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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
----------------------
FORM 10-Q
QUARTERLY REPORT PURSUANT TO
Section 13 of
The Securities Exchange Act of 1934
FOR QUARTERLY PERIOD ENDED SEPTEMBER 30, 1999
Commission File Number 005-57091
FIRST MUTUAL BANCSHARES, INC.
------------------------------------
(Exact name of company as specified in charter)
WASHINGTON
----------
(State of incorporation)
91-2005970
----------
(I.R.S. Employee Identification Number)
400 108th Avenue N.E., Bellevue, WA 98004
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(Address of principal office) (Zip code)
Company's telephone number, including area code: (425) 453-5301
--------------
Indicate by check mark whether the company (1) has filed all
reports required to be filed by Section 13 of the Securities
Exchange Act of 1934 during the preceding 12 months (or for
such shorter period that the company was required to file such
reports),
Yes X No
------- -------
and (2) has been subject to such filing requirements for the
past 90 days.
Yes X No
------- -------
The number of shares outstanding of the registrant's common
stock as of September 30, 1999 was: 4,681,136
---------
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Item 1. Financial Statements
FIRST MUTUAL BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
ASSETS September 30 December 31
- ------ 1999 1998
------------- -------------
(Unaudited)
CASH AND CASH EQUIVALENTS:
Interest-earning deposits $ 592,344 $ 216,953
Noninterest-earning demand deposits
and cash on hand 3,783,895 5,312,192
------------- -------------
4,376,239 5,529,145
MORTGAGE-BACKED AND OTHER SECURITIES
AVAILABLE FOR SALE 17,866,386 20,336,611
LOANS RECEIVABLE, HELD FOR SALE 15,484,819 27,370,815
MORTGAGE-BACKED AND OTHER SECURITIES
HELD TO MATURITY 88,653,784 61,764,431
LOANS RECEIVABLE 412,030,385 365,104,245
RESERVE FOR LOAN LOSSES (6,237,637) (5,569,431)
------------- -------------
LOANS RECEIVABLE, NET 405,792,748 359,534,814
ACCRUED INTEREST RECEIVABLE 3,597,771 3,311,122
LAND, BUILDINGS AND EQUIPMENT, NET 5,511,377 5,536,748
FEDERAL HOME LOAN BANK (FHLB) STOCK, 5,151,800 4,876,500
at cost
MORTGAGE SERVICING RIGHTS 154,245 356,585
OTHER ASSETS 1,235,112 613,368
------------- -------------
TOTAL $ 547,824,281 $ 489,230,139
============= =============
1
FIRST MUTUAL BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(Continued)
September 30 December 31
1999 1998
------------- -------------
(Unaudited)
LIABILITIES:
Deposits:
Investor custodial checking $ 3,498,509 $ 8,146,226
Money market deposit and
checking accounts 102,052,492 90,773,090
Regular savings 10,914,151 12,247,457
Time Deposits 286,343,473 300,084,375
------------- -------------
Total deposits 402,808,625 411,251,148
Drafts payable 913,817 4,382,611
Accounts payable and other liabilities 3,957,694 5,652,174
Advance payments by borrowers for
taxes and insurance 2,527,591 1,517,253
FHLB advances 99,309,375 31,765,000
------------- -------------
Total liabilities 509,517,102 454,568,186
STOCKHOLDERS' EQUITY:
Common stock, $1 par value-
Authorized, 10,000,000 shares
Issued and outstanding, 4,681,136
and 4,247,275 shares, respectively 4,681,136 4,247,275
Additional paid-in capital 31,150,359 25,848,681
Employee Stock Ownership Plan debt (325,931) (603,738)
Retained earnings 3,267,756 5,181,720
Accumulated other comprehensive income(loss):
Unrealized (loss) on securities available for sale,
net of federal income tax (466,141) (11,985)
------------- -------------
Total stockholders' equity 38,307,179 34,661,953
------------- -------------
TOTAL $ 547,824,281 $ 489,230,139
============= =============
2
FIRST MUTUAL BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF INCOME
Quarters ended September 30 Nine Months ended September 30
1999 1998 1999 1998
----------- ----------- ----------- -----------
(Unaudited)
INTEREST INCOME:
Loans Receivable $ 8,936,776 $ 8,804,227 $25,873,836 $25,955,823
Mortgage-backed and related securities 956,932 361,671 2,747,790 1,059,340
Interest-earning deposits with banks 9,549 25,693 30,183 44,826
FHLB stock dividends 92,455 88,744 275,470 264,091
U.S. Treasury, government agency
and other securities 693,023 668,578 2,044,309 1,983,764
----------- ----------- ----------- -----------
10,688,735 9,948,913 30,971,588 29,307,844
INTEREST EXPENSE:
Deposits 4,618,023 5,059,986 13,883,218 14,841,583
FHLB advances and other 1,239,176 428,366 3,033,717 1,496,231
----------- ----------- ----------- -----------
5,857,199 5,488,352 16,916,935 16,337,814
----------- ----------- ----------- -----------
Net interest income 4,831,536 4,460,561 14,054,653 12,970,030
PROVISION FOR LOAN LOSSES 250,000 385,000 685,000 585,000
----------- ----------- ----------- -----------
Net interest income, after provision
for loan losses 4,581,536 4,075,561 13,369,653 12,385,030
OTHER OPERATING INCOME (EXPENSE):
Gain(Loss) on sales of loans 557,780 430,345 1,334,168 1,412,204
Servicing fees, net of amortization 124,373 96,344 353,736 350,965
Fees on deposits 84,519 49,051 245,717 148,330
Other 157,384 217,438 558,865 587,293
----------- ----------- ----------- -----------
Total other operating income 924,056 793,178 2,492,486 2,498,793
BALANCE, carried forward 5,505,592 4,868,739 15,862,139 14,883,823
3
FIRST MUTUAL BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF INCOME
(CONTINUED)
Quarters ended September 30 Nine Months ended September 30
1999 1998 1999 1998
----------- ----------- ----------- -----------
(Unaudited)
BALANCE, brought forward $ 5,505,592 $ 4,868,739 $15,862,139 $14,883,823
OPERATING EXPENSES:
Salaries and employees benefits 2,074,783 1,786,740 5,704,939 5,933,712
Occupancy 382,593 335,982 1,071,794 1,023,746
Other 706,171 708,667 2,355,758 2,074,406
----------- ----------- ----------- -----------
Total other operating expenses 3,163,547 2,831,389 9,132,491 9,031,864
----------- ----------- ----------- -----------
Income before federal income taxes 2,342,045 2,037,350 6,729,648 5,851,959
FEDERAL INCOME TAXES 794,600 692,699 2,282,988 1,989,666
----------- ----------- ----------- -----------
NET INCOME $ 1,547,445 $ 1,344,651 $ 4,446,660 $ 3,862,293
=========== =========== =========== ===========
PER SHARE DATA(1):
BASIC EARNINGS PER COMMON SHARE $ 0.33 $ 0.29 $ 0.95 $ 0.83
=========== =========== =========== ===========
EARNINGS PER COMMON SHARE-ASSUMING DILUTION $ 0.33 $ 0.28 $ 0.93 $ 0.81
=========== =========== =========== ===========
WEIGHTED AVERAGE SHARES OUTSTANDING 4,679,239 4,669,710 4,674,441 4,625,926
=========== =========== =========== ===========
WEIGHTED AVERAGE SHARES OUTSTANDING
INCLUDING DILUTIVE STOCK OPTIONS 4,759,314 4,772,181 4,760,432 4,759,035
=========== =========== =========== ===========
(1) Comparative Earnings Per Share data for the prior year has been restated to
conform with Statement of Financial Accounting Standards No.128. See Note 5.
4
FIRST MUTUAL BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(UNAUDITED)
Additional
Common stock paid-in Retained
Shares Amount capital earnings
----------- ----------- ----------- -----------
BALANCE, JANUARY 1, 1997 3,680,141 $ 3,680,141 $19,941,490 $ 4,805,295
Options exercised 76,890 76,890 552,607
10% stock dividend 368,196 368,196 4,388,676 (4,756,872)
Repayment of employee stock ownership plan debt
Cash dividends declared ($.50 per share) (1) (2,046,925)
Comprehensive income:
Net income 4,518,680
Other comprehensive income(loss)--Change in unrealized
losses on securities available for sale, net of
federal income tax
Comprehensive income
----------- ----------- ----------- -----------
BALANCE, DECEMBER 31, 1997 4,125,227 $ 4,125,227 $24,882,773 $ 2,520,178
Options exercised 122,048 122,048 965,908
Repayment of employee stock ownership plan debt
Cash dividends declared ($.60 per share) (1) (2,546,154)
Comprehensive income:
Net income 5,207,696
Other comprehensive income(loss)--Change in unrealized
losses on securities available for sale, net of
federal income tax
Comprehensive income
----------- ----------- ----------- -----------
BALANCE, DECEMBER 31, 1998 4,247,275 $ 4,247,275 $25,848,681 $ 5,181,720
Options exercised 9,378 9,378 48,701
10% stock dividend 424,483 424,483 5,252,977 (5,677,460)
Repayment of employee stock ownership plan debt
Cash dividends declared ($.15 per share) (1) (683,164)
Comprehensive income:
Net income 4,446,660
Other comprehensive income(loss)--Change in unrealized
losses on securities available for sale, net of
federal income tax
Comprehensive income
----------- ----------- ----------- -----------
BALANCE, SEPTEMBER 30, 1999 4,681,136 $ 4,681,136 $31,150,359 $ 3,267,756
=========== =========== =========== ===========
Employee stock Accumulated
ownership Comprehensive
plan debt Income(loss) Total
----------- ----------- -----------
BALANCE, JANUARY 1, 1997 $(1,024,111) $ (6,752) $27,396,063
Options exercised 629,497
10% stock dividend --
Repayment of employee stock ownership plan debt 152,541 152,541
Cash dividends declared ($.50 per share) (1) (2,046,925)
Comprehensive income:
Net income 4,518,680
Other comprehensive income(loss)--Change in unrealized
losses on securities available for sale, net of
federal income tax 1,972 1,972
-----------
Comprehensive income 4,520,652
----------- ----------- -----------
BALANCE, DECEMBER 31, 1997 $ (871,570) $ (4,780) $30,651,828
Options exercised 1,087,956
Repayment of employee stock ownership plan debt 267,832 267,832
Cash dividends declared ($.60 per share) (1) (2,546,154)
Comprehensive income:
Net income 5,207,696
Other comprehensive income(loss)--Change in unrealized
losses on securities available for sale, net of
federal income tax (7,205) (7,205)
-----------
Comprehensive income 5,200,491
----------- ----------- -----------
BALANCE, DECEMBER 31, 1998 $ (603,738) $ (11,985) $34,661,953
Options exercised 58,079
10% stock dividend --
Repayment of employee stock ownership plan debt 277,807 277,807
Cash dividends declared ($.15 per share) (1) (683,164)
Comprehensive income:
Net income 4,446,660
Other comprehensive income(loss)--Change in unrealized
losses on securities available for sale, net of
federal income tax (454,156) (454,156)
-----------
Comprehensive income 3,992,504
----------- ----------- -----------
BALANCE, SEPTEMBER 30, 1999 $ (325,931) $ (466,141) $38,307,179
=========== =========== ===========
(1) Cash dividends declared divided by weighted average shares outstanding of
4,062,824 in 1997, 4,215,764 in 1998 and 4,679,239 in 1999.
5
FIRST MUTUAL BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Nine months ended September 30
----------------------------------
1999 1998
------------- -------------
(Unaudited)
OPERATING ACTIVITIES:
Net income $ 4,446,660 $ 3,862,293
Adjustments to reconcile net cash
provided (used) by operating activities:
Provision for loan losses 685,000 585,000
Depreciation 431,514 392,957
Deferred loan origination fees, net of accretion (43,018) 179,947
Amortization of Mortgage servicing rights 128,378 307,672
(Gain) Loss on sales of loans (1,395,183) (1,569,659)
(Gain) Loss on sale of repossessed real estate (17,029) --
FHLB stock dividends (275,300) (263,900)
Cash provided (used) by changes in
operating assets and liabilities:
Loans receivable held for sale 11,885,996 (11,020,402)
Accrued interest receivable (286,649) (245,471)
Other assets (621,744) (91,004)
Drafts payable (3,468,794) (272,578)
Accounts payable, federal income taxes and
other liabilities (127,002) 387,470
Advance payments by borrowers for
taxes and insurance 1,010,338 954,842
------------- -------------
Net cash provided (used) by operating activities 12,353,167 (6,792,833)
INVESTING ACTIVITIES:
Loan originations (147,263,447) (124,613,029)
Loan principal repayments 98,035,330 97,114,310
Increase (decrease) in undisbursed loan proceeds 2,235,460 9,695,327
Principal repayments & redemptions on mortgage-backed
and other securities 14,617,287 37,622,977
Purchase of mortgage-backed and other securities (39,717,343) (29,358,069)
Purchase of mortgage-backed securities available for sale -- (9,874,010)
Purchases of premises and equipment (440,986) (507,498)
Proceeds from sale of Loans 1,843,672 1,900,197
Proceeds from sale of Real Estate Held for Sale 119,738 210,270
------------- -------------
Net cash provided (used) by
investing activities, carried forward (70,570,289) (17,809,525)
6
FIRST MUTUAL BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Continued)
Nine months ended September 30
----------------------------------
1999 1998
------------- -------------
(Unaudited)
BALANCE, net cash provided (used) by
investing activities, brought forward $ (70,570,289) $ (17,809,525)
FINANCING ACTIVITIES:
Net increase (decrease) in deposit accounts (22,483,234) 12,345,891
Interest credited to deposit accounts 14,040,711 14,833,964
Proceeds from FHLB advances 318,751,375 144,214,000
Repayment of FHLB advances (251,207,000) (147,329,000)
Dividends paid (2,360,484) (2,071,558)
Proceeds from exercise of stock options 45,041 537,772
Repayment of Employee Stock Ownership debt 277,807 255,330
------------- -------------
Net cash provided (used) by financing activities 57,064,216 22,786,399
------------- -------------
NET INCREASE IN CASH AND CASH EQUIVALENTS (1,152,906) (1,815,959)
CASH:
Beginning of year 5,529,145 5,909,165
------------- -------------
End of quarter $ 4,376,239 $ 4,093,206
============= =============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Loans originated for mortgage banking activities $ 89,410,934 $ 161,428,378
Loans originated for investment activities 147,263,447 124,613,029
------------- -------------
Total loans originated for mortgage banking
activities and investment activities $ 236,674,381 $ 286,041,407
============= =============
Cash paid during nine months ended Sept. 30
Interest $ 16,807,092 $ 16,323,772
============= =============
Income taxes $ 2,660,155 $ 1,395,000
============= =============
SUPPLEMENTAL DISCLOSURES OF NONCASH INVESTING ACTIVITIES:
Loans securitized into securities held to maturity $ -- $ 6,048,279
Loans transferred to (from) real estate
held for sale, net $ -- $ 230,299
============= =============
7
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE 1.
FORMATION OF BANK HOLDING COMPANY
First Mutual Bancshares, Inc. (the "Company"), a Washington corporation, is a
holding company primarily engaged in the business of planning, directing, and
coordinating the activities of its wholly-owned subsidiary, First Mutual Bank
(formerly First Mutual Savings Bank). On October 26, 1999, First Mutual Savings
Bank converted into the holding company form of ownership in a tax-free
reorganization. In the reorganization, First Mutual Savings Bank changed its
name to First Mutual Bank and became the wholly owned subsidiary of the Company.
First Mutual Bank is also referred to as the "Bank" in this report.
BASIS OF PRESENTATION
Preparing financial statements requires management to make estimates and
assumptions that affect the reported amounts of assets, liabilities, revenues
and expenses. Changes in these estimates and assumptions are considered
reasonably possible and may have a material impact on the financial statements.
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
presentation in conformity with generally accepted accounting principles. All
such adjustments are of a normal recurring nature. Certain amounts in the prior
periods' financial statements and/or schedules have been reclassified to conform
to the current period's presentation.
The consolidated financial statements include the Company's wholly owned
subsidiary, First Mutual Bank, and its wholly owned subsidiary, First Mutual
Services, Inc. The information included in this Form 10-Q should be read in
conjunction with Management's Discussion and Analysis and financial statements
and notes thereto included in the First Mutual Savings Bank and Subsidiary 1998
Annual Report and Form 10-K.
8
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, 1999 and December 31, 1998 are summarized as follows:
Gross Gross Estimated
Amortized unrealized unrealized fair
cost gains losses value
----------- ----------- ----------- -----------
SEPTEMBER 30, 1999:
FHLMC securities $ 429,132 $ 8,816 -- $ 437,948
FNMA securities 16,246,727 21,489 654,063 15,614,153
GNMA securities 1,899,755 -- 85,470 1,814,285
----------- ----------- ----------- -----------
$18,575,614 $ 30,305 $ 739,533 $17,866,386
=========== =========== =========== ===========
DECEMBER 31, 1998:
FHLMC securities $ 648,646 $ 17,941 -- $ 666,587
FNMA securities 17,679,888 35,825 41,675 17,674,038
GNMA securities 1,996,385 -- 399 1,995,986
----------- ----------- ----------- -----------
$20,324,919 $ 53,766 $ 42,074 $20,336,611
=========== =========== =========== ===========
NOTE 3.
MORTGAGE-BACKED AND OTHER SECURITIES HELD TO MATURITY
The amortized cost and estimated fair value of mortgage-backed and other
securities is summarized as follows:
Gross Gross Estimated
Amortized unrealized unrealized fair
cost gains losses value
----------- ----------- ----------- -----------
SEPTEMBER 30, 1999:
FNMA certificates $40,106,704 $ 147,426 $ 1,140,868 $39,113,262
FHLMC certificates 1,990,277 20,172 -- 2,010,449
U.S. Government Agency securities 42,649,445 190,193 886,555 41,953,083
Merrill Lynch corporate bond 2,536,746 -- 87,145 2,449,601
Municipal bonds 625,865 -- 16,281 609,584
REMICS 744,747 15,537 -- 760,284
----------- ----------- ----------- -----------
$88,653,784 $ 373,328 $ 2,130,849 $86,896,263
=========== =========== =========== ===========
DECEMBER 31, 1998:
FNMA certificates $14,241,885 $ 238,948 $ 14,235 $14,466,598
FHLMC certificates 3,555,875 14,470 4,180 3,566,165
U.S. Government Agency securities 38,643,616 656,784 151,235 39,149,165
Merrill Lynch corporate bond 2,544,950 -- 33,450 2,511,500
Municipal bonds 627,083 -- 36,313 590,770
REMICS 1,151,194 31,631 -- 1,182,825
U.S. Treasury securities 999,828 172 -- 1,000,000
----------- ----------- ----------- -----------
$61,764,431 $ 942,005 $ 239,413 $62,467,023
=========== =========== =========== ===========
9
NOTE 4.
NONPERFORMING ASSETS
The Bank had nonperforming assets as follows:
September December
30, 1999 31, 1998
-------- --------
Nonperforming loans $464,252 $298,503
Real Estate Held for Sale 9,613 37,628
-------- --------
Totals $473,865 $336,131
======== ========
At September 30, 1999 and December 31, 1998, the Bank had no impaired loans
as 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 years ending
September 30, 1999 and September 30, 1998:
Income Shares Per share
(numerator) (denominator) amount
------------------------------------------
Quarter ended September 30, 1999
- --------------------------------
Basic EPS:
Income available to common shareholders $1,547,445 4,679,239 $ 0.33
========
Effect of dilutive stock options -- 80,075
---------- ----------
Diluted EPS:
Income available to common shareholders
plus assumed stock options exercise $1,547,445 4,759,314 $ 0.33
==========================================
Year ended September 30, 1999
- -----------------------------
Basic EPS:
Income available to common shareholders $4,446,660 4,674,441 $ 0.95
========
Effect of dilutive stock options -- 85,991
---------- ----------
Diluted EPS:
Income available to common shareholders
plus assumed stock options exercise $4,446,660 4,760,432 $ 0.93
==========================================
Quarter ended September 30, 1998
- --------------------------------
Basic EPS:
Income available to common shareholders $1,344,651 4,669,710 $ 0.29
========
Effect of dilutive stock options -- 102,471
---------- ----------
Diluted EPS:
Income available to common shareholders
plus assumed stock options exercise $1,344,651 4,772,181 $ 0.28
==========================================
Year ended September 30, 1998
- -----------------------------
Basic EPS:
Income available to common shareholders $3,862,293 4,625,926 $ 0.83
========
Effect of dilutive stock options -- 133,109
---------- ----------
Diluted EPS:
Income available to common shareholders
plus assumed stock options exercise $3,862,293 4,759,035 $ 0.81
==========================================
10
NOTE 6.
RATE VOLUME ANALYSIS
(Dollars in thousands)
THIRD QUARTER 1999 NINE MONTHS ENDED SEPT. 30, 1999
VS VS
THIRD QUARTER 1998 NINE MONTHS ENDED SEPT. 30, 1998
INCREASE (DECREASE) DUE TO INCREASE (DECREASE) DUE TO
TOTAL TOTAL
VOLUME RATE CHANGE VOLUME RATE CHANGE
- --------------------------------------------------------------------------------------- -----------------------------------
INTEREST INCOME
Investments:
Mortgage-backed and related securities $ 810 $ (215) $ 595 $ 2,054 $ (366) $ 1,688
Interest-earning deposits with banks (20) 4 (16) (13) (2) (15)
Other equity investments 7 (4) 3 21 (10) 11
U.S. Treasury and Govt. Agencies 75 (51) 24 239 (179) 60
------- ------- ------- ------- ------- -------
Total investments 872 (266) 606 2,301 (557) 1,744
Loans:
Residential (470) (33) (503) (1,890) (112) (2,002)
Residential construction 25 (32) (7) 208 (215) (7)
Multifamily 437 (210) 227 1,237 (609) 628
Multifamily construction 83 (38) 45 201 (106) 95
Commercial real estate and Business 490 (212) 278 1,431 (533) 898
Commercial real estate construction 30 (16) 14 97 (42) 55
Consumer & Other 80 (1) 79 247 5 252
------- ------- ------- ------- ------- -------
Total loans 675 (542) 133 1,531 (1,612) (81)
Total interest income 1,547 (808) 739 3,832 (2,169) 1,663
INTEREST EXPENSE
Deposits:
Money market deposit and checking 152 (12) 140 507 (81) 426
Regular savings (11) (7) (18) (44) (30) (74)
Time deposits (255) (309) (564) (450) (861) (1,311)
------- ------- ------- ------- ------- -------
Total deposits (114) (328) (442) 13 (972) (959)
FHLB advances and other 929 (118) 811 1,967 (429) 1,538
------- ------- ------- ------- ------- -------
Total interest expense 815 (446) 369 1,980 (1,401) 579
Net interest income $ 732 $ (362) $ 370 $ 1,852 $ (768) $ 1,084
======= ======= ======= ======= ======= =======
11
NOTE 7.
SEGMENTS
The Bank is organized based on the products and services that it offers. Under
this organizational structure, the Bank has three reportable segments: consumer
banking, residential lending, and commercial lending.
Consumer banking offers depositor banking services, home equity lending,
direct consumer loans, and consumer dealer financing contracts.
Residential lending offers conventional or government-insured loans to
borrowers to purchase, refinance, or build homes, secured by one-to-four unit
family dwellings. Embedded within the residential lending segment is a
mortgage banking operation, which sells loans in the secondary mortgage
market. The mortgage banking operation generally retains the right to service
the loans sold (i.e., collection of principal and interest payments) for
which it receives a fee based on the unpaid principal balance. The servicing
rights may be resold at opportune market conditions.
Commercial lending offers permanent and interim (construction) loans for
multifamily housing (over 4 units), commercial real estate properties, and
loans to small and medium-sized businesses for financing inventory, accounts
receivable and equipment, among other things. The underlying real estate
collateral or business asset being financed typically secures these loans.
Segment results are determined based on the Bank's management accounting
process, which assigns balance sheet and income statement items to each
responsible business unit. This process is dynamic and subjective, and unlike
financial accounting, there is no body of guidance for management equivalent to
generally accepted accounting principles.
The amounts for the segments would differ from the actual consolidated financial
statements due to the various methods for allocating costs and the inferring of
interest-earning assets. For example, the Consumer Banking segment includes
inferred interest earning assets on branch banking deposits, which are
essentially the same assets from the lending segments, but credited with a
proportionate interest yield. Consequently, adding the assets of the three
segments results in a larger total than what is shown in the consolidated
financial statements.
FINANCIAL INFORMATION FOR THE BANK'S SEGMENTS IS SHOWN BELOW FOR 1999 AND 1998:
CONSUMER RESIDENTIAL COMMERCIAL
QUARTER ENDED SEPTEMBER 30: BANKING LENDING LENDING TOTALS
---------- ---------- ---------- ------------
Revenues from external customers 1999 $2,310,595 $2,244,001 $6,834,970 $ 11,389,566
1998 1,636,586 2,565,414 6,264,749 10,466,749
Revenues from other segments of the Bank 1999 4,256,010 72,441 413,991 4,742,442
1998 5,344,132 99,671 375,080 5,818,883
Total Revenues 1999 6,566,605 2,316,442 7,248,961 16,132,008
1998 6,980,718 2,665,085 6,639,829 16,285,632
Net interest revenue 1999 1,585,371 399,706 2,630,793 4,615,870
1998 1,588,940 544,683 2,388,215 4,521,838
Income before federal income taxes 1999 125,432 507,459 1,839,396 2,472,287
1998 435,837 497,470 1,700,494 2,633,801
Total assets as of September 30: 1999 411,571,160 98,177,125 315,886,644 825,634,929
1998 402,153,081 109,895,075 267,723,456 779,771,612
CONSUMER RESIDENTIAL COMMERCIAL
YEAR-TO-DATE ENDED SEPTEMBER 30: BANKING LENDING LENDING TOTALS
---------- ---------- ---------- ------------
Revenues from external customers 1999 6,686,067 6,546,361 19,568,719 $ 32,801,147
1998 4,702,957 8,480,841 17,908,002 31,091,800
Revenues from other segments of the Bank 1999 13,011,876 222,429 1,193,479 14,427,784
1998 15,989,035 337,969 1,104,631 17,431,635
Total Revenues 1999 19,697,943 6,768,790 20,762,198 47,228,931
1998 20,691,992 8,818,810 19,012,633 48,523,435
Net interest revenue 1999 4,803,119 1,332,725 7,423,836 13,559,680
1998 4,912,191 1,547,724 6,463,125 12,923,040
Pretax income 1999 606,479 1,349,729 5,104,700 7,060,908
1998 1,316,623 1,669,869 4,433,542 7,420,034
12
NOTE 7.
SEGMENTS (CONTINUED)
Reconciliations of segment data to the Company consolidated financial statements
are shown in the table below. The amounts for the segments would differ from the
actual consolidated financial statements due to a funds transfer pricing
mechanism that uses internal, proxy market interest rates, and also, various
methods for allocating costs.
YEAR-TO-DATE YEAR-TO-DATE
QUARTER ENDED ENDED QUARTER ENDED ENDED
1999 1999 1998 1998
------------- ------------- ------------- -------------
TOTAL REVENUES FOR SEPTEMBER 30:
Segment total revenues $ 16,132,008 $ 47,228,931 $ 16,285,632 $ 48,523,435
Back out or add back:
Revenues from other segments of the Company (4,742,442) (14,427,784) (5,818,883) (17,431,635)
Revenues of administrative departments netted against
overhead costs and reallocated as net costs 223,225 662,927 275,341 714,837
------------- ------------- ------------- -------------
Consolidated Company total revenues $ 11,612,791 $ 33,464,074 $ 10,742,090 $ 31,806,637
NET INTEREST REVENUE FOR SEPTEMBER 30:
Segment net interest revenue $ 4,615,870 $ 13,559,680 $ 4,521,838 $ 12,923,040
Back out or add back:
Difference between actual Company interest expense
and intersegment funding allocation 40,687 (9,834) (280,277) (495,175)
Interest revenues of administrative departments netted
against overhead costs and reallocated as net costs 174,979 504,807 219,000 542,165
------------- ------------- ------------- -------------
Consolidated Company net interest revenue $ 4,831,536 $ 14,054,653 $ 4,460,561 $ 12,970,030
INCOME BEFORE FEDERAL INCOME TAXES FOR SEPTEMBER 30:
Segment pre-tax income $ 2,472,287 $ 7,060,908 $ 2,633,801 $ 7,420,034
Back out or add back:
Unallocated loan losses (250,000) (668,206) (385,000) (585,000)
Unallocated net expenses of administrative departments -- -- -- (789,582)
Difference between actual total Company funding cost
and total intersegment funding allocation 119,758 336,946 (211,451) (193,493)
------------- ------------- ------------- -------------
Consolidated Company pre-tax income $ 2,342,045 $ 6,729,648 $ 2,037,350 $ 5,851,959
TOTAL ASSETS AS OF SEPTEMBER 30:
SEGMENT TOTAL ASSETS $ 825,634,929 779,771,612
Back out or add back:
Inferred intersegment interest earning assets on branch deposits (277,588,741) (306,241,438)
Unallocated reserve for loan loss (6,220,843) (5,404,431)
Unallocated nonearning assets of administrative departments 5,998,936 5,965,922
------------- -------------
Consolidated Company total assets $ 547,824,281 $ 474,091,665
13
PART I
FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
Consolidated Financial Statements of the Company begin on page 2.
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 holding company primarily engaged in the business of planning,
directing, and coordinating the activities of its wholly-owned subsidiary, First
Mutual Bank (formerly First Mutual Savings Bank). On October 26, 1999, First
Mutual Savings Bank converted into the holding company form of ownership in a
tax-free reorganization. In the reorganization, First Mutual Savings Bank
changed its name to First Mutual Bank and became the wholly owned subsidiary of
the Company. The formation of First Mutual Bancshares, Inc. gives the Company a
broader platform for further growth.
First Mutual Bank (the "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"). First
Mutual Bank conducts business from its headquarters in Bellevue, Washington and
has nine full-service facilities located in Bellevue (3), Redmond, Seattle (2),
Issaquah, Bellingham, and Monroe, Washington, and has three income property loan
production offices located in Salem, Oregon, and Bellingham and Tacoma,
Washington. The business of First Mutual Bank 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, loans secured by savings accounts, and consumer loans. In
addition to portfolio lending, First Mutual Bank conducts a significant mortgage
banking operation.
The following discussion should be read in conjunction with the
attached consolidated financial statements and notes thereto, and with the
audited financial statements and notes thereto for First Mutual Savings Bank and
Subsidiary for the year ended December 31, 1998.
RESULTS OF OPERATIONS
- ---------------------
Net Interest Income
-------------------
Net interest income increased $371,000, or 8.3%, in the third quarter of 1999 as
contrasted with the same quarter in 1998. The net interest margin for the
quarter was 3.69%, which compares to 3.65%, 3.69%, 3.79%, and 3.89%, for the
quarters ended June 30, 1999, March 31, 1999, December 31, 1998, and September
30, 1998, respectively.
Net interest income improved principally as a result of an increase in earning
assets, which contributed $732,000 in the third quarter. Offsetting the benefit
from greater earning assets, which grew from $460,448,000 at September 30, 1998,
to $533,542,000 at quarter-end September 1999, was the negative impact of
$362,000 from a change in interest rates. The unfavorable change in the net
interest margin is attributable to a greater decrease in interest income than
the corresponding figure for interest expense. Interest income, as measured by
the ratio of interest income/average-earning assets, dropped from 8.68% in the
third quarter of 1998 to 8.16% in the same period in 1999. Interest expense, as
gauged by the ratio of interest expense/average-earning assets, also decreased,
14
falling from 4.79% in the third quarter of 1998 to 4.47% in 1999. Thus, even
though the interest expense ratio fell .32%, the decline of .52% in the interest
income ratio was significantly greater.
One of the factors that contributed to the decrease in the net interest margin
was the Bank's 29.7% increase in investment securities. At September 30, 1999,
investment securities totaled $106,520,000, up $24,419,000 from the prior
year-end balance of $82,101,000. The yield from investment securities is
dramatically less than that received from the loan portfolio; for example,
investment securities at quarter-end September 1999 had an average return of
6.08%, as compared to 8.21% for the loan portfolio.
Although investment securities will continue to be purchased in the normal
course of business, the Bank has no present intent to acquire securities on the
scale that occurred in the first three quarters of 1999.
Net interest income year-to-date 1999 rose $1,085,000, or 8.36%, over the
comparable period in 1998. Like the third quarter, the improvement in net
interest income was the result of a growth in earning assets. Greater earning
assets contributed $1,852,000, which was partially offset by an unfavorable
variance of $768,000 in interest rates. See Note 6 for further information
regarding volume and rate relationships affecting net interest income.
Although the Bank's loan portfolio is composed of adjustable-rate loans,
totaling 85% of the portfolio, a further rise in interest rates would most
likely degrade the net interest margin. Rising interest rates generally increase
the Bank's cost of funds faster than the yield on earning assets.
The provision for loan losses decreased from $385,000 in the third quarter of
1998 to $250,000 in the like period in 1999. 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 Bank's loan
portfolio. In determining the appropriate reserve balance, the Bank takes into
consideration the local and national economic outlook and the historical
performance of the loan portfolio.
Of keen interest to the Bank is the mix of its loan portfolio. Currently, 20.8%
of the portfolio is residential loans, and the remaining 79.2% is composed of
commercial, construction, and consumer loans. The residential figure of 20.8%
compares, according to the second-quarter 1999 FDIC QUARTERLY BANKING PROFILE
(latest available data), to 71.2% for FDIC-insured thrift institutions and 22.8%
for FDIC-insured commercial banks. Management's assessment of this information
is that its loan portfolio is closely related to that of a commercial bank.
The Bank's loan loss reserves to total loans ratio was 1.46% at September 30,
1999. The comparable ratios for FDIC-insured savings institutions and commercial
banks, as of June 30, 1999, were .94% and 1.74%, respectively. Although the
Bank's loan mix is similar to that of a commercial bank, and therefore arguably
its ratio of loan loss reserves to total loans should correspond to the national
average, management believes that the Bank's current ratio of nonperforming
loans to assets warrants favorable consideration. As of quarter-end September
1999 the Bank's nonperforming assets to total assets ratio was .09%. That number
compares to the national ratios of .62% for savings institutions and .64% for
commercial banks as of June 30, 1999.
In summary, the Bank's provision for loan loss reserves is based on historical
credit analysis and an assessment of local and national economic conditions, and
it appears to be reasonable in light of the national ratio for comparable loan
portfolios when tempered by the Bank's favorable nonperforming asset status.
15
Other Operating Income
----------------------
Gain on sales of loans, which amounted to $558,000 in the third quarter of 1999,
and is up 29.8% from $430,000 in the like quarter of 1998, is comprised of three
distinct categories--sale of mortgage servicing rights, secondary market fees,
and capitalized mortgage servicing rights.
The gain from the sale of servicing rights amounted to $419,000 in the quarter
ending September 30, 1999, up modestly from $412,000 a year earlier. The Bank
sold $27 million in servicing rights in the third quarter of 1999 compared to
$31 million in 1998.
Year-to-date the gain from the sale of servicing rights amounted to $1,604,000
in 1998, and $1,441,000 this year. Total sales in 1998 were $149 million,
substantially greater than the $99 million in servicing rights sales in 1999. In
the first quarter of last year the Bank sold approximately one-third of its
servicing portfolio, $93 million, to mitigate the risk of an early prepayment of
the servicing portfolio.
In the fourth quarter, the sale of servicing rights is expected to drop to
approximately $5 million, which is 19% of the third quarter sale and 13% of the
sale in second quarter. Furthermore, the outlook for servicing rights sales in
the year 2000 is anticipated to be down substantially from sales realized in
1999. Because of the rise in interest rates experienced in 1999, the refinance
loan origination activity has declined dramatically. The Bank does not expect a
return to the residential single-family origination volume experienced in 1998
and the first half of 1999 until such time as the home loan rates decline
significantly from the current yields.
Secondary market fees are the cash gains or losses from the sale of loans into
the securities market. Cash gains on loan sales of $10,386,000 in the third
quarter totaled $115,000. That figure compares to a loss of $24,000 on loan
sales of $50,468,000 in the same quarter of 1998. Because of the sudden drop in
loan sales in the third quarter of 1999, the Bank held commitments for loan
sales in excess of the amount of loans that it could deliver to the securities
market. These commitments had been made earlier in the year when mortgage loan
rates were lower, and thus had increased in value with the subsequent rise in
rates.
The Bank does not anticipate a similar benefit in the fourth quarter. Loan sales
in the fourth quarter are expected to be at approximately the level seen in the
third quarter. Secondary market activity will most likely result in a cash loss,
which is the usual result from such sales. The year-to-date trend from the gain
on sale of loans is in contrast to the third quarter results. The secondary
market losses in the first three quarters of 1999 totaled $359,000. The figure
for the comparable period in 1998 was a loss of $314,000.
The gains recorded for capitalized mortgage servicing rights are pursuant to
Statement of Financial Accounting Standard (SFAS) No. 125, ACCOUNTING FOR
TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND EXTINGUISHMENTS OF LIABILITIES,
which requires the capitalization of internally generated servicing rights. The
amount recognized as income in the third quarter of 1998 totaled $43,000, as
compared to $24,000 in the same period of 1999. The drop in mortgage servicing
rights (MSR) income is the result of a 79% decline in loan sales, partially
offset by a change in sales procedures. Earlier this year, the Bank chose to
sell all of the servicing rights to third parties. In prior years, a portion of
the servicing rights had been sold to Fannie Mae to mitigate the loss from
secondary market sales.
The year-to-date results for MSR gains show a different trend than the third
quarter. MSR gains on loan sales of $101,297,000 in 1999 amounted to $252,000,
16
as compared to $123,000 on loan sales of $150,408,000 a year earlier. Again, the
change with Fannie Mae as to the amount of servicing retained by the Bank
favorably affected the MSR gains realized in 1999.
Fee income from deposits rose $36,000, or 72.3%, in 1999 on a quarter-to-quarter
comparison. Contributing to the gain in deposit fees was the growth in money
market and checking accounts. At September 30, 1998, money market and checking
accounts totaled $83,969,000, and represented 21% of total deposits. At the end
of third quarter 1999, the balance of those accounts was $102,052,000, and
represented 25.3% of total deposits. In addition to the growth of fee-producing
accounts, the Bank has focused its attention on collecting the fees that it is
due.
The year-to-date results for fees on deposits are comparable to the third
quarter in that income has risen $97,000, or 65.7%. The same trends affecting
the third quarter favorably influenced the year-to-date figures.
Other income fell $60,000, or 27.6%, from $217,000 in the three months ending
September 30, 1998, to $157,000 in the like quarter of 1999. Adversely affecting
third quarter 1999 was a decrease in brokered loan fees of $30,000 and an
absence of dividends from the TransAlliance partnership. Brokered loan fees are
down as a result of the decline in refinanced home loans. The Bank anticipates
that fourth quarter broker fee income will be comparable with that for third
quarter. The TransAlliance partnership, which distributed dividends of $65,000
last year, has yet to pay out any dividends this year. Nor has there been any
indication from the partnership that dividends will be paid in the fourth
quarter.
Year-to-date other income is modestly down in 1999 as compared to the prior
year. Income for the first three quarters of 1999 was $559,000, as compared to
$587,000 in 1998. The drop in fee income for 1999 is largely attributed to the
TransAlliance partnership.
Operating Expenses
------------------
Salaries and employees benefits rose 16.1%, from $1,787,000 in the third quarter
of 1998 to $2,075,000 in the same period this year. The increased compensation
cost is largely the result of bonus compensation for the staff and a decline in
SFAS No. 91 benefits.
Bonus compensation for the staff increased from $269,000 in the third quarter of
1998 to $459,000 in the same period this year. Year-to-date bonus compensation
amounted to $662,000 in 1998, as compared to $843,000 in expense in the first
three quarters of 1999. Bonus compensation is composed of quarterly bonuses paid
on individual performance and an annual bonus determined by the after-tax profit
of the Bank. The annual bonus is accrued throughout the year based on the Bank's
estimate of its obligation at year-end.
The direction for salaries and employee benefits for the first nine months of
1999 is in contrast to that of the third quarter. Salaries and benefits dropped
$229,000, or 3.9%. Favorably affecting year-to-date costs was the discontinuance
of discretionary bonuses for directors and senior management, totaling $808,000
paid in 1998. Partially offsetting that benefit was the capitalization of direct
loan origination costs, as required by SFAS No. 91. In accordance with SFAS No.
91, standard loan costs are determined annually for common loan types. The
predetermined standard loan costs are deducted from operating expenses with the
net figures reported in the financial statements. Year-to-date the SFAS No. 91
benefit has amounted to $1,073,000 as compared to $1,234,000 last year. The
decrease in SFAS No. 91 benefits is largely the result of a drop in loan
originations this year. Loans closed in 1999 totaled $237 million as compared to
$286 million the prior year.
17
Other operating expenses declined slightly in the third quarter of 1999 to
$706,000, from $709,000 in the like quarter of 1998. Legal and outside service
expenses, both of which decreased, were partially offset by a rise in audit
costs. Legal expenses fell on a quarter-to-quarter comparison to $26,000, from
$51,000 in 1998. Outside service costs, likewise, declined from $54,000 in the
third quarter of 1998 to $22,000 this year. Adding to other expense was a rise
in audit and examination costs, which increased from $3,000 in 1998 to $23,000
this year.
Year-to-date other operating expenses rose $282,000, from $2,074,000 in the
first three quarters of 1998 to $2,356,000 in 1999. Legal expenses year-to-date
are up $147,000, from $95,000 in 1998 to $242,000 this year. The increase in
legal expense is principally attributable to the formation of a bank holding
company, which was completed in October. Outside services also rose year-to-date
1999 to $160,000, from $87,000 last year. In July of last year, the Bank engaged
outside consultants to review the operating procedures of the Bank. That project
was completed in the second quarter of 1999. Audit expense year-to-date rose
dramatically from $10,000 in 1998 to $68,000 this year. The Bank anticipates
that its audit expense next year will be comparable to 1999, with no significant
increases.
Net Income
----------
Net income increased 15.1%, from $1,345,000 in the third quarter of 1998, to
$1,547,000 in the same period of 1999. The improvement in net income was a
reflection of higher net interest income, improved fee income, offset by
increased operating expenses. Year-to-date net income has also risen 15.1%, from
$3,862,000 in 1998 to $4,447,000 this year. Net interest income has grown 8.36%;
other operating income is down slightly; and operating expenses have increased
modestly.
BUSINESS SEGMENTS
- -----------------
The Bank has identified three distinct segments of business for the purposes of
management reporting. (See Note 7 to the Financial Statements.) Segment results
are determined based on the Bank's management accounting process, which assigns
balance sheet and income statement items to each responsible business unit. This
process is dynamic and somewhat subjective. Unlike financial accounting, there
is no body of guidance for management accounting equivalent to generally
accepted accounting principles.
The amounts for the segments would differ from the actual consolidated financial
statements due to the various methods for allocating costs and the inferring of
interest-earning assets. For example, the Consumer Banking segment includes
inferred interest earning assets on branch banking deposits, which are
essentially the same assets from the lending segments, but credited with a
proportionate interest yield. Consequently, adding the assets of the three
segments results in a larger total than what is shown in the consolidated
financial statements. (See the reconciliation section in Note 7 to the Financial
Statements.)
The management accounting process measures the performance of the business
segments based on the management structure of the Bank and is not necessarily
comparable with similar information for any other financial institution. Changes
in management structure and/or the allocation process may result in changes in
allocations, transfers, and assignments.
Consumer Banking
----------------
Income before taxes for the consumer-banking segment dropped sharply from
$436,000 in the third quarter of 1998 to $125,000 in the same quarter in 1999.
Adversely impacting the consumer-banking segment was a decline in both interest
and non-interest income and increased operating expenses.
18
Net interest income was down slightly, $4,000, for this business segment,
dropping from $1,589,000 in the third quarter of 1998 to $1,585,000 this year.
The net interest margin also declined modestly from 1.58% in 1998 to 1.57% in
1999. Average assets rose slightly, to $405,121,000 in the third quarter of
1999, as compared to $401,366,000 last year.
Non-interest income fell from $162,000 in the three months ending September 1998
to $134,000 in the same quarter this year. The decline in non-interest revenues
for the consumer-banking segment is principally due to the decrease in gains on
sales of servicing-released loans in the Home Equity Loan Department, partially
offset by an increase of 72.3% in fee income from deposits. Third quarter loan
sales in the Home Equity Loan Department have declined from $1,337,000 in 1998
to $369,000 in 1999.
Operating expense rose $279,000, or 21%, in the third quarter of 1999.
Contributing to the increase in operating expenses for this business segment
were the additions of three new operating units: Private Banking, Direct
Consumer Lending, and Small Business Banking. These new units joined the
existing Indirect Consumer Lending, Home Equity Lending, and the retail branch
units to offer a full spectrum of consumer banking options for the Bank's retail
customers.
The trend in year-to-date pretax income is similar to the third quarter,
dropping 53.9% from $1,317,000 in the first three quarters of 1998 to $606,000
this year. Again, both net interest income and non-interest income were down,
and operating expense rose.
Net interest income fell 2.2% on a year-to-date comparison. Although average
assets, year-to-date 1999, are $413,190,000 compared to $387,920,000 in 1998,
the decline in net interest margin more than offset the growth in assets. The
net interest margin for the nine months ending September 30, 1998, was 1.69%,
which compares to 1.55% year-to-date 1999.
Non-interest income for the first nine months of 1998 totaled $449,000, as
compared to $405,000 this year. Again, the Home Equity Loan Department
contributed to most of that decline, wherein gains of loans sold
servicing-released decreased from $99,000 year-to-date 1998 to $23,000 in 1999.
Operating expenses were up 13.4% on a nine-month-to-nine-month comparison.
Impacting 1999 is the formation of the three new Consumer Banking units noted
earlier, and the full year's effect of the Bellingham Branch, which began
operations in the late summer of 1998.
Residential Lending
-------------------
Income before taxes increased 2% for the residential lending segment, from
$497,000 in the third quarter of 1998 to $507,000 in 1999. This segment
benefited from an increase in non-interest income, offset by a drop in
net-interest income and a rise in operating expenses.
Non-interest income rose $184,000, or 35.6%, on a quarter-to-quarter comparison.
The growth in non-interest income is principally a result of the favorable gains
from secondary market fees. In the third quarter of last year, secondary market
losses on loan sales amounted to $24,000. In the like quarter of this year,
secondary market activity resulted in a gain of $115,000 as opposed to the norm,
which would be a loss. This unusual event is attributable to commitments
exceeding loans held for sale in a rising rate environment. As was noted
earlier, secondary market fees in the fourth quarter will most likely result in
a loss.
Net interest income declined for this business segment, from $545,000 in the
third quarter of 1998 to $400,000 this year. Average assets fell from
$119,179,000 at September 30, 1998, to $93,081,000 a year later. The net
19
interest margin also decreased, from 1.83% in the third quarter of 1998 to 1.72%
in 1999. For a number of years the Bank has favored commercial real estate,
consumer, and business banking loans over residential home products, as the
average yields on those loans are significantly higher than residential loans.
Operating expenses increased 5.2%, from $564,000 in the three months ending
September 30, 1998, to $593,000 in the same period of 1999. Contributing to that
rise in operating expenses was a drop in SFAS No. 91 benefits, from $191,000 in
the third quarter of 1998 to $98,000 this year. The SFAS No. 91 benefits are
dependent on residential loan originations, which declined 43.4% on a
quarter-to-quarter comparison.
The year-to-date trend for residential lending is similar to that of the third
quarter. Net income before taxes is down $320,000, or 19.2%, from $1,670,000 in
the first nine months of 1998 to $1,350,000 this year. Net interest income has
fallen 13.9%; non-interest income is up modestly; and operating expenses jumped
11.2%.
Net interest income declined, from $1,548,000 in the first three quarters of
1998 to $1,333,000 in the like period of 1999. Both the net interest margin and
average earning assets decreased for this business segment. The net interest
margin dropped from 1.76% in 1998 to 1.73% this year, and earning assets fell
from $117,150,000 to $102,599,000 in 1999.
Non-interest income increased slightly from $1,682,000 in the first nine months
of 1998 to $1,753,000 this year. Contributing to the gain in non-interest income
in 1999 was the unusual effect of a net gain, rather than the normal net loss,
in secondary market fees in the third quarter.
Operating expenses increased 11.2%, from $1,560,000 in the first three quarters
of 1998 to $1,736,000 this year. Because of the decline in residential loan
volume, from $166,126,000 year-to-date 1998 to $101,890,000 this year, the SFAS
No. 91 benefit fell from $707,000 in 1998 to $438,000 in 1999.
Commercial Lending
------------------
Income before taxes for this business segment rose 8.2%, from $1,700,000 in the
third quarter of 1998 to $1,839,000 in the like period of 1999. Net interest
revenue grew $243,000, while operating expenses increased $79,000.
Net interest revenue benefited from an 18.4% increase in average assets. Average
assets rose from $262,893,000 in the third quarter of 1998 to $311,135,000 this
year. Partially offsetting the benefit from the growth in assets was a
significant decline, from 3.63% in 1998 to 3.38% this year, in the net interest
margin.
Operating expenses rose 10.5%, from $753,000 in the third quarter of 1998 to
$832,000 in the same period in 1999. Increased operating costs were largely due
to the opening of the Salem Loan Production Office, and increased income
property loan officer commissions associated with a 16.8% increase in income
property loan originations.
The year-to-date trend parallels the third quarter. Income before federal income
taxes has risen 15.1%, from $4,434,000 in 1998 to $5,105,000 in 1999. Net
interest revenue is up 14.9% and operating costs have increased 11.4%.
Net interest income grew from $6,463,000 in the first three quarters of 1998 to
$7,424,000 in 1999. Average assets have grown 17.3%, from $251,521,000 in 1998
to $295,061,000 this year. The net interest margin fell from 3.43% year-to-date
1998 to 3.35% in 1999.
20
Operating expenses year-to-date are up from $2,240,000 in the first three
quarters of 1998 to $2,495,000 this year. Like the second quarter, commission
expense and increased operating costs for the Salem Production Office
contributed to the year-to-date difference. Commission expense for the first
nine months of 1999 was $169,000, as compared to $88,000 a year ago.
FINANCIAL CONDITION
- -------------------
Assets increased 12%, from $489,230,000 at year-end 1998 to $547,824,000 as of
September 30, 1999. The change in assets is principally the result of an
increase in portfolio loans and investment securities, offset by a decline in
loans held for sale.
Loans receivable rose from $365,104,000 at year-end 1998 to $412,030,000, an
increase of 12.9% in nine months. The growth in loan balances is largely due to
an increase in the commercial real estate loan portfolio. Loan originations for
commercial real estate totaled $93 million in the first three quarters of 1999,
as compared to $79 million in the same period the previous year.
Loans held for sale declined 43.4%, from $27,371,000 at year-end 1998 to
$15,485,000 as of September 30, 1999. Due to generally rising interest rates,
loans originated for mortgage banking activities have dropped on a year-to-year
comparison by $72,017,000, or 44.6%. Interest rates have continued to remain at
levels, which would, at the present time, most likely indicate a further
decrease in loan originations and loans held for sale.
Security investments (securities available for sale and mortgage-backed and
other securities held to maturity) increased $24,419,000, or 29.7%, from
December 31, 1998, to the end of the third quarter 1999. The Bank acquired
investment securities to take advantage of a favorable relationship between its
Tier I and risk-adjusted capital ratios.
The Bank classifies 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, 1999, the balance
of the unrealized loss, net of federal income taxes, was $466,000, which
compares to an unrealized loss at year-end 1998 of $12,000. 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.
Real estate held for sale and nonperforming loans totaled $474,000 at September
30, 1999, and constituted a ratio of .09% of assets. That figure compares to the
national thrift average of .62% (FDIC Quarterly Banking Profile, second quarter
1999).
Deposits declined $8,443,000, or 2.1%, in the first nine months of 1999. The
Bank is concerned about the erosion of its deposit base, which could eventually
seriously degrade the Bank's ability to fund the growth of earning assets.
Actions taken to date to correct this problem include new leadership and branch
incentive programs. Although there has been some improvement since May, when
deposits reached a low of $390 million, the results achieved to date have not
been satisfactory. It is the Bank's current intent to continue with changes made
earlier this year. It will take another six to nine months to determine if those
actions were adequate to address the slow growth in deposits. In the event that
those changes are not effective, or only partially effective, the Bank will
consider raising interest rates to attract funds, increasing its advertising
effort, or acquiring broker deposits from wholesale sources.
The Federal Home Loan Bank (FHLB) advances grew from $31,765,000 at year-end
1998 to $99,309,000 as of the end of the third quarter. The $67,544,000, or
212.6%, increase in FHLB advances largely reflects the $24 million rise in
21
security investments, the $35 million growth in loans, and the $8 million drop
in deposits. As of September 30, 1999, the Bank had the capacity to borrow up to
$192 million in FHLB advances, subject to sufficient collateral to support those
advances. At the present time the Bank is capable of funding its banking
activity through its credit line with the FHLB. However, management believes
that continued reliance on the FHLB and other wholesale sources of funds is less
desirable than the utilization of retail deposits.
Liquidity and Capital Reserves
------------------------------
The net change in cash, as reported in the Statement of Cash Flows, fell by
$1,153,000 in the first nine months of 1999. The deposit flows for the first
half of 1999 were negative, and the Bank added substantially to its investment
securities and loan portfolios.
The Bank's long-term liquidity objective is to fund growth through consumer
deposits. Whenever that source is inadequate to meet the Bank's asset growth
requirements, FHLB advances are normally accessed. The current ratio of FHLB
advances to assets is 18.1%, which is below the Bank's credit limit of 35% of
assets. Other sources of liquidity include the sale of loans into the secondary
market, net income after the payment of dividends, and reverse repurchase
agreement credit lines of $82,000,000.
On October 28, the Company announced a stock repurchase program for up to
225,000 shares, or approximately 5% of the Company's common stock outstanding.
Shares may be purchased from time to time, depending on market conditions, price
and other management considerations. At $12.00 per share, the closing price for
the Company's stock that day, the cost for the repurchase program would be
$2,700,000. The effect of the repurchase program is twofold. It will reduce
capital by the amount paid for shares purchased, and will also reduce earnings
assets by a like amount. To mitigate the impact on capital, the Company intends
to borrow the funds at the Company level and to service that debt from dividends
from the insured Bank subsidiary.
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, 1999, the Bank exceeded the capital levels required to meet the
definition of a well-capitalized institution:
FDIC Requirement
First Mutual Bank for Well-Capitalized
September 30, 1999 Institutions
------------------ --------------------
Leverage Ratio 7.17% 5.00%
Tier I Risk-Based Capital Ratio 10.24% 6.00%
Total Risk-Based Capital Ratio 11.49% 10.00%
YEAR 2000 ISSUES
- ----------------
The paragraphs in this section constitute a "Year 2000 Readiness Disclosure" as
defined in the Year 2000 Information and Readiness Disclosure Act. The Bank
relies on third-party vendors for almost all of its data processing and
telecommunications systems. Consequently, its efforts to ensure that the Bank is
ready for Year 2000 and that there are no meaningful interruptions to its
operations are necessarily dependent on the performance of those vendors and
adequate testing by the vendors and the Bank.
To date the Bank has conducted a comprehensive review of its computer systems to
identify applications that could be affected by Year 2000. It has surveyed its
vendors to find out their status in addressing Year-2000 issues and has
monitored their progress.
22
The Bank's primary data processor supports its deposit, loan, general ledger,
customer information file, accounts payable, and fixed-assets accounting
systems. This processor completed its programming efforts during the second
quarter 1998 and indicated that the Bank was now running, on what the processor
believed, was Year-2000-ready software and hardware. During the third quarter
the Bank conducted an extensive test of the software on a separate test computer
provided by the processor to its clients. The computer was set ahead to the end
of 1999 and rolled through January 3, 2000; in addition, it was also run through
the end of February 2000 to test for leap year. Only a few minor errors were
identified, and not all of them were date related. The processor has reported
that all errors discovered by its clients during testing have been corrected.
All of the other dates recommended for testing by the Federal Financial
Institutions Examination Council were separately tested by the processor; a
single Year-2000-related error was discovered, and it has been corrected. This
processor will not be charging the Bank, nor its other clients, for expenses
related to remediating its software to address Year-2000 issues.
In the Bank's initial assessment, most of the Bank's other third-party vendors
indicated that their systems would be Year-2000 ready by the end of 1998. The
Bank has tested those systems judged to be critical to its operations. Many of
these services (such as check processing, automated teller machine transactions,
automated clearinghouse transactions, and investor reporting) interface with the
Bank's primary data processor, and were tested in conjunction with that
processor. The testing was completed by June 30, 1999, and no material problems
were discovered.
While the Bank does not operate any mainframe computers, it does run several
local area networks to support personal-computer workstations running
standardized word processing, spreadsheet, and database software to support its
operations. All models of the personal-computer workstations, and most of the
individual workstations, have been tested for Year-2000 functionality. All of
the workstations are Year-2000 ready. A total of six personal computers have
been replaced through normal attrition; one of the servers for a local area
network likewise needed replacement. The Bank anticipates no other material
expense related to their replacement. Likewise, the standardized software has
been tested for all critical systems and found to be Year-2000 ready. The Bank
does not expect that any additional material investment will be required to
replace any of the personal-computer hardware or software at this point in time.
If it becomes advisable to replace one or more of these systems, the investment
would likely be a material amount.
In addition to computer software, it is possible that computer hardware and
other equipment used in the Bank's operations or buildings may have
microprocessors with Year-2000 issues. Most of the hardware involved in the
Bank's networks and work stations has been replaced over the past several years
for reasons unrelated to Year 2000. In addition, surveys have been completed of
items such as heating and cooling systems, vault doors, automated teller
machines, and security systems. No material investments are expected related to
Year-2000 readiness for these ancillary systems.
Most of the Bank's costs in this effort has involved the time of its existing
staff; no one has been hired whose job is primarily related to Year-2000 issues.
The Bank does not expect the cost of this project to have a material effect on
its financial position or results of operations. The costs of changing to
alternate vendors, or replacement of one or more in-house systems, would be
material and, while not expected, could be incurred if, despite satisfactory
testing, a system or service provides performance results which are unacceptable
to the Bank.
After the Bank identified its significant vendors, it concentrated its efforts
on determining where they are in the process of ensuring their services will be
Year-2000 ready, monitoring their progress, and testing their systems. A
23
contingency plan to deal with systems that may unexpectedly fail once Year 2000
arrives has been completed. Training on alternate procedures should a system
fail and testing the use of those procedures will occur during the third and
fourth quarters of this year.
The Bank's operations are very dependent on the availability of utility services
such as electrical power and telephone services. The Bank is monitoring their
progress on Year-2000 preparedness through information posted by them on the
Internet.
The Bank operates within the lending and banking community, including the check
clearing houses. In common with other financial institutions, it has the
inherent risk that a failure of any significant system of interchange among the
financial institutions, or the failure of a system within one or more large
banks in the Bank's geographic area, could have a material adverse effect on the
Bank.
While the Bank currently believes that Year 2000 will not pose significant
operational problems, there can be no assurance that its systems and the systems
of other companies on which the Bank relies will perform in all respects as
expected from testing, or that any significant failures would not have a
material impact on the operations of the Bank.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
There has been no material change in the Bank's market risk position
from the end of the preceding fiscal year, December 31, 1998.
24
PART II
OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company has certain litigations and negotiations in progress resulting from
activities arising from normal operations. In the opinion of management, none of
these matters is likely to have a material adverse effect on the Bank's
financial position.
ITEM 5. OTHER INFORMATION
On October 28, 1999, the Company announced that its Board of Directors
has approved a stock repurchase program authorizing the repurchase of up to
225,000 shares of common stock, or approximately 5% of the Company's common
stock outstanding. Shares may be purchased from time to time, depending on
market conditions, price and other management considerations.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
Exhibit
Number Description
------ -----------
27. Financial Data Schedule
(b) Reports (s) on Form 8-K.
Date Filed Purpose
---------- -------
November 10, 1999 Announcement of the formation of First Mutual
Bancshares, Inc., under a tax-free reorganization
effected on October 26, 1999, and related
transactions.
FORWARD-LOOKING STATEMENTS DISCLAIMER
- -------------------------------------
Except for historical information, matters described herein are forward-looking
statements within the meaning of the Private Securities Litigation Reform Act of
1995. They are subject to risks and uncertainties that could cause actual
results to differ materially. Among these are governmental fiscal policy,
general interest rate changes, and other economic, competitive and operational
factors.
These are some examples. Management's expectations concerning Year 2000 costs
are based on test results to date. These expectations may not be achieved if
additional testing, or the Bank's operating experience, show that greater
changes are necessary. The sale of servicing rights is a decision based in part
on interest rate expectations, as to which there is no certain predictability.
The market for servicing rights is similarly affected by the interest rate
expectations of potential purchasers. It is possible that the Bank may, at
times, be unable to market servicing rights at a price acceptable to the Bank.
Other risks include the effect of rising or falling interest rates on net
interest income, the market value of securities, loan originations, the outlook
for gains and losses in the secondary market, the possibility or lack thereof of
partnership dividends, the Bank's actions in regards to its deposit funding
sources, the Bank's ability to acquire future advances from the Federal Home
Loan Bank, and the Bank's future actions pertaining to the stock repurchase plan
and the funding sources for that program.
25
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the Company has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
FIRST MUTUAL BANCSHARES, INC.
By /S/ John R. Valaas
-----------------------------
John R. Valaas
President and Chief Executive Officer
By /s/ Roger A. Mandery
-----------------------------
Roger A. Mandery
Executive Vice President
(Principal Financial Officer)