XNAS:HTBK Heritage Commerce Corp Quarterly Report 10-Q Filing - 6/30/2012

Effective Date 6/30/2012

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Table of Contents

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549



FORM 10-Q

(MARK ONE)    

ý

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2012

OR

o

 

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                        to                       

Commission file number 000-23877

Heritage Commerce Corp
(Exact name of Registrant as Specified in its Charter)

California
(State or Other Jurisdiction of
Incorporation or Organization)
  77-0469558
(I.R.S. Employer Identification No.)

150 Almaden Boulevard, San Jose, California
(Address of Principal Executive Offices)

 

95113
(Zip Code)

(408) 947-6900
(Registrant's Telephone Number, Including Area Code)

N/A
(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)

        Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    YES ý    NO o

        Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    YES ý    NO o

        Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o   Accelerated filer ý   Non-accelerated filer o
(Do not check if a
smaller reporting company)
  Smaller reporting company o

        Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    YES o    NO ý

        The Registrant had 26,293,277 shares of Common Stock outstanding on July 30, 2012.

   


Table of Contents


HERITAGE COMMERCE CORP
QUARTERLY REPORT ON FORM 10-Q
TABLE OF CONTENTS

 
   
  Page No.

Cautionary Note on Forward-Looking Statements

  3

Part I. FINANCIAL INFORMATION

   

Item 1.

 

Consolidated Financial Statements (unaudited):

  5

 

Consolidated Balance Sheets

  5

 

Consolidated Statements of Income

  6

 

Consolidated Statements of Comprehensive Income

  7

 

Consolidated Statement of Changes in Shareholders' Equity

  8

 

Consolidated Statements of Cash Flows

  9

 

Notes to Consolidated Financial Statements

  10

Item 2.

 

Management's Discussion and Analysis of Financial Condition and Results of Operations

  36

Item 3.

 

Quantitative and Qualitative Disclosures About Market Risk

  68

Item 4.

 

Controls and Procedures

  69

PART II. OTHER INFORMATION

   

Item 1.

 

Legal Proceedings

  70

Item 1A.

 

Risk Factors

  70

Item 2.

 

Unregistered Sales of Equity Securities and Use of Proceeds

  70

Item 3.

 

Defaults Upon Senior Securities

  70

Item 4.

 

Mine Safety Disclosures

  70

Item 5.

 

Other Information

  70

Item 6.

 

Exhibits

  71

SIGNATURES

  72

EXHIBIT INDEX

  73

2


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Cautionary Note Regarding Forward-Looking Statements

        This Report on Form 10-Q contains various statements that may constitute 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, and are intended to be covered by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Any statements about our expectations, beliefs, plans, objectives, assumptions or future events or performance are not historical facts and may be forward- looking. These forward-looking statements often can be, but are not always, identified by the use of words such as "assume," "expect," "intend," "plan," "project," "believe," "estimate," "predict," "anticipate," "may," "might," "should," "could," "goal," "potential" and similar expressions. We base these forward-looking statements on our current expectations and projections about future events, our assumptions regarding these events and our knowledge of facts at the time the statements are made. These statements include statements relating to our projected growth, anticipated future financial performance, and management's long-term performance goals, as well as statements relating to the anticipated effects on results of operations and financial condition.

        These forward-looking statements are subject to various risks and uncertainties that may be outside our control and our actual results could differ materially from our projected results. In addition, our past results of operations do not necessarily indicate our future results. The forward-looking statements could be affected by many factors, including but not limited to:

    Competition for loans and deposits and failure to attract or retain deposits and loans;

    Local, regional, and national economic conditions and events and the impact they may have on us and our customers, and our assessment of that impact on our estimates including, the allowance for loan losses;

    Risks associated with concentrations in real estate related loans;

    Changes in the level of nonperforming assets and charge-offs and other credit quality measures, and their impact on the adequacy of the Company's allowance for loan losses and the Company's provision for loan losses;

    The effects of and changes in trade, monetary and fiscal policies and laws, including the interest rate policies of the Federal Open Market Committee of the Federal Reserve Board;

    Stability of funding sources and continued availability of borrowings;

    Our ability to raise capital or incur debt on reasonable terms;

    Regulatory limits on Heritage Bank of Commerce's ability to pay dividends to the Company;

    Continued volatility in credit and equity markets and its effect on the global economy;

    The impact of reputational risk on such matters as business generation and retention, funding and liquidity;

    Oversupply of inventory and continued deterioration in values of California commercial real estate;

    A prolonged slowdown in construction activity;

    The effect of changes in laws and regulations (including laws and regulations concerning taxes, banking, securities, and executive compensation) which we must comply, including but not limited to, the Dodd-Frank Act of 2010;

    The effects of security breaches and computer viruses that may affect our computer systems;

    Changes in consumer spending, borrowings and saving habits;

3


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    Changes in the competitive environment among financial or bank holding companies and other financial service providers;

    The effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board, the Financial Accounting Standards Board and other accounting standard setters;

    The costs and effects of legal and regulatory developments, including resolution of legal proceedings or regulatory or other governmental inquiries, and the results of regulatory examinations or reviews;

    The ability to increase market share and control expenses; and

    Our success in managing the risks involved in the foregoing items.

        We are not able to predict all the factors that may affect future results. You should not place undue reliance on any forward looking statement, which speaks only as of the date of this Report on Form 10-Q. Except as required by applicable laws or regulations, we do not undertake any obligation to update or revise any forward looking statement, whether as a result of new information, future events or otherwise.

4


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Part I—FINANCIAL INFORMATION

ITEM 1—CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)


HERITAGE COMMERCE CORP

CONSOLIDATED BALANCE SHEETS (Unaudited)

 
  June 30, 2012   December 31, 2011  
 
  (Dollars in thousands, except per share data)
 

Assets

             

Cash and due from banks

  $ 21,885   $ 20,861  

Interest-bearing deposits in other financial institutions

    24,476     52,011  
           

Total cash and cash equivalents

    46,361     72,872  

Securities available-for-sale, at fair value

    389,820     380,455  

Loans held-for-sale—SBA, at lower of cost or fair value, including deferred costs

    2,714     753  

Loans held-for-sale—other, at lower of cost or fair value, including deferred costs

    177     413  

Loans, including deferred costs

    798,106     764,591  

Allowance for loan losses

    (20,023 )   (20,700 )
           

Loans, net

    778,083     743,891  

Federal Home Loan Bank and Federal Reserve Bank stock, at cost

    10,897     9,925  

Company owned life insurance

    47,496     46,388  

Premises and equipment, net

    7,740     7,980  

Intangible assets

    2,246     2,491  

Accrued interest receivable and other assets

    39,168     41,026  
           

Total assets

  $ 1,324,702   $ 1,306,194  
           

Liabilities and Shareholders' Equity

             

Liabilities:

             

Deposits:

             

Demand, noninterest-bearing

  $ 367,937   $ 344,303  

Demand, interest-bearing

    148,777     134,119  

Savings and money market

    290,867     282,478  

Time deposits—under $100

    28,009     28,557  

Time deposits—$100 and over

    164,056     168,874  

Time deposits—CDARS

    5,427     6,371  

Time deposits—brokered

    97,680     84,726  
           

Total deposits

    1,102,753     1,049,428  

Subordinated debt

    23,702     23,702  

Accrued interest payable and other liabilities

    33,556     35,233  
           

Total liabilities

    1,160,011     1,108,363  

Shareholders' equity:

             

Preferred stock, no par value; 10,000,000 shares authorized

             

Series A fixed rate cumulative preferred stock, 40,000 shares issued and outstanding (liquidation preference of $40,250) at December 31, 2011

        39,846  

Discount on Series A preferred stock

        (833 )

Series C convertible perpetual preferred stock, 21,004 shares issued and outstanding at June 30, 2012 and December 31, 2011 (liquidation preference of $21,004 at June 30, 2012 and December 31, 2011)

    19,519     19,519  

Common stock, no par value; 60,000,000 shares authorized; 26,293,277 shares issued and outstanding at June 30, 2012 and 26,295,001 shares issued and outstanding at December 31, 2011

    131,443     131,172  

Retained earnings

    10,566     7,172  

Accumulated other comprehensive income

    3,163     955  
           

Total shareholders' equity

    164,691     197,831  
           

Total liabilities and shareholders' equity

  $ 1,324,702   $ 1,306,194  
           

   

See notes to consolidated financial statements

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HERITAGE COMMERCE CORP

CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

 
  Three Months Ended
June 30,
  Six Months Ended
June 30,
 
 
  2012   2011   2012   2011  
 
  (Dollars in thousands, except per share data)
 

Interest income:

                         

Loans, including fees

  $ 10,292   $ 10,685   $ 20,608   $ 21,675  

Securities

    2,975     2,278     6,072     4,240  

Interest-bearing deposits in other financial institutions

    29     52     65     86  
                   

Total interest income

    13,296     13,015     26,745     26,001  
                   

Interest expense:

                         

Deposits

    738     1,068     1,454     2,339  

Subordinated debt

    472     467     946     932  

Other

    2     8     2     62  
                   

Total interest expense

    1,212     1,543     2,402     3,333  
                   

Net interest income before provision for loan losses

    12,084     11,472     24,343     22,668  

Provision for loan losses

    815     955     915     1,725  
                   

Net interest income after provision for loan losses

    11,269     10,517     23,428     20,943  
                   

Noninterest income:

                         

Service charges and fees on deposit accounts

    601     587     1,191     1,154  

Servicing income

    447     435     907     846  

Increase in cash surrender value of life insurance

    429     419     858     845  

Gain on sale of SBA loans

    376     476     412     855  

Gain on sale of securities

    32         59      

Other

    205     253     386     387  
                   

Total noninterest income

    2,090     2,170     3,813     4,087  
                   

Noninterest expense:

                         

Salaries and employee benefits

    5,377     5,111     11,044     10,504  

Occupancy and equipment

    967     1,031     1,963     2,069  

Professional fees

    470     456     1,681     1,295  

Software subscriptions

    313     274     603     529  

Low income housing investment losses

    262     40     531     202  

Data processing

    247     198     492     419  

Insurance expense

    224     244     447     486  

FDIC deposit insurance premiums

    202     383     427     907  

Other real estate owned expense

    105     127     220     147  

Other

    1,287     1,608     2,902     3,345  
                   

Total noninterest expense

    9,454     9,472     20,310     19,903  
                   

Income before income taxes

    3,905     3,215     6,931     5,127  

Income tax expense

    1,226     1,129     2,177     1,460  
                   

Net income

    2,679     2,086     4,754     3,667  

Dividends and discount accretion on preferred stock

        (604 )   (1,206 )   (1,200 )
                   

Net income available to common shareholders

  $ 2,679   $ 1,482   $ 3,548   $ 2,467  
                   

Earnings per common share:

                         

Basic

  $ 0.08   $ 0.05   $ 0.11   $ 0.08  

Diluted

  $ 0.08   $ 0.05   $ 0.11   $ 0.08  

   

See notes to consolidated financial statements

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HERITAGE COMMERCE CORP

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)

 
  For the Three Months Ended
June 30,
  For the Six Months Ended
June 30,
 
 
  2012   2011   2012   2011  
 
  (Dollars in thousands)
 

Net income

  $ 2,679   $ 2,086   $ 4,754   $ 3,667  

Net unrealized holding gains on available-for-sale securities and I/O strips

    3,398     4,243     3,769     3,876  

Reclassification adjustment for (gains) realized in income

    (32 )       (59 )    

Deferred income taxes

    (1,414 )   (1,782 )   (1,558 )   (1,628 )
                   

Change in unrealized gains on available-for-sale securities and I/O strips, net of deferred income taxes

    1,952     2,461     2,152     2,248  
                   

Net pension and other benefit plan liability adjustment

    41     89     97     195  

Deferred income taxes

    (17 )   (37 )   (41 )   (82 )
                   

Change in pension and other benefit plan liability, net of deferred income taxes

    24     52     56     113  
                   

Other comprehensive income

    1,976     2,513     2,208     2,361  
                   

Total comprehensive income

  $ 4,655   $ 4,599   $ 6,962   $ 6,028  
                   

   

