UNITED STATES SECURITIES AND EXCHANGE
COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

ý

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

 

FOR THE QUARTERLY PERIOD ENDED June 30, 2003

 

 

OR

 

 

o

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.....0-20800

 

STERLING FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

 

Washington

 

91-1572822

(State or other jurisdiction of
incorporation or organization)

 

(I.R.S. Employer
Identification No.)

 

111 North Wall Street, Spokane, Washington 99201

(Address of principal executive offices) (Zip Code)

 

(509) 458-2711

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 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 ý  No o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).  Yes ý  No o

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date:

 

Class

 

Outstanding as of July 31, 2003

 

 

 

Common Stock ($1.00 par value)

 

14,781,418

 

 



 

STERLING FINANCIAL CORPORATION

 

FORM 10-Q
For the Quarter Ended June 30, 2003

 

TABLE OF CONTENTS

 

PART I - Financial Information

 

 

Item 1 -

Financial Statements (Unaudited)

 

 

Consolidated Balance Sheets

 

 

Consolidated Statements of Income

 

 

Consolidated Statements of Cash Flows

 

 

Consolidated Statements of Comprehensive Income

 

 

Notes to Consolidated Financial Statements

 

 

Item 2 -

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

 

Item 3 -

Quantitative and Qualitative Disclosures About Market Risk

 

 

Item 4 -

Controls and Procedures

 

PART II - Other Information

 

 

Item 1 -

Legal Proceedings

 

 

Item 2 -

Changes in Securities and Use of Proceeds

 

 

Item 3 -

Defaults Upon Senior Securities

 

 

Item 4 -

Submission of Matters to a Vote of Security Holders

 

 

Item 5 -

Other Information

 

 

Item 6 -

Exhibits and Reports on Form 8-K

 

Signatures

 



 

PART I - Financial Information
Item 1 - Financial Statements
STERLING FINANCIAL CORPORATION
Consolidated Balance Sheets
(Unaudited)

 

 

 

June 30,
2003

 

December 31,
2002

 

 

 

(Dollars in thousands)

 

ASSETS:

 

 

 

 

 

Cash and cash equivalents:

 

 

 

 

 

Interest bearing

 

$

10,100

 

$

2,525

 

Non-interest bearing and vault

 

74,540

 

74,540

 

Restricted

 

8,965

 

1,526

 

Investments and asset-backed securities (“ABS”):

 

 

 

 

 

Available for sale

 

1,073,869

 

826,692

 

Held to maturity

 

2,834

 

3,476

 

Loans receivable, net

 

2,668,990

 

2,390,263

 

Loans held for sale

 

50,625

 

22,549

 

Accrued interest receivable

 

16,205

 

14,625

 

Real estate owned, net

 

3,982

 

3,953

 

Office properties and equipment, net

 

51,921

 

47,745

 

Bank-owned life insurance (“BOLI”)

 

71,189

 

59,399

 

Goodwill

 

45,075

 

43,977

 

Other intangible assets

 

3,038

 

0

 

Mortgage servicing rights, net

 

2,078

 

1,680

 

Prepaid expenses and other assets, net

 

11,176

 

13,114

 

Total assets

 

$

4,094,587

 

$

3,506,064

 

 

 

 

 

 

 

LIABILITIES:

 

 

 

 

 

Deposits

 

$

2,393,707

 

$

2,014,096

 

Advances from Federal Home Loan Bank of Seattle (“FHLB Seattle”)

 

995,119

 

874,515

 

Securities sold subject to repurchase agreements and funds purchased

 

276,958

 

249,769

 

Other borrowings

 

139,782

 

127,682

 

Cashiers checks issued and payable

 

13,418

 

13,371

 

Borrowers’ reserves for taxes and insurance

 

1,825

 

1,401

 

Accrued interest payable

 

7,158

 

6,344

 

Accrued expenses and other liabilities

 

20,277

 

15,230

 

Total liabilities

 

3,848,244

 

3,302,408

 

 

 

 

 

 

 

Commitments and Contingencies

 

 

 

 

 

 

 

 

 

 

 

SHAREHOLDERS’ EQUITY:

 

 

 

 

 

Preferred stock, $1 par value; 10,000,000 shares authorized; no shares issued and outstanding

 

0

 

0

 

Common stock, $1 par value; 40,000,000 shares authorized; 14,781,418 and 11,958,948 shares issued and outstanding

 

14,781

 

11,959

 

Additional paid-in capital

 

180,825

 

125,177

 

Accumulated other comprehensive income (loss):
Unrealized gains (losses) on investments and ABS available-for-sale, net of deferred income taxes of $(509) and $1,852

 

(945

)

3,439

 

Retained earnings

 

51,682

 

63,081

 

 

 

 

 

 

 

Total shareholders’ equity

 

246,343

 

203,656

 

 

 

 

 

 

 

Total liabilities and shareholders’ equity

 

$

4,094,587

 

$

3,506,064

 

 

1



 

STERLING FINANCIAL CORPORATION
Consolidated Statements of Income
(Unaudited)

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2003

 

2002

 

2003

 

2002

 

 

 

(Dollars in thousands, except per share data)

 

 

 

 

 

 

 

 

 

 

 

Interest income:

 

 

 

 

 

 

 

 

 

Loans

 

$

42,376

 

$

38,885

 

$

82,715

 

$

78,080

 

ABS

 

9,214

 

7,786

 

19,186

 

15,587

 

Investments and cash equivalents

 

1,061

 

1,030

 

2,235

 

2,200

 

Total interest income

 

52,651

 

47,701

 

104,136

 

95,867

 

 

 

 

 

 

 

 

 

 

 

Interest expense:

 

 

 

 

 

 

 

 

 

Deposits

 

9,493

 

11,590

 

18,513

 

22,850

 

Short-term borrowings

 

2,695

 

1,546

 

5,466

 

3,275

 

Long-term borrowings

 

10,423

 

11,197

 

21,546

 

22,985

 

Total interest expense

 

22,611

 

24,333

 

45,525

 

49,110

 

 

 

 

 

 

 

 

 

 

 

Net interest income

 

30,040

 

23,368

 

58,611

 

46,757

 

 

 

 

 

 

 

 

 

 

 

Provision for losses on loans

 

(2,550

)

(2,227

)

(4,800

)

(4,313

)

Net interest income after provision for losses on loans

 

27,490

 

21,141

 

53,811

 

42,444

 

 

 

 

 

 

 

 

 

 

 

Other income:

 

 

 

 

 

 

 

 

 

Fees and service charges

 

4,909

 

4,089

 

9,208

 

7,929

 

Mortgage banking operations

 

2,496

 

1,050

 

4,713

 

2,356

 

Loan servicing fees (costs)

 

(153

)

320

 

(69

)

594

 

Net gains on sales of securities

 

1,677

 

311

 

3,037

 

397

 

Real estate owned operations

 

(180

)

(2

)

(209

)

(194

)

Charge related to early repayment of debt

 

0

 

0

 

(1,464

)

0

 

BOLI

 

968

 

881

 

1,790

 

1,702

 

Other noninterest income (expense)

 

(28

)

96

 

(208

)

(210

)

 

 

 

 

 

 

 

 

 

 

Total other income

 

9,689

 

6,745

 

16,798

 

12,574

 

Operating expenses

 

22,604

 

19,752

 

44,015

 

39,419

 

 

 

 

 

 

 

 

 

 

 

Income before income taxes

 

14,575

 

8,134

 

26,594

 

15,599

 

Income tax provision

 

(5,058

)

(2,398

)

(9,294

)

(4,282

)

 

 

 

 

 

 

 

 

 

 

Net income

 

$

9,517

 

$

5,736

 

$

17,300

 

$

11,317

 

 

 

 

 

 

 

 

 

 

 

Earnings per share - basic

 

$

0.64

 

$

0.44

 

$

1.21

 

$

0.88

 

 

 

 

 

 

 

 

 

 

 

Earnings per share - diluted

 

$

0.63

 

$

0.43

 

$

1.18

 

$

0.85

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding - basic

 

14,771,708

 

13,031,704

 

14,244,227

 

12,903,754

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding - diluted

 

15,147,572

 

13,465,641

 

14,602,015

 

13,392,933

 

 

The accompanying notes are an integral part of the consolidated financial statements.

 

2



 

STERLING FINANCIAL CORPORATION
Consolidated Statements of Cash Flows
(Unaudited)

 

 

 

Six Months Ended
June 30,

 

 

 

2003

 

2002

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

Cash flows from operating activities:

 

 

 

 

 

Net income

 

$

17,300

 

$

11,317

 

Adjustments to reconcile net income to net cash provided by operating activities:

 

 

 

 

 

Provisions for losses on loans and real estate owned

 

4,945

 

4,491

 

Stock dividends on FHLB Seattle stock

 

(2,928

)

(1,190

)

Net gain on sales of loans, investments and ABS

 

(6,387

)

(2,892

)

Other losses

 

113

 

610

 

Change in cash surrender value of BOLI

 

(1,790

)

(1,705

)

Depreciation and amortization

 

5,806

 

4,615

 

Change in:

 

 

 

 

 

Accrued interest receivable

 

(1,309

)

488

 

Prepaid expenses and other assets

 

6,578

 

(3,684

)

Cashiers checks issued and payable

 

(1,888

)

(4,581

)

Accrued interest payable

 

323

 

1,690

 

Accrued expenses and other liabilities

 

777

 

(6,110

)

Proceeds from sales of loans

 

209,735

 

134,360

 

Real estate loans originated for sale

 

(206,385

)

(131,865

)

 

 

 

 

 

 

Net cash provided by operating activities

 

24,890

 

5,544

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Change in restricted cash

 

(7,439

)

438

 

Loans funded

 

(1,074,374

)

(726,815

)

Loan principal received

 

828,734

 

654,368

 

Purchase of investments

 

(11,853

)

(32,039

)

Proceeds from maturities of investments

 

1,531

 

29,929

 

Proceeds from sales of available-for-sale investments

 

10,681

 

1,400

 

Cash and cash equivalents acquired as part of acquisitions

 

143,631

 

0

 

Purchase of BOLI

 

(10,000

)

(25,000

)

Purchase of ABS

 

(991,720

)

(251,906

)

Principal payments on ABS

 

166,722

 

92,759

 

Proceeds from sales of ABS

 

581,160

 

202,131

 

Purchase of office properties and equipment

 

(2,150

)

(406

)

Improvements and other changes to real estate owned

 

123

 

(830

)

Proceeds from sales and liquidation of real estate owned

 

1,875

 

3,950

 

 

 

 

 

 

 

Net cash used in investing activities

 

(363,079

)

(52,021

)

 

The accompanying notes are an integral part of the consolidated financial statements.

