UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2012

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

For the transition period from to

COMMISSION FILE NUMBER No: 001-35026

LOGO

(Exact Name of Registrant as Specified in its Charter)


Delaware		95-3673456

(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

1021 Anacapa St. Santa Barbara, California		93101

(Address of principal executive offices)		(Zip Code)

(805) 564-6405

(Registrant’s telephone number, including area code)

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 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 x No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer ¨ Accelerated filer x Non-accelerated filer ¨ Smaller reporting company ¨

(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x

Number of shares of common stock of the registrant outstanding as of October 31, 2012: 32,945,391

TABLE OF CONTENTS


			Page

PART I – FINANCIAL INFORMATION

	Forward-Looking Statements		3

	Item 1.	Financial Statements:	6

		Consolidated Balance Sheets	6

		Consolidated Statements of Income	7

		Consolidated Statements of Comprehensive Income	8

		Consolidated Statements of Changes in Shareholders’ Equity	9

		Consolidated Statements of Cash Flows	10

		Notes to Consolidated Financial Statements	12

	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	71

	Item 3.	Quantitative and Qualitative Disclosures About Market Risk	96

	Item 4.	Controls and Procedures	99

Glossary			100

PART II – OTHER INFORMATION			103

	Item 1.	Legal Proceedings	103

	Item 1A.	Risk Factors	103

	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	103

	Item 3.	Defaults on Senior Securities	103

	Item 4.	Mine Safety Disclosures	103

	Item 5.	Other Information	103

	Item 6.	Exhibits	104

SIGNATURES			105

PART I - FINANCIAL INFORMATION

Forward-Looking Statements

This Quarterly Report on Form 10-Q (“Form 10-Q”) contains “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. Pacific Capital Bancorp (the “Company” or “PCBC”) intends such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements in these provisions. All statements, other than statements of historical fact, are “forward-looking statements” for purposes of federal and state securities laws, including, but not limited to, statements about anticipated future operating and financial performance, financial position and liquidity, business prospects, strategic alternatives, business strategies, regulatory and competitive outlook, investment and expenditure plans, capital and financing needs and availability, acquisition and divestiture opportunities, plans and objectives of management for future operations, consummation of the transaction with UnionBanCal Corporation (“UNBC”) and other similar forecasts and statements of expectation and statements of assumptions underlying any of the foregoing. Words such as “will likely result,” “aims,” “anticipates,” “believes,” “could,” “estimates,” “expects,” “hopes,” “intends,” “may,” “plans,” “projects,” “seeks,” “should,” “will,” and variations of these words and similar expressions are intended to identify these forward-looking statements.

Forward-looking statements are based on the Company’s current expectations and assumptions regarding its business, the regulatory environment, the economy and other future conditions. Because forward-looking statements relate to the future, they are subject to inherent uncertainties, risks and changes in circumstances that are difficult to predict. The Company’s actual results may differ materially from those contemplated by the forward-looking statements. The Company cautions the reader of these statements therefore against relying on any of these forward-looking statements. They are neither statements of historical fact nor guarantees or assurances of future performance. Important factors that could cause actual results to differ materially from those in the forward-looking statements include, but are not limited to, the following:

Inability to continuously satisfy the requirements of the Operating Agreement dated September 2, 2010, by and between Santa Barbara Bank & Trust, N.A. (“the Bank”) and the Office of the Comptroller of the Currency (“OCC”);

Inability to close the proposed merger with UNBC when expected or at all because required regulatory or other approvals and other conditions to closing are not received or satisfied on a timely basis or at all;

Reputational risks and the reaction of the Company’s customers and employees to the proposed merger;

Diversion of the Company’s resources and Management’s time and focus on merger-related issues;

Inability to generate assets on acceptable terms or at all;

Management’s ability to effectively execute the Company’s business plan;

Inability to raise additional capital, if and when necessary, on acceptable terms or at all;

Inability to receive dividends from the Bank;

Costs and effects of legal and regulatory developments, including the resolution of legal proceedings or regulatory or other governmental inquiries, and the results of regulatory examinations or reviews;

Changes in capital classification;

The impact of current economic conditions and the Company’s results of operations on its ability to borrow additional funds to meet its liquidity needs;

Local, regional, national and international economic conditions and events and the impact they may have on the Company and its clients;

Changes in the economy affecting real estate values;

Inability to attract and retain deposits;

Changes in the level of non-performing assets and charge-offs;

Changes in estimates of future reserve requirements based upon the periodic review thereof under relevant regulatory and accounting requirements;

Changes in the financial performance and/or condition of the Bank’s borrowers;

Effect of additional provision for loan losses;

Long term negative trends in the Company’s market capitalization;

Effects of any changes in trade and monetary and fiscal policies and laws, including the interest rate policies of the Board of Governors of the Federal Reserve System;

Inflation, interest rate, cost of funds, securities market and monetary fluctuations;

Political instability;

Acts of war or terrorism, natural disasters such as earthquakes or fires, or the effects of pandemic flu;

The timely development and acceptance of new products and services and perceived overall value of these products and services by users;

Changes in consumer spending, borrowings and savings habits;

Technological changes, including the implementation of new systems;

Changes in the Company’s organization, management, compensation and benefit plans;

Competitive pressures from other financial institutions;

Continued consolidation in the financial services industry;

Inability to maintain or increase market share and control expenses;

Impact of reputational risk on such matters as business generation and retention, funding and liquidity;

Rating agency downgrades;

Continued volatility in the credit and equity markets and its effect on the general economy;

Effect of changes in laws and regulations (including the implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010) and other changes in laws concerning banking, taxes and securities with which the Company and its subsidiaries must comply;

Effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board, the Financial Accounting Standards Board (“FASB”) and other accounting standard setters;

Other factors that are described under the heading “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 (the “2011 Form 10-K”); and

The Company’s success at managing the risks involved in the foregoing items.

Forward-looking statements speak only as of the date they are made, and the Company does not undertake to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made, whether as a result of new information, future developments or otherwise, except as may be required by law.

Definition of Terms

Specific accounting and banking industry terms and acronyms used throughout this document are defined in the glossary on pages 100 through 102.

ITEM 1.

FINANCIAL STATEMENTS

Pacific Capital Bancorp and Subsidiaries

CONSOLIDATED BALANCE SHEETS


(dollars and shares in thousands, except per share amounts) (unaudited)	September 30, 2012			December 31, 2011
ASSETS
Cash and due from banks	$	46,512		$	49,324
Interest bearing demand deposits in other financial institutions		520,272			173,408

Cash and cash equivalents		566,784			222,732
Investment securities available for sale		1,244,120			1,503,425
Loans held for sale		18,071			3,072
Loans held for investment		3,743,898			3,660,961
Allowance for loan and lease losses		(7,168	)		(5,528	)

Net loans held for investment		3,736,730			3,655,433
Premises and equipment, net		82,119			75,749
FHLB stock and other investments		68,861			76,356
Goodwill and other intangible assets		84,106			89,255
Other assets		190,494			224,000

TOTAL ASSETS	$	5,991,285		$	5,850,022


LIABILITIES
Deposits
Noninterest bearing	$	1,157,173		$	1,175,532
Interest bearing		3,500,608			3,441,508

Total deposits		4,657,781			4,617,040
Securities sold under agreements to repurchase		313,434			315,919
Other borrowings		72,766			66,524
Other liabilities		91,457			88,569

TOTAL LIABILITIES		5,135,438			5,088,052
SHAREHOLDERS’ EQUITY
Common stock ($0.001 par value; 50,000 authorized; 32,922 and 32,905 shares issued and outstanding at September 30, 2012, and December 31, 2011, respectively)		33			33
Paid in capital		652,697			651,066
Retained earnings		170,211			96,266
Accumulated other comprehensive income		32,906			14,605

TOTAL SHAREHOLDERS’ EQUITY		855,847			761,970

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY	$	5,991,285		$	5,850,022

The accompanying notes are an integral part of these Consolidated Financial Statements.

Pacific Capital Bancorp and Subsidiaries

CONSOLIDATED STATEMENTS OF INCOME


(dollars and shares in thousands, except per share amounts)	Three Months Ended September 30,				Nine Months Ended September 30,
(unaudited)	*2012*		*2011*		*2012*		*2011*
Interest income
Loans	$	62,517	$	58,271	$	182,618	$	182,435
Investment securities		6,791		7,229		21,677		20,337
Other		639		548		1,875		1,711

TOTAL INTEREST INCOME		69,947		66,048		206,170		204,483
Interest expense
Deposits		5,422		6,149		16,168		19,645
Securities sold under agreements to repurchase		2,478		2,502		7,399		7,088
Other borrowings		849		1,549		2,521		7,427

TOTAL INTEREST EXPENSE		8,749		10,200		26,088		34,160

NET INTEREST INCOME		61,198		55,848		180,082		170,323
Provision for loan losses		860		787		2,012		4,253

NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES		60,338		55,061		178,070		166,070
Noninterest income
Service charges and fees		5,284		5,879		16,372		17,509
Trust and investment advisory fees		5,390		5,266		16,359		15,920
Gain/(loss) on securities, net		995		(35)		1,144		(251)
Other		8,397		1,883		15,728		5,196

TOTAL NONINTEREST INCOME		20,066		12,993		49,603		38,374
Noninterest expense
Salaries and employee benefits		22,139		25,867		71,734		71,860
Net occupancy expense		5,792		6,042		17,782		17,396
Other		19,134		16,187		62,944		57,290

TOTAL NONINTEREST EXPENSE		47,065		48,096		152,460		146,546

INCOME BEFORE INCOME TAX EXPENSE/(BENEFIT)		33,339		19,958		75,213		57,898
Income tax expense/(benefit)		135		(515)		1,268		(309)

NET INCOME	$	33,204	$	20,473	$	73,945	$	58,207


Earnings per share:
Basic	$	1.01	$	0.62	$	2.25	$	1.77
Diluted	$	1.01	$	0.62	$	2.24	$	1.77
Weighted average number of common shares outstanding:
Basic		32,921		32,905		32,912		32,904
Diluted		32,982		32,958		32,967		32,928

The accompanying notes are an integral part of these Consolidated Financial Statements.

Pacific Capital Bancorp and Subsidiaries

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME


(dollars in thousands)	Three Months Ended September 30,					*Nine Months Ended* *September 30,*
(unaudited)	*2012*			*2011*		*2012*			*2011*

NET INCOME	$	33,204		$	20,473	$	73,945		$	58,207
Unrealized gain on investment securities - AFS		7,866			19,481		19,445			43,266
Realized (gain) / loss on sale of investment securities - AFS included in net income		(995	)		35		(1,144	)		251

Total other comprehensive income		6,871			19,516		18,301			43,517

TOTAL COMPREHENSIVE INCOME	$	40,075		$	39,989	$	92,246		$	101,724

The accompanying notes are an integral part of these Consolidated Financial Statements.

Pacific Capital Bancorp and Subsidiaries

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY


	*Common Stock*						Accumulated Other					*Total*
(dollars and shares in thousands) (unaudited)	*Shares*		*Amount*		Paid in Capital		Comprehensive (Loss)/Income			Retained Earnings		Shareholders’ Equity
Balance, December 31, 2010		32,901	$	33	$	650,010	$	(33,104	)	$	25,744	$	642,683
Net income		—		—		—		—			58,207		58,207
Unrealized gain on AFS securities		—		—		—		43,266			—		43,266
Net realized loss on sales and calls of AFS securities included in earnings		—		—		—		251			—		251
Stock option compensation		—		—		97		—			—		97
Restricted stock activity		4		—		475		—			—		475

Balance, September 30, 2011		32,905	$	33	$	650,582	$	10,413		$	83,951	$	744,979


Balance, December 31, 2011		32,905	$	33	$	651,066	$	14,605		$	96,266	$	761,970
Net income		—		—		—		—			73,945		73,945
Unrealized gain on AFS securities		—		—		—		19,445			—		19,445
Net realized gains on sales and calls of AFS securities included in earnings		—		—		—		(1,144	)		—		(1,144	)
Stock option compensation		—		—		271		—			—		271
Restricted stock activity		17		—		1,360		—			—		1,360

Balance, September 30, 2012		32,922	$	33	$	652,697	$	32,906		$	170,211	$	855,847

The accompanying notes are an integral part of these Consolidated Financial Statements.

Pacific Capital Bancorp and Subsidiaries

CONSOLIDATED STATEMENTS OF CASH FLOWS


(dollars in thousands)	*Nine Months Ended* *September 30,*
(unaudited)	*2012*		*2011*
OPERATING ACTIVITIES:
Net income	$	73,945	$	58,207
Adjustments to reconcile net income to net cash (used in)/provided by operating activities:
Provision for loan losses		2,012		4,253
Reserve for off-balance sheet commitments, net		(3,253)		64
Depreciation, amortization and accretion		6,061		8,170
Operating lease impairment		1,184		—
Accretion of PCI Term Pools		(128,319)		(149,388)
Stock-based compensation		1,667		580
Net amortization of discounts and premiums for investment securities - AFS		2,558		4,403
Gains on sale of assets		(13,992)		(5,687)
Loans originated for sale, net of sales and principal collections		(9,989)		17,442
Collection of taxes receivable		3,579		49,594
Changes in:
Other assets		5,145		220
Other liabilities		12,041		(1,832)

NET CASH USED IN OPERATING ACTIVITIES		(47,361)		(13,974)
INVESTING ACTIVITIES:
Proceeds from sales of loans held for investment		3,850		3,298
Loans originated for investment, net of principal collections		241,906		459,149
Purchase of loans held for investment		(227,153)		(224,780)
Proceeds from sale of investment securities - AFS		26,919		10,709
Principal pay downs, calls and maturities of investment securities - AFS		249,273		282,923
Purchase of investment securities - AFS		—		(423,915)
Proceeds from sale of low income housing tax credit partnerships, net		3,782		11,155
Purchase of premises and equipment, net		(14,508)		(10,154)
Purchase of Federal Reserve Bank stock		(46)		(576)
Proceeds from redemption of FHLB stock		7,532		7,889
Proceeds from sale of OREO, net		56,123		39,367

NET CASH PROVIDED BY INVESTING ACTIVITIES		347,678		155,065

(continued on next page)

Pacific Capital Bancorp and Subsidiaries

CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)


(dollars in thousands)	*Nine Months Ended* *September 30,*
(unaudited)	*2012*		*2011*
FINANCING ACTIVITIES:
Increase/(decrease) in deposits, net		43,771		(310,844)
Decrease in short term borrowings, net		—		(1,668)
Repayment of long term debt and other borrowings		—		(18,789)
Other, net		(36)		(8)

NET CASH PROVIDED BY/(USED IN) FINANCING ACTIVITIES		43,735		(331,309)


INCREASE/(DECREASE) IN CASH AND CASH EQUIVALENTS		344,052		(190,218)
CASH AND CASH EQUIVALENTS AT
BEGINNING OF PERIOD		222,732		495,864
CASH AND CASH EQUIVALENTS AT

END OF PERIOD	$	566,784	$	305,646


SUPPLEMENTAL DISCLOSURE OF CASH FLOWS INFORMATION:
Cash paid during the period for:
Interest	$	26,513	$	34,362
Income taxes		3,025		4,278
Non-cash investing activity:
Net transfers from loans held for investment to loans held for sale		2,649		3,838
Transfers to OREO		26,869		46,770

The accompanying notes are an integral part of these Consolidated Financial Statements.

