10-Q 1 jun0510q.txt NORTHERN EMPIRE BANCSHARES JUNE 05 10Q SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2005 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission File Number 2-91196 NORTHERN EMPIRE BANCSHARES (Exact name of registrant as specified in its charter) California 94-2830529 (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification No.) 801 Fourth Street, Santa Rosa, California 95404 (Address of principal executive offices) (Zip code) 707-579-2265 (Registrant's telephone number, including area code) NONE (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 X No --- --- Indicate by check mark whether the registrant is an accelerated filer (as defined in rule 12b-2 of the Exchange act). Yes X No --- --- APPLICABLE ONLY TO CORPORATE ISSUERS Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Title of class: Common Stock, no par value. Outstanding shares as of June 30, 2005: 10,384,740 PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS NORTHERN EMPIRE BANCSHARES AND SUBSIDIARY CONSOLIDATED BALANCE SHEETS (dollars in thousands) ASSETS June 30, 2005 December 31, 2004 ------------- ----------------- (unaudited) Cash and equivalents: Cash and due from banks $ 34,428 $ 21,006 Federal funds sold 101,373 95,498 ---------- ---------- Total cash and equivalents 135,801 116,504 Investment securities available-for-sale 1,081 1,082 Federal Home Loan Bank (FHLB) stock, at cost 11,639 9,020 Federal Reserve Bank stock, at cost 166 254 Loans receivable, net 1,020,650 938,104 Leasehold improvements and equipment, net 3,406 2,709 Accrued interest receivable and other assets 14,557 13,251 ---------- ---------- Total assets $1,187,300 $1,080,924 ========== ========== LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities: Deposits $ 852,263 $ 791,025 FHLB Advances 230,395 191,912 Accrued interest payable and other liabilities 6,298 8,109 ---------- ---------- Total liabilities 1,088,956 991,046 ---------- ---------- Shareholders' equity: Common stock, no par value; authorized, 40,000,000 shares; shares issued and outstanding, 10,384,740 at June 30, 2005 and 10,346,770 at December 31, 2004 (retroactively stated for 5% stock dividend) 60,574 47,302 Additional paid-in-capital 7,681 7,681 Accumulated other comprehensive income (loss) (11) (10) Retained earnings 30,100 34,905 ---------- ---------- Total shareholders' equity 98,344 89,878 Total liabilities and shareholders' equity $1,187,300 $1,080,924 ========== ========== See Notes to Consolidated Financial Statements NORTHERN EMPIRE BANCSHARES AND SUBSIDIARY CONSOLIDATED STATEMENTS OF INCOME (Unaudited) Three Months Six Months Ended June 30, Ended June 30, ------------------ ------------------ 2005 2004 2005 2004 (dollars in thousands, except -------- -------- -------- -------- per share data) Interest income: Loans $ 17,230 $ 12,870 $ 33,179 $ 24,912 Federal funds sold and investment securities 920 297 1,626 546 -------- -------- -------- -------- Total interest income 18,150 13,167 34,805 25,458 Interest expense 6,877 3,475 12,348 6,807 -------- -------- -------- -------- Net interest income before provision for loan losses 11,273 9,692 22,457 18,651 Provision for loan losses 525 325 1,050 550 -------- -------- -------- -------- Net interest income after provision for loan losses 10,748 9,367 21,407 18,101 -------- -------- -------- -------- Other income: Service charges on deposits 124 180 252 251 Gain on sale of loans 853 248 1,365 700 Other 211 179 414 631 -------- -------- -------- -------- Total other income 1,188 607 2,031 1,582 -------- -------- -------- -------- Other expenses: Salaries and employee benefits 2,870 2,362 5,486 4,775 Occupancy 479 337 902 643 Equipment 315 215 568 416 Advertising and business development 249 161 440 303 Outside customer services 93 80 170 174 Director and shareholder expenses 125 105 240 163 Deposit and other insurance 132 112 262 224 Professional fees 201 89 413 194 Other 532 279 902 600 -------- -------- -------- -------- Total other expenses 4,996 3,740 9,383 7,492 -------- -------- -------- -------- Income before provision for income taxes 6,940 6,234 14,055 12,191 Provision for income taxes 2,864 2,585 5,780 4,961 -------- -------- -------- -------- Net income $ 4,076 $ 3,649 $ 8,275 $ 7,230 ======== ======== ======== ======== Basic earnings per common share $ 0.39 $ 0.35 $ 0.80 $ 0.71 ======== ======== ======== ======== Diluted earnings per common share $ 0.38 $ 0.31 $ 0.77 $ 0.62 ======== ======== ======== ======== See notes to Consolidated Financial Statements NORTHERN EMPIRE BANCSHARES AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) Six months ended June 30, ------------------------- (dollars in thousands) 2005 2004 ---- ---- Cash flows from operating activities: Net income $ 8,275 $ 7,230 Adjustments to reconcile net income to net cash from operating activities: Provision for loan losses 1,050 550 Depreciation and amortization 400 281 FHLB Stock dividends (184) (108) Tax benefit from stock option exercised - 2,073 Gain on sale of loans (1,365) (700) Change in deferred income taxes 98 (467) Changes in operating assets and liabilities: Change in deferred loan fees and discounts 171 119 Change in interest receivable and other assets (1,404) (1,055) Change in accrued interest payable and other liabilities (2,031) 555 -------- -------- Net cash provided by operating activities 5,010 8,478 -------- -------- Cash flows from investing activities: Purchases of investment securities - (1,100) Proceeds from the sale of investment securities - 638 Purchase of restricted stock, net of redemption (2,347) (1,301) Net increase in loans receivable (82,181) (90,462) Purchase of leasehold improvements and equipment, net (1,097) (1,106) Net cash used by investing activities (85,625) (93,331) Cash flows from financing activities: Net change in deposits 61,238 62,564 Net change in FHLB advances 38,483 36,984 Payment of cash dividends (9) (6) Proceeds from exercise of stock options 200 2,158 -------- -------- Net cash from financing activities 99,912 101,700 -------- -------- Net change in cash and cash equivalents 19,297 16,847 Cash and cash equivalents, at beginning of year 116,504 94,575 -------- -------- Cash and cash equivalents, at end of period $135,801 $111,422 ======== ======== Supplemental cash-flow information: Interest paid $ 11,865 $ 6,646 ======== ======== Income taxes paid $ 8,410 $ 3,345 ======== ======== See Notes to Consolidated Financial Statements Northern Empire Bancshares and Subsidiary Notes to Consolidated Financial Statements June 30, 2005 Note 1 - Basis of Presentation The unaudited financial information contained in this report reflects all adjustments which, in the opinion of Management, are necessary to present fairly the financial condition of Northern Empire Bancshares and Subsidiary at June 30, 2005 and the results of operations for the three and six months then ended. The results of operations for the three and six months ended June 30, 2005, are not necessarily indicative of the operating results to be anticipated for the year ending December 31, 2005. The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect amounts reported in the consolidated financial statements. Changes in these estimates and assumptions are considered reasonably possible and may have a material impact on the consolidated financial statements and thus actual results could differ from the amounts reported and disclosed herein. The Company considers the allowance for loan loss a critical accounting policy subject to estimate. Certain information and footnote disclosures presented in the Corporation's annual consolidated financial statements are not included in these interim financial statements. Accordingly, the accompanying unaudited interim consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Corporation's 2004 Annual Report on Form 10-K. Note 2 - Net Income per Common and Common Equivalent Share Basic earnings per share (EPS) is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding during the period. Diluted EPS is computed by dividing income available to shareholders by the weighted average number of common shares and common equivalent shares outstanding, which include dilutive stock options. The computation of common stock equivalent shares is based on the weighted average market price of the Corporation's common stock throughout the period adjusted for the impact of the 5% stock dividends declared on March 22, 2005 and March 16, 2004. Earnings per share on a diluted basis are calculated based on the average number of shares outstanding including options at the time. There was a substantial reduction in the number of shares subject to outstanding options in November 2004. The Corporation's EPS data is as follows:

Note 3 - Stock Based Compensation The Company accounts for stock-based employee compensation arrangements using the intrinsic value method in accordance with the provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB No. 25) and complies with the disclosure provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock- Based Compensation (SFAS No. 123). Under APB No. 25, compensation expense is the excess, if any, of the fair value of the Company's stock at a measurement date over the amount that must be paid to acquire the stock. As of December 31, 2002, the Company adopted the disclosure requirements of SFAS 148, Accounting for Stock Based Compensation, which amends Accounting Principals Board ("APB") No. 25 by adding to the list of disclosures to be made for interim periods. SFAS No. 123 requires a fair value method to be used when determining compensation expense for stock options and similar equity instruments. SFAS No. 123 permits a company to continue to use APB No. 25 to account for stock-based compensation to employees, but pro forma disclosures of net income and earnings per share must be made as if SFAS No. 123 had been adopted in its entirety. For purposes of pro forma disclosures, the estimated fair value of the options is amortized over the options' vesting period. Stock options issued to non-employees are valued under the provisions of SFAS No. 123. Had compensation cost for the Company's options been determined based on the methodology prescribed under SFAS No. 123, the Company's net income and income per share would have been as follows:

The fair value of each option is estimated on date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions. No options were granted in the six-month period ended June 30, 2005. June 30, 2004 ------------- Dividends 0% Expected volatility 26.8% Risk-free interest rate 2.57% Expected life 3 years On July 26, 2006, nonstatutory stock options for an aggregate of 37,000 shares of the Corporation's common stock were granted to the seven directors of the Bank, five of whom are also directors of the Corporation. The options were granted pursuant to the Corporation's 1997 Stock Option Plan, as amended. Each option is exercisable immediately and may be exercised for a period of ten years. Each option was granted at an exercise price of $26.65, which was the per share market value of the Corporation's common stock as of the date of grant. Note 4 - Comprehensive Income The Corporation's total comprehensive earnings presentation is as follows: For the three For the six months ended months ended June 30, June 30, (In thousands) 2005 2004 2005 2004 ------------------------------------- Net Income $4,076 $3,649 $8,275 $7,230 ------ ------ ------ ------ Other Comprehensive income (loss): Change in unrealized holding gain (losses) arising during the period 9 (20) (1) (23) Income tax benefit (expense) (3) (10) 0 10 ------ ------ ------ ------ Net Other Comprehensive income (loss): 6 (10) (1) (13) ------ ------ ------ ------ Comprehensive income $4,082 $3,639 $8,274 $7,217 ====== ====== ====== ====== ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Northern Empire Bancshares (the "Corporation") is the bank holding company of Sonoma National Bank (the "Bank"). Since the principal business of the Corporation is the Bank, the following discussion pertains mainly to the Bank. Critical Accounting Policies The Corporation and Bank's accounting policies are fundamental to understanding management's discussion and analysis of results of operations and financial condition. One policy, Allowance for Loan Losses, has been identified as being critical because it requires management to make difficult and subjective judgments about matters that are inherently uncertain and because of the likelihood that materially different amounts would be reported under different conditions or using different assumptions. This policy is reviewed by Loan Committee and approved by the Board of Directors. The Allowance for Loan Losses represents management's estimate of probable losses inherent in the loan portfolio at the balance sheet date. The allowance for loan losses is reviewed monthly and is based on allocations for each loan category (e.g. Real Estate, Commercial) plus an allocation for any outstanding loans which have been classified and are on the "Watch List." Each loan that has been classified is individually analyzed for the risk involved and an allowance provided according to the risk assessment. In addition to the allocated component, there is an unallocated component. The unallocated component incorporates management's judgment of the inherent risks in the portfolio based on: historical loan loss experience, loan concentrations, evaluations made by regulatory agencies and our outside consultants, and assessment of economic conditions. The allocated and unallocated components represent the total allowance for loan losses that management estimates is adequate to cover losses inherent in the loan portfolio. Changes in the estimate related to the allowance for loan losses can materially affect net income. The process of determining the allowance requires us to make assumptions regarding the inherent losses which are highly uncertain, requires a high degree of judgment; and is impacted by regional, national and global economic trends. Different assumptions regarding possible future economic conditions could have been used and may have had a material impact on the provision for loan losses and on the consolidated results of operations. Forward-looking statements The discussion of certain matters in this report may constitute "forward- looking statements" as defined in section 27A of the Securities Act of 1933, and section 21E of the Securities Exchange Act of 1934, which include statements such as projections, plans, objectives and assumptions about the future, and such forward looking statements are subject to the safe harbor created by these sections. Although the Corporation and the Bank have based their plans and projections on certain assumptions, there can be no assurances that such assumptions will be correct, or that their plans and projections can be achieved. Many factors, risks and uncertainties could cause the actual results, amounts or events to differ materially from those the Corporation and the Bank expect to achieve or occur. Such factors, risks and uncertainties include, but are not limited to the following: Changes in the market interest rates and volatility of rate sensitive loans and deposits. Changes in interest rates impact the demand for new loans, the rates received on loans and securities and the rates paid on deposits and borrowings. Significant fluctuations in interest rates may have an adverse effect on the business, financial condition and results of operations of the Corporation and the Bank. Competitive pressures in the banking industry. The banking business is highly competitive, and competition among financial institutions for all types of financial products and services is expected to increase. The ability of the Bank to compete in the future will depend on the nature and level of future competition. Changes in the legislative and regulatory environment. Banks and bank holding companies are subject to extensive supervision and regulation. The banking business is also affected by the monetary and fiscal policies of the United States government and the Federal Reserve Board. The future