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SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
-----------------
FORM 10-K
[X] Annual Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the fiscal year ended December 31, 2001
[_] Transition Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934.
Commission File No. 0-29480
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HERITAGE FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
Washington 91-1857900
(State or other jurisdiction (IRS Employer
of incorporation or organization) Identification No.)
201 Fifth Avenue SW, Olympia, Washington 98501
(Address of principal executive offices, including zip code)
Registrant's telephone number, including area code: (360) 943-1500
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, no par value per share
(Title of class)
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Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [_]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [_]
The aggregate market value of the voting stock held by non-affiliates of the
registrant is $75,047,465 and is based upon the last sales price as quoted on
the NASDAQ Stock Market for March 8, 2002.
The Registrant had 7,474,700 shares of common stock outstanding as of March
8, 2002.
DOCUMENTS TO BE INCORPORATED BY REFERENCE
Portions of the Registrant's definitive Proxy Statement dated March 22, 2002
for the 2002 Annual Meeting of Stockholders will be incorporated by reference
into Part III of this Form 10-K.
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HERITAGE FINANCIAL CORPORATION
FORM 10-K
December 31, 2001
TABLE OF CONTENTS
Page
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PART I
ITEM 1. BUSINESS........................................................ 3
LENDING ACTIVITIES.............................................. 4
INVESTMENT ACTIVITIES........................................... 12
DEPOSIT ACTIVITIES AND OTHER SOURCES OF FUNDS................... 14
SUPERVISION AND REGULATION...................................... 17
COMPETITION..................................................... 21
ITEM 2. PROPERTIES...................................................... 22
ITEM 3. LEGAL PROCEEDINGS............................................... 22
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS............. 22
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS........................................... 23
ITEM 6. SELECTED FINANCIAL DATA......................................... 25
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS......................................... 26
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK...... 35
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA..................... 36
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURES..................................... 36
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.............. 37
ITEM 11. EXECUTIVE COMPENSATION.......................................... 37
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT.................................................... 37
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.................. 37
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 10-K 38
2
PART I
ITEM 1. BUSINESS
General
Heritage Financial Corporation is a bank holding company incorporated in the
State of Washington in August 1997. We were organized for the purpose of
acquiring all of the capital stock of Heritage Savings Bank upon our
reorganization from a mutual holding company form of organization to a stock
holding company form of organization ("Conversion").
We are primarily engaged in the business of planning, directing and
coordinating the business activities of our wholly owned subsidiaries: Heritage
Savings Bank ("Heritage Bank") and Central Valley Bank, N.A. Heritage Bank is a
Washington state-chartered savings bank whose deposits are insured by the
Federal Deposit Insurance Corporation ("FDIC") under the Savings Association
Insurance Fund ("SAIF"). Heritage Bank conducts business from its main office
in Olympia, Washington and its eleven branch offices located in Thurston,
Pierce, and Mason Counties. Central Valley Bank is a national bank whose
deposits are insured by the FDIC under the Bank Insurance Fund ("BIF"). Central
Valley Bank conducts business from its main office in Toppenish, Washington,
and its five branch offices located in Yakima and Kittitas Counties.
Our business consists primarily of lending and deposit relationships with
small businesses including agribusiness and their owners in our market area,
attracting deposits from the general public and originating for sale or
investment purposes first mortgage loans on residential properties located in
western and central Washington State. We also make residential construction,
income property, and consumer loans.
On March 5, 1999, we merged with Washington Independent Bancshares, Inc.
whose wholly owned subsidiary was Central Valley Bank. In that merger we
exchanged 1,058,009 shares of our common stock for all of the outstanding
shares of Washington Independent Bancshares' common stock. This merger was
accounted for as a pooling of interests, and accordingly, our financial
information has been restated to include the accounts and results of operations
of Washington Independent Bancshares, Inc. for all periods presented. Effective
June 12, 1998, we acquired North Pacific Bancorporation, whose wholly owned
subsidiary was North Pacific Bank, in a transaction accounted for as a
purchase. North Pacific Bank was a Washington state-chartered commercial bank,
which was merged into Heritage Bank effective November 20, 1998.
Effective with the year ending December 31, 1998, we changed our fiscal year
end from June 30th to December 31st. On December 31, 1998, we filed a
Transition Report Form 10-K with the SEC reporting for the six month period
ended December 31, 1998. This filing of Form 10-K for the fiscal year ended
December 31, 2001 will be the third full twelve month period filed with a
calendar year end. Throughout this report, every effort has been made to
clarify the accounting period being referenced (i.e. six months ending December
31, 1998 or year ending June 30, 1998) and when appropriate year to year
comparisons are made that reflect equivalent twelve month periods (i.e. twelve
months ending December 31, 1998 to twelve months ending December 31, 1999).
Market Areas
We offer financial services to meet the needs of the communities we serve
through community-oriented financial institutions. Headquartered in Olympia,
Thurston County, Washington, we conduct business through Heritage Bank and
Central Valley Bank. Heritage Bank has twelve full service offices, with six in
Pierce County, five in Thurston County, and one in Mason County. Heritage Bank
has two mortgage origination offices, with one in Thurston County and one in
Pierce County, both of which operate within banking offices. Central Valley
Bank operates six full service offices, with five in Yakima County and one in
Kittitas County.
3
Olympia enjoys a stable economic climate, largely due to federal and state
government employees and retired and active duty military personnel (Fort Lewis
and McChord Air Force Base are both located in our primary market area). State
government is by far the largest employer in Thurston County, employing over
26% of the total county work force. Federal, county, and municipal government
together comprise nearly 40% of the county's civilian employment base.
Thurston County has a population of 207,355 and grew at a rate of over 28%
during the 1990's according to the U.S. Census Bureau 2000 Census. Thurston
County's growth has been spurred by increased government employment and the
expansion of a large retirement population, including many former military
personnel.
Pierce County, where the City of Tacoma is located, has a population of
700,820 according to the U.S. Census Bureau 2000 Census. Its economy is
well-diversified, with the principal industries being aerospace, shipping,
military-related government employment, agriculture, and forest products.
Mason County, which includes the City of Shelton, has a population of 49,405
according to the U.S. Census Bureau 2000 Census. The largest employer in the
county is government, but its economy is substantially dependent upon the
timber and forest products industries.
Yakima County is located in central Washington. It has a population of
222,581, according to the U.S. Census Bureau 2000 Census, and its economy is
substantially dependent upon agriculture. Yakima County is a leading producer
of tree fruits, hops, and other agricultural products.
Kittitas County also located in central Washington and its county seat is
the City of Ellensburg. The population of Kittitas County was 33,362 according
to the U.S. Census Bureau 2000 Census. The county's largest employer is
government, and its economy is largely dependent upon agriculture.
Lending Activities
General. Our lending activities are carried on through Heritage Bank and
Central Valley Bank. We offer commercial, real estate, income property,
agricultural, and consumer loans. We have focused on commercial lending in
recent years, which reflects our efforts to broaden our products and services
to those more closely related to commercial banking. These efforts contributed
to an increase in commercial loans to $263.1 million, or 52.8% of total loans,
as of December 31, 2001 from $234.2 million, or 48.6% of total loans, as of
December 31, 2000. We continue to provide real estate mortgages, both single
and multifamily residential and commercial. Real estate mortgages decreased to
$198.6 million, or 39.8% of total loans at December 31, 2001, from
$217.1 million, or 45.0% of total loans at December 31, 2000. As we pursue our
strategy to focus on commercial lending, management continues to emphasize
strong asset quality.
Our overall lending operations are guided by loan policies, which are
reviewed and approved annually by our board of directors. These policies
outline the basic policies and procedures by which lending operations are
conducted. The policies address the types of loans, underwriting and collateral
requirements, terms, interest rate and yield considerations, compliance with
laws and regulations, and compliance with internal lending limits. We
supplement our own supervision of the loan underwriting and approval process
with periodic loan audits by experienced external loan specialists who review
credit quality, loan documentation, and compliance with laws and regulations.
4
The following table provides information about our loan portfolio by type of
loan for the dates indicated. These balances are net of deferred loan fees and
prior to deduction for the allowance for loan losses.
At June 30, At December 31,
---------------------------------- -----------------------------------------------------
1997 1998 1998 1999 2000
---------------- ---------------- ---------------- ---------------- ----------------
% of % of % of % of % of
Balance Total Balance Total Balance Total Balance Total Balance Total
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
(Dollars in thousands)
Commercial.......................... $ 53,994 22.22% $117,655 37.46% $128,171 39.20% $192,088 45.98% $234,166 48.55%
Real Estate Mortgages...............
One-four family residential(1)..... 107,010 44.02 100,753 32.07 97,277 29.76 97,907 23.44 107,501 22.28
Five or more family residential and
commercial properties............. 66,260 27.26 72,406 23.05 70,139 21.45 94,242 22.56 109,560 22.71
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Total real estate mortgages..... 173,270 71.28 173,159 55.12 167,416 51.21 192,149 46.00 217,061 44.99
Real estate construction............
One-four family residential........ 13,142 5.41 19,505 6.21 26,640 8.15 23,293 5.58 27,412 5.68
Five or more family residential and
commercial properties............. 1,029 0.42 527 0.17 2,123 0.65 7,537 1.80 -- --
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Total real estate
construction(2)................ 14,171 5.83 20,032 0.38 28,763 8.80 30,830 7.38 27,412 5.68
Consumer............................ 2,692 1.11 4,477 1.43 4,001 1.22 4,273 1.02 5,466 1.13
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Total loans......................... 244,127 100.44% 315,323 100.39% 328,351 100.43% 419,340 100.38% 484,105 100.35%
Less deferred loan fees and other... (1,079) (0.44) (1,228) (0.39) (1,400) (0.43) (1,578) (0.38) (1,670) (0.35)
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Net loans........................... $243,048 100.00% $314,095 100.00% $326,951 100.00% $417,762 100.00% $482,435 100.00%
======== ====== ======== ====== ======== ====== ======== ====== ======== ======
2001
----------------
% of
Balance Total
-------- ------
Commercial.......................... $263,063 52.75%
Real Estate Mortgages...............
One-four family residential(1)..... 91,189 18.28
Five or more family residential and
commercial properties............. 107,450 21.55
-------- ------
Total real estate mortgages..... 198,639 39.83
Real estate construction............
One-four family residential........ 32,494 6.51
Five or more family residential and
commercial properties............. 83 0.02
-------- ------
Total real estate
construction(2)................ 32,577 6.53
Consumer............................ 5,794 1.16
-------- ------
Total loans......................... 500,073 100.27%
Less deferred loan fees and other... (1,368) (0.27)
-------- ------
Net loans........................... $498,705 100.00%
======== ======
- --------
(1) Includes loans held for sale of $6,323, $6,411, $7,618, $589, $1,931 and
$6,275 respectively.
(2) Balances are net of undisbursed loan proceeds.
The following table presents at December 31, 2001 (i) the aggregate
maturities of loans in the named categories of our loan portfolio and (ii) the
aggregate amounts of fixed rate and variable or adjustable rate loans in the
named categories that mature after one year.
Maturing
------------------------------------
Within After
1 year 1-5 years 5 years Total
-------- --------- -------- --------
(Dollars in thousands)
Commercial....................... $ 93,443 $50,673 $118,947 $263,063
Real estate construction......... 28,237 4,340 -- 32,577
-------- ------- -------- --------
Total......................... $121,680 $55,013 $118,947 $295,640
======== ======= ======== ========
Fixed rate loans................. $45,409 $ 39,739 $ 85,148
Variable or adjustable rate loans 9,604 79,208 88,812
------- -------- --------
Total......................... $55,013 $118,947 $173,960
======= ======== ========
Real Estate Lending
One- to Four-Family Residential Real Estate Lending. The majority of our
residential loans are secured by one- to four-family residences located in our
primary market area. Our underwriting standards require that one- to
four-family portfolio loans generally are owner-occupied and do not exceed 80%
(90% with private mortgage insurance) of the current appraised value or cost,
whichever is lower, of the underlying collateral. Terms typically range from 15
to 30 years. We offer both fixed rate mortgages and adjustable rate mortgages
("ARMs") with repricing based on a Treasury Bill or other index. However, our
ability to generate volume in ARMs is largely a function of consumer preference
and the interest rate environment. Our current policy is not to make ARMs with
discounted initial interest rates (i.e., "teasers"). We generally sell all
government guaranteed mortgages, both fixed rate and adjustable rate.
Management determines to what extent we will retain or sell other ARMs and
other fixed rate mortgages in their strategy to control our interest rate
sensitivity position. See
5
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Asset/Liability Management".
Multifamily and Commercial Real Estate Lending. We have made, and
anticipate continuing to make, on a selective basis, multifamily and commercial
real estate loans in our primary market areas. Commercial real estate loans are
made for small shopping centers, warehouses, and professional offices. Cash
flow coverage to debt servicing requirements is generally 1.2 times or more.
Our underwriting standards generally require that the loan-to-value ratio for
multifamily and commercial real estate loans not exceed 80% of appraised value
or cost, whichever is lower.
Multifamily and commercial real estate mortgage lending affords our banks an
opportunity to receive interest at rates higher than those generally available
from one-to four-family residential lending. However, loans secured by such
properties usually are greater in amount, more difficult to evaluate and
monitor and, therefore, involve a greater degree of risk than one- to
four-family residential mortgage loans. Because payments on loans secured by
multifamily and commercial real estate properties are often dependent on the
successful operation and management of the properties, repayment of these loans
may be affected by adverse conditions in the real estate market or the economy.
