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 June 30, 2009
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 has submitted electronically and
posted on its corporate Web site, if any, every Interactive Data File required
to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section
232.405 of this chapter) during the preceding 12 months (or for such shorter
period that the registrant was required to submit and post such files).
YES 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 August 3, 2009, 11,994,945 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
Consolidated Statements of Stockholders' Equity 4
Consolidated Statements of Cash Flows 5-6
Selected Notes to Consolidated Financial Statements 7-14
Item 2 Management's Discussion and Analysis of Financial
Condition and Results of Operations 15-31
Item 3 Quantitative and Qualitative Disclosures About
Market Risk 31
Item 4 Controls and Procedures 32
PART II OTHER INFORMATION
Item 1 Legal Proceedings 33
Item 1A Risk Factors 33
Item 2 Unregistered Sales of Equity Securities and Use of
Proceeds 33
Item 3 Defaults Upon Senior Securities 33
Item 4 Submission of Matters to a Vote of Security Holders 34
Item 5 Other Information 34
Item 6 Exhibits 34-35
SIGNATURES 36
Exhibit Index 37
1
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements (unaudited)
HORIZON FINANCIAL CORP.
Consolidated Statements of Financial Position (unaudited)
ASSETS
June 30, March 31,
(In thousands) 2009 2009
---------- ----------
Cash and cash equivalents $ 17,523 $ 17,881
Interest-bearing deposits 117,876 126,159
Investment securities
Available-for-sale, at fair value 63,420 66,865
Held-to-maturity, at amortized cost 8 8
Federal Home Loan Bank ("FHLB") stock 7,247 7,247
Loans held for sale 2,982 4,745
Loans receivable, net of allowance for loan losses
of $51,499 at June 30, 2009 and $38,981 at March
31, 2009 1,034,776 1,123,660
Investment in real estate joint venture 18,087 17,985
Accrued interest and dividends receivable 6,345 6,629
Bank premises and equipment, net 25,733 26,195
Net deferred income tax assets - 15,164
Income tax receivable 21,018 12,442
Real estate owned 22,537 19,227
Bank owned life insurance 20,350 20,134
Other assets 3,133 3,630
---------- ----------
TOTAL ASSETS $1,361,035 $1,467,971
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits $1,172,178 $1,229,764
Other borrowed funds 109,456 114,348
Borrowing related to investment in real estate
joint venture 24,500 24,440
Accrued interest payable and other liabilities 5,644 3,959
Advances by borrowers for taxes and insurance 172 377
Deferred compensation 1,726 1,923
---------- ----------
Total liabilities 1,313,676 1,374,811
---------- ----------
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; 11,994,945 and 11,980,796 issued and
outstanding at June 30, 2009 and March 31, 2009,
respectively 11,995 11,981
Additional paid-in capital 51,155 51,298
Retained earnings (deficit) (17,368) 28,333
Accumulated other comprehensive income 1,458 1,414
Noncontrolling interests 119 134
---------- ----------
Total stockholders' equity 47,359 93,160
---------- ----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $1,361,035 $1,467,971
========== ==========
(See Notes to Consolidated Financial Statements)
2
HORIZON FINANCIAL CORP.
Consolidated Statements of Operations (unaudited)
Three months ended
June 30,
(In thousands, except share data) 2009 2008
-------- --------
INTEREST INCOME
Interest and fees on loans $ 13,684 $ 20,446
Interest on investment securities 864 961
-------- --------
Total interest income 14,548 21,407
-------- --------
INTEREST EXPENSE
Interest on deposits 8,257 8,587
Interest on other borrowings 725 1,593
-------- --------
Total interest expense 8,982 10,180
-------- --------
Net interest income 5,566 11,227
PROVISION FOR LOAN LOSSES 35,521 3,000
-------- --------
Net interest income (loss) after provision for
loan losses (29,955) 8,227
-------- --------
NONINTEREST INCOME
Service fees 830 960
Net gain on sales of loans - servicing released 481 204
Net gain on sales of loans - servicing retained 4 -
Net gain on sales of investment securities - 579
Other-than-temporary impairment on investment securities (204) -
Other noninterest income 462 512
-------- --------
Total noninterest income 1,573 2,255
-------- --------
NONINTEREST EXPENSE
Compensation and employee benefits 3,376 4,503
Building occupancy 1,086 1,126
Real estate owned/collection expense 4,503 85
FDIC insurance 1,768 45
Data processing 260 244
Advertising 139 219
Other noninterest expense 1,138 1,363
-------- --------
Total noninterest expense 12,270 7,585
-------- --------
NET INCOME (LOSS) BEFORE PROVISION (BENEFIT)
FOR INCOME TAX (40,652) 2,897
Provision (benefit) for income tax (14,336) 881
Deferred tax valuation allowance 19,400 -
-------- --------
NET INCOME (LOSS) $(45,716) $ 2,017
Less: Net income (loss) attributable to
noncontrolling interests (15) (3)
-------- --------
NET INCOME (LOSS) ATTRIBUTABLE TO HORIZON
FINANCIAL CORP. $(45,701) $ 2,020
======== ========
BASIC EARNINGS (LOSS) PER SHARE $(3.81) $0.17
====== =====
DILUTED EARNINGS (LOSS) PER SHARE $(3.81) $0.17
====== =====
(See Notes to Consolidated Financial Statements)
3
HORIZON FINANCIAL CORP.
Consolidated Statements of Stockholders' Equity
Three Months Ended June 30, 2009 and 2008
(unaudited)
Accumulated
Other Total
Common Stock Compre- Compre-
---------------- Additional Retained hensive Non- Stock- hensive
Number of Paid-In Earnings Income controlling holders' Income
(In thousands) Shares At Par Capital (Deficit) (Loss) Interests Equity (Loss)
-------- ------ ------- --------- ------ --------- ------- ------
<s> <c> <c> <c> <c> <c> <c> <c> <c>
BALANCE, March 31, 2008 11,892 $11,892 $50,597 $63,906 $ 1,922 $ 164 $128,481
Comprehensive income
Net income - - - 2,020 - (3) 2,017 $ 2,017
Other comprehensive income
(loss)
Reclassification for net
gains realized in
income, net tax expense
of $203 - - - - (376) - (376) (376)
Change in unrealized
losses on available-for-
sale securities, net tax
benefit of $569 - - - - (1,057) - (1,057) (1,057)
--------
Total other comprehensive
loss (1,433)
--------
Comprehensive income $ 584
========
Cash dividends on common
stock at $.135/sh - - - (1,608) - - (1,608)
Stock options exercised 5 5 22 - - - 27
Stock award plan 20 20 87 - - - 107
------ ------- ------- ------- ------- ----- --------
BALANCE, June 30, 2008 11,917 $11,917 $50,706 $64,318 $ 489 $ 161 $127,591
====== ======= ======= ======= ======= ===== ========
BALANCE, March 31, 2009 11,981 $11,981 $51,298 $28,333 $ 1,414 134 $ 93,160
Comprehensive loss
Net loss - - - (45,701) - (15) (45,716) $(45,716)
Other comprehensive income
(loss)
Reclassification for net
losses realized in
income, net tax benefit
of $71 - - - - 133 - 133 133
Change in unrealized
losses on available-for-
sale securities, net
tax benefit of $48 - - - - (89) - (89) (89)
--------
Total other comprehensive
income 44
--------
Comprehensive loss $(45,672)
========
Stock award plan 14 14 (143) - - (129)
------ ------- ------- ------- ------- ----- --------
BALANCE, June 30, 2009 11,995 $11,995 $51,155 $17,368 $ 1,458 $ 119 $ 47,359
====== ======= ======= ======= ======= ===== ========
(See Notes to Consolidated Financial Statements)
4
HORIZON FINANCIAL CORP.
Consolidated Statements of Cash Flows (unaudited)
Three Months Ended
(In thousands) June 30,
2009 2008
-------- --------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss) $(45,701) $ 2,020
Adjustments to reconcile net income (loss) to net
cash provided by operating activities:
Depreciation and amortization 786 630
Provision for loan losses 35,521 3,000
Provision for loss - real estate owned 695 -
Loss on sale of real estate owned 1,369 -
Net gain on sale of investment securities - (579)
Other-than-temporary impairment on investment
securities available for sale 204 -
Net gain on mortgage loans held for sale (481) (204)
Proceeds from sales of mortgage loans held for sale 42,068 16,269
Origination of mortgage loans held for sale (39,824) (15,735)
Stock award plan compensation (129) 107
Deferred income taxes (4,236) 75
Valuation allowance on deferred income taxes 19,400 -
Changes in assets and liabilities:
Interest and dividends receivable 284 737
Interest payable (273) (122)
Federal income tax receivable (8,576) (1,799)
Other assets 281 (289)
Other liabilities 1,542 (863)
-------- --------
Net cash flows from operating activities 2,930 3,247
-------- --------
CASH FLOWS FROM INVESTING ACTIVITIES
Investment in interest-bearing deposits, net 8,283 81
Purchases of investment securities - available-
for-sale - (4,000)
Proceeds from sales and maturities of
investment securities - available-for-sale 3,284 5,487
Proceeds from maturities of investment
securities - held-to-maturity - 15
Purchases of FHLB Stock - (1,148)
Net change in loans 36,999 (59,321)
Purchases of bank premises and equipment (52) (104)
Proceeds from the sale of real estate owned 10,718 -
Net change in investment in joint venture (102) (137)
-------- --------
Net cash flows from investing activities 59,130 (59,127)
-------- --------
5
HORIZON FINANCIAL CORP.
Consolidated Statements of Cash Flows (unaudited)
(continued)
Three Months Ended
(In thousands) June 30,
2009 2008
-------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES
Net change in deposits (57,586) 57,962
Advances of other borrowed funds 21,940 121,644
Repayments of other borrowed funds (26,832) (121,000)
Borrowing related to investment in real estate
joint venture 60 535
Common stock issued - 27
Cash dividends paid - (1,605)
-------- ---------
Net cash flows from financing activities (62,418) 57,563
-------- ---------
NET CHANGE IN CASH AND CASH EQUIVALENTS (358) 1,683
CASH AND CASH EQUIVALENTS, beginning of period 17,881 22,412
-------- ---------
CASH AND CASH EQUIVALENTS, end of period $ 17,523 $ 24,095
======== =========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the period for interest $ 9,256 $ 10,302
======== =========
Cash paid during the period for income tax $ - $ 2,700
======== =========
NONCASH INVESTING AND FINANCING TRANSACTIONS
Property taken in settlement of loans $ 17,620 $ 2,109
======== =========
Bank financed sale of other real estate owned $ 1,528 $ -
======== =========
(See Notes to Consolidated Financial Statements)
6
HORIZON FINANCIAL CORP.
SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE MONTHS ENDED JUNE 30, 2009 AND 2008
(unaudited)
NOTE 1 - Basis of Presentation and Significant Accounting Policies
Basis of Presentation
- ---------------------
The consolidated financial statements as of and for the three months
ended June 30, 2009 and 2008, 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
month periods ended June 30, 2009 and 2008 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, 2009.
In preparing these financial statements, the Corporation has evaluated
events and transactions for potential recognition or disclosure through August
7, 2009, the date the financial statements were issued. In management's
opinion, all accounting adjustments necessary to accurately reflect the
financial position and results of operations on the accompanying financial
statements have been made. These adjustments include normal and recurring
accruals considered necessary for a fair and accurate presentation. The
results for interim periods are not necessarily indicative of results for the
full year or any other interim period. Certain reclassifications of prior
period amounts have been made to conform with current classifications.
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 investment in real estate is recorded as an asset and the related debt is
recorded as the Corporation's liability. As of June 30, 2009, the real estate
joint venture had a carrying amount of approximately $18.1 million, with a
related borrowing of approximately $24.5 million after consolidation treatment
under FIN 46R. During the process of consolidation, inter-company
transactions were eliminated; including $24.5 million loan receivable and the
associated $7.16 million in capitalized interest receivable from GBNW and
payable to Horizon Bank.
7
NOTE 1 - Basis of Presentation and Significant Accounting Policies (continued)
The Corporation adopted SFAS No. 160, Noncontrolling Interests on April
1, 2009. As a result, we reclassified $119,000 of minority interest
liabilities from liabilities to equity on our balance sheet. Noncontrolling
interests' share of net income (loss) was $(15,000) and $(3,000) for the three
months ended June 30, 2009 and 2008, respectively.
NOTE 2 - Regulatory Actions
On February 26, 2009, the Bank entered into a Stipulation and Consent to
the Issuance of an Order to Cease and Desist ("Order") with the FDIC and the
Washington State Department of Financial Institutions ("DFI"). The Order was
effective March 2, 2009.
The Order is a result of a regulatory examination conducted by the FDIC
in September 2008. Under the terms of the Order, the Bank cannot declare
dividends without the prior written approval of the FDIC and the DFI. Other
material provisions of the Order require the Bank to:
Strengthen the Bank's board of directors' oversight of management and
operations of the Bank;
Increase and subsequently maintain specified capital levels;
Enhance its practices and written policies for determining the adequacy
of the allowance for loan and lease losses;
Eliminate loans classified as "Loss" and "Doubtful" at its regulatory
examination, and reduce the loans classified as "Substandard" as a
percent of capital;
Not extend additional credit to borrowers whose loan had been
classified as "Loss" and is uncollected;
Develop a plan to reduce delinquent loans;
Develop a plan to reduce the amount of construction and land
development loans;
Develop a three year strategic plan outlining specific goals for loans,
investments and deposits, acceptable to the FDIC;
Enhance its written funds management and liquidity policy;
Not increase brokered deposits and develop a plan to reduce brokered
deposits; and
Prepare and submit progress reports to the FDIC and the DFI.
The Bank has implemented a comprehensive plan to achieve full compliance
with the Order. No monetary penalties were imposed or recommended by the FDIC
or DFI in connection with the Order. The Order will remain in effect until
modified or terminated by the FDIC and the DFI.
In connection with the FDIC order, the Federal Reserve Bank of San
Francisco ("FRB") has notified the Corporation that neither the Corporation
nor the Bank may appoint any new director or senior executive officer or
change the responsibilities of any current senior executive officers without
notifying the FRB. In addition, neither the Corporation nor the Bank may make
indemnification and severance payments without complying with certain
statutory restrictions including prior written approval by the FRB and
concurrence from the FDIC.
The Order contains target dates to achieve the above referenced
objectives, which are also outlined in the Form 8-K filing and in Horizon's
Form 10-K filing for its fiscal year ended March 31, 2009. As of June 30,
2009, we have completed on-time and submitted to our regulators all
requirements that were due within 90 days of the Order's effective date.
There are two key objectives that remain outstanding and were given 270 days
for compliance. The first is the requirement to reduce our balances of loans
which were classified "substandard" and "doubtful" as of the most recent
regulatory exam date to specified levels is expected to be completed by the
270 day target date. The second requirement is to increase our Tier 1 capital
ratio to 10% within 270 days. At June 30, 2009, Horizon Bank's Tier 1 capital
was $45.3 million, representing 3.17% of average assets. We continue to work
with professional investment bankers and other qualified advisors to bring in
additional capital to meet the 10% regulatory requirement in accordance with
the terms of the agreement.
8
NOTE 3 - Regulatory Capital
The Bank's ratio of total capital to risk-weighted assets was 5.28% as of
June 30, 2009, which caused the Bank to be deemed "significantly
undercapitalized" as of that date under regulatory capital guidelines. The
Bank's ratios of Tier 1 capital to average assets and Tier 1 capital to
risk-weighted assets were 3.17% and 3.97%, respectively, as of June 30, 2009.
In order to be "adequately capitalized" under regulatory capital guidelines,
an institution's ratios of total capital to risk-weighted assets, Tier 1
capital to risk-weighted assets and Tier 1 capital to average assets must be
at least 8.0%, 4.0% and 4.0%, respectively.
As a result of the Bank's regulatory capital ratios being below the
adequately capitalized level, certain requirements and restrictions are
imposed on the Bank, including the following: (i) the Bank generally may not
make any capital distributions to the Corporation; (ii) the Bank must submit a
capital restoration plan to the FDIC for the FDIC's review and approval, and
the Corporation must guarantee the Bank's performance under that plan; (iii)
the Bank may not permit its average total assets during any calendar quarter
to exceed its average total assets during the preceding calendar quarter
unless (A) the FDIC has accepted the Bank's capital restoration plan, (B) any
increase in the Bank's total assets is consistent with the plan, and (C) the
Bank's ratio of tangible equity to assets increases during the calendar
quarter at a rate sufficient to enable the Bank to become adequately
capitalized within a reasonable time; and (iv) the Bank may not acquire any
interest in any company or other bank, establish or acquire any additional
branch office or engage in any new line of business without prior regulatory
approval. The Bank is also prohibited from accepting, renewing or rolling
over brokered deposits and is restricted in the effective yield it can offer
on deposits.
As a result of the Bank's "significantly undercapitalized" status as of
June 30, 2009, a number of other requirements or restrictions can or will be
imposed on the Corporation and the Bank in addition to those described above.
These additional requirements and restrictions: (i) prohibit the Bank from
paying any bonus to a senior executive officer or providing compensation to a
senior executive officer at a rate exceeding the officer's average rate of
compensation (excluding bonuses, stock options and profit-sharing) during the
12 months preceding the month in which the Bank became undercapitalized,
without prior written approval from the FDIC; and (ii) require the FDIC to
impose one or more of the following on the Bank: (A) require a sale of Bank
shares or obligations of the Bank sufficient to return the Bank to adequately
capitalized status; (B) if grounds exist for the appointment of a receiver or
conservator for the Bank, require the Bank to be acquired or merged with
another institution; (C) impose additional restrictions on transactions with
affiliates beyond the normal restrictions applicable to all banks; (D)
restrict interest paid on deposits to prevailing rates in the Bank's area as
determined by the FDIC; (E) impose more stringent growth restrictions than
those discussed in the immediately preceding paragraph, or require the Bank to
reduce its total assets; (F) require the Bank to alter, reduce or terminate
any activities the FDIC determines pose excessive risk to the Bank; (G) order
a new election of Bank directors; (H) require the Bank to dismiss any senior
executive officer or director who held office for more than 180 days before
the Bank became undercapitalized; (I) require the Bank to employ "qualified"
senior executive officers; (J) prohibit the Bank from accepting, renewing or
rolling over deposits from correspondent institutions; (K) prohibit the
Corporation from making capital distributions without Federal Reserve Board
approval; (L) require the Corporation to divest the Bank if the regulators
determine that the divestiture would improve the Bank's financial condition
and future prospects; and (M) require the Bank to take any other action that
the FDIC determines will better carry out the purposes of the statute
requiring the imposition of one or more of the restrictions described in
(A)-(L) above. The FDIC also has the discretion to impose certain
restrictions applicable to a "critically undercapitalized" institution (which
is an institution which has a ratio of tangible equity to total assets of 2.0%
or less), including requiring prior regulatory approval for material
transactions outside the usual course of business, extending credit for a
highly leveraged transactions, amending the Bank's charter or bylaws, making a
material change to accounting methods, paying excessive compensation or
bonuses, and paying interest on new or renewed liabilities at a rate that
would increase the Bank's weighted average cost of funds to a level
significantly exceeding the prevailing rates on interest on deposits in the
Bank's normal market areas).
9
NOTE 4 - 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
June 30,
---------------------
2009 2008
-------- --------
Basic weighted average shares outstanding 11,981,529 11,893,813
Dilutive shares - 71,965
---------- ----------
Diluted weighted average shares outstanding 11,981,529 11,965,778
========== ==========
Ant-dilutive shares outstanding related to
options to acquire the Corporation's common
stock 156,564 94,863
========== ==========
NOTE 5 - 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. The Corporation recognized
compensation expense of $121,000 and $107,000, respectively, for the quarters
ended June 30, 2009 and 2008. Also included in additional paid in capital for
the quarter ended June 30, 2009 was $149,000 of compensation expense reversals
due to pre-vesting forfeitures and $115,000 in tax shortfall due to the change
in the fair value of restricted stock awards. As of June 30, 2009 and 2008,
there was approximately $85,000 and $395,000, 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 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 common stock on the date of grant. Dividends are not
paid on any option awards until the option is exercised by the recipient.
The following table summarizes the stock option activity for the three
months ended June 30, 2009:
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, 2009 156,256 $12.61
Granted - -
Exercised - -
Forfeited, expired or
cancelled (2,478) 20.46
------- ------ ---- -----
Balance, June 30, 2009 153,778 $12.49 4.23 $ -
======= ====== ==== =====
Exercisable, June 30, 2009 128,311 $12.26 3.44 $ -
======= ====== ==== =====
10
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 three months ended June 30, 2009 and 2008 was $0
and $6,500, respectively.
The following table summarizes the award activity for the three months
ended June 30, 2009 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, 2009 23,708 $20.58 0.47
Granted - -
Released (14,149) 21.37
Forfeited, expired or
cancelled (3,593) 20.50
------ ------ ----
Balance, June 30, 2009 5,966 $18.73 0.75
====== ====== ====
NOTE 6 - Fair Value Measurements
FSP No. FAS 107-1 and APB 28-1, Disclosures about Fair Value of Financial
Instruments, requires disclosure of fair value information about financial
instruments, whether or not recognized in the consolidated financial
statements. The following table presents estimated fair values of our
financial instruments at June 30, 2009 (in thousands):
Carrying
(In thousands) Amount Fair Value
---------- ------------
Financial Assets
Cash and cash equivalents $ 17,523 $ 17,523
Interest-bearing deposits 117,876 117,876
Investment securities 63,428 63,431
Federal Home Loan Bank stock 7,247 7,247
Loans held-for-sale 2,982 2,982
Loans receivable 1,034,776 1,044,620
Investment in real estate joint venture 18,087 21,800
Bank owned life insurance 20,350 20,350
Accrued interest and dividends receivable 6,345 6,345
Financial Liabilities
Demand and savings deposits 315,903 315,903
Time deposits 856,275 863,640
Accrued interest payable 1,617 1,617
Other borrowed funds 109,456 110,576
Borrowing related to investment in real
estate joint venture 24,500 24,500
We determined the estimated fair value amounts using available market
information and appropriate valuation methodologies. However, considerable
judgment is necessary to interpret market data in the development of the
estimates of fair value. The use of different market assumptions and/or
estimation methodologies may have a material effect on the estimated fair
value amounts.
The following methods and assumptions were used to estimate the fair
value of the following classes of financial instruments (under SFAS No. 157)
and for estimating the fair value for financial instruments not recorded at
fair value (under SFAS No. 107):
Cash Equivalents and Interest-Bearing Deposits - Due to the relatively
short period of time between the origination of these instruments and their
expected realization, the carrying amount is estimated to approximate fair
value.
11
NOTE 6 - Fair Value Measurements (continued)
Investment and Mortgage-Backed Securities - Securities fair values are
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). Available for sale securities are carried at fair value. Held to maturity
securities are carried at cost on the financial statements.
Federal Home Loan Bank of Seattle Stock - FHLB stock is carried at $100
par value. This investment is considered restricted, at a minimum, the
investment must be maintained in order to obtain borrowing commitments from
FHLB. The Corporation may redeem its investment only at par value, which is
used as the estimated market value. In January 2009, the FHLB announced it
suspended excess FHLB stock redemptions and dividend payments. As a result of
the FHLB's announcement, we evaluated the carrying value of our FHLB stock
investment for impairment based on the FHLB of Seattle's May 20, 2009 press
release and filing date of the March 31, 2009 Form 10-Q. Our review of its
financial statement disclosures, capital position, and bond ratings resulted
in our conclusion that such investment was not impaired at June 30, 2009.
Loan Receivables - The fair value of loans generally is estimated by
discounting the future cash flows using the current rates at which similar
loans would be made to borrowers with similar credit ratings and for the same
remaining maturities. The fair value calculation, however, does not take into
consideration the ultimate collectibility of the loan. For certain
homogeneous categories of loans, such as those written to FHLMC standards,
fair value is estimated using the quoted market prices for securities backed
by similar loans, adjusted for differences in loan characteristics. For
variable rate loans that reprice frequently and with no significant change in
credit risk, fair values are based on carrying values.
Loans Held for Sale - The fair value of loans held for sale is based on
the estimated value at which the loans could be sold in the secondary market.
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.
Investment and Borrowing in Investment in Real Estate Joint Venture - The
fair value of the investment in real estate in a joint venture was determined
based on an appraisal of the underlying collateral. The borrowing associated
with the investment is an adjustable rate borrowing; therefore, the recorded
book value is believed to approximate fair value.
Real Estate Owned - The fair value of foreclosed real estate is generally
based on estimated market prices from independently prepared appraisals or
negotiated sales prices with potential buyers and are included in the
nonrecurring basis table below.
Bank Owned Life Insurance - The fair value of Bank owned life insurance
policies are based on cash surrender value of the insurance contract, less any
applicable surrender charges.
Accrued Interest Income and Expense Accounts - Due to the short-term
nature of these amounts, recorded book value is believed to approximate fair
value.
Deposit Liabilities, Repurchase Agreements and Other Borrowed Funds - The
fair value of demand deposits, savings accounts, certain money market
deposits, and federal funds purchased, is the amount payable on demand at the
reporting date. The fair value of fixed-maturity certificates of deposit,
repurchase agreements and other borrowed funds are estimated by discounting
the estimated future cash flows using the rates currently offered for these
instruments with similar remaining maturities.
Off-Balance-Sheet Instruments - The Corporation's off-balance-sheet
instruments include unfunded commitments to extend credit and borrowing
facilities available to the Corporation. The fair value of these instruments
is not considered practicable to estimate because of the lack of quoted market
price and the inability to estimate fair value without incurring excessive
costs.
12
NOTE 6 - Fair Value Measurements (continued)
FASB Statement No. 157, Fair Value Measurements, 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. The
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.
The following table presents the Corporation's financial assets measured
at fair value on a recurring basis at June 30, 2009 (in thousands):
Level 1 Level 2 Level 3 Total
------- ------- ------- -----
Assets
Available for Sale
Investment securities $1,042 $62,378 $ - $63,420
------ ------- ------ -------
Total $1,042 $62,378 $ - $63,420
====== ======= ====== =======
The following table presents the Corporation's assets measured at fair
value on a nonrecurring basis at June 30, 2009 and the total losses resulting
from these fair value adjustments for the three months ended June 30, 2009 (in
thousands):
Total
Level 1 Level 2 Level 3 Total Losses
------- ------- ------- ----- ------
Assets
Impaired loans $ - $ - $196,871 $196,871 $23,174
Real estate owned - - 22,537 22,537 1,369
----- ------ -------- -------- -------
Total $ - $ - $219,408 $219,408 $24,543
===== ====== ======== ======== =======
In accordance with FASB Statement 114, Accounting by Creditors for
Impairment of a Loan, impaired loans, with carrying amounts of $154.9 million
had specific valuation allowances totaling $38.9 million at June 30, 2009,
which were included in the allowance for loan losses. The remaining
difference between the $196.9 million of impaired loans and the $154.9 million
with specific valuation allowances is comprised of $42.0 million of impaired
loans with no measureable amount of probable loss.
NOTE 7 - Investments
- --------------------
The Corporation reviews securities for the presence of
other-than-temporary impairment ("OTTI") on an ongoing basis when economic or
market concerns warrant such evaluation. Consideration is given to: (1) the
length of time and extent to which the fair value has been less than cost, (2)
the financial condition and near term prospects of the issuer and (3) intent
and ability to retain a security for a period of time sufficient to allow for
any anticipated recovery in fair value. Declines in the fair value of
available for sale and held to maturity securities below their cost that are
deemed to be other-than-temporary are reflected in earnings as realized
losses. During the quarter ended June 30, 2009, the Bank recognized a
$204,000 OTTI charge related to 19 non-agency private-label mortgage-backed
securities. These private label mortgage-backed securities are included in
investments available for sale where the default rates, declines in investment
ratings and loss severities of the underlying collateral indicate credit
losses have occurred that are not expected to be recovered. The measured loss
has been identified with the credit component of the securities and is not
reflective of a temporary change in market value. These securities were
valued by third party pricing services using readily available market quotes.
There were no similar charges recorded during the three months ended March 31,
2009 and June 30, 2008.
13
NOTE 8 - Income Taxes
- ---------------------
At June 30, 2009, the Corporation had $19.4 million of net deferred tax
asset which were comprised of tax-affected cumulative temporary differences,
which have resulted, to a large extent, from the significant increase in the
provision for loan losses. In evaluating the need for a valuation allowance,
the Corporation considered all of the events and evidence available, including
the Corporation's cumulative loss position, income tax carry-back and
carry-forward benefits and the challenges in predicting future operating
results. Management concluded that it is more likely than not that the
majority of the net deferred tax asset will not be available as a benefit in
future periods due to uncertainties surrounding the Corporation's ability to
generate sufficient taxable income. This determination was a result of recent
events in the market and the challenges we face in forecasting future profit
levels on a continuing basis. Therefore, at June 30, 2009 the Corporation
recognized a valuation allowance to fully reserve against the net deferred tax
asset. The Corporation incurred an additional accounting income tax provision
in the amount of $19.4 million, primarily as a result of recognizing the
valuation allowance against the net deferred tax asset.
The non-cash valuation allowance that has been established may be
partially or entirely reduced in future periods to the extent the Corporation
can generate taxable income sufficient to offset the tax deductions
represented by the net deferred tax asset. If the valuation allowance is
reduced or eliminated, future tax benefits will be recognized that will have a
positive non-cash impact on the Corporation's net income and stockholders'
equity.
NOTE 9 - Impact of New Accounting Pronouncements
- ------------------------------------------------
In June 2009, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 168, The FASB
Accounting Standards Codification and the Hierarchy of Generally Accepted
Accounting Principles, a replacement of SFAS No. 162, The Hierarchy of
Generally Accepted Accounting Principles. This Statement identifies the
sources of accounting principles and the framework for selecting the
principles used in the preparation of financial statements of nongovernmental
entities that are presented in conformity with generally accepted accounting
principles ("GAAP") in the United States (the GAAP hierarchy). This Statement
is effective for financial statements issued for interim and annual periods
ending after September 15, 2009, and is not expected to have a material impact
on our consolidated financial statements.
In June 2009, the FASB issued SFAS No. 167, Amendments to FASB
Interpretation No. 46(R) ("SFAS 167"). SFAS 167 changes how to determine when
an entity that is insufficiently capitalized or is not controlled through
voting (or similar rights) should be consolidated. The determination of
whether to consolidate an entity is based on, among other things, an entity's
purpose and design and the Corporation's ability to direct the activities of
the entity that most significantly impact the entity's economic performance.
SFAS 167 requires additional disclosures about the Corporation's involvement
with variable interest entities and any significant changes in risk exposure
due to that involvement. Required disclosures include how the involvement
with a variable interest entity affects the company's financial statements.
SFAS 167 is effective for fiscal years beginning after November 15, 2009, and
is not expected to have a material impact on our consolidated financial
statements.
In June 2009, the FASB issued SFAS No. 166, Accounting for Transfers of
Financial Assets ("SFAS 166"). SFAS 166 is a revision to Statement No. 140,
Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities, and will require more information about transfers of financial
assets, including securitization transactions, and where companies have
continuing exposure to the risks related to transferred financial assets. It
eliminates the concept of a "qualifying special-purpose entity," changes the
requirements for derecognizing financial assets, and requires additional
disclosures. SFAS 166 enhances information reported to users of financial
statements by providing greater transparency about transfers of financial
assets and a company's continuing involvement in transferred financial assets.
SFAS 166 is effective for fiscal years beginning after November 15, 2009, and
is not expected to have a material impact on our consolidated financial
statements.
14
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
within the meaning of the Private Securities Litigation Reform Act of 1995.
These forward-looking statements may be identified by the use of words such as
"believe," "expect," "anticipate," "intend," "should," "plan," "project,"
"estimate," "potential," "seek," "strive," or "try" or other conditional verbs
such as "will," "would," "should," "could," or "may" or similar expressions.
These forward-looking statements relate to, among other things, expectations
of the business environment in which we operate, projections of future
performance, perceived opportunities in the market, potential future credit
experience, and statements regarding our strategies. Our ability to predict
results or the actual effects of our plans or strategies is inherently
uncertain. Although we believe that our plans, intentions and expectations, as
reflected in these forward-looking statements are reasonable, we can give no
assurance that these plans, intentions or expectations will be achieved or
realized. Our actual results, performance, or achievements may differ
materially from those suggested, expressed, or implied by forward-looking
statements as a result of a wide variety or range of factors including, but
not limited to: the credit risks of lending activities, including changes in
the level and trend of loan delinquencies and write-offs that may be impacted
by deterioration in the housing and commercial real estate markets and may
lead to increased losses and non-performing assets in our loan portfolio,
result in our allowance for loan losses not being adequate to cover actual
losses, and require us to materially increase our reserves; changes in general
economic conditions, either nationally or in our market areas; changes in the
levels of general interest rates, and the relative differences between short
and long term interest rates, deposit interest rates, our net interest margin
and funding sources; deposit flows; fluctuations in the demand for loans, the
number of unsold homes and other properties and fluctuations in real estate
values in our market areas; adverse changes in the securities markets
including changes in the ability of the issuers of trust preferred securities
we own to repay their obligations; results of examinations of us by the
Federal Reserve Bank of San Francisco and our bank subsidiary by the Federal
Deposit Insurance Corporation ("FDIC"), the Washington State Department of
Financial Institutions, Division of Banks ("DFI") or other regulatory
authorities, including the possibility that any such regulatory authority may,
among other things, require us to increase our reserve for loan losses,
write-down assets, change our regulatory capital position or affect our
ability to borrow funds or maintain or increase deposits, which could
adversely affect our liquidity and earnings; the possibility that we will be
unable to comply with the conditions imposed upon us by the Order to Cease and
Desist issued by the DFI and the FDIC, including but not limited to our
ability to increase our capital, reduce our non-performing assets and reduce
our reliance on brokered certificates of deposit, which could result in the
imposition of additional restrictions on our operations; our ability to
control operating costs and expenses; the use of estimates in determining fair
value of certain of our assets, which estimates may prove to be incorrect and
result in significant declines in valuation; difficulties in reducing risk
associated with the loans on our balance sheet; staffing fluctuations in
response to product demand or the implementation of corporate strategies that
affect our work force and potential associated charges; computer systems on
which we depend could fail or experience a security breach, or the
implementation of new technologies may not be successful; our ability to
manage loan delinquency rates; 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 including changes in
regulatory policies and principles, including the interpretation of regulatory
capital or other rules; the availability of resources to address changes in
laws, rules, or regulations or to respond to regulatory actions; adverse
changes in the securities markets; the inability of key third-party providers
to perform their obligations to us; changes in accounting policies, principles
and practices, as may be adopted by the financial institution regulatory
agencies or the Financial Accounting Standards Board, including additional
guidance and interpretation on accounting issues and details of the
implementation of new accounting methods; the economic impact of war or any
terrorist activities; other economic, competitive, governmental, regulatory,
and technological factors affecting our operations; pricing, products and
services; our ability to lease excess space in Company-owned buildings; and
other risks detailed in this Form 10-Q and our Form 10-K for the fiscal year
ended March 31, 2009. Any of the forward-looking statements that we make in
this Form 10-Q and in the other public statements we make may turn out to be
wrong because of the inaccurate assumptions we might make, because of the
factors illustrated above or because of other factors that we cannot foresee.
Additionally, the timing and occurrence or non-occurrence of events may be
subject to circumstances beyond our control. We caution readers not to place
undue reliance on any forward-looking statements. We do not undertake and
specifically disclaim any obligation to revise any forward-looking statements
to reflect the occurrence of anticipated or unanticipated events or
circumstances
15
after the date of such statements. These risks could cause our actual results
for the remainder of 2009 and beyond to differ materially from those expressed
in any forward-looking statements by, or on behalf of, us, and could
negatively affect the Corporation's operating and stock performance.
Overview
- --------
Horizon Financial Corp. ("Horizon Financial" or the "Corporation") was
formed under Washington law on May 22, 1995, and became the holding company
for Horizon Bank ("Horizon Bank" or the "Bank") effective October 13, 1995.
At June 30, 2009, Horizon Financial had total assets of $1.36 billion, total
deposits of $1.17 billion and total equity of $47.4 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 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". Effective March 1, 2000, the Bank changed its name to its current
name, "Horizon Bank". The Bank became a member of the Federal Home Loan Bank
("FHLB") of Seattle in December 1998. Effective August 1, 2005, the Bank
converted from a state chartered savings bank organized under Title 32 of the
Revised Code of Washington ("RCW") to a state chartered commercial bank
organized under Title 30 of the RCW. The Bank's deposits are insured by the
Federal Deposit Insurance Corporation ("FDIC") up to applicable limits.
The Corporation's results of operations depend on revenue generated from
its net interest income and to a lesser extent from 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-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, mortgage origination fee income 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 real estate owned/collection
expense, compensation and benefits, occupancy, equipment, data processing,
marketing, automated teller machine costs, legal, accounting and, FDIC deposit
insurance premiums. The Corporation's results of operations may also be
affected significantly by economic and competitive conditions, changes in
market interest rates, changes in real estate market conditions, governmental
policies and actions of regulatory authorities, as well as other factors
identified under the caption "Forward Looking Statements" above.
Financial Overview
- ------------------
Highlights for the first fiscal quarter ended June 30, 2009 include the
following:
The net loss for the three months ended June 30, 2009 was $45.7 million
or $3.81 per diluted share as compared to net income of $2.0 million or
$0.17 per diluted share for the three month period ended June 30, 2008.
The loss was largely due a $35.5 million provision for loan losses, a
$19.4 million valuation allowance against the net deferred tax asset
and an increase in non-interest expenses.
The current period losses resulted in the Bank being "significantly
undercapitalized" by regulatory definition as of June 30, 2009. See
Note 2 of the notes to the consolidated financial statements.
A $19.4 million valuation allowance was taken against the net deferred
tax asset, which is comprised of tax effected cumulative temporary
differences, largely from the provision for loan losses. Management
considered all evidence available, including the tax carry-back and
carry-forward benefits, and concluded that it is more likely than not
that the majority of the net deferred tax asset will not be available
as a benefit in future periods.
During the quarter ended June 30, 2009, we charged off $204,000
associated with our measurement for other than temporary impairment of
our private label mortgage-backed securities.
The provision for loan losses for the three months ended June 30, 2009
was $35.5 million as compared to the year ago quarter of $3.0 million,
which was necessary to meet management's estimate for probable losses.
The total non-interest expense for the three months ended June 30, 2009
was $12.3 million as compared to $7.6 million for the three months
ended June 30, 2008. The largest contributors to the increase in
non-interest expense came from write-downs from other real estate
owned, an increase in FDIC premiums and higher costs associated with
loan workouts and credit administration.
16
Total non-performing assets increased to $138.4 million as of June 30,
2009 compared to $104.7 million at March 31, 2009 and $38.6 million as
of June 30, 2008 due in large part to a transition of delinquent loans
to non-accrual status.
Total assets were $1.36 billion as of June 30, 2009 as compared to
$1.47 billion as of March 31, 2009 and $1.45 billion as of June 30,
2008.
Gross loans were $1.09 billion as of June 30, 2009 as compared to $1.16
billion as of March 31, 2009 and $1.26 billion as of June 30, 2008.
The decline in loans is the result of management's efforts to
de-leverage the balance sheet by transitioning problem loans off the
balance sheet or to real estate owned in order to market the acquired
property for sale.
Total deposits were $1.2 billion as of June 30, 2009 as compared to
$1.2 billion as of March 31, 2009 and $1.1 billion as of June 30, 2008.
Management has increased core deposits by paying above average deposit
rates and focusing the retail branches on deposit gathering campaigns.
The Bank will now be limited in its ability to pay rates on deposits,
which is capped at 75 basis points above the prevailing market rate as
a result of its "significantly undercapitalized" status as of June 30,
2009.
The net interest margin for the three months ended June 30, 2009 was
1.73% as compared to the same period ended June 30, 2008 at 3.40%. The
net interest margin has declined as a result of the increase in
non-performing assets, and an increase of liquidity that is earning
lower yields than the cost of the liabilities.
The Bank's regulatory Tier 1 capital ratio was 3.97% for the quarter
ended June 30, 2009 compared to 7.29% as of March 31, 2009 and 9.31% as
of June 30, 2008. Our regulatory capital ratios have trended downward
due to the net losses resulting from provision for loan losses, the
valuation allowance for the net deferred tax asset, the increase in
non-interest expenses and lower net interest income.
Business 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 has 18
full-service offices, four commercial loan centers and four real estate loan
centers throughout Whatcom, Skagit, Snohomish and Pierce Counties in
Washington.
The Corporation's immediate business focus is to return the Bank to a
well-capitalized and profitable community bank, dedicated to a diversified
base of commercial lending, home mortgage lending, consumer lending, small
business lending and providing competitive deposit and cash-management
services to our personal and business customers. The Corporation has sought
to implement this strategy by: (i) focusing our sales efforts on commercial
banking opportunities; (ii) providing competitive, personalized financial
services to individuals and business customers served by our branch network;
(iii) selling our fixed rate mortgages to the secondary market; (iv) working
with financially challenged borrowers to achieve an efficient resolution in
order to improve asset quality; (v) prudently managing our operating expenses
by reducing compensation costs and renegotiating vendor contracts; (vi)
seeking opportunities to meet the capital requirements set forth in the Order;
(vii) increase liquidity by offering above average deposit rates in our retail
branches; though we are limited by regulation to offering deposit rates at or
below the limitation of 75 basis points above the prevailing market rate as a
result of the Bank's status as a "significantly undercapitalized" institution
as of June 30, 2009; and (viii) reducing reliance on FHLB borrowings and
brokered CDs, as we are currently prohibited from accepting or renewing
brokered deposits.
One of our high priorities from the above business focus list is to
increase the regulatory capital levels to the required level and to improve
asset quality and deleverage the balance sheet. We mobilized our efforts
beginning with the quarter ended September 30, 2008 when we expanded our
special assets team, which is responsible for working out problem assets that
have grown substantially over the past nine months ended June 30, 2009. We
have successfully shifted some of our lending personnel within the Bank to
assist with loan workouts, collections and monitoring. Our capital raise
strategy includes the engagement of professional investment bankers to assist
with the process of identifying and securing a capital injection.
The primary long-term business strategy of the Bank is to acquire funds
in the form of deposits gathered from our retail branches and to use the funds
to originate 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 and brokered deposits from its current
levels as it focuses on deleveraging its balance sheet. In the future, once
it has returned to adequately capitalized status or better and is no longer
subject to regulatory restrictions on its asset growth, the Bank expects to
increase loans at a pace that is consistent with its ability to grow core
deposits in its retail and commercial branch network.
17
Comparison of Financial Condition at June 30, 2009 and March 31, 2009
- ---------------------------------------------------------------------
Overview. Our assets are comprised primarily of loans for which we
receive interest and principal repayments from our customers, as well as cash
and investment securities. Total consolidated assets for the Corporation at
June 30, 2009, decreased to $1.36 billion or 7.3% from $1.47 billion at March
31, 2009. This decrease in assets was primarily attributable to a decrease in
net loans receivable to $1.03 billion as of June 30, 2009 compared to $1.12
billion as of March 31, 2009.
Loans. Total loans receivable decreased $76.4 million or 6.6% during the
first quarter of fiscal 2010 to $1.09 billion at June 30, 2009 compared to
$1.16 billion at March 31, 2009. The decrease in total loans receivable was
attributable to reductions in several loan categories, including a $38.6
million decrease in commercial construction loans, $15.4 million in commercial
land development loans, $12.1 million in one-to-four family mortgage loans and
$8.7 million in commercial business loans. The commercial construction
category includes commercial speculative one-to-four family (large one-to-four
family developments and condominium projects), multifamily and commercial.
These reductions were the result of a combination of factors, including
management's efforts to work out of specific loans resulting in payoffs, $17.6
million in loan balances were transferred to the Bank's real estate owned and
borrower's paid down principal balances.
As reflected in the table below, approximately 63.4% of our total net
loan portfolio consists of commercial and multifamily real estate and
construction and land development loans.
The following is an analysis of the loan portfolio by major loan
categories:
June 30, % March 31, %
(Dollars in thousands) 2009 of Portfolio 2009 of Portfolio
------- ------------ -------- ------------
One-to-four family mortgage
loans
One-to-four family $ 153,005 14.1% $ 167,048 14.4%
One-to-four family
construction 21,396 1.9% 28,290 2.4%
Less participations sold (34,006) (3.1)% (42,853) (3.7)%
---------- ----- ---------- -----
Net one-to-four family
mortgage loans 140,395 12.9% 152,485 13.1%
Commercial land development 171,198 15.8% 186,580 16.0%
Commercial construction (1) 183,579 16.9% 222,207 19.1%
Multifamily residential 55,180 5.1% 51,970 4.5%
Commercial real estate 278,928 25.6% 281,481 24.2%
Commercial business loans 193,307 17.8% 201,973 17.4%
Home equity secured 54,387 5.0% 58,228 5.0%
Other consumer loans 9,301 .9% 7,717 .7%
---------- ----- ---------- -----
Subtotal 945,880 87.1% 1,010,156 86.9%
---------- ----- ---------- -----
Total loans receivable 1,086,275 100.0% 1,162,641 100.0%
---------- ----- ---------- -----
Less:
Allowance for loan losses (51,499) (38,981)
---------- ----------
Net loans receivable $1,034,776 $1,123,660
========== ==========
Net residential loans $ 136,680 13.2% $ 149,625 13.3%
Net commercial business loans 182,117 17.6% 193,687 17.2%
Net commercial real estate
loans (2) 655,616 63.4% 716,743 63.8%
Net consumer loans (3) 60,363 5.8% 63,605 5.7%
---------- ----- ---------- -----
$1,034,776 100.0% $1,123,660 100.0%
========== ===== ========== =====
(1) Includes $33.6 million and $37.2 million in condominium construction
projects at June 30, 2009 and March 31, 2009, respectively.
(2) Includes construction and development, multi-family and commercial real
estate loans.
(3) Includes home equity and other consumer loans.
Management is focused on a strategy to reduce the level of exposure to
construction and land development loans at this time during the economic
slowdown and has discontinued this type of lending. The current concentration
level could subject us to further losses resulting from declines in real
estate values and the related effects on our borrowers. As a result of the
volatile real estate market, we have recognized the risk in construction loans
in our allowance for loan losses.
18
Management intends to continue reducing its concentration in construction and
land development loans in order to improve liquidity and mitigate the risk to
future losses.
The following table is provides additional details on the Corporation's
construction and land development loan portfolio:
June 30, 2009 March 31, 2009
----------------- -----------------
(Dollars in thousands) Amount Percent Amount Percent
------ ------- ------ -------
Speculative construction one-to-four
family $ 13,374 3.6% $ 19,280 4.4%
Custom construction one-to-four
family 8,022 2.1% 9,010 2.1%
-------- ----- -------- -----
Total one-to-four family
construction 21,396 5.7% 28,290 6.5%
Commercial speculative construction
one-to-four family 107,362 28.6% 142,315 32.6%
Commercial construction multi family 4,306 1.1% 8,439 1.9%
Commercial construction 71,911 19.1% 71,453 16.3%
Commercial residential land
development 171,198 45.5% 186,580 42.7%
-------- ----- -------- -----
Total commercial construction and
land development 354,777 94.3% 408,787 93.5%
-------- ----- -------- -----
Total construction loans $376,173 100.0% $437,077 100.0%
======== ===== ======== =====
Federal Home Loan Bank ("FHLB") Stock. The investment in the FHLB of
Seattle stock totaled $7.25 million as of June 30, 2009 as compared to $10.0
million as of the same period one year ago. The investment in the FHLB stock
is a restricted investment carried at par value ($100 per share), which
approximates its fair value.
Management has evaluated the FHLB stock for impairment by giving
consideration to the length of time the FHLB of Seattle is likely to withhold
cash dividends, redeem stock, and meet commitments to make payments. We are
carefully evaluating the impact of regulatory capital changes and the
liquidity position on the potential for impairment. We have reviewed the most
recent unaudited financial statements included in the March 31, 2009 Form 10-Q
filing of the FHLB of Seattle. The Form 10-Q filing noted that the FHLB of
Seattle did not meet one of the three statutory capital requirements. The
three capital requirements are 1) risk-based capital, 2) capital-to-asset
ratio, and 3) leverage capital ratio. The FHLB of Seattle did not meet the
risk-based capital requirements as of March 31, 2009, but was in compliance
with the other two statutory capital ratios. It was further noted in the Form
10-Q of the FHLB of Seattle that a recovery in the market value of the
private-label mortgage-backed securities held by the FHLB of Seattle occurred
in January and February 2009, which allowed the FHLB of Seattle to redeem
$669,000 of Class B capital stock. On February 28, 2009, stock redemptions
were once again halted when the private-label securities were downgraded by a
rating agency. The FHLB of Seattle Board of Directors has taken steps to
restore the risk-based capital by suspending the issuance of Class A stock,
issuing only Class B stock (considered permanent capital) and suspended the
redemption and repurchase of Class A and Class B stock and the payment of
dividends until such time the deficiency of the risk-based capital ratio is
corrected.
The FHLB of Seattle reported a $16.3 million loss for the quarter ended
March 31, 2009. The FHLB of Seattle attributes its first quarter 2009 net
loss primarily to $71.7 million of OTTI charges on certain of its
private-label mortgage-backed securities that are classified as
held-to-maturity. As a result of its net loss for the first quarter 2009, the
FHLB of Seattle also reported a $1.1 billion accumulated other comprehensive
loss and total capital of $961 million as of March 31, 2009, as compared with
total capital of $1.8 billion as of December 31, 2008. The OTTI recognized in
accumulated other comprehensive loss is accreted to the carrying value of each
security on a prospective basis, based on the amount and timing of future cash
flows, over the remaining life of each security. The accretion increases the
carrying value of each security and does not affect earnings unless the
security is subsequently sold or has an additional OTTI charge that is
recognized in earnings. The FHLB of Seattle's first quarter 2009 OTTI charge
reflects the effects of isolating the portion of the loss that is directly
associated with the other than temporary impairment of the private-label
mortgage-backed securities. As a result of our review and intent to hold the
security to maturity, the Corporation has not recorded an OTTI charge on its
investment in FHLB of Seattle stock.
Investment Securities. The Bank's investment portfolio is comprised of
the following securities: government agencies, municipal bonds,
mortgage-backed securities, collateralized mortgage obligations ("CMOs") and
common stock. The total carrying amount of these securities was $63.4 million
as of June 30, 2009 as compared to $66.9 million as of March 31, 2009, which
represented a decrease of $3.5 million or 5.2%. During the quarter ended June
30, 2009, the Bank elected not to renew maturing securities or replace pay
downs of principal with new investment securities.
19
The table below presents the available for sale ("AFS") and
held-to-maturity ("HTM") amortized cost, fair value and unrealized gain or
loss as of June 30, 2009:
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 $25,534 $ 824 $ (13) $(331) $26,014
Marketable equity
securities 562 588 (108) - 1,042
Mortage-backed
securities and
collateralized
mortgage
obligations (CMOs) 35,082 1,634 - (352) 36,364
------- ------ ----- ----- -------
Total available-for-
sale securities 61,178 3,046 (121) (683) 63,420
------- ------ ----- ----- -------
HTM Securities
Mortgage-backed
securities and CMOs 8 3 - - 11
------- ------ ----- ----- -------
Total held-to-
maturity securities 8 3 - - 11
------- ------ ----- ----- -------
Total securities $61,186 $3,049 $(121) $(683) $63,431
======= ====== ===== ===== =======
Certain investment securities shown above currently have fair values less
than amortized cost and therefore contain unrealized losses. At June 30, 2009,
the Corporation has evaluated these securities and determined that the decline
in value was temporary and related to the change in market interest rates
since purchase as well as the current instability in the credit markets. The
decline in value was not related to any company or industry specific event. At
June 30, 2009, there are 60 investment securities exceeding a twelve month
period with an amortized cost of $5.7 million. The Corporation anticipates
full recovery of amortized cost with respect to these securities at maturity
or sooner in the event of more favorable market interest rates.
Management evaluated securities for other-than-temporary impairment at
least on an annual basis, and more frequently when economic or market concerns
warrant such evaluation. Consideration is given to: (1) the length of time and
extent to which the fair value has been less than cost, (2) the financial
condition and near term prospects of the issuer and (3) intent and ability to
retain a security for a period of time sufficient to allow for any anticipated
recovery in fair value. Declines in the fair value of available for sale and
held to maturity securities below their cost that are deemed to be
other-than-temporary are reflected in earnings as realized losses. During the
quarter ended June 30, 2009, the Bank recognized a $204,000 OTTI charge
related to 19 non-agency private-label mortgage-backed securities. These
private label mortgage-backed securities are included in investments available
for sale where the default rates, declines in investment ratings and loss
severities of the underlying collateral indicate credit losses have occurred
that are not expected to be recovered. The measured loss has been identified
with the credit component of the securities and is not reflective of a
temporary change in market value. These securities were valued by third party
pricing services using readily available market quotes. There were no similar
charges recorded during the three months ended March 31, 2009 and June 30,
2008.
The table below presents the AFS and HTM maturity schedule of the
securities as of June 30, 2009:
Maturity Schedule of Securities at June 30, 2009
-----------------------------------------------
Available-For-Sale Held-To-Maturity
---------------------- ----------------------
Amortized Estimated Amortized Estimated
(In thousands) Cost Fair Value Cost Fair Value
--------- ---------- --------- ----------
Maturities:
Less than one year $ 1,244 $ 1,259 $ - $ -
One to five years 12,307 12,958 - -
Over five to ten years 22,606 23,125 8 11
Over ten years 24,459 25,036 - -
------- ------- ---- ----
60,616 62,378 8 11
------- ------- ---- ----
Mutual funds and marketable
equity securities 562 1,042 - -
------- ------- ---- ----
Total investment securities $61,178 $63,420 $ 8 $ 11
======= ======= ==== ====
20
The following table shows securities, which were pledged to secure
borrowings, public deposits, repurchase agreements and other items, as
permitted or required by law at June 30, 2009:
Book Market
(In thousands) Value Value
------- -------
To the Federal Home Loan Bank to secure borrowings $ 4,770 $ 5,007
To the Federal Reserve Bank to secure borrowings 7,999 8,305
To state government to secure public funds 11,917 12,528
To secure repurchase agreements 10,946 11,135
To the Federal Reserve Bank to secure customer tax
payments 914 977
Other pledged investments 2,197 2,316
------- -------
$38,713 $40,268
======= =======
Asset Quality and Non-Performing Assets. The Corporation manages its
credit risk exposure by managing the loan concentrations, ensuring sufficient
underwriting policies and procedures, conducting loan reviews, and monitoring
overall best practices. Delinquent and problem loans, however, are a part of
any financial institution and become the responsibility of the special assets
group to monitor and work out. 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. There are several elements that contribute to
management's estimate of the allowance for loan losses ("ALLL"). The
foundation of our ALLL begins with a proper loan grading system. The loan
grading system ensures that loans are properly graded based on the risk
profile which takes into account such factors as net worth, cash flow,
capacity to service debt, eligible collateral and financial capacity of
guarantors (if applicable). Our loan grading system ranges from 1 8, with a
"1" being considered a prime borrower of strong financial capacity and an "8"
being a loan classified as a loss. Loans that are identified to be "high"
risk (rating a 6 or above) are defined as adversely classified. The loan
grading system is the responsibility of our Credit Administration, which
administers the internal controls and oversight to ensure the loan grading
system identifies, classifies and monitors all graded loans. We regularly
evaluate our loan portfolio to ensure the accuracy of risk ratings throughout
the life of the loans.
The measurement of the ALLL is a culmination of the two separate
measurements performed in accordance with FASB SFAS No. 5 and No. 114. The
measurement for contingent losses for SFAS 114 are measured for impairment at
the individual loan level, whereas for SFAS 5 they are analyzed by applying
loss rates to the aggregate groups of loan balances with common risk
characteristics. Each of these are explained in greater detail in the
subsequent paragraphs.
The work performed in accordance with SFAS No. 114 measures individual
loans for impairment when it is probable that the Bank will be unable to
collect all amounts due (including both interest and principal) according to
the contractual terms of the loan agreement. These loans are often defined as
adversely classified and are measured by the most appropriate method using
either the present value of the expected future cash flows, or the net
realizable value (fair value of collateral less costs to complete and sell),
or the loan's observable market price. The majority of our impaired loans as
of June 30, 2009 were measured using the net realizable value since the loans
were dependent upon the sale of collateral to meet the obligation. The
process of measuring for impairment includes obtaining market appraisals and
estimating the costs to complete and sell the collateral supporting the loan.
Management does apply judgment and estimates to measuring a collateral
dependent loan for impairment. Management may consider other sources for
information such as internet websites that publish fair values of properties
and track market changes in real estate values as well as published
subscriptions to industry experts such as RealEstats. The information
obtained from recent appraisals and other sources for information resulted in
an increase in loans measured for impairment on an individual basis in
accordance with SFAS 114, which contributed to the $35.5 million provision for
loan losses at June 30, 2009, which increased the allowance for loan losses
from $39.0 million at March 31, 2009 to $51.5 million at June 30, 2009.
The loans that do not meet the definition for "impairment" are aggregated
into separate pools based on loan type and loan risk (grade) in accordance
with FASB SFAS No. 5. A loan loss rate is applied to each pool using a range
of values obtained from historical data published from relevant sources or the
Bank's own loan loss experience. The range of loss rates used in our SFAS 5
analysis at June 30, 2009 were from a low of 0.16% to a high of 9.24%. The
calculated range of loss rates were applied to the corresponding loan pools
based on risk characteristics in order to arrive at the measured reserve
amount for unallocated loans. Management does consider other factors that
influence the reasonable range for the SFAS 5 estimated contingent losses.
Some of the qualitative factors influencing the SFAS 5 calculations include:
1) trends in charge-offs, 2) trends in delinquent loans, 3) trends in
non-performing loans, 4) changes in the nature and volume of loans, 5)
experience and ability of lending management, 6) trends in adversely
classified loans, 7) changes in loan concentration, and
21
8) national and local economics. Based on management's methodology and best
estimate, we measured the accounting contingent loss for the SFAS 5 portion of
the allowance to be above the mid-point of the range due to the influence of
the negative trends of the qualitative factors.
The ALLL reflects the aggregate amount of the two separate measurements
described above (SFAS 5 and SFAS 114), which as of June 30, 2009 totaled $51.5
million. The methodology for measuring the ALLL is documented in our policies
and reflects management's best estimate of future probable loan losses, which
have been carefully reviewed and approved by our Board of Directors. 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.
The following table summarizes the allowance for loan losses,
charge-offs, and loan recoveries:
For the Quarter Ended
--------------------------------
June 30, March 31, June 30,
2009 2009 2008
------- -------- -------
(Dollars in thousands)
Allowance at beginning of period $ 38,981 $ 25,309 $ 19,114
Provision for loan losses 35,521 40,000 3,000
Charge offs (net of recoveries) (23,003) (26,328) (2,965)
-------- -------- --------
Allowance at end of period $ 51,499 $ 38,981 $ 19,149
======== ======== ========
Allowance for loan losses as a percentage
of gross loans receivable at the end of
the period 4.74% 3.35% 1.51%
Allowance for loan losses as a percentage
of net loans receivable at the end of
the period 4.98% 3.47% 1.54%
Net charge-offs as a percentage of average
loans outstanding during the period 2.08% 2.24% 0.24%
Allowance for loan losses as a percentage
of non-performing loans 44.43% 45.63% 53.46%
Allowance for loan losses as a percentage
of non-performing assets 37.20% 37.25% 49.63%
The allowance for loan losses reflects the estimated losses and is
adjusted through the provision for loan losses, which is charged to earnings.
Loan charge-offs against the allowance occur when management believes the
collection of the identified loan balance is not likely to occur. Subsequent
recoveries, if any, are credited to the allowance.
Liability for Unfunded Loan Commitments. At June 30, 2009, the unfunded
loan commitments were reviewed and measured for an accounting loss estimate.
The reserve for unfunded commitments is increased or decreased through charges
through income included in other non-interest expense. The unfunded loan
commitments were analyzed in a manner similar to the allowance for loan loss
methodology. The unfunded loan commitments were grouped by risk rating and an
estimated loss estimate was applied to each group with similar risk
characteristics. As of June 30, 2009, the amount of loss estimate for the
liability for unfunded loan commitments was measured to be in the amount of
$600,000, which is lower from March 31, 2009 when the liability for unfunded
loan commitments was $800,000. The reduction in the unfunded loan commitment
was due in large part to a decline in the outstanding amount of loan
commitments; thereby reducing the overall risk exposure and requiring a lower
reserve for contingent losses. Loan commitments have fallen from $223.3
million as of March 31, 2009 to $182.0 million as of June 30, 2009, a decline
of $41.3 million or 18.5%.
Non-Performing Assets. As of June 30, 2009, there was one loan in the
loan portfolio over 90 days delinquent and accruing interest and 50 loan
relationships on non-accrual status. At June 30, 2009, total non-performing
loans were $115.9 million compared to $85.4 million at March 31, 2009 and
$35.8 million at June 30, 2008. The Bank had 24 properties in the real estate
owned category totaling $22.5 million at June 30, 2009. Total non-performing
assets represented $138.4 million,
22
or 10.2% of total assets at June 30, 2009 compared to $104.7 million or 7.1%
of total assets at March 31, 2009 and $38.6 million or 2.7% of total assets at
June 30, 2008.
Troubled Debt Restructured ("TDR") assets represented $29.0 million, or
2.1% of total assets at June 30, 2009 compared to $26.4 million or 1.8% of
total assets at March 31, 2009 and there were no TDRs at June 30, 2008. The
TDRs at June 30, 2009 were all accruing, except two loans totaling $2.6
million which are on nonaccrual. Management is working with the borrowers to
work out a plan to either return the borrower to accruing status or take
appropriate measures to secure the collateral for disposition.
The following table summarizes 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 June 30, As of March 31,
-------------------- --------------
Non-performing assets 2009 2008 2009
-------- ------- --------------
(Dollars in thousands)
Accruing loans - 90 days past due $ 14 $ - $ 500
Non-accrual loans 115,894 35,819 84,924
-------- ------- --------
Total non-performing loans 115,908 35,819 85,424
Real estate owned 22,537 2,764 19,227
-------- ------- --------
Total non-performing assets $138,445 $38,583 $104,651
======== ======= ========
Total non-performing loans/gross loans 10.67% 2.83% 7.35%
Total non-performing assets/total
assets 10.17% 2.67% 7.13%
Total non-performing assets to total
capital plus allowance for loan losses 140.21% 26.32% 79.28%
Troubled debt restructuring at the end
of the period $ 29,039 $ - $ 26,383
======== ======= ========
The non-performing assets by loan classification as well as location of
the non-performing assets by county (Whatcom, Skagit, Snohomish, King and
Pierce county areas of Washington) are presented in the table below. The two
loan categories titled commercial land development and commercial construction
comprise 82% of the non-performing assets; whereas the two counties with the
most non-performing assets are Snohomish and and Pierce counties with $77.4
million or 55.9% of the non-performing assets. These areas in which our
non-performing assets reside represent the focus of our special assets group
to mitigate the risk for losses. The regional economy is making it difficult
to reduce the level of non-performing collateral dependent loans because of
the challenges with selling the underlying collateral. One of the indicators
monitored by management is the available housing inventory levels, which
estimates the average number of months that it would take to eliminate the
available housing inventory at the current level of sales. For the month
ending June 30, 2009, according to RealEstats, Inc, the available housing
inventory levels for Snohomish, Skagit, Pierce, King and Whatcom counties were
8.8, 11.8, 7.6, 6.8 and 7.0 months, respectively. This is an improvement from
the levels at March 31, 2009, which were 14.5, 16.0, 10.9, 11.5 and 10.4
months, respectively, according to RealEstats, Inc. This information is
helpful to understanding some of the historical trends that have an might
impact on our ability to reduce non-performing assets and mitigate future
losses.
23
The following table summarizes the Bank's total non-performing assets at
June 30, 2009 by county and by classification:
Thurston/
Non-performing Assets by Whatcom Skagit Snohomish King Pierce Other Total % of
Classification County County County County County County NPAs NPAs
------- ------ --------- ------ ------ ------ -------- -----
(Dollars in thousands)
<s> <c> <c> <c> <c> <c> <c> <c> <c>
One-to-four family
residential $ 3,226 $ - $ 425 $ - $ 1,990 $ - $ 5,641 4%
One-to-four family
construction 382 - 601 - 1,095 - 2,078 2%
------- ------ ------- ------- ------- ------- -------- ---
Subtotal 3,608 - 1,026 - 3,085 - 7,719 6%
Commercial land development 8,559 162 30,577 5,149 14,835 10,898 70,180 51%
Commercial construction (1) 278 920 4,963 19,348 12,845 3,750 42,104 31%
Multi-family residential - - - - - - - -
Commercial real estate 1,993 5,628 8,250 - - - 15,871 11%
Commercial business 190 350 - - - - 540 -
Home equity secured 73 96 55 - 1,732 - 1,956 1%
Other consumer 70 5 - - - - 75 -
------- ------ ------- ------- ------- ------- -------- ---
Subtotal 11,163 7,161 43,845 24,497 29,412 14,648 130,726 94%
Total non-performing assets $14,771 $7,161 $44,871 $24,497 $32,497 $14,648 $138,445 100%
======= ====== ======= ======= ======= ======= ======== ===
(1) The commercial construction totals include $9.1 million in condominium construction projects, with the
majority of the remaining balance consisting of various commercial speculative one-to-four family
construction projects.
In addition, at June 30, 2009 the Bank identified $103.3 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 or troubled-debt
restructuring; therefore, they 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.
Real Estate Owned. Real estate owned ("REO") 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 REO being
shown in other noninterest income or expense.
The following table summarizes changes in the REO portfolio during the
three months ended June 30, 2009 and 2008:
For the Three Months Ended
June 30,
2009 2008
------ ------
(In thousands)
Balance at beginning of period $ 19,227 $ 655
Additions to REO 17,620 2,109
Valuation adjustments (695) -
Disposition of REO (13,615) -
-------- -------
Balance at end of period $ 22,537 $2,764
======== ======
24
The Corporation recognized write-downs or losses on REO of $1.4 million
for the three months ended June 30, 2009 compared to no loss for the three
months ended June 30, 2008 related to the disposition of properties. At June
30, 2009 there were 24 projects totaling $22.5 million held in REO, 10 of
which are located in Snohomish County, seven in Whatcom County, two projects
each in Skagit, King and Pierce Counties and one project in Thurston County.
The 10 projects in Snohomish County include one 7.44 acre parcel of
commercially zoned raw land, two projects with five completed homes, two
projects with 10 completed homes and 32 building lots, three projects with 59
building lots, one undeveloped piece of land and one condominium project with
15 unsold units. The Whatcom County properties include four parcels of land,
one finished house, one mini storage facility and one project with 16 building
lots. The Skagit County properties include one project with two finished
homes and one project with four building lots. The Pierce County properties
include one building lot and one project with one home and 10 building lots.
The King County properties include a condominium conversion project with one
unsold unit (out of an original 57 unit project) located in Ballard,
Washington, just north of Seattle and one project with 12 building lots. The
Thurston County property is a project with 28 building lots. In addition to
our efforts to market these properties directly to potential purchasers, the
Bank enlists the services of various industry experts to assist in these
disposition efforts. The majority of the real estate owned detailed above is
finished homes under purchase and sale agreements.
Management of the Bank continually evaluates loans in nonaccrual status
for possible foreclosure or deed in lieu opportunities, at which point these
loans would then become other real estate owned. Management views this as an
ordinary part of the collection process and efforts are continually maintained
to reduce and minimize such non-performing assets.
Investment in Real Estate Joint Venture. The investment in real estate
for a joint venture as of June 30, 2009 was $18.1 million. The largest
component of the joint venture was created in 2005 when Westward Financial, a
50% partner in GBNW (Greenbriar Northwest LLC), purchased an 85 acre parcel of
land in Bellingham, Washington for future development known as Fairhaven
Highlands. The smaller portion of the joint venture includes some residual
from the net investment in a residential development joint venture that has
been completed. In connection with the joint venture, there is a $24.5
million liability presented on the Consolidated Statements of Financial
Position, which 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. A
Preliminary Draft Environment Impact Statement ("EIS") is expected to be
available in August 2009 on the city's website at www.cob.org and is open for
public comment for a 45 day period. 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 assurance can be
made as to when (or if) this project will be approved for future development.
The joint venture is exposed to the same market 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.
The investment in GBNW is a variable interest entity as provided in the
accounting guidance FIN 46(R) and is consolidated in the Corporation's
financial statements. As of June 30, 2009, the real estate joint venture had
a consolidated carrying amount of $27.2 million, with a related borrowing of
$24.5 million before consolidation treatment under FIN 46(R). During the
process of consolidation, inter-company transactions were eliminated;
including the $24.5 million loan receivable and the associated $7.2 million in
capitalized interest receivable from GBNW and payable to Horizon Bank. These
inter-company transactions were eliminated in the consolidation process and
represent our accounting for the terms and conditions established between the
companies.
The Corporation adopted SFAS No. 160, Noncontrolling Interests on April
1, 2009. As a result, we reclassified $119,000 of minority interest
liabilities from liabilities to equity on our balance sheet. Noncontrolling
interests' share of net income (loss) was $(15,000) and $(3,000) for the three
months ended June 30, 2009and 2008, respectively.
As of our fiscal year-end, March 31, 2009, we conducted a review of the
accounting treatment and measured the value of the GBNW joint real estate
development for potential impairment and whether to continue capitalizing
interest. We took the following steps to ensure compliance with generally
accepted accounting principles: (1) performed a recoverability test under SFAS
144 (Accounting for the Impairment or Disposal of Long-Lived Asset) and (2)
evaluated the capitalization of interest in conformity with SFAS 34
(Capitalization of Interest Cost). The conclusion of the recoverability test
determined that the Fairhaven Highland development was positively accretive,
which then supported the continuation for capitalization of interest during
the development phase of the project. At June 30, 2009, we reviewed the
analysis and there was no change in our conclusion from March 31, 2009.
25
Deposits. Total liabilities decreased $61.1 million or 4.5% to $1.31
billion at June 30, 2009, from $1.37 billion at March 31, 2009. This decrease
in liabilities was primarily the result of a decrease in deposits, which
decreased 4.7% to $1.17 billion at June 30, 2009 from $1.23 billion at March
31, 2009 as brokered certificates of deposit ("CDs"), matured and paid off.
This is consistent with the Bank's current operating strategy as required by
regulators to eliminate our reliance on brokered certificates. The Bank may
not accept or renew additional brokered deposits, which will be paid with
available liquid funds and funds generated from the sale of loans and growth
in core deposits.
The following is an analysis of the deposit portfolio by major type of
deposit at June 30, 2009 and March 31, 2009:
June 30, March 31,
(In thousands) 2009 2009
---------- ----------
Core deposits
Savings $ 15,980 $ 15,850
Checking 81,349 83,286
Checking (noninterest-bearing) 92,988 80,103
Money Market 125,586 133,022
Certificates of deposit less than $100,000 353,910 352,785
---------- ----------
669,813 665,046
---------- ----------
Other deposits
Certificates of deposit $100,000 and above 290,440 303,308
Brokered certificates of deposit 211,925 261,410
---------- ----------
502,365 564,718
---------- ----------
Total deposits $1,172,178 $1,229,764
========== ==========
Borrowings. The Bank has two available borrowing lines of credit that it
uses to provide a source of cash and manage liquidity. The lines of credit
are with the Federal Home Loan Bank of Seattle ("FHLB") and the other is with
the Federal Reserve Bank of San Francisco ("FRB"). As of June 30, 2009, our
borrowing capacity at the FHLB was $125.5 million and at the FRB it was
approximately $7.0 million. As of June 30, 2009, we had outstanding at the
FHLB a total of $125.5 million as compared to $129.5 million at March 31,
2009. At the FRB, we had no balance outstanding as of June 30, 2009 and March
31, 2009. As the Bank receives funds from other sources (i.e. its retail
deposit base, loan paydowns, sale of loans, etc.), the Bank intends to paydown
a portion of its FHLB borrowings.
Stockholders' Equity. Stockholders' equity at June 30, 2009 decreased
$45.8 million or 49.2% to $47.4 million from $93.2 million at March 31, 2009.
This decrease was the result of the net loss of $45.7 million for the three
months ended June 30, 2009. The Corporation has conducted various stock
buy-back programs since August 1996; however at this time our strategy is to
preserve and manage capital to ensure compliance with the Order and the other
regulatory restrictions to which we are now subject. Therefore, the
Corporation did not renew its stock repurchase plan that would have run
concurrent with the 2010 fiscal year. The Corporation's stockholder
equity-to-assets ratio was 3.5% at June 30, 2009, compared to 6.3% at March
31, 2009.
Comparison of Operating Results for the Three Months Ended June 30, 2009 and
- ----------------------------------------------------------------------------
June 30, 2008
- -------------
General. The Corporation recognized a net loss of $45.7 million for the
three months ended June 30, 2009 compared to net income of $2.0 million for
the three months ended June 30, 2008. Diluted loss per share for the three
months ended June 30, 2009 was $(3.81) on weighted average diluted shares
outstanding of 11,981,529, compared to diluted earnings per share of $0.17 on
weighted average diluted shares of 11,965,778 for the three months ended June
30, 2008.
Net Interest Income. Net interest income before provision for loan
losses for the three months ended June 30, 2009 decreased $5.7 million or
50.4% to $5.6 million from $11.2 million for the comparable period in 2008.
Total interest income decreased 32.0% in the quarter ended June 30, 2009 to
$14.5 million from $21.4 million in the quarter ended June 30, 2008.
Interest income on loans for the quarter ended June 30, 2009 decreased 33.1%
to $13.7 million, from $20.4 million for the comparable quarter a year ago.
This decrease was a result of a combination of factors, including a 175 basis
point drop in the Prime rate from the prior year. Each 25 basis point decline
in the Prime rate equates to a reduction of approximately $675,000 in interest
income on an annual basis. Also contributing to this decline was $1.7 million
in interest reversals related to the increase in non-accrual loans during the
three months ended June 30 2009 compared to $1.1 million for the quarter ended
June 30, 2008.
26
Also included in interest income for the three months ended June 30, 2009
and 2008 were $520,000 and $1.1 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
June 30, 2009 and 2008:
For the Three Months Ended
June 30,
--------------------------
2009 2008
------- ------
(In thousands)
Commercial loan deferred fees $ 414 $ 970
One-to-four real estate mortgage loan deferred fees 106 177
----- ------
Total $ 520 $1,147
===== ======
Interest on investments and mortgage-backed securities decreased 10.1% to
$864,000 for the three months ended June 30, 2009 from $961,000 for the
comparable period a year ago. Contributing to this decline was a drop in
interest income received from non-agency collateralized mortgage obligations
and the elimination of the FHLB of Seattle's cash dividend during the quarter
ended December 31, 2008. The decline in non-agency collateralized mortgage
obligation interest income is a result of rising delinquency rates and
foreclosures within the individual mortgages underlying the securities. The
drop in interest income from the 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 expense for the quarter ended June 30, 2009 decreased
11.8% to $9.0 million from $10.2 million for the quarter ended June 30, 2008.
Interest on deposits decreased to $8.3 million for the three months ended June
30, 2009 from $8.6 million for the three months ended June 30, 2008 as a
result of an overall lower level of interest rates compared to the previous
period. At June 30, 2009, approximately 43% 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 49 basis points to 2.76% for the three months ended June
30, 2009 from 3.25% for the same three months in 2008, due to lower market
rates.
Interest on borrowings decreased to $725,000 during the quarter ended
June 30, 2009, compared to $1.6 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 June
30, 2009 of $125.6 million compared to $222.5 million during the quarter ended
June 30, 2008, as well as lower interest rates during the current period. The
Bank's average cost of borrowings decreased 55 basis points to 2.31% for the
three months ended June 30, 2009 from 2.86% for the same three months in 2008.
The Bank's average cost of funds decreased 46 basis points to 2.72% for the
three months ended June 30, 2009 from 3.18% for the same three months in 2008.
The effect of the changes in the interest-earning asset yield and
interest-bearing liability costs have reduced the net interest margin from
3.40% for the quarter ended at June 30, 2008 to 1.73% for the quarter ended
June 30, 2009. The most significant factor contributing to the decline in the
net interest margin occurred from the drop in loan yields as a result of our
inability to collect interest income on non-performing loans, the variable
priced loans tied to the Prime rate re-pricing lower and the reversal of
interest income from the addition of loans migrating to non-accrual status.
Management believes that the pressure on loan yields will continue to result
in below normal net interest margins in the near-term future.
27
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 June 30,
-----------------------------------------------------
2009 2008
-------------------------- --------------------------
Average Average
Average Yield/ Average Yield/
Balance Interest Cost Balance Interest Cost
(Dollars in thousands) ------- -------- ------ ------- -------- ------
Interest-earning assets:
Loans receivable $1,104,524 $13,684 4.96% $1,231,791 $20,446 6.64%
Investment securities 180,972 864 1.91% 89,020 961 4.32%
---------- ------- ------ ---------- ------- ------
Total interest-
earning assets $1,285,496 $14,548 4.53% $1,320,811 $21,407 6.48%
Interest-bearing liabilities:
Deposits 1,196,743 8,257 2.76% 1,056,157 8,587 3.25%
Borrowings 125,627 725 2.31% 222,470 1,593 2.86%
---------- ------- ------ ---------- ------- ------
Total interest-
bearing
liabilities $1,322,370 $ 8,982 2.72% $1,278,627 $10,180 3.18%
------- -------
Net interest income $ 5,566 $11,227
======= =======
Interest rate spread 1.81% 3.30%
Net interest margin 1.73% 3.40%
Ratio of average interest-earning
assets to average interest-
bearing liabilities 97.21% 103.30%
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. The provision for loan losses was $35.5 million for the three
months ended June 30, 2009 compared to $40.0 million for the three months
ended March 31, 2009 and $3.0 million for the three months ended June 30,
2008. These provisions reflect management's ongoing analysis of the changes
in loan portfolio concentrations, changes in loan balances, the loan risk
ratings of the portfolio, loss experience, individual valuations of impaired
loans and the current economic conditions. The allowance for loan losses was
$51.5 million, or 4.98% of net loans receivable at June 30, 2009, compared to
$39.0 million, or 3.47% of net loans receivable at March 31 2009 and $19.1
million, or 1.54% of net loans receivable at June 30, 2008. The $35.5 million
provision for loan losses contributed to a significantly higher allowance
resulting from a combination of the following factors in addition to the
continued negative economic outlook; 1) higher level of non-performing loans
at June 30, 2009 of $115.9 million compared to $85.4 million at March 31, 2009
and $35.8 million at June 30, 2008, 2) a relatively high level of
delinquencies on performing loans, though down from the preceding quarter,
with 30 to 89 days past due at June 30, 2009 totaling $29.4 million compared
to $83.9 million at March 31, 2009 and $13.4 million at June 30, 2008, and 3)
a continued high level of net charge-offs at $23.0 million for the quarter
ended June 30, 2009 compared to $26.3 million and $3.0 million for the
quarters ended March 31, 2009 and June 30, 2008, respectively.
Risks contributing to this increase in provision are discussed in more
detail in the section entitled "Asset Quality and Non-Performing Assets -
Allowance for Loan Loss."
Noninterest Income. Noninterest income for the three months ended June
30, 2009 decreased 29.7% to $1.6 million compared to $2.3 million for the same
period a year ago. Service fee income decreased 13.5% to $830,000 for the
quarter ended June 30, 2009 from $960,000 for the same quarter in the prior
period due in large part to the decrease in loan fees, such as letter of
credit fees, participation fees and pre-payment penalties. The net gain on
the sale of mortgage loans with servicing released increased 135.8% to
$481,000 for the quarter ended June 30, 2009 from $204,000 in the comparable
period one year ago due primarily to the effect of lower rates in the market
place which contributed to an active mortgage refinance market in the current
period. The Bank originated $39.8 million in mortgage loans held for sale
during the quarter ended June 30, 2009 compared to $15.7 million for the
quarter ended June 30, 2008. The Bank continued its practice of selling most
of its single-family mortgage loan production into the secondary market.
28
There was no gain or loss on sales of investment securities for the three
months ended June 30, 2009 compared to a $579,000 gain for the three months
ended June 30, 2008. The Bank elected to sell selected equity securities from
the investment portfolio during the three months ended June 30, 2008. In
addition, there was an OTTI charge in the amount of $204,000 for the three
months ended June 30, 2009 compared to no charge for the three months ended
June 30, 2008. The impairment loss was the difference between the fair value
and the carrying value attributable to a small group of non-agency
collateralized mortgage obligation securities that were deemed to contain
permanent losses based on the Bank's methodology for measuring OTTI. The Bank
analyzes investment securities for OTTI based on: (1) the investment rating of
the security, (2) the probability that we will collect all amounts due on the
security, (3) whether the fair value of the security is significantly below
its carrying value, and (4) whether the economic environment is not likely to
improve the borrower's ability to repay the debt.
Other noninterest income for the quarter ended June 30, 2009 declined
7.5% to $462,000 compared to $512,000 for the three months ended June 30,
2008. Contributing to the lower noninterest income were decreases in bank
owned life insurance income, check card income and lease income.
Noninterest Expense. Noninterest expense for the three months ended June
30, 2009 increased 61.8% to $12.3 million from $7.6 million for the comparable
quarter one year ago. Compensation and employee benefits decreased 25.0% to
$3.4 million for the quarter ended June 30, 2009 compared to $4.5 million for
the same period last year. During the third quarter of fiscal 2009, the Bank
completed a strategic staffing reduction which is expected to result in
approximately $3.0 million in annual savings. Building occupancy expense
remained almost unchanged during the quarter ended June 30, 2009 from the
quarter ended June 30, 2008 at $1.1 million.
Real estate owned/collection expense increased to $4.5 million for the
three months ended June 30, 2009 from $85,000 in the quarter ended June 30,
2008 as a result of increased legal, appraisal, collection and related
expenses pertaining to delinquent and non-performing assets. FDIC insurance
premiums increased to $1.8 million for the quarter ended June 30, 2009 from
$45,000 in the quarter ended June 30, 2008. The Federal Deposit Insurance
Reform Act of 2005 provided banks with a one-time assessment credit to be used
against future premiums. For the Bank, 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. The Bank's regular quarterly assessment
has increased for the three months ended June 30, 2009 as a result of the Bank
is no longer considered "well capitalized" for regulatory capital purposes,
and the Bank's risk profile has increased based on the last FDIC examination
and regulatory agreement. In addition to the regular quarterly assessments,
due to losses and projected losses to the deposit insurance fund attributed to
failed institutions, the FDIC has adopted a rule imposing a special assessment
of five basis points on the amount of each depository institution's assets
reduced by the amount of its Tier 1 capital as of June 30, 2009. The Bank's
assessment amount was approximately $660,000 and was included in the expense
for the three months ended June 30, 2009. The rule adopted by the FDIC
authorized the FDIC to impose additional special assessments of up to the same
amount based on assets as of September 30, 2009 and December 31, 2009.
Other noninterest expense decreased 16.5% to $1.1 million for the quarter
ended June 30, 2009 compared to $1.4 million for the quarter ended June 30,
2008. The primary reason for the decrease from the prior period was a
decrease in the provision for unfunded commitments by $200,000.
Benefit or Provision for Income Tax. We did not recognize any income tax
benefit associated with the net loss for the quarter ended June 30, 2009.
Excluding the deferred tax valuation allowance of $19.4 million, the benefit
for income tax would have been 35.3% for June 30, 2009. This compares to an
income tax rate of 30.4% for the quarter ended June 30, 2008.
At June 30, 2009, the Corporation had $19.4 million of net deferred tax
assets which were comprised of tax-affected cumulative temporary differences,
which have resulted, to a large extent, from the significant increase in the
provision for loan losses. In evaluating the need for a valuation allowance,
the Corporation considered all of the events and evidence available, including
the Corporation's cumulative loss position, income tax carry-back and
carry-forward benefits and the challenges in predicting future operating
results. Management concluded that it is more likely than not that the
majority of the net deferred tax asset will not be available as a benefit in
future periods due to uncertainties surrounding the Corporation's ability to
generate sufficient taxable income. This determination was a result of recent
events in the market and the challenges we face in forecasting future profit
levels on a continuing basis. Therefore, at June 30, 2009 the Corporation
recognized a valuation allowance to fully reserve against the net deferred tax
asset. The Corporation incurred an additional accounting income tax provision
in the amount of $19.4 million, primarily as a result of recognizing the
valuation allowance against the net deferred tax asset.
29
The non-cash valuation allowance that has been established may be
partially or entirely reduced in future periods to the extent the Corporation
can generate taxable income sufficient to offset the tax deductions
represented by the net deferred tax asset. If the valuation allowance is
reduced or eliminated, future tax benefits will be recognized that will have a
positive non-cash impact on the Corporation's net income and stockholders'
equity.
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).
Three Months Ended June 30,
2009 vs. 2008
Increase (Decrease) Due to
-------------------------------------
Rate/
(In thousands) Volume Rate Volume Total
-------- ------ -------- -------
Interest income:
Interest and fees on loans $(2,112) $(5,185) $ 535 $(6,762)
Investment securities and other
interest-bearing securities 993 (536) (554) (97)
------- ------- ----- -------
Total interest-earning assets $(1,119) $(5,721) $ (19) $(6,859)
======= ======= ===== =======
Interest expense:
Deposit accounts $ 1,143 $(1,300) $(173) $ (330)
Borrowings (693) (309) 134 (868)
------- ------- ----- -------
Total interest-bearing liabilities $ 450 $(1,609) $ (39) $(1,198)
======= ======= ===== =======
Increase (decrease) in net interest
income $ (669) $(7,330) $ (58) $(8,057)
======= ======= ===== =======
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 June 30, 2009, the Bank had liquid assets
(cash and marketable securities with maturities of one year or less) of $137.2
million.
As of June 30, 2009, the total amortized cost of investments and
mortgage-backed securities was $61.2 million compared to a market value of
$63.4 million with a net unrealized gain of $2.2 million. As of March 31,
2009, the total amortized cost of investments and mortgage-backed securities
was $64.7 million, compared to a market value of $66.9 million with a net
unrealized gain of $2.2 million.
The Corporation's primary sources of funds are cash flows from
operations, which consist primarily of mortgage loan repayments, deposit
increases, loan sales, real estate owned 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. Retail deposits are our
primary source of liquidity. At June 30, 2009 we had $1.2 billion of deposits
and $211.9 million or 18.1% of our total deposits were in brokered
certificates of deposit. The Bank, however, is operating under the Cease and
Desist Order and was "significantly undercapitalized as of June 30, 2009 and
as a result is not permitted to accept or renew brokered deposits and is
limited on the pricing of deposits to 75 basis points above the market
average. As a result, we are restricted in our liquidity options.
In addition to deposits, we have a borrowing line with the FHLB of
Seattle but no additional amounts may be borrowed under that line as of June
30, 2009. We also have the ability to borrow up to $7.0 million from the
discount window at the Federal Reserve Bank of San Francisco and additional
amounts through the use of reverse repurchase agreements.
30
A secondary source of liquidity is from the sale of loans or other assets
but the prices for these assets is subject to market volatility that often
discounts the value below our original carrying value of the asset.
Consequently, even though we may increase liquidity by the sale of assets, we
would recognize a loss and further reduce our capital if we were to sell
assets at below their carrying value.
Stockholders' equity as of June 30, 2009 was $47.4 million, or 3.5% of
assets, compared to $93.2 million, or 6.3% of assets at March 31, 2009. As of
June 30, 2009, the Bank fell below the minimum level required to be adequately
capitalized by regulatory standards and is considered to be "significantly
undercapitalized." The total risk based capital ratio was 5.28% compared to
the 8.0% level required to be considered adequately capitalized. As of June
30, 2009, the Bank's Tier 1 leverage ratio was 3.17% and the Tier 1 risk based
capital ratio was 3.97%, compared to the 4.0% level required for both ratios
to be considered adequately capitalized. As a result of the Bank's
significantly undercapitalized status, we are subject to a number of
requirements and restrictions on our operations. See Note 3 of the notes to
the unaudited consolidated financial statements.
Regulatory Capital
- ------------------
The following table compares the Corporation's and the Bank's actual
capital amounts at June 30, 2009 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 $60,702 5.32% $91,266 >8.00% N/A
Horizon Bank $60,258 5.28% $91,241 >8.00% $114,051 >10.00%
Tier I Capital
(to Risk Weighted
Assets)
Consolidated $45,766 4.01% $45,633 >4.00% N/A
Horizon Bank $45,301 3.97% $45,621 >4.00% $68,431 >6.00%
Tier I Capital
(to Average Assets)
Consolidated $45,766 3.21% $57,111 >4.00% N/A
Horizon Bank $45,301 3.17% $57,101 >4.00% $71,376 >5.00%
As noted above, Horizon Bank is deemed "significantly undercapitalized"
by regulatory definition. The Board of Directors and management have taken
and are continuing to take various steps to improve our capital position,
including; 1) de-leveraging the balance sheet, 2) reducing expenses to support
earnings, 3) engaging investment banking professionals to assist in the
endeavor to raise capital, and 4) elimination of the cash dividend on our
common stock. No assurances can be made regarding the Corporation's ability
to declare future dividends. In addition, consistent with its strategy to
preserve and manage capital, the Corporation did not renew its stock
repurchase plan that would have run concurrent with the 2010 fiscal year.
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 June 30, 2009, the
Corporation had no significant off-balance sheet derivative financial
instruments, nor did it have a trading portfolio of investments. At June 30,
2009, 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,
2009.
31
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 June 30, 2009, 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)
to allow timely decisions regarding required disclosure, and (ii) recorded,
processed, summarized, and reported within the time periods specified in the
SEC's rules and forms.
In the quarter ended June 30, 2009, 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.
32
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, 2009. You should carefully consider
the risks and uncertainties described below and in the Form 10-K for the year
ended March 31, 2009.
We are subject to additional requirements and restrictions on our operations
as a result of the Bank's "significantly undercapitalized" status.
As of June 30, 2009, the Bank's capital ratios had fallen below the level
required for "adequately capitalized" status to the "significantly
undercapitalized" level. As a result, in addition to the requirements and
restrictions already imposed on us under the Order and under the notification
given to the Corporation by the Federal Reserve Bank of San Francisco, a
number of other requirements and restrictions can or will be imposed on us by
our regulators that could have a material adverse effect on our business and
results of operations and further limit our ability to grow. These additional
requirements and restrictions are described in Note 2 of the notes to the
unaudited consolidated financial statements.
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 ended June 30, 2009, we recorded a provision for loan
losses of $35.5 million compared to $40.0 million for the quarter ended March
31, 2009 and $3.0 million for the quarter ended June 30, 2008, which
substantially reduced our results of operations for those periods. We also
recorded net loan charge-offs of $23.0 million for the quarter ended June 30,
2009, compared with $26.3 million for the quarter ended March 31, 2009 and
$3.0 million for the quarter ended June 30, 2008. We are continuing to
experience a high level of 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 high
levels of delinquencies. At June 30, 2009, our total non-performing loans had
increased to $115.9 million compared to $85.4 million at March 31, 2009 and
$35.8 million at June 30, 2008. Our portfolio is concentrated in construction
and land development 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 $358.4 million or 32.8% of
our total loan portfolio at June 30, 2009, they represented $112.3 million or
82.0% 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 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.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
None
Item 3. Defaults Upon Senior Securities
None
33
Item 4. Submission of Matters to a Vote of Security Holders
The Corporation's 2009 Annual Meeting of Shareholders was held on July
21, 2009 at the Hotel Bellwether located at One Bellwether Way, 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 2012 by the following
vote:
FOR: WITHHELD:
Number of Votes Percentage Number of Votes Percentage
--------------- ---------- --------------- ----------
Robert C. Diehl 8,848,427 92.2% 753,607 7.8%
Gary E. Goodman 8,886,504 92.5% 715,530 7.5%
The following directors, who were not up for re-election at the Annual Meeting
of Shareholders, will continue to serve as directors: V. Lawrence Evans,
Richard P. Jacobson, Robert C. Tauscher and James A. Strengholt.
Item 5. Other Information
None
Item 6. Exhibits
(a) Exhibits
--------
(3.1) 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)
(3.2) 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)
(10.1) 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)
(10.2) Deferred Compensation Plan (incorporated by reference to the
Registrant's Annual Report on Form 10-K for the year ended
March 31, 1996)
(10.3) 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)
(10.4) 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)
(10.5) 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)
(10.6) 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))
(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)
34
(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
35
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: August 7, 2009
36
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
37
Exhibit 31.1
Certification
I, Richard P. Jacobson, certify that:
1. I have reviewed this Quarterly Report on Form 10-Q of Horizon Financial
Corp;
2. Based on my knowledge, this report does not contain any untrue statement
of a material fact or omit to state a material fact necessary to make the
statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this report, fairly present in all material
respects the financial condition, results of operations and cash flows of
the registrant as of, and for, the periods presented in this report;
4. I am responsible for establishing and maintaining disclosure controls and
procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and
internal control over financial reporting (as defined in Exchange Act
Rules 13a-15(f) and 15d-15(f)) for the registrant and have:
(a) Designed such disclosure controls and procedures, or caused such
disclosure controls and procedures to be designed under our
supervision, to ensure that material information relating to the
registrant, including its consolidated subsidiaries, is made known to
us by others within those entities, particularly during the period
in which this report is being prepared;
(b) Designed such internal control over financial reporting, or caused
such internal control over financial reporting to be designed under
our supervision, to provide reasonable assurance regarding the
reliability of financial reporting and the preparation of financial
statements for external purposes in accordance with generally
accepted accounting principles.
(c) Evaluated the effectiveness of the registrant's disclosure controls
and procedures and presented in this report our conclusions about the
effectiveness of the disclosure controls and procedures, as of the
end of the period covered by this report based on such evaluation;
and
(d) Disclosed in this report any change in the registrant's internal
control over financial reporting that occurred during the
registrant's most recent fiscal quarter (the registrant's fourth
fiscal quarter in the case of an annual report) that has materially
affected, or is reasonably likely to materially affect, the
registrant's internal control over financial reporting; and
5. I have disclosed, based on our most recent evaluation of internal control
over financial reporting, to the registrant's auditors and the audit
committee of the registrant's board of directors (or persons performing
the equivalent functions):
(a) All significant deficiencies and material weaknesses in the design or
operation of internal control over financial reporting which are
reasonably likely to adversely affect the registrant's ability to
record, process, summarize and report financial information; and
(b) Any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
control over financial reporting.
Date: August 7, 2009
/s/ Richard P. Jacobson
-----------------------------
Richard P. Jacobson
Chief Executive Officer
38
Exhibit 31.2
Certification
I, Greg B. Spear, certify that:
1. I have reviewed this Quarterly Report on Form 10-Q of Horizon Financial
Corp;
2. Based on my knowledge, this report does not contain any untrue statement
of a material fact or omit to state a material fact necessary to make the
statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this report, fairly present in all material
respects the financial condition, results of operations and cash flows of
the registrant as of, and for, the periods presented in this report;
4. I am responsible for establishing and maintaining disclosure controls and
procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and
internal control over financial reporting (as defined in Exchange Act
Rules 13a-15(f) and 15d-15(f)) for the registrant and have:
(a) Designed such disclosure controls and procedures, or caused such
disclosure controls and procedures to be designed under our
supervision, to ensure that material information relating to the
registrant, including its consolidated subsidiaries, is made known to
us by others within those entities, particularly during the period
in which this report is being prepared;
(b) Designed such internal control over financial reporting, or caused
such internal control over financial reporting to be designed under
our supervision, to provide reasonable assurance regarding the
reliability of financial reporting and the preparation of financial
statements for external purposes in accordance with generally
accepted accounting principles.
(c) Evaluated the effectiveness of the registrant's disclosure controls
and procedures and presented in this report our conclusions about the
effectiveness of the disclosure controls and procedures, as of the
end of the period covered by this report based on such evaluation;
and
(d) Disclosed in this report any change in the registrant's internal
control over financial reporting that occurred during the
registrant's most recent fiscal quarter (the registrant's fourth
fiscal quarter in the case of an annual report) that has materially
affected, or is reasonably likely to materially affect, the
registrant's internal control over financial reporting; and
5. I have disclosed, based on our most recent evaluation of internal control
over financial reporting, to the registrant's auditors and the audit
committee of the registrant's board of directors (or persons performing
the equivalent functions):
(a) All significant deficiencies and material weaknesses in the design or
operation of internal control over financial reporting which are
reasonably likely to adversely affect the registrant's ability to
record, process, summarize and report financial information; and
(b) Any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
control over financial reporting.
Date: August 7, 2009
/s/ Greg B. Spear
-----------------------------
Greg B. Spear
Chief Financial Officer
39
Exhibit 32
CERTIFICATION OF CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER OF
HORIZON FINANCIAL CORP.
PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C.
Section 1350), each of the undersigned hereby certifies in his capacity as an
officer of Horizon Financial Corp. (the "Company") and in connection with this
Quarterly Report on Form 10-Q ("Report"), that:
1. the report fully complies with the requirements of Sections 13(a)
and 15(d) of the Securities Exchange Act of 1934, as amended, and
2. the information contained in the report fairly presents, in all
material respects, the Company's financial condition and results of
operations, as of the dates and for the periods presented in the
financial statements included in the Report.
/s/ Richard P. Jacobson /s/ Greg B. Spear
- ----------------------------- ----------------------------
Richard P. Jacobson Greg B. Spear
Chief Executive Officer Chief Financial Officer
Dated: August 7, 2009
40