Quarterly Report on Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

FOR THE QUARTERLY PERIOD ENDED September 30, 2009

OR

 

¨ 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) 458-3711

(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  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Date File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes  ¨    No  ¨

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

 

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

(Do not check if a smaller
reporting company)

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes  ¨    No  x

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 October 30, 2009

Common Stock ($1.00 par value)   52,208,069

 

 

 


Table of Contents

STERLING FINANCIAL CORPORATION

FORM 10-Q

For the Quarter Ended September 30, 2009

TABLE OF CONTENTS

 

     Page

PART I - Financial Information

   1

Item 1

   Financial Statements (Unaudited)    1
   Consolidated Balance Sheets    1
   Consolidated Statements of Income    2
   Consolidated Statements of Cash Flows    3
   Consolidated Statements of Comprehensive Income    5
   Notes to Consolidated Financial Statements    6

Item 2

   Management's Discussion and Analysis of Financial Condition and Results of Operations    26

Item 3

   Quantitative and Qualitative Disclosures About Market Risk    52

Item 4

   Controls and Procedures    52

PART II - Other Information

   53

Item 1

   Legal Proceedings    53

Item 1A

   Risk Factors    53

Item 2

   Unregistered Sales of Equity Securities and Use of Proceeds    53

Item 3

   Defaults Upon Senior Securities    53

Item 4

   Submission of Matters to a Vote of Security Holders    53

Item 5

   Other Information    53

Item 6

   Exhibits    53

Signatures

   54


Table of Contents

PART I – Financial Information

Item 1 – Financial Statements

STERLING FINANCIAL CORPORATION

Consolidated Balance Sheets

(Unaudited)

 

     September 30,
2009
    December 31,
2008
 
     (Dollars in thousands)  

ASSETS:

    

Cash and cash equivalents:

    

Interest bearing

   $ 353,655      $ 171   

Non-interest bearing

     97,565        138,631   
                

Total cash and cash equivalents

     451,220        138,802   
                

Restricted cash

     16,719        1,493   

Investment securities and mortgage-backed securities (“MBS”):

    

Available for sale

     2,489,359        2,639,290   

Held to maturity

     167,559        175,830   

Loans receivable, net

     7,968,947        8,807,094   

Loans held for sale (at fair value: $186,675 and $112,191)

     187,637        112,777   

Accrued interest receivable

     52,190        57,306   

Other real estate owned, net (“OREO”)

     71,187        62,320   

Office properties and equipment, net

     91,692        93,195   

Bank-owned life insurance (“BOLI”)

     162,948        157,236   

Goodwill

     0        227,558   

Other intangible assets

     23,052        26,725   

Mortgage servicing rights, net

     11,115        5,706   

Prepaid expenses and other assets, net

     179,865        285,384   
                

Total assets

   $ 11,873,490      $ 12,790,716   
                

LIABILITIES:

    

Deposits

   $ 8,277,107      $ 8,350,407   

Advances from Federal Home Loan Bank (“FHLB”)

     1,435,809        1,726,549   

Securities sold subject to repurchase agreements and funds purchased

     1,092,968        1,163,023   

Other borrowings

     248,280        248,276   

Cashiers checks issued and payable

     8,928        8,762   

Borrowers’ reserves for taxes and insurance

     4,275        1,987   

Accrued interest payable

     26,449        41,631   

Accrued expenses and other liabilities

     113,826        109,045   
                

Total liabilities

     11,207,642        11,649,680   
                

SHAREHOLDERS’ EQUITY:

    

Preferred stock, $1 par value; $1,000 stated value; 10,000,000 shares authorized; 303,000 shares issued and outstanding

     293,614        291,964   

Common stock, $1 par value; 750,000,000 shares authorized; 52,397,717 and 52,134,030 shares issued and outstanding

     52,398        52,134   

Additional paid-in capital

     910,535        909,386   

Accumulated other comprehensive loss:

    

Unrealized gain (loss) on investment securities and MBS available-for-sale, net of deferred income taxes of $15,544 and $10,690

     26,279        (17,866

Accumulated deficit

     (616,978     (94,582
                

Total shareholders’ equity

     665,848        1,141,036   
                

Total liabilities and shareholders’ equity

   $ 11,873,490      $ 12,790,716   
                

See notes to consolidated financial statements.

 

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Table of Contents

STERLING FINANCIAL CORPORATION

Consolidated Statements of Income (Loss)

(Unaudited)

 

    Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
    2009     2008     2009     2008  
    (Dollars in thousands, except per share data)  

Interest income:

       

Loans

  $ 119,096      $ 147,585      $ 369,967      $ 461,976   

MBS

    27,148        25,219        84,606        75,304   

Investments and cash equivalents

    2,524        3,523        8,845        8,672   
                               

Total interest income

    148,768        176,327        463,418        545,952   
                               

Interest expense:

       

Deposits

    40,606        57,101        133,528        177,409   

Short-term borrowings

    4,154        3,061        13,353        15,900   

Long-term borrowings

    16,949        26,157        53,511        76,429   
                               

Total interest expense

    61,709        86,319        200,392        269,738   
                               

Net interest income

    87,059        90,008        263,026        276,214   

Provision for credit losses

    (195,505     (36,950     (341,114     (105,080
                               

Net interest income (loss) after provision for credit losses

    (108,446     53,058        (78,088     171,134   
                               

Non-interest income:

       

Fees and service charges

    15,088        15,327        43,806        45,490   

Mortgage banking operations

    9,485        6,434        36,525        20,859   

Loan servicing fees

    1,146        737        1,701        1,286   

OREO

    (6,475     102        (29,144     (242

BOLI

    1,815        1,362        5,221        4,575   

Gains on sales of securities

    825        0        12,382        409   

Other

    (928     (943     (3,886     (2,698
                               

Total non-interest income

    20,956        23,019        66,605        69,679   
                               

Non-interest expenses before impairment charge

    83,892        71,520        246,360        216,074   

Goodwill impairment

    227,558        0        227,558        0   
                               

Non-interest expenses

    311,450        71,520        473,918        216,074   
                               

Income (loss) before income taxes

    (398,940     4,557        (485,401     24,739   

Income tax (provision) benefit

    (60,467     441        (23,982     (5,190
                               

Net income (loss)

    (459,407     4,998        (509,383     19,549   

Preferred stock dividend

    (4,318     0        (13,012     0   
                               

Net income (loss) available to common shareholders

  $ (463,725   $ 4,998      $ (522,395   $ 19,549   
                               

Earnings per share - basic

  $ (8.93   $ 0.10      $ (10.06   $ 0.38   
                               

Earnings per share - diluted

  $ (8.93   $ 0.10      $ (10.06   $ 0.38   
                               

Weighted average shares outstanding - basic

    51,922,871        51,821,446        51,913,907        51,678,981   

Weighted average shares outstanding - diluted

    51,922,871        52,006,215        51,913,907        51,892,900   

See notes to consolidated financial statements.

 

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STERLING FINANCIAL CORPORATION

Consolidated Statements of Cash Flows

(Unaudited)

 

     Nine Months Ended
September 30,
 
     2009     2008  
     (Dollars in thousands)  

Cash flows from operating activities:

    

Net income (loss)

   $ (509,383   $ 19,549   

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

    

Provision for credit losses and OREO

     365,481        105,080   

Goodwill impairment

     227,558        0   

Deferred tax asset valuation allowance

     143,000        0   

Accretion of deferred gain on sale of branches

     (603     (603

Net gain on sales of loans, investments and MBS

     (51,483     (14,883

Stock based compensation

     2,204        1,901   

Excess tax benefit from stock based compensation

     804        (844

Stock issuances relating to 401(k) match and direct stock purchases

     13        1,979   

Loss on OREO

     31,284        0   

Other (gains) and losses

     3,157        3,049   

Increase in cash surrender value of BOLI

     (5,221     (5,091

Depreciation and amortization

     24,329        18,620   

Change in:

    

Accrued interest receivable

     5,116        6,644   

Prepaid expenses and other assets

     (71,143     (46,908

Cashiers checks issued and payable

     166        12,988   

Accrued interest payable

     (15,182     (2,467

Accrued expenses and other liabilities

     754        (5,705

Proceeds from sales of loans originated for sale

     2,067,704        868,126   

Loans originated for sale

     (2,028,603     (853,166
                

Net cash provided by operating activities

     189,952        108,269   
                

Cash flows from investing activities:

    

Change in restricted cash

     (15,226     50   

Loans funded and purchased

     (1,657,832     (3,048,586

Loan principal received

     1,940,570        2,733,861   

Purchase of investment securities

     (689,320     (644,735

Proceeds from maturities of investment securities

     761,750        630,656   

Proceeds from sale of investment securities

     80,855        0   

Proceeds from sale - MBS

     296,500        0   

Purchase of MBS

     (821,702     (524,265

Principal payments on MBS

     601,662        219,442   

Purchase of office properties and equipment

     (10,746     (8,417

Sales of office properties and equipment

     27        73   

Improvements and other changes to OREO

     1,914        1,923   

Proceeds from sales of OREO

     73,003        6,197   

Proceeds from sales of other loans

     0        (77
                

Net cash provided by (used in) investing activities

     561,455        (633,878
                

See notes to consolidated financial statements.

 

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STERLING FINANCIAL CORPORATION

Consolidated Statements of Cash Flows

(Unaudited)

 

     Nine Months Ended
September 30,
 
     2009     2008  
     (Dollars in thousands)  

Cash flows from financing activities:

    

Net change in transaction and savings deposits

   $ 74,648      $ (293,667

Proceeds from issuance of time deposits

     2,356,990        3,904,739   

Payments for maturing time deposits

     (2,648,392     (3,388,151

Interest credited to deposits

     143,454        172,610   

Advances from FHLB

     90,500        780,245   

Repayment of advances from FHLB

     (380,885     (680,505

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

     (70,055     (583

Repayment of other borrowings

     0        (24,000

Proceeds from stock options exercised

     0        1,390   

Excess tax benefit from stock based compensation

     (804     844   

Cash dividends paid to preferred shareholders

     (6,733     0   

Cash dividends paid to common shareholders

     0        (15,275

Other

     2,288        1,962   
                

Net cash (used in) provided by financing activities

     (438,989     459,609   
                

Net change in cash and cash equivalents

     312,418        (66,000

Cash and cash equivalents, beginning of period

     138,802        194,478   
                

Cash and cash equivalents, end of period

   $ 451,220      $ 128,478   
                

Supplemental disclosures:

    

Cash paid (received) during the period for:

    

Interest

   $ 200,392      $ 272,205   

Income taxes

     (68,062     15,968   

Noncash financing and investing activities:

    

Loans converted into OREO

     157,156        51,840   

Common stock cash dividends accrued

     0        5,211   

Preferred stock cash dividend accrued

     5,682        0   

See notes to consolidated financial statements.

 

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STERLING FINANCIAL CORPORATION

Consolidated Statements of Comprehensive Income

(Unaudited)

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2009     2008     2009     2008  
     (Dollars in thousands)  

Net income (loss)

   $ (459,407   $ 4,998      $ (509,383   $ 19,549   
                                

Other comprehensive income (loss):

        

Change in unrealized gain (loss) on investments and MBS available-for-sale

     50,958        2,116        70,356        (20,506

Less deferred income taxes benefit (provision)

     (18,854     (780     (26,032     7,594   
                                

Net other comprehensive income (loss)

     32,104        1,336        44,324        (12,912
                                

Comprehensive income (loss)

   $ (427,303   $ 6,334      $ (465,059   $ 6,637   
                                

See notes to consolidated financial statements.

 

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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 as disclosed in the annual report on Form 10-K for the year ended December 31, 2008. 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.

In addition to other established accounting policies, the following is a discussion of recent accounting pronouncements:

In June 2009, the Financial Accounting Standards Board (“FASB”) issued FAS 168, “The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles - replacement of FAS 162” (the “Codification”). The Codification supersedes all existing accounting and reporting standards other than the rules of the Securities and Exchange Commission (the “SEC”). Updates to the Codification are being issued as Accounting Standards Updates, which will also provide background information about the guidance, and provide the basis for conclusions on changes in the Codification. The Codification became effective for Sterling for the interim period ending September 30, 2009, and did not have a material impact on its consolidated financial statements.

In December 2007, the FASB updated the standard on business combinations, establishing principles and requirements for how the acquirer: 1) recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any non-controlling interest in the acquiree; 2) recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase; 3) determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. Depending on the level of future acquisitions, this accounting standard may have a material effect on Sterling, mainly in regards to the valuation of loans, and the treatment for acquisition costs.

In February 2008, the FASB issued a staff position on transfers of financial assets and repurchase financing transactions. For linked transactions, a transferor and transferee shall not separately account for a transfer of a financial asset and a related repurchase financing unless (a) the two transactions have a valid and distinct business or economic purpose for being entered into separately and (b) the repurchase financing does not result in the initial transferor regaining control over the financial asset. This guidance was effective for Sterling as of January 1, 2009, and did not have a material impact on its consolidated financial statements.

In March 2008, the FASB issued a standard on disclosure requirements for derivative instruments and hedging activities. This section of the Codification requires enhanced disclosures about how and why an entity uses derivative instruments, how derivative instruments and related hedged items are accounted for, and how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. This guidance was effective for Sterling as of January 1, 2009, and did not have a material effect on its consolidated financial statements.

 

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In June 2008, the FASB issued a staff position on determining whether instruments granted in share-based payment transactions are participating securities. The guidance clarifies that all outstanding unvested share-based payment awards that contain non-forfeitable rights to dividends are participating securities and are required to be included in computing basic and diluted earnings per share under the two-class method. This guidance was effective for Sterling as of January 1, 2009, and did not have a material impact on its consolidated financial statements.

In April 2009, the FASB issued staff positions on the recognition and presentation of Other-Than-Temporary Impairment (“OTTI”), determining fair value when the volume and level of activity for the asset or liability have significantly decreased and identifying transactions that are not orderly, and interim disclosures about fair value of financial instruments. For debt securities, the guidance differentiates credit driven and market driven OTTI. Only the portion of the impairment loss representing credit losses would be recognized in earnings as an OTTI. The balance of the impairment loss would be recognized as a charge to other comprehensive income. A non-credit related OTTI charge to other comprehensive income for securities classified as held to maturity will be amortized from accumulated other comprehensive income back to the security over the securities remaining life. Financial statement presentation will require segregation of accumulated comprehensive income for non-credit OTTI charges on held to maturity and available for sale securities from other components of accumulated comprehensive income. Additional guidance was included for the determination of whether a market for an asset is not active and when a price for a transaction is not distressed. Previously required annual disclosures have been extended to interim periods. This guidance was effective for Sterling as of June 30, 2009. See Notes 2 and 13.

In May 2009, the FASB issued guidance on subsequent events that standardizes accounting for and disclosures of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. As a public entity, Sterling is required to evaluate subsequent events through the date its financial statements are issued. Accordingly, Sterling has completed an evaluation of subsequent events through November 2, 2009. These rules became effective for Sterling during its interim period ending after June 15, 2009, and did not have a material impact on its consolidated financial statements.

In June 2009, the FASB issued standards on accounting for transfers of financial assets, removing the concept of qualifying special-purpose entities as an accounting criteria that had provided an exception to consolidation, and provided additional guidance on requirements for consolidation. This guidance is effective for annual periods ending after November 15, 2009, and is not expected to have a material impact on Sterling’s consolidated financial statements.