regulatory environment may significantly affect the Bank's business. Declines in the national or regional economy. A worsening of economic conditions could reduce the demand for loans, cause credit quality deterioration and/or result in a decline in the value of real estate collateral securing a substantial portion of the Bank's loans. Any of these factors could have an adverse impact on the Bank's financial condition. Changes in accounting standards by the Financial Accounting Standards Board, the Securities and Exchange Commission (SEC) or other standard-setting bodies. Such changes could affect the manner in which the Corporation and the Bank are required to account for and report income, expenses, reserves, or a merger or acquisition, if any and could materially affect the Corporation's business and financial statements Changes in the U.S. Small Business Administration (SBA) program. The Bank makes a significant portion of its commercial loans through the U.S. Small Business Administration program, which guarantees a portion of such loans, and the Bank generates income through the sale of such loans. Changes in the Small Business Administration program could have an adverse effect on the Bank's business. Changes in economic conditions and real estate collateral. At June 30, 2005, 97.6%, or $1,006.2 million of the Bank's loans, including real estate and a majority of the Bank's SBA loans, were secured by real estate as the principal source of collateral. A worsening of economic conditions, a decline in real estate values and/or rising interest rates could have an effect on the value of real estate securing these loans and could have an adverse effect on the financial condition of the Bank. Changes in Federal Home Loan Bank (FHLB) borrowing policies. The Bank relies upon the FHLB for a large portion of the funding which is collateralized by loan assets. Based upon the current policies of the FHLB we believe the advances are renewable. Changes in the requirements of the FHLB could materially affect the Bank's business and financial statements. Investors are cautioned to consider these and other risks and uncertainties. The Corporation specifically disclaims any obligation to update any such factors or to publicly announce the results of any revisions to any forward-looking statements in this report to reflect future events or developments. Summary of Financial Results Total consolidated assets of $1,187,300,000 at June 30, 2005, grew $106 million during the first six months of 2005 compared to $1,080,924,000 at December 31, 2004. Net loans totaled $1,020,650,000, an increase of $82.5 million during 2005, with $33.8 million in growth occurring within the second quarter. Cash and equivalents increased $14.2 million during the second quarter. Deposits totaled $852,263,000 at June 30, 2005, an increase of $49.8 million during the second quarter. Net income after tax for the first six months of 2005 equaled $8,275,000 compared to $7,230,000 for the comparable period in 2004, an increase of 14.5%. Net income for the second quarter of 2005 equaled $4,076,000, an increase of 11.7% when compared to net income of $3,649,000 for the second quarter of 2004. Increased profit resulted primarily from growth in net interest income due to loan growth. Net Interest Income Net interest income (before the provision for loan losses) of $11,273,000 for the second quarter of 2005 increased 16.3% from $9,692,000 for the comparable period last year. This increase in net interest income resulted primarily from volume increases of $237.2 million in average earning assets for the current quarter compared to the second quarter of 2004. Average loans outstanding increased $209.7 million for the current quarter compared to the second quarter of 2004. Additionally, average investments, average funds held in interest bearing accounts and average Fed Funds investments increased $27.5 million during the second quarter of 2005. Average interest bearing deposits for the second quarter increased $107.7 million over the same period last year and average borrowings with the Federal Home Loan Bank increased $90.6 million. The net interest margin equaled 3.95% during the second quarter of 2005 compared to net interest margin for the second quarter of 2004 of 4.30% and 4.20% for the year ended December 31, 2004. The yield on average loans equaled 6.75% in the second quarter compared to 6.36% for the same period last year, while the Bank's cost of funds increased to 2.79% for the second quarter of 2005 from 1.77% for the second quarter of 2004. Several factors impact the Bank's interest margin. These include changes in market interest rates, level of loans relative to deposits, mix of loan and earning assets, non-accrual loan balances and mix of deposits and other funding sources. Changes in Market Interest Rates -------------------------------- Changes in economic conditions and the actions of the Federal Reserve Board to increase or decrease the Fed Funds and Discount rates have a direct impact on the Bank's net interest margin. The prime rate and other market indices generally move in response to Federal Reserve Board actions. During 2004, the prime rate increased 125 basis points to 5.25% at year end. During the first six months of 2005, the prime rate has increased an additional 100 basis points to 6.25%. While short term rates have increased 225 basis points during the past twelve months, long term rates (i.e. the 10 year Treasury) have decreased approximately 60 basis points. Changes in market interest rates and the shape of the yield curve have a complex impact on the Bank's balance sheet and net interest income. Rising short term interest rates have contributed to an increasing yield on our variable rate loans. However, combined with falling longer term rates, borrowers are provided an incentive to refinance their variable rate loans into fixed rate alternatives. As a result of these market forces, rising short term interest rates, combined with a flattening yield curve, have contributed to an acceleration of prepayment speeds within our adjustable rate loan portfolio. There are no assurances that earnings will not be adversely impacted by future actions of the Federal Reserve Board and changes in market interest rates. The full impact of rate changes on the Bank's earnings is not realized for several months, since not all loans or deposits reprice immediately. The majority of SBA loans are tied to the prime rate and reprice on a calendar quarter basis. The Bank also has adjustable rate loans, mainly commercial real estate loans, which are tied to a variety of indices including the prime rate, the Eleventh District Cost of Funds Index (COFI), LIBOR, the six-month constant maturity treasury (CMT) and the five-year CMT. Each of these indices react to changes in market interest rates at different speeds and magnitudes. The Bank also has a fixed rate loan portfolio which generally reduces net interest margin as interest rates rise and benefits interest margin as rates decline. Of the Bank's loan portfolio totaling $1,031.2 million at June 30, 2005, $577.8 million or 56.0% of total loans were adjustable rate loans which had not reached a floor or ceiling rate. Of that total, approximately $322.4 million were prime-based loans, of which $105.8 million reprice when prime changes and $216.6 million reprice on a quarterly basis. Market rates also impact the Bank's ability to attract deposits and grow the loan portfolio. The current relatively low rates offered on deposits makes them less attractive to depositors. The Bank has also experienced an increase in loan payoffs as borrowers have refinanced their existing loans with loans at more attractive rates and terms. The Bank had $65.0 million and $113.2 million in loans paid off during the three and six month periods ended June 30, 2005 compared to $41.4 million and $72.6 million for the same periods one year ago. Interest rates offered on deposits have increased due to an increasing interest rate environment. The Bank has responded to the highly competitive rate environment by