We seek to minimize these risks by strictly scrutinizing the financial
condition of the borrower, the quality of the collateral, and the management of
the property securing the loan. We also generally obtain personal guarantees
from financially capable borrowers based on a review of personal financial
statements.
Construction Loans. We originate one- to four-family residential
construction loans for the construction of custom homes (where the home buyer
is the borrower) and provide financing to builders for the construction of
pre-sold homes and speculative residential construction (i.e. built before a
buyer is identified). We lend to builders who have demonstrated a favorable
record of performance and profitable operations and who are building in markets
that management understands and is comfortable with existing economic
conditions. We further endeavor to limit our construction lending risk through
adherence to strict underwriting procedures. Loans to one builder are generally
limited on a case-by-case basis with unsold home limits based on builder
strengths. Our underwriting standards require that the loan-to-value ratio for
pre-sold homes and speculative residential construction generally not exceed
80% of appraised value or builder's cost less overhead, whichever is less.
Speculative construction and land development loans are generally short term in
nature and priced with a variable rate of interest using the prime rate as the
index. We generally require builders to have some tangible form of equity in
each construction project. Also, we generally require prompt and thorough
documentation of all draw requests and use outside inspectors to inspect the
project prior to paying any draw requests from builders.
Construction lending affords us the opportunity to achieve higher interest
rates and fees with shorter terms to maturity than does our single-family
permanent mortgage lending. However, construction lending is generally
considered to involve a higher degree of risk than single-family permanent
mortgage lending because of the inherent difficulty in estimating both a
property's value at completion of the project and the estimated costs of the
project. As a result, these loans are generally more difficult to evaluate and
monitor. If the estimate of construction cost proves to be inaccurate, we may
be required to advance funds beyond the amount originally committed to permit
completion of the project. If the estimate of value upon completion proves to
be inaccurate, we may be confronted with a project whose value is insufficient
to ensure full repayment. Projects may also be jeopardized by disagreements
between borrowers and builders, and the failure of builders to pay
subcontractors. Loans to builders to construct homes for which no purchaser has
been identified carry more risk because the liquidation of the loan depends on
the builder's ability to sell the property.
Commercial Business Lending
We offer commercial loans to sole proprietorships, partnerships, and
corporations with an emphasis on real estate related industries and businesses
in agricultural, health care, legal, and other professions. The types of
commercial loans offered are business lines of credit secured primarily by real
estate, accounts receivable and
6
inventory, business term loans secured by real estate for either working
capital or lot acquisition, Small Business Administration ("SBA") loans, and
unsecured business loans.
Commercial business lending generally involves greater risk than residential
mortgage lending and risks different from those associated with residential and
commercial real estate lending. Commercial real estate lending is generally
considered to be collateral based lending with loan amounts based on
predetermined loan to collateral values, where liquidation of the underlying
real estate collateral is viewed as the primary source of repayment if the
borrower defaults. Although our commercial business loans are often
collateralized by real estate, the decision to grant a commercial business loan
depends primarily on the creditworthiness and cash flow of the borrower (and
any guarantors), while liquidation of collateral is a secondary source of
repayment.
As of December 31, 2001, we had $263.1 million, or 52.75% of our total loans
receivable, in commercial loans. The average loan size is approximately
$225,000 with loans generally in amounts of $500,000 or less.
Origination and Sales of Loans
We originate real estate and other loans with approximately two-thirds of
the residential mortgage volumes generated from our mortgage loan origination
office. Walk-in customers and referrals from real estate brokers are important
sources of loan originations.
Consistent with our asset/liability management strategy, we sell a majority
of our fixed rate and ARM residential mortgage loans to the secondary market.
At Heritage Bank, commitments to sell mortgage loans generally are made during
the period between the taking of the loan application and the closing of the
mortgage loan. The timing of making these sale commitments is dependent upon
the timing of the borrower's election to lock-in the mortgage interest rate and
fees prior to loan closing. Most of these sale commitments are made on a "best
efforts" basis whereby Heritage Bank is only obligated to sell the mortgage if
the mortgage loan is approved and closed by Heritage Bank. As a result,
management believes that market risk is minimal. At Central Valley Bank, all
mortgage loan production is brokered to other lenders prior to funding.
When we sell mortgage loans, we typically sell the servicing of the loans
(i.e., collection of principal and interest payments). However, we serviced
$9.5 million, $7.9 million, and $6.3 million in mortgage loans for others as of
December 31, 1999, 2000, and 2001, respectively. We received fee income for
servicing activities on mortgage loans of $34,000, $27,000 and $22,000 for the
years ended December 31, 1999, 2000, and 2001, respectively.
The following table presents summary information concerning our origination
and sale of residential mortgage loans and the gains achieved on such
activities.
Six months
ended
Years ended June 30, December 31, Years ended December 31,
-------------------- ------------ ------------------------
1997 1998 1998 1999 2000 2001
-------- -------- ------------ ------- ------- --------
(Dollars in thousands)
One- to four-family residential mortgage
loans:
Originated........................... $104,145 $118,774 $68,434 $78,248 $55,630 $103,634
Sold................................. 87,003 101,903 57,490 58,266 35,876 97,807
Gains on sales of loans, net............ $ 2,006 $ 2,406 $ 1,297 $ 1,079 $ 684 $ 1,669
We have a minimal amount of purchased mortgage loans and mortgage loan
participations.
7
Commitments and Contingent Liabilities
In the ordinary course of business, we enter into various types of
transactions that include commitments to extend credit that are not included in
our consolidated financial statements. We apply the same credit standards to
these commitments as we use in all our lending activities and have included
these commitments in our lending risk evaluations. Our exposure to credit loss
under commitments to extend credit is represented by the amount of these
commitments. At December 31, 2001, we had outstanding commitments to extend
credit, including letters of credit, in the amount of $87.4 million.
Delinquencies and Nonperforming Assets
Delinquency Procedures. We send a borrower a delinquency notice 15 days
after the due date when the borrower fails to make a required payment on a
loan, except for commercial loans. If the delinquency is not brought current by
the 30th day, we mail a second notice and, if appropriate, call the borrower.
Additional written and oral contacts are made with the borrower between 60 and
90 days after the due date.
If a real estate loan payment is past due for 45 days or more, loan
servicing personnel perform an in-depth review of the loan status, the
condition of the property, and the borrower's financial circumstances. Based
upon the results of our review, we may negotiate and accept a repayment program
with the borrower, accept a voluntary deed in lieu of foreclosure or, when
considered necessary, begin foreclosure proceedings. If foreclosed on, real
property is sold at a public sale and we may bid on the property to protect our
interest. A decision as to whether and when to begin foreclosure proceedings is
based on such factors as the amount of the outstanding loan in relation to the
value of the property securing the original indebtedness, the extent of the
delinquency, and the borrower's ability and willingness to cooperate in
resolving the delinquency.
Real estate acquired by us is classified as real estate owned until it is
sold. When property is acquired, it is recorded at the lower of cost or
estimated fair value at the date of acquisition, not to exceed net realizable
value, and any resulting write-down is charged to the allowance for loan
losses. Upon acquisition, all costs incurred in maintaining the property are
expensed. Costs relating to the development and improvement of the property,
however, are capitalized to the extent of the property's net realizable value.
We consider loans as an in-substance foreclosure if the borrower has little
or no equity in the property based upon its estimated fair value, repayment can
be expected only from operation or sale of the collateral, the borrower has
effectively abandoned control of the collateral, or it is doubtful the borrower
will be able to repay the loan in the foreseeable future because of the
borrower's current financial status. In substance foreclosures are accounted
for as if the properties were held as other real estate.
Delinquencies in the commercial business loan portfolio are handled on a
case-by-case basis. Generally, notices are sent and personal contact is made
with the borrower when the loan is 15 days past due. Loan officers are
responsible for collecting loans they originate or which are assigned to them.
Depending on the nature of the loan and the type of collateral securing the
loan, we may negotiate and accept a modified payment program or take other
actions as circumstances warrant.
Classification of Assets. Federal regulations require that our banks
periodically evaluate the risk inherent in their loan portfolio. In addition,
Division of Banks of the Washington State Department of Financial Institutions
("Division"), the Office of the Comptroller of the Currency ("OCC"), and the
FDIC have authority to identify problem assets and, if appropriate, require
them to be classified by risk. There are three classifications for problem
assets: Substandard, Doubtful, and Loss. Substandard assets have one or more
defined weaknesses and are characterized by the distinct possibility that the
institution will sustain some loss if the deficiencies are not corrected.
Doubtful assets have the weaknesses of Substandard assets, with the additional
characteristics that the weaknesses make collection or liquidation in full on
the basis of currently existing facts, conditions, and values questionable.
There is a high possibility of loss in assets classified as Doubtful. An asset
classified as Loss
8
is considered uncollectible and of such little value that continuance as an
asset of the institution is not warranted. If an asset or a portion of the
asset is classified as Loss, the institution must charge off this amount. The
FDIC examined Heritage Bank in March 2001 and the Division examined Heritage
Bank in March 2000. The OCC examined Central Valley Bank in May 2001. The
regulators' assessments of our banks' classified assets were consistent with
our banks' internal classifications.
Nonperforming Assets. Nonperforming assets consist of nonaccrual loans,
restructured loans, and real estate owned. The following table provides
information about our nonaccrual loans, restructured loans, and real estate
owned for the indicated dates.
At June 30, At December 31,
------------------ ----------------------------------
1997 1998 1998 1999 2000 2001
-------- -------- ------- ------- ------- -------
(Dollars in thousands)
Nonaccrual loans.................... $ 146 $ 385 $ 401 $ 1,804 $ 1,607 $ 1,962
Restructured loans.................. -- -- -- -- -- --
-------- -------- ------- ------- ------- -------
Total nonperforming loans........ 146 385 401 1,804 1,607 1,962
Real estate owned................... -- 82 -- -- -- 1,053
-------- -------- ------- ------- ------- -------
Total nonperforming assets....... $ 146 $ 467 $ 401 $ 1,804 $ 1,607 $ 3,015
-------- -------- ------- ------- ------- -------
Accruing loans past due 90 days or
more.............................. $ -- $ 15 $ 8 $ -- $ 1,086 $ 306
Potential problem loans............. 239 1,758 877 2,826 2,422 4,631
Allowance for loan losses........... 3,105 3,929 3,957 4,264 5,063 5,751
Nonperforming loans to loans........ 0.06% 0.06% 0.12% 0.43% 0.33% 0.39%
Allowance for loan losses to loans.. 1.28% 1.25% 1.21% 1.02% 1.05% 1.15%
Allowance for loan losses to
nonperforming loans............... 2133.01% 1019.90% 984.70% 236.27% 315.02% 293.12%
Nonperforming assets to total assets 0.05% 0.10% 0.08% 0.35% 0.28% 0.49%
Nonaccrual Loans. Our financial statements are prepared on the accrual
basis of accounting, including the recognition of interest income on our loan
portfolio, unless a loan is placed on nonaccrual. Loans are considered to be
impaired and are placed on nonaccrual when there are serious doubts about the
collectibility of principal or interest. Our policy is to place a loan on
nonaccrual when the loan becomes past due for 90 days or more, is less than
fully collateralized, and is not in the process of collection. Amounts received
on nonaccrual loans generally are applied first to principal and then to
interest only after all principal has been collected.
Interest foregone on nonaccrual loans was $59,613, $129,612, and $173,371
for the years ended December 31, 1999, 2000, and 2001, respectively. Previous
period interest foregone was immaterial.
Real estate owned at December 31, 2001 was $1,269,000 with $1,053,000 of
this reported as a nonperforming asset. The difference is guaranteed by the
Small Business Administration.
Potential Problem Loans. Potential problem loans are those loans which are
currently accruing interest, but which are considered possible credit problems
because financial information of the borrowers causes us to seriously doubt
their ability to comply with the present repayment program and may result in
placing the loan on nonaccrual. The increase of $2.2 million in potential
problem loans from December 31, 2000 to December 31, 2001 is primarily due to
one loan on a strip mall. The loan is adequately collateralized and is, at this
time, performing at an acceptable level. However, we believed that adverse
borrower trends warranted reporting this loan as a potential problem loan.
9
Analysis of Allowance for Loan Losses
Management maintains an allowance for loan losses to absorb losses inherent
in the loan portfolio. We determine the allowance through our ongoing quarterly
assessments of estimated potential losses inherent in the loan portfolio.
We assess the estimated losses inherent in our non-classified loan portfolio
by considering a number of elements including:
. Levels and trends in delinquencies and nonaccruals;
. Trends in loan demand and structure including terms and interest rates;
. National and local economic trends;
. Specific industry conditions such as commercial and residential
construction;
. Concentrations of credits in specific industries;
. Bank regulatory examination results and our own credit examinations; and
. Recent loss experience in the portfolio.
After evaluating these elements and trends, we calculate a risk factor in
percentage points that is applied to the non-classified loan portfolio to
establish what we believe is an appropriate allowance for the non-classified
portion of our loan portfolio. For the classified portion of our loan
portfolio, we add specific dollar provisions to the total for identified
problem loans and assets to determine an adequate allowance.
We forecast expected loan growth by type for the subsequent three months and
apply the same risk factor we established for the non-classified portion of our
portfolio to the expected loan growth to determine additional necessary
provisions to the allowance for the subsequent period. From this, we establish
our monthly provision for the next three months.
Historically, we have not experienced significant losses in any segment of
our loan portfolio. We believe that it is necessary to maintain a higher level
of reserves against future potential losses for our commercial loan portfolio
than our historical loss experience would indicate, because our commercial loan
portfolio, which, based upon industry standards, inherently tends to have a
higher loss experience and has been growing faster than other segments of our
loan portfolio.
