.6 million and $1.4 million, respectively, and † amortization of intangible expense increases of $0.2 million and $0.5 million, respectively. MISN related merger, restructure, and integration costs of $0.7 million for the three months and $8.8 million for the nine months ended September 30, 2014, respectively, also contributed to the year-over-year increase in non-interest expense. The Company also experienced an increase in professional services expense of $1.1 million for the third quarter and $1.5 million for the year to date, September 30, 2014 as compared to prior year periods. The increase in professional services expense for both the quarter and year to date is primarily attributable to litigation costs with a specific borrower and increased BSA monitoring and compliance costs, which were incurred in response to the issues raised in connection with the issuance of the Consent Order. Other expenses also increased by $0.2 million and $0.6 million for the three and nine months ended September 30, 2014, respectively. For the year to date period through September 30, 2014 these increases to non-interest expense were partially offset by a reduction in the provision for mortgage loan repurchases. We expect MISN operating costs to continue to decline until the end of 2014 as we execute our plan for consolidating 17 branches into 11 branches. As of September 30, 2014 a majority of restructuring costs have concluded, because we have completed the systems conversion of MISN's core banking systems and consolidated all but one of the MISN branch locations. † No provision for loan and lease losses was recorded in the three and nine months ended September 30, 2014 and 2013. Although we recorded net charge-offs of $1.1 million for the first nine months of 2014, no additional provision was required to cover such charge-offs due to the offsetting positive trends in our historical loan loss experience, and level of non-performing and delinquent loans. As of September 30, 2014, MISN legacy loans have no ALLL allocated to them, as the existing un-accreted purchase discounts, which represent 3.27% of these loans has been deemed adequate by management to absorb losses inherent in the acquired portfolio. † Non-interest income increased by $0.6 million to $3.0 million for the third quarter of 2014, and decreased by $3.8 million to $7.2 million for the year to date through September 30, 2014 compared to $2.4 million and $11.0 million for the same prior year periods, respectively. Non-interest income declined for the year to date through September 30, 2014, primarily as a result of a $3.4 million decline of gain on the sale of investment securities, and a decline in mortgage banking income, both of which were partially offset by increased customer fee income attributable to the new MISN customer accounts. The increase in non-interest income for the third quarter of 2014 as compared to the prior year period was largely the result of other income generated by the recovery of fully charged-off former MISN loans, which had no value at the acquisition date, as well as increases in fee and service charge income, and gain on the sale of investment securities. These quarterly increases were all partially offset by a decline in mortgage banking income. Critical Accounting Policies and Estimates Our accounting policies are integral to understanding the Company's financial condition and results of operations. Accounting policies that management considers to be significant, including newly issued standards to be adopted in future periods, are disclosed in Note 1, Summary of Significant Accounting Policies, of the Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2013. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America ("U.S. GAAP") requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially and adversely from those estimates. Heritage Oaks Bancorp | - 44 - -------------------------------------------------------------------------------- Table of Contents Estimates that are particularly susceptible to significant change relate to the determination of purchase accounting adjustments to the fair value of assets purchased and liabilities assumed through strategic acquisitions, the ALLL, the valuation of real estate acquired through foreclosure, the carrying value of the Company's net deferred tax assets and estimates used in the determination of the fair value of certain financial instruments. Fair Value of Assets Purchased and Liabilities Assumed through Strategic Acquisitions When the Company acquires the assets and assumes the liabilities of other financial institutions, GAAP requires an assessment of the fair value of those individual assets and liabilities. This fair value may differ from the cost basis recorded on the acquired institution's financial statements. Management performs an initial assessment to determine which assets and liabilities must be designated for fair value analysis. Management typically engages experts in the field of valuation to perform the valuation of significant assets and liabilities and, after assessing the resulting fair value computation, will utilize such value in computing the initial purchase accounting adjustments for the acquired institution. It is possible that these values could be viewed differently through either alternative valuation approaches or if performed by different experts. Management is responsible for determining that the values determined by experts are reasonable. These computations are also left open for final adjustments for a period of up to one year, primarily to allow for completion of analysis and for possible new information that existed as of the acquisition date to be incorporated into the purchase accounting. See also Note 7. Goodwill and Other Intangible Assets, of the Condensed Consolidated Financial Statements filed in this Form 10-Q. Allowance for Loan Losses and Valuation of Foreclosed Real Estate In connection with the determination of the specific credit component of the ALLL for non-performing loans in the loan portfolio and the value of foreclosed real estate, management obtains independent appraisals at least once a year for significant properties. Although management uses available information to recognize losses on non-performing loans and foreclosed real estate, future additions to the ALLL may be necessary based on changes in local economic conditions or other factors outside our control. The general portfolio component of the ALLL is determined by pooling performing loans by collateral type and purpose. These loans are then further segmented by an internal loan grading system that classifies the credit quality of loans as: pass, special mention, substandard and doubtful. Estimated loss rates are then applied to each segment according to loan grade to determine the amount of the general portfolio allocation. Estimated loss rates are determined through an analysis of historical loss rates for each segment of the loan portfolio, based on the Company's prior experience with such loans. In addition, qualitatively determined adjustments are made to the historical loss history to give effect to certain internal and external factors that may have either a positive or negative impact on the overall credit quality of the loan portfolio. Because of all the variables that go into the determination of both the specific and general allocation components of the ALLL, as well as the valuation of foreclosed real estate, it is reasonably possible that the ALLL and foreclosed real estate values may change in future periods and those changes could be material and have an adverse effect on our financial condition and results of operations. See also Note 5. Loans and Allowance for Loan and Lease Losses, of the Condensed Consolidated Financial Statements filed in this Form 10-Q. Realizability of Deferred Tax Assets The Company uses an estimate of its future earnings in determining if it is more likely than not that the carrying value of its deferred tax assets will be realized over the period they are expected to reverse. If based on all available evidence, the Company believes that a portion or all of its deferred tax assets will not be realized, a valuation allowance must be established. See also Note 6. Income Taxes, of the Condensed Consolidated Financial Statements filed in this Form 10-Q. Fair Value of Financial Instruments The degree of judgment utilized in measuring the fair value of financial instruments generally correlates to the level of observable pricing. Financial instruments with readily available active quoted prices or for which fair value can be measured from actively quoted prices generally will have a higher degree of observable pricing and a lesser degree of judgment utilized in measuring fair value. Conversely, financial instruments rarely traded or not quoted will generally have little or no observable pricing and a higher degree of judgment is utilized in measuring the fair value of such instruments. Observable pricing is impacted by a number of factors, including the type of financial instrument, whether the financial instrument is new to the market and the characteristics specific to the financial instrument, including but not limited to credit and duration profiles. See also Note 3. Fair Value of Assets and Liabilities, of the Condensed Consolidated Financial Statements filed in this Form 10-Q. Heritage Oaks Bancorp | - 45 - -------------------------------------------------------------------------------- Table of Contents Accrual for Restructuring Activities From time to time the Company plans organizational restructuring activities to optimize the efficiency of its operations. Generally accepted accounting principles allow the Company to accrue for certain future restructuring expenses, such as employee termination, retention and relocation costs, contract cancellation costs and fixed asset disposal costs, as long as the Company has adopted a board approved plan for restructuring activities and notified the affected personnel, landlords and vendors within a prescribed timeframe. See Note 11. Restructuring Activities, of the Condensed Consolidated Financial Statements filed on this Form 10-Q. Where You Can Find More Information Under Section 13 of the Securities Exchange Act of 1934, as amended, periodic and current reports must be filed with the U.S. Securities and Exchange Commission (the "SEC"). The Company electronically files the following documents with the SEC: Annual Reports on Form 10-K; Quarterly Reports on Form 10-Q; Current Reports on Form 8-K; and Definitive Proxy Statements on Form DEF 14A. The Company may file additional documents from time to time. The SEC maintains an internet site, www.sec.gov, from which all documents filed or furnished electronically may be accessed. Additionally, all documents filed with the SEC and additional shareholder information is available free of charge on the Company's website: www.heritageoaksbancorp.com. The Company posts these reports and other filings to its website as soon as reasonably practicable after filing them with or furnishing them to the SEC. None of the information on or hyperlinked from the Company's website is incorporated into this Quarterly Report on Form 10-Q. Heritage Oaks Bancorp | - 46 - -------------------------------------------------------------------------------- Table of Contents Selected Financial Data The table below provides selected financial data that highlights the Company's quarterly performance results: At or For The Three Months Ended 9/30/2014 6/30/2014 3/31/2014 12/31/2013 9/30/2013 (dollars in thousands except per share data) Consolidated Income Data: Interest income $ 16,895 $ 16,541 $ 13,602 $ 11,736 $ 11,509 Interest expense 1,324 1,344 1,151 1,049 1,027 Net interest income 15,571 15,197 12,451 10,687 10,482 Provision for loan losses - - - - - Net interest income after provision for loan and lease losses 15,571 15,197 12,451 10,687 10,482 Non-interest income 2,982 2,476 1,750 1,879 2,423 Non-interest expense 13,382 12,986 17,038 9,624 8,551 Income (loss) before income tax expense (benefit) 5,171 4,687 (2,837 ) 2,942 4,354 Income tax expense (benefit) 1,742 1,738 (1,074 ) 1,308 1,593 Net income (loss) 3,429 2,949 (1,763 ) 1,634 2,761 Dividends and accretion on preferred stock - - - - 181 Net income (loss) available to common shareholders $ 3,429 $ 2,949 $ (1,763 ) $ 1,634 $ 2,580 Share Data: Earnings (loss) per common share - basic $ 0.10 $ 0.09 $ (0.06 ) $ 0.06 $ 0.10 Earnings (loss) per common share - diluted $ 0.10 $ 0.09 $ (0.06 ) $ 0.06 $ 0.10 Dividends declared per common share $ 0.03 $ - $ - $ - $ - Common book value per share $ 5.76 $ 5.68 $ 5.55 $ 4.84 $ 4.78 Tangible common book value per share $ 4.85 $ 4.76 $ 4.61 $ 4.34 $ 4.29 Actual shares outstanding at end of period 33,082,205 33,032,436 33,003,414 25,397,780 25,391,343 Weighted average shares outstanding - basic 33,992,465 33,967,670 27,816,911 26,382,523 26,362,467 Weighted average shares outstanding - diluted 34,146,200 34,142,364 27,816,911 26,550,442 26,549,568 Consolidated Balance Sheet Data: Total cash and cash equivalents $ 50,827 $ 83,756 $ 65,857 $ 26,238 $ 33,281 Total investments and other securities $ 382,437 $ 359,630 $ 347,977 $ 276,795 $ 267,179 Total gross loans $ 1,151,576 $ 1,096,883 $ 1,114,070 $ 827,484 $ 777,154 Allowance for loan and lease losses $ (16,787 ) $ (16,635 ) $ (17,968 ) $ (17,859 ) $ (17,468 ) Total assets $ 1,716,224 $ 1,677,672 $ 1,662,200 $ 1,203,651 $ 1,153,843 Total deposits $ 1,422,934 $ 1,394,183 $ 1,365,829 $ 973,895 $ 956,952 Federal Home Loan Bank borrowings $ 75,562 $ 67,566 $ 85,571 $ 88,500 $ 57,500 Junior subordinated debt $ 13,179 $ 13,125 $ 13,071 $ 8,248 $ 8,248 Total shareholders' equity $ 194,119 $ 191,205 $ 186,640 $ 126,427 $ 125,092 Selected Other Balance Sheet Data: Average assets $ 1,691,508 $ 1,667,486 $ 1,362,466 $ 1,180,936 $ 1,123,875 Average earning assets $ 1,552,548 $ 1,532,149 $ 1,267,400 $ 1,088,741 $ 1,028,879 Average shareholders' equity $ 193,061 $ 189,804 $ 149,042 $ 127,087 $ 129,517 Selected Financial Ratios: Return (loss) on average assets 0.80% 0.71% -0.52% 0.55% 0.97% Return (loss) on average equity 7.05% 6.23% -4.80% 5.10% 8.46% Return (loss) on average tangible common equity 8.55% 7.61% -5.74% 5.85% 9.04% Net interest margin (1) 3.98% 3.98% 3.98% 3.89% 4.04% Efficiency ratio (2) 71.91% 71.90% 118.28% 75.33% 67.10% Non-interest expense to average assets 3.14% 3.12% 5.07% 3.23% 3.02% Capital Ratios: Average equity to average assets 11.41% 11.38% 10.94% 10.76% 11.52% Leverage Ratio 10.00% 9.83% 11.64% 10.20% 10.58% Tier 1 Risk-Based Capital ratio 12.87% 12.85% 12.25% 12.91% 13.27% Total Risk-Based Capital ratio 14.12% 14.10% 13.50% 14.17% 14.53% Selected Asset Quality Ratios: Non-performing loans to total gross loans (3) 0.89% 1.04% 0.89% 1.22% 1.63% Non-performing assets to total assets (4) 0.60% 0.69% 0.62% 0.84% 1.10% Allowance for loan and lease losses to total gross loans 1.46% 1.52% 1.61% 2.16% 2.25% Net charge-offs (recoveries) to average loans -0.06% 0.48% -0.05% -0.20% 0.24% (1) Net interest