Pacific Capital Bancorp and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1.

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Nature of Operations

Pacific Capital Bancorp is a bank holding company organized under the laws of the state of Delaware. The Company provides a full range of commercial and consumer banking services to households, professionals, and businesses through its wholly-owned subsidiary Santa Barbara Bank & Trust, National Association (“SBB&T”). These banking services include depository, lending and wealth management services. The Bank’s lending products include commercial and industrial (“commercial”), consumer, commercial and residential real estate loans and Small Business Administration (“SBA”) loans. Depository services include checking, interest bearing checking (“NOW”), money market demand accounts (“MMDA”), savings, and certificates of deposit (“CD”) accounts, as well as safe deposit boxes, travelers’ checks, money orders, foreign exchange services, and cashier’s checks. The Bank also offers a wide range of wealth management services through a full service trust operation and two registered investment advisors (“RIA”) that are wholly-owned subsidiaries, Morton Capital Management (“MCM”) and R.E. Wacker Associates (“REWA”). The Bank conducts its banking operations in the counties of Santa Barbara, Ventura, Los Angeles, Monterey, San Luis Obispo, Santa Clara, Santa Cruz, and San Benito.

Basis of Presentation

The accompanying Consolidated Financial Statements of PCBC are unaudited and, in the opinion of Management, include all adjustments necessary for a fair statement of the Company’s financial position and results of operations for the periods presented. All inter-company balances and transactions are eliminated in consolidation.

The Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011, also referred to as the “2011 Form 10-K.” The accompanying unaudited Consolidated Financial Statements and related footnotes have been prepared in accordance with generally accepted accounting principles in the United States (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X and conform to practices within the financial services industry. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. The results of operations, for the three and nine months ended September 30, 2012, are not necessarily indicative of the results to be expected for the fiscal year ending December 31, 2012. The Consolidated Financial Statements refer to “Management” within the disclosures. The Company’s definition of Management is the executive management team of the Company and its subsidiaries.

The preparation of financial statements in conformity with GAAP requires Management to make estimates and assumptions that affect the amount of assets and liabilities as well as disclosures of contingent assets and liabilities at the date of the financial statements. Although Management believes these estimates to be reasonably accurate, actual amounts may differ. In the opinion of Management, all adjustments considered necessary have been reflected in the financial statements during their preparation. Certain amounts in the 2011 Consolidated Financial Statements have been reclassified to be comparable with classifications used in the 2012 Consolidated Financial Statements.

Recent Developments

On March 12, 2012, the Company announced that it had entered into a Merger Agreement with UNBC (the “Merger Agreement”). Pursuant to the Merger Agreement, each outstanding share of the Company’s common stock will be converted into the right to receive cash in the amount of $46.00 per share upon consummation of the Merger. The acquisition requires approval from banking regulators and is subject to other customary closing conditions, and is expected to be completed in the fourth quarter of 2012.

Pacific Capital Bancorp and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED

NOTE 1.

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES – CONTINUED

Recapitalization through the Investment Transaction and Purchase Accounting

On August 31, 2010, pursuant to the terms of an Investment Agreement (the “Investment Agreement”), dated as of April 29, 2010, by and among the Company, the Bank and SB Acquisition Company LLC, a wholly-owned subsidiary of Ford Financial Fund, L.P. (the “Investor”), the Company issued common and preferred stock to the Investor for the aggregate consideration paid to the Company by the Investor of $500 million in cash, herein referred to as the “Investment Transaction.”

As a result of the Investment Transaction, pursuant to which the Investor acquired and controlled 98.1% of the voting securities of the Company, the Company followed the acquisition or purchase method of accounting as required by the Business Combinations Topic of the Accounting Standard Codification (“ASC”) Topic 805, Business Combinations (“ASC 805”). Under the rules of the Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin T. 5J, New Basis of Accounting Required in Certain Circumstances (“SEC SAB T. 5J”) or ASC 805-50-S99, the application of “push down” accounting is required.

Purchase accounting requires that the assets purchased, the liabilities assumed, and noncontrolling interests all be reported in the acquirer’s financial statements at their fair value, with any excess of purchase consideration over the net assets being reported as goodwill. Although the $500 million in cash from the Investor was received on August 31, 2010, the purchase accounting adjustments are reflected in the Consolidated Financial Statements after the close of business on August 31, 2010, and herein is referred to as “the Transaction Date.”

In addition to the new accounting basis established for assets, liabilities and noncontrolling interests, purchase accounting requires the reclassification of any retained earnings from periods prior to the acquisition to be recognized as common share equity and the elimination of any accumulated other comprehensive income (“AOCI”) or loss and paid in capital within the Company’s Shareholders’ Equity section of the Company’s Consolidated Financial Statements. For information regarding the authorized shares and stock issuances related to the Investment Transaction refer to Note 2, “Business Combinations – Investment Transaction” of the Consolidated Financial Statements in the Company’s 2011 Form 10-K.

Consolidation of Subsidiaries and Variable Interest Entities

The Company has five wholly-owned subsidiaries: SBB&T and four unconsolidated subsidiaries used as business trusts in connection with issuance of trust preferred securities as described in Note 15, “Segments” of these Consolidated Financial Statements.

SBB&T has three wholly-owned consolidated subsidiaries:

MCM and REWA, registered investment advisors that provide investment advisory services to individuals, foundations, retirement plans and select institutional clients; and

PCB Service Corporation, utilized as a trustee of deeds of trust in which SBB&T is the beneficiary.

SBB&T also retains ownership in several low income housing tax credit partnerships (“LIHTCP”) that generate tax credits. These partnerships are not consolidated into these Consolidated Financial Statements. These investments play a role in meeting SBB&T’s Community Reinvestment Act (“CRA”) requirements as well as providing tax credits to reduce the Company’s taxable income. The Company does not have any other entities that should be considered for consolidation.

Pacific Capital Bancorp and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED

NOTE 1.

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES – CONTINUED

Recent Accounting Pronouncements

During the nine months ended September 30, 2012, the following accounting pronouncement applicable to the Company was issued:

In July 2012, the FASB issued Accounting Standards Update (“ASU”) 2012-02, Intangibles-Goodwill and Other (Topic 350). This ASU allows an entity to first assess qualitative factors to determine whether it is necessary to perform the quantitative impairment test for indefinite-lived intangible assets. An organization that elects to perform a qualitative assessment is required to perform the quantitative impairment test for an indefinite-lived intangible asset if it is more likely than not that the asset is impaired. This update is effective for fiscal years beginning after September 15, 2012, and should be applied to annual and interim impairment testing. Early adoption is permitted for annual and interim impairment tests as of a date before July 27, 2012, provided that an entity’s financial statements for the most recent annual or interim period have yet to have been issued. The adoption of this new guidance is not expected to have a material impact on the Company’s Consolidated Financial Statements.

Cash Reserve Requirement

All depository institutions are required by law to maintain reserves against their transaction deposits. The Bank’s reserves must be held in cash or with the Federal Reserve Bank of San Francisco (“Reserve Bank”). The amount of the reserve may vary each day as banks are permitted to meet this requirement by maintaining the specified amount as an average balance over a two-week period. In addition, the Bank must maintain sufficient balances to cover the checks written by the Bank’s clients that are clearing through the Reserve Bank because they have been deposited at other banks.

Investment Securities

All investment securities are debt securities and are classified as available for sale (“AFS”). The appropriate classification is determined at the time of purchase. Securities classified as AFS are reported as an asset on the Consolidated Balance Sheets at their estimated fair value. As the fair value of AFS securities changes, the changes are reported (net of income taxes, if applicable) as an element of AOCI. When AFS securities, specifically identified, are sold, the unrealized gain or loss is reclassified from AOCI to noninterest income.

When the estimated fair value of a security is lower than the book value, a security is considered to be temporarily impaired. On a quarterly basis, Management evaluates any securities in a loss position to determine whether the impairment is other-than-temporary. If there is intent to sell the security or if the Company will be required to sell the security or if the Company believes it will not recover the entire cost basis of the security, the security is other-than-temporarily impaired (“OTTI”) and impairment is recognized. The amount of impairment resulting from credit loss is recognized in earnings and impairment related to all other factors, such as general market conditions, is recognized in AOCI.

Management considers a number of factors in its analysis of whether a decline in a security’s estimated fair value is an OTTI. Certain factors considered include, but are not limited to: (a) changes in the financial condition of the issuer, (b) the payment structure of debt securities, (c) adverse changes in ratings issued by rating agencies, (d) and the intent and ability of the Company to hold the security for a period of time sufficient to allow for any anticipated recovery in fair value. Interest income is recognized based on the coupon rate, and is increased by the accretion of discounts earned or decreased by the amortization of premiums paid over the contractual life of the security using the effective interest method.

Pacific Capital Bancorp and Subsidiaries

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NOTE 1.

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES – CONTINUED

The Bank is a member of both the Reserve Bank and the Federal Home Loan Bank of San Francisco (“FHLB”), and as a condition of membership in both organizations, it is required to purchase stock. In the case of the Reserve Bank, the amount of stock that is required to be held is based on the Bank’s capital. The required ownership of FHLB stock is based on the borrowing capacity used by the Bank. These investments are considered equity securities with no actively traded market. Therefore, the shares are considered restricted investment securities and reported in FHLB stock and other investments in the Consolidated Balance Sheets. Such investments are carried at cost, which is equal to the value at which they may be redeemed. The dividend income received from the stock is reported in interest income.

Loans Held for Sale

Periodically, the Company originates or identifies loans it expects to sell prior to maturity. When loans are originated or identified to be sold, they are recorded as held for sale and reported at the lower of cost or fair value with any adjustment for net unrealized losses reported in noninterest income. Generally, the fair value of loans held for sale is based on what secondary markets are currently offering for loans with similar characteristics or based on an agreed upon sales price. A loan’s cost basis includes unearned deferred fees and costs, and premiums and discounts. These loans are generally held between 30 to 90 days from their origination date. Due to the short period of time loans are held for sale, deferred fees or expenses are not amortized. Any subsequent decreases in fair value are recognized in noninterest income, and increases in fair value are not recognized until the loans are sold. If a loan has been reported as held for sale and is then determined that it is unlikely to be sold, the loan is reclassified to loans held for investment at the lower of cost or fair value. The majority of loans held for sale by the Company are residential real estate loans. Loans classified as held for sale are disclosed in Note 4, “Loans” of these Consolidated Financial Statements.

Loans Held for Investment

Loans held for investment, except for Purchased Credit Impaired (“PCI”) Loan Pools described below, are reported at their outstanding principal balances net of any unearned income, cumulative charge-offs, unamortized deferred fees and costs on originated loans and unamortized premiums or discounts on purchased loans.

Loans originated or purchased since the Transaction Date are included in “Loans Held for Investment” within these Consolidated Financial Statements and are referred to within these Consolidated Financial Statements as “Loans originated or purchased since the Transaction Date.” At September 30, 2012 and December 31, 2011, a majority of the loans reported as Loans Held for Investment are in PCI Loan Pools. The accounting for PCI Loan Pools is significantly different from the accounting for loans originated or purchased since the Transaction Date. The accounting policies for the loans originated or purchased since the Transaction Date is covered within this section, while the accounting for PCI Loan Pools is described in the section below called “Accounting for PCI Loan Pools.”

Interest income on loans originated or purchased since the Transaction Date is accrued daily, except for loans in a nonaccrual status. Loan fees collected for the origination of loans less direct loan origination costs (net deferred loan fees) are amortized over the contractual life of the loan through interest income. If a loan has scheduled payments, the amortization of the net deferred loan fee is calculated using the effective interest method over the contractual life of the loan. If the loan does not have scheduled payments, such as a line of credit, the net deferred loan fee is recognized as interest income on a straight line basis over the contractual life of the loan commitment. Loan fees received for loan commitments are recognized as interest income over the term of the commitment. Premiums and discounts recorded in connection with the purchase of loans are accounted for in a similar manner as net deferred loan fees. Any premium or discount from a loan purchase is recognized in interest income over the life of the contractual life of the loan through interest income. When loans are repaid, any remaining unamortized balances of unearned fees, deferred fees and costs, premiums, and discounts are recognized in interest income.

Pacific Capital Bancorp and Subsidiaries

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NOTE 1.

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Unfunded Loan Commitments and Letters of Credit

Letters and lines of credit are commitments to extend credit and standby letters of credit to the Bank’s clients. These commitments meet the financing needs of the Bank’s clients in the normal course of business and are commitments with “off-balance sheet” risk since the Bank has committed to issuing funds to or on behalf of clients, but there is no current loan outstanding. Included in unfunded loan commitments are secured and unsecured lines of credit.

Lines of credit are obligations to lend money to a borrower. Credit risk arises when the borrowers’ current financial condition may indicate less ability to pay than when the commitment was originally made. Standby letters of credit and financial guarantees are conditional commitments issued by the Company to guarantee the performance of a client to a third party in borrowing arrangements. In the case of standby letters of credit, the risk arises from the possibility of the failure of the client to perform according to the terms of a contract. In such a situation, the third party might draw on the standby letter of credit to pay for completion of the contract and the Company would have to look to its client to repay these funds to the Company with interest. The Company uses the same credit policies in making commitments and conditional obligations as it would for a loan to that client.