Over the past several years, we have increased our allowance for loan losses
during a period of loan growth and change in loan portfolio composition, as
well as recent weakening economic trends. While our loan portfolio, and in
particular commercial loans, has grown substantially over the past five years,
our asset quality has remained satisfactory. Although our nonperforming assets
to total assets ratio is higher than past periods, we believe it is manageable
especially considering the weakening economy. In the year ended December 31,
2001, we experienced net charge offs of $505,000. Because commercial business
lending generally involves greater risk than those associated with residential
and commercial real estate lending, we have increased the portion of our
allowance for loan losses allocated to our commercial loans over the past five
years.
While we believe that we use the best information available to determine the
allowance for loan losses, net income could be significantly affected if
circumstances differ substantially from the assumptions used in determining the
allowance or unforeseen market conditions result in adjustments to the
allowance for loan losses.
10
The following table provides information regarding changes in our allowance
for loan losses for the indicated periods:
Six Months
Ended
Years Ended June 30, December 31, Years Ended December 31,
------------------- ------------ ----------------------------
1997 1998 1998 1999 2000 2001
-------- -------- ------------ -------- -------- --------
(Dollars in thousands)
Total loans outstanding at end of
period(1).......................... $243,048 $314,095 $326,952 $417,762 $482,435 $498,705
-------- -------- -------- -------- -------- --------
Average loans outstanding during
period............................. $213,560 $251,816 $319,645 $361,116 $445,813 $494,379
-------- -------- -------- -------- -------- --------
Allowance balance at beginning of
period............................. $ 2,221 $ 3,105 $ 3,929 $ 3,957 $ 4,264 $ 5,063
Provision for loan losses............ (265) 149 202 408 787 1,193
Allowance acquired with North Pacific
Bank............................... -- 670 -- -- -- --
Charge-offs:
Real estate(2).................... -- -- (36) (120) (4) (407)
Commercial........................ (2) -- (146) (117) (34) (88)
Consumer.......................... (7) (3) (5) (10) (2) (12)
-------- -------- -------- -------- -------- --------
Total charge-offs............. (9) (3) (187) (247) (40) (507)
-------- -------- -------- -------- -------- --------
Recoveries:
Real estate(2).................... 1,155 4 4 113 22 1
Commercial........................ 3 1 9 32 29 --
Consumer.......................... -- 3 -- 1 1 1
-------- -------- -------- -------- -------- --------
Total recoveries.............. 1,158 8 13 146 52 2
-------- -------- -------- -------- -------- --------
Net (charge-offs)
recoveries............... 1,149 5 (174) (101) 12 (505)
-------- -------- -------- -------- -------- --------
Allowance balance at end of period... $ 3,105 $ 3,929 $ 3,957 $ 4,264 $ 5,063 $ 5,751
======== ======== ======== ======== ======== ========
Ratio of net (charge-offs) recoveries
during period to average loans
outstanding........................ 0.54% 0.00% 0.05% -0.03% 0.00% -0.10%
======== ======== ======== ======== ======== ========
- --------
(1) Includes loans held for sale
(2) During the periods shown, the charge-offs and recoveries shown under the
Real Estate category relate to real estate mortgages, with the exception of
the activity during 2001. Only during 2001 did a portion of the activity
relate to real estate construction loans.
11
The following table shows the allocation of the allowance for loan losses
for the indicated periods. The allocation is based upon an evaluation of
defined loan problems, historical loan loss ratios, and industry wide and other
factors that may affect future loan losses in the categories shown below:
At June 30, At December 31,
------------------------------ --------------------------------------------------------------
1997 1998 1998 1999 2000 2001
-------------- -------------- -------------- -------------- -------------- --------------
% of % of % of % of % of % of
Total Total Total Total Total Total
Amount Loans(1) Amount Loans(1) Amount Loans(1) Amount Loans(1) Amount Loans(1) Amount Loans(1)
------ -------- ------ -------- ------ -------- ------ -------- ------ -------- ------ --------
(Dollars in thousands)
Commercial............... $1,242 22.1% $2,217 37.4% $2,670 39.2% $3,070 45.8% $3,644 48.4% $4,141 52.7%
Real Estate Mortgage
One-four family
residential............ 164 43.9% 156 32.0% 156 29.6% 168 23.3% 200 22.2% 227 18.1%
Five or more family
residential and
commercial properties.. 900 27.2% 678 22.9% 669 21.3% 721 22.5% 856 22.6% 972 21.5%
Real estate construction:
One-four family
residential............ 202 5.3% 214 6.1% 135 8.1% 145 5.6% 274 5.7% 310 6.5%
Five or more family
residential and
commercial properties.. 31 0.4% 10 0.2% 16 0.6% 17 1.8% 20 -- 23 --
Consumer................. 20 1.1% 53 1.4% 54 1.2% 58 1.0% 69 1.1% 78 1.2%
Unallocated.............. 546 601 257 85 -- --
------ ----- ------ ----- ------ ----- ------ ----- ------ ----- ------ -----
Net loans............. $3,105 100.0% $3,929 100.0% $3,957 100.0% $4,264 100.0% $5,063 100.0% $5,751 100.0%
====== ===== ====== ===== ====== ===== ====== ===== ====== ===== ====== =====
- --------
(1) Represents the total of all outstanding loans in each category as a percent
of total loans outstanding.
Investment Activities
At December 31, 2001, our investment securities portfolio totaled $30.2
million, which consisted of $26.5 million of securities available for sale and
$3.7 million of securities held to maturity. This compares with a total
portfolio of $38.8 million at December 31, 2000, which was comprised of $33.7
million of securities available for sale and $5.1 million of securities held to
maturity. The composition of the two investment portfolios by type of security,
at each respective date, is presented in the financial statement footnotes.
Our investment policy is established by the board of directors and monitored
by the Audit and Finance Committee. It is designed primarily to provide and
maintain liquidity, generate a favorable return on investments without
incurring undue interest rate and credit risk, and complement our bank's
lending activities. The policy dictates the criteria for classifying securities
as either available for sale or held for investment. The policy permits
investment in various types of liquid assets permissible under applicable
regulations, which include U.S. Treasury obligations, U.S. Government agency
obligations, some certificates of deposit of insured banks, mortgage backed and
mortgage related securities, some corporate notes, municipal bonds, FHLB stock,
and federal funds. Investment in non-investment grade bonds, structured notes,
and stripped mortgage backed securities are not permitted under the policy.
12
The following table provides information regarding the carrying value,
weighted average yields, and maturities or periods to repricing of our
investment securities available for sale.
At December 31, 2001
-----------------------
Weighted
Book Fair Average
Value Value Yield
------- ------- --------
(Dollars in thousands)
Obligations of US Government agencies:
Due within one year................... $ 750 $ 768 5.96%
Due after 1 year but within 5 years... 18,567 18,529 5.82
------- -------
19,317 19,297
------- -------
Mortgage backed securities
Due after 5 years but within 10 years. 524 643 5.03
Due after 10 years.................... 4,417 4,408 6.71
------- -------
4,941 5,051
------- -------
Collateralized mortgage obligations
Due after 5 years but within 10 years. 123 125 6.11
Due after 10 years.................... 2,036 2,006 4.71
------- -------
2,159 2,131
------- -------
Total all investments available for sale. $26,417 $26,479
======= =======
The following table provides information regarding the carrying value,
weighted average yields, and maturities or periods to repricing of our
investment securities held to maturity.
At December 31, 2001
----------------------
Weighted
Book Fair Average
Value Value Yield (1)
------ ------ ---------
(Dollars in thousands)
Municipal bonds
Due within one year............................ $ 425 $ 432 6.75%
Due after 1 year but within 5 years............ 1,379 1,426 6.35
Due after 5 years but within 10 years.......... 341 347 6.26
------ ------
2,145 2,205
------ ------
Mortgage backed securities
Due within one year............................ 32 33 6.58
Due after 1 year but within 5 years............ 9 9 7.23
Due after 5 years but within 10 years.......... 227 242 8.73
Due after 10 years............................. 1,290 1,395 8.26
------ ------
1,558 1,679
------ ------
Total all investments held to maturity..... $3,703 $3,884
====== ======
- --------
(1) Taxable equivalent weighted average yield.
We held $2.8 million of FHLB stock at December 31, 2001. The stock has no
contractual maturity and amounts in excess of the required minimum for FHLB
membership may be redeemed at par. At December 31, 2001, we were required to
maintain an investment in the stock of the FHLB of Seattle of at least $1.8
million.
13
Deposit Activities and Other Sources of Funds
General. Our primary sources of funds are deposits and loan repayments.
Scheduled loan repayments are a relatively stable source of funds, while
deposits and unscheduled loan prepayments, which are influenced significantly
by general interest rate levels, interest rates available on other investments,
competition, economic conditions, and other factors are not. Our deposit
balances increased by $54.8 million in 2001. Customer deposits remain an
important source, but these balances have been influenced in the past by
adverse market changes in the industry and may be affected by similar future
developments. Borrowings may be used on a short-term basis to compensate for
reductions in other sources of funds (such as deposit inflows at less than
projected levels). Borrowings may also be used on a longer-term basis to
support expanded lending activities and match the maturity of repricing
intervals of assets.
Deposit Activities. We offer a variety of deposit accounts designed to
attract both short-term and long-term deposits. These accounts include
certificates of deposit ("CDs"), regular savings accounts, money market
accounts, checking and negotiable order of withdrawal ("NOW") accounts, and
individual retirement accounts ("IRAs"). These accounts generally earn interest
at rates established by management based on competitive market factors and
management's desire to increase or decrease certain types or maturities of
deposits. At December 31, 2001, we had no brokered deposits. The more
significant deposit accounts offered by us are described below.
Certificates of Deposit. We offer several types of CDs with maturities
ranging from one to five years and which require a minimum deposit of $100. In
addition, we offer a CD that has a maturity of three to eleven months and a
minimum deposit of $2,500, and permits additional deposits at the initial rate
throughout the CD term. Interest is compounded daily and credited quarterly or
at maturity. Finally, negotiable CDs are offered in amounts of $100,000 or more
for terms of 30 days to 12 months. The negotiable CDs pay simple interest
credited at maturity.
Regular Savings Accounts. We offer savings accounts that allow for
unlimited deposits and withdrawals, provided that a $100 minimum balance is
maintained. Interest is compounded daily and credited quarterly.
Money Market Accounts. Money market accounts pay a variable interest rate
that is tiered depending on the balance maintained in the account. Minimum
opening balances vary. Interest is compounded daily and paid monthly.
Checking and NOW Accounts. Checking and NOW accounts are non-interest and
interest bearing, and may be charged service fees based on activity and
balances. NOW accounts pay interest, but require a higher minimum balance to
avoid service charges.
Individual Retirement Accounts. IRAs permit annual contributions regulated
by law and pay interest at fixed rates. Maturities are available from one to
five years, and interest is compounded daily and credited quarterly.
14
Sources of Funds
Deposit Activities. The following table provides the average balances
outstanding and the weighted average interest rates for each major category of
deposits for the years ended December 31,:
1999 2000 2001
--------------- --------------- ---------------
Average Average Average Average Average Average
Balance Rate Balance Rate Balance Rate
(1) Paid (1) Paid (1) Paid
-------- ------- -------- ------- -------- -------
(Dollars in Thousands)
Interest bearing demand and money market
accounts.............................. $ 91,281 2.69% $ 99,089 2.81% $126,302 2.07%
Savings................................. 68,484 3.33 62,594 2.81 61,190 3.50
Certificates of deposit................. 165,490 5.00 226,335 3.56 244,369 5.24
-------- -------- --------
Total interest bearing deposits...... 325,255 4.00 388,018 4.80 431,861 4.06
Demand and other noninterest bearing
deposits.............................. 37,906 -- 44,038 -- 47,455 --
-------- ---- -------- ---- -------- ----
Total deposits....................... $363,161 3.58% $432,056 4.31% $479,316 3.66%
======== ==== ======== ==== ======== ====
- --------
(1) Average balances were calculated using average daily balances.
The following table provides the change in the balances of deposits during
the year and the impact of credited interest on those deposits for the years
ended December 31,:
1999 2000 2001
-------- -------- --------
(Dollars in thousands)
Net increase (decrease) in deposits............. $ 37,964 $ 55,166 $ 54,846
Less: Interest credited...................... (12,631) (18,456) (18,126)
-------- -------- --------
Net increase(decrease) before interest credited. $ 25,333 $ 36,710 $ 36,720
-------- -------- --------
The following table shows the amount and maturity of certificates of
deposits of $100,000 or more as of December 31, 2001:
(Dollars in
thousands)
Remaining maturity:
Three months or less.................................... $25,050
Over three months through six months.................... 54,839
Over six months through 12 months....................... 12,194
Over twelve months...................................... 4,971
-------
Total............................................... $97,054
=======
At December 31, 2000 and December 31, 2001, certificates of deposits with
balances of $100,000 or more totaled $96.1 million and $97.1 million,
respectively.
Borrowings. Savings deposits are the primary source of funds for our
lending and investment activities, and our general business purposes. We rely
upon advances from the FHLB of Seattle to supplement our supply of lendable
funds and meet deposit withdrawal requirements. The FHLB of Seattle has served
as one of our secondary sources of liquidity at both Heritage Bank and Central
Valley Bank. Advances from the FHLB of Seattle are typically secured by our
first mortgage loans, and stock issued by the FHLB of Seattle, which is owned
by us. At Central Valley Bank we also have the ability to purchase federal
funds up to $3.7 million with Key Bank. At the holding company level, we
maintain a line of credit for $5 million with Key Bank to supplement any cash
needs not covered by dividends from the banks or earnings from investments
retained from proceeds of the conversion from mutual to stock ownership.
