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Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED June 30, 2010

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.....001-34696

 

 

STERLING FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

 

 

 

Washington   91-1572822

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

111 North Wall Street, Spokane, Washington 99201

(Address of principal executive offices) (Zip Code)

(509) 458-3711

(Registrant’s telephone number, including area code)

 

 

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Date 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 for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer   ¨    Accelerated filer   x
Non-accelerated filer   ¨  (Do not check if a smaller reporting company)    Smaller reporting company   ¨

Indicate by 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 as of July 29, 2010

Common Stock ($1.00 par value)

  52,190,859

 

 

 


Table of Contents

STERLING FINANCIAL CORPORATION

FORM 10-Q

For the Quarter Ended June 30, 2010

TABLE OF CONTENTS

 

                  Page

PART I - Financial Information

   1
 

Item 1

     Financial Statements (Unaudited)    1
       Consolidated Balance Sheets    1
       Consolidated Statements of Income    2
       Consolidated Statements of Cash Flows    3
       Consolidated Statements of Comprehensive Income    5
       Notes to Consolidated Financial Statements    6
 

Item 2

     Management’s Discussion and Analysis of Financial Condition and Results of Operations    25
 

Item 3

     Quantitative and Qualitative Disclosures About Market Risk    48
 

Item 4

     Controls and Procedures    48

PART II - Other Information

   50
 

Item 1

     Legal Proceedings    50
 

Item 1a

     Risk Factors    51
 

Item 2

     Unregistered Sales of Equity Securities and Use of Proceeds    68
 

Item 3

     Defaults Upon Senior Securities    68
 

Item 4

     (Reserved)    68
 

Item 5

     Other Information    68
 

Item 6

     Exhibits    68

Signatures

   69


Table of Contents

PART I - Financial Information

Item 1 - Financial Statements

STERLING FINANCIAL CORPORATION

Consolidated Balance Sheets

(Unaudited)

 

      June 30,
2010
    December 31,
2009
 
     (Dollars in thousands)  

ASSETS:

    

Cash and cash equivalents:

    

Interest bearing

   $ 646,737      $ 424,008   

Non-interest bearing

     162,998        140,775   
                

Total cash and cash equivalents

     809,735        564,783   
                

Restricted cash

     13,580        8,223   

Investment securities and mortgage-backed securities (“MBS”):

    

Available for sale

     1,940,710        2,160,325   

Held to maturity

     15,180        17,646   

Loans receivable, net

     6,140,913        7,344,199   

Loans held for sale (at fair value: $191,338 and $189,185)

     192,411        190,412   

Accrued interest receivable

     35,014        43,869   

Other real estate owned, net (“OREO”)

     135,233        83,272   

Office properties and equipment, net

     85,841        92,037   

Bank-owned life insurance (“BOLI”)

     165,805        164,743   

Core deposit intangibles

     19,378        21,827   

Mortgage servicing rights, net

     12,777        12,062   

Prepaid expenses and other assets, net

     171,204        174,025   
                

Total assets

   $ 9,737,781      $ 10,877,423   
                

LIABILITIES:

    

Deposits

   $ 7,240,769      $ 7,775,190   

Advances from Federal Home Loan Bank (“FHLB”)

     875,134        1,337,167   

Securities sold subject to repurchase agreements and funds purchased

     1,023,027        1,049,146   

Other borrowings

     248,283        248,281   

Cashiers checks issued and payable

     3,574        6,443   

Borrowers’ reserves for taxes and insurance

     2,594        2,283   

Accrued interest payable

     18,319        22,245   

Accrued expenses and other liabilities

     132,962        113,419   
                

Total liabilities

     9,544,662        10,554,174   
                

SHAREHOLDERS’ EQUITY:

    

Preferred stock, $1 par value; $1,000 stated value; 10,000,000 shares authorized;
303,000 shares issued and outstanding

     295,203        294,136   

Common stock, $1 par value; 750,000,000 shares authorized; 52,190,859 and 52,211,090 shares issued and outstanding

     52,191        52,211   

Additional paid-in capital

     911,409        910,663   

Accumulated other comprehensive loss:

    

Unrealized gains on investment securities and MBS available-for-sale, net of deferred income taxes of ($18,419) and ($9,518)

     31,362        16,284   

Accumulated deficit

     (1,097,046     (950,045
                

Total shareholders’ equity

     193,119        323,249   
                

Total liabilities and shareholders’ equity

   $ 9,737,781      $ 10,877,423   
                

See notes to consolidated financial statements.

 

1


Table of Contents

STERLING FINANCIAL CORPORATION

Consolidated Statements of Income (Loss)

(Unaudited)

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2010     2009     2010     2009  
     (Dollars in thousands, except per share data)  

Interest income:

        

Loans

   $ 93,885      $ 123,948      $ 190,861      $ 250,871   

MBS

     18,616        27,578        38,442        57,458   

Investments and cash equivalents

     2,708        2,993        5,398        6,321   
                                

Total interest income

     115,209        154,519        234,701        314,650   
                                

Interest expense:

        

Deposits

     25,063        44,608        52,514        92,922   

Short-term borrowings

     2,103        4,548        4,214        9,199   

Long-term borrowings

     14,948        17,744        29,988        36,562   
                                

Total interest expense

     42,114        66,900        86,716        138,683   
                                

Net interest income

     73,095        87,619        147,985        175,967   

Provision for credit losses

     (70,781     (79,744     (159,337     (145,609
                                

Net interest income (expense) after provision for credit losses

     2,314        7,875        (11,352     30,358   
                                

Non-interest income:

        

Fees and service charges

     14,233        14,878        27,268        28,718   

Mortgage banking operations

     11,713        13,732        22,945        27,040   

Loan servicing fees

     (408     1,022        738        555   

BOLI

     1,560        2,000        3,855        3,406   

Gains on sales of securities

     15,349        992        17,260        11,557   

Other

     (1,219     (932     (5,541     (2,958
                                

Total non-interest income

     41,228        31,692        66,525        68,318   
                                

Non-interest expenses

     97,315        105,149        193,292        185,137   
                                

Loss before income taxes

     (53,773     (65,582     (138,119     (86,461

Income tax benefit

     0        36,049        0        36,485   
                                

Net loss

     (53,773     (29,533     (138,119     (49,976

Preferred stock dividend

     (4,469     (4,347     (8,881     (8,694
                                

Net loss available to common shareholders

   $ (58,242   $ (33,880   $ (147,000   $ (58,670
                                

Earnings (loss) per share - basic

   $ (1.12   $ (0.65   $ (2.83   $ (1.13
                                

Earnings (loss) per share - diluted

   $ (1.12   $ (0.65   $ (2.83   $ (1.13
                                

Weighted average shares outstanding - basic

     52,009,290        51,922,407        51,994,737        51,909,350   

Weighted average shares outstanding - diluted

     52,009,290        51,922,407        51,994,737        51,909,350   

See notes to consolidated financial statements.

 

2


Table of Contents

STERLING FINANCIAL CORPORATION

Consolidated Statements of Cash Flows

(Unaudited)

 

     Six Months Ended June 30,  
     2010     2009  
     (Dollars in thousands)  

Cash flows from operating activities:

    

Net loss

   $ (138,119   $ (49,976

Adjustments to reconcile net income to net cash provided by operating activities:

    

Provision for credit losses and OREO

     175,447        164,679   

Accretion of deferred gain on sale of branches

     (402     (402

Net gain on sales of loans, investments and MBS

     (37,494     (39,300

Stock based compensation

     708        1,459   

Excess tax benefit from stock based compensation

     0        744   

Stock issuances relating to direct stock purchase

     18        12   

Loss at foreclosure and on sale of OREO

     30,278        30,911   

Other losses

     2,942        2,699   

Increase in cash surrender value of BOLI

     (3,855     (4,035

Depreciation and amortization

     16,524        15,334   

Change in:

    

Accrued interest receivable

     8,855        1,818   

Prepaid expenses and other assets

     (6,311     20,609   

Cashiers checks issued and payable

     (2,869     (3,377

Accrued interest payable

     (3,926     (9,073

Accrued expenses and other liabilities

     12,130        3,242   

Proceeds from sales of loans originated for sale

     1,105,740        1,391,201   

Loans originated for sale

     (1,216,103     (1,362,913
                

Net cash (used in) provided by operating activities

     (56,437     163,632   
                

Cash flows from investing activities:

    

Change in restricted cash

     (5,357     319   

Loans funded and purchased

     (382,977     (1,302,272

Loan principal received

     1,092,544        1,319,176   

Proceeds from sales of other loans

     296,532        0   

Purchase of investment securities

     (2,501     (683,359

Proceeds from maturities of investment securities

     4,951        716,180   

Proceeds from sale of investment securities

     17,192        80,310   

Proceeds from sale - MBS

     542,367        140,998   

Purchase of MBS

     (642,574     (534,689

Principal payments on MBS

     336,583        402,699   

Purchase of office properties and equipment

     (1,367     (6,099

Sales of office properties and equipment

     46        62   

Improvements and other changes to OREO

     (2,005     (10,356

Proceeds from sales of OREO

     70,027        43,474   
                

Net cash provided by (used in) investing activities

     1,323,461        166,443   
                

See notes to consolidated financial statements.

 

3


Table of Contents

STERLING FINANCIAL CORPORATION

Consolidated Statements of Cash Flows

(Unaudited)

 

     Six Months Ended June 30,  
     2010     2009  
     (Dollars in thousands)  

Cash flows from financing activities:

    

Net change in transaction and savings deposits

   $ (223,356   $ 126,246   

Proceeds from issuance of time deposits

     823,807        1,735,358   

Payments for maturing time deposits

     (1,192,474     (2,007,454

Interest credited to deposits

     57,602        99,184   

Advances from FHLB

     495,750        121,000   

Repayment of advances from FHLB

     (957,593     (345,840

Net change in securities sold subject to repurchase agreements and funds purchased

     (26,119     (66,893

Excess tax benefit from stock based compensation

     0        (744

Cash dividends paid to preferred shareholders

     0        (6,733

Other

     311        1,071   
                

Net cash provided by (used in) financing activities

     (1,022,072     (344,805
                

Net change in cash and cash equivalents

     244,952        (14,730

Cash and cash equivalents, beginning of period

     564,783        138,802   
                

Cash and cash equivalents, end of period

   $ 809,735      $ 124,072   
                

Supplemental disclosures:

    

Cash paid (received) during the period for:

    

Interest

   $ 90,642      $ 147,756   

Income taxes

     (49,390     (68,062

Noncash financing and investing activities:

    

Loans converted into OREO

     166,371        85,960   

Preferred stock cash dividend accrued

     7,815        1,894   

See notes to consolidated financial statements.

 

4


Table of Contents

STERLING FINANCIAL CORPORATION

Consolidated Statements of Comprehensive Income (Loss)

(Unaudited)

 

     Three Months Ended June 30,     Six Months Ended June 30,  
     2010     2009     2010     2009  
     (Dollars in thousands)  

Net loss

   $ (53,773   $ (29,533   $ (138,119   $ (49,976
                                

Other comprehensive income (loss):

        

Change in unrealized losses on investments and MBS available-for-sale

     7,852        12,516        23,979        19,440   

Less deferred income taxes benefit

     (2,915     (4,631     (8,901     (7,193
                                

Net other comprehensive income

     4,937        7,885        15,078        12,247   
                                

Comprehensive loss

   $ (48,836   $ (21,648   $ (123,041   $ (37,729
                                

See notes to consolidated financial statements.

 

5


Table of Contents

Notes to Consolidated Financial Statements

1. Basis of Presentation:

The foregoing unaudited interim consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X as promulgated by the Securities and Exchange Commission. Accordingly, these financial statements do not include all of the disclosures required by accounting principles generally accepted in the United States of America for complete financial statements. These unaudited interim consolidated financial statements should be read in conjunction with the audited consolidated financial statements as disclosed in the annual report on Form 10-K for the year ended December 31, 2009. In the opinion of management, the unaudited interim consolidated financial statements furnished herein include all adjustments, all of which are of a normal recurring nature, necessary for a fair statement of the results for the interim periods presented.

The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities known to exist as of the date the financial statements are published, and the reported amounts of revenues and expenses during the reporting period. Uncertainties with respect to such estimates and assumptions are inherent in the preparation of Sterling Financial Corporation’s (“Sterling’s”) consolidated financial statements; accordingly, it is possible that the actual results could differ from these estimates and assumptions, which could have a material effect on the reported amounts of Sterling’s consolidated financial position and results of operations. These financial statements have been prepared under the assumption that the entity is a going concern, an assumption for which Sterling’s Independent Public Accountants expressed substantial doubt in their opinion relating to the December 31, 2009 consolidated financial statements.

