For the third quarter of 2008, net interest income on a tax equivalent basis was $24.2 million, down from $30.2 million in the third quarter of 2007. Lower construction loan balances caused a negative volume variance and a negative rate variance was due to deposit rates failing to match the decline in earning asset yields. Net interest income was also reduced by interest reversals on loans placed on nonaccrual status during the quarter and lower loan fee income. Net interest income for the three months ended September 30, 2008, included a $.43 million adjustment to a tax equivalent basis, while the adjustment included in the same period of 2007 was $.39 million.
Average yields on earning assets decreased 202 basis points to 5.85% in the third quarter of 2008 from 7.87% in the third quarter of 2007 due primarily to lower market interest rates, the effect of a materially lower volume of interest accruing construction loans, interest reversals on two-step loans and a higher balance of nonperforming construction loans in our loan portfolio. Also, average interest earning assets decreased $33.2 million, or 1%, to $2.39 billion in the third quarter of 2008 from $2.43 billion for the same period in 2007. Third quarter 2008 average rates paid on interest bearing liabilities decreased 150 basis points to 2.36% from 3.86%, from the same period in 2007, while average interest bearing liabilities increased $24.4 million, or 1%, to $1.9 billion. Interest earning assets have re-priced more quickly than our interest bearing liabilities in the decreasing rate environment during the first three quarters of 2008, leading to additional pressure on the net interest margin.
The net interest margin for the third quarter of 2008 decreased to 4.02% from 4.94% in the third quarter of 2007. The lower net interest margin was partly due to the 52 basis point decrease in spreads between earning assets and rates paid on interest bearing liabilities. Interest reversals accounted for 15 basis points of the 52 basis point decrease in spread. The remaining approximately 37 basis point contraction in the spread resulted from competitive pressures for interest bearing deposits, lower construction loan fees and the foregone interest on nonaccrual loans. Additionally, the net interest margin was negatively affected by lower value and balances of noninterest bearing demand deposits. The recently announced further reduction in the federal funds rate is expected to put additional pressure on our net interest margin.
For the nine months ended September 30, 2008, our net interest income declined by $15.3 million and our net interest margin declined by 98 basis points. Lower interest income, particularly on construction loans, was only partially offset by lower interest expense on interest bearing liabilities. Interest reversals, which reduce interest income, were $6.5 million during the first nine months of 2008 compared to none during the same period in 2007. Moreover, the value of noninterest bearing demand deposits also was lower in the first half of 2008.
Changing interest rate environments, including the slope and level of, as well as changes in, the yield curve, and competitive pricing pressure, could lead to higher deposit costs, lower loan yields, reduced net interest margin and spread and lower loan fees, all of which could lead to additional pressure on our net interest income. At September 30, 2008 we remain asset sensitive, meaning that earning assets mature or reprice more quickly than interest bearing liabilities in a given time period. For more information see the discussion under the heading "Quantitative and Qualitative Disclosures about Market Risk" in our 2007 10-K.
Loans transitioning into nonaccrual status require interest income reversals, consequently decreasing interest income. We expect the level of interest reversals associated with borrowers defaulting on two-step loans to continue to decline in the fourth quarter of 2008 compared to the first three quarters and therefore to have less negative impact on net interest income and net interest margin. We anticipate construction loan balances and associated loan fee revenue will decline further. Additionally, the cost of holding higher balances of nonaccruing loans and OREO properties and the lower value of noninterest bearing deposits in a lower interest rate environment are projected to continue to put pressure on our net interest margin for the remainder of 2008.
Provision for Credit Losses.Bancorp recorded provision for credit losses for the third quarters of 2008 and 2007 of $9.1 million and $2.7 million, respectively. Of the $9.1 million in provision in the current quarter, $2.0 million related to the two-step loan portfolio. The $7.1 million provision for credit losses for loans other than two-step represented an increase of $6.3 million from third quarter 2007. This higher provision for loans other than two-step was generally consistent with the current credit cycle and predominantly due to unfavorable risk rating migrations in commercial and residential construction loan portfolios, as well as from higher general valuation allowance in certain loan portfolio segments and increased net charge-offs in the residential construction loan portfolio outside the two-step program. The provision for credit losses for the nine months ended September 30, 2008 was $23.9 million, up from $9.0 million in the same period in 2007. For more information, see the discussion under the subheading “Allowance for Credit Losses and Net Loan Charge-offs” below.
Noninterest Income. Total noninterest income was $1.1 million for the three months ended September 30, 2008, a decline from $8.1 million in the third quarter of 2007. This decrease predominantly reflected a $6.3 million pretax other-than-temporary impairment (“OTTI”) charge recorded during third quarter 2008 related to a Lehman Brothers bond, Freddie Mac preferred stock and two pooled trust preferred securities. As a result of steady account growth in both business and consumer transaction accounts and cards associated with those new accounts, along with a decline in earnings credit for business accounts, deposit service charge revenues grew a robust 30% or $1.0 million from the same quarter a year ago. The account growth also boosted payment systems revenues which increased $.2 million, or 10%, over the third quarter 2007, with particularly strong growth in card related revenues. Gain on sales of loans declined 30% or $.2 million compared to the third quarter 2007 as a result of significantly lower residential mortgage loan activity and trust and investment revenues declined 25% or $.4 million due to the difficult conditions in the equity markets. Noninterest income for the nine months ended September 30, 2008 was $20.3 million, down from $24.9 million in the first nine months of 2007.
Increased competition, other competitive factors or regulatory changes could adversely affect our ability to sustain fee generation from deposit service charges and payment systems related revenues or from the sales of Small Business Administration loans or investment products. Moreover, a decline or significant volatility in the equity market may negatively impact trust and investment revenues.
Noninterest Expense. Noninterest expense for the three months ended September 30, 2008, was $22.2 million, a decrease of $.4 million, or 2%, compared to $22.6 million for the same period in 2007. Personnel expense decreased 17% in third quarter 2008 due to significantly lower incentive and commission expense compared to third quarter 2007. The Company reversed $.8 million in previously accrued performance pay during the third quarter of 2008. The decline in personnel costs was largely offset by $1.2 million in collection and disposition expenses related to the two-step loan portfolio, along with a $.5 million increase in FDIC insurance. Noninterest expense for the nine months ended September 30, 2008 was $67.8 million, up from $65.1 million for the same period in 2007. The total expense associated with the two-step program, including personnel, legal and other collections, holding and disposition expenses were approximately $1.2 million in the third quarter and $2.7 million for the nine months ended September 30, 2008 compared to minimal two-step expenses during the same time periods in 2007.
We have made an effort to increase operating efficiencies and control expenses without negative affects on our customers. For more information see the discussion above under the subheading "Recent Developments." However, we expect our noninterest expenses will continue to be affected by costs associated with foreclosures related to the two-step loan portfolio and nonperforming two-step assets due to personnel costs, legal, and other costs associated with collection, holding and disposition of such properties. In addition, an FDIC deposit insurance expense credit was applied against FDIC insurance expense during 2007; consequently, FDIC insurance expense will increase significantly in the fourth quarter compared to the same period in 2007, even if premiums were to stay unchanged, which is unlikely.
Changing business conditions, increased costs in connection with retention of, or a failure to retain key employees, lower loan production volumes causing deferred loan origination costs to decline, or a failure to manage our operating and control environments could adversely affect our ability to limit expense growth in the future.
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Income taxes.The Company recorded a benefit from income taxes of $4.2 million in the third quarter 2008, compared to tax expense of $4.3 million for the same quarter 2007. The decrease in tax expense was caused by a decrease in pretax net income in the third quarter of 2008 and related revisions in earnings estimates for the full year. For the nine months ended September 30, 2008 the benefit from income taxes was $2.7 million, compared to $12.9 million in expense for the same period in 2007.
Balance Sheet Overview
Period end total assets were $2.6 billion as of September 30, 2008 down 3% since year end 2007. Period end total loans also decreased by 3% or $63 million since December 31, 2007, while total deposits remained approximately unchanged in the same period. Our balance sheet management efforts are focused on growth in targeted areas that support our corporate objectives and include:
In order to fund our growth, we put an emphasis on launching depository services to satisfy the cash and deposit transaction needs of business customers. Our success in growing and retaining low cost demand deposit balances over this past year can be attributed to the continued emphasis on our free checking products for both the business and consumer segments. Customer demand deposit balances and the attractiveness of interest bearing deposit products, such as money market and time deposit products, are influenced by the level and shape of the yield curve. This, in turn, influences whether we pursue time deposits or other funding sources on a short term basis.
We anticipate real estate construction loan balances will continue to materially contract for the remainder of 2008. As a result, we anticipate little, if any, overall asset growth this year, and total loan balances are expected to be lower at the end of 2008 compared to year end 2007. Our ability to achieve loan and deposit growth in the future will be dependent on many factors, including the outcome of government regulatory initiatives, the effects of competition, health of the real estate market, economic conditions in our markets, availability of capital, retention of key personnel and valued customers and our ability to close loans in the pipeline.
Investment Portfolio
The composition and carrying value of Bancorp’s investment portfolio is as follows:
| | September 30, 2008 | | December 31, 2007 |
| | Amortized | | | | | Unrealized | | Amortized | | | | Unrealized |
| (Dollars in thousands) | Cost | | Fair Value | | Gain/(Loss) | | Cost | | Fair Value | | Gain/(Loss) |
| Treasury securities | $ | 199 | | $ | 213 | | $ | 14 | | | $ | 200 | | $ | 207 | | $ | 7 | |
| U.S. Government agency securities | | 8,306 | | | 8,325 | | | 19 | | | | 60,554 | | | 61,557 | | | 1,003 | |
| Corporate securities | | 15,135 | | | 12,969 | | | (2,166 | ) | | | 20,201 | | | 19,568 | | | (633 | ) |
| Mortgage-backed securities | | 100,014 | | | 97,983 | | | (2,031 | ) | | | 85,050 | | | 84,197 | | | (853 | ) |
| Obligations of state and political subdivisions | | 82,491 | | | 81,532 | | | (959 | ) | | | 85,876 | | | 86,106 | | | 230 | |
| Equity and other securities | | 5,163 | | | 4,965 | | | (198 | ) | | | 7,963 | | | 7,495 | | | (468 | ) |
| Total Investment Portfolio | $ | 211,308 | | $ | 205,987 | | $ | (5,321 | ) | | $ | 259,844 | | $ | 259,130 | | $ | (714 | ) |
The September 30, 2008, investment portfolio balance of $206.0 million decreased $53.1 million from December 31, 2007. At September 30, 2008, total investment securities available for sale had a pre-tax net unrealized loss of $5.3 million.
In the third quarter of 2008, the Company recorded three OTTI charges totaling $6.3 million pretax; $.4 million relating to an investment in a Lehman Brothers bond, $3.1 million related to two pooled trust preferred investments in our corporate security portfolio, as well as $2.8 million for an investment in Freddie Mac preferred stock held in the Company’s equity and other securities portfolio. In reaching the determination to record this impairment management reviewed the facts and circumstances surrounding the securities, including the duration and amount of the unrealized loss, the financial condition of the issuer, and the prospects for a change in market value within a reasonable period of time. Based on its assessment, management determined that the impairment was other-than-temporary in accordance with GAAP and that a charge was appropriate.
We regularly review investment securities for the presence of other-than-temporary impairment, taking into consideration available information regarding current market conditions, fair value in relation to cost, extent and nature of change in fair value, issuer rating changes and trends, issuer financial condition, our ability to hold investments until a recovery of fair value, which may be maturity, and other factors. Future reviews for OTTI will consider the particular facts and circumstances during the reporting period in review.
For additional detail regarding our investment portfolio, see Note 3 “Investment Securities Available for Sale” of our interim financial statements included under Item 1 of this report.
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Loan Portfolio
The composition of Bancorp’s loan portfolio is as follows for the periods shown:
| | | | | | | | | | | | | | | | | | | | Change from |
| (Dollars in thousands) | September 30, 2008 | | June 30, 2008 | | December 31, 2007 | | December 31, 2007 |
| | Amount | | Percent | | Amount | | Percent | | Amount | | Percent | | Amount | | Percent |
| Commercial | $ | 498,715 | | | 24% | | $ | 512,689 | | | 24% | | $ | 504,101 | | | 23% | | $ | (5,386 | ) | | -1% |
| Real estate construction | | 330,833 | | | 16% | | | 392,724 | | | 18% | | | 517,988 | | | 24% | | | (187,155 | ) | | -36% |
| Real estate mortgage | | 389,553 | | | 18% | | | 377,771 | | | 18% | | | 330,803 | | | 15% | | | 58,750 | | | 18% |
| Commercial real estate | | 867,902 | | | 41% | | | 847,430 | | | 39% | | | 796,622 | | | 37% | | | 71,280 | | | 9% |
| Installment and other consumer | | 22,514 | | | 1% | | | 23,102 | | | 1% | | | 23,155 | | | 1% | | | (641 | ) | | -3% |
| Total loans | | 2,109,517 | | | 100% | | | 2,153,716 | | | 100% | | | 2,172,669 | | | 100% | | $ | (63,152 | ) | | -3% |
| Allowance for loan losses | | (33,498 | ) | | 1.59% | | | (35,723 | ) | | 1.66% | | | (46,917 | ) | | 2.16% | | | | | | |
| Total loans, net | $ | 2,076,019 | | | | | $ | 2,117,993 | | | | | $ | 2,125,752 | | | | | | | | | |
The Company’s total loan portfolio was $2.1 billion at September 30, 2008, a decrease of $63 million, or 3%, from December 31, 2007. We believe that continued sluggishness in home sales, elevated housing inventory levels and negative impacts from worsening economic conditions will hinder our efforts to grow our loan portfolio for the remainder of 2008. Interest and fees earned on our loan portfolio is our primary source of revenue, and a decline in loan originations will not only have a negative impact on loan balances but also interest income and loan fees.
As of September 30, 2008, the Company had outstanding loans to persons serving as directors, officers, principal stockholders and their related interests. These loans, when made, were on substantially the same terms, including interest rates, maturities and collateral, as comparable loans made to other customers of the Company. At September 30, 2008, and December 31, 2007, Bancorp had no bankers’ acceptances.
Below is a discussion of our loan portfolio by category.
Commercial. The commercial loan portfolio decreased $5 million, or 1%, since year end 2007. During the first nine months of 2008 we tactically placed strict limits on financing for selective market sectors in order to manage our risk exposure and manage our risk weighted asset base in this uncertain environment. However, in terms of our long term strategy we expect the commercial loan portfolio to be an important contributor to growth in future revenues. We believe we have been successful in growing our commercial portfolio over the past few years as a result of strong, experienced commercial lending teams throughout our market areas. In addition, over the past several years developments in our treasury management product line, including the introduction of our iDeposit and Re$ubmitIt products, we have enhanced our ability to attract and retain commercial core deposit and lending relationships. We also believe that our expanding branch network continues to be an important point of service contact for not only our retail customers but also our commercial relationships.