margin represents net interest income as a percentage of average interest-earning assets. (2) The efficiency ratio is defined as total non-interest expense as a percent of the combined net interest income plus non-interest income, exclusive of gains and losses on security sales, other than temporary impairment losses, gains and losses on sale of OREO and other OREO related costs, gains and losses on sale of fixed assets, and the amortization of intangible assets. (3) Non-performing loans are defined as loan that are past due 90 days or more as well as loan placed in non-accrual status. (4) Non-performing assets are defined as loans that are past due 90 days or more and loans placed in non-accrual status plus other real estate owned. Heritage Oaks Bancorp | - 47 - -------------------------------------------------------------------------------- Table of Contents Results of Operations Net Interest Income and Margin Net interest income, the primary component of the net earnings of a financial institution, refers to the difference between the interest earned on loans and investments and the interest paid on deposits and borrowings. The net interest margin is the amount of net interest income expressed as a percentage of average interest earning assets. Factors considered in the analysis of net interest income are the composition and volume of interest-earning assets and interest-bearing liabilities, the amount of non-interest bearing liabilities and non-accrual loans, and changes in market interest rates. For the three months ended September 30, 2014 and 2013, net interest margin was 3.98% and 4.04%, respectively. Net interest margin for the nine months ended September 30, 2014 and 2013 was 3.98% and 4.07%, respectively. The tables below set forth the details that make up net interest margin including, average balance sheet information, interest income and expense, average yields and rates and net interest income and margin: For the Three Months Ended For the Three Months Ended September 30, 2014 September 30, 2013 Yield/ Income/ Yield/ Income/ Balance Rate (4) Expense Balance Rate (4) Expense (dollars in thousands) Interest Earning Assets Interest earning deposits in other banks $ 72,348 0.20 % $ 36 $ 11,729 0.27 % $ 8 Investment securities 374,359 2.06 % 1,946 254,997 2.10 % 1,347 Other investments 9,839 6.77 % 168 6,642 5.38 % 90 Loans (1) (2) 1,096,002 5.34 % 14,745 755,511 5.28 % 10,064 Total interest earning assets 1,552,548 4.32 % 16,895 1,028,879 4.44 % 11,509 Allowance for loan and lease losses (16,696 ) (18,055 ) Other assets 155,656 113,051 Total assets $ 1,691,508 $ 1,123,875 Interest Bearing Liabilities Interest bearing demand $ 106,382 0.11 % $ 30 $ 80,523 0.10 % $ 21 Savings 104,757 0.10 % 26 41,563 0.10 % 10 Money market 438,824 0.29 % 317 303,842 0.34 % 257 Time deposits 289,886 0.75 % 545 201,670 0.87 % 443 Total interest bearing deposits 939,849 0.39 % 918 627,598 0.46 % 731 Federal Home Loan Bank borrowing 65,824 1.59 % 264 62,598 1.61 % 254 Junior subordinated debentures 13,145 4.29 % 142 8,248 2.02 % 42 Total borrowed funds 78,969 2.04 % 406 70,846 1.66 % 296 Total interest bearing liabilities 1,018,818 0.52 % 1,324 698,444 0.58 % 1,027 Non interest bearing demand 467,868 288,380 Total funding 1,486,686 0.35 % 1,324 986,824 0.41 % 1,027 Other liabilities 11,761 7,534 Total liabilities 1,498,447 994,358 Shareholders' Equity Total shareholders' equity 193,061 129,517 Total liabilities and shareholders' equity $ 1,691,508 $ 1,123,875 Net interest margin (3) 3.98 % 4.04 % Interest rate spread 3.80 % $ 15,571 3.86 % $ 10,482 (1) Non-accruing loans have been included in total loans. (2) Loan fees have been included in interest income computation. (3) Net interest margin has been calculated by dividing the net interest income by total average earning assets. (4) Yield / Rate is annualized using actual number of days in period. Heritage Oaks Bancorp | - 48 - -------------------------------------------------------------------------------- Table of Contents For the Nine Months Ended For the Nine Months Ended September 30, 2014 September 30, 2013 Yield/ Income/ Yield/ Income/ Balance Rate (4) Expense Balance Rate (4) Expense (dollars in thousands) Interest Earning Assets: Interest earning deposits in other banks $ 57,818 0.18 % $ 77 $ 15,007 0.22 % $ 25 Investment securities 343,561 2.08 % 5,355 256,462 2.08 % 3,993 Other investments 8,920 6.86 % 458 6,573 3.89 % 191 Loans (1) (2) 1,041,358 5.28 % 41,134 734,271 5.36 % 29,448 Total interest earning assets 1,451,657 4.33 % 47,024 1,012,313 4.45 % 33,657 Allowance for loan and lease losses (17,559 ) (17,986 ) Other assets 140,930 104,247 Total assets $ 1,575,028 $ 1,098,574 Interest Bearing Liabilities: Interest bearing demand $ 101,677 0.11 % $ 83 $ 75,153 0.10 % $ 59 Savings 92,013 0.10 % 67 40,322 0.10 % 30 Money market 407,086 0.31 % 931 294,123 0.33 % 722 Time deposits 276,912 0.76 % 1,580 193,502 0.89 % 1,290 Total interest bearing deposits 877,688 0.41 % 2,661 603,100 0.47 % 2,101 Federal Home Loan Bank borrowing 77,548 1.38 % 801 57,866 1.37 % 592 Junior subordinated debentures 12,061 3.96 % 357 8,248 2.03 % 125 Total borrowed funds 89,609 1.73 % 1,158 66,114 1.45 % 717 Total interest bearing liabilities 967,297 0.53 % 3,819 669,214 0.56 % 2,818 Non interest bearing demand 419,949 276,499 Total funding 1,387,246 0.37 % 3,819 945,713 0.40 % 2,818 Other liabilities 10,331 11,444 Total liabilities 1,397,577 957,157 Shareholders' Equity: Total shareholders' equity 177,451 141,417 Total liabilities and shareholders' equity $ 1,575,028 $ 1,098,574 Net interest margin (3) 3.98 % 4.07 % Interest rate spread 3.80 % $ 43,205 3.89 % $ 30,839 (1) Non-accruing loans have been included in total loans. (2) Loan fees have been included in interest income computation. (3) Net interest margin has been calculated by dividing net interest income by total average earning assets. (4) Yield / Rate is annualized using actual number of days in period. Heritage Oaks Bancorp | - 49 - -------------------------------------------------------------------------------- Table of Contents The volume and rate variance tables below set forth the dollar difference in interest earned and paid for each major category of interest earning assets and interest bearing liabilities as compared to the corresponding period a year earlier, and the amount of such change attributable to changes in average balances (volume), changes in average yields and rates (rate) and the interplay of the impacts of the changes in rates and volumes (rate/volume): For The Three Months Ended, For The Nine Months Ended, September 30, 2014 over 2013 September 30, 2014 over 2013 Volume Rate Rate/Volume Total Volume Rate Rate/Volume Total (dollars in thousands) Interest income: Interest bearing deposits in other banks $ 41 $ (2 ) $ (11 ) $ 28 $ 70 $ (4 ) $ (14 ) $ 52 Investment securities 632 (26 ) (7 ) 599 1,355 - 7 1,362 Other investments 43 23 12 78 68 146 53 267 Loans 4,531 114 36 4,681 12,311 (439 ) (186 ) 11,686 Net increase (decrease) 5,247 109 30 5,386 13,804 (297 ) (140 ) 13,367 Interest expense: Interest bearing demand 7 2 - 9 20 6 (2 ) 24 Savings 16 - - 16 39 - (2 ) 37 Money market 116 (38 ) (18 ) 60 279 (44 ) (26 ) 209 Time deposits 193 (61 ) (30 ) 102 555 (188 ) (77 ) 290 Federal Home Loan Bank borrowing 13 (3 ) - 10 202 4 3 209 Long term borrowings 25 47 28 100 58 119 55 232 Net increase (decrease) 370 (53 ) (20 ) 297 1,153 (103 ) (49 ) 1,001 Total net increase (decrease) $ 4,877 $ 162 $ 50 $ 5,089 $ 12,651 $ (194 ) $ (91 ) $ 12,366 For the three-month and nine-month periods ended September 30, 2014, as compared to the corresponding periods in 2013, the continued current low interest rate environment has had an adverse impact on yields of new and renewing loans. However, the purchase discount accretion of the acquired MISN loan portfolio has provided a significant offset to the decline in new loan yields for both the three and nine month periods ended September 30, 2014. Total discount accretion on acquired loans was $0.9 million, and $2.2 million for the three and nine months ended September 30, 2014, respectively. This mix of these positive and negative factors has resulted in an increase of 6 basis points, and a decrease of 8 basis points for the three and nine months ended September 30, 2014, respectively. The low interest rate environment and relative flatness of interest yield curves have had a compounding impact on securities' yields as new investments are typically providing lower yields. Such lower yields however, have been partially offset by slower prepayment speeds in 2014. These offsetting factors have resulted in no change in securities yields on a year to date basis, and a 4 basis point decrease on a quarterly basis, when comparing the quarter and year to date ended September 30, 2014, to the same prior year periods. The final significant factor impacting earning asset yields for both periods ended September 30, 2014 is the shift in asset mix to a greater proportion of lower-yielding interest earning deposits in other banks, which resulted in a lower proportion of investment securities and loans when compared to the same prior year periods. These combined factors have resulted in a decline in the yield on earning assets for both the three and nine month periods ended September 30, 2014 of 12 basis points, as compared to the corresponding periods in 2013. While the loan portfolio has continued to grow since the second quarter of 2013, both due to the acquisition of MISN loans and through organic loan production, and continues to contribute to a more favorable earning asset mix, we continue to hold a large portion of our earning assets in lower yielding investment securities and, more recently, in much lower yielding interest earning deposits in other banks. Modest decreases in funding costs related to shifts in the composition of deposits from interest-bearing accounts to more liquid non-interest bearing deposit accounts, along with reduced rates of interest paid on interest bearing deposits, have resulted in a lower cost of funds that has partially offset the reduced yields on interest-earning assets. These factors have resulted in 6 and 9 basis point declines, respectively, in our net interest margin for the three and nine month periods ended September 30, 2014, as compared to the same periods a year earlier. The decrease in loan yields for the third quarter and year to date, through September 30, 2014, as compared to the same periods a year earlier, are attributable to the repayment of existing Heritage Oaks loans and origination of lower yielding new loans, which had negative 39 and 46 basis point impacts to loan yields, respectively. The impact of loan prepayment fees offset this negative trend for both the three and nine months ended September 30, 2014 by 2 basis points, however, loan prepayment fees contributed 5 and 1 less basis points to loan yields during the first three months and nine months of 2014 as compared to the same prior year period. Heritage Oaks Bancorp | - 50 - -------------------------------------------------------------------------------- Table of Contents The third quarter of 2014 represents the second full quarter of contribution from MISN earning assets to the Company's net interest margin. The average yield of acquired MISN earning assets was 18 basis points lower than that of the legacy Heritage Oaks earning asset yield at the time of acquisition. However, the impact of purchase loan discount accretion had positive 22 and 20 basis point impacts to both the net interest margin and earning asset yields for the third quarter of 2014 and the year to date September 30, 2014, respectively. Forgone interest on non-accrual loans continued to negatively impact interest income for the three month and nine month periods ended September 30, 2014. Total forgone interest related to non-accrual loans, which includes (1) the initial accrued interest reversal when a loan is transferred to non-accrual status, (2) interest lost prospectively for the period of time a loan is on non-accrual status and (3) lost interest due to restructuring terms below original note terms or below current market-rate terms, was approximately $0.2 million and $0.3 million during the three months ended September 30, 2014 and 2013, respectively, and $0.6 million and $0.8 million for the nine months periods ended September 30, 2014 and 2013. Total forgone interest on non-accrual loans reduced the yield on the loan portfolio by 7 basis points for the three months and by 8 basis points for the nine months ended September 30, 2014 as compared to 13 basis points and 14 basis points for the corresponding periods in 2013, respectively. The reasons for the reduced negative impact of foregone interest to the loan portfolio's yield in 2014 is an increase in the average balance of the loan portfolio attributable to the MISN merger and organic growth achieved over the last year in the legacy Heritage Oaks loan portfolio, as well as a decline in the total dollar amount of forgone interest. Our earnings are influenced by changes in interest rates. The Company is in a net asset sensitive position. A large percentage of our interest sensitive assets and liabilities re-price with changes in market interest rates. A significant portion of the variable rate component of the Company's loan portfolio has had the interest rates set to their respective contractual interest rate floors. To the extent that overall interest rates rise, the Company will not experience the benefit of rising interest rates until such rates rise above such interest rate floors. See Item 3, Qualitative and Quantitative Disclosures About Market Risk, included in this Quarterly Report on Form 10-Q, for further discussion of the Company's sensitivity to interest rate movements based on our current net asset sensitive profile, as well as the impact of interest rate floors on the variable rate component of our loan portfolio. The yield on investment securities for the third quarter of 2014 was 4 basis points lower at 2.06% compared to 2.10% for the third quarter of 2013. The decrease in investment securities yield for the third quarter of 2014 is primarily attributable to decreased capital market interest rates which have contributed to decreased yields on reinvested cash flows. Offsetting this trend has been an increase in the allocation of higher yielding tax-exempt bonds in 2014 as compared to 2013 which has helped to augment current year yields. The tax-exempt securities portfolio increased from 16.5% of the total portfolio in the third quarter of 2013 to 19.2% for the third quarter of 2014. Investment securities yields were unchanged at 2.08% for the nine months ended September 30, 2013 and 2014. The yield on the portfolio was unchanged due to the same competing influences of a decline in capital market interest rates and an increase in higher yielding tax-exempt municipal bonds discussed with regard to the quarterly yield. The impact of these two factors on the year to date yield on investment securities resulted in no change