In addition to other established accounting policies, the following is a discussion of recent accounting pronouncements:

In June 2009, the Financial Accounting Standards Board (the “FASB”) issued Accounting Standards Update (“ASU”) 2009-16,” Accounting for Transfers of Financial Assets.” This standard removes the concept of qualifying special-purpose entities as an accounting criteria that had provided an exception to consolidation, provided additional guidance on requirements for consolidation, and is an update to codification topic 860. This guidance became effective for Sterling on January 1, 2010, and did not have a material impact on its consolidated financial statements.

In January 2010, the FASB issued ASU 2010-06,” Fair Value Measurements and Disclosures.” This guidance is related to implementation of fair value measurement disclosures. This update to the codification topic 820 specifically addresses: 1) transfers between levels 1, 2 and 3 of the fair value hierarchy; 2) level of disaggregation of derivative contracts for fair value measurement disclosures; and 3) disclosures about fair value measurement inputs and valuation techniques. This guidance became effective for Sterling on March 31, 2010, and did not have a material impact on its consolidated financial statements.

In February 2010, the FASB issued ASU 2010-09,” Amendments to Certain Recognition and Disclosure Requirements,” that standardizes accounting for and disclosures of events that occur after the balance sheet date but before financial statements are issued or are available to be issued, and was an update to codification topic 855. As a public reporting company, Sterling is required to evaluate subsequent events through the date its financial statements are issued. The adoption of these rules did not have a material impact on Sterling’s consolidated financial statements.

In April 2010, the FASB issued ASU 2010-18, “Effect of a Loan Modification When the Loan Is Part of a Pool That Is Accounted for as a Single Asset.” This update addresses modifications of loans that are accounted for within a pool by specifying that a troubled debt restructuring would not result in the removal of those loans from the pool for impairment analysis purposes. This guidance will be effective for Sterling as of September 30, 2010. Sterling does not currently have any loans for which this guidance would be applicable.

 

6


Table of Contents

In July 2010, the FASB issued ASU 2010-20,” Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses.” This update amends codification topic 310 on receivables to improve the disclosures that an entity provides about the credit quality of its financing receivables and the related allowance for credit losses. As a result of these amendments, an entity is required to disaggregate by portfolio segment or class certain existing disclosures and provide certain new disclosures about its financing receivables and related allowance for credit losses. This guidance is being phased in, with the new disclosure requirements for period end balances effective as of December 31, 2010, and the new disclosure requirements for activity during the reporting period are effective March 31, 2011.

2. Investments and MBS:

The carrying and fair values of investments and MBS are summarized as follows:

 

     Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
    Fair Value
     (Dollars in thousands)

June 30, 2010

       

Available for sale

          

MBS

   $ 1,687,384    $ 54,979    $ (968   $ 1,741,395

Municipal bonds

     177,137      3,893      (2,810     178,220

Other

     25,993      2      (4,900     21,095
                            

Total

   $ 1,890,514    $ 58,874    $ (8,678   $ 1,940,710
                            

Held to maturity

          

Tax credits

   $ 15,180    $ 0    $ 0      $ 15,180
                            

Total

   $ 15,180    $ 0    $ 0      $ 15,180
                            

December 31, 2009

          

Available for sale

          

MBS

   $ 1,912,736    $ 44,579    $ (12,326   $ 1,944,989

Municipal bonds

     195,807      3,500      (4,025     195,282

Other

     25,979      0      (5,925     20,054
                            

Total

   $ 2,134,522    $ 48,079    $ (22,276   $ 2,160,325
                            

Held to maturity

          

Tax credits

   $ 17,646    $ 0    $ 0      $ 17,646
                            

Total

   $ 17,646    $ 0    $ 0      $ 17,646
                            

Tax credit investments are in low income housing partnerships. Other available for sale securities were primarily comprised of a trust preferred security at both June 30, 2010 and December 31, 2009. During the six months ended June 30, 2010 and 2009, Sterling sold available-for-sale investments and MBS and recorded the following results:

 

     Proceeds from
Sales
   Gross Realized
Gains
   Gross Realized
(Losses)
 
     (Dollars in thousands)  

Six months ended:

        

June 30, 2010

   $ 559,559    $ 23,681    $ (6,421

June 30, 3009

     221,308      11,135      (122

During the six months ended June 30, 2010, Sterling sold $61.1 million of collateralized mortgage obligations at a loss of $6.0 million. The sales were a result of an updated assessment of the credit risk of certain securities held in the portfolio, including downgrades and potential downgrades by rating agencies. Sterling repositioned the portfolio by reinvesting the proceeds from other securities sales during the first half of 2010 in securities with a shorter duration. Reclassification adjustments from other comprehensive income, representing realized net gains on available-for-sale securities, net of related deferred income taxes, were as follows for the periods presented:

 

     Three Months Ended
June 30,
   Six Months Ended
June 30,
     2010    2009    2010    2009
     (Dollars in thousands)

Realized net gains reclassified from other comprehensive income

   $ 15,223    $ 1,412    $ 11,793    $ 9,348

 

7


Table of Contents

The following table summarizes Sterling’s investments and MBS that had a market value below their amortized cost basis as of June 30, 2010 and December 31, 2009, grouped by the amount of time these securities have been in this unrealized loss position:

 

     Less than 12 months     12 months or longer     Total  
     Market Value    Unrealized
Losses
    Market Value    Unrealized
Losses
    Market Value    Unrealized
Losses
 
     (Dollars in thousands)  
June 30, 2010                

Municipal bonds

   $ 0    $ 0      $ 37,329    $ (2,810   $ 37,329    $ (2,810

MBS

     91,216      (660     17,840      (308     109,056      (968

Other

     0      0        19,863      (4,900     19,863      (4,900
                                             

Total

   $ 91,216    $ (660   $ 75,032    $ (8,018   $ 166,248    $ (8,678
                                             

December 31, 2009

               

Municipal bonds

   $ 13,758    $ (317   $ 45,729    $ (3,708   $ 59,487    $ (4,025

MBS

     190,004      (4,039     115,266      (8,287     305,270      (12,326

Other

     0      0        18,791      (5,925     18,791      (5,925
                                             

Total

   $ 203,762    $ (4,356   $ 179,786    $ (17,920   $ 383,548    $ (22,276
                                             

The amortized cost and fair value of available-for-sale and held-to-maturity debt securities as of June 30, 2010, are listed below according to contractual maturity date. Expected or actual maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

     Held-to-maturity    Available-for-sale
     Amortized Cost    Estimated Fair
Value
   Amortized Cost    Estimated Fair
Value
     (Dollars in thousands)

Due within one year

   $ 0    $ 0    $ 0    $ 0

Due after one year through five years

     0      0      782      796

Due after five years through ten years

     0      0      104,218      106,814

Due after ten years

     15,180      15,180      1,785,514      1,833,100
                           

Total

   $ 15,180    $ 15,180    $ 1,890,514    $ 1,940,710
                           

Management evaluates investment securities for other than temporary declines in fair value on a quarterly basis. If the fair value of investment securities falls below their amortized cost and the decline is deemed to be other than temporary, the securities will be written down to current market value, resulting in a loss. There were no investment securities that management identified to be other than-temporarily impaired at June 30, 2010, because the decline in fair value of certain classes of securities was attributable to temporary disruptions of credit markets and the related impact on securities within those classes, not deteriorating credit quality of specific securities. Sterling holds a single-issuer trust preferred security that has been negatively impacted by temporary credit market disruptions. As of June 30, 2010, the trust preferred security is rated A1 by Moody’s and has an amortized cost of $24.8 million compared to a $19.9 million market value, or an unrealized loss of $4.9 million.

 

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As of June 30, 2010, Sterling also held private label collateralized mortgage obligations with an aggregate amortized cost of $66.5 million compared to a $66.9 million market value, or a net unrealized gain of $417,000. All private label collateralized mortgage obligations are internally monitored monthly and independently stress-tested quarterly for both credit quality and collateral strength, and are AAA- rated according to at least one major rating agency. The vintage, or years of issuance, for these nonagency MBS ranges from 2003 to 2005.

As of June 30, 2010, Sterling expects the return of all principal and interest on all securities within its investment and mortgage-backed securities portfolio pursuant to the contractual terms, has the ability and intent to hold these investments, has no intent to sell securities that are deemed to have a market value impairment, and does not believe it is more likely than not that it would be required to sell these investments before a recovery in market price occurs, or until maturity. Realized losses could occur in future periods due to a change in management’s intent to hold the investments to recovery, a change in management’s assessment of credit risk, or a change in regulatory or accounting requirements.

3. Allowance for Credit Losses:

The following is an analysis of the changes in the allowances for credit losses:

 

     Six Months Ended June 30,  
     2010     2009  
     (Dollars in thousands)  

Allowance for credit losses

    

Allowance - loans, January 1

   $ 343,443      $ 208,365   

Provision

     159,791        145,609   

Charge-offs

     (252,700     (145,450

Recoveries

     14,316        5,225   

Transfers

     0        9,960   
                

Allowance - loans, June 30

     264,850        223,709   
                

Allowance - unfunded commitments, January 1

     11,967        21,334   

Provision

     (454     0   

Charge-offs

     (562     0   

Transfers

     0        (9,960
                

Allowance - unfunded commitments, June 30

     10,951        11,374   
                

Total credit allowance

   $ 275,801      $ 235,083   
                

The level of the provision is in response to the amount of classified loans and charge-offs, with higher loss rates related to the decline in collateral values, particularly in the construction, commercial real estate and residential real estate portfolios. Classified assets include performing substandard loans, nonperforming loans and OREO. Nonperforming loans and OREO comprise nonperforming assets, for which the following summarizes as of the dates indicated:

 

     June 30,
2010
    December 31,
2009
    June 30,
2009
 
           (Dollars in thousands)  

Past due 90 days

   $ 0      $ 0      $ 0   

Nonaccrual loans

     760,136        824,652        592,450   

Restructured loans

     123,999        71,279        105,283   
                        

Total nonperforming loans

     884,135        895,931        697,733   

OREO

     149,302        91,478        89,721   
                        

Total nonperforming assets

     1,033,437        987,409        787,454   

Specific reserves

     (32,128     (35,334     (24,554
                        

Net nonperforming assets

   $ 1,001,309      $ 952,075      $ 762,900   
                        

 

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Cumulatively, Sterling has written down its nonperforming assets by $592.8 million as of June 30, 2010, compared with write-downs of $579.7 million as of December 31, 2009 and $282.1 million as of June 30, 2009, primarily reflecting lower real estate appraisal values. Additionally, Sterling has established specific reserves of $18.1 million against its nonperforming loans for valuation changes between appraisals, and $14.1 million for its OREO properties.

At the applicable foreclosure date, other real estate owned is recorded at the fair value of the real estate, less the costs to sell the real estate. The carrying value of OREO is regularly evaluated and, if necessary, an allowance is established to reduce the carrying value to net realizable value. Changes in this allowance are as follows for the periods presented:

 

     Six Months Ended June 30,  
     2010     2009  
     (Dollars in thousands)  

Balance, January 1

   $ 8,204      $ 17,555   

Provision

     16,110        19,070   

Charge-offs

     (10,246     (12,085
                

Balance, June 30

   $ 14,068      $ 24,540   
                

4. Other Borrowings:

The components of other borrowings are as follows:

 

     June 30,
2010
   December 31,
2009
     (Dollars in thousands)

Junior subordinated debentures

   $ 245,283    $ 245,281

Other

     3,000      3,000
             

Total other borrowings

   $ 248,283    $ 248,281
             

Sterling has raised capital through the formation of trust subsidiaries (“Capital Trusts”), which issue capital securities (“Trust Preferred Securities”) to investors. The Capital Trusts are business trusts in which Sterling owns all of the common equity. The proceeds from the sale of the Trust Preferred Securities are used to purchase junior subordinated deferrable interest debentures (“Junior Subordinated Debentures”) issued by Sterling. Sterling’s obligations under the Junior Subordinated Debentures and related documents, taken together, constitute a full and unconditional guarantee by Sterling of the Capital Trusts’ obligations under the Trust Preferred Securities. The Trust Preferred Securities are treated as debt of Sterling. The Junior Subordinated Debentures and related Trust Preferred Securities generally mature 30 years after issuance and are redeemable at the option of Sterling under certain conditions, including, with respect to certain of the Trust Preferred Securities, payment of call premiums. During the third quarter of 2009, Sterling elected to defer regularly scheduled interest payments on these securities, and continued to defer these payments through June 30, 2010. As of June 30, 2010 and December 31, 2009, the accumulated deferred interest that was accrued on these securities was $6.4 million and $3.4 million, respectively. Sterling is allowed to defer payments of interest on the junior subordinated notes for up to 20 consecutive quarterly periods without triggering an event of default.