The Company has exposure to losses from unfunded loan commitments and letters of credit. Since the funds have not been disbursed on these commitments, they are not reported as loans outstanding. Potential losses related to these commitments are not included in the Allowance for Loan and Lease Losses (“ALLL”) reported in Note 6, “Allowance for Loan and Lease Losses” of these Consolidated Financial Statements. Instead, they are accounted for as a separate loss contingency or reserve within other liabilities on the Company’s Consolidated Balance Sheets. This reserve is discussed within Note 1, “Summary of Significant Accounting Policies” in a section called “Reserve for Off-Balance Sheet Commitments.”

Prior to the funding of a loan, the Company may provide an interest rate lock commitment for mortgage loans that will be originated with the intent to sell. The Company may also enter into mandatory delivery contracts, which are loan sale agreements in which the Company has committed to deliver a certain principal amount of mortgage loans to a third party investor at a specified price on or before a specified date. These interest rate lock commitments and mandatory delivery contracts qualify as derivatives under GAAP. The fair value of the interest rate lock commitments is based on the change in interest rates between the date the interest rate lock commitment is executed and the date the loan is funded. The fair value of the mandatory delivery contracts is calculated by comparing the price on the contract accepted date to the price on the actual sale date. The fair value of these derivatives is reported as other assets or other liabilities and changes in the fair values are reflected through noninterest income in the Company’s Consolidated Financial Statements.

Accounting for PCI Loan Pools

Loans acquired in a transfer, including business combinations, where there is evidence of credit deterioration since origination and it is probable at the date of acquisition that the acquirer will not collect all contractually required principal and interest payments, are accounted for using the guidance for PCI Loan Pools, which is contained in the ASC 310-30, Receivables, Loans and Debt Securities Acquired with Deteriorated Credit Quality (“ASC 310-30”). In addition, the American Institute of Certified Public Accountants (“AICPA”) reached an understanding with the SEC that permits an acquirer to elect to account for acquired loans that are not impaired by means of expected cash flows rather than contractual cash flows. This understanding was documented in a letter from the AICPA to the SEC dated December 18, 2009. The Company has elected an accounting policy to apply expected cash flows accounting guidance to all loans subject to the business combination, and push-down accounting requirements for loan portfolios acquired in a business combination, and will herein be referred to as “PCI Term Pools.”

Pacific Capital Bancorp and Subsidiaries

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Some loans that otherwise meet the definition of credit impaired, such as revolving lines of credit, are specifically excluded from the scope of the accounting guidance in ASC 310-30 and are accounted for using ASC 310-20, Receivables, Nonrefundable Fees and Other Costs (“ASC 310-20”). However, Management considers these revolving lines of credit to also be credit impaired and has pooled these revolving lines of credit purchased through the Investment Transaction and herein will refer to these loans as “PCI Revolving Pools.”

PCI Term Pools

PCI Term Pools are initially recorded at fair value, and any related ALLL from before the acquisition was reversed. Fair value is determined by estimating the principal and interest cash flows expected to be collected after discounting at the prevailing market rate of interest. The difference between contractual cash flows and expected cash flows, on an undiscounted basis, represents the nonaccretable difference. The difference between undiscounted expected cash flows and discounted expected cash flows represents the accretable yield. The Company’s estimate for expected cash flows on PCI Loan Pools takes into consideration estimated prepayments based on the characteristics of the loans contained in each loan pool, and expected charge-offs and recoveries of the PCI Loan Pools. The accretable yield is recognized in interest income over the remaining life of the pool of loans using the effective interest method or cost recovery method if the cash flows are not estimable.

Management elected to aggregate PCI term loans into several pools based on common risk characteristics as allowed under ASC 310-30. Each pool is accounted for as a single asset with a single composite discount rate and an aggregate expectation of cash flows. Both the accretion of interest income and the comparison of actual cash flows to expected cash flows are completed at the pool level rather than on individual loans. PCI term loans may not be removed from a pool, added to a pool, or moved from one pool to another. All activity such as payments, charge-offs, recoveries, and prepayments received are applied to the loan pool in which the loan was placed. Payments in excess of expectations in one pool may not be applied to other pools to avoid the recognition of impairment for deficient payments within another pool. Only the payoff or prepayment by the borrower, foreclosure of the collateral, or charge-off, or disposal of a loan, as a result of sales of loans to third parties, will result in the removal of a loan from a loan pool. When a loan is removed from a pool, it is removed at its carrying amount.

Quarterly, the Company compares actual cash flows to expected cash flows for PCI Term Pools to determine whether actual cash flows are substantially the same as was expected at the time the loans expected cash flows were last estimated. Differences in actual cash flows from that previously expected may result in a revision to the Company’s estimate for expected cash flows. If upon reevaluation of expected cash flows the Company determines that as a result of credit deterioration there will be less expected cash flows than previously estimated, an ALLL is established through a charge to the provision for loan losses and an impairment amount is recorded. Other changes in cash flows due to changes in interest rates, certain refinancing activities or prepayments are accounted for prospectively as an adjustment to the discount rate on the pool. If reevaluation of expected cash flows indicates there is a significant and probable increase over that previously expected, the Company would decrease any previously established ALLL, and record an adjustment to interest income through the change in the discount rate used to calculate the accretable yield.

The classification and disclosures are at pool levels regardless of the underlying individual loan performance because at acquisition PCI Term Pools were written down to an amount estimated to be collectible and aggregated into pool levels. PCI Term Pools are not reported as nonaccrual, impaired or troubled debt restructurings (“TDRs”) even though some of the underlying loans may be contractually past due, on nonaccrual, impaired or TDRs, as the pool is evaluated as a single unit of account. If the Company determines it can no longer reasonably estimate future cash flows for a PCI Term Pool, the Company would cease accretion on such pools.

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PCI Revolving Pools

As mentioned above, acquired loans with revolving features are excluded from ASC 310-30. The accounting for purchase discounts on pooled revolving lines of credit is determined in accordance with ASC 310-20. PCI Revolving Pools were recorded at fair value at the Transaction Date, similar to PCI Term Pools, based on expected cash flows, which included estimated losses inherent in those pools at the Transaction Date. A new carrying amount was established for PCI Revolving Pools based on their fair value, which represents its net realizable value. The difference between the carrying value and the net realizable value is the purchase discount.

Cash flows associated with the PCI Revolving Pools determine the amount of purchase discount that is to be accreted based on when the net realizable value exceeds the net carrying amount. Therefore, the Company only records interest income on these pools based at the contractual rate of the underlying loans, to the extent considered collectible. Management periodically reassesses the net realizable value of each PCI Revolving Pool and records interest income relating to the purchase discount in accordance with ASC 310-20. Such amounts are recognized in income using the effective interest method over the period the revolving line of credit is active, assuming that borrowings are outstanding for the maximum term provided in the loan contract. In the event that credit losses inherent in the portfolio are higher than expectations, the Company records an ALLL to the extent that the carrying value exceeds the amounts expected to be collected.

Unlike PCI Term Pools, accounting guidance requires that disclosures be made on the underlying loans in PCI Revolving Pools even though such loans were recorded at fair value on the Transaction Date. As a result, the underlying loans in PCI Revolving Pools are reported as contractually delinquent, nonaccrual, impaired, or TDRs to the extent applicable.

Allowance for Loan and Lease Losses

Credit risk is inherent in the business of extending loans and leases to borrowers and this risk is addressed through a valuation allowance. The ALLL represents a creditor’s estimate of loan losses inherent within the loan portfolio at each balance sheet date and is netted against the outstanding loan balance. The ALLL reduces the carrying amount to the creditor’s estimate of what will be collected from borrowers. The ALLL is established through charges to current period earnings by recording a provision for loan losses. When losses become specifically identifiable and quantifiable, the loan balance is reduced through recording a charge-off against the ALLL. Should payments be received on charged-off loans, the payment is credited to the ALLL as a recovery.

Loan charge-offs are generally processed by policy and regulatory guidance. Secured consumer loans, including residential real estate loans, that are 120 days past due are written down to the fair value of the collateral. Unsecured consumer loans are charged-off once the loan is 120 days past due. Decisions on when to charge-off commercial loans and loans secured by commercial real estate are made on an individual basis rather than length of delinquency, though it is a factor in the decision. The financial resources of the borrower and/or guarantor and the nature and value of any collateral are other factors considered such as if the loan is for business purposes or to a consumer.

The purchase accounting guidance for business combinations significantly impacted the Company’s ALLL as of the Transaction Date. The revaluation of assets required by this accounting guidance resulted in all loans being reported at their fair value as of the Transaction Date. The fair value is presumed to take into account the contractual payments on loans that are not expected to be received, and consequently no ALLL was carried over for the Company’s loans as of the Transaction Date. In accordance with purchase accounting guidance, charge-offs and recoveries related to loans within PCI Term Pools and PCI Revolving Pools are not to be recorded through the ALLL. Instead, charge-offs and recoveries related to PCI Loan Pools are recorded against the purchase accounting adjustment for loans in the PCI Term Pools, and against the purchase discount for loans within PCI Revolving Pools. ALLL is comprised of the Company’s estimate of losses inherent in loans originated or purchased since the Transaction Date; the differential between current expected cash flows and prior expected cash flows for PCI Term Pools when current expected cash flows are less than prior expected cash flows as a result of credit deterioration; and the amount of credit losses inherent in PCI Revolving Pools in excess of the net realizable value.

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NOTE 1.

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Credit risk grades are assigned to all loans for the overall monitoring of credit risk within the loan portfolio. For PCI Loan Pools, the individual loans within each pool are assigned a credit grade but, then are aggregated to review the total credit risk of each pool which are then monitored by Management for each loan pool and monitoring of expected cash flows. For loans originated or purchased since the Transaction Date, credit risk grades are monitored by Management on a loan by loan basis.

Portfolio Segments

When the Company’s credit administration department reviews and updates credit risk rating for loans, there are two main groups or portfolio segments: Commercial Loans and Consumer Loans. The risk characteristics and approaches to reviewing credit risk for each portfolio segment are described in the following paragraphs.

Commercial Loans

Commercial loans consist of multifamily loans, commercial real estate loans, construction loans, and commercial lines of credit. Such loans are made primarily to borrowers to provide financing for the acquisition of or development of commercial properties, including the construction of single family, multifamily, and multi-unit commercial properties. Commercial loans are subject to underwriting standards and processes specific to the risks related to each credit, including but not limited to: geographic location of the project, and/or operations of the borrower, financial condition of the borrower and/or guarantor(s), debt service coverage analyses, and knowledge of local economic conditions. Risks associated with commercial loans are largely related to general economic conditions, changes in, and sustainability of cash flows for the underlying business servicing the obligation, declines in collateral values for collateral dependent loans, and in the case of certain construction loans, the ability of the borrower to obtain longer-term financing. The Company mitigates and monitors risk associated with such loans through its internal review and risk grading process, making loans to in-market borrowers, controlling loan structure, and monitoring the financial conditions of the underlying businesses/borrowers.

Credit risk grades for large problem loans in the commercial loan portfolio are reviewed quarterly, at a minimum. A credit risk grade for a commercial loan is assessed and will generally require a credit risk grade change when the following events occur:

New credit requests;

Loan renewals;

Review of borrower financial statements or non-receipt of borrower financial statements when requested;

Appearance on delinquency reports;

Outside credit inquires;

Identified facts demonstrate change in risk of nonpayment;

Pacific Capital Bancorp and Subsidiaries

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Historical payment experience;

Current economic trends;

Emerging industry problems; and/or

Contact with borrower provides new credit information.

Consumer Loans

Consumer loans consist largely of residential and revolving 1 to 4 family loans, and consumer installment loans. The majority of the consumer portfolio is comprised of financing for single family dwellings, which are predominately owner-occupied. Such loans are typically made based on the borrower’s financial condition, credit scores, debt-to-income ratios, and the type, location, and value of the underlying collateral. Risks associated with such loans are primarily related to general economic conditions, including the level of unemployment, and declines in the value of the underlying collateral. Consumer loans made for purposes other than for the financing of residential real estate are typically secured and unsecured shorter term loans made to borrowers for various purposes, including automobile and recreational vehicle purchases, and personal liquidity needs. The Company primarily makes such loans to in-market borrowers, and bases lending decisions on factors related to the financial condition of the borrower. Risks associated with these loans are mitigated in part by the smaller amount of the individual loans spread across many borrowers.

A credit risk grade in the consumer loan portfolio is assessed and will generally require a grade change when the following events occur:

New credit requests;

Deterioration of credit score;

Loan renewals;

Appearance on delinquency reports;

Identified facts demonstrate change risk of nonpayment;

Historical payment experience; and/or

Contact with borrower provides new credit information.

The change in a borrower’s credit risk grade is not limited to this list. Quarterly, the Company’s credit administration department obtains a credit score refreshment report which assesses consumer loan borrowers’ credit scores to identify borrowers who could have a deterioration of credit score which would trigger a credit risk grade change. Once a credit risk grade is assessed for a loan, its classification is determined based on the expectation of repayment. Nonclassified loans generally include those loans that are expected to be repaid in accordance with contractual loan terms. Classified loans are those loans that are classified as substandard or doubtful consistent with regulatory guidelines as described below.

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Loans Classified as Substandard

A substandard loan is a loan which is inadequately protected by a current sound worth and paying capacity of the borrower or the collateral pledged, if any. The extension of credit has a well-defined weakness and/or the Company identifies a distinct possibility that a loss will be incurred if the deficiency identified is not corrected. When a loan is classified as substandard it does not necessarily imply there is a loss exposure in a specific loan, but a loss potential does exist.

Loans Classified as Doubtful

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

ALLL Model Methodology

After reviewing the credit risk ratings in the loan portfolio, the second step is to develop an estimate of the loss inherent in individual loans or groups of similar loans. The estimation of probable losses takes into consideration the loan credit risk ratings and other factors such as:

Loan balances;

Loan pool segmentation;

Historical loss analysis;

Identification, review, and valuation of impaired loans;

Changes in the economy impacting lending activities;

Changes in the concentrations of various loan types;

Changes in the growth rate or volume of lending activities;

Changes in the trends for delinquent and problem loans;

Changes in the control environment or procedures;

Changes in the management and staffing effectiveness;

Changes in the loan review effectiveness;

Changes in the underlying collateral values of loans;

Changes in the competition/regulatory/legal issues; and

Unanticipated events.

