UNITED STATES SECURITIES AND EXCHANGE COMMISSION

 

Washington, D.C.  20549

 

FORM 10-K

(Mark One)

 

 

ý

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the year ended December 31, 2003

 

OR

o

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                                 to                                 

 

COMMISSION FILE NUMBER   0-20800

 

STERLING FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

 

Washington

 

91-1572822

(State or other jurisdiction of
incorporation or organization)

 

(IRS Employer Identification No.)

 

 

 

111 North Wall Street, Spokane, Washington 99201

(Address of principal executive offices) (Zip code)

 

 

 

Registrant’s telephone number, including area code: (509) 458-3711

 

 

 

Securities registered pursuant to Section 12(b) of the Act:

None

 

None

(Title of each class)

 

(Name of each exchange on which registered)

 

 

 

Securities registered pursuant to Section 12(g) of the Act:

Common Stock ($1.00 par value)

(Title of class)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes ý     No o     

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

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

 

As of June 30, 2003, the aggregate market value of the common equity held by non-affiliates of the registrant, computed by reference to the average of the bid and asked prices on such date as reported by The NASDAQ National Market, was $337,696,829.

 

The number of shares outstanding of the registrant’s Common Stock, par value $1.00 per share, as of January 30, 2004 was 20,294,984.

 

DOCUMENTS INCORPORATED BY REFERENCE

Specific portions of the registrant’s Proxy Statement dated April 1, 2004 are incorporated by reference into Part III hereof.

 

 



 

STERLING FINANCIAL CORPORATION
DECEMBER 31, 2003 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS

 

PART I

 

 

Item 1.

Business

 

 

 

General

 

 

 

Company Growth

 

 

 

Lending Activities

 

 

 

Investments and Asset-Backed Securities

 

 

 

Sources of Funds

 

 

 

Subsidiaries

 

 

 

Competition

 

 

 

Personnel

 

 

 

Environmental Laws

 

 

 

Regulation

 

 

 

Forward-Looking Statements

 

 

 

Where You Can Find More Information

 

 

Item 2.

Properties

 

 

Item 3.

Legal Proceedings

 

 

Item 4.

Submission of Matters to a Vote of Security Holders

 

PART II

 

 

Item 5.

Market for the Registrant’s Common Equity and Related Shareholder Matters

 

 

 

Stock Market and Dividend Information

 

 

Item 6.

Selected Financial Data

 

 

Item 7.

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

 

 

 

Executive Summary

 

 

 

Critical Accounting Policies

 

 

 

Results of Operations for the Years Ended December 31, 2003 and 2002

 

 

 

Results of Operations for the Years Ended December 31, 2002 and 2001

 

 

 

Net Interest Income Analysis

 

 

 

Asset and Liability Management

 

 

 

Financial Position

 

 

 

Liquidity and Capital Resources

 

 

 

Off-Balance Sheet Arrangements and Aggregate Contractual Obligations

 

 

 

Capital

 

 

 

Goodwill Litigation

 

 

 

New Accounting Policies

 

 

 

Effects of Inflation and Changing Prices

 

 

Item 7A.

Quantitative and Qualitative Disclosures About Market Risk

 

 

Item 8.

Financial Statements and Supplementary Data

 

 

Item 9.

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

 

 

Item 9A.

Controls and Procedures

 

 

 

Disclosure Controls and Procedures

 

 

 

Changes in Internal Control Over Financial Reporting

 

PART III

 

 

 

Item 10.

Directors and Executive Officers of the Registrant

 

 

Item 11.

Executive Compensation

 

 

Item 12.

Security Ownership of Certain Beneficial Owners and Management

 

 

Item 13.

Certain Relationships and Related Transactions

 

 

Item 14.

Principal Accounting Fees and Services

 

PART IV

 

 

Item 15.

Exhibits, Financial Statement Schedules and Reports on Form 8-K

 

 

 

SIGNATURES

 

 



 

PART I

 

Item 1.   Business

 

General

 

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

 

Sterling provides personalized, quality financial services to its customers as exemplified by its “Hometown Helpful” philosophy.  Sterling believes that this dedication to personalized service has enabled it to grow both its retail deposit base and its lending portfolio in the Pacific Northwest region.  With $4.28 billion in total assets at December 31, 2003, Sterling attracts Federal Deposit Insurance Corporation (“FDIC”) insured deposits from the general public through 86 retail branches located in Washington, Oregon, Idaho and Montana.  Sterling originates loans through its branch offices as well as Action Mortgage residential loan production offices in the four-state area and through INTERVEST commercial real estate lending offices in Washington, Oregon and Arizona.  Sterling also markets tax-deferred annuities, mutual funds and other financial products through Harbor Financial and property and casualty insurance coverage in Montana through The Dime Service Corporation, a subsidiary of Sterling Savings Bank.

 

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

 

Company Growth

 

On February 28, 2003, Empire Federal Bancorp, Inc. (“Empire”) was merged with and into Sterling, with Sterling being the surviving corporation in the merger.  Sterling issued 1,401,370 shares of common stock in exchange for all of the stock of Empire.  Sterling acquired approximately $144 million of cash, $67 million of loans, $184 million of deposits and $29 million of capital in the transaction.  See Note 25 of “Notes to Consolidated Financial Statements.”

 

On July 15, 2003, Sterling announced that it had entered into an Agreement and Plan of Merger (the “Klamath Merger”) with Klamath First Bancorp, Inc. (“Klamath”), an Oregon corporation.  Subsequent to the end of the year, on January 2, 2004, Klamath was merged with and into Sterling, with Sterling being the surviving corporation in the merger.  Klamath’s wholly-owned subsidiary, Klamath First Federal Savings and Loan Association, was merged with and into Sterling’s wholly-owned subsidiary, Sterling Savings Bank, with Sterling Savings Bank being the surviving institution.

 

Under the terms of the Klamath Merger, each share of Klamath common stock was converted into 0.77 shares of Sterling common stock.  Sterling issued 5,431,067 shares of common stock in exchange for all of the stock of Klamath.  As a result of the merger, Sterling acquired approximately $988 million in deposits, $767 million in investments and ABS, $566 million in loans and $145 million in capital, while adding approximately 450 employees to its work force.  In addition, Sterling added 48 retail branches and significantly increased its deposit market share in Oregon from 0.5% to over 4.0%.  See Note 26 of “Notes to Consolidated Financial Statements.”

 

1



 

With the increase to 134 branches serving Washington, Oregon, Idaho and Montana, Sterling strengthens its position as a leading regional community bank.  This merger is consistent with Sterling’s growth strategy to become the leading community bank in the Pacific Northwest region and furthers Sterling’s goal of providing extensive coverage throughout the region by further extending Sterling’s geographic footprint in Oregon.  Klamath’s strong deposit base complements Sterling’s strong asset growth, while the combined branch network and access to capital gives Sterling the opportunity to continue its growth in the region.

 

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

 

Lending Activities

 

Focus on Community Lending.  In recent years, Sterling focused its efforts on becoming more like a community bank.  Sterling increased its commercial real estate, business banking, consumer and construction lending.  Commercial real estate, business banking, consumer and construction loans generally produce higher yields than residential permanent mortgage loans.  Such loans, however, generally involve a higher degree of risk than the financing of residential real estate.

 

Business Banking Lending.  Sterling’s Business Banking Group provides a full range of credit products to small- and medium-sized businesses and individuals.  Credit products include lines of credit, receivable and inventory financing, equipment loans and permanent and construction real restate financing.  Loans may be made unsecured, partially secured or fully secured based on certain credit criteria.  The credit product line for both businesses and individuals includes standardized products as well as customized accommodations.

 

Sterling’s Private Banking Group provides services to higher-net-worth and higher-income borrowers by originating a variety of consumer and business banking loans.  Such loans generally, but do not always, meet the same underwriting requirements or have the same terms as general consumer loans of the same type.

 

Sterling’s Corporate Banking Group provides a full line of financial services to middle market companies in its service area.  Credit products include lines of credit, receivable and inventory financing, equipment loans and permanent and construction financing.  Loans may be made on an unsecured, partially-secured or fully-secured basis.  The Corporate Banking Group also serves the needs of the owners and key employees of its business customers.

 

Sterling has established minimum underwriting standards which delineate criteria for sources of repayment, financial strength and credit enhancements such as guarantees.  Typically, the primary source of repayment is recurring cash flow of the borrower or cash flow from the business or project being financed.  Depending on the type of loan, underwriting standards include minimum financial requirements, maximum loan-to-collateral value ratios, minimum cash flow coverage of debt service, debt-to-income ratios and minimum liquidity requirements.  Exceptions to the minimum underwriting standards may be made depending upon the type of loan and financial strength of the borrower.  Exceptions are reported to the appropriate level of authority up to and including the board of directors.  Common forms of collateral pledged to secure business banking loans include real estate, accounts receivable, inventory, equipment, agricultural crops or livestock and marketable securities. Most loans have maximum terms of one to ten years and loan-to-value ratios in the range of 65% to 80%, based on an analysis of the collateral pledged.

 

Business, private and corporate banking loans generally involve a higher degree of risk than the financing of real estate, primarily because collateral is more difficult to appraise, the collateral may be difficult to obtain or liquidate following an uncured default and it is difficult to accurately predict the borrower’s ability to generate future cash flows.  These loans, however, typically offer relatively higher yields and variable interest rates.  The availability of such loans enables potential depositors to establish full-service banking relationships with Sterling.

 

2



 

Multifamily Residential and Commercial Real Estate Lending.  Sterling offers multifamily residential and commercial real estate loans as both construction and permanent loans collateralized by real property.  Although Sterling’s market for such loans is primarily in the Pacific Northwest, Sterling has also recently established a production office in Phoenix, Arizona.  Construction loans on such properties typically have terms of 12 to 24 months and have variable interest rates. Permanent fixed- and adjustable-rate loans on existing properties typically have maturities of three to ten years. Multifamily residential and commercial real estate loans generally involve a higher degree of risk than one- to four-family residential real estate loans, because they typically involve large loan balances to single borrowers or groups of related borrowers.  The payment experience on such loans typically is dependent on the successful operation of the real estate project and is subject to certain risks not present in one- to four-family residential mortgage lending.  These risks include excessive vacancy rates or inadequate operating cash flows.  Construction lending is subject to risks such as construction delays, cost overruns, insufficient values and an inability to obtain permanent financing in a timely manner.  Sterling attempts to reduce its exposure to these risks by limiting loan amounts to the amounts readily accepted in the secondary market, by closely monitoring the construction disbursement process, by investigating the borrowers’ finances and, depending on the circumstances, requiring annual financial statements from the borrowers, requiring operating statements on the properties or acquiring personal guarantees from the borrowers.

 

One- to Four-Family Residential Lending.  Sterling originates fixed-rate and adjustable-rate residential mortgages (“ARMs”), which have interest rates that adjust annually or every three, five and seven years and are indexed to a variety of market indices.

 

Sterling continues to originate conventional and government-insured residential loans for sale into the secondary mortgage market.  Within the secondary mortgage market for conventional loans, Sterling sells its residential loans both on a servicing-released and servicing-retained basis to others.  Sterling also sells loans to the Federal Home Loan Mortgage Corporation (“FHLMC”) and the Federal National Mortgage Association (“FNMA”). Sterling endeavors to underwrite residential loans in compliance with FHLMC and FNMA underwriting standards.  Loans sold into the secondary market are all sold without recourse to Sterling, except that Sterling may be obligated to repurchase any loans which are not underwritten in accordance with FHLMC and FNMA or applicable investor underwriting guidelines.

 

Conventional residential mortgage loans are originated for up to 103% of the appraised value or selling price of the mortgaged property, whichever is less.  Borrowers must purchase private mortgage insurance from approved third parties so that Sterling’s risk is limited to approximately 80% of the appraised value on all loans with loan-to-value ratios in excess of 80%.  Sterling’s residential lending programs are designed to comply with all applicable regulatory requirements.  For a discussion of Sterling’s management of interest rate risk (“IRR”) on conventional loans, see “Secondary Market Activities.”

 

Sterling originates residential construction loans on custom homes, presold homes and spec homes.  Sterling also provides acquisition and development loans for residential subdivisions.  Construction financing is generally considered to involve a higher degree of risk than long-term financing on improved, occupied real estate.  Sterling’s risk of loss on construction loans depends largely upon the accuracy of the initial estimate of the property’s value at completion of construction or development and the estimated cost (including interest) of construction.  If the estimate of construction costs proves to be inaccurate, Sterling might have to advance funds beyond the amount originally committed to permit completion of the development and to protect its security position.  Sterling also might be confronted, at or prior to maturity of the loan, with a project with insufficient value to ensure full repayment. Sterling’s underwriting, monitoring and disbursement practices with respect to construction financing are intended to ensure that sufficient funds are available to complete construction projects.  Sterling endeavors to limit its risk through its underwriting procedures by using only approved, qualified appraisers and by dealing only with qualified builders/ borrowers.  The properties that serve as underlying collateral for these construction loans are located primarily in the states of Washington, Oregon, Idaho and Montana.

 

At December 31, 2003, approximately 48% of Sterling’s one- to four-family residential construction loans consisted of loans for spec properties.  Further, approximately 46% of Sterling’s one- to four-family residential construction loan portfolio was concentrated in the greater Portland, Oregon market.  A reduction in market values or in the demand for residential housing, particularly in the Portland market, could lead to higher delinquencies and foreclosures and have a negative impact on Sterling.

 

3



 

Consumer Lending.  Consumer loans and lines of credit are originated directly through Sterling’s retail branches and Private Banking Group, and indirectly through Sterling’s Dealer Banking Department.  Sterling finances purchases of consumer goods including automobiles, boats, and recreational vehicles and lines of credit for personal use.  Generally, consumer loans are originated for terms ranging from six months to ten years.  Interest rates may be either fixed or adjustable based on a contractual formula tied to established external indices.  Sterling also makes loans secured by borrowers’ savings accounts and equity loans collateralized by residential real estate.  Equity loans may have maturities of up to 15 years.

 

The following table sets forth information on loan originations for the periods indicated.

 

 

 

Years Ended December 31,

 

 

 

2003

 

2002

 

2001

 

 

 

Amount

 

%

 

Amount

 

%

 

Amount

 

%

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Mortgage - permanent:

 

 

 

 

 

 

 

 

 

 

 

 

 

One- to four-family residential

 

$

504,169

 

22.2

 

$

350,973

 

19.2

 

$

204,503

 

14.0

 

Multifamily residential

 

71,962

 

3.2

 

77,761

 

4.3

 

50,111

 

3.4

 

Commercial real estate

 

114,487

 

5.0

 

66,492

 

3.6

 

146,391

 

10.0

 

 

 

690,618

 

30.4

 

495,226

 

27.1

 

401,005

 

27.4

 

Mortgage - construction:

 

 

 

 

 

 

 

 

 

 

 

 

 

One- to four-family residential

 

531,875

 

23.4

 

481,328

 

26.3

 

351,824

 

24.0

 

Multifamily residential

 

79,463

 

3.5

 

62,498

 

3.4

 

53,470

 

3.6

 

Commercial property

 

96,213

 

4.2

 

54,621

 

3.0

 

80,875

 

5.5

 

 

 

707,551

 

31.1

 

598,447

 

32.7

 

486,169

 

33.1

 

Total mortgage loans

 

1,398,169

 

61.5

 

1,093,673

 

59.8

 

887,174

 

60.5

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Commercial and consumer:

 

 

 

 

 

 

 

 

 

 

 

 

 

Corporate banking

 

204,733

 

9.0

 

121,348

 

6.6

 

0

 

0.0

 

Business banking

 

386,521

 

17.0

 

403,181

 

22.1

 

389,470

 

26.5

 

Consumer - direct

 

211,505

 

9.3

 

146,575

 

8.0

 

129,133

 

8.8

 

Consumer - indirect

 

73,046

 

3.2

 

64,333

 

3.5

 

62,374

 

4.2

 

Total commercial and consumer loans

 

875,805

 

38.5

 

735,437

 

40.2

 

580,977

 

39.5

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total loans originated

 

$

2,273,974

 

100.0

 

$

1,829,110

 

100.0

 

$

1,468,152

 

100.0

 

 

4



 

Loan Portfolio Analysis.  The following table sets forth the composition of Sterling’s loan portfolio by type of loan at the dates indicated.

 

 

 

 

December 31,

 

 

 

2003

 

2002

 

2001

 

2000

 

1999

 

 

 

Amount

 

%

 

Amount

 

%

 

Amount

 

%

 

Amount

 

%

 

Amount

 

%

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Mortgage - permanent:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

One- to four-family residential

 

$

407,999

 

13.8

 

$

358,359

 

14.8

 

$

315,242

 

14.8

 

$

409,592

 

20.6

 

$

396,565

 

21.9

 

Multifamily residential

 

167,220

 

5.7

 

161,547

 

6.7

 

155,250

 

7.3

 

163,675

 

8.2

 

137,835

 

7.6

 

Commercial real estate

 

463,191

 

15.7

 

458,712

 

18.9

 

438,594

 

20.5

 

347,654

 

17.5

 

317,565

 

17.6

 

Land and other

 

0

 

0.0

 

0

 

0.0

 

925

 

0.0

 

956

 

0.0

 

0

 

0.0

 

 

 

1,038,410

 

35.2

 

978,618

 

40.4

 

910,011

 

42.6

 

921,877

 

46.3

 

851,965

 

47.1

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Mortgage - construction:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

One- to four-family residential

 

271,480

 

9.2

 

280,514

 

11.6

 

214,849

 

10.1

 

215,844

 

10.9

 

184,081

 

10.2

 

Multifamily residential

 

127,424

 

4.3

 

96,297

 

4.0

 

88,977

 

4.2

 

80,728

 

4.1

 

71,024

 

3.9

 

Commercial real estate

 

154,061

 

5.2

 

104,108

 

4.3

 

92,089

 

4.3

 

81,347

 

4.1

 

32,018

 

1.8

 

 

 

552,965

 

18.7

 

480,919

 

19.9

 

395,915

 

18.6

 

377,919

 

19.1

 

287,123

 

15.9

 

Total mortgage loans

 

1,591,375

 

53.9

 

1,459,537

 

60.3

 

1,305,926

 

61.2

 

1,299,796

 

65.4

 

1,139,088

 

63.0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Commercial and consumer:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Business, private and corporate banking

 

948,304

 

32.2

 

655,727

 

27.0

 

520,866

 

24.3

 

435,284

 

21.9

 

348,941

 

19.3

 

Consumer - direct

 

309,931

 

10.5

 

246,578

 

10.2

 

244,097

 

11.4

 

235,423

 

11.8

 

223,286

 

12.4

 

Consumer - indirect

 

99,697

 

3.4

 

62,896

 

2.5

 

65,169

 

3.1

 

17,682

 

0.9

 

96,602

 

5.3

 

Total commercial and consumer loans

 

1,357,932

 

46.1

 

965,201

 

39.7

 

830,132

 

38.8

 

688,389

 

34.6

 

668,829

 

37.0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total loans receivable

 

2,949,307

 

100.0

 

2,424,738

 

100.0

 

2,136,058

 

100.0

 

1,988,185

 

100.0

 

1,807,917

 

100.0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Deferred loan origination fees, net of costs

 

(7,276

)

 

 

(6,450

)

 

 

(5,980

)

 

 

(5,518

)

 

 

(4,543

)

 

 

Gross loans receivable

 

2,942,031

 

 

 

2,418,288

 

 

 

2,130,078

 

 

 

1,982,667

 

 

 

1,803,374

 

 

 

Allowance for loan losses

 

(35,605

)

 

 

(27,866

)

 

 

(20,599

)

 

 

(16,740

)

 

 

(15,603

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loans receivable, net

 

$

2.906,426

 

 

 

$

2,390,422

 

 

 

$

2,109,479

 

 

 

$

1,965,927

 

 

 

$

1,787,771

 

 

 

 

5



 

Contractual Principal Payments.  The following table sets forth the scheduled contractual principal repayments for Sterling’s loan portfolio at December 31, 2003.  Demand loans, loans having no stated repayment schedule and no stated maturity, and overdrafts are reported as due in one year or less. Loan balances do not include undisbursed loan proceeds, deferred loan origination costs and fees, or allowances for loan losses.

 

 

 

Balance
Outstanding at

 

Principal Payments
Contractually Due in Fiscal Years

 

 

 

December 31, 2003

 

2004

 

2005-2008

 

Thereafter

 

 

 

(Dollars in thousands)

 

Mortgage - permanent:

 

 

 

 

 

 

 

 

 

Fixed rate

 

$

413,559

 

$

12,911

 

$

72,903

 

$

327,745

 

Variable rate

 

624,851

 

42,963

 

155,867

 

426,021

 

Mortgage - construction

 

552,965

 

354,160

 

173,091

 

25,714

 

Consumer - direct

 

309,931

 

120,429

 

68,725

 

120,777

 

Consumer - indirect

 

99,697

 

18,677

 

72,932

 

8,088

 

Business, private and corporate banking

 

948,304

 

461,167

 

245,515

 

241,622

 

 

 

$

2,949,307

 

$

1,010,307

 

$

789,033

 

$

1,149,967

 

 

Loan Servicing.  Sterling services its own loans as well as loans owned by others.  Loan servicing includes collecting and remitting loan payments, accounting for principal and interest, holding escrow funds for the payment of real estate taxes and insurance premiums, contacting delinquent borrowers and supervising foreclosures in the event of unremedied defaults.  Sterling generally receives a fee based on the unpaid principal balance of each loan to compensate for the costs of performing the servicing function.

 

For residential mortgage loans serviced for other investors, Sterling receives a fee, generally ranging from 0.24% to 0.375% of the unpaid principal balance.  At December 31, 2003 and 2002, Sterling serviced for itself and for other investors residential mortgage loans totaling $737.6 million and $718.5 million, respectively.  Of such mortgage loans, Sterling serviced $329.4 million and $198.3 million, respectively, at these dates for FHLMC, FHLB and FNMA. Sterling’s ability to continue as a seller/servicer for FHLMC and FNMA is dependent upon meeting the qualifications of these agencies.  Sterling currently meets all applicable requirements.

 

Sterling receives a fee for servicing commercial real estate loans for other investors.  This fee generally ranges from 0.10% to 0.25% of the unpaid principal balance.  At December 31, 2003 and 2002, Sterling serviced for itself and other investors commercial real estate loans totaling $842.0 million and $698.6 million, respectively.

 

Sterling also receives a fee of 0.50% of the unpaid principal balance of each loan for servicing automobile loans for other investors.  At December 31, 2003 and 2002, Sterling serviced $25.9 million and $54.4 million of such loans, respectively.

 

Secondary Market Activities.  Sterling has developed correspondent relationships with a number of mortgage companies and financial institutions to facilitate the origination or purchase and sale of mortgage loans in the secondary market on either a participation or whole loan basis.  Substantially all of such purchased loans or participations are secured by real estate.  Those agents who present loans to Sterling for purchase are required to provide a processed loan package prior to commitment.  Sterling then underwrites the loan in accordance with its established lending standards.

 

Sterling, from time to time, sells participations in certain commercial real estate loans to investors on a servicing-retained basis.  During the years ended December 31, 2003, 2002 and 2001, Sterling sold approximately $35.9 million, $65.1 million and $51.5 million in loans under participation agreements, resulting in net gains of $328,000, $618,000 and $380,000, respectively.

 

Sterling generally receives a fee of approximately 1.0% to 2.0% of the principal balance of mortgage loans for releasing the servicing.  In 2003, 40.9% of Sterling’s sales of Federal Housing Administration (“FHA”) and Veteran’s Administration (“VA”) insured loans have been sold into the secondary market on a loan-by-loan servicing-released basis. In 2002, 66.3% of such sales were sold on a servicing-released basis.

 

6



 

In 2003, 59.1% of Sterling’s sales of conventional, FHA and VA insured loans were sold into the secondary market on a servicing-retained basis.  This compares with 33.7% in 2002.  Sterling records a valuation of approximately 1.00% to 1.15% of the principal balance of such loans for retaining the servicing.  At December 31, 2003 and 2002, Sterling had recorded as net assets $3.5 million and $1.7 million in servicing rights, respectively.  See Note 3 of “Notes to Consolidated Financial Statements.”

 

Loan Commitments.  Sterling makes written commitments to individual borrowers and mortgage brokers for the purposes of originating and purchasing loans.  These loan commitments establish the terms and conditions under which Sterling will fund the loans.  Sterling had outstanding commitments to originate or purchase loans aggregating $762.3 million at December 31, 2003.  Sterling also had secured and unsecured commercial and personal lines of credit totaling approximately $754.1 million, of which the undisbursed portion was approximately $343.2 million at December 31, 2003.  See Note 17 of “Notes to Consolidated Financial Statements.”

 

Derivatives and Hedging.  Sterling, through its subsidiary Action Mortgage, enters into interest rate lock commitments (“rate locks”) to prospective residential mortgage borrowers.  Traditionally, Action Mortgage has endeavored to hedge IRR by entering into non-binding (“best-efforts”) forward sales agreements with third parties.  In July 2003, in an effort to improve and protect the profit margin on loans sold into the secondary market, Action Mortgage began hedging IRR by entering into mandatory forward sales agreements on ABS with third parties.

 

The risks inherent in such mandatory forward sales agreements include the risk that, if for any reason Action Mortgage does not close and sell the loans in question, it is nonetheless obligated to deliver ABS to the counterparty on the agreed terms.  Action Mortgage could incur significant costs in acquiring replacement loans or ABS and such costs could have a material adverse impact on mortgage banking operations in future periods, especially in rising interest rate environments.  During the year ended December 31, 2003, Sterling recorded $1.1 million in revenue from forward sales agreements and similar transactions.  This revenue is a component of other gains and losses on sales of loans into the secondary market.

 

Rate locks and forward sales agreements are considered to be derivatives. Sterling has recorded the estimated fair values of the rate locks and forward sales agreements on its balance sheet in either other assets or other liabilities. Changes in the fair values of these derivative instruments are recorded in net gain on sales of mortgage loans in the income statement as the changes occur.  The estimated fair value of rate locks was $85,000 and the estimated fair value of forward sales agreements was $(73,000) at December 31, 2003.

 

Classified Assets, Real Estate Owned and Delinquent Loans.  To measure the quality of assets, including loans and real estate owned (“REO”), Sterling has established guidelines for classifying assets and determining provisions for anticipated loan and REO losses. Under these guidelines, an allowance for anticipated loan and REO losses is established when certain conditions exist. This system for classifying and reserving for loans and REO is administered by Sterling’s Special Assets Department, which is responsible for minimizing loan deficiencies and losses therefrom.  An oversight committee, comprised of senior management, monitors the activities of the Special Assets Department and reports results to Sterling’s Board of Directors.

 

Under this system, Sterling classifies loans and other assets it considers of questionable quality.  Sterling’s system employs the classification categories of “substandard,” “doubtful” and “loss.” Substandard assets have deficiencies which give rise to the distinct possibility that Sterling will sustain some loss if the deficiencies are not corrected.  Doubtful assets have the weaknesses of substandard assets, and on the basis of currently existing facts, there is a high probability of loss.  An asset classified as loss is considered uncollectible and of such little value that it should not be included as an asset of Sterling.  Total classified assets increased slightly to $84.8 million at December 31, 2003 from $84.7 million at December 31, 2002.  As a percentage of total assets, classified assets decreased from the prior year.  The percentage of classified assets to total assets was 2.0% and 2.4% at December 31, 2003 and 2002, respectively.  See “Major Classified Loans.

 

Assets classified as substandard or doubtful require the establishment of valuation allowances in amounts considered by management to be adequate under accounting principles generally accepted in the United States of America (“GAAP”).  Assets classified as loss require either a specific valuation allowance of 100% of the amount classified or a write-off of such amount.  At December 31, 2003, Sterling’s assets classified as loss totaled $3.3 million compared to $4.0 million at December 31, 2002.  Judgments regarding the adequacy of a valuation allowance are based

 

7



 

on on-going evaluations of the nature, volume and quality of the loan portfolio, REO and other assets, specific problem assets and current economic conditions that may affect the recoverability of recorded amounts.

 

REO is recorded at the lower of estimated fair value, less estimated selling expenses, or carrying value at foreclosure. Fair value is defined as the amount in cash or other consideration that a real estate asset would yield in a current sale between a willing buyer and a willing seller.  Development and improvement costs relating to the property are capitalized to the extent they are deemed to be recoverable upon disposal.  The carrying value of REO is continuously evaluated and, if necessary, an allowance is established to reduce the carrying value to net realizable value which considers, among other things, estimated direct holding costs and selling expenses.

 

The following table sets forth the activity in Sterling’s REO for the periods indicated.

 

 

 

Years Ended December 31,

 

 

 

2003

 

2002

 

2001

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

Balance at beginning of period

 

$

3,953

 

$

2,982

 

$

6,407

 

Loan foreclosures and other additions

 

3,900

 

7,876

 

5,599

 

Improvements and other changes

 

282

 

715

 

(211

)

Sales

 

(3,729

)

(7,382

)

(8,354

)

Provisions for losses

 

(180

)

(238

)

(459

)

 

 

 

 

 

 

 

 

Balance at end of period

 

$

4,226

 

$

3,953

 

$

2,982

 

 

Major Classified Loans.  Sterling’s classified loans with a net carrying value at December 31, 2003 of more than $4.0 million included the following, which together constitute 39.3% of classified assets.

 

Sterling holds an income property loan secured by a specialized care facility located in Arizona.  The aggregate carrying value of this loan at December 31, 2003 was $8.1 million.  This loan has matured and is currently in default.  Sterling has entered into negotiations for an extension agreement.

 

Sterling holds two income property construction loans and a commercial line of credit secured by a hotel in western Washington.  The aggregate carrying value of these three loans at December 31, 2003 was $5.7 million.  The loans were classified as substandard due to lack of stable occupancy, insufficient debt service coverage, and payment and property tax defaults.  Borrowers are performing under the terms of a conditional forbearance agreement.  Taxes and loan payments are current.  The loans continue to be closely monitored for adherence to the forbearance agreement.

 

Sterling holds an income property loan secured by a specialized care facility located in western Washington.  The aggregate carrying value of this loan at December 31, 2003 was $5.3 million.  Although this facility has been classified as substandard because it has failed to reach a stabilized level of occupancy or satisfactory debt service coverage, there have been recent improvements in both of these areas.  The loan continues to perform as agreed and is being closely monitored.

 

Sterling holds an income property loan secured by four hotel properties located in Washington, Oregon and Idaho.  The aggregate carrying value of this loan at December 31, 2003 was $5.2 million.  The loan was classified as substandard due to the borrower’s delinquency.  Judicial foreclosure proceedings and lawsuits against guarantors are currently in process.  These hotels are operating under receivership.

 

Sterling holds six business banking loans secured by inventory in Idaho.  The aggregate carrying value of these loans at December 31, 2003 was $4.8 million.  The loans were classified as substandard due to operating losses.  As of December 31, 2003, the loans continue to perform as agreed and are being closely monitored.

 

Sterling holds three business banking loans secured by real estate, accounts receivable, equipment and inventory in western Oregon.  The aggregate carrying value of these loans at December 31, 2003 was $4.1 million.  The loans were classified as substandard due to operating losses, lack of operating capital and past due accounts receivable.  Sterling has entered into negotiations for a forbearance agreement.

 

8



 

Major Real Estate Owned.  At December 31, 2003, the aggregate value of outstanding REO properties was $4.2 million.  None of the REO properties had a carrying value of more than $1.0 million.

 

Delinquent Loan Procedures.  Delinquent and problem loans are part of any lending business. If a borrower fails to make a required payment when due, Sterling institutes internal collection procedures. For residential mortgage and consumer loans, Sterling’s collection procedures generally require that an initial request for payment be mailed to the borrower when the loan is 15 days past due. At 25 days past due, the borrower is contacted by telephone and payment is requested orally.  At 30 days past due, Sterling records the loan as a delinquency. In the case of delinquent residential mortgage loans, a notice of intent to foreclose is mailed at 45 days past due. If the loan is still delinquent 30 days following the mailing of the notice of intent to foreclose, Sterling generally initiates foreclosure proceedings.

 

For consumer loans, a demand letter is sent when the account becomes delinquent for two payments. Additional collection work or repossession may follow. In certain instances, Sterling may modify the loan or grant a limited moratorium on loan payments to enable the borrower to reorganize his or her financial affairs. Similar collection procedures to those for consumer and mortgage loans are followed for business loans with the exception that these accounts are generally handled as a joint effort between the originating loan officer and the collection department during initial stages of delinquency. On or before 75 days of delinquency, the collection effort is typically shifted from the originating loan officer to the collection department with legal action to follow.

 

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

 

 

 

December 31,

 

 

 

2003

 

2002

 

2001

 

2000

 

1999

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

 

 

Nonaccrual loans

 

$

16,208

 

$

16,278

 

$

21,102

 

$

8,385

 

$

9,259

 

Restructured loans

 

1,164

 

594

 

886

 

0

 

66

 

Total nonperforming loans

 

17,372

 

16,872

 

21,988

 

8,385

 

9,325

 

Real estate owned (1)

 

4,226

 

3,953

 

2,982

 

6,407

 

7,299

 

 

 

 

 

 

 

 

 

 

 

 

 

Total nonperforming assets (2)

 

$

21,598

 

$

20,825

 

$

24,970

 

$

14,792

 

$

16,624

 

 

 

 

 

 

 

 

 

 

 

 

 

Ratio of total nonperforming assets to total assets

 

0.50

%

0.59

%

0.82

%

0.56

%

0.65

%

 

 

 

 

 

 

 

 

 

 

 

 

Ratio of total nonperforming loans to gross loans

 

0.59

%

0.70

%

1.03

%

0.42

%

0.52

%

Ratio of allowance for estimated losses on loans to total nonperforming loans (3)

 

216.6

%

174.3

%

91.9

%

190.1

%

164.4

%

 


(1)      Amount is net of the allowance for REO losses.

 

(2)      Includes $6.5 million, $3.2 million and $4.4 million in nonperforming assets acquired from Empire and Source Capital outstanding at December 31, 2003, 2002 and 2001, respectively.

 

(3)      Excludes loans classified as loss. Loans classified as loss that are excluded from allowance for loan losses were $2,897,000, $2,067,000, $1,843,000, $803,000 and $275,000 at December 31, 2003, 2002, 2001, 2000 and 1999, respectively.  There were no loans classified as loss that are excluded from total nonperforming loans in any of the periods.

 

Sterling regularly reviews the collectibility of accrued interest and generally ceases to accrue interest on a loan when either principal or interest is past due by 90 days or more. Any accrued and uncollected interest is reversed from income at that time. Loans may be placed in nonaccrual status earlier if, in management’s judgment, the loan may be uncollectible. Interest on such a loan is then recognized as income only if collected or if the loan is restored to performing status. Interest income of $1,025,000, $1,103,000 and $707,000 was recorded on these loans during the years ended December 31, 2003, 2002 and 2001, respectively.  Additional interest income of $1,487,000, $778,000 and $762,000 would have been recorded during the years ended December 31, 2003, 2002 and 2001, respectively, if nonaccrual and restructured loans had been current in accordance with their original contractual terms.

