Based on our observations of the portfolio and hedge over the course of the quarter, we elected to further reduce the size of the portfolio and unwind the hedge position. Consequently, in early July we sold securities with market values totaling approximately $41 million and unwound the hedge position. Our net losses from those activities totaled $213,000. At the present time, we do not anticipate conducting any further securities transactions.
In June of 2002, we issued our first Trust Preferred Security (TPS) in the amount of $9 million with an interest rate adjustable on a quarterly basis. At the same time, we entered into an interest rate swap with the FHLB in order to protect against potential adverse interest rate volatility from the TPS by fixing the interest rate payable for the first five years of the TPS’ life. The swap matured in July of this year, resulting in a funding cost subject to adjustment on a quarterly basis at 3.65% over the current three-month LIBOR rate.
As margins on current TPS issues have declined to approximately 1.35% to 1.65% over three-month LIBOR, we had previously expressed an intention to call the outstanding $9 million TPS at the earliest contractual redemption date, in this case September 2007, and replace the issue with a new TPS at a lower margin. We have since, in consideration of the pending merger with Washington Federal Inc., elected instead to call the outstanding $9 million TPS without replacement. However, because we issued a commitment to replace the redeemed TPS we were required to pay a cancellation fee of $55,000.
Even with the retirement and non-replacement of the TPS, we expect to remain “well capitalized” in accordance with regulatory guidelines.
ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
GENERAL
First Mutual Bancshares, Inc. (the “Company”), a Washington corporation, is a bank holding company owning all of the equity of its wholly owned subsidiary, First Mutual Bank. The Company is subject to regulation by the Federal Reserve Bank of San Francisco. This discussion refers to the consolidated statements of the Company and the Bank, and therefore the references to “Bank” in this discussion refer to both entities.
First Mutual Bank is a Washington-chartered savings bank subject to regulation by the State of Washington Department of Financial Institutions and the Federal Deposit Insurance Corporation (“FDIC”). The Bank conducts business from its headquarters in Bellevue, Washington, and has 12 full-service retail banking centers located in Bellevue (3), Issaquah, Kirkland (2), Monroe, Redmond, Sammamish, Seattle (2), and Woodinville. We also have consumer loan offices located in Orange Park, Florida and Mt. Clemens, Michigan. The Bank’s business consists mainly of attracting deposits from the general public as well as wholesale funding sources, and investing those funds primarily in real estate loans, small and mid-sized business loans, and consumer loans.
OVERVIEW
For the second quarter and first half of 2007, our net income declined significantly relative to the same periods last year, totaling $1.8 million and $4.5 million, down from $2.7 million and $5.4 million for the quarter and six months ended June 30, 2006. Our earnings per diluted share fell to $0.25 and $0.64, compared to $0.40 and $0.80 per diluted share in the second quarter and first six months of last year. Our return on average equity (ROE) totaled 9.62% for the quarter and 12.41% on a year-to-date basis, compared to 17.25% and 17.52% in the prior year. As a result, we were unsuccessful in achieving our general corporate goals, an ROE of at least 15% and year-over-year net income growth in the range of 10% to 12%. On July 2, 2007, we announced that we had entered into a definitive merger agreement with Washington Federal, Inc. (NASDAQ: WFSL) which provides, subject to certain conditions, for a merger of First Mutual with and into Washington Federal.
Our performance for the quarter was negatively impacted by several one-time expenses, including $175,000 in legal and other fees related to the Washington Federal transaction, a $158,000 retention bonus to our CFO for remaining with the Bank past his retirement date, $163,000 in expenditures for the payoff of a contract for an outside operations consultant, and a charitable contribution in the amount of $188,000. We had originally intended to make this contribution in a series of installments, but instead elected to lump-sum the remaining contribution during the second quarter because of the pending merger with Washington Federal.
The primary source of revenue for each of our business lines is net interest income, which is generally measured with the net interest margin ratio. For the second quarter and first half of 2007, our net interest income totaled $8.9 million and $18.2 million, down $1.2 million and $2.0 million from the levels earned in the prior year, as our net interest margin for the quarter declined to 3.62%, down from 3.73% in the previous quarter. A key driver of net interest income is the level of our earning assets, which declined in the second quarter of 2007, averaging $979 million, representing a decrease of more than of $48 million from the second quarter of last year. The drop in earning assets was due largely to securities sales, which reduced the size of the portfolio as of June 30, 2007 by nearly $37 million compared to the level at the June 2006 quarter-end. Also contributing to the decline in earning assets was a substantial reduction in loan originations, which fell from $158 million in the second quarter of last year to $128 million in the most recent quarter, along with continued high levels of loan payoffs and sales. Please see the “Net Interest Income” and “Business Segments” sections for further discussions of net interest income and earning assets.
A secondary source of revenue is our noninterest income, which increased $74,000 and $1.0 million compared to the second quarter and first half of last year, based on increases in loan and securities sales and the resulting gains thereon as well as a higher level of service fees collected on assets serviced for other institutions. During the second quarter and first half of 2007, we sold approximately $14 million and $30 million of sales finance loans, which resulted in significant increases in gains on sales of loans and should contribute incremental servicing fee income in future quarters. Please see the “Noninterest Income” section for additional discussion.
Despite the one-time items mentioned above, our operating expenses remained comparable to those of the prior year, rising only $406,000 for the second quarter, or 5% over the same period last year, and by $454,000, or 3% on a year-to-date basis, as reductions in occupancy and credit insurance expenses partially offset increases in personnel and other noninterest expenses. Please refer to the “Noninterest Expense” section for additional information.
For the quarter ended June 30, 2007, our credit quality remained acceptable, with non-performing assets (NPAs) totaling $3.5 million, or 0.34% of total assets, little changed compared to the similar $3.5 million, or 0.32% at the 2006 year-end. For the quarter, we reserved $86,000 in provisions for loan losses and our reserve for loan losses, including unfunded commitments, totaled approximately $10.0 million, down from $10.1 million the year-end level. The allowance for loan losses represented 1.12% of gross loans at the quarter-end, up from 1.11% at the 2006 year-end. For additional information regarding our credit quality please refer to the “Asset Quality” section.
RESULTS OF OPERATIONS
Net Income
Net income declined $955,000 or 35% for the second quarter of 2007 as compared to the like quarter last year. Year-to-date net income decreased $954,000 or 18%. Net interest income, after provision for loan losses, declined $1.1 million for the quarter and $2.1 million for the first six months of 2007. Noninterest income increased $74,000 on a second-quarter comparison and $1.0 million year-to-date, while noninterest expense increased $406,000 for the quarter and $454,000 for the first six months of the year.
Net Interest Income
For the quarter and six months ended June 30, 2007, our net interest income declined $1.2 million and $2.0 million relative to the same periods last year. The net effects of asset and liability repricing negatively impacted net interest income for both periods, while the contraction of earning asset levels reduced second quarter income, after resulting in improvement in the first quarter. The following table illustrates the impacts to our net interest income from our level of earning assets and rate changes on our assets and liabilities, with the results attributable to asset levels classified as “volume” and the effect of asset and liability repricing labeled “rate.”
Rate/Volume Analysis
| | | Quarter Ended June 30, 2007 vs. June 30, 2006 | | | Six Months Ended June 30, 2007 vs. June 30, 2006 | |
| | | Increase/(Decrease) due to | | | Increase/(Decrease) due to | |
| | | Volume | | | Rate | | | Total | | | Volume | | | Rate | | | Total | |
| | | | (Dollars in thousands) | |
| Total Investments | | $ | (196 | ) | | $ | 368 | | | $ | 172 | | | $ | 45 | | | $ | 8 | | | $ | 53 | |
| Total Loans | | | (791 | ) | | | 365 | | | | (426 | ) | | | (870 | ) | | | 1,397 | | | | 527 | |
| Total Interest Income | | $ | (987 | ) | | $ | 733 | | | $ | (254 | ) | | $ | (825 | ) | | $ | 1,405 | | | $ | 580 | |
| | | | | | | | | | | | | | | | | | | | |
| Interest Expense | | | | | | | | | | | | | | | | | | | | | | | | |
| Total Deposits | | | (193 | ) | | | 1,233 | | | | 1,040 | | | | (103 | ) | | | 2,937 | | | | 2,834 | |
| FHLB and Other | | | (848 | ) | | | 718 | | | | (130 | ) | | | (1,532 | ) | | | 1,322 | | | | (210 | ) |
| Total Interest Expense | | $ | (1,041 | ) | | $ | 1,951 | | | $ | 910 | | | $ | (1,635 | ) | | $ | 4,259 | | | $ | 2,624 | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Net Interest Income | | $ | 54 | | | $ | (1,218 | ) | | $ | (1,164 | ) | | $ | 810 | | | $ | (2,854 | ) | | $ | (2,044 | ) |
Earning Asset Growth (Volume)
For the second quarter and first six months of 2007, declines in our levels of earning assets resulted in reductions of $987,000 and $825,000 in interest income relative to the same periods last year. More than offsetting the second quarter and year-to-date reductions, however, were lower levels of interest expense resulting from the elimination of funding sources previously needed to accommodate asset levels. Consequently, the net impacts of earning asset levels were an improvement in second-quarter net interest income of approximately $54,000 and a year-to-date improvement of $810,000 compared to the quarter and six months ended June 30, 2006.
Quarter Ending | Earning Assets | Net Loans (incl.LHFS) | Deposits |
| | (Dollars in thousands) |
| $ 1,036,750 | $ 919,418 | $ 760,344 |
| $ 1,034,332 | $ 919,837 | $ 774,914 |
| $ 1,012,896 | $ 897,436 | $ 805,795 |
| $ 995,058 | $ 881,849 | $ 771,659 |
| $ 962,998 | $ 878,490 | $ 759,786 |
As can be seen in the table above, our loan portfolio and overall level of earning assets have exhibited declining trends over the last several quarters.
The decline observed in the loan portfolio during the first half of 2007 was disappointing and contrary to our expectation for loan growth of approximately $0 to $5 million in each of the first two quarters. In the first six months of this year, we experienced declines in our income property, consumer, and residential construction loans. On a positive note, our balances of business banking loans and single-family permanent loans ended the second quarter at levels higher than those observed at the 2006 year-end. Additionally, while consumer loan balances declined relative to the year-end, they did so largely as a result of high loan sales volumes, which totaled approximately $30 million in the first half of the year. Were it not for these sales, growth would likely have been observed in this portfolio segment as well.
Further contributing to the decline in earning assets, the balance of our securities portfolio (including trading, available-for-sale, and held-to-maturity securities) totaled approximately $67 million as of June 30, 2007, down from its year-end and first-quarter 2007 levels of $95 million and nearly $97 million, respectively. The portfolio contraction followed significant trading volumes and portfolio turnover resulting from our election to adopt early SFAS 159.
Following the end of the first quarter, we sold several longer-maturity securities from the newly established trading portfolio, replaced the sold issues with approximately $34 million in shorter-term hybrid ARM securities, and began evaluating the potential risks and benefits of employing strategies to hedge against movements in the market value of the trading portfolio. In the first week of May, based on the earnings volatility presented by the new accounting treatment, we elected to proceed with a plan to reduce the volatility of the portfolio by reselling these recently purchased securities, leaving the portfolio at a much smaller size than that at which it began the quarter.
On the liabilities side of the balance sheet, our total deposit balances declined $46 million, or approximately 6% in the first half of the year, including $12 million in the second quarter. Our non-maturity deposit balances rose nearly $17 million in the first half of the year, with $5 million occurring in the second quarter, while time deposits, including certificates issued through brokerage services, declined nearly $63 million, with $17 million occurring in the most recent quarter. Brokered and other institutional certificates of deposit accounted for approximately $34 million of the year-to-date reduction. The decrease in retail certificate balances occurred as we attempted to move away from offering rates competitive with the higher rates in the local market. While this has resulted in some of the more rate-sensitive depositors exiting the Bank for higher rates elsewhere, most of these funds have remained on our books at significantly lower costs to the Bank.
Asset Yields and Funding Costs (Rate)
Quarter Ended | Net Interest Margin |
| June 30, 2006 | 3.91% |
| September 30, 2006 | 3.94% |
| December 31, 2006 | 3.78% |
| March 31, 2007 | 3.73% |
| June 30, 2007 | 3.62% |
The effects of interest rate movements and repricing on our loan portfolio accounted for $365,000 and $1.4 million in additional interest income relative to the second quarter and first half of last year. Adjustable-rate loans, which reprice according to terms specified in our loan agreements with the borrowers, accounted for approximately 77% of our loan portfolio as of June 30, 2007, down from 80% at the 2006 year-end. While most of the repricing of these loans occurs on an annual basis, a notable exception is those loans tied to the prime rate, which typically reprice within one or two days of any change in the Federal Funds target rate by the Federal Reserve.
