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



FORM 10-Q



(MARK ONE)    

ý

 

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

For the quarterly period ended June 30, 2011

OR

o

 

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

For the transition period from                   to                   

Commission file number 000-23877

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

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

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

 

95113
(Zip Code)

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

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

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

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

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

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

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

        The Registrant had 26,295,001 shares of Common Stock outstanding on July 22, 2011.


Table of Contents


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

 
   
  Page No.  
Cautionary Note on Forward-Looking Statements     3  

PART I. FINANCIAL INFORMATION

 

 

 

 

Item 1.

 

Consolidated Financial Statements (unaudited):

 

 

5

 

 

 

Consolidated Balance Sheets

 

 

5

 

 

 

Consolidated Statements of Operations

 

 

6

 

 

 

Consolidated Statement of Changes in Shareholders' Equity

 

 

7

 

 

 

Consolidated Statements of Cash Flows

 

 

8

 

 

 

Notes to Consolidated Financial Statements

 

 

9

 

Item 2.

 

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

 

 

29

 

Item 3.

 

Quantitative and Qualitative Disclosures About Market Risk

 

 

62

 

Item 4.

 

Controls and Procedures

 

 

62

 

PART II. OTHER INFORMATION

 

 

 

 

Item 1.

 

Legal Proceedings

 

 

64

 

Item 1A.

 

Risk Factors

 

 

64

 

Item 2.

 

Unregistered Sales of Equity Securities and Use of Proceeds

 

 

64

 

Item 3.

 

Defaults Upon Senior Securities

 

 

64

 

Item 4.

 

Reserved

 

 

64

 

Item 5.

 

Other Information

 

 

64

 

Item 6.

 

Exhibits

 

 

65

 

SIGNATURES

 

 

66

 

EXHIBIT INDEX

 

 

67

 

2


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Cautionary Note Regarding Forward-Looking Statements

        This Report on Form 10-Q contains various statements that may constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and are intended to be covered by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Any statements about our expectations, beliefs, plans, objectives, assumptions or future events or performance are not historical facts and may be forward- looking. These forward-looking statements often can be, but are not always, identified by the use of words such as "assume," "expect," "intend," "plan," "project," "believe," "estimate," "predict," "anticipate," "may," "might," "should," "could," "goal," "potential" and similar expressions. We base these forward-looking statements on our current expectations and projections about future events, our assumptions regarding these events and our knowledge of facts at the time the statements are made. These statements include statements relating to our projected growth, anticipated future financial performance, and management's long-term performance goals, as well as statements relating to the anticipated effects on results of operations and financial condition.

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

3


Table of Contents

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

4


Table of Contents


Part I—FINANCIAL INFORMATION

ITEM 1—CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

        


HERITAGE COMMERCE CORP

CONSOLIDATED BALANCE SHEETS (Unaudited)

 
  June 30,
2011
  December 31,
2010
 
 
  (Dollars in thousands, except per share data)
 

Assets

             

Cash and due from banks

  $ 20,334   $ 7,692  

Interest-bearing deposits in other financial institutions

    67,928     64,485  
           
     

Total cash and cash equivalents

    88,262     72,177  

Securities available-for-sale, at fair value

    302,968     232,165  

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

    3,657     8,750  

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

    435     2,260  

Loans, including deferred costs

    782,080     846,049  

Allowance for loan losses

    (23,167 )   (25,204 )
           
     

Loans, net

    758,913     820,845  

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

   
9,917
   
9,174
 

Company owned life insurance

    44,776     43,682  

Premises and equipment, net

    8,086     8,397  

Intangible assets

    2,753     3,014  

Accrued interest receivable and other assets

    42,302     45,905  
           
     

Total assets

  $ 1,262,069   $ 1,246,369  
           

Liabilities and Shareholders' Equity

             

Liabilities:

             
 

Deposits:

             
   

Demand, noninterest-bearing

  $ 333,199   $ 280,258  
   

Demand, interest-bearing

    128,464     153,917  
   

Savings and money market

    276,538     272,399  
   

Time deposits—under $100

    30,676     33,499  
   

Time deposits—$100 and over

    114,208     137,514  
   

Time deposits—CDARS

    20,839     17,864  
   

Time deposits—brokered

    94,631     98,467  
           
     

Total deposits

    998,555     993,918  
 

Securities sold under agreement to repurchase

        5,000  
 

Subordinated debt

    23,702     23,702  
 

Short-term borrowings

        2,445  
 

Securities purchased pending settlement

    19,755     2,902  
 

Accrued interest payable and other liabilities

    32,578     36,250  
           
   

Total liabilities

    1,074,590     1,064,217  

Shareholders' equity:

             
 

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

             
   

Series A fixed rate cumulative preferred stock, 40,000 shares issued and outstanding (liquidation preference of $43,816 at June 30, 2011 and $42,810 at December 31, 2010)

    39,846     39,846  
   

Discount on Series A preferred stock

    (1,033 )   (1,227 )
   

Series C convertible perpetual preferred stock, 21,004 shares issued and outstanding at June 30, 2011 and December 31, 2010 (liquidation preference of $21,004 at June 30, 2011 and December 31, 2010)

    19,519     19,519  
 

Common stock, no par value; 60,000,000 shares authorized; 26,295,001 shares issued and outstanding at June 30, 2011 and 26,233,001 shares issued and outstanding at December 31, 2010

    130,836     130,531  
 

Retained earnings / (Accumulated deficit)

    601     (1,866 )
 

Accumulated other comprehensive loss

    (2,290 )   (4,651 )
           
   

Total shareholders' equity

    187,479     182,152  
           
     

Total liabilities and shareholders' equity

  $ 1,262,069   $ 1,246,369  
           

See notes to consolidated financial statements

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HERITAGE COMMERCE CORP

CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)

 
  Three Months Ended
June 30,
  Six Months Ended
June 30,
 
 
  2011   2010   2011   2010  
 
  (Dollars in thousands, except per share data)
 

Interest income:

                         
 

Loans, including fees

  $ 10,685   $ 12,737   $ 21,675   $ 25,911  
 

Securities

    2,278     1,459     4,240     2,621  
 

Interest-bearing deposits in other financial institutions

    52     16     86     27  
                   
   

Total interest income

    13,015     14,212     26,001     28,559  
                   

Interest expense:

                         
 

Deposits

    1,068     2,157     2,339     4,521  
 

Subordinated debt

    467     468     932     934  
 

Repurchase agreements

        113     24     244  
 

Short-term borrowings

    8     46     38     63  
                   
   

Total interest expense

    1,543     2,784     3,333     5,762  
                   
   

Net interest income before provision for loan losses

    11,472     11,428     22,668     22,797  

Provision for loan losses

    955     18,600     1,725     23,695  
                   
 

Net interest income (loss) after provision for loan losses

    10,517     (7,172 )   20,943     (898 )
                   

Noninterest income:

                         
 

Service charges and fees on deposit accounts

    587     579     1,154     1,128  
 

Gain on sales of SBA loans

    476     163     855     277  
 

Servicing income

    435     425     846     846  
 

Increase in cash surrender value of life insurance

    419     413     845     822  
 

Other

    253     298     387     489  
                   
   

Total noninterest income

    2,170     1,878     4,087     3,562  
                   

Noninterest expense:

                         
 

Salaries and employee benefits

    5,111     5,491     10,504     11,373  
 

Occupancy and equipment

    1,031     983     2,069     1,942  
 

Professional fees

    456     1,144     1,295     2,421  
 

FDIC deposit insurance premiums

    383     1,019     907     2,210  
 

Software subscriptions

    274     252     529     486  
 

Insurance expense

    244     269     486     525  
 

Data processing

    198     219     419     430  
 

Low income housing investment losses

    40     133     202     358  
 

Other real estate owned expense

    127     69     147     488  
 

Impairment of goodwill

        43,181         43,181  
 

Other

    1,608     1,792     3,345     3,337  
                   
   

Total noninterest expense

    9,472     54,552     19,903     66,751  
                   
     

Income (loss) before income taxes

    3,215     (59,846 )   5,127     (64,087 )

Income tax expense (benefit)

    1,129     (5,753 )   1,460     (5,874 )
                   
 

Net income (loss)

    2,086     (54,093 )   3,667     (58,213 )

Dividends and discount accretion on preferred stock

    (604 )   (1,009 )   (1,200 )   (1,600 )
                   
 

Net income (loss) allocable to common shareholders

  $ 1,482   $ (55,102 ) $ 2,467   $ (59,813 )
                   

Earnings (loss) per common share:

                         
 

Basic

  $ 0.05   $ (4.66 ) $ 0.08   $ (5.06 )
 

Diluted

  $ 0.05   $ (4.66 ) $ 0.08   $ (5.06 )

See notes to consolidated financial statements

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HERITAGE COMMERCE CORP

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (Unaudited)

 
  Six Months Ended June 30, 2011 and 2010  
 
  Preferred Stock   Common Stock   Retained
Earnings/
(Accumulated
Deficit)
  Accumulated
Other
Comprehensive
Loss
   
   
 
 
  Total
Shareholders'
Equity
  Comprehensive
Income (Loss)
 
 
  Shares   Amount   Discount   Shares   Amount  
 
  (Dollars in thousands, except share data)
 

Balance, January 1, 2010

    40,000   $ 39,846   $ (1,598 )   11,820,509   $ 80,222   $ 56,389   $ (2,554 ) $ 172,305        

Net loss

                        (58,213 )       (58,213 ) $ (58,213 )

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

                            1,848     1,848     1,848  

Net change in liability and other postretirement obligations, net of deferred income taxes

                            137     137     137  
                                                       
   

Total comprehensive loss

                                                  $ (56,228 )
                                                       

Issuance of Series B manditorily convertible cumulative perpetual preferred stock, net of issuance costs

    53,996     50,385                         50,385        

Issuance of Series C convertible perpetual preferred stock, net of issuance costs

    21,004     19,599                         19,599        

Amortization of restricted stock award, net of forfeitures and taxes

                    2             2        

Cash dividends accrued on Series A preferred stock

                        (1,005 )       (1,005 )      

Accretion of unearned discount on Series A preferred stock

            183             (183 )              

Stock option expense, net of forfeitures and taxes

                    586             586        
                                         

Balance, June 30, 2010

    115,000   $ 109,830   $ (1,415 )   11,820,509   $ 80,810   $ (3,012 ) $ (569 ) $ 185,644        
                                         

Balance, January 1, 2011

   
61,004
 
$

59,365
 
$

(1,227

)
 
26,233,001
 
$

130,531
 
$

(1,866

)

$

(4,651

)

$

182,152
       

Net income

                        3,667         3,667   $ 3,667  

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

                            2,248     2,248     2,248  

Net change in liability and other postretirement obligations, net of deferred income taxes

                            113     113     113  
                                                       
   

Total comprehensive income

                                                  $ 6,028  
                                                       

Issuance of restricted stock awards

                62,000     320             320        

Amortization of restricted stock awards, net of forfeitures and taxes

                    (346 )           (346 )      

Cash dividends accrued on Series A preferred stock

                        (1,006 )       (1,006 )      

Accretion of discount on Series A preferred stock

            194             (194 )              

Stock option expense, net of forfeitures and taxes

                    331             331        
                                         

Balance, June 30, 2011

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

See notes to consolidated financial statements

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HERITAGE COMMERCE CORP

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

 
  Six Months Ended
June 30,
 
 
  2011   2010  
 
  (Dollars in thousands)
 

CASH FLOWS FROM OPERATING ACTIVITIES:

             

Net income (loss)

  $ 3,667   $ (58,213 )

Adjustments to reconcile net income (loss) to net cash provided by operating activities:

             

Amortization (accretion) of discounts and premiums on securities

    533     (137 )

Gain on sale of SBA loans

    (855 )   (277 )

Proceeds from sale of SBA loans originated for sale

    8,967     5,504  

Net change in SBA loans originated for sale

    (3,019 )   (9,167 )

Writedowns on other loans held-for-sale

    29      

Provision for loan losses

    1,725     23,695  

Increase in cash surrender value of life insurance

    (845 )   (822 )

Depreciation and amortization

    390     402  

Amortization of other intangible assets

    261     287  

(Gains) losses on sale of foreclosed assets, net

    (42 )   416  

Stock option expense, net

    331     586  

Amortization of restricted stock awards, net

    (26 )   2  

Goodwill impairment

        43,181  

Effect of changes in:

             
 

Accrued interest receivable and other assets

    891     (2,821 )
 

Accrued interest payable and other liabilities

    (7,385 )   (1,349 )
           
   

Net cash provided by operating activities

    4,622     1,287  
           

CASH FLOWS FROM INVESTING ACTIVITIES:

             

Purchase of securities available-for-sale

    (62,605 )   (39,351 )

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

    14,775     10,333  

Net change in SBA loans previously transferred to held-for-sale

        (630 )

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

    27      

Net change in loans

    59,136     91,493  

Changes in Federal Home Loan Bank stock and other investments

    (743 )    

Purchase of premises and equipment

    (79 )   (122 )

Redemption (Purchase) of restricted stock and other investments

        155  

Proceeds from sale of foreclosed assets

    2,240     1,270  

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

        1,079  

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

    1,769      

(Purchases) and redemptions of company owned life insurance

    (249 )   308  
           
 

Net cash provided by investing activities

    14,271     64,535  
           

CASH FLOWS FROM FINANCING ACTIVITIES:

             

Net change in deposits

    4,637     (51,860 )

Issuance of preferred stock, net of offering costs

        69,984  

Net change in securities sold under agreement to repurchase

    (5,000 )   (5,000 )

Net change in short-term borrowings

    (2,445 )   (16,008 )
           

Net cash used in financing activities

    (2,808 )   (2,884 )
           
 

Net increase in cash and cash equivalents

    16,085     62,938  

Cash and cash equivalents, beginning of period

    72,177     45,562  
           
 

Cash and cash equivalents, end of period

  $ 88,262   $ 108,500  
           

Supplemental disclosures of cash flow information:

             
 

Interest paid

  $ 5,887   $ 4,864  
 

Income taxes paid

    320      

Supplemental schedule of non-cash investing activity:

             
 

Due to broker for securities purchased

  $ 19,755   $  
 

Transfer from portfolio loans to loans held-for-sale

        17,079  
 

Transfer of loans held-for-sale to loan portfolio

        1,942  
 

Loans transferred to foreclosed assets

    1,071      
 

Cash dividend accrued on Series A preferred stock

    1,006     1,005  

See notes to consolidated financial statements

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2011

(Unaudited)

1) Basis of Presentation

        The unaudited consolidated financial statements of Heritage Commerce Corp (the "Company") and its wholly owned subsidiary, Heritage Bank of Commerce (sometimes referred to as "HBC"), have been prepared pursuant to the rules and regulations for reporting on Form 10-Q. Accordingly, certain information and notes required by accounting principles generally accepted in the United States of America ("GAAP") for annual financial statements are not included herein. The interim statements should be read in conjunction with the consolidated financial statements and notes that were included in the Company's Form 10-K for the year ended December 31, 2010. The Company has also established the following unconsolidated subsidiary grantor trusts: Heritage Capital Trust I; Heritage Statutory Trust I; Heritage Statutory Trust II; and Heritage Commerce Corp Statutory Trust III which are Delaware Statutory business trusts formed for the exclusive purpose of issuing and selling trust preferred securities.

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

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

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

        The results for the three and six months ended June 30, 2011 are not necessarily indicative of the results expected for any subsequent period or for the entire year ending December 31, 2011.

Reclassifications

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

Adoption of New Accounting Standards

        In July 2010, the FASB updated disclosure requirements with respect to the credit quality of financing receivables and the allowance for credit losses. According to the guidance there are two levels of detail at which credit information will be presented—the portfolio segment and class levels. The portfolio segment level is defined as the level where financing receivables are aggregated in developing a Company's systematic method for calculating its allowance for credit losses. The class level is the second level at which credit information will be presented and represents the categorization of

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2011

(Unaudited)

1) Basis of Presentation (Continued)


financing related receivables at a slightly less aggregated level than the portfolio segment level. Companies will now be required to provide the following disclosures as a result of this update: a rollforward of the allowance for credit losses at the portfolio segment level with the ending balances further categorized according to impairment method along with the balance reported in the related financing receivables at period end; additional disclosure of nonaccrual and impaired financing receivables by class as of period end; credit quality and past due/aging information by class as of period end; information surrounding the nature and extent of loan modifications and troubled-debt restructurings and their effect on the allowance for credit losses during the period; and detail of any significant purchases or sales of financing receivables during the period. The increased period-end disclosure requirements became effective for periods ending on or after December 15, 2010, with the exception of additional disclosures surrounding troubled-debt restructurings, which were deferred in December 2010 and become effective for periods ending on or after June 15, 2011. The increased disclosures for activity within a reporting period became effective for periods beginning on or after December 15, 2010. The provisions of this update expanded the Company's current disclosures with respect to the allowance for loan losses.

Newly Issued But Not Yet Effective Accounting Standards

        In April 2011, the FASB issued an accounting standard to amend previous guidance with respect to troubled debt restructurings. This updated guidance is designed to assist creditors with determining whether or not a restructuring constitutes a troubled debt restructuring. In particular, additional guidance has been added to help creditors determine whether a concession has been granted and whether a debtor is experiencing financial difficulties. Both of these conditions are required to be met for a restructuring to constitute a troubled debt restructuring. The amendments in the update are effective for the first interim period beginning on or after June 15, 2011, and will be applied retrospectively to the beginning of the annual period of adoption. The provisions of this update are not expected to have a material impact on the Company's financial position, results of operations or cash flows.