In making commercial loans, our underwriting standards may include maximum loan to value ratios, target levels for debt service coverage and other financial covenants specific to the loan and the borrower. Common forms of collateral pledged to secure our commercial loans are real estate, accounts receivable, inventory, equipment, agricultural crops and/or livestock and marketable securities. Commercial loans typically have maximum terms of one to ten years and loan to value ratios in the range of 50% to 80%.
Real Estate Construction. The composition of real estate construction loans by type of project is as follows for the periods shown:
| | | | | | | | | | | | | | | | | | | | Change from |
| | September 30, 2008 | | June 30, 2008 | | December 31, 2007 | | December 31, 2007 |
| (Dollars in thousands) | Amount | | Percent | | Amount | | Percent | | Amount | | Percent | | Amount | | Percent |
| Commercial construction | $ | 88,716 | | | 27% | | $ | 94,779 | | | 24% | | $ | 90,670 | | | 17% | | $ | (1,954 | ) | | -2% |
| Two-step residential construction to individuals | | 97,894 | | | 30% | | | 145,703 | | | 37% | | | 262,952 | | | 51% | | | (165,058 | ) | | -63% |
| Residential construction to builder | | 73,391 | | | 22% | | | 77,129 | | | 20% | | | 80,737 | | | 16% | | | (7,346 | ) | | -9% |
| Residential subdivision or site development | | 71,125 | | | 21% | | | 75,626 | | | 19% | | | 84,620 | | | 16% | | | (13,495 | ) | | -16% |
| Net deferred fees | | (293 | ) | | 0% | | | (513 | ) | | 0% | | | (991 | ) | | 0% | | | 698 | | | -70% |
| Total real estate construction loans | $ | 330,833 | | | 100% | | $ | 392,724 | | | 100% | | $ | 517,988 | | | 100% | | $ | (187,155 | ) | | -36% |
At September 30, 2008, the balance of real estate construction loans was $331 million, down $187 million or 36% from $518 million at December 31, 2007 predominantly due to the decline in the two-step loan portfolio over the same period. Real estate construction loans represented 16% of the loan portfolio at the end of the third quarter, down from 24% at December 31, 2007. We expect this percentage to continue to decline in the future quarters due to the continued run-off of outstanding loans associated with the two-step portfolio and a low level of new residential construction. The unfunded two-step and other than two-step construction commitments declined significantly from September 30, 2007 to September 30, 2008, from $69.9 million and $146.7 million, respectively, at September 30, 2007, to $2.0 million and $123.4 million, respectively, at quarter end.
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Real estate construction loans to builders are secured by the underlying property financed. Construction loans to builders and developers typically have terms from 12 to 24 months and initial loan to value ratios in the range of 75% to 85%, based on the estimated value of the collateral to be built at the time of loan origination. Given the 11 months inventory of residential homes in our market in September 2008, which is an increase from the 8.9 months inventory in September 2007, we are limiting the origination of new residential construction loans to specific sectors with less risk; for example, construction loans for pre-sold homes to well qualified borrowers. For the same reason, we are also seeing a material decrease in the demand for residential construction loans in the market place. We are not currently pursuing acquisition of new builder clients for single family residential financing, nor are we financing additional residential land or the development of residential lots at this time.
The following table shows the components of our construction and land loans outside the two-step portfolio as of the dates shown:
| | Construction and land loans outside the two-step portfolio |
| (Dollars in thousands) | September 30, 2008 | | June 30, 2008 | | September 30, 2007 |
| | Amount | | Percent | | Amount | | Percent | | Amount | | Percent |
| Land loans1 | $ | 44,805 | | 16% | | $ | 44,256 | | 15% | | $ | 44,088 | | 15% |
| Residential construction loans other than two-step loans | | 144,517 | | 52% | | | 152,755 | | 52% | | | 150,432 | | 52% |
| Commercial construction loans | | 88,630 | | 32% | | | 94,779 | | 33% | | | 94,278 | | 33% |
| Total construction and land loans other than two-step loans | $ | 277,952 | | 100% | | $ | 291,790 | | 100% | | $ | 288,798 | | 100% |
| |
| |
| Components of residential construction and land loans other than two-step loans: | | | | | | | | | | | | | | |
| Land loans1 | $ | 24,038 | | 14% | | $ | 25,809 | | 15% | | $ | 21,723 | | 12% |
| Site development | | 71,125 | | 42% | | | 75,790 | | 42% | | | 80,370 | | 47% |
| Vertical construction | | 73,392 | | 44% | | | 76,965 | | 43% | | | 70,062 | | 41% |
| Total residential construction and land loans other than two-step loans | $ | 168,555 | | 100% | | $ | 178,564 | | 100% | | | 172,155 | | 100% |
| |
| |
| Components of commercial construction and land loans: | | | | | | | | | | | | | | |
| Land loans1 | $ | 20,767 | | 19% | | $ | 18,447 | | 16% | | $ | 22,365 | | 19% |
| Site development | | 77 | | 0% | | | 1,122 | | 1% | | | - | | 0% |
| Vertical construction | | 88,553 | | 81% | | | 93,657 | | 83% | | | 94,278 | | 81% |
| Total commercial construction and land loans | $ | 109,397 | | 100% | | $ | 113,226 | | 100% | | $ | 116,643 | | 100% |
| |
| |
| Components of total construction and land loans other than two-step loans: | | | | | | | | | | | | | | |
| Land loans1 | $ | 44,805 | | 16% | | $ | 44,256 | | 15% | | $ | 44,088 | | 15% |
| Site development | | 71,202 | | 26% | | | 76,912 | | 26% | | | 80,370 | | 28% |
| Vertical construction | | 161,945 | | 58% | | | 170,622 | | 59% | | | 164,340 | | 57% |
| Total construction and land loans other than two-step loans | $ | 277,952 | | 100% | | $ | 291,790 | | 100% | | $ | 288,798 | | 100% |
1 Land loans represent balances that are carried in the Company's residential real estate mortgage of approximately $24 million and in the commercial real estate loan portfolio of approximately $21 million in the period shown.
As shown in the table above, residential construction loans represented slightly over half of the real estate construction and land loans outside the two-step portfolio, while the commercial construction category accounted for about one third. In terms of the construction and land loan components, the majority or $162 million was for vertical construction purposes, with the land component at 16% and site development at 26%. Within the commercial construction category, vertical construction accounted for 81% of loan balances. In the residential category, the loan balances were more evenly split between the site development and vertical construction components. At this time, we believe the risk and loss exposure associated with residential vertical construction is less than with either of the land and site development components.
At $45 million, land loans account for just 2% of the Company’s total loan portfolio at September 30, 2008. Our land loans typically had loan to value ratios of 60% or less at the time of origination. The Bank's land commitments were split fairly evenly between commercial and residential uses. Geographically, neither residential nor commercial land is heavily concentrated in any single county within our market areas. At September 30, 2008, the land loan portfolio had nonaccrual loans of $5 million and $.5 million in delinquent loans.
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Real Estate Mortgage.The following table presents the components of our real estate mortgage loan portfolio.
| | | | | | | | | | | | | | | | Change from |
| | | | September 30, 2008 | | June 30, 2008 | | December 31, 2007 | | December 31, 2007 |
| (Dollars in thousands) | | | Amount | | Percent | | Amount | | Percent | | Amount | | Percent | | Amount | | Percent |
| Standard mortgage | | | $ | 89,348 | | 23% | | $ | 87,526 | | 23% | | $ | 86,901 | | 26% | | $ | 2,447 | | 3% |
| Nonstandard mortgage product | | | | 33,820 | | 9% | | | 30,745 | | 8% | | | 7,495 | | 2% | | | 26,325 | | 351% |
| Home equity loans and lines of credit | | | | 266,385 | | 68% | | | 259,500 | | 69% | | | 236,407 | | 72% | | | 29,978 | | 13% |
| Total real estate mortgage | | | $ | 389,553 | | 100% | | $ | 377,771 | | 100% | | $ | 330,803 | | 100% | | $ | 58,750 | | 18% |
At September 30, 2008, real estate mortgage loan balances were $390 million or approximately 18% of the Company’s total loan portfolio. We have developed a set of mortgage loan products to provide bridge financing and permanent mortgage loans, collectively called nonstandard mortgages, to motivated borrowers with maturing two-step loans. This product is designed to assist two-step borrowers in their transition from a construction loan to permanent financing. Financing terms are generally more flexible than our standard products; however, in all cases, each loan request is considered based on a thorough review of the borrower’s repayment capacity. Under certain circumstances, we may consider discounting debt in order to restructure the loan to fit the borrower’s debt service capacity. At September 30, 2008, nonstandard loans were $33.8 million, with 54 loans in the portfolio, while nonaccrual nonstandard loans were $11.8 million and delinquent nonstandard loans, 30-89 days past due, were $.8 million. At September 30, 2008 the allowance for credit losses associated with nonstandard loans was $1.9 million. Looking forward, the number of nonstandard loan originations is expected to be relatively limited.
Home equity lines and loans represented about 68% or $266 million of the real estate mortgage portfolio. The Bank’s home equity lines and loans were almost entirely generated within our market area and were originated by our branches. The portfolio has grown steadily over the past few years as a result of focused and ongoing marketing efforts. Growth has slowed in the last quarter as a result of the Bank’s ongoing analysis of market conditions and adjustments being made to our pricing and underwriting standards. As shown below, the home equity line utilization percentage has averaged approximately 54% and has been fairly consistent with over the past five years.
| | | Year of Origination |
| | | YTD | | | | | | | | | | | | | | | | | | |
| | | September | | | | | | | | | | | | | | 2003& | | | |
| (Dollars in thousands) | | 2008 | | 2007 | | 2006 | | 2005 | | 2004 | | Earlier | | | Total |
| Home Equity Lines | | | | | | | | | | | | | | | | | | | | | |
| Commitments | | $ | 64,019 | | $ | 91,820 | | $ | 97,129 | | $ | 73,756 | | $ | 34,354 | | $ | 67,905 | | $ | 428,983 |
| Outstanding Balance | | | 32,190 | | | 50,340 | | | 55,922 | | | 43,202 | | | 17,810 | | | 30,368 | | | 229,832 |
| |
| Utilization | | | 50.3% | | | 54.8% | | | 57.6% | | | 58.6% | | | 51.8% | | | 44.7% | | | 53.6% |
| |
| Home Equity Loans | | | | | | | | | | | | | | | | | | | | | |
| Outstanding Balance | | | 12,120 | | | 9,322 | | | 7,817 | | | 1,898 | | | 1,247 | | | 4,149 | | | 36,553 |
| | | | | | | | | | | | | | | | | | | | | |
| Total Home Equity Outstanding | | $ | 44,310 | | $ | 59,662 | | $ | 63,739 | | $ | 45,100 | | $ | 19,057 | | $ | 34,517 | | $ | 266,385 |
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As indicated in the table below, the average Beacon score for the home equity line and loan portfolios were 764 and 728, respectively. The delinquencies and charge-offs have been very modest within these portfolios. The original average loan-to-value ratios of 65% and 64% for home equity line and loan portfolios, respectively, reflect that the majority of the originations were done at loan-to-value ratios of less that 80%. The significant amount of related loans and deposits is a result of our home equity line and loan portfolios being sourced to relationship customers through our branch network.
The following table presents an overview of home equity lines of credit and loans as of the dates shown.
| (Dollars in thousands) | | | | | | | | |
| | | September 30, 2008 | | June 30, 2008 |
| | | Lines | | Loans | | Lines | | Loans |
| Total Outstanding Balance | | $229,832 | | $36,553 | | $225,672 | | $33,828 |
| |
| Average Current Beacon Score | | 764 | | 728 | | 768 | | 730 |
| |
| Delinquent % 30 Days or Greater | | 0.26% | | 0.10% | | 0.09% | | 0.30% |
| % Net Charge-Offs (Recoveries) Year to Date | | 0.03% | | 0.06% | | -0.01% | | 0.06% |
| |
| % 1st Lien Position | | 33% | | 37% | | 36% | | 39% |
| % 2nd Lien Position | | 67% | | 63% | | 74% | | 61% |
| |
| Overall Original Loan-to-Value | | 65% | | 64% | | 63% | | 62% |
| |
| Original Loan-to-Value < 80% | | 77% | | 66% | | 78% | | 68% |
| Original Loan-to-Value > 80, < 90% | | 22% | | 27% | | 21% | | 26% |
| Original Loan-to-Value > 90, < 100% | | 1% | | 7% | | 1% | | 6% |
| | | 100% | | 100% | | 100% | | 100% |
| |
| Total $ Related Loans / Deposits1 | | $371,042 | | $35,363 | | $368,714 | | $54,587 |
1These amounts represent other loan and deposit balances associated with our customers having a home equity line or loan.
