Attached files

file filename
10-K - 10-K - WASHINGTON FEDERAL INCwafd930201610k.htm
EX-32 - EXHIBIT 32 - WASHINGTON FEDERAL INCwafdex3209302016.htm
EX-31.2 - EXHIBIT 31.2 - WASHINGTON FEDERAL INCwafdex31209302016.htm
EX-31.1 - EXHIBIT 31.1 - WASHINGTON FEDERAL INCwafdex31109302016.htm
EX-23.1 - EXHIBIT 23.1 - WASHINGTON FEDERAL INCwafdex231dtconsent09302016.htm
EX-10.2 - EXHIBIT 10.2 - WASHINGTON FEDERAL INCwafdex1022011incentiveplan.htm

WASHINGTON FEDERAL, INC. AND SUBSIDIARIES
2016 ANNUAL REPORT


Table of Contents



1


WASHINGTON FEDERAL, INC. AND SUBSIDIARIES
2016 ANNUAL REPORT




BUSINESS DESCRIPTION

Washington Federal Inc. (“Company” or “Washington Federal”) is a bank holding company headquartered in Seattle, Washington that conducts its operations through Washington Federal, National Association (“Bank”), a federally chartered national bank subsidiary.
The Company had its origins on April 24, 1917 in Ballard, Washington and this year is celebrating its First 100 Years in business. Washington Federal is engaged primarily in providing lending, depository, insurance and other banking services to consumers, mid-sized to large businesses, and owners and developers of commercial real estate. On November 9, 1982 the Company listed and began trading on the NASDAQ. Profitable operations have been recorded every year since and the Company is often leading the industry in important measures of financial performance such as efficiency and capital strength. Today the stock trades at 85 times its original 1982 offering price, has paid 135 consecutive quarterly cash dividends and, with cash dividends reinvested, has returned 12,177% total shareholder return to those who invested 33 years ago.
Over the years, the Company has expanded to serve banking clients in eight western states. While much has changed since its founding, one constant has been the commitment to doing business with integrity and treating employees, clients and investors fairly. Our tagline “invested here” is intended to reflect our people-first values and express the Company’s dedication to helping our neighborhoods and communities thrive.


FINANCIAL HIGHLIGHTS
As of and for the year end September 30,
2016
2015
% Change
 
(In thousands, except per share data)
Assets
$
14,888,063

$
14,568,324

+2.2%
Cash and cash equivalents
450,368

284,049

+58.6
Investment securities
849,983

1,117,339

(23.9)
Loans receivable, net
9,910,920

9,170,634

+8.1
Mortgage-backed securities
2,490,510

2,906,440

(14.3)
Customer accounts
10,600,852

10,631,703

(0.3)
FHLB advances and other borrowings
2,080,000

1,830,000

+13.7
Stockholders’ equity
1,975,731

1,955,679

+1.0
Net income
164,049

160,316

+2.3
Diluted earnings per share
1.78

1.67

+6.6
Dividends per share
0.55

0.54

+1.9
Stockholders’ equity per share
22.03

21.04

+4.7
Shares outstanding
89,681

92,936

(3.5)
Return on average stockholders’ equity
8.33
%
8.21
%
+1.5
Return on average assets
1.12

1.10

1.8
Efficiency ratio (1)
50.80

49.54

+2.5

(1)
Calculated as total operating costs divided by net interest income, plus other income (excluding non-operating gains)



2


WASHINGTON FEDERAL, INC. AND SUBSIDIARIES
2016 ANNUAL REPORT

TO OUR STOCKHOLDERS

Fellow Stockholder,

It is my privilege to report that in 2016 your Company completed its ninety-ninth year in business with record results. Net income for the year totaled $164,049,000, a 2.3% increase over prior year earnings of $160,316,000. Earnings per share improved for the sixth year in succession to $1.78 from $1.67, a 6.6% increase from fiscal 2015 and also the highest in our history. It was a great year in virtually all regards. Washington Federal has now reported profitable operations to shareholders for 34 consecutive years since our initial public offering in 1982.

The strong financial performance of the Company translated to healthy rewards for shareholders, with total return for the year of 19.69%. In January, the cash dividend increased by 7.7% to fourteen cents per share. Contributing to increasing shareholder returns over the last few years has been our disciplined approach to repurchasing shares. During the fiscal year, 3,867,563 shares, representing 4.16% of those outstanding, were repurchased at a weighted average price of $22.72, and in September the Board of Directors approved an additional five million shares for the program. We believe that repurchase of our stock continues to be a viable alternative for excess capital, although investment in growth is always preferable. I’d like to call your attention to the accompanying chart that compares the performance of the Company’s stock to some of the peer banks within our market going back to the onset of the last recession. The chart visually displays the value of long-term thinking and our conservative approach to financial management.

wafdstockpricecomparisonfina.jpg

Several operational accomplishments contributed to our good results. For example, one of our key strategies is to diversify the loan portfolio by increasing the volume of loans originated for business purposes. I am pleased to report that management delivered on the strategy as commercial loans represented nearly 70% of all new loan originations, which totaled a record $3.9 billion. We favor commercial over consumer loans at present for two reasons: 1) Reduced exposure to rising interest rates due to shorter terms and floating rates, and 2) Fewer regulatory burdens as commercial borrowers are presumed by the government to be sophisticated. Consumer loans outstanding are centered in plain vanilla, thirty-year fixed-rate mortgages that we originate for our own portfolio. Mortgage lending is still a large part of our business and remains very important to our long-term prosperity. That portfolio is composed of the highest quality loans we place on the books, and has historically been a source of earnings stability during recessionary periods. We are in the mortgage business for the long haul.

We also made substantial progress toward the goal of improving the bank’s deposit mix. Ten years ago certificates of deposit (“CDs”) represented nearly 80% of total deposits. At September 30th, the funding concentration in CDs had been reduced to 43%. Our goal is to increase transaction accounts until CDs represent 20% or less of total deposits. While more expensive to service, transaction accounts are a more stable source of funds over time and through business cycles.

A strong capital position is the keystone of our financial management philosophy. Like equity in your own home, the capital on our balance sheet allows us to operate with less debt and enhances our financial stability. Our conservative approach has always led us to hold more capital than other banks of similar size. We know that there is a measurable cost of underleveraged capital during periods of economic prosperity, but we have yet to develop a formula that can tell us exactly the right amount of cushion needed to get through the next recession. We gladly pay a reasonable opportunity cost in times of economic expansion to insure that Washington Federal will be standing strong after the next crisis passes, just as we were after the Great Recession. At fiscal year-end, SNL, an independent bank rating agency, listed Washington Federal as having the strongest capital position among the 100 largest banks in the United States after adjusting for the riskiness of assets.


3


WASHINGTON FEDERAL, INC. AND SUBSIDIARIES
2016 ANNUAL REPORT

The primary driver of profits in our business is known as Net Interest Income, which is the net difference between interest income from earning assets and interest expense paid for funding. Despite ultra low yields on loans and investments, Net interest Income improved by $6.8 million over the prior year. The improvement was accomplished largely by shifting funds from lower yielding investments to higher yielding loans. We have also worked tenaciously over the last several years to position the Company to benefit somewhat from higher interest rates. Should both long and short term rates move higher in tandem, we expect that Net Interest Income would improve.

Our business model has historically focused on margin and therefore has not generated a prodigious amount of fee income. Although Other Income increased during the past year, this is one area that holds prospects for improved performance. One strategic initiative will add significant economic value to our consumer checking products that we believe clients will welcome with a willingness to pay. Another opportunity is to begin collecting fees that we chose to forego last year due to the impact to clients of the system conversion described below. Lastly, we hope to continue to grow our insurance revenues.

Expenses increased from the prior year by $10.6 million, generally due to higher spending on technology early in the fiscal year, although costs are now trending lower. Our efficiency ratio, a measure of pennies spent to produce one dollar of revenue, amounted to 50.8%; a high ratio by our standards yet still among the best in the industry. We expect the efficiency ratio to improve this year, although investors should know that cost pressures, particularly labor related expenses, are increasing.

Finally, net income was bolstered by several events, including a $10 million pre-tax gain on the sale of real estate owned. Improved asset quality also enabled the Company to recapture $6.3 million in expense previously taken for expected loan losses that did not materialize. It seems each year we experience some unexpected gains and that may continue; however, investors should be aware that there is always the potential for non-recurrence. The sum of the parts enabled Return on Assets to increase to 1.12%, versus 1.10% in the prior year, while Return on Equity increased from 8.21% to 8.33%.

Financial results were especially impressive given that the first half of the fiscal year found management attention laser-focused on the conversion of virtually all of the Company’s operating systems. Planning, implementation and the subsequent cleanup activities were incredibly intense and did not really abate until the end of the second fiscal quarter, leaving many of my colleagues in need of a well-earned vacation. The project was a terrific team building experience though that created great confidence in our ability to execute on even the biggest and most complex tasks. Improving our competitiveness, the new systems provide real time processing consistent with the expectation of today’s market, and should also provide growth capacity for at least a generation. The total upgrade investment amounted to approximately $40 million and will increase the baseline cost of information technology expense by $2-3 million per year. Technology continues to advance, so ongoing investment will be needed to maintain competitive products and provide for ever-improving security measures to protect sensitive client information. The conversion did entail some disruption and we are ever so thankful to our clients for their patience with this process.

Although we wish that the endless rulemaking driven by Congress would stop, we appreciate our regulators and believe that over time we have built a relationship of mutual trust that makes it easier for all of us to function within an amazingly complex environment. This year a brief comment on our consumer sales practices is necessary in light of well-publicized shortcomings found at another institution. Investors and clients alike should know that our branch personnel have never operated on commission, and do not face hard cross-selling goals. Rather, they are trained to have conversations with our clients to identify needs that can be matched against the benefits of our products. They are also trained that accounts are to be opened and fee services provided only when the client both wants and needs them. Our view has always been that if we simply treat people fairly and conduct business with integrity, in the long run the world will find a path to our door. For the sake of society, I hope that we’re right.

This year there have been some executive management changes that deserve acknowledgement. Executive Vice Presidents Linda Brower, Tom Kasanders and Jack Jacobson have been virtually indispensable in building our capabilities over the past many years. As Chief Administrative Officer, Linda transformed our back office operations to support a much larger and more complex institution than she found, while Tom and Jack led unprecedented growth in the Business Banking and Commercial Real Estate segments, respectively. Their retirements come too soon for me, but are healthy for the organization as they open new opportunities for those they have trained so well for succession. On behalf of everyone at Washington Federal, I thank them for their professionalism, hard work, support and friendship and wish them the very best futures. I also wish to acknowledge and congratulate Brent Beardall for his title promotion. In July, he became only the sixth person in nearly a century to be awarded the title of President.