        In June 2011, the FASB issued an accounting standards update to increase the prominence of items included in Other Comprehensive Income and facilitate the convergence of US GAAP with IFRS. The update prohibits continued presentation of Other Comprehensive Income in the statement of Stockholders' Equity. The update requires that all non-owner changes in stockholders' equity be presented in either a single continuous statement of comprehensive income or in two separate but continuous statements. The amendments in the update are effective for interim and annual periods beginning on or after December 15, 2011. The provisions of this update are only expected to change the manner in which our other comprehensive income is disclosed.

2) Earnings Per Share

        Basic earnings (loss) per common share is computed by dividing net income (loss), less dividends and discount accretion on preferred stock, by the weighted average common shares outstanding. The 21,004 shares of Series C Preferred Stock are convertible into 5,601,000 shares of common stock. The Series C Preferred Stock participates in the earnings of the Company and, therefore, the shares issued

10


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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2011

(Unaudited)

2) Earnings Per Share (Continued)


on the conversion of the Series C Preferred Stock would be considered outstanding under the two-class method of computing basic earnings per common share during periods of earnings. Due to the Company's net loss allocable to common shareholders for the three months and six months ended June 30, 2010, the shares issued on the conversion of the Series C Preferred Stock were excluded from the computation of basic loss per average common share. Diluted earnings (loss) per share reflect potential dilution from outstanding stock options and common stock warrants, using the treasury stock method. Due to the Company's net loss allocable to common shareholders for the three months and six months ended June 30, 2010, all stock options and common stock warrants were excluded from the computation of diluted loss per average common share. A reconciliation of the weighted average shares used in computing basic and diluted earnings (loss) per common share is as follows:

 
  For the Three Months Ended
June 30,
  For the Six Months Ended
June 30,
 
 
  2011   2010   2011   2010  

Weighted average common shares outstanding

    26,243,334     11,820,509     26,238,168     11,820,509  

Effect of convertible preferred stock

    5,601,000     N/A     5,601,000     N/A  
                   
 

Shares used in computing basic earnings (loss) per common share

    31,844,334     11,820,509     31,839,168     11,820,509  

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

    3,675     N/A     5,566     N/A  
                   
 

Shares used in computing diluted earnings (loss) per common share

    31,848,009     11,820,509     31,844,734     11,820,509  
                   

3) Securities

        The amortized cost and estimated fair value of securities at June 30, 2011 and December 31, 2010 were as follows:

June 30, 2011
  Amortized
Cost
  Gross
Unrealized
Gains
  Gross
Unrealized
Losses
  Estimated
Fair
Value
 
 
  (Dollars in thousands)
 

Securities available-for-sale:

                         
 

Agency Mortgage-Backed Securities

  $ 302,150   $ 3,104   $ (2,286 ) $ 302,968  
                   

 

December 31, 2010
  Amortized
Cost
  Gross
Unrealized
Gains
  Gross
Unrealized
Losses
  Estimated
Fair
Value
 
 
  (Dollars in thousands)
 

Securities available-for-sale:

                         
 

Agency Mortgage-Backed Securities

  $ 235,099   $ 1,079   $ (4,013 ) $ 232,165  
                   

11


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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2011

(Unaudited)

3) Securities (Continued)

        At June 30, 2011 and December 31, 2010, all agency mortgage backed securities were issued by Fannie Mae, Freddie Mac, or the Government National Mortgage Association ("Ginnie Mae"), and there were no holdings of securities of any one issuer, other than the U.S. Government and its sponsored entities, in an amount greater than 10% of shareholders' equity.

        At June 30, 2011, the Company held 142 securities, of which 58 had fair values below amortized cost. No securities had been carried with an unrealized loss for over 12 months. Unrealized losses were due to higher interest rates. The issuers are of high credit quality and all principal amounts are expected to be paid when securities mature. The fair value is expected to recover as the securities approach their maturity date and/or market rates decline. The Company does not intend to sell any securities with an unrealized loss and does not believe that it is more likely than not that the Company will be required to sell a security in an unrealized loss position prior to recovery in value. The Company does not consider these securities to be other-than-temporarily impaired at June 30, 2011.

        At December 31, 2010, the Company held 106 securities, of which 54 had fair values below amortized cost. No securities have been carried with an unrealized loss for over 12 months. The Company did not consider these securities to be other-than-temporarily impaired at December 31, 2010.

        The amortized cost and estimated fair values of securities as of June 30, 2011, by weighted average life, are shown below. The weighted average life will differ from contractual maturities because borrowers may have the right to call or pre-pay obligations with or without call or pre-payment penalties.

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

Due within one year

  $   $  

Due after one through five years

    56,268     57,713  

Due after five through ten years

    211,879     211,260  

Due after ten years

    34,003     33,995  
           
 

Total

  $ 302,150   $ 302,968  
           

12


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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2011

(Unaudited)

4) Loans

        Loans were as follows:

 
  June 30,
2011
  December 31,
2010
 
 
  (Dollars in thousands)
 

Loans held-for-sale:

             
 

Loans held-for-sale—SBA

  $ 3,657   $ 8,750  
 

Loans held-for-sale—other

    435     2,260  
           
   

Total loans held-for-sale

  $ 4,092   $ 11,010  
           

Loans held-for-investment:

             
 

Commercial

    358,227   $ 378,412  
 

Real estate:

             
   

Commercial and residential

    315,426     337,457  
   

Land and construction

    41,987     62,356  
   

Home equity

    52,621     53,697  
 

Consumer

    13,040     13,244  
           
   

Loans

    781,301     845,166  

Deferred loan origination costs and fees, net

    779     883  
           
 

Loans, including deferred costs

    782,080     846,049  

Allowance for loan losses

    (23,167 )   (25,204 )
           
 

Loans, net

  $ 758,913   $ 820,845  
           

        Prior to February 15, 2011, SBA loans that were sold were subject to a warranty for a period of 90 days. In accordance with generally accepted accounting principles, the Company treated sold SBA loans as secured borrowings during the warranty period. The secured borrowings were classified as "short-term borrowings" on the unaudited consolidated balance sheets. At December 31, 2010, the balance of loans held-for-sale included $2,445,000 of SBA loans that were transferred to third parties, with associated deferred gains of $192,000, which are included in other liabilities on the unaudited consolidated balance sheets. Effective February 15, 2011, the SBA no longer required a warranty period in loan sales agreements. Therefore, gains on loan sales completed after February 15, 2011 are recognized upon completion of the transaction. The Company had no deferred gains associated with the SBA loans held-for-sale at June 30, 2011.

13


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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2011

(Unaudited)

4) Loans (Continued)

        Changes in the allowance for loan losses were as follows:

 
   
   
   
   
  Three
Months
Ended
June 30, 2010
Total
 
 
  Three Months Ended June 30, 2011  
 
  Commercial   Real Estate   Consumer   Total  
 
  (Dollars in thousands)
 

Balance, beginning of period

  $ 13,594   $ 9,539   $ 876   $ 24,009   $ 26,527  

Charge-offs

    (1,681 )   (601 )   (8 )   (2,290 )   (18,681 )

Recoveries

    91     401     1     493     307  
                       
 

Net charge-offs

    (1,590 )   (200 )   (7 )   (1,797 )   (18,374 )

Provision for loan losses

    1,988     (1,177 )   144     955     18,600  
                       
 

Balance, end of period

  $ 13,992   $ 8,162   $ 1,013   $ 23,167   $ 26,753  
                       

 

 
  Six Months Ended June 30, 2011    
 
 
  Six Months Ended
June 30, 2010
Total
 
 
  Commercial   Real Estate   Consumer   Total  
 
  (Dollars in thousands)
 

Balance, beginning of period

  $ 13,952   $ 10,363   $ 889   $ 25,204   $ 28,768  

Charge-offs

    (2,800 )   (1,596 )   (8 )   (4,404 )   (26,383 )

Recoveries

    230     411     1     642     673  
                       
 

Net charge-offs

    (2,570 )   (1,185 )   (7 )   (3,762 )   (25,710 )

Provision for loan losses

    2,610     (1,016 )   131     1,725     23,695  
                       
 

Balance, end of period

  $ 13,992   $ 8,162   $ 1,013   $ 23,167   $ 26,753  
                       

        The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment, based on the impairment method as of June 30, 2011 and December 31, 2010:

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

Allowance for loan losses:

                         
 

Ending allowance balance attributable to loans:

                         
   

Individually evaluated for impairment

  $ 4,296   $ 621   $ 880   $ 5,797  
   

Collectively evaluated for impairment

    9,696     7,541     133     17,370  
                   
     

Total ending allowance balance

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

Loans:

                         
   

Individually evaluated for impairment

  $ 13,038   $ 10,034   $ 983   $ 24,055  
   

Collectively evaluated for impairment

    345,189     400,000     12,057     757,246  
                   
     

Total ending loan balance

  $ 358,227   $ 410,034   $ 13,040   $ 781,301  
                   

14


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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2011

(Unaudited)

4) Loans (Continued)

 
  December 31, 2010  
 
  Commercial   Real Estate   Consumer   Total  
 
  (Dollars in thousands)
 

Allowance for loan losses:

                         
 

Ending allowance balance attributable to loans:

                         
   

Individually evaluated for impairment

  $ 3,427   $ 1,855   $ 778   $ 6,060  
   

Collectively evaluated for impairment

    10,525     8,508     111     19,144  
                   
     

Total ending allowance balance

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

Loans:

                         
   

Individually evaluated for impairment

  $ 14,374   $ 16,041   $ 898   $ 31,313  
   

Collectively evaluated for impairment

    364,038     437,469     12,346     813,853  
                   
     

Total ending loan balance

  $ 378,412   $ 453,510   $ 13,244   $ 845,166  
                   

        The following table presents loans held-for-investment individually evaluated for impairment by class of loans as of June 30, 2011 and December 31, 2010. The recorded investment included in the following table represents loan principal net of any partial charge-offs recognized on the loans. The unpaid principal balance represents the recorded balance prior to any partial charge-offs.

 
  June 30, 2011   December 31, 2010  
 
  Unpaid
Principal
Balance
  Recorded
Investment
  Allowance
for Loan
Losses
Allocated
  Unpaid
Principal
Balance
  Recorded
Investment
  Allowance
for Loan
Losses
Allocated
 
 
  (Dollars in thousands)
 

With no related allowance recorded:

                                     
 

Commercial

  $ 4,478   $ 4,184   $   $ 5,557   $ 5,125   $  
 

Real estate:

                                     
   

Commercial and residential

    2,396     2,396         4,392     2,431      
   

Land and construction

    3,040     3,040         6,138     3,429      
 

Consumer

                         
                           
   

Total with no related allowance recorded

    9,914     9,620         16,087     10,985      

With an allowance recorded:

                                     
 

Commercial

    9,940     8,854     4,296     9,695     9,249     3,427  
 

Real estate:

                                     
   

Commercial and residential

    198     198     71     4,753     4,753     1,002  
   

Land and construction

    5,001     4,400     550     6,862     5,428     853  
   

Home Equity

                         
 

Consumer

    983     983     880     898     898     778  
                           
   

Total with an allowance recorded

    16,122     14,435     5,797     22,208     20,328     6,060  
                           
   

Total

  $ 26,036   $ 24,055   $ 5,797   $ 38,295   $ 31,313   $ 6,060  
                           

15


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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2011

(Unaudited)

4) Loans (Continued)

        The following table presents interest recognized and cash-basis interest earned on impaired loans:

 
  Three Months Ended June 30, 2011    
 
 
   
  Real Estate    
   
  Three
Months
Ended
June 30, 2010
Total
 
 
  Commercial   Commercial and
Residential
  Land and
Construction
  Home
Equity
  Consumer   Total  
 
  (Dollars in thousands)
 

Average of impaired loans during the period

  $ 13,146   $ 2,780   $ 7,306   $ 141   $ 938   $ 24,311   $ 58,491  

Interest income during impairment

  $   $   $   $   $   $   $ 19  

Cash-basis interest earned

  $   $   $   $   $   $   $ 26  

 
  Six Months Ended June 30, 2011    
 
 
   
  Real Estate    
   
  Six
Months
Ended
June 30, 2010
Total
 
 
  Commercial   Commercial and
Residential
  Land and
Construction
  Home
Equity
  Consumer   Total  
 
  (Dollars in thousands)
 

Average of impaired loans during the period

  $ 13,555   $ 4,248   $ 7,823   $ 94   $ 925   $ 26,645   $ 59,785  

Interest income during impairment

  $ 1   $   $   $ 1   $   $ 2   $ 36  

Cash-basis interest earned

  $   $   $   $ 1   $   $ 1   $ 27  

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

 
  June 30,    
 
 
  December 31,
2010
 
 
  2011   2010  
 
  (Dollars in thousands)
 

Nonaccrual loans—held-for-sale

  $ 202   $ 9,806   $ 2,026  

Nonaccrual loans—held-for-investment

    21,607     47,263     28,821  

Restructured and loans over 90 days past due and still accruing

    2,448     2,516     2,492  
               
 

Total

  $ 24,257   $ 59,585   $ 33,339  
               

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Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2011

(Unaudited)

4) Loans (Continued)

        The following table presents the nonperforming loans by class as of June 30, 2011 and December 31, 2010:

 
  June 30, 2011   December 31, 2010  
 
  Nonaccrual   Restructured and
Loans Over 90 Days
Past Due and
Still Accruing
  Total   Nonaccrual   Restructured and
Loans Over 90 Days
Past Due and
Still Accruing
  Total  
 
  (Dollars in thousands)
 

Commercial

  $ 10,690   $ 2,336   $ 13,026   $ 13,545   $ 829   $ 14,374  

Real estate:

                                     
 

Commercial and residential

    2,594         2,594     6,450     1,663     8,113  
 

Land and construction

    7,654         7,654     9,954         9,954  
 

Home equity

                         

Consumer

    871     112     983     898         898  
                           
 

Total

  $ 21,809   $ 2,448   $ 24,257   $ 30,847   $ 2,492   $ 33,339  
                           

        The following table presents the aging of past due loans as of June 30, 2011 by class of loans:

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

Commercial

  $ 1,912   $ 3,860   $ 5,921   $ 11,693   $ 346,534   $ 358,227  

Real estate:

                                     
 

Commercial and residential

    1,413         1,467     2,880     312,546     315,426  
 

Land and construction

        1,876     5,564     7,440     34,547     41,987  
 

Home equity

    282               282     52,339     52,621  

Consumer

            983     983     12,057     13,040  
                           
 

Total

  $ 3,607   $ 5,736   $ 13,935   $ 23,278   $ 758,023   $ 781,301  
                           

17


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2011

(Unaudited)

4) Loans (Continued)

        The following table presents the aging of past due loans as of December 31, 2010 by class of loans:

 
  December 31, 2010  
 
  30 - 59
Days
Past Due
  60 - 89
Days
Past Due
  90 Days or
Greater
Past Due
  Total
Past Due
  Loans Not
Past Due
  Total  
 
  (Dollars in thousands)
 

Commercial

  $ 3,176   $ 807   $ 14,374   $ 18,357   $ 360,055   $ 378,412  

Real estate:

                                     
 

Commercial and residential

    1,078     1,595     7,184     9,857     327,600     337,457  
 

Land and construction

            8,857     8,857     53,499     62,356  
 

Home equity

    80             80     53,617     53,697  

Consumer

            898     898     12,346     13,244  
                           
 

Total

  $ 4,334   $ 2,402   $ 31,313   $ 38,049   $ 807,117   $ 845,166  
                           

        Past due loans totaled $23,278,000 and $38,049,000 at June 30, 2011 and December 31, 2010, respectively, of which $15,898,000 and $28,821,000 were on nonaccrual. At June 30, 2011, there were also $5,709,000 current loans included in nonaccrual loans held-for-investment. There were no current loans included in nonaccrual loans held-for-investment at December 31, 2010. Management's classification of a loan as "nonaccrual" is an indication that there is reasonable doubt as to the full recovery of principal or interest on the loan. At that point, the Company stops accruing interest income, and reverses any uncollected interest that had been accrued as income. The Company begins recognizing interest income only as cash interest payments are received and it has been determined the collection of all outstanding principal is not in doubt. The loans may or may not be collateralized, and collection efforts are pursued.

Credit Quality Indicators

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

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

18


Table of Contents


HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2011

(Unaudited)

4) Loans (Continued)


accordance with contractual loans terms. Classified loans are those loans that are assigned a substandard, substandard-nonaccrual, or doubtful risk rating using the following definitions:

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

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

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

        The following table provides a summary of the loan portfolio by loan type and credit quality classification at June 30, 2011 and December 31, 2010:

 
  June 30, 2011   December 31, 2010  
 
  Nonclassified   Classified   Total   Nonclassified   Classified   Total  
 
  (Dollars in thousands)
 

Commercial

  $ 324,910   $ 33,317   $ 358,227   $ 340,319   $ 38,093   $ 378,412  

Real estate:

                                     
 

Commercial and residential

    299,524     15,902     315,426     320,867     16,590     337,457  
 

Land and construction

    17,683     24,304     41,987     32,664     29,692     62,356  
 

Home equity

    51,689     932     52,621     50,757     2,940     53,697  

Consumer

    12,036     1,004     13,040     12,346     898     13,244  
                           
 

Total

  $ 705,842   $ 75,459   $ 781,301   $ 756,953   $ 88,213   $ 845,166  
                           

5) Preferred Stock

Series A Preferred Stock

        On November 21, 2008, the Company issued 40,000 shares of Series A Fixed Rate Cumulative Perpetual Preferred Stock ("Series A Preferred Stock") to the U.S. Treasury under the terms of the U.S. Treasury Capital Purchase Program for $40,000,000 with a liquidation preference of $1,000 per share. The Series A Preferred Stock carries a coupon of 5% for five years and 9% thereafter. In November 2009, the Company announced that it was exercising its right to suspend payment of dividends on its Series A Preferred Stock. As of June 30, 2011, the Company had accrued but had not

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2011

(Unaudited)

5) Preferred Stock (Continued)


paid approximately $3,816,000 in dividends on its Series A Preferred Stock. See Note 12 for a summary of subsequent events regarding the Series A Preferred Stock.