The following table shows home equity lines and loans of credit by market areas at and indicates a geographic distribution of balances representative of our branch presence in these markets.
| (Dollars in thousands) | | | | | | | | | |
| | | September 30, | | June 30, | | December 31, |
| Region | | 2008 | | 2008 | | 2007 |
| Portland, Oregon / Vancouver, Washington | | $ | 112,899 | | $ | 107,755 | | $ | 97,322 |
| Western Washington (Olympia, Seattle) | | | 34,524 | | | 35,067 | | | 31,701 |
| Central Oregon (Bend, Redmond) | | | 7,624 | | | 7,201 | | | 6,593 |
| Oregon Coast (Newport, Lincoln City) | | | 24,019 | | | 24,083 | | | 21,191 |
| Willamette Valley (Salem, Eugene) | | | 84,599 | | | 83,203 | | | 77,330 |
| Southern Oregon (Medford, Roseburg) | | | 185 | | | 156 | | | 129 |
| Other | | | 2,535 | | | 2,035 | | | 2,141 |
| Total home equity loans and lines of credit | | $ | 266,385 | | $ | 259,500 | | $ | 236,407 |
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Commercial Real Estate.The composition of commercial real estate loan types based on collateral is as follows:
| (Dollars in thousands, rounded) | | September 30, 2008 | | December 31, 2007 |
| | | Amount | | Percent | | Amount | | Percent |
| Office Buildings | | $ | 197,700 | | 22.8% | | $ | 179,000 | | 22.5% |
| Retail Facilities | | | 112,900 | | 12.9% | | | 110,100 | | 13.8% |
| Commercial/Agricultural | | | 62,100 | | 7.2% | | | 54,400 | | 6.8% |
| Multi-Family - 5+ Residential | | | 61,600 | | 7.1% | | | 61,600 | | 7.7% |
| Medical Offices | | | 60,900 | | 7.0% | | | 51,400 | | 6.5% |
| Industrial parks and related | | | 53,700 | | 6.2% | | | 48,800 | | 6.1% |
| Manufacturing Plants | | | 41,000 | | 4.7% | | | 39,200 | | 4.9% |
| Hotels/Motels | | | 36,500 | | 4.2% | | | 42,100 | | 5.3% |
| Land Development and Raw Land | | | 32,500 | | 3.7% | | | 25,000 | | 3.1% |
| Mini Storage | | | 21,700 | | 2.5% | | | 17,000 | | 2.1% |
| Assisted Living | | | 20,500 | | 2.4% | | | 12,400 | | 1.6% |
| Food Establishments | | | 17,700 | | 2.0% | | | 18,300 | | 2.3% |
| Other | | | 149,100 | | 17.3% | | | 137,300 | | 17.3% |
| Total commercial real estate loans | | $ | 867,900 | | 100% | | $ | 796,600 | | 100% |
As shown above, the commercial real estate portfolio balance increased $71 million or 9% from December 31, 2007 to September 30, 2008 with two-thirds of the growth coming in the non-owner occupied segment which, by occupancy type, represented 53% of the total commercial real estate loans portfolio at September 30, 2008. Due to the market conditions and loan policy concentration limits, we project the non-owner occupied segment originations to decline relative to the owner occupied segment in the future. Office buildings and retail facilities account for 36% of the collateral securing the $868 million commercial real estate portfolio at the end of the third quarter. The term commercial real estate portfolio is seasoned with balance between owner occupied at 47% and non-owner occupied at 53% of the total commercial real estate portfolio. At September 30, 2008, commercial real estate loans 30 to 89 days past due were .04% of total commercial real estate loans, as compared to .10% at June 30, 2008. Nonaccrual loans increased from $2.1 million at June 30, 2008 to $5.6 million at September 30, 2008, yet remained well within an acceptable range as a percentage of the total commercial real estate portfolio at .64%. We believe Bancorp’s underwriting of commercial real estate loans is consistent with the industry with loan to value ratios generally not exceeding 75% and debt service coverage ratios generally at 120% or better at origination.
The composition of the commercial real estate loan portfolio by occupancy type is as follows:
| | | September 30, 2008 | | December 31, 2007 | | Change |
| (Dollars in thousands) | | Amount | | Percent | | Amount | | Percent | | Amount | | Percent |
| Owner occupied | | $ | 404,874 | | 47% | | $ | 382,387 | | 48% | | $ | 22,487 | | 6% |
| Non-owner occupied | | | 463,028 | | 53% | | | 414,235 | | 52% | | | 48,793 | | 12% |
| Total commercial real estate loans | | $ | 867,902 | | 100% | | $ | 796,622 | | 100% | | $ | 71,280 | | 9% |
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Credit Management
Credit risk is inherent in our lending activities. We manage the general risks inherent in the loan portfolio by following loan policies and underwriting practices designed to result in prudent lending activities. We have established minimum underwriting standards that outline our expectations for financial reporting, global cash flow and guarantor support. In addition, we manage credit risk through our credit administration and credit review functions that are designed to help ensure compliance with our credit standards. Through the credit review function we monitor all credit related policies and practices on a post approval basis. The findings of these reviews are communicated to the chief credit officer and chief executive officer and the Loan, Investment, and Asset Liability Committee, which is made up of certain directors.
Credit risk in the loan portfolio can be amplified by concentrations. Loan concentrations may exist when there are amounts loaned to borrowers engaged in similar activities or similar types of loans extended to a diverse group of borrowers that would cause them to be similarly affected by economic or other conditions. We manage our concentration risk on an ongoing basis by establishing concentration limits by portfolio, portfolio segment and, when appropriate, for individual borrowers.
Our concentration in residential construction loans to developers and builders involves higher risk to the Bank. The current downturn in residential real estate has slowed lot and home sales within our markets and has resulted in lengthening the marketing period for completed homes and has negatively affected borrower liquidity and collateral values. Accordingly, we have been reducing our exposure in residential construction by curtailing new originations. We have also heightened the level of loan portfolio oversight to identify potential problem loans and to develop timely action plans, which may include requiring borrowers to replenish interest reserves, making principal curtailments, or transferring the borrowing relationship to our special assets team. In our experience, the downturn in the housing industry has also increased the risk profile of related commercial borrowers. We expect a number of commercial businesses in the supply chain of products and/or services used by the housing industry to face declining revenue and cash flow, i.e. wood products, contractors, wholesale suppliers and certain product specialized nurseries. In turn, we are monitoring the financial condition of existing borrowers within these segments.
As part of our ongoing lending process, internal risk ratings are assigned to each commercial, commercial real estate and commercial real estate construction loan before the funds are advanced to the customer. Our risk ratings are an important component in determining our allowance for credit losses. Credit risk ratings are based on our assessment of the borrower’s credit worthiness and the quality of our collateral position at the time a particular loan is made. Thereafter, credit risk ratings are evaluated on an ongoing basis focusing on our interpretation of relevant risk factors known to us at the time of each evaluation. Large balance loans have the credit risk rating reviewed on at least an annual basis. Our Reserve Adequacy Committee (“RAC”) also provides oversight in reviewing adversely risk rated loans, loans evaluated for impairment and large balance loans that can have an important impact on the Bank’s provision requirements should future circumstances cause a downgrade. The RAC meets at least quarterly.
Credit files are also examined periodically on a sample test basis by our credit review department and internal auditors, as well as by regulatory examiners. Our relationship managers are also responsible for evaluating the ongoing financial condition of each borrower in their respective portfolio of loans. These activities include, but are not limited to, maintaining open communication channels with borrowers, analyzing periodic financial statements and cash flow projections, evaluating collateral and monitoring covenant compliance.
Although a risk of nonpayment exists with respect to all loans, certain specific types of risks are associated with different types of loans. The expected source of repayment of Bancorp’s loans is generally the cash flow of a particular project, income from the borrower's business, proceeds from the sale of real property, proceeds of refinancing, or personal income. As a result of the nature of our customer base and the growth experienced in the market areas we serve, real estate is frequently a material component of collateral for the Company’s loans. Risks associated with loans secured by real estate include decreasing land and property values, material increases in interest rates, deterioration in local economic conditions, tightening credit or refinancing markets. In addition, we face increased risks if we have a concentration of loans within any one area. See “Risk Factors” under Part II, Item 1A of this report and in our 2007 10-K.
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Nonperforming Assets and Delinquencies
Nonperforming Assets. Nonperforming assets consist of nonaccrual loans, loans past due more than 90 days and still accruing and OREO. The following table presents information with respect to nonaccrual loans by category and OREO for the periods shown.
| (Dollars in thousands) | | September 30, 2008 | | June 30, 2008 | | December 31, 2007 |
| Loans on nonaccrual status: | | | | | | | | | |
| Commercial | | $ | 6,650 | | $ | 4,168 | | $ | 2,401 |
| Real estate construction | | | 104,015 | | | 105,270 | | | 22,121 |
| Real estate mortgage: | | | | | | | | | |
| Standard mortgage | | | 6,384 | | | 1,888 | | | 552 |
| �� Nonstandard mortgage product | | | 11,834 | | | 5,849 | | | - |
| Home equity lines of credit | | | 644 | | | 278 | | | - |
| Total real estate mortgage | | | 18,862 | | | 8,015 | | | 552 |
| Commercial real estate | | | 5,636 | | | 2,074 | | | 1,353 |
| Installment and consumer | | | 14 | | | 2 | | | - |
| Total nonaccrual loans | | | 135,177 | | | 119,529 | | | 26,427 |
| Other real estate owned | | | 48,121 | | | 27,892 | | | 3,255 |
| Total nonperforming assets | | $ | 183,298 | | $ | 147,421 | | $ | 29,682 |
| |
| Nonperforming loans to total loans | | | 6.41% | | | 5.55% | | | 1.22% |
| Nonperforming assets to total assets | | | 7.12% | | | 5.60% | | | 1.12% |
At September 30, 2008, total nonperforming assets were $183.3 million, or 7.12% of total assets, compared to $29.7 million, or 1.12%, at December 31, 2007, and $147.4 million, or 5.60%, at June 30, 2008. The two-step loan portfolio accounted for $127.7 million or 70% of total nonperforming assets at September 30, 2008. For additional information, see “Nonperforming Assets and Delinquencies – Two-Step Loans” below. The amount and level of nonaccrual loans depends on portfolio growth, portfolio seasoning, problem loan recognition and resolution through collections, sales or charge-offs. The performance of any one loan can be affected by external factors, such as economic or market conditions, or factors particular to a borrower, such as actions of a borrower’s management or conditions affecting a borrower’s business.
The following table presents activity in the total OREO portfolio for the periods shown.
| | | 2008 | | 2007 |
| (Dollars in thousands) | | Amount | | Number | | Amount | | Number |
| Beginning balance January 1 | | $ | 3,255 | | | 15 | | | $ | - | | | 1 | |
| Additions to OREO | | | 2,461 | | | 10 | | | | 340 | | | 1 | |
| Capitalized improvements | | | 246 | | | | | | | - | | | | |
| Valuation adjustments | | | - | | | | | | | - | | | | |
| Disposition of OREO | | | (274 | ) | | (1 | ) | | | (340 | ) | | (1 | ) |
| Ending balance March 31 | | $ | 5,688 | | | 24 | | | $ | - | | | 1 | |
| |
| Additions to OREO | | | 25,197 | | | 94 | | | | - | | | - | |
| Capitalized improvements | | | 193 | | | | | | | - | | | | |
| Valuation adjustments | | | (245 | ) | | | | | | - | | | | |
| Disposition of OREO | | | (2,941 | ) | | (10 | ) | | | - | | | - | |
| Ending balance June 30 | | $ | 27,892 | | | 108 | | | $ | - | | | 1 | |
| |
| Additions to OREO | | | 26,786 | | | 103 | | | | 1,374 | | | 6 | |
| Capitalized improvements | | | 179 | | | | | | | - | | | | |
| Valuation adjustments | | | (1,118 | ) | | | | | | - | | | | |
| Disposition of OREO | | | (5,618 | ) | | (22 | ) | | | (191 | ) | | (1 | ) |
| Ending balance September 30 | | $ | 48,121 | | | 189 | | | $ | 1,183 | | | 6 | |
OREO is real property of which the Bank has taken possession or that has been deeded to the Bank through a deed-in-lieu of foreclosure, non-judicial foreclosure, judicial foreclosure or similar process in partial or full satisfaction of a loan or loans. The Company had 189 OREO properties at September 30, 2008, with a total net book value of $48.1 million. Of the 189 OREO properties at September 30, 2008, 173 were related to two-step loans. OREO is recorded at the lower of the carrying amount of the loan or fair value less estimated costs to sell. During the first nine months of 2008, the Company sold 33 OREO properties, 29 of which were two-step related. Outside of the OREO portfolio the Bank also closed 29 two-step related short sales in the same period for a total of 58 two-step related sales. Short sales occur when we accept an agreement with a loan obligor to sell the Bank's collateral on a loan that produces net proceeds that is less than what is owed. The obligor receives no proceeds; however, the debt is fully extinguished. A short sale is an alternative to foreclosure. The losses on short sales and write-downs on loans prior to taking ownership of property in OREO were recorded directly to the two-step allowance for loan losses.
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Management is responsible for estimating the fair market value of OREO and utilizes appraisals and internal judgments in its assessment of fair market value and estimated selling costs. This amount becomes the property’s book value at the time it is taken into OREO. Any write-downs based on our determination of estimated fair market value less cost to sell at the date a particular property is acquired are charged to the allowance for loan losses at that time. Management then periodically reviews OREO to determine whether the property continues to be carried at the lower of its recorded book value or estimated fair value, net of costs to sell. Any further write-downs of OREO properties or gains on the sale of OREO are recorded to other noninterest expense. Expenses from the acquisition, maintenance and disposition of OREO properties are included in other noninterest expense in the statements of income. We expect this expense to continue to increase in future periods as a result of the projected increase in the number of OREO properties.
Delinquencies.The following table summarizes total delinquent loan balances by type of loan as of the dates shown:
| | | September 30, 2008 | | June 30, 2008 | | December 31, 2007 |
| | | | | | Percent of | | | | | Percent of | | | | | Percent of |
| | | | | | loan | | | | | loan | | | | | loan |
| (Dollars in thousands) | | Amount | | category | | Amount | | category | | Amount | | category |
| Loans 30-89 days past due, not in nonaccrual status | | | | | | | | | | | | | | | |
| Commercial | | $ | 299 | | 0.06% | | $ | 983 | | 0.19% | | $ | 6,086 | | 1.21% |
| Real estate construction | | | 12,222 | | 3.69% | | | 7,521 | | 1.92% | | | 36,941 | | 7.13% |
| Real estate mortgage: | | | | | | | | | | | | | | | |
| Standard mortgage | | | 595 | | 0.67% | | | 914 | | 1.04% | | | 486 | | 0.56% |
| Nonstandard mortgage product | | | 840 | | 2.48% | | | 3,846 | | 12.51% | | | - | | 0.00% |
| Home equity lines of credit | | | 634 | | 0.24% | | | 598 | | 0.23% | | | 45 | | 0.02% |
| Total real estate mortgage | | | 2,069 | | 0.53% | | | 5,358 | | 1.42% | | | 531 | | 0.16% |
| Commercial real estate | | | 307 | | 0.04% | | | 824 | | 0.10% | | | 792 | | 0.10% |
| Installment and consumer | | | 111 | | 0.49% | | | 208 | | 0.90% | | | 134 | | 0.58% |
| Total loans 30-89 days past due, not in nonaccrual status | | $ | 15,008 | | | | $ | 14,894 | | | | $ | 44,484 | | |
| |
| Delinquent loans past due 30-89 days to total loans | | | 0.71% | | | | | 0.69% | | | | | 2.05% | | |
Bancorp also monitors delinquencies, defined as loan balances over 30-89 days past due, not in nonaccrual status, as an important indicator for future nonperforming assets. Total delinquencies were .71% of total loans at September 30, 2008, down from 2.05% at December 31, 2007, primarily as a result of a shift of a large amount of two-step loans from delinquent to nonaccrual status during 2008, fewer two-step loans becoming delinquent in the third quarter of 2008, as well as lower delinquencies in commercial and construction other than two-step loan categories. Delinquencies in the real estate construction category decreased materially from $36.9 million at December 31, 2007, to $12.2 million at September 30, 2008. The significant reduction in real estate construction delinquencies was also impacted by the effect of changes in our loan practices and policies, as applied to the two-step loan portfolio that led to the shift of a large amount of loans from delinquent to nonaccrual status earlier in the year. The reduction in delinquencies in the two-step loan portfolio did not reflect an improvement in credit quality but reflected fewer two-step loans outstanding as of September 30, 2008 compared to December 31, 2007. The delinquency levels stayed relatively flat from June 30, 2008. Increased delinquencies in non two-step residential construction loans offset declines in nearly all remaining loan categories, especially in the nonstandard mortgage loans category where the delinquency rate declined from 12.5% at June 30, 2008 to 2.5% at September 30, 2008. For further discussion, see sections “Nonperforming Assets and Delinquencies – Other Than Two-Step Loans” and “Nonperforming Assets and Delinquencies – Two-Step Loans” below.