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The amount of the allowance recorded at the end of the prior reporting period is then compared with the new estimate of inherent loss. If additional allowance is required to cover the revised estimate, the additional amount is provided through a charge to provision for loan losses. If the recorded allowance is higher than the revised estimate, the allowance is reduced by a negative provision for loan losses.

When reviewing cash flows for PCI Loan Pools, Management makes a determination whether the estimate of expected cash flows from these loans needs revision. This determination is based on actual cash flows received, general market conditions, and any information available about borrowers and their financial condition that would lead Management to conclude that expected cash flows will be substantially different from what was previously estimated. Of the factors noted above for PCI Loan Pools, those that relate specifically to the borrower, to the economy, and to credit deterioration seen for similar borrowers or similar businesses or industries will be most relevant.

As is indicated in the section above for PCI Loan Pools, the Company aggregated all of these loans into pools with similar risk characteristics that became the individual units of accounting. The estimates of expected cash flows are therefore calculated at the pool level. An unfavorable change in the estimate of expected cash flows due to credit may require the recognition of impairment by establishing an ALLL on a pool by pool basis. A favorable change in the estimate of expected cash flows would result in reversing any previously established allowance due to an unfavorable change, but no negative allowance is recorded if the favorable change exceeds any previously recorded allowance. The excess expected cash flows are accreted into income over the remaining estimated terms of the loans in the pool. Additional information on the ALLL is provided in Note 6, “Allowance for Loan and Lease Losses” of these Consolidated Financial Statements.

The Company considers both quantitative and qualitative factors when determining the level of estimated ALLL. Quantitative factors are based primarily on historical credit losses for each portfolio of similar loans over a time horizon or “look-back” period. The Company generally uses historical credit losses over the past six quarters as a basis for its quantitative factors. The look-back period has been the past six quarters since the second quarter of 2009, when Management shortened the timeframe to better capture current risk conditions. The shorter time frame, coupled with less reliance on qualitative factors, was determined to be more responsive to the increasing risk seen in economic conditions and rapidly deteriorating real estate collateral values over the last few years.

Qualitative factors are generally used to adjust historical loss rates based on the Company’s estimate of the losses inherent in the outstanding balance of the loan portfolio that are not fully captured by the quantitative factors alone. Qualitative factors taken into consideration in calculations of the ALLL include: concentrations of types of loans, loan growth, control environment, delinquency and classified loan trends, Management and staffing experience and turnover, economic conditions, results of independent loan review, underlying collateral values, competition, regulatory, legal issues, structured finance and syndicated national credits, and other factors. These qualitative factors are applied as adjustments to the historical loss rates when Management believes they are necessary to better reflect current conditions.

Nonaccrual Loans, Impaired Loans, and Restructures of Troubled Debt

As discussed above in the PCI Loan Pools section, the accounting for PCI loans has implications for classification and reporting disclosures of loans classified as nonaccrual, impaired, or TDRs. Because the Company’s loans were written down to fair value and pooled as of the Transaction Date, the carrying amount of these loans in the Company’s Consolidated Financial Statements is based upon amounts estimated to be collected. PCI Term Pools are not classified as nonaccrual, impaired or TDRs even though some of the underlying loans may be contractually past due, nonperforming, or restructured as TDRs. PCI Term Pools are accounted for and reported as a single unit of account, based on expectations for future cash flows, in accordance with ASC 310-30, and therefore the performance of the underlying loans within PCI Term Pools are not reported in the Company’s Consolidated Financial Statements.

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The reporting for PCI Revolving Pools differs from that of PCI Term Pools, because the accounting and reporting for such loans is not within the scope of ASC 310-30, and therefore the underlying loans are required to be reported and accounted for as delinquent, nonaccrual, impaired or TDR. Quarterly, PCI Loan Pools are assessed for the overall collectability of the expected cash flows on a pool by pool basis.

For all loans originated or purchased since the Transaction Date, when an individual borrower discontinues making payments as contractually required by the note, the Company must determine whether it is appropriate to continue to accrue interest. Generally, the Company places loans in a nonaccrual status and ceases recognizing interest income when the loan has become delinquent by 90 days or more and/or when Management determines that the repayment of principal and collection of interest is unlikely. The Company may decide that it is appropriate to continue to accrue interest on certain loans 90 days or more delinquent if they are well secured by collateral and collection is in process.

When a loan is placed on nonaccrual status, any accrued but uncollected interest for the loan is reversed out of interest income in the period in which the status is changed. Subsequent payments received from the client are applied to principal and no further interest income is recognized until the principal has been paid in full or until circumstances have changed such that payments are again consistently received as contractually required. In the case of commercial clients, the pattern of payment must also be accompanied by a positive change in the financial condition of the borrower.

A loan is identified as impaired when it is probable that interest and principal will not be collected according to the contractual terms of the loan agreement. However, there are some loans that are termed impaired because of doubt regarding collectability of interest and principal according to the contractual terms, which are both fully secured by collateral and are current in their interest and principal payments. Once a loan is identified as impaired, the amount of any impairment is determined based on the extent to which the Company’s recorded investment in the loan exceeds the loan’s estimated fair value. The Company determines an impaired loan’s fair value based on either the present value of the expected future cash flows discounted at the loan’s effective interest rate, or the fair value of the collateral securing the loan. When using the fair value of the collateral securing an impaired loan as the basis for measuring impairment, the Company takes into consideration estimated costs to sell the collateral when determining the loan’s fair value. A valuation allowance is established for an impaired loan through a charge to earnings when the fair value of the loan is less than the Company’s recorded investment in the loan. An impaired loan may be placed back on accrual if the loan is no longer considered to be impaired. For additional information in obtaining the fair value of a loan, refer to Note 2, “Fair Value of Financial Instruments” of these Consolidated Financial Statements.

A loan may be restructured when the Company determines that a borrower’s financial condition has deteriorated, but still has the ability to repay at least some portion of the loan. A loan is considered to be a TDR when the borrower is experiencing financial difficulty, and the original terms have been modified in favor of the borrower such that either principal or interest has been forgiven, contractual payments are deferred, or the interest rate is reduced (i.e. a concession in accordance with ASU 2011-02, Receivables (Topic 310): A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring). A loan may also be considered a TDR when the loan of a financially troubled borrower is renewed with the same terms as were offered when the borrower was not troubled, because it is normally expected that interest rates will be higher to cover the increased credit risk from a troubled borrower. Generally, when a loan is identified as a TDR, the loan is also disclosed as an impaired loan.

Additional information regarding loans classified nonaccrual, impaired, and TDR is disclosed in Note 6, “Allowance for Loan and Lease Losses” of these Consolidated Financial Statements.

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Premises and Equipment

Premises and equipment are reported at cost less accumulated depreciation. Depreciation is expensed over the estimated useful lives of the assets. The Company depreciates assets utilizing straight line depreciation. The estimated useful lives of premises and equipment are as follows:


Buildings			40 years

Building improvements			3 – 40 years

Furniture and equipment			5 – 7 years

Electronic equipment and software			3 – 10 years

Leasehold improvements are amortized over the terms of the leases or the estimated useful lives of the improvements, whichever is shorter. Management annually reviews premises and equipment in order to determine if facts and circumstances suggest that the value of an asset is not recoverable.

Leases

The Company leases a majority of its branches and support offices. Most of these leases are operating leases for which a monthly rental expense is recognized. However, when the terms of the lease are such that the Company is leasing the building for most of its useful economic life or the present value of the sum of lease payments represents most of the fair value of the building, the transaction is accounted for as a capital lease. In a capital lease, the building is recognized as an asset of the Company and the net present value of the contracted lease payments is recognized as a long term liability. The long term liability recognized as part of a capital lease is accounted for using the interest method, and is included in other borrowings of the Company’s Consolidated Financial Statements. The Company’s capital leases were recorded at fair value in conjunction with the Investment Transaction. The amortization charge relating to assets recorded under capital leases is included with depreciation expense.

Some of the Company’s leases have cost-of-living adjustments based on the consumer price index. Some of the leases have fixed increases provided for in the terms or increases based on the index but have a minimum increase irrespective of the change in index. In these cases, the total fixed or minimum lease expense is recognized on a straight line basis over the term of the lease. As part of the purchase accounting due to the Investment Transaction, the Company evaluated all of its leases. A liability was recorded as of the Transaction Date because the contractual operating lease payments were above the current market rates for several leased properties in aggregate. The contractual obligations for operating and capital leases are disclosed in Note 11, “Commitments and Contingencies” of these Consolidated Financial Statements.

Goodwill and Intangible Assets

Intangible assets are generally acquired through an acquisition with the exception of the mortgage serving rights. If the benefit of the intangible asset is obtained through contractual or other legal rights, or if the intangible asset can be sold, transferred, licensed, rented, or exchanged, regardless of the acquirer’s intent to do so, the acquired intangible asset will be a separately recognized asset. Such intangible assets are subject to amortization over their useful lives unless they have an indefinite life. Among these identifiable intangible assets are core deposit intangibles (“CDI”), customer relationship intangibles (“CRI”), non-compete intangibles, and trade name intangibles. The Company amortizes CDI and CRI over their estimated useful lives.

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SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES – CONTINUED

Any excess of the purchase price over the estimated fair value of the assets received and liabilities assumed is an unidentifiable intangible asset and is recorded as goodwill. Goodwill must be reviewed for impairment when there is evidence to suggest that the estimated fair value of the net assets is lower than the carrying value, or at a minimum of once a year. This evidence may be in the form of a triggering event or a series of events or developments.

Testing goodwill for impairment consists of a two-part test to determine the fair value of goodwill. In Step 1, the fair value of the reporting unit is determined and compared to its carrying value including goodwill. If the fair value of the reporting unit is more than its carrying value, goodwill is not impaired. If the fair value of the reporting unit is less than its carrying value, the company must proceed with Step 2. In Step 2, the implied fair value of goodwill is estimated. The implied fair value of goodwill is the excess of fair value of the reporting unit over the fair values of the assets and liabilities of the reporting unit as they would be determined in an acquisition. If the carrying amount of the goodwill is more than its implied fair value, it is impaired and an impairment charge must be recognized.

All of the goodwill recognized in the Company’s Consolidated Financial Statements, as of September 30, 2012, is the result of the purchase accounting for the Investment Transaction. Additional information regarding goodwill and the computation of goodwill at September 30, 2012, is disclosed in Note 7, “Goodwill and Intangible Assets” of these Consolidated Financial Statements.

Included in goodwill and other intangible assets are mortgage and other loan servicing rights associated with the sale of loans for which the servicing of the loan is retained. The Company receives a fee for servicing these loans. The right to receive this fee for performing servicing is of value to the Company and could be sold should the Company choose to do so. Companies engaged in selling loans and retaining servicing rights for a fee are required to recognize servicing rights as an asset or liability. The rights are recorded at the net present value of the fees that will be collected, less estimated servicing costs, which approximates the fair value. Loan servicing rights are amortized into noninterest income in proportion to, and over the period of, estimated future net servicing income. Estimates of the lives of the loans are based on several industry standard sources and take into consideration prepayment rates expected in the current market interest rate environment.

Each quarter Management evaluates servicing rights for impairment. Impairment occurs when the fair value of loan servicing rights is less than amortized cost. The rates at which consumers prepay their loans are impacted by changes in interest rates—prepayments generally increase as interest rates fall, and generally decrease as interest rates rise so the value of the servicing right changes with changes in interest rates. When prepayments increase, the Company will collect less servicing fees, and the value of the servicing rights declines. A valuation of the servicing assets is performed at each reporting period and reductions to the servicing assets’ carrying values are made when the carrying balance is higher than the fair value of the servicing asset, utilizing the lower of cost or fair value valuation methodology.

Bank Owned Life Insurance

Bank owned life insurance (“BOLI”) involves the purchase of life insurance by the Company on a chosen group of employees. The Company is the owner and beneficiary of the policies. This life insurance investment is carried as an asset at the cash surrender value of the underlying policies. In cases where the Company is a joint beneficiary of the policies, the Company has recorded a liability for the portion of the cash surrender value owned by the other party. Income from the increase in cash surrender value of the policies is reflected in noninterest income. The cash surrender value approximates fair value.

Pacific Capital Bancorp and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED

NOTE 1.

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES – CONTINUED

Other Real Estate Owned

Real estate acquired through foreclosure on a loan or by the surrender of real estate in lieu of foreclosure is referred to as other real estate owned (“OREO”). When real estate is foreclosed on, the collateral is transferred to OREO at estimated fair value less costs to sell with exception to PCI loans. PCI loans are transferred at carrying value except when the carrying value exceeds the fair value. If the outstanding balance of the loan or carrying balance for a PCI loan is greater than the fair value of the OREO at the time of foreclosure, the excess of the loan balance over the fair value is charged-off against the ALLL or PCI Loan Pool’s valuation adjustment before recording the asset as an OREO. OREO is maintained in the Company’s Consolidated Financial Statements at the lower of its carrying value or fair value of the OREO, less estimated costs to sell. OREO is recorded as other assets within the Consolidated Financial Statements.

Once the collateral is foreclosed on and the property becomes an OREO, Management periodically obtains appraisals to determine if further valuation adjustments are required. Valuation adjustments are also required when the listing price to sell an OREO has had to be reduced below the current carrying value. If there is a decrease in the fair value of the property from the last valuation, the decrease in value is charged against noninterest income. During the time the property is held, all related operating and maintenance costs are expensed as incurred. Increases in the values of properties are not recognized until sale. All income produced from OREO, such as from renting the property, is included in noninterest income.

Securities Sold Under Agreement to Repurchase

The Company enters into repurchase agreements whereby it sells securities or loans to another institution and agrees to repurchase them at a later date for an amount in excess of the sale price. While in form these are agreements to sell and repurchase, in substance they are secured borrowings in which the excess of the repurchase price over the sale price represents interest expense. This expense is accrued over the term of the borrowing. For security or collateral, the Company must pledge assets with a higher fair value than the amount borrowed. Information about the amounts held and the interest rates may be found in Note 14, “Securities Sold Under Agreements to Repurchase and Federal Funds Purchased” of the 2011 Form 10-K’s Consolidated Financial Statements. There was a purchase accounting premium recorded as a result of the Investment Transaction for the repurchase agreements based on current market rates for similar instruments.