Private Placement

        On June 21, 2010, the Company issued to various institutional investors 53,996 shares of Series B Mandatory Convertible Perpetual Preferred Stock ("Series B Preferred Stock") and 21,004 shares of Series C Convertible Perpetual Preferred Stock ("Series C Preferred Stock") for an aggregate purchase price of $75,000,000. The Series B Preferred Stock was mandatorily convertible into common stock, upon approval by the shareholders, at a conversion price of $3.75 per share. The Series C Preferred Stock is mandatorily convertible into common stock at a conversion price of $3.75 per share upon both approval by the shareholders and thereafter, a subsequent transfer of the Series C Preferred Stock to third parties not affiliated with the holder in a widely dispersed offering. The Series B Preferred Stock and the Series C Preferred Stock did not include a beneficial conversion feature, as the conversion price of $3.75 per share was not below the fair market value of the Company's common stock on the commitment date.

        At the Company's Special Meeting of shareholders held on September 15, 2010, the Company's shareholders approved the issuance of common stock upon the conversion of the Series B Preferred Stock and upon the conversion of the Series C Preferred Stock, as required by the NASDAQ Stock Market and California corporate law. As a result, on September 16, 2010, the Series B Preferred Stock was converted into 14,398,992 shares of common stock of the Company and the shares of Series B Preferred Stock ceased to be outstanding.

        The Series C Preferred Stock remains outstanding until it has been converted into common stock in accordance with its terms. The Series C Preferred Stock is non-voting except in the case of certain transactions that would affect the rights of the holders of the Series C Preferred Stock or applicable law. Holders of Series C Preferred Stock will receive dividends if and only to the extent dividends are paid to holders of common stock. The Series C Preferred Stock is not redeemable by the Company or by the holders and has a liquidation preference of $1,000 per share. The Series C Preferred Stock ranks senior to the Company's common stock and ranks on parity with the Company's Series A Preferred Stock.

6) Income Taxes

        Some items of income and expense are recognized in different years for tax purposes than when applying generally accepted accounting principles, leading to timing differences between the Company's actual tax liability and the amount accrued for this liability based on book income. These temporary differences comprise the "deferred" portion of the Company's tax expense or benefit, which is accumulated on the Company's books as a deferred tax asset or deferred tax liability until such time as they reverse. At June 30, 2011, the Company had a net deferred tax asset of approximately $24,501,000, compared to $27,361,000 at December 31, 2010. The deferred tax asset at June 30, 2011 and December 31, 2010 is net of a $3,700,000 partial valuation allowance.

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2011

(Unaudited)

6) Income Taxes (Continued)

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

7) Supplemental Retirement Plan

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

 
  Three Months Ended
June 30,
  Six Months Ended
June 30,
 
 
  2011   2010   2011   2010  
 
  (Dollars in thousands)
 

Components of net periodic benefit cost:

                         
 

Service cost

  $ 236   $ 244   $ 472   $ 488  
 

Interest cost

    206     209     412     418  
 

Amortization of prior service cost

    9     9     18     18  
 

Amortization of net actuarial loss

    31     17     62     34  
                   
   

Net periodic benefit cost

  $ 482   $ 479   $ 964   $ 958  
                   

8) Fair Value

        Accounting guidance establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

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

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

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2011

(Unaudited)

8) Fair Value (Continued)

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

Financial Assets and Liabilities Measured on a Recurring Basis

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

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

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

Assets at June 30, 2011:

                         
 

Available-for-sale securities:

                         
   

Agency Mortgage-Backed Securities

  $ 302,968       $ 302,968      
 

I/O strip receivables

    2,185         2,185      

Assets at December 31, 2010:

                         
 

Available-for-sale securities:

                         
   

Agency Mortgage-Backed Securities

  $ 232,165       $ 232,165      
 

I/O strip receivables

    2,140         2,140      

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

Assets and Liabilities Measured on a Non-Recurring Basis

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

        The fair value of impaired loans with specific allocations of the allowance for loan losses is generally based on recent real estate appraisals. The appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2011

(Unaudited)

8) Fair Value (Continued)

        Nonrecurring adjustments to certain commercial and residential estate properties classified as other real estate owned are measured at the lower of carrying amount or fair value, less costs to sell. Fair values are generally based on third party appraisals of the property, resulting in a Level 3 classification. In cases where the carrying amount exceeds the fair value, less costs to sell, an impairment loss is recognized.

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

Assets at June 30, 2011:

                         
 

Impaired loans held-for-sale—other:

                         
   

Real estate:

                         
     

Land and construction

  $ 202       $ 202      
                       
 

Impaired loans—held-for-investment:

                         
   

Commercial

  $ 7,015           $ 7,015  
   

Real estate:

                         
     

Commercial and residential

    1,245             1,245  
     

Land and construction

    4,135             4,135  
   

Consumer

    104             104  
                       

  $ 12,499           $ 12,499  
                       
 

Other real estate owned

 
$

248
   
   
 
$

248
 

Assets at December 31, 2010:

                         
 

Loans held-for-sale—other:

                         
   

Real estate:

                         
     

Commercial and residential

  $ 929       $ 929      
     

Land and construction

    1,097         1,097      
                       

  $ 2,026       $ 2,026      
                       
 

Impaired loans—held-for-investment:

                         
   

Commercial

  $ 6,725           $ 6,725  
   

Real estate:

                         
     

Commercial and residential

    5,982             5,982  
     

Land and construction

    8,005             8,005  
   

Consumer

    120             120  
                       

  $ 20,832           $ 20,832  
                       
 

Other real estate owned

 
$

1,296
   
   
 
$

1,296
 

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2011

(Unaudited)

8) Fair Value (Continued)

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

 
  June 30, 2011   December 31, 2010  
 
  (Dollars in thousands)
 

Impaired loans held-for-investment:

             
 

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

  $ 18,296   $ 26,892  
 

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

    5,759     4,421  
           
   

Total impaired loans held-for-investment

  $ 24,055   $ 31,313  
           

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

             
 

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

  $ 18,296   $ 26,892  
 

Specific valuation allowance

    (5,797 )   (6,060 )
           
   

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

  $ 12,499   $ 20,832  
           

        Impaired loans held-for-investment which are measured primarily for impairment using the fair value of the collateral were $24,055,000 at June 30, 2011, after partial charge-offs of $3,679,000 in the first six months of 2011. In addition, these loans had a specific valuation allowance of $5,797,000 at June 30, 2011. Impaired loans held-for-investment totaling $18,296,000 at June 30, 2011 were carried at fair value as a result of the aforementioned partial charge-offs and specific valuation allowances at period-end. The remaining $5,759,000 of impaired loans were carried at cost at June 30, 2011, as the fair value of the collateral exceeded the cost basis of each respective loan. Partial charge-offs and changes in specific valuation allowances during the first six months of 2011 on impaired loans held-for-investment carried at fair value at June 30, 2011 resulted in an additional provision for loan losses of $3,961,000.

        Total other real estate owned, consisting of three properties, had a fair value of $248,000 at June 30, 2011.

        Impaired loans held-for-investment which are measured primarily for impairment using the fair value of the collateral totaled $31,313,000 at December 31, 2010, after partial charge-offs of $6,982,000 in 2010. In addition, these loans had a specific valuation allowance of $6,060,000 at December 31, 2010. Impaired loans held-for-investment totaling $26,892,000 at December 31, 2010 were carried at fair value as a result of the aforementioned partial charge-offs and specific valuation allowances at year-end. The remaining $4,421,000 of impaired loans were carried at cost at December 31, 2010, as the fair value of the collateral exceeded the cost basis of each respective loan. Partial charge-offs and changes in specific valuation allowances during 2010 on impaired loans held-for-investment carried at fair value at December 31, 2010 resulted in an additional provision for loan losses of $9,791,000.

        Total other real estate owned, consisting of one property, had a fair value of $1,296,000 at December 31, 2010.

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2011

(Unaudited)

8) Fair Value (Continued)

        The carrying amounts and estimated fair values of the Company's financial instruments for the periods indicated were as follows:

 
  June 30, 2011   December 31, 2010  
 
  Carrying
Amounts
  Estimated
Fair
Value
  Carrying
Amounts
  Estimated
Fair
Value
 
 
  (Dollars in thousands)
 

Assets:

                         
 

Cash and cash equivalents

  $ 88,262   $ 88,262   $ 72,177   $ 72,177  
 

Securities available-for-sale

    302,968     302,968     232,165     232,165  
 

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

    763,005     766,296     831,855     855,327  
 

FHLB and FRB stock

    9,917     N/A     9,174     N/A  
 

Accrued interest receivable

    3,372     3,372     3,215     3,215  
 

Loan servicing rights and I/O strips receivables

    3,021     5,424     3,055     5,340  

Liabilities:

                         
 

Time deposits

  $ 260,354   $ 260,970   $ 287,344   $ 288,798  
 

Other deposits

    738,201     738,201     706,574     706,574  
 

Securities sold under agreement to repurchase

            5,000     5,018  
 

Short-term borrowings

            2,445     2,445  
 

Subordinated debt

    23,702     18,078     23,702     14,445  
 

Accrued interest payable

    256     256     2,810     2,810  

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

Cash and Cash Equivalents and Accrued Interest Receivable and Payable

        The carrying amount approximates fair value because of the short maturities of these instruments.

Loans

        Loans with similar financial characteristics are grouped together for purposes of estimating their fair value. Loans are segregated by type such as commercial, term real estate, construction and land development, and consumer. Each loan category is further segmented into fixed and adjustable rate interest terms.

        The fair value of performing, fixed rate loans is calculated by discounting scheduled future cash flows using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan. The fair value of variable rate loans approximates the carrying amount as these loans generally reprice within 90 days.

        The fair value of loans held-for-sale is based on estimated market values from third party investors.

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2011

(Unaudited)

8) Fair Value (Continued)

FHLB and FRB Stock

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

Deposits

        The fair value of deposits with no stated maturity, such as demand deposits, savings, and money market accounts, approximates the amount payable on demand. The carrying amount approximates the fair value of time deposits with a remaining maturity of less than 90 days. The fair value of all other time deposits is calculated based on discounting the future cash flows using rates currently offered for time deposits with similar remaining maturities.

Subordinated Debt and Securities Sold Under Agreement to Purchase

        The fair values of subordinated debt and securities sold under agreement to repurchase were determined based on the current market value for like kind instruments of a similar maturity and structure.

Short-term Borrowings and Note Payable

        The carrying amount approximates the fair value of short-term borrowings and the note payable that reprice frequently and fully.

Off-Balance Sheet Items

        The fair value of off-balance sheet items, such as commitments to extend credit, is not considered material and therefore is not included in the table above.

Limitations

        Fair value estimates are made at a specific point in time, based on relevant market information about the financial instruments. These estimates do not reflect any premium or discount that could result from offering for sale at one time the entire holdings of a particular financial instrument. Fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.

9) Regulatory Matters

        The Federal Reserve Bank of San Francisco ("FRB") and the State of California Department of Financial Institutions ("DFI") issued a joint order terminating the regulatory written agreement ("Written Agreement") entered into on February 17, 2010, among the Company, HBC, the FRB and the DFI. Effective June 9, 2011, the Company and HBC are no longer subject to the terms and conditions of the Written Agreement.

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2011

(Unaudited)

10) Equity Plan

        The Company granted 62,000 restricted shares of its common stock to eight officers pursuant to the terms of the restricted stock agreements, dated June 16, 2011, under the Amended and Restated 2004 Equity Plan. The grant price was $5.16. Under the terms of the agreements, the period of restriction, during which the Common Shares shall be subject to the Company's return right, shall lapse upon the later of the following (a) and (b) to occur: (a) on the date the Company has redeemed all of the issued and outstanding shares of the Company's Series A Fixed Rate Cumulative Perpetual Preferred Stock, or (b) upon the second anniversary of the grant date. However, upon the occurrence of a change in control, or the death or disability of the participant, the Company's return right will lapse immediately. The fair value of stock awards at the grant date was $319,920, which is being amortized over a two and half period on the straight-line method. Amortization expense related to the 62,000 shares was $4,800 in the second quarter of 2011. None of the shares were vested at June 30, 2011.

        The Company also granted 150,000 shares of incentive stock options to directors and employees in June 2011. The exercise price was $5.16 per share, and the options vest over four years. As of June 30, 2011, there was $431,000 of unrecognized compensation expense related to the 150,000 nonvested stock options granted in June 2011.

11) Comprehensive Income (Loss)

        Comprehensive income (loss) consists of other comprehensive income and net income (loss). Other comprehensive income refers to gains and losses that are included in comprehensive income (loss) but are excluded from net income (loss) because they have been recorded directly in equity under the

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HERITAGE COMMERCE CORP

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2011

(Unaudited)

11) Comprehensive Income (Loss) (Continued)


provisions of other accounting guidance. The following is a summary of the components of other comprehensive (loss) income:

 
  For the Three Months Ended
June 30,
  For the Six Months Ended
June 30,
 
 
  2011   2010   2011   2010  
 
  (Dollars in thousands)
 

Net income (loss)

  $ 2,086   $ (54,093 ) $ 3,667   $ (58,213 )

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

    4,243     2,968     3,876     3,186  

Less: Deferred income tax

    (1,782 )   (1,247 )   (1,628 )   (1,338 )
                   
 

Change in unrealized gains (losses) on available-for-sale

                         
   

securities and I/O strips, net of deferred income tax

    2,461     1,721     2,248     1,848  
                   

Net pension and other post retirement plan liability adjustment

    89     210     195     236  

Less: Deferred income tax

    (37 )   (88 )   (82 )   (99 )
                   
 

Change in pension and other post retirement plan liability, net of deferred income tax

    52     122     113     137  
                   
   

Other comprehensive income

    2,513     1,843     2,361     1,985  
                   
     

Total comprehensive income (loss)

  $ 4,599   $ (52,250 ) $ 6,028   $ (56,228 )
                   

12) Subordinated Debt

        In November 2009, the Company announced that it was exercising its right to defer regularly scheduled interest payments on its $23,702,000 of junior subordinated notes relating to its trust preferred securities. From the time it deferred interest payments, the Company accrued the expense of each deferred interest payment at the normal rate on a compounded basis. On June 24, 2011, the Company paid all of the deferred interest payments on its outstanding trust preferred subordinated debt securities in the amount of $3,884,000, which includes all payments due through September 8, 2011. The cash payment of the deferred arrearage did not have any impact on the Company's earnings for the three and six months ended June 30, 2011.

13) Subsequent Events

        On July 28, 2011, the Board of Directors of the Company declared a dividend on its Series A Preferred Stock held by the U.S. Treasury in an aggregate amount of $4,172,000. The dividend was paid on August 1, 2011. Of the aggregate dividend declared and paid, $3,500,000 is attributable to the dividend periods ending November 15, 2009 through May 15, 2011 and $172,000 is for interest on the deferred dividend payments. The balance of $500,000 is the dividend payable for the period ending August 15, 2011. As a result of the dividend payment, the Company is current with respect to dividends accrued and owed to the U.S. Treasury.

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Table of Contents

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

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

EXECUTIVE SUMMARY

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

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

Recent Events

        The Federal Reserve Bank of San Francisco ("FRB") and the State of California Department of Financial Institutions ("DFI") issued a joint order terminating the regulatory written agreement ("Written Agreement") entered into on February 17, 2010, among the Company, HBC, the FRB and the DFI. Effective June 9, 2011, the Company and HBC are no longer be subject to the terms and conditions of the Written Agreement.

        On June 24, 2011, the Company paid all of the deferred interest payments on its outstanding trust preferred subordinated debt securities in the amount of $3.9 million, which includes all payments due through September 8, 2011. In November 2009, the Company announced that it was exercising its right to defer regularly scheduled interest payments on its $23.7 million of junior subordinated notes relating to its trust preferred securities. From the time it deferred interest payments, the Company accrued the expense of each deferred interest payment at the normal rate on a compounded basis. Therefore, the cash payment of the deferred arrearage did not have any impact on the Company's earnings for the three and six months ended June 30, 2011.

        On July 28, 2011, the Company's Board of Directors declared a dividend on its Series A Preferred Stock held by the U.S. Treasury in an aggregate amount of $4.2 million. The dividend was paid on August 1, 2011. Of the aggregate dividend declared and paid, $3.5 million is attributable to the dividend periods ending November 15, 2009 through May 15, 2011 and $172,000 is for interest on the deferred dividend payments, that have been previously accrued. The balance of $500,000 is the dividend payable for the period ending August 15, 2011. As a result of the dividend payment, the Company is current with respect to dividends accrued and owed to the U.S. Treasury.