Allowance for Credit Losses and Net Loan Charge-offs
Allowance for Credit Losses.An allowance for credit losses has been established based on management’s best estimate, as of the balance sheet date, of probable losses inherent in the loan portfolio. Please see the Company’s 2007 10-K under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Allowance for Credit Losses and Net Loan Charge-offs” for a discussion of Bancorp’s methodologies underlying the calculation of the Company’s allowance for credit losses.
Our allowance incorporates the results of measuring impaired loans as provided in Statement of Financial Accounting Standards (“SFAS”) No. 114, “Accounting by Creditors for Impairment of a Loan,” and SFAS No. 118, “Accounting by Creditors for Impairment of a Loan – Income Recognition and Disclosures.” These accounting standards prescribe the measurement, income recognition and guidelines concerning impaired loans. For example, impairments associated with collateral dependent loans are charged-off promptly. In certain cases, specific reserves may be established for collateral dependent impaired loans. Upon receipt of required information, specific reserves are discontinued and charge-offs for impairment are processed. This is limited to occasions where loans are considered impaired, but where the Bank has yet to receive required information. This practice is not applied to loans in the two-step loan portfolio. In addition, net overdraft losses are included in the calculation of the allowance for credit losses per the guidance provided by regulatory authorities early in 2005, “Joint Guidance on Overdraft Protection Programs.”
The Company maintains its allowance for credit losses by charging a provision for credit losses against income in periods in which management believes additional allowance is appropriate to accommodate its estimate of losses in the loan portfolio. The evaluation of the adequacy of specific and general valuation allowances is an ongoing process. This process includes analysis of information derived from many sources: historical loss trends, portfolio risk rating migrations, delinquency and nonaccrual loan growth, portfolio diversification, current and anticipated economic conditions, the effectiveness of loan policies and collection practices, expertise of credit personnel, regulatory guidance and other factors.
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Changes in the allowance for credit losses for year to date September 30, 2008, and full year ended December 31, 2007, are presented in the following table.
| | | Nine months ended | | Year ended |
| (Dollars in thousands) | | September 30, 2008 | | December 31, 2007 |
| Loans outstanding at end of period | | $ | 2,109,517 | | | $ | 2,172,669 | |
| Average loans outstanding during the period | | | 2,164,982 | | | | 2,094,977 | |
| |
| Allowance for credit losses, beginning of period | | | 54,903 | | | | 23,017 | |
| Loan charge-offs: | | | | | | | | |
| Commercial | | | (3,256 | ) | | | (3,798 | ) |
| Real estate construction | | | (41,113 | ) | | | (2,540 | ) |
| Real estate mortgage | | | (840 | ) | | | (71 | ) |
| Commercial real estate | | | (44 | ) | | | - | |
| Installment and consumer | | | (502 | ) | | | (254 | ) |
| Overdraft | | | (927 | ) | | | (1,050 | ) |
| Total loan charge-offs | | | (46,682 | ) | | | (7,713 | ) |
| Recoveries: | | | | | | | | |
| Commercial | | | 81 | | | | 269 | |
| Real estate construction | | | 2,020 | | | | 7 | |
| Real estate mortgage | | | 30 | | | | 33 | |
| Commercial real estate | | | - | | | | 2 | |
| Installment and consumer | | | 63 | | | | 112 | |
| Overdraft | | | 179 | | | | 220 | |
| Total recoveries | | | 2,373 | | | | 643 | |
| Net loan charge-offs | | | (44,309 | ) | | | (7,070 | ) |
| Provision for credit losses | | | 23,850 | | | | 38,956 | |
| Allowance for credit losses, end of period | | $ | 34,444 | | | $ | 54,903 | |
| |
| Components of allowance for credit losses | | | | | | | | |
| Allowance for loan losses | | $ | 33,498 | | | $ | 46,917 | |
| Reserve for unfunded commitments | | | 946 | | | | 7,986 | |
| Total allowance for credit losses | | $ | 34,444 | | | $ | 54,903 | |
| |
| Net loan charge-offs to average loans annualized | | | 2.73 | % | | | 0.34 | % |
| |
| Allowance for loan losses to total loans | | | 1.59 | % | | | 2.16 | % |
| Allowance for credit losses to total loans | | | 1.63 | % | | | 2.53 | % |
At September 30, 2008, the Company’s allowance for credit losses was $34.4 million, consisting of a $28.0 million formula allowance, a $3.6 million specific allowance, a $1.9 million unallocated allowance and a $.9 million reserve for unfunded commitments. At December 31, 2007, our allowance for credit losses was $54.9 million, consisting of a $41.4 million formula allowance, a $3.6 million specific allowance, a $1.9 million unallocated allowance and an $8.0 million reserve for unfunded commitments.
Changes in the allocation of the allowance for loan losses in the first nine months of 2008 were due primarily to unfavorable migration of risk ratings within our portfolio, increased general valuation percentages associated with specific loan portfolio segments, as well as loan charge-offs and recovery activities. Also, a large portion of the year to date provision relates to construction loans, which have a higher inherent risk profile and are therefore allocated a higher allowance for credit losses relative to other loan categories in the portfolio.
At September 30, 2008, Bancorp’s allowance for credit losses and loan losses were 1.63% and 1.59% of total loans compared with an allowance for credit losses and loan losses at December 31, 2007, of 2.53% and 2.16% of total loans. The decline in allowance for credit loss and loan losses was associated with charge-offs of two-step loans during the reporting period against the allowance for credit losses established at year end 2007.
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Overall, we believe that the allowance for credit losses is adequate to absorb losses in the loan portfolio at September 30, 2008, although there can be no assurance that future loan losses will not exceed our current estimates. The process for determining the adequacy of the allowance for credit losses is critical to our financial results. It requires difficult, subjective and complex judgments as a result of the need to make estimates about the effect of matters that are uncertain. Therefore, we cannot provide assurance that, in any particular period, we will not have sizeable credit losses in relation to the amount reserved. We may later need to significantly adjust the allowance for credit losses considering factors in existence at such time, including economic, market, or business conditions and the results of ongoing internal and external examination processes. Please see risk factors under Part II, Item 1A “Risk Factors” in this report and in our 2007 10-K.
Net Loan Charge-offs. For the nine months ended September 30, 2008, total net loan charge-offs were $44.3 million compared to $7.1 million for the year ended December 31, 2007. The 2008 year to date annualized net loan charge-offs to total average loans outstanding was 2.73%, up from .23% in the same period in 2007. See “Two-Step Loan Portfolio” below for more information.
Additional Loan Portfolio Disclosure
We are providing additional information below regarding nonperforming assets and the allowance for credit losses that distinguishes loans other than two-step loans from those in our two-step loan portfolio. Management is providing this information to aid in the readers’ understanding of the impact of the two-step loan portfolio on our entire loan portfolio.
The first section includes additional information regarding loans in our loan portfolio other than two-step loans. The second section includes information solely relating to loans in our two-step loan portfolio. For information regarding our total loan portfolio, please see the preceding section.
Loans Other Than Two-Step Loans
The following table shows our total loan portfolio by category, as well as the breakout of the two-step loan portfolio from our other real estate construction loans.
| (Dollars in thousands) | | September 30, | | June 30, | | December 31, |
| | | 2008 | | 2008 | | 2007 |
| Commercial loans | | $ | 498,715 | | $ | 512,689 | | $ | 504,101 |
| Real estate construction loans1 | | | 330,833 | | | 392,724 | | | 517,988 |
| Real estate mortgage loans: | | | | | | | | | |
| Standard mortgage | | | 89,348 | | | 88,106 | | | 86,901 |
| Nonstandard mortgage product | | | 33,820 | | | 30,902 | | | 7,495 |
| Home equity line of credit | | | 266,385 | | | 258,763 | | | 236,407 |
| Total real estate mortgage loans | | | 389,553 | | | 377,771 | | | 330,803 |
| Commercial real estate loans | | | 867,902 | | | 847,430 | | | 796,622 |
| Installment and other consumer loans | | | 22,514 | | | 23,102 | | | 23,155 |
| Total loans | | $ | 2,109,517 | | $ | 2,153,716 | | $ | 2,172,669 |
| |
| 1Two-step loans | | $ | 97,894 | | $ | 145,703 | | $ | 262,952 |
| All other construction loans | | | 232,939 | | | 247,021 | | | 255,036 |
| Total real estate construction loans | | $ | 330,833 | | $ | 392,724 | | $ | 517,988 |
| |
| Two-step loans | | $ | 97,894 | | $ | 145,703 | | $ | 262,952 |
| Total loans other than two-step loans | | | 2,011,623 | | | 2,008,013 | | | 1,909,717 |
| Total loans | | $ | 2,109,517 | | $ | 2,153,716 | | $ | 2,172,669 |
As shown above, the loan portfolio other than two-step loans was $2.0 billion at September 30, 2008, up $102 million, or 5%, from December 31, 2007 with the growth concentrated in the commercial real estate, home equity and nonstandard mortgage categories.
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Nonperforming Assets and Delinquencies – Loans Other Than Two-Step Loans
Nonperforming Assets - Loans Other Than Two-Step Loans.The following table presents information about nonperforming assets and delinquencies relating to loans other than two-step loans at the dates shown.
| | September 30, 2008 | | June 30, 2008 | | December 31, 2007 |
| | | | Percent of | | | | Percent of | | | | Percent of |
| | | | | loan | | | | loan | | | | loan |
| (Dollars in thousands) | | Amount | | category | | Amount | | category | | Amount | | category |
| Commercial loans | | $ | 6,650 | | | 1.33 | % | | $ | 4,168 | | | 0.81 | % | | $ | 2,401 | | | 0.48 | % |
| Real estate construction loans | | | 21,025 | | | 9.03 | % | | | 6,542 | | | 2.65 | % | | | 1,576 | | | 0.62 | % |
| Real estate mortgage loans: | | | | | | | | | | | | | | | | | | | | | |
| Standard mortgage | | | 6,384 | | | 7.15 | % | | | 1,888 | | | 2.16 | % | | | 552 | | | 0.64 | % |
| Nonstandard mortgage product | | | 11,834 | | | 34.99 | % | | | 5,849 | | | 19.02 | % | | | - | | | 0.00 | % |
| Home equity line of credit | | | 644 | | | 0.24 | % | | | 278 | | | 0.11 | % | | | - | | | 0.00 | % |
| Total real estate mortgage loans | | | 18,862 | | | 4.84 | % | | | 8,015 | | | 2.12 | % | | | 552 | | | 0.17 | % |
| Commercial real estate loans | | | 5,636 | | | 0.65 | % | | | 2,074 | | | 0.24 | % | | | 1,353 | | | 0.17 | % |
| Installment and other consumer loans | | | 14 | | | 0.06 | % | | | 2 | | | 0.01 | % | | | - | | | 0.00 | % |
| Total nonaccrual loans | | | 52,187 | | | | | | | 20,801 | | | | | | | 5,882 | | | | |
| 90 day past due and accruing interest | | | - | | | | | | | - | | | | | | | - | | | | |
| Total nonperforming loans other than two-step loans | | | 52,187 | | | | | | | 20,801 | | | | | | | 5,882 | | | | |
| |
| Other real estate owned other than two-step loans | | | 3,446 | | | | | | | 1,432 | | | | | | | - | | | | |
| Total nonperforming assets other than two-step loans | | $ | 55,633 | | | | | | $ | 22,233 | | | | | | $ | 5,882 | | | | |
| |
| Delinquent other than two-step loans 30-89 days past due | | $ | 10,919 | | | | | | $ | 9,432 | | | | | | $ | 7,706 | | | | |
| |
| Nonperforming loans other than two-step loans to total loans other than two-step loans | | | 2.59% | | | | | | | 1.04% | | | | | | | 0.31% | | | | |
| Nonperforming assets other than two-step assets to total assets | | | 2.16% | | | | | | | 0.84% | | | | | | | 0.22% | | | | |
| Delinquent loans other than two-step loans to total loans other than two-step loans | | | 0.54% | | | | | | | 0.47% | | | | | | | 0.40% | | | | |
Nonperforming assets other than two-step loans increased from $5.9 million at year end 2007 to $55.6 million, or 2.16% of total assets, at September 30, 2008. The increase in nonperforming loans was primarily due to higher nonaccrual loans which increased $46.3 million from December 31, 2007. The majority of the increase in other than two-step nonperforming loans since June 30, 2008 was comprised of $14.5 million growth in nonaccrual residential construction loans and $6.0 million growth in nonaccrual nonstandard residential mortgage loans made to two-step borrowers.