increasing rates, especially savings and certificate of deposit rates. The Bank had $103.3 million of Sonoma Investor Reserve accounts (money market rate deposit accounts) at June 30, 2005. The cost of these deposits equaled 1.81% during the second quarter of 2005 and 1.08% for the second quarter of last year. The Bank had $559.3 million in time certificates of deposits at June 30, 2005. These accounts reprice at the time the certificate matures which delays the impact of rising interest rates. The Bank has offered competitive market rates for deposits when compared to other financial institutions in our area. The cost of time deposits equaled 3.04% for the second quarter of 2005 compared to 2.27% in the second quarter of the preceding year. Level of Loans Relative to Deposits ----------------------------------- The Bank's ratio of loans-to-deposits increased to an average of 123.0% in the second quarter of 2005 compared to 115.2% for the same period last year. An increase in the loan-to-deposit ratio generally has a positive impact on net interest margin. Mix of Loans and Earning Assets ------------------------------- Changes in the mix of loans also impact the Bank's interest margin. The largest loan growth occurred in real estate mortgage loans growing to $742.2 million at this quarter end from $663.6 million at December 31, 2004. The yield on this category was 6.66%, which is 9 basis points lower than the yield on the entire loan portfolio for the quarter. The Bank has developed new loan products tied to US Treasury and LIBOR index with other favorable terms to attract new loan volume. Loan volume has increased as a result of these new products and the Bank's competitive rate structure. Construction loans were relatively unchanged at $40.7 million at the end of this quarter compared to $41.1 million at December 31, 2004. Despite experiencing $18.9 million in payoff activity during the first six months of 2005, construction lending activity continues to remain strong. Residential construction lending continues to benefit from competitive and continued low rates on residential mortgages. The Bank's Construction loans yielded 7.43% in the second quarter compared to 7.53% for the second quarter of last year. Construction loans generally have higher yields than other real estate loans. General economic conditions greatly influence the demand for construction loans and there are no guarantees that the current level of construction lending will continue. SBA loans totaling $216.3 million at June 30, 2005, which generally are secured by real estate, are classified as commercial loans. Commercial loans totaled $242.3 million at June 30, 2005 compared to $236.7 million at December 31, 2004. Under the SBA's 504 program 55% of the loan is funded by the Bank compared to 100% of loan amount under the 7(a) program. The 504 loans also carry additional risks since the Bank's loan amount is not guaranteed by the SBA; however, this is mitigated by the lower loan to collateral value ratio of approximately 50%. Under the current federal government SBA 7(a) program the maximum guaranty amount was increased to $1.5 million last year, providing for a $2 million limit on each 7(a) loan. The 7(a) loan program was approved at an authorization level of $16.5 billion last year. This provides for a more stable loan program as it eliminates the appropriation battles that have historically hampered the program resulting in periodic caps and program shut downs. The zero subsidy was achieved by increasing borrower and bank fees. Budget funds are no longer appropriated to fund the program, hence there is a zero subsidy from the government. Should the default rates within the government SBA program increase dramatically, the borrower and bank fees could rise, thereby impacting the profitability of the program for the Bank. Additional government actions may further alter the SBA program, which could have a negative impact on the Bank's profits. Economic conditions and competition have impacted the mix of loans. The increasing interest rate environment has resulted in higher rates on loans. The structure of the variable interest rate loans determines how often and how rapidly interest rates increase on loans. Refinancing activity continues to be strong as borrowers seek loan products which will reduce their interest cost during an increasing rate environment. The Bank offers loan products tied to prime rate, U.S. Treasury rates or LIBOR which may have lower interest rates at the time of funding but reprice at a faster rate than loans tied to COFI. The Bank continues to experience strong competition for loans, which has resulted in lower loan pricing in the market place, which impacts the Bank's offering rates on new loans and negatively impacts the Bank's net interest margin. Non-Accrual Loan Balances ------------------------- Loans which have been placed on non-accrual status also impact the net interest margin. At the time a loan is placed on non-accrual, the unpaid interest is reversed and interest accruals are discontinued until the credit quality of the loan justifies returning it to accrual status. As of June 30, 2005, the Bank had $2,015,000 in non-accrual loans or 0.20% of total loans compared to $311,000 at December 31, 2004. When a non-accrual loan pays off, or is reinstated to accrual status, the interest income is reinstated to income which has a positive effect on loan yields. The current level of non-accrual loans is considered by management to be a low level of non-accrual loans based upon comparisons to our peer group (other banks of comparable asset size). See Allowance for Loan Losses for additional information. Mix of Deposits and Other Funding Sources ----------------------------------------- The mix of funding sources determines the cost of funds for the Bank. Certificates of deposit reprice at the time the certificate matures, which delays the impact to the Bank's cost of funds in a upward interest rate market. Sonoma Investor Reserve accounts are repriced weekly at the discretion of the Bank. The impact of increasing interest rates is more immediate since all balances will earn at the higher rates at the time of a rate change. Competition also is a factor in the repricing of certain deposit products. In an increasing rate environment deposit rates are monitored to be competitive in the market place to retain existing deposits and when liquidity is needed higher rates are offered to attract new deposits to fund growth. The Bank also has a borrowing line with the Federal Home Loan Bank (FHLB) which has been used as a source of funding balance sheet growth and liquidity. The initial borrowing rates are generally below rates offered on certificates of deposits and the Bank has increased the use of this line as a way to reduce our cost of funds. As of June 30, 2005, the Bank increased borrowed funds from the FHLB to $230.4 million as compared to $156.7 million at June 30, 2004, an increase of $73.7 million. Interest expense increased to $6,877,000 in the second quarter of 2005 from $3,475,000 in the second quarter of 2004. A major factor was the increase in funds borrowed from the FHLB to fund loan growth and an increase in interest bearing deposits. Variable rate advances totaled $203.5 million at June 30, 2005 as compared to $135.0 million at June 30, 2004. The cost of FHLB advances increased to 3.09% during the second quarter from 1.24% for the same period last year. The increased costs associated with the FHLB advances is not only the result of an increase of $68.5 million in the amount of prime rate based advances, but also the result of the 225 basis point increase in the prime rate during the last twelve months. As the prime rate increases or decreases, the cost related to these advances will increase or decrease accordingly. In addition, the average cost of interest bearing deposits increased to 2.70% from 1.89% when comparing the second quarter of this year to the second quarter of last year. The following is an analysis of the net interest margin:

The following table sets forth changes in interest income and interest expense for each major category of interest-earning asset and interest- bearing liability, and the amount of change attributable to volume and rate changes for the three and six months ended June 30, 2005 and 2004. Changes not solely attributable to rate or volume have been allocated to rate. For the three months ended June 30, 2005 over June 30, 2004 (dollars in thousands) Volume Yield/Rate Total ------ ---------- ----- Increase (decrease) in interest income: Loans $3,432 $ 928 $4,360 Investment securities and other interest bearing investments 64 10 74 Federal funds sold 44 505 549 ------ ------ ------ Total increase 3,540 1,443 4,983 ------ ------ ------ Increase in interest expense Interest-bearing transaction accounts 85 450 535 Time deposits 881 610 1,491 Other borrowings 279 1,097 1,376 ------ ------ ------ Total increase 1,245 2,157 3,402 ------ ------ ------ Increase (decrease) in net interest income $2,295 ($714) $1,581 ====== ====== ====== For the six months ended June 30, 2005 over June 30, 2004 (dollars in thousands) Volume Yield/Rate Total ------ ---------- ----- Increase (decrease) in interest income: Loans $6,864 $1,403 $8,267 Investment securities and other interest bearing investments 99 32 131 Federal funds sold 85 864 949 ------ ------ ------ Total increase 7,048 2,299 9,347 ------ ------ ------ Increase in interest expense Interest-bearing transaction accounts 153 669 822 Time deposits 952 1,406 2,358 Other borrowings 541 1,820 2,361 ------ ------ ------ Total increase 1,646 3,895 5,541 ------ ------ ------ Increase (decrease) in net interest income $5,402 $(1,596) $3,806 ====== ====== ====== Provision for Loan Losses The provision for loan losses for the three and six months ended June 30, 2005, amounted to $525,000 and $1,050,000 compared to $325,000 and $550,000 for the same time periods last year. The provision was based upon the overall growth in loans and nonperforming loans at the end of the current quarter. For further discussion see Allowance for Loan Losses. Non-Interest Income Other income is derived primarily from service charges, SBA loan sales, SBA loan servicing and sales of other real estate owned. Other income increased to $1,188,000 from $607,000 when comparing the second quarter of 2005 to the same period last year. The majority of the increased results come from increased volume in SBA loan sales during the second quarter as compared to the second quarter of 2004. The following table sets forth non-interest income by category for the periods indicated. (in thousands) Three months ended Six months ended June 30, June 30, 2005 2004 2005 2004 ---- ---- ---- ---- Gains on loan sales $853 $248 $1,365 $700 Service charges on deposits 124 124 252 251 Other Service charges 69 56 125 105 Loan servicing fees 91 90 195 187 Income on insurance policies 24 34 48 68 Gain on OREO sales - - - 183 Other 27 55 46 88 ------ ----- ------ ------ Total Other Income $1,188 $607 $2,031 $1,582 ====== ===== ====== ====== The increase in gains on the sale of the guaranteed portion of SBA loans results from the increase in the volume of loan sales with $8.1 million and $12.5 million sold during the three and six month periods in 2005 compared to $2.2 million and $6.0 million during the same periods in 2004. The Bank continues to retain the majority of the SBA loans it makes, in order to realize the interest yield, rather than selling the guaranteed portion for a one time gain and servicing fees. Management considers the Bank's liquidity needs and anticipates loan and deposit growth as a part of the decision to hold SBA guaranteed loans versus selling them. The average percent gain on sales in the second quarter of 2005 equaled 10.5% compared to 11.3% for the second quarter of 2004. Premium on loan sales are market driven based upon factors such as rate of prepayments of SBA loans experienced throughout the country and there is no guarantee that premiums will continue at the current level. SBA servicing fees are based on loan payments and payoffs received on the sold potion of SBA loans, and therefore, vary from quarter to quarter. The Bank's average SBA loan portfolio serviced was $56.8 million in the second quarter of 2005 compared to $51.2million for the same period last year. The serviced portfolio reflects SBA loan payoffs and volume of new sales during the period. There can be no assurances that the SBA program will continue to generate significant amounts of other non-interest income in the future. Governmental actions may alter the SBA program at any time, which could have a negative impact on the Bank's profits. The Bank did not hold any OREO property during 2005 and therefore there were no OREO sales during the three and six month periods. During the first six months of 2004 the Bank took possession of property as a result of a loan foreclosure. This property was sold at a gain of $183,000 during the first quarter of 2004. Non-Interest Expenses For the second quarter of 2005, non-interest expense totaled $4,996,000, an increase of 33.6% from $3,740,000 for the second quarter last year. The following table outlines the components of non-interest expense for the periods indicated: (In thousands) Three months Ended June 30, Percentage Expense Item 2005 2004 Change ------------ ---- ---- ---------- Salaries & Employee Benefits $2,870 $2,362 21.5% Occupancy 479 337 42.1 Equipment 315 215 46.5 Advertising/Business Development/Donations 249 161 54.7 Outside Customer Services 93 80 16.3 Director & Shareholder expenses 125 105 19.0 Deposit and Other Insurance 132 112 17.9 Postage & courier expenses 101 79 27.8 Professional Fees 201 89 125.8 Stationery & Supplies 89 76 17.1 Telephone expense 60 48 25.0 Loan expenses 67 (5) (1440.0) Other 215 81 165.4 ------ ------ ----- TOTAL $4,996 $3,740 33.6% ====== ====== ===== (In thousands) Six months Ended June 30, Percentage Expense Item 2005 2004 Change ------------ ---- ---- ---------- Salaries & Employee Benefits $5,486 $4,775 14.9% Occupancy 902 643 40.3 Equipment 568 416 36.5 Advertising/Business Development/Donations 440 303 45.2 Outside Customer Services 170 174 (2.3) Director & Shareholder expenses 240 163 47.2 Deposit and Other Insurance 262 224 17.0 Postage & courier expenses 203 160 26.9 Professional Fees 413 194 112.9 Stationery & Supplies 163 144 13.2 Telephone expense 111 89 24.7 Loan expenses 86 49 75.5 Other 339 158 114.6 ------ ------ ----- TOTAL $9,383 $7,492 25.2% ====== ====== ===== Most of the Bank's expense categories increased as a result of Bank expansion. The San Rafael branch opened in the third quarter of 2004, the Walnut Creek branch opened during the first quarter of 2005, the Petaluma branch opened in the second quarter of 2005 and the Concord branch opened in July 2005. The Bank also relocated its lending functions and certain administrative departments to a larger location in Santa Rosa during the second quarter of 2004. Additionally, premises for the operations center were expanded in mid 2004. In addition to increases in the categories mentioned below, increases in postage & courier, stationery & supplies and telephone expenses grew due to the Bank's expansion. The increase in salaries and employee benefits results primarily from an increase in staffing levels, with the Bank's full time equivalent employees (FTE) increasing to 167 at June 30, 2005 compared to 147 at June 30, 2004. The increase in staff is primarily caused by new staff hired for the new branches. Personnel costs are also impacted by annual salary increases, incentives based upon production goals and changes in insurance and benefit costs. Occupancy expenses increased due to the expansion discussed above. Occupancy expenses will continue to increase as and if the Bank continues to expand. Growth in equipment costs was also caused by Bank expansion. The Bank continues to upgrade computer equipment, which will result in an increase in these costs. In 2004, the Bank purchased equipment for imaging of bank documents and customer checks which has resulted in operational efficiencies and better service for our