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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended June 30, 2012
[ ] 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 0-15641
CALIFORNIA FIRST NATIONAL BANCORP
(Exact name of registrant as specified in its charter)
18201 Von Karman Avenue, Suite 800, Irvine, CA 92612
(Address of principal executive offices)
Registrant's telephone number, including area code: (949) 255-0500
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act Yes o No þ
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act Yes o No þ
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 and 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 þ No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “accelerated filer, large accelerated filer and smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer o Accelerated filer o Non-accelerated filer o Smaller reporting company þ
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No þ
The aggregate market value of the Common Stock held by non-affiliates of the Registrant as of December 31, 2011 was $37,273,118. Number of shares outstanding as of September 7, 2012: Common Stock 10,447,227.
DOCUMENTS INCORPORATED BY REFERENCE
Part III incorporates information by reference from Registrant's definitive Proxy Statement to be filed with the Commission within 120 days after the close of the Registrant's fiscal year ended June 30, 2012.
TABLE OF CONTENTS
ITEM 1. BUSINESS
California First National Bancorp, a California corporation (the “Company”), is a bank holding company headquartered in Orange County, California with a bank subsidiary, California First National Bank (“CalFirst Bank” or the “Bank”) and leasing subsidiary, California First Leasing Corp (“CalFirst Leasing”). The primary business of the Company is leasing and financing capital assets, while CalFirst Bank also participates in the syndicated commercial loan market, provides business loans to fund the purchase of assets leased by third parties, including CalFirst Leasing, and offers commercial loans directly to businesses. CalFirst Bank gathers deposits from a centralized location primarily through posting rates on the Internet. All banking and other operations are conducted from one central location.
This Form 10-K contains forward-looking statements. Forward-looking statements include, among other things, information concerning our possible future consolidated results of operations, business and growth strategies, financing plans, our competitive position and the effects of competition. Forward-looking statements include all statements that are not historical facts and can be identified by forward-looking words such as “anticipate”, “believe”, “could”, “estimate”, “expect”, “intend”, “plan”, “may”, “should”, “will”, “would”, “project” and similar expressions. These forward-looking statements are based on information currently available to us and are subject to inherent risks and uncertainties, and certain factors could cause actual results to differ materially from those anticipated. Some of the risks and uncertainties that may cause our actual results or performance to differ materially from such forward-looking statements are included in “Item 1A. Risk Factors” of this report. All forward-looking statements are qualified in their entirety by this cautionary statement and the Company undertakes no obligation to revise or update any forward-looking statements to reflect events or circumstances arising after the date on which they were made.
At June 30, 2012, leases accounted for 75% of the Company’s net investment in leases and loans. The Company leases and finances most capital assets used by businesses and organizations, with a focus on high technology systems and other mission critical assets. The leases are structured individually and can accommodate a variety of our customers’ objectives. In addition to computer systems and networks, property leased includes automated manufacturing and distribution management systems, production systems, printing presses and warehouse distribution systems. Telecommunications systems include digital private branch equipment and switching equipment as well as voice over Internet protocol (“VoIP”) systems, wireless networks and satellite tracking systems. Retail point-of-sale and inventory tracking systems often integrate computers, scanners and software. Other electronic equipment leased includes robotic surgical systems, ultrasound and medical imaging systems, computer-based patient monitoring systems, testing equipment, and copying equipment. In addition, the Company leases a wide variety of non-high technology property, including oil and gas production equipment, machine tools, school buses, trucks, exercise equipment and office and dormitory furniture. Of the leases booked in fiscal 2012, approximately 36% involved computer equipment and software, 15% manufacturing and distribution equipment, 9% furniture and fixtures, 9% yellow equipment, 7% transportation equipment, 6% exercise equipment and 5% medical equipment.
CalFirst Leasing and CalFirst Bank provide leasing and financing to customers throughout the United States and across a breadth of industries and disciplines, including commercial, industrial and financial companies, as well as government and non-profit entities. The average size of the lease transactions booked during fiscal 2012 was approximately $560,000, compared with $535,000 during fiscal 2011. Two customers accounted for 7% and 5%, respectively, of the property cost subject to leases booked during fiscal 2012, while in fiscal 2011 another customer accounted for 9% and in fiscal 2010 one customer accounted for 27% of leases booked in that year. Leases primarily are originated directly through a centralized marketing program and direct delivery channels, although since fiscal 2010 a portion of leases have been acquired through other banks or origination sources. The marketing program includes a confidential database of current and potential users of business property, a training program to introduce new marketing employees to leasing, and in-house computer and telecommunication systems. The marketing programs have been augmented through the expanded use of web sites and the Internet to identify and communicate with potential customers. Prospect management software is utilized to enhance the productivity of the sales effort. Specific information about potential customers is entered into a confidential database accessible to sales professionals and their managers that allows them to efficiently focus on the most likely purchaser or lessee of capital assets. The prospect management system and an integrated in-house telecommunications system permit sales management to monitor account executive activity, daily prospect status and pricing information. The ability to monitor account activity and offer immediate assistance in negotiating or pricing a transaction makes it possible to be responsive to customers and prospects.
Leases generally are for initial terms ranging from two to five years. Substantially all leases are non-cancelable "net" leases which contain "hell-or-high-water" provisions under which the lessee must make all lease payments regardless of any defects in the property, and which require the lessee to maintain and service the property, insure the property against casualty loss and pay all property, sales and other taxes. CalFirst Leasing or the Bank retain ownership of the property on leases they originate, and in the event of default by the lessee, they may declare the lessee in default, accelerate all lease payments due under the lease and pursue other available remedies, including repossession of the property. Upon the expiration of the lease term, the lessee typically has an option, which is dependent upon each lease's defined end of term options, to either purchase the property at a negotiated price, or in the case of a "conditional sales contract," at a predetermined minimum price, or to renew the lease. If the original lessee does not exercise the purchase option, once the leased property is returned, CalFirst Leasing or CalFirst Bank will seek to sell the leased property.
Through its lease purchase operations, CalFirst Bank purchases lease receivables on a non-recourse basis from other intermediaries. All banks or lessors from whom the Bank purchases lease receivables are subject to an individual credit review and investigation by the Bank and must be approved by the Bank’s board of directors prior to establishing a discounting relationship. The Bank generally does not assume any obligations as lessor for these transactions, and the original lessor retains ownership of any underlying asset, with the Bank taking a priority first lien position. Periodically, the Bank will purchase a whole lease and assume the role as lessor and take a residual interest in the property subject to such lease. The Bank verifies the completeness of all lease documentation prior to purchase, to confirm that all documentation is correct and secure, that liens have been perfected, and legal documentation has been filed as appropriate. Leases purchased from unaffiliated third parties during fiscal 2012 aggregated to $36.1 million, or 21% of total leases booked. In fiscal 2011, purchased leases of $43.4 million represented 28% of total bookings, and included a $6.3 million investment in a residual interest in the subject property.
The Company conducts the leasing business in a manner designed to minimize risk, however, we are subject to risks through the investment in lease receivables held in our own portfolios, lease transactions-in-process, and residual investments. We do not purchase leased property until we have received a binding non-cancelable lease from the customer. A portion of lease originations are discounted to banks or finance companies on a non-recourse basis at fixed interest rates that reflect the customers' financial condition. The lender to which a lease has been assigned has no recourse against the Company, unless we are in default under the terms of the agreement by which the lease was assigned. The institution to which a lease has been assigned may take title to the leased property, but only in the event the lessee fails to make lease payments or otherwise defaults under the terms of the lease. If this occurs, the Company may not realize our residual investment in the leased property.
During the fiscal years ended June 30, 2012, 2011 and 2010, 95%, 99% and 85%, respectively, of the total dollar amount of new leases completed by the Company were retained in the Company’s portfolios, with the balance of such leases in each fiscal year discounted to unaffiliated financial institutions. Approximately 50% of the new leases booked by CalFirst Leasing were assigned to CalFirst Bank in fiscal 2012 and 2011. Pursuant to bank regulations, CalFirst Bank can purchase no more than 50% of the extensions of credit originated by CalFirst Leasing during the preceding 12 calendar months.
The Company applies a portfolio management system intended to develop portfolios with different risk/reward profiles. Each lease transaction held must meet or exceed certain credit or profitability requirements established, on a case-by-case basis, by the credit committee for the portfolio. The Bank’s strategy is to develop a conservative, diversified portfolio of leases with high credit quality lessees. The Bank’s credit committee has established underwriting standards and criteria for the lease portfolio and performs an independent credit analysis and due diligence on each lease transaction originated or purchased. The committee applies the same underwriting standards to all leases, regardless of how they are sourced. Through the use of non-recourse financing, the Company avoids risks that do not meet our risk/reward requirements. Certain portfolios hold leases where the credit profile of the lessee or the value of the underlying leased property is not acceptable to other financial institutions.
The table below presents the discounted minimum lease payments receivable (“Net Lease Receivable") related to leases retained in the Company’s portfolios at June 30, 2012, 2011 and 2010, respectively. Of the Bank’s Net Lease Receivable, approximately 48%, 46% and 66%, respectively, represented leases originated directly by the Bank, with 28% and 23% of the Bank’s Net Lease Receivables at June 30, 2012 and 2011, respectively, related to leases purchased from unaffiliated parties.
The Company often makes payments to purchase leased property prior to the commencement of the lease. The disbursements for such lease transactions-in-process are generally made to facilitate the property implementation schedule of the lessees. The lessee generally is contractually obligated to make rental payments during the period that the transaction is in process, and obligated to reimburse us for all disbursements under certain circumstances. Income is not recognized while a transaction is in process and prior to the commencement of the lease. At June 30, 2012, 2011, and 2010, the Company’s total investment in property acquired for transactions-in-process amounted to $18.5 million, $29.2 million and $26.8 million, respectively. Of such amounts, approximately 66%, 44% and 14%, respectively, for each respective year related to CalFirst Bank, with the balance held by CalFirst Leasing.
Beginning in fiscal 2007, the Bank began developing a commercial loan portfolio. Commercial loans of $85.0 million accounted for 25% of the Company’s investment in leases and loans at June 30, 2012, down from $95.8 million, or 30%, at June 30, 2011. Due to conditions imposed by the Bank’s primary regulator, during fiscal 2012 the Bank was restricted from making new commercial loan commitments beyond maintaining its existing relationships. In late June 2012, the Bank received clearance to renew efforts to originate commercial loans.