 

3



 

STERLING FINANCIAL CORPORATION
Consolidated Statements of Cash Flows (continued)
(Unaudited)

 

 

 

Six Months Ended
June 30,

 

 

 

2003

 

2002

 

 

 

(Dollars in thousands)

 

Cash flows from financing activities:

 

 

 

 

 

Net change in checking, passbook and money market deposits

 

$

54,404

 

$

106,974

 

Proceeds from issuance of certificates of deposit

 

785,335

 

565,173

 

Payments for maturing certificates of deposit

 

(661,334

)

(567,831

)

Interest credited to deposits

 

16,983

 

21,367

 

Advances from FHLB Seattle

 

296,102

 

74,000

 

Repayment of FHLB Seattle advances

 

(185,072

)

(86,805

)

Net change in securities sold subject to repurchase agreements and funds purchased

 

27,189

 

(67,291

)

Proceeds from other borrowings

 

54,000

 

0

 

Repayment of other borrowings

 

(41,900

)

(5,000

)

Payments for fractional shares

 

(30

)

(21

)

Proceeds from exercise of stock options, net of repurchases

 

583

 

672

 

Deferred financing costs

 

(732

)

0

 

Other

 

236

 

316

 

Net cash provided by financing activities

 

345,764

 

41,554

 

 

 

 

 

 

 

Net change in cash and cash equivalents

 

7,575

 

(4,923

)

Cash and cash equivalents, beginning of period

 

77,065

 

65,654

 

 

 

 

 

 

 

Cash and cash equivalents, end of period

 

$

84,640

 

$

60,731

 

 

 

 

 

 

 

Supplemental disclosures:

 

 

 

 

 

Cash paid during the period for:

 

 

 

 

 

Interest

 

$

46,299

 

$

47,780

 

Income taxes

 

9,457

 

7,868

 

 

 

 

 

 

 

Noncash financing and investing activities:

 

 

 

 

 

Loans converted into real estate owned

 

1,309

 

5,354

 

Common stock dividend

 

28,699

 

23,809

 

Common stock issued upon business combination

 

28,107

 

0

 

 

The accompanying notes are an integral part of the consolidated financial statements.

 

4



 

STERLING FINANCIAL CORPORATION
Consolidated Statements of Comprehensive Income
(Unaudited)

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2003

 

2002

 

2003

 

2002

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

9,517

 

$

5,736

 

$

17,300

 

$

11,317

 

 

 

 

 

 

 

 

 

 

 

Other comprehensive income:

 

 

 

 

 

 

 

 

 

Change in unrealized gains (losses) on investments and ABS available-for-sale

 

(6,943

)

8,999

 

(6,745

)

8,644

 

Less deferred income taxes

 

2,430

 

(3,149

)

2,361

 

(3,024

)

 

 

 

 

 

 

 

 

 

 

Net other comprehensive income (loss)

 

(4,513

)

5,850

 

(4,384

)

5,620

 

 

 

 

 

 

 

 

 

 

 

Comprehensive income

 

$

5,004

 

$

11,586

 

$

12,916

 

$

16,937

 

 

The accompanying notes are an integral part of the consolidated financial statements.

 

5



 

STERLING FINANCIAL CORPORATION
Notes to Consolidated Financial Statements

 

1.                                      Basis of Presentation:

The foregoing unaudited interim consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X as promulgated by the Securities and Exchange Commission.  Accordingly, these financial statements do not include all of the disclosures required by accounting principles generally accepted in the United States of America for complete financial statements.  These unaudited interim consolidated financial statements should be read in conjunction with the audited consolidated financial statements for the year ended December 31, 2002.  In the opinion of management, the unaudited interim consolidated financial statements furnished herein include all adjustments, all of which are of a normal recurring nature, necessary for a fair statement of the results for the interim periods presented.

 

The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities known to exist as of the date the financial statements are published, and the reported amounts of revenues and expenses during the reporting period.  Uncertainties with respect to such estimates and assumptions are inherent in the preparation of Sterling Financial Corporation’s (“Sterling’s”) consolidated financial statements; accordingly, it is possible that the actual results could differ from these estimates and assumptions, which could have a material effect on the reported amounts of Sterling’s consolidated financial position and results of operations.

 

2.                                      Other Borrowings:

The components of other borrowings are as follows (in thousands):

 

 

 

June 30,
2003

 

December 31,
2002

 

 

 

 

 

 

 

Term note payable(1)

 

$

25,000

 

$

25,000

 

Advances on revolving line of credit(2)

 

0

 

0

 

Sterling obligated mandatorily redeemable preferred capital securities of subsidiary trusts holding solely junior subordinated deferrable interest debentures of Sterling(3)

 

78,000

 

64,000

 

Floating Rate Notes Due 2006(4)

 

30,000

 

30,000

 

Other(5)

 

6,782

 

8,682

 

 

 

 

 

 

 

Total other borrowings

 

$

139,782

 

$

127,682

 

 


(1)          Sterling has a variable-rate term note with U.S. Bank, N.A. (“U.S. Bank”).  This note matures on September 17, 2007.  Interest accrues at the 30-day London Interbank Offering Rate (“LIBOR”) plus 2.50% (3.82% at June 30, 2003) and is payable monthly.  Principal payments are due in annual installments of $3.0 million commencing September 30, 2003, with the entire unpaid balance due at maturity.  This note is collateralized by a majority of the Common and Preferred Stock of Sterling Savings Bank.

 

(2)          Sterling has a $5.0 million revolving line-of-credit with U.S. Bank. This line of credit matures on September 15, 2003.  The interest rate is adjustable monthly at the 30-day LIBOR plus 2.50% (3.82% at June 30, 2003) and is payable monthly.  This note is collateralized by a majority of the Common and Preferred Stock of Sterling Savings Bank.  At June 30, 2003, no amounts were outstanding under this line.

 

(3)          Sterling raises capital from time to time through the formation of trusts (“Sterling Capital Trusts”), which issue capital securities (“Trust Preferred Securities”) to investors. The Sterling Capital Trusts are business trusts in which Sterling owns all of the common equity.  The proceeds from the sale of the Trust Preferred Securities are used to purchase junior subordinated deferrable interest debentures (“Junior Subordinated Debentures”) issued by Sterling.  Sterling’s obligations under the Junior Subordinated Debentures and related

 

6



 

                        documents, taken together, constitute a full and unconditional guarantee by Sterling of Sterling Capital Trusts’ obligations under the Trust Preferred Securities.  The Trust Preferred Securities are treated as debt of Sterling.  Although Sterling, as a savings and loan holding company, is not subject to the Federal Reserve capital requirements for bank holding companies, the Trust Preferred Securities have been structured to qualify as Tier 1 capital, subject to certain limitations, if Sterling were to become regulated as a bank holding company.  The Junior Subordinated Debentures and related Trust Preferred Securities generally mature 30 years after issuance and are redeemable at the option of Sterling under certain conditions.  Interest is paid quarterly or semi-annually.  Details of the Trust Preferred Securities are as follows:

 

Subsidiary Issuer

 

Issue
Date

 

Maturity
Date

 

Mandatorily Redeemable
Capital Security

 

Rate At
June 30, 2003

 

Amount
(In Thousands)

 

 

 

 

 

 

 

 

 

 

 

 

 

Sterling Capital Trust VI

 

June 2003

 

April 2033

 

Floating Rate Capital Securities

 

4.32

%

$

10,000

 

 

 

 

 

 

 

 

 

 

 

 

 

Sterling Capital Statutory Trust V

 

May 2003

 

May 2033

 

Floating Rate Capital Securities

 

4.54

%

20,000

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sterling Capital Trust IV

 

May 2003

 

May 2033

 

Floating Rate Preferred Securities

 

4.44

%

10,000

 

 

 

 

 

 

 

 

 

 

 

 

 

Sterling Capital Trust III

 

April 2003

 

Sept 2033

 

Floating Rate Capital Securities

 

4.54

%

14,000

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sterling Capital Trust II

 

July 2001

 

July 2031

 

10.25% Cumulative Capital Securities

 

10.25

%

24,000

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

$

78,000

 

 

(4)          Sterling has outstanding $30.0 million of Floating Rate Notes Due 2006.  These notes are unsecured general obligations of Sterling and are subordinated to certain other existing and future indebtedness.  Under the terms of the notes, Sterling is limited in the amount of certain long-term debt that it may incur, and the notes restrict Sterling, under certain circumstances, as to the amount of cash dividends on its preferred or common stock and capital distributions which can be made.  At June 30, 2003, Sterling could have incurred approximately $52.5 million of additional long-term debt.  At June 30, 2003, Sterling could have paid up to approximately $33.6 million in additional dividends.  Interest accrues at the 90-day LIBOR plus 2.50% (3.62% at June 30, 2003) and is adjustable and payable quarterly.  The notes mature in 2006 and may be redeemed under certain conditions.

