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, 2010

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......001-34696

 

 

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   ¨  (Do not check if a smaller reporting company)    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 29, 2010

Common Stock ($1.00 par value)   4,080,903,859

 

 

 


Table of Contents

 

STERLING FINANCIAL CORPORATION

FORM 10-Q

For the Periods Ended September 30, 2010

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 Changes in Shareholder’s Equity      3   
      Consolidated Statements of Cash Flows      4   
      Consolidated Statements of Comprehensive Income      6   
      Notes to Consolidated Financial Statements      7   
   Item 2    Management’s Discussion and Analysis of Financial Condition and Results of Operations      27   
   Item 3    Quantitative and Qualitative Disclosures About Market Risk      50   
   Item 4    Controls and Procedures      50   
PART II - Other Information      51   
   Item 1    Legal Proceedings      51   
   Item 1a    Risk Factors      52   
   Item 2    Unregistered Sales of Equity Securities and Use of Proceeds      68   
   Item 3    Defaults Upon Senior Securities      68   
   Item 4    (Reserved)      69   
   Item 5    Other Information      69   
   Item 6    Exhibits      69   
Signatures      70   


Table of Contents

 

PART I - Financial Information

Item  1 - Financial Statements

STERLING FINANCIAL CORPORATION

Consolidated Balance Sheets

(Unaudited)

 

     September 30,
2010
    December 31,
2009
 
     (Dollars in thousands)  

ASSETS:

    

Cash and cash equivalents:

    

Interest bearing

   $ 601,067      $ 424,008   

Non-interest bearing

     90,024        140,775   
                

Total cash and cash equivalents

     691,091        564,783   
                

Restricted cash

     22,900        8,223   

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

    

Available for sale

     2,708,595        2,160,325   

Held to maturity

     14,322        17,646   

Loans receivable, net

     5,665,503        7,344,199   

Loans held for sale (at fair value: $314,784 and $189,185)

     314,784        190,412   

Accrued interest receivable

     36,404        43,869   

Other real estate owned, net (“OREO”)

     156,801        83,272   

Office properties and equipment, net

     83,527        92,037   

Bank-owned life insurance (“BOLI”)

     167,391        164,743   

Core deposit intangibles

     18,153        21,827   

Mortgage servicing rights, net

     13,140        12,062   

Prepaid expenses and other assets, net

     137,432        174,025   
                

Total assets

   $ 10,030,043      $ 10,877,423   
                

LIABILITIES:

    

Deposits

   $ 6,909,214      $ 7,775,190   

Advances from Federal Home Loan Bank (“FHLB”)

     837,303        1,337,167   

Securities sold subject to repurchase agreements and funds purchased

     1,034,945        1,049,146   

Other borrowings

     248,284        248,281   

Cashiers checks issued and payable

     7,930        6,443   

Borrowers’ reserves for taxes and insurance

     5,653        2,283   

Accrued interest payable

     18,074        22,245   

Accrued expenses and other liabilities

     123,593        113,419   
                

Total liabilities

     9,184,996        10,554,174   
                

SHAREHOLDERS’ EQUITY:

    

Preferred stock

     0        294,136   

Common stock, 722,903,859 and 52,211,090 shares issued and outstanding

     1,959,697        962,874   

Accumulated other comprehensive income:

    

Unrealized gains on investment securities and MBS available-for-sale, net of deferred income taxes of ($19,608) and ($9,518)

     33,133        16,284   

Accumulated deficit

     (1,147,783     (950,045
                

Total shareholders’ equity

     845,047        323,249   
                

Total liabilities and shareholders’ equity

   $ 10,030,043      $ 10,877,423   
                

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,
 
     2010     2009     2010     2009  
     (Dollars in thousands, except per share data)  

Interest income:

        

Loans

   $ 85,886      $ 119,096      $ 276,747      $ 369,967   

MBS

     18,127        27,148        56,569        84,606   

Investments and cash equivalents

     2,641        2,524        8,039        8,845   
                                

Total interest income

     106,654        148,768        341,355        463,418   
                                

Interest expense:

        

Deposits

     22,639        40,606        75,153        133,528   

Short-term borrowings

     1,220        4,154        5,434        13,353   

Long-term borrowings

     15,360        16,949        45,348        53,511   
                                

Total interest expense

     39,219        61,709        125,935        200,392   
                                

Net interest income

     67,435        87,059        215,420        263,026   

Provision for credit losses

     (60,892     (195,505     (220,229     (341,114
                                

Net interest income (expense) after provision for credit losses

     6,543        (108,446     (4,809     (78,088
                                

Non-interest income:

        

Fees and service charges

     13,826        15,088        41,094        43,806   

Mortgage banking operations

     19,409        9,485        42,354        36,525   

Loan servicing fees

     (1,120     1,146        (382     1,701   

BOLI

     1,570        1,815        5,425        5,221   

Gains on sales of securities

     7,005        825        24,265        12,382   

Other

     (1,032     (928     (6,573     (3,886
                                

Total non-interest income

     39,658        27,431        106,183        95,749   
                                

Non-interest expenses before impairment charge

     94,223        90,367        287,515        275,504   

Goodwill impairment

     0        227,558        0        227,558   
                                

Non-interest expenses

     94,223        317,925        287,515        503,062   
                                

Loss before income taxes

     (48,022     (398,940     (186,141     (485,401

Income tax expense

     0        (60,467     0        (23,982
                                

Net loss

     (48,022     (459,407     (186,141     (509,383

Preferred stock dividend

     (2,715     (4,318     (11,596     (13,012

Benefit to common shareholders (1)

     84,329        0        84,329        0   
                                

Net income (loss) available to common shareholders

   $ 33,592      $ (463,725   $ (113,408   $ (522,395
                                

Earnings (loss) per share - basic

   $ 0.11      $ (8.93   $ (0.81   $ (10.06
                                

Earnings (loss) per share - diluted

   $ 0.02      $ (8.93   $ (0.81   $ (10.06
                                

Weighted average shares outstanding - basic

     314,481,750        51,922,871        140,451,899        51,913,907   

Weighted average shares outstanding - diluted

     1,698,932,091        51,922,871        140,451,899        51,913,907   

 

(1) The August 26, 2010 conversion of the U.S. Treasury Capital Purchase Program preferred stock into common stock resulted in an increase in income available to common shareholders.

See notes to consolidated financial statements.

 

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STERLING FINANCIAL CORPORATION

Consolidated Statements of Changes in Shareholders’ Equity

(Unaudited)

 

     Preferred Stock     Common Stock      Other
Comprehensive
     Retained     Total
Shareholders’
 
     Shares     Amount     Shares     Amount      Income (Loss)      Earnings     Equity  

Balance, January 1, 2010

     303,000      $ 294,136        52,211,090      $ 962,874       $ 16,284       $ (950,045   $ 323,249   

Accretion of preferred stock

       1,248                (1,248     0   

Shares issued direct stock purchases

         23,769        18              18   

Shares of Series B and Series D preferred stock and common stock issued

     7,300,000        604,592        292,000,000        76,152              680,744   

Preferred stock beneficial conversion feature discount

       (604,592       604,592              0   

Shares issued from Series A preferred stock conversion into Series C preferred stock, and simultaneous conversion into common stock

     (303,000     (295,384     378,750,000        315,248              19,864   

Change in unrealized gain or loss on investments and MBS available for sale, net of income tax

              16,849           16,849   

Preferred dividend

                 (10,349     (10,349

Equity based compensation

         (81,000     813              813   

Net loss

                 (186,141     (186,141
                                                          

Balance, September 30, 2010

     7,300,000      $ (0     722,903,859      $ 1,959,697       $ 33,133       $ (1,147,783   $ 845,047   
                                                          

See notes to consolidated financial statements.

 

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STERLING FINANCIAL CORPORATION

Consolidated Statements of Cash Flows

(Unaudited)

 

     Nine Months Ended September 30,  
     2010     2009  
     (Dollars in thousands)  

Cash flows from operating activities:

    

Net loss

   $ (186,141   $ (509,383

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

    

Provision for credit losses and OREO

     241,124        365,481   

Goodwill impairment

     0        227,558   

Deferred tax asset valuation allowance

     76,000        143,000   

Accretion of deferred gain on sale of branches

     (603     (603

Net gain on sales of loans, investments and MBS

     (63,101     (51,483

Stock based compensation

     813        2,204   

Excess tax benefit from stock based compensation

     0        804   

Stock issuances relating to direct stock purchase

     18        13   

Loss at foreclosure and on sale of OREO

     45,379        31,284   

Other losses

     5,211        3,157   

Increase in cash surrender value of BOLI

     (5,425     (5,221

Depreciation and amortization

     22,082        24,329   

Change in:

    

Accrued interest receivable

     7,465        5,116   

Prepaid expenses and other assets

     (38,543     (71,143

Cashiers checks issued and payable

     1,487        166   

Accrued interest payable

     (4,171     (15,182

Accrued expenses and other liabilities

     6,246        754   

Proceeds from sales of loans originated for sale

     1,678,816        2,067,704   

Loans originated for sale

     (1,739,032     (2,028,603
                

Net cash provided by operating activities

     47,625        189,952   
                

Cash flows from investing activities:

    

Change in restricted cash

     (14,677     (15,226

Loans funded and purchased

     (680,106     (1,657,832

Loan principal received

     1,545,650        1,940,570   

Proceeds from sales of other loans

     310,155        0   

Purchase of investment securities

     (20,857     (689,320

Proceeds from maturities of investment securities

     8,035        761,750   

Proceeds from sale of investment securities

     17,429        80,855   

Proceeds from sale - MBS

     763,437        296,500   

Purchase of MBS

     (1,711,340     (821,702

Principal payments on MBS

     437,644        601,662   

Purchase of office properties and equipment

     (2,579     (10,746

Sales of office properties and equipment

     235        27   

Improvements and other changes to OREO

     (2,887     1,914   

Proceeds from sales of OREO

     120,532        73,003   
                

Net cash provided by investing activities

     770,671        561,455   
                

See notes to consolidated financial statements.