customers. Advertising, business development and donations increased due to expansion to new locations which required additional publicity. Regulatory assessments and FDIC insurance costs grew due to the increase in deposits. There is no assurance that regulatory assessments will continue at the current low level. The cost of other insurance was higher due to expansion, increases in coverage and insurance rates. Professional fees significantly increased due to legal costs, consulting costs for our internal controls review, and accounting costs associated with SEC reporting and compliance with new regulations, such as the Sarbanes Oxley Act. Audit or review services are contracted by the Audit Committee and are performed on a varying schedule with most of the audit fees occurring during the first quarter. Professional fees were incurred as part of the preparation and filing of the application with NASDAQ for the listing of the Company's common stock on the NASDAQ National Market. It is expected that the cost of professional services will continue to increase with the expansion of the Bank. Outside customer services vary depending upon the costs incurred by analysis customers. The Bank pays for certain direct costs (i.e.: payroll services, escrow fees, etc.), which are included in non-interest expense. These costs are based upon the depositor using the analysis system. The analysis customer receives earnings credits based upon their deposit account balances, which can be used to offset these charges. The customer is charged a bank service fee if their earnings credits do not cover the costs. With the lower interest rate environment, the earnings credit rate is low and as a result our customers have the option of paying for covered services, or increasing their average balances to increase the earnings on their accounts. These expenses vary depending upon the cost of services incurred by the analysis customers. Included in shareholder and director expenses are directors' fees for attending Board, Loan Committee, ALCO, Executive Committee and Audit Committee meetings. The cost of the Corporation's annual report, transfer agent fees and other costs of communicating with shareholders are also included in this expense category. Loan expenses vary depending upon the level of problem loans and the use of contracted loan services to assist staff during periods of high loan production. The Bank generally charges for direct costs associated with loan originations. Loan expenses totaled $67,000 for the second quarter of 2005 as compared to ($5,000) for the second quarter of 2004, of which $21,000 relates to reimbursement of previously paid expenses. During the second quarter of 2005, the Bank incurred higher loan related expenses as a result of increased loan production and an increase of $1,723,000 in the level of non-accrual loans. Additionally, during the second quarter of 2005, the Bank recorded $19,000 related to the allowance for unfunded loan commitments, where there was no similar accrual during the second quarter of 2004. Other expenses increased during the second quarter of 2005 to $215,000 compared to $81,000 one year ago. The increase in other expenses during the second quarter of 2005 is primarily due to the one time application fee of $95,000 associated with the listing of the Company's shares on the NASDAQ National Market. Costs related to publications and subscriptions, business travel costs and operational losses are also included in this category. Income Taxes The effective tax rate was 41.3% for the second quarter of 2005, compared to 41.5% for the second quarter of last year. The effective tax rate is affected by several factors which include apportionment ratios between states, the enterprise zone deduction and applicable tax rates. Liquidity and Investment Portfolio Liquidity is a bank's ability to meet possible deposit withdrawals, to meet loan commitments and increased loan demand, and to take advantage of other investment opportunities as they arise. The Bank's liquidity practices are defined in both the Asset and Liability Policy and the Investment Policy. These policies define acceptable liquidity measures in terms of ratios to total assets, deposits, liabilities and capital. Cash and due from banks, federal funds sold and interest bearing deposits totaled $135.8 million or 11.4% of total assets at June 30, 2005, compared to $116.5 million or 10.8% of total assets at December 31, 2004. The Bank sold $8.1 million in SBA loans during the second quarter of 2005 which increased the Bank's liquidity. Bank deposits increased 6.2% to $852.3 million during the second quarter of 2005. The Bank has offered, and continues to offer, special rates on time deposit promotions to attract new deposits to contribute to projected loan growth. Management used borrowing from the FHLB to fund loan growth at favorable rates as compared with current rates offered on time deposits. The Bank considers the unsold guaranteed portion of 7(a) SBA loans as a secondary source of liquidity. There is an established market for these loans and a sale transaction can typically be completed within 30 days. As of June 30, 2005, the Bank held $145.7 million in SBA guaranteed loans which could be sold for additional liquidity. At June 30, 2005, the Bank had unused federal funds lines of credit totaling $26.0 million. The Bank also has a credit line with the Federal Home Loan Bank which is based upon the value of collateral (investments and loans). At June 30, 2005, the Bank had collateral pledged which would allow the Bank to borrow up to $295.3 million. The FHLB will permit the Bank to borrow up to 25% of the Bank's total assets provided that adequate collateral has been pledged to the FHLB. At June 30, 2005, the Bank had borrowed $230.4 million, which left $64.9 million available to borrow. Management believes this amount of secondary liquidity is adequate to meet any cash demands that may arise. At present, the Corporation's primary sources of liquidity are from interest on deposits, exercise of stock options and dividends from the Bank. The Bank's ability to pay dividends to the Corporation is subject to the restrictions of the national banking laws and, under certain circumstances, the approval of the Comptroller of the Currency. At June 30, 2005, the Corporation had non-interest and interest bearing cash balances of $10.8 million, which management believes is adequate to meet the Corporation's operational expenses. The Corporation and the Bank do not engage in hedging transactions (interest rate futures, caps, swap agreements, etc.). Deposits During the second quarter of 2005, deposits increased to $852.3 million compared to $791.0 million at the end of the year. The following table outlines the components of deposits on the dates indicated: (in thousands) June 30, 2005 December 31, 2004 ------------- ----------------- Non-interest bearing demand deposits $ 81,315 $ 72,156 Interest bearing transaction accounts 211,678 210,959 Time certificates, $100,000 and over 260,645 228,838 Other time certificates 298,625 279,072 -------- -------- $852,263 $791,025 ======== ======== Demand deposits and interest bearing transaction account balances vary depending upon the activity of customers. Approximately 47% of these accounts are business accounts which tend to be more volatile than consumer deposits. Money market accounts, which are included in interest bearing transaction accounts, are a limited transaction account with a discretionary rate set by management. The Bank has tried to remain competitive without offering the highest rates, which has made retention of these accounts more challenging as market rates continue to increase. In September 2004, the Bank offered a new saving product at a more competitive rate and was successful in attracting new money into that account. Many depositors continue to retain funds in transaction accounts rather that locking in time certificate rates even though rates on time certificates have improved due to the increasing interest rate market. These funds are also more volatile