================================================================================
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
Exchange Act of 1934 For the quarterly period ended September 30,
2004
OR
[_] Transition Report Pursuant to Section 13 or 15(d) of The Securities
Exchange Act of 1934 For the transition period from ______ to ______
Commission File Number 005-57091
FIRST MUTUAL BANCSHARES, INC.
- --------------------------------------------------------------------------------
(Exact name of registrant as specified in its charter)
WASHINGTON 91-2005970
---------- ----------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
400 108th Avenue N.E., Bellevue, WA 98004
-----------------------------------------
(Address of principal executive offices) (Zip code)
Registrant's telephone number, including area code: (425) 453-5301
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes [X] No [_]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes [X] No [_]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date. November 12, 2004 5,285,414
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FIRST MUTUAL BANCSHARES, INC.
QUARTERLY REPORT ON FORM 10-Q
September 30, 2004
TABLE OF CONTENTS
Page
----
PART I: FINANCIAL INFORMATION.................................................................... 1
Forward-Looking Statements Disclaimer............................................. 1
ITEM 1. Financial Statements.................................................................. 1
ITEM 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations............................................................. 16
General...................................................................... 16
Overview..................................................................... 16
Results of Operations........................................................ 18
Net Income.............................................................. 18
Net Interest Income..................................................... 18
Noninterest Income...................................................... 20
Noninterest Expense..................................................... 22
Financial Condition.......................................................... 26
Asset Quality................................................................ 28
Portfolio Information........................................................ 29
Deposit Information.......................................................... 31
Business Segments............................................................ 31
Consumer Lending........................................................ 32
Residential Lending..................................................... 34
Business Banking Lending................................................ 35
Income Property Lending................................................. 36
Liquidity.................................................................... 37
Planned Expenditures for Plant and Equipment................................. 39
Capital...................................................................... 40
ITEM 3. Quantitative and Qualitative Disclosures About Market Risk............................ 41
ITEM 4. Controls and Procedures............................................................... 49
PART II: OTHER INFORMATION....................................................................... 49
ITEM 1. Legal Proceedings..................................................................... 49
ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds........................... 49
ITEM 3. Defaults Upon Senior Securities....................................................... 50
ITEM 4. Submission of Matters to a Vote of Security Holders................................... 50
ITEM 5. Other Information..................................................................... 50
ITEM 6. Exhibits.............................................................................. 50
SIGNATURES....................................................................................... 51
CERTIFICATIONS
i
PART I: FINANCIAL INFORMATION
FORWARD-LOOKING STATEMENTS DISCLAIMER
- -------------------------------------
Our Form 10-Q contains statements concerning future operations, trends,
expectations, plans, capabilities, and prospects of First Mutual Bancshares,
Inc. and First Mutual Bank (together, the "Bank") that are forward-looking
statements for the purposes of the safe harbor provisions under the Private
Securities Litigation Reform Act of 1995. Such forward-looking statements
include references to our goals and expectations regarding net income, return on
equity and interest rate margins, our anticipated loan production and quality
and growth and sales of loans and investment securities, references to trends in
income and expenses and anticipated banking center expansion, observations
pertaining to the potential disparate movement and repricing of assets and
liabilities, and information based on our market risk models and analysis.
Although we believe that the expectations expressed in these forward-looking
statements are based on reasonable assumptions within the bounds of our
knowledge of our business, operations, and prospects, these forward-looking
statements are subject to numerous uncertainties and risks, and actual events,
results, and developments will ultimately differ from the expectations and may
differ materially from those expressed or implied in such forward-looking
statements. Factors which could affect actual results include economic
conditions in our market area and the nation as a whole, interest rate
fluctuations, the impact of competitive products, services, and pricing, credit
risk management, our ability to control our costs and expenses, loan delinquency
rates, and the legislative and regulatory changes affecting the banking
industry. There are other risks and uncertainties that could affect us which are
discussed from time to time in our filings with the Securities and Exchange
Commission. These risks and uncertainties should be considered in evaluating the
forward-looking statements, and undue reliance should not be placed on such
statements. We are not responsible for updating any such forward-looking
statements.
ITEM 1. FINANCIAL STATEMENTS
In the opinion of management, the accompanying consolidated statements of
financial condition and related interim consolidated statements of income,
comprehensive income, stockholders' equity and cash flows reflect all
adjustments (which include reclassifications and normal recurring adjustments)
that are necessary for a fair presentation in conformity with accounting
principles generally accepted in the United States of America ("GAAP"). The
preparation of financial statements in conformity with GAAP requires management
to make estimates and assumptions that affect amounts reported in the financial
statements. Changes in these estimates and assumptions are considered reasonably
possible and may have a material impact on the financial statements.
Certain reclassifications have been made to the 2003 financial statements to
conform to the 2004 presentation. All significant intercompany transactions and
balances have been eliminated.
The information included in this Form 10-Q should be read in conjunction with
the First Mutual Bancshares, Inc. Year 2003 Annual Report on Form 10-K to the
Securities and Exchange Commission. Interim results are not necessarily
indicative of results for a full year.
Consolidated Financial Statements of the Company begin on page 2.
1
ITEM 1. FINANCIAL STATEMENTS
FIRST MUTUAL BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
September 30, December 31,
2004 2003
------------ ------------
ASSETS: (Unaudited)
CASH AND CASH EQUIVALENTS:
Interest-earning deposits $ 244,499 $ 845,607
Noninterest-earning demand deposits
and cash on hand 14,152,844 6,581,448
------------ ------------
14,397,343 7,427,055
MORTGAGE-BACKED AND OTHER SECURITIES
AVAILABLE-FOR-SALE 122,582,506 77,623,789
LOANS RECEIVABLE, HELD-FOR-SALE 16,300,328 10,143,319
MORTGAGE-BACKED AND OTHER SECURITIES
HELD-TO-MATURITY 7,980,387 8,903,441
LOANS RECEIVABLE 785,920,927 723,710,645
RESERVE FOR LOAN LOSSES (9,156,889) (8,406,198)
------------ ------------
LOANS RECEIVABLE, net 776,764,038 715,304,447
ACCRUED INTEREST RECEIVABLE 4,141,786 3,649,032
LAND, BUILDINGS AND EQUIPMENT, net 25,100,882 24,180,509
REAL ESTATE HELD-FOR -SALE 98,004 --
FEDERAL HOME LOAN BANK (FHLB) STOCK, 12,918,700 11,035,500
at cost
SERVICING ASSETS 1,235,071 468,413
OTHER ASSETS 1,644,754 2,108,572
------------ ------------
TOTAL $983,163,799 $860,844,077
============ ============
2
FIRST MUTUAL BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(Continued)
September 30, December 31,
2004 2003
------------ ------------
(Unaudited)
LIABILITIES:
Deposits:
Money market deposit and
checking accounts $236,442,189 $191,948,350
Regular savings 8,374,921 8,710,867
Time deposits 413,484,391 383,231,431
------------ ------------
Total deposits 658,301,501 583,890,648
Drafts payable 493,235 357,256
Accounts payable and other liabilities 13,493,495 12,899,194
Advance payments by borrowers for
taxes and insurance 3,262,387 1,727,345
FHLB advances 231,627,264 193,642,878
Other advances 1,000,000 500,000
Long term debentures payable 17,000,000 17,000,000
------------ ------------
Total liabilities 925,177,882 810,017,321
STOCKHOLDERS' EQUITY:
Common stock, $1 par value-
Authorized, 10,000,000 shares
Issued and outstanding, 5,285,414
and 4,729,693 shares, respectively 5,285,414 4,729,693
Additional paid-in capital 45,573,016 33,678,181
Retained earnings 7,435,398 12,832,652
Accumulated other comprehensive income(loss):
Unrealized (loss) on securities
available-for-sale and interest rate
swap, net of federal income tax (307,911) (413,770)
------------ ------------
Total stockholders' equity 57,985,917 50,826,756
------------ ------------
TOTAL $983,163,799 $860,844,077
============ ============
3
FIRST MUTUAL BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF INCOME
Quarters ended September 30, Nine months ended September 30,
---------------------------- -------------------------------
2004 2003 2004 2003
----------- ----------- ----------- -----------
(Unaudited) (Unaudited)
INTEREST INCOME:
Loans Receivable $12,722,386 $11,491,346 $36,925,337 $33,685,016
Interest on AFS Securities 1,209,939 722,572 2,872,226 2,059,613
Interest on HTM Securities 102,647 138,640 319,006 511,857
Interest Other 150,566 171,534 434,633 552,708
----------- ----------- ----------- -----------
14,185,538 12,524,092 40,551,202 36,809,194
INTEREST EXPENSE:
Deposits 3,106,614 2,965,163 8,965,459 8,995,474
FHLB advances and other 1,819,608 1,648,206 4,979,575 5,390,805
----------- ----------- ----------- -----------
4,926,222 4,613,369 13,945,034 14,386,279
----------- ----------- ----------- -----------
Net interest income 9,259,316 7,910,723 26,606,168 22,422,915
PROVISION FOR LOAN LOSSES 525,000 350,000 1,215,000 810,000
----------- ----------- ----------- -----------
Net interest income, after provision
for loan losses 8,734,316 7,560,723 25,391,168 21,612,915
NONINTEREST INCOME:
Gain on sales of loans 528,065 281,978 1,195,328 661,035
Servicing fees, net of amortization 88,825 17,574 202,466 47,071
Gain on sales of investments -- 189,041 70,870 662,564
Fees on deposits 147,569 132,123 438,734 383,411
Other 424,588 336,527 1,107,688 1,072,054
----------- ----------- ----------- -----------
Total noninterest income 1,189,047 957,243 3,015,086 2,826,135
4
FIRST MUTUAL BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF INCOME
(Continued)
Quarters ended September 30, Nine months ended September 30,
---------------------------- -------------------------------
2004 2003 2004 2003
----------- ----------- ----------- -----------
(Unaudited) (Unaudited)
NONINTEREST EXPENSE:
Salaries and employee benefits $ 3,553,389 $ 2,955,713 $10,208,582 $ 8,942,596
Occupancy 674,449 620,437 2,018,962 1,780,449
Other 1,861,167 1,512,191 5,541,761 4,066,078
----------- ----------- ----------- -----------
Total noninterest expense 6,089,005 5,088,341 17,769,305 14,789,123
----------- ----------- ----------- -----------
Income before federal income taxes 3,834,358 3,429,625 10,636,949 9,649,927
FEDERAL INCOME TAXES 1,308,553 1,160,400 3,610,153 3,263,927
----------- ----------- ----------- -----------
NET INCOME $ 2,525,805 $ 2,269,225 $ 7,026,796 $ 6,386,000
=========== =========== =========== ===========
PER SHARE DATA:
Basic earnings per common share $ 0.48 $ 0.44 $ 1.34 $ 1.23
Earnings per common share, assuming dilution $ 0.46 $ 0.42 $ 1.28 $ 1.20
WEIGHTED AVERAGE SHARES OUTSTANDING 5,279,971 5,185,909 5,256,990 5,173,914
WEIGHTED AVERAGE SHARES OUTSTANDING
INCLUDING DILUTIVE STOCK OPTIONS 5,529,531 5,374,523 5,505,854 5,325,814
5
FIRST MUTUAL BANCSHARES, INC, AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME
Accumulated
Common Stock Additional Comprehensive
---------------------- Paid-in Retained Income
Shares Amount Capital Earnings (Loss) Total
---------- ---------- ----------- ----------- ----------- -----------
BALANCE, December 31, 2001 4,725,966 $4,725,966 $31,411,296 $16,025,853 $ (191,818) $51,971,297
---------- ---------- ----------- ----------- ----------- -----------
Comprehensive income:
Net income 7,797,370 7,797,370
Other comprehensive income (loss), net of tax:
Unrealized gain on securities available-for-sale 1,391,521 1,391,521
Unrealized (loss) on interest rate swap (405,862) (405,862)
-----------
Total comprehensive income 8,783,029
Options exercised, including tax benefit of $169,903 67,573 67,573 551,848 619,421
Retirement of shares repurchased (1,019,256) (1,019,256) (13,963,793) (815,419) (15,798,468)
10% stock dividend 472,883 472,883 6,029,259 (6,502,142) --
Cash dividend declared ($0.28 per share) (1,291,442) (1,291,442)
---------- ---------- ----------- ----------- ----------- -----------
BALANCE, December 31, 2002 4,247,166 4,247,166 24,028,610 15,214,220 793,841 44,283,837
---------- ---------- ----------- ----------- ----------- -----------
Comprehensive income:
Net income 8,395,738 8,395,738
Other comprehensive income (loss), net of tax:
Unrealized gain on securities available-for-sale 87,186 87,186
Unrealized (loss) on interest rate swap (1,294,797) (1,294,797)
-----------
Total comprehensive income 7,188,127
Options exercised, including tax benefit of $219,124 53,040 53,040 571,618 624,658
Issuance of stock through employees' stock plans 1,386 1,386 23,617 25,003
10% stock dividend 428,101 428,101 9,054,336 (9,482,437) --
Cash dividend declared ($0.28 per share) (1,294,869) (1,294,869)
---------- ---------- ----------- ----------- ----------- -----------
BALANCE, December 31, 2003 4,729,693 4,729,693 33,678,181 12,832,652 (413,770) 50,826,756
========== ========== =========== =========== =========== ===========
Comprehensive income:
Net income 7,026,796 7,026,796
Other comprehensive income (loss), net of tax:
Unrealized gain on securities available-for-sale 836 836
Unrealized gain on interest rate swap 105,023 105,023
-----------
Total comprehensive income 7,132,655
Options exercised, including tax benefit of $337,052 77,622 77,622 1,116,000 1,193,622
Issuance of stock through employees' stock plans 2,019 2,019 47,992 50,011
10% stock dividend 476,080 476,080 10,730,843 (11,206,923) --
Cash dividend declared ($0.23 per share) (1,217,127) (1,217,127)
---------- ---------- ----------- ----------- ----------- -----------
BALANCE, September 30, 2004 5,285,414 $5,285,414 $45,573,016 $ 7,435,398 $ (307,911) $57,985,917
========== ========== =========== =========== =========== ===========
6
FIRST MUTUAL BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Nine months ended September 30,
-------------------------------
2004 2003
------------ ------------
(Unaudited)
OPERATING ACTIVITIES:
Net income $ 7,026,796 $ 6,386,000
Adjustments to reconcile net income to net cash
from operating activities:
Provision for loan losses 1,215,000 810,000
Depreciation and amortization 1,027,413 809,027
Deferred loan origination fees, net of accretion (51,829) (1,080,520)
Amortization of servicing assets 543,144 40,859
Gain on sales of loans (1,195,327) (661,037)
Gain on sale of securities available-for-sale (70,870) (662,563)
Loss on sale of repossed assets 7,200 --
FHLB stock dividends (338,800) (455,000)
Changes in operating assets & liabilities:
Loans receivable held-for-sale (6,157,009) 1,030,529
Accrued interest receivable (492,754) (217,694)
Other assets 463,818 71,733
Drafts payable 135,979 16,347
Accounts payable and other liabilities 449,692 (1,462,700)
Advance payments by borrowers for taxes
and insurance 1,535,042 1,284,161
------------ ------------
Net cash provided by operating activities 4,097,495 5,909,142
------------ ------------
INVESTING ACTIVITIES:
Loan originations (267,703,629) (259,630,209)
Loan principal repayments 189,454,472 154,774,527
Increase in undisbursed loan proceeds 15,783,029 27,310,743
Principal repayments & redemptions on
mortgage-backed and other securities 10,196,197 33,711,894
Purchase of securities held-to-maturity (1,126,983) (1,098,881)
Purchase of securities available-for-sale (55,243,492) (67,699,719)
Purchases of premises and equipment (1,900,661) (13,752,620)
Purchase of FHLB stock (1,544,400) --
Proceeds from sale of securities 2,228,958 25,442,072
------------ ------------
Net cash (used) by investing activities (109,856,509) (100,942,193)
7
FIRST MUTUAL BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Continued)
Nine months ended September 30,
-------------------------------
2004 2003
------------ ------------
(Unaudited)
FINANCING ACTIVITIES:
Net increase in deposit accounts $ 66,064,933 $ 50,000,917
Interest credited to deposit accounts 8,345,920 8,555,690
Proceeds from long-term debentures
(trust preferred securities) -- 4,000,000
Issuance of stock through employees's stock plans 50,011 25,003
Proceeds from advances 733,007,196 365,860,754
Repayment of advances (694,522,810) (337,886,832)
Dividends paid (1,072,518) (930,810)
Proceeds from exercise of stock options 856,570 285,242
------------ ------------
Net cash provided by financing activities 112,729,302 89,909,964
------------ ------------
NET INCREASE (DECREASE) IN CASH AND CASH
EQUIVALENTS $ 6,970,288 $ (5,123,087)
CASH & CASH EQUIVALENTS:
Beginning of year 7,427,055 14,971,527
------------ ------------
End of quarter $ 14,397,343 $ 9,848,440
============ ============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW
INFORMATION:
Loans originated for mortgage banking activities $ 79,779,185 $ 67,009,444
============ ============
Loans originated for investment activities $267,703,629 $259,630,209
============ ============
Proceeds from sales of loans held-for-sale $ 73,622,176 $ 68,039,973
============ ============
Cash paid during the year for:
Interest $ 13,819,639 $ 14,604,857
============ ============
Income taxes $ 2,528,000 $ 2,566,000
============ ============
SUPPLEMENTAL DISCLOSURES OF NONCASH
INVESTING ACTIVITIES:
Loans transferred to real estate
held-for-sale, net $ 98,004 $ 214,703
============ ============
8
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE 1.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The results of operations for the interim periods shown in this report are not
necessarily indicative of results to be expected for the fiscal year. In the
opinion of management, the information contained herein reflects all adjustments
necessary to make the results of operations for the interim periods a fair
statement of such operations.
The Bank had three stock-based employee/director compensation plans, which are
described more fully in the 2003 annual report. The plans are accounted for
under the recognition and measurement principles of APB Opinion No. 25,
Accounting for Stock Issued to Employees, and related interpretations. No
stock-based employee or director compensation cost is reflected in net income,
as all options granted under those plans had an exercise price equal to the
market value of the underlying common stock on the date of grant. The following
table illustrates the effect on net income and earnings per share if the fair
value recognition provisions of FASB Statement No. 123, Accounting for
Stock-Based Compensation, had been adopted.
Quarters Ended September 30, Nine Months Ended September 30,
---------------------------- -------------------------------
2004 2003 2004 2003
----------- ----------- ----------- -----------
Net Income, as reported $ 2,525,805 $ 2,269,225 $ 7,026,796 $ 6,386,000
Deduct: Total stock-based employee/
director compensation expense
determined under fair value based
method for all awards, net of related
tax effects (123,956) (111,274) (321,091) (216,187)
----------- ----------- ----------- -----------
Pro forma net income $ 2,401,849 $ 2,157,951 $ 6,705,705 $ 6,169,813
=========== =========== =========== ===========
Earnings per share:
Basic - as reported $ 0.48 $ 0.44 $ 1.34 $ 1.23
Basic - pro forma $ 0.45 $ 0.42 $ 1.28 $ 1.19
Diluted - as reported $ 0.46 $ 0.42 $ 1.28 $ 1.20
Diluted - pro forma $ 0.43 $ 0.40 $ 1.22 $ 1.16
Weighted average shares outstanding:
Basic 5,279,971 5,185,909 5,256,990 5,173,914
Diluted 5,529,531 5,374,523 5,505,854 5,325,814
The compensation expense included in the pro forma net income and net income per
share figures in the previous table are not likely to be representative of the
effect on reported net income for future years because options vest over several
years and additional awards generally are made each year.
9
NOTE 2.
MORTGAGE-BACKED AND OTHER SECURITIES AVAILABLE-FOR-SALE
The amortized cost and estimated fair value of securities available-for-sale at
September 30, 2004, and December 31, 2003 are summarized as follows:
Gross Gross
Gross unrealized unrealized Estimated
Amortized unrealized losses less losses more fair
cost gains than 1 Year than 1 Year value
------------ --------- --------- --------- ------------
SEPTEMBER 30, 2004
Freddie Mac securities $ 15,910,294 $ 45,811 $ -- $ 155,727 $ 15,800,378
Fannie Mae securities 40,580,828 150,844 57,254 252,379 40,422,039
Ginnie Mae securities 43,262,740 73,506 69,096 -- 43,267,150
US agency securities 22,983,282 121,658 12,000 -- 23,092,940
------------ --------- --------- --------- ------------
$122,737,144 $ 391,819 $ 138,350 $ 408,106 $122,582,507
============ ========= ========= ========= ============
DECEMBER 31, 2003
Freddie Mac securities $ 15,708,833 $ 60,174 $ 222,620 $ -- $ 15,546,387
Fannie Mae securities 43,069,484 292,309 324,031 -- 43,037,762
Ginnie Mae securities 8,010,938 -- 24,688 -- 7,986,250
US agency securities 10,980,831 105,409 32,850 -- 11,053,390
------------ --------- --------- --------- ------------
$ 77,770,086 $ 457,892 $ 604,189 $ -- $ 77,623,789
============ ========= ========= ========= ============
Certain investment securities shown above currently have fair values less
than amortized cost and therefore contain unrealized losses. The Bank has
evaluated these securities and has determined that the decline in value is
temporary and is related to the change in market interest rates since purchase.
The decline in value is not related to any company or industry specific event.
At September 30, 2004 and December 31, 2003 there were 13 and 8 investment
securities with unrealized losses, respectively. The Bank anticipates full
recovery of amortized cost with respect to these securities at maturity or
sooner in the event of a more favorable market interest rate environment.
NOTE 3.
MORTGAGE-BACKED AND OTHER SECURITIES HELD-TO-MATURITY
The amortized cost and estimated fair value of mortgage-backed and other
securities are summarized as follows:
Gross Gross
Gross unrealized unrealized Estimated
Amortized unrealized losses less losses more fair
cost gains than 1 Year than 1 Year value
------------ --------- --------- --------- ------------
September 30, 2004
Fannie Mae securities $ 6,262,886 $ 146,390 $ 15,404 $ -- $ 6,393,872
Freddie Mac securities 497,641 12,620 -- -- 510,261
Municipal bonds 1,219,860 3,916 -- 5,162 1,218,614
------------ --------- --------- --------- ------------
$ 7,980,387 $ 162,926 $ 15,404 $ 5,162 $ 8,122,747
============ ========= ========= ========= ============
December 31, 2003
Fannie Mae securities $ 7,028,766 $ 217,292 $ 2,118 $ -- $ 7,243,940
Freddie Mac securities 549,870 11,925 -- -- 561,795
Municipal bonds 1,324,283 2,598 -- 23,503 1,303,378
REMICs 522 -- -- -- 522
------------ --------- --------- --------- ------------
$ 8,903,441 $ 231,815 $ 2,118 $ 23,503 $ 9,109,635
============ ========= ========= ========= ============
Certain investment securities shown above currently have fair values less
than amortized cost and therefore contain unrealized losses. The Bank has
evaluated these securities and has determined that the decline in value is
temporary and is related to the change in market interest rates since purchase.
The decline in value is not related to any company or industry specific event.
At September 30, 2004 and December 31, 2003 there were 3 and 2 investment
securities with unrealized losses, respectively. The Bank anticipates full
recovery of amortized cost with respect to these securities at maturity or
sooner in the event of a more favorable market interest rate environment.
10
NOTE 4.
NONPERFORMING ASSETS
The Bank had nonperforming assets as follows:
September 30, 2004 December 31, 2003
------------------ -----------------
Nonperforming loans $ 899,055 $ 526,869
Real Estate and Repossessed assets
held-for-sale 101,004 11,200
----------- ----------
Total Nonperforming Assets $ 1,000,059 $ 538,069
=========== ==========
At September 30, 2004 and December 31, 2003, the Bank had three impaired loans
totaling $139,886, and $16,445, respectively defined under Statement of
Financial Accounting Standards (SFAS) No. 114, "Accounting by Creditors for
Impairment of a Loan."
NOTE 5.
EARNINGS PER SHARE
Basic Earnings Per Share is computed by dividing net income by the
weighted-average number of shares outstanding during the year. Diluted EPS
reflects the potential dilutive effect of stock options and is computed by
dividing net income by the weighted-average number of shares outstanding during
the year, plus the dilutive common shares that would have been outstanding had
the stock options been exercised.
The following is a reconciliation of the numerators and denominators of the
basic and diluted earnings per share computations for quarters and nine months
ending September 30, 2004 and September 30, 2003:
Income Shares Per share
(numerator) (denominator) amount
------------------------------------------------
Quarter ended September 30, 2004
Basic EPS:
Income available to common shareholders $ 2,525,805 5,279,971 $ 0.48
===========
Effect of dilutive stock options -- 249,560
------------- -----------
Diluted EPS:
Income available to common shareholders
plus assumed stock options exercised $ 2,525,805 5,529,531 $ 0.46
================================================
Nine months ended September 30, 2004
Basic EPS:
Income available to common shareholders $ 7,026,796 5,256,990 $ 1.34
===========
Effect of dilutive stock options -- 248,864
------------- -----------
Diluted EPS:
Income available to common shareholders
plus assumed stock options exercised $ 7,026,796 5,505,854 $ 1.28
================================================
Quarter ended September 30, 2003
Basic EPS:
Income available to common shareholders $ 2,269,225 5,185,909 $ 0.44
===========
Effect of dilutive stock options -- 188,614
------------- -----------
Diluted EPS:
Income available to common shareholders
plus assumed stock options exercised $ 2,269,225 5,374,523 $ 0.42
================================================
Nine months ended September 30, 2003
Basic EPS:
Income available to common shareholders $ 6,386,000 5,173,914 $ 1.23
===========
Effect of dilutive stock options -- 151,900
------------- -----------
Diluted EPS:
Income available to common shareholders
plus assumed stock options exercised $ 6,386,000 5,325,814 $ 1.20
================================================
11
NOTE 6.
RATE VOLUME ANALYSIS THIRD QUARTER 2004 NINE MONTHS ENDED SEPT 30, 2004
(Dollars in thousands) VS VS
THIRD QUARTER 2003 NINE MONTHS ENDED SEPT 30, 2003
INCREASE (DECREASE) DUE TO INCREASE (DECREASE) DUE TO
TOTAL TOTAL
VOLUME RATE CHANGE VOLUME RATE CHANGE
- -------------------------------------------------------------------------------- -----------------------------------
INTEREST INCOME
Investments:
Available-for-sale securities $ 424 $ 63 $ 487 $ 889 $ (77) $ 812
Held-to-maturity securities (32) (4) (36) (188) (3) (191)
Other equity investments 13 (33) (20) 29 (146) (117)
--------------------------------- -----------------------------------
Total investments 405 26 431 730 (226) 504
--------------------------------- -----------------------------------
Loans:
Residential $ 744 $ (127) $ 617 $ 2,072 $ (391) $ 1,681
Residential construction 419 40 459 1,576 21 1,597
Multifamily 193 (370) (177) 359 (1,229) (870)
Multifamily construction 21 (37) (16) 144 (83) 61
Commercial real estate and business (88) (117) (205) (123) (995) (1,118)
Commercial real estate construction 31 33 64 21 66 87
Consumer & other 360 128 488 1,296 504 1,800
--------------------------------- -----------------------------------
Total loans 1,680 (450) 1,230 5,345 (2,107) 3,238
--------------------------------- -----------------------------------
Total interest income $ 2,085 $ (424) $ 1,661 $ 6,075 $(2,333) $ 3,742
INTEREST EXPENSE
Deposits:
Money market deposit and checking $ 175 $ (16) $ 159 $ 519 $ (55) $ 464
Regular savings -- -- -- - (1) (1)
Time deposits 410 (427) (17) 1,036 (1,528) (492)
--------------------------------- -----------------------------------
Total deposits 585 (443) 142 1,555 (1,584) (29)
FHLB advances and other 270 (98) 172 882 (1,293) (411)
--------------------------------- -----------------------------------
Total interest expense 855 (541) 314 2,437 (2,877) (440)
Net interest income $ 1,230 $ 117 $ 1,347 $ 3,638 $ 544 $ 4,182
================================= ===================================
12
NOTE 7.
SEGMENTS
Beginning January 1, 2004 we changed the presentation of our Business Segments
to more accurately reflect the way these segments are managed within the Bank.
Prior to 2004 we had 3 segments: 1) Consumer Lending, 2) Commercial Lending, and
3) Investment Securities. We have made some changes to the original 3 segments
by:
Separating Residential Lending from the Consumer Segment
Splitting the Commercial Segment into two separate segments: Business
Banking and Income Property Lending
Allocating the income and expenses from the former Investment Securities
Segment to the new segments based upon asset size
The management reporting process measures the performance of the operating
segments based on the management structure of the Bank and is not necessarily
comparable with similar information for any other financial institution.
The reportable segments include the following:
Consumer Lending - Consumer lending includes home equity lending, direct
consumer loans, and indirect home improvement loans (sales finance). These
loans include lines of credit and loans for primarily consumer purposes.
This segment also sells loans into the secondary market. We may choose to
retain or sell the right to service the loans sold (i.e., collection of
principal and interest payments) depending upon market conditions.
Residential Lending - Residential lending offers loans to borrowers to
purchase, refinance, or build homes secured by one-to-four-unit family
dwellings. They also finance the purchase or refinance of buildable
residential lots. This segment also sells loans into the secondary market.
We may choose to retain or sell the right to service the loans sold (i.e.,
collection of principal and interest payments) depending upon market
conditions.
Business Banking - Business banking offers a full range of banking services
to small and medium sized businesses including deposit and cash management
products, loans to finance receivables, inventory, equipment as well as
permanent and interim construction loans for commercial real estate. The
underlying real estate collateral or business asset being financed
typically secures these loans.
Income Property Lending - Income Property Lending offers permanent and
interim construction loans for multifamily housing (over four units),
commercial real estate properties, and spec single-family construction. The
underlying real estate collateral being financed typically secures these
loans.
These segments are managed separately because each business unit requires
different processes and different marketing strategies to reach the customer
base that purchases the products and services. The segments derive a majority of
their revenue from interest income, and we rely primarily on net interest
revenue in managing these segments. No single customer provides more than 10% of
the Bank's revenues.
13
Financial information for the Bank's segments is shown below for Sept 30, 2004,
2003, and 2002:
BUSINESS INCOME
CONSUMER RESIDENTIAL BANKING PROPERTY
QUARTER ENDED SEPTEMBER 30: LENDING LENDING LENDING LENDING TOTALS
- --------------------------- ----------- ----------- ----------- ----------- -----------
Interest income 2004 $ 2,368,071 $ 4,057,970 $ 1,478,372 $ 6,281,125 $14,185,538
2003 1,791,768 3,015,371 1,352,364 6,364,589 12,524,092
2002 1,134,217 2,495,645 1,397,734 7,179,274 12,206,870
Interest Expense 2004 655,417 1,609,897 384,618 2,276,290 4,926,222
2003 578,637 1,306,029 325,779 2,402,924 4,613,369
2002 527,702 1,198,066 531,344 3,137,849 5,394,961
Net Interest Income 2004 1,712,654 2,448,073 1,093,754 4,004,835 9,259,316
2003 1,213,131 1,709,342 1,026,585 3,961,665 7,910,723
2002 606,515 1,297,579 866,390 4,041,425 6,811,909
Provision for loan losses 2004 132,290 208,765 45,310 138,635 525,000
2003 99,351 33,740 48,397 168,512 350,000
2002 137,991 59,876 67,447 384,686 650,000
Net interest income, after
provision for loan losses 2004 1,580,364 2,239,308 1,048,444 3,866,200 8,734,316
2003 1,113,780 1,675,602 978,188 3,793,153 7,560,723
2002 468,524 1,237,703 798,943 3,656,739 6,161,909
Noninterest income 2004 575,549 289,897 108,352 215,249 1,189,047
2003 178,422 331,840 93,559 353,422 957,243
2002 169,799 473,018 84,911 351,482 1,079,210
Noninterest expense 2004 1,524,205 1,512,514 1,269,703 1,782,583 6,089,005
2003 1,216,730 1,196,906 931,512 1,743,193 5,088,341
2002 699,919 845,666 664,806 1,853,154 4,063,545
Income before federal income taxes 2004 631,708 1,016,691 (112,907) 2,298,866 3,834,358
2003 75,472 810,536 140,235 2,403,382 3,429,625
2002 (61,596) 865,055 219,048 2,155,067 3,177,574
Federal income taxes 2004 215,409 347,100 (39,513) 785,557 1,308,553
2003 24,931 273,955 47,169 814,345 1,160,400
2002 (21,500) 292,680 73,817 729,642 1,074,639
Net income 2004 416,299 669,591 (73,394) 1,513,309 2,525,805
2003 50,541 536,581 93,066 1,589,037 2,269,225
2002 (40,096) 572,375 145,231 1,425,425 2,102,935
Total Interest Earning assets
(ending period balances) 2004 112,932,675 279,687,177 107,201,051 444,847,887 944,668,790
2003 93,244,409 202,616,402 85,879,137 432,864,165 814,604,113
2002 60,064,315 146,207,045 77,226,890 409,643,819 693,142,069
14
NOTE 7.
SEGMENTS (CONTINUED)
BUSINESS INCOME
CONSUMER RESIDENTIAL BANKING PROPERTY
YEAR-TO-DATE ENDED SEPTEMBER 30: LENDING LENDING LENDING LENDING TOTALS
- -------------------------------- ----------- ----------- ----------- ----------- -----------
Interest income 2004 $ 6,453,804 $11,592,479 $ 4,085,381 $18,419,538 $40,551,202
2003 4,544,282 8,331,555 4,082,976 19,850,381 36,809,194
2002 3,178,942 6,979,781 3,937,375 22,368,060 36,464,158
Interest Expense 2004 1,752,923 4,522,289 1,016,769 6,653,053 13,945,034
2003 1,714,034 3,552,754 1,229,706 7,889,785 14,386,279
2002 1,473,760 3,422,624 1,576,026 9,973,189 16,445,599
Net Interest Income 2004 4,700,881 7,070,190 3,068,611 11,766,486 26,606,168
2003 2,830,248 4,778,801 2,853,270 11,960,596 22,422,915
2002 1,705,182 3,557,157 2,361,349 12,394,871 20,018,559
Provision for loan losses 2004 381,924 278,169 126,704 428,203 1,215,000
2003 214,846 83,799 107,686 403,669 810,000
2002 165,482 73,833 81,006 464,679 785,000
Net interest income, after
provision for loan losses 2004 4,318,957 6,792,021 2,941,907 11,338,283 25,391,168
2003 2,615,402 4,695,002 2,745,584 11,556,927 21,612,915
2002 1,539,700 3,483,324 2,280,343 11,930,192 19,233,559
Noninterest income 2004 1,322,551 652,410 281,940 758,185 3,015,086
2003 385,318 961,601 299,475 1,179,741 2,826,135
2002 480,608 783,717 192,541 1,034,679 2,491,545
Noninterest expense 2004 4,149,611 4,335,059 3,655,838 5,628,797 17,769,305
2003 3,109,595 3,485,346 2,883,998 5,310,184 14,789,123
2002 2,211,700 2,443,501 2,044,784 5,974,568 12,674,553
-
Income before federal income taxes 2004 1,491,897 3,109,372 (431,991) 6,467,671 10,636,949
2003 (108,875) 2,171,257 161,061 7,426,484 9,649,927
2002 (191,392) 1,823,540 428,100 6,990,303 9,050,551
Federal income taxes 2004 506,567 1,055,311 (149,181) 2,197,456 3,610,153
2003 (38,924) 734,007 52,928 2,515,916 3,263,927
2002 (66,533) 616,519 143,677 2,366,747 3,060,410
Net income 2004 985,330 2,054,061 (282,810) 4,270,215 7,026,796
2003 (69,951) 1,437,250 108,133 4,910,568 6,386,000
2002 (124,859) 1,207,021 284,423 4,623,556 5,990,141
Total Interest Earning assets
(Averages) 2004 105,868,685 266,403,325 100,951,018 441,549,203 914,772,231
2003 82,438,926 183,120,043 87,327,342 434,261,850 787,148,161
2002 56,372,082 135,883,599 73,886,497 422,906,983 689,049,161
15
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
GENERAL
- -------
First Mutual Bancshares, Inc. (the "Company"), a Washington corporation, is a
bank holding company owning all of the equity of its wholly owned subsidiary,
First Mutual Bank. The Company is subject to regulation by the Federal Reserve
Bank of San Francisco. This discussion refers to the consolidated statements of
the Company and the Bank, and therefore the references to "Bank" in this
discussion refer to both entities.
First Mutual Bank is a Washington-chartered savings bank subject to regulation
by the State of Washington Department of Financial Institutions and the Federal
Deposit Insurance Corporation ("FDIC"). The Bank conducts business from its
headquarters in Bellevue, Washington, and has 12 full-service facilities located
in Bellevue (3), Issaquah, Kirkland (2), Monroe, Redmond, Sammamish, Seattle
(2), and Woodinville. We also have income property loan production offices
located in Bellingham and Tacoma, Washington and a consumer loan office located
in Jacksonville, Florida. The Bank's business consists mainly of attracting
deposits from the general public as well as wholesale funding sources, and
investing those funds primarily in real estate loans, small and mid-sized
business loans, and consumer loans.
OVERVIEW
- --------
As general corporate goals we seek to obtain a 15% or greater year-over-year
increase in net income and a 15% or better return on equity (ROE), although, as
would be expected, our net income and ROE will vary from period to period and
year to year. These are corporate goals and not forecasts. Our actual results
from the past four years are as follows:
YEAR-OVER-YEAR ANNUALIZED
INCREASE IN NET INCOME RETURN ON EQUITY
---------------------- ----------------
Third Quarter 2001 5% 14.13%
Third Quarter 2002 19% 17.11%
Third Quarter 2003 8% 18.72%
Third Quarter 2004 11% 17.92%
YEAR-OVER-YEAR ANNUALIZED
INCREASE IN NET INCOME RETURN ON EQUITY
---------------------- ----------------
Year-to-Date 2001 6% 14.37%
Year-to-Date 2002 15% 16.94%
Year-to-Date 2003 7% 18.27%
Year-to-Date 2004 10% 17.22%
Although our ROE ratio exceeded our corporate target for the last couple of
years, our net income growth has generally lagged our profit objectives. During
that period we have utilized
16
part of our earnings for investment in new business lines. About seven years ago
we realized that for the Bank to continue to achieve its goal of consistent
earnings we needed to expand our business lines from two to four. At that time
our operations consisted of residential and income property (commercial real
estate) lending. Those business lines were, and continue to be, solid
operations. However, for the Bank to continue to produce consistent earnings we
needed to broaden the operating base by two new lines, Business Banking and
Consumer Lending. The process of developing those lines has been expensive and
has added to both our staff and operating costs. The encouraging news is that
the Consumer Lending business line has been contributing to the Bank's profit
goals for the past year. The third quarter ROE for the business line was 18.34%
and year-to-date 15.83%. We anticipate that the results for the fourth quarter
and the year will top our corporate goal of 15%. The important point, however,
is that the results so far this year for Consumer Lending are improved from
prior years when we had negative returns on investment. Please see the "Business
Segments" and "Noninterest Expenses" sections for a further discussion of this
topic.
Our business lines obtain most of their revenue from net interest income, and a
key ratio that measures net interest income is the net interest margin. The net
interest margin hit a high of 4.09% in the fourth quarter of last year and has
declined to 4.03% in the first quarter to 3.97% last quarter. The third quarter
experienced a slight recovery, increasing 2 basis points. We are forecasting for
fourth quarter 2004 a range of 3.95% to 4.05%. In the first quarter of the year
we extended the maturities of our funding sources in anticipation of rising
rates, and in the second quarter we funded a $31.4 million purchase of
securities with longer-term liabilities. In addition, the strong growth in low
cost transaction accounts, coupled with the changes in the various interest rate
indices, have helped to improve the net interest margin.
The second key component of net interest income is the growth of earning assets
in the business lines. In the third quarter earning assets increased $133
million, as compared to the same quarter last year, with most of that growth
occurring in the loan portfolio, which has risen $83 million, or 12%. In the
last 12 months our assets have increased 17% which compares to the national
average of 8.13% for FDIC insured institutions for the 12 months ending June 30,
2004.* Please see the "Net Interest Income" and "Asset and Liability Management"
sections for a further discussion of net interest income and the processes by
which we manage that source of revenue.
A secondary source of revenue is noninterest income, which constituted 11% of
our third quarter, and 10% year-to-date, of our revenues (net interest income
plus noninterest income). Gain on sales of loans accounted for 44% of
noninterest income in the third quarter and 40% year-to-date. Deposit fee
income, which has steadily grown over the last few years, contributed 12% for
the quarter and 14% for the first nine months of the year. The miscellaneous
category, which amounted to 36% and 39% for the two periods, respectively, is
heavily influenced by rental income. Rental income is derived primarily from our
corporate headquarters. Within our corporate headquarters we occupy 43% of the
space, lease 32%, and offer for lease the remaining 25%. Additionally loan fees
have also been a significant contributor to miscellaneous noninterest income
this quarter. Please refer to the "Noninterest Income" section for a further
discussion of this subject. Servicing fee income accounts for the remaining 8%
and 7% for the third quarter and nine months ended September 30, 2004.
A critical factor in achieving our goal of consistent earnings is the credit
quality of our loan portfolio. That portfolio constitutes 82% of our assets, and
thus a deterioration in the performance of that asset class would quickly
undermine our earnings. Fortunately, for many years we have enjoyed credit
quality that has exceeded the national average. In the third quarter
17
of 2004, we again experienced solid credit quality as measured by the
non-performing assets to total assets ratio of 0.10%. That figure compares to
the national average of 0.60% for FDIC insured institutions as of June 30,
2004.* For additional information regarding our credit quality, please refer to
the "Asset Quality" section.
*FDIC QUARTERLY BANKING PROFILE, SECOND QUARTER 2004
RESULTS OF OPERATIONS
- ---------------------
NET INCOME
----------
Net income increased approximately 11%, from $2.3 million in the third quarter
of 2003 to $2.5 million in the same period of 2004. Net interest income, after
provision, rose $1.2 million, and noninterest income increased $232,000 on a
third quarter comparison. Partially offsetting the growth in revenue was a rise
of $1.0 million in noninterest expense.
NET INTEREST INCOME
-------------------
Our net interest income for the quarter and nine months ended September 30,
2004, increased $1.3 million and $4.2 million, or 17% and 19%, respectively,
over the same periods for the prior year. Relative to last year, growth in our
earning assets accounted for the majority of the improvement in net interest
income, though liability costs declining more than asset yields also contributed
$117,000 and $544,000 to net interest income over the three- and nine-month
periods. The following table illustrates the effects to our net interest income
of balance sheet growth and rate changes on our assets and liabilities, with the
results attributable to the level of earning assets classified as "volume" and
the effects of asset and liability repricing labeled "rate."
Rate/Volume Analysis Nine Months Ended Sept. 30, 2004
(Dollars in 000s) 3Q2004 vs. 3Q2003 vs. Nine Months Ended Sept. 30, 2003
Increase/(Decrease) due to Increase/(Decrease) due to
Volume Rate Total Volume Rate Total
------- ------- ------- ------- ------- -------
Interest Income
Total Investments $ 405 $ 26 $ 431 $ 730 $ (226) $ 504
Total Loans 1,680 (450) 1,230 5,345 (2,107) 3,238
------- ------- ------- ------- ------- -------
Total Interest Income 2,085 (424) 1,661 6,075 (2,333) 3,742
Interest Expense
Total Deposits 585 (443) 142 1,555 (1,584) (29)
FHLB and Other 270 (98) 172 882 (1,293) (411)
------- ------- ------- ------- ------- -------
Total Interest Expense 855 (541) 314 2,437 (2,877) (440)
------- ------- ------- ------- ------- -------
Net Interest Income $ 1,230 $ 117 $ 1,347 $ 3,638 $ 544 $ 4,182
======= ======= ======= ======= ======= =======
The growth in our earning assets contributed an additional $2.1 million and $6.1
million in incremental interest income for the quarter and nine months ended
September 30, 2004, compared with the same periods in the prior year. Partially
offsetting this income, however, was additional interest expense incurred from
the funding sources used to accommodate the asset growth. The additional expense
associated with these funding sources totaled $855,000 and $2.4 million for the
respective three- and nine-month periods. The net of these two factors resulted
in
18
an improvement in net interest income of $1.2 million, or 91% of the total
improvement for the quarter, and $3.6 million, or 87% of the total increase for
the first nine months of 2004.
(Dollars in 000s)
QUARTER ENDED AVERAGE EARNING ASSETS AVERAGE NET LOANS AVERAGE DEPOSITS
------------- ---------------------- ----------------- ----------------
September 30, 2003 $ 789,511 $ 691,672 $ 537,288
December 31, 2003 813,622 715,963 569,908
March 31, 2004 844,439 742,498 594,141
June 30, 2004 893,451 773,561 620,606
September 30, 2004 929,335 790,319 647,560
Based primarily on continued growth in our loan portfolio, our average earning
assets during the third quarter of 2004 totaled $929 million, an increase of
nearly $140 million, or 18%, over the third quarter of 2003. For the nine months
ended September 30, 2004, average earning assets totaled $880 million, an
increase of $119 million over the same period last year. In addition to the loan
growth illustrated in the table above, we had a number of security purchases
settle in the second and third quarters of this year. With these additional
securities, our portfolio totaled $131 million at the end of the third quarter,
compared to $82 million at September 30, 2003.
The majority of asset growth was funded with additional deposits, including
certificates issued in institutional markets through deposit brokerage services.
Additionally, we utilize wholesale borrowings, primarily advances from the
Federal Home Loan Bank of Seattle (FHLB), to facilitate asset growth beyond that
which our deposit growth will accommodate, as well as to match-fund specific
asset categories. For the third quarter of 2004, our deposits averaged $648
million, representing growth of approximately $110 million over the average
level of third quarter 2003. Results for the nine months ended September 30 were
similar, with average deposits rising from $527 million in 2003 to $621 million
this year. On a quarter-end versus quarter-end basis, deposits grew $102
million, with checking and money market balances accounting for $66 million, or
64% of the total growth. The growth in these deposit product balances going
forward is an important facet of our overall funding strategy.
Net Interest Margin
-------------------
QUARTER ENDED NET INTEREST MARGIN
------------- -------------------
September 30, 2003 4.01%
December 31, 2003 4.09%
March 31, 2004 4.03%
June 30, 2004 3.97%
September 30, 2004 3.99%
Our net interest margin totaled 3.99% for the third quarter, rising two basis
points from that of the second quarter. With the exception of the 4.09% achieved
in the fourth quarter of 2003, our margin has remained in a fairly consistent
range near the 4.00% level over the last year. Contributing to the improvement
in the last quarter was the above-mentioned growth in checking and money market
deposit balances, as well as increases in various major rate indexes to which
many of our loans are tied.
On a quarter-end versus quarter-end basis, deposits grew $102 million, with
checking and money market balances accounting for $66 million, or 64% of the
total growth. Strong third quarter
19
growth in these lower-cost transaction accounts helped reduce our overall cost
of funds and thus contributed to the quarter's improvement in net interest
margin.
Also contributing to the improvement were increases in various interest rate
indexes over the last several months. Adjustable rate loans account for the vast
majority of our loan portfolio, and most of these loans are subject to regular
repricing based on changes in one of these rate indexes. While the above
Rate/Volume Analysis table indicates that our overall third quarter loan yields
resulted in less interest income than in the third quarter of last year,
improvement was observed among some loan products relative to the second quarter
of this year as the underlying interest rate indexes used to price the loans
have moved upwards from historically low levels.
Partially offsetting the margin improvement from increases in these rate indexes
was the above-mentioned growth in our securities portfolio. Since securities
typically carry lower yields than loans, adding securities rather than loans to
the balance sheet will generally result in a reduction in the net interest
margin.
NONINTEREST INCOME
------------------
Noninterest income increased $232,000, or 24%, for the third quarter of 2004 as
compared to the like quarter in 2003. Year-to-date the results show a rise of
$189,000, or 7%. The increase for the quarter was mainly attributable to the
rise in gain on sales of loans which was somewhat offset by the decline in gain
on sales of investments. The year-to-date results were affected by the same two
factors but with a much larger impact on the decline in sales of investments.
Gain on Sales of Loans
----------------------
Year-to-Date Year-to-Date
Gain on Loan Sales 3Q2004 3Q2003 Sept. 30, 2004 Sept. 30, 2003
----------- ----------- -------------- --------------
Consumer Loan Sale Gains $ 442,000 $ 103,000 $ 974,000 $ 183,000
Commercial Loan Sale Gains 37,000 32,000 108,000 77,000
Residential Loan Sale Gains 49,000 147,000 113,000 401,000
----------- ----------- ----------- -----------
Total Gains on Loan Sales $ 528,000 $ 282,000 $ 1,195,000 $ 661,000
=========== =========== =========== ===========
Year-to-Date Year-to-Date
Loans Sold 3Q2004 3Q2003 Sept. 30, 2004 Sept. 30, 2003
----------- ----------- -------------- --------------
Consumer Loans Sold $11,029,000 $ 3,070,000 $26,293,000 $ 6,104,000
Commercial Loans Sold 4,820,000 7,099,000 22,366,000 17,425,000
Residential Loans Sold 8,307,000 11,232,000 24,963,000 44,511,000
----------- ----------- ----------- -----------
Total Loans Sold $24,156,000 $21,401,000 $73,622,000 $68,040,000
=========== =========== =========== ===========
Through the first two quarters of 2004, our gains on loan sales had
significantly outpaced those of the prior year, driven largely by increased
sales of our consumer loans. This trend continued in the third quarter, as gains
totaled $528,000, an increase of $246,000, or 87% over the third quarter 2003
level. On a year-to-date basis, gains of $1.2 million exceeded the prior year
level by $534,000, or nearly 81%. As evidence that a change in the mix of loans
sold was responsible for the increase in gains on sales, rather than increased
total sales volume, total loans sold increased only 13% for the quarter and 8%
on a year-to-date basis relative to the prior year.
Sales finance loan sales contributed most significantly to our loan sale gains
this year. In 2003, the vast majority of these loans were retained with the
objective of growing the portfolio. As loan production increased and the
portfolio gained in size, the decision was made to manage the
20
portfolio's size through quarterly sales of sales finance loans. For the quarter
and nine months ended September 30, 2004, we realized gains of $442,000 and
$974,000 on loan sales totaling $11.0 million and $26.3 million, respectively.
These exceeded several times over the $103,000 and $183,000 in gains realized on
sales of $3.1 million and $6.1 million for the same periods last year. Our
current plan is to continue selling approximately $6 million to $8 million in
sales finance loans each quarter, although we may occasionally sell as much as
the $11 million we sold in the third quarter this year. Additionally, we
continue to service those loans that have been sold from the portfolio. This has
resulted in substantial growth in our service fee income, described below.
Commercial loan sales, and gains thereon, also increased relative to the prior
year, though not nearly to the same extent as consumer loans. For the quarter
and nine months ended September 30, 2004, we realized gains of $37,000 and
$108,000, representing increases of 15% and 39% over prior year levels.
Additionally, while third quarter sales of commercial loans were down relative
to last year, year-to-date 2004 sales totaled $22.4 million, representing an
increase of 28% over 2003. We generally utilize commercial loan sales to
accommodate additional loan requests from existing borrowers. To limit our
credit exposure to the borrower, we may sell their loan, in whole or in part, as
participations. As with consumer loans, we will typically continue to service
those loans sold from the portfolio and remain the point of contact for the
borrower following the sale.
In contrast, residential loan sale gains were down significantly from the prior
year, declining 66% for the quarter and 72% for the nine months ended September
30, 2004. The declines in gains occurred as residential loan sales fell to $8.3
million for the third quarter, compared to $11.2 million in the same period last
year. On a year-to-date basis, loan sales for 2004 totaled 44% less than in the
prior year. We believe the sales volumes observed in 2003 were a product of the
high level of refinancing activity that occurred during that time, and the
substantial reduction in sales volumes in 2004 represents a more normalized
residential lending environment.
Servicing Fee Income.
---------------------
With the additional consumer loan sales this year, our income from servicing
loans for others has increased dramatically, with income rising 405% from the
third quarter of 2003, and 330% on a year-to-date basis. Servicing fees earned
on the sales finance loans sold totaled $157,000 through the first nine months
of 2004, with $69,000 of that earned in the third quarter. These fees are
expected to continue to grow as additional loans are sold each quarter to manage
the size of the sales finance loan portfolio.
Commercial loans serviced for others account for most of the remaining servicing
fee income. In contrast to commercial loans, residential loans are typically
sold servicing released, which means we no longer service those loans once they
are sold. Consequently, servicing fees from residential loans sold would not be
considered a significant source of fee income.
Gain on Sales of Investments
----------------------------
Gains on sales of investments are opportunistic in nature, and we will not
generally make any attempt to forecast future securities sales or gains thereon.
Furthermore, with interest rates
21
having risen over the last year and appearing to trend upward, the opportunity
to realize any future gains on securities sales is unlikely. For the third
quarter of 2004, we did not sell any securities from our portfolio. For the nine
months ended September 30, 2004, gains on investment sales totaled $71,000 based
on a $2 million sale in the first quarter. By comparison, in the lower interest
rate environment of 2003, third quarter and year-to-date gains totaled $189,000
and $662,000, respectively. We do not currently have any sales pending, nor do
we anticipate any sales in the fourth quarter.
Other Fee Income
----------------
Year-to-Date Year-to-Date
3Q2004 3Q2003 Sept. 30, 2004 Sept. 30, 2003
--------- --------- -------------- --------------
Rental Income $ 140,000 $ 182,000 $ 475,000 $ 546,000
Loan Fees 156,000 49,000 260,000 177,000
ATM/Wire Transfer/Safe
Deposit Box 52,000 36,000 140,000 97,000
Late Charges 45,000 29,000 118,000 89,000
Miscellaneous 32,000 40,000 115,000 162,000
--------- --------- ---------- ----------
Total Other Income $ 425,000 $ 336,000 $1,108,000 $1,071,000
========= ========= ========== ==========
Other fee income for the third quarter of 2004 rose $89,000, or 26%, over the
prior year, driven by a significant increase in loan fee income. On a
year-to-date basis, the additional income was sufficient to increase total fee
income by approximately 3%, or $36,000, over the prior year level.
Loan fees, which include both prepayment and broker fees, rose $107,000 on a
quarter-to-quarter comparison. Loan prepayment fees totaled $156,000 for the
quarter, up from $42,000 in third quarter 2003. On a year-to-date basis,
prepayment fees totaled $260,000 compared to $111,000 for the same period last
year. We believe the higher level of prepayment fees this year, and particularly
the third quarter, is a result of upward movements in shorter-term interest
rates in recent months and expectations that rates may continue moving upwards
in the next few years. These movements may have prompted borrowers with loans
that would reprice at some point in the next few years to refinance their loans
now, before rates could potentially move higher. Given the uncertainties in
interest rates and borrower expectations, we do not know if the higher level of
prepayment fees is likely to continue. Loan brokerage fees fell $7,000 and
$66,000 on a quarterly and year-to-date basis, respectively, as our retail
brokerage activity was nil through the first nine months of this year. The
decline in broker fees was driven by our loan officers' preference to sell our
Bank products over those offered by other financial institutions. We don't
anticipate a change in that trend in the last quarter of 2004.
Our rental income declined $42,000 in the quarter and $71,000 in the first nine
months of this year, or approximately 23% and 13%, relative to the respective
periods ended September 30, 2003. In the third quarter of last year, we lost
several large tenants at First Mutual Center, our corporate headquarters. We
have not replaced those tenants, nor do we have any serious negotiations
underway with potential tenants for that space. We are also remodeling several
floors in the building so that space is not currently available to lease.
NONINTEREST EXPENSE
-------------------
Salaries and Employee Benefits
------------------------------
22
Salaries and employee benefit expenses rose by $597,000, or 20%, on a
quarter-versus-quarter basis, from $3.0 million in the third quarter of 2003 to
almost $3.6 million in 2004, accounting for approximately 60% of the total
increase in noninterest expense. On a year-to-date basis, the increase was $1.3
million or 14%, over the nine-month period ended September 30, 2003.
Salaries and Employee Benefits Quarter Ended Nine Months Ended
September 30, September 30,
2004 2003 2004 2003
---------- ---------- ----------- ----------
Salaries $2,276,000 $1,921,000 $ 6,710,000 $5,811,000
Commissions and Incentive Bonuses 541,000 451,000 1,315,000 1,274,000
Employment Taxes & Insurance 195,000 161,000 676,000 568,000
Temporary Office Help 69,000 65,000 152,000 237,000
Benefits 472,000 358,000 1,355,000 1,053,000
---------- ---------- ----------- ----------
Total Salaries & Benefits Expenses $3,553,000 $2,956,000 $10,208,000 $8,943,000
========== ========== =========== ==========
Most of the increase in salary and benefit expense was the result of a net
increase of 14% in the number of employees during the past 12 months. Our
staffing level, as measured by full-time-equivalent (FTE) employee count,
increased from 188 on September 30, 2003, to 214 FTE on the same date in 2004.
DATE FTE COUNT
---- ---------
September 30, 2003 188
December 31, 2003 201
March 31, 2004 204
June 30, 2004 201
September 30, 2004 214
The new Sammamish banking center, which opened in the fourth quarter of 2003,
accounted for four of the new employees. The other new positions added over the
past year were for various departments throughout the Bank.
Contributing to the growth in compensation expense was an increase of $114,000
from the third quarter of 2003, and an increase of $303,000 year-to-date from
the prior year for employee benefits. Those costs include health care insurance,
employee stock ownership plan expense and 401(k) plan matching costs. Due to the
combination of more employees and higher premiums per employee, we have
experienced a 22% increase in health care costs as compared to third quarter
2003. Also, our contributions to the employee stock ownership and 401(k)
matching plans have risen from $278,000 in 2003 to $378,000 year-to-date.
EFFECT OF DEFERRED LOAN ORIGINATION COSTS QUARTER ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
----------------------------- -----------------------------
2004 2003 2004 2003
------------ ------------ ------------ ------------
Salaries and Employee Benefits $ 4,122,000 $ 3,584,000 $ 11,950,000 $ 10,634,000
Deferred Loan Origination Costs (569,000) (628,000) (1,742,000) (1,691,000)
------------ ------------ ------------ ------------
NET SALARIES AND EMPLOYEE BENEFITS $3,553,00 $ 2,956,000 $ 10,208,000 $ 8,943,000
============ ============ ============ ============
An issue that complicates the reporting of our compensation expense is the
deferral of loan origination costs. In accordance with current accounting
literature, certain loan origination costs are deferred and amortized over the
life of the loan. Each year, costs associated with loan origination activities
are analyzed to determine a standard loan cost. Standard loan costs, which are
determined for each loan type, are then deducted from operating expense, with
the net figures
23
reported in the financial statements. Compensation expense can vary based upon
loan origination volumes, the mix of different loan types, and changes in the
valuation of standard loan costs from year to year.
Certain other items, such as loan analysis tools and loan processing fees from
the other noninterest expense section, are also partially deducted from
operating costs to arrive at a net operating expense. As discussed above,
factors such as loan origination volumes, the mix of different loan types and
changes in the valuation of standard loan costs from year to year contribute in
determining net operating expense. For instance, for the first nine months of
2004 compared to the same time period in 2003, the standard loan cost for each
income property loan was reduced by $1,759. This reduction combined with 46
fewer loans of this type closed in 2004, resulted in $354,000 less deferred
costs. Conversely, during the same time period, each sales finance loan
increased its standard loan cost by $38 and the volume of these loans increased
by 381. These two factors combined to increase deferred loan costs by $226,000
for this type of loan. In total, deferred loan costs were $656,000 in the
current quarter compared to $756,000 in the third quarter of 2003. On a
year-to-date basis, deferred loan costs totaled $1,980,000 in 2004 compared to
$2,077,000 in 2003.
Occupancy Expense
-----------------
Occupancy expenses increased $55,000, or 9%, from $620,000 in the third quarter
of 2003 to $675,000 in 2004. For the nine months ended September 30, 2004,
occupancy expenses increased $240,000, or 13%, from the same period in 2003.
Occupancy Expenses Quarter Ended Nine Months Ended
September 30, September 30,
2004 2003 2004 2003
-------- -------- ---------- ----------
Rent Expense $ 76,000 $ 49,000 $ 236,000 $ 247,000
Utilities and Maintenance 135,000 137,000 448,000 373,000
Depreciation Expense 340,000 287,000 974,000 782,000
Other Occupancy Costs 124,000 147,000 362,000 378,000
-------- -------- ---------- ----------
Total Occupancy Expenses $675,000 $620,000 $2,020,000 $1,780,000
======== ======== ========== ==========
Occupancy costs in 2004 were affected by growth in capital expenditures over the
past year, which resulted in $53,000 of higher depreciation expense and
leasehold improvement amortization for the third quarter and $192,000 for the
nine months ended September 30, 2004. Contributing substantially to these recent
capital expenditures was a remodeling project to one of our banking centers and
upgrades to our information systems infrastructure. Also, the new Sammamish
banking center, which opened in the fourth quarter of 2003, accounted for
$27,000 of additional rent expense in the third quarter of 2004 compared to the
prior year. Additional maintenance, repair and utilities expenses of $75,000
were incurred in the first nine months of 2004 over the same period in 2003, due
mainly to the ownership of the First Mutual Center, purchased in the first
quarter of 2003.
Other Noninterest Expense
-------------------------
Other noninterest expenses increased by $349,000, or 23%, from $1.5 million in
the third quarter of 2003 to nearly $1.9 million for the same period in 2004.
This accounted for approximately
24
35% of the total increase in operating expenses. For the nine months ended
September 30, 2004, other noninterest expenses grew $1.5 million, or 36%, over
the same nine-month period in 2003.
Other Noninterest Expenses Quarter Ended September 30, Nine Months Ended September 30,
2004 2003 2004 2003
----------- ----------- ----------- -----------
Marketing & Public Relations $ 297,000 $ 286,000 $ 885,000 $ 766,000
Credit Insurance 280,000 81,000 783,000 136,000
Outside Services 145,000 129,000 462,000 332,000
Taxes 120,000 134,000 355,000 341,000
Informations Systems 261,000 179,000 760,000 469,000
Legal Fees 83,000 127,000 341,000 338,000
Other 675,000 576,000 1,955,000 1,683,000
----------- ----------- ----------- -----------
Total Other Noninterest Expenses $1,861,000 $1,512,000 $5,541,000 $4,065,000
=========== =========== =========== ===========
The most significant growth in other noninterest expenses, at $199,000 for the
third quarter, came from credit insurance premiums for our sales finance loan
portfolio. This same expense increased by $647,000 in the nine months ended
September 30, 2004 compared to the same period in 2003. In the fourth quarter of
2002, we began to insure against default risk on loans to borrowers with credit
scores below 720. Our insurance contract contains a variable premium that ranges
between a low of 0.60% and a ceiling of 2.70% (as an annualized percentage of
the outstanding insured balances). The most likely premium is 2.70%, with the
final premium to be determined at a later date based on our actual loan loss
history. The total expense, both paid and accrued, for the insurance premium
related to the sales finance portfolio in the third quarter was $276,000, which
reflects the maximum premium of 2.70%. There is the possibility that in future
periods our experience will be more favorable and we will receive a rebate on
premiums paid. However, based on our loss experience in the last three quarters
we are not optimistic about any future rebates. Please refer to the "Sales
Finance (Home Improvement) Loans" section for a further discussion of this
topic.
Also contributing to the increase in expenses for third quarter and year-to-date
2004 were costs related to information systems, charitable donations and
accounting and auditing fees. The increase in information systems expenses for
the third quarter was largely attributable to an internet network conversion and
an upgrade to greater bandwidth, which accounted for approximately $25,000 of
additional expense over the third quarter of 2003. Additionally, as noted in the
"Salaries and Employee Benefits" section above, certain costs incurred as part
of the loan origination process are deferred and amortized over the life of the
loan, including some information systems expenses. Based on our calculations and
estimates of our information systems costs as they relate to the loan
origination process, a larger amount of these costs were capitalized in 2003
than this year, on both a quarterly and year-to-date basis. This change in the
amount of information systems costs capitalized this year versus 2003 resulted
in a significant difference in overall costs, with third quarter and
year-to-date impacts totaling $35,000 and $111,000, respectively. Charitable
donations for the third quarter 2004 rose significantly compared to the same
period in 2003, increasing $49,000 from the prior year level. Accounting and
auditing fees increased $35,000 in the current quarter over the third quarter of
2003 due mainly to additional work required for the Sarbanes-Oxley Act of 2002
requirements. Offsetting these increases was a reduction of $44,000 in legal
fees during the third quarter compared to the same period in 2003. This
difference was principally due to the increased costs related to the updating of
our deposit contracts and sales finance lending program during the third quarter
of 2003.
25
Outside services have increased on a year-to-date basis over 2003 by $127,000.
Contributing to this variance was a $31,000 consulting engagement to review
sales finance operations and $24,000 in expenses tied to the additional security
for our Bellevue West Office and routine expenses associated with our Sammamish
banking centers which was not opened until the fourth quarter of 2003. Also
contributing to the year-to-date variance was a $101,000 increase in advertising
expenses to support deposit and loan growth initiatives.
FINANCIAL CONDITION
- -------------------
Assets. Assets increased 14%, from $860.8 million at year-end 2003 to $983.2
million as of September 30, 2004. The change in assets is principally the result
of an increase in the investment securities and loan portfolios.
Securities. We classify investment securities in one of the following
categories: 1) trading, 2) available-for-sale, or 3) held-to-maturity.
Securities classified as available-for-sale are reviewed regularly, and any
unrealized gains or losses are recorded in the shareholders' equity account. At
September 30, 2004, the balance of the unrealized loss, net of federal income
taxes, was $94,000, which compares to an unrealized loss at year-end 2003 of
$95,000. Generally, falling interest rates will increase the amount recorded as
unrealized gain, and rising rates will decrease any unrealized gains, as the
market value of securities inversely adjusts to the change in interest rates.
PERCENTAGE OF
(Dollars in 000's) TOTAL SECURITIES TOTAL ASSETS TOTAL ASSETS
---------------- ------------ -------------
December 31, 1999 $105,431 $581,116 18%
December 31, 2000 123,690 643,231 19%
December 31, 2001 72,347 678,349 11%
December 31, 2002 74,738 745,295 10%
December 31, 2003 86,527 860,844 10%
September 30, 2004 130,563 983,164 13%
Security investments (available-for-sale and held-to-maturity) increased $44.0
million, or 51%, from December 31, 2003, to the end of the third quarter 2004 as
a result of security purchases this year, primarily during the second quarter.
As can be seen in the above table, prior to 2001 our securities portfolio
represented a much larger component of our total asset mix than in the last
three years. As rates declined in 2001, 2002 and 2003, prepayments on securities
held in our portfolio accelerated, typically due to the underlying mortgages
being refinanced at lower rates. Additionally, the falling interest rates
resulted in many securities trading at premiums to their par values.
Consequently, some securities were sold from the portfolio during this timeframe
to recognize the gains on those investments before the securities paid off at
their par values. The volume of new securities acquired during these periods was
typically well below the value of securities paid off and/or sold, as we were
reluctant to add significant volumes of securities to the balance sheet with
interest rates approaching historical lows. With rates finally starting to move
upward in 2004, the decision was made to build up the portfolio with short-term
hybrid ARM securities.
Loans. Loans receivable, excluding loans held-for-sale, rose from $723.7 million
at year-end 2003 to $785.9 million, an increase of $62.2 million in nine months.
Residential loans accounted
26
for approximately 74% of this growth, while commercial real estate and business
banking loans made up roughly 26% of the total.
The growth in our portfolio through the first three quarters of 2004 has been
less than anticipated, despite the fact that loan originations increased 8%, to
$122 million for the third quarter of 2004, compared to $113 million in the
third quarter of 2003, and rose 6% on a year-to-date basis relative to 2003. A
key factor hindering our ability to grow our portfolio this year has been very
rapid prepayment speeds on various segments of the loan portfolio. We believe
these high levels of prepayments are attributable, in part, to recent increases
in various interest rate indexes and expectations of future interest rates.
Given the low interest rate environment of the last couple years, many borrowers
have likely expected that rates would begin rising at some point. Over the last
few months, major market indexes, such as the Constant Maturity Treasury (CMT)
and the London Interbank Offering Rate (LIBOR) have been rising, and the Federal
Reserve issued a 25 basis point rate increase at each of their June, August, and
September meetings. Given these events, some borrowers may believe that we have
entered a period of rising interest rates. We expect that many of these
borrowers who had been considering refinancing existing variable-rate debt
elected to do so, with the expectation of facing higher interest rates should
they wait to take action. This would have contributed to the high level of
prepayments experienced thus far in 2004.
Based on our observations of current loan production volumes, prepayments, and
anticipated loan sales, we expect our overall loan portfolio in the fourth
quarter to improve relative to third quarter, with anticipated loan portfolio
growth in the $5 million to $15 million range.
Loans Held for Sale. Loans held for sale (LHFS) totaled $16 million for the
quarter as compared to $10 million at year-end. In prior periods the composition
of the LHFS was typically limited to residential loans as the sales finance
loans that were sold were limited to those that had been originated during the
quarter in which they were sold. However, in third quarter 2004 it was necessary
to expand the pool of sales finance loans beyond those originated in the quarter
as the sale of $11 million in loans was larger than our normal quarterly sales.
As a result of this change in operating procedure, the LHFS now includes both
residential and sales finance loans. Residential loans totaled $6 million and
constituted 38% of the LHFS, and the sales finance loans accounted for the
remaining $10 million.
Servicing Assets. Servicing assets have grown $767,000, or 164%, since year-end
2003. Although this increase was not a major factor in the quarter's asset
growth, this area is expected to continue to increase rapidly with the planned
sales of sales finance loans.
3rd Qtr. 2004 2nd Qtr. 2004 1st Qtr. 2004 4th Qtr. 2003
------------- ------------- ------------- -------------
Servicing Assets:
Income Property $ 133,000 $ 115,000 $ 114,000 $ 94,000
Residential 17,000 21,000 27,000 36,000
Sales Finance 1,085,000 742,000 572,000 338,000
----------- --------- --------- ----------
Total $ 1,235,000 $ 878,000 $ 713,000 $ 468,000
=========== ========= ========= ==========
Serviced For Others Loan
Balances $109,226,000 $ 97,177,000 $ 90,745,000 $ 76,424,000
============ ============ ============ ============
27
As illustrated in the table, most of the growth in the servicing asset balance
is coming from the sales finance area due to the quarterly sales of loans. In
the third quarter of 2003 we began selling sales finance loans servicing
retained, and as a result we have been adding to the servicing asset. The growth
in this area is a combination of the assets generated from the sale of loans
sold servicing retained netted with the amortization and prepayments of the
underlying loans and any impairment charges that may occur.
Liabilities. Deposits rose $74.4 million, or 12.7%, in the first nine months of
2004, totaling $658 million as compared to $584 million at year-end 2003.
Brokered deposits accounted for approximately 38% of that increase. During the
first nine months of the year, new brokered deposits totaled $28.4 million to
help fund the $55.4 million in security purchases. The remaining increase in
deposits combined with the growth in FHLB borrowings, were used to fund the
growth in the loan portfolio.
The FHLB borrowings increased from $194 million at year-end 2003 to $232 million
as of the end of the third quarter this year. As of September 30, 2004, we had
the authority to borrow up to a total of $393 million in FHLB advances, subject
to sufficient collateral to support those advances.
ASSET QUALITY
- -------------
Provision and Reserve for Loan Losses.
- --------------------------------------
The provision for reserve for loan losses increased from $350,000 in the third
quarter of last year to $525,000. The provision is also up sequentially from
$250,000 in the first quarter rising to $440,000 in the second quarter of this
year. The provision for loan losses reflects the amount deemed appropriate to
produce an adequate reserve for possible loan losses inherent in the risk
characteristics of the loan portfolio. In determining the appropriate reserve
balance, we consider the amount and type of new loans added to the portfolio,
our level of non-performing loans, the amount of loans charged off, and the
economic conditions that we currently operate within.
The increase for the third quarter is largely due to the inherent risks
identified in the portfolio and also includes an impairment charge of $171,000
for a single-family residential loan. The loan portfolio (excluding LHFS) has
also grown $62 million year-to-date, or 8.6% (11.5% annualized). Also affecting
the level of reserve for loan losses are the net loan charge-offs. Net
charge-offs for the quarter (including the impairment charge of $171,000)
remained flat at $233,000 as compared to third quarter last year. This has not
been the case year-to-date. Through September 2004, net charge-offs totaled
$464,000 as compared to $363,000 last year. With the exception of this quarter,
the charge-offs are largely related to our home improvement (sales finance) loan
portfolio. Year-to-date, sales finance loans accounted for 56% of the total net
charge-offs in 2004, and 59% last year.
Sales finance loans constitute 9% of the total portfolio. However, due to the
characteristics of these loans, they comprise the bulk of our loan write-offs.
Please see the section, "Sales Finance (Home Improvement) Loans" for a further
discussion of this business line.
Our non-performing assets have increased from $538,000 at year-end 2003 to $1.0
million at the end of the third quarter of 2004. The current level of
non-performing assets has improved as compared to first and second quarters'
levels of $1.6 million and $1.2 million, respectively. The ratio of
non-performing assets to total assets was 0.10% at September 30, 2004, which
compares
28
to 0.12% at June 30, 2004 and 0.17% at March 31, 2004. Those ratios compare to
0.60% for FDIC insured institutions at June 30, 2004.*
* FDIC Quarterly Banking Profile, Second Quarter 2004
Noted below is a summary of our exposure to non-performing loans and repossessed
assets:
One single-family residence, OR. No anticipated loss. $ 421,000
Twenty-three consumer loans. Full recovery anticipated
from insurance claims. 165,000
One single-family residence, Western WA (impaired loan). * 125,000
Seven consumer loans. No loss anticipated. 96,000
Two community business loans. No loss anticipated. 51,000
One community business loan. Possible loss of $25,000. 25,000
Three consumer loans. Possible loss of $8,000. 8,000
One consumer loan. Paid in full in October 2004. 8,000
----------
TOTAL NON-PERFORMING LOANS $ 899,000
TOTAL REAL ESTATE OWNED AND REPOSSESSED ASSETS 101,000
----------
TOTAL NON-PERFORMING ASSETS $1,000,000
==========
* The total loan amount was $296,000 less the impairment charge against the
reserve for loan losses of $171,000 resulting in an adjusted loan amount of
$125,000.
PORTFOLIO INFORMATION
- ---------------------
Commercial Real Estate Loans. The average loan size (excluding construction
loans) in the commercial real estate portfolio was $720,900 as of September 30,
2004, with an average loan-to-value ratio of 64%. At quarter-end, none of these
commercial loans were delinquent for 30 days or more. Small individual investors
or their limited liability companies and business owners typically own the
properties securing these loans. The portfolio is split between residential use
(multi-family or mobile home parks) and commercial use. At quarter-end, the
breakdown was 48% residential and 52% commercial.
The loans in our commercial real estate portfolio are well diversified, secured
by small retail shopping centers, office buildings, warehouses, mini-storage
facilities, restaurants and gas stations, as well as other properties classified
as general commercial use.
To diversify our risk and to continue serving our customers, we sell
participation interests in some loans to other financial institutions. About 16%
of commercial real estate loan balances originated by the Bank have been sold in
this manner. We continue to service the customer's loan and are paid a servicing
fee by the participant. Likewise, we occasionally buy an interest in loans
originated by other lenders. About $9 million of the portfolio, or 2%, has been
purchased in this manner.
Sales Finance (Home Improvement) Loans. The sales finance portfolio grew at a
steady pace throughout 2003. Even though loan production has increased in 2004,
the portfolio growth has slowed. We are selling a greater percentage of the
portfolio and loan prepayment speeds on our existing portfolio continue at a
rate of between 35% and 40%.
29
Insured Balance
Bank Portfolio (Bank and
Balance Servicing Balance Servicing Portfolios)
------- ----------------- ---------------------
September 30, 2003 $56 million $ 3 million $20 million
December 31, 2003 62 million 10 million 27 million
March 31, 2004 63 million 16 million 32 million
June 30, 2004 67 million 22 million 39 million
September 30, 2004 68 million 31 million 45 million
During the third quarter of 2004, the average new loan amount was $10,700. The
current average balance on loans in the portfolio is $9,200. We insured 41% of
the Bank's portfolio balance for credit risk, and 44% of total new loans in the
third quarter.
Noted below are the charge-off table for the uninsured portfolio and the claims
experience table for the insured portfolio:
UNINSURED PORTFOLIO
-------------------
Charge-Offs as a
Loan Balance Percent of Delinquent Loans as a
(Bank Portfolio) Net Charge-Offs Portfolio Percent of Portfolio
---------------- --------------- --------- --------------------
September 30, 2003 $38 million $ 73,000 0.19% 0.89%
December 31, 2003 40 million 100,000 0.25% 0.76%
March 31, 2004 40 million 50,000 0.13% 0.81%
June 30, 2004 41 million 136,000 0.33% 0.51%
September 30, 2004 40 million 71,000 0.18% 0.75%
INSURED PORTFOLIO
-----------------
Delinquent Loans
Claims as a Percent as a Percent of Portfolio
Claims Paid of Insured Balance (Bank and Servicing Portfolios)
----------- ------------------ -------------------------------
September 30, 2003 $ 33,000 0.21% 1.36%
December 31, 2003 89,000 0.38% 2.32%
March 31, 2004 351,000 1.18% 1.72%
June 30, 2004 315,000 0.89% 1.57%
September 30, 2004 265,000 0.64% 2.17%
Our portfolio at September 30, 2004 totaled $68 million, of which $28 million is
insured. The $40 million of uninsured loans with an average credit score of 728
has performed at a fairly consistent level, in terms of loan losses as a percent
of the portfolio, over the last five quarters, ranging from 0.13% to 0.33%. The
significant change has occurred in the insured portfolio, which has an average
credit score of 667. Losses incurred in that portfolio are submitted to our
credit insurer for reimbursement. The claims experience in the last 12 months
has jumped from 0.21% (claims as a percent of insured balances) in the third
quarter of last year to a high of 1.18% in the first quarter of 2004, and then
dropping to 0.64% in the third quarter. The actual claims paid have risen
accordingly from $33,000 a year ago to a high of $351,000 in the first quarter
this year and subsequently falling to $265,000 in the third quarter of 2004.
Similar trends occurred in the delinquency ratios until the third quarter of
2004, where we saw an increase in delinquencies to 2.17%. For the new policy
year beginning October 1, 2004, our insurer has indicated that the premium
structure will remain unchanged from the previous two policy years.
The contract with the credit insurer also has a maximum exposure limit to the
insurer of 10% of the loan balances. Each year's loan production that is insured
is treated as a separate portfolio in terms of the 10% limit. The first pool
that was insured included loans closed between October 2002 and September 2003,
and totaled $21.8 million with a maximum loss that could be claimed of $2.2
million. That pool currently has a balance of $14.4 million, and we have a
remaining
30
lifetime loss credit of $1.3 million. Because of the prepayment of
loans in that pool, our loss credit is still 9.0% of the remaining balance even
though the insurance company has paid claims totaling $890,000. The comparable
figures for the 2003 pool (loans insured between October 2003 and September
2004) are $35 million in insured balances for a maximum loss of $3.5 million.
Our remaining insured balance is $30.4 million and our credit loss limit is $3.3
million. To date, we have submitted $176,000 in claims against the pool.
DEPOSIT INFORMATION
- -------------------
The number of business checking accounts increased 38%, from 1,364 at September
30, 2003, to 1,877 as of September 30, 2004, a gain of 513 accounts. The deposit
balances for those accounts grew 57%. Consumer checking accounts also increased,
from 5,341 in the third quarter of 2003 to 6,546 this year, an increase of 1,205
accounts, or 23%. Our total balances for consumer checking accounts rose 55%.
Money
Time Deposits Checking Market Accounts Regular Savings
------------- -------- --------------- ---------------
September 30, 2003 68% 10% 21% 1%
December 31, 2003 66% 10% 22% 2%
March 31, 2004 64% 11% 23% 2%
June 30, 2004 65% 12% 22% 1%
September 30, 2004 63% 13% 23% 1%
BUSINESS SEGMENTS
- -----------------
Beginning January 1, 2004, we changed the presentation of our Business Segments
to more accurately reflect the way these segments are managed within the Bank.
Prior to 2004 we had three segments: 1) Consumer Lending, 2) Commercial Lending,
and 3) Investment Securities. We have made some changes to the original three
segments by:
o Separating Residential Lending from the Consumer Lending segment
o Splitting the Commercial Lending segment into two separate segments:
Business Banking Lending and Income Property Lending
o Allocating the income and expenses from the Investment Securities
segment to the new segments based upon asset size.
The management reporting process measures the performance of the operating
segments based on the management structure of the Bank and is not necessarily
comparable with similar information for any other financial institution.
The reportable segments include the following:
o CONSUMER LENDING - Consumer lending includes home equity lending,
direct consumer loans, and indirect home improvement loans (sales
finance). These loans include lines of credit and loans for primarily
consumer purposes. This segment also sells loans into the secondary
market. We may choose to retain or sell the right to service the loans
sold (i.e., collection of principal and interest payments) depending
upon market conditions.
o RESIDENTIAL LENDING - Residential lending offers loans to borrowers to
purchase, refinance, or build homes secured by one-to-four-unit family
dwellings. They also
31
finance the purchase or refinance of buildable residential lots. This
segment also sells loans into the secondary market. We may choose to
retain or sell the right to service the loans sold (i.e., collection
of principal and interest payments) depending upon market conditions.
o BUSINESS BANKING LENDING - Business Banking offers a full range of
banking services to small and medium size businesses including deposit
and cash management products, loans for financing receivables,
inventory, equipment as well as permanent and interim construction
loans for commercial real estate. The underlying real estate
collateral or business asset being financed typically secures these
loans.
o INCOME PROPERTY LENDING - Income Property Lending offers permanent and
interim construction loans for multi-family housing (over four units),
commercial real estate properties, and spec single-family
construction. The underlying real estate collateral being financed
typically secures these loans.
These segments are managed separately because each business unit requires
different processes and different marketing strategies to reach the customer
base that purchases the products and services. The segments derive a majority of
their revenue from interest income, and we rely primarily on net interest
revenue in managing these segments. No single customer provides more than 10% of
the Bank's revenues.
CONSUMER LENDING
----------------
Quarter Ended Nine Months Ended
Net Income/(Loss) Return on Equity Net Income/(Loss) Return on Equity
----------------- ---------------- ----------------- ----------------
Sept. 30, 2002 ($40,000) (3.75%) ($125,000) (3.51%)
Sept. 30, 2003 51,000 3.12% (70,000) (1.63%)
Sept. 30, 2004 416,000 18.34% 985,000 15.83%
Net income for the Consumer Lending segment totaled $416,000 and $985,000 for
the quarter and nine months ended September 30, 2004, marking significant
improvement from income of $51,000 and a net loss of $70,000 for the same
periods last year and net losses of $40,000 and $125,000 in 2002. The
profitability achieved in 2004 is a combination of earning asset growth, related
incremental net interest income, and additional gains on loan sales compared to
the prior year. The increase in revenue was partially offset by rising operating
expenses.
The Consumer Lending segment's quarterly average earning assets totaled $113
million as of September 30, 2004, up from $93 million in September 2003 and $60
million in 2002. Earning asset growth over the last two years was largely
attributable to our sales finance (home improvement) loan portfolio and our
decision to retain within the portfolio a greater portion of the loans
originated outside the Northwest. With these additional assets and higher
yields, interest income earned on the portfolio totaled $2,368,000 in third
quarter 2004, up 32% from the same period in 2003, which was in turn 58% over
the third quarter 2002 level. On a year-to-date basis, interest income totaled
$6,454,000, an increase of 42% over the prior year level.
By comparison, interest expense for the quarter rose only 13%, or $77,000,
compared to the third quarter of 2003, as the impact of reductions in funding
rates largely offset the cost of the
32
additional funds required to support the growth in earning assets. On a
year-to-date basis, the effect of reductions in funding rates was even more
pronounced, with interest expense rising only 2% from the prior year level.
Prior to this quarter, funding costs bank-wide had declined over the last three
years as rates on our time deposits gradually repriced at lower levels after the
Federal Reserve cut rates 11 times in 2001, and once in each of 2002 and 2003.
Based on the lagging nature of time deposit pricing, the cuts in 2001 were the
primary driver of substantial reductions in funding costs in 2002. Later rate
reductions then contributed to the continued funding cost reductions in 2003 and
into 2004. With three rate increases by the Federal Reserve in recent months and
short term market indexes having begun to rise, the potential exists for rates
paid our deposits to trend upwards from their current levels. Whether or not
such a trend will emerge could depend largely on major macro-economic and
financial market factors and events including, but not limited to continued
economic recovery and growth, as well as additional increases in short term
market interest rates and the Federal Funds target rate. Also contributing to
the reduction in our funding costs over this timeframe were growth in lower-cost
checking and money market product balances, as well as the strategic use of FHLB
advances during times when pricing on these advances presented a competitive
advantage compared to running promotional time deposit campaigns.
Net interest income for this segment, after the provision for loan losses,
totaled $1,580,000 and $4,319,000 for the three and nine months ended September
30, 2004, representing improvement of 42% and 65% over the same periods in 2003.
The Consumer Lending segment's quarterly noninterest income rose 223%, from
$178,000 in the third quarter of 2003 to $576,000 this year. On a year-to-date
basis, a similar increase was observed, with noninterest income rising 243% to
$1,323,000. The improvement was primarily a result of increased gains on sales
of consumer loans, specifically home improvement loans. In 2003, sales of
consumer loans declined relative to 2002 as a result of a change in strategy
from selling loans originated outside the Northwest to retaining these loans in
our portfolio with the objective of growing the portfolio. As loan production
increased and the portfolio gained in size, the decision was made to manage the
portfolio's size through quarterly sales of sales finance loans. For the quarter
and nine months ended September 30, 2004, we realized gains of $442,000 and
$974,000 on loan sales totaling $11.0 million and $26.3 million. These exceeded
several times over the $103,000 and $183,000 in gains realized on sales of $3.1
million and $6.1 million for the same periods last year. Our current plan is to
continue selling approximately $6 million to $8 million in sales finance loans
each quarter, although we may occasionally sell as much as the $11 million we
sold in the third quarter of this year.
Additionally, our income from servicing loans has increased dramatically.
Servicing fees earned on the sales finance loans serviced totaled $157,000
through the first nine months of 2004, with $69,000 of that earned in the third
quarter. These fees are expected to continue to grow as additional loans are
sold each quarter to manage the size of the sales finance loan portfolio.
The Consumer Lending segment's noninterest expense increased $307,000 and
$1,040,000, or 25% and 33%, for the three and nine months ended September 30,
2004 compared to the prior year. The growth in costs this year was due largely
to credit insurance premiums on the insured part of the sales finance portfolio.
Rising administrative and other allocated costs also contributed to the
increase.
The most significant growth in other noninterest expenses, at $199,000 for the
third quarter, came from credit insurance premiums for our sales finance loan
portfolio. This expense increased by $647,000 in the nine months ended September
30, 2004 compared to the same
33
period in 2003. In the fourth quarter of 2002, we began to insure against
default risk on loans to borrowers with credit scores below 720. Our insurance
contract contains a variable premium that ranges between a low of 0.60% and a
ceiling of 2.70% (as an annualized percentage of the outstanding insured
balances). The most likely premium is 2.70%, with the final premium to be
determined at a later date based on our actual loan loss history. The total
expense, both paid and accrued, for the insurance premium related to the sales
finance portfolio in the third quarter was $276,000, which reflects the maximum
premium of 2.70%. There is the possibility that in future periods our experience
will be more favorable and we will receive a rebate on premiums paid. However,
based on our loss experience in the last three quarters we are not optimistic
about any future rebates. Please refer to the "Sales Finance (Home Improvement)
Loans" section for a further discussion of this topic.
Among other noninterest expense categories, administrative and support costs
allocated to this segment have increased since the prior year. Included in these
allocated costs are retail banking center expenses which have risen with the
segment's growth, as well as expenses related to our Asset Management
department. The Asset Management expenses allocated to this segment have risen
based on the increased efforts required to manage the growing sales finance
portfolio.
RESIDENTIAL LENDING
-------------------
Quarter Ended Nine Months Ended
Net Income Return on Equity Net Income Return on Equity
---------- ---------------- ---------- ----------------
Sept. 30, 2002 $572,000 40.94% $1,207,000 26.13%
Sept. 30, 2003 537,000 27.83% 1,437,000 27.58%
Sept. 30, 2004 670,000 24.21% 2,054,000 26.24%
Net income for the Residential Lending segment totaled $670,000 and $2,054,000
for the quarter and nine months ended September 30, 2004 compared to $537,000
and $1,437,000 for the same periods in the prior year. This year's increase in
net income was a result of substantial growth in earning assets and net interest
income, which was partly offset by a reduction in noninterest income and rising
operating expenses.
Net interest income for the Residential Lending segment after the provision for
loan losses totaled $2,239,000 and $6,792,000 for the quarter and nine months
ended September 30, 2004. These represented increases of 34% and 45% over the
$1,676,000 and $4,695,000 earned in 2003, as well as continued improvement over
the 2002 levels of $1,238,000 and $3,483,000. This improvement in net interest
income was primarily attributable to a 38% quarter-over-quarter increase in this
segment's earning assets, which totaled $280 million as of September 30, 2004,
up from $203 million one year prior and $146 million at September 2002. On a
year-to-date basis, earning assets averaged $266 million, up 46% from the first
nine months of 2003. With these additional assets, interest income earned on the
portfolio totaled $4,058,000 for the third quarter of 2004, up nearly 35% from
third quarter 2003. By comparison, interest expense for the quarter rose only
23% from the prior year due to the reductions in funding rates described
earlier. Similarly, for the first nine months of 2004, interest income rose 39%,
more than offsetting a 27% increase in interest expense.
The Residential Lending segment's third quarter noninterest income fell $42,000,
or 13%, relative to the prior year, based primarily on a significant reduction
in residential loan sales. On a
34
year-to-date basis, noninterest income was down $309,000, or 32%. Residential
loan sale gains were down significantly from the prior year, declining 66% for
the quarter, to $49,000, and 72% for the first nine months of the year. The
declines in gains occurred as residential loan sales fell to $8.3 million for
the third quarter, compared to $11.2 million in the same period last year. This
resulted in year-to-date loan sales for 2004 of $25.0 million, approximately 44%
below the prior year's volume. We believe that the sales volumes observed in
2003 were a product of the high level of refinancing activity that occurred
during that time, and that the substantial reduction in sales volumes in 2004
represents movement to a more normalized residential lending environment.
The Residential Lending segment's noninterest expense increased $316,000 and
$850,000, or 26% and 24%, for the three and nine months ended September 30,
2004, compared to the same periods in the prior year. The growth in costs this
year has been largely attributable to rising administrative and other allocated
costs. The administrative costs include both expenses for general corporate
activities, which are allocated to all the business segments, as well as loan
servicing and administration costs attributable to the Residential Lending
segment's originations and portfolio management. Other allocated expenses
included expenses incurred at the banking centers and allocated to the
Residential Lending segment. As with the Consumer Lending segment, these
allocations have increased with the growth of the Residential segment.
BUSINESS BANKING LENDING
------------------------
Quarter Ended Nine Months Ended
Net Income/(Loss) Return on Equity Net Income/(Loss) Return on Equity
----------------- ---------------- ----------------- ----------------
Sept. 30, 2002 $145,000 10.07% $284,000 5.81%
Sept. 30, 2003 93,000 5.72% 108,000 2.20%
Sept. 30, 2004 (73,000) (3.63%) (283,000) (4.92%)
Net income for the Business Banking segment declined $166,000 and $391,000 for
the three and nine months ended September 30, 2004, as increasing net interest
income was more than offset by additional operating expenses. In the first three
quarters of 2003, the segment's net income had also declined from prior year
levels, as again improvements in net interest income were insufficient to offset
higher noninterest expenses.
For the third quarter of 2004, the Business Banking segment's net interest
income after provision for loan losses rose $70,000, or 7%, as a $126,000
increase in interest income more than offset an additional $59,000 in interest
expense. The provision for loan losses declined $3,000 relative to the third
quarter of 2003. On a year-to-date basis, net interest income after provision
improved by $196,000, or 7%, driven by a $213,000 reduction in interest expense.
Interest income for the nine months of 2004 was virtually unchanged from the
same period in 2003, rising only $2,000, while the provision for loan losses
increased $19,000 relative to the first three quarters of 2003.
Like the Consumer and Residential segments, the Business Banking segment also
succeeded in building incremental assets over the prior year, with earning
assets totaling $107 million as of September 30, 2004, representing an increase
of 25% compared to the prior year.
The Business Banking segment's noninterest income remained relatively consistent
with that of 2003, increasing $15,000 for the quarter and declining $18,000 for
the nine months ended September 30, 2004, as additional fee income earned in
2004 largely offset a reduction in
35
allocated gains on security investment sales compared to 2003. In total,
$662,000 in gains on securities sales were realized in the nine months ended
September 30, 2003, with $189,000 occurring in the third quarter. This income
was then allocated to the four business lines. By comparison, only one security
was sold in 2004, generating a gain of $71,000 in the first quarter. The
significant reduction in gains on sales between the two periods impacted
noninterest income for all business segments. As a smaller business line
relative to others, the Business Banking segment lags the other segments in
generating noninterest income. Consequently, the impact of reductions in
allocated noninterest income is more noticeable for Business Banking than for
other business lines that generate higher noninterest income from their own
operations.
Third quarter and year-to-date 2004 noninterest expense rose $338,000 and
$772,000, or 36% and 27%, over the same periods in 2003. The additional expenses
this year were largely driven by increases in the retail banking center expenses
allocated to the Business Banking segment. These expenses, which are allocated
to each of the four business segments, have increased based on our deposit
growth over the past year. The expense allocated to the Business Banking segment
has seen a particularly significant increase as a result of the strong growth of
our business checking and other commercial deposit accounts.
INCOME PROPERTY LENDING
-----------------------
Quarter Ended Nine Months Ended
Net Income Return on Equity Net Income Return on Equity
---------- ---------------- ---------- ----------------
Sept. 30, 2002 $1,425,000 21.36% $4,624,000 18.57%
Sept. 30, 2003 1,589,000 22.51% 4,911,000 23.05%
Sept. 30, 2004 1,513,000 20.34% 4,270,000 19.49%
For the quarter and nine months ended September 30, 2004, net income for the
Income Property segment declined $76,000 and $640,000, or 5% and 13%, relative
to the same periods in 2003, based on flat net interest income, declining
noninterest income, and rising operating expenses.
The Income Property segment's net interest income after provision for loan loss
rose $73,000, or 2%, for the third quarter of 2004, as a $127,000 reduction in
interest expense and $30,000 reduction in the provision for loan losses more
than offset an $83,000 decline in interest income. On a year-to-date basis,
however, the $1,237,000 reduction in funding costs failed to offset a $1,431,000
reduction in interest income and $25,000 increase in the provision for loan
loss. Unlike the other segments, the Income Property segment did not benefit
from double-digit growth in average earning assets compared to 2003. The Income
Property segment's average earning assets totaled $445 million as of September
30, 2004 and averaged $442 million for the first nine months of 2004,
representing growth of 3% and 2% versus the same measures for 2003. Contributing
to this growth in earning assets were securities purchases made in the first
three quarters of 2004 and resulting growth in our securities portfolio. As
noted above, prior to 2004, our investment securities activities were contained
within their own business segment. For 2004, however, our segments were revised
and the assets, income, and expenses associated with our securities activities
were allocated to the new segments based upon their asset size. As our largest
business segment, Income Property is the recipient of the largest allocations of
our investment securities operations. Were it not for these allocations and the
substantial securities balances acquired in the second quarter of this year,
this segment would not have achieved the asset growth noted above.
36
The Income Property segment's noninterest income declined significantly compared
to 2003, falling $138,000 for the third quarter and $422,000 for the first nine
months of the year. A significant part of this reduction was attributable to the
above-mentioned reduction in gains on securities sales. As the Income Property
segment accounted for nearly half of all earning assets in the first three
quarters of 2004, and more than half for the first nine months of 2003, it was
the recipient of the largest allocation of these gains. The greatest reduction
in the level of these gains compared to the prior year then appears in the
noninterest income for this segment.
Noninterest expense rose $39,000 and $319,000, or 2% and 6%, for the three and
nine months ended September 30, 2004. This followed expense reductions for the
third quarter and first nine months of 2003 compared to the same periods in
2002. The additional costs in 2004 were largely attributable to a decline in
cost-reducing benefits derived from our loan production. Certain expenses tied
to the production of new loans are classified as "standard loan costs." As loans
are originated, these costs can be capitalized, thus reducing current period
expenses. As these costs are tied to loan production and vary based on the type
of loan originated, changes in the number or type of loans originated affect the
level benefits realized. Based on differences in the volumes of loans and mix of
loan types originated in 2004 versus 2003, the amount of costs capitalized
through the first three quarters of this year was well below the amount
capitalized last year. This resulted in higher costs incurred through the first
three quarters of 2004.
LIQUIDITY
- ---------
Our primary sources of liquidity are loan and security sales and repayments,
deposits, and wholesale funds. A secondary source of liquidity is cash from
operations. Our principal uses of liquidity are the origination and acquisition
of loans and securities and the purchases of facilities and equipment.
In the first nine months of 2004 we originated $347 million in loans and
purchased $55 million in securities.
Third Third Year to Date Year to Date
Quarter Quarter September 30, September 30,
(Dollars in 000s) 2004 2003 2004 2003
--------- --------- --------- ----------
Loan Originations $ 101,000 $ 105,000 $ 331,000 $ 300,000
(disbursed balance)
Security Purchases 12,000 10,000 55,000 69,000
--------- --------- --------- ----------
Total Originations and
Purchases $ 113,000 $ 115,000 $ 386,000 $ 369,000
Loan and Security Repayments $ 74,000 $ 63,000 $ 200,000 $ 188,000
Sale of Securities 0 6,000 2,000 25,000
Sale of Loans 24,000 21,000 74,000 68,000
--------- --------- --------- ----------
Total Repayments and Sales $ 98,000 $ 90,000 $ 276,000 $ 281,000
Net Difference $ 15,000 $ 25,000 $ 110,000 $ 88,000
========= ========= ========= ==========
Our primary sources of funding, loan and security sales and repayments, are
heavily influenced by trends in mortgage rates. When rates trend downward, our
prepayment speeds increase. The loan portfolio, excluding loans sold into the
secondary market and spec construction loans,
37
experienced an annual prepayment rate of 25% in 2002, and 27% last year. Through
September 2004, our annualized year-to-date rate was 30%. With the recent upward
movement in various interest rate indexes and rate increases by the Federal
Reserve, we would expect prepayment speeds to decelerate in the final quarter of
the year. Given the volatility of interest rates and various macro-economic
variables, however, we recognize that a significant probability exists that
actual results may vary from this expectation. Security sales are also
influenced by rising interest rates. In low or falling rate environments, we
often sell securities to capture the market gain before the security prepays at
par. With the recent increase in rates we would not expect to execute any
significant amount of security sales.
Our preferred method of funding the net difference in loan and security
purchases is with deposits.
Third Third Year to Date Year to Date
Quarter Quarter September 30, September 30,
(Dollars in 000s) 2004 2003 2004 2003
--------- --------- --------- ----------
Deposits $ 19,000 $ 34,000 $ 66,000 $ 50,000
Advances (12,000) (2,000) 38,000 28,000
--------- --------- --------- ---------
Total $ 7,000 $ 32,000 $ 104,000 $ 78,000
========= ========= ========= =========
The inflow of deposits varies from period-to-period. Our ability to raise
liquidity from this source is dependent on our effectiveness in competing with
other financial institutions. That competition tends to focus on rate and
service and although we control the quality of service that we provide, we have
no control over the prevailing rates in our marketplace.
Our other major source of liquidity is wholesale funds, which includes FHLB
borrowings, brokered deposits, reverse repurchase lines of credit, and a
revolving line of credit at the First Mutual Bancshares holding company level.
We rely significantly upon these wholesale funds as sources of liquidity, as
doing so allows us to avoid maintaining balances of lower-yielding liquid assets
for potential liquidity requirements.
The most utilized source is the FHLB advances which totaled $232 million at
September 30, 2004. Our credit line with the FHLB is reviewed annually and is
currently set at 40% of assets. As a percentage of assets, our FHLB borrowings
were 24% at September 30, 2004, which compares to 23% at year-end 2003 and 25%
at September 30, 2003. The risks associated with this funding source include the
reduction or non-renewal of the line, and insufficient collateral to utilize the
line. We try to mitigate the risk of non-renewal of the line by maintaining the
credit quality of our loans and securities and attending to the quality and
consistency of our earnings.
The risk of insufficient collateral to fully utilize the line is a more
strategic concern. Our long-term goal is to increase the relative level of our
business banking loan portfolio. In the last year we have also increased the
relative percentage of our consumer loans. As a general rule, both of those
types of loans are not eligible for collateral. Construction loans and many
types of commercial real estate loans are also not eligible for collateral. The
two principal sources of collateral are residential and multi-family loans. As
we continue to evolve towards a community bank, we lower the source of our FHLB
collateral. We presently have sufficient collateral to meet any foreseeable
funding needs; however the long-term trend is an item of continuing management
attention.
38
Brokered deposits, which are included in the deposit totals, amounted to $40
million as of September 30, 2004, following the reduction of $8 million in such
instruments during the third quarter. This represented an unusually high usage
of these deposits, which were issued to reduce our level of FHLB borrowings
following our use of one-, two-, and three-year advances to match fund our third
quarter purchases of hybrid ARM securities. Internal policies limit our total
usage of these deposits to no more than 10% of all deposits, and we do not have
plans at this time to substantially increase these deposits above their current
levels.
Reverse repurchase lines are lines of credit collateralized by securities. We
currently have lines totaling $60 million, of which the full amount is currently
available. These lines were not used during the quarter ended September 30,
2004. The risks, attendant with these lines, are the withdrawal of the line
based on credit standing of the Bank or the potential lack of sufficient
collateral to support the lines.
An additional source of liquidity is cash from operations, which, though not a
significant source, is a consistent source based upon the quality of our
earnings. On a very limited basis it can be viewed as cash from operations
adjusted for items such as the provision for loan loss and depreciation. See the
"Consolidated Statements of Cash Flows" in the financial statements section of
this filing for a calculation of net cash provided by operating activities.
In addition to using liquidity to fund loans and securities, we routinely invest
in facilities and equipment. In the first nine months of 2004 we purchased $1.9
million of those assets.
PLANNED EXPENDITURES FOR PLANT AND EQUIPMENT
- --------------------------------------------
FOURTH QUARTER 2004 FIRST QUARTER 2005
------------------- ------------------
Remodel of Banking Centers $1,150,000 $1,700,000
West Seattle Banking Center 1,000,000 --
---------- ----------
TOTAL PURCHASES $2,150,000 $1,700,000
========== ==========
During the first quarter of 2004 we began implementing plans for the extensive
remodeling of three banking centers, and the construction of a new facility
replacing one of our banking centers.. We have completed the remodel activity at
our Bellevue West office and are under construction of our new Crossroads
banking center. We currently anticipate all remodel activity to be completed by
third quarter 2005. Based on current construction costs and updated plans, we
are now estimating capital costs will be $4.5 million.
In October 2004, the Bank closed on the purchase of land in West Seattle, where
we intend to build a full-service banking center. Our existing banking center in
West Seattle resides in leased storefront space. The expenditure listed above
for the West Seattle Banking Center is for unimproved land and initial
development expenses. The full-service banking center, which is scheduled to be
completed in 2005, is expected to cost an additional $1.3 million to $1.5
million. We have completed the due diligence process and have begun the
permitting process for the new office. We hope to begin construction by second
quarter 2005.
The Bank is currently developing a long-term maintenance and upgrade plan for
its seven story corporate headquarters. This plan involves several major capital
expenditures, including an expansion of the heating and cooling system, a
sprinkler system, a security access system, drive-
39
up banking capability, and upgrades to common areas. We are also currently
implementing a plan to consolidate our occupancy of the building onto three
entire floors, providing for greater use and efficiency of space. It is possible
some of these expenses could occur in 2004, but more likely they will occur in
2005. The total capital costs could range from $1.8 million to $2.4 million, and
that projection is subject to several variables that are yet unknown. When all
anticipated moves are complete, we will occupy 53% of the building.
In addition, a property acquisition that has been under consideration for
several years is the Canyon Park site. We are anticipating that we will close on
this purchase in fourth quarter, 2004 and begin construction in 2005. The
capital costs related to the purchase of this land and initial development
expenses would be approximately $1.1 million. We originally intended to place a
banking center and three-story office building on this site, and estimated that
the capital costs would approach $4.3 million. After reconsideration, we now
intend to build a 4,000 square-foot banking center and anticipate the capital
costs will be in the range of $1.8 to $2.2 million.
CAPITAL
- -------
The FDIC's statutory framework for capital requirements establishes five
categories of capital strength, ranging from a high of well capitalized to a low
of critically under-capitalized. An institution's category depends upon its
capital level in relation to relevant capital measures, including a risk-based
capital measure, a leverage capital measure, and certain other factors. At
September 30, 2004, we exceeded the capital levels required to meet the
definition of a well-capitalized institution:
For Capital Well Capitalized
Actual Adequacy Minimum Minimum Ratio
------ ---------------- -------------
Total capital (to risk-weighted assets):
First Mutual Bancshares, Inc. 11.82% 8.00% 10.00%
First Mutual Bank 11.56 8.00 10.00
Tier I capital (to risk-weighted assets):
First Mutual Bancshares, Inc. 10.22 4.00 6.00
First Mutual Bank 10.31 4.00 6.00
Tier I capital (to average assets):
First Mutual Bancshares, Inc. 7.21 4.00 5.00
First Mutual Bank 7.41 4.00 5.00
During the third quarter of 2004, the Bank and its legal counsel analyzed its
treatment of off-balance-sheet items in regards to risk-based capital treatment.
The result of this review was the determination that many of our outstanding
construction commitments (the undisbursed portion of our construction loans)
contractually extend beyond one year. Because they extend beyond one year, these
off-balance-sheet commitments are now being included in the calculation of the
Banks' risk-based capital calculation for regulatory purposes. As a result, both
the 'Total Capital to Risk-Weighted Assets' ratio and the 'Tier I Capital to
Risk-Weighted Assets' ratio for the Bank and the Company decreased approximately
7 - 21 basis points as compared to second quarter 2004. The Bank has taken steps
to reduce the impact of this change in future quarters by changing the loan
terms on newly originated loans so
40
that the commitments will not extend beyond one year. It is anticipated that
over the next 12 to 18 months, many of the currently outstanding construction
loans will have paid off reducing the impact of this adjustment. Most of the new
construction loans now being added to the portfolio have loan terms which
contractually limit the commitment to less than one year.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is defined as the sensitivity of income and capital to changes in
interest rates and other relevant market rates or prices. Our profitability is
largely dependent on our net interest income. Consequently, our primary exposure
to market risk arises from the interest rate risk inherent in our lending,
mortgage banking, deposit, and borrowing activities. Interest rate risk is the
risk to earnings or capital resulting from adverse movements in interest rates.
To that end, we actively monitor and manage our exposure to interest rate risk.
A number of measures are utilized to monitor and manage interest rate risk,
including net interest income and economic value of equity simulation models, as
well as traditional "gap" models, each of which is described below. We prepare
these models on a monthly basis for review by our Asset Liability Committee
(ALCO), senior management, and Board of Directors. The use of these models
requires us to formulate and apply assumptions to various balance sheet items.
Assumptions regarding interest rate risk are inherent in all financial
institutions, and may include prepayment speeds on loans and mortgage-backed
securities, cash flows and maturities of financial instruments held for purposes
other than trading, changes in market conditions, loan volumes and pricing,
deposit sensitivities, consumer preferences, and management's capital leverage
plans. We believe that the data and assumptions used for our models are
reasonable representations of our portfolio and possible outcomes under the
various interest rate scenarios. Nonetheless, these assumptions are inherently
uncertain; therefore, the models cannot precisely estimate net interest income
or predict the impact of higher or lower interest rates on net interest income.
Actual results may differ significantly from simulated results due to timing,
magnitude, and frequency of interest rate changes, and changes in market
conditions and specific strategies, among other factors.
ASSET AND LIABILITY MANAGEMENT
Our primary objective in managing interest rate risk is to minimize the adverse
impact of changes in interest rates on our net interest income and capital,
while structuring the asset and liability components to maximize net interest
margin, utilize capital effectively, and provide adequate liquidity. We rely
primarily on our asset and liability structure to control interest rate risk.
Asset and liability management is the responsibility of the Asset Liability
Committee, which acts within policy directives established by the Board of
Directors. This committee meets regularly to monitor the composition of the
balance sheet, assess projected earnings trends, and formulate strategies
consistent with the objectives for liquidity, interest rate risk, and capital
adequacy. The objective of asset/liability management is to maximize long-term
shareholder returns by optimizing net interest income within the constraints of
credit quality, interest rate risk policies, levels of capital leverage, and
adequate liquidity. Assets and liabilities are managed by matching maturities
and repricing characteristics in a systematic manner.
41
HEDGING TECHNIQUES
We review interest rate trends on a monthly basis and employ hedging techniques
where appropriate. These techniques may include financial futures, options on
financial futures, interest rate caps and floors, interest rate swaps, and
extended commitments on future lending activities. Typically, the extent of our
off-balance-sheet derivative agreements has been the use of forward loan
commitments, which are used to hedge our loans held-for-sale. Additionally, in
2002 we entered into an interest rate swap with the FHLB. The purpose of the
swap is to protect against potential adverse interest rate volatility that could
be realized from the Trust Preferred Securities (TPS) issued in June 2002. The
swap accomplishes this by fixing the interest rate payable for the first five
years of the TPS' life.
NET INTEREST INCOME (NII) AND ECONOMIC VALUE OF EQUITY (EVE) SIMULATION MODEL
RESULTS
September 30, 2004 December 31, 2003
Percentage Percentage
Change Change
- ---------------------------------------------------------------------------
Change in Interest Net Economic Net Economic
Rates Interest Value of Interest Value of
(in basis points) Income Equity Income Equity
- ---------------------------------------------------------------------------
+200 0.00% (1.06%) 1.14% (8.50%)
+100 n/a (0.13%) n/a (5.06%)
-100 (0.89%) (0.56%) (1.18%) 2.34%
-200 * * * *
* Because a large percentage of our loan portfolio is tied to indexes that were
at very low levels as of December 31, 2003 and September 30, 2004, the downward
200 bps scenarios could not be computed.
NET INTEREST INCOME SIMULATION
The "Net Interest Income" figures in the above table refer to changes from a
"base case" scenario, and assume a zero-growth balance sheet and a steady
increase or decrease in interest rates in the magnitudes specified over a
12-month period. The "base case" represents our forecast of net interest income
under the simulation assumptions if rates were to remain unchanged from the
current rates. In the event the simulation model demonstrates that a gradual 200
basis point increase or 100 basis point (200 basis point when applicable)
decrease in interest rates over the next 12 months would adversely affect our
net interest income over the same period by more than 10% relative to the "base
case" scenario, we would consider the indicated risk to have exceeded our
internal policy limit. As illustrated in the above results, we are operating
within the 10% internal policy limit.
The September 30, 2004 results of our income simulation model indicate that our
net interest income would be expected to remain unchanged from its "base case"
level in a scenario in which rates are assumed to rise by 200 basis points, and
decline in an environment where interest rates are assumed to fall by 100 bps.
The magnitude of the change, however, suggests that there is little sensitivity
in net interest income over a 12-month horizon, with less than a one percent
change in net interest income from the base case projection indicated in the
falling rate scenario.
42
Incorporated into the model assumptions is the observed tendency for loan and
investment prepayments to accelerate in falling interest rate scenarios and slow
when interest rates rise. In all interest rate scenarios, the size of the
balance sheet is assumed to remain stable, with no balance sheet growth or
contraction regardless of interest rate movements. Therefore, implicit in this
assumption are additional assumptions for increased new securities purchases and
loan originations at lower interest rate levels to offset accelerated
prepayments, and conversely, reduced securities purchases and loan production
when rates increase and prepayments slow.
ECONOMIC VALUE OF EQUITY (EVE) SIMULATION
The EVE analysis goes beyond simulating earnings for a specified period to
estimating the present value of all financial instruments in our portfolio and
then analyzing how the economic value of the portfolio would be affected by
various alternative interest rate scenarios. The portfolio's economic value is
calculated by generating principal and interest cash flows for the entire life
of all assets and liabilities, and then discounting these cash flows back to
their present values. The assumed discount rate used for each projected cash
flow is a current market rate, such as a LIBOR, FHLB, or swap curve rate, and
from alternative instruments of comparable risk and duration. In the event the
simulation model demonstrates that a 200 basis point increase or 100 basis point
(200 basis point when applicable) decrease in rates would adversely affect our
EVE by more than 25%, we consider the indicated risk to have exceeded our
internal policy limit. Again, as illustrated in the above results, we are
operating within the 25% internal policy limit.
In the simulated 200 bps upward shift of the yield curve, the discount rates
used to calculate the present values of assets and liabilities will increase,
causing the present values of both assets and liabilities to fall, with more
prominent effects on longer-term, fixed-rate instruments. Additionally, when
interest rates rise, the cash flows on our assets will typically decelerate as
borrowers become less likely to prepay their loans. As the cash flows on these
assets are shifted further into the future, their present values are further
reduced. Our EVE simulation model results as of September 30, 2004 indicate that
our liabilities would be expected to exhibit greater sensitivity to the effects
of rising rates than would our assets, with the economic value of liabilities
declining by an estimated 2.86% versus an approximately 2.68% decline in the
value of assets. Given, however, that the economic value of assets exceeds the
economic value of liabilities, the 2.68% reduction in the asset value was
greater than the 2.86% impact on liabilities. Consequently, the economic value
of our equity was negatively impacted in this scenario, declining 1.06%.
The opposite occurs when rates decline, as the discount rates used to calculate
the present values of assets and liabilities will decrease, causing the present
values of both assets and liabilities to rise. Based on the above, our EVE would
be expected to be positively impacted in this scenario. Counteracting this
effect, however, is the tendency of cash flows to accelerate in a falling rate
environment, as borrowers refinance their existing loans at lower interest
rates. These loan prepayments prevent the present values of these assets from
increasing in a declining rate scenario, illustrating an effect referred to as
negative convexity. Taking this negative convexity into account, the simulation
results indicated that the impact to EVE was less pronounced in the falling rate
scenario. In this case, the economic values of both assets and liabilities at
September 30, 2004 were positively impacted when rates were assumed to fall by
100 bps, assets by 1.31% and liabilities by 1.52%. In contrast to the rising
rate scenario described above, in this instance the 1.52% increase in the
economic value of liabilities exceeded the 1.31% increase in the
43
economic value of assets. As a result, with liability values rising more than
asset values, our economic value of equity was negatively impacted in this
scenario as well, declining 0.56%.
The Net Interest Income and Economic Value of Equity sensitivity analyses do not
necessarily represent forecasts. As previously noted, there are numerous
assumptions inherent in the simulation models as well as in the gap report,
including the nature and timing of interest rate levels, the shape of the yield
curve, loan and deposit growth, prepayments on loans and securities, deposit
decay rates, pricing decisions on loans and deposits, reinvestment/replacement
of asset and liability cash flows, customer preferences, and competitor and
economic influences.
GAP MODEL
The gap model, which represents a traditional view of interest rate sensitivity,
quantifies the mismatch between assets maturing, repricing, or prepaying within
a period, and liabilities maturing or repricing within the same period. A gap is
considered positive when the amount of interest-rate-sensitive assets exceeds
the amount of interest-rate-sensitive liabilities within a given period. A gap
is considered negative in the reverse situation.
Certain shortcomings are inherent in gap analysis. For example, some assets and
liabilities may have similar maturities or repricing characteristics, but they
may react differently to changes in interest rates. This illustrates a facet of
interest rate exposure referred to as "basis risk." Additionally, assets such as
adjustable-rate mortgage loans may have features that limit the effect that
changes in interest rates have on the asset in the short-term and/or over the
life of the loan, for example a limit on the amount by which the interest rate
on the loan is allowed to adjust each year. This illustrates another area of
interest rate exposure referred to as "option risk." Due to the limitations of
the gap analysis, these features are not taken into consideration. Additionally,
in the event of a change in interest rates, prepayment and early withdrawal
penalties could deviate significantly from those assumed in the gap calculation.
As a result, we utilize the gap report as a complement to our income simulation
and economic value of equity models.
Our 12-month interest rate sensitivity gap, expressed as a percentage of assets,
fell from 7.9% at year-end 2003 to 4.9% at September 30, 2004. These results
indicate that we remain asset sensitive, or positively gapped, with more assets
than liabilities expected to mature, reprice, or prepay within the next year.
The Gap report has implied an asset sensitive position for a number of quarters,
dating back to September 2001. The change in the Gap was caused by the mix of
the additional assets and liabilities to each side of the balance sheet, as well
as the overall balance sheet growth.
ONE YEAR INTEREST RATE SENSITIVITY GAP
(Dollars in 000s)
SEPT. 30, 2004 DEC. 31, 2003
-------------- -------------
One Year Repricing / Maturing Assets $ 677,886 $ 632,428
One Year Repricing / Maturing Liabilities 628,781 564,707
----------- -----------
One Year Gap $ 49,105 $ 67,721
=========== ===========
Total Assets $ 992,234 $ 860,844
=========== ===========
(September 30, 2004 figure includes
off-balance-sheet item)
One Year Interest Rate Gap as a
Percentage of Assets 4.9% 7.9%
44
Consistent with the trend observed over the last year, asset growth of $131
million in the first three quarters of 2004 was centered in assets that would
not be subject to maturity or repricing in the following 12 months. These assets
consisted largely of new single- and multi-family residential ARMs, typically
with rates tied to one-year LIBOR or FHLB indexes, but for which the interest
rate is fixed for the first three to ten years of the loan, as well as
fixed-rate home improvement loans. In addition to the loan growth, we had a
number of hybrid ARM securities trades settle in late June. These instruments
bear a fixed interest rate for an initial period, typically three to seven
years, after which their rates become adjustable annually based on a set margin
over a major market index. Overall, those assets not subject to maturity or
repricing within 12 months rose nearly $86 million over the first nine months of
2004, accounting for roughly 65% of asset growth. Assets expected to mature or
reprice within a 12 month time horizon increased approximately $45 million from
their level as of December 2003.
A change in modeling procedure, rather than actual asset growth, accounted for
$9 million of this $45 million repricing in the next 12 months. As previously
noted, in 2002 we entered into an interest rate swap agreement to fix the
interest rate on our first trust preferred security issue for a period of five
years. As of the December 2003 year end, for the purposes of the gap report, we
classified the TPS as a five-year, fixed-rate instrument. In 2004, we changed
our methodology to reflect the interest rate swap in the gap report. In doing
so, the TPS was reclassified as a variable-rate liability, offset by the asset
side of the swap, under which the Bank receives payments tied to the same
quarterly adjustable rate as the TPS issue. The other side of the swap, under
which the Bank makes payments based on a fixed interest rate, was then applied
to the liability side of the gap report based on the remaining life of the swap,
approximately three years. As a result of these additions/modifications, the
swap is now reflected in the gap model, and the resulting asset base for gap
purposes exceeds our total assets by $9 million, the notional principal amount
of the interest rate swap.
By comparison, as of the September quarter end, the net change in liabilities
from December 31, 2003 was almost evenly split between those subject to
repricing or maturity within 12 months and those with horizons exceeding one
year. Liabilities subject to maturity or repricing in the next 12 months rose
approximately $64 million over the year-end level, including the $9 million
increase that resulted from moving the 2002 TPS issue into the
less-than-one-year category, as described above. By comparison, liabilities with
maturities or expected repricing dates in excess of one year rose by $67 million
compared to their year-end levels. This represented a departure from the trend
observed last year, when roughly 75% of liability growth was subject to maturity
or repricing within one year. For most of 2003, the majority of promotional
deposit rates focused on shorter-term time deposits, most commonly the
seven-month certificate. Consequently, throughout 2003, most of the new time
deposit balances brought in were subject to maturity within 12 months.
Additionally, those time deposits that matured throughout 2003 were frequently
rolled to the shorter promotional rate instruments upon maturity, further
increasing the shorter-term liabilities. By comparison, our time deposit
promotions this year have typically included at least two promotional deposit
rates, one short term, typically six to eight months, as well as one
intermediate term, generally from 12 to 18 months. In some instances, a third,
longer-term rate, typically in excess of 24 months has also been included in our
promotions. Additionally, while our FHLB advances are typically structured with
one-year
45
terms, during the first half of 2004, we expanded our usage of advances with
terms longer than 12 months, largely to match fund the above-mentioned
securities settled in the second quarter.
The greater increase of liabilities maturing/repricing in the next 12 months
versus assets resulted in a net $19 million reduction in our dollar gap. This
gap ratio was further reduced by the overall growth in the balance sheet during
the period, which increased from $861 to $992 million, including the addition of
$9 million in the off-balance-sheet interest rate swap. The combined effect of
these two factors led to the decline in the one-year gap ratio from 7.9% to 4.9%
of total assets.
SECURITIES
ITEM 3.
The following table sets forth certain information regarding carrying values and
percentage of total carrying values of the Bank's consolidated portfolio of
securities classified as available-for-sale and held-to-maturity (dollars in
thousands).
---------------------------------------------------------------------------
September 30,
---------------------------------------------------------------------------
2004 2003
---------------------------------- ----------------------------------
AVAILABLE-FOR-SALE: Carrying Value Percent of Total Carrying Value Percent of Total
- ------------------- ---------------------------------- ----------------------------------
US Government Treasury and agency obligations $ 23,093 19% $ 11,050 15%
Mortgage backed securities:
Freddie Mac 15,800 13% 16,071 23%
Ginnie Mae 43,267 35% -- 0%
Fannie Mae 40,422 33% 44,794 62%
---------------------------------- ----------------------------------
Total mortgage-backed securities 99,489 81% 60,865 85%
---------------------------------------------------------------------------------- ----------------------------------
TOTAL SECURITIES AVAILABLE-FOR-SALE $ 122,582 100% $ 71,915 100%
---------------------------------------------------------------------------------- ----------------------------------
---------------------------------------------------------------------------
September 30,
---------------------------------------------------------------------------
2004 2003
---------------------------------- ----------------------------------
HELD-TO-MATURITY: Carrying Value Percent of Total Carrying Value Percent of Total
- ----------------- ---------------------------------- ----------------------------------
Municipal Bonds $ 1,220 15% $ 1,327 13%
Mortgage backed securities:
Freddie Mac 497 6% 556 6%
Fannie Mae 6,263 79% 7,994 81%
---------------------------------- ----------------------------------
Total mortgage-backed securities 6,760 85% 8,550 87%
CMO's -- 0% 5 0%
---------------------------------- ----------------------------------
---------------------------------------------------------------------------------- ----------------------------------
TOTAL SECURITIES HELD-TO-MATURITY $ 7,980 100% $ 9,882 100%
---------------------------------------------------------------------------------- ----------------------------------
-------------------------------------------------------------- --------------
ESTIMATED MARKET VALUE $ 8,123 $ 10,103
-------------------------------------------------------------- --------------
46
ITEM 3A.
The following table shows the maturity or period to repricing of the Bank's
consolidated portfolio of securities available-for-sale and held-to-maturity
(dollars in thousands):
------------------------------------------------------------------------------------
Available-for-sale at September 30, 2004
------------------------------------------------------------------------------------
One Year or Less Over One to Three Years Over Three to Five Years
------------------------ ------------------------ ------------------------
Weighted Weighted Weighted
Carrying Average Carrying Average Carrying Average
Value Yield Value Yield Value Yield
---------- ---------- ---------- ---------- ---------- ----------
AVAILABLE-FOR-SALE:
- -------------------
US Government Treasury and agency
obligations $ 11,988 0.00% $ -- 0.00% $ -- 0.00%
Mortgage backed securities:
Ginnie Mae -- 0.00% 7,697 3.75% -- 0.00%
Freddie Mac 301 4.10% -- 0.00% 775 5.50%
Fannie Mae 527 4.01% -- 0.00% 1,433 5.50%
---------- ---------- ---------- ---------- ---------- ----------
Total mortgage-backed securities 828 4.04% 7,697 3.75% 2,208 5.50%
------------------------------------------------------------------------------------
Total securities available-for-sale
-- Carrying Value $ 12,816 0.26% $ 7,697 3.75% $ 2,208 5.50%
------------------------------------------------------------------------------------
------------------------------------------------------------------------------------
Total securities available-for-sale
-- Amortized Cost $ 12,805 0.25% $ 7,723 3.75% $ 2,113 5.50%
------------------------------------------------------------------------------------
------------------------------------------------------------------------------------
Available-for-sale at September 30, 2004
------------------------------------------------------------------------------------
Over Five to Ten Years Over Ten to Twenty Years Over Twenty Years
------------------------ ------------------------ ------------------------
Weighted Weighted Weighted
Carrying Average Carrying Average Carrying Average
Value Yield Value Yield Value Yield
---------- ---------- ---------- ---------- ---------- ----------
AVAILABLE-FOR-SALE:
- -------------------
US Government Treasury and agency
obligations $ 6,102 4.08% $ 5,003 4.00% $ -- 0.00%
Mortgage backed securities:
Ginnie Mae -- 0.00% -- 0.00% 35,570 4.17%
Freddie Mac 4,187 3.50% 8,626 4.50% 1,911 3.75%
Fannie Mae -- 0.00% 33,600 4.30% 4,862 4.13%
---------- ---------- ---------- ---------- ---------- ----------
Total mortgage-backed securities 4,187 3.50% 42,226 4.31% 42,343 4.15%
------------------------------------------------------------------------------------
Total securities available-for-sale
-- Carrying Value $ 10,289 3.84% $ 47,229 4.31% $ 42,343 4.15%
------------------------------------------------------------------------------------
------------------------------------------------------------------------------------
Total securities available-for-sale
-- Amortized Cost $ 10,272 3.84% $ 47,469 4.30% $ 42,346 4.15%
------------------------------------------------------------------------------------
------------------------
Available-for-sale
at September 30, 2004
------------------------
Total
------------------------
Weighted
Carrying Average
Value Yield
---------- ----------
AVAILABLE-FOR-SALE:
- -------------------
US Government Treasury and agency
obligations $ 23,093 1.94%
Mortgage backed securities:
Ginnie Mae 43,267 4.10%
Freddie Mac 15,800 4.19%
Fannie Mae 40,422 4.32%
---------- ----------
Total mortgage-backed securities 99,489 4.19%
------------------------
Total securities available-for-sale
-- Carrying Value $ 122,582 3.78%
------------------------
------------------------
Total securities available-for-sale
-- Amortized Cost $ 122,728 3.77%
------------------------
47
------------------------------------------------------------------------------------
Held-to-Maturity at September 30, 2004
------------------------------------------------------------------------------------
One Year or Less Over One to Three Years Over Three to Five Years
------------------------ ------------------------ ------------------------
Weighted Weighted Weighted
Carrying Average Carrying Average Carrying Average
Value Yield Value Yield Value Yield
---------- ---------- ---------- ---------- ---------- ----------
HELD-TO-MATURITY:
- -----------------
Municipal Bonds $ -- 0.00% $ -- 0.00% $ -- 0.00%
Mortgage backed securities:
Freddie Mac 497 3.48% -- 0.00% -- 0.00%
Fannie Mae 2,240 4.28% 1,225 5.67% 1,910 2.28%
---------- ---------- ---------- ---------- ---------- ----------
Total mortgage-backed securities 2,737 4.13% 1,225 5.67% 1,910 2.28%
------------------------------------------------------------------------------------
Total securities held-to-maturity
-- Carrying Value $ 2,737 4.13% $ 1,225 5.67% $ 1,910 2.28%
------------------------------------------------------------------------------------
------------------------------------------------------------------------------------
Total securities held-to-maturity
-- Fair Market Value $ 2,827 4.13% $ 1,260 5.67% $ 1,931 2.35%
------------------------------------------------------------------------------------
------------------------------------------------------------------------------------
Held-to-Maturity at September 30, 2004
------------------------------------------------------------------------------------
Over Five to Ten Years Over Ten to Twenty Years Over Twenty Years
------------------------ ------------------------ ------------------------
Weighted Weighted Weighted
Carrying Average Carrying Average Carrying Average
Value Yield Value Yield Value Yield
---------- ---------- ---------- ---------- ---------- ----------
HELD-TO-MATURITY:
- -----------------
Municipal Bonds $ -- 0.00% $ 220 5.38% $ 1,000 6.26%
Mortgage backed securities:
Freddie Mac -- 0.00% -- 0.00% -- 0.00%
Fannie Mae -- 0.00% 888 4.50% -- 0.00%
---------- ---------- ---------- ---------- ---------- ----------
Total mortgage-backed securities -- 0.00% 888 4.50% -- 0.00%
------------------------------------------------------------------------------------
Total securities held-to-maturity
-- Carrying Value $ -- 0.00% $ 1,108 4.67% $ 1,000 6.26%
------------------------------------------------------------------------------------
------------------------------------------------------------------------------------
Total securities held-to-maturity
-- Fair Market Value $ -- 0.00% $ 1,109 4.67% $ 995 6.27%
------------------------------------------------------------------------------------
------------------------
Held-to-Maturity
at September 30, 2004
------------------------
Total
------------------------
Weighted
Carrying Average
Value Yield
---------- ----------
HELD-TO-MATURITY:
- -----------------
Municipal Bonds $ 1,220 6.10%
Mortgage backed securities:
Freddie Mac 497 3.48%
Fannie Mae 6,263 3.97%
---------- ----------
Total mortgage-backed securities 6,760 3.93%
------------------------
Total securities held-to-maturity
-- Carrying Value $ 7,980 4.26%
------------------------
------------------------
Total securities held-to-maturity
-- Fair Market Value $ 8,123 4.28%
------------------------
48
ITEM 4. CONTROLS AND PROCEDURES
The Bank's Chief Executive Officer and Chief Financial Officer and other
appropriate officers have evaluated the Bank's disclosure controls and
procedures designed to ensure that information required to be disclosed in our
filings under the Securities Exchange Act of 1934 is recorded, processed,
summarized and reported within the time periods specified in the Securities
Exchange Commission's rules and forms, and have concluded that, although there
are inherent limitations in all control systems and although we apply certain
reasonable cost/benefit considerations to the design of our disclosure controls
and procedures, as of September 30, 2004 those disclosure controls and
procedures are effective.
We are currently undergoing a comprehensive effort to ensure compliance with
Section 404 of the Sarbanes-Oxley Act of 2002 for our fiscal year ending
December 31, 2004. This effort includes internal control documentation and
review under the direction of senior management. During the course of these
activities, we have identified certain internal control issues which management
believed would benefit from improvement. These control issues are, in large
part, the result of our increased size and need for documentation. The review
has not identified any material weakness in internal control. However, we have
made improvements to our internal controls over financial reporting as a result
of our review efforts and will continue to do so. These improvements include
control activities, monitoring controls and the enhancements of written policies
and procedures.
PART II: OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
At September 30, 2004, the Company was not engaged in any litigation, which in
the opinion of management, after consultation with its legal counsel, would be
material to the Company.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None.
49
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS
(a)
(3.1) Articles of Incorporation, incorporated by reference to the Current
Report on Form 8-K filed with the SEC on September 21, 2000.
(3.2) Amendment to Articles of Incorporation, incorporated by reference on
Form 10-Q filed with the SEC on May 13, 2002.
(3.3) Bylaws (as amended and restated), incorporated by reference on Form
10-Q filed with the SEC on August 13, 2004.
(11) Statement regarding computation of per share earnings. Reference is
made to the Company's Consolidated Statements of Income attached
hereto as part of Item I Financial Statements, which are
incorporated herein by reference.
(31.1) Certification by President and Chief Executive Officer pursuant to
Section 302 of the Sarbanes-Oxley Act.
(31.2) Certification by Executive Vice President and Chief Financial
Officer Pursuant to Section 302 of the Sarbanes-Oxley Act.
(32) Certification by Chief Executive Officer and Chief Financial Officer
pursuant to Section 906 of the Sarbanes-Oxley Act.
50
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.
Date: November 12, 2004 FIRST MUTUAL BANCSHARES, INC.
/s/ John R. Valaas
------------------------------
John R. Valaas
President and Chief Executive Officer
/s/ Roger A. Mandery
------------------------------
Roger A. Mandery
Executive Vice President
(Principal Financial Officer)
51