Other Borrowings

Management utilizes a variety of sources to raise borrowed funds at competitive rates, including FHLB borrowings and subordinated debt. FHLB borrowings typically carry rates approximating the London Inter-Bank Offered Rate (“LIBOR”) for the equivalent term because they are secured with investments or high quality loans. Interest is accrued on a monthly basis, based on the outstanding borrowing’s interest rate, and is included in interest expense.

In past periods, a majority of the long term and short term debt of the Company were advances with the FHLB. Long term funding through the FHLB is collateralized by pledging qualifying loans and/or securities. Virtually all of the FHLB advances were repaid by the Company in early September 2010 from the proceeds received in the Investment Transaction and deposits maintained at the Reserve Bank. Purchase accounting adjustments were made based on current market rates for similar instruments. Refer to Note 10, “Other Borrowings” of these Consolidated Financial Statements for the current period activity within other borrowings.

Reserve for Off-Balance Sheet Commitments

The Company has exposure to losses from unfunded loan commitments and letters of credit. Since the funds have not been disbursed on these commitments, they are not reported as loans outstanding. Estimated losses related to these commitments are not included in the ALLL reported in Note 6, “Allowance for Loan and Lease Losses” of these Consolidated Financial Statements. Instead, they are accounted for as a separate loss contingency or reserve as a liability within other liabilities on the Company’s Consolidated Balance Sheets also referred to as a “Reserve for Off-Balance Sheet Commitments.” Losses are experienced when the Company is contractually obligated to make a payment under these instruments and must seek repayment from a party that may not be as financially sound in the current period as it was when the commitment was originally made.

Pacific Capital Bancorp and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED

NOTE 1.

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES – CONTINUED

The reserve for off-balance sheet commitments originated after the Transaction Date applies the same historical loss rates and qualitative factors used in the calculation for ALLL to the off-balance sheet obligations in determining an estimate of losses inherent in these contractual obligations. For off-balance sheet commitments made prior to the Investment Transaction, a different model is utilized. This model assesses the unfunded commitments for the same group of loans at the Transaction Date at the end of each quarter and applies an estimated funding factor and probability of default for the remaining unfunded commitments to estimate the required reserve. To the extent that the credit exposure has increased, additional reserve for off-balance sheet commitments will increase and to the extent the credit exposure has decreased, the off-balance sheet reserve will decrease.

The estimate of reserves for off-balance sheet commitments is included as a contingent liability under the provisions of ASC 450, Loss Contingencies and is reported within other liabilities and is adjusted for changes in the estimated reserve requirement by an adjustment to noninterest expense. Additional disclosure regarding the Company’s reserve for off-balance sheet commitments is located in Note 4, “Loans” of these Consolidated Financial Statements.

Derivative Financial Instruments

GAAP requires that all derivatives be recorded at their fair value on the balance sheet. Certain derivative transactions that meet specified criteria qualify for hedge accounting under GAAP. The Company does not hold any derivatives that meet the criteria for hedge accounting. Gains or losses associated with changes in fair value of derivative instruments are immediately recognized in noninterest income.

Trust Assets and Investment and Advisory Fees

The Company has a trust department and two registered investment advisory subsidiaries, MCM and REWA, each of which have fiduciary responsibility for the assets that they manage on behalf of clients. These assets are not owned by the Company and are not reflected in the Consolidated Balance Sheets. Fees for most trust services are based on the market value of client assets, and the fees are accrued monthly. All of the activity for the trust department and investment and advisory services are reported in the Wealth Management segment.

Stock-Based Compensation

The Company grants nonqualified stock options, restricted stock, performance stock options and performance restricted stock to directors and employees as a form of compensation. All stock-based compensation is accounted for in accordance with GAAP which requires compensation expense for the issuance of stock-based compensation be recognized over the vesting period of the share-based award or when it is probable that the performance stock grants performance measures will be met.

The amount of compensation expense to be recognized for options is based on the fair value of the stock options, utilizing the Black-Scholes-Merton technique, at the date of the grant. The Black-Scholes-Merton technique is used to value the stock options since this model provides the most appropriate stock option valuation in the opinion of Management. The fair value for the options is estimated based on the length of their term, the volatility of the stock price in past periods, and other factors. The expected term is calculated using the simplified method. The simplified method is used because historical stock option exercise data does not provide a reasonable basis upon which to estimate the expected term. Expected volatility is based on historical volatility of the Company’s stock price. Details regarding the accounting for stock-based compensation expense are disclosed in Note 18, “Shareholders’ Equity” of the Company’s 2011 Form 10-K’s Consolidated Financial Statements.

Pacific Capital Bancorp and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED

NOTE 1.

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES – CONTINUED

A valuation model is not used for pricing restricted stock because the value is based on the closing price of the Company’s stock on the grant date. The total value of the restricted stock is the number of shares granted multiplied by the stock price.

The amount of compensation expense to be recognized for performance stock grants is based on the probability of meeting specific performance goals. These estimates are reassessed at each reporting period, and if the probability has changed, the amount of expense is adjusted based on the most recent assessment of probability.

Income Taxes

The Company uses the asset and liability method, which recognizes a liability or asset representing the tax effects of future deductible or taxable amounts attributable to events that have been recognized in these Consolidated Financial Statements. Due to tax regulations, several items of income and expense are recognized in different periods for tax return purposes than for financial reporting purposes. These items represent “temporary differences.” The Company is required to provide in its Consolidated Financial Statements for the eventual liability or deduction in its tax return for these temporary differences until the item of income or expense has been recognized for both financial reporting and for taxes. The provision is recorded in the form of deferred tax expense or benefit as the temporary differences arise, with the accumulated amount recognized as a deferred tax liability or asset. Deferred tax assets represent future deductions in the Company’s income tax return, while deferred tax liabilities represent future payments to tax authorities. In August 2011, in connection with the Investment Transaction, the Company recorded a deferred tax liability of $5.2 million related to an indefinite life trade name intangible. This related deferred tax liability will remain on the Company’s Consolidated Financial Statements as long as the SBB&T trade name intangible exists.

When realization of the benefit of a deferred tax asset is uncertain, the Company is required to recognize a valuation allowance. A full valuation allowance was recorded by the Company in 2009. Management assesses the realizability of its deferred tax asset each quarter. The realization of the Company’s deferred tax asset is subject to considerable judgment and could occur as a single event or over a period of time, depending upon the level of forecasted taxable income, the degree of risk related to realizing the forecasted taxable income, and the estimated risk related to credit quality.

Earnings Per Share

The computation of basic earnings per share for all periods presented in the Consolidated Statements of Income is based on the weighted average number of shares outstanding during each period retroactively adjusted for the reverse stock split effective December 28, 2010. Diluted earnings per share include the effect of common stock equivalents for the Company, which consist of shares issuable on the exercise of outstanding options and restricted stock awards and common stock warrants.

The number of options assumed to be exercised is computed using the “treasury stock method.” This method assumes that all options with an exercise price lower than the average stock price for the period have been exercised at the average market price for the period and that the proceeds from the assumed exercise have been used for market repurchases of shares at the average market price. Normally, the Company would receive a tax benefit for the difference between the market price and the exercise price of nonqualified options when options are exercised. The treasury stock method also assumes that the tax benefit from the assumed exercise of options is used to retire shares thereby lowering the number of shares assumed to be exercised. Options that have an exercise price higher than the average market price are excluded from the computation because they are anti-dilutive. When the Company’s net income available to common shareholders is in a loss position, the diluted earnings per share calculation utilizes only the average shares outstanding, because assuming the exercise of stock options or warrants would lower the loss per share. Once stock options are exercised, restricted stock vests, or once a performance measurement has been met, the shares are included in the actual weighted average shares outstanding rather than as common stock equivalents.

Pacific Capital Bancorp and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED

NOTE 1.

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES – CONTINUED

Statement of Cash Flows

For purposes of reporting cash flows, “cash and cash equivalents” includes cash and due from banks, Federal funds sold, and securities purchased under agreements to resell. Federal funds sold and securities purchased under agreements to resell are one-day transactions, with the Company’s funds being returned to it the next business day.

Segments

GAAP requires that the Company disclose certain information related to the performance of various segments of its business. Segments are defined based on how the chief operating decision maker of the Company views the Company’s operations. Management has determined that the Company has two reportable operating segments: (1) Commercial & Community Banking and (2) Wealth Management. The All Other segment is not considered an operating segment, but includes all corporate administrative support departments such as human resources, legal, finance and accounting, treasury, information technology, internal audit, risk management, facilities management, marketing, and the Bank’s holding company. The factors used in determining these reportable segments are explained in Note 15, “Segments” of these Consolidated Financial Statements.

NOTE 2.

FAIR VALUE OF FINANCIAL INSTRUMENTS

The accounting guidance for fair value establishes a framework for measuring fair value and establishes a three-level valuation hierarchy for disclosure of fair value measurement. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The three levels are defined as follows:


Level 1:		Observable quoted prices in active markets for identical assets and liabilities.

Level 2:		Observable quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.

Level 3:		Model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The assets and liabilities which are fair valued on a recurring basis are described below and contained in the following tables. In addition, the Company may be required to record other assets and liabilities at fair value on a nonrecurring basis. These nonrecurring fair value adjustments involve the lower of carrying value or fair value accounting and write downs resulting from impairment of assets. The following methods and assumptions were used to estimate the fair value of each class of financial instruments that are recorded in the Company’s Consolidated Financial Statements at fair value on a recurring and nonrecurring basis.

Pacific Capital Bancorp and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED

NOTE 2.

FAIR VALUE OF FINANCIAL INSTRUMENTS – CONTINUED

Investment Securities - AFS

Investment securities are recorded at fair value on a recurring basis. Where quoted prices are available in an active market for identical assets, securities are classified within Level 1 of the valuation hierarchy such as United States Department of the Treasury (“U.S. Treasury”) securities. All of the Company’s securities are reported as Level 2 of the fair value hierarchy. Investment securities are fair valued by an independent third party that obtains observable market prices for similar assets or by obtaining quoted market prices that are not in an active market or in pricing models which have inputs that are observable in the market to obtain the fair value. When observable market information is not available for securities or there is limited activity or less transparency around inputs, such securities would be classified within Level 3 of the valuation hierarchy. The Company does not have any securities within the Level 1 or Level 3 hierarchy.

Derivatives

The Company’s swap derivatives are not listed on an exchange and are instead executed over the counter (“OTC”). As no quoted market prices exist for such instruments, the Company values these OTC derivatives primarily based on third party broker pricing indications and valuation techniques that use readily observable market parameters. As a result, the swap values are classified within Level 2 of the fair value hierarchy.

As discussed in Note 1, “Summary of Significant Accounting Policies,” of these Consolidated Financial Statements, prior to the funding of a mortgage loan, the Company may provide an interest rate lock commitment and mandatory delivery contracts for mortgage loans originated for sale that qualify as derivatives under GAAP. The value of the interest rate lock commitments is based on the change in interest rates between the date the interest rate lock commitment is executed and the date the loan is funded. The interest rates used to fair value these derivatives are from similar assets in observable markets. The value of the mandatory delivery contract is calculated by comparing the price on the contract accepted date to the price on the actual sale date on similar assets that are currently being sold. As a result, these derivatives are classified within Level 2 of the fair value hierarchy.

Foreclosed Collateral

Foreclosed collateral is carried at book or fair value less estimated cost to sell. Fair value is determined by the lower of suggested market prices obtained from independent certified appraisers, the current listing price, or the net present value of expected cash flows of the asset received. When the fair value of the collateral is based on a current appraised value or the appraised value, the asset is classified as nonrecurring Level 2. When a net present value technique using the cash flows of the asset received is used, the asset is classified as nonrecurring Level 3.

Mortgage and Other Loan Servicing Rights

Servicing rights are carried at the lower of aggregate cost or estimated fair value. Servicing rights are subject to quarterly impairment testing. When the fair value of the servicing rights is lower than their carrying value, impairment is recorded by establishing or increasing the amount of a valuation allowance so that the net carrying amount is equal to the fair value. The Company uses independent third parties to value the servicing rights. The valuation model takes into consideration discounted cash flows using current interest rates and prepayment speeds for each type of the underlying asset being serviced. The Company uses discounted cash flows to obtain the fair value for servicing rights and therefore servicing rights are classified as nonrecurring Level 3. Significant changes in any of the assumption inputs within the valuation model such as prepayment speeds, internal rates of return, and estimated inflation rates could result in a significantly different fair value measurement. Generally, as interest rates decrease, prepayment speeds increase resulting in a lower fair value. Contrarily, as interest rates increase, prepayment speeds decrease resulting in a higher fair value.

Pacific Capital Bancorp and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED

NOTE 2.

FAIR VALUE OF FINANCIAL INSTRUMENTS – CONTINUED

Financial Assets and Liabilities Measured at Fair Value on a Recurring Basis

Assets and liabilities measured at fair value on a recurring basis at September 30, 2012, and December 31, 2011, are summarized in the following tables:


			*Recurring Fair Value Measurements at Reporting*

(dollars in thousands)	As of September 30, 2012		Quoted prices in active markets for identical assets (Level 1)		Active markets for similar *assets* *(Level 2)*		Unobservable inputs *(Level 3)*

Assets:

Available for Sale:
U.S. Agency securities	$	87,897	$	—	$	87,897	$	—
Collateralized mortgage obligations		766,007		—		766,007		—
Mortgage-backed securities (1)		198,411		—		198,411		—
State and municipal securities		191,805		—		191,805		—

Total available for sale securities		1,244,120		—		1,244,120		—
Fair value swap asset		7,278		—		7,278		—
Fair value of derivative loan contracts		218		—		218		—

Total assets at fair value	$	1,251,616	$	—	$	1,251,616	$	—

Liabilities:
Fair value swap liability	$	7,312	$	—	$	7,312	$	—
Fair value of derivative loan contracts		841		—		841		—

Total liabilities at fair value	$	8,153	$	—	$	8,153	$	—

(1) The mortgage-backed securities (“MBS”) included in the tables above are residential MBS.