 

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Details of the Trust Preferred Securities are as follows:

 

Subsidiary Issuer

   Issue Date    Maturity
Date
   Initial Call
Date
   Rate at June 30, 2010     Amount
(in Thousands)

Sterling Capital Trust IX

   July 2007    Oct 2037    N/A    Floating    1.69   $ 46,392

Sterling Capital Trust VIII

   Sept 2006    Sept 2036    N/A    Floating    2.17        51,547

Sterling Capital Trust VII

   June 2006    June 2036    N/A    Floating    2.06        56,702

Lynnwood Capital Trust II

   June 2005    June 2035    June 2010    Floating    2.34        10,310

Sterling Capital Trust VI

   June 2003    Sept 2033    Sept 2008    Floating    3.74        10,310

Sterling Capital Statutory Trust V

   May 2003    May 2033    June 2008    Floating    3.79        20,619

Sterling Capital Trust IV

   May 2003    May 2033    May 2008    Floating    3.59        10,310

Sterling Capital Trust III

   April 2003    April 2033    April 2008    Floating    3.59        14,433

Lynnwood Capital Trust I

   Mar 2003    Mar 2033    Mar 2007    Floating    3.69        9,457

Klamath First Capital Trust I

   July 2001    July 2031    June 2006    Floating    4.14        15,203
                    
               2.59 %*    $ 245,283
                    

 

* Weighted average rate

In April 2010, Sterling’s previously announced consent solicitation relating to a discounted purchase offer for its outstanding Trust Preferred Securities expired. No amendments were made to applicable indentures, and Sterling is no longer seeking approval for such amendments or to purchase its outstanding Trust Preferred Securities.

5. Shareholders’ Equity:

At June 30, 2010, under regulatory guidelines, Sterling was categorized as “significantly undercapitalized,” and Sterling Savings Bank was categorized as “undercapitalized.” As a result, Sterling and Sterling Savings Bank are subject to various restrictions, including restrictions on asset growth, acquisitions, new activities and new branches. Sterling and Sterling Savings Bank are operating under regulatory agreements. Sterling Savings Bank’s regulators have directed Sterling Savings Bank to increase its overall capital levels and, in particular, are requiring Sterling Savings Bank to increase its Tier 1 leverage ratio to 10.0%.

In May 2010, Sterling entered into agreements with Thomas H. Lee Equity Fund VI, L.P., Thomas H. Lee Parallel Fund VI, L.P. and Thomas H. Lee Parallel (DT) Fund, VI, L.P. (collectively, “THL”) and with Warburg Pincus Private Equity X, L.P. (“Warburg”), pursuant to which THL and Warburg agreed to purchase a combination of preferred and common stock at a purchase price of up to $0.20 per underlying common share and to receive warrants with an exercise price of up to $0.22 per share (the “THL and Warburg Transactions”). If the THL and Warburg Transactions are completed THL and Warburg would each own 20.5% of Sterling’s outstanding common stock on an as-converted basis, assuming the exercise of the warrants by such investor, for an aggregate investment by each of approximately $139 million.

On December 5, 2008, Sterling issued 303,000 shares of preferred stock and a warrant for 6,437,677 shares of common stock to the U.S. Department of the Treasury for $303.0 million of Capital Purchase Program funds. During the third quarter of 2009, Sterling elected to defer the payment of dividends on this cumulative preferred stock, and continued to defer these payments through June 30, 2010. As of June 30, 2010 and December 31, 2009, the accumulated deferred dividends that were accrued were $17.3 million and $9.5 million, respectively. Under the terms of the preferred stock, failure to pay dividends for six dividend periods, whether or not consecutive, would cause the authorized number of directors constituting Sterling’s board of directors to be automatically increased by two, and the holders of the preferred stock, together with the holders of any outstanding parity stock with like voting rights, would be entitled to elect the two additional members of Sterling’s board of directors. During the second quarter of 2010, in connection with the THL and Warburg Transactions, Sterling executed a definitive exchange

 

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agreement (the “Treasury Exchange Agreement”) with the U.S. Department of the Treasury (the “Treasury”) providing for (i) the exchange of the 303,000 shares of preferred stock held by the Treasury through its Capital Purchase Program for 303,000 shares of a newly-created Series C Fixed Rate Cumulative Mandatorily Convertible Preferred Stock (the “Series C Stock”) with a liquidation preference of $303 million, (ii) the exchange of the Series C Stock at a discounted exchange value of $75.75 million into 378,750,000 shares of Common Stock at a conversion price of $0.20 per share prior to the closing of the THL and Warburg Transactions; and (iii) the amendment of the terms of the warrant currently held by Treasury to provide for an exercise price of $0.20 per share for a ten-year term following the THL and Warburg Transactions (the “Treasury Exchange Transaction”).

The THL and Warburg Transactions and the Treasury Exchange Transaction are conditioned upon each other and on other closing conditions, including Sterling raising a total of at least $720 million (inclusive of the THL and Warburg Transactions), which would enable Sterling to meet all of its regulatory capital requirements.

 

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6. Earnings (Loss) Per Share:

The following table presents the basic and diluted earnings per common share computations.

 

     Three Months Ended June 30,  
     2010     2009  
     Net Income
(Loss)
Available to
Common
Shareholders
    Weighted
Average
Shares
   Per
Share
Amount
    Net Income
(Loss)
Available to
Common
Shareholders
    Weighted
Average
Shares
   Per
Share
Amount
 
           (Dollars in thousands, except per share amounts)       

Basic computations

   $ (58,242   52,009,290    $ (1.12   $ (33,880   51,922,407    $ (0.65

Effect of dilutive securities:

              

Common stock options and restricted shares

     0      0      0.00        0      0      0.00   

Common stock warrant

     0      0      0.00        0      0      0.00   
                                          

Diluted computations

   $ (58,242   52,009,290    $ (1.12   $ (33,880   51,922,407    $ (0.65
                                          

Antidilutive securities not included in diluted earnings per share:

              

Common stock options

     1,351,160        1,819,472   

Common stock warrant

     6,437,677        6,437,677   

Restricted shares

     152,250        217,368   
                  

Total antidilutive

     7,941,087        8,474,517   
                  
     Six Months Ended June 30,  
     2010     2009  
     Net Income
(Loss)
Available to
Common
Shareholders
    Weighted
Average
Shares
   Per
Share
Amount
    Net Income
(Loss)
Available to
Common
Shareholders
    Weighted
Average
Shares
   Per
Share
Amount
 
           (Dollars in thousands, except per share amounts)       

Basic computations

   $ (147,000   51,994,737    $ (2.83   $ (58,670   51,909,350    $ (1.13

Effect of dilutive securities:

              

Common stock options and restricted shares

     0      0      0.00        0      0      0.00   

Common stock warrant

     0      0      0.00        0      0      0.00   
                                          

Diluted computations

   $ (147,000   51,994,737    $ (2.83   $ (58,670   51,909,350    $ (1.13
                                          

Antidilutive securities not included in diluted earnings per share:

              

Common stock options

     1,438,728        1,872,465   

Common stock warrant

     6,437,677        6,437,677   

Restricted shares

     168,613        229,196   
                  

Total antidilutive

     8,045,018        8,539,338   
                  

 

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The accounting standards codification requires a two-class method of computing earnings per share for entities that have participating securities such as Sterling’s unvested restricted shares. Application of the two-class method resulted in the materially equivalent earnings per share as the application of the treasury method, which is presented above.

7. Non-Interest Expenses:

The following table details the components of Sterling’s total non-interest expenses:

 

     Three Months Ended June 30,    Six Months Ended June 30,
     2010    2009    2010    2009
          (Dollars in thousands)     

Employee compensation and benefits

   $ 41,350    $ 42,927    $ 81,798    $ 83,115

Insurance

     10,191      12,087      22,876      16,377

Occupancy and equipment

     9,281      10,111      18,757      20,104

OREO operations

     17,206      20,185      28,129      26,290

Data processing

     5,359      5,176      10,464      10,330

Legal and accounting

     2,511      3,058      8,634      5,828

Depreciation

     3,372      3,507      6,940      7,051

Advertising

     3,329      3,099      5,824      5,854

Amortization of core deposit intangibles

     1,224      1,224      2,449      2,449

Travel and entertainment

     1,027      1,439      1,832      2,654

Other

     2,465      2,336      5,589      5,085
                           

Total

   $ 97,315    $ 105,149    $ 193,292    $ 185,137
                           

Changes in Federal Deposit Insurance Corporation (“FDIC”) deposit insurance premiums and expenses related to increased credit resolution costs and OREO operations have been the main causes of the fluctuation in non-interest expenses over the periods presented. Expenses during the six month comparative periods were also affected in 2010 by the costs associated with Sterling’s recapitalization efforts.

8. Income Taxes:

Sterling uses an estimate of future earnings, and an evaluation of its loss carryback ability and tax planning strategies to determine whether or not the benefit of its net deferred tax asset will be realized. Sterling has assessed whether it was more likely than not that it would realize the benefits of its deferred tax asset. Sterling determined that the negative evidence associated with a projected three-year cumulative loss, the regulatory agreement in place between Sterling Savings Bank and the FDIC (the “SSB Consent Agreement”) and between Sterling and the Federal Reserve Bank of San Francisco (the “Reserve Bank Agreement”), and continued credit deterioration in its loan portfolio outweighed the positive evidence. Therefore, during the third quarter of 2009, a full valuation allowance was established against its deferred tax asset, with the allowance totaling $325.0 million as of June 30, 2010, compared with $269.0 million as of December 31, 2009. Sterling’s deferred tax asset includes approximately $222 million of net operating loss carryforwards as of June 30, 2010.

In April 2010, Sterling’s Board of Directors adopted a shareholder rights plan designed to preserve substantial tax assets that include net operating losses, capital losses and certain built-in losses that could be utilized in certain circumstances to offset taxable income and reduce its federal income tax liability. Sterling’s ability to use its tax assets would be substantially limited if there were an “ownership change” as defined under Section 382 of the Internal Revenue Code and related Internal Revenue Service pronouncements. In general, an ownership change would occur if Sterling’s “5-percent shareholders,” as defined under Section 382, collectively increase their ownership in Sterling by more than 50 percentage points over a rolling three-year period. Five-percent shareholders do not include certain institutional holders, such as mutual fund companies, that hold Sterling equity securities on behalf of several individual mutual funds where no single fund owns 5 percent or more of Sterling equity securities.

 

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As part of the plan, the Sterling Board of Directors declared a dividend of one preferred share purchase right for each outstanding share of its common stock. The preferred share purchase rights were distributable to shareholders of record as of April 15, 2010, as well as to holders of common stock and Sterling securities convertible into common stock issued after that date, but would only be activated if triggered pursuant to the terms of the plan. See Sterling’s Current Report on Form 8-K, as filed with the SEC on April 15, 2010, for additional information regarding the shareholder rights plan.

9. Segment Information:

For purposes of measuring and reporting financial results, Sterling is divided into five business segments:

 

 

The Community Banking segment provides traditional banking and wealth management services through the retail, private and commercial banking groups of Sterling’s subsidiary, Sterling Savings Bank.

 

 

The Residential Construction Lending segment has historically originated and serviced loans through the real estate division of Sterling’s subsidiary, Sterling Savings Bank. Activity in this segment has been curtailed, and realigned with an emphasis on credit resolution.

 

 

The Residential Mortgage Banking segment originates and sells servicing-retained and servicing-released residential loans through loan production offices of Sterling’s subsidiary, Golf Savings Bank.

 

 

The Commercial Mortgage Banking segment originates, sells and services commercial real estate loans and participation interests in commercial real estate loans through offices in the western region of the United States primarily through Sterling Savings Bank’s subsidiary INTERVEST-Mortgage Investment Company (“INTERVEST”).

 

 

The Other and Eliminations segment represents the parent company expenses and intercompany eliminations of revenue and expenses.

