The Company’s short-term investments in debt securities, all of which are classified as trading securities, are carried at their fair value based on the quoted prices of the securities at September 30, 2007. Net realized and unrealized gains and losses on trading securities are included in net earnings. For purpose of determining realized gains and losses, the cost of securities sold is based on specific identification.
The composition of trading securities is as follows at September 30, 2007. There were no trading securities in 2006.
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 third quarter and first nine months of 2007, our net income declined significantly relative to the same periods last year, totaling $1.9 million and $6.4 million, down from $3.0 million and $8.4 million for the quarter and nine months ended September 30, 2006. Our earnings per diluted share fell to $0.28 and $0.92, compared to $0.43 and $1.23 per diluted share in the third quarter and first nine months of last year, while return on average equity (ROE) totaled 10.42% for the quarter and 11.74% on a year-to-date basis, compared to 18.29% and 17.74% in the prior year, respectively.
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 second and third quarters was negatively impacted by expenses related to this transaction, including third quarter expenditures for merger-related legal and other services, a penalty for the cancellation of a commitment to issue $9 million in new trust preferred securities, and retention bonuses paid to our former CFO for remaining with the Bank past his scheduled April 2007 retirement date.
The primary source of revenue for each of our business lines is net interest income. For the third quarter and first nine months of 2007, our net interest income totaled $9.3 million and $27.5 million, down $902,000 and $2.9 million from the levels earned in the prior year. A key driver of net interest income is the level of our earning assets, which declined relative to the prior year, averaging $954 million for the quarter, down from $1,036 million in the third quarter of last year. The drop in earning assets was due largely to securities sales, which reduced the size of the
portfolio as of September 30, 2007 by nearly $75 million compared to the level at the September 2006 quarter-end. Also contributing to the decline in earning assets was a substantial reduction in loan originations, which fell from $400 million through the first three quarters of last year to $353 million in the first nine months of 2007, combined 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 declined $656,000 compared to the third quarter of last year, based on a substantial reduction in consumer loan sales during the quarter as market demand for these loans softened. Based on the higher levels of sales in the first half of this year, as well as higher levels of loan servicing fee income, noninterest income through the first nine months of the year still outpaced the prior year by approximately $366,000. Please see the “Noninterest Income” section for additional discussion.
Despite the unique expenses mentioned above, our operating expenses declined $140,000 relative to the third quarter of last year, and increased by only $314,000 on a year-to-date basis, as reductions in occupancy and credit insurance expenses partially offset increases in other noninterest expenses. Please refer to the “Noninterest Expense” section for additional information.
For the quarter ended September 30, 2007, our credit quality remained acceptable, with non-performing assets (NPAs) totaling $3.2 million, or 0.31% 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 $449,000 in provisions for loan losses and our reserve for loan losses, including unfunded commitments, totaled approximately $10.2 million, which was again little changed compared to $10.1 million at 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 nearly $1.1 million or approximately 35% for the third quarter of 2007 as compared to the same quarter last year, while year-to-date net income fell $2.0 million or 24% relative to last year. Net interest income declined $902,000 for the quarter and $2.9 million for the first nine months of 2007, while noninterest income fell $656,000 for the quarter but improved $366,000 on a year-to-date basis, and noninterest expense declined $140,000 for the quarter but increased $314,000 for the first nine months of the year.
Net Interest Income
For the quarter and nine months ended September 30, 2007, our net interest income declined $902,000 and $2.9 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 changes in the levels and mix of earning assets and funding sources positively impacted net interest income for both the quarter and nine month periods. 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 September 30, 2007 vs. September 30, 2006 | | | Nine Months Ended September 30, 2007 vs. September 30, 2006 | |
| | | Volume | | | Rate | | | Total | | | Volume | | | Rate | | | Total | |
| Interest Income | | (Dollars in thousands) | |
| Total Investments | | $ | (715 | ) | | $ | 29 | | | $ | (686 | ) | | $ | (670 | ) | | $ | 37 | | | $ | (633 | ) |
| Total Loans | | | (924 | ) | | | (11 | ) | | | (935 | ) | | | (1,794 | ) | | | 1,386 | | | | (408 | ) |
| Total Interest Income | | $ | (1,639 | ) | | $ | 18 | | | $ | (1,621 | ) | | $ | (2,464 | ) | | $ | 1,423 | | | $ | (1,041 | ) |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Interest Expense | | | | | | | | | | | | | | | | | | |
| Total Deposits | | | (247 | ) | | | 879 | | | | 632 | | | | (350 | ) | | | 3,816 | | | | 3,466 | |
| FHLB and Other | | | (1,620 | ) | | | 269 | | | | (1,351 | ) | | | (3,152 | ) | | | 1,591 | | | | (1,561 | ) |
| Total Interest Expense | | $ | (1,867 | ) | | $ | 1,148 | | | $ | (719 | ) | | $ | (3,502 | ) | | $ | 5,407 | | | $ | 1,905 | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Net Interest Income | | $ | 228 | | | $ | (1,130 | ) | | $ | (902 | ) | | $ | 1,038 | | | $ | (3,984 | ) | | $ | (2,946 | ) |
Earning Asset Growth (Volume)
For the third quarter and first nine months of 2007, declines in our levels of earning assets resulted in reductions of $1.6 million and $2.5 million in interest income relative to the same periods last year. More than offsetting these 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 third-quarter net interest income of approximately $228,000 and a year-to-date improvement of $1.0 million compared to the first nine months of 2006.
Quarter Ending | Earning Assets | Net Loans (incl.LHFS) | Deposits |
| | (Dollars in thousands) |
| September 30, 2006 | $ 1,034,332 | $ 919,837 | $ 774,914 |
| December 31, 2006 | $ 1,012,896 | $ 897,436 | $ 805,795 |
| March 31, 2007 | $ 995,058 | $ 881,849 | $ 771,659 |
| June 30, 2007 | $ 962,998 | $ 878,490 | $ 759,786 |
| September 30, 2007 | $ 944,195 | $ 902,669 | $ 750,675 |
As can be seen in the table above, our overall levels of deposits and earning assets have exhibited declining trends over the last several quarters, as had our loan portfolio prior to the most recent quarter.
Driving the decline in earning assets, the balance of our securities portfolio (including trading, available-for-sale, and held-to-maturity securities) totaled approximately $25 million as of September 30, 2007, down from its year-end 2006 and second-quarter 2007 levels of $95 million and $67 million, respectively. The portfolio contraction followed significant trading volumes and portfolio turnover resulting from our election to early adopt 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 smaller size than that at which it began the quarter.
