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EX-32.1 - CEO SECTION 906 CERTIFICATION - FRONTIER FINANCIAL CORP /WA/ex32-1.htm
EX-31.2 - CFO SECTION 302 CERTIFICATION - FRONTIER FINANCIAL CORP /WA/ex31-2.htm
EX-31.1 - CEO SECTION 302 CERTIFICATION - FRONTIER FINANCIAL CORP /WA/ex31-1.htm
EX-32.2 - CFO SECTION 906 CERTIFICATION - FRONTIER FINANCIAL CORP /WA/ex32-2.htm



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

FORM 10-Q
 
                 
 /x/   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended September 30, 2009

OR
                   
   / /     TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from ______ to ______

Commission File Number 000-15540

FRONTIER FINANCIAL CORPORATION
(Exact Name of Registrant as Specified in its Charter)

                                                                                                                
 
   Washington      91-1223535   
    (State or Other Jurisdiction of           (IRS Employer Identification  
   Incorporation or Organization)                Number)  
       
 
332 SW Everett Mall Way
 
P.O. Box 2215
 
Everett, Washington 98213
 
  (Address of Principal Executive Offices)  (Zip Code)
 
(425) 514-0700
 
(Registrant’s Telephone Number, Including Area Code)
 
(Former name, former address and former fiscal year, if changed since last report)
                                                                                                              
 

                                                                                 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.                     Yes [X]     No [  ]

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or such shorter period that the registrant was required to submit and post such files).     Yes [X]     No [  ]


 
 

 


Indicate by a check mark whether the registrant is a large accelerated filer, an accelerated filer, a nonaccelerated filer, or a smaller reporting company. See definition of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Act. (Check one):

Large accelerated filer [  ]                                                      Accelerated filer [X]                                           Nonaccelerated filer [  ]                                           Smaller reporting company [  ]

Indicate by a check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes [  ]     No [X]
 
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
 
    Class             Outstanding at October 30, 2009  
   Common Stock, no par value        47,131,853  
 
                                                       
 
 

 

FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
REPORT ON FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2009
     
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   Signatures     57   




FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
(In thousands, except for number of shares)


   
(Unaudited)
       
   
September 30, 2009
   
December 31, 2008
 
ASSETS
           
Cash and due from banks
  $ 36,921     $ 52,022  
Federal funds sold
    363,081       117,740  
Securities
               
Available for sale, at fair value
    73,834       90,606  
Held to maturity, at amortized cost
    3,079       3,085  
Total securities
    76,913       93,691  
                 
Loans held for resale
    3,464       6,678  
Loans
    3,147,540       3,772,055  
Allowance for loan losses
    (142,229 )     (112,556 )
Net loans
    3,008,775       3,666,177  
                 
Premises and equipment, net
    48,826       51,502  
Intangible assets
    634       794  
Federal Home Loan Bank (FHLB) stock
    19,885       19,885  
Bank owned life insurance
    25,116       24,321  
Other real estate owned
    101,805       10,803  
Other assets
    90,153       67,510  
Total assets
  $ 3,772,109     $ 4,104,445  
                 
LIABILITIES
               
Deposits
               
Noninterest bearing
  $ 403,534     $ 395,451  
Interest bearing
    2,822,087       2,879,714  
Total deposits
    3,225,621       3,275,165  
Federal funds purchased and
               
securities sold under repurchase agreements
    15,584       21,616  
Federal Home Loan Bank advances
    375,752       429,417  
Junior subordinated debentures
    5,156       5,156  
Other liabilities
    20,329       21,048  
Total liabilities
    3,642,442       3,752,402  
                 
SHAREHOLDERS' EQUITY
               
Preferred stock, no par value; 10,000,000 shares authorized
    -       -  
Common stock, no par value; 100,000,000 shares authorized; 47,131,853
               
   and 47,095,103 shares issued and outstanding at September 30, 2009
               
   and December 31, 2008
    258,425       256,137  
Retained earnings (accumulated deficit)
    (126,873 )     98,020  
Accumulated other comprehensive loss, net of tax
    (1,885 )     (2,114 )
Total shareholders' equity
    129,667       352,043  
Total liabilities and shareholders' equity
  $ 3,772,109     $ 4,104,445  


The accompanying notes are an integral part of these financial statements.


FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
(In thousands, except for number of shares and per share amounts)
(Unaudited)


   
Three Months Ended
   
Nine Months Ended
 
   
September 30,
   
September 30,
   
September 30,
   
September 30,
 
   
2009
   
2008
   
2009
   
2008
 
INTEREST INCOME
                       
Interest and fees on loans
  $ 40,595     $ 67,161     $ 134,727     $ 214,049  
Interest on federal funds sold
    195       274       547       377  
Interest on investments
    700       1,386       2,288       4,237  
Total interest income
    41,490       68,821       137,562       218,663  
INTEREST EXPENSE
                               
Interest on deposits
    18,703       24,390       61,486       73,376  
Interest on borrowed funds
    3,909       3,705       11,995       12,272  
Total interest expense
    22,612       28,095       73,481       85,648  
Net interest income
    18,878       40,726       64,081       133,015  
PROVISION FOR LOAN LOSSES
    140,000       42,100       275,000       75,600  
Net interest (loss) income after provision
                               
for loan losses
    (121,122 )     (1,374 )     (210,919 )     57,415  
                                 
NONINTEREST INCOME
                               
Provision for loss on securities
    -       (6,431 )     -       (6,431 )
Net gain (loss) on sale of securities
    -       (1,026 )     (102 )     1,442  
Gain on sale of secondary mortgage loans
    232       308       1,446       1,074  
Net gain (loss) on other real estate owned
    (1,068 )     81       (1,519 )     93  
Service charges on deposit accounts
    1,611       1,384       4,596       4,130  
Other noninterest income
    2,103       2,511       6,369       7,020  
Total noninterest income (loss)
    2,878       (3,173 )     10,790       7,328  
                                 
NONINTEREST EXPENSE
                               
Salaries and employee benefits
    11,290       12,420       35,927       39,005  
Occupancy expense
    2,694       3,161       8,264       8,742  
State business taxes
    239       498       744       1,643  
FDIC insurance
    2,682       1,236       11,162       1,920  
Other noninterest expense
    7,909       4,742       17,396       13,825  
Total noninterest expense
    24,814       22,057       73,493       65,135  
                                 
LOSS BEFORE BENEFIT FOR INCOME TAXES
    (143,058 )     (26,604 )     (273,622 )     (392 )
BENEFIT FOR INCOME TAXES
    (1,970 )     (8,808 )     (48,729 )     (171 )
NET LOSS
  $ (141,088 )   $ (17,796 )   $ (224,893 )   $ (221 )
Weighted average number of
                               
shares outstanding for the period
    47,131,853       47,010,944       47,126,801       46,987,948  
Basic losses per share
  $ (2.99 )   $ (0.38 )   $ (4.77 )   $ (0.00 )
Weighted average number of diluted shares
                               
outstanding for period
    47,131,853       47,010,944       47,126,801       46,987,948  
Diluted losses per share
  $ (2.99 )   $ (0.38 )   $ (4.77 )   $ (0.00 )



The accompanying notes are an integral part of these financial statements.


FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
(In thousands)
(Unaudited)


   
Nine Months Ended September 30,
 
   
2009
   
2008
 
Cash flows from operating activities
           
Net loss
  $ (224,893 )   $ (221 )
Adjustments to reconcile net loss to net cash
               
provided by operating activities
               
Depreciation
    2,890       2,902  
Amortization
    423       184  
Intangible amortization
    160       212  
Provision for loan losses
    275,000       75,600  
Provision for loss on securities
    -       6,431  
(Gain) loss on sale of securities
    102       (1,442 )
Gain on sale of other real estate owned
    (3,124 )     (93 )
Valuation adjustment on other real estate owned
    4,643       -  
Gain on sale of secondary mortgage loans
    (1,446 )     (1,074 )
Deferred taxes
    36,354       (19,703 )
Share-based compensation
    2,288       2,170  
Excess tax benefits associated with share-based compensation
    -       (49 )
Increase in surrender value of bank owned life insurance
    (795 )     (322 )
Changes in operating assets and liabilities
               
Proceeds from sale of mortgage loans
    122,862       77,961  
Origination of mortgage loans held for sale
    (118,202 )     (73,764 )
Income taxes receivable
    (65,422 )     -  
Income taxes payable
    396       (154 )
Interest receivable
    6,668       2,137  
Interest payable
    (6,044 )     2,130  
Other operating activities
    5,543       (1,207 )
Net cash provided by operating activities
    37,403       71,698  
                 
Cash flows from investing activities
               
Net change in federal funds sold
    (245,341 )     (130,329 )
Purchase of securities available for sale
    (47,276 )     (273,230 )
Proceeds from sale of available for sale securities
    1,407       17,338  
Principal repayments on mortgage-backed securities
    5,373       -  
Proceeds from maturities of available for sale securities
    57,103       277,165  
Net cash flows from loan activities
    261,870       (251,914 )
Purchases of premises and equipment
    (531 )     (7,432 )
Redemption of Federal Home Loan Bank stock
    -       3,116  
Proceeds from the sale of other real estate owned
    24,515       2,355  
Capitalized improvement related to other real estate owned
    (383 )     (513 )
Net cash provided by (used in) investing activities
  $ 56,737     $ (363,444 )





The accompanying notes are an integral part of these financial statements.


FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
(In thousands)
(Unaudited)


   
Nine Months Ended September 30,
 
   
2009
   
2008
 
Cash flows from financing activities
           
Net change in core deposit accounts
  $ (26,892 )   $ (37,892 )
Net change in certificates of deposit
    (22,652 )     498,650  
Net change in federal funds purchased and securities
               
sold under repurchase agreements
    (6,032 )     (223,444 )
Advances from Federal Home Loan Bank
    45,000       185,000  
Repayment of Federal Home Loan Bank advances
    (98,665 )     (153,803 )
Stock options exercised
    -       389  
Excess tax benefits associated with share-based compensation
    -       49  
Cash dividends paid
    -       (19,598 )
Net cash provided by (used in) financing activities
    (109,241 )     249,351  
                 
Decrease in cash and due from banks
    (15,101 )     (42,395 )
                 
Cash and due from banks at beginning of period
    52,022       99,102  
                 
Cash and due from banks at end of period
  $ 36,921     $ 56,707  
                 
                 
Supplemental disclosure of cash flow information
               
Cash paid during the period for interest
  $ 79,525     $ 83,518  
Cash paid during the period for income taxes
  $ -     $ 20,340  
                 
Supplemental information about noncash investing and financing activities
               
Transfer of loans to other real estate owned
  $ 116,653     $ 5,075  
Transfer of premises and equipment to other real estate owned
  $ 317     $ -  
Change in portion of reserve identified for undisbursed loans and
               
reclassified as a liability
  $ 982       826  














The accompanying notes are an integral part of these financial statements.


 
-4-

FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)



The consolidated financial statements of Frontier Financial Corporation (“FFC”, the “Corporation”, “us”, “we” or “our”) include the accounts of Frontier Financial Corporation, a bank holding company, and our wholly-owned subsidiary Frontier Bank (the “Bank”).  All material intercompany balances and transactions have been eliminated.  The consolidated financial statements have been prepared substantially consistent with the accounting principles applied in the 2008 Annual Report incorporated by reference on Form 10-K for the year ended December 31, 2008.  In the opinion of management, the consolidated financial statements reflect all adjustments necessary for a fair presentation of the financial condition and results of operation for the interim periods presented.  Operating results for the three and nine months ended September 30, 2009, are not necessarily indicative of the results that may be expected for the year ending December 31, 2009.  Subsequent events were evaluated through November 2, 2009, the date these consolidated financial statements were issued.

Certain amounts in the prior years’ financial statements have been reclassified to conform to the 2009 presentation.  These reclassifications have no effect on the previously reported financial condition or results of operations of the Corporation.

Note 2: Recently Issued Accounting Pronouncements

In June 2009, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 168, The FASB Accounting Standards Codification TM and the Hierarchy of Generally Accepted Accounting Principles – a replacement of FASB Statement No. 162 (“SFAS 168”).  SFAS 168 establishes the FASB Accounting Standards Codification TM (“ASC”) as the source of authoritative generally accepted accounting principles (“GAAP”) for nongovernmental entities.  FASB ASC does not change GAAP.  Instead, it takes the thousands of individual pronouncements that currently comprise GAAP and reorganizes them into approximately 90 accounting Topics, and displays all Topics using a consistent structure.  Contents in each Topic are further organized first by Subtopic, then Section and finally Paragraph.

In conjunction with the issuance of SFAS 168, the FASB also issued its first Accounting Standards Update No. 2009-1, Topic 105 –Generally Accepted Accounting Principles (“ASU 2009-1”) which includes SFAS 168 in its entirety as a transition to the ASC.    ASU 2009-1 is effective for interim and annual periods ending after September 15, 2009, and will not have an impact on the Corporation’s financial position or results of operations but will change the referencing system for accounting standards.  Certain of the following pronouncements were issued prior to the issuance of the ASC and adoption of the ASUs. For such pronouncements, citations to the applicable Codification by Topic, Subtopic and Section are provided where applicable in addition to the original standard type and number.

SFAS 167 (not yet reflected in FASB ASC), Amendments to FASB Interpretation No. 46(R), (“SFAS 167”) was issued in June 2009.  The standard amends FIN 46(R) to require a company to analyze whether its interest in a variable interest entity (“VIE”) gives it a controlling financial interest.  A company must assess whether it has an implicit financial responsibility to ensure that the VIE operates as designed when determining whether it has the power to direct the activities of the VIE that significantly impact its economic performance.  Ongoing reassessment of whether a company is the primary beneficiary is also required by the standard.  SFAS 167 amends the criteria to qualify as a primary beneficiary as well as how to determine the existence of a VIE.  The standard also eliminates certain exceptions that were available under FIN 46(R).  SFAS 167 is effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period, and for interim and annual reporting periods thereafter.  Earlier application is prohibited.  Comparative disclosures will be required for periods after the effective date.  We do not expect the standard to have any impact on our consolidated financial statements.

The FASB issued ASU 2009–05, Fair Value Measurements and Disclosures (Topic 820) – Measuring Liabilities at Fair Value, in August 2009 to provide guidance when estimating the fair value of a liability.  When a quoted price in an active market for the identical liability is not available, fair value should be measured using (a) the quoted price of an identical liability when traded as an asset; (b) quoted prices for similar liabilities or similar liabilities when traded as assets; or (c) another valuation technique consistent with the principles of Topic 820 such as an income approach or a market approach.  If a restriction exists that prevents the transfer of the liability, a separate adjustment related to the restriction is not required when estimating fair value.  The ASU was effective October 1, 2009, and will have no impact on our consolidated financial statements.

 
-5-

FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


Note 2: Recently Issued Accounting Pronouncements (continued)

ASU 2009-12, Fair Value Measurements and Disclosures (Topic 820) - Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent), issued in September 2009, allows a company to measure the fair value of an investment that has no readily determinable fair market value on the basis of the investee’s net asset value per share as provided by the investee. This allowance assumes that the investee has calculated net asset value in accordance with the GAAP measurement principles of Topic 946 as of the reporting entity’s measurement date.   Examples of such investments include investments in hedge funds, private equity funds, real estate funds and venture capital funds. The update also provides guidance on how the investment should be classified within the fair value hierarchy based on the value for which the investment can be redeemed.  The amendment is effective for interim and annual periods ending after December 15, 2009, with early adoption permitted.  We do not have investments in such entities and, therefore, there will be no impact to our consolidated financial statements.

ASU 2009-13, Revenue Recognition (Topic 605): Multiple-Deliverable Revenue Arrangements – a consensus of the FASB Emerging Issues Task Force, was issued in October 2009 and provides guidance on accounting for products or services (deliverables) separately rather than as a combined unit utilizing a selling price hierarchy to determine the selling price of a deliverable.  The selling price is based on vendor-specific evidence, third-party evidence or estimated selling price.  The amendments in the update are effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, with early adoption permitted.  We do not expect the standard to have any impact on our consolidated financial statements.

Issued October, 2009, ASU 2009-15, Accounting for Own-Share Lending Arrangements in Contemplation of Convertible Debt Issuance or Other Financing, amends ASC Topic 470 and provides guidance for accounting and reporting for own-share lending arrangements issued in contemplation of a convertible debt issuance.  At the date of issuance, a share-lending arrangement entered into on an entity’s own shares should be measured at fair value in accordance with Topic 820 and recognized as an issuance cost, with an offset to additional paid-in capital.  Loaned shares are excluded from basic and diluted earnings per share unless default of the share-lending arrangement occurs.  The amendments also require several disclosures including a description and the terms of the arrangement and the reason for entering into the arrangement.  The effective dates of the amendments are dependent upon the date the share-lending arrangement was entered into and include retrospective application for arrangements outstanding as of the beginning of fiscal years beginning on or after December 15, 2009.  We currently have no plans to issue convertible debt and, therefore, do not expect the update to have an impact on our consolidated financial statements.

Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on our consolidated financial statements.


 
-6-

FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


Note 3: Regulatory Actions, Strategic Plan and Continuing Operations

Regulatory Actions

FDIC Order

On March 20, 2009, Frontier Bank entered into a Stipulation and Consent to the Issuance of an Order to Cease and Desist (the “FDIC Order”) with the Federal Deposit Insurance Corporation (the “FDIC”) and the Washington Department of Financial Institutions (the “Washington DFI”).  The regulators alleged that Frontier Bank had engaged in unsafe or unsound banking practices by operating with inadequate management and board supervision; engaging in unsatisfactory lending and collection practices; operating with inadequate capital in relation to the kind and quality of assets held at Frontier Bank; operating with an inadequate loan valuation reserve; operating with a large volume of poor quality loans; operating in such a manner as to produce low earnings and operating with inadequate provisions for liquidity.  By consenting to the FDIC Order, Frontier Bank neither admitted nor denied the alleged charges.

Under the terms of the FDIC Order, Frontier Bank cannot declare dividends or pay any management, consulting or other fees or funds to the Corporation, without the prior written approval of the FDIC and the Washington DFI.  Other material provisions of the FDIC Order require Frontier Bank to: (1) review the qualifications of Frontier Bank’s management, (2) provide the FDIC with 30 days written notice prior to adding any individual to the Board of Directors of Frontier Bank (the “Frontier Bank Board”) or employing any individual as a senior executive officer, (3) increase director participation and supervision of Frontier Bank affairs, (4) improve Frontier Bank’s lending and collection policies and procedures, particularly with respect to the origination and monitoring of real estate construction and land development loans, (5) develop a capital plan and increase Tier 1 leverage capital to 10% of Frontier Bank’s total assets by July 29, 2009, and maintain that capital level, in addition to maintaining a fully funded allowance for loan losses satisfactory to the regulators, (6) implement a comprehensive policy for determining the adequacy of the allowance for loan losses and limiting concentrations in commercial real estate and acquisition, development and construction loans, (7) formulate a written plan to reduce Frontier Bank’s risk exposure to adversely classified loans and nonperforming assets, (8) refrain from extending additional credit with respect to loans charged-off or classified as “loss” and uncollected, (9) refrain from extending additional credit with respect to other adversely classified loans without collecting all past due interest, without the prior approval of a majority of the directors on the Frontier Bank Board or its loan committee, (10) develop a plan to control overhead and other expenses to restore profitability, (11) implement a liquidity and funds management policy to reduce Frontier Bank’s reliance on brokered deposits and other non-core funding sources, and (12) prepare and submit progress reports to the FDIC and the Washington DFI.  The FDIC Order will remain in effect until modified or terminated by the FDIC and the Washington DFI.

The FDIC Order does not restrict Frontier Bank from transacting its normal banking business.  Frontier Bank will continue to serve its customers in all areas including making loans, establishing lines of credit, accepting deposits and processing banking transactions.  Customer deposits remain fully insured to the highest limits set by FDIC.  The FDIC and Washington DFI did not impose any monetary penalties in connection with the FDIC Order.