We also continue to update and diversify the Board of Directors. In September we added Erin Lantz to the Board. Erin is Vice President and General Manager of Mortgages at Zillow Group, Inc. She brings deep knowledge of the entire home buying and financing process, along with a keen understanding of consumer behaviors and the value of big data. I look forward to introducing her to you at the upcoming Annual Meeting.

4


WASHINGTON FEDERAL, INC. AND SUBSIDIARIES
2016 ANNUAL REPORT


Looking to the future, prospects for growth in our core business are as promising as they’ve been in some time. The Company is in great shape financially, with the deepest management bench in our long history. New systems are stable and being steadily enhanced, asset quality is nearing historic highs, the pipeline for lending activity is robust and most of our Western U.S markets are prosperous and experiencing faster than average growth. While we haven’t forgotten the hard lessons of the last economic downturn, it’s exciting to have the systems, leadership and financial wherewithal to be once again focused on growth and service to our clients as we celebrate our First 100 Years. We won’t be here to see it, but as always we’ll go about our business with a spirit of stewardship intended to enable a future generation to have a chance at celebrating the Second 100 Years.

In closing, allow me to thank the Board of Directors and my colleagues on the Executive Management Committee and throughout our eight state territory for their hard work and support of the Company’s values throughout a very interesting, challenging and in the end, a most rewarding year.

I look forward to seeing you at the Sheraton Hotel in downtown Seattle on January 18, 2017 at 2:00 P.M for the Annual Meeting of Shareholders. In the meantime, you can help our business grow and prosper by referring your friends, neighbors and the businesses you associate with to Washington Federal for all their banking needs


Sincerely,
rmwsignaturea01a01.jpg
Roy M. Whitehead
Chairman of the Board and Chief Executive Officer






5

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

We make statements in this Annual Report that constitute forward-looking statements. Words such as “expects,” “anticipates,” “believes,” “estimates,” “intends,” “forecasts,” “projects” and other similar expressions as well as future or conditional verbs such as “will,” “should,” “would” and “could” are intended to help identify such forward-looking statements. These statements are not historical facts, but instead represent current expectations, plans or forecasts of the Company and are based on the beliefs and assumptions of the management of the Company and the information available to management at the time that these disclosures were prepared. The Company intends for all such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and the provisions of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements are not guarantees of future results or performance and involve certain risks, uncertainties and assumptions that are difficult to predict and often are beyond the Company's control. Actual outcomes and results may differ materially from those expressed in, or implied by, the Company's forward-looking statements.
You should not place undue reliance on any forward-looking statement and should consider the following uncertainties and risks, as well as the risks and uncertainties discussed elsewhere in this report, including under "Item 1A. Risk Factors” contained in our Form 10-K and in any of the Company's other subsequent Securities and Exchange Commission filings, which could cause our future results to differ materially from the plans, objectives, goals, estimates, intentions, and expectations expressed in forward-looking statements:

a deterioration in economic conditions, including declines in the real estate market and home sale volumes and financial stress on borrowers as a result of the uncertain economic environment;
economic downturn, including high unemployment rates and declines in housing prices and property values;
the effects of and changes in monetary and fiscal policies of the Board of Governors of the Federal Reserve System and the U.S. Government;
fluctuations in interest rate risk and changes in market interest rates;
the Company's ability to make accurate assumptions and judgments about the collectability of its loan portfolio, including the creditworthiness of its borrowers and the value of the assets securing these loans;
the Company's ability to successfully complete merger and acquisition activities and realize expected strategic and operating efficiencies associated with such activities;
the Company's ability to manage its expenses to remain at levels that are appropriate for its business activities and their level of complexity;
legislative and regulatory limitations, including those arising under the Dodd-Frank Wall Street Reform Act and potential limitations in the manner in which we conduct our business and undertake new investments and activities;
the ability of the Company to obtain external financing, including client deposits and wholesale borrowing sources, to fund its operations or obtain this financing on favorable terms;
changes in other economic, competitive, governmental, regulatory, and technological factors affecting the Company's markets, operations, pricing, products, services and fees;
the ability of the Company to identify and mitigate information security risks;
the success of the Company at managing the risks involved in the foregoing and managing its business; and
the timing and occurrence or non-occurrence of events that may be subject to circumstances beyond the Company's control.

All forward-looking statements speak only as of the date on which such statements are made, and Washington Federal undertakes no obligation to update or revise any forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events, changes to future operating results over time, or the impact of circumstances arising after the date the forward-looking statement was made.

6

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

GENERAL
Washington Federal, Inc. is a Washington corporation headquartered in Seattle, Washington. The Company is a bank holding company that conducts its operations through a national bank subsidiary, Washington Federal, National Association. The Bank is principally engaged in the business of attracting deposits from the general public and investing these funds, together with borrowings and other funds, in commercial and consumer loans. As used throughout this document, the terms "Washington Federal" or the "Company" refer to Washington Federal, Inc. and its consolidated subsidiaries and the term "Bank" refers to the operating subsidiary Washington Federal, National Association.
The Company's fiscal year end is September 30th. All references to 2016, 2015 and 2014 represent balances as of September 30, 2016, September 30, 2015 and September 30, 2014, or activity for the fiscal years then ended.
CRITICAL ACCOUNTING POLICIES
Preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires the use of estimates and assumptions that affect reported amounts of certain assets, liabilities, revenues and expenses in the Company's consolidated financial statements. Accordingly, estimated amounts may fluctuate from one reporting period to another due to changes in assumptions underlying estimated values.
The Company has determined that the only accounting policy critical to an understanding of the consolidated financial statements of Washington Federal relates to the methodology for determining the amount of the allowance for loan losses. The Company maintains an allowance to absorb losses inherent in the loan portfolio. The allowance is based on ongoing, quarterly assessments of the probable and estimable losses inherent in the loan portfolio.
The general loan loss allowance is established by applying a loss percentage factor to the different loan types. For example, residential real estate loans are not individually analyzed for impairment and loss exposure because of the significant number of loans, their relatively small balances and their historically low level of losses. See the "Asset Quality and Allowance for Loan Losses" section below for additional information about establishing the loss factors. Specific allowances may be established for loans that are individually evaluated.

INTEREST RATE RISK

The primary source of income for the Company is net interest income, which is the difference between the interest income generated by interest-earning assets and the interest expense incurred for interest-bearing liabilities. The level of net interest income is a function of the average balance of interest-earning assets and interest-bearing liabilities and the difference between the yield on earning assets and the cost of interest-bearing liabilities. Both the pricing and mix of the Company's interest-earning assets and interest-bearing liabilities influence these factors. All else being equal, if the interest rates on the Company's interest-bearing liabilities increase at a faster pace than the interest rates on its interest-earning assets, the result would be a reduction in net interest income and with it, a reduction in net earnings.

Based on Management's assessment of the current interest rate environment, the Company has taken steps, including growing shorter-term loans and transaction deposit accounts, investing in variable-rate securities and extending the maturity on borrowings, to position the Company for changing interest rates.

The Company's balance sheet strategy, in conjunction with low operating costs, has allowed the Company to manage interest rate risk, within guidelines established by the Board, through all interest rate cycles. It is management's objective to grow the dollar amount of net interest income, through the rate cycles, acknowledging that there will be some periods of time when that will not be feasible.

Management relies on various measures of interest rate risk, including modeling of changes in the Company's forecasted net interest income under various rate change scenarios, the impact of interest rate changes on the net portfolio value ("NPV") and an asset/liability maturity gap analysis.
Net Interest Income Sensitivity. We estimate the sensitivity of our net interest income to changes in market interest rates using an interest rate simulation model that includes assumptions related to the level of balance sheet growth, deposit repricing characteristics and the rate of prepayments for multiple interest rate change scenarios. Interest rate sensitivity depends on certain

7

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

repricing characteristics in our interest-earnings assets and interest-bearing liabilities, including the maturity structure of assets and liabilities and their repricing characteristics during the periods of changes in market interest rates. The analysis assumes a constant balance sheet. Actual results would differ from the assumptions used in this model, as Management monitors and adjusts loan and deposit pricing and the size and composition of the balance sheet to respond to changing interest rates.

In the event of an immediate and parallel increase of 200 basis points in both short and long-term interest rates, the model estimates that net interest income would increase by 3.2% in the next year. This compares to an estimated decrease of 2.2% as of the September 30, 2015 analysis. It is noted that a flattening yield curve where the spread between short-term rates and long-term rates decreases would likely result in lower net interest income. However, Management estimates that a gradual increase of 300 basis points in short term rates and 100 basis points in long term rates over two years would result in a net interest income increase of 2.1% in the first year and increase of 4.4% in the second year assuming a constant balance sheet and no management intervention.

NPV Sensitivity. The NPV is an estimate of the market value of shareholders' equity at a point in time. It is derived by calculating the difference between the present value of expected cash flows from interest-earning assets and the present value of expected cash flows from interest-paying liabilities and off-balance-sheet contracts. The sensitivity of the NPV to changes in interest rates provides a longer term view of interest rate risk as it incorporates all future expected cash flows. As of September 30, 2016, in the event of an immediate and parallel increase of 200 basis points in interest rates, the NPV is estimated to decline by $479 million or 18.6% and the NPV to total assets ratio to decline to 14.8% from a base of 16.9%. As of September 30, 2015, the NPV in the event of a 200 basis point increase in rates was estimated to decline by $536 million or 19.7% and the NPV to total assets ratio to decline to 15.9% from a base of 18.4%. The decreased NPV sensitivity and lower base NPV ratio is primarily due to lower interest rates as of September 30, 2016.
Repricing Gap Analysis. At September 30, 2016, the Company had approximately $1.5 billion more in liabilities subject to maturity or repricing in the next year than assets, which resulted in a one-year repricing gap of (10.1)% of total assets. This compares to the (13.4)% gap as of September 30, 2015. A negative repricing gap implies that funding costs will change more rapidly than interest income on earning assets with movements in interest rates. A negative repricing gap typically results in lower margins when interest rates rise and higher margins when interest rates decline. The interest rate gap analysis provides management with a high-level indication of interest rate risk, but it is considered less reliable than more detailed modeling. Cash and cash equivalents of $450 million and stockholders' equity of $2.0 billion provide management with additional flexibility in managing interest rate risk going forward.
The following table shows the estimated repricing periods for earning assets and paying liabilities:
 
Repricing Period
 
 
September 30, 2016
Within One
Year
 
After 1 year -
before 6 Years
 
Thereafter
 
Total
 
(In thousands)
 
 
Earning Assets (1)
$
5,095,776

 
$
4,885,359

 
$
3,763,346

 
$
13,744,481

Paying Liabilities (2)
(6,599,318
)
 
(3,922,868
)
 
(2,174,161
)
 
(12,696,347
)
Excess (Liabilities) Assets
$
(1,503,542
)
 
$
962,491

 
$
1,589,185

 
 
Excess as % of Total Assets
(10.10
)%
 
 
 
 
 
 
Policy limit for one year excess
(20.00
)%
 
 
 
 
 
 
(1) Asset repricing period includes estimated prepayments based on historical activity.
(2) Liability repricing includes estimated duration of non-maturity deposits.