Based on our observations of the portfolio and hedge over the remainder of the second quarter, we elected to further reduce the size of the portfolio in the third quarter. Consequently, in early July we sold securities with market values totaling approximately $41 million, leaving the portfolio at approximately its current size, and unwound the hedge position established in mid-May. At the present time, we do not anticipate conducting any further securities transactions.
Through the first three quarters of this year, we experienced declines in our income property and residential construction loans, while balances of business banking loans, commercial construction, consumer, and single-family permanent loans ended the third quarter at levels higher than those observed at the 2006 year-end. Additionally, while consumer loan balances declined during the first half of the year, they did so largely as a result of high loan sales volumes, which totaled approximately $30 million for the first two quarters of the year. Were it not for these sales, growth would likely have been observed in this portfolio segment as well, as it was in the most recent quarter with sales totaling less than $6 million.
On the liabilities side of the balance sheet, our total deposit balances declined $55 million, or approximately 7% in the first nine months of the year, including $9 million in the most recent quarter. Our non-maturity deposit balances grew more than $21 million through the first three quarters of the year, with more than $4 million occurring in the most recent quarter, while time deposits, including certificates issued through brokerage services, declined $76 million, with nearly $14 million occurring in the third quarter. Brokered certificates of deposit accounted for approximately $36 million of the year-to-date reduction, including $2 million in the third quarter. 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 lower costs to the Bank.
Asset Yields and Funding Costs (Rate)
Quarter Ended | Net Interest Margin |
| September 30, 2006 | 3.94% |
| December 31, 2006 | 3.78% |
| March 31, 2007 | 3.73% |
| June 30, 2007 | 3.62% |
| September 30, 2007 | 3.90% |
While the effects of interest rate movements and repricing on our loan portfolio negatively impacted the income earned on our loan portfolio by $11,000 for the third quarter, repricing accounted for an additional $1.4 million in interest income relative to last year on a year-to-date
basis. Adjustable-rate loans, which reprice according to terms specified in our loan agreements with the borrowers, accounted for approximately 74% of our loan portfolio as of September 30, 2007, down from 80% at the 2006 year-end.
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 more than $1.1 million for the quarter and $5.4 million on a year-to-date basis. As a result, for the third quarter and first nine months of 2007, the net effects of rate movements and repricing negatively impacted our net interest income by $1.1 million and $4.0 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.
Noninterest Income
Relative to the third quarter of last year, our noninterest income fell $656,000, or approximately 28%, as a result of a substantial reduction in consumer loan sales and resulting gains thereon. On a year-to-date basis, noninterest income increased by approximately 6%, or $366,000 as compared to the prior year, based on a comparable level of loan sales 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 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 reflected the partial offset from a $244,000 gain on 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, 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, which resulted in gains on sale totaling $69,000 for the quarter, bringing our year-to-date gains on securities sales to $185,000. With these transactions completed in mid-July, our net SFAS No. 159-related losses for the third quarter totaled $119,000, resulting in a net year-to-date SFAS No. 159-related gain of $117,000. At the present time, we do not anticipate conducting any further securities transactions.
Gains/(Losses) on Sales of Loans
| | | Quarter Ended September 30, | | | Nine Months Ended September 30, | |
| | | 2007 | | | 2006 | | | 2007 | | | 2006 | |
Gains/(Losses) on Sales: | | | | | | | | | | |
| Consumer | | $ | 238,000 | | | $ | 784,000 | | | $ | 1,917,000 | | | $ | 1,962,000 | |
| Residential | | | (34,000 | ) | | | 69,000 | | | | 80,000 | | | | 68,000 | |
| Commercial | | | 37,000 | | | | 62,000 | | | | 90,000 | | | | 195,000 | |
| Total Gains on Loan Sales | | $ | 241,000 | | | $ | 915,000 | | | $ | 2,087,000 | | | $ | 2,225,000 | |
| | | | | | | | | | | | | | | | | |
Loans Sold: | | | | | | | | | | | | | | | | |
| Consumer | | $ | 5,511,000 | | | $ | 17,987,000 | | | $ | 35,525,000 | | | $ | 41,030,000 | |
| Residential | | | 10,783,000 | | | | 12,701,000 | | | | 42,581,000 | | | | 35,814,000 | |
| Commercial | | | 10,244,000 | | | | 6,382,000 | | | | 14,300,000 | | | | 11,574,000 | |
| Total Loans Sold | | $ | 26,538,000 | | | $ | 37,070,000 | | | $ | 92,406,000 | | | $ | 88,418,000 | |
Contrary to the trend observed over the last several quarters, our third quarter gains on loan sales declined significantly relative to the prior year based on a substantial reduction in sales of our consumer loans. Following sales of $30 million in the first half of 2007, sales of consumer loan sales totaled less than $6 million for the third quarter due to a softening in market demand. Based on uncertainties of the marketplace we are not offering a forecast for anticipated loan sales at this time.
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 and third quarters, 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.
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 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 generally result in future servicing income.
Service Fee Income/(Expense)
| | | Quarter Ended September 30, | | | Nine Months Ended September 30, | |
| | | 2007 | | | 2006 | | | 2007 | | | 2006 | |
| Consumer Loans | | $ | 428,000 | | | $ | 300,000 | | | $ | 1,320,000 | | | $ | 930,000 | |
| Commercial Loans | | | 2,000 | | | | 0 | | | | (59,000 | ) | | | 9,000 | |
| Residential Loans | | | 2,000 | | | | (3,000 | ) | | | 7,000 | | | | (7,000 | ) |
| Service Fee Income | | $ | 432,000 | | | $ | 297,000 | | | $ | 1,268,000 | | | $ | 932,000 | |
Our servicing fee income rose 45% from the level earned in the third quarter of last year and 36% on a year-to-date basis, as income from consumer loans serviced for other institutions increased in response to higher levels of loan sales in late 2006 and the first half of 2007. 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 third quarter and first nine 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 43% 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, a minimal level of servicing income was earned during the third quarter, while on a year-to-date basis, payoffs during the first half of the year 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 $12,000 and $32,000, both approximately 6%, compared to the third quarter and first nine months of last year, 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.