FRB Agreement

In addition, on July 2, 2009, the Corporation entered into a Written Agreement (the “FRB Written Agreement”) with the Federal Reserve Bank of San Francisco (the “FRB”).  Under the terms of the FRB Written Agreement, the Corporation has agreed to: (1) refrain from declaring or paying any dividends without prior written consent of the FRB; (2) refrain from taking dividends or any other form of payment that represents a reduction in capital from Frontier Bank without prior written consent of the FRB; (3) refrain from making any distributions of interest or principal on subordinated debentures or trust preferred securities without prior written consent of the FRB; (4) refrain from incurring, increasing or guaranteeing any debt without prior written consent of the FRB; (5) refrain from purchasing or redeeming any shares of its stock without prior written consent of the FRB; (6) implement a capital plan and maintain sufficient capital; (7) comply with notice and approval requirements established by the FRB relating to the appointment of directors and senior executive officers as well as any change in the responsibility of any current senior executive officer; (8) not pay or agree to pay any indemnification and severance payments except under certain circumstances, and with the prior approval of the FRB; and (9) provide quarterly progress reports to the FRB.


 
-7-

FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


Note 3: Regulatory Actions, Strategic Plan and Continuing Operations (continued)

Compliance Memorandum of Understanding

Frontier Bank and the Frontier Bank Board also entered into a Memorandum of Understanding with the FDIC dated August 20, 2008, relating to the correction of certain violations of applicable consumer protection and fair lending laws and regulations, principally including the failure to provide certain notices to consumers pursuant to the Flood Disaster Protection Act of 1973, and certain violations of the Truth in Lending Act and Regulation Z.

The Memorandum of Understanding requires Frontier Bank and the Frontier Bank Board to (1) correct all violations found and implement procedures to prevent their recurrence; (2) increase oversight of the Frontier Bank Board’s compliance function, including monthly reports from Frontier Bank’s compliance officer to the Frontier Bank Board detailing actions taken to comply with the Memorandum of Understanding; (3) review its compliance policies and procedures and develop and implement detailed operating procedures and controls, where necessary, to ensure compliance with all consumer protection laws and regulations; (4) establish monitoring procedures to ensure compliance with all consumer protection laws and regulations (including flood insurance), including the documentation and reporting of all exceptions to the Frontier Bank Board and its audit committee; (5) review, expand and improve the quality of such compliance with the frequency of compliance audits to be reviewed and approved annually by the Frontier Bank Board or audit committee, with a goal of auditing compliance at least annually; (6) ensure that Frontier Bank’s compliance management function has adequate staff, resources, training and authority for the size and structure of Frontier Bank; (7) establish flood insurance monitoring procedures to ensure loans are not closed without flood insurance and prior notices to customers required by law, that lapses of flood insurance do not occur, and to develop methods to ensure that adequate amounts of flood insurance are provided, with Frontier Bank agreeing to force place flood insurance when necessary; (8) provide additional training for all Frontier Bank personnel, including the Frontier Bank Board and audit and compliance staff for applicable laws and regulations and (9) furnish quarterly progress reports to the Regional Director of the FDIC detailing the actions taken to secure compliance with the Memorandum of Understanding until the Regional Director has released the institution, in writing, from submitting further reports. Frontier Bank was assessed civil monetary penalties of $48,895 for flood insurance violations and required to pay $10,974 in restitution to customers for certain violations of the Truth in Lending Act and Regulation Z.

We have been actively engaged in responding to the concerns raised in the FDIC Order, the FRB Agreement and the Memorandum of Understanding and believes we have addressed all the regulators’ requirements and that we are in compliance with all the terms of these regulatory actions, with the exception of increasing Tier 1 leverage capital to 10% of the Bank’s total assets.  See “Strategic Plan – Capital Preservation” below.

These regulatory actions may adversely affect our ability to obtain regulatory approval for future initiatives requiring regulatory action, such as acquisitions. The regulatory actions will remain in effect until modified or terminated by the regulators.

 
-8-

FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)

 
Note 3: Regulatory Actions, Strategic Plan and Continuing Operations (continued)

Compliance Efforts in Response to Regulatory Actions

We are actively engaged in responding to the concerns raised by the regulators and have acted promptly on directions received by taking the following actions:
 
     
 
• 
Engaged Patrick M. Fahey as chairman of the board and chief executive officer of Frontier, and Michael J. Clementz as president, on December 4, 2008;
     
 
• 
Retained an independent consultant to review and evaluate the loan portfolio in the Fall of 2008, and again in July, 2009;
     
 
• 
Organized a special assets group staffed by 37 managers and employees, to accelerate the collection and resolution of delinquent and adversely classified loans;
     
 
• 
Developed capital management, liquidity and funds management plans;
     
 
• 
Increased board and senior management oversight of Frontier Bank, its lending and operations, including special weekly board meetings;
     
 
• 
Established a communications procedure for reporting progress in all areas to the FDIC, Washington DFI and FRB.
 
 
Strategic Plan

The results for the first nine months of 2009 reflect continued pressure from an uncertain economy and the negative impact of the local housing market.  Despite these challenging times, the Board of Directors and management continue to take important steps to strengthen the Corporation.

Diversifying the Loan Portfolio

Management has been diligently working to reduce the concentration in real estate construction and land development loans, and has successfully reduced these portfolios by $537.4 million, or 35.1%, from December 31, 2008 to September 30, 2009.  In addition, undisbursed loan commitments related to these portfolios decreased $158.1 million, or 88.2%, for the same period.

Asset Quality

Management continues to proactively manage credit quality and loan collections and address work out strategies. For the nine months ended September 30, 2009, net charge-offs totaled $246.3 million.

Capital Preservation

As of September 30, 2009, Frontier Bank’s total risk-based capital ratio was less than 6.0%, and therefore, Frontier Bank is considered “significantly undercapitalized” under federal regulatory guidelines, as a result of significant additional provisions for loan losses and charge-offs in the third quarter of 2009.  In addition, Frontier Bank’s Tier 1 leverage capital ratio remains less than the 10% required by the terms of the FDIC Order.  See “Regulatory Actions” above.

We continue to take steps to strengthen our capital position.  Efforts to raise additional capital began in the third quarter of 2008, when the Board of Directors retained an investment banking firm to assist in raising capital and deleveraging our balance sheet.  Our ability to raise additional capital has been adversely affected by unfavorable conditions in the capital markets and our financial performance, and we have not been able to raise additional capital to date.  If we cannot raise additional capital, continue to shrink our balance sheet and/or enter into a strategic merger or sale, we may not be able to sustain further deterioration in our financial condition and further regulatory actions or restrictions may be taken against us.

 
-9-

FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


Note 3: Regulatory Actions, Strategic Plan and Continuing Operations (continued)

Liquidity

We continue to closely monitor and manage our liquidity position, understanding that this is of critical importance in the current adverse economic environment.  Attracting and retaining customer deposits remains our primary source of liquidity.  Noninterest bearing deposits increased $8.1 million, or 2.0%, from December 31, 2008 to September 30, 2009.

During the third quarter 2009, we announced our continued participation in the Federal Deposit Insurance Corporation's ("FDIC") voluntary Transaction Account Guarantee ("TAG") portion of the Temporary Liquidity Guarantee Program through June 30, 2010.  Under this program, noninterest bearing transaction accounts and qualified NOW checking accounts are fully guaranteed by the FDIC for an unlimited amount of coverage. The coverage under the TAG program is in addition to, and separate from, the coverage available under the FDIC's general deposit insurance protection.

In an effort to increase on-balance sheet liquidity, we have been focused on restructuring our balance sheet, and in particular, reducing the loan portfolio.  For the nine months ended September 30, 2009, total loans decreased $627.7 million, or 16.6%, compared to December 31, 2008.  Additionally, we have increased our federal funds sold balances to $363.1 million at September 30, 2009, an increase of $245.3 million from December 31, 2008.

Expense Reduction Measures

We continue to seek out feasible expense reduction measures.  Previously announced expense reduction measures include: a six percent reduction in workforce, the suspension of the Corporation’s matching of employee 401(K) Plan contributions, effective May 1, 2009, and reductions to executive compensation, salary freezes and the elimination of performance bonuses and discretionary profit sharing contributions to the 401(K) Plan.  Additionally, full time equivalents (“FTE”) employees are down 158, or 18.5%, from the peek in May 2008 to September 30, 2009.

Continuing Operations

Our consolidated financial statements have been prepared assuming that we will continue as a going concern.

In connection with continuing turmoil in the economy, and more specifically, within the local real estate market, we recorded net losses of $141.1 million and $224.9 million for the three and nine months ended September 30, 2009, respectively.  These losses were primarily the result of increases in our provision for loan losses during these periods, and declining net interest margins caused by increased amounts of nonperforming loans.  These losses, the FDIC Order, and the high level of risk associated with our real estate loan portfolio have resulted in Frontier Bank being regarded by our regulators as “significantly undercapitalized.”  See Note 6 - Shareholders’ Equity and Regulatory Matters.  The net losses for the periods have had a negative impact on our operations, liquidity and capital adequacy and could result in further actions by our regulators to restrict our operations as discussed below.

On July 31, 2009, we announced the signing of an agreement and plan of merger with SP Acquisition Holdings (“SPAH”).  The merger was expected to close in the fourth quarter of 2009.  SPAH was a special purpose acquisition company with nearly $429 million in liquid assets.  On October 5, 2009, we mutually agreed to terminate the agreement and plan of merger with SPAH due to the fact that certain closing conditions contained in the merger agreement could not be met.

In order to achieve compliance with the risk-based capital requirement of the FDIC Order and return to being at least “adequately capitalized” for federal regulatory purposes, we will need to either raise capital, sell assets to deleverage, or both.  Our ability to accomplish these goals is significantly constricted by the current adverse economic environment, in which access to capital markets has been limited, and we can give no assurances that we will be able to access any such capital or sell more assets.  See “Capital Preservation” above.