 

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STERLING FINANCIAL CORPORATION

Consolidated Statements of Cash Flows

(Unaudited)

 

     Nine Months Ended September 30,  
     2010     2009  
     (Dollars in thousands)  

Cash flows from financing activities:

    

Net change in transaction and savings deposits

   $ (212,531   $ 74,648   

Proceeds from issuance of time deposits

     1,016,445        2,356,990   

Payments for maturing time deposits

     (1,751,572     (2,648,392

Interest credited to deposits

     81,682        143,454   

Advances from FHLB

     538,050        90,500   

Repayment of advances from FHLB

     (1,037,643     (380,885

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

     (14,201     (70,055

Excess tax benefit from stock based compensation

     0        (804

Proceeds from stock issuance, net

     684,412        0   

Cash dividends paid to preferred shareholders

     0        (6,733

Other

     3,370        2,288   
                

Net cash used in financing activities

     (691,988     (438,989
                

Net change in cash and cash equivalents

     126,308        312,418   

Cash and cash equivalents, beginning of period

     564,783        138,802   
                

Cash and cash equivalents, end of period

   $ 691,091      $ 451,220   
                

Supplemental disclosures:

    

Cash paid (received) during the period for:

    

Interest

   $ 130,106      $ 200,392   

Income taxes

     (49,340     (68,062

Noncash financing and investing activities:

    

Loans converted into OREO

     257,448        157,156   

Preferred stock cash dividend accrued

     10,349        5,682   

Conversion of preferred stock into common stock

     295,384        0   

Conversion of preferred stock accrued dividend into common stock

     19,865        0   

Conversion of Treasury warrants

     3,669        0   

See notes to consolidated financial statements.

 

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STERLING FINANCIAL CORPORATION

Consolidated Statements of Comprehensive Income (Loss)

(Unaudited)

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2010     2009     2010     2009  
     (Dollars in thousands)  

Net loss

   $ (48,022   $ (459,407   $ (186,141   $ (509,383
                                

Other comprehensive income (loss):

        

Change in unrealized losses on investments and MBS available-for-sale

     2,960        50,958        26,939        70,356   

Less deferred income taxes benefit

     (1,189     (18,854     (10,090     (26,032
                                

Net other comprehensive income

     1,771        32,104        16,849        44,324   
                                

Comprehensive loss

   $ (46,251   $ (427,303   $ (169,292   $ (465,059
                                

 

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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, 2009. 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. These financial statements have been prepared under the assumption that the entity is a going concern, an assumption for which Sterling’s Independent Public Accountants expressed substantial doubt in their opinion relating to the December 31, 2009 consolidated financial statements. On August 26, 2010, Sterling completed several transactions as part of its recapitalization and recovery plan, receiving proceeds of $730.0 million. Following the recapitalization, the regulatory agreement between Sterling Savings Bank and its regulators was terminated. For further discussion see Notes 5 and 13.

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

In June 2009, the Financial Accounting Standards Board (the “FASB”) issued Accounting Standards Update (“ASU”) 2009-16, “Accounting for Transfers of Financial Assets.” This standard removes the concept of qualifying special-purpose entities as an accounting criteria that had provided an exception to consolidation, provided additional guidance on requirements for consolidation, and is an update to codification topic 860. This guidance became effective for Sterling on January 1, 2010, and did not have a material impact on its consolidated financial statements.

In January 2010, the FASB issued ASU 2010-06, “Fair Value Measurements and Disclosures.” This guidance is related to implementation of fair value measurement disclosures. This update to the codification topic 820 specifically addresses: 1) transfers between levels 1, 2 and 3 of the fair value hierarchy; 2) level of disaggregation of derivative contracts for fair value measurement disclosures; and 3) disclosures about fair value measurement inputs and valuation techniques. This guidance became effective for Sterling on March 31, 2010, and did not have a material impact on its consolidated financial statements.

In February 2010, the FASB issued ASU 2010-09, “Amendments to Certain Recognition and Disclosure Requirements,” 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, and was an update to codification topic 855. As a public reporting company, Sterling is required to evaluate subsequent events through the date its financial statements are issued. The adoption of these rules did not have a material impact on Sterling’s consolidated financial statements.

In April 2010, the FASB issued ASU 2010-18, “Effect of a Loan Modification When the Loan Is Part of a Pool That Is Accounted for as a Single Asset.” This update addresses modifications of loans that are accounted for within a pool by specifying that a troubled debt restructuring would not result in the removal of those loans from the pool for impairment analysis purposes. This guidance will be effective for Sterling as of September 30, 2010. Sterling does not currently have any loans for which this guidance would be applicable.

 

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In July 2010, the FASB issued ASU 2010-20, “Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses.” This update amends codification topic 310 on receivables to improve the disclosures that an entity provides about the credit quality of its financing receivables and the related allowance for credit losses. As a result of these amendments, an entity is required to disaggregate by portfolio segment or class certain existing disclosures and provide certain new disclosures about its financing receivables and related allowance for credit losses. This guidance is being phased in, with the new disclosure requirements for period end balances effective as of December 31, 2010, and the new disclosure requirements for activity during the reporting period are effective March 31, 2011.

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, 2010

          

Available for sale

          

MBS

   $ 2,437,382       $ 54,250       $ (2,503   $ 2,489,129   

Municipal bonds

     193,678         7,986         (1,878     199,786   

Other

     24,794         0         (5,114     19,680   
                                  

Total

   $ 2,655,854       $ 62,236       $ (9,495   $ 2,708,595   
                                  

Held to maturity

          

Tax credits

   $ 14,322       $ 0       $ 0      $ 14,322   
                                  

Total

   $ 14,322       $ 0       $ 0      $ 14,322   
                                  

December 31, 2009

          

Available for sale

          

MBS

   $ 1,912,736       $ 44,579       $ (12,326   $ 1,944,989   

Municipal bonds

     195,807         3,500         (4,025     195,282   

Other

     25,979         0         (5,925     20,054   
                                  

Total

   $ 2,134,522       $ 48,079       $ (22,276   $ 2,160,325   
                                  

Held to maturity

          

Tax credits

   $ 17,646       $ 0       $ 0      $ 17,646   
                                  

Total

   $ 17,646       $ 0       $ 0      $ 17,646   
                                  

Tax credit investments are in low income housing partnerships. Other available for sale securities were primarily comprised of a trust preferred security at both September 30, 2010 and December 31, 2009. During the nine months ended September 30, 2010 and 2009, 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, 2010

   $ 780,866       $ 30,686       $ (6,421

September 30, 2009

     377,355         15,458         (3,076

 

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During the nine months ended September 30, 2010, Sterling sold $61.1 million of private label collateralized mortgage obligations at a loss of $6.0 million. The sales were a result of an updated assessment of the credit risk of certain securities held in the portfolio, including downgrades and potential downgrades by rating agencies. During 2010, Sterling has reduced the effective duration of its investment portfolio from 3.46 years at December 31, 2009 to 2.64 years at September 30, 2010. The reduction in duration was the result of Sterling selling primarily 30 year MBS and reinvesting in lower duration 15 year and 10 year MBS. Reclassification adjustments from other comprehensive income, representing realized net gains on available-for-sale securities, net of related deferred income taxes, were as follows for the periods presented:

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2010      2009     2010      2009  
     (Dollars in thousands)  

Realized net (gains) losses reclassified from other comprehensive income

   $ 6,532       $ (843   $ 13,155       $ 7,278   

The following table summarizes Sterling’s investments and MBS that had a market value below their amortized cost basis as of September 30, 2010 and December 31, 2009, grouped by the amount of time these securities have been in this unrealized loss position:

 

     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, 2010

  

Municipal bonds

   $ 4,107       $ (48   $ 18,109       $ (1,830   $ 22,216       $ (1,878

MBS

     439,029         (2,503     0         0        439,029         (2,503

Other

     0         0        19,675         (5,114     19,675         (5,114
                                                   

Total

   $ 443,136       $ (2,551   $ 37,784       $ (6,944   $ 480,920       $ (9,495
                                                   

December 31, 2009

               

Municipal bonds

   $ 13,758       $ (317   $ 45,729       $ (3,708   $ 59,487       $ (4,025

MBS

     190,004         (4,039     115,266         (8,287     305,270         (12,326

Other

     0         0        18,791         (5,925     18,791         (5,925
                                                   

Total

   $ 203,762       $ (4,356   $ 179,786       $ (17,920   $ 383,548       $ (22,276
                                                   

The amortized cost and fair value of available-for-sale and held-to-maturity debt securities as of September 30, 2010, are listed below according to contractual maturity date. Expected or actual maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

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

Due within one year

   $ 0       $ 0       $ 25       $ 25   

Due after one year through five years

     0         0         758         776   

Due after five years through ten years

     0         0         98,575         101,940   

Due after ten years

     14,322         14,322         2,556,496         2,605,854   
                                   

Total

   $ 14,322       $ 14,322       $ 2,655,854       $ 2,708,595   
                                   

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 at September 30, 2010, 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. Sterling holds a single-issuer trust preferred security that has been negatively impacted by temporary credit market disruptions. As of September 30, 2010, the trust preferred security is rated A1 by Moody’s and has an amortized cost of $24.8 million compared to a $19.7 million market value, or an unrealized loss of $5.1 million.

As of September 30, 2010, Sterling also held private label collateralized mortgage obligations with an aggregate amortized cost of $57.4 million compared to a $59.0 million market value, or a net unrealized gain of $1.6 million. All private label collateralized mortgage obligations are internally monitored monthly and independently stress-tested quarterly for both credit quality and collateral strength, and are AAA rated according to at least one major rating agency. The vintage, or years of issuance, for these nonagency MBS ranges from 2003 to 2005.