On the liability side of the balance sheet, however, the effects of interest rate movements and repricing were more pronounced, increasing our interest expense on deposits and wholesale funding by nearly $2.0 million for the quarter and $4.3 million for the first six months of the year.
As a result, for the second quarter and first six months of 2007, the net effects of rate movements and repricing negatively impacted our net interest income by $1.2 million and $2.9 million relative to the same periods in the prior year, as the large volumes of maturing/repricing liabilities resulted in a greater increase in liability costs than was observed for asset yields.
Contrary to our expectations, we observed continued compression of our net interest margin in the second quarter of 2007. In our first-quarter press release, we indicated that we expected to see modest improvement in our net interest margin, forecasting a second-quarter margin in the 3.80% to 3.85% range. This forecast had been based on the assumptions that we would experience no significant changes in our loan or deposit portfolios in the quarter, with estimated growth of $0 to $5 million for each. Instead, as previously noted, we have experienced substantial declines in both our loan and deposit portfolios in recent quarters, continuing through the second quarter of this year.
Noninterest Income
Relative to the second quarter of last year, our noninterest income rose $74,000, or approximately 4%, as increases in loan and securities sales and the resulting gains thereon were more than sufficient to offset a reduction in miscellaneous operating income and the negative impact of marking certain financial instruments to market under SFAS No. 159.
On a year-to-date basis, noninterest income increased by slightly more than $1 million as compared to the prior year, with loan sales being the most significant contributor to the additional income, followed by a positive year-to-date SFAS No. 159 impact and higher servicing fee income.
SFAS No. 157 and 159 Related Gains/(Losses)
Effective January 1, 2007, we elected early adoption of SFAS No. 157 and 159, which were issued in February 2007, and generally permit the mark-to-market of selected eligible financial instruments. In our case, we elected to apply the standards to certain investments held in our securities portfolio and a $9 million long term debenture payable (trust preferred security). With the early adoption, we recorded total pre-tax, SFAS No. 159-related, mark-to-market gains of $447,000 for the first quarter. In the second quarter, however, we experienced net SFAS No. 159-related losses totaling $211,000 resulting primarily from adverse movements in the prices of
our securities. This net loss was offset by a $244,000 gain from a hedge position against those securities, which had been established in the second week of May.
Based on our observations of the portfolio and hedge over the course of the quarter, we elected to further reduce the size of the portfolio and unwind the hedge position. Consequently, in early July we sold securities with market values totaling approximately $41 million and unwound the hedge position. Our net losses from those activities totaled $213,000. At the present time, we do not anticipate conducting any further securities transactions.
Gains/(Losses) on Sales of Loans
| | | Quarter Ended June 30, | | | Six Months Ended June 30, | |
| | | 2007 | | | 2006 | | | 2007 | | | 2006 | |
Gains/(Losses) on Sales: | | | | | | | | | | |
| Consumer | | $ | 746,000 | | | $ | 430,000 | | | $ | 1,679,000 | | | $ | 1,178,000 | |
| Residential | | | 73,000 | | | | 18,000 | | | | 114,000 | | | | (2,000 | ) |
| Commercial | | | 54,000 | | | | 106,000 | | | | 53,000 | | | | 134,000 | |
| Total Gains on Loan Sales | | $ | 873,000 | | | $ | 554,000 | | | $ | 1,846,000 | | | $ | 1,310,000 | |
| | | | | | | | | | | | | | | | | |
Loans Sold: | | | | | | | | | | | | | | | | |
| Consumer | | $ | 14,364,000 | | | $ | 10,028,000 | | | $ | 30,013,000 | | | $ | 23,043,000 | |
| Residential | | | 20,920,000 | | | | 13,717,000 | | | | 31,798,000 | | | | 23,113,000 | |
| Commercial | | | 4,057,000 | | | | 4,182,000 | | | | 4,057,000 | | | | 5,192,000 | |
| Total Loans Sold | | $ | 39,341,000 | | | $ | 27,927,000 | | | $ | 65,868,000 | | | $ | 51,348,000 | |
| | | | | | | | | | | | | | | | | |
Continuing the trend observed in the first quarter of this year, our second quarter gains on loan sales significantly exceeded those of 2006 based primarily on a substantial increase in sales of our consumer loans. Following an increase of $217,000, or 29% in the first quarter of this year, gains on sales for the second quarter totaled $873,000, representing a 58% increase over the same period last year.
Following first quarter 2007 sales of nearly $16 million, second quarter consumer loan sales totaled more than $14 million, which was within the $12 million to $18 million range estimated in the outlook presented in our first-quarter 2007 press release. Although current levels of loan production are consistent with what we have experienced in prior periods, we are seeing a softening in market demand for loan sales resulting from the issues affecting subprime lending. Whether or not loan sales in the third quarter will approximate prior quarters is unknown at this time.
Compared to the markets for our consumer and commercial loan sales, the market for residential loan sales is significantly larger and more efficient. As a result, residential loan sales are typically sold for very modest gains or potentially even at slight losses when interest rates are rising quickly. We believe the construction phase to be the most profitable facet of residential lending and the primary objective in a residential lending relationship. Following the construction process, our practice is to retain in our portfolio those residential mortgages that we consider to be beneficial to the Bank, but to sell those that we consider less attractive assets. Included in these less attractive assets would be those mortgages with fixed rates, which we offer
for competitive reasons. Additionally, as residential loans are typically sold servicing released, sales do not result in future servicing income.
Following an absence of commercial real estate loan sales in the first quarter of 2007, we sold participations in commercial real estate loans during the second quarter, though gains trailed their year-ago levels. Commercial real estate loan transactions, particularly those that are candidates for sales of participations to other institutions, tend to be larger-dollar credits and unpredictable in their timing and frequency of occurrence. As a result, the volumes of commercial real estate loans sold, and gains thereon, can be expected to vary considerably from one quarter to the next depending on the timing of the loan and sales transactions.
Service Fee Income/(Expense)
| | | Quarter Ended June 30, | | | Six Months Ended June 30, | |
| | | 2007 | | | 2006 | | | 2007 | | | 2006 | |
| Consumer Loans | | $ | 431,000 | | | $ | 298,000 | | | $ | 892,000 | | | $ | 630,000 | |
| Commercial Loans | | | (36,000 | ) | | | 0 | | | | (62,000 | ) | | | 9,000 | |
| Residential Loans | | | 4,000 | | | | 2,000 | | | | 6,000 | | | | (4,000 | ) |
| Service Fee Income | | $ | 399,000 | | | $ | 300,000 | | | $ | 836,000 | | | $ | 635,000 | |
Our servicing fee income rose 33% from the level earned in the second quarter of last year and 32% on a year-to-date basis, as servicing income from consumer loans serviced for other institutions increased in response to higher levels of loan sales. Servicing fee income represents the net of servicing income received less the amortization of servicing assets, which are recorded when we sell loans from our portfolio to other investors. The values of these servicing assets are determined at the time of the sale using a valuation model that calculates the present value of future cash flows for the loans sold, including cash flows related to the servicing of the loans. The servicing asset is recorded based on fair value. The servicing rights are then amortized in proportion to, and over the period of, the estimated future servicing income.
For the second quarter and first six months of 2007, service fee income earned on consumer loans serviced for other investors exceeded that earned in the same periods of the prior year by 45% and 42%. This improvement was based on a significant increase in the balances of consumer loans serviced, which was in turn a product of the increased volume of loan sales in 2006 and the first half of 2007.
In the case of commercial loans serviced, payoffs during the quarter of balances sold to and serviced for other institutional investors required us to immediately write-off the related servicing assets, which resulted in the loss presented above.
In contrast to consumer and commercial loans, residential loans are typically sold servicing released, which means we no longer service those loans once they are sold. Consequently, we do not view these loans as a significant source of servicing fee income.
Fees on Deposits
Fee income earned on deposit accounts rose by $14,000, or 7%, compared to the second quarter of last year, and $20,000, or 5% on a year-to-date basis, based primarily on a higher level of
checking account service charges. This source of fee income has grown as we have continued our efforts to expand our base of business and consumer checking accounts. A higher level of IRA service fees also contributed to the improvement.
Other Noninterest Income
| | | Quarter Ended June 30, | | | Six Months Ended June 30, | |
| | | 2007 | | | 2006 | | | 2007 | | | 2006 | |
ATM/Wire/Safe Deposit Fees | | $ | 96,000 | | | $ | 79,000 | | | $ | 184,000 | | | $ | 154,000 | |
| Late Charges | | | 72,000 | | | | 66,000 | | | | 144,000 | | | | 117,000 | |
| Loan Fee Income | | | 182,000 | | | | 155,000 | | | | 399,000 | | | | 250,000 | |
| Rental Income | | | 189,000 | | | | 186,000 | | | | 357,000 | | | | 343,000 | |
| Miscellaneous | | | 207,000 | | | | 523,000 | | | | 280,000 | | | | 587,000 | |
Other Noninterest Income | | $ | 746,000 | | | $ | 1,009,000 | | | $ | 1,364,000 | | | $ | 1,451,000 | |
Our noninterest income from sources other than those described earlier declined $263,000, or 26% for the quarter and $88,000, or 6% on a year-to-date basis relative to the same periods last year. The decline, however, was primarily attributable to an extraordinary item, specifically the receipt of $400,000 in insurance proceeds from a key-man life insurance policy, in the second quarter of last year as opposed to any adverse changes in our 2007 operations.
We continued to observe growth in our ATM/Wire/Safe Deposit Fees, which totaled $96,000 for the quarter and $184,000 on a year-to-date basis, representing increases of 21% and 20% over the same periods last year. Most of this growth is attributable to Visa and ATM fee income, which we expect to continue rising as checking accounts become a greater piece of our overall deposit mix.
Loan fee income increased compared to the prior year based on a higher level of non-deferred loan fees. These typically include fees collected in connection with loan modifications or extensions, non-conversion of construction loans to permanent mortgages, and letters of credit originated for commercial borrowers. Further contributing to the additional income were quarterly and year-to-date increases of $6,000 and $37,000 in loan brokerage fees and $7,000 and $15,000 in loan prepayment fees relative to the prior year.
Noninterest Expense
Noninterest expense increased $406,000 for the second quarter, or 5% over the same period last year, and by $454,000, or 3% on a year-to-date basis.
Salaries and Employee Benefits Expense
Our personnel-related expenses remained well contained in the first half of 2007, increasing slightly more than 2% relative to the first six months of last year, as the majority of a 7% increase in compensation expense was offset by improvements across other expense categories.
For the quarter, salary expense increased 8% and commission and incentive compensation by 5% as total personnel expense increased by 3%.
| | | Quarter Ended June 30, | | | Six Months Ended June 30, | |
| | | 2007 | | | 2006 | | | 2007 | | | 2006 | |
| Salaries | | $ | 3,238,000 | | | $ | 2,994,000 | | | $ | 6,399,000 | | | $ | 5,966,000 | |
Commissions and Incentives | | | 663,000 | | | | 634,000 | | | | 1,189,000 | | | | 1,174,000 | |
Employment Taxes and Insurance | | | 269,000 | | | | 267,000 | | | | 558,000 | | | | 568,000 | |
Temporary Office Help | | | 72,000 | | | | 59,000 | | | | 150,000 | | | | 154,000 | |
| Benefits | | | 375,000 | | | | 523,000 | | | | 830,000 | | | | 1,061,000 | |
| Total | | $ | 4,617,000 | | | $ | 4,477,000 | | | $ | 9,126,000 | | | $ | 8,923,000 | |
The increase in overall personnel-related expenses was primarily attributable to salaries expense, which increased 8% and 7% relative to the second quarter and first six months of 2006. For the quarter, Directors’ compensation increased $124,000 as compared to the same quarter last year, primarily as a result of a $100,000 payment to one of our directors for consulting services regarding the upcoming Washington Federal acquisition. Also contributing to compensation expense was a retention bonus paid to the CFO for staying on past his retirement date. On a year-to-date basis, the most significant contribution to salary costs came from regular compensation expense, which grew largely as a result of annual increases in staff salaries. The annual compensation adjustments take effect in April of each year and generally fall within a 2% to 4% range. Further adding to the increase in salaries expense was a higher level of stock option compensation expense, which rose from $260,000 in the first half of 2006 to $326,000 this year.