The commercial loan portfolio consists primarily of participations in syndicated transactions led by other financial institutions, with approximately 14% of the loan portfolio the result of a direct origination effort. Direct loan origination is targeted primarily to existing Bank and CalFirst Leasing relationships. These commercial loans are a complementary product leveraging existing relationships and extending customer longevity. Commercial loan products originated directly include lines of credit, term loans and commercial mortgages, and generally will be secured by a first priority filing on the customer’s assets, including accounts receivable and inventory, capital equipment or commercial real estate, but unsecured loans or lines of credit will be considered, depending on the nature of the credit. Commercial loans originated directly have terms from one to ten years, and priced with fixed or floating rates. Commercial loan commitments directly originated as of June 30, 2012 ranged in amount from approximately $1.0 million to $6.0 million.
Syndicated bank loans have structures ranging from working capital loans secured by accounts receivable and inventories, term loans secured by all assets to leveraged loans supported by operating cash flow and enterprise valuation. Loans are priced at variable rates, and generally are made to larger corporations with debt ratings of BB or Ba, or higher, as rated by Standard & Poor’s or Moody’s Investors Service, respectively; however, $10.7 million, or approximately 15% of the syndicated loan portfolio, relates to companies that are rated lower or are unrated. Credits that the Company characterizes as highly leveraged account for approximately 20% of the syndicated loan portfolio, down from 27% at June 30, 2011. All syndicated loan transactions are participations through major money-center banking institutions and are diversified across industries, with the loan commitments ranging in size from $2.0 million to $8.0 million. At June 30, 2012, the average principal outstanding was $3.9 million, and the remaining terms were from three to six years.
The Bank’s underwriting of commercial loans has been maintained in accordance with its existing credit standards, although its policies have been augmented to address credit issues related to the larger average investment in individual loans and regulatory issues governing the loan participation market. The risks associated with loans in which the Bank participates as part of a syndicate of financial institutions are similar to those of directly originated commercial loans; however, additional risks may arise from the Bank’s limited ability to control actions of the syndicate. Existing staff administer loan operations including documentation, lien perfection, funding, payments and collections. The Bank’s current computer systems are capable of fully processing loans and have the requisite connectivity to the Company’s accounting, customer service and collections processes.
Commercial loan transactions funded during fiscal 2012 of $6.8 million related solely to syndicated loans, and was down from $76.9 funded during fiscal 2011, all of which were purchased under syndication. Yields earned on commercial loans tend to be lower than yields earned on lease transactions, but the average life or duration of the investment is expected to be longer and such yields will vary more with changes in market interest rates.
Credit Risk Management
The Company’s strategy for credit risk management includes stringent credit authority centered at the most senior levels of management. The strategy also emphasizes diversification on both a geographic and customer level, and spreading risk across a breadth of leases and loans while minimizing the risk to any one area. The credit policy requires each lease or loan, regardless of whether it is directly originated or acquired through syndication, to have viable repayment sources. The credit process primarily focuses on a customer’s ability to repay the lease or loan through their cash flow, and generally, collateral securing a transaction represents a secondary source of repayment. The credit process includes a policy of classifying all leases and loans in accordance with a risk rating classification system, monitoring changes in the risk ratings of lessees and borrowers, identification of problem leases and loans and special procedures for the collection of problem leases and loans. The lease and loan classification system is consistent with regulatory models under which leases and loans may be rated as “pass”, “special mention”, “substandard”, “doubtful” or “loss”.
An Asset Management (“AM”) group handles the day-to-day management and oversight of the lease portfolios. The AM group monitors the performance of all leases held in the portfolios, transactions-in-process as well as lease transactions assigned to lenders, if the Company retains a residual investment in the leased property subject to the lease. The AM group conducts an ongoing review of all leases 10 or more days delinquent, contacts the lessee directly and generally sends the lessee a notice of non-payment within 15 days after the due date. In the event that payment is not then received, senior management becomes involved. Delinquent leases are coded in the AM tracking system in order to provide management visibility, periodic reporting, and appropriate reserves. Legal recourse is considered and promptly undertaken if alternative resolutions are not obtained. At 90 days past due, leases and loans will be placed on non-accrual status such that interest income no longer accretes into income, unless the Company believes the amounts due are otherwise recoverable.
Allowance for Credit Losses
The allowance for credit losses is an estimate of probable and assessable losses in the Company’s lease and loan portfolios applying the principles of Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 450, “Contingencies,” and ASC Topic 310-35, “Loan Impairment.” The allowance recorded is based on a quarterly review of all leases and loans outstanding and transactions-in-process. The determination of the appropriate amount of any provision is based on management’s judgment at that time and takes into consideration all known relevant internal and external factors that may affect the lease and loan portfolios. The primary responsibility for setting reserves resides with executive management who report quarterly to the Company’s Audit Committee and Board of Directors regarding overall asset quality, problem leases and loans and the adequacy of valuation allowances. The Bank's classification of its assets and the amount of its valuation allowances are subject to review by regulators who can order the establishment of additional loss allowances.
The Company individually analyzes the net book value of each non-performing or problem lease and loan to determine whether the carrying value is less than or equal to the expected recovery anticipated to be derived from lease or loan payments, additional collateral or residual realization. The amount estimated as unrecoverable is recognized as a reserve specifically identified for the lease or impaired loan. An analysis of the remaining portfolios is conducted, taking into account recent loss experience, known and inherent risks in the portfolio, levels of delinquencies, adverse situations that may affect the customer’s ability to repay, trends in volume and other factors, including regulatory guidance and current and anticipated economic conditions in the market. This portfolio analysis includes a stratification of the lease and loan portfolio by risk classification and segments, and estimation of potential losses based on risk classification or segment. The composition of the portfolio based on risk ratings is monitored, and changes in the overall risk profile of the portfolio also is factored into the evaluation of inherent risks in the portfolios. Regardless of the extent of the Company's analysis of customer performance or portfolio evaluation, certain inherent but undetected losses are probable within the lease and loan portfolios. This is due to several factors including inherent delays in obtaining information regarding a customer’s financial condition or change in business conditions; the judgmental nature of individual credit evaluations and classification, and the interpretation of economic trends; volatility of economic or customer-specific conditions affecting the identification and estimation of losses and the sensitivity of assumptions utilized to establish allowances for losses, among other factors. Therefore, an estimated inherent loss not based directly on the specific problem assets is recorded as an unallocated allowance. The level of such unallocated allowance is determined based on a review of prior years’ loss experience, and may vary depending on general market conditions. The aggregate allowance in any one period is apportioned between allowance for doubtful accounts and allowance for valuation of residual value.
The Bank is focused on gathering deposits from depositors nationwide for the primary purpose of funding its investment in leases and loans. The Bank’s strategy is to be a low cost producer through marketing its products and services directly to end-users. The Bank believes that its operating costs generally will be lower than those of traditional "bricks and mortar" banks because it does not have the expense of a traditional branch network to generate deposits and conduct operations.
At June 30, the Bank had $253.3 million in deposits, of which $79.2 million were demand and savings accounts and $174.1 million, or 69% were time deposits. The Bank’s deposits have been gathered primarily through the Internet. Other strategies to identify depositors are through direct mail, telephone campaigns, purchase of leads from private sources and more extensive print advertisements. The Bank offers interest-bearing checking accounts, money market accounts, savings accounts and three (3) month to three (3) year certificates of deposit (“CDs”) to taxable and IRA depositors. CDs are offered with varying maturities in order to achieve a fair approximation or match of the average life of the Bank’s lease and loan portfolio. With leases generally providing for fixed rental rates, a matching fixed rate CD book is intended to allow the Bank to minimize interest rate fluctuation risk. Most of the Bank’s commercial loans are floating rate.
To open a new account, a customer can complete an on-line enrollment form on the Bank’s web site, or can call the Bank’s toll-free customer service number and open an account telephonically. Signature cards and deposits are then mailed to the Bank. Customers can make deposits by wire transfer, via direct deposit programs, or by mail. No teller line is maintained. The Bank’s customers have 24-hour access to account information. Customers can view their banking records and current balances, and transfer funds between accounts through the use of personal computers. They can also pay bills on-line. Customers can receive a free ATM card upon opening a demand or savings account. In order to obtain cash, the Bank’s customers use other banks’ automated teller machines that are affiliated with the Plusä system. The Bank generally will reimburse customers for some portion of any ATM fees charged by other financial institutions. The Bank believes that any inconvenience resulting from the Bank not maintaining automated teller machines or a local branch office will be offset by the Bank’s higher investment yields and lower banking fees.
As part of the Bank’s entry into broader services for commercial customers, CalFirst Bank can provide on-line cash management services for its commercial customers. Leveraging on its existing Internet banking platform, through the Bank’s remote deposit capture system customers provided with a desktop scanner can scan items for deposit and electronically send images of the items securely to the Bank’s electronic banking system. These systems are attractive to commercial customers who are able to perform more banking functions on-site, avoid courier and other costs and enhance cash flow through faster access to payments received.
The Bank’s operations have been developed by outsourcing certain principal functions to leading bank industry service providers and by sharing established systems utilized by CalFirst Leasing or the Company. Outsourced systems include the Bank’s core processing and electronic banking system, electronic bill payment systems and depositary services, including item processing. The Bank believes it benefits from the service provider's expertise and investments in developing technology. A critical element to the Bank’s success is the ability to provide secure transmission of confidential information over the Internet. The Bank’s service providers utilize sophisticated technology to provide maximum security. All banking transactions are encrypted and all transactions are routed from the Internet server through a "firewall" that limits access to the Bank’s and service provider’s systems. Systems are in place to detect attempts by third parties to access other users' accounts and feature a high degree of physical security, secure modem access, service continuity and transaction monitoring. The Bank has implemented the two-factor authentication security to its Internet banking procedures and platform.
CalFirst Leasing provides certain services to the Bank pursuant to formal agreements, including servicing the Bank’s lease portfolio on the Bank’s behalf.
In addition to leases and loans, the Company had total cash and cash equivalents and investment securities of $123.7 million at June 30, 2012 compared to $163.6 million at June 30, 2011. This investment portfolio consists of interest-earning deposits with banks and short-term money market securities, as well as corporate bonds, Federal Reserve Bank and Federal Home Loan Bank stock and other investments. The Company is authorized to invest in high-quality United States agency obligations, mortgage backed securities, investment grade corporate bonds and municipal securities and selected preferred and equity securities. The investment portfolio may increase or decrease depending upon the comparative returns on investments in relation to leases and loans.