 

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The following table presents certain financial information regarding Sterling’s segments and provides a reconciliation to Sterling’s consolidated totals for the periods presented:

 

     As of and for the Three Months Ended June 30, 2010  
     Community
Banking
    Residential
Construction
Lending
    Residential
Mortgage
Banking
    Commercial
Mortgage
Banking
    Other and
Eliminations
    Total  
     (Dollars in thousands)  

Interest income

   $ 105,631      $ 2,208      $ 6,569      $ 801      $ 0      $ 115,209   

Interest expense

     (32,390     (5,343     (2,930     0        (1,451     (42,114
                                                

Net interest income (expense)

     73,241        (3,135     3,639        801        (1,451     73,095   

Provision for credit losses

     (50,527     (16,473     (3,781     0        0        (70,781

Noninterest income

     26,929        12        13,894        499        (106     41,228   

Noninterest expense

     (79,993     (1,408     (12,913     (1,003     (1,998     (97,315
                                                

Income (loss) before income taxes

   $ (30,350   $ (21,004   $ 839      $ 297      $ (3,555   $ (53,773
                                                

Total assets

   $ 8,587,871      $ 578,445      $ 559,517      $ 6,588      $ 5,360      $ 9,737,781   
                                                
     As of and for the Three Months Ended June 30, 2009  
     Community
Banking
    Residential
Construction
Lending
    Residential
Mortgage
Banking
    Commercial
Mortgage
Banking
    Other and
Eliminations
    Total  
     (Dollars in thousands)  

Interest income

   $ 132,445      $ 8,219      $ 7,363      $ 6,266      $ 226      $ 154,519   

Interest expense

     (49,630     (11,937     (3,364     0        (1,969     (66,900
                                                

Net interest income (expense)

     82,815        (3,718     3,999        6,266        (1,743     87,619   

Provision for credit losses

     (34,843     (38,157     (6,744     0        0        (79,744

Noninterest income

     19,087        16        15,133        901        (3,445     31,692   

Noninterest expense

     (90,542     (1,967     (9,416     (2,056     (1,168     (105,149
                                                

Income (loss) before income taxes

   $ (23,483   $ (43,826   $ 2,972      $ 5,111      $ (6,356   $ (65,582
                                                

Total assets

   $ 10,501,738      $ 1,295,970      $ 614,356      $ 12,689      $ (24,978   $ 12,399,775   
                                                

 

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Table of Contents
     As of and for the Six Months Ended June 30, 2010  
     Community
Banking
    Residential
Construction
Lending
    Residential
Mortgage
Banking
    Commercial
Mortgage
Banking
    Other and
Eliminations
    Total  
     (Dollars in thousands)  

Interest income

   $ 214,586      $ 4,922      $ 12,703      $ 2,420      $ 70      $ 234,701   

Interest expense

     (66,127     (11,672     (5,993     0        (2,924     (86,716
                                                

Net interest income (expense)

     148,459        (6,750     6,710        2,420        (2,854     147,985   

Provision for credit losses

     (99,460     (52,540     (7,337     0        0        (159,337

Noninterest income

     39,610        23        26,487        1,162        (757     66,525   

Noninterest expense

     (156,629     (3,023     (24,983     (2,411     (6,246     (193,292
                                                

Income (loss) before income taxes

   $ (68,020   $ (62,290   $ 877      $ 1,171      $ (9,857   $ (138,119
                                                

Total assets

   $ 8,587,871      $ 578,445      $ 559,517      $ 6,588      $ 5,360      $ 9,737,781   
                                                
     As of and for the Six Months Ended June, 2009  
     Community
Banking
    Residential
Construction
Lending
    Residential
Mortgage
Banking
    Commercial
Mortgage
Banking
    Other and
Eliminations
    Total  
     (Dollars in thousands)  

Interest income

   $ 267,431      $ 19,065      $ 15,062      $ 12,636      $ 456      $ 314,650   

Interest expense

     (112,389     (15,066     (7,055     0        (4,173     (138,683
                                                

Net interest income (expense)

     155,042        3,999        8,007        12,636        (3,717     175,967   

Provision for credit losses

     (59,535     (72,465     (13,609     0        0        (145,609

Noninterest income

     44,033        247        29,244        1,439        (6,645     68,318   

Noninterest expense

     (158,341     (4,131     (16,192     (4,250     (2,223     (185,137
                                                

Income (loss) before income taxes

   $ (18,801   $ (72,350   $ 7,450      $ 9,825      $ (12,585   $ (86,461
                                                

Total assets

   $ 10,501,738      $ 1,295,970      $ 614,356      $ 12,689      $ (24,978   $ 12,399,775   
                                                

10. Stock-Based Compensation:

The following is a summary of stock option and restricted stock activity during the six months ended June 30, 2010:

 

     Stock Options    Restricted Stock
     Number     Weighted
Average
Exercise
Price
   Number     Weighted
Average
Grant Price

Balance, January 1, 2010

   1,892,882      $ 21.04    261,750      $ 9.40

Granted

   0        0.00    0        0.00

Exercised/vested

   0        0.00    (65,500     12.53

Cancelled/expired

   (548,993     22.49    (44,000     6.20
                         

Outstanding, June 30, 2010

   1,343,889      $ 20.45    152,250      $ 8.98
                         

Exercisable, June 30, 2010

   1,028,764      $ 22.42     
                 

 

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At June 30, 2010, the weighted average remaining contractual life and the aggregate intrinsic value of stock options outstanding was 3.5 years and $0, respectively, and of stock options exercisable was 3.3 years and $0, respectively, and at December 31, 2009, were 2.9 years and $0, respectively, and 2.4 years and $0, respectively. As of June 30, 2010, a total of 2,123,785 shares remained available for grant under Sterling’s 2001, 2003 and 2007 Long-Term Incentive Plans. The stock options granted under these plans have terms of four, six, eight or ten years. The stock options and restricted shares granted during 2009 have vesting schedules ranging from two to four years. During the six months ended June 30, 2010 and 2009, the intrinsic value of options exercised were $0 and $0, respectively, and fair value of options granted were $0 and $193,000, respectively. The Black-Scholes option-pricing model was used in estimating the fair value of option grants. The weighted average assumptions used were:

 

     Six Months Ended June 30,  
     2010    2009  

Expected volatility

   n/a    72

Expected term (in years)

   n/a    4.4   

Expected dividend yield

   n/a    0.00

Risk free interest rate

   n/a    2.07

Stock-based compensation expense recognized during the periods presented was as follows:

 

     Six Months Ended June 30,
     2010    2009
     (Dollars in thousands)

Stock based compensation expense:

     

Stock options

   $ 386    $ 551

Restricted stock

     322      909
             

Total

   $ 708    $ 1,460
             

As of June 30, 2010, unrecognized equity compensation expense totaled $1.9 million, as the underlying outstanding awards had not yet been earned. This amount will be recognized over a weighted average period of 1.4 years. During the six months ended June 30, 2010, 21,000 stock options were forfeited, and 44,000 shares of restricted stock were forfeited.

 

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11. Derivatives and Hedging:

As part of its mortgage banking activities, Sterling issues interest rate lock commitments to prospective borrowers on residential mortgage loan applications. Pricing for the sale of these loans is fixed with various qualified investors under both non-binding (“best-efforts”) and binding (“mandatory”) delivery programs. For mandatory delivery programs, Sterling hedges interest rate risk by entering into offsetting forward sale agreements on MBS with third parties. Risks inherent in mandatory delivery programs include the risk that if Sterling does not close the loans subject to interest rate lock commitments, it is nevertheless obligated to deliver MBS to the counterparty under the forward sale agreement. Sterling could incur significant costs in acquiring replacement loans or MBS and such costs could have a material adverse effect on mortgage banking operations in future periods.

Interest rate lock commitments and loan delivery commitments are off balance sheet commitments that are considered to be derivatives. As of June 30, 2010, Sterling had $149.1 million of interest rate lock commitments, $55.2 million of warehouse loans held for sale that were not committed to investors, and held offsetting forward sale agreements on MBS valued at $273.2 million. In addition, Sterling had mandatory delivery commitments to sell mortgage loans to investors valued at $106.2 million as of June 30, 2010. As of December 31, 2009, Sterling had $110.0 million of interest rate lock commitments, $119.7 million of warehouse loans held for sale that were not committed to investors, and held offsetting forward sale agreements on MBS valued at $234.0 million. In addition, Sterling had mandatory delivery commitments to sell mortgage loans to investors valued at $29.5 million as of December 31, 2009. As of June 30, 2010 and December 31, 2009, Sterling had entered into best efforts forward commitments to sell $33.4 million and $51.6 million of mortgage loans, respectively.

In the normal course of business, Sterling enters into interest rate swap transactions with loan customers. The interest rate risk on these swap transactions is managed by entering into offsetting interest rate swap agreements with various counterparties (“broker-dealers” or “dealers”). The counterparty swap agreements include certain representations, warranties and covenants, which include terms that allow for an early termination in the event of default. Failure to maintain a well capitalized position is one event that may be considered a default, and counterparties to the swap agreements could require an early termination settlement or an increase in the collateral to secure derivative instruments that are in net liability positions to Sterling. The “early termination provision” of the swap agreements could result in Sterling reimbursing the counterparty and recording a charge equal to the current market value of the swap agreement if terminated. During the six months ended June 30, 2010, no additional counterparties declared an early termination event. The aggregate fair value of all derivative instruments with credit risk related contingent features that are in a liability position on June 30, 2010 was $5.0 million for which Sterling had already posted collateral with a market value of $6.0 million. Both customer and dealer related interest rate derivatives are carried at fair value by Sterling.

12. Fair Value:

Fair value estimates are determined as of a specific date using quoted market prices, where available, or various assumptions and estimates. As the assumptions underlying these estimates change, the fair value of the financial instruments will change. The use of assumptions and various valuation techniques, as well as the absence of secondary markets for certain financial instruments, will likely reduce the comparability of fair value disclosures between financial institutions. Accordingly, the aggregate fair value amounts presented do not represent and should not be construed to represent the full underlying value of Sterling.

 

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The carrying amounts and fair values of financial instruments as of the periods indicated, were as follows. Other assets are comprised of FHLB stock and derivatives, while other liabilities are comprised of derivatives:

 

     June 30, 2010    December 31, 2009
     Carrying
Amount
   Fair Value    Carrying
Amount
   Fair Value
     (Dollars in thousands)

Financial assets:

           

Cash and cash equivalents

   $ 823,315    $ 823,315    $ 573,006    $ 573,006

Investments and MBS:

           

Available for sale

     1,940,710      1,940,710      2,160,325      2,160,325

Held to maturity

     15,180      15,180      17,646      17,646

Loans held for sale

     192,411      192,411      190,412      190,412

Loans receivable, net

     6,140,913      6,043,177      7,344,199      7,309,894

Accrued interest receivable

     35,014      35,014      43,869      43,869

Other assets

     107,823      107,823      108,502      108,502

Financial liabilities:

           

Non-maturity deposits

     3,377,742      3,239,365      3,593,703      3,331,416

Deposits with stated maturities

     3,863,027      3,930,841      4,181,487      4,241,141

Borrowings

     2,146,444      2,150,809      2,634,594      2,581,832

Accrued interest payable

     18,319      18,319      22,245      22,245

Other liabilities

     5,022      5,022      4,319      4,319

Companies have the option of carrying financial assets and liabilities at fair value, which can be implemented on all or individually selected financial instruments. The framework for defining and measuring fair value requires that one of three valuation methods be used to determine fair market value: the market approach, the income approach or the cost approach. To increase consistency and comparability in fair value measurements and related disclosures, the standard also creates a fair value hierarchy to prioritize the inputs to these valuation methods into the following three levels:

 

 

Level 1 inputs are a select class of observable inputs, based upon the quoted prices for identical instruments in active markets that are accessible as of the measurement date, and are to be used whenever available.

 

 

Level 2 inputs are other types of observable inputs, such as quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are inactive; or other inputs that are observable or can be derived from or supported by observable market data. Level 2 inputs are to be used whenever Level 1 inputs are not available.

 

 

Level 3 inputs are significantly unobservable, reflecting the reporting entity’s own assumptions regarding what market participants would assume when pricing a financial instrument. Level 3 inputs are to be used only when Level 1 and Level 2 inputs are unavailable.

