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SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
-----------------
FORM 10-K
[X] Annual Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the fiscal year ended December 31, 2001
[_] Transition Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934.
Commission File No. 0-29480
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HERITAGE FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
Washington 91-1857900
(State or other jurisdiction (IRS Employer
of incorporation or organization) Identification No.)
201 Fifth Avenue SW, Olympia, Washington 98501
(Address of principal executive offices, including zip code)
Registrant's telephone number, including area code: (360) 943-1500
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, no par value per share
(Title of class)
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Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [_]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [_]
The aggregate market value of the voting stock held by non-affiliates of the
registrant is $75,047,465 and is based upon the last sales price as quoted on
the NASDAQ Stock Market for March 8, 2002.
The Registrant had 7,474,700 shares of common stock outstanding as of March
8, 2002.
DOCUMENTS TO BE INCORPORATED BY REFERENCE
Portions of the Registrant's definitive Proxy Statement dated March 22, 2002
for the 2002 Annual Meeting of Stockholders will be incorporated by reference
into Part III of this Form 10-K.
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HERITAGE FINANCIAL CORPORATION
FORM 10-K
December 31, 2001
TABLE OF CONTENTS
Page
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PART I
ITEM 1. BUSINESS........................................................ 3
LENDING ACTIVITIES.............................................. 4
INVESTMENT ACTIVITIES........................................... 12
DEPOSIT ACTIVITIES AND OTHER SOURCES OF FUNDS................... 14
SUPERVISION AND REGULATION...................................... 17
COMPETITION..................................................... 21
ITEM 2. PROPERTIES...................................................... 22
ITEM 3. LEGAL PROCEEDINGS............................................... 22
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS............. 22
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS........................................... 23
ITEM 6. SELECTED FINANCIAL DATA......................................... 25
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS......................................... 26
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK...... 35
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA..................... 36
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURES..................................... 36
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.............. 37
ITEM 11. EXECUTIVE COMPENSATION.......................................... 37
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT.................................................... 37
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.................. 37
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 10-K 38
2
PART I
ITEM 1. BUSINESS
General
Heritage Financial Corporation is a bank holding company incorporated in the
State of Washington in August 1997. We were organized for the purpose of
acquiring all of the capital stock of Heritage Savings Bank upon our
reorganization from a mutual holding company form of organization to a stock
holding company form of organization ("Conversion").
We are primarily engaged in the business of planning, directing and
coordinating the business activities of our wholly owned subsidiaries: Heritage
Savings Bank ("Heritage Bank") and Central Valley Bank, N.A. Heritage Bank is a
Washington state-chartered savings bank whose deposits are insured by the
Federal Deposit Insurance Corporation ("FDIC") under the Savings Association
Insurance Fund ("SAIF"). Heritage Bank conducts business from its main office
in Olympia, Washington and its eleven branch offices located in Thurston,
Pierce, and Mason Counties. Central Valley Bank is a national bank whose
deposits are insured by the FDIC under the Bank Insurance Fund ("BIF"). Central
Valley Bank conducts business from its main office in Toppenish, Washington,
and its five branch offices located in Yakima and Kittitas Counties.
Our business consists primarily of lending and deposit relationships with
small businesses including agribusiness and their owners in our market area,
attracting deposits from the general public and originating for sale or
investment purposes first mortgage loans on residential properties located in
western and central Washington State. We also make residential construction,
income property, and consumer loans.
On March 5, 1999, we merged with Washington Independent Bancshares, Inc.
whose wholly owned subsidiary was Central Valley Bank. In that merger we
exchanged 1,058,009 shares of our common stock for all of the outstanding
shares of Washington Independent Bancshares' common stock. This merger was
accounted for as a pooling of interests, and accordingly, our financial
information has been restated to include the accounts and results of operations
of Washington Independent Bancshares, Inc. for all periods presented. Effective
June 12, 1998, we acquired North Pacific Bancorporation, whose wholly owned
subsidiary was North Pacific Bank, in a transaction accounted for as a
purchase. North Pacific Bank was a Washington state-chartered commercial bank,
which was merged into Heritage Bank effective November 20, 1998.
Effective with the year ending December 31, 1998, we changed our fiscal year
end from June 30th to December 31st. On December 31, 1998, we filed a
Transition Report Form 10-K with the SEC reporting for the six month period
ended December 31, 1998. This filing of Form 10-K for the fiscal year ended
December 31, 2001 will be the third full twelve month period filed with a
calendar year end. Throughout this report, every effort has been made to
clarify the accounting period being referenced (i.e. six months ending December
31, 1998 or year ending June 30, 1998) and when appropriate year to year
comparisons are made that reflect equivalent twelve month periods (i.e. twelve
months ending December 31, 1998 to twelve months ending December 31, 1999).
Market Areas
We offer financial services to meet the needs of the communities we serve
through community-oriented financial institutions. Headquartered in Olympia,
Thurston County, Washington, we conduct business through Heritage Bank and
Central Valley Bank. Heritage Bank has twelve full service offices, with six in
Pierce County, five in Thurston County, and one in Mason County. Heritage Bank
has two mortgage origination offices, with one in Thurston County and one in
Pierce County, both of which operate within banking offices. Central Valley
Bank operates six full service offices, with five in Yakima County and one in
Kittitas County.
3
Olympia enjoys a stable economic climate, largely due to federal and state
government employees and retired and active duty military personnel (Fort Lewis
and McChord Air Force Base are both located in our primary market area). State
government is by far the largest employer in Thurston County, employing over
26% of the total county work force. Federal, county, and municipal government
together comprise nearly 40% of the county's civilian employment base.
Thurston County has a population of 207,355 and grew at a rate of over 28%
during the 1990's according to the U.S. Census Bureau 2000 Census. Thurston
County's growth has been spurred by increased government employment and the
expansion of a large retirement population, including many former military
personnel.
Pierce County, where the City of Tacoma is located, has a population of
700,820 according to the U.S. Census Bureau 2000 Census. Its economy is
well-diversified, with the principal industries being aerospace, shipping,
military-related government employment, agriculture, and forest products.
Mason County, which includes the City of Shelton, has a population of 49,405
according to the U.S. Census Bureau 2000 Census. The largest employer in the
county is government, but its economy is substantially dependent upon the
timber and forest products industries.
Yakima County is located in central Washington. It has a population of
222,581, according to the U.S. Census Bureau 2000 Census, and its economy is
substantially dependent upon agriculture. Yakima County is a leading producer
of tree fruits, hops, and other agricultural products.
Kittitas County also located in central Washington and its county seat is
the City of Ellensburg. The population of Kittitas County was 33,362 according
to the U.S. Census Bureau 2000 Census. The county's largest employer is
government, and its economy is largely dependent upon agriculture.
Lending Activities
General. Our lending activities are carried on through Heritage Bank and
Central Valley Bank. We offer commercial, real estate, income property,
agricultural, and consumer loans. We have focused on commercial lending in
recent years, which reflects our efforts to broaden our products and services
to those more closely related to commercial banking. These efforts contributed
to an increase in commercial loans to $263.1 million, or 52.8% of total loans,
as of December 31, 2001 from $234.2 million, or 48.6% of total loans, as of
December 31, 2000. We continue to provide real estate mortgages, both single
and multifamily residential and commercial. Real estate mortgages decreased to
$198.6 million, or 39.8% of total loans at December 31, 2001, from
$217.1 million, or 45.0% of total loans at December 31, 2000. As we pursue our
strategy to focus on commercial lending, management continues to emphasize
strong asset quality.
Our overall lending operations are guided by loan policies, which are
reviewed and approved annually by our board of directors. These policies
outline the basic policies and procedures by which lending operations are
conducted. The policies address the types of loans, underwriting and collateral
requirements, terms, interest rate and yield considerations, compliance with
laws and regulations, and compliance with internal lending limits. We
supplement our own supervision of the loan underwriting and approval process
with periodic loan audits by experienced external loan specialists who review
credit quality, loan documentation, and compliance with laws and regulations.
4
The following table provides information about our loan portfolio by type of
loan for the dates indicated. These balances are net of deferred loan fees and
prior to deduction for the allowance for loan losses.
At June 30, At December 31,
---------------------------------- -----------------------------------------------------
1997 1998 1998 1999 2000
---------------- ---------------- ---------------- ---------------- ----------------
% of % of % of % of % of
Balance Total Balance Total Balance Total Balance Total Balance Total
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
(Dollars in thousands)
Commercial.......................... $ 53,994 22.22% $117,655 37.46% $128,171 39.20% $192,088 45.98% $234,166 48.55%
Real Estate Mortgages...............
One-four family residential(1)..... 107,010 44.02 100,753 32.07 97,277 29.76 97,907 23.44 107,501 22.28
Five or more family residential and
commercial properties............. 66,260 27.26 72,406 23.05 70,139 21.45 94,242 22.56 109,560 22.71
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Total real estate mortgages..... 173,270 71.28 173,159 55.12 167,416 51.21 192,149 46.00 217,061 44.99
Real estate construction............
One-four family residential........ 13,142 5.41 19,505 6.21 26,640 8.15 23,293 5.58 27,412 5.68
Five or more family residential and
commercial properties............. 1,029 0.42 527 0.17 2,123 0.65 7,537 1.80 -- --
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Total real estate
construction(2)................ 14,171 5.83 20,032 0.38 28,763 8.80 30,830 7.38 27,412 5.68
Consumer............................ 2,692 1.11 4,477 1.43 4,001 1.22 4,273 1.02 5,466 1.13
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Total loans......................... 244,127 100.44% 315,323 100.39% 328,351 100.43% 419,340 100.38% 484,105 100.35%
Less deferred loan fees and other... (1,079) (0.44) (1,228) (0.39) (1,400) (0.43) (1,578) (0.38) (1,670) (0.35)
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Net loans........................... $243,048 100.00% $314,095 100.00% $326,951 100.00% $417,762 100.00% $482,435 100.00%
======== ====== ======== ====== ======== ====== ======== ====== ======== ======
2001
----------------
% of
Balance Total
-------- ------
Commercial.......................... $263,063 52.75%
Real Estate Mortgages...............
One-four family residential(1)..... 91,189 18.28
Five or more family residential and
commercial properties............. 107,450 21.55
-------- ------
Total real estate mortgages..... 198,639 39.83
Real estate construction............
One-four family residential........ 32,494 6.51
Five or more family residential and
commercial properties............. 83 0.02
-------- ------
Total real estate
construction(2)................ 32,577 6.53
Consumer............................ 5,794 1.16
-------- ------
Total loans......................... 500,073 100.27%
Less deferred loan fees and other... (1,368) (0.27)
-------- ------
Net loans........................... $498,705 100.00%
======== ======
- --------
(1) Includes loans held for sale of $6,323, $6,411, $7,618, $589, $1,931 and
$6,275 respectively.
(2) Balances are net of undisbursed loan proceeds.
The following table presents at December 31, 2001 (i) the aggregate
maturities of loans in the named categories of our loan portfolio and (ii) the
aggregate amounts of fixed rate and variable or adjustable rate loans in the
named categories that mature after one year.
Maturing
------------------------------------
Within After
1 year 1-5 years 5 years Total
-------- --------- -------- --------
(Dollars in thousands)
Commercial....................... $ 93,443 $50,673 $118,947 $263,063
Real estate construction......... 28,237 4,340 -- 32,577
-------- ------- -------- --------
Total......................... $121,680 $55,013 $118,947 $295,640
======== ======= ======== ========
Fixed rate loans................. $45,409 $ 39,739 $ 85,148
Variable or adjustable rate loans 9,604 79,208 88,812
------- -------- --------
Total......................... $55,013 $118,947 $173,960
======= ======== ========
Real Estate Lending
One- to Four-Family Residential Real Estate Lending. The majority of our
residential loans are secured by one- to four-family residences located in our
primary market area. Our underwriting standards require that one- to
four-family portfolio loans generally are owner-occupied and do not exceed 80%
(90% with private mortgage insurance) of the current appraised value or cost,
whichever is lower, of the underlying collateral. Terms typically range from 15
to 30 years. We offer both fixed rate mortgages and adjustable rate mortgages
("ARMs") with repricing based on a Treasury Bill or other index. However, our
ability to generate volume in ARMs is largely a function of consumer preference
and the interest rate environment. Our current policy is not to make ARMs with
discounted initial interest rates (i.e., "teasers"). We generally sell all
government guaranteed mortgages, both fixed rate and adjustable rate.
Management determines to what extent we will retain or sell other ARMs and
other fixed rate mortgages in their strategy to control our interest rate
sensitivity position. See
5
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Asset/Liability Management".
Multifamily and Commercial Real Estate Lending. We have made, and
anticipate continuing to make, on a selective basis, multifamily and commercial
real estate loans in our primary market areas. Commercial real estate loans are
made for small shopping centers, warehouses, and professional offices. Cash
flow coverage to debt servicing requirements is generally 1.2 times or more.
Our underwriting standards generally require that the loan-to-value ratio for
multifamily and commercial real estate loans not exceed 80% of appraised value
or cost, whichever is lower.
Multifamily and commercial real estate mortgage lending affords our banks an
opportunity to receive interest at rates higher than those generally available
from one-to four-family residential lending. However, loans secured by such
properties usually are greater in amount, more difficult to evaluate and
monitor and, therefore, involve a greater degree of risk than one- to
four-family residential mortgage loans. Because payments on loans secured by
multifamily and commercial real estate properties are often dependent on the
successful operation and management of the properties, repayment of these loans
may be affected by adverse conditions in the real estate market or the economy.
We seek to minimize these risks by strictly scrutinizing the financial
condition of the borrower, the quality of the collateral, and the management of
the property securing the loan. We also generally obtain personal guarantees
from financially capable borrowers based on a review of personal financial
statements.
Construction Loans. We originate one- to four-family residential
construction loans for the construction of custom homes (where the home buyer
is the borrower) and provide financing to builders for the construction of
pre-sold homes and speculative residential construction (i.e. built before a
buyer is identified). We lend to builders who have demonstrated a favorable
record of performance and profitable operations and who are building in markets
that management understands and is comfortable with existing economic
conditions. We further endeavor to limit our construction lending risk through
adherence to strict underwriting procedures. Loans to one builder are generally
limited on a case-by-case basis with unsold home limits based on builder
strengths. Our underwriting standards require that the loan-to-value ratio for
pre-sold homes and speculative residential construction generally not exceed
80% of appraised value or builder's cost less overhead, whichever is less.
Speculative construction and land development loans are generally short term in
nature and priced with a variable rate of interest using the prime rate as the
index. We generally require builders to have some tangible form of equity in
each construction project. Also, we generally require prompt and thorough
documentation of all draw requests and use outside inspectors to inspect the
project prior to paying any draw requests from builders.
Construction lending affords us the opportunity to achieve higher interest
rates and fees with shorter terms to maturity than does our single-family
permanent mortgage lending. However, construction lending is generally
considered to involve a higher degree of risk than single-family permanent
mortgage lending because of the inherent difficulty in estimating both a
property's value at completion of the project and the estimated costs of the
project. As a result, these loans are generally more difficult to evaluate and
monitor. If the estimate of construction cost proves to be inaccurate, we may
be required to advance funds beyond the amount originally committed to permit
completion of the project. If the estimate of value upon completion proves to
be inaccurate, we may be confronted with a project whose value is insufficient
to ensure full repayment. Projects may also be jeopardized by disagreements
between borrowers and builders, and the failure of builders to pay
subcontractors. Loans to builders to construct homes for which no purchaser has
been identified carry more risk because the liquidation of the loan depends on
the builder's ability to sell the property.
Commercial Business Lending
We offer commercial loans to sole proprietorships, partnerships, and
corporations with an emphasis on real estate related industries and businesses
in agricultural, health care, legal, and other professions. The types of
commercial loans offered are business lines of credit secured primarily by real
estate, accounts receivable and
6
inventory, business term loans secured by real estate for either working
capital or lot acquisition, Small Business Administration ("SBA") loans, and
unsecured business loans.
Commercial business lending generally involves greater risk than residential
mortgage lending and risks different from those associated with residential and
commercial real estate lending. Commercial real estate lending is generally
considered to be collateral based lending with loan amounts based on
predetermined loan to collateral values, where liquidation of the underlying
real estate collateral is viewed as the primary source of repayment if the
borrower defaults. Although our commercial business loans are often
collateralized by real estate, the decision to grant a commercial business loan
depends primarily on the creditworthiness and cash flow of the borrower (and
any guarantors), while liquidation of collateral is a secondary source of
repayment.
As of December 31, 2001, we had $263.1 million, or 52.75% of our total loans
receivable, in commercial loans. The average loan size is approximately
$225,000 with loans generally in amounts of $500,000 or less.
Origination and Sales of Loans
We originate real estate and other loans with approximately two-thirds of
the residential mortgage volumes generated from our mortgage loan origination
office. Walk-in customers and referrals from real estate brokers are important
sources of loan originations.
Consistent with our asset/liability management strategy, we sell a majority
of our fixed rate and ARM residential mortgage loans to the secondary market.
At Heritage Bank, commitments to sell mortgage loans generally are made during
the period between the taking of the loan application and the closing of the
mortgage loan. The timing of making these sale commitments is dependent upon
the timing of the borrower's election to lock-in the mortgage interest rate and
fees prior to loan closing. Most of these sale commitments are made on a "best
efforts" basis whereby Heritage Bank is only obligated to sell the mortgage if
the mortgage loan is approved and closed by Heritage Bank. As a result,
management believes that market risk is minimal. At Central Valley Bank, all
mortgage loan production is brokered to other lenders prior to funding.
When we sell mortgage loans, we typically sell the servicing of the loans
(i.e., collection of principal and interest payments). However, we serviced
$9.5 million, $7.9 million, and $6.3 million in mortgage loans for others as of
December 31, 1999, 2000, and 2001, respectively. We received fee income for
servicing activities on mortgage loans of $34,000, $27,000 and $22,000 for the
years ended December 31, 1999, 2000, and 2001, respectively.
The following table presents summary information concerning our origination
and sale of residential mortgage loans and the gains achieved on such
activities.
Six months
ended
Years ended June 30, December 31, Years ended December 31,
-------------------- ------------ ------------------------
1997 1998 1998 1999 2000 2001
-------- -------- ------------ ------- ------- --------
(Dollars in thousands)
One- to four-family residential mortgage
loans:
Originated........................... $104,145 $118,774 $68,434 $78,248 $55,630 $103,634
Sold................................. 87,003 101,903 57,490 58,266 35,876 97,807
Gains on sales of loans, net............ $ 2,006 $ 2,406 $ 1,297 $ 1,079 $ 684 $ 1,669
We have a minimal amount of purchased mortgage loans and mortgage loan
participations.
7
Commitments and Contingent Liabilities
In the ordinary course of business, we enter into various types of
transactions that include commitments to extend credit that are not included in
our consolidated financial statements. We apply the same credit standards to
these commitments as we use in all our lending activities and have included
these commitments in our lending risk evaluations. Our exposure to credit loss
under commitments to extend credit is represented by the amount of these
commitments. At December 31, 2001, we had outstanding commitments to extend
credit, including letters of credit, in the amount of $87.4 million.
Delinquencies and Nonperforming Assets
Delinquency Procedures. We send a borrower a delinquency notice 15 days
after the due date when the borrower fails to make a required payment on a
loan, except for commercial loans. If the delinquency is not brought current by
the 30th day, we mail a second notice and, if appropriate, call the borrower.
Additional written and oral contacts are made with the borrower between 60 and
90 days after the due date.
If a real estate loan payment is past due for 45 days or more, loan
servicing personnel perform an in-depth review of the loan status, the
condition of the property, and the borrower's financial circumstances. Based
upon the results of our review, we may negotiate and accept a repayment program
with the borrower, accept a voluntary deed in lieu of foreclosure or, when
considered necessary, begin foreclosure proceedings. If foreclosed on, real
property is sold at a public sale and we may bid on the property to protect our
interest. A decision as to whether and when to begin foreclosure proceedings is
based on such factors as the amount of the outstanding loan in relation to the
value of the property securing the original indebtedness, the extent of the
delinquency, and the borrower's ability and willingness to cooperate in
resolving the delinquency.
Real estate acquired by us is classified as real estate owned until it is
sold. When property is acquired, it is recorded at the lower of cost or
estimated fair value at the date of acquisition, not to exceed net realizable
value, and any resulting write-down is charged to the allowance for loan
losses. Upon acquisition, all costs incurred in maintaining the property are
expensed. Costs relating to the development and improvement of the property,
however, are capitalized to the extent of the property's net realizable value.
We consider loans as an in-substance foreclosure if the borrower has little
or no equity in the property based upon its estimated fair value, repayment can
be expected only from operation or sale of the collateral, the borrower has
effectively abandoned control of the collateral, or it is doubtful the borrower
will be able to repay the loan in the foreseeable future because of the
borrower's current financial status. In substance foreclosures are accounted
for as if the properties were held as other real estate.
Delinquencies in the commercial business loan portfolio are handled on a
case-by-case basis. Generally, notices are sent and personal contact is made
with the borrower when the loan is 15 days past due. Loan officers are
responsible for collecting loans they originate or which are assigned to them.
Depending on the nature of the loan and the type of collateral securing the
loan, we may negotiate and accept a modified payment program or take other
actions as circumstances warrant.
Classification of Assets. Federal regulations require that our banks
periodically evaluate the risk inherent in their loan portfolio. In addition,
Division of Banks of the Washington State Department of Financial Institutions
("Division"), the Office of the Comptroller of the Currency ("OCC"), and the
FDIC have authority to identify problem assets and, if appropriate, require
them to be classified by risk. There are three classifications for problem
assets: Substandard, Doubtful, and Loss. Substandard assets have one or more
defined weaknesses and are characterized by the distinct possibility that the
institution will sustain some loss if the deficiencies are not corrected.
Doubtful assets have the weaknesses of Substandard assets, with the additional
characteristics that the weaknesses make collection or liquidation in full on
the basis of currently existing facts, conditions, and values questionable.
There is a high possibility of loss in assets classified as Doubtful. An asset
classified as Loss
8
is considered uncollectible and of such little value that continuance as an
asset of the institution is not warranted. If an asset or a portion of the
asset is classified as Loss, the institution must charge off this amount. The
FDIC examined Heritage Bank in March 2001 and the Division examined Heritage
Bank in March 2000. The OCC examined Central Valley Bank in May 2001. The
regulators' assessments of our banks' classified assets were consistent with
our banks' internal classifications.
Nonperforming Assets. Nonperforming assets consist of nonaccrual loans,
restructured loans, and real estate owned. The following table provides
information about our nonaccrual loans, restructured loans, and real estate
owned for the indicated dates.
At June 30, At December 31,
------------------ ----------------------------------
1997 1998 1998 1999 2000 2001
-------- -------- ------- ------- ------- -------
(Dollars in thousands)
Nonaccrual loans.................... $ 146 $ 385 $ 401 $ 1,804 $ 1,607 $ 1,962
Restructured loans.................. -- -- -- -- -- --
-------- -------- ------- ------- ------- -------
Total nonperforming loans........ 146 385 401 1,804 1,607 1,962
Real estate owned................... -- 82 -- -- -- 1,053
-------- -------- ------- ------- ------- -------
Total nonperforming assets....... $ 146 $ 467 $ 401 $ 1,804 $ 1,607 $ 3,015
-------- -------- ------- ------- ------- -------
Accruing loans past due 90 days or
more.............................. $ -- $ 15 $ 8 $ -- $ 1,086 $ 306
Potential problem loans............. 239 1,758 877 2,826 2,422 4,631
Allowance for loan losses........... 3,105 3,929 3,957 4,264 5,063 5,751
Nonperforming loans to loans........ 0.06% 0.06% 0.12% 0.43% 0.33% 0.39%
Allowance for loan losses to loans.. 1.28% 1.25% 1.21% 1.02% 1.05% 1.15%
Allowance for loan losses to
nonperforming loans............... 2133.01% 1019.90% 984.70% 236.27% 315.02% 293.12%
Nonperforming assets to total assets 0.05% 0.10% 0.08% 0.35% 0.28% 0.49%
Nonaccrual Loans. Our financial statements are prepared on the accrual
basis of accounting, including the recognition of interest income on our loan
portfolio, unless a loan is placed on nonaccrual. Loans are considered to be
impaired and are placed on nonaccrual when there are serious doubts about the
collectibility of principal or interest. Our policy is to place a loan on
nonaccrual when the loan becomes past due for 90 days or more, is less than
fully collateralized, and is not in the process of collection. Amounts received
on nonaccrual loans generally are applied first to principal and then to
interest only after all principal has been collected.
Interest foregone on nonaccrual loans was $59,613, $129,612, and $173,371
for the years ended December 31, 1999, 2000, and 2001, respectively. Previous
period interest foregone was immaterial.
Real estate owned at December 31, 2001 was $1,269,000 with $1,053,000 of
this reported as a nonperforming asset. The difference is guaranteed by the
Small Business Administration.
Potential Problem Loans. Potential problem loans are those loans which are
currently accruing interest, but which are considered possible credit problems
because financial information of the borrowers causes us to seriously doubt
their ability to comply with the present repayment program and may result in
placing the loan on nonaccrual. The increase of $2.2 million in potential
problem loans from December 31, 2000 to December 31, 2001 is primarily due to
one loan on a strip mall. The loan is adequately collateralized and is, at this
time, performing at an acceptable level. However, we believed that adverse
borrower trends warranted reporting this loan as a potential problem loan.
9
Analysis of Allowance for Loan Losses
Management maintains an allowance for loan losses to absorb losses inherent
in the loan portfolio. We determine the allowance through our ongoing quarterly
assessments of estimated potential losses inherent in the loan portfolio.
We assess the estimated losses inherent in our non-classified loan portfolio
by considering a number of elements including:
. Levels and trends in delinquencies and nonaccruals;
. Trends in loan demand and structure including terms and interest rates;
. National and local economic trends;
. Specific industry conditions such as commercial and residential
construction;
. Concentrations of credits in specific industries;
. Bank regulatory examination results and our own credit examinations; and
. Recent loss experience in the portfolio.
After evaluating these elements and trends, we calculate a risk factor in
percentage points that is applied to the non-classified loan portfolio to
establish what we believe is an appropriate allowance for the non-classified
portion of our loan portfolio. For the classified portion of our loan
portfolio, we add specific dollar provisions to the total for identified
problem loans and assets to determine an adequate allowance.
We forecast expected loan growth by type for the subsequent three months and
apply the same risk factor we established for the non-classified portion of our
portfolio to the expected loan growth to determine additional necessary
provisions to the allowance for the subsequent period. From this, we establish
our monthly provision for the next three months.
Historically, we have not experienced significant losses in any segment of
our loan portfolio. We believe that it is necessary to maintain a higher level
of reserves against future potential losses for our commercial loan portfolio
than our historical loss experience would indicate, because our commercial loan
portfolio, which, based upon industry standards, inherently tends to have a
higher loss experience and has been growing faster than other segments of our
loan portfolio.
Over the past several years, we have increased our allowance for loan losses
during a period of loan growth and change in loan portfolio composition, as
well as recent weakening economic trends. While our loan portfolio, and in
particular commercial loans, has grown substantially over the past five years,
our asset quality has remained satisfactory. Although our nonperforming assets
to total assets ratio is higher than past periods, we believe it is manageable
especially considering the weakening economy. In the year ended December 31,
2001, we experienced net charge offs of $505,000. Because commercial business
lending generally involves greater risk than those associated with residential
and commercial real estate lending, we have increased the portion of our
allowance for loan losses allocated to our commercial loans over the past five
years.
While we believe that we use the best information available to determine the
allowance for loan losses, net income could be significantly affected if
circumstances differ substantially from the assumptions used in determining the
allowance or unforeseen market conditions result in adjustments to the
allowance for loan losses.
10
The following table provides information regarding changes in our allowance
for loan losses for the indicated periods:
Six Months
Ended
Years Ended June 30, December 31, Years Ended December 31,
------------------- ------------ ----------------------------
1997 1998 1998 1999 2000 2001
-------- -------- ------------ -------- -------- --------
(Dollars in thousands)
Total loans outstanding at end of
period(1).......................... $243,048 $314,095 $326,952 $417,762 $482,435 $498,705
-------- -------- -------- -------- -------- --------
Average loans outstanding during
period............................. $213,560 $251,816 $319,645 $361,116 $445,813 $494,379
-------- -------- -------- -------- -------- --------
Allowance balance at beginning of
period............................. $ 2,221 $ 3,105 $ 3,929 $ 3,957 $ 4,264 $ 5,063
Provision for loan losses............ (265) 149 202 408 787 1,193
Allowance acquired with North Pacific
Bank............................... -- 670 -- -- -- --
Charge-offs:
Real estate(2).................... -- -- (36) (120) (4) (407)
Commercial........................ (2) -- (146) (117) (34) (88)
Consumer.......................... (7) (3) (5) (10) (2) (12)
-------- -------- -------- -------- -------- --------
Total charge-offs............. (9) (3) (187) (247) (40) (507)
-------- -------- -------- -------- -------- --------
Recoveries:
Real estate(2).................... 1,155 4 4 113 22 1
Commercial........................ 3 1 9 32 29 --
Consumer.......................... -- 3 -- 1 1 1
-------- -------- -------- -------- -------- --------
Total recoveries.............. 1,158 8 13 146 52 2
-------- -------- -------- -------- -------- --------
Net (charge-offs)
recoveries............... 1,149 5 (174) (101) 12 (505)
-------- -------- -------- -------- -------- --------
Allowance balance at end of period... $ 3,105 $ 3,929 $ 3,957 $ 4,264 $ 5,063 $ 5,751
======== ======== ======== ======== ======== ========
Ratio of net (charge-offs) recoveries
during period to average loans
outstanding........................ 0.54% 0.00% 0.05% -0.03% 0.00% -0.10%
======== ======== ======== ======== ======== ========
- --------
(1) Includes loans held for sale
(2) During the periods shown, the charge-offs and recoveries shown under the
Real Estate category relate to real estate mortgages, with the exception of
the activity during 2001. Only during 2001 did a portion of the activity
relate to real estate construction loans.
11
The following table shows the allocation of the allowance for loan losses
for the indicated periods. The allocation is based upon an evaluation of
defined loan problems, historical loan loss ratios, and industry wide and other
factors that may affect future loan losses in the categories shown below:
At June 30, At December 31,
------------------------------ --------------------------------------------------------------
1997 1998 1998 1999 2000 2001
-------------- -------------- -------------- -------------- -------------- --------------
% of % of % of % of % of % of
Total Total Total Total Total Total
Amount Loans(1) Amount Loans(1) Amount Loans(1) Amount Loans(1) Amount Loans(1) Amount Loans(1)
------ -------- ------ -------- ------ -------- ------ -------- ------ -------- ------ --------
(Dollars in thousands)
Commercial............... $1,242 22.1% $2,217 37.4% $2,670 39.2% $3,070 45.8% $3,644 48.4% $4,141 52.7%
Real Estate Mortgage
One-four family
residential............ 164 43.9% 156 32.0% 156 29.6% 168 23.3% 200 22.2% 227 18.1%
Five or more family
residential and
commercial properties.. 900 27.2% 678 22.9% 669 21.3% 721 22.5% 856 22.6% 972 21.5%
Real estate construction:
One-four family
residential............ 202 5.3% 214 6.1% 135 8.1% 145 5.6% 274 5.7% 310 6.5%
Five or more family
residential and
commercial properties.. 31 0.4% 10 0.2% 16 0.6% 17 1.8% 20 -- 23 --
Consumer................. 20 1.1% 53 1.4% 54 1.2% 58 1.0% 69 1.1% 78 1.2%
Unallocated.............. 546 601 257 85 -- --
------ ----- ------ ----- ------ ----- ------ ----- ------ ----- ------ -----
Net loans............. $3,105 100.0% $3,929 100.0% $3,957 100.0% $4,264 100.0% $5,063 100.0% $5,751 100.0%
====== ===== ====== ===== ====== ===== ====== ===== ====== ===== ====== =====
- --------
(1) Represents the total of all outstanding loans in each category as a percent
of total loans outstanding.
Investment Activities
At December 31, 2001, our investment securities portfolio totaled $30.2
million, which consisted of $26.5 million of securities available for sale and
$3.7 million of securities held to maturity. This compares with a total
portfolio of $38.8 million at December 31, 2000, which was comprised of $33.7
million of securities available for sale and $5.1 million of securities held to
maturity. The composition of the two investment portfolios by type of security,
at each respective date, is presented in the financial statement footnotes.
Our investment policy is established by the board of directors and monitored
by the Audit and Finance Committee. It is designed primarily to provide and
maintain liquidity, generate a favorable return on investments without
incurring undue interest rate and credit risk, and complement our bank's
lending activities. The policy dictates the criteria for classifying securities
as either available for sale or held for investment. The policy permits
investment in various types of liquid assets permissible under applicable
regulations, which include U.S. Treasury obligations, U.S. Government agency
obligations, some certificates of deposit of insured banks, mortgage backed and
mortgage related securities, some corporate notes, municipal bonds, FHLB stock,
and federal funds. Investment in non-investment grade bonds, structured notes,
and stripped mortgage backed securities are not permitted under the policy.
12
The following table provides information regarding the carrying value,
weighted average yields, and maturities or periods to repricing of our
investment securities available for sale.
At December 31, 2001
-----------------------
Weighted
Book Fair Average
Value Value Yield
------- ------- --------
(Dollars in thousands)
Obligations of US Government agencies:
Due within one year................... $ 750 $ 768 5.96%
Due after 1 year but within 5 years... 18,567 18,529 5.82
------- -------
19,317 19,297
------- -------
Mortgage backed securities
Due after 5 years but within 10 years. 524 643 5.03
Due after 10 years.................... 4,417 4,408 6.71
------- -------
4,941 5,051
------- -------
Collateralized mortgage obligations
Due after 5 years but within 10 years. 123 125 6.11
Due after 10 years.................... 2,036 2,006 4.71
------- -------
2,159 2,131
------- -------
Total all investments available for sale. $26,417 $26,479
======= =======
The following table provides information regarding the carrying value,
weighted average yields, and maturities or periods to repricing of our
investment securities held to maturity.
At December 31, 2001
----------------------
Weighted
Book Fair Average
Value Value Yield (1)
------ ------ ---------
(Dollars in thousands)
Municipal bonds
Due within one year............................ $ 425 $ 432 6.75%
Due after 1 year but within 5 years............ 1,379 1,426 6.35
Due after 5 years but within 10 years.......... 341 347 6.26
------ ------
2,145 2,205
------ ------
Mortgage backed securities
Due within one year............................ 32 33 6.58
Due after 1 year but within 5 years............ 9 9 7.23
Due after 5 years but within 10 years.......... 227 242 8.73
Due after 10 years............................. 1,290 1,395 8.26
------ ------
1,558 1,679
------ ------
Total all investments held to maturity..... $3,703 $3,884
====== ======
- --------
(1) Taxable equivalent weighted average yield.
We held $2.8 million of FHLB stock at December 31, 2001. The stock has no
contractual maturity and amounts in excess of the required minimum for FHLB
membership may be redeemed at par. At December 31, 2001, we were required to
maintain an investment in the stock of the FHLB of Seattle of at least $1.8
million.
13
Deposit Activities and Other Sources of Funds
General. Our primary sources of funds are deposits and loan repayments.
Scheduled loan repayments are a relatively stable source of funds, while
deposits and unscheduled loan prepayments, which are influenced significantly
by general interest rate levels, interest rates available on other investments,
competition, economic conditions, and other factors are not. Our deposit
balances increased by $54.8 million in 2001. Customer deposits remain an
important source, but these balances have been influenced in the past by
adverse market changes in the industry and may be affected by similar future
developments. Borrowings may be used on a short-term basis to compensate for
reductions in other sources of funds (such as deposit inflows at less than
projected levels). Borrowings may also be used on a longer-term basis to
support expanded lending activities and match the maturity of repricing
intervals of assets.
Deposit Activities. We offer a variety of deposit accounts designed to
attract both short-term and long-term deposits. These accounts include
certificates of deposit ("CDs"), regular savings accounts, money market
accounts, checking and negotiable order of withdrawal ("NOW") accounts, and
individual retirement accounts ("IRAs"). These accounts generally earn interest
at rates established by management based on competitive market factors and
management's desire to increase or decrease certain types or maturities of
deposits. At December 31, 2001, we had no brokered deposits. The more
significant deposit accounts offered by us are described below.
Certificates of Deposit. We offer several types of CDs with maturities
ranging from one to five years and which require a minimum deposit of $100. In
addition, we offer a CD that has a maturity of three to eleven months and a
minimum deposit of $2,500, and permits additional deposits at the initial rate
throughout the CD term. Interest is compounded daily and credited quarterly or
at maturity. Finally, negotiable CDs are offered in amounts of $100,000 or more
for terms of 30 days to 12 months. The negotiable CDs pay simple interest
credited at maturity.
Regular Savings Accounts. We offer savings accounts that allow for
unlimited deposits and withdrawals, provided that a $100 minimum balance is
maintained. Interest is compounded daily and credited quarterly.
Money Market Accounts. Money market accounts pay a variable interest rate
that is tiered depending on the balance maintained in the account. Minimum
opening balances vary. Interest is compounded daily and paid monthly.
Checking and NOW Accounts. Checking and NOW accounts are non-interest and
interest bearing, and may be charged service fees based on activity and
balances. NOW accounts pay interest, but require a higher minimum balance to
avoid service charges.
Individual Retirement Accounts. IRAs permit annual contributions regulated
by law and pay interest at fixed rates. Maturities are available from one to
five years, and interest is compounded daily and credited quarterly.
14
Sources of Funds
Deposit Activities. The following table provides the average balances
outstanding and the weighted average interest rates for each major category of
deposits for the years ended December 31,:
1999 2000 2001
--------------- --------------- ---------------
Average Average Average Average Average Average
Balance Rate Balance Rate Balance Rate
(1) Paid (1) Paid (1) Paid
-------- ------- -------- ------- -------- -------
(Dollars in Thousands)
Interest bearing demand and money market
accounts.............................. $ 91,281 2.69% $ 99,089 2.81% $126,302 2.07%
Savings................................. 68,484 3.33 62,594 2.81 61,190 3.50
Certificates of deposit................. 165,490 5.00 226,335 3.56 244,369 5.24
-------- -------- --------
Total interest bearing deposits...... 325,255 4.00 388,018 4.80 431,861 4.06
Demand and other noninterest bearing
deposits.............................. 37,906 -- 44,038 -- 47,455 --
-------- ---- -------- ---- -------- ----
Total deposits....................... $363,161 3.58% $432,056 4.31% $479,316 3.66%
======== ==== ======== ==== ======== ====
- --------
(1) Average balances were calculated using average daily balances.
The following table provides the change in the balances of deposits during
the year and the impact of credited interest on those deposits for the years
ended December 31,:
1999 2000 2001
-------- -------- --------
(Dollars in thousands)
Net increase (decrease) in deposits............. $ 37,964 $ 55,166 $ 54,846
Less: Interest credited...................... (12,631) (18,456) (18,126)
-------- -------- --------
Net increase(decrease) before interest credited. $ 25,333 $ 36,710 $ 36,720
-------- -------- --------
The following table shows the amount and maturity of certificates of
deposits of $100,000 or more as of December 31, 2001:
(Dollars in
thousands)
Remaining maturity:
Three months or less.................................... $25,050
Over three months through six months.................... 54,839
Over six months through 12 months....................... 12,194
Over twelve months...................................... 4,971
-------
Total............................................... $97,054
=======
At December 31, 2000 and December 31, 2001, certificates of deposits with
balances of $100,000 or more totaled $96.1 million and $97.1 million,
respectively.
Borrowings. Savings deposits are the primary source of funds for our
lending and investment activities, and our general business purposes. We rely
upon advances from the FHLB of Seattle to supplement our supply of lendable
funds and meet deposit withdrawal requirements. The FHLB of Seattle has served
as one of our secondary sources of liquidity at both Heritage Bank and Central
Valley Bank. Advances from the FHLB of Seattle are typically secured by our
first mortgage loans, and stock issued by the FHLB of Seattle, which is owned
by us. At Central Valley Bank we also have the ability to purchase federal
funds up to $3.7 million with Key Bank. At the holding company level, we
maintain a line of credit for $5 million with Key Bank to supplement any cash
needs not covered by dividends from the banks or earnings from investments
retained from proceeds of the conversion from mutual to stock ownership.
15
The FHLB functions as a central reserve bank providing credit for member
financial institutions. As members, Heritage Bank and Central Valley Bank are
required to own capital stock in the FHLB and are authorized to apply for
advances on the security of such stock and certain of its mortgage loans and
other assets (principally securities which are obligations of, or guaranteed
by, the United States) provided certain standards related to creditworthiness
have been met. Advances are made pursuant to several different programs. Each
credit program has its own interest rate and range of maturities. Depending on
the program, limitations on the amount of advances are based either on a fixed
percentage of an institution's net worth or on the FHLB's assessment of the
institution's creditworthiness. Under its current credit policies, the FHLB of
Seattle limits advances to 20% of assets for Heritage Bank and 10% of assets
for Central Valley Bank.
The following table is a summary of FHLB advances for the years ended
December 31,:
1999 2000 2001
------ ------- -------
(Dollars in thousands)
Balance at period end...................... $2,800 $23,125 $ 8,000
Average balance during the period.......... 958 10,451 17,924
Maximum amount outstanding at any month end 3,300 23,125 33,300
Average interest rate:
During the period....................... 5.90% 6.58% 5.33%
At period end........................... 5.70% 6.81% 5.01%
The holding company maintains a line of credit with Key Bank for short-term
corporate funding needs. The following table is a summary of usage on the Key
Bank line of credit for the years ended December 31,:
1999 2000 2001
---- ------ -----
(Dollars in thousands)
Balance at period end...................... $-- $ -- $ --
Average balance during the period.......... -- 380 118
Maximum amount outstanding at any month end -- 2,043 168
Average interest rate:
During the period....................... -- 9.86% 7.12%
At period end........................... -- 9.50% 4.75%
The following table is a summary of other borrowed funds for the years ended
December 31,:
1999 2000 2001
----- ------ -----
(Dollars in thousands)
Notes Payable:
Balance at period end....................... $ 8 $ -- $ --
Average balance during the period........... 12 2 --
Maximum amount outstanding at any month end. 16 7 --
Average interest rate:
During the period....................... -- -- --
At period end........................... -- -- --
Fed Funds Purchased:
Balance at period end....................... $ -- $1,000 $ --
Average balance during the period........... 20 501 82
Maximum amount outstanding at any month end. -- 1,300 175
Average interest rate:
During the period....................... 5.41% 6.84% 6.52%
At period end........................... -- 7.13% --
16
Notes Payable at December 31, 1999 include a noninterest bearing note to
Tacoma City Light for energy conservation improvement that was acquired in June
1998 with North Pacific Bank. This note was paid off in September 2000.
Supervision and Regulation
We are subject to extensive federal and Washington state legislation,
regulation, and supervision. These laws and regulations are primarily intended
to protect depositors and the FDIC rather than stockholders. The laws and
regulations affecting banks and bank holding companies have changed
significantly over recent years, and it is reasonable to expect that similar
changes will continue in the future. Any change in applicable laws,
regulations, or regulatory policies may have a material effect on our business,
operations, and prospects. We cannot predict the nature or the extent of the
effects on our business and earnings that any fiscal or monetary policies or
new federal or state legislation may have in the future.
The following information is qualified in its entirety by reference to the
particular statutory and regulatory provisions described.
Heritage Financial. We are subject to regulation as a bank holding company
within the meaning of the Bank Holding Company Act of 1956, as amended, and are
supervised by the Federal Reserve. The Federal Reserve has the authority to
order bank holding companies to cease and desist from unsound practices and
violations of conditions imposed on it. The Federal Reserve is also empowered
to assess civil money penalties against companies and individuals who violate
the Bank Holding Company Act or orders or regulations thereunder in amounts up
to $1.0 million per day. The Federal Reserve may order termination of
non-banking activities by non-banking subsidiaries of bank holding companies,
or divestiture of ownership and control of a non-banking subsidiary by a bank
holding company. Some violations may also result in criminal penalties. The
FDIC and OCC are authorized to exercise comparable authority under the Federal
Deposit Insurance Act, the National Bank Act, and other statutes for state
nonmember banks such as Heritage Bank or national banks such as Central Valley
Bank.
The Federal Reserve takes the position that a bank holding company is
required to serve as a source of financial and managerial strength to its
subsidiary banks and may not conduct its operations in an unsafe or unsound
manner. In addition, the Federal Reserve provides that bank holding companies
should serve as a source of strength to its subsidiary banks by being prepared
to use available resources to provide adequate capital funds to its subsidiary
banks during periods of financial stress or adversity, and should maintain the
financial flexibility and capital raising capacity to obtain additional
resources for assisting its subsidiary banks. A bank holding company's failure
to meet its obligation to serve as a source of strength to its subsidiary banks
will generally be considered by the Federal Reserve to be an unsafe and unsound
banking practice or a violation of the Federal Reserve's regulations or both.
The Federal Deposit Insurance Act requires an undercapitalized institution to
send to the Federal Reserve a capital restoration plan with a guaranty by each
company having control of the bank's compliance with the plan.
We are required to file an annual report and periodic reports with the
Federal Reserve and provide additional information as the Federal Reserve may
require. The Federal Reserve may examine us, and any of our subsidiaries, and
charge us for the cost of the examination.
We, and any subsidiaries which we may control, are considered "affiliates"
within the meaning of the Federal Reserve Act, and transactions between our
bank subsidiaries and affiliates are subject to numerous restrictions. With
some exceptions, we, and our subsidiaries are prohibited from tying the
provision of various services, such as extensions of credit, to other services
offered by us, or our affiliates.
Bank regulations require bank holding companies and banks to maintain a
minimum "leverage" ratio of core capital to adjusted quarterly average total
assets of at least 3%. In addition, banking regulators have adopted risk-
17
based capital guidelines under which risk percentages are assigned to various
categories of assets and off-balance sheet items to calculate a risk-adjusted
capital ratio. Tier I capital generally consists of common stockholders' equity
(which does not include unrealized gains and losses on securities), less
goodwill and certain identifiable intangible assets. Tier II capital includes
Tier I capital plus the allowance for loan losses and subordinated debt, both
subject to some limitations. Regulatory risk-based capital guidelines require
Tier I capital of 4% of risk-adjusted assets and minimum total capital ratio
(combined Tier I and Tier II) of 8% of risk-adjusted assets.
Subsidiaries. Heritage Bank is a Washington state-chartered savings bank,
the deposits of which are insured by the FDIC. Heritage Bank is subject to
regulation by the FDIC and Division of Banks of the Washington Department of
Financial Institutions ("Division"). Central Valley Bank is a national bank
chartered by the Office of the Comptroller of the Currency ("OCC") and insured
by the FDIC. In addition, Central Valley Bank is a member of the Federal
Reserve System. Although Heritage Bank is not a member of the Federal Reserve
System, the Federal Reserve has supervisory authority over us and our
subsidiary banks.
Among other things, applicable federal and state statutes and regulations
which govern a bank's operations relate to minimum capital requirements,
required reserves against deposits, investments, loans, legal lending limits,
mergers and consolidation, borrowings, issuance of securities, payment of
dividends, establishment of branches, and other aspects of its operations. The
Division, the OCC, and the FDIC also have authority to prohibit banks under
their supervision from engaging in what they consider to be unsafe and unsound
practices.
The banks are required to file periodic reports with the FDIC, the Division,
and the OCC, and are subject to periodic examinations and evaluations by those
regulatory authorities. Based upon these evaluations, the regulators may
revalue the assets of an institution and require that it establish specific
reserves to compensate for the differences between the regulator-determined
value and the book value of such assets. These examinations must be conducted
every 12 months, except that well-capitalized banks may be examined every 18
months. The FDIC and the Division may each accept the results of an examination
by the other in lieu of conducting an independent examination.
As subsidiaries of a bank holding company, our banks are subject to various
restrictions in their dealings with us and other companies that may become
affiliated with us.
Dividends paid by our subsidiaries provide substantially all of our cash
flow. Applicable federal and Washington state regulations restrict capital
distributions by our banks, including dividends. Such restrictions are tied to
the institution's capital levels after giving effect to such distributions. The
FDIC and OCC have established the qualifications necessary for a
"well-capitalized" bank, which affects FDIC risk-based insurance premium rates.
To qualify as "well-capitalized", banks must have a Tier I risk-adjusted
capital ratio of at least 6%, a total risk-adjusted capital ratio of at least
10%, and a leverage ratio of at least 5%. Both Heritage Bank and Central Valley
Bank were "well-capitalized" at December 31, 2001.
Federal laws generally bar institutions which are not well capitalized from
accepting brokered deposits. The FDIC has issued rules, which prohibit
under-capitalized institutions from soliciting or accepting brokered deposits.
Adequately capitalized institutions are allowed to solicit brokered deposits,
but only to accept them if a waiver is obtained from the FDIC.
Other Regulatory Developments. Congress has enacted significant federal
banking legislation in recent years. The following summarizes some of the
recent significant federal banking legislation.
Financial Institutions Reform, Recovery, and Enforcement Act of 1989
("FDICIA"). FIRREA, among other things,
. created two deposit insurance funds administered by the FDIC, the Bank
Insurance Fund ("BIF") and the Savings Association Insurance Fund ("SAIF");
18
. permitted commercial banks that meet certain housing-related asset
requirements to secure advances and other financial services from local
Federal Home Loan Banks ("FHLBs");
. restructured the federal regulatory agencies for savings associations; and
. greatly enhanced the regulators enforcement powers over financial
institutions and their affiliates.
Federal Deposit Insurance Corporation Improvement Act of 1991
("FDICIA"). FDICIA went substantially farther than FIRREA in establishing a
more rigorous regulatory environment. Under FDICIA, regulatory authorities are
required to enact a number of new regulations, substantially all of which are
now effective. These regulations include, among other things,
. a new method for calculating deposit insurance premiums based on risk;
. restrictions on acceptance of brokered deposits except by well-capitalized
institutions;
. additional limitations on loans to executive officers and directors of
banks;
. the employment of interest rate risk in the calculation of risk-based
capital;
. safety and soundness standards that take into consideration, among other
things, management, operations, asset quality, earnings and compensation;
. a five-tiered rating system from well-capitalized to critically
undercapitalized, along with the prompt corrective action the agencies may
take depending on the category; and
. new disclosure and advertising requirements with respect to interest paid
on savings accounts.
FDICIA and regulations adopted by the FDIC impose additional requirements
for annual independent audits and reporting when a bank begins a fiscal year
with assets of $500 million or more. These banks, or their holding companies,
are also required to establish audit committees consisting of directors who are
independent of management.
The Riegle-Neal Interstate Banking and Branching Efficiency Act of
1994. The Interstate Banking Act provides banks with greater opportunities to
merge with other institutions and open branches nationwide, and also allows a
bank holding company whose principal operations are in one state to apply to
the Federal Reserve for approval to acquire a bank that is headquartered in a
different state. States cannot "opt out" but may impose minimum time periods,
not to exceed five years, for the target bank's existence. The Interstate
Banking Act also allows bank subsidiaries of bank holding companies to
establish "agency" relationships with their depository institution affiliates.
In an agency relationship, a bank can accept deposits, renew time deposits,
close and service loans, and receive payments for a depository institution
affiliate. States cannot "opt out". The Interstate Banking Act allows banks
whose principal operations are located in different states to apply to federal
regulators to merge. This provision took effect June 1, 1997, unless states
enacted laws to either authorize such transactions at an earlier date or
prohibit such transactions entirely. The Interstate Banking Act also allows
banks to apply to establish de novo branches in states in which they do not
already have a branch office. This provision took effect June 1, 1997, but (i)
states must enact laws to permit such branching and (ii) a bank's primary
federal regulator must approve any such branch establishment. The Washington
legislature passed legislation that allows, subject to certain conditions,
mergers or other combinations, relocations of banks' main office and branching
across state lines in advance of the June 1, 1997 date established by federal
law.
Recent Legislation
Financial Services Reform Legislation. On November 12, 1999, the
Gramm-Leach-Bliley Act ("GLBA") was enacted into law. The GLBA removes various
barriers imposed by the Glass-Steagall Act of 1933, specifically those
prohibiting banks and bank holding companies from engaging in the securities
and insurance business. The GLBA also expands the bank holding company act
framework to permit bank holding companies
19
with subsidiary banks meeting certain capital and management requirements to
elect to become a "financial holding company".
Beginning March 2000, financial holding companies may engage in a full range
of financial activities, including not only banking, insurance, and securities
activities, but also merchant banking and additional activities determined to
be "financial in nature" or "complementary" to an activity that is financial in
nature. The GLBA also provides that the list of permissible financial
activities will be expanded as necessary for a financial holding company to
keep abreast of competitive and technological changes.
The GLBA also expands the activities in which insured state banks may
engage. Under the GLBA, insured state banks are given the ability to engage in
financial activities through a subsidiary, as long as the bank and its bank
affiliates meet and comply with certain requirements. First, the state bank and
each of its bank affiliates must be "well capitalized". Second, the bank must
comply with certain capital deduction and financial statement requirements
provided under the GLBA. Third, the bank must comply with certain financial and
operational safeguards provided under the GLBA. Fourth, the bank must comply
with the limits imposed by the GLBA on transactions with affiliates.
Although the GLBA preserves the Federal Reserve as the umbrella supervisor
of financial holding companies, it adopts an administrative approach to
regulation that defers to the action and paperwork requirements of the
"functional" regulators of insurers, broker-dealers, investment companies, and
banks. Thus, the various state and federal regulators of a financial holding
company's operating subsidiaries would retain their jurisdiction and authority
over those operating entities. As the umbrella supervisor, however, the Federal
Reserve has the potential to affect the operations and activities of a
financial holding company's subsidiaries through its power over the financial
holding company parent. In addition, the GLBA contains numerous trigger points
related to legal non-compliance and other serious problems affecting bank
affiliates that could lead to direct Federal Reserve involvement and the
possible exercise of remedial authority affecting both financial holding
companies and their affiliated operating companies.
USA Patriot Act. On October 26, 2001, President George W. Bush signed into
law the USA Patriot Act ("Patriot Act"). Title III of the Patriot Act concerns
money laundering provisions that may affect many community banks. These
provisions include:
. The Secretary of the Treasury is authorized to impose special measures,
such as recordkeeping or reporting, on domestic financial institutions
that are a primary concern;
. Financial institutions with private or correspondent accounts with
non-U.S. citizens must establish policies and procedures to detect money
laundering through those accounts;
. Financial institutions are barred from maintaining correspondent accounts
for foreign shell banks (that is a bank that does not have a physical
presence in any county);
. The Secretary of the Treasury is required to prescribe regulations to
further encourage cooperation among financial institutions, regulators,
and law enforcement agencies and officials to share information about
terrorist acts and money laundering activities;
. The Secretary of the Treasury is required to issue regulations to
establish minimum procedures for financial institutions to use in
verifying customer identity during the account-opening process;
. Depository institutions are permitted to provide information to other
institutions concerning the possible involvement in potentially unlawful
activity by a current or former employee;
. The Secretary of the Treasury is required to establish a secure website to
receive suspicious activity reports and currency transaction reports, and
provide institutions with alerts and other information regarding
suspicious activity that warrant immediate attention; and
20
. The federal bank regulators are required to consider the anti-money
laundering record of each depository institution in evaluating
applications under the Bank Merger Act.
Deposit Insurance. Heritage Bank's deposit accounts are insured by the FDIC
under the SAIF to the maximum extent permitted by law. Central Valley Bank is
insured by the FDIC under the BIF to the maximum extent permitted by law. Each
bank pays deposit insurance premiums to the FDIC based on a risk-based
assessment system established by the FDIC for all member institutions. Under
applicable regulations, institutions are assigned to one of three capital
groups that are based solely on the level of an institution's capital ("well
capitalized", "adequately capitalized" or " undercapitalized"), which are
defined in the same manner as the regulations establishing the prompt
corrective action system under the FDIC as described above. The matrix so
created results in nine assessment risk classifications.
Pursuant to recent changes in federal law, the FDIC imposed a special
assessment on each depository institution with SAIF-assessable deposits, which
resulted in the SAIF achieving its designated reserve ratio. In addtion, the
FDIC reduced the assessment schedule for SAIF members, effective January 1,
1997, to a range of 0% to 0.27%, with most institutions, including Heritage
Bank, paying 0%. This assessment schedule is the same as that for the BIF,
which reached its designated reserve ratio in 1995. In addition, since January
1, 1997, SAIF members are charged an assessment of approximately 0.06% of
SAIF-assessable deposits for the purpose of paying interest on the bonds issued
by the Financing Corporation in the 1980s to help fund the thrift industry
cleanup. BIF-assessable deposits will be charged an assessment to help pay
interest on the bonds at a rate of approximately .013% until the earlier of
December 31, 1999 or the date upon which the last savings association ceases to
exist, after which time the assessment will be the same for all insured
deposits. Recent legislative changes provided for the merger of the BIF and
SAIF into the Deposit Insurance Fund on January 1, 1999, but only if no insured
depository institutions were savings associations on that date. This merger did
not occur.
The FDIC recently notified all insured institutions about the possibility of
higher deposit insurance premiums in the second half of 2002. The higher
premiums, if they prove necessary, would likely affect only those banks and
thrifts with deposits insured by BIF. The FDIC expects that the deposit
insurance premium increase would be at most 5 basis points of BIF-assessable
deposits each year.
Competition
We compete for loans and deposits with other thrifts, commercial banks,
credit unions, mortgage bankers, and other institutions in the scope and type
of services offered, interest rates paid on deposits, pricing of loans, and
number and locations of branches, among other things. Many of our competitors
have substantially greater resources than we do. Particularly in times of high
or rising interest rates, we also face significant competition for investors'
funds from short-term money market securities and other corporate and
government securities.
We compete for loans principally through the range and quality of the
services we provide, interest rates and loan fees, and the locations of our
banks' branches. We actively solicit deposit-related clients and compete for
deposits by offering depositors a variety of savings accounts, checking
accounts, and other services.
Employees
At December 31, 2001, we had 198 full-time equivalent employees. We believe
that employees play a vital role in the success of a service company. None of
our employees are covered by a collective bargaining agreement.
21
ITEM 2. PROPERTIES
Our executive offices and the main office of Heritage Bank are located in
approximately 22,000 square feet of the headquarters building and adjacent
office space which are owned and located in downtown Olympia. At December 31,
2001, Heritage Bank had six offices located in Tacoma and surrounding areas of
Pierce County, (all but one of which are owned) five offices located in
Thurston County (all of which are owned with one office located on leased
land), and one office in Shelton, Mason County (which is owned). Central Valley
Bank had six offices, five located in Yakima County and one in Kittitas County
(all of which are owned with two on leased land).
ITEM 3. LEGAL PROCEEDINGS
We, and our banks, have certain litigation and possible negotiated
settlements in progress resulting from activities arising from normal
operations. In our opinion, none of these matters is likely to have a material
adverse effect on our financial position or results of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
22
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
Our common stock is traded on the NASDAQ National Market System(R) under the
symbol HFWA. At December 31, 2001, we had approximately 1,300 stockholders of
record (not including the number of persons or entities holding stock in
nominee or street name through various brokerage firms) and 7,534,232
outstanding shares of common stock. The last reported sales price on March 8,
2002 was $12.47 per share. The following table provides bid information per
share of our common stock as reported on the NASDAQ National Market System(R)
for the indicated quarters.
2001 Quarter ended:
-----------------------------------------
March 31 June 30 September 30 December 31
-------- ------- ------------ -----------
High......................... $10.69 $10.93 $11.98 $11.97
Low.......................... $ 9.38 $ 9.65 $10.30 $10.86
2000 Quarter ended:
-----------------------------------------
March 31 June 30 September 30 December 31
-------- ------- ------------ -----------
High......................... $ 8.63 $ 8.69 $ 9.88 $10.19
Low.......................... $ 7.50 $ 7.13 $ 8.50 $ 8.75
Since our stock offering in January 1998, we have declared the following
quarterly cash dividends:
Cash
Dividend
Declared per share Record Date Paid
-------- --------- ---------------- ----------------
March 24, 1998............... $0.035 April 6, 1998 April 15, 1998
June 23, 1998................ $0.040 July 6, 1998 July 15, 1998
September 18, 1998........... $0.045 October 6, 1998 October 15, 1998
December 17, 1998............ $0.050 January 15, 1999 January 25, 1999
March 25, 1999............... $0.055 April 15, 1999 April 26, 1999
June 18, 1999................ $0.060 July 15, 1999 July 27, 1999
September 17, 1999........... $0.065 October 15, 1999 October 27, 1999
December 16, 1999............ $0.070 January 14, 2000 January 27, 2000
March 17, 2000............... $0.075 April 14, 2000 April 28, 2000
June 16, 2000................ $0.080 July 14, 2000 July 28, 2000
September 21, 2000........... $0.085 October 16, 2000 October 27, 2000
December 22, 2000............ $0.090 January 19, 2001 January 31, 2001
March 27, 2001............... $0.095 April 16, 2001 April 27, 2001
June 26, 2001................ $0.100 July 16, 2001 July 25, 2001
September 28, 2001........... $0.105 October 15, 2001 October 29, 2001
December 19, 2001............ $0.110 January 15, 2002 January 30, 2002
Dividends to shareholders depend primarily upon the receipt of dividends
from our subsidiary banks. The FDIC and the Division have the authority under
their supervisory powers to prohibit the payment of dividends by Heritage Bank
to us. For a period of ten years after the conversion from mutual to stock
ownership, Heritage Bank may not, without prior approval of the Division,
declare or pay a cash dividend in excess of one-half of the greater of the
Bank's net income for the current fiscal year or the average of the Bank's net
income for the current fiscal year, and the retained earnings of the two prior
fiscal years. In addition, Heritage Bank may not declare or pay a cash dividend
on its common stock if the effect of the dividend would be to reduce the Bank's
net worth below the amount required for the liquidation account. For Central
Valley Bank, the approval of the Comptroller of the Currency is required if the
total of all dividends declared by Central Valley Bank in any
23
calendar year exceeds the total of its net income of that year combined with
its retained net income of the preceding two years, less any required transfer
of surplus or fund for the retirement of any preferred stock. Other than the
specific restrictions mentioned above, current regulations allow us, and our
subsidiary banks to pay dividends on their common stock if our or our bank's
regulatory capital would not be reduced below the statutory capital
requirements set by the Federal Reserve, the OCC, and the FDIC.
24
ITEM 6. SELECTED FINANCIAL DATA
For the six
For the years ended months ended
June 30, December 31, For the years ended December 31,
------------------ ------------ -------------------------------
1997 1998 1998 1999 2000 2001
-------- -------- ------------ -------- -------- --------
(Dollars in thousands, except per share data)
Operations Data:
Net interest income................. $ 12,043 $ 16,110 $ 11,017 $ 23,458 $ 24,841 $ 26,632
Provision for loan losses........... (265) 149 202 408 787 1,193
Noninterest income.................. 3,748 4,261 2,901 4,038 4,190 5,925
Noninterest expense................. 13,445 13,690 10,275 18,773 19,323 20,624
Provision (benefit) for income taxes 12 2,273 1,275 2,958 2,947 3,778
Net income.......................... 2,598 4,259 2,166 5,357 5,974 6,962
Earnings per share
Basic............................ 0.25 0.41 0.20 0.50 0.66 0.87
Diluted.......................... 0.24 0.40 0.20 0.49 0.65 0.86
Dividend payout ratio(1)............ NM 18.4% 47.3% 50.1% 50.2% 46.9%
Performance Ratios:
Net interest spread................. 4.30% 4.14% 4.13% 4.56% 4.12% 4.33%
Net interest margin(2).............. 4.80% 5.05% 5.16% 5.49% 5.04% 4.98%
Efficiency ratio(3)................. 85.15% 67.20% 73.83% 68.27% 66.56% 63.35%
Return on average assets............ 0.94% 1.23% 0.92% 1.14% 1.11% 1.19%
Return on average equity............ 8.74% 6.77% 4.36% 5.32% 6.66% 8.52%
At June 30, At December 31,
------------------ --------------------------------------------
1997 1998 1998 1999 2000 2001
-------- -------- ------------ -------- -------- --------
Balance Sheet Data:
Total assets........................ $291,323 $471,030 $475,871 $510,958 $573,530 $609,643
Loans receivable, net............... 233,621 303,754 315,376 412,909 475,441 486,679
Loans held for sale................. 6,322 6,412 7,618 589 1,931 6,275
Deposits............................ 254,024 363,529 366,998 405,068 460,234 515,080
Federal Home Loan Bank advances..... 890 698 687 2,800 23,125 8,000
Other borrowings.................... 525 1,633 17 8 1,000 --
Stockholders' equity................ 31,588 98,593 100,559 95,264 83,005 78,528
Book value per share................ NM $ 9.20 $ 9.27 $ 9.50 $ 10.09 $ 10.42
Equity to assets ratio.............. 10.84% 20.93% 21.13% 18.68% 14.47% 12.88%
Asset Quality Ratios:
Nonperforming loans to loans........ 0.06% 0.06% 0.12% 0.43% 0.33% 0.39%
Allowance for loan losses to loans.. 1.28% 1.25% 1.21% 1.02% 1.05% 1.15%
Allowance for loan losses to
nonperforming loans............... 2133.01% 1019.90% 984.70% 236.27% 315.02% 293.12%
Nonperforming assets to total assets 0.05% 0.10% 0.08% 0.35% 0.28% 0.49%
Other Data:
Number of banking offices........... 12 14 16 17 18 18
Number of full-time equivalent
employees......................... 170 180 229 222 211 198
- --------
(1) Dividend payout ratio is declared dividends per share divided by earnings
per share. Cash dividends prior to the January 1998 stock offering and
conversion are not comparable to prior periods due to the former mutual
holding company's waiver of its pro rata cash dividends.
(2) Net interest margin is net interest income divided by average interest
earning assets.
(3) The efficiency ratio is recurring noninterest expense divided by the sum of
net interest income and noninterest income, excluding nonrecurring items.
Heritage Bank paid a one-time assessment of $1.09 million to the SAIF in
November 1996 (fiscal year 1997). This amount was excluded from the
calculation of the efficiency ratio for 1997.
25
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following discussion is intended to assist in understanding the
financial condition and results of operations of the Company. The information
contained in this section should be read with the December 31, 2001 audited
consolidated financial statements and notes to those financial statements
included in this Form 10-K.
Statements concerning future performance, developments or events, concerning
expectations for growth and market forecasts, and any other guidance on future
periods, constitute forward-looking statements and are subject to a number of
risks and uncertainties which might cause actual results to differ materially
from stated expectations. Specific factors include, but are not limited to the
effect of interest rate changes, risks associated with acquisition of other
banks and opening new branches, the ability to control costs and expenses, and
general economic conditions. Additional information on these and other factors,
which could affect our financial results are included in our filings with the
Securities and Exchange Commission.
General
In the fiscal year ended June 30, 1994, we began to implement a growth
strategy to broaden our products and services from traditional thrift offerings
to those more closely related to commercial banking. That strategy included,
geographic and product expansion, loan portfolio diversification, development
of relationship banking, and maintenance of asset quality.
In the fiscal year ended June 30, 1998, our growth strategy was bolstered by
two significant events--the January 1998 stock offering and conversion, and our
acquisition of North Pacific Bancorporation.
Through the January 1998 stock offering, we raised $63.0 million in net new
capital, which has, and will continue to, enhance our ability to implement our
growth strategy. Using $17.5 million of the net proceeds of the stock offering,
we completed our first bank acquisition in June 1998 by purchasing all of the
outstanding stock of North Pacific Bancorporation whose wholly owned subsidiary
was North Pacific Bank. The all cash transaction was accounted for using
purchase accounting rules. The acquisition of North Pacific Bank provided
further geographical expansion into the Pierce County market area and enhanced
expertise in commercial banking. During the six months ended December 31, 1998,
we integrated the operations of North Pacific Bank into Heritage Bank
culminating in the merging of data processing systems effective November 20,
1998 and substantially upgrading North Pacific Bank's item processing
capability to handle existing and projected future volumes.
Consistent with our strategy, on March 5, 1999, we merged with Washington
Independent Bancshares, Inc., whose wholly owned subsidiary was Central Valley
Bank. In the merger, we exchanged 1,058,009 shares of our common stock for all
of the outstanding shares of Washington Independent Bancshares, Inc. common
stock. This merger was accounted for as a pooling of interests and accordingly,
our financial information has been restated to include the accounts and results
of operations of Washington Independent Bancshares, Inc. for all periods
presented.
In 1999, we were continuing to operate with capital levels well in excess of
regulatory requirements and well in excess of our internal needs. We determined
that buying our own shares with some of our excess capital was the best use of
this capital and we began to buy back our outstanding shares. We began in April
1999 with the repurchase of 100,000 shares of our outstanding common stock for
$0.8 million, or $8.56 per share. In October 1999, we began the first of four
phases of the stock repurchase programs. The first phase of the repurchase
program totaled 1,082,389 shares, or 10% of the then outstanding shares, which
began in October 1999 and ended in February 2000. The second phase totaled
976,748 shares, or 10% of the then outstanding shares, which began in February
2000 and ended in August 2000. The third phase totaled 890,000 shares, which
represented 10% of the then outstanding shares, which began in August 2000 and
ended in May 2001. The fourth
26
phase began during May 2001 for a total of 800,000 shares, which represented
10% of the then outstanding shares, of which 521,089 shares were repurchased as
of December 31, 2001. By December 31, 2001, we repurchased a total of 3,573,380
shares of our stock representing 33% of the total outstanding as of March 31,
1999 at an average price of $9.13 per share.
In 2000, we conducted an extensive review of our strategic direction
culminating in a new strategic plan that reaffirmed our 1994 goals with an
increased emphasis on return on average equity and efficiency of operations. In
pursuit of this strategy, we announced in January 2001 an initiative titled
"Vision 2001" for Heritage Bank. To assist us, we engaged Alex Sheshunoff
Management Services, L.P. ("ASM"). ASM completed an opportunities assessment
during fiscal year 2000 for Heritage Bank with the objective of determining
ways that we can optimize our earnings performance. Beginning in March 2001,
ASM worked with us to implement those opportunities identified. We incurred the
majority of the expenses associated with this project during the first and
second quarters of 2001. We realized the benefits in the form of revenue
enhancements and reduced expenses beginning with the third quarter of 2001.
Net Interest Income
Our profitability depends primarily on our net interest income, which is the
difference between the income we receive on our loan and investment portfolios,
and our cost of funds, which consists of interest paid on deposits and borrowed
funds. Like most financial institutions, our interest income and cost of funds
are affected significantly by general economic conditions, particularly changes
in market interest rates and government policies.
Changes in net interest income result from changes in volume, net interest
spread, and net interest margin. Volume refers to the average dollar amounts of
interest earning assets and interest bearing liabilities. Net interest spread
refers to the difference between the average yield on interest earning assets
and the average cost of interest bearing liabilities. Net interest margin
refers to net interest income divided by average interest earning assets and is
influenced by the level and relative mix of interest earning assets and
interest bearing liabilities.
27
The following table provides relevant net interest income information for
selected time periods. The average loan balances presented in the table are net
of allowances for loan losses. Nonaccrual loans have been included in the
tables as loans carrying a zero yield.
Years Ended December 31,
----------------------------------------------------------------------------
1999 2000 2001
------------------------ ------------------------ ------------------------
Average Interest Average Interest Average Interest
Balance Earned/ Average Balance Earned/ Average Balance Earned/ Average
(1) Paid Rate (1) Paid Rate (1) Paid Rate
-------- -------- ------- -------- -------- ------- -------- -------- -------
(Dollars in thousands)
Interest Earning Assets:
Loans............................. $361,116 $32,886 9.11% $445,813 $41,510 9.31% $494,379 $43,111 8.72%
Mortgage Backed Securities........ 2,773 227 8.19 2,174 180 8.27 4,069 301 7.40
Investment securities and FHLB
stock............................ 44,270 2,591 5.85 41,885 2,393 5.71 25,622 1,406 5.49
Interest earning deposits......... 18,745 820 4.37 2,898 159 5.50 11,019 372 3.38
-------- ------- ------ -------- ------- ------ -------- ------- ------
Total interest earning assets..... $426,904 $36,524 8.56% $492,770 $44,242 8.98% $535,089 $45,190 8.45%
Noninterest earning assets........ 44,637 47,394 50,582
-------- -------- --------
Total assets................... $471,541 $540,164 $585,671
======== ======== ========
Interest Bearing Liabilities:
Certificates of deposit........... $165,490 $ 8,271 5.00% $226,334 $13,617 6.02% $244,369 12,797 5.24%
Savings accounts.................. 68,484 2,279 3.33 62,594 2,226 3.56 61,190 2,140 3.50
Interest bearing demand and
money market accounts............ 91,281 2,458 2.69 99,089 2,787 2.81 126,302 2,618 2.07
-------- ------- ------ -------- ------- ------ -------- ------- ------
Total interest bearing deposits... 325,255 13,008 4.00 388,017 18,630 4.80 431,861 17,555 4.06
FHLB advances..................... 1,021 57 5.53 10,441 722 6.92 18,002 961 5.34
Other borrowed funds.............. 37 1 3.54 477 49 10.16 202 42 20.85
-------- ------- ------ -------- ------- ------ -------- ------- ------
Total interest bearing
liabilities................... $326,313 $13,066 4.00% $398,935 $19,401 4.86% $450,065 $18,558 4.12%
Demand and other noninterest
bearing deposits................. 37,906 44,038 47,455
Other noninterest bearing
liabilities...................... 6,712 7,463 6,479
Stockholders' equity.............. 100,610 89,728 81,672
-------- -------- --------
Total liabilities and
stockholders' equity.......... $471,541 $540,164 $585,671
======== ======== ========
Net interest income............... $23,458 $24,841 $26,632
Net interest spread............... 4.56% 4.12% 4.33%
Net interest margin............... 5.49% 5.04% 4.98%
Average interest earning assets to
average interest bearing
liabilities...................... 130.83% 123.52% 118.89%
28
The following table provides the amount of change in our net interest income
attributable to changes in volume and changes in interest rates. Changes
attributable to the combined effect of volume and interest rates have been
allocated proportionately for changes due to volume and interest rates.
Years Ended December 31,
----------------------------------------------------
1999 Compared to 2000 2000 Compared to 2001
Increase (Decrease) Due to Increase (Decrease) Due to
------------------------- -------------------------
Volume Rate Total Volume Rate Total
------- ------- ------- ------- ------- ------
Interest Earning Assets:
Loans................................... $ 7,713 $ 910 $ 8,623 $ 4,523 $(2,921) $1,602
Mortgage backed securities.............. (49) 2 (47) 157 (36) 121
Investment securities and FHLB stock.... (140) (58) (198) (929) (58) (987)
Interest earning deposits............... (693) 33 (660) 447 (235) 212
------- ------- ------- ------- ------- ------
Total interest income................ $ 6,831 $ 887 $ 7,718 $ 4,198 $(3,250) $ 948
======= ======= ======= ======= ======= ======
Interest bearing liabilities:
Certificates of deposit................. $(3,041) $(2,305) $(5,346) $(1,085) $ 1,905 $ 820
Savings accounts........................ 196 (143) 53 50 36 86
Interest bearing demand and money market
accounts.............................. (210) (118) (328) (765) 934 169
------- ------- ------- ------- ------- ------
Total interest bearing deposits...... (3,055) (2,566) (5,621) (1,800) 2,875 1,075
FHLB advances........................... (522) (144) (666) (523) 284 (239)
Other borrowings........................ (16) (32) (48) 29 (22) 7
------- ------- ------- ------- ------- ------
Total interest bearing liabilities... $(3,593) $(2,742) $(6,335) $(2,294) $ 3,137 $ 843
======= ======= ======= ======= ======= ======
Financial Condition
Our total assets grew $36.1 million (6.3%) to $609.6 million at December 31,
2001 from $573.5 million at December 31, 2000. Deposits grew $54.8 million
(11.9%) to $515.0 million at December 31, 2001 from $460.2 million at December
31, 2000. Total loans grew by $16.3 million (3.4%) to $498.7 million at
December 31, 2001 from $482.4 million at December 31, 2000. The majority of the
loan growth was in commercial loans as they grew to $263.1 million at December
31, 2001 from $234.2 million at December 31, 2000, an increase of $28.9 million
(12.3%).
Results of Operations for the Years Ended December 31, 2001 and 2000
Net Income. Our net income was $6.96 million or $0.86 per diluted share for
the year ended December 31, 2001 compared to $5.97 million or $0.65 per diluted
share for the previous year. The growth in income primarily resulted from a
strong mortgage banking environment leading to increased loan sale gains, the
success of Heritage Bank's Vision 2001 initiative, and our ability to maintain
our net interest margin in a sharply declining interest rate environment.
Average earning assets increased 42.3 million, ending the year at $535.1
million compared to the previous year end of $492.8 million. The average rate
on average earning assets declined by 53 basis points. Average costing
liabilities grew $51.1 million with cost of funds declining by 74 basis points
over the prior year. The difference in growth between average earning assets
and costing liabilities is the result of stock repurchases during the year.
Net Interest Income. Net interest income increased $1.8 million (7.2%), for
the year ended December 31, 2001 compared with the previous year. The growth in
net interest income resulted primarily from maintaining the net interest margin
in a sharply declining interest-rate environment. Average loans increased by
$48.6 million (10.9%) with a decline in the average rate of 59 basis points.
Average deposits increased $43.8 million (11.3%) with a more significant
decline in the average rate of 74 basis points.
29
Net interest income as a percentage of average earning assets (net interest
margin) for the year ended December 31, 2001 decreased to 4.98% from 5.04% for
the previous year. Our net interest spread for the year ended December 31, 2001
increased to 4.33% from 4.12% for the prior year. This corresponded with the
decrease in the average cost of funds to 4.12% for the year ended December 31,
2001 from 4.86% for the same period last year as well as the decrease in the
average rate of interest earning assets to 8.45% for the year ended December
31, 2001 from 8.98% for the same period last year. The declining rate
environment is a result of a weakening economy and an effort by the Federal
Reserve to stimulate the economy.
Provision for Loan Losses. During the year ended December 31, 2001, we
provided $1.19 million through operations to maintain our allowance at an
adequate level because of a weakening economy and the increase in our
commercial loan portfolio. For the year ended December 31, 2001, we experienced
net charge-offs of $505,000. The provision increased our allowance for loan
loss as a percentage of total loans to 1.15% at December 31, 2001 from 1.05% at
the end of 2000. While our loan portfolio, and in particular commercial loans,
has grown substantially over the past several years, our asset quality has
remained solid as demonstrated by the nonperforming assets to total assets
ratio of 0.49% at December 31, 2001.
We consider the allowance for loan losses at December 31, 2001 to adequately
cover reasonably foreseeable loan losses based on our assessment of various
factors affecting the loan portfolio, including the level of problem loans,
business conditions, estimated collateral values, loss experience, and credit
concentrations. See the previous discussion on the allowance for loan losses
for further information about these factors.
Noninterest Income. Total noninterest income increased $1.7 million (41.4%)
for the year ended December 31, 2001 compared with the prior year. Mortgage
banking income increased $985,000 as result of the declining interest rates and
the large increase in refinancing of real estate loans. Total sales of mortgage
loans increased by $61.9 million to $97.8 million for the year ended 2001
versus $35.9 million in 2000. Service charges on deposits increased $399,000
(25.1%) resulting from increased service charges and increased demand for
deposit products. Other income increased $427,000 (28.8%) for 2001 as compared
to 2000. This increase in other income was due to the $267,000 (42.5%) increase
in Merchant Visa Income, which is a relatively new product line that continues
to expand. Additionally, the increase in other income was attributable to the
sale of Heritage Bank's ownership interest in Transalliance Corporation (a
debit/credit card processor), which resulted in a gain on sale of investment of
$157,000.
Noninterest Expense. Total noninterest expense increased $1.3 million
(6.7%) for the year ended 2001 compared to the 2000 period. Personnel expenses
increased a modest $188,000 (1.9%) despite the $407,000 increase in mortgage
commissions. As a result of the Vision 2001 initiative, Heritage Bank
experienced employee layoffs and restructured mortgage commission incentives.
Therefore, personnel expenses did not increase during the year. Other expenses
increased $956,000 (27.4%) due primarily to the costs associated with the
Vision 2001 initiative of $589,000. We incurred Vision 2001 expenses during the
first half of the year, which were primarily consulting fees paid to Alex
Sheshunoff Management Services, L.P. Merchant Visa expenses also increased by
$220,000 (43.2%), which was in line with the increase in Merchant Visa income.
Results of Operations for the Years Ended December 31, 2000 and 1999
Net Income. Our net income was $5.97 million or $0.65 per diluted share for
the year ended December 31, 2000 as compared to $5.36 million or $0.49 per
diluted share for 1999. The growth in income primarily resulted from a $65.9
million growth in average earning assets for the year 2000 compared to 1999.
Average costing liabilities grew $72.6 million contributing to a narrowing net
interest margin. The difference in growth between average earning assets and
costing liabilities is the result of stock repurchases during the year.
Net Interest Income. Net interest income increased $1.4 million (5.9%), for
the year ended December 31, 2000 compared with 1999, primarily as a result of
the $84.7 million (23.5%) increase in the average balance of loans. Average
interest earning assets grew $65.9 million (15.4%) as average short-term
investments (primarily
30
overnight deposits) decreased by $18.8 million (28.6%). The reduction of
short-term investments was used along with the growth in average deposits of
$62.8 million (19.3%) to fund loan growth and repurchase stock.
Net interest income as a percentage of average earning assets (net interest
margin) for the year ended December 31, 2000 decreased to 5.04% from 5.49% for
1999. The decrease resulted from the strong growth in average deposits,
particularly certificates of deposit which grew $60.8 million ($36.8%) but
which have a higher cost. During 1998 and 1999 we were able to utiliz