Interest Rate Spread. The interest rate spread is measured as the difference between the rate on total loans and investments and the rate on costing liabilities at the end of each period. The interest rate spread decreased to 2.65% at September 30, 2016 from 2.73% at September 30, 2015. The spread decrease of 8 basis points is primarily due to payoffs of loans at generally higher interest rates and new loan originations being at lower interest rates, as well as an increase in the proportion of funding provided by FHLB advances at rates higher than the average cost of customer deposits. As of September 30, 2016, the weighted average rate on

8

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

loans, mortgage backed securities and investments decreased by 5 basis points to 3.58% compared to September 30, 2015, while the weighted average cost of funds increased by 3 basis point to 0.93%.

 
SEP 2016
 
JUN 2016
 
MAR 2016
 
DEC 2015
 
SEP 2015
 
JUN 2015
 
MAR 2015
 
DEC 2014
Interest rate on loans and mortgage-backed securities
3.86
%
 
3.92
%
 
3.94
%
 
3.90
%
 
3.94
%
 
3.96
%
 
4.10
%
 
4.14
%
Interest rate on investment securities
1.25

 
1.17

 
1.29

 
1.25

 
1.19

 
1.12

 
0.94

 
1.02

Combined earning assets
3.58

 
3.61

 
3.69

 
3.61

 
3.63

 
3.61

 
3.63

 
3.68

Interest rate on customer accounts
0.50

 
0.51

 
0.50

 
0.48

 
0.48

 
0.48

 
0.48

 
0.50

Interest rate on borrowings
3.15

 
3.13

 
3.23

 
3.20

 
3.35

 
3.43

 
3.49

 
3.49

Combined cost of funds
0.93

 
0.94

 
0.93

 
0.90

 
0.90

 
0.90

 
0.92

 
0.94

Interest rate spread
2.65
%
 
2.67
%
 
2.76
%
 
2.71
%
 
2.73
%
 
2.71
%
 
2.71
%
 
2.74
%

The chart below shows the volatility of our period end net interest spread (dashed line measured against the right axis) compared to the relatively consistent growth in net interest income (solid line measured against the left axis). The relative consistency of net interest income is accomplished by actively managing the size and composition of the balance sheet through different rate cycles.
spreadniigraph.jpg
Net Interest Margin. The net interest margin is measured using the interest income and expense over the average assets and liabilities for the period. The net interest margin increased to 3.11% for the year ended September 30, 2016 from 3.08% for the year ended September 30, 2015. The yield on earning assets increased 2 basis points to 3.97% and the cost of interest bearing liabilities declined by 1 basis point to 0.93%. The higher yield on earning assets is the result of changes in the asset mix as the average balance of mortgage-backed securities and other investment securities decreased while the average balance of loans receivable increased. The decrease in interest cost was due to changes in the mix of customer deposits and FHLB advances.


9

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

For the year ended September 30, 2016, average earning assets increased by 0.6% to $13,530,558,000, up from $13,444,499,000 for the year ended September 30, 2015. During 2016, average loans receivable increased $912,916,000 or 10.6%, while the combined average balances of mortgage backed securities, other investment securities and cash decreased by $802,078,000 or 17.0%. Management views organic loan growth as the highest and best use of capital, thus the shift in earning assets away from investment securities and into loans receivable is seen as beneficial.

During 2016, average customer deposit accounts decreased $66,870,000 or 0.6% and the average balance of borrowings increased by $143,530,000 or 7.8% from 2015.


10

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following table sets forth the information explaining the changes in the net interest income and net interest margin for 2016 compared to the prior year.
 
Twelve Months Ended September 30, 2016
 
Twelve Months Ended September 30, 2015
 
Average Balance
 
Interest
 
Average Rate
 
Average Balance
 
Interest
 
Average Rate
 
(In thousands)
 
(In thousands)
Assets
 
 
 
 
 
 
 
 
 
 
 
Loans and covered loans
$
9,511,351

 
$
454,085

 
4.77
%
 
$
8,598,435

 
$
437,002

 
5.08
%
Mortgaged-backed securities
2,737,947

 
62,949

 
2.30

 
3,073,180

 
71,392

 
2.32

Cash & Investments
1,167,596

 
16,282

 
1.39

 
1,634,441

 
20,363

 
1.25

FHLB & FRB stock
113,664

 
3,477

 
3.06

 
138,443

 
1,796

 
1.30

 
 
 


 


 


 


 


 Total interest-earning assets
13,530,558

 
536,793

 
3.97
%
 
13,444,499

 
530,553

 
3.95
%
Other assets
1,181,975

 
 
 
 
 
1,102,827

 


 


Total assets
$
14,712,533

 
 
 
 
 
$
14,547,326

 

 

 
 
 
 
 
 
 
 
 
 
 
 
Liabilities and Equity
 
 
 
 
 
 
 
 
 
 
 
Customer accounts
$
10,589,817

 
$
52,485

 
0.50
%
 
$
10,656,687

 
$
51,054

 
0.48
%
FHLB advances
1,992,434

 
64,059

 
3.22

 
1,848,904

 
66,018

 
3.57

 

 

 


 

 

 


Total interest-bearing liabilities
12,582,251

 
116,544

 
0.93
%
 
12,505,591

 
117,072

 
0.94
%
Other liabilities
161,446

 
 
 
 
 
89,140

 
 
 
 
               Total liabilities
12,743,697

 
 
 
 
 
12,594,731

 
 
 
 
Stockholders' equity
1,968,836

 
 
 
 
 
1,952,595

 
 
 
 
 


 
 
 
 
 


 
 
 
 
Total liabilities and equity
$
14,712,533

 
 
 
 
 
$
14,547,326

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net interest income
 
 
$
420,249

 
 
 
 
 
$
413,481

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net interest margin
 
 
 
 
3.11
%
 
 
 
 
 
3.08
%



11

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

ASSET QUALITY & ALLOWANCE FOR LOAN LOSSES
The Company maintains an allowance to absorb losses inherent in the loan portfolio. The amount of the allowance is based on ongoing, quarterly assessments of the probable and estimable losses inherent in the loan portfolio. The Company's methodology for determining the appropriateness of the allowance is primarily based on a general allowance methodology and also includes specific allowances. The Company also has a reserve for unfunded commitments.
The loan loss allowance is primarily established by applying a loss percentage factor to the different loan types. Management believes loan types are the most relevant factor in the allowance calculation for groups of homogeneous loans as the risk characteristics within these groups are similar. The loss percentage factor is made up of two parts - the historical loss factor (“HLF”) and the qualitative loss factor (“QLF”).
The HLF takes into account historical charge-offs by loan type. The Company uses a 10 year average of historical loss rates for each loan category multiplied by an estimated loss emergence period. The loss emergence period is the likely period of time during which a residential or commercial loan borrower experiencing financial difficulties might be utilizing their cash reserves prior to becoming delinquent on their loan, plus the period of time that it takes the bank to work out the loans. The Company's use of a 10 year average is intended to encompass a full credit cycle.
The QLF is based on management's continuing evaluation of the pertinent factors underlying the quality of the loan portfolio, including changes in the size and composition of the loan portfolio, actual loan loss experience, delinquency trends, current economic conditions, collateral values, geographic concentrations, seasoning of the loan portfolio, specific industry conditions, and the duration of the current business cycle. These factors are considered by loan type. Single family residential loan sub-types are evaluated in groups by loan to value, non-owner or owner occupied, and delinquency status. Credit quality has been improving in most loan categories during the year, but at different paces. In addition, loan growth or declines for each loan category are taken into consideration.
The total allowance for loan loss increased by $6,665,000, or 6.2% from $106,829,000 as of September 30, 2015 to $113,494,000 at September 30, 2016. As of September 30, 2016, the Company had $366,000 of specific reserves for individually evaluated loans and the remaining balance of $113,128,000 is general allowance, which was comprised of $89,918,000 related to HLF and $23,210,000 related to qualitative factors. The Company released $6,400,000 of allowance for loan losses in 2016 due in large part to net recoveries of previously charged off loans of $13,065,000. This was comprised of $19,065,000 in recoveries and $6,000,000 in charge offs in 2016.
The ratio of the allowance for loan losses and reserves for unfunded commitments to total gross loans decreased to 1.07% as of September 30, 2016 from 1.13% as of September 30, 2015 due to the combination of improving credit quality and loan growth.
The reserve for unfunded commitments was $3,235,000 as of September 30, 2016 compared to $3,085,000 as of September 30, 2015.
The recovery of the carrying value of loans is susceptible to future market conditions beyond the Company's control, which may result in losses or recoveries differing from those estimated.
Restructured loans. Restructured single-family residential loans are reserved for under the Company's loan loss reserve methodology. Most troubled debt restructured ("TDR") loans are accruing and performing loans where the borrower has proactively approached the Company about modifications due to temporary financial difficulties. Each request is individually evaluated for merit and likelihood of success. As of September 30, 2016, single-family residential loans comprised 87.2% of restructured loans. The concession for these loans is typically a payment reduction through a rate reduction of 100 to 200 bps for a specific term, usually six to twelve months. Interest-only payments may also be approved during the modification period.
Outstanding TDRs decreased to $261,531,000 as of September 30, 2016 from $302,713,000 as of the prior year end. As of September 30, 2016, 96.2% of the restructured loans were performing. During 2016, there were additions of $27,184,000 and reductions of $68,366,000 due to prepayments and transfers to real estate owned ("REO").
Concessions for construction, land A&D and multi-family loans are typically an extension of maturity combined with a rate reduction of normally 100 bps. Before granting approval to modify a loan in a TDR, a borrower’s ability to repay is considered

12

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

by evaluating its current income levels, debt to income ratio, credit score, loan payment history, and an updated evaluation of the secondary repayment source.
If a loan is on non-accrual status before becoming a TDR it will stay on non-accrual status following restructuring until it has been performing for at least six months, at which point it may be moved to accrual status. If a loan is on accrual status before it becomes a TDR, and it is concluded that a full repayment is highly probable, it will remain on accrual status following restructuring. If the homogeneous restructured loan does not perform, it is placed in non-accrual status when it is 90 days delinquent. For commercial loans, six consecutive payments on newly restructured loan terms are required prior to returning the loan to accrual status. After the required six consecutive payments are made, a management assessment may conclude that collection of the entire principal and interest due is still in doubt. In those instances, the loan will remain on non-accrual. A loan that defaults and is subsequently modified would impact the Company's delinquency trend, which is part of the QLF component of the general reserve calculation. Any modified loan that re-defaults and is charged-off would impact the HLF component of our general reserve calculation.
Non-performing assets. Non-performing assets were $71,441,000, or 0.48% of total assets, at September 30, 2016 compared to $128,908,000, or 0.88% of total assets, at September 30, 2015.
The following table provides detail related to the Company's non-performing assets.
 
