STERLING FINANCIAL CORP /WA/ - 10-Q Quarterly Report

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)
ý	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED September 30, 2002
OR
o	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 0-20800

STERLING FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)

Washington (State or other jurisdiction of incorporation or organization)		91-1572822 (I.R.S. Employer Identification No.)
111 North Wall Street, Spokane, Washington 99201 (Address of principal executive offices) (Zip Code)
(509) 458-2711 (Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 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 ý No o

Indicate the number of shares outstanding of each of the issuer's classes of common stock as of the latest practicable date:

Class		Outstanding as of October 31, 2002
Common Stock ($1.00 par value)		11,958,948

STERLING FINANCIAL CORPORATION

FORM 10-Q
For the Quarter Ended September 30, 2002

TABLE OF CONTENTS

			Page
PART I—Financial Information			1
	Item 1—Financial Statements		1
		Consolidated Balance Sheets	1
		Consolidated Statements of Income	2
		Consolidated Statements of Cash Flows	3
		Consolidated Statements of Comprehensive Income	5
		Notes to Consolidated Financial Statements	6
	Item 2—Management's Discussion and Analysis of Financial Condition and Results of Operations		14
	Item 3—Quantitative and Qualitative Disclosures About Market Risk		27
	Item 4—Disclosure Controls and Procedures		27
PART II—Other Information			28
	Item 1—Legal Proceedings		28
	Item 2—Changes in Securities and Use of Proceeds		28
	Item 3—Defaults Upon Senior Securities		28
	Item 4—Submission of Matters to a Vote of Security Holders		28
	Item 5—Other Information		28
	Item 6—Exhibits and Reports on Form 8-K		28
Signatures			29
Certifications			30

PART I—Financial Information

Item 1—Financial Statements

STERLING FINANCIAL CORPORATION

Consolidated Balance Sheets

(Unaudited)

				September 30, 2002		December 31, 2001
				(Dollars in thousands)
ASSETS:
	Cash and cash equivalents:
		Interest bearing		$	34	$	3,938
		Non-interest bearing and vault			69,156		61,716
		Restricted			1,818		1,527
	Investments and asset-backed securities ("ABS"):
		Available for sale			803,784		686,995
		Held to maturity			6,667		7,053
	Loans and leases receivable, net				2,243,164		2,109,479
	Loans held for sale				18,616		12,077
	Accrued interest receivable				15,472		15,302
	Real estate owned, net				5,336		2,982
	Office properties and equipment, net				47,347		48,305
	Goodwill, net				43,977		43,977
	Mortgage servicing rights, net				1,789		1,638
	Bank-owned life insurance ("BOLI")				58,543		30,988
	Prepaid expenses and other assets, net				13,872		12,616

			Total assets	$	3,329,575	$	3,038,593

LIABILITIES:
	Transaction deposits				626,037		368,636
	Savings and money market deposits				328,741		422,659
	Certificates of deposit				1,063,646		1,062,241

			Total deposits		2,018,424		1,853,536
	Advances from Federal Home Loan Bank of Seattle ("FHLB Seattle")				738,086		633,054
	Securities sold subject to repurchase agreements and funds purchased				221,960		218,549
	Other borrowings				119,000		127,500
	Cashiers checks issued and payable				14,016		16,057
	Borrowers' reserves for taxes and insurance				2,580		1,197
	Accrued interest payable				7,577		8,187
	Accrued expenses and other liabilities				11,454		14,823

			Total liabilities		3,133,097		2,872,903

SHAREHOLDERS' EQUITY:
	Preferred stock, $1 par value; 10,000,000 shares authorized; no shares issued and outstanding				0		0
	Common stock, $1 par value; 20,000,000 shares authorized; 11,957,448 and 10,544,653 shares issued and outstanding				11,957		10,545
	Additional paid-in capital				125,166		98,439
	Unrealized gains (losses) on investments and ABS available-for-sale, net of deferred income taxes of $(2,834) and $2,473				3,916		(4,596	)
	Retained earnings				55,439		61,302

			Total shareholders' equity		196,478		165,690

			Total liabilities and shareholders' equity	$	3,329,575	$	3,038,593

The accompanying notes are an integral part of the consolidated financial statements.

STERLING FINANCIAL CORPORATION

Consolidated Statements of Income

(Unaudited)

			Three Months Ended September 30,						Nine Months Ended September 30,
			2002			2001			2002			2001
			(Dollars in thousands, except per share data)
Interest income:
	Loans and leases		$	40,260		$	39,714		$	118,340		$	126,050
	ABS			8,797			8,617			24,384			19,924
	Investments and cash equivalents			1,052			1,361			3,252			5,174

		Total interest income		50,109			49,692			145,976			151,148

Interest expense:
	Deposits			11,175			15,347			34,025			51,049
	Short-term borrowings			2,144			2,390			5,419			6,100
	Long-term borrowings			10,926			11,350			33,911			32,851

		Total interest expense		24,245			29,087			73,355			90,000

		Net interest income		25,864			20,605			72,621			61,148
Provision for losses on loans and leases				(3,277	)		(1,525	)		(7,590	)		(4,400	)

		Net interest income after provision		22,587			19,080			65,031			56,748

Other income (expense):
	Fees and service charges			4,352			3,416			12,281			9,799
	Mortgage banking operations			1,307			723			3,663			2,451
	Loan servicing fees			271			314			865			899
	Net gains on sales of securities			1,399			1,072			1,796			1,429
	Real estate owned operations			(8	)		(138	)		(202	)		(445	)
	BOLI			731			454			2,433			532
	Other noninterest income (expense)			15			(99	)		(195	)		(93	)

		Total other income		8,067			5,742			20,641			14,572

Operating expenses				21,119			18,757			60,538			53,918

	Income before income taxes			9,535			6,065			25,134			17,402
Income tax provision				(2,906	)		(1,994	)		(7,188	)		(5,947	)

Net income			$	6,629		$	4,071		$	17,946		$	11,455

Income per share—basic			$	0.55		$	0.34		$	1.52		$	0.96

Income per share—diluted			$	0.54		$	0.33		$	1.47		$	0.95

Weighted average shares outstanding—basic				11,950,633			11,913,571			11,804,806			11,885,089
Weighted average shares outstanding—diluted				12,243,940			12,174,789			12,208,035			12,065,541

The accompanying notes are an integral part of the consolidated financial statements.

STERLING FINANCIAL CORPORATION

Consolidated Statements of Cash Flows

(Unaudited)

				Nine Months Ended September 30,
				2002			2001
				(Dollars in thousands)
Cash flows from operating activities:
	Net income			$	17,946		$	11,455
	Adjustments to reconcile net income to net cash provided by (used in) operating activities:
		Provisions for losses on loans, leases and real estate owned			7,828			4,734
		Stock dividends on FHLB Seattle stock			(1,808	)		(3,468	)
		Net gain on sales of loans, investments and ABS			(5,074	)		(1,928	)
		Other losses (gains)			491			(95	)
		Change in cash surrender value of BOLI			(2,555	)		(532	)
		Depreciation and amortization			8,276			9,243
		Change in:
			Accrued interest receivable		(170	)		1,354
			Prepaid expenses and other assets		(6,633	)		(2,042	)
			Cashiers checks issued and payable		(2,041	)		(1,028	)
			Accrued interest payable		(159	)		(1,510	)
			Accrued expenses and other liabilities		(3,815	)		5,920
		Proceeds from sales of loans			184,406			220,680
		Real estate loans originated for sale			(181,128	)		(218,642	)

			Net cash provided by operating activities		15,564			24,141

Cash flows from investing activities:
	Change in restricted cash				(290	)		(258	)
	Loans funded				(1,140,121	)		(730,809	)
	Loan and lease principal received				984,737			722,201
	Purchase of investments				(32,039	)		(24	)
	Proceeds from maturities of investments				29,929			82,396
	Proceeds from sales of available-for-sale investments				1,410			9,953
	Purchase of BOLI				(25,000	)		(30,000	)
	Cash and cash equivalents acquired as part of acquisitions				0			1,498
	Purchase of ABS				(592,031	)		(520,428	)
	Principal payments on ABS				142,560			74,066
	Proceeds from sales of ABS				345,290			143,240
	Purchase of office properties and equipment				(2,216	)		(1,797	)
	Improvements and other changes to real estate owned				(866	)		180
	Proceeds from sales and liquidation of real estate owned				6,065			7,158

			Net cash used in investing activities		(282,572	)		(242,624	)

The accompanying notes are an integral part of the consolidated financial statements.

STERLING FINANCIAL CORPORATION

Consolidated Statements of Cash Flows (continued)

(Unaudited)

				Nine Months Ended September 30,
				2002			2001
				(Dollars in thousands)
Cash flows from financing activities:
	Net change in checking, passbook and money market deposits			$	157,785		$	67,803
	Proceeds from issuance of certificates of deposit				858,652			530,261
	Payments for maturing certificates of deposit				(884,527	)		(630,166	)
	Interest credited to deposits				32,978			52,980
	Advances from FHLB Seattle				221,875			184,000
	Repayment of FHLB Seattle advances				(116,843	)		(76,031	)
	Net change in securities sold subject to repurchase agreements and funds purchased				3,410			81,174
	Payments for fractional shares				(19	)		0
	Proceeds from other borrowings				0			54,000
	Repayment of other borrowings				(5,000	)		(40,000	)
	Proceeds from exercise of stock options, net of repurchases				851			78
	Other				1,382			690

			Net cash provided by financing activities		270,544			224,789

Net change in cash and cash equivalents					3,536			6,306
Cash and cash equivalents, beginning of period					65,654			60,595

Cash and cash equivalents, end of period				$	69,190		$	66,901

Supplemental disclosures:
	Cash paid during the period for:
		Interest		$	49,629		$	88,292
		Income taxes			8,798			4,377
	Noncash financing and investing activities:
		Loans converted into real estate owned			7,570			4,722
		Common stock issued upon business combination			0			9,141
		Common stock dividend			23,809			12,837

The accompanying notes are an integral part of the consolidated financial statements.

STERLING FINANCIAL CORPORATION

Consolidated Statements of Comprehensive Income

(Unaudited)

		Three Months Ended September 30,						Nine Months Ended September 30,
		2002			2001			2002			2001
		(Dollars in thousands)
Net income		$	6,629		$	4,071		$	17,946		$	11,455
Other comprehensive income:
	Change in net unrealized gains/losses on investments and ABS available-for-sale		4,450			9,283			13,094			10,806
	Deferred income taxes		(1,558	)		(3,249	)		(4,582	)		(3,782	)

	Net other comprehensive income		2,892			6,034			8,512			7,024

Comprehensive income		$	9,521		$	10,105		$	26,458		$	18,479

The accompanying notes are an integral part of the consolidated financial statements.

STERLING FINANCIAL CORPORATION

Notes to Consolidated Financial Statements

1. Basis of Presentation:

The foregoing unaudited interim consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X as promulgated by the Securities and Exchange Commission. Accordingly, these financial statements do not include all of the disclosures required by accounting principles generally accepted in the United States of America for complete financial statements. These unaudited interim consolidated financial statements should be read in conjunction with the audited consolidated financial statements for the year ended December 31, 2001. In the opinion of management, the unaudited interim consolidated financial statements furnished herein include all adjustments, all of which are of a normal recurring nature, necessary for a fair statement of the results for the interim periods presented.

The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities known to exist as of the date the financial statements are published, and the reported amounts of revenues and expenses during the reporting period. Uncertainties with respect to such estimates and assumptions are inherent in the preparation of Sterling Financial Corporation's ("Sterling's") consolidated financial statements; accordingly, it is possible that the actual results could differ from these estimates and assumptions, which could have a material effect on the reported amounts of Sterling's consolidated financial position and results of operations.

2. Interim Financial Statements:

The financial information set forth in the unaudited interim consolidated financial statements reflects the adjustments, all of which are of a normal and recurring nature, which, in the opinion of management, are necessary for a fair presentation of the periods reported.

3. Other Borrowings:

The components of other borrowings are as follows (in thousands):

		September 30, 2002		December 31, 2001
Term note payable(1)		$	25,000	$	30,000
Advances on revolving line of credit(2)			0		0
Sterling obligated mandatorily redeemable preferred capital securities of subsidiary trusts holding solely junior subordinated deferrable interest debentures of Sterling(3)(4)			64,000		64,000
Floating Rate Notes Due 2006(5)			30,000		30,000
Convertible Subordinated Debentures Due 2008			0		3,500

	Total other borrowings	$	119,000	$	127,500

(1): Sterling has a variable-rate term note with U.S. Bank, N.A. ("U.S. Bank") with a balance of $25.0 million outstanding at September 30, 2002. This note matures on September 17, 2007. Interest accrues at the 30-day London Interbank Offering Rate ("LIBOR") plus 2.50% (4.32%) and is payable monthly. This note is collateralized by a majority of the Common and Preferred Stock of Sterling Savings Bank.

(2): Sterling has a $5.0 million revolving line-of-credit with U.S. Bank. This line of credit matures on September 15, 2003. The interest rate is adjustable monthly at the 30-day LIBOR plus 2.50% (4.32%) and is payable monthly. This note is collateralized by a majority of the Common and Preferred Stock of Sterling Savings Bank. At September 30, 2002, no amounts were outstanding under this line.
(3): Sterling has outstanding $41.2 million of 9.50% junior subordinated deferrable interest debentures ("Junior Subordinated Debentures-I") to Sterling Capital Trust I ("Trust-I"), a Delaware business trust, of which Sterling owns all of the common equity. The sole asset of Trust-I is the Junior Subordinated Debentures-I. Trust-I issued $40.0 million of 9.50% Cumulative Capital Securities ("Trust-I Preferred Securities") to investors. Sterling's obligations under the Junior Subordinated Debentures-I and related documents, taken together, constitute a full and unconditional guarantee by Sterling of Trust-I's obligations under the Trust-I Preferred Securities. The Trust-I Preferred Securities are treated as debt of Sterling. Although Sterling, as a savings and loan holding company, is not subject to the Federal Reserve capital requirements for bank holding companies, the Trust-I Preferred Securities have been structured to qualify as Tier I capital, subject to certain limitations, if Sterling were to become regulated as a bank holding company. The Junior Subordinated Debentures-I and related Trust-I Preferred Securities mature in 2027 and are redeemable at the option of Sterling under certain conditions. The Trust-I Preferred Securities must be redeemed upon maturity of the Junior Subordinated Debentures-I in 2027.
(4): Sterling has outstanding $24.7 million of 10.25% junior subordinated deferrable interest debentures ("Junior Subordinated Debentures-II") to Sterling Capital Trust II ("Trust-II"), a Delaware business trust, in which Sterling owns all of the common equity. The sole asset of Trust-II is the Junior Subordinated Debentures-II. Trust-II issued $24.0 million of 10.25% Cumulative Capital Securities ("Trust-II Preferred Securities") to investors. Sterling's obligations under Junior Subordinated Debentures-II and related documents, taken together, constitute a full and unconditional guarantee by Sterling of Trust-II's obligations under the Trust-II Preferred Securities. The Trust-II Preferred Securities are treated as debt of Sterling. Although Sterling, as a savings and loan holding company, is not subject to the Federal Reserve capital requirements for bank holding companies, the Trust-II Preferred Securities have been structured to qualify as Tier 1 capital, subject to certain limitations, if Sterling were to become regulated as a bank holding company. The Junior Subordinated Debentures-II and related Trust-II Preferred Securities mature in 2031 and are redeemable at the option of Sterling under certain conditions. The Trust-II Preferred Securities must be redeemed upon maturity of the Junior Subordinated Debentures-II in 2031.
(5): Sterling has outstanding $30.0 million of Floating Rate Notes Due 2006. These notes are unsecured general obligations of Sterling and are subordinated to certain other existing and future indebtedness. Under terms of the notes, Sterling is limited in