in the yield for 2014 as compared to prior year. For the three months ended September 30, 2014, average interest-earning assets increased $523.7 million, or 50.9%, over that reported in the corresponding period in 2013. Average interest-earning assets for the nine months ended September 30, 2014 increased $439.3 million, or 43.4% over the corresponding period in 2013. Growth in average earning assets for both the three month and nine month periods was largely driven by growth across all earning asset types due to the loans purchased and excess liquidity generated by the deposits assumed through the MISN merger. The average balance of interest-bearing liabilities was $320.4 million, or 45.9%, higher for the three months ended September 30, 2014, as compared to the corresponding period a year earlier. Average interest-bearing liabilities for the nine months ended September 30, 2014 increased by $298.1 million, or 44.5%, as compared to the corresponding period in 2013. Growth in average interest-bearing liabilities was primarily the result of the merger with MISN. Average interest-bearing deposits were $312.3 million, or 49.8%, higher for the three months ended September 30, 2014, as compared to the corresponding period a year earlier, and $274.6 million, or 45.5%, higher for the nine month period. Heritage Oaks Bancorp | - 51 - -------------------------------------------------------------------------------- Table of Contents The rate paid on interest bearing deposits declined by 7 basis points, to 0.39%, for the three months, and declined by 6 basis points to 0.41%, for the nine months ended September 30, 2014 as compared to the same periods a year earlier. This decline is in part due to the historically low interest rate environment that has existed for the last few years, but is also due to our efforts to systematically lower our cost of deposits over this same time period. Although such efforts have contributed to a moderate decline in time deposits (for legacy Heritage Oaks balances), the overall deposit mix and cost of our deposit portfolio has greatly improved as a result of these efforts. We also benefitted from lower cost of deposits acquired through the MISN merger in both the three and nine month periods ended September 30, 2014. This benefit was fully realized in the second and third quarters of the 2014. In addition to the favorable effects realized from these changes in our interest bearing deposits, our quarterly average non-interest bearing demand deposit balances have increased by $179.5 million, to $467.9 million, for the three months ended September 30, 2014 as compared to the prior year period. The contribution to reduced funding costs of our non-interest bearing demand deposit balances has had a positive impact of 17 basis points on total funding costs for the three months ended September 30, 2014, and 2013; for the first nine months, of both 2014 and 2013, the impact of increased non-interest bearing deposit balances on our total cost of funds was 16 basis points. Total cost of funds for the three-month and nine-month periods ended September 30, 2014 were 0.35% and 0.37% respectively, decreases of 6 basis points and 3 basis points, respectively, as compared to the corresponding periods in 2013. For each of the three-month and nine-month periods ended September 30, 2014, the average rate paid on interest bearing liabilities was 0.52% and 0.53%, respectively as compared with 0.58% and 0.56%, respectively, for the corresponding periods in 2013. The benefits from the deposit portfolio rate reductions previously discussed were substantially offset by an increase in funding costs for Federal Home Loan Bank ("FHLB") borrowings and increased interest expense from the addition of MISN-acquired junior subordinated debentures (including purchase discount amortization expense, which is a component of interest expense), as the Company has strategically decided to lock in historically low fixed rates to match-fund longer term fixed rate loans, as well as an increase in the cost of junior subordinated debentures attributable to the MISN purchase discount. Provision for Loan and Lease Losses The ALLL is maintained at a level considered by management to be adequate to provide for probable credit losses inherent in the loan portfolio as of the balance sheet date and is based on methodologies applied on a consistent basis with the prior year. Management's review of the adequacy of the ALLL includes, among other things, an analysis of past loan loss experience and management's evaluation of the loan portfolio under current economic conditions. See also Note 5. Loans and Allowance for Loan and Lease Losses, of the Condensed Consolidated Financial Statements, filed with this Quarterly Report on Form 10-Q, for additional detail on the ALLL. The ALLL is based on estimates, and actual losses may vary from current estimates. Such variances could be material and could have an adverse effect on the Company's performance. The Company recognizes that the risk of loss will vary with, among other things: general economic conditions; the type of loan being made; the creditworthiness of the borrower over the term of the loan; and, in the case of a collateralized loan, the quality of the collateral for such loans. The ALLL represents the Company's best estimate of the amount necessary to provide for probable losses inherent in the portfolio as of the balance sheet date. The Company did not record a provision for loan and lease losses during the three and nine months ended September 30, 2014 and 2013. Although the Company recorded net charge-offs of $1.1 million during the first nine months of 2014, positive adjustments to the general reserve, driven by a reduction in our historical losses, negated the need for additional ALLL and related provision expense. The lack of a loan loss provision in 2014 and 2013 is reflective of the continuing improvements in the overall credit quality of the loan portfolio, the overall improvement in the historical charge-off history over the last year, the improvement in property values that serve as collateral for a large portion of our loans, as well as the limited amount of new loans moving into non-accrual status and therefore requiring specific reserves, all of which were largely offset by increased ALLL requirements due to the growth in the loan portfolio. As of September 30, 2014, the Company's ALLL represented 1.46% of total gross loans. For additional information, see the "Allowance for Loan and Lease Losses" discussion in the Financial Condition section of Management's Discussion and Analysis of Financial Condition and Results of Operations. Heritage Oaks Bancorp | - 52 - -------------------------------------------------------------------------------- Table of Contents Non-Interest Income The table below sets forth changes in non-interest income as compared to the corresponding period a year earlier: For the Three Months Ended For the Nine Months Ended Variances September 30, September 30, For the Three Months For the Nine Months 2014 2013 2014 2013 dollar percentage dollar percentage (dollars in thousands) Fees and service charges $ 1,410 $ 1,195 $ 3,949 $ 3,330 $ 215 18.0% $ 619 18.6% Net gain on sale of loans 411 513 967 1,949 (102 ) -19.9% (982 ) -50.4% Mortgage origination income 64 143 223 570 (79 ) -55.2% (347 ) -60.9% Gain on sale of investment securities 450 344 549 3,935 106 30.8% (3,386 ) -86.0% Other income 647 228 1,533 1,212 419 183.8% 321 26.5% Total $ 2,982 $ 2,423 $ 7,221 $ 10,996 $ 559 23.1% $ (3,775 ) -34.3% Non-interest income increased by $0.6 million, to $3.0 million, for the third quarter of 2014, from $2.4 million for the same prior year period, and decreased by $3.8 million to $7.2 million for the year to date through September 30, 2014, from $11.0 million for the same prior year period. The increase in quarterly non-interest income for the third quarter of 2014 as compared to the same prior year period was due to a $0.4 million increase in other income, primarily attributable to the recovery of fully charged-off former MISN loans, which had no value at the acquisition date, and a $0.2 million increase in fees and service charge income, attributable to the new MISN customer accounts. These positive quarterly variances were offset by a $0.1 million decline in both mortgage origination and gain on sale income. The decline in non-interest income for the year to date through September 30, 2014 is primarily the result of a $3.4 million decline of gains on the sale of investment securities for 2014 as compared to the same prior year period. This decline was attributable to the gain on sale of $89.3 million of securities which were sold in the first quarter of 2013. These securities were sold to reduce the overall duration of the investment securities portfolio to limit interest rate risk and to provide a funding source for our growing loan demand. In addition, we experienced a reduction in the gain on mortgage loan sales and mortgage origination fee income of $1.3 million during the first nine months of 2014 as compared to the same prior year period. These negative year to date variances were partially offset by increases in fees and service charges of $0.6 million, and in other income of $0.3 million attributable to the recovery of fully charged-off former MISN loans, which had no value at the acquisition date. Non-Interest Expenses The table below sets forth changes in non-interest expenses as compared to the corresponding period last year: For the Three Months Ended For the Nine Months Ended Variances Variances September 30, September 30, For the Three Months For the Nine Months 2014 2013 2014 2013 dollar percentage dollar percentage (dollars in thousands) Salaries and employee benefits $ 6,164 $ 4,529 $ 18,121 $ 14,535 $ 1,635 36.1% $ 3,586 24.7% Occupancy and equipment 1,776 1,176 4,989 3,629 600 51.0% 1,360 37.5% Information technology 756 658 2,403 1,925 98 14.9% 478 24.8% Professional services 1,839 729 3,610 2,082 1,110 152.3% 1,528 73.4% Regulatory assessments 351 212 862 851 139 65.6% 11 1.3% Sales and marketing 232 170 595 438 62 36.5% 157 35.8% Foreclosed asset costs and write-downs 55 23 182 131 32 139.1% 51 38.9% Provision for mortgage loan repurchases 27 - 27 570 27 - (543 ) -95.3% Amortization of intangible assets 297 100 760 300 197 197.0% 460 153.3% Merger, restructure and integration 748 - 8,785 - 748 - 8,785 - Other expense 1,137 954 3,073 2,478 183 19.2% 595 24.0% Total $ 13,382 $ 8,551 $ 43,407 $ 26,939 $ 4,831 56.5% $ 16,468 61.1% Non-interest expense increased by $4.8 million and $16.5 million for the three and nine month periods ended September 30, 2014, as compared to the same prior year periods. These increases were largely driven by the impacts of the MISN merger. Increases of $1.6 million in salaries and employee benefits costs and $0.6 million in occupancy and equipment costs for the three months ended September 30, 2014 were primarily attributable to the addition of MISN operating costs and MISN merger, restructure and integration costs contributed another $0.7 million to the third quarter, 2014 increase in non-interest expenses as compared to the third quarter of 2013. Another significant component of the increase in quarterly non-interest expenses was due to increased professional service expenses of: 1) legal expenses of $0.6 million primarily related to a borrower litigation, 2) $0.3 million of outsourced bank secrecy act and anti-money laundering compliance, monitoring, and auditing services, and 3) $0.2 million related to the outsourcing of information technology management services, when compared to the third quarter of 2013. Amortization of the intangible assets derived from the MISN purchase accounting and other expenses each contributed another $0.2 million increase in quarterly non-interest expenses for the third quarter, 2014 as compared to the same prior year period as well. Heritage Oaks Bancorp | - 53 - -------------------------------------------------------------------------------- Table of Contents The largest variances for the nine month period ended September 30, 2014 were: 1) $8.8 million of merger, restructure, and integration costs, 2) $3.6 million increase in salaries and employee benefits, 3) $1.5 million increase in professional services, and 4) $1.4 million increase in occupancy and equipment expense. MISN related merger, restructure and integration costs included $3.7 million of accruals related to termination benefits paid to employees displaced as a result of the merger and for retention of key employees through integration-related milestone dates, $2.1 million attributable to elimination of owned and leased facilities and related fixed assets, $1.8 million related to contractual cancellation costs of duplicative systems and services, $0.5 million to integrate the two banks' operating systems, and $0.7 million of professional services paid to help facilitate the merger and integration. The addition of MISN operations is the primary reason for the $3.6 million increase in salaries and employee benefits and $1.4 million increase in occupancy and equipment expense for the nine months ended September 30, 2014 as compared to the same prior year period. Professional services expenses were also elevated by $1.5 million on a year to date basis through September 30, 2014 due to: 1) increased costs related to the outsourcing of information technology management services of $0.5 million, 2) $0.4 million of outsourced bank secrecy act and anti-money laundering compliance, monitoring, and auditing services, and 3) $0.4 million due to litigation with a borrower, when compared to the same period in 2013. Amortization of the intangible assets derived from the MISN purchase accounting and other expenses contributed $0.5 million and $0.6 million increases in quarterly non-interest expenses for the third quarter, 2014, respectively, as compared to the same prior year period. The first nine months of 2014 were also favorably impacted by the $0.5 million decline in the provision for mortgage repurchases. Excluding the $8.8 million of merger, restructure, and integration costs from the first nine months of 2014 would result in total non-interest expense of $34.6 million, or 2.9% of assets on an annualized basis. This compares with $26.9 million for the first nine months of 2013, or 3.3% of assets, annualized. Provision for Income Taxes For the three-month and nine-month periods ended September 30, 2014, the Company recorded income tax expense of approximately $1.7 million and $2.4 million, respectively. This compares to an income tax provision of $1.6 million and $5.7 million for the comparable periods in 2013. The changes in the provision for income taxes for the 2014 periods, as compared to the corresponding periods in 2013, can be attributed to the incremental changes in the components of earnings before taxes discussed above, most notably due to the merger, restructure, and integration expenses incurred in 2014 related to the merger with MISN. The Company's effective tax rate was 33.7% for the three