Pacific Capital Bancorp and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED

NOTE 2.

FAIR VALUE OF FINANCIAL INSTRUMENTS – CONTINUED


			*Recurring Fair Value Measurements at Reporting*

(dollars in thousands)	As of December 31, 2011		Quoted prices in active markets for identical assets (Level 1)		Active markets for similar *assets* *(Level 2)*		Unobservable inputs *(Level 3)*

Assets:
Available for Sale:
U.S. Agency securities	$	114,906	$	—	$	114,906	$	—
Collateralized mortgage obligations		938,964		—		938,964		—
Mortgage-backed securities (1)		237,044		—		237,044		—
State and municipal securities		212,511		—		212,511		—

Total available for sale securities		1,503,425		—		1,503,425		—
Fair value swap asset		9,200		—		9,200		—
Fair value of derivative loan contracts		8		—		8		—

Total assets at fair value	$	1,512,633	$	—	$	1,512,633	$	—

Liabilities:
Fair value swap liability	$	9,242	$	—	$	9,242	$	—
Fair value of derivative loan contracts		2		—		2		—

Total liabilities at fair value	$	9,244	$	—	$	9,244	$	—

(1)	The MBS included in the tables above are residential MBS.

Pacific Capital Bancorp and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED

NOTE 2.

FAIR VALUE OF FINANCIAL INSTRUMENTS – CONTINUED

Financial Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

The Company is required to periodically measure certain financial assets at fair value on a nonrecurring basis. The financial assets identified in the table below are fair value measurements that resulted from the application of lower of cost or fair value accounting and were written-down to the fair value during the nine months ended September 30, 2012, and September 30, 2011. The amounts disclosed in the table below represent the fair value as of the date of the most recent fair value adjustment as well as the losses for the periods. A summary of the assets measured at fair value on a nonrecurring basis are summarized in the tables below:


			*Nonrecurring Fair Value* *Measurements at Reporting*
(dollars in thousands)	As of September 30, 2012		Quoted prices in active markets for identical assets *(Level 1)*		Active markets for similar assets (Level 2)		Unobservable inputs *(Level 3)*		Losses for the Nine Months Ended September 30, 2012

Foreclosed collateral	$	15,863	$	—	$	15,863	$	—	$	2,358	(1)

Servicing rights		917		—		—		917		98	(2)

Total assets at fair value	$	16,780	$	—	$	15,863	$	917	$	2,456


			*Nonrecurring Fair Value* *Measurements at Reporting*
(dollars in thousands)	As of September 30, 2011		Quoted prices in active markets for identical assets *(Level 1)*		Active markets for similar assets (Level 2)		Unobservable inputs *(Level 3)*		Losses for the Nine Months Ended September 30, 2011

Foreclosed collateral	$	24,434	$	—	$	24,434	$	—	$	4,554	(1)

Servicing rights		313		—		—		313		111	(2)

Total assets at fair value	$	24,747	$	—	$	24,434	$	313	$	4,665

(1)	Losses were recognized due to the decline of real estate values.

(2)	Losses were recognized due to higher than previously estimated prepayments as a result of a decline in overall interest rates.

There were no liabilities measured at fair value on a nonrecurring basis for the periods presented within this note of these Consolidated Financial Statements. There were no transfers in or out of the Company’s Level 3 financial assets during the periods presented within this note of these Consolidated Financial Statements by reason of a change in the methodology for establishing the fair value.

Pacific Capital Bancorp and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED

NOTE 2.

FAIR VALUE OF FINANCIAL INSTRUMENTS – CONTINUED

Disclosure of the Fair Value of Financial Instruments

The disclosure below provides the carrying value and fair value of the financial instruments which are not carried on the Company’s Consolidated Financial Statements at fair value or are carried at the lower of cost or fair value and not disclosed in the recurring or nonrecurring fair value measurements in the tables above.


	*September 30, 2012*				*December 31, 2011*
(dollars in thousands)	*Carrying* *Amount*		*Fair* *Value*		Carrying Amount		*Fair* *Value*

Assets:
Cash and due from banks		$ 46,512		$ 46,512		$ 49,324		$ 49,324
Interest bearing demand deposits in other financial institutions		520,272		520,272		173,408		173,408
Loans held for investment, net		3,736,730		3,804,460		3,655,433		3,704,493
FHLB stock and other investments		68,861		68,861		76,356		76,356

Liabilities:
Deposits (excluding CDs)		3,282,902		3,282,902		3,058,078		3,058,078
CDs		1,374,879		1,394,988		1,558,962		1,578,189
Other borrowings		72,766		78,704		66,524		70,735
Securities sold under agreements to repurchase		313,434		326,020		315,919		318,370

A summary of the valuation methodology used to disclose the fair value of the financial instruments in the table above is as follows:

Cash and Due from Banks and Interest Bearing Demand Deposits in Other Financial Institutions

The carrying values of cash and interest bearing demand deposits in other financial institutions represent the fair value. The Company classifies cash and interest bearing demand deposits in other financial institutions within Level 1 of the fair value hierarchy.

Loans Held for Investment, net

The carrying value of the loans held for investment at September 30, 2012, and December 31, 2011, was significantly impacted by the write down to fair value at the Transaction Date due to the application of purchase accounting related to the Investment Transaction. At the Transaction Date, the loans purchased were at fair value based on the contractual cash flows expected to be collected. The fair value presented above is calculated based on the present value of expected principal and interest cash flows. The carrying value of the loans is net of the ALLL which represents Management’s evaluation of expected credit losses inherent in those loan portfolios. These methods are based on the entrance price concept versus the exit price concept described in ASC 820, Fair Value Measurements.

Pacific Capital Bancorp and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED

NOTE 2.

FAIR VALUE OF FINANCIAL INSTRUMENTS – CONTINUED

The methods used to estimate the fair value of loans are sensitive to the assumptions and estimates used. While Management has attempted to use assumptions and estimates that best reflect the Company’s loan portfolio and current market conditions, a greater degree of subjectivity is inherent in these values than in those determined in active markets. Accordingly, readers are cautioned in using this information for purposes of evaluating the financial condition and/or value of the Company in and of itself or in comparison with any other company and amounts presented may not be realized in a current sale between willing buyers and willing sellers. The Company classifies these loans within Level 3 of the fair value hierarchy.

Deposits (excluding Certificates of Deposit)

The fair value of demand deposits, money market accounts, and savings accounts is the amount payable on demand at September 30, 2012, and December 31, 2011. The Company classifies these deposits in Level 1 of the fair value hierarchy.

Certificates of Deposit

The fair value of fixed-maturity CDs is estimated by discounting the interest and principal payments using the rates currently offered for deposits of similar remaining maturities. The Company classifies these deposits in Level 3 of the fair value hierarchy.

Other Borrowings

The fair value of trust preferred securities is estimated by using discounted cash flow model which uses the interest and principal payments using current market rates for comparable debt. Accordingly, other borrowings are classified in Level 2 of the fair value hierarchy.

Securities Sold Under Agreements to Repurchase

The fair value of repurchase agreements is determined by reference to rates in the wholesale repurchase market. The rates paid to the Company’s clients are slightly lower than rates in the wholesale market and, consequently, the fair value will generally be less than the carrying amount. The fair value of the long term repurchase agreements is determined in the same manner as other borrowings above. Therefore, repurchase agreements are classified in Level 2 of the fair value hierarchy.

Disclosed Fair Value of Financial Instruments is not Equivalent to Franchise Value

The financial instruments disclosed in this note include such items as securities, loans, deposits, debt, and other instruments. Disclosure of fair values is not required for certain assets and liabilities that are not financial instruments such as premises and equipment, prepaid expenses, and income tax assets and liabilities. Accordingly, the aggregate fair value of amounts presented in this note does not purport to represent, and should not be considered representative of, the underlying “market” or franchise value of the Company. Further, due to a variety of alternative valuation techniques and approaches permitted by the fair value measurement accounting standards as well as the significant assumptions that are required to be made in the process of valuation, the determinations or estimations of fair value for many of the financial instruments disclosed in this note could and do differ between various market participants. A direct comparison of the Company’s fair value information with that of other financial institutions may not be appropriate.

Pacific Capital Bancorp and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED

NOTE 3.

INVESTMENT SECURITIES

A summary of investment securities held by the Company at September 30, 2012, and December 31, 2011, is as follows:


	*September 30, 2012*
(dollars in thousands)	*Amortized* *Cost*		Gross Unrealized *Gains*		Gross Unrealized *Losses*		*Fair Value*
Available for sale:
U.S. Agency securities (1)	$	87,568	$	329	$	—	$	87,897
Mortgage-backed securities (2)		191,289		7,153		(31)		198,411
Collateralized mortgage obligations (3)		754,482		11,991		(466)		766,007
State and municipal securities		177,875		14,727		(797)		191,805

Total securities	$	1,211,214	$	34,200	$	(1,294)	$	1,244,120


	*December 31, 2011*
(dollars in thousands)	*Amortized* *Cost*		Gross Unrealized Gains		Gross Unrealized Losses		*Fair Value*
Available for sale:
U.S. Agency securities (1)	$	114,278	$	628	$	—	$	114,906
Mortgage-backed securities (2)		232,737		4,378		(71)		237,044
Collateralized mortgage obligations (3)		931,875		9,471		(2,382)		938,964
State and municipal securities		209,930		4,583		(2,002)		212,511

Total securities	$	1,488,820	$	19,060	$	(4,455)	$	1,503,425

(1)

U.S. Agency securities are general obligations that are not backed by the full faith and credit of the United States government and consist of Government Sponsored Enterprises issued by the Federal Farm Credit, Federal Home Loan Mortgage Corporation (“FHLMC”), Federal National Mortgage Association (“FNMA”), Federal Home Loan Bank and Tennessee Valley Authority.

(2)

Mortgage-backed securities are securitized mortgage loans that are not backed by the full faith and credit of the United States Government and consist of Government Sponsored Enterprises which guarantee the collection of principal and interest payments. The securities primarily consist of securities issued by FHLMC and FNMA.

(3)

Collateralized mortgage obligations (“CMOs”) are securities which pool together mortgages and separate them into short, medium, or long term positions called tranches. The CMOs in the table above primarily consist of securities issued by Government National Mortgage Association (“GNMA”), FNMA, FHLMC, and private label.

Pacific Capital Bancorp and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED

NOTE 3.

INVESTMENT SECURITIES – CONTINUED

Available for Sale Securities

At September 30, 2012, and December 31, 2011, the Company held $1.24 billion and $1.50 billion, respectively, of securities in its AFS portfolio. Unrealized gains or losses relating to AFS securities are accounted for by adjusting the carrying amount of the securities. An offsetting entry after the adjustment for taxes at the Company’s corporate effective tax rate, when applicable, is recognized in AOCI.

Fair values are obtained from independent sources based on current market prices for the specific security held by the Company or for a security with similar characteristics. If a security is in an unrealized loss position, Management is required to determine whether or not the security is temporarily or permanently impaired.

The following tables show all AFS securities that are in an unrealized loss position, and temporarily impaired, as of September 30, 2012, and December 31, 2011:


	*September 30, 2012*
	*Less than 12 months*				*12 months or more*				*Total*
(dollars in thousands)	*Fair Value*		Unrealized Loss		*Fair Value*		Unrealized Loss		*Fair Value*		Unrealized Loss
Municipal bonds	$	6,057	$	(293)	$	12,701	$	(504)	$	18,758	$	(797)
Mortgage-backed securities		1,184		(26)		391		(5)		1,575		(31)
Collateralized mortgage obligations		1,666		(9)		18,791		(457)		20,457		(466)

Total	$	8,907	$	(328)	$	31,883	$	(966)	$	40,790	$	(1,294)


	*December 31, 2011*
	*Less than 12 months*				*12 months or more*				*Total*
(dollars in thousands)	*Fair Value*		Unrealized Loss		*Fair Value*		Unrealized Loss		*Fair Value*		Unrealized Loss
Municipal bonds	$	6,359	$	(21)	$	45,230	$	(1,981)	$	51,589	$	(2,002)
Mortgage-backed securities		2,784		(36)		2,910		(35)		5,694		(71)
Collateralized mortgage obligations		184,141		(1,978)		1,450		(404)		185,591		(2,382)

Total	$	193,284	$	(2,035)	$	49,590	$	(2,420)	$	242,874	$	(4,455)

As of September 30, 2012, and December 31, 2011, 65 and 142 AFS securities were in a loss position, respectively. The $1.3 million and $4.5 million of unrealized losses for the AFS portfolio as of September 30, 2012, and December 31, 2011, respectively, are primarily a result of changes in market interest rates. The fair value is based on current market prices obtained from independent sources for each security held. At September 30, 2012, the issuers of these securities have not, to the Company’s knowledge, established any cause for default on these securities and the most recent credit ratings on all securities have an investment grade rating. At September 30, 2012, the Company holds no securities with a credit rating below investment grade. At September 30, 2012, Management does not intend to sell any of the securities in a loss position nor are there any conditions present at September 30, 2012, that would require Management to sell them. As such, Management does not believe that there are any securities that are OTTI as of September 30, 2012.

Pacific Capital Bancorp and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED

NOTE 3.

INVESTMENT SECURITIES – CONTINUED

Contractual Maturities for Securities Portfolio

The amortized cost and estimated fair value of debt securities at September 30, 2012, and December 31, 2011, by weighted average contractual maturity, are shown in the table below:


	*September 30, 2012*				*December 31, 2011*
(dollars in thousands)	Amortized Cost		Estimated Fair Value		Amortized Cost		Estimated Fair Value
Available for sale securities:
In one year or less	$	79,201	$	79,459	$	83,611	$	83,892
After one year through five years		902,317		919,148		1,063,218		1,072,379
After five years through ten years		96,787		101,120		190,895		194,750
After ten years		132,909		144,393		151,096		152,404

Total securities	$	1,211,214	$	1,244,120	$	1,488,820	$	1,503,425

Expected maturities will differ from contractual maturities because borrowers or issuers have the right to call or prepay investment securities. Changes in interest rates may also impact borrowers or issuers of investment securities and cause them to prepay investment securities earlier than the contractual term.