Other Noninterest Income
| | | Quarter Ended September 30, | | | Nine Months Ended September 30, | |
| | | 2007 | | | 2006 | | | 2007 | | | 2006 | |
ATM/Wire/Safe Deposit Fees | | $ | 95,000 | | | $ | 87,000 | | | $ | 280,000 | | | $ | 241,000 | |
| Late Charges | | | 92,000 | | | | 73,000 | | | | 236,000 | | | | 189,000 | |
| Loan Fee Income | | | 298,000 | | | | 294,000 | | | | 697,000 | | | | 545,000 | |
| Rental Income | | | 198,000 | | | | 192,000 | | | | 554,000 | | | | 535,000 | |
| Miscellaneous | | | 155,000 | | | | 270,000 | | | | 435,000 | | | | 857,000 | |
Other Noninterest Income | | $ | 838,000 | | | $ | 916,000 | | | $ | 2,202,000 | | | $ | 2,367,000 | |
Our noninterest income from sources other than those described earlier declined $78,000, or 9% for the quarter and $165,000, or 7% on a year-to-date basis relative to the same periods last year.
We continued to observe growth in our ATM/Wire/Safe Deposit Fees, which totaled $95,000 for the quarter and $280,000 on a year-to-date basis, representing increases of 10% and 16% 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.
Late charges earned from our loan portfolio increased 26% and 24% relative to the third quarter and first nine months of 2006 based on higher fees collected from real estate loans.
Income received from miscellaneous sources declined significantly relative to both the third quarter and first nine months of last year. For the quarter, the decline was largely a result of changes in the market values of interest rate derivative contracts. These derivatives are utilized to hedge interest rate risk associated with extending longer-term, fixed-rate periods on commercial real-estate loans, and structured such that a gain on any given derivative is matched against a nearly identical loss on an offsetting derivative, reflected in our miscellaneous operating expense category, resulting in essentially no net earnings impact to the Bank. In the third quarter and first nine months of last year, appreciation in the market values of these instruments resulted in noninterest income totaling $190,000 and $240,000 compared to $77,000 and $181,000 in the same periods this year. These changes in the market values of the positions were largely offset by similar levels of expense reflected in our miscellaneous operating expense category. Accounting rules require any change in the market value of such instruments to be reflected in the current period income.
Also contributing to the significant year-to-date decline in miscellaneous income was a unique item that occurred in the second quarter of 2006, specifically the receipt of $400,000 in insurance proceeds from a key-man life insurance policy.
Partially offsetting these declines, loan fee income increased on a year-to-date basis compared to the prior year based on higher levels of prepayment penalties and 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.
Noninterest Expense
Noninterest expense for the third quarter declined $140,000, or 2% relative to the same period last year, but increased $314,000, or slightly more than 1% on a year-to-date basis.
Salaries and Employee Benefits Expense
Our personnel-related expenses remained well contained in the first nine months of 2007, with no change observed for the third quarter relative to the prior year and an increase of less than 2% on a year-to-date basis.
| | | | | | | | | | | | | |
| | | Quarter Ended September 30, | | | Nine Months Ended September 30, | |
| | | 2007 | | | 2006 | | | 2007 | | | 2006 | |
| Salaries | | $ | 2,982,000 | | | $ | 3,077,000 | | | $ | 9,381,000 | | | $ | 9,044,000 | |
Commissions and Incentives | | | 668,000 | | | | 506,000 | | | | 1,857,000 | | | | 1,680,000 | |
Employment Taxes and Insurance | | | 215,000 | | | | 225,000 | | | | 773,000 | | | | 793,000 | |
Temporary Office Help | | | 72,000 | | | | 24,000 | | | | 222,000 | | | | 178,000 | |
| Benefits | | | 414,000 | | | | 520,000 | | | | 1,244,000 | | | | 1,580,000 | |
| Total | | $ | 4,351,000 | | | $ | 4,352,000 | | | $ | 13,477,000 | | | $ | 13,275,000 | |
While annual increases in staff salaries resulted in higher expense on a year-to-date basis, regular employee salary expense actually declined from $2,583,000 in the third quarter of last year to $2,504,000 this year based primarily on employee attrition and non-replacement since the announcement of the Washington Federal acquisition.
Also contributing to the year-to-date increase in salary expense were certain merger-related items that impacted the second quarter. Specifically, Directors’ compensation increased $124,000 for the second quarter as compared to the prior year, primarily as a result of a $100,000 payment to one of our directors for consulting services regarding the upcoming Washington Federal acquisition.
Among the categories of incentive compensation, loan officer commissions increased $51,000 for the quarter but declined $147,000 on a year-to-date basis based largely on loan origination volumes exceeding the prior year for the third quarter, but lagging for the year-to-date period. Other incentive compensation rose $101,000 for the quarter and $370,000 through the first nine months of the year based primarily on retention bonuses paid to our former CFO in the second and third quarters for staying on past his retirement date.
Expenditures for temporary office help increased significantly relative to the prior year as temporary employees were frequently used to staff positions left vacant as a result of employee attrition following the announcement of the Washington Federal acquisition.
Employee benefit expense declined significantly relative to the third quarter and first nine months of last year, falling $105,000 and $336,000, or 20% and 21%, respectively. The reduction was largely attributable to a decision to forego profit sharing contributions to our 401K and ESOP plans. Reductions in Director and Officer insurance expense and employee insurance benefits also contributed to the lower level of expense.
Occupancy Expense
Occupancy expense declined by $101,000 and $204,000, or 10% and 7%, compared to the third quarter and first nine months of last year, based on reductions in depreciation and other occupancy expenses.
| | | Quarter Ended September 30, | | | Nine Months Ended September 30, | |
| | | 2007 | | | 2006 | | | 2007 | | | 2006 | |
| Rent | | $ | 70,000 | | | $ | 64,000 | | | $ | 210,000 | | | $ | 222,000 | |
Utilities and Maintenance | | | 181,000 | | | | 180,000 | | | | 587,000 | | | | 582,000 | |
| Depreciation | | | 487,000 | | | | 528,000 | | | | 1,434,000 | | | | 1,555,000 | |
| Other Occupancy | | | 199,000 | | | | 266,000 | | | | 656,000 | | | | 732,000 | |
| Total Occupancy Expense | | $ | 937,000 | | | $ | 1,038,000 | | | $ | 2,887,000 | | | $ | 3,091,000 | |
For the third quarter, depreciation expense declined $41,000, or nearly 8% relative to the 2006 level, based primarily on reductions in furniture/fixture and network software depreciation expense. On a year-to-date basis, depreciation expense was down $121,000, also nearly 8%, based on reductions in the same categories as well as other PC and network depreciation expense.
Additionally, the first quarter saw a $48,000 reduction in depreciation expense 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.