 

9



 

Allowance for Loan and Real Estate Owned Losses.  Generally, Sterling establishes specific allowances for the difference between the anticipated fair value (market value less selling costs, foreclosure costs and projected holding costs), adjusted for other possible sources of repayment, and the book balance (loan principal and accrued interest or carrying value of REO) of its loans classified as loss and REO.  Each classified loan and REO property is reviewed at least monthly. Allowances are established or periodically adjusted, if necessary, based on the review of information obtained through on-site inspections, market analysis, appraisals and purchase offers.

 

The allowance for loan losses is maintained at a level deemed appropriate by management to adequately provide for known and probable losses and inherent risks in the loan portfolio.  The allowance is based upon a number of factors, including prevailing and anticipated economic trends, industry experience, estimated collateral values, management’s assessment of credit risk inherent in the portfolio, delinquency trends, historical loss experience, specific problem loans and other relevant factors.

 

Additions to the allowance, in the form of provisions, are reflected in current operating results, while charge-offs to the allowance are made when a loss is determined to have occurred.  Because the allowance for loan losses is based on estimates, ultimate losses may materially differ from the estimates.  See Note 5 of “Notes to Consolidated Financial Statements.”

 

Management believes that the allowance for loan losses is adequate given the composition and risks of the loan portfolios, although there can be no assurance that the allowance will be adequate to cover all contingencies.  The following table sets forth information regarding changes in Sterling’s allowance for estimated losses on loans for the periods indicated.

 

 

 

­Years Ended December 31,

 

 

 

2003

 

2002

 

2001

 

2000

 

1999

 

 

 

(Dollars in thousands)

 

Balance at beginning of period

 

$

27,866

 

$

20,599

 

$

16,740

 

$

15,603

 

$

14,623

 

Charge-offs:

 

 

 

 

 

 

 

 

 

 

 

Mortgage - permanent

 

(165

)

(48

)

(270

)

(209

)

(483

)

Mortgage - construction

 

(106

)

(868

)

(756

)

(618

)

(227

)

Consumer - direct

 

(1,146

)

(954

)

(1,011

)

(1,181

)

(1,434

)

Consumer - indirect

 

(445

)

(407

)

(544

)

(1,048

)

(925

)

Business, private and corporate banking

 

(2,391

)

(2,776

)

(2,016

)

(835

)

(103

)

Total charge-offs

 

(4,253

)

(5,053

)

(4,597

)

(3,891

)

(3,172

)

Recoveries:

 

 

 

 

 

 

 

 

 

 

 

Mortgage - permanent

 

42

 

19

 

9

 

27

 

16

 

Mortgage - construction

 

3

 

2

 

31

 

1

 

0

 

Consumer - direct

 

160

 

208

 

203

 

165

 

76

 

Consumer - indirect

 

149

 

170

 

184

 

209

 

152

 

Business, private and corporate banking

 

268

 

54

 

29

 

26

 

8

 

Total recoveries

 

622

 

453

 

456

 

428

 

252

 

Net charge-offs

 

(3,631

)

(4,600

)

(4,141

)

(3,463

)

(2,920

)

Provisions for loan losses

 

10,500

 

11,867

 

8,000

 

4,600

 

3,900

 

Allowance for losses on assets acquired

 

870

 

0

 

0

 

0

 

0

 

Balance at end of period

 

$

35,605

 

$

27,866

 

$

20,599

 

$

16,740

 

$

15,603

 

Allowances allocated to loans classified as loss

 

$

2,897

 

$

2,067

 

$

1,843

 

$

803

 

$

275

 

Ratio of net charge-offs to average loans outstanding during the period

 

0.13

%

0.21

%

0.21

%

0.18

%

0.17

%

 

10



 

Allowances are provided for individual loans when management considers ultimate collection to be questionable. Such allowances are based, among other factors, upon the estimated net realizable value of the collateral of the loan or guarantees, if applicable. The following table sets forth the allowances for estimated losses on loans by category and summarizes the percentage of total loans in each category to total loans.

 

 

 

December 31,

 

 

 

2003

 

2002

 

2001

 

2000

 

1999

 

 

 

Allowance
Amount

 

Loans in
Category
as a
Percentage
of Total
Loans

 

Allowance
Amount

 

Loans in
Category
as a
Percentage
of Total
Loans

 

Allowance
Amount

 

Loans in
Category
as a
Percentage
of Total
Loans

 

Allowance
Amount

 

Loans in
Category
as a
Percentage
of Total
Loans

 

Allowance
Amount

 

Loans in
Category
as a
Percentage
of Total
Loans

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Mortgage - permanent

 

$

4,902

 

35.2

 

$

2,881

 

40.4

 

$

2,285

 

42.6

 

$

3,801

 

46.3

 

$

4,837

 

47.1

 

Mortgage - construction

 

6,336

 

18.7

 

6,199

 

19.9

 

3,601

 

18.6

 

3,903

 

19.1

 

3,336

 

15.9

 

Consumer - direct

 

3,843

 

10.5

 

2,986

 

10.2

 

2,812

 

11.4

 

2,907

 

11.8

 

2,397

 

12.4

 

Consumer - indirect

 

1,676

 

3.4

 

1,349

 

2.5

 

1,202

 

3.1

 

760

 

0.9

 

938

 

5.3

 

Business, private and corporate banking

 

17,979

 

32.2

 

14,014

 

27.0

 

10,211

 

24.3

 

5,166

 

21.9

 

3,595

 

19.3

 

Unallocated

 

869

 

N/A

 

437

 

N/A

 

488

 

N/A

 

203

 

N/A

 

500

 

N/A

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

$

35,605

 

100.0

 

$

27,866

 

100.0

 

$

20,599

 

100.0

 

$

16,740

 

100.0

 

$

15,603

 

100.0

 

 

11



 

Investments and Asset-Backed Securities

 

Investments and ABS that management has the positive intent and ability to hold to maturity are classified as held to maturity and carried at amortized cost.  At December 31, 2003 and 2002, investments and ABS classified as held to maturity were $2.2 million and $3.5 million, respectively.  Unrealized gains and losses on such investments and ABS are not reported in the Consolidated Financial Statements, as these investments and ABS are held for investment purposes.

 

Sterling classifies specific investments and ABS as available for sale.  Investments classified as available for sale are carried at fair value. Unrealized gains and losses that are considered to be temporary are excluded from earnings and are reported net of deferred income tax as a separate component of accumulated comprehensive income (loss) in shareholders’ equity until such investments and ABS mature or are actually sold.  These investments and ABS may be sold in response to changes in market interest rates and related changes in prepayment risk, needs for liquidity, changes in the availability of and the yield on alternative investments and changes in funding sources and terms.

 

At December 31, 2003 and 2002, investments and ABS classified as available for sale were $1.07 billion and $826.7 million, respectively.  The carrying value of these investments and ABS at December 31, 2003 and 2002 includes net unrealized losses of $23.4 million and net unrealized gains of $5.3 million, respectively.  Fluctuations in prevailing interest rates continue to cause volatility in this component of accumulated comprehensive income and may continue to do so in future periods.

 

Sterling invests primarily in ABS issued by FHLMC and FNMA and other agency obligations.  Such investments provide Sterling with a relatively liquid source of interest income and collateral which can be used to secure borrowings. Sterling invests primarily in investment-grade investments and ABS.  See “Management’s Discussion and Analysis of Financial Condition and Results of Operations (“Management’s Discussion and Analysis”) – Results of Operations – Other Income/Expense” and Note 1 of “Notes to Consolidated Financial Statements.”

 

12



 

The following table provides the carrying values, contractual maturities and weighted average yields of Sterling’s investment and ABS portfolio at December 31, 2003.  Actual maturities may differ from the contractual maturities, because issuers may have the right to call or prepay obligations with or without prepayment penalties.

 

 

 

Maturity

 

 

 

Less than
One Year

 

One to
Five Years

 

Over Five to
Ten Years

 

Over Ten
Years

 

Total

 

 

 

(Dollars in thousands)

 

Asset-backed securities

 

 

 

 

 

 

 

 

 

 

 

Balance

 

$

0

 

$

779

 

$

92,472

 

$

890,485

 

$

983,736

 

Weighted average yield

 

0.00

%

11.09

%

4.10

%

4.70

%

4.65

%

U.S. government and agency obligations

 

 

 

 

 

 

 

 

 

 

 

Balance

 

$

4,988

 

$

8,345

 

$

0

 

$

0

 

$

13,333

 

Weighted average yield

 

5.06

%

3.31

%

0.00

%

0.00

%

3.98

%

FHLB Seattle stock, at cost

 

 

 

 

 

 

 

 

 

 

 

Balance

 

$

0

 

$

0

 

$

0

 

$

51,261

 

$

51,261

 

Weighted average yield (1)

 

0.00

%

0.00

%

0.00

%

5.00

%

5.00

%

Municipal bonds

 

 

 

 

 

 

 

 

 

 

 

Balance

 

$

748

 

$

2,574

 

$

1,005

 

$

1,958

 

$

6,285

 

Weighted average yield (2)

 

6.14

%

4.15

%

3.59

%

5.05

%

4.57

%

Other (3)

 

 

 

 

 

 

 

 

 

 

 

Balance

 

$

0

 

$

0

 

$

54

 

$

18,515

 

$

18,569

 

Weighted average yield

 

0.00

%

0.00

%

0.00

%

1.79

%

1.79

%

 

 

 

 

 

 

 

 

 

 

 

 

Total carrying value

 

$

5,736

 

$

11,698

 

$

93,531

 

$

962,219

 

$

1,073,184

 

Weighted average yield

 

5.20

%

4.01

%

4.10

%

4.67

%

4.62

%

 


(1)          The weighted average yield on Federal Home Loan Bank of Seattle (“FHLB Seattle”) stock is based upon the dividends received for the year ended December 31, 2003.

(2)          The weighted average yields on municipal bonds reflect the actual yields on the bonds and are not presented on a tax-equivalent basis.

(3)          Other investments relate primarily to trust-preferred securities.

 

13



 

The following table sets forth the carrying values and classifications for financial statement reporting purposes of Sterling’s investment and ABS portfolio at the dates indicated.

 

 

 

December 31,

 

 

 

2003

 

2002

 

2001

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

Asset-backed securities

 

$

983,736

 

$

743,610

 

$

617,569

 

U.S. government and agency obligations

 

13,333

 

13,666

 

7,178

 

FHLB Seattle stock

 

51,261

 

42,213

 

39,699

 

Municipal bonds

 

6,285

 

3,352

 

6,879

 

Other

 

18,569

 

27,327

 

22,723

 

 

 

 

 

 

 

 

 

Total

 

$

1,073,184

 

$

830,168

 

$

694,048

 

 

 

 

 

 

 

 

 

Available for sale

 

1,070,955

 

826,692

 

686,995

 

Held to maturity

 

2,229

 

3,476

 

7,053

 

 

 

 

 

 

 

 

 

Total

 

$

1,073,184

 

$

830,168

 

$

694,048

 

 

 

 

 

 

 

 

 

Weighted average yield

 

4.62

%

4.65

%

5.76

%

 

Sources of Funds

 

General.  Sterling’s primary sources of funds for use in lending and for other general business purposes are deposits, loan repayments, FHLB Seattle advances, secured lines of credit and other borrowings, proceeds from sales of investments and ABS and proceeds from sales of loans. Scheduled loan repayments are a relatively stable source of funds, while other sources of funds are influenced significantly by prevailing interest rates, interest rates available on other borrowings and other economic conditions. Borrowings also may be used on a short-term basis to compensate for reductions in other sources of funds (such as deposit inflows at less than projected levels). Borrowings may also be used on a longer-term basis to support expanded lending activities and to match repricing intervals of assets. See “Lending Activities” and “Investments and Asset-Backed Securities.”

 

Deposit Activities.  As a community bank, Sterling offers a variety of accounts for depositors designed to attract both short-term and long-term deposits from the general public. These accounts include money market demand accounts (“MMDA”) and checking accounts in addition to more traditional savings accounts and certificates of deposit (“CDs”) accounts. Sterling offers both interest- and noninterest-bearing checking accounts. The interest-bearing checking accounts can be subject to monthly service charges, unless a minimum balance is maintained. MMDA, CDs and savings accounts earn interest at rates established by management and are based on a competitive market analysis. The method of compounding varies from simple interest credited at maturity to daily compounding, depending on the type of account.

 

With the exception of certain promotional CDs and variable-rate 18-month Individual Retirement Account certificates, all CDs carry a fixed rate of interest for a defined term from the opening date of the account. Substantial penalties are imposed if principal is withdrawn from most CDs prior to maturity.

 

Sterling supplements its retail deposit gathering by soliciting funds from public entities and acquiring brokered deposits. Public funds were 13.9% and 14.2% of deposits at December 31, 2003 and 2002, respectively. Public funds are generally obtained by competitive bidding among qualifying financial institutions. Sterling had $114.2 million and $19.6 million of brokered deposits at December 31, 2003 and 2002, respectively.

 

14



 

The primary deposit vehicles being utilized by Sterling’s customers are CDs with terms of one year or less, regular savings accounts, money market accounts, commercial checking, or noninterest-bearing demand accounts and negotiable order of withdrawal (“NOW”) accounts. The following table presents the average balance outstanding and weighted average interest rate paid for each major category of deposits for the periods indicated.

 

 

 

Years Ended December 31,

 

 

 

2003

 

2002

 

2001

 

 

 

Average
Balance

 

Weighted
Average
Interest
Rate

 

Average
Balance

 

Weighted
Average
Interest
Rate

 

Average
Balance

 

Weighted
Average
Interest
Rate

 

 

 

(Dollars in thousands)

 

 

 

 

 

Time deposits

 

$

1,152,281

 

2.54

%

$

1,052,792

 

3.44

%

$

981,243

 

5.35

%

Regular savings  and money market accounts

 

572,842

 

1.15

 

364,823

 

1.62

 

406,551

 

2.42

 

Checking accounts:

 

 

 

 

 

 

 

 

 

 

 

 

 

NOW accounts

 

318,722

 

0.31

 

335,003

 

0.44

 

209,020

 

0.52

 

Noninterest-bearing demand accounts

 

280,990

 

0.00

 

206,323

 

0.00

 

129,096

 

0.00

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

$

2,324,835

 

1.58

%

$

1,958,941

 

2.23

%

$

1,725,910

 

3.68

%

 

The following table shows the amounts and remaining maturities of time deposits that had balances of $100,000 or more at December 31, 2003 and 2002.

 

 

 

December 31,

 

 

 

2003

 

2002

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

Less than three months

 

$

296,458

 

$

175,647

 

Three to six months

 

113,516

 

102,134

 

Six to twelve months

 

164,436

 

149,151

 

Over twelve months

 

87,859

 

59,248

 

 

 

 

 

 

 

 

 

$

662,269

 

$

486,180

 

 

15



 

The following table presents the types of deposit accounts and the rates offered by Sterling Savings Bank and the balances in such accounts as of the specified dates.

 

 

 

 

 

December 31, 2003

 

December 31, 2002

 

Minimum
Term

 

Category

 

Minimum
Balances

 

Amount

 

Percentage
of Total
Deposits

 

Interest Rate
Offered

 

Minimum
Balances

 

Amount

 

Percentage
of Total
Deposits

 

Interest Rate
Offered

 

 

 

 

 

(Dollars in thousands, except minimum amounts)

 

Transaction Accounts:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

None

 

NOW checking

 

Varies

 

$

301,197

 

12.3

 

0.10

%

Varies

 

$

367,391

 

18.2

 

0.10

%

None

 

Commercial checking

 

Varies

 

306,456

 

12.5

 

0.00

 

Varies

 

239,033

 

11.9

 

0.00

 

 

 

Total transaction accounts

 

 

 

607,653

 

24.8

 

 

 

 

 

606,424

 

30.1

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Savings Accounts:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

None

 

Regular savings

 

100

 

118,251

 

4.8

 

0.40

 

100

 

89,474

 

4.4

 

0.50

 

None

 

Money market demand

 

1,000

 

545,607

 

22.2

 

1.14

 

1,000

 

311,865

 

15.5

 

1.17

 

 

 

Total savings accounts

 

 

 

663,858

 

27.0

 

 

 

 

 

401,339

 

19.9

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Time Deposits:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Less than 90 days

 

Fixed term, fixed rate

 

5,000

 

2,803

 

0.1

 

0.50

 

5,000

 

2,035

 

0.1

 

0.63

 

3 months

 

Fixed term, fixed rate

 

500

 

5,772

 

0.2

 

0.75

 

500

 

4,099

 

0.2

 

1.00

 

6 months

 

Fixed term, fixed rate

 

500

 

34,260

 

1.4

 

0.85

 

500

 

123,750

 

6.2

 

1.14

 

9 months

 

Fixed term, adjustable rate

 

5,000

 

87,471

 

3.6

 

0.90

 

5,000

 

60,291

 

3.0

 

1.98

 

11 months

 

Fixed term, fixed rate

 

500

 

49,383

 

2.0

 

1.24

 

500

 

70,238

 

3.5

 

1.24

 

12 months

 

Fixed term, fixed rate

 

500

 

54,770

 

2.2

 

0.90

 

500

 

43,484

 

2.2

 

1.29

 

12 months

 

Fixed term, adjustable rate

 

N/A

 

2

 

0.0

 

N/A

(1)

N/A

 

1

 

0.0

 

N/A

(1)

15 months

 

Fixed term, adjustable rate

 

5,000

 

75,121

 

3.1

 

1.00

 

5,000

 

37,625

 

1.9

 

1.39

 

18 months

 

Fixed term, fixed rate

 

500

 

22,812

 

0.9

 

1.49

 

500

 

38,806

 

1.9

 

1.49

 

24 months

 

Fixed term, fixed rate

 

500

 

32,326

 

1.3

 

1.83

 

500

 

28,765

 

1.4

 

1.98

 

36 months

 

Fixed term, fixed rate

 

500

 

120,333

 

4.9

 

2.52

 

500

 

123,439

 

6.1

 

2.72

 

Greater than 36 months

 

Fixed term, fixed rate

 

500

 

204,662

 

8.3

 

3.06

 

500

 

139,259

 

6.9

 

3.30

 

18 months

 

Variable rate, IRA

 

100

 

4,214

 

0.2

 

1.53

 

100

 

4,911

 

0.2

 

1.79

 

18 months

 

Fixed rate, IRA

 

500

 

6,460

 

0.3

 

1.24

 

500

 

2,427

 

0.1

 

1.39

 

36 months

 

Variable rate, IRA

 

2,000

 

10,491

 

0.4

 

N/A

(1)

2,000

 

13,401

 

0.7

 

N/A

(1)

9 months

 

Mini-jumbos

 

80,000

 

5,442

 

0.2

 

1.05

 

80,000

 

6,257

 

0.3

 

1.20

 

6 months

 

Jumbos

 

100,000

 

353,059

 

14.4

 

1.10

 

100,000

 

287,910

 

14.3

 

1.30

 

Less than 1 year

 

Brokered

 

N/A

 

114,184

 

4.7

 

1.33

 

N/A

 

19,635

 

1.0

 

1.65

 

 

 

Total time deposits

 

 

 

1,183,565

 

48.2

 

 

 

 

 

1,006,333

 

50.0

 

 

 

 

 

Total deposits

 

 

 

$

2,455,076

 

100.0

 

 

 

 

 

$

2,014,096

 

100.0

 

 

 

 


(1)  Not currently offered.

 

16



 

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

 

 

 

December 31,

 

 

 

2003

 

2002

 

 

 

Amount

 

Percentage
of Total
Deposits

 

Amount

 

Percentage
of Total
Deposits

 

 

 

(Dollars in thousands)

 

 

 

 

 

NOW checking

 

$

301,197

 

12.3

 

$

367,391

 

18.2

 

Commercial checking

 

306,456

 

12.5

 

239,033

 

11.9

 

Regular savings

 

118,251

 

4.8

 

89,474

 

4.4

 

Money market demand

 

545,607

 

22.2

 

311,865

 

15.5

 

 

 

 

 

 

 

 

 

 

 

Variable-rate time deposits:

 

 

 

 

 

 

 

 

 

9-36 months

 

177,300

 

7.2

 

116,229

 

5.8

 

 

 

 

 

 

 

 

 

 

 

Fixed-rate time deposits:

 

 

 

 

 

 

 

 

 

1-11 months

 

564,903

 

23.0

 

513,924

 

25.5

 

12-35 months

 

165,920

 

6.8

 

113,482

 

5.6

 

36-240 months

 

275,442

 

11.2

 

262,698

 

13.1

 

 

 

 

 

 

 

 

 

 

 

Total deposits

 

$

2,455,076

 

100.0

 

$

2,014,096

 

100.0

 

 

Substantially all of Sterling’s depositors are residents of the States of Washington, Oregon, Idaho and Montana.  Sterling has 66 automated teller machines (“ATM”) to better serve customers in those markets. Customers also can access ATMs operated by other financial institutions. Sterling is a member of The Exchange, an ATM system that allows participating customers to deposit or withdraw funds from NOW accounts, MMDA and savings accounts throughout the United States and Canada. Sterling is also a member of the Plus System ATM network, with numerous locations in the United States and internationally.

 

Borrowings.  Deposit accounts are Sterling’s primary source of funds. Sterling does, however, rely upon advances from the FHLB Seattle and reverse repurchase agreements to supplement its funding and to meet deposit withdrawal requirements.  See “Management’s Discussion and Analysis – Liquidity and Capital Resources.”

 

The FHLB Seattle is part of a system, which consists of 12 regional Federal Home Loan Banks (the “FHL Banks”) each subject to Federal Housing Finance Board supervision and regulation, that functions as a central reserve bank providing credit to savings institutions.  As a condition of membership in the FHLB Seattle, Sterling is required to own stock of the FHLB Seattle in an amount determined by a formula based upon Sterling’s total mortgages outstanding or total advances from the FHLB Seattle.  At December 31, 2003, Sterling exceeded the minimum FHLB Seattle stock ownership requirement.  The stock of the FHLB Seattle always has been redeemable at par value, but there can be no assurance that this always will be the case.

 

As a member of the FHLB Seattle, Sterling Savings Bank can apply for advances on the security of its FHLB Seattle stock and certain of its mortgage loans and other assets (principally securities which are obligations of, or guaranteed by, the United States or its agencies), provided certain standards related to creditworthiness, including a minimum ratio of total capital assets of at least five percent, are met.  Each available credit program has its own interest rate and range of maturities.  At December 31, 2003, Sterling had advances totaling $1.03 billion from the FHLB Seattle which mature from 2004 through 2015 at interest rates ranging from 1.14% to 8.40%.  See “Management’s Discussion and Analysis – Liquidity and Capital Resources” and Note 9 of “Notes to Consolidated Financial Statements.”

 

Sterling also borrows funds under reverse repurchase agreements pursuant to which it sells investments (generally U.S. agency and ABS) under an agreement to buy them back at a specified price at a later date. These agreements to repurchase are deemed to be borrowings collateralized by the investments and ABS sold. Sterling uses these borrowings to supplement deposit gathering for funding the origination of loans. Sterling had $360.6 million and $249.8 million in wholesale and retail reverse repurchase agreements outstanding at December 31, 2003 and 2002, respectively.  The use of reverse repurchase agreements may expose Sterling to certain risks not associated with other

 

17



 

borrowings, including IRR and the possibility that additional collateral may have to be provided if the market value of the pledged collateral declines. For additional information regarding reverse repurchase agreements, see “Management’s Discussion and Analysis – Asset and Liability Management,” “Management’s Discussion and Analysis – Liquidity and Capital Resources” and Note 10 of “Notes to Consolidated Financial Statements.”

 

Other Borrowings.  Sterling has a variable-rate term note with U.S. Bank, N.A. (“U.S. Bank”) with a balance of $22.0 million outstanding at December  31, 2003.  This note matures on September 17, 2007.  Interest accrues at the 30-day London Interbank Offering Rate (“LIBOR”) plus 2.00% and is payable monthly.  Sterling also has a $5.0 million revolving line of credit with U.S. Bank.  This line of credit matures on September 15, 2004.  The interest rate is adjustable monthly at the 30-day LIBOR plus 2.00% and is payable monthly.  At December 31, 2003, no amounts were outstanding on the line of credit.  The term note and line of credit are collateralized by a majority of the Common and Preferred Stock of Sterling Savings Bank.  See Note 11 of “Notes to Consolidated Financial Statements.”

 

At December 31, 2003, Sterling had outstanding $78.0 million in various series of Trust Preferred Securities issued to investors.  See Note 11 of “Notes to Consolidated Financial Statements.”

 

Sterling has outstanding $30.0 million of Floating Rate Notes Due 2006.  Interest accrues at the 90-day LIBOR plus 2.50% and is adjustable and payable quarterly.  The notes mature in 2006 and may be redeemed under certain conditions.  See Note 11 of “Notes to Consolidated Financial Statements.”

 

The following table sets forth certain information regarding Sterling’s short-term borrowings as of and for the periods indicated.

 

 

 

Years Ended December 31,

 

 

 

2003

 

2002

 

2001

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

Maximum amount outstanding at any month-end during the period:

 

 

 

 

 

 

 

Short-term reverse repurchase agreements

 

$

285,637

 

$

154,769

 

$

115,971

 

Short-term advances

 

372,500

 

238,975

 

115,648

 

 

 

 

 

 

 

 

 

Average amount outstanding during the period:

 

 

 

 

 

 

 

Short-term reverse repurchase agreements

 

56,518

 

45,728

 

66,718

 

Short-term advances

 

197,500

 

55,641

 

96,544

 

 

 

 

 

 

 

 

 

Weighted average interest rate paid during the period:

 

 

 

 

 

 

 

Short-term reverse repurchase agreements

 

1.82

%

1.85

%

3.56

%

Short-term advances

 

2.73

%

4.69

%

5.71

%

 

 

 

 

 

 

 

 

Weighted average interest rate paid at end of period:

 

 

 

 

 

 

 

Short-term reverse repurchase agreements

 

1.59

%

1.83

%

2.68

%

Short-term advances

 

2.51

%

3.69

%

5.06

%

 

18



 

The following table sets forth certain information concerning Sterling’s outstanding borrowings for the periods indicated.

 

 

 

December 31,

 

 

 

2003

 

2002

 

2001

 

 

 

Amount

 

%

 

Amount

 

%

 

Amount

 

%

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

FHLB Seattle advances:

 

 

 

 

 

 

 

 

 

 

 

 

 

Short-term

 

$

408,685

 

26.8

 

$

238,975

 

19.1

 

$

117,376

 

12.0

 

Long-term

 

617,346

 

40.5

 

635,540

 

50.8

 

515,678

 

52.6

 

Securities sold subject to reverse repurchase agreements and funds purchased:

 

 

 

 

 

 

 

 

 

 

 

 

 

Short-term

 

288,137

 

18.9

 

154,769

 

12.3

 

114,999

 

11.7

 

Long-term

 

75,000

 

4.9

 

95,000

 

7.6

 

103,550

 

10.6

 

Convertible Subordinated Debt

 

0

 

0.0

 

0

 

0.0

 

3,500

 

0.4

 

Floating Rate Notes Due 2006

 

30,000

 

2.0

 

30,000

 

2.4

 

30,000

 

3.1

 

Term note payable

 

22,000

 

1.4

 

25,000

 

2.0

 

30,000

 

3.1

 

Trust Preferred Securities

 

78,000

 

5.1

 

64,000

 

5.1

 

64,000

 

6.5

 

Other

 

5,583

 

0.4

 

8,682

 

0.7

 

0

 

0.0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total borrowings

 

$

 1,524,751

 

100.0

 

$

 1,251,966

 

100.0

 

$

 979,103

 

100.0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted average interest rate at end of period

 

 

 

3.40

%

 

 

4.50

%

 

 

5.52

%

 

Subsidiaries

 

Sterling’s principal subsidiary is Sterling Savings Bank.  Sterling Savings Bank has three principal subsidiaries which have been previously described: Action Mortgage, INTERVEST and Harbor Financial.  Additionally, Sterling and Sterling Savings Bank have the following other wholly-owned, direct subsidiaries:

 

Sterling Financial Corporation.

 

(1)                      Sterling Capital Trust II (“Trust-II”) was organized in July 2001 as a Delaware business trust.  Sterling owns all the common equity of Trust-II.  The sole asset of Trust-II is the Junior Subordinated Debentures-II issued by Sterling.  See Note 11 of “Notes to Consolidated Financial Statements.”

 

(2)                      Sterling Capital Trust III (“Trust-III”) was organized in April 2003 as a Delaware business trust.  Sterling owns all the common equity of Trust-III.  The sole asset of Trust-III is the Junior Subordinate Debentures-III issued by Sterling.  See Note 11 of “Notes to Consolidated Financial Statements.”

 

(3)                      Sterling Capital Trust IV (“Trust-IV”) was organized in May 2003 as a Delaware business trust.  Sterling owns all the common equity of Trust-IV.  The sole asset of Trust-IV is the Junior Subordinate Debentures-IV issued by Sterling.  See Note 11 of “Notes to Consolidated Financial Statements.”

 

(4)                      Sterling Capital Statutory Trust V (“Trust-V”) was organized in May 2003 as a Connecticut business trust.  Sterling owns all the common equity of Trust-V.  The sole asset of Trust-V is the Junior Subordinate Debentures-V issued by Sterling.  See Note 11 of “Notes to Consolidated Financial Statements.”

 

(5)                      Sterling Capital Trust VI (“Trust-VI”) was organized in June 2003 as a Delaware business trust.  Sterling owns all the common equity of Trust-VI.  The sole asset of Trust-VI is the Junior Subordinate Debentures-VI issued by Sterling.  See Note 11 of “Notes to Consolidated Financial Statements.”

 

19



 

(6)                      Tri-Cities Mortgage Corporation was organized to engage in real estate development.

 

Sterling Savings Bank.

 

(1)                      Fidelity Service Corporation was organized to acquire and sell real and personal property in Washington and Idaho.

 

(2)                      Evergreen Environmental Development Corporation was organized to engage in real estate development.

 

(3)                      Tri-West Mortgage, Inc. was organized to engage in mortgage banking.

 

(4)                      Evergreen First Service Corporation owns all of the outstanding capital stock of Harbor Financial, through which Sterling offers tax-deferred annuities, mutual funds and other financial products.

 

(5)                      Sterling Automobile Loan Securitization 2000-1, L.L.C. was established as a special purpose entity to enable Sterling Savings Bank to sell approximately $93 million of motor vehicle retail installment contracts.  See Note 1 of “Notes to Consolidated Financial Statements.”

 

(6)                      Source Capital Corporation was acquired in September 2001.  The corporation holds and services loans.

 

(7)                      The Dime Service Corporation was acquired as part of a merger in February 2003.  The corporation markets property and casualty insurance coverage.

 

Competition

 

Sterling faces strong competition, both in attracting deposits and in originating, purchasing and selling real estate and other loans, from savings and loan associations, mutual savings banks, credit unions, commercial banks and other institutions, many of which have greater resources than Sterling. Sterling also faces strong competition in marketing financial products such as annuities, mutual funds and other financial products and in pursuing acquisition opportunities.  Some or all of these competitive businesses operate in Sterling’s market areas.

 

Personnel

 

As of December 31, 2003, Sterling, including its subsidiaries, had 1,121 full-time equivalent employees.  Employees are not represented by a collective bargaining unit.  Sterling believes its relationship with its employees is excellent.  On January 2, 2004, Sterling added approximately 450 employees as a result of the merger with Klamath.

 

Environmental Laws

 

Environmentally related hazards have become a source of high risk and potentially unlimited liability for financial institutions relative to their loans.  Environmentally contaminated properties owned by an institution’s borrowers may result in a drastic reduction in the value of the collateral securing the institution’s loans to such borrowers, high environmental clean-up costs to the borrower affecting its ability to repay the loans, the subordination of any lien in favor of the institution to a state or federal lien securing clean-up costs, and liability to the institution for clean-up costs if it forecloses on the contaminated property or becomes involved in the management of the borrower.  To minimize this risk, Sterling may require an environmental examination of and report with respect to the property of any borrower or prospective borrower if circumstances affecting the property indicate a potential for contamination, taking into consideration the potential loss to the institution in relation to the burdens to the borrower.  Such examination must be performed by an engineering firm experienced in environmental risk studies and acceptable to the institution, and the costs of such examinations and reports are the responsibility of the borrower.  These costs may be substantial and may deter a prospective borrower from entering into a loan transaction with Sterling.  Sterling is not aware of any borrower who is currently subject to any environmental investigation or clean-up proceeding which is likely to have a material adverse effect on the financial condition or results of operations of Sterling.

 

20



 

Regulation

 

IntroductionThe following is not intended to be a complete discussion but is intended to be a summary of some of the most significant provisions of laws applicable to Sterling and its subsidiaries.

 

Sterling is a savings and loan holding company and as such is subject to OTS regulations, examinations and reporting requirements.  Sterling Savings Bank is chartered by the State of Washington and its deposits are insured by the FDIC.  Sterling Savings Bank is subject to comprehensive regulation, examination and supervision by the OTS, the FDIC and the Washington Supervisor.  Furthermore, certain transactions and savings deposits are subject to regulations and controls promulgated by the Federal Reserve Board (the “Fed”).

 

Savings and Loan Holding Company Regulation.  Sterling is registered as a savings and loan holding company under the Home Owners’ Loan Act (the “HOLA”).  The HOLA generally permits a savings and loan holding company to engage in activities which are unrelated to the operation of a savings and loan association, provided the holding company controls only one savings and loan association and such savings and loan association meets the Qualified Thrift Lender Test (the “QTL Test”).  Sterling presently controls only one savings and loan association, Sterling Savings Bank, which at December 31, 2003 met the QTL Test.

 

If Sterling Savings Bank fails to meet the QTL Test in the future, Sterling will become subject to restrictions on the activities in which it may engage.  Such activities would generally be limited to any activity that the Fed by regulation has determined is permissible for bank holding companies pursuant to Section 4(c) of the Bank Holding Company Act of 1956, as amended (unless limited or prohibited by the OTS by regulation), and certain other limited services and activities.  Although Sterling Savings Bank expects to remain in compliance with the QTL Test in the future, there can be no assurance in this regard.

 

Under the HOLA, no person may acquire control of a savings association or a savings and loan holding company without the prior approval of the OTS.  As a savings and loan holding company, Sterling is prohibited from acquiring: (i) control of another savings association or a savings and loan holding company without the prior approval of the OTS; (ii) the assets of another savings association or savings and loan holding company by merger, consolidation or purchase, without the prior approval of the OTS; (iii) more than 5% of the voting shares of a savings association or a savings and loan holding company which is not a subsidiary of Sterling; or (iv) control of a depository institution, the accounts of which are not insured by the FDIC.