In contrast to other categories, employee benefit expense declined significantly relative to the second quarter of last year, falling nearly $147,000, or 28%. The reduction was largely attributable to a decision to forego contributions to our 401K profit sharing plan and ESOP for the quarter. By comparison, $105,000 and $189,000 was contributed in the second quarter and first half of 2006, while this year’s contributions were a recovery of $21,000 in the second quarter and an expense of $18,000 in the first half.
Occupancy Expense
Occupancy expense declined by $75,000 and $103,000, or more than 7% and 5%, compared to the second quarter and first half of last year, based on reductions across the various categories of occupancy expense.
| | | Quarter Ended June 30, | | | Six Months Ended June 30, | |
| | | 2007 | | | 2006 | | | 2007 | | | 2006 | |
| Rent | | $ | 70,000 | | | $ | 79,000 | | | $ | 140,000 | | | $ | 158,000 | |
Utilities and Maintenance | | | 178,000 | | | | 198,000 | | | | 406,000 | | | | 402,000 | |
| Depreciation | | | 486,000 | | | | 518,000 | | | | 947,000 | | | | 1,028,000 | |
| Other Occupancy | | | 234,000 | | | | 248,000 | | | | 457,000 | | | | 465,000 | |
| Total Occupancy Expense | | $ | 968,000 | | | $ | 1,043,000 | | | $ | 1,950,000 | | | $ | 2,053,000 | |
The reduction in rent expense was attributable to the closings of Income Property lending offices as well as the relocation of the West Seattle Banking Center from a leased space to a new building that we own, all of which occurred in 2006.
For the second quarter, depreciation expense declined $32,000, or 6% relative to the 2006 level, based on reductions in software, furniture, and other PC and network depreciation expense. On a year-to-date basis, depreciation expense was down $80,000, or nearly 8%. In the first quarter, depreciation expense declined $48,000 due to the correction of a booking error associated with the purchase of our Juanita Banking Center. In that transaction, the value of the land had been included in the cost of the building and consequently depreciated based on the building’s amortization schedule. As land is not depreciable, this error was corrected upon its discovery and resulted in a one-time $40,000 credit to depreciation for the quarter.
Credit Insurance
Credit insurance premium costs fell nearly 21% in the second quarter, and more than 14% on a year-to-date basis compared to the same periods in 2006. As we stated in our 2006 year-end press release, we expected that expenditures for credit insurance would decline over the course of 2007. The majority of credit insurance premiums is attributable to our sales finance loans, including both those loans retained in our portfolio as well as those loans serviced for other institutions. In mid-2006, after evaluating our use of credit insurance, we concluded that the benefits of the insurance no longer outweighed the costs and chose to forego the insurance and assume the credit risk on future sales finance loan production. Those loans insured prior to August 1, 2006 remain insured under their existing policies. Additionally, some loans originated on or after August 1, 2006 were sold to institutional investors with insurance placed prior to sale and remain insured under the policy effective August 1, 2006. All other loan volumes originated on or after August 1 have not been insured. To a much lesser extent, residential land loans and a small percentage of the consumer and income property loan portfolios are also insured. While these insured balances may continue to increase in future quarters, the premiums paid on these balances are sufficiently small relative to those paid on sales finance loans such that total premiums paid are still expected to decline.
Other Noninterest Expense
Other noninterest expense grew by $440,000, or 24% relative to the second quarter of 2006, and $490,000, or nearly 14% on a year-to-date basis with a number of unique and/or merger-related items contributing to the increase in the second quarter.
| | | Quarter Ended June 30, | | | Six Months Ended June 30, | |
| | | 2007 | | | 2006 | | | 2007 | | | 2006 | |
Marketing and Investor Relations | | $ | 234,000 | | | $ | 268,000 | | | $ | 456,000 | | | $ | 520,000 | |
| Outside Services | | | 344,000 | | | | 255,000 | | | | 526,000 | | | | 423,000 | |
| Information Systems | | | 257,000 | | | | 226,000 | | | | 499,000 | | | | 430,000 | |
| Taxes | | | 193,000 | | | | 159,000 | | | | 356,000 | | | | 303,000 | |
| Legal | | | 191,000 | | | | 118,000 | | | | 364,000 | | | | 305,000 | |
| Other | | | 1,057,000 | | | | 810,000 | | | | 1,894,000 | | | | 1,624,000 | |
| Total | | $ | 2,276,000 | | | $ | 1,836,000 | | | $ | 4,095,000 | | | $ | 3,605,000 | |
Expenditures on outside services increased $90,000 in the second quarter and $104,000 for the first half of 2007 as compared to the same periods in the prior year. The increase in the second quarter’s expense was the result of a final $163,000 payment on a consulting service contract.
Legal fees grew by $73,000 in the second quarter and $59,000 for the first six months of the year, as approximately $46,000 in legal expenses related to the Washington Federal transaction were recognized during the second quarter of 2007.
Partially offsetting the overall increase in other noninterest expenses, our marketing and investor relations costs declined $34,000 for the quarter and $64,000 on a year-to-date basis relative to the same periods last year.
Other miscellaneous operating expenses rose significantly in the second quarter, totaling $247,000, or almost 31% more than in the same quarter last year. On a year-to-date basis, these expenses increased $270,000, or nearly 17%. Driving this increase were an additional $199,000 in charitable contributions and $159,000 in recruiting expenses compared to the second quarter of last year. The increase in charitable contributions was the result of a $188,000 contribution to a local performing arts organization. We had originally expected to make this contribution in several installments over time, but given the pending merger with Washington Federal Savings, we elected to go ahead and lump-sum the remaining contribution. The unusually high level of recruiting expense resulted from the use of employment services in connection with our search for a new CFO, as well as the hiring of a new business banking officer, income property lending officer and production assistant, treasury management officer, as well as various other personnel including accounting and IS staff.
FINANCIAL CONDITION
Assets
Because of a decline in security and loan portfolio balances, our assets totaled $1.029 billion at June 30, 2007, down from $1.057 billion at the start of the quarter and representing a decline of approximately 5% from the $1.079 billion 2006 year-end level. The reduction in the securities portfolio was an indirect result of our decision to elect early adoption of SFAS 159, while the decline in the loan portfolio was attributable to a substantial reduction in loan originations relative to the previous year combined with continued high levels of loan payoffs and sales.
Securities
Following significant trading volumes and portfolio turnover resulting from our election to early adopt SFAS 159, the balance of our securities portfolio (including trading, available-for-sale, and held-to-maturity securities) totaled approximately $67 million as of June 30, 2007, down from its year-end and first-quarter 2007 levels of $95 million and nearly $97 million.
Following the end of the first quarter, we sold several longer-maturity securities from the newly established trading portfolio, replaced the sold issues with approximately $34 million in shorter-term hybrid ARM securities, and began evaluating the potential risks and benefits of employing
strategies to hedge against movements in the market value of the trading portfolio. In the first week of May, based on the earnings volatility presented by the new accounting treatment, we elected to proceed with a plan to reduce the volatility of the portfolio by reselling our recently purchased securities in the secondary market and utilizing an interest rate swap to partially hedge against movements in the market value of the remaining trading portfolio. Based on our observations of the portfolio and hedge over the remainder of the quarter, we elected to further reduce the size of the portfolio and unwind the hedge position. Consequently, in early July we sold additional securities with market values totaling approximately $41 million and unwound the hedge position. These securities were seasoned hybrid ARM securities and two FHLB agency bullet securities that had been moved from the available-for-sale or held-to-maturity category to the trading portfolio at the time of our SFAS 159 adoption. At the present time, we do not anticipate conducting any further significant securities transactions.
Any investment security purchased is classified in one of the following categories: 1) trading, 2) available-for-sale, or 3) held-to-maturity. Prior to our early adoption of SFAS 159, the majority of the securities in our present portfolio had been classified as available-for-sale, while no securities were classified in the trading category. Available-for-sale securities are reviewed regularly, and any unrealized gains or losses are recorded in comprehensive income in the shareholders’ equity account. In contrast, any change in market value of trading securities during the period is reflected in current period income. Generally, falling interest rates will increase the market values of securities, thus enhancing the amounts recorded as gains or reducing losses, while rising rates will have the opposite effect. The passage of time partially counteracts these interest rate effects, as the unrealized gain or loss on a given security will gradually decline to zero as the security approaches its maturity date.
Loans
Loans receivable, excluding loans held-for-sale, declined approximately $4 million for the quarter and $27 million in the first six months of the year, to less than $867 million at June 30, 2007. The drop in the loan portfolio is partly attributable to a decrease in loan originations which fell to $128 million and $223 million compared to $158 million and $280 million in the second quarter and first half of last year. In addition to the decline in originations, the loan portfolio was impacted by a combination of continued high prepayment speeds and significant volumes of loan sales.
Portfolio Composition | | June 30, 2007 | | | March 31, 2007 | | | December 31, 2006 | |
| | | (Dollars in thousands) | |
| Single Family Residential | | $ | 261,699 | | | $ | 256,583 | | | $ | 254,374 | |
| Income Property | | | 220,056 | | | | 234,527 | | | | 248,100 | |
| Business Banking | | | 164,151 | | | | 153,552 | | | | 144,771 | |
| Commercial Construction | | | 47,864 | | | | 40,944 | | | | 47,153 | |
| Single Family Construction | | | | | | | | | | | | |
| Spec Construction | | | 29,146 | | | | 29,043 | | | | 31,315 | |
| Custom Construction | | | 49,129 | | | | 62,482 | | | | 70,541 | |
| Consumer | | | 94,813 | | | | 93,576 | | | | 97,177 | |
Total | | $ | 866,858 | | | $ | 870,707 | | | $ | 893,431 | |
The decrease observed in the loan portfolio during the first and second quarters was disappointing and contrary to our expectation for flat to modest growth for each quarter. In each
of the last two quarters we have experienced significant declines in our income property and custom construction loan portfolios.
While our total loan portfolio experienced a decline over the last two quarters, respectable growth occurred in our business banking loan portfolio. This segment has been very successful in building earning assets in recent years, and is looked to as a key contributor to asset growth going forward. More modest loan growth was also observed in our residential lending permanent loan portfolio. The single family residential loans held in our portfolio are typically non-conforming loans that do not meet the requirements for resale in the secondary market, but generally offer higher yields than conforming residential mortgages and are still considered eligible collateral for borrowing from the FHLB. Additionally, while consumer loan balances declined relative to the year-end, they did so largely as a result of loan sales totaling more than $14 million in the second quarter and $30 million in the first half of the year. Were it not for these sales, growth would likely have been observed in this portfolio segment as well.
Income property loans, which consist of mortgages on investor-owned commercial real estate and multifamily properties, have demonstrated a gradual downward trend in recent years. This decline has been largely the result of lower originations of loans, along with a high level of prepayments, which we attribute to a combination of increased competition from other lenders, including conduit programs, and a flat-to-inverted yield curve. The flattening of the yield curve reduced the rate differential between short- and long-term financing costs and provided a financial incentive for borrowers to select longer-term, fixed-rate loans as opposed to short-term or adjustable-rate financing. As we have historically been an originator of short-term and adjustable-rate loans, this has impacted us in two ways. First, as prospective buyers sought loans with terms that fell outside of our typical underwriting structures, our originations of permanent multifamily and commercial real estate loans declined. Second, with the yield curve providing borrowers with a financial incentive to refinance adjustable-rate loans, which make up the majority of our loan portfolio, with longer-term, fixed-rate debt, the prepayment rates on our income property portfolio remained at relatively high levels. Increased competition among lenders in our local market accelerated both the decline in new loans as well as portfolio payoffs, as the competition frequently resulted in lenders offering prospective borrowers new loan commitments or existing borrowers the opportunity to refinance at lower margins than we would consider appropriate for the risks presented by the credits.
Servicing Assets
Servicing assets represent the deferred servicing rights generated from sales of loans that are sold servicing retained, reduced by the amortization and prepayments of those loans, as well as any impairment charges that may occur. While our servicing assets have not and do not represent a significant percentage of our total assets, this area has grown with high volumes of loan sales.