 

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Assets and Liabilities Measured at Fair Value on a Recurring Basis. The following presents Sterling’s financial instruments that are measured at fair value on a recurring basis:

 

     Total          Level 1          Level 2    Level 3
     (Dollars in thousands)

Balance, June 30, 2010:

           

Investment securities available-for-sale:

           

MBS

   $ 1,741,395    $ 0    $ 1,741,395    $ 0

Municipal bonds

     178,220      0      178,220      0

Other

     21,095      0      21,095      0
                           

Total investment securities available-for-sale

     1,940,710      0      1,940,710      0

Loans held for sale

     192,411      0      192,411      0

Other assets - derivatives

     7,379      0      2,115      5,264
                           

Total assets

   $ 2,140,500    $ 0    $ 2,135,236    $ 5,264
                           

Other liabilities - derivatives

   $ 5,022    $ 0    $ 0    $ 5,022
                           

Balance, December 31, 2009:

           

Investment securities available-for-sale:

           

MBS

   $ 1,944,989    $ 0    $ 1,944,989    $ 0

Municipal bonds

     195,282      0      195,282      0

Other

     20,054      0      20,054      0
                           

Total investment securities available-for-sale

     2,160,325      0      2,160,325      0

Loans held for sale

     190,412      0      190,412      0

Other assets - derivatives

     7,820      0      3,273      4,547
                           

Total assets

   $ 2,358,557    $ 0    $ 2,354,010    $ 4,547
                           

Other liabilities - derivatives

   $ 4,319    $ 0    $ 0    $ 4,319
                           

The following table provides a reconciliation of interest rate swaps measured at fair value using significant unobservable or Level 3 inputs on a recurring basis during the six months ended June 30, 2010 and the year ended December 31, 2009. Gains and losses on these interest rate swaps are included in earnings as interest income or expense.

 

     Beginning
Balance
   Change included
in earnings
    Ending
Balance
     (Dollars in thousands)

Six Months Ended June 30, 2010

       

Other assets - derivatives

   $ 4,547    $ 717      $ 5,264

Other liabilities - derivatives

     4,319      703        5,022

Year Ended December 31, 2009

       

Other assets - derivatives

     7,460      (2,913     4,547

Other liabilities - derivatives

     7,460      (3,141     4,319

Level 2 derivatives represent mortgage banking interest rate lock and loan delivery commitments, while level 3 derivatives represent interest rate swaps, with market values for these instruments being a function of the interest rate and term of the underlying loan. See Note 11 for a further discussion of these derivatives. Changes in the fair value of available-for-sale securities are recorded on the balance sheet under accumulated-other-comprehensive income, while gains and losses from sales are recognized as income. The difference between the aggregate fair value and the aggregate unpaid principal balance of loans held for sale that are carried at fair value were included in earnings as follows:

 

     Six Months Ended June 30,
     2010    2009
     (Dollars in thousands)

Mortgage banking operations

   $ 6,846    $ 374

 

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Assets and Liabilities Measured at Fair Value on a Non-recurring Basis. Sterling may be required, from time to time, to measure certain other financial assets at fair value on a non-recurring basis from application of lower of cost or market (“LOCOM”) accounting or write-downs of individual assets. The following table presents the carrying value for these financial assets as of the dates indicated:

 

     June 30, 2010
     Total Carrying
Value
       Level 1            Level 2        Level 3
     (Dollars in thousands)

Loans

   $ 724,187    $ 0    $ 0    $ 724,187

OREO

     132,797      0      0      132,797

Mortgage servicing rights

     12,777      0      12,777      0
     December 31, 2009
     Total Carrying
Value
   Level 1    Level 2    Level 3

Loans

   $ 702,477    $ 0    $ 0    $ 702,477

OREO

     78,302      0      0      78,302

Goodwill

     0      0      0      0

Mortgage servicing rights

     12,062      0      12,062      0

The loans disclosed above represent the carrying value of impaired loans at period end. Mortgage servicing rights were written down mainly due to market derived assumptions associated with expected accelerated mortgage prepayment speeds based upon lower interest rates. Sterling carries its mortgage servicing rights at LOCOM, and as such, they are measured at fair value on a non-recurring basis. OREO represents the carrying value after write-downs taken at foreclosure that were charged to the loan loss allowance, as well as specific reserves established subsequent to foreclosure due to updated appraisals. Goodwill is presented at fair value, net of impairment charges.

The methods and assumptions used to estimate the fair value of each class of financial instruments are as follows:

Cash and Cash Equivalents

The carrying value of cash and cash equivalents approximates fair value due to the relatively short-term nature of these instruments.

Investments and MBS

The fair value of investments and MBS has been valued using a matrix pricing technique based on quoted prices for similar instruments, which Sterling validates with non-binding broker quotes, in depth collateral analysis and cash flow stress testing.

Loans Held for Sale

Sterling has elected to carry loans held for sale at fair value. The fair values are based on investor quotes in the secondary market based upon the fair value of options and commitments to sell or issue mortgage loans. The fair value election was made to match changes in the value of these loans with the value of their economic hedges. Loan origination fees, costs and servicing rights, which were previously deferred on these loans, are now recognized as part of the loan value at origination. As of June 30, 2010 and December 31, 2009, Sterling had $1.8 million and $1.3 million, respectively, of loans held for sale that were being reported at the lower of amortized cost or market value.

 

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Loans Receivable

The fair value of performing loans is estimated by discounting the cash flows using interest rates that consider the current credit and interest rate risk inherent in the loans and current economic and lending conditions. The fair value of nonperforming loans is estimated by discounting management’s current estimate of future cash flows using a rate estimated to be commensurate with the risks involved. The fair value of nonperforming collateral dependent loans is estimated based upon the value of the underlying collateral. In addition, to reflect current market conditions, a liquidity discount has been applied against the portfolio.

Mortgage Servicing Rights

The fair value of mortgage servicing rights is estimated using a discounted cash flow methodology to arrive at the present value of future expected earnings from the servicing of the loans. Model inputs include prepayment speeds, market interest rates, contractual interest rates on the loans being serviced, and the amount of other fee income generated over the servicing contract.

OREO

The fair value of OREO is estimated using third party appraisals, subject to updates to reflect comparable market transactions, with appraisals ordered for “as is” or “disposal value.”

Deposits

The fair values of deposits subject to immediate withdrawal such as interest and noninterest bearing checking, regular savings, and money market deposit accounts, are equal to the amounts payable on demand at the reporting date, net of a core deposit intangible. Fair values for time deposits are estimated by discounting future cash flows using interest rates currently offered on time deposits with similar remaining maturities.

Borrowings

The carrying amounts of short-term borrowings under repurchase agreements, federal funds purchased, short-term FHLB advances and other short-term borrowings approximate their fair values due to the relatively short period of time between the origination of the instruments and the expected payment dates on the instruments. The fair value of advances under lines of credit approximates their carrying value because such advances bear variable rates of interest. The fair value of long-term FHLB advances and other long-term borrowings is estimated using discounted cash flow analyses based on Sterling’s current incremental borrowing rates for similar types of borrowing arrangements with similar remaining terms.

13. Going Concern:

These financial statements have been prepared under the assumption that Sterling is a going concern. As a result of the uncertainty regarding Sterling’s ability to comply with the Reserve Bank Agreement and the SSB Consent Agreement, Sterling’s Independent Registered Public Accounting Firm added an explanatory paragraph in its audit opinion issued in connection with our December 31, 2009 consolidated financial statements, expressing substantial doubt regarding our ability to continue as a going concern. Management’s plans to address this uncertainty include the raising of capital, or the potential sale of Sterling or some or all of its assets. During the second quarter of 2010, Sterling entered into the THL and Warburg Agreements, which are subject to various conditions, including, among others, Sterling raising total capital of at least $720 million (inclusive of the THL and Warburg Transactions), and a conversion of the Treasury’s preferred stock to common stock at a discount to the face value. There can be no assurance that any of these efforts will be successful, and if Sterling were to be unsuccessful, its ongoing viability would be in doubt.

 

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14. Subsequent Events:

In the second quarter, Sterling received regulatory approval to consolidate Golf Savings Bank with and into Sterling Savings Bank, which was completed on August 2, 2010. The mortgage banking operations of Golf Savings Bank are continuing to operate as a division within Sterling Savings Bank. Both Golf Savings Bank and Sterling Savings Bank were wholly owned subsidiaries and the transaction therefore did not impact the consolidated financial statements of Sterling.

 

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PART I – Financial Information (continued)

Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations

STERLING FINANCIAL CORPORATION

June 30, 2010

This report contains forward-looking statements. For a discussion about such statements, including the risks and uncertainties inherent therein, see “Forward-Looking Statements.” Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Consolidated Financial Statements and Notes presented elsewhere in this report and in Sterling’s 2009 annual report on Form 10-K.

General

Sterling Financial Corporation (“Sterling”) is a bank holding company, organized under the laws of Washington State in 1992. The principal operating subsidiaries of Sterling are Sterling Savings Bank and Golf Savings Bank. Sterling Savings Bank, headquartered in Spokane, Washington, commenced operations in 1983 as a Washington State-chartered federally insured stock savings and loan association, and in 2005 converted to a commercial bank. Sterling Savings Bank offers commercial banking products and services, mortgage lending, construction financing and investment products to individuals, small business, commercial organizations and corporations. The main focus of Golf Savings Bank, a Washington State-chartered savings bank acquired by Sterling in July 2006, is the origination and sale of residential mortgage loans. Subsequent to June 30, 2010, Golf Savings Bank was merged with and into Sterling Savings Bank, with the mortgage banking operations of Golf Savings Bank continuing to operate as a division of Sterling Savings Bank.

Sterling’s dedication to personalized service and relationship banking has enabled it to attract both retail deposits and lending relationships in the western United States. With $9.74 billion in total assets as of June 30, 2010, Sterling originates loans and attracts Federal Deposit Insurance Corporation (“FDIC”) insured and uninsured deposits from the general public throughout its five state footprint through its two subsidiary banks, Sterling Savings Bank and Golf Savings Bank, and through its commercial real estate division INTERVEST-Mortgage Investment Company (“INTERVEST’). Sterling also markets fixed income and equities, mutual funds, annuities and other financial products through wealth management representatives located throughout Sterling’s financial service centers network.

Recent Developments

Sterling faces a number of challenges resulting from operating losses, driven by credit quality issues, and currently is categorized as being significantly undercapitalized pursuant to regulatory guidelines. Both Sterling and Sterling Savings Bank are currently operating under regulatory agreements. Sterling has entered into a regulatory agreement with the Federal Reserve Bank of San Francisco (the “Reserve Bank Agreement”), and Sterling Savings Bank has entered into a regulatory agreement with the FDIC and the Washington Department of Financial Institutions (the “SSB Consent Agreement”). Both agreements require, among other things, a return to “well capitalized” status. As a result of the uncertainty regarding Sterling’s ability to comply with these agreements, Sterling’s Independent Registered Public Accounting Firm added an explanatory paragraph in its audit opinion issued in connection with our December 31, 2009 consolidated financial statements, expressing substantial doubt regarding our ability to continue as a going concern.

During the second quarter of 2010, Sterling entered into agreements with Thomas H. Lee Equity Fund VI, L.P., Thomas H. Lee Parallel Fund VI, L.P. and Thomas H. Lee Parallel (DT) Fund, VI, L.P. (collectively, “THL”) and with Warburg Pincus Private Equity X, L.P. (“Warburg”), pursuant to which THL and Warburg agreed to purchase a combination of preferred and common stock at a purchase price of up to $0.20 per underlying common share and to receive warrants with an exercise price of up to $0.22 per share (the “THL and Warburg Transactions”). If the THL and Warburg Transactions are completed THL and Warburg would each own 20.5% of Sterling’s outstanding common stock on an as-converted basis, assuming the exercise of the warrants by such investor, for an aggregate investment by each of approximately $139 million.

 

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Also during the second quarter of 2010, Sterling executed a definitive exchange agreement (the “Treasury Exchange Agreement”) with the U.S. Department of the Treasury (the “Treasury”) providing for (i) the exchange of the 303,000 shares of preferred stock held by the Treasury through its Capital Purchase Program for 303,000 shares of a newly-created Series C Fixed Rate Cumulative Mandatorily Convertible Preferred Stock (the “Series C Stock”) with a liquidation preference of $303 million, (ii) the exchange of the Series C Stock at a discounted exchange value of $75.75 million into 378,750,000 shares of Common Stock at a conversion price of $0.20 per share prior to the closing of the investments by THL and Warburg; and (iii) the amendment of the terms of the warrant currently held by Treasury to provide for an exercise price of $0.20 per share for a ten-year term following closing of the THL and Warburg Transactions, (the “Treasury Exchange Transaction”).

The THL and Warburg Transactions and the Treasury Exchange Transaction are conditioned upon each other and on other closing conditions, including Sterling raising a total of at least $720 million (inclusive of the THL and Warburg Transactions), which would enable Sterling to meet all of its regulatory capital requirements (collectively, the “Recapitalization Transactions”). As of June 30, 2010, costs that were capitalized in anticipation of the closing of the Recapitalization Transactions totaled $6.8 million.