Our ability to decrease our levels of nonperforming assets is also vulnerable to market conditions as many of our borrowers rely on an active real estate market as a source of repayment, particularly our real estate construction and real estate development loan borrowers.  If the real estate market does not improve or declines further, our level of nonperforming assets may not decline.


 
-10-

FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


Note 3: Regulatory Actions, Strategic Plan and Continuing Operations (continued)

As a result of the asset quality and capital concerns affecting us, we have been aggressively addressing our liquidity needs to maintain an adequate cash flow position to sustain operations.  At September 30, 2009, we maintained approximately $363.1 million of federal funds sold to increase on-balance sheet liquidity.

We have ceased originating new real estate construction development loans and completed lot loans, although we continue to selectively fund on commitments previously issued.  Finally, our special assets group has been aggressively marketing foreclosed real estate in an effort to sell noninterest earning assets at sales prices that do not further deteriorate our capital position.
    
We have determined that significant additional sources of capital will be required for us to continue operations through 2009 and beyond.  We have engaged financial advisors to assist us in our efforts to raise additional capital and explore other strategic alternatives to address our current and expected capital deficiencies.  Based on their assessment of our ability to continue to operate in compliance with the FDIC Order, our regulators may take other and further actions, including the assessment of civil money penalties against the Bank or the Corporation and their respective officers, directors and other interested parties or they may seek to enforce the order or agreement in federal court.  If the Bank or the Corporation were to engage in other unsafe and unsound banking practices, the regulators have various enforcement tools available to them including the issuance of capital directives, orders to cease engaging in certain business activities and the issuance of modified or additional orders or agreements.

There can be no assurances that our actions referred to above will be successful.  These events raise doubt about our ability to continue as a going concern.  The consolidated financial statements do not include any adjustments that might result from the outcome of these uncertainties.

 
-11-

FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


Note 4: Securities

Our investment portfolio is classified into two groups - securities available for sale (“AFS”) and securities held to maturity (“HTM”).  Securities that are classified as AFS are carried at fair value.  Unrealized gains and losses for AFS securities are excluded from earnings and reported as a separate component of equity, net of tax.  AFS securities may be sold at any time.  Securities that are classified as HTM are carried at cost, adjusted for amortization of premiums and accretion of discounts which are recognized as adjustments to income.  Gains and losses on both AFS and HTM securities that are disposed of prior to maturity are based on the net proceeds and the adjusted carrying amount of the specific security sold.

The following table presents the amortized cost, unrealized gains, unrealized losses and fair value of available for sale and held to maturity securities at September 30, 2009 (in thousands).  At September 30, 2009, there were no securities classified as trading.
 
   
Amortized Cost
   
Gross Unrealized Gains
   
Gross Unrealized Losses (less than 12 months)
   
Gross Unrealized Losses (12 months or more)
   
Aggregate Fair Value
 
AFS Securities
                             
Equities
  $ 6,106     $ 183     $ -     $ (3,811 )   $ 2,478  
U.S. Treasuries
    251       64       -       -       315  
U.S. Agencies
    29,902       75       (12 )     -       29,965  
Corporate securities
    2,516       -       (327 )     -       2,189  
Mortgage-backed securities
    35,613       631       (117 )     -       36,127  
Municipal securities
    2,665       96       -       (1 )     2,760  
      77,053       1,049       (456 )     (3,812 )     73,834  
                                         
HTM Securities
                                       
Corporate securities
    1,524       -       (38 )     -       1,486  
Municipal securities
    1,555       21       -       -       1,576  
      3,079       21       (38 )     -       3,062  
Total
  $ 80,132     $ 1,070     $ (494 )   $ (3,812 )   $ 76,896  

Certain securities shown above currently have fair values less than amortized cost, and therefore, contain unrealized losses.  In the opinion of management, these securities are considered only temporarily impaired due to changes in market interest rates, the widening of market spreads subsequent to the initial purchase of the securities or to disruptions to credit markets and not due to concerns regarding the underlying credit of the issuers or the underlying collateral.  There were 12 securities with unrealized losses at September 30, 2009.

Management evaluates securities and FHLB stock for other-than-temporary impairment at least on an annual basis, and more frequently when economic or market concerns warrant such evaluation.  Consideration is given to: (1) the length of time and extent to which the fair value has been less than cost, (2) the financial condition and near term prospects of the issuer, (3) our intent and ability to retain a security for a period of time sufficient to allow for any anticipated recovery in fair value and (4) whether we expect to recover the amortized cost basis of the security.  We did not recognize any other-than-temporary impairment losses for the three or nine months ended September 30, 2009.  For the three and nine months ended September 30, 2008, we recognized a $6.4 million pre-tax loss related to other than temporarily impaired investments in Fannie Mae, Freddie Mac and Lehman Brothers.

Investments in equity securities consist of investments in the common stock of three financial institutions.  We have evaluated the near term prospects of the issuer and have considered their cash position, earnings and revenue outlook, liquidity and capital levels, among other factors.  Based on this evaluation and our ability and intent to hold these securities for a reasonable period of time sufficient for a forecasted recovery of fair value, we do not consider these securities to be other-than-temporarily impaired.

 
-12-

FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


Note 4: Securities (continued)

The unrealized losses on investments in U.S. Agencies securities were caused by changes in market interest rates.  The contractual terms of these investments do not permit the issuer to settle the securities at a price less than par.  Because we do not intend to sell the securities and it is not more likely than not that we will be required to sell the securities before recovery of their amortized cost bases, which may be maturity, the unrealized losses on these securities are not considered other-than-temporarily impaired.

The unrealized losses on corporate securities, which consist of trust preferred securities, were primarily attributable to temporary disruptions of credit markets and the related impact on the securities within those classes, not deteriorating credit quality of specific securities.  Because the decline in fair value is attributable to disruptions of credit markets and not credit quality, and because we do not intend to sell the security and it is not more likely than not that we will be required to sell the security before recovery of their amortized cost bases, which may be maturity, the unrealized losses on these investments are not considered other-than-temporarily impaired.

The unrealized losses on mortgage-backed securities were caused by changes in market interest rates.  The contractual cash flows of these securities are guaranteed by an agency of the U.S. government, and accordingly, we do not expect these securities to be settled at a price less than the amortized cost of the investment.  Because the decline in fair value is attributable to changes in interest rates and not credit quality, and because we do not intend to sell the security and it is not more likely than not that we will be required to sell the security before recovery of their amortized cost bases, which may be maturity, the unrealized losses on these securities are not considered other-than-temporarily impaired.

The unrealized losses on obligations of municipalities were caused by changes in market interest rates or the widening of market spreads subsequent to the initial purchase of the securities. Management monitors published credit ratings of these securities and no adverse ratings changes have occurred since the date of purchase on obligations of municipalities in an unrealized loss position as of September 30, 2009. Because the decline in fair value is attributable to changes in interest rates or widening market spreads and not credit quality, and because we do not intend to sell the security and it is not more likely than not that we will be required to sell the security before recovery of their amortized cost bases, which may be maturity, the unrealized losses on these investments are not considered other-than-temporarily impaired.

Contractual maturities of securities at September 30, 2009, are shown below (in thousands).  Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without prepayment penalties.


   
Available for Sale
   
Held to Maturity
 
Maturity
 
Amortized Cost
   
Fair Value
   
Amortized Cost
   
Fair Value
 
0 - 1 years
  $ 7,011     $ 7,051     $ 571     $ 573  
1 - 5 years
    23,225       23,253       984       1,003  
5 - 10 years
    1,609       1,710       -       -  
Over 10 years
    45,208       41,820       1,524       1,486  
    $ 77,053     $ 73,834     $ 3,079     $ 3,062  


 
-13-

FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


Note 5: Loans and Allowance for Loan Losses

The major classifications of loans, excluding loans held for resale, are as follows (in thousands):
 
   
September 30, 2009
   
December 31, 2008
 
Commercial and industrial
  $ 406,170     $ 458,263  
Real Estate:
               
Commercial
    991,572       1,048,431  
Construction
    588,632       952,619  
Land development
    405,706       581,683  
Completed lots
    257,602       250,405  
Residential 1-4 family
    434,607       425,874  
Installment and other loans
    70,803       65,490  
      3,155,092       3,782,765  
Unearned fee income
    (7,552 )     (10,710 )
Total loans
  $ 3,147,540     $ 3,772,055  

The following table presents the activity related to the allowance for loan losses (in thousands):
 
   
Nine Months Ended
   
Twelve Months Ended
 
   
September 30, 2009
   
December 31, 2008
 
Beginning balance
  $ 114,638     $ 57,658  
Provision for loan losses
    275,000       120,000  
Charge-offs
    (249,284 )     (63,526 )
Recoveries
    2,975       506  
Balance before portion identified for undisbursed loans
    143,329       114,638  
Portion of reserve identified for undisbursed
               
loans and reclassified as a liability
    (1,100 )     (2,082 )
Balance at end of period
  $ 142,229     $ 112,556  


 
-14-

FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


Note 5: Loans and Allowance for Loan Losses (continued)

Nonperforming Assets

Nonaccruing loans, restructured loans and other real estate owned (“OREO”) are summarized as follows (in thousands):
 
   
September 30, 2009
   
December 31, 2008
 
Commercial and industrial
  $ 29,147     $ 12,908  
Real estate:
               
Commercial
    81,870       10,937  
Construction
    277,146       181,905  
Land development
    274,959       177,139  
Completed lots
    85,341       34,005  
Residential 1-4 family
    60,669       17,686  
Installment and other
    1,388       645  
Total nonaccruing loans
    810,520       435,225  
                 
Other real estate owned
    101,805       10,803  
Total nonperforming assets
  $ 912,325     $ 446,028  
                 
Restructured loans
  $ -     $ -  
                 
Total loans at end of period (1)
  $ 3,151,004     $ 3,778,733  
Total assets at end of period
  $ 3,772,109     $ 4,104,445  
                 
Total nonaccruing loans to total loans
    25.72 %     11.52 %
Total nonperforming assets to total assets
    24.19 %     10.87 %
                 
(1) Includes loans held for resale.
               