 

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2. Investments and MBS:

The carrying and fair values of investments and MBS are summarized as follows:

 

     Amortized Cost    Gross
Unrealized
Gains
   Gross
Unrealized
Losses
    Fair Value
     (Dollars in thousands)

September 30, 2009

  

Available for sale

          

MBS

   $ 2,360,133    $ 66,115    $ (19,783   $ 2,406,465

Municipal bonds

     61,461      3,559      (1,538     63,482

Other

     25,942      0      (6,530     19,412
                            

Total

   $ 2,447,536    $ 69,674    $ (27,851   $ 2,489,359
                            

Held to maturity

          

Municipal bonds

   $ 149,518    $ 7,007    $ (815   $ 155,710

Other

     18,041      0      0        18,041
                            

Total

   $ 167,559    $ 7,007    $ (815   $ 173,751
                            

December 31, 2008

          

Available for sale

          

MBS

   $ 2,441,908    $ 27,659    $ (49,555   $ 2,420,012

Municipal bonds

     100,878      7,751      (2,723     105,906

Short term commercial paper

     99,117      0      0        99,117

Other

     25,920      0      (11,665     14,255
                            

Total

   $ 2,667,823    $ 35,410    $ (63,943   $ 2,639,290
                            

Held to maturity

          

Municipal bonds

   $ 154,967    $ 1,117    $ (5,541   $ 150,543

Other

     20,863      0      0        20,863
                            

Total

   $ 175,830    $ 1,117    $ (5,541   $ 171,406
                            

During the nine months ended September 30, 2009 and 2008, Sterling sold available-for-sale investments and MBS and recorded the following results:

 

     Proceeds from
Sales
   Gross Realized
Gains
   Gross Realized
Losses
 
     (Dollars in thousands)  

Nine months ended:

        

September 30, 2009

   $ 377,355    $ 15,458    $ (3,076

September 30, 2008

     0      0      0   

 

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The following table summarizes Sterling’s gross unrealized losses on temporarily impaired investments and MBS as of the dates indicated:

 

     Less than 12 months     12 months or longer     Total  
     Market Value    Unrealized
Losses
    Market Value    Unrealized
Losses
    Market Value    Unrealized
Losses
 
     (Dollars in thousands)  

September 30, 2009

  

Municipal bonds

   $ 1,002    $ (11   $ 20,850    $ (2,342   $ 21,852    $ (2,353

MBS

     215,354      (1,483     211,045      (18,300     426,399      (19,783

Other

     0      0        18,161      (6,530     18,161      (6,530
                                             

Total

   $ 216,356    $ (1,494   $ 250,056    $ (27,172   $ 466,412    $ (28,666
                                             

December 31, 2008

               

Municipal bonds

   $ 37,682    $ (2,003   $ 66,223    $ (6,261   $ 103,905    $ (8,264

MBS

     243,401      (4,905     499,950      (44,650     743,351      (49,555

Short term commercial paper

     99,117      0        0      0        99,117      0   

Other

     1      (3     12,948      (11,662     12,949      (11,665
                                             

Total

   $ 380,201    $ (6,911   $ 579,121    $ (62,573   $ 959,322    $ (69,484
                                             

The amortized cost and fair value of available-for-sale and held-to-maturity debt securities as of September 30, 2009, are listed below according to contractual maturity date. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

     Held-to-maturity    Available-for-sale
     Amortized Cost    Estimated Fair
Value
   Amortized Cost    Estimated Fair
Value
     (Dollars in thousands)

Due within one year

   $ 694    $ 696    $ 0    $ 0

Due after one year through five years

     3,126      3,165      0      0

Due after five years through ten years

     9,358      9,524      256,417      264,069

Due after ten years

     154,381      160,366      2,191,119      2,225,290
                           

Total

   $ 167,559    $ 173,751    $ 2,447,536    $ 2,489,359
                           

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, resulting in a loss. There were no investment securities that management identified to be other-than-temporarily impaired for the period ended September 30, 2009, because the decline in fair value of certain classes of securities was attributable to temporary disruptions of credit markets and the related impact on securities within those classes, not deteriorating credit quality of specific securities. As of September 30, 2009, Sterling held positions in classes of securities negatively impacted by temporary credit market disruptions, including one single-issuer trust preferred security, and 20 private label collateralized mortgage obligations. The trust preferred security is rated A1 by Moody’s and has an amortized cost of $24.6 million compared to an $18.1 million market value, or an unrealized loss of $6.5 million. As of September 30, 2009, the private label collateralized mortgage obligations had an aggregate amortized cost of $229.7 million compared to a $211.4 million market value, or an unrealized loss of $18.3 million. These securities are investment grade, and all are stress-tested monthly for both credit quality and collateral strength. As of September 30, 2009, Sterling expects the return of all principal and interest on all securities within the portfolios pursuant to the contractual terms, has the ability and intent to hold these investments, has no intent to sell securities that are deemed to have a market value impairment, nor does Sterling believe it is more likely than not that it would be required to sell these investments before a recovery in market price occurs, or until maturity. Realized losses could occur in future periods due to a change in management’s intent to hold the investments to recovery, a change in management’s assessment of credit risk, or a change in regulatory or accounting requirements. See “ – New Accounting Pronouncements.”

 

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3. Allowance for Credit Losses:

The following is an analysis of the changes in the allowances for credit losses:

 

     Nine Months Ended September 30,  
     2009     2008  
     (Dollars in thousands)  

Allowance for credit losses

    

Allowance - loans, January 1

   $ 208,365      $ 111,026   

Provision

     341,114        105,081   

Charge-offs

     (298,540     (40,230

Recoveries

     14,981        1,433   

Transfers

     9,831        (3
                

Allowance - loans, September 30,

     275,751        177,307   
                

Allowance - unfunded commitments, January 1

     21,334        6,306   

Provision

     0        53   

Amounts written off

     0        (6

Transfers

     (9,831     12   
                

Allowance - unfunded commitments, September 30,

     11,503        6,365   
                

Total credit allowance

   $ 287,254      $ 183,672   
                

The increase in the provision stems from higher levels of classified assets and higher loss rates as a result of the recessionary economy. Classified assets include performing substandard loans, nonperforming loans and OREO. The following is a summary of loans and other assets that are not performing in accordance with their original contractual terms:

 

     September 30,
2009
    December 31,
2008
    September 30,
2008
 
     (Dollars in thousands)  

Past due 90 days

   $ 0      $ 0      $ 0   

Nonaccrual loans

     646,092        474,172        380,599   

Restructured loans

     101,437        56,618        1,153   
                        

Total nonperforming loans

     747,529        530,790        381,752   

OREO

     81,361        79,875        54,957   
                        

Total nonperforming assets

     828,890        610,665        436,709   

Specific reserves

     (9,898     (19,535     (37,554
                        

Net nonperforming assets

   $ 818,992      $ 591,130      $ 399,155   
                        

Cumulatively, Sterling has written down its nonperforming assets by $386.2 million as of September 30, 2009, compared with write-downs of $207.7 million as of December 31, 2008 and $67.7 million as of September 30, 2008, reflecting lower real estate appraisal values. At September 30, 2009, nonperforming assets include $18.1 million of restructured loans that are performing in accordance with their new terms and are accruing interest, compared with $29.5 million as of December 31, 2008, and none as of September 30, 2008.

 

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At the applicable foreclosure date, other real estate owned is recorded at the fair value of the real estate, less the costs to sell the real estate. The carrying value of OREO is regularly evaluated and, if necessary, an allowance is established to reduce the carrying value to net realizable value. As of September 30, 2009, the allowance for losses on OREO totaled $10.2 million. Changes in this allowance are as follows for the periods presented:

 

     Nine months ended September 30,
     2009     2008
     (Dollars in thousands)

Balance, January 1

   $ 17,555      $ 0

Provision

     24,366        163

Charge-offs

     (31,747     0
              

Balance, September 30

   $ 10,174      $ 163
              

4. Goodwill and Other Intangible Assets:

During the three months ended September 30, 2009, Sterling recorded a goodwill impairment charge of $227.6 million, reducing the balance of goodwill to zero, as compared to the December 31, 2008 balance of $227.6 million. Goodwill represents the difference between the value of consideration paid and the fair value of the net assets received in a business combination. Sterling records impairment losses as charges to noninterest expense and adjustments to the carrying value of goodwill. As of September 30, 2009, Sterling had other intangible assets related to acquired depository relationships of $23.1 million, as compared to $26.7 million as of December 31, 2008. Other intangible assets are periodically assessed for impairment when certain triggering events occur that indicate the possibility of impairment. Goodwill is tested for impairment on an annual basis, or more frequently as events occur, or as current circumstances and conditions warrant. The analysis compares the fair value of each of the reporting units, including goodwill, to the respective carrying amounts. If the carrying amount of the reporting unit, including goodwill, exceeds the fair value of that reporting unit, then further testing for goodwill impairment is performed. Sterling’s Community Banking segment was the only reporting unit of Sterling that had any goodwill ascribed to it during 2009.

During the fourth quarter of 2008, due to reduced expectations for near term profitability, and the protracted decline in Sterling’s stock price and market capitalization, Sterling determined that impairment had occurred, and at that time wrote off $223.8 million of its goodwill. On October 9, 2009, Sterling Savings Bank entered into a Stipulation and Consent to the Issuance of an Order to Cease and Desist (the “SSB Order”) with the Federal Deposit Insurance Corporation (“FDIC”) and the Washington Department of Financial Institutions (“WDFI”). See Note 14 for further discussion of the SSB Order. Sterling considered the execution of the SSB Order to be a triggering event that required Sterling to test its goodwill for impairment as of September 30, 2009.

In order to determine the fair value of its Community Banking segment, Sterling employed three valuation approaches: the Control Premium approach, the Comparable Transactions approach and the Discounted Cash Flow approach. The Control Premium approach used Sterling’s trading multiples of price-to-earnings, price-to-book value and price-to-tangible book value to estimate the Community Banking segment’s value as if it were publicly traded, with the Community Banking segment’s public equivalent value then adjusted upwards for an appropriate premium to reflect an acquisition of control. The Comparable Transactions approach reflected pricing ratios paid by third parties acquiring control of banking companies with similar characteristics in recent periods, and these multiples were used to develop a range of fair values for acquiring control of the Bank. The Discounted Cash Flow approach determined fair value based on the present value of assumed dividends over a five year period, assuming the Community Banking segment were to remain independent, plus the present value of a terminal value determined based on assumed acquisition pricing for the Community Banking segment at the end of the fifth year. Due to the inability to project future earnings with reasonable certainty, no value was assigned to the Discounted Cash Flow approach. The values derived from the Control Premium approach and the Comparable Transaction approach were considered within the hierarchy prescribed by fair value accounting standards to determine the fair value of the reporting unit. The comparison of the fair value of the reporting unit to its carrying value indicated that potential impairment existed. This was a result of the SSB Order, uncertain near term earnings prospects, and the recent decline in Sterling’s stock price and market capitalization. Sterling then performed the second step of goodwill

 

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impairment testing to determine how much, if any, impairment existed. In Step 2, Sterling assigned a fair value to all of the assets and liabilities of the reporting unit as if it had been acquired in a business combination. The Step 2 analysis indicated that the implied fair value of the goodwill was less than the carrying value of goodwill. As a result of this analysis, Sterling wrote off the balance of its goodwill at September 30, 2009.

5. Other Borrowings:

The components of other borrowings are as follows:

 

     September 30,
2009
   December 31,
2008
     (Dollars in thousands)

Junior subordinated debentures

   $ 245,280    $ 245,276

Other

     3,000      3,000
             

Total other borrowings

   $ 248,280    $ 248,276
             

Sterling has raised capital through the formation of trust subsidiaries (“Capital Trusts”), which issue capital securities (“Trust Preferred Securities”) to investors. The 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 documents, taken together, constitute a full and unconditional guarantee by Sterling of the Capital Trusts’ obligations under the Trust Preferred Securities. The Trust Preferred Securities are treated as debt of Sterling. 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, including, with respect to certain of the Trust Preferred Securities, payment of call premiums. During the third quarter of 2009, Sterling elected to defer regularly scheduled interest payments on these securities. Sterling is allowed to defer payments of interest on the junior subordinated notes for up to 20 consecutive quarterly periods without triggering an event of default.

Details of the Trust Preferred Securities are as follows:

 

Subsidiary Issuer

   Issue Date    Maturity
Date
   Rate at September 30, 2009     Amount
(in thousands)

Sterling Capital Trust IX

   July 2007    Oct 2037    Floating   2.00   $ 46,392

Sterling Capital Trust VIII

   Sept 2006    Sept 2036    Floating   1.93        51,547

Sterling Capital Trust VII

   June 2006    June 2036    Floating   1.82        56,702

Lynnwood Capital Trust II

   June 2005    June 2035    Floating   2.10        10,310

Sterling Capital Trust VI

   June 2003    Sept 2033    Floating   3.50        10,310

Sterling Capital Statutory Trust V

   May 2003    May 2033    Floating   3.53        20,619

Sterling Capital Trust IV

   May 2003    May 2033    Floating   3.50        10,310

Sterling Capital Trust III

   April 2003    April 2033    Floating   3.73        14,433

Lynnwood Capital Trust I

   Mar 2003    Mar 2033    Floating   3.43        9,462

Klamath First Capital Trust I

   July 2001    July 2031    Floating   4.70        15,195
                
           2.53 %*    $ 245,280
                

 

* Weighted average rate

 

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6. Shareholders’ Equity:

On December 5, 2008, Sterling issued 303,000 shares of preferred stock and a warrant for 6,437,677 shares of common stock to the U.S. Department of the Treasury for $303.0 million of Capital Purchase Program funds. The preferred stock bears a coupon of 5% for five years, and 9% thereafter. The warrant has a ten year life and an exercise price of $7.06 per share. The initial value allocated to the preferred stock was $292 million, with the remaining $11 million attributed to the warrant. During the third quarter of 2009, Sterling elected to defer the payment of dividends on this cumulative preferred stock. Under the terms of the preferred stock, failure to pay dividends for six dividend periods, whether or not consecutive, would cause the authorized number of directors constituting Sterling’s board of directors to be automatically increased by two, and the holders of the preferred stock, together with the holders of any outstanding parity stock with like voting rights, would be entitled to elect the two additional members of Sterling’s board of directors.

 

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7. Earnings Per Share:

The following table presents the basic and diluted earnings per common share computations.

 

     Three Months Ended September 30,
     2009     2008
     Net Loss
Available to
Common
Shareholders
    Weighted
Average
Shares
   Per Share
Amount
    Net Income    Weighted
Average
Shares
   Per Share
Amount
     (Dollars in thousands, except per share amounts)

Basic computations

   $ (463,725   51,922,871    $ (8.93   $ 4,998    51,821,446    $ 0.10

Effect of dilutive securities:

               

Common stock options and restricted shares

     0      0      0.00        0    184,769      0.00

Common stock warrant

     0      0      0.00        0    0      0.00
                                       

Diluted computations

   $ (463,725   51,922,871    $ (8.93   $ 4,998    52,006,215    $ 0.10
                                       

Antidilutive securities not included in diluted earnings per share:

               

Common stock options

     1,986,471         1,823,738   

Common stock warrant

     6,437,677         0   

Restricted shares

     209,793         0   
                   

Total antidilutive

     8,633,941         1,823,738   
                   
     Nine Months September 30,
     2009     2008
     Net Loss
Available to
Common
Shareholders
    Weighted
Average
Shares
   Per Share
Amount
    Net Income    Weighted
Average
Shares
   Per Share
Amount
     (Dollars in thousands, except per share amounts)

Basic computations

   $ (522,395   51,913,907    $ (10.06   $ 19,549    51,678,981    $ 0.38

Effect of dilutive securities:

               

Common stock options and restricted shares

     0      0      0.00        0    213,919      0.00

Common stock warrant

     0      0      0.00        0    0      0.00
                                       

Diluted computations

   $ (522,395   51,913,907    $ (10.06   $ 19,549    51,892,900    $ 0.38
                                       

Antidilutive securities not included in diluted earnings per share:

               

Common stock options

     2,009,394         1,700,224   

Common stock warrant

     6,437,677         0   

Restricted shares

     223,005         0   
                   

Total antidilutive

     8,670,076         1,700,224   
                   

 

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The Codification requires a two-class method of computing earnings per share for entities that have participating securities such as Sterling’s unvested restricted shares. Application of the two-class method resulted in materially equivalent earnings per share as the application of the treasury method, which is presented above.