Servicing Assets | | June 30, 2007 | | | March 31, 2007 | | | December 31, 2006 | |
| Commercial | | $ | 114,000 | | | $ | 165,000 | | | $ | 224,000 | |
| Residential | | | 72,000 | | | | 57,000 | | | | 63,000 | |
| Consumer | | | 4,798,000 | | | | 4,386,000 | | | | 3,724,000 | |
Total | | $ | 4,984,000 | | | $ | 4,608,000 | | | $ | 4,011,000 | |
| | | | | | | | | | | | | |
| Loan Balances Serviced for Others | | $ | 154,199,000 | | | $ | 150,437,000 | | | $ | 155,025,000 | |
As a result of the more than $14 million in consumer loan sales during the quarter, and $30 million in the first half of the year, our servicing assets related to consumer loans increased $412,000, or approximately 9% during the second quarter, and $1.1 million, or 29% over the first six months of 2007.
Servicing assets related to commercial loans continued to decline as some existing commercial loan pools were paid off in the second quarter of 2007. These payoffs required us to immediately write off the remaining servicing assets associated with these credits.
Residential loans are generally sold servicing released. Consequently, no servicing assets are recognized following the vast majority of residential loan sales.
Deposits and Borrowings
Through the first half of the year, our total deposit balances fell $46 million, or approximately 6% from their year-end level, including $12 million in the second quarter. Non-maturity deposit balances, however, rose nearly $17 million, with $5 million occurring in the second quarter. Time deposits, including certificates issued through brokerage services, declined nearly $63 million, with a $17 million decrease occurring in the most recent quarter. Brokered and other institutional certificates of deposit accounted for approximately $34 million of the year-to-date reduction.
The growth of checking and money market accounts typically helps us reduce our overall cost of funds. Consequently, we consider the growth of these types of account types to be an important part of our funding strategy. To encourage this growth, we actively monitor the products and rates offered by our competition in the local market and develop new products and/or offer aggressive rates to attract new balances in the most cost-effective manner possible.
The decrease in retail certificate balances occurred as we attempted to move away from offering rates competitive with the higher rates in the local market. While this has resulted in some of the more rate-sensitive depositors exiting the Bank for higher rates elsewhere, most of those deposits have remained on our books at significantly lower costs to the Bank.
Our preferred supplemental funding mechanism is borrowing funds from the Federal Home Loan Bank of Seattle (FHLB). With the reduction in assets exceeding the decline in deposit balances, we experienced a modest decrease in our FHLB advances to $163 million at the end of the second quarter, compared to $178 million at the end of the first quarter of 2007 and $172 million at the 2006 year-end. As of June 30, 2007, we had the authority to borrow up to approximately $412 million from the FHLB, subject to maintaining a sufficient level of eligible collateral.
ASSET QUALITY
Provision and Reserve for Loan Loss and Loan Commitments Liability
The provision for loan losses reflects the amount deemed appropriate to produce an adequate reserve for probable loan losses inherent in the risk characteristics of the loan portfolio. In determining the appropriate reserve balance, we consider the current and historical performance of the loan portfolio, the amount and type of new loans added to the portfolio, our level of non-performing loans, the amount of loans charged off, and the economic conditions in which we currently operate.
The provisions for the second quarter and first six months of 2007 totaled $86,000 and $238,000 compared to provisions of $135,000 and $206,000 in the same periods last year. The reduction in the second quarter provision was prompted by the decline in our loan portfolio over the course of the quarter and continued high sales volumes of our sales finance loans, which typically account for the majority of charged-off loan balances.
Nonperforming assets, both in terms of balances and as a percentage of total assets, were little changed from the $3.5 million and 0.32% observed at the 2006 year-end, totaling $3.5 million and 0.34% at the end of the second quarter. While this level of nonperforming assets remains at the high end of our historical experience, it remains below industry standards. Noted below are the ratios from 1998 and the comparative industry ratios.
Year | First Mutual Bank | FDIC Insured Commercial Banks |
| 1998 | 0.07% | 0.65% |
| 1999 | 0.06% | 0.63% |
| 2000 | 0.38% | 0.74% |
| 2001 | 0.08% | 0.92% |
| 2002 | 0.28% | 0.94% |
| 2003 | 0.06% | 0.77% |
| 2004 | 0.10% | 0.55% |
| 2005 | 0.08% | 0.48% |
| 2006 | 0.32% | 0.51% |
| Second Quarter 2007 | 0.34% | N/A |
Including a $205,000 liability for unfunded commitments, our reserve for loan losses totaled approximately $10.0 million at June 30, 2007, down from $10.1 million at the 2006 year-end. At this level, the allowance for loan losses represented 1.12% of gross loans at June 30, 2007, compared to 1.11% at the 2006 year-end.
Non-Performing Assets
Our exposure to non-performing assets as of June 30, 2007 was:
| Two single-family residential loans in the Oregon market. No anticipated loss. | | $ | 1,451,000 | |
One mobile-home park loan in Oregon. No anticipated loss. Two single-family residential loans in Washington. No anticipated loss. Two custom construction loans in Oregon market. Impairment charges taken in 2006. No further losses anticipated. | | | 732,000 574,000 240,000 | |
| One single-family residential loan in the Puget Sound market. No anticipated loss. | | | 166,000 | |
| One land loan in Western Wa. No anticipated loss. | | | 86,000 | |
Nineteen consumer loans. Full recovery expected from insurance claims. One lease pool. No anticipated loss. Five consumer loans. Possible loss of $38,000. | | | 77,000 56,000 38,000 | |
| Eleven insured consumer loans that have exceeded the credit insurance limit. Possible loss of $35,000. | | | 35,000 | |
| Eight consumer loans. No anticipated loss. | | | 27,000 | |
| Total Non-Performing Assets | | $ | 3,482,000 | |
BUSINESS SEGMENTS
Beginning January 1, 2007, we changed the presentation of our Business Segments to more accurately reflect the way these segments are managed within the Bank. Prior to 2007, we recognized four business segments: 1) Consumer Lending, 2) Residential Lending, 3) Business Banking Lending, and 4) Income Property Lending. All other departments, including our Banking Centers and investment portfolio were assumed to support these business lines. Consequently, all income generated and expenses incurred at these support centers were allocated to the four business segments, resulting in no net income or loss at any department except the four lending units.
To better reflect how we manage the Bank, we have changed our business segments as follows:
| · | Established a “Retail Banking” segment which includes our banking centers and direct consumer lending. The Home Equity Lines of Credit (HELOC’s) and other consumer lending originated through the Banking Centers, which were previously included in the “Consumer Lending” segment, are included in this segment. The “Retail Banking” segment does not include Sales Finance lending. This segment also includes Community Business Banking (small business lending) which had been previously included in the “Business Banking” segment. |
| · | Isolated our Investment Securities activities as a separate business segment so that any changes in the investment portfolio’s market value or level of earning assets do not distort the reported operating results of our other business segments. |
In moving the banking centers, our primary source of funds generation, from an allocated overhead category to an operating segment, it became necessary to implement a new process for transferring funds from our funds-generating operations to the users of such funds. The objective of the funds transfer process is to isolate the true profit contribution of each side of the balance sheet. Prior to 2007, the profitability of the funds-generating operations, such as the banking centers, was defined as break-even with the lending segments collectively compensating the funds-generating operations such that this result was achieved. Under the new methodology, the rates at which funds are transferred between the generators and users of funds are based on market rates of interest. The profitability of the business segments, including retail banking, then varies depending on the actual rates earned on assets and paid on liabilities as well as expenses incurred in the segments’ operations. To assist in tracking and evaluating the profitability of such funds transfers, we now utilize four line items in determining each segment’s net interest income:
| · | Interest Income – This represents the actual interest received from the segment’s loans or securities. |
| · | Interest Income on Funding Sources – This represents the interest income received from selling funding sources generated by the segment (i.e. deposits or FHLB advances) to a centralized treasury function. The interest rate paid to the segment is based on the point on the FHLB rate curve for advances of a duration comparable to the segment’s funding source. |
| · | Funding Costs – This represents the interest paid to the centralized treasury function by each business segment for the funding sources necessary to support earning asset balances. Again, the interest rate charged to the segment is based on the point on the FHLB rate curve for advances of a duration comparable to the segment’s earning assets. |
| · | Interest Expense – This represents the actual interest paid on the segment’s liabilities (i.e. deposits or FHLB advances). |
The management reporting process measures the performance of the operating segments based on the management structure of the Bank and is not necessarily comparable with similar information for any other financial institution.
The reportable segments include the following:
| · | Retail Banking – Retail Banking is the segment primarily responsible for the generation of funding sources, specifically our consumer and small business deposit accounts. In addition to our banking centers, the segment includes our direct consumer and Community Business Banking (small business) lending departments. |
| · | Sales Finance Lending – Sales Finance generates indirect unsecured consumer loans in connection with home improvement projects. A large percentage of this segment’s loan volume is sold into the secondary market on a servicing-retained basis, meaning we continue to process payments and service the loan following the sale. |
| · | Residential Lending - Residential Lending offers loans to borrowers to purchase, refinance, or build homes secured by one-to-four-unit family dwellings. This segment also sells loans into the secondary market. We may choose to retain or sell the right to service the loans sold (i.e., collection of principal and interest payments) depending upon market conditions. |
| · | Business Banking Lending – Business Banking offers a full range of banking services to middle-market size businesses including deposit and cash management products, loans for financing receivables, inventory, equipment as well as permanent and interim construction loans for commercial real estate. The underlying real estate collateral or business asset being financed typically secures these loans. |
| · | Income Property Lending – Income Property Lending offers permanent and interim construction loans for multifamily housing (over four units) and commercial real estate properties. The underlying real estate collateral being financed typically secures these loans. |
| · | Investment Securities - The investment securities segment includes the investment securities portfolio, FHLB stock, and interest-earning cash balances. Although management does not consider this to be an operating business line, security investments represent a necessary part of liquidity management for the Bank. |
These segments are managed separately because each business unit requires different processes and different marketing strategies to reach the customer base that purchases the products and services. The segments derive a majority of their revenue from interest income, and we rely
primarily on net interest revenue in managing these segments. No single customer provides more than 10% of the Bank’s revenues.
Retail Banking
| | | Quarter Ended | | | Six Months Ended | |
| | | Net Income/(Loss) | | | Return on Equity | | | Net Income/(Loss) | | | Return on Equity | |
| June 30, 2005 | | $ | (347,000 | ) | | | (9.64 | %) | | $ | (685,000 | ) | | | (9.94 | %) |
| June 30, 2006 | | $ | 676,000 | | | | 20.27 | % | | $ | 1,067,000 | | | | 15.78 | % |
| June 30, 2007 | | $ | (235,000 | ) | | | (5.78 | %) | | $ | (329,000 | ) | | | (4.20 | %) |
Second quarter and year-to-date net income for our Retail Banking segment declined $911,000 and $1.4 million relative to the prior year based on a sharp reduction in net interest income, as rates paid on deposits continued to increase while market rates of interest, and thus the rates at which the retail operations are credited for their deposits, remained comparatively stable over the last four quarters.
As our Retail Banking segment includes our banking centers, the majority of this segment’s income is received from selling funding sources, specifically deposits generated and serviced in the banking centers, to lending units in need of funding to support earning asset balances. This income appears in the accompanying notes to our financial statements as “Treasury Income and Interest Income on Funding Sources” The line labeled “Funding Costs” represents the expense paid by the users of these funds to support their earning asset balances.
Relative to the second quarter of last year, the segment’s transferable funding sources (deposit balances) increased approximately $13.6 million, or 2%, totaling $674 million at the quarter-end. Combined with the movements in market rates of interest, at which these funds are transferred to our lending units, the Retail segment’s interest income from funding sources rose only $173,000, or 2%, from its second quarter 2006 level. Year-to-date results were slightly better, with income from funding sources rising $781,000, or more than 4%, compared to the first half of 2006. Other interest income for the segment, which consists of interest received on home equity, personal, and small business loans and lines, totaled $892,000 for the quarter, up $34,000 from the same period last year.
By comparison, the interest paid on deposits rose more than $1.1 million for the second quarter and $2.5 million for the first half of the year, as competition in the local marketplace continued to keep retail deposit rates high. As a result, the segment’s net interest income declined $931,000 relative to the second quarter and $1.7 million compared to the first half of last year.