 
September 30,
 
 
 
 
Non-Performing Assets
 
2016
 
2015
 
$ Change
 
% Change
 
 
(In thousands)
 
 
Non-accrual loans:
 
 
 
 
 
 
 
 
Single-family residential
 
$
33,148

 
$
59,074

 
$
(25,926
)
 
(43.9
)%
Construction
 

 
754

 
(754
)
 
(100.0
)
Construction – custom
 

 
732

 
(732
)
 
(100.0
)
Land – acquisition & development (A&D)
 
58

 

 
58

 
N/M

Land – consumer lot loans
 
510

 
1,273

 
(763
)
 
(59.9
)
Multi-Family
 
776

 
2,558

 
(1,782
)
 
(69.7
)
Commercial real estate
 
7,100

 
2,176

 
4,924

 
226.3

Commercial & industrial
 
583

 

 
583

 
N/M

HELOC
 
239

 
563

 
(324
)
 
(57.5
)
Consumer
 

 
680

 
(680
)
 
(100.0
)
Total non-accrual loans
 
42,414

 
67,810

 
(25,396
)
 
(37.5
)
Real estate owned
 
29,027

 
61,098

 
(32,071
)
 
(52.5
)
Total non-performing assets
 
$
71,441

 
$
128,908

 
$
(57,467
)
 
(44.6
)%
The ratio of the allowance for loan losses to non-accrual loans increased to 267.59% as of September 30, 2016 from 157.54% as of September 30, 2015. This is primarily due to the 37.5% decrease in non-accrual loans.


13



LIQUIDITY AND CAPITAL RESOURCES

The principal sources of funds for the Company's activities are loan repayments, net deposit inflows, repayments and sales of investments, borrowings and retained earnings. Washington Federal's principal sources of revenue are interest on loans and interest and dividends on investments.
The Company's net worth at September 30, 2016 was $1,975,731,000 or 13.27% of total assets as compared to $1,955,679,000 or 13.42% of total assets at September 30, 2015. The Company's net worth was impacted in the year by net income of $164,049,000, the payment of $49,926,000 in cash dividends, treasury stock purchases that totaled $87,850,000, as well as a decrease in accumulated other comprehensive income (loss) of $11,509,000. The Company paid out 30.4% of its 2016 earnings in cash dividends to common shareholders, compared with 31.9% last year. For the year ended September 30, 2016, the Company returned 88.7% of net income to shareholders in the form of cash dividends, stock repurchases and warrant repurchases as compared to 110.9% for the year ended September 30, 2015. Management believes the Company's strong net worth position allows it to manage balance sheet risk and provide the capital support needed for controlled growth in a regulated environment.
The Bank has a credit line with the Federal Home Loan Bank of Des Moines ("FHLB") equal to 49.0% of total assets, providing a substantial source of additional liquidity if needed. The level of FHLB stock held varies depending on the amount of advances and other activities with the FHLB. As of September 30, 2016, the Bank had $2,391,411,000 of additional borrowing capacity at the FHLB.

The Bank has entered into borrowing agreements with the FHLB to borrow funds under a short-term floating rate cash management advance program and fixed-rate term loan agreements. All borrowings are secured by stock of the FHLB, deposits with the FHLB, and a blanket pledge of qualifying loans receivable as provided in the agreements with the FHLB.
The Company's cash and cash equivalents were $450,368,000 at September 30, 2016, which is an 58.6% increase from the balance of $284,049,000 as of the prior year end. See “Interest Rate Risk” above and the “Statement of Cash Flows” included in the financial statements for details regarding this change.


14

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

CHANGES IN FINANCIAL CONDITION
Available-for-sale and held-to-maturity securities. Available-for-sale securities decreased $457,669,000, or 19.23%, during the year ended September 30, 2016 to $1,922,894,000 due to principal repayments of $537,255,000 and the sale of $50,741,000 of available-for-sale securities that were partially offset by purchases of $137,591,000 of available-for-sale securities. As of September 30, 2016, the Company had a net unrealized gain on available-for-sale securities of $13,710,000, which is recorded net of tax as part of stockholders' equity.
Held-to-maturity securities declined by $225,617,000, or 13.73%, during the year ended September 30, 2016 to $1,417,599,000 due to paydowns and maturities. There were no held to maturity securities purchased or sold during the year ended September 30, 2016. Rising interest rates may cause these securities to be subject to unrealized losses. As of September 30, 2016, the net unrealized gain on held-to-maturity securities was $23,957,000, which management attributes to the change of interest rates since acquisition.
Loans receivable. Loans receivable, net of related contra accounts, increased $740,286,000, or 8.1%, to $9,910,920,000 at September 30, 2016, from $9,170,634,000 one year earlier. This increase resulted primarily from record high originations of $3,948,534,000, which represented a 27.2% increase over originations in the prior year. There were also loan purchases of $105,420,000 during the year ended September 30, 2016. Commercial loan originations accounted for 69.1% of total originations and consumer originations were 30.9%. The significant increase in loan origination resulted from a strategic emphasis on commercial lending, coupled with growing economies in all major markets. Loan repayments for 2016 totaled $2,935,167,000, a $516,620,000 or 21.4% increase from the total repayments of $2,418,547,000 in 2015. Loan repayments continue to be relatively high due to the ongoing historically low interest rate environment.
The following table presents the gross loan balances by category and the year over year change.
 
September 30, 2016
 
September 30, 2015
 
Change
 
(In thousands)
 
(In thousands)
 
$
%
Non-Acquired loans
 
 
 
 
 
 
 
 
   Single-family residential
$
5,621,066

51.3
%
 
$
5,651,845

57.5
%
 
$
(30,779
)
(0.5)%
   Construction
1,110,411

10.1

 
200,509

2.0

 
909,902

453.8
   Construction - custom
473,069

4.3

 
396,307

4.0

 
76,762

19.4
   Land - acquisition & development
116,156

1.1

 
94,208

1.0

 
21,948

23.3
   Land - consumer lot loans
101,853

0.9

 
103,989

1.1

 
(2,136
)
(2.1)
   Multi-family
1,118,801

10.2

 
1,125,722

11.5

 
(6,921
)
(0.6)
   Commercial real estate
956,164

8.7

 
986,270

10.0

 
(30,106
)
(3.1)
   Commercial & industrial
946,648

8.6

 
612,836

6.2

 
333,812

54.5
   HELOC
134,785

1.2

 
127,646

1.3

 
7,139

5.6
   Consumer
137,450

1.3

 
194,655

2.0

 
(57,205
)
(29.4)
Total non-acquired loans
10,716,403

97.9
%
 
9,493,987

96.6
%
 
1,222,416

12.9%
Acquired loans
115,394

1.1

 
166,293

1.7

 
(50,899
)
(30.6)
Credit impaired acquired loans
89,837

0.8

 
87,081

0.9

 
2,756

3.2
Covered loans
28,974

0.3

 
75,909

0.8

 
(46,935
)
(61.8)
Total gross loans
10,950,608

100
%
 
9,823,270

100
%
 
1,127,338

11.5%
   Less:
 
 
 
 
 
 
 
 
      Allowance for probable losses
113,494

 
 
106,829

 
 
6,665

6.2
      Loans in process
879,484

 
 
476,796

 
 
402,688

84.5
      Discount on acquired loans
11,306

 
 
30,095

 
 
(18,789
)
(62.4)
      Deferred net origination fees
35,404

 
 
38,916

 
 
(3,512
)
(9.0)
Total loan contra accounts
1,039,688

 
 
652,636

 
 
387,052

59.3
Net Loans
$
9,910,920

 
 
$
9,170,634

 
 
$
740,286

8.1%

The following table shows the change in the geographic distribution by state of the gross loan portfolio.

15

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

September 30,
2016
2015
Change
Washington
47.6
%
49.8
%
(2.2
)
Oregon
14.5

15.6

(1.1
)
Arizona
9.5

10.7

(1.2
)
Other (1)
7.5

3.3

4.2

Utah
7.0

6.8

0.2

Idaho
4.2

4.2


New Mexico
4.2

4.8

(0.6
)
Texas
3.8

3.1

0.7

Nevada
1.7

1.7


 
100
%
100
%
 
(1) Includes loans in other states and purchased loan pools and other loans without state property information.
As of September 30, 2016, FDIC covered loans net of related discounts were $28,974,000, a decrease of $46,935,000 or 61.8%, from $75,909,000 as of September 30, 2015. The decrease is attributable to FDIC loss share coverage on commercial loans from the former Home Valley Bank that expired after September 30, 2015. The FDIC loss share coverage for single family residential loans will continue for another four years. The remaining portfolio of covered loans is expected to continue to decline over time, absent another FDIC assisted transaction. When FDIC loss share agreements expire, any remaining loans will be transferred to the non covered portfolio. The Company continues to accrue a liability for the termination of the loss share agreements for what is known as the clawback provision of the agreement with the FDIC. The Company estimates the amount of this liability based on actual loss experience and projected future losses and recoveries. Contractually, the amount that will have to be paid to the FDIC for a clawback liability, if any, will be determined in 2020, after full expiry of the loss share agreements.

Non-performing assets. NPAs (excludes discounted acquired assets) decreased to $71,441,000 as of September 30, 2016 from $128,908,000 at September 30, 2015, a 44.6% decrease. The decrease is due to improving credit conditions and credit quality as well as sales of REO. Non-performing assets as a percentage of total assets was 0.48% at September 30, 2016 compared to 0.88% at September 30, 2015.