Interest Income

The following table summarizes interest income from investment securities:


	*Three Months Ended* *September 30,*				*Nine Months Ended* *September 30,*
(dollars in thousands)	*2012*		*2011*		*2012*		*2011*
Interest income for AFS securities:
Taxable:
U.S. Agency securities	$	230	$	296	$	724	$	1,114
Asset-backed securities		—		—		—		73
CMO’s and MBS		4,630		4,784		14,964		12,677
Nontaxable:
State and municipal securities		1,931		2,149		5,989		6,473

Total interest income for AFS securities	$	6,791	$	7,229	$	21,677	$	20,337

Pledged Securities

Securities with a carrying value of approximately $710.9 million and $688.3 million at September 30, 2012, and December 31, 2011, respectively, were pledged to secure public funds, trust deposits, repurchase agreements and other borrowings as required or permitted by law.

Pacific Capital Bancorp and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED

NOTE 3.

INVESTMENT SECURITIES – CONTINUED

Investment in FHLB and Reserve Bank Stock

The Company’s investment in stock of the FHLB was $46.6 million and $54.3 million at September 30, 2012, and December 31, 2011, respectively. As with other investment securities, the investment in FHLB stock is periodically evaluated for impairment based on, among other things, the capital adequacy of the FHLB and its overall financial condition. Based on the current capital adequacy, liquidity position and recent credit ratings of the FHLB, Management believes there is no impairment in the Company’s investment at September 30, 2012, and that the cost of the investment approximates fair value. The Company’s investment in stock of the Reserve Bank was $18.8 million at September 30, 2012, and December 31, 2011. The investments of FHLB and Reserve Bank stock are included in FHLB stock and other investments on the Company’s Consolidated Balance Sheets.

NOTE 4.

LOANS

Loans Held for Sale

As of September 30, 2012, and December 31, 2011, the Company had loans held for sale with a carrying value of $18.1 million, and $3.1 million, respectively, representing residential 1 to 4 family unit loans.

Loans Held for Investment

The composition of the Company’s loans held for investment portfolio at carrying value is as follows:


(dollars in thousands)	September 30, 2012		December 31, 2011

Real estate:
Residential - 1 to 4 family	$	1,204,734	$	1,040,126
Multifamily		543,391		344,643
Commercial		1,486,464		1,588,852
Construction		67,290		185,400
Revolving - 1 to 4 family		226,357		249,857
Commercial loans		164,498		189,226
Consumer loans		40,181		49,977
Other loans		10,983		12,880

Total loans held for investment	$	3,743,898	$	3,660,961

The table above includes PCI Term Pools and PCI Revolving Pools, which were recorded at fair value at the Transaction Date. The loan balances above are net of deferred loan origination fees, commitment extension fees and origination costs. These unamortized net deferred costs totaled $3.0 million and $1.1 million at September 30, 2012, and December 31, 2011, respectively, and relate only to loans originated after the Transaction Date. Unamortized net deferred fees were eliminated in the purchase accounting at the Transaction Date.

Pacific Capital Bancorp and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED

NOTE 4.

LOANS - CONTINUED

A summary of the carrying balances of loans originated or purchased since the Transaction Date are as follows, and excludes loans held for sale:


(dollars in thousands)	September 30, 2012		December 31, 2011

Real estate:
Residential - 1 to 4 family	$	567,667	$	296,257
Multifamily		365,115		151,417
Commercial		159,801		114,307
Construction		10,993		1,793
Revolving - 1 to 4 family		5,434		3,890
Commercial loans		26,444		11,622
Consumer loans		5,702		6,404
Other loans		3,658		2,335

Total	$	1,144,814	$	588,025

Loan Purchases

The following table summarizes loans the Company purchased during the periods presented:


	Three Months Ended September 30,				Nine Months Ended September 30,
(dollars in thousands)	*2012*		*2011*		*2012*		*2011*
Real estate:
Residential - 1 to 4 family	$	79,679	$	14,023	$	184,147	$	39,991
Multifamily		—		5,110		44,268		102,901
Commercial		—		—		—		90,559
Net, purchase premium/(discount)		1,473		227		(1,262)		(8,671)

Total loans purchased	$	81,152	$	19,360	$	227,153	$	224,780

During the three and nine months ended September 30, 2012, the Company purchased $81.2 million and $227.2 million of loans, respectively. Loans purchased during the three months ended September 30, 2012, were residential real estate 1 to 4 family loans. Loan purchases for the nine months ended September 30, 2012, were residential real estate 1 to 4 family and multifamily loans.

During the three and nine months ended September 30, 2011, the Company purchased loans of $19.4 million, and $224.8 million, respectively. These loans consisted of residential real estate 1 to 4 family loans, multifamily and commercial real estate loans.

All loans purchased during the three and nine months ended September 30, 2012, and 2011, were performing loans at the time of purchase, and are not considered credit impaired. The determination to not classify loans purchased at a discount as purchased credit impaired was based on due diligence performed prior to their purchase. When reviewing and selecting loans for purchase, the Company required that the loans have no delinquencies during the previous 36 months, i.e., all contractual payments had been made on time. In addition, a majority of the loans purchased were seasoned loans which were originated prior to 2005. All these loans were assigned an internal credit risk grade of “Pass” at the date of purchase.

Pacific Capital Bancorp and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED

NOTE 4.

LOANS - CONTINUED

Loan Sales and Transactions

A summary of the loan sale activities by loan portfolio, excluding SBA loans, is below:


	*Three Months Ended* *September 30,*				*Nine Months Ended* *September 30,*
(dollars in thousands)	*2012*		*2011*		*2012*		*2011*
Loans sold:
Residential real estate loans	$	50,157	$	11,685	$	105,182	$	53,478
Commercial real estate and construction loans		3,850		—		3,850		2,500

Total loans sold, net carrying value	$	54,007	$	11,685	$	109,032	$	55,978

Net gain on loans sold:
Net gain on residential real estate loans	$	1,367	$	214	$	2,361	$	819

Total net gain on loans sold	$	1,367	$	214	$	2,361	$	819

Loans sold with servicing released:
Residential real estate loans	$	5,307	$	1,849	$	9,350	$	28,340
Commercial real estate and construction loans		3,850		—		3,850		2,500

Total loans sold with servicing released, net carrying value	$	9,157	$	1,849	$	13,200	$	30,840

Loans sold with servicing retained:
Residential real estate loans	$	44,850	$	9,836	$	95,832	$	25,138

Total loans sold with servicing retained, net carrying value	$	44,850	$	9,836	$	95,832	$	25,138


Servicing rights recorded on loans sold:	$	347	$	92	$	819	$	259

Pledged Loans

At September 30, 2012, and December 31, 2011, loans secured by residential and commercial real estate with principal balances totaling $55.7 million, and $45.9 million, respectively, were pledged to the FHLB as collateral for borrowings. The amounts pledged do not represent the amount of outstanding borrowings that are required to be supported by collateral. The Company maintains an excess of collateral at these institutions so that it may borrow without having to first transfer collateral to them.

Pacific Capital Bancorp and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED

NOTE 4.

LOANS - CONTINUED

Unfunded Loan Commitments and Letters of Credit

As of September 30, 2012, and December 31, 2011, the contractual commitments for unfunded commitments and letters of credit are as follows:


	*September 30, 2012*
(dollars in thousands)	*Total*		Less than one year		One to three years		Three to five years		More than five years
Unfunded commitments	$	412,286	$	142,340	$	58,186	$	42,131	$	169,629
Standby letters of credit and financial guarantees		75,855		23,120		14,441		32,839		5,455

Total	$	488,141	$	165,460	$	72,627	$	74,970	$	175,084


	*December 31, 2011*
(dollars in thousands)	*Total*		Less than one year		One to three years		Three to five years		More than five years
Unfunded commitments	$	488,611	$	145,827	$	60,156	$	81,248	$	201,380
Standby letters of credit and financial guarantees		69,426		40,553		13,417		3,119		12,337

Total	$	558,037	$	186,380	$	73,573	$	84,367	$	213,717

Standby letters of credit and financial guarantees are conditional commitments issued by the Company to guarantee the performance of a client to a third party in borrowing arrangements. At September 30, 2012, the maximum undiscounted future payments that the Company could be required to make were $488.1 million. Approximately 33.9% of these arrangements mature within one year. The Company generally has recourse to recover from the client any amounts paid under these guarantees. Most of the guarantees are fully collateralized by the same types of assets used as loan collateral, however several are unsecured.

The Company anticipates that a majority of the above commitments will not be fully drawn on by clients. Consumers do not tend to borrow the maximum amounts available under their home equity lines and businesses typically arrange for credit lines in excess of their expected needs to handle contingencies. A majority of the lines of credit are adjustable rate commitments that are tied to an interest rate index. If a rate is fixed on a line of credit, the commitments are not usually for more than three months.

The reserve for the unfunded loan commitments and letters of credit was $12.9 million and $16.2 million at September 30, 2012, and December 31, 2011, respectively. The reserve for unfunded loan commitments declined during 2012, primarily due to the expiration of commitments. Refer to Note 1, “Summary of Significant Accounting Policies” of these Consolidated Financial Statements for additional information regarding the accounting for unfunded commitments and letters of credit.

Pacific Capital Bancorp and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED

NOTE 4.

LOANS - CONTINUED

The table below summarizes the reserve for unfunded loan commitments:


	Three Months Ended September 30,				Nine Months Ended September 30,
(dollars in thousands)	*2012*		*2011*		*2012*		*2011*
Beginning balance	$	14,435	$	19,063	$	16,184	$	19,032
(Reductions)/additions, net		(1,504)		33		(3,253)		64

Balance	$	12,931	$	19,096	$	12,931	$	19,096

Related Parties

In the ordinary course of business, the Company has extended credit to directors and executive officers of the Company. These extensions of credit were made on the same terms, including interest rates and collateral, as those prevailing at the time for comparable loans with persons not related to the Company. These related party loans totaled $1.9 million at September 30, 2012, and December 31, 2011. At September 30, 2012, the maturities of the related party loans were approximately 26 years, and were made to senior officers of the Company. Such loans are subject to ratification by the Board of Directors, exclusive of the borrowing director or officer. Federal banking regulations require that any such extensions of credit not be offered on terms more favorable than would be offered to non-related party borrowers of similar credit worthiness.

NOTE 5.

PURCHASED CREDIT IMPAIRED POOLS

As discussed in Note 1, “Summary of Significant Accounting Policies” of these Consolidated Financial Statements, the Company has classified all of the loans acquired on the Transaction Date as PCI loans, and grouped those loans into pools, with each pool containing loans that possess similar risk characteristics. PCI loans that are revolving lines of credit are referred to as PCI Revolving Pools, while the remainder of the loans purchased are referred to as PCI Term Pools.

Pacific Capital Bancorp and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED

NOTE 5.

PURCHASED CREDIT IMPAIRED POOLS – CONTINUED

The following table summarizes the balance of PCI Term Pools:


(dollars in thousands)	September 30, 2012		December 31, 2011
Real estate:
Residential - 1 to 4 family	$	584,362	$	679,282
Multifamily		176,929		191,850
Commercial		1,322,142		1,454,837
Construction		51,605		179,646
Revolving - 1 to 4 family		—		5,949
Commercial loans		40,551		56,806
Consumer loans		17,936		22,342
Other loans		4,905		5,838

Total PCI term pools - carrying balance	$	2,198,430	$	2,596,550



Total PCI term pools - unpaid principal balance	$	2,411,020	$	2,841,625

The following table summarizes the balance of the PCI Revolving Pools:


(dollars in thousands)	September 30, 2012		December 31, 2011
Real estate:
Residential - 1 to 4 family	$	52,705	$	64,587
Multifamily		1,347		1,376
Commercial		4,521		19,708
Construction		4,692		3,961
Revolving - 1 to 4 family		220,923		240,018
Commercial loans		97,503		120,798
Consumer loans		16,543		21,231
Other loans		2,420		4,707

Total PCI revolving pools - carrying balance	$	400,654	$	476,386



Total PCI revolving pools - unpaid principal balance	$	468,661	$	557,023

Pacific Capital Bancorp and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED

NOTE 5.

PURCHASED CREDIT IMPAIRED POOLS – CONTINUED

The following table summarizes the accretable yield or income expected to be collected for PCI Term Pools purchased:


	Three Months Ended September 30,				*Nine Months Ended* *September 30,*
(dollars in thousands)	*2012*		*2011*		*2012*		*2011*

Balance at beginning of period	$	537,093	$	686,671	$	577,105	$	785,001
Accretion of income (1)		(42,158)		(45,492)		(128,319)		(149,388)
Reclassification from nonaccretable difference related to improvement in credit loss expectations (2)		10,845		2,880		70,963		8,446
Reclassification to nonaccretable difference related to changes in prepayment expectations and other factors (3)		(22,251)		—		(36,220)		—

Balance at end of period	$	483,529	$	644,059	$	483,529	$	644,059

(1)	Accretion of income represents the recognition of the discount rate used to present value the expected cash flows.

(2)	Relates to changes in credit loss expectations.

(3)	Relates primarily to changes in prepayment expectations, and also relates to changes in spot rates for variable rate loans.

Pacific Capital Bancorp and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED

NOTE 6.

ALLOWANCE FOR LOAN AND LEASE LOSSES

The following tables summarize the activity within the ALLL for the three and nine months ended September 30, 2012, and 2011:


	*Three Months Ended September 30, 2012*
(dollars in thousands)	Beginning Balance at June 30, *2012*		*Charge-offs*		*Recoveries*		Provision for loan and lease losses		Ending Balance at September 30, 2012
Real estate:
Residential - 1 to 4 family	$	3,182	$	—	$	—	$	750	$	3,932
Multifamily		906		—		—		171		1,077
Commercial		762		—		1		162		925
Construction		66		—		—		214		280
Revolving - 1 to 4 family		100		—		—		6		106
Commercial loans		835		—		—		(286)		549
Consumer loans		101		—		54		(146)		9
Other loans		70		(35)		12		28		75
Purchased credit impaired loans		527		(273)		—		(39)		215

Total	$	6,549	$	(308)	$	67	$	860	$	7,168


	*Three Months Ended September 30, 2011*
(dollars in thousands)	Beginning Balance at June 30, *2011*		*Charge-offs*		*Recoveries*		Provision for loan and lease losses		Ending Balance at September 30, 2011
Real estate:
Residential - 1 to 4 family	$	1,398	$	—	$	—	$	81	$	1,479
Multifamily		528		—		—		133		661
Commercial		537		—		—		92		629
Construction		7		—		—		(6)		1
Revolving - 1 to 4 family		72		—		—		(11)		61
Commercial loans		623		(25)		—		282		880
Consumer loans		250		—		—		64		314
Other loans		162		(73)		22		152		263

Total	$	3,577	$	(98)	$	22	$	787	$	4,288

Pacific Capital Bancorp and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED

NOTE 6.

