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 September 30, 2009
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OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND
EXCHANGE ACT of 1934
For the transition period from to
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Commission file number 0-27062
Horizon Financial Corp.
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(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
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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
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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
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Non-accelerated filer Smaller reporting company
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Indicate by check mark whether the registrant is a shell corporation (as
defined in Rule 12b-2 of the Exchange Act).
YES NO X
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As of November 2, 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 3-4
Consolidated Statements of Stockholders' Equity 5
Consolidated Statements of Cash Flows 6-7
Selected Notes to Consolidated Financial Statements 8-16
Item 2 Management's Discussion and Analysis of Financial
Condition and Plan of Operations 17-36
Item 3 Quantitative and Qualitative Disclosures About
Market Risk 36
Item 4 Controls and Procedures 37
PART II OTHER INFORMATION
Item 1 Legal Proceedings 38
Item 1A Risk Factors 38-40
Item 2 Unregistered Sales of Equity Securities and Use of
Proceeds 40
Item 3 Defaults Upon Senior Securities 40
Item 4 Submission of Matters to a Vote of Security Holders 40
Item 5 Other Information 40
Item 6 Exhibits 41
SIGNATURES 42
Exhibit Index 43
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements (unaudited)
HORIZON FINANCIAL CORP.
Consolidated Statements of Financial Position (unaudited)
ASSETS
September 30, March 31,
(In thousands) 2009 2009
---------- ----------
Cash and cash equivalents $ 10,636 $ 17,881
Interest-bearing deposits 148,406 126,159
Investment securities
Available-for-sale, at fair value 62,009 66,865
Held-to-maturity, at amortized cost - 8
Federal Home Loan Bank ("FHLB") stock 7,247 7,247
Loans held for sale 1,253 4,745
Loans receivable, net of allowance for loan losses
of $35,941 at September 30, 2009 and $38,981 at
March 31, 2009 938,051 1,123,660
Investment in real estate joint venture 18,164 17,985
Accrued interest and dividends receivable 4,543 6,629
Bank premises and equipment, net 25,257 26,195
Net deferred income tax assets - 15,164
Income tax receivable 21,018 12,442
Real estate owned 40,117 19,227
Bank owned life insurance 20,569 20,134
Other assets 2,830 3,630
---------- ----------
TOTAL ASSETS $1,300,100 $1,467,971
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits $1,174,020 $1,229,764
Other borrowed funds 84,029 114,348
Borrowing related to investment in real estate
joint venture 24,500 24,440
Accrued interest payable and other liabilities 2,725 3,959
Advances by borrowers for taxes and insurance 348 377
Deferred compensation 1,701 1,923
---------- ----------
Total liabilities 1,287,323 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; 11,995,504 and 11,980,796 issued
and outstanding at September 30, 2009 and
March 31, 2009, respectively 11,996 11,981
Additional paid-in capital 51,167 51,298
Retained earnings (deficit) (52,482) 28,333
Accumulated other comprehensive income 1,992 1,414
Noncontrolling interests 104 134
---------- ----------
Total stockholders' equity 12,777 93,160
---------- ----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $1,300,100 $1,467,971
========== ==========
(See Notes to Consolidated Financial Statements)
2
HORIZON FINANCIAL CORP.
Consolidated Statements of Operations (unaudited)
Three months ended
September 30,
(In thousands, except share data) 2009 2008
-------- --------
INTEREST INCOME
Interest and fees on loans $ 12,813 $ 19,808
Interest on investment securities 816 949
-------- --------
Total interest income 13,629 20,757
-------- --------
INTEREST EXPENSE
Interest on deposits 7,932 8,500
Interest on other borrowings 701 1,334
-------- --------
Total interest expense 8,633 9,834
-------- --------
Net interest income 4,996 10,923
PROVISION FOR LOAN LOSSES 29,000 12,000
-------- --------
Net interest loss after provision for loan losses (24,004) (1,077)
-------- --------
NONINTEREST INCOME (LOSS)
Service fees 681 819
Net gain (loss) on sales of loans (98) 144
Net loss on sales and impairment of real estate owned (2,044) (335)
Net loss on sales of investment securities (54) (777)
Other-than-temporary impairment on investment securities (1) -
Other noninterest income 456 1,288
-------- --------
Total noninterest income (loss) (1,060) 1,139
-------- --------
NONINTEREST EXPENSE
Compensation and employee benefits 3,624 4,337
Building occupancy 1,086 1,175
Real estate owned/collection expense 2,040 206
FDIC insurance 1,452 214
Data processing 244 241
Advertising 140 219
Other noninterest expense 1,767 1,387
-------- --------
Total noninterest expense 10,353 7,779
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NET LOSS BEFORE BENEFIT
FOR INCOME TAX (35,417) (7,717)
Current benefit for income tax (12,791) (3,109)
Deferred tax valuation allowance 12,503 -
-------- --------
NET LOSS $(35,129) $ (4,608)
Less: Net loss attributable to noncontrolling
interests (15) (3)
-------- --------
NET LOSS ATTRIBUTABLE TO HORIZON
FINANCIAL CORP. $(35,114) $ (4,605)
======== ========
BASIC LOSS PER SHARE $(2.93) $(0.39)
====== ======
DILUTED LOSS PER SHARE $(2.93) $(0.39)
====== ======
(See Notes to Consolidated Financial Statements)
3
HORIZON FINANCIAL CORP.
Consolidated Statements of Operations (unaudited)
Six months ended
September 30,
(In thousands, except share data) 2009 2008
-------- --------
INTEREST INCOME
Interest and fees on loans $ 26,497 $ 40,254
Interest on investment securities 1,681 1,910
-------- --------
Total interest income 28,178 42,164
-------- --------
INTEREST EXPENSE
Interest on deposits 16,189 17,087
Interest on other borrowings 1,427 2,927
-------- --------
Total interest expense 17,616 20,014
-------- --------
Net interest income 10,562 22,150
PROVISION FOR LOAN LOSSES 64,521 15,000
-------- --------
Net interest income (loss) after provision for
loan losses (53,959) 7,150
-------- --------
NONINTEREST INCOME (LOSS)
Service fees 1,511 1,779
Net gain on sales of loans 387 348
Net loss on sales and impairment of real estate
owned (4,108) (335)
Net loss on sales of investment securities (54) (198)
Other-than-temporary impairment on investment
securities (205) -
Other noninterest income 918 1,800
-------- --------
Total noninterest income (loss) (1,551) 3,394
-------- --------
NONINTEREST EXPENSE
Compensation and employee benefits 7,000 8,840
Building occupancy 2,172 2,301
Real estate owned/collection expense 4,479 311
FDIC insurance 3,220 259
Data processing 504 485
Advertising 279 438
Other noninterest expense 2,905 2,730
-------- --------
Total noninterest expense 20,559 15,364
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NET LOSS BEFORE BENEFIT
FOR INCOME TAX (76,069) (4,820)
Current benefit for income tax (27,127) (2,228)
Deferred tax valuation allowance 31,903 -
-------- --------
NET LOSS $(80,845) $ (2,592)
Less: Net loss attributable to noncontrolling
interests (30) (7)
-------- --------
NET LOSS ATTRIBUTABLE TO HORIZON
FINANCIAL CORP. $(80,815) $ (2,585)
======== ========
BASIC LOSS PER SHARE $(6.74) $(0.22)
====== ======
DILUTED LOSS PER SHARE $(6.74) $(0.22)
====== ======
(See Notes to Consolidated Financial Statements)
4
HORIZON FINANCIAL CORP.
Consolidated Statements of Stockholders' Equity
Six Months Ended September 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 loss - - - (2,585) - (7) (2,592) $ (2,592)
Other comprehensive income
(loss)
Reclassification for net
losses recognized in income,
net tax benefit of $69 - - - - 129 - 129 129
Change in unrealized
losses on available-for-
sale securities, net tax
benefit of $1,109 - - - - (2,061) - (2,061) (2,061)
--------
Total other comprehensive
loss (1,932)
--------
Comprehensive loss $ (4,524)
========
Cash dividends on common
stock at $.185/sh - - - (2,206) - - (2,206)
Dividend reinvestment plan 27 27 200 - - - 227
Stock options exercised 20 20 114 - - - 134
Tax benefit associated
with stock options - - 4 - - - 4
Stock award plan 21 21 171 - - - 192
------ ------- ------- ------- ------- ----- --------
BALANCE, September 30,
2008 11,960 $11,960 $51,086 $59,115 $ (10) $ 157 $122,308
====== ======= ======= ======== ====== ===== ========
BALANCE, March 31, 2009 11,981 $11,981 $51,298 $28,333 $ 1,414 134 $ 93,160
Comprehensive loss
Net loss - - - (80,815) - (30) (80,845) $(80,845)
Other comprehensive
income
Reclassification for net
losses recognized in
income, net tax benefit
of $91 - - - - 168 - 168 168
Change in unrealized gains
on available-for-sale
securities, net tax of
$221 - - - - 410 - 410 410
--------
Total other comprehensive
income 578
--------
Comprehensive loss $(80,267)
========
Dividend reinvestment plan 1 1 - - - - 1
Stock award plan 14 14 (131) - - - (117)
------ ------- ------- ------- ------- ----- --------
BALANCE, September 30,
2009 11,996 $11,996 $51,167 $(52,482) $1,992 $ 104 $ 12,777
====== ======= ======= ======== ====== ===== ========
(See Notes to Consolidated Financial Statements)
5
HORIZON FINANCIAL CORP.
Consolidated Statements of Cash Flows (unaudited)
Six Months Ended
(In thousands) September 30,
2009 2008
-------- --------
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss $(80,815) $ (2,585)
Adjustments to reconcile net loss to net
cash provided by operating activities:
Depreciation and amortization 1,561 1,670
Provision for loan losses 64,521 15,000
Provision for loss - real estate owned 2,714 -
Loss on sale of real estate owned 1,394 335
Net loss on sale of investment securities 54 198
Other-than-temporary impairment on investment
securities available for sale 205 -
Excess tax benefits from the exercise of stock
options - (4)
Net gain on sale of loans (387) (348)
Proceeds from sales of loans 64,178 29,249
Origination of loans held for sale (60,299) (27,753)
Stock award plan compensation (117) 192
Deferred income taxes (16,739) 52
Valuation allowance on deferred income taxes 31,903 -
Changes in assets and liabilities:
Interest and dividends receivable 2,086 974
Interest payable (762) 91
Federal income tax receivable (8,576) (6,285)
Other assets 365 (470)
Other liabilities (753) (292)
-------- --------
Net cash flows from operating activities 533 10,024
-------- --------
CASH FLOWS FROM INVESTING ACTIVITIES
Investment in interest-bearing deposits, net (22,247) (15,904)
Purchases of investment securities - available-for-sale (4,503) (7,584)
Proceeds from sales and maturities of
investment securities - available-for-sale 9,686 13,007
Proceeds from maturities of investment
securities - held-to-maturity - 20
Redemption of FHLB Stock - 287
Net change in loans 77,794 (65,873)
Purchases of bank premises and equipment (84) (429)
Proceeds from the sale of real estate owned 17,757 511
Net change in investment in joint venture (179) (175)
-------- --------
Net cash flows from investing activities 78,224 (76,140)
-------- --------
6
HORIZON FINANCIAL CORP.