Restructured Loans. Total restructured loans declined to $261,531,000 as of September 30, 2016 from $302,713,000 as of September 30, 2015. As of September 30, 2016, 96.2% of the restructured loans were performing. The $9,948,000 of non-performing restructured loans are included in the NPAs total. Total non-performing assets and restructured loans as a percent of total assets has declined to 2.17% as of September 30, 2016 from 2.89% as of September 30, 2015.

Real estate owned. As of September 30, 2016, real estate owned totaled $29,027,000, a decrease of $32,071,000 or 52.5% from $61,098,000 as of September 30, 2015 as the Bank continued to liquidate foreclosed properties. During 2016, the Company sold real estate owned properties for total net proceeds of $61,132,000.

Interest Receivable. Interest receivable was $37,669,000 as of September 30, 2016, a decrease of $2,760,000 or 6.83% since September 30, 2015. The change is primarily due to lower yields on earning assets.

Bank Owned Life Insurance. Bank owned life insurance increased to $208,123,000 as of September 30, 2016 from $102,496,000 as of September 30, 2015. The Company purchased another $100,000,000 in bank-owned life insurance during 2016 to assist in funding the growth of employee benefit costs.
Intangible assets. The Company's intangible assets are made up of $291,503,000 of goodwill and the unamortized balance of the core deposit intangible of $5,486,000 at September 30, 2016.

Customer deposits. As of September 30, 2016, customer deposits totaled $10,600,852,000 compared with $10,631,703,000 at September 30, 2015, a $30,851,000 or 0.29% decrease due primarily to a reduction in time deposits. Consistent with its management strategy, the Company was able to increase transaction accounts by $184,714,000 or 3.2%, while time deposits decreased by

16

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

$215,565,000 or 4.5%. The weighted average rate paid on customer deposits during the year was 0.50%, an increase of 2 basis points from 2015, as a result of the low interest rate environment.
FHLB advances and other borrowings. Total FHLB advances were $2,080,000,000 at September 30, 2016 as compared to $1,830,000,000 at September 30, 2015. During 2016, new FHLB advances totaling $300,000,000 were executed coterminously with interest rate swaps to effectively fix the weighted average interest rate at 1.38% for 6.7 years as a hedge against rising interest rates. Partially offsetting these additional borrowings was the maturity of $50,000,000 of short term borrowings with a rate of 0.61%.
Contractual obligations. The following table presents the Company's significant fixed and determinable contractual obligations, within the categories described below, by contractual maturity or payment amount.
September 30, 2016
 
Total
 
Less than
1 Year
 
1 to 5
Years
 
Over 5
Years
 
 
(In thousands)
Customer accounts (1)
 
$
10,600,852

 
$
8,900,492

 
$
1,694,398

 
$
5,962

Debt obligations (2)
 
2,080,000

 
200,000

 
1,480,000

 
400,000

Operating lease obligations
 
31,191

 
4,902

 
13,130

 
13,159

 
 
$
12,712,043

 
$
9,105,394

 
$
3,187,528

 
$
419,121

(1) Includes non-maturing customer transaction accounts.
(2) Represents final maturities of debt obligations.
These obligations, except for the operating leases, are included in the Consolidated Statements of Financial Condition. The payment amounts of the operating lease obligations represent those amounts contractually due.


17

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

RESULTS OF OPERATIONS
For highlights of the quarter-by-quarter results for the years ended September 30, 2016 and 2015, see Note Q, “Selected Quarterly Financial Data (Unaudited)”.
COMPARISON OF 2016 RESULTS WITH 2015
Net Income: Net income increased $3,733,000, or 2.3%, to $164,049,000 for the year ended September 30, 2016 as compared to $160,316,000 for the year ended September 30, 2015.
Net Interest Income: For the year ended September 30, 2016, net interest income was $420,249,000, an increase of $6,768,000 from the year ended September 30, 2015. The increase was primarily driven by a higher average balance on loans receivable. For the year ended September 30, 2016, average earning assets increased by 0.6% to $13,530,558,000, up from $13,444,499,000 for the year ended September 30, 2015. During 2016, average loans receivable increased $912,916,000 or 10.6%, while the combined average balances of mortgage backed securities, other investment securities and cash decreased by $802,078,000 or 17.0%. The net interest margin increased to 3.11% for the year ended September 30, 2016 from 3.08% for the year ended September 30, 2015. The yield on earning assets increased 2 basis points to 3.97% and the cost of interest bearing liabilities declined by 1 basis point to 0.93%. The higher yield on earning assets is the result of changes in the asset mix as the average balance of mortgage-backed securities and other investment securities decreased while the average balance of loans receivable increased. The decrease in interest cost was due to changes in the mix of customer deposits and FHLB advances.
The following table sets forth certain information explaining changes in interest income and interest expense for the period indicated compared to the same period one year ago. For each category of interest-earning asset and interest-bearing liability, information is provided on changes attributable to (1) changes in volume (changes in volume multiplied by old rate) and (2) changes in rate (changes in rate multiplied by old volume). The change in interest income and interest expense attributable to changes in both volume and rate has been allocated proportionately to the change due to volume and the change due to rate.

Rate / Volume Analysis: 
 
Comparison of Year Ended September 30, 2016 and
September 30, 2015
($ in thousands)
Volume
Rate
Total
Interest income:
 
 
 
  Loans receivable
$
44,395

$
(27,312
)
$
17,083

  Mortgaged-backed securities
(7,824
)
(619
)
(8,443
)
  Investments (1)
(7,283
)
4,883

(2,400
)
 
 
 
 
     All interest-earning assets
29,288

(23,048
)
6,240

 
 
 
 
Interest expense:
 
 
 
  Customer accounts
(370
)
1,801

1,431

  FHLB advances and other borrowings
3,900

(5,859
)
(1,959
)
 
 
 
 
All interest-bearing liabilities
3,530

(4,058
)
(528
)
 
 
 
 
Change in net interest income
$
25,758

$
(18,990
)
$
6,768

 
 
 
 
(1) Includes interest on cash equivalents and dividends on FHLB & FRB stock
 

Provision (Release) for Loan Losses: The Company recorded a release of allowance for loan losses of $6,400,000 for the year ended September 30, 2016, which compares to a release of $11,162,000 for the year ended September 30, 2015. The releases recorded for both periods was a result of continued improvement in credit quality of the loan portfolio offset by net growth in the loan portfolio. The related improvement in the credit quality of the loan portfolio relates to the following factors.

18

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The Company had recoveries, net of charge-offs, of $13,065,000 for the year ended September 30, 2016, compared with $5,370,000 of net recoveries for the year ended September 30, 2015. Non-accrual loans were $42,414,000, or 0.28% of total assets, at September 30, 2016, as compared to $67,810,000, or 0.47% of total assets, at September 30, 2015, representing a decrease of 37.5%.
Unfunded commitments tend to vary depending on our loan mix and the proportion share of commercial loans. The reserve for unfunded commitments was $3,235,000 as of September 30, 2016, which is an increase from $3,085,000 at September 30, 2015. Management believes the allowance for loan losses plus the reserve for unfunded commitments, totaling $116,729,000, or 1.07% of gross loans, is sufficient to absorb estimated losses inherent in the portfolio. See Note E for further discussion and analysis of the allowance for loan losses as of and for the year ended September 30, 2016.

Other Income: Other income was $47,036,000 for the year ended September 30, 2016, an increase of $6,613,000 or 16.4% from the $40,423,000 for the year ended September 30, 2015. The increase is primarily because 2016 included a gain of $3,800,000 resulting from the sale-leaseback of a branch property. During 2015, the Company sold available-for-sale securities for $246,826,000 and recognized a $9,641,000 gain on sale and recorded $10,554,000 of expense related to prepayment of a Federal Home Loan Bank advance. Deposit fee income was $21,738,000 for the year ended September 30, 2016 compared to $22,459,000 for the year ended September 30, 2015.

Other Expense: Operating expense was $235,447,000 for the year ended September 30, 2016, an increase of $10,596,000 or 4.7% from the $224,851,000 for the year ended September 30, 2015. The increase in 2016 is primarily due to higher information technology costs, which increased by $15,006,000, and other expense, which increased by $4,390,000. These expenses were elevated due to the Company's implementation of new core systems in November 2015. Management believes that the new technology and systems better position the Company to support future growth and expansion. These increases were partially offset by lower compensation and benefits expense, which declined by $7,055,000. The number of staff, including part-time employees on a full-time equivalent basis, was 1,806 and 1,838 at September 30, 2016 and 2015, respectively. Total operating expense for the years ended September 30, 2016 and 2015 equaled 1.60% and 1.55%, respectively, of average assets.

Gain (Loss) on Real Estate Owned: Net gain on real estate owned was $10,046,000 for the year ended September 30, 2016, an increase of $742,000 or 8.0% from the $9,304,000 for the year ended September 30, 2015. This amount includes ongoing maintenance expense, periodic valuation adjustments, and gains (losses) on sales of REO.

Income Tax Expense: Income tax expense was $84,085,000 for the year ended September 30, 2016, a decrease of $5,118,000 or 5.74% from the $89,203,000 for the year ended September 30, 2015. The effective tax rate for 2016 was 33.89% as compared to 35.75% for the year ended September 30, 2015. The lower effective tax rate is primarily due to the effects of the addition of bank owned life insurance and increased investment in low income housing tax credit partnerships as well as tax free loans.
COMPARISON OF 2015 RESULTS WITH 2014

Net income increased $2,952,000, or 1.9%, to $160,316,000 for the year ended September 30, 2015 as compared to $157,364,000 for the year ended September 30, 2014. Net interest income was higher in 2015 by $7,861,000 primarily due to loan growth and reduced cost of funds. Increases in operating expenses were attributable to a full year of operations of 74 branches that were acquired in fiscal 2014 and the related increase in customer transactions. Other income increased by $9,764,000 or 31.8% driven by increased volume of fee generating services related to the acquired branches and transaction deposit accounts. Net income for the year ended September 30, 2015 continued to benefit from improving credit quality. The release of allowance for loan losses amounted to $11,162,000 for the year ended September 30, 2015 as compared to a release of $15,401,000 for the year ended September 30, 2014.