15
The FHLB functions as a central reserve bank providing credit for member
financial institutions. As members, Heritage Bank and Central Valley Bank are
required to own capital stock in the FHLB and are authorized to apply for
advances on the security of such stock and certain of its mortgage loans and
other assets (principally securities which are obligations of, or guaranteed
by, the United States) provided certain standards related to creditworthiness
have been met. Advances are made pursuant to several different programs. Each
credit program has its own interest rate and range of maturities. Depending on
the program, limitations on the amount of advances are based either on a fixed
percentage of an institution's net worth or on the FHLB's assessment of the
institution's creditworthiness. Under its current credit policies, the FHLB of
Seattle limits advances to 20% of assets for Heritage Bank and 10% of assets
for Central Valley Bank.
The following table is a summary of FHLB advances for the years ended
December 31,:
1999 2000 2001
------ ------- -------
(Dollars in thousands)
Balance at period end...................... $2,800 $23,125 $ 8,000
Average balance during the period.......... 958 10,451 17,924
Maximum amount outstanding at any month end 3,300 23,125 33,300
Average interest rate:
During the period....................... 5.90% 6.58% 5.33%
At period end........................... 5.70% 6.81% 5.01%
The holding company maintains a line of credit with Key Bank for short-term
corporate funding needs. The following table is a summary of usage on the Key
Bank line of credit for the years ended December 31,:
1999 2000 2001
---- ------ -----
(Dollars in thousands)
Balance at period end...................... $-- $ -- $ --
Average balance during the period.......... -- 380 118
Maximum amount outstanding at any month end -- 2,043 168
Average interest rate:
During the period....................... -- 9.86% 7.12%
At period end........................... -- 9.50% 4.75%
The following table is a summary of other borrowed funds for the years ended
December 31,:
1999 2000 2001
----- ------ -----
(Dollars in thousands)
Notes Payable:
Balance at period end....................... $ 8 $ -- $ --
Average balance during the period........... 12 2 --
Maximum amount outstanding at any month end. 16 7 --
Average interest rate:
During the period....................... -- -- --
At period end........................... -- -- --
Fed Funds Purchased:
Balance at period end....................... $ -- $1,000 $ --
Average balance during the period........... 20 501 82
Maximum amount outstanding at any month end. -- 1,300 175
Average interest rate:
During the period....................... 5.41% 6.84% 6.52%
At period end........................... -- 7.13% --
16
Notes Payable at December 31, 1999 include a noninterest bearing note to
Tacoma City Light for energy conservation improvement that was acquired in June
1998 with North Pacific Bank. This note was paid off in September 2000.
Supervision and Regulation
We are subject to extensive federal and Washington state legislation,
regulation, and supervision. These laws and regulations are primarily intended
to protect depositors and the FDIC rather than stockholders. The laws and
regulations affecting banks and bank holding companies have changed
significantly over recent years, and it is reasonable to expect that similar
changes will continue in the future. Any change in applicable laws,
regulations, or regulatory policies may have a material effect on our business,
operations, and prospects. We cannot predict the nature or the extent of the
effects on our business and earnings that any fiscal or monetary policies or
new federal or state legislation may have in the future.
The following information is qualified in its entirety by reference to the
particular statutory and regulatory provisions described.
Heritage Financial. We are subject to regulation as a bank holding company
within the meaning of the Bank Holding Company Act of 1956, as amended, and are
supervised by the Federal Reserve. The Federal Reserve has the authority to
order bank holding companies to cease and desist from unsound practices and
violations of conditions imposed on it. The Federal Reserve is also empowered
to assess civil money penalties against companies and individuals who violate
the Bank Holding Company Act or orders or regulations thereunder in amounts up
to $1.0 million per day. The Federal Reserve may order termination of
non-banking activities by non-banking subsidiaries of bank holding companies,
or divestiture of ownership and control of a non-banking subsidiary by a bank
holding company. Some violations may also result in criminal penalties. The
FDIC and OCC are authorized to exercise comparable authority under the Federal
Deposit Insurance Act, the National Bank Act, and other statutes for state
nonmember banks such as Heritage Bank or national banks such as Central Valley
Bank.
The Federal Reserve takes the position that a bank holding company is
required to serve as a source of financial and managerial strength to its
subsidiary banks and may not conduct its operations in an unsafe or unsound
manner. In addition, the Federal Reserve provides that bank holding companies
should serve as a source of strength to its subsidiary banks by being prepared
to use available resources to provide adequate capital funds to its subsidiary
banks during periods of financial stress or adversity, and should maintain the
financial flexibility and capital raising capacity to obtain additional
resources for assisting its subsidiary banks. A bank holding company's failure
to meet its obligation to serve as a source of strength to its subsidiary banks
will generally be considered by the Federal Reserve to be an unsafe and unsound
banking practice or a violation of the Federal Reserve's regulations or both.
The Federal Deposit Insurance Act requires an undercapitalized institution to
send to the Federal Reserve a capital restoration plan with a guaranty by each
company having control of the bank's compliance with the plan.
We are required to file an annual report and periodic reports with the
Federal Reserve and provide additional information as the Federal Reserve may
require. The Federal Reserve may examine us, and any of our subsidiaries, and
charge us for the cost of the examination.
We, and any subsidiaries which we may control, are considered "affiliates"
within the meaning of the Federal Reserve Act, and transactions between our
bank subsidiaries and affiliates are subject to numerous restrictions. With
some exceptions, we, and our subsidiaries are prohibited from tying the
provision of various services, such as extensions of credit, to other services
offered by us, or our affiliates.
Bank regulations require bank holding companies and banks to maintain a
minimum "leverage" ratio of core capital to adjusted quarterly average total
assets of at least 3%. In addition, banking regulators have adopted risk-
17
based capital guidelines under which risk percentages are assigned to various
categories of assets and off-balance sheet items to calculate a risk-adjusted
capital ratio. Tier I capital generally consists of common stockholders' equity
(which does not include unrealized gains and losses on securities), less
goodwill and certain identifiable intangible assets. Tier II capital includes
Tier I capital plus the allowance for loan losses and subordinated debt, both
subject to some limitations. Regulatory risk-based capital guidelines require
Tier I capital of 4% of risk-adjusted assets and minimum total capital ratio
(combined Tier I and Tier II) of 8% of risk-adjusted assets.
Subsidiaries. Heritage Bank is a Washington state-chartered savings bank,
the deposits of which are insured by the FDIC. Heritage Bank is subject to
regulation by the FDIC and Division of Banks of the Washington Department of
Financial Institutions ("Division"). Central Valley Bank is a national bank
chartered by the Office of the Comptroller of the Currency ("OCC") and insured
by the FDIC. In addition, Central Valley Bank is a member of the Federal
Reserve System. Although Heritage Bank is not a member of the Federal Reserve
System, the Federal Reserve has supervisory authority over us and our
subsidiary banks.
Among other things, applicable federal and state statutes and regulations
which govern a bank's operations relate to minimum capital requirements,
required reserves against deposits, investments, loans, legal lending limits,
mergers and consolidation, borrowings, issuance of securities, payment of
dividends, establishment of branches, and other aspects of its operations. The
Division, the OCC, and the FDIC also have authority to prohibit banks under
their supervision from engaging in what they consider to be unsafe and unsound
practices.
The banks are required to file periodic reports with the FDIC, the Division,
and the OCC, and are subject to periodic examinations and evaluations by those
regulatory authorities. Based upon these evaluations, the regulators may
revalue the assets of an institution and require that it establish specific
reserves to compensate for the differences between the regulator-determined
value and the book value of such assets. These examinations must be conducted
every 12 months, except that well-capitalized banks may be examined every 18
months. The FDIC and the Division may each accept the results of an examination
by the other in lieu of conducting an independent examination.
As subsidiaries of a bank holding company, our banks are subject to various
restrictions in their dealings with us and other companies that may become
affiliated with us.
Dividends paid by our subsidiaries provide substantially all of our cash
flow. Applicable federal and Washington state regulations restrict capital
distributions by our banks, including dividends. Such restrictions are tied to
the institution's capital levels after giving effect to such distributions. The
FDIC and OCC have established the qualifications necessary for a
"well-capitalized" bank, which affects FDIC risk-based insurance premium rates.
To qualify as "well-capitalized", banks must have a Tier I risk-adjusted
capital ratio of at least 6%, a total risk-adjusted capital ratio of at least
10%, and a leverage ratio of at least 5%. Both Heritage Bank and Central Valley
Bank were "well-capitalized" at December 31, 2001.
Federal laws generally bar institutions which are not well capitalized from
accepting brokered deposits. The FDIC has issued rules, which prohibit
under-capitalized institutions from soliciting or accepting brokered deposits.
Adequately capitalized institutions are allowed to solicit brokered deposits,
but only to accept them if a waiver is obtained from the FDIC.
Other Regulatory Developments. Congress has enacted significant federal
banking legislation in recent years. The following summarizes some of the
recent significant federal banking legislation.
Financial Institutions Reform, Recovery, and Enforcement Act of 1989
("FDICIA"). FIRREA, among other things,
. created two deposit insurance funds administered by the FDIC, the Bank
Insurance Fund ("BIF") and the Savings Association Insurance Fund ("SAIF");
18
. permitted commercial banks that meet certain housing-related asset
requirements to secure advances and other financial services from local
Federal Home Loan Banks ("FHLBs");
. restructured the federal regulatory agencies for savings associations; and
. greatly enhanced the regulators enforcement powers over financial
institutions and their affiliates.
Federal Deposit Insurance Corporation Improvement Act of 1991
("FDICIA"). FDICIA went substantially farther than FIRREA in establishing a
more rigorous regulatory environment. Under FDICIA, regulatory authorities are
required to enact a number of new regulations, substantially all of which are
now effective. These regulations include, among other things,
. a new method for calculating deposit insurance premiums based on risk;
. restrictions on acceptance of brokered deposits except by well-capitalized
institutions;
. additional limitations on loans to executive officers and directors of
banks;
. the employment of interest rate risk in the calculation of risk-based
capital;
. safety and soundness standards that take into consideration, among other
things, management, operations, asset quality, earnings and compensation;
. a five-tiered rating system from well-capitalized to critically
undercapitalized, along with the prompt corrective action the agencies may
take depending on the category; and
. new disclosure and advertising requirements with respect to interest paid
on savings accounts.
FDICIA and regulations adopted by the FDIC impose additional requirements
for annual independent audits and reporting when a bank begins a fiscal year
with assets of $500 million or more. These banks, or their holding companies,
are also required to establish audit committees consisting of directors who are
independent of management.
The Riegle-Neal Interstate Banking and Branching Efficiency Act of
1994. The Interstate Banking Act provides banks with greater opportunities to
merge with other institutions and open branches nationwide, and also allows a
bank holding company whose principal operations are in one state to apply to
the Federal Reserve for approval to acquire a bank that is headquartered in a
different state. States cannot "opt out" but may impose minimum time periods,
not to exceed five years, for the target bank's existence. The Interstate
Banking Act also allows bank subsidiaries of bank holding companies to
establish "agency" relationships with their depository institution affiliates.
In an agency relationship, a bank can accept deposits, renew time deposits,
close and service loans, and receive payments for a depository institution
affiliate. States cannot "opt out". The Interstate Banking Act allows banks
whose principal operations are located in different states to apply to federal
regulators to merge. This provision took effect June 1, 1997, unless states
enacted laws to either authorize such transactions at an earlier date or
prohibit such transactions entirely. The Interstate Banking Act also allows
banks to apply to establish de novo branches in states in which they do not
already have a branch office. This provision took effect June 1, 1997, but (i)
states must enact laws to permit such branching and (ii) a bank's primary
federal regulator must approve any such branch establishment. The Washington
legislature passed legislation that allows, subject to certain conditions,
mergers or other combinations, relocations of banks' main office and branching
across state lines in advance of the June 1, 1997 date established by federal
law.
Recent Legislation
Financial Services Reform Legislation. On November 12, 1999, the
Gramm-Leach-Bliley Act ("GLBA") was enacted into law. The GLBA removes various
barriers imposed by the Glass-Steagall Act of 1933, specifically those
prohibiting banks and bank holding companies from engaging in the securities
and insurance business. The GLBA also expands the bank holding company act
framework to permit bank holding companies
19
with subsidiary banks meeting certain capital and management requirements to
elect to become a "financial holding company".
Beginning March 2000, financial holding companies may engage in a full range
of financial activities, including not only banking, insurance, and securities
activities, but also merchant banking and additional activities determined to
be "financial in nature" or "complementary" to an activity that is financial in
nature. The GLBA also provides that the list of permissible financial
activities will be expanded as necessary for a financial holding company to
keep abreast of competitive and technological changes.
The GLBA also expands the activities in which insured state banks may
engage. Under the GLBA, insured state banks are given the ability to engage in
financial activities through a subsidiary, as long as the bank and its bank
affiliates meet and comply with certain requirements. First, the state bank and
each of its bank affiliates must be "well capitalized". Second, the bank must
comply with certain capital deduction and financial statement requirements
provided under the GLBA. Third, the bank must comply with certain financial and
operational safeguards provided under the GLBA. Fourth, the bank must comply
with the limits imposed by the GLBA on transactions with affiliates.