ALLOWANCE FOR LOAN AND LEASE LOSSES - CONTINUED


	*Nine Months Ended September 30, 2012*
(dollars in thousands)	Beginning Balance at December 31, 2011		*Charge-offs*		*Recoveries*		Provision for loan and lease losses		Ending Balance at September 30, 2012
Real estate:
Residential - 1 to 4 family	$	1,952	$	—	$	—	$	1,980	$	3,932
Multifamily		783		—		—		294		1,077
Commercial		722		(1)		1		203		925
Construction		20		—		—		260		280
Revolving - 1 to 4 family		71		—		—		35		106
Commercial loans		437		—		—		112		549
Consumer loans		327		(75)		77		(320)		9
Other loans		349		(137)		36		(173)		75
Purchased credit impaired loans		867		(273)		—		(379)		215

Total	$	5,528	$	(486)	$	114	$	2,012	$	7,168


	*Nine Months Ended September 30, 2011*
(dollars in thousands)	Beginning Balance at December 31, 2010		*Charge-offs*		*Recoveries*		Provision for loan and lease losses		Ending Balance at September 30, 2011
Real estate:
Residential - 1 to 4 family	$	120	$	—	$	—	$	1,359	$	1,479
Multifamily		—		—		—		661		661
Commercial		—		—		—		629		629
Construction		—		—		—		1		1
Revolving - 1 to 4 family		28		—		—		33		61
Commercial loans		206		(25)		—		699		880
Consumer loans		69		(8)		—		253		314
Other loans		97		(203)		51		318		263
Purchased credit impaired loans		—		(300)		—		300		—

Total	$	520	$	(536)	$	51	$	4,253	$	4,288

The ALLL at September 30, 2012, and December 31, 2011, relates to the Company’s estimate of credit losses inherent in loans originated or purchased since the Transaction Date, as well as estimates for losses in PCI Loan Pools to the extent that estimates for cash flows from those pools are below Management’s prior expectations. At September 30, 2012, and December 31, 2011, the majority of the ALLL relates to loans the Company originated or purchased since the Transaction Date. At September 30, 2012, and December 31, 2011, the portion of the ALLL that related to PCI Loan Pools was $215,000, and $867,000, respectively, and is attributed to one PCI Term Pool. At September 30, 2012, cash flows from all other PCI Loan Pools were within Management’s expectations, and no additional ALLL was required to be recognized during the nine months ended September 30, 2012.

Pacific Capital Bancorp and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED

NOTE 6.

ALLOWANCE FOR LOAN AND LEASE LOSSES – CONTINUED

For the three and nine months ended September 30, 2012, and 2011, charge-offs and recoveries related to overdrafts, and small consumer loans. Charge-offs during the three and nine months ended September 30, 2011, primarily relate to a write down on one PCI Term Pool and overdrafts. Provision for loan and lease losses for the three and nine months ended September 30, 2012, and 2011, relate primarily to an increase in the balance of originated or purchased loans during those periods with lower historical loss rates, and better performance than expected in the PCI Loan Pools.

Nonperforming Loans

Nonperforming loans include nonaccrual loans, loans past due 90 days which are accruing interest, and TDRs. The reporting for nonperforming loans was significantly impacted by the Investment Transaction as described in Note 1, “Summary of Significant Accounting Policies,” and Note 5, “Purchased Credit Impaired Pools” of these Consolidated Financial Statements, because all loans were recorded at their fair value at the Transaction Date, and the majority of the Company’s loans as of and since the Transaction Date are accounted for as PCI loans under ASC 310-30. At September 30, 2012, and December 31, 2011, all of the nonperforming loans reported in the table below are from the PCI Revolving Pools, or were originated or purchased since the Transaction Date.

The table below summarizes loans classified as nonperforming:


(dollars in thousands)	September 30, 2012		December 31, 2011
Nonaccrual loans:
Real estate:
Residential - 1 to 4 family	$	2,308	$	2,896
Multifamily		247		—
Commercial		1,191		426
Construction		—		320
Revolving - 1 to 4 family		7,157		6,842
Commercial loans		3,962		5,275
Consumer loans		79		155
Other loans		329		481

Total nonaccrual loans (1)		15,273		16,395

Troubled debt restructured loans:
Real estate:
Residential - 1 to 4 family		1,031		732
Revolving - 1 to 4 family		196		—
Commercial loans		398		305
Consumer loans		77		—

Total troubled debt restructured loans		1,702		1,037


Total nonperforming loans	$	16,975	$	17,432

(1)

Nonaccrual loans do not include TDRs that have been placed on nonaccruing status.

Pacific Capital Bancorp and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED

NOTE 6.

ALLOWANCE FOR LOAN AND LEASE LOSSES – CONTINUED

The table below summarizes troubled debt restructurings:


(dollars in thousands)	September 30, 2012		December 31, 2011
Troubled debt restructurings:
Nonaccrual status	$	1,194	$	1,037
Accrual status		508		—

Total troubled debt restructured loans	$	1,702	$	1,037

Pacific Capital Bancorp and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED

NOTE 6.

ALLOWANCE FOR LOAN AND LEASE LOSSES – CONTINUED

Classified and Nonclassified Loans

The following table summarizes classified and nonclassified loans as defined in Note 1, “Summary of Significant Accounting Policies” of these Consolidated Financial Statements. The amounts are reported at the net carrying amounts at September 30, 2012, and December 31, 2011:


	*September 30, 2012*
(dollars in thousands)	*Non-Classified*		*Classified*		*Total*

Loans Originated or Purchased Since Transaction Date:
Real estate:
Residential - 1 to 4 family	$	567,667	$	—	$	567,667
Multifamily		364,868		247		365,115
Commercial		159,060		741		159,801
Construction		10,993		—		10,993
Revolving - 1 to 4 family		5,434		—		5,434
Commercial loans		25,456		988		26,444
Consumer loans		5,702		—		5,702
Other loans		3,576		82		3,658

		1,142,756		2,058		1,144,814

PCI Revolving Pools:
Real estate:
Residential - 1 to 4 family		47,486		5,219		52,705
Multifamily		1,347		—		1,347
Commercial		3,549		972		4,521
Construction		4,692		—		4,692
Revolving - 1 to 4 family		210,370		10,553		220,923
Commercial loans		82,603		14,900		97,503
Consumer loans		16,155		388		16,543
Other loans		1,961		459		2,420

		368,163		32,491		400,654

PCI Term Pools:
Real estate:
Residential - 1 to 4 family		526,556		57,806		584,362
Multifamily		163,941		12,988		176,929
Commercial		1,109,650		212,492		1,322,142
Construction		32,927		18,678		51,605
Commercial loans		29,112		11,439		40,551
Consumer loans		17,446		490		17,936
Other loans		4,645		260		4,905

		1,884,277		314,153		2,198,430



Total loans held for investment	$	3,395,196	$	348,702	$	3,743,898

Pacific Capital Bancorp and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED

NOTE 6.

ALLOWANCE FOR LOAN AND LEASE LOSSES – CONTINUED


	*December 31, 2011*
(dollars in thousands)	*Non-Classified*		*Classified*		*Total*

Loans Originated or Purchased Since Transaction Date:
Real estate:
Residential - 1 to 4 family	$	296,257	$	—	$	296,257
Multifamily		151,417		—		151,417
Commercial		114,307		—		114,307
Construction		1,793		—		1,793
Revolving - 1 to 4 family		3,890		—		3,890
Commercial loans		11,622		—		11,622
Consumer loans		6,404		—		6,404
Other loans		2,222		113		2,335

		587,912		113		588,025

PCI Revolving Pools:
Real estate:
Residential - 1 to 4 family		59,505		5,082		64,587
Multifamily		1,376		—		1,376
Commercial		18,923		785		19,708
Construction		3,641		320		3,961
Revolving - 1 to 4 family		227,889		12,129		240,018
Commercial loans		107,268		13,530		120,798
Consumer loans		20,542		689		21,231
Other loans		4,054		653		4,707

		443,198		33,188		476,386

PCI Term Pools:
Real estate:
Residential - 1 to 4 family		595,104		84,178		679,282
Multifamily		180,971		10,879		191,850
Commercial		1,158,546		296,291		1,454,837
Construction		69,318		110,328		179,646
Revolving - 1 to 4 family		2,086		3,863		5,949
Commercial loans		34,937		21,869		56,806
Consumer loans		21,563		779		22,342
Other loans		4,662		1,176		5,838

		2,067,187		529,363		2,596,550



Total loans held for investment	$	3,098,297	$	562,664	$	3,660,961

Pacific Capital Bancorp and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED

NOTE 6.

ALLOWANCE FOR LOAN AND LEASE LOSSES – CONTINUED

The Company closely monitors and assesses credit quality and credit risk in the loan portfolio on an ongoing basis. Loan credit risk grades and classifications of loans are reviewed and updated periodically. The credit risk grades for large classified loans are reviewed at a minimum on a quarterly basis as disclosed in Note 1, “Summary of Significant Accounting Policies” of these Consolidated Financial Statements.

The Company uses internally assigned credit risk grades in monitoring the credit quality of the loan portfolio. Changes in credit risk grades serve as indications of potential problem loans, and improvement or worsening of existing problem loans, which assist the Company with the process of determining the ultimate collectability of the loan portfolio for loans originated or purchased since the Transaction Date, and assists with determining future cash flows for the PCI Loan Pools. Changes in balances of classified and nonclassified loans are factors that impact the required level of the ALLL for new and purchased loans since the Transaction Date under the Company’s periodic evaluation of the adequacy of the ALLL. Changes in classified and nonclassified loans are also considered by the Company in its periodic evaluation of cash flows from PCI Loan Pools, but do not necessarily indicate impairment or the need for an ALLL or a reversal of a previously established ALLL for PCI Loan Pools, as such loans are accounted for based on expected cash flows, as more fully described in Note 1, “Summary of Significant Accounting Policies,” of these Consolidated Financial Statements. Changes in credit risk grades for PCI Loan Pools serve primarily as a basis for the Company to manage the underlying credit quality and collection efforts of loans within PCI Loan Pools, and for the establishment of assumptions used by the Company in estimating cash flows expected to be collected from these pools in future periods.

Aging of Past Due Loans

A majority of the loans held by the Company have been pooled into PCI Term Pools and none of the pools were considered past due at September 30, 2012, and December 31, 2011, when reporting on a pooled basis in accordance with ASC 310-30. The following tables provide the aging of past due loans on an individual loan basis at the net carrying amount at September 30, 2012, and December 31, 2011.

Pacific Capital Bancorp and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED

NOTE 6.

ALLOWANCE FOR LOAN AND LEASE LOSSES – CONTINUED


	*September 30, 2012*
(dollars in thousands)	*Current*		30-89 Days Past Due		90+ Days Past Due - Still Accruing		*Nonaccrual (1)*		*Total*
Loans Originated or Purchased Since Transaction Date:
Real estate:
Residential - 1 to 4 family	$	567,667	$	—	$	—	$	—	$	567,667
Multifamily		364,819		49		—		247		365,115
Commercial		159,060		—		—		741		159,801
Construction		10,993		—		—		—		10,993
Revolving - 1 to 4 family		5,434		—		—		—		5,434
Commercial loans		26,444		—		—		—		26,444
Consumer loans		5,702		—		—		—		5,702
Other loans		3,622		36		—		—		3,658

		1,143,741		85		—		988		1,144,814

PCI Revolving Pools:
Real estate:
Residential - 1 to 4 family		48,691		843		—		3,171		52,705
Multifamily		1,347		—		—		—		1,347
Commercial		4,071		—		—		450		4,521
Construction		4,692		—		—		—		4,692
Revolving - 1 to 4 family		212,556		1,014		—		7,353		220,923
Commercial loans		88,782		4,624		—		4,097		97,503
Consumer loans		16,313		151		—		79		16,543
Other loans		1,976		115		—		329		2,420

		378,428		6,747		—		15,479		400,654

PCI Term Pools:
Real estate:
Residential - 1 to 4 family		567,002		5,263		12,097		—		584,362
Multifamily		175,515		661		753		—		176,929
Commercial		1,293,504		11,591		17,047		—		1,322,142
Construction		44,275		792		6,538		—		51,605
Commercial loans		35,233		306		5,012		—		40,551
Consumer loans		17,503		433		—		—		17,936
Other loans		4,905		—		—		—		4,905

		2,137,937		19,046		41,447		—		2,198,430



Total loans held for investment	$	3,660,106	$	25,878	$	41,447	$	16,467	$	3,743,898

(1)

At September 30, 2012, $8.1 million of nonaccruing loans were current, and $2.0 million of nonaccruing loans were 30-89 days past due.

Pacific Capital Bancorp and Subsidiaries

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – CONTINUED

NOTE 6.

ALLOWANCE FOR LOAN AND LEASE LOSSES – CONTINUED


	*December 31, 2011*
(dollars in thousands)	*Current*		30-89 Days Past Due		90+ Days Past Due - Still Accruing		*Nonaccrual (1)*		*Total*

Loans Originated or Purchased Since Transaction Date:
Real estate:
Residential - 1 to 4 family	$	296,257	$	—	$	—	$	—	$	296,257
Multifamily		151,314		103		—		—		151,417
Commercial		114,306		1		—		—		114,307
Construction		1,793		—		—		—		1,793
Revolving - 1 to 4 family		3,890		—		—		—		3,890
Commercial loans		11,321		301		—		—		11,622
Consumer loans		6,335		69		—		—		6,404
Other loans		2,306		29		—		—		2,335

		587,522		503		—		—		588,025

PCI Revolving Pools:
Real estate:
Residential - 1 to 4 family		58,973		1,986		—		3,628		64,587
Multifamily		1,376

PACIFIC CAPITAL BANCORP /CA/ 10-Q