months ended September 30, 2014, and 34.3% for the nine months ended September 30, 2014. The effective tax rate for the corresponding periods in 2013 were 36.6% and 38.2%, respectively. During the third quarter of 2014, the Bank's combined overall federal and state tax rate before the impact of permanent differences increased to 42.05% from 41.67%, resulting in a one-time true-up to the balance of deferred tax assets. Excluding the impact of this change, the Company's effective overall tax rate for the three and nine months ended September 30, 2014 would have been 37.9% and 37.4%, respectively. Excluding the impact of the merger and integration expenses in 2014, the effective tax rate would have been 39.1% for the nine months ended September 30, 2014. The determination as to whether a valuation allowance should be established against deferred tax assets is based on the consideration of all available evidence using a "more likely than not" standard. Management evaluates the realizability of the deferred tax assets on a quarterly basis. Please see Note 6. Income Taxes, of the Condensed Consolidated Financial Statements, filed with this Quarterly Report on Form 10-Q for additional information concerning the Company's deferred tax assets. Financial Condition At September 30, 2014, total assets were approximately $1.7 billion. This represents an increase of $513 million or 42.6% from that reported at December 31, 2013, of which $454 million was attributable to the merger with MISN. At September 30, 2014, total deposits were approximately $1.4 billion, which was $449 million, or 46.1%, more than that reported at December 31, 2013. The merger with MISN contributed $372 million to total deposits as of the merger date. Heritage Oaks Bancorp | - 54 - -------------------------------------------------------------------------------- Table of Contents Total Cash and Cash Equivalents Total cash and cash equivalents were $50.8 million and $26.2 million at September 30, 2014 and December 31, 2013, respectively. This line item will vary depending on daily cash settlement activities, the amount of highly liquid assets needed based on known events such as the repayment of borrowings or loans expected to be funded in the near future, and actual cash on hand in the branches. On February 28, 2014, $37.6 million in cash and cash equivalents were acquired in conjunction with the MISN merger. Investment Securities and Other Earning Assets Other earning assets are comprised of interest-earning deposits with the Federal Reserve, Federal Funds Sold (funds the Company lends on a short-term basis to other banks), investments in securities and short-term interest-earning deposits at other financial institutions. These assets are maintained for the liquidity needs of the Company, collateralization of public deposits, and diversification of the earning asset mix. Securities Available for Sale The Company manages its securities portfolio to provide a source of both liquidity and earnings. The Company has invested in a mix of securities including obligations of U.S government agencies, mortgage backed securities and state and municipal securities. The Company has an Asset/Liability Committee that has developed investment policies based upon the Company's operating needs and market circumstances. The Company's investment policy is formally reviewed and approved annually by the Board of Directors. The Asset/Liability Committee is responsible for reporting and monitoring compliance with the investment policy. Reports are provided to the Company's Board of Directors on a regular basis. The following table provides a summary of investment securities by securities type: September 30, 2014 December 31, 2013 Amortized Amortized Cost Fair Value Cost Fair Value (dollars in thousands) Obligations of U.S. government agencies $ 16,923 $ 16,891 $ 6,243 $ 6,208 Mortgage backed securities U.S. government sponsored entities and agencies 242,947 241,130 186,981 182,931 Non-agency 11,913 11,936 10,924 11,032 State and municipal securities 78,829 80,687 51,532 50,030 Asset backed securities 31,988 31,793 26,935 26,594 Total available for sale securities $ 382,600 $ 382,437 $ 282,615 $ 276,795 At September 30, 2014, the fair value of the investment portfolio was approximately $382.4 million, or $105.6 million higher than that reported at December 31, 2013. The increase in the balance of the portfolio can primarily be attributed to the $76.2 million in investments acquired in the merger with MISN coupled with deposit growth over the year increasing available cash to invest. Also during the first three quarters of 2014, the Bank sold $98.4 million of securities from the portfolio at a net gain of $549 thousand. Securities available for sale are carried at fair value with related unrealized net gains or losses, net of deferred income taxes, recorded as an adjustment to equity capital. At September 30, 2014, the securities portfolio had unrealized losses, net of taxes, of approximately $0.1 million, an improvement of approximately $3.3 million from that reported at December 31, 2013. Fluctuations in the fair value of the investment portfolio in the last three years can be attributed to market turbulence and volatility in overall interest rates, stemming in part from economic conditions. All fixed and adjustable rate mortgage pools and collateralized mortgage obligations contain a certain amount of risk related to the uncertainty of prepayments of the underlying mortgages, where prepayments are directly impacted by interest rate changes. The Company uses computer simulation models to test the average life, duration, market volatility and yield volatility of mortgage pools and collateralized mortgage obligations under various interest rate assumptions to monitor volatility. The majority of the Company's mortgage backed securities were issued by The Government National Mortgage Association ("Ginnie Mae"); The Federal National Mortgage Association ("Fannie Mae"); and The Federal Home Loan Mortgage Corporation ("Freddie Mac"). These securities carry the guarantee of the issuing agencies. At September 30, 2014, approximately $241.1 million or 95.3% of the Company's mortgage related securities were issued by a government agency or government sponsored entities. Heritage Oaks Bancorp | - 55 - -------------------------------------------------------------------------------- Table of Contents The following table sets forth the maturity distribution of available for sale securities in the investment portfolio and the weighted average yield for each category: September 30, 2014 Over 1 Over 5 Years One Year Or Through 5 Through 10 Less Years Years Over 10 Years Total (dollars in thousands) Obligations of U.S. government agencies $ 117 $ 476 $ 14,503 $ 1,795 $ 16,891 Mortgage backed securities U.S. government sponsored entities and agencies 36,510 96,446 56,776 51,398 241,130 Non-agency 731 10,704 501 - 11,936 State and municipal securities 975 14,473 60,808 4,431 80,687 Asset backed securities - 2,534 11,794 17,465 31,793 Total available for sale securities $ 38,333 $ 124,633 $ 144,382 $ 75,089 $ 382,437 Amortized cost $ 38,459 $ 124,890 $ 143,476 $ 75,775 $ 382,600 Weighted average yield 1.92% 2.00% 2.52% 2.76% 2.34% Federal Home Loan Bank ("FHLB") Stock As a member of the FHLB of San Francisco, the Company is required to hold a specified amount of FHLB capital stock based on the level of borrowings the Company has obtained from the FHLB. As such, the amount of FHLB stock the Company carries can vary from one period to another based on, among other things, the current liquidity needs of the Company. At September 30, 2014 and December 31, 2013, the Company held approximately $7.9 million and $4.7 million, respectively, in FHLB stock. The increase of FHLB stock from December 31, 2013 was primarily due to FHLB stock acquired in the MISN merger. Loans Summary of Market Conditions The addition of a new sales team focused on our region's largest industry-agriculture-as well as the commercial and small business segments of the market, and single-family mortgages, has continued to contribute to net loan growth in 2014. Gross loans increased $324.1 million during the first nine months of 2014, of which $280.3 million can be attributed to loans acquired in the MISN acquisition (as of February 28, 2014). Excluding the impact of the loans acquired in the MISN acquisition, gross loans increased $43.8 million during the first nine months of 2014. This increase is attributable to the Bank's continued focus on organic loan growth in our region following our attention to the integration and retention of MISN customers during the second quarter of 2014, as well as $27.2 million in selective multi-family loan purchases during the third quarter of 2014 which were acquired for portfolio diversification. We continue to see improving borrower activity and we anticipate that this increased activity in our existing markets, in conjunction with the Bank's new sales team and our expansion into Ventura and Santa Barbara Counties with the opening of loan production offices during 2012 and 2013, have positioned the Bank for continued growth in the loan portfolio. Although we are seeing some signs of stabilization in the local economies in which the Company operates, management realizes that a renewed decline in the global, national, state or local economies, and / or continued drought conditions on the Central Coast of California, may negatively impact local borrowers, as well as negatively impact values of real estate within our market footprint. As such, management continues to closely monitor credit trends and leading indicators for renewed signs of deterioration. The Bank employs stringent lending standards and remains very selective with regard to loan originations, including CRE, real estate construction, land and commercial loans that it chooses to originate, in an effort to effectively manage risk in the current credit environment. Additionally, purchased loans are evaluated under the same standards as originated loans. The Company is focused on monitoring credit in order to take proactive steps, when and if necessary, to mitigate any material adverse impacts on the Company. Heritage Oaks Bancorp | - 56 - -------------------------------------------------------------------------------- Table of Contents Credit Quality The Company's primary business is the extension of credit to individuals and businesses and the safekeeping of customers' deposits. The Company's policies concerning the extension of credit require risk analysis, including an extensive evaluation of the purpose for the loan request and the borrower's ability and willingness to repay the Bank as agreed. The Company also considers other factors when evaluating whether or not to extend new credit to a potential borrower. These factors include the current level of diversification in the loan portfolio and the impact that funding a new loan will have on that diversification, legal lending limit constraints and any regulatory limitations concerning the extension of certain types of credit. The credit quality of the loan portfolio is impacted by numerous factors, including the economic environment in the markets in which the Company operates, which can have a direct impact on the value of real estate securing collateral-dependent loans. An inability of certain borrowers to continue to perform under the original terms of their respective loan agreements, in conjunction with declines in real estate collateral values, may result in increases in provisions for loan and lease losses that would, in turn, have an adverse impact on the Company's operating results. See also Note 5. Loans and Allowance for Loan and Lease Losses, of the Condensed Consolidated Financial Statements, filed with this Quarterly Report on Form 10-Q for a more detailed discussion concerning credit quality, including the Company's related policy. Loans Held for Sale Loans held for sale primarily consist of residential mortgage originations that have already been specifically designated for sale pursuant to correspondent mortgage loan investor agreements. There is minimal interest rate risk associated with these loans as purchase commitments are entered into with investors at the time the Company funds the loans. Settlement from the correspondents is typically within 30 to 60 days of funding the mortgage. At September 30, 2014, mortgage correspondent loans (loans held for sale) totaled approximately $6.0 million compared to $2.4 million at December 31, 2013. The increase in mortgage loans held for sale is reflective of increased activity in both purchase and refinance business. Residential purchases have picked up due to the normal seasonal transition from the slow winter months, while refinance activity has been supported by the drop in interest rates from the start of the year. Under the terms of the mortgage purchase agreements, the purchaser has the right to require the Company to either repurchase the mortgage or reimburse losses incurred by the purchaser, which are determined to have been directly caused by borrower fraud or misrepresentation. Although the Company intends to vigorously challenge these and any future claims, the Company has a reserve of $0.4 million for these potential repurchases at September 30, 2014. The Company has incurred losses of $1.6 million related to the settlement of nine loans since the beginning of 2011, the majority of which were associated with a group of loans originated and sold in 2007 that were made to related borrowers subsequently found guilty of financial fraud. Heritage Oaks Bancorp | - 57 - -------------------------------------------------------------------------------- Table of Contents Summary of Loan Portfolio At September 30, 2014, total gross loan balances were $1.2 billion. This represents an increase of approximately $324.1 million, or 39.2%, from the $827.5 million reported at December 31, 2013. The MISN merger provided $280.3 million of gross loans held for investment as of the February 28, 2014 merger date. The following table provides a breakdown of total gross loans: September 30, December 31, 2014 2013 Variance Balance Percentage Balance Percentage Dollar Percentage (dollars in thousands) Real Estate Secured Multi-family residential $ 76,821 6.7% $ 31,140 3.8% $ 45,681 146.7% Residential 1 to 4 family 121,061 10.5% 88,904 10.7% 32,157 36.2% Home equity line of credit 37,967 3.3% 31,178 3.8% 6,789 21.8% Commercial 582,600 50.6% 432,203 52.1% 150,397 34.8% Farmland 93,965 8.2% 50,414 6.1% 43,551 86.4% Land 24,634 2.1% 24,523 3.0% 111 0.5% Construction 17,845 1.5% 13,699 1.7% 4,146 30.3% Total real estate secured 954,893 82.9% 672,061 81.2% 282,832 42.1% Commercial Commercial and industrial 143,861 12.5% 119,121 14.4% 24,740 20.8% Agriculture 44,204 3.8% 32,686 4.0% 11,518 35.2% Other 20 0.0% 38 0.0% (18) -47.4% Total commercial 188,085 16.3% 151,845 18.4% 36,240 23.9% Installment loans to individuals 8,198 0.8% 3,246 0.4% 4,952 152.6% Overdrafts 400 0.0% 332 0.0% 68 20.5% Total gross loans 1,151,576 100.0% 