Leasing and loan customers include major corporations and middle-market companies, subsidiaries and divisions of Fortune 1000 companies, private and state-related educational institutions, municipalities and other not-for-profit organizations and institutions located throughout the United States. The Company does not believe the loss of any one customer would have a material adverse effect on its operations taken as a whole.
The Bank’s deposit customers are primarily individuals from across the nation who places a substantial portion of their savings in safe, government-insured deposits and businesses that spread their liquid investments among a breadth of banks in order to ensure that they are government insured. Such depositors are seeking to maximize their interest income and, therefore, are more inclined to move their investments to a bank that offers the highest yield regardless of the geographic location of the depository.
The Company competes for the lease and loan financing of capital assets with other banks, commercial finance companies, and other financial institutions, independent leasing companies, credit companies affiliated with equipment manufacturers, and equipment brokers and dealers. Many of the Company's competitors have substantially greater resources, capital, and more extensive and diversified operations than the Company. The Company believes that the principal competitive factors are rate, responsiveness to customer needs, flexibility in structuring lease financing and loans, financial technical proficiency and the offering of a broad range of financing options. The level of competition varies depending upon market and economic conditions, the interest rate environment, and availability of capital.
The Bank competes with other banks and financial institutions to attract deposits. The Bank faces competition from established local and regional banks and savings and loan institutions. Many of them have larger customer bases, greater name recognition and brand awareness, greater financial and other resources, broader product offerings and longer operating histories. The market for Internet banking has seen increased competition over the past several years as large national banks have deployed and aggressively promoted their own on-line banking platforms. Additionally, new competitors and competitive factors are likely to emerge with the continued development of Internet banking.
Supervision and Regulation
The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended, and is registered with, regulated and examined by the Board of Governors of the Federal Reserve System (the “FRB”). In addition to the regulation of the Company by the FRB, the Bank is subject to extensive regulation and periodic examination, principally by the Office of the Comptroller of the Currency (“OCC”). The Federal Deposit Insurance Corporation (“FDIC”) insures the Bank’s deposits up to certain prescribed limits and the Bank is a member bank within the San Francisco Federal Reserve district. The Company is also subject to jurisdiction of the Securities and Exchange Commission ("SEC") and to the disclosure and regulatory requirements of the Securities Act of 1933 and the Securities Exchange Act of 1934, and through the listing of the common stock on the NASDAQ Global Select Market is subject to the rules of NASDAQ.
The Bank Holding Company Act, the Federal Reserve Act, and the Federal Deposit Insurance Act subject the Company and the Bank to a number of laws and regulations. The primary concern of banking regulation is “Safety and Soundness” with an emphasis on asset quality and capital adequacy. These laws and regulations also encompasses a broad range of other regulatory concerns including insider transactions, the adequacy of the allowance for credit losses, inter-company transactions, regulatory reporting, adequacy of systems of internal controls and limitations on permissible activities. The federal banking agencies possess broad powers to take corrective action as deemed appropriate for an insured depository institution and its holding company. The FRB routinely examines the Company, which exam includes CalFirst Leasing. The OCC, which has primary supervisory authority over the Bank, regularly examines banks in such areas as reserves, loans, investments, management practices, and other aspects of operations. These examinations are designed for the protection of the Bank’s depositors rather than the Company’s shareholders. The Bank must furnish annual and quarterly reports to the OCC, which has the authority under the Financial Institutions Supervisory Act to prevent a national bank from engaging in an unsafe or unsound practice in conducting its business. The OCC may impose restrictions or new requirements on the Bank, including, but not limited to, growth limitations, dividend restrictions, individual increased regulatory capital requirements, lease and loan loss reserve requirements, increased supervisory assessments, activity limitations or other restrictions that could have an adverse effect on the Bank, the Company or holders of our common stock. Many banking laws and regulations have undergone significant change in recent years and, given the recent financial crisis in the United States, regulators have increased their oversight of financial institutions and taken a more active role in imposing restrictions on bank operations, the classification of assets and determination of the allowance for credit losses. Future changes to these laws and regulations, and other new financial services laws and regulations are likely, and cannot be predicted with certainty.
Under FRB policy, the Company is expected to serve as a source of financial and managerial strength to the Bank and, under appropriate circumstances, to commit resources to support the Bank. Certain loans by the Company to the Bank would be subordinate in right of payment to deposits in, and certain other indebtedness of, the Bank.
Among the regulations that affect the Company and the Bank are provisions of Section 23A of the Federal Reserve Act. Section 23A places limits on the amount of loans or extensions of credit the Bank may make to affiliates and the amount of assets purchased from affiliates, except for transactions exempted by the FRB. The aggregate of all of the above transactions is limited in amount, as to any one affiliate, to 10% of a bank’s capital and surplus and, as to all affiliates combined, to 20% of a bank's capital and surplus. The Bank and the Company must also comply with certain provisions designed to avoid the Bank buying low-quality assets. The Company and the Bank are also subject to the provisions of Section 23B of the Federal Reserve Act which, among other things, prohibits an institution from engaging in transactions with affiliates unless the transactions are on terms substantially the same, or at least as favorable to the institution as those prevailing at the time for comparable transactions with non-affiliated companies. All services provided by the Company or CalFirst Leasing to the Bank are in accordance with this provision.
Regulation W (“Reg. W”), which implements, interprets and applies statutory provision in sections 23A and 23B became effective April 1, 2003. Under Reg. W, a bank does not have to comply with the quantitative limits of Section 23A when making a loan or extension of credit to an affiliate if 1) the extension of credit was originated by the affiliate; 2) the bank makes an independent evaluation of the creditworthiness of the borrower and commits to purchase the extension of credit before the affiliate makes or commits to make the extension of credit; 3) the bank does not make a blanket advance commitment to purchase loans from the affiliate and 4) the dollar amount of all purchases over any 12 month period by the bank from an affiliate does not represent more than 50% of that affiliate’s credit extensions during such period. The Company believes the Bank’s purchase of lease receivables from CalFirst Leasing conforms to the requirements of Reg. W. In addition, the Company has agreed with the FRB that the Bank’s purchase of leases from CalFirst Leasing will not exceed 50% of the Bank’s lease portfolio.
In connection with its approval of the Company’s purchase of the stock of the Bank, the FRB and the OCC required the Company and the Bank to make certain commitments with respect to the operation of the Bank. The commitments as modified include: (i) the Bank and the Company entered into a binding written agreement setting forth the Company’s obligations to provide capital maintenance and liquidity support to the Bank, if and when necessary; (ii) the Bank must obtain prior approval from the OCC before implementing any significant deviation or change from its original operating plan; and (iii) the Company must comply with Reg. W.
In September 2006, the OCC approved a change in the Bank’s original operating plan that provided for the Bank to begin originating commercial loans. In October 2010, the OCC advised the Bank that the scope and volume of its commercial loan business exceeded the forecast provided in July 2006 and therefore was a deviation from the Bank's business plan approved in September 2006. While the Bank does not agree that it deviated significantly from forecasts and documents submitted to the OCC in 2008 and 2009, the Bank submitted an updated plan and request for no objection to its continued development of the commercial loan portfolio. In June 2012, the OCC provided a written determination of no objection to the Bank's revised business plan with certain conditions that require the Bank to maintain a Tier 1 capital ratio of not less than 14% through June 30, 2015 and limit the growth in the commercial loan portfolio within certain guidelines.
Bank holding companies are subject to risk-based capital guidelines adopted by the FRB. The Company currently is required to maintain (i) Tier 1 capital equal to at least six percent of its risk-weighted assets and (ii) total capital (the sum of Tier 1 and Tier 2 capital) equal to ten percent of risk-weighted assets. The FRB also requires the Company to maintain a minimum Tier 1 "leverage ratio" (measuring Tier 1 capital as a percentage of adjusted total assets) of at least five percent. At June 30, 2012 and 2011, the Company exceeded all these requirements. Federal bank regulatory agencies have jointly issued proposed rules that would revise the general risk-based capital rules to incorporate certain revisions by the Basel Committee on Banking Supervision to the Basel capital framework (“Basel III”). The proposed rule would generally revise the definition of regulatory capital components and related calculations and is applicable to the Company; however, most of the changes are not meaningful for the Company or the Bank.
The Bank is also subject to risk-based and leverage capital requirements mandated by the OCC. In general, banks are required to maintain a minimum ratio of qualifying total capital to risk-adjusted assets of 8% and a minimum ratio of Tier 1 capital to risk-adjusted assets of 4%. In addition to the risk-based guidelines, banks are generally required to maintain a minimum ratio of Tier 1 capital to adjusted total assets, referred to as the leverage ratio, of 4%. At June 30, 2012 and 2011, the Bank had capital in excess of all minimum risk-based and leverage capital requirements.
Under the Community Reinvestment Act (“CRA”), the Bank has a continuing and affirmative obligation, consistent with safe and sound operation, to help meet the credit needs of their entire communities, including low- and moderate-income neighborhoods. CalFirst Bank is designated as a wholesale institution for CRA purposes. To evaluate the CRA performance of banks with this designation, regulatory agencies use the community development test. This includes an assessment of the level and nature of the Bank’s community development lending, investments and services. The CRA requires the OCC, in connection with its examination of the Bank, to assess and assign one of four ratings to the Bank’s record of meeting the credit needs of its community. The CRA also requires that the Bank publicly disclose their CRA ratings. During fiscal 2008, CalFirst Bank was subjected to a CRA examination and received a “satisfactory” rating on the CRA performance evaluation. There was no CRA examination for fiscal 2012.