As of September 30, 2010, Sterling expects the return of all principal and interest on all securities within its investment and mortgage-backed securities portfolio 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, 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.

 

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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,  
     2010     2009  
     (Dollars in thousands)  

Allowance for credit losses

    

Allowance - loans, January 1

   $ 343,443      $ 208,365   

Provision

     220,590        341,114   

Charge-offs

     (336,507     (298,540

Recoveries

     20,979        14,981   

Transfers

     0        9,831   
                

Allowance - loans, September 30

     248,505        275,751   
                

Allowance - unfunded commitments, January 1

     11,967        21,334   

Provision

     (361     0   

Charge-offs

     (589     0   

Transfers

     0        (9,831
                

Allowance - unfunded commitments, September 30

     11,017        11,503   
                

Total credit allowance

   $ 259,522      $ 287,254   
                

The decline in the level of the provision over these periods primarily relates to the reduction in the level of classified loans, particularly in the construction portfolio, and the amount of losses previously recognized on these classified loans. Classified assets include performing substandard loans, nonperforming loans and OREO. Nonperforming loans and OREO comprise nonperforming assets, for which the following summarizes as of the dates indicated:

 

     September 30,
2010
    December 31,
2009
    September 30,
2009
 
     (Dollars in thousands)  

Past due 90 days

   $ 0      $ 0      $ 0   

Nonaccrual loans

     658,678        824,652        646,092   

Restructured loans

     150,293        71,279        101,437   
                        

Total nonperforming loans

     808,971        895,931        747,529   

OREO

     170,010        91,478        81,361   
                        

Total nonperforming assets

     978,981        987,409        828,890   

Specific reserves

     (28,269     (35,334     (9,898
                        

Net nonperforming assets

   $ 950,712      $ 952,075      $ 818,992   
                        

Cumulatively, Sterling has written down its nonperforming assets by $588.4 million as of September 30, 2010, compared with write-downs of $579.7 million as of December 31, 2009 and $386.2 million as of September 30, 2009, primarily reflecting lower real estate appraisal values. Additionally, Sterling has established specific reserves of $15.1 million against its nonperforming loans for valuation changes between appraisals, and $13.2 million for its OREO properties.

 

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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. Changes in this allowance are as follows for the periods presented:

 

     Nine Months Ended September 30,  
     2010     2009  
     (Dollars in thousands)  

Balance, January 1

   $ 8,204      $ 17,555   

Provision

     20,894        24,366   

Charge-offs

     (15,889     (31,747
                

Balance, September 30

   $ 13,209      $ 10,174   
                

4. Other Borrowings:

The components of other borrowings are as follows:

 

     September 30,
2010
     December 31,
2009
 
     (Dollars in thosuands)  

Junior subordinated debentures

   $ 245,284       $ 245,281   

Other

     3,000         3,000   
                 

Total other borrowings

   $ 248,284       $ 248,281   
                 

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, and continued to defer these payments through September 30, 2010. As of September 30, 2010 and December 31, 2009, the accumulated deferred interest that was accrued on these securities was $8.1 million and $3.4 million, respectively. 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.

 

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Details of the Trust Preferred Securities are as follows:

 

Subsidiary Issuer

  

Issue Date

  

Maturity
Date

  

Initial Call
Date

  

Rate at September 30,
2010

    (in
Thousands)
 

Sterling Capital Trust IX

   July 2007    Oct 2037    N/A    Floating      1.93   $ 46,392   

Sterling Capital Trust VIII

   Sept 2006    Sept 2036    N/A    Floating      1.92        51,547   

Sterling Capital Trust VII

   June 2006    June 2036    N/A    Floating      1.82        56,702   

Lynnwood Capital Trust II

   June 2005    June 2035    June 2010    Floating      2.09        10,310   

Sterling Capital Trust VI

   June 2003    Sept 2033    Sept 2008    Floating      3.49        10,310   

Sterling Capital Statutory Trust V

   May 2003    May 2033    June 2008    Floating      3.54        20,619   

Sterling Capital Trust IV

   May 2003    May 2033    May 2008    Floating      3.53        10,310   

Sterling Capital Trust III

   April 2003    April 2033    April 2008    Floating      3.72        14,433   

Lynnwood Capital Trust I

   Mar 2003    Mar 2033    Mar 2007    Floating      3.44        9,455   

Klamath First Capital Trust I

   July 2001    July 2031    June 2006    Floating      4.43        15,206   
                      
                 2.50 %*    $ 245,284   
                      

 

* Weighted average rate

5. Shareholders’ Equity:

As of September 30, 2010, Sterling had 10 million shares of preferred stock authorized, with two series issued and outstanding. The preferred stock issued and outstanding consisted of 3,418,300 shares of Series B Convertible Participating Voting Preferred Stock (the “Series B preferred stock”), and 3,881,700 shares of Series D Convertible Participating Voting Preferred Stock (the “Series D preferred stock”). As of December 31, 2009, Sterling had 10 million shares of preferred stock authorized, with one series issued and outstanding, consisting of 303,000 shares of Series A preferred stock. As of both September 30, 2010 and December 31, 2009, Sterling had 750 million shares of common stock authorized, with one class of common stock issued and outstanding. As of September 30, 2010, the number of common shares that were issued and outstanding was 722,903,859. As of December 31, 2009, the number of common shares that were issued and outstanding was 52,211,090. During 2010, Sterling’s articles of incorporation were amended to eliminate the par value of its common stock. For comparability, prior period presentations within this report on Form 10-Q reflect the amendment.

On August 26, 2010, Sterling completed several transactions as part of its recapitalization and recovery plan, which included the issuance of 3,418,300 shares of Series B preferred stock at $92 per share, 3,881,700 shares of Series D preferred stock at $92 per share, 670,750,000 shares of common stock at $0.20 per share, and warrants to purchase 173,250,000 shares of common stock at an exercise price of $0.22 per share, raising aggregate proceeds for Sterling of $730.0 million (collectively, the “Recapitalization Transactions” or the “Recapitalization”). The Recapitalization consisted of three principal transactions.

 

   

an investment of approximately $170.9 million by each of (a) Thomas H. Lee Equity Fund VI, L.P., Thomas H. Lee Parallel Fund VI, L.P., Thomas H. Lee Parallel (DT) Fund VI, L.P. and THL Sterling Equity Investors, L.P. (collectively, “THL” or an “Anchor Investor”) and (b) Warburg Pincus Private Equity X, L.P. (“Warburg Pincus” or an “Anchor Investor”), pursuant to which each received 68,366,000 shares of common stock, 1,709,150 shares of Series B preferred stock, and a seven-year warrant to purchase 86,625,000 shares of common stock at an exercise price of $0.22 per share (the “Anchor Investments”);

 

   

the exchange of 303,000 shares of preferred stock held by the U.S. Department of the Treasury (“Treasury”) at a discounted exchange value into 378,750,000 shares of common stock at a conversion price of $0.20 per share, and amendment of the terms of the warrant held by Treasury to purchase 6,437,677 shares of common stock at an exercise price of $7.06 per share to provide for an exercise price of $0.20 per share for a ten-year term (the “Treasury Exchange”); and

 

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investments by accredited investors of an aggregate of $388.2 million in exchange for an aggregate of 155,268,000 shares of common stock and 3,881,700 shares of Series D preferred stock.

The Treasury Exchange resulted in a non-cash increase in income available to common shareholders of $84.3 million because the book value of the preferred stock plus accrued dividends was greater than the $230.9 million fair value of the common stock issued to Treasury and the fair value of the new warrant. This accounting treatment had no effect on Sterling’s total equity or its regulatory capital position.

The issuance price on an as-converted basis of $0.20 per common share for the Series B and D preferred stock represented a discount to the common stock’s market price of $0.60 per share. For accounting purposes, this $0.40 per-share discount is considered a beneficial conversion feature. Accordingly, Sterling recorded this discount, valued at $604.6 million in aggregate, as a reduction to preferred stock and as an increase to common stock.

In addition to the adjustment to the exercise price of the warrant held by Treasury, the terms of the warrant were revised to include a future adjustment to the exercise price for any subsequent issuances of common stock by Sterling that would result in dilution to the warrant. This term is deemed a “ratchet provision,” resulting in the warrant being carried as a derivative liability as compared to a common stock equity equivalent for balance sheet purposes. As a derivative liability, the warrant is carried at fair value, with subsequent remeasurements flowing through earnings. The initial value attributed to the warrant was $3.7 million, with the fair value estimated using the Black-Scholes option pricing model, with assumptions of 105% volatility, a risk-free rate of 2.63%, a yield of 0% and an estimated life of 10 years. From August 26, 2010 through September 30, 2010, this instrument’s estimated value change resulted in an expense of $317,000 being recorded in other noninterest income.

Subsequent to the Recapitalization Transactions on August 26, 2010, and assuming the warrants held by THL, Warburg and Treasury are fully exercised, THL and Warburg together owned approximately 45% of Sterling on an as-converted basis, and Treasury owned approximately 9% of Sterling on an as-converted basis.

Pursuant to the terms of the Recapitalization agreements, Sterling agreed to call a special meeting of its shareholders (the “Special Meeting”) to seek approval to increase the authorized number of shares of common stock from 750 million to 10 billion and convert the outstanding Series B and D preferred stock into common stock, and the exercisability of the warrants issued to THL and Warburg Pincus for shares of common stock. On October 21, 2010, Sterling held the Special Meeting at which shareholders approved: (1) the increase in the authorized number of shares of common stock from 750 million to 10 billion; (2) the conversion of outstanding Series B and D preferred stock into common stock, and the exercisability of the warrants issued to THL and Warburg Pincus for shares of common stock; and (3) an amendment to Sterling’s Restated Articles of Incorporation to effect a reverse stock split of Sterling’s common stock at a ratio to be determined by Sterling’s board of directors between one-for-50 and one-for-125 shares of common stock.