The following table sets forth certain information explaining changes in interest income and interest expense for the period indicated compared to the same period one year ago. For each category of interest-earning asset and interest-bearing liability, information is provided on changes attributable to (1) changes in volume (changes in volume multiplied by old rate) and (2) changes in rate (changes in rate multiplied by old volume). The change in interest income and interest expense attributable to changes in both volume and rate has been allocated proportionately to the change due to volume and the change due to rate.
Rate / Volume Analysis: 


19

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 
Comparison of Year Ended September 30, 2015 and
September 30, 2014
($ in thousands)
Volume
Rate
Total
Interest income:
 
 
 
  Loans receivable
$
30,507

$
(24,355
)
$
6,152

  Mortgaged-backed securities
(4,941
)
(3,927
)
(8,868
)
  Investments (1)
(2,594
)
2,166

(428
)
 
 
 
 
     All interest-earning assets
22,972

(26,116
)
(3,144
)
 
 
 
 
Interest expense:
 
 
 
  Customer accounts
1,879

(9,349
)
(7,470
)
  FHLB advances and other borrowings
(3,358
)
(177
)
(3,535
)
 
 
 
 
All interest-bearing liabilities
(1,479
)
(9,526
)
(11,005
)
 
 
 
 
Change in net interest income
$
24,451

$
(16,590
)
$
7,861

 
 
 
 
(1) Includes interest on cash equivalents and dividends on FHLB & FRB stock
 


Provision (Release) for Loan Losses: The Company recorded a release of allowance for loan losses of $11,162,000 for the year ended September 30, 2015, which compares to a release of $15,401,000 for the year ended September 30, 2014. The releases recorded for both periods was a result of continued improvement in credit quality of the loan portfolio offset by net growth in the loan portfolio. The related improvement in the credit quality of the loan portfolio relates to the following factors.
The Company had recoveries, net of charge-offs, of $5,370,000 for the year ended September 30, 2015, compared with $14,365,000 of net recoveries for the year ended September 30, 2014. Non-accrual loans were $67,810,000, or 0.47% of total assets, at September 30, 2015, as compared to $87,431,000, or 0.59% of total assets, at September 30, 2014, representing a decrease of 37.5%.
Unfunded commitments tend to vary depending on our loan mix and the proportion share of commercial loans. The reserve for unfunded commitments was $3,085,000 at September 30, 2015, which is an increase from $2,910,000 at September 30, 2014.

Other Income: Other income was $40,423,000 for the year ended September 30, 2015, an increase of $9,764,000 or 31.8% from the $30,659,000 for the year ended September 30, 2014. The increase is primarily due to deposit fee income rising by $8,153,000 in 2015 as compared to 2014 because of an increase in the number of transaction accounts and higher fees from client derivatives. In 2015, the Company had a $9,641,000 gain on sales of investment securities and $10,554,000 of expense related to prepayment of a Federal Home Loan Bank advance.

Other Expense: Operating expense was $224,851,000 for the year ended September 30, 2015, an increase of $20,842,000 or 10.22% from the $204,009,000 for the year ended September 30, 2014. The increase is primarily due to an increase of $10,209,000 for compensation expense and $7,352,000 for product delivery expense. These increases mostly relate to the addition of the employees from branches acquired during 2014 as they were with the Company for a full year in 2015 and also from growth in our commercial banking business. The number of staff, including part-time employees on a full-time equivalent basis, was 1,838 and 1,909 at September 30, 2015 and 2014, respectively. The decline in full-time equivalent employees occurred as the Company continues to consolidate under-performing branches and streamline back-office operations. Total operating expense for the years ended September 30, 2015 and 2014 equaled 1.55% and 1.43%, respectively, of average assets.

Gain (Loss) on Real Estate Owned: Net gain on real estate owned was $9,304,000 for the year ended September 30, 2015, compared to a loss of $2,743,000 for the year ended September 30, 2014. This amount includes ongoing maintenance expense, periodic valuation adjustments, and gains (losses) on sales of REO.


20

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Income Tax Expense: Income tax expense was $89,203,000 for the year ended September 30, 2015, an increase of $1,639,000 or 1.9% from the $87,564,000 for the year ended September 30, 2014. The effective tax rate for was 35.75% for the years ended September 30, 2015 and 2014.

21



SELECTED FINANCIAL DATA
Year ended September 30,
2016
2015
2014
2013
2012
 
 
(In thousands, except per share data)
Interest income
$
536,793

$
530,553

$
533,697

$
516,291

$
590,271

Interest expense
116,544

117,072

128,077

136,159

193,249

Net interest income
420,249

413,481

405,620

380,132

397,022

Provision (reversal) for loan losses
(6,250
)
(11,162
)
(15,401
)
1,350

44,955

Other income
57,082

49,727

27,916

20,074

6,698

Other expense
235,447

224,851

204,009

164,240

142,854

Income before income taxes
248,134

249,519

244,928

234,616

215,911

Income taxes
84,085

89,203

87,564

83,111

77,728

Net income
$
164,049

$
160,316

$
157,364

$
151,505

$
138,183

Per share data
 
 
 
 
 
Basic earnings
$
1.79

$
1.68

$
1.56

$
1.45

$
1.29

Diluted earnings
1.78

1.67

1.55

1.45

1.29

Cash dividends
0.55

0.54

0.41

0.36

0.32

 
 
 
 
 
 
September 30,
2016
2015
2014
2013
2012
Total assets
$
14,888,063

$
14,568,324

$
14,756,041

$
13,082,859

$
12,472,944

Loans receivable, net
9,910,920

9,170,634

8,324,798

7,823,977

7,740,374

Mortgage-backed securities
2,490,510

2,906,440

3,231,691

2,902,655

2,360,668

Investment securities
849,983

1,117,339

1,366,018

1,109,772

612,524

Cash and cash equivalents
450,368

284,049

781,843

203,563

751,430

Customer accounts
10,600,852

10,631,703

10,716,928

9,090,271

8,576,618

FHLB advances
2,080,000

1,830,000

1,930,000

1,930,000

1,880,000

Stockholders’ equity
1,975,731

1,955,679

1,973,283

1,937,635

1,899,752

Number of





Customer accounts
491,098

517,871

548,872

332,177

308,282

Loans
41,418

41,036

43,569

44,838

48,030

Offices
238

247

251

182

166




22

WASHINGTON FEDERAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION



 
September 30, 2016
 
September 30, 2015
 
(In thousands, except share data)
ASSETS
 
 
 
Cash and cash equivalents
$
450,368

 
$
284,049

Available-for-sale securities, at fair value
1,922,894

 
2,380,563

Held-to-maturity securities, at amortized cost
1,417,599

 
1,643,216

Loans receivable, net of allowance for loan losses of $113,494 and $106,829
9,910,920

 
9,170,634

Interest receivable
37,669

 
40,429

Premises and equipment, net
281,951

 
276,247

Real estate owned
29,027

 
61,098

FHLB & FRB stock
117,205

 
107,198

Bank owned life insurance
208,123

 
102,496

Intangible assets, including goodwill of $291,503
296,989

 
299,358

Federal and state income tax assets, net
16,047

 
14,513

Other assets
199,271

 
188,523

 
$
14,888,063

 
$
14,568,324

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Liabilities
 
 
 
Customer accounts
 
 
 
Transaction deposit accounts
$
6,005,592

 
$
5,820,878

Time deposit accounts
4,595,260

 
4,810,825

 
10,600,852

 
10,631,703

FHLB advances
2,080,000

 
1,830,000

Advance payments by borrowers for taxes and insurance
42,898

 
50,224

Accrued expenses and other liabilities
188,582

 
100,718

 
12,912,332

 
12,612,645

Stockholders’ equity
 
 
 
Common stock, $1.00 par value, 300,000,000 shares authorized; 134,307,818 and 133,695,803 shares issued; 89,680,847 and 92,936,395 shares outstanding
134,308

 
133,696

Paid-in capital
1,648,388

 
1,643,712

Accumulated other comprehensive income (loss), net of taxes
(11,156
)
 
353

Treasury stock, at cost; 44,626,971 and 40,759,408 shares
(739,686
)
 
(651,836
)
Retained earnings
943,877

 
829,754

 
1,975,731

 
1,955,679

 
$
14,888,063

 
$
14,568,324




SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
23

WASHINGTON FEDERAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS

Year ended September 30,
2016
2015
2014
 
(In thousands, except share data)
INTEREST INCOME
 
 
 
Loans receivable
$
454,085

$
437,002

$
430,850

Mortgage-backed securities
62,949

71,392

80,260

Investment securities and cash equivalents
19,759

22,159

22,587

 
536,793

530,553

533,697

INTEREST EXPENSE
 
 
 
Customer accounts
52,485

51,054

58,524

FHLB advances and other borrowings
64,059

66,018

69,553

 
116,544

117,072

128,077

Net interest income
420,249

413,481

405,620

Provision (release) for loan losses
(6,250
)
(11,162
)
(15,401
)
Net interest income after provision (release) for loan losses
426,499

424,643

421,021

 
 
 
 
OTHER INCOME
 
 
 
Gain on sale of investment securities

9,641


Prepayment penalty on long-term debt

(10,554
)

Loan fee income
5,548

8,788

7,706

Deposit fee income
21,738

22,459

14,306

Other income
19,750

10,089

8,647


47,036

40,423

30,659

OTHER EXPENSE
 
 
 
Compensation and benefits
112,884

119,939

109,730

Occupancy
33,568

33,956

30,452

FDIC insurance premiums
11,824

7,916

11,009

Product delivery
17,060

22,325

14,973

Information technology
30,982

15,976

14,303

Other expense
29,129

24,739

23,542

 
235,447

224,851

204,009

Gain (loss) on real estate owned, net
10,046

9,304

(2,743
)
Income before income taxes
248,134

249,519

244,928

Income tax expense
 
 
 
   Current
60,773

86,477

75,784

   Deferred
23,312

2,726

11,780

 
84,085

89,203

87,564

NET INCOME
$
164,049

$
160,316

$
157,364

 
 
 
 
PER SHARE DATA
 
 
 
Basic earnings per share
$
1.79

$
1.68

$
1.56

Diluted earnings per share
1.78

1.67

1.55

Dividends paid on common stock per share
0.55

0.54

0.41

Basic weighted average number of shares outstanding
91,399,038

95,644,639

101,154,030

Diluted weighted average number of shares outstanding
91,912,918

96,053,959

101,590,351


SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
24

WASHINGTON FEDERAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME


Year ended September 30,
2016
 
2015
 
2014
 
(In thousands)
Net income
$
164,049

 
$
160,316

 
$
157,364

Other comprehensive income (loss) net of tax:


 


 


   Net unrealized gains (losses) on available-for-sale securities
(1,403
)
 
(27,536
)
 
22,924

   Reclassification adjustment of net gains from sale
of available-for-sale securities included in net income

 
9,641

 

   Related tax benefit (expense)
516

 
6,577

 
(8,425
)
 
(887
)
 