The Bank is a member of the Deposit Insurance Fund (“DIF”) maintained by the FDIC. Through the DIF, the FDIC insures the deposits of the Bank up to prescribed limits for each depositor. As a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “2010 Financial Reform Act”), the maximum deposit insurance amount has been increased permanently from $100,000 to $250,000. The FDIC utilizes a risk-based assessment system that imposes insurance premiums based upon a risk matrix that takes into account a bank’s capital level and supervisory rating. As of January 1, 2009, there are four risk categories, which are distinguished by capital levels and supervisory ratings. The three capital categories are “well capitalized,” “adequately capitalized,” and “undercapitalized.” Under the regulations, assessment rates for calendar 2009 ranged from 12 to 16 basis points per $100 of deposits for banks in Risk Category I, to 45 basis points for banks assigned to Risk Category IV. On May 22, 2009, the FDIC adopted a final rule imposing a 5 basis point special assessment on each insured depository institution’s assets minus Tier 1 capital as of June 30, 2009. The special assessment was collected on September 30, 2009. In lieu of further special assessments, on November 12, 2009, the FDIC approved a final rule to require all insured depository institutions to prepay their estimated risk-based assessments for the fourth quarter of 2009, and for all of 2010, 2011, and 2012 on December 30, 2009. The Bank prepaid $722,526 of such premium on December 30, 2009 and $294,409 remains as a prepaid balance at June 30, 2012. The expense related to this prepayment is anticipated to be recognized over the next 12 months based on actual calculations of quarterly premiums. The actual assessment would be applied against the prepaid assessment until exhausted. Any funds remaining after June 30, 2013 will be returned to the institution. The FDIC may still increase or decrease the assessment rate in the future, and any such increase could have an adverse impact on the earnings of insured institutions, including the Bank.
In November 2008, the FDIC implemented the Temporary Liquidity Guarantee Program (TLGP), which applies to U.S. depository institutions insured by the FDIC and U.S. bank holding companies. The Bank elected to participate in the deposit account guarantee component of the TLGP (the “Transaction Account Guarantee”), pursuant to which the FDIC guaranteed all noninterest-bearing transaction accounts in full until December 31, 2010, regardless of the existing deposit insurance limit of $250,000. As a result of the 2010 Financial Reform Act, beginning December 31, 2010 through December 31, 2012, all non-interest bearing transaction accounts are fully insured, regardless of the balance of the account at all FDIC-insured institutions. The unlimited insurance coverage is available to all depositors, including consumers, businesses, and government entities. This unlimited insurance coverage is separate from, and in addition to, the insurance coverage provided to a depositor’s other deposit accounts held at an FDIC-insured institution.
The Bank also is required to make payments for the servicing of obligations of the Financing Corporation (“FICO”) issued in connection with the resolution of savings and loan associations, so long as such obligations remain outstanding. The FICO annual assessment rate as of June 30, 2012 is 0.66 cents per $100 of deposits.
The FDIC can terminate insurance of the Bank’s deposits upon a finding that the Bank has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule, order, or condition imposed by the OCC. The termination of deposit insurance could have a material adverse effect on the Company’s earnings.
The principal source of cash flow to the Company, including cash flow to pay dividends on its common shares, is dividends from its subsidiaries and fees for services rendered to its subsidiaries. Various statutory and regulatory provisions limit the amount of dividends or fees that may be paid to the Company by the Bank. In general, the Bank may not declare or pay a dividend to the Company in excess of 100% of its net retained earnings for the current year combined with its net retained earnings for the preceding two calendar years without prior approval of the OCC. The Company has not received any dividends from the Bank to date, and believes CalFirst Leasing and CalFirst Bank have sufficient resources to meet the Company’s requirements.
There are numerous laws, regulations and policies affecting financial services businesses currently in effect and they are continually under review by Congress and state legislatures and federal and state regulatory agencies. The Gramm-Leach-Bliley Act established requirements for financial institutions to provide privacy protections to consumers and notices to customers about its privacy policies and practices. The USA Patriot Act imposes obligations to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering and terrorist financing and to verify the identity of customers. The 2010 Financial Reform Act provides for sweeping financial regulatory reform and may have the effect of increasing the cost of doing business, limiting or expanding permissible activities and affect the competitive balance between banks and other financial intermediaries. While many of the provisions of the 2010 Financial Reform Act do not impact the existing business of the Bank, the extension of FDIC insurance to all non-interest bearing deposit accounts and the repeal of prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts, will likely increase deposit rates to be paid by the Bank in order to retain or grow deposits. Changes in the laws, regulations or policies that impact the Company cannot necessarily be predicted, and they may have a material effect on the business and earnings of the Company.
The commercial banking business is also influenced by the monetary and fiscal policies of the federal government and the policies of the FRB. The FRB implements national monetary policies through its management of the discount rate, the money supply, and reserve requirements on bank deposits. Indirectly, such policies and actions may impact the ability of non-bank financial institutions to compete with the Bank. Monetary policies of the FRB have had, and will continue to have, a significant effect on the operating results of financial institutions. The nature and impact of any future changes in monetary or other policies of the FRB cannot be predicted.
At June 30, 2012, the Company and its subsidiaries had 149 employees, none of whom are represented by a labor union. The Company believes that its relations with its employees are satisfactory.
Our Internet address is www.calfirstbancorp.com. There we make available, by link to the SEC, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments to those reports, as soon as reasonably practical after we electronically file such material with, or furnish it to, the SEC. Our SEC reports can be accessed through the Investor Information section of our Internet site. Our Corporate Governance Guidelines and our Code of Ethics for Senior Financial Management are available for viewing and printing under the Corporate Governance section of our Internet site. The information found on our Internet site is not part of this or any other report we file with or furnish to the SEC and is not incorporated herein by reference.
ITEM 1A. RISK FACTORS
There are a number of factors, including those specified below, that may adversely affect the Company’s business, financial results or stock price. Additional risks that the Company currently does not know about or currently views as immaterial may also affect the Company’s business or adversely impact its financial results or stock price.
Industry Risk Factors
The Company’s business and financial results are subject to general business and economic conditions. The Company’s business activities and earnings are affected by general business conditions in the United States. The recent economic downturn resulted in a deterioration of credit quality of certain lessees and borrowers and reduced demand for financing capital assets. Continued weakness in the financial performance and condition of customers could negatively affect the repayment of their obligations. In addition, changes in securities markets and monetary fluctuations adversely affect the availability and terms of funding necessary to meet the Company’s liquidity needs.
Changes in the domestic interest rate environment could reduce the Company’s net direct finance and interest income. The Company’s net direct finance and interest income, which is the difference between income earned on leases, loans and investments and interest expense paid on deposits, is affected by market rates of interest, which in turn are affected by prevailing economic conditions, by the fiscal and monetary policies of the Federal government and by the policies of various regulatory agencies. The Federal Open Market Committee (“FOMC) of the FRB has promulgated a policy of keeping short term interest rates near zero through 2015 and this may continue to have a negative impact on the Company’s net interest income.
Disruptions in the domestic credit markets and interest rate environment, including changes in interest spreads and the yield curve, could reduce net interest income. Low prevailing interest rates have reduced the income earned on the Company’s available cash balances. Declines in treasury rates and libor, which affect the yields earned on most earning assets, have exceeded the reduction in rates generally offered on CDs, resulting in a decline in our net interest margin. Higher interest rates and the inability to access capital markets could negatively affect certain customers and result in increased lease and loan losses.
Changes in the laws, regulations and policies governing financial services companies could alter the Company’s business environment and adversely affect operations. The Board of Governors of the Federal Reserve System regulates the supply of money and credit in the United States. Its fiscal and monetary policies determine in a large part the Company’s cost of funds and the return that can be earned on leases, loans and investments, which affect the Company’s net direct finance, loan and interest income.
The Company and the Bank are regulated by governmental entities. This regulation is to protect depositors, federal deposit insurance funds and the banking system as a whole. Bank regulators can impose restrictions on the ability of the Company to undertake certain business and growth. Following the recent financial crisis, regulators have increased their oversight of banks and taken a more active role in imposing restrictions on bank operations, the classification of assets and determination of the allowance for credit losses. The 2010 Financial Reform Act provides for sweeping financial regulatory reform, much of which does not impact the existing business of the Bank, however, the extension of FDIC insurance to all non-interest bearing deposit accounts and the repeal of prohibitions on the payment of interest on demand deposits will likely increase deposit rates to be paid by the Bank in order to retain or grow deposits. These changes in regulations or policies could affect the Company in substantial and unpredictable ways. The Company cannot predict whether any additional legislation will be enacted, and if enacted, the effect that it or any regulations would have on the Company’s financial condition or results of operations.
The financial services industry is highly competitive, and competitive pressures could intensify and adversely affect the Company’s financial results. The Company operates in a highly competitive industry that could become even more competitive as a result of legislative, regulatory and technological changes. The Company competes with other commercial banks, savings and lease associations, mutual savings banks, finance companies, credit unions and investment companies, many of which have greater resources than the Company.
Acts or threats of terrorism and political or military actions taken by the United States or other governments could adversely affect general economic or industry conditions.
Company Risk Factors
The Company’s allowance for credit losses may not be adequate to cover actual losses. The Company’s subsidiaries retain approximately 90% of lease transactions and all loans in their own portfolios, which expose the Company to credit risk. The Company maintains an allowance for credit losses to provide for probable and estimatable losses in the portfolio. The Company’s allowance for credit losses is based on its historical experience as well industry data, an evaluation of the risks associated with its portfolio, including the size and composition of the lease and loan portfolio, current economic conditions and concentrations within the portfolio. The allowance for credit losses may not be adequate to cover losses resulting from unanticipated adverse changes in the economy or the financial markets. If the credit quality of the customer base materially decreases, or if the reserve for credit losses is not adequate, future provisions for credit losses could materially and adversely affect financial results.
The Company may suffer losses in its lease and loan portfolio despite its underwriting practices. The Company seeks to mitigate the risks inherent in its lease and loan portfolio by adhering to specific credit practices. Although the Company believes that its criteria are appropriate for the various kinds of leases and loans it makes, the Company may incur losses on leases and loans that meet these criteria.
The Bank’s commercial loan initiative may increase the Company’s risk of losses. The commercial loan portfolio contains a number of commercial loans with relatively larger balances than its historical lease portfolio. About 20% of the commercial loan portfolio is comprised of highly leveraged loans, with 8% of the portfolio rated substandard. The deterioration of one or a few of these loans could cause a significant increase in non-performing loans. An increase in non-performing loans could result in an increase in the provision for credit losses and an increase in charge-offs, all of which could have a material adverse effect on the Company’s results of operations.
The Bank’s expanded lease purchase operations may increase the Company’s risk of losses. CalFirst Bank has implemented a program to grow its lease portfolio through the purchase of lease receivables on a non-recourse basis from other banks and finance companies. The Company seeks to mitigate the risks inherent in this third-party business by adhering to specific underwriting practices, but many of these relationships are new and untested, and the Bank could be exposed to risks not inherent with the lease transactions originated directly or acquired from its affiliates, including unfamiliar documentation and reliance on sales and funding professionals not subject to the Bank’s policies and practices.