The following table presents activity in the loans other than two-step OREO portfolio for the periods shown.
| | 2008 | | 2007 |
| (Dollars in thousands) | | Amount | | Number | | Amount | | Number |
| Beginning balance January 1 | | $ | - | | | 1 | | | $ | - | | 1 |
| Additions to OREO | | | - | | | | | | | - | | - |
| Capitalized improvements | | | - | | | | | | | - | | |
| Valuation adjustments | | | - | | | | | | | - | | |
| Disposition of OREO | | | - | | | | | | | - | | - |
| Ending balance March 31 | | $ | - | | | 1 | | | $ | - | | 1 |
| |
| Additions to OREO | | | 1,651 | | | 7 | | | | - | | - |
| Capitalized improvements | | | 5 | | | | | | | - | | - |
| Valuation adjustments | | | - | | | | | | | - | | |
| Disposition of OREO | | | (224 | ) | | (1 | ) | | | - | | - |
| Ending balance June 30 | | $ | 1,432 | | | 7 | | | $ | - | | 1 |
| |
| Additions to OREO | | | 2,760 | | | 12 | | | | - | | - |
| Capitalized improvements | | | 5 | | | | | | | - | | - |
| Valuation adjustments | | | - | | | | | | | - | | |
| Disposition of OREO | | | (751 | ) | | (3 | ) | | | - | | - |
| Ending balance September 30 | | $ | 3,446 | | | 16 | | | $ | - | | 1 |
- 37 -
The following table shows the components of our nonaccrual construction and land loans outside the two-step portfolio as of the dates shown.
| | Nonaccrual construction and land loans oustide the two-step portfolio |
| (Dollars in thousands) | | September 30, 2008 | | June 30, 2008 | | September 30, 2007 |
| | | | Percent of | | | | Percent of | | | | Percent |
| | | | loan | | | | loan | | | | of loan |
| | Amount | | category2 | | Amount | | category2 | | Amount | | category |
| Land loans1 | | $ | 5,308 | | 1.91 | % | | $ | 1,396 | | 0.48 | % | | $ | - | | 0.00 | % |
| Residential construction loans other than two-step loans | | | 21,025 | | 7.56 | % | | | 6,542 | | 2.24 | % | | | - | | 0.00 | % |
| Commercial construction loans | | | - | | 0.00 | % | | | - | | 0.00 | % | | | - | | 0.00 | % |
| Total nonaccrual construction and land loans other than two-steploans | | $ | 26,333 | | 9.47 | % | | $ | 7,938 | | 2.72 | % | | $ | - | | 0.00 | % |
| |
| Components of nonaccrual residential construction and land loans | | | | | | | | | | | | | | | | | | |
| other than two-step loans: | | | | | | | | | | | | | | | | | | |
| Land loans1 | | $ | 5,308 | | 3.15 | % | | $ | 1,396 | | 0.78 | % | | $ | - | | 0.00 | % |
| Site development | | | 13,731 | | 8.15 | % | | | 2,830 | | 1.58 | % | | | - | | 0.00 | % |
| Vertical construction | | | 7,294 | | 4.33 | % | | | 3,712 | | 2.08 | % | | | - | | 0.00 | % |
| Total nonaccrual residential construction and land loans other thantwo-step loans | | $ | 26,333 | | 15.63 | % | | $ | 7,938 | | 4.45 | % | | $ | - | | 0.00 | % |
| |
| |
| Components of nonaccrual commercial construction and land loans: | | | | | | | | | | | | | | | | | | |
| Land loans1 | | | - | | 0.00 | % | | | - | | 0.00 | % | | | - | | 0.00 | % |
| Site development | | | - | | 0.00 | % | | | - | | 0.00 | % | | | - | | 0.00 | % |
| Vertical construction | | | - | | 0.00 | % | | | - | | 0.00 | % | | | - | | 0.00 | % |
| Total nonaccrual commercial construction and land loans | | $ | - | | 0.00 | % | | $ | - | | 0.00 | % | | $ | - | | 0.00 | % |
| |
| Components of total nonaccrual construction and land loans other | | | | | | | | | | | | | | | | | | |
| than two-step loans: | | | | | | | | | | | | | | | | | | |
| Land loans1 | | $ | 5,308 | | 1.91 | % | | $ | 1,396 | | 0.48 | % | | $ | - | | 0.00 | % |
| Site development | | | 13,731 | | 4.94 | % | | | 2,830 | | 0.97 | % | | | - | | 0.00 | % |
| Vertical construction | | | 7,294 | | 2.62 | % | | | 3,712 | | 1.27 | % | | | - | | 0.00 | % |
| Total nonaccrual construction and land loans other than two-steploans | | $ | 26,333 | | 9.47 | % | | $ | 7,938 | | 2.72 | % | | $ | - | | 0.00 | % |
1 Land loans represent balances that are carried in the Company's residential real estate mortgage and commercial real estate loan portfolios in the period
2 Calculations have been based on more detailed information and therefore may not recompute exactly due to rounding.
As indicated in the above table and reflecting the difficulties in the housing market, the $26.3 million in nonaccrual construction and land loan balances outside the two-step portfolio were all related to the residential category. The residential construction nonaccrual balance increased from prior periods and represented 15.6% of residential construction and land loans outstanding construction and 9.5% of land loan balances at September 30, 2008. The residential nonaccrual loans were spread across the land, site development and vertical construction components. There were no nonaccrual commercial construction or commercial land loans at the end of the third quarter.
- 38 -
Delinquencies - Loans Other Than Two-Step Loans.As shown in the table on page 39, delinquencies in the other than two-step loan portfolio increased from 40 basis points at December 31, 2007 to 54basis points at September 30, 2008 remaining at a relatively modest level overall.
The following table shows the components of our delinquent construction and land loans outside the two-step portfolio as of the dates shown.
| | Delinquent construction and land loans outside the two-step loan portfolio |
| (Dollars in thousands) | | September 30, 2008 | | June 30, 2008 | | September 30, 2007 |
| | | | | Percent of | | | | | Percent of | | | | |
| | | | | loan | | | | | loan | | | | Percent of |
| | Amount | | category2 | | Amount | | category2 | | Amount | | loan category |
| Land loans1 | | $ | 461 | | 0.17 | % | | $ | - | | 0.00 | % | | $ | - | | 0.00 | % |
| Residential construction loans other than two-step loans | | | 7,241 | | 2.61 | % | | | 1,976 | | 0.68 | % | | | - | | 0.00 | % |
| Commercial construction loans | | | 807 | | 0.29 | % | | | 83 | | 0.03 | % | | | - | | 0.00 | % |
| Total 30-89 days past due construction loans other than two-step loans | | $ | 8,509 | | 3.07 | % | | $ | 2,059 | | 0.71 | % | | $ | - | | 0.00 | % |
| |
Components of 30-89 days past due residential construction and land loans
other than two-step loans: | | | | | | | | | | | | | | | | | | |
| Land loans1 | | $ | 461 | | 0.27 | % | | $ | - | | 0.00 | % | | $ | - | | 0.00 | % |
| Site development | | | 5,586 | | 3.31 | % | | | - | | 0.00 | % | | | 6,150 | | 3.44 | % |
| Vertical construction | | | 1,655 | | 0.98 | % | | | 1,976 | | 1.11 | % | | | - | | 0.00 | % |
Total 30-89 days past due residential construction and land loans
other thantwo-step loans | | $ | 7,702 | | 4.56 | % | | $ | 1,976 | | 1.11 | % | | $ | 6,150 | | 3.44 | % |
| |
| Components of 30-89 days past due commercial construction and land loans: | | | | | | | | | | | | | | | | | | |
| Land loans1 | | $ | - | | 0.00 | % | | $ | - | | 0.00 | % | | $ | - | | 0.00 | % |
| Site development | | | - | | 0.00 | % | | | - | | 0.00 | % | | | - | | 0.00 | % |
| Vertical construction | | | 807 | | 0.74 | % | | | 83 | | 0.07 | % | | | - | | 0.00 | % |
| Total 30-89 days past due commercial construction and land loans | | $ | 807 | | 0.74 | % | | $ | 83 | | 0.07 | % | | $ | - | | 0.00 | % |
| |
| Components of total 30-89 days past due construction and land loans other | | | | | | | | | | | | | | | | | | |
| than two-step loans: | | | | | | | | | | | | | | | | | | |
| Land loans1 | | $ | 461 | | 0.17 | % | | $ | - | | 0.00 | % | | $ | - | | 0.00 | % |
| Site development | | | 5,586 | | 2.01 | % | | | - | | 0.00 | % | | | 6,150 | | 2.11 | % |
| Vertical construction | | | 2,462 | | 0.89 | % | | | 2,059 | | 0.71 | % | | | - | | 0.00 | % |
| Total 30-89 days past due construction and land loans other than two-steploans | | $ | 8,509 | | 3.07 | % | | $ | 2,059 | | 0.71 | % | | $ | 6,150 | | 2.11 | % |
1 Land loans represent balances that are carried in the Company's residential real estate mortgage and commercial real estate loan portfolios in the period shown.
2 Calculations have been based on more detailed information and therefore may not recompute exactly due to rounding.
Overall, delinquent construction and land loans outside the two-step portfolio were at 3.07% of such loans as of September 30, 2008, up from 2.11% at September 30, 2007. The majority of the $8.5 million in delinquent loans was concentrated in the site development and vertical construction components of the residential category.
- 39 -
Allowance for Credit Losses and Net Loan Charge-offs – Loans Other Than Two-Step Loans
Allowance for Credit Losses - Loans Other Than Two-Step Loans.The following table presents information with respect to the change in our allowance for credit losses relating to loans other than two-step loans.
| | | Year to date | | Year to date | | Year ended |
| (Dollars in thousands) | | September 30, | | June 30, | | December 31, |
| | | 2008 | | 2008 | | 2007 |
| Allowance for credit losses other than two-step loans, beginning of period | | $ | 23,838 | | | $ | 23,838 | | | $ | 20,399 | |
| Provision for credit losses other than two-step loans | | | 19,126 | | | | 11,998 | | | | 7,976 | |
| |
| Charge-offs other than two-step loans | | | | | | | | | | | | |
| Loan charge-offs: | | | | | | | | | | | | |
| Commercial | | | (3,256 | ) | | | (2,741 | ) | | | (3,798 | ) |
| Real estate construction | | | (4,806 | ) | | | (573 | ) | | | - | |
| Real estate mortgage | | | (840 | ) | | | (259 | ) | | | (71 | ) |
| Commercial real estate | | | (44 | ) | | | (32 | ) | | | | |
| Installment and consumer | | | (502 | ) | | | (119 | ) | | | (254 | ) |
| Overdraft | | | (927 | ) | | | (605 | ) | | | (1,050 | ) |
| Total loan charge-offs other than two-step loans | | | (10,375 | ) | | | (4,329 | ) | | | (5,173 | ) |
| Recoveries: | | | | | | | | | | | | |
| Commercial | | | 81 | | | | 32 | | | | 269 | |
| Real estate construction | | | - | | | | - | | | | - | |
| Real estate mortgage | | | 30 | | | | 52 | | | | 33 | |
| Commercial real estate | | | - | | | | - | | | | 2 | |
| Installment and consumer | | | 63 | | | | 54 | | | | 112 | |
| Overdraft | | | 179 | | | | 120 | | | | 220 | |
| Total recoveries other than two-step loans | | | 353 | | | | 258 | | | | 636 | |
| Net loan charge-offs other than two-step loans | | | (10,022 | ) | | | (4,071 | ) | | | (4,537 | ) |
| |
| Allowance for credit losses, from acquisition | | | - | | | | - | | | | - | |
| Total allowance for credit losses other than two-step loans | | $ | 32,942 | | | $ | 31,765 | | | $ | 23,838 | |
| |
| Components of allowance for credit losses other than two-step loans | | | | | | | | | | | | |
| Allowance for loan losses other than two-step loans | | $ | 32,026 | | | $ | 30,865 | | | $ | 23,000 | |
| Reserve for unfunded commitments other than two-step loans | | | 916 | | | | 900 | | | | 838 | |
| Total allowance for credit losses other than two-step loans | | $ | 32,942 | | | $ | 31,765 | | | $ | 23,838 | |
| |
| Net loan charge-offs to average loans other than two-step loans annualized | | | 0.62% | | | | 0.38% | | | | 0.22% | |
| Allowance for other than two-step loan losses to total other than two-step loans | | | 1.59% | | | | 1.54% | | | | 1.20% | |
| Allowance for other than two-step credit losses to total other than two-step loans | | | 1.64% | | | | 1.58% | | | | 1.25% | |
| Allowance for other than two-step loan losses to non-performing other than two-step loans | | | 61% | | | | 148% | | | | 391% | |
| Allowance for other than two-step credit losses to non-performing other than two-step loans | | | 63% | | | | 153% | | | | 405% | |
The allowance for credit losses for loans other than two-step loans at September 30, 2008 was $32.9 million, up from $23.8 million at December 31, 2007. The allowance for other than two-step credit losses to total other than two-step loans increased to 1.64% from 1.25% at year end 2007. The drivers of the higher allowance for credit losses, and thus an increased provision for credit losses for loans other than two-step, were unfavorable risk rating migrations, higher general valuation allowance percentages for specific loan segments in the allowance for credit loss model and increased net charge-offs. These factors were only partly offset by lower loan balances and unused commitments at the end of the third quarter. The unfavorable risk rating migration largely consisted of commercial loans and residential construction loans to builders and developers being moved to higher risk rating categories. At September 30, 2008, the allowance for credit losses for loans other than two-step loans totaled $32.9 million and consisted of a $26.5 million formula allowance, a $3.6 million specific allowance, a $1.9 million unallocated allowance and a $.9 million reserve for unfunded commitments. At December 31, 2007, the total allowance for credit losses for loans other than two-step loans of $23.8 million consisted of a $20.3 million formula allowance, a $.7 million specific allowance, a $1.9 million unallocated allowance and a $.9 million reserve for unfunded commitments.
Net Loan Charge-offs – Loans Other Than Two-Step Loans.The net loan charge-offs in the nine months ended September 30, 2008 for loans other than two-step loans were $10.0 million, and largely attributable to the commercial and real estate construction categories, compared to $2.8 million in the same period ended September 30, 2007. The 2008 year to date annualized net loan charge-offs as a percentage of average loans other than two-step loans was .62%, an increase from .22% for the entire year ended December 31, 2007.
- 40 -
Two-Step Loan Portfolio
Our two-step loan program, which involved loans to individual borrowers to finance construction of residential properties, began in the first quarter 2002, but activity in the two-step loan portfolio accelerated significantly beginning in the first quarter of 2005. The program was referred to as the “two-step” loan program because each project involved two steps; initial construction financing that was provided by the Bank and secondary, or take-out, financing that was intended to be provided by third parties. The program was discontinued on October 19, 2007.