Both noninterest income and noninterest expense for the segment were relatively little changed relative to the prior year. Noninterest income declined $85,000 over the first half of the year, while noninterest expense increased $468,000, or approximately 7% over the first six months of 2006. The increase in operating expense was attributable to both growth among ordinary expenses, such as salary expense, which increases each year as a result of annual increases in staff salaries, as well as allocations of the unusual expenses incurred in the quarter, which were described in the “Noninterest Expense” section. These expenses, which were allocated to the various business segments, included $175,000 in legal and other fees related to the Washington Federal transaction, a $158,000 retention bonus to our CFO for remaining with the Bank past his
retirement date, $163,000 in expenditures for the payoff of a contract for an outside operations consultant, and a charitable contribution in the amount of $188,000.
Sales Finance
| | | Quarter Ended | | | Six Months Ended | |
| | | Net Income | | | Return on Equity | | | Net Income | | | Return on Equity | |
| June 30, 2005 | | $ | 145,000 | | | | 10.42 | % | | $ | 511,000 | | | | 20.27 | % |
| June 30, 2006 | | $ | 232,000 | | | | 16.64 | % | | $ | 622,000 | | | | 22.23 | % |
| June 30, 2007 | | $ | 54,000 | | | | 3.88 | % | | $ | 389,000 | | | | 14.25 | % |
Net income for our Sales Finance segment declined $178,000, or approximately 77%, from the level earned in the second quarter of 2006, and $233,000, or 38%, from the level in the first half of last year, as significant increases in noninterest income, particularly gains on loan sales, were insufficient to offset a reduction in net interest income and increase in the loan loss provision.
The Sales Finance segment’s quarter-end earning assets declined significantly relative to the prior year level because of a substantial increase in the level of loan sales relative to prior years. Loan sales of more than $14 million in the second quarter and $30 million in the first half of this year exceeded the $10 million and $23 million sold in the same periods last year. With these sales, and resulting decline in earning assets, the segment’s second quarter and year-to-date interest income fell 24% and 22% relative to the prior year. While the lower level of earning assets also reduced the segment’s funding requirement, and consequently its interest expense, the 18% and 15% reductions for the second quarter and first half funding costs offset only a portion of the lost interest income. As a result, the segment’s net interest income declined $288,000 and $599,000, or 30% and 31% from the second quarter and first half 2006 levels. With the segment’s second quarter loan loss provision increasing $338,000 relative to the prior year, net interest income after the loan loss provision declined $626,000, or 62%. On a year-to-date basis, net interest income after provision was down $1.1 million, or 54%. The increase in the loan loss provision relative to the prior year was related to the insured loan pools for years 2002-2003 and 2003-2004 reaching their 10% coverage limits. In relation to probable losses inherent in those pools, we have increased the segment’s loan loss provision.
While the increased level of loan sales over the last five quarters has negatively impacted the segment’s net interest income, it has contributed to improvements in noninterest income, which rose $404,000 and $731,000 relative to the second quarter and first six months of last year. The increase was attributable to additional gains on loan sales, which rose from $430,000 and $1.2 million in the second quarter and first half of 2006 to $746,000 and $1.7 million this year, as well as service fee income, which increased from $298,000 and $630,000 in 2006 to $431,000 and $892,000 this year.
The segment’s noninterest expense remained well contained relative to the second quarter of last year, increasing $47,000 or approximately 3% compared to the second quarter of 2006, and only $11,000, or less than 1% on a year-to-date basis. The modest rate of increase was partly attributable to a reduction in credit insurance premiums. As we stated in our 2006 year-end press release, after evaluating our use of credit insurance, we concluded that the benefits of the insurance no longer outweighed the costs and chose to forego the insurance and assume the credit risk on future sales finance loan production. Consequently, it was our expectation that expenditures for credit insurance would decline in 2007. Those loans insured prior to August 1,
2006 remain insured under their existing policies, and some loans originated on or after August 1, 2006 were sold to institutional investors with insurance placed prior to sale and remain insured under the policy effective August 1, 2006.
Residential Lending
| | | Quarter Ended | | | Six Months Ended | |
| | | Net Income | | | Return on Equity | | | Net Income | | | Return on Equity | |
| June 30, 2005 | | $ | 777,000 | | | | 28.97 | % | | $ | 1,423,000 | | | | 28.66 | % |
| June 30, 2006 | | $ | 550,000 | | | | 19.61 | % | | $ | 1,293,000 | | | | 23.27 | % |
| June 30, 2007 | | $ | 661,000 | | | | 20.16 | % | | $ | 1,432,000 | | | | 21.81 | % |
The Residential Lending segment’s net income for the second quarter totaled $661,000, representing a 20% increase over the same period last year, based on a reduction in the segment’s provision for loan losses. On a year-to-date basis, net income rose by nearly 11% as a result of a lower provision as well as modest improvements in net interest and noninterest income - - which were partly offset by higher noninterest expenses.
While the Residential segment has been one of the largest contributors to our earning asset growth in recent years, the segment’s earning assets dropped relative to their level as of June 30, 2006, falling $11 million, or approximately 3%, as a slowdown in residential lending resulted in a substantial reduction in both the number of loans originated and the portfolio balances. Based on the reduction in assets, and taking into account any repricing effects resulting from movements of interest rate indexes from which the loan rates are set, interest income earned on the portfolio declined nearly 4% relative to the second quarter of last year. The segment’s funding costs and resulting net interest income also fell approximately 4% and 3% relative to the second quarter of 2006. For the year-to-date period, interest income, funding costs, and the resulting net interest income each rose by approximately 1%. The segment’s provision for loan loss declined $236,000 from the second quarter 2006 level based on recoveries of $198,000 in the second quarter and no new charged-off balances.
For the quarter and six months ended June 30, 2007, the Residential Lending segment’s noninterest income rose $20,000 and $141,000, respectively, compared to the same periods last year, based largely on additional loan fee income and gains on loan sales. Loan fee income increased relative to the prior year based on a higher level of fees collected in connection with loan modifications or extensions, and non-conversion of construction loans to permanent mortgages. Gains on residential loan sales fluctuate from quarter to quarter, and typically result in modest gains or even slight losses when interest rates are rising quickly. We believe the construction phase to be the most profitable facet of residential lending and the primary objective in a residential lending relationship. Following the construction process, our practice is to retain in our portfolio those residential mortgages that we consider to be beneficial to the Bank, but to sell those that we consider less attractive assets.
The Residential segment’s noninterest expense increased $21,000, or 2% for the quarter, and $131,000, or 6% through the first six months of the year, partially offsetting the quarter’s income growth over the same period last year. A reduction in the amount of loan origination expenses eligible for deferral and amortization contributed significantly to the increase relative to last year.
In accordance with current accounting standards, certain loan origination costs, including some salary expenses tied to loan origination, are deferred and amortized over the life of each loan originated, rather than expensed in the current period. Expenses are then reported in the financial statements net of these deferrals. The amount of expense subject to deferral and amortization can vary from one period to the next based upon the number of loans originated, the mix of loan types, and year-to-year changes in “standard loan costs”. In this instance, both the number of loans originated by our Residential lending area in the first half of 2007 as well as the deferred costs associated with each origination declined relative to the prior year. This resulted in a higher level of expense being recognized in the current period.
Business Banking Lending
| | | Quarter Ended | | | Six Months Ended | |
| | | Net Income | | | Return on Equity | | | Net Income | | | Return on Equity | |
| June 30, 2005 | | $ | 333,000 | | | | 17.78 | % | | $ | 570,000 | | | | 16.09 | % |
| June 30, 2006 | | $ | 283,000 | | | | 11.11 | % | | $ | 439,000 | | | | 10.17 | % |
| June 30, 2007 | | $ | 375,000 | | | | 11.14 | % | | $ | 673,000 | | | | 10.77 | % |
With earning assets totaling more than $162 million for the second quarter of 2007, an increase of 12% over the prior year level and the only asset growth among the lending segments, Business Banking’s interest income grew $608,000 and $1.2 million, or 24% and 26% over the levels earned in the second quarter and first half of 2006. Additionally, with deposit growth of nearly $26 million, or approximately 64%, compared to June 30, 2006, income credited for funding sources rose $312,000 and $636,000 over the prior year. Partially offsetting these improvements, however, were an additional $771,000 and $1.6 million in funding costs for the quarter and six months, respectively. Taking all of these into account, the Business Banking segment’s second quarter and six month net interest income after provision for loan losses rose $176,000 and $310,000, or 14% and 13%, over the same periods last year.
For the quarter and six months ended June 30, 2007, the Business Banking segment’s noninterest income declined $171,000 and $154,000 relative to prior year levels. This reduction was largely attributable to changes in the valuations of interest rate derivatives utilized by the segment to hedge interest rate risk on longer-term, fixed-rate commercial real estate loans. These derivatives were structured such that a gain on any given derivative would be matched against a comparable loss on a second, corresponding derivative, resulting in minimal net impact to the Bank’s earnings. Whereas changes in the values of these instruments contributed $50,000 to noninterest income in the first six months of the prior year, the impact through the first six months of 2007 was a reduction to noninterest income of approximately $105,000. That loss was essentially matched by a $108,000 reduction in noninterest expense resulting from market value changes in corresponding derivatives.
Taking into account the $158,000 reduction in noninterest expense attributable to the changes in derivative values, $50,000 in expense in 2006 versus a reduction of $108,000 in 2007, the segment’s noninterest expense declined $135,000 and $195,000 relative to the second quarter and first six months of 2006. Also worth noting is that under the new method of presenting our business segments, the business banking segment no longer faces significant increases in allocated overhead expenses as a result of deposit growth. Under the previous method of segmenting our business lines, our banking centers were deemed to be overhead cost centers
rather than an operating segment, and consequently all income and expenses associated with the banking centers was allocated among the four lending units. Consequently, the Business Banking segment’s deposit growth in prior years resulted in increasing allocations of banking center-related expense, which frequently negated the benefit of the additional deposits. With the banking centers now included in the Retail Banking segment, the Business Banking and other lending segments are no longer subject to allocations of banking center expense. Similarly, the lending segments no longer receive the benefit of funds generated by the banking centers at below-market rates of interest. The segment results for 2005 and 2006 have been restated to reflect this methodology consistently throughout the three years presented here.
Income Property Lending
| | | Quarter Ended | | | Six Months Ended | |
| | | Net Income | | | Return on Equity | | | Net Income | | | Return on Equity | |
| June 30, 2005 | | $ | 1,346,000 | | | | 22.26 | % | | $ | 2,759,000 | | | | 22.85 | % |
| June 30, 2006 | | $ | 1,074,000 | | | | 19.74 | % | | $ | 1,983,000 | | | | 18.40 | % |
| June 30, 2007 | | $ | 990,000 | | | | 16.54 | % | | $ | 2,235,000 | | | | 18.72 | % |
The Income Property segment’s second quarter net income declined $84,000, or 8% relative to the same quarter last year, as growth in net interest income was more than offset by falling noninterest income and rising noninterest expense. On a year-to-date basis, net income rose $252,000, or 13%, as the growth in net interest income was more than sufficient to offset the falling noninterest income and rising noninterest expense over that timeframe.
Compared to the prior year, the segment’s net interest income after provision for loan loss grew $116,000 and $574,000, or 5% and 13%, for the quarter and six months ended June 30. For the quarter, the improvement was the result of interest income from earning assets falling by a lesser amount than did interest expense on funding sources. On a year-to-date basis, not only did the segment’s funding costs decline, but interest income actually increased by $100,000 relative to the first six months of last year. The provision for loan loss declined $42,000 and $140,000 compared to the second quarter and first half of 2006, due in large part to a continued decline in portfolio balances.
The Income Property segment’s decrease in earning assets during the first half of 2007 continued a trend observed over the last couple of years, and is primarily a product of declining originations of permanent multifamily and commercial real estate loans, combined with a high level of prepayments on the loan portfolio, which we attribute to a combination of increased competition from other lenders and the flat yield curve. Increased competition from conduit lenders as well as lenders in our local market accelerated both the drop in new volumes as well as portfolio payoffs, as the competition frequently resulted in lenders offering prospective borrowers new loan commitments, or existing borrowers the opportunity to refinance, at unusually low margins. The flat yield curve, which has resulted from a number of increases in short-term interest rates, has reduced the rate differential between short- and long-term financing costs and provided a financial incentive for borrowers to select longer-term, fixed-rate loans as opposed to adjustable-rate financing. As we have historically been an originator of short-term and adjustable-rate loans, this impacted us in two ways. First, as prospective borrowers sought loans with terms that fell outside of our typical underwriting structures, our originations of permanent multifamily and commercial real estate loans declined. Second, with the yield curve
providing borrowers with a financial incentive to refinance adjustable-rate loans, which make up the majority of our loan portfolio, with longer-term, fixed-rate debt, the prepayment rates on our Income Property portfolio remained at relatively high levels.