If the Recapitalization Transactions are completed, in addition to the strategies described in Sterling’s Annual Report on Form 10-K for the year ended December 31, 2009, Sterling plans to pursue a strategy of acquiring additional banks, through FDIC-assisted transactions or otherwise. However, in order to be qualified to bid on FDIC-assisted transactions, Sterling must, among other things, work with its regulators to terminate the written agreements to which Sterling and Sterling Savings Bank are subject. There can be no assurances that the Recapitalization Transactions can be completed or, even if completed, that this strategic goal will be achieved in a short time frame or even at all. See “Risk Factors—We cannot assure you whether or when certain agreements entered into with our regulators will be lifted” and “Risk Factors—Our strategy of pursuing FDIC-assisted acquisition opportunities may not be successful.”

Sterling’s board of directors is in the process of identifying new candidates to serve on the board of directors following the completion of the Recapitalization Transactions. During the second quarter of 2010, Leslie (“Les”) S. Biller, former Vice Chairman and Chief Operating Officer of Wells Fargo, was appointed chairman of the board of directors, subject to approval by Sterling’s banking regulators and the successful completion of the Sterling Recapitalization Transactions. The board currently expects that following closing of the recapitalization, the board of directors will be further reconstituted and the number of directors will be reduced. The directors are expected to consist of the Chief Executive Officer; the Chairperson; Scott Jaeckel, THL Managing Director, as a representative of THL; David Coulter, Warburg Managing Director, as a representative of Warburg; and a number of other current and/or new independent directors to be selected based on their expertise, backgrounds and other qualifications. Before any directors are appointed, our Governance/Nominating Committee must evaluate the qualifications of each new and incumbent candidate and requisite regulatory approvals must be received.

Sterling also announced during the quarter the appointment of Dave DePillo as Chief Credit Officer of Sterling Savings Bank, subject to receipt of regulatory approval and consummation of the pending Recapitalization Transactions. As noted above, Golf Savings Bank was merged with and into Sterling Savings Bank on August 2, 2010.

Executive Summary and Highlights

Sterling reported a net loss attributable to common shareholders during the three and six months ended June 30, 2010 of $58.2 million and $147.0 million, respectively, or $1.12 and $2.83 per common share, respectively. The provision for credit losses declined to $70.8 million during the second quarter of 2010 from $88.6 million in the first quarter of 2010. Sterling’s cumulative efforts to address credit quality over the last several quarters have led to a lower provision for credit losses, a reduced rate of annualized net charge-offs and a reduction in the balance of total classified assets. Sterling continues to grow and expand customer relationships as demonstrated by the growth in retail time deposits during 2010 of 7 percent on an annualized basis. The decline in net interest income reflects a lower balance of earning assets and an increase in the amount of interest that was reversed which was related to nonperforming loans. When a loan reaches nonperforming status, interest income is no longer recognized on the loan. Sterling continues to record a full valuation allowance against the future tax benefits of its operating losses,

 

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and has implemented a shareholders’ rights plan designed to preserve this asset. As of June 30, 2010, Sterling’s total risk-based capital ratio was 5.8%. Sterling continues to devote significant effort to raising the required amount of additional capital and fulfilling the other conditions to closing its agreements with the U.S. Treasury, THL and Warburg. Available liquidity as of June 30, 2010 totaled $2.04 billion. Deleveraging during 2010 resulted in a decline in the ratio of loans-to-deposits of 9 percentage points, ending the quarter at 85 percent as of June 30, 2010.

Key financial measures:

 

 

Classified assets decreased during the first half of 2010 by $249.9 million, or 15 percent.

 

 

Non-performing loans declined 8 percent to $884.1 million at June 30, 2010, compared to $958.8 million in the first quarter of 2010, and $895.9 million at December 31, 2009.

 

 

Retail time deposits increased 10 percent during the first half of 2010.

 

 

The number of total transaction accounts increased 4 percent over last year’s second quarter, or 3 percent on an annualized basis since December 31, 2009.

 

 

Deposit funding costs were 136 basis points during the second quarter of 2010, 72 basis points below the same period in 2009, and 40 basis points below the fourth quarter of 2009.

 

 

Allowance for credit losses to total loans at June 30, 2010 was 4.31%, compared with 4.36% at March 31, 2010, 4.62% at December 31, 2009, and 2.71% at June 30, 2009.

 

 

Liquidity, as measured by the 85% net loans-to-deposits ratio at the end of the second quarter, improved by 17 percentage points year over year and by 9 percentage points since December 31, 2009.

Critical Accounting Policies

The accounting and reporting policies of Sterling conform to accounting principles generally accepted in the United States of America (“GAAP”) and to general practices within the banking industry. The preparation of the financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Sterling’s management has identified the accounting policies described below as those that, due to the judgments, estimates and assumptions inherent in those policies are critical to an understanding of Sterling’s Consolidated Financial Statements and Management’s Discussion and Analysis.

Income Recognition. Sterling recognizes interest income by methods that conform to general accounting practices within the banking industry. In the event management believes collection of all or a portion of contractual interest or principal on a loan has become doubtful, which generally occurs when the loan is 90 days past due or when Sterling restructures it as a troubled loan, Sterling discontinues the accrual of interest, and any previously accrued interest recognized in income deemed uncollectible is reversed. Interest received on nonperforming loans is included in income only if principal recovery is reasonably assured. A nonperforming loan is restored to accrual status when it is brought current, has performed in accordance with contractual terms for a reasonable period of time (generally at least six months), and the collectability of the total contractual principal and interest is no longer in doubt.

Allowance for Credit Losses. The allowance for credit losses is comprised of the allowance for loan losses and the reserve for unfunded credit commitments. In general, determining the amount of the allowance requires significant judgment and the use of estimates by management. Sterling maintains an allowance for credit losses to absorb probable losses in the loan portfolio based on a quarterly analysis of the portfolio and expected future losses. This analysis is designed to determine an appropriate level and allocation of the allowance for losses among loan types by considering factors affecting loan losses, including specific and confirmed losses, levels and trends in classified and nonperforming loans, historical loan loss experience, loan migration analysis, current national and local economic conditions, volume, growth and composition of the portfolio, regulatory guidance and other relevant factors. Management monitors the loan portfolio to evaluate the adequacy of the allowance. The allowance can increase or decrease each quarter based upon the results of management’s analysis.

 

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The portfolio is grouped into standard industry categories for homogeneous loans based on characteristics such as loan type, borrower and collateral. Annual and quarterly loan migration to loss data is used to determine the probability of default. Historically, Sterling had used both one-year and three-year losses to establish the expected loss rate on loans. During the fourth quarter of 2009, as a result of the higher loss rates experienced during 2009, Sterling began using losses from the most recent twelve months to estimate the amount that would be lost if a default were to occur, which is termed the “loss given default.” The probability of default is multiplied by the loss given default to calculate the expected losses for each loan category.

Individual loan reviews are based upon specific quantitative and qualitative criteria, including the size of the loan, loan quality ratings, value of collateral, repayment ability of borrowers, and historical experience factors. The historical experience factors utilized and allowances for homogeneous loans (such as residential mortgage loans, consumer loans, etc.) are collectively evaluated based upon historical loss experience, loan migration analysis, trends in losses and delinquencies, growth of loans in particular markets, and known changes in economic conditions in each particular lending market.

A loan is considered impaired when, based on current information and events, it is probable Sterling will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price or the fair value of collateral if the loan is collateral dependent.

The fair value of the underlying collateral for real estate loans, which may or may not be collateral dependent, is determined by using appraisals from qualified external sources. For commercial properties and residential development loans, the external appraisals are reviewed by qualified internal appraisal staff to ensure compliance with appropriate standards and technical accuracy. Updated appraisals are ordered in accordance with regulatory provisions for extensions or restructurings of commercial or residential real estate construction and permanent loans that have not performed within the terms of the original loan. Updated appraisals are also ordered for loans that have not been restructured, but that have stale valuation information, generally defined in the current market as information older than six months, and deteriorating credit quality that warrants classification as substandard.

The timing of obtaining appraisals may vary, depending on the nature and complexity of the property being evaluated and the general breadth of appraisal activity in the marketplace, but generally it is within 30 to 90 days of recognition of substandard status, following determination of collateral dependency, or in connection with a loan’s maturity or a negotiation that may result in the restructuring or extension of a real estate secured loan. Delays in timing may occur to comply with actions such as a bankruptcy filing or provisions of an SBA guarantee.

Estimates of fair value may be used for substandard collateral dependent loans at quarter end if external appraisals are not expected to be completed in time for determining quarter end results or to update values between appraisal dates to reflect recent sales activity of comparable inventory or pending property sales of the subject collateral. During the fourth quarter of 2009, as a result of the large decline in real estate values during 2009, Sterling began to record a specific reserve for impaired loans for which an updated valuation analysis has not been completed within the last quarter. The specific reserve is calculated by applying an estimated fair value adjustment to each loan based on market and property type. Estimates of value are not used to raise a value; however, estimates may be used to recognize deterioration of market values in quarters between appraisal updates. The judgment with respect to recognition of any provision or related charge-off for a confirmed loss also takes into consideration whether the loan is collateral dependent or whether it is supported by sources of repayment or cash flow beyond the collateral that is

 

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being valued. For loans that are deemed to be collateral dependent, the amount of charge-offs is determined in relation to the collateral’s appraised value. For loans that are not deemed to be collateral dependent, the amount of charge-offs may differ from the collateral’s appraised value because there is additional support for the loan, such as cash flow from other sources.

While management uses available information to provide for loan losses, the ultimate collectability of a substantial portion of the loan portfolio and the need for future additions to the allowance will be influenced by changes in economic conditions and other relevant factors. The current slowdown in economic activity and further declines in real estate values could continue to adversely affect cash flows for both commercial and individual borrowers, and as a result Sterling could experience further increases in nonperforming assets, delinquencies and losses on loans. There can be no assurance that the allowance for credit losses will be adequate to cover all losses, but management believes the allowance for credit losses was adequate at June 30, 2010.

Investments and MBS. Assets in the investment and MBS portfolios are initially recorded at cost, which includes any premiums and discounts. Sterling amortizes premiums and discounts as an adjustment to interest income over the estimated life of the security. The cost of investment securities sold, and any resulting gain or loss, is based on the specific identification method. Sterling’s MBS are primarily in agency securities, with limited investments in non-agency obligations. The majority of the municipal bonds that Sterling holds are all general obligation bonds, spread throughout Sterling’s footprint. Sterling does not invest in collateralized debt obligations or similar exotic structured investment products.

The loans underlying Sterling’s MBS are subject to the prepayment of principal of the underlying loans. The rate at which prepayments are expected to occur in future periods impacts the amount of premium to be amortized in the current period. If prepayments in a future period are higher or lower than expected, then Sterling will need to amortize a larger or smaller amount of the premium to interest income in that future period.

Management determines the appropriate classification of investment securities at the time of purchase. Held-to-maturity securities are those securities that Sterling has the positive intent and ability to hold to maturity and are recorded at amortized cost. Available-for-sale securities are those securities that would be available to be sold in the future in response to Sterling’s liquidity needs, changes in market interest rates, and asset-liability management strategies, among other factors. Available-for-sale securities are reported at fair value, with unrealized holding gains and losses reported in shareholders’ equity as a separate component of other comprehensive income, net of applicable deferred income taxes.

Management evaluates investment securities for other than temporary declines in fair value on a quarterly basis. If the fair value of investment securities falls below their amortized cost and the decline is deemed to be other than temporary, the securities will be written down to current market value, resulting in a loss. There were no investment securities that management identified to be other than-temporarily impaired at June 30, 2010, because the decline in fair value of certain classes of securities was attributable to temporary disruptions of credit markets and the related impact on securities within those classes, not deteriorating credit quality of specific securities. Sterling holds a single-issuer trust preferred security that has been negatively impacted by temporary credit market disruptions. As of June 30, 2010, the trust preferred security is rated A1 by Moody’s and has an amortized cost of $24.8 million compared to a $19.9 million market value, or an unrealized loss of $4.9 million.

As of June 30, 2010, Sterling also held private label collateralized mortgage obligations with an aggregate amortized cost of $66.5 million compared to a $66.9 million market value, or a net unrealized gain of $417,000. All private label collateralized mortgage obligations are internally monitored monthly and independently stress-tested quarterly for both credit quality and collateral strength, and are AAA- rated according to at least one major rating agency. The vintage, or years of issuance, for these nonagency MBS ranges from 2003 to 2005.