827,484 100.0% 324,092 39.2% Deferred loan fees (1,414) (1,281) (133) 10.4% Allowance for loan and lease losses (16,787) (17,859) 1,072 -6.0% Total net loans $ 1,133,375 $ 808,344 $ 325,031 40.2% Loans held for sale $ 5,977 $ 2,386 $ 3,591 150.5% Real Estate Secured Loans As of September 30, 2014, real estate secured portfolios represented approximately $954.9 million or 82.9% of total gross loans. When compared to that reported at December 31, 2013, this represents an increase of approximately $282.8 million, or 42.1%, of which $219.1 million can be attributed to the MISN merger. Land Loans The following table provides a break-down of the land segment of the Company's real estate secured loan portfolio by property type: September 30, 2014 Percent of Single Undisbursed Total Bank Percent Total Risk Number Largest Balance Commitment Exposure Composition Based Capital of Loans Loan (1) (dollars in thousands) Land Single family residential $ 2,416 $ - $ 2,416 9.5% 1.4% 20 $ 340 Single family residential - Spec. 447 - 447 1.8% 0.3% 4 303 Tract 8,833 - 8,833 34.7% 5.0% 6 10,673 Land - Multifamily 2,898 533 3,431 13.5% 1.9% 3 3,100 Commercial 9,480 258 9,738 38.3% 5.5% 23 1,680 Hospitality 560 - 560 2.2% 0.3% 1 599 Total land $ 24,634 $ 791 $ 25,425 100.0% 14.3% 57 $ 10,673 (1) Amount reported reflects the original loan amount for the single largest loan that remains outstanding as of September 30, 2014. Heritage Oaks Bancorp | - 58 - -------------------------------------------------------------------------------- Table of Contents At September 30, 2014, the land portfolio represented approximately $24.6 million, or 2.1%, of total gross loan balances, essentially unchanged from the corresponding balance reported at December 31, 2013. The ratio of total land loans, including undisbursed commitments, to risk-based capital decreased from 20.0% at December 31, 2013 to 14.3% at September 30, 2014. As of September 30, 2014, a total of $7.1 million of the land portfolio was risk graded special mention, substandard or doubtful. This compares to $8.4 million of the land portfolio being risk graded special mention, substandard or doubtful as of December 31, 2013. Construction Loans The following table provides a break-down of the construction loan segment of the Company's real estate secured loan portfolio by property type: September 30, 2014 Percent of Single Undisbursed Total Bank Percent Total Risk Number Largest Balance Commitment Exposure Composition Based Capital of Loans Loan (1) (dollars in thousands) Construction Single family residential $ 5,742 $ 3,065 $ 8,807 23.6% 5.0% 13 $ 2,250 Single family residential - Spec. 395 1,178 1,573 4.2% 0.9% 3 1,000 Tract 811 - 811 2.2% 0.5% 2 812 Multi-family 195 2,500 2,695 7.2% 1.5% 2 2,500 Commercial 5,031 9,896 14,927 39.9% 8.4% 6 8,000 Hospitality 5,671 2,905 8,576 22.9% 4.8% 2 5,000 Total construction $ 17,845 $ 19,544 $ 37,389 100.0% 21.1% 28 $ 8,000 (1) Amount reported reflects the original loan amount for the single largest loan that remains outstanding as of September 30, 2014. At September 30, 2014, the construction portfolio represented approximately $17.9 million, or 1.5%, of total gross loan balances, an increase of $4.2 million, or 30.3%, from that reported at December 31, 2013. This increase can be attributed to the MISN merger, which included $13.1 million of construction loans as of the merger date. Construction loans are typically granted for a one year period and then refinanced at the completion of the construction project into permanent loans with varying maturities. The ratio of total construction loans, including undisbursed commitments, to risk-based capital increased from 20.8% at December 31, 2013 to 21.1% at September 30, 2014. As of September 30, 2014, there were $0.4 million of construction balances graded special mention, substandard or doubtful. At December 31, 2013, there were no construction loans risk graded special mention, substandard or doubtful. Heritage Oaks Bancorp | - 59 - -------------------------------------------------------------------------------- Table of Contents Other Real Estate Secured Loans The following table provides a break-down of all other real estate secured loans by type of real estate: September 30, 2014 Percent of Single Undisbursed Total Bank Percent Total Risk Number Largest Owner Balance Commitment Exposure Composition Based Capital of Loans Loan (1) Occupied (dollars in thousands) Real Estate Secured Retail $ 78,924 $ 1 $ 78,925 8.3% 44.5% 90 $ 9,000 $ 27,097 Professional 76,048 148 76,196 8.0% 43.0% 125 7,480 22,518 Hospitality 136,219 2,521 138,740 14.5% 78.3% 60 10,209 12,883 Multi-family 76,821 643 77,464 8.1% 43.7% 58 9,000 13,595 Home equity lines of credit 37,967 29,814 67,781 7.1% 38.3% 468 1,200 36,967 Residential 1 to 4 family 121,061 3,808 124,869 13.1% 70.5% 270 3,000 84,753 Farmland 93,965 4,598 98,563 10.3% 55.6% 61 6,900 58,317 Healthcare / medical 35,499 - 35,499 3.7% 20.0% 48 7,500 21,948 Restaurants / hospitality 12,998 - 12,998 1.4% 7.3% 24 2,393 8,569 Commercial 156,045 160 156,205 16.4% 88.2% 177 9,250 64,168 Other 86,867 206 87,073 9.1% 49.2% 66 13,713 36,634 Total real estate secured $ 912,414 $ 41,899 $ 954,313 100.0% 538.6% 1,447 $ 13,713 $ 387,449 (1) Amount reported reflects the original loan amount for the single largest loan that remains outstanding as of September 30, 2014. As of September 30, 2014, other real estate secured portfolios represented approximately $912.4 million or 79.2% of total gross loans. When compared to that reported at December 31, 2013, this represents an increase of approximately $278.6 million, or 44.0%, of which $203.0 million can be attributed to the MISN merger. As of September 30, 2014, a total of $41.9 million of the other real estate secured portfolio was risk graded as special mention, substandard or doubtful, with the largest single component being the commercial real estate segment, which represented $32.9 million. This compares to $22.9 million of the other real estate secured balance and $18.1 million of commercial real estate loans being risk graded special mention, substandard or doubtful as of December 31, 2013. Special mention, substandard or doubtful other real estate secured loans acquired in the MISN merger totaled $23.5 million, of which $20.8 million were in the commercial segment. At September 30, 2014 and December 31, 2013, other real estate secured balances, including undisbursed commitments, represented 539% and 526%, respectively, of total risk-based capital. The increase in this percentage not only reflects impacts of the MISN merger, but also the increase in real estate lending over the first nine months of the year. At September 30, 2014, approximately $387.5 million, or 42.5%, of the other real estate secured segment of the loan portfolio was considered owner occupied. Heritage Oaks Bancorp | - 60 - -------------------------------------------------------------------------------- Table of Contents Commercial Loans The following table provides a break-down of the commercial and industrial ("C&I") segment of the Company's commercial loan portfolio by business type: September 30, 2014 Percent of Single Undisbursed Total Bank Percent Total Risk Number Largest Balance Commitment Exposure Composition Based Capital of Loans Loan (1) (dollars in thousands) Commercial and Industrial Agriculture $ 6,034 $ 1,400 $ 7,434 3.0% 4.2% 38 $ 2,000 Oil gas and utilities 1,975 962 2,937 1.2% 1.7% 7 888 Construction 11,142 26,481 37,623 15.2% 21.2% 160 5,000 Manufacturing 18,012 11,377 29,389 11.9% 16.6% 116 3,000 Wholesale and retail 17,573 11,409 28,982 11.7% 16.4% 156 2,500 Transportation and warehousing 4,800 952 5,752 2.3% 3.2% 68 596 Media and information services 3,337 1,265 4,602 1.9% 2.6% 22 1,500 Financial services 7,176 2,333 9,509 3.8% 5.4% 40 3,000 Real estate / rental and leasing 19,271 14,425 33,696 13.6% 19.0% 116 6,522 Professional services 23,196 18,445 41,641 16.8% 23.5% 203 3,185 Healthcare / medical 8,342 8,007 16,349 6.6% 9.2% 106 11,464 Restaurants / hospitality 12,775 3,517 16,292 6.6% 9.2% 94 4,600 All other 10,228 3,473 13,701 5.4% 7.7% 247 2,000 Total commercial and industrial $ 143,861 $ 104,046 $ 247,907 100.0% 139.9% 1,373 $ 11,464 (1) Amount reported reflects the original loan amount for the single largest loan that remains outstanding as of September 30, 2014 At September 30, 2014, commercial and industrial loans represented approximately $143.9 million or 12.5% of total gross loan balances. This represents an increase of approximately $24.7 million, or 20.8%, from December 31, 2013. The year to date increase is attributed to the MISN merger, which added $34.6 million of commercial and industrial loans. The ratio of total commercial and industrial loan balances, including undisbursed commitments, to risk-based capital decreased from 158% at December 31, 2013 to 140% at September 30, 2014. The Company's credit exposure within the commercial and industrial segment remains diverse with respect to the industries to which credit has been extended. As of September 30, 2014, a total of $9.9 million of the commercial and industrial portfolio was risk graded as special mention, substandard or doubtful. This compares to $13.1 million of the commercial and industrial portfolio being risk graded special mention, substandard or doubtful as of December 31, 2013. Heritage Oaks Bancorp | - 61 - -------------------------------------------------------------------------------- Table of Contents Agriculture Loans The following table provides a break-down of the types of agriculture loans in the Company's commercial loan portfolio: September 30, 2014 Percent of Single Undisbursed Total Bank Percent Total Risk Number Largest Balance Commitment Exposure Composition Based Capital of Loans Loan (1) (dollars in thousands) Agriculture Vegetable and mellon farming $ 9,320 $ 5,770 $ 15,090 17.7% 8.5% 17 $ 4,000 Fruit and tree nut farming 16,765 19,215 35,980 42.2% 20.3% 31 6,470 Other crop farming 36 1,175 1,211 1.4% 0.7% 4 650 Animal production 2,850 5,542 8,392 9.8% 4.7% 39 1,500 Support activities for agriculture 3,485 4,574 8,059 9.4% 4.5% 22 1,800 Food, beverage and tobacco 6,881 3,917 10,798 12.7% 6.1% 26 2,000 Wholesale merchants 3,009 928 3,937 4.6% 2.2% 9 1,500 Transportation and warehousing 148 1 149 0.2% 0.1% 4 75 All other 1,710 - 1,710 2.0% 0.9% 4 1,600 Total agriculture $ 44,204 $ 41,122 $ 85,326 100.0% 48.2% 156 $ 6,470 (1) Amount reported reflects the original loan amount for the single largest loan that remains outstanding as of September 30, 2014. At September 30, 2014, the agriculture portfolio totaled approximately $44.2 million, or 3.8%, of total gross loan balances, which represents an increase of $11.5 million, or 35.2%, when compared to that reported at December 31, 2013. The increase in the portfolio is associated with the MISN merger, which provided an additional $18.1 million of agriculture loans, partially offset by repayments of existing loans. At September 30, 2014 and December 31, 2013, the agriculture portfolio, including undisbursed commitments, represented 48%, of the Bank's total risk-based capital. As of September 30, 2014, a total of $2.6 million of the agriculture portfolio was risk graded as special mention, substandard or doubtful. This compares to $1.4 million of the agriculture portfolio being risk graded special mention, substandard or doubtful as of December 31, 2013. The increase in the special mention, substandard or doubtful risk grades of agriculture loans is attributable to loans acquired in the MISN merger. Consumer Installment Loans At September 30, 2014, the installment loan portfolio totaled approximately $8.2 million, as compared to the $3.2 million reported at December 31, 2013. This increase is due to the MISN merger, which included $7.5 million of consumer installment loans as of the merger date. Installment loans include revolving credit plans, consumer loans and credit card balances. Heritage Oaks Bancorp | - 62 - -------------------------------------------------------------------------------- Table of Contents Maturities and Sensitivities of Loans to Changes in Interest Rates The following table provides a summary of the approximate maturities and sensitivity to changes in interest rates for the loan portfolio as well as information about fixed and variable rate loans. A large portion of the growth in the loan portfolio is for loans with maturities of more than 5 years, which is consistent with the fact that much of the loan growth has been in the real estate secured segment. Variable rate loans currently at or below their floor are classified as variable in the table below: September 30, 2014 Due Over Due Over Due Over Due Less Due 12 Months 3 Years 5 Years Than 3 3 To 12 Through Through Through Due Over Months Months 3 Years 5 Years 15 Years 15 Years Total (dollars in thousands) Real Estate Secured Multi-family residential $ 3,111 $ 2,934 $ 11,431 $ 37,268 $ 21,814 $ 263 $ 76,821 Residential 1 to 4 family 5,873 3,398 15,756 44,506 48,884 2,644 121,061 Home equity line of credit 37,840 80 38 - - 9 37,967 Commercial 52,160 57,944 129,291 170,000 172,802 403 582,600 Farmland 11,610 377 13,018 13,701 55,259 - 93,965 Land 18,395 717 2,094 2,289 1,139 - 24,634 Construction 8,877 1,177 420 3,543 3,828 - 17,845 Commercial Commercial and industrial 77,678 10,150 12,772 23,748 19,290 223 143,861 Agriculture 35,502 384 3,164 4,565 589 - 44,204 Other - 20 - - - - 20 Installment loans to individuals 800 307 338 610 5,072 1,071 8,198 Overdrafts 400 - - - - - 400 Total loans held for investment $ 252,246 $ 77,488 $ 188,322 $ 300,230 $ 328,677 $ 4,613 $ 1,151,576 Variable rate loans (1) $ 230,388 $ 63,587 $ 131,698 $ 214,526 $ 111,844 $ 263 $ 752,306 Fixed rate loans 21,858 13,901 56,624 85,704 216,833 4,350 399,270 Total loans held for investment $ 252,246 $ 77,488 $ 188,322 $ 300,230 $ 328,677 $ 4,613 $ 1,151,576 (1) Variable rate loans include $553.6 million of loans that are at or below their contractual floor rates. To the extent that overall interest rates rise, the Company will not experience the benefit of rising interest rates until rates rise above their floors. Allowance for Loan and Lease Losses The Company maintains an ALLL to absorb probable incurred losses inherent in the loan and lease portfolio as of the balance sheet date. The ALLL is based on ongoing assessments of the estimated probable losses presently inherent in the loan portfolio. In evaluating the level of the ALLL, management considers the types of loans and leases and the amount of loans and leases in the portfolio, peer group information, historical loss experience, adverse situations that may affect the borrower's ability to repay, estimated value of any underlying collateral, and prevailing economic conditions. This methodology takes into account many factors, including the Company's own historical loss trends, loan and lease level credit quality ratings, loan and lease specific attributes, along with a review of various credit metrics and trends. The process involves subjective as well as complex judgments. The