See notes to consolidated financial statements

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HERITAGE COMMERCE CORP

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (Unaudited)

 
  Six Months Ended June 30, 2012 and 2011  
 
  Preferred Stock   Common Stock    
  Accumulated
Other
Comprehensive
Income / (Loss)
   
 
 
  Retained
Earnings
  Total
Shareholders'
Equity
 
 
  Shares   Amount   Discount   Shares   Amount  
 
  (Dollars in thousands, except share data)
 

Balance, January 1, 2011

    61,004   $ 59,365   $ (1,227 )   26,233,001   $ 130,531   $ (1,866 ) $ (4,651 ) $ 182,152  

Net income

                        3,667         3,667  

Net change in unrealized gain/(loss) on securities available-for-sale and interest-only strips, net of reclassification adjustment and deferred income taxes

                            2,248     2,248  

Net change in pension and other benefit plan liability, net of deferred income taxes

                            113     113  

Issuance of restricted stock awards

                62,000     320             320  

Amortization of restricted stock award, net of forfeitures and taxes

                    (346 )           (346 )

Cash dividends accrued on Series A preferred stock

                        (1,006 )       (1,006 )

Accretion of discount on Series A preferred stock

            194             (194 )        

Stock option expense, net of fortfeitures and taxes

                    331             331  
                                   

Balance, June 30, 2011

    61,004   $ 59,365   $ (1,033 )   26,295,001   $ 130,836   $ 601   $ (2,290 ) $ 187,479  
                                   

Balance, January 1, 2012

   
61,004
 
$

59,365
 
$

(833

)
 
26,295,001
 
$

131,172
 
$

7,172
 
$

955
 
$

197,831
 

Net income

                        4,754         4,754  

Net change in unrealized gain/(loss) on securities available-for-sale and interest-only strips, net of reclassification adjustment and deferred income taxes

                            2,152     2,152  

Net change in pension and other benefit plan liability, net of deferred income taxes

                            56     56  

Repurchase of Series A preferred stock

    (40,000 )   (40,000 )                         (40,000 )

Series A preferred stock capitalized offering costs

        154                   (154 )        

Issuance (forfeitures) of restricted stock awards, net

                (4,000 )                

Reversal of restricted stock awards due to forfeitures

                    39             39  

Cash dividends accrued on Series A preferred stock

                        (373 )       (373 )

Accretion of discount on Series A preferred stock

            833             (833 )        

Stock option expense, net of fortfeitures and taxes

                    223             223  

Stock options exercised

                2,276     9             9  
                                   

Balance, June 30, 2012

    21,004   $ 19,519   $     26,293,277   $ 131,443   $ 10,566   $ 3,163   $ 164,691  
                                   

   

See notes to consolidated financial statements

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HERITAGE COMMERCE CORP

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

 
  Six Months Ended
June 30,
 
 
  2012   2011  
 
  (Dollars in thousands)
 

CASH FLOWS FROM OPERATING ACTIVITIES:

             

Net income

  $ 4,754$     3,667  

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

             

Amortization (accretion) of discounts and premiums on securities

    1,071     533  

Gain on sale of securities available-for-sale

    (59 )    

Gain on sale of SBA loans

    (412 )   (855 )

Proceeds from sale of SBA loans originated for sale

    5,785     8,967  

Net change in SBA loans originated for sale

    (7,334 )   (3,019 )

Write-downs on other loans held-for-sale

        29  

Provision for loan losses

    915     1,725  

Increase in cash surrender value of life insurance

    (858 )   (845 )

Depreciation and amortization

    385     390  

Amortization of intangible assets

    245     261  

Gains on sale of foreclosed assets, net

    (84 )   (42 )

Stock option expense, net

    223     331  

Reversal (amortization) of restricted stock awards, net

    39     (26 )

Effect of changes in:

             

Accrued interest receivable and other assets

    2,381     891  

Accrued interest payable and other liabilities

    283     (7,385 )
           

Net cash provided by operating activities

    7,334     4,622  
           

CASH FLOWS FROM INVESTING ACTIVITIES:

             

Purchase of securities available-for-sale

    (49,688 )   (62,605 )

Maturities/paydowns/calls of securities available-for-sale

    38,472     14,775  

Proceeds from sale of securities available-for-sale

    2,280      

Net change in other loans transferred to held-for-sale

        27  

Net change in loans

    (37,064 )   59,136  

Change in Federal Home Loan Bank and Federal Reserve Bank stock

    (972 )   (743 )

Purchase of premises and equipment

    (145 )   (79 )

Proceeds from sale of foreclosed assets

    341     2,240  

Proceeds from sale of other loans transferred to held-for-sale

    220     1,769  

Purchases of company owned life insurance

    (250 )   (249 )
           

Net cash (used in) provided by investing activities

    (46,806 )   14,271  
           

CASH FLOWS FROM FINANCING ACTIVITIES:

             

Net change in deposits

    53,325     4,637  

Repayment of preferred stock

    (40,000 )    

Payment of cash dividends—preferred stock

    (373 )    

Exercise of stock options

    9      

Net change in securities sold under agreement to repurchase

        (5,000 )

Net change in short-term borrowings

        (2,445 )
           

Net cash provided by financing activities

    12,961     (2,808 )
           

Net increase (decrease) in cash and cash equivalents

    (26,511 )   16,085  

Cash and cash equivalents, beginning of period

    72,872     72,177  
           

Cash and cash equivalents, end of period

  $ 46,361   $ 88,262  
           

Supplemental disclosures of cash flow information:

             

Interest paid

  $ 2,418   $ 5,887  

Income taxes paid

    1,230     320  

Supplemental schedule of non-cash investing activity:

             

Due from broker for securities sold

  $ (378 ) $  

Due to broker for securities purchased

    3,330     19,755  

Loans transferred to foreclosed assets

    1,973     1,071  

Cash dividend accrued on Series A preferred stock

        1,006  

   

See notes to consolidated financial statements

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(Unaudited)

1) Basis of Presentation

        The unaudited consolidated financial statements of Heritage Commerce Corp (the "Company" or "HCC") and its wholly owned subsidiary, Heritage Bank of Commerce (sometimes referred to as the "Bank" or "HBC"), have been prepared pursuant to the rules and regulations for reporting on Form 10-Q. Accordingly, certain information and notes required by accounting principles generally accepted in the United States of America ("GAAP") for annual financial statements are not included herein. The interim statements should be read in conjunction with the consolidated financial statements and notes that were included in the Company's Form 10-K for the year ended December 31, 2011. The Company has also established the following unconsolidated subsidiary grantor trusts: Heritage Capital Trust I; Heritage Statutory Trust I; Heritage Statutory Trust II; and Heritage Commerce Corp Statutory Trust III which are Delaware Statutory business trusts formed for the exclusive purpose of issuing and selling trust preferred securities.

        HBC is a commercial bank serving customers located in Santa Clara, Alameda, and Contra Costa counties of California. No customer accounts for more than 10 percent of revenue for HBC or the Company. Management evaluates the Company's performance as a whole and does not allocate resources based on the performance of different lending or transaction activities. Accordingly, the Company and its subsidiary operate as one business segment.

        In management's opinion, all adjustments necessary for a fair presentation of these consolidated financial statements have been included and are of a normal and recurring nature. All intercompany transactions and balances have been eliminated.

        The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ significantly from these estimates.

        The results for the three months and six months ended June 30, 2012 are not necessarily indicative of the results expected for any subsequent period or for the entire year ending December 31, 2012.

Reclassifications

        Certain reclassifications of prior year balances have been made to conform to the current year presentation. These reclassifications had no impact on the Company's consolidated financial position, results of operations or net change in cash and cash equivalents.

Adoption of New Accounting Standards

        In May 2011, the FASB issued an accounting standards update to improve the comparability between U.S. GAAP fair value accounting and reporting requirements and International Financial Reporting Standards ("IFRS") fair value accounting and reporting requirements. Additional disclosures required by the update include: (i) disclosure of quantitative information regarding the unobservable inputs used in any fair value measurement classified as Level 3 in the fair value hierarchy in addition to an explanation of the valuation techniques used in valuing Level 3 items and information regarding the

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2012

(Unaudited)

1) Basis of Presentation (Continued)

sensitivity in the valuation of Level 3 items to changes in the values assigned to unobservable inputs; (ii) categorization by level within the fair value hierarchy of items not recognized on the Statement of Financial Position at fair value but for which fair values are required to be disclosed; and (iii) instances where the fair values disclosed for non-financial assets were based on a highest and best use assumption when in fact the assets are not being utilized in that capacity. The amendments in the update are effective for interim and annual periods beginning on or after December 15, 2011. The effect of adopting this standard did not have a material effect on the Company's operating results or financial condition, but the additional disclosures are included in Note 8.

        In June 2011, the FASB issued an accounting standards update to increase the prominence of items included in Other Comprehensive Income and facilitate the convergence of U.S. GAAP with IFRS. The update prohibits continued presentation of Other Comprehensive Income in the statement of stockholders' equity. The update requires that all non-owner changes in stockholders' equity be presented in either a single continuous statement of comprehensive income or in two separate but continuous statements. The amendments in the update are effective for interim and annual periods beginning on or after December 15, 2011. The adoption of this amendment changed the presentation of the statement of comprehensive income for the Company to two consecutive statements, instead of presented as part of the consolidated statements of shareholders' equity.

2) Earnings Per Share

        Basic earnings per common share is computed by dividing net income, less dividends and discount accretion on preferred stock, by the weighted average common shares outstanding. On June 21, 2010, the Company issued to various institutional investors 21,004 shares of Series C Convertible Perpetual Preferred Stock ("Series C Preferred Stock"). The 21,004 shares of Series C Preferred Stock remain outstanding as of June 30, 2012, and are convertible into 5,601,000 shares of common stock. The Series C Preferred Stock participate in the earnings of the Company and, therefore, the shares issued on the conversion of the Series C Preferred Stock are considered outstanding under the two-class method of computing basic earnings per common share during periods of earnings. Diluted earnings per share reflect potential dilution from outstanding stock options and common stock warrants, using the treasury stock method. The common stock warrant was antidilutive at June 30, 2012 and 2011. A

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2012

(Unaudited)

2) Earnings Per Share (Continued)

reconciliation of these factors used in computing basic and diluted earnings per common share is as follows:

 
  For the Three Months Ended
June 30,
  For the Six Months Ended
June 30,
 
 
  2012   2011   2012   2011  

Net income available to common shareholders

  $ 2,679   $ 1,482   $ 3,548   $ 2,467  

Less: net income allocated to Series C Preferred Stock

    470     260     623     434  
                   

Net income allocated to common shareholders

  $ 2,209   $ 1,222   $ 2,925   $ 2,033  
                   

Weighted average common shares outstanding for basic earnings per common share

    26,290,480     26,243,334     26,289,907     26,238,168  

Dilutive effect of stock options oustanding, using the the treasury stock method

    27,011     3,675     28,058     5,566  
                   

Shares used in computing diluted earnings per common share

    26,317,491     26,247,009     26,317,965     26,243,734  
                   

Basic earnings per share

  $ 0.08   $ 0.05   $ 0.11   $ 0.08  

Diluted earnings per share

  $ 0.08   $ 0.05   $ 0.11   $ 0.08  

3) Securities

        The amortized cost and estimated fair value of securities at June 30, 2012 and December 31, 2011 were as follows:

June 30, 2012
  Amortized
Cost
  Gross
Unrealized
Gains
  Gross
Unrealized
Losses
  Estimated
Fair
Value
 
 
  (Dollars in thousands)
 

Securities available-for-sale:

                         

Agency mortgage-backed securities

  $ 314,020   $ 11,906   $   $ 325,926  

Corporate bonds

    22,771     508     (58 )   23,221  

Trust preferred securities

    40,758     65     (150 )   40,673  
                   

Total

  $ 377,549   $ 12,479   $ (208 ) $ 389,820  
                   

 

December 31, 2011
  Amortized
Cost
  Gross
Unrealized
Gains
  Gross
Unrealized
Losses
  Estimated
Fair
Value
 
 
  (Dollars in thousands)
 

Securities available-for-sale:

                         

Agency mortgage-backed securities

  $ 341,901   $ 8,484   $ (37 ) $ 350,348  

Trust preferred securities

    29,947     194     (34 )   30,107  
                   

Total

  $ 371,848   $ 8,678   $ (71 ) $ 380,455  
                   

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2012

(Unaudited)

3) Securities (Continued)

        Mortgage-backed securities decreased $24,422,000 to $325,926,000 at June 30, 2012, from $350,348,000 at December 31, 2011. At June 30, 2012 and December 31, 2011, all agency mortgage-backed securities were issued by the Federal National Mortgage Association ("Fannie Mae") the Federal Home Loan Mortgage Corporation ("Freddie Mac"), or the Government National Mortgage Association ("Ginnie Mae"). At June 30, 2012, the investment portfolio included $23,221,000 of corporate bonds, compared to no corporate bonds in the investment portfolio at December 31, 2011. At June 30, 2012, the Company's investment portfolio included single entity issue trust preferred securities by four issuers with a carrying value of $40,758,000 and market value of $40,673,000, compared to a carrying value of $29,947,000 and a market value of $30,107,000 of single entity issue trust preferred securities at December 31, 2011. There were no holdings of securities of any one issuer, other than the U.S. Government and its sponsored entities, in an amount greater than 10% of shareholders' equity.