 

The HOLA authorizes the OTS to issue a directive to a savings and loan holding company and any of its subsidiaries if the OTS determines that there is reasonable cause to believe that the continuation by the holding company of any activity constitutes a serious risk to the financial safety, soundness or stability of the holding company’s subsidiary savings association.  The OTS may impose restrictions through such directive to limit such risk, including limiting: (i) the payment of dividends by the savings association; (ii) transactions between the savings association, the holding company and the subsidiaries or affiliates of either; and (iii) any activities of the savings association that might create a serious risk that the liabilities of the holding company and its other affiliates may be imposed on the savings association. Such a directive has the same effect as a final cease and desist order.  The issuance of the directive can be appealed to the Director of the OTS.

 

The Fair and Accurate Credit Transactions Act.  On December 4, 2003, the Fair and Accurate Credit Transactions Act of 2003 (the “FACT”) was signed into law.  The FACT includes many provisions concerning national credit reporting standards and permits consumers, including the customers of Sterling, to opt out of information sharing among affiliated companies for marketing purposes.  The FACT also requires financial institutions to provide consumers certain information regarding the consumer’s credit score.  Additionally, financial institutions must notify their customers if they report negative information about them to credit bureaus or if the credit terms offered to a customer are materially less favorable than the most favorable terms offered to a substantial portion of customers because of information in the customer’s credit report.  The FACT also contains provisions intended to help detect identity theft.

 

The Sarbanes-Oxley Act.  In July 2002, the Sarbanes-Oxley Act of 2002 (the “SOA”) was enacted in response to public concerns regarding corporate accountability. The stated goals of the SOA are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities

 

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laws.  The SOA represents a comprehensive revision of laws affecting corporate governance, accounting obligations and corporate reporting.  The SOA generally applies to all companies that file or are required to file periodic reports with the SEC, under the Securities Exchange Act of 1934, as amended (“Exchange Act”).

 

The SOA includes new disclosure requirements and corporate governance rules, requires the SEC and securities exchanges to adopt extensive additional disclosure, corporate governance and other related rules and mandates further studies of certain issues by the SEC and the Comptroller General.  In particular, the SOA establishes: new requirements for audit committees; additional responsibilities regarding financial statements of reporting companies; new standards for auditors and regulation of audits; increased disclosure and reporting obligations for a reporting company and its directors and executive officers; and new civil and criminal penalties for violation of the securities laws. The SEC is directed to enact rules to implement various of the provisions with respect to, among other matters, disclosure in periodic filings pursuant to the Exchange Act.

 

The U.S.A. Patriot Act.  In December 2001, the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “Patriot Act”) became effective.  The Patriot Act is designed to combat money laundering and terrorist financing while protecting the U.S. financial system.  The Patriot Act imposes enhanced policy, record keeping and due diligence requirements on domestic financial institutions.  The Patriot Act also amended the Bank Secrecy Act to facilitate access to customer account information by government officials while immunizing banks from liability for releasing such information.

 

The Gramm-Leach-Bliley Act.  In November 1999, the Gramm-Leach-Bliley Act (the “GLBA”) was enacted.  The GLBA is also known as the Financial Services Modernization Act due to its sweeping overhaul of the financial services industry. Enactment of the GLBA allows banks, securities firms and insurance companies to affiliate.  Now financial institutions can act as financial “supermarkets” offering customers “one stop shopping” for bank accounts, insurance policies and securities transactions.

 

The GLBA, among other things, provides customers with greater financial privacy by requiring financial institutions to safeguard their nonpublic personal information.  Financial institutions must advise customers of their policies regarding the sharing of nonpublic personal information with non-affiliated third parties and allow customers to “opt-out” of such sharing (subject to several exceptions related mainly to processing customer-initiated transactions and compliance with current law).

 

The Home Ownership and Equity Protection Act of 1994.  The Federal Reserve Board has adopted amendments to the Home Ownership and Equity Protection Act of 1994 (“HOEPA”), which expand the protections of HOEPA to cover more transactions and prohibit certain practices deemed harmful to borrowers.  If a loan qualifies as a HOEPA loan, certain practices and terms on high-cost mortgages are restricted and require special consumer disclosures.  The interest rate trigger on first-time liens used to determine whether a loan qualifies as a HOEPA loan has been lowered from 10% to 8% and the cost of single-premium credit insurance products has been added to the points and fees test.  As a result, more of Sterling’s loans are expected to be subject to HOEPA restrictions and disclosure requirements.

 

The Federal Deposit Insurance Corporation Improvement Act of 1991. The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”) provides for expanded regulation of depository institutions and their affiliates, including parent holding companies.  FDICIA further provides the OTS with broad powers to take “prompt corrective action” to resolve problems of insured depository institutions.  The extent of these powers depends upon whether the institution in question is “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized.”

 

Under OTS regulations which implement the “prompt corrective action” system mandated by FDICIA, an institution is “well capitalized” if its total risk-based capital ratio (the ratio of qualifying total capital to risk-weighted assets) is 10% or more, its Tier 1 risked-based capital ratio (the ratio of core (Tier 1) capital to risk-weighted assets) is 6% or more, its core (Tier 1) capital ratio (the ratio of core (Tier 1) capital to total assets) is 5% or more and it is not subject to any written agreement, order or directive to meet a specified capital level.  At December 31, 2003, Sterling Savings Bank met the standards for a “well capitalized” institution.

 

An institution which is “undercapitalized” must submit a capital restoration plan to the OTS.  The plan may be approved only if the OTS determines it is likely to succeed in restoring the institution’s capital and will not appreciably

 

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increase the risks to which the institution is exposed. The institution’s performance under the plan must be guaranteed by any company which controls the institution, up to a maximum of 5% of the institution’s assets.  The OTS also may require an undercapitalized institution to take various actions deemed appropriate to minimize the potential losses to the deposit insurance fund.  Institutions that are “significantly undercapitalized” or “critically undercapitalized” are subject to additional sanctions.

 

FDICIA directs each bank regulatory agency and the OTS to review its capital standards every two years to determine whether those standards require sufficient capital to facilitate prompt corrective action to prevent or minimize loss to the deposit insurance funds. FDICIA, as amended, also requires the OTS to prescribe minimum operational and managerial standards and standards for asset quality, earnings and stock valuation for savings institutions. Any savings institution which fails to meet the standards may be required to submit a plan for corrective action.  If a savings institution fails to submit or implement an acceptable plan, the OTS may require the institution to take any action the OTS determines will best carry out the purpose of prompt corrective action.

 

Under FDICIA, only a “well capitalized” depository institution may accept brokered deposits without prior regulatory approval.  FDICIA also requires annual examinations of all insured depository institutions by the appropriate federal banking agency, with some exceptions for small, well capitalized institutions and state-chartered institutions examined by state regulators.  The federal banking agencies are required to set compensation standards for insured depository institutions that prohibit excessive compensation, fees or benefits to officers, directors, employees and principal shareholders.  FDICIA also contains a number of consumer banking provisions, including disclosure requirements and substantive contractual limitations with respect to deposit accounts.  FDICIA also greatly expanded the range of merger, purchase and assumption, and deposit transfer transactions involving banks and savings associations that are exempt from payment of exit and entry fees as transfers of deposits between the FDIC’s Bank Insurance Fund and its Savings Association Insurance Fund (“SAIF”).  Many of the provisions of FDICIA have been implemented through the adoption of regulations by the federal banking agencies.

 

Regulatory Capital Requirements.  Pursuant to the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”), the OTS adopted regulations implementing new capital standards applicable to all savings associations, including Sterling Savings Bank.  Such capital standards require that savings associations maintain: (i) capital of not less than 1.5% of adjusted total assets; (ii) core (Tier 1) capital of not less than 4% of adjusted total assets;  and (iii) total risk-based capital of not less than 8% of risk-weighted assets.  As of December 31, 2003, Sterling Savings Bank met all regulatory capital requirements.  For additional information, see “Management’s Discussion and Analysis – Liquidity and Capital Resources.”

 

Core (Tier 1) capital consists of: common shareholders’ equity, including retained earnings; non-cumulative perpetual preferred stock; certain non-withdrawable and pledged deposits; and minority interests in equity accounts of fully consolidated subsidiaries.  In calculating core (Tier 1) capital, certain items must be deducted.  These items are goodwill and other intangible assets, nonqualifying purchased mortgage servicing rights and investments (whether debt or equity) in subsidiaries engaged as of April 1989 in activities which were permissible for national banks.  The face amount of credit-enhancing interest-only-strips that exceeds 25% of Tier 1 capital must also be deducted from core (Tier 1) capital.  With respect to purchased mortgage servicing rights, the amount that qualifies to be included in core (Tier 1) capital is the lower of (a) 90% of fair market value if determinable, (b) 90% of original cost or (c) the current amortized book value.

 

The total risk-based capital requirement is an amount equal to 8% of risk-adjusted  assets.  A risk weight is assigned to both the on-balance sheet assets and off-balance sheet commitments of a savings association. Risk weights range from zero to 100% depending on the type of asset.

 

Both core (Tier 1) capital and supplementary (Tier 2) capital may be used to meet the total risk-based capital requirement, although Tier 2 capital is limited to 100% of Tier 1 capital.  For purposes of the total risk-based capital requirement, Tier 2 capital includes permanent capital instruments such as cumulative perpetual preferred stock, perpetual or mandatory convertible subordinated debt, maturing capital instruments such as subordinated debt, intermediate-term preferred stock, commitment notes and certain grandfathered mandatory redeemable preferred stock (although the amount included declines as the instrument approaches maturity), and general valuation loan loss allowances up to a maximum of 1.25% of risk-weighted assets.

 

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The following tables set forth Sterling Savings Bank’s core (Tier 1) capital, core (Tier 1) risk-based capital and total risk-based capital positions as reported on the quarterly Thrift Financial Report at December 31, 2003 and 2002.  See “Management’s Discussion and Analysis – Capital.”

 

 

 

December 31,

 

 

 

2003

 

2002

 

 

 

Core (Tier 1) Capital

 

 

 

Dollars

 

%(1)

 

Dollars

 

%

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

Total shareholders’ equity

 

$

346,989

 

8.18

 

$

309,328

 

8.95

 

Adjustment:

 

 

 

 

 

 

 

 

 

Unrealized (gains) losses on securities

 

15,193

 

0.36

 

(3,439

)

(0.10

)

Less:

 

 

 

 

 

 

 

 

 

Nonqualifying servicing assets

 

(317

)

(0.01

)

0

 

0.00

 

Goodwill and other intangibles

 

(46,479

)

(1.10

)

(43,977

)

(1.27

)

Investment in non-includable subsidiaries

 

0

 

0.00

 

(327

)

(0.01

)

Total core (Tier 1) capital (2)

 

315,386

 

7.43

 

261,585

 

7.57

 

Core (Tier 1) capital requirement

 

169,711

 

4.00

 

138,171

 

4.00

 

 

 

 

 

 

 

 

 

 

 

Core (Tier 1) capital excess

 

$

145,675

 

3.43

 

$

123,414

 

3.57

 

 

 

 

Core (Tier 1) Risk-Based Capital

 

 

 

Dollars

 

%

 

Dollars

 

%

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

Total core (Tier 1) capital

 

$

315,386

 

9.89

 

$

261,585

 

9.98

 

Core (Tier 1) risk-based capital requirement

 

127,313

 

4.00

 

104,300

 

4.00

 

 

 

 

 

 

 

 

 

 

 

Core (Tier 1) risk-based capital excess

 

$

188,073

 

5.89

 

$

157,285

 

5.98

 

 

 

 

Total Risk-Based Capital

 

 

 

Dollars

 

%

 

Dollars

 

%

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

Total core (Tier 1) capital

 

$

315,386

 

9.90

 

$

261,585

 

10.03

 

General valuation allowances

 

32,707

 

1.03

 

25,799

 

0.99

 

Low-level recourse deduction

 

(723

)

(0.02

)

(1,477

)

(0.06

)

Total risk-based capital

 

347,370

 

10.91

 

285,907

 

10.96

 

Risk-based capital requirement

 

254,627

 

8.00

 

208,599

 

8.00

 

 

 

 

 

 

 

 

 

 

 

Risk-based capital excess

 

$

92,743

 

2.91

 

$

77,308

 

2.96

 

 


(1) Ratio of core (Tier 1) capital to adjusted total assets for the core (Tier 1) capital ratio and ratio of core (Tier 1) and total risk-based capital to risk-weighted assets for core (Tier 1) risk-based and total risk-based capital.

 

(2) Sterling exceeds “well capitalized” requirements under FDICIA which are 10% for total risk-based capital, 6% for Tier 1 risk- based capital, and 5% for Tier 1 leverage capital.

 

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Savings associations that fail to meet the core (Tier 1) or risk-based capital requirements are subject to a number of sanctions or restrictions. Under FIRREA, the OTS must prohibit any asset growth, except that the OTS may permit growth in an amount not in excess of net interest credited to the savings association’s deposit liabilities, if: (i) the savings association obtains the prior approval of the OTS; (ii) any increase in assets is accompanied by an increase in core (Tier 1) capital in an amount not less than 3.0% of the increase in assets; (iii) any increase in assets is accompanied by an increase in capital not less in percentage amount than required under the risk-based capital standards then applicable; (iv) any increase in assets is invested in low-risk assets; and (v) the savings association’s ratio of core (Tier 1) capital to total assets is not less than the ratio existing on January 1, 1991.

 

The OTS also may require any savings association not in compliance with capital standards (including any individual minimum capital requirement) to comply with a capital directive issued by the OTS.  Such a capital directive may order the savings association to: (a) achieve its minimum capital requirements by a specified date; (b) adhere to a compliance schedule for achieving its minimum capital requirements; (c) submit and adhere to a capital plan acceptable to the OTS; and/or (d) take other actions, including reducing its assets or rate of liability growth and/or restricting its payment of dividends in order to reach the required capital levels.  The OTS, by such capital directive, enforcement proceedings or otherwise, may require an association not in compliance with the capital requirements to: (i) increase the amount of its regulatory capital to a specified level; (ii) convene a meeting with the OTS supervision staff for the purpose of accomplishing the objectives of the regulations; (iii) reduce or limit the rate of interest that may be paid on savings accounts; (iv) limit the receipt of deposits to those made to existing accounts; (v) cease or limit lending or the making of a particular loan or category of loan; (vi) cease or limit the purchase of loans or the making of specified other investments; (vii) limit operational expenditures to specific levels; (viii) increase liquid assets and maintain such increased liquidity at specified levels; or (ix) take such other action or actions as the OTS may deem necessary or appropriate for the safety and soundness of the savings association or the protection of its depositors.  The material failure of a savings association to comply with any plan, regulation, written agreement, order or directive issued will be treated as an unsafe or unsound practice which could result in the imposition of certain penalties or sanctions, including but not limited to the assessment of civil monetary penalties, the issuance of a cease and desist order or the appointment of a conservator or receiver.

 

Any savings association which does not meet its regulatory capital requirements may not accept, without a written waiver from the OTS, brokered deposits if such deposits, together with any existing brokered deposits outstanding, would exceed 5.0% of the association’s total deposits.  In addition, the FDIC prohibits, with certain exceptions, an “insolvent institution” from accepting any brokered deposits. An insolvent institution is defined as any insured depository institution which does not meet the minimum capital requirements applicable with respect to such institution. This prohibition includes any renewal of an account in any insolvent institution and any rollover of any amount on deposit. The FDIC may waive this restriction upon application by an insured depository institution and a finding that the acceptance of such deposits does not constitute an unsafe or unsound practice with respect to such institution.  As a “well capitalized” institution, Sterling is qualified to have brokered deposits without prior approval from the OTS.  Sterling had $114.2 million and $19.6 million in brokered deposits at December 31, 2003 and 2002, respectively.

 

A savings association which is not in compliance with its capital requirements may apply to the OTS for an exemption from the sanctions and penalties imposed upon a savings association for failure to comply with its minimum capital standards.  Pursuant to FIRREA, the OTS may approve an application for a capital exemption if such exemption would pose no significant risk to the affected insurance fund, the savings association’s management is competent, the savings association is in compliance with all applicable statutes, regulations, orders and supervisory agreements and directives and the savings association’s management has not engaged in insider dealing, speculative practices or any other activities that could have jeopardized the association’s safety and soundness or contributed to impairing the association’s capital.  Any application for a capital exemption must be accompanied by an acceptable capital plan.  If a savings association receives approval of capital exemption and operates in accordance with an acceptable capital plan, it will be deemed to be in compliance with its capital standards for purposes of OTS capital regulation only.  The savings association must request and receive approval of specific, express exemptions from the provisions of other rules, regulations and policy statements as part of the accepted capital plan to be deemed in capital compliance for purposes of such other rules, regulations and policy statements.

 

Federal Deposit Insurance Corporation. Sterling’s deposits are insured up to $100,000 per insured depositor (as defined by law and regulations) by the FDIC through the SAIF. The SAIF is administered and managed by the FDIC. The FDIC is authorized to conduct examinations of and to require reporting by SAIF member institutions. The

 

25



 

FDIC may prohibit any SAIF member institution from engaging in any activity the FDIC determines by regulation or order poses a serious threat to the SAIF. The FDIC also has the authority to initiate enforcement actions against savings associations.

 

Deposits insured by SAIF are currently assessed at the rate of zero for well-capitalized institutions displaying little risk to the SAIF to $0.27 per $100 of domestic deposits for undercapitalized institutions displaying high risk.  The SAIF assessment rate may increase or decrease as is necessary to maintain the designated SAIF reserve ratio of 1.25% of insured deposits.

 

The Financing Corporation (“FICO”), established by the Competitive Equality Banking Act of 1987, is a mixed-ownership government corporation whose sole purpose was to function as a financing vehicle for the Federal Savings & Loan Insurance Corporation.  Outstanding FICO bonds, which are 30-year noncallable bonds, mature in 2017 through 2019.  The FICO has assessment authority separate from the FDIC’s authority to assess risk-based premiums for deposit insurance, to collect funds from FDIC-insured institutions sufficient to pay interest on FICO bonds.  The FDIC acts as collection agent for the FICO.  The FICO assessment rate, currently $0.40 per $100 of deposits, is adjusted quarterly.

 

The FDIC is empowered to initiate a termination of insurance proceeding in cases where the FDIC determines that an insured depository institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated an applicable law, regulation, order or condition imposed by the FDIC.  The FDIC may deem failure to comply with applicable regulatory capital requirements an unsafe and unsound practice.  If the FDIC terminates a savings association’s deposit insurance, funds then on deposit continue to be insured for at least six months and up to two years after notice of such termination is provided to the account holders. Furthermore, if the FDIC initiates an insurance termination proceeding against a savings association that has no core (Tier 1) capital, the FDIC may issue a temporary order immediately suspending deposit insurance on all deposits received by such savings association.

 

Loans to Affiliates.  As directed by HOLA, the OTS has revised the regulations governing transactions between thrifts and their affiliates and incorporated applicable provisions of Regulation W as adopted by the Federal Reserve Board.  Effective April 1, 2003, Regulation W implements restrictions on affiliate transactions as provided in Sections 23A and 23B of the Federal Reserve Act (the “FRA”).  Such transactions are subject to the restrictions of Sections 23A and 23B of the FRA in the same manner and to the same extent as if the savings association were a member bank as defined in the FRA, except that a savings association may not (i) extend credit to any affiliate engaged in activities that are impermissible for a bank holding company or (ii) purchase or invest in any securities of an affiliate other than shares of a subsidiary.

 

Section 23A of the FRA limits the aggregate amount of “covered transactions” with any one affiliate to 10% of the capital stock and surplus of the member bank.  Covered transactions with all affiliates are limited to no more than 20% of the member bank’s capital stock and surplus. “Covered transactions” are defined in Section 23A to include extending credit to, purchasing the assets of, issuing a guarantee, acceptance or letter of credit on behalf of, or investing in the stock or securities of, any affiliate. Covered transactions also include transactions between a member bank and a nonaffiliated third party to the extent that proceeds of the transactions are used for the benefit of or transferred to the affiliate.  Section 23A also requires a bank to obtain specified levels of collateral for any extension of credit to an affiliate. Section 23B, in general, requires that any transaction with an affiliate be on terms and conditions no less favorable to the member bank than those applicable to transactions with unaffiliated entities. The OTS has recently adopted regulations further defining and clarifying the applicability of Section 23A and 23B to savings associations. The OTS has the authority to impose any additional restrictions on any transaction between a savings association and an affiliate that it determines are necessary to protect the safety and soundness of the association.

 

In addition, FIRREA provides that extensions of credit to executive officers, directors and principal shareholders of a savings association are governed by the FRA.  The FRA requires prior approval by the board of directors of the bank before a loan can be made to an executive officer, director or 10% shareholder.  In addition, such loan or extension of credit must be made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unaffiliated persons and may not involve more than the normal risk of repayment or present other unfavorable features. The FRA also prohibits any loan or extension of credit to an executive officer or a controlling shareholder if such loan or extension of credit (when aggregated with the amount of all

 

26



 

other loans or extensions of credit then outstanding to such individual) would exceed the limits on loans to a single borrower applicable to national banks.  The OTS may impose additional restrictions for safety and soundness reasons.

 

Loans-to-One-Borrower.  Under FIRREA, the permissible amount of loans-to-one-borrower follows the national bank standard for all loans made by savings associations (except that loans-to-one-borrower not in excess of $500,000 may be made in any event).  OTS regulations generally do not permit loans-to-one-borrower to exceed 15% of unimpaired capital and unimpaired surplus.  Loans in an amount equal to an additional 10% of unimpaired capital and unimpaired surplus also may be made to a borrower if the loans are fully secured by readily marketable collateral.  In addition, institutions which meet applicable capital requirements may make domestic residential housing development loans in an amount up to the lesser of $30.0 million or 15% of the institution’s unimpaired capital and unimpaired surplus, subject to certain conditions.  At December 31, 2003, Sterling’s loans-to-one-borrower limit was $52.2 million, which management believes is adequate to allow for loan originations.

 

Qualified Thrift Lender.  Under the QTL Test, an institution generally is required to invest at least 65% of its portfolio assets (as defined in the OTS regulations) in “qualified thrift investments” on a monthly average basis in nine out of every twelve months.  Qualified thrift investments include, in general, loans, securities and other investments that are related to housing and small business.  At December 31, 2003, Sterling’s qualified thrift investments were 79.0% of portfolio assets.  An institution’s failure to remain a qualified thrift lender may result in: (1) limitations on new investments and activities; (2) imposition of branching restrictions; (3) loss of borrowing privileges at the FHLB Seattle; and (4) limitations on the payment of dividends.

 

Restriction on Business Banking Loans.  As a thrift, Sterling is permitted to hold no more than 20% of its assets in certain business banking loans as defined in the Thrift Financial Report.  At December 31, 2003, Sterling had $713.6 million of such loans, or 16.7% of total assets.  In addition, Sterling is permitted to hold no more than 10% of its assets as certain business loans which do not qualify as small business loans as defined by the OTS.  At December 31, 2003, Sterling had $278.5 million of such loans, or 6.5% of total assets.

 

Community Reinvestment.  Under the Community Reinvestment Act (“CRA”), as implemented by the OTS regulations, a savings institution has a continuing and affirmative obligation consistent with its safe and sound operation to help meet the credit needs of its entire community, including low and moderate income neighborhoods.  The CRA does not establish specific lending requirements or programs for financial institutions nor does it limit an institution’s discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA.  The CRA requires the OTS, in connection with its examination of a financial institution, to assess the institution’s record of meeting the credit needs of its community and to take such record into account in its evaluation of certain applications by such institutions.  The CRA requires public disclosure of an institution’s CRA rating and requires the OTS to provide a written evaluation of an institution’s CRA performance utilizing a four-tiered descriptive rating system of “outstanding,” “satisfactory,” “needs to improve” or “substantial noncompliance.”  Sterling’s current CRA rating is “satisfactory.”

 

Change of Control.  Under applicable statutes and regulations, a person may not acquire control of a savings association without the prior approval of the OTS and the Washington Supervisor.  Control is conclusively deemed to be acquired when, among other things, a person, either alone or acting in concert with others, acquires more than 25% of any class of voting stock of a savings association.  Under federal statutes and regulations, a rebuttable presumption of control arises if a person acquires, either alone or acting in concert with others, more than ten percent of any class of voting stock of a savings association and is subject to a “control factor,” or acquires more than 25% of any class of stock, and is subject to a “control factor.”  A person is subject to a control factor as a result of specified ownership levels of the savings association’s debt or equity or as a result of certain relationships with the savings association.

 

As indicated above, if a person’s ownership of the savings association stock is below the threshold levels for control, such person may nevertheless be deemed to be “acting in concert” with one or more other persons who own stock in the savings association, in which case all of the stock ownership of each person acting in concert will be aggregated and attributed to each member of the group, thereby putting each one over the control threshold. Under certain circumstances, acquirers will be presumed to be acting in concert.  For example: (i) a company will be presumed to be acting in concert with a controlling shareholder or management official; (ii) a company controlling or controlled by another company and companies under common control will be presumed to be acting in concert; and (iii) persons will be presumed to be acting in concert where they constitute a group under Section 13 or the proxy rules under Section 14 of the Exchange Act.

 

27



 

Restrictions on Activities of State-Chartered Associations.  FIRREA prohibits a state-chartered savings association from engaging in any type of activity or any activity in an amount that is not permissible for a federal savings association unless (i) the FDIC has determined that such activity poses no threat to the insurance fund and (ii) the savings association continues to be in compliance with applicable capital requirements.  If the FDIC determines that the amount of such activity does not pose a significant threat to the insurance fund, an association which is in compliance with applicable capital requirements may engage in activities in an amount greater than that permissible for a federal savings association. FIRREA also prohibits a state-chartered savings association from acquiring or retaining any equity investment (other than shares in certain service corporations) of a type or in an amount not permissible for a federal savings association.  A savings association must divest any such equity investment as quickly as can be prudently done.

 

Restrictions on Capital Distributions by Savings Associations.  The OTS has adopted a capital distribution regulation which limits the ability of savings institutions to make capital distributions.  Certain factors are considered by the OTS in determining whether to permit a savings institution to pay dividends, including, among other things, whether an institution meets applicable capital requirements.  Those savings institutions which meet the applicable capital requirements have discretion in making capital distributions, while those with lower capitalization have less discretion in this regard and, in some cases, are required to seek the approval of the OTS.

 

Sterling’s income is derived primarily from dividends to the extent they are declared and paid by Sterling Savings Bank.  Current OTS regulations require Sterling Savings Bank to give the OTS 30 days advance notice of any proposed declaration of dividends to Sterling, as its holding company.  The OTS has approved all of Sterling Savings Bank Preferred Stock dividend payments to Sterling, but there can be no assurance as to the approval of future dividends.

 

Federal Reserve System.  Sterling Savings Bank is subject to various regulations promulgated by the Fed, including, among others, Regulation B (Equal Credit Opportunity), Regulation D (Reserves), Regulation E (Electronic Fund Transfers), Regulation Z (Truth in Lending), Regulation CC (Availability of Funds) and Regulation DD (Truth in Savings). Regulation D requires noninterest-bearing reserve maintenance in the form of either vault cash or funds on deposit at the Federal Reserve Bank of San Francisco or another designated depository institution in an amount calculated by formula.  The balances maintained to meet the reserve requirements imposed by the Fed may be used to satisfy liquidity requirements.

 

Under the provisions of the Depository Institutions Deregulation and Monetary Control Act of 1980, savings and loan associations, like Sterling Savings Bank, also have authority to borrow from the Federal Reserve Bank “discount window,” but Federal Reserve regulations require associations to exhaust all FHL Bank sources before borrowing from the Fed.

 

Federal Taxation.  Sterling is subject to federal income taxation under the Internal Revenue Code of 1986 as amended, in the same manner as other corporations.  Sterling files consolidated federal income tax returns on the accrual basis.  See Note 12 of “Notes to Consolidated Financial Statements.”

 

State Law and Regulation. Sterling Savings Bank is a Washington State-chartered institution and is subject to regulation by the Washington Supervisor, which conducts regular examinations to ensure that Sterling Savings Bank’s operations and policies conform with sound industry practice. The liquidity and other requirements set by the Washington Supervisor are generally no stricter than the liquidity and other requirements set by the OTS. State law regulates the amount of credit that can be extended to any one person or marital community and the amount of money that can be invested in any one property. Without the Washington Supervisor’s approval, Sterling Savings Bank currently cannot extend credit to any one person or marital community in an amount greater than 2.5% of Sterling Savings Bank’s total assets. State law also regulates the types of loans Sterling Savings Bank can make. Without the Washington Supervisor’s approval, Sterling Savings Bank cannot currently invest more than 10% of its total assets in other corporations. Sterling Savings Bank also operates branches within the States of Oregon, Idaho and Montana and therefore is also subject to the supervision of the Oregon Department of Consumer and Business Services, the Idaho Department of Finance and the Montana Department of Finance.

 

28



 

Forward-Looking Statements

 

From time to time, Sterling and its senior managers have made and will make forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.  Such statements may be contained in this report and in other documents that Sterling files with the Securities and Exchange Commission.  Such statements may also be made by Sterling and its senior managers in oral or written presentations to analysts, investors, the media and others.  Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts.  Also, forward-looking statements can generally be identified by words such as “may,” “could,” “should,” “would,” “believe,” “anticipate,” “estimate,” “seek,” “expect,” “intend,” “plan” and similar expressions.

 

Forward-looking statements provide our expectations or predictions of future conditions, events or results.  They are not guarantees of future performance.  By their nature, forward-looking statements are subject to risks and uncertainties.  These statements speak only as of the date they are made.  We do not undertake to update forward-looking statements to reflect the impact of circumstances or events that arise after the date the forward-looking statements were made.  There are a number of factors, many of which are beyond our control, that could cause actual conditions, events or results to differ significantly from those described in the forward-looking statements.  These factors, some of which are discussed elsewhere in this report, include:

 

                  the strength of the United States economy in general and the strength of the local economies in which Sterling conducts its operations;

 

                  the effects of inflation, interest rate levels and market and monetary fluctuations;

 

                  trade, monetary and fiscal policies and laws, including interest rate policies of the federal government;

 

                  applicable laws and regulations and legislative or regulatory changes;

 

                  the timely development and acceptance of new products and services of Sterling;

 

                  the willingness of customers to substitute competitors’ products and services for Sterling’s products and services;

 

                  Sterling’s success in gaining regulatory approvals, when required;

 

                  technological and management changes;

 

                  growth and acquisition strategies;

 

                  lower-than-expected revenue or cost savings or other issues in connection with mergers and acquisitions;

 

                  changes in consumer spending and saving habits; and

 

                  Sterling’s success at managing the risks involved in the foregoing.

 

Where You Can Find More Information

 

The periodic reports Sterling files with the SEC are available on Sterling’s website at http://www.sterlingsavingsbank.com after the reports are filed with the SEC.  The SEC maintains a website located at http://www.sec.gov that also contains this information.  Sterling will provide you with copies of these reports, without charge, upon request made to:

 

Investor Relations

Sterling Financial Corporation

111 North Wall Street

Spokane, Washington 99201

(509) 458-3711

 

29



 

Item 2.   Properties

 

At December 31, 2003, the net book value of Sterling’s property (including land and buildings) and its furniture, fixtures and equipment was $54.6 million.  Sterling’s corporate headquarters is in Spokane, Washington.  A summary of Sterling’s properties by state as of December 31, 2003 is as follows:

 

 

 

Action
Leased

 

INTERVEST
Leased

 

Dime
Leased

 

Sterling
Savings
Bank
Leased

 

Sterling
Savings
Bank
Owned

 

Total

 

Total
Approximate
Square Footage

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Washington

 

2

 

2

 

0

 

22

 

45

 

71

 

534,000

 

Oregon

 

3

 

2

 

0

 

4

 

5

 

14

 

45,000

 

Idaho

 

1

 

0

 

0

 

2

 

8

 

11

 

57,000

 

Montana

 

1

 

0

 

1

 

1

 

7

 

10

 

32,000

 

Arizona

 

0

 

1

 

0

 

0

 

0

 

1

 

2,000

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

7

 

5

 

1

 

29

 

65

 

107

 

670,000

 

 

Leases on these properties expire between 2004 and 2014.  Sterling believes it will be able to renew the leases or obtain comparable properties.  Sterling significantly increased the number of leased and owned properties through its merger with Klamath in January 2004.  See “Business – General – Company Growth.”

 

Item 3 Legal Proceedings

 

Periodically, various claims are brought in connection with Sterling’s business.  No material loss is expected from any of such pending claims or lawsuits, although there can be no assurance in this regard.

 

Item 4.   Submission of Matters to a Vote of Security Holders

 

Sterling held a special meeting of shareholders on December 11, 2003, at which a majority of the shareholders of Sterling approved the Klamath Merger pursuant to which Klamath merged with and into Sterling on January 2, 2004.  There were 14,811,661 shares of Sterling common stock entitled to vote on the merger.  The following is a record of the votes cast by Sterling’s shareholders at the special meeting:

 

Votes

 

 

 

For:

 

11,363,992

Against:

 

114,941

Abstentions:

 

24,685

 

PART II

 

Item 5.   Market for the Registrant’s Common Equity and Related Shareholder Matters

 

Stock Market and Dividend Information

 

Sterling has outstanding one class of Common Stock.  As of January 30, 2004, there were 20,294,984 shares of Common Stock outstanding.  As of January 30, 2004, the Common Stock was owned by 2,558 shareholders of record and the closing price as of that date for the Common Stock was $37.90.  The Common Stock is listed on The NASDAQ National Market under the symbol “STSA.”  For information concerning the payment of dividends, see “Business – Regulation – Regulatory Capital Requirements,” “Management’s Discussion and Analysis – Capital” and Note 24 of “Notes to Consolidated Financial Statements.”

 

30


The following table sets forth the high and low bid prices per share for Sterling’s Common Stock for the periods indicated.  Prior period amounts have been restated to reflect the 10% stock dividend paid in May 2003.

 

 

 

High

 

Low

 

 

 

 

 

 

 

Year ended December 31, 2003:

 

 

 

 

 

Fourth quarter

 

$

35.80

 

$

27.87

 

Third quarter

 

29.18

 

24.00

 

Second quarter

 

24.75

 

18.91

 

First quarter

 

19.30

 

17.01

 

 

 

 

 

 

 

Year ended December 31, 2002:

 

 

 

 

 

Fourth quarter

 

$

18.67

 

$

15.23

 

Third quarter

 

18.45

 

14.43

 

Second quarter

 

21.00

 

16.86

 

First quarter

 

18.80

 

12.19

 

 

Sterling has paid stock dividends in the past but has never paid cash dividends on its shares of common stock.  The board of directors of Sterling is currently evaluating the payment of cash dividends in the future, although it has reached no decision in this regard.  The timing and amount of any future dividends will depend upon earnings, cash requirements, capital requirements, the financial condition of Sterling and its subsidiaries, applicable government regulations and other factors deemed relevant by Sterling’s board of directors.