Customer concentration may increase the risk of loss in the event of the deterioration of one of these customers or industries. At June 30, 2012, approximately 18% of the Company’s net investment in leases and loans was with public and private colleges, universities, elementary and secondary schools located throughout the United States. Hospitals, nursing homes and related medical facilities represented 11% of the total investment in leases and loans while 9% was related to professional, scientific and technical services.
The Company’s diversification into broader investment alternatives may increase the Company’s risk of losses. The Company’s investment portfolio may include U.S. Treasury and Agency Securities, corporate and municipal bonds and closed-end mutual funds, in addition to interest-earning deposits, short-term money market securities and federal funds previously held. These securities subject the Company to increased risk of volatility in the valuation of the investment, as well as greater interest and market risks. The deterioration of one or a few of these investments on a permanent basis could result in an determination that the investment has been permanently impaired and require a write-down of such investment, all of which could have a material adverse effect on the Company’s results of operations.
The Company may be adversely affected by significant changes in the bank deposit market and interest rates. CalFirst Bank has grown to represent 77% of the Company’s assets, and bank deposits now exceed $253 million. As a result, the Company’s sensitivity to changes in interest rates and demand for bank deposits has increased from historical levels. Time deposits due within one year of June 30, 2012 totaled $141 million. If these maturing deposits do not roll over, CalFirst Bank may be required to seek other sources of funds, including other time deposits and borrowings. Depending on market conditions, rates paid on deposits and borrowings may be higher than currently paid or no longer available. Although the Bank employs a funding strategy designed to correlate the repricing characteristics of assets with liabilities, the impact of interest rate movements and customer demand is not always consistent during different market cycles, and changes in the costs for deposits and yields on assets may not coincide.
The change in residual value of leased assets may have an adverse impact on the Company’s financial results. A portion of the Company’s leases is subject to the risk that the residual value of the property under lease will be less than the Company’s recorded value. Adverse changes in the residual value of leased assets can have a negative impact on the Company’s financial results. The risk of changes in the realized value of the leased assets compared to recorded residual values depends on many factors outside of the Company’s control.
The financial services business involves significant operational risks. Operational risk is the risk of loss resulting from the Company’s operations, including, but not limited to, the risk of fraud by employees or persons outside of the Company, the execution of unauthorized transactions by employees, errors relating to transaction processing and technology, breaches of the internal control system and compliance requirements, and failure of business continuation and disaster recovery plans. This risk of loss also includes the potential legal actions that could arise as a result of an operational deficiency or as a result of noncompliance with applicable regulatory standards, adverse business decisions or their implementation, and customer attrition due to potential negative publicity. In the event of a breakdown in the internal control system, improper operation of systems or improper employee actions, the Company could suffer financial loss, face regulatory action and suffer damage to its reputation.
Bank regulators can impose restrictions on the Company’s ability to execute its strategic plan. The OCC has approved the Bank's plan for the continued development of the commercial loan portfolio but the OCC has limited the growth of the commercial loan portfolio within certain guidelines and imposed a requirement that the bank maintain a Tier 1 capital ratio of 14% that is in excess of the general regulatory requirement of 6%.
Quarterly operating results may fluctuate significantly. Operating results may differ from quarter to quarter due to a variety of factors, including the volume and profitability of leased property being remarketed, the size and credit quality of the lease and loan portfolio, the interest rate environment, the volume of new lease and loan originations, including variations in the property mix and funding of such originations and economic conditions in general. The results of any quarter may not be indicative of results in the future.
Negative publicity could damage the Company’s reputation and adversely impact its business and financial results. Reputation risk, or the risk to the Company’s business from negative publicity, is inherent in the Company’s business. Negative publicity can result from the Company’s actual or alleged conduct in any number of activities, including leasing practices, corporate governance, and actions taken by government regulators in response to those activities. Negative publicity can adversely affect the Company’s ability to keep and attract customers and can expose the Company to litigation and regulatory action.
The Company’s reported financial results are subject to certain assumptions and estimates and management’s selection of accounting method. The Company’s management must exercise judgment in selecting and applying many accounting policies and methods so they comply with generally accepted accounting principles and reflect management’s judgment of the most appropriate manner to report the Company’s financial condition and results. In some cases, management may select an accounting policy which might be reasonable under the circumstances yet might result in the Company’s reporting different results than would have been reported under a different alternative.
Certain accounting policies are critical to presenting the Company’s financial condition and results. They require management to make difficult, subjective or complex judgments about matters that are uncertain. Materially different amounts could be reported under different conditions or using different assumptions or estimates. These critical accounting policies include the estimate of residual values, the allowance for credit losses, and income taxes. For more information, refer to “Critical Accounting Policies and Estimates”.
Changes in accounting standards could materially impact the Company’s financial statements. The Financial Accounting Standards Board (FASB) may change the financial accounting and reporting standards that govern the preparation of the Company’s financial statements. These changes can be hard to predict and can materially impact how the Company records and reports its financial condition and results of operations. Recently, FASB has proposed new accounting standards related to accounting for leases that could materially change the Company’s financial statements in the future. In some cases, the Company could be required to apply a new or revised standard retroactively, resulting in the Company’s restating prior period financial statements.
Loss of certain key officers would adversely affect the Company’s business. The Company‘s business and operating results are substantially dependent on the certain key employees, including the Chief Executive Officer, Chief Operating Officer, the President and Chief Credit Officer of the Bank and certain key sales managers. The loss of the services of these individuals, particularly the Chief Executive Officer, would have a negative impact on the business because of their expertise and years of industry experience.
The Company’s business could suffer if the Company fails to attract and retain qualified people. The Company’s success depends, in large part, on its ability to attract and retain key people. Competition for personnel in most activities the Company engages in can be intense. The Company may not be able to hire the best people or to keep them.
The Company relies on other companies to provide components of the Company’s business infrastructure. Third party vendors provide certain components of the Company’s business infrastructure, such as the Bank’s core processing and electronic banking systems, item processing, and Internet connections. While the Company has selected these third party vendors carefully, it does not control their actions. Any problems caused by these third parties not providing the Company their services for any reason or their performing their services poorly, could adversely affect the Company’s ability to deliver products and services to the Company’s customers and otherwise to conduct its business. Replacing these third party vendors could also entail significant delay and expense.
A natural disaster could harm the Company’s business. Natural disasters could harm the Company’s operations directly through interference with communications, including the interruption or loss of the Company’s websites, which would prevent the Company from gathering deposits, originating leases and loans and processing and controlling its flow of business, as well as through the destruction of facilities and the Company’s operational, financial and management information systems.
The Company faces systems failure risks as well as security risks, including “hacking” and “identity theft.” The computer systems and network infrastructure the Company and others use could be vulnerable to unforeseen problems. These problems may arise in both our internally developed systems and the systems of our third-party service providers. Our operations are dependent upon our ability to protect computer equipment against damage from fire, power loss or telecommunication failure. Any damage or failure that causes an interruption in our operations could adversely affect our business and financial results. In addition, our computer systems and network infrastructure present security risks, and could be susceptible to hacking or identity theft.
The Company relies on dividends from its subsidiaries for its liquidity needs. The Company is a separate and distinct legal entity from CalFirst Leasing and the Bank. The principal source of funds to pay dividends on the Company’s stock is from distributions from the subsidiaries. Various regulations limit the amount of dividends that the Bank may pay to the Company.
The Company’s stock price can be volatile. The Company’s stock price can fluctuate widely in response to a variety of factors, including: actual or anticipated variations in the Company’s quarterly operating results; operating and stock price performance of other companies that investors deem comparable to the Company; news reports relating to trends, concerns and other issues in the financial services industry, and changes in government regulations. General market fluctuations, industry factors and general economic and political conditions and events, including terrorist attacks, economic slowdowns or recessions, interest rate changes, credit loss trends or currency fluctuations, could also cause the Company’s stock price to decrease regardless of the Company’s operating results. In addition, the volume of trading in the Company’s stock is very limited and can result in fluctuations in prices between trades.
The Company is a “controlled company” as defined by NASDAQ, with over 64% of the stock held by the Chief Executive Officer, over 77% held by two senior executives and fewer than 100 shareholders of record. As a result, senior management has the ability to exercise significant influence over the Company’s policies and business, and determine the outcome of corporate actions requiring stockholder approval. These actions may include, for example, the election of directors, the adoption of amendments to corporate documents, the approval of mergers, sales of assets and the continuation of the Company as a registered company with obligations to file periodic reports and other filings with the SEC.
ITEM 1B. UNRESOLVED STAFF COMMENTS
ITEM 2. PROPERTIES
At June 30, 2012 the Company and its subsidiaries occupied approximately 43,000 square feet of office space in Irvine, California leased from an unaffiliated party. The lease provides for monthly rental payments that average $140,336 from July 2012 through August 2013.
ITEM 3. LEGAL PROCEEDINGS
The Company is sometimes named as a defendant in litigation relating to its business operations. Management does not expect the outcome of any existing suit to have a material adverse effect on the Company's financial condition or results of operations.
ITEM 4. MINE SAFETY DISCLOSURES
ITEM 5. MARKET FOR COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
The common stock of California First National Bancorp trades on the NASDAQ Global Market System under the symbol CFNB. The following high and low closing sale prices for the periods shown reflect inter-dealer prices without retail markup, markdown or commissions and may not necessarily reflect actual transactions.
The Company had approximately 28 stockholders of record and in excess of 400 beneficial owners as of September 7, 2012.
For the three fiscal years ended June 30, 2012, the Board of Directors pursued a dividend policy that provided for one annual dividend payment each year. The Company paid an annual dividend in the amount of $.48 per share on December 16, 2009, $1.00 on December 16, 2010 and $1.10 and December 17, 2011. The Board of Directors will continue to review the dividend policy on an ongoing basis, and the decision to pay dividends in fiscal 2013 and beyond has not been made.
In April 2001, the Board of Directors authorized management, at its discretion, to repurchase up to 1,000,000 shares of common stock. This authorization has no termination date, but the Board of Directors reviews the authorization to repurchase common stock from time to time. The Company repurchased no shares of common stock under this authorization during the year ended June 30, 2012 and 2011 and repurchased 25,654 during fiscal 2010. As of September 15, 2012, 368,354 shares remain available under this authorization.