        At June 30, 2012, the Company held 181 securities, of which ten had fair values below amortized cost. No securities had been carried with an unrealized loss for over 12 months. Unrealized losses were due to higher interest rates. The issuers are of high credit quality and all principal amounts are expected to be paid when securities mature. The fair value is expected to recover as the securities approach their maturity date and/or market rates decline. The Company does not intend to sell any securities with an unrealized loss and does not believe that it is more likely than not that the Company will be required to sell a security in an unrealized loss position prior to recovery in value. The Company does not consider these securities to be other-than-temporarily impaired at June 30, 2012.

        At December 31, 2011, the Company held 165 securities, of which five had fair values below amortized cost. No securities had been carried with an unrealized loss for over 12 months. The Company did not consider these securities to be other-than-temporarily impaired at December 31, 2011.

        The amortized cost and estimated fair values of securities as June 30, 2012, by contractual maturity, are shown below. The expected maturities will differ from contractual maturities if borrowers have the right to call or pre-pay obligations with or without call or pre-payment penalties. Securities not due at a single maturity date are shown separately.

 
  Available-for-sale  
 
  Amortized Cost   Estimated Fair Value  
 
  (Dollars in thousands)
 

Due within one year

  $   $  

Due after one through five years

    909     921  

Due after five through ten years

    21,862     22,300  

Due after ten years

    40,758     40,673  

Agency mortgage-backed securities

    314,020     325,926  
           

Total

  $ 377,549   $ 389,820  
           

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2012

(Unaudited)

4) Loans

        Loans were as follows:

 
  June 30,
2012
  December 31,
2011
 
 
  (Dollars in thousands)
 

Loans held-for-investment:

             

Commercial

  $ 384,260   $ 366,590  

Real estate:

             

Commercial and residential

    333,048     311,479  

Land and construction

    19,822     23,016  

Home equity

    47,813     52,017  

Consumer

    13,024     11,166  
           

Loans

    797,967     764,268  

Deferred loan origination costs and fees, net

    139     323  
           

Loans, including deferred costs

    798,106     764,591  

Allowance for loan losses

    (20,023 )   (20,700 )
           

Loans, net

  $ 778,083   $ 743,891  
           

        Changes in the allowance for loan losses were as follows:

 
  Three Months Ended June 30, 2012  
 
  Commercial   Real Estate   Consumer   Total  
 
  (Dollars in thousands)
 

Balance, beginning of period

  $ 13,734   $ 6,409   $ 163   $ 20,306  

Charge-offs

    (1,280 )   (101 )       (1,381 )

Recoveries

    60     223         283  
                   

Net (charge-offs)/recoveries

    (1,220 )   122         (1,098 )

Provision/(credit) for loan losses

    864     8     (57 )   815  
                   

Balance, end of period

  $ 13,378   $ 6,539   $ 106   $ 20,023  
                   

 

 
  Three Months Ended June 30, 2011  
 
  Commercial   Real Estate   Consumer   Total  
 
  (Dollars in thousands)
 

Balance, beginning of period

  $ 13,594   $ 9,539   $ 876   $ 24,009  

Charge-offs

    (1,681 )   (601 )   (8 )   (2,290 )

Recoveries

    91     401     1     493  
                   

Net (charge-offs)/recoveries

    (1,590 )   (200 )   (7 )   (1,797 )

Provision/(credit) for loan losses

    1,988     (1,177 )   144     955  
                   

Balance, end of period

  $ 13,992   $ 8,162   $ 1,013   $ 23,167  
                   

14


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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2012

(Unaudited)

4) Loans (Continued)


 
  Six Months Ended June 30, 2012  
 
  Commercial   Real Estate   Consumer   Total  
 
  (Dollars in thousands)
 

Balance, beginning of period

  $ 13,215   $ 7,338   $ 147   $ 20,700  

Charge-offs

    (2,190 )   (146 )       (2,336 )

Recoveries

    521     223         744  
                   

Net (charge-offs)/recoveries

    (1,669 )   77         (1,592 )

Provision/(credit) for loan losses

    1,832     (876 )   (41 )   915  
                   

Balance, end of period

  $ 13,378   $ 6,539   $ 106   $ 20,023  
                   

 

 
  Six Months Ended June 30, 2011  
 
  Commercial   Real Estate   Consumer   Total  
 
  (Dollars in thousands)
 

Balance, beginning of period

  $ 13,952   $ 10,363   $ 889   $ 25,204  

Charge-offs

    (2,800 )   (1,596 )   (8 )   (4,404 )

Recoveries

    230     411     1     642  
                   

Net (charge-offs)/recoveries

    (2,570 )   (1,185 )   (7 )   (3,762 )

Provision/(credit) for loan losses

    2,610     (1,016 )   131     1,725  
                   

Balance, end of period

  $ 13,992   $ 8,162   $ 1,013   $ 23,167  
                   

15


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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2012

(Unaudited)

4) Loans (Continued)

        The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment, based on the impairment method as of June 30, 2012 and December 31, 2011:

 
  June 30, 2012  
 
  Commercial   Real Estate   Consumer   Total  
 
  (Dollars in thousands)
 

Allowance for loan losses:

                         

Ending allowance balance attributable to loans:

                         

Individually evaluated for impairment

  $ 1,944   $ 82   $ 18   $ 2,044  

Collectively evaluated for impairment

    11,434     6,457     88     17,979  
                   

Total ending allowance balance

  $ 13,378   $ 6,539   $ 106   $ 20,023  
                   

Loans:

                         

Individually evaluated for impairment

  $ 11,121   $ 3,690   $ 160   $ 14,971  

Collectively evaluated for impairment

    373,139     396,993     12,864     782,996  
                   

Total ending loan balance

  $ 384,260   $ 400,683   $ 13,024   $ 797,967  
                   

 

 
  December 31, 2011  
 
  Commercial   Real Estate   Consumer   Total  
 
  (Dollars in thousands)
 

Allowance for loan losses:

                         

Ending allowance balance attributable to loans:

                         

Individually evaluated for impairment

  $ 2,249   $ 76   $ 2   $ 2,327  

Collectively evaluated for impairment

    10,966     7,262     145     18,373  
                   

Total ending allowance balance

  $ 13,215   $ 7,338   $ 147   $ 20,700  
                   

Loans:

                         

Individually evaluated for impairment

  $ 11,954   $ 5,948   $ 12   $ 17,914  

Collectively evaluated for impairment

    354,636     380,564     11,154     746,354  
                   

Total ending loan balance

  $ 366,590   $ 386,512   $ 11,166   $ 764,268  
                   

        The following table presents loans held-for-investment individually evaluated for impairment by class of loans as of June 30, 2012 and December 31, 2011. The recorded investment included in the

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2012

(Unaudited)

4) Loans (Continued)

following table represents loan principal net of any partial charge-offs recognized on the loans. The unpaid principal balance represents the recorded balance prior to any partial charge-offs.

 
  June 30, 2012   December 31, 2011  
 
  Unpaid
Principal
Balance
  Recorded
Investment
  Allowance
for Loan
Losses
Allocated
  Unpaid
Principal
Balance
  Recorded
Investment
  Allowance
for Loan
Losses
Allocated
 
 
  (Dollars in thousands)
 

With no related allowance recorded:

                                     

Commercial

  $ 7,421   $ 6,470   $   $ 7,644   $ 5,972   $  

Real estate:

                                     

Commercial and residential

    1,092     1,092         2,916     2,057      

Land and construction

    2,197     2,197         3,491     3,039      

Consumer

                         
                           

Total with no related allowance recorded

    10,710     9,759         14,051     11,068      

With an allowance recorded:

                                     

Commercial

    4,651     4,651     1,944     6,526     5,982     2,249  

Real estate:

                                     

Commercial and residential

    3     3     1     80     80     44  

Land and construction

                817     740     32  

Home Equity

    398     398     81     32     32      

Consumer

    160     160     18     12     12     2  
                           

Total with an allowance recorded

    5,212     5,212     2,044     7,467     6,846     2,327  
                           

Total

  $ 15,922   $ 14,971   $ 2,044   $ 21,518   $ 17,914   $ 2,327  
                           

        The following tables present interest recognized and cash-basis interest earned on impaired loans for the periods indicated:

 
  Three Months Ended June 30, 2012  
 
   
  Real Estate    
   
 
 
  Commercial   Commercial and
Residential
  Land and
Construction
  Home
Equity
  Consumer   Total  
 
  (Dollars in thousands)
 

Average of impaired loans during the period

  $ 11,034   $ 2,252   $ 2,210   $ 199   $ 86   $ 15,781  

Interest income during impairment

  $   $   $   $   $   $  

Cash-basis interest earned

  $   $   $   $   $   $  

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Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2012

(Unaudited)

4) Loans (Continued)


 
  Three Months Ended June 30, 2011  
 
   
  Real Estate    
   
 
 
  Commercial   Commercial and
Residential
  Land and
Construction
  Home
Equity
  Consumer   Total  
 
  (Dollars in thousands)
 

Average of impaired loans during the period

  $ 13,146   $ 2,780   $ 7,306   $ 141   $ 938   $ 24,311  

Interest income during impairment

  $   $   $   $   $   $  

Cash-basis interest earned

  $   $   $   $   $   $  

 

 
  Six Months Ended June 30, 2012  
 
   
  Real Estate    
   
 
 
  Commercial   Commercial and
Residential
  Land and
Construction
  Home
Equity
  Consumer   Total  
 
  (Dollars in thousands)
 

Average of impaired loans during the period

  $ 11,341   $ 2,214   $ 2,733   $ 143   $ 61   $ 16,492  

Interest income during impairment

  $   $ 1   $ 14   $   $   $ 15  

Cash-basis interest earned

  $   $ 1   $ 14   $   $   $ 15  

 

 
  Six Months Ended June 30, 2011  
 
   
  Real Estate    
   
 
 
  Commercial   Commercial and
Residential
  Land and
Construction
  Home
Equity
  Consumer   Total  
 
  (Dollars in thousands)
 

Average of impaired loans during the period

  $ 13,555   $ 4,248   $ 7,823   $ 94   $ 925   $ 26,645  

Interest income during impairment

  $ 1   $   $   $ 1   $   $ 2  

Cash-basis interest earned

  $   $   $   $ 1   $   $ 1  

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Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2012

(Unaudited)

4) Loans (Continued)

        Nonperforming loans include both smaller dollar balance homogenous loans that are collectively evaluated for impairment and individually classified loans. Nonperforming loans were as follows at period-end:

 
  June 30,    
 
 
  December 31,
2011
 
 
  2012   2011  
 
  (Dollars in thousands)
 

Nonaccrual loans—held-for-sale

  $ 177   $ 202   $ 186  

Nonaccrual loans—held-for-investment

    12,890     21,607     14,353  

Restructured and loans over 90 days past due and still accruing

    1,665     1,073     2,291  
               

Total nonperforming loans

  $ 14,732   $ 22,882   $ 16,830  
               

Other restructured loans

  $ 416   $ 1,375   $ 1,270  

Impaired loans, excluding loans held-for-sale

  $ 14,971   $ 24,055   $ 17,914  

        The following table presents the nonperforming loans by class as of June 30, 2012 and December 31, 2011:

 
  June 30, 2012   December 31, 2011  
 
  Nonaccrual   Restructured and
Loans Over
90 Days
Past Due and
Still Accruing
  Total   Nonaccrual   Restructured and
Loans Over
90 Days
Past Due and
Still Accruing
  Total  
 
  (Dollars in thousands)
 

Commercial

  $ 9,040   $ 1,665   $ 10,705   $ 8,876   $ 1,803   $ 10,679  

Real estate:

                                     

Commercial and residential

    1,104         1,104     2,137         2,137  

Land and construction

    2,365         2,365     3,514     456     3,970  

Home equity

    398         398         32     32  

Consumer

    160         160     12         12  
                           

Total

  $ 13,067   $ 1,665   $ 14,732   $ 14,539   $ 2,291   $ 16,830  
                           

19


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2012

(Unaudited)

4) Loans (Continued)

        The following table presents the aging of past due loans as of June 30, 2012 by class of loans:

 
  June 30, 2012  
 
  30 - 59
Days
Past Due
  60 - 89
Days
Past Due
  90 Days or
Greater
Past Due
  Total
Past Due
  Loans Not
Past Due
  Total  
 
  (Dollars in thousands)
 

Commercial

  $ 1,718   $ 2,794   $ 2,189   $ 6,701   $ 377,559   $ 384,260  

Real estate:

                                     

Commercial and residential

    1,164     1,369     101     2,634     330,414     333,048  

Land and construction

    2,472             2,472     17,350     19,822  

Home equity

                    47,813     47,813  

Consumer

                    13,024     13,024  
                           

Total

  $ 5,354   $ 4,163   $ 2,290   $ 11,807   $ 786,160   $ 797,967  
                           

        The following table presents the aging of past due loans as of December 31, 2011 by class of loans:

 
  December 31, 2011  
 
  30 - 59
Days
Past Due
  60 - 89
Days
Past Due
  90 Days or
Greater
Past Due
  Total
Past Due
  Loans Not
Past Due
  Total  
 
  (Dollars in thousands)
 

Commercial

  $ 1,999   $ 508   $ 3,394   $ 5,901   $ 360,689   $ 366,590  

Real estate:

                                     

Commercial and residential

    2,293             2,293     309,186     311,479  

Land and construction

            1,532     1,532     21,484     23,016  

Home equity

    753         32     785     51,232     52,017  

Consumer

                    11,166     11,166  
                           

Total

  $ 5,045   $ 508   $ 4,958   $ 10,511   $ 753,757   $ 764,268  
                           

        Past due loans 30 days or greater totaled $11,807,000 and $10,511,000 at June 30, 2012 and December 31, 2011, respectively, of which $5,353,000 and $6,312,000 were on nonaccrual. At June 30, 2012, there were also $7,537,000 loans less than 30 days past due included in nonaccrual loans held-for-investment. At December 31, 2011, there were also $8,041,000 loans less than 30 days past due included in nonaccrual loans held-for-investment. Management's classification of a loan as "nonaccrual" is an indication that there is reasonable doubt as to the full recovery of principal or interest on the loan. At that point, the Company stops accruing interest income, and reverses any uncollected interest that had been accrued as income. The Company begins recognizing interest income only as cash interest payments are received and it has been determined the collection of all outstanding principal is not in doubt. The loans may or may not be collateralized, and collection efforts are pursued.

20


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2012

(Unaudited)

4) Loans (Continued)

Credit Quality Indicators

        Concentrations of credit risk arise when a number of clients are engaged in similar business activities, or activities in the same geographic region, or have similar features that would cause their ability to meet contractual obligations to be similarly affected by changes in economic conditions. The Company's loan portfolio is concentrated in commercial (primarily manufacturing, wholesale, and service) and real estate lending, with the balance in consumer loans. While no specific industry concentration is considered significant, the Company's lending operations are located in the Company's market areas that are dependent on the technology and real estate industries and their supporting companies. Thus, the Company's borrowers could be adversely impacted by a continued downturn in these sectors of the economy which could reduce the demand for loans and adversely impact the borrowers' ability to repay their loans.

        The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. The Company analyzes loans individually by classifying the loans as to credit risk. This analysis is performed on a quarterly basis. Nonclassified loans generally include those loans that are expected to be repaid in accordance with contractual loans terms. Classified loans are those loans that are assigned a substandard, substandard-nonaccrual, or doubtful risk rating using the following definitions:

        Substandard.    Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.

        Substandard-Nonaccrual.    Loans classified as substandard-nonaccrual are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected. In addition, the Company no longer accrues interest on the loan because of the underlying weaknesses.

        Doubtful.    Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2012

(Unaudited)

4) Loans (Continued)

        The following table provides a summary of the loan portfolio by loan type and credit quality classification at June 30, 2012 and December 31, 2011:

 
  June 30, 2012   December 31, 2011  
 
  Nonclassified   Classified   Total   Nonclassified   Classified   Total  
 
  (Dollars in thousands)
 

Commercial

  $ 353,651   $ 30,609   $ 384,260   $ 333,506   $ 33,084   $ 366,590  

Real estate:

                                     

Commercial and residential

    317,845     15,203     333,048     294,653     16,826     311,479  

Land and construction

    13,832     5,990     19,822     15,343     7,673     23,016  

Home equity

    47,168     645     47,813     51,368     649     52,017  

Consumer

    12,635     389     13,024     10,853     313     11,166  
                           

Total

  $ 745,131   $ 52,836   $ 797,967   $ 705,723   $ 58,545   $ 764,268  
                           

        In order to determine whether a borrower is experiencing financial difficulty, an evaluation is performed of the probability that the borrower will be in payment default on any of its debt in the foreseeable future without the modification. This evaluation is performed under the Company's underwriting policy.

        During the three months and six months ended June 30, 2012, the terms of certain loans were modified as troubled debt restructurings. The modification of the terms of such loans included one or more combination of the following: a reduction of the stated interest rate of the loan; or an extension of maturity date at a stated rate of interest lower than the current market rate for new debt with similar risk.

        The recorded investment of troubled debt restructurings at June 30, 2012 was $5,240,000, which included $3,163,000 of nonaccrual loans and $2,077,000 of accruing loans. The book balance of troubled debt restructurings at December 31, 2011 was $7,396,000, which included $4,323,000 of nonaccrual loans and $3,073,000 of accruing loans. Approximately $849,000 and $574,000 in specific reserves were established with respect to these loans as of June 30, 2012 and December 31, 2011, respectively. As of June 30, 2012 and December 31, 2011, the Company had no additional amounts committed on any loan classified as a troubled debt restructuring.

        The following table presents loans by class modified as troubled debt restructurings during the three month period ended June 30, 2012:

 
  During the Three Months Ended
June 30, 2012
 
Troubled Debt Restructurings:
  Number of
Contracts
  Pre-modification
Outstanding
Recorded
Investment
  Post-modification
Outstanding
Recorded
Investment
 
 
  (Dollars in thousands)
 

Consumer

    1   $ 117   $ 117  

22


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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2012

(Unaudited)

4) Loans (Continued)

        The troubled debt restructurings described above increased the allowance for loan losses by $13,000 through the allocation of specific reserves, and resulted in no net charge-offs during the three months period ended June 30, 2012.

        The following table presents loans by class modified as troubled debt restructurings during the six month period ended June 30, 2012:

 
  During the Six Months Ended
June 30, 2012
 
Troubled Debt Restructurings:
  Number of
Contracts
  Pre-modification
Outstanding
Recorded
Investment
  Post-modification
Outstanding
Recorded
Investment
 
 
  (Dollars in thousands)
 

Commercial

    1   $ 112   $ 112  

Consumer

    1     117     117  
               

Total

    2   $ 229   $ 229  
               

        The troubled debt restructurings described above increased the allowance for loan losses by $44,000 through the allocation of specific reserves, and resulted in no net charge-offs during the six months period ended June 30, 2012.

        A loan is considered to be in payment default when it is 30 days contractually past due under the modified terms. There were no defaults on troubled debt restructurings, within twelve months following the modification, during the three month and six month periods ended June 30, 2012.

5) Income Taxes

        Some items of income and expense are recognized in different years for tax purposes than when applying generally accepted accounting principles, leading to timing differences between the Company's actual tax liability and the amount accrued for this liability based on book income. These temporary differences comprise the "deferred" portion of the Company's tax expense or benefit, which is accumulated on the Company's books as a deferred tax asset or deferred tax liability until such time as they reverse.

        Realization of the Company's deferred tax assets is primarily dependent upon the Company generating sufficient taxable income to obtain benefit from the reversal of net deductible temporary differences and utilization of tax credit carryforwards and the net operating loss carryforwards for Federal and California state income tax purposes. The amount of deferred tax assets considered realizable is subject to adjustment in future periods based on estimates of future taxable income. Under generally accepted accounting principles, a valuation allowance is required to be recognized if it is "more likely than not" that a deferred tax asset will not be realized. The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning management's evaluation of both positive and negative evidence, including forecasts of future income, cumulative losses, applicable tax planning strategies, and assessments of current and future economic and business conditions.

23


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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2012

(Unaudited)

5) Income Taxes (Continued)

        The Company had net deferred tax assets of $19,522,000, and $21,870,000, at June 30, 2012, and December 31, 2011, respectively. After consideration of the matters in the preceding paragraph, the Company determined that it is more likely than not that the net deferred tax asset at June 30, 2012 and December 31, 2011 will be fully realized in future years.

6) Benefit Plans

Supplemental Retirement Plan

        The Company has a supplemental retirement plan (the "Plan") covering current and former key executives and directors. The Plan is a nonqualified defined benefit plan. Benefits are unsecured as there are no Plan assets. The following table presents the amount of periodic cost recognized for the periods indicated:

 
  Three Months Ended
June 30,
  Six Months Ended
June 30,
 
 
  2012   2011   2012   2011  
 
  (Dollars in thousands)
 

Components of net periodic benefit cost:

                         

Service cost

  $ 294   $ 236   $ 588   $ 472  

Interest cost

    193     206     386     412  

Amortization of prior service cost

    7     9     14     18  

Amortization of net actuarial loss

    63     31     126     62  
                   

Net periodic benefit cost

  $ 557   $ 482   $ 1,114   $ 964  
                   

Split-Dollar Life Insurance Benefit Plan

        The Company maintains life insurance policies for current and former directors and officers that are subject to split-dollar life insurance agreements. The following table sets forth the funded status of the split-dollar life insurance benefits for the six months ended June 30, 2012 and the year ended December 31, 2011:

 
  June 30,
2012
  December 31,
2011
 
 
  (Dollars in thousands)
 

Change in projected benefit obligation

             

Projected benefit obligation at beginning of year

  $ 4,525   $ 6,361  

Interest cost

    93     306  

Actuarial gain (loss)

    (11 )   831  

Amendments to split dollar agreements

        (2,973 )
           

Projected benefit obligation at end of period

  $ 4,607   $ 4,525  
           

24


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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2012

(Unaudited)

6) Benefit Plans (Continued)

        Amounts recognized in accumulated other comprehensive income at June 30, 2012 and December 31, 2011 consist of the following:

 
  June 30,
2012
  December 31,
2011
 
 
  (Dollars in thousands)
 

Net actuarial gain

  $ 525   $ 454  

Prior transition obligation

    1,730     1,776  
           

Accumulated other comprehensive loss

  $ 2,255   $ 2,230  
           

7) Preferred Stock

Series A Preferred Stock

        On November 21, 2008, the Company issued 40,000 shares of Series A Fixed Rate Cumulative Perpetual Preferred Stock ("Series A Preferred Stock") to the U.S. Treasury under the terms of the U.S. Treasury Capital Purchase Program for $40,000,000 with a liquidation preference of $1,000 per share. On March 7, 2012, in accordance with approvals received from the U.S. Treasury and the Federal Reserve Board, the Company repurchased all of the Series A Preferred Stock and paid all of the related accrued and unpaid dividends. HCC used available cash and proceeds from a $30,000,000 distribution approved by the California Department of Financial Institutions from HBC to HCC. The repurchase of the Series A Preferred Stock accelerated the accretion of the remaining issuance discount on the Series A Preferred Stock. Total dividends and discount accretion on Preferred Stock, including accelerated accretion of approximately $765,000, reduced net income available to common shareholders by $1,206,000 in the first quarter of 2012. The Company did not repurchase the related warrant that was issued to the U.S Treasury, and the warrant remains outstanding as of the date of this report.