 

31



 

Item 6.   Selected Financial Data (1) (2)

 

 

 

Years Ended December 31,

 

 

 

2003

 

2002

 

2001

 

2000

 

1999

 

 

 

(Dollars in thousands, except per share amounts)

 

 

 

 

 

Interest income

 

$

214,727

 

$

197,313

 

$

201,385

 

$

205,310

 

$

177,109

 

Interest expense

 

(89,807

)

(96,965

)

(116,516

)

(125,544

)

(102,004

)

Net interest income

 

124,920

 

100,348

 

84,869

 

79,766

 

75,105

 

Provision for losses on loans

 

(10,500

)

(11,867

)

(8,000

)

(4,600

)

(3,900

)

Net interest income after provision for losses on loans

 

114,420

 

88,481

 

76,869

 

75,166

 

71,205

 

Other income

 

33,735

 

29,080

 

21,021

 

14,488

 

13,562

 

Merger, acquisition and conversion costs

 

(792

)

0

 

(283

)

0

 

0

 

Amortization of goodwill and other intangibles

 

(262

)

(644

)

(5,377

)

(5,490

)

(5,692

)

Goodwill litigation

 

(600

)

(1,100

)

(890

)

(1,074

)

(272

)

Other operating expenses

 

(92,910

)

(79,199

)

(66,743

)

(61,404

)

(58,514

)

Income before income taxes

 

53,591

 

36,618

 

24,597

 

21,686

 

20,289

 

Income tax provision

 

(18,678

)

(11,031

)

(8,409

)

(8,033

)

(7,470

)

Net income

 

$

34,913

 

$

25,587

 

$

16,188

 

$

13,653

 

$

12,819

 

Earnings per share:

 

 

 

 

 

 

 

 

 

 

 

Basic (1)

 

$

2.40

 

$

1.96

 

$

1.34

 

$

1.15

 

$

1.08

 

Diluted (1)

 

$

2.34

 

$

1.91

 

$

1.31

 

$

1.15

 

$

1.08

 

Weighted average shares outstanding:

 

 

 

 

 

 

 

 

 

 

 

Basic (1)

 

14,533,402

 

13,027,884

 

12,105,546

 

11,857,657

 

11,834,358

 

Diluted (1)

 

14,940,108

 

13,432,770

 

12,364,029

 

11,911,639

 

11,919,534

 

Financial Ratios:

 

 

 

 

 

 

 

 

 

 

 

Book value per share at end of period (1)

 

$

16.84

 

$

15.48

 

$

12.99

 

$

11.92

 

$

9.93

 

Return on average assets

 

0.88

%

0.80

%

0.58

%

0.52

%

0.52

%

Return on average shareholders’ equity

 

14.4

%

13.9

%

10.5

%

11.0

%

10.7

%

Shareholders’ equity to total assets at end of period

 

5.9

%

5.8

%

5.5

%

5.3

%

4.6

%

Operating efficiency

 

59.6

%

62.5

%

69.2

%

72.1

%

72.7

%

Net interest margin

 

3.35

%

3.37

%

3.27

%

3.25

%

3.33

%

Nonperforming assets to total assets at end of period

 

0.50

%

0.59

%

0.82

%

0.56

%

0.65

%

 

32



 

 

 

 

Years Ended December 31,

 

 

 

2003

 

2002

 

2001

 

2000

 

1999

 

 

 

(Dollars in thousands, except per share amounts)

 

 

 

 

 

 

 

 

 

 

 

 

 

Reported net income

 

$

34,913

 

$

25,587

 

$

16,188

 

$

13,653

 

$

12,819

 

Add back: goodwill amortization net of tax (3)

 

0

 

0

 

2,538

 

2,494

 

2,621

 

Total

 

$

34,913

 

$

25,587

 

$

18,726

 

$

16,147

 

$

15,440

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic earnings per share:

 

 

 

 

 

 

 

 

 

 

 

Reported net income

 

$

2.40

 

$

1.96

 

$

1.34

 

$

1.15

 

$

1.08

 

Goodwill amortization

 

0.00

 

0.00

 

0.21

 

0.21

 

0.22

 

Adjusted net income

 

$

2.40

 

$

1.96

 

$

1.55

 

$

1.36

 

$

1.30

 

 

 

 

 

 

 

 

 

 

 

 

 

Diluted earnings per share:

 

 

 

 

 

 

 

 

 

 

 

Reported net income

 

$

2.34

 

$

1.91

 

$

1.31

 

$

1.15

 

$

1.08

 

Goodwill amortization

 

0.00

 

0.00

 

0.21

 

0.21

 

0.22

 

Adjusted net income

 

$

2.34

 

$

1.91

 

$

1.52

 

$

1.36

 

$

1.30

 

 

 

 

Years Ended December 31,

 

 

 

2003

 

2002

 

2001

 

2000

 

1999

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance Sheet Data:

 

 

 

 

 

 

 

 

 

 

 

Total assets

 

$

4,276,906

 

$

3,507,021

 

$

3,038,593

 

$

2,652,709

 

$

2,546,925

 

Loans receivable, net

 

2,906,426

 

2,390,422

 

2,109,479

 

1,965,927

 

1,787,771

 

Asset-backed securities

 

983,736

 

743,610

 

617,569

 

314,434

 

343,310

 

Investments

 

89,448

 

86,558

 

76,479

 

171,748

 

162,420

 

Deposits

 

2,455,076

 

2,014,096

 

1,853,536

 

1,724,219

 

1,617,368

 

FHLB Seattle advances

 

1,026,031

 

874,515

 

633,054

 

530,652

 

490,503

 

Reverse repurchase agreements and funds purchased

 

363,137

 

249,769

 

218,549

 

110,326

 

179,515

 

Other borrowings

 

135,583

 

127,682

 

127,500

 

110,000

 

110,000

 

Shareholders’ equity

 

250,348

 

203,656

 

165,690

 

141,338

 

117,639

 

 

 

 

 

 

 

 

 

 

 

 

 

Capital Ratios(4):

 

 

 

 

 

 

 

 

 

 

 

Core capital ratio

 

7.43

%

7.57

%

8.00

%

7.10

%

6.77

%

Tier 1 risk-based capital ratio

 

9.89

%

9.98

%

10.83

%

9.71

%

9.50

%

Total risk-based capital ratio

 

10.91

%

10.96

%

11.69

%

10.25

%

10.36

%

 

 

 

 

 

 

 

 

 

 

 

 

Statistical Data:

 

 

 

 

 

 

 

 

 

 

 

Number of:

 

 

 

 

 

 

 

 

 

 

 

Employees (full-time equivalents).

 

1,121

 

953

 

890

 

822

 

817

 

Full service branches

 

86

 

79

 

77

 

77

 

77

 

 


(1)          All prior period per share and weighted average share amounts have been restated to reflect the 10% Common Stock dividend distributed in May 2003.  The selected financial data (except the ratios and statistical data) of Sterling for each of the periods has been derived from Sterling’s audited consolidated financial statements.

 

(2)          Comparability could be affected by past acquisitions and is affected by the change in accounting for goodwill amortization.

 

(3)          Sterling adopted SFAS No. 142 “Goodwill and Intangible Assets” on January 1, 2002.  The tabular presentation reflects retroactive application of SFAS No. 142, even though SFAS No. 142 by its terms applies prospectively.

 

(4)          For Sterling Savings Bank.

 

33



 

Item 7.   Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following discussion and analysis should be read in conjunction with the Consolidated Financial Statements and Notes thereto presented elsewhere in this report.  This report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.  For a discussion of the risks and uncertainties inherent in such statements, see “Business — Forward-Looking Statements.”

 

Executive Summary

 

Net income for the year ended December 31, 2003, increased 36% to $34.9 million, or $2.34 per diluted share, compared with net income of $25.6 million, or $1.91 per diluted share, for last year’s comparable period.  The increase in earnings primarily reflects increases in net interest income and other income.

 

Key performance ratios for the year ended December 31, 2003.

 

                  Return on average equity of 14.4%, compared to 13.9% for 2002.

 

                  Net charge-offs to average loans of 0.13%, a five-year low.

 

                  Nonperforming assets to total assets at year end of 0.50%, compared to 0.59% at year-end 2002.

 

                  Operating efficiency improved to 59.6%, compared to 62.5% a year ago.

 

Highlights of 2003 achievements.

 

                  Net interest income increased to $124.9 million for the year ended December 31, 2003, from $100.3 million for the year ended December 31, 2002.

 

                  Sterling Savings Bank’s wholly-owned subsidiary, Action Mortgage, originated a record $1.01 billion in residential construction and residential permanent loans.

 

                  Fees and service charges income increased 15% year over year.

 

                  Mortgage banking operations income increased to $8.5 million for the year ended December 31, 2003, from $6.0 million for the year ended December 31, 2002, a 42% increase.

 

                  Opened two de novo branches along Interstate 5 corridor in Oregon, and expanded corporate banking operations by opening an office in Eugene, Oregon.

 

                  Expanded INTERVEST operations to include a commercial real estate lending office in Phoenix, Arizona that will house three loan officers to cover the southwestern United States.

 

                  Total loan originations were a record $2.27 billion, up by 24% over 2002.

 

                  Deposits continued on an upward trend.  Deposits at December 31, 2003, were $2.46 billion, an increase of 22% over December 31, 2002.

 

                  The $40.0 million Sterling Capital Trust I Securities were redeemed on May 16, 2003.

 

                  Sterling announced that its wholly-owned subsidiaries, Trust-III through Trust-VI, sold $54.0 million of trust-preferred securities with an initial weighted average interest cost of 4.5%.

 

Critical Accounting Policies

 

The accounting and reporting policies of Sterling conform to GAAP and to general practices within the banking industry. The preparation of the financial statements in conformity with GAAP requires management to make estimates

 

34



 

and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.  Sterling’s management has identified the accounting policies described below as those that, due to the judgments, estimates and assumptions inherent in those policies, are critical to an understanding of Sterling’s Consolidated Financial Statements and Management’s Discussion and Analysis.

 

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

 

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

 

The amount of the allowance for the various loan types represents management’s estimate of expected losses from existing loans based upon specific allocations for individual lending relationships and historical loss experience for each category of homogeneous loans.  The allowance for loan losses related to impaired loans is based on discounted cash flows using the loan’s initial effective interest rate or the fair value of the collateral for certain collateral dependent loans. This evaluation requires management to make estimates of the amounts and timing of future cash flows on impaired loans, which consist primarily of non-accrual and restructured loans.

 

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

 

There can be no assurance that the allowance for loan losses will be adequate to cover all losses, but management believes the allowance for loan losses was adequate at December 31, 2003. While management uses available information to provide for loan losses, the ultimate collectibility of a substantial portion of the loan portfolio and the need for future additions to the allowance will be based on changes in economic conditions and other relevant factors. A slowdown in economic activity could adversely affect cash flows for both commercial and individual borrowers, as a result of which Sterling could experience increases in nonperforming assets, delinquencies and losses on loans.

 

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

 

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

 

35



 

losses reported in shareholders’ equity as a separate component of other comprehensive income, net of applicable deferred income taxes.

 

Management evaluates investment securities for other than temporary declines in fair value on a quarterly basis.  If the fair value of investment securities falls below their amortized cost and the decline is deemed to be other than temporary, the securities will be written down to current market value and the write down will be deducted from earnings under realized losses. There were no investment securities which management identified to be other-than-temporarily impaired for the year ended December 31, 2003.  Charges to income could occur in future periods due to a change in management’s intent to hold the investments to maturity, a change in management’s assessment of credit risk, or a change in regulatory or accounting requirements.  See Note 1 of “Notes to Consolidated Financial Statements.”

 

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

 

Under GAAP in effect through December 31, 2001, Sterling amortized goodwill on a straight-line basis over periods ranging from ten to fifteen years. Effective January 1, 2002, Sterling adopted SFAS 142 and SFAS 147 and was therefore was no longer required to amortize previously recorded goodwill.

 

Sterling performed the required annual test of its goodwill assets as of June 30, 2003, and concluded that the recorded value of goodwill was not impaired. There are many assumptions and estimates underlying the determination of impairment. Another estimate using different, but still reasonable, assumptions could produce a significantly different result. Additionally, future events could cause management to conclude that Sterling’s goodwill is impaired, which would result in Sterling recording an impairment loss. Any resulting impairment loss could have a material adverse impact on Sterling’s financial condition and results of operations.

 

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

 

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

 

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

 

Results of Operations for the Years Ended December 31, 2003 and 2002

 

Net Interest IncomeNII for the years ended December 31, 2003 and 2002 was $124.9 million and $100.3 million, respectively.  The 25% increase in NII was primarily due to growth in loan and ABS volumes.  During the year ended December 31, 2003, average loans increased by $479.5 million, an increase of 21% over 2002.

 

During the same periods, the net interest margins were 3.35% and 3.37%, respectively and net interest spreads were 3.30% and 3.36%, respectively.  Net interest spread decreased primarily due to a more rapid repricing of loans relative to Sterling’s interest-bearing liabilities.  The decreases in net interest margin and net interest spread reflected the decrease in prevailing interest rates and a greater decrease in the yield on loans than in the cost of deposits.  Sterling generally has been asset sensitive during the past year.  See – Net Interest Income Analysis.

 

36



 

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

 

Sterling recorded provisions for losses on loans of $10.5 million and $11.9 million for the years ended December 31, 2003 and 2002, respectively.  The current provision reflects the analysis and assessment of the relevant factors mentioned in the preceding paragraph.  Management anticipates that its provisions for losses on loans will continue to increase, reflecting Sterling’s strategy to originate more commercial real estate, construction, business banking and consumer loans, all of which have a somewhat higher loss profile than the traditional thrift institution mix of loans.

 

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

 

 

 

Years Ended December 31,

 

 

 

2003

 

2002

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

Balance at beginning of the year

 

$

27,866

 

$

20,599

 

Allowance for loan losses acquired

 

870

 

0

 

Provision for losses on loans

 

10,500

 

11,867

 

Amounts written off net of recoveries and other

 

(3,631

)

(4,600

)

Balance at December 31

 

$

35,605

 

$

27,866

 

 

At December 31, 2003, Sterling’s total classified assets were $84.8 million, compared with $84.7 million at December 31, 2002.  Total nonperforming assets were $21.6 million at December 31, 2003, compared with $20.8 million at December 31, 2002.  Excluding the nonperforming assets acquired from Empire and the increase in assets of Source that became nonperforming since the acquisition dates, nonperforming assets would have been $15.0 million or 0.35% of total assets.  At December 31, 2003, Sterling’s loan delinquency rate (60 days or more) as a percentage of total loans was 0.90%, compared with 0.82% at December 31, 2002.  Excluding delinquent loans from Empire and Source, the delinquency ratio at December 31, 2003 would have been 0.72%, compared with 0.66% at December 31, 2002.

 

Other Income/Expense.  The following table summarizes the components of other income for the periods indicated.

 

 

 

Years Ended
December 31,

 

 

 

2003

 

2002

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

Fees and service charges

 

$

19,168

 

$

16,678

 

Mortgage banking operations

 

8,482

 

5,982

 

Loan servicing fees

 

566

 

536

 

Net gains on sales of securities

 

3,694

 

2,925

 

Real estate owned operations

 

(73

)

(126

)

Bank-owned life insurance

 

3,742

 

3,280

 

Charge related to early repayment of debt

 

(1,464

)

0

 

Other noninterest income (expense)

 

(380

)

(195

)

 

 

 

 

 

 

Total other income

 

$

33,735

 

$

29,080

 

 

37



 

Fees and service charges primarily consist of service charges on deposit accounts, fees for certain customer services, commissions on sales of credit life insurance, commissions on sales of mutual funds and annuity products and late charges on loans.  The increase for the year ended December 31, 2003, compared with the year ended December 31, 2002, was primarily due to the increase in business banking activities that generate business banking accounts.  The number of business checking accounts have increased year over year, along with a wider range of business services being offered for a fee.

 

The increase in income from mortgage banking operations for the year ended December 31, 2003 compared to the year ended December 31, 2002, was primarily due to increased refinancing activity and loan sales, reflecting the lower interest rate environment.

 

The following table summarizes originations and sales of residential and commercial real estate loans for the periods indicated.

 

 

 

Years Ended
December 31,

 

 

 

2003

 

2002

 

 

 

(Dollars in millions)

 

 

 

 

 

 

 

Originations of one- to four-family permanent mortgage loans

 

$

504.2

 

$

351.0

 

Sales of residential loans

 

360.5

 

211.0

 

Sales of commercial real estate loans

 

35.9

 

65.1

 

Principal balances of residential loans serviced for others

 

329.6

 

198.6

 

Principal balances of commercial real estate loans serviced for others

 

211.5

 

239.9

 

 

During the year ended December 31, 2003, Sterling sold approximately $705.2 million of investments and ABS, resulting in net gains of $3.7 million.  During the year ended December 31, 2002, Sterling sold approximately $635.9 million of investments, resulting in net gains of $2.9 million.  The increase in sales of investments and ABS in 2003 was primarily due to an acceleration of prepayments and management’s desire to maintain a targeted maturity structure within the portfolio.

 

Operating Expenses.  Operating expenses were $94.6 million and $80.9 million for the years ended December 31, 2003 and 2002, respectively, an increase of 17%.  The higher level of operating expenses was primarily a result of expanded staffing in Sterling’s branch delivery network, occupancy costs and advertising.

 

Employee compensation and benefits were $51.1 million and $42.9 million for the years ended December 31, 2003 and 2002, respectively.  The employee costs reflected increased mortgage banking staff, additional staff for Sterling’s Seattle, Portland and Eugene Corporate Banking Centers and increased staffing from Empire.  In addition, Sterling began hiring loan officers and other support staff in anticipation of the Klamath merger.  At December 31, 2003, full-time-equivalent employees were 1,121, compared with 953 at December 31, 2002.  With the addition of Klamath and additional growth in the branch delivery network, full-time-equivalent employees are expected to increase by 650 by the end of 2004.

 

Occupancy and equipment expenses were $14.7 million and $12.5 million for the years ended December 31, 2003 and 2002, respectively.  The increase was primarily due to expenses associated with the Seattle, Portland and Eugene Corporate Banking Centers, the new Empire branches, expanded mortgage banking branches and higher equipment costs.

 

Advertising expenses were $5.3 million and $4.2 million for the years ended December 31, 2003 and 2002, respectively.  The increase was primarily due to an increase in costs associated with Sterling’s new image campaign, partially influenced by the Klamath merger.

 

Amortization of goodwill and other intangibles was $262,000 and $644,000 for the years ended December 31, 2003 and 2002, respectively.  As a result of the merger with Klamath, the amortization of other intangibles is expected to increase in future periods.

 

38



 

Goodwill litigation expenses were $600,000 and $1.1 million for the years ended December 31, 2003 and 2002, respectively.  Because of the effort required to bring the case to conclusion, Sterling likely will continue to incur legal expenses at recent levels over the next one to two years.

 

Income Tax Provision.  Sterling recorded federal and state income tax provisions of $18.7 million and $11.0 million for the years ended December 31, 2003 and 2002, respectively.  The effective tax rates for these periods were 34.9% and 30.1%.  The increase in the effective tax rates was primarily due to the effect of a lower portion of tax-preferred income included in income before taxes.

 

Results of Operations for the Years Ended December 31, 2002 and 2001

 

Overview.  Sterling recorded net income of $25.6 million, or $1.91 per diluted share, for the year ended December 31, 2002, compared with net income of $16.2 million, or $1.31 per diluted share, for the year ended December 31, 2001.  The increase in net income reflected higher NII, other income and discontinuance of goodwill amortization.

 

Net Interest Income.  NII for the years ended December 31, 2002 and 2001 was $100.3 million and $84.9 million, respectively.  The 18% increase in NII was primarily due to an increase in the average volumes of loans and ABS with higher net interest spreads and a decrease in the cost of funds as liabilities repriced.  During the year ended December 31, 2002, average loans increased by $225.5 million, an increase of 11.0% over 2001.  The volume factor, attributable primarily to an increase in loans and ABS, resulted in an increase in NII of approximately $15.5 million.

 

During the same periods, the net interest margins were 3.37% and 3.27%, respectively.  Net interest spreads were 3.36% and 3.25%, respectively.  Net interest spread decreased primarily due to a more rapid repricing of loans relative to Sterling’s interest-bearing liabilities.  Net interest margin increased due to higher NII.

 

Sterling recorded provisions for losses on loans of $11.9 million and $8.0 million for the years ended December 31, 2002 and 2001, respectively.  The level of loan charge-offs to average loans was 0.21% for the years ended December 31, 2002 and 2001.  At December 31, 2002, Sterling’s loan delinquency rate (60 days or more) as a percentage of total loans was 0.82%, compared with 1.12% at December 31, 2001.  Total nonperforming loans were $16.9 million, or 0.71% of net loans at December 31, 2002, compared with $22.0 million, or 1.04% of net loans at December 31, 2001.  Management believes that Sterling’s asset quality remains at acceptable levels and reflects the greater emphasis on higher-risk commercial real estate, construction, business banking and consumer loans.  Management further anticipates it may need to continue to maintain and enhance its overall allowance position proportionate with growth and diversification in the loan portfolio.

 

Classified assets at December 31, 2002 were $84.7 million compared to $55.1 million at December 31, 2001.  The 60-day-plus loan delinquency ratio dropped from 1.12% at December 31, 2001 to 0.82% at December 31, 2002.

 

Management believes the provisions for losses on loans for the years ended December 31, 2002 and 2001 are appropriate based upon its evaluation of factors affecting the adequacy of valuation allowances, although there can be no assurance in this regard.  Such factors include locations and concentrations of loans, loan loss experience and economic factors affecting the Pacific Northwest economy.

 

39



 

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

 

 

 

Years Ended
December 31,

 

 

 

2002

 

2001

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

Allowance for losses on loans:

 

 

 

 

 

 

 

 

 

 

 

Balance at beginning of year

 

$

20,599

 

$

16,740

 

 

 

 

 

 

 

Provision for losses on loans

 

11,867

 

8,000

 

Amounts written off net of recoveries and other

 

(4,600

)

(4,141

)

Balance at December 31

 

$

27,866

 

$

20,599

 

 

Other Income/Expense.  The following table summarizes the components of other income for the periods indicated.

 

 

 

Years Ended
December 31,

 

 

 

2002

 

2001

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

Fees and service charges

 

$

16,678

 

$

13,147

 

Mortgage banking operations

 

5,982

 

3,567

 

Loan servicing fees

 

536

 

1,147

 

Net gains on sales of securities

 

2,925

 

3,746

 

Real estate owned operations

 

(126

)

(657

)

Bank-owned life insurance

 

3,280

 

988

 

Other noninterest income (expense)

 

(195

)

(917

)

 

 

 

 

 

 

Total other income

 

$

29,080

 

$

21,021

 

 

Fees and service charges primarily consist of service charges on deposit accounts, fees for certain customer services, commissions on sales of credit life insurance, commissions on sales of mutual funds and annuity products and late charges on loans.  The increase for the year ended December 31, 2002, compared with the year ended December 31, 2001, was primarily due to the implementation of new service charges associated with transaction accounts, improved efficiencies in assessing overdraft charges and additional charges for loan revisions.  The growth in fees from transaction accounts primarily reflects the increase in corporate banking activities and promotional efforts for retail account growth.

 

The increase in income from mortgage banking operations for the year ended December 31, 2002 compared to the same period in 2001, was primarily due to increased refinancing activity and loan sales driven by lower interest rates.

 

The following table summarizes originations and sales of residential and commercial real estate loans for the periods indicated.

 

 

 

Years Ended
December 31,

 

 

 

2002

 

2001

 

 

 

(Dollars in millions)

 

 

 

 

 

 

 

Originations of one- to four-family permanent mortgage loans

 

$

351.0

 

$

204.5

 

Sales of residential loans

 

211.0

 

221.5

 

Sales of commercial real estate loans

 

65.1

 

51.5

 

Principal balances of residential loans serviced for others

 

198.6

 

201.0

 

Principal balances of commercial real estate loans serviced for others

 

239.9

 

214.5

 

 

The decrease in loan servicing fees during the year ended December 31, 2002, compared to the same period in 2001, was primarily due to write downs of mortgage servicing rights in the fourth quarter of 2002.

 

The increase in income from bank-owned life insurance (“BOLI”) for the year ended December 31, 2002, compared to the same period in 2001, was primarily due to additional purchases of BOLI in the first quarter of 2002.

 

40



 

REO operations and other for the year ended December 31, 2002 showed a loss of $126,000, compared with a loss of $657,000 for the year ended December 31, 2001.  The change in REO operations and other for the year ended December 31, 2002 was primarily due to an increase in the provision for losses on REO from 2001.

 

During the year ended December 31, 2002, Sterling sold approximately $635.9 million of investments and ABS, resulting in net gains of $2.9 million.  During the year ended December 31, 2001, Sterling sold approximately $344.3 million of investments, resulting in net gains of $3.7 million.  The increase in sales of ABS in 2002 was primarily due to a change in  the maturity structure in response to a rapidly changing interest rate environment.

 

Operating Expenses.  Operating expenses were $80.9 million and $73.3 million for the years ended December 31, 2002 and 2001, respectively, an increase of 10%.  The higher level of operating expenses was primarily a result of expanding staffing in Sterling’s branch delivery network, an increase in employee benefits, data processing, occupancy costs and advertising costs, partially offset by the elimination of goodwill amortization in 2002.

 

Employee compensation and benefits were $42.9 million and $35.3 million for the years ended December 31, 2002 and 2001, respectively. The employee costs reflected increased mortgage banking staff and additional staff for Sterling’s cash management operations and the Corporate Banking Centers.  At December 31, 2002, full-time-equivalent employees were 953, compared with 890 at December 31, 2001.

 

Data processing expense was $6.2 million and $5.3 million for the years ended December 31, 2002 and 2001, respectively.  The increase was primarily due to an increase in costs associated with the higher volumes of transactions related to Sterling’s deposit growth.

 

Goodwill litigation expenses were $1.1 million and $890,000 for the years ended December 31, 2002 and 2001, respectively.  Because of the effort required to bring the case to conclusion, Sterling likely will continue to incur legal expenses at recent levels over the next one to two years.

 

For the years ended December 31, 2002 and 2001, respectively, amortization of goodwill was $0 and $3.8 million, reflecting the cessation of goodwill amortization.  Pursuant to SFAS No. 142, goodwill and intangible assets with indefinite lives are no longer amortized, but will be tested annually for impairment.

 

Advertising expenses were $4.2 million and $2.9 million for the years ended December 31, 2002 and 2001, respectively.  The increase reflected additional advertising for Sterling’s image campaign.

 

Income Tax Provision.  Sterling recorded federal and state income tax provisions of $11.0 million and $8.4 million for the years ended December 31, 2002 and 2001, respectively.  The effective tax rates during these periods were 30.1% and 34.2%, reflecting tax-exempt BOLI and municipal bond investment income.

 

41



 

Net Interest Income Analysis

 

The most significant component of earnings for a financial institution typically is NII, which is the difference between interest income, primarily from loan, ABS and investment portfolios, and interest expense, primarily on deposits and borrowings.  Changes in NII result from changes in volume, net interest spread and net interest margin.  Volume refers to the dollar level of interest-earning assets and interest-bearing liabilities.  Net interest spread refers to the difference between the yield on interest-earning assets and the rate paid on interest-bearing liabilities.  Net interest margin refers to NII divided by total interest-earning assets and is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities.  During the year ended December 31, 2003, the increase in NII was primarily due to growth in loan and ABS volumes, combined with a decrease in the cost of deposits and other borrowings.  During the year ended December 31, 2002, the increase in NII was primarily due to the same factors.

 

42



 

The following table sets forth, for the periods indicated, information with regard to Sterling’s NII, net spread and net interest margin.

 

 

 

Years Ended December 31,

 

 

 

2003

 

2002

 

2001

 

 

 

Average
Balance(1)

 

Interest
Earned
or
Paid

 

Average
Yield
or
Cost(2)

 

Average
Balance(1)

 

Interest
Earned
or
Paid

 

Average
Yield
or
Cost(2)

 

Average
Balance(1)

 

Interest
Earned
or
Paid

 

Average
Yield
or
Cost(2)

 

 

 

(Dollars in thousands)

 

 

 

 

 

Loans

 

$

2,721,149

 

$

169,411

 

6.23

%

$

2,241,643

 

$

159,278

 

7.11

%

$

2,016,167

 

$

165,976

 

8.23

%

Asset-backed securities

 

913,260

 

41,193

 

4.51

 

640,425

 

33,539

 

5.24

 

473,923

 

29,062

 

6.13

 

Investment and cash equivalents

 

96,783

 

4,123

 

4.26

 

93,519

 

4,496

 

4.81

 

104,757

 

6,347

 

6.06

 

Total interest-earning assets

 

$

3,731,192

 

$

214,727

 

5.75

 

$

2,975,587

 

$

197,313

 

6.63

%

$

2,594,847

 

$

201,385

 

7.76

%

Noninterest-earning assets

 

223,966

 

 

 

 

 

226,415

 

 

 

 

 

194,473

 

 

 

 

 

Total assets

 

$

3,955,158

 

 

 

 

 

$

3,202,002

 

 

 

 

 

$

2,789,320

 

 

 

 

 

Interest-bearing liabilities:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Time deposits

 

$

1,152,281

 

$

29,262

 

2.54

%

$

1,052,792

 

$

36,255

 

3.44

%

$

981,243

 

$

52,510

 

5.35

%

Regular savings and money market accounts

 

572,842

 

6,578

 

1.15

 

364,823

 

5,906

 

1.62

 

406,551

 

9,838

 

2.42

 

Interest-bearing demand accounts

 

318,722

 

991

 

0.31

 

335,003

 

1,471

 

0.44

 

209,020

 

1,086

 

0.52

 

Total interest-bearing deposits

 

2,043,845

 

36,831

 

1.80

 

1,752,618

 

43,632

 

2.49

 

1,596,814

 

63,434

 

3.97

 

Noninterest-bearing demand deposits

 

280,990

 

0

 

0.00

 

206,323

 

0

 

0.00

 

129,096

 

0

 

0.00

 

Total deposits

 

2,324,835

 

36,831

 

1.58

 

1,958,941

 

43,632

 

2.23

 

1,725,910

 

63,434

 

3.68

 

FHLB Seattle advances

 

969,833

 

36,662

 

3.78

 

703,568

 

36,278

 

5.16

 

577,403

 

34,594

 

5.99

 

All other borrowings

 

244,699

 

8,660

 

3.54

 

185,826

 

8,047

 

4.33

 

161,169

 

8,896

 

5.52

 

Trust Preferred Securities

 

72,929

 

5,464

 

7.49

 

64,000

 

6,346

 

9.92

 

50,968

 

4,931

 

9.67

 

Term note payable

 

24,250

 

918

 

3.79

 

26,223

 

1,150

 

4.39

 

13,710

 

438

 

3.19

 

Convertible Subordinated Debt

 

0

 

0

 

0.00

 

1,167

 

44

 

3.77

 

882

 

66

 

7.48

 

Floating Rate Notes Due 2006

 

30,000

 

1,272

 

4.24

 

30,000

 

1,468

 

4.89

 

30,000

 

2,241

 

7.47

 

Advances under lines of credit

 

0

 

0

 

0.00

 

0

 

0

 

0.00

 

21,720

 

1,916

 

8.82

 

Total interest-bearing liabilities

 

3,666,546

 

$

89,807

 

2.45

%

2,969,725

 

$

96,965

 

3.27

%

2,581,762

 

$

116,516

 

4.51

%

Other noninterest-bearing liabilities

 

46,393

 

 

 

 

 

48,114

 

 

 

 

 

53,550

 

 

 

 

 

Total liabilities

 

3,712,939

 

 

 

 

 

3,017,839

 

 

 

 

 

2,635,312

 

 

 

 

 

Shareholders’ equity

 

242,219

 

 

 

 

 

184,163

 

 

 

 

 

154,008

 

 

 

 

 

Total liabilities and shareholders’ equity

 

$

3,955,158

 

 

 

 

 

$

3,202,002

 

 

 

 

 

$

2,789,320

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net interest spread

 

 

 

$

124,920

 

3.30

%

 

 

$

100,348

 

3.36

%

 

 

$

84,869

 

3.25

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net interest margin

 

 

 

 

 

3.35

%

 

 

 

 

3.37

%

 

 

 

 

3.27

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Ratio of average interest-earning assets to average interest-bearing liabilities

 

 

 

 

 

101.76

%

 

 

 

 

100.20

%

 

 

 

 

100.51

%

 


(1)  Average balances are computed on a monthly basis.

(2)  The yield information for the available-for-sale portfolio does not give effect to changes in fair value that are reflected as a component of shareholders’ equity.

 

43



 

Changes in Sterling’s NII are a function of changes in both rates and volumes of interest-earning assets and interest-bearing liabilities.  The following table sets forth information regarding changes in Sterling’s interest income and expense for the years indicated.  For each category of interest-earning assets and interest-bearing liabilities, the following table provides information on changes attributable to:

 

                        changes in volume—changes in volume multiplied by comparative period rate;

                        changes in rate—changes in rate multiplied by comparative period volume; and

                        changes in rate/volume—changes in rate multiplied by changes in volume.

 

Interest-earning asset and interest-bearing liability balances used in the calculations represent annual average balances computed using the average of each month’s daily average balance during the years indicated.