On October 22, 2010 the series B and D preferred stock were converted into 3,358,000,000 shares of common stock. Upon conversion, the $604.6 million beneficial conversion feature was amortized and recognized as a non-cash dividend paid to the preferred shareholders. The amortization of the beneficial conversion feature will result in a non-cash reduction in income available to common shareholders during the fourth quarter of 2010 but will have no effect on Sterling’s total equity or its regulatory capital position.

 

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6. Earnings (Loss) Per Share:

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

 

     Three Months Ended September 30,  
     2010     2009  
     Net Income
(Loss)
Available to
Common
Shareholders
    Weighted
Average Shares
     Per
Share
Amount
    Net Income
(Loss)
Available to
Common
Shareholders
    Weighted
Average
Shares
     Per
Share
Amount
 
     (Dollars in thousands, except per share amounts)  

Basic computations

   $ 33,592        314,481,750       $ 0.11      $ (463,725     51,922,871       $ (8.93

Effect of dilutive securities:

              

Common stock warrants

     0        70,312,569         0.00        0        0         0.00   

Convertible preferred stock

     0        1,314,000,000         (0.09     0        0         0.00   

Restricted shares

     0        137,772         0.00        0        0         0.00   
                                                  

Diluted computations

   $ 33,592 (1)      1,698,932,091       $ 0.02      $ (463,725     51,922,871       $ (8.93
                                                  

Antidilutive securities not included in diluted earnings per share:

              

Common stock options

       1,308,986             1,986,471      

Common stock warrant

       0             6,437,677      

Restricted shares

       0             209,793      
                          

Total antidilutive

       1,308,986             8,633,941      
                          

 

(1)

Includes the $84.3 million noncash increase in income available to common shareholders from the Treasury preferred stock conversion into common stock.

 

     Nine Months Ended September 30,  
     2010     2009  
     Net Income
(Loss)
Available to
Common
Shareholders
    Weighted
Average
Shares
     Per
Share
Amount
    Net Income
(Loss)
Available to
Common
Shareholders
    Weighted
Average
Shares
     Per
Share
Amount
 
     (Dollars in thousands, except per share amounts)  

Basic computations

   $ (113,408     140,451,899       $ (0.81   $ (522,395     51,913,907       $ (10.06

Effect of dilutive securities:

     0        0         0.00        0        0         0.00   
                                                  

Diluted computations

   $ (113,408 )(1)      140,451,899       $ (0.81   $ (522,395     51,913,907       $ (10.06
                                                  

Antidilutive securities not included in diluted earnings per share:

              

Common stock options

       1,393,372             2,009,394      

Common stock warrants

       23,695,078             6,437,677      

Convertible preferred stock

       442,813,187             0      

Restricted shares

       158,220             223,005      
                          

Total antidilutive

       468,059,857             8,670,076      
                          

 

(1)

Includes the $84.3 million noncash increase in income available to common shareholders from the Treasury preferred stock conversion into common stock.

The accounting standards 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 the materially equivalent earnings per share as the application of the treasury method, which is presented above.

 

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On October 22, 2010, outstanding Series B and D preferred stock were converted into common stock. Upon conversion, the $604.6 million preferred stock beneficial conversion feature was amortized and recognized as a non-cash dividend paid to the preferred shareholders. The amortization of the discount will result in a non-cash reduction in income available to common shareholders during the fourth quarter of 2010 but will have no effect on Sterling’s total equity or its regulatory capital position. See Note 5 for a discussion.

7. Non-Interest Expenses:

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

 

     Three Months Ended September,      Nine Months Ended September 30,  
     2010      2009      2010      2009  
     (Dollars in thousands)  

Employee compensation and benefits

   $ 44,077       $ 41,924       $ 125,875       $ 125,039   

OREO operations

     10,456         9,808         38,585         36,097   

Occupancy and equipment

     9,489         12,859         28,246         35,736   

Insurance

     6,632         6,975         29,508         23,353   

Professional fees

     6,277         1,439         14,911         4,494   

Data processing

     5,858         5,221         16,322         15,551   

Advertising

     3,484         3,077         9,308         8,931   

Depreciation

     3,326         3,566         10,266         10,616   

Amortization of core deposit intangibles

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

Travel and entertainment

     910         1,321         2,742         3,975   

Other

     2,489         2,952         8,078         8,038   
                                   

Non-interest expense before impairment charge

     94,223         90,367         287,515         275,504   

Goodwill impairment

     0         227,558         0         227,558   
                                   

Total

   $ 94,223       $ 317,925       $ 287,515       $ 503,062   
                                   

The increase in noninterest expenses over the three month comparative period, excluding the goodwill impairment, was due to higher professional and advisory fees, board of director fees and higher commissions related to increased residential lending production levels, with the increase in the nine month comparative periods, before the goodwill impairment charge, from higher levels of Federal Deposit Insurance Corporation (“FDIC”) deposit insurance premiums, and professional and advisory fees. These increases were partially offset by declines in occupancy and equipment.

8. 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. 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 recent loss history, the regulatory agreements in place at the time of the assessment, and the credit condition of its loan portfolio outweighed the positive evidence. Therefore, during the third quarter of 2009, a full valuation allowance was established against its deferred tax asset, with the allowance totaling $345.0 million as of September 30, 2010, compared with $269.0 million as of December 31, 2009. As of September 30, 2010 and December 31, 2009, Sterling’s deferred tax asset included approximately $247 million and $136 million, respectively, of net operating loss carryforwards.

In April 2010, Sterling’s Board of Directors adopted a shareholder rights plan designed to preserve substantial tax assets that include net operating losses, capital losses and certain built-in losses that could be utilized in certain circumstances to offset taxable income and reduce its federal income tax liability. Sterling’s ability to use its tax assets would be substantially limited if there were an “ownership change” as defined under Section 382 of the Internal Revenue Code and related Internal Revenue Service pronouncements. In general, an ownership change

 

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would occur if Sterling’s “5-percent shareholders,” as defined under Section 382, collectively increase their ownership in Sterling by more than 50 percentage points over a rolling three-year period. Five-percent shareholders do not include certain institutional holders, such as mutual fund companies, that hold Sterling equity securities on behalf of several individual mutual funds where no single fund owns 5 percent or more of Sterling equity securities.

As part of the plan, the Sterling Board of Directors declared a dividend of one preferred share purchase right for each outstanding share of its common stock. The preferred share purchase rights were distributable to shareholders of record as of April 15, 2010, as well as to holders of common stock and Sterling securities convertible into common stock issued after that date, but would only be activated if triggered pursuant to the terms of the plan. See Sterling’s Current Report on Form 8-K, as filed with the SEC on April 15, 2010, for additional information regarding the shareholder rights plan.

9. 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, private and commercial banking groups of Sterling’s subsidiary, Sterling Savings Bank.

 

 

The Residential Construction Lending segment has historically originated and serviced loans through the real estate division of Sterling’s subsidiary, Sterling Savings Bank. Activity in this segment has been curtailed, and realigned with an emphasis on credit resolution.

 

 

The Residential Mortgage Banking segment originates and sells servicing-retained and servicing-released residential loans through loan production offices of Sterling’s home loan division. The home loan division’s operations were previously performed by Sterling’s subsidiary Golf Savings Bank, which on August 2, 2010 was merged into Sterling 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 of the United States 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.

 

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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, 2010  
     Community
Banking
    Residential
Construction
Lending
    Residential
Mortgage
Banking
    Commercial
Mortgage
Banking
    Other and
Eliminations
    Total  
     (Dollars in thousands)  

Interest income

   $ 99,481      $ 1,391      $ 5,131      $ 717      $ (66   $ 106,654   

Interest expense

     (31,544     (3,380     (2,636     0        (1,659     (39,219
                                                

Net interest income (expense)

     67,937        (1,989     2,495        717        (1,725     67,435   

Provision for credit losses

     (52,371     (7,629     (892     0        0        (60,892

Noninterest income

     23,675        5        14,759        843        376        39,658   

Noninterest expense

     (79,770     (1,364     (6,609     (1,659     (4,821     (94,223
                                                

Income (loss) before income taxes

   $ (40,529   $ (10,977   $ 9,753      $ (99   $ (6,170   $ (48,022
                                                

Total assets

   $ 8,976,324      $ 398,881      $ 655,536      $ 7,658      $ (8,356   $ 10,030,043   
                                                
     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

     17,782        23        11,929        760        (3,063     27,431   

Noninterest expense

     (302,414     (1,720     (10,544     (2,042     (1,205     (317,925
                                                

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   
                                                

 

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     As of and for the Nine Months Ended September 30, 2010  
     Community
Banking
    Residential
Construction
Lending
    Residential
Mortgage
Banking
    Commercial
Mortgage
Banking
    Other and
Eliminations
    Total  
     (Dollars in thousands)  

Interest income

   $ 314,067      $ 6,313      $ 17,834      $ 3,137      $ 4      $ 341,355   

Interest expense

     (97,671     (15,052     (8,629     0        (4,583     (125,935
                                                

Net interest income (expense)

     216,396        (8,739     9,205        3,137        (4,579     215,420   

Provision for credit losses

     (151,831     (60,169     (8,229     0        0        (220,229

Noninterest income

     63,285        28        41,246        2,005        (381     106,183   

Noninterest expense

     (236,399     (4,387     (31,592     (4,070     (11,067     (287,515
                                                

Income (loss) before income taxes

   $ (108,549   $ (73,267   $ 10,630      $ 1,072      $ (16,027   $ (186,141
                                                

Total assets

   $ 8,976,324      $ 398,881      $ 655,536      $ 7,658      $ (8,356   $ 10,030,043   
                                                
     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

     61,817        270        41,173        2,199        (9,710     95,749   

Noninterest expense

     (460,757     (5,851     (26,736     (6,292     (3,426     (503,062
                                                

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   
                                                

10. Stock-Based Compensation:

The following is a summary of stock option and restricted stock activity during the nine months ended September 30, 2010:

 

     Stock Options      Restricted Stock  
     Number     Weighted
Average
Exercise
Price
     Number     Weighted
Average
Grant Price
 

Balance, January 1, 2010

     1,892,882      $ 21.04         261,750      $ 9.40   

Granted

     0        0.00         0        0.00   

Exercised/vested

     0        0.00         (65,500     12.53   

Cancelled/expired

     (631,705     22.14         (81,000     11.15   
                                 

Outstanding, September 30, 2010

     1,261,177      $ 20.52         115,250      $ 6.40   
                                 

Exercisable, September 30, 2010

     966,299      $ 22.68        
                     

 

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At September 30, 2010, the weighted average remaining contractual life and the aggregate intrinsic value of stock options outstanding was 3.1 years and $0, respectively, and of stock options exercisable was 2.8 years and $0, respectively, and at December 31, 2009, were 2.9 years and $0, respectively, and 2.4 years and $0, respectively. As of September 30, 2010, a total of 2,235,035 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 intrinsic value of options exercised during the nine months ended September 30, 2010 and 2009 was $0 for both periods because no options were exercised during the periods, and fair value of options granted were $0 and $193,000, respectively. The stock options and restricted shares granted during 2009 have vesting schedules ranging from two to four years. 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,  
     2010    2009  

Expected volatility

   n/a      72

Expected term (in years)

   n/a      4.4   

Expected dividend yield

   n/a      0.00

Risk free interest rate

   n/a      2.07

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

 

     Nine Months Ended September 30,  
     2010      2009  
     (Dollars in thousands)  

Stock based compensation expense:

     

Stock options

   $ 567       $ 800   

Restricted stock

     246         1,404   
                 

Total

   $ 813       $ 2,204   
                 

As of September 30, 2010, unrecognized equity compensation expense totaled $1.1 million, as the underlying outstanding awards had not yet been earned. This amount will be recognized over a weighted average period of 1.3 years. During the nine months ended September 30, 2010, 33,750 stock options were forfeited, and 81,000 shares of restricted stock were forfeited.

 

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11. 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, 2010, Sterling had $211.9 million of interest rate lock commitments, $257.8 million of warehouse loans held for sale that were not committed to investors, and held offsetting forward sale agreements on MBS valued at $436.4 million. In addition, Sterling had mandatory delivery commitments to sell mortgage loans to investors valued at $29.9 million as of September 30, 2010. As of December 31, 2009, Sterling had $110.0 million of interest rate lock commitments, $119.7 million of warehouse loans held for sale that were not committed to investors, and held offsetting forward sale agreements on MBS valued at $234.0 million. In addition, Sterling had mandatory delivery commitments to sell mortgage loans to investors valued at $29.5 million as of December 31, 2009. As of September 30, 2010 and December 31, 2009, Sterling had entered into best efforts forward commitments to sell $23.0 million and $51.6 million of mortgage loans, respectively.

In the normal course of business, Sterling enters into interest rate swap transactions with loan customers. The interest rate risk on these swap transactions is managed by entering into offsetting interest rate swap agreements with various counterparties (“broker-dealers” or “dealers”). The counterparty swap agreements include certain representations, warranties and covenants, which include terms that allow for an early termination in the event of default. Failure to maintain a well capitalized position is one event that may be considered a default, and counterparties to the swap agreements could require an early termination settlement or an increase in the collateral to secure derivative instruments that are in net liability positions to Sterling. During the nine months ended September 30, 2010, no counterparties declared an early termination event. During the third quarter, Sterling received $730.0 million in connection with the Recapitalization Transactions, and management therefore believes that Sterling is not likely to experience an early termination event in connection with its capital levels. Both customer and dealer related interest rate derivatives are carried at fair value by Sterling.

12. 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. Other assets are comprised of FHLB stock and derivatives, while other liabilities are comprised of derivatives:

 

     September 30, 2010      December 31, 2009  
     Carrying      Fair Value      Carrying      Fair Value  
     (Dollars in thousands)  

Financial assets:

           

Cash and cash equivalents

   $ 713,991       $ 713,991       $ 573,006       $ 573,006   

Investments and MBS:

           

Available for sale

     2,708,595         2,708,595         2,160,325         2,160,325   

Held to maturity

     14,322         14,322         17,646         17,646   

Loans held for sale

     314,784         314,784         190,412         190,412   

Loans receivable, net

     5,665,503         5,624,942         7,344,199         7,309,894   

Accrued interest receivable

     36,404         36,404         43,869         43,869   

Other assets

     110,755         110,755         108,502         108,502   

Financial liabilities:

           

Non-maturity deposits

     3,391,261         3,251,170         3,593,703         3,331,416   

Deposits with stated maturities

     3,517,953         3,591,862         4,181,487         4,241,141   

Borrowings

     2,120,532         2,143,339         2,634,594         2,581,832   

Accrued interest payable

     18,074         18,074         22,245         22,245   

Other liabilities

     9,583         9,583         4,319         4,319   

Companies have the option of carrying financial assets and liabilities at fair value, which can be implemented on all or individually selected financial instruments. 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 unavailable.

 

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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, 2010:

           

Investment securities available-for-sale:

           

MBS

   $ 2,489,129       $ 0       $ 2,489,129       $ 0   

Municipal bonds

     199,786         0         199,786         0   

Other

     19,680         0         19,680         0   
                                   

Total investment securities available-for-sale

     2,708,595         0         2,708,595         0   

Loans held for sale

     314,784         0         314,784         0   

Other assets - derivatives

     10,548         0         4,680         5,868   
                                   

Total assets

   $ 3,033,927       $ 0       $ 3,028,059       $ 5,868   
                                   

Other liabilities - derivatives

   $ 9,583       $ 0       $ 3,987       $ 5,596   
                                   

Balance, December 31, 2009:

           

Investment securities available-for-sale:

           

MBS

   $ 1,944,989       $ 0       $ 1,944,989       $ 0   

Municipal bonds

     195,282         0         195,282         0   

Other

     20,054         0         20,054         0   
                                   

Total investment securities available-for-sale

     2,160,325         0         2,160,325         0   

Loans held for sale

     190,412         0         190,412         0   

Other assets - derivatives

     7,820         0         3,273         4,547   
                                   

Total assets

   $ 2,358,557       $ 0       $ 2,354,010       $ 4,547   
                                   

Other liabilities - derivatives

   $ 4,319       $ 0       $ 0       $ 4,319   
                                   

The following table provides a reconciliation of interest rate swaps measured at fair value using significant unobservable or Level 3 inputs on a recurring basis during the nine months ended September 30, 2010 and the year ended December 31, 2009. Gains and losses on these interest rate swaps are included in earnings as interest income or expense.

 

     Beginning
Balance
     Change included
in earnings
    Ending
Balance
 
     (Dollars in thousands)  

Nine Months Ended September 30, 2010

  

Other assets - derivatives

   $ 4,547       $ 1,321      $ 5,868   

Other liabilities - derivatives

     4,319         1,277        5,596   

Year Ended December 31, 2009

       

Other assets - derivatives

     7,460         (2,913     4,547   

Other liabilities - derivatives

     7,460         (3,141     4,319   

Level 2 derivatives represent mortgage banking interest rate lock and loan delivery commitments, as well as a common stock warrant carried as a derivative liability. Level 3 derivatives represent interest rate swaps, with market values for these instruments being a function of the interest rate and term of the underlying loan. See Note 11 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,  
     2010      2009  
     (Dollars in thousands)  

Mortgage banking operations

   $ 8,778       $ 5,174   

 

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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:

 

     September 30, 2010  
     Total Carrying
Value
     Level 1      Level 2      Level 3  
     (Dollars in thousands)  

Loans

   $ 663,251       $ 0       $ 0       $ 663,251   

OREO

     153,565         0         0         153,565   

Mortgage servicing rights

     13,140         0         13,140         0   
     December 31, 2009  
     Total Carrying
Value
     Level 1      Level 2      Level 3  

Loans

   $ 702,477       $ 0       $ 0       $ 702,477   

OREO

     78,302         0         0         78,302   

Mortgage servicing rights

     12,062         0         12,062         0   

The loans disclosed above represent the carrying value of impaired loans at period end. Mortgage servicing rights were written down mainly due to market derived assumptions associated with expected accelerated mortgage prepayment speeds based upon lower interest rates. 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. During 2009, goodwill was tested for impairment and determined to be fully impaired.

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. 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.

 

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Table of Contents

 

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.

Mortgage Servicing Rights

The fair value of mortgage servicing rights is estimated using a discounted cash flow methodology to arrive at the present value of future expected earnings from the servicing of the loans. Model inputs include prepayment speeds, market interest rates, contractual interest rates on the loans being serviced, and the amount of other fee income generated over the servicing contract.

OREO

The fair value of OREO is estimated using third party appraisals, subject to updates to reflect comparable market transactions, with appraisals ordered for “as is” or “disposal value.”

Deposits

The fair values of deposits subject to immediate withdrawal such as interest and noninterest 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.

13. Regulatory Matters and Capital Position:

On September 27, 2010, Sterling announced that its banking regulators had terminated the cease and desist order put in place in October 2009 with Sterling Savings Bank, reflecting a strengthened balance sheet and capital position. Although the cease and desist is no longer applicable, Sterling Savings Bank will continue to be subject to enhanced supervisory review by the FDIC and WDFI under a memorandum of understanding (the “SSB MOU”), pursuant to which Sterling Savings Bank must maintain Tier 1 capital in an amount that ensures that its leverage ratio is at least 8 percent. Sterling Savings Bank will also be required to meet certain asset quality targets and comply with other requirements. As of the date of this filing, Sterling continues to be subject to a regulatory agreement with the Federal Reserve Bank of San Francisco.