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Performance Overview

        For the three months ended June 30, 2011, net income was $2.1 million. The net income allocable to common shareholders was $1.5 million, or $0.05 per common share for the three months ended June 30, 2011, which included a $955,000 provision for loan losses, and $604,000 in dividends and discount accretion on preferred stock. In the three months ended June 30, 2010, the net loss was ($54.1) million. The net loss allocable to common shareholders was ($55.1) million, or $(4.66) per common share for the three months ended June 30, 2010, which included a $43.2 million charge for impairment of goodwill, an $18.6 million provision for loan losses, a $3.7 million partial valuation allowance on the deferred tax asset and $1.0 million in dividends and discount accretion on preferred stock.

        For the six months ended June 30, 2011, net income was $3.7 million. The net income allocable to common shareholders was $2.5 million, or $0.08 per common share, which included a $1.7 million provision for loan losses, and $1.2 million in dividends and discount accretion on preferred stock. In the six months ended June 30, 2010, the net loss was ($58.2) million. The net loss allocable to common shareholders was ($59.8) million, or $(5.06) per common share, which included a $43.2 million charge for impairment of goodwill, a $23.7 million provision for loan losses, a $3.7 million partial valuation allowance on the deferred tax asset, and $1.6 million in dividends and discount accretion on preferred stock.

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

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

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Deposits

        The composition and cost of the Company's deposit base are important in analyzing the Company's net interest margin and balance sheet liquidity characteristics. Except for brokered time deposits, the Company's depositors are generally located in its primary market area. Depending on loan demand and other funding requirements, the Company also obtains deposits from wholesale sources including deposit brokers. The Company had $94.6 million in brokered deposits at June 30, 2011, compared to $163.7 million at June 30, 2010, and $98.5 million at December 31, 2010. Deposits from title insurance companies, escrow accounts and real estate exchange facilitators increased to $33.3 million at June 30, 2011, compared to $27.2 million at June 30, 2010, and $39.0 million at December 31, 2010. The Company has a policy to monitor all deposits that may be sensitive to interest rate changes to help assure that liquidity risk does not become excessive due to concentrations. Deposits at June 30, 2011 were $998.6 million, compared to $1.04 billion at June 30, 2010, and $993.9 million at December 31, 2010. Over the first six months of 2011, our reliance on noncore funding has improved with the ratio of noncore funding to total assets at 18.20% at June 30, 2011, compared to 20.96% at December 31, 2010.

        HBC is a member of the Certificate of Deposit Account Registry Service ("CDARS") program. The CDARS program allows customers with deposits in excess of FDIC insured limits to obtain coverage on time deposits through a network of banks within the CDARS program. Deposits gathered through this program are considered brokered deposits under regulatory guidelines. Deposits in the CDARS program totaled $20.8 million at June 30, 2011, compared to $18.2 million at June 30, 2010, and $17.9 million at December 31, 2010.

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Liquidity

        Our liquidity position refers to our ability to maintain cash flows sufficient to fund operations and to meet obligations and other commitments in a timely fashion. At June 30, 2011, we had $88.3 million in cash and cash equivalents and approximately $260.2 million in available borrowing capacity from various sources including the Federal Home Loan Bank ("FHLB"), the Federal Reserve Bank of San Francisco ("FRB"), and Federal funds facilities with several financial institutions. The Company also had $250.0 million in unpledged securities available at June 30, 2011. Our loan to deposit ratio decreased to 78.32% at June 30, 2011, compared to 90.39% at June 30, 2010, and 85.12% at December 31, 2010, primarily due to a reduction in the loan portfolio.

Lending

        Our lending business originates primarily through our branch offices located in our primary market. The Company also has an additional SBA loan production office in Santa Rosa, California. The total loan portfolio remains well diversified with commercial loans accounting for 46% of the portfolio at June 30, 2011. Commercial and residential real estate loans accounted for 40% of the total loan portfolio at June 30, 2011, of which 52% were owner-occupied by businesses. We have actively lowered our exposure to land and construction loans and our overall credit risk on these portfolios has been reduced. Land and construction loans decreased $68.2 million to $42.0 million at June 30, 2011, compared to $110.2 million at June 30, 2010, and accounted for 5% of our total loan portfolio at June 30, 2011. Consumer and home equity loans accounted for the remaining 9% of total loans at June 30, 2011. The yield on the loan portfolio was 5.31% for the second quarter of 2011 and 5.30% for the first six months of 2011, compared to 5.09% and 5.06% for the respective periods in 2010. Loans, excluding loans held-for-sale, decreased 17% to $782.1 million at June 30, 2011, from $937.8 million a year ago, and decreased 8% from $846.0 million at December 31, 2010. The decline in gross loans in the first six months of 2011 was primarily due to diminished loan demand, loan payoffs exceeding draw downs of loan commitments and the result of efforts to reduce classified loans. Lower volume of loan originations can be attributed in part to lower demand for certain types of credit as well as more selectivity with respect to the types of loans the Company chooses to originate.

Net Interest Income

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

        Because of our focus on commercial lending to closely held businesses, the Company will continue to have a high percentage of floating rate loans and other assets. Given the current volume, mix and repricing characteristics of our interest-bearing liabilities and interest-earning assets, we believe our interest rate spread is expected to increase in a rising rate environment, and decrease in a declining interest rate environment.

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

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

        The net interest margin expanded during the first six months of 2011, compared to the same period in 2010 primarily due to a lower cost of deposits as a result of higher noninterest-bearing demand deposit balances, along with a lower level of nonaccrual loans.

Management of Credit Risk

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

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

Noninterest Income

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

        A significant percentage of the Company's noninterest income is associated with its SBA lending activity, consisting of gains on the sale of loans sold in the secondary market and servicing income from loans sold with servicing retained. Prior to February 15, 2011, the sale of SBA loans were subject to a warranty for a period of 90 days. In accordance with generally accepted accounting principles, the Company treated the SBA loans sold as secured borrowings during the warranty period. Effective February 15, 2011, the SBA no longer required a warranty period in loan sales agreements. Therefore, gains on loan sales completed after February 15, 2011 are recognized upon completion of the transaction.

        Other sources of noninterest income include loan servicing fees, service charges and fees, cash surrender value from company owned life insurance policies, and gains on the sale of securities.

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Noninterest Expense

        Management considers the control of operating expenses to be a critical element of the Company's performance. Over the last 12 months the Company has undertaken several initiatives to reduce its noninterest expense and improve its efficiency. Noninterest expense decreased $3.7 million in the first six months of 2011, compared to the first six months of 2010, excluding the impairment of goodwill, primarily due to lower salaries and benefits, FDIC deposit insurance premiums, professional fees related to problem loans, and expenses related to OREO properties.

Capital Management

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

        On November 21, 2008, the Company issued to the U.S. Treasury under its Capital Purchase Program 40,000 shares of Series A Preferred Stock for $40.0 million and issued a warrant to purchase 462,963 shares of common stock at an exercise price of $12.96. The terms of the U.S. Treasury Capital Purchase Program could reduce investment returns to our shareholders by restricting dividends to common shareholders, diluting existing shareholders' interests, and restricting capital management practices.

        Under the terms of the Capital Purchase Program with the U.S. Treasury, so long as our Series A Preferred Stock is outstanding, we are prohibited from increasing quarterly dividends on our common stock in excess of $0.08 per share, and from making certain repurchases of equity securities, including our common stock, without the U.S. Treasury consent until the third anniversary of the U.S. Treasury investment or until the U.S. Treasury has transferred all of the Series A Preferred Stock it purchased under the Capital Purchase Program to third parties. As long as the Series A Preferred Stock is outstanding, dividend payments and repurchases or redemptions relating to certain equity securities, including our common stock, and the Series C Preferred Stock, are also prohibited until all accrued and unpaid dividends are paid on such preferred stock, subject to certain limited exceptions. On November 6, 2009, we suspended dividend payments on our Series A Preferred Stock. On August 1, 2011, the Company paid a dividend on its Series A Preferred Stock held by the U.S. Treasury in an aggregate amount of $4.2 million, of which $3.7 million had been previously accrued. As a result of the dividend payment, the Company is current with respect to dividends accrued and owed to the U.S. Treasury.

        On June 21, 2010, the Company issued Series B Mandatorily Convertible Cumulative Perpetual Preferred Stock ("Series B Preferred Stock") and Series C Convertible Perpetual Preferred Stock ("Series C Preferred Stock") to a limited number of institutional investors for an aggregate amount of $75.0 million. HCC then downstreamed $40 million of the proceeds from the private placement to the capital of HBC.

        After receiving shareholder approval in September 2010, the outstanding Series B Preferred Stock converted into approximately 14.4 million shares of the Company's common stock. The Series C Preferred Stock remains outstanding until converted to common stock upon the transfer of the Series C Preferred Stock in accordance with its terms. Holders of Series C Preferred Stock will receive dividends if and only to the extent dividends are paid to holders of common stock.

        We have supported our growth through the issuance of trust preferred securities from special purpose trusts and accompanying sales of subordinated debt to these trusts. The subordinated debt that we issued to the trusts is senior to our shares of common stock, Series A Preferred Stock, and Series C Preferred Stock. As a result, we must make payments on the subordinated debt before any dividends can be paid on our common stock, Series A Preferred Stock, and Series C Preferred Stock. Under the

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terms of the subordinated debt, we may defer interest payments for up to five years. On November 6, 2009, we exercised our right to defer regularly scheduled interest payments on our $23.7 million of subordinated debt relating to our trust preferred securities. During the second quarter of 2011, the Company paid all the deferred interest payments on its outstanding trust preferred subordinated debt securities in the amount of $3.9 million that it had previously accrued.

        At June 30, 2011, HBC's total risk-based capital ratio was 19.5%, compared to the 10% regulatory requirement for well-capitalized banks under the regulatory framework for prompt corrective actions. HBC's Tier 1 risk-based capital ratio of 18.2% and leverage ratio of 13.6% at June 30, 2011 also exceeded regulatory guidelines for well-capitalized banks under the prompt corrective actions framework. On a consolidated basis, the Company has a total risk-based capital ratio of 22.0%, a Tier 1 risk-based capital ratio of 20.8%, and a leverage ratio of 15.5% at June 30, 2011.

RESULTS OF OPERATIONS

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

Net Interest Income and Net Interest Margin

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

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

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Distribution, Rate and Yield

 
  For the Three Months Ended
June 30, 2011
  For the Three Months Ended
June 30, 2010
 
NET INTEREST INCOME AND
NET INTEREST MARGIN
  Average
Balance
  Interest
Income/
Expense
  Average
Yield/
Rate
  Average
Balance
  Interest
Income/
Expense
  Average
Yield/
Rate
 
 
  (Dollars in thousands)
 

Assets:

                                     

Loans, gross(1)

  $ 806,839   $ 10,685     5.31 % $ 1,002,987   $ 12,737     5.09 %

Securities

    278,908     2,278     3.28 %   149,254     1,458     3.92 %

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

    77,937     52     0.27 %   41,124     17     0.17 %
                               
 

Total interest earning assets

    1,163,684     13,015     4.49 %   1,193,365     14,212     4.78 %
                                   

Cash and due from banks

    20,932                 20,821              

Premises and equipment, net

    8,160                 8,825              

Goodwill and other intangible assets

    2,829                 46,088              

Other assets

    70,542                 63,828              
                                   
 

Total assets

  $ 1,266,147               $ 1,332,927              
                                   

Liabilities and shareholders' equity:

                                     

Deposits:

                                     
   

Demand, noninterest-bearing

  $ 332,535               $ 258,902              
   

Demand, interest-bearing

    132,079     65     0.20 %   150,565     83     0.22 %
   

Savings and money market

    280,870     259     0.37 %   294,628     363     0.49 %
   

Time deposits—under $100

    32,194     61     0.76 %   38,514     133     1.39 %
   

Time deposits—$100 and over

    121,929     342     1.13 %   132,062     470     1.43 %
   

Time deposits—CDARS

    21,254     24     0.45 %   18,849     48     1.02 %
   

Time deposits—brokered

    92,131     317     1.38 %   177,184     1,060     2.40 %
                               
 

Total interest-bearing deposits

    680,457     1,068     0.63 %   811,802     2,157     1.07 %
                               
 

Total deposits

    1,012,992     1,068     0.42 %   1,070,704     2,157     0.81 %

Subordinated debt

   
23,702
   
467
   
7.90

%
 
23,702
   
468
   
7.92

%

Securities sold under agreement to repurchase

            N/A     20,000     113     2.27 %

Short-term borrowings

    1,005     8     3.29 %   5,393     46     3.42 %
                               
 

Total interest-bearing liabilities

    705,164     1,543     0.88 %   860,897     2,784     1.30 %
                               
 

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

    1,037,699     1,543     0.60 %   1,119,799     2,784     1.00 %

Other liabilities

    42,537                 34,961              
                                   
 

Total liabilities

    1,080,236                 1,154,760              

Shareholders' equity

    185,911                 178,167              
                                   
 

Total liabilities and shareholders' equity

  $ 1,266,147               $ 1,332,927              
                                   
                                   

Net interest income / margin

        $ 11,472     3.95 %       $ 11,428     3.84 %
                                   

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

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  For the Six Months Ended
June 30, 2011
  For the Six Months Ended
June 30, 2010
 
NET INTEREST INCOME AND
NET INTEREST MARGIN
  Average
Balance
  Interest
Income/
Expense
  Average
Yield/
Rate
  Average
Balance
  Interest
Income/
Expense
  Average
Yield/
Rate
 
 
  (Dollars in thousands)
 

Assets:

                                     

Loans, gross(1)

  $ 825,206   $ 21,675     5.30 % $ 1,033,270   $ 25,911     5.06 %

Securities

    262,476     4,240     3.26 %   138,191     2,621     3.82 %

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

    69,228     86     0.25 %   29,451     27     0.18 %
                               
 

Total interest earning assets

    1,156,910     26,001     4.53 %   1,200,912     28,559     4.80 %
                                   

Cash and due from banks

    20,742                 21,002              

Premises and equipment, net

    8,244                 8,891              

Goodwill and other intangible assets

    2,895                 46,400              

Other assets

    68,499                 66,196              
                                   
 

Total assets

  $ 1,257,290               $ 1,343,401              
                                   

Liabilities and shareholders' equity:

                                     

Deposits:

                                     
   

Demand, noninterest-bearing

  $ 322,345               $ 256,671              
   

Demand, interest-bearing

    133,907     132     0.20 %   149,966     169     0.23 %
   

Savings and money market

    274,346     526     0.39 %   298,111     762     0.52 %
   

Time deposits—under $100

    32,698     132     0.81 %   39,036     281     1.45 %
   

Time deposits—$100 and over

    127,856     761     1.20 %   132,215     968     1.48 %
   

Time deposits—CDARS

    21,389     49     0.46 %   19,110     101     1.07 %
   

Time deposits—brokered

    93,589     739     1.59 %   177,301     2,240     2.55 %
                               
 

Total interest-bearing deposits

    683,785     2,339     0.69 %   815,739     4,521     1.12 %
                               
 

Total deposits

    1,006,130     2,339     0.47 %   1,072,410     4,521     0.85 %

Subordinated debt

   
23,702
   
932
   
7.93

%
 
23,702
   
934
   
7.95

%

Securities sold under agreement to repurchase

    1,436     24     3.37 %   21,354     244     2.30 %

Short-term borrowings

    1,865     38     4.11 %   13,064     63     0.97 %
                               
 

Total interest-bearing liabilities

    710,788     3,333     0.95 %   873,859     5,762     1.33 %
                               
 

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

    1,033,133     3,333     0.65 %   1,130,530     5,762     1.03 %

Other liabilities

    39,966                 36,882              
                                   
 

Total liabilities

    1,073,099                 1,167,412              

Shareholders' equity

    184,191                 175,989              
                                   
 

Total liabilities and shareholders' equity

  $ 1,257,290               $ 1,343,401              
                                   
                                   

Net interest income / margin

        $ 22,668     3.95 %       $ 22,797     3.83 %
                                   

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

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Volume and Rate Variances

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

 
  Three Months Ended June 30,
2011 vs. 2010
Increase (Decrease) Due to
Change In:
 
 
  Average
Volume
  Average
Rate
  Net
Change
 
 
  (Dollars in thousands)
 

Income from interest earning assets:

                   
 

Loans, gross

  $ (2,593 ) $ 541   $ (2,052 )
 

Securities

    1,057     (237 )   820  
 

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

    24     11     35  
               
   

Total interest income from interest earnings assets

    (1,512 )   315     (1,197 )
               

Expense on interest-bearing liabilities:

                   
 

Demand, interest-bearing

    (10 )   (8 )   (18 )
 

Savings and money market

    (13 )   (91 )   (104 )
 

Time deposits—under $100

    (12 )   (60 )   (72 )
 

Time deposits—$100 and over

    (30 )   (98 )   (128 )
 

Time deposits—CDARS

    3     (27 )   (24 )
 

Time deposits—brokered

    (293 )   (450 )   (743 )
 

Subordinated debt

        (1 )   (1 )
 

Securities sold under agreement to repurchase

    (113 )       (113 )
 

Short-term borrowings

    (36 )   (2 )   (38 )
               
   

Total interest expense on interest-bearing liabilities

    (504 )   (737 )   (1,241 )
               
     

Net interest income

  $ (1,008 ) $ 1,052   $ 44  
               

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  Six Months Ended June 30,
2011 vs. 2010
Increase (Decrease) Due to
Change In:
 
 
  Average
Volume
  Average
Rate
  Net
Change
 
 
  (Dollars in thousands)
 

Income from interest earning assets:

                   
 

Loans, gross

  $ (5,482 ) $ 1,246   $ (4,236 )
 

Securities

    2,006     (387 ) $ 1,619  
 

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

    49     10   $ 59  
               
   

Total interest income from interest earnings assets

    (3,427 )   869     (2,558 )
               

Expense on interest-bearing liabilities:

                   
 

Demand, interest-bearing

    (17 )   (20 )   (37 )
 

Savings and money market

    (51 )   (185 )   (236 )
 

Time deposits—under $100

    (25 )   (124 )   (149 )
 

Time deposits—$100 and over

    (26 )   (181 )   (207 )
 

Time deposits—CDARS

    5     (57 )   (52 )
 

Time deposits—brokered

    (659 )   (842 )   (1,501 )
 

Subordinated debt

        (2 )   (2 )
 

Securities sold under agreement to repurchase

    (333 )   113     (220 )
 

Short-term borrowings

    (228 )   204     (25 )
               
   

Total interest expense on interest-bearing liabilities

    (1,334 )   (1,095 )   (2,429 )
               
     

Net interest income

  $ (2,093 ) $ 1,964   $ (129 )
               

        The Company's net interest margin expressed as a percentage of average earning assets increased to 3.95% for both the second quarter and six months ended June 30, 2011, compared to 3.84% and 3.83% for the respective periods in 2010. The increase in the net interest margin for the second quarter and first six months of 2011 was principally due to a lower cost of deposits as a result of higher noninterest-bearing demand deposit balances and a lower level of nonaccrual loans.