Company uses a "stake in the ground" historical loss experience, which covers the Company's losses for the period from October 2009 through current quarter end in analyzing an appropriate reserve factor for all loans. The purpose of retaining the fourth quarter 2009 losses in our historical loss experience is to ensure that we retain a complete credit cycle in our ALLL analysis. In addition, the Company uses adjustments for numerous factors, including those found in the Interagency Guidance on ALLL, which include current economic conditions, loan and lease seasoning, underwriting experience, and collateral value changes, among others. The Company evaluates all impaired loans and leases individually, using guidance from ASC 310, primarily through the evaluation of cash flows or collateral values. Heritage Oaks Bancorp | - 63 - -------------------------------------------------------------------------------- Table of Contents The ALLL is increased by provisions for loan and lease losses charged to earnings, and decreased by loan and lease charge-offs, net of recovered balances. Please see Note 4. Loans, and Note 5. Allowance for Loan Losses of the Condensed Consolidated Financial Statements filed as part of the Annual Report on Form 10-K for the year ended December 31, 2013, for a detailed discussion concerning the Company's methodology for determining an adequate ALLL. Also see Note 1. Summary of Significant Accounting Policies, of the Consolidated Financial Statements filed as part of the Annual Report on Form 10-K for the year ended December 31, 2013, which contains additional discussion concerning the ALLL, loan charge-offs, and credit risk management. The Company allocates the ALLL across product types within the loan portfolio. The following table provides a summary of the ALLL and its allocation to each major product type of the loan portfolio, as well as the proportion that each major category's ALLL represents as a percentage of the gross loan balances in the category: September 30, December 31, 2014 2013 2013 Percent Percent Percent Amount of Loan Amount of Loan Amount of Loan Allocated Segment Allocated Segment Allocated Segment (dollars in thousands) Real Estate Secured Multi-family residential $ 441 0.6% $ 157 0.8% $ 239 0.8% Residential 1 to 4 family 1,354 1.1% 685 1.4% 1,225 1.4% Home equity line of credit 112 0.3% 146 0.4% 147 0.5% Commercial 6,048 1.0% 4,789 1.1% 6,456 1.5% Farmland 1,564 1.7% 514 1.1% 958 1.9% Land 2,225 9.0% 4,631 19.6% 3,402 13.9% Construction 117 0.7% 239 2.3% 258 1.9% Commercial Commercial and industrial 3,291 2.3% 5,155 4.6% 3,653 3.1% Agriculture 1,023 2.3% 971 3.9% 1,128 3.5% Other - 0.0% - 0.0% - 0.0% Installment loans to individuals 74 0.9% 88 2.1% 99 3.1% Overdrafts 35 8.8% 32 19.4% 32 9.6% Unallocated 503 60 262 Total allowance for loan and lease losses $ 16,787 1.5% $ 17,468 2.4% $ 17,859 2.2% The Company acquired MISN on February 28, 2014 and the loans and leases acquired are recorded according to the guidance under ASC 805, "Accounting for Acquisitions." See also Note 2. Business Combination of the Consolidated Financial Statements for more information concerning the acquisition of MISN. The acquired loans and leases include loans and leases that are accounted for under ASC 310-30. During the nine months ended September 30, 2014, there was no provision for loan and lease losses or ALLL related to these loans, as they were acquired at an aggregate $10.0 million, or 3.4%, discount to the aggregated unpaid principal balances. As of September 30, 2014, the remaining unaccreted discount on the acquired MISN loans was $8.3 million and was determined by management to be adequate to absorb credit losses inherent in that portfolio. Of the total loans acquired through the MISN transaction 5.7% are designated as PCI as of the acquisition date. These PCI loans carried an average 23.2% discount at acquisition. The remaining 94.3% of loans are accounted for under ASC 310 "Receivables" and carried an average discount of 2.3% at acquisition. The Company may need to recognize provisions for loan and lease losses in the future if there is further deterioration in these loans after the purchase date such that the impairment exceeds the non-accretable yield and purchase discount. On a quarterly basis, the Company re-forecasts its expected cash flows for the PCI loans relating to the MISN acquisition to determine if there is potential impairment, which may require additional provisions for loan and lease losses or, if projected cash flows are significantly improved, a reclassification of the non-accretable yield to accretable yield may result. The third quarter 2014 cash flow re-forecast resulted in no adjustment to goodwill and did not result in any impairment. Heritage Oaks Bancorp | - 64 - -------------------------------------------------------------------------------- Table of Contents The balance of the ALLL decreased by $1.1 million during the first nine months of 2014 due to net charge-offs, and decreased by 79 basis points as a percentage of gross loans, as compared to the corresponding period in 2013, primarily due to the fact that no ALLL has been provided for the MISN loans acquired at February 28, 2014 and because the credit quality of the legacy Heritage Oaks portfolio has improved over the last year. The improvement in the credit quality of the legacy Heritage Oaks portfolio is reflected in a number of indicators, all of which have trended favorably over the last year, and virtually all of which are at or near their lowest levels since the credit crisis peaked in 2010. The indicators we believe are most indicative of the improving credit quality of the legacy Heritage Oaks portfolio include: the level of legacy substandard and doubtful loans, which have declined $17.7 million or 38.6% since the third quarter of 2013; the level of Heritage Oaks' legacy non-accrual loans, which have declined $2.8 million, or 22.0% since the third quarter of 2013; and the ratio of classified assets to Tier 1 capital plus the ALLL, which has improved from 33.6% to 24.9% since the third quarter of 2013. The following table details changes in the ALLL for the periods indicated: For the Nine Months Ended September 30, 2014 2013 (dollars in thousands) Balance, beginning of period $ 17,859 $ 18,118 Charge-offs: Real Estate Secured Residential 1 to 4 family 92 23 Commercial 1,027 108 Land - 34 Construction - 169 Commercial Commercial and industrial 650 770 Agriculture - 367 Installment loans to individuals 8 380 Total charge-offs 1,777 1,851 Recoveries: Real Estate Secured Residential 1 to 4 family - 43 Home equity line of credit 10 9 Commercial 25 77 Farmland - 14 Land 30 45 Construction 2 2 Commercial Commercial and industrial 582 832 Agriculture 46 115 Installment loans to individuals 10 64 Total recoveries 705 1,201 Net charge-offs 1,072 650 Balance, end of period $ 16,787 $ 17,468 Gross loans, end of period $ 1,151,576 $ 777,154 Allowance for loan and lease losses to total gross loans 1.46% 2.25% Net charge-offs to average loans 0.14% 0.12% Net charge-offs during the nine months ended September 30, 2014 totaled $1.1 million. This compares to net charge-offs of approximately $0.7 million, reported for the corresponding period last year. The charge-offs for the nine months ended September 30, 2014 were attributable primarily to two larger loans which totaled $1.7 million. For the nine months ended September 30, 2013, charge-offs were largely attributable to a $0.2 million loss realized on the sale of collateral for the loan transferred into OREO in the first quarter of 2013. Annualized net charge-offs to average loans for the three month and nine month periods ended September 30, 2014 were (0.06)% and 0.14%, respectively. This compares to 0.24% and 0.12%, respectively, reported for the corresponding periods in 2013. At September 30, 2014, the ALLL represented 1.46% of total gross loans compared to 2.25% reported at December 31, 2013. The decline is due to the impact of MISN acquired loans on this ratio and the $1.1 million of net charge-offs for the year to date 2014 period. MISN acquired loans are included in gross loans but have no ALLL as they are carried at their fair value. Heritage Oaks Bancorp | - 65 - -------------------------------------------------------------------------------- Table of Contents The ALLL that was collectively evaluated for impairment on legacy Heritage loans and leases at September 30, 2014 was $14.7 million, or 1.64% of total legacy Heritage loans and leases, $14.7 million, or 1.81% of total legacy Heritage loans and leases, as of December 31, 2013 and $10.6 million or 1.40% at September 30, 2013. Including the non-credit impaired loans acquired through the MISN acquisition, the ALLL that was collectively evaluated for impairment was $14.7 million as of September 30, 2014, which represents 1.31% of the total of such loans and leases. The qualitative component of the ALLL that was collectively evaluated for impairment was $5.3 million, or 0.46%, at September 30, 2014, $4.1 million or 0.51% at December 31, 2013, and $2.8 million or 0.37% at September 30, 2013, as a percentage of loans and leases collectively evaluated for impairment. When the impact of the inclusion of the MISN loans is removed from the percentage calculation of our qualitative factors as a percentage of gross loans, this component of the ALLL represents 0.58% of legacy Heritage loans and leases at September 30, 2014. The qualitative component of the ALLL increased on a dollar basis and as a percentage basis of legacy Heritage loans over the last year primarily due to the potential impacts resulting from the concentration in CRE loans and of the prolonged California drought on our loan portfolio. We have increased our qualitative factors for the impact of the California drought on our customer's businesses over the past quarter due to our concern about the impact directly to agriculture, and indirectly to other businesses such as hospitality and tourism, because of the continued lack of precipitation in California, and our region of the state. Evidence of the drought's impact on agricultural businesses are noted in recent studies indicating that the 2014 drought is responsible for the greatest absolute reduction in water availability to agriculture ever seen in California and that it is statistically likely that the drought will continue through 2015, regardless of El Nino conditions. Furthermore, certain municipalities within California have also begun to mandate water conservation measures that cite specific usage reductions and have limited the use of water for particular applications such as landscape watering, car washing and other applications. These facts along with discussions with some of our borrowers as it relates to expected decreases in cash flows related to the drought supported management's decision to increase the qualitative factors within the ALLL for the impact of the drought on our loan portfolio. The component of the ALLL that was for legacy Heritage and acquired MISN loans and leases individually evaluated for impairment was $2.1 million at September 30, 2014, compared to $3.1 million at December 31, 2013 and $6.8 million at September 30, 2013. An unallocated ALLL of $503 thousand was held at September 30, 2014, as compared to $262 thousand as of December 31, 2013 and $60 thousand as of September 30, 2013. The Company provided no provision for loan and lease losses during the nine-month periods ended September 30, 2014, and September 30, 2013. As of September 30, 2014, management believes that the ALLL was sufficient to cover current estimable losses in the Company's loan portfolio. Non-Performing Assets Non-performing assets are comprised of loans placed on non-accrual status and foreclosed assets (OREO and other repossessed assets). Generally, the Company places loans on non-accruing status when (1) the full and timely collection of all amounts due become uncertain, (2) a loan becomes 90 days or more past due (unless well-secured and in the process of collection) or (3) any portion of outstanding principal has been charged-off. See Note 5. Loans and Allowance for Loan and Lease Losses, of the Condensed Consolidated Financial Statements, filed with this Quarterly Report on Form 10-Q for additional discussion concerning non-performing loans, as well as a discussion concerning credit quality. The following table provides a summary of non-performing loans and foreclosed assets: September 30, December 31, Variance 2014 2013 Dollar Percent (dollars in thousands) Non-performing loans Residential 1-4 family $ 97 $ 449 $ (352 ) -78.4% Home equity lines of credit 100 - 100 100.0% Commercial real estate 1,938 672 1,266 188.4% Land 5,226 5,910 (684 ) -11.6% Commercial and industrial 2,182 2,180 2 0.1% Agriculture 685 789 (104 ) -13.2% Installment 46 117 (71 ) -60.7% Total non-performing loans 10,274 10,117 157 1.6% Other real estate owned - - - - Total non-performing assets $ 10,274 $ 10,117 $ 157 1.6% TDRs Accruing $ 5,245 $ 5,853 $ (608 ) -10.4% Included in non-performing loans 6,791 7,076 (285 ) -4.0% Total TDRs $ 12,036 $ 12,929 $ (893 ) -6.9% Ratio of allowance for loan and lease losses to total gross loans 1.46% 2.16% Ratio of non-performing loans to total gross loans 0.89% 1.22% Ratio of non-performing assets to total assets 0.60% 0.84% Heritage Oaks Bancorp | - 66 - -------------------------------------------------------------------------------- Table of Contents At September 30, 2014, the balance of non-accruing loans was approximately $10.3 million or $0.2 million higher than that reported at December 31, 2013. The increase in non-accruing loans during the first nine months of 2014 can be attributed to: $6.1 million of loans placed in non-accruing status, including $0.7 million of additions from the MISN transaction, net paydowns of $3.0 million, $2.1 million of loans returned to accrual status and $1.5 million of net charge-offs and transfers to foreclosed collateral. The following tables reconcile the change in total non-accruing balances for the three and nine months ended September 30, 2014: Balance Additions to Transfers Returns to Balance June 30, Non-Accruing Net toForeclosed Performing Net September 30, 2014 Balances Paydowns Collateral Status Charge-offs 2014 (dollars in thousands) Real Estate Secured Residential 1 to 4 family $ 101 $ - $ (4 ) $ - $ - $ - $ 97 Home equity line of credit 100 - - - - - 100 Commercial 2,109 1,565 (501 ) - (1,225 ) (10 ) 1,938 Land 5,903 108 (785 ) - - - 5,226 Commercial Commercial and industrial 2,455 249 (396 ) - (126 ) - 2,182 Agriculture 724 - (2 ) - (37 ) - 685 Installment loans to individuals 19 29 (2 ) - - - 46 Totals $ 11,411 $ 1,951 $ (1,690 ) $ - $ (1,388 ) $ (10 ) $ 10,274 Balance Additions to Additions Transfers Returns to Balance December 31, Non-Accruing due to Net to Foreclosed Performing Net September 30, 2013 Balances merger Paydowns Collateral Status Charge-offs 2014 (dollars in thousands) Real Estate Secured Residential 1 to 4 family $ 449 $ - $ - $ (12 ) $ (248 ) $ - $ (92 ) $ 97 Home equity line