 

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During the third quarter of 2010, Sterling Savings Bank returned to a well-capitalized status following the termination of the FDIC cease and desist order, with the termination of the order occurring subsequent to Sterling receiving aggregate proceeds of $730.0 million in connection with the Recapitalization Transactions and Sterling downstreaming $650.0 million to Sterling Savings Bank in the form of a common stock investment. The following table sets forth the respective capital positions for Sterling and Sterling Savings Bank for the periods presented:

 

     Sept 30,
2010
    December 31,
2009
 

Sterling Financial Corporation:

    

Tier 1 leverage ratio

     10.5     3.5

Tier 1 risk-based capital ratio

     16.0     4.9

Total risk-based capital ratio

     17.3     7.9

Sterling Savings Bank:

    

Tier 1 leverage ratio

     10.2     4.2

Tier 1 risk-based capital ratio

     15.5     5.9

Total risk-based capital ratio

     16.8     7.3

14. Subsidiary Merger:

On August 2, 2010, Golf Savings Bank was merged into Sterling Savings Bank. The mortgage banking operations of Golf Savings Bank are continuing to operate as a division within Sterling Savings Bank. Both Golf Savings Bank and Sterling Savings Bank were wholly owned subsidiaries of Sterling and the transaction therefore did not impact the consolidated financial statements of Sterling.

15. Subsequent Events:

On October 21, 2010, Sterling held the Special Meeting at which shareholders approved: (1) the increase in the authorized number of shares of common stock from 750 million to 10 billion; (2) the conversion of outstanding Series B and D preferred stock into, and the exercisability of the warrants issued to THL and Warburg Pincus for shares of common stock; and (3) an amendment to Sterling’s Restated Articles of Incorporation to effect a reverse stock split of Sterling’s common stock at a ratio to be determined by Sterling’s board of directors between one-for-50 and one-for-125 shares of common stock. On October 22, 2010, the series B and D preferred stock were converted into 3,358,000,000 shares of common stock.

 

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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, 2010

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 2009 annual report on Form 10-K.

General

Sterling Financial Corporation (“Sterling”) is a bank holding company, organized under the laws of Washington State in 1992. The principal operating subsidiary of Sterling is Sterling Savings Bank. Sterling Savings Bank, headquartered in Spokane, Washington, commenced operations in 1983 as a Washington State-chartered federally insured stock savings and loan association, and in 2005 converted to a commercial bank. Sterling Savings Bank offers commercial banking products and services, mortgage lending, construction financing and investment products to individuals, small business, commercial organizations and corporations.

Sterling’s dedication to personalized service and relationship banking has enabled it to attract both retail deposits and lending relationships in the western United States. With $10.03 billion in total assets as of September 30, 2010, Sterling originates loans and attracts Federal Deposit Insurance Corporation (“FDIC”) insured and uninsured deposits from the general public throughout its five state footprint through Sterling Savings Bank and through its commercial real estate division INTERVEST-Mortgage Investment Company (“INTERVEST’). On August 2, 2010, Golf Savings Bank, which was a wholly owned subsidiary of Sterling, was merged into Sterling Savings Bank, with the residential units of both banks combined within the home loan division (“Home Loan Division”) of Sterling Savings Bank. The Home Loan Division originates residential loans, both for sale into the secondary market and for the loan portfolio. Sterling also markets fixed income and equities, mutual funds, annuities and other financial products through wealth management representatives located throughout Sterling’s financial service centers network.

Recent Developments

Sterling has been facing a number of challenges resulting from operating losses, driven by credit quality issues. On September 27, 2010, the cease and desist order put in place by the FDIC and the Washington Department of Financial Institutions was removed from Sterling Savings Bank. As of September 30, 2010, Sterling Savings Bank had returned to well-capitalized status. On August 26, 2010, Sterling completed several transactions as part of its recapitalization and recovery plan, receiving $730.0 million in aggregate proceeds (collectively, the “Recapitalization Transactions” or the “Recapitalization”). The Recapitalization comprised three principal transactions:

 

   

an investment of approximately $170.9 million by each of (a) Thomas H. Lee Equity Fund VI, L.P., Thomas H. Lee Parallel Fund VI, L.P., Thomas H. Lee Parallel (DT) Fund VI, L.P. and THL Sterling Equity Investors, L.P. (collectively, “THL” or an “Anchor Investor”) and (b) Warburg Pincus Private Equity X, L.P. (“Warburg Pincus” or an “Anchor Investor”), pursuant to which each received 68,366,000 shares of common stock, 1,709,150 shares of Series B preferred stock, and a seven-year warrant to purchase 86,625,000 shares of common stock at an exercise price of $0.22 per share (the “Anchor Investments”);

 

   

the exchange of 303,000 shares of preferred stock held by the U.S. Department of the Treasury (“Treasury”) at a discounted exchange value into 378,750,000 shares of common stock at a conversion price of $0.20 per share, and amendment of the terms of the warrant held by Treasury to purchase 6,437,677 shares of common stock at an exercise price of $7.06 per share to provide for an exercise price of $0.20 per share for a ten-year term (the “Treasury Exchange”); and

 

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investments by accredited investors of an aggregate of $388.2 million in exchange for an aggregate of 155,268,000 shares of common stock and 3,881,700 shares of Series D preferred stock.

The Treasury Exchange resulted in a non-cash increase in income available to common shareholders of $84.3 million because the book value of the preferred stock plus accrued dividends was greater than the $230.9 million fair value of the common stock issued to Treasury and the fair value of the new warrant. This accounting treatment had no effect on Sterling’s total equity or its regulatory capital position.

The issuance price on an as-converted basis of $0.20 per common share for the Series B and D preferred stock represented a discount to the common stock’s market price of $0.60 per share. For accounting purposes, this $0.40 per-share discount is considered a beneficial conversion feature. Accordingly, Sterling recorded this discount, valued at $604.6 million in aggregate, as a reduction to preferred stock and as an increase to common stock.

Pursuant to the terms of the Recapitalization agreements, Sterling agreed to call a special meeting of its shareholders (the “Special Meeting”) to seek approval to increase the authorized number of shares of common stock from 750 million to 10 billion and convert the outstanding Series B and D preferred stock into common stock, and the exercisability of the warrants issued to THL and Warburg Pincus for shares of common stock. On October 21, 2010, Sterling held the Special Meeting at which shareholders approved: (1) the increase in the authorized number of shares of common stock from 750 million to 10 billion; (2) the conversion of outstanding Series B and D preferred stock into common stock, and the exercisability of the warrants issued to THL and Warburg Pincus for shares of common stock; and (3) an amendment to Sterling’s Restated Articles of Incorporation to effect a reverse stock split of Sterling’s common stock at a ratio to be determined by Sterling’s board of directors between one-for-50 and one-for-125 shares of common stock.

On October 22, 2010, the series B and D preferred stock were converted into 3,358,000,000 shares of common stock. Upon conversion the $604.6 million beneficial conversion feature was amortized and recognized as a non-cash dividend paid to the preferred shareholders. The amortization of the beneficial conversion feature will result in a non-cash reduction in income available to common shareholders during the fourth quarter of 2010 but will have no effect on Sterling’s total equity or its regulatory capital position.

Recent additions to Sterling’s board of directors and officers bring a broad level of financial services experience and regulatory expertise. Les Biller, the former vice chairman and chief operating officer of Wells Fargo & Company, now serves as non-executive chairman of Sterling’s board. Additional board appointments include David A. Coulter, managing director of Warburg Pincus and former chairman and chief executive officer of BankAmerica Corp.; Scott Jaeckel, managing director of THL and director for several public and private companies; Robert H. Hartheimer, a former FDIC division director, investment banker and regulatory consultant; and Robert C. Donegan, president of Seattle based Ivar’s Inc. At Sterling Savings Bank, Dave DePillo, a 25 year industry veteran, joined as chief credit officer.

In addition to the strategies described in Sterling’s Annual Report on Form 10-K for the year ended December 31, 2009, Sterling plans to pursue a strategy of acquiring additional banks, through FDIC-assisted transactions or otherwise. There can be no assurances that this strategic goal will be achieved in a short time frame or even at all. See “Risk Factors—We cannot determine whether or when certain agreements entered into with our regulators will be lifted” and “Risk Factors—Our strategy of pursuing FDIC-assisted acquisition opportunities may not be successful.”

Executive Summary and Highlights

Sterling reported a net loss attributable to common shareholders during the nine months ended September 30, 2010 and 2009 of $113.4 million and $522.4 million, respectively, or $0.81 and $10.06 per common share, respectively. The 2010 results included a provision for credit losses of $220.2 million, a one-time, non-cash increase to income available to common shareholders of $84.3 million related to conversion of Treasury’s preferred stock investment into common stock, and an increase in the allowance for deferred tax assets of $76.0 million. The 2009 results included a provision for credit losses of $341.1 million, a non-cash charge for goodwill of $227.6 million and an allowance for deferred tax assets of $143.0 million. Sterling’s cumulative efforts to address credit quality have led to the lower provision for credit losses, and a decline in the balance of total classified assets.

 

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Net interest income declined 23 percent and 18 percent over the respective three and nine months ended September 30, 2010 compared to the 2009 periods, reflecting the decline in average loan balances, the reversal of interest income on nonperforming loans, and the increase in cash and short term investments relative to loans. Loan originations during the three and nine months ended September 30, 2010 totaled $810.5 million and $2.03 billion, respectively, the majority of which were through the Home Loan Division for sale into the secondary market.

Sterling continued to deleverage its balance sheet throughout the nine months ended September 30, 2010, as reflected in assets with a 23 percent, or $1.68 billion decline in loan balances, and in liabilities with a 71 percent, or $762.5 million reduction of brokered deposits, 37 percent, or $499.9 million decline in FHLB advances, and the 58 percent, or $300.8 million decline in public transaction accounts. The concentration of construction loans declined, reflecting progress in credit risk management. Retail deposits increased as a percentage of total deposits reflecting improvement in the mix of the deposit base.