 

 

 

December 31, 2003
Increase (Decrease) Due to:

 

December 31, 2002
Increase (Decrease) Due to:

 

 

 

Volume

 

Rate

 

Rate/
Volume

 

Total

 

Volume

 

Rate

 

Rate/
Volume

 

Total

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income on:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loans

 

$

34,071

 

$

(19,720

)

$

(4,218

)

$

10,133

 

$

18,562

 

$

(22,719

)

$

(2,541

)

$

(6,698

)

Asset-backed securities

 

14,288

 

(4,652

)

(1,982

)

7,654

 

10,210

 

(4,243

)

(1,490

)

4,477

 

Investment and cash equivalents

 

157

 

(512

)

(18

)

(373

)

(681

)

(1,311

)

141

 

(1,851

)

Total interest income

 

48,516

 

(24,884

)

(6,218

)

17,414

 

28,091

 

(28,273

)

(3,890

)

(4,072

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest-bearing deposits:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Time deposits

 

3,426

 

(9,520

)

(899

)

(6,993

)

3,829

 

(18,719

)

(1,365

)

(16,255

)

Regular savings and money market accounts

 

3,368

 

(1,717

)

(979

)

672

 

(1,010

)

(3,256

)

334

 

(3,932

)

Interest-bearing demand accounts

 

(71

)

(429

)

20

 

(480

)

655

 

(168

)

(102

)

385

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total deposits

 

6,723

 

(11,666

)

(1,858

)

(6,801

)

3,474

 

(22,143

)

(1,133

)

(19,802

)

FHLB Seattle advances

 

13,729

 

(9,681

)

(3,664

)

384

 

7,559

 

(4,821

)

(1,054

)

1,684

 

All other borrowings

 

2,549

 

(1,471

)

(465

)

613

 

1,361

 

(1,917

)

(293

)

(849

)

Trust Preferred Securities

 

885

 

(1,551

)

(216

)

(882

)

1,261

 

123

 

31

 

1,415

 

Term note payable

 

(87

)

(157

)

12

 

(232

)

400

 

163

 

149

 

712

 

Convertible Subordinated Debt

 

(44

)

0

 

0

 

(44

)

21

 

(33

)

(10

)

(22

)

Floating Rate Notes Due 2006

 

0

 

(196

)

0

 

(196

)

0

 

(773

)

0

 

(773

)

Advances under lines of credit

 

0

 

0

 

0

 

0

 

(1,916

)

0

 

0

 

(1,916

)

Total interest expense

 

23,755

 

(24,722

)

(6,191

)

(7,158

)

12,160

 

(29,401

)

(2,310

)

(19,551

)

Net interest income

 

$

24,761

 

$

(162

)

$

(27

)

$

24,572

 

$

15,931

 

$

1,128

 

$

(1,580

)

$

15,479

 

 

Asset and Liability Management

 

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

 

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

 

44



 

Sterling maintains an asset and liability management program intended to manage NII through interest rate cycles and to protect its NPV by controlling its exposure to changing interest rates.  Sterling uses a simulation model designed to measure the sensitivity of NII and NPV to changes in interest rates. This simulation model is designed to enable Sterling to generate a forecast of NII and NPV given various interest rate forecasts and alternative strategies. The model is also designed to measure the anticipated impact that prepayment risk, basis risk, customer maturity preferences, volumes of new business and changes in the relationship between long-term and short-term interest rates have on the performance of Sterling.  The model calculates the present value of assets, liabilities, off-balance sheet financial instruments, and equity at current interest rates and at hypothetical higher and lower interest rates at various intervals.  The present value of each major category of financial instruments is calculated using estimated cash flows based on weighted-average contractual rates and terms, then discounted at the estimated current market interest rate for similar financial instruments.  The present value of longer term fixed-rate financial instruments is more difficult to estimate because such instruments are susceptible to changes in market interest rates. Present value estimates of adjustable-rate financial instruments are more reliable since they represent the difference between the contractual and discounted rates until the next interest rate repricing date.

 

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

 

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

 

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

 

45



 

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

 

 

 

At December 31, 2003

 

At December 31, 2002

 

Change in
Interest Rate
in Basis Points
(Rate Shock)

 

NPV

 

Ratio of NPV
to the Present
Value of
Total Assets

 

%
Change
in NPV

 

NPV

 

Ratio of NPV
to the Present
Value of
Total Assets

 

%
Change
in NPV

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

+300

 

 

$

232,820

 

5.10

%

(23.3

)

$

233,622

 

6.36

%

4.8

 

+200

 

 

260,054

 

5.66

 

(14.3

)

229,759

 

6.53

 

7.6

 

+100

 

 

285,298

 

6.09

 

(6.0

)

234,577

 

6.67

 

9.9

 

Static

 

 

303,395

 

6.44

 

0.0

 

213,442

 

6.07

 

0.0

 

-100

 

 

270,817

 

5.19

 

(10.8

)

164,741

 

4.68

 

(22.8

)

-200

 

 

        N/A(1)

 

N/A

(1)

N/A

(1)

         N/A(1)

 

N/A

(1)

N/A

(1)

-300

 

 

        N/A(1)

 

N/A

(1)

N/A

(1)

         N/A(1)

 

N/A

(1)

N/A

(1)

 


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

 

Sterling also uses gap analysis, a traditional analytical tool designed to measure the difference between the amount of interest-earning assets and the amount of interest-bearing liabilities expected to mature or reprice in a given period.  Sterling calculated its one-year cumulative gap position to be a negative 6.1% and a positive 5.8% at December 31, 2003 and 2002, respectively.  Sterling calculated its three-year gap position to be a negative 1.0% and a positive 2.8% at December 31, 2003 and 2002, respectively.  The move to a liability-sensitive position was primarily due to restructuring of certain assets and liabilities to offset projected highly asset-sensitive positioning of certain interest-earning assets and interest-bearing liabilities acquired from the merger with Klamath on January 2, 2004. Management attempts to maintain Sterling’s gap position between positive 10% and negative 25%.  At December 31, 2003, Sterling’s gap positions were within limits established by its Board of Directors.  Management is pursuing strategies to increase its NII without significantly increasing its cumulative gap positions in future periods.  There can be no assurance that Sterling will be successful implementing these strategies or that, if these strategies are implemented, they will have the intended effect of increasing its NII.  See “Results of Operations – Net Interest Income” and “Capital.”

 

46



 

The following table sets forth the estimated maturity/repricing and the resulting gap between Sterling’s interest-earning assets and interest-bearing liabilities at December 31, 2003.  Other than loans which are in the held-for-sale portfolio, all of the financial instruments of Sterling are intended to be held to maturity.  The estimated maturity/repricing amounts reflect contractual maturities and amortizations, assumed loan prepayments based upon Sterling’s historical experience, estimates from secondary market sources such as FHLMC and estimated regular savings deposit decay rates (the rate of withdrawals or transfers to higher-yielding CDs).  Management believes these assumptions and estimates are reasonable, but there can be no assurance in this regard.  The classification of mortgage loans, investments and ABS is based upon regulatory reporting formats and, therefore, may not be consistent with the financial information contained elsewhere in this Report on Form 10-K.

 

 

 

Maturity or Repricing

 

 

 

0 to 3
Months

 

Over
3 Months
to 1 Year

 

Over
1 Year
to 3 Years

 

Over
3 Years
to 5 Years

 

Over
5 Years

 

Total

 

 

 

(Dollars in thousands)

 

Interest-earning assets:

 

 

 

 

 

 

 

 

 

 

 

 

 

Mortgage loans and ABS:

 

 

 

 

 

 

 

 

 

 

 

 

 

ARM, balloon mortgage loans and ABS

 

$

711,090

 

$

239,098

 

$

253,084

 

$

146,557

 

$

39,234

 

$

1,389,063

 

Fixed-rate mortgage loans and ABS

 

98,034

 

223,797

 

345,051

 

157,477

 

399,877

 

1,224,236

 

Loans held for sale

 

676

 

1,548

 

3,377

 

2,224

 

6,791

 

14,616

 

Total mortgage loans and ABS

 

809,800

 

464,443

 

601,512

 

306,258

 

445,902

 

2,627,915

 

Commercial and consumer loans:

 

 

 

 

 

 

 

 

 

 

 

 

 

Consumer

 

131,632

 

169,211

 

150,429

 

75,200

 

10,797

 

537,269

 

Commercial

 

543,693

 

78,445

 

135,405

 

46,034

 

16,115

 

819,692

 

Total loans and ABS

 

1,485,125

 

712,099

 

887,346

 

427,492

 

472,814

 

3,984,876

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash and investments

 

56,260

 

736

 

6,814

 

3,892

 

80,811

 

148,513

 

 

 

1,541,385

 

712,835

 

894,160

 

431,384

 

553,625

 

4,133,389

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash on hand and in banks

 

0

 

0

 

0

 

0

 

66,982

 

66,982

 

Other noninterest-earning assets

 

0

 

0

 

0

 

0

 

76,535

 

76,535

 

Total assets

 

$

1,541,385

 

$

712,835

 

$

894,160

 

$

431,384

 

$

697,142

 

$

4,276,906

 

Interest-bearing liabilities:

 

 

 

 

 

 

 

 

 

 

 

 

 

Deposits:

 

 

 

 

 

 

 

 

 

 

 

 

 

Time deposits

 

$

421,050

 

$

461,747

 

$

136,548

 

$

94,353

 

$

69,867

 

$

1,183,565

 

Checking accounts

 

17,328

 

43,427

 

115,805

 

115,805

 

315,288

 

607,653

 

Money market accounts

 

461,857

 

83,750

 

0

 

0

 

0

 

545,607

 

Passbook accounts

 

6,267

 

14,101

 

37,604

 

37,604

 

22,675

 

118,251

 

Total deposits

 

906,502

 

603,025

 

289,957

 

247,762

 

407,830

 

2,455,076

 

FHLB Seattle advances

 

388,967

 

215,000

 

307,342

 

30,661

 

84,061

 

1,026,031

 

Repurchase agreements and funds purchased

 

105,809

 

182,328

 

75,000

 

0

 

0

 

363,137

 

Other borrowings

 

111,583

 

0

 

0

 

0

 

24,000

 

135,583

 

Total interest-bearing liabilities

 

$

1,512,861

 

$

1,000,353

 

$

672,299

 

$

278,423

 

$

515,891

 

$

3,979,827

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other noninterest-bearing liabilities

 

0

 

0

 

0

 

0

 

46,731

 

46,731

 

Shareholders’ equity

 

0

 

0

 

0

 

0

 

250,348

 

250,348

 

Total liabilities and shareholders’ equity

 

$

1,512,861

 

$

1,000,353

 

$

672,299

 

$

278,423

 

$

812,970

 

$

4,276,906

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net gap

 

$

28,524

 

$

(287,518

)

$

221,861

 

$

152,961

 

$

(115,828

)

$

0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cumulative gap

 

$

28,524

 

$

(258,994

)

$

(37,133

)

$

115,828

 

$

0

 

$

0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cumulative gap to total assets

 

0.67

%

(6.06

)%

(0.87

)%

2.71

%

0.00

%

0.00

%

 

47



 

Financial Position

 

Assets.  At December 31, 2003, Sterling’s assets were $4.28 billion, up 22% from $3.51 billion at December 31, 2002.  For a discussion of the potential impact of the Klamath merger on Sterling’s consolidated total assets, see “Business – General – Company Growth.”

 

Investments and ABS.  Sterling’s investment and ABS portfolio at December 31, 2003 was $1.07 billion, an increase of $243.0 million from the December 31, 2002 balance of $830.2 million.  The increase was primarily due to the purchase of additional securities during the period to enhance its NII.

 

Loans Receivable.  At December 31, 2003, net loans receivable were $2.91 billion, up $516.0 million from $2.39 billion at December 31, 2002.  The increase was primarily due to $67.3 million in loans from the Empire transaction, as well as net increases in business and private banking, corporate banking, and residential construction loans.  During the year ended December 31, 2003, total loan originations were $2.27 billion compared with $1.83 billion for the prior year.  The year-over-year increase in net loans receivable and loan originations was influenced by strong loan growth both in the Portland and Seattle Corporate Banking offices, and in the Peterkort Center loan office opened this year just south of Portland.  At December 31, 2003, approximately $239 million in combined loans outstanding were from the Seattle and Portland Corporate Banking offices.  See “Business – Lending Activities – Loan Portfolio Analysis.”

 

BOLI.  BOLI increased to $73.1 million at December 31, 2003 from $59.4 million at December 31, 2002.  The increase was primarily due to the purchase of $10.0 million in BOLI.  Sterling purchases BOLI to fund employee benefit costs.  Through the purchase of BOLI, Sterling becomes the beneficiary of life insurance policies on certain officers who consent to the issuance of the policies.  On January 2, 2004, Sterling recorded an additional $16.3 million of BOLI as a result of the merger with Klamath.

 

Goodwill and Other Intangible Assets.  Goodwill and other intangible assets increased to $48.0 million at December 31, 2003 from $44.0 million at December 31, 2002.  Sterling recorded $1.1 million in goodwill and $3.1 million in other intangible assets in connection with the business combination with Empire.  On January 2, 2004, Sterling recorded approximately $95 million in goodwill and other intangible assets as a result of the merger with Klamath.  See Note 26 of “Notes to Consolidated Financial Statements.”

 

Deposits.  Total deposits increased $441.0 million to $2.46 billion at December 31, 2003 from $2.01 billion at December 31, 2002, primarily due to the acquisition of $184.2 million in deposits from Empire and to increases in money market accounts and time deposits.  See “Business – General – Company Growth.”

 

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

 

 

 

December 31, 2003

 

December 31, 2002

 

 

 

Amount

 

%

 

Amount

 

%

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

Noninterest checking

 

$

306,456

 

12.5

 

$

239,033

 

11.9

 

NOW checking

 

301,197

 

12.3

 

367,391

 

18.2

 

Savings and money market

 

663,858

 

27.0

 

401,339

 

19.9

 

Time deposits

 

1,183,565

 

48.2

 

1,006,333

 

50.0

 

 

 

 

 

 

 

 

 

 

 

Total deposits

 

$

2,455,076

 

100.0

 

$

2,014,096

 

100.0

 

 

 

 

 

 

 

 

 

 

 

Annualized cost of deposits

 

 

 

1.58

%

 

 

2.23

%

 

The shift in the mix of deposits since December 2002 reflects a shift to money market accounts from NOW checking accounts and a strong increase in new business checking deposits.  As of December 31, 2003, the number of business checking accounts had increased by approximately 10% from a year ago.

 

Borrowings.  Deposit accounts are Sterling’s primary source of funds.  Sterling does, however, rely upon advances from the FHLB Seattle, reverse repurchase agreements and other borrowings to supplement its funding and to

 

48



 

meet deposit withdrawal requirements.  At December 31, 2003, the total of such borrowings was $1.52 billion compared with $1.25 billion at December 31, 2002.  See “Liquidity and Capital Resources.”

 

Liquidity and Capital Resources

 

As a financial institution, Sterling’s primary sources of funds are investing and financing activities, including the collection of loan principal and interest payments.  Financing activities consist primarily of customer deposits, advances from FHLB Seattle and other borrowings.  Deposits increased to $2.46 billion at December 31, 2003 from $2.01 billion at December 31, 2002, primarily due to the acquisition of $184.2 million in deposits from Empire and to additional increases in money market accounts and CDs.  The net increase in deposits was primarily used to fund loans, purchase ABS and pay down other borrowings.

 

Sterling Savings Bank actively manages its liquidity in an effort to maintain an adequate margin over the level necessary to support expected and potential loan fundings and deposit withdrawals.  This is balanced with the need to maximize yield on alternative investments.  The liquidity ratio may vary from time to time, depending on economic conditions, savings flows and loan funding needs.

 

During the year ended December 31, 2003, cash used in investing activities consisted primarily of the funding of loans and the purchase of ABS.  The levels of these payments increase or decrease depending on the size of the loan and ABS portfolios and the general trend and level of interest rates, which influences the level of refinancing and mortgage prepayments.  During the same period, cash provided by investing activities consisted primarily of principal payments on loans, proceeds from sales of ABS, principal payments on ABS and cash acquired from the Empire transaction.  During the year ended December 31, 2003, cash provided by operating activities consisted primarily of proceeds from sales of loans.

 

Sterling Savings Bank’s credit line with FHLB Seattle provides for borrowings up to a percentage of its total assets subject to collateralization requirements.  At December 31, 2003, this credit line represented a total borrowing capacity of $1.22 billion, of which $127.0 million was available.  Sterling Savings Bank also borrows on a secured basis from major broker/dealers and financial entities by selling securities subject to repurchase agreements.  At December 31, 2003, Sterling Savings Bank had $360.6 million in outstanding borrowings under reverse repurchase agreements and had securities available for additional secured borrowings of approximately $75.5 million.

 

Sterling, on a parent company-only basis, had cash and other resources of approximately $26.8 million and a revolving line of credit from U.S. Bank of $5.0 million at December 31, 2003 with no funds drawn on this line of credit.  This line of credit as well as a $22.0 million term note are secured by a majority of the Common and Preferred Stock of Sterling Savings Bank.  See Note 11 of “Notes to Consolidated Financial Statements.”

 

At December 31, 2003 and 2002, Sterling had an investment of $110.1 million in the Preferred Stock of Sterling Savings Bank.  At December 31, 2003 and 2002, Sterling had an investment in the Common Stock of Sterling Savings Bank of $132.5 million and $106.2 million, respectively.  Sterling received cash dividends on Sterling Savings Bank Preferred Stock of $11.6 million during the year ended December 31, 2003.  These resources were sufficient to meet the operating needs of Sterling, including interest expense on its long-term debt.  Sterling Savings Bank’s ability to pay dividends is limited by its earnings, financial condition and capital requirements, as well as rules and regulations imposed by the OTS.  See Note 24 of “Notes to Consolidated Financial Statements.”

 

Sterling also borrows funds under reverse repurchase agreements pursuant to which it sells investments (generally U.S. agency securities and ABS) under an agreement to buy them back at a specified price at a later date. These agreements to repurchase are deemed to be borrowings collateralized by the investments and ABS sold. Sterling uses these borrowings to supplement deposit gathering for funding the origination of loans. Sterling had $360.6 million and $249.8 million in wholesale and retail reverse repurchase agreements outstanding at December 31, 2003 and 2002, respectively.  The use of reverse repurchase agreements may expose Sterling to certain risks not associated with other borrowings, including IRR and the possibility that additional collateral may have to be provided if the market value of the pledged collateral declines. For additional information regarding reverse repurchase agreements, see “Management’s Discussion and Analysis – Asset and Liability Management” and Note 10 of “Notes to Consolidated Financial Statements.”

 

49



 

Off-Balance Sheet Arrangements and Aggregate Contractual Obligations

 

The following table represents Sterling’s on-and-off balance sheet aggregate contractual obligations to make future payments as of December 31, 2003.

 

 

 

Payments Due by Period

 

 

 

Total

 

Less than
1 year

 

1 to 3 years

 

Over
3 to 5 years

 

More than
5 years

 

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

 

 

Long-term debt(1)

 

$

130,000

 

$

0

 

$

30,000

 

$

22,000

 

$

78,000

 

Capital lease obligations(2).

 

13,533

 

3,032

 

4,764

 

2,463

 

3,274

 

Operating leases

 

0

 

0

 

0

 

0

 

0

 

Purchase obligations(2), (3).

 

10,911

 

10,810

 

101

 

0

 

0

 

Other long-term liabilities reflected on the registrant’s balance sheet under GAAP

 

0

 

0

 

0

 

0

 

0

 

Total

 

$

154,444

 

$

13,842

 

$

34,865

 

$

24,463

 

$

81,274

 

 


(1)          Excludes interest payments.  See Note 11 of “Notes to Consolidated Financial Statements.”

(2)          Includes payment of certain material merger-related contractual obligations incurred on January 2, 2004.

(3)          Excludes recurring accounts payable amounts due in the first quarter of 2004.

 

Sterling, in the conduct of ordinary business operations routinely enters into contracts for services.  These contracts may require payment for services to be provided in the future and may also contain penalty clauses for the early termination of the contracts.  Sterling is also party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers.  These financial instruments include commitments to extend credit and standby letters of credit.  Management does not believe that these off-balance sheet arrangements have a material current effect on Sterling’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources but there is no assurance that such arrangements will not have a future effect.  See Note 17 of “Notes to Consolidated Financial Statements.”

 

Sterling, through its subsidiary Action Mortgage, enters into rate locks to prospective residential mortgage borrowers.  Traditionally, Action Mortgage has endeavored to hedge the associated IRR by entering into best-efforts forward sales agreements with third parties.  In July 2003, in an effort to improve and protect the profit margin on loans sold into the secondary market, Action Mortgage began hedging IRR by entering into mandatory forward sales agreements on ABS with third parties.

 

The risks inherent in such mandatory forward sales agreements include the risk that, if for any reason Action Mortgage does not close and sell the loans in question, it is nonetheless obligated to deliver ABS to the counterparty on the agreed terms.  Action Mortgage could incur significant costs in acquiring replacement loans or ABS and such costs could have a material adverse impact on mortgage banking operations in future periods, especially in rising interest rate environments.  During the year ended December 31, 2003, Sterling recorded $1.1 million in revenue from forward sales agreements and similar transactions.  This revenue is a component of other gains and losses on sales of loans into the secondary market.

 

Rate locks and forward sales agreements are considered to be derivatives. Sterling has recorded the estimated fair values of the rate locks and forward sales agreements on its balance sheet in either other assets or other liabilities. Changes in the fair values of these derivative instruments are recorded in net gain on sales of mortgage loans in the income statement as the changes occur.  The estimated fair value of rate locks was $85,000 and the estimated fair value of forward sales agreements was $(73,000) at December 31, 2003.

 

50



 

Capital

 

Sterling’s total shareholders’ equity was $250.3 million at December 31, 2003 compared with $203.7 million at December 31, 2002.  The increase in total shareholders’ equity was primarily due to the business combination with Empire and the increase in net income.  Shareholders’ equity was 5.9% of total assets at December 31, 2003 compared with 5.8% at December 31, 2002.

 

Sterling has outstanding various series of Trust Preferred Securities issued to investors.  The Trust Preferred Securities are treated as debt of Sterling.  Although Sterling, as a savings and loan holding company, is not subject to the Federal Reserve capital requirements for bank holding companies, the Trust Preferred Securities have been structured to qualify as Tier 1 capital, subject to certain limitations, if Sterling were to become regulated as a bank holding company.  For a complete description, see Note 11 of “Notes to Consolidated Financial Statements.”

 

Sterling has a variable-rate term note with U.S. Bank with a balance of $22.0 million outstanding at December  31, 2003.  This note matures on September 17, 2007.  Interest accrues at the 30-day LIBOR plus 2.00% and is payable monthly.  Sterling also has a $5.0 million revolving line of credit with U.S. Bank.  This line of credit matures on September 15, 2004.  The interest rate is adjustable monthly at the 30-day LIBOR plus 2.00% and is payable monthly.  At December 31, 2003, no amounts were outstanding on the line of credit.  The term note and line of credit are collateralized by a majority of the Common and Preferred Stock of Sterling Savings Bank.  See Note 11 of “Notes to Consolidated Financial Statements.”

 

Sterling’s $30.0 million of Floating Rate Notes Due 2006 were designed to be treated as Tier 2 capital, subject to certain limitations, if Sterling were to become regulated as a bank holding company.  See Note 11 of “Notes to Consolidated Financial Statements” and “Other Borrowings.”

 

At December 31, 2003, Sterling had an unrealized loss of $15.2 million, net of related income taxes, on investments and ABS classified as available for sale.  At December 31, 2002, Sterling had an unrealized gain of $3.4 million, net of related income taxes, on investments and ABS classified as available for sale.  The change since December 31, 2002 primarily reflects sales of ABS and the recent upward trend in interest rates at the end of the quarter.  Fluctuations in prevailing interest rates continue to cause volatility in this component of accumulated comprehensive income or loss in shareholders’ equity and may continue to do so in future periods.

 

Sterling Savings Bank is required by applicable regulations to maintain certain minimum capital levels with respect to core (Tier 1) capital, core (Tier 1) risk-based capital and total risk-based capital.  Sterling Savings Bank will endeavor to enhance its capital resources and regulatory capital ratios through the retention of earnings and the management of the level and mix of assets, although there can be no assurance in this regard.  At December 31, 2003, Sterling Savings Bank exceeded all such regulatory capital requirements and was “well-capitalized” pursuant to OTS regulations.  See Note 16 of “Notes to Consolidated Financial Statements.”

 

Goodwill Litigation

 

In contracts made in connection with Sterling Savings Bank’s acquisition of three insolvent savings institutions between 1985 and 1988, the U.S. government agreed that Sterling could use $38.0 million of “supervisory goodwill” associated with the acquisitions to help meet its regulatory capital requirements.  In 1989, Congress enacted FIRREA which provided, among other things, that savings institutions such as Sterling Savings Bank were no longer permitted to include supervisory goodwill in their regulatory capital.  Consequently, Sterling Savings Bank was required to discontinue use of its supervisory goodwill in calculating its capital ratios, which resulted in Sterling Savings Bank’s failing to comply with its minimum regulatory capital requirements from 1989 through 1991.

 

In May 1990, Sterling sued the U.S. Government with respect to the loss of the goodwill treatment and other matters relating to Sterling’s past acquisitions of troubled thrift institutions (the “Goodwill Litigation”).  In the Goodwill Litigation, Sterling seeks damages for, among other things, breach of contract and for deprivation of property without just compensation.

 

In September 2002, the U.S. Court of Federal Claims granted Sterling Savings Bank’s motion for summary judgment as to liability on its contract claim, holding that the United States government owed contractual obligations to Sterling with respect to its acquisition of three failing regional thrifts during the 1980’s and had breached its contracts

 

51



 

with Sterling.  Sterling is waiting for a trial date to be set to determine what amount, if any, the government must pay in damages for its breach.  The timing and ultimate outcome of the Goodwill Litigation cannot be predicted with certainty.  Because of the effort required to bring the case to conclusion, Sterling likely will continue to incur legal expenses at recent levels over the next one to two years.

 

New Accounting Policies

 

In December 2003, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 46 (Revised), “Consolidation of Variable Interest Entities” (“FIN No. 46R”), which provides further guidance on the accounting for variable interest entities.  Sterling adopted FIN No. 46R as of December 31, 2003 and Sterling will apply the provisions of FIN No. 46R beginning in the first quarter of 2004.  Following the adoption of FIN No. 46R, Sterling plans to deconsolidate its subsidiary statutory trusts that issue Trust Preferred Securities to investors.  The amounts payable to these trusts will continue to be treated as other borrowings.  Management believes the adoption of FIN No. 46R will not have a material effect on Sterling’s consolidated financial statements.  Sterling’s retained interest in its auto loan securitizations and its investments in commercial mortgage-backed securities will not be consolidated since both transaction structures are exempt from the requirements of FIN No. 46 and FIN No. 46R.  See Notes 1 and 11 of “Notes to Consolidated Financial Statements.”

 

In December 2003, the American Institute of Certified Public Accountants issued Statement of Position (“SOP”) No. 03-3, “Accounting for Certain Loans or Debt Securities Acquired in a Transfer.”  SOP No. 03-3 addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor’s initial investment in loans acquired in a transfer if those differences are attributable, at least in part, to credit quality.  SOP No. 03-3 is effective for loans acquired in fiscal years beginning after December 15, 2004.  Management believes the implementation of SOP No. 03-3 will not have a material effect on Sterling’s consolidated financial statements.

 

In November 2003, the Emerging Issues Task Force (“EITF”) reached a consensus relating to the application of EITF No. 03-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments.”  The new disclosure requirements are part of the EITF’s project to provide guidance on other-than-temporary impairment and its application to debt and equity investments. The requirements apply to investments in debt and marketable equity securities that are accounted for under SFAS No. 115 and to investments by not-for-profit entities accounted for under SFAS No. 124.  The amendment to EITF No. 03-1 is effective for fiscal years ending after December 15, 2003.  Sterling adopted the additional disclosure provisions of the pronouncement.  Management believes the implementation of EITF No. 03-1 did not have a material effect on Sterling’s consolidated financial statements.

 

In May 2003, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.”  SFAS No. 150 establishes standards on the classification and measurement of certain financial instruments with characteristics of both liabilities and equity.  Management believes the implementation of SFAS No. 150 did not have a material effect on Sterling’s consolidated financial statements.

 

In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.”  SFAS No. 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under FASB Statement No. 133, “Accounting for Derivative Instruments and Hedging Activities.”  SFAS No. 149 is effective for all contracts created or modified after June 30, 2003 except for hedging relationships designated after June 30, 2003.  Management believes the implementation of SFAS No. 149 did not have a material effect on Sterling’s consolidated financial statements.

 

Effective December 31, 2002, Sterling adopted the disclosure provisions of FASB interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness to Others” (“FIN No. 45”), which required additional disclosures by a guarantor about its obligations under certain guarantees that it has issued.  Effective January 1, 2003 Sterling adopted the accounting provisions of FIN No. 45, which also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee.  The most significant financial instruments impacted for Sterling are its commercial and standby letters of credit.  The required FIN No. 45 disclosures have been incorporated into Note 17 of “Notes to Consolidated Financial Statements.”  Management believes the implementation of FIN No. 45 did not have a material effect on Sterling’s consolidated financial statements.

 

52



 

Effects of Inflation and Changing Prices

 

A savings institution has an asset and liability structure that is interest-rate sensitive.  As a holder of monetary assets and liabilities, a financial institution’s performance may be significantly influenced by changes in interest rates.  Although changes in the prices of goods and services do not necessarily move in the same direction as interest rates, increases in inflation generally have resulted in increased interest rates, which may have an adverse effect on Sterling’s business.

 

Item 7A.   Quantitative and Qualitative Disclosures About Market Risk

 

For a discussion of Sterling’s market risk, see “Management’s Discussion and Analysis – Asset and Liability Management.”

 

Item 8.   Financial Statements and Supplementary Data

 

The required information is contained on pages F-1 through F-48 of this Form 10-K.

 

Item 9.   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

 

There were no disagreements with Sterling’s independent accountants on accounting and financial disclosures.

 

Item 9A.   Controls and Procedures

 

Disclosure Controls and Procedures

 

Sterling’s management, with the participation of Sterling’s principal executive officer and principal financial officer, has evaluated the effectiveness of Sterling’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this report.  Based on such evaluation, Sterling’s principal executive officer and principal financial officer have concluded that, as of the end of such period, Sterling’s disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by Sterling in the reports that it files or submits under the Exchange Act.

 

Changes in Internal Control Over Financial Reporting

 

There were no changes in Sterling’s internal control over financial reporting that occurred during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, Sterling’s internal control over financial reporting.

 

PART III

 

Item 10.   Directors and Executive Officers of the Registrant

 

In response to this Item, the information set forth in Sterling’s Proxy Statement dated April 1, 2004 under the headings “Board of Directors of Sterling Financial Corporation,” “Executive Officers,” and “Section 16(a) Beneficial Ownership Reporting Compliance” is incorporated herein by reference.

 

Information concerning Sterling’s Audit Committee financial expert is set forth under the caption “Board of Directors of Sterling Financial Corporation - Committees of the Board of Directors” in Sterling’s Proxy Statement and is incorporated herein by reference.

 

Sterling has adopted a Code of Ethics that applies to all Sterling employees and directors, including Sterling’s senior financial officers.  The Code of Ethics is publicly available on Sterling’s website at http://www.sterlingsavingsbank.com.

 

Item 11.   Executive Compensation

 

In response to this Item, the information set forth in the Proxy Statement under the headings “Personnel Committee Report on Executive Compensation” and “Executive Compensation” is incorporated herein by reference.

 

Item 12.   Security Ownership of Certain Beneficial Owners and Management

 

In response to this Item, the information set forth in the Proxy Statement under the heading “Security Ownership of Certain Beneficial Owners and Management” is incorporated herein by reference.

 

Item 13.   Certain Relationships and Related Transactions

 

In response to this Item, the information set forth in the Proxy Statement under the heading “Interest of Directors, Officers and Others in Certain Transactions” is incorporated herein by reference.

 

Item 14.   Principal Accounting Fees and Services

 

In response to this Item, the information set forth in the Proxy Statement under the headings “Ratification of Appointment of Independent Auditors,” “Audit Committee Report,” and “Independent Accountant’s Fees” is incorporated herein by reference.

 

53



 

PART IV

 

Item 15.   Exhibits, Financial Statement Schedules and Reports on Form 8-K

 

(a)

Documents which are filed as a part of this report:

 

 

 

 

1.

Financial Statements:  The required financial statements are contained in pages F-1 through F-48 of this Form 10-K.

 

 

 

 

 

2.

Financial Statement Schedules:  Financial statement schedules have been omitted as they are not applicable or the information is included in the Consolidated Financial Statements.

 

 

 

 

 

3.

Exhibits:

 

Exhibit No.

 

Exhibit

 

 

 

 

2

 

Agreement and Plan of Merger by and between Sterling and Klamath dated as of July 14, 2003.  Filed as Annex A to Sterling’s Registration Statement on Form S-4 dated September 15, 2003 and incorporated by reference herein.

 

 

 

 

 

3.1

 

Restated Articles of Incorporation of Sterling.  Filed as Exhibit 3.1 to Sterling’s report on Form 10-Q filed May 15, 2003 and incorporated by reference herein.

 

 

 

 

 

3.2

 

Amended and Restated Bylaws of Sterling.  Filed as Exhibit 3.3 to Sterling’s Registration Statement on Form S-4 dated December 9, 2002 and incorporated by reference herein.

 

 

 

 

 

4.1

 

Reference is made to Exhibits 3.1 and 3.2.

 

 

 

 

 

4.2

 

Sterling has outstanding certain long-term debt.  None of such debt exceeds ten percent of Sterling’s total assets; therefore, copies of the constituent instruments defining the rights of the holders of such debt are not included as exhibits. Copies of instruments with respect to such long-term debt will be furnished to the Securities and Exchange Commission upon request.

 

 

 

 

 

10.1

 

Klamath 1996 Stock Option Plan.  Filed as Exhibit 99.1 to Sterling’s Form S-8 dated January 9, 2004 and incorporated by reference herein.

 

 

 

 

 

10.2

 

Sterling Financial Corporation 2001 Long-Term Incentive Plan.  Filed as Exhibit A to Sterling’s Proxy Statement in connection with the Annual Meeting of Shareholders held on April 24, 2001 and incorporated by reference herein.

 

 

 

 

 

10.3

 

Sterling Financial Corporation Amended and Restated Deferred Compensation Plan, effective July 1, 1999.  Filed as Exhibit 10.5 to Sterling’s Annual Report on Form 10-K dated February 22, 2000 and incorporated by reference herein.

 

 

 

 

 

10.4

 

Sterling Financial Corporation 1998 Long-Term Incentive Plan.  Filed as Exhibit A to Sterling’s Proxy Statement in connection with the Annual Meeting of Shareholders held on April 28, 1998 and incorporated by reference herein.

 

 

 

 

 

10.5

 

Sterling Savings Bank 1992 Incentive Stock Option Plan.  Filed as Exhibit 10.2 to Sterling’s Form S-4 dated August 28, 1992 and incorporated by reference herein.

 

 

 

 

 

10.6

 

Sterling Savings Bank Employment Savings and Incentive Plan and Trust dated September 21, 1990.  Filed as Exhibit 10.4 to Sterling’s Form S-4 dated August 28, 1992 and incorporated by reference herein.

 

54



 

 

10.7

 

Sterling Financial Corporation and Sterling Savings Bank Supplemental Executive Retirement Plan, filed as Exhibit 10.9 to Sterling’s Annual Report on Form 10-K dated March 21, 2003 and incorporated by reference herein.

 

 

 

 

 

12.1

 

Statement regarding Computation of Return on Average Common Shareholders’ Equity.  Filed herewith.

 

 

 

 

 

12.2

 

Statement regarding Computation of Return on Average Assets.  Filed herewith.

 

 

 

 

 

21

 

List of Subsidiaries of Sterling.  Filed herewith.

 

 

 

 

 

23

 

Consent of BDO Seidman LLP.  Filed herewith.

 

 

 

 

 

31.1

 

Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

 

 

 

 

31.2

 

Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

 

 

 

 

32.1

 

Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

 

 

 

 

32.2

 

Certification of Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

 

 

 

(b)

Reports on Form 8-K.  During the quarter ended December 31, 2003, there were three reports filed on Form 8-K.