 

(5)          During 2002, Sterling financed the sale of certain loans to an unrelated party.  Since the underlying sold loans were collateral on the loan to the purchaser, this sale was accounted for as a financing.  At June 30, 2003, $6.8 million remained outstanding on the financing.

 

7



 

3.                                      Earnings Per Share:

The following table presents the basic and diluted earnings per share computations including the effect of the 10% stock dividend which was paid on May 30, 2003:

 

 

 

Three Months Ended June 30,

 

 

 

2003

 

2002

 

 

 

Net
Income

 

Weighted
Avg. Shares

 

Per Share
Amount

 

Net
Income

 

Weighted
Avg. Shares

 

Per Share
Amount

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic computations

 

$

9,517,000

 

14,771,708

 

$

0.64

 

$

5,736,000

 

13,031,704

 

$

0.44

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Effect of dilutive securities:

 

 

 

 

 

 

 

 

 

 

 

 

 

Common stock options

 

0

 

375,864

 

(0.01

)

0

 

351,145

 

(0.01

)

Convertible subordinated debt

 

0

 

0

 

0.00

 

0

 

82,792

 

0.00

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Diluted computations

 

$

9,517,000

 

15,147,572

 

$

0.63

 

$

5,736,000

 

13,465,641

 

$

0.43

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Antidilutive options not included in diluted earnings per share

 

 

 

0

 

 

 

 

 

0

 

 

 

 

 

 

Six Months Ended June 30,

 

 

 

2003

 

2002

 

 

 

Net
Income

 

Weighted
Avg. Shares

 

Per Share
Amount

 

Net
Income

 

Weighted
Avg. Shares

 

Per Share
Amount

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic computations

 

$

17,300,000

 

14,244,227

 

$

1.21

 

$

11,317,000

 

12,903,754

 

$

0.88

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Effect of dilutive securities:

 

 

 

 

 

 

 

 

 

 

 

 

 

Common stock options

 

0

 

357,788

 

(0.03

)

0

 

322,681

 

(0.02

)

Convertible subordinated debt

 

0

 

0

 

0.00

 

44,000

 

166,498

 

(0.01

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Diluted computations

 

$

17,300,000

 

14,602,015

 

$

1.18

 

$

11,361,000

 

13,392,933

 

$

0.85

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Antidilutive options not included in diluted earnings per share

 

 

 

0

 

 

 

 

 

0

 

 

 

 

8



 

4.                                      Operating Expenses:

The following table details Sterling’s components of total operating expenses:

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2003

 

2002

 

2003

 

2002

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

Employee compensation and benefits

 

$

11,997

 

$

10,409

 

$

23,955

 

$

21,027

 

Occupancy and equipment

 

3,657

 

3,154

 

7,164

 

6,168

 

Depreciation

 

1,241

 

1,060

 

2,401

 

2,126

 

Amortization of identifiable intangible assets

 

79

 

261

 

105

 

644

 

Advertising

 

1,689

 

867

 

2,049

 

1,497

 

Data processing

 

1,615

 

1,504

 

3,226

 

3,029

 

Insurance

 

183

 

166

 

350

 

272

 

Legal and accounting

 

409

 

450

 

913

 

858

 

Travel and entertainment

 

721

 

597

 

1,259

 

1,049

 

Goodwill litigation costs

 

64

 

225

 

314

 

520

 

Acquisition and merger costs

 

45

 

0

 

188

 

0

 

Other

 

904

 

1,059

 

2,091

 

2,229

 

 

 

 

 

 

 

 

 

 

 

Total operating expenses

 

$

22,604

 

$

19,752

 

$

44,015

 

$

39,419

 

 

5.                                      Segment Information:

For purposes of measuring and reporting the financial results, Sterling is divided into the following five business segments:

 

                  The Community Banking segment consists of the operations conducted by Sterling’s subsidiary, Sterling Savings Bank.

 

                  The Residential Mortgage Banking segment originates and sells servicing-retained and servicing-released residential loans through loan production offices in the Spokane and Seattle, Washington; Portland and Bend, Oregon and Boise, Idaho metropolitan areas primarily through Action Mortgage Company.

 

                  The Commercial Mortgage Banking segment originates, sells and services commercial real estate loans and participation interests in commercial real estate loans through offices in the metropolitan areas of Portland, Oregon; Spokane, Washington; and the Puget Sound region primarily through INTERVEST-Mortgage Investment Company.

 

                  The Insurance and Retail Brokerage segment markets tax-deferred annuities, mutual funds, insurance and other financial products through sales representatives within the Sterling Savings Bank branch network primarily through Harbor Financial Services, Inc. and Dime Insurance Agency.

 

             The Eliminations and Other segment represents the parent company expenses and intercompany eliminations of revenue and expenses.

 

9



 

The following table presents certain financial information regarding Sterling’s segments and provides a reconciliation to Sterling’s consolidated totals for the three and six months ended June 30, 2003 and 2002:

 

 

 

As of and for the Three Months Ended June 30, 2003

 

 

 

Community
Banking

 

Residential
Mortgage
Banking

 

Commercial
Mortgage
Banking

 

Insurance/
Retail
Brokerage

 

Eliminations
and
Other

 

Total

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

$

48,964

 

$

2,258

 

$

1,428

 

$

1

 

$

0

 

$

52,651

 

Interest expense

 

20,697

 

0

 

0

 

0

 

1,914

 

22,611

 

Net interest income (expense)

 

28,267

 

2,258

 

1,428

 

1

 

(1,914

)

30,040

 

Provision for loan losses

 

(2,550

)

0

 

0

 

0

 

0

 

(2,550

)

Noninterest income

 

10,462

 

2,523

 

618

 

508

 

(4,422

)

9,689

 

Noninterest expense

 

19,263

 

2,550

 

620

 

399

 

(228

)

22,604

 

Income before income taxes

 

$

16,916

 

$

2,231

 

$

1,426

 

$

110

 

$

(6,108

)

$

14,575

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total assets

 

$

4,135,402

 

$

19,211

 

$

13,298

 

$

1,417

 

$

(74,741

)

$

4,094,587

 

 

 

 

As of and for the Three Months Ended June 30, 2002

 

 

 

Community
Banking

 

Residential
Mortgage
Banking

 

Commercial
Mortgage
Banking

 

Insurance/
Retail
Brokerage

 

Eliminations
and
Other

 

Total

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

$

44,720

 

$

1,810

 

$

1,171

 

$

0

 

$

0

 

$

47,701

 

Interest expense

 

22,147

 

0

 

0

 

0

 

2,186

 

24,333

 

Net interest income (expense)

 

22,573

 

1,810

 

1,171

 

0

 

(2,186

)

23,368

 

Provision for loan losses

 

(2,227

)

0

 

0

 

0

 

0

 

(2,227

)

Noninterest income

 

7,637

 

1,088

 

357

 

429

 

(2,766

)

6,745

 

Noninterest expense

 

17,277

 

1,659

 

475

 

277

 

64

 

19,752

 

Income before income taxes

 

$

10,706

 

$

1,239

 

$

1,053

 

$

152

 

$

(5,014

)

$

8,134

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total assets

 

$

3,130,149

 

$

13,669

 

$

14,893

 

$

747

 

$

(71,380

)

$

3,088,078

 

 

10



 

 

 

As of and for the Six Months Ended June 30, 2003

 

 

 

Community
Banking

 

Residential
Mortgage
Banking

 

Commercial
Mortgage
Banking

 

Insurance/
Retail
Brokerage

 

Eliminations
and
Other

 

Total

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

$

96,969

 

$

4,309

 

$

2,857

 

$

1

 

$

0

 

$

104,136

 

Interest expense

 

41,514

 

0

 

0

 

0

 

4,011

 

45,525

 

Net interest income (expense)

 

55,455

 

4,309

 

2,857

 

1

 

(4,011

)

58,611

 

Provision for loan losses

 

(4,800

)

0

 

0

 

0

 

0

 

(4,800

)

Noninterest income

 

19,972

 

5,135

 

606

 

966

 

(9,881

)

16,798

 

Noninterest expense

 

37,730

 

4,650

 

1,363

 

725

 

(453

)

44,015

 

Income before income taxes

 

$

32,897

 

$

4,794

 

$

2,100

 

$

242

 

$

(13,439

)

$

26,594

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total assets

 

$

4,135,402

 

$

19,211

 

$

13,298

 

$

1,417

 

$

(74,741

)

$

4,094,587

 

 

 

 

As of and for the Six Months Ended June 30, 2002

 

 

 

Community
Banking

 

Residential
Mortgage
Banking

 

Commercial
Mortgage
Banking

 

Insurance/
Retail
Brokerage

 

Eliminations
and
Other

 

Total

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

$

90,232

 

$

3,359

 

$

2,276

 

$

0

 

$

0

 

$

95,867

 

Interest expense

 

44,588

 

0

 

0

 

0

 

4,522

 

49,110

 

Net interest income (expense)

 

45,644

 

3,359

 

2,276

 

0

 

(4,522

)

46,757

 

Provision for loan losses

 

(4,313

)

0

 

0

 

0

 

0

 

(4,313

)

Noninterest income

 

13,959

 

2,204

 

1,074

 

726

 

(5,389

)

12,574

 

Noninterest expense

 

34,520

 

3,347

 

1,055

 

511

 

(14

)

39,419

 

Income before income taxes

 

$

20,770

 

$

2,216

 

$

2,295

 

$

215

 

$

(9,897

)

$

15,599

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total assets

 

$

3,130,149

 

$

13,669

 

$

14,893

 

$

747

 

$

(71,380

)

$

3,088,078

 

 

6.                                      Stock Options:

As allowed by SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”), Sterling has elected to retain the compensation measurement principles of APB Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”), and its related interpretations, for stock options.  Under APB No. 25, compensation cost is recognized at the measurement date in the amount, if any, that the quoted market price of Sterling’s common stock exceeds the option exercise price.  The measurement date is the date at which both the number of options and the exercise price for each option are known.