        Net interest income in the second quarter of 2011 remained relatively flat at $11.5 million, compared to $11.4 million in the second quarter of 2010. Net interest income in the first half of 2011 remained relatively flat at $22.7 million, compared to $22.8 million for the first half of 2010. Net interest income was adversely impacted by a decrease in loan balances, partially offset by an increase in investment securities.

        A substantial portion of the Company's earning assets are variable-rate loans that re-price when the Company's prime lending rate is changed, versus a large base of core deposits that are generally slower to re-price. This causes the Company's balance sheet to be asset-sensitive, which means that all else being equal, the Company's net interest margin will be lower during periods when short-term interest rates are falling and higher when rates are rising.

Provision for Loan Losses

        Credit risk is inherent in the business of making loans. The Company establishes an allowance for loan losses through charges to earnings, which are shown in the statements of operations as the provision for loan losses. Specifically identifiable and quantifiable known losses are promptly charged off against the allowance. The provision for loan losses is determined by conducting a quarterly evaluation of the adequacy of the Company's allowance for loan losses and charging the shortfall, if any, to the current quarter's expense. This has the effect of creating variability in the amount and

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frequency of charges to the Company's earnings. The provision for loan losses and level of allowance for each period are dependent upon many factors, including loan growth, net charge-offs, changes in the composition of the loan portfolio, delinquencies, management's assessment of the quality of the loan portfolio, the valuation of problem loans and the general economic conditions in the Company's market area.

        The Company had a provision for loan losses of $955,000 for the quarter ended June 30, 2011 and $1.7 million for the six months ended June 30, 2011. The Company had a provision for loan losses of $18.6 million for the quarter ended June 30, 2010 and $23.7 million for the six months ended June 30, 2010. During the second quarter of 2010, the Company identified $31.0 million of real estate loans classified as substandard or substandard-nonaccrual that it intended to sell in the third quarter of 2010. The loans were transferred to the held-for-sale portfolio and the Company recorded a $13.9 million of related loan charge-offs in the second quarter of 2010.

        The allowance for loan losses represented 2.96%, 2.85% and 2.98% of total loans at June 30, 2011, June 30, 2010, and December 31, 2010, respectively. Provisions for loan losses are charged to operations to bring the allowance for loan losses to a level deemed appropriate by the Company based on the factors discussed under "Allowance for Loan Losses".

Noninterest Income

        The following table sets forth the various components of the Company's noninterest income for the periods indicated:

 
  For the Three Months Ended
June 30,
  Increase
(decrease)
2011 versus 2010
 
 
  2011   2010   Amount   Percent  
 
  (Dollars in thousands)
 

Service charges and fees on deposit accounts

    587     579     8     1 %

Gain on sales of SBA loans

    476     163     313     192 %

Servicing income

    435     425     10     2 %

Increase in cash surrender value of life insurance

    419     413     6     1 %

Other

    253     298     (45 )   -15 %
                     
 

Total noninterest income

  $ 2,170   $ 1,878   $ 292     16 %
                     

 

 
  For the Six Months Ended
June 30,
  Increase
(decrease)
2011 versus 2010
 
 
  2011   2010   Amount   Percent  
 
  (Dollars in thousands)
 

Service charges and fees on deposit accounts

    1,154     1,128     26     2 %

Gain on sales of SBA loans

    855     277     578     209 %

Servicing income

    846     846         0 %

Increase in cash surrender value of life insurance

    845     822     23     3 %

Other

    387     489     (102 )   -21 %
                     
 

Total noninterest income

  $ 4,087   $ 3,562   $ 525     15 %
                     

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        The increase in noninterest income in the second quarter and first six months of 2011 compared to the same periods in 2010 was primarily attributable to the gain on sales of SBA loans, as a previously deferred gain of $192,000 from sales in the first quarter of 2011 was recognized in the second quarter of 2011. Other sources of noninterest income include loan servicing fees, service charges and fees, and cash surrender value from company owned life insurance policies.

        A significant percentage of the Company's noninterest income is associated with its SBA lending activity, consisting of gains on sale of loans sold in the secondary market and servicing income from loans sold with servicing retained. Prior to February 15, 2011, when the Company sold SBA loans to third parties, the loans were subject to a 90 day SBA warranty. In accordance with generally accepted accounting principles, the Company treated the SBA loans sold as secured borrowings during the warranty period. Effective February 15, 2011, the SBA no longer required a warranty period in loan sales agreements. Therefore, gains on loan sales completed after February 15, 2011 are recognized upon completion of the transaction. At June 30, 2011 there were no SBA loans that were transferred to third parties. During the first half of 2011, SBA loan sales resulted in an $855,000 gain, compared to a $277,000 gain on sale of SBA loans in the first half of 2010. The servicing assets that result from the sale of SBA loans, with servicing retained, are amortized over the expected term of the loans using a method approximating the interest method. Servicing income generally declines as the respective loans are repaid.

        The increase in cash surrender value of life insurance approximates a 3.91% after tax yield on the policies. To realize this tax advantaged yield, the policies must be held until death of the insured individuals, who are current and former officers and directors of the Company.

Noninterest Expense

        The following table sets forth the various components of the Company's noninterest expense for the periods indicated:

 
  For the Three Months Ended
June 30,
  Increase (decrease)
2011 versus 2010
 
 
  2011   2010   Amount   Percent  
 
  (Dollars in thousands)
 

Salaries and employee benefits

  $ 5,111   $ 5,491   $ (380 )   -7 %

Occupancy and equipment

    1,031     983     48     5 %

Professional fees

    456     1,144     (688 )   -60 %

FDIC deposit insurance premiums

    383     1,019     (636 )   -62 %

Software subscriptions

    274     252     22     9 %

Insurance expense

    244     269     (25 )   -9 %

Data processing

    198     219     (21 )   -10 %

Low income housing investment losses

    40     133     (93 )   -70 %

Other real estate owned expense

    127     69     58     84 %

Impairment of goodwill

        43,181     (43,181 )   -100 %

Other

    1,608     1,792     (184 )   -10 %
                     
 

Total noninterest expense

  $ 9,472   $ 54,552   $ (45,080 )   -83 %
                     

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  For the Six Months Ended
June 30,
  Increase (decrease)
2011 versus 2010
 
 
  2011   2010   Amount   Percent  
 
  (Dollars in thousands)
 

Salaries and employee benefits

  $ 10,504   $ 11,373   $ (869 )   -8 %

Occupancy and equipment

    2,069     1,942     127     7 %

Professional fees

    1,295     2,421     (1,126 )   -47 %

FDIC deposit insurance premiums

    907     2,210     (1,303 )   -59 %

Software subscriptions

    529     486     43     9 %

Insurance expense

    486     525     (39 )   -7 %

Data processing

    419     430     (11 )   -3 %

Low income housing investment losses

    202     358     (156 )   -44 %

Other real estate owned expense

    147     488     (341 )   -70 %

Impairment of goodwill

        43,181     (43,181 )   -100 %

Other

    3,345     3,337     8     0 %
                     
 

Total noninterest expense

  $ 19,903   $ 66,751   $ (46,848 )   -70 %
                     

        The following table indicates the percentage of noninterest expense in each category:

Noninterest Expense by Category

 
  For The Three Months Ended June 30,  
 
  2011   Percent
of Total
  2010   Percent
of Total
 
 
  (Dollars in thousands)
 

Salaries and employee benefits

  $ 5,111     54 % $ 5,491     10 %

Occupancy and equipment

    1,031     11 %   983     2 %

Professional fees

    456     5 %   1,144     2 %

FDIC deposit insurance premiums

    383     4 %   1,019     2 %

Software subscriptions

    274     3 %   252     1 %

Insurance expense

    244     3 %   269     1 %

Data processing

    198     2 %   219     0 %

Low income housing investment losses

    40     0 %   133     0 %

Other real estate owned expense

    127     1 %   69     0 %

Impairment of goodwill

        0 %   43,181     79 %

Other

    1,608     17 %   1,792     3 %
                   
 

Total noninterest expense

  $ 9,472     100 % $ 54,552     100 %
                   

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  For The Six Months Ended June 30,  
 
  2011   Percent
of Total
  2010   Percent
of Total
 
 
  (Dollars in thousands)
 

Salaries and employee benefits

  $ 10,504     53 % $ 11,373     17 %

Occupancy and equipment

    2,069     10 %   1,942     3 %

Professional fees

    1,295     6 %   2,421     4 %

FDIC deposit insurance premiums

    907     5 %   2,210     3 %

Software subscriptions

    529     3 %   486     1 %

Insurance expense

    486     2 %   525     1 %

Data processing

    419     2 %   430     0 %

Low income housing investment losses

    202     1 %   358     0 %

Other real estate owned expense

    147     1 %   488     1 %

Impairment of goodwill

        0 %   43,181     65 %

Other

    3,345     17 %   3,337     5 %
                   
 

Total noninterest expense

  $ 19,903     100 % $ 66,751     100 %
                   

        Salaries and employee benefits decreased $380,000, or 7%, for the second quarter of 2011 from the same period in 2010, primarily due to a reduction in force implemented in the fourth quarter of 2010. Full-time equivalent employees were 187 and 205 at June 30, 2011 and 2010, respectively. Professional fees decreased $688,000, or 60%, for the second quarter of 2011 from the same period in 2010 primarily due to a decrease in legal fees related to loan workouts and litigation and decreased expenses for bank regulatory compliance. FDIC deposit insurance premiums decreased $636,000, or 62%, for the second quarter of 2011 compared to the same period in 2010, due to a decrease in the FDIC deposit assessment rate and lower deposit balances.

        Salaries and employee benefits decreased $869,000, or 8%, for the first six months of 2011 from the same period in 2010, primarily due to a reduction in force implemented in the fourth quarter of 2010. Professional fees decreased $1.1 million, or 47%, for the first six months of 2011 from the same period in 2010 primarily due to a decrease in legal fees related to loan workouts and litigation and decreased expenses for bank regulatory compliance. FDIC deposit insurance premiums decreased $1.3 million, or 59%, for the first six months of 2011 compared to the same period in 2010, due to a decrease in the FDIC deposit assessment rate and lower deposit balances. OREO expense decreased $341,000, or 70%, in the first six months of 2011, compared to the same period in 2010 due to a decrease in write-downs of OREO properties.

Income Tax Expense

        The Company computes its provision for income taxes on a monthly basis. The effective tax rate is determined by applying the Company's statutory income tax rates to pre-tax book income as adjusted for permanent differences between pre-tax book income and actual taxable income. These permanent differences include, but are not limited to, tax-exempt interest income, increases in the cash surrender value of life insurance policies, California Enterprise Zone deductions, certain expenses that are not allowed as tax deductions, and tax credits.

        The Company's Federal and state income tax expense for the quarter and six months ended 2011 was $1.1 million and $1.5 million, respectively. The income tax benefit was ($5.8) million and ($5.9)

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million for the same periods in 2010. The following table shows the Company's effective income tax rates for the periods indicated:

 
  For the Three Months Ended
June 30,
  For the Six Months Ended
June 30,
 
 
  2011   2010   2011   2010  

Effective income tax rate

    35.1 %   -9.6 %   28.5 %   -9.2 %

        The difference in the effective tax rate compared to the combined Federal and state statutory tax rate of 42% is primarily the result of the Company's investment in life insurance policies whose earnings are not subject to taxes and tax credits related to investments in low income housing limited partnerships.

        The Company has total investments of $4.5 million in low-income housing limited partnerships as of June 30, 2011. These investments have generated annual tax credits of approximately $1.0 million and $1.1 million in the years ended December 31, 2010 and 2009, respectively.

        Some items of income and expense are recognized in different years for tax purposes than when applying generally accepted accounting principles, leading to timing differences between the Company's actual tax liability and the amount accrued for this liability based on book income. These temporary differences comprise the "deferred" portion of the Company's tax expense or benefit, which is accumulated on the Company's books as a deferred tax asset or deferred tax liability until such time as they reverse. At June 30, 2011, the Company had a net deferred tax asset of approximately $24.5 million, compared to $27.4 million at December 31, 2010. The deferred tax asset at June 30, 2011 and December 31, 2010 is net of a $3.7 million valuation allowance.

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

        In assessing the realization of deferred tax assets at June 30, 2011, the Company estimates that it has sufficient forecasted future taxable income and various tax planning strategies which could be implemented to generate taxable income in future periods, to support the balance of deferred tax assets net of the $3.7 million valuation allowance.

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FINANCIAL CONDITION

        As of June 30, 2011, total assets decreased to $1.26 billion, compared to $1.30 billion at June 30, 2010, and increased from $1.25 billion at December 31, 2010. Total securities available-for-sale (at fair value) were $303.0 million at June 30, 2011, an increase of 113% from $142.2 million at June 30, 2010, and an increase of 30% from $232.2 million at December 31, 2010. The total loan portfolio, excluding loans held-for-sale, was $782.1 million at June 30, 2011, a decrease of 17% from $937.8 million at June 30, 2010, and a decrease of 8% from $846.0 million at December 31, 2010. Total deposits decreased 4% to $998.6 million at June 30, 2011, from $1.04 billion at June 30, 2010. Total deposits remained relatively flat when compared to $993.9 million at December 31, 2010. There were no securities sold under agreement to repurchase at June 30, 2011, compared to $20.0 million at June 30, 2010, and $5.0 million at December 31, 2010.

Securities Portfolio

        The following table reflects the estimated fair values for each category of securities at the dates indicated:

 
  June 30,    
 
 
  December 31,
2010
 
 
  2011   2010  
 
  (Dollars in thousands)
 

Securities available-for-sale (at fair value)

                   
 

U.S. Government Sponsored Entities

  $   $ 2,002   $  
 

Agency Mortgage-Backed Securities

    302,968     136,692     232,165  
 

Collateralized Mortgage Obligations

        3,518      
               
   

Total

  $ 302,968   $ 142,212   $ 232,165  
               

        The following table summarizes the weighted average life and weighted average yields of securities at June 30, 2011:

 
  Weighted Average Life  
 
  Within One
Year
  After One and
Within Five
Years
  After Five and
Within Ten
Years
  After Ten Years   Total  
 
  Amount   Yield   Amount   Yield   Amount   Yield   Amount   Yield   Amount   Yield  
 
  (Dollars in thousands)
 

Securities available-for-sale (at fair value):

                                                             
 

Agency Mortgage-Backed Securities

  $       $ 57,713     3.21 % $ 211,260     3.27 % $ 33,995     3.83 % $ 302,968     3.32 %
                                                     

        The securities portfolio is the second largest component of the Company's interest-earning assets, and the structure and composition of this portfolio is important to any analysis of the financial condition of the Company. The portfolio serves the following purposes: (i) it provides a source of pledged assets for securing certain deposits and borrowed funds, as may be required by law or by specific agreement with a depositor or lender; (ii) it can be used as an interest rate risk management tool, since it provides a large base of assets, the maturity and interest rate characteristics of which can be changed more readily than the loan portfolio to better match changes in the deposit base and other funding sources of the Company; and (iii) it is an alternative interest-earning use of funds when loan demand is weak or when deposits grow more rapidly than loans.

        The Company's securities are all currently classified under existing accounting rules as "available-for-sale" to allow flexibility for the management of the portfolio. Accounting guidance requires available-for-sale securities to be marked to fair value with an offset to accumulated other

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comprehensive income (loss), a component of shareholders' equity. Monthly adjustments are made to reflect changes in the fair value of the Company's available-for-sale securities.

        The Company's portfolio is historically comprised primarily of: (i) U.S. Treasury securities and U.S. Government sponsored entities' debt securities for liquidity and pledging; (ii) mortgage-backed securities, which in many instances can also be used for pledging, and which generally enhance the yield of the portfolio; (iii) municipal obligations, which provide tax free income and limited pledging potential; and (iv) collateralized mortgage obligations, which generally enhance the yield of the portfolio.