(11,318
)
 
14,499

 
 
 
 
 
 
    Net unrealized gain (loss) on long-term borrowing hedges
(16,793
)
 
(14,287
)
 
(268
)
    Related tax benefit (expense)
6,171

 
5,250

 
99

 
(10,622
)
 
(9,037
)
 
(169
)
 
 
 
 
 
 
Other comprehensive income (loss)
(11,509
)
 
(20,355
)
 
14,330

Comprehensive income
$
152,540

 
$
139,961

 
$
171,694






SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
25

WASHINGTON FEDERAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY


(In thousands)
Common
Stock
Paid-in
Capital
Retained
Earnings
Accumulated
Other
Comprehensive
Income (Loss)
Treasury
Stock
Total
Balance at September 30, 2013
$
132,573

$
1,625,051

$
594,450

$
6,378

$
(420,817
)
$
1,937,635

 
 
 
 
 
 
 
Net income
 
 
157,364

 
 
157,364

Other comprehensive income (loss)
 
 
 
14,330

 
14,330

Dividends on common stock
 
 
(45,665
)
 
 
(45,665
)
Compensation expense related to common stock options
 
324

 
 
 
324

Proceeds from exercise of common stock options
501

9,641

 
 
 
10,142

Restricted stock expense
249

3,195

 
 
 
3,444

Treasury stock purchased
 
 
 
 
(104,291
)
(104,291
)
Balance at September 30, 2014
$
133,323

$
1,638,211

$
706,149

$
20,708

$
(525,108
)
$
1,973,283

 
 
 
 
 
 
 
Net income
 
 
160,316

 
 
160,316

Other comprehensive income (loss)
 
 
 
(20,355
)
 
(20,355
)
Dividends on common stock
 
 
(36,711
)
 
 
(36,711
)
Compensation expense related to common stock options
 
231

 
 
 
231

Proceeds from exercise of common stock options
129

1,941

 
 
 
2,070

Restricted stock expense
244

3,329

 
 
 
3,573

Treasury stock purchased
 
 
 
 
(126,728
)
(126,728
)
Balance at September 30, 2015
$
133,696

$
1,643,712

$
829,754

$
353

$
(651,836
)
$
1,955,679

 
 
 
 
 
 
 
Net income
 
 
164,049

 
 
164,049

Other comprehensive income (loss)
 
 
 
(11,509
)
 
(11,509
)
Dividends on common stock
 
 
(49,926
)
 
 
(49,926
)
Compensation expense related to common stock options
 
90

 
 
 
90

Proceeds from exercise of common stock options
433

8,850

 
 
 
9,283

Restricted stock expense
179

3,480

 
 
 
3,659

Repurchase of stock warrants
 
(7,744
)
 
 
 
(7,744
)
Treasury stock purchased
 
 
 
 
(87,850
)
(87,850
)
Balance at September 30, 2016
$
134,308

$
1,648,388

$
943,877

$
(11,156
)
$
(739,686
)
$
1,975,731





SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
26

WASHINGTON FEDERAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS

Year ended September 30,
2016
 
2015
 
2014
 
(In thousands)
CASH FLOWS FROM OPERATING ACTIVITIES
 
 
 
Net income
$
164,049

 
$
160,316

 
$
157,364

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
 
    Depreciation, amortization, accretion and restricted stock expense
22,988

 
21,217

 
17,347

    Cash received from (paid to) FDIC under loss share
1,730

 
720

 
2,502

    Stock option compensation expense
90

 
231

 
324

    Provision (release) for loan losses
(6,250
)
 
(11,162
)
 
(15,401
)
    Loss (gain) on sale of investment securities and real estate owned, net
(16,476
)
 
(28,527
)
 
(2,510
)
    Loss on extinguishment of debt

 
10,554

 

    Decrease (increase) in accrued interest receivable
2,760

 
11,608

 
(2,819
)
    Decrease (increase) in FDIC loss share receivable

 
1,795

 
(1,795
)
    Decrease (increase) in federal and state income tax receivable
5,153

 
13,829

 
18,890

    Decrease (increase) in cash surrender value of bank owned life insurance
(5,627
)
 
(2,496
)
 

    Net realized (gain) loss on sales of premises and equipment
(3,563
)
 

 

    Decrease (increase) in other assets
(14,204
)
 
(29,220
)
 
(17,799
)
    Increase (decrease) in accrued expenses and other liabilities
71,071

 
(5,994
)
 
17,612

    Net cash provided (used) by operating activities
221,721

 
142,871

 
173,715

 
 
 
 
 
 
CASH FLOWS FROM INVESTING ACTIVITIES
 
 
 
 
 
Origination of loans and principal repayments, net
(622,884
)
 
(554,350
)
 
(261,401
)
Loans purchased
(105,420
)
 
(279,936
)
 
(218,544
)
FHLB & FRB stock purchase
(36,347
)
 
(4,067
)
 

FHLB & FRB stock redeemed
26,340

 
55,708

 
14,017

Available-for-sale securities purchased
(137,591
)
 
(315,114
)
 
(1,280,477
)
Principal payments and maturities of available-for-sale securities
537,255

 
721,951

 
609,395

Proceeds from sales of available-for-sale investment securities
50,741

 
246,826

 

Held-to-maturity securities purchased

 
(259,489
)
 

Principal payments and maturities of held-to-maturity securities
218,958

 
159,947

 
103,617

Net cash received from mergers and acquisitions

 

 
1,776,660

Proceeds from sales of real estate owned
61,132

 
74,895

 
89,549

Purchase of bank owned life insurance
(100,000
)
 
(100,000
)
 

Proceeds from sales of premises and equipment
14,685

 

 

Premises and equipment purchased and REO improvements
(37,933
)
 
(36,860
)
 
(51,794
)
Net cash provided (used) by investing activities
(131,064
)
 
(290,489
)
 
781,022

 
 
 
 
 
 
CASH FLOWS FROM FINANCING ACTIVITIES
 
 
 
 
 
Net increase (decrease) in customer accounts
(30,775
)
 
(85,073
)
 
(226,914
)
Proceeds from borrowings
1,118,000

 
100,000

 

Repayments of borrowings
(868,000
)
 
(210,554
)
 

Proceeds from exercise of common stock options and related tax benefit
9,283

 
2,070

 
10,252

Dividends paid on common stock
(49,926
)
 
(51,111
)
 
(42,065
)
Repurchase of warrants
(7,744
)
 

 

Treasury stock purchased
(87,850
)
 
(126,728
)
 
(104,291
)
Increase (decrease) in advance payments by borrowers for taxes and insurance
(7,326
)
 
21,220

 
(13,439
)
Net cash provided (used) by financing activities
75,662

 
(350,176
)
 
(376,457
)
Increase (decrease) in cash and cash equivalents
166,319

 
(497,794
)
 
578,280

Cash and cash equivalents at beginning of year
284,049

 
781,843

 
203,563

Cash and cash equivalents at end of year
$
450,368

 
$
284,049

 
$
781,843


SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
27

WASHINGTON FEDERAL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS




Year ended September 30,
2016
 
2015
 
2014
 
(In thousands)
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
 
 
 
 
 
Non-cash investing activities
 
 
 
 
 
Real estate acquired through foreclosure
$
16,535

 
$
31,916

 
$
46,469

Cash paid during the year for
 
 
 
 
 
Interest
$
114,506

 
$
116,226

 
$
128,733

Income taxes
68,507

 
65,720

 
64,372

Summary of non-cash activities related to acquisitions
 
 
 
 
 
Fair value of assets and intangibles acquired, including goodwill
$

 
$

 
$
80,242

Fair value of liabilities assumed

 

 
(1,856,902
)
Net fair value of acquired assets (liabilities)
$

 
$

 
$
(1,776,660
)



SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
28


WASHINGTON FEDERAL, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED SEPTEMBER 30, 2016, 2015 AND 2014


NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Company and nature of operations. Washington Federal, Inc. is a Washington corporation headquartered in Seattle, Washington. The Company is a bank holding company that conducts its operations through a national bank subsidiary, Washington Federal, National Association. The Bank is principally engaged in the business of attracting deposits from the general public and investing these funds, together with borrowings and other funds, in one-to-four family residential real estate loans, multi-family real estate loans and commercial loans. As used throughout this document, the terms "Washington Federal" or the "Company" refer to Washington Federal, Inc. and its consolidated subsidiaries and the term "Bank" refers to the operating subsidiary Washington Federal, National Association. The Bank conducts its activities through a network of 238 offices located in Washington, Oregon, Idaho, Utah, Arizona, Nevada, New Mexico, and Texas.
Basis of presentation and use of estimates. The Company’s accounting and financial reporting policies conform to accounting principles generally accepted in the United States of America (U.S. GAAP). Inter-company balances and transactions have been eliminated in consolidation. In preparing the consolidated financial statements, the Company makes estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements and revenues and expenses during the reporting periods and related disclosures. The areas that require application of significant management judgments often result in the need to make estimates about the effect of matters that are inherently uncertain and may change in future periods. Actual results could differ materially from those estimates. In certain instances, amounts in text are presented by rounding to the nearest thousand.
The Company's fiscal year end is September 30th. All references to 2016, 2015 and 2014 represent balances as of September 30, 2016, September 30, 2015 and September 30, 2014, or activity for the fiscal years then ended.

Acquisitions. Certain Branches of Bank of America, National Association. During the 2014 fiscal year, the Bank acquired 74 branches from Bank of America, National Association. This included: effective as of the close of business on October 31, 2013, 11 branches located in New Mexico; effective as of the close of business on December 6, 2013, 40 branches located in Washington, Oregon, and Idaho; and effective as of the close of business on May 2, 2014, 23 branches located in Arizona and Nevada. The combined acquisitions provided $1.9 billion in deposit accounts, $13 million of loans, and $25 million in branch properties. The Bank paid a 1.99% premium on the total deposits and received $1.8 billion in cash from the transactions. The acquisition method of accounting was used to account for the acquisitions. The purchased assets and assumed liabilities are recorded at their respective acquisition date estimated fair values. The Bank recorded $11 million in core deposit intangible and $31 million in goodwill related to these transactions. The operating results of the Company include the operating results produced by the first 11 branches beginning November 1, 2013, for the additional 40 branches beginning December 7, 2013, and for the most recent 23 branches from May 3, 2014 forward.