Common Stock Performance Graph
The following graph shows a comparison of the five-year cumulative return among the Company, the NASDAQ Composite Index and the Russell 2000. As required by Securities and Exchange Commission rules, total return in each case assumes the reinvestment of dividends paid.
Equity Compensation Plan Information
The following table provides information about shares of the Company’s Common Stock that may be issued upon the exercise of options under our existing equity compensation plans as of June 30, 2012.
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth selected financial data and operating information of the Company and its subsidiaries. The selected financial data should be read in conjunction with the Financial Statements and notes thereto and Management's Discussion and Analysis of Results of Operations and Financial Condition contained herein.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Company’s results include the operations of CalFirst Bank and CalFirst Leasing. The Company’s direct finance, loan and interest income includes interest income earned on the Company’s investment in lease receivables and residuals, commercial loans and investment securities. Non-interest income primarily includes gains realized on the sale of leased property, income from sales-type and operating leases, gains realized on the sale of leases, gains or losses recorded on investment securities and other income. Income from sales-type leases relates to the re-lease of off-lease property (“lease extensions”) while operating lease income generally involves lease extensions that do not meet the accounting treatment required for sales-type leases.
The Company's operating results are subject to quarterly fluctuations resulting from a variety of factors, including the size and credit quality of the lease and loan portfolios, the volume and profitability of leased property being re-marketed through re-lease or sale, the interest rate environment, the market for investment securities, the volume of new lease or loan originations, including variations in the mix and funding of such originations, and economic conditions in general. The Company’s principal market risk exposure currently is related to interest rates and the differences in the repricing characteristics of interest-earning assets and interest-bearing liabilities. The Company’s current balance sheet structure is short-term in nature, with over 55% of assets and 75% of liabilities that mature or reprice within one year. The Company’s interest margin also is susceptible to timing lags related to varying movements in market interest rates. Many of the Company’s leases, loans and liquid investments are tied to U.S. treasury rates and Libor that often do not move in step with bank deposit rates. As a result, this can result in a greater change in net interest income than indicated by the repricing asset and liability comparison.
The Company conducts its business in a manner designed to mitigate risks. However, the assumption of risk is a key source of earnings in the leasing and banking industries and the Company is subject to risks through its investment in leases and loans held in its own portfolio, securities, lease transactions-in-process, and residual investments. The Company takes steps to manage risks through the implementation of strict credit and risk management processes and on-going risk management review procedures.
Critical Accounting Policies and Estimates
The preparation of the Company’s financial statements requires management to make certain critical accounting estimates that impact the stated amount of assets and liabilities at a financial statement date and the reported amount of income and expenses during a reporting period. These accounting estimates are based on management’s judgment and are considered to be critical because of their significance to the financial statements and the possibility that future events may differ from current judgments, or that the use of different assumptions could result in materially different estimates. The following is a description of the most critical accounting policies management applies, all of which require the use of accounting estimates and management’s judgment, based on the relevant information available at the end of each period.
Allowance for Credit Losses – The allowance for credit losses provides coverage for probable and estimatable losses in the Company’s lease and commercial loan portfolios. The allowance recorded is based on a quarterly review of all leases and loans outstanding, loan commitments and transactions-in-process. The determination of the appropriate amount of any provision is highly dependent on management’s judgment at that time and takes into consideration all known relevant internal and external factors that may affect the lease and loan portfolio, including levels of non-performing leases and loans, customers financial condition, leased property values and collateral appraisals as well as general economic conditions and credit quality indicators. The Company’s allowance includes an estimate of reserves needed to cover specifically identified lease and loan losses and certain unidentified but inherent risks in the portfolio.
Fair Value of Investments – Investment securities are characterized as held-to-maturity (Investments) or as available-for-sale (Securities Available-for-Sale) based on management’s ability and intent regarding such investment at acquisition. On an ongoing basis, management must estimate the fair value of its investment securities based on information and assumptions it deems reliable and reasonable, which may be quoted market prices or if quoted market prices are not available, fair values extrapolated from the quoted prices of similar instruments. Based on this information, an assessment must be made as to whether any decline in the fair value of an investment security should be considered an other-than-temporary impairment and recorded in non-interest income as a loss on investments. The determination of such impairment is subject to a variety of factors, including management’s judgment and experience.
Residual Values – For capital leases that qualify as direct financing leases, the aggregate lease payments receivable and estimated residual value, if any, are recorded on the balance sheet, net of unearned income and allowances, as net investment in leases. Of the volume of leases booked during the fiscal years ended June 30, 2012, 2011 and 2010, approximately 22.8%, 27.8% and 59.9%, respectively, were structured such that the Company owns the leased asset at the end of the term and recorded a residual value. The residual value is an estimate for accounting purposes of the fair value of the leased property at lease termination and is determined at the inception of the lease based on the property leased and the terms and conditions of the underlying lease contract. The realizability of any estimated residual value depends on future collateral values, contractual options available to the lessee, the credit of the lessee, market conditions and other subjective and qualitative factors. The estimated residual values established at lease inception are periodically reviewed to determine if values are realizable and any identified losses are recognized at such time.
Initial Direct Costs Deferred – A portion of the Company’s non-interest expenses that management estimates is directly related to originating lease and loan transactions is deferred through a reduction to non-interest expenses recognized in a period. The amount deferred reflects management’s estimate of the expenses applicable to the origination process, taking into account a variety of factors including sales productivity, credit and documentation efficiency and estimates of completion percentages.
Deferred Income Taxes and Valuation Allowance – Deferred tax assets and liabilities result from temporary differences between the time income or expense items are recognized for financial statement purposes and for tax reporting. Such amounts are calculated using the enacted tax rates and laws that are expected to be in effect when the differences are expected to reverse. The determination of current and deferred income taxes is based on complex analyses of many factors including interpretation of Federal and state income tax laws, the difference between tax and financial reporting basis of assets and liabilities (temporary differences), estimates of amounts due or owed such as the timing of reversals of temporary differences and current financial accounting standards. A valuation allowance is established if, based upon the relevant facts and circumstances, management believes that some or all of certain tax assets will not be realized. The Company has open tax years that may in the future be subject to examination by Federal and state taxing authorities. Management periodically evaluates the adequacy of related valuation allowances, taking into account open tax return positions, tax assessments received and tax law changes. The process of evaluating allowance accounts involves the use of estimates and a high degree of management judgment. Actual results could differ significantly from the estimates and interpretations used in determining the current and deferred income tax liabilities and reserves.
The Company's estimates are reviewed continuously to ensure reasonableness. However, the amounts the Company may ultimately realize could differ from such estimated amounts.
Overview of Results, Trends and Outlook
Net earnings for the year ended June 30, 2012 of $8.9 million were 18.4% below the $10.9 million reported in fiscal 2011. A 2% decrease in net direct finance, loan and interest income, a 26% decrease in non-interest income and a higher effective income tax rate contributed to the reduction in net earnings reported.
For the year ended June 30, 2012, total leases and loans booked of $180.9 million were 22% below fiscal 2011 bookings. New lease bookings of $174.1 million, including $36.2 million of lease purchases, were up 13% from the $154.6 million booked in the prior fiscal year, while commercial loans boarded of $6.8 million were down from $76.6 million boarded in fiscal 2011. The net investment in leases and loans of $336.5 million at June 30, 2012 was up 6% from $317.2 million at June 30, 2011. The Bank’s investment in leases and loans of $285.3 million increased 14.9% from $248.3 million at June 30, 2011 to account for 85% of the Company’s consolidated investment at June 30, 2012.
New lease and loan transactions approved (“lease and loan originations”) of $207 million during fiscal 2012 were 7% below the levels of the prior year. However, for most of the year, the Bank was precluded from increasing its loan commitments. Looking just at leases, fiscal 2012 lease originations of $202.4 were up 24% from $163.5 million, with fourth quarter 2012 new lease originations up by 50% from the fourth quarter of the prior year. As a result, the estimated backlog of approved lease and loan commitments of $136.7 million at June 30, 2012 is up 11% from $123.2 million at June 30, 2011, 88% of which relate to leases. In June 2012, the Bank received a conditional no objection to a revised business plan and has renewed its efforts to originate commercial loans.
Consolidated Statement of Earnings Analysis
Summary – For the fiscal year ended June 30, 2012, net earnings decreased 18.4% to $8.9 million, compared to $10.9 million for fiscal 2011. Diluted earnings per share decreased 18.6% to $0.85 for fiscal year ended June 30, 2012, compared to $1.05 per share for fiscal 2011. The decline in net earnings is largely due to a $2.3 million decrease in the gain recognized from the sale of securities, and includes the impact of a higher effective tax rate of 37.6% compared to the prior year’s effective tax rate of 35.6%.
Net Direct Finance, Loan and Interest Income – Net direct finance, loan and interest income is the difference between interest earned on the investment in leases, loans, securities and other interest earning assets and interest paid on deposits or other borrowings. Net direct finance, loan and interest income is affected by changes in the volume and mix of interest earning assets and liabilities, the movement of interest rates, and funding and pricing strategies.
Net direct finance, loan and interest income was $20.7 million for the fiscal year ended June 30, 2012 compared to $22.2 million for fiscal 2011 and $21.9 million in fiscal 2010. The decrease in fiscal 2012 from fiscal 2011 was due to a decrease of $1.3 million in loan income together with reductions in direct finance income of $622,000 and investment income of $215,000. Offsetting these reductions was a $699,000 decrease in interest expense. The decrease in commercial loan income reflects an 8.1% decrease in average balances and a 100 basis point decrease in average yield earned. The decrease in direct finance income includes the benefit of a 13.0% increase in average investment in leases directly held by the Company that was offset by a 118 basis point decline in average yield on such leases. The decrease in investment income reflects a 3.8% increase in average investment balances offset by a 24 basis point decrease in average yield. The lower interest expense on deposits reflected an 11.4% increase in average balances to $261.1 million while the average rate paid decreased by 38 basis points to 1.07%. The Company paid off borrowings from the FHLB in fiscal 2012 which resulted in a $99,000 reduction in borrowing costs.
The average yield on all interest-earning assets in fiscal 2012 decreased to 5.1% from 5.9% the prior year, while the average rate paid on all interest-earning liabilities decreased to 1.1% from 1.5% in fiscal 2011. As a result, the net interest margin for the year decreased from 5.0% in fiscal 2011 to 4.4% in fiscal 2012. The prolonged period of low interest rates has allowed the continued run off of higher yielding leases and securities that have been replaced with leases and variable rate loans based on current historically low rates, and the Bank is limited in its ability to lower deposit rates in tandem.