        In the second quarter of 2011, the securities portfolio increased by $160.8 million, or 113%, and increased to 24% of total assets at June 30, 2011 from 11% at June 30, 2010, and increased by $70.8 million, or 30%, from December 31, 2010. The Company increased its holding of mortgage-back securities to offset a portion of the contraction in the loan portfolio.

Loans

        The Company's loans represent the largest portion of invested assets, substantially greater than the securities portfolio or any other asset category, and the quality and diversification of the loan portfolio is an important consideration when reviewing the Company's financial condition.

        Gross loans, excluding loans held-for-sale, represented 62% of total assets at June 30, 2011, as compared to 72% of total assets at June 30, 2010, and 68% of total assets at December 31, 2010. The ratio of loans to deposits decreased to 78.32% at June 30, 2011 from 90.39% at June 30, 2010 and 85.12% at December 31, 2010. Demand for loans has weakened within the Company's markets due to the current economic environment, and the Company has been more selective with respect to the types of loans the Company chooses to originate.

Loan Distribution

        The Loan Distribution table that follows sets forth the Company's gross loans, excluding loans held-for-sale, outstanding and the percentage distribution in each category at the dates indicated:

 
  June 30, 2011   June 30, 2010   December 31, 2010  
 
  Balance   % to Total   Balance   % to Total   Balance   % to Total  
 
  (Dollars in thousands)
 

Commercial

  $ 358,227     46 % $ 388,471     41 % $ 378,412     45 %

Real estate:

                                     
 

Commercial and residential

    315,426     40 %   373,000     40 %   337,457     40 %
 

Land and construction

    41,987     5 %   110,194     12 %   62,356     7 %
 

Home equity

    52,621     7 %   52,419     6 %   53,697     6 %

Consumer

    13,040     2 %   12,837     1 %   13,244     2 %
                           
   

Total loans

    781,301     100 %   936,921     100 %   845,166     100 %

Deferred loan costs

    779         852         883      
                           
 

Loans, including deferred costs

    782,080     100 %   937,773     100 %   846,049     100 %
                                 

Allowance for loan losses

    (23,167 )         (26,753 )         (25,204 )      
                                 

Loans, net

  $ 758,913         $ 911,020         $ 820,845        
                                 

        The Company's loan portfolio is concentrated in commercial loans, primarily manufacturing, wholesale, and services, and commercial real estate, with the balance in land development and construction and home equity and consumer loans. The decrease in the Company's loan portfolio in the second quarter of 2011 compared to the second and fourth quarters of 2010 is due to diminished loan demand, and loan payoffs exceeding draw downs of loan commitments. Outstanding loan balances to

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total loan commitments were 74% at June 30, 2011, and 76% at June 30, 2010 and 75% at December 31, 2010. The Company does not have any concentrations by industry or group of industries in its loan portfolio, however, 52% of its gross loans were secured by real property at June 30, 2011, compared to 57% at June 30, 2010, and 54% at December 31, 2010. While no specific industry concentration is considered significant, the Company's lending operations are located in areas that are dependent on the technology and real estate industries and their supporting companies.

        The Company's commercial loans are made for working capital, financing the purchase of equipment or for other business purposes. Commercial loans include loans with maturities ranging from thirty days to one year and "term loans" with maturities normally ranging from one to five years. Short-term business loans are generally intended to finance current transactions and typically provide for periodic principal payments, with interest payable monthly. Term loans normally provide for floating interest rates, with monthly payments of both principal and interest.

        The Company is an active participant in the SBA and U.S. Department of Agriculture guaranteed lending programs, and has been approved by the SBA as a lender under the Preferred Lender Program. The Company regularly makes such guaranteed loans (collectively referred to as "SBA loans"). The guaranteed portion of these loans is typically sold in the secondary market depending on market conditions. When the guaranteed portion of an SBA loan is sold, the Company retains the servicing rights for the sold portion. During the first six months of 2011, loans were sold resulting in a gain on sale of SBA loans of $855,000.

        As of June 30, 2011, commercial and residential real estate mortgage loans of $315.4 million consist primarily of adjustable and fixed rate loans secured by deeds of trust on commercial and residential property. The real estate mortgage loans at June 30, 2011 consist of $162.8 million, or 52%, of commercial owner occupied properties, $149.0 million, or 47%, of commercial investment properties, and $3.6 million, or 1% in residential properties. Properties securing the commercial real estate mortgage loans are primarily located in the Company's primary market, which is the Greater San Francisco Bay Area.

        The Company's commercial real estate loans consist primarily of loans based on the borrower's cash flow and are secured by deeds of trust on commercial and residential property to provide a secondary source of repayment. The Company generally restricts real estate term loans to no more than 75% of the property's appraised value or the purchase price of the property during the initial underwriting of the credit, depending on the type of property and its utilization. The Company offers both fixed and floating rate loans. Maturities on real estate mortgage loans are generally between five and ten years (with amortization ranging from fifteen to twenty-five years and a balloon payment due at maturity); however, SBA and certain other real estate loans that can be sold in the secondary market may be granted for longer maturities.

        The Company's land and construction loans are primarily to finance the development/construction of commercial and single family residential properties. The Company utilizes underwriting guidelines to assess the likelihood of repayment from sources such as sale of the property or availability of permanent mortgage financing prior to making the construction loan. Land and construction loans decreased $68.2 million to $42.0 million, or 5% of total loans at June 30, 2011, from $110.2 million, or 12% of total loans at June 30, 2010, and decreased $20.4 million from $62.4 million, or 7% of total loans at December 31, 2010.

        The Company makes home equity lines of credit available to its existing customers. Home equity lines of credit are underwritten initially with a maximum 70% loan to value ratio. Home equity lines are reviewed at least semiannually, with specific emphasis on loans with a loan to value ratio greater than 70% and loans that were underwritten from mid-2005 through 2008, when real estate values were at the peak in the cycle. The Company takes measures to work with customers to reduce line

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commitments and minimize potential losses. There have been no adverse classifications to date as a result of the review.

        Additionally, the Company makes consumer loans for the purpose of financing automobiles, various types of consumer goods, and other personal purposes. Consumer loans generally provide for the monthly payment of principal and interest. Most of the Company's consumer loans are secured by the personal property being purchased or, in the instances of home equity loans or lines, real property.

        With certain exceptions, state chartered banks are permitted to make extensions of credit to any one borrowing entity up to 15% of the bank's capital and reserves for unsecured loans and up to 25% of the bank's capital and reserves for secured loans. For HBC, these lending limits were $30.8 million and $51.4 million at June 30, 2011, respectively.

Loan Maturities

        The following table presents the maturity distribution of the Company's loans (excluding loans held-for-sale) as of June 30, 2011. The table shows the distribution of such loans between those loans with predetermined (fixed) interest rates and those with variable (floating) interest rates. Floating rates generally fluctuate with changes in the prime rate as reflected in the Western Edition of The Wall Street Journal. As of June 30, 2011, approximately 68% of the Company's loan portfolio consisted of floating interest rate loans.

 
  Due in
One Year
or Less
  Over One
Year But
Less than
Five Years
  Over
Five Years
  Total  
 
  (Dollars in thousands)
 

Commercial

  $ 243,376   $ 33,852   $ 80,999   $ 358,227  

Real estate:

                         
 

Commercial and residential

    87,951     190,333     37,142     315,426  
 

Land and construction

    40,683     1,304         41,987  
 

Home equity

    50,783     417     1,421     52,621  

Consumer

    12,043     997         13,040  
                   
   

Loans

  $ 434,836   $ 226,903   $ 119,562   $ 781,301  
                   

Loans with variable interest rates

  $ 393,123   $ 57,120   $ 80,035   $ 530,278  

Loans with fixed interest rates

    41,713     169,783     39,527     251,023  
                   
   

Loans

  $ 434,836   $ 226,903   $ 119,562   $ 781,301  
                   

Loan Servicing

        As of June 30, 2011 and 2010, $172.1 million and $166.1 million, respectively, in SBA loans were serviced by the Company for others. Activity for loan servicing rights was as follows:

 
  For the Three Months Ended
June 30,
  For the Six Months Ended
June 30,
 
 
  2011   2010   2011   2010  
 
  (Dollars in thousands)
  (Dollars in thousands)
 

Beginning of period balance

  $ 869   $ 1,034   $ 915   $ 1,067  

Additions

    71     48     156     129  

Amortization

    (104 )   (126 )   (235 )   (240 )
                   
 

End of period balance

  $ 836   $ 956   $ 836   $ 956  
                   

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        Loan servicing rights are included in accrued interest receivable and other assets on the consolidated balance sheets and reported net of amortization. There was no valuation allowance as of June 30, 2011 and 2010, as the fair market value of the assets was greater than the carrying value.

        Activity for the I/O strip receivable was as follows:

 
  For the Three Months Ended
June 30,
  For the Six Months Ended
June 30,
 
 
  2011   2010   2011   2010  
 
  (Dollars in thousands)
   
   
 

Beginning of period balance

  $ 2,193   $ 2,015   $ 2,140   $ 2,116  

Amortization

    (38 )   (57 )   (78 )   (129 )

Unrealized holding gain

    30     102     123     73  
                   
 

End of period balance

  $ 2,185   $ 2,060   $ 2,185   $ 2,060  
                   

Nonperforming Assets

        Financial institutions generally have a certain level of exposure to credit quality risk, and could potentially receive less than a full return of principal and interest if a debtor becomes unable or unwilling to repay. Since loans are the most significant assets of the Company and generate the largest portion of its revenues, the Company's management of credit quality risk is focused primarily on loan quality. Banks have generally suffered their most severe earnings declines as a result of customers' inability to generate sufficient cash flow to service their debts and/or downturns in national and regional economies and declines in overall asset values including real estate. In addition, certain debt securities that the Company may purchase have the potential of declining in value if the obligor's financial capacity to repay deteriorates.

        The Company's policies and procedures identify market segments, set goals for portfolio growth or contraction, and establish limits on industry and geographic credit concentrations. In addition, these policies establish the Company's underwriting standards and the methods of monitoring ongoing credit quality. The Company's internal credit risk controls are centered in underwriting practices, credit granting procedures, training, risk management techniques, and familiarity with loan customers as well as the relative diversity and geographic concentration of our loan portfolio.

        The Company's credit risk may also be affected by external factors such as the level of interest rates, employment, general economic conditions, real estate values, and trends in particular industries or geographic markets. As an independent community bank serving a specific geographic area, the Company must contend with the unpredictable changes in the general California market and, particularly, primary local markets. The Company's asset quality has suffered in the past from the impact of national and regional economic recessions, consumer bankruptcies, and depressed real estate values.

        Nonperforming assets are comprised of the following: loans and loans held-for-sale for which the Company is no longer accruing interest; restructured loans; loans 90 days or more past due and still accruing interest (although they are generally placed on nonaccrual when they become 90 days past due, unless they are both well-secured and in the process of collection); and OREO from foreclosures. Management's classification of a loan as "nonaccrual" is an indication that there is reasonable doubt as to the full recovery of principal or interest on the loan. At that point, the Company stops accruing interest income, and reverses any uncollected interest that had been accrued as income. The Company begins recognizing interest income only as cash interest payments are received and it has been determined the collection of all outstanding principal is not in doubt. The loans may or may not be collateralized, and collection efforts are pursued. Loans may be restructured by management when a borrower has experienced some change in financial status causing an inability to meet the original

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repayment terms and where the Company believes the borrower will eventually overcome those circumstances and make full restitution. OREO consists of properties acquired by foreclosure or similar means that management is offering or will offer for sale. Total OREO was $248,000 at June 30, 2011, compared to $555,000 at June 30, 2010 and $1.3 million at December 31, 2010. At June, 2011, the $24.5 million of nonperforming assets included $1.2 million of SBA guaranteed loans.

        The following table summarizes the Company's nonperforming assets at the dates indicated:

 
  June 30,    
 
 
  December 31,
2010
 
 
  2011   2010  
 
  (Dollars in thousands)
 

Nonaccrual loans—held-for-sale

  $ 202   $ 9,806   $ 2,026  

Nonaccrual loans—held-for-investment

    21,607     47,263     28,821  

Restructured and loans over 90 days past due and still accruing

    2,448     2,516     2,492  
               
 

Total nonperforming loans

    24,257     59,585     33,339  

Other real estate owned

    248     555     1,296  
               
 

Total nonperforming assets

  $ 24,505   $ 60,140   $ 34,635  
               

Nonperforming assets as a percentage of loans plus other real estate owned plus nonaccruals loans held-for-sale

    3.13 %   6.34 %   4.08 %

Nonperforming assets as a percentage of total assets

    1.94 %   4.61 %   2.78 %

        The following table provides nonaccrual loans by loan type as of June 30, 2011:

 
  Nonaccrual   Restructured and
Loans Over 90 Days
Past Due and
Still Accruing
  Total  
 
  (Dollars in thousands)
 

Commercial

  $ 10,690   $ 2,336   $ 13,026  

Real estate:

                   
 

Commercial and residential

    2,594         2,594  
 

Land and construction

    7,654         7,654  
 

Home equity

             

Consumer

    871     112     983  
               
   

Total

  $ 21,809   $ 2,448   $ 24,257  
               

Allowance for Loan Losses

        The allowance for loan losses is an estimate of probable incurred losses in the loan portfolio. Loans are charged-off against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance for loan losses. Management's methodology for estimating the allowance balance consists of several key elements, which include specific allowances on individual impaired loans and the formula driven allowances on pools of loans with similar risk characteristics. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management's judgment, should be charged-off.

        Specific allowances are established for impaired loans. Management considers a loan to be impaired when it is probable that the Company will be unable to collect all amounts due according to the original contractual terms of the loan agreement, including scheduled interest payments. Loans for which the terms have been modified with a concession granted, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and classified as impaired.

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When a loan is considered to be impaired, the amount of impairment is measured based on the fair value of the collateral less costs to sell if the loan is collateral dependent, or on the present value of expected future cash flows or values that are observable in the secondary market. If the measure of the impaired loans is less than the investment in the loan, the deficiency will be charged off against the allowance for loan losses if the amount is a confirmed loss, or, alternatively, a specific allocation within the allowance will be established. Loans that are considered impaired are specifically excluded from the formula portion of the allowance for loan losses analysis.

        The estimated loss factors for pools of loans that are not impaired are based on determining the probability of default and loss given default for loans within each segment of the portfolio, adjusted for significant factors that, in management's judgment, affect collectibility as of the evaluation date. The Company's historical delinquency experience and loss experience are utilized to determine the probability of default and loss given default for segments of the portfolio where the Company has experienced losses in the past. For segments of the portfolio where the Company has no significant prior loss experience, the Company uses quantifiable observable industry data to determine the probability of default and loss given default.

        Loans that demonstrate a weakness for which there is a possibility of loss if the weakness is not corrected, are categorized as "classified." Classified assets include all loans considered as substandard, substandard-nonaccrual, and doubtful and may result from problems specific to a borrower's business or from economic downturns that affect the borrower's ability to repay or that cause a decline in the value of the underlying collateral (particularly real estate), and OREO. The principal balance of classified assets, net of SBA guarantees of $1.5 million, was $76.1 million at June 30, 2011, $151.1 million at June 30, 2010, and $91.8 million at December 31, 2010. Included in the $76.1 million of classified assets at June 30, 2011, were $435,000 of loans held-for-sale. Loans held-for-sale are carried at the lower of cost or estimated fair value, and are not allocated an allowance for loan losses. Management of the level of classified assets will continue to be a focus for executive management, the lending staff and the Company's Special Assets Department.

        It is the policy of management to maintain the allowance for loan losses at a level adequate for risks inherent in the loan portfolio. On an ongoing basis, we have engaged an outside firm to perform independent credit reviews of our loan portfolio. The Federal Reserve Bank of San Francisco and the California Department of Financial Institutions also review the allowance for loan losses as an integral part of the examination process. Based on information currently available, management believes that the allowance for loan losses is adequate. However, the loan portfolio can be adversely affected if California economic conditions and the real estate market in the Company's market area were to further weaken. Also, any weakness of a prolonged nature in the technology industry would have a negative impact on the local market. The effect of such events, although uncertain at this time, could result in an increase in the level of nonperforming loans and increased loan losses, which could adversely affect the Company's future growth and profitability. No assurance of the ultimate level of credit losses can be given with any certainty.

