UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND
EXCHANGE ACT of 1934
For the quarterly period ended December 31, 2008
-----------------
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND
EXCHANGE ACT of 1934
For the transition period from ______________ to __________________
Commission file number 0-27062
Horizon Financial Corp.
-----------------------
(Exact name of registrant as specified in its charter)
Washington
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(State or other jurisdiction of incorporation or organization)
91-1695422
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(I.R.S. Employer Identification No.)
1500 Cornwall Avenue
Bellingham, Washington
----------------------
(Address of principal executive offices)
98225
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(Zip Code)
Registrant's telephone number, including area code: (360) 733-3050
--------------
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days.
YES X NO
---- ----
Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company.
See definition of "large accelerated filer," "accelerated filer" and "smaller
reporting company" in Rule 12b-2 of the Exchange Act:
Large accelerated filer Accelerated filer X
------ ------
Non-accelerated filer Smaller reporting company
------ ------
Indicate by check mark whether the registrant is a shell corporation (as
defined in Rule 12b-2 of the Exchange Act).
YES NO X
---- ----
As of February 2, 2009, 11,976,669 common shares, $1.00 par value, were
outstanding.
HORIZON FINANCIAL CORP.
INDEX PAGE
- ----- ----
PART 1 FINANCIAL INFORMATION
Item 1 Financial Statements (Unaudited)
Consolidated Statements of Financial Position 2
Consolidated Statements of Operations 3-4
Consolidated Statements of Stockholders' Equity 5
Consolidated Statements of Cash Flows 6-7
Selected Notes to Consolidated Financial Statements 8-13
Item 2 Management's Discussion and Analysis of Financial
Condition and Results of Operations 14-29
Item 3 Quantitative and Qualitative Disclosures About
Market Risk 30
Item 4 Controls and Procedures 30
PART II OTHER INFORMATION
Item 1 Legal Proceedings 31
Item 1A Risk Factors 31-35
Item 2 Unregistered Sales of Equity Securities and Use of Proceeds 35
Item 3 Defaults Upon Senior Securities 36
Item 4 Submission of Matters to a Vote of Security Holders 36
Item 5 Other Information 36
Item 6 Exhibits 36-37
SIGNATURES 38
Exhibit Index 39
1
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements (unaudited)
HORIZON FINANCIAL CORP.
Consolidated Statements of Financial Position (unaudited)
ASSETS
December 31, March 31,
(In thousands, except share data) 2008 2008
------------ ---------
Cash and cash equivalents $ 23,391 $ 22,412
Interest-bearing deposits 80,869 2,912
Investment securities
Available-for-sale 28,425 41,241
Mortgage-backed securities
Available-for-sale 39,954 39,100
Held-to-maturity 9 30
Federal Home Loan Bank stock 7,247 8,867
Loans held for sale 2,072 2,644
Loans receivable, net of allowance for loan losses
of $25,309 at December 31, 2008 and $19,114 at
March 31, 2008 1,187,170 1,191,478
Investment in real estate in a joint venture 17,879 17,567
Accrued interest and dividends receivable 6,598 7,916
Bank premises and equipment, net 26,691 27,778
Deferred tax benefit 6,698 6,253
Income tax receivable 5,694 -
Bank owned life insurance 19,999 20,308
Other real estate owned 16,791 655
Other assets 2,825 3,017
---------- ----------
TOTAL ASSETS $1,472,312 $1,392,178
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits $1,195,424 $1,038,792
Accounts payable and other liabilities 3,625 5,746
Borrowed funds 128,968 192,343
Borrowing related to investment in real estate
in a joint venture 23,942 22,448
Advances by borrowers for taxes and insurance 195 414
Income tax currently payable - 2,174
Deferred compensation 1,837 1,944
---------- ----------
Total liabilities 1,353,991 1,263,861
---------- ----------
STOCKHOLDERS' EQUITY
Serial preferred stock, $1 par value, 10,000,000
shares, authorized; none issued or outstanding - -
Common stock, $1 par value, 30,000,000 shares
authorized; 11,976,669 and 11,892,208 issued
and outstanding at December 31, 2008
and March 31, 2008, respectively 11,977 11,892
Additional paid-in capital 51,210 50,597
Retained earnings53,99463,906
Accumulated other comprehensive income 1,140 1,922
---------- ----------
Total stockholders' equity 118,321 128,317
---------- ----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $1,472,312 $1,392,178
========== ==========
(See Notes to Consolidated Financial Statements)
2
HORIZON FINANCIAL CORP.
Consolidated Statements of Operations (unaudited)
Three months ended
December 31,
(In thousands, except share data) 2008 2007
------- -------
INTEREST INCOME
Interest on loans $ 18,363 $24,917
Interest on investments and mortgage-backed
securities 862 992
------- -------
Total interest income 19,225 25,909
------- -------
INTEREST EXPENSE
Interest on deposits 8,927 9,573
Interest on borrowed funds 1,019 2,536
------- -------
Total interest expense 9,946 12,109
------- -------
Net interest income 9,279 13,800
PROVISION FOR LOAN LOSSES 10,000 900
------- -------
Net interest income (loss) after provision for loan
losses (721) 12,900
------- -------
NONINTEREST INCOME
Service fees 747 893
Net gain on sales of loans - servicing released 81 170
Net gain on sales of loans - servicing retained - 1
Net gain on sales of investment securities 7 -
Other-than-temporary impairment on investment
securities (309) -
Other income 451 452
------- -------
Total noninterest income 977 1,516
------- -------
NONINTEREST EXPENSE
Compensation and employee benefits 4,103 4,205
Building occupancy 1,180 1,232
Real estate owned/collection expense 488 78
FDIC insurance 228 29
Data processing 243 234
Advertising 152 197
Goodwill impairment 545 -
Other expense 1,376 1,447
------- -------
Total noninterest expense 8,315 7,422
------- -------
NET INCOME (LOSS) BEFORE PROVISION (BENEFIT)
FOR INCOME TAX (8,059) 6,994
PROVISION (BENEFIT) FOR INCOME TAX (2,939) 2,282
------- -------
NET INCOME (LOSS) $(5,120) $ 4,712
======= =======
BASIC EARNINGS (LOSS) PER SHARE $ (0.43) $ 0.39
DILUTED EARNINGS (LOSS) PER SHARE $ (0.43) $ 0.39
(See Notes to Consolidated Financial Statements)
3
HORIZON FINANCIAL CORP.
Consolidated Statements of Operations (unaudited)
Nine months ended
December 31,
(In thousands, except share data) 2008 2007
-------- -------
INTEREST INCOME
Interest on loans $ 58,617 $73,683
Interest on investments and mortgage-backed
securities 2,772 3,017
-------- -------
Total interest income 61,389 76,700
-------- -------
INTEREST EXPENSE
Interest on deposits 26,013 28,858
Interest on borrowed funds 3,947 6,658
-------- -------
Total interest expense 29,960 35,516
-------- -------
Net interest income 31,429 41,184
PROVISION FOR LOAN LOSSES 25,000 2,100
-------- -------
Net interest income after provision for loan losses 6,429 39,084
-------- -------
NONINTEREST INCOME
Service fees 2,526 2,692
Net gain on sales of loans - servicing released 431 657
Net gain (loss) on sales of loans - servicing retained (2) 18
Net loss on sales of investment securities (191) -
Other-than-temporary impairment on investment
securities (309) -
Other income 2,258 1,463
-------- -------
Total noninterest income 4,713 4,830
-------- -------
NONINTEREST EXPENSE
Compensation and employee benefits 12,943 12,632
Building occupancy 3,482 3,493
REO/collection expense 1,133 121
FDIC insurance expense 487 85
Data processing 728 713
Advertising 589 612
Goodwill impairment 545 -
Other expense 4,107 4,473
-------- -------
Total noninterest expense 24,014 22,129
-------- -------
NET INCOME (LOSS) BEFORE PROVISION (BENEFIT)
FOR INCOME TAX (12,872) 21,785
PROVISION (BENEFIT) FOR INCOME TAX (5,167) 7,144
-------- -------
NET INCOME (LOSS) $ (7,705) $14,641
======== =======
BASIC EARNINGS (LOSS) PER SHARE $ (0.65) $ 1.21
======== =======
DILUTED EARNINGS (LOSS) PER SHARE $ (0.65) $ 1.19
======== =======
(See Notes to Consolidated Financial Statements)
4
HORIZON FINANCIAL CORP.
Consolidated Statements of Stockholders' Equity
Nine Months Ended December 31, 2008 and 2007
(unaudited)
Accumulated
Other Total
Common Stock Compre- Compre-
--------------------- Additional hensive Stock- hensive
Number of Paid-In Retained Income holders' Income
(In thousands) Shares At Par Capital Earnings (Loss) Equity (Loss)
--------- -------- --------- --------- ---------- -------- -------
<s> <c> <c> <c> <c> <c> <c> <c>
BALANCE, March 31, 2007 12,254 $12,254 $ 51,489 $56,770 $3,342 $123,855
Comprehensive income
Net income - - - 14,641 - 14,641 $14,641
Other comprehensive income
(loss)
Change in unrealized losses
on available-for-sale
securities, net tax benefit
of $512 - - - - (951) (951) (951)
-------
Total other comprehensive
(loss) (951)
-------
Comprehensive income $13,690
=======
Cash dividends on common
stock at $.395/sh - - - (4,780) - (4,780)
Stock options exercised 16 16 85 - - 101
Stock award plan 9 9 465 - - 474
Tax benefit associated with
stock options - - 43 - - 43
Retirement of treasury stock (280) (280) (1,243) (3,922) - (5,445)
------ ------- ------- ------- ------ --------
BALANCE, December 31, 2007 11,999 $11,999 $50,839 $62,709 $2,391 $127,938
====== ======= ======= ======= ====== ========
BALANCE, March 31, 2008 11,892 $11,892 $50,597 $63,906 $1,922 $128,317
Comprehensive income (loss)
Net (loss) - - - (7,705) - (7,705) $(7,705)
Other comprehensive income
(loss)
Reclassification for net
losses realized in income,
net tax benefit of $175 - - - - 326 326 326
Change in unrealized losses
on available-for-sale
securities, net tax
benefit of $596 - - - - (1,108) (1,108) (1,108)
-------
Total other comprehensive
income (loss) (782)
-------
Comprehensive (loss) $(8,487)
=======
Cash dividends on common
stock at $.185/sh - - - (2,207) - (2,207)
Dividend reinvestment plan 41 41 258 - - 299
Stock options exercised 20 20 114 - - 134
Stock award plan 24 24 237 - - 261
Tax benefit associated with
stock options - - 4 - - 4
------ ------- ------- ------- ------ --------
BALANCE, December 31, 2008 11,977 $11,977 $51,210 $53,994 $1,140 $118,321
====== ======= ======= ======= ====== ========
(See Notes to Consolidated Financial Statements)
5
HORIZON FINANCIAL CORP.
Consolidated Statements of Cash Flows (unaudited)
Nine Months Ended
(In thousands) December 31,
2008 2007
--------- ---------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss) $ (7,705) $ 14,641
Adjustments to reconcile net income (loss) to net
cash provided by operating activities:
Depreciation and amortization 2,715 1,819
Stock award plan compensation 261 474
Provision for deferred income tax 39 (106)
Provision for loan losses 25,000 2,100
Provision for loss - Other Real Estate Owned 70
Loss on sale of investment securities 191 -
Other-than-temporary impairment on investment
securities available for sale 309 -
Loss on sale of real estate owned 373 -
Goodwill impairment 545 -
Excess tax benefits from the exercise of stock
options (4) (43)
Net gain on mortgage loans held for sale (431) (657)
Proceeds from sales of mortgage loans held for sale 37,819 59,842
Origination of mortgage loans held for sale (36,816) (57,253)
Changes in assets and liabilities:
Accrued interest and dividends receivable 1,318 (1,255)
Interest payable 290 (1,429)
Federal income tax receivable (7,868) (1,516)
Other assets (41) (1,029)
Other liabilities (1,131) (1,706)
--------- ---------
Net cash flows from operating activities 14,864 13,952
--------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES
Investment in interest-bearing deposits, net (77,957) 2,594
Purchases of investment securities -
available-for-sale (6,000) (15,065)
Proceeds from sales and maturities of
investment securities - available-for-sale 14,149 18,155
Purchases of mortgage-backed securities -
available-for-sale (2,728) (10,176)
Proceeds from sales and maturities of
Investment securities - held-to-maturity - 370
Proceeds from maturities of mortgage-backed
securities - available-for-sale 4,775 4,336
Proceeds from maturities of mortgage-backed
securities - held-to-maturity 21 101
Redemption of Federal Home Loan Bank Stock 1,620 -
Net change in loans (39,756) (138,118)
Proceeds from the sale of other real estate owned 1,440 -
Purchases of bank premises and equipment (512) (2,065)
Net change in investment in real estate in a joint
venture (312) (306)
--------- ---------
Net cash flows from investing activities (105,260) (140,174)
--------- ---------
6
HORIZON FINANCIAL CORP.
Consolidated Statements of Cash Flows (unaudited)
(continued)
Nine Months Ended
(In thousands) December 31,
2008 2007
--------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES
Net change in deposits 156,632 34,645
Advances from borrowed funds 186,506 586,340
Repayments of borrowed funds (249,881) (502,500)
Advances on borrowing related to investment in
real estate in a joint venture 1,494 1,704
Common stock issued, net 433 101
Tax benefit associated with stock options 4 43
Cash dividends paid (3,813) (4,692)
Treasury stock purchased - (5,445)
--------- ---------
Net cash flows from financing activities 91,375 110,196
--------- ---------
NET CHANGE IN CASH AND CASH EQUIVALENTS 979 (16,026)
CASH AND CASH EQUIVALENTS, beginning of period 22,412 40,833
--------- ---------
CASH AND CASH EQUIVALENTS, end of period $ 23,391 $ 24,807
========= =========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the period for interest $ 29,670 $ 36,945
========= =========
Cash paid during the period for income tax $ 4,100 $ 8,717
========= =========
Transfer of loans to other real estate owned $ 18,313 $ -
========= =========
Bank financed sale of other real estate owned $ 364 $ -
========= =========
In-kind distribution for mutual funds $ 3,278 $ -
========= =========
(See Notes to Consolidated Financial Statements)
7
HORIZON FINANCIAL CORP.
SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE AND NINE MONTHS ENDED DECEMBER 31, 2008 AND 2007
(unaudited)
NOTE 1 - Basis of Presentation and Significant Accounting Policies
Basis of Presentation
- ---------------------
The consolidated financial statements as of and for the three and nine
months ended December 31, 2008 and 2007, include the accounts of Horizon
Financial Corp. ("Horizon Financial" or the "Corporation"), and its
wholly-owned subsidiary Horizon Bank ("Horizon Bank" or the "Bank"), and other
subsidiaries of the Bank. Significant intercompany balances and transactions
have been eliminated in consolidation. The Corporation has not engaged in any
significant activity other than holding the stock of the Bank.
The preparation of the financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect amounts reported in
the consolidated financial statements. Changes in these estimates and
assumptions are considered reasonably possible and may have a material impact
on the financial statements and thus actual results could differ from the
amounts reported and disclosed herein.
Certain reclassifications have been made to prior financial statements to
conform with the current presentation. These reclassifications have no effect
on operations, equity, or earnings (loss) per share.