and fluctuate during various business cycles. During 2005, deposit totals increased $61.2 million to $852.3 million, an increase of 8% over $791.0 million at December 31, 2004. Included in this deposit growth is $29.9 million related to the opening of the San Rafael branch in the third quarter of 2004, the Walnut Creek branch in the first quarter of 2005 and the West Petaluma branch opening in the second quarter of 2005. Certificates of deposit totaled $559.3 million at June 30, 2005, an increase of 10.1% over $507.9 million at December 31, 2004. The Bank has offered time deposit promotions during this quarter. Competition has increased with a new community bank opening during the first quarter of 2005 and other competitors offering similar rates and products, which has made it more challenging to attract new deposits. The interest rate environment and the increased competition have made it more difficult to attract new deposits at favorable rates. The Bank continually monitors competitors' rates, strives to be competitive in pricing deposits, and has offered attractive time deposit rates to raise funds during periods of high loan growth. Loans Loans, net of discounts and reserves, equaled $1,020.7 million at June 30, 2005 compared to $938.1 million at December 31, 2004, increasing 8.8% over year end and 23.8% over the June 30, 2004 balance of $824.4 million. While the Bank continues to benefit from strong loan demand, during the second quarter of 2005, the Bank experienced $113.2 million in loan payoffs. The following is an analysis of the loan portfolio. Type of Loan June 30, December 31, (in thousands) 2005 2004 -------------- ---------- ----------- Real estate - mortgage $ 742,190 $663,620 Real estate - construction 40,730 41,145 Commercial loans 242,288 236,718 Consumer installment loans 6,015 6,193 ---------- -------- 1,031,223 947,676 Deferred loan fees and discount (1,024) (853) Allowance for loan losses (9,549) (8,719) ---------- -------- TOTAL $1,020,650 $938,104 ========== ======== The SBA loan program continues to be a popular program; however, competition remains very strong in our market areas. At June 30, 2005, total SBA (7a) guaranteed loans equaled $216.3 million, net of $58.7 million in SBA loans sold and being serviced by the Bank. The majority of the Bank's SBA loans are secured by real estate; however, they are reported as commercial loans. SBA loans have the same underwriting requirements as the Bank's other loans, except they are sometimes for longer terms (7 to 25 years) and have higher loan-to-value ratios than the Bank typically accepts. The federal government SBA 7(a) program is now operating at a zero subsidy thereby removing the budget considerations at the government level. With a $16.5 billion dollar government authorization level, the program will not be subject to any limitations on funding. Major changes to the default rates and subsequent subsidy calculation could affect the Bank's profitability and future SBA loan growth. The guaranteed portion of SBA loans which could be sold in the secondary market was $145.7 million at June 30, 2005 compared to $139.3 million at June 30, 2004. The Bank continues to emphasize commercial and real estate lending. At June 30, 2005, 23.5% of the loans held for investment were commercial loans and 75.9% were commercial and residential real estate and construction loans, compared to 25.0% and 74.4% respectively at December 31, 2004. The Bank has continued to grow its commercial and commercial real estate portfolio through its reputation as an experienced business and real estate lender which facilitates the successful negotiation of complex commercial loans. The Bank maintains high credit qualifications with most real estate loans having 60-75% loan to value ratios. Management is aware of the risk factors in making commercial and real estate loans and is continually monitoring the local market place. At June 30, 2005, 97.6%, or $1,006.2 million of the Bank's loans, including real estate and a majority of the Bank's SBA loans, were secured by real estate as the principal source of collateral. A decline in real estate values and/or demand, a worsening of economic conditions or a natural disaster could potentially have an adverse impact on the value of collateral, on the loan portfolio, and on the financial condition of the Bank. Construction loans totaled $40.7 million at June 30, 2005, compared to $41.1 million at December 31, 2004. Despite $18.9 million in payoff activity experienced during 2005, construction loan activity remains strong. Construction loans are made to owner/occupied and owner/users of the properties and occasionally to developers with a successful history of developing projects in the Bank's market area. The construction lending business is subject to, among other things, the volatility of interest rates, real estate prices in the area and the market availability of conventional real estate financing to repay such construction loans. A decline in real estate values and/or demand could potentially have an adverse impact on this portion of the loan portfolio and on the earnings and financial condition of the Bank. The Bank offers residential equity lines of credit on a limited basis. The Bank has a small portfolio of consumer loans which equaled 0.6% of the total loan portfolio at June 30, 2005 and 0.8% at December 31, 2004. Allowance for Loan Losses The allowance for loan losses equaled $9,549,000 at June 30, 2005, compared to $8,719,000 at December 31, 2004. At June 30, 2005, the allowance for loan losses equaled 1.08% of loans (net of the guaranteed portion of SBA loans). The allowance for loan losses is reviewed on a monthly basis, based upon an allocation for each loan category, plus an allocation for any outstanding loans which have been classified by regulators or internally for the "Watch List". Each loan that has been classified is individually analyzed for the risk involved with a specific reserve allocation assigned according to the risk assessment. At June 30, 2005, there were four borrowers on non-accrual totaling $2,015,000 with $2,007,000 of that amount collateralized by real estate and $421,000 of it also guaranteed by the SBA. There were no loans past due 90 days or more. Loans past due 30 to 89 days totaled $3,651,000, with $3,582,000 of that amount collateralized by real estate. At December 31, 2004, the Bank had $311,000 in non-accrual loans and $777,000 in loans past due 90 or more days and still accruing interest. Past due 30 to 89 days totaled $5,368,000 at December 31, 2004. During the second quarter of 2005, there were no loans charged off and there were no recoveries on loans previously charged off. The Bank continues to have a low charge off experience compared to industry standards but there can be no assurances that this will continue or that the Bank will not experience loan losses. The following is an analysis of the activity in the allowance for loan losses during the quarter: Three months Six months (In thousands) ended ended June 30, 2005 June 30, 2005 ------------- ------------- Balance - Beginning of period $9,024 $8,719 Reclassification to other liabilities - (220) Provision for loan losses 525 1,050 Charge offs - - Recoveries - - ------ ------ Balance - End of period $9,549 $9,549 ====== ====== Capital Resources Pursuant to regulations under the FDIC Improvement Act of 1991 (FDICIA), five capital levels were prescribed as applicable for banks, ranging from well-capitalized to critically under-capitalized. At June 30, 2005, the Bank was considered "well capitalized." The capital ratios for the Bank and the Corporation are presented in the following table. Sonoma National Northern Empire Bank Bancshares ---------------------- ---------------------- June 30, December 31, June 30, December 31, 2005 2004 2005 2004 ---- ---- ---- ---- Tier 1 leverage ratio 7.5% 7.6% 8.6% 8.6% Tier 1 risk-based capital ratio 9.8% 9.7% 11.0% 11.1% Total risk based capital ratio 10.9% 10.8% 12.1% 12.1% The Corporation declared a 5% stock dividend on March 22, 2005 with a record date of May 2, 