8. Non-Interest Expenses:

The following table details the components of Sterling’s total non-interest expenses:

 

     Three Months Ended
September 30,
   Nine Months Ended
September 30,
     2009    2008    2009    2008
     (Dollars in thousands)

Employee compensation and benefits

   $ 41,924    $ 39,851    $ 125,039    $ 121,874

Occupancy and equipment

     12,859      10,829      35,736      33,054

Data processing

     5,221      5,179      15,551      15,665

Insurance

     6,975      1,869      23,353      5,507

Depreciation

     3,566      3,445      10,616      10,516

Advertising

     3,077      3,158      8,931      8,975

Legal and accounting

     1,439      560      4,494      2,097

Amortization of core deposit intangibles

     1,225      1,225      3,674      3,677

Travel and entertainment

     1,321      1,586      3,975      5,032

Other

     6,285      3,818      14,991      9,677
                           

Non-interest expense before impairment charge

     83,892      71,520      246,360      216,074

Goodwill impairment

     227,558      0      227,558      0
                           

Total

   $ 311,450    $ 71,520    $ 473,918    $ 216,074
                           

The increase in non-interest expenses was mainly due to goodwill impairment, and an increase in Federal Deposit Insurance Corporation (“FDIC”) deposit insurance premiums, including a special FDIC assessment of $5.6 million during the second quarter of 2009. FDIC deposit insurance premiums rose by $17.6 million, or 356%, for the nine months ended September 30, 2009 versus the nine months ended September 30, 2008. The remaining increase mainly reflected expenses related to expanded credit resolution efforts as well as costs associated with the growth of Sterling’s mortgage banking operations.

9. Income Taxes:

Sterling uses an estimate of future earnings, and an evaluation of its loss carryback ability and tax planning strategies to determine whether or not the benefit of its net deferred tax asset will be realized. At September 30, 2009, Sterling assessed whether it was more likely than not that it would realize the benefits of its deferred tax asset. Sterling determined that the negative evidence associated with a projected three year cumulative loss for the period ending December 31, 2009, the recent SSB Order entered into with its regulators, and continued credit deterioration in its loan portfolio outweighed the positive evidence. Therefore, Sterling established a valuation allowance of $143.0 million against its deferred tax asset. After recording the valuation allowance Sterling had a net deferred tax liability of $14.1 million as of September 30, 2009, compared to a net deferred tax asset of $90.1 million as of December 31, 2008. As of September 30, 2009, Sterling has recorded a $52.5 million income tax receivable which represents amounts that can be realized through loss carrybacks to prior tax years and refunds of estimated tax payments.

 

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10. Segment Information:

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

 

   

The Community Banking segment provides traditional banking and wealth management services through the retail and commercial banking groups of Sterling’s subsidiary, Sterling Savings Bank.

 

   

The Residential Construction Lending segment originates and services loans through the real estate division of 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 of Sterling’s subsidiary, Golf Savings Bank.

 

   

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 western region primarily through Sterling Savings Bank’s subsidiary INTERVEST-Mortgage Investment Company (“INTERVEST”).

 

   

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

On May 1, 2009, Sterling Savings Bank’s subsidiary, Harbor Financial Services, Inc., which provides certain wealth management services, was renamed Sterling Savings Banc Financial Services, Inc.

The following table presents certain financial information regarding Sterling’s segments and provides a reconciliation to Sterling’s consolidated totals for the periods presented:

 

     As of and for the Three Months Ended September 30, 2009  
     Community
Banking
    Residential
Construction
Lending
    Residential
Mortgage
Banking
    Commercial
Mortgage
Banking
    Other and
Eliminations
    Total  
     (Dollars in thousands)  

Interest income

   $ 129,744      $ 6,286      $ 6,729      $ 5,776      $ 233      $ 148,768   

Interest expense

     (47,933     (8,836     (3,309     0        (1,631     (61,709
                                                

Net interest income (expense)

     81,811        (2,550     3,420        5,776        (1,398     87,059   

Provision for credit losses

     (116,024     (74,976     (4,505     0        0        (195,505

Noninterest income

     11,891        23        11,347        760        (3,065     20,956   

Noninterest expense

     (296,523     (1,720     (9,962     (2,042     (1,203     (311,450
                                                

Income (loss) before income taxes

   $ (318,845   $ (79,223   $ 300      $ 4,494      $ (5,666   $ (398,940
                                                

Total assets

   $ 10,134,623      $ 1,157,089      $ 577,895      $ 16,412        (12,529   $ 11,873,490   
                                                
     As of and for the Three Months Ended September 30, 2008  
     Community
Banking
    Residential
Construction
Lending
    Residential
Mortgage
Banking
    Commercial
Mortgage
Banking
    Other and
Eliminations
    Total  
     (Dollars in thousands)  

Interest income

   $ 140,776      $ 23,178      $ 7,407      $ 4,766      $ 200      $ 176,327   

Interest expense

     (64,739     (14,529     (4,144     0        (2,907     (86,319
                                                

Net interest income (expense)

     76,037        8,649        3,263        4,766        (2,707     90,008   

Provision for credit losses

     (25,106     (10,894     (950     0        0        (36,950

Noninterest income

     17,895        1,160        5,417        926        (2,379     23,019   

Noninterest expense

     (57,470     (4,040     (7,036     (2,276     (698     (71,520
                                                

Income (loss) before income taxes

   $ 11,356      $ (5,125   $ 694      $ 3,416      $ (5,784   $ 4,557   
                                                

Total assets

   $ 10,537,444      $ 1,620,553      $ 495,513      $ 12,921      $ (43,522   $ 12,622,909   
                                                

 

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     As of and for the Nine Months Ended September 30, 2009  
     Community
Banking
    Residential
Construction
Lending
    Residential
Mortgage
Banking
    Commercial
Mortgage
Banking
    Other and
Eliminations
    Total  
     (Dollars in thousands)  

Interest income

   $ 397,175      $ 25,351      $ 21,791      $ 18,412      $ 689      $ 463,418   

Interest expense

     (160,322     (23,902     (10,364     0        (5,804     (200,392
                                                

Net interest income (expense)

     236,853        1,449        11,427        18,412        (5,115     263,026   

Provision for credit losses

     (175,559     (147,441     (18,114     0        0        (341,114

Noninterest income

     33,737        270        40,109        2,199        (9,710     66,605   

Noninterest expense

     (432,677     (5,851     (25,672     (6,292     (3,426     (473,918
                                                

Income (loss) before income taxes

   $ (337,646   $ (151,573   $ 7,750      $ 14,319      $ (18,251   $ (485,401
                                                

Total assets

   $ 10,134,623      $ 1,157,089      $ 577,895      $ 16,412      $ (12,529   $ 11,873,490   
                                                
     As of and for the Nine Months Ended September 30, 2008  
     Community
Banking
    Residential
Construction
Lending
    Residential
Mortgage
Banking
    Commercial
Mortgage
Banking
    Other and
Eliminations
    Total  
     (Dollars in thousands)  

Interest income

   $ 424,878      $ 84,280      $ 23,577      $ 12,690      $ 527      $ 545,952   

Interest expense

     (197,149     (49,276     (13,504     0        (9,809     (269,738
                                                

Net interest income (expense)

     227,729        35,004        10,073        12,690        (9,282     276,214   

Provision for credit losses

     (53,900     (48,150     (3,030     0        0        (105,080

Noninterest income

     51,894        3,318        17,537        2,849        (5,919     69,679   

Noninterest expense

     (175,723     (9,942     (20,300     (7,106     (3,003     (216,074
                                                

Income (loss) before income taxes

   $ 50,000      $ (19,770   $ 4,280      $ 8,433      $ (18,204   $ 24,739   
                                                

Total assets

   $ 10,537,444      $ 1,620,553      $ 495,513      $ 12,921      $ (43,522   $ 12,622,909   
                                                

 

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11. Stock-Based Compensation:

The following is a summary of stock option and restricted stock activity during the nine months ended September 30, 2009:

 

     Stock Options    Restricted Stock
     Number     Weighted
Average
Price
   Number     Weighted
Average
Price

Balance, January 1, 2009

   1,977,968      $ 22.41    284,750      $ 20.17

Granted

   183,500        1.85    260,000        1.85

Exercised/vested

   0        0.00    (86,500     19.81

Cancelled/expired

   (183,350     19.89    (3,500     8.68
                         

Outstanding, September 30, 2009

   1,978,118      $ 20.74    454,750      $ 9.86
                         

Exercisable, September 30, 2009

   1,467,868      $ 22.17     
                 

At September 30, 2009, the weighted average remaining contractual life and the aggregate intrinsic value of stock options outstanding was 4.0 years and $0, respectively, and of stock options exercisable was 3.7 years and $0, respectively, and at December 31, 2008, were 4.3 years and $0, respectively, and 4.0 years and $0, respectively. As of September 30, 2009, a total of 1,361,535 shares remained available for grant under Sterling’s 2001, 2003 and 2007 Long-Term Incentive Plans. The stock options granted under these plans have terms of four, six, eight or ten years. The stock options and restricted shares granted during 2009 have vesting schedules ranging from two to four years. During the nine months ended September 30, 2009 and 2008, the intrinsic value of options exercised were $0 and $2.5 million, respectively, and fair value of options granted were $193,000 and $1.1 million, respectively. The Black-Scholes option-pricing model was used in estimating the fair value of option grants. The weighted average assumptions used were:

 

     Nine Months Ended
September 30,
         2009           2008    

Expected volatility

   72%   30% -33%

Expected term (in years)

   4.4   4.3

Expected dividend yield

   0.00%   2.14% -3.32%

Risk free interest rate

   2.07%   2.93% -3.11%

Stock-based compensation expense recognized during the periods presented was as follows:

 

     Nine Months Ended
September 30,
     2009    2008
     (Dollars in thousands)

Stock based compensation expense:

     

Stock options

   $ 800    $ 816

Restricted stock

     1,404      1,085
             

Total

   $ 2,204    $ 1,901
             

As of September 30, 2009, unrecognized equity compensation expense totaled $5.2 million, as the underlying outstanding awards had not yet been earned. This amount will be recognized over a weighted average period of 2.0 years. During the nine months ended September 30, 2009, 3,500 stock options were forfeited, and 3,500 shares of restricted stock were forfeited. Any increase in forfeitures would lower the amount of future equity compensation expense to be recognized.

 

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12. Derivatives and Hedging:

As part of its mortgage banking activities, Sterling issues interest rate lock commitments to prospective borrowers on residential mortgage loan applications. Pricing for the sale of these loans is fixed with various qualified investors under both non-binding (“best-efforts”) and binding (“mandatory”) delivery programs. For mandatory delivery programs, Sterling hedges interest rate risk by entering into offsetting forward sale agreements on MBS with third parties. Risks inherent in mandatory delivery programs include the risk that if Sterling does not close the loans subject to interest rate lock commitments, it is nevertheless obligated to deliver MBS to the counterparty under the forward sale agreement. Sterling could incur significant costs in acquiring replacement loans or MBS and such costs could have a material adverse effect on mortgage banking operations in future periods.

Interest rate lock commitments and loan delivery commitments are off balance sheet commitments that are considered to be derivatives. As of September 30, 2009, Sterling had $169.5 million of interest rate lock commitments, $84.6 million of warehouse loans held for sale that were not committed to investors, and held offsetting forward sale agreements on MBS valued at $264.0 million. In addition Sterling had mandatory delivery commitments to sell mortgage loans to investors valued at $52.0 million as of September 30, 2009. As of December 31, 2008, Sterling had $75.4 million of interest rate lock commitments, $71.8 million of warehouse loans held for sale that were not committed to investors, and held offsetting forward sale agreements on MBS valued at $114.4 million. In addition, Sterling had mandatory delivery commitments to sell mortgage loans to investors valued at $1.4 million as of December 31, 2008. As of September 30, 2009 and December 31, 2008, Sterling had entered into best efforts forward commitments to sell $98.2 million and $71.0 million of mortgage loans, respectively.

Sterling enters into interest rate swap derivative contracts with customers. The interest rate risk on these contracts is offset by entering into comparable, offsetting interest rate swap agreements with various counterparties. The agreements impose various requirements on Sterling and include terms that provide for early termination or events of default, including the failure to maintain certain capital ratios or to remain well capitalized. Should Sterling fail to meet specific requirements and a counterparty declare an early termination event, Sterling would settle the swap obligation at fair value and then assume the interest rate risk on the customer interest rate swap as a direct liability. These contracts are carried as an offsetting asset and liability at fair value, and are included in other assets and other liabilities, respectively. As of September 30, 2009 and December 31, 2008, the fair value of these contracts was $5.5 million and $7.5 million, respectively.

13. Fair Value:

Fair value estimates are determined as of a specific date using quoted market prices, where available, or various assumptions and estimates. As the assumptions underlying these estimates change, the fair value of the financial instruments will change. The use of assumptions and various valuation techniques, as well as the absence of secondary markets for certain financial instruments, will likely reduce the comparability of fair value disclosures between financial institutions. Accordingly, the aggregate fair value amounts presented do not represent and should not be construed to represent the full underlying value of Sterling.

 

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The carrying amounts and fair values of financial instruments as of the periods indicated, were as follows:

 

     September 30, 2009    December 31, 2008
     Carrying
Amount
   Fair Value    Carrying
Amount
   Fair Value
     (Dollars in thousands)

Financial assets:

           

Cash and cash equivalents

   $ 467,939    $ 467,939    $ 140,295    $ 140,295

Investments and MBS:

           

Available for sale

     2,489,359      2,489,359      2,639,290      2,639,290

Held to maturity

     167,559      173,751      175,830      171,406

Loans held for sale

     187,637      187,637      112,777      112,777

Loans receivable, net

     7,968,947      7,714,203      8,807,094      8,944,214

Accrued interest receivable

     52,190      52,190      57,306      57,306

Financial liabilities:

           

Non-maturity deposits

     3,549,364      3,319,573      3,459,683      3,237,036

Deposits with stated maturities

     4,727,743      4,791,961      4,890,724      4,990,484

Borrowings

     2,777,057      2,764,190      3,137,848      3,251,560

Accrued interest payable

     26,449      26,449      41,631      41,631

Companies have the option of carrying financial assets and liabilities at fair value, which can be implemented on all or individually selected financial instruments. Effective January 1, 2008, Sterling made this fair value election on newly originated loans held for sale under mandatory delivery programs. After analyzing the effects of carrying held for sale loans at fair value, Sterling elected to apply fair value accounting to all newly originated held for sale loans effective April 1, 2008. The fair value election was made to match changes in the value of these loans with the value of their economic hedges. Loan origination fees, costs and servicing rights, which were previously deferred on these loans, are now recognized as part of the loan value at origination. There was no transition adjustment upon adoption.

The framework for defining and measuring fair value requires that one of three valuation methods be used to determine fair market value: the market approach, the income approach or the cost approach. To increase consistency and comparability in fair value measurements and related disclosures, the standard also creates a fair value hierarchy to prioritize the inputs to these valuation methods into the following three levels:

 

   

Level 1 inputs are a select class of observable inputs, based upon the quoted prices for identical instruments in active markets that are accessible as of the measurement date, and are to be used whenever available.

 

   

Level 2 inputs are other types of observable inputs, such as quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are inactive; or other inputs that are observable or can be derived from or supported by observable market data. Level 2 inputs are to be used whenever Level 1 inputs are not available.

 

   

Level 3 inputs are significantly unobservable, reflecting the reporting entity’s own assumptions regarding what market participants would assume when pricing a financial instrument. Level 3 inputs are to be used only when Level 1 and Level 2 inputs are not available.