of credit - 100 - - - - - 100 Commercial 672 4,388 137 (871 ) (137 ) (1,225 ) (1,026 ) 1,938 Land 5,910 296 - (980 ) - - - 5,226 Commercial Commercial and industrial 2,180 1,283 568 (1,012 ) - (837 ) - 2,182 Agriculture 789 - - (67 ) - (37 ) - 685 Installment loans to individuals 117 31 - (100 ) - - (2 ) 46 Totals $ 10,117 $ 6,098 $ 705 $ (3,042 ) $ (385 ) $ (2,099 ) $ (1,120 ) $ 10,274 Heritage Oaks Bancorp | - 67 - -------------------------------------------------------------------------------- Table of Contents Goodwill The following table summarizes the consideration paid for MISN, the amounts of assets acquired and liabilities assumed and the resulting goodwill recognized at the acquisition date: February 28, 2014 (dollars in thousands) Consideration paid Cash payments for MISN shares outstanding $ 2,554 Cash payments for MISN warrants 5,766 Cash payments for MISN options 387 Shares issued, @ $7.99 per share 60,255 Total consideration $ 68,962 Net assets pre-acquisition 41,526 Fair value adjustments: Loans receivable $ (9,982) Allowance for loan and lease losses 4,441 Fixed Assets 845 Core deposit intangible 5,060 Deferred taxes assets, net 11,885 Other assets (217) Certificates of deposit purchase premium (78) Federal Home Loan Bank advances (71) Junior subordinated debentures 3,444 Lease liability (1,217) Other liabilities 27 Total fair value adjustments 14,137 Fair value of net assets acquired 55,663 Excess of consideration paid over fair value of net assets acquired, i.e., goodwill $ 13,299 The goodwill of $13.3 million arising from the acquisition represents the additional consideration paid above the fair value of net assets acquired. As this transaction was structured as a tax-free exchange, the goodwill will not be deductible for tax purposes. During the three months ended September 30, 2014, goodwill related to the MISN acquisition was increased by $60 thousand. The net impact of decreases in goodwill resulting from upward revisions of deferred tax assets of $105 thousand and increases of goodwill, due to $102 thousand of decreased value of buildings held for sale, additional pre-acquisition expenses recognized of $39 thousand, and a $24 thousand reduction in the value of SBA servicing assets acquired, resulted in a combined increase to goodwill during the measurement period. Other Real Estate Owned ("OREO") At September 30, 2014 and December 31, 2013 the Company held no OREO. The Company foreclosed on one loan in the first quarter of 2013, and sold the underlying collateral within that same quarter at a loss of $0.2 million, which was reflected as a charge-off against the ALLL. The Company also foreclosed on a $1.2 million commercial property that was the underlying collateral on a former MISN loan which carried no value at acquisition because the loan had been guaranteed by the Small Business Administration ("SBA"), and MISN had previously collected the 90% guarantee from the SBA upon borrower default and subsequently charged off the remaining 10%. The Company received the rights to foreclose on the collateral after the February 28, 2014 acquisition date, and subsequently foreclosed on and sold the property in the third quarter of 2014. The majority of the sales proceeds were returned to the SBA as a refund of their 90% guarantee; however there were additional funds from the collateral sale above the amount reimbursable to the SBA of $0.1 million which were recorded as other non-interest income. Heritage Oaks Bancorp | - 68 - -------------------------------------------------------------------------------- Table of Contents Deposits and Borrowed Funds Deposits The following table provides a summary for the year to date change in various categories of deposit balances: September 30, December 31, Variance 2014 2013 Dollar Percentage (dollars in thousands) Non-interest bearing deposits $ 469,435 $ 291,856 $ 177,579 60.84% Interest bearing deposits: NOW accounts 108,186 87,298 20,888 23.93% Other savings deposits 106,211 42,648 63,563 149.04% Money market deposit accounts 455,045 332,272 122,773 36.95% Time deposits 284,057 219,821 64,236 29.22% Total deposits $ 1,422,934 $ 973,895 $ 449,039 46.11% As indicated in the table above, total deposit balances at September 30, 2014 were approximately $1.4 billion. This represents an increase of approximately $449.0 million, or 46.1%, when compared to that reported at December 31, 2013. The MISN merger contributed $371.5 million to deposit growth as of the merger date, including $137.6 million in non-interest bearing deposits. The Company continues to focus on gathering and retaining core relationships, which has helped to reduce the overall cost of funding. At September 30, 2014, core deposits, which are defined as total deposits exclusive of time deposits over $100,000, represented 85.1% of total deposits, up from the 84.7% reported at December 31, 2013, due largely to core deposits acquired in the MISN merger. Borrowed Funds The Bank has a variety of sources from which it may obtain secondary funding beyond deposit balances. These sources include, among others, the FHLB, the FRB and credit lines established with correspondent banks. At September 30, 2014, FHLB borrowings were $75.6 million, or $12.9 million lower than that reported at December 31, 2013. Borrowings are obtained for a variety of reasons which include, but are not limited to: asset-liability management; funding loan growth; and to provide additional liquidity. The decrease in the level of FHLB borrowings in 2014 was the result of maturities of short-term borrowings that were not rolled over. Capital At September 30, 2014, the balance of shareholders' equity was approximately $194.1 million. This represents an increase of approximately $67.7 million over that reported at December 31, 2013. The year to date change was primarily attributable to 7,541,326 shares issued at a price of $7.99 per common share as part of the consideration in the MISN merger, which totaled $60.3 million and was partially offset by $0.3 million of related stock issuance costs. Current year net income contributed $4.6 million to shareholders' equity and was offset by payment of $1.0 million of common stock dividends. The components of comprehensive income (net income and unrealized gains on securities available for sale) provided $3.3 million of equity for the first nine months of 2014, while adjustments related to share based compensation provided an additional $0.9 million. Dividends On July 23, 2014, the Company's Board of Directors declared a cash dividend of $0.03 per share, payable on September 15, 2014, to shareholders of the Company's common stock as of August 29, 2014. Holders of the Company's Series C Preferred Stock are also entitled to a per share dividend equivalent to the common dividend declared for which each share of Series C Preferred Stock is convertible into common stock. Heritage Oaks Bancorp | - 69 - -------------------------------------------------------------------------------- Table of Contents On October 29, 2014, the Company's Board of Directors declared a cash dividend of $0.05 per share, payable on December 1, 2014, to shareholders of the Company's common stock as of November 17, 2014. Holders of the Company's Series C Preferred Stock are also entitled to a per share dividend equivalent to the common dividend declared for which each share of Series C Preferred Stock is convertible into common stock. The Company did not pay any dividends on its common stock in 2013. Regulatory Capital Bancorp and the Bank seek to maintain strong levels of capital in order to be considered "well-capitalized" as determined by regulatory agencies. Bancorp's potential sources of capital include retained earnings and the issuance of equity. At September 30, 2014, Bancorp had $16.5 million in Junior Subordinated Deferrable Interest Debentures (the "debt securities") issued and outstanding. These debt securities were issued to three different trusts, as follows: Amount Carrying Current Issue Scheduled Issued Value Rate Date Maturity Rate Type (dollars in thousands) Heritage Oaks Variable 3-month Capital Trust II $ 8,248 $ 8,248 1.96% 27-Oct-06 Aug-37 LIBOR + 1.72% Mission Community Variable 3-month Capital Trust I $ 3,093 $ 2,128 3.18% 14-Oct-03 Oct-33 LIBOR + 2.95% Santa Lucia Bancorp (CA) Variable 3-month Capital Trust $ 5,155 $ 2,803 1.71% 28-Apr-06 Jul-36 LIBOR + 1.48% These three issues of debt securities are callable by Bancorp at par. At September 30, 2014, the Company included $12.8 million of the debt securities in its Tier I Capital for regulatory reporting purposes. For a more detailed discussion regarding junior subordinated debt securities, see Note 11, Borrowings, in the Company's Consolidated Financial Statements under Item 8 of Part II of the Company's Annual Report on Form 10-K for the year ended December 31, 2013. Beginning in April 2012 and through its termination in April 2013, the Bank operated subject to the terms of a MOU with the FDIC and the DFI, which replaced the consent order stipulated to by the Bank in March 2010. Under the MOU the Bank agreed to continue to adhere to the 10.0% Tier 1 leverage ratio previously set by the consent order. With the termination of the MOU in April 2013, the need to continue to adhere to the 10.0% leverage ratio was removed. See also Note 19, Regulatory Matters, in the Company's Consolidated Financial Statements under Item 8 of Part II of the Company's Annual Report on Form 10-K for the year ended December 31, 2013 for additional information related to the consent order and written agreement as they pertain to these requirements. On July 17, 2013, Bancorp repurchased all 21,000 outstanding shares of the Series A Preferred Stock that was held by the U.S. Department of the Treasury under the TARP CPP program. The shares were repurchased at par plus accrued but unpaid dividends for a total of $21.2 million. On July 30, 2013, Bancorp reached an agreement with the U.S. Department of the Treasury to repurchase the related warrant to purchase 611,650 shares of Bancorp's common stock for $1.6 million. The decision to repurchase the Preferred Stock and the outstanding warrant was made to mitigate the dilutive effect these instruments had on common shareholders. The funds for this repurchase were made available through a one-time dividend from the Bank to Bancorp. The following table provides the general minimum regulatory capital ratios and a summary of Company and Bank regulatory capital ratios, which reflect that both Bancorp and Bank meet the criteria to be considered "well capitalized": Regulatory Standard to September 30, 2014 December 31, 2013 September 30, 2013 be Well Heritage Oaks Heritage Oaks Heritage Oaks Capitalized Bancorp Bank Bancorp Bank Bancorp Bank Ratio Leverage ratio 5.00% 10.00% 9.77% 10.20% 9.82% 10.58% 10.05% Tier I capital to risk weighted assets 6.00% 12.87% 12.58% 12.91% 12.42% 13.27% 12.59% Total capital to risk weighted assets 10.00% 14.12% 13.83% 14.17% 13.68% 14.53% 13.85% Bancorp's Leverage Ratio declined by 20 basis points to 10.00% for the third quarter of 2014 from 10.20% for the fourth quarter of 2013, primarily due to the increase in disallowed intangibles and deferred tax assets related to the MISN merger. Comparing the components of our Leverage Ratio for the third quarter of 2014 to those reported for the fourth quarter of 2013 reveals that total capital increased by 53.5% compared to a 41.4% increase in average quarterly assets. Heritage Oaks Bancorp | - 70 - -------------------------------------------------------------------------------- Table of Contents This implies that our Leverage Ratio may have increased as compared to the fourth quarter of 2013 however, the increase in disallowed intangibles and deferred tax assets muted the increase to Tier 1 Capital which only rose by 38.3%, after factoring in these adjustments, resulting in a slightly smaller increase to Tier 1 Capital than the increase to average quarterly assets for the third quarter of 2014 compared to the fourth quarter of 2013. Bancorp's Leverage Ratio declined by 58 basis points for the third quarter of 2014 when compared to the third quarter of 2013, for the same reason as the decline compared to December 31, 2013, however the decline was more pronounced due to a larger spread between the increase in Tier 1 Capital and the increase in average assets. As of September 30, 2014, Bancorp's Tier 1 Risk Based Capital Ratio and Total Risk Based Capital Ratio decreased from year-end 2013 by 4 and 5 basis points, to 12.87% and 14.12%, respectively, due primarily to the impact of the MISN acquisition. Risk Weighted Assets, Total Risk Based Capital and Tier 1 Capital all increased by similar amounts due to the MISN merger and, therefore, there was not a material change in our Risk Based Capital Ratios as compared to the fourth quarter of 2013. On a year over year basis, Bancorp's Tier 1 Risk Based Capital Ratio and Total Risk Based Capital Ratio decreased by 40 and 41 basis points, because risk weighted assets grew by a faster rate than our Tier 1 Capital and Total Risk Based Capital. Off-Balance Sheet Arrangements Off-balance sheet arrangements are any contractual arrangement to which an unconsolidated entity is a party, under which the Company has: (1) any obligation under a guarantee contract; (2) a retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement that serves as credit, liquidity or market risk support to that entity for such assets; (3) any obligation under certain derivative instruments; or (4) any obligation under a material variable interest held by the Company in an unconsolidated entity that provides financing, liquidity, market risk or credit risk support to the Company, or engages in leasing, hedging or research and development services with the Company. In the ordinary course of business, the Company has entered into off-balance sheet arrangements consisting of commitments to extend credit, commercial letters of credit, and standby letters of credit. Such financial instruments are recorded in the financial statements when they are funded or related fees are incurred or received. For a more detailed discussion of these financial instruments, refer to Note 18, Commitments and Contingencies, in the Company's Consolidated Financial Statements under Item 8 of Part II of the Company's Annual Report on Form 10-K for the year ended December 31, 2013. In the ordinary course of business, the Company is a party to various operating leases, including an office building lease obligation that was assumed in the MISN merger and expires in 2024. Monthly rentals under this lease are currently approximately $44 thousand, subject to annual escalation based on the Consumer Price Index. For a more detailed discussion of other operating leases, refer to Note 18, Commitments and Contingencies, in the Company's Consolidated Financial Statements under Item 8 of Part II of the Company's Annual Report on Form 10-K for the year ended December 31, 2013. The Company is contingently liable for letters of credit made to its customers in the ordinary course