 

11



 

Sterling has chosen not to record compensation expense using fair value measurement provisions in the statement of income.  Had compensation cost for Sterling’s plans been determined based on the fair value at the grant dates for awards under the plans, Sterling’s reported net income and earnings per share would have been changed to the pro forma amounts indicated below:

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2003

 

2002

 

2003

 

2002

 

 

 

(Dollars in thousands, except per share amounts)

 

 

 

 

 

 

 

 

 

 

 

Reported net income

 

$

9,517

 

$

5,736

 

$

17,300

 

$

11,317

 

Add back: Stock-based employee compensation expense, net of related tax effects

 

0

 

0

 

0

 

0

 

Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects

 

(548

)

(387

)

(1,097

)

(773

)

Pro forma

 

$

8,969

 

$

5,349

 

$

16,203

 

$

10,544

 

 

 

 

 

 

 

 

 

 

 

Basic earnings per share:

 

 

 

 

 

 

 

 

 

Reported earnings per share

 

$

0.64

 

$

0.44

 

$

1.21

 

$

0.88

 

Stock-based employee compensation, fair value

 

(0.04

)

(0.03

)

(0.07

)

(0.06

)

Pro forma earnings per share

 

$

0.60

 

$

0.41

 

$

1.14

 

$

0.82

 

 

 

 

 

 

 

 

 

 

 

Diluted earnings per share:

 

 

 

 

 

 

 

 

 

Reported earnings per share

 

$

0.63

 

$

0.43

 

$

1.18

 

$

0.85

 

Stock-based employee compensation, fair value

 

(0.04

)

(0.03

)

(0.07

)

(0.06

)

Pro forma earnings per share

 

$

0.59

 

$

0.40

 

$

1.11

 

$

0.79

 

 

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for grants in the periods above: dividend yield of 0% in each period, expected stock price volatility of 85% to 132% each period, risk-free interest rates of 2.98% to 6.52% and expected lives of four to ten years, respectively.

 

7.                                      Other Accounting Policies:

In December 2002, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 148 “Accounting for Stock-Based Compensation, Transition and Disclosure, an amendment of FASB Statement No. 123.”  SFAS No. 148 provides alternative methods of transition for an entity that voluntarily changes to the fair value based method of accounting for stock-based employee compensation.  It also amends the disclosure provisions of SFAS No. 123 to require prominent disclosure about the effects of reported net income of an entity’s accounting policy decisions with respect to stock-based employee compensation.  Finally, this Statement amends Accounting Principles Board (“APB”) Opinion No. 28, Interim Financial Reporting, to require disclosure about those effects in interim financial information.  The amendments to SFAS No. 123, which provide alternative methods of transition for an entity that voluntarily changes to the fair value based method of accounting for stock- based employee compensation is effective for financial statements for fiscal years ending after December 15, 2002.  The amendment to SFAS No. 123 relating to disclosures and the amendment to Opinion 28 is effective for financial reports containing condensed financial statements for interim periods beginning after December 15, 2002.  Sterling has adopted the disclosure provisions of SFAS No. 148 but does not intend to adopt the fair value provisions of SFAS No. 123.

 

12



 

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.”  SFAS No. 150 establishes standards on the classification and measurement of certain financial instruments with characteristics of both liabilities and equity.        SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003 and to all other instruments that exist as of the beginning of the first interim financial reporting period beginning after June 15, 2003.   Sterling does not believe that the adoption of SFAS No.150 will have a material effect on Sterling’s consolidated financial statements.

 

8.                                      Hedging Activities and Derivatives:

As of January 1, 2001, Sterling adopted the provisions of SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended by SFAS Nos. 137 and 138.  This Statement establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. The Statement requires that Sterling recognize all derivatives as either assets or liabilities in the balance sheet and measure those instruments at fair value. Changes in the fair value of the derivatives are reported in either earnings or other comprehensive income (loss), depending on the use of the derivative and whether or not it qualifies for hedge accounting.

 

In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.”  SFAS No. 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under FASB Statement No. 133, “Accounting for Derivative Instruments and Hedging Activities.”  SFAS No. 149 is effective for all contracts created or modified after June 30, 2003 except for hedging relationships designated after June 30, 2003.  In addition, except as stated below, all provisions of SFAS No. 149 should be applied prospectively.  Sterling does not believe that the adoption of this standard will have a material effect on Sterling’s consolidated financial statements.

 

Sterling periodically uses financial options and other contractual instruments for the purpose of hedging interest rate risk relative to its investment and ABS portfolios and to its mortgage lending operations. Sterling invests in ABS tranches that perform in concert with the underlying mortgages or assets; i.e., improving in value with falling interest rates and declining in value with rising interest rates. Sterling typically does not invest in “derivative products” that are structured to perform in a way that magnifies the normal impact of changes in interest rates or in a way dissimilar to the movement in value of the underlying securities.  However, Sterling may invest in such products in the future.

 

As a normal part of its operations, Action Mortgage incurs interest rate risk from the date it closes a loan to the date the loan is sold in the secondary market.  Additionally, Action Mortgage incurs interest rate risk from the date it commits to make a loan to the date the loan closes in those cases where it sells interest rate lock commitments (“rate locks”) to the prospective borrower.  Traditionally, Action Mortgage has endeavored to hedge this interest rate risk by entering into non-binding (“best-efforts”) forward sales agreements with third parties.  In July 2003, in an effort to improve the spread on loans sold into the secondary market, Action Mortgage began hedging interest rate risk by entering into mandatory forward sales agreements on ABS with third parties.

 

The risks inherent in such mandatory forward sales agreements include the risk that, if for any reason Action Mortgage does not close and sell the loans in question, it is nonetheless obligated to deliver ABS to the counterparty on the agreed terms.  Action Mortgage could incur significant costs in acquiring replacement loans or ABS and such costs could have a material adverse impact on mortgage banking operations in future periods, especially in rising interest rate environments.

 

13



 

Rate locks and forward sales agreements are considered to be derivatives under SFAS No. 133. Sterling has recorded the estimated fair values of the rate locks and forward sales agreements on its balance sheet in either other assets or other liabilities. Changes in the fair values of these derivative instruments are recorded in net gain on sales of mortgage loans in the income statement as the changes occur.

 

9.                                      Business Combinations:

On February 28, 2003, Sterling merged with Empire Federal Bancorp, Inc. (“Empire”).  The results of Empire’s operations have been included in the consolidated financial statements since that date.  The acquisition allowed Sterling to expand into Montana markets both on a lending and depository basis.  The acquisition strengthened Sterling’s capital base, adding approximately $29.2 million in capital.  Sterling also acquired approximately $143.6  million in cash, $67.3 million in loans and $184.2 million in deposits as a result of the merger.

 

The aggregate purchase price was $29.2 million which was comprised of 1,401,370 shares of the common stock of Sterling.  Sterling recorded a deposit intangible in the amount of $3.1 million related to the acquisition of Empire.  The deposit intangible will be amortized over an estimated life of 10 years.  Sterling also recorded goodwill related to the transaction of $1.0 million.  This asset is subject to SFAS No. 142 accounting rules, which include annual impairment testing.  Any estimated impairment would result in Sterling recording an impairment loss.

 

10.                               Subsequent Events

On July 15, 2003, Sterling announced that it had entered into an Agreement and Plan of Merger (the “Klamath Merger”) with Klamath First Bancorp, Inc., an Oregon corporation (“Klamath”).  Klamath will be merged with and into Sterling, with Sterling being the surviving corporation in the merger.  Klamath’s wholly-owned subsidiary, Klamath First Federal Savings and Loan Association (“Klamath First Federal”), will be merged with and into Sterling’s wholly-owned subsidiary, Sterling Savings Bank, with Sterling Savings Bank being the surviving institution.  As of June 30, 2003, Klamath had 59 branches in Oregon and Washington, with a presence in 26 of Oregon’s 36 counties.  As of June 30, 2003, Klamath reported approximately $1.4 billion in total assets including $555.0 million in loans, $1.1 billion in deposits and $121.5 million of equity.

 

Under the terms of the Klamath Merger, each share of Klamath common stock will be converted into 0.77 shares of Sterling common stock subject to certain conditions.  Based upon the closing price for Sterling on July 14, 2003 of $26.55 per share, the consideration is equivalent to $20.44 per share of Klamath common stock.                      The merger will be structured as a tax-free reorganization and is expected to be completed in the first quarter of 2004, subject to the approval of Sterling’s and Klamath’s shareholders and regulators.

 

14



 

STERLING FINANCIAL CORPORATION

Comparison of the Three and Six Months Ended June 30, 2003 and 2002

 

This report contains forward-looking statements.  For a discussion about such statements, including the risks and uncertainties inherent therein, see “Forward-Looking Statements.”  Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Consolidated Financial Statements and Notes presented elsewhere in this report and in Sterling’s current annual report on Form 10-K.

 

General

 

Sterling Financial Corporation (“Sterling”) is a unitary savings and loan holding company, the significant operating subsidiary of which is Sterling Savings Bank. The significant operating subsidiaries of Sterling Savings Bank are Action Mortgage Company (“Action Mortgage”), INTERVEST-Mortgage Investment Company (“INTERVEST”), Dime Insurance Agency (“Dime”) and Harbor Financial Services, Inc. (“Harbor Financial”). Sterling Savings Bank commenced operations in 1983 as a Washington State-chartered, federally insured stock savings and loan association headquartered in Spokane, Washington.