 

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Assets and Liabilities Measured at Fair Value on a Recurring Basis. The following presents Sterling’s financial instruments that are measured at fair value on a recurring basis:

 

     Total    Level 1    Level 2    Level 3
     (Dollars in thousands)

Balance, September 30, 2009:

           

Investment securities available-for-sale

           

MBS

   $ 2,406,465    $ 0    $ 2,406,465    $ 0

Municipal bonds

     63,482      0      63,482      0

Other

     19,412      0      19,412      0
                           

Total investment securities available-for-sale

     2,489,359      0      2,489,359      0
                           

Loans held for sale

     186,675      0      186,675      0

Other assets - derivatives

     9,990      0      4,520      5,470
                           

Total assets

   $ 2,686,024    $ 0    $ 2,680,554    $ 5,470
                           

Other liabilities - derivatives

   $ 5,782    $ 0    $ 312    $ 5,470
                           

Balance, December 31, 2008:

           

Investment securities available-for-sale

           

MBS

   $ 2,420,012    $ 0    $ 2,420,012    $ 0

Municipal bonds

     105,906      0      105,906      0

Short term commercial paper

     99,117      0      99,117      0

Other

     14,255      0      14,255      0
                           

Total investment securities available-for-sale

     2,639,290      0      2,639,290      0
                           

Loans held for sale

     112,191      0      112,191      0

Other assets - derivatives

     10,085      0      2,625      7,460
                           

Total assets

   $ 2,761,566    $ 0    $ 2,754,106    $ 7,460
                           

Other liabilities - derivatives

   $ 7,709    $ 0    $ 249    $ 7,460
                           

Investments and mortgage-backed securities have been valued using a matrix pricing technique based on quoted prices for similar instruments, while loans held for sale have been valued using investor quoted pricing inputs. Level 2 derivatives represent mortgage banking interest rate lock and loan delivery commitments, while level 3 derivatives represent interest rate swaps. See Note 12 for a further discussion of these derivatives. Changes in the fair value of available-for-sale securities are recorded on the balance sheet under accumulated-other-comprehensive income, while gains and losses from sales are recognized as income. The difference between the aggregate fair value and the aggregate unpaid principal balance of loans held for sale that are carried at fair value were included in earnings as follows:

 

     Nine Months Ended
September 30,
     2009    2008
     (Dollars in thousands)

Mortgage banking operations

   $ 5,174    $ 813

 

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Assets and Liabilities Measured at Fair Value on a Non-recurring Basis. Sterling may be required, from time to time, to measure certain other financial assets at fair value on a non-recurring basis from application of lower of cost or market (“LOCOM”) accounting or write-downs of individual assets. The following table presents the carrying value for these financial assets as of the dates indicated:

 

     Total Carrying
Value
   Level 1    Level 2    Level 3
     (Dollars in thousands)

September 30, 2009

           

Loans

   $ 520,180    $ 0    $ 0    $ 520,180

Mortgage servicing rights

     11,115      0      11,115      0

OREO

     58,009      0      0      58,009

Goodwill

     0      0      0      0

December 31, 2008

           

Loans

   $ 296,605    $ 0    $ 0    $ 296,605

Mortgage servicing rights

     5,706      0      5,706      0

OREO

     60,019      0      0      60,019

Goodwill

     227,558      0      0      227,558

The loans disclosed above represent the carrying value of impaired loans at period end. Mortgage servicing rights were written down mainly due to an acceleration of mortgage prepayments. Sterling carries its mortgage servicing rights at LOCOM, and as such, they are measured at fair value on a non-recurring basis. OREO represents the carrying value after write-downs taken at foreclosure that were charged to the loan loss allowance, as well as specific reserves established subsequent to foreclosure due to updated appraisals. Goodwill is presented at fair value, net of impairment charges. See Note 4.

The methods and assumptions used to estimate the fair value of each class of financial instruments are as follows:

Cash and Cash Equivalents

The carrying value of cash and cash equivalents approximates fair value due to the relatively short-term nature of these instruments.

Investments and MBS

The fair value of investments and MBS has been valued using a matrix pricing technique based on quoted prices for similar instruments, which Sterling validates with non-binding broker quotes, in depth collateral analysis and cash flow stress testing.

Loans Held for Sale

Sterling has elected to carry loans held for sale at fair value. The fair values are based on investor quotes in the secondary market based upon the fair value of options and commitments to sell or issue mortgage loans. On January 1, 2008, Sterling adopted fair value accounting rules, which give companies the option of carrying their financial assets and liabilities at fair value and can be implemented on all or individually selected financial instruments. Effective January 1, 2008, Sterling elected to apply fair value accounting rules to newly originated loans held for sale under mandatory delivery programs. After analyzing the effects of carrying held for sale loans at fair value, Sterling elected to apply fair value accounting to all newly originated held for sale loans effective April 1, 2008. The fair value election was made to match changes in the value of these loans with the value of their economic hedges. Loan origination fees, costs and servicing rights, which were previously deferred on these loans, are now recognized as part of the loan value at origination. There was no transition adjustment upon adoption. As of September 30, 2009 and December 31, 2008, Sterling had $2.0 million and $585,000, respectively, of loans held for sale that were being reported at the lower of amortized cost or market value.

 

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Loans Receivable

The fair value of performing loans is estimated by discounting the cash flows using interest rates that consider the current credit and interest rate risk inherent in the loans and current economic and lending conditions. The fair value of nonperforming loans is estimated by discounting management’s current estimate of future cash flows using a rate estimated to be commensurate with the risks involved. The fair value of nonperforming collateral dependent loans is estimated based upon the value of the underlying collateral. In addition, to reflect current market conditions, a liquidity discount has been applied against the portfolio.

Deposits

The fair values of deposits subject to immediate withdrawal such as interest and non-interest bearing checking, regular savings, and money market deposit accounts, are equal to the amounts payable on demand at the reporting date, net of a core deposit intangible. Fair values for time deposits are estimated by discounting future cash flows using interest rates currently offered on time deposits with similar remaining maturities.

Borrowings

The carrying amounts of short-term borrowings under repurchase agreements, federal funds purchased, short-term FHLB advances and other short-term borrowings approximate their fair values due to the relatively short period of time between the origination of the instruments and the expected payment dates on the instruments. The fair value of advances under lines of credit approximates their carrying value because such advances bear variable rates of interest. The fair value of long-term FHLB advances and other long-term borrowings is estimated using discounted cash flow analyses based on Sterling’s current incremental borrowing rates for similar types of borrowing arrangements with similar remaining terms.

14. Subsequent Events:

On October 9, 2009, Sterling Savings Bank entered into the SSB Order. Among other things, under the terms of the SSB Order, Sterling Savings Bank has agreed to:

 

   

Have and retain qualified management, and notify the FDIC and the WDFI of any changes in Sterling Savings Bank’s Board of Directors or senior executive officers at least 30 days before the change is intended to be effective and receive notice of nondisapproval from the FDIC and the WDFI of any such change;

 

   

Assure that its Board of Directors will have on-going participation in Sterling Savings Bank’s affairs, including full responsibility for approving Sterling Savings Bank’s policies and objectives, and supervising Sterling Savings Bank’s activities;

 

   

Increase by December 15, 2009, Sterling Savings Bank’s Tier 1 capital by at least $300 million and thereafter maintain a Tier 1 leverage ratio of not less than 10%;

 

   

Within 60 days of the SSB Order, develop and adopt a written capital plan to meet and maintain the capital requirements of the SSB Order, which shall include a contingency plan to be implemented by Sterling Savings Bank upon receipt of notice from the FDIC and WDFI that Sterling Savings Bank has failed to: (i) comply with the capital requirements of the SSB Order; (ii) submit a capital plan acceptable to the FDIC and WDFI; or (iii) implement or comply with the capital plan;

 

   

Not pay cash dividends or make any other payments or distributions representing a reduction of Sterling Savings Bank capital without the prior written consent of the FDIC and the WDFI;

 

   

Within 60 days of the SSB Order, review, and revise if necessary, the appropriateness of Sterling Savings Bank’s allowance for loan and lease losses and its a comprehensive policy for determining the appropriate level of the allowance for loan and lease losses;

 

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Remedy any deficiency in the allowance for loan and lease losses in the calendar quarter it is discovered and thereafter maintain an adequate allowance for loan and lease losses at all times;

 

   

Within 60 days of the SSB Order, develop a written plan to systematically reduce the number of nonperforming assets and assets listed on Sterling Savings Bank’s watchlist to an acceptable level;

 

   

Within 60 days of the SSB Order, develop or revise, and implement a written plan, acceptable to the FDIC and the WDFI, to systematically reduce the number of commercial real estate and acquisition, land development and construction loans;

 

   

Within 60 days of the SSB Order, adopt and implement a policy prohibiting extensions of additional credit to borrowers with existing credits classified as “Loss,” “Doubtful’ or “Substandard” except in limited circumstances;

 

   

Within 120 days of the SSB Order, adopt and implement a written three-year strategic plan to improve Sterling Savings Bank’s profitability and risk profile;

 

   

Within 60 days of the SSB Order, develop or revise, adopt and implement, a written liquidity and funds management policy that addresses liquidity needs and contingency funding and reduces reliance on non-core funding sources;

 

   

Comply with the interest rate limitations on solicitation and acceptance of brokered deposits under the FDIC’s rules and regulations and submit to the FDIC and the WDFI within 60 days of the SSB Order, a written plan for reducing its reliance on brokered deposits; and

 

   

Within 35 days of the end of each quarter after the effective date of the SSB Order, provide quarterly written progress reports to the FDIC and the WDFI.

The SSB Order will remain in effect until modified or terminated by the FDIC and the WDFI.

The foregoing description of the SSB Order does not purport to be complete and is qualified in its entirety by reference to the complete copies of the documents attached as Exhibits 10.1, 10.2 and 99.1 to the current report on Form 8-K filed by Sterling with the SEC on October 15, 2009.

The Boards of Directors of Sterling and Sterling Savings Bank are committed to taking all actions necessary to meet each of the requirements of the SSB order in the timeframes as agreed upon with the FDIC. The Boards brought in a new management team to lead the efforts to strengthen Sterling’s capital and liquidity positions, work through problem loans and put into place processes to improve credit quality. The SSB Order formalizes steps that already were underway to restore capital, liquidity and credit quality in order to maintain Sterling’s ability to provide the highest levels of service and safety to the customers and communities served throughout its geographic footprint. Steps immediately being taken by the Boards of Directors include creation of Regulatory Oversight Committees for each of the respective Boards and engaging independent experts to oversee, assist and support actions by the Boards and management to address each requirement of the SSB Order.

On October 14, 2009, Sterling announced the appointment of Sterling director William L. Eisenhart as non-executive Chairman of its Board of Directors. Sterling also appointed J. Gregory “Greg” Seibly, President of Sterling Savings Bank, to serve as acting President and Chief Executive Officer of Sterling and as acting Chief Executive Officer of Sterling Savings Bank and Golf Savings Bank. In addition, Ezra Eckhardt, Executive Vice President and Chief Operating Officer of Sterling Savings Bank, was appointed acting Chief Operating Officer of Sterling and acting President of Sterling Savings Bank. Also, Donn C. Costa, Executive Vice President of Golf Savings Bank, was appointed acting President of Golf Savings Bank. Mr. Seibly’s, Mr. Eckhardt’s, and Mr. Costa’s appointments are subject to review and non-disapproval by Sterling’s regulators, who have been informed of the changes. Mr. Eckhardt will also continue to serve as Chief Operating Officer of Sterling Savings Bank.

 

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Sterling also announced the departure of Harold B. Gilkey, from his positions as Chairman of the Board, President and Chief Executive Officer of Sterling, and as a Director of Sterling and Sterling Savings Bank, and the departure of Heidi B. Stanley from her positions as Chairman of the Board and Chief Executive Officer of Sterling Savings Bank and as a Director of Sterling Savings Bank.

 

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Table of Contents

PART I – Financial Information (continued)

Item 2 – Management's Discussion and Analysis of Financial Condition and Results of Operations

STERLING FINANCIAL CORPORATION

September 30, 2009

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 2008 annual report on Form 10-K.

General

Sterling Financial Corporation (“Sterling”) is a bank holding company, organized under the laws of Washington in 1992. The principal operating subsidiaries of Sterling are Sterling Savings Bank and Golf Savings Bank. The principal operating subsidiary of Sterling Savings Bank is INTERVEST-Mortgage Investment Company (“INTERVEST”). Sterling Savings Bank commenced operations in 1983 as a Washington State-chartered federally insured stock savings and loan association headquartered in Spokane, Washington. On July 8, 2005, Sterling Savings Bank converted to a commercial bank. The main focus of Golf Savings Bank, a Washington State-chartered savings bank acquired by Sterling in July 2006, is the origination and sale of residential mortgage loans.

Sterling provides personalized, quality financial services and “Perfect Fit” banking products to its customers consistent with its “Hometown Helpful” philosophy. Sterling believes that its dedication to personalized service and relationship banking has enabled it to grow both its retail deposit base and its lending portfolio in the western United States. With $11.87 billion in total assets as of September 30, 2009, Sterling originates loans and attracts Federal Deposit Insurance Corporation (“FDIC”) insured deposits from the general public through 178 depository banking offices located in Washington, Oregon, California, Idaho and Montana. In addition, Sterling originates loans through Golf Savings Bank and Sterling Savings Bank residential loan production offices, and through INTERVEST commercial real estate lending offices throughout the western United States. Sterling also markets fixed income and equity products, mutual funds, fixed and variable annuities and other financial products through wealth management representatives located throughout Sterling’s financial service center network.

Sterling’s goal is to be the leading community bank in the West by offering customers a range of highly personalized financial products and services consistent with our “Hometown Helpful”® philosophy. This business model centers on bringing the full product suite of a large regional institution to customers with the personalized service of a local community bank. Sterling’s emphasis on relationship banking is characterized by its focus on delivering consistent high quality service through knowledgeable bankers, fair pricing, a broad range of products and customer convenience. Management believes that this emphasis on relationship banking will increase its commercial and customer deposits, particularly transaction accounts, will provide a more stable source of funding, will enhance its net interest income (the difference between the interest earned on loans and investments and the interest paid on deposits and borrowings) and will increase other fee income, although there can be no assurance in this regard. Sterling’s revenues are derived primarily from interest earned on loans and mortgage-backed securities (“MBS”), fees and service charges, and mortgage banking operations. The operations of Sterling, and banking institutions generally, are influenced significantly by general economic conditions and by policies of its primary regulatory authorities, the Board of Governors of the Federal Reserve System (the “Federal Reserve”), the FDIC and the Washington State Department of Financial Institutions.

 

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Executive Summary and Highlights

Sterling’s performance and earnings per share continue to be impacted by the economic downturn which has led to higher levels of both classified and nonperforming assets, and higher credit costs, as well as a $227.6 million non-cash charge to reflect the impairment of goodwill, and a $143.0 million non-cash valuation allowance against its deferred tax asset. Sterling reported a net loss of $463.7 million, or approximately $8.93 per common share, for the third quarter of 2009. During the three and nine months ended September 30, 2009, Sterling recorded a provision for credit losses of $195.5 million and $341.1 million, respectively, compared to $37.0 million and $105.1 million, respectively, during the comparable 2008 periods. Expenses associated with the resolution of other real estate owned (“OREO”) and FDIC insurance premiums, including a special assessment, have increased during 2009. Income from mortgage banking operations increased 47% and 75%, respectively, over the three and nine months ended September 30, 2008, reflecting lower prevailing interest rates and new lending initiatives, which led to a significant increase in the volume of residential mortgage originations. The year over year decrease in Sterling’s net interest income and net interest margin for the three and nine month periods primarily reflects a higher level of nonperforming assets (including nonaccrual loans and OREO).

During the third quarter of 2009, Sterling elected to defer regularly scheduled interest payments on its junior subordinated notes, and the regular quarterly cash dividend payments on its $303 million in preferred stock. Sterling is allowed to defer payments of interest on the junior subordinated notes for up to 20 consecutive quarterly periods without triggering an event of default. See Liquidity and Capital Resources.

Subsequent to September 30, 2009, Sterling Savings Bank entered into a Stipulation and Consent to the Issuance of an Order to Cease and Desist (the “SSB Order”) with the Federal Deposit Insurance Corporation (“FDIC”) and the Washington Department of Financial Institutions (“WDFI”). Under the terms of the agreement, Sterling Savings Bank shall increase its Tier 1 capital by at least $300 million by December 15, 2009, and thereafter maintain a Tier 1 leverage ratio of not less than 10%. See “- Regulation and Compliance.” A management change was announced on October 14, 2009, of the appointment of Sterling director William L. Eisenhart as non-executive Chairman of its Board of Directors, the promotion of J. Gregory “Greg” Seibly to acting President and Chief Executive Officer, and the promotion of Ezra A. Eckhardt to acting Chief Operating Officer. Sterling also announced the departure of Harold B. Gilkey, who co-founded Sterling in 1983, from his roles as Chairman of the Board, President and Chief Executive Officer of Sterling and as a Director of Sterling’s Board, and the departure of Heidi B. Stanley, from her positions as Chairman of the Board and Chief Executive Officer of Sterling Savings Bank and Director of Sterling Savings Bank.