Series C Preferred Stock

        On June 21, 2010, the Company issued to various institutional investors 21,004 shares of Series C Convertible Perpetual Preferred Stock ("Series C Preferred Stock"). The Series C Preferred Stock is mandatorily convertible into common stock at a conversion price of $3.75 per share upon a subsequent transfer of the Series C Preferred Stock to third parties not affiliated with the holder in a widely dispersed offering. The Series C Preferred Stock remains outstanding until it has been converted into common stock in accordance with its terms. The Series C Preferred Stock is non-voting except in the case of certain transactions that would affect the rights of the holders of the Series C Preferred Stock or applicable law. Holders of Series C Preferred Stock will receive dividends if and only to the extent dividends are paid to holders of common stock. The Series C Preferred Stock is not redeemable by the Company or by the holders and has a liquidation preference of $1,000 per share. The Series C Preferred Stock ranks senior to the Company's common stock.

8) Fair Value

        Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly

25


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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2012

(Unaudited)

8) Fair Value (Continued)

transaction between market participants on the measurement date. There are three levels of inputs that may be used to measure fair values:

        Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

        Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities in active markets; quoted prices for identical assets or liabilities in markets that are not active; or other inputs that are observable or can be corroborated by observable market data (for example, interest rates and yield curves observable at commonly quoted intervals, prepayment speeds, credit risks, and default rates).

        Level 3: Significant unobservable inputs that reflect a reporting entity's own assumptions about the assumptions that market participants would use in pricing an asset or liability.

Financial Assets and Liabilities Measured on a Recurring Basis

        The fair values of securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges (Level 1 inputs) or matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities, but rather by relying on the securities' relationship to other benchmark quoted securities (Level 2 inputs).

        The fair value of interest-only ("I/O") strip receivable assets is based on a valuation model used by a third party. The Company is able to compare the valuation model inputs and results to widely available published industry data for reasonableness (Level 2 inputs).

 
   
  Fair Value Measurements Using  
 
  Balance   Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
  Significant
Other
Observable
Inputs
(Level 2)
  Significant
Unobservable
Inputs
(Level 3)
 
 
  (Dollars in thousands)
 

Assets at June 30, 2012:

                         

Available-for-sale securities:

                         

Agency mortgage-backed securities

  $ 325,926       $ 325,926      

Corporate bonds

    23,221         23,221      

Trust preferred securities

    40,673         40,673      

I/O strip receivables

    2,140         2,140      

Assets at December 31, 2011:

                         

Available-for-sale securities:

                         

Agency mortgage-backed securities

  $ 350,348   $   $ 350,348      

Trust preferred securities

    30,107         30,107      

I/O strip receivables

    2,094         2,094      

26


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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2012

(Unaudited)

8) Fair Value (Continued)

        There were no transfers between Level 1 and Level 2 during the period for assets measured at fair value on a recurring basis.

Assets and Liabilities Measured on a Non-Recurring Basis

        The fair value of loans held-for-sale is generally based on obtaining bids and broker indications on the estimated value of these loans held-for-sale, resulting in a Level 2 classification.

        At the time a loan is considered impaired, it is valued at the lower of cost or fair value. Impaired loans carried at fair value generally receive specific allocations of the allowance for loan losses. For collateral dependent loans, fair value is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. Non-real estate collateral may be valued using an appraisal, net book value per the borrower's financial statements, or aging reports, adjusted or discounted based on management's historical knowledge, changes in market conditions from the time of the valuation, and management's expertise and knowledge of the client and client's business, resulting in a Level 3 fair value classification. Impaired loans are evaluated on a quarterly basis for additional impairment and adjusted accordingly.

        Assets acquired through or instead of loan foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. These assets are subsequently accounted for at lower of cost or fair value less estimated costs to sell. Fair value is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.

27


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2012

(Unaudited)

8) Fair Value (Continued)

 
   
  Fair Value Measurements Using  
 
  Balance   Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
  Significant
Other
Observable
Inputs
(Level 2)
  Significant
Unobservable
Inputs
(Level 3)
 
 
  (Dollars in thousands)
 

Assets at June 30, 2012:

                         

Impaired loans held-for-sale—other:

                         

Real estate:

                         

Land and construction

  $ 177       $ 177      
                       

Impaired loans—held-for-investment:

                         

Commercial

  $ 4,873           $ 4,873  

Real estate:

                         

Commercial and residential

    906             906  

Land and construction

    1,697             1,697  

Home equity

    317                 317  

Consumer

    142             142  
                       

  $ 7,935           $ 7,935  
                       

Foreclosed assets:

                         

Commercial and residential

  $ 183           $ 183  

Land and construction

    2,915             2,915  
                       

  $ 3,098               $ 3,098  
                       

Assets at December 31, 2011:

                         

Impaired loans held-for-sale—other:

                         

Real estate:

                         

Land and construction

  $ 186       $ 186      
                       

Impaired loans—held-for-investment:

                         

Commercial

  $ 6,526           $ 6,526  

Real estate:

                         

Commercial and residential

    1,794             1,794  

Land and construction

    1,590             1,590  

Home equity

    32                 32  

Consumer

    10             10  
                       

  $ 9,952           $ 9,952  
                       

Foreclosed assets:

                         

Commercial and residential

  $ 156           $ 156  

Land and construction

    2,156             2,156  
                       

  $ 2,312               $ 2,312  
                       

28


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2012

(Unaudited)

8) Fair Value (Continued)

        The following table shows the detail of the impaired loans held-for-investment and the impaired loans held-for-investment carried at fair value for the periods indicated:

 
  June 30,
2012
  December 31,
2011
 
 
  (Dollars in thousands)
 

Impaired loans held-for-investment:

             

Book value of impaired loans held-for-investment carried at fair value

  $ 9,786   $ 12,279  

Book value of impaired loans held-for-investment carried at cost

    4,796     5,635  
           

Total impaired loans held-for-investment

  $ 14,582   $ 17,914  
           

Impaired loans held-for-investment carried at fair value:

             

Book value of impaired loans held-for-investment carried at fair value

  $ 9,786   $ 12,279  

Specific valuation allowance

    (1,851 )   (2,327 )
           

Impaired loans held-for-investment carried at fair value, net

  $ 7,935   $ 9,952  
           

        Impaired loans held-for-investment which are measured primarily for impairment using the fair value of the collateral were $14,582,000 at June 30, 2012, after partial charge-offs of $951,000 in the first six months of 2012. In addition, these loans had a specific valuation allowance of $1,851,000 at June 30, 2012. Impaired loans held-for-investment totaling $9,786,000 at June 30, 2012 were carried at fair value as a result of the aforementioned partial charge-offs and specific valuation allowances at period-end. The remaining $4,796,000 of impaired loans were carried at cost at June 30, 2012, as the fair value of the collateral exceeded the cost basis of each respective loan. Partial charge-offs and changes in specific valuation allowances during the first six months of 2012 on impaired loans held-for-investment carried at fair value at June 30, 2012 resulted in an additional provision for loan losses of $1,024,000.

        Foreclosed assets measured at fair value less costs to sell, had a net carrying amount of $3,098,000, which is made up of the outstanding balance of $3,098,000, with no valuation allowance at June 30, 2012.

        Impaired loans held-for-investment which are measured primarily for impairment using the fair value of the collateral were $17,914,000 at December 31, 2011, after partial charge-offs of $3,604,000 in 2011. In addition, these loans had a specific valuation allowance of $2,327,000 at December 31, 2011. Impaired loans held-for-investment totaling $12,279,000 at December 31, 2011 were carried at fair value as a result of the aforementioned partial charge-offs and specific valuation allowances at year-end. The remaining $5,635,000 of impaired loans were carried at cost at December 31, 2011, as the fair value of the collateral exceeded the cost basis of each respective loan. Partial charge-offs and changes in specific valuation allowances during 2011 on impaired loans held-for-investment carried at fair value at December 31, 2011 resulted in an additional provision for loan losses of $2,916,000.

29


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2012

(Unaudited)

8) Fair Value (Continued)

        At December 31, 2011, foreclosed assets had a carrying amount of $2,312,000, with no valuation allowance at December 31, 2011.

        The following table presents quantitative information about level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at June 30, 2012:

 
  Fair Value   Valuation
Techniques
  Unobservable Inputs   Range
(Weighted
Average)
 
  (Dollars in thousands)

Impaired loans—held-for-investment:

                 

Commercial

  $ 4,873   Market Approach   Discount adjustment for differences between comparable sales   2% to 34% (17%)

Real estate:

                 

Commercial and residential

    906   Market Approach   Discount adjustment for differences between comparable sales   2% to 7% (5%)

Land and construction

    1,697   Market Approach   Discount adjustment for differences between comparable sales   1% to 36% (12%)

Foreclosed assets:

                 

Land and construction

    2,915   Market Approach   Discount adjustment for differences between comparable sales   0% to 23% (6%)

        The Company obtains third party appraisals on its impaired loans held-for-investment and foreclosed assets to determine fair value. Generally, the third party appraisals apply the "market approach," which is a valuation technique that uses prices and other relevant information generated by market transactions involving identical or comparable (that is, similar) assets, liabilities, or a group of assets and liabilities, such as a business. Adjustments are then made based on the type of property, age of appraisal, current status of property and other related factors to estimate the current value of collateral.

30


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2012

(Unaudited)

8) Fair Value (Continued)

        The carrying amounts and estimated fair values of financial instruments at June 30, 2012 are as follows:

 
   
  Estimated Fair Value  
 
  Carrying
Amounts
  Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
  Significant
Other
Observable
Inputs
(Level 2)
  Significant
Unobservable
Inputs
(Level 3)
  Total  
 
  (Dollars in thousands)
 

Assets:

                               

Cash and cash equivalents

  $ 46,361   $ 46,361   $   $   $ 46,361  

Securities available-for-sale

    389,820         389,820         389,820  

Loans (including loans held-for-sale), net

    780,974         2,891     777,736     780,627  

FHLB and FRB stock

    10,897                 N/A  

Accrued interest receivable

    3,877         3,877         3,877  

Loan servicing rights and I/O strips receivables

    2,920         5,228         5,228  

Liabilities:

                               

Time deposits

  $ 295,172   $   $ 296,090   $   $ 296,090  

Other deposits

    807,581         807,581         807,581  

Subordinated debt

    23,702             19,310     19,310  

Accrued interest payable

    768         768         768  

        The carrying amounts and estimated fair values of the Company's financial instruments at December 31, 2011:

 
  Carrying
Amounts
  Estimated
Fair Value
 
 
  (Dollars in thousands)
 

Assets:

             

Cash and cash equivalents

  $ 72,872   $ 72,872  

Securities available-for-sale

    380,455     380,455  

Loans (including loans held-for-sale), net

    745,057     745,421  

FHLB and FRB stock

    9,925     N/A  

Accrued interest receivable

    3,719     3,719  

Loan servicing rights and I/O strips receivables

    2,886     5,261  

Liabilities:

             

Time deposits

  $ 288,528   $ 289,512  

Other deposits

    760,900     760,900  

Subordinated debt

    23,702     15,950  

Accrued interest payable

    784     784  

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2012

(Unaudited)

8) Fair Value (Continued)

        The methods and assumptions, not previously discussed, used to estimate the fair value are described as follows:

Cash and Cash Equivalents

        The carrying amounts of cash on hand, noninterest and interest bearing due from bank accounts, and fed funds sold approximate fair values and are classified as Level 1.

Loans

        The fair value of loans held-for-sale is estimated based upon binding contracts and quotes from third party investors resulting in a Level 2 classification.

