ITEM 1: BUSINESS.
THE COMPANY
First State Bancorporation is a New Mexico-based bank holding company that provides commercial banking services to small- and medium-sized businesses through its subsidiary bank, First State Bank of Taos ("First State Bank" which, together with First State Bancorporation, is referred to herein as the "Company" unless the content indicates otherwise). The Company operates three offices in Taos, five offices in Albuquerque, two offices in Santa Fe, and one office each in Rio Rancho, Los Lunas, Bernalillo, Questa, Placitas, and Moriarty, New Mexico. First State Bank, the largest bank in Taos County, has operated in the county since 1922. The Company acquired three Albuquerque branches in 1991 by merging the business operations of First State Bank with an affiliated bank. The Company entered the Santa Fe market with the acquisition of First State Bank of Santa Fe (the "Santa Fe Bank") on December 1, 1993. The Santa Fe Bank was merged into First State Bank on June 5, 1994. See " -- History." At December 31, 1998, the Company had total assets, total deposits, and total stockholders' equity of $493.7 million, $409.0 million, and $44.2 million, respectively.
Management's strategy is to provide a business culture in which customers are provided individualized customer service. As part of its operating and growth strategies, the Company is working to (i) place greater emphasis on attracting core deposits from, and providing financial services to, small and medium-sized businesses; (ii) expand operations in the Albuquerque metropolitan area, which consists of Albuquerque, Rio Ranchos, and Los Lunas; Santa Fe, and other strategic areas in New Mexico; (iii) improve asset quality through reductions in nonperforming assets and strict adherence to credit administration standards; (iv) manage interest rate risk; (v) continue to improve internal operating systems; and (vi) manage non-interest expenses.
Management believes that the Company is well qualified to pursue an aggressive growth strategy throughout New Mexico due to its responsive customer service, its streamlined management structure, the strong community involvement of the Company's management and employees, and recent trends in the New Mexico banking environment. Continued consolidation in the banking industry has led to the acquisition of banks with significant market share in New Mexico by large out-of-state institutions. See "--Growth Strategy." Management believes that, in many cases, the acquiring institutions have shifted the focus of the acquired banks away from the small- and medium-sized businesses that are at the core of the Company's marketing efforts. The Company intends to capitalize on this environment by expanding internally and through de novo branching opportunities, and select acquisitions.
Management believes that the changes in the competitive environment have created expansion opportunities for the Company. These opportunities are primarily centered in the Albuquerque metropolitan area, and Santa Fe markets. The Company has added staff to service the additional volume of loans and deposits obtained as a result of expansion in these marketplaces. The level of any additional staffing and related expenses will depend on the magnitude of continued growth. In addition, the Company will consider potential acquisition targets that complement the Company's existing operations and provide economies of scale when combined with its existing locations. See "--Growth Strategy."
At December 31, 1998, First State Bank was "well capitalized" under regulatory capital guidelines.
The Company's executive offices are located at 7900 Jefferson NE., Albuquerque, New Mexico 87109, and its telephone number is (505) 241-7500.
HISTORY
The Company and an affiliated company, New Mexico Bank Corporation, were formed in 1988 to acquire banking institutions in New Mexico. In December 1988, the Company acquired First State Bank, and New Mexico Bank Corporation acquired National Bank of Albuquerque ("NBA"). After a change in New Mexico banking laws in 1991, the Company and New Mexico Bank Corporation merged, and the operations of NBA were merged into First State Bank in December 1991.
At the time of its acquisition, First State Bank had high levels of non-interest expense and problem assets relative to total assets and an unacceptable record of loan charge-offs. To address these problems, Michael R. Stanford, who had been appointed President of First State Bank in April 1988 and is President of the Company, and his management team focused on (i) strengthening underwriting standards and increasing senior management involvement in loan approvals, (ii) pursuing an aggressive policy of foreclosing upon nonperforming loans and selling the underlying collateral, and (iii) implementing expense and overhead reductions, including eliminating two unprofitable branch offices and one redundant branch and reducing staffing levels in the remaining three branches.
On December 1, 1993, the Company purchased 94.5% of the outstanding shares of common stock of the Santa Fe Bank. These selling shareholders included members of the current management and directors of the Company, and two officers of First State Bank.
Since its initial public offering in 1993, the Company has made significant investments in expansion and technology. Since 1993, First State Bank has opened eight new branches which have contributed $158.8 million in deposits and $101.9 million in loans.
OPERATING STRATEGY
The Company's operating strategies include:
. Providing responsive, personal customer service . Attracting new account relationships . Emphasizing community involvement . Developing new business opportunities . Increasing efficiency . Optimizing asset/liability management
Customer service. The Company's objective is to increase market share in both lending volume and deposits by providing responsive customer service that is tailored to its customers' needs. By maximizing personal contact with customers, maintaining low employee turnover, and endeavoring to understand the needs and preferences of its customers, the Company is working to maintain and further enhance its reputation of providing excellent customer service, allowing it to achieve its growth and earnings goals.
The Company has developed a streamlined management structure that allows it to make credit and other banking decisions rapidly. Management believes that this structure, when compared to other competing institutions, enables the Company to provide a higher degree of service and increased flexibility to creditworthy customers.
New account relationships. The Company's strategy is to increase its emphasis on relationship banking with small- and medium-sized businesses and individual customers across all product lines. The acquisition of most of the Company's local competitors by out-of-state banking companies has reduced the service level offered to customers of those banks and has created an opportunity for the Company to expand its customer base. The Company intends to capitalize on this opportunity by targeting its marketing efforts to those businesses and individuals who prefer the personalized customer service emphasized by the Company.
Community Involvement. First State Bank management and other employees participate actively in a wide variety of civic and community activities and organizations, including local chambers of commerce, a board of education, United Way, Boys and Girls Clubs, and Habitat for Humanity. First State Bank also sponsors a number of community-oriented events each year. The Company believes that these activities assist First State Bank through increased visibility and through development and maintenance of customer relationships.
New Business Opportunities. The Company has and will continue to consider a variety of new banking opportunities, whether through the opening of de novo branches, acquisition of an existing commercial bank or bank holding company, or other opportunities permissible under state and federal banking regulations. Expansion efforts will be focused in areas or markets that are complementary to First State Bank's existing customer base and areas of operation. See "--Growth Strategy."
Increasing Efficiency. Management believes that investments in technology and facilities made since 1993 will allow the Company to grow revenues significantly faster than expenses over the next few years. Management believes these investments will allow the Company to expand its asset base without a commensurate increase in non-interest expense.
Asset/Liability Management. The Company's asset/liability management policy is designed to provide stable net interest income growth by protecting its earnings from undue interest rate risk. The Company maintains a strategy of keeping the rate adjustment period on the majority of both assets and liabilities to an earning neutral position, with a substantial amount of these assets and liabilities adjustable in 90 days or less. See Item 7: "Management's Discussion and Analysis of Financial Condition and Results of Operations--Asset/Liability Management."
GROWTH STRATEGY
The Company expects to pursue an aggressive growth strategy through a combination of internal growth, de novo branching, and select acquisitions. Several banks that compete with the Company have been acquired by large out-of-state financial institutions since 1993. Management believes that these changes in the competitive environment have caused the acquired banks to significantly alter their operating procedures and their approach to customer service, affording the Company an opportunity to gain profitable new account relationships and to expand existing relationships.
In addition, management believes that there may be attractive opportunities to open new branches and acquire branches of existing or merged institutions in New Mexico. Consolidation in the banking industry and increased regulatory burdens on existing institutions provide a favorable environment for such openings and acquisitions. Management considers a variety of criteria when evaluating potential branch expansion, including (i) the short- and long-term growth prospects for the location, (ii) the management and other resources required to integrate the operations, if desirable, (iii) the degree to which the branch would enhance the geographic diversification of the Company, (iv) the degree to which the branch would enhance the Company's presence in an existing market, and (v) the costs of operating the branch. The Company plans to open two new branches in 1999, one on Albuquerque's westside in the second quarter and one in Belen, a community approximately
35 miles south of Albuquerque, early in the third quarter. An additional future branch site has been acquired in Santa Fe.
The Company's goal over the next five years is to create a broad-based, well-capitalized, customer-focused New Mexico financial institution with assets of $600.0 million to $1.0 billion. Management believes that a financial institution of this size is large enough to meet the needs of most customers, yet small enough to deliver personal, high-quality service. To accommodate the Company's anticipated growth, management intends to further develop the existing management of the Company and further develop its management information systems and other appropriate internal management systems. There can be no assurance, however, that the Company will achieve its growth objectives.
MARKET AREAS AND BANKS
Markets. First State Bank serves three distinct market areas within New Mexico: Taos County, the Albuquerque metropolitan area, and Santa Fe. Taos County is a popular year-round recreation and tourist area. Ski and golf resorts in the area attract visitors from throughout the southwestern and western United States. Taos also has an active art community catering to the tourist trade.
The Albuquerque metropolitan area is the largest metropolitan area in New Mexico and is the financial center of the state. It has a diverse economy centered around federal and state government, military, service, and industries of technology. Military facilities include Kirtland Air Force Base and Sandia National Laboratories. A number of companies, including Intel, Lockheed Martin, Taco Bell, Sumitomo, General Mills, America On Line and Victoria's Secret, have initiated or expanded operations in the area in the past several years.
Santa Fe is the state capital of New Mexico. Its principal industries are government and tourism. Like Taos, Santa Fe is widely known for its southwestern art galleries and amenities, including the Santa Fe Opera. Santa Fe is one of the largest art markets in the United States, attracting visitors from all parts of the United States and many foreign countries.
First State Bank. The following table sets forth certain information concerning the banking offices of First State Bank as of December 31, 1998:
Total Number of Total Loans and Location facilities Deposits Leases - ---------------------------------- ------------ ---------- ----------- (Dollars in the thousands) First State Bank: Taos ........................ 4 $ 91,658 $ 41,335 Santa Fe .................... 2 82,948 47,152 Albuquerque.................. 5 159,456 174,821 Los Lunas ................... 2 24,429 34,970 Rio Rancho .................. 3 58,604 36,741 ------------ ---------- ----------- Total.................. 16 $417,095 $335,019 ============ ========== ===========
First State Bank offers a full range of financial services to commercial and individual customers, including checking accounts, short- and medium-term loans, revolving credit facilities, inventory and accounts receivable financing, equipment financing, residential and small commercial construction lending, commercial leases, various savings programs, installment and personal loans, safe deposit services, and credit cards.
The Taos locations provide conventional commercial and SBA loans to established commercial businesses and businesses that support the tourism and skiing industries. The Taos branches also provide a broad range of consumer banking services, including a full complement of deposit and residential construction and other loan services.
The Albuquerque metropolitan area locations primarily serve established commercial businesses and individuals who may require a full range of banking services. In addition to an emphasis on conventional commercial and SBA lending, these locations are active in residential construction lending in the Albuquerque metropolitan area.