The decline in other occupancy expenses for both the quarter and year-to-date periods was attributable to a reduction in purchases of assets for less than $1,000, which are expensed rather than capitalized. Given the pending Washington Federal transaction, we have largely foregone such purchases this year. Consequently, these purchases totaled $84,000 through the first nine months of 2007 and only $7,000 for the most recent quarter. By comparison, $177,000 in such purchases occurred in the first nine months of 2006, with nearly $81,000 in the third quarter.
Credit Insurance
Credit insurance premium costs fell 11% in the third quarter, and 13% 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 are 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, 2006 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 small relative to those paid on sales finance loans so that total premiums are still expected to decline.
Other Noninterest Expense
Other noninterest expense remained unchanged relative to the third quarter of 2006 as reductions in some categories offset increases in others. On a year-to-date basis, other noninterest expense rose $494,000, or 9%, due to a number of unique and/or merger-related items in the second quarter of the year.
| | | Quarter Ended September 30, | | | Nine Months Ended September 30, | |
| | | 2007 | | | 2006 | | | 2007 | | | 2006 | |
Marketing and Investor Relations | | $ | 185,000 | | | $ | 211,000 | | | $ | 641,000 | | | $ | 730,000 | |
| Outside Services | | | 220,000 | | | | 193,000 | | | | 747,000 | | | | 616,000 | |
| Information Systems | | | 299,000 | | | | 244,000 | | | | 798,000 | | | | 674,000 | |
| Taxes | | | 169,000 | | | | 205,000 | | | | 525,000 | | | | 509,000 | |
| Legal | | | 203,000 | | | | 115,000 | | | | 567,000 | | | | 420,000 | |
| Other | | | 844,000 | | | | 948,000 | | | | 2,737,000 | | | | 2,572,000 | |
| Total | | $ | 1,920,000 | | | $ | 1,916,000 | | | $ | 6,015,000 | | | $ | 5,521,000 | |
Expenditures on outside services increased nearly $27,000 in the third quarter, and more significantly $130,000 through the first nine months of 2007 as compared to the same periods in the prior year. Included in the third quarter expenses were a $55,000 fee for the cancellation of a commitment to issue $9 million in trust preferred securities and $29,000 in due diligence related expenses. Both of these expenses were incurred as a result of the pending Washington Federal transaction.
Legal fees grew by $88,000 for the quarter and $147,000 on a year-to-date basis. Our legal expense has exceeded its historical norm over the last two quarters, also based largely upon expenses related to the Washington Federal transaction.
Partially offsetting the overall increase in other noninterest expenses, our marketing and investor relations costs declined $26,000 for the quarter and $90,000 on a year-to-date basis relative to the same periods last year.
Other miscellaneous operating expenses declined $104,000 for the third quarter, or 11% relative to the same quarter last year, but remained nearly $166,000, or 6%, above last year’s level on a year-to-date basis. Compared to the prior year, charitable contributions declined $42,000 for the quarter, but increased $139,000 for the year-to-date period as a result of a $188,000 contribution to a local performing arts organization in the second quarter. We had originally expected to make this contribution in several installments over time, but given the pending merger with Washington Federal, we elected to go ahead and lump-sum the remaining contribution. Similarly, recruiting expenses declined $1,000 for the quarter, but increased $217,000 for the year-to-date period. The unusually high level of recruiting expense in the first half of the year 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 information systems staff.
Among other items included in this category, lower levels of expense associated with the marking-to-market of interest rate derivatives reduced our other noninterest expense for both the quarter and year-to-date periods. As previously noted, however, these derivatives are structured such that a loss on any given derivative is matched against a nearly identical gain on an offsetting derivative, reflected in our miscellaneous noninterest income category. Consequently, the lower level of expense was nearly matched by the previously mentioned lower level of noninterest income, resulting in essentially no net earnings impact to the Bank.
FINANCIAL CONDITION
Assets
Because of a decline in the securities portfolio balances, our assets totaled $1.017 billion at September 30, 2007, down from $1.029 billion at the start of the quarter and representing a decline of approximately 6% 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.
Securities
The balance of our securities portfolio (including trading, available-for-sale, and held-to-maturity securities) totaled approximately $25 million as of September 30, 2007, down from its year-end and second-quarter 2007 levels of $95 million and nearly $67 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, 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, grew by nearly $13 million for the quarter, but still ended September at a level $14 million less than at the start of the year. While loan originations in the most recent quarter exceeded those of the prior year, totaling $129 million, up from $120 million at the end of the third quarter last year, originations have typically lagged 2006 this year, totaling $353 million through the first nine months of 2007 compared to $400 million through the first three quarters of 2006. 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 | | September 30, 2007 | | | June 30, 2007 | | | December 31, 2006 | |
| | | (Dollars in thousands) | |
| Single Family Residential | | $ | 265,705 | | | $ | 261,699 | | | $ | 254,374 | |
| Income Property | | | 217,488 | | | | 220,056 | | | | 248,100 | |
| Business Banking | | | 168,986 | | | | 164,151 | | | | 144,771 | |
| Commercial Construction | | | 54,291 | | | | 47,864 | | | | 47,153 | |
| Single Family Construction | | | | | | | | | | | | |
| Spec Construction | | | 27,469 | | | | 29,146 | | | | 31,315 | |
| Custom Construction | | | 47,683 | | | | 49,129 | | | | 70,541 | |
| Consumer | | | 98,043 | | | | 94,813 | | | | 97,177 | |
Total | | $ | 879,665 | | | $ | 866,858 | | | $ | 893,431 | |
While our total loan portfolio experienced a decline since the last year-end, respectable growth occurred in our business banking loan portfolio, which has been very successful in building earning assets in recent years. 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 rose only minimally relative to the year-end, they did so despite loan sales totaling nearly $36 million in the first nine months of the year. Were it not for these sales, substantial 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 | | September 30, 2007 | | | June 30, 2007 | | | December 31, 2006 | |
| Commercial | | $ | 123,000 | | | $ | 114,000 | | | $ | 224,000 | |
| Residential | | | 66,000 | | | | 72,000 | | | | 63,000 | |
| Consumer | | | 4,537,000 | | | | 4,798,000 | | | | 3,724,000 | |
Total | | $ | 4,726,000 | | | $ | 4,984,000 | | | $ | 4,011,000 | |
| | | | | | | | | | | | | |
| Loan Balances Serviced for Others | | $ | 161,580,000 | | | $ | 154,199,000 | | | $ | 155,025,000 | |
As a result of the nearly $36 million in loan sales for the first nine months of the year, our servicing assets related to consumer loans increased significantly relative to the year-end level. However, due to the substantial reduction in loan sale volumes in the third quarter combined with high payoff rates and rapid amortization of these servicing assets, the consumer loan servicing asset declined relative to the previous quarter-end.