Noninterest income for the Income Property segment declined $169,000 relative to both the second quarter and first half of last year, based on the combination of an unusual event last year and a negative impact from servicing asset write-offs this year. In the second quarter of 2006, the segment recognized an unusually high level of noninterest income as a result of an allocation of insurance proceeds received from a key-man life insurance policy. Additionally, the current quarter results were negatively impacted by the payoffs of loan participation balances sold to and serviced for other institutional investors. As these loans were paid off, we were forced to immediately write-off the related servicing assets, which negatively impacted the quarter’s noninterest income.
The segment’s noninterest expense increased modestly, rising $71,000 for the quarter and only $39,000 on a year-to-date basis compared to the same periods in 2006. As noted above, the Income Property segment has seen its earning asset balances decline over the last couple of years, and as a result, the segment has become a smaller component of our overall asset mix. Consequently, for a number of different administrative and overhead expenses that we allocate out to the business segments, such as accounting and information systems related costs, the percentages allocated to other business lines has tended to increase, thus reducing the percentage allocated to the Income Property segment.
Investment and Treasury
| | | Quarter Ended | | | Six Months Ended | |
| | | Net Income/(Loss) | | | Return on Equity | | | Net Income | | | Return on Equity | |
| June 30, 2005 | | $ | 264,000 | | | | 47.25 | % | | $ | 524,000 | | | | 47.57 | % |
| June 30, 2006 | | $ | (103,000 | ) | | | (25.65 | %) | | $ | 22,000 | | | | 2.47 | % |
| June 30, 2007 | | $ | (88,000 | ) | | | (25.23 | %) | | $ | 72,000 | | | | 8.67 | % |
The Investment and Treasury segment includes our investment securities portfolio on the asset side and, on the liability side, our FHLB advances and certificates of deposit issued through brokerage services. While management does not consider this to be an operating business line, our security investments and wholesale borrowings represent a necessary part of liquidity management, and their impact on our operations has been recognized as its own segment so as not to distort the results of our other business lines.
For the second quarter and first half of 2007, the segment posted net interest losses of $242,000 and $415,000, compared to a loss of $136,000 in the second quarter and net interest income of $74,000 for the first six months of last year. In the past, the cost of funding the securities portfolio exceeded its yield, while the FHLB advances and brokered deposits originated by the segment were “sold” to the lending units at rates exceeding the cost of those funding sources. In the second quarter of 2007, however, the securities portfolio moved into a profitable position, though not sufficiently so to achieve profitability on a year-to-date basis, while the funding sources became modestly unprofitable, resulting in the net interest loss.
Noninterest income for the segment, which had been virtually nonexistent prior to this year, totaled $132,000 and $563,000 for the second quarter and first six months of 2007, largely as a
result of our early adoption of SFAS 157 and 159, effective January 1, 2007. SFAS 159, which was issued in February 2007, generally permits the mark-to-market of selected eligible financial instruments. In the case of our early adoption, SFAS 159-related gains on affected instruments totaled $236,000 through the first six months of the year. Additionally, we recognized $116,000 in gains on securities sales during the second quarter.
The segment’s noninterest expense is virtually immaterial, totaling $33,000 for the second quarter and $56,000 for the first half of 2007, both comparable to the prior year levels, and represents allocations of accounting and administrative overhead costs associated with the management of the portfolio.
LIQUIDITY
Our primary sources of liquidity are loan and security sales and repayments, deposits, and wholesale funds. A secondary source of liquidity is cash from operations, which, though not a significant source of liquidity, is a consistent source based upon the quality of our earnings. Our principal uses of liquidity are the origination and acquisition of loans and securities, and to a lesser extent, purchases of facilities and equipment.
| | | Quarter Ended June 30, | | | Six Months Ended June 30, | |
| | | 2007 | | | 2006 | | | 2007 | | | 2006 | |
| | | (Dollars in thousands) | |
| Loan Originations (disbursed) | | $ | (128,000 | ) | | $ | (158,000 | ) | | $ | (223,000 | ) | | $ | (280,000 | ) |
| Increase/(Decrease) in Undisbursed Loan Proceeds | | | 0 | | | | 3,000 | | | | (17,000 | ) | | | (2,000 | ) |
| Security Purchases | | | (37,000 | ) | | | 0 | | | | (42,000 | ) | | | (7,000 | ) |
| Total Originations and Purchases | | $ | (165,000 | ) | | $ | (155,000 | ) | | $ | (282,000 | ) | | $ | (289,000 | ) |
| | | | | | | | | | | | | | | | | |
| Loan and Security Repayments | | $ | 101,000 | | | $ | 105,000 | | | $ | 206,000 | | | $ | 217,000 | |
| Sales of Securities | | | 59,000 | | | | 0 | | | | 58,000 | | | | 0 | |
| Sales of Loans | | | 39,000 | | | | 28,000 | | | | 66,000 | | | | 51,000 | |
| Total Repayments and Sales | | $ | 199,000 | | | $ | 133,000 | | | $ | 330,000 | | | $ | 268,000 | |
| | | | | | | | | | | | | | | | | |
| Net Difference | | $ | 34,000 | | | $ | (22,000 | ) | | $ | 48,000 | | | $ | (21,000 | ) |
Loan and security sales and repayments, our primary sources of funding, are heavily influenced by trends in mortgage rates. When rates trend downward, our prepayment speeds typically increase as borrowers refinance their loans at lower interest rates. Conversely, as rates move upwards, prepayments will generally tend to slow, as fewer borrowers will have a financial incentive to refinance their loans. The loan portfolio, excluding loans sold into the secondary market and spec construction loans, experienced an annualized prepayment rate of 36% in the first half of 2007, comparable to the 38% and 39% rates observed for the first half of 2006 and fiscal year 2006, respectively.
We believe the flat-to-inverted shape of the yield curve that has persisted since mid-2005 to the present time likely contributed to the continued high level of prepayments, as the rate differential between short- and long-term financing diminished and reduced the financial incentive for borrowers to use shorter-term, adjustable-rate financing rather than longer-term fixed rate loans.
This, in turn, provides borrowers holding short-term or adjustable-rate loans, which represent the majority of our loan portfolio, with an incentive to refinance with long-term fixed-rate loans.
Our preferred method of funding the net difference between originations/purchases and repayments/sales is with deposits. To the extent that deposit growth is insufficient to fully fund the difference, we may rely on wholesale funding sources including, but not limited to FHLB advances, brokered certificates of deposit, and reverse repurchase agreements. During the second quarters and first halves of 2006 and 2007, changes in funds from deposits and borrowings were as follows:
| | | Quarter Ended June 30, | | | Six Months Ended June 30, | |
| | | 2007 | | | 2006 | | | 2007 | | | 2006 | |
| Deposits | | $ | (12,000 | ) | | $ | (23,000 | ) | | $ | (46,000 | ) | | $ | (37,600 | ) |
| Borrowings | | | (15,000 | ) | | | 41,000 | | | | (8,000 | ) | | | 23,000 | |
| Total | | $ | (27,000 | ) | | $ | 18,000 | | | $ | (54,000 | ) | | $ | 23,000 | |
Through the first half of the year, our total deposit balances fell $46 million, or approximately 6% from their year-end level, including $12 million in the second quarter. Non-maturity deposit balances, however, rose nearly $17 million, with $5 million occurring in the second quarter. Time deposits, including certificates issued through brokerage services, declined nearly $63 million, with a $17 million decrease occurring in the most recent quarter. Brokered and other institutional certificates of deposit accounted for approximately $39 million of the year-to-date reduction.
The inflows and outflows of deposits vary from period to period, and our ability to raise liquidity from this source is dependent on our effectiveness in competing with other financial institutions in our local market. That competition tends to focus on rate and service. Although we control the quality of service that we provide, we have no control over the prevailing rates in our marketplace.
Our other major source of liquidity is wholesale funds, which include borrowings from the FHLB, brokered deposits, reverse repurchase agreements, and a revolving line of credit at the Holding Company level. The most utilized wholesale funding source is FHLB advances, which totaled $163 million at the end of the second quarter, down slightly from $172 million at the 2006 year-end. Our credit line with the FHLB is reviewed annually, and our maximum allowable borrowing level is currently set at 40% of assets, or $412 million based on assets as of June 30, 2007. As a percentage of quarter-end assets, our FHLB borrowings totaled approximately 16% at both June 30, 2007 as well as the 2006 year-end. Potential risks associated with this funding source include the reduction or non-renewal of the line and insufficient collateral to utilize the line. We attempt to mitigate the risk of non-renewal by maintaining the credit quality of our loans and securities and attending to the quality and consistency of our earnings.
The potential risk of not holding enough collateral to fully utilize our available FHLB advances is monitored to ensure that ample collateral is available to meet our funding needs. Our two principal sources of preferred collateral are single-family residential and multifamily loans. Because single-family lending has exhibited significant growth in recent years, we are encouraged that this business line will be able to provide sufficient collateral to meet our FHLB borrowing requirements.
Brokered deposits, which are included in the deposit totals, amounted to $14 million as of June 30, 2007, compared to $47 million as of the 2006 year-end. While the rates on these deposits are typically very comparable to those of FHLB advances, at various times in late 2005 and throughout 2006, the rates on brokered deposits fell below those of similar term FHLB advances. At such times, and subject to our funding needs, we elected to increase our use of this funding source and routinely issued brokered deposits to replace maturing FHLB advances. As of June 30, 2007, brokered deposits represented 1.8% of total deposits compared to 5.9% at the 2006 year-end. Our internal policy limits restrict our total usage of brokered certificates to no more than 10% of total deposits.
Reverse repurchase lines are lines of credit collateralized by securities. We currently have lines totaling $35 million, of which the full amount is currently available. There has been no usage of these lines in the previous three years. The risks associated with these lines are the withdrawal of the line based on the credit standing of the Bank and the potential lack of sufficient collateral to support the lines.
An additional source of liquidity has been our cash from operations, which, though not a significant source of liquidity, we consider to be a consistent source based upon our earnings. On a very limited basis it can be viewed as cash from operations adjusted for items such as provision for loan loss and depreciation. See the “Consolidated Statements of Cash Flows” in the financial statements section of this filing for a calculation of net cash provided by operating activities.
In addition to using liquidity to fund loans and securities, we routinely invest in facilities and equipment. In the second quarter and first half of 2007 we invested $226,000 and $817,000 in these assets, down from $1.3 million and $2.7 million in the same periods in 2006, as most of our major capital projects were completed by the end of last year.
CAPITAL
The FDIC’s statutory framework for capital requirements establishes five categories of capital strength, ranging from a high of well capitalized to a low of critically under-capitalized. An institution’s category depends upon its capital level in relation to relevant capital measures, including a risk-based capital measure, a leverage capital measure, and certain other factors. At June 30, 2007, we exceeded the capital levels required to meet the definition of a well-capitalized institution:
| | Actual | Minimum for Capital Adequacy Purposes | Minimum to be Categorized as “Well Capitalized” Under Prompt Corrective Action Provisions |
| | | | |
| Total capital (to risk-weighted assets): | | | |
| First Mutual Bancshares, Inc. | 12.65% | 8.00% | N/A |
| First Mutual Bank | 12.92 | 8.00 | 10.00% |
| | | | |
| Tier I capital (to risk-weighted assets): | | | |
| First Mutual Bancshares, Inc. | 11.40 | 4.00 | N/A |
| First Mutual Bank | 11.67 | 4.00 | 6.00 |
| | | | |
| Tier I capital (to average assets): | | | |
| First Mutual Bancshares, Inc. | 8.76 | 4.00 | N/A |
| First Mutual Bank | 8.97 | 4.00 | 5.00 |
SUBSEQUENT EVENTS
Merger with Washington Federal
On July 2, 2007 we announced the signing of a definitive merger agreement. The merger agreement calls for the merger of First Mutual with and into the Company, followed by the merger of First Mutual Bank into the Company’s wholly owned subsidiary, Washington Federal Savings, in a stock and cash transaction valued at approximately $189.8 million. After consummation of the merger, the combined Company will have 148 offices in eight western states with total assets of approximately $11 billion and total deposits of approximately $6.8 billion.