 

Sterling provides personalized, quality financial services to its customers as exemplified by its “Hometown Helpful” philosophy.  Sterling believes that this dedication to personalized service has enabled it to maintain a stable retail deposit base.  With $4.09 billion in total assets at June 30, 2003, Sterling attracts Federal Deposit Insurance Corporation (“FDIC”)-insured deposits from the general public through 83 retail branches located in Washington, Oregon, Idaho and Montana.

 

Sterling originates loans through its branch offices as well as Action Mortgage residential loan production offices in the metropolitan areas of Spokane and Seattle, Washington; Portland and Bend, Oregon; Boise, Idaho; and in Montana; and through INTERVEST commercial real estate lending offices located in the metropolitan areas of Spokane and Seattle, Washington; and Portland, Oregon.  Sterling brokers property and casualty insurance coverage through Dime in Montana.  Sterling also markets tax-deferred annuities, mutual funds and other financial products through Harbor Financial.

 

Sterling continues to enhance its presence as a community bank by increasing its commercial real estate, business banking, consumer and construction lending while increasing its retail deposits, particularly transaction accounts.  Commercial real estate, business banking, consumer and construction loans generally produce higher yields than residential loans.  Management believes that a community bank mix of assets and liabilities will enhance its net interest income (“NII”) (the difference between the interest earned on loans and investments and the interest paid on liabilities) and other fee income will increase, although there can be no assurance in this regard.  Such loans, however, generally involve a higher degree of risk than financing residential real estate.  Sterling’s revenues are derived primarily from interest earned on loans and asset-backed securities (“ABS”), from fees and service charges and from mortgage banking operations.  The operations of Sterling Savings Bank, and savings institutions generally, are influenced significantly by general economic conditions and by policies of its primary regulatory authorities, the Office of Thrift Supervision (“OTS”), the FDIC and the State of Washington Department of Financial Institutions (“Washington Supervisor”).

 

During the quarter ended June 30, 2003, Sterling redeemed $40.0 million of 9.50% Cumulative Capital Securities and issued a series of floating rate trust preferred securities totaling $54.0 million.  See “Liquidity and Sources of Funds” and Note 2 of “Notes to Consolidated Financial Statements.”  In May 2003, Sterling paid a 10% stock dividend to shareholders of record at May 5, 2003.  As a result, Sterling issued 1,342,428 shares of its common stock.

 

On February 28, 2003, Sterling acquired Empire Federal Bancorp, Inc.  Empire was merged with and into Sterling, with Sterling being the surviving corporation in the merger.  Sterling issued 1,401,370 shares of common stock in exchange for all of the stock of Empire.  Sterling acquired approximately $143.6 million of cash, $67.3 million of loans, $184.2 million of deposits and $29.2 million of capital in the transaction.  See Note 9 of “Notes to Consolidated Financial Statements.”

 

15



 

On July 15, 2003, Sterling announced that it had entered into an Agreement and Plan of Merger (the “Klamath Merger”) with Klamath First Bancorp, Inc., an Oregon corporation (“Klamath”).  Klamath will be merged with and into Sterling, with Sterling being the surviving corporation in the merger.  Klamath’s wholly-owned subsidiary, Klamath First Federal Savings and Loan Association, will be merged with and into Sterling’s wholly-owned subsidiary, Sterling Savings Bank, with Sterling Savings Bank being the surviving institution.

 

Under the terms of the Klamath Merger, each share of Klamath common stock will be converted into 0.77 shares of Sterling common stock subject to certain conditions.  Based upon the closing price for Sterling on July 14, 2003 of $26.55 per share, the consideration is equivalent to $20.44 per share of Klamath common stock.  The merger will be structured as a tax-free reorganization and is expected to be completed in the first quarter of 2004.  See Note 10 of “Notes to Consolidated Financial Statements.”

 

Sterling intends to continue to pursue an aggressive growth strategy to become the leading community bank in the Pacific Northwest.  This strategy may include acquiring other financial businesses or branches thereof or other substantial assets or deposit liabilities.  Sterling may not be successful in identifying further acquisition candidates, integrating acquisitions or preventing such acquisitions from having an adverse effect on Sterling.  There is significant competition for acquisitions in Sterling’s market area, and Sterling may not be able to acquire other businesses on attractive terms.  Furthermore, the success of Sterling’s growth strategy will depend on increasing and maintaining sufficient levels of regulatory capital, obtaining necessary regulatory approvals, generating appropriate growth and favorable economic and market conditions.  There can be no assurance that Sterling will be successful in implementing its growth strategy.

 

Critical Accounting Policies

 

The accounting and reporting policies of Sterling conform to accounting principles generally accepted in the United States of America (“GAAP”) and to general practices within the banking industry. The preparation of the financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.  Sterling’s management has identified the accounting policies described below as those that, due to the judgments, estimates and assumptions inherent in those policies, are critical to an understanding of Sterling’s Consolidated Financial Statements and Management’s Discussion and Analysis.

 

Income RecognitionSterling recognizes interest income by methods that conform to general accounting practices within the banking industry. In the event management believes collection of all or a portion of contractual interest on a loan has become doubtful, which generally occurs after the loan is 90 days past due, Sterling discontinues the accrual of interest and any previously accrued interest recognized in income deemed uncollectible is reversed.  Interest received on nonperforming loans is included in income only if principal recovery is reasonably assured. A nonperforming loan is restored to accrual status when it is brought current, has performed in accordance with contractual terms for a reasonable period of time, and the collectibility of the total contractual principal and interest is no longer in doubt.

 

Allowance For Loan Losses.  In general, determining the amount of the allowance for loan losses requires significant judgment and the use of estimates by management. Sterling maintains an allowance for loan losses to absorb probable losses in the loan portfolio based on a quarterly analysis of the portfolio and expected future losses. This analysis is designed to determine an appropriate level and allocation of the allowance for losses among loan types by considering factors affecting loan losses, including specific losses, levels and trends in impaired and nonperforming loans, historical loan loss experience, current national and local economic conditions, volume, growth and composition of the portfolio, regulatory guidance and other relevant factors. Management monitors the loan portfolio to evaluate the adequacy of the allowance.  The allowance can increase or decrease each quarter based upon the results of management’s analysis.

 

The amount of the allowance for the various loan types represents management’s estimate of expected losses from existing loans based upon specific allocations for individual lending relationships and historical loss experience for each category of homogeneous loans.  The allowance for loan losses related to impaired loans is

 

16



 

based on discounted cash flows using the loan’s initial effective interest rate or the fair value of the collateral for certain collateral dependent loans. This evaluation requires management to make estimates of the amounts and timing of future cash flows on impaired loans, which consist primarily of non-accrual and restructured loans.

 

Individual loan reviews are based upon specific quantitative and qualitative criteria, including the size of the loan, loan quality ratings, value of collateral, repayment ability of borrowers, and historical experience factors. The historical experience factors utilized are based upon past loss experience, trends in losses and delinquencies, the growth of loans in particular markets and industries, and known changes in economic conditions in the particular lending markets. Allowances for homogeneous loans (such as residential mortgage loans, personal loans, etc.) are collectively evaluated based upon historical loss experience, trends in losses and delinquencies, growth of loans in particular markets, and known changes in economic conditions in each particular lending market.

 

There can be no assurance that the allowance for loan losses will be adequate to cover all losses, but management believes the allowance for loan losses was adequate at June 30, 2003. While management uses available information to provide for loan losses, the ultimate collectibility of a substantial portion of the loan portfolio and the need for future additions to the allowance will be based on changes in economic conditions and other relevant factors. A slowdown in economic activity could adversely affect cash flows for both commercial and individual borrowers, as a result of which Sterling could experience increases in nonperforming assets, delinquencies and losses on loans.

 

Investments and ABSAssets in the investment and ABS portfolios are initially recorded at cost, which includes any premiums and discounts. Sterling amortizes premiums and discounts as an adjustment to interest income using the level interest yield method over the estimated life of the security. The cost of investment securities sold, and any resulting gain or loss, is based on the specific identification method.

 

Management determines the appropriate classification of investment securities at the time of purchase. Held-to-maturity securities are those securities that Sterling has the positive intent and ability to hold to maturity and are recorded at amortized cost. Available-for-sale securities are those securities that would be available to be sold in the future in response to Sterling’s liquidity needs, changes in market interest rates, and asset-liability management strategies, among others. Available-for-sale securities are reported at fair value, with unrealized holding gains and losses reported in shareholders’ equity as a separate component of other comprehensive income, net of applicable deferred income taxes.

 

Management evaluates investment securities for other than temporary declines in fair value on a quarterly basis.  If the fair value of investment securities falls below their amortized cost and the decline is deemed to be other than temporary, the securities will be written down to current market value and the write down will be deducted from earnings under realized losses. There were no investment securities which management identified to be other-than-temporarily impaired for the six months ended June 30, 2003.  Charges to income could occur in future periods due to a change in management’s intent to hold the investments to maturity, a change in management’s assessment of credit risk, or a change in regulatory or accounting requirements.

 

Goodwill And Other Intangible AssetsGoodwill arising from business combinations represents the value attributable to unidentifiable intangible elements in the business acquired.  Sterling’s goodwill relates to value inherent in the banking business and the value is dependent upon Sterling’s ability to provide quality, cost effective services in a competitive market place. As such, goodwill value is supported ultimately by revenue that is driven by the volume of business transacted. A decline in earnings as a result of a lack of growth or the inability to deliver cost effective services over sustained periods can lead to impairment of goodwill that could adversely impact earnings in future periods.