As of June 30, 2010, Sterling expects the return of all principal and interest on all securities within its investment and mortgage-backed securities portfolio pursuant to the contractual terms, has the ability and intent to hold these investments, has no intent to sell securities that are deemed to have a market value impairment, and does not believe it is more likely than not that it would be required to sell these investments before a recovery in market price occurs, or until maturity. Realized losses could occur in future periods due to a change in management’s intent to hold the investments to recovery, a change in management’s assessment of credit risk, or a change in regulatory or accounting requirements.

 

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Fair Value of Financial Instruments. Sterling’s available-for-sale securities portfolio totaled $1.94 billion and $2.16 billion as of June 30, 2010 and December 31, 2009, respectively, and was the majority of Sterling’s financial instruments that are carried at fair value. These securities are valued using a pricing service’s matrix technique based on quoted prices for similar instruments, which Sterling validates with non-binding broker quotes, in-depth collateral analysis and cash flow stress testing.

Loans held for sale are also carried at fair value in order to match changes in the value of the loans with the value of the economic hedges on the loans without having to apply complex hedge accounting. The fair value of loans held for sale is determined based upon an analysis of investor quoted pricing inputs.

Other Real Estate Owned. Prior to foreclosure, Sterling considers all viable alternatives, checks with the proper authorities to ensure the existence of a valid and recorded lien on the property and determines the current market value of the collateral. Property and other assets acquired through foreclosure of defaulted mortgage or other collateralized loans are carried at fair value, less estimated costs to sell the property and other assets. The fair value of OREO is generally determined using “as is” or disposition values from appraisals obtained by independent appraisers.

An allowance for losses on OREO is designed to include amounts for estimated losses as a result of impairment in value of the real property after repossession. Sterling reviews its real estate owned for impairment in value at least quarterly or whenever events or circumstances indicate that the carrying value of the property or other assets may not be recoverable. In performing the review, if the fair value, less selling costs, is less than its carrying value, an impairment loss is recognized as a charge to operating expenses.

Income Taxes. Sterling estimates income taxes payable based on the amount it expects to owe various taxing authorities. Accrued income taxes represent the net estimated amount due to, or to be received from, taxing authorities. In estimating accrued income taxes, Sterling assesses the relative merits and risks of the appropriate tax treatment of transactions, taking into account the applicable statutory, judicial and regulatory guidance in the context of Sterling’s tax position. Sterling also considers recent audits and examinations, as well as its historical experience in making such estimates. Although Sterling uses available information to record income taxes, underlying estimates and assumptions can change over time as a result of unanticipated events or circumstances. Penalties and interest associated with any potential estimate variances would be included in income tax expense on the Consolidated Statement of Income.

Sterling uses an estimate of future earnings, and an evaluation of its loss carryback ability and tax planning strategies to determine whether or not the benefit of its net deferred tax asset will be realized. Sterling has assessed whether it was more likely than not that it would realize the benefits of its deferred tax asset. Sterling determined that the negative evidence associated with a projected three-year cumulative loss, the SSB Consent Agreement and Reserve Bank Agreement, and continued credit deterioration in its loan portfolio outweighed the positive evidence. Therefore, during the third quarter of 2009, a full valuation allowance was established against its deferred tax asset, with the allowance totaling $325.0 million as of June 30, 2010, compared with $269.0 million as of December 31, 2009. Sterling’s deferred tax asset includes approximately $222 million of net operating loss carryforwards as of June 30, 2010.

Results of Operations

Overview. Sterling reported a net loss attributable to common shareholders during the three months ended June 30, 2010 of $58.2 million, or $1.12 per common share, as compared with $33.9 million, or $0.65 per common share, for the three months ended June 30, 2009, with the decline primarily resulting from not recognizing an income tax benefit during the period, as well as a lower level of net interest income, partially offset by gains on the sale of securities, a lower level of credit loss provisioning and lower noninterest expenses. The net loss attributable to common shareholders during the six months ended June 30, 2010 was $147.0 million, or $2.83 per common share, as compared with $58.7 million, or $1.13 per common share, for the six months ended June 30, 2009. The decline is

 

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primarily the result of not recognizing an income tax benefit during 2010 and a lower level of net interest income. Also contributing to the decline in operating results for the six month comparative periods was a higher level of credit loss provisioning and higher noninterest expenses from increased FDIC insurance premiums and higher credit resolution costs during 2010.

Net Interest Income. The most significant component of earnings for a financial institution typically is net interest income, which is the difference between interest income, primarily from loan, MBS and investment securities portfolios, and interest expense, primarily on deposits and borrowings. Net interest spread refers to the difference between the yield on interest-earning assets and the rate paid on interest-bearing liabilities. Net interest margin refers to net interest income divided by total average interest-earning assets and is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities. During the past year, Sterling has been reducing the leverage in its balance sheet by reducing its higher risk assets and its wholesale funding, including brokered deposits. The following table sets forth, on a tax equivalent basis, information with regard to Sterling’s net interest income, net interest spread and net interest margin:

 

     Three Months Ended  
     June 30, 2010     June 30, 2009  
     Average
Balance
    Amount    Average
Rate
    Average
Balance
   Amount    Average
Rate
 
     (Dollars in thousands)  

ASSETS:

               

Loans:

               

Mortgage

   $ 4,422,646      $ 49,048    4.45   $ 5,464,596    $ 70,951    5.21

Commercial and consumer

     3,042,025        44,981    5.93     3,766,628      53,124    5.66
                                         

Total loans (1)

     7,464,671        94,029    5.05     9,231,224      124,075    5.39

MBS

     1,699,662        18,616    4.39     2,363,603      27,578    4.68

Investments and cash (2)

     1,196,083        3,815    1.28     814,425      3,981    1.96
                                         

Total interest-earning assets

     10,360,416        116,460    4.51     12,409,252      155,634    5.03
                               

Noninterest-earning assets (3)

     (143,420          450,620      
                         

Total average assets

   $ 10,216,996           $ 12,859,872      
                         

LIABILITIES and EQUITY:

               

Deposits:

               

Transaction

   $ 1,826,959        496    0.11   $ 1,991,833      887    0.18

Savings

     1,627,954        2,934    0.72     1,734,687      3,754    0.87

Time deposits

     3,910,900        21,633    2.22     4,857,696      39,967    3.30
                                         

Total deposits

     7,365,813        25,063    1.36     8,584,216      44,608    2.08

Borrowings

     2,515,958        17,051    2.72     3,042,457      22,292    2.94
                                         

Total interest-bearing liabilities

     9,881,771        42,114    1.71     11,626,673      66,900    2.31
                               

Noninterest-bearing liabilities

     120,464             120,839      
                         

Total average liabilities

     10,002,235             11,747,512      

Total average equity

     214,761             1,112,360      
                         

Total average liabilities and equity

   $ 10,216,996           $ 12,859,872      
                         

Tax equivalent net interest income and spread (4)

     $ 74,346    2.80      $ 88,734    2.72
                               

Tax equivalent net interest margin (4)

        2.88         2.87
                       

 

(1) Includes gross nonaccrual loans.
(2) Does not include market value adjustments on available for sale securities that are included in accumulated other comprehensive income.
(3) Includes confirmed losses on nonaccrual loans and the allowance for credit losses.
(4) Interest income on certain loans and securities are presented gross of their applicable tax savings using a 37% effective tax rate.

 

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     Six Months Ended  
     June 30, 2010     June 30, 2009  
     Average
Balance
    Amount    Average
Rate
    Average
Balance
   Amount    Average
Rate
 
     (Dollars in thousands)  

ASSETS:

               

Loans:

               

Mortgage

   $ 4,564,131      $ 98,926    4.37   $ 5,499,120    $ 143,026    5.24

Commercial and consumer

     3,163,018        92,222    5.88     3,776,824      108,103    5.77
                                         

Total loans (1)

     7,727,149        191,148    4.99     9,275,944      251,129    5.46

MBS

     1,745,152        38,442    4.44     2,374,411      57,458    4.88

Investments and cash (2)

     1,113,482        7,697    1.39     623,691      8,348    2.70
                                         

Total interest-earning assets

     10,585,783        237,287    4.52     12,274,046      316,935    5.20
                               

Noninterest-earning assets (3)

     (144,494          540,077      
                         

Total average assets

   $ 10,441,289           $ 12,814,123      
                         

LIABILITIES and EQUITY:

               

Deposits:

               

Transaction

   $ 1,929,208        1,359    0.14   $ 1,735,527      1,180    0.14

Savings

     1,592,656        5,883    0.74     1,843,957      9,309    1.02

Time deposits

     3,990,990        45,272    2.29     4,889,949      82,433    3.40
                                         

Total deposits

     7,512,854        52,514    1.41     8,469,433      92,922    2.21

Borrowings

     2,539,784        34,202    2.72     3,062,455      45,762    3.01
                                         

Total interest-bearing liabilities

     10,052,638        86,716    1.74     11,531,888      138,684    2.43
                               

Noninterest-bearing liabilities

     134,786             156,840      
                         

Total average liabilities

     10,187,424             11,688,728      

Total average equity

     253,865             1,125,395      
                         

Total average liabilities and equity

   $ 10,441,289           $ 12,814,123      
                         

Tax equivalent net interest income and spread (4)

     $ 150,571    2.78      $ 178,251    2.77
                               

Tax equivalent net interest margin (4)

        2.87         2.93
                       

 

(1) Includes gross nonaccrual loans.
(2) Does not include market value adjustments on available for sale securities that are included in accumulated other comprehensive income.
(3) Includes confirmed losses on nonaccrual loans and the allowance for credit losses.
(4) Interest income on certain loans and securities are presented gross of their applicable tax savings using a 37% effective tax rate.

Net interest income and net interest margin have been negatively affected by the increase in nonperforming assets, and a change in the mix of interest earnings assets. When loans reach nonperforming status, the reversal and cessation of accruing interest has an immediate negative impact on net interest margin. During the three months ended June 30, 2010, the reversal of interest income on non-performing loans reduced the margin by 80 basis points compared to a reduction of 41 basis points during the same period in 2009, and a reduction of 84 basis points for the six months ended June 30, 2010 compared with a reduction of 37 basis points during the same period in 2009. The effect of nonaccrual interest and the change in the mix of interest earning assets on Sterling’s net interest margin has been partially offset by a decline in funding costs.

Provision for Credit Losses. Management’s policy is to establish valuation allowances for estimated losses by charging corresponding provisions against income. The evaluation of the adequacy of specific and general valuation allowances is an ongoing process. This process includes information derived from many factors, including historical loss trends, trends in classified assets, trends in delinquent and non-accrual loans, trends in portfolio volume, diversification as to type of loan, size of individual credit exposure, current and anticipated economic conditions, loan policies, collection policies and effectiveness, quality of credit evaluation, effectiveness of policies, procedures and practices, and recent loss experience of peer banking institutions.

 

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Sterling recorded provisions for credit losses of $70.8 million and $159.3 million for the three and six months ended June 30, 2010, respectively. This compares to a provision for credit losses of $79.7 million and $145.6 million for the three and six months ended June 30, 2009, respectively. The level of the provision relates to the change in the level of classified loans, particularly in the construction, commercial real estate and commercial banking portfolios, and loss rates as determined by appraisal values. Sterling evaluates classified loans for impairment and charges-off losses when identified. As of June 30, 2010, Sterling had written down 58% of its classified loans to fair value, compared to 39% as of June 30, 2009. The following table summarizes the allowance for credit losses for the periods indicated:

 

     Six Months Ended June 30,  
     2010     2009  
     (Dollars in thousands)  

Allowance - loans, January 1

   $ 343,443      $ 208,365   

Provision

     159,791        145,609   

Charge-offs

     (252,700     (145,450

Recoveries

     14,316        5,225   

Transfers

     0        9,960   
                

Allowance - loans, June 30

     264,850        223,709   
                

Allowance - unfunded commitments, January 1

     11,967        21,334   

Provision

     (454     0   

Charge-offs

     (562     0   

Transfers

     0        (9,960
                

Allowance - unfunded commitments, June 30

     10,951        11,374   
                

Total credit allowance

   $ 275,801      $ 235,083   
                

 

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At June 30, 2010, 51% of classified loans are related to construction, with the decline during the second quarter of 2010 a result of asset resolution activities, including note sales. The following table presents classified assets by type, and also by market for Sterling’s classified construction assets:

 

     June 30,
2010
    December 31,
2009
    June 30,
2009
 
     (Dollars in thousands)  

Residential construction

  

Puget Sound

   $ 124,933    10   $ 197,227    13   $ 159,260    14

Portland, OR

     75,788    6     121,352    8     148,157    13

Bend, OR

     11,061    1     25,996    2     29,855    3

Northern California

     23,308    2     17,148    1     1,646    0

Vancouver, WA

     14,521    1     22,509    1     24,281    2

Boise, ID

     9,804    1     21,924    1     26,224    2

Southern California

     6,580    1     9,920    1     55,846    5

Utah

     2,877    0     4,752    0     5,957    1

Other

     30,335    2     66,961    4     70,758    6
                                       

Total residential construction

     299,207    24     487,789    31     521,984    46
                                       

Commercial construction

               

Southern California

     56,396    5     109,793    7     12,977    1

Puget Sound

     51,989    4     53,440    3     32,654    3

Northern California

     30,813    2     47,644    3     50,379    4

Other

     100,036    8     126,503    8     77,598    7
                                       

Total commercial construction

     239,234    19     337,380    21     173,608    15
                                       

Multi-Family construction

               

Puget Sound

     60,680    5     75,420    5     34,959    3

Portland, OR

     12,544    1     19,032    1     9,014    1

Other

     26,406    2     30,256    2     38,611    3
                                       

Total multi-family construction

     99,630    8     124,708    8     82,584    7
                                       

Total construction

     638,071    51     949,877    60     778,176    68
                                       

Commercial banking

     252,719    20     269,521    17     192,207    17

Commercial real estate

     164,982    13     154,859    10     62,184    6

Residential real estate

     131,533    11     128,561    8     62,785    6

Multi-family real estate

     43,878    4     44,258    3     22,290    2

Consumer

     20,178    1     11,996    2     7,908    1
                                       

Total classified loans

     1,251,361    100     1,559,072    100     1,125,550    100
                           

OREO

     149,302        91,478        89,721   
                           

Total classified assets (1)

   $ 1,400,663      $ 1,650,550      $ 1,215,271   
                           

 

(1) Net of cumulative confirmed losses on loans and OREO of $592.8 million for June 30, 2010, $579.7 million for December 31, 2009, and $282.1 million for June 30, 2009.