Although the GLBA preserves the Federal Reserve as the umbrella supervisor
of financial holding companies, it adopts an administrative approach to
regulation that defers to the action and paperwork requirements of the
"functional" regulators of insurers, broker-dealers, investment companies, and
banks. Thus, the various state and federal regulators of a financial holding
company's operating subsidiaries would retain their jurisdiction and authority
over those operating entities. As the umbrella supervisor, however, the Federal
Reserve has the potential to affect the operations and activities of a
financial holding company's subsidiaries through its power over the financial
holding company parent. In addition, the GLBA contains numerous trigger points
related to legal non-compliance and other serious problems affecting bank
affiliates that could lead to direct Federal Reserve involvement and the
possible exercise of remedial authority affecting both financial holding
companies and their affiliated operating companies.
USA Patriot Act. On October 26, 2001, President George W. Bush signed into
law the USA Patriot Act ("Patriot Act"). Title III of the Patriot Act concerns
money laundering provisions that may affect many community banks. These
provisions include:
. The Secretary of the Treasury is authorized to impose special measures,
such as recordkeeping or reporting, on domestic financial institutions
that are a primary concern;
. Financial institutions with private or correspondent accounts with
non-U.S. citizens must establish policies and procedures to detect money
laundering through those accounts;
. Financial institutions are barred from maintaining correspondent accounts
for foreign shell banks (that is a bank that does not have a physical
presence in any county);
. The Secretary of the Treasury is required to prescribe regulations to
further encourage cooperation among financial institutions, regulators,
and law enforcement agencies and officials to share information about
terrorist acts and money laundering activities;
. The Secretary of the Treasury is required to issue regulations to
establish minimum procedures for financial institutions to use in
verifying customer identity during the account-opening process;
. Depository institutions are permitted to provide information to other
institutions concerning the possible involvement in potentially unlawful
activity by a current or former employee;
. The Secretary of the Treasury is required to establish a secure website to
receive suspicious activity reports and currency transaction reports, and
provide institutions with alerts and other information regarding
suspicious activity that warrant immediate attention; and
20
. The federal bank regulators are required to consider the anti-money
laundering record of each depository institution in evaluating
applications under the Bank Merger Act.
Deposit Insurance. Heritage Bank's deposit accounts are insured by the FDIC
under the SAIF to the maximum extent permitted by law. Central Valley Bank is
insured by the FDIC under the BIF to the maximum extent permitted by law. Each
bank pays deposit insurance premiums to the FDIC based on a risk-based
assessment system established by the FDIC for all member institutions. Under
applicable regulations, institutions are assigned to one of three capital
groups that are based solely on the level of an institution's capital ("well
capitalized", "adequately capitalized" or " undercapitalized"), which are
defined in the same manner as the regulations establishing the prompt
corrective action system under the FDIC as described above. The matrix so
created results in nine assessment risk classifications.
Pursuant to recent changes in federal law, the FDIC imposed a special
assessment on each depository institution with SAIF-assessable deposits, which
resulted in the SAIF achieving its designated reserve ratio. In addtion, the
FDIC reduced the assessment schedule for SAIF members, effective January 1,
1997, to a range of 0% to 0.27%, with most institutions, including Heritage
Bank, paying 0%. This assessment schedule is the same as that for the BIF,
which reached its designated reserve ratio in 1995. In addition, since January
1, 1997, SAIF members are charged an assessment of approximately 0.06% of
SAIF-assessable deposits for the purpose of paying interest on the bonds issued
by the Financing Corporation in the 1980s to help fund the thrift industry
cleanup. BIF-assessable deposits will be charged an assessment to help pay
interest on the bonds at a rate of approximately .013% until the earlier of
December 31, 1999 or the date upon which the last savings association ceases to
exist, after which time the assessment will be the same for all insured
deposits. Recent legislative changes provided for the merger of the BIF and
SAIF into the Deposit Insurance Fund on January 1, 1999, but only if no insured
depository institutions were savings associations on that date. This merger did
not occur.
The FDIC recently notified all insured institutions about the possibility of
higher deposit insurance premiums in the second half of 2002. The higher
premiums, if they prove necessary, would likely affect only those banks and
thrifts with deposits insured by BIF. The FDIC expects that the deposit
insurance premium increase would be at most 5 basis points of BIF-assessable
deposits each year.
Competition
We compete for loans and deposits with other thrifts, commercial banks,
credit unions, mortgage bankers, and other institutions in the scope and type
of services offered, interest rates paid on deposits, pricing of loans, and
number and locations of branches, among other things. Many of our competitors
have substantially greater resources than we do. Particularly in times of high
or rising interest rates, we also face significant competition for investors'
funds from short-term money market securities and other corporate and
government securities.
We compete for loans principally through the range and quality of the
services we provide, interest rates and loan fees, and the locations of our
banks' branches. We actively solicit deposit-related clients and compete for
deposits by offering depositors a variety of savings accounts, checking
accounts, and other services.
Employees
At December 31, 2001, we had 198 full-time equivalent employees. We believe
that employees play a vital role in the success of a service company. None of
our employees are covered by a collective bargaining agreement.
21
ITEM 2. PROPERTIES
Our executive offices and the main office of Heritage Bank are located in
approximately 22,000 square feet of the headquarters building and adjacent
office space which are owned and located in downtown Olympia. At December 31,
2001, Heritage Bank had six offices located in Tacoma and surrounding areas of
Pierce County, (all but one of which are owned) five offices located in
Thurston County (all of which are owned with one office located on leased
land), and one office in Shelton, Mason County (which is owned). Central Valley
Bank had six offices, five located in Yakima County and one in Kittitas County
(all of which are owned with two on leased land).
ITEM 3. LEGAL PROCEEDINGS
We, and our banks, have certain litigation and possible negotiated
settlements in progress resulting from activities arising from normal
operations. In our opinion, none of these matters is likely to have a material
adverse effect on our financial position or results of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
22
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
Our common stock is traded on the NASDAQ National Market System(R) under the
symbol HFWA. At December 31, 2001, we had approximately 1,300 stockholders of
record (not including the number of persons or entities holding stock in
nominee or street name through various brokerage firms) and 7,534,232
outstanding shares of common stock. The last reported sales price on March 8,
2002 was $12.47 per share. The following table provides bid information per
share of our common stock as reported on the NASDAQ National Market System(R)
for the indicated quarters.
2001 Quarter ended:
-----------------------------------------
March 31 June 30 September 30 December 31
-------- ------- ------------ -----------
High......................... $10.69 $10.93 $11.98 $11.97
Low.......................... $ 9.38 $ 9.65 $10.30 $10.86
2000 Quarter ended:
-----------------------------------------
March 31 June 30 September 30 December 31
-------- ------- ------------ -----------
High......................... $ 8.63 $ 8.69 $ 9.88 $10.19
Low.......................... $ 7.50 $ 7.13 $ 8.50 $ 8.75
Since our stock offering in January 1998, we have declared the following
quarterly cash dividends:
Cash
Dividend
Declared per share Record Date Paid
-------- --------- ---------------- ----------------
March 24, 1998............... $0.035 April 6, 1998 April 15, 1998
June 23, 1998................ $0.040 July 6, 1998 July 15, 1998
September 18, 1998........... $0.045 October 6, 1998 October 15, 1998
December 17, 1998............ $0.050 January 15, 1999 January 25, 1999
March 25, 1999............... $0.055 April 15, 1999 April 26, 1999
June 18, 1999................ $0.060 July 15, 1999 July 27, 1999
September 17, 1999........... $0.065 October 15, 1999 October 27, 1999
December 16, 1999............ $0.070 January 14, 2000 January 27, 2000
March 17, 2000............... $0.075 April 14, 2000 April 28, 2000
June 16, 2000................ $0.080 July 14, 2000 July 28, 2000
September 21, 2000........... $0.085 October 16, 2000 October 27, 2000
December 22, 2000............ $0.090 January 19, 2001 January 31, 2001
March 27, 2001............... $0.095 April 16, 2001 April 27, 2001
June 26, 2001................ $0.100 July 16, 2001 July 25, 2001
September 28, 2001........... $0.105 October 15, 2001 October 29, 2001
December 19, 2001............ $0.110 January 15, 2002 January 30, 2002
Dividends to shareholders depend primarily upon the receipt of dividends
from our subsidiary banks. The FDIC and the Division have the authority under
their supervisory powers to prohibit the payment of dividends by Heritage Bank
to us. For a period of ten years after the conversion from mutual to stock
ownership, Heritage Bank may not, without prior approval of the Division,
declare or pay a cash dividend in excess of one-half of the greater of the
Bank's net income for the current fiscal year or the average of the Bank's net
income for the current fiscal year, and the retained earnings of the two prior
fiscal years. In addition, Heritage Bank may not declare or pay a cash dividend
on its common stock if the effect of the dividend would be to reduce the Bank's
net worth below the amount required for the liquidation account. For Central
Valley Bank, the approval of the Comptroller of the Currency is required if the
total of all dividends declared by Central Valley Bank in any
23
calendar year exceeds the total of its net income of that year combined with
its retained net income of the preceding two years, less any required transfer
of surplus or fund for the retirement of any preferred stock. Other than the
specific restrictions mentioned above, current regulations allow us, and our
subsidiary banks to pay dividends on their common stock if our or our bank's
regulatory capital would not be reduced below the statutory capital
requirements set by the Federal Reserve, the OCC, and the FDIC.
24
ITEM 6. SELECTED FINANCIAL DATA
For the six
For the years ended months ended
June 30, December 31, For the years ended December 31,
------------------ ------------ -------------------------------
1997 1998 1998 1999 2000 2001
-------- -------- ------------ -------- -------- --------
(Dollars in thousands, except per share data)
Operations Data:
Net interest income................. $ 12,043 $ 16,110 $ 11,017 $ 23,458 $ 24,841 $ 26,632
Provision for loan losses........... (265) 149 202 408 787 1,193
Noninterest income.................. 3,748 4,261 2,901 4,038 4,190 5,925
Noninterest expense................. 13,445 13,690 10,275 18,773 19,323 20,624
Provision (benefit) for income taxes 12 2,273 1,275 2,958 2,947 3,778
Net income.......................... 2,598 4,259 2,166 5,357 5,974 6,962
Earnings per share
Basic............................ 0.25 0.41 0.20 0.50 0.66 0.87
Diluted.......................... 0.24 0.40 0.20 0.49 0.65 0.86
Dividend payout ratio(1)............ NM 18.4% 47.3% 50.1% 50.2% 46.9%
Performance Ratios:
Net interest spread................. 4.30% 4.14% 4.13% 4.56% 4.12% 4.33%
Net interest margin(2).............. 4.80% 5.05% 5.16% 5.49% 5.04% 4.98%
Efficiency ratio(3)................. 85.15% 67.20% 73.83% 68.27% 66.56% 63.35%
Return on average assets............ 0.94% 1.23% 0.92% 1.14% 1.11% 1.19%
Return on average equity............ 8.74% 6.77% 4.36% 5.32% 6.66% 8.52%
At June 30, At December 31,
------------------ --------------------------------------------
1997 1998 1998 1999 2000 2001
-------- -------- ------------ -------- -------- --------
Balance Sheet Data:
Total assets........................ $291,323 $471,030 $475,871 $510,958 $573,530 $609,643
Loans receivable, net............... 233,621 303,754 315,376 412,909 475,441 486,679
Loans held for sale................. 6,322 6,412 7,618 589 1,931 6,275
Deposits............................ 254,024 363,529 366,998 405,068 460,234 515,080
Federal Home Loan Bank advances..... 890 698 687 2,800 23,125 8,000
Other borrowings.................... 525 1,633 17 8 1,000 --
Stockholders' equity................ 31,588 98,593 100,559 95,264 83,005 78,528
Book value per share................ NM $ 9.20 $ 9.27 $ 9.50 $ 10.09 $ 10.42
Equity to assets ratio.............. 10.84% 20.93% 21.13% 18.68% 14.47% 12.88%
Asset Quality Ratios:
Nonperforming loans to loans........ 0.06% 0.06% 0.12% 0.43% 0.33% 0.39%
Allowance for loan losses to loans.. 1.28% 1.25% 1.21% 1.02% 1.05% 1.15%
Allowance for loan losses to
nonperforming loans............... 2133.01% 1019.90% 984.70% 236.27% 315.02% 293.12%
Nonperforming assets to total assets 0.05% 0.10% 0.08% 0.35% 0.28% 0.49%
Other Data:
Number of banking offices........... 12 14 16 17 18 18
Number of full-time equivalent
employees......................... 170 180 229 222 211 198
- --------
(1) Dividend payout ratio is declared dividends per share divided by earnings
per share. Cash dividends prior to the January 1998 stock offering and
conversion are not comparable to prior periods due to the former mutual
holding company's waiver of its pro rata cash dividends.
(2) Net interest margin is net interest income divided by average interest
earning assets.
(3) The efficiency ratio is recurring noninterest expense divided by the sum of
net interest income and noninterest income, excluding nonrecurring items.
Heritage Bank paid a one-time assessment of $1.09 million to the SAIF in
November 1996 (fiscal year 1997). This amount was excluded from the
calculation of the efficiency ratio for 1997.
25
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following discussion is intended to assist in understanding the
financial condition and results of operations of the Company. The information
contained in this section should be read with the December 31, 2001 audited
consolidated financial statements and notes to those financial statements
included in this Form 10-K.
Statements concerning future performance, developments or events, concerning
expectations for growth and market forecasts, and any other guidance on future
periods, constitute forward-looking statements and are subject to a number of
risks and uncertainties which might cause actual results to differ materially
from stated expectations. Specific factors include, but are not limited to the
effect of interest rate changes, risks associated with acquisition of other
banks and opening new branches, the ability to control costs and expenses, and
general economic conditions. Additional information on these and other factors,
which could affect our financial results are included in our filings with the
Securities and Exchange Commission.