During the third quarter of 2010, Sterling Savings Bank returned to a well-capitalized status following the termination of the FDIC cease and desist order, with the termination of the order occurring subsequent to the receipt of aggregate proceeds of $730.0 million from the Recapitalization. Driven by the inflow of funds from the Recapitalization Transactions, the investment securities portfolio grew by $767.0 million during the third quarter. Key financial measures as of and for the periods ended September 30, 2010 include:

 

 

Tier 1 leverage ratio was 10.5% at September 30, 2010 compared with 2.0% at June 30, 2010.

 

 

Classified assets declined by $315.0 million, or 19 percent from the beginning of the year.

 

 

Non-performing loans declined 10 percent to $809.0 million, compared to $895.9 million at December 31, 2009.

 

 

Construction loans were 12 percent of the loan portfolio as of September 30, 2010, as compared with 20 percent as of December 31, 2009.

 

 

Retail deposits increased to 87 percent of total deposits from 76 percent of total deposits at the beginning of the year.

 

 

Deposit funding costs were 127 basis points during the third quarter of 2010, which was 70 basis points below the same period in 2009.

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 or principal on a loan has become doubtful, which generally occurs when the loan is 90 days past due or when Sterling restructures it as a troubled loan, 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 (generally at least six months), and the collectability of the total contractual principal and interest is no longer in doubt.

 

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Allowance for Credit Losses. The allowance for credit losses is comprised 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, loan migration analysis, current national and local economic conditions, volume, growth and composition of the portfolio, regulatory guidance and other relevant factors. Management monitors the loan portfolio to evaluate the adequacy of the allowance. The allowance can increase or decrease each quarter based upon the results of management’s analysis.

The portfolio is grouped into standard industry categories for homogeneous loans based on characteristics such as loan type, borrower and collateral. Annual and quarterly loan migration to loss data is used to determine the probability of default. Historically, Sterling had used both one-year and three-year losses to establish the expected loss rate on loans. During the fourth quarter of 2009, as a result of the higher loss rates experienced during 2009, Sterling began using losses from the most recent twelve months to estimate the amount that would be lost if a default were to occur, which is termed the “loss given default.” The probability of default is multiplied by the loss given default to calculate the expected losses for each loan category.

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, loan migration analysis, trends in losses and delinquencies, growth of loans in particular markets, and known changes in economic conditions in each particular lending market.

A loan is considered impaired when, based on current information and events, it is probable Sterling will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price or the fair value of collateral if the loan is collateral dependent.

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, generally defined in the current market as information older than six months, and deteriorating credit quality that warrants classification as substandard.

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 fair 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 to reflect recent sales activity of comparable inventory or pending property sales of the subject collateral.

 

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During the fourth quarter of 2009, as a result of the large decline in real estate values during 2009, Sterling began to record a specific reserve for impaired loans for which an updated valuation analysis has not been completed within the last quarter. The specific reserve is calculated by applying an estimated fair value adjustment to each loan based on market and property type. Estimates of value are not 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 current disruption in economic activity and further declines in real estate values could continue to adversely affect cash flows for both commercial and individual borrowers, and as a result 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, 2010.

Investments and MBS. Assets in the investment 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. The majority of the municipal bonds that Sterling holds are all general obligation bonds, 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 of the underlying loans. 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 at September 30, 2010, 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. Sterling holds a single-issuer trust preferred security that has been negatively impacted by temporary credit market disruptions. As of September 30, 2010, the trust preferred security is rated A1 by Moody’s and has an amortized cost of $24.8 million compared to a $19.7 million market value, or an unrealized loss of $5.1 million.

As of September 30, 2010, Sterling also held private label collateralized mortgage obligations with an aggregate amortized cost of $57.4 million compared to a $59.0 million market value, or a net unrealized gain of $1.6 million. All private label collateralized mortgage obligations are internally monitored monthly and independently stress-tested quarterly for both credit quality and collateral strength, and are AAA rated according to at least one major rating agency. The vintage, or years of issuance, for these nonagency MBS ranges from 2003 to 2005.

 

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As of September 30, 2010, Sterling expects the return of all principal and interest on all securities within its investment and mortgage-backed securities portfolio 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, 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.

Fair Value of Financial Instruments. Sterling’s available-for-sale securities portfolio totaled $2.71 billion and $2.16 billion as of September 30, 2010 and December 31, 2009, respectively, and was the majority 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.

Other Real Estate Owned. Prior to foreclosure, Sterling considers all viable alternatives, checks with the proper authorities to ensure the existence of a valid and recorded lien on the property and determines the current market value of the collateral. Property and other assets acquired through foreclosure of defaulted mortgage or other collateralized loans are carried at fair value, less estimated costs to sell the property and other assets. The fair value of OREO is generally determined using “as is” or disposition values from appraisals obtained by independent appraisers.

An allowance for losses on OREO is designed to include amounts for estimated losses as a result of impairment in value of the real property after repossession. Sterling reviews its real estate owned for impairment in value at least quarterly or whenever events or circumstances indicate that the carrying value of the property or other assets may not be recoverable. In performing the review, if the fair value, less selling costs, is less than its carrying value, an impairment loss is recognized as a charge to operating expenses.

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. 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 recent loss history, the regulatory agreements in place at the time of the assessment, and the credit condition of its loan portfolio outweighed the positive evidence. Therefore, during the third quarter of 2009, a full valuation allowance was established against its deferred tax asset, with the allowance totaling $345.0 million as of September 30, 2010, compared with $269.0 million as of December 31, 2009. Sterling’s deferred tax asset includes approximately $247 million of net operating loss carryforwards as of September 30, 2010.

 

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Results of Operations

Overview. Sterling’s results during the three months ended September 30, 2010 included a net loss of $48.0 million and a one-time, non-cash increase in income available to common shareholders of $84.3 million related to the conversion of the preferred stock held by Treasury into common stock. As a result, net income attributable to common shareholders was $33.6 million, or $0.02 per diluted common share, as compared with a net loss of $463.7 million, or $8.93 per common share, for the three months ended September 30, 2009. The net loss attributable to common shareholders during the nine months ended September 30, 2010 was $113.4 million, or $0.81 per common share versus $522.4 million, or $10.06 per common share in 2009. During the three and nine months ended September 30, 2010, return on common equity (“ROE”) was 50.4% and (244.1%), respectively, and return on assets (“ROA”) was (1.94%) and (2.43%), respectively. During the three and nine months ended September 30, 2009, ROE was (257.4%) and (88.1%), respectively, and ROA was (14.98%) and (5.41%), respectively. The comparability of these periods was affected by the 2009 impairment charge for goodwill, the valuation allowance that was established against the deferred tax assets, the greater level of credit loss provisioning in 2009 versus 2010, and the 2010 non-cash increase in income available to common shareholders from the Treasury Exchange.

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. Net interest spread refers to the difference between the yield on interest-earning assets and the rate paid on interest-bearing liabilities. Net interest margin refers to 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. During the past year, Sterling reduced the leverage in its balance sheet by reducing its higher risk assets and wholesale funding, including brokered deposits. Also during the period, Sterling carried a higher balance of cash and cash equivalents resulting in an increase in its on-balance sheet liquidity. The following table sets forth, on a tax equivalent basis, information with regard to Sterling’s net interest income, net interest spread and net interest margin:

 

     Three Months Ended  
     September 30, 2010     September 30, 2009  
     Average
Balance
     Interest
Income/
Expense
     Yields/
Rates
    Average
Balance
     Interest
Income/
Expense
     Yields/
Rates
 
     (Dollars in thousands)  

ASSETS:

                

Loans:

                

Mortgage

   $ 3,954,265       $ 43,495         4.36   $ 5,230,402       $ 66,500         5.04

Commercial and consumer

     2,843,072         42,474         5.93     3,658,281         52,725         5.72
                                                    

Total loans (1)

     6,797,337         85,969         5.02     8,888,683         119,225         5.32

MBS

     1,920,690         18,127         3.74     2,348,941         27,148         4.59

Investments and cash (2)

     1,101,576         3,722         1.34     510,093         3,493         2.72
                                                    

Total interest-earning assets

     9,819,603         107,818         4.36     11,747,717         149,866         5.06
                                        

Noninterest-earning assets (3)

     5,906              420,265         
                            

Total average assets

   $ 9,825,509            $ 12,167,982         
                            

LIABILITIES and EQUITY:

                

Deposits:

                

Transaction

   $ 1,738,126         315         0.07   $ 1,854,150         630         0.13

Savings

     1,653,751         2,288         0.55     1,730,058         3,434         0.79

Time deposits

     3,671,278         20,036         2.17     4,611,249         36,542         3.14
                                                    

Total deposits

     7,063,155         22,639         1.27     8,195,457         40,606         1.97

Borrowings

     2,152,611         16,580         3.06     2,771,325         21,103         3.02
                                                    

Total interest-bearing liabilities

     9,215,766         39,219         1.69     10,966,782         61,709         2.23
                                        

Noninterest-bearing liabilities

     165,568              193,097         
                            

Total average liabilities

     9,381,334              11,159,879         

Total average equity

     444,175              1,008,103         
                            

Total average liabilities and equity

   $ 9,825,509            $ 12,167,982         
                            

Tax equivalent net interest income and spread (4)

      $ 68,599         2.67      $ 88,157         2.83
                                        

Tax equivalent net interest margin (4)

           2.77           2.98
                            

 

(1) Includes gross nonaccrual loans.

 

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(2) Does not include market value adjustments on available for sale securities that are included in accumulated other comprehensive income.
(3) Includes confirmed losses on nonaccrual loans and the allowance for credit losses.
(4) Interest income on certain loans and securities are presented gross of their applicable tax savings using a 37% effective tax rate.