 

 

 

 

 

On October 28, 2003, Sterling filed a report on Form 8-K containing a press release announcing Sterling’s results of operations for the quarter ending September 30, 2003.

 

 

 

 

 

On December 9, 2003, Sterling filed a report on Form 8-K containing a press release announcing that its merger with Klamath and the merger of Klamath First Federal Savings and Loan Association with and into Sterling Savings Bank had been approved by the OTS.

 

 

 

 

 

On December 11, 2003, Sterling filed a report on Form 8-K containing a press release announcing that the shareholders of Sterling and Klamath approved the Klamath Merger dated July 14, 2003.

 

 

 

 

(c)

See (a)(3) above for all exhibits filed herewith.

 

 

 

 

(d)

All schedules are omitted as the required information is not applicable or the information is presented in the Consolidated Financial Statements or related notes.

 

55



 

SIGNATURES

 

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

 

STERLING FINANCIAL CORPORATION

 

 

 

March 11, 2004

By

/s/ Harold B. Gilkey

 

 

Harold B. Gilkey

 

 

Chairman of the Board, Chief Executive Officer

 

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

 

 

March 11, 2004

By

/s/ Harold B. Gilkey

 

 

Harold B. Gilkey

 

 

Chairman of the Board, Chief Executive Officer,

 

 

Principal Executive Officer

 

 

 

March 11, 2004

By

/s/ William W. Zuppe

 

 

William W. Zuppe

 

 

President, Chief Operating Officer, Director

 

 

 

March 11, 2004

By

/s/ Daniel G. Byrne

 

 

Daniel G. Byrne

 

 

Senior Vice President – Finance, Assistant Secretary and

 

 

Principal Financial Officer

 

 

 

March 11, 2004

By

/s/ William R. Basom

 

 

William R. Basom

 

 

Vice President, Treasurer and Principal

 

 

Accounting Officer

 

 

 

March 11, 2004

By

/s/ Ned M. Barnes

 

 

Ned M. Barnes, Secretary, Director

 

 

 

March 11, 2004

By

/s/ Rodney W. Barnett

 

 

Rodney W. Barnett, Director

 

 

 

March 11, 2004

By

/s/ Thomas H. Boone

 

 

Thomas H. Boone, Director

 

 

 

March 11, 2004

By

/s/ James P. Fugate

 

 

James P. Fugate, Director

 

 

 

March 11, 2004

By

/s/ Robert D. Larrabee

 

 

Robert D. Larrabee, Director

 

 

 

March 11, 2004

By

/s/ Donald N. Bauhofer

 

 

Donald N. Bauhofer, Director

 

 

 

March 11, 2004

By

/s/ William L. Eisenhart

 

 

William L. Eisenhart, Director

 

56


 

Report of Independent Certified Public Accountants

 

 

The Board of Directors and Shareholders

Sterling Financial Corporation

Spokane, Washington

 

We have audited the accompanying consolidated balance sheets of Sterling Financial Corporation as of December 31, 2003 and 2002 and the related consolidated statements of income, comprehensive income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2003.  These financial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinion on these financial statements based on our audits.

 

We conducted our audits in accordance with auditing standards generally accepted in the United States of America.  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.  An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.  An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Sterling Financial Corporation at December 31, 2003 and 2002, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2003 in conformity with accounting principles generally accepted in the United States of America.

 

 

BDO Seidman, LLP

 

Spokane, Washington

January 30, 2004

 

F-1



 

Sterling Financial Corporation
Consolidated Balance Sheets
December 31, 2003 and 2002
(Dollars in thousands)

 

 

 

2003

 

2002

 

Assets:

 

 

 

 

 

Cash and cash equivalents:

 

 

 

 

 

Interest bearing

 

$

1

 

$

2,525

 

Non-interest bearing and vault

 

65,478

 

75,338

 

Restricted

 

1,504

 

1,526

 

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

 

 

 

 

 

Available for sale

 

1,070,955

 

826,692

 

Held to maturity

 

2,229

 

3,476

 

Loans receivable, net

 

2,906,426

 

2,390,422

 

Loans held for sale

 

14,616

 

22,549

 

Accrued interest receivable

 

16,531

 

14,625

 

Real estate owned, net

 

4,226

 

3,953

 

Office properties and equipment, net

 

54,620

 

47,745

 

Bank-owned life insurance (“BOLI”)

 

73,141

 

59,399

 

Goodwill

 

45,075

 

43,977

 

Other intangible assets

 

2,881

 

0

 

Mortgage servicing rights, net

 

3,500

 

1,680

 

Prepaid expenses and other assets, net

 

15,723

 

13,114

 

Total assets

 

$

4,276,906

 

$

3,507,021

 

 

 

 

 

 

 

Liabilities:

 

 

 

 

 

Deposits

 

$

2,455,076

 

$

2,014,096

 

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

 

1,026,031

 

874,515

 

Securities sold subject to repurchase agreements and funds purchased

 

363,137

 

249,769

 

Other borrowings

 

135,583

 

127,682

 

Cashiers checks issued and payable

 

17,624

 

13,371

 

Borrowers’ reserves for taxes and insurance

 

1,347

 

1,401

 

Accrued interest payable

 

8,223

 

7,410

 

Accrued expenses and other liabilities

 

19,537

 

15,121

 

Total liabilities

 

4,026,558

 

3,303,365

 

 

 

 

 

 

 

Commitments and contingencies (Notes 9, 10, 11, 17 and 18)

 

 

 

 

 

 

 

 

 

 

 

Shareholders’ equity:

 

 

 

 

 

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

 

0

 

0

 

Common stock, $1 par value; 40,000,000 shares authorized; 14,863,917 and 11,958,948 shares issued and outstanding

 

14,864

 

11,959

 

Additional paid-in capital

 

181,382

 

125,177

 

Accumulated other comprehensive income (loss):

 

 

 

 

 

Unrealized gains (losses) on investments and ABS available for sale, net of deferred income taxes of $8,181 and $(1,852)

 

(15,193

)

3,439

 

Retained earnings

 

69,295

 

63,081

 

Total shareholders’ equity

 

250,348

 

203,656

 

Total liabilities and shareholders’ equity

 

$

4,276,906

 

$

3,507,021

 

 

See accompanying summary of significant accounting policies and notes to the consolidated financial statements.

 

F-2



 

Sterling Financial Corporation
Consolidated Statements of Income
For the Years Ended December 31, 2003, 2002 and 2001
(Dollars in thousands, except per share amounts)

 

 

 

2003

 

2002

 

2001

 

Interest income:

 

 

 

 

 

 

 

Loans

 

$

169,411

 

$

159,278

 

$

165,976

 

ABS

 

41,193

 

33,539

 

29,062

 

Investments and cash equivalents

 

4,123

 

4,496

 

6,347

 

Total interest income

 

214,727

 

197,313

 

201,385

 

 

 

 

 

 

 

 

 

Interest expense:

 

 

 

 

 

 

 

Deposits

 

36,831

 

43,632

 

63,434

 

Short-term borrowings

 

11,753

 

8,396

 

8,507

 

Long-term borrowings

 

41,223

 

44,937

 

44,575

 

Total interest expense

 

89,807

 

96,965

 

116,516

 

Net interest income

 

124,920

 

100,348

 

84,869

 

 

 

 

 

 

 

 

 

Provision for losses on loans

 

(10,500

)

(11,867

)

(8,000

)

 

 

 

 

 

 

 

 

Net interest income after provision for losses on loans

 

114,420

 

88,481

 

76,869

 

 

 

 

 

 

 

 

 

Other income (expense):

 

 

 

 

 

 

 

Fees and service charges

 

19,168

 

16,678

 

13,147

 

Mortgage banking operations

 

8,482

 

5,982

 

3,567

 

Loan servicing fees

 

566

 

536

 

1,147

 

Net gains on sales of securities

 

3,694

 

2,925

 

3,746

 

Real estate owned operations

 

(73

)

(126

)

(657

)

BOLI

 

3,742

 

3,280

 

988

 

Charge related to early repayment of debt

 

(1,464

)

0

 

0

 

Other noninterest income (expense)

 

(380

)

(195

)

(917

)

Total other income

 

33,735

 

29,080

 

21,021

 

 

 

 

 

 

 

 

 

Operating expense (Note 19)

 

94,564

 

80,943

 

73,293

 

 

 

 

 

 

 

 

 

Income before income taxes

 

53,591

 

36,618

 

24,597

 

 

 

 

 

 

 

 

 

Income tax benefit (provision):

 

 

 

 

 

 

 

Current

 

(25,558

)

(9,676

)

(9,767

)

Deferred

 

6,880

 

(1,355

)

1,358

 

Total income tax provision

 

(18,678

)

(11,031

)

(8,409

)

 

 

 

 

 

 

 

 

Net income

 

$

34,913

 

$

25,587

 

$

16,188

 

 

 

 

 

 

 

 

 

Earnings per share - basic

 

$

2.40

 

$

1.96

 

$

1.34

 

 

 

 

 

 

 

 

 

Earnings per share - diluted

 

$

2.34

 

$

1.91

 

$

1.31

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding - basic

 

14,533,402

 

13,027,884

 

12,105,546

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding - diluted

 

14,940,108

 

13,432,770

 

12,364,029

 

 

See accompanying summary of significant accounting policies and notes to the consolidated financial statements.

 

F-3



 

Sterling Financial Corporation
Consolidated Statements of Comprehensive Income
For the Years Ended December 31, 2003, 2002 and 2001
(Dollars in thousands)

 

 

 

2003

 

2002

 

2001

 

 

 

 

 

 

 

 

 

Net income

 

$

34,913

 

$

25,587

 

$

16,188

 

Other comprehensive income (loss):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Change in unrealized gains or losses on investments and ABS available for sale, net of reclassification adjustments

 

(28,665

)

12,360

 

(1,596

)

Less deferred income tax benefit (provision)

 

10,033

 

(4,325

)

558

 

 

 

 

 

 

 

 

 

Net other comprehensive income (loss)

 

(18,632

)

8,035

 

(1,038

)

 

 

 

 

 

 

 

 

Comprehensive income

 

$

16,281

 

$

33,622

 

$

15,150

 

 

See accompanying summary of significant accounting policies and notes to the consolidated financial statements.

 

F-4



 

Sterling Financial Corporation
Consolidated Statements of Changes in Shareholders’ Equity
For the Years Ended December 31, 2003, 2002 and 2001
(Dollars in thousands)

 

 

 

 

 

 

 

Additional
Paid-In
Capital

 

Other
Comprehensive
Income (Loss)

 

Retained
Earnings

 

Total
Shareholders’
Equity

 

Common Stock

Shares

 

Amount

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, January 1, 2001

 

8,911,150

 

$

8,911

 

$

78,035

 

$

(3,558

)

$

57,950

 

$

141,338

 

Shares issued upon exercise of stock options

 

137,173

 

137

 

388

 

 

 

 

 

525

 

Shares acquired and retired

 

(89,401

)

(89

)

(357

)

 

 

 

 

(446

)

Shares issued for business combination

 

628,248

 

628

 

8,513

 

 

 

 

 

9,141

 

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

 

 

 

 

 

 

 

(1,038

)

 

 

(1,038

)

10% common stock dividend

 

958,675

 

959

 

11,877

 

 

 

(12,836

)

0

 

Cash paid for fractional shares

 

(1,192

)

(1

)

(17

)

 

 

 

 

(18

)

Net income

 

 

 

 

 

 

 

 

 

16,188

 

16,188

 

Balance, December 31, 2001

 

10,544,653

 

10,545

 

98,439

 

(4,596

)

61,302

 

165,690

 

Shares issued upon exercise of stock options

 

121,246

 

121

 

1,133

 

 

 

 

 

1,254

 

Shares acquired and retired

 

(18,963

)

(19

)

(371

)

 

 

 

 

(390

)

Shares issued upon debt conversion

 

228,305

 

228

 

3,272

 

 

 

 

 

3,500

 

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

 

 

 

 

 

 

 

8,035

 

 

 

8,035

 

10% common stock dividend

 

1,084,646

 

1,085

 

22,723

 

 

 

(23,808

)

0

 

Cash paid for fractional shares

 

(939

)

(1

)

(19

)

 

 

 

 

(20

)

Net income

 

 

 

 

 

 

 

 

 

25,587

 

25,587

 

Balance, December 31, 2002

 

11,958,948

 

11,959

 

125,177

 

3,439

 

63,081

 

203,656

 

Shares issued upon exercise of stock options

 

184,682

 

185

 

1,539

 

 

 

 

 

1,724

 

Shares acquired and retired

 

(23,268

)

(23

)

(478

)

 

 

 

 

(501

)

Shares issued for business combination

 

1,401,370

 

1,401

 

27,817

 

 

 

 

 

29,218

 

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

 

 

 

 

 

 

 

(18,632

)

 

 

(18,632

)

10% common stock dividend

 

1,343,599

 

1,343

 

27,356

 

 

 

(28,699

)

0

 

Cash paid for fractional shares

 

(1,414

)

(1

)

(29

)

 

 

 

 

(30

)

Net income

 

 

 

 

 

 

 

 

 

34,913

 

34,913

 

Balance, December 31, 2003

 

14,863,917

 

$

14,864

 

$

181,382

 

$

(15,193

)

$

69,295

 

$

250,348

 

 

See accompanying summary of significant accounting policies and notes to the consolidated financial statements.

 

F-5



 

Sterling Financial Corporation
Consolidated Statements of Cash Flows
For the Years Ended December 31, 2003, 2002 and 2001
(Dollars in thousands)

 

 

 

2003

 

2002

 

2001

 

 

 

 

 

 

 

 

 

Cash flows from operating activities:

 

 

 

 

 

 

 

Net income

 

$

34,913

 

$

25,587

 

$

16,188

 

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

 

 

 

 

 

 

 

Provisions for losses on loans and real estate owned

 

10,680

 

12,105

 

8,459

 

Stock dividends on FHLB Seattle stock

 

(2,682

)

(2,514

)

(2,616

)

Net gain on sales of loans, investments and ABS

 

(9,412

)

(7,797

)

(6,451

)

Other losses

 

164

 

341

 

971

 

Change in cash surrender value of BOLI

 

(3,742

)

(3,411

)

(988

)

Depreciation and amortization

 

12,271

 

11,050

 

13,207

 

Deferred income tax (provision) benefit

 

6,880

 

(1,355

)

1,358

 

Change in:

 

 

 

 

 

 

 

Accrued interest receivable

 

(1,635

)

677

 

3,826

 

Prepaid expenses and other assets

 

1,375

 

(4,154

)

(811

)

Cashiers checks issued and payable

 

2,318

 

(2,686

)

(1,472

)

Accrued interest payable

 

322

 

(1,843

)

(1,627

)

Accrued expenses and other liabilities

 

(4,804

)

412

 

7,150

 

Proceeds from sales of loans

 

417,880

 

281,024

 

275,717

 

Loans originated for sale

 

(412,162

)

(276,152

)

(273,015

)

Net cash provided by operating activities

 

52,366

 

31,284

 

39,896

 

 

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

 

 

Change in restricted cash

 

22

 

1

 

388

 

Loans funded

 

(2,258,247

)

(1,697,084

)

(848,838

)

Loan principal received

 

1,803,824

 

1,394,767

 

722,201

 

Purchase of investments

 

(6,089

)

(52,422

)

(1,061

)

Proceeds from maturities of investments

 

2,627

 

4,590

 

83,996

 

Proceeds from sales of available-for-sale investments

 

14,881

 

40,430

 

9,953

 

Cash and cash equivalents acquired as part of merger

 

143,631

 

0

 

1,498

 

Purchase of BOLI

 

(10,000

)

(25,000

)

(30,000

)

Purchase of ABS

 

(1,245,335

)

(970,092

)

(751,424

)

Principal payments on ABS

 

279,343

 

253,888

 

117,301

 

Proceeds from sales of ABS

 

694,023

 

598,418

 

334,340

 

Purchase of office properties and equipment

 

(7,442

)

(3,697

)

(2,487

)

Improvements and other changes to real estate owned

 

(282

)

(715

)

211

 

Proceeds from sales and liquidation of real estate owned

 

3,986

 

7,754

 

8,311

 

Net cash used in investing activities

 

(585,058

)

(449,162

)

(355,611

)

 

 

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

 

 

Net change in checking, regular savings and money market deposits

 

$

153,046

 

$

208,859

 

$

69,449

 

Proceeds from issuance of time deposits

 

1,586,006

 

1,255,814

 

952,814

 

Payments for maturing time deposits

 

(1,518,327

)

(1,348,372

)

(960,228

)

Interest credited to deposits

 

36,032

 

44,259

 

65,784

 

Advances from FHLB Seattle

 

635,589

 

358,975

 

198,470

 

Repayment of FHLB Seattle advances

 

(493,526

)

(117,514

)

(96,068

)

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

 

113,368

 

31,220

 

108,223

 

Proceeds from other borrowings

 

54,000

 

0

 

54,000

 

Repayment of other borrowings

 

(46,099

)

(5,000

)

(70,515

)

Payments for fractional shares

 

(30

)

(20

)

(18

)

Proceeds from exercise of stock options, net of repurchases

 

1,223

 

864

 

79

 

Deferred financing costs

 

(732

)

0

 

(764

)

Other

 

(242

)

204

 

(452

)

Net cash provided by financing activities

 

520,308

 

429,289

 

320,774

 

 

 

 

 

 

 

 

 

Net change in cash and cash equivalents

 

(12,384

)

12,209

 

5,059

 

Cash and cash equivalents, beginning of year

 

77,863

 

65,654

 

60,595

 

 

 

 

 

 

 

 

 

Cash and cash equivalents, end of year

 

$

65,479

 

$

77,863

 

$

65,654

 

 

 

 

 

 

 

 

 

Supplemental disclosures:

 

 

 

 

 

 

 

Cash paid during the period for:

 

 

 

 

 

 

 

Interest

 

$

87,928

 

$

95,122

 

$

117,944

 

Income taxes

 

17,976

 

12,175

 

9,080

 

 

 

 

 

 

 

 

 

Non-cash financing and investing activities:

 

 

 

 

 

 

 

Loans converted into real estate owned

 

$

3,124

 

$

7,876

 

$

5,065

 

Common stock dividend

 

28,699

 

23,808

 

12,836

 

Common stock issued upon business combination

 

29,218

 

0

 

9,141

 

Debt converted to common stock

 

0

 

3,500

 

0

 

Financed sale of loans

 

0

 

8,682

 

0

 

 

See accompanying summary of significant accounting policies and notes to the consolidated financial statements.

 

F-6



 

Sterling Financial Corporation
Summary of Significant Accounting Policies
For the Years Ended December 31, 2003, 2002 and 2001

 

Business

 

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

 

Sterling provides personalized, quality financial services to its customers as exemplified by its “Hometown Helpful” philosophy.  Sterling believes that this dedication to personalized service has enabled it to grow both its retail deposit base and its lending portfolio in the Pacific Northwest region.  With $4.28 billion in total assets at December 31, 2003, Sterling attracts Federal Deposit Insurance Corporation insured deposits from the general public through 86 retail branches located in Washington, Oregon, Idaho and Montana.  Sterling originates loans through branch offices as well as Action residential loan production offices in the four-state area and through INTERVEST commercial real estate lending offices in Washington, Oregon and Arizona.  Sterling also markets tax-deferred annuities, mutual funds and other financial products through Harbor and property and casualty insurance coverage in Montana through The Dime Service Corporation, a subsidiary of Sterling Savings Bank.

 

Principles of Consolidation

 

The accompanying consolidated financial statements include the accounts of Sterling and its directly and indirectly wholly owned subsidiaries.  All significant intercompany accounts and transactions have been eliminated in consolidation.

 

Estimates

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods.  Actual results could differ materially from those estimates.  Material estimates that are particularly susceptible to significant changes in the near term relate to the determination of the allowance for loan losses, valuation of investments and ABS, real estate owned and deferred tax assets.

 

Cash and Cash Equivalents

 

Cash equivalents are any highly liquid investments with a remaining maturity of three months or less at the date of purchase.  Cash and cash equivalents are on deposit with other banks and financial institutions in amounts that periodically exceed the federal insurance limit.  Sterling evaluates the credit quality of these banks and financial institutions to mitigate its credit risk.

 

At December 31, 2003 and 2002, Sterling had approximately $339,000 and $183,000, respectively, of uninsured non-interest bearing deposits.  Restricted cash consisted primarily of non-interest bearing deposits maintained as a reserve at the Federal Reserve Bank.

 

F-7



 

Sterling occasionally purchases securities under an agreement to resell substantially identical securities with another institution.  The amounts advanced under this agreement represent short-term loans and are reflected as interest bearing cash equivalents in the consolidated balance sheet.  The securities underlying the agreements are comprised of shares of a mutual fund, which trades primarily in U.S. government securities.

 

Investments and ABS

 

Sterling classifies debt and equity investments and ABS as follows:

 

        Available for Sale. Except for Federal Home Loan Bank of Seattle (“FHLB Seattle”) stock, debt and equity investments and ABS that will be held for indefinite periods of time are classified as available for sale and are carried at market value. Market value is determined using published quotes or other indicators of value as of the close of business on December 31, 2003 and 2002. Unrealized gains and losses are reported, net of deferred income taxes, as a component of accumulated other comprehensive income or loss in shareholders’ equity until realized.

 

FHLB Seattle (class B1) stock may only be redeemed by FHLB Seattle or sold to other member institutions at par.  Therefore, while FHLB stock is classified as “available for sale,” the investment is restricted and is carried at cost.

 

        Held to Maturity. Investments in debt securities that management of Sterling has the intent and ability to hold until maturity are classified as held to maturity and are carried at their remaining unpaid principal balance, net of unamortized premiums or unaccreted discounts.

 

Premiums are amortized and discounts are accreted using the level interest yield method over the estimated remaining term of the underlying security.  Realized gains and losses on sales of investments and ABS are recognized in the statement of income in the period sold using the specific identification method.

 

Loans Receivable

 

Loans receivable that management of Sterling has the intent and ability to -hold for the foreseeable future or until maturity or pay-off are reported at their outstanding principal balance less any unamortized origination and commitment fees, net of direct loan origination costs and an associated allowance for losses on loans.

 

Interest income is recognized over the term of the loans receivable on a level yield basis. The accrual of interest on impaired loans is discontinued when, in management’s opinion, the borrower may be unable to make payments as they become due. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income is subsequently recognized only to the extent cash payments are received.

 

Allowance for Losses on Loans

 

The allowance for loan losses is maintained at a level deemed appropriate by management to adequately provide for known and probable losses and inherent risks in the loan portfolio. Sterling has a systematic methodology for determining an appropriate allowance for loan losses.  The allowance is based upon a number of factors, including prevailing and anticipated economic trends, industry experience, estimated

 

F-8



 

collateral values, management’s assessment of credit risk inherent in the portfolio, delinquency trends, historical loss experience, specific problem loans and other relevant factors.  As a result of changing economic conditions, it is reasonably possible that the amount or adequacy of the allowance for losses on loans could change.

 

Additions to the allowance, in the form of provisions, are reflected in current operating results, while charge-offs to the allowance are made when a loss is determined to have occurred.  Because the allowance for loan losses is based on estimates, ultimate losses may vary from the current estimates.

 

A loan is considered impaired, based on current information and events, if it is probable that Sterling will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement.  Any allowance on impaired loans is generally based on one of three methods.  Impaired loans are measured at either, 1) the present value of expected cash flows at the loan’s effective interest rate, 2) the loan’s observable market price, or 3) the fair value of the collateral of the loan.

 

Loans Held for Sale

 

Loans held for sale are reported at the lower of amortized cost or market value as determined on an aggregate basis.  Any loan that management determines will not be held to maturity is classified as held for sale.  Market value is determined for loan pools of common interest rates using published quotes as of the balance sheet date.  Unrealized losses on loans held for sale are included in the consolidated statements of income in the period that the unrealized loss is identified.

 

Loan Origination and Commitment Fees

 

Loan origination fees, net of direct origination costs, are deferred and recognized as interest income using the level interest yield method or methods that approximate the level yield method over the contractual term of each loan adjusted for actual loan prepayment experience. If the related loan is sold, the remaining net amount, which is part of the basis of the loan, is considered in determining the gain or loss on sale.

 

Loan commitment fees are deferred until the expiration of the commitment period unless management believes there is a remote likelihood that the underlying commitment will be exercised, in which case the fees are amortized to fee income using the straight-line method over the commitment period. If a loan commitment is exercised, the deferred commitment fee is accounted for in the same manner as a loan origination fee. Deferred commitment fees associated with expired commitments are recognized as fee income.

 

Office Properties and Equipment

 

Office properties and equipment are carried at cost less accumulated depreciation and amortization. Depreciation and amortization are computed using the straight-line method over the lesser of the estimated useful lives or the related lease terms of the assets. Expenditures for new properties and equipment and major renewals or betterments are capitalized. Expenditures for repairs and maintenance are charged to expense as incurred. Upon sale or retirement, the cost and related accumulated depreciation are removed from the respective property or equipment accounts, and the resulting gains or losses are reflected in operations.

 

F-9



 

Real Estate Owned

 

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

 

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

 

Goodwill and Other Intangible Assets

 

In January 2002, Sterling adopted SFAS No. 142.  Under SFAS No. 142, goodwill and intangible assets with indefinite lives are no longer amortized, but are tested for impairment at least annually and also in the event of an impairment indicator.  Prior to January 1, 2002, Sterling amortized goodwill and unidentified intangible assets on a straight-line basis over periods ranging from ten to fifteen years.  Intangible assets consisting of core deposit intangibles, with definite lives are amortized over the estimated life of the depositor relationships acquired (generally 8 to 10 years).

 

Mortgage Banking Operations

 

Sterling, through Action and INTERVEST, originates and sells loans and participating interests in loans to provide additional funds for general corporate purposes. Loans and participating interests therein are held for sale and are carried at the lower of cost or market value. Sterling recognizes a gain or loss on these loan sale transactions, which include a component reflecting the differential between the contractual interest rate of the loan and the interest rate, which will be received by the investor. The present value of the estimated future profit for servicing the loans, together with the normal servicing fee rate and changes in the fair value of any derivatives, is taken into account in determining the amount of gain or loss on the sale of loans.

 

At December 31, 2003 and 2002, mortgage-servicing rights were approximately $3.5 million and $1.7 million, respectively, which are net of accumulated amortization of approximately $2.2 million and $1.5 million, respectively. The cost of mortgage servicing rights is amortized in proportion to, and over the period of, estimated net servicing revenues. Impairment of mortgage servicing rights is assessed based on the fair value of those rights. Fair values are estimated using discounted cash flows based on a current market interest rate. For purposes of measuring impairment, the rights are stratified based primarily on prepayment and interest rate risks. The amount of impairment recognized is the amount by which the capitalized mortgage servicing rights for a stratum exceeds their fair value.

 

Income Taxes

 

Sterling accounts for income taxes using the liability method, which requires that deferred tax assets and liabilities be determined based on the temporary differences between the financial statement carrying amounts and tax basis of assets and liabilities and tax attributes using enacted tax rates in effect in the years in which the temporary differences are expected to reverse.

 

F-10



 

Earnings Per Share

 

Earnings per share - basic is computed by dividing net income by the weighted average number of shares outstanding during the period.  Earnings per share - diluted is computed by dividing net income adjusted for interest expense, net of tax, on convertible subordinated debt by the weighted average number of shares outstanding increased by the additional shares that would have been outstanding if all potentially dilutive shares had been issued.

 

Stock-Based Compensation

 

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

 

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

 

 

 

Years Ended December 31,

 

 

 

2003

 

2002

 

2001

 

 

 

 

 

 

 

 

 

Reported net income:

 

$

34,913

 

$

25,587

 

$

16,188

 

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

 

0

 

0

 

0

 

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

 

(2,486

)

(1,546

)

(804

)

Pro forma net income

 

$

32,427

 

$

24,041

 

$

15,384

 

 

 

 

 

 

 

 

 

Basic earnings per share:

 

 

 

 

 

 

 

Reported earnings per share

 

$

2.40

 

$

1.96

 

$

1.34

 

Stock-based employee compensation, fair value

 

(0.17

)

(0.12

)

(0.07

)

Pro forma earnings per share

 

$

2.23

 

$

1.84

 

$

1.27

 

 

 

 

 

 

 

 

 

Diluted earnings per share:

 

 

 

 

 

 

 

Reported earnings per share

 

$

2.34

 

$

1.91

 

$

1.31

 

Stock-based employee compensation, fair value

 

(0.17

)

(0.12

)

(0.07

)

Pro forma earnings per share

 

$

2.17

 

$

1.79

 

$

1.24

 

 

F-11



 

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for grants in the periods above: dividend yield of 0% in each period, expected stock price volatility of 85% to 132% each period, risk-free interest rates of 2.86% to 6.52% and expected lives of four to ten years.

 

Comprehensive Income

 

Sterling has adopted Statement of Financial Accounting Standards No. 130, “Reporting Comprehensive Income” (“SFAS No. 130”).  SFAS No. 130 establishes standards for reporting and display of comprehensive income and its components (revenues, expenses, gains and losses) in a full set of general-purpose financial statements.

 

Reclassification adjustments, representing the net (gains) losses on available-for-sale securities that were realized during the period, net of related deferred income taxes, were as follows (in thousands):

 

 

 

Amount

 

 

 

 

 

Year ended December 31, 2003

 

$

(2,046

)

Year ended December 31, 2002

 

3,291

 

Year ended December 31, 2001

 

(804

)

 

These (gains) losses had previously been included in other comprehensive income as unrealized (gains) losses on investments and ABS available for sale.

 

Hedging Activities

 

Sterling recognizes all derivatives as either assets or liabilities in the balance sheet and measures those instruments at fair value.  Changes in the fair value of the derivatives are reported in either earnings or other comprehensive income (loss), depending on the use of the derivative and whether or not it qualifies for hedge accounting.

 

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

 

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

 

F-12



 

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

 

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

 

Rate locks and forward sales agreements are considered to be derivatives.  Sterling has recorded the estimated fair values of the rate locks and forward sales agreements on its balance sheet in either other assets or other liabilities.  The estimated fair value of rate locks was $84,000 and the estimated fair value of forward sales agreements was $(73,000) at December 31, 2003.  Changes in the fair values of these derivative instruments are recorded in net gain on sales of mortgage loans in the income statement as the changes occur.  During the year ended December 31, 2003, Sterling recorded $1.1 million in revenue from forward sales agreements and similar transactions.  This revenue is a component of other gains and losses on sales of loans into the secondary market.

 

Reclassifications

 

Certain amounts in the 2002 and 2001 financial statements have been reclassified to conform to the current year’s presentation. These reclassifications had no effect on retained earnings or net income as previously reported.

 

Other Accounting Pronouncements

 

In December 2003, the FASB issued FIN No. 46R, “Consolidation of Variable Interest Entities,” which provides further guidance on the accounting for variable interest entities.  As permitted by FIN No. 46R, Sterling applied the provisions of FIN No. 46 as of December 31, 2003.  Sterling will adopt the provisions of FIN No. 46R in the first quarter 2004.  Sterling plans to deconsolidate its subsidiary statutory trusts that issue Trust Preferred Securities to investors.  The amounts payable to these trusts will continue to be treated as other borrowings.  Sterling believes the adoption of FIN No. 46R in the first quarter of 2004 will not have a material effect on Sterling’s consolidated financial statements.  Sterling’s retained interest in its auto loan securitizations and its investments in commercial mortgage-backed securities will not be consolidated since both transaction structures are exempt from the requirements of FIN No. 46 and FIN No. 46R (see Notes 1 and 11).

 

In December 2003, the AICPA issued SOP No. 03-3, “Accounting for Certain Loans or Debt Securities Acquired in a Transfer.”  SOP No. 03-3 addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor’s initial investment in loans acquired in a transfer if those

 

F-13



 

differences are attributable, at least in part, to credit quality.  SOP No. 03-3 is effective for loans acquired in fiscal years beginning after December 15, 2004.  Sterling believes the implementation of SOP No. 03-3 will not have a material effect on Sterling’s consolidated financial statements.

 

In November 2003, the EITF reached a consensus relating to the application of EITF No. 03-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments.”  The new disclosure requirements are part of the EITF’s project to provide guidance on other-than-temporary impairment and its application to debt and equity investments. The requirements apply to investments in debt and marketable equity securities that are accounted for under SFAS No. 115 and to investments by not-for-profit entities accounted for under SFAS No. 124.  The amendment to EITF No. 03-1 is effective for fiscal years ending after December 15, 2003.  Sterling adopted the additional disclosure provisions of the pronouncement.

 

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.”  SFAS No. 150 establishes standards on the classification and measurement of certain financial instruments with characteristics of both liabilities and equity.  The adoption of SFAS No. 150 in 2003 did not have a material effect on Sterling’s consolidated financial statements.

 

Effective December 31, 2002, Sterling adopted the disclosure provisions of FIN No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness to Others,” which required additional disclosures by a guarantor about its obligations under certain guarantees that it has issued.  Effective January 1, 2003, Sterling adopted the accounting provisions of FIN No. 45, which also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee.  The most significant financial instruments impacted for Sterling are its commercial and standby letters of credit.  The required FIN No. 45 disclosures have been incorporated into Note 17, “Commitments and Contingent Liabilities.”  The adoption of FIN No. 45 did not have a material effect on Sterling’s consolidated financial statements.

 

F-14



 

Sterling Financial Corporation
Notes to Consolidated Financial Statements
For the Years Ended December 31, 2003, 2002 and 2001

 

1. Investments and ABS:

 

The carrying and fair values of investments and ABS are summarized as follows (in thousands):

 

 

 

Available for Sale

 

 

 

Amortized
Cost

 

Gross
Unrealized
Gains

 

Gross
Unrealized
Losses

 

Carrying/
Fair Value

 

 

 

 

 

 

 

 

 

 

 

December 31, 2003

 

 

 

 

 

 

 

 

 

U.S. Government and agency obligations

 

$

13,143

 

$

202

 

$

(12

)

$

13,333

 

FHLB Seattle stock (restricted)

 

51,261

 

0

 

0

 

51,261

 

Municipal bonds

 

3,907

 

150

 

(1

)

4,056

 

Mortgage-backed securities (“MBS”)

 

1,005,540

 

1,771

 

(24,354

)

982,957

 

Retained residual interests from securitization

 

723

 

56

 

0

 

779

 

Other

 

19,755

 

0

 

(1,186

)

18,569

 

Total

 

$

1,094,329

 

$

2,179

 

$

(25,553

)

$

1,070,955

 

 

 

 

 

 

 

 

 

 

 

December 31, 2002

 

 

 

 

 

 

 

 

 

U.S. Government and agency obligations

 

$

13,185

 

$

481

 

$

0

 

$

13,666

 

FHLB Seattle stock (restricted)

 

42,213

 

0

 

0

 

42,213

 

MBS

 

734,634

 

7,539

 

(146

)

742,027

 

Retained residual interests from securitization

 

1,477

 

0

 

(18

)

1,459

 

Other

 

29,893

 

90

 

(2,656

)

27,327

 

Total

 

$

821,402

 

$

8,110

 

$

(2,820

)

$

826,692

 

 

 

 

Held to Maturity

 

 

 

Amortized
Cost/
Carrying
Value

 

Gross
Unrealized
Gains

 

Gross
Unrealized
Losses

 

Fair Value

 

 

 

 

 

 

 

 

 

 

 

December 31, 2003

 

 

 

 

 

 

 

 

 

Municipal bonds

 

$

2,229

 

$

154

 

$

0

 

$

2,383

 

 

 

 

 

 

 

 

 

 

 

December 31, 2002

 

 

 

 

 

 

 

 

 

Municipal bonds

 

$

3,352

 

$

189

 

$

0

 

$

3,541

 

MBS

 

124

 

8

 

0

 

132

 

Total

 

$

3,476

 

$

197

 

$

0

 

$

3,673

 

 

At December 31, 2003 and 2002, accrued interest on investments and ABS was $4.6 million and $4.1 million, respectively.