At September 30, 2009 and December 31, 2008, nonaccruing loans totaling $396.7 million and $96.2 million had related specific reserves in the allowance for loan losses of $66.8 million and $12.9 million, respectively.  Nonaccruing loans without related specific reserves in the allowance for loan losses at September 30, 2009 and December 31, 2008, totaled $413.8 million and $339.0 million, respectively.

Other Real Estate Owned

The following table presents the activity related to other real estate owned (“OREO”) (in thousands):
 
   
Nine Months Ended
   
Twelve Months Ended
 
   
September 30, 2009
   
December 31, 2008
 
   
Amount
   
Number
   
Amount
   
Number
 
Beginning balance
  $ 10,803       64     $ 367       1  
Additions to OREO
    116,653       357       12,992       76  
Capitalized improvements
    383               623          
Valuation adjustments
    (4,643 )             (68 )        
Disposition of OREO
    (21,391 )     (99 )     (3,111 )     (13 )
Ending balance
  $ 101,805       322     $ 10,803       64  



 
-15-

FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


Note 6: Shareholders’ Equity and Regulatory Matters

Regulatory Capital Guidelines: Federal bank regulatory agencies use capital adequacy guidelines in the examination and regulation of bank holding companies and banks.  The guidelines are “risk-based,” meaning that they are designed to make capital requirements more sensitive to differences in risk profiles among banks and bank holding companies.  We are subject to regulatory actions, including an FDIC Order requiring Frontier Bank to raise its Tier 1 leverage capital ratio to the higher than normal level of 10% of its total assets.   See “Note 3:  — Regulatory Actions, Strategic Plan and Continuing Operations.”

The minimum ratios and the actual capital ratios at September 30, 2009, are set forth in the table below (in thousands):
 
   
Frontier Financial Corporation
   
Frontier Bank
   
Well Capitalized Minimum
   
Adequately Capitalized Minimum
 
Total capital to risk-weighted assets
    5.62 %     5.35 %     10.00 %     8.00 %
Tier 1 capital to risk-weighted assets
    4.33 %     4.06 %     6.00 %     4.00 %
Tier 1 leverage capital to average assets
    3.40 %     3.19 %     5.00 %     4.00 %
 
Prompt Corrective Action: Under the guidelines, an institution is assigned to one of five capital categories depending on its total risk-based capital ratio, Tier I risk-based capital ratio, and leverage ratio, together with certain subjective factors. The categories are “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” and “critically undercapitalized.”  Institutions that are deemed to be undercapitalized, depending on the category to which they are assigned, are subject to certain mandatory supervisory corrective actions.

Frontier Bank’s total capital to risk-weighted assets ratio dropped below 6.0% as of September 30, 2009, as a result of the additional provisions for loan losses and charge-offs in the third quarter of 2009, and therefore, the Corporation and the Bank were “significantly undercapitalized” as of September 30, 2009.

Note 7: Share-Based Compensation Plans

Stock Incentive Plan

In 2006, our shareholders approved a Stock Incentive Plan (the “Plan”) to promote the best interest of the Corporation, our subsidiaries and our shareholders, by providing an incentive to those key employees who contribute to our success.  The Plan allows for incentive stock options, stock grants and stock appreciation rights to be awarded.  The maximum number of shares that may be issued under the Plan is 5,250,000 common shares.  At September 30, 2009, 4,400,204 common shares were available for grant.  Shares issued and outstanding are adjusted to reflect common stock dividends, splits, recapitalization or reorganization.  Options are granted at fair market value, generally vest over three years, and expire ten years from the date of grant.  Dividends are paid on stock grants but not paid on incentive stock options.  Certain options provide for accelerated vesting if there is a change in control.

The following table presents the activity related to options for the nine months ended September 30, 2009:
 
   
Options Outstanding
   
Weighted Average Exercise Price
   
Weighted Average Contractual Terms (in years)
   
Aggregate Intrinsic Value (in thousands)
 
Outstanding, January 1, 2009
    1,374,734     $ 16.69              
Granted
    -       -              
Exercised
    -       -              
Forfeited/expired
    (172,404 )   $ 16.59              
Balance, September 30, 2009
    1,202,330     $ 16.70       5.6     $ -  
                                 
Exercisable, September 30, 2009
    895,388     $ 16.90       4.6     $ -  


 
-16-

FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


Note 7: Share-Based Compensation Plans (continued)

The following table presents the activity related to nonvested stock awards under the Plan for the nine months ended September 30, 2009:

   
Shares
   
Weighted Average Grant Date Fair Value
 
Nonvested at January 1, 2009
    269,762     $ 11.74  
Awarded
    36,000     $ 3.02  
Vested
    (36,750 )   $ 3.21  
Forfeited
    (24,904 )   $ 11.40  
Nonvested at September 30, 2009
    244,108     $ 11.78  

At September 30, 2009, there was $2.1 million of total unrecognized compensation expense related to the nonvested share-based compensation arrangements granted under the Plan.  The cost is expected to be recognized over a weighted-average period of 1.5 years.  No stock options were granted during the three or nine months ended September 30, 2009 or 2008.

The total fair value of shares and options vested and recognized as compensation expense under this Plan for the three and nine months ended September 30, 2009, was $731 thousand and $2.3 million, compared to $693 thousand and $2.1 million for the three and nine months ended September 30, 2008, respectively.

There were no stock option exercises for the nine months ended September 30, 2009. The total intrinsic value, amount by which the fair value of the underlying stock exceeded the exercise price of an option on exercise date, of options exercised for the nine months ended September 30, 2008, was $159 thousand.  Cash received and the actual tax benefit realized for the tax deductions from options exercised was $389 thousand and $49 thousand, respectively, for the nine months ended September 30, 2008.

1999 Employee Stock Award Plan

We adopted a 1999 Employee Stock Award Plan to recognize, motivate and reward eligible employees for longstanding performance.  Employees eligible to receive stock awards under this Plan must have been employees for at least 20 years, or some other tenure as determined from time to time by the Board of Directors.  The maximum number of shares that may be issued is 45,000 and is adjusted to reflect future common share dividends, splits, recapitalization or reorganization.  The stock awards vest immediately when granted.  The Plan expires in 2009 and there are currently no plans to renew the Plan.  Any future grants will be made out of the 2006 Stock Incentive Plan, as noted above.

There were no shares issued from this Plan during the nine months ended September 30, 2009.  For the nine months ended September 30, 2008, 1,470 shares were issued from this Plan with a total fair value of $25 thousand recognized as compensation expense.


 
-17-

FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


Note 8: Losses per Share

The following table reconciles basic to diluted weighted average shares outstanding used to calculate losses per share data and provides a summary of the calculation of both basic and diluted losses per share (in thousands, except per share amounts):
 
   
Three Months Ended
   
Nine Months Ended
 
   
September 30,
   
September 30,
   
September 30,
   
September 30,
 
   
2009
   
2008
   
2009
   
2008
 
                         
Net loss
  $ (141,088 )   $ (17,796 )   $ (224,893 )   $ (221 )
                                 
Average basic shares outstanding
    47,132       47,011       47,127       46,988  
                                 
Dilutive shares
    -       -       -       -  
                                 
Average diluted shares outstanding
    47,132       47,011       47,127       46,988  
                                 
Basic losses per share
  $ (2.99 )   $ (0.38 )   $ (4.77 )   $ (0.00 )
                                 
Diluted losses per share
  $ (2.99 )   $ (0.38 )   $ (4.77 )   $ (0.00 )

Note 9:  Fair Values

FASB ASC 820, Fair Value Measurements and Disclosure, and FASB ASC 825, Financial Instruments, (formerly FSP No. FAS 107-1 and APB 28-1, Disclosures about Fair Value of Financial Instruments), requires disclosure of fair value information about financial instruments, whether or not recognized in the consolidated financial statements.  The following table presents estimated fair values of our financial instruments at September 30, 2009 and December 31, 2008 (in thousands):
 
   
September 30, 2009
   
December 31, 2008
 
   
Carrying
   
Fair
   
Carrying
   
Fair
 
   
Value
   
Value
   
Value
   
Value
 
Assets
                       
Cash and due from banks
  $ 36,921     $ 36,921     $ 52,022     $ 52,022  
Federal funds sold
    363,081       363,081       117,740       117,740  
Securities
                               
Available for sale
    73,834       73,834       90,606       90,606  
Held to maturity
    3,079       3,062       3,085       3,340  
Loans held for resale
    3,464       3,464       6,678       6,678  
Loans, net
    3,008,725       2,836,454       3,666,177       3,714,492  
Bank owned life insurance
    25,116       25,166       24,321       24,321  
                                 
Liabilities
                               
Noninterest bearing deposits
    403,534       403,534       395,451       395,451  
Interest bearing deposits
    2,822,087       2,852,126       2,879,714       2,909,730  
Federal funds purchased and securities
                               
sold under agreements to repurchase
    15,584       15,584       21,616       21,616  
FHLB advances
    375,752       392,854       429,417       444,441  
Junior subordinated debentures
    5,156       2,191       5,156       1,676  

We determined the estimated fair value amounts using available market information and appropriate valuation methodologies. However, considerable judgment is necessary to interpret market data in the development of the estimates of fair value. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.

 
-18-

FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)

 
Note 9:  Fair Values (continued)

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate fair value.

Cash Equivalents and Federal Funds Sold - For these short-term instruments, the carrying amount is a reasonable estimate of fair value.

Securities - Securities fair values are based on quoted market prices or dealer quotes, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.

Loans Held for Resale – For loans held for resale, carrying value approximates fair value.

Loans - The fair value of loans generally is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.  The fair value calculation, however, does not take into consideration the ultimate collectibility of the loan.  For certain homogeneous categories of loans, such as Small Business Administration guaranteed loans, fair value is estimated using the quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics.

Bank Owned Life Insurance – The fair value of Bank owned life insurance policies are based on cash surrender value of the insurance contract, less any applicable surrender charges.

Deposits and Federal Funds Purchased - The fair value of demand deposits, savings accounts, certain money market deposits, and federal funds purchased, is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is estimated by discounting the future cash flows using the rates currently offered for deposits of similar remaining maturities.