        Fair values of loans, excluding loans held for sale, are estimated as follows: For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values resulting in a Level 3 classification. Fair values for other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level 3 classification. Impaired loans are valued at the lower of cost or fair value as described previously. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.

FHLB and FRB Stock

        It was not practical to determine the fair value of FHLB and FRB stock due to restrictions placed on its transferability.

Accrued Interest Receivable/Payable

        The carrying amounts of accrued interest approximate fair value resulting in a Level 2 classification.

Deposits

        The fair values disclosed for demand deposits (e.g., interest and noninterest checking, passbook savings, and certain types of money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amount) resulting in a Level 2 classification. The carrying amounts of variable rate, fixed-term money market accounts approximate their fair values at the reporting date resulting in a Level 2 classification. The carrying amounts of variable rate, certificates of deposit approximate their fair values at the reporting date resulting in a Level 2 classification. Fair values for fixed rate certificates of deposit are estimated using a discounted cash flows calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits resulting in a Level 2 classification.

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2012

(Unaudited)

8) Fair Value (Continued)

Subordinated Debt

        The fair values of the subordinated debentures are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 3 classification.

Off-balance Sheet Instruments

        Fair values for off-balance sheet, credit-related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties' credit standing. The fair value of commitments is not material.

9) Equity Plan

        The Company granted 18,000 restricted shares of its common stock, at a grant price of $6.39, to three officers pursuant to the terms of the restricted stock agreements, dated May 1, 2012, under the Amended and Restated 2004 Equity Plan. Under the terms of the agreements, the common stock is subject to risk of forfeiture until the common stock has vested. The common stock will vest upon the second anniversary of the grant date. However, upon the occurrence of a change in control, or the death or disability of the participant, the common stock will vest immediately. The fair value of stock awards at the grant date was $115,020, which is being amortized over a two year period on the straight-line method. Amortization expense related to the 18,000 shares was $9,600 for the second quarter of 2012. None of the shares were vested at June 30, 2012. There were 22,000 shares of restricted stock forfeited and the related amortized expense of $48,000 was reversed during the first six months of 2012.

        The Company also granted 201,500 shares of unqualified stock options to directors and employees during the first six months of 2012. The exercise price was $6.39 per share, and the options vest over four years. Stock option expense related to the 201,500 shares was $32,000 for the six months ended June 30, 2012. As of June 30, 2012, there was $703,000 of unrecognized compensation expense related to the 201,500 stock options granted during the first six months of 2012.

10) Loss Contingencies

        Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. The Company's accounting policy for legal costs related to loss contingencies is to accrue for the probable fees that can be reasonably estimated. The Company's accounting policy for uncertain recoveries is to recognize the anticipated recovery when realization is deemed probable. During the first quarter of 2012, the Company accrued $500,000 for probable costs related to an anticipated legal claim that has not yet been asserted, regarding an apparent transfer of funds for personal use by an authorized signatory of a customer. As of the date of this report, this anticipated legal claim has not yet been asserted, and no additional accruals related to this matter were recorded during the second quarter of 2012. This accrual was reduced by payments of $126,000 during the second quarter of 2012, resulting in a balance of $374,000 at June 30, 2012. It is reasonably possible

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2012

(Unaudited)

10) Loss Contingencies (Continued)

that the outcome may result in a liability exceeding the amount accrued in the financial statements; however, based on the status of the unasserted claim, a range of the reasonably possible gross loss or gross anticipated recoveries cannot be estimated.

11) Subordinated Debt

        The table below summarizes the Company's subordinated debt as of the periods indicated:

 
  June 30,
2012
  December 31,
2011
 
 
  (Dollars in thousands)
 

Subordinated debentures due to Heritage Capital Trust I with interest payable semi-annually at 10.875%, redeemable with a premium beginning March 8, 2010 and with no premium beginning March 8, 2020, due March 8, 2030

  $ 7,217   $ 7,217  

Subordinated debentures due to Heritage Statutory Trust I with interest payable semi-annually at 10.60%, redeemable with a premium beginning September 7, 2010 and with no premium beginning September 7, 2020, due September 7, 2030

   
7,206
   
7,206
 

Subordinated debentures due to Heritage Statutory Trust II with interest payable quarterly based on 3-month Libor plus 3.58% (4.04% at June 30, 2012), redeemable with a premium beginning July 31, 2006 and with no premium beginning July 31, 2011, due July 31, 2031

   
5,155
   
5,155
 

Subordinated debentures due to Heritage Statutory Trust III with interest payable quarterly based on 3-month Libor plus 3.40% (3.86% at June 30, 2012), redeemable with no premium beginning September 26, 2007 and due September 26, 2032

   
4,124
   
4,124
 
           

Total

 
$

23,702
 
$

23,702
 
           

        For regulatory reporting purposes, the Company's subordinated debt qualifies for Tier 1 capital treatment.

12) Subsequent Events

Subordinated Debt

        In July 2012, the Company provided notice to the holders that it intends to redeem the Company's 10.875% fixed-rate subordinated debentures in the amount of $7,000,000 issued to Heritage Capital Trust I, the related common securities of $217,000 and premium charge of $304,500, and the

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2012

(Unaudited)

12) Subsequent Events (Continued)

Company's 10.60% fixed-rate subordinated debentures in the amount of $7,000,000 issued to Heritage Statutory Trust I, and the related common securities of $206,000 and premium charge of $296,800 (collectively referred to as the "Fixed-Rate Sub Debt"). The redemption of the 10.60% fixed-rate subordinated debentures is expected to be completed on September 7, 2012, and the 10.875% fixed-rate subordinated debentures on September 8, 2012. Additionally, the Company will pay its regularly scheduled interest payments on the Fixed-Rate Sub Debt totaling approximately $752,000 on the respective redemption dates. The Company will use available cash and proceeds from a $15,000,000 distribution from HBC to HCC for the redemptions.

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ITEM 2—MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

        The following discussion provides information about the results of operations, financial condition, liquidity, and capital resources of Heritage Commerce Corp (the "Company" or "HCC") and its wholly owned subsidiary, Heritage Bank of Commerce (sometimes referred to as the "Bank" or "HBC"). This information is intended to facilitate the understanding and assessment of significant changes and trends related to our financial condition and the results of operations. This discussion and analysis should be read in conjunction with our consolidated financial statements and the accompanying notes presented elsewhere in this report. Unless we state otherwise or the context indicates otherwise, references to the "Company," "Heritage," "we," "us," and "our," in this Report on Form 10-Q refer to Heritage Commerce Corp and Heritage Bank of Commerce.

EXECUTIVE SUMMARY

        This summary is intended to identify the most important matters on which management focuses when it evaluates the financial condition and performance of the Company. When evaluating financial condition and performance, management looks at certain key metrics and measures. The Company's evaluation includes comparisons with peer group financial institutions and its own performance objectives established in the internal planning process.

        The primary activity of the Company is commercial banking. The Company's operations are located entirely in the southern and eastern regions of the general San Francisco Bay Area of California in the counties of Santa Clara, Alameda and Contra Costa. The largest city in this area is San Jose and the Company's market includes the headquarters of a number of technology based companies in the region known commonly as Silicon Valley. The Company's customers are primarily closely held businesses and professionals.

Performance Overview

        For the three months ended June 30, 2012, net income was $2.7 million, compared to $2.1 million for the three months ended June 30, 2011. Following the redemption of its $40 million of Series A Fixed Rate Cumulative Perpetual Preferred Stock ("Series A Preferred Stock") issued to the U.S. Treasury Department under the TARP Capital Purchase Program in the first quarter of 2012, the Company did not have any preferred dividends and discount accretion on preferred stock in the second quarter of 2012. The net income available to common shareholders was $2.7 million, or $0.08 per common share for the three months ended June 30, 2012. After accrued dividends and discount accretion on preferred stock of $604,000, net income available to shareholders was $1.5 million, or $0.05 per average diluted common share, for the second quarter a year ago. The Company's annualized return on average assets was 0.81% and annualized return on average equity was 6.61% for the second quarter of 2012, compared to 0.66% and 4.50%, respectively, a year ago.

        For the six months ended June 30, 2012, net income available to common shareholders was $3.6 million, or $0.11 per average diluted common share, up from $2.5 million, or $0.08 per average diluted common share, for the six months ended June 30, 2011. The Company's annualized return on average assets was 0.72% and annualized return on average equity was 5.44% for the first six months of 2012, compared to 0.59% and 4.01%, respectively, a year ago.

        The following are major factors that impacted the Company's results of operations:

    The net interest margin remained flat at 3.95% in the second quarter of 2012, compared to the second quarter of 2011, as a decrease in average yields on loans and investment securities was mainly offset by a lower cost of deposits in the second quarter of 2012. The Company's net interest margin increased six basis points to 4.01% for the six months ended June 30, 2012,

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      compared to 3.95% for the six months ended June 30, 2011, primarily as a result of a higher yield on loans, a lower level of interest-bearing deposits in other institutions, and a lower cost of deposits.

    Net interest income was $12.1 million for the second quarter of 2012, compared to $11.5 million for the second quarter of 2011. The increase in net interest income for the second quarter of 2012 compared to the same period in 2011 was primarily due to an increase in the average balance of investment securities and a lower cost of deposits, partially offset by a decrease in average balance of loans and the yield on loans. Net interest income was $24.3 million for the six months ended June 30, 2012, compared to $22.7 million for the six months ended June 30, 2011. The increase in net interest income for the first six months of 2012 compared to the same period in 2011 was primarily due to an increase in the average balance of investment securities and a lower cost of deposits, partially offset by a decrease in average balance of loans.

    The provision for loan losses was $815,000 for the second quarter of 2012, compared to $955,000 for the second quarter of 2011. The provision for loan losses for the six months ended June 30, 2012 was $915,000, compared to $1.7 million for the first six months of 2011. The decrease in provision for loan losses for the three months and six months ended June 30, 2012, compared to the same periods in 2011 reflects a lower volume of classified assets and nonperforming loans, and a decrease in loan charge-offs.

    Noninterest income decreased 4% to $2.1 million in the second quarter of 2012, from $2.2 million in the second quarter of 2011, and decreased 7% to $3.8 million in the first six months of 2012 from $4.1 million in the first six months of 2011, primarily due to lower gain on sales of SBA loans.

    Noninterest expense remained flat at $9.5 million for the second quarter of 2012, compared to the second quarter of 2011. For the six months ended June 30, 2012, noninterest expense was $20.3 million, compared to $19.9 million for the six months ended June 30, 2011. The increase in noninterest expense in the first six months of 2012 was primarily due to a first quarter $500,000 accrual for probable costs related to an anticipated legal claim that has not yet been asserted, regarding an apparent transfer of funds for personal use by an authorized signatory of a customer.

    The efficiency ratio was 66.70% for the second quarter of 2012, compared to 69.43% for the second quarter of 2011. The efficiency ratio for the six months ended June 30, 2012 was 72.13%, compared to 74.39% for the six months ended June 30, 2011.

    Income tax expense for the quarter ended June 30, 2012 was $1.2 million, compared to $1.1 million for the second quarter of 2011. For the first six months of 2012, income tax expense was $2.2 million, compared to $1.5 million for the first six months a year ago. The effective tax rate for the second quarter of 2012 was 31%, compared to 35% for the second quarter a year ago. The effective tax rate for the six months ended June 30, 2012 was 31%, compared to 28% for the six months ended June 30, 2011.

        The following are important factors in understanding our current financial condition and liquidity position:

    Cash, Federal funds sold, interest-bearing deposits in other financial institutions and securities available-for-sale increased 11% to $436.2 million at June 30, 2012, from $391.2 million at June 30, 2011, and decreased 4% from $453.3 million at December 31, 2011.

    Total loans, excluding loans held-for-sale, increased $16.0 million, or 2%, to $798.1 million at June 30, 2012, compared to $782.1 million at June 30, 2011, and increased $33.5 million, or 4%, from $764.6 million at December 31, 2011. Land and construction loans decreased $22.2 million,

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      or 53%, to $19.8 million at June 30, 2012, compared to $42.0 million at June 30, 2011, and decreased $3.2 million, or 14%, from $23.0 million at December 31, 2011.