The following table presents two-step loan balances, unused commitment and total commitment detail as of the end of each period presented:
| (Dollars in thousands) | | | | | | Two-step total |
| | | Two-step | | Two-step loan | | commitments (loan balance |
| Period ended | | loan balance | | unused commitments | | plus unused commitments) |
| First quarter 2006 | | $ | 85,129 | | $ | 66,914 | | $ | 152,043 |
| Second quarter 2006 | | | 111,256 | | | 77,846 | | | 189,102 |
| Third quarter 2006 | | | 138,939 | | | 105,246 | | | 244,185 |
| Fourth quarter 2006 | | | 171,692 | | | 132,732 | | | 304,424 |
| First quarter 2007 | | | 216,371 | | | 160,918 | | | 377,289 |
| Second quarter 2007 | | | 256,332 | | | 149,902 | | | 406,234 |
| Third quarter 2007 | | | 274,747 | | | 123,447 | | | 398,194 |
| Fourth quarter 2007 | | | 262,952 | | | 78,585 | | | 341,537 |
| First quarter 2008 | | | 211,406 | | | 34,201 | | | 245,607 |
| Second quarter 2008 | | | 145,703 | | | 12,628 | | | 158,331 |
| Third quarter 2008 | | | 97,894 | | | 2,039 | | | 99,933 |
Total two-step loan balances plus unused commitments (“two-step total commitments”) peaked in second quarter 2007 and has since contracted by $306.3 million, or 75%, to $99.9 million as of September 30, 2008. At September 30, 2008, the outstanding balance of loans originated in the two-step loan program was $97.9 million, down 63% from $274.7 million a year ago. Included in the $97.9 million loan balance at September 30, 2008 was $83.0 million in nonaccrual loans and $14.9 million in loans that were accruing interest. Remaining unused commitments totaled $2.0 million at September 30, 2008, down from $123.4 million a year ago.
It is anticipated that the two-step loan balances will continue to run-off over the next three to six months as performing loans are paid off and nonaccrual loans which do not pay off become OREO property.
The following table presents two-step total commitments outstanding at September 30, 2008, by the scheduled period in which the underlying loans mature or matured.
| (Dollars in thousands) | | |
| | | Two-step |
| Maturities in period ended | | total commitments |
| Fourth quarter 2007 | | $ | 4,942 |
| First quarter 2008 | | | 14,719 |
| Second quarter 2008 | | | 27,146 |
| Third quarter 2008 | | | 23,166 |
| Fourth quarter 2008 | | | 24,625 |
| First quarter 2009 | | | 4,394 |
| Second quarter 2009 | | | - |
| Third quarter 2009 | | | 941 |
| Total | | $ | 99,933 |
The majority of future maturities are scheduled to occur in the fourth quarter of 2008. Actual maturities may occur somewhat later than indicated in the table as certain commitments may be extended in the regular course of the construction lending business.
- 41 -
The following table illustrates two-step total commitments by geographic areas as of the dates shown.
| (Dollars in thousands) | | | | | | |
| | | September 30, | | December 31, |
| Region | | 2008 | | 2007 |
| Western Washington (Olympia, Seattle) | | $ | 26,442 | | $ | 113,331 |
| Portland, Oregon / Vancouver, Washington | | | 25,758 | | | 102,336 |
| Central Oregon (Bend, Redmond) | | | 15,850 | | | 44,310 |
| Willamette Valley (Salem, Eugene) | | | 14,149 | | | 34,331 |
| Oregon Coast (Newport, Lincoln City) | | | 12,756 | | | 32,655 |
| Southern Oregon (Medford, Roseburg) | | | 4,978 | | | 14,574 |
| Total residential real estate construction loan commitments | | $ | 99,933 | | $ | 341,537 |
Credit Management - Two-Step Loans
Management action focused on the two-step loan portfolio has been concentrated in the following key areas:
Increasing customer contact prior to loan maturity and encouraging early action to secure permanent financing or identify reasonable alternatives. This typically includes helping the borrower identify permanent mortgage programs, extending the construction period for successful home completion and if third party or company take-out mortgage financing is not expected to materialize, attempting to pursue the least costly alternative in terms of property disposition.
Identifying higher risk elements within the portfolio and developing risk mitigation strategies. As patterns emerge that allow us to isolate risk elements, we evaluate appropriate action steps for risk mitigation and appropriate reserve adequacy.
Adding resources to assist with collection efforts. We formed a dedicated team to address all of the activities associated with acquiring, maintaining and disposing of two-step OREO properties.
Providing mortgage loans to two-step borrowers who qualify. We have developed a set of mortgage loan products to provide bridge financing and permanent mortgage loans, collectively called replacement financing, to certain borrowers with maturing two-step loans. This program is designed to assist two-step borrowers in their transition from a construction loan to permanent financing. Financing terms were generally more flexible than our standard products. Under certain circumstances, we have discounted debt in order to restructure the loan to fit a particular borrower’s debt service capacity. See "Loan Portfolio – RealEstate Mortgage" above for additional disclosures relating to our nonstandard mortgage product.
In the first quarter, we also discontinued our practice of establishing specific reserves associated with collateral dependent impaired loans. Thereafter, we have charged-off the amount of impairment at the time of impairment, rather than placing the impaired amount in a specific reserve. Applying this new practice continues to accelerate the timing of charge-offs associated with collateral dependent two-step loans.
- 42 -
Nonperforming Assets and Delinquencies – Two-Step Loans
Nonperforming Assets – Two-Step Loans. The following table presents information about nonperforming assets and delinquencies relating to two-step loans at the dates shown.
| (Dollars in thousands) | | September 30, | | June 30, | | December 31, |
| | 2008 | | 2008 | | 2007 |
| Non-accruing two-step loans | | $ | 82,990 | | $ | 98,728 | | $ | 20,545 |
| 90 days past due and accruing interest two-step loans | | | - | | | - | | | - |
| Total nonperforming two-step loans | | | 82,990 | | | 98,728 | | | 20,545 |
| |
| Other real estate owned two-step | | | 44,675 | | | 26,460 | | | 3,255 |
| Total nonperforming two-step assets | | $ | 127,665 | | $ | 125,188 | | $ | 23,800 |
| |
| Delinquent two-step loans 30-89 days past due | | $ | 4,089 | | $ | 5,462 | | $ | 36,778 |
| |
| Nonperforming two-step loans to total two-step loans | | | 84.78% | | | 67.76% | | | 7.81% |
| Nonperforming two-step assets to total assets | | | 4.96% | | | 4.75% | | | 0.90% |
| Delinquent two-step loans to total two-step loans | | | 4.18% | | | 3.75% | | | 13.99% |
Nonperforming two-step assets were $127.7 million at September 30, 2008, up from $23.8 million at December 31, 2007, but relatively constant to such nonperforming assets at June 30, 2008. At September 30, 2008, total nonperforming two-step assets of $127.7 million consisted of $83.0 million in nonaccrual loans and the book value of 173 residential properties carried in OREO in the amount of $44.7 million. At September 30, 2008, the $83.0 million two-step nonaccrual balance included $9.7 million in loan balances where payments are current, $11.3 million that were 30-89 days past due and $62.0 million that were over 90 days past due. We believe the level of two-step nonperforming assets peaked in the third quarter of 2008.The following table presents activity in two-step OREO portfolio and for short sales for the periods shown.
| | | | | | | | | | | | | | Total OREO property sales |
| | OREO 2008 | | Short Sales 2008 | | and short sales |
| (Dollars in thousands) | | Amount | | Number | | Amount | | Number | | Amount | | Number |
| Beginning balance January 1 | | $ | 3,255 | | | 14 | | | | | | | | | | |
| Additions to OREO | | | 2,461 | | | 10 | | | | | | | | | | |
| Capitalized improvements | | | 246 | | | | | | | | | | | | | |
| Valuation adjustments | | | - | | | | | | | | | | | | | |
| Disposition of OREO properties and short sales | | | (274 | ) | | (1 | ) | | | (286) | | (1) | | (560) | | (2) |
| Ending balance March 31 | | $ | 5,688 | | | 23 | | | | | | | | | | |
| |
| Additions to OREO | | | 23,546 | | | 87 | | | | | | | | | | |
| Capitalized improvements | | | 188 | | | | | | | | | | | | | |
| Valuation adjustments | | | (245 | ) | | | | | | | | | | | | |
| Disposition of OREO properties and short sales | | | (2,717 | ) | | (9 | ) | | | (5,633) | | (15) | | (8,350) | | (24) |
| Ending balance June 30 | | $ | 26,460 | | | 101 | | | | | | | | | | |
| |
| Additions to OREO | | | 24,025 | | | 91 | | | | | | | | | | |
| Capitalized improvements | | | 175 | | | | | | | | | | | | | |
| Valuation adjustments | | | (1,036 | ) | | | | | | | | | | | | |
| Disposition of OREO properties and short sales | | | (4,949 | ) | | (19 | ) | | $ | (4,391) | | (13) | | (9,340) | | (32) |
| Ending balance September 30 | | $ | 44,675 | | | 173 | | | $ | (10,310) | | (29) | | | | |
Two-step OREO property represents real property which the Bank has taken possession of that has been deeded to the Bank through a deed-in-lieu of foreclosure, non-judicial foreclosure, judicial foreclosure or similar process in partial or full satisfaction of a loan or loans. It typically takes two to seven months following initial delinquency before property is recorded into OREO depending upon the resolution strategy and the complexities associated with the specific property.
During the third quarter we disposed of 32 properties, 19 of which were OREO sales and 13 were short sales. The combined balance of OREO properties sold and loans associated with short sales was $9.3 million. In addition to the 173 properties in the two-step OREO portfolio at September 30, 2008, we had approximately 230 additional two-step related properties in various stages of foreclosure, representing a total of $74 million of the balance included in our nonaccruing loans. We expect to have approximately 110 of these properties representing an estimated $34 million in balances booked into OREO during the fourth quarter of 2008. As this occurs, the balances are moved from nonperforming loan status to OREO on our balance sheet. To date, the majority of the OREO properties were acquired through non-judicial foreclosures, as the borrowers have not shown capacity to support the debt. Additional recoveries from two-step loan borrowers are expected to be limited. We expect the number of two-step OREO properties sold to increase over the next six months, subject to seasonal market area slowing in the rate of home sales. As a result of the two-step OREO property sales and short sales, we anticipate the nonaccruing two-step loan balances to decline by a greater amount than the two-step OREO balance will increase by.
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Delinquencies - Two-Step Loans.Delinquencies in the two-step loan portfolio decreased to $4.1 million at September 30, 2008 from $36.8 million at year end 2007, primarily as a consequence of implementing a modified loan policy during the first quarter which included accelerating the timing of the shift of loans with certain characteristics into nonaccrual status that in prior periods would have been reported as delinquent loans and materially fewer loans with scheduled maturity in the most recent quarter compared to prior quarters. Delinquent two-step loans were 4.18% of total two-step loans at September 30, 2008, down from 13.99% at December 31, 2007.
Allowance for Credit Losses and Net Loan Charge-offs – Two-Step Loans
Allowance for Credit Losses - - Two-Step Loans.The following table presents information with respect to the change in our allowance for credit losses relating to the two-step loan portfolio.
| | Year to date | | Year to date | | Year ended |
| (Dollars in thousands) | | September 30, | | June 30, | | December 31, |
| | 2008 | | 2008 | | 2007 |
| Allowance for credit losses two-step loans, beginning of period | | $ | 31,065 | | | $ | 31,065 | | | $ | 2,618 | |
| Provision for credit losses two-step loans | | | 4,724 | | | | 2,727 | | | | 30,980 | |
| |
| Loan charge-offs two-step loans | | | (36,307 | ) | | | (29,817 | ) | | | (2,540 | ) |
| Recoveries two-step loans | | | 2,020 | | | | 1,305 | | | | 7 | |
| Net loan charge-offs two-step loans | | | (34,287 | ) | | | (28,512 | ) | | | (2,533 | ) |
| |
| Total allowance for credit losses two-step loans | | $ | 1,502 | | | $ | 5,280 | | | $ | 31,065 | |
| |
| Components of allowance for credit losses two-step loans | | | | | | | | | | | | |
| Allowance for loan losses two-step loans | | $ | 1,472 | | | $ | 4,858 | | | $ | 23,917 | |
| Reserve for unfunded commitments two-step loans | | | 30 | | | | 422 | | | | 7,148 | |
| Total allowance for credit losses two-step loans | | $ | 1,502 | | | $ | 5,280 | | | $ | 31,065 | |
| |
| Net charge-offs two-step loans to average total loans annualized | | | 2.12% | | | | 2.63% | | | | 0.12% | |
| Allowance for two-step loan losses to nonperforming two-step loans1 | | | 1.77% | | | | 4.92% | | | | 116.41% | |
| Allowance for two-step loan losses to total two-step loans | | | 1.50% | | | | 3.33% | | | | 9.10% | |
| Allowance for two-step credit losses to total two-step loans | | | 1.53% | | | | 3.62% | | | | 11.81% | |
1 Two-step nonaccrual loans are net of chargeoffs previously taken against the balance.
The provision for two-step credit losses was $4.7 million year to date 2008. The allowance for credit losses associated with the two-step loan portfolio decreased to $1.5 million, from $31.1 million at year end 2007. There was no allowance for credit losses established for nonaccruing two-step loans at September 30, 2008, as these collateral dependent loans have all been individually impaired with a corresponding charge-off down to estimated fair market value less sales expense in accordance with the loan policy established in the first quarter. We will continue to record actual future charge-offs in the two-step loan portfolio against the allowance for loan losses assigned to the portfolio.
The following table provides additional two-step loan and allowance for credit losses information.
(Dollars in thousands)
| | | | | | | | | | | | | | | | | Allowance for | | |
| | | | | | | | | | | | | | | | | credit losses on | | Allowance for credit |
| | | | | | | | | | | | | | | | | two-step loans | | losses on two-step loans |
| | | | | | | | | | | Total accruing | | Allowance for | | as a % of | | as a % of total accruing |
| | Total two-step | | Nonperforming | | Accruing two- | | two-step loan | | credit losses on | | accruing two- | | two-step loan |
| Period ended | | loans | | two-step loans | | step loans | | commitments | | two-step loans | | step loans | | commitments |
| 12/31/2007 | | $ | 262,952 | | $ | 20,545 | | $ | 242,407 | | $ | 320,991 | | $ | 31,065 | | 12.8% | | 9.7% |
| 3/31/2008 | | | 211,406 | | | 88,784 | | | 122,622 | | | 156,823 | | | 11,812 | | 9.6% | | 7.5% |
| 6/30/2008 | | | 145,703 | | | 98,728 | | | 46,975 | | | 59,603 | | | 5,280 | | 11.2% | | 8.9% |
| 9/30/2008 | | | 97,894 | | | 82,990 | | | 14,904 | | | 16,943 | | | 1,502 | | 10.1% | | 8.9% |
The table above shows that the allowance for credit losses relating to the two-step loan portfolio has been fairly consistent relative to the remaining portfolio of performing two-step loans and the commitments associated with those loans. As previously noted at September 30, 2008 there was no allowance for credit losses associated with nonperforming two-step loans because all those loans had previously been deemed impaired and charged off to their estimated fair market value less selling costs.