of business totaling $15.4 million and $17.0 million at September 30, 2014 and December 31, 2013, respectively. The Company has also guaranteed to a third party servicer, the repayment of the funded and available balances of credit card accounts acquired in the MISN acquisition. This guarantee totaled approximately $0.8 million at September 30, 2014. For a more detailed discussion of these financial instruments refer to Note 18, Commitments and Contingencies, in the Company's Consolidated Financial Statements under Item 8 of Part II of the Company's Annual Report on Form 10-K for the year ended December 31, 2013. Additionally, at September 30, 2014 and December 31, 2013, the Company had undisbursed loan commitments made in the ordinary course of business totaling $229.5 million and $181.5 million, respectively. These loan commitments and letters of credit are shown in the table below. Heritage Oaks Bancorp | - 71 - -------------------------------------------------------------------------------- Table of Contents September 30, December 31, 2014 2013 (dollars in thousands) Commitments to extend credit Home equity lines of credit $ 29,814 $ 23,365 Credit card lines 1,565 1,770 Commitments secured by real estate 33,370 35,005 Commitments not secured by real estate 7,571 7,030 Commercial and industrial commitments 98,914 73,461 Agriculture commitments 41,122 28,010 Other unused commitments 17,108 12,804 Standby letters of credit 15,430 17,036Total commitments and standby letters of credit $ 244,894 $ 198,481 At both September 30, 2014 and December 31, 2013, the Company's allowance for losses on unfunded loan commitments was $0.5 million and $0.4 million, respectively. In connection with the $8.25 million in debt securities issued to Heritage Oaks Capital Trust II, the Company issued a full and unconditional payment guarantee of certain accrued distributions by Heritage Oaks Capital Trust II. Similarly, for the $8.25 million in par value of trust preferred securities that the Company assumed as part of the merger with MISN, the Company is the full and unconditional guarantor of distributions of the issuing trusts. There are no Special Purpose Entity trusts, corporations, or other legal entities established by the Company which reside off-balance sheet. Management is not aware of any other off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on the Company's financial condition, results of operations, liquidity, capital expenditures or capital resources that would be material to investors. The following table provides a summary for the Company's long-term debt and other long-term obligations, including the anticipated payments under salary continuation plans, assuming attainment of the designated retirement age, as of September 30, 2014: Less Than One to Three Three to Five More than September 30, September 30, One Year Years Years Five Years 2014 2013 (dollars in thousands) FHLB Advances and other borrowings $ 10,000 $ 20,000 $ 22,500 $ 23,000 $ 75,500 $ 57,500 Operating lease obligations 1,884 2,574 1,850 2,978 9,286 3,054 Salary continuation payments 235 516 536 4,306 5,593 5,842 Junior subordinated debentures - - - 16,496 16,496 8,248 Total obligations $ 12,119 $ 23,090 $ 24,886 $ 46,780 $ 106,875 $ 74,644 The Company has leases that contain options to extend for periods from three to seven years. Options to extend which have been exercised and the related lease commitments are included in the table above. Liquidity The objective of liquidity management is to ensure the continuous availability of funds to meet the demands of depositors, investors and borrowers. Asset liquidity is primarily derived from loan payments and the maturity of other earning assets. Liquidity from liabilities is obtained primarily from the receipt of new deposits. The Company's Asset Liability Committee ("ALCO") is responsible for managing the on and off-balance sheet commitments to meet the needs of customers while achieving the Company's financial objectives. ALCO meets regularly to assess the projected funding requirements by reviewing historical funding patterns, current and forecasted economic conditions and individual customer funding needs. Deposits generated from the Company's customers serve as the primary source of liquidity. The Bank also has credit arrangements with correspondent banks that serve as a secondary liquidity source. At September 30, 2014, these credit lines totaled $62.0 million and are unsecured. Additionally, the Bank has a borrowing facility with the FRB. The amount of available credit under the FRB facility is determined by the collateral provided by the Bank. As of September 30, 2014, the borrowing availability related to this facility was $7.7 million. At September 30, 2014, the Bank had no borrowings against the credit lines or the FRB facility. As previously mentioned, the Bank is a member of the FHLB and has available collateralized borrowing capacity of $340.9 million at September 30, 2014, in addition to the $75.6 million currently outstanding. Heritage Oaks Bancorp | - 72 - -------------------------------------------------------------------------------- Table of Contents The Bank also manages liquidity by maintaining an investment portfolio of readily marketable and liquid securities. These investments include mortgage backed securities and obligations of state and political subdivisions (municipal bonds) that provide a stream of cash flows. As of September 30, 2014, the Company believes investments in the portfolio can be liquidated at their current fair values in the event they are needed to provide liquidity. The ratio of liquid assets not pledged for collateral and other purposes as a percentage of deposits and other liabilities was 26.4% at September 30, 2014 compared to 26.3% at December 31, 2013. The ratio of gross loans to deposits, another key liquidity ratio, decreased to 80.9% at September 30, 2014 compared to 85.0% at December 31, 2013, due to the MISN acquisition. In addition to the Bank's sources of liquidity, Bancorp has a $10.0 million revolving line of credit arrangement with a correspondent bank, subject to annual renewal. Bancorp pays a 0.25% annual fee to maintain the credit facility plus 0.25% (annual rate) on the unused portion of the line. Interest on borrowings will be at the prime rate (floating) or, at Bancorp's option, at a fixed rate based on LIBOR. The line had no outstanding balance as of September 30, 2014. Management believes the level of liquid assets and available credit facilities are sufficient to meet current and anticipated funding needs. In addition, the Bank's ALCO oversees the Company's liquidity position by reviewing a monthly liquidity report. Management is not aware of any trends, demands, commitments, events or uncertainties that will result or are reasonably likely to result in a material change in the Company's liquidity. Subsequent Events Consent Order On October 29, 2014, the Bank entered into a Stipulation to the Issuance of a Consent Order with its bank regulatory agencies, the Federal Deposit Insurance Corporation ("FDIC") and the California Department of Business Oversight ("CDBO"), consenting to the issuance of a consent order ("the Consent Order") relating to identified deficiencies in the Bank's centralized Bank Secrecy Act and anti-money laundering compliance program, which is designed to comply with the requirements of the Bank Secrecy Act, the USA Patriot Act of 2001 and related anti-money laundering regulations (collectively, the "BSA/AML Requirements"). Per the Consent Order, the Bank must review, update and implement an enhanced risk assessment process based on the 2010 Federal Financial Institutions Examination Council Bank Secrecy Act/Anti-Money Laundering ("BSA/AML") Examination Manual. Some of the areas highlighted in the Consent Order include the requirements to: i) enhance customer due-diligence procedures; ii) improve the enhanced due diligence analysis for high-risk customers; iii) ensure the proper identification and reporting of suspicious activity; iv) address and correct the noted violations of law; v) ensure that there is sufficient and qualified staff; and vi) ensure that all staff are properly trained to carry out the BSA/AML programs. Management and the Board have been working diligently to comply with the Consent Order and believe they have allocated sufficient resources to address the corrective actions required by the FDIC and CDBO. Compliance and resolution of the Consent Order will ultimately be determined by the FDIC and CDBO. The foregoing summary description of the Consent Order is not complete and is qualified in its entirety by reference to the full text of the Consent Order, a copy of which is filed as Exhibit 10.1 to a Current Report on Form 8-K that was filed with the SEC on October 29, 2014. CEO Employment Agreement On October 29, 2014, the Company and the Bank entered into an employment agreement with its President and Chief Executive Officer, Simone Lagomarsino. The employment agreement was approved by the Board of Directors of the Company and the Bank as it was determined that it was advisable and in the best interest of the Company, the Bank and the Company's shareholders that Ms. Lagomarsino be provided with an employment agreement that aligns her interests with the interests of the Company and incentivizes her to remain in the employ of the Company. The employment agreement provides that Ms. Lagomarsino shall serve on the Board of Directors of the Company and the Bank. The term of Ms. Lagomarsino's employment agreement shall continue until terminated in accordance with its terms. Pursuant to the terms and conditions of the employment agreement, Ms. Lagomarsino will receive an annual base salary, is eligible to earn an annual cash bonus award, and is entitled to receive certain other benefits that the Bank extends to all of its executive employees, such as life insurance, disability insurance, health, dental, vision and other insurance benefits, 401(k) plan participation and certain fringe benefits and perquisites. Under the employment agreement, the Company may grant from time to time to Ms. Lagomarsino equity awards under and subject to the terms and conditions of the equity incentive plan that the Company is then regularly granting equity awards to its executive officers under. Heritage Oaks Bancorp | - 73 - -------------------------------------------------------------------------------- Table of Contents The employment agreement provides that if Ms. Lagomarsino terminates her employment for "Good Reason" or is terminated without "Cause," as those terms are defined in the employment agreement, she is entitled to certain severance payments detailed in the employment agreement. The employment agreement also provides for a "double-trigger" change in control payment in the event Ms. Lagomarsino terminates her employment for "Good Reason" or is terminated without "Cause" within twelve months of a "Change in Control" as that term is defined in the employment agreement. Finally, the employment agreement provides for certain benefits in the event of the "Disability," as that term is defined in the employment agreement, or death of Ms. Lagomarsino. As a condition to the receipt of any of the foregoing payments and benefits (except in the case of termination of employment due to death), Ms. Lagomarsino is required to provide the Company and the Bank with a general release from any and all claims, known and unknown, that Ms. Lagomarsino may have against the Company and/or the Bank. The employment agreement contains standard confidentiality and other business protection covenants, including covenants not to solicit or disparage. Generally speaking, Ms. Lagomarsino agrees not to induce any employees to leave or otherwise interfere with or disrupt the relationships between the Bank and its employees, or divert or attempt to divert from the Bank any of its customers, during the term of her employment and for a period of one year following her separation from the Bank. The employment agreement also contains a standard indemnification provision. The foregoing description of Ms. Lagomarsino's employment agreement is not complete and is qualified in its entirety by reference to the full text of the agreement, a copy of which is filed as Exhibit 10.2 to a Current Report on Form 8-K that was filed with the SEC on October 29, 2014. Exchange Agreement On October 29, 2014, the Company entered into an Exchange Agreement with Castle Creek Capital Partners IV, LP "Castle Creek"). Pursuant to the terms of the Exchange Agreement, Castle Creek will exchange 1,189,538 shares of the Company's Series C Convertible Perpetual Preferred Stock having a liquidation preference of $3.25 per share for shares of the Company's common stock, no par value, on a one-for-one exchange ratio basis. The consummation of the transactions contemplated by the Exchange Agreement is subject to (i) Castle Creek having received a non-control determination with respect to the Company from the Board of Governors of the Federal Reserve System (or the Federal Reserve Bank of San Francisco) and the California Department of Business Oversight, Division of Financial Institutions, (ii) the receipt of any approvals, non-objections or authorizations of all governmental entities required for the consummation of the transactions contemplated by the Exchange Agreement, (iii) no provision of law and no judgment, injunction, order or decree of any governmental entity shall prohibit consummation of the transactions contemplated by the Exchange Agreement, and (iv) the satisfaction or waiver of certain other customary closing conditions. The Company agreed in the Exchange Agreement to file, as soon as practicable, and in any event within 30 days of the closing of the transactions contemplated by the Exchange Agreement, a registration statement on Form S-3 under the Securities Act covering the resale by Castle Creek of all of the shares of the Company's common stock received in the exchange, and to cause such shares to be authorized for listing on The NASDAQ Capital Market. The Company anticipates that the closing of the transactions contemplated by the Exchange Agreement should occur during the fourth quarter of 2014. The foregoing description of the Exchange Agreement is not complete and is qualified in its entirety by reference to the full text of the Exchange Agreement, a copy of which is filed as Exhibit 10.3 to a Current Report on Form 8-K that was filed with the SEC on October 29, 2014. Dividend Declaration On October 29, 2014, the Company's Board of Directors declared a cash dividend of $0.05 per share, payable on December 1, 2014, to shareholders of the Company's common stock as of November 17, 2014. Holders of the Company's Series C Preferred Stock are also entitled to a per share dividend equivalent to the common dividend declared for which each share of Series C Preferred Stock is convertible into common stock. Heritage Oaks Bancorp | - 74 - -------------------------------------------------------------------------------- Table of Contents |