FHLB Advances and Securities Sold Under Agreements to Repurchase - Fair value is determined by discounting future cash flows using rates currently available to the Bank for debt with similar terms and remaining maturities.

Junior Subordinated Debentures – The fair value of junior subordinated debentures is estimated using a discounted cash flow model.

FASB ASC 820, Fair Value Measurements and Disclosure (formerly SFAS 157, Fair Value Measurements), defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.  FASB ASC 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

Level 2: Significant other observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active and other inputs that are observable or can be corroborated by observable market data.

Level 3: Significant unobservable inputs that reflect a company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

The following is a description of the valuation methodologies used to measure and disclose the fair value of assets and liabilities on a recurring or nonrecurring basis:


 
-19-

FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


Note 9:  Fair Values (continued)

Securities

Securities available for sale are recorded at fair value on a recurring basis.  Fair value is determined by obtaining quoted prices on nationally recognized securities exchanges (Level 1), through the use of alternative approaches, such as matrix or model pricing, when market quotes are not readily available (Level 2) or through the use of valuation techniques, such as discounted cash flow models (Level 3).

We use an outside vendor to price our securities, Interactive Data Corporation (“IDC”).  IDC provides independent evaluations and is recognized industry-wide as one of the most reliable valuation services.  IDC’s evaluations are based on market data. IDC utilizes evaluated pricing models that vary based on asset class and include available trade, bid and other market information.  Methodology includes broker quotes, proprietary modes, vast descriptive terms and conditions databases, as well as extensive quality control programs.  IDC uses a pricing model only on our municipal securities totaling $3.8 million which are subject to IDC’s quality control program.

All pricing information and quotes we obtain from IDC on our securities are reviewed for reasonableness and used directly for the preparation of our financial statement.  We have not had to adjust prices provided by IDC, since the majority of our security prices are based on market data.

Impaired Loans
 
From time to time, and on a nonrecurring basis, fair value adjustments to collateral dependent loans are recorded to reflect partial write-downs based on the current appraised value of the collateral or internally developed models which contain management’s assumptions (Level 3).

Other Real Estate Owned

Other real estate owned (“OREO”) consists principally of properties acquired through foreclosure.  At the time of foreclosure, OREO is recorded at the lower of the carrying amount of the loan or fair value less costs to sell, which becomes the new basis. Subsequent to the transfer of loans to OREO, and on a nonrecurring basis, fair value adjustments are recorded to reflect partial write-downs based on the current appraised value or internally developed models which contain management’s assumptions (Level 3).


 
-20-

FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


Note 9:  Fair Values (continued)

The following table presents the balances of assets measured at fair value on a recurring basis at September 30, 2009 and December 31, 2008 (in thousands):
 
   
Fair Value at September 30, 2009
 
   
Level 1
   
Level 2
   
Level 3
   
Total
 
Available for sale securities
                       
Equities
  $ 1,868     $ 610     $ -     $ 2,478  
U.S. Treasuries
    -       315       -       315  
U.S. Agencies
    -       29,965       -       29,965  
Corporate securities
    -       990       1,199       2,189  
Mortgage-backed securities
    -       36,127       -       36,127  
Municipal securities
    -       2,760       -       2,760  
Total
  $ 1,868     $ 70,767     $ 1,199     $ 73,834  
 
   
Fair Value at December 31, 2008
 
   
Level 1
   
Level 2
   
Level 3
   
Total
 
Available for sale securities
                               
Equities
  $ 1,327     $ 603     $ -     $ 1,930  
U.S. Treasuries
    -       6,457       -       6,457  
U.S. Agencies
    -       52,055       -       52,055  
Corporate securities
    -       2,939       1,500       4,439  
Mortgage-backed securities
    -       22,791       -       22,791  
Municipal securities
    -       2,934       -       2,934  
Total
  $ 1,327     $ 87,779     $ 1,500     $ 90,606  

The following table presents the fair value adjustments of assets measured on a recurring basis, using significant unobservable inputs (Level 3), for the nine months ended September 30, 2009 (in thousands).  There were no financial assets or liabilities measured at fair value using Level 3 inputs on a recurring basis during the nine months ended September 30, 2008.
 
   
Fair Value Measurements Using Significant Unobservable Inputs (Level 3)
 
Balance at January 1, 2009
  $ 1,500  
Total unrealized gains or losses
    (301 )
Purchases
    -  
Transfers in and/or out of Level 3
    -  
Balance at September 30, 2009
  $ 1,199  

At September 30, 2009, we valued an investment in a single issuer trust preferred security using a discounted cash flow model.  As a result of unprecedented disruptions of certain financial markets, we determined that the level and volume of activity for this type of security had significantly decreased, and therefore, there were insufficient transactions to accurately determine the fair value.  Using a discounted cash flow method, the fair value of this security was determined to be $1.2 million at September 30, 2009.  In our model, we used a discount factor of 14%, which we estimated based on risk and the current market for this type of security.  This determination is considered a Level 3 input.  For the nine months ended September 30, 2009, there were no realized losses with respect to this security.


 
-21-

FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


Note 9:  Fair Values (continued)

The following table presents the balance of assets measured at fair value on a nonrecurring basis at September 30, 2009 and December 31, 2008 (in thousands):
 
   
Fair Value at September 30, 2009
 
   
Level 1
   
Level 2
   
Level 3
   
Total
 
Impaired loans (1)
  $ -     $ -     $ 582,447     $ 582,447  
OREO (2)
    -       -       94,900       94,900  
    $ -     $ -     $ 677,347     $ 677,347  
 
   
Fair Value at December 31, 2008
 
   
Level 1
   
Level 2
   
Level 3
   
Total
 
Impaired loans (1)
  $ -     $ -     $ 268,193     $ 268,193  
OREO (2)
    -       -       10,803       10,803  
    $ -     $ -     $ 278,996     $ 278,996  

The following table presents the losses resulting from nonrecurring fair value adjustments for the nine months ended September 30, 2009 and 2008 (in thousands):
 
   
Nine Months Ended
 
   
September 30,
 
   
2009
   
2008
 
Impaired loans (1)
  $ 167,455     $ 27,661  
OREO (2)
    53,537       947  
Total loss from nonrecurring measurements
  $ 220,992     $ 28,608  
 
(1)  
The balance of impaired loans measured at fair value at September 30, 2009 and December 31, 2008, represents nonaccruing loans that have had charge-offs and/or have a specific reserve in the allowance for loan losses.  The loss on impaired loans for the nine months ended September 30, 2009 and 2008, represents charge-offs or impairments on collateral dependent loans for fair value adjustments based on the fair value of collateral recognized through the allowance for loan losses.
 
(2)  
The balance of OREO measured at fair value at September 30, 2009 and December 31, 2008, represents real estate that was recorded at fair value less costs to sell at the time of foreclosure and/or has had a valuation adjustment subsequent to becoming OREO.  The loss on OREO for the nine months ended September 30, 2009, represents charge-offs of $48.9 million at the time of foreclosure and subsequent valuation adjustments of $4.6 million.  The loss on OREO for the nine months ended September 30, 2008, presents charge-offs at the time of foreclosure.

There were no material liabilities carried at fair value, measured on a recurring or nonrecurring basis, at September 30, 2009 or 2008.

Note 10: Income Taxes

We adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, on January 1, 2007 (“FIN 48”).  This Interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.  We had no unrecognized tax benefits which would require an adjustment to the January 1, 2007, beginning balance of retained earnings.  We had no unrecognized tax benefits at January 1, 2007, September 30, 2008, or September 30, 2009.

 
-22-

FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


Note 10: Income Taxes (continued)

During the nine months ended September 30, 2009, we reclassified our deferred tax asset to income taxes receivable, resulting from the preparation of our 2008 income tax return.  Both the deferred tax asset and receivable for income taxes are included in other assets, and therefore, this reclassification had no effect on our consolidated balance sheet at September 30, 2009.  Management has evaluated the tax positions taken on our 2008 income tax return and believes it is more likely than not that we will be entitled to a tax refund of approximately $73.5 million, included in other assets, resulting from the carry back of losses in 2008 and 2009.

We recognize interest accrued and penalties related to unrecognized tax benefits in tax expense.  For the three and nine months ended September 30, 2009 and 2008, we recognized no interest or penalties.

We file federal and various state and local income tax returns.  With few exceptions, we are no longer subject to U.S. federal or state/local income tax examinations by tax authorities for years before 2006.             

Note 11: Subsequent Event

As previously announced, on October 5, 2009, the Corporation and SP Acquisition Holdings, Inc. (“SPAH”) mutually agreed to terminate the Agreement and Plan of Merger, dated as of July 30, 2009, by and between SPAH and Frontier, as amended by Amendment No. 1 to Agreement and Plan of Merger, dated as of August 10, 2009, effective immediately, due to the fact that certain closing conditions contained in the merger agreement could not be met.  We continue to seek out private equity investors and other capital sources, and to facilitate this process, we have engaged an investment banking firm.