 

Sterling has performed the transitional impairment tests on its goodwill assets and has concluded the recorded value of goodwill was not impaired as of June 30, 2003. There are many assumptions and estimates underlying the determination of impairment. Another estimate using different, but still reasonable, assumptions could produce a significantly different result. Additionally, future events could cause management to conclude that

 

17



 

Sterling’s goodwill is impaired, which would result in Sterling recording an impairment loss. Any resulting impairment loss could have a material adverse impact on Sterling’s financial condition and results of operations.

 

Other intangible assets consisting of core-deposit intangibles with definite lives are amortized over the estimated life of the acquired depositor relationships (generally eight to ten years).

 

Real Estate Owned.  Property acquired through foreclosure of defaulted mortgage loans is carried at the lower of cost or fair value less estimated costs to sell.  Development and improvement costs relating to the property are capitalized to the extent they are deemed to be recoverable.

 

An allowance for losses on real estate owned is designed to include amounts for estimated losses as a result of impairment in value of the real property after repossession.  Sterling reviews its real estate owned for impairment in value whenever events or circumstances indicate that the carrying value of the property may not be recoverable.  In performing the review, if expected future undiscounted cash flow from the use of the property or the fair value, less selling costs, from the disposition of the property is less than its carrying value, an impairment loss is recognized.  As a result of changes in the real estate markets in which these properties are located, it is reasonably possible that the carrying values could be reduced in the near term.

 

Results of Operations

 

Overview.  Sterling recorded net income of $9.5 million, or $0.63 per diluted share, for the three months ended June 30, 2003, compared with net income of $5.7 million, or $0.43 per diluted share, for the three months ended June 30, 2002.  Sterling recorded net income of $17.3 million, or $1.18 per diluted share for the six months ended June 30, 2003, compared with $11.3 million, or $0.85 per diluted share.  The increase in net income for both periods reflected an increase in net interest income and other income.

 

The annualized return on average assets was 0.98% and 0.75% for the three months ended June 30, 2003 and 2002, respectively.  For the six months ended June 30, 2003 and 2002, the annualized return on average assets was 0.92% and 0.75%, respectively.  The annualized return on average equity was 15.5% and 13.0% for the three months ended June 30, 2003 and 2002, respectively.  The annualized return on average equity was 15.0% and 13.2% for the six months ended June 30, 2003 and 2002, respectively.  The increases in the ratios were primarily due to the increase in net income.

 

Net Interest Income.  The most significant component of earnings for a financial institution typically is NII, which is the difference between interest income, primarily from loan, ABS and investment portfolios, and interest expense, primarily on deposits and borrowings.  During the three months ended June 30, 2003 and 2002, NII was $30.0 million and $23.4 million, respectively, an increase of 28%.  For the six months ended June 30, 2003 and 2002, NII was $58.6 million and $46.8 million, an increase of 25%.  The increase in NII during the three and six months ended June 30, 2003, compared to the same periods in 2002, was primarily due to an increase in loan and ABS volumes and an improved mix of interest-earning assets compared to interest-bearing liabilities.

 

Changes in NII result from changes in volume, net interest spread and net interest margin.  Volume refers to the dollar level of interest-earning assets and interest-bearing liabilities.  Net interest spread refers to the difference between the yield on interest-earning assets and the rate paid on interest-bearing liabilities.  Net interest margin refers to NII divided by total interest-earning assets and is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities.

 

Average interest-earning assets for the three months ended June 30, 2003 and 2002 were $3.64 billion and $2.86 billion, respectively.  Average loans increased by $520.7 million, while average investments and ABS increased by $268.6 million over the same amounts in 2002.  Net interest spread during these periods was 3.26% and 3.28%, respectively.  The net interest margin for the three months ended June 30, 2003 and 2002 was 3.31% and 3.28%, respectively.  Net interest margin increased primarily due to the increase in average interest-earning assets relative to interest-bearing liabilities.  Net interest spread decreased primarily because the yield on loans declined

 

18



 

slightly more than the cost of deposits, reflecting continued refinancing activity in the residential and commercial real estate portfolios and competition for deposits.

 

Average interest-earning assets for the six months ended June 30, 2003 and 2002 were $3.55 billion and $2.85 billion, respectively.  Average loans increased by $428.7 million, while average investments and ABS increased by $268.1 million over the prior comparable period.  The net interest spread for the six months ended June 30, 2003 and 2002 was 3.29% and 3.30%, respectively, while the net interest margin for the same periods was 3.33% and 3.30%, respectively.  Net interest spread decreased due to a greater decrease in the yields on average interest-earning assets relative to the cost of funds, also reflecting continued refinancing activity.  However, the increase in the average volume of loans and ABS offset this, generating the increase in NII, thereby increasing the margin compared to the same period in 2002.

 

Provision for Losses on Loans.  Management’s policy is to establish valuation allowances for estimated losses by charging corresponding provisions against income.  The evaluation of the adequacy of specific and general valuation allowances is an ongoing process.  This process includes information derived from many factors including historical loss trends, trends in classified assets, trends in delinquency and nonaccrual loans, trends in portfolio volume, diversification as to type of loan, size of individual credit exposure, current and anticipated economic conditions, loan policies, collection policies and effectiveness, quality of credit personnel, effectiveness of policies, procedures and practices, and recent loss experience of peer banking institutions.

 

Sterling recorded provisions for losses on loans of $2.6 million and $2.2 million for the three months ended June 30, 2003 and 2002, respectively.  Sterling recorded provisions for losses on loans of $4.8 million and $4.3 million for the six months ended June 30, 2003 and 2002, respectively.  The current provision reflects the analysis and assessment of the relevant factors mentioned in the preceding paragraph.  Management anticipates that its provisions for losses on loans will continue to increase, reflecting Sterling’s strategic direction of originating more commercial real estate, construction, business banking and consumer loans which have a somewhat higher loss profile than the traditional thrift institution mix of loans.

 

The following table summarizes loan loss allowance activity for the periods indicated.

 

 

 

Six Months Ended June 30,

 

 

 

2003

 

2002

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

Balance at January 1

 

$

27,866

 

$

20,599

 

Acquired allowance for loan losses

 

869

 

0

 

Provision for losses on loans

 

4,800

 

4,313

 

Amounts written off net of recoveries and other

 

(1,501

)

(3,377

)

Balance at June 30

 

$

32,034

 

$

21,535

 

 

At June 30, 2003, Sterling’s total classified assets were $80.5 million, compared with $67.6 million at June 30, 2002.  Total nonperforming assets were $31.4 million at June 30, 2003, compared with $28.9 million at June 30, 2002.  The increase in nonperforming loans and classified assets was primarily attributable to the loans and nonperforming assets acquired in the business combinations with Source Capital Corporation (“Source”) and Empire.  Excluding the nonperforming assets acquired from Empire and the increase in nonperforming assets of Source since the acquisition date, nonperforming assets would have been $22.0 million or 0.54% of total assets.  At June 30, 2003, Sterling’s loan delinquency rate (60 days or more) as a percentage of total loans was 1.13%, compared with 1.09% at June 30, 2002.  Excluding delinquent loans from Empire and Source since the acquisition date, the delinquency ratio at June 30, 2003 would have been 0.83%, compared with 0.74% at June 30, 2002.

 

Other Income.  Other income was $9.7 million and $6.7 million for the three months ended June 30, 2003 and 2002, respectively.  Other income was $16.8 million and $12.6 million for the six months ended June 30, 2003 and 2002, respectively.  The increase for the three and

 

19



 

six months ended June 30, 2003, compared with the three and six months ended June 30, 2002 was primarily due to the gain on the sale of securities, an increase in income from mortgage banking operations and increases in fees and service charges.

 

Fees and service charge income increased by 20% to $4.9 million for the three months ended June 30, 2003 from $4.1 million for the same period last year.  For the six months ended June 30, 2003 and 2002, fees and service charge income increased by 16%, or $1.3 million.  This increase primarily reflects the increase in corporate banking activities that generate transaction accounts.  The number of business checking accounts have increased year over year, along with a wider range of business services being offered for a fee.

 

The increase in income from mortgage banking operations for the three and six months ended June 30, 2003 compared to the same periods in 2002, was primarily due to increased refinancing activity and loan sales, reflecting the low interest rate environment.  The following table summarizes loan originations and sales of loans and serviced mortgage loans for the periods indicated.

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2003

 

2002

 

2003

 

2002

 

 

 

(Dollars in millions)

 

Originations of one- to four-family permanent mortgage loans

 

$

146.4

 

$

58.0

 

$

278.7

 

$

116.1

 

Sales of residential loans

 

92.8

 

37.7

 

188.1

 

72.4

 

Sales of commercial real estate loans

 

18.3

 

5.5

 

18.3

 

59.5

 

Principal balances of mortgage loans serviced for others

 

410.0

 

383.0

 

410.0

 

383.0

 

 

As a normal part of its operations, Action Mortgage incurs interest rate risk from the date it closes a loan to the date the loan is sold in the secondary market.  Additionally, Action Mortgage incurs interest rate risk from the date it commits to make a loan to the date the loan closes in those cases where it sells rate locks to the prospective borrower.  Traditionally, Action Mortgage has endeavored to hedge this interest rate risk by entering into best-efforts forward sales agreements with third parties.  In July 2003, in an effort to improve the spread on loans sold into the secondary market, Action Mortgage began hedging interest rate risk by entering into mandatory forward sales agreements on ABS with third parties.

 

The risks inherent in such mandatory forward sales agreements include the risk that, if for any reason Action Mortgage does not close and sell the loans in question, it is nonetheless obligated to deliver ABS to the counterparty on the agreed terms.  Action Mortgage could incur significant costs in acquiring replacement ABS and such costs could have a material adverse impact on mortgage banking operations in future periods, especially in rising interest rate environments.