    Classified assets (net of SBA guarantees) decreased to $54.9 million at June 30, 2012, compared to $76.1 million at June 30, 2011, and decreased from $59.5 million at December 31, 2011.

    The allowance for loan losses at June 30, 2012 was $20.0 million, or 2.51% of total loans, representing 137.57% of nonperforming loans excluding nonaccrual loans in loans held-for-sale. The allowance for loan losses at June 30, 2011 was $23.1 million, or 2.96% of total loans, representing 102.15% of nonperforming loans excluding nonaccrual loans in loans held-for-sale. The allowance for loan losses at December 31, 2011, was $20.7 million, or 2.71% of total loans, representing 124.37% of nonperforming loans excluding nonaccrual loans in loans held-for-sale.

    Nonperforming assets were $17.8 million, or 1.35% of total assets at June 30, 2012, compared to $23.1 million or 1.83% of total assets at June 30, 2011, and $19.1 million, or 1.47% of total assets at December 31, 2011.

    Net loan charge-offs were $1.1 million for the second quarter of 2012, compared to $1.8 million for the second quarter of 2011. Net loan charge-offs were $1.6 million for the fourth quarter of 2011.

    Core deposits continued to increase for the second quarter of 2012:

    Noninterest-bearing demand deposits increased 10% to $367.9 million at June 30, 2012, from $333.2 million at June 30, 2011, and increased 7% from $344.3 million at December 31, 2011.

    Interest-bearing demand deposits increased 16% to $148.8 million at June 30, 2012, from $128.5 million at June 30, 2011, and increased 11% from $134.1 million at December 31, 2011.

    Savings and money market deposits increased 5% to $290.9 million at June 30, 2012, from $276.5 million at June 30, 2011, and increased 3% from $282.5 million at December 31, 2011.

    The ratio of noncore funding (which consists of time deposits—$100,000 and over, CDARS deposits, brokered deposits, securities under agreement to repurchase and short-term borrowings) to total assets was 20.17% at June 30, 2012, compared to 18.20% at June 30, 2011, and 19.90% at December 31, 2011.

    The loan to deposit ratio was 72.37% at June 30, 2012, compared to 78.32% at June 30, 2011, and 72.86% at December 31, 2011.

    Capital ratios substantially exceed regulatory requirements for a well-capitalized financial institution, both on a consolidated basis and at the bank level at June 30, 2012. The leverage ratio at the holding company was 12.7%, with a Tier 1 risk-based capital ratio of 16.0%, and a total risk-based capital ratio of 17.3% at June 30, 2012. The leverage ratio for HBC was 11.9%, with a Tier 1 risk-based capital ratio of 14.9%, and a total risk-based capital ratio of 16.2% at June 30, 2012. The regulatory well-capitalized guidelines are a minimum of a 5% leverage ratio, a 6% Tier 1 risk-based capital ratio, and a 10% total risk-based capital ratio.

Recent Events

        In July 2012, the Company provided notice to the holders that it intends to redeem the Company's 10.875% fixed-rate subordinated debentures in the amount of $7.0 million issued to Heritage Capital Trust I, and the related common securities of $217,000 and premium cost of $304,500, and the Company's 10.60% fixed-rate subordinated debentures in the amount of $7.0 million issued to Heritage

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Statutory Trust I, and the related common securities of $206,000 and premium cost of $296,800 (collectively referred to as the "Fixed-Rate Sub Debt"). The redemption of the 10.60% fixed-rate subordinated debentures is expected to be completed on September 7, 2012, and the 10.875% fixed-rate subordinated debentures on September 8, 2012. Additionally, the Company will pay its regularly scheduled interest payments on the Fixed-Rate Sub Debt totaling approximately $752,000 on the respective redemption dates. The Company will use available cash and proceeds from a $15 million distribution from HBC to HCC for the redemptions. The redemption of the Fixed-Rate Sub Debt does not significantly reduce capital ratios of HCC or HBC. The Company will incur a charge of $601,300 in the third quarter of 2012, for the early payoff premiums on the redemption of the Fixed-Rate Sub Debt. On an annual basis, the redemption of the Fixed-Rate Sub Debt will eliminate approximately $1.5 million in interest expense.

Deposits

        The composition and cost of the Company's deposit base are important in analyzing the Company's net interest margin and balance sheet liquidity characteristics. Except for brokered time deposits, the Company's depositors are generally located in its primary market area. Depending on loan demand and other funding requirements, the Company also obtains deposits from wholesale sources including deposit brokers. The Company had $97.7 million in brokered deposits at June 30, 2012, compared to $94.6 million at June 30, 2011, and $84.7 million at December 31, 2011. Deposits from title insurance companies, escrow accounts and real estate exchange facilitators increased to $35.7 million at June 30, 2012, compared to $33.3 million at June 30, 2011, and $37.6 million at December 31, 2011. Certificates of deposit from the State of California totaled $50.0 million at June 30, 2012, compared to none at June 30, 2011, and $50 million at December 31, 2011. Deposits at June 30, 2012 were $1.1 billion, compared to $998.6 million at June 30, 2011 and $1.0 billion at December 31, 2011. Core deposits (excluding all time deposits) grew 9% to $807.6 million at June 30, 2012, an increase of $69.4 million from June 30, 2011, and increased $46.7 million, or 6%, from $760.9 million at December 31, 2011. The Company has a policy to monitor all deposits that may be sensitive to interest rate changes to help assure that liquidity risk does not become excessive due to concentrations.

        HBC is a member of the Certificate of Deposit Account Registry Service ("CDARS") program. The CDARS program allows customers with deposits in excess of FDIC insured limits to obtain coverage on time deposits through a network of banks within the CDARS program. Deposits gathered through this program are considered brokered deposits under regulatory guidelines. Deposits in the CDARS program totaled $5.4 million at June 30, 2012, compared to $20.8 million at June 30, 2011, and $6.4 million at December 31, 2011.

Liquidity

        Our liquidity position refers to our ability to maintain cash flows sufficient to fund operations and to meet obligations and other commitments in a timely fashion. At June 30, 2012, we had $46.4 million in cash and cash equivalents and approximately $368.3 million in available borrowing capacity from various sources including the Federal Home Loan Bank ("FHLB"), the Federal Reserve Bank of San Francisco ("FRB"), and Federal funds facilities with several financial institutions. The Company also had $301.2 million in unpledged securities available at June 30, 2012. Our loan to deposit ratio decreased to 72.37% at June 30, 2012, compared to 78.32% at June 30, 2011, and 72.86% at December 31, 2011.

Lending

        Our lending business originates principally through our branch offices located in our primary markets. The Company also has an additional SBA loan production office in Santa Rosa, California.

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The total loan portfolio remains well diversified with commercial and industrial ("C&I") loans accounting for 48% of the portfolio at June 30, 2012. Commercial and residential real estate loans accounted for 42% of the total loan portfolio at June 30, 2012, of which 51% were owner-occupied by businesses. We have actively lowered our exposure to land and construction loans and our overall credit risk on this portfolio has been reduced. Land and construction loans decreased $22.2 million to $19.8 million at June 30, 2012, compared to $42.0 million at June 30, 2011, and accounted for 2% of our total loan portfolio at June 30, 2012, compared to 5% at June 30, 2011, and 3% at December 31, 2011. Consumer and home equity loans accounted for the remaining 8% of total loans at June 30, 2012. The yield on the loan portfolio was 5.23% for the second quarter of 2012, compared to 5.31% for the same period in 2011, and 5.41% for the first quarter of 2012. The 18 basis points decrease in the second quarter of 2012 from the first quarter of 2012 was due to several positive adjustments in the first quarter of 2012 from loan interest recoveries and lower rates (due to competitive factors) on some new and renewed loans in the second quarter of 2012. The yield on the loan portfolio was 5.32% for the six months ended June 30, 2012, compared to 5.30% for six months ended June 30, 2011. Loans, excluding loans held-for-sale, increased 2% to $798.1 million at June 30, 2012, from $782.1 million a year ago, and increased 4% from $764.6 million at December 31, 2011.

Net Interest Income

        The management of interest income and expense is fundamental to the performance of the Company. Net interest income, the difference between interest income and interest expense, is the largest component of the Company's total revenue. Management closely monitors both total net interest income and the net interest margin (net interest income divided by average earning assets).

        The Company, through its asset and liability policies and practices, seeks to maximize net interest income without exposing the Company to an excessive level of interest rate risk. Interest rate risk is managed by monitoring the pricing, maturity and repricing options of all classes of interest bearing assets and liabilities. This is discussed in more detail under "Liquidity and Asset/Liability Management." In addition, we believe there are measures and initiatives we can take to improve the net interest margin, including increasing loan rates, adding floors on floating rate loans, reducing nonperforming assets, managing deposit interest rates, and reducing higher cost deposits.

        The net interest margin is also adversely impacted by the reversal of interest on nonaccrual loans and the reinvestment of loan payoffs into lower yielding investment securities and other short-term investments.

Management of Credit Risk

        We continue to proactively identify, quantify, and manage our problem loans. Early identification of problem loans and potential future losses helps enable us to resolve credit issues with potentially less risk and ultimate losses. We maintain an allowance for loan losses in an amount that we believe is adequate to absorb probable incurred losses in the portfolio. While we strive to carefully manage and monitor credit quality and to identify loans that may be deteriorating, circumstances can change at any time for loans included in the portfolio that may result in future losses, that as of the date of the financial statements have not yet been identified as potential problem loans. Through established credit practices, we adjust the allowance for loan losses accordingly. However, because future events are uncertain, there may be loans that deteriorate some of which could occur in an accelerated time frame. As a result, future additions to the allowance for loan losses may be necessary. Because the loan portfolio contains a number of commercial loans, commercial real estate, construction and land development loans with relatively large balances, deterioration in the credit quality of one or more of these loans may require a significant increase to the allowance for loan losses. Future additions to the allowance may also be required based on changes in the financial condition of borrowers, such as have resulted due to the current, and potentially worsening, economic conditions. Additionally, Federal and

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state banking regulators, as an integral part of their supervisory function, periodically review our allowance for loan losses. These regulatory agencies may require us to recognize further loan loss provisions or charge-offs based upon their judgments, which may be different from ours. Any increase in the allowance for loan losses would have an adverse effect, which may be material, on our financial condition and results of operation.

        Further discussion of the management of credit risk appears under "Provision for Loan Losses" and "Allowance for Loan Losses."

Noninterest Income

        While net interest income remains the largest single component of total revenues, noninterest income is an important component.

        A portion of the Company's noninterest income is associated with its SBA lending activity, consisting of gains on the sale of loans sold in the secondary market and servicing income from loans sold with servicing retained. Other sources of noninterest income include loan servicing fees, service charges and fees, cash surrender value from company owned life insurance policies, and gains on the sale of securities.

Noninterest Expense

        Management considers the control of operating expenses to be a critical element of the Company's performance. The Company has undertaken several initiatives to reduce its noninterest expense and improve its efficiency. Nevertheless, noninterest expense for the first six months of 2012 increased 2% to $20.3 million, compared to $19.9 million for the first six months of 2011, primarily due to a $500,000 accrual established in the first quarter of 2012 for probable costs related to an anticipated legal claim that has not yet been asserted, regarding an apparent transfer of funds for personal use by an authorized signatory of a customer and higher salaries and employee benefits expense.

Capital Management

        As part of its asset and liability management process, the Company continually assesses its capital position to take into consideration growth, expected earnings, risk profile and potential corporate activities that it may choose to pursue.

        On November 21, 2008, the Company issued to the U.S. Treasury under its Capital Purchase Program 40,000 shares of Series A Preferred Stock for $40.0 million and issued a warrant to purchase 462,963 shares of common stock at an exercise price of $12.96.

        On March 7, 2012, in accordance with approvals received from the U.S. Treasury and the Federal Reserve, the Company repurchased all shares of the Series A Preferred Stock and paid the related accrued and unpaid dividends. The repurchase of the Series A Preferred Stock will save $2.0 million in annual dividends. At the time the Company repurchased the Series A Preferred Stock, it did not repurchase the related warrant. The warrant was outstanding as of the date of this report.