Consolidated Statements of Cash Flows (unaudited)
(continued)
Six Months Ended
(In thousands) September 30,
2009 2008
-------- --------
CASH FLOWS FROM FINANCING ACTIVITIES
Net change in deposits (55,744) 108,486
Advances of other borrowed funds 31,940 187,044
Repayments of other borrowed funds (62,259) (227,816)
Borrowing related to investment in real estate
joint venture 60 956
Common stock issued 1 134
Tax benefit associated with stock options - 4
Cash dividends paid - (2,987)
-------- --------
Net cash flows from financing activities (86,002) 65,821
-------- --------
NET CHANGE IN CASH AND CASH EQUIVALENTS (7,245) (295)
CASH AND CASH EQUIVALENTS, beginning of period 17,881 22,412
-------- --------
CASH AND CASH EQUIVALENTS, end of period $ 10,636 $ 22,117
======== ========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the period for interest $ 9,396 $ 19,924
======== ========
Cash paid during the period for income tax $ - $ 4,100
======== ========
NONCASH INVESTING AND FINANCING TRANSACTIONS
Property taken in settlement of loans $ 44,282 $ 2,413
======== ========
Bank financed sale of other real estate owned $ 1,528 $ 364
======== ========
In-kind distribution for mutual funds $ - $ 3,278
======== ========
(See Notes to Consolidated Financial Statements)
7
HORIZON FINANCIAL CORP.
SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE AND SIX MONTHS ENDED SEPTEMBER 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 and six
months ended September 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 loss per share.
The unaudited consolidated financial statements have been prepared in
accordance with accounting principles generally accepted in the United States
of America for interim financial information and with the instructions to the
Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include
all of the information and footnotes required by accounting principles
generally accepted in the United States of America for complete financial
statements. In the opinion of management, all adjustments (consisting only of
normal recurring accruals) necessary for a fair presentation are reflected in
the interim financial statements. The results of operations for the three and
six month periods ended September 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
November 9, 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 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 and is subject to consolidation.
Accordingly, GBNW is consolidated in the Corporation's consolidated balance
sheet, and the investment in real estate is recorded as an asset and the
related debt is recorded as the Corporation's liability. As of September 30,
2009, the real estate joint venture had a carrying amount of approximately
$18.2 million, with a related borrowing of approximately $24.5 million after
consolidation. During the process of consolidation, inter-company
transactions were eliminated; including the $24.5 million receivable and the
associated $6.8 million in capitalized interest receivable from GBNW and
payable to Horizon Bank.
The Corporation adopted the consolidation of noncontrolling interests
under the provisions of Financial Accounting Standards Board ("FASB")
Accounting Standards Codification ("ASC") 810, Consolidation on April 1, 2009.
As a result, we reclassified $104,000 and $134,000 of minority interest
liabilities as of September 30, 2009 and March 31, 2009, respectively from
liabilities to equity on our balance sheet. Noncontrolling interests' share
of net loss was $15,000 and $30,000 for the three and six months ended
September 30, 2009 and $3,000 and $7,000 for the three and six months end
September 30, 2008.
8
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 3, 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, which
are above the regulatory minimums;
* 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 in attempt 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 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 that was filed with the
SEC on March 2, 2009 and in Horizon's Form 10-K filing for its fiscal year
ended March 31, 2009. As of June 30, 2009, we had completed on-time and
submitted to our regulators all requirements that were due within 90 days of
the Order's effective date. As of September 30, 2009, there are two key
objectives that remain outstanding and were given 270 days from the Order's
effective date 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. We have successfully
reduced our "substandard" balances below the threshold required by the Order.
The reduction in balances of loans classified "doubtful" 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 September 30, 2009,
Horizon Bank's Tier 1 capital was $10.4 million, representing 0.77% of average
assets. We continue to work with investment bankers and other qualified
advisors to bring in additional capital to meet the 10% regulatory requirement
in accordance with the terms of the Order. While the Bank continues to act
upon both tactical and strategic alternatives to raise capital and restructure
its balance sheet, as has been widely publicized, access to capital markets is
extremely limited in the current economic environment, making it highly
unlikely that in the current financial environment and in light of its capital
position its efforts will be successful and will result in sufficient capital
preservation or infusion in order to comply with the Order. The Bank's ability
to decrease its levels of classified assets is also vulnerable to market
conditions as its construction loan borrowers rely on an active real estate
market as a source of repayment, and the sale of loans in this market is
difficult. If the real estate market does not improve, the Bank's level of
classified and non-performing assets may continue to increase. Any material
failure to comply with the provisions of the Order could result in further
enforcement actions by both the FDIC or the DFI or the placing of the Bank
into conservatorship or receivership.
9
NOTE 3 - Regulatory Capital and Going Concern Considerations
The Bank's ratio of total capital to risk-weighted assets was 1.98% as of
September 30, 2009, which caused the Bank to be deemed "critically
undercapitalized" as of that date within the meaning of the Federal Deposit
Insurance Act ("FDI Act") Prompt Correction Action ("PCA") capital
requirements (12 U.S.C. Section 1831o). The Bank's ratios of Tier 1 capital
to average assets and Tier 1 capital to risk-weighted assets were 0.77% and
0.99%, respectively, as of September 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 "critically undercapitalized" status as of
September 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; (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; and (iii) 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.
Under the FDI Act, depository institutions that are "critically
undercapitalized" must be placed into conservatorship or receivership within
90 days of becoming critically undercapitalized, unless the institution's
primary Federal regulatory authority (here, the FDIC) determines and documents
that "other action" would better achieve the purposes of PCA. If the Bank
remains critically undercapitalized on average during the calendar quarter
beginning 270 days after it became critically undercapitalized, the FDI Act
requires the appointment of a a receiver unless the Bank and the FDIC
affirmatively can determine that, among other things, the Bank has positive
net worth and the FDIC can certify that the Bank is viable and not expected to
fail. Also as stated above as result of its current capital condition, the
Bank is also subject to restrictions on the interest rates it may offer to its
depositors. Many of our competitors are paying higher rates than we are
permitted to offer. As a result the Bank's liquidity may be negatively
impacted, possibly materially, due to deposit run-off to the extent that it is
unable to continue offering competitive rates.
While the Corporation intends to take such actions as may be necessary to
enable the Bank to comply with the requirements of the Order, and to withstand
the potential impact of the interest rate restrictions, it is highly unlikely
that the Bank will be able to comply fully with the provisions of the Order or
that efforts to comply with the Order will not have material and adverse
effects on the operations and financial condition of the Corporation. The
Corporation has determined that significant additional sources of external
capital will be required for it to continue operations through 2009 and
beyond. To date, its efforts to achieve a capital investment, sale, strategic
merger or some form of restructuring have been unsuccessful and it is highly
unlikely that the Corporation will succeed in this endeavor and be able to
comply with applicable regulatory requirements. In addition, a transaction,
which would likely involve equity financing, would result in substantial
dilution to current stockholders and could adversely affect the price of the
Corporation's common stock. If the Corporation does not increase its capital,
the FRB may take additional enforcement action against it.
In addition, it is unclear at this point what impact, if any, the
applicable interest rate restrictions and our decreasing capital condition
will have on the Bank's continued ability to maintain adequate liquidity. As a
result of the Bank's financial
10
NOTE 3 - Regulatory Capital and Going Concern Considerations (continued)
condition, its regulators are continually monitoring its liquidity and capital
adequacy. Based on their assessment of its ability to operate in a safe and
sound manner, the Bank's regulators at any time may take other and further
actions, including placing the Bank into conservatorship or receivership, to
protect the interests of depositors insured by the FDIC.
As of September 30, 2009, due to the Corporation's significant net loss
from operations in the three and six months ended September 30, 2009,
deterioration in the credit quality of the loan portfolio, and the decline in
the level of its regulatory capital to support operations, there is
substantial doubt about the Corporation's ability to continue as a going
concern. Further, due to its capital condition, the Bank is prohibited from
paying a dividend to the Corporation. The accompanying consolidated financial
statements have been prepared on a going concern basis, which contemplates the
realization of assets and the discharge of liabilities in the normal course of
business for the foreseeable future, and do not include any adjustments to
reflect the possible future effects on the recoverability or classification of
assets, and the amounts or classification of liabilities that may result from
the outcome of any regulatory action, which would affect the Corporation's
ability to continue as a going concern.
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 Six Months Ended
September 30, September 30,
---------------------- ----------------------
2009 2008 2009 2008
---------- ---------- ---------- ----------
Basic weighted average shares
outstanding 11,995,279 11,940,064 11,988,442 11,917,065
Dilutive shares - - - -
---------- ---------- ---------- ----------
Diluted weighted average shares
outstanding 11,995,279 11,940,064 11,988,442 11,917,065
========== ========== ========== ==========
Anti-dilutive shares
outstanding related to options
to acquire the Corporation's
common stock 133,616 126,784 144,113 95,822
========== ========== ========== ==========
NOTE 5 - Stock Option and Restricted Stock Award Plans
Share Based Payment
- -------------------
The Corporation accounts for stock compensation using the "modified
prospective" method. For the three and six months ended September 30, 2009,
the Corporation recognized $34,000 and $169,000 in stock option and restricted
stock award compensation expense as a component of salaries and benefits,
compared to $85,000 and $192,000 for the three and six months ended September
30, 2008. Also included in additional paid in capital for the six months
ended September 30, 2009 was $171,000 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 September 30, 2009 and 2008,
there was approximately $53,000 and $308,000, 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, when and if declared by the Board
of Directors on the Corporation's common stock, 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.
11
NOTE 5 - Stock Option and Restricted Stock Award Plans (continued)
The following table summarizes the stock option activity for the six months
ended September 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 (34,376) 9.83
------- ------ ------- -------
Balance, September 30, 2009 121,880 $13.40 4.56 $ -
======= ====== ======= =======
Exercisable, September 30, 2009 103,071 $12.94 3.96 $ -
======= ====== ======= =======
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 six months ended September 30, 2009 and 2008 was
$0 and $54,000, respectively.
The following table summarizes the restricted stock award activity for
the six months ended September 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 (4,001) 20.30
------ ------ ----
Balance, September 30, 2009 5,558 $18.73 0.50
====== ====== ====
12
NOTE 6 - Fair Value of Financial Instruments and Fair Value Measurements
The following table presents estimated fair values of our financial instruments at September 30, 2009
and March 31, 2009 (in thousands):
September 30, 2009 March 31, 2009
Carrying Carrying
(In thousands) Amount Fair Value Amount Fair Value
-------- ---------- -------- -----------
<s> <c> <c> <c> <c>
Financial Assets
Cash and cash equivalents $ 10,636 $ 10,636 $ 17,881 $ 17,881
Interest-bearing deposits 148,406 148,406 126,159 126,159
Investment securities 62,009 62,009 66,873 66,876
Federal Home Loan Bank stock 7,247 7,247 7,247 7,247
Loans held-for-sale 1,253 1,253 4,745 4,745
Loans receivable 938,051 889,499 1,123,660 1,134,413
Investment in real estate joint venture 18,164 21,800 17,985 21,800
Bank owned life insurance 20,569 20,569 20,134 20,134
Accrued interest and dividends receivable 4,543 4,543 6,629 6,629
Financial Liabilities
Demand and savings deposits 308,517 308,517 312,261 312,261
Time deposits 865,503 870,491 917,503 927,128
Accrued interest payable 1,128 1,128 1,890 1,890
Other borrowed funds 84,029 84,867 114,348 115,484
Borrowing related to investment in real
estate in a joint venture 24,500 24,500 24,440 24,440
We determine 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 each class of financial instruments for which it is practicable to
estimate that value:
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.
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.
The Corporation's framework for measuring fair value is 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
framework 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 methods and assumptions were used to estimate the fair
value of each class of financial instruments for which it is practicable to
estimate that value:
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.
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.
13
NOTE 6 - Fair Value of Financial Instruments and Fair Value Measurements
(continued)
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. The Corporation evaluates FHLB stock for
impairment under the provisions of FASB ASC 942 Financial Services, Depository
and Lending. The Corporation's determination of whether these investments are
impaired is based on the assessment of the ultimate recoverability of cost
rather than by recognizing temporary declines in value. The determination of
whether a decline affects the ultimate recoverability of cost is influenced by
criteria such as (1) the significance of any decline in net assets of the FHLB
as compared to the capital stock amount for the FHLB and the length of time
this situation has persisted, (2) commitments by the FHLB to make payments
required by law or regulation and the level of such payments in relation to
the operating performance of the FHLB, (3) the impact of legislative and
regulatory changes on financial institutions and, accordingly, the customer
base of the FHLB, and (4) the liquidity position of the FHLB. The Corporation
has determined there is not an other-than-temporary impairment on the FHLB
stock investment as of September 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.
14
NOTE 6 - Fair Value of Financial Instruments and Fair Value Measurements
(continued)
The following table presents the Corporation's financial assets measured
at fair value on a recurring basis at September 30, 2009 (in thousands):
Level 1 Level 2 Level 3 Total
------- ------- ------- -------
Assets
Available for Sale
Investment securities $ 933 $61,076 $ - $62,009
----- ------- ----- -------
Total $ 933 $61,076 $ - $62,009
===== ======= ===== =======
The following table presents the Corporation's assets measured at fair
value on a nonrecurring basis at September 30, 2009 and the total losses
resulting from these fair value adjustments for the six months ended September
30, 2009 (in thousands):
Total
Level 1 Level 2 Level 3 Total Losses
------- ------- ------- ------- ------
Assets
Impaired loans $ - $ - $138,858 $138,858 $44,811
Real estate owned
("REO") - - 40,117 40,117 4,108
------ ------ -------- -------- -------
Total $ - $ - $178,975 $178,975 $48,919
====== ====== ======== ======== =======
Impaired loans, with carrying amounts of $95.7 million had specific
valuation allowances totaling $18.1 million at September 30, 2009, which were
included in the allowance for loan losses. The remaining difference between
the $138.8 million of impaired loans and the $95.7 million with specific
valuation allowances is comprised of $43.1 million of impaired loans with no
measureable amount of probable loss.
NOTE 7 - Investments
- --------------------
The table below presents the available for sale ("AFS") amortized cost,
fair value and unrealized gain or loss as of September 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 $ 24,786 $ 1,233 $ (24) $ (208) $ 25,787
Marketable equity
securities 312 688 (67) - 933
Mortage-backed
securities and
collateralized
mortgage obligations
(CMOs) 33,846 1,767 - (324) 35,289
---------- ---------- ----------- ------------ --------
Total available-for-
sale securities 58,944 3,688 (91) (532) 62,009
---------- ---------- ----------- ------------ --------
Certain investment securities shown above currently have fair values less
than amortized cost and therefore contain unrealized losses. At September 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 September 30, 2009, there are 37 investment securities in an
unrealized loss position exceeding a twelve month period with an amortized
cost of $2.8 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. 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 to sell or required to sell 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 securities below their cost that are
deemed to be other-than-temporary are reflected in earnings as realized
losses. During the three and six months ended September 30, 2009, the Bank
recognized a $1,000 and $205,000 OTTI charge related to non-agency
private-label mortgage-backed securities. These private label
15
NOTE 7 - Investments (continued)
- --------------------------------
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 and six months ended September 30, 2008.
In addition, given the current regulatory restrictions and the
considerations about the Corporation's ability to continue as a going concern,
the Corporation reclassified $8,000 in held-to-maturity securities as
available-for-sale during the quarter ended September 30, 2009.
NOTE 8 - Income Taxes
- ---------------------
At September 30, 2009, the Corporation had $31.9 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 viability
and its 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
September 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 $31.9 million for
the six months ended September 30, 2009, 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 - Accounting Standards Updates
- -------------------------------------
In August 2009, the FASB issued Accounting Standards Update No. 2009-05
("ASU 2009-05"), Fair Value Measurements and Disclosures (Topic 820)
Measuring Liabilities at Fair Value. ASU 2009-05 applies to all entities that
measure liabilities at fair value within the scope of ASC Topic 820. ASU
2009-05 provides clarification that in circumstances in which a quoted price
in an active market for the identical liability is not available, a reporting
entity is required to measure fair value using one or more of the following
techniques:
1.) A valuation technique that uses:
a. The quoted price of the identical liability when traded as an
asset.
b. Quoted prices for similar liabilities or similar liabilities
when traded as assets.
2.) Another valuation technique that is consistent with the principles of
ASC Topic 820. Two examples would be an income approach, such as a
technique that is based on the amount at the measurement date that
the reporting entity would pay to transfer the identical liability or
would receive to enter into the identical liability.
The amendments in ASU 2009-5 also clarify that when estimating the fair
value of a liability, a reporting entity is not required to include a separate
input or adjustment to other inputs relating to the existence of a restriction
that prevents the transfer of the liability. It also clarifies that both a
quoted price in an active market for the identical liability at the
measurement date and the quoted price for the identical liability when traded
as an asset in an active market when no adjustments to the quoted price of the
asset are required are Level 1 fair value measurements. The guidance provided
in ASU 2009-5 is effective for the first reporting period beginning after
issuance. The adoption of ASU 2009-5 will not have a material effect on the
Corporation's consolidated financial condition or results of operations.
In September 2009, the FASB issued Accounting Standards Update No.
2009-12 ("ASU 2009-12"), Fair Value Measurements and Disclosures (Topic 820),
Investments in Certain Entities that Calculate Net Asset Value per Share (or
Its Equivalent). ASU 2009-12 provides amendments to Subtopic 820-10, Fair
Value Measurements and Disclosures - Overall, for the fair value measurement
of investments in certain entities that calculate net asset value per share.
This ASU also requires disclosures by major category of investment about the
attributes of investments within the scope of the amendments in this Update.
The amendments in this Update are effective for interim and annual periods
after December 15, 2009. The adoption of this guidance will not have a
material effect on the Corporation's consolidated financial condition or
results of operations.
16
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND PLAN
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 are based on the Corporation's expectations
and are subject to risks and uncertainties that cannot be predicted or
quantified and are beyond the Corporation's control, including the potential
that (1) the Corporation may not be able to continue as a going concern and
(2) because of our critically undercapitalized status, our regulators may
initiate additional enforcement actions against us, which could include
placing the Bank under conservatorship or into receivership
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 risk that the Bank will be placed into conservatorship
or receivership as result of being critically undercapitalized under the PCA
or because the Corporation is not able to improve its capital position; the
possibility that the Bank will not be unable to comply with the conditions
imposed by the Order, including but not limited to its ability to increase
capital, reduce non-performing assets and reduce its reliance on brokered
certificates of deposit, or to comply with statutory obligations applicable to
critically undercapitalized institutions under PCA or to comply with other
regulatory requirements which could result in the imposition of further
enforcement action imposing additional restrictions on our operations or
placing the Bank into conservatorship or receivership at any time; the credit
risks of lending activities, including changes in the level and trend of loan
delinquencies and write-offs; the risk that borrowers will not be able to
complete construction projects in a timely fashion and/or within budget and
that any guarantees, including completion guarantees will not be honored; the
risk that continued negative publicity regarding our financial condition will
have an adverse effect on our operations; 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 the Corporation
by the Federal Reserve Bank of San Francisco and its 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,; 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
17
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 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 further 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 September 30, 2009, Horizon Financial had total assets of $1.30 billion,
total deposits of $1.17 billion and total equity of $12.8 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 is currently subject to the Order and is critically undercapitalized
under PCA and accordingly is operating under significant operating
restrictions. Please refer to Notes 2 and 3 of the Selected Notes to the
Consolidated Financial Statements for a discussion of regulatory actions,
regulatory capital and going concern considerations.
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
- ------------------
Important financial results for the second fiscal quarter ended September 30,
2009 include the following:
* The net loss for the three months ended September 30, 2009 was $35.1
million or $2.93 per diluted share as compared to a net loss of $4.6
million or $0.39 per diluted share for the three month period ended
September 30, 2008. The loss was largely due to a $29.0 million
provision for loan losses, a $12.5 million valuation allowance
against the net deferred tax asset, a decrease in interest income
from non-performing assets and an increase in non-interest expenses.
* The current period losses resulted in the Bank being classified for
regulatory purposes as "critically undercapitalized" by regulatory
definition as of September 30, 2009 which may result in the
imposition of additional enforcement actions against us by our bank
regulators, and possibly the appointment of a receiver or conservator
for the Bank. See Notes 2 and 3 of the Selected Notes to the
Consolidated Financial Statements.
* The provision for loan losses for the three months ended September
30, 2009 was $29.0 million as compared to the year ago quarter of
$12.0 million, which was necessary to meet management's estimate for
probable losses.
* Charge-offs were $44.6 million for the three months ended September
30, 2009 compared to $5.6 million for the same period a year ago.
18
* A $12.5 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.
* The total non-interest expense for the three months ended September
30, 2009 was $10.4 million as compared to $7.8 million for the three
months ended September 30, 2008. The largest contributors to the
increase in non-interest expense came, an increase in FDIC premiums
and higher costs associated with loan workouts and credit
administration.
* Total non-performing assets increased to $128.4 million as of
September 30, 2009 compared to $104.7 million at March 31, 2009 and
$80.2 million as of September 30, 2008 due in large part to a
transition of delinquent loans to non-accrual status.
* Total assets were $1.30 billion as of September 30, 2009 as compared
to $1.47 billion as of March 31, 2009 and $1.45 billion as of
September 30, 2008.
* Gross loans were $974.0 million as of September 30, 2009 as compared
to $1.16 billion as of March 31, 2009 and $1.26 billion as of
September 30, 2008. The decline in loans is the result of
management's efforts to de-leverage the balance sheet by working out
specific loans resulting in payoffs or to real estate owned in order
to market the acquired property for sale.
* Total deposits were $1.17 billion as of September 30, 2009 and March
31, 2009 and $1.15 billion as of September 30, 2008. The Bank is
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
"critically undercapitalized" status as of September 30, 2009.
* The net interest margin for the three months ended September 30, 2009
was 1.64% as compared to 3.26% for the same period in 2008. 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 leverage ratio was 0.77% for the
quarter ended September 30, 2009 compared to 6.11% as of March 31,
2009 and 8.38% as of September 30, 2008. Our regulatory capital
ratios have declined significantly as a result of 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 increase its and the
Bank's regulatory capital levels to the required level and to improve asset
quality and deleverage the balance sheet. Our capital raise strategy includes
the engagement of investment bankers to assist with the process of identifying
and securing a capital injection. At this point in time, however, the
Corporation believes that it is highly unlikely that it will be able to obtain
additional outside capital that does not include the provision of substantial
assistance by the FDIC or other Federal governmental authorities. The
Corporation continues to consult with the FRB, FDIC and DFI on a regular basis
concerning the Corporation's proposals to obtain outside capital and to
develop action plans that will be acceptable to bank regulatory authorities,
but there can be no assurance that these actions will be successful, or that
even if one or more of the Corporation's proposals are acceptable, that these
proposals will be successfully implemented.
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 also
intends to deleverage its balance sheet and reduce its future reliance on FHLB
advances and brokered deposits from current levels. In the future, if the
Bank has returned to adequately capitalized status or better and is no longer
subject to regulatory restrictions on its asset growth, the Bank expects to
pursue a more moderate growth strategy, increasing loans at a pace that is
consistent with its ability to grow core deposits in its retail and commercial
branch network as well as prudent risk management strategies and capital
levels.
19
Comparison of Financial Condition at September 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
September 30, 2009, decreased to $1.30 billion or 11.4% from $1.47 billion at
March 31, 2009. This decrease in assets was primarily attributable to a
decrease in net loans receivable to $938.1 million as of September 30, 2009
compared to $1.12 billion as of March 31, 2009.
Loans. Total loans receivable decreased $188.6 million or 16.2% to
$974.0 million at September 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 $86.0 million decrease in commercial
construction loans, $49.5 million in commercial land development loans, $22.4
million in one-to-four family mortgage loans and $25.6 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, $44.3 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 62.2% of our total net
loan portfolio at September 30, 2009 consisted 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:
September 30, % March 31, %
(Dollars in thousands) 2009 of Portfolio 2009 of Portfolio
------- ------------ -------- ------------
One-to-four family mortgage
loans
One-to-four family $144,603 14.9% $ 167,048 14.4%
One-to-four family
construction 18,169 1.9% 28,290 2.4%
Less participations sold (32,683) (3.4)% (42,853) (3.7)%
-------- ----- ---------- -----
Net one-to-four family
mortgage loans 130,089 13.4% 152,485 13.1%
Commercial land development 137,030 14.1% 186,580 16.0%
Commercial construction (1) 136,214 14.0% 222,207 19.1%
Multifamily residential 57,190 5.9% 51,970 4.5%
Commercial real estate 278,346 28.5% 281,481 24.2%
Commercial business loans 176,368 18.1% 201,973 17.4%
Home equity secured 52,418 5.4% 58,228 5.0%
Other consumer loans 6,337 .6% 7,717 .7%
-------- ----- ---------- -----
Subtotal 843,903 86.6% 1,010,156 86.9%
-------- ----- ---------- -----
Total loans receivable 973,992 100.0% 1,162,641 100.0%
-------- ----- ---------- -----
Less:
Allowance for loan losses (35,941) (38,981)
-------- ----------
Net loans receivable $938,051 $1,123,660
======== ==========
Net residential loans $128,628 13.7% $ 149,625 13.3%
Net commercial business
loans 167,936 17.9% 193,687 17.2%
Net commercial real estate
loans (2) 583,689 62.2% 716,743 63.8%
Net consumer loans (3) 57,798 6.2% 63,605 5.7%
-------- ----- ---------- -----
$938,051 100.0% $1,123,660 100.0%
======== ===== ========== =====
(1) Includes $26.1 million and $37.2 million in condominium construction
projects at September 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 measurable risk in
construction loans in our allowance for loan losses. 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.
20
The following table provides additional details on the Corporation's
construction and land development loan portfolio:
September 30, 2009 March 31, 2009
-------------------- --------------------
(Dollars in thousands) Amount Percent Amount Percent
-------- ------- -------- -------
Speculative construction
one-to-four family $ 11,699 4.0% $ 19,280 4.4%
Custom construction one-to-four
family 6,469 2.2% 9,010 2.1%
-------- ----- -------- -----
Total one-to-four family
construction 18,168 6.2% 28,290 6.5%
Commercial speculative
construction one-to-four family 80,981 27.8% 142,315 32.6%
Commercial construction multi
family 2,295 0.8% 8,439 1.9%
Commercial construction 52,938 18.2% 71,453 16.3%
Commercial residential land
development 137,031 47.0% 186,580 42.7%
-------- ----- -------- -----
Total commercial construction
and land development 273,245 93.8% 408,787 93.5%
-------- ----- -------- -----
Total construction loans $291,413 100.0% $437,077 100.0%
======== ===== ======== =====
Federal Home Loan Bank ("FHLB") Stock. The investment in the FHLB of
Seattle stock totaled $7.3 million as of September 30, 2009 as compared to
$8.6 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 evaluates 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 June 30, 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 June 30, 2009, but was in compliance
with the other two statutory capital ratios. 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. As of July 31, 2009, the FHLB of
Seattle regained compliance with all three statutory capital requirements.
The FHLB of Seattle reported a $34.3 million and $50.5 million loss for
the three and six months ended June 30, 2009. The FHLB of Seattle attributes
its net loss primarily to $61.8 million and $133.5 million of OTTI charges for
the three and six months ended June 30, 2009 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 half 2009, the FHLB of Seattle also
reported a $1.2 billion accumulated other comprehensive loss and total capital
of $796 million as of June 30, 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 three and six month of 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 $62.0 million
as of September 30, 2009 as compared to $66.9 million as of March 31, 2009,
which represented a decrease of $4.9 million or 7.3%. In an effort to
increase on-balance sheet liquidity, the Bank elected not to renew maturing
securities or replace pay downs of principal with new investment securities
during the six months ended September 30, 2009.
21
The table below presents the available for sale ("AFS") amortized cost,
fair value and unrealized gain or loss as of September 30, 2009:
Gross Gross
Unrealized Unrealized
Gross Losses Losses Estimated
Amortized Unrealized 12 Months Greater Than Fair
Cost Gains or Less 12 Months Value
--------- ---------- --------- ------------ ---------
(In thousands)
AFS Securities
State and political
subdivisions and U.S.
government agency
securities $24,786 $1,233 $ (24) $ (208) $25,787
Marketable equity
securities 312 688 (67) - 933
Mortage-backed
securities and
collateralized
mortgage obligations
(CMOs) 33,846 1,767 - (324) 35,289
------- ------ ------- ------- -------
Total available-
for-sale securities 58,944 3,688 (91) (532) 62,009
------- ------ ------- ------- -------
Certain investment securities shown above currently have fair values less
than amortized cost and therefore contain unrealized losses. At September 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 September 30, 2009, there are 37 investment securities in an
unrealized loss position exceeding a twelve month period with an amortized
cost of $2.8 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 to sell or
required to sell 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 three and six months ended September 30, 2009, the Bank recognized a
$1,000 and $205,000 OTTI charge related to 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 and six months ended September 30, 2008.
The table below presents the AFS maturity schedule of the securities as
of September 30, 2009:
Maturity Schedule of Securities
at September 30, 2009
----------------------------
Available-For-Sale
----------------------------
Amortized Estimated
(In thousands) Cost Fair Value
--------- ----------
Maturities:
Less than one year $ 525 $ 536
One to five years 11,160 11,854
Over five to ten years 21,483 22,412
Over ten years 25,464 26,274
------- -------
58,632 61,076
------- -------
Mutual funds and marketable
equity securities 312 933
------- -------
Total investment securities $58,944 $62,009
======= =======
22
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 September 30, 2009:
Book Market
(In thousands) Value Value
------- -------
To the Federal Home Loan Bank to secure borrowings $ 4,788 $ 4,988
To the Federal Reserve Bank to secure borrowings 7,999 8,341
To state government to secure public funds 11,032 11,563
To secure repurchase agreements 9,965 10,278
To the Federal Reserve Bank to secure customer tax
payments 1,858 1,942
Other pledged investments 2,197 2,313
------- -------
$37,839 $39,425
======= =======
Asset Quality and Non-Performing Assets. The Corporation manages its
credit risk exposure by managing the loan concentrations, ensuring sufficient
underwriting policies and procedures, and conducting loan reviews. 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. The foundation of our
allowance for loan losses begins with a proper loan grading system. The loan
grading system classifies loans 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 allowance for loan losses is comprised of: (1) a
component for individual loan impairment, and (2) a measure of collective loan
impairment. Each of these are explained in greater detail in the subsequent
paragraphs.
The individual loan impairment component 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 September 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, which
contributed to the $29.0 million and $64.5 million provision for loan losses
for the three and six months ended September 30, 2009. Despite the additional
provision, the allowance for loan losses declined to $35.9 million at
September 30, 2009 from $39.0 million at March 31, 2009 as a result of a
substantial amount of charge-offs during the period.
The loans that do not meet the definition for "impairment" are aggregated
into separate pools based on loan type and loan risk (grade). 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 collective loan impairment analysis at
September 30, 2009 were from a low of 0.16% to a high of 10.49%. 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 estimated contingent losses. Some of
the qualitative factors influencing the collective loan impairment
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 8) national and local
economics. Based on management's methodology and best estimate, we measured
the accounting contingent loss for the collective loan impairment 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.
23
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 further 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
September 30, June 30, September 30,
2009 2009 2008
_----------- ----------- -----------
(Dollars in thousands)
Allowance at beginning of period $ 51,499 $ 38,981 $ 19,149
Provision for loan losses 29,000 35,521 12,000
Charge offs (net of recoveries) (44,558) (23,003) (5,570)
----------- ----------- -----------
Allowance at end of period $ 35,941 $ 51,499 $ 25,579
=========== =========== ===========
Allowance for loan losses as a
percentage of gross loans receivable
at the end of the period 3.69% 4.74% 2.02%
Allowance for loan losses as a
percentage of net loans receivable at
the end of the period 3.83% 4.98% 2.06%
Net charge-offs as a percentage of average
loans outstanding during the period 4.44% 2.08% 0.45%
Allowance for loan losses as a
percentage of non-performing loans 40.71% 44.43% 32.64%
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 September 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 September 30, 2009, the amount of loss estimate
for the liability for unfunded loan commitments was measured to be in the
amount of $525,000, 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 as we have virtually ceased originating loans; thereby
reducing the overall risk exposure and requiring a lower reserve for
contingent losses. Loan commitments have declined from $223.3 million as of
March 31, 2009 to $150.2 million as of September 30, 2009, a decline of $73.1
million or 32.8%.
Non-Performing Assets. As of September 30, 2009, there was one loan in
the loan portfolio over 90 days delinquent and accruing interest and 64 loans
on non-accrual status. At September 30, 2009, total non-performing loans were
$88.3 million compared to $85.4 million at March 31, 2009 and $78.4 million at
September 30, 2008. The Bank had 31 properties in the real estate owned
category totaling $40.1 million at September 30, 2009. Total non-performing
assets represented $128.4 million, or 9.9% of total assets at September 30,
2009 compared to $104.7 million or 7.1% of total assets at March 31, 2009 and
$80.2 million or 5.5% of total assets at September 30, 2008.
24
Troubled Debt Restructured ("TDR") assets represented $29.2 million, or
2.2% of total assets at September 30, 2009 compared to $26.4 million or 1.8%
of total assets at March 31, 2009 and there were no TDRs at September 30,
2008. The TDRs at September 30, 2009 were all accruing, except three loans
totaling $2.2 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 September 30, As of March 31,
-------------------- ----------------
Non-performing assets 2009 2008 2009
-------- -------- ----------------
(Dollars in thousands)
Accruing loans - 90 days past due $ 47 $ 589 $ 500
Non-accrual loans 88,242 77,781 84,924
-------- -------- ----------------
Total non-performing loans 88,289 78,370 85,424
Real estate owned 40,117 1,859 19,227
-------- -------- ----------------
Total non-performing assets $128,406 $ 80,229 $ 104,651
======== ======== ================
Total non-performing loans/gross loans 9.06% 6.15% 7.35%
Total non-performing assets/total assets 9.88% 5.53% 7.13%
Total non-performing assets to
total capital plus allowance for
loan losses 263.57% 54.25% 79.20%
Troubled debt restructuring at the end
of the period $ 29,188 $ - $ 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 75% of the non-performing assets; whereas the two counties with the
most non-performing assets are Snohomish and and Pierce counties with $79.0
million or 61.5% 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
ended September 30, 2009, according to RealEstats, Inc, the available housing
inventory levels for Snohomish, Skagit, Pierce, King and Whatcom counties were
9.2, 11.9, 7.5, 6.9 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 might have an
impact on our ability to reduce non-performing assets and mitigate future
losses.
25
The following table summarizes the Bank's total non-performing assets at September 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 $ 3,056 $ - $ 62 $ - $ 1,990 $ - $ 5,108 4%
One-to-four family construction - 253 191 - 544 - 988 1%
-------- -------- -------- -------- -------- -------- -------- -------
Subtotal 3,056 253 253 - 2,534 - 6,096 5%
Commercial land development 7,119 162 25,110 3,773 8,426 12,047 56,637 44%
Commercial construction (1) 296 212 5,348 12,042 18,923 2,396 39,217 31%
Multi-family residential - - - - - - - -
Commercial real estate 1,990 5,148 11,831 - 2,094 - 21,063 16%
Commercial business 1 719 2,735 - 148 - 3,603 3%
Home equity secured 85 82 - - 1,620 - 1,787 1%
Other consumer 3 - - - - - 3 -
-------- -------- -------- -------- -------- -------- -------- -------
Subtotal 9,494 6,323 45,024 15,815 31,211 14,443 122,310 95%
Total non-performing assets $12,550 $6,576 $ 45,277 $15,815 $33,745 $14,443 $128,406 100%
======== ======== ========= ======== ======== ======== ======== =======
(1) The commercial construction totals include $9.0 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 September 30, 2009 the Bank identified $127.7 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 and six months ended September 30, 2009 and 2008:
For the Three For the Six
Months Ended Months Ended
September 30, September 30,
2009 2008 2009 2008
------- ------ ------- --------
(In thousands)
Balance at beginning of period $22,537 $2,764 $19,227 $ 655
Additions to REO 26,662 304 44,282 2,413
Valuation adjustments (2,019) (160) (2,714) (160)
Disposition of REO (7,063) (1,049) (20,678) (1,049)
------- ------ ------- --------
Balance at end of period $40,117 $1,859 $40,117 $ 1,859
======= ====== ======= ========
The Corporation recognized write-downs or losses on REO of $2.0 million
and $4.1 million for the three and six months ended September 30, 2009
compared to $335,000 for both the three and six months ended September 30,
2008 related to the disposition of properties. At September 30, 2009 REO
totaled $40.1 million and consisted of 31 properties located in Whatcom,
Skagit, Snohomish, King, Pierce and Thurston counties in Washington state,
with balances ranges from $20,000 to $7.2 million. 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.
26
The following table summarizes the Bank's real estate owned at September 30, 2009 by county and by
classification:
Real estate owned by Whatcom Skagit Snohomish King Pierce Other Total % of
classification County County County County County County REO REO
-------- -------- -------- -------- -------- -------- -------- ------
(Dollars in thousands)
<s> <c> <c> <c> <c> <c> <c> <c> <c>
One-to-four family construction $ - $ - $ - $ - $ 20 $ - $ 20 -
Commercial land development 4,085 162 14,175 2,982 1,734 985 24,123 60%
Commercial construction 296 211 3,006 247 4,106 970 8,836 22%
Commercial real estate 1,990 5,148 - - - - 7,138 18%
-------- -------- -------- -------- -------- -------- -------- ------
Total real estate owned $ 6,371 $ 5,521 $17,181 $ 3,229 $ 5,860 $ 1,955 $40,117 100%
======== ======== ======== ======== ======== ======== ======== ======
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 September 30, 2009 was $18.2 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") was published in
September 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.
Due to the decline in the Bank's capital levels at September 30, 2009 the
aggregate amount invested in real estate joint ventures now exceeds the 25% of
Tier 1 capital requirement set forth in the FDIC's letter to Horizon Bank
dated May 24, 1994 (said letter allows Horizon Bank to continue engaging in
residential real estate development activities). As such, the Bank does not
intend to develop the properties owned by the Bank's real estate development
subsidiary until such time as the Bank regains compliance with the capital
provisions outlined in the May 24, 1994 letter referenced above. Instead, the
Bank will limit the activities solely to working towards obtaining the
entitlements for said properties, which are necessary for obtaining permits in
the future.
The investment in GBNW is a variable interest entity with the Corporation
as the primary beneficiary and is subject to consolidation under the
provisions of Financial Accounting Standards Board ("FASB") Accounting
Standards Codification ("ASC") 810, Consolidation. As of September 30, 2009,
the real estate joint venture had a carrying amount of approximately $18.2
million, with a related borrowing of approximately $24.5 million after
consolidation. During the process of consolidation, inter-company
transactions were eliminated; including the $24.5 million receivable and the
associated $6.8 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 the consolidation of noncontrolling interests
under the provisions of Financial Accounting Standards Board ("FASB")
Accounting Standards Codification ("ASC") 810, Consolidation on April 1, 2009.
As a result, we reclassified $104,000 and $134,000 of minority interest
liabilities as of September 30, 2009 and March 31, 2009, respectively from
liabilities to equity on our balance sheet. Noncontrolling interests' share
of net loss was $15,000 and $30,000 for the three and six months ended
September 30, 2009 and $3,000 and $7,000 for the three and six months ended
September 30, 2008.
27
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.
At September 30, 2009, we reviewed the analysis and there was no change in our
conclusion from March 31, 2009.
Deposits. Total liabilities decreased $87.5 million or 6.4% to $1.29
billion at September 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 4.5% to $1.17 billion at September 30, 2009 from $1.23 billion
at March 31, 2009 as brokered certificates of deposit ("CDs"), matured and
paid off. Brokered deposits declined $73.1 million, or 28.0% from $261.4
million at March 31, 2009 to $188.3 million at September 30, 2009. This
decline was consistent with the Bank's current operating strategy as required
by the existing Order to eliminate our reliance on brokered certificates. The
Bank may not accept new brokered deposits or renew existing brokered deposits.
Maturities for brokered deposits are $46.0 million through March 31, 2010,
$97.2 million in fiscal 2011 and $45.1 million in fiscal 2012, 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 September 30, 2009 and March 31, 2009:
September 30, March 31,
(In thousands) 2009 2009
------------- -----------
Core deposits
Savings $ 15,977 $ 15,850
Checking 83,920 83,286
Checking (noninterest-bearing) 93,679 80,103
Money Market 114,941 133,022
Certificates of deposit less than $100,000 361,326 352,785
------------- -----------
669,843 665,046
------------- -----------
Other deposits
Certificates of deposit $100,000 and above 315,838 303,308
Brokered certificates of deposit 188,339 261,410
------------- -----------
504,177 564,718
------------- -----------
Total deposits $1,174,020 $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"). However, as of September
30, 2009, no additional amounts may be borrowed under both the FHLB and FRB
lines. As of September 30, 2009, we had outstanding at the FHLB a total of
$100.5 million as compared to $129.5 million at March 31, 2009. At the FRB,
we had no balance outstanding as of September 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 September 30, 2009
decreased $80.4 million or 86.3% to $12.8 million from $93.2 million at March
31, 2009. This decrease was the result of the net loss of $35.1 million and
$80.8 million for the three and six months ended September 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 0.98% at September 30,
2009, compared to 6.35% at March 31, 2009.
28
Comparison of Operating Results for the Three Months Ended September 30, 2009
and September 30, 2008
- -----------------------------------------------------------------------------
General. The Corporation recognized a net loss of $35.1 million for the
three months ended September 30, 2009 compared to a net loss of $4.6 million
for the three months ended September 30, 2008. Diluted loss per share for the
three months ended September 30, 2009 was $2.93 on weighted average diluted
shares outstanding of 11,995,279, compared to diluted loss per share of $0.39
on weighted average diluted shares of 11,940,064 for the three months ended
September 30, 2008.
Net Interest Income. Net interest income before provision for loan losses
for the three months ended September 30, 2009 decreased $5.9 million or 54.3%
to $5.0 million from $10.9 million for the comparable period in 2008. Total
interest income decreased 34.3% in the quarter ended September 30, 2009 to
$13.6 million from $20.8 million in the quarter ended September 30, 2008.
Interest and fee income on loans for the quarter ended September 30, 2009
decreased 35.3% to $12.8 million, from $19.8 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 $535,000 in interest income on an annual basis. The average
yield on loans decreased 126 basis points to 5.10% for the three months ended
September 30, 2009 from 6.36% for the comparable period in 2008. Also
contributing to this decline was an overall lower level of average loans
outstanding at September 30, 2009 of $1.00 billion compared to $1.25 billion
at September 30, 2008. In addition, there were $1.0 million in interest
reversals related to the increase in non-accrual loans during the three months
ended September 30, 2009 compared to $1.1 million for the quarter ended
September 30, 2008.
Included in interest income for the three months ended September 30, 2009
and 2008 were $479,000 and $984,000, 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
September 30, 2009 and 2008:
For the Three Months Ended
September 30,
---------------------------
2009 2008
--------- ---------
(In thousands)
Commercial loan deferred fees $ 390 $ 826
One-to-four real estate mortgage loan
deferred fees 89 158
--------- ---------
Total $ 479 $ 984
========= ==========
Interest on investment securities decreased 14.0% to $816,000 for the
three months ended September 30, 2009 from $949,000 for the comparable period
a year ago. In an effort to increase on-balance sheet liquidity, the Bank
elected not to renew maturing securities or replace pay downs of principal
with new investment securities during the six months ended September 30, 2009.
Also 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.
Total interest expense for the quarter ended September 30, 2009 decreased
12.2% to $8.6 million from $9.8 million for the quarter ended September 30,
2008. Interest on deposits decreased to $7.9 million for the three months
ended September 30, 2009 from $8.5 million for the three months ended
September 30, 2008 as a result of an overall lower level of interest rates
compared to the previous period. At September 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 our success in this regard.
In addition, the Bank is operating under the Order and was "critically
undercapitalized as of September 30, 2009 and as a result is limited on the
pricing of deposits to 75 basis points above the market average. The Bank's
average cost of deposits decreased 35 basis points to 2.69% for the three
months ended September 30, 2009 from 3.04% for the same three months in 2008,
due to lower market rates.
Interest on borrowings decreased to $701,000 during the quarter ended
September 30, 2009, compared to $1.3 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
September 30, 2009 of $119.7 million compared to
29
$182.7 million during the quarter ended September 30, 2008, as well as lower
interest rates during the current period. The Bank's average cost of
borrowings decreased 58 basis points to 2.34% for the three months ended
September 30, 2009 from 2.92% for the same three months in 2008. The Bank's
average cost of funds decreased 36 basis points to 2.66% for the three months
ended September 30, 2009 from 3.02% 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
3.26% for the quarter ended September 30, 2008 to 1.64% for the quarter ended
September 30, 2009. Significant factors contributing to the decline in the
net interest margin include 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, an overall lower level
of average loans outstanding 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. Also contributing to the decline in
the net interest margin was the drop in investment yields as a result of
management's decision to increase on-balance sheet liquidity with surplus cash
balances being held in the Bank's Federal Reserve settlement account,
currently paying 0.25%.
Average Balances, Interest and Average Yields/Costs. The following table
presents at the date and for the periods indicated, the average balances of
our interest-earning assets and interest-bearing liabilities and 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 September 30,
-----------------------------------------------------
2009 2008
-------------------------- --------------------------
Average Average
Average Yield/ Average Yield/
Balance Interest Cost Balance Interest Cost
(Dollars in thousands) ------- -------- ------ ------- -------- ------
Interest-earning assets:
Loans receivable $1,004,674 $ 12,813 5.10% $1,246,410 $19,808 6.36%
Investment securities 210,467 816 1.55% 93,757 949 4.05%
---------- -------- ------ --------- -------- ------
Total interest-
earning assets $1,215,141 $ 13,629 4.49% $1,340,167 $20,757 6.20%
Interest-bearing liabilities:
Deposits 1,177,285 7,932 2.69% 1,118,799 8,500 3.04%
Borrowings 119,698 701 2.34% 182,656 1,334 2.92%
---------- -------- ------ --------- -------- ------
Total interest-
bearing liabilit-
ies $1,296,983 $ 8,633 2.66% $1,301,455 $ 9,834 3.02%
-------- --------
Net interest income $ 4,996 $10,923
======== ========
Interest rate spread 1.82% 3.17%
Net interest margin 1.64% 3.26%
Ratio of average interest-earning
assets to average interest-
bearing liabilities 93.69% 102.97%
Provision for Loan Losses. The provision for loan losses represents an
expense against current period income that is added to the 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 $29.0 million for the three months ended September 30, 2009
compared to $35.5 million for the three months ended June 30, 2009 and $12.0
million for the three months ended September 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 $35.9 million, or 3.83% of net loans
receivable at September 30, 2009, compared to $39.0 million, or 3.47% of net
loans receivable at March 31 2009 and $25.6 million, or 2.06% of net loans
receivable at September 30, 2008. The $29.0 million provision for loan losses
resulted from a combination of the following factors in addition to the
continued negative economic outlook; (1) a continued high level of
non-performing loans at September 30, 2009 of $88.3 million compared to $85.4
million at March 31, 2009 and $78.4 million at September 30, 2008, (2) a
relatively
30
high level of delinquencies on performing loans, with 30 to 89 days past due
at September 30, 2009 totaling $47.3 million compared to $83.9 million at
March 31, 2009 and $46.0 million at September 30, 2008, and (3) a continued
high level of net charge-offs at $44.6 million for the quarter ended September
30, 2009 compared to $26.3 million and $5.6 million for the quarters ended
March 31, 2009 and September 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 (Loss). Noninterest income for the three months ended
September 30, 2009 decreased 193.0% to a loss of $1.0 million compared to
income of $1.1 million for the same period a year ago. Service fee income
decreased 16.9% to $681,000 for the quarter ended September 30, 2009 from
$819,000 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. There was a net loss on the sale of loans of $98,000
for the quarter ended September 30, 2009 compared to a net gain of $144,000 in
the comparable period one year ago due primarily to the discounted sale of
commercial loans in the current period. The Bank originated $17.1 million in
single-family mortgage loans held for sale during the quarter ended September
30, 2009 compared to $12.8 million for the quarter ended September 30, 2008.
The Bank continued its practice of selling most of its single-family mortgage
loan production servicing-released into the secondary market.
There was a net loss on sale of real estate owned of $2.0 million for the
three months ended September 30, 2009 compared to a net loss of $335,000 for
the three months ended September 30, 2008. The continued downturn in the
local housing market, which has negatively affected our real estate
construction, land development and completed lot loan portfolios, has led to
an increase of foreclosures into real estate owned on these related
properties. For the three months ended September 30, 2009, the Bank recognized
an REO valuation adjustment of $2.0 million, in addition to a $25,000 loss on
sale of REO. The REO valuation adjustment was the result of declines in the
market value of these properties subsequent to foreclosure.
There was a net loss on sales of investment securities of $54,000 for the
three months ended September 30, 2009 compared to a net loss of $777,000 for
the three months ended September 30, 2008. Due to the Bank's capital
condition, the Bank is prohibited from paying a dividend to the Corporation.
In an effort to increase cash balances available to cover expenses, the
Corporation elected to sell all equity securities held in the Corporation
during the three months ended September 30, 2009. The loss during the three
months ended September 30, 2008 resulted from the Bank electing to take a
redemption in-kind distribution for its $5.0 million investment in the AMF
family of mutual funds, due to the continuing decline in the net asset value
precipitated by the unprecedented disruption in the mortgage backed securities
markets. In addition, there was an OTTI charge in the amount of $1,000 for
the three months ended September 30, 2009 compared to no charge for the three
months ended September 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 September 30, 2009 declined
64.5% to $456,000 compared to $1.3 million for the three months ended
September 30, 2008. During the quarter ended September 30, 2008, the Bank
realized $767,000 in death benefits from the settlement of a Bank owned life
insurance policy.
Noninterest Expense. Noninterest expense for the three months ended
September 30, 2009 increased 33.1% to $10.4 million from $7.8 million for the
comparable quarter one year ago. Compensation and employee benefits decreased
16.4% to $3.6 million for the quarter ended September 30, 2009 compared to
$4.3 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 September
30, 2009 from the quarter ended September 30, 2008 at $1.1 million.
Real estate owned/collection expense increased to $2.0 million for the
three months ended September 30, 2009 from $206,000 in the quarter ended
September 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 $1.5 million for the quarter ended September
30, 2009 from $214,000 in the quarter ended September 30, 2008. The Bank's
regular quarterly assessment has increased for the three months ended
September 30, 2009 as a result of the Bank 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.
31
Other noninterest expense increased 27.4% to $1.8 million for the quarter
ended September 30, 2009 compared to $1.4 million for the quarter ended
September 30, 2008. During the quarter ended September 30, 2009, the Bank
incurred a loss of approximately $380,000 related to wire fraud.
Benefit or Provision for Income Tax. As a result of the Corporation's
determination that future taxable income may not be available to absorb
existing deferred tax assets, all tax benefits from operating losses in fiscal
2010 have been deferred and all deferred tax assets have been fully reserved.
The Corporation did not recognize any tax benefit for operating losses
incurred during the three months ended September 30, 2009. Excluding the
deferred tax valuation allowance of $12.5 million, the benefit for income tax
would have been 35.3% for September 30, 2009. This compares to an income tax
rate of 46.3% for the quarter ended September 30, 2008.
Comparison of Operating Results for the Six Months Ended September 30, 2009,
and September 30, 2008
- ----------------------------------------------------------------------------
General. The Corporation realized a net loss of $80.8 million for the six
months ended September 30, 2009, compared to a net loss of $2.6 million for
the six months ended September 30, 2008. Diluted loss per share for the six
months ended September 30, 2009, was $(6.74) on weighted average diluted
shares outstanding of 11,988,442, compared to diluted loss per share of
$(0.22) on weighted average diluted shares of 11,917,065 for the six months
ended September 30, 2008.
Net Interest Income. Net interest income before provision for loan losses
for the six months ended September 30, 2009, decreased 52.3% to $10.6 million
from $22.2 million for the comparable period in 2008. Interest on loans for
the six months ended September 30, 2009, decreased 34.2% to $26.5 million,
from $40.3 million for the comparable period a year ago. This decrease was a
result of a combination of factors, including 175 basis point reductions in
the Prime rate from September 2008 to September 2009. For each 25 basis point
decline in the Prime rate, this equates to a reduction of approximately
$535,000 in interest on an annual basis. The average yield on loans decreased
147 basis points to 5.03% for the six months ended September 30, 2009 from
6.50% for the comparable period in 2008. Also contributing to this decline
was an overall lower level of average loans outstanding at September 30, 2009
of $1.05 billion compared to $1.24 billion at September 30, 2008. In
addition, there was approximately $2.8 million in non-accrual interest
reversals related to the increase in non-accrual loans during the six months
ended September 30, 2009, compared to $2.2 million in interest reversals for
the six months ended September 30, 2008.
Also included in interest income for the six months ended September 30,
2009 and 2008 were $1.0 million and $2.1 million, respectively, of deferred
fee income recognition. The table below presents an analysis of deferred fee
recognition for the six months ended September 30, 2009 and 2008:
For the Six Months Ended
September 30,
-------------------------
2009 2008
-------- --------
(In thousands)
Commercial loan deferred fees $ 804 $ 1,796
One-to-four real estate mortgage loan
deferred fees 195 336
-------- --------
Total $ 999 $ 2,132
======== ========
Interest on investment securities decreased 12.0% to $1.7 million for the
six months ended September 30, 2009 from $1.9 million for the comparable
period a year ago. Total interest income decreased 33.2% to $28.2 million at
September 30, 2009 from $42.2 million in the comparable period one year ago as
a result of the factors discussed above.
Total interest paid on deposits decreased 5.3% to $16.2 million for the
six months ended September 30, 2009 from $17.1 million for the six months
ended September 30, 2008, as a result of overall lower interest rates during
the six months ended September 30, 2009 compared to the comparable period in
2008. The Bank's average cost of deposits decreased 41 basis points to 2.73%
for the six months ended September 30, 2009 from 3.14% for the same six months
in 2008.
Interest on borrowings decreased 51.3% to $1.4 million during the six
months ended September 30, 2009, compared to $2.9 million for the comparable
period one year ago. The decrease in interest expense during the period was a
result of a lower average balance of borrowings outstanding during the six
months ended September 30, 2009 of $122.7 million compared to $202.6 million
during the six months ended September 30, 2008, as well as lower interest
rates during the current period. The Bank's average cost of borrowings
decreased 56 basis points to 2.33% for the six months ended September 30, 2009
from 2.89% for the same six months in 2008. The Bank's average cost of funds
decreased 41 basis points to 2.69% for the six months ended September 30, 2009
from 3.10% for the same six months in 2008.
32
The effect of the changes in the interest-earning asset yield and
interest-bearing liability costs have reduced the net interest margin from
3.33% for the six months ended at September 30, 2008 to 1.69% for the six
months ended September 30, 2009. Significant factors contributing to the
decline in the net interest margin include 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.
Average Balances, Interest and Average Yields/Costs. The following table
presents for the periods indicated, the average balances of our
interest-earning assets and interest-bearing liabilities and 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 Six Months Ended September 30,
-----------------------------------------------------
2009 2008
-------------------------- --------------------------
Average Average
Average Yield/ Average Yield/
Balance Interest Cost Balance Interest Cost
(Dollars in thousands) ------- -------- ------ ------- -------- ------
Interest-earning assets:
Loans receivable $1,054,599 $ 26,497 5.03% $1,239,101 $ 40,254 6.50%
Investment securities 195,719 1,681 1.72% 91,388 1,910 4.18%
---------- -------- ----- ---------- -------- -----
Total interest-
earning assets $1,250,318 $ 28,178 4.51% $1,330,489 $ 42,164 6.34%
Interest-bearing liabilities:
Deposits 1,187,014 16,189 2.73% 1,087,478 17,087 3.14%
Borrowings 122,663 1,427 2.33% 202,563 2,927 2.89%
---------- -------- ----- ---------- -------- -----
Total interest-
bearing liabilit-
ies $1,309,677 $ 17,616 2.69% $1,290,041 $ 20,014 3.10%
-------- --------
Net interest income $ 10,562 $ 22,150
======== ========
Interest rate spread 1.82% 3.24%
Net interest margin 1.69% 3.33%
Ratio of average interest-earning
assets to average interest-
bearing liabilities 95.47% 103.14%
Provision for Loan Losses. For the six months ended September 30, 2009
the provision for loan losses was $64.5 million, compared to $15.0 million for
the same period in 2008 primarily due to deteriorating credit quality
indicators in the commercial construction and land development loan portfolio.
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 $64.5 million provision for loan losses
resulted from a combination of the following factors in addition to the
continued negative economic outlook; (1) a continued high level of
non-performing loans at September 30, 2009 of $88.3 million compared to $85.4
million at March 31, 2009 and $78.4 million at September 30, 2008, (2) a
relatively high level of delinquencies on performing loans, with 30 to 89 days
past due at September 30, 2009 totaling $47.3 million compared to $83.9
million at March 31, 2009 and $46.0 million at September 30, 2008, and (3) a
continued high level of net charge-offs at $44.6 million for the quarter ended
September 30, 2009 compared to $26.3 million and $5.6 million for the
quarters ended March 31, 2009 and September 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."
33
Noninterest Income (Loss). Noninterest income for the six months ended
September 30, 2009 decreased 145.7% to a loss of $1.6 million as compared to
noninterest income of $3.4 million for the same period a year ago. Service
fee income decreased 15.1% to $1.5 million for the six months ended September
30, 2009 from $1.8 million for six months ended September 30, 2008 due in
large part to the decrease in loan fees, such as letter of credit fees,
participation fees and pre-payment penalties. There was a net gain on the
sale of loans of $387,000 for the six months ended September 30, 2009 compared
to $348,000 in the comparable period one year ago primarily as a result of
the slowdown in the housing market. Included in this amount for the six months
ended September 30, 2009, was approximately $240,000 loss on the discount sale
of commercial loans during the period.
There was a net loss on sale of real estate owned of $4.1 million for
the six months ended September 30, 2009 compared to a net loss of $335,000 for
the six months ended September 30, 2008. The continued downturn in the local
housing market, which has negatively affected our real estate construction,
land development and completed lot loan portfolios, has led to an increase of
foreclosures on these related properties. For the six months ended September
30, 2009, the Bank recognized an REO valuation adjustment of $2.7 million, in
addition to a $1.4 million loss on sale of REO. The REO valuation adjustment
was the result of declines in the market value of these properties subsequent
to foreclosure.
There was a net loss on sales of investment securities of $54,000 for the
six months ended September 30, 2009 compared to a net loss of $198,000 for the
six months ended September 30, 2008. The Bank elected to sell selected equity
securities from the investment portfolio during the six months ended September
30, 2009. The loss during the three months ended September 30, 2008 resulted
from the Bank electing to take a redemption in-kind distribution for its $5.0
million investment in the AMF family of mutual funds, due to the continuing
decline in the net asset value precipitated by the unprecedented disruption in
the mortgage backed securities markets. In addition, there was an OTTI charge
in the amount of $205,000 for the six months ended September 30, 2009 compared
to no charge for the six months ended September 30, 2008.
Other noninterest income decreased 48.9% to $918,000 for the six months
ended September 30, 2009 from $1.8 million for the six months ended September
30, 2008, due primarily to a $767,000 death benefit realized from the
settlement of a Bank-owned life insurance policy in the 2008 period.
Noninterest Expense. Noninterest expense for the six months ended
September 30, 2009 increased 33.8% to $20.6 million from $15.4 million for the
comparable six months in 2008. Compensation and employee benefits decreased
20.8% for the six months ended September 30, 2009 to $7.0 million from $8.8
million for the comparable six months in 2008. 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 decreased slightly to $2.2 million for the six months ended
September 30, 2009 as compared to $2.3 million for the six months ended
September 30, 2008.
Real estate owned/collection expense increased to $4.5 million for the
six months ended September 30, 2009 from $311,000 in the six months ended
September 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 $3.2 million for the six months ended
September 30, 2009 from $259,000 in the six months ended September 30, 2008.
The Bank's regular quarterly assessment has increased for the six months ended
September 30, 2009 as a result of the Bank 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 six months
ended September 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 increased 6.4% to $2.9 million for the six
months ended September 30, 2009 compared to $2.7 million for the six months
ended September 30, 2008. During the current period, the Bank incurred a loss
of approximately $380,000 related to wire fraud.
34
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).
Six Months Ended September 30,
2009 vs. 2008
Increase (Decrease) Due to
--------------------------------------
Rate/
(In thousands) Volume Rate Volume Total
------ ------- ------ -------
Interest income:
Interest and fees on loans $ (5,994) $ (9,121) $ 1,358 $(13,757)
Investment securities and other
interest-bearing securities 2,181 (1,125) (1,285) (229)
--------- ---------- -------- --------
Total interest-earning assets $ (3,813) $ (10,246) $ 73 $(13,986)
========= ========== ======== ========
Interest expense:
Deposit accounts $ 1,564 $ (2,256) $ (206) $ (898)
Borrowings (1,188) (526) 214 (1,500)
--------- ---------- -------- --------
Total interest-bearing liabilities $ 376 $ (2,782) $ 8 $ (2,398)
========= ========== ======== ========
Increase (decrease) in net interest
income $ (4,189) $ (7,464) $ 65 $(11,588)
========= ========== ======== ========
Liquidity and Capital Resources
- -------------------------------
Historically, the Corporation's primary source of funds has been
dividends from the Bank. Because of its capital condition, the Bank is not
permitted to pay dividends or make any other payments to the Corporation. At
September 30, 2009, the Corporation had liquid assets (cash and marketable
securities with maturities of one year or less) of $159.9 million. The
Corporation's consolidated financial statements have been prepared on a going
concern basis, which contemplates the realization of assets and the
satisfaction of liabilities in the normal course of business. Our ability to
continue as a going concern is substantially dependent on the successful
execution of the actions referred to in Notes 2 and 3 of the Notes to the
Selected Consolidated Financial Statements. The uncertainty of successful
execution of our plan, among other factors, raises substantial doubt as to our
ability to continue as a going concern. The accompanying consolidated
financial statements do not include any adjustments that might result from the
outcome of this uncertainty.
As of September 30, 2009, the total amortized cost of investments and
mortgage-backed securities was $58.9 million compared to a market value of
$62.0 million with a net unrealized gain of $3.1 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.
Our 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 September 30, 2009, we had $1.17 billion of deposits and $188.3
million or 16.0% of our total deposits were in brokered certificates of
deposit. The Bank, however, is operating under the Order and was "critically
undercapitalized as of September 30, 2009 and as a result is not permitted to
accept or renew brokered deposits. Maturities for brokered deposits are
$46.0 million through March 31, 2010, $97.2 million in fiscal 2011 and $45.1
million in fiscal 2012, which will be paid with available liquid funds and
funds generated from the sale of loans and growth in core deposits. In
addition, the Bank 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 and as a result of the restrictions we are under on the pricing of
deposit interest rates, our liquidity may be negatively impacted, possibly
materially.
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
September 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.
35
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 September 30, 2009 was $12.8 million, or 0.98%
of assets, compared to $93.2 million, or 6.3% of assets at March 31, 2009. As
of September 30, 2009, the Bank fell below the minimum level required to be
adequately capitalized by regulatory standards and is considered to be
"critically undercapitalized." The total risk based capital ratio was 1.98%
compared to the 8.0% level required to be considered adequately capitalized.
As of September 30, 2009, the Bank's Tier 1 leverage ratio was 0.77% and the
Tier 1 risk based capital ratio was 0.99%, compared to the 4.0% level required
for both ratios to be considered adequately capitalized. As a result of the
Bank's critically 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 September 30, 2009 to its minimum regulatory capital
requirements at that date (in thousands):
To Be Well Capitalized
For Capital Under Prompt Corrective
Actual Adequacy Purposes Action Provisions
--------------- ------------------ ----------------------
Amount Ratio Amount Ratio Amount Ratio
------- ------- -------- --------- -------- -----------
Total Capital
(to Risk Weighted
Assets)
Consolidated $ 21,332 2.02% $ 84,376 >8.00% N/A
Horizon Bank $ 20,876 1.98% $ 84,367 >8.00% $105,458 >10.00%
Tier I Capital
(to Risk Weighted
Assets)
Consolidated $ 10,666 1.01% $ 42,188 >4.00% N/A
Horizon Bank $ 10,438 0.99% $ 42,183 >4.00% $ 63,275 > 6.00%
Tier I Capital
(to Average
Assets)
Consolidated $ 10,666 0.79% $ 54,133 >4.00% N/A
Horizon Bank $ 10,438 0.77% $ 54,126 >4.00% $ 67,657 > 5.00%
As noted above, Horizon Bank is deemed "critically undercapitalized" by
regulatory definition. See Notes 2 and 3 of the Notes to the Selected
Consolidated Financial Statements.
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 September 30, 2009, the
Corporation had no significant off-balance sheet derivative financial
instruments, nor did it have a trading portfolio of investments. At September
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.
36
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 September 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 September 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.
37
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.
There is substantial doubt about our ability to continue as a going concern.
Our ability to continue as a going concern is in substantial doubt as a
result of our significant net loss from operations in the three and six months
ended September 30, 2009, deterioration in the credit quality of the loan
portfolio, and the decline in the level of our regulatory capital to support
operations there is substantial doubt about the Corporation's ability to
continue as a going concern and is subject to our ability to identify and
consummate a strategic transaction, including a capital infusion, a merger or
sale of the Corporation or the Bank. We can give no assurance that we will
identify an alternative that allows our stockholders to realize an increase in
the value of the Corporation's stock and it is highly unlikely that we will be
able to do so. We also can give no assurance that a transaction or other
strategic alternative, once identified, evaluated and consummated, will
provide greater value to our stockholders than that reflected in the current
stock price. In addition, a transaction, which would likely involve equity
financing, would result in substantial dilution to our current stockholders
and could adversely affect the price of our common stock. Unless we return to
profitability or identify and execute a viable strategic alternative, which is
highly unlikely, it is not likely that we will be able to continue as a going
concern.
It is likely that the Bank will be placed into a federal conservatorship or
receivership.
As of September 30, 2009 the Bank was critically undercapitalized for
PCA purposes. Under the FDI Act, depository institutions that are "critically
undercapitalized" must be placed into conservatorship or receivership within
90 days of becoming critically undercapitalized, unless the institution's
primary Federal regulatory authority (here, the FDIC) determines and documents
that "other action" would better achieve the purposes of PCA. If the Bank
remains critically undercapitalized on average during the calendar quarter
beginning 270 days after it became critically undercapitalized, the FDI Act
requires the appointment of a a receiver unless the Bank and the FDIC
affirmatively can determine that, among other things, the Bank has positive
net worth and the FDIC can certify that the Bank is viable and not expected to
fail. Based on current circumstances, it is unlikely that the regulators would
pursue a course of action other than conservatorship or receivership. If the
Bank is placed into conservatorship or receivership, the Corporation would
suffer a complete loss of the value of its ownership interest in the Bank, and
subsequently may be exposed to significant claims by the FDIC and the DFI.
We are subject to additional requirements and restrictions on our operations
as a result of the Bank's "critically undercapitalized" status and the cost of
compliance, as well as any possible failure to comply, could have a material
adverse effect on our business, financial condition and results of operations.
As of September 30, 2009, the Bank's capital ratios had fallen below the
level required for "adequately capitalized" status to the "critically
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. These additional requirements and restrictions are described
in Notes 2 and 3 of the notes to the unaudited consolidated financial
statements. While the Corporation intends to take such actions as may be
necessary to enable the Bank to comply with the requirements of the Order, it
is highly unlikely that the Bank will be able to comply fully with the
provisions of the Order or that efforts to comply with the Order will not have
material and adverse effects on the operations and financial condition of the
Corporation. Our failure to comply with the Order or any additional
restrictions imposed upon us could have a material adverse effect on our
business and results of operations.
38
We may be subjected to negative publicity that may adversely affect our
business, financial condition, liquidity and results of operations.
We may be the subject of negative news reports discussing our current
financial situation and various departures of senior management as the press
and others speculate about whether we will be able to continue as a going
concern. These reports may have a negative impact on our business. For
example, even though our deposits are insured by the FDIC, customers may
choose to withdraw their deposits, and new customers may choose to do business
elsewhere. In addition, we may find that our service providers will be
reluctant to commit to long-term projects with us. Even if we are able to
improve our current financial situation, we may be the object of negative
publicity and speculation about our future.
We are subject to restrictions on the amount of interest that we can pay our
customers, which could cause our deposits to decrease. Because we depend on
deposits as a source of liquidity, a decrease in deposits would adversely
affect our ability to continue as a going concern.
Virtually all of our funding comes from traditional deposit products.
The Bank promotes selected deposit accounts to both individuals and businesses
at competitive rates. The Bank competes for customer deposits largely on the
basis of the interest rates that it pays out. The Bank is now restricted in
the amount of interest that it can pay out. As a result, we likely could
experience a decrease in new deposits, and our existing customers may transfer
their deposits to other institutions that are able to offer a higher interest
rate, which could have a material adverse effect on our ability to continue as
a going concern.
The Corporation and the Bank are prohibited from paying any dividends or
distributions on their respective equity securities.
As a result of their respective capital levels, neither the Corporation
nor the Bank may pay any dividends or make any distributions on their
respective equity securities without, among other things, prior written
regulatory approval. Given the Company's and the Bank's current condition, it
is doubtful that any regulator would approve any dividend payment or capital
distribution now or in the foreseeable future. Accordingly, the Corporation
will not be able to look to the Bank's financial resources to satisfy its own
financial obligations.
It is unlikely that we will be able to return to the business of originating
new loans or offering new products.
In light of regulatory restrictions and the current market conditions,
our current focus is on servicing our existing loan portfolio and we are
unsure when, if ever, we will begin to originate new loans or offer new
products. If we are unable to originate new, profitable loans for an extended
period, our financial condition and results of operations will continue to be
adversely affected.
We may be required to make further increases in our provisions for loan losses
and to charge off additional loans in the future, which could adversely affect
our results of operations.
For the quarter and six months ended September 30, 2009, we recorded a
provision for loan losses of $29.0 and $64.5 million, respectively compared to
$40.0 million for the quarter ended March 31, 2009 and $12.0 and $15.0 million
for the three and six months ended September 30, 2008, respectively, which
substantially reduced our results of operations for those periods. We also
recorded net loan charge-offs of $44.6 and $67.6 million for the quarter and
six months ended September 30, 2009, respectively compared with $26.3 million
for the quarter ended March 31, 2009 and $5.6 and $8.5 million for the three
and six months ended September 30, 2009, respectively. 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 September 30, 2009, our total non-performing loans
had increased to $88.3 million compared to $85.4 million at March 31, 2009 and
$78.4 million at September 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 $273.2 million
or 28.1% of our total loan portfolio at September 30, 2009, they represented
$95.9 million or 74.6% 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. An increase
in our credit losses or our provision for loan losses would adversely affect
our financial condition and results of operations.
39
If the trading price of our common shares fails to comply with the continued
listing requirements of The Nasdaq Global Select Market, we would face
possible delisting, which would result in a limited public market for our
common shares.
If we do not continue to comply with the continued listing requirements
for The Nasdaq Global Select Market, then Nasdaq may provide written
notification regarding the delisting of our securities. At that time, we would
have the right to request a hearing to appeal. The Nasdaq determination and
would also have the option to apply to transfer our securities to The Nasdaq
Capital Market.
We cannot be sure that our price will comply with the requirements for
continued listing of our common shares on The Nasdaq Global Select Market, or
that any appeal of a decision to delist our common shares will be successful.
If our common shares lose their status on The Nasdaq Global Select Market and
we are not successful in obtaining a listing on The Nasdaq Capital Market, our
common shares would likely trade in the over-the-counter market.
If our shares were to trade on the over-the-counter market, selling our
common shares could be more difficult because smaller quantities of shares
would likely be bought and sold, transactions could be delayed, and security
analysts' coverage of us may be reduced. In addition, in the event our common
shares are delisted, broker-dealers have certain regulatory burdens imposed
upon them, which may discourage broker-dealers from effecting transactions in
our common shares, further limiting the liquidity thereof. These factors could
result in lower prices and larger spreads in the bid and ask prices for common
shares.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
None
Item 3. Defaults Upon Senior Securities
None
Item 4. Submission of Matters to a Vote of Security Holders
None
Item 5. Other Information
None
40
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
September 27, 2006)
(10.12) Amended Salary Continuation Agreement between Horizon Bank and
Richard P. Jacobson (incorporated by reference to Exhibit 10.1
contained in the Registrant's Current Report on Form 8-K dated
January 23, 2008)
(10.13) Transition agreement with V. Lawrence Evans (incorporated by
reference to the registrant's Current Report on Form 8-K dated
March 25, 2008)
(10.14) Severance Agreement with Greg B. Spear (incorporated by
reference to the Registrant's Current Report on Form 8-K dated
October 24, 2008)
(14) Code of Ethics (incorporated by reference to the Registrant's
Annual Report on Form 10-K for the year ended March 31, 2007)
(31) Certification of Chief Executive Officer and Chief financial
Officer Pursuant to Section 302 of the Sarbanes-Oxley Act
(32) Certification of Chief Executive Officer and Chief Financial
Officer Pursuant to Section 906 of the Sarbanes-Oxley Act
41
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/Kelli J. Holz
--------------------------------
Kelli J. Holz
Interim Chief Financial Officer
Dated: November 9, 2009
----------------
42
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
43
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: November 9, 2009
/s/Richard P. Jacobson
-------------------------------------
Richard P. Jacobson
Chief Executive Officer
Exhibit 31.2
Certification
I, Kelli J. Holz, 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: November 9, 2009
/s/Kelli J. Holz
-----------------------------------
Kelli J. Holz
Interim Chief Financial Officer
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/Kelli J. Holz
- ---------------------------- --------------------------------
Richard P. Jacobson Kelli J. Holz
Chief Executive Officer Interim Chief Financial Officer
Dated: November 9, 2009