DBRS Downgrades Pacific Capital Bancorp to BBB; Places all Ratings Under Review Negative

DBRS has today downgraded the ratings of Pacific Capital Bancorp (PCBC or the Company) and its bank subsidiary, Pacific Capital Bank, N.A, including the Company’s Issuer & Senior Debt rating to BBB from BBB (high). At the same time, DBRS placed the long- and short-term ratings of the Company Under Review with Negative Implications.

The ratings action follows a first quarter loss of $7.9 million driven by continued elevated loan loss provisioning and weaker than anticipated Refund Anticipation Loan (RAL) results. As stated in its press release last quarter, DBRS noted that PCBC must deliver another successful RAL season in order to provide capital to absorb future potential credit losses to prevent a downgrade. While the RAL and Refund Transfer (RT) businesses were positive contributors in the quarter, the results were down 49% compared to last year and were not sufficient to offset losses at the Core Bank (excludes RAL & RT results).

The Company’s ratings are underpinned by a well-established community banking franchise along the demographically attractive central California coastline. The ratings also take into account PCBC’s strong niche in the nationwide RAL and RT programs, where it processes more than 30% of all transactions in the industry.

Driving the 49% decline for the RAL and RT programs were higher losses associated with a change in IRS tax return methodology, a change in mix to less profitable RTs, higher funding costs and lower overall volume. The change in IRS screening was detected three weeks into the program and the Company subsequently adopted internal underwriting guidelines to match the new methodology. However, those three weeks prior to changing internal underwriting standards led to increased losses and provisioning. Despite the softer year, management remains committed to the business and expects future results to improve based on its tougher internal screening, especially when the economy begins to improve.

Asset quality at the Core Bank remains under pressure. During the quarter, non-performing loans (NPLs) increased $26.9 million driven primarily by commercial loans related to the residential construction industry. Specifically, NPLs represent a high 4.59% of Core Bank total loans held for investment compared to 4.07% last quarter and 2.93% a year ago. Delinquencies are still increasing as well pointing to additional problems in the future. Meanwhile, annualized net charge-offs (NCOs) were a substantial 5.18% at the Core Bank, up from 3.50% the prior quarter. Over half of the NCOs were related to the problematic construction portfolio that saw further significant declines in collateral values. With California unemployment at record levels and housing values yet to find a bottom, DBRS expects credit costs to remain elevated the remainder of the year and mute earnings. To address asset quality issues, PCBC plans to reduce its overall concentration in commercial real estate, decrease hold limits to make the loan portfolio more granular, will no longer make out-of-footprint loans and has increased staff to deal with problem loans.

Positively, the Company was able to grow core deposits in the quarter to enhance liquidity. However, these deposits were invested in short-term low risk assets with low yields, which compressed the margin to 2.83% from 2.87% at the Core Bank. DBRS notes that the pressured margin combined with lower contributions from fee-based businesses have hurt income before provisions and taxes (IBPT). In the first quarter, IBPT was only $3.7 million, which makes it difficult for the Company to earn its way out of asset quality problems, especially given the weaker RAL results. To address this issue, PCBC has already announced a headcount reduction of approximately 22% and is in the process of evaluating additional strategic moves that could include asset sales, outsourcing or other changes.

Management expects the Office of the Comptroller of the Currency (OCC) to establish stricter capital requirements for PCBC. The toughest condition would be an increased leverage ratio, which stood at 6.8% at quarter end. The Company expects the OCC to require an 8.5% leverage ratio at the end of the second quarter and a 9% leverage ratio by the end of the third quarter. While management believes they will be in compliance with the new capital requirements, any higher than anticipated losses could put PCBC under the OCC guidelines and could result in more regulatory actions. DBRS notes that the balance sheet will come down following the RAL season and management is looking to participate out portions of some of their larger performing loans to other banks.

The review will focus on what strategic plans management will undertake to position the Company for improved financial fundamentals, whether balance sheet initiatives will achieve the desired regulatory capital ratios mandated by the OCC and whether elevated credit costs will continue to invade capital and pressure overall results. DBRS notes that there is a high amount of uncertainty where the ratings will ultimately come out given all the moving parts under the review.

Pacific Capital Bancorp, a financial holding company based in Santa Barbara, California, reported total assets of $9.2 billion at March 31, 2009.

Notes:
All figures are in U.S. dollars unless otherwise noted.

The applicable methodologies are Rating Banks and Bank Holding Companies Operating in the United States, and Enhanced Methodology for Bank Ratings – Intrinsic and Support Assessments which can be found on our website under Methodologies.

This is a Corporate (Financial Institutions) rating.