Financial highlights were as follows:

 

   

Total deposits increased 3% from September 30, 2008 to $8.28 billion.

 

   

Tier I leverage capital ratio was 7.0%.

 

   

Allowance for credit losses was 3.48% of loans receivable, up from 2.71% at June 30, 2009.

 

   

The pace of growth of classified and nonperforming assets has slowed as compared to the June 30, 2009 quarter.

 

   

Net interest margin was 2.98% for the quarter ended September 30, 2009, an improvement of 11 basis points as compared to the June 30, 2009 quarter.

Company Strategy

Sterling’s goal is to be the leading community bank in the West by offering customers a range of highly personalized financial products and services consistent with our “Hometown Helpful”® philosophy. This business model centers on bringing the full product suite of a large regional institution to customers with the personalized service of a local community bank. A key component of Sterling’s strategy is expanding existing relationships and attracting new customers through its relationship-driven deposit strategy. Sterling is committed to maintaining safe, sound and secure banking practices by maintaining strong capital and liquidity positions and is pursuing strategies that align asset levels and asset mix with capital requirements. In the near term, Sterling is focused on organic deposit growth, asset realignment, strong liquidity and capital management, especially within the current geographic service areas of Sterling’s existing depository branches and financial service centers. In the long term, Sterling’s strategy may

 

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include acquiring other financial businesses or branches thereof, or other substantial assets or deposit liabilities. Current market conditions in the banking industry, as well as Sterling’s current capital and regulatory restrictions, may limit acquisition opportunities, and there is no assurance that Sterling will be successful in completing any acquisitions, achieving additional growth or adequately managing capital.

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 Recognition. Sterling 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 when 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 collectability of the total contractual principal and interest is no longer in doubt.

Allowance for Credit Losses. The allowance for credit losses is composed of the allowance for loan losses and the reserve for unfunded credit commitments. In general, determining the amount of the allowance requires significant judgment and the use of estimates by management. Sterling maintains an allowance for credit 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 and confirmed losses, levels and trends in classified 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.

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 and allowances for homogeneous loans (such as residential mortgage loans, consumer 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.

Sterling estimates the fair value of loans being tested for impairment based on the present value of the expected future cash flows discounted at the loan’s effective interest rate. The expected future cash flows exclude potential cash flows from certain guarantors. To the extent these guarantors are able to provide repayments; a recovery would be recorded upon receipt. If an impaired loan is considered collateral dependant the fair value of the loan is calculated based on the fair value of the collateral less the cost to sell.

The fair value of the underlying collateral for real estate loans, which may or may not be collateral dependent, is determined by using appraisals from qualified external sources. For commercial properties and residential development loans, the external appraisals are reviewed by qualified internal appraisal staff to ensure compliance with appropriate standards and technical accuracy. Updated appraisals are ordered in accordance with regulatory provisions for extensions or restructurings of commercial or residential real estate construction and permanent loans that have not performed within the terms of the original loan. Updated appraisals are also ordered for loans that have not been restructured, but that have stale valuation information and deteriorating credit quality that warrants classification as substandard.

 

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The timing of obtaining appraisals may vary, depending on the nature and complexity of the property being evaluated and the general breadth of appraisal activity in the marketplace, but generally it is within 30 to 90 days of recognition of substandard status, following determination of collateral dependency, or in connection with a loan’s maturity or a negotiation that may result in the restructuring or extension of a real estate secured loan. Delays in timing may occur to comply with actions such as a bankruptcy filing or provisions of an SBA guarantee.

Estimates of market value may be used for substandard collateral dependent loans at quarter end if external appraisals are not expected to be completed in time for determining quarter end results or to update values between appraisal dates that reflect updated values based on recent sales activity of comparable inventory or pending property sales of the subject collateral. Estimates of value are never used to raise a value; however, estimates may be used to recognize deterioration of market values in quarters between appraisal updates. The judgment with respect to recognition of any provision or related charge-off for a confirmed loss also takes into consideration whether the loan is collateral dependent or whether it is supported by sources of repayment or cash flow beyond the collateral that is being valued. For loans that are deemed to be collateral dependent, the amount of charge-offs is determined in relation to the collateral’s appraised value. For loans that are not deemed to be collateral dependent, the amount of charge-offs may differ from the collateral’s appraised value because there is additional support for the loan, such as cash flow from other sources.

While management uses available information to provide for loan losses, the ultimate collectability of a substantial portion of the loan portfolio and the need for future additions to the allowance will be influenced by changes in economic conditions and other relevant factors. The slowdown in economic activity could continue to adversely affect cash flows for both commercial and individual borrowers, as a result of which Sterling could experience further increases in nonperforming assets, delinquencies and losses on loans. There can be no assurance that the allowance for credit losses will be adequate to cover all losses, but management believes the allowance for credit losses was adequate at September 30, 2009.

Investment Securities and MBS. Assets in the investment securities and MBS portfolios are initially recorded at cost, which includes any premiums and discounts. Sterling amortizes premiums and discounts as an adjustment to interest income 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. Sterling’s MBS are primarily in agency securities, with limited investments in non-agency obligations. Municipal bonds that Sterling holds are all general obligation in nature, spread throughout Sterling’s footprint. Sterling does not invest in collateralized debt obligations or similar exotic structured investment products.

The loans underlying Sterling’s MBS are subject to the prepayment of principal. The rate at which prepayments are expected to occur in future periods impacts the amount of premium to be amortized in the current period. If prepayments in a future period are higher or lower than expected, then Sterling will need to amortize a larger or smaller amount of the premium to interest income in that future period.

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 other factors. 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, resulting in a loss. There were no investment securities that management identified to be other-than-temporarily impaired for the period ended September 30, 2009, because the decline in fair value of certain classes of securities was attributable to temporary disruptions of

 

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credit markets and the related impact on securities within those classes, not deteriorating credit quality of specific securities. As of September 30, 2009, Sterling held positions in classes of securities negatively impacted by temporary credit market disruptions, including one single-issuer trust preferred security, and 20 private label collateralized mortgage obligations. The trust preferred security is rated A1 by Moody’s and has an amortized cost of $24.6 million compared to an $18.1 million market value, or an unrealized loss of $6.5 million. As of September 30, 2009, the private label collateralized mortgage obligations had an aggregate amortized cost of $229.7 million compared to a $211.4 million market value, or an unrealized loss of $18.3 million. These securities are investment grade, and all are stress-tested monthly for both credit quality and collateral strength. As of September 30, 2009, Sterling expects the return of all principal and interest on all securities within the portfolios pursuant to the contractual terms, has the ability and intent to hold these investments and does not believe it is more likely than not that it would be required to sell these investments before a recovery in market price occurs, or until maturity. Realized losses could occur in future periods due to a change in management’s intent to hold the investments to recovery, a change in management’s assessment of credit risk, or a change in regulatory or accounting requirements. See “ – New Accounting Pronouncements.”

Fair Value of Financial Instruments. Sterling’s available-for-sale securities portfolio totaled $2.49 billion and $2.64 billion as of September 30, 2009 and December 31, 2008, respectively, and were the most substantial of Sterling’s financial instruments that are carried at fair value. These securities are valued using a pricing service’s matrix technique based on quoted prices for similar instruments, which Sterling validates with non-binding broker quotes, in-depth collateral analysis and cash flow stress testing.

Loans held for sale are also carried at fair value in order to match changes in the value of the loans with the value of the economic hedges on the loans without having to apply complex hedge accounting. The fair value of loans held for sale is determined based upon an analysis of investor quoted pricing inputs.

Goodwill and Other Intangible Assets. During the three months ended September 30, 2009, Sterling recorded a goodwill impairment charge of $227.6 million, reducing the balance of goodwill to zero, as compared to the December 31, 2008 balance of $227.6 million. Goodwill represents the difference between the value of consideration paid and the fair value of the net assets received in a business combination. Sterling records impairment losses as charges to noninterest expense and adjustments to the carrying value of goodwill. As of September 30, 2009, Sterling had other intangible assets related to acquired depository relationships of $23.1 million, as compared to $26.7 million as of December 31, 2008. Other intangible assets are periodically assessed for impairment when certain triggering events occur that indicate the possibility of impairment. Goodwill is tested for impairment on an annual basis, or more frequently as events occur, or as current circumstances and conditions warrant. The analysis compares the fair value of each of the reporting units, including goodwill, to the respective carrying amounts. If the carrying amount of the reporting unit, including goodwill, exceeds the fair value of that reporting unit, then further testing for goodwill impairment is performed. Sterling’s Community Banking segment was the only reporting unit of Sterling that had any goodwill ascribed to it during 2009.

During the fourth quarter of 2008, due to reduced expectations for near term profitability, and the protracted decline in Sterling’s stock price and market capitalization, Sterling determined that impairment had occurred, and at that time wrote off $223.8 million of its goodwill. On October 9, 2009, Sterling Savings Bank entered into a Stipulation and Consent to the Issuance of an Order to Cease and Desist (the “SSB Order”) with the Federal Deposit Insurance Corporation (“FDIC”) and the Washington Department of Financial Institutions (“WDFI”). See Note 14 for further discussion of the SSB Order. Sterling considered the execution of the SSB Order to be a triggering event that required Sterling to test its goodwill for impairment as of September 30, 2009.

In order to determine the fair value of its Community Banking segment, Sterling employed three valuation approaches: the Control Premium approach, the Comparable Transactions approach and the Discounted Cash Flow approach. The Control Premium approach used Sterling’s trading multiples of price-to-earnings, price-to-book value and price-to-tangible book value to estimate the Community Banking segment’s value as if it were publicly traded, with the Community Banking segment’s public equivalent value then adjusted upwards for an appropriate premium to reflect an acquisition of control. The Comparable Transactions approach reflected pricing ratios paid by third parties acquiring control of banking companies with similar characteristics in recent periods, and these multiples were used to develop a range of fair values for acquiring control of the Bank. The Discounted Cash Flow approach

 

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determined fair value based on the present value of assumed dividends over a five year period, assuming the Community Banking segment were to remain independent, plus the present value of a terminal value determined based on assumed acquisition pricing for the Community Banking segment at the end of the fifth year. Due to the inability to project future earnings with reasonable certainty, no value was assigned to the Discounted Cash Flow approach. The values derived from the Control Premium approach and the Comparable Transaction approach were considered within the hierarchy prescribed by fair value accounting standards to determine the fair value of the reporting unit. The comparison of the fair value of the reporting unit to its carrying value indicated that potential impairment existed. This was a result of the SSB Order, uncertain near term earnings prospects, and the recent decline in Sterling’s stock price and market capitalization. Sterling then performed the second step of goodwill impairment testing to determine how much, if any, impairment existed. In Step 2, Sterling assigned a fair value to all of the assets and liabilities of the reporting unit as if it had been acquired in a business combination. The Step 2 analysis indicated that the implied fair value of the goodwill was less than the carrying value of goodwill. As a result of this analysis, Sterling wrote off the balance of its goodwill at September 30, 2009.

Other Real Estate Owned. At the applicable foreclosure date, other real estate owned is recorded at the fair value of the real estate, less the cost to sell the real estate. The fair value of OREO is generally determined from appraisals obtained by independent appraisers. Development and improvement costs relating to such property are capitalized to the extent they are deemed to be recoverable.

An allowance for losses on OREO includes amounts for estimated losses as a result of impairment in value of the property after repossession. Sterling reviews its OREO for impairment in value whenever events or circumstances indicate that the carrying value of the property or other assets may not be recoverable. In performing the review, if expected future undiscounted cash flow from the use of the property or other assets, or the fair value, less selling costs, from the disposition of the property or other assets is less than its carrying value, an impairment loss is recognized.

Loans Held for Sale. The majority of loans held for sale are carried at fair value in order to match changes in the value of the loans with the value of the economic hedges on the loans without having to apply complex hedge accounting. A small portion of Sterling’s held for sale portfolio is reported at the lower of amortized cost or market value, as the fair value of certain loan types cannot be efficiently estimated. Any loan that management determines will not be held to maturity is classified as held for sale. Loan origination fees, costs and servicing rights are recognized as part of the loan value at origination. The fair value of loans held for sale is determined based upon an analysis of investor quoted pricing inputs. This value is based on quoted prices for similar instruments in both active and inactive markets, therefore, these loans are classified as level 2.

Income Taxes. Sterling estimates income taxes payable based on the amount it expects to owe various taxing authorities. Accrued income taxes represent the net estimated amount due to, or to be received from, taxing authorities. In estimating accrued income taxes, Sterling assesses the relative merits and risks of the appropriate tax treatment of transactions, taking into account the applicable statutory, judicial and regulatory guidance in the context of Sterling’s tax position. Sterling also considers recent audits and examinations, as well as its historical experience in making such estimates. Although Sterling uses available information to record income taxes, underlying estimates and assumptions can change over time as a result of unanticipated events or circumstances. Penalties and interest associated with any potential estimate variances would be included in income tax expense on the Consolidated Statement of Income.

Sterling uses an estimate of future earnings, and an evaluation of its loss carryback ability and tax planning strategies to determine whether or not the benefit of its net deferred tax asset will be realized. At September 30, 2009, Sterling assessed whether it was more likely than not that it would realize the benefits of its deferred tax asset. Sterling determined that the negative evidence associated with a projected three year cumulative loss for the period ending December 31, 2009, the recent SSB Order entered into with its regulators, and continued credit deterioration in its loan portfolio outweighed the positive evidence. Therefore, Sterling established a valuation allowance of $143.0 million against its deferred tax asset. After recording the valuation allowance Sterling had a net deferred tax liability of $14.1 million as of September 30, 2009, compared to a net deferred tax asset of $96.1 million as of December 31, 2008. As of September 30, 2009, Sterling has recorded a $52.5 million income tax receivable which represents amounts that can be realized through loss carrybacks to prior tax years and refunds of estimated tax payments.

 

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Results of Operations

Overview. Sterling reported a net loss attributable to Sterling’s common shareholders of $463.7 million, or $8.93 per common share, compared with net income in last year’s third quarter of $5.0 million or $0.10 per common share. The net loss was $459.4 million before the accrual of $4.3 million in cumulative preferred dividends associated with the U.S. Treasury’s Capital Purchase Program. The net loss available to common shareholders for the nine months ended September 30, 2009 was $522.4 million, or $10.06 per common share, compared with net income of $19.5 million, or $0.38 per common share, for the same period in 2008. The annualized return on average assets was negative 14.98% and positive 0.16% for the three months ended September 30, 2009 and 2008, respectively. The annualized return on average common equity was negative 257.4% and positive 1.7% for the three months ended September 30, 2009 and 2008, respectively. The decrease in net income and performance ratios reflects impairment charges for goodwill and Sterling’s deferred tax asset, elevated credit costs from the provision for credit losses, OREO charges, loss of interest income on nonperforming loans, and increased FDIC premiums, including a special assessment.

Net Interest Income. The most significant component of earnings for a financial institution typically is net interest income, which is the difference between interest income, primarily from loan, MBS and investment securities portfolios, and interest expense, primarily on deposits and borrowings. During the three and nine months ended September 30, 2009, net interest income was $87.1 million and $263.0 million, respectively, as compared to $90.0 million and $276.2 million, respectively, for the three and nine months ended September 30, 2008. The decrease was primarily due to the increase in nonperforming assets.

Changes in Sterling’s net interest income are a function of changes in both rates and volumes of interest-earning assets and interest-bearing liabilities. Net interest margin refers to net interest income divided by total average interest-earning assets and is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities. The following table presents the composition of the change in net interest income, on a tax equivalent basis, for the periods presented. Municipal loan and bond interest income are presented gross of their applicable tax savings. For each category of interest-earning assets and interest-bearing liabilities, the following table provides information on changes attributable to:

 

   

Volume – changes in volume multiplied by comparative period rate;

 

   

Rate – changes in rate multiplied by comparative period volume; and

 

   

Rate/volume – changes in rate multiplied by changes in volume.