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        The following table summarizes the Company's loan loss experience, as well as provisions and charges to the allowance for loan losses and certain pertinent ratios for the periods indicated:

 
   
   
   
   
  Three
Months
Ended
June 30, 2010
Total
 
 
  Three Months Ended June 30, 2011  
 
  Commercial   Real Estate   Consumer   Total  
 
  (Dollars in thousands)
 

Balance, beginning of period

  $ 13,594   $ 9,539   $ 876   $ 24,009   $ 26,527  

Charge-offs

    (1,681 )   (601 )   (8 )   (2,290 )   (18,681 )

Recoveries

    91     401     1     493     307  
                       
 

Net charge-offs

    (1,590 )   (200 )   (7 )   (1,797 )   (18,374 )

Provision for loan losses

    1,988     (1,177 )   144     955     18,600  
                       
 

Balance, end of period

  $ 13,992   $ 8,162   $ 1,013   $ 23,167   $ 26,753  
                       

RATIOS:

                               
 

Net charge-offs to average loans(1)

    0.80 %   0.10 %   0.00 %   0.90 %   7.43 %
 

Allowance for loan losses to total loans(1)

    1.79 %   1.04 %   0.13 %   2.96 %   2.85 %
 

Allowance for loan losses to nonperforming loans

    57.68 %   33.65 %   4.18 %   95.51 %   44.90 %

 

 
  Six Months Ended June 30, 2011    
 
 
  Six Months Ended
June 30, 2010
Total
 
 
  Commercial   Real Estate   Consumer   Total  
 
  (Dollars in thousands)
 

Balance, beginning of period

  $ 13,952   $ 10,363   $ 889   $ 25,204   $ 28,768  

Charge-offs

    (2,800 )   (1,596 )   (8 )   (4,404 )   (26,383 )

Recoveries

    230     411     1     642     673  
                       
   

Net charge-offs

    (2,570 )   (1,185 )   (7 )   (3,762 )   (25,710 )

Provision for loan losses

    2,610     (1,016 )   131     1,725     23,695  
                       
   

Balance, end of period

  $ 13,992   $ 8,162   $ 1,013   $ 23,167   $ 26,753  
                       

RATIOS:

                               
   

Net charge-offs to average loans(1)

    0.64 %   0.29 %   0.00 %   0.93 %   5.08 %
 

Allowance for loan losses to total loans(1)

    1.79 %   1.04 %   0.13 %   2.96 %   2.85 %
 

Allowance for loan losses to nonperforming loans

    57.68 %   33.65 %   4.18 %   95.51 %   44.90 %

(1)
Average loans and total loans exclude loans held-for-sale.

        The Company's allowance for loan losses decreased $3.6 million at June 30, 2011 from June 30, 2010, and decreased $2.0 million from December 31, 2010. The decrease in the provision for loan losses at June 30, 2011 was primarily due to a lower volume of classified and nonperforming loans and lower total loans.

        Net loans charged-off reflects the realization of losses in the portfolio that were partially recognized previously through provisions for loan losses. Net charge-offs were $3.8 million in the first six months of 2011, compared to net charge-offs of $25.7 million in the first six months of 2010, including $13.9 million of net charge-offs related to the real estate loans transferred to "held-for-sale". Historical net loan charge-offs are not necessarily indicative of the amount of net charge-offs that the Company will realize in the future.

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        The following table provides a summary of the allocation of the allowance for loan losses for specific class at the dates indicated. The allocation presented should not be interpreted as an indication that charges to the allowance for loan losses will be incurred in these amounts or proportions, or that the portion of the allowance allocated to each category represents the total amount available for charge-offs that may occur within these classes.

Allocation of Loan Loss Allowance Table

 
  June 30,   December 31,  
 
  2011   2010   2010  
 
  Allowance   Percent of
Loans
in each
category
to total
loans
  Allowance   Percent of
Loans
in each
category
to total
loans
  Allowance   Percent of
Loans
in each
category
to total
loans
 
 
  (Dollars in thousands)
 

Commercial

  $ 13,992     46 % $ 10,892     41 % $ 13,952     45 %

Real estate:

                                     
 

Commercial and residential

    4,508     40 %   6,134     40 %   5,500     40 %
 

Land and construction

    3,162     5 %   7,961     12 %   4,271     7 %
 

Home equity

    492     7 %   901     6 %   592     6 %

Consumer

    1,013     2 %   865     1 %   889     2 %
                           
 

Total

  $ 23,167     100 % $ 26,753     100 % $ 25,204     100 %
                           

Deposits

        The composition and cost of the Company's deposit base are important components in analyzing the Company's net interest margin and balance sheet liquidity characteristics, both of which are discussed in greater detail in other sections herein. The Company's liquidity is impacted by the volatility of deposits or other funding instruments or, in other words, by the propensity of that money to leave the institution for rate-related or other reasons. Deposits can be adversely affected if economic conditions in California, and the Company's market area in particular, continue to weaken. Potentially, the most volatile deposits in a financial institution are jumbo certificates of deposit, meaning time deposits with balances that equal or exceed $100,000, as customers with balances of that magnitude are typically more rate-sensitive than customers with smaller balances.

        The following table summarizes the distribution of deposits and the percentage of distribution in each category of deposits for the periods indicated:

 
  June 30, 2011   June 30, 2010   December 31, 2010  
 
  Balance   % to Total   Balance   % to Total   Balance   % to Total  
 
  (Dollars in thousands)
 

Demand deposits, noninterest-bearing

  $ 333,199     33 % $ 249,017     24 % $ 280,258     28 %

Demand deposits, interest-bearing

    128,464     13 %   153,173     15 %   153,917     16 %

Savings and money market

    276,538     28 %   281,619     27 %   272,399     27 %

Time deposits—under $100

    30,676     3 %   38,201     3 %   33,499     3 %

Time deposits—$100 and over

    114,208     11 %   133,443     13 %   137,514     14 %

Time deposits—CDARS

    20,839     2 %   18,240     2 %   17,864     2 %

Time deposits—brokered

    94,631     10 %   163,732     16 %   98,467     10 %
                           
 

Total deposits

  $ 998,555     100 % $ 1,037,425     100 % $ 993,918     100 %
                           

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        The Company obtains deposits from a cross-section of the communities it serves. The Company's business is not generally seasonal in nature. The Company is not dependent upon funds from sources outside the United States. At June 30, 2011 and 2010, less than 1% of deposits were from public sources, respectively.

        Noninterest-bearing demand deposit accounts increased $84.2 million, or 34%, at June 30, 2011 from June 30, 2010, and increased $52.9 million, or 19%, from December 31, 2010. At June 30, 2011, brokered deposits decreased $69.1 million, or 42%, to $94.6 million, compared to $163.7 million at June 30, 2010, decreased $3.8 million, or 4%, from $98.5 million at December 31, 2010.

        The following table indicates the contractual maturity schedule of the Company's time deposits of $100,000 and over, and all CDARS and brokered deposits as of June 30, 2011:

 
  Balance   % of Total  
 
  (Dollars in thousands)
 

Three months or less

  $ 90,443     39 %

Over three months through six months

    38,245     17 %

Over six months through twelve months

    32,865     14 %

Over twelve months

    68,125     30 %
           
 

Total

  $ 229,678     100 %
           

        The Company focuses primarily on providing and servicing business deposit accounts that are frequently over $100,000 in average balance per account. As a result, certain types of business clients that the Company serves typically carry average deposits in excess of $100,000. The account activity for some account types and client types necessitates appropriate liquidity management practices by the Company to help ensure its ability to fund deposit withdrawals.

Return (Loss) on Equity and Assets

        The following table indicates the ratios for return (loss) on average assets and average equity, and average equity to average assets for the periods indicated:

 
  Three Months Ended
June 30,
  Six Months Ended
June 30,
 
 
  2011   2010   2011   2010  

Annualized return (loss) on average assets

    0.66 %   -16.28 %   0.59 %   -8.74 %

Annualized return (loss) on average tangible assets

    0.66 %   -16.86 %   0.59 %   -9.05 %

Annualized return (loss) on average equity

    4.50 %   -121.78 %   4.01 %   -66.70 %

Annualized return (loss) on average tangible equity

    4.57 %   -164.27 %   4.08 %   -90.59 %

Average equity to average assets ratio

    14.68 %   13.37 %   14.65 %   13.10 %

Off-Balance Sheet Arrangements

        In the normal course of business, the Company makes commitments to extend credit to its customers as long as there are no violations of any conditions established in the contractual arrangements. These commitments are obligations that represent a potential credit risk to the Company, yet are not reflected on the Company's consolidated balance sheets. Total unused commitments to extend credit were $273.2 million at June 30, 2011, as compared to $293.7 million at June 30, 2010 and $284.0 million at December 31, 2010. Unused commitments represented 35%, 31%, and 34% of outstanding gross loans at June 30, 2011 and 2010, and December 31, 2010, respectively.

        The effect on the Company's revenues, expenses, cash flows and liquidity from the unused portion of the commitments to provide credit cannot be reasonably predicted, because there is no certainty that

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lines of credit and letters of credit will ever be fully utilized. The following table presents the Company's commitments to extend credit for the periods indicated:

 
  June 30,    
   
 
 
  December 31,
2010
 
 
  2011   2010  
 
  (Dollars in thousands)
   
 
 
  Fixed Rate   Variable Rate   Fixed Rate   Variable Rate   Fixed Rate   Variable Rate  

Unused lines of credit and commitments to make loans

  $ 8,369   $ 247,040   $ 8,109   $ 267,154   $ 6,740   $ 256,575  

Standby letters of credit

    2,291     15,514     417     18,013     2,291     18,419  
                           

  $ 10,660   $ 262,554   $ 8,526   $ 285,167   $ 9,031   $ 274,994  
                           

Liquidity and Asset/Liability Management

        Liquidity refers to the Company's ability to maintain cash flows sufficient to fund operations and to meet obligations and other commitments in a timely and cost effective fashion. At various times the Company requires funds to meet short-term cash requirements brought about by loan growth or deposit outflows, the purchase of assets, or liability repayments. An integral part of the Company's ability to manage its liquidity position appropriately is the Company's large base of core deposits, which are generated by offering traditional banking services in its service area and which have, historically, been a stable source of funds. To manage liquidity needs properly, cash inflows must be timed to coincide with anticipated outflows or sufficient liquidity resources must be available to meet varying demands. The Company manages liquidity to be able to meet unexpected sudden changes in levels of its assets or deposit liabilities without maintaining excessive amounts of balance sheet liquidity. Excess balance sheet liquidity can negatively impact the Company's interest margin. In order to meet short-term liquidity needs, the Company utilizes overnight Federal funds purchase arrangements and other borrowing arrangements with correspondent banks, solicits brokered deposits if cost effective deposits are not available from local sources and maintains collateralized lines of credit with the FHLB and FRB. In addition, the Company can raise cash for temporary needs by selling securities under agreements to repurchase and selling securities available-for-sale.

        At June 30, 2011, the Company had loan contraction, including loans held-for-sale, of $181.0 million from June 30, 2010, and it has experienced an improvement in its liquidity position. One of the measures we analyze for liquidity is our loan to deposit ratio. Our loan to deposit ratio improved to 78.32% at June 30, 2011 compared to 90.39% at June 30, 2010, and 85.12% at December 31, 2010.

FHLB and FRB Borrowings & Available Lines of Credit

        The Company has off-balance sheet liquidity in the form of Federal funds purchase arrangements with correspondent banks, including the FHLB and FRB. The Company can borrow from the FHLB on a short-term (typically overnight) or long-term (over one year) basis. The Company had no overnight borrowings from the FHLB at June 30, 2011, June 30, 2010 and December 31, 2010. The Company had $195.7 million of loans pledged to the FHLB as collateral on an available line of credit of $106.3 million at June 30, 2011.

        The Company can also borrow from FRB's discount window. The Company had $205.9 million of loans pledged to the FRB as collateral on an available line of credit of $123.9 million at June 30, 2011, none of which was outstanding.

        At June 30, 2011, the Company had Federal funds purchase arrangements available of $30.0 million. There were no Federal funds purchased outstanding June 30, 2011, June 30, 2010, and December 31, 2010.

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        The Company had no secured borrowings at June 30, 2011. The Company had a $4.0 million secured borrowing at June 30, 2010, and a $2.4 million secured borrowing at December 31, 2010. Secured borrowings represented the guaranteed portions of SBA 7a loans transferred to third parties subject to a SBA warranty for a period of 90 days. This required the Company to treat these loans as secured borrowings during the warranty period. Effective February 15, 2011, the SBA no longer required a warranty period in loan sales agreements.

        The Company may also utilize securities sold under repurchase agreements to manage our liquidity position. There were no securities sold under agreements to at June 30, 2011, compared to $20.0 million at June 30, 2010, and $5.0 million at December 31, 2010. Repurchase agreements are accounted for as collateralized financial transactions and were secured by mortgage-backed securities carried at an amortized cost of $21.0 million at June 30, 2010, and $6.3 million at December 31, 2010.

        The following table summarizes the Company's borrowings under its Federal funds purchased, security repurchase arrangements and lines of credit for the periods indicated:

 
  June 30,    
 
 
  December 31,
2010
 
 
  2011   2010  
 
  (Dollars in thousands)
 

Average balance year-to-date

  $ 1,436   $ 31,674   $ 23,888  

Average interest rate year-to-date

    3.37 %   1.61 %   1.78 %

Maximum month-end balance during the quarter

  $   $ 30,708   $ 15,000  

Average rate at period-end

    N/A     2.27 %   3.09 %

Capital Resources

        The Company uses a variety of measures to evaluate capital adequacy. Management reviews various capital measurements on a regular basis and takes appropriate action to ensure that such measurements are within established internal and external guidelines. The external guidelines, which are issued by the Federal Reserve Board and the FDIC, establish a risk-adjusted ratio relating capital to different categories of assets and off-balance sheet exposures. There are two categories of capital under the Federal Reserve Board and FDIC guidelines: Tier 1 and Tier 2 Capital. Our Tier 1 Capital currently consists of total shareholders' equity (excluding accumulated other comprehensive income or loss) and the proceeds from the issuance of trust preferred securities (trust preferred securities are counted only up to a maximum of 25% of Tier 1 capital), less goodwill and other intangible assets and disallowed deferred tax assets. Our Tier 2 Capital includes the allowances for loan losses and off-balance sheet credit losses.

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        The following table summarizes risk-based capital, risk-weighted assets, and risk-based capital ratios of the consolidated Company:

 
  June 30,    
   
   
 
 
  December 31,
2010
   
   
 
 
  2011   2010    
   
 
 
  (Dollars in thousands)
   
   
 

Capital components:

                               
 

Tier 1 Capital

  $ 194,001   $ 112,797   $ 185,775              
 

Tier 2 Capital

    11,825     83,295     11,988              
                           
   

Total risk-based capital

  $ 205,826   $ 196,092   $ 197,763              
                           

Risk-weighted assets

  $ 934,361   $ 1,050,949   $ 945,499              

Average assets for capital purposes

  $ 1,248,090   $ 1,304,239   $ 1,316,600              

 

 

 


 

 


 

 


 

Well-Capitalized
Regulatory
Requirements

 

Minimum
Regulatory
Requirements

 

Capital ratios:

                               
 

Total risk-based capital

    22.0 %   18.7 %   20.9 %   10.00 %   8.00 %
 

Tier 1 risk-based capital

    20.8 %   10.7 %   19.7 %   6.00 %   4.00 %
 

Leverage(1)

    15.5 %   8.6 %   14.1 %   N/A     4.00 %

(1)
Tier 1 capital divided by quarterly average assets (excluding goodwill, other intangible assets and disallowed deferred tax assets).

        The table above presents the capital ratios of the consolidated Company computed in accordance with applicable regulatory guidelines and compared to the standards for minimum capital adequacy requirements for bank holding companies.

        The following table summarizes risk-based capital, risk-weighted assets, and risk-based capital ratios of HBC:

 
  June 30,    
   
   
 
 
  December 31,
2010
   
   
 
 
  2011   2010    
   
 
 
  (Dollars in thousands)
   
   
 

Capital components:

                               
 

Tier 1 Capital

  $ 170,524   $ 152,251   $ 159,192              
 

Tier 2 Capital

    11,843     13,310     11,993              
                           
   

Total risk-based capital

  $ 182,367   $ 165,561   $ 171,185              
                           

Risk-weighted assets

  $ 935,830   $ 1,050,908   $ 945,918              

Average assets for capital purposes

  $ 1,249,964   $ 1,303,879   $ 1,316,969              

 

 

 


 

 


 

 


 

Well-Capitalized
Regulatory
Requirements

 

Minimum
Regulatory
Requirements

 

Capital ratios:

                               

Total risk-based capital

    19.5 %   15.8 %   18.1 %   10.00 %   8.00 %

Tier 1 risk-based capital

    18.2 %   14.5 %   16.8 %   6.00 %   4.00 %

Leverage(1)

    13.6 %   11.7 %   12.1 %   5.00 %   4.00 %

(1)
Tier 1 capital divided by quarterly average assets (excluding goodwill, other intangible assets and disallowed deferred tax assets).

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        The table above presents the capital ratios of HBC computed in accordance with applicable regulatory guidelines and compared to the standards for minimum capital adequacy requirements under the FDIC's prompt corrective action authority.

        At June 30, 2011 and 2010, and December 31, 2010, HCC's and HBC's capital met all minimum regulatory requirements. As of June 30, 2011, HBC's capital ratios exceed the highest regulatory capital requirement of "well-capitalized" under the prompt corrective action provisions.

        At June 30, 2011, the Company had total shareholders' equity of $187.5 million, including $58.3 million in preferred stock, $130.8 million in common stock, $601,000 in retained earnings, and ($2.3) million of accumulated other comprehensive loss. The components of other comprehensive loss at June 30, 2011 include the following: an unrealized gain on available-for-sale securities of $477,000, an unrealized loss on split dollar insurance contracts of ($2.0) million, an unrealized loss on the supplemental executive retirement plan of ($2.0) million and an unrealized gain on interest-only strip from SBA loans of $1.3 million.