        On June 21, 2010, the Company issued Series C Convertible Perpetual Preferred Stock ("Series C Preferred Stock") to a limited number of institutional investors. The Series C Preferred Stock remains outstanding until its conversion to common stock upon the transfer of the Series C Preferred Stock in accordance with its terms. Holders of Series C Preferred Stock will receive dividends if and only to the extent dividends are paid to holders of common stock.

        We have supported our growth through the issuance of trust preferred securities from special purpose trusts and accompanying sales of subordinated debt to these trusts. The subordinated debt that we issued to the trusts is senior to our shares of common stock and Series C Preferred Stock. As a

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result, we must make payments on the subordinated debt before any dividends can be paid on our common stock and Series C Preferred Stock. Under the terms of the subordinated debt, we may defer interest payments for up to five years. The Company is current with respect to interest accrued on trust preferred subordinated debt securities as of June 30, 2012 and was current as of December 31, 2011.

        In July 2012, the Company provided notice to the holders that it intends to redeem the Company's Fixed-Rate Sub Debt. The redemption of the 10.6% fixed-rate subordinated debentures is expected to be completed on September 7, 2012, and the 10.875% fixed-rate subordinated debentures on September 8, 2012.

        At June 30, 2012, HBC's total risk-based capital ratio was 16.2%, compared to the 10% regulatory requirement for well-capitalized banks under the regulatory framework for prompt corrective actions. HBC's Tier 1 risk-based capital ratio of 14.9% and leverage ratio of 11.9% at June 30, 2012 also exceeded regulatory guidelines for well-capitalized banks under the prompt corrective actions framework. On a pro forma basis, assuming HBC distributed $15.0 million to HCC for the redemption of the $14 million Fixed-Rate Sub Debt, the total risk-based capital ratio would be 14.7%, the Tier 1 risk-based capital ratio would be 13.5%, and the leverage ratio would be 10.7% for HBC at June 30, 2012. On a consolidated basis, the Company has a total risk-based capital ratio of 17.3%, a Tier 1 risk-based capital ratio of 16.0%, and a leverage ratio of 12.7% at June 30, 2012. On a pro forma basis, assuming the redemption of the $14 million Fixed-Rate Sub Debt plus the related redemption premiums, the total risk-based capital ratio would be 15.9%, the Tier 1 risk-based capital ratio would be 14.6%, and the leverage ratio would be 11.6% for the Company at June 30, 2012.

RESULTS OF OPERATIONS

        The Company earns income from two primary sources. The first is net interest income, which is interest income generated by earning assets less interest expense on interest-bearing liabilities. The second is noninterest income, which primarily consists of gains on the sale of loans, loan servicing fees, customer service charges and fees, the increase in cash surrender value of life insurance, and gains on the sale of securities. The majority of the Company's noninterest expenses are operating costs that relate to providing a full range of banking services to our customers.

Net Interest Income and Net Interest Margin

        The level of net interest income depends on several factors in combination, including yields on earning assets, the cost of interest-bearing liabilities, the relative volumes of earning assets and interest-bearing liabilities, and the mix of products which comprise the Company's earning assets, deposits, and other interest-bearing liabilities. To maintain its net interest margin, the Company must manage the relationship between interest earned and paid.

        The following Distribution, Rate and Yield table presents the average amounts outstanding for the major categories of the Company's balance sheet, the average interest rates earned or paid thereon, and the resulting net interest margin on average interest earning assets for the periods indicated. Average balances are based on daily averages.

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Table of Contents

Distribution, Rate and Yield

 
  For the Three Months Ended
June 30, 2012
  For the Three Months Ended
June 30, 2011
 
NET INTEREST INCOME AND NET INTEREST MARGIN
  Average
Balance
  Interest
Income/
Expense
  Average
Yield/
Rate
  Average
Balance
  Interest
Income/
Expense
  Average
Yield/
Rate
 
 
  (Dollars in thousands)
 

Assets:

                                     

Loans, gross(1)

  $ 791,660   $ 10,292     5.23 % $ 806,839   $ 10,685     5.31 %

Securities

    398,143     2,975     3.01 %   278,908     2,278     3.28 %

Federal funds sold and interest-bearing deposits in other financial institutions

    41,508     29     0.28 %   77,937     52     0.27 %
                               

Total interest earning assets

    1,231,311     13,296     4.34 %   1,163,684     13,015     4.49 %
                                   

Cash and due from banks

    21,191                 20,932              

Premises and equipment, net

    7,841                 8,160              

Intangible assets

    2,316                 2,829              

Other assets

    69,115                 70,542              
                                   

Total assets

  $ 1,331,774               $ 1,266,147              
                                   

Liabilities and shareholders' equity:

                                     

Deposits:

                                     

Demand, noninterest-bearing

  $ 370,086               $ 332,535              

Demand, interest-bearing

   
147,767
   
56
   
0.15

%
 
132,079
   
65
   
0.20

%

Savings and money market

    298,544     179     0.24 %   280,870     259     0.37 %

Time deposits—under $100

    28,011     35     0.50 %   32,194     61     0.76 %

Time deposits—$100 and over

    166,486     246     0.59 %   121,929     342     1.13 %

Time deposits—CDARS

    5,900     3     0.20 %   21,254     24     0.45 %

Time deposits—brokered

    93,259     219     0.94 %   92,131     317     1.38 %
                               

Total interest-bearing deposits

    739,967     738     0.40 %   680,457     1,068     0.63 %
                               

Total deposits

    1,110,053     738     0.27 %   1,012,992     1,068     0.42 %

Subordinated debt

   
23,702
   
472
   
8.01

%
 
23,702
   
467
   
7.90

%

Short-term borrowings

    3,196     2     0.25 %   1,005     8     3.19 %
                               

Total interest-bearing liabilities

    766,865     1,212     0.64 %   705,164     1,543     0.88 %
                               

Total interest-bearing liabilities and demand,

                                     

noninterest-bearing / cost of funds

    1,136,951     1,212     0.43 %   1,037,699     1,543     0.60 %

Other liabilities

    31,905                 42,537              
                                   

Total liabilities

    1,168,856                 1,080,236              

Shareholders' equity

    162,918                 185,911              
                                   

Total liabilities and shareholders' equity

  $ 1,331,774               $ 1,266,147              
                                   

                                     
                                   

Net interest income / margin

        $ 12,084     3.95 %       $ 11,472     3.95 %
                                   

(1)
Includes loans held-for-sale. Yield amounts earned on loans include loan fees and costs. Nonaccrual loans are included in average balance.

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Table of Contents

 
  For the Six Months Ended
June 30, 2012
  For the Six Months Ended
June 30, 2011
 
NET INTEREST INCOME AND NET INTEREST MARGIN
  Average
Balance
  Interest
Income/
Expense
  Average
Yield/
Rate
  Average
Balance
  Interest
Income/
Expense
  Average
Yield/
Rate
 
 
  (Dollars in thousands)
 

Assets:

                                     

Loans, gross(1)

  $ 778,640   $ 20,608     5.32 % $ 825,206   $ 21,675     5.30 %

Securities

    394,031     6,072     3.10 %   262,476     4,240     3.26 %

Federal funds sold and interest-bearing deposits in other financial institutions

    48,750     65     0.27 %   69,228     86     0.25 %
                               

Total interest earning assets

    1,221,421     26,745     4.40 %   1,156,910     26,001     4.53 %
                                   

Cash and due from banks

    21,089                 20,742              

Premises and equipment, net

    7,909                 8,244              

Intangible assets

    2,378                 2,895              

Other assets

    69,082                 68,499              
                                   

Total assets

  $ 1,321,879               $ 1,257,290              
                                   

Liabilities and shareholders' equity:

                                     

Deposits:

                                     

Demand, noninterest-bearing

  $ 358,689               $ 322,345              

Demand, interest-bearing

   
145,208
   
109
   
0.15

%
 
133,907
   
132
   
0.20

%

Savings and money market

    293,374     345     0.24 %   274,346     526     0.39 %

Time deposits—under $100

    28,117     73     0.52 %   32,698     132     0.81 %

Time deposits—$100 and over

    168,090     501     0.60 %   127,856     761     1.20 %

Time deposits—CDARS

    6,083     6     0.20 %   21,389     49     0.46 %

Time deposits—brokered

    88,992     420     0.95 %   93,589     739     1.59 %
                               

Total interest-bearing deposits

    729,864     1,454     0.40 %   683,785     2,339     0.69 %
                               

Total deposits

    1,088,553     1,454     0.27 %   1,006,130     2,339     0.47 %

Subordinated debt

    23,702     946     8.03 %   23,702     932     7.93 %

Securities sold under agreement to repurchase

            N/A     1,436     24     3.37 %

Short-term borrowings

    1,618     2     0.25 %   1,865     38     4.11 %
                               

Total interest-bearing liabilities

    755,184     2,402     0.64 %   710,788     3,333     0.95 %
                               

Total interest-bearing liabilities and demand, noninterest-bearing / cost of funds

    1,113,873     2,402     0.43 %   1,033,133     3,333     0.65 %

Other liabilities

    32,287                 39,966              
                                   

Total liabilities

    1,146,160                 1,073,099              

Shareholders' equity

    175,719                 184,191              
                                   

Total liabilities and shareholders' equity

  $ 1,321,879               $ 1,257,290              
                                   

                                     
                                   

Net interest income / margin

        $ 24,343     4.01 %       $ 22,668     3.95 %
                                   

(1)
Includes loans held-for-sale. Yield amounts earned on loans include loan fees and costs. Nonaccrual loans are included in average balance.

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Table of Contents

Volume and Rate Variances

        The Volume and Rate Variances table below sets forth the dollar difference in interest earned and paid for each major category of interest-earning assets and interest-bearing liabilities for the noted periods, and the amount of such change attributable to changes in average balances (volume) or changes in average interest rates. Volume variances are equal to the increase or decrease in the average balance times the prior period rate, and rate variances are equal to the increase or decrease in the average rate times the prior period average balance. Variances attributable to both rate and volume changes are equal to the change in rate times the change in average balance and are included below in the average volume column.

 
  Three Months Ended June 30,
2012 vs. 2011
Increase (Decrease) Due to
Change In:
 
 
  Average
Volume
  Average
Rate
  Net
Change
 
 
  (Dollars in thousands)
 

Income from interest earning assets:

                   

Loans, gross

  $ (200 ) $ (193 ) $ (393 )

Securities

    888     (191 )   697  

Federal funds sold and interest-bearing deposits in other financial institutions

    (25 )   2     (23 )
               

Total interest income from interest earnings assets

    663     (382 )   281  
               

Expense on interest-bearing liabilities:

                   

Demand, interest-bearing

    7     (16 )   (9 )

Savings and money market

    11     (91 )   (80 )

Time deposits—under $100

    (5 )   (21 )   (26 )

Time deposits—$100 and over

    67     (163 )   (96 )

Time deposits—CDARS

    (8 )   (13 )   (21 )

Time deposits—brokered

    4     (102 )   (98 )

Subordinated debt

        5     5  

Short-term borrowings

    1     (7 )   (6 )
               

Total interest expense on interest-bearing liabilities

    77     (408 )   (331 )
               

Net interest income

  $ 586   $ 26   $ 612  
               

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Table of Contents


 
  Six Months Ended June 30,
2012 vs. 2011
Increase (Decrease) Due to
Change In:
 
 
  Average
Volume
  Average
Rate
  Net
Change
 
 
  (Dollars in thousands)
 

Income from interest earning assets:

                   

Loans, gross

  $ (1,223 ) $ 156   $ (1,067 )

Securities

    2,026     (194 )   1,832  

Federal funds sold and interest-bearing deposits in other financial institutions

    (28 )   7     (21 )
               

Total interest income from interest earnings assets

    775     (31 )   744  
               

Expense on interest-bearing liabilities:

                   

Demand, interest-bearing

    9     (32 )   (23 )

Savings and money market

    18     (199 )   (181 )

Time deposits—under $100

    (12 )   (47 )   (59 )

Time deposits—$100 and over

    120     (380 )   (260 )

Time deposits—CDARS

    (15 )   (28 )   (43 )

Time deposits—brokered

    (22 )   (297 )   (319 )

Subordinated debt