 

During the quarter ended June 30, 2003, Sterling Savings Bank sold $373.5 million in investments and ABS, compared with $127.9 million for the quarter ended June 30, 2002.  Sterling recognized a net gain of $1.7 million during the quarter ended June 30, 2003, compared to $311,000 for the same period last year.  During the six months ended June 30, 2003, Sterling sold $588.8 million in investments and ABS compared with $231.7 million for the same period in 2002.  Sterling recognized a net gain of $3.0 million for the six months ended June 30, 2003, compared with $397,000 for the six months ended June 30, 2002.  The increase in sales of investments and ABS compared to the prior year’s comparable periods reflected an acceleration of change in the maturity structure of the portfolio.

 

Operating Expenses.  Operating expenses were $22.6 million and $19.8 million for the three months ended June 30, 2003 and 2002, respectively.  Operating expenses were $44.0 million and $39.4 million for the six months ended June 30, 2003 and 2002, respectively.  The higher level of operating expenses was primarily a result of expanded staffing in Sterling’s branch delivery network, occupancy costs and advertising.

 

Employee compensation and benefits were $12.0 million and $10.4 million for the three months ended June 30, 2003 and 2002, respectively.  Employee compensation and benefits were $24.0 million and $21.0 million

 

20



 

for the six months ended June 30, 2003 and 2002, respectively.  The employee costs reflected increased staffing from Empire, increased mortgage banking staff and additional staff for Sterling’s Seattle and Portland Corporate Banking Centers.  At June 30, 2003, full-time-equivalent employees were 1,058, compared with 944 at June 30, 2002.

 

Occupancy and equipment expenses were $3.7 million and $3.2 million for the three months ended June 30, 2003 and 2002, respectively.  Occupancy and equipment expenses were $7.2 million and $6.2 million for the six months ended June 30, 2003 and 2002, respectively.  The increase was primarily due to expenses associated with the Portland and Seattle Corporate Banking Centers, the new Empire branches, expanded mortgage banking branches and higher equipment costs.

 

Advertising expense was $1.7 million and $867,000 for the three months ended June 30, 2003 and 2002, respectively.  Advertising expenses were $2.0 million and $1.5 million for the six months ended June 30, 2003 and 2002, respectively.  The increase was primarily due to an increase in costs associated with Sterling’s new image campaign and acquisition-related costs.

 

Income Tax Provision.  Sterling recorded federal and state income tax provisions of $5.1 million and $2.4 million for the three months ended June 30, 2003 and 2002, respectively.  For the six months ended June 30, 2003 and 2002, Sterling recorded federal and state income tax provisions of $9.3 million and $4.3 million, respectively.  The income tax provisions in 2003 reflect an increase in taxable earnings.  The effective tax rates for these periods were 34.7%, 29.5%, 34.9% and 27.5%, respectively.  The increase in the effective tax rates compared to the June 30, 2002 periods is due to the tax effect of the tax treatment relating to certain discounts of the Source acquisition.

 

Financial Position

 

Assets.  At June 30, 2003, Sterling’s assets were $4.09 billion, up $588.5 million from $3.51 billion at December 31, 2002.

 

Investments and ABS.  Sterling’s investment and ABS portfolio at June 30, 2003 was $1.08 billion, an increase of $246.5 million from the December 31, 2002 balance of $830.2 million.  The increase was primarily due to net purchases of ABS.

 

Loans Receivable.  At June 30, 2003, net loans receivable were $2.67 billion, up $278.7 million from $2.39 billion at December 31, 2002.  The increase was primarily due to $67.3 million in loans from the Empire transaction, as well as net increases in business and private banking, corporate banking, and residential construction loans.  During the six months ended June 30, 2003, total loan originations were $1.14 billion compared with $806.6 million for the prior year’s comparable quarter.  Approximately 65% of these were construction, business banking, corporate banking and consumer loans.

 

21



 

The following table sets forth the composition of Sterling’s loan portfolio at the dates indicated.  Loan balances exclude deferred loan origination costs and fees or allowances for loan losses.

 

 

 

June 30, 2003

 

December 31, 2002

 

 

 

Amount

 

%

 

Amount

 

%

 

 

 

(Dollars in thousands)

 

Residential real estate

 

$

369,293

 

13.64

 

$

358,359

 

14.78

 

Multifamily real estate

 

164,656

 

6.08

 

161,547

 

6.66

 

Commercial real estate

 

478,849

 

17.68

 

458,712

 

18.92

 

Real estate construction

 

540,301

 

19.95

 

480,919

 

19.84

 

Consumer -direct

 

268,720

 

9.92

 

246,578

 

10.17

 

Consumer -indirect

 

77,383

 

2.86

 

62,896

 

2.59

 

Business and private banking

 

654,639

 

24.18

 

546,819

 

22.56

 

Corporate banking

 

152,377

 

5.63

 

105,975

 

4.37

 

Commercial leases receivable

 

1,579

 

0.06

 

2,774

 

0.11

 

Gross loans receivable

 

2,707,797

 

100.00

 

2,424,579

 

100.00

 

Net deferred origination fees

 

(6,773

)

 

 

(6,450

)

 

 

Allowance for losses on loans

 

(32,034

)

 

 

(27,866

)

 

 

Loans receivable, net

 

$

2,668,990

 

 

 

$

2,390,263

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted average yield at end of period

 

6.01

%

 

 

6.38

%

 

 

 

The following table sets forth Sterling’s loan originations for the periods indicated.

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2003

 

2002

 

% Change

 

2003

 

2002

 

% Change

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Residential real estate

 

$

146,405

 

$

57,970

 

152.6

 

$

278,693

 

$

116,127

 

140.0

 

Multifamily real estate

 

17,077

 

4,140

 

312.5

 

30,442

 

17,808

 

70.9

 

Commercial real estate

 

48,304

 

9,410

 

413.3

 

85,403

 

31,725

 

169.2

 

Real estate construction

 

195,137

 

169,742

 

15.0

 

324,291

 

285,693

 

13.5

 

Consumer -direct

 

61,632

 

36,790

 

67.5

 

93,940

 

75,980

 

23.6

 

Consumer -indirect

 

15,594

 

16,042

 

(2.8

)

29,862

 

33,286

 

(10.3

)

Business and private banking

 

122,857

 

121,464

 

1.1

 

197,443

 

183,836

 

7.4

 

Corporate banking

 

51,780

 

35,380

 

46.4

 

98,630

 

62,193

 

58.6

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total loans originated

 

$

658,786

 

$

450,938

 

46.1

 

$

1,138,704

 

$

806,648

 

41.2

 

 

BOLI.  Bank-owned life insurance (“BOLI”) increased to $71.2 million at June 30, 2003 from $59.4 million at December 31, 2002.  The increase was primarily due to the purchase of $10.0 million in BOLI.  Sterling purchases BOLI to fund employee benefit costs.  Through the purchase of BOLI, Sterling becomes the beneficiary of life insurance policies on certain officers who consent to the issuance of the policies.

 

Goodwill and Other Intangible Assets.  Goodwill and other intangible assets increased to $48.1 million at June 30, 2003 from $44.0 million at December 31, 2002.  Sterling recorded $1.0 million in goodwill and $3.1 million in other intangible assets in connection with the business combination with Empire.

 

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Deposits.  Total deposits increased $379.6 million to $2.39 billion at June 30, 2003 from $2.01 billion at December 31, 2002, primarily due to the acquisition of $184.2 million in deposits from Empire and to increases in money market accounts and time deposits.

 

The following table sets forth the composition of Sterling’s deposits at the dates indicated.

 

 

 

June 30, 2003

 

December 31, 2002

 

 

 

Amount

 

%

 

Amount

 

%

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

Noninterest checking

 

$

281,542

 

11.8

 

$

239,033

 

11.9

 

NOW checking

 

320,419

 

13.4

 

367,391

 

18.2

 

Savings and money market

 

566,501

 

23.6

 

401,339

 

19.9

 

Certificates of deposit

 

1,225,245

 

51.2

 

1,006,333

 

50.0

 

 

 

 

 

 

 

 

 

 

 

Total deposits

 

$

2,393,707

 

100.0

 

$

2,014,096

 

100.0

 

 

 

 

 

 

 

 

 

 

 

Annualized cost of deposits

 

 

 

1.65

%

 

 

1.91

%

 

The shift in the mix of deposits since December 2002 reflects a shift to money market accounts from NOW checking accounts and a strong increase in new business checking deposits.  As of June 30, 2003, the number of business checking accounts has increased by approximately 38% from a year ago.

 

Borrowings.  Deposit accounts are Sterling’s primary source of funds.  Sterling does, however, rely upon advances from the Federal Home Loan Bank of Seattle (“FHLB Seattle”), reverse repurchase agreements and other borrowings to supplement its funding and to meet deposit withdrawal requirements.  At June 30, 2003, the total of such borrowings was $1.41 billion compared with $1.25 billion at December 31, 2002.  See “Liquidity and Sources of Funds.”

 

Asset and Liability Management

 

The results of operations for financial institutions may be materially and adversely affected by changes in prevailing economic conditions, including rapid changes in interest rates, declines in real estate market values and the monetary and fiscal policies of the federal government.  Like all savings institutions, Sterling’s NII and the net present value of assets, liabilities and off-balance sheet contracts (“NPV”), or estimated fair value, are subject to fluctuations in interest rates.  For example, some of Sterling’s adjustable-rate mortgages (“ARMs”) are indexed to the one-year or five-year U.S. Treasury index or periodic fixed-rate LIBOR and swaps curves. When interest-earning assets such as loans are funded by interest-bearing liabilities such as deposits, FHLB Seattle advances and other borrowings, a changing interest rate environment may have a dramatic effect on Sterling’s earnings.  Currently, Sterling’s interest-earning assets mature or reprice more frequently, or on different terms, than do its interest-bearing liabilities. The fact that assets mature or reprice more frequently on average than liabilities may be beneficial in times of increasing interest rates; however, such an asset/liability structure may result in declining NII during periods of falling interest rates.