 

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Net interest margin for each of the last five quarters was as follows:

 

     Three Months Ended September 30,
2009 vs. 2008 Increase (Decrease) Due to:
    Nine Months Ended September 30,
2009 vs. 2008 Increase (Decrease) Due to:
 
     Volume     Rate     Rate/
Volume
    Total     Volume     Rate     Rate/
Volume
    Total  
     (Dollars in thousands)  

Rate/volume analysis:

                

Interest income:

                

Loans

   $ (7,823   $ (20,089   $ (583   $ (28,495   $ (3,588   $ (25,459   $ (62,982   $ (92,029

MBS

     4,278        (2,068     (281     1,929        4,395        (1,074     5,981        9,302   

Investments and cash equivalents

     18        (882     (106     (970     1,421        (728     (207     486   
                                                                

Total interest income

     (3,527     (23,039     (970     (27,536     2,228        (27,261     (57,208     (82,241
                                                                

Interest expense:

                

Deposits

     (2,239     (16,496     2,240        (16,495     (2,239     (16,496     (25,146     (43,881

Borrowings

     (4,538     (4,932     1,355        (8,115     (4,538     (4,932     (15,995     (25,465
                                                                

Total interest expense

     (6,777     (21,428     3,595        (24,610     (6,777     (21,428     (41,141     (69,346
                                                                

Changes in net interest income

   $ 3,250      $ (1,611   $ (4,565   $ (2,926   $ 9,005      $ (5,833   $ (16,067   $ (12,895
                                                                

 

Three Months Ended

   Tax Equivalent
Net Interest Margin
 

September 30, 2009

   2.98

June 30, 2009

   2.87

March 31, 2009

   2.98

December 31, 2008

   2.80

September 30, 2008

   3.04

Net interest income and net interest margin have been negatively affected by the increase in nonperforming assets. When loans reach nonperforming status, the reversal and cessation of accruing interest has an immediate negative impact on net interest margin. The increase in net interest margin during the third quarter of 2009 compared to the linked quarter was due to a decrease in funding costs.

Provision for Credit Losses. 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 and trends in classified assets, delinquency and non-accrual loans, and portfolio volume, diversification as to type of loan, size of individual credit exposure, current and anticipated economic conditions, as well as 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 $195.5 million and $37.0 million for the three months ended September 30, 2009 and 2008, respectively, and $341.1 million and $105.1 million for the nine months ended September 30, 2009 and 2008, respectively. Sterling has increased its provision for credit losses in response to an increase in the level of classified loans, particularly in the construction portfolio, and increases in loss rates due to reduced appraisal values.

 

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The following table summarizes the allowance for credit losses for the periods indicated:

 

     Nine Months Ended September 30,  
     2009     2008  
     (Dollars in thousands)  

Allowance for credit losses

    

Allowance - loans, January 1

   $ 208,365      $ 111,026   

Provision

     341,114        105,081   

Charge-offs

     (298,540     (40,230

Recoveries

     14,981        1,433   

Transfers

     9,831        (3
                

Allowance - loans, September 30,

     275,751        177,307   
                

Allowance - unfunded commitments, January 1

     21,334        6,306   

Provision

     0        53   

Charge-offs

     0        (6

Transfers

     (9,831     12   
                

Allowance - unfunded commitments, September 30,

     11,503        6,365   
                

Total credit allowance

   $ 287,254      $ 183,672   
                

At September 30, 2009, Sterling’s total classified assets were 10.53% of total assets, compared with 5.32% of total assets at September 30, 2008. The following table describes classified assets by asset type as of the dates indicated:

 

     September 30,
2009
   June 30,
2009
   March 31,
2009
   December 31,
2008
   September 30,
2008
     (Dollars in thousands)

Residential real estate

   $ 74,448    $ 62,785    $ 31,400    $ 34,333    $ 36,863

Multifamily real estate

     31,921      22,290      15,814      16,741      7,313

Commercial real estate

     81,754      62,184      41,364      37,890      14,931

Construction

              

Residential construction

     527,630      521,984      558,170      548,384      405,753

Multifamily and commercial construction

     275,817      256,192      145,629      119,348      17,109
                                  

Total construction

     803,447      778,176      703,799      667,732      422,862
                                  

Consumer - direct and indirect

     9,016      7,908      6,816      4,556      4,489

Commercial banking

     168,790      192,207      170,678      143,748      130,250
                                  

Total classified loans

     1,169,376      1,125,550      969,871      905,000      616,708

OREO

     81,361      89,721      100,512      79,875      54,795
                                  

Total classified assets

   $ 1,250,737    $ 1,215,271    $ 1,070,383    $ 984,875    $ 671,503
                                  

 

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At September 30, 2009, 68% of classified assets were related to construction, the majority of which was residential. The commercial construction and commercial banking loan portfolios have also been affected by the downturn in the housing market. Sterling’s classified assets as of September 30, 2009, included 20 borrowers who each held loans that in aggregate exceeded $10 million, and together constitute 33% of classified assets. Additional information regarding the classified assets of these 20 borrowers as of September 30, 2009 is provided in the following table:

 

Description

 

Location

   September 30, 2009
         (Dollars in thousands)

Multifamily: 5 loan

  Puget Sound, WA & Other OR      43,803

Commercial Construction: 3 loans

  Puget Sound, WA & Other WA      43,122

Residential Construction; A&D, land, specs and lots: 11 loans

  Puget Sound, WA, OR, CA & UT      38,711

Residential Construction; A&D, land, specs and lots: 62 loans

  Portland, OR & Other WA      31,092

Residential Construction; A&D, land, specs and lots: 170 loans

  Portland, OR & Vancouver, WA      24,888

Residential Contruction; A&D, land: 3 loans

  Puget Sound, WA      24,885

Residential Construction; land, specs and lots: 12 loans

  Other OR      20,111

Residential Contruction; specs & lots: 14 loans

  Puget Sound, WA      19,293

Commercial Construction: 2 loans

  Other OR      19,125

Residential Construction; A&D, specs & lots: 109 loans

  Puget Sound, WA      18,075

Commercial Construction: 1 loan

  Other WA      17,389

Commerical & residential mix use: 4 loans

  Other WA      15,542

Multifamily: 1 loan

  Puget Sound, WA      15,371

Multifamily & commerical: 3 loans

  Puget Sound, WA      13,112

Multifamily: 1 loan

  Other ID      12,650

Residential Construction; A&D, specs & lots: 1 loan

  Other ID      12,236

Residential Construction; specs & lots: 68 loans

  Puget Sound, WA      12,061

Residential Construction; specs & lots: 24 loans

  Portland, OR      10,810

Commercial Construction: 1 loan

  CA      10,718

Residential Contruction; specs & lots: 4 loans

  Boise, ID      10,021
        

Total - Classified Assets of top 20 borrowers

     $ 413,015
        

In early 2008, in order to proactively address credit quality issues within its construction portfolios, Sterling established a Residential Construction Special Project Team with the goal of identifying, managing and resolving credit quality issues before they become classified. Sterling has also added resources to its Credit Administration and Special Assets Departments to address the increased volume of classified assets. When an asset becomes classified, the relationship is transferred to Sterling’s Special Assets Department. Sterling actively engages the borrower and guarantor to remedy the situation by requiring current financial information from the borrower(s) and guarantor(s) to determine a course of action. In addition, new collateral values are requested in order for Sterling’s management to perform evaluations for regulatory and decision making purposes and updated title information is obtained to determine the status of encumbrances on the collateral. When possible, Sterling will require the borrower to provide additional collateral or capital. In conjunction with the receipt of additional collateral, Sterling will sometimes modify the terms of the loan. Often the new modified terms of the loan are consistent with terms that Sterling would offer a new borrower. If the modification of terms is considered concessionary, Sterling classifies the loan as a Troubled Debt Restructure and reports it as a nonperforming loan.

Sterling also may consider allowing a borrower to sell the underlying collateral for less than the outstanding balance on the loan if the current collateral evaluation supports the offer price. In such situations, Sterling typically requires the borrower to sign a new note for the resulting deficiency or bring cash to closing. In some situations Sterling releases the collateral only in a sale transaction, preserving its right to seek monetary judgments against the borrowers and guarantors.

If Sterling and a borrower are unable to achieve an acceptable resolution, Sterling may take a deed in lieu of foreclosure or initiate foreclosure on the underlying collateral. Under such circumstances, Sterling also simultaneously evaluates legal action for recovery against the borrowers and guarantors. After obtaining the collateral, Sterling actively works to sell the collateral.

 

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Nonperforming assets, a subset of classified assets that includes nonperforming loans and OREO, were 6.98% of total assets at September 30, 2009, compared with 3.46% of total assets at September 30, 2008. At September 30, 2009, the delinquency ratio for loans 60 days or more past due was 7.43% of total loans compared to 3.69% of total loans at September 30, 2008. Sterling, like many other financial institutions, has experienced deterioration in the credit quality of residential and commercial construction loans and increases in delinquencies due to declining market values and weakness in housing sales, as well as slower lease-ups of commercial properties in certain of its markets.

The following table summarizes the principal balances of nonperforming assets at the dates indicated:

 

     Sept 30,
2009
    June 30,
2009
    Sept 30,
2008
 
     (Dollars in thousands)  

Past due 90 days

   $ 0      $ 0      $ 0   

Nonaccrual loans

     646,092        592,450        380,599   

Restructured loans

     101,437        105,283        1,153   
                        

Total nonperforming loans

     747,529        697,733        381,752   

OREO

     81,361        89,721        54,957   
                        

Total nonperforming assets

     828,890        787,454        436,709   

Specific reserves

     (9,898     (24,554     (37,554
                        

Net nonperforming assets

   $ 818,992      $ 762,900      $ 399,155   
                        

At September 30, 2009, nonperforming assets include $18.1 million of restructured loans that are performing in accordance with their new terms and are accruing interest, compared with $29.5 million as of December 31, 2008, and none as of September 30, 2008.

 

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The following table presents nonperforming assets:

 

     September 30, 2009     December 31, 2008     September 30, 2008  
     (Dollars in thousands)  

Residential construction

            

Puget Sound

   $ 134,730      16   $ 73,878      12   $ 38,128      9

Portland, OR

     124,849      15        117,350      19        92,599      21   

Southern California

     37,777      5        67,824      11        32,322      7   

Boise, ID

     23,550      3        23,356      4        41,046      9   

Bend, OR

     22,926      3        22,136      4        22,793      5   

Vancouver, WA

     15,504      2        14,486      2        19,704      5   

Utah

     5,244      1        29,586      5        38,143      9   

Other

     77,073      9        61,722      10        32,047      7   
                                          

Total residential construction

     441,653      54        410,338      67        316,782      72   

Commercial construction

     127,306      15        70,607      12        17,715      4   

Commercial banking

     100,370      12        61,520      10        45,163      10   

Residential real estate

     68,045      8        46,043      7        35,358      8   

Commercial real estate

     44,225      5        7,753      1        8,636      2   

Multi-family construction

     27,414      3        3,894      1        3,894      1   

Multi-family real estate

     13,474      2        4,757      1        4,133      1   

Consumer

     6,403      1        5,753      1        5,028      2   
                                          

Total nonperforming assets (1)

     828,890      100     610,665      100     436,709      100
                        

Specific reserves

     (9,898       (19,535       (37,554  
                              

Total net nonperforming assets (1)

   $ 818,992        $ 591,130        $ 399,155     
                              

 

(1)

Net of confirmed losses of $386.2 million for September 30, 2009, $207.7 million for December 31, 2008, and $67.7 million for September 30, 2008.

The $227.9 million increase in nonperforming assets since December 31, 2008 was driven by increases in nonperforming construction, commercial real estate, and commercial banking loans. The $31.3 million increase in residential construction nonperforming loans was primarily in the Puget Sound region. The Puget Sound region is Sterling’s largest market for residential construction and has a higher concentration of vertical construction. The $80.2 million increase in commercial construction is due to slower lease-up rates, which is delaying the stabilization of the property and the borrower’s ability to obtain permanent financing. Cumulatively, Sterling has written down its nonperforming assets by $386.2 million as of September 30, 2009, compared with write-downs of $207.7 million as of December 31, 2008 and $67.7 million as of September 30, 2008. OREO, net of allowances, was $71.2 million at quarter end, compared with $62.3 million at December 31, 2008, and $54.8 million in the year-ago quarter. During the nine months ended September 30, 2009, sales of foreclosed real estate totaled $75.6 million, compared to $6.2 million for the nine months ended September 30, 2008. Weakness in the overall economy has contributed to increased levels of nonperforming assets in the construction, commercial real estate, commercial banking, and residential (primarily non-owner occupied) loan portfolios.

 

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Non-Interest Income. Non-interest income was as follows for the periods presented:

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2009     2008     2009     2008  
     (Dollars in thousands)  

Fees and service charges

   $ 15,088      $ 15,327      $ 43,806      $ 45,490   

Mortgage banking operations

     9,485        6,434        36,525        20,859   

Loan servicing fees

     1,146        737        1,701        1,286   

OREO

     (6,475     102        (29,144     (242

BOLI

     1,815        1,362        5,221        4,575   

Gains on sales of securities

     825        0        12,382        409   

Other

     (928     (943     (3,886     (2,698
                                

Total

   $ 20,956      $ 23,019      $ 66,605      $ 69,679   
                                

The decrease in non-interest income was driven by higher OREO costs, which offset increases in income from mortgage banking operations, and gains on the sale of securities. The elevation in OREO costs reflects losses from the impairment in values of the properties subsequent to repossession, and expenses associated with Sterling’s efforts to resolve problem accounts through foreclosure and liquidation. The mortgage banking segment experienced growth in both the number of originations and the amount of revenue, driven by lower interest rates and recent programs designed to spur lending consistent with the U.S. Department of the Treasury’s Capital Purchase Program. During 2009, Golf Savings Bank has made significant gains in its share of mortgage originations for both new home purchases and refinancings in the states of Washington, Oregon and Idaho. Favorable market conditions provided the opportunity to realize gains within the securities portfolio during 2009. The decrease in fees and service charges was a result of lower loan related fees, including prepayment penalties. In 2008, fees and service charges income benefited from higher financial services commissions reflecting more non-deposit product transactions and higher real estate exchange fees.

The following table summarizes certain information regarding Sterling’s residential and commercial mortgage banking activities for the periods indicated:

 

     Three Months Ended
September 30,
   Nine Months Ended
September 30,
     2009    2008    2009    2008
     (Dollars in thousands)

Originations of residential mortgage loans

   $ 705,721    $ 336,392    $ 2,362,753    $ 1,123,630

Originations of commercial real estate loans

     18,771      68,947      134,729      251,864

Sales of residential mortgage loans

     734,082      288,244      2,150,137      1,000,706

Sales of commercial real estate loans

     10,000      7,535      28,534      10,528

Principal balances of residential loans serviced for others

     953,675      519,754      953,675      519,754

Principal balances of commercial real estate loans serviced for others

     1,672,479      1,667,497      1,672,479      1,667,497

 

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Non-Interest Expenses. Non-interest expenses were as follows for the periods presented:

 

     Three Months Ended
September 30,
   Nine Months Ended
September 30,
     2009    2008    2009    2008
     (Dollars in thousands)

Employee compensation and benefits

   $ 41,924    $ 39,851    $ 125,039    $ 121,874

Occupancy and equipment

     12,859      10,829      35,736      33,054

Data processing

     5,221      5,179      15,551      15,665

Insurance

     6,975      1,869      23,353      5,507

Depreciation

     3,566      3,445      10,616      10,516

Advertising

     3,077      3,158      8,931      8,975

Legal and accounting

     1,439      560      4,494      2,097

Amortization of core deposit intangibles

     1,225      1,225      3,674      3,677

Travel and entertainment

     1,321      1,586      3,975      5,032

Other

     6,285      3,818      14,991      9,677
                           

Non-interest expense before impairment charge

     83,892      71,520      246,360      216,074

Goodwill impairment

     227,558      0      227,558      0
                           

Total

   $ 311,450    $ 71,520    $ 473,918    $ 216,074
                           

The increase in non-interest expenses was mainly due to goodwill impairment, and an increase in Federal Deposit Insurance Corporation (“FDIC”) deposit insurance premiums, including a special FDIC assessment of $5.6 million during the second quarter of 2009. FDIC deposit insurance premiums rose by $17.6 million, or 356%, for the nine months ended September 30, 2009 versus the nine months ended September 30, 2008. The remaining increase mainly reflected expenses related to expanded credit resolution efforts as well as costs associated with the growth of Sterling’s mortgage banking operations.