 

F-15



 

During the years ended December 31, 2003, 2002 and 2001, Sterling sold available-for-sale investments and ABS which resulted in the following (in thousands):

 

 

 

Proceeds
from Sales

 

Gross
Realized
Gains

 

Gross
Unrealized
Losses

 

 

 

 

 

 

 

 

 

Year ended December 31, 2003

 

$

708,904

 

$

4,590

 

$

896

 

Year ended December 31, 2002

 

638,848

 

3,797

 

872

 

Year ended December 31, 2001

 

344,293

 

3,746

 

0

 

 

At December 31, 2003, the amortized cost and fair value of available-for-sale and held-to-maturity debt securities, by contractual maturity (in thousands), are shown below.  Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

 

 

Amortized
Cost

 

Fair Value

 

Available-for-sale MBS:

 

 

 

 

 

After five years through ten years

 

$

93,364

 

$

92,472

 

After ten years

 

912,176

 

890,485

 

 

 

$

1,005,540

 

$

982,957

 

Available-for-sale U.S. Government and agency obligations:

 

 

 

 

 

Under one year

 

$

5,000

 

$

4,988

 

After one year through five years

 

8,143

 

8,345

 

 

 

$

13,143

 

$

13,333

 

Available-for-sale municipal bonds:

 

 

 

 

 

Under one year

 

$

500

 

$

512

 

After one year through five years

 

570

 

580

 

After five through ten years

 

967

 

1,005

 

After ten years

 

1,870

 

1,959

 

 

 

$

3,907

 

$

4,056

 

Held-to-maturity municipal bonds:

 

 

 

 

 

Under one year

 

$

236

 

$

244

 

After one year through five years

 

1,993

 

2,139

 

 

 

$

2,229

 

$

2,383

 

Available-for-sale residual interests from securitization:

 

 

 

 

 

After one year through five years

 

$

723

 

$

779

 

 

 

 

 

 

 

Other available-for-sale securities:

 

 

 

 

 

After five through ten years

 

$

54

 

$

54

 

After ten years

 

70,962

 

69,776

 

 

 

$

71,016

 

$

69,830

 

 

F-16



 

Pursuant to EITF No. 03-1, the following table summarizes Sterling’s gross unrealized losses on temporarily impaired investments and ABS (in thousands):

 

 

 

Held less than 12 months

 

Held 12 months or longer

 

Total

 

 

 

Market Value

 

Unrealized
Losses

 

Market Value

 

Unrealized
Losses

 

Market
Value

 

Unrealized
Losses

 

U.S. Government and agency obligations

 

$

4,988

 

$

(12

)

$

0

 

$

0

 

$

4,988

 

$

(12

)

Trust preferred securities

 

0

 

0

 

13,738

 

(1,186

)

13,738

 

(1,186

)

Municipal bonds

 

24

 

(1

)

0

 

0

 

24

 

(1

)

MBS

 

784,203

 

(24,181

)

0

 

0

 

784,203

 

(24,181

)

Collateralized mortgage obligations

 

46,262

 

(173

)

0

 

0

 

46,262

 

(173

)

Total

 

$

835,477

 

$

(24,367

)

$

13,738

 

$

(1,186

)

$

849,215

 

$

(25,553

)

 

Sterling’s investment and ABS portfolio is managed to provide and maintain liquidity, maintain a balance of high quality diversified investments to minimize risk, provide collateral for pledging and maximize returns.  Management believes all unrealized losses as of December 31, 2003 to be market driven, with no permanent sector or issuer credit concerns or impairments.  As such, Sterling’s investments and ABS are believed to be temporarily, not permanently, impaired in value.

 

Sterling measures the impact of potential interest rate movements on both the balance sheet and the income statement as part of its regular asset and liability management process, and makes investment strategy decisions based upon consideration of both.  As interest rate cycles can take many years to complete, substantial unrealized losses may be reflected on the balance sheet, while offsetting improvements in valuations of liabilities used for funding sources are not.

 

At December 31, 2003 and 2002, U.S. government and agency obligations and ABS with an aggregate fair value of $71.4 million and $36.4 million, respectively, were pledged as collateral for the treasury tax and loan account in accordance with Federal Reserve Board regulations or for wholesale public funds deposits in accordance with Washington, Oregon and Montana state laws and regulations. Additionally, Sterling periodically utilizes ABS as collateral for reverse repurchase agreements and other borrowing transactions (see Notes 9 and 10).

 

In December 2000, Sterling securitized and sold approximately $93.3 million in automobile loans. In the securitization, Sterling retained servicing responsibilities and certain subordinated interests. Sterling receives annual servicing fees approximating 0.5 percent of the outstanding principal balance and rights to future cash flows arising after the investors in the securitization trust have received the return for which they are contracted. The investors and the securitization trust have no recourse to Sterling’s other assets for failure of debtors to pay when due. Sterling must, however, repurchase any loans as to which there has been a breach of any

 

F-17



 

representation or warranty made at the time of sale.  Sterling’s retained and residual interests are subordinate to investor’s interests. The value of the retained and residual interest is subject to credit, prepayment, and interest rate risks on the transferred financial interests.

 

During 2003 and 2002, Sterling wrote down the value of the retained and residual interests by $421,000 and $718,000, respectively, due to higher than projected prepayment rates on the automobile securitization.  At December 31, 2003 and 2002, the residual interest balance was $0.7 million and $1.5 million, respectively.

 

Market prices are used to determine retained interest fair values when readily available.  However, quotes are generally not available for retained interests, so Sterling estimates fair value based on the present value of future expected cash flows using management’s best estimates of certain key assumptions including credit losses, prepayment speeds, forward yield curves and discount rates commensurate with the risks involved.  Retained interests have been valued using a discounted cash flow methodology.

 

Key economic assumptions used in measuring both the retained, unrated residual interest and the interest-only strip were as follows:

 

 

 

December 31,

 

 

 

2003

 

2002

 

 

 

 

 

 

 

Prepayment speed (annual rate)

 

42.00

%

57.70

%

Weighted-average life (in years)

 

1.48

 

1.44

 

Expected annualized credit losses

 

2.90

%

0.81

%

Discount rate

 

11.95

%

11.95

%

 

Static pool losses are calculated by summing the actual and projected future credit losses and dividing them by the original balance of each pool of assets.  Actual and projected credit losses are 0.43%, 0.21% and 0.01% for the years ending December 31, 2003, 2004 and 2005, respectively. Actual credit losses that are substantially larger than projected may adversely impact the calculated value of the retained residual values.

 

F-18



 

2. Loans Receivable:

 

The components of loans receivable are as follows (in thousands):

 

 

 

December 31,

 

 

 

2003

 

2002

 

Real estate loans:

 

 

 

 

 

Variable rate:

 

 

 

 

 

1-4 unit residential

 

$

73,496

 

$

57,580

 

5 or more unit residential

 

134,559

 

112,350

 

Commercial

 

416,466

 

389,069

 

Land and other

 

330

 

501

 

Fixed rate:

 

 

 

 

 

Conventional 1-4 unit residential

 

328,339

 

295,278

 

1-4 unit residential, insured by FHA/VA

 

1,236

 

2,137

 

5- and 7-year balloon or reset 1-4 unit residential

 

3,663

 

2,145

 

5 or more unit residential

 

32,661

 

49,197

 

Commercial

 

46,395

 

69,226

 

Land and other

 

1,265

 

1,135

 

Construction:

 

 

 

 

 

1-4 unit residential

 

271,480

 

280,514

 

5 or more unit residential

 

127,424

 

96,297

 

Commercial

 

154,061

 

104,108

 

 

 

1,591,375

 

1,459,537

 

Other loans:

 

 

 

 

 

Commercial loans

 

885,323

 

606,812

 

Commercial and personal lines of credit

 

157,183

 

124,798

 

Consumer loans

 

315,426

 

233,591

 

 

 

1,357,932

 

965,201

 

Total loans receivable

 

2,949,307

 

2,424,738

 

Deferred loan fees, net of direct origination costs

 

(7,276

)

(6,450

)

Gross loans receivable

 

2,942,031

 

2,418,288

 

Allowance for losses on loans

 

(35,605

)

(27,866

)

Loans receivable, net

 

$

2,906,426

 

$

2,390,422

 

Weighted average interest rate

 

5.71

%

6.39

%

 

Accrued interest on loans receivable was approximately $13.6 million and $10.5 million at December 31, 2003 and 2002, respectively.

 

Sterling originates the majority of its loans throughout the Pacific Northwest.  Loans originated outside this area are primarily for immediate sale into the secondary market.  The value of real estate properties in this region is affected by changes in the economic environment.  It is reasonably possible that these values could change in the near term, which may adversely affect Sterling’s estimate of its allowance for losses on loans associated with these loans receivable.

 

F-19



 

Sterling originates both variable and fixed-rate loans. The variable-rate loans have interest rate adjustment limitations and are generally indexed to various indices. Variable-rate real estate loans are typically indexed to the prime rate, one-year or five-year U.S. Treasury index, or periodic fixed-rate LIBOR swap curve. Future market factors may affect the correlation of the interest rates Sterling pays on the short-term deposits that have been primarily utilized to fund these loans.

 

At December 31, 2003, the contractual principal payments due on outstanding loans receivable (in thousands) are shown below. Actual payments may differ from expected payments because borrowers have the right to prepay loans, with or without prepayment penalties.

 

Years Ending December 31,

 

Amount

 

 

 

 

 

2004

 

$

1,010,307

 

2005

 

305,708

 

2006

 

197,042

 

2007

 

135,068

 

2008

 

151,215

 

Thereafter

 

1,149,967

 

 

 

$

2,949,307

 

 

3. Loan Servicing:

 

Loans serviced for others are not included in the consolidated balance sheets. The unpaid principal balances of these loans as of the dates indicated are summarized as follows (in thousands):

 

 

 

December 31,

 

 

 

2003

 

2002

 

2001

 

Loan portfolios serviced for:

 

 

 

 

 

 

 

FHLMC

 

$

184,931

 

$

116,254

 

$

96,361

 

FNMA

 

143,157

 

81,998

 

102,474

 

FHLB

 

1,317

 

0

 

0

 

Other residential permanent

 

205

 

365

 

2,174

 

Commercial real estate

 

211,539

 

239,871

 

214,536

 

Consumer

 

25,927

 

54,364

 

51,046

 

 

 

$

567,076

 

$

492,852

 

$

466,591

 

 

Custodial escrow balances maintained in connection with loans serviced for others were approximately $1.7 million and $1.2 million at December 31, 2003 and 2002, respectively.

 

F-20



 

The following is an analysis of the changes in mortgage servicing rights (in thousands):

 

 

 

Amount

 

 

 

 

 

Balance, January 1, 2001

 

$

349

 

Additions

 

1,596

 

Amortization

 

(307

)

Balance, December 31, 2001

 

1,638

 

Additions

 

1,135

 

Amortization

 

(645

)

Net write-down

 

(448

)

Balance, December 31, 2002

 

1,680

 

Additions

 

2,553

 

Amortization

 

(1,113

)

Net write-up

 

380

 

Balance, December 31, 2003

 

$

3,500

 

 

Sterling has sold participations in certain commercial real estate loans to investors on a servicing retained basis. During the years ended December 31, 2003, 2002 and 2001, Sterling sold approximately $35.9 million, $65.1 million and $51.5 million in commercial real estate loans under participation agreements, resulting in net gains of $328,000, $618,000 and $380,000, respectively.

 

4. Real Estate Owned:

 

The components of real estate owned are as follows (in thousands):

 

 

 

December 31,

 

 

 

2003

 

2002

 

 

 

 

 

 

 

Commercial

 

$

3,118

 

$

2,499

 

Residential

 

674

 

729

 

Construction

 

224

 

652

 

Other

 

213

 

312

 

 

 

4,229

 

4,192

 

Allowance for losses

 

(3

)

(239

)

 

 

 

 

 

 

Real estate owned, net

 

$

4,226

 

$

3,953

 

 

F-21



 

5. Allowances for Losses on Loans and Real Estate Owned:

 

The following is an analysis of the changes in the allowances for losses on loans and real estate owned (in thousands):

 

 

 

Loans

 

Real Estate
Owned

 

Total

 

 

 

 

 

 

 

 

 

Balance, January 1, 2001

 

$

16,740

 

$

406

 

$

17,146

 

Provision

 

8,000

 

459

 

8,459

 

Amounts written off

 

(4,597

)

(346

)

(4,943

)

Recoveries

 

456

 

0

 

456

 

Balance, December 31, 2001

 

20,599

 

519

 

21,118

 

Provision

 

11,867

 

238

 

12,105

 

Amounts written off

 

(5,053

)

(518

)

(5,571

)

Recoveries

 

453

 

0

 

453

 

Balance, December 31, 2002

 

27,866

 

239

 

28,105

 

Provision

 

10,500

 

180

 

10,680

 

Allowance for losses on assets acquired

 

870

 

0

 

870

 

Amounts written off

 

(4,253

)

(416

)

(4,669

)

Recoveries

 

622

 

0

 

622

 

Balance, December 31, 2003

 

$

35,605

 

$

3

 

$

35,608

 

 

The following is a summary of loans that are not performing in accordance with their original contractual terms (in thousands):

 

 

 

December 31,

 

 

 

2003

 

2002

 

 

 

 

 

 

 

Non-accrual loans (1)

 

$

16,208

 

$

16,278

 

Restructured loans (2)

 

1,164

 

594

 

Total impaired loans

 

$

17,372

 

$

16,872

 

 


(1)                                  The total allowance for losses on loans related to these loans was $2.9 million and $2.1 million at December 31, 2003 and 2002, respectively.  Interest income of $1,025,000, $1,103,000 and $707,000 was recorded during the years ended December 31, 2003, 2002 and 2001, respectively, in connection with such loans.  For loans on non-accrual status at period end, additional gross interest income of $1,487,000, $778,00 and $762,000 would have been recorded during the years ended December 31, 2003, 2002 and 2001, respectively, if non-accrual and restructured loans had been current in accordance with their original contractual terms.

 

The average recorded investment in impaired loans during the years ended December 31, 2003, 2002 and 2001, was $22.3 million, $18.4 million and $10.9 million, respectively.

 

F-22



 

(2)                                  Restructured loans occur when Sterling has agreed to compromise the contractual loan terms to provide a reduction in the rate of interest and, in most instances, an extension of payments of principal or interest, or both, because of deterioration in the financial position of the borrower. Restructured loans performing in accordance with their new terms are not included in non-accrual loans unless there is uncertainty as to the ultimate collection of principal or interest.

 

6. Office Properties and Equipment:

 

The components of office properties and equipment are as follows (in thousands):

 

 

 

December 31,

 

Estimated
Useful Life

 

2003

 

2002

 

 

 

 

 

 

 

 

Buildings and improvements

 

$

42,505

 

$

39,585

 

20-40 years

 

Furniture, fixtures, equipment and computer software

 

35,169

 

28,307

 

3-10 years

 

Leasehold improvements

 

4,246

 

3,607

 

5-20 years

 

Automobiles

 

145

 

65

 

3-5 years

 

 

 

82,065

 

71,564

 

 

 

Less accumulated depreciation and amortization

 

(36,014

)

(31,761

)

 

 

 

 

46,051

 

39,803

 

 

 

Land

 

8,569

 

7,942

 

 

 

Total office properties and equipment

 

$

54,620

 

$

47,745

 

 

 

 

7. Goodwill and Other Intangible Assets:

 

Sterling has goodwill and core deposit intangible assets, which were recorded in connection with the acquisition of certain business combinations.  The value of the core deposit intangibles are amortized over the estimated useful life of the deposit relationship.  At December 31, 2003 and 2002, the net carrying value of core deposit intangibles was $2.9 million and $0 million, respectively. Amortization expense related to core deposit intangibles for the years ended December 31, 2003, 2002 and 2001, was $262,000, $644,000 and $1.5 million, respectively.

 

Prior to January 1, 2002, Sterling amortized goodwill over periods up to 15 years.  Upon the implementation of SFAS No. 142 on January 1, 2002, Sterling ceased amortization of goodwill, which resulted in the reduction of expenses, net of taxes of approximately $2.5 million.  SFAS No. 142 requires Sterling to test its goodwill for impairment at least annually.  Sterling tested its goodwill and found no impairment during 2003 and 2002.  Goodwill has been allocated to the Community Banking segment of Sterling.

 

F-23



 

The changes in the carrying value of goodwill for the years ended December 31, 2003 and 2002 are as follows (in thousands):

 

 

 

Amount

 

 

 

 

 

Balance as of January 1, 2002

 

$

43,977

 

Goodwill acquired during the year

 

0

 

Impairment losses

 

0

 

Goodwill written off to sale of business unit

 

0

 

Balance as of January 1, 2003

 

43,977

 

Goodwill acquired during the year

 

1,098

 

Impairment losses

 

0

 

Goodwill written off to sale of business unit

 

0

 

 

 

$

45,075

 

 

In accordance with SFAS No. 142, the effect of this accounting change is reflected prospectively.  Comparative disclosure as if the changes had been retroactively applied to the prior years is as follows (in thousands, except per share amounts):

 

 

 

2003

 

2002

 

2001

 

 

 

 

 

 

 

 

 

Reported net income

 

$

34,913

 

$

25,587

 

$

16,188

 

Add back:  goodwill amortization, net of tax

 

0

 

0

 

2,538

 

Total

 

$

34,913

 

$

25,587

 

$

18,726

 

 

 

 

 

 

 

 

 

Basic earnings per share:

 

 

 

 

 

 

 

Reported net income

 

$

2.40

 

$

1.96

 

$

1.34

 

Goodwill amortization

 

0.00

 

0.00

 

0.21

 

Adjusted earnings per share

 

$

2.40

 

$

1.96

 

$

1.55

 

 

 

 

 

 

 

 

 

Diluted earnings per share:

 

 

 

 

 

 

 

Reported net income

 

$

2.34

 

$

1.91

 

$

1.31

 

Goodwill amortization

 

0.00

 

0.00

 

0.21

 

Adjusted earnings per share

 

$

2.34

 

$

1.91

 

$

1.52

 

 

F-24



 

8. Deposits:

 

The components of deposits and applicable yields are as follows (in thousands):

 

 

 

December 31,

 

 

 

2003

 

2002

 

Transaction accounts:

 

 

 

 

 

NOW checking, 0.10%

 

$

301,197

 

$

367,391

 

Commercial checking

 

306,456

 

239,033

 

Total transaction accounts

 

607,653

 

606,424

 

 

 

 

 

 

 

Savings accounts:

 

 

 

 

 

Regular savings, 0.40% to 0.50%

 

118,251

 

89,474

 

Money market demand, 0.10% to 0.75%

 

545,607

 

311,865

 

Total savings accounts

 

663,858

 

401,339

 

 

 

 

 

 

 

Time deposit accounts:

 

 

 

 

 

Up to 1.99%

 

787,104

 

313,628

 

2.00 to 2.99%

 

119,327

 

380,536

 

3.00 to 3.99%

 

94,237

 

103,894

 

4.00 to 4.99%

 

106,559

 

107,449

 

5.00 to 5.99%

 

46,775

 

55,524

 

6.00 to 6.99%

 

22,548

 

37,546

 

7.00 and over

 

7,015

 

7,756

 

Total time deposit accounts

 

1,183,565

 

1,006,333

 

Total deposits

 

$

2,455,076

 

$

2,014,096

 

 

The weighted average interest rate of all deposits was 1.40% and 1.72% at December 31, 2003 and 2002, respectively.

 

At December 31, 2003, the scheduled maturities of time deposit accounts are as follows (in thousands):

 

 

 

Amount

 

Weighted
Average
Interest
Rate

 

 

 

 

 

 

 

Due in one year

 

$

881,378

 

1.66

%

Due in two years

 

108,904

 

3.40

 

Due in three years

 

29,063

 

4.03

 

Due in four years

 

41,757

 

4.72

 

Due in five years

 

52,596

 

3.75

 

Due after five years

 

69,867

 

4.99

 

 

 

$

1,183,565

 

 

 

 

F-25



 

At December 31, 2003 and 2002, the remaining maturities of time deposit accounts with a minimum balance of $100,000 were as follows (in thousands):

 

 

 

December 31,

 

 

 

2003

 

2002

 

 

 

 

 

 

 

Less than three months

 

$

296,458

 

$

175,647

 

Over three to six months

 

113,516

 

102,134

 

Over six to twelve months

 

164,436

 

149,151

 

Over twelve months

 

87,859

 

59,248

 

 

 

$

662,269

 

$

486,180

 

 

The components of interest expense associated with deposits are as follows (in thousands):

 

 

 

Years Ended December 31,

 

 

 

2003

 

2002

 

2001

 

 

 

 

 

 

 

 

 

Transaction accounts

 

$

991

 

$

1,471

 

$

1,086

 

Regular savings accounts

 

635

 

574

 

1,081

 

Money market demand accounts

 

5,943

 

5,332

 

8,757

 

Time deposit accounts

 

29,262

 

36,255

 

52,510

 

 

 

$

36,831

 

$

43,632

 

$

63,434

 

 

9. Advances from Federal Home Loan Bank of Seattle:

 

Advances from FHLB Seattle are collateralized by certain investments and ABS and qualifying loans with a carrying value of approximately $1.73 billion and $1.29 billion at December 31, 2003 and 2002, respectively.  Sterling Savings Bank’s credit line with FHLB Seattle is limited to a percentage of its total regulatory assets subject to collateralization requirements.  At December 31, 2003, Sterling Savings Bank had the ability to borrow an additional $127.0 million from FHLB Seattle.

 

The advances from FHLB Seattle at December 31, 2003 and 2002, are repayable as follows (in thousands):

 

 

 

December 31, 2003

 

December 31, 2002

 

 

 

Amount

 

Weighted
Average
Interest Rate

 

Amount

 

Weighted
Average
Interest Rate

 

 

 

 

 

 

 

 

 

 

 

Due in one year

 

$

408,685

 

2.30

%

$

238,975

 

3.69

%

Due in two years

 

205,812

 

4.75

 

170,000

 

3.86

 

Due in three years

 

71,813

 

2.75

 

130,591

 

6.28

 

Due in four years

 

120,000

 

2.63

 

25,785

 

4.03

 

Due in five years

 

30,661

 

3.02

 

120,000

 

2.63

 

Due after five years

 

189,060

 

5.35

 

189,164

 

5.35

 

 

 

$

1,026,031

 

 

 

$

874,515

 

 

 

 

F-26



 

10. Securities Sold Subject to Repurchase Agreements:

 

Sterling enters into sales of securities under agreements to repurchase the same or similar securities (“reverse repurchase agreements”). Fixed-coupon reverse repurchase agreements are treated as financings, and the obligations to repurchase securities sold are reflected as a liability on the consolidated balance sheet.  The dollar amount of securities underlying the agreements remains in the applicable asset accounts.  These agreements had a weighted average interest rate of 2.51% at December 31, 2003.  Substantially all of Sterling’s reverse repurchase agreements are transacted with Morgan Stanley (MS) ($234.2 million), Merrill Lynch (ML) ($97.4 million) and Citigroup (CIT) ($20.0 million), with the balance of such short-term repurchase agreements of $9.1 million, held by various other retail customers.  The ABS underlying these agreements were held by MS, ML and CIT.  The risk of default under such agreements is limited by the financial strength of these broker-dealers and the level of borrowings relative to the market value of pledged securities.  At December 31, 2003, under the reverse repurchase agreements, Sterling has pledged as collateral investments and ABS with aggregate amortized costs and market values of $377.4 million and $369.6 million, respectively.

 

The average balances of securities sold subject to reverse repurchase agreements were $236.0 million, $182.8 million and $170.3 million during the years ended December 31, 2003, 2002 and 2001, respectively. The maximum amount outstanding at any month end during these same periods was $360.6 million, $249.8 million and $219.5 million, respectively.

 

At December 31, 2003 and 2002, securities sold subject to repurchase agreements are repayable as follows (in thousands):

 

 

 

December 31, 2003

 

December 31, 2002

 

 

 

Amount

 

Weighted
Average
Interest Rate

 

Amount

 

Weighted
Average
Interest Rate

 

 

 

 

 

 

 

 

 

 

 

Due in one year

 

$

285,637

 

1.59

%

$

154,769

 

1.83

%

Due in two years

 

75,000

 

5.97

 

20,000

 

6.70

 

Due in three years

 

0

 

0.00

 

75,000

 

5.97

 

 

 

$

360,637

 

 

 

$

249,769

 

 

 

 

F-27



 

11. Other Borrowings:

 

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

 

 

 

December 31,

 

 

 

2003

 

2002

 

 

 

 

 

 

 

Term note payable (1)

 

$

22,000

 

$

25,000

 

Advances on revolving line of credit (2)

 

0

 

0

 

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

 

78,000

 

64,000

 

Floating rate notes due 2006 (4)

 

30,000

 

30,000

 

Other (5)

 

5,583

 

8,682

 

Total other borrowings

 

$

135,583

 

$

127,682

 

 


(1)                                  Sterling has a variable-rate term note with U.S. Bank, N.A. (“U.S. Bank”).  This note matures on September 17, 2007.  Interest accrues at the 30-day London Interbank Offering Rate (“LIBOR”) plus 2.00% and is payable monthly.  Principal payments are due in annual installments of $3.0 million each September, with the entire unpaid balance due at maturity.  This note is collateralized by a majority of the common and preferred stock of Sterling Savings Bank.

 

(2)                                  Sterling has a $5.0 million revolving line-of-credit with U.S. Bank.  This line of credit matures on September 15, 2004.  The interest rate is adjustable monthly at the 30-day LIBOR plus 2.00% and is payable monthly.  This note is collateralized by a majority of the common and preferred stock of Sterling Savings Bank.  At December 31, 2003 and 2002, no amounts were outstanding under this line.

 

(3)                                  Sterling raises capital from time to time through the formation of trusts (“Sterling Capital Trusts”), which issue capital securities (“Trust Preferred Securities”) to investors.  The Sterling Capital Trusts are business trusts in which Sterling owns all of the common equity.  The proceeds from the sale of the Trust Preferred Securities are used to purchase junior subordinated deferrable interest debentures (“Junior Subordinated Debentures”) issued by Sterling.  Sterling’s obligations under the Junior Subordinated Debentures and related documents, taken together, constitute a full and unconditional guarantee by Sterling of Sterling Capital Trusts’ obligations under the Trust Preferred Securities.  The Trust Preferred Securities are treated as debt of Sterling.  Although Sterling, as a savings and loan holding company, is not subject to the Federal Reserve capital requirements for bank holding companies, the Trust Preferred Securities have been structured to qualify as Tier 1 capital, subject to certain limitations, if Sterling were to become regulated as a bank holding company.  The Junior Subordinated Debentures and related Trust Preferred Securities generally mature 30 years after issuance and are redeemable at the option of Sterling under certain conditions.  Interest is paid quarterly or semi-annually.

 

F-28



 

Details of the Trust Preferred Securities are as follows:

 

Subsidiary Issuer

 

Issue
Date

 

Maturity
Date

 

Call Date

 

Mandatorily
Redeemable
Capital Security

 

Rate at
December 31,
2003

 

Amount (in
Thousands)

 

Sterling Capital
Trust VI

 

June 2003

 

Sept 2033

 

Sept 2008

 

Floating Rate Capital Securities

 

4.37

%

$

10,000

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sterling Capital
Statutory Trust V

 

May 2003

 

June 2033

 

June 2008

 

Floating Rate Capital Securities

 

4.42

%

20,000

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sterling Capital
Trust IV

 

May 2003

 

May 2033

 

May 2008

 

Floating Rate Preferred Securities

 

4.32

%

10,000

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sterling Capital
Trust III

 

April 2003

 

April 2033

 

April 2008

 

Floating Rate Capital Securities

 

4.41

%

14,000

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sterling Capital
Trust II

 

July 2001

 

July 2031

 

July 2006

 

10.25 % Cumulative Capital Securities

 

10.25

%

24,000

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

$

78,000

 

 

(4)                                  Sterling has outstanding $30.0 million of Floating Rate Notes Due 2006.  These notes are unsecured general obligations of Sterling and are subordinated to certain other existing and future indebtedness.  Under the terms of the notes, Sterling is limited in the amount of certain long-term debt that it may incur, and the notes restrict Sterling, under certain circumstances, as to the amount of cash dividends on its preferred or common stock and capital distributions which can be made.  At December 31, 2003, Sterling could have incurred approximately $69.2 million in additional long-term debt, and could have paid approximately $40.3 million in additional dividends.  Interest accrues at the 90-day LIBOR plus 2.50% and is adjustable and payable quarterly.  The notes mature in 2006 and may be redeemed under certain conditions.

 

(5)                                  During 2002, Sterling financed the sale of certain loans to an unrelated party.  Since the underlying sold loans were collateral on the loan to the purchaser, this sale was accounted for as a financing.  At December 31, 2003 and 2002, $5.6 million and $8.7 million remained outstanding on the financing, respectively.

 

F-29



 

12. Income Taxes:

 

The tax effects of the principal temporary differences giving rise to deferred tax assets and liabilities were as follows (in thousands):

 

 

 

December 31,

 

 

 

2003

 

2002

 

 

 

Assets

 

Liabilities

 

Assets

 

Liabilities

 

 

 

 

 

 

 

 

 

 

 

Allowance for losses on loans

 

$

12,836

 

$

0

 

$

10,801

 

$

0

 

Unrealized gains on available-for-sale securities

 

8,181

 

0

 

0

 

1,852

 

Net operating loss carryforward

 

188

 

0

 

351

 

0

 

Purchase accounting discount

 

1,576

 

4,289

 

2,704

 

1,867

 

Deferred compensation

 

1,031

 

0

 

1,436

 

0

 

FHLB Seattle dividends

 

0

 

10,037

 

0

 

9,074

 

Deferred loan fees

 

0

 

1,999

 

0

 

2,143

 

Office properties and equipment

 

0

 

1,060

 

0

 

342

 

Mortgage servicing rights

 

0

 

792

 

0

 

440

 

Other

 

243

 

0

 

248

 

824

 

 

 

$

24,055

 

$

18,177

 

$

15,540

 

$

16,542

 

 

A valuation allowance against deferred tax assets has not been established as it is more likely than not that these assets will be realized.  The following table summarizes the calculation of Sterling’s effective tax rates for the periods presented (in thousands):

 

 

 

For the Years Ended December 31,

 

 

 

2003

 

2002

 

2001

 

 

 

Amount

 

%

 

Amount

 

%

 

Amount

 

%

 

Income tax provision at the federal statutory rate

 

$

18,757

 

35.0

%

$

12,816

 

35.0

%

$

8,609

 

35.0

%

Tax effect of:

 

 

 

 

 

 

 

 

 

 

 

 

 

State taxes, net of federal benefit

 

697

 

1.3

 

446

 

1.2

 

228

 

0.9

 

Non-deductible stock acquisition costs

 

0

 

0.0

 

0

 

0.0

 

85

 

0.3

 

Amortization of goodwill

 

0

 

0.0

 

0

 

0.0

 

7

 

0.0

 

Tax-exempt interest

 

(171

)

(0.3

)

(93

)

(0.3

)

(117

)

(0.4

)

Bank owned life insurance

 

(1,310

)

(2.4

)

(1,148

)

(3.1

)

(346

)

(1.4

)

Other, net

 

705

 

1.3

 

(990

)

(2.7

)

(57

)

(0.2

)

 

 

$

18,678

 

34.9

%

$

11,031

 

30.1

%

$

8,409

 

34.2

%

 

At December 31, 2003 and 2002, Sterling had available net operating loss carryforwards of approximately $523,000 and $971,000, which expire through 2005.  Utilization of the operating loss carryforwards is limited to approximately $448,000 per year.

 

F-30



 

13. Stock Options:

 

Sterling has granted options to purchase shares of its common stock at exercise prices equal to the fair market value of the stock at the date of grant.  The options vest over one to four years and are exercisable from four to ten years from the date of grant.  Sterling is authorized to grant 2,600,000 options under various stock option incentive plans.  At December 31, 2003, 892,500 options remained available for grant.

 

Stock option transactions are summarized as follows:

 

 

 

Number of
Shares

 

Weighted
Average
Exercise Price

 

Exercise Price Per
Share

 

Balance, January 1, 2001

 

847,152

 

$

8.62

 

$

2.37

-

$

14.00

 

 

Options granted

 

210,276

 

11.01

 

$

6.53

-

$

12.28

 

 

Options exercised

 

(137,173

)

8.06

 

$

2.63

-

$

10.74

 

 

Options canceled

 

(2,500

)

11.73

 

$

9.19

-

$

13.98

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, December 31, 2001

 

917,755

 

9.23

 

$

2.63

-

$

14.00

 

 

Options granted

 

201,000

 

16.91

 

$

16.91

-

$

17.15

 

 

Options exercised

 

(121,246

)

9.32

 

$

2.63

-

$

14.30

 

 

Options canceled

 

(6,200

)

8.68

 

$

7.33

-

$

11.24

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, December 31, 2002

 

991,309

 

10.88

 

$

6.10

-

$

17.15

 

 

Options granted

 

233,000

 

32.17

 

$

28.55

-

$

33.07

 

 

Options exercised

 

(184,000

)

8.76

 

$

6.10

-

$

13.98

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, December 31, 2003

 

1,040,309

 

$

16.02

 

$

6.53

-

$

33.07

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Exercisable, December 31, 2003

 

765,709

 

$

11.28

 

 

 

 

 

 

The weighted average fair value of options granted during the years ended December 31, 2003, 2002 and 2001, was $26.29, $16.83 and $11.16, respectively.

