By Pacific Coast Business Times Staff Monday, March 15th, 2010

Forty-eight hours after the release of a memorandum of understanding with regulators, Paso Robles-based Heritage Oaks Bank slammed the door on further proceedings when it announced it was raising $60 million in new securities.

The infusion of preferred and convertible stock will make Heritage Oaks, with $947 million in assets, one of the best-capitalized banks in the region. But don’t look for the banking company to stray too far from its core operations in San Luis Obispo and Santa Barbara counties.

In an interview with the Business Times, President and CEO Larry Ward said the new capital will allow the company to “focus on organic growth” in its core markets, including Santa Barbara, where it operates two Business First Bank branches.

The capital comes at a hefty price tag. The $60 million in preferred stock and convertible bonds will equal roughly 60 percent of its market capitalization. The conversion price of $3.25 per share means the bank’s stock will likely trade at that range for some time.

But the bank also is undertaking a rare feat — selling equity in a difficult environment at a time when it is actually under an order to raise capital by regulators. “This has been a long and arduous process,” Ward said. “Now, we’re moving forward.”

Buyers of the securities include a number of institutional investors, including one fund that will own 14.4 percent of Heritage Oaks’ common stock based on the conversion price. Another institutional investor will own 4.9 percent of Heritage Oaks common stock and the balance in non-voting preferred stock, Ward said.

The timing of the capital infusion raised questions about the March 8 release of a memorandum of understanding with Federal banking regulators. Under the MOU, which Heritage Oaks said earlier was likely to happen, it agreed to halt common stock dividends and accept other restrictions.

Ward said the company had no choice but to release the details of the memorandum as soon as they became public. By closing a capital round so quickly after the MOU announcement, any concerns about the bank’s viability have been laid to rest.

In a release announcing the $60 million in investments, the bank, which has 13 tri-county branches, said the money will be used to increase its capital and strengthen its balance sheet. The deal is expected to close March 12, Heritage Oaks said.

The bulk of the capital will be raised by selling non-voting shares that would convert immediately to voting stock if shareholders approve the deal at a shareholder meeting slated for Sept. 30. The deal also requires approval from regulators.

On March 8, federal banking regulators halted dividends at Heritage Oaks and gave the company two months to submit a plan to keep up its capital levels. At the end of the year, Heritage Oaks had a tier-one capital ratio — its free capital divided by its loans and other assets — of 9.9 percent.

That figure remains above the 4 percent required by federal regulators. But throughout the financial crisis, regulators have demanded that banks maintain higher-than-minimum capital levels to guard against higher risk in their loan portfolios.

Growth plans

As it has experienced trouble in SLO County, Heritage Oaks’ Santa Barbara operations have contributed to growth in loans and deposits. At the end of 2009, the bank had $947 million in assets, up 17.6 percent from the year before. It also grew total deposits 28 percent to $775 million.

Ward said the new capital will allow the bank to continue to expand in the Santa Barbara area, where assets increased 50 percent last year. Among other initiatives, Heritage Oaks and Business First are planning on expanding their U.S. Small Business Administration-guaranteed lending efforts, where they can add customers without pressing up against regulatory hurdles.

Heritage Oaks also will look at expanding its agricultural lending portfolio and loans to specialized companies that aren’t tied to real estate or development.

Raising that much capital in a short period of time is a testament to the bank’s viability at a time when regulators are heavily scrutinizing financial institutions whose fortunes are tied to loans on commercial real estate. Indeed, it was in part the bank’s heavy dependence on real estate loans in the battered North San Luis Obispo County market that drew the scrutiny of regulators.

Commercial real estate

At the end of September, more than 70 percent of Heritage Oaks’ loan portfolio was backed by real estate, according to documents filed with the Securities and Exchange Commission. Ward said that Heritage Oaks would continue to make commercial real estate loans but that he was aware of a number of cases where otherwise healthy borrowers were underwater on their loans because of falling valuations.

“The commercial markets are going to be the next big problem and the values of these are much bigger,” said Brad Kemp, director of regional research at Beacon Economics and regional economist for the UCSB Economic Forecast Project. “It’s going to create wealth loss.”

After a spate of high-value commercial real estate transactions in 2008, there were no transactions in 2009 in North San Luis Obispo County, making it tough to value loans and workouts based on comparable sales, Kemp said. “You could call it a cliff chart. All of a sudden, boom, nothing,” Kemp said. “You have to have a transaction to tell you what the price is going to be.”

Over 2009, Heritage Oaks’ nonaccrual loans, where borrowers hadn’t made any payments for more than 60 days, jumped from $18.3 million to $34.5 million, according to its fourth-quarter report. The biggest problems have surfaced in Heritage Oaks’ commercial real estate and land loan portfolios. In the commercial real estate category, non-paying loans swelled from $1.9 million in 2008 to $11 million in 2009 primarily because of 10 loans to eight borrowers. Problem land loans went from $2.7 million to $6.3 million between 2008 and 2009, though one $10.7 million loan marked as nonaccrual began paying again.

In its fourth-quarter report, Heritage Oaks said it added troubled-loan specialists to find and fix problems faster. Ward said one reason his bank was able to raise capital was that it was able to earn enough from operations to cover virtually all of the increase in nonperforming loans.

But Kemp, the economic forecaster, said staying power will be the key. His analysis suggests that commercial property in San Louis Obispo County probably won’t bottom out until 2011 with recovery not likely until 2012.

Ward said: “We’re not going to shrink the bank, layoff employees or close branches.

“In today’s economy, capital is king,” he said.

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