The Santa Fe locations primarily serve a diverse group of small- to medium-sized business and individual customers, including commercial businesses that support the tourism industry.
The following is a summary of the Company's percentage of its deposits to total deposits of FDIC insured institutions in the counties in which it does business as of June 30, 1998:
Taos..................... 40.33% Bernalillo............... 3.19% Santa Fe................. 6.89% Sandoval................. 15.32% Valencia ................ 6.01% Torrance ................ 2.03%
Management believes that its greatest opportunity for growth is in Bernalillo, Santa Fe, Valencia, and Sandoval counties. First State Bank is the largest bank in Taos County, and growth in that market is expected to come from economic growth and not as a result of increased market share.
COMPETITION
First State Bank competes for loans, leases, and deposits with other commercial banks, savings banks, savings and loan associations, credit unions, finance companies, mutual funds, insurance companies, brokerage and investment banking firms, asset-based non-bank lenders, governmental organizations, and other institutions with respect to the scope and type of services offered, interest rates paid on deposits, and pricing of loans, among other things. Many of these competitors have significantly greater financial and other resources than the Company. First State Bank also faces significant competition for investors' funds from sellers of short-term money market securities and other corporate and government securities.
First State Bank competes for loans and leases principally through the range and quality of its services, interest rates, and loan fees. First State Bank believes its personal-service philosophy enables it to compete favorably with other financial institutions in its focus market of small- and medium-sized businesses. First State Bank actively solicits deposit-related clients and competes for deposits by offering customers personal attention and professional service.
EMPLOYEES
As of December 31, 1998, the Company had 226 full-time equivalent employees. The Company places a high priority on staff development, training, and selective hiring. New hires are selected on the basis of both technical skills and customer-service capabilities. Staff development involves intensive training in marketing,
customer service, and regulatory compliance. None of the Company's employees is covered by a collective bargaining agreement with the Company, and management believes that its relationship with its employees is good.
OTHER
For a discussion of asset/liability management, the investment portfolio, loan portfolio, nonperforming assets, allowance for loan losses, and deposits see Item 7: "Management's Discussion and Analysis of Financial Condition and Results of Operations."
ITEM 2:
ITEM 2: PROPERTIES.
With the exception of its Main and Southside facilities in Taos, the Journal Center facility in Albuquerque, and the Bernalillo facility, which are owned by First State Bank, the Company leases its banking facilities. See Item 13: "Certain Relationships and Related Transactions." The following table shows the size and age of each of the banking facilities owned or leased by the Company:
ITEM 3:
ITEM 3: LEGAL PROCEEDINGS
Periodically and in the ordinary course of business, various claims and lawsuits are brought against the
Company, such as claims to enforce liens, condemnation proceedings on properties in which the Company holds security interests, claims involving the making and servicing of real property loans, and other issues incident to the Company's business. In the opinion of the Company's management, the ultimate liability, if any, resulting from such claims or lawsuits will not have a material adverse effect on the financial position or results of operations of the Company.
ITEM 4:
ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
No matters were submitted to a vote of the Company's security holders during the fourth quarter of 1998.
PART II
ITEM 5:
ITEM 5: MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
PRICE RANGE OF COMMON STOCK
The Company's Common Stock is traded on The Nasdaq Stock Market's National Market under the symbol "FSNM." The following table sets forth, for the periods indicated, the high and low closing sale prices on The Nasdaq Stock Market's National Market as reported by Nasdaq. The Company's Common Stock commenced trading on November 3, 1993. The quotations in the over-the-counter market reflect inter-dealer prices, without retail markup, markdown, or commissions and may not necessarily represent actual transactions.
High Low ----------------------------------- ---- First Quarter............. $27.75 $18.75 Second Quarter............ 27.38 22.75 Third Quarter............. 25.00 17.00 Fourth Quarter............ 21.00 16.50 ---- First Quarter............. $16.13 $14.50 Second Quarter............ 17.50 12.88 Third Quarter............. 20.50 16.50 Fourth Quarter............ 21.63 17.00 ---- First Quarter............. $12.75 $11.25 Second Quarter............ 13.00 10.88 Third Quarter............. 14.00 12.25 Fourth Quarter............ 15.25 13.25
The last reported sale price of the Company's Common Stock on March 15,1999, was $19.313 per share. As of March 15,1999, there were approximately 88 shareholders of record, not including shareholders who beneficially own Common Stock held in nominee or street name.
DIVIDEND POLICY
The Company paid cash dividends of $790,306 or $0.25 per share in 1998, $522,870 or $0.21 per share in 1997, and $408,489 or $0.20 per share in 1996, which amounted to 18.76% , 15.70%, and 19.82% of net income in 1998, 1997, and 1996, respectively. The declaration and payment of cash dividends are determined by the Board of Directors in light of the earnings, capital requirements, and financial condition of the Company, and other relevant factors. The ability of the Company to pay cash dividends depends on the amount of cash dividends paid to it by First State Bank and the capital position of the Company. Capital distributions, including dividends, by First State Bank are subject to federal and state regulatory restrictions tied to its earnings and capital.
ITEM 6:
ITEM 6: SELECTED FINANCIAL DATA.
Selected Financial Data are filed as part of this report and appear immediately following the signature page.
ITEM 7:
ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Management's Discussion and Analysis of Financial Condition and Results of Operations are filed as part of this report and appear immediately following Selected Financial Data.
ITEM 7A:
ITEM 7A: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Quantitative and Qualitative Disclosures About Market Risk are filed as part of this report and appear within Management Discussion and Analysis of Financial Condition and Results of Operations under the caption Asset/Liability Management.
ITEM 8:
ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The Company's financial statements are filed as a part of this report and appear immediately following the Management's Discussion and Analysis of Financial Condition and Results of Operations.
ITEM 9:
ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
PART III
ITEM 10:
ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The following table sets forth information concerning the directors and executive officers of the Company.
_________________ (1) Member of Executive Committee (2) Member of Audit Committee (3) Member of Compensation Committee
Each officer of the Company serves at the discretion of the Board of Directors. There are no family relationships among any of the directors, officers, or key employees of the Company. The current authorized number of directors of the Company is ten.
Michael R. Stanford, a Director of the Company since its organization in 1988, is President and Chief Executive Officer of the Company and First State Bank. Mr. Stanford's entire career has been in the banking
industry. Prior to joining First State Bank in 1987, Mr. Stanford spent five years with New Mexico Banquest Corporation as Senior Vice President in charge of loan administration. Mr. Stanford is a past director of the New Mexico Bankers Association. In addition, Mr. Stanford is involved in a variety of civic organizations.
H. Patrick Dee has been a Director of the Company since 1991 and presently serves as Executive Vice President, Chief Operating Officer, and Secretary/Treasurer of the Company, and Executive Vice President and Chief Operating Officer of First State Bank, a position he has held since December 1991. Prior to joining the Company, Mr. Dee spent four years with New Mexico Banquest Corporation and, after its acquisition by Livingston & Co. Southwest, LP in 1988, with NBA. In 1989, Mr. Dee became Senior Vice President and Chief Financial Officer of Livingston & Co. Southwest, LP. Mr. Dee is a certified public accountant.
Brian C. Reinhardt, a Senior Vice President and Chief Financial Officer of the Company since 1995, joined First State Bank in September 1994. Prior to joining First State Bank, Mr. Reinhardt was a Senior Manager with KPMG, LLP. Mr. Reinhardt joined KPMG, LLP in 1984.
Eloy A. Jeantete, a Director of the Company since August 1993 and Chairman of the Board since January 1994, joined First State Bank 50 years ago as a bookkeeper and has spent his entire working career with First State Bank rising to his present position of Chairman of the Board of the Company. As a lifetime resident of Taos, N.M., Mr. Jeantete has accumulated a long list of civic achievements and community involvement, culminating with his election in 1990 as Mayor of Taos, New Mexico, a position he held until March 1994.
Leonard J. DeLayo, Jr., a Director of the Company since November 1993, served as a director of First State Bank from 1988 to January 1992. Mr. DeLayo has been engaged in a general corporate and commercial law practice in New Mexico since 1974 and is the President and sole shareholder of Leonard J. DeLayo, Jr., P.C., which currently provides legal services to the Company and First State Bank as outside counsel. Mr. DeLayo serves on the Albuquerque Board of Education. See "Certain Business Relationships--Legal Services."
Bradford M. Johnson, a Director of the Company since November 1993, is President of Heron Hill Corporation, a private company engaged in investments and financial consulting. From 1991 to November 1993, Mr. Johnson was a partner and Director of Research of Sterne, Agee & Leach, Inc., an investment banking firm in Atlanta, Georgia. Mr. Johnson studied at the University of Paris-Sorbonne from 1987 to 1991.
Douglas M. Smith, M.D., a Director of the Company since November 1993, is a Board Certified radiologist and the owner/general partner of The Historic Taos Inn, Taos, New Mexico. Dr. Smith is the co-founder and former President of Palm Beach Imaging, Inc., West Palm Beach, Florida, and a former member of the Board of Directors of the PIE Medical Insurance Co., a physician-owned medical malpractice insurance company headquartered in Cleveland, Ohio.
Herman N. Wisenteiner, a Director of the Company since November 1993, is President and Chief Executive Officer of Horn Distributing Company, a real estate holding company which he founded in 1971 in Santa Fe, New Mexico. In addition to his many civic activities in northern New Mexico, from 1984 to 1993 Mr. Wisenteiner was also Chairman and Chief Executive Officer of CLX Exploration Inc., a publicly traded oil and natural gas exploration and production company headquartered in Denver, Colorado and served as a Director of First Interstate Bank, Santa Fe, New Mexico from 1980 to 1993. See "Certain Business Relationships--Santa Fe Branch Location."
Marshall G. Martin, a Director of the Company since June 1997, is a senior partner with the law firm of Hinkle, Cox, Eaton, Coffield & Hensley LLP, a position he has held since June 1997, and prior to January of 1997. For the period from January 1997 through June 1997 Mr. Martin was Vice President-General Counsel of Solv-Ex Corporation which filed for chapter 11 bankruptcy reorganization in August 1997 and which emerged from bankruptcy in 1998. Hinkle, Cox, Eaton, Coffield & Hensley LLP, is the Company's corporate counsel. See "Certain Business Relationships--Legal Services." Mr. Martin is involved in a variety of civic organizations.
Kevin L. Reid, was appointed by the Board of Directors to fill a vacancy created by the resignation of Manuel Lujan, Jr. Mr. Reid will complete the term created by that resignation which runs until the 1999 annual meeting. Mr. Reid is President and Owner of Reid & Associates, a design/build construction company, a position he has held since 1997, when he assumed the presidency of Reid & Elliott and changed the name of the Company to Reid & Associates. Mr. Reid co- founded Reid and Elliott in 1991.
COMMITTEES
The Board of Directors has an Executive Committee, an Audit Committee and a Compensation Committee. The members of the Audit Committee and Compensation Committee are outside directors.
COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT
Section 16(a) of the Securities Exchange Act of 1934 requires the Company's officers, directors, and persons who own more than 10% of a registered class of the Company's equity securities and certain other affiliated persons to file reports of ownership and changes in ownership with the Securities and Exchange Commission and the National Association of Securities Dealers, Inc. Officers, directors, and greater than 10% shareholders are required by SEC regulations to furnish the Company with copies of all Section 16(a) forms they file.
Based solely on review of the copies of such forms furnished to the Company, or written representations that no other forms were required, the Company believes that during the fiscal year ended December 31, 1998, all Section 16(a) filing requirements applicable to its officers, directors, and greater than 10% beneficial owners were complied with.
ITEM 11:
ITEM 11: EXECUTIVE COMPENSATION.
The following tables set forth the compensation paid by the Company to the three executive officers of the Company and one officer of the bank subsidiary who received in excess of $100,000 in cash compensation.
- ------------------------------ (1) Represents insurance premiums paid by the Company on behalf of the employee, amounts contributed by the Company to the employee's Section 401(k) plan, auto allowance, and dues.
Aggregated Option Exercises in Fiscal Year and Fiscal Year-End Options Value
- ------------------------------- (1) The closing price of the Company's Common Stock on December 31, 1998, was $20.75 per share.
- --------------------------
EXECUTIVE INSURANCE
First State Bank has key-person insurance policies on each of Messrs. Stanford and Dee. Under these policies, First State Bank is named as beneficiary of $577,865 of term life insurance on Mr. Stanford and $321,516 of term life insurance on Mr. Dee (the "Term Life Policies"). In addition, First State Bank also pays the premiums on $922,135 of additional whole life insurance for Mr. Stanford and $878,484 for Mr. Dee under which each of these individuals is able to name the beneficiary (the "Whole Life Policies"). Under the provisions of the Term Life Policies the amount of term insurance under each policy is gradually decreased over a period of 10 years. However, First State Bank's premium payments are kept level during the entire 10 year period with the excess premiums from the Term Life Policies being applied to the Whole Life Policies. As a result of the increasing portion of the premiums which are allocated to the Whole Life Policies, at the end of the 10 year period the Whole Life Policies are fully paid. Upon termination of employment, the Whole Life Policies would be transferable to Messrs. Stanford or Dee, as the case may be, who could elect to continue making the premium payment if such termination occurred prior to the tenth year of the policy. The annual premium which will be paid for the Whole Life Policies will constitute compensation to such individuals.
STOCK OPTION AGREEMENT
Under the terms of a stock option agreement, Michael R. Stanford can exercise an option to purchase 6,612 shares of Common Stock at a price of $5.01 per share. As originally granted, the option allowed Mr. Stanford to purchase up to 10% of the common stock of New Mexico Bank Corporation ("NMBC"), the parent holding company of NBA, at the book value of the NMBC common stock as of November 19, 1990. In December 1991, the option was converted to an option to purchase the Company's Common Stock when
NMBC was merged into the Company. The option may be exercised at any time by Mr. Stanford and will expire on October 12, 2003.
EXECUTIVE INCOME PROTECTION PLAN
The Company has an Executive Income Protection Plan (the "Plan") with the following participants: H. Patrick Dee, Brian C. Reinhardt, and Michael R. Stanford, which provides for benefits upon a Control Change. Following a Control Change (as defined in the Plan), the Plan provides for a three-year employment term and specifies the employee's position, salary, bonus, and benefits payable during that period. If the employee (i) resigns; (ii) is discharged for any reason other than cause, death, or disability; (iii) experiences a Reduction in Position (as defined in the Plan) within a three-year period beginning on the date of the Control Change, then the employee shall have income protection benefits consisting of (a) a compensation benefit, payable in a single sum, equal to three times his Compensation (as defined in the Plan) in the case of Messrs. Dee and Stanford and two times his Compensation in the case of Mr. Reinhardt; (b) the same level of fringe benefits as existed on the date of the Control Change for a period ending three years after the Control Change including, without limitation, any plan or arrangement to receive and exercise stock options and/or stock appreciation rights, restricted stock or grants thereof in which the employee is participating on the date of the Control Change (or plans or arrangements providing him with substantially similar benefits); (c) an amount equal to the employee's non-vested accrued benefit in the Company's retirement plans, determined as of the last valuation date under such plans, if the employee is not fully vested under the terms of such plans; (d) up to a maximum of 30 percent of his Compensation for out-placement services for the employee; and (e) a lump sum payment at the same time as the compensation payment described in (a) above, if the Company has purchased a split-dollar life insurance policy on the life of an employee.
"Control Change" is defined in the Plan as (i) a sale or sales (including an exchange) of shares of the Company, other than pursuant to a public offering, at one or more times by the Company, a stockholder or stockholders of the Company, or by any combination of the foregoing, which in the aggregate results in the beneficial ownership of more than 50% of the combined voting power of the Company's outstanding securities after the sale or sales by one or more stockholders who were not stockholders of the Company on April 19, 1996 (the effective date of the Plan), and who were not controlled after the sale or sales, directly or indirectly, by one or more of the stockholders of the Company on April 19, 1996; (ii) a sale or sales by the Company of all or substantially all of its assets to one or more persons or entities who were not stockholders of the Company on April 19, 1996, and who are not controlled after the sale or sales, directly or indirectly, by one or more of such stockholders; or (iii) a merger or other combination in which the Company is either the surviving or disappearing corporation, which results in the beneficial ownership of more than 50% of the combined voting power of the outstanding securities of the surviving corporation by one or more persons or entities which were not stockholders of the Company on April 19, 1996, and which are not controlled after such merger or other combination, directly or indirectly, by one or more of such stockholders; (iv) the approval by the stockholders of the Company of any plan or proposal to liquidate or dissolve the Company; or (v) during any period of two consecutive years, individuals who at the beginning of the period constitute the entire Board of Directors of the Company cease for any reason to constitute a majority thereof, unless the election or the nomination for election by the Company's stockholders of each new director was approved by a vote of at least two-thirds of the directors then still in office who were directors at the beginning of the period.
"Compensation" means the sum of; (i) the employee's average taxable compensation from the Company; (ii) the employee's average elective salary reduction contributions to plans under Internal Revenue Code (the "Code") Sections 401(k) and/or 125; and (iii) the productof the average percentage of covered payroll contributed by the Company to the Company's 401(k) profit sharing plan multiplied by the sum of (i) and (ii) in each case for the five calendar years preceding the Control Change.
"Reduction in Position" shall occur if an employee (i) is removed as an officer or director; (ii) experiences a significant decrease in managerial or supervisory authority; (iii) experiences a reduction in salary or bonus;
(iv) is required by the Company to relocate to an office more than 50 miles from his location before the Control Change; (v) is reduced in the rate of his awards under any stock option plan in effect before the Control Change; (vi) experiences a material adverse change in his terms and conditions of employment.
The Plan provides that the employees will be entitled to a gross-up payment if it is determined that any payment would be subject to the excise tax imposed by Section 4999 of the Code. The Plan also provides for the Company to pay the employee's legal fees incurred in any contest relating to the Plan and certain other indemnifications to the extent permitted under applicable New Mexico or federal law and under the Company's Bylaws and Articles of Incorporation.
The aggregate cost to the Company of the requirements for payments to employees covered under the Plan (including the cost of early vesting under employee plans) would not exceed $2.5 million.
COMPENSATION OF DIRECTORS
Each director who is not an employee of the Company (the "Outside Directors") is paid an annual fee of $3,000 and a per meeting fee of $500 and will be reimbursed for expenses incurred in attending meetings of the Board of Directors and the committee meetings of the Board of Directors.
SECTION 401(K) PLAN
In 1991 the Company adopted a tax-qualified profit sharing 401(k) plan (the "Saving Plan") covering all employees who have attained 21 years of age and have completed one year of service with the Company. Each participant in the Saving Plan may reduce his or her salary by as much as the lesser of 20% of his or her compensation or $10,000, in 1998. The dollar limit is adjusted each year for inflation. The Company is required to make matching contributions of up to 50% of the first 6% of a participant's deferred compensation up to a maximum of 3%. The Company may, but is not required to, contribute additional amounts to the Saving Plan. Any such additional amounts are allocated to the accounts of participants who were active participants on the last day of the plan year or who retired or died or were disabled during the plan year. The allocation is in proportion to the eligible participants' compensation. During 1998, 1997, and 1996, First State Bank made contributions to the Saving Plan of approximately $146,000, $125,000, and $106,000, respectively.
All contributions by a participant are 100% vested and non-forfeitable at all times. The Company's contributions become 100% vested after three years of service with the Company. A participant may direct the investment of his or her account pursuant to the investment options offered by the trustee of the Saving Plan. Distribution of a participant's account under the Saving Plan normally occurs upon the participant's retirement or the participant's termination of employment with the Company.
INCENTIVE PLANS
Effective October 5, 1993, the Company adopted the First State Bancorporation 1993 Stock Option Plan (the "Stock Option Plan"), which provides for the granting of options to purchase up to 400,000 shares of the Company's common stock. Exercise dates and prices for the options are set by a committee of the Board of Directors. The Stock Option Plan also provides that options other than those qualifying as incentive stock options may be granted.
The Stock Option Plan is administered by a committee composed of disinterested members of the Board of Directors (the "Committee"). Subject to the terms of the Stock Option Plan, the Committee determines the persons to whom awards are granted, the type of award granted, the number of shares granted, the vesting schedule, the type of consideration to be paid to the Company upon exercise of options, and the term of each option (not to exceed ten years).
Under the Stock Option Plan, the Company may grant both incentive stock options ("incentive stock options") intended to qualify under Section 422 of the Internal Revenue Code of 1986, as amended (the "Code"), and options which are not qualified as incentive stock options ("non-qualified stock options"). Incentive stock options must be granted at an exercise price equal to or greater than the fair market value of the Common Stock on the date of grant. The exercise price of non-qualified stock options granted under the Stock Option Plan will be determined by the Committee on the date of grant. The exercise price of incentive stock options granted to holders of more than 10% of the Common Stock must be at least 110% of the fair market value of the Common Stock on the date of grant, and the term of these options may not exceed five years.
The Stock Option Plan provides that the total number of shares covered by the plan, the number of shares covered by each option, and the exercise price per share may be proportionately adjusted by the Board of Directors or the Committee in the event of a stock split, reverse stock split, stock dividend, or similar capital adjustment effected without receipt of consideration by the Company.
Upon a change in control of the Company, stock options outstanding under the Stock Option Plan immediately become fully vested and exercisable. Also, in the event of a merger or consolidation in which the Company is not the surviving corporation, the sale of all or substantially all of the Company's assets, certain reorganizations or the liquidation of the Company, each option granted under the Stock Option Plan may, at the election of the holder, become immediately exercisable.