Income Tax Provision. Sterling recorded a federal and state income tax provision of $60.5 million for the three months ended September 30, 2009, and a benefit of $441,000 for the three months ended September 30, 2008, and a provision of $24.0 million and $5.2 million for the nine months ended September 30, 2009 and 2008, respectively. The effective tax rates were 15% and 10%, respectively, for the three month comparative periods, and 5% and 21%, respectively, for the nine month comparative periods. In September 2009, due to the uncertainty about Sterling’s ability to generate taxable income in the near term, Sterling recorded a valuation allowance of $143.0 million against its deferred tax asset. Sterling will not be able to recognize the tax benefits on future losses until it can show that it is more likely than not that it will generate enough taxable income in future periods to realize the benefits of its deferred tax asset and loss carryforwards.

Financial Position

Assets. At September 30, 2009, Sterling’s assets were $11.87 billion, down $917.2 million from $12.79 billion at December 31, 2008, with decreases in the loan and securities portfolios, goodwill and deferred tax assets, outweighing growth in cash and the balance of held-for-sale loans.

Investment Securities and MBS. Sterling’s investment and MBS portfolio at September 30, 2009 was $2.66 billion, a decrease of $158.2 million from the December 31, 2008 balance of $2.82 billion, due to principal repayments, maturities and sales exceeding purchases. On September 30, 2009, the investment and MBS portfolio had an unrealized gain of $41.7 million versus an unrealized loss of $28.4 million at December 31, 2008.

Loans Receivable. At September 30, 2009, net loans receivable were $7.97 billion, compared to $8.81 billion at December 31, 2008, and $9.07 billion at September 30, 2008. The contraction in Sterling’s loan portfolio reflects charge-offs, Sterling’s goal of reducing construction loans as a percent of its total loan portfolio, and a lessening of demand for credit in the current economy. At the end of the third quarter of 2009, residential construction loans represented 12% of Sterling’s loan portfolio, compared with 18% at the end of the third quarter of 2008. Over the last year, residential construction loans decreased by $696.0 million to $988.8 million at September 30, 2009.

 

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

 

     September 30, 2009     December 31, 2008  
     Amount     %     Amount     %  
     (Dollars in thousands)  

Residential real estate

   $ 862,526      10   $ 867,384      10

Multifamily real estate

     525,580      6        477,615      5   

Commercial real estate

     1,406,977      17        1,364,885      15   

Construction:

        

Residential

     988,827      12        1,455,860      16   

Multifamily

     264,399      3        324,818      4   

Commercial

     654,840      8        754,017      8   
                            

Total Construction

     1,908,066      23        2,534,695      28   

Consumer - direct

     812,695      10        859,222      10   

Consumer - indirect

     355,936      4        389,298      4   

Commercial banking

     2,380,888      30        2,532,158      28   
                            

Gross loans receivable

     8,252,668      100     9,025,257      100
                

Net deferred origination fees

     (7,970       (9,798  

Allowance for losses on loans

     (275,751       (208,365  
                    

Loans receivable, net

   $ 7,968,947        $ 8,807,094     
                    

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

 

     Three Months Ended    Nine Months Ended
     September 30,
2009
   December 31,
2008
   September 30,
2008
   September
2009
   September
2008
     (Dollars in thousands)

Residential real estate

   $ 705,721    $ 341,043    $ 336,392    $ 2,362,753    $ 1,123,630

Multifamily real estate

     12,781      39,026      20,047      79,416      131,949

Commercial real estate

     18,771      74,989      68,947      134,729      251,864

Construction:

              

Residential

     5,182      33,984      61,018      23,830      349,938

Multifamily

     0      13,050      9,574      0      12,324

Commercial

     13,550      35,350      26,630      30,533      157,405
                                  

Total construction

     18,732      82,384      97,222      54,363      519,667

Consumer - direct

     50,811      48,815      72,313      162,491      277,948

Consumer - indirect

     24,420      30,935      43,819      91,025      159,242

Commercial banking

     58,282      102,672      120,785      251,536      439,306
                                  

Total loans originated

   $ 889,518    $ 719,864    $ 759,525    $ 3,136,313    $ 2,903,606
                                  

Stimulated by historically low mortgage rates and new initiatives to provide affordable housing, residential mortgage originations climbed over 100% from the same periods a year ago. This sequential increase reflects Sterling’s effort, since December 2008, to expand and enhance lending initiatives to support and restore economic growth and development in the communities it serves with capital raised through the U.S. Department of the Treasury’s Capital Purchase Program. Sterling’s new lending initiatives focus on funding affordable housing, small business loans and financing programs to support business growth. The decrease in construction loan originations reflects Sterling’s goal of reducing construction loans as a percent of its total loan portfolio.

 

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

 

     September 30, 2009     December 31, 2008  
     Amount    %     Amount    %  
     (Dollars in thousands)  

Interest-bearing checking

   $ 818,281    10      $ 449,060    5   

Noninterest-bearing checking

     1,011,443    12        897,198    11   

Savings and money market demand accounts

     1,719,640    21        2,113,425    25   

Time deposits

     4,727,743    57        4,890,724    59   
                          

Total deposits

   $ 8,277,107    100   $ 8,350,407    100
                          

Annualized cost of deposits

      1.97      2.91
                  

During 2009, there was a shift of uninsured savings and money market account balances to FDIC insured interest bearing transaction accounts. This was related to changes in the collateralization requirements associated with uninsured public funds deposits and Sterling’s participation in the FDIC voluntary expanded insurance program, which provides, without charge to depositors, full guarantee on non-interest bearing and certain interest-bearing transaction accounts held by any depositor, regardless of dollar amount. Total deposits declined since December 31, 2008, mostly as a result of a reduction in brokered and public deposits, which was partially offset by an increase in retail deposits. The increase in retail deposits reflects Sterling’s simplification of product offerings, more convenient branch hours for customers, fair pricing, and enhanced internal sales training.

Borrowings. Deposit accounts are Sterling’s primary source of funds. Sterling does, however, rely upon advances from the Federal Home Loan Bank (“FHLB”), reverse repurchase agreements and other borrowings to fund assets and meet deposit withdrawal requirements. During the nine months ended September 30, 2009, these borrowings decreased a total of $360.8 million, consistent with Sterling’s strategy of reducing total assets to manage its capital position.

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. The mismatch between maturities, interest rate sensitivities and prepayment characteristics of assets and liabilities, and the changes in each of these attributes under different interest rate scenarios results in interest-rate risk.

Sterling, like most financial institutions, has material interest-rate risk exposure to changes in both short-term and long-term interest rates as well as variable interest rate indices. Sterling’s results of operations are largely dependent upon its net interest income and its ability to manage its interest rate risk.

Sterling’s subsidiary banks’ Asset/Liability Committees (“ALCO”) manage their interest-rate risk based on interest rate expectations and other factors within policies and practices approved by the subsidiary banks’ Boards of Directors. The principal objective of Sterling’s subsidiary banks’ asset and liability management activities is to provide maximum levels of net interest income while maintaining acceptable levels of interest-rate risk and liquidity risk while facilitating funding needs. ALCO manages this process at both the subsidiary and consolidated levels. ALCO measures interest rate risk exposure through three primary measurements: management of the relationship between its interest bearing assets and its interest bearing liabilities, interest rate shock simulations of net interest income, and economic value of equity (“EVE”) simulation.

 

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The difference between a financial institution’s interest rate sensitive assets (i.e., assets that will mature or reprice within a specific time period) and interest rate sensitive liabilities (i.e. liabilities that will mature or reprice within the specific time period) is commonly referred to as its “interest rate sensitivity gap.” An institution having more interest rate sensitive assets than interest rate sensitive liabilities within a given time period is said to be “asset sensitive,” which generally means that if interest rates increase (other things being equal), a company’s net interest income will increase and if interest rates decrease (other things being equal), its net interest income will decrease. The opposite is true for an institution that is liability sensitive. During 2008 and for the first two quarters of 2009, Sterling was “asset sensitive.” As of September 30, 2009, under the most likely interest rate scenario, Sterling moved to a “liability sensitive” position, with a higher level of deposits and borrowings potentially re-pricing faster in the short term than interest earnings assets.

ALCO uses interest rate shock simulations of net interest income to measure the effect of changes in interest rates on the net interest income for Sterling over a 12 month period. This simulation consists of measuring the change in net interest income over the next 12 months from a base case scenario when rates are shocked, in a parallel fashion, up 100 and 200 basis points. Based on the current interest rate environment, downward interest rate shocks do not generate meaningful results. The base case uses the assumption of the existing balance sheet and existing interest rates to simulate the base line of net interest income over the next 12 months. The simulation requires numerous assumptions, including relative levels of market interest rates, instantaneous and parallel shifts in the yield curve, loan prepayments and reactions of depositors to changes in interest rates, and should not be relied upon as being indicative of actual or future results. Further, the analysis does not contemplate actions Sterling may undertake in response to changes in interest rates and market conditions. The results of this interest rate shock simulation as of September 30, 2009 and December 31, 2008 are included in the following table:

 

Change in
Interest Rate in
Basis Points
(Rate Shock)

   September 30,
2009
% Change in
Net Interest
Income
  December 31,
2008
% Change in
Net Interest
Income
+200    (4.7)   3.6
+100    (0.2)   2.2
Static    0.0   0.0
-100    N/A   N/A

ALCO uses EVE simulation analysis to measure risk in the balance sheet that might not be taken into account in the net interest income simulation analysis. Whereas net interest income simulation highlights exposure over a relatively short time period of 12 months, EVE simulation analysis incorporates all cash flows over the estimated remaining life of all balance sheet positions. The EVE simulation analysis of the balance sheet, at a point in time, is defined as the discounted present value of asset cash flows minus the discounted value of liability cash flows. The discount rates that are used represent an assumption for the current market rates of each group of assets and liabilities. The difference between the present value of the asset and liability represents the EVE. As with net interest income, this is used as the base line to measure the change in EVE when interest rates are shocked, in a parallel fashion, up 100 and 200 basis points. Based on the current interest rate environment, downward interest rate shocks do not generate meaningful results. As with the net interest income simulation model, EVE simulation analysis is based on key assumptions about the timing and variability of balance sheet cash flows. However, because the simulation represents much longer time periods, inaccuracy of assumptions may increase the variability of outcomes within the simulation. It also does not take into account actions management may undertake in response to anticipated changes in interest rates. The results of this EVE simulation at September 30, 2009 and December 31, 2008 are included in the following table:

 

Change in
Interest Rate
in Basis Points
(Rate Shock)

   At September 30,
2009
%
Change

in EVE
  At December 31,
2008
%
Change
in EVE
+200    (10.0)   (3.8)
+100     1.4   (2.7)
Static     0.0   0.0
-100    N/A   N/A

 

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Sterling occasionally enters into customer-related financial derivative transactions primarily consisting of interest rate swaps. Risk exposure from customer positions is managed through transactions with other broker dealers. As of September 30, 2009, Sterling has not entered into asset/liability related derivative transactions as part of managing its interest rate risk. However, Sterling continues to consider derivatives, including interest rate swaps, caps and floors, as a viable alternative in the asset and liability management process.

Liquidity and Capital Resources

Sterling’s primary sources of funds are: customer deposits; wholesale funds from commercial banks, the FHLB, and the Federal Reserve; the collection of principal and interest primarily from loans, as well as from mortgage backed securities; and the sale of loans into the secondary market in connection with Sterling’s mortgage banking activities.

Sterling Savings Bank and Golf Savings Bank actively manage their liquidity in an effort to maintain an adequate margin over the level necessary to support the funding of loans and deposit withdrawals. This is balanced with the need to maximize yield on alternative investments. The liquidity ratio may vary from time to time, depending on economic conditions, deposit fluctuations and loan funding needs.

Sterling uses wholesale funds to supplement deposit gathering for funding the origination of loans or purchasing assets such as MBS and investment securities. These borrowings include advances from the FHLB, reverse repurchase agreements, primary and secondary credits and term auction facilities from the Federal Reserve, and federal funds purchased. Sterling had access to $3.24 billion and $3.23 billion of additional liquidity from all sources as of September 30, 2009 and December 31, 2008, respectively. In 2009, certain states have increased the collateralization requirements for uninsured public funds. The increased collateralization requirements required that Sterling pledge additional collateral, which reduced Sterling’s collateral available for liquidity. Sterling Savings Bank and Golf Savings Bank have credit lines with FHLB of Seattle that provide for borrowings up to a percentage of each of their total assets, subject to collateralization requirements. At September 30, 2009 and December 31, 2008, these credit lines represented a total borrowing capacity of $2.47 billion and $2.92 billion, of which $907.9 million and $1.33 billion was available, respectively. At September 30, 2009 and December 31, 2008, Sterling had $1.04 billion and $1.09 billion in outstanding borrowings under reverse repurchase agreements, respectively. Sterling had unpledged securities available for additional secured borrowings of approximately $1.19 billion and $548.9 million as of September 30, 2009 and December 31, 2008, respectively.

Reverse repurchase agreements allow Sterling to sell investments (generally U.S. agency securities and MBS) under an agreement to buy them back at a specified price at a later date. These agreements to repurchase are deemed to be borrowings collateralized by the investments and MBS sold. The use of reverse repurchase agreements may expose Sterling to certain risks not associated with other borrowings, including interest rate risk and the possibility that additional collateral may have to be provided if the market value of the pledged collateral declines. The terms of certain of Sterling’s borrowings and reverse repurchase agreements that Sterling has entered into, impose various requirements on Sterling, including the requirement to remain well capitalized. As a result of the SSB Order, Sterling may be deemed to have triggered an event of default with regard to fully collateralized, structured reverse

 

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repurchase agreements valued at approximately $500 million. A notice of early termination, if received due to a default, could result in the recognition of approximately $45 million in additional costs related to settlement of the borrowings at current fair value. Sterling has an additional $500 million of fully collateralized, structured reverse repurchase agreements that may generate similar costs, if Sterling were required to settle the agreements pursuant to an event of default. Certain MBS pledged against these borrowings, if sold, may result in securities gains that could mitigate these settlement costs. Should these actions occur, Sterling’s interest costs would be reduced and these actions may improve its Tier 1 leverage capital ratio in the future, although there can be no assurance that these improvements will occur. At September 30, 2009, Sterling also had $3.0 million of borrowings in the form of a subordinated debenture. While the debenture remains in place in accordance with its original terms, it bears a default rate of interest of 7.75% since Sterling has defaulted on certain covenants regarding regulatory actions.

As of September 30, 2009 and December 31, 2008, Sterling also had $52.7 million and $69.0 million, respectively, of federal funds purchased and discount window borrowings, which are short term borrowings from correspondent banks and the Federal Reserve. Through the Federal Reserve’s 12th District Bank, Sterling Savings Bank participates in the Borrower in Custody Program which allows Sterling Savings Bank to borrow against certain pledged loans on an overnight basis. Golf Savings Bank can borrow under the Borrower in Custody Program for terms ranging from overnight to 90 days. Golf Savings Bank is also eligible to participate in the Term Auction Facility which allows Golf Savings Bank to bid on funds to be borrowed for terms of 28 to 84 days. Following receipt of the SSB Order, Sterling may be required to provide a higher level of collateral for any funds that Sterling borrows from the Federal Reserve or its other funding sources. Any additional collateral requirements or limitations on Sterling’s ability to access additional funding sources are expected to have a negative impact on Sterling’s liquidity.