Securities
Based on our observations of the portfolio and hedge over the course of the quarter, we elected to further reduce the size of the portfolio and unwind the hedge position. Consequently, in early July we sold securities with market values totaling approximately $41 million and unwound the hedge position. Our net losses from those activities totaled $213,000. At the present time, we do not anticipate conducting any further securities transactions.
Trust Preferred Securities
In June of 2002, we issued our first Trust Preferred Security (TPS) in the amount of $9 million with an interest rate adjustable on a quarterly basis. At the same time, we entered into an interest rate swap with the FHLB in order to protect against potential adverse interest rate volatility from the TPS by fixing the interest rate payable for the first five years of the TPS’ life. The swap matured in July of this year, resulting in a funding cost subject to adjustment on a quarterly basis at 3.65% over the current three-month LIBOR rate.
As margins on current TPS issues have declined to approximately 1.35% to 1.65% over three-month LIBOR, we had previously expressed an intention to call the outstanding $9 million TPS at the earliest contractual redemption date, in this case September 2007, and replace the issue with a new TPS at a lower margin. We have since, in consideration of the pending merger with Washington Federal Inc., elected instead to call the outstanding $9 million TPS without replacement. However, because we issued a commitment to replace the redeemed TPS we were required to pay a cancellation fee of $55,000.
Even with the retirement and non-replacement of the TPS, we expect to remain “well capitalized” in accordance with regulatory guidelines.
ITEM 3. Quantitative and Qualitative Disclosures About Market Risk
Market risk is defined as the sensitivity of income and capital to changes in interest rates, and other relevant market rates or prices. Our profitability is largely dependent on our net interest income. Consequently, our primary exposure to market risk arises from the interest rate risk inherent in our lending, mortgage banking, deposit, and borrowing activities. Interest rate risk is the risk to earnings and capital resulting from adverse movements in interest rates. To that end, we actively monitor and manage our exposure to interest rate risk.
A number of measures are utilized to monitor and manage interest rate risk, including net interest income and economic value of equity simulation models, as well as traditional “gap” models. We prepare these models on a quarterly basis for review by our Asset Liability Committee (ALCO), senior management, and Board of Directors. The use of these models requires us to formulate and apply assumptions to various balance sheet items. Assumptions regarding interest rate risk are inherent in all financial institutions, and may include, but are not limited to, prepayment speeds on loans and mortgage-backed securities, cash flows and maturities of financial instruments held for purposes other than trading, changes in market conditions, loan volumes and pricing, deposit sensitivities, consumer preferences, and management’s capital leverage plans. We believe that the data and assumptions used for our models are reasonable representations of our portfolio and possible outcomes under the various interest rate scenarios. Nonetheless, these assumptions are inherently uncertain; therefore, the models cannot precisely estimate net interest income or predict the impact of higher or lower interest rates on net interest income. Actual results may differ significantly from simulated results due to timing, magnitude, and frequency of interest rate changes, and changes in market conditions and specific strategies, among other factors.
Asset and Liability Management
Our primary objective in managing interest rate risk is to minimize the adverse impact of changes in interest rates on our net interest income and capital, while structuring the asset and liability components to maximize net interest margin, utilize capital effectively, and provide adequate liquidity. We rely primarily on our asset and liability structure to control interest rate risk.
Asset and liability management is the responsibility of the Asset Liability Committee, which acts within policy directives established by the Board of Directors. This committee meets regularly to monitor the composition of the balance sheet, to assess projected earnings trends, and to formulate strategies consistent with the objectives for liquidity, interest rate risk, and capital adequacy. The objective of asset/liability management is to maximize long-term shareholder returns by optimizing net interest income within the constraints of credit quality, interest rate risk policies, levels of capital leverage, and adequate liquidity. Assets and liabilities are managed by matching maturities and repricing characteristics in a systematic manner.
Hedging Techniques
We review interest rate trends on a monthly basis and employ hedging techniques where appropriate. These techniques may include financial futures, options on financial futures, interest rate caps and floors, interest rate swaps, and extended commitments on future lending activities.
Typically, the extent of our off-balance-sheet derivative agreements has been the use of forward loan commitments, which are used to hedge our loans held-for-sale. Additionally, in 2002 we entered into an interest rate swap with the FHLB. The purpose of the swap was to protect against potential adverse interest rate volatility that could be realized from the Trust Preferred Securities (TPS) issued in June 2002. The swap accomplished this by fixing the interest rate payable for the first five years of the TPS’ life, and matured in June of this year.
In the second quarter of 2006, we began to utilize interest rate swaps in connection with the underwriting of longer-term, fixed-rate commercial real estate loans. This decision was the result of prospective borrowers’ demand for longer-term, fixed-rate loans, and the preference of depositors for instruments of significantly shorter terms. Under this program, we originated commercial mortgage loans with amortization schedules of up to thirty years and initial ten-year fixed rates. To hedge the interest rate risk exposure presented by ten-year, fixed-rate instruments, we utilized interest rate swaps on a loan-by-loan basis to convert each loan’s fixed rate to an adjustable rate subject to regular repricing relative to a market index rate, typically the one-month LIBOR rate. Only a few of these interest rate swaps were originated, and we do not consider the notional principal of the swaps, which totals less than $5 million, to be material relative to the size of our commercial loan portfolio. Additionally, the swaps originated under this program were used solely for the purpose of managing the interest rate risk associated with longer-term, fixed-rate assets, and not for any speculative purposes.
Finally, in the first quarter of this year, we elected early adoption of SFAS 157 and 159 with respect to the majority of our securities portfolio, the previously mentioned TPS, and selected other financial instruments. Consequently, these assets and liabilities would be reflected on our statements of condition at their fair values, with any changes in market value over the course of a period recognized as income or losses in the current period’s operating results. In the first week of May, based on the earnings volatility presented by the new accounting treatment, we elected to reduce the volatility of the securities portfolio by reselling some recently purchased securities in the secondary market and utilizing interest rate swaps with notional principal totaling $42 million to partially hedge against movements in the market value of the remaining trading portfolio. Based on our observations of the portfolio and hedge over the remainder of the quarter, we elected to further reduce the size of the portfolio and unwind the hedge position. Consequently, in early July we sold additional securities with market values totaling approximately $40 million and unwound the hedge position.
Net Interest Income (NII) and Economic Value of Equity (EVE) Simulation Model Results
| | | June 30, 2007 | | December 31, 2006 |
| | | Percentage Change | | Percentage Change |
Change in Interest Rates | | Net Interest | Economic Value | | Net Interest | Economic Value |
(in basis points) | | Income | of Equity | | Income | of Equity |
| +200 | | 1.32% | 1.08% | | 2.40% | (1.07%) |
| +100 | | n/a | 1.31% | | n/a | 0.06% |
| -100 | | n/a | (1.69%) | | n/a | (0.88%) |
| -200 | | 0.60% | (5.46%) | | 0.23% | (3.76%) |
Net Interest Income Simulation
Our income simulation model based on information as of June 30, 2007 indicated that our net interest income over the following twelve months was projected to increase from its “base case” level in scenarios in which interest rates were assumed to either gradually increase or decline by 200 bps over a twelve-month period. The magnitudes of the changes, however, suggest that there is little sensitivity in net interest income from the “base case” level over a twelve-month horizon in either scenario, as an increase in net interest income of 1.32% was observed in the rising rate environment and an improvement of 0.60% was indicated in the falling rate scenario.
The changes indicated by the simulation model represent variances from a “base case” scenario, which is a projection of net interest income assuming interest rates remain unchanged from their current levels over the life of the forecast, and that the size of the balance sheet remains stable over the forecast timeframe, with no growth or contraction regardless of interest rate movements. The base model will, however, illustrate the future effects of rate changes that have already occurred but have not yet flowed through to all the assets and liabilities on our balance sheet. These changes can either increase or decrease net interest income, depending on the timing and magnitudes of those changes. Additionally, the tendencies for loan and investment prepayments to accelerate in falling interest rate scenarios and slow when interest rates rise have been incorporated into the model assumptions. Implicit in these assumptions are additional assumptions for increased securities purchases and loan originations at lower interest rate levels to offset accelerated prepayments, and conversely, reduced securities purchases and loan production when rates increase and prepayments slow.
The rising and falling rate ramp scenarios then indicate that if the slope of the yield curve remains the same, and customer loan and deposit preferences do not change in response to further movements of the yield curve, then a parallel 200 basis point increase or decrease in rates will not significantly change net interest income from what is presently expected in the “base case.” In the event the simulation model indicated that the increase or decrease in interest rates over the following twelve months would adversely affect our net interest income over the same period by more than 10% relative to the “base case” scenario, we would consider the indicated risk to have exceeded our internal policy limit.
Economic Value of Equity (EVE) Simulation
The EVE analysis goes beyond simulating net interest income for a specified period to estimating the present value of all financial instruments in our portfolio and then analyzing how the economic value of the portfolio would be affected by various alternative interest rate scenarios. The portfolio’s economic value is calculated by generating principal and interest cash flows for the entire life of all assets and liabilities, then discounting these cash flows back to their present values. The assumed discount rate used for each projected cash flow is based on a current market rate, such as a LIBOR, FHLB, or swap curve rate, and from alternative instruments of comparable risk and duration. In the event the simulation model demonstrates that a 200 basis point increase or decrease in rates would adversely affect our EVE by more than 25%, we consider the indicated risk to have exceeded our internal policy limit. Again, as illustrated in the above results, we are operating within the 25% internal policy limit in all scenarios.
In the simulated 200 bps upward shift of the yield curve, the discount rates used to calculate the present values of assets and liabilities will increase, causing the present values of both assets and liabilities to fall, with more prominent effects on longer-term, fixed-rate instruments. Additionally, when interest rates rise, the cash flows on our assets are typically expected to decelerate as borrowers are assumed to become less likely to prepay their loans. As the cash flows on these assets are shifted further into the future, their present values are further reduced. Our EVE simulation model results as of June 30, 2007 indicated that our liabilities would be expected to exhibit a greater level of sensitivity to rising rates than assets, with the economic value of assets declining by 2.36%, compared to a decline of 2.83% for our liabilities. Given the greater sensitivity of liabilities, the reduction in the economic value of liabilities exceeded the impact on assets. Consequently, the economic value of our equity was positively impacted in this scenario, rising 1.08%.
The opposite occurs when rates decline, as the discount rates used to calculate the present values of assets and liabilities will decrease, causing the present values of both assets and liabilities to rise. Counteracting this effect on assets, however, is the tendency for cash flows from assets to accelerate in a falling rate scenario, as borrowers refinance their existing loans at lower interest rates. These loan prepayments prevent the economic values of these assets from increasing in a declining rate scenario, illustrating an effect referred to as negative convexity. Taking this negative convexity into account, the simulation results indicated a negative impact to EVE in the falling rate scenario. In this case, the economic values of both assets and liabilities were positively impacted when rates were assumed to fall by 200 bps, assets by 1.84% and liabilities by 2.84%. As a result, with the value of liabilities rising more than asset values, our economic value of equity was negatively impacted in this scenario, declining 5.46%.
The Net Interest Income and Economic Value of Equity sensitivity analyses do not necessarily represent forecasts. As previously noted, there are numerous assumptions inherent in the simulation models as well as in the gap report, including the nature and timing of interest levels, the shape of the yield curve, loan and deposit growth, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, reinvestment/replacement of asset and liability cash flows, customer preferences, and competitor and economic influences.
Gap Model
In addition to the above simulation models, an interest “gap” analysis is used to measure the matching of our assets and liabilities and exposure to changes in interest rates. This model, which represents a traditional view of interest rate sensitivity, quantifies the mismatch between assets maturing, repricing, or prepaying within a period, and liabilities maturing or repricing within the same period. A gap is considered positive when the amount of interest-rate-sensitive assets exceeds the amount of interest-rate-sensitive liabilities within a given period. A gap is considered negative in the reverse situation.