 
-23-

ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS



This quarterly report on Form 10-Q includes forward-looking statements, within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and subject to the safe harbor created by the Private Securities Litigation Reform Act of 1995, that are subject to risks and uncertainties that could cause actual results to differ materially from those projected. These statements may be identified by the use of forward-looking terminology such as “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “might,” “plan,” “potential,” “predict,” “should” or “will” or the negative thereof or other variations thereon or comparable terminology. We have based these forward-looking statements on our current expectations, assumptions, estimates and projections. While we believe these expectations, assumptions, estimates and projections are reasonable, such forward-looking statements are only predictions and involve known and unknown risks and uncertainties, many of which are beyond our control. These and other important factors, including those discussed in our December 31, 2008 Form 10-K, filed with the Securities and Exchange Commission, under the headings “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Business,” and those discussed in this Form 10-Q under Part II, Item 1A "Risk Factors" below, may cause our actual results, performance or achievements to differ materially from any future results, performance or achievements expressed or implied by these forward-looking statements. Some of the key factors that could cause actual results to differ from our expectations are:
 
·  
changes in general economic conditions, either nationally or locally in western Washington and Oregon;
 
·  
the extent and duration of continued economic, credit, housing and financial market disruptions and governmental actions to address these disruptions;
 
·  
inflation, interest rate, market and monetary fluctuations;
 
·  
legislative or regulatory changes or changes in accounting principles, policies or guidelines;
 
·  
the adequacy of our credit risk management and the allowance for loan losses, asset quality and our ability to collect on delinquent loans, including residential construction and land development loans;
 
·  
the availability of and costs associated with sources of liquidity;
 
·  
changes in real estate values generally, within the markets in which we generate loans, which could adversely affect the demand for loans and may adversely affect collateral held on outstanding loans;
 
·  
the possibility that we will be unable to raise capital and comply with the conditions imposed upon us in the FDIC Order or the FRB Agreement, which could result in the imposition of further restrictions on our operations, penalties or other regulatory actions;
 
·  
our ability to successfully defend against claims asserted against us in lawsuits arising out of, or related to, our lending operations or any regulatory action taken against us, as well as any unanticipated litigation or other regulatory proceedings;
 
·  
the possibility that we may be required to pay significantly higher FDIC insurance premiums in the future;
 
·  
our success at managing the risks involved in the foregoing; and
 
·  
other risks which may be described in our future filings with the SEC under the Securities Exchange Act of 1934.
 

 
-24-

ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)


Given these risks and uncertainties, you are cautioned not to place undue reliance on such forward-looking statements. The forward-looking statements included or incorporated by reference into this report are made only as of the date hereof. We do not undertake and specifically decline any obligation to update any such statements or to publicly announce the results of any revisions to any such statements to reflect future events or developments. In addition, we may make certain statements in future Securities and Exchange Commission (“SEC”) filings, in press releases and in oral and written statements that are not statements of historical fact and may constitute forward-looking statements.

The information contained in this section should be read in conjunction with the Consolidated Financial Statements and accompanying Notes to the Consolidated Financial Statements.

Frontier Financial Corporation (the “Corporation”), a Washington corporation, is a bank holding company owning all of the equity of its wholly owned subsidiary, Frontier Bank (the "Bank").

Financial Overview

The results for the first nine months of 2009 reflect continued pressure from an uncertain economy and the negative impact of the economy on the local housing market in Washington and Oregon.  For the three months ended September 30, 2009, we reported a net loss of $141.1 million, or ($2.99) per diluted share, compared to a net loss of $17.8 million, or ($0.38) per diluted share, for the three months ended September 30, 2008.  For the nine months ended September 30, 2009, net losses totaled $224.9 million, or ($4.77) per diluted share, compared to a net loss of $221 thousand, or ($0.00) per diluted share for the same period in 2008.  Contributing to the net losses for the three and nine months ended September 30, 2009, were provisions for loan losses of $140.0 million and $275.0 million, respectively.
 
The following table presents the basic and diluted losses per share, cash dividends declared per common share, the dividend payout ratio, the returns on average assets and average shareholders’ equity for the three and nine months ended September 30, 2009 and 2008 (in thousands):
 
   
Three Months Ended
   
Nine Months Ended
 
   
September 30,
   
September 30,
 
   
2009
   
2008
   
2009
   
2008
 
Net loss
  $ (141,088 )   $ (17,796 )   $ (224,893 )   $ (221 )
Basic losses per share
  $ (2.99 )   $ (0.38 )   $ (4.77 )   $ (0.00 )
Diluted losses per share
  $ (2.99 )   $ (0.38 )   $ (4.77 )   $ (0.00 )
Cash dividends declared
                               
per common share
  $ -     $ 0.06     $ -     $ 0.30  
Dividend payout ratio
    -       -15.79 %     -    
NM
 
Return on Average
                               
Assets
    -14.39 %     -1.69 %     -7.38 %     -0.01 %
Equity
    -234.71 %     -15.32 %     -100.06 %     -0.06 %
Average equity/average assets
    6.13 %     11.00 %     7.37 %     11.45 %
                                 
NM - Not meaningful.
                               

Despite these challenging times, the Board of Directors and management continue to take important steps to strengthen the Corporation.  Management has been diligently working to reduce the concentration in real estate construction and land development loans, improve asset quality, capital and on-balance sheet liquidity and reduce expenses.

Management has been diligently working to reduce the concentration in real estate construction and land development loans, and has successfully reduced these portfolios by $537.4 million, or 35.1%, from December 31, 2008 to September 30, 2009.  In addition, undisbursed loan commitments related to these portfolios decreased $158.1 million, or 88.2%, for the same period.

We continue to proactively manage credit quality and loan collections and address work out strategies.  In addition, we continue to charge-off confirmed losses against specific reserves in the allowance for loan losses.  For the nine months ended September 30, 2009, net charge-offs totaled $246.3 million.

 
-25-

ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)


As of September 30, 2009, Frontier Bank’s total risk-based capital ratio was less than 6.0%, and therefore, Frontier Bank is considered “significantly undercapitalized” under federal regulatory guidelines, as a result of significant additional provisions for loan losses and charge-offs in the third quarter of 2009.  In addition, Frontier Bank’s Tier 1 leverage capital ratio remains less than the 10% required by the terms of the FDIC Order.  See “Regulatory Actions” above.

We continue to take steps to strengthen our capital position.  Efforts to raise additional capital began in the third quarter of 2008, when the Board of Directors retained an investment banking firm to assist in raising capital and deleveraging our balance sheet.  Our ability to raise additional capital has been adversely affected by unfavorable conditions in the capital markets and our financial performance, and we have not been able to raise additional capital to date.  If we cannot raise additional capital, continue to shrink our balance sheet and/or enter into a strategic merger or sale, we may not be able to sustain further deterioration in our financial condition and further regulatory actions or restrictions may be taken against us.

We continue to closely monitor and manage our liquidity position, understanding that this is of critical importance in the current economic environment.  Attracting and retaining customer deposits remains our primary source of liquidity.  Noninterest bearing deposits increased $8.1 million, or 2.0%, from December 31, 2008 to September 30, 2009.

During the third quarter 2009, we announced our continued participation in the Federal Deposit Insurance Corporation's ("FDIC") voluntary Transaction Account Guarantee ("TAG") portion of the Temporary Liquidity Guarantee Program through June 30, 2010.  Under this program, noninterest bearing transaction accounts and qualified NOW checking accounts are fully guaranteed by the FDIC for an unlimited amount of coverage. The coverage under the TAG program is in addition to, and separate from, the coverage available under the FDIC's general deposit insurance protection.

In an effort to increase on-balance sheet liquidity, we have been focused on restructuring our balance sheet, and in particular, reducing the loan portfolio.  For the nine months ended September 30, 2009, total loans decreased $627.7 million, or 16.6%, compared to December 31, 2008.  Additionally, we have increased our federal funds sold balances to $363.1 million at September 30, 2009, an increase of $245.3 million from December 31, 2008.

Expense Reduction Measures

We continue to seek out feasible expense reduction measures.  Previously announced expense reduction measures include: a six percent reduction in workforce, the suspension of the Corporation’s matching of employee 401(K) Plan contributions, effective May 1, 2009, and reductions to executive compensation, salary freezes and the elimination of performance bonuses and discretionary profit sharing contributions to the 401(K) Plan.  Additionally, full time equivalents (“FTE”) employees are down 158, or 18.5%, from the peek in May 2008 to September 30, 2009.

Regulatory Actions

FDIC Order

On March 20, 2009, Frontier Bank entered into a Stipulation and Consent to the Issuance of an Order to Cease and Desist (the “FDIC Order”) with the Federal Deposit Insurance Corporation (the “FDIC”) and the Washington Department of Financial Institutions (the “Washington DFI”). The regulators alleged that Frontier Bank had engaged in unsafe or unsound banking practices by operating with inadequate management and board supervision; engaging in unsatisfactory lending and collection practices; operating with inadequate capital in relation to the kind and quality of assets held at Frontier Bank; operating with an inadequate loan valuation reserve; operating with a large volume of poor quality loans; operating in such a manner as to produce low earnings and operating with inadequate provisions for liquidity. By consenting to the FDIC Order, Frontier Bank neither admitted nor denied the alleged charges.


 
-26-

ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)


Under the terms of the FDIC Order, Frontier Bank cannot declare dividends or pay any management, consulting or other fees or funds to the Corporation, without the prior written approval of the FDIC and the Washington DFI.  Other material provisions of the FDIC Order require Frontier Bank to: (1) review the qualifications of Frontier Bank’s management, (2) provide the FDIC with 30 days written notice prior to adding any individual to the Board of Directors of Frontier Bank (the “Frontier Bank Board”) or employing any individual as a senior executive officer, (3) increase director participation and supervision of Frontier Bank affairs, (4) improve Frontier Bank’s lending and collection policies and procedures, particularly with respect to the origination and monitoring of real estate construction and land development loans, (5) develop a capital plan and increase Tier 1 leverage capital to 10% of Frontier Bank’s total assets by July 29, 2009, and maintain that capital level, in addition to maintaining a fully funded allowance for loan losses satisfactory to the regulators, (6) implement a comprehensive policy for determining the adequacy of the allowance for loan losses and limiting concentrations in commercial real estate and acquisition, development and construction loans, (7) formulate a written plan to reduce Frontier Bank’s risk exposure to adversely classified loans and nonperforming assets, (8) refrain from extending additional credit with respect to loans charged-off or classified as “loss” and uncollected, (9) refrain from extending additional credit with respect to other adversely classified loans without collecting all past due interest, without the prior approval of a majority of the directors on the Frontier Bank Board or its loan committee, (10) develop a plan to control overhead and other expenses to restore profitability, (11) implement a liquidity and funds management policy to reduce Frontier Bank’s reliance on brokered deposits and other non-core funding sources, and (12) prepare and submit progress reports to the FDIC and the Washington DFI. The FDIC Order will remain in effect until modified or terminated by the FDIC and the Washington DFI.