 

     Nine Months Ended  
     September 30, 2010     September 30, 2009  
     Average
Balance
    Interest
Income/
Expense
     Yields/
Rates
    Average
Balance
     Interest
Income/
Expense
     Yields/
Rates
 
     (Dollars in thousands)  

ASSETS:

               

Loans:

               

Mortgage

   $ 4,360,842      $ 142,414         4.37   $ 5,409,547       $ 209,518         5.18

Commercial and consumer

     3,056,369        134,702         5.89     3,737,310         160,836         5.57
                                                   

Total loans (1)

     7,417,211        277,116         5.00     9,146,857         370,354         5.41

MBS

     1,803,665        56,569         4.19     2,365,921         84,606         4.78

Investments and cash (2)

     1,109,513        11,420         1.38     602,651         11,842         2.63
                                                   

Total interest-earning assets

     10,330,389        345,105         4.47     12,115,429         466,802         5.15
                                       

Noninterest-earning assets (3)

     (75,661          481,673         
                           

Total average assets

   $ 10,254,728           $ 12,597,102         
                           

LIABILITIES and EQUITY:

               

Deposits:

               

Transaction

   $ 1,865,514        1,674         0.12   $ 1,776,041         1,810         0.14

Savings

     1,209,766        8,172         0.90     1,805,992         12,743         0.94

Time deposits

     3,884,419        65,308         2.25     4,797,049         118,975         3.32
                                                   

Total deposits

     6,959,699        75,154         1.44     8,379,082         133,528         2.13

Borrowings

     2,410,727        50,779         2.82     2,965,411         66,864         3.01
                                                   

Total interest-bearing liabilities

     9,370,426        125,933         1.80     11,344,493         200,392         2.36
                                       

Noninterest-bearing liabilities

     566,303             166,741         
                           

Total average liabilities

     9,936,729             11,511,234         

Total average equity

     317,999             1,085,868         
                           

Total average liabilities and equity

   $ 10,254,728           $ 12,597,102         
                           

Tax equivalent net interest income and spread (4)

     $ 219,172         2.67      $ 266,410         2.79
                                       

Tax equivalent net interest margin (4)

          2.84           2.94
                           

 

(1) Includes gross nonaccrual loans.
(2) Does not include market value adjustments on available for sale securities that are included in accumulated other comprehensive income.
(3) Includes confirmed losses on nonaccrual loans and the allowance for credit losses.
(4) Interest income on certain loans and securities are presented gross of their applicable tax savings using a 37% effective tax rate.

Net interest income and net interest margin have been negatively affected by the increase in nonperforming assets, and a change in the mix of interest earnings assets. When loans reach nonperforming status, the reversal and cessation of accruing interest has an immediate negative impact on net interest margin. During the three months ended September 30, 2010, the reversal of interest income on nonperforming loans reduced the margin by 70 basis points compared to a reduction of 56 basis points during the same period in 2009, and a reduction of 80 basis points for the nine months ended September 30, 2010 compared with a reduction of 43 basis points during the same period in 2009. The effect of nonaccrual interest and the change in the mix of interest earning assets on Sterling’s net interest margin has been partially offset by a decline in funding costs.

 

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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, trends in classified assets, trends in delinquent and non-accrual loans, trends in portfolio volume, diversification as to type of loan, size of individual credit exposure, current and anticipated economic conditions, loan policies, collection policies and effectiveness, quality of credit evaluation, effectiveness of policies, procedures and practices, and recent loss experience of peer banking institutions.

Sterling recorded provisions for credit losses of $60.9 million and $220.2 million for the three and nine months ended September 30, 2010, respectively. This compares to a provision for credit losses of $195.5 million and $341.1 million for the three and nine months ended September 30, 2009, respectively. The decline in the level of the provision over these periods primarily relates to the reduction in the level of classified loans, particularly in the construction portfolio, and the amount of losses previously recognized on these classified loans. The following table summarizes the allowance for credit losses for the periods indicated:

 

     Nine Months Ended
September 30,
 
     2010     2009  
     (Dollars in thousands)  

Allowance for credit losses

    

Allowance - loans, January 1

   $ 343,443      $ 208,365   

Provision

     220,590        341,114   

Charge-offs

     (336,507     (298,540

Recoveries

     20,979        14,981   

Transfers

     0        9,831   
                

Allowance - loans, September 30

     248,505        275,751   
                

Allowance - unfunded commitments, January 1

     11,967        21,334   

Provision

     (361     0   

Charge-offs

     (589     0   

Transfers

     0        (9,831
                

Allowance - unfunded commitments, September 30

     11,017        11,503   
                

Total credit allowance

   $ 259,522      $ 287,254   
                

 

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The following table presents classified assets by type, and also by market for Sterling’s classified construction assets:

 

     September 30,
2010
    December 31,
2009
    September 30,
2009
 
     (Dollars in thousands)  

Residential construction

  

Puget Sound

   $ 72,217         6   $ 197,227         13   $ 208,988         18

Portland, OR

     52,509         5     121,352         8     135,643         12

Bend, OR

     6,665         1     25,996         2     22,049         2

Northern California

     13,062         1     17,148         1     3,712         0

Vancouver, WA

     14,912         1     22,509         1     17,529         1

Boise, ID

     5,414         0     21,924         1     23,962         2

Southern California

     4,999         0     9,920         1     39,710         3

Utah

     1,060         0     4,752         0     6,386         1

Other

     24,858         2     66,961         4     69,651         6
                                                   

Total residential construction

     195,696         16     487,789         31     527,630         45
                                                   

Commercial construction

               

Southern California

     53,876         5     109,793         7     26,063         2

Puget Sound

     51,475         4     53,440         3     31,414         3

Northern California

     49,675         4     47,644         3     34,131         3

Other

     93,550         8     126,503         8     104,625         9
                                                   

Total commercial construction

     248,576         21     337,380         21     196,233         17
                                                   

Multi-Family construction

               

Puget Sound

     58,108         5     75,420         5     34,716         3

Portland, OR

     26,391         2     19,032         1     7,784         1

Other

     25,139         2     30,256         2     37,084         3
                                                   

Total multi-family construction

     109,638         9     124,708         8     79,584         7
                                                   

Total construction

     553,910         46     949,877         60     803,447         69
                                                   

Commercial banking

     226,858         19     269,521         17     168,790         14

Commercial real estate

     193,124         17     154,859         10     81,754         7

Residential real estate

     129,001         11     128,561         8     74,448         6

Multi-family real estate

     42,054         4     44,258         3     31,921         3

Consumer

     20,573         3     11,996         2     9,016         1
                                                   

Total classified loans

     1,165,520         100     1,559,072         100     1,169,376         100
                                 

OREO

     169,985           91,478           81,361      
                                 

Total classified assets (1)

   $ 1,335,505         $ 1,650,550         $ 1,250,737      
                                 

 

(1) Net of cumulative confirmed losses on loans and OREO of $588.4 million for September 30, 2010, $579.7 million for December 31, 2009, and $386.2 million for September 30, 2009.

 

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While there has been an increase in commercial real estate classified assets during the last nine months, most other asset classes have reflected declines. Asset resolution activities, including loan sales, contributed to the decline in classified construction loans as a percentage of total classified loans. The following table provides information regarding the classified assets of the top 30 borrowing relationships as of September 30, 2010, which together constituted 29% of all classified assets at period end:

 

Description

  

Location

   September 30, 2010  
          (Dollars in thousands)  

Commercial Construction: 3 loans

   Puget Sound, WA & Other WA    $ 31,061   

Commercial Construction & Real Estate: 5 loans

   Other WA & Other OR      29,116   

Commercial & Residential Construction: 2 loans

   Puget Sound, WA & Other ID      21,476   

Commercial Construction: 3 loans

   Southern CA      21,352   

Commercial Construction & Real Estate: 2 loans

   Northern CA & Nevada      18,290   

Commercial Construction: 1 loan

   Puget Sound, WA      17,921   

Commercial Construction & Real Estate: 2 loans

   Northern CA      17,651   

Commercial Construction: 1 loan

   Portland, OR      14,578   

Commercial Construction & Commercial: 2 loans

   Puget Sound, WA & Other OR      14,576   

Commercial Construction & Real Estate: 4 loans

   Puget Sound, WA      13,640   

Commercial Construction: 1 loan

   Northern CA      11,772   

Multifamily: 3 loans

   Puget Sound, WA      11,375   

Residential Construction & Commercial Real Estate: 5 loans

   Portland, OR      11,236   

Commercial Construction: 2 loans

   Arizona      11,108   

Multifamily: 1 loan

   Portland, OR      10,864   

Commercial Real Estate: 1 loan

   Puget Sound, WA      10,146   

Multifamily: 2 loans

   Northern CA      9,901   

Commercial: 1 loan

   Arizona      9,736   

Commercial & Commercial Construction: 4 loans

   Other WA & Other OR      9,422   

Commercial & Residential Construction: 4 loans

   Portland, OR      9,370   

Residential Construction: 1 loan

   Puget Sound, WA      9,331   

Commercial Construction: 1 loan

   Southern CA      8,978   

Commercial: 1 loan

   Other OR      8,828   

Residential Construction: 17 loans

   Puget Sound, WA      8,484   

Commercial Construction: 1 loan

   Other OR      8,470   

Multifamily: 2 loans

   Northern CA      8,357   

Commercial Construction: 3 loans

   Puget Sound, WA      8,350   

Commercial Construction: 1 loan

   Northern CA      8,348   

Residential Construction & Commercial Real Estate: 12 loans

   Portland, OR & Southern CA      8,209   

Commercial Construction: 1 loan

   Arizona      7,695   
           

Total - Classified Assets of top 30 borrowers

      $ 389,641   
           

 

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Nonperforming assets, a subset of classified assets that includes nonperforming loans and OREO, and related information are summarized in the following table as of the dates indicated:

 

     September 30,
2010
  <