2005. ITEM 3. Quantitative and Qualitative Disclosures about Market Risk The Bank's financial performance is impacted by, among other factors, interest rate risk and credit risk. The Bank utilizes no derivatives to mitigate its credit risk, relying instead on loan review and adequate loan loss reserves. See Allowance for Loan Losses. Interest rate risk is the risk of loss in value due to changes in interest rates. Since virtually all of the Corporation's interest rate risk exposure lies at the Bank level, this risk is addressed by the Bank's Asset Liability Committee ("ALCO"), which includes members of the Board of Directors and senior officers of the Bank. ALCO attempts to manage the various components of the Corporation's balance sheet to minimize the impact of sudden and sustained changes in interest rates on portfolio values and net interest income. A fundamental objective is to manage its assets and liabilities to maximize the economic value of the Bank while maintaining adequate liquidity and minimizing exposure to interest rate risk. Management believes an acceptable degree of exposure to interest rate risk results from the management of assets and liabilities through maturity, pricing and mix with the goal of limiting its exposure to interest rate risk. The Bank's profitability is dependent to a large extent upon its net interest income. The Bank is subject to interest rate risk to the degree that its interest-earning assets reprice differently than its interest-bearing liabilities. Interest rate sensitivity analysis is used to measure the Bank's interest rate risk by computing estimated changes in the net present value (NPV) of its cash flows from assets, liabilities and off-balance sheet items in the event of a range of assumed changes in market interest rates. NPV represents the market value of portfolio equity and is equal to the market value of assets minus the market value of liabilities, with adjustments made for off-balance sheet items. This analysis assesses the risk of loss in market rate sensitive instruments in the event of sudden and sustained increases and decreases in market interest rates of 100 and 200 basis points. The Bank has no trading securities. Management expects that, in a declining rate environment, the Bank's net interest margin would tend to decline, and, in an increasing rate environment, the Bank's net interest margin would tend to increase. On a monthly basis, management prepares an analysis of interest rate risk exposure. Such analysis calculates the change in net interest income given a change in general interest rates of 100 and 200 basis points up or down. All changes are measured in dollars and are compared to projected net interest income and the value of the Bank's equity is calculated by discounting cash flows associated with the Bank's assets and liabilities. The following table summarizes the simulated change in Net Interest Income based on the next twelve months given a change in general interest rates of 100 and 200 basis points up or down. Change in Estimated Estimated Change in Interest Rate Net Interest Income Net Interest Income (basis points) (in thousands) (in thousands) +200 $42,008 $ (48) +100 42,305 249 Base Scenario 42,056 - -100 41,542 (514) -200 41,317 (739) The model utilized by management to create the report presented above makes numerous assumptions, including relative levels of market interest rates, loan prepayments and deposit runoff and should not be relied upon as indicative of actual future results. Computations do not contemplate any actions that ALCO could undertake in response to changes in interest rates. Actual results could differ significantly from those estimates, which would result in significant differences in the calculated projected change. Interest rate risk management is a function of the repricing characteristics of the portfolio of assets and liabilities. Interest rate risk management focuses on the maturity structure of assets and liabilities and their repricing characteristics during periods of changes in market interest rates. Effective interest rate risk management seeks to ensure that both assets and liabilities respond to changes in interest rates within an acceptable time frame, thereby minimizing the effect of interest rate movements on net interest income. Interest rate sensitivity is measured as the difference between the volume of assets and liabilities in the current portfolio that is subject to repricing at various time horizons. The differences are known as interest rate sensitivity gaps. The following schedule represents interest rate sensitivity profile as of June 30, 2005 of assets, liabilities and shareholders' equity classified by earliest possible repricing opportunity or maturity date.

ITEM 4. Controls and Procedures As of the end of the period covered by this report, the Corporation carried out an evaluation, under the supervision and with the participation of the Corporation's management, including its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Corporation's disclosure controls and procedures, as defined in Securities Exchange Act Rule 13a-15(e). Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Corporation's disclosure controls and procedures are effective in a timely manner to alert them to material information relating to the Corporation which is required to be included in the Corporation's periodic Securities and Exchange Commission filings. No change in internal control over financial reporting, as defined in Securities and Exchange Act Rule 13a-15(f), occurred during the fiscal quarter ended June 30, 2005 that has materially affected or is reasonably likely to materially affect the Corporation's internal control over financial reporting. PART II - OTHER INFORMATION Item 1. Legal Proceedings - None other than in the ordinary course of business. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds - None Item 3. Defaults Upon Senior Securities - None Item 4. Submission of Matters to a Vote of Security Holders The Annual Meeting of Shareholders of the Corporation was held on May 17, 2005. Under Proposal 1, Election of Directors, the following candidates received the votes indicated: For Withheld --------- -------- Clement C. Carinalli 8,675,394 22,090 Patrick R. Gallaher 8,660,999 36,485 William E. Geary 8,670,954 26,530 Dennis R. Hunter 8,675,394 22,090 James B. Keegan, Jr 8,672,400 25,084 All candidates were re-elected, constituting the full board of directors of the Corporation. Under Proposal 2, Approval of the December 28, 2004 grant of a stock option to each director of the Corporation, the grant of a stock option to each director was approved as follows: Abstained/ For Against Broker Non-Votes --------- --------- ---------------- Clement C. Carinalli 4,724,553 435,588 3,537,343 Patrick R. Gallaher 4,733,586 444,100 3,519,798 William E. Geary 4,535,471 436,588 3,725,425 Dennis R. Hunter 4,603,053 436,588 3,657,843 James B. Keegan, Jr 4,716,962 436,588 3,543,934 Robert V. Pauley (former director, deceased on February 18, 2005) 4,512,821 529,174 3,655,489 There were no other matters voted on at the meeting. Item 5. Other Information - None Item 6. Exhibits Exhibits: (3) (a) Restated Articles of Incorporation, as amended through December 1, 2003 (filed as Exhibit (3)(d) to the Corporation's Annual Report on Form 10-K for the Fiscal Year Ended December 31, 2003, file number 2-9116, and incorporated herein by this reference). (b) Secretary's certificate of Amendment to the Bylaws of the Corporation and revised Bylaws (filed as Exhibit (3)(b) to the Corporation's Annual Report on Form 10-K for the Fiscal Year Ended December 31, 2004 and incorporated herein by this reference). (31) Rule 13a-14(a)/15d-14(a) Certifications (32) Section 1350 Certification 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. NORTHERN EMPIRE BANCSHARES Date: August 08, 2005 /s/ Deborah A. Meekins /s/ Jame M. Baker ---------------------- ----------------- Deborah A. Meekins Jane M. Baker President and Chief Executive Officer Chief Financial Officer

NORTHERN EMPIRE BANCSHARES 10-Q