On December 5, 2008, Sterling completed the sale of 303,000 shares of preferred stock and issued a warrant to purchase 6,437,677 shares of Sterling’s common stock to the U.S. Department of the Treasury, raising total proceeds of $303 million. The $303 million in proceeds are treated as Tier 1 capital. The 303,000 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A (the “Preferred Shares”), issued by Sterling will pay a cumulative compounding dividend of 5% per year for the first five years and will reset to a rate of 9% per year after five years. During the third quarter 2009, Sterling elected to defer the payment of dividends on this cumulative preferred stock. Under the terms of the preferred stock, failure to pay dividends for six dividend periods, whether or not consecutive, would cause the authorized number of directors constituting Sterling’s board of directors to be automatically increased by two and the holders of the preferred stock, together with the holders of any outstanding parity stock with like voting rights, would be entitled to elect the two additional members of Sterling’s board of directors. Subject to approval by Sterling’s banking regulators, the Preferred Shares may be redeemed by Sterling at their issue price, plus all accrued and unpaid dividends. In addition to the Preferred Shares, the Treasury Department received a warrant with a ten year exercise period to purchase 6,437,677 shares of Sterling common stock at an exercise price of $7.06 per share. The initial value allocated to the preferred stock was $292 million, with the remaining $11 million attributed to the warrant. The allocation was based on the relative fair value for the preferred stock and the warrant, respectively, to the total fair value of the combined preferred stock and warrant. The fair value of the preferred stock was estimated using a discounted cash flow methodology at an assumed market equivalent rate of 12%, with 20 quarterly payments over a five year period. The fair value of the warrant was estimated using the Black-Scholes option pricing model, with assumptions of 50% volatility, a risk-free rate of 2.68%, a yield of 6.53% and an estimated life of 10 years. The value attributed to the warrant is being accreted as a discount on the preferred stock using the effective interest method over five years.

Sterling, on a parent company-only basis, had cash of approximately $26.0 million and $86.2 million at September 30, 2009 and December 31, 2008, respectively. Sterling’s total investment in Sterling Saving Bank as of September 30, 2009 was $847.8 million compared to $1.25 billion as of December 31, 2008, with the decrease due to losses during the period. Sterling’s investment in Sterling Savings Bank consisted of $414.7 million of common stock and $433.1 million of preferred stock as of September 30, 2009 and $865.8 million of common stock and $383.1 million of preferred stock as of December 31, 2008. Sterling’s total investment in Golf Savings Bank was $60.7 million as of both September 30, 2009 and December 31, 2008. Sterling received cash dividends from Sterling Savings Bank of $9.7 million and $28.6 million during the nine months ended September 30, 2009 and 2008, respectively, and from Golf Savings Bank of $606,000 and $0 for the same respective periods. Sterling Savings Bank’s and Golf Savings Bank’s ability to pay dividends is generally limited by their earnings, financial condition, capital requirements, and applicable regulatory requirements. As of September 30, 2009, Sterling’s subsidiary banks were not paying dividends to Sterling.

 

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Sterling has had the ability to secure additional capital through the capital markets, including the issuance of capital securities (“Trust Preferred Securities”) to investors. 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. During the third quarter of 2009, Sterling elected to defer payments of interest on the Junior Subordinated Debentures. Sterling may defer such interest payments for up to 20 consecutive quarterly periods without triggering an event of default.

The availability and cost of capital is partially dependent on Sterling’s credit ratings. In May 2009, citing “elevated levels of nonperforming loans, recent poor operating performance and the prospect for continued losses for the remainder of 2009,” Fitch Ratings (“Fitch”) downgraded Sterling’s credit ratings, changing the outlook to negative from watch negative, and its individual rating to D from C. In August, Fitch further downgraded Sterling to D/E from D upon announcement by Sterling of its election to defer interest payments on its trust preferred borrowings and dividends on its preferred stock issued to the U.S. Treasury Department under the Capital Purchase Program.

In July 2009, Sterling filed a universal shelf registration statement on Form S-3 with the Securities and Exchange Commission (“SEC”). This registration statement replaces Sterling’s prior shelf registration statement, and increases the amount of money that Sterling may raise under the registration statement. Sterling may issue up to an aggregate of $500 million of equity, debt, or other types of securities from time to time and through one or more methods of distribution. The SSB Order requires Sterling to raise at least $300 million of capital by December 15, 2009 and thereafter maintain a Tier 1 leverage ratio of not less than 10%. There can be no assurance that Sterling will continue to be able to access the capital markets in the future.

Off-Balance Sheet Arrangements and Aggregate Contractual Obligations

Sterling, in the conduct of ordinary business operations routinely enters into contracts for services. These contracts may require payment for services to be provided in the future and may also contain penalty clauses for the early termination of the contracts. Sterling is also party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Management does not believe that these off-balance sheet arrangements have a material current effect on Sterling’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources but there is no assurance that such arrangements will not have a future effect.

The reserve for unfunded commitments as of September 30, 2009 was $11.5 million, and as of December 31, 2008 was $21.3 million, with the decline due to Sterling reducing the amount of unfunded commitments on nonperforming loans. The adequacy of the reserve for unfunded commitments is evaluated on a quarterly basis.

As part of its mortgage banking activities, Sterling issues interest rate lock commitments to prospective borrowers on residential mortgage loan applications. Pricing for the sale of these loans is fixed with various qualified investors under both non-binding (“best-efforts”) and binding (“mandatory”) delivery programs. For mandatory delivery programs, Sterling hedges interest rate risk by entering into offsetting forward sale agreements on MBS with third parties. Risks inherent in mandatory delivery programs include the risk that if Sterling does not close the loans subject to interest rate lock commitments, it is nevertheless obligated to deliver MBS to the counterparty under the forward sale agreement. Sterling could incur significant costs in acquiring replacement loans or MBS and such costs could have a material adverse effect on mortgage banking operations in future periods.

 

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Interest rate lock commitments and loan delivery commitments are off balance sheet commitments that are considered to be derivatives. As of September 30, 2009, Sterling had $169.5 million of interest rate lock commitments, $84.6 million of warehouse loans held for sale that were not committed to investors, and held offsetting forward sale agreements on MBS valued at $264.0 million. In addition Sterling had mandatory delivery commitments to sell mortgage loans to investors valued at $52.0 million as of September 30, 2009. As of December 31, 2008, Sterling had $75.4 million of interest rate lock commitments, $71.8 million of warehouse loans held for sale that were not committed to investors, and held offsetting forward sale agreements on MBS valued at $114.4 million. In addition, Sterling had mandatory delivery commitments to sell mortgage loans to investors valued at $1.4 million as of December 31, 2008. As of September 30, 2009 and December 31, 2008, Sterling had entered into best efforts forward commitments to sell $98.2 million and $71.0 million of mortgage loans, respectively.

Sterling enters into interest rate swap derivative contracts with customers. The interest rate risk on these contracts is offset by entering into comparable, offsetting interest rate swap agreements with various counterparties. The agreements impose various requirements on Sterling and include terms that provide for early termination or events of default, including the failure to maintain certain capital ratios or to remain well capitalized. Should Sterling fail to meet specific requirements and a counterparty declare an early termination event, Sterling would settle the swap obligation at fair value and then assume the interest rate risk on the customer interest rate swap as a direct liability. These contracts are carried as an offsetting asset and liability at fair value, and are included in other assets and other liabilities, respectively. As of September 30, 2009 and December 31, 2008, the fair value of these contracts was $5.5 million and $7.5 million, respectively.

Capital

Sterling’s total shareholders’ equity decreased $475.2 million to $665.8 million during the nine months ended September 30, 2009 from $1.14 billion at December 31, 2008, reflecting the net loss, including noncash charges of $227.6 million for the impairment of goodwill, the $143.0 million valuation allowance against Sterling’s deferred tax asset, and the preferred stock dividends under the U.S. Department of the Treasury CPP Program, partially offset by a gain on the available for sale securities portfolio.

At September 30, 2009 and December 31, 2008, Sterling had an unrealized gain of $41.7 million and an unrealized loss of $28.4 million, respectively, on investment securities and MBS classified as available for sale. Fluctuations in prevailing interest rates and other market factors continue to cause volatility in this component of accumulated comprehensive income or loss in shareholders’ equity and may continue to do so in future periods. Shareholders’ equity was 5.61% of total assets at September 30, 2009 compared with 8.92% at December 31, 2008.

As of both September 30, 2009 and December 31, 2008, Sterling had $245.3 million outstanding of various series of Trust Preferred Securities issued to investors. The Trust Preferred Securities are treated as debt of Sterling, and can qualify as Tier 1 capital, but are subject to certain limitations, including the Federal Reserve capital distribution limitations. As of September 30, 2009, Sterling had $24.8 million of Trust Preferred Securities that were being excluded from its Tier 1 capital, compared to $0 being excluded as of December 31, 2008.

Sterling, Sterling Savings Bank and Golf Savings Bank are required by applicable regulations to maintain certain minimum capital levels. Sterling’s management intends to enhance the capital resources and regulatory capital ratios of Sterling and its banking subsidiaries through the retention of an adequate amount of earnings and the management of the level and mix of assets, although there can be no assurance in this regard. At September 30, 2009, each of the companies exceeded all such regulatory capital requirements and were “well capitalized” pursuant to such regulations. Subsequent to September 30, 2009, under the SSB Order, Sterling Savings Bank’s regulators have directed Sterling Savings Bank to increase its overall capital levels and, in particular, are requiring Sterling Savings Bank to increase its Tier 1 leverage ratio to 10.0% by December 15, 2009. As a result of this capital maintenance provision, Sterling Savings Bank is no longer deemed to be well capitalized. Since Sterling Savings Bank is no longer deemed to be well capitalized it must comply with interest rate limitations on the solicitation of retail deposits and cannot accept brokered deposits. The following table sets forth their respective capital positions at September 30, 2009:

 

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     Minimum Capital
Requirements
    Well-Capitalized
Requirements
    Actual  
     Amount    Ratio     Amount    Ratio     Amount    Ratio  
     (Dollars in thousands)  

Tier 1 leverage (to average assets)

               

Sterling

   $ 479,214    4.0   $ 599,017    5.0   $ 837,600    7.0

Sterling Savings Bank

     456,818    4.0     271,020    5.0     781,475    6.8

Golf Savings Bank

     21,981    4.0     27,476    5.0     62,741    11.4

Tier 1 (to risk-weighted assets)

               

Sterling

     351,564    4.0     527,346    6.0     837,600    9.5

Sterling Savings Bank

     337,683    4.0     506,524    6.0     781,475    9.3

Golf Savings Bank

     13,408    4.0     20,112    6.0     62,741    18.7

Total (to risk-weighted assets)

               

Sterling

     703,129    8.0     878,911    10.0     977,464    11.1

Sterling Savings Bank

     675,365    8.0     844,207    10.0     892,163    10.6

Golf Savings Bank

     26,816    8.0     33,521    10.0     66,961    20.0

Goodwill Litigation

In the fourth quarter of 2008, following mediation, Sterling settled on the amount of damages owed to Sterling and fully resolved its goodwill lawsuit against the U.S. government for its breach of contract related to past acquisitions of failed savings institutions. Sterling was paid $1.8 million in January 2009. Sterling is satisfied that it prevailed in the litigation, which now is fully concluded.

New Accounting Pronouncements

In June 2009, the Financial Accounting Standards Board (“FASB”) issued FAS 168, “The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles - replacement of FAS 162” (the “Codification”). The Codification supersedes all existing accounting and reporting standards other than the rules of the SEC. Updates to the Codification are being issued as Accounting Standards Updates, which will also provide background information about the guidance, and provide the basis for conclusions on changes in the Codification. The Codification became effective for Sterling for the interim period ending September 30, 2009, and did not have a material impact on its consolidated financial statements.

In December 2007, the FASB updated the standard on business combinations, establishing principles and requirements for how the acquirer: 1) recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any non-controlling interest in the acquiree; 2) recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase; 3) determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. Depending on the level of future acquisitions, this accounting standard may have a material effect on Sterling, mainly in regards to the valuation of loans, and the treatment for acquisition costs.

In February 2008, the FASB issued a staff position on transfers of financial assets and repurchase financing transactions. For linked transactions, a transferor and transferee shall not separately account for a transfer of a financial asset and a related repurchase financing unless (a) the two transactions have a valid and distinct business or economic purpose for being entered into separately and (b) the repurchase financing does not result in the initial transferor regaining control over the financial asset. This guidance was effective for Sterling as of January 1, 2009, and did not have a material impact on its consolidated financial statements.

In March 2008, the FASB issued a standard on disclosure requirements for derivative instruments and hedging activities. This section of the Codification requires enhanced disclosures about how and why an entity uses derivative instruments, how derivative instruments and related hedged items are accounted for, and how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. This guidance was effective for Sterling as of January 1, 2009, and did not have a material effect on its consolidated financial statements.

 

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In June 2008, the FASB issued a staff position on determining whether instruments granted in share-based payment transactions are participating securities. The guidance clarifies that all outstanding unvested share-based payment awards that contain non-forfeitable rights to dividends are participating securities and are required to be included in computing basic and diluted earnings per share under the two-class method. This guidance was effective for Sterling as of January 1, 2009, and did not have a material impact on its consolidated financial statements.

In April 2009, the FASB issued staff positions on the recognition and presentation of Other-Than-Temporary Impairment (“OTTI”), determining fair value when the volume and level of activity for the asset or liability have significantly decreased and identifying transactions that are not orderly, and interim disclosures about fair value of financial instruments. For debt securities, the guidance differentiates credit driven and market driven OTTI. Only the portion of the impairment loss representing credit losses would be recognized in earnings as an OTTI. The balance of the impairment loss would be recognized as a charge to other comprehensive income. A non-credit related OTTI charge to other comprehensive income for securities classified as held to maturity will be amortized from accumulated other comprehensive income back to the security over the securities remaining life. Financial statement presentation will require segregation of accumulated comprehensive income for non-credit OTTI charges on held to maturity and available for sale securities from other components of accumulated comprehensive income. Additional guidance was included for the determination of whether a market for an asset is not active and when a price for a transaction is not distressed. Previously required annual disclosures have been extended to interim periods. This guidance was effective for Sterling as of June 30, 2009. See Notes 2 and 13.

In May 2009, the FASB issued guidance on subsequent events that standardizes accounting for and disclosures of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. As a public entity, Sterling is required to evaluate subsequent events through the date its financial statements are issued. Accordingly, Sterling has completed an evaluation of subsequent events through November 2, 2009. These rules became effective for Sterling during its interim period ending after June 15, 2009, and did not have a material impact on its consolidated financial statements.

In June 2009, the FASB issued standards on accounting for transfers of financial assets, removing the concept of qualifying special-purpose entities as an accounting criteria that had provided an exception to consolidation, and provided additional guidance on requirements for consolidation. This guidance is effective for annual periods ending after November 15, 2009, and is not expected to have a material impact on Sterling’s consolidated financial statements.

Regulation and Compliance

Sterling is subject to many laws and regulations applicable to banking activities. As a bank holding company, Sterling is subject to comprehensive examination and regulation by the Federal Reserve. Sterling Savings Bank, as a Washington State-chartered bank, and Golf Savings Bank, as a Washington State-chartered savings bank, are subject to comprehensive regulation and examination by the Washington Department of Financial Institutions and the FDIC. Sterling Savings Bank and Golf Savings Bank are further subject to Federal Reserve regulations related to deposit reserves and certain other matters.

On October 3, 2008, in response to upheaval within the financial markets, the President signed into law the Emergency Economic Stabilization Act of 2008 (the “EESA”), which authorized the United States Department of Treasury (the “Treasury Department”) to establish the Troubled Assets Relief Program (“TARP”) to purchase “troubled assets” held by financial institutions. Under the TARP program the Treasury Department is authorized to purchase, and to make and fund commitments to purchase, troubled assets from any financial institution, on such terms and conditions as are determined by the Treasury Department. The purpose of this program is to restore confidence and stability to the financial markets and to encourage the flow of credit within the financial system.

 

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On October 14, 2008, the Treasury Department announced the terms of the TARP Capital Purchase Program (“CPP”), through which the Treasury Department has made capital investments in banking institutions, including Sterling, by purchasing senior preferred shares. On December 5, 2008, in accordance with the CPP, Sterling completed the sale of 303,000 shares of preferred stock and issued a warrant to purchase 6,437,677 shares of Sterling’s common stock to the Treasury Department, raising total proceeds of $303 million.

In February 2009, the American Recovery and Reinvestment Act of 2009 (“ARRA”) was enacted, which contains a comprehensive set of government spending initiatives and tax incentives aimed at stimulating the U.S. economy. The ARRA also amends, among other things, the TARP program legislation by directing the Treasury Department to issue regulations implementing strict limitations on the payment of incentive compensation and any severance or golden parachute payments to certain high