 

F-31



 

The following table summarizes information about Sterling’s plans at December 31, 2003:

 

 

 

Options Outstanding

 

Options Exercisable

 

Range of Exercise
Prices

 

Number
Outstanding

 

Weighted Average
Remaining
Contractual Life

 

Weighted
Average
Exercise Price

 

Number
Exercisable

 

Weighted
Average
Exercise Price

 

$

3.31

-

$

6.61

 

2,138

 

7.1 years

 

$

6.53

 

2,138

 

$

6.53

 

$

6.61

-

$

9.92

 

328,758

 

4.2 years

 

7.90

 

318,358

 

7.92

 

$

9.92

-

$

13.23

 

236,413

 

5.4 years

 

11.06

 

224,513

 

11.05

 

$

13.23

-

$

16.54

 

39,000

 

3.0 years

 

13.98

 

39,000

 

13.98

 

$

16.54

-

$

19.84

 

201,000

 

6.3 years

 

16.91

 

181,700

 

16.91

 

$

26.46

-

$

29.76

 

47,000

 

9.5 years

 

28.59

 

0

 

0.00

 

$

29.76

-

$

33.07

 

186,000

 

7.2 years

 

33.07

 

0

 

0.00

 

 

 

 

 

1,040,309

 

 

 

 

 

765,709

 

 

 

 

All share and dollar amounts have been restated to reflect the conversion of options upon the consummation of business combinations into a Sterling stock option at the exchange ratio.  All exercise prices have been restated to reflect all common stock dividends paid to date.

 

14. Shareholders’ Equity:

 

On February 28, 2003, Empire was merged with and into Sterling, with Sterling being the surviving corporation in the merger.  Sterling issued 1,401,370 shares of common stock in exchange for all of the stock of Empire.

 

Sterling’s Board of Directors approved the distribution of stock dividends in the years ended December 31, 2003, 2002 and 2001.  Cash in lieu of fractional shares was distributed based upon the closing price as of the record dates.  All weighted average shares outstanding and per share amounts have been retroactively restated to reflect these common stock dividends.

 

Sterling’s Board of Directors has the authority to issue preferred stock of Sterling in one or more series and to fix the rights, privileges, preferences and restrictions granted to or imposed upon any unissued shares of preferred stock, without further vote or action by the common shareholders.

 

15. Earnings Per Share:

 

The following table (dollars in thousands, except per share amounts) presents a reconciliation of the numerators and denominators used in the basic and diluted earnings per share computations, which includes the number of antidilutive securities that were not included in the dilutive earnings per share computations.  These antidilutive securities occur when options outstanding held an option price greater than the average market price for the period.  All periods have been restated to reflect all common stock dividends.

 

F-32



 

 

 

For the Year Ended December 31, 2003

 

 

 

Net Income (Numerator)

 

Weighted
Average Shares
(Denominator)

 

Per Share
Amount

 

 

 

 

 

 

 

 

 

Earnings per common share – basic

 

$

34,913

 

14,533,402

 

$

2.40

 

Effect of dilutive securities: Common stock options

 

0

 

406,706

 

(0.06

)

Earnings per common share – diluted

 

$

34,913

 

14,940,108

 

$

2.34

 

Antidilutive options not included in diluted earnings per share

 

 

 

0

 

 

 

 

 

 

For the Year Ended December 31, 2002

 

 

 

Net Income (Numerator)

 

Weighted
Average Shares (Denominator)

 

Per Share
Amount

 

 

 

 

 

 

 

 

 

Earnings per common share – basic

 

$

25,587

 

13,027,884

 

$

1.96

 

Effect of dilutive securities: Common stock options

 

0

 

322,321

 

0.00

 

Effect of convertible subordinated debt

 

43

 

82,565

 

(0.05

)

Earnings per common share – diluted

 

$

25,630

 

13,432,770

 

$

1.91

 

Antidilutive options not included in diluted earnings per share

 

 

 

0

 

 

 

 

 

 

For the Year Ended December 31, 2001

 

 

 

Net Income (Numerator)

 

Weighted
Average Shares (Denominator)

 

Per Share
Amount

 

 

 

 

 

 

 

 

 

Earnings per common share – basic

 

$

16,188

 

12,105,546

 

$

1.34

 

Effect of dilutive securities: Common stock options

 

0

 

188,163

 

0.00

 

Effect of convertible subordinate debt

 

41

 

70,320

 

(0.03

)

Earnings per common share – diluted

 

$

16,229

 

12,364,029

 

$

1.31

 

Antidilutive options not included in diluted earnings per share

 

 

 

83,628

 

 

 

 

F-33



 

16. Regulatory Capital:

 

In connection with the insurance of its deposits by the Federal Deposit Insurance Corporation (“FDIC”) and general regulatory oversight by the Office of Thrift Supervision (“OTS”), Sterling Savings Bank is required to maintain minimum levels of regulatory capital, including core (Tier 1) risk-based and total risk-based capital.  At December 31, 2003, Sterling Savings Bank was in compliance with all regulatory capital requirements.  The OTS is empowered to take “prompt, corrective action” to resolve problems of insured depository institutions.  The extent of these powers depends on whether an institution is classified as “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly under capitalized,” or “critically undercapitalized.” At December 31, 2003 and 2002, Sterling Savings Bank was considered “well capitalized.”

 

The following table sets forth the amounts and ratios regarding actual and minimum core (Tier I) risk-based and total risk-based capital requirements, together with the amounts and ratios required in order to meet the definition of a “well-capitalized” institution, without giving effect to forbearance or capital provisions contained in certain merger and acquisition agreements (dollars in thousands).

 

 

 

Minimum Capital
Requirements

 

Well-Capitalized
Requirements

 

Actual

 

 

 

Amount

 

Ratio

 

Amount

 

Ratio

 

Amount

 

Ratio

 

As of December 31, 2003:

 

 

 

 

 

 

 

 

 

 

 

 

 

Total risk-based capital (to risk-weighted assets)

 

$

254,627

 

8.00

%

$

318,283

 

10.00

%

$

347,370

 

10.91

%

Core (Tier I) captial (to risk-weighted assets)

 

127,313

 

4.00

 

190,970

 

6.00

 

315,386

 

9.89

 

Core (Tier I) capital (to adjusted assets)

 

169,711

 

4.00

 

212,139

 

5.00

 

315,386

 

7.43

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

As of December 31, 2002:

 

 

 

 

 

 

 

 

 

 

 

 

 

Total risk-based capital (to risk-weighted assets)

 

$

208,599

 

8.00

%

$

260,749

 

10.00

%

$

285,907

 

10.96

%

Core (Tier I) capital (to risk-weighted assets)

 

104,300

 

4.00

 

156,449

 

6.00

 

261,585

 

9.98

 

Core (Tier I) capital (to adjusted assets)

 

138,171

 

4.00

 

172,714

 

5.00

 

261,585

 

7.57

 

 

F-34



 

17. Commitments and Contingent Liabilities:

 

At December 31, 2003, Sterling had loan commitments to borrowers and brokers totaling $762.3 million, comprised of $252.3 million of fixed-rate loans and $510.0 million of variable-rate loans.  At     December 31, 2003, commitments to secondary market institutions to sell fixed-rate loans totaled $13.4 million. Commitments, which are disbursed subject to certain limitations, extend over various periods of time, with the majority of funds being disbursed within a twelve-month period. Substantially all of the commitments are for loans that have credit risk similar to Sterling’s existing portfolio.

 

At December 31, 2003, Sterling had made available to borrowers various secured and unsecured commercial and personal lines of credit totaling approximately $754.1 million, of which the undisbursed portion is approximately $343.2 million. These lines of credit provide for periodic adjustment to market rates of interest and have credit risk similar to Sterling’s existing portfolio.

 

As of December 31, 2003, Sterling had approximately $13.4 million of commercial and standby letters of credit outstanding.  Sterling collected approximately $105,000 in fees from these off balance sheet arrangements.

 

Sterling historically has not realized material credit losses due to these off-balance sheet credits. Based on this fact and Sterling’s analysis of the undisbursed portion of these lines of credit, no specific valuation allowances were recorded for these off balance sheet credits at December 31, 2003 and 2002.

 

As of December 31, 2003, Sterling had committed to invest a total of $5.0 million in a limited partnership for the development of low-income housing.  As of December 31, 2003, $50,000 of this commitment was disbursed.  Subsequent to year end, Sterling increased its investment commitment to $15.0 million.  The fund will invest in a series of low-income projects throughout the Pacific Northwest.  Sterling receives tax deductions and tax credits from the partnership that Sterling anticipates will give it a positive return on investment but anticipates the partnership interest to have no value at the end of the fifteen-year term.

 

Rent expense for office properties under operating leases was approximately $2.5 million, $2.0 million and $1.7 million for the years ended December 31, 2003, 2002 and 2001, respectively.

 

The above commitments do not include any additional commitments that Sterling acquired in the   January 2, 2004 merger with Klamath.

 

Future minimum rental commitments (including those from the Klamath merger) as of December 31, 2003, under non-cancelable operating leases with initial or remaining terms of more than one year, are as follows (in thousands):

 

Years Ending December 31,

 

Amount

 

 

 

 

 

2004

 

$

3,032

 

2005

 

2,548

 

2006

 

2,216

 

2007

 

1,488

 

2008

 

975

 

Thereafter

 

3,274

 

 

 

$

13,533

 

 

F-35



 

18. Benefit Plans:

 

Sterling maintains an employee savings plan under Section 401(k) of the Internal Revenue Code. Substantially all employees are eligible to participate in the plan subject to certain requirements. Under the plan, employees may elect to contribute up to 10% of their salary, and Sterling will make a matching contribution equal to 35% of the employee’s contribution. All matching contributions are made exclusively in the form of Sterling common stock.  Each employee may make a supplemental contribution of an additional 10% of their salary. All employee contributions vest immediately, and employer contributions vest over the employee’s first three years of employment or participation in the plan. Employees have the option of investing their contributions among selected mutual funds and Sterling common stock. During the years ended December 31, 2003, 2002 and 2001, Sterling contributed approximately $882,000, $763,000 and $640,000, respectively, to the employee savings plan.

 

Since 1984, Sterling has maintained a nonqualified Deferred Compensation Plan.  The Deferred Compensation Plan component of the overall compensation plan is intended to link compensation to the long-term performance of Sterling and to provide a strong incentive for increasing shareholder value.  As of December 31, 2003, there were eight participants in the Deferred Compensation Plan.  The Board of Directors (the “Board”) may, as it has done in the past, choose additional participants from a group of management employees.  Contributions to the Deferred Compensation Plan for each given year are determined by the Board.  No further contributions are anticipated as the Deferred Compensation Plan was replaced with a Supplemental Executive Retirement Plan in 2002.  All amounts in a participant’s account become 100% vested upon a change of control; when the participant attains normal retirement age; when the employment of the participant terminates due to death or disability; or upon termination of the Plan.  Prior to such an event, amounts in a participant’s account vest at the rate of 10% per year of service, provided that such vesting shall reach 100% when the participant reaches the age of 60.  Payment of an account may be in a lump sum or in installments as determined by the Board, and installments may be accelerated by the Board.  Payment must be commenced within one year of the termination of the participant’s employment with Sterling.  Sterling had $180,560, $147,457 and $396,716 in expense related to this plan for the years ending December 31, 2003, 2002 and 2001, respectively.

 

Since 2002, Sterling has maintained a Supplemental Executive Retirement Plan (the “SERP”).  The SERP is a non-qualified, unfunded plan that is designed to provide retirement benefits for certain key employees of Sterling.  Depending on their classification under the Plan, participants will receive from 40%-60% of their base salary amount at January 1, 2002, for 10 to 15 years beginning at normal retirement age.  Retirement benefits vest at the rate of 10% per year of service.  Except for participants who have completed 25 years of service, benefits are reduced for early retirement.  Retirement benefits become 100% vested if, within two years of a change of control of Sterling Savings Bank, either the Plan or the participant’s employment are terminated.  Sterling had 20 participants and had $723,751 and $934,060 in expense related to this plan for the years ended December 31, 2003 and 2002, respectively.

 

F-36



 

19. Operating Expenses:

 

The components of total operating expenses are as follows (in thousands):

 

 

 

Years Ended December 31,

 

 

 

2003

 

2002

 

2001

 

 

 

 

 

 

 

 

 

Employee compensation and benefits

 

$

51,066

 

$

42,861

 

$

35,291

 

Occupancy and equipment

 

14,687

 

12,534

 

11,161

 

Amortization of goodwill and other intangibles

 

262

 

644

 

5,377

 

Data processing

 

6,786

 

6,176

 

5,335

 

Depreciation

 

4,994

 

4,257

 

4,496

 

Advertising

 

5,316

 

4,199

 

2,893

 

Travel and entertainment

 

2,711

 

2,182

 

1,827

 

Legal and accounting

 

2,206

 

1,927

 

1,445

 

Insurance

 

750

 

596

 

736

 

Goodwill litigation

 

600

 

1,100

 

890

 

Merger and acquisition costs

 

792

 

0

 

283

 

Other

 

4,394

 

4,467

 

3,559

 

 

 

$

94,564

 

$

80,943

 

$

73,293

 

 

20. Segment Information:

 

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

 

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

        The Residential Mortgage Banking segment originates and sells servicing-retained and servicing-released residential loans through loan production offices in Washington, Oregon, Idaho and Montana, primarily through Action.

        The Commercial Mortgage Banking segment originates, sells and services commercial real estate loans and participation interests in commercial real estate loans through offices in Oregon, Washington and Arizona, primarily through INTERVEST.

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

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

 

F-37



 

 

The following table presents certain financial information regarding Sterling’s segments and provides a reconciliation to Sterling’s consolidated totals for the years ended December 31, 2003, 2002 and 2001, (in thousands):

 

 

 

As of and for the Year Ended December 31, 2003

 

 

 

Community
Banking

 

Residential
Mortgage
Banking

 

Commercial
Mortgage
Banking

 

Retail
Brokerage

 

Other and
Eliminations

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

$

199,799

 

$

9,054

 

$

5,871

 

$

3

 

$

0

 

$

214,727

 

Interest expense

 

82,423

 

0

 

0

 

0

 

7,384

 

89,807

 

Net interest income (expense)

 

117,376

 

9,054

 

5,871

 

3

 

(7,384

)

124,920

 

Provision for loan losses

 

(10,500

)

0

 

0

 

0

 

0

 

(10,500

)

Non-interest income

 

37,923

 

9,816

 

1,326

 

2,070

 

(17,400

)

33,735

 

Non-interest expense

 

80,614

 

10,638

 

2,892

 

1,564

 

(1,144

)

94,564

 

Income (loss) before income taxes

 

$

64,185

 

$

8,232

 

$

4,305

 

$

509

 

$

(23,640

)

$

53,591

 

Total assets

 

$

4,323,170

 

$

22,734

 

$

15,779

 

$

1,909

 

$

(86,686

)

$

4,276,906

 

 

 

 

As of and for the Year Ended December 31, 2002

 

 

 

Community
Banking

 

Residential
Mortgage
Banking

 

Commercial
Mortgage
Banking

 

Retail
Brokerage

 

Other and
Eliminations

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

$

184,955

 

$

7,442

 

$

4,916

 

$

0

 

$

0

 

$

197,313

 

Interest expense

 

88,071

 

0

 

0

 

0

 

8,894

 

96,965

 

Net interest income (expense)

 

96,884

 

7,442

 

4,916

 

0

 

(8,894

)

100,348

 

Provision for loan losses

 

(11,867

)

0

 

0

 

0

 

0

 

(11,867

)

Non-interest income

 

32,696

 

6,286

 

1,732

 

1,675

 

(13,309

)

29,080

 

Non-interest expense

 

71,116

 

7,033

 

2,267

 

1,111

 

(584

)

80,943

 

Income (loss) before income taxes

 

$

46,597

 

$

6,695

 

$

4,381

 

$

564

 

$

(21,619

)

$

36,618

 

Total assets

 

$

3,539,109

 

$

9,041

 

$

5,548

 

$

489

 

$

(47,166

)

$

3,507,021

 

 

 

 

As of and for the Year Ended December 31, 2001

 

 

 

Community
Banking

 

Residential
Mortgage
Banking

 

Commercial
Mortgage
Banking

 

Retail
Brokerage

 

Other and
Eliminations

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

$

191,145

 

$

5,987

 

$

4,253

 

$

0

 

$

0

 

$

201,385

 

Interest expense

 

107,026

 

0

 

0

 

0

 

9,490

 

116,516

 

Net interest income (expense)

 

84,119

 

5,987

 

4,253

 

0

 

(9,490

)

84,869

 

Provision for loan losses

 

(8,000

)

0

 

0

 

0

 

0

 

(8,000

)

Non-interest income

 

24,912

 

3,185

 

1,493

 

1,214

 

(9,783

)

21,021

 

Non-interest expense

 

65,731

 

4,495

 

2,136

 

979

 

(48

)

73,293

 

Income (loss) before income taxes

 

$

35,300

 

$

4,677

 

$

3,610

 

$

235

 

$

(19,225

)

$

24,597

 

Total assets

 

$

3,074,055

 

$

8,340

 

$

6,853

 

$

523

 

$

(51,178

)

$

3,038,593

 

 

F-38



 

21. Quarterly Financial Data (Unaudited):

 

The following tables present Sterling’s condensed operations on a quarterly basis for the years ended December 31, 2003 and 2002 (in thousands, except per share amounts):

 

 

 

Year Ended December 31, 2003

 

 

 

First Quarter

 

Second
Quarter

 

Third Quarter

 

Fourth
Quarter

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

$

51,485

 

$

52,651

 

$

54,696

 

$

55,895

 

Interest expense

 

(22,914

)

(22,611

)

(22,368

)

(21,914

)

Provision for losses on loans

 

(2,250

)

(2,550

)

(2,850

)

(2,850

)

 

 

 

 

 

 

 

 

 

 

Net interest income after provision for losses on loans

 

26,321

 

27,490

 

29,478

 

31,131

 

 

 

 

 

 

 

 

 

 

 

Net gain (loss) on sales of securities

 

1,360

 

1,677

 

(308

)

965

 

Other income

 

5,749

 

8,012

 

8,704

 

7,576

 

Operating expenses

 

21,411

 

22,604

 

24,655

 

25,894

 

Income before income taxes

 

12,019

 

14,575

 

13,219

 

13,778

 

Income tax provision

 

(4,236

)

(5,058

)

(4,594

)

(4,790

)

Net income

 

$

7,783

 

$

9,517

 

$

8,625

 

$

8,988

 

Earnings per share – basic

 

$

0.57

 

$

0.64

 

$

0.58

 

$

0.61

 

Earnings per share – diluted

 

$

0.55

 

$

0.63

 

$

0.57

 

$

0.59

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding – basic

 

13,710,886

 

14,771,708

 

14,791,399

 

14,844,325

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding – diluted

 

14,066,518

 

15,147,572

 

15,220,484

 

15,286,227

 

 

F-39



 

 

 

Year Ended December 31, 2002

 

 

 

First Quarter

 

Second
Quarter

 

Third Quarter

 

Fourth
Quarter

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

$

48,166

 

$

47,701

 

$

50,109

 

$

51,337

 

Interest expense

 

(24,777

)

(24,333

)

(24,245

)

(23,610

)

Provision for losses on loans

 

(2,086

)

(2,227

)

(3,277

)

(4,277

)

 

 

 

 

 

 

 

 

 

 

Net interest income after provision for losses on loans

 

21,303

 

21,141

 

22,587

 

23,450

 

 

 

 

 

 

 

 

 

 

 

Net gain on sales of securities

 

86

 

311

 

1,399

 

1,129

 

Other income

 

5,743

 

6,434

 

6,668

 

7,310

 

Operating expenses

 

(19,667

)

(19,752

)

(21,119

)

(20,405

)

Income before income taxes

 

7,465

 

8,134

 

9,535

 

11,484

 

Income tax provision

 

(1,884

)

(2,398

)

(2,906

)

(3,843

)

Net income

 

$

5,581

 

$

5,736

 

$

6,629

 

$

7,641

 

Earnings per share – basic

 

$

0.44

 

$

0.44

 

$

0.50

 

$

0.58

 

Earnings per share – diluted

 

$

0.42

 

$

0.43

 

$

0.49

 

$

0.57

 

Weighted average shares outstanding – basic

 

12,774,380

 

13,031,704

 

13,145,696

 

13,154,287

 

Weighted average shares outstanding – diluted

 

13,379,073

 

13,465,641

 

13,439,003

 

13,462,131

 

 

22. Fair Values of Financial Instruments:

 

Fair value estimates are determined as of a specific date in time utilizing 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. Additionally, Sterling has not disclosed highly subjective values of core deposit intangibles or other non-financial instruments. Accordingly, the aggregate fair value amounts presented do not represent and should not be construed to represent the full underlying value of Sterling.

 

The methods and assumptions used to estimate the fair values 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.

 

F-40



 

Investments and ABS

 

The fair value of investments and ABS is based on quoted market prices.  If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments.  The carrying value of FHLB stock approximates fair value based on the redemption provisions of the FHLB Seattle.

 

Loans Held for Sale

 

The fair values are based on the estimated value at which the loans could be sold in the secondary market considering the fair value of options and commitments to sell or issue mortgage loans.

 

Loans Receivable

 

The fair values of performing residential mortgage loans and home equity loans are estimated using current market comparable information for securitizable mortgages, adjusting for credit and other relevant characteristics. The fair value of performing commercial real estate construction, permanent financing, consumer and commercial 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 or the underlying collateral.

 

Deposits

 

The fair values for deposits subject to immediate withdrawal such as interest and non-interest bearing checking, regular savings, and money market deposit accounts, are equal to the amounts payable on demand at the reporting date.  The carrying amounts for variable-rate certificates of deposit and other time deposits approximate their fair value at the reporting date.  Fair values for fixed-rate 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 Seattle 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 their expected payment. 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 Seattle 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.

 

F-41



 

The carrying and fair values of financial instruments were the following (in thousands):

 

 

 

December 31,

 

 

 

2003

 

2002

 

 

 

Carrying
Amount

 

Fair
Value

 

Carrying
Amount

 

Fair
Value

 

 

 

 

 

 

 

 

 

 

 

Financial assets:

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

66,983

 

$

66,983

 

$

79,389

 

$

79,389

 

 

 

 

 

 

 

 

 

 

 

Investments and ABS:

 

 

 

 

 

 

 

 

 

Available for sale

 

1,070,955

 

1,070,955

 

826,692

 

826,692

 

Held to maturity

 

2,229

 

2,383

 

3,476

 

3,673

 

Loans held for sale

 

14,616

 

14,616

 

22,549

 

22,549

 

Loans receivable, net

 

2,906,426

 

2,939,162

 

2,390,422

 

2,413,650

 

Accrued interest receivable

 

16,531

 

16,531

 

14,625

 

14,625

 

 

 

 

 

 

 

 

 

 

 

Financial liabilities:

 

 

 

 

 

 

 

 

 

Non-maturity deposits

 

1,271,511

 

1,271,511

 

1,007,763

 

1,007,763

 

Deposits with stated maturities

 

1,183,565

 

1,195,664

 

1,006,333

 

1,017,017

 

Borrowings

 

1,524,751

 

1,583,141

 

1,251,966

 

1,305,021

 

Accrued interest payable

 

8,223

 

8,223

 

7,410

 

7,410

 

 

The fair value estimates above do not include the value of mortgage loan servicing rights on Sterling’s residential and commercial mortgage loan-servicing portfolio, which totaled approximately $541.1 million and $438.5 million at December 31, 2003 and 2002, respectively.  The gross fair value of these rights is estimated to be approximately $5.5 million and $4.6 million at December 31, 2003 and 2002, respectively.  The carrying amount of all mortgage loan-servicing rights was approximately $3.5 million and $1.7 million at December 31, 2003 and 2002, respectively.

 

23. Related-Party Transactions:

 

One of Sterling’s directors is a principal in a law firm that provides legal services to Sterling.  During the years ended December 31, 2003, 2002 and 2001, Sterling incurred legal fees of approximately $2.0 million, $2.4 million and $2.2 million, respectively, related to services provided by this firm.

 

At December 31, 2003 and 2002, loans outstanding to directors and executive officers were $959,000 and $1.1 million, respectively.  These loans were extended as part of Sterling’s normal course of business, and are not subject to preferential terms or conditions.

 

F-42



 

24. Parent Company-Only Financial Information:

 

The following Sterling Financial Corporation parent company-only financial information should be read in conjunction with the other notes to consolidated financial statements. The accounting policies for the parent company-only financial statements are the same as those used in the presentation of the consolidated financial statements other than the parent company-only financial statements account for the parent company’s investments in its subsidiaries under the equity method (in thousands).

 

 

 

December 31,

 

 

 

2003

 

2002

 

Condensed Balance Sheets

 

 

 

 

 

Assets:

 

 

 

 

 

Cash and cash equivalents

 

$

26,789

 

$

8,917

 

Investments in subsidiaries:

 

 

 

 

 

Sterling Savings Bank

 

346,989

 

309,328

 

Tri-Cities Mortgage Company

 

32

 

32

 

Sterling Capital Trusts

 

2,415

 

1,980

 

Receivable from subsidiaries

 

5,297

 

2,479

 

Available for sale investments

 

55

 

55

 

Income taxes receivable

 

865

 

0

 

Other assets

 

2,155

 

3,637

 

Total assets

 

$

384,597

 

$

326,428

 

 

 

 

 

 

 

Liabilities and Shareholders’ Equity:

 

 

 

 

 

Accrued expenses payable

 

$

1,717

 

$

1,089

 

Term note payable

 

22,000

 

25,000

 

Floating Rate Notes Due 2006

 

30,000

 

30,000

 

Junior Subordinated Debentures

 

80,415

 

65,980

 

Due to affiliates

 

32

 

32

 

Income taxes payable

 

85

 

671

 

Shareholders’ equity

 

250,348

 

203,656

 

Total liabilities and shareholders’ equity

 

$

384,597

 

$

326,428

 

 

F-43



 

 

 

Years Ended December 31,

 

 

 

2003

 

2002

 

2001

 

 

 

(in thousands)

 

Condensed Statements of Income

 

 

 

 

 

 

 

Interest income

 

$

269

 

$

113

 

$

181

 

Interest expense

 

(7,653

)

(8,963

)

(9,605

)

Net interest expense

 

(7,384

)

(8,850

)

(9,424

)

Equity in net earnings of subsidiary

 

41,586

 

31,863

 

22,929

 

Operating expenses

 

(1,745

)

(1,128

)

(1,277

)

Other non-interest income (expense)

 

(1,464

)

0

 

0

 

Income before income taxes

 

30,993

 

21,885

 

12,228

 

Income tax benefit

 

3,920

 

3,702

 

3,960

 

Net income

 

$

34,913

 

$

25,587

 

$

16,188

 

 

 

 

 

 

 

 

 

Condensed Statements of Cash Flows

 

 

 

 

 

 

 

Cash flows from operating activities:

 

 

 

 

 

 

 

Net income

 

$

34,913

 

$

25,587

 

$

16,188

 

Adjustments to reconcile net income to net cash used in operating activities

 

(42,815

)

(36,726

)

(25,068

)

 

 

 

 

 

 

 

 

Net cash used in operating activities

 

(7,902

)

(11,139

)

(8,880

)

 

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

 

 

Investments in subsidiaries, net

 

(436

)

32

 

(28,902

)

Repayment of advances to subsidiaries

 

0

 

8,161

 

14,036

 

Dividends from subsidiary

 

11,616

 

11,616

 

10,512

 

Net cash provided by (used in) investing activities

 

11,180

 

19,809

 

(4,354

)

 

 

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

 

 

Proceeds from other borrowings

 

55,672

 

0

 

54,000

 

Repayment of other borrowings

 

(44,237

)

(5,000

)

(40,000

)

Proceeds from exercise of stock options, net of repurchases

 

1,223

 

864

 

79

 

Payments for fractional shares

 

(30

)

(20

)

(18

)

Deferred financing costs

 

(732

)

0

 

(764

)

Cash from mergers and acquisitions

 

2,698

 

0

 

0

 

Other, net

 

0

 

1

 

(1

)

Net cash provided by (used in) financing activities

 

14,594

 

(4,155

)

13,296

 

 

 

 

 

 

 

 

 

Net change in cash and cash equivalents

 

17,872

 

4,515

 

62

 

Cash and cash equivalents, beginning of year

 

8,917

 

4,402

 

4,340

 

 

 

 

 

 

 

 

 

Cash and cash equivalents, end of year

 

$

26,789

 

$

8,917

 

$

4,402

 

 

F-44



 

Federal law prohibits Sterling Financial Corporation from borrowing from its subsidiary savings association unless the loans are collateralized by specified assets and are generally limited to 10% of the subsidiary savings association’s capital and surplus.

 

During the years ended December 31, 2003, 2002 and 2001, Sterling purchased $0 million, $0 million and $28.9 million of Sterling Savings Bank common and preferred stock, respectively.

 

Current income taxes are allocated to Sterling and its subsidiaries as if they were separate tax paying entities.

 

The payment of dividends to Sterling Financial Corporation by its savings association subsidiary is subject to various federal and state regulatory limitations. Under current regulations, at December 31, 2003, the savings association subsidiary could have declared approximately $43.9 million of aggregate dividends in addition to amounts previously paid.

 

25. Business Combination:

 

On February 28, 2003, Empire was merged with and into Sterling, with Sterling being the surviving corporation in the merger.  Empire’s wholly owned subsidiary, Empire Bank, was merged with and into Sterling’s wholly-owned subsidiary, Sterling Savings Bank, with Sterling Savings Bank being the surviving institution.  The merger strengthened Sterling’s capital base, adding approximately $29 million in capital.  Sterling acquired approximately $144 million of cash, $67 million of loans, $184 million of deposits and five branches in Montana.  Under the terms of the Empire merger, each share of Empire common stock was converted into 0.9392 shares of Sterling common stock.  The merger was structured as a tax-free reorganization.  The aggregate purchase price was $29.2 million, which was comprised of 1,401,370 shares of Sterling’s common stock issued at $20.85 per share, which was determined based on the closing price of Sterling’s common stock at the effective date of the merger.  As a result of the merger, Sterling recorded goodwill of $1.1 million and a deposit intangible in the amount of $3.1 million.

 

F-45



 

The following summarizes the fair values of the assets acquired and liabilities assumed on February 28, 2003, the effective date of the merger (dollars in thousands):

 

 

 

Amount

 

 

 

 

 

Cash and cash equivalents

 

$

143,632

 

Investments and ABS

 

6,709

 

Loans receivable, net

 

67,272

 

Goodwill and other intangibles

 

4,241

 

Other assets

 

8,128

 

Total assets acquired

 

$

229,982

 

 

 

 

 

Deposits

 

$

184,223

 

Other borrowings

 

9,657

 

Other liabilities

 

6,884

 

Total liabilities assumed

 

200,764

 

Net assets acquired

 

$

29,218

 

 

The following summarizes the unaudited pro forma results of operations as if Sterling acquired Empire as of the beginning of each of the periods presented.  The information presented below includes Sterling’s years ended December 31, 2003 and 2002, and Empire’s two months ended February 28, 2003 and year ended December 31, 2002.

 

 

 

Years Ended December 31,

 

 

 

2003

 

2002

 

 

 

(in thousands)

 

 

 

 

 

 

 

Pro forma interest income

 

$

216,166

 

$

206,724

 

Pro forma interest expense

 

90,697

 

103,272

 

Pro forma net interest income

 

125,469

 

103,452

 

Pro forma net income

 

34,813

 

25,211

 

Pro forma earnings per share - basic

 

$

2.25

 

$

1.81

 

Pro forma earnings per share - diluted

 

$

2.19

 

$

1.76

 

 

26. Subsequent Event:

 

On July 15, 2003, Sterling announced that it had entered into an Agreement and Plan of Merger with Klamath.  Subsequent to the end of the year, on January 2, 2004, Klamath was merged with and into Sterling, with Sterling being the surviving corporation in the merger.  Klamath’s wholly-owned subsidiary, Klamath First Federal Savings and Loan Association, was merged with and into Sterling’s wholly-owned subsidiary, Sterling Savings Bank, with Sterling Savings Bank being the surviving institution.

 

F-46



 

Under the terms of the Klamath Merger, each share of Klamath common stock was converted into 0.77 shares of Sterling common stock.  The merger was structured as a tax-free reorganization.  Sterling issued 5,431,067 shares of common stock in exchange for all of the stock of Klamath.  As a result of the merger, Sterling acquired approximately $988 million in deposits, $767 million in investments and ABS, $566 million in loans and $145 million in capital, while adding approximately 450 employees to its work force.  In addition, Sterling added 48 retail branches and significantly increased its deposit market share in Oregon from 0.5% to over 4.0%.

 

As of the announcement of the merger, the aggregate purchase price was $145.2 million, including $5.5 million related to the value of Klamath’s vested stock options and $139.7 million related to the value of Klamath’s common stock.  The value of the common shares issued by Sterling was $26.06 per share, which was determined based on the average market closing price of Sterling’s common stock five business days prior to and subsequent to the merger announcement date.

 

With the increase to 134 branches serving Washington, Oregon, Idaho and Montana, Sterling strengthens its position as a leading regional community bank.  This merger is consistent with Sterling’s growth strategy to become the leading community bank in the Pacific Northwest region and furthers Sterling’s goal of providing extensive coverage throughout the region by further extending Sterling’s geographic footprint in Oregon.  Klamath’s strong deposit base compliments Sterling’s strong asset growth, while the combined branch network and access to capital gives Sterling the opportunity to continue its growth in the region.

 

The following summarizes the preliminary estimated fair values of the assets acquired and liabilities assumed on January 2, 2004, the effective date of the merger (dollars in thousands):

 

 

 

Amount

 

 

 

 

 

Cash and cash equivalents

 

$

44,703

 

Investments and ABS

 

767,250

 

Loans receivable, net

 

565,509

 

Goodwill and other intangibles

 

95,217

 

Other assets

 

72,931

 

Total assets acquired

 

$

1,545,610

 

 

 

 

 

Deposits

 

$

987,864

 

Other borrowings

 

391,801

 

Other liabilities

 

20,778

 

Total liabilities assumed

 

1,400,443

 

Net assets acquired

 

$

145,167

 

 

F-47



 

The following summarizes the unaudited pro forma results of operations as if Sterling acquired Klamath as of the beginning of each of the periods presented.  Sterling’s fiscal year end is December 31 and Klamath’s fiscal year end was September 30.  Therefore, the information presented below includes Sterling’s years ended December 31, 2003 and 2002 and Klamath’s twelve months ended December 31, 2003 and fiscal year ended September 30, 2002.

 

 

 

Years Ended December 31,

 

 

 

2003

 

2002

 

 

 

(in thousands, except per share amounts)

 

 

 

 

 

 

 

Pro forma interest income

 

$

283,353

 

$

283,962

 

Pro forma interest expense

 

118,740

 

133,448

 

Pro forma net interest income

 

164,613

 

150,514

 

Pro forma net income

 

31,835

 

33,525

 

Pro forma earnings per share - basic

 

$

1.62

 

$

1.87

 

Pro forma earnings per share - diluted

 

$

1.57

 

$

1.82

 

 

F-48