General
In the fiscal year ended June 30, 1994, we began to implement a growth
strategy to broaden our products and services from traditional thrift offerings
to those more closely related to commercial banking. That strategy included,
geographic and product expansion, loan portfolio diversification, development
of relationship banking, and maintenance of asset quality.
In the fiscal year ended June 30, 1998, our growth strategy was bolstered by
two significant events--the January 1998 stock offering and conversion, and our
acquisition of North Pacific Bancorporation.
Through the January 1998 stock offering, we raised $63.0 million in net new
capital, which has, and will continue to, enhance our ability to implement our
growth strategy. Using $17.5 million of the net proceeds of the stock offering,
we completed our first bank acquisition in June 1998 by purchasing all of the
outstanding stock of North Pacific Bancorporation whose wholly owned subsidiary
was North Pacific Bank. The all cash transaction was accounted for using
purchase accounting rules. The acquisition of North Pacific Bank provided
further geographical expansion into the Pierce County market area and enhanced
expertise in commercial banking. During the six months ended December 31, 1998,
we integrated the operations of North Pacific Bank into Heritage Bank
culminating in the merging of data processing systems effective November 20,
1998 and substantially upgrading North Pacific Bank's item processing
capability to handle existing and projected future volumes.
Consistent with our strategy, on March 5, 1999, we merged with Washington
Independent Bancshares, Inc., whose wholly owned subsidiary was Central Valley
Bank. In the merger, we exchanged 1,058,009 shares of our common stock for all
of the outstanding shares of Washington Independent Bancshares, Inc. common
stock. This merger was accounted for as a pooling of interests and accordingly,
our financial information has been restated to include the accounts and results
of operations of Washington Independent Bancshares, Inc. for all periods
presented.
In 1999, we were continuing to operate with capital levels well in excess of
regulatory requirements and well in excess of our internal needs. We determined
that buying our own shares with some of our excess capital was the best use of
this capital and we began to buy back our outstanding shares. We began in April
1999 with the repurchase of 100,000 shares of our outstanding common stock for
$0.8 million, or $8.56 per share. In October 1999, we began the first of four
phases of the stock repurchase programs. The first phase of the repurchase
program totaled 1,082,389 shares, or 10% of the then outstanding shares, which
began in October 1999 and ended in February 2000. The second phase totaled
976,748 shares, or 10% of the then outstanding shares, which began in February
2000 and ended in August 2000. The third phase totaled 890,000 shares, which
represented 10% of the then outstanding shares, which began in August 2000 and
ended in May 2001. The fourth
26
phase began during May 2001 for a total of 800,000 shares, which represented
10% of the then outstanding shares, of which 521,089 shares were repurchased as
of December 31, 2001. By December 31, 2001, we repurchased a total of 3,573,380
shares of our stock representing 33% of the total outstanding as of March 31,
1999 at an average price of $9.13 per share.
In 2000, we conducted an extensive review of our strategic direction
culminating in a new strategic plan that reaffirmed our 1994 goals with an
increased emphasis on return on average equity and efficiency of operations. In
pursuit of this strategy, we announced in January 2001 an initiative titled
"Vision 2001" for Heritage Bank. To assist us, we engaged Alex Sheshunoff
Management Services, L.P. ("ASM"). ASM completed an opportunities assessment
during fiscal year 2000 for Heritage Bank with the objective of determining
ways that we can optimize our earnings performance. Beginning in March 2001,
ASM worked with us to implement those opportunities identified. We incurred the
majority of the expenses associated with this project during the first and
second quarters of 2001. We realized the benefits in the form of revenue
enhancements and reduced expenses beginning with the third quarter of 2001.
Net Interest Income
Our profitability depends primarily on our net interest income, which is the
difference between the income we receive on our loan and investment portfolios,
and our cost of funds, which consists of interest paid on deposits and borrowed
funds. Like most financial institutions, our interest income and cost of funds
are affected significantly by general economic conditions, particularly changes
in market interest rates and government policies.
Changes in net interest income result from changes in volume, net interest
spread, and net interest margin. Volume refers to the average dollar amounts of
interest earning assets and interest bearing liabilities. Net interest spread
refers to the difference between the average yield on interest earning assets
and the average cost of interest bearing liabilities. Net interest margin
refers to net interest income divided by average interest earning assets and is
influenced by the level and relative mix of interest earning assets and
interest bearing liabilities.
27
The following table provides relevant net interest income information for
selected time periods. The average loan balances presented in the table are net
of allowances for loan losses. Nonaccrual loans have been included in the
tables as loans carrying a zero yield.
Years Ended December 31,
----------------------------------------------------------------------------
1999 2000 2001
------------------------ ------------------------ ------------------------
Average Interest Average Interest Average Interest
Balance Earned/ Average Balance Earned/ Average Balance Earned/ Average
(1) Paid Rate (1) Paid Rate (1) Paid Rate
-------- -------- ------- -------- -------- ------- -------- -------- -------
(Dollars in thousands)
Interest Earning Assets:
Loans............................. $361,116 $32,886 9.11% $445,813 $41,510 9.31% $494,379 $43,111 8.72%
Mortgage Backed Securities........ 2,773 227 8.19 2,174 180 8.27 4,069 301 7.40
Investment securities and FHLB
stock............................ 44,270 2,591 5.85 41,885 2,393 5.71 25,622 1,406 5.49
Interest earning deposits......... 18,745 820 4.37 2,898 159 5.50 11,019 372 3.38
-------- ------- ------ -------- ------- ------ -------- ------- ------
Total interest earning assets..... $426,904 $36,524 8.56% $492,770 $44,242 8.98% $535,089 $45,190 8.45%
Noninterest earning assets........ 44,637 47,394 50,582
-------- -------- --------
Total assets................... $471,541 $540,164 $585,671
======== ======== ========
Interest Bearing Liabilities:
Certificates of deposit........... $165,490 $ 8,271 5.00% $226,334 $13,617 6.02% $244,369 12,797 5.24%
Savings accounts.................. 68,484 2,279 3.33 62,594 2,226 3.56 61,190 2,140 3.50
Interest bearing demand and
money market accounts............ 91,281 2,458 2.69 99,089 2,787 2.81 126,302 2,618 2.07
-------- ------- ------ -------- ------- ------ -------- ------- ------
Total interest bearing deposits... 325,255 13,008 4.00 388,017 18,630 4.80 431,861 17,555 4.06
FHLB advances..................... 1,021 57 5.53 10,441 722 6.92 18,002 961 5.34
Other borrowed funds.............. 37 1 3.54 477 49 10.16 202 42 20.85
-------- ------- ------ -------- ------- ------ -------- ------- ------
Total interest bearing
liabilities................... $326,313 $13,066 4.00% $398,935 $19,401 4.86% $450,065 $18,558 4.12%
Demand and other noninterest
bearing deposits................. 37,906 44,038 47,455
Other noninterest bearing
liabilities...................... 6,712 7,463 6,479
Stockholders' equity.............. 100,610 89,728 81,672
-------- -------- --------
Total liabilities and
stockholders' equity.......... $471,541 $540,164 $585,671
======== ======== ========
Net interest income............... $23,458 $24,841 $26,632
Net interest spread............... 4.56% 4.12% 4.33%
Net interest margin............... 5.49% 5.04% 4.98%
Average interest earning assets to
average interest bearing
liabilities...................... 130.83% 123.52% 118.89%
28
The following table provides the amount of change in our net interest income
attributable to changes in volume and changes in interest rates. Changes
attributable to the combined effect of volume and interest rates have been
allocated proportionately for changes due to volume and interest rates.
Years Ended December 31,
----------------------------------------------------
1999 Compared to 2000 2000 Compared to 2001
Increase (Decrease) Due to Increase (Decrease) Due to
------------------------- -------------------------
Volume Rate Total Volume Rate Total
------- ------- ------- ------- ------- ------
Interest Earning Assets:
Loans................................... $ 7,713 $ 910 $ 8,623 $ 4,523 $(2,921) $1,602
Mortgage backed securities.............. (49) 2 (47) 157 (36) 121
Investment securities and FHLB stock.... (140) (58) (198) (929) (58) (987)
Interest earning deposits............... (693) 33 (660) 447 (235) 212
------- ------- ------- ------- ------- ------
Total interest income................ $ 6,831 $ 887 $ 7,718 $ 4,198 $(3,250) $ 948
======= ======= ======= ======= ======= ======
Interest bearing liabilities:
Certificates of deposit................. $(3,041) $(2,305) $(5,346) $(1,085) $ 1,905 $ 820
Savings accounts........................ 196 (143) 53 50 36 86
Interest bearing demand and money market
accounts.............................. (210) (118) (328) (765) 934 169
------- ------- ------- ------- ------- ------
Total interest bearing deposits...... (3,055) (2,566) (5,621) (1,800) 2,875 1,075
FHLB advances........................... (522) (144) (666) (523) 284 (239)
Other borrowings........................ (16) (32) (48) 29 (22) 7
------- ------- ------- ------- ------- ------
Total interest bearing liabilities... $(3,593) $(2,742) $(6,335) $(2,294) $ 3,137 $ 843
======= ======= ======= ======= ======= ======
Financial Condition
Our total assets grew $36.1 million (6.3%) to $609.6 million at December 31,
2001 from $573.5 million at December 31, 2000. Deposits grew $54.8 million
(11.9%) to $515.0 million at December 31, 2001 from $460.2 million at December
31, 2000. Total loans grew by $16.3 million (3.4%) to $498.7 million at
December 31, 2001 from $482.4 million at December 31, 2000. The majority of the
loan growth was in commercial loans as they grew to $263.1 million at December
31, 2001 from $234.2 million at December 31, 2000, an increase of $28.9 million
(12.3%).
Results of Operations for the Years Ended December 31, 2001 and 2000
Net Income. Our net income was $6.96 million or $0.86 per diluted share for
the year ended December 31, 2001 compared to $5.97 million or $0.65 per diluted
share for the previous year. The growth in income primarily resulted from a
strong mortgage banking environment leading to increased loan sale gains, the
success of Heritage Bank's Vision 2001 initiative, and our ability to maintain
our net interest margin in a sharply declining interest rate environment.
Average earning assets increased 42.3 million, ending the year at $535.1
million compared to the previous year end of $492.8 million. The average rate
on average earning assets declined by 53 basis points. Average costing
liabilities grew $51.1 million with cost of funds declining by 74 basis points
over the prior year. The difference in growth between average earning assets
and costing liabilities is the result of stock repurchases during the year.
Net Interest Income. Net interest income increased $1.8 million (7.2%), for
the year ended December 31, 2001 compared with the previous year. The growth in
net interest income resulted primarily from maintaining the net interest margin
in a sharply declining interest-rate environment. Average loans increased by
$48.6 million (10.9%) with a decline in the average rate of 59 basis points.
Average deposits increased $43.8 million (11.3%) with a more significant
decline in the average rate of 74 basis points.
29
Net interest income as a percentage of average earning assets (net interest
margin) for the year ended December 31, 2001 decreased to 4.98% from 5.04% for
the previous year. Our net interest spread for the year ended December 31, 2001
increased to 4.33% from 4.12% for the prior year. This corresponded with the
decrease in the average cost of funds to 4.12% for the year ended December 31,
2001 from 4.86% for the same period last year as well as the decrease in the
average rate of interest earning assets to 8.45% for the year ended December
31, 2001 from 8.98% for the same period last year. The declining rate
environment is a result of a weakening economy and an effort by the Federal
Reserve to stimulate the economy.
Provision for Loan Losses. During the year ended December 31, 2001, we
provided $1.19 million through operations to maintain our allowance at an
adequate level because of a weakening economy and the increase in our
commercial loan portfolio. For the year ended December 31, 2001, we experienced
net charge-offs of $505,000. The provision increased our allowance for loan
loss as a percentage of total loans to 1.15% at December 31, 2001 from 1.05% at
the end of 2000. While our loan portfolio, and in particular commercial loans,
has grown substantially over the past several years, our asset quality has
remained solid as demonstrated by the nonperforming assets to total assets
ratio of 0.49% at December 31, 2001.
We consider the allowance for loan losses at December 31, 2001 to adequately
cover reasonably foreseeable loan losses based on our assessment of various
factors affecting the loan portfolio, including the level of problem loans,
business conditions, estimated collateral values, loss experience, and credit
concentrations. See the previous discussion on the allowance for loan losses
for further information about these factors.
Noninterest Income. Total noninterest income increased $1.7 million (41.4%)
for the year ended December 31, 2001 compared with the prior year. Mortgage
banking income increased $985,000 as result of the declining interest rates and
the large increase in refinancing of real estate loans. Total sales of mortgage
loans increased by $61.9 million to $97.8 million for the year ended 2001
versus $35.9 million in 2000. Service charges on deposits increased $399,000
(25.1%) resulting from increased service charges and increased demand for
deposit products. Other income increased $427,000 (28.8%) for 2001 as compared
to 2000. This increase in other income was due to the $267,000 (42.5%) increase
in Merchant Visa Income, which is a relatively new product line that continues
to expand. Additionally, the increase in other income was attributable to the
sale of Heritage Bank's ownership interest in Transalliance Corporation (a
debit/credit card processor), which resulted in a gain on sale of investment of
$157,000.
Noninterest Expense. Total noninterest expense increased $1.3 million
(6.7%) for the year ended 2001 compared to the 2000 period. Personnel expenses
increased a modest $188,000 (1.9%) despite the $407,000 increase in mortgage
commissions. As a result of the Vision 2001 initiative, Heritage Bank
experienced employee layoffs and restructured mortgage commission incentives.