One-Year Interest Rate Sensitivity Gap
| | | June 30, 2007 | | | December 31, 2006 | |
| | | (Dollars in thousands) | |
| One-Year Repricing/Maturing Assets | | $ | 623,534 | | | $ | 673,514 | |
| One-Year Repricing/Maturing Liabilities | | | 664,410 | | | | 725,636 | |
| | | | | | | | | |
| One-Year Gap | | $ | (40,876 | ) | | $ | (52,122 | ) |
| | | | | | | | | |
| Total Assets | | $ | 1,029,030 | | | $ | 1,079,272 | |
| | | | | | | | | |
| One-Year Interest Rate Gap as a Percentage of Assets | | | (4.0 | %) | | | (4.8 | %) |
At a negative, or liability sensitive, 4.0% of assets, our twelve-month interest rate sensitivity gap as of June 30, 2007 indicated a modest degree of liability sensitivity comparable to the 4.8% observed at the 2006 year-end. Certain shortcomings are inherent in gap analysis, including the failure to recognize differences in the frequencies and magnitudes of repricing for different balance sheet instruments. Additionally, some assets and liabilities may have similar maturities or repricing characteristics, but they may react differently to changes in interest rates. This illustrates a facet of interest rate exposure referred to as “basis risk.” Assets, such as adjustable-rate mortgage loans, may also have features that limit the effect that changes in interest rates have on the asset in the short-term and/or over the life of the loan, for example a limit on the amount by which the interest rate on the loan is allowed to adjust each year. This illustrates another area of interest rate exposure referred to as “option risk.” Due to the limitations of the gap analysis, these features are not taken into consideration. Additionally, in the event of a change in interest rates, prepayment and early withdrawal penalties could deviate significantly from those assumed in the gap calculation. As a result, we utilize the gap report as a complement to our income simulation and economic value of equity models.
Securities
The following table sets forth certain information regarding carrying values and percentage of total carrying values of the Bank’s consolidated portfolio of securities classified as available-for-sale and held-to-maturity.
| | | June 30, | |
| | | 2007 | | | 2006 | |
Available-for-Sale: | | Carrying Value | | | Percent of Total | | | Carrying Value | | | Percent of Total | |
| | | (Dollars in thousands) | |
| | | | |
| US Government treasury and agency obligations | | $ | | | | | 0 | % | | $ | 10,611 | | | | 11 | % |
| Mortgage-backed securities: | | | | | | | | | | | | | | | | |
| Freddie Mac | | | 472 | | | | 11 | % | | | 14,847 | | | | 15 | % |
| Ginnie Mae | | | 2,588 | | | | 62 | % | | | 37,871 | | | | 39 | % |
| Fannie Mae | | | 1,121 | | | | 27 | % | | | 33,810 | | | | 35 | % |
| Total mortgage-backed securities | | | 4,181 | | | | 100 | % | | | 86,528 | | | | 89 | % |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
Total securities available-for-sale | | $ | 4,181 | | | | 100 | % | | $ | 97,139 | | | | 100 | % |
| | | June 30, | |
| | | 2007 | | | 2006 | |
Held-to-Maturity: | | Carrying Value | | | Percent of Total | | | Carrying Value | | | Percent of Total | |
| | | (Dollars in thousands) | |
| | | | |
| Municipal bonds | | $ | 4,136 | | | | 53 | % | | $ | 1,166 | | | | 19 | % |
| Mortgage-backed securities: | | | | | | | | | | | | | | | | |
| Freddie Mac | | | 96 | | | | 1 | % | | | 325 | | | | 5 | % |
| Fannie Mae | | | 3,660 | | | | 46 | % | | | 4,662 | | | | 76 | % |
| Total mortgage-backed securities | | | 3,756 | | | | 47 | % | | | 4,987 | | | | 81 | % |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
Total securities held-to-maturity | | $ | 7,892 | | | | 100 | % | | $ | 6,153 | | | | 100 | % |
| | | | | | | | | | | | | | | | | |
Estimated market value | | $ | 7,819 | | | | | | | $ | 6,032 | | | | | |
The following table shows the maturity or period to repricing of the Bank’s consolidated portfolio of securities available-for-sale and held-to-maturity:
| | | Available-for-sale at June 30, 2007 | |
| | | One Year or Less | | | Over One to Three Years | | | Over Three to Five Years | | | Over Five to Ten Years | | | Over Ten to Twenty Years | | | Over Twenty Years | | | Total | |
| | | Carrying Value | | | Weighted Average Yield | | | Carrying Value | | | Weighted Average Yield | | | Carrying Value | | | Weighted Average Yield | | | Carrying Value | | | Weighted Average Yield | | | Carrying Value | | | Weighted Average Yield | | | Carrying Value | | | Weighted Average Yield | | | Carrying Value | | | Weighted Average Yield | |
Available-for-Sale: | | (Dollars in thousands) | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Mortgage-backed securities: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Ginnie Mae | | $ | 2,588 | | | | 3.87 | % | | $ | | | | | 0.00 | % | | $ | | | | | 0.00 | % | | $ | | | | | 0.00 | % | | $ | | | | | 0.00 | % | | $ | | | | | 0.00 | % | | $ | 2,588 | | | | 3.87 | % |
| Freddie Mac | | | 216 | | | | 7.13 | % | | | 256 | | | | 5.50 | % | | | | | | | 0.00 | % | | | | | | | 0.00 | % | | | | | | | 0.00 | % | | | | | | | 0.00 | % | | | 472 | | | | 6.24 | % |
| Fannie Mae | | | 197 | | | | 7.20 | % | | | 239 | | | | 5.50 | % | | | | | | | 0.00 | % | | | | | | | 0.00 | % | | | 685 | | | | 4.50 | % | | | | | | | 0.00 | % | | | 1,121 | | | | 5.19 | % |
| Total mortgage-backed securities | | | 3,001 | | | | 4.32 | % | | | 495 | | | | 5.50 | % | | | | | | | 0.00 | % | | | | | | | 0.00 | % | | | 685 | | | | 4.50 | % | | | | | | | 0.00 | % | | | 4,181 | | | | 4.49 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Total securities available-for-sale -- Carrying Value | | $ | 3,001 | | | | 4.32 | % | | $ | 495 | | | | 5.50 | % | | $ | | | | | 0.00 | % | | $ | | | | | 0.00 | % | | $ | 685 | | | | 4.50 | % | | $ | | | | | 0.00 | % | | $ | 4,181 | | | | 4.49 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Total securities available-for-sale -- Amortized Cost | | $ | 2,996 | | | | 4.32 | % | | $ | 489 | | | | 5.50 | % | | $ | | | | | 0.00 | % | | $ | | | | | 0.00 | % | | $ | 717 | | | | 4.50 | % | | $ | | | | | 0.00 | % | | $ | 4,202 | | | | 4.49 | % |
| | | Held-to-Maturity at June 30, 2007 | |
| | | One Year or Less | | | Over One to Three Years | | | Over Three to Five Years | | | Over Five to Ten Years | | | Over Ten to Twenty Years | | | Over Twenty Years | | | Total | |
| | | Carrying Value | | | Weighted Average Yield | | | Carrying Value | | | Weighted Average Yield | | | Carrying Value | | | Weighted Average Yield | | | Carrying Value | | | Weighted Average Yield | | | Carrying Value | | | Weighted Average Yield | | | Carrying Value | | | Weighted Average Yield | | | Carrying Value | | | Weighted Average Yield | |
Held-to-Maturity: | | (Dollars in thousands) | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Municipal bonds | | $ | | | | | 0.00 | % | | $ | | | | | 0.00 | % | | $ | | | | | 0.00 | % | | $ | | | | | 0.00 | % | | $ | 3,220 | | | | 5.14 | % | | $ | 916 | | | | 6.31 | % | | $ | 4,136 | | | | 5.40 | % |
| Mortgage-backed securities: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Freddie Mac | | | 96 | | | | 7.38 | % | | | | | | | 0.00 | % | | | | | | | 0.00 | % | | | | | | | 0.00 | % | | | | | | | 0.00 | % | | | | | | | 0.00 | % | | | 96 | | | | 7.38 | % |
| Fannie Mae | | | 1,053 | | | | 7.53 | % | | | 1,260 | | | | 4.75 | % | | | | | | | 0.00 | % | | | | | | | 0.00 | % | | | 1,347 | | | | 4.77 | % | | | | | | | 0.00 | % | | | 3,660 | | | | 5.55 | % |
| Total mortgage-backed securities | | | 1,149 | | | | 7.52 | % | | | 1,260 | | | | 4.75 | % | | | | | | | 0.00 | % | | | | | | | 0.00 | % | | | 1,347 | | | | 4.77 | % | | | | | | | 0.00 | % | | | 3,756 | | | | 5.60 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Total securities held-to-maturity -- Carrying Value | | $ | 1,149 | | | | 7.52 | % | | $ | 1,260 | | | | 4.75 | % | | $ | | | | | 0.00 | % | | $ | | | | | 0.00 | % | | $ | 4,567 | | | | 5.03 | % | | $ | 916 | | | | 6.31 | % | | $ | 7,892 | | | | 5.50 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Total securities held-to-maturity -- Fair Market Value | | $ | 1,162 | | | | 7.52 | % | | $ | 1,248 | | | | 4.78 | % | | $ | | | | | 0.00 | % | | $ | | | | | 0.00 | % | | $ | 4,500 | | | | 5.04 | % | | $ | 909 | | | | 6.32 | % | | $ | 7,819 | | | | 5.51 | % |
ITEM 4. Controls and Procedures
An evaluation of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) of the Securities Exchange Act of 1934 (the “Act”)) was carried out under the supervision and with the participation of the Company’s Chief Executive Officer, Chief Financial Officer, and other members of the Company’s senior management, as of the end of the period covered by this report (the “Evaluation Date”). Based upon this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that, as of the Evaluation Date, the Company’s disclosure controls and procedures are effective in providing reasonable assurance that the material information required to be disclosed by the Company in the reports it files or submits under the Act is (i) accumulated and communicated to the Company’s management (including the Company’s Chief Executive Officer and Chief Financial Officer) in a timely manner, and (ii) recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms.
PART II: OTHER INFORMATION
ITEM 1. Legal Proceedings
At June 30, 2007, the Company was not engaged in any litigation, which in the opinion of management, after consultation with its legal counsel, would be material to the Company.
ITEM 1A. Risk Factors
For information regarding certain Risk Factors, please refer to Part I, Item 1A, in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006.
ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds
None.
ITEM 3. Defaults Upon Senior Securities
None.
ITEM 4. Submission of Matters to a Vote of Security Holders
The Annual Meeting of Shareholders of First Mutual Bancshares, Inc. was held on April 26, 2007. The results of votes on the matters presented at the Meeting are as follows:
The following individuals were elected as directors for the term noted:
CLASS III DIRECTORS | VOTES FOR | VOTES WITHHELD | TERM |
| | | | |
| Mary Case Dunnam | 6,471,614 | 79,444 | 3 Years |
| George W. Rowley, Jr. | 6,471,618 | 79,440 | 3 Years |
| John R. Valaas | 6,446,628 | 104,430 | 3 Years |
The terms of the Class I and II directors expire at the Annual Meeting of Shareholders for 2008 and 2009, respectively.
CLASS I DIRECTORS, term expires in 2008
Janine Florence
F. Kemper Freeman, Jr.
Robert J. Herbold
Victor E. Parker
CLASS II DIRECTORS, term expires in 2009
James J. Doud Jr.
Richard S. Sprague
Robert C. Wallace
ITEM 5. Other Information
None.
ITEM 6. Exhibits
| (2.0) | Agreement and Plan of Merger Between Washington Federal, Inc. and First Mutual Bancshares, Inc., incorporated by reference on Form 8-K filed with the SEC on July 3, 2007. |
| (3.1) | Amended and Restated Articles of Incorporation, incorporated by reference on Form 10-Q filed with the SEC on August 8, 2005. |
| (3.3) | Bylaws (as amended and restated), incorporated by reference on Form 8-K filed with the SEC on July 5, 2006. |
| (11) | Statement regarding computation of per share earnings. Reference is made to the Company’s Consolidated Statements of Income attached hereto as part of Item I Financial Statements, which are incorporated herein by reference. |
| (31.1) | Certification by President and Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| (31.2) | Certification by Executive Vice President and Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| (32) | Certification by Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| | FIRST MUTUAL BANCSHARES, INC. | |
| | | | |
| Date: August 9, 2007 | By: | /s/ John R. Valaas | |
| | | John R. Valaas | |
| | | President and Chief Executive Officer | |
| | | | |
| | | |
| | | | |
| | By: | /s/ Roger A. Mandery | |
| | | Roger A. Mandery | |
| | | Executive Vice President (Principal Financial Officer) | |
| | | | |