Net Loan Charge-offs – Two-Step Loans.Net charge-offs in the two-step loan portfolio were $34.3 million in the first nine months of 2008. The timing of charge-offs and interest reversals relating to the two-step loan portfolio during the first nine months of 2008 were affected by the modification in our loan policy in the first quarter 2008 regarding the timing of moving particular loans to nonaccrual status. The application of the modified loan policy caused us to recognize significant loan charge-offs and interest reversals in the first quarter that otherwise would have been recognized in later periods.
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Deposits and Borrowings
The following table summarizes the quarterly average dollar amount in, and the average interest rate paid on, each of the deposit and borrowing categories for the third quarters of 2008 and 2007.
| | Third Quarter 2008 | | Third Quarter 2007 |
| | Quarterly Average | | Percent | | Rate | | Quarterly Average | | Percent | | Rate |
| (Dollars in thousands) | �� | Balance | | of total | | Paid | | Balance | | of total | | Paid |
| Demand deposits | | $ | 482,780 | | 23.6% | | - | | $ | 490,336 | | 23.6% | | - |
| Interest bearing demand | | | 276,973 | | 13.5% | | 0.56% | | | 267,588 | | 12.9% | | 1.07% |
| Savings | | | 71,035 | | 3.5% | | 0.44% | | | 73,909 | | 3.6% | | 0.84% |
| Money market | | | 672,051 | | 32.8% | | 2.06% | | | 680,027 | | 32.7% | | 3.97% |
| Time deposits | | | 543,451 | | 26.6% | | 3.20% | | | 565,550 | | 27.2% | | 4.79% |
| Total deposits | | | 2,046,290 | | 100% | | 2.19% | | | 2,077,410 | | 100% | | 3.76% |
| |
| Short-term borrowings | | | 140,967 | | | | 2.79% | | | 144,711 | | | | 5.23% |
| Long-term borrowings1 | | | 159,291 | | | | 4.37% | | | 107,602 | | | | 5.51% |
| Total borrowings | | | 300,258 | | | | 3.63% | | | 252,313 | | | | 5.35% |
| |
| Total deposits and borrowings | | $ | 2,346,548 | | | | 2.36% | | $ | 2,329,723 | | | | 3.86% |
1 Long-term borrowings include junior subordinated debentures.
Third quarter 2008 average total deposits decreased 1%, or $31 million, from the third quarter 2007. Our deposit mix also remained fairly consistent year over year third quarter, with slightly more growth in the interest bearing demand category and a slight decrease in the total time deposit category. Within the time deposit category, reflecting the turmoil in financial markets, the greater than $100,000 time deposit balances declined $55.4 million compared to third quarter 2007, reflecting the turmoil in financial markets. The time deposits less than $100,000 increased significantly due to FDIC coverage in this segment and the Company’s participation in the Certificate of Deposit Account Registry Service (“CDARS”) network. We do not have any brokered deposits outside of the CDARS network and we expect CDARS balances, which are classified as brokered deposits for regulatory purposes, to decline due to the increases in FDIC insurance limits. The important average noninterest bearing demand category represented 23.6% of total deposits, consistent the prior year third quarter. The rate paid on deposits in the most recent quarter declined 157 basis points from third quarter 2007 primarily due to lower market interest rates. Whether we will be successful in not only maintaining, but also growing, our deposit base will depend on various factors, including pricing and our success in competing in uncertain economic and market conditions.
Average borrowings increased 19% or $48 million from the third quarter of 2007 as a result of higher borrowings from the Federal Home Loan Bank (“FHLB”) and the Federal Reserve Bank (“FRB”). Such borrowings were competitively priced relative to interest bearing deposits, including certificates of deposit.
Our deposit and borrowing cost decreased 150 basis points since the third quarter of 2007, primarily reflecting the decline in short-term market interest rates over the past year. Looking forward, we intend to price our deposit products competitively in connection with our efforts to maintain and grow our strong relationship deposit base. The future funding mix will depend on and be affected by funding needs, customer demand, the level of FDIC insurance available to customers and the relative cost and availability of other funding sources including FHLB borrowings and other government lending or investment programs.
The balance of junior subordinated debentures at September 30, 2008 was $51 million. For additional detail regarding Bancorp’s outstanding debentures, see Note 8 in the financial statements included under Item 1 of this report and our 2007 10-K under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Sources of Funds.”
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Capital Resources
The following table summarizes the consolidated risk based capital ratios of Bancorp and the Bank at September 30, 2008, and December 31, 2007.
| | September 30, 2008 | | December 31, 2007 |
| | | | | | | Amount | | Minimum | | | | | | | | Amount | | Minimum |
| | | | | | | Required For | | percent | | | | | | | | Required For | | percent |
| | | | | | | Well | | required for | | | | | | | | Well | | required for |
| | | | | | | Capitalized | | Well | | | | | | | | Capitalized | | Well |
| (Dollars in thousands) | | Actual Amount | | Ratio | | Status | | Capitalized | | Actual Amount | | Ratio | | Status | | Capitalized |
| Tier 1 capital | | | | | | | | | | | | | | | | | | | | | |
| Common stockholders' equity | | $ | 204,222 | | | | | | | | | $ | 208,241 | | | | | | | | |
| Qualifying capital securities | | | 51,000 | | | | | | | | | | 51,000 | | | | | | | | |
| Less: Goodwill | | | 14,153 | | | | | | | | | | 14,491 | | | | | | | | |
| Other adjustments | | | 3,181 | | | | | | | | | | (585 | ) | | | | | | | |
| West Coast Bancorp total tier 1 capital | | $ | 244,250 | | 10.16% | | $ | 144,198 | | 6% | | $ | 244,165 | | | 9.88% | | $ | 148,206 | | 6% |
| | | | | | | | | | | | | | | | | | | | | | |
| Common stockholders' equity | | $ | 238,517 | | | | | | | | | $ | 244,047 | | | | | | | | |
| Qualifying capital securities | | | - | | | | | | | | | | - | | | | | ` | | | |
| Less: Goodwill | | | 14,153 | | | | | | | | | | 14,491 | | | | | | | | |
| Other adjustments | | | 3,191 | | | | | | | | | | (580 | ) | | | | | | | |
| West Coast Bank total tier 1 capital | | $ | 227,555 | | 9.52% | | $ | 143,357 | | 6% | | $ | 228,976 | | | 9.28% | | $ | 148,030 | | 6% |
| | | | | | | | | | | | | | | | | | | | | | |
| Tier 2 capital | | | | | | | | | | | | | | | | | | | | | |
| Allowance for loans losses allowed | | $ | 30,096 | | | | | | | | | $ | 31,141 | | | | | | | | |
| West Coast Bancorp total tier 2 capital | | $ | 30,096 | | | | | | | | | $ | 31,141 | | | | | | | | |
| |
| Allowance for loans losses allowed | | $ | 29,923 | | | | | | | | | $ | 31,104 | | | | | | | | |
| West Coast Bank total tier 2 capital | | $ | 29,923 | | | | | | | | | $ | 31,104 | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | |
| Total capital | | | | | | | | | | | | | | | | | | | | | |
| West Coast Bancorp | | $ | 274,346 | | 11.42% | | $ | 240,331 | | 10% | | $ | 275,306 | | | 11.15% | | $ | 247,010 | | 10% |
| West Coast Bank | | | 257,478 | | 10.78% | | | 238,929 | | 10% | | | 260,080 | | | 10.54% | | | 246,717 | | 10% |
| | | | | | | | | | | | | | | | | | | | | | |
| Leverage ratio | | | | | | | | | | | | | | | | | | | | | |
| West Coast Bancorp | | $ | 244,250 | | 9.56% | | $ | 127,771 | | 5% | | $ | 244,165 | | | 9.41% | | $ | 129,759 | | 5% |
| West Coast Bank | | | 227,555 | | 8.91% | | | 127,674 | | 5% | | | 228,976 | | | 8.83% | | | 129,714 | | 5% |
| |
| Risk weighted assets | | | | | | | | | | | | | | | | | | | | | |
| Risk weighted assets on balance sheet | | $ | 2,254,866 | | | | | | | | | $ | 2,309,966 | | | | | | | | |
| Risk weighted assets off balance sheet exposure | | | 166,940 | | | | | | | | | | 195,781 | | | | | | | | |
| Less: Goodwill | | | 14,153 | | | | | | | | | | 14,491 | | | | | | | | |
| Less: Disallowed allowance for loan losses | | | 4,348 | | | | | | | | | | 21,159 | | | | | | | | |
| Other adjustments | | | - | | | | | | | | | | - | | | | | | | | |
| West Coast Bancorp risk weighted assets | | $ | 2,403,305 | | | | | | | | | $ | 2,470,097 | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | |
| Risk weighted assets on balance sheet | | $ | 2,241,025 | | | | | | | | | $ | 2,307,070 | | | | | | | | |
| Risk weighted assets off balance sheet exposure | | | 166,940 | | | | | | | | | | 195,781 | | | | | | | | |
| Less: Goodwill | | | 14,153 | | | | | | | | | | 14,491 | | | | | | | | |
| Less: Disallowed allowance for loan losses | | | 4,521 | | | | | | | | | | 21,195 | | | | | | | | |
| Other adjustments | | | - | | | | | | | | | | - | | | | | | | | |
| West Coast Bank total risk weighted assets | | $ | 2,389,291 | | | | | | | | | $ | 2,467,165 | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | |
| Average total assets | | | | | | | | | | | | | | | | | | | | | |
| West Coast Bancorp | | $ | 2,555,410 | | | | | | | | | $ | 2,595,174 | | | | | | | | |
| West Coast Bank | | | 2,553,473 | | | | | | | | | | 2,594,280 | | | | | | | | |
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The FRB and the FDIC have established minimum requirements for capital adequacy for bank holding companies and state non-member banks. The requirements address both risk-based capital and leveraged capital. The regulatory agencies may also establish higher minimum requirements for particular institutions if, for example, a corporation has previously received special attention or is perceived to have a high susceptibility to interest rate or other risk. The FRB and FDIC risk-based capital guidelines require banks and bank holding companies to have a ratio of tier one capital to total risk-weighted assets of at least 6%, and a ratio of total capital to total risk-weighted assets of 10% or greater to be considered well capitalized. In addition, the leverage ratio of tier one capital to total assets less intangibles is required to be at least 5% to be considered well capitalized. As of September 30, 2008, Bancorp and the Bank are considered “Well Capitalized” under the regulatory risk based capital guidelines.
Bancorp’s stockholders' equity was $204 million at September 30, 2008, down from $208 million at December 31, 2007. Nonetheless, the total capital ratio at the Bank was 10.78% at September 30, 2008 an increase from 10.54% at December 31, 2007, while Bank Tier 1 capital increased from 9.28% to 9.52% over the same period. The Company increased its capital ratios at September 30, 2008 from year end 2007 mainly as a result of the declining risk weighted assets during the nine month period. The Company expects risk weighted assets to continue to decline for the remainder of 2008, primarily as a result of declining loan balances. Whether this decline will result in continued increases on our total capital ratios will depend on the Company’s earnings and other factors.
The Company closely monitors and manages its capital position. During the third quarter of 2008, the Company reduced its quarterly cash dividend to shareholders to $.01 per share as part of its efforts to preserve capital. The Company may also preserve capital by slowing new loan commitments, participating out additional loans, and selling assets, including loans, and eliminating the quarterly cash dividend all together. The degree to which and the duration of time during which the Company may take steps to preserve and increase its capital will depend on various factors including general economic and real estate market conditions in our service areas, our ability to raise additional capital, regulatory considerations, the level of consumer confidence in our institution and the banking sector generally and our ability to manage and limit the adverse effects of losses on existing loans.
The risk based capital ratios of Bancorp include $51 million of trust preferred securities that qualify as Tier 1 capital at September 30, 2008, under guidance issued by the Board of Governors of the Federal Reserve System. Bancorp expects to continue to rely on common equity and trust preferred securities to remain well capitalized, although it does not expect to issue additional trust preferred securities in the near future due to current market conditions. Bancorp may offer and issue other hybrid equity or debt instruments, including convertible preferred stock or subordinated debt, to maintain its capital ratios or to improve its financial condition. Any equity or debt financing, if available at all, may not be available on terms that are favorable to current shareholders or even acceptable to the Company. Furthermore, the Company may participate in the U.S. Treasury’s Capital Purchase Program that was implemented in connection with the TARP. If it participates, the Company would issue senior preferred stock, together with warrants to purchase shares of common stock, on the terms announced by the Treasury Department and available on its website.
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Liquidity and Sources of Funds
The Bank’s primary sources of funds are customer deposits, maturities of investment securities, sales of "Available for Sale" securities, loan sales, loan repayments, net income, advances from the Federal Home Loan Bank (“FHLB”), loans taken out at the Federal Reserve discount window, and the use of Federal Funds markets. Scheduled loan repayments are a relatively stable source of funds, while deposit inflows and unscheduled loan prepayments are not. Deposit inflows and unscheduled loan prepayments are influenced by general interest rate levels, interest rates available on other investments, competition, economic conditions and other factors.
Deposits are the primary source of new funds. Total deposits were $2.1 billion at September 30, 2008, unchanged from $2.1 billion at December 31, 2007.
The Company has an agreement with Promontory Interfinancial Network that makes it possible to offer FDIC insured deposits in excess of the current deposit limits. The CDARS network uses a deposit-matching program to match CDARS deposits in other participating banks, dollar for dollar. This product is designed to enhance our ability to attract and retain customers and increase deposits, by providing additional FDIC coverage to customers. CDARS deposits can be reciprocal or one-way. While, due to the nature of the placement of funds, CDARS deposits are defined as "brokered deposits" by regulatory agencies, the Company does not have any other forms of deposits considered brokered deposits. The Company’s reciprocal CDARS balance was $85.0 million at September 30, 2008, of the majority of which was associated with customers whom either have or had a prior banking relationship with the Bank beyond the CDARS product. With media focus on the financial sector and customer concern with FDIC insurance limits over the past quarter, customer interest in and demand for CDARS deposits has increased. CDARS deposits might decline due to the recent increase in FDIC insurance limits. There can be no assurance that CDARS deposits will be available for the Company to offer its customers in the future.
The Bank will participate in the FDIC Temporary Liquidity Guarantee Program (“TLGP”) which will insure noninterest bearing transaction deposit accounts, regardless of amount, until December 31, 2009 at an additional cost to the Bank.