 

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The 15% decrease in classified assets since December 31, 2009 included a 33% decline in classified construction assets. The following table provides information regarding the classified assets of the top 30 borrowing relationships as of June 30, 2010, which together constituted 27% of all classified assets at period end:

 

Description

  

Location

   June 30, 2010
          (Dollars in thousands)

Commercial Construction: 3 loans

   Puget Sound, WA & Other WA    $ 30,805

Commercial Construction & Real Estate: 5 loans

   Other WA & Other OR      29,125

Commercial & Residential Construction: 2 loans

   Puget Sound, WA & Other ID      21,796

Commercial Construction: 3 loans

   Southern CA      21,352

Commercial Construction: 1 loan

   Puget Sound, WA      17,921

Residential Construction: 10 loans

   Puget Sound, WA, Portland, OR, Northern CA, UT      17,569

Commercial Construction & Commercial: 3 loans

   Puget Sound, WA & Other OR      14,576

Commercial Construction & Real Estate: 4 loans

   Puget Sound, WA      14,473

Multifamily: 3 loans

   Puget Sound, WA      12,087

Commercial & Residential Construction: 6 loans

   Other WA & Other OR      12,074

Commercial Construction: 2 loans

   Other OR      11,870

Residential Construction & Commercial Real Estate: 5 loans

   Portland, OR      11,784

Commercial & Residential Construction: 7 loans

   Portland, OR      11,557

Multifamily: 1 loan

   Portland, OR      11,497

Residential Construction: 3 loans

   Puget Sound, WA      11,380

Commercial Construction: 2 loans

   Arizona      11,108

Commercial Real Estate: 1 loan

   Puget Sound, WA      10,255

Commercial: 1 loan

   Arizona      9,791

Residential Construction: 1 loan

   Puget Sound, WA      9,576

Commercial Construction: 1 loan

   Northern CA      9,375

Commercial Construction: 1 loan

   Southern CA      8,978

Commercial: 2 loans

   Puget Sound, WA & Other WA      8,940

Residential Construction: 17 loans

   Puget Sound, WA      8,638

Residential Construction: 15 loans

   Puget Sound, WA      8,566

Residential Construction: 105 loans

   Portland, OR      8,391

Multifamily: 2 loans

   Northern CA      8,354

Residential Construction & Commercial Real Estate: 13 loans

   Portland, OR, Southern CA, Other OR      8,282

Commercial Construction: 1 loan

   Arizona      7,983

Residential Construction: 2 loans

   Portland, OR & Other OR      7,819

Commercial Construction: 1 loan

   Arizona      7,692
         

Total - Classified Assets of top 30 borrowing relationships

      $ 383,614
         

 

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Nonperforming assets, a subset of classified assets that includes nonperforming loans and OREO, are summarized in the following table as of the dates indicated:

 

     June 30,
2010
    December 31,
2009
    June 30,
2009
 
     (Dollars in thousands)  

Past due 90 days

   $ 0      $ 0      $ 0   

Nonaccrual loans

     760,136        824,652        592,450   

Restructured loans

     123,999        71,279        105,283   
                        

Total nonperforming loans

     884,135        895,931        697,733   

OREO

     149,302        91,478        89,721   
                        

Total nonperforming assets

     1,033,437        987,409        787,454   

Specific reserves:

      

Loans

     (18,060     (27,129     (14

OREO

     (14,068     (8,205     (24,540
                        

Total specific reserves

     (32,128     (35,334     (24,554
                        

Net nonperforming assets

   $ 1,001,309      $ 952,075      $ 762,900   
                        

Nonperforming loans before charge-offs, gross

   $ 1,187,072      $ 1,202,660      $ 665,435   

Charge-offs on nonperforming loans

     (462,885     (500,183     (224,680
                        

Nonperforming loans carried at fair value

     724,187        702,477        440,755   

Nonperforming loans with no charge-offs (1)

     159,948        193,454        256,978   
                        

Total nonperforming loans

   $ 884,135      $ 895,931      $ 697,733   
                        

Nonperforming assets to total assets

     10.61     9.08     6.35

Nonperforming loans to loans

     13.80     11.65     8.05

Nonperforming loans carried at fair value to total nonperforming loans

     81.9     78.4     63.2

Charge-offs to gross nonperforming loans

     39.0     41.6     33.8

Charge-offs plus specific loan reserves to gross nonperforming loans

     40.5     43.8     33.8

Loan loss allowance to nonperforming loans

     30.0     38.3     32.1

Loan loss allowance to nonperforming loans excluding loans carried at fair value (2)

     154.3     163.5     87.0

 

(1) Charge-offs have not been recorded on these nonperforming loans, as the value of the underlying collateral exceeds the carrying value of the loans.
(2) Excludes the specific loan loss reserve.

 

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As of June 30, 2010, Sterling has recognized confirmed losses totaling $462.9 million on collateral dependent nonperforming loans held in its portfolio. As a result of these confirmed losses, Sterling has written down the carrying value of these loans to the appraisal value of their underlying collateral. After taking into account confirmed losses and specific reserves held against these loans, Sterling carried them at 59.5% of the outstanding principal balance as of June 30, 2010. The loan loss coverage ratio, excluding these loans for which the full loss to date has been charged off, was 154.3% of nonperforming loans at June 30, 2010. Further declines in real estate appraisal values could result in additional losses on these loans. The following table presents nonperforming assets by type, and also by market for Sterling’s nonperforming construction assets:

 

     June 30, 2010     December 31, 2009     June 30, 2009  
     (Dollars in thousands)  

Residential construction

            

Puget Sound

   $ 130,557      13   $ 154,369      16   $ 129,248      16

Portland, OR

     84,222      8     114,628      12     121,037      15

Bend, OR

     14,058      1     29,344      3     29,474      4

Northern California

     22,701      2     20,535      2     2,644      0

Vancouver, WA

     14,995      1     23,332      2     20,447      3

Boise, ID

     10,746      1     21,659      2     27,270      4

Southern California

     6,761      1     8,893      1     42,960      6

Utah

     1,464      0     4,451      0     20,230      3

Other

     39,835      4     62,267      6     73,940      9
                                          

Total residential construction

     325,339      31     439,478      44     467,250      60

Commercial construction

            

Southern California

     38,094      4     38,003      4     20,613      3

Puget Sound

     47,682      5     22,045      2     25,981      3

Northern California

     30,234      3     47,044      5     50,379      6

Other

     101,640      10     60,775      6     3,374      0
                                          

Total commercial construction

     217,650      22     167,867      17     100,347      12

Multi-Family construction

            

Puget Sound

     53,748      5     27,195      3     2,715      0

Portland, OR

     11,497      1     15,497      2     0      0

Other

     32,042      3     32,639      3     24,658      3
                                          

Total multi-family construction

     97,287      9     75,331      8     27,373      3
                                          

Total construction

     640,276      62     682,676      69     594,970      75
                                          

Commercial banking

     150,405      15     136,464      14     86,117      11

Residential real estate

     117,543      11     71,642      7     61,761      8

Commercial real estate

     87,726      8     69,540      7     26,947      3

Multi-family real estate

     27,447      3     20,478      2     10,898      2

Consumer

     10,040      1     6,609      1     6,761      1
                                          

Total nonperforming assets

     1,033,437      100     987,409      100     787,454      100
                        

Specific reserves

     (32,128       (35,334       (24,554  
                              

Net nonperforming assets (1)

   $ 1,001,309        $ 952,075        $ 762,900     
                              

 

(1)

Net of cumulative confirmed losses on loans and OREO of $592.8 million for June 30, 2010, $579.7 million for December 31, 2009, and $282.1 million for June 30, 2009.

During the first six months of 2010, total nonperforming construction assets declined, including a decline of 26% in residential construction nonperforming assets. This reflects in part Sterling’s disposal activities through note sales and short sales. Increases in commercial construction nonperforming assets in the Puget Sound region during 2010 were primarily the result of two relationships totaling an aggregate of approximately $25 million of nonperforming assets. The increase in multi-family construction nonperforming assets also was from two relationships which also totaled an aggregate of approximately $25 million of nonperforming assets. The increase in nonperforming commercial real estate since December 31, 2009 included three relationships totaling approximately $17 million of nonperforming assets. The increase in nonperforming residential real estate during 2010 was predominantly non-owner occupied.

 

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Non-Interest Income. Non-interest income was as follows for the periods presented:

 

     Three Months Ended June 30,     Six Months Ended June 30,  
     2010     2009     2010     2009  
     (Dollars in thousands)  

Fees and service charges

   $ 14,233      $ 14,878      $ 27,268      $ 28,718   

Mortgage banking operations

     11,713        13,732        22,945        27,040   

Loan servicing fees

     (408     1,022        738        555   

BOLI

     1,560        2,000        3,855        3,406   

Gains on sales of securities

     15,349        992        17,260        11,557   

Other

     (1,219     (932     (5,541     (2,958
                                

Total

   $ 41,228      $ 31,692      $ 66,525      $ 68,318   
                                

The increase in the gain on sales of investments for the three and six months periods ended June 30, 2010 compared to the same periods in 2009 was due to Sterling selling $458.1 million of securities during the second quarter of 2010. The securities were sold to reposition the securities portfolio by reinvesting the proceeds in securities with a shorter duration.

The decline in mortgage banking operations income for the six months ended June 30, 2010 compared to the same period in 2009 was due to a lower level of refinancing activity during 2010. However, the decline in originations was partially offset by an increase in the margin on residential loan sales, as margin for the six months ended June 30, 2010 expanded to 2.14% from 1.49% during the 2009 comparative period.

Other noninterest income for the six months ended 2010 includes $4.9 million of losses on the sale of loans, of which $3.7 million occurred during the first quarter of 2010 primarily due to the sale of $218.5 million of consumer indirect auto loans. Other noninterest income for the six months ended 2009 includes a $1.1 million loss resulting from the failure of a Washington state public depository bank. The increase in bank owned life insurance (“BOLI”) for the six months ended June 30, 2010 was due to $699,000 of gain in excess of cash surrender value on the proceeds of four policies received during the first quarter of 2009. The change in loan servicing income is due to fluctuations in the value of mortgage servicing rights.

The following table summarizes certain information regarding Sterling’s residential and commercial mortgage banking activities for the periods indicated:

 

     As of and for the
Three Months Ended June 30,
   As of and for the
Six Months Ended June 30,
     2010    2009    2010    2009
     (Dollars in thousands)

Originations of residential mortgage loans

   $ 622,144    $ 946,468    $ 1,053,201    $ 1,657,032

Originations of commercial real estate loans

     5,237      63,500      37,327      82,668

Sales of residential mortgage loans - delivered

     660,310      814,156      1,146,915      1,416,055

Sales of commercial real estate loans

     57,917      18,534      61,781      18,534

Principal balances of residential loans serviced for others

     1,331,086      753,014