ITEM 12:
ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The following table sets forth certain information regarding beneficial ownership of the Company's Common Stock as of March 15, 1999, by (i) each shareholder known by the Company to be the beneficial owner of more than 5% of the outstanding Common Stock, (ii) each director of the Company, and (iii) all directors and executive officers as a group. Unless otherwise indicated, based on information furnished by such owners, the Company believes that the stockholders listed below have sole investment and voting power with respect to their shares. Unless otherwise indicated, the address of such person is the Company's address, 7900 Jefferson NE., Albuquerque, New Mexico 87109.
- ------------------------------------------ * Less than 1% (1) Represents the aggregate shares held by Hovde Capital, Inc. and its affiliates: Financial Institution Partners, LP, Financial Institution Partners II, LP, Hovde Capital, LLC, and Hovde Acquisition, LLC. (2) Includes 6,612 shares that are subject to an option exercisable at $5.01 per share, 62,500 shares that are subject to an option which is exercisable at $8.40 per share, and 8,000 shares that are subject to an option exercisable at $17.25 per share. (3) Includes 43,750 shares that are subject to an option which is exercisable at $8.40 per share, and 4,000 shares that are subject to an option exercisable at $17.25 per share. (4) Includes 12,500 shares that are subject to an option which is exercisable at $8.40 per share. (5) Includes 2,000 shares that are subject to an option which is exercisable at $8.40 per share, and 4,000 shares that are subject to an option exercisable at $17.25 per share.
ITEM 13:
ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
CREDIT TRANSACTIONS
The executive officers, directors and principal stockholders of the Company and the Bank, and members of their immediate families and businesses in which these individuals hold controlling interests, are customers of the Bank and it is anticipated that such parties will continue to be customers of the Bank in the future. Credit transactions with these parties are subject to review by the Bank's Board of Directors. All outstanding loans and extensions of credit by the Bank to these parties were made in the ordinary course of business on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons, and in the opinion of management did not involve more than the normal risk of collectability or present other unfavorable features. At December 31, 1998, the aggregate balance of the Bank's loans and advances under existing lines of credit to these parties was $1,157,068, or 0.35% of the Bank's total loans. All payments of principal and interest on these loans are current. These loans represented 2.62% of the Company's equity as of December 31, 1998.
LEGAL SERVICES
Mr. DeLayo was a director of First State Bank from 1988 through January 1992, was a director of the Santa Fe Bank from March 1993 to June 1994 and was appointed as a director of the Company in November 1993. Mr. DeLayo acts as general counsel to the Company and First State Bank. Mr. DeLayo and his firm, Leonard J. DeLayo, P.C., are involved in representing the Company in numerous collection matters. The Company paid Mr. DeLayo's firm approximately $219,000, $205,000, and $146,000 for its services in 1998, 1997 and 1996.
Marshall G. Martin was elected to the Board as a director in June 1997. Mr Martin is a partner in the firm of Hinkle, Cox, Eaton, Coffield & Hensley, LLP, which serves as the Company's corporate counsel. The Company paid Hinkle, Cox, Eaton, Coffield & Hensley, LLP, approximately $32,000 and $85,000 for its services in 1998 and 1997, respectively.
SANTA FE BRANCH LOCATION
The Downtown Santa Fe location was constructed on land owned by Herman Wisenteiner, a Director of the Company. The Company is leasing the site from Mr. Wisenteiner for an initial term of 15 years. Lease payments made to Mr. Wisenteiner were $63,700 for 1998, $61,800 in 1997, and $60,000 in 1996, respectively. In the opinion of management, the lease is on terms similar to other third-party commercial transactions in the ordinary course of business.
PART IV
ITEM 14:
ITEM 14: EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
EXHIBITS.
Number Description of Exhibits - ------ ----------------------- 3.1 Restated Articles of Incorporation of First State Bancorporation. (1) 3.2 Articles of Amendment to the Restated Articles of Incorporation of First State Bancorporation. (5) 3.3 Bylaws of First State Bancorporation. (5) 4.1 Shareholder Protection Rights Agreement dated October 25, 1996. (3) 10.1 Stock Option Plan of the Company. (2) 10.2 Stock Option Agreement with Michael R. Stanford. (2) 10.3 Executive Income Protection Plan. (4) 22 Subsidiaries of the Small Business Issuer. (1) 23 Consent of KPMG, LLP. (6) 27 Financial Data Schedule. (6) - -------------------- (1) Incorporated by reference from the Company's Registration Statement on Form S-2, Commission File No. 333-24417, declared effective April 25, 1997. (2) Incorporated by reference from the Company's Registration Statement on Form SB-2, Commission File No.33-68166, declared effective November 3, 1993. (3) Incorporated by reference from the Company's Form 10-QSB for the quarter ended September 30, 1996. (4) Incorporated by reference from the Company's Form 10-QSB for the quarter ended June 30, 1996. (5) Incorporated by reference from the Company's 10- KSB for the year ended December 31, 1997. (6) Filed Herwith.
FINANCIAL STATEMENT SCHEDULES
Exhibit 27
REPORTS ON FORM 8-K.
None
SIGNATURES
In accordance with Section 13 or 15(d) of the Exchange Act, the registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
FIRST STATE BANCORPORATION
By: /s/ Michael R. Stanford ---------------------------------- Michael R. Stanford, President
In accordance with the Exchange Act, this report has been signed by the following persons in the capacities and on the dates stated.
FIRST STATE BANCORPORATION AND SUBSIDIARY
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
GENERAL
The Company's net income increased to $4.2 million in 1998, from $3.3 million in 1997, and $2.1 million in 1996. The increase in net income was primarily due to an increase in net interest income to $23.4 million in 1998, from $19.5 million in 1997, and $16.1 million in 1996. The increase in net interest income was due to increases in loans and leases, and increases in investment securities. The increase in net interest income was partially offset by increases in non-interest expense to $19.7 million in 1998, from $17.4 million in 1997, and $14.6 million in 1996. The increases in net interest income and non-interest expense resulted from the Company's expansion strategy which is to increase market share by capitalizing on the dislocation of customers caused by continued consolidation in the banking industry. Total assets have grown to $493.7 million in 1998, from $401.0 million in 1997. Total deposits have grown to $409.0 million in 1998, from $345.6 million in 1997.
NET INTEREST INCOME
The primary component of earnings for financial institutions is net interest income. Net interest income is the difference between interest income, principally from loan, lease, and investment securities portfolios, and interest expense, principally on customer deposits and borrowings. Changes in net interest income result from changes in volume, spread, and margin. Volume refers to the average dollar level of interest-earning assets and interest-bearing liabilities. Spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities. Margin refers to net interest income divided by average interest-earning assets and is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities. During the years ended December 31, 1998, 1997, and 1996, the Company's average interest-earning assets were $392.0 million, $327.1 million, and $257.2 million, respectively. For the same periods, the Company's net interest margins were 5.97%, 5.96%, and 6.25%.
During the years ended December 31, the Company's net interest income increased by $3.9 million to $23.4 million or 20.05% in 1998 from $19.5 million in 1997, which was an increase of $3.4 million or 21.12% from $16.1 million in 1996. These increases were due to a $35.5 million or 13.0% increase in average loans to $308.3 million in 1998, from $272.8 million in 1997, a $54.0 million or 24.68% increase from $218.8 million in 1996. This increase in volume was partially offset by a decrease in the average yield on earning assets and the increase in investment securities as a percentage of total assets. The Company's average yield on earning assets decreased to 9.32% in 1998, from 9.71% in 1997, and 9.99% in 1996. The decrease in average yields on commercial and real estate loans is due to increased competition, and the decrease in prime rate precipitated by the Federal Reserve Bank's interest rate reductions in the fourth quarter of 1998. Net interest margin for the fourth quarter of 1998 was 5.81% compared to 6.15% for the previous quarter.
The following tables set forth, for the periods indicated, information with respect to average balances of assets and liabilities, as well as the total dollar amounts of interest income from interest-earning assets and interest expense from interest-bearing liabilities, resultant yields or costs, net interest income, net interest spread, net interest margin, and the ratio of average interest-earning assets to average interest-bearing liabilities for the Company. No tax equivalent adjustments were made and all average balances are daily average balances. Non-accruing loans have been included in the table as loans carrying a zero yield.
Loan fees of $2.3 million, $1.9 million, and $1.9 million, are included in interest income for the years ended December 31, 1998, 1997, and 1996, respectively.
The following table illustrates the changes in the Company's net interest income due to changes in volume and changes in interest rate. Changes attributable to the combined effect of volume and interest rates have been included in the changes due to volume.
ASSET/LIABILITY MANAGEMENT
The Company's results of operations depend substantially on its net interest income. Like most financial institutions, the Company's interest income and cost of funds are affected by general economic conditions and by competition in the marketplace.
The purpose of asset/liability management is to provide stable net interest income growth by protecting the Company's earnings from undue interest rate risk. Exposure to interest rate risk arises from volatile interest rates and changes in the balance sheet mix. The Company maintains an asset/liability management policy that provides guidelines for controlling exposure to interest rate risk. The Company's policy is to control the exposure of its earnings to changing interest rates by generally maintaining a position within a narrow range around an "earnings neutral position," which is defined as the mix of assets and liabilities that generates a net interest margin that is least affected by interest rate changes.
To effectively measure and manage interest rate risk, the Company uses gap analysis and simulation analysis to determine the impact on net interest income under various interest rate scenarios, balance sheet trends, and strategies. From
these analysis, interest rate risk is quantified and appropriate strategies are developed and implemented. Additionally, duration and market value sensitivity measures are utilized when they provide added value to the overall interest rate risk management process. The overall interest rate risk position and strategies are reviewed by management and the Bank's Board of Directors on an ongoing basis.
Rising and falling interest rate environments can have various impacts on a bank's net interest income, depending on the short-term interest rate gap that the bank maintains, the relative changes in interest rates that occur when the bank's various assets and liabilities reprice, unscheduled repayments of loans, early withdrawals of deposits and other factors. As of December 31, 1998, the Company's cumulative interest rate gap for the period up to three months was a negative $53.2 million and for the period up to one year was a negative $48.9 million. Based solely on the Company's interest rate gap of twelve months or less, net income of the Company could be unfavorably impacted by an increase in interest rates or favorably impacted by a decrease in interest rates.
The following table sets forth the estimated maturity or repricing, and the resulting interest rate gap of the Company's interest-earning assets and interest-bearing liabilities at December 31, 1998. The amounts are based upon regulatory reporting formats and, therefore, may not be consistent with financial information appearing elsewhere in this report that has been prepared in accordance with generally accepted accounting principles. The amounts could be significantly affected by external factors such as changes in prepayment assumptions, early withdrawals of deposits, and competition.
The following table presents an analysis of the sensitivity inherent in the Company's net interest income and market value of portfolio equity (market value of assets, less the market value of liabilities.) The interest rate scenarios presented in the table include interest rates at December 31, 1998, and as adjusted by instantaneous parallel rate changes upward and downward of up to 200 basis points. Each rate scenario reflects unique prepayment and repricing assumptions.