The FDIC Order does not restrict Frontier Bank from transacting its normal banking business.  Frontier Bank will continue to serve its customers in all areas including making loans, establishing lines of credit, accepting deposits and processing banking transactions. Customer deposits remain fully insured to the highest limits set by FDIC.  The FDIC and Washington DFI did not impose any monetary penalties in connection with the FDIC Order.

FRB Agreement

In addition, on July 2, 2009, the Corporation entered into a Written Agreement (the “FRB Written Agreement”) with the Federal Reserve Bank of San Francisco (the “FRB”).  Under the terms of the FRB Written Agreement, the Corporation has agreed to: (1) refrain from declaring or paying any dividends without prior written consent of the FRB; (2) refrain from taking dividends or any other form of payment that represents a reduction in capital from Frontier Bank without prior written consent of the FRB; (3) refrain from making any distributions of interest or principal on subordinated debentures or trust preferred securities without prior written consent of the FRB; (4) refrain from incurring, increasing or guaranteeing any debt without prior written consent of the FRB; (5) refrain from purchasing or redeeming any shares of its stock without prior written consent of the FRB; (6) implement a capital plan and maintain sufficient capital; (7) comply with notice and approval requirements established by the FRB relating to the appointment of directors and senior executive officers as well as any change in the responsibility of any current senior executive officer; (8) not pay or agree to pay any indemnification and severance payments except under certain circumstances, and with the prior approval of the FRB; and (9) provide quarterly progress reports to the FRB.

Compliance Memorandum of Understanding

Frontier Bank and the Frontier Bank Board also entered into a Memorandum of Understanding with the FDIC dated August 20, 2008, relating to the correction of certain violations of applicable consumer protection and fair lending laws and regulations, principally including the failure to provide certain notices to consumers pursuant to the Flood Disaster Protection Act of 1973, and certain violations of the Truth in Lending Act and Regulation Z.

 

 
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ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)


The Memorandum of Understanding requires Frontier Bank and the Frontier Bank Board to (1) correct all violations found and implement procedures to prevent their recurrence; (2) increase oversight of the Frontier Bank Board’s compliance function, including monthly reports from Frontier Bank’s compliance officer to the Frontier Bank Board detailing actions taken to comply with the Memorandum of Understanding; (3) review its compliance policies and procedures and develop and implement detailed operating procedures and controls, where necessary, to ensure compliance with all consumer protection laws and regulations; (4) establish monitoring procedures to ensure compliance with all consumer protection laws and regulations (including flood insurance), including the documentation and reporting of all exceptions to the Frontier Bank Board and its audit committee; (5) review, expand and improve the quality of such compliance with the frequency of compliance audits to be reviewed and approved annually by the Frontier Bank Board or audit committee, with a goal of auditing compliance at least annually; (6) ensure that Frontier Bank’s compliance management function has adequate staff, resources, training and authority for the size and structure of Frontier Bank; (7) establish flood insurance monitoring procedures to ensure loans are not closed without flood insurance and prior notices to customers required by law, that lapses of flood insurance do not occur, and to develop methods to ensure that adequate amounts of flood insurance are provided, with Frontier Bank agreeing to force place flood insurance when necessary; (8) provide additional training for all Frontier Bank personnel, including the Frontier Bank Board and audit and compliance staff for applicable laws and regulations and (9) furnish quarterly progress reports to the Regional Director of the FDIC detailing the actions taken to secure compliance with the Memorandum of Understanding until the Regional Director has released the institution, in writing, from submitting further reports. Frontier Bank was assessed civil monetary penalties of $48,895 for flood insurance violations and required to pay $10,974 in restitution to customers for certain violations of the Truth in Lending Act and Regulation Z.

We have been actively engaged in responding to the concerns raised in the FDIC Order, the FRB Agreement and the Memorandum of Understanding and believes we have addressed all the regulators’ requirements and that we are in compliance with all the terms of these regulatory actions, with the exception of increasing Tier 1 leverage capital to 10% of the Bank’s total assets.  See “Strategic Plan – Capital Preservation” below.

These regulatory actions may adversely affect our ability to obtain regulatory approval for future initiatives requiring regulatory action, such as acquisitions. The regulatory actions will remain in effect until modified or terminated by the regulators.

Compliance Efforts in Response to Regulatory Actions

We are actively engaged in responding to the concerns raised by the regulators and have acted promptly on directions received from by taking the following actions:
 
     
 
• 
Engaged Patrick M. Fahey as chairman of the board and chief executive officer of Frontier, and Michael J. Clementz as president, on December 4, 2008;
     
 
• 
Retained an independent consultant to review and evaluate the loan portfolio in the Fall of 2008, and again in July, 2009;
     
 
• 
Organized a special assets group staffed by 37 managers and employees, to accelerate the collection and resolution of delinquent and adversely classified loans;
     
 
• 
Developed capital management, liquidity and funds management plans;
     
 
• 
Increased board and senior management oversight of Frontier Bank, its lending and operations, including special weekly board meetings;
     
 
• 
Established a communications procedure for reporting progress in all areas to the FDIC, Washington DFI and FRB.
 


 
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ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)


Continuing Operations

In connection with continuing turmoil in the economy, and more specifically, within the local real estate market, we recorded net losses of $141.1 million and $224.9 million for the three and nine months ended September 30, 2009, respectively.  These losses were primarily the result of necessary increases in our provision for loan losses during these periods, and declining net interest margins caused by increased amounts of nonperforming loans.  These losses, the FDIC Order, and the high level of risk associated with our real estate loan portfolio have resulted in Frontier Bank being regarded by our regulators as “significantly undercapitalized” at September 30, 2009.  The net losses for the periods have had a negative impact on our operations, liquidity and capital adequacy and could result in further actions by our regulators to restrict our operations as discussed below.

On July 31, 2009, we announced the signing of an agreement and plan of merger with SP Acquisition Holdings (“SPAH”).  The merger was expected to close in the fourth quarter of 2009.  SPAH was a special purpose acquisition company with nearly $429 million in assets.  On October 5, 2009, we mutually agreed to terminate the agreement and plan of merger with SPAH due to the fact that certain closing conditions contained in the merger agreement could not be met.

In order to achieve compliance with the risk-based capital requirement of the FDIC Order, we will need to either raise capital, sell assets to deleverage, or both.  Our ability to accomplish these goals is significantly constricted by the current economic environment, in which access to capital markets has been limited, and we can give no assurances that we will be able to access any such capital or sell more assets.

Our ability to decrease our levels of nonperforming assets is also vulnerable to market conditions as many of our borrowers rely on an active real estate market as a source of repayment, particularly our real estate construction and real estate development loan borrowers.  If the real estate market does not improve or declines further, our level of nonperforming assets may continue to increase.

As a result of the asset quality and capital concerns affecting us, we have been aggressively addressing our liquidity needs to maintain an adequate cash flow position to sustain operations.  At September 30, 2009, we maintained approximately $363.1 million of federal funds sold to increase on-balance sheet liquidity.

We have ceased originating new real estate construction development loans and completed lot loans, although we continue to selectively fund on commitments previously issued.  Finally, our special assets group has been aggressively marketing foreclosed real estate in an effort to sell noninterest earning assets at sales prices that do not further deteriorate our capital position.
    
We have determined that significant additional sources of capital will be required for us to continue operations through 2009 and beyond.  We have engaged financial advisors to assist us in our efforts to raise additional capital and explore other strategic alternatives to address our current and expected capital deficiencies.  Based on their assessment of our ability to continue to operate in compliance with the FDIC Order, our regulators may take other and further actions, including the assessment of civil money penalties against the Bank or the Corporation and their respective officers, directors and other interested parties or they may seek to enforce the order or agreement in federal court.  If the Bank or the Corporation were to engage in other unsafe and unsound banking practices, the regulators have various enforcement tools available to them including the issuance of capital directives, orders to cease engaging in certain business activities and the issuance of modified or additional orders or agreements.


 
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ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

 
Review of Financial Condition – September 30, 2009 and December 31, 2008

Federal Funds Sold

At September 30, 2009, federal funds sold totaled $363.1 million, compared to $117.7 million at December 31, 2008, an increase of $245.3 million, or 208.4%.  Federal funds sold fluctuate on a daily basis depending on our net cash position for the day.  In addition, increased federal fund sold balances improves on-balance sheet liquidity, which is an ongoing focus of management.

Securities

The following table represents the available for sale and held to maturity securities portfolios by type at September 30, 2009 and December 31, 2008 (in thousands):
 
   
Securities Available for Sale
 
   
September 30, 2009
   
December 31, 2008
 
   
Fair Value
   
% of total
   
Fair Value
   
% of total
 
Equities
  $ 2,478       3.4 %   $ 1,930       2.1 %
U.S. Treasuries
    315       0.4 %     6,457       7.1 %
U.S. Agencies
    29,965       40.6 %     52,055       57.5 %
Corporate securities
    2,189       3.0 %     4,439       4.9 %
Mortgage-backed securities
    36,127       48.9 %     22,791       25.2 %
Municipal securities
    2,760       3.7 %     2,934       3.2 %
Total
  $ 73,834       100.0 %   $ 90,606       100.0 %
 
   
Securities Held to Maturity
 
   
September 30, 2009
   
December 31, 2008
 
   
Amortized Cost
   
% of total
   
Amortized Cost
   
% of total
 
Corporate securities
  $ 1,524       49.5 %   $ 1,524       49.4 %
Municipal securities
    1,555       50.5 %     1,561       50.6 %
Total
  $ 3,079       100.0 %   $ 3,085       100.0 %

Available for sale securities totaled $73.8 million at September 30, 2009, compared to $90.6 million at December 31, 2008, a decrease of $16.8 million, or 18.5%.  This decrease is primarily attributable to calls and maturities totaling $57.1 million, principal pay-downs on mortgage-backed securities of $5.4 million and sales of corporate securities totaling $1.4 million; partially offset by the purchase of $47.3 million of securities, principally U.S. Agencies and mortgage-backed securities.


 
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ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)


Loans

The following table represents the loan portfolio by type, excluding loans held for resale and net of unearned income, at September 30, 2009 and December 31, 2008 (in thousands):
 
   
September 30, 2009
   
December 31, 2008