Net direct finance, loan and interest income was $22.2 million for the fiscal year ended June 30, 2011 compared to $21.9 million for fiscal 2010 and $23.2 million in fiscal 2009. The increase in fiscal 2011 from fiscal 2010 was due to an increase of $1.8 million in loan income together with a $1.3 million decrease in interest expense offset by reductions of $1.4 in both direct finance income and investment income. The increase in commercial loan income reflects a 38.2% increase in average balances and a 34 basis point increase in average yield earned. The decrease in direct finance income reflects a 4.8% increase in average investment in leases directly held by the Company and a 109 basis point decline in average yield on such leases. The decrease in investment income reflects a 16.0% decrease in average investment balances and a 45 basis point decrease in average yield. The lower interest expense on deposits reflected an 8.5% increase in average balances to $234.3 million while the average rate paid decreased by 69 basis points to 1.45%. The borrowings from the FHLB stayed at $10.0 million during fiscal 2011 at an average cost of 2.1% compared to fiscal 2010 where borrowings averaged $20.9 million at an average cost of 1.2%.
The following table presents the components of the increases (decreases) in net direct finance, loan and interest income by volume and rate:
The following table presents the Company’s average balance sheets, direct finance and loan income and interest earned or interest paid, the related yields and rates on major categories of the Company’s interest-earning assets and interest-bearing liabilities:
Provision for Credit Losses – The Company did not record a provision for credit losses in fiscal 2012, compared to a provision of $1.0 million recorded in fiscal 2011 and a provision of $350,000 in fiscal 2010. The Company did not make a provision for credit losses in fiscal 2012 as the growth in total risk assets was only 2% and the overall credit quality remained stable. The 2011 provision related to a 23% growth in the lease and loan portfolio during the year and a change in the credit profile in the combined lease and loan portfolios. The Company recorded a provision for credit losses of $350,000 in fiscal 2010, which related to a 9% decline in the lease and loan portfolio during fiscal 2010 that offset any significant changes with the credit risk within the portfolios.
Total Non-interest Income – Total non-interest income of $5.9 million for the year ended June 30, 2012 decreased $2.0 million, or 25.6%, from $7.9 million in 2011. Non-interest income in fiscal 2012 includes gains from the sale of investment securities of $56,000, compared to gains of $2.3 million in fiscal 2011. Excluding such investment activity, non-interest income for fiscal 2012 was up $275,000 as a result of an increase of $628,000 from operating and sales-type lease income offset by a decline of $280,000 in gain on sale of leases, loans and leased property, and lower other income.
Total non-interest income of $7.9 million for the year ended June 30, 2011 decreased $219,000, or 2.7%, from $8.1 million in 2010. Non-interest income in fiscal 2011 includes gains from the sale of investment securities of $2.3 million, compared to gains of $3.4 million in fiscal 2010. Excluding such investment activity, non-interest income for fiscal 2011 was up $875,000 as a result of an increase of $961,000 from gain on sale of leases, loans and leased property, and an increase $129,000 from operating and sales-type lease income offset by lower other income.
Non-interest Expenses – The Company’s non-interest expenses increased $219,000, or 1.8%, to $12.3 million recognized for the year ended June 30, 2012. This compared to non-interest expenses in fiscal 2011 of $12.1 million, which had increased by $448,000, or 3.9%, from $11.6 million in fiscal 2010. The increase in non-interest expenses during fiscal 2012 is primarily due to higher compensation costs recognized related to the sales organization.
Non-interest expenses for the year ended June 30, 2011 increased $448,000, or 3.9%, to $12.1 million compared to non-interest expenses in fiscal 2010 of $11.6 million. The increase in non-interest expenses during fiscal 2011 is primarily due to higher compensation costs related to the sales organization.
Income Taxes – Income taxes were accrued at a tax rate of 37.6% for the fiscal year ended June 30, 2012, 35.6% for fiscal year ended June 30, 2011 and 38.25% for fiscal year ended June 30, 2010, representing the Company’s estimated annual tax rates for each respective year. The income tax rate increased in fiscal 2012 compared to 2011 due to lower tax exempt interest and the decrease in deductions related to the exercise of stock options during the year. The income tax rate declined in fiscal 2011 compared to 2010 due to a release of unrecognized tax benefits and a lower effective state income tax rate. Tax-exempt leases represented approximately 8.6% of new lease bookings in fiscal 2012, 7.8% in fiscal 2011, and 5.2% during fiscal 2010.
Financial Condition Analysis
During the fiscal year ended June 30, 2012, 95% of the total dollar amount of new leases booked by the Company were held in its own portfolio, compared to 99% during fiscal 2011 and 85% during fiscal 2010. For the fiscal year ended June 30, 2012, the Company’s net investment in lease receivables increased by $30.8 million and the investment in estimated residual values decreased by $658,000. The increase in the investment in lease receivables is primarily due to new lease transactions booked and retained by the Company, while the decrease in investment in residual values is due to a lower volume of new leases on which the Company records a residual compared to the volume of residual values recognized at end of term.
The Company often makes payments to purchase leased property prior to the commencement of the lease. The disbursements for these lease transactions-in-process are generally made to facilitate the lessees’ property implementation schedule. The lessee generally is contractually obligated by the lease to make rental payments directly to the Company during the period that the transaction is in process, and obligated to reimburse the Company for all disbursements under certain circumstances. Income is not recognized while a transaction is in process and prior to the commencement of the lease. At June 30, 2012, the Company’s investment in property acquired for transactions-in-process was $18.5 million, down from $29.2 million at June 30, 2011, and down from the $26.8 million at June 30, 2010. The decline in transactions in process is largely due to a change in the nature of direct lease originations to involve less pre-commencement implementation.
The Company leases capital assets to businesses and other commercial or non-profit organizations. All leases are secured by the underlying property being leased. The Company’s strategy is to develop lease portfolios with risk/reward profiles that meet its objectives. The Company avoids risks that do not meet these requirements through the use of non-recourse financing. The strategy emphasizes diversification on both a geographic and customer level, and spreading the Company’s risk across a breadth of leases while managing the risk to any one customer. During the year ended June 30, 2012, two commercial credits each accounted for 7.1% and 5.2% of the aggregate property cost of leases booked during the fiscal year, with the five largest commercial accounts aggregating to 25% of leases booked. In fiscal 2011, one customer accounted for 9% of the aggregate property cost of leases booked during that fiscal year, while a different customer accounted for 27% in fiscal 2010. At June 30, 2012, no customer accounted for more than 5% of the Company’s net investment in leases, compared to two customers accounting for 5.6% and 5.2% of the lease portfolio at June 30, 2011 and one customer accounting for 8.5% of the lease portfolio at June 30, 2010.
Commercial Loan Portfolio
The Company’s commercial loan portfolio was $82.9 million at June 30, 2012, a decrease of 11.5% from $93.7 million at June 30, 2011. The commercial loan portfolio is comprised primarily of participations in commercial loan syndications where the loans are secured by the borrower and any subsidiary guarantors’ assets. Commercial loan participation represents 86.1% of the commercial loan portfolio with the remainder of the portfolio comprised of commercial real estate loans and revolving lines of credit originated directly. The loan portfolio at June 30, 2012 is distributed among 23 credits with an average balance of $3.7 million and the largest outstanding at $6.0 million. Syndicated loans that the Company characterizes as highly leveraged account for approximately 17% of the commercial loan portfolio. The following table summarizes the Company’s commercial loan portfolio as of June 30, 2012, 2011 and 2010:
The estimated repayment of principal on the commercial loan portfolio as of June 30, 2012 is as follows:
The investment in leases and loans is diversified geographically, with the Company’s portfolio spread across all fifty states. At June 30, 2012, Texas (14%) and California (10%) were the only states that represented more than 10% of the Company’s net investment in leases and loans. The Company has no exposure to foreign lessees. The lease and loan portfolios include companies in a wide spectrum of industries; however, at June 30, 2012 approximately 18% of the Company’s net investment in leases and loans were with public and private colleges, universities, elementary and secondary schools located throughout the United States (compared to 18% at June 30, 2011). The educational portfolio includes over 394 leases with over 183 different lessees. Only one university represented over 1% of the net investment. There is also some concentration involving hospitals, medical centers and other health care facilities with 11% of the lease and loan portfolio comprised of these credits. The hospital portfolio involves 17 different credits, and over 300 hospitals in at least 36 different states.
The Company maintains a portfolio of securities to generate interest and investment income from the investment of excess funds depending on lease and loan demand and to provide liquidity. Total securities available-for-sale were $63.6 million as of June 30, 2012, compared to $62.7 million at June 30, 2011. The carrying cost and fair value of the Company’s securities portfolio at June 30, 2012 and 2011 is as follows:
During the fiscal year ended June 30, 2012, the Company’s portfolio of investment securities increased $893,000 to $63.6 million. The increase during the year related to the purchase of $21.9 million of corporate bonds, offset by maturities and pay downs of $16.5 million and proceeds of $3.1 million resulting from the exercise of a call provision for a pretax gain on $56,000. Management evaluates investment securities for other-than-temporary impairment on a quarterly basis. Consideration is given to the length of time and the extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.
At June 30, 2012 the available-for-sale securities portfolio included a $1.1 million net unrealized pre-tax gain compared with a net unrealized pre-tax gain of $2.2 million at June 30, 2011. The weighted-average maturity at June 30, 2012 was 1.8 years and the corresponding weighted-average yield was 4.2 percent.
The Company monitors the performance of all leases and loans held in its own portfolio, transactions-in-process and loan commitments as well as lease transactions assigned to lenders, if the Company retains a residual investment in the leased property subject to those leases. An ongoing review of all leases and loans ten or more days delinquent is conducted. Customers who are delinquent with the Company or an assignee are coded in the Company’s accounting and tracking systems in order to provide management visibility, periodic reporting, and appropriate reserves. The accrual of interest income on leases and loans will be discontinued when the customer becomes ninety days or more past due on its lease or loan payments with the Company, unless the Company believes the investment is otherwise recoverable. Leases and loans may be placed on non-accrual earlier if the Company has significant doubt about the ability of the customer to meet its lease or loan obligations, as evidenced by consistent delinquency, deterioration in the customer’s financial condition or other relevant factors.