Servicing assets related to commercial loans increased modestly during the third quarter as deferred servicing rights related to participations sold during the quarter slightly exceeded the amortization of existing servicing assets. On a year-to-date basis, commercial servicing assets declined as some existing commercial loan pools were paid off in the first half 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 nine months of the year, our total deposit balances declined $55 million, or approximately 7%, including $9 million in the most recent quarter. Our non-maturity deposit balances grew more than $21 million through the first three quarters of the year, with more than $4 million occurring in the most recent quarter, while time deposits, including certificates issued through brokerage services, declined $76 million, with nearly $14 million occurring in the third quarter. Brokered certificates of deposit accounted for approximately $36 million of the year-to-date reduction, including $2 million in the third quarter.
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 accounts 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). We experienced a modest decrease in our FHLB advances to $159 million at the end of the third quarter, compared to $163 million at the end of the second quarter of 2007 and $172 million at the 2006 year-end. As of September 30, 2007, we had the authority to borrow up to approximately $407 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 third quarter and first nine months of 2007 totaled $449,000 and $687,000 compared to provisions of $267,000 and $473,000 in the same periods last year. The increase in the provision for the quarter was prompted by the growth in our loan portfolio over the course of the quarter, a reduced volume of consumer loan sales, and the downgrade of a borrowing relationship in our Income Property portfolio during the third quarter. Information we received subsequent to the end of the third quarter has necessitated a further downgrade of this relationship’s risk rating, and is consequently expected to increase our reserve requirement for the fourth quarter. Please see the “Subsequent Events” section for further information.
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 $3.2 million and 0.31% at the end of the third 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% |
| Third Quarter 2007 | 0.31% | N/A |
Including a $198,000 liability for unfunded commitments, our reserve for loan losses totaled approximately $10.2 million at September 30, 2007, little changed from $10.1 million at the 2006 year-end. At this level, the allowance for loan losses represented 1.12% of gross loans at the end of the quarter, compared to 1.11% at the 2006 year-end.
Non-Performing Assets
Our exposure to non-performing assets as of September 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. | | | 732,000 | |
| Two single-family residential loans in Washington. No anticipated loss. | | | 320,000 | |
| One custom construction loan in the Oregon market. Impairment charges taken in 2006. No further losses anticipated | | | 240,000 | |
| One land loan in Western Washington. No anticipated loss. | | | 151,000 | |
| Thirty consumer loans. Full recovery expected from insurance claims. | | | 138,000 | |
| One lease pool. Possible loss of $52,000. | | | 52,000 | |
| Eighteen consumer loans. Possible loss of $34,000. | | | 34,000 | |
| Six consumer loans. No anticipated loss. | | | 26,000 | |
| One multifamily loan with an impairment balance of $1,000. | | | 11,000 | |
| Six insured consumer loans that have exceeded the credit insurance limit. Possible loss of $10,000. | | | 10,000 | |
| One commercial line of credit possible loss of $4,000. | | | 4,000 | |
| Total Non-Performing Assets | | $ | 3,169,000 | |
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, and 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 and Treasury - The Investment and Treasury 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 | | Nine Months Ended |
| | Net Income/(Loss) | Return on Equity | | Net Income/(Loss) | Return on Equity |
| Sept. 30, 2005 | 76,000 | 2.04% | | (609,000) | (5.74%) |
| Sept. 30, 2006 | 124,000 | 3.51% | | 1,191,000 | 11.69% |
| Sept. 30, 2007 | (242,000) | (5.92%) | | (571,000) | (4.80%) |
Third quarter and year-to-date net income for our Retail Banking segment declined $366,000 and $1.8 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 several 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 third quarter of last year, the segment’s transferable funding sources (deposit balances) remained virtually unchanged totaling slightly less than $668 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 declined $35,000 from its third quarter 2006 level. Year-to-date results were slightly better, with income from funding sources rising $746,000, or nearly 3%, compared to the first nine months of
2006. Other interest income for the segment, which consists of interest received on home equity, personal, and small business loans and lines, totaled $928,000 for the quarter, up 4% from the same period last year.
By comparison, the interest paid on deposits rose more than $824,000 for the quarter and $3.3 million on a year-to-date basis, as competition in the local marketplace continued to keep retail deposit rates high. As a result, the segment’s net interest income declined $836,000 relative to the third quarter and $2.5 million compared to the first nine months of last year.
Both noninterest income and noninterest expense for the segment were relatively little changed relative to the prior year. Noninterest income declined $75,000 compared to the first nine months of last year, while noninterest expense increased $318,000, or approximately 3% relative to the first three quarters 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 legal and other fees related to the Washington Federal transaction, as well as retention bonuses to our CFO for remaining with the Bank past his retirement date, again related to the Washington Federal transaction.
Sales Finance
| | Quarter Ended | | Nine Months Ended |
| | Net Income/(Loss) | Return on Equity | | Net Income/(Loss) | Return on Equity |
| Sept. 30, 2005 | 141,000 | 9.27% | | 652,000 | 16.18% |
| Sept. 30, 2006 | 448,000 | 31.52% | | 1,070,000 | 25.31% |
| Sept. 30, 2007 | 94,000 | 5.54% | | 483,000 | 11.08% |
Net income for our Sales Finance segment declined $354,000, or approximately 79%, from the level earned in the third quarter of 2006, and $587,000, or nearly 55%, compared to the first nine months of last year based primarily on a reduction in net interest income and increase in the segment’s loan loss provision.
While the Sales Finance segment’s quarter-end earning assets showed modest growth relative to the prior year, up 4% to nearly $81 million, the average level through the first three quarters of the year declined significantly relative to 2006 based on a substantial increase in the level of loan sales relative to prior years. While less than $6 million in loans were sold in the most recent quarter, sales for the first half of this year totaled $30 million.
With these sales, the segment’s net interest income declined $570,000, or 19% compared to the first nine months of 2006, but showed signs of recovery with the reduced sales in the third quarter, exceeding the third quarter 2006 net interest income by $29,000. With the segment’s third quarter loan loss provision increasing $169,000 relative to the prior year, net interest income after the loan loss provision declined $140,000, or 15%. On a year-to-date basis, the segment’s loan loss provision increased $650,000 relative to the prior year, with net interest income after provision down $1.2 million, or 41%. 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, the segment’s loan loss provision was increased.