The unaudited consolidated financial statements have been prepared in
accordance with accounting principles generally accepted in the United States
of America for interim financial information and with the instructions to the
Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include
all of the information and footnotes required by accounting principles
generally accepted in the United States of America for complete financial
statements. In the opinion of management, all adjustments (consisting only of
normal recurring accruals) necessary for a fair presentation are reflected in
the interim financial statements. The results of operations for the three and
nine month periods ended December 31, 2008 and 2007 are not necessarily
indicative of the operating results for the full year. For further
information, refer to the consolidated financial statements and footnotes
thereto in the Horizon Financial Corp. Annual Report on Form 10-K for the year
ended March 31, 2008.
Consolidation of Real Estate Joint Venture
- ------------------------------------------
In January 2003, the Financial Accounting Standards Board ("FASB") issued
FASB Interpretation No. ("FIN") 46R, Consolidation of Variable Interest
Entities. FIN 46R explains the concept of a variable interest entity and
requires consolidation by the primary beneficiary where the variable interest
entity does not have sufficient equity at risk to finance its activities
without additional subordinated financial support from other parties. This
interpretation applies to variable interest entities in which an enterprise
holds a variable interest. In October 2004, the Bank's wholly-owned
subsidiary, Westward Financial Services, Inc. ("Westward Financial"), entered
into a real estate development joint venture with Greenbriar Northwest LLC
("GBNW"), an established residential land development company headquartered in
Bellingham, Washington. The Corporation believes that GBNW is a variable
interest entity with the Corporation as the primary beneficiary. Under FIN
46R, GBNW is consolidated in the Corporation's consolidated balance sheet.
The Corporation also accounts for the portion not owned by Westward Financial,
as a minority interest, which is included in other liabilities. The
investment in real estate is recorded as an asset and the related debt is
recorded as the Corporation's liability. As of December 31, 2008, the real
estate joint venture had a carrying amount of approximately $17.9 million,
with a related borrowing of approximately $23.9 million. No income is
currently being recognized in the Corporation's financial statements; however,
in accordance with FIN 46R, the related funding expense is included in the
Corporation's interest on other borrowings expense which was approximately
$34,000 and $134,000 for the three months ended December 31, 2008 and 2007,
respectively, and $173,000 and $426,000 for the nine months ended December 31,
2008 and 2007, respectively.
8
NOTE 2 - Stockholders' Equity
Earnings (Loss) Per Share
- -------------------------
The following table illustrates the reconciliation of weighted average
shares, as adjusted, used for earnings (loss) per share for the noted periods:
Three Months Ended Nine Months Ended
December 31, December 31,
------------------ -------------------
2008 2007 2008 2007
------ ------ ------ ------
Basic weighted average shares
outstanding 11,970,478 12,064,265 11,934,934 12,148,772
Dilutive shares - 93,200 - 103,548
---------- ---------- ---------- ----------
Diluted weighted average shares
outstanding 11,970,478 12,157,465 11,934,934 12,252,320
========== ========== ========== ==========
Ant-dilutive shares outstanding
related to options to acquire
the Corporation's common stock 164,144 45,998 125,802 16,506
========== ========== ========== ==========
Cash Dividend Declared
- ----------------------
On December 22, 2008, the Corporation announced its decision to suspend
the quarterly cash dividend previously paid on shares of its common stock.
NOTE 3 - Share Based Payment and Stock Option and Restricted Stock Award Plans
Share Based Payment
- -------------------
The Corporation adopted Statement of Financial Accounting Standard
("SFAS" or "Statement") No. 123R, Share-Based Payment, on April 1, 2006 using
the "modified prospective" method. Under this method, awards that are
granted, modified, or settled after March 31, 2006 are measured and accounted
for in accordance with Statement No. 123R. Also under this method, expense is
recognized for unvested awards that were granted prior to April 1, 2006 based
upon the fair value determined at the grant date under Statement No. 123,
Accounting for Stock-based Compensation. For the three and nine months ended
December 31, 2008, the Corporation recognized $69,000 and $261,000 in stock
option and restricted stock award compensation expense, net of tax, as a
component of salaries and benefits, compared to $191,000 and $474,000 for the
three and nine months ended December 31, 2007. As of December 31, 2008 and
2007, there was approximately $243,000 and $749,000, respectively, of total
unrecognized compensation cost related to nonvested options and restricted
stock awards which is scheduled to amortize over the next three years. The
Corporation measures the fair value of each stock option grant at the date of
grant, using the Black Scholes option pricing model. The following
assumptions were used in arriving at the fair value of options granted during
the nine months ended December 31, 2008:
Nine Months Ended
December 31, 2008
-----------------
Risk-free interest rate 1.00%
Dividend yield rate 0.00%
Price volatility 78.14%
Expected life of options 5.90 years
The Corporation may grant awards, typically options and restricted stock,
for a maximum of 937,500 shares, as adjusted, of authorized common stock to
certain officers and key employees under the 2005 Incentive Stock Plan. These
awards may or may not vest immediately upon issuance based on the terms
established by the Board of Directors. All awards are generally exercisable
within one to five years from the date of grant and, in the case of option
awards, expire after ten years. Dividends are paid on restricted stock grants
during the restricted period. All options are granted at an exercise price
equal to the fair market value (average of the high and low price for the day)
of the Corporation's commons stock on the date of grant. Dividends are not
paid on any option awards until the option is exercised by the recipient.
9
NOTE 3 - Share Based Payment and Stock Option and Restricted Stock Award Plans
(continued)
The following table summarizes the stock option activity for the nine
months ended December 31, 2008 under both the 1995 and 2005 stock plans:
Weighted
Weighted average
Out- average remaining Aggregate
standing exercise contractual intrinsic
under price term value (in
Stock Options plan per share (in years) thousands)
- ------------- ------- --------- ---------- ---------
Balance, March 31, 2008 193,076 $ 12.44
Granted 7,000 3.90
Exercised (20,161) 6.64
Forfeited, expired or
cancelled (11,194) 14.09
------- -------- ---- -------
Balance, December 31, 2008 168,721 $ 12.67 5.06 $ 2
======= ======== ==== =======
Exercisable, December 31, 2008 126,148 $ 11.39 3.88 $ -
======= ======== ==== =======
The total intrinsic value, the amount by which the fair value of the
underlying stock exceeds the exercise price of an option on the exercise date,
of options exercised for the nine months ended December 31, 2008 and 2007 was
$0 and $178,000, respectively.
The following table summarizes the award activity for the nine months
ended December 31, 2008 under the 2005 stock plan:
Weighted
Weighted average
Out- average remaining
standing grant contractual
under price term
Restricted Stock Awards plan per share (in years)
- ----------------------- ------- --------- ----------
Balance, March 31, 2008 51,761 $ 20.66
Granted - -
Released (23,234) 20.76
Forfeited, expired or
cancelled (4,819) 20.54
------ ------- ----
Balance, December 31, 2008 23,708 $ 20.58 0.72
====== ======= ====
NOTE 4 - Fair Value Measurements
Effective April 1, 2008, the Corporation partially adopted FASB Statement
No. 157, Fair Value Measurements, for all financial instruments accounted for
at fair value on a recurring basis. The Corporation elected the deferral
reporting on non-financial instruments as permitted in FASB Staff Position
157-2 until fiscal years beginning after November 15, 2008. Statement No. 157
establishes a new framework for measuring fair value and expands related
disclosures. Statement No. 157 framework requires fair value to be determined
based on the exchange price that would be received for an asset or paid to
transfer a liability (an exit price) in the principal or most advantageous
market for the asset or liability in an orderly transaction between market
participants. Statement No. 157 establishes a fair value hierarchy which
requires an entity to maximize the use of observable inputs and minimize the
use of unobservable inputs when measuring fair value. The standard describes
three levels of inputs that may be used to measure fair value:
Level 1: Quoted prices for identical assets or liabilities in active
markets that the entity has the ability to access as of the
measurement date.
Level 2: Significant other observable inputs other than Level 1 prices,
such as quoted prices for similar assets or liabilities, quoted
prices in markets that are not active and other inputs that are
observable or can be corroborated by observable market data.
Level 3: Significant unobservable inputs that reflect a company's own
assumptions about the assumptions that market participants
would use in pricing an asset or liability.
10
NOTE 4 - Fair Value Measurements (continued)
SFAS 157 defines fair value as the price that would be received to sell
an asset or paid to transfer a liability in an orderly transaction between
market participants at the measurement date. SFAS 157 establishes a
three-level hierarchy for disclosure of assets and liabilities recorded at
fair value. The classification of assets and liabilities within the hierarchy
is based on whether the inputs to the valuation methodology used for
measurement are observable or unobservable. Observable inputs reflect
market-derived or market-based information obtained from independent sources,
while unobservable inputs reflect our estimates about market data. In general,
fair values determined by Level 1 inputs utilize quoted prices for identical
assets or liabilities traded in active markets that the Company has the
ability to access. Fair values determined by Level 2 inputs utilize inputs
other than quoted prices included in Level 1 that are observable for the asset
or liability, either directly or indirectly. Level 2 inputs include quoted
prices for similar assets and liabilities in active markets, and inputs other
than quoted prices that are observable for the asset or liability, such as
interest rates and yield curves that are observable at commonly quoted
intervals. Level 3 inputs are unobservable inputs for the asset or liability,
and include situations where there is little, if any, market activity for the
asset or liability. In certain cases, the inputs used to measure fair value
may fall into different levels of the fair value hierarchy. In such cases,
the level in the fair value hierarchy within which the fair value measurement
in its entirety falls has been determined based on the lowest level input that
is significant to the fair value measurement in its entirety. The Company's
assessment of the significance of a particular input to the fair value
measurement in its entirety requires judgment, and considers factors specific
to the asset or liability.
The following is a description of the valuation methodologies of
financial assets on a recurring or nonrecurring basis:
Investments in debt and equity securities: Securities available for sale
are recorded at fair value on a recurring basis. Fair value is
determined by obtaining quoted prices on nationally recognized securities
exchanges (Level 1) or through the use of alternative approaches, such as
matrix or model pricing, when market quotes are not readily available
(Level 2).
Impaired loans: A loan is considered impaired when, based upon currently
known information, it is deemed probable that the Corporation will be
unable to collect all amounts due as scheduled according to the original
terms of the agreement. Impaired loans are measured based on the present
value of expected future cash flows discounted at the loan's effective
interest rate or, as a practical expedient, based on the loan's
observable market price or the fair value of the collateral based on an
appraisal, if the loan is collateral dependent. Impaired loans, which
are collateral dependent, are included in the nonrecurring basis table
below.
The following table presents the Corporation's financial assets measured
at fair value on a recurring basis at December 31, 2008 (in thousands):
Level 1 Level 2 Level 3 Total
------- ------- ------- -------
Assets
Investment securities $ 1,174 $67,205 $ - $68,379
------- ------- ------- -------
Total $ 1,174 $67,205 $ - $68,379
======= ======= ======= =======
The following table presents the Corporation's assets measured at fair
value on a nonrecurring basis at December 31, 2008 (in thousands):
Level 1 Level 2 Level 3 Total
------- ------- ------- -------
Assets
Impaired loans $ - $ - $82,451 $82,451
------- ------- ------- -------
Total $ - $ - $82,451 $82,451
======= ======= ======= =======
In accordance with FASB Statement 114, Accounting by Creditors for
Impairment of a Loan, impaired loans, with carrying amounts of $82.5 million
had specific valuation allowances totaling $13.3 million at December 31, 2008,
which were included in the allowance for loan losses.
11
NOTE 5 - Goodwill
- -----------------
Goodwill generally arises from business combinations accounted for under
the purchase method. Goodwill that is deemed to have an indefinite life as a
result of a purchase business combination is not subject to amortization and
is instead tested for impairment no less than annually.
As a result of the Corporation's market capitalization being less than
its total stockholders' equity at December 31, 2008, the Corporation performed
a valuation analysis to assist us in determining whether and to what extent
the goodwill asset was impaired. The accounting rules with respect to
goodwill require that we compare the implied fair value of goodwill to the
carrying amount of goodwill on the Corporation's balance sheet. Upon
completion of the analysis, management eliminated the carrying amount of the
goodwill with a charge to earnings for the entire amount. This impairment
charge had no effect on the Corporation's or the Bank's cash balances,
liquidity or regulatory ratios. The following table presents the changes in
goodwill for the nine months ended December 31, 2008:
For the nine months ended
December 31, 2008
-----------------
(In thousands)
Balance, beginning of period $ 545
Goodwill write-off (545)
-----
Balance, end of period $ -
=====
NOTE 6 - Investments
- --------------------
The Corporation reviews investment securities on an ongoing basis for the
presence of OTTI, taking into consideration current market conditions, fair
value in relationship to cost, extent and nature of the change in fair value,
issuer rating changes and trends, its ability and intent to hold investments
until a recovery of fair value, which may be maturity, and other factors.
During the quarter ended December 31, 2008, the Corporation recorded a
$309,000 OTTI and is included in noninterest income. Charges of $309,000
related to 15 non-agency collateralized mortgage obligations in investments
available for sale where the default rates, declines in investment ratings and
loss severities of the underlying collateral indicate credit losses are
expected to occur. These securities were valued by third party pricing
services using readily available market quotes. There were no similar charges
recorded during the three or nine months ended December 31, 2007.
NOTE 7 - Impact of New Accounting Pronouncements
- ------------------------------------------------
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements
(SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring
fair value in generally accepted accounting principles (GAAP), and expands
disclosures about fair value measurements. This Statement applies to other
accounting pronouncements that require or permit fair value measurements.
Accordingly, this Statement does not require any new fair value measurements.
This Statement is effective for financial statements issued for fiscal years
beginning after November 15, 2007, and interim periods within those fiscal
years. The Corporation implemented of this Statement April 1, 2008, and it did
not have a material impact on the Corporation's consolidated financial
statements.
In February 2007, the Financial Accounting Standards Board released
Statement No. 159, Fair Value Option for Financial Assets and Financial
Liabilities. This Statement permits entities to choose to measure many
financial instruments and certain other items at fair value. This Statement is
effective for financial statements issued for fiscal years beginning after
November 15, 2007, and interim periods within those years. The Corporation
implemented of this Statement April 1, 2008, and it did not have a material
impact on the Corporation's consolidated financial statements.
In October 2008, the FASB issued FASB Staff Position No. FAS 157-3,
Determining the Fair Value of a Financial Asset When the Market for The Asset
Is Not Active ("FSP 157-3). FSP 157-3 clarifies the application of FAS 157 in
a market that is not active. The FSP is intended to address the following
application issues: (a) how the reporting entity's own assumptions (that is,
expected cash flows and appropriately risk-adjusted discount rates) should be
considered when measuring fair value; (b) how available observable inputs in a
market that is not active should be considered when measuring fair value; and
(c) how the use of market quotes (for example, broker quotes or pricing
services for the same or similar financial assets) should be considered when
assessing the relevance of observable and unobservable inputs available to
measure fair value. FSP 157-3 is effective on issuance, including prior
periods for which financial statements have not been issued. The Corporation
adopted FSP 157-3 for the quarter ended December 31, 2008 and the effect of
adoption on the consolidated financial statements was not material.