Therefore, personnel expenses did not increase during the year. Other expenses
increased $956,000 (27.4%) due primarily to the costs associated with the
Vision 2001 initiative of $589,000. We incurred Vision 2001 expenses during the
first half of the year, which were primarily consulting fees paid to Alex
Sheshunoff Management Services, L.P. Merchant Visa expenses also increased by
$220,000 (43.2%), which was in line with the increase in Merchant Visa income.
Results of Operations for the Years Ended December 31, 2000 and 1999
Net Income. Our net income was $5.97 million or $0.65 per diluted share for
the year ended December 31, 2000 as compared to $5.36 million or $0.49 per
diluted share for 1999. The growth in income primarily resulted from a $65.9
million growth in average earning assets for the year 2000 compared to 1999.
Average costing liabilities grew $72.6 million contributing to a narrowing net
interest margin. The difference in growth between average earning assets and
costing liabilities is the result of stock repurchases during the year.
Net Interest Income. Net interest income increased $1.4 million (5.9%), for
the year ended December 31, 2000 compared with 1999, primarily as a result of
the $84.7 million (23.5%) increase in the average balance of loans. Average
interest earning assets grew $65.9 million (15.4%) as average short-term
investments (primarily
30
overnight deposits) decreased by $18.8 million (28.6%). The reduction of
short-term investments was used along with the growth in average deposits of
$62.8 million (19.3%) to fund loan growth and repurchase stock.
Net interest income as a percentage of average earning assets (net interest
margin) for the year ended December 31, 2000 decreased to 5.04% from 5.49% for
1999. The decrease resulted from the strong growth in average deposits,
particularly certificates of deposit which grew $60.8 million ($36.8%) but
which have a higher cost. During 1998 and 1999 we were able to utilize our
excess capital from the January 1998 proceeds of the conversion from mutual to
stock ownership to reduce our reliance on higher costing sources of funds. With
the stock repurchase beginning in the fourth quarter of 1999, we reduced our
excess capital levels to the benefit of our return on average equity and
earnings per share but at the expense of a greater reliance on costing
liabilities. Our net interest spread for the year ended December 31, 2000
decreased to 4.12% from 4.56% for the prior year. This corresponded with the
increase in the average cost of funds to 4.86% for the year ended December 31,
2000 from 4.00% for the same period last year. These rate shifts resulted from
the increased demand for funds to support loan growth and the stock repurchase
program.
Provision for Loan Losses. During the year ended December 31, 2000, we
provided $787,000 through operations to maintain our allowance for loan losses
at an adequate level during a time of change in loan portfolio composition and
loan growth. In the year ended December 31, 2000, we experienced net recoveries
of $12,000. The provision increased our allowance for loan loss to total loan
ratio to 1.05% at December 31, 2000 from 1.02% at the end of 1999. While our
loan portfolio, and in particular commercial loans, has grown substantially
over the past three years, our asset quality has remained strong as
demonstrated by the nonperforming assets to total assets ratio of 0.28% at
December 31, 2000. We did not include one credit for $899,000 in the year end
totals that we now expect to foreclose on in the first quarter of 2001. This
credit was classified as performing due to the strength of the underlying
collateral. Had this credit been included with nonperforming assets the ratio
to total assets would have been only 0.44%. Because commercial business lending
generally involves greater risk than those associated with residential and
commercial real estate lending, we have increased the portion of our general
allowance for loan losses allocated to our commercial loans over the past four
years.
We consider the allowance for loan losses at December 31, 2000 to adequately
cover reasonably foreseeable loan losses based on our assessment of various
factors affecting the loan portfolio, including the level of problem loans,
business conditions, estimated collateral values, loss experience, and credit
concentrations.
Noninterest Income. Total noninterest income increased $152,000 (3.8%) for
the year ended December 31, 2000 compared with the prior year. Increases in
service charges on deposits offset the reduction in mortgage banking income.
Service charges on deposits increased $212,000 (15.4%) resulting from increased
service charges and demand for deposit products. Other income increased
$289,000 (24.2%) for 2000 as compared to 1999. The decrease in mortgage banking
income is attributable to the region wide reduction in the level of mortgage
banking activity beginning the second quarter of 1999. Loan sale gains fell
$395,000 (36.6%) to $684,000 for 2000 from $1,079,000 in 1999. This corresponds
with a reduction of total mortgage production of $55.6 million during the year
ended December 31, 2000, which was down from the prior year production of $78.2
million by $22.6 million (28.9%).
Noninterest Expense. Total noninterest expense increased $550,000 (2.9%)
for the year ended 2000 compared to the 1999 period. Increased personnel and
occupancy costs were offset with reductions in all other categories. Personnel
costs increased $488,000 (5.1%) for 2000 as a result of reduced salary
deferrals resulting from lower loan production. Costs deferred in 2000 were
$663,000 compared to $1,094,000 for 1999, a decrease of $431,000 (39.4%).
Occupancy costs increased $196,000 (6.8%) in 2000 resulting from increased
maintenance and repair expenses the construction of a new branch to replace
Heritage Bank's old Spanaway branch and the opening of a new branch in
Ellensburg, Washington by Central Valley Bank. Other expenses decreased $78,000
(2.3%) for 2000 compared to 1999.
31
Liquidity and Capital Resources
Our primary sources of funds are deposits, loan repayments, loan sales,
interest earned on and proceeds from investment securities, and advances from
the FHLB of Seattle. These funds, together with retained earnings, equity and
other borrowed funds, are used to make loans, acquire investment securities and
other assets, and fund continuing operations. While maturities and scheduled
amortization of loans are a predictable source of funds, deposit flows and
mortgage prepayments are greatly influenced by the level of interest rates,
economic conditions, and competition.
We must maintain an adequate level of liquidity to ensure the availability
of sufficient funds to fund loan originations and deposit withdrawals, satisfy
other financial commitments, and fund operations. We generally maintain
sufficient cash and short-term investments to meet short-term liquidity needs.
At December 31, 2001, cash and cash equivalents totaled $50.78 million, or 8.3%
of total assets. At December 31, 2001, our banks maintained a credit facility
with the FHLB of Seattle for $122 million (of which $8.0 million was
outstanding at that date).
To fund growth in 2001, our strategy has been to acquire core deposits
(which we define to include all deposits except public funds) from our retail
accounts, acquire noninterest bearing demand deposits from our commercial
customers, and use available credit lines. Total deposits increased $54.8
million, or 11.9%, to $515.0 million at December 31, 2001 from $460.2 million
at December 31, 2000. The largest increase in deposits occurred in savings
accounts, which grew $33.7 million (61.5%) to $88.5 million at December 31,
2001 from $54.8 million at December 31, 2000. Borrowings decreased $16.1
million, primarily through FHLB advances, which decreased to $8.0 million at
December 31, 2001 from $23.1 million at December 31, 2000. We anticipate that
we will continue to rely on the same sources of funds in the future and use
those funds primarily to make loans and purchase investment securities.
We, and our banks, are subject to various regulatory capital requirements.
As of December 31, 2001, we, and our banks were classified as "well
capitalized" institutions under the criteria established by the Federal Deposit
Insurance Act. Our initial public offering in January of 1998 significantly
increased our capital to levels well in excess of regulatory requirements and
our internal needs. As more fully discussed in the General section of the
Management's Discussion and Analysis of Financial Condition and Results of
Operations, in 1999 we determined that buying our own shares with some of our
excess capital was the best use of this capital and we began to buy back our
Company's outstanding shares. As of December 31, 2001, we have repurchased
3,573,380 shares of our stock representing 33% of the total outstanding as of
March 31, 1999 at an average price of $9.13 reducing our capital levels by
$32.6 million.
Our capital levels will also be modestly impacted by our 401(k) Employee
Stock Ownership Plan and Trust ("KSOP"). The Employee Stock Ownership Plan
("ESOP") purchased 2% of the common stock issued in the January 1998 stock
offering and borrowed from the Company to fund the purchase of the Company's
common stock. The loan to the ESOP will be repaid principally from the Bank's
contributions to the ESOP. The Bank's contributions will be sufficient to
service the debt over the 15 year loan term at the interest rate of 8.5%. As
the debt is repaid, shares are released, and allocated to plan participants
based on the proportion of debt service paid during the year. As shares are
released, compensation expense is recorded equal to the then current market
price of the shares, our capital is increased, and the shares become
outstanding for earnings per share calculations. For the year ended December
31, 2001, the Company has allocated or committed to be released to the ESOP
8,817 earned shares and has 97,718 unearned, restricted shares remaining to be
released. The fair value of unearned, restricted shares held by the ESOP trust
was $1,166,000 at December 31, 2001.
Asset/Liability Management
Our primary financial objective is to achieve long term profitability while
controlling our exposure to fluctuations in market interest rates. To
accomplish this objective, we have formulated an interest rate risk
32
management policy that attempts to manage the mismatch between asset and
liability maturities while maintaining an acceptable interest rate sensitivity
position. The principal strategies which we employ to control our interest rate
sensitivity are: selling most long term, fixed rate, one- to four-family
residential mortgage loan originations; originating commercial loans and
residential construction loans at variable interest rates for terms generally
one year or less; and offering noninterest bearing demand deposit accounts to
businesses and individuals. The longer-term objective is to increase the
proportion of noninterest bearing demand deposits, low interest bearing demand
deposits, money market accounts, and savings deposits relative to certificates
of deposit to reduce interest sensitivity and risk.
Our asset and liability management strategies have resulted in a positive
3-month "gap" of 14.68% and a positive one year "gap" of 6.85% as of December
31, 2001. These "gaps" measure the difference between the dollar amount of our
interest earning assets and interest bearing liabilities that mature or reprice
within the designated period (three months and one year) as a percentage of
total interest earning assets, based on certain estimates and assumptions as
discussed below. We believe that the implementation of our operating strategies
has reduced the potential effects of changes in market interest rates on our
results of operations. The positive gap for the 0-3 month period indicates that
decreases in market interest rates may adversely affect our results over that
period.
The following table provides the estimated maturity or repricing and the
resulting interest rate sensitivity gap of our interest earning assets and
interest bearing liabilities at December 31, 2001 based upon estimates of
expected mortgage prepayment rates and deposit reduction rates consistent with
national trends. We adjusted mortgage loan maturities for loans held for sale
by reflecting these loans in three month category which is consistent with
their sale in the secondary mortgage market. The amounts in the table are
derived from our internal data. We used certain assumptions in presenting this
data so the amounts may not be consistent with other financial information
prepared in accordance with generally accepted accounting principles. The
amounts in the tables also could be significantly affected by external factors,
such as changes in prepayment assumptions, early withdrawal of deposits, and
competition.
Estimated Maturity or Repricing Within
----------------------------------------------------------
0-3 4-12 1-5 5-15 More than
months months years years 15 years Total
-------- -------- -------- ------- --------- --------
(Dollars in thousands)
Interest Earnings Assets:
Loans..................................... $149,161 $108,793 $138,476 $77,525 $24,750 $498,705
Investment securities..................... 10,072 1,807 13,501 3,122 1,680 30,182
FHLB stock................................ 2,911 -- -- -- -- 2,911
Fed funds sold............................ 5,000 -- -- -- -- 5,000
Interest earning deposits................. 20,437 -- -- -- -- 20,437
-------- -------- -------- ------- ------- --------
Total interest earning assets......... $187,581 $110,600 $151,977 $80,647 $26,430 $557,235
======== ======== ======== ======= ======= ========
Interest Bearing Liabilities:
Total interest bearing deposits........... 105,804 146,216 206,823 -- -- 458,843
FHLB advances and other borrowings........ -- 8,000 -- -- -- 8,000
-------- -------- -------- ------- ------- --------
Total interest bearing liabilities.... $105,804 $154,216 $206,823 $ -- $ -- $466,843
======== ======== ======== ======= ======= ========
Rate sensitivity gap...................... $ 81,777 $(43,616) $(54,846) $80,647 $26,430 $ 90,392
Cumulative rate sensitivity gap:
Amount.................................... 81,777 38,161 (16,685) 63,962 90,392
As a percentage of interest earning assets 14.68% 6.85% (2.99)% 11.48% 16.22%
======== ======== ======== ======= =======
Certain shortcomings are inherent in the method of analysis presented in the
foregoing table. For example, although certain assets and liabilities may have
similar maturities or periods to repricing, they may react in different degrees
to changes in market interest rates. Also, the interest rates on some types of
assets and liabilities
33
may fluctuate in advance of changes in market interest rates, while interest
rates on other types may lag behind changes in market interest rates.
Additionally, some assets, such as adjustable rate mortgages, have features,
which restrict changes in the interest rates of those assets both on a
short-term basis and over the lives of such assets. Further, if a change in
market interest rates occurs, prepayment, and early withdrawal levels could
deviate significantly from those assumed in calculating the tables. Finally,
the ability of many borrowers to service their adjustable rate debt may
decrease if market interest rates increase substantially.
Impact of Inflation and Changing Prices
Inflation affects our operations by increasing operating costs. Unlike most
industrial companies, virtually all the assets and liabilities of a financial
institution are monetary in nature. As a result, changes in interest rates
generally have a more significant impact on a financial institution's
performance than the effects of general levels of inflation. Although interest
rates do not necessarily move in the same direction or the same extent as the
prices of goods and services, increases in inflation generally have resulted in
increased interest rates.