While the increased loan sales prior to the most recent quarter negatively impacted the segment’s net interest income, they contributed to improvements in noninterest income in the first half of the year. For the most recent quarter, however, the segment’s noninterest income declined $411,000 relative to the prior year based on the significant reduction in loan sales. Besides gains on sales, loan sale transactions also result in additional service fee income on an ongoing basis after loans are sold. The segment’s servicing fee income increased from $300,000 and $930,000 in the third quarter and first nine months of 2006 to $428,000 and $1.3 million this year.
The segment’s noninterest expense remained well contained relative to the third quarter of last year, declining $20,000 compared to the third quarter of 2006, and $9,000 on a year-to-date basis. The improvement 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 | | Nine Months Ended |
| | Net Income/(Loss) | Return on Equity | | Net Income/(Loss) | Return on Equity |
| Sept. 30, 2005 | 821,000 | 28.78% | | 2,244,000 | 28.84% |
| Sept. 30, 2006 | 1,089,000 | 35.80% | | 2,382,000 | 27.96% |
| Sept. 30, 2007 | 721,000 | 21.95% | | 2,153,000 | 21.90% |
The Residential Lending segment’s net income for the third quarter totaled $721,000, representing a 34% decline relative to the same period last year, based primarily on a reduction in the segment’s net interest income. On a year-to-date basis, net income fell nearly 10% also as a result of a reduction in the segment’s net interest income.
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 substantially relative to their level as of September 30, 2006, falling $19 million, or approximately 6%, 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, net interest income earned on the portfolio declined $519,000, or approximately 22% relative to the third quarter of last year. For the year-to-date period, interest income and funding costs each declined by approximately 3%, with net interest income before the provision for loan losses falling nearly 8%. While the segment’s third quarter provision for loan losses rose $91,000 compared to the same quarter last year, its year-to-date provision declined by $47,000 based on recoveries of $103,000 in the second quarter.
For the quarter, the Residential Lending segment’s noninterest income fell $17,000 compared to the prior year, as additional loan fee income largely offset a reduction in gains on loan sales. On a year-to-date basis, noninterest income rose $124,000, based primarily on the additional loan fee income, which 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 declined $77,000, or 7% for the quarter, and rose only $54,000, or less than 2% through the first nine months of the year.
Business Banking Lending
| | Quarter Ended | | Nine Months Ended |
| | Net Income/(Loss) | Return on Equity | | Net Income/(Loss) | Return on Equity |
| Sept. 30, 2005 | 262,000 | 13.56% | | 832,000 | 15.52% |
| Sept. 30, 2006 | 351,000 | 13.08% | | 790,000 | 11.42% |
| Sept. 30, 2007 | 252,000 | 7.17% | | 925,000 | 9.49% |
With earning assets totaling more than $169 million at the end of the third quarter, an increase of 19% over the prior year level, Business Banking’s interest income grew $333,000 and $1.6 million, or 11% and 20% over the levels earned in the third quarter and first nine months of 2006. Additionally, with deposit growth of $34 million, or approximately 86%, compared to September 30, 2006, income credited for funding sources rose $200,000 for the quarter and $836,000 year-to-date compared to the prior year. Partially offsetting these improvements, however, were an additional $185,000 and $1.3 million in funding costs for the quarter and nine months, respectively. Taking all of these into account, the Business Banking segment’s third quarter and nine month net interest income after provision for loan losses rose $29,000 and $339,000, or 2% and 9%, respectively, over the same periods last year.
For the quarter and nine months ended September 30, 2007, the Business Banking segment’s noninterest income declined $92,000 and $246,000 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. In the third quarter and first nine months of last year, appreciation in the market values of these instruments resulted in additions to noninterest income of $238,000 and $188,000 compared to $108,000 and $2,000 in the same periods this year. These were largely offset by similar levels of expense reflected in our miscellaneous operating expense category. Accounting rules require any change in the market value of such instruments to be reflected in the current period income.
Including the corresponding reduction in noninterest expense attributable to the changes in derivative values, changes in the segment’s noninterest expense were rather modest, increasing $83,000 and declining $112,000 relative to the third quarter and first nine 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 | | Nine Months Ended |
| | Net Income/(Loss) | Return on Equity | | Net Income/(Loss) | Return on Equity |
| Sept. 30, 2005 | 1,141,000 | 18.92% | | 3,900,000 | 21.62% |
| Sept. 30, 2006 | 1,211,000 | 20.98% | | 3,194,000 | 19.43% |
| Sept. 30, 2007 | 1,177,000 | 19.38% | | 3,412,000 | 19.01% |
The Income Property segment’s third quarter net income declined $34,000, or 3% relative to the same quarter last year, based on flat net interest income, falling noninterest income, and rising noninterest expense. On a year-to-date basis, net income rose $218,000, or 7%, as 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 losses grew $577,000 for nine months ended September 30 as a result of interest income from earning assets falling by a lesser amount than did interest expense on funding sources. The provision for loan loss declined $12,000 and $152,000 compared to the third quarter and first nine months of 2006, due in large part to continued declines in portfolio balances.
The Income Property segment’s decrease in earning assets during the first three quarters 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 $13,000 and $182,000 relative to the third quarter and first nine months of last year, with the year-to-date reduction 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 year-to-date results were negatively impacted by payoffs earlier this year 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 noninterest income.
The segment’s noninterest expense increased modestly, rising $31,000 for the quarter and $70,000 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 | | Nine Months Ended |
| | Net Income/(Loss) | Return on Equity | | Net Income/(Loss) | Return on Equity |
| Sept. 30, 2005 | 288,000 | 53.48% | | 812,000 | 49.19% |
| Sept. 30, 2006 | (222,000) | (51.51%) | | (200,000) | (15.30%) |
| Sept. 30, 2007 | (60,000) | (36.04%) | | 12,000 | 1.21% |
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 third quarter and first nine months of 2007, the segment posted net interest losses of $21,000 and $436,000, compared to losses of $373,000 and $299,000 in the third quarter and first nine months of last year. Generally, 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 and third quarters of 2007, however, the funding sources became modestly unprofitable, contributing to the net interest loss.
Noninterest income for the segment, which had been virtually nonexistent prior to this year, totaled a loss of $80,000 and income of $483,000 for the third quarter and first nine 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 $117,000 through the first nine months of the year. Additionally, we
recognized $69,000 in gains on securities sales during the third quarter, bringing the year-to-date total to $185,000.