Cash and cash equivalents. Cash and cash equivalents include cash on hand, amounts due from banks, overnight investments and repurchase agreements with an initial maturity of three months or less.
Investments and mortgage-backed securities. The Company accounts for investments and mortgage-backed securities in two categories: held-to-maturity and available-for-sale. Premiums and discounts on investments are deferred and recognized into income over the life of the asset using the effective interest method.
Held-to-maturity securities are accounted for at amortized cost, but the Company must have both the positive intent and the ability to hold those securities to maturity. There are very limited circumstances under which securities in the held-to-maturity category can be sold without jeopardizing the cost basis of accounting for the remainder of the securities in this category.
Available-for-sale securities are accounted for at fair value. Gains and losses realized on the sale of these securities are accounted for based on the specific identification method. Unrealized gains and losses for available-for-sale securities are excluded from earnings and reported net of the related tax effect in the accumulated other comprehensive income component of stockholders' equity.
Realized gains and losses on securities sold as well as other than temporary impairment charges, if any, are shown on the Consolidated Statements of Operations under the Other Income heading. Management evaluates debt and equity securities for other than temporary impairment on a quarterly basis based on the securities' current credit quality, market interest rates, term to maturity and management's intent and ability to hold the securities until the net book value is recovered.

29


WASHINGTON FEDERAL, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED SEPTEMBER 30, 2016, 2015 AND 2014

Loans receivable. Loans that are performing in accordance with their contractual terms are carried at their amortized cost and expected interest is accrued. The Bank also receives fees for originating loans in addition to various fees and charges related to existing loans, which may include prepayment charges, late charges and assumption fees.
When a borrower fails to make a required payment on a loan, the Bank attempts to cure the deficiency by contacting the borrower. Contact is made after a payment is 30 days past its grace period. In most cases, deficiencies are cured promptly. If the delinquency is not cured within 90 days, the Bank may institute appropriate action to foreclose on the property. If foreclosed, the property is sold at a public sale and may be purchased by the Bank.
Restructured loans. The Bank will consider modifying the interest rates and terms of a loan if it determines that a modification is a better alternative to foreclosure. Most troubled debt restructured ("TDR") loans are accruing and performing loans where the borrower has proactively approached the Bank about modifications due to temporary financial difficulties. Each request is individually evaluated for merit and likelihood of success. The concession for these loans is typically a payment reduction through a rate reduction of 100 to 200 bps for a specific term, usually six to twelve months. Interest-only payments may also be approved during the modification period. Principal forgiveness is generally not an available option for restructured loans. Before granting approval to modify a loan in a TDR, the borrower’s ability to repay is evaluated, including: current income levels and debt to income ratio, borrower’s credit score, payment history of the loan, and updated evaluation of the secondary repayment source. The Bank also modifies some loans that are not classified as TDRs as the modification is due to a restructuring where the effective interest rate on the debt is reduced to reflect a decrease in market interest rates.
Non accrual loans. Loans are placed on nonaccrual status when, in the judgment of management, the probability of collection of interest is deemed to be insufficient to warrant further accrual. When a loan is placed on nonaccrual status, previously accrued but unpaid interest is deducted from interest income. The Bank does not accrue interest on loans 90 days or more past due. If payment is made on a loan so that the loan becomes less than 90 days past due, and the Bank expects full collection of principal and interest, the loan is returned to full accrual status. Any interest ultimately collected is credited to income in the period of recovery. A loan is charged-off when the loss is estimable and it is confirmed that the borrower is not expected be able to meet contractual obligations.
If a consumer loan is on non-accrual status before becoming a TDR it will stay on non-accrual status following restructuring until it has been performing for at least six months, at which point it may be moved to accrual status. If a loan is on accrual status before it becomes a TDR, and management concludes that full repayment is probable based on internal evaluation, it will remain on accrual status following restructuring. If the restructured consumer loan does not perform, it is placed on non-accrual status when it is 90 days delinquent. For commercial loans, six consecutive payments on newly restructured loan terms are required prior to returning the loan to accrual status. In some instances after the required six consecutive payments are made management will conclude that collection of the entire principal and interest due is still in doubt. In those instances, the loan will remain on non-accrual.
Impaired loans. Impaired loans consist of loans receivable that are not expected to have their principal and interest repaid in accordance with their contractual terms. This includes TDRs that are on non-accrual status. Collateral dependent impaired loans are measured using the fair value of the collateral less selling costs. Non-collateral dependent loans are measured at the present value of expected future cash flows.
Deferred fees and discounts on loans. Loan discounts and loan fees are deferred and recognized over the life of the loans using the effective interest method.
Allowance for loan losses. The Bank maintains an allowance for loan losses to absorb losses inherent in the loan portfolio. The allowance is based on ongoing, quarterly assessments of the probable and estimable losses inherent in the loan portfolio. The Bank's general methodology for assessing the appropriateness of the allowance is to apply a loss percentage factor to the different loan types. The loss percentage factor is made up of two parts - the historical loss factor (“HLF”) and the qualitative loss factor (“QLF”). The HLF takes into account historical charge-offs by loan type. The Bank uses an average of historical loss rates for each loan category multiplied by a loss emergence period. This is the likely period of time during which a residential or commercial loan borrower experiencing financial difficulties might deplete their cash prior to becoming delinquent on their loan, plus the period of time that it takes the bank to work out the loans. The QLF are based on management's continuing evaluation of the pertinent factors underlying the quality of the loan portfolio, including changes in the size and composition of the loan portfolio,

30


WASHINGTON FEDERAL, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED SEPTEMBER 30, 2016, 2015 AND 2014

actual loan loss experience, current economic conditions, collateral values, geographic concentrations, seasoning of the loan portfolio, specific industry conditions, and the duration of the current business cycle. These factors are considered by loan type.
Specific allowances are established for loans which are individually evaluated, in cases where management has identified significant conditions or circumstances related to a loan that management believes indicate the probability that a loss has been incurred. The Bank has also established a reserve for unfunded commitments.
The recovery of the carrying value of loans is susceptible to future market conditions beyond the Bank's control, which may result in losses or recoveries differing from those estimated.
Acquired credit impaired loans. Acquired credit impaired loans are accounted for under Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") 310-30 when there is evidence of credit deterioration since origination and for which it is probable, at acquisition, that the Company would be unable to collect all contractually required payments. Interest income, through accretion of the difference between the carrying amount of the loans and the expected cash flows, are recognized on all acquired loans.
Covered assets. Covered loans consist of single family loans acquired from Horizon Bank in 2010 and certain loans acquired from South Valley Bank and Trust ("SVBT") in fiscal 2013 that were originally recorded at their estimated fair value at the time acquired. Loans that were classified as non-performing loans by Horizon Bank and SVBT are no longer classified as non-performing because, at acquisition, the carrying value of these loans was adjusted to reflect fair value and are covered under the FDIC loss sharing agreements. Management believes that the book value reflects an amount that will ultimately be collected. Covered real estate held for sale represents the foreclosed properties that were originally Horizon Bank loans or certain SVBT loans. Covered real estate held for sale is carried at the estimated fair value of the repossessed real estate. The covered loans and covered real estate held for sale are collectively referred to as “covered assets." When FDIC loss share agreements expire, any remaining loans will be transferred to the non covered portfolio. Covered loans are included within loans receivable on the statement of financial condition. Covered real estate owned are included within real estate owned on the statement of financial condition.
FDIC indemnification asset. FDIC indemnification asset is the receivable recorded due to the guarantee provided by the FDIC on the covered assets. This asset declines due to collections from the FDIC on claims or the eventual expiration of the FDIC loss share agreements. The FDIC indemnification asset is included within other assets on the statement of financial condition.
Client derivatives. Interest rate swap agreements are provided to certain clients who desire to convert their obligations from variable to fixed interest rates. Under these agreements, the Bank enters into a variable-rate loan agreement with a customer in addition to a swap agreement, and then enters into a corresponding swap agreement with a third party in order to offset its exposure on the customer swap agreement. As the interest rate swap agreements with the customers and third parties are not designated as hedges under FASB ASC 815, Derivatives and Hedging, the instruments are marked to market in earnings. The change in fair value of the offsetting swaps are included in interest income and interest expense and there is no impact on net income. There is fee income earned on the swaps that is included in loan fee income.
Long term borrowing hedges. The Company has entered into interest rate swaps to convert a series of future short-term borrowings to fixed-rate payments. These interest rate swaps qualify as cash flow hedging instruments under ASC 815 so gains and losses are recorded in Other Comprehensive Income to the extent the hedge is effective. Gains and losses on the interest rate swaps are reclassified from OCI to earnings in the period the hedged transaction affects earnings and are included in the same income statement line item that the hedged transaction is recorded.
Commercial loan hedges. The Company has entered into interest rate swaps to hedge long term fixed rate commercial loans. These hedges qualify as fair value hedges under ASC 815 and provide for matching of the recognition of the gains and losses on the interest rate swap and the related hedged loan.
Premises and equipment. Premises and equipment are stated at cost, less accumulated depreciation. Depreciation is computed on the straight-line method over the estimated useful lives of the respective assets. Expenditures are capitalized for betterments and major renewals. Charges for ordinary maintenance and repairs are expensed to operations as incurred.

31


WASHINGTON FEDERAL, INC. AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED SEPTEMBER 30, 2016, 2015 AND 2014

Real estate owned. Real estate properties acquired through foreclosure of loans or through acquisitions are recorded initially at fair value less selling costs and are subsequent recorded at lower of cost or fair value. Any gains (losses) are shown on the real estate acquired through foreclosure line item.
Intangible assets. Goodwill represents the excess of the cost of businesses acquired over the fair value of the net assets acquired. The core deposit intangibles are acquired assets that lack physical substance but can be distinguished from goodwill. Goodwill is evaluated for impairment on an annual basis during the fourth quarter. Other intangible assets are amortized over their estimated lives and are subject to impairment testing when events or circumstances change. If circumstances indicate that the carrying value of the assets may not be recoverable, an impairment charge could be recorded. The Bank amortizes the core deposit intangibles over their estimated lives using an accelerated method.
The table below provides detail regarding the Company's intangible assets.
 
Goodwill
 
Core Deposit Intangible
 
Total
 
(In thousands)
Balance at September 30, 2014
$
291,503

 
$
11,406

 
$
302,909

Amortization

 
(3,551
)
 
(3,551
)
Balance at September 30, 2015
291,503

 
7,855

 
299,358

Amortization

 
(2,369
)
 
(2,369
)
Balance at September 30, 2016
$
291,503

 
$
5,486

 
$
296,989

The table below presents the estimated core deposit intangible asset amortization expense for the next five years.
Fiscal Year
 
Expense
 
 
(In thousands)
2017
 
$
1,648

2018
 
1,204

2019
 
1,157