12
NOTE 7 - Impact of New Accounting Pronouncements (continued)
In December 2008, the FASB has issued FASB Staff Position (FSP) FAS 140-4
and FIN 46(R)-8, Disclosures by Public Entities (Enterprises) about Transfers
of Financial Assets and Interests in Variable Interest Entities. FSP 140-4
requires additional disclosures by public companies about transfers of
financial assets and interests in variable interest entities. The FSP amends
both FASB Statement 140, Accounting for Transfers and Servicing of Financial
Assets and Extinguishments of Liabilities, and FASB Interpretation (FIN) No.
46 (Revised December 2003), Consolidation of Variable Interest Entities, to
require:
* Additional disclosures about transferors' continuing involvements
with transferred financial assets;
* Additional disclosures about a public entities' (including sponsors)
involvement with variable interest entities;
* Disclosures by a public enterprise that is: (a) a sponsor of a
qualifying special-purpose entity (SPE) that holds a variable
interest in the qualifying SPE but was not the transferor of
financial assets to the qualifying SPE; and (b) a servicer of a
qualifying SPE that holds a significant variable interest in the
qualifying SPE but was not the transferor of financial assets to the
qualifying SPE.
The Corporation adopted FSP 140-4 and FIN 46(R)-8 for the quarter ended
December 31, 2008 and the effect of the adoption on the consolidated financial
statements was not material.
13
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following discussion is intended to assist in understanding the
financial condition and results of operations of the Corporation and its
subsidiaries. The information contained in this section should be read in
conjunction with the Consolidated Financial Statements and the accompanying
Notes contained herein.
Forward Looking Statements
- --------------------------
Management's Discussion and Analysis of Financial Condition and Results
of Operations and this Form 10-Q contain certain forward-looking statements
which are based on assumptions and describe future plans, strategies and
expectations of the Corporation. Management desires to take advantage of the
safe harbor provisions of the Private Securities Litigation Reform Act of 1995
and is including this statement for the express purpose of availing the
Corporation of the protections of the safe harbor with respect to all
forward-looking statements in this Form 10-Q. These forward-looking
statements are generally identified by use of the word "believe," "expect,"
"intend," "anticipate," "estimate," "project," or similar words. The
Corporation's ability to predict results of the actual effect of future plans
or strategies is uncertain. Factors which could cause actual results to
differ materially include, but are not limited to, the credit risks of lending
activities, including changes in the level and trend of loan delinquencies and
write-offs; changes in general economic conditions, either nationally or in
our market areas; changes in the levels of general interest rates, deposit
interest rates, our net interest margin and funding sources; fluctuations in
the demand for loans, the number of unsold homes and other properties and
fluctuations in real estate values in our market areas; results of
examinations of us by the Federal Reserve and our savings bank subsidiary by
the Federal Deposit Insurance Corporation, the Washington Department of
Financial Institutions or other regulatory authorities, including the
possibility that any such regulatory authority may, among other things, impose
restrictions on our operations or require us to increase our reserve for loan
losses or to write-down assets; our ability to control operating costs and
expenses; our ability to successfully integrate any assets, liabilities,
customers, systems, and management personnel we have acquired or may in the
future acquire into our operations and our ability to realize related revenue
synergies and cost savings within expected time frames and any goodwill
charges related thereto; our ability to manage loan delinquency rates and
dispose of real estate we may acquire as a result of loan foreclosures; our
ability to retain key members of our senior management team; costs and effects
of litigation, including settlements and judgments; increased competitive
pressures among financial services companies; changes in consumer spending,
borrowing and savings habits; legislative or regulatory changes that adversely
affect our business; adverse changes in the securities markets; inability of
key third-party providers to perform their obligations to us; changes in
accounting policies and practices, as may be adopted by the financial
institution regulatory agencies or the Financial Accounting Standards Board;
war or terrorist activities; other economic, competitive, governmental,
regulatory, and technological factors affecting our operations, pricing,
products and services and other risks detailed in the Corporation's reports
filed with the Securities and Exchange Commission, including the Annual Report
on Form 10-K for the fiscal year ended March 31, 2008. The Corporation
undertakes no responsibility to update or revise any forward-looking
statements. These risks and uncertainties should be considered in evaluating
forward-looking statements and you should not rely too much on these
statements.
General
- -------
Horizon Financial was formed under Washington law on May 22, 1995, and
became the holding company for Horizon Bank effective October 13, 1995. At
December 31, 2008, Horizon Financial had total assets of $1.47 billion, total
deposits of $1.20 billion and total equity of $118.3 million. The
Corporation's business activities generally are limited to passive investment
activities and oversight of its investment in the Bank. Accordingly, the
information set forth in this report, including consolidated financial
statements and related data, relates primarily to the Bank and its subsidiary.
The Bank (a subsidiary of Horizon Financial) was organized in 1922 as a
Washington State chartered mutual savings and loan association and converted
to a federal mutual savings and loan association in 1934. In 1979, the Bank
converted to a Washington State chartered mutual savings bank. On August 12,
1986, the Bank converted to a state chartered stock savings bank under the
name "Horizon Bank, a savings bank". The Bank became a member of the Federal
Home Loan Bank ("FHLB") of Seattle in December 1998. Effective March 1, 2000,
the Bank changed its name to its current name, "Horizon Bank". Effective
August 1, 2005, the Bank converted from a state chartered savings bank to a
state chartered commercial bank. The Bank's deposits are insured by the
Federal Deposit Insurance Corporation ("FDIC") up to applicable limits.
The Corporation's results of operations depend primarily on revenue
generated as a result of its net interest income and noninterest income. Net
interest income is the difference between the interest income the Corporation
earns on its interest-earning assets (consisting primarily of loans and
investments securities) and the interest the Corporation pays on its interest-
14
bearing liabilities (consisting primarily of customer savings and money market
accounts, time deposits and borrowings). Noninterest income consists
primarily of service charges on deposit and loan accounts, gains on the sale
of loans and investments, and loan servicing fees. The Corporation's results
of operations are also affected by its provisions for loan losses and other
expenses. Other expenses consist primarily of noninterest expense, including
compensation and benefits, occupancy, equipment, data processing, marketing,
automated teller machine costs and, when applicable, deposit insurance
premiums. The Corporation's results of operations may also be affected
significantly by general and local economic and competitive conditions,
changes in market interest rates, governmental policies and actions of
regulatory authorities, as well as other factors identified under the caption
"Forward Looking Statements" above.
Business Strategy
- -----------------
The Corporation's business strategy is to operate Horizon Bank as a
well-capitalized, profitable and independent community bank, dedicated to a
diversified base of commercial lending, home mortgage lending, consumer
lending, small business lending and providing quality financial services to
local personal and business customers. The Corporation has sought to
implement this strategy by: (i) focusing on commercial banking opportunities;
(ii) continuing efforts towards the origination of residential mortgage loans,
focusing on loans eligible for sale in the secondary market; (iii) providing
high quality, personalized financial services to individuals and business
customers and communities served by its branch network; (iv) selling many of
its fixed rate mortgages to the secondary market; (v) focusing on asset
quality; (vi) containing operating expenses; and (vii) maintaining capital in
excess of regulatory requirements combined with prudent growth. In the past,
this strategy included a focus on residential construction and development
lending; however this is not part of the future strategy of the Corporation,
as the focus now is on diversifying the balance sheet and decreasing its
concentration in this area.
As a result of the downturn in the economy and the net losses realized
for the three and nine months ended December 31, 2008, the Bank's efforts are
focused primarily on improving asset quality, capital preservation, expense
reduction, managing liquidity and core deposit growth. Beginning with the
quarter ended September 30, 2008, the Bank expanded its special assets team
which is responsible for working out problem assets which have grown
substantially over the past six months, by shifting personnel within the
Corporation.. The Bank has continued to focus on core deposit growth to
enhance its liquidity position. At December 31, 2008, the Bank's core
deposits increased $24.0 million, or 3.8% to $654.5 million from $630.5
million at March 31, 2008, as shown in the table later in this document
illustrating an analysis of the deposit portfolio by major type of deposit.
In addition, the Bank has performed an extensive review of potential expense
reductions. In evaluating the controllable expenses, the Bank determined the
need to make several strategic staffing reductions. As of November 4, 2008,
the Bank completed a reduction in force of 27 full-time positions at the Bank,
and also identified several areas where responsibilities will be shifted to
accommodate the revised staffing levels. In the weeks leading up to the
November 4, 2008 strategic staffing reduction, other positions were not filled
when vacated by the employees previously occupying these positions These
reductions in personnel, along with strategic reductions in other noninterest
expense areas are expected to result in over $3 million in expense savings on
an annual basis. In connection with the reduction in personnel, the Company
incurred approximately $135,000 in severance related expenses during the
quarter ended December 31, 2008.
Operating Strategy
- ------------------
The Corporation serves as a holding company for the Bank, providing
strategic oversight, management, access to capital and other resources and
activities typically performed by bank holding companies. The Bank currently
has two offices in Pierce County (south of King County), with the remaining
offices all located north of King County.
The primary business of the Bank is to acquire funds in the form of
deposits gathered from our retail branches and to use the funds to make
commercial, consumer, and real estate loans in its primary market area. In
addition, and to a lesser extent, the Bank invests in a variety of investment
grade securities including, but not necessarily limited to U.S. Government and
federal agency obligations, mortgage-backed securities, corporate debt, equity
securities, and municipal securities. The Bank intends to reduce its reliance
on FHLB advances, brokered deposits, and other wholesale borrowings from its
current levels as it focuses on deleveraging its balance sheet.
The Corporation's profitability depends primarily on its net interest
income, which is the difference between the income it receives on the Bank's
loan and investment portfolio and the Bank's cost of funds, which consists of
interest paid on deposits and borrowings. The Bank reviews its opportunities
with respect to both assets and liabilities. In recent years, for example,
the Bank chose to concentrate its commercial lending efforts on growing its
Prime-based loan portfolio, at a time when some lenders were offering fixed
rate real estate loans at sub-Prime rates. In this regard, the Bank's loan
portfolio growth is heavily concentrated in the real estate development and
construction markets in the Puget Sound region. Through its relationships
with established real estate developers and builders, the Bank's loan officers
increased this portion of the Bank's portfolio, which is primarily Prime-based
business. With the Federal Reserve Board's Federal Open Market Committee's
("FOMC") 400 basis point reductions from December 2007 through December 2008,
the Corporation is experiencing a decline
15
in its net interest margin. This rapid pace of easing monetary policy by the
FOMC will contribute to further declines in the Corporation's net interest
margin. On the liability side of the balance sheet, these changing rates also
impact the Bank's earnings. Management acknowledges that there is a lag
effect in this regard, in both increasing and decreasing rate environments as
the rates on the Bank's certificate of deposit liabilities do not adjust
instantly, rather the impact occurs more gradually than the impact on its
assets, as certificates of deposit mature and reprice in a changing interest
rate environment.
Net interest income is also affected by the relative amounts of
interest-earning assets and interest-bearing liabilities. When
interest-earning assets equal or exceed interest-bearing liabilities, any
positive interest rate spread will generate net interest income. The
Corporation's profitability is also affected by the level of the Bank's other
income and expenses. Other noninterest income includes income associated with
the origination and sale of mortgage loans, loan servicing fees, deposit
account related fees, and net gains and losses on sales of interest-earning
assets. This portion of the Bank's income is heavily dependent on the Bank's
success at originating and selling one-to-four family mortgage loans into the
secondary market. Recently the Bank's mortgage banking activity has declined
commensurate with the slowdown in the housing industry. In addition, the
Bank's ability to generate fee income on its deposit accounts impacts this
portion of the Bank's income stream.
Other noninterest expenses include compensation and benefits, occupancy
and equipment expenses, deposit insurance premiums, data servicing expenses
and other operating costs.
Finally, the Corporation's results of operations are also significantly
affected by general economic and competitive conditions, particularly loan
delinquencies, changes in market interest rates, conditions in the financial
services industry, government legislation, regulation, and monetary and fiscal
policies. In the Corporation's primary market areas, there have been an
increasing number of adverse employment announcements. In late January 2008,
it was reported that Boeing intends to layoff 10,000 employees, representing
approximately 6% of its workforce. In addition, Microsoft announced its
intention to cut 5,000 employees from its payrolls, and Starbucks announced
they would be laying off 7,000 workers and closing 300 stores worldwide.
These adverse employment reports followed reports from the Washington State
Employment Security Department which showed unemployment levels higher in
December 2008 in each of the Corporation's markets (compared to December 2007
levels). These reports lead management to the conclusion that the challenges
being faced in the housing markets are not likely to improve in the near
future.
Financial Condition
- -------------------
Total consolidated assets for the Corporation at December 31, 2008,
increased to $1.47 billion or 5.8% from $1.39 billion at March 31, 2008. This
increase in assets was primarily a result of the growth in interest bearing
deposits, which increased $77.9 million to $80.9 million at December 31, 2008
from $2.9 million at March 31, 2008. The increase in interest bearing
deposits was a result of the strategy to enhance the Bank's liquidity
position, accomplished in part by utilizing brokered deposits and by paying
above average retail deposit rates in our local markets. Net loans receivable
was relatively unchanged at $1.19 billion as of December 31, 2008 and March
31, 2008. The decrease in net loans receivable was attributable to a
combination of factors, including a $39.6 million decrease in commercial
construction loans as the Bank worked to decrease its balances in this
business line. Commercial construction includes commercial speculative
one-to-four family (large one-to-four family developments and condominium
projects), multifamily and commercial buildings as shown in the construction
and land development table later in this section. During the period, the
commercial business loan category increased $31.4 million, or 17.7% as the
Bank continues to focus on increasing its commercial lines of credit balances
in order to diversify its loan portfolio and expand its relationships with
businesses in its markets. One-to-four family mortgage loans, net of
participations sold, increased 5.1% to $154.3 million at December 31, 2008
from $146.9 million at March 31, 2008. The Bank implemented a key lending
program to help the Bank's commercial builder/developers sell inventory, which
focused on offering special mortgages to prospective home buyers. The Bank
had net sales of $37.4 million of real estate loans during the nine months
ended December 31, 2008, compared to $59.2 million during the nine months
ended December 31, 2007 as a result of a slowdown in the overall real estate
market.
The following is an analysis of the loan portfolio by major loan categories:
December 31, % of March 31, % of
(Dollars in thousands) 2008 Portfolio 2008 Portfolio
----------- --------- -------- ---------
One-to-four family mortgage loans
One-to-four family $167,737 13.8% $ 165,824 13.7%
One-to-four family construction 35,500 2.9% 35,303 2.9%
Less participations sold (48,943) (4.0)% (54,269) (4.5)%
-------- ---- -------- ----
Net one-to-four family
mortgage loans 154,294 12.7% 146,858 12.1%
16
Commercial land development 201,683 16.6% 183,827 15.2%
Commercial construction (1) 263,113 21.7% 302,708 25.0%
Multifamily residential 42,722 3.5% 45,049 3.7%
Commercial real estate 273,906 22.6% 300,109 24.8%
Commercial business loans 209,072 17.3% 177,685 14.7%
Home equity secured 59,538 4.9% 47,351 3.9%
Other consumer loans 8,151 .7% 7,005 .6%
---------- ----- ---------- ----
Subtotal 1,058,185 87.3% 1,063,734 87.9%
---------- ----- ---------- ----
Total loans receivable 1,212,479 100.0% 1,210,592 100.0%
---------- ----- ---------- ----
Less:
Allowance for loan losses (25,309) (19,114)
---------- ----------
Net loans receivable $1,187,170 $1,191,478
========== ==========
December 31, % of March 31, % of
(Dollars in thousands) 2008 Portfolio 2008 Portfolio
----------- --------- -------- ---------
Net residential loans $ 152,502 12.8% $ 145,565 12.2%
Net commercial business loans 203,760 17.2% 174,263 14.6%
Net commercial real estate
loans (2) 764,714 64.4% 818,215 68.7%
Net consumer loans (3) 66,194 5.6% 53,435 4.5%
---------- ----- ---------- ----
$1,187,470 100.0% $1,191,478 100%
========== ===== ========== ====
(1) Includes $37.3 million and $54.6 million in condominium construction
projects at December 31, 2008 and March 31, 2008, respectively.
(2) Includes construction and development, multi-family and commercial real
estate loans.
(3) Includes home equity and other consumer loans.
As reflected in the table above, approximately 64.4% of our total net
loan portfolio consists of commercial and multifamily real estate and
construction and land development loans. Management has made the strategic
decision to reduce the level of exposure to these types of loans during the
economic slowdown and has dramatically reduced its lending to this type of
borrower. Management intends to continue these efforts to reduce its
concentration in construction and land development loans. These loans are
typically greater in amount, more difficult to evaluate and monitor and,
therefore, involve a greater degree of complexity and risk than single family
residential mortgage loans. Because payments on loans secured by commercial
and multifamily real estate often depend upon the successful operation and
management of the properties, repayment of such loans are being challenged at
this time by adverse conditions in the real estate market and our local
economy. The Bank seeks to reduce these risks by reducing the overall
percentage of concentration in commercial and multifamily real estate and
construction and land development loans until such time real estate markets
stabilize and the economy shows signs of recovery.
Construction and land development lending generally involves a higher
degree of risk than permanent financing for a finished residence or commercial
building, because of the inherent difficulty in estimating the cost of the
project, the property's value at completion, and the future market demand for
the product upon completion. If the estimated cost of construction proves to
be inaccurate, the Bank may be required to advance funds beyond the amount
originally committed to complete the project. To address this risk, and
because of the level of construction loans in the Bank's portfolio, the Bank
has personnel dedicated specifically to monitoring the progress of its
construction projects, and making on-site inspections of the properties. The
Bank also utilizes the services of experienced inspectors to monitor the
progress and draw process in the more complex construction projects. In
addition, in an effort to monitor the available inventory in its markets, the
Bank also regularly reviews the overall building and development activity in
its markets. In an effort to reduce the risks related to construction
lending, the Bank primarily deals with experienced builders, with acceptable
credit histories, sound financial statements, and a proven track record in the
industry. In some instances, borrower arrangements include available lines
of credit that can only be used to meet the ongoing maintenance requirements
known as "interest reserves." We have 12 commercial borrowers with
commitments of $34.0 million with $1.0 million in available interest reserves.
There are 72 one-to-four family construction loans with commitments of $115.0
million with $3.4 million in available interest reserves. The interest
reserves serve to meet the loan payment terms during the construction and
completion phase of a commercial or one-to-four family real estate loans.
The risks associated with the loan portfolio are managed by the credit
administration team, with established policies and procedures and oversight by
senior management. The Bank has an experienced appraisal staff, and members
of senior
17
management with related appraisal education and experience, who regularly
review the appraisals utilized by the Bank in analyzing prospective
construction projects. Members of the Bank's senior management and loan
committees have a significant amount of experience in the areas of
construction lending, appraisals, and loan underwriting, further mitigating
he Bank's risk in this area. Despite all of the Bank's best efforts to address
the risks involved in construction and land development lending, deteriorating
economic conditions, including tightening credit markets, declining home
values and higher unemployment have had a materially adverse impact on the
Bank's borrowers and in particular on this segment of the Bank's loan
portfolio. See the "Asset Quality" section below for details on the Bank's
non-performing assets and comments regarding identified potential weaknesses
in its loan portfolio.
The Bank originates construction loans through its Mortgage Loan Division
and its Commercial Loan Division. The Bank's Mortgage Loan Division generally
oversees the single family custom construction loans, and to a lesser extent,
speculative construction loans (i.e., loans for homes that do not have a
contract with a buyer for the purchase of the home upon completion of the
construction) to smaller contractors building a limited number of speculative
homes per year. These construction loans are further broken down in the first
two lines of the table below (speculative construction one-to-four family and
custom construction one-to-four family). The Bank's Commercial Lending
Division is responsible for the speculative construction projects for the
Bank's larger builders (including large one-to-four family developments), in
addition to the Bank's multi-family construction loans, non-residential
commercial construction loans, and the Bank's land development loans.
The following table is provided to show additional details on the
Corporation's construction and land development loan portfolio:
December 31, 2008 March 31, 2008
------------------ -----------------
(Dollars in thousands) Amount Percent Amount Percent
------ ------- ------ -------
Speculative construction one-to-
four family $ 26,957 5.4% $ 27,206 5.2%
Custom construction one-to-four
family 8,543 1.7% 8,097 1.6%
-------- ----- -------- -----
Total one-to-four family
construction 35,500 7.1% 35,303 6.8%
Commercial speculative construction
one-to-four family 171,648 34.3% 236,536 45.3%
Commercial construction multi family 11,619 2.3% 11,732 2.3%
Commercial construction 79,846 16.0% 54,439 10.4%
Commercial residential land
development 201,683 40.3% 183,828 35.2%
-------- ----- -------- -----
Total commercial construction and
land development 464,796 92.9% 486,535 93.2%
-------- ----- -------- -----
Total construction loans $500,296 100.0% $521,838 100.0%
======== ===== ======== =====
The tables below set forth the characteristics of the available for sale
("AFS") and held-to-maturity ("HTM") investment and mortgage-backed securities
portfolios as of December 31, 2008:
Gross Gross
Unrealized Unrealized
Gross Losses Losses Estimated
Amortized Unrealized 12 Months Greater Than Fair
(In thousands) Cost Gains or Less 12 Months Value
--------- ---------- --------- ------------ ---------
AFS Securities
State and political
subdivisions and U.S.
government agency
securities $26,495 $1,090 $ - $ (334) $27,251
Marketable equity
securities 562 628 (16) - 1,174
Mortage-backed
securities and
collateralized
mortgage obligations
(CMOs) 39,568 986 - (600) 39,954
------- ------ ----- ------ -------
Total available-for-
sale securities 66,625 2,704 (16) (934) 68,379
------- ------ ----- ------ -------
HTM Securities
Mortgage-backed
securities and
CMOs 9 3 - - 12
------- ------ ----- ------ -------
Total held-to-maturity
securities 9 3 - - 12
------- ------ ----- ------ -------
Total securities $66,634 $2,707 $ (16) $ (934) $68,391
======= ====== ===== ====== =======
18
Maturity Schedule of Securities
at December 31, 2008
-----------------------------------------------
Available-For-Sale Held-To-Maturity
---------------------- ----------------------
Amortized Estimated Amortized Estimated
(In thousands) Cost Fair Value Cost Fair Value
--------- ---------- --------- ----------
Maturities:
Less than one year $ 1,727 $ 1,756 $ - $ -
One to five years 10,147 10,756 1 1
Over five to ten years 24,387 24,633 8 11
Over ten years 29,802 30,060 - -
------- ------- ------ ------
66,063 67,205 9 12
------- ------- ------ ------
Mutual funds and marketable
equity securities 562 1,174 - -
------- ------- ------ ------
Total investment securities $66,625 $68,379 $ 9 $ 12
======= ======= ====== ======
Total liabilities increased $90.1 million or 7.1% to $1.35 billion at
December 31, 2008, from $1.26 billion at March 31, 2008. This increase in
liabilities was primarily the result of growth in deposits, which increased
15.1% to $1.20 billion at December 31, 2008 from $1.04 billion at March 31,
2008 as brokered certificates of deposit ("CDs") were utilized to fund loan
growth and repay borrowed funds from the FHLB. Many of these brokered
certificates of deposit have a call option in the Bank's favor that allows the
Bank to pre-pay the balance without a penalty. At December 31, 2008,
approximately 50% of the Bank's brokered certificates of deposit had such a
call feature. As the Bank receives funds from other sources (i.e. its retail
deposit base, loan paydowns, etc.), the Bank will be able to exercise these
options and repay the brokered certificates of deposit prior to maturity, if
it is deemed appropriate at that time. This is consistent with the Bank's
current operating strategy to reduce its reliance on FHLB advances, brokered
certificates of deposit and other wholesale borrowings from current levels.
The Bank has an agreement with Promontory Interfinancial Network, LLC
that makes it possible to offer FDIC insurance on deposits in excess of the
current deposit limits. The program is known as the Certificate of Deposit
Account Registry Service ("CDARS") which uses a deposit matching program to
match CDARS deposits in other participating banks, dollar for dollar.
Included in the brokered CD totals were approximately $11 million in CDARS
deposits, which shifted from the Bank's retail deposit products as certain
customers sought the FDIC insurance coverage that the CDARs product offers.
The following is an analysis of the deposit portfolio by major type of
deposit at December 31, 2008 and March 31, 2008:
December 31, March 31,
(In thousands) 2008 2008
---------- ----------
Core deposits
Savings $ 17,677 $ 17,933
Checking 76,626 72,434
Checking (noninterest-bearing) 90,376 70,438
Money Market 154,021 183,063
Certificates of deposit less than $100,000 315,827 286,657
---------- ----------
654,527 630,525
---------- ----------
Other deposits
Certificates of deposit $100,000 and above 290,227 287,281
Brokered certificates of deposit 239,353 120,986
CDARS deposits 11,317 -
---------- ----------
540,897 408,267
---------- ----------
Total deposits $1,195,424 $1,038,792
========== ==========
The December 31, 2008 balance sheet also includes an investment in real
estate of a joint venture and the corresponding borrowing. During the fiscal
year ended March 31, 2005, Westward Financial, as a 50% partner in GBNW
(Greenbriar Northwest LLC), purchased an 85 acre parcel of land in Bellingham,
Washington for future development. GBNW intends to develop the property in
future years into a neighborhood community to be known as Fairhaven Highlands.
The $17.9 million is reflected on the Corporation's Consolidated Statements of
Financial Position as an asset at December 31, 2008 represents the current
level of the investment in real estate joint ventures, including the Fairhaven
Highlands joint venture. This amount also includes the remaining net
investment in a residential development joint venture that has since been
completed and closed. The $23.9 million shown in the liability section of the
Consolidated Statements of Financial Position
19
represents the corresponding wholesale borrowing obtained from the FHLB which
was used to fund the investment in the Fairhaven Highlands joint venture. At
this time, the partnership is in the process of meeting with the appropriate
public and private entities in connection with its planning efforts relating
to the future development of the property. Presently, a Preliminary Draft
Environment Impact Statement ("EIS") is being prepared utilizing consultants
hired by the City of Bellingham. According to city officials, a preliminary
draft of the EIS is expected to be available prior to April 30, 2009. While
this project is still in its planning and pre-permit phase, management
continues to believe that this will be a viable development project in the
future. However, no assurances can be made as to when (or if) this project
will be approved for future development. The joint venture is exposed to the
same risks experienced by any land developer, including but not necessarily
limited to regulatory risks, environmental risks, adverse response from
neighboring property owners, fluctuations in market values, and the demand for
finished lots at such time as the development might be completed in the
future.
Stockholders' equity at December 31, 2008 decreased $10.0 million or 7.8%
to $118.3 million from $128.3 million at March 31, 2008. This decrease was
the result of a $800,000 decline in the unrealized gain on AFS securities and
$2.2 million paid in cash dividends, as well as a $7.7 million net loss for
the nine months ended December 31, 2008. Contributing to the decline in the
unrealized gain on AFS securities was the overall decline in the financial
sector, as many of the securities with unrealized gains are equities in
financial related companies. The Corporation's stockholder equity-to-assets
ratio was 8.0% at December 31, 2008, compared to 9.2% at March 31, 2008.
Asset Quality
- -------------
The Corporation manages its credit risk through diversification of its
loan portfolio and the application of its underwriting policies, procedures,
and monitoring practices. Delinquent and problem loans, however, are a part
of any financial institution. When a borrower fails to make payments, the
Corporation implements certain strategies that are designed to work with the
borrower in order to collect delinquent loans. In those cases where
collection efforts are exhausted, the Bank works to gain control of the
property through foreclosure or other available means.
Allowance for Loan Losses. Provisions for loan losses are charges to
earnings to credit the total allowance for loan losses to a level considered
by management as adequate to provide for known and inherent risks in the loan
portfolio, based on management's continuing analysis of factors underlying the
quality of the loan portfolio at the time financial statements are prepared.
These factors include changes in portfolio size and composition, actual loss
experience, current economic conditions, detailed analysis of individual loans
for which full collectibility may not be assured, and determination of the
existence and realizable value of the collateral and guarantees securing the
loans. The ultimate recovery of loans is susceptible to future market factors
beyond the Corporation's control, which may result in losses or recoveries
differing significantly from those provided for in the financial statements.
The following table summarizes the allowance for loan losses,
charge-offs, and loan recoveries:
For the Quarter Ended For the Nine Months Ended
December 31, December 31,
-------------------- ---------------------
2008 2007 2008 2007
-------- -------- -------- --------
(Dollars in thousands)
Allowance at beginning of
period $ 25,579 $ 17,023 $ 19,114 $ 15,889
Provision for loan losses 10,000 900 25,000 2,100
Charge offs (net of
recoveries) (10,270) (32) (18,805) (98)
-------- -------- -------- --------
Allowance at end of period $ 25,309 $ 17,891 $ 25,309 $ 17,891
======== ======== ======== ========
Allowance for loan losses as
a percentage of gross loans
receivable at the end of
the period 2.09% 1.48% 2.09% 1.48%
Allowance for loan losses as
a percentage of net loans
receivable at the end of
the period 2.13% 1.50% 2.13% 1.50%
Net charge-offs as a
percentage of average loans
outstanding during the period 0.84% 0.00% 1.52% 0.01%
Allowance for loan losses as
a percentage of non-performing
loans 37.81% 1,807.29% 37.81% 1,807.29%
Allowance for loan losses as
a percentage of non-performing
assets 30.23% 1,087.51% 30.23% 1,087.51%
20
The allowance for loan losses is established as losses are estimated to
have occurred through the provision for loan losses charged to earnings. Loan
charge-offs against the allowance occur when management believes the
uncollectibility of a loan balance is confirmed. Subsequent recoveries, if
any, are credited to the allowance.
The provision for loan losses was $10.0 million for the quarter ended
December 31, 2008 and $25.0 million for the nine months ended December 31,
2008 compared to $900,000 and $2.1 million for the three and nine months ended
December 31, 2007, respectively. These provisions reflect management's
ongoing analysis of changes in loan portfolio composition by collateral
categories, balances outstanding, overall credit quality of the portfolio,
historical industry loss experience, and current economic conditions. The
allowance for loan losses was $25.3 million, or 2.13% of net loans receivable
at December 31, 2008, compared to $19.1 million, or 1.60% of net loans
receivable at March 31, 2008 and $17.9 million, or 1.50% at December 31, 2007.
The level of the allowance was a result of a combination of factors, including
a higher level of non-performing loans at December 31, 2008 of $66.9 million
compared to $11.6 million at March 31, 2008 and $990,000 at December 31, 2007.
Loan portfolios totals were relatively unchanged at $1.2 billion for the
periods ended December 31, 2008, March 31, 2008 and December 31, 2007.
Contributing to the elevated provision for loan losses during the three
and nine months ended December 31, 2008 was the increase in delinquencies on
performing loans, with those 30 to 89 days past due at December 31, 2008
totaling $73.2 million, compared to $30.6 million at March 31, 2008 and $31.7
million at December 31, 2007. In addition, at December 31, 2008 the Bank
identified $53.0 million of additional potential problem loans, primarily
single family construction and land development loans. These potential
problem loans are loans that do not meet the criteria for placement on
non-accrual status, therefore are not included in the non-performing loan
totals. Management has concerns as to the ability of the borrower to comply
with present loan repayment terms, and may result in the future inclusion of
such loans in the non-accrual category. If there is not an improvement in the
single family housing sector, management believes these numbers could increase
significantly.
Other factors influencing the allowance for loan losses include market
conditions. The majority of the Corporation's loan portfolio consists of
commercial loans and single-family residential loans secured by real estate in
the Whatcom, Skagit, Snohomish, King and Pierce County areas of Washington.
Regional economic conditions have deteriorated, particularly in Snohomish and
Pierce Counties, where housing inventories have increased and the overall
sales activity has slowed. For example, at December 31, 2008, data indicates
that the Snohomish County market has 20.4 months of available housing
inventory (using December 2008 actual sales versus available inventory)
according to RealEstats, Inc. As a comparison, housing inventory was shown at
11.4 months at March 31, 2008 and 9.6 months at December 31, 2007 for
Snohomish County. In Pierce County, housing inventory at December 31, 2008
was 16.0 months, compared to 12.4 months in March 2008 and 9.5 months in
December 2007. Inventory levels in King County are also worth noting, as low
levels and the higher price of homes helped support the activity in Snohomish
and Pierce counties in recent years, as buyers migrated to the more affordable
and more available options in these counties, as compared to King County. At
December 31, 2008, housing inventory levels in King County were 10.5 months,
compared to 8.0 months at March 31, 2008 and 6.6 months at December 31, 2007.
Additional details on the geographic distribution of the Bank's non-performing
assets ("NPAs") are presented in a table on the subsequent page.
The allowance for loan losses at December 31, 2008 represents management
of the Bank's best estimate of losses inherent in the loan portfolio, given
the changing portfolio mix and the current economic environment. While the
Bank believes it has established its existing allowance for loan losses in
accordance with accounting principles generally accepted in the United States,
there can be no assurance that regulators, in reviewing the Bank's loan
portfolio, will not request the Bank to significantly increase or decrease its
allowance for loan losses. In addition, because future events affecting
borrowers and collateral cannot be predicted with certainty, there can be no
assurance that the existing allowance for loan losses is adequate or that
substantial increases will not be necessary should the quality of any loans
deteriorate as a result of the factors discussed elsewhere in this document.
Any material increase in the allowance for loan losses would adversely affect
the Bank's financial condition and results of operations.
Non-Performing Assets. As of December 31, 2008, there were two loans in
the loan portfolio over 90 days delinquent and accruing interest and 34 loan
relationships on non-accrual status. At December 31, 2008, total
non-performing loans were $66.9 million compared to $11.6 million at March 31,
2008 and $990,000 at December 31, 2007. The Bank had five properties in the
real estate owned category totaling $16.8 million at December 31, 2008. Total
non-performing assets represented $83.7 million, or 5.69% of total assets at
December 31, 2008 compared to $12.3 million or 0.88% of total assets at March
31, 2008 and $1.6 million or 0.12% of total assets at December 31, 2007.
21
The following tables summarize the Bank's non-performing assets and
restructured loans within the meaning of SFAS No. 15, Accounting by Debtors
and Creditors for Trouble Debt Restructuring:
As of December 31, As of March 31,
------------------ ---------------
Non-performing assets 2008 2007 2008
------ ------ --------------
(Dollars in thousands)
Accruing loans - 90 days past due $ 5,643 $ - $ -
Non-accrual loans 61,288 990 11,608
------- ------ -------
Total non-performing loans 66,931 990 11,608
Real estate owned 16,791 655 655
------- ------ -------
Total non-performing assets $83,722 $1,645 $12,263
======= ====== =======
Total non-performing loans/gross loans 5.52% 0.08% 0.96%
Total non-performing assets/total assets 5.69% 0.12% 0.88%
Total non-performing assets to
total capital plus reserves 58.29% 1.13% 8.32%
Troubled debt restructuring at the end
of the period $15,189 $ - $ -
======= ====== =======
The following table summarizes the Bank's total NPAs at December 31, 2008
by county and by classification:
<s> <c> <c> <c> <c> <c> <c> <c> <c> <c>
Non-performing Assets by Whatcom Skagit Snohomish King Kitsap Pierce Thurston Total % of
Classification County County County County County County County NPAs NPAs
------- ------ --------- ------ ------ ------ -------- ----- -----
(Dollars in thousands)
One-to-four family residential $ 75 $ - $ 1,289 $ - $ - $ - $ - $ 1,364 2%
One-to-four family
construction - - 768 - 580 2,037 - 3,385 4%
------ ------ ------- ------- ----- ------- ------ ------- ---
Subtotal 75 - 2,057 - 580 2,037 - 4,749 6
Commercial land development 8,780 - 16,816 - - 5,667 2,286 33,549 40%
Commercial construction (1) - 221 11,622 13,656 - 13,214 468 39,181 47%
Multi-family residential - - - - - - - - -
Commercial real estate - 5,628 - - - - - 5,628 6%
Commercial business - - 500 - - - - 500 1%
Home equity secured 100 15 - - - - - 115 -
Other consumer - - - - - - - - -
------ ------ ------- ------- ----- ------- ------ ------- ---
Subtotal 8,880 5,864 28,938 13,656 - 18,881 2,754 78,973 94%
Total non-performing assets $8,955 $5,864 $30,995 $13,656 $ 580 $20,918 $2,754 $83,722 100%
====== ====== ======= ======= ===== ======= ====== ======= ===
(1) The commercial construction totals include $6.9 million in condominium construction projects, with the
majority of the remaining balance consisting of various commercial speculative one-to-four family
construction projects.
Commercial construction, commercial land development, commercial real
estate and multi-family residential real estate loans represent larger
individual loan amounts, which have a greater single impact on the total
portfolio quality in the event of delinquency or default. Further, while the
Bank believes that the loss potential for its non-performing assets is
properly reserved currently, the Bank is closely watching its construction and
land development loan portfolio, and believes there is a potential for
significant additions to non-performing loans, charge-offs, provisions for
loan and lease losses, and/or real estate owned in the future if the housing
market conditions do not improve.
22
The Bank has added personnel and redirected the duties of certain lending
staff members to address the needs of these special credits. The Bank's Chief
Credit Officer and Chief Lending Officer are actively managing the Bank's
work-out problem credits, with attention to marketing existing non-performing
assets, working with borrowers, and working to obtain control of properties,
where necessary. In addition, the Bank is working with certain borrowers to
enhance their marketing efforts by providing attractive financing programs to
buyers of homes currently financed by the Bank. Generally, these loans are
granted at below secondary market rates to credit-worthy borrowers and include
an initial fixed rate period of not more than five years. Management elected
to employ this strategy based on its belief that it was in the Bank's best
interest to transfer the primary source of repayment for these properties to a
homeowner with other sources of income, as opposed to having the primary
source of repayment remain with the builder's ability to sell the property.
Other Real Estate Owned. Other real estate owned ("OREO") is carried at
the lesser of book value or market value less selling costs. The costs
related to maintenance and repair or other costs of such properties, are
generally expensed with any gains or shortfalls from the ultimate sale of OREO
being shown in other noninterest income or expense.
The following table summarizes changes in the OREO portfolio during the
three and nine months ended December 31, 2008 and 2007:
For the Three For the Nine
Months Ended Months Ended
December 31, December 31,
2008 2007 2008 2007
------ ------ ------ ------
(In thousands)
Balance at beginning of period $ 1,859 $ 725 $ 655 $ 725
Additions to OREO 15,899 - 18,313 -
Valuation adjustments - (70) (160) (70)
Disposition of OREO (967) - (2,017) -
------- ----- ------- -----
Balance at end of period $16,791 $ 655 $16,791 $ 655
======= ===== ======= =====
The Corporation recognized $38,000 and $373,000 in losses related to the
disposition of properties during the three and nine months ended December 31,
2008. At December 31, 2008 there were five projects totaling $16.8 million
held in OREO, four of which are located in Snohomish County and one project
located in King County. The four projects in Snohomish County include one
project with two developed building lots; a project with four completed
building lots and five finished homes; a project with three finished homes;
and a 7.44 acre parcel of commercially zoned raw land. The King County
property is a condominium conversion project with 51 unsold units (out of an
original 57 unit project) located in Ballard, Washington, just north of
Seattle. In addition to its efforts to market these properties directly to
potential purchasers, the Bank enlists the services of various industry
experts to assist in these disposition efforts. Of the Real Estate Owned
detailed above, all of the finished homes in Snohomish County are presently
under purchase and sale agreements. The remaining properties remain available
for sale.
Management of the Bank continually evaluates loans in nonaccrual status
for possible foreclosure or deed in lieu, at which point these loans would
then become OREO. Management views this as an ordinary part of the collection
process and efforts are continually maintained to reduce and minimize such
non-performing assets.
Comparison of Operating Results for the Three Months Ended December 31, 2008
- ----------------------------------------------------------------------------
and December 31, 2007
- ---------------------
General. The Corporation recognized a net loss of $5.1 million for the
three months ended December 31, 2008 compared to net income of $4.7 million
for the three months ended December 31, 2007. Diluted loss per share for the
three months ended December 31, 2008 was $(0.43) on weighted average diluted
shares outstanding of 11,970,478, compared to diluted earnings per share of
$0.39 on weighted average diluted shares of 12,157,465 for the three months
ended December 31, 2007.
Net Interest Income. Net interest income before provision for loan
losses for the three months ended December 31, 2008 decreased $4.5 million or
32.8% to $9.3 million from $13.8 million for the comparable period in 2007.
Interest on loans for the quarter ended December 31, 2008 decreased 26.3% to
$18.4 million, from $24.9 million for the comparable quarter a year ago. This
decrease was a result of a combination of factors, including the effects of a
400 basis point drop in the Prime rate from the prior year. The Bank's loan
portfolio includes over $400 million in Prime based loans, or approximately
35% of gross loans outstanding, and each quarter point decrease in the Prime
lending rate equates to an annualized decrease in interest income on these
loans of approximately $1.0 million. The decline in interest rates resulted in
a decrease in the yield on loans from 8.55% for the three months ended
December 31, 2007 to 5.97% for the comparable period in 2008. Interest income
from loans also declined from the reversal of approximately $930,000 in
interest income compared to no interest reversals during the quarter ended
December 31, 2007.
23
Also included in interest income for the three months ended December 31,
2008 and 2007 were $866,000 and $1.3 million, respectively, of deferred fee
income recognition. Most of these fees were related to the Bank's commercial
land development and commercial construction loan portfolios. Real estate
development loans typically are shorter term in nature so the deferred fee
recognition during the effective life of the loan is greater than what would
be recognized for a comparable loan fee on a longer amortizing term loan.
However, due to current economic conditions, the effective life of these loans
has increased similar to that of longer amortizing loans, therefore
contributing to the decrease in deferred loan fee income. The table below
presents an analysis of deferred fee recognition for the three months ended
December 31, 2008 and 2007:
For the Three Months Ended
December 31,
--------------------------
2008 2007
------- -------
(In thousands)
Commercial loan deferred fees $ 739 $1,067
One-to-four real estate mortgage loan
deferred fees 127 222
----- ------
Total $ 866 $1,289
===== ======
Interest on investments and mortgage-backed securities decreased 13.1% to
$862,000 for the three months ended December 31, 2008 from $992,000 for the
comparable period a year ago. Total interest income decreased 25.8% to $19.2
million at December 31, 2008 from $25.9 million in the comparable period one
year ago as a result of the factors discussed above. Contributing to this
decline was a drop in interest income received from non-agency collateralized
mortgage obligations and the elimination of the Federal Home Loan Bank's cash
dividend during the quarter ended December 31, 2008. The drop in interest
income from the non-agency collateralized mortgage obligations occurred during
the same period when management identified an other than temporary impairment
of the securities, which is discussed in the subsequent section under
"non-interest income."
Total interest paid on deposits decreased 6.8% to $8.9 million for the
quarter ended December 31, 2008 from $9.6 million for the quarter ended
December 31, 2007. Contributing to the decrease was an overall lower level of
interest rates compared to the previous period. At December 31, 2008,
approximately 45% of the Bank's deposits were in the form of certificates of
deposit greater than $100,000 and brokered certificates of deposit. While
management continues its efforts to increase core deposits as a funding
source, the competitive marketplace for core deposit dollars has limited
success in this regard. The Bank's average cost of deposits decreased 81
basis points to 3.07% for the three months ended December 31, 2008 from 3.88%
for the same three months in 2007.
Interest on borrowings decreased 59.8% to $1.0 million during the quarter
ended December 31, 2008, compared to $2.5 million for the comparable period
one year ago. The decrease in interest expense in the current quarter was a
result of a lower average balance of borrowings outstanding during the quarter
ended December 31, 2008 of $153.6 million compared to $224.6 million during
the quarter ended at December 31, 2007, as well as lower interest rates during
of the current period. The Bank continues to utilize wholesale borrowings as
an alternative liquidity source and to better manage its interest rate risk
profile. The Bank's average cost of borrowings decreased 186 basis points to
2.66% for the three months ended December 31, 2008 from 4.52% for the same
three months in 2007. The Bank's average cost of funds decreased 98 basis
points to 3.02% for the three months ended December 31, 2008 from 4.00% for
the same three months in 2007.
The effect of the changes in the interest-earning asset yield and
interest-bearing liability costs have reduced the net interest margin from
4.40% for the quarter ended at December 31, 2007 to 2.77% for the quarter
ended December 31, 2008. The most significant factor to the decline in the
net interest margin occurred from the drop in loan yields as a result of
variably priced loans tied to the Prime rate re-pricing lower and the reversal
of interest income from the increase in non-accruing loans. Management
believes that these pressures on loan yields will likely result in a continued
gradual downward trending of its net interest margin in the near future.
24
Average Balances, Interest and Average Yields/Costs. The following table
presents at the date and for the periods indicated, the total dollar amount of
interest income and interest expense, as well as the resulting yields earned
and rates paid. For the purposes of this table, loans receivable average
balances include nonaccrual loans. The yield on investment securities is
calculated using historical cost basis.
For the three months ended December 31,
-----------------------------------------------------
2008 2007
-------------------------- --------------------------
Average Average
Average Yield/ Average Yield/
Balance Interest Cost Balance Interest Cost
(Dollars in thousands) ------- -------- ------ ------- -------- ------
Interest-earning assets:
Loans receivable $1,229,327 $18,363 5.97% $1,165,555 $24,917 8.55%
Investment securities 71,500 339 1.90% 56,167 575 4.09%
Mortgage-backed
securities 40,300 523 5.19% 32,520 417 5.13%
---------- ------- ------ ---------- ------- ------
Total interest-
earning assets $1,341,127 $19,225 5.73% $1,254,242 $25,909 8.26%
Interest-bearing
liabilities:
Deposits 1,163,647 8,927 3.07% 987,250 9,573 3.88%
Borrowings 153,579 1,019 2.66% 224,558 2,536 4.52%
---------- ------- ------ ---------- ------- ------
Total interest-
bearing liabilities $1,317,226 $ 9,946 3.02% $1,211,808 $12,109 4.00%
------- -------
Net interest income $ 9,279 $13,800
======= =======
Interest rate spread 2.71% 4.27%
Net interest margin 2.77% 4.40%
Ratio of average
interest-earning
assets to average
interest- bearing
liabilities 101.81% 103.50%
Provision for Loan Losses. The provision for loan losses represents an
expense against current period income that allows the Corporation to establish
an appropriate allowance for loan losses. Charges to the provision for loan
losses result from our ongoing analysis of probable losses in the Bank's loan
portfolio. For the three months ended December 31, 2008 the provision for loan
losses was $10.0 million, compared to $900,000 for the three months ended
December 31, 2007 primarily due to deteriorating credit quality indicators in
the commercial construction and land development loan portfolio. Risks
contributing to this increase in provision are discussed in more detail in the
section entitled "Asset Quality - Allowance for Loan Loss."
Noninterest Income. Noninterest income for the three months ended
December 31, 2008 decreased 35.6% to $977,000 compared to $1.5 million for the
same period a year ago. Service fee income decreased 16.3% to $747,000 for the
quarter ended December 31, 2008 from $893,000 for the same quarter in the
prior period due in large part to the decrease in loan origination and related
fees. The Bank originated $39.8 million in loans during the quarter ended
December 31, 2008 compared to $137.3 million for the quarter ended December
31, 2007. The net gain on the sale of loans servicing released decreased
52.6% to $81,000 for the quarter ended December 31, 2008 from $170,000 in the
comparable period one year ago due primarily to the slowdown in the housing
market. The Bank continued its practice of selling most of its single-family
long term fixed rate loan production into the secondary market.
There was a net gain on sales of investment securities of $7,000 for the
three months ended December 31, 2008 due to the disposition of one FHLMC note
compared to no gain or loss for the three months ended December 31, 2007.
There was an OTTI charge of $309,000 for the three months ended December 31,
2008 compared to no charge for the three months ended December 31, 2007. The
OTTI was attributable to a small group of non-agency collateralized mortgage
obligation securities. Other income for the quarter ended December 31, 2008
was nearly unchanged at $451,000 compared to $452,000 for the three months
ended December 31, 2007.
Noninterest Expense. Noninterest expense for the three months ended
December 31, 2008 increased 12.0% to $8.3 million from $7.4 million for the
comparable quarter one year ago. Compensation and employee benefits decreased
2.4% to $4.1 million for the quarter ended December 31, 2008 compared to $4.2
million for the same period last year. During the quarter the Bank completed
a strategic staffing reduction which is expected to result in approximately
$3.0 million in annual
25
savings and resulted in severance costs of $135,000 for the quarter ended
December 31, 2008. Real estate owned/collection expense increased to $488,000
for the three months ended December 31, 2008 from $78,000 in the quarter ended
December 31, 2007 as a result of increased legal, appraisal, collection and
related expenses pertaining to delinquent and non-performing assets. FDIC
insurance premiums increased to $228,000 for the quarter ended December 31,
2008 from $29,000 in the quarter ended December 31, 2007. The Federal Deposit
Insurance Reform Act of 2005 provided banks with a one-time assessment credit
to be used against future premiums. For Horizon, that amounted to a credit of
approximately $649,000. This credit was utilized beginning April 1, 2007 and
was fully depleted at June 30, 2008, accounting for the difference between
these periods. Other noninterest expense was relatively unchanged at $1.9
million for the quarters ended December 31, 2008 and December 31, 2007.
During the quarter ended December 31, 2008 the Bank charged off the entire
balance of goodwill of $545,000. Management performed a valuation analysis as
a result of the Corporation's market capitalization being less than its
stockholder's equity at December 31, 2008. The valuation analysis compared
the implied fair value of the goodwill with the carrying amount of the
goodwill on the balance sheet. The conclusion of the valuation analysis was
that the carrying value of the goodwill was impaired.
Comparison of Operating Results for the Nine Months Ended December 31, 2008
- ---------------------------------------------------------------------------
and December 31, 2007
- ---------------------
General. The Corporation realized a net loss of $7.7 million for the
nine months ended December 31, 2008 compared to net income of $14.6 million
for the nine months ended December 31, 2007. Diluted loss per share for the
nine months ended December 31, 2008 was $(0.65) on weighted average diluted
shares outstanding of 11,934,934, compared to diluted earnings per share of
$1.19 on weighted average diluted shares of 12,252,320 for the nine months
ended December 31, 2007.
Net Interest Income. Net interest income before provision for loan
losses for the nine months ended December 31, 2008 decreased 23.7% to $31.4
million from $41.2 million for the comparable period in 2007. Interest on
loans for the nine months ended December 31, 2008 decreased 20.4% to $58.6
million, from $73.7 million for the comparable period a year ago. This
decrease was a result of a combination of factors, including 400 basis point
reductions in the Prime lending rate from December 2007 to December 2008. For
each 25 basis point decline in the Prime rate, this equates to a reduction of
approximately $1.0 million in interest on an annual basis. Also contributing
to this decline was approximately $3.6 million in non-accrual interest
reversals related to the increase in non-accrual loans during the nine months
ended December 31, 2008 compared to no interest reversals for the nine months
ended December 31, 2007.
Also included in interest income for the nine months ended December 31,
2008 and 2007 were $3.0 million and $3.9 million, respectively, of deferred
fee income recognition. The table below presents an analysis of deferred fee
recognition for the nine months ended December 31, 2008 and 2007:
For the Nine Months Ended
December 31,
-------------------------
2008 2007
------ ------
(In thousands)
Commercial loan deferred fees $2,534 $3,284
One-to-four real estate mortgage loan
deferred fees 463 581
------ ------
Total $2,997 $3,865
====== ======
Interest on investments and mortgage-backed securities decreased 8.1% to
$2.8 million for the nine months ended December 31, 2008 from $3.0 million for
the comparable period a year ago. Total interest income decreased 20.0% to
$61.4 million at December 31, 2008 from $76.7 million in the comparable period
one year ago as a result of the factors discussed above.
Total interest paid on deposits decreased 9.9% to $26.0 million for the
nine months ended December 31, 2008 from $28.9 million for the nine months
ended December 31, 2007, as a result of overall lower interest rates during
the nine months ended December 31, 2008 compared to the previous period. At
December 31, 2008, approximately 45% of the Bank's deposits were in the form
of certificates of deposit greater than $100,000 and brokered certificates of
deposit. The Bank's average cost of deposits decreased 79 basis points to
3.12% for the nine months ended December 31, 2008 from 3.91% for the same nine
months in 2007.
Interest on borrowings decreased 40.7% to $3.9 million during the nine
months ended December 31, 2008, compared to $6.7 million for the comparable
period one year ago. The decreased expense in the current year was a result
of a declining interest rate environment during most of the period. The
Bank's average cost of borrowings decreased 198 basis points to 2.79% for the
nine months ended December 31, 2008 from 4.77% for the same nine months in
2007. The Bank's average cost
26
of funds decreased 98 basis points to 3.07% for the nine months ended December
31, 2008 from 4.05% for the same nine months in 2007.
Average Balances, Interest and Average Yields/Costs. The following table
presents at the date and for the periods indicated, the total dollar amount of
interest income and interest expense, as well as the resulting yields earned
and rates paid. For the purposes of this table, loans receivable average
balances include nonaccrual loans. The yield on investment securities is
calculated using historical cost basis.
For the Nine Months Ended December 31,
-----------------------------------------------------
2008 2007
-------------------------- --------------------------
Average Average
Average Yield/ Average Yield/
Balance Interest Cost Balance Interest Cost
(Dollars in thousands) ------- -------- ------ ------- -------- ------
Interest-earning assets:
Loans receivable $1,235,843 $58,617 6.32% $1,118,727 $73,683 8.78%
Investment securities 59,093 1,255 2.83% 57,663 1,812 4.19%
Mortgage-backed
securities 39,099 1,517 5.17% 32,390 1,205 4.96%
---------- ------- ------ ---------- ------- ------
Total interest-
earning assets $1,334,035 $61,389 6.14% $1,208,780 $76,700 8.46%
Interest-bearing
liabilities:
Deposits 1,112,868 26,013 3.12% 983,495 28,858 3.91%
Borrowings 188,831 3,947 2.79% 186,038 6,658 4.77%
---------- ------- ------ ---------- ------- ------
Total interest-
bearing liabilities $1,301,699 $29,960 3.07% $1,169,533 $35,516 4.05%
------- -------
Net interest income $31,429 $41,184
======= =======
Interest rate spread 3.07% 4.41%
Net interest margin 3.14% 4.54%
Ratio of average
interest-earning
assets to average
interest-bearing
liabilities 102.48% 103.36%
Provision for Loan Losses. The provision for loan losses represents an
expense against current period income that allows the Corporation to establish
an appropriate allowance for loan losses. Charges to the provision for loan
losses result from our ongoing analysis of probable losses in its loan
portfolio. For the nine months ended December 31, 2008 the provision for loan
losses was $25.0 million, compared to $2.1 million for the same period in 2007
primarily due to deteriorating credit quality indicators in the commercial
construction and land development loan portfolio. Risks contributing to this
increase in provision are discussed in more detail in the section entitled
"Asset Quality - Allowance for Loan Loss."
Noninterest Income. Noninterest income for the nine months ended
December 31, 2008 decreased 2.4% to $4.7 million as compared to $4.8 million
for the same period a year ago. Service fee income decreased 6.2% to $2.5
million for the nine months ended December 31, 2008 from $2.7 million for nine
months ended December 31, 2007 due in large part to the decrease in loan
origination and related fees. The net gain on the sale of loans servicing
released decreased 34.4% to $431,000 for the nine months ended December 31,
2008 from $657,000 in the comparable period one year ago primarily as a
result of the slowdown in the housing market. Other noninterest income
increased 54.3% to $2.3 million for the nine months ended December 31, 2008
from $1.5 million for the nine months ended December 31, 2007, due primarily
to a $767,000 death benefit realized from the settlement of a bank-owned life
insurance policy.
There was a net loss on sales of investment securities of $191,000 for
the nine months ended December 31, 2008 compared to no gain or loss for the
nine months ended December 31, 2007 due to management's decision to sell
selected equity securities from the Bank's investment portfolio as well as the
redemption in-kind distribution for its $5.0 million investment in the AMF
family of mutual funds, which occurred due to the continuing decline in the
net asset value as a result of the unprecedented disruption in the
mortgage-backed securities markets. There was an impairment loss of $309,000
for the nine months ended December 31, 2008 compared to no loss for the nine
months ended December 31, 2007. The impairment loss resulted from the Bank
recognizing an OTTI on selected non-agency collateralized mortgage obligation
securities.
27
Noninterest Expense. Noninterest expense for the nine months ended
December 31, 2008 increased 8.5% to $24.0 million from $22.1 million for the
comparable nine months in 2007. Compensation and employee benefits increased
2.5% for the nine months ended December 31, 2008 to $12.9 million from $12.6
million for the comparable nine months in 2007. Increases in compensation and
employee benefits resulted from the overall growth of the Bank, including the
opening of a full service retail facility and mortgage loan center in
Puyallup, Washington in June 2007. We have recently undergone an extensive
review of potential expense reductions. In evaluating the controllable
expenses, the Bank determined the need to make several strategic staffing
reductions. As of November 4, 2008, the Bank completed a reduction in force
of 27 full-time positions and identified several areas where responsibilities
will be shifted to accommodate the revised staffing levels. In addition,
other positions were not filled when vacated by the employees previously
occupying these positions. As a result of this initiative to reduce
personnel, the Bank incurred approximately $135,000 in severance related
expenses during the period.
Other real estate owned collection expense increased to $1.1 million for
the nine months ended December 31, 2008 from $121,000 in the nine months ended
December 31, 2007 as a result of increased legal, appraisal, collection and
related expenses pertaining to delinquent and nonperforming assets. FDIC
insurance premiums increased to $487,000 for the nine months ended December
31, 2008 from $85,000 in the same period in 2007. We expect our FDIC deposit
insurance premiums to increase further during fiscal 2009 as a result of
recent FDIC imposed increases in the assessment rates, which are scheduled to
commence during the first quarter of calendar year 2009. Other expense
decreased 8.2% to $4.1 million for the nine months ended December 31, 2008
from $4.5 million in the nine months ended December 31, 2007. The increased
expenses in the prior period were due to a variety of factors, including
increased recruiting fees and increased business and occupation taxes paid on
higher levels of commercial loans outstanding as of December 31, 2007 compared
to December 31, 2008.
Rate/Volume Analysis
- --------------------
The table below sets forth certain information regarding changes in
interest income and interest expense for the Corporation for the periods
indicated. For each category of interest-earning asset and interest-bearing
liability, information is provided on changes attributable to (1) changes in
volume (change in volume multiplied by old rate); (2) changes in rates (change
in rate multiplied by old volume); (3) changes to rate-volume (changes in rate
multiplied by the change in volume); and (4) the total changes (the sum of the
prior columns).
Nine Months Ended December 31,
2008 vs. 2007
Increase (Decrease) Due to
--------------------------------------
Rate/
(In thousands) Volume Rate Volume Total
------ -------- ------- --------
Interest income:
Interest and fees on loans $7,714 $(20,621) $(2,159) $(15,066)
Investment securities and other
interest-bearing securities 273 (475) (43) (245)
------ -------- ------- --------
Total interest-earning assets $7,987 $(21,096) $(2,202) $(15,311)
====== ======== ======= ========
Interest expense:
Deposit accounts $3,796 $ (5,869) $ (772) $ (2,845)
Borrowings 100 (2,770) (41) (2,711)
------ -------- ------- --------
Total interest-bearing liabilities $3,896 $ (8,639) $ (813) $ (5,556)
====== ======== ======= ========
Liquidity and Capital Resources
- -------------------------------
The Bank maintains liquid assets in the form of cash and short-term
investments to provide a source to fund loans, savings withdrawals, and other
short-term cash requirements. At December 31, 2008, the Bank had liquid
assets (cash and marketable securities with maturities of one year or less) of
$106.5 million. In addition, the Bank has established lines of credit with
the FHLB. The amount available under this line of credit is in excess of $110
million as of December 31, 2008.
As of December 31, 2008, the total amortized cost of investments and
mortgage-backed securities was $66.6 million compared to a market value of
$68.4 million with a net unrealized gain of $1.8 million. As of March 31,
2008, the total amortized cost of investments and mortgage-backed securities
was $77.4 million, compared to a market value of $80.4 million with a net
unrealized gain of $3.0 million. The primary reasons for this change relate to
an in-kind distribution redemption for its $5.0 million investment in the AMF
family of mutual funds, the measurement of an OTTI on selected non-agency
28
collateralized mortgage obligation securities, as well as declining values in
the Corporation's portfolio of equities, which are heavily concentrated in the
financial sector.
The Corporation's primary sources of funds are cash flows from
operations, which consist primarily of mortgage loan repayments, deposit
increases, loan sales, borrowings and cash received from the maturity or sale
of investment securities. The Corporation's liquidity fluctuates with the
supply of funds and management believes that the current level of liquidity is
adequate at this time. If additional liquidity is needed, the Corporation's
options include, but are not necessarily limited to: (i) selling additional
loans in the secondary market; (ii) entering into reverse repurchase
agreements; (iii) borrowing from the FHLB of Seattle; (iv) acquiring brokered
deposits; or (v) accessing the discount window of the Federal Reserve Bank of
San Francisco.
Stockholders' equity as of December 31, 2008 was $118.3 million, or 8.0%
of assets, compared to $128.3 million, or 9.2% of assets at March 31, 2008.
The Bank continues to exceed the 5.0% minimum tier one capital required by the
FDIC in order to be considered well-capitalized. The Bank's total
risk-adjusted capital ratio as of December 31, 2008 was 10.27% compared to
11.0% as of March 31, 2008. These figures remain above the well-capitalized
minimum of 10% set by the FDIC. The Corporation continues to remain
well-capitalized on all measures established under the regulatory guidelines.
Regulatory Capital
- ------------------
The following table compares the Corporation's and the Bank's actual
capital amounts at December 31, 2008 to its minimum regulatory capital
requirements at that date (in thousands):
To Be Well
Capitalized
Under Prompt
For Capital Corrective
Actual Adequacy Purposes Action Provisions
------------------ ------------------ -----------------
Amount Ratio Amount Ratio Amount Ratio
-------- ------- -------- ------- -------- -------
Total Capital
(to Risk Weighted
Assets)
Consolidated $133,736 10.33% $103,567 >8.00% N/A
Horizon Bank $132,871 10.27% $103,527 >8.00% $129,409 >10.00%
Tier I Capital
(to Risk Weighted
Assets)
Consolidated $117,158 9.05% $ 51,784 >4.00% N/A
Horizon Bank $116,299 8.99% $ 51,764 >4.00% $ 77,646 > 6.00%
Tier I Capital
(to Average
Assets)
Consolidated $117,158 8.05% $ 58,199 >4.00% N/A
Horizon Bank $116,299 8.00% $ 58,118 >4.00% $ 72,647 > 5.00%
To support its capital preservation efforts, the Corporation suspended
the cash dividend paid on its common stock. No assurances can be made
regarding the Corporation's ability to declare future dividends.
The Corporation has conducted various stock buy-back programs since
August 1996. In March 2008, the Board of Directors approved a new stock
repurchase plan that runs concurrent with the 2009 fiscal year, allowing the
Corporation to repurchase up to 2.5% of total shares outstanding, or
approximately 300,000 shares. This marked the Corporation's tenth stock
repurchase plan. During the three and nine months ended December 31, 2008,
the Corporation did not repurchase any shares consistent with its current
focus on preserving and managing capital. The Corporation does not
anticipate repurchasing shares under the current plan. When the Corporation
is repurchasing shares, the number of shares of stock to be repurchased and
the price to be paid is the result of many factors, several of which are
outside of the control of the Corporation. The primary factors, however, are
market and economic factors such as the price at which the stock is trading in
the market, the number of shares available in the market; the attractiveness
of other investment alternatives in terms of the rate of return and risk
involved in the investment; the ability to increase the value and/or earnings
per share of the remaining outstanding shares; the Corporation's liquidity and
capital needs; and regulatory requirements.
29
Item 3. Quantitative and Qualitative Disclosures About Market Risk
The Corporation continues to be exposed to interest rate risk.
Currently, the Corporation's assets and liabilities are not materially exposed
to foreign currency or commodity price risk. At December 31, 2008, the
Corporation had no significant off-balance sheet derivative financial
instruments, nor did it have a trading portfolio of investments. At December
31, 2008, there were no material changes in the Corporation's market risk from
the information provided in the Form 10-K for the fiscal year ended March 31,
2008.
Item 4. Controls and Procedures
An evaluation of the Corporation's disclosure controls and procedures (as
defined in Rule 13(a)-15(e) of the Securities Exchange Act of 1934 (the
"Act")) was carried out under the supervision and with the participation of
the Corporation's Chief Executive Officer, Chief Financial Officer, and
several other members of the Corporation's senior management as of the end of
the period preceding the filing date of this quarterly report. Based on this
evaluation, the Corporation's Chief Executive Officer and Chief Financial
Officer concluded that, as of December 31, 2008, the Corporation's disclosure
controls and procedures were effective in ensuring that the information
required to be disclosed by the Corporation in the reports it files or submits
under the Act is (i) accumulated and communicated to the Corporation's
management (including the Chief Executive Officer and Chief Financial Officer)
in a timely manner, and (ii) recorded, processed, summarized, and reported
within the time periods specified in the SEC's rules and forms.
In the quarter ended December 31, 2008, the Corporation did not make any
changes in its internal control over financial reporting (as defined in Rule
13a-15(f) of the Exchange Act) that has materially affected, or is reasonably
likely to materially affect, the Corporation's internal control over financial
reporting. While the Corporation believes the present designs of its
disclosure controls and procedures and internal control over financial
reporting are effective to achieve their goals, future events affecting its
business may cause the Corporation to modify its disclosure controls and
procedures and/or internal control over financial reporting.
The Corporation does not expect that its disclosure controls and
procedures and internal control over financial reporting will prevent all
error and fraud. A control procedure, no matter how well conceived and
operated, can provide only reasonable, not absolute, assurance that the
objectives of the control procedure are met. Because of the inherent
limitations in all control procedures, no evaluation of controls can provide
absolute assurance that all control issues and instances of fraud, if any,
within the Corporation have been detected. These inherent limitations include
the realities that judgments in decision-making can be faulty, and that
breakdowns in controls or procedures can occur because of simple error or
mistake. Additionally, controls can be circumvented by the individual acts of
some persons, by collusion of two or more people, or by management override of
the control. The design of any control procedure is based in part upon
certain assumptions about the likelihood of future events, and there can be no
assurance that any design will succeed in achieving its stated goals under all
potential future conditions; over time, controls become inadequate because of
changes in conditions, or the degree of compliance with the policies or
procedures may deteriorate. Because of the inherent limitations in a
cost-effective control procedure, misstatements due to error or fraud may
occur and not be detected.
30
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
Horizon Financial Corp. has certain litigation and/or settlement
negotiations in progress resulting from activities arising from normal
operations. In the opinion of management, none of these matters are likely to
have a materially adverse effect on the Corporation's financial position or
results of operation.
Item 1A. Risk Factors
The following risk factors inherent to our business are in addition to
the risk factors previously disclosed in the Corporation's Annual Report on
Form 10-K for the year ended March 31, 2008. You should carefully consider
the risks and uncertainties described below and in the Form 10-K for the year
ended March 31, 2008.
We are subject to various regulatory requirements and may be subject to future
regulatory restrictions and enforcement actions.
In light of the current challenging operating environment, along with our
elevated level of non-performing assets, delinquencies, and adversely
classified assets, we may be subject to increased regulatory scrutiny,
regulatory restrictions, and potential enforcement actions. Such enforcement
actions could place limitations on our business and adversely affect our
ability to implement our business plans. Even though we remain
well-capitalized in terms of our capital ratios, the regulatory agencies have
the authority to restrict our operations to those consistent with adequately
capitalized institutions. For example, if the regulatory agencies were to
implement such a restriction, we would likely have limitations on our lending
activities and requirements to reduce our level of construction and land
development loans and our non-performing assets and be limited in our ability
to utilize brokered funds as a funding source, an area that has been a source
of funds for us in recent years. In addition, the regulatory agencies have the
power to limit the rates paid by the Corporation to attract retail deposits in
its local markets. In addition, we may be required to provide notice to the
FDIC regarding any additions or changes to directors or senior executive
officers and we would not be able to pay certain severance and other forms of
compensation without regulatory approval. Further, we may be required to
reduce our levels of classified or non-performing assets within specified time
frames. These time frames might not necessarily result in maximizing the
price which might otherwise be received for the properties. In addition, if
such restrictions were also imposed upon other institutions which operate in
the Bank's markets, multiple institutions disposing of properties at the same
time could further diminish the potential proceeds received from the sale of
these properties. If any of these or similar restrictions are placed on us,
it would limit the resources currently available as a well-capitalized
institution.
We may be required to make further increases in our provisions for loan losses
and to charge off additional loans in the future, which could adversely affect
our results of operations.
For the quarter and nine months ended December 31, 2008 we recorded a
provision for loan losses of $10.0 million and $25.0 million, respectively,
compared to $900,000 and $2.1 million for the quarter and nine months ended
December 31, 2007, which reduced our results of operations for the third
quarter and first nine months of fiscal 2009. We also recorded net loan
charge-offs of $10.3 million and $18.8 million for the quarter and nine months
ended December 31, 2008, respectively, compared to $32,000 and $98,000 for the
quarter and nine months ended December 31, 2007. We are experiencing
increasing loan delinquencies and credit losses. Generally, our
non-performing loans and assets reflect operating difficulties of individual
borrowers resulting from weakness in the economy of the Pacific Northwest. In
addition, slowing housing and developed lot sales have been a contributing
factor to the increase in non-performing loans as well as the increase in
delinquencies. At December 31, 2008 our total non-performing loans had
increased to $66.9 million compared to $990,000 at December 31, 2007. In that
regard, our portfolio is concentrated in construction and land loans and
commercial and multi-family loans, all of which have a higher risk of loss
than residential mortgage loans. While commercial construction and land
development loans represented $464.8 million or 38.3% of our total loan
portfolio at December 31, 2008 they represented $72.7 million or 86.9% of our
non-performing assets at that date. If current trends in the housing and real
estate markets continue, we expect that we will continue to experience
increased delinquencies and credit losses. Moreover, if the recession
continues we expect that it will continue to negatively impact economic
conditions in our market areas and that we could experience significantly
higher delinquencies and credit losses. An increase in our credit losses or
our provision for loan losses would adversely affect our financial condition
and results of operations.
Liquidity risk could impair our ability to fund operations and jeopardize our
financial condition.
Liquidity is essential to our business. An inability to raise funds
through deposits, borrowings, the sale of loans and other sources could have a
substantial negative effect on our liquidity. Our access to funding sources in
amounts adequate to
31
finance our activities or the terms of which are acceptable to us could be
impaired by factors that affect us specifically or the financial services
industry or economy in general. Factors that could detrimentally impact our
access to liquidity sources include a decrease in the level of our business
activity as a result of a downturn in the markets in which our loans are
concentrated or adverse regulatory action against us. Our ability to borrow
could also be impaired by factors that are not specific to us, such as a
disruption in the financial markets or negative views and expectations about
the prospects for the financial services industry in light of the recent
turmoil faced by banking organizations and the continued deterioration in
credit markets.
If external funds were not available, this could adversely impact our growth
and prospects.
We rely on retail deposits, brokered deposits, and advances from the
Federal Home Loan Bank ("FHLB") of Seattle and other borrowings to fund our
operations. Although we have historically been able to replace maturing
deposits and advances as necessary, we might not be able to replace such funds
in the future if, among other things, our results of operations or financial
condition or the results of operations or financial condition of the FHLB of
Seattle or market conditions were to change. In addition, if we fall below the
FDIC's thresholds to be considered "well capitalized" we will be unable to
continue with uninterrupted access to the brokered funds markets.
Although we consider these sources of funds adequate for our liquidity
needs, we may be compelled or elect to seek additional sources of financing in
the future. Likewise, we may seek additional debt in the future to achieve
our long-term business objectives, in connection with future acquisitions or
for other reasons. Additional borrowings, if sought, may not be available to
us or, if available, may not be available on reasonable terms. If additional
financing sources are unavailable or not available on reasonable terms, our
financial condition, results of operations and future prospects could be
materially adversely affected.
We may elect or be compelled to seek additional capital in the future, but
that capital may not be available when it is needed.
We are required by federal and state regulatory authorities to maintain
adequate levels of capital to support our operations. In addition, we may
elect to raise additional capital to support our business or to finance
acquisitions, if any, or we may otherwise elect to raise additional capital.
In that regard, a few financial institutions have recently raised capital as a
result of a deterioration in their results of operations and financial
condition arising from the turmoil in the mortgage loan market, deteriorating
economic conditions, declines in real estate values and other factors. Should
we be required by regulatory authorities or otherwise elect to raise
additional capital, we may seek to do so through the issuance of, among other
things, our common stock or securities convertible into our common stock,
which could dilute your ownership interest in the Corporation.
Our ability to raise additional capital, if needed, will depend on
conditions in the capital markets, economic conditions and a number of other
factors, many of which are outside our control, and on our financial
performance. If we cannot raise additional capital when needed, it may have a
material adverse effect on our financial condition, results of operations and
prospects.
Difficult market conditions have adversely affected our industry.
We are particularly exposed to downturns in the U.S. housing market.
Dramatic declines in the housing market over the past year, with falling home
prices and increasing foreclosures, unemployment and under-employment, have
negatively impacted the credit performance of mortgage loans and resulted in
significant write-downs of asset values by financial institutions, including
government-sponsored entities, major commercial and investment banks, and
regional financial institutions such as our Company. Reflecting concern about
the stability of the financial markets generally and the strength of
counterparties, many lenders and institutional investors have reduced or
ceased providing funding to borrowers, including to other financial
institutions. This market turmoil and tightening of credit have led to an
increased level of commercial and consumer delinquencies, lack of consumer
confidence, increased market volatility and widespread reduction of business
activity. The resulting economic pressure on consumers and lack of confidence
in the financial markets have adversely affected our business, financial
condition and results of operations. We do not expect that the difficult
conditions in the financial markets are likely to improve in the near future.
A worsening of these conditions would likely exacerbate the adverse effects of
these difficult market conditions on us and others in the financial
institutions industry. In particular, we may face the following risks in
connection with these events:
* Our stock price could be negatively impacted by these events and is
likely to remain under pressure until a market recovery is under way.
32
* Increased regulation of our industry. Compliance with such
regulation may increase our costs and limit our ability to pursue
business opportunities.
* Rising delinquencies and non-performing loans will adversely impact
earnings.
* The process we use to estimate losses inherent in our credit exposure
requires subjective and complex judgments, including forecasts of
economic conditions and how these economic conditions might impair
the ability of our borrowers to repay their loans. The level of
uncertainty concerning economic conditions may adversely affect the
accuracy of our estimates which may, in turn, impact the reliability
of the financial statements.
* Continued losses could reduce our capital levels and markets may not
be open to invest in community banks in order to re-capitalize.
* We may be required to pay significantly higher Federal deposit
insurance premiums because market developments have significantly
depleted the insurance fund of the FDIC and reduced the ratio of
reserves to insured deposits.
* Consumer confidence in financial institutions is deteriorating, which
could lead to declines in our deposit totals and impact liquidity.
Our business is subject to general economic risks that could adversely impact
our results of operations and financial condition.
* Changes in economic conditions, particularly a further economic slowdown
in our local markets, including Whatcom, Skagit, Snohomish, King and
Pierce Counties, could increase our exposure to losses.
Our business is directly affected by market conditions, trends in
industry and finance, legislative and regulatory changes, and changes in
governmental monetary and fiscal policies and inflation, all of which are
beyond our control. In 2007, the housing and real estate sectors experienced
an economic slowdown that has continued through 2008 and into 2009. Further
deterioration in economic conditions, in particular within our primary market
area in the Whatcom, Skagit, Snohomish, King and Pierce County real estate
markets, could result in the following consequences, among others, any of
which could negatively impact our business materially:
o loan delinquencies may increase;
o problem assets and foreclosures may increase;
o demand for our products and services may decline; and
o collateral for loans made by us, especially real estate, may
decline in value, in turn reducing a customer's borrowing power
and reducing the value of assets and collateral securing our
loans.
o the increase in workload could challenge our credit
administration.
* Further downturns in the real estate markets in our primary market area
could hurt our business.
Our business activities and credit exposure are primarily concentrated in
Whatcom, Skagit, Snohomish, King and Pierce Counties. Our construction and
land loan portfolios, our commercial and multifamily loan portfolios and
certain of our other loans have been affected by the downturn in the
residential real estate market. We anticipate that further declines in the
real estate markets in our primary market area will hurt our business. As of
December 31, 2008, a significant portion of our loan portfolio consisted of
loans secured by real estate located in our local market areas. If real
estate values continue to decline the collateral for our loans will provide
less security. As a result, our ability to recover on defaulted loans by
selling the underlying real estate will be diminished, and we would be more
likely to suffer losses on defaulted loans. The events and conditions
described in this risk factor could therefore have a material adverse effect
on our business, results of operations and financial condition.
* We may suffer losses in our loan portfolio despite our underwriting
practices.
We seek to mitigate the risks inherent in our loan portfolio by adhering
to specific underwriting practices. Although we believe that our underwriting
criteria are appropriate for the various kinds of loans we make, we may incur
losses on loans that meet our underwriting criteria, and these losses may
exceed the amounts set aside as reserves in our allowance for loan losses.
33
Recent negative developments in the financial industry and credit markets may
continue to adversely impact our financial condition and results of
operations.
Negative developments beginning in the latter half of 2007 in the
sub-prime mortgage market and the securitization markets for such loans,
together with other factors, have resulted in uncertainty in the financial
markets in general and a related general economic downturn, which have
continued in 2008. Many lending institutions, including us, have experienced
substantial declines in the performance of their loans, including construction
and land development loans, multifamily loans, commercial loans and consumer
loans. Moreover, competition among depository institutions for deposits has
increased significantly. In addition, the values of real estate collateral
supporting many construction and land, commercial and multifamily and other
commercial loans and home mortgages have declined and may continue to decline.
Bank and holding company stock prices have been negatively affected, as has
the ability of banks and holding companies to raise capital or borrow in the
debt markets compared to recent years. These conditions may have a material
adverse effect on our financial condition and results of operations. In
addition, as a result of the foregoing factors, there is a potential for new
federal or state laws and regulations regarding lending and funding practices
and liquidity standards, and bank regulatory agencies are expected to be
aggressive in responding to concerns and trends identified in examinations,
including the expected issuance of formal enforcement orders. Further
negative developments in the financial industry and the impact of new
legislation in response to those developments could restrict our business
operations, including our ability to originate or sell loans, and adversely
impact our results of operations and financial condition.
Recently enacted legislation and other measures undertaken by the Treasury,
the Federal Reserve and other governmental agencies may not help stabilize the
U.S. financial system or improve the housing market.
On October 3, 2008, President Bush signed into law the Emergency Economic
Stabilization Act of 2008 (the "EESA"), which, among other measures,
authorized the Treasury Secretary to establish the Troubled Asset Relief
Program ("TARP"). EESA gives broad authority to Treasury to purchase, manage,
modify, sell and insure the troubled mortgage related assets that triggered
the current economic crisis as well as other "troubled assets." EESA includes
additional provisions directed at bolstering the economy, including:
* Authority for the Federal Reserve to pay interest on depository
institution balances;
* Mortgage loss mitigation and homeowner protection;
* Temporary increase in Federal Deposit Insurance Corporation ("FDIC")
insurance coverage from $100,000 to $250,000 through December 31,
2009; and
* Authority to the Securities and Exchange Commission (the "SEC") to
review and evaluate the mark-to-market accounting requirements for
any issuer or class of category of transactions.
Pursuant to the TARP, the Treasury has the authority to, among other
things, purchase up to $700 billion (of which $250 billion is currently
available) of mortgages, mortgage-backed securities and certain other
financial instruments from financial institutions for the purpose of
stabilizing and providing liquidity to the U.S. financial markets. Under the
TARP, the Treasury has created a capital purchase program, pursuant to which
it is providing access to capital to financial institutions through a
standardized program to acquire preferred stock (accompanied by warrants) from
eligible financial institutions that will serve as Tier 1 capital.
EESA followed, and has been followed by, numerous actions by the Federal
Reserve, Congress, Treasury, the SEC and others to address the currently
liquidity and credit crisis that has followed the sub-prime meltdown that
commenced in 2007. These measures include homeowner relief that encourage
loan restructuring and modification; the establishment of significant
liquidity and credit facilities for financial institutions and investment
banks; the lowering of the federal funds rate; emergency action against short
selling practices; a temporary guaranty program for money market funds; the
establishment of a commercial paper funding facility to provide back-stop
liquidity to commercial paper issuers; coordinated international efforts to
address illiquidity and other weaknesses in the banking sector.
In addition, the Internal Revenue Service has issued an unprecedented
wave of guidance in response to the credit crisis, including a relaxation of
limits on the ability of financial institutions that undergo an "ownership
change" to utilize their pre-change net operating losses and net unrealized
built-in losses. The relaxation of these limits may make significantly more
attractive the acquisition of financial institutions whose tax basis in their
loan portfolios significantly exceeds the fair market value of those
portfolios.
34
On October 14, 2008, the FDIC announced the establishment of a temporary
liquidity guarantee program to provide insurance for all non-interest bearing
transaction accounts and guarantees of certain newly issued senior unsecured
debt issued by financial institutions (such as Horizon Bank), bank holding
companies and savings and loan holding companies (such as Horizon Financial).
Financial institutions are automatically covered by this program for the
30-day period commencing October 14, 2008 and will continue to be covered as
long as they do not affirmatively opt out of the program. Under the program,
newly issued senior unsecured debt issued on or before June 30, 2009 will be
insured in the event the issuing institution subsequently fails, or its
holding company files for bankruptcy. The debt includes all newly issued
unsecured senior debt (e.g., promissory notes, commercial paper and inter-bank
funding). The aggregate coverage for an institution may not exceed 125% of its
debt outstanding on December 31, 2008 that was scheduled to mature before June
30, 2009. The guarantee will extend to June 30, 2012 even if the maturity of
the debt is after that date. Many details of the program still remain to be
worked out.
The actual impact that EESA and such related measures undertaken to
alleviate the credit crisis will have generally on the financial markets,
including the extreme levels of volatility and limited credit availability
currently being experienced, is unknown. The failure of such measures to help
stabilize the financial markets and a continuation or worsening of current
financial market conditions could materially and adversely affect our
business, financial condition, results of operations, access to credit or the
trading price of our common stock.
Current levels of market volatility are unprecedented.
The capital and credit markets have been experiencing volatility and
disruption for more than a year. In recent months, the volatility and
disruption has reached unprecedented levels. In some cases, the markets have
produced downward pressure on stock prices and credit availability for certain
issuers without regard to those issuers' underlying financial strength. If
current levels of market disruption and volatility continue or worsen, there
can be no assurance that we will not experience an adverse effect, which may
be material, on our ability to access capital and on our business, financial
condition and results of operations.
Our deposit insurance assessments will increase substantially, which will
adversely affect our profits
Our Federal Deposit Insurance Corporation deposit insurance assessments
expense for the nine months ended December 31, 2008 was $487,000. Deposit
insurance assessments will increase in 2009 due to recent strains on the
Federal Deposit Insurance Corporation deposit insurance fund resulting from
the cost of recent bank failures and an increase in the number of banks likely
to fail over the next few years. The current rates for Federal Deposit
Insurance Corporation assessments range from five to 43 basis points,
depending on the financial health of the insured institution. On December 16,
2008, the Federal Deposit Insurance Corporation issued a final rule increasing
that assessment range to 12 to 50 basis points for the first quarter of 2009.
For the remainder of 2009, the Federal Deposit Insurance Corporation has
proposed a range of - ten to 45 basis points for institutions that do not
trigger the brokered deposits adjustment, the secured liability adjustment, or
the unsecured debt adjustment. For institutions that are subject to those
adjustments, the Federal Deposit Insurance Corporation proposes rate
assessments in the range of eight to 77.5 basis points. In this regard, the
brokered deposit adjustment can range from 0 to ten basis points, the secured
liability adjustment (which includes, among others, Federal Home Loan Bank
advances, securities sold under repurchase agreements, secured federal funds
purchased, and certain other secured borrowings) can range from 0 to 22.5
basis points, and the unsecured debt adjustment can range from minus two to 0
basis points. The Federal Deposit Insurance Corporation has stated that it
may need to set a higher base rate schedule at the time of the issuance of its
final assessment rate rule, depending upon the information available at that
time including, without limitation, on its updated bank failure and loss
projections. The Federal Deposit Insurance Corporation=s proposal would
continue to allow it to adopt actual assessment rates that are higher or lower
than the total base assessment rates without the necessity of further notice
and comment rulemaking, although this power is subject to several limitations.
The Federal Deposit Insurance Corporation has announced that it intends to
issue a final rule in early 2009, to be effective on April 1, 2009, to set new
assessment rates beginning with the second quarter of 2009 and to make other
changes to its assessment rule.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Stock Repurchases
In March 2008, the Board of Directors approved a new stock repurchase
plan that runs concurrent with the 2009 fiscal year, allowing the Corporation
to repurchase up to 2.5% of total shares outstanding, or approximately 300,000
shares. This marked the Corporation's tenth stock repurchase plan. The
Corporation did not repurchase any shares during the three and nine months
ended December 31, 2008. Management does not intend to repurchase shares
under the current plan.
35
Item 3. Defaults Upon Senior Securities
None
Item 4. Submission of Matters to a Vote of Security Holders
The Corporation's 2008 Annual Meeting of Shareholders was held on July
22, 2008 at the Fox Hall located at
1661 W. Bakerview Road, Bellingham, Washington. The results of the vote on
the items presented at the meeting was as
follows:
Election of Directors:
Shareholders elected the following nominees to the Board of Directors for a
three-year term ending in 2011 by the following vote:
FOR: WITHHELD:
Number of Votes Percentage Number of Votes Percentage
--------------- ---------- --------------- ----------
V. Lawrence Evans 9,146,347 94.0% 580,230 6.0%
Richard R. Haggen (1) 8,803,205 90.5% 923,372 9.5%
Robert C. Tauscher 9,075,371 93.3% 651,206 6.7%
(1) resigned effective September 2, 2008.
Shareholders elected the following nominee to the Board of Directors for a
two-year term ending in 2010 by the following vote:
FOR: WITHHELD:
Number of Votes Percentage Number of Votes Percentage
--------------- ---------- --------------- ----------
Richard P. Jacobson 9,130,185 93.9% 596,392 6.1%
The following directors, who were not up for re-election at the Annual Meeting
of Shareholders, will continue to serve as directors: Robert C. Diehl, Gary
E. Goodman, Dennis C. Joines and James A. Strengholt.
Item 5. Other Information
None
Item 6. Exhibits
(a) Exhibits
--------
(2.1) Articles of Incorporation of Horizon Financial, Corp.
(incorporated by reference to Exhibit 3.1 to the Registrant's
Current Report on Form 8-K dated October 13, 1995)
(2.2) Bylaws of Horizon Financial Corp. (incorporated by reference
to Exhibit 3.2 to the Registrant's Current Report on Form 8-K
dated October 13, 1995)
(9.1) Amended and Restated Employment Agreement with V. Lawrence
Evans (incorporated by reference to the Registrant's Annual
Report on Form 10-K for the year ended March 31, 1996)
(9.2) Deferred Compensation Plan (incorporated by reference to the
Registrant's Annual Report on Form 10-K for the year ended
March 31, 1996)
(9.3) Bank of Bellingham 1993 Employee Stock Option Plan
(incorporated by reference to Exhibit 99 to the Registrant's
Registration Statement on Form S-8 (File No. 33-88571)
(9.4) Severance Agreement with Dennis C. Joines (incorporated by
reference to the Registrant's Annual Report on Form 10-K for
the year ended March 31, 2002)
(9.5) Severance Agreement with Richard P. Jacobson, as amended
(incorporated by reference to the Registrant's Current Report
on Form 8-K dated January 23, 2008)
(9.6) Severance Agreement with Steven L. Hoekstra (incorporated by
reference to the Registrant's Quarterly Report on Form 10-Q
for the quarter ended September 30, 2002)
(10.7) Stock Incentive Plan (incorporated by reference to Exhibit 99
to the Registrant's Registration Statement on Form S-8 (File
No. 333-127178))
36
(10.8) Form of Incentive Stock Option Award Agreement under the 2005
Stock Incentive Plan (incorporated by reference to Exhibit
99.1 contained in the Registrant's Current Report on Form 8-K
dated July 27, 2005)
(10.9) Form of Non-qualified Stock Option Award Agreement under the
2005 Stock Incentive Plan (incorporated by reference to
Exhibit 99.1 contained in the Registrant's Current Report on
Form 8-K dated July 27, 2005)
(10.10) Form of Restricted Stock Award Agreement under the 2005 Stock
Incentive Plan (incorporated by reference to Exhibit 99.1
contained in the Registrant's Current Report on Form 8-K
dated July 27, 2005)
(10.11) Form of Salary Continuation Agreement between Horizon Bank
and Executive Officers Steven L. Hoekstra, Richard P.
Jacobson and Dennis C. Joines (incorporated by reference to
Exhibit 99.1 contained in the Registrant's current Report on
Form 8-K dated June 27, 2006)
(10.12) Amended Salary Continuation Agreement between Horizon Bank
and Richard P. Jacobson (incorporated by reference to Exhibit
10.1 contained in the Registrant's Current Report on Form 8-
K dated January 23, 2008)
(10.13) Transition agreement with V. Lawrence Evans (incorporated by
reference to the registrant's Current Report on Form 8-K
dated March 25, 2008)
(10.14) Severance Agreement with Greg B. Spear (incorporated by
reference to the Registrant's Current Report on Form 8-K
dated October 24, 2008)
(14) Code of Ethics (incorporated by reference to the Registrant's
Annual Report on Form 10-K for the year ended March 31, 2007)
(31) Certification of Chief Executive Officer and Chief financial
Officer Pursuant to Section 302 of the Sarbanes-Oxley Act
(32) Certification of Chief Executive Officer and Chief Financial
Officer Pursuant to Section 906 of the Sarbanes-Oxley Act
37
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
HORIZON FINANCIAL CORP.
By: /s/ Richard P. Jacobson
--------------------------
Richard P. Jacobson
Chief Executive Officer
By: /s/ Greg B. Spear
--------------------------
Greg B. Spear
Chief Financial Officer
Dated: February 6, 2009
-------------------------
38
Exhibit Index
-------------
Exhibit 31.1 Certification of Chief Executive Officer Pursuant to Section
302 of the Sarbanes-Oxley Act
Exhibit 31.2 Certification of Chief Financial Officer Pursuant to Section
302 of the Sarbanes-Oxley Act
Exhibit 32 Certification of Chief Executive Officer and Chief Financial
Officer Pursuant to Section 906 of the Sarbanes-Oxley Act
39