The segment’s noninterest expense is virtually immaterial, totaling $19,000 for the third quarter and $75,000 for the first nine months of 2007, both slightly less than 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 September 30, | | | Nine Months Ended September 30, | |
| | | 2007 | | | 2006 | | | 2007 | | | 2006 | |
| | | (Dollars in thousands) | |
| Loan Originations (disbursed) | | $ | (129,000 | ) | | $ | (120,000 | ) | | $ | (353,000 | ) | | $ | (400,000 | ) |
| Decrease in Undisbursed Loan Proceeds | | | (3,000 | ) | | | (13,000 | ) | | | (20,000 | ) | | | (15,000 | ) |
| Security Purchases | | | 0 | | | | 0 | | | | (42,000 | ) | | | (7,000 | ) |
| Total Originations and Purchases | | $ | (132,000 | ) | | $ | (133,000 | ) | | $ | (415,000 | ) | | $ | (422,000 | ) |
| | | | | | | | | | | | | | | | | |
| Loan and Security Repayments | | $ | 74,000 | | | $ | 100,000 | | | $ | 279,000 | | | $ | 317,000 | |
| Sales of Securities | | | 40,000 | | | | 0 | | | | 98,000 | | | | 0 | |
| Sales of Loans | | | 27,000 | | | | 37,000 | | | | 92,000 | | | | 88,000 | |
| Total Repayments and Sales | | $ | 141,000 | | | $ | 137,000 | | | $ | 469,000 | | | $ | 405,000 | |
| | | | | | | | | | | | | | | | | |
| Net Difference | | $ | 9,000 | | | $ | 4,000 | | | $ | 54,000 | | | $ | (17,000 | ) |
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 nearly 35% in the first nine months of 2007, comparable to the 37% and 39% rates observed for the first nine months 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 third quarter and first nine months of 2006 and 2007, changes in funds from deposits and borrowings were as follows:
| | | Quarter Ended Sept. 30, | | | Nine Months Ended Sept. 30, | |
| | | 2007 | | | 2006 | | | 2007 | | | 2006 | |
| Deposits | | $ | (9,000 | ) | | $ | 15,000 | | | $ | (55,000 | ) | | $ | 14,000 | |
| Borrowings | | | (4,000 | ) | | | (31,000 | ) | | | (13,000 | ) | | | (8,000 | ) |
| Total | | $ | (13,000 | ) | | $ | 16,000 | | | $ | (68,000 | ) | | $ | 6,000 | |
Through the first nine months of the year, our total deposit balances declined $55 million, or approximately 7%, including $9 million in the most recent quarter. Our non-maturity deposit balances grew more than $21 million through the first three quarters of the year, with more than $4 million occurring in the most recent quarter, while time deposits, including certificates issued through brokerage services, declined $76 million, with nearly $14 million occurring in the third quarter. Brokered certificates of deposit accounted for approximately $36 million of the year-to-date reduction, including $2 million in the third quarter.
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 $159 million at the end of the third quarter, down from $172 million at the 2006 year-end. Our credit line with the FHLB is reviewed annually, and our maximum allowable borrowing level, subject to sufficient collateral, is currently set at 40% of assets, or $407 million based on assets as of September 30, 2007.
We had brokered deposits outstanding totaling $11 million as of the end of the third quarter, down from $47 million as of the 2006 year-end. In anticipation of the closing of the Washington Federal transaction, we elected to replace $8 million in brokered deposits, which matured shortly before the quarter-end, with short-term FHLB advances. 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 first nine months of 2007 we invested $1.3 million in these assets, down from $3.4 million in the same period 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 September 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. | 11.48% | 8.00% | N/A |
| First Mutual Bank | 11.66 | 8.00 | 10.00% |
| | | | |
| Tier I capital (to risk-weighted assets): | | | |
| First Mutual Bancshares, Inc. | 10.23 | 4.00 | N/A |
| First Mutual Bank | 10.41 | 4.00 | 6.00 |
| | | | |
| Tier I capital (to average assets): | | | |
| First Mutual Bancshares, Inc. | 8.33 | 4.00 | N/A |
| First Mutual Bank | 8.49 | 4.00 | 5.00 |
SUBSEQUENT EVENTS
Subsequent to the quarter end, we received unexpected information regarding a borrowing relationship in our Income Property portfolio. While this relationship had been subject to a downgrade during the third quarter, the information we received subsequent to the quarter end necessitated a further downgrade of the relationship’s risk rating. The loans involved totaled $6,692,000 at September 30, 2007. Subsequent to quarter end they were downgraded from “other loans especially mentioned” to “substandard”. The additional downgrade is expected to increase our reserve requirement for the fourth quarter.
| 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 regular 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.
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
| | | September 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 | | 2.40% | 0.30% | | 2.40% | (1.07%) |
| +100 | | n/a | 1.14% | | n/a | 0.06% |
| -100 | | n/a | (1.84%) | | n/a | (0.88%) |
| -200 | | (1.02%) | (5.97%) | | 0.23% | (3.76%) |
| | | | | | | |
Net Interest Income Simulation
Our income simulation model based on information as of September 30, 2007 indicated that our net interest income over the following twelve months was projected to increase from its “base case” level in a scenario in which interest rates were assumed to gradually increase by 200 bps over a twelve-month period, and decline assuming a gradual 200 bps reduction in rates. 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 2.40% was observed in the rising rate environment and a decline of 1.02% 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 September 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 2.25%, compared to a decline of 2.55% 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 0.30%.
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 1.68% and liabilities by 2.56%. 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 5.97%.
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
| | | September 30, 2007 | | | December 31, 2006 | |
| | | (Dollars in thousands) | |
| One-Year Repricing/Maturing Assets | | $ | 676,566 | | | $ | 673,514 | |
| One-Year Repricing/Maturing Liabilities | | | 678,124 | | | | 725,636 | |
| | | | | | | | | |
| One-Year Gap | | $ | (1,559 | ) | | $ | (52,122 | ) |
| | | | | | | | | |
| Total Assets | | $ | 1,017,321 | | | $ | 1,079,272 | |
| | | | | | | | | |
| One-Year Interest Rate Gap as a Percentage of Assets | | | (0.2 | %) | | | (4.8 | %) |
| | | | | | | | | |
At a negative, or liability sensitive, 0.2% of assets, our twelve-month interest rate sensitivity gap as of September 30, 2007 indicated a virtually neutral position of asset/liability sensitivity compared to the 4.8% liability sensitive position 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
ITEM 3
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.