Recent Financial Accounting Pronouncements
In June 1998, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for
Derivative Instruments and Hedging Activities". This statement establishes
accounting and reporting standards for derivative instruments, including
certain derivative instruments embedded in other contracts (collectively
referred to as derivatives) and hedging activities. In May 1999, the FASB
delayed the effective date of SFAS No. 133 until fiscal years beginning after
June 15, 2000, with interim reporting required. In June 2000, the FASB issued
SFAS No. 138, "Accounting for Certain Derivative Instruments and Certain
Hedging Activities", an amendment of SFAS No. 133, which makes minor
modifications to SFAS No. 133. This statement was adopted January 1, 2001 and
did not have a material effect on the results of our operations or financial
position.
In September 2000, the FASB issued SFAS No. 140, "Accounting for Transfers
and Servicing of Financial Assets and Extinguishments of Liabilities," and
replaced SFAS No. 125 of the same title. This statement revises the standards
for accounting for securitizations and other transfers of financial assets and
collateral and requires certain disclosures, but carries over most of SFAS No.
125's provisions without reconsideration. This statement is effective for
transfers and servicing of financial assets and extinguishments of liabilities
occurring after March 31, 2001. It is effective for recognition and
reclassification of collateral and disclosures relating to securitization
transactions and collateral for fiscal years ending after December 15, 2000. We
adopted SFAS No. 140 and it did not have a material impact on our consolidated
financial statements.
In July 2001, the FASB issued SFAS No. 141 "Business Combinations" and SFAS
No. 142 "Goodwill and Other Intangible Assets". SFAS No. 141 requires business
combinations initiated after June 30, 2001 to be accounted for using the
purchase method of accounting, and broadens the criteria for recording
intangible assets separate from goodwill. Recorded goodwill and intangibles
will be evaluated against this new criteria and may result in certain
intangibles being included in goodwill. Alternatively, certain amounts
initially recorded as goodwill may be separately identified and recognized
apart from goodwill. SFAS No. 142 requires the use of a nonamortization
approach to account for purchased goodwill and certain intangibles. Under a
nonamortization approach, goodwill and certain intangibles will not be
amortized into results of operations, but instead would be reviewed for
impairment and written down and charged to results of operations only in the
periods in which the recorded value of goodwill and certain intangibles is more
than its fair value. The provisions of each statement, which apply to goodwill
and intangible assets acquired prior to June 30, 2001 will be adopted by us on
January 1, 2002. Nonamortized goodwill in the amount of $6,640 is subject to
the transition provisions of SFAS Nos. 141 and 142.
In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement
Obligations", which addresses financial accounting and reporting for
obligations associated with the retirement of tangible long-lived
34
assets and the associated asset retirement costs. The standard applies to legal
obligations associated with the retirement of long-lived assets that result
from the acquisition, construction, development and (or) normal use of the
asset. SFAS No. 143 requires that the fair value of a liability for an asset
retirement obligation be recognized in the period in which it is incurred if a
reasonable estimate of fair value can be made. The fair value of the liability
is added to the carrying amount of the associated asset and this additional
carrying amount is depreciated over the life of the asset. The liability is
accreted at the end of each period through charges to operating expense. If the
obligation is settled for other than the carrying amount of the liability, we
will recognize a gain or loss on settlement. We are required and plan to adopt
the provisions of SFAS No. 143 for the quarter ending March 31, 2003.
Management does not expect the adoption of this statement to have a material
impact on the results of our operations or financial position.
In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment
or Disposal of Long-Lived Assets", which addresses financial accounting and
reporting for the impairment or disposal of long-lived assets. While SFAS No.
144 supersedes SFAS No. 121, "Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to Be Disposed Of", it retains many of the
fundamental provisions of that statement. SFAS No. 144 also supersedes the
accounting and reporting provisions of Accounting Principles Board ("APB")
Opinion No. 30, "Reporting the Results of Operations--Reporting the Effects of
Disposal of a Segment of a Business, and Extraordinary, Unusual and
Infrequently Occurring Events and Transactions", for the disposal of a segment
of a business. However, it retains the requirement in Opinion No. 30 to report
separately discontinued operations and extends that reporting to a component of
an entity that either has been disposed of (by sale, abandonment, or
distribution to owners) or is classified as held for sale. This statement was
adopted January 1, 2002 and did not have a material effect on the results of
our operations or financial position.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to interest rate risk through our lending and deposit
gathering activities. For a discussion of how this exposure is managed and the
nature of changes in our interest rate risk profile during the past year, see
"Asset/Liability Management" under Management's Discussion and Analysis of
Financial Condition and Results of Operation.
Neither we, nor our banks, maintain a trading account for any class of
financial instrument, nor do we or they engage in hedging activities or
purchase high risk derivative instruments. Moreover, neither we, nor our banks,
are subject to foreign currency exchange rate risk or commodity price risk.
35
The table below provides information about our financial instruments that
are sensitive to changes in interest rates as of December 31, 2001. The table
presents principal cash flows and related weighted average interest rates by
expected maturity dates. The data in this table may not be consistent with the
amounts in the preceding table, which represents amounts by the repricing date
or maturity date (whichever occurs sooner) adjusted by estimates such as
mortgage prepayments and deposit reduction or early withdrawal rates.
By Expected Maturity Date
-----------------------------------------------------------------
Year Ended December 31,
-----------------------------------------------------------------
2005- After Fair
2002 2003 2004 2006 2007 Total Value
-------- ------- ------- -------- -------- -------- --------
(Dollars in thousands)
Investment Securities
Amounts maturing:
Fixed rate....................... $ 1,346 $ 2,198 $ 4,098 $ 13,621 $ 8,887 $ 30,150
Weighted average interest rate... 6.20% 3.90% 5.35% 4.82% 6.66%
Adjustable Rate.................. 31 -- -- -- -- 31
Weighted average interest rate... 6.22% -- -- -- --
-------- ------- ------- -------- -------- -------- --------
Totals........................ 1,377 2,198 4,098 13,621 8,887 $ 30,181 $ 30,363
Loans
Amounts maturing:
Fixed rate........................ $ 62,232 $20,859 $ 9,678 $ 35,366 $148,067 $276,202
Weighted average interest rate.... 7.49% 8.64% 8.16% 8.24% 7.94%
Adjustable rate................... 104,754 4,102 15,845 87,459 10,343 222,503
Weighted average interest rate.... 6.96% 8.15% 8.05% 8.05% 7.53%
-------- ------- ------- -------- -------- -------- --------
Totals........................ $166,986 $24,961 $25,523 $122,825 $158,410 $498,705 $502,946
Certificates of Deposit
Amounts maturing:
Fixed rate........................ $215,886 $20,070 $ 2,349 $ 320 $ -- $247,001 $240,137
Weighted average interest rate.... 3.66% 2.69% 4.21% 4.87% --
FHLB Advances
Amounts maturing:
Fixed rate........................ $ 8,000 $ -- $ -- $ -- $ -- $ 8,000 $ 8,000
Weighted average interest rate.... 5.01% -- -- -- --
The terrorist attacks that took place in the United States on September 11,
2001 were unprecedented events that have created many economic and political
uncertainties. The long-term effects of the September 11, 2001 attacks on our
business and revenues are unknown. The potential for future terrorist attacks,
the national and international responses to terrorist attacks, and other acts
of war or hostility have created many economic and political uncertainties,
which could adversely affect our business and revenues in the short or
long-term in ways that can not presently be predicted.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
For financial statements, see Index to Consolidated Financial Statements on
page F-1.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
36
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information concerning directors of the registrant is incorporated by
reference to the section entitled "Election of Directors" of our definitive
Proxy Statement dated March 22, 2002 ("Proxy Statement") for the annual meeting
of shareholders to be held April 25, 2002.
The required information with respect to our executive officers is
incorporated by reference to the section entitled "Executive Officers" of the
Proxy Statement.
The required information with respect to compliance with Section 16(a) of
the Exchange Act is incorporated by reference to the section entitled "Section
16(a) Beneficial Ownership Reporting Compliance" of the Proxy Statement.
ITEM 11. EXECUTIVE COMPENSATION
For information concerning executive compensation see "Executive
Compensation" of the Proxy Statement, which is incorporated as part of this
document by reference. Neither the Report of the Personnel and Compensation
Committee nor the Stock Performance Graph, both of which are contained in the
Proxy Statement, are incorporated as part of this document by this reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
For information concerning security ownership of certain beneficial owners
and management, see "Security Ownership of Management" of the Proxy Statement,
which is incorporated as part of this document by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
For information concerning certain relationships and related transactions,
see "Interest of Management in Certain Transactions" of the Proxy Statement,
which is incorporated as part of this document by reference.
37
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a)(1) The consolidated financial statements are contained as listed on the
"Index to Consolidated Financial Statements" on page F-1.
(2) All schedules are omitted because they are not required or applicable,
or the required information is shown in the consolidated financial statements
or notes.
(3) Exhibits
Exhibit
No.
- -------
3.1 Articles of Incorporation(1)
3.2 Bylaws of the Company(1)
10.1 1998 Stock Option and Restricted Stock Award Plan(2)
10.5 Form of Severance Agreement entered into between the Company and seven additional
executives, effective as of October 1, 1997.(1)
10.6 1997 Stock Option and Restricted Stock Award Plan(3)
10.7 Employment Agreement between the Company and Michael Broadhead, effective September 28,
1998(4)
10.8 Employment Agreement between the Company and Brian L. Vance, effective June 1, 2001.
10.9 Employment Agreement between the Company and Donald V. Rhodes, effective June 1, 2001.
21.0 Subsidiaries of the Company
23.0 Consent of KPMG LLP
24.0 Power of Attorney dated March 19, 2002
---
(1) Incorporated by reference to the Registration Statement on Form S-1
(Reg. No. 333-35573) declared effective on November 12, 1997.
(2) Incorporated by reference to the definitive Proxy Statement dated
September 14, 1998 for the Annual Meeting of Shareholders held on
October 15, 1998.
(3) Incorporated by reference to the Registration Statement on Form S-8
(Reg. No. 333-57513).
(4) Incorporated by reference to the Registration Statement on Form S-4
dated January 20, 1999.
(b) Reports on Form 8-K. The Company filed three reports on Form 8-K during
2001 as follows:
(1) April 26, 2001 Form 8-K announcing that the board of Heritage
Financial Corporation authorized the repurchase of an additional 10% of its
outstanding stock.
(2) May 14, 2001 Form 8-K announcing that Heritage Financial Corporation
completed the third round of share repurchases and commences the fourth stock
repurchase program.
(3) May 17, 2001 Form 8-K announcing a correction to the Form 8-K filed on
May 14, 2001 in regards to the inception date of repurchasing shares from
October 1999 to April 1999.
38
SIGNATURES
Pursuant to the requirements of Section 13 of the Securities Exchange Act of
1934, the Registrant has duly caused this report to be signed on its behalf by
the undersigned.
HERITAGE FINANCIAL CORPORATION
Principal Executive Officer:
/S/ DONALD V. RHODES
--------------------------------------
Donald V. Rhodes
Chairman, President and Chief
Executive Officer
Principal Financial Officer:
/S/ EDWARD D. CAMERON
--------------------------------------
Edward D. Cameron
Vice President and Treasurer
Dated: March 20, 2002
Donald V. Rhodes, pursuant to powers of attorney, which are being filed with
this Annual Report on Form 10-K, has signed this report on March 20, 2002, as
attorney-in-fact for the following directors who constitute a majority of the
board of directors.
Lynn M. Brunton Brian Charneski Jeffrey S. Lyon
Daryl D. Jensen H. Edward Odegard
James P. Senna Peter Fluetsch
Philip S. Weigand Melvin R. Lewis
/S/ DONALD V. RHODES
--------------------------------------
Donald V. Rhodes
Attorney in fact
March 19, 2002
39
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1999, 2000, and 2001
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
----
Independent Auditors' Report........................................................... F-2
Consolidated Statements of Financial Condition--December 31, 2000 and December 31, 2001 F-3
Consolidated Statements of Income--Years ended December 31, 1999, 2000, and 2001....... F-4
Consolidated Statements of Stockholders' Equity and Comprehensive Income--Years ended
December 31, 1999, 2000, and 2001.................................................... F-5
Consolidated Statements of Cash Flows--Years ended December 31, 1999, 2000, and 2001... F-6
Notes to Consolidated Financial Statements............................................. F-7
F-1
Independent Auditors' Report
The Board of Directors
Heritage Financial Corporation:
We have audited the accompanying consolidated statements of financial condition
of Heritage Financial Corporation and subsidiaries (Corporation) as of December
31, 2000 and 2001, and the related consolidated statements of income,
stockholders' equity and comprehensive income, and cash flows for each of the
years in the three year period ended December 31, 2001. These consolidated
financial statements are the responsibility of the Corporation's management.
Our responsibility is to express an opinion on these consolidated financial
statements based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of
Heritage Financial Corporation and subsidiaries as of December 31, 2000 and
2001, and the results of their operations and their cash flows for each of the
years in the three year period ended December 31, 2001 in conformity with
accounting principles generally accepted in the United States of America.
/s/ KMPG LLP
Seattle, Washington
February 8, 2002
F-2
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
December 31, 2000 and 2001
(Dollars in thousands)
2000 2001
-------- --------
ASSETS
Cash on hand and in banks...................................................... $ 20,187 $ 24,465
Interest earning deposits...................................................... 1,278 21,311
Federal funds sold............................................................. -- 5,000
Investment securities available for sale....................................... 33,693 26,479
Investment securities held to maturity......................................... 5,076 3,703
Loans held for sale............................................................ 1,931 6,275
Loans receivable............................................................... 480,504 492,430
Less: Allowance for loan losses................................................ (5,063) (5,751)
-------- --------
Loans receivable, net....................................................... 475,441 486,679
Real Estate Owned.............................................................. -- 1,269
Premises and equipment, at cost, net........................................... 19,510 18,984
Federal