DBRS Downgrades Pacific Capital Bancorp to B; Ratings Still Under Review with Negative Implications

DBRS has today downgraded all ratings of Pacific Capital Bancorp (PCBC or the Company) and its bank subsidiary, Pacific Capital Bank, N.A (the Bank), including PCBC’s Issuer & Senior Debt rating to B from BB (high) and the Bank’s Deposits & Senior Debt rating to BB from BBB. All ratings remain Under Review with Negative Implications.

The ratings action follows a much greater than expected Q2 2009 net loss of $362.6 million. The downgrade reflects continued outsized losses from elevated problem loans at the Company and DBRS’s expectation of further quarterly losses even with the announcement of future expense reduction initiatives. Excluding the large one-time charges taken in the second quarter, DBRS notes that the Company’s income before provisions and taxes (IBPT) is currently negative, making it extremely difficult for PCBC to work through its significant asset quality issues. As a result of the greater than expected Q2 2009 net loss, PCBC has been unable to meet the Office of the Comptroller of the Currency’s (OCC) stricter capital requirements, which could result in more regulatory actions and/or additional scrutiny. Ratings also reflect recent market events, which further constrains the Company’s financial flexibility.

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.

In Q2 2009, PCBC reported a large net loss available to common shareholders of $362.6 million compared to a net loss of $7.9 million in the first quarter, which is typically the Company’s best performing quarter as it includes the vast majority of its RAL and RT business results. DBRS notes that the current quarter included a non-cash $128.7 million goodwill impairment and a non-cash $25.6 million tax expense from the creation of a full valuation allowance of the Company’s deferred tax asset. Excluding these two non-cash items, the net loss would still have been a very large $208.3 million. Driving the loss was another outsized loan loss provision of $194.1 million at the Core Bank. Even excluding the provision and all one-time items incurred during the quarter, the Company was still unable to generate positive IBPT as expenses outpaced total revenues. DBRS notes that the margin did improve 26 basis points during the quarter to 2.99%, but planned asset sales and expenses associated with problem loans should continue to pressure IBPT over the intermediate term.

Despite high levels of charge-offs, non-performing assets (NPAs) continue to increase at a rapid rate. Indeed, NPAs increased another 29% to $348.3 million, or a very high 6.17% of total loans held for investment driven by commercial real estate loans. It does appear that the Company has become more aggressive in addressing problem loans. Approximately, 27% of all NPAs were still current, but have evidenced weakness. Furthermore, PCBC has revised its loan loss reserve methodology to place more emphasis on recent losses, which contributed $88 million of the increase in the provision. Of the $194.1 million in provisions at the Core Bank, $77.1 million went to cover net charge-offs (NCOs) and $117 million built the reserve to a high 4.57% of loans and 74% of NPAs. Approximately 75% of the NCOs were related to the Company’s residential construction and commercial and industrial portfolios. Annualized, Q2 2009 NCOs were 5.40% of average loans compared to 5.18% in the first quarter and 2.05% a year ago. With rising delinquencies, California unemployment at record levels and housing values yet to find a bottom, DBRS expects credit costs to remain elevated over the intermediate term and mute earnings.

While regulatory capital remains above the normal well-capitalized threshold, the large loss prevented the Company from meeting the higher Tier 1 leverage ratio mandated by the OCC’s memorandum of understanding. Specifically, PCBC’s leverage ratio was 5.6%, which was significantly below the required 8.5%. This requirement increases to 9% by the end of the third quarter. DBRS is most concerned with the declining tangible common equity (TCE) ratio, which DBRS estimates to be approaching 3%, which signifies PCBC’s loss absorption abilities are waning. Even with asset sales, the Company will be hard pressed to meet the stricter capital requirements or maintain an adequate TCE ratio, especially without a capital raise. PCBC has acknowledged that it has hired a firm to explore strategic alternatives and has submitted a three year strategic and capital plan to the OCC. Highlights of the plan include selling $150 million of real estate secured loans by the end of the year to reduce its CRE concentration and provide capital relief. Additionally, the Company is undertaking comprehensive expense reduction initiatives that are expected to save $45 to $55 million annually by 2012.

Another major concern is whether the regulators will allow the Company to operate under lower capital levels during the 2010 tax season or that some sort of off-balance sheet vehicle will be available to support the refund anticipation loan (RAL) and refund transfer (RT) business, which generates much needed capital. If PCBC is unable to operate this business at or near its full potential, there would likely be further negative rating implications.

The review will focus on what strategic plans management will undertake to position the Company for improved financial fundamentals, the ability of PCBC to operate its RAL/RT business at or near capacity, 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. With a weak tangible common equity ratio and more potential losses coming, DBRS notes that significant downside risk to the ratings remain if large quarterly losses continue. The Company must make progress during the third quarter with asset sales and raising common equity to bolster capital metrics.

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.