| | | September 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 | % | | $ | 10,800 | | | | 12 | % |
| Mortgage-backed securities: | | | | | | | | | | | | | | | | |
| Freddie Mac | | | 456 | | | | 12 | % | | | 14,504 | | | | 15 | % |
| Ginnie Mae | | | 2,346 | | | | 64 | % | | | 35,688 | | | | 38 | % |
| Fannie Mae | | | 895 | | | | 24 | % | | | 32,683 | | | | 35 | % |
| Total mortgage-backed securities | | | 3,697 | | | | 100 | % | | | 82,875 | | | | 88 | % |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
Total securities available-for-sale | | $ | 3,697 | | | | 100 | % | | $ | 93,675 | | | | 100 | % |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| | | September 30, | |
| | | 2007 | | | 2006 | |
Held-to-Maturity: | | Carrying Value | | | Percent of Total | | | Carrying Value | | | Percent of Total | |
| | | (Dollars in thousands) | |
| | | | | | | | | | | | | | | | | |
| Municipal bonds | | $ | 4,122 | | | | 54 | % | | $ | 1,147 | | | | 20 | % |
| Mortgage-backed securities: | | | | | | | | | | | | | | | | |
| Freddie Mac | | | 94 | | | | 1 | % | | | 321 | | | | 6 | % |
| Fannie Mae | | | 3,371 | | | | 45 | % | | | 4,265 | | | | 74 | % |
| Total mortgage-backed securities | | | 3,465 | | | | 46 | % | | | 4,586 | | | | 80 | % |
| | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
Total securities held-to-maturity | | $ | 7,587 | | | | 100 | % | | $ | 5,733 | | | | 100 | % |
| | | | | | | | | | | | | | | | | |
Estimated market value | | $ | 7,553 | | | | | | | $ | 5,689 | | | | | |
ITEM 3A
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 September 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 | | $ | 2,346 | | | | 3.86 | % | | $ | — | | | | 0.00 | % | | $ | — | | | | 0.00 | % | | $ | — | | | | 0.00 | % | | $ | — | | | | 0.00 | % | | $ | — | | | | 0.00 | % | | $ | 2,346 | | | | 3.86 | % |
| Freddie Mac | | | 456 | | | | 6.22 | % | | | — | | | | 0.00 | % | | | — | | | | 0.00 | % | | | — | | | | 0.00 | % | | | — | | | | 0.00 | % | | | — | | | | 0.00 | % | | | 456 | | | | 6.22 | % |
| Fannie Mae | | | 136 | | | | 6.36 | % | | | 145 | | | | 5.50 | % | | | — | | | | 0.00 | % | | | — | | | | 0.00 | % | | | 614 | | | | 4.50 | % | | | — | | | | 0.00 | % | | | 895 | | | | 4.94 | % |
| Total mortgage-backed securities | | | 2,938 | | | | 4.34 | % | | | 145 | | | | 5.50 | % | | | — | | | | 0.00 | % | | | — | | | | 0.00 | % | | | 614 | | | | 4.50 | % | | | — | | | | 0.00 | % | | | 3,697 | | | | 4.42 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Total securities available-for-sale -- Carrying Value | | $ | 2,938 | | | | 4.34 | % | | $ | 145 | | | | 5.50 | % | | $ | | | | | 0.00 | % | | $ | — | | | | 0.00 | % | | $ | 614 | | | | 4.50 | % | | $ | — | | | | 0.00 | % | | $ | 3,697 | | | | 4.42 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Total securities available-for-sale -- Amortized Cost | | $ | 2,913 | | | | 4.35 | % | | $ | 143 | | | | 5.50 | % | | $ | — | | | | 0.00 | % | | $ | — | | | | 0.00 | % | | $ | 633 | | | | 4.50 | % | | $ | — | | | | 0.00 | % | | $ | 3,689 | | | | 4.42 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Held-to-Maturity at September 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 | % | | $ | 902 | | | | 6.33 | % | | $ | 4,122 | | | | 5.40 | % |
| Mortgage-backed securities: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Freddie Mac | | | 94 | | | | 7.38 | % | | | — | | | | 0.00 | % | | | — | | | | 0.00 | % | | | — | | | | 0.00 | % | | | — | | | | 0.00 | % | | | — | | | | 0.00 | % | | | 94 | | | | 7.38 | % |
| Fannie Mae | | | 881 | | | | 7.57 | % | | | 1,179 | | | | 4.65 | % | | | — | | | | 0.00 | % | | | — | | | | 0.00 | % | | | 1,311 | | | | 4.76 | % | | | — | | | | 0.00 | % | | | 3,371 | | | | 5.46 | % |
| Total mortgage-backed securities | | | 975 | | | | 7.55 | % | | | 1,179 | | | | 4.65 | % | | | — | | | | 0.00 | % | | | — | | | | 0.00 | % | | | 1,311 | | | | 4.76 | % | | | — | | | | 0.00 | % | | | 3,465 | | | | 5.51 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Total securities held-to-maturity -- Carrying Value | | $ | 975 | | | | 7.55 | % | | $ | 1,179 | | | | 4.65 | % | | $ | — | | | | 0.00 | % | | $ | — | | | | 0.00 | % | | $ | 4,531 | | | | 5.03 | % | | $ | 902 | | | | 6.33 | % | | $ | 7,587 | | | | 5.45 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Total securities held-to-maturity -- Fair Market Value | | $ | 986 | | | | 7.55 | % | | $ | 1,185 | | | | 4.66 | % | | $ | — | | | | 0.00 | % | | $ | — | | | | 0.00 | % | | $ | 4,485 | | | | 5.04 | % | | $ | 897 | | | | 6.33 | % | | $ | 7,553 | | | | 5.46 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| 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, Principal 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 Principal 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 Principal 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 |
At September 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.
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 |
A Special Meeting of Shareholders of First Mutual Bancshares, Inc. was held on October 11, 2007. The results of votes on the matter presented at the Meeting are as follows:
The proposal to approve the Agreement and Plan of Merger, dated July 2, 2007, and as amended on August 27, 2007, as further described in the proxy statement/prospectus dated September 5, 2007, received the following votes:
| | VOTES | | PERCENT OF OUTSTANDING |
| For | 5,697,405 | | 85.06 |
| Against | 63,613 | | 0.95 |
| Abstain | 713 | | - |
| Broker non votes | 964,907 | | - |
The proposal has been approved.
None.
| (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 Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| (32) | Certification by Chief Executive Officer and Principal 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: November 8, 2007 | By: | /s/ John R. Valaas | |
| | | John R. Valaas | |
| | | President and Chief Executive Officer | |
| | | | |
| | | |
| | | | |
| | By: | /s/ Kari A. Stenslie | |
| | | Kari A. Srenslie | |
| | | Senior Vice President/Controller (Principal Financial Officer) | |
| | | | |