The following table summarizes the Company’s non-performing leases and loans.
Non-performing assets decreased during fiscal 2012 due to the return to performing status of a lease that was restructured in 2009 and which has been current with its payments since that time. Direct finance income that would have been recorded had non-accrual leases at each respective fiscal year end been current in accordance with their original terms would have been $12,248, $54,723 and $112,150 during fiscal 2012, 2011 and 2010, respectively. The amount of direct finance income actually recorded on non-performing leases was $70,364, $134,657 and $115,329 during fiscal 2012, 2011 and 2010, respectively.
In addition to the transactions identified as non-performing above, there was $882,000 of investment in leases and $8.0 million of loans at June 30, 2012 which are rated substandard and therefore at higher risk for not being able to meet their existing obligations. This compared to $2.2 million of leases and $11.4 million of loans considered substandard at June 30, 2011. Although these substandard or doubtful leases and loans have been identified as potential problems, they may never become non-performing. These potential problem leases and loans are considered in the determination of the allowance for credit losses. The amount has fluctuated throughout the year ended June 30, 2012 as transactions have been reclassified and potential problems have been identified, with increases offset by payments received, re-classification as non-accrual or actual charge-offs.
Allowance for Credit Losses
The allowance for credit losses and the residual valuation allowance provide coverage for probable and estimatable losses in the Company’s lease and loan portfolios. The allowance recorded is based on a quarterly review of all leases and loans outstanding, loan commitments and transactions-in-process to determine that it is adequate to cover these inherent losses. The evaluation of each element and the overall allowance is based on a continuing assessment of problem credits, recent loss experience and other factors, including regulatory guidance and economic conditions. The Company utilizes similar processes to estimate its liability for unfunded loan commitments, which is included in other liabilities in the Consolidated Balance Sheets. Both the allowance for credit losses and the liability for unfunded loan commitments are included in the Company’s analysis of credit losses. Lease receivables, loans or residuals are charged off when they are deemed completely uncollectible. The determination of the appropriate amount of any provision is based on management’s judgment at that time and takes into consideration all known relevant internal and external factors that may affect the lease and loan portfolio.
The allowance for credit losses increased to $5.2 million (1.5% of net investment in leases and loans) at June 30, 2012 from $5.06 million (1.6% of net investment in leases and loans) at June 30, 2011. The allowance at June 30, 2012 consisted of $559,000 allocated to specific accounts that were identified as problems and $4.66 million that was available to cover losses inherent in the portfolio. This compared to $787,000 allocated to specific accounts at June 30, 2011 and $4.27 million that was available to cover losses inherent in the portfolio at such date. The allowance allocated to specific accounts decreased by $228,000 primarily due to the pay-off of almost $450,000 in problem receivables while few new specific problems were identified. At June 30, 2012, the volume of transactions-in-process was down 36% and the net investment in leases and loans before allowance was up 6% from the end of the prior year while the volume of unfunded commitments increased 26%. Based on the above factors, the Company considers the allowance for credit losses of $5.2 million at June 30, 2012 adequate to cover losses specifically identified as well as inherent in the lease and loan portfolios. However, no assurance can be given that the Company will not, in any particular period, sustain lease and loan losses that are sizeable in relation to the amount reserved, or that subsequent evaluations of the lease portfolio, in light of factors then prevailing, including economic conditions and the on-going credit review process, will not require significant increases in the allowance for credit losses. Among other factors, a continued economic slowdown may have an adverse impact on the adequacy of the allowance for credit losses by increasing credit risk and the risk of potential loss even further. As the Company has retained a significantly greater percentage of leases and loans in its own portfolio, this creates increased exposure to delinquencies, repossessions, foreclosures and losses than the Company has historically experienced.
Liquidity and Capital Resources
The Company funds its operating activities through internally generated funds, bank deposits and non-recourse debt. At June 30, 2012 and 2011, the Company’s cash and cash equivalents were $59.9 million and $97.3 million, respectively. Stockholders’ equity at June 30, 2012 was $196.4 million, or 40.4% of total assets, compared to $199.6 million, or 38.1% of total assets, at June 30, 2011. At June 30, 2012, the Company and the Bank exceed their regulatory capital requirements and are considered “well-capitalized” under guidelines established by the FRB and the OCC.
Deposits at CalFirst Bank totaled $253.3 million at June 30, 2012, compared to $274.8 million at June 30, 2011. The $21.5 million decrease was commensurate with the decrease in the Bank’s cash position offset by the decrease in the Bank’s loan portfolio. Deposit balances decreased 8% in fiscal 2012, but were up 23% from June 30, 2010. The Bank is competitive with major institutions in terms of its structure of interest rates, and generally offers interest rates on deposit accounts that are higher than the national average. Rates paid by the Bank on deposits have declined in varying degrees in response to the general decrease in market rates and the competitive environment. The following table presents average balances and average rates paid on deposits for years ended June 30, 2012, 2011 and 2010:
The following table shows the maturities of certificates of deposits at the dates indicated:
The Bank has borrowing agreements with the Federal Home Loan Bank of San Francisco and as such, can take advantage of FHLB programs for overnight and term advances at published daily rates. The Bank had no outstanding balance at June 30, 2012 and a balance of $10.0 million under the Federal Home Loan Bank agreement at June 30, 2011. Under terms of the blanket collateral agreement, advances from the FHLB are collateralized by qualifying securities and real estate loans, with $2.4 million available under the agreement as of June 30, 2012. The Bank also has the authority to borrow from the Federal Reserve Bank (“FRB”) discount window amounts secured by certain lease receivables with unused borrowing availability of approximately $86.9 million.
The Company periodically funds certain leases by assigning certain lease term payments to banks or other financial institutions, with the associated financing characterized as non-recourse debt. The assigned lease payments are discounted at fixed rates such that the lease payments are sufficient to fully amortize the aggregate outstanding debt. At June 30, 2012, the Company had outstanding non-recourse debt aggregating $3.8 million relating to property under leases assigned to unaffiliated parties. In the past, the Company has been able to obtain adequate non-recourse funding commitments, and the Company believes it will be able to do so in the future.
At June 30, 2012, CalFirst Leasing has a $15 million line of credit with a bank. The purpose of the line is to provide resources as needed for investment in transactions-in-process and leases. The agreement, as amended, provides for borrowings based on Libor, requires a commitment fee on the unused line balance and allows for advances through March 31, 2013. The agreement is unsecured, however, the Company guarantees CalFirst Leasing’s obligations. There were no borrowings under this line of credit as of June 30, 2012.
Contractual Obligations and Commitments
The following table summarizes various contractual obligations at June 30, 2012. Commitments to purchase property for unfunded leases are binding but generally have fixed expiration dates and other termination clauses. Commercial loan commitments are agreements to purchase participation or lend to a customer provided there is no violation of any condition in the contract. These commitments generally have fixed expiration dates or other termination clauses. Since the Company expects some of the commitments to expire without being funded, the total commitment amounts do not necessarily represent the Company’s future liquidity requirements.
The need for cash for operating activities will increase as the Company expands. The Company believes that existing cash balances, cash flow from operations, cash flows from its financing and investing activities, and assignments (on a non-recourse basis) of lease payments will be sufficient to meet its foreseeable financing needs.
Inflation has not had a significant impact upon the operations of the Company.
Recent Accounting Pronouncements
See Note 1, “Summary of Significant Accounting Policies,” of the Company’s consolidated financial statements for disclosure of recent accounting pronouncements.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the risk of loss in a financial instrument arising from changes in market indices such as interest rates and equity prices. The Company’s principal market risk exposure is interest rate risk, which is the exposure due to differences in the repricing characteristics of interest-earning assets and interest-bearing liabilities. Market risk also arises from the impact that fluctuations in interest rates may have on security prices that may result in changes in the values of financial instruments, such as available-for-sale securities that are accounted for at fair value. As the banking operations of the Company have grown and securities and deposits represent a greater portion of the Company’s assets and liabilities, the Company is subject to increased market risk. The Bank has an Asset/Liability Management Committee and policies established to manage its interest rate and market risk.
At June 30, 2012, the Company had $28.9 million of cash or invested in securities of very short duration, with another $11.2 million of securities that mature within twelve months. The Company’s gross investment in lease payments receivable and loan principal of $361.9 million consists of leases with fixed rates and loans with fixed and variable rates, however, $197.9 million of such investment is due within one year of June 30, 2012. This compares to the Bank’s interest bearing deposit liabilities of $253.3 million, of which 86.3%, or $218.7 million, mature within one year. CalFirst Leasing has no interest-bearing debt, and non-recourse debt does not represent an interest rate risk to the Company because it is fully amortized through direct payments from lessees to the purchaser of the lease receivable. Based on the foregoing, at June 30, 2012 the Company had assets of $267.9 million subject to changes in interest rates over the next twelve months, compared to repricing liabilities of $218.7 million.
The consolidated gap analysis below sets forth the maturity and repricing characteristics of interest-earning assets and interest-bearing liabilities for selected time bands. The mismatch between repricings or maturities within a time band is commonly referred to as the “gap” for that period. A positive gap (asset sensitive) where interest rate sensitive assets exceed interest rate sensitive liabilities generally will result in the net interest margin increasing in a rising rate environment and decreasing in a falling rate environment. A negative gap (liability sensitive) will generally have the opposite result on the net interest margin. However, the traditional gap analysis does not assess the relative sensitivity of assets and liabilities to changes in interest rates and other factors that could have an impact on interest rate sensitivity or net interest income. Sudden and substantial increase or decrease in interest rates may adversely impact our income to the extent that the interest rates associated with the assets and liabilities do not change at the same speed, to the same extent, or on the same basis.
Consolidated Interest Rate Sensitivity
In addition to the consolidated gap analysis, the Bank measures its asset/liability position through duration measures and sensitivity analysis, and calculates the potential effect on earnings using maturity gap analysis. The interest rate sensitivity modeling includes the creation of prospective twelve month "baseline" and "rate shocked" net interest income simulations. After a "baseline" net interest income is determined, using assumptions that the Bank deems reasonable, market interest rates are raised or lowered by 100 to 300 basis points instantaneously, parallel across the entire yield curve, and a "rate shocked" simulation is run. Interest rate sensitivity is then measured as the difference between calculated "baseline" and "rate shocked" net interest income.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The following financial statements and supplementary financial information are included herein at the pages indicated below: