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SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
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FORM 10-K
[_]Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934
[X]Transition Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from June 30, 1998 to December 31, 1998.
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)
----------------
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 $84,158,016 and is based upon the last sales price as quoted on
the NASDAQ Stock Market for March 22, 1999.
The Registrant had 10,976,540 shares of common stock outstanding as of March
22, 1999.
DOCUMENTS TO BE INCORPORATED BY REFERENCE
Portions of the Registrant's definitive Proxy Statement dated March 31, 1999
for the 1999 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, 1998
INDEX
Page
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PART I
ITEM 1. BUSINESS...................................................... 3
LENDING ACTIVITIES............................................ 4
INVESTMENT ACTIVITIES......................................... 11
DEPOSIT ACTIVITIES AND OTHER SOURCES OF FUNDS................. 14
SUPERVISION AND REGULATION.................................... 17
COMPETITION................................................... 20
EMPLOYEES..................................................... 21
ITEM 2. PROPERTIES.................................................... 21
ITEM 3. LEGAL PROCEEDINGS............................................. 21
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS........... 21
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS.......................................... 22
ITEM 6. SELECTED FINANCIAL DATA....................................... 23
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS.......................... 24
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 8-K.................................................. 38
2
ITEM 1. BUSINESS
General
Heritage Financial Corporation (the "Company") is a bank holding company
incorporated in the State of Washington in August 1997. The Company was
organized for the purpose of acquiring all of the capital stock of Heritage
Bank upon its reorganization from a mutual holding company form of
organization to the stock holding company form of organization (the
"Conversion").
The Company is primarily engaged in the business of planning, directing and
coordinating the business activities of its wholly owned subsidiary, Heritage
Bank (the "Bank"). Heritage Bank is a Washington-chartered savings bank whose
deposits are insured by the Federal Deposit Insurance Corporation (FDIC) under
the Savings Association Insurance Fund (SAIF) and for the deposits acquired
from North Pacific Bank, the Bank Insurance Fund (BIF). The Bank conducts
business from its main office in Olympia, Washington and its eleven branch
offices located in Thurston, Pierce and Mason Counties. Effective June 12,
1998, the Company acquired North Pacific Bank, a Washington-chartered
commercial bank, which was merged into the Bank effective November 20, 1998.
The business of Heritage Bank consists primarily of focusing on lending and
deposit relationships with small businesses and their owners in its market
area, attracting deposits from the general public and originating for sale or
investment purposes first mortgage loans on residential properties located in
western Washington. HB also makes residential construction loans, income
property loans and consumer loans, primarily second mortgage loans.
On September 28, 1998, the Company entered into a definitive merger
agreement with Washington Independent Bancshares, Inc. (Washington
Independent) whereby the Company would acquire all of the outstanding common
stock of Washington Independent (whose wholly owned subsidiary is Central
Valley Bank, N.A., Toppenish, Washington). Effective on the transaction
closing on March 5, 1999, the Company exchanged 1,058,200 shares of its common
stock for all of the 1,781,449 outstanding shares of Washington Independent
common stock. At March 5, 1999, Central Valley Bank had total assets of $61
million and operated 5 full-service banking offices in Yakima County. This
transaction will be accounted for as a pooling of interests and accordingly,
the Company's historical consolidated financial statements presented in future
reports will be restated to include the accounts and results of operations of
Washington Independent.
Market Areas
The Company offers financial services to meet the needs of the communities
it serves through community-oriented financial institutions. Headquartered in
Olympia, Thurston County, Washington, the Company conducts business from
twelve full service offices, six in Pierce County, five in Thurston County and
one in Mason County. The Company has two mortgage origination offices, one in
Thurston and one in Pierce County, both of which operate within banking
offices.
Olympia enjoys a stable economic climate, largely due to government
employment and military personnel, both retired and active. State government
is by far the largest employer in Thurston County, employing over 40% of the
total county work force. Federal, county and municipal government comprise
nearly 50% of the county's employment base. Fort Lewis and McChord Air Force
Base are both located in the Company's primary market area.
Thurston County has a population of 199,700 as of April 1, 1998 and was one
of the fastest growing metropolitan counties in the state of Washington as
reported in the national 1990 census. Thurston County's growth has been
spurred by an increase in government employment in the 1980's and the
expansion of a large retirement population, including many former military
personnel.
Pierce County, where Tacoma is located, has a population of 686,800 as of
April 1, 1998. Its economy is well-diversified, with the principal industry
being aerospace, shipping, military-related government employment,
3
agriculture and forest products. The Puget Sound Economic Forecaster, a
regional publication providing economic forecasts and commentary, predicts
that Pierce County will likely have the strongest economic performance in the
Puget Sound region through 1999. Forbes magazine recently published its
prediction that the Tacoma area would be among the top twenty-five cities in
the United States in terms of job growth, especially in the areas of computers
and semiconductors.
The Company's market area also includes Shelton and the surrounding Mason
County area. The population of Mason county is approximately 49,500 as of
April 1, 1998, and its economy is substantially dependent upon timber and the
forest products industries.
Lending Activities
General. The Company's principal lending activities are carried on through
the Bank. The Company traditionally has originated one- to four-family
residential mortgage loans and, to a lesser extent, multifamily, commercial
real estate and construction loans. In fiscal 1994, the Company implemented a
growth strategy which is intended to broaden its products and services from
traditional thrift products and services to those more closely related to
commercial banking. In this regard, in 1993, the Company began to emphasize
relationship banking, in order to improve customer loyalty through maximizing
the number of lending and deposit relationships with a customer. This strategy
also included expanding the Company's commercial business lending
capabilities. In early fiscal 1997, several commercial loan officers,
experienced in the Puget Sound region, were hired to continue the expansion.
The loan officers, in addition to bringing to the Company some previous
customer relationships, have taken advantage of the opportunity to attract
customers of banks that have been acquired in the recent wave of mergers with
out-of-area acquirers. In June 1998, the Company completed its acquisition of
North Pacific Bank, a $104 million asset commercial bank, which accelerated
the Company's expansion of its commercial banking focus. These efforts
contributed to an increase in commercial loans to $111.8 million, or 38.7% of
total loans, as of December 31, 1998 from $39.4 million, or 18.9% of total
loans, as of June 30, 1997. As the Company pursues its strategy, management is
continuing to emphasize strong asset quality.
The Company's overall lending operations are guided by loan policies which
are reviewed and approved annually by its Board of Directors, and which
outline the basic policies and procedures by which lending operations are
conducted. Generally, the policies address the types of loans, underwriting
and collateral requirements, terms, interest rate and yield considerations,
and compliance with laws and regulations. The Company supplements its 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.
Residential mortgage loans to be placed in the Company's loan portfolio are
approved or denied by a loan committee consisting of senior loan officers and
the Chief Executive Officer. Loan requests for less than $3.5 million and
where the borrower's total bank liability is less then $3.5 million may be
approved by the Chief Executive Officer. Loan requests for over $3.5 million
or any request where the borrower's total bank liabilities exceeds $3.5
million must be approved by the Chief Executive Officer and either the Board
of Directors or the Board's Executive Committee.
4
The following table sets forth at the dates indicated the Company's loan
portfolio by type of loan. These balances are net of deferred loan fees and
prior to deduction for the allowance for loan losses.
At June 30,
---------------------------------------------------------------------- At December 31,
1995 1996 1997 1998 1998
---------------- ---------------- ---------------- ---------------- ----------------
% of % of % of % of % of
Balance Total Balance Total Balance Total Balance Total Balance Total
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
(Dollars in thousands)
Commercial.............. $ 9,983 6.31% $ 18,269 10.82% $ 39,445 18.95% $100,489 36.44% $111,817 38.72%
Real Estate Mortgages
One-four family
residential(1)........ 90,985 57.52 93,157 55.15 103,439 49.68 97,598 35.39 93,442 32.36
Five or more family
residential and
commercial
properties............ 38,494 24.33 42,560 25.20 51,209 24.60 57,158 20.73 55,121 19.09
Total real estate
mortgages............. 129,479 81.85 135,717 80.35 154,648 74.28 154,756 56.12 148,563 51.45
Real estate construction
One to four family
residential........... 16,504 10.43 14,509 8.59 12,683 6.09 18,192 6.60 24,922 8.63
Five or more family
residential and
commercial
properties............ 1,538 0.97 393 0.23 1,029 0.49 527 0.19 2,124 .74
Total real estate
construction(2)....... 18,042 11.41 14,902 8.82 13,712 6.59 18,719 6.79 27,046 9.37
Consumer................ 1,812 1.15 1,105 0.65 1,467 0.70 3,030 1.10 2,717 .94
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Total loans............ 159,316 100.71% 169,993 100.65% 209,272 100.52% 276,994 100.45% 290,143 100.48%
Less deferred loan fees
and other.............. (1,126) -0.71 (1,090) -0.65 (1,079) -0.52 (1.228) -0.45 (1,400) -0.48%
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Net loans.............. $158,190 100.00% $168,903 100.00% $208,193 100.00% $275,766 100.00% $288,743 100.00%
======== ====== ======== ====== ======== ====== ======== ====== ======== ======
- --------
(1) Includes loans held for sale of $5,944, $5,286, $6,323, $6,411, and
$7,618, respectively.
(2) Balances are net of undisbursed loan proceeds.
The following table presents at December 31, 1998, (i) the aggregate
maturities of loans in the named categories of the Company's 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 1-5 After
1 year years 5 years Total
------- ------- ------- --------
(Dollars in thousands)
Commercial................................. $34,163 $25,139 $52,515 $111,817
Real estate construction................... 20,418 6,628 -- 27,046
------- ------- ------- --------
Total.................................... $54,581 $31,767 $52,515 $138,863
======= ======= ======= ========
Fixed rate loans........................... $15,972 $16,660 $ 32,632
Variable or adjustable rate loans.......... 15,795 35,855 51,650
------- ------- --------
Total.................................... $31,767 $52,515 $ 84,282
======= ======= ========
Real Estate Lending
One- to Four-Family Residential Real Estate Lending. The majority of the
Company's residential loans are secured by one- to four-family residences
located in the Company's primary market area. The Company's underwriting
standards require that one- to four-family portfolio loans generally be owner-
occupied and that loan amounts 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. The Company
offers both fixed-rate mortgages and adjustable rate mortgages("ARMs"), with
repricing based on a Treasury Bill or other index. The Company's ability to
generate volume in ARMs however, is largely a function of consumer preference
and the interest rate environment. The Company's current policy is not to make
ARMs with discounted initial interest rates (i.e., "teasers"). The Company
generally sells all government guaranteed mortgages, both fixed rate and
adjustable rate. In addition, in connection with management's strategies to
control the Company's interest rate sensitivity position, management
determines from time to time to what extent it will
5
retain or sell other ARMs and other fixed rate mortgages. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations--
Asset/Liability Management".
Multifamily and Commercial Real Estate Lending. The Company has made, and
anticipates continuing to make, on a selective basis, multifamily and
commercial real estate loans in its primary market areas. Commercial real
estate loans are made for small shopping centers, warehouses and professional
offices, generally owner occupied. Cash flow coverage to debt servicing
requirements is generally 1.2 times or more. The Company's 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 the Bank 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 such loans
may be affected by adverse conditions in the real estate market or the
economy. The Company seeks 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. The Company also generally
obtains personal guarantees from financially capable borrowers based on a
review of personal financial statements.
Construction Loans. The Company originates one- to four-family residential
construction loans for the construction of custom homes (where the home buyer
is the borrower) and provides financing to builders for the construction of
pre-sold homes and speculative residential construction. The Company loans to
builders who have demonstrated a favorable record of performance and
profitable operations and who are building in markets that management
understands and in which management is comfortable with the economic
conditions. The Company further endeavors to limit its 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. The Company's underwriting standards require that the loan-
to-value ratio for pre-sold homes and speculative residential construction not
exceed 80% of appraised value or builder's cost less overhead, whichever is
less. Speculative construction and land development loans are generally priced
with a variable rate of interest using the prime rate as the index. The
Company generally requires builders to have some tangible form of equity in
each construction project. That objective may be achieved by restricting draws
to less than the acquisition cost of land plus a percentage of the builder's
costs less overhead incurred to date, requiring the loan fees be paid from
outside funds, requiring the builder to place equity funds in a construction
loan account or by not reimbursing fees incurred by the builder such as legal
fees, architectural fees, and building permits. Also, the Company generally
requires prompt and thorough documentation of all draw requests and utilizes
outside inspectors to inspect the project prior to paying any draw requests
from builders.
Construction lending affords the Company the opportunity to achieve higher
interest rates and fees with shorter terms to maturity than does its single-
family permanent mortgage lending. Construction lending, however, 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. The nature of these loans is such that they are generally more
difficult to evaluate and monitor. If the estimate of construction cost proves
to be inaccurate, the Company 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, the Company may be
confronted with a project whose value is insufficient to assure full
repayment. Projects may also be jeopardized by disagreements between borrowers
and builders and by 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 payoff for the loan depends on the builder's ability to
sell the property prior to the time that the construction loan is due.
6
Commercial Business Lending
The Company offers commercial loans to sole proprietorships, partnerships
and corporations with an emphasis on real estate related industries and firms
in the 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 inventory, business term loans secured by real estate
for either working capital or lot acquisition, Small Business Association
("SBA") loans and unsecured business loans. All unsecured loans in excess of
$750,000 require approval of the Board of Directors.
Commercial business lending generally involves greater risk than residential
mortgage lending and risks that are different from those associated with
residential and commercial real estate lending. Real estate lending is
generally considered to be collateral based lending with loan amounts based on
predetermined loan to collateral values, and liquidation of the underlying
real estate collateral is viewed as the primary source of repayment in the
event of borrower default. Although the Company's commercial business loans
are often collateralized by real estate, the decision to grant a commercial
business loan depends primarily on the credit worthiness and cash flow of the
borrower (and any guarantors), while liquidation of collateral is a secondary
source of repayment.
As of December 31, 1998, the Company had $111.8 million, or 38.7% of the
Company's total loans receivable, in commercial business loans. Collateral for
these loans is generally owner occupied business or residential real estate.
The average loan size is approximately $200,000 with loans generally in
amounts of $500,000 or less. The Company generally limits its exposure to any
one borrowing relationship to around $4 million; however, there are a few
lending relationships in excess of $4 million with the largest having
approximately $6.0 million in loan commitments.
Origination and Sales of Loans
The Company originates real estate and other loans with approximately two-
thirds of the residential mortgage volumes generated from its two mortgage
loan origination offices. Walk-in customers and referrals from real estate
brokers are important sources of loan originations.
Consistent with the Company's asset/liability management strategy, the
Company sells a majority of its fixed rate and ARM residential mortgage loans
into the secondary market. 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 the Company is only obligated to
sell the mortgage if the mortgage loan is approved and closed by the Company.
When the Company sells mortgage loans, it typically also sells the servicing
of the loans (i.e., collection of principal and interest payments). The
Company serviced $25.6 million and $18.8 million in loans for others as of
June 30, 1998 and December 31, 1998, respectively. The Company received fee
income of $60,000 and $79,000 for the year ended June 30, 1998 and during the
six months ended December 31, 1998 for these servicing activities.
The following table presents summary information concerning the Company's
origination and sale of residential mortgage loans and the gains achieved on
such activities.
Six Months
Year ended June 30, ended
-------------------------- December 31,
1996 1997 1998 1998
-------- -------- -------- ------------
(Dollars in thousands)
One- to four-family residential
mortgage loans:
Originated...................... $140,232 $104,145 $118,774 $68,434
Sold............................ 119,544 87,003 101,903 57,490
Gains on sales of loans, net...... $ 3,049 $ 2,006 $ 2,406 $ 1,297
7
The Company has a minimal amount of purchased loans and loan participations.
Commitments and Contingent Liabilities
In the ordinary course of business, the Company enters into various types of
transactions that include commitments to extend credit that are not included
in the Consolidated Financial Statements. The Company applies the same credit
standards to these commitments as it uses in all its lending activities and
has included these commitments in its lending risk evaluations. The Company's
exposure to credit loss under commitments to extend credit is represented by
the amount of these commitments. At December 31, 1998, the Company had
outstanding commitments to extend credit, including letters of credit, in the
amount of $44.7 million.
Delinquencies and Nonperforming Assets
Delinquency Procedures. When a borrower fails to make a required payment on
a loan, the Company attempts to cause the delinquency to be cured by
contacting the borrower. In the case of loans other than commercial business
loans, a late notice is sent 15 days after the due date. If the delinquency is
not cured by the 30th day, a second notice is mailed and, if appropriate, the
borrower is contacted by telephone. Additional written and verbal contacts are
made with the borrower between 60 and 90 days after the due date.
In the event 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 circumstances of the borrower. Based upon
the results of its review, the Company may negotiate and accept a repayment
program with the borrower, accept a voluntary deed in lieu of foreclosure or,
when deemed necessary, initiate foreclosure proceedings. If foreclosed on,
real property is sold at a public sale and the Company may bid on the property
to protect its interest. A decision as to whether and when to initiate
foreclosure proceedings is made by the loan committee and 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 curing the
delinquency.
Real estate acquired by the Company by deed in lieu of foreclosure is
classified as real estate owned ("REO") 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 write-down
resulting therefrom 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.
The Company considers loans as in-substance foreclosed if the borrower has
little or no equity in the property based upon its estimated fair value, if
repayment can be expected only to come from operation or sale of the
collateral, and if the borrower has effectively abandoned control of the
collateral or has continued to retain control of the collateral but because of
the borrower's current financial status, it is doubtful that the borrower will
be able to repay the loan in the foreseeable future.
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, the Company may negotiate and accept a modified payment program or take
such other actions as the circumstances warrant.
Classification of Assets. Federal regulations require that the Banks
classify assets on a regular basis. In addition, in connection with
examinations of each Bank, the Division and FDIC examiners have authority to
identify problem assets and, if appropriate, require them to be classified.
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
8
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, and there is a high possibility of loss. An asset classified as
Loss is considered uncollectible and of such little value that continuance as
an asset of the institution is not warranted. Assets classified as Substandard
or Doubtful require the institution to establish prudent general allowances
for loan losses. If an asset or portion thereof is classified as Loss, the
institution must charge off such amount. The most recent examinations by the
Division were performed in September 1997 on North Pacific Bank and in March
1998 on Heritage Bank. The regulators' assessment of the Banks' classified
assets is consistent with the Banks' internal classifications.
Nonperforming Assets. Nonperforming assets consist of nonaccrual loans and
restructured loans and real estate owned. The following table sets forth at
the dates indicated information with respect to nonaccrual loans, restructured
loans and real estate owned of the Company.
June 30,
--------------------------------- December 31,
1995 1996 1997 1998 1998
------- ------- ------- ------ ------------
(Dollars in thousands)
Nonaccrual loans.............. $ 96 $ 51 $ 133 $ 369 $ 392
Restructured loans............ -- -- -- -- --
------- ------- ------- ------ ------
Total nonperforming loans... 96 51 133 369 392
Real estate owned............. -- -- -- 82 --
------- ------- ------- ------ ------
Total nonperforming assets.. $ 96 $ 51 $ 133 $ 451 $ 392
------- ------- ------- ------ ------
Accruing loans past due 90
days or more................. $ -- $ -- $ -- $ 15 $ 8
Potential problem loans....... 3,718 1,613 68 1,069 212
Allowance for loan losses..... 1,720 1,873 2,752 3,542 3,550
Nonperforming loans to loans.. 0.06% 0.03% 0.06% 0.13% 0.14%
Allowance for loan losses to
loans........................ 1.09% 1.11% 1.32% 1.28% 1.23%
Allowance for loan losses to
nonperforming loans.......... 1791.67% 3672.55% 2069.17% 959.89% 905.61%
Nonperforming assets to total
assets....................... 0.05% 0.02% 0.05% 0.11% 0.10%
Nonaccrual Loans. The Company's financial statements are prepared on the
accrual basis of accounting, including the recognition of interest income on
its loan portfolio, unless a loan is placed on a nonaccrual basis. Loans are
considered to be impaired and are placed on nonaccrual status when there are
serious doubts about the collectibility of principal or interest. The
Company's policy is to place a loan on nonaccrual status when the loan becomes
past due for 90 days or more. Amounts received on nonaccrual loans generally
are applied first to principal and then to interest only after all principal
has been collected.
Interest on nonaccrual loans foregone (recovered) was $0, $990, $5,431, and
$(21,613) for the years ended June 30, 1996, 1997, and 1998 and for the six
months ended December 31, 1998, respectively.
Analysis of Allowance for Loan Losses
The allowance for loan losses is maintained at a level considered adequate
by management to provide for reasonably foreseeable loan losses based on
management's assessment of various factors affecting the loan portfolio,
including a review of problem loans, business conditions and loss experience
and an overall evaluation of the quality of the underlying collateral, holding
and disposal costs and costs of capital. The allowance is increased by
provisions for loan losses charged to operations and reduced by loans charged
off, net of recoveries.
Over the past two years, the Company has increased its allowance for loan
losses during a period of loan growth and change in loan portfolio
composition. While the Company's loan portfolio, and in particular commercial
loans, have grown substantially over the past three years, the Company's asset
quality has remained
9
very solid as demonstrated by the low charge-offs and the low nonperforming
assets to total assets ratio during that period. In the six months ended
December 31, 1998, the Company experienced net charge offs of $172,000, most
of which were related to loans originated and classified by North Pacific Bank
prior to the Company's acquisition of North Pacific Bank in June 1998. Because
commercial business lending generally involves greater risk than those
associated with residential and commercial real estate lending, the Company
has increased the portion of its general allowance for loan losses allocated
to its commercial loans over the past three years.
While management believes that it uses the best information available to
determine the allowance for loan losses, unforeseen market conditions could
result in adjustments to the allowance for loan losses, and net income could
be significantly affected, if circumstances differ substantially from the
assumptions used in determining the allowance.
The following table sets forth for the periods indicated information
regarding changes in the Company's allowance for loan losses:
Six Months
Year Ended June 30, Ended
-------------------------------------- December 31,
1995 1996 1997 1998 1998
-------- -------- -------- -------- ------------
(Dollars in thousands)
Total loans outstanding at
end of period(1)......... $158,190 $168,903 $208,192 $275,766 $288,743
-------- -------- -------- -------- --------
Average loans outstanding
during period............ $144,266 $161,501 $184,617 $213,161 $284,376
-------- -------- -------- -------- --------
Allowance balance at
beginning of period...... $ 1,705 $ 1,720 $ 1,873 $ 2,752 $ 3,542
Provision for loan
losses................... -- -- (270) 120 180
Acquired with North
Pacific Bank............. -- -- -- 670 --
Charge-offs:
Real estate(2).......... -- -- -- -- (36)
Commercial.............. -- -- (3) -- (145)
Consumer................ -- -- -- -- --
-------- -------- -------- -------- --------
Total charge-offs..... -- -- (3) -- (181)
-------- -------- -------- -------- --------
Recoveries:
Real estate(2).......... 15 153 1,152 -- --
Commercial.............. -- -- -- -- 9
Consumer................ -- -- -- -- --
-------- -------- -------- -------- --------
Total recoveries...... 15 153 1,152 -- 9
-------- -------- -------- -------- --------
Net (charge-offs)
recoveries......... 15 153 1,149 -- (172)
-------- -------- -------- -------- --------
Allowance balance at end
of period................ $ 1,720 $ 1,873 $ 2,752 $ 3,542 $ 3,550
======== ======== ======== ======== ========
Ratio of net (charge-offs)
recoveries during
period to average loans
outstanding.............. 0.01% 0.09% 0.62% 0.00% (0.06%)
======== ======== ======== ======== ========
- --------
(1) Includes loans held for sale
(2) During the periods shown, all of the charge-offs and recoveries shown
under the Real Estate category relate to real estate mortgages. None of
the above activity related to real estate construction loans.
10
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 ratios of loan losses for the Company and
industry wide and other factors which may affect future loan losses in the
categories shown below:
At June 30, At
--------------------------------------------------------------- December 31,
1995 1996 1997 1998 1998
--------------- --------------- --------------- --------------- ---------------
% of % of % of % of % of
Total Total Total Total Total
Amount Loans(1) Amount Loans(1) Amount Loans(1) Amount Loans(1) Amount Loans(1)
------ -------- ------ -------- ------ -------- ------ -------- ------ --------
(Dollars in thousands)
Balance applicable to:
Commercial.............. $ 200 6.3% $ 446 10.8% $1,094 18.8% $2,044 36.3% $2,496 38.7%
Real estate mortgages:
One- to four-family
residential........... 115 57.1 110 54.8 128 49.4 124 35.2 115 32.0
Five or more family
residential and
commercial
properties............ 1,136 24.2 959 25.0 748 24.5 524 20.6 509 19.1
Real estate
construction:
One- to four-family
residential........... 182 10.4 239 8.5 197 6.1 201 6.6 117 8.6
Five or more family
residential and
commercial
properties............ 29 0.9 12 0.2 31 0.5 10 0.2 16 0.7
Consumer................ 10 1.1 3 0.7 7 0.7 38 1.1 40 0.9
Unallocated............. 48 103 546 601 257
------ ----- ------ ----- ------ ----- ------ ----- ------ -----
Total.................. $1,720 100.0% $1,873 100.0% $2,752 100.0% $3,542 100.0% $3,550 100.0%
====== ===== ====== ===== ====== ===== ====== ===== ====== =====
- --------
(1) Represents the total of all outstanding loans in each category as a
percent of total loans outstanding.
Investment Activities
At December 31, 1998, the investment securities portfolio totaled $38.9
million, consisting of $25.8 million of securities available for sale and
$13.1 million of securities held to maturity. This compares with a total
portfolio of $38.8 million at June 30, 1998, comprised of $9.0 million of
securities available for sale and $29.7 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 tables below.
The investment policies of the Company are established by the Boards of
Directors and monitored by the Audit and Finance Committee. They are designed
primarily to provide and maintain liquidity, to generate a favorable return on
investments without incurring undue interest rate and credit risk, and to
compliment the Bank's lending activities. These policies dictate the criteria
for classifying securities as either available for sale or held for
investment. The policies permit investment in various types of liquid assets
permissible under applicable regulations, which include U.S. Treasury
obligations, U.S. Government agency obligations, certain certificates of
deposit of insured banks, mortgage backed and mortgage related securities,
certain corporate notes, municipal bonds, FHLB stock and federal funds.
Investment in non-investment grade bonds is not permitted under the policies.
11
The following table summarizes the amortized cost, gross unrealized gains
and losses and the resulting fair value of securities available for sale:
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
--------- ---------- ---------- -------
(DOLLARS IN THOUSANDS)
June 30, 1998
U.S. Government and its
agencies........................ $ 8,022 $ 6 $-- $ 8,028
Corporate notes.................. 1,013 -- -- 1,013
------- ---- ---- -------
Totals......................... $ 9,035 $ 6 $-- $ 9,041
======= ==== ==== =======
December 31, 1998
U.S. Government and its
agencies........................ $21,093 $ 56 $(47) $21,102
Collateralized mortgage
obligations..................... 2,690 (10) 2,680
Corporate notes and other........ 2,001 9 2,010
------- ---- ---- -------
Totals......................... $25,784 $ 65 $(57) $25,792
======= ==== ==== =======
The Company had no securities available for sale at June 30, 1997. The
Company had no securities available for trading at June 30, 1997 and 1998 and
at December 31, 1998.
The following table sets forth certain information regarding the carrying
value, weighted average yields and maturities or periods to repricing of the
Company's investment securities available for sale at December 31, 1998.
AT DECEMBER 31, 1998
------------------------
WEIGHTED
BOOK FAIR AVERAGE
VALUE VALUE YIELD
------- ------- --------
(DOLLARS IN THOUSANDS)
Obligations of US Government agencies:
Due within one year............................... 3,993 4,028 6.08%
Due after 1 year but within 5 years............... 17,100 17,074 5.42
------- -------
21,093 21,102
------- -------
Corporate notes and other investments:
Due after 1 year but within 5 years............... 501 510 6.73
Due after 5 years but within 10 years............. 500 500 6.29
Due after 10 years................................ 1,000 1,000 5.42
------- -------
2,001 2,010
------- -------
Collateralized mortgage obligations.................
Due after 10 years................................ 2,690 2,680 5.64
------- -------
Total all investments available for sale............ $25,784 $25,792
======= =======
12
The following table summarizes the amortized cost, gross unrealized gains
and losses and the resulting fair value of investment securities held to
maturity:
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
--------- ---------- ---------- -------
(DOLLARS IN THOUSANDS)
June 30, 1998:
U.S. Government and its agencies.............. $22,996 $ 5 $(22) $22,979
Mortgage backed securities.................... 3,844 247 (8) 4,083
Municipal bonds............................... 2,891 25 (3) 2,913
------- ---- ---- -------
Total held for investment................. 29,731 277 (33) 29,975
======= ==== ==== =======
December 31, 1998:
U.S. Government and its agencies.............. 7,348 10 (3) 7,355
Mortgage backed securities.................... 3,262 86 -- 3,348
Municipal bonds............................... 2,539 76 -- 2,615
------- ---- ---- -------
Total held for investment................. $13,149 $172 $ (3) $13,318
======= ==== ==== =======
The following table sets forth certain information regarding the carrying
value, weighted average yields and maturities or periods to repricing of the
Company's investment securities held to maturity at December 31, 1998.
AT DECEMBER 31, 1998
------------------------
WEIGHTED
BOOK FAIR AVERAGE
VALUE VALUE YIELD(1)
------- ------- --------
(DOLLARS IN THOUSANDS)
Obligations of US Government agencies:
Due within one year............................... 1,700 1,698 5.41%
Due after 1 year but within 5 years............... 5,648 5,657 5.95
------- -------
7,348 7,355
------- -------
Municipal bonds
Due within one year............................... 392 398 7.55
Due after 1 year but within 5 years............... 1,047 1,074 6.76
Due after 5 years but within 10 years............. 1,100 1,143 6.49
------- -------
2,539 2,615
------- -------
Mortgage backed securities
Due after 1 year but within 5 years............... 36 36 7.63
Due after 5 years but within 10 years............. 159 161 8.25
Due after 10 years................................ 3,067 3,151 8.33
------- -------
3,262 3,348
------- -------
Total all investments held to maturity.......... $13,149 $13,318
======= =======
- --------
(1) Tax equivalent weighted average yield.
The Company held $2.1 million of FHLB stock at December 31, 1998. 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, 1998, the Company was
required to maintain an investment in the stock of FHLB of Seattle of at least
$1.4 million.
13
Deposit Activities and Other Sources of Funds
General. The Company's primary sources of funds are customer deposits and
loan repayments. Scheduled loan repayments are a relatively stable source of
funds, while deposit inflows and outflows and unscheduled loan prepayments,
which are influenced significantly by general interest rate levels, interest
rates available on other investments, competition, economic condition and
other factors, are not. Although the Company's deposit balances have been
increasing, such balances have been influenced in the past by adverse changes
in the thrift industry and may be affected by such developments in the future.
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 to match the maturity of repricing intervals
of assets.
Deposit Activities. The Company offers a variety of accounts for depositors
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, 1998, the Company had no brokered
deposits. The more significant deposit accounts offered by the Company are
described below.
Certificates of Deposit. The Company offers several types of CDs with
maturities ranging from 30 days to five years and which require a minimum
deposit of $100. In addition, the Company offers a CD that has a maturity of
four to 11 months and a minimum deposit of $2,500 and permits additional
deposits at the initial rate throughout the certificate term. Interest is
credited quarterly or at maturity. Finally, jumbo CDs are offered in amounts
of $100,000 or more for terms of 30 days to 12 months. The jumbo CDs pay
simple interest and are credited either quarterly or at maturity.
Regular Savings Accounts. The Company offers 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 contributions of up to $2,000
per year 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 sets forth for the periods indicated
the average balances outstanding and the weighted average interest rates for
each major category of deposits:
Year Ended June 30
-------------------------------------------------------- Six Months Ended
1996 1997 1998 December 31, 1998
------------------ ------------------ ------------------ ------------------
Average Average Average Average
Average Rate Average Rate Average Rate Average Rate
Balance(1) Paid Balance(1) Paid Balance(1) Paid Balance(1) Paid
---------- ------- ---------- ------- ---------- ------- ---------- -------
(Dollars in thousands)
Interest bearing demand
and money market
accounts............... $ 36,930 3.15% $ 42,271 3.18% $ 50,156 3.14% $ 71,484 2.72%
Savings................. 28,407 3.63 29,703 3.55 36,033 3.60 57,675 3.55
Certificates of
deposit................ 109,559 5.78 119,133 5.54 130,591 5.55 153,566 5.46
Total interest bearing
deposits.............. 174,895 4.88 191,107 4.71 216,780 4.67 282,725 4.38
Demand and other
noninterest bearing
deposits............... 6,537 -- 7,955 -- 13,140 -- 22,914 --
-------- ---- -------- ---- -------- ---- -------- ----
Total deposits......... $181,432 4.70% $199,063 4.52% $229,920 4.40% $305,639 4.05%
======== ==== ======== ==== ======== ==== ======== ====
- --------
(1) Average balances were calculated using average daily balances.
The following table sets forth for the periods indicated the change in the
balances of deposits during the year and the impact of interest credited
thereon.
Six Months
Year Ended June 30, Ended
-------------------------- December 31,
1996 1997 1998 1998
------- ------- -------- ------------
(Dollars in thousands)
Net increase (decrease) in
deposits......................... $16,322 $18,662 $104,339 $ (5,309)
Less: Interest credited......... (8,528) (8,999) (10,002) (5,393)
------- ------- -------- --------
Net increase (decrease) before
interest credited................ $ 7,794 $ 9,663 $ 94,337 $(10,702)
======= ======= ======== ========
Of the $104.3 million net increase in deposits for the year ended June 30,
1998, $82.4 million resulted from the acquisition of North Pacific Bank, which
was effective June 12, 1998.
The following table shows the amount and maturity of certificates of
deposits of $100,000 or more as of December 31, 1998:
December 31,
1998
------------
(Dollars in
thousands)
Remaining maturity:
Three months or less...................................... $14,139
Over three months through six months...................... 4,902
Over six months through 12 months......................... 6,256
Over twelve months........................................ 990
-------
Total................................................... $26,287
=======
At June 30, 1998 and December 31, 1998 certificates of deposits with
balances of $100,000 or more totaled $23.0 million and $26.3 million,
respectively.
Borrowings. Savings deposits are the primary source of funds for the
Company's lending and investment activities and for its general business
purposes. The Company relies upon advances from the FHLB of Seattle to
15
supplement its supply of lendable funds and to meet deposit withdrawal
requirements. The FHLB of Seattle has served as one of the Company's secondary
sources of liquidity. Advances from the FHLB of Seattle are typically secured
by the Company's first mortgage loans, and stock issued by the FHLB of
Seattle, which is held by the Company.
The FHLB functions as a central reserve bank providing credit for savings
and loan associations and certain other member financial institutions. As a
member, the Bank is required to own capital stock in the FHLB and is
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
generally limits advances to 20.0% of a member's assets, and short term
borrowings of less than one year may not exceed 10.0% of the institution's
assets. The FHLB of Seattle determines specific lines of credit for each
member institution.
The following table is a summary of FHLB advances for the years ended June
30, 1997 and 1998 and the six months ended December 31, 1998:
At or for At or for
the year ended the six
June 30, months ended
------------------ December 31,
1996 1997 1998 1998
----- ------ ---- ------------
(Dollars in thousands)
Balance at period end..................... $ -- $ 890 $698 $687
Average balance during the period......... -- 27 156 693
Maximum amount outstanding at any month
end...................................... -- 1,300 698 696
Average interest rate
During the period....................... -- 5.47% 5.73% 6.20%
At period end........................... -- 6.45% 6.20% 6.20%
The following table is a summary of other borrowed funds for the year ended
June 30, 1998 and the six months ended December 31, 1998. There were no other
borrowed funds outstanding during the years ended June 30, 1996 and 1997.
At or for
At or for the six months
the year ended ended December
June 30, 1998 31,
-------------- --------------
(Dollars in thousands)
Securities sold under agreements to
repurchase:
Balance at period end..................... $610 $ --
Average balance during the period......... 21 320
Maximum amount outstanding at any month
end...................................... 610 483
Average interest rate
During the period....................... 3.25% 3.25%
At period end........................... 3.25% --
Subordinated debentures:
Balance at period end..................... $500 $ --
Average balance during the period......... 25 500
Maximum amount outstanding at any month
end...................................... 500 500
Average interest rate
During the period....................... 7.64% 7.64%
At period end........................... 7.64% --
16
Supervision and Regulation
The Company and the Bank 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 shareholders
of the Company. The laws and regulations affecting banks and bank holding
companies have changed significantly over recent years, and there is reason 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 the business, operations and prospects of the Company. The Company is
unable to predict the nature or the extent of the effects on its 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 herein.
The Company. The Company is subject to regulation as a bank holding company
within the meaning of the Bank Holding Company Act of 1956, as amended, (the
"BHCA"). As such, the Company is 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 BHCA or orders or
regulations thereunder in amounts up to $1.0 million per day or order
termination of non-banking activities of non-banking subsidiaries of bank
holding companies, and to order termination of ownership and control of a non-
banking subsidiary by a bank holding company. Certain violations may also
result in criminal penalties. The FDIC is authorized to exercise comparable
authority under the Federal Deposit Insurance Act and other statutes with
respect to state nonmember banks such as the Banks.
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, it is the Board's position that in serving as a source of
strength to its subsidiary banks, bank holding companies should be 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 obligations to serve as a source of strength to its subsidiary
banks will generally be considered by the Board to be an unsafe and unsound
banking practice or a violation of the Board's regulations or both. The
Federal Deposit Insurance Act requires an undercapitalized institution to
submit to the Federal Reserve a capital restoration plan with a guarantee by
each company having control of the bank's compliance with the plan.
The BHCA prohibits a bank holding company, with certain exceptions, from
acquiring direct or indirect ownership or control of any company which is not
a bank or from engaging in any activities other than those of banking,
managing or controlling banks and certain other subsidiaries, or furnishing
services to or performing services for its subsidiaries. One principal
exception to these prohibitions allows a bank holding company to acquire an
interest in companies whose activities are found by the Federal Reserve, by
order or by regulation, to be so closely related to banking or managing or
controlling banks as to be a proper incident thereto. The Company must obtain
the approval of the Federal Reserve before it acquires all, or substantially
all, of any bank, or ownership or control of more than 5% of the voting shares
of a bank.
The Company is required under the BHCA to file an annual report and periodic
reports with the Federal Reserve and such additional information as the
Federal Reserve may require pursuant to the BHCA. The Federal Reserve may
examine a bank holding company and any of its subsidiaries and charge the
company for the cost of such an examination.
17
The Company and any subsidiaries which it may control are deemed
"affiliates' within the meaning of the Federal Reserve Act, and transactions
between bank subsidiaries of the company and its affiliates are subject to
certain restrictions. With certain exceptions, the Company and its
subsidiaries are prohibited from tying the provision of certain services, such
as extensions of credit, to other services offered by the Company or its
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-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 shareholders'
equity (which does not include unrealized gains and losses on securities),
less goodwill and certain identifiable intangible assets, while Tier II
capital includes the allowance for loan losses and subordinated debt, both
subject to certain 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%.
Bank. Heritage Bank is a Washington state-chartered savings bank, the
deposits of which are insured by the FDIC. The Bank is subject to regulation
by the FDIC and the Washington Department of Financial Institutions (the
"Division"). Although the Bank is not a member of the Federal Reserve System,
the Federal Reserve supervisory authority over the Company may also affect the
Bank.
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 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 Bank is required to file periodic reports with the FDIC and the Division
and is subject to periodic examinations and evaluations by those regulatory
authorities. Based upon such an evaluation, 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 certain 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 a subsidiary of a bank holding company, the Bank is subject to certain
restrictions in their dealings with the Company and with other companies that
may become affiliated with the Company.
In addition to earnings on the portion of net stock offering proceeds
retained by the Company, dividends paid by the Bank will provide substantially
all of the Company's cash flow. Applicable federal and Washington state
regulations restrict capital distributions by institutions such as the Bank,
including dividends. Such restrictions are tied to the institution's capital
levels after giving effect to such distributions. The FDIC has established the
qualifications necessary to be classified as a "well-capitalized" bank,
primarily for assignment of FDIC risk-based insurance premium rates beginning
in 1993. 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%. The Bank qualified as
"well-capitalized" at December 31, 1998.
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 such deposits.
Adequately capitalized institutions are allowed to solicit such 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. Included in this legislation have been
the FIRREA and the Federal Deposit Insurance Corporation
18
Improvement Act of 1991 ("FDICIA"). FIRREA, among other thing, (i) created two
deposit insurance funds administered by the FDIC, the Bank Insurance Fund
("BIF") and the SAIF; (ii) permitted commercial banks that meet certain
housing-related asset requirements to secure advances and other financial
services from local FHLBs; (iii) restructured the federal regulatory agencies
for savings associations; and (iv) greatly enhanced the regulators enforcement
powers over financial institutions and their affiliates.
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, (i) a new method
for calculating deposit insurance premiums based on risk, (ii) restrictions on
acceptance of brokered deposits except by well-capitalized institutions, (iii)
additional limitations on loans to executive officers and directors of banks,
(iv) the employment of interest rate risk in the calculation of risk-based
capital, (v) safety and soundness standards that take into consideration,
among other things, management, operations, asset quality, earnings and
compensation, (vi) 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 (vii) 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. Such banks, or their holding companies,
are also required to establish audit committees consisting of directors who
are independent of management.
Also, 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 to open branches nationwide.
The Interstate Banking Act 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".
In addition, 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 (i) authorize such transactions at an earlier date or (ii) 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.
Further effects on the Company and the Banks may result from the Riegle
Community Development and Regulatory Improvement Act of 1994 (the "Community
Development Act"). The Community Development Act (i) establishes and funds
institutions that are focused on investing in economically distressed areas
and (ii) streamlines the procedures for certain transactions by financial
institutions with federal banking agencies.
Among other things, the Community Development Act requires the federal
banking agencies to (i) consider the burdens that are imposed on financial
institutions when new regulations are issued or new compliance
19
burdens are created and (ii) coordinate their examinations of financial
institutions when more than one agency is involved. The Community Development
Act also streamlines the procedures for forming certain one-bank holding
companies and engaging in authorized non-banking activities.
The Bank's deposit accounts are insured by the FDIC, primarily under the
SAIF (and under the BIF for deposits acquired through North Pacific Bank) to
the maximum extent permitted by law. The 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 connection
therewith, 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 the 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
obligations issued by the Financing Corporation ("FICO") in the 1980s to help
fund the thrift industry cleanup. BIF-assessable deposits will be charged an
assessment to help pay interest on the FICO 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 provide 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 recent Act contemplates the development of a common charter
for all federally chartered depository institutions and the abolition of
separate charters for national banks and federal savings associations. It is
not known what form the common charter may take and what effect, if any, the
adoption of a new charter would have on the operation of the Bank.
In addition to the changes to the BIF and SAIF assessment rates implemented
by the recent legislation, various regulatory relief provisions were enacted.
The new legislation, among other things, (i) changes the Truth in Lending Act
and the Real Estate Settlement Procedures Act to coordinate and simplify the
two laws' disclosure requirements; (ii) eliminates civil liability for
violations of the Truth in Savings Act after five years; (iii) streamlines the
application process for a number of bank holding company and bank
applications; (iv) establishes a privilege from discovery in any civil or
administrative proceeding or bank examination for any fair lending self-test
results conducted by, or on behalf of, a financial institution in certain
circumstances; (v) repeals the FDICIA requirement that independent public
accountants attest to compliance with designated safety and soundness
regulations; (vi) imposes a continuous regulatory review of regulations to
identify and eliminate outdated and unnecessary rules; and (vii) includes
various other miscellaneous provisions to reduce bank regulatory burden.
The Company is also subject to the information, proxy solicitation, insider
trading restrictions and other requirements of the Securities Exchange Act of
1934.
Competition
The Company competes 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 these
competitors have substantially
20
greater resources than the Company. Particularly in times of high interest
rates, the Company also faces significant competition for investors' funds
from short term money market securities and other corporate and government
securities.
The Company competes for loans principally through the range and quality of
the services it provides, interest rates and loan fees, and the locations of
its Banks' branches. The Company actively solicits deposit-related clients and
competes for deposits by offering depositors a variety of savings accounts,
checking accounts and other services.
Employees
At December 31, 1998, the Company had 191 full-time equivalent employees.
The Company believes that employees play a vital role in the success of a
service company. None of the Company's employees are covered by a collective
bargaining agreement with the Company and management believes that they have a
good relationship with the employees.
ITEM 2. PROPERTIES
The Company's 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, 1998, the 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).
ITEM 3. LEGAL PROCEEDINGS
The Company and the Banks have certain litigation and negotiations in
progress resulting from activities arising from normal operations. In
management's opinion, none of these matters is likely to have a material
adverse effect on the financial position or results of operations of the
Company.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
At the Company's Annual Meeting of Stockholders held on October 15, 1998,
the directors nominated for election as described in the Proxy Statement (John
A. Clees, James P. Senna and Peter K. Wallerich) were elected to serve as
members of the Company's Board of Directors until the Annual Meeting of
Stockholders in 2001 by a vote of 8,268,863 in favor and 197,156 votes in
opposition. Directors Donald V. Rhodes, Daryl D. Jensen and H. Edward Odegard
will continue in office until the 1999 Annual Meeting. Directors Lynn M.
Brunton and Philip S. Weigand will continue in office until the 2000 Annual
Meeting.
In addition, the 1998 Stock Option and Restricted Stock Award Plan as
described in the Proxy Statements was voted on at this meeting. The 1998 Stock
Option and Restricted Award Plan provides for the grant of stock options and
stock awards for up to 461,125 shares. The Plan was approved by a vote of
7,690,183 in favor, 647,026 votes in opposition and 128,810 votes abstained.
On October 15, 1998, the Company's Board voted to change the Company's
fiscal year from June 30 to the calendar year ending December 31 effective on
January 1, 1999. The Proxy Statement for the October 15, 1998 annual meeting
of the Company's shareholders indicated that shareholder proposals for the
1999 annual meeting would be due by May 1, 1999. Since the Company's fiscal
year has changed, the Board determined to conduct the Company's 1999 annual
meeting on April 27, 1999---earlier than the originally anticipated October,
1999 annual meeting date. The Board will receive shareholder proposals for
review and, if appropriate, presentation at the April 27, 1999 annual meeting
by April 17, 1999.
21
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
The Company's common stock is traded on the NASDAQ National Market under the
symbol HFWA. At December 31, 1998, the Company had approximately 1,412
stockholders of record (not including the number of persons or entities
holding stock in nominee or street name through various brokerage firms) and
9,793,145 outstanding shares of common stock. The last reported sales price on
March 22, 1999 was $8.75 per share. The following table sets forth for the
quarters indicated the range of high and low bid information per share of the
common stock of the Company as reported on the NASDAQ National Market.
Quarter ended:
----------------------------------------
June
March 31 30 September 30 December 31
-------- ------ ------------ -----------
High.............................. $15.50 $16.06 $15.00 $12.38
Low............................... $12.63 $13.50 $ 8.88 $ 9.13
Since its stock offering in January 1998, the Company has 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
Dividends from the Company depend, in part, upon earnings from the
investment of the net proceeds from the Conversion retained by the Company and
receipt of dividends from its subsidiary bank. The FDIC and the Division have
the authority under their supervisory powers to prohibit the payment of
dividends by the Bank to the Company. For a period of ten years after the
Conversion, the Bank may not, without prior approval of the Division, declare
or pay a cash dividend in an amount in excess of one-half of (i) the greater
of the Bank's net income for the current fiscal year or (ii) the average of
the Bank's net income for the current fiscal year and not more than two of the
immediately preceding fiscal years. In addition, the Bank may not declare or
pay a cash dividend on its common stock if the effect thereof would be to
reduce the Bank's net worth below the amount required for the liquidation
account. Other than the specific restrictions mentioned above, current
regulations allow the Company and its subsidiary bank to pay dividends on
their common stock if the Company's or Bank's regulatory capital would not be
reduced below the statutory capital requirements set by the Federal Reserve
and the FDIC.
22
ITEM 6. SELECTED FINANCIAL DATA
For the six
months
For the year ended June 30, ended
------------------------------------------------ December 31,
1994 1995 1996 1997 1998 1998
-------- -------- -------- -------- -------- ------------
(Dollars in thousands, except per share data)
Operations Data:
Net interest income..... $ 6,788 $ 8,227 $ 8,332 $ 9,512 $ 13,013 $ 9,412
Provision for loan
losses................. -- -- -- (270) 120 180
Noninterest income...... 4,019 3,040 4,298 3,347 3,791 2,439
Noninterest expense..... 7,421 7,425 8,422 11,105 11,093 8,629
Provision (benefit) for
income taxes........... 1,154 1,308 1,435 (245) 1,963 1,118
Net income.............. 2,232 2,534 2,773 2,269 3,628 1,924
Earnings per share (1)
Basic................. NA 0.27 0.30 0.24 0.38 0.20
Diluted............... NA 0.27 0.30 0.24 0.37 0.19
Dividend payout ratio
(2).................... NM NM NM NM 19.74% 47.50%
Performance Ratios:
Net interest spread..... 3.45% 4.14% 3.84% 4.06% 3.87% 4.03%
Net interest margin
(3).................... 3.83 4.57 4.31 4.50 4.80 5.07
Efficiency ratio (4).... 68.67 65.90 66.68 77.89 66.01 66.50
Return on average
assets................. 1.18 1.30 1.31 0.99 1.24 0.94
Return on average
equity................. 13.05 11.67 11.38 8.62 6.15 4.06
At June 30,
------------------------------------------------ At
1994 1995 1996 1997 1998 December 31,
-------- -------- -------- -------- -------- ------------
Balance Sheet Data:
Total assets............ $197,102 $204,897 $222,052 $242,164 $415,851 $411,983
Loans receivable, net... 123,258 150,526 161,744 199,188 265,813 277,575
Loans held for sale..... 4,110 5,944 5,286 6,323 6,411 7,618
Deposits................ 165,922 174,797 191,119 209,781 314,120 308,811
Federal Home Loan Bank
advances............... -- -- -- 890 698 687
Other borrowings........ 4,100 3,252 -- -- 1,132 17
Stockholders' equity.... 20,662 23,065 25,633 27,714 93,887 95,433
Book value per share.... NM NM NM NM $ 9.72 $ 9.74
Equity to assets ratio.. 11.64% 11.26% 11.54% 11.44% 22.57% 23.16%
Asset Quality Ratios:
Nonperforming loans to
loans.................. 0.07% 0.06% 0.03% 0.06% 0.13% 0.14%
Allowance for loan
losses to loans........ 1.32 1.09 1.11 1.32 1.28 1.23
Allowance for loan
losses to nonperforming
loans.................. 1,776.04 1,791.67 3,672.55 2,069.17 959.89 905.61
Nonperforming assets to
total assets........... 0.05 0.05 .0.2 0.05 0.11 0.10
Other Data:
Number of banking
offices................ 5 7 8 10 12 12
Number of full-time
equivalent
employees.............. 119 116 136 145 192 191
- --------
(1) The Bank became a stock-owned company as of January 31, 1994. Per share
data prior to 1995 is not applicable.
(2) Dividend payout ratio is declared per share divided by earnings per share.
Cash dividends prior to 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.
(3) Net interest margin is net interest income divided by average interest
earning assets.
(4) The efficiency ratio is recurring noninterest expense divided by the sum
of net interest income and noninterest income, excluding nonrecurring
items. The Bank paid a one-time assessment of $ 1.09 million to the Savings
Association Insurance Fund in November 1996. This amount was excluded from
the calculation of the efficiency ratio for 1997.
23
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 in conjunction with the December 31,
1998 audited consolidated financial statements and notes thereto included in
this Form 10-K.
Statements concerning future performance, development or events, concerning
expectations for growth and market forecasts, and any other guidance on future
periods, constitute forward-looking statements and 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 condition. Additional information on these and other factors
which could affect the Company's financial results are included in filings by
the Company with the Securities and Exchange Commission.
General
In fiscal 1994, the Company began to implement a growth strategy intended to
broaden its products and services from traditional thrift offerings to those
more closely related to commercial banking. That strategy entails (1)
geographic and product expansion, (2) loan portfolio diversification, (3)
development of relationship banking, and (4) maintenance of asset quality. The
Company has incurred substantial expenses as it carried out its growth
strategy. Those expenses have been concentrated in (i) personnel hired in
anticipation of growth and expanded market share; (ii) maintaining the
mortgage origination capacity during times of fluctuating mortgage origination
volumes; (iii) facilities expansion and (iv) upgrading data processing
capabilities. These expenditures had a negative impact on the Company's
earnings in fiscal 1997, fiscal 1998 and for the six months ended December 31,
1998. Management believes these investments will have a positive impact on
earnings into 1999.
In fiscal 1998, the Company's growth strategy was further bolstered by two
significant events: (1) the January 1998 stock offering and conversion and (2)
its acquisition of North Pacific Bancorporation. Through the January 1998
stock offering, the Company raised $63.0 million in net new capital which has,
and will continue to, enhance its ability to implement its growth strategy.
Using $17.5 million of the net proceeds of the stock offering, the Company
completed its 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. This acquisition of North Pacific Bank
provided further geographical expansion into the Pierce County market area and
enhanced expertise in commercial banking. This is demonstrated by the
substantial shift in loan portfolio composition as commercial loans increased
to $111.8 million, or 38.7% of total loans, as of December 31, 1998 from
$39.4 million, or 18.9% of total loans, as of June 30, 1997. While this
acquisition had a significant impact on the Company's growth and financial
condition at June 30, 1998, North Pacific Bank's operations had a minimal
impact on the Company's earnings for the year ended June 30, 1998 due to the
timing of the closing of the transaction on June 12, 1998. During the six
months ended December 31, 1998, management 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. Management invested $1.1 million in item processing hardware and
software and facilities which became operational in December 1998.
Net Interest Income
The Company's profitability depends primarily on its net interest income,
which is the difference between the income it receives on its loan and
investment portfolios and its cost of funds, which consists of interest paid
on deposits and borrowed funds. Like most financial institutions, the
Company's interest income and cost of funds are affected significantly by
general economic conditions, particularly changes in market interest rates and
by government policies.
24
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.
The following tables set forth for the periods indicated information for the
Company with respect to average balances of assets and liabilities, as well as
the total dollar amounts of interest income from interest earning assets and
interest expense on interest bearing liabilities, resultant yields or costs,
net interest income, net interest spread, net interest margin and the ratio of
average interest earning assets to average interest bearing liabilities. 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. The December 31, 1997 and 1998 figures are unaudited.
Six Months Ended December 31,
--------------------------------------------------------
1997 1998
--------------------------- ---------------------------
Interest Interest
Average Earned/ Average Average Earned/ Average
Balance(1) Paid Rate(2) Balance(1) Paid Rate(2)
---------- -------- ------- --------- -------- -------
(Dollars in thousands)
Interest Earning Assets:
Loans................... $207,913 $ 9,599 9.23% $281,050 $13,181 9.38%
Mortgage Backed
Securities............. 4,929 208 8.45 3,593 151 8.42
Investment securities
and FHLB stock......... 9,543 296 6.20 37,906 961 5.07
Interest earning
deposits............... 11,578 327 5.64 48,895 1,353 5.53
-------- ------- ------ -------- ------- ------
Total interest earning
assets................. 233,963 $10,430 8.92% 371,444 $15,646 8.42%
Noninterest earning
assets................. 20,793 37,026
-------- --------
Total assets........... $254,756 $408,470
======== ========
Interest Bearing
Liabilities:
Certificates of
deposit................ $126,546 $ 3,528 5.58% $153,566 $ 4,193 5.46%
Savings accounts........ 35,279 656 3.72 57,675 1,024 3.55
Interest bearing demand
and money market
accounts............... 48,449 784 3.24 71,484 971 2.72
-------- ------- ------ -------- ------- ------
Total interest bearing
deposits............... 210,274 4,968 4.73 282,725 6,188 4.38
FHLB advances........... 243 8 6.22 693 22 6.24
Other borrowed funds.... -- -- 0.00 891 24 5.45
-------- ------- ------ -------- ------- ------
Total interest bearing
liabilities........... 210,517 $ 4,976 4.73% 284,309 $ 6,234 4.39%
Demand and other
noninterest bearing
deposits............... 12,667 22,914
Other noninterest
bearing liabilities.... 3,764 6,602
Stockholders' equity.... 27,808 94,644
-------- --------
Total liabilities and
stockholders' equity.. $254,756 $408,469
======== ========
Net interest income
(2).................... $ 5,454 $ 9,412
Net interest spread
(2).................... 4.19% 4.03%
Net interest margin
(2).................... 4.66% 5.07%
Average interest earning
assets to average
interest bearing
liabilities ........... 111.14% 130.65%
- --------
(1) Calculated using average daily balances
(2) Annualized
25
Year Ended June 30,
-------------------------------------------------------------------------------------
1996 1997 1998
--------------------------- --------------------------- ---------------------------
Interest Interest Interest
Average Earned/ Average Average Earned/ Average Average Earned/ Average
Balance(1) Paid Rate Balance(1) Paid Rate Balance(1) Paid Rate
---------- -------- ------- ---------- -------- ------- ---------- -------- -------
(Dollars in thousands)
Interest Earning Assets:
Loans................... $160,823 $14,894 9.26% $182,791 $16,743 9.16% $216,001 $19,888 9.21%
Mortgage Backed
Securities............. 6,715 552 8.22 5,598 464 8.29 4,603 397 8.63
Investment securities
and FHLB stock......... 15,096 854 5.66 12,360 757 6.12 15,540 889 5.72
Interest earning
deposits............... 10,820 575 5.31 10,414 548 5.26 34,863 1,967 5.64
-------- ------- ------ -------- ------- ------ -------- ------- ------
Total interest earning
assets................. 193,454 $16,875 8.72% 211,163 $18,512 8.77% 271,007 $23,141 8.54%
Noninterest earning
assets................. 18,002 18,974 22,293
-------- -------- --------
Total assets........... $211,456 $230,137 $293,300
======== ======== ========
Interest Bearing
Liabilities:
Certificates of
deposit................ $109,559 $ 6,335 5.78% $119,133 $ 6,599 5.54% $130,591 $ 7,404 5.67%
Savings accounts........ 28,407 1,031 3.63 29,703 1,055 3.55 36,033 1,298 3.60
Interest bearing demand
and money market
accounts............... 36,930 1,162 3.15 42,271 1,345 3.18 50,156 1,413 2.82
-------- ------- ------ -------- ------- ------ -------- ------- ------
Total interest bearing
deposits............... 174,896 8,528 4.88 191,107 8,999 4.71 216,780 10,115 4.67
FHLB advances........... -- -- 27 1 4.99 156 10 6.69
Other borrowed funds.... 171 15 8.77 -- -- -- 46 3 4.61
-------- ------- ------ -------- ------- ------ -------- ------- ------
Total interest bearing
liabilities............ 175,067 $ 8,543 4.88% 191,134 $ 9,000 4.71% 216,982 $10,128 4.67%
Demand and other
noninterest bearing
deposits............... 6,537 7,955 13,140
Other noninterest
bearing liabilities.... 5,489 4,711 4,168
Stockholders' equity.... 24,363 26,337 59,010
-------- -------- --------
Total liabilities and
stockholders' equity.. $211,456 $230,137 $293,300
======== ======== ========
Net interest income..... $ 8,332 $ 9,512 $13,013
Net interest spread..... 3.84% 4.06% 3.87%
Net interest margin..... 4.31% 4.50% 4.80%
Average interest earning
assets to average
interest bearing
liabilities............ 110.51% 110.48% 124.90%
- --------
(1) Calculated using average daily balances
26
The following table sets forth the amounts of the changes in the Company's
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 to changes due to volume and the
changes due to interest rates.
Six Months Ended December 31,
1997 Compared to 1998 Increase
(Decrease) Due to
--------------------------------
Volume Rate Total
---------- -------- ----------
Interest Earning Assets:
Loans....................................... $ 3,371 $ 211 $ 3,582
Mortgage backed securities.................. (56) (1) (57)
Investment securities and FHLB stock........ 879 (214) 665
Interest earning deposits................... 1,052 (26) 1,026
---------- -------- ----------
Total interest income..................... 5,246 (30) 5,216
========== ======== ==========
Interest bearing liabilities:
Certificates of deposit..................... (757) 92 (665)
Savings accounts............................ (417) 49 (368)
Interest bearing demand and money market
accounts................................... (373) 186 (187)
---------- -------- ----------
Total interest bearing deposits........... (1,547) 327 (1,220)
FHLB advances............................... (14) -- (14)
Other borrowed fundings..................... (24) -- (24)
---------- -------- ----------
Total interest bearing liabilities........ (1,585) 327 (1,258)
========== ======== ==========
Year Ended June 30,
-------------------------------------------------------------
1996 Compared to 1997 1997 Compared to 1998
------------------------------ -----------------------------
Increase (Decrease) Due to Increase (Decrease) Due to
------------------------------ -----------------------------
Volume Rate Total Volume Rate Total
--------- -------- --------- --------- ------- ---------
Interest Earning Assets:
Loans................... $ 2,034 $ (185) $ 1,849 $ 3,042 $ 102 $ 3,144
Mortgage backed
securities............. (92) 4 (88) (82) 15 (67)
Investment securities
and FHLB stock......... (155) 58 (97) 195 (63) 132
Interest earning
deposits............... (22) (5) (27) 1,287 133 1,420
--------- -------- --------- --------- ------- ---------
Total interest income.. $ 1,765 $ (128) $ 1,637 $ 4,442 $ 187 $ 4,629
========= ======== ========= ========= ======= =========
Interest bearing
liabilities:
Certificates of
deposit................ $ 554 $ (291) $ 263 $ 635 $ 10 $ 645
Savings accounts........ 47 (22) 25 225 18 243
Interest bearing demand
deposits............... 168 15 183 251 (22) 229
--------- -------- --------- --------- ------- ---------
Total interest on
deposits.............. 769 (298) 471 1,111 6 1,117
FHLB advances........... 1 -- 1 9 -- 9
Other borrowed funds.... (15) -- (15) 2 -- 2
--------- -------- --------- --------- ------- ---------
Total interest
expense............... $ 755 $ (298) $ 457 $ 1,122 $ 6 $ 1,128
========= ======== ========= ========= ======= =========
Financial Condition
The Company's total assets and deposits at December 31, 1998 were $412.0
million and $308.8 million, respectively, which decreased slightly compared to
June 30, 1998 due to the one time withdrawal of approximately $17 million in
temporary funds deposited in June 1998. Excluding the impact of this $17
million
27
withdrawal, total assets and deposits increased 3% and 4%, respectively,
during the six months ended December 31, 1998. Loans increased $13.0 million,
or 5%, to $288.7 million for the six months ended December 31, 1998.
Commercial loans increased to $111.8 million at December 31, 1998 compared
with $100.5 million at June 30, 1998, an increase of 11.2%.
Results of Operations for the Six Month Periods Ended December 31, 1998 and
1997
Net Income. The Company's net income before merger related charges was $2.4
million or $0.24 per diluted share for the six months ended December 31, 1998
as compared to $1.3 million or $0.13 per diluted share for the same period
last year. Including merger related charges of $748,000 on a pre-tax basis,
net income for the six months ended December 31, 1998 was $1.9 million or
$0.19 per diluted share. These nonrecurring charges were related to severance
and other costs associated with the merger and integration of North Pacific
Bank into Heritage Bank in November 1998, costs associated with the formerly
proposed acquisition of Harbor Bancorp which was terminated by mutual
agreement in December 1998, and costs associated with the pending acquisition
of Washington Independent Bancshares, Inc. (WIB). The WIB transaction was
consummated effective March 5, 1999 and will be accounted for as a pooling of
interests.
Net Interest Income. Net interest income increased $4.0 million, or 72.6%,
for the six months ended December 31, 1998 compared with the same period last
year, primarily as a result of a $137.5 million increase in the average
balance of interest earning assets. This growth in interest earning assets was
attributable to $68.9 million in interest earning assets acquired through
North Pacific Bank in June 1998 and the interest earning assets funded by the
$63 million in net proceeds raised in the Company's January 1998 stock
offering. Average loan balances increased $73.1 million, or 35.2%, which was
concentrated in commercial loans.
Net interest income as a percentage of average interest earning assets (net
interest margin) annualized for the six months ended December 31, 1998
increased to 5.07% from 4.66% for the same period last year. The increase was
the result of strong growth in commercial loans which have higher yields and a
lower cost funding mix attributable to the $63 million in net proceeds from
the Company's January 1998 stock offering and the addition of lower cost
deposits acquired with North Pacific Bank. The significant shift in the
Company's funding mix is demonstrated in the Company's ratio of average
interest earning assets to average interest bearing liabilities which
increased to 130.65% for the six months ended December 31, 1998 from 111.14%
for the same period prior year. This ratio indicates that the Company is
funding more of its earning asset growth with noninterest bearing funds
(capital and noninterest bearing deposits). The Company's net interest spread
annualized for the six months ended December 31, 1998 has declined to 4.03%
from 4.19% for the same period last year as a result of the decrease in the
average yield on earning assets to 8.42% for the six months ended December 31,
1998 from 8.92% for the same period last year. Although the average yield on
loans increased to 9.38% for the six months ended December 31, 1998 from 9.23%
for the same period last year due primarily to the growth in commercial loans
with higher yields, the increase in the average balances of investment
securities and interest earning deposits at yields significantly below the
average earning asset yield, as well as the decline in market interest rates,
had the effect of decrea