 

Additionally, the extent to which borrowers prepay loans is affected by prevailing interest rates.  When interest rates increase, borrowers are less likely to prepay loans; whereas when interest rates decrease, borrowers are more likely to prepay loans.  Prepayments may affect the levels of loans retained in an institution’s portfolio as well as its NII.

 

Sterling maintains an asset and liability management program intended to manage NII through interest rate cycles and to protect its NPV by controlling its exposure to changing interest rates.  Sterling uses a simulation model designed to measure the sensitivity of NII and NPV to changes in interest rates. This simulation model is designed to enable Sterling to generate a forecast of NII and NPV given various interest rate forecasts and alternative strategies. The model is also designed to measure the anticipated impact that prepayment risk, basis risk, customer maturity preferences, volumes of new business and changes in the relationship between long-term and short-term interest

 

23



 

rates have on the performance of Sterling.  The model calculates the present value of assets, liabilities, off-balance sheet financial instruments, and equity at current interest rates and at hypothetical higher and lower interest rates at various intervals.  The present value of each major category of financial instruments is calculated using estimated cash flows based on weighted-average contractual rates and terms, then discounted at the estimated current market interest rate for similar financial instruments.  The present value of longer term fixed-rate financial instruments is more difficult to estimate because such instruments are susceptible to changes in market interest rates. Present value estimates of adjustable-rate financial instruments are more reliable since they represent the difference between the contractual and discounted rates until the next interest rate repricing date.

 

The calculations of present value have certain shortcomings.  The discount rates utilized for loans, investments and ABS are based on estimated nationwide market interest rate levels for similar loans and securities, with prepayment assumptions based on historical experience and market forecasts.  The unique characteristics of Sterling’s loans and ABS may not necessarily parallel those in the model.  The discount rates utilized for deposits and borrowings are based upon available alternative types and sources of funds which are not necessarily indicative of the market value of deposits and FHLB Seattle advances since such deposits and advances are unique to and have certain price and customer relationship advantages for depository institutions.  The present values are determined based on the discounted cash flows over the remaining estimated lives of the financial instruments on the assumption that the resulting cash flows are reinvested in financial instruments with virtually identical terms.

 

The total measurement of Sterling’s exposure to interest-rate risk (“IRR”) as presented in the following table may not be representative of the actual values which might result from a higher or lower interest rate environment.  A higher or lower interest rate environment most likely will result in different investment and borrowing strategies by Sterling designed to further mitigate the effect on the value of and the net earnings generated from Sterling’s net assets from any change in interest rates.

 

Sterling is continuing to pursue strategies to manage the level of its IRR while increasing its NII and NPV: a) through the origination and retention of variable-rate consumer, business banking, construction and commercial real estate loans, which generally have higher yields than residential permanent loans, b) by the sale of certain long-term fixed-rate loans and investments, and c) by increasing the level of its core deposits, which are generally a lower-cost funding source than wholesale borrowings.  There can be no assurance that Sterling will be successful implementing any of these strategies or that, if these strategies are implemented, they will have the intended effect of reducing IRR or increasing NII and NPV.

 

The following table presents Sterling’s estimates of changes in NPV for the periods indicated.  The results indicate the potential effects of instantaneous, parallel shifts in the market yield curve.  These calculations are highly subjective and technical and are relative measurements of IRR which do not necessarily reflect any expected rate movement.

 

 

 

At June 30, 2003

 

At December 31, 2002

 

Change in
Interest Rate
in Basis Points
(Rate Shock)

 

NPV

 

Ratio of NPV
to the Present
Value of
Total Assets

 

Change
in NPV

 

NPV

 

Ratio of NPV
to the Present
Value of
Total Assets

 

Change
in NPV

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

+300

 

$

163,254

 

4.01

%

(13.4

)

$

223,622

 

6.36

%

4.8

 

+200

 

175,923

 

4.32

 

(6.7

)

229,759

 

6.53

 

7.6

 

+100

 

185,821

 

4.56

 

(1.5

)

234,577

 

6.67

 

9.9

 

Static

 

188,580

 

4.63

 

0

 

213,442

 

6.07

 

0

 

-100

 

116,310

 

2.85

 

(38.3

)

164,741

 

4.68

 

(22.8

)

-200

 

N/A

(1)

N/A

(1)

N/A

(1)

N/A

(1)

N/A

(1)

N/A

(1)

-300

 

N/A

(1)

N/A

(1)

N/A

(1)

N/A

(1)

N/A

(1)

N/A

(1)

 


(1)                                    In low interest rate environments, the calculations are not meaningful.

 

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Sterling also uses gap analysis, a traditional analytical tool designed to measure the difference between the amount of interest-earning assets and the amount of interest-bearing liabilities expected to mature or reprice in a given period.  Sterling calculated its one-year cumulative gap position to be a positive 2.6% and a positive 5.8% at June 30, 2003 and December 31, 2002, respectively.  Sterling calculated its three-year cumulative gap position to be a positive 3.3% and a positive 2.8% at June 30, 2003 and December 31, 2002, respectively.  The decrease in the positive readings at the one-year gap position was primarily due to a shortening of the maturities of certain borrowings impacted by the current interest rate environment.  Management attempts to maintain Sterling’s gap position between positive 10% and negative 25%.  At June 30, 2003, Sterling’s gap positions were within limits established by its Board of Directors.  Management is pursuing strategies to increase its NII without significantly increasing its cumulative gap positions in future periods.  There can be no assurance that Sterling will be successful implementing these strategies or that, if these strategies are implemented, they will have the intended effect of increasing its NII.  See “Results of Operations - Net Interest Income” and “Capital Resources.”

 

Liquidity and Sources of Funds

 

As a financial institution, Sterling’s primary sources of funds are investing and financing activities, including the collection of loan principal and interest payments.  Financing activities consist primarily of customer deposits, advances from FHLB Seattle and other borrowings.  Deposits increased to $2.39 billion at June 30, 2003 from $2.01 billion at December 31, 2002, primarily due to the acquisition of $184.2 million in deposits from Empire and to an increase in money market accounts and certificates of deposit.  The net increase in deposits was primarily used to fund loans, purchase ABS and pay down other borrowings.  At June 30, 2003 and December 31, 2002, securities sold subject to repurchase agreements were $277.0 million and $249.8 million, respectively.  These borrowings are required to be collateralized by investments and ABS with a market value exceeding the face value of the borrowings.  Under certain circumstances, Sterling could be required to pledge additional securities or reduce the borrowings.

 

During the six months ended June 30, 2003, cash used in investing activities consisted primarily of the funding of loans and the purchase of ABS.  The levels of these payments increase or decrease depending on the size of the loan and ABS portfolios and the general trend and level of interest rates, which influences the level of refinancing and mortgage prepayments.  During the same period, cash provided by investing activities consisted primarily of principal payments on loans, proceeds from sales of ABS and cash acquired from the Empire transaction.  During the six months ended June 30, 2003, cash provided by operating activities consisted primarily of proceeds from sales of loans.

 

Sterling Savings Bank’s credit line with FHLB Seattle provides for borrowings up to a percentage of its total assets subject to collateralization requirements.  At June 30, 2003, this credit line represented a total borrowing capacity of $1.15 billion, of which $150.8 million was available.  Sterling Savings Bank also borrows on a secured basis from major broker/dealers and financial entities by selling securities subject to repurchase agreements.  At June 30, 2003, Sterling Savings Bank had $277.0 million in outstanding borrowings under reverse repurchase agreements and had securities available for additional secured borrowings of approximately $360.4 million.

 

Sterling, on a parent company-only basis, had cash and other resources of approximately $27.4 million and a revolving line of credit from U.S. Bank of $5.0 million at June 30, 2003 with no funds drawn on this line of credit.  This line of credit as well as a $25.0 million term note are secured by a majority of the Common and Preferred Stock of Sterling Savings Bank.  See Note 2 of “Notes to Consolidated Financial Statements.”

 

At June 30, 2003 and December 31, 2002, Sterling had an investment of $110.1 million in the Preferred Stock of Sterling Savings Bank.  At June 30, 2003 and December 31, 2002, Sterling had an investment in the Common Stock of Sterling Savings Bank of $132.5 million and $106.2 million, respectively.  Sterling received cash dividends on Sterling Savings Bank Preferred Stock of $5.8 million during the six months ended June 30, 2003.  These resources were sufficient to meet the operating needs of Sterling, including interest expense on its long-term debt.  Sterling Savings Bank’s ability to pay dividends is limited by its earnings, financial condition and capital requirements, as well as rules and regulations imposed by the OTS.  See Note 2 of “Notes to Consolidated Financial Statements.”

 

25



 

In May 2003, Sterling redeemed $40.0 million of 9.50% Cumulative Capital Securities.  Sterling subsequently issued a series of floating rate trust preferred securities totaling $54.0 million, described below.  See Note 2 of “Notes to Consolidated Financial Statements.”

 

In April 2003, Sterling’s wholly-owned subsidiary Sterling Capital Trust III completed a private placement of $14.0 million of floating rate trust preferred securities.  These securities bear an initial interest rate of 4.54%.  The rate will be adjusted quarterly at 90-day LIBOR plus 3.25%.  The trust preferred securities will mature in 2033.

 

In May 2003, Sterling’s wholly-owned subsidiary Sterling Capital Trust IV completed a private placement of $10.0 million of floating rate trust preferred securities.  These securities bear an initial rate of 4.