The holding company is a separate entity from the Bank and must provide for its own liquidity. Substantially all of the holding company’s liquidity comes from dividends declared and paid by the Bank and, to a lesser extent, proceeds from the sale of trust preferred securities. There are statutory and regulatory provisions that could limit the ability of the Bank to pay dividends to the holding company. We believe that such restrictions will not have an adverse impact on the ability of the holding company to meet its liquidity needs which include quarterly cash dividend distributions to shareholders, if any, and debt service on the $51 million of outstanding junior subordinated debentures. In addition, the holding company receives cash from the exercise of options. As of September 30, 2008, the holding company did not have any borrowing arrangements of its own.
Management expects to continue relying on customer deposits, cash flow from investment securities, sales of "Available for Sale" securities, loan sales, loan repayments, net income, Federal Funds markets, advances from the FHLB, the Federal Reserve discount window and other borrowings to provide liquidity. Other potential sources of funds include lines of credit with correspondent banking partners and brokered time deposits. Although deposit balances at times have shown historical growth, such balances may be influenced by changes in the financial services industry, interest rates available on other investments, changes in consumer confidence in depository institutions, general economic conditions, competition, customer management of cash resources and other factors. Borrowings may be used on a short-term and long-term basis to compensate for reductions in other sources of funds. Borrowings may also be used on a long-term basis to support expanded lending activities and to match maturities, duration, or repricing intervals of assets. The sources of such funds may include, but are not limited to, Federal Funds purchased, reverse repurchase agreements and borrowings from the FHLB.
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Off-Balance Sheet Arrangements
The Company’s primary off-balance sheet arrangements consist of commitments to make loans and extend credit. The follow table summarizes the Bank’s off balance sheet unfunded commitments as of the dates displayed.
| | Contract or | | Contract or |
| | Notional Amount | | Notional Amount |
| (Dollars in thousands) | | September 30, 2008 | | December 31, 2007 |
| Financial instruments whose contract amounts represent credit risk: | | | | | | |
| Commitments to extend credit in the form of loans | | | | | | |
| Commercial | | $ | 349,602 | | $ | 395,203 |
| Real estate construction | | | | | | |
| Two-step loans | | | 2,046 | | | 78,585 |
| Other than two-step loans | | | 69,938 | | | 149,833 |
| Total real estate construction | | | 71,984 | | | 228,418 |
| Real estate mortgage | | | | | | |
| Standard mortgage | | | 5,611 | | | 7,320 |
| Non-standard mortgage | | | - | | | - |
| Home equity line of credit | | | 199,314 | | | 198,331 |
| Total real estate mortgage loans | | | 204,925 | | | 205,651 |
| Commercial real estate | | | 24,312 | | | 27,116 |
| Installment and consumer | | | 17,736 | | | 19,232 |
| Other1 | | | 11,557 | | | 24,223 |
| Standby letters of credit and financial guarantees | | | 10,552 | | | 8,081 |
| Account overdraft protection instruments | | | 63,985 | | | 54,093 |
| Total | | $ | 754,653 | | $ | 962,017 |
1 The category “other” represents commitments extended to clients or borrowers that have not yet been fully executed. While we believe these commitments to be binding, they are not yet classified nor have they been placed into our loan system.
The Bank’s unfunded commitments to make loans decreased $207 million, or 22%, since December 31, 2007, primarily as a result of the $156 million, or 68%, decline in unused commitments in its real estate construction portfolio and a $46 million, or 12%, decline in the commercial portfolio. The reduction in unused commitments in real estate construction was attributed to run off associated with the discontinued two-step program and restricting new originations in the other than two-step residential construction portfolio. Loan commitments extended longer than one year qualify as risk weighted assets and impact our risk based capital ratios. By decreasing the volume of loan commitments extended longer than one year risk weighted assets decline and, all else equal, the Bank and Bancorp’s regulatory capital ratios improve.
For a further discussion of off-balance sheet arrangements, see Note 21, “Financial Instruments with Off-Balance Sheet Risk.” in our audited financial statement included in the 2007 10-K financial statements.
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Item 3. Quantitative and Qualitative Disclosures About Market Risk
There has been no material change in the market risks disclosure under Item 7A “Quantitative and Qualitative Disclosures about Market Risk” in the Company’s 2007 10-K.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Our disclosure controls and procedures are designed to ensure that information the Company must disclose in its reports filed or submitted under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized, and reported on a timely basis. Our management has evaluated, with the participation and under the supervision of our chief executive officer (“CEO”) and chief financial officer (“CFO”), the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act) as of the end of the period covered by this report. Based on this evaluation, our CEO and CFO have concluded that, as of such date, the Company’s disclosure controls and procedures were not effective because of the material weakness in our internal control over financial reporting, as described below.
Material Weakness
A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company’s annual or interim financial statements will not be prevented or detected on a timely basis.
In preparing our Consolidated Statement of Cash Flows for the nine months ended September 30, 2008, we discovered as part of our review and analysis process that our previously issued Consolidated Statement of Cash Flows for the six months ended June 30, 2008 contained a cash flows presentation error relating to loans transferred to OREO. As a result of this cash flows presentation error, on November 6, 2008, management recommended to the Company's Audit Committee that the previously issued financial statements be restated to properly reflect the cash flows. The Audit Committee concurred with management’s recommendation and concluded that the Financial Statements should be restated. A Form 10-Q/A was filed on November 7, 2008 for that purpose. See Note 11 of Notes to Consolidated Financial Statements included in Item 1 of our Form 10-Q/A for a discussion of the restatement.
As a result of the restatement described above, our management determined that the Company had a material weakness in our internal control over financial reporting, that existed as of June 30, 2008. As previously disclosed, the Company concluded that its established processes for review of the Consolidated Statement of Cash Flows intended to result in the proper identification and classification of cash flows failed to identify the inappropriate inclusion of noncash entries related to the increase of OREO in the Consolidated Statement of Cash Flows for the six months ended June 30, 2008. We believe this material weakness continued as of September 30, 2008, the close of the current quarter. We did not identify the error until the Company’s normal review of its Statement of Cash Flows for the nine months as of September 30, 2008, a process that occurred in the normal course after the close of the quarter. Although identified timely for the purposes of this Form 10-Q, the error and related material weakness in internal control over financial reporting were not identified and remedied as of September 30, 2008.
Remediation Steps to Address Material Weakness
The Company has since taken steps to correct the control deficiency noted above, including evaluation and confirmation of the effectiveness of the review process for the Company's financial statements in subsequent periods and the enhancement of the technical competencies of personnel performing these review procedures, principally the reassignment of review responsibilities to more senior level accounting personnel.
Changes in Internal Control Over Financial Reporting
No change in the Company’s internal control over financial reporting occurred during our third quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
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PART II: OTHER INFORMATION
Item 1. Legal Proceedings
None applicable.
Item 1A. Risk Factors
The following are certain risks that management believes are specific to our business. This should not be viewed as an all inclusive list or in any particular order. See “Item 1A. Risk Factors” of our 2007 10-K for additional risks that may affect our business.
Future loan losses may exceed our allowance for loan losses.
We are subject to credit risk, which is the risk that borrowers will fail to repay loans in accordance with their terms. A continued downturn in the economy or a specific industry sector or a rapid change in interest rates could have further adverse affect on our borrowers’ ability to repay loans while any further declines in the relevant real estate markets could adversely affect the value and salability of the collateral for many of our loans. As a result, we could face losses in excess of our allowance for loan losses. In addition, to the extent that loan payments from borrowers are not timely, the loans will be placed on nonaccrual status, thereby reducing and/or reversing previously accrued interest income.
We maintain an allowance for loan losses that represents management’s best estimate, as of a particular date, of the probable amount of loan receivables that the Bank will be unable to collect. When available information confirms that specific loans or portions of loans are uncollectible, those amounts are charged off against the allowance for loan losses. Our management establishes the allowance for loan losses based on a continual evaluation of lending concentrations, specific credit risks, past loan loss experience, loan portfolio and collateral quality, and relevant economic, political, and regulatory conditions. Adverse changes in any of these or other factors that management considers relevant may result in an increase in the allowance for loan losses. In addition, federal and state banking regulators periodically review the allowance for loan losses and may require that the Bank increase the allowance or recognize loan charge-offs. Any additional provision for loan losses to increase the allowance for loan losses results in a decrease in net income, and possibly risk-based capital, and may have a material adverse effect on our financial condition and results of operations. For more information on this topic, see “Critical Accounting Policies” and “Allowance for Credit Losses and Net Loan Charge-offs” in our 2007 10-K and related sections in this quarterly report under Part 1, Item 2 above.
Defaults and related losses in our two-step residential construction loan portfolio could be greater than currently anticipated and are expected to result in a significant increase in other real estate owned (“OREO”) balances and number of properties to be disposed, which is expected to adversely affect our financial results.
Actual losses related to loans in the two-step loan portfolio (“two-step loans”) may be greater then anticipated, resulting in additional provision for credit losses in future periods. In addition, as part of our collection process for all nonperforming loans, including nonperforming two-step loans, we may foreclose on and take title to the real estate serving as collateral for the loan. Real estate owned by the Bank and not used in the ordinary course of its operations is referred to as “other real estate owned” or “OREO” property. We expect to take a significant number of properties into OREO in the fourth quarter of 2008 and, consequently we expect a larger OREO balance. Increased OREO balances lead to greater expenses as we incur costs to manage and dispose of the properties and, in certain cases, complete construction of residences prior to sale. Any decrease in sale prices on homes may lead to OREO write-downs with a corresponding expense in our income statement. We expect that our earnings over the next several quarters will be negatively affected by various expenses associated with OREO, including personnel costs, insurance and taxes, completion and repair costs, and other costs associated with property ownership, as well as by the funding costs associated with assets that are tied up in real estate properties during the period they are held in OREO. We will also be at risk of further declines in real estate prices and liquidity in the market areas in which we conduct our lending business.
A significant decline in the Company’s market value could result in an impairment of goodwill.
Recently, the Company’s common stock has been trading at a price below its book value, including goodwill and other intangible assets. If impairment of goodwill was deemed to exist, we would be required to write down our assets resulting in a charge to earnings. See section titled “Goodwill and Other Intangible Assets” in Item 7 of our 2007 10-K.
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We may need to raise additional capital which may not be available or may adversely affect existing shareholders. Alternatively, we may have to take steps to preserve capital.
Bancorp may need to raise additional capital in the future through financings to maintain desired levels of capital ratios, to improve its financial condition, or to increase liquidity available for operations. Any equity or debt financing, if available at all, may not be available on terms that are favorable to the Company. In the case of equity financings, dilution to Bancorp’s shareholders could result and, in any case, securities may have rights, preferences and privileges that are senior to those of Bancorp’s current shareholders. Debt financing could also negatively affect future earnings due to interest charges. In the event additional capital is projected to be or becomes needed and is unavailable on acceptable terms through available financing sources, we may need to take steps to preserve capital, including possibly slowing our lending activities and new loan commitments, selling certain assets, or increasing loan participations. During the third quarter, we reduced our cash dividend to $.01 per share as part of our efforts to preserve capital. We may eliminate our cash dividend to shareholders in the future.
Market and other constraints on our construction loan origination volumes are expected to lead to decreases in our interest and fee income that are not expected to be offset by reductions in our non-interest expenses.
Due to existing conditions in housing markets in the areas where we operate and other factors, we project our construction loan originations to be materially constrained for the remainder of 2008. This will lower interest income and fees generated from this part of our business. Unless this revenue decline is offset by other areas of our operations, our total revenues may decline relative to our total non-interest expenses. We expect that it will be difficult to find new revenue sources in the near term to completely offset expected declines in our interest income, and we do not plan steps to significantly trim our non-interest expenses at this time because management believes such actions would be imprudent.
The value of certain securities in our investment securities portfolio may be negatively affected by disruptions in the market for these securities.
The market for certain investment securities held within our investment portfolio has over the past year become more volatile. The volatile market may affect the value of these securities, such as through reduced valuations due to the perception of heightened credit and liquidity risks, in addition to interest rate risk typically associated with these securities. There can be no assurance that the declines in market value associated with these disruptions will not result in impairments of these assets, which would lead to accounting charges that could have a material adverse effect on our net income, equity, and capital ratios.
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Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
| (c) | | The following table provides information about repurchases of common stock by the Company during the quarter ended September 30, 2008: |
| | |
| | | | | | | Total Number of Shares | | |
| | | | | | | Purchased as Part of Publicly | | Maximum Number of Shares Remaining |
| | Total Number of Shares | | Average Price Paid | | Announced Plans or Programs | | at Period End that May Be Purchased |
| Period | | Purchased (1) | | per Share | | (2) | | Under the Plans or Programs |
| 7/1/08 - 7/31/08 | | - | | $ | 0.00 | | - | | 1,051,821 |
| 8/1/08 - 8/31/08 | | - | | $ | 0.00 | | - | | 1,051,821 |
| 9/1/08 - 9/30/08 | | 225 | | $ | 17.05 | | - | | 1,051,821 |
| Total for quarter | | 225 | | | | | - | | |
| (1) | | Shares repurchased by Bancorp during the quarter include shares repurchased from employees in connection with stock option swap exercises and cancellation of restricted stock to pay withholding taxes totaling 0 shares, 0 shares, and 225 shares, respectively, for the periods indicated. There were no shares repurchased in the periods indicated pursuant to the Company’s corporate stock repurchase program publicly announced in July 2000 (the “Repurchase Program”) and described in footnote 2 below. |
| | | | |
| (2) | | Under the Repurchase Program, the board of directors originally authorized the Company to repurchase up to 330,000 common shares, which amount was increased by 550,000 shares in September 2000, by 1.0 million shares in September 2001, by 1.0 million shares in September 2002, by 1.0 million shares in April 2004, and by 1.0 million shares in September 2007 for a total authorized repurchase amount as of September 30, 2008, of approximately 4.9 million shares. |
Item 3. Defaults Upon Senior Securities
None
Item 4. Submission of Matters to a Vote of Security Holders
None
Item 5. Other Information
None
Item 6. Exhibits
| | Exhibit No. | | Exhibit | |
| 31.1 | | Certification of CEO under Rule 13(a) – 14(a) of the Exchange Act. |
| 31.2 | | Certification of CFO under Rule 13(a) – 14(a) of the Exchange Act. |
| 32 | | Certification of CEO and CFO under 18 U.S.C. Section 1350. |
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, this registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| | | WEST COAST BANCORP |
| | | (Registrant) |
| |
| |
| |
| Dated: November 7, 2008 | | /s/ Robert D. Sznewajs |
| | | Robert D. Sznewajs |
| | | President and Chief Executive Officer |
| |
| |
| |
| Dated: November 7, 2008 | | /s/ Anders Giltvedt |
| | | Anders Giltvedt |
| | | Executive Vice President and Chief Financial Officer |
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