Mandatory Redeemable Cumulative Trust Preferred Securities

        To enhance regulatory capital and to provide liquidity, the Company, through unconsolidated subsidiary grantor trusts, issued the following mandatory redeemable cumulative trust preferred securities of subsidiary grantor trusts: In the first quarter of 2000, the Company issued $7.2 million aggregate principal amount of 10.87% subordinated debt due on March 8, 2030 to a subsidiary trust, which in turn issued a similar amount of trust preferred securities. In the third quarter of 2000, the Company issued $7.2 million aggregate principal amount of 10.60% subordinated debt due on September 7, 2030 to a subsidiary trust, which in turn issued a similar amount of trust preferred securities. In the third quarter of 2001, the Company issued $5.2 million aggregate principal amount of Floating Rate Junior Subordinated Deferrable Interest Debentures due on July 31, 2031 to a subsidiary trust, which in turn issued a similar amount of trust preferred securities. In the third quarter of 2002, the Company issued $4.1 million of aggregate principal amount of Floating Rate Junior Subordinated Deferrable Interest Debentures due on September 26, 2032 to a subsidiary trust, which in turn issued a similar amount of trust preferred securities. The subordinated debt is recorded as a component of long-term debt and includes the value of the common stock issued by the trusts to the Company. The common stock is recorded as other assets for the amount issued. Under applicable regulatory guidelines, the trust preferred securities currently qualify as Tier I capital. The subsidiary trusts are not consolidated in the Company's consolidated financial statements. Under the Dodd-Frank Wall Street Reform and Consumer Protection Act, certain trust preferred securities will no longer be eligible to be included as Tier 1 capital for regulatory purposes. However, an exception to this statutory prohibition applies to securities issued prior to May 19, 2010 by bank holding companies with less than $15 billion of total assets; therefore, our trust preferred securities will continue to be eligible to be treated as Tier 1 capital, subject to other rules and limitations.

        In November 2009, the Company announced that it was exercising its right to defer interest payments on its outstanding trust preferred subordinated debt securities. During the second quarter of 2011, the Company paid all of the deferred interest payments on its outstanding trust preferred subordinated debt securities in the amount of $3.9 million, which includes all payments due through September 8, 2011.

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U.S. Treasury Capital Purchase Program

        The Company received $40 million in November 2008 through the issuance of its Series A Preferred Stock and a warrant to purchase 462,963 shares of its common stock to the Treasury through the U.S. Treasury Capital Purchase Program. The Series A Preferred Stock qualifies as a component of Tier 1 capital. In November 2009, the Company announced that it was exercising its right to suspend payment of dividends on its Series A Preferred Stock. On August 1, 2011, the Company paid a dividend on its Series A Preferred Stock held by the US Treasury in an aggregate amount of $4.2 million. As a result of the dividend payment, the Company is current in the dividends accrued and owed to the US Treasury.

Private Placement

        On June 21, 2010, the Company issued to various institutional investors 53,996 shares of Series B Mandatorily Convertible Cumulative Perpetual Preferred Stock ("Series B Preferred Stock") and 21,004 shares of newly issued Series C Convertible Perpetual Preferred Stock ("Series C Preferred Stock") for an aggregate purchase price of $75.0 million. The Series B Preferred Stock was mandatorily convertible into common stock, upon approval by the shareholders at a conversion price of $3.75 per share. The Series C Preferred Stock is mandatorily convertible into common stock at a conversion price of $3.75 per share upon both approval by the shareholders and thereafter, a subsequent transfer of the Series C Preferred stock to third parties not affiliates with the holder in a widely dispersed offering. The Series B Preferred Stock and the Series C Preferred Stock did not include a beneficial conversion feature, as the conversion price at $3.75 per share was not below the fair market value of the Company's common stock on the commitment date.

        At the Company's Special Meeting of shareholders held on September 15, 2010, the Company's shareholders approved the issuance of common stock upon the conversion of the Series B Preferred Stock and upon the conversion of the Series C Preferred Stock. As a result, on September 16, 2010, the Series B Preferred Stock was converted into 14,398,992 shares of common stock of the Company and the shares of Series B Preferred Stock ceased to be outstanding.

        The Series C Preferred Stock remains outstanding until it has been converted into common stock in accordance with its terms. The Series C Preferred Stock is non-voting except in the case of certain transactions that would affect the rights of the holders of the Series C Preferred Stock or applicable law. Holders of Series C Preferred Stock will receive dividends if and only to the extent dividends are paid to holders of common stock. The Series C Preferred Stock is not redeemable by the Company or by the holders and has a liquidation preference of $1,000 per share. The Series C Preferred Stock ranks senior to the Company's common stock and ranks on parity with the Company's Series A Preferred Stock.

Market Risk

        Market risk is the risk of loss of future earnings, fair values, or future cash flows that may result from changes in the price of a financial instrument. The value of a financial instrument may change as a result of changes in interest rates, foreign currency exchange rates, commodity prices, equity prices and other market changes that affect market risk sensitive instruments. Market risk is attributed to all market risk sensitive financial instruments, including securities, loans, deposits and borrowings, as well as the Company's role as a financial intermediary in customer-related transactions. The objective of market risk management is to avoid excessive exposure of the Company's earnings and equity to loss and to reduce the volatility inherent in certain financial instruments.

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Interest Rate Management

        Market risk arises from changes in interest rates, exchange rates, commodity prices and equity prices. The Company's market risk exposure is primarily that of interest rate risk, and it has established policies and procedures to monitor and limit earnings and balance sheet exposure to changes in interest rates. The Company does not engage in the trading of financial instruments, nor does the Company have exposure to currency exchange rates.

        The principal objective of interest rate risk management (often referred to as "asset/liability management") is to manage the financial components of the Company in a manner that will optimize the risk/reward equation for earnings and capital in relation to changing interest rates. The Company's exposure to market risk is reviewed on a regular basis by the Asset/Liability Committee. Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximizing income. Management realizes certain risks are inherent, and that the goal is to identify and manage the risks. Management uses two methodologies to manage interest rate risk: (i) a standard GAP analysis; and (ii) an interest rate shock simulation model.

        The planning of asset and liability maturities is an integral part of the management of an institution's net interest margin. To the extent maturities of assets and liabilities do not match in a changing interest rate environment, the net interest margin may change over time. Even with perfectly matched repricing of assets and liabilities, risks remain in the form of prepayment of loans or securities or in the form of delays in the adjustment of rates of interest applying to either earning assets with floating rates or to interest bearing liabilities. The Company has generally been able to control its exposure to changing interest rates by maintaining primarily floating interest rate loans and a majority of its time certificates with relatively short maturities.

        Interest rate changes do not affect all categories of assets and liabilities equally or at the same time. Varying interest rate environments can create unexpected changes in prepayment levels of assets and liabilities, which may have a significant effect on the net interest margin and are not reflected in the interest sensitivity analysis table. Because of these factors, an interest sensitivity gap report may not provide a complete assessment of the exposure to changes in interest rates.

        The Company uses modeling software for asset/liability management in order to simulate the effects of potential interest rate changes on the Company's net interest margin, and to calculate the estimated fair values of the Company's financial instruments under different interest rate scenarios. The program imports current balances, interest rates, maturity dates and repricing information for individual financial instruments, and incorporates assumptions on the characteristics of embedded options along with pricing and duration for new volumes to project the effects of a given interest rate change on the Company's interest income and interest expense. Rate scenarios consisting of key rate and yield curve projections are run against the Company's investment, loan, deposit and borrowed funds portfolios. These rate projections can be shocked (an immediate and parallel change in all base rates, up or down) and ramped (an incremental increase or decrease in rates over a specified time period), based on current trends and econometric models or stable economic conditions (unchanged from current actual levels).

        The following table sets forth the estimated changes in the Company's annual net interest income that would result from the designated instantaneous parallel shift in interest rates noted, as of June 30, 2011. Computations of prospective effects of hypothetical interest rate changes are based on numerous

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assumptions including relative levels of market interest rates, loan prepayments and deposit decay, and should not be relied upon as indicative of actual results.

 
  Increase/(Decrease)
in Estimated Net
Interest Income
 
 
  Amount   Percent  
 
  (Dollars in thousands)
 

Change in Interest Rates (basis points)

             
 

+400

  $ 14,050     28.4 %
 

+300

  $ 10,424     21.1 %
 

+200

  $ 6,763     13.7 %
 

+100

  $ 3,174     6.4 %
 

       0

  $     0.0 %
 

-100

  $ (3,950 )   -8.0 %
 

-200

  $ (9,020 )   -18.2 %

        This data does not reflect any actions that we may undertake in response to changes in interest rates such as changes in rates paid on certain deposit accounts based on local competitive factors, which could reduce the actual impact on net interest income.

        As with any method of gauging interest rate risk, there are certain shortcomings inherent to the methodology noted above. The model assumes interest rate changes are instantaneous parallel shifts in the yield curve. In reality, rate changes are rarely instantaneous. The use of the simplifying assumption that short-term and long-term rates change by the same degree may also misstate historic rate patterns, which rarely show parallel yield curve shifts. Further, the model assumes that certain assets and liabilities of similar maturity or period to repricing will react in the same way to changes in rates. In reality, certain types of financial instruments may react in advance of changes in market rates, while the reaction of other types of financial instruments may lag behind the change in general market rates. Additionally, the methodology noted above does not reflect the full impact of annual and lifetime restrictions on changes in rates for certain assets, such as adjustable rate loans. When interest rates change, actual loan prepayments and actual early withdrawals from certificates may deviate significantly from the assumptions used in the model. Finally, this methodology does not measure or reflect the impact that higher rates may have on adjustable-rate loan clients' ability to service their debt. All of these factors are considered in monitoring the Company's exposure to interest rate risk.

CRITICAL ACCOUNTING POLICIES

        Critical accounting policies are discussed in our Form 10-K for the year ended December 31, 2010. There are no changes to these policies as of June 30, 2011.

ITEM 3—QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

        The information concerning quantitative and qualitative disclosure or market risk called for by Item 305 of Regulation S-K is included as part of Item 2 above.

ITEM 4—CONTROLS AND PROCEDURES

Disclosure Control and Procedures

        The Company has carried out an evaluation, under the supervision and with the participation of the Company's management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures as of June 30, 2011. As defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), disclosure controls and procedures are controls and procedures designed to

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reasonably assure that information required to be disclosed in our reports filed or submitted under the Exchange Act are recorded, processed, summarized and reported on a timely basis. Disclosure controls are also designed to reasonably assure that such information is accumulated and communicated to our management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. Based upon their evaluation, our Chief Executive Officer and Chief Financial Officer concluded the Company's disclosure controls were effective as of June 30, 2011, the period covered by this report on Form 10-Q.

        During the six months ended June 30, 2011, there were no changes in our internal controls over financial reporting that materially affected, or are reasonably likely to affect, our internal controls over financial reporting.

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Part II—OTHER INFORMATION

ITEM 1—LEGAL PROCEEDINGS

        The Company is involved in certain legal actions arising from normal business activities. Management, based upon the advice of legal counsel, believes the ultimate resolution of all pending legal actions will not have a material effect on the financial statements of the Company.

ITEM 1A—RISK FACTORS

        In addition to the other information set forth in this Report, you should carefully consider the factors discussed in Part I, "Item 1A. Risk Factors" in our Annual Report on Form 10-K for the year ended December 31, 2010, which could materially affect our business, financial condition and/or operating results. There were no material changes from risk factors previously disclosed in our 2010 Annual Report on Form 10-K. The risk factors identified are in addition to those contained in any other cautionary statements, written or oral, which may be made or otherwise addressed in connection with a forward-looking statement or contained in any of our subsequent filings with the Securities and Exchange Commission.

ITEM 2—UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

        None

ITEM 3—DEFAULTS UPON SENIOR SECURITIES

        As of June 30, 2011, the Company has deferred seven dividend payments on its Series A Preferred Stock totaling approximately $3.5 million. On July 28, 2011, the Company's Board of Directors declared a dividend on its Series A Preferred Stock held by the U.S. Treasury in an aggregate amount of $4.2 million. The dividend was paid on August 1, 2011. Of the aggregate dividend declared and paid, $3.5 million is attributable to the dividend periods ending November 15, 2009 through May 15, 2011 and $172,000 is for interest on the deferred dividend payments, that have been previously accrued. The balance of $500,000 is the dividend payable for the period ending August 15, 2011. As a result of the dividend payment, the Company is current with respect to dividends accrued and owed to the U.S. Treasury.

ITEM 4—RESERVED

ITEM 5—OTHER INFORMATION

        None

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ITEM 6—EXHIBITS

Exhibit   Description
  3.1   Heritage Commerce Corp Restated Articles of Incorporation, as amended (incorporated by reference to Exhibit 3.1 to the Registrant's Annual Report on Form 10-K filed on March 4, 2010)

 

3.2

 

Certificate of Amendment of Articles of Incorporation of Heritage Commerce Corp as filed with the California Secretary of State on June 1, 2010 (incorporated by reference to Exhibit 3.1 to the Registrant's Registration Statement on Form S-1 filed July 23, 2010).

 

3.3

 

Heritage Commerce Corp Bylaws, as amended (incorporated by reference to the Registrant's Registration Statement Form S-1 filed on July 23, 2010)

 

4.1

 

Certificate of Determination for Fixed Rate Cumulative Perpetual Preferred Stock, Series A (incorporated by reference to Exhibit 3.1 to the Registrant's Form 8-K filed November 26, 2008)

 

4.2

 

Warrant to Purchase Common Stock dated November 21, 2008 (incorporated by reference to Exhibit 4.2 to the Registrant's Form 8-K filed on November 26, 2008)

 

4.3

 

Certificate of Determination for Series C Convertible Perpetual Preferred Stock (incorporated by reference to the Registrant's Form 8-K filed on June 22, 2010)

 

12.1

 

Calculation of Ratio of Earnings to Fixed Charges and Ratio of Earnings to Fixed Charges and Preferred Stock Dividends

 

31.1

 

Certification of Registrant's Chief Executive Officer Pursuant To Section 302 of the Sarbanes-Oxley Act of 2002

 

31.2

 

Certification of Registrant's Chief Financial Officer Pursuant To Section 302 of the Sarbanes-Oxley Act of 2002

 

32.1

 

Certification of Registrant's Chief Executive Officer Pursuant To 18 U.S.C. Section 1350

 

32.2

 

Certification of Registrant's Chief Financial Officer Pursuant To 18 U.S.C. Section 1350

 

101.INS

 

XBRL Instance Document, furnished herewith

 

101.SCH

 

XBRL Taxonomy Extension Schema Document, furnished herewith

 

101.CAL

 

XBRL Taxonomy Extension Calculation Linkbase Document, furnished herewith

 

101.DEF

 

XBRL Taxonomy Extension Definition Linkbase Document, furnished herewith

 

101.LAB

 

XBRL Taxonomy Extension Label Linkbase Document, furnished herewith

 

101.PRE

 

XBRL Taxonomy Extension Presentation Linkbase Document, furnished herewith

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SIGNATURES

        Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

    Heritage Commerce Corp (Registrant)

Date:  August 8, 2011

 

/s/ WALTER T. KACZMAREK

Walter T. Kaczmarek
Chief Executive Officer

Date:  August 8, 2011

 

/s/ LAWRENCE D. MCGOVERN

Lawrence D. McGovern
Chief Financial Officer

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EXHIBIT INDEX

Exhibit   Description
  3.1   Heritage Commerce Corp Restated Articles of Incorporation, as amended (incorporated by reference to Exhibit 3.1 to the Registrant's Annual Report on Form 10-K filed on March 4, 2010)

 

3.2

 

Certificate of Amendment of Articles of Incorporation of Heritage Commerce Corp as filed with the California Secretary of State on June 1, 2010 (incorporated by reference to Exhibit 3.1 to the Registrant's Registration Statement on Form S-1 filed July 23, 2010).

 

3.3

 

Heritage Commerce Corp Bylaws, as amended (incorporated by reference to the Registrant's Registration Statement Form S-1 filed on July 23, 2010)

 

4.1

 

Certificate of Determination for Fixed Rate Cumulative Perpetual Preferred Stock, Series A (incorporated by reference to Exhibit 3.1 to the Registrant's Form 8-K filed November 26, 2008)

 

4.2

 

Warrant to Purchase Common Stock dated November 21, 2008 (incorporated by reference to Exhibit 4.2 to the Registrant's Form 8-K filed on November 26, 2008)

 

4.3

 

Certificate of Determination for Series C Convertible Perpetual Preferred Stock (incorporated by reference to the Registrant's Form 8-K filed on June 22, 2010)

 

12.1

 

Calculation of Ratio of Earnings to Fixed Charges and Ratio of Earnings to Fixed Charges and Preferred Stock Dividends

 

31.1

 

Certification of Registrant's Chief Executive Officer Pursuant To Section 302 of the Sarbanes-Oxley Act of 2002

 

31.2

 

Certification of Registrant's Chief Financial Officer Pursuant To Section 302 of the Sarbanes-Oxley Act of 2002

 

32.1

 

Certification of Registrant's Chief Executive Officer Pursuant To 18 U.S.C. Section 1350

 

32.2

 

Certification of Registrant's Chief Financial Officer Pursuant To 18 U.S.C. Section 1350

 

101.INS

 

XBRL Instance Document, furnished herewith

 

101.SCH

 

XBRL Taxonomy Extension Schema Document, furnished herewith

 

101.CAL

 

XBRL Taxonomy Extension Calculation Linkbase Document, furnished herewith

 

101.DEF

 

XBRL Taxonomy Extension Definition Linkbase Document, furnished herewith

 

101.LAB

 

XBRL Taxonomy Extension Label Linkbase Document, furnished herewith

 

101.PRE

 

XBRL Taxonomy Extension Presentation Linkbase Document, furnished herewith

67