Since there are limitations inherent in any methodology used to estimate the exposure to changes in market interest rates, this analysis is not intended to be a forecast of the actual effect of a change in market interest rates on the Company. This analysis is based on the Company's assets and liabilities, at December 31, 1998.
INVESTMENT PORTFOLIO
The following table provides the carrying value of the Company's investment portfolio at each of the dates indicated. At December 31, 1998, the carrying value exceeded the market value by approximately $25,000. At December 31, 1997 and 1996, the market value exceeded the carrying value by approximately $56,000, and $50,000, respectively.
The table below provides the carrying values, maturities and weighted average yield of the investment portfolio of the Company as of December 31, 1998.
LOAN AND LEASE PORTFOLIO
The following table presents the amount of loans and leases of the Company, by category, at the dates indicated.
The following table presents the aggregate maturities of loans and leases in each major category of the Company's loan and lease portfolio at December 31, 1998. Actual maturities may differ from the contractual maturities shown as a result of renewals and prepayments.
NONPERFORMING ASSETS
Nonperforming assets consist of loans and leases past due 90 days or more, non-accrual loans and leases, restructured loans and leases, and other real estate owned. The Company generally places a loan on non-accrual status and ceases accruing interest when loan payment performance is deemed unsatisfactory. All loans past due 90 days, however, are placed on non-accrual status, unless the loan is both well collateralized and in the process of collection. Cash payments received while a loan is classified as non-accrual are recorded as a reduction of principal as long as doubt exists as to collection. The following table sets forth information with respect to these assets at the dates indicated.
ANALYSIS OF THE ALLOWANCE FOR LOAN AND LEASE LOSSES
The allowance for loan and lease losses represents management's recognition of the risks of extending credit and its evaluation of the quality of the loan and lease portfolios. The allowance is maintained at a level considered
adequate to provide for anticipated loan and lease losses based on management's assessment of various factors affecting the loan and lease portfolios, including a review of problem loans and leases, business conditions and loss experience and an overall evaluation of the quality of the underlying collateral, holding and disposing costs, and costs of capital. The allowance is increased by provisions charged to operations and reduced by loans and leases charged off, net of recoveries.
The following table sets forth information regarding changes in the allowance for loan and lease losses of the Company for the periods indicated.
Specific reserves are provided for individual loans and leases where ultimate collection is considered questionable by management after reviewing the current status of loans and leases that are contractually past due and considering the net realizable value of the security and of the loan and lease guarantees, if applicable. The following table sets forth the allowance for loan and lease losses by category, based upon management's assessment of the risk associated with these categories at the dates indicated and summarizes the percentage of gross loans and leases in each category as a percentage of total loans and leases.
DEPOSITS
The following table presents the average balances outstanding for each major category of the Company's deposits and weighted average interest rate paid for interest-bearing deposits for the periods indicated.
The following table shows the amount and maturity of certificates of deposit that had balances of $100,000 or more and the percentage of the total for each maturity.
SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE
Securities sold under agreements to repurchase totaled $36.7 million, $10.1 million, and $14.0 million at December 31, 1998, 1997, and 1996, respectively. The weighted average interest rate on securities sold under agreements to repurchase was 4.07%, 4.88%, and 5.34% at December 31, 1998, 1997, and 1996, respectively.
Securities sold under agreements to repurchase are summarized as follows:
RETURN ON EQUITY AND ASSETS
The following table shows the return on average assets, return on average equity, dividend payout ratio, and ratio of average equity to average assets, for the periods indicated.
RESULTS OF OPERATIONS--YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
Overview. The Company's net income increased to $4.2 million from $3.3 million in 1997, and from $2.1 million in 1996. Net interest income increased to $23.4 million in 1998, compared to $19.5 million in 1997, and $16.1 million in 1996. This increase was offset by non-interest expenses that increased to $19.7 million in 1998, compared to $17.4 million in 1997, and $14.6 million in 1996. Income tax expense increased to $2.2 million in 1998, from $1.7 million in 1997, and $1.1 million in 1996.
Interest Income. Interest income increased to $36.5 million in 1998, from $31.8 million in 1997, and $25.7 million in 1996. This increase was due to an increase in average interest-earning assets. Average interest-earning assets were $391.9 million in 1998, compared to $327.1 million in 1997, and $257.2 million in 1996. Average yield on interest-earning assets decreased to 9.32% in 1998, from 9.71% in 1997, and from 9.99% in 1996. The increase in average interest-earning assets occurred in investment securities, and loans and leases, and was funded by an increase in interest-bearing liabilities. The average balance in investment securities increased to $74.9 million in 1998, from $48.8 million in 1997, and $35.6 million in 1996. The average balance in loans and leases increased to $308.3 million in 1998, from $272.8 million in 1997, and $218.8 million in 1996. The average yield on loans and leases decreased to 10.29% in 1998, from 10.42% in 1997, and from 10.66% in 1996. The decrease in average yields on loans is due to increased competition and the decrease in the prime rate precipitated by the Federal Reserve Bank's interest rate reductions in the fourth quarter of 1998. Because a significant portion of the Company's loans are tied to the prime rate management believes that the average yield on both loans and investment securities will continue to decrease during 1999.
Interest Expense. Interest expense increased to $13.1 million in 1998, from $12.3 million in 1997, and $9.6 million in 1996. This increase was due to increases in average interest-bearing liabilities. Average interest-bearing liabilities increased to $317.0 million in 1998, from $276.0 million in 1997, and $219.0 million in 1996. The increase
in average interest-bearing liabilities was due to an increase in average interest-bearing deposits of $38.0 million, an increase in average short term borrowings of $7.6 million, offset by a decrease in average long-term debt of $4.5 million. The increase in interest-bearing deposits is a result of the Company's success in increasing its market share. The increase in short term borrowings is the result of an increase in securities sold under agreements to repurchase. These are agreements with customers with high dollar short-term balances which the Company invests in like-termed securities. The decrease in long-term debt is the result of the Company calling for redemption of its 7.5% convertible subordinated debentures which were due 2017. All of the debenture holders exercised the conversion privilege resulting in the extinguishment of the debt and the issuance of 823,869 shares of common stock and $12.9 million being added to common equity. The average cost of interest-bearing liabilities decreased to 4.15% in 1998, from 4.45% in 1997, and 4.39% in 1996. The decrease in the average cost of interest-bearing liabilities was the result of decreased rates paid on interest-bearing deposit due to the general decline in interest rates and the Federal Reserve Banks rate reductions in the fourth quarter of 1998. The average cost of deposits decreased to 4.04% in 1998, from 4.28% in 1997, and 4.27% in 1996. The increase in the cost of interest-bearing liabilities in 1997, was primarily due to the increase in average long-term debt.
Net Interest Income. Net interest income increased to $23.4 million in 1998, from $19.5 million in 1997, and $16.1 million in 1996. This increase was due to increases in average loans and leases of $35.5 million and average investment securities of $26.1 million. Net interest margin was virtually unchanged at 5.97% in 1998, from 5.96% in 1997. While the margin was mostly unchanged in 1998 from 1997 the average yield on interest earning assets decreased to 9.32% in 1998, from 9.71% in 1997, and the cost of interest-bearing liabilities decreased to 4.15% in 1998, from 4.45% in 1997, as a result of general decrease in interest rates and the Federal Reserve Bank Board's interest rate reductions in the fourth quarter of 1998. The Company's net interest margin for the fourth quarter of 1998 was 5.81% compared to 6.01% for the fourth quarter of 1997. The net interest margin decreased in 1997 from 6.25% in 1996, as a result of decreased average yields on loans and leases, increased cost of interest-bearing liabilities, and the increase in the ratio of investment securities to loans and leases. Management believes that any additional rate reductions will depress the net interest margin further.
Provision for Loan and Lease Losses. The provision for loan and lease losses increased to $2.3 million in 1998, from $1.5 million in 1997, and $1.2 million in 1996. This increase was necessitated by the increase in loans and leases outstanding and increased charge-offs. Management anticipates growth in the provision for loan and lease losses at least proportional to loan and lease growth. Charge-offs net of recoveries of loans and leases were $1.7 million in 1998, $768,000 in 1997, and $572,000 in 1996. The percentage of total charge-offs to average loans and leases was 0.56% in 1998 and 0.28% in 1997.
Non-interest Income. Non-interest income was $5.1 million in 1998, compared to $4.5 million in 1997, and $2.9 million in 1996. The increase for 1998 from 1997 was due to increased service charges on deposit accounts, resulting from increased deposits, increased credit card merchant fees, off-set by a reduction in operating lease income. The increase for 1997 from 1996 was due to increased service charges on deposit accounts, increased rental income from operating leases, and increased credit card merchant fees. Service charges on deposit accounts were $1.7 million in 1998, $1.5 million in 1997, and $1.1 million in 1996. Rental income from operating leases was $821,000 in 1998, and $1.0 million in 1997. The decrease in operating lease income was the result of leases classified as operating leases maturing or being paid off early, while new lease volume was in leases classified as loans. Credit card transaction income was $1.3 million in 1998, $1.2 million in 1997, and $797,000 in 1996.
Non-interest Expense. Non-interest expense increased to $19.7 million in 1998, from $17.4 million in 1997, and $14.6 million in 1996. This increase was due largely to increases in salaries and employee benefits, occupancy, equipment, and marketing expense as a result of the Company's growth. Salaries and employee benefits increased to $8.9 million in 1998, from $7.5 million in 1997, and $6.4 million in 1996. Occupancy expense increased to $2.3 million in 1998, from $2.1 million in 1997, and $1.9 million in 1996. Equipment expense increased to $1.5 million in 1998, from $1.2 million in 1997, and $1.1 million in 1996. Marketing expense increased to $856,000 in 1998, compared to $760,000 in 1997, and $637,000 in 1996. The increases in salary and occupancy expense are due to growth in assets and deposits. The growth in marketing expense is a result of the Company's efforts to capture market
share and capitalize on the opportunity to do so as a result of acquisitions of banks with New Mexico operations by companies outside New Mexico.
Management anticipates that non-interest expense will continue to increase with additional growth. The Company also has plans to open two new branch locations in 1999, one late in the first quarter, and one early in the third quarter. The addition of these new branches will cause non-interest expense to rise in 1999.
Income Tax Expense. Income tax expense increased to $2.2 million in 1998, from $1.7 million in 1997, and $1.1 million in 1996. In 1998, the Company began paying state income taxes in New Mexico to which it was not subject in previous years due to state tax net operating loss carry-forwards. Management anticipates that the Company's marginal tax rate will be slightly higher in 1999.
LIQUIDITY AND SOURCES OF FUNDS
The Company's primary sources of funds are customer deposits, loan and lease repayments. These funds are used to make loans and leases, acquire investment securities and other assets, and fund continuing operations. Scheduled loan and lease repayments are a relatively stable source of funds, while deposit inflows and unscheduled loan and lease prepayments, which are influenced by general interest rate levels, interest rates available on other investments, competition, economic conditions, and other factors, are not a relatively stable source of funds. Deposits of the Company increased to $409.0 million at December 31, 1998, from $345.6 million at December 31, 1997. Growth in deposits has occurred primarily as a result of the Company's efforts to increase market share by taking advantage of market dislocations caused by the acquisition of local competitors and growth in the economy of the Company's trade area.
Net loans of the Company increased to $331.1 million at December 31, 1998, from $285.1 million as of December 31, 1997. During 1998, real estate loans increased by $19.8 million, leases increased by $17.1 million, commercial loans increased by $8.5 million, and consumer loans increased by $1.3 million. The increase in loans is due to the Company's successful efforts to increase its market share by taking advantage of market dislocations caused by the acquisition of local competitors and growth in the economy of the Company's market area.
Management anticipates that the Company will continue to rely primarily on customer deposits and loan and lease repayments, as well as retained earnings, to provide liquidity and will use funds so provided primarily to make loans and leases and to purchase securities. The Company believes that its customer deposits provide a strong source of liquidity because of the high percentage of core deposits. Borrowings are used to compensate for reductions in other sources of funds. Borrowings may also be used on a longer-term basis to support expanded lending activities and to match the maturity or repricing intervals of assets. The sources of such borrowings are federal funds sold, securities sold under agreements to repurchase, and borrowings from the Federal Home Loan Bank ("FHLB.")
CAPITAL RESOURCES
The Company's total stockholders' equity increased to $44.1 million at December 31, 1998, from $27.7 million at December 31, 1997. Of the $16.4 million increase, $4.2 million was produced by earnings and $12.9 million was produced by the conversion of the 7.5% convertible subordinated debentures. This increase was partially offset by dividend payments of $790,000. Management currently intends to continue to retain a major portion of the Company's earnings to support anticipated growth. As of December 31, 1998, the Company and First State Bank met the fully phased-in regulatory capital requirements as further disclosed in note 10 to the consolidated financial statements.
IMPACT OF INFLATION
The consolidated financial statements and related financial data and notes presented herein have been prepared in accordance with generally accepted accounting principles, which require the measurement of financial position and operating results in terms of historical dollars, without considering changes in the relative purchasing power of money over time due to inflation.
Unlike most industrial companies, virtually all of the assets and liabilities of the Company are monetary in nature. As a result, interest rates have a more significant impact on the Company's performance than the effects of general price levels.
YEAR 2000
The Company began its Year 2000 planning and evaluation process in 1997. Early on, the awareness stage was completed by management and the Board of Directors. The various systems (hardware and software) of the Company have been assigned into the various categories of critical, essential and moderate importance. The assessment stage is essentially complete for the critical and essential systems and substantially complete for the systems of moderate importance.
All of the Company's systems are provided by third party vendors, with only very minor programming changes made internally. Sixteen systems have been identified as critical to the Company's daily processing. Of those, thirteen have been certified by the provider to be Year 2000 compliant, while one has been certified by the provider to not be date sensitive. The other two critical systems have been determined by Company personnel to not be date sensitive. Twenty-seven systems have been identified as essential to the Company's daily operations. Twenty-six of the essential systems have been certified by the provider as being Year 2000 compliant. One essential system is scheduled for full compliance by March 1999. One other system previously considered essential was down graded and is now considered of moderate importance, with a reasonable alternative process which can easily be done manually.
The Company's Year 2000 testing began in the second quarter of 1998 and is progressing on schedule to be complete by March 31, 1999, with critical system testing scheduled to be complete by March 31, 1999. To date, no significant problems have been encountered in the testing process.
Many of the Company's larger loan and deposit customers have been contacted regarding their readiness for the Year 2000, to determine if the Company has significant credit risk or exposure to declining liquidity, due to potential problems of customers related to Year 2000 issues. Information is being gathered on most of these larger customers and determinations made regarding the relative risk to these customers. To date, significant loss or liquidity exposure has not been identified among the Company's customer base, but additional evaluation is being performed on an ongoing basis.
The direct costs to date of the Company's Year 2000 effort have totaled approximately just under $200,000. These include allocated salary costs of approximately $59,000 and equipment costs of approximately $120,000. There are indirect costs related to significant amounts of time being spent by existing Company personnel, for development of test plans, test scripts, and for actual testing. Most of this time is spent as part of their normal job responsibilities, with no additional direct cost incurred.
The major risks of the Company's Year 2000 issues are its ability to provide consistent daily processing of customer information and the soundness of the Company's loan portfolio. The Company is managing this risk by performing extensive analysis and testing to identify potential problem areas for its systems and throughout its customer base. The possible impacts on the Company would include a substantial loss of customers and the related revenue on those customers' relationships, as well as possible loan losses resulting from the inability of the Company's customers to repay their loans on a timely basis.
The Company is developing contingency plans which are anticipated to be completed by June 30, 1999. These plans include plans for replacement of non- compliant systems, other processing alternatives, and liquidity matters.
FORWARD-LOOKING STATEMENTS
Statements which are forward-looking are not historical facts, and involve risks and uncertainties that could cause the Company's results to differ materially from those in any forward-looking statements. These risks include the possible loss of key personnel, need for additional capital should the Company experience faster than anticipated growth, changes in economic conditions, interest rate risk, factors which could affect the Company's ability to compete in its trade areas, changes in regulations and governmental policies, and the risks described in the Company's Securities and Exchange Commission filings. Forward-looking statements with respect to the Year 2000 may differ materially if commitments or representations from third parties are not fulfilled.
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholders First State Bancorporation:
We have audited the accompanying consolidated balance sheets of First State Bancorporation and subsidiary as of December 31, 1998 and 1997, and the related consolidated statements of operations, comprehensive income, stockholders' equity, and cash flows for each of the years in the three year period ended December 31, 1998. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentations. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of First State Bancorporation and subsidiary as of December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the years in the three year period ended December 31, 1998 in conformity with generally accepted accounting principles.
KPMG LLP
Albuquerque, New Mexico January 28, 1999
FIRST STATE BANCORPORATION AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
See accompanying notes to consolidated financial statements.
FIRST STATE BANCORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
See accompanying notes to consolidated financial statements.
FIRST STATE BANCORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
See accompanying notes to consolidated financial statements
FIRST STATE BANCORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
See accompanying notes to consolidated financial statements.
FIRST STATE BANCORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes to consolidated financial statements.
FIRST STATE BANCORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Summary of Significant Accounting Policies
(a) Organization, Basis of Presentation and Principles of Consolidation
First State Bancorporation ("FSNM") is a New Mexico-based holding company that is focused on New Mexico markets. In 1988, FSNM acquired First State Bank of Taos ("FSBT"). In December 1993, FSNM acquired First State Bank of Santa Fe ("the Santa Fe Bank"). On June 5, 1994, the Santa Fe Bank was merged into FSBT. As a result of the merger, FSNM purchased the interest of the minority stockholders of the Santa Fe Bank. FSBT is a state chartered bank with locations in Taos, Albuquerque, Santa Fe, Rio Rancho, Los Lunas, Bernalillo, Placitas, Questa, and Moriarty, New Mexico. First State Bancorporation and its wholly owned subsidiary FSBT are collectively referred to as "the Company."
All significant intercompany accounts and transactions have been eliminated in the consolidated financial statements.
In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. Actual results could differ significantly from those estimates.
Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan and lease losses and the valuation of real estate acquired in satisfaction of loans. In connection with the determination of the allowances for loan and lease losses and real estate owned, management obtains independent appraisals for significant properties.
Management believes that the estimates and assumptions it uses to prepare the financial statements, particularly as they relate to the allowances for losses on loans and leases, and real estate owned, are adequate. However, future additions to these allowances may be necessary based on changes in economic conditions. Further, regulatory agencies, as an integral part of their examination process, periodically review the allowances for losses on loans and leases, and real estate owned and may require the Company to recognize additions to these allowances based on their judgments about information available to them at the time of their examinations.
The Company's results of operations depend on its net interest income. The components of net interest income, interest income and interest expense, are affected by general economic conditions and by competition in the marketplace.
Interest rate risk arises from volatile interest rates and changes in the balance sheet mix. The Company maintains an asset/liability management policy that provides guidelines for controlling exposure to interest rate risk. The Company's policy is to control the exposure of its earnings to changing interest rates by generally maintaining a position within a narrow range around an "earnings neutral position," which is defined as the mix of assets and liabilities that generates a net interest margin that is least affected by interest rate changes.
(b) Investment Securities
The Company accounts for investment securities under Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" (FAS 115). FAS 115 requires that investment securities be classified in one of three categories and accounted for as follows: (i) debt securities that the Company has the positive intent and ability to hold to maturity are classified as held to maturity and carried at amortized cost; (ii) debt
FIRST STATE BANCORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
and equity securities that are bought and held primarily for the purpose of selling them in the near term are classified as trading securities and carried at fair value, with unrealized gains and losses included in earnings; and (iii) debt and equity securities not classified as either held to maturity securities or trading securities are classified as available for sale securities. These are securities which the Company will hold for an indefinite period of time and may be used as a part of the Company's asset/liability management strategy and may be sold in response to changes in interest rates, prepayments, or similar factors. Available for sale securities are carried at estimated market value, with unrealized gains and losses excluded from earnings and reported as a separate component of stockholders' equity, net of related deferred income taxes. Upon purchase of investment securities, management designates securities as either held to maturity or available for sale. The Company does not maintain a trading portfolio.
(c) Loans, Leases, and Allowance for Loan and Lease Losses
Interest on loans is recognized as income based upon the daily principal amount outstanding. Interest on non-accrual loans is recognized as income when the loan is returned to accrual status. When a loan is placed on non-accrual, any uncollected interest accrued in the current year is charged against income, with prior years' accruals charged to the allowance for loan and lease losses unless in management's opinion the loan is well secured and in the process of collection. Interest accrued on loans is discontinued in most instances when a loan becomes 90 days past due and/or management believes the borrower's financial condition is such that collection of future principal and interest payments is doubtful. Loans are removed from non-accrual status when they become current as to both principal and interest, and concern no longer exists as to the collectibility of principal or interest.
Leases which meet the criteria to be classified as direct financing leases are carried at the gross investment in the lease, less unearned income. Unearned income is recognized in a manner to produce a constant periodic rate of return. The gross investment in the lease includes the minimum lease payment due under the term of the lease, plus initial direct costs and the estimated residual value of the collateral underlying the lease. Initial direct costs are amortized using the level yield method. The value of unguaranteed residuals are reviewed periodically and any necessary adjustments are charged against operations. For leases which meet the operating lease criteria, income is recognized as rental payments are earned. The equipment leased under operating leases is carried as property and equipment at cost, less accumulated depreciation. Depreciation expense is calculated using the straight-line method over the estimated useful life of the equipment, generally three to five years.
The allowance for loan and lease losses is that amount which, in management's judgment, is considered adequate to provide for potential losses in the loan and lease portfolios. Management's determination of the allowance for loan and lease losses is made with consideration of such factors as delinquencies, changing collateral values, previous charge-off experience, local and national economic conditions and other factors which, in management's opinion, deserve current recognition in the allowance.
FIRST STATE BANCORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
First State Bank's loan portfolio is concentrated in Albuquerque, Santa Fe, Los Lunas, Rio Rancho, and Taos, New Mexico. A significant portion of the loan portfolio is secured by real estate in those communities. Accordingly, the ultimate collectibility of First State Bank's loan portfolio is dependent upon real estate values in those markets.
Loan origination fees and certain direct loan origination costs are deferred and amortized to income over the contractual life of the loan using the interest method. Any unamortized balance of the deferred fees is recognized as income if the loans are sold, participated or repaid prior to maturity.
The Company accounts for impaired loans under Statement of Financial Accounting Standards No. 114 and 118, "Accounting by Creditors for Impairment of a Loan" (FAS 114 and 118).
(d) Premises and Equipment
Premises and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation and amortization are computed by the straight- line method over the estimated useful lives of the related assets.
(e) Intangible Assets
The excess of cost over the fair value of the net assets of acquired banks is recorded as goodwill, which is amortized on a straight-line basis over a period of 15 years. Core deposit intangibles are amortized over a 10-year period using the straight-line method. At December 31, 1998 and 1997, unamortized core deposit intangibles included in other assets in the accompanying financial statements, totaled zero and $28,916, respectively.
The Company assesses the recoverability of goodwill and core-deposit intangibles by determining whether the amortization of the intangibles over their remaining lives can be recovered through projected undiscounted future results of operations.
(f) Other Real Estate Owned
Other real estate owned consists of loan-related properties acquired through foreclosure and by deed-in-lieu of foreclosure.
Other real estate owned is carried at the lower of the investment in the related loan or fair value of the assets received. Fair value of such assets is determined based on independent appraisals minus estimated costs of disposition. Declines in value subsequent to acquisition are accounted for within the allowance for other real estate owned. Provisions for losses subsequent to acquisition, operating expenses, and gain or losses from sales of other real estate owned, are charged or credited to other operating costs.
(g) Income Taxes
The Company files a consolidated tax return with its wholly owned subsidiary. The Company uses the asset and liability method prescribed in the Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (FAS 109). Under the asset and liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
FIRST STATE BANCORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
(h) Statement of Cash Flows
For the purpose of reporting cash flows, cash and cash equivalents include cash and due from banks and federal funds sold.
(i) Earnings per Common Share
In February 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 128, "Earnings per Share" (FAS 128). FAS 128 requires the computation of basic earnings per share and diluted earnings per share. Basic earnings per share is computed by dividing income available to common stockholders (the numerator) by the weighted-average number of common shares outstanding during the period (the denominator). Diluted earnings per share is calculated by increasing the basic earnings per share denominator by the number of additional common shares that would have been outstanding if dilutive potential common shares for options, warrants, and convertible debentures had been issued and increasing the basic earnings per share numerator by the after tax amount of interest and amortization associated with the convertible debentures. FAS 128 is effective for years ended after December 31, 1997, and is required to be applied retroactively upon adoption. All previous periods have been restated to conform to the requirements of FAS 128. The following is a reconciliation of the numerators and denominators of basic and diluted earnings per share.
(j) Stock Options
Prior to January 1, 1996, the Company accounted for its stock option plan in accordance with the provisions of Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees and related interpretations." As such, compensation expense was recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. On January 1, 1996, the Company adopted Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" (FAS 123), which permits entities to recognize as expense over the vesting period the fair value of all stock-based awards on the date of grant. Alternatively, FAS 123 also allows entities to continue to apply the provisions of APB Opinion No. 25 and provide pro forma net income and pro forma earnings per share disclosures for employee stock option grants made in 1995 and future years as if the fair-value-based method defined in FAS 123 had been applied. The Company has elected to continue to apply the provisions of APB Opinion No. 25.
(k) Reclassifications
Certain previous period balances have been reclassified to conform to the 1998 presentation.
(l) Reporting Comprehensive Income
In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" (FAS 130). FAS 130 requires disclosure in the financial
FIRST STATE BANCORPORATION AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
statements of comprehensive income that encompasses earnings and those items currently required to be reported directly in the equity section of the balance sheet, such as unrealized gains and losses on available-for-sale securities. Management has adopted the provisions of FAS 130 effective January 1, 1998, and all previous periods have been restated to conform to the provisions of FAS 130.
(m) Accounting Standards Issued but not yet Adopted
In June, 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No.133, Accounting for Derivative Instruments and Hedging Activities (FAS 133). FAS 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in the contracts, and for hedging activities. This Statement is effective for all fiscal quarters of all fiscal years beginning after June 15, 1999. The impact of FAS 133 is not expected to be material in relation to the consolidated financial statements.
2. CASH AND DUE FROM BANKS
First State Bank is required to maintain certain daily reserve balances on hand in accordance with Federal Reserve Board requirements. The consolidated reserve balances maintained in accordance with these requirements were approximately $714,000 and $9,415,000 at December 31, 1998 and 1997, respectively.
3. INVESTMENT SECURITIES
Following is a summary of amortized costs and approximate market values of investment securities:
FIRST STATE BANCORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The amortized cost and estimated market value of investment securities at December 31, 1998, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations.
Marketable securities with an amortized cost of approximately $104,630,000 and $56,515,000 were pledged to collateralize deposits as required by law and for other purposes at December 31, 1998 and 1997, respectively.
Proceeds from sales of investments in debt securities for the years ended December 31 were zero in 1998, zero in 1997, and $500,156 in 1996. Gross losses realized were zero in 1998, zero in 1997, and zero in 1996. Gross gains realized were zero in 1998, zero in 1997, and $156 in 1996. The Company calculates gain or loss on sale of securities based on the specific identification method.
4. LOANS AND LEASES
Following is a summary of loans and leases by major categories:
FIRST STATE BANCORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The Company's leasing operations consist principally of the leasing of various types of transportation equipment, construction equipment, industrial and manufacturing equipment, and data processing equipment. The majority of the Company's leases are classified as direct financing leases.
Future minimum lease receivables under noncancellable leasing arrangements as of December 31, 1998 are as follows:
Following is a summary of changes to the allowance for loan and lease losses:
The recorded investment in loans which are considered impaired under the provisions of Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan," as amended by the Statement of Financial Accounting Standards No. 118, "Accounting by Creditors for Impairment of a Loan-Income Recognition and Disclosures," was $6,262,498 at December 31, 1998, $3,122,765 at December 31, 1997, and $1,057,802 at December 31, 1996. The average investment in loans for which impairment has been recognized was $5,452,000 in 1998 and $2,090,000 in 1997. The allowance for loan losses related to these loans was $96,000 at December 31, 1998, $395,000 at December 31, 1997, and zero at December 31, 1996. The allowance for impaired loans is included in the allowance for loan and lease losses. Interest income recognized on impaired loans was zero in 1998, $6,218 in 1997, and $18,293 in 1996.
Loans on which the accrual of interest has been discontinued amounted to $6,262,498, $3,122,765, and $946,408 at December 31, 1998, 1997, and 1996, respectively. If interest on such loans had been accrued, such income would have been approximately $409,000 in 1998, $144,978 in 1997, and $12,000 in 1996. Actual interest income on those loans, which is recorded only when received, amounted to zero in 1998, $6,218 in 1997, and zero in 1996.
FIRST STATE BANCORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Activity during 1998 and 1997 regarding outstanding loans to certain related-party loan customers of the subsidiary bank's (executive officers, directors and principal shareholders of First State Bank including their families and companies in which they are principal owners) was as follows:
5. PREMISES AND EQUIPMENT
Following is a summary of premises and equipment, at cost:
Depreciation and amortization expense on premises and equipment in 1998, 1997, and 1996 was $2,040,832, $1,911,497, and $1,331,147, respectively.
6. DEPOSITS
Following is a summary of interest-bearing deposits:
FIRST STATE BANCORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
7. BORROWINGS
Securities sold under agreements to repurchase
Securities sold under agreements to repurchase are comprised of customer deposit agreements with overnight maturities. The obligations are not federally insured but are collateralized by a security interest in U.S. Treasury or U.S. government agency securities. These securities are segregated and safekept by third-party banks. These securities had a market value of $36,692,999 and $10,105,190, at December 31, 1998 and 1997, respectively. Interest expense included in the statement of operations was $947,181, $527,746, and $561,541 for the years ended December 31, 1998, 1997, and 1996.
Securities sold under agreements to repurchase are summarized as follows:
Subordinated Debentures
On April 28, 1998, the Company notified the holders of its 7.5% convertible subordinated debentures due 2017 that the debentures would be called for redemption at 100% of the original principal plus accrued interest on May 29, 1998. The Indenture allowed management to redeem the debentures at par when the Company's common stock closed at 140% of the exercise price ($16.75) for 30 consecutive trading days. As of April 24, 1998 this condition was met. All of the debenture holders exercised the conversion privilege, resulting in 823,869 shares of common stock being issued and $12.9 million being added to common equity.
On April 30, 1997, the Company called for redemption of its 7% convertible subordinated debentures due November 3, 2003, with a balance of $3,788,000 at December 31, 1996. Prior to the redemption date, $3,773,000 principal amount of the debentures were converted into the Company's common stock at a conversion rate of $10.50 per share or 359,285 shares. The remaining $15,000 were redeemed at 101% of the original principal balance plus accrued interest.
Federal Home Loan Bank advance
First State Bank has a note payable to the Federal Home Loan Bank of Dallas included in long-term debt, dated January 30, 1995, with an outstanding balance of $177,394 and $198,594 at December 31, 1998, and 1997, respectively. The note is payable in monthly installments of principal and interest at 8.26% through February 1, 2005.
FIRST STATE BANCORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Note Payable
On April 30, 1997, the Company purchased its main banking facility in Taos, New Mexico subject to a real estate contract with an original balance of $1,050,000 which bears interest at 9.50% adjustable every five years through 2017, payable $9,787 monthly. The balance at December 31, 1998, was $1,018,175 with principal payments of $21,648 in 1999, $23,797 in 2000, $26,159 in 2001, $28,755 in 2002, $31,609 in 2003, and $886,207 thereafter.
8. LEASES
First State Bank leases certain of its premises and equipment under noncancellable operating leases from unrelated parties. Rent expense for the years ended December 31, 1998, 1997, and 1996, totaled approximately $968,000, $949,000 and $829,000, respectively. Minimum future payments under these leases at December 31, 1998, are as follows:
9. INCOME TAXES
Income tax expense (benefit) consisted of the following:
FIRST STATE BANCORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Actual income tax expense from continuing operations differs from the "expected" tax expense for 1998, 1997, and 1996 (computed by applying the U.S. federal corporate tax rate of 34 percent to income from continuing operations before income taxes) as follows:
Components of deferred income tax assets and liabilities are as follows:
In order to fully realize the deferred tax asset on the Company's balance sheet at December 31, 1998, of $1,471,582, the Company will need to generate future taxable income of approximately $4,328,000. Based on the Company's historical and current pre-tax income, management believes it is more likely than not that the Company will realize the benefit of the temporary differences prior to the expiration of the carry-forward period and further believes that the existing net deductible temporary differences will reverse during periods in which the Company generates net taxable income. There can be no assurance, however, that the Company will generate taxable income or any specific level of continuing taxable income.
FIRST STATE BANCORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
10. STOCKHOLDERS' EQUITY
At December 31, 1998, under terms of a stock option agreement, an officer of First State Bank has an outstanding option to purchase 6,612 common shares of the Company at a price of $5.01 per share. The options may be exercised at any time and expire on October 12, 2003. The officer exercised 43,000 options for a total of $215,000 in 1997.
Effective October 5, 1993, the Company adopted the First State Bancorporation 1993 Stock Option Plan, which provides for the granting of options to purchase up to 400,000 shares of the Company's common stock. Exercise dates and prices for the options are set by a committee of the Board of Directors. The plan also provides that options other than those qualifying as incentive stock options may be granted. Vesting of these options is 20% at the date of grant and 20% per year thereafter until fully vested. A summary of options under this plan is as follows:
Compensation expense of $308,208, $20,430, and $33,453 was recognized pursuant to the grant of options in 1998, 1997, and 1996. Had the compensation costs been determined consistent with the fair value method of FAS 123 at the grant dates for awards, net income and earnings per common share would have changed to the pro forma amounts indicated below.
In determining the following pro forma disclosures, the fair value of options granted were estimated as of the grant date using the Black-Scholes option- pricing model assuming a risk free interest rate of 5.50% for 1997 and 5.38% for 1995; dividend yield of 0.98% for 1997 and 1.27% for 1995; expected lives of 5 years for 1997 and 5 years for 1995; and volatility of 40.23% for 1997 and 45.27% for 1995. In June 1998, the Company's shareholders approved the addition of 175,000 options available for grant. Of those options, 78,515 were granted in 1997 subject to that approval. These options were measured at June 6, 1998, assuming a risk free interest rate of 5.43%, dividend yield of 0.86%, expected lives of five years, and volatility of 37.98%
FIRST STATE BANCORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
On October 25, 1996, the Board of Directors approved a shareholder protection rights agreement to protect the stockholders of the Company from abusive or unfair take-over practices. The terms of the agreement provide one right for each share of common stock held. The rights become exercisable only if a person or a group accumulates ten percent or more of the Company's common shares. The Company would be entitled to redeem the rights for $0.01 per right until the tenth day following a public announcement of an acquisition of 10% of its common shares. The rights expire on October 25, 2006.
On October 25, 1996, the Board of Directors approved a dividend reinvestment plan. The plan allows any stockholder of record of 300 shares of common stock to reinvest dividends on those shares in common shares issued by the Company pursuant to the plan. Holders of 300 or more shares may also acquire shares from the Company through the plan in an amount not to exceed $30,000 quarterly.
In connection with the common stock and 7% convertible debenture offering, the Company sold to the underwriter for $100 a five-year warrant with a put provision to purchase 48,125 shares of common stock. On June 30, 1997, the underwriter exercised the put provision and the Company paid the underwriter $308,000 for redemption of the warrants which was accounted for as a charge to retained earnings.
Bank regulations specify the level of dividends that can be paid by First State Bank. As of December 31, 1998, First State Bank had approximately $9.0 million in retained earnings, which were available for the payment of dividends to the Company subject to regulatory capital requirements. Future dividend payments will be dependent upon the level of earnings generated by First State Bank and/or regulatory restrictions, if any.
On April 28, 1998, the Company notified the holders of its 7.5% convertible debentures due 2017 that the debentures would be called for redemption at 100% of the original principal plus accrued interest on May 29, 1998. The indenture allowed management to redeem the debentures at par when the Company's common stock closed at 140% of the exercise price ($16.75) for 30 consecutive trading days. As of April 24, 1998 this condition was met. All of the debenture holders exercised the conversion privilege, resulting in 823,869 shares of common stock being issued and $12.9 million being added to common equity.
On April 30, 1997, the Company called for redemption of its 7% convertible subordinated debentures due November 3, 2003, with a balance of $3,788,000 at December 31, 1996. Prior to the redemption date, $3,773,000 principal amount of the debentures were converted into the Company's common stock at a conversion rate of $10.50 per share or 359,285 shares. The remaining $15,000 were redeemed at 101% of the original principal balance plus accrued interest.
The Bank is subject to various regulatory capital requirements administered by federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory--and possibly discretionary--actions by regulators that, if undertaken, could have a direct material effect on the Company's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company must meet specific capital guidelines that involve quantitative measures of the Company's assets, liabilities, and certain off balance sheet items as calculated under regulatory accounting practices. The Company's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Company to maintain minimum amounts and ratios of total and Tier I capital (as defined in regulations) to risk-weighted assets, and of Tier I capital, and of Tier I capital to total assets. Management believes, as of December 31, 1998, that the Company meets all capital adequacy requirements to which it is subject.
FIRST STATE BANCORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
As of December 31, 1998, the most recent notification from the Federal Reserve Bank of Kansas City categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the following table. There are no conditions or events since that notification that management believes have changed the institution's category.
11. EMPLOYEE BENEFIT PLANS
Effective January 1, 1991, First State Bank adopted an employee tax-sheltered savings plan for substantially all full-time employees which provides a mandatory 50% matching by First State Bank of employee contributions up to a maximum of 6% of gross annual wages. Full vesting occurs after three years. Contributions to the plan totaled $146,114 in 1998, $125,171 in 1997, and $105,788 in 1996.
12. COMMITMENTS AND CONTINGENCIES
In the normal course of business, various commitments and contingent liabilities are outstanding, such as standby letters of credit and commitments to extend credit. These financial instruments with off balance sheet risk are not reflected in the financial statements. Financial instruments with off balance sheet risk involve elements of credit risk, interest rate risk, liquidity risk, and market risk. Management does not anticipate any significant losses as a result of these transactions. The following table summarizes these financial instruments:
FIRST STATE BANCORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The Bank's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. The Bank controls the credit risk of these transactions through credit approvals, limits, and monitoring procedures.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.
Standby letters of credit are written conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.
The Bank evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management's credit evaluation of the customer. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties.
In the normal course of business, the Company is involved in various legal matters. After consultation with legal counsel, management does not believe the outcome of these legal matters will have an adverse impact on the Company's financial position.
13. CONDENSED FINANCIAL INFORMATION OF PARENT COMPANY
The assets of the Company, as parent company, consist primarily of the investment in its subsidiary bank and a money market savings account held in the subsidiary bank. The primary sources of the parent company's cash revenues are dividends from its subsidiary bank along with interest received from the money market account. Following are condensed financial statements of the parent company.
CONDENSED STATEMENTS OF CONDITION
FIRST STATE BANCORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
CONDENSED STATEMENTS OF OPERATIONS
CONDENSED STATEMENTS OF CASH FLOWS
FIRST STATE BANCORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
14. FAIR VALUE OF FINANCIAL INSTRUMENTS
Statement of Financial Accounting Standards No. 107, "Disclosures About Fair Value of Financial Instruments" (FAS 107), requires disclosure of current fair value of all financial instruments, both assets and liabilities recognized and not recognized in the balance sheet, for which it is practicable to estimate fair value. FAS 107 defines fair value as the amount at which a financial instrument could be exchanged in a current transaction between willing parties other than in a forced or liquidation sale.
Financial instruments are defined as cash, evidence of ownership in an entity, or a contract that both imposes on one entity a contractual obligation: (1) to deliver cash or another financial instrument to a second entity, or (2) to exchange other financial instruments on potentially unfavorable terms with a second entity, and conveys to the second entity a contractual right: (a) to receive cash or another financial instrument from the first entity, or (b) to exchange other financial instruments on potentially favorable terms with the first entity.
Fair value estimates are made at a specific point in time based on available relevant market information about the financial instrument. However, a significant portion of the Company's financial instruments, such as commercial real estate loans, do not currently have an active marketplace in which they can be readily sold or purchased to determine fair value. Consequently, fair value estimates for those financial instruments are based on assumptions made by management regarding the financial instrument's credit risk characteristics, prevailing interest rates, future estimated cash flows, expected loss experience, current and future economic conditions and other factors which affect fair value. As a result, these fair value estimates are subjective in nature and involve uncertainties and matters of significant judgment, and therefore, cannot be determined with precision. Accordingly, changes in management's assumptions could cause the fair value estimates to deviate substantially. Further, these estimates do not reflect any additional premium or discount that could result from offering for sale, at one time, the Company's entire holdings of a particular financial instrument or any estimated transaction costs. Lastly, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on the fair value estimates and have not been considered in the estimates.
The carrying values and estimated fair values of the Company's financial instruments at December 31, are as follows:
The following methods and assumptions were used to estimate the fair value of each class of financial instruments:
Cash and due from banks. Carrying value approximates fair value since these instruments are payable on demand and do not present credit concerns.
Federal funds sold. Carrying value approximates fair value since these instruments have short-term maturities and do not present credit concerns.
FIRST STATE BANCORPORATION AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Marketable securities available for sale and held to maturity. The estimated fair value of securities available for sale and held to maturity is based on independent dealer quotations or published market price bid quotes.
Loans, net. The estimated fair value of the loan portfolio is calculated by discounting scheduled cash flows over the estimated maturity of loans using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities or repricing terms. Credit risk is accounted for through a reduction of contractual cash flows by loss estimates of classified loans and as a component of the discount rate.
Accrued interest receivable. Carrying value of interest receivable approximates fair value, since these instruments have short-term maturities.
Deposits. The estimated fair value of deposits with no stated maturity, such as demand deposits, savings accounts and money market deposits, approximates the amounts payable on demand at December 31, 1998 and 1997. The fair value of fixed maturity certificates of deposit is estimated by discounting the future contractual cash flows using the rates currently offered for deposits of similar remaining maturities.
Securities sold under agreements to repurchase. The estimated fair value of securities sold under agreements to repurchase, which reset frequently to market interest rates, approximate fair value.
Long-term debt. In 1997, long-term debt consisted of 7.5% convertible subordinated debentures which were traded on the Nasdaq Small Cap Market and their fair value was their market price on December 31, 1997. Also included is a real estate contract for purchase of a banking facility; its fair value is determined based on future cash out flows at current interest rates.
Off Balance Sheet Items. The estimated fair values of the Company's off balance sheet items are not material to the fair value of financial instruments included in the statements of financial condition. Rates currently available to the Company and subsidiary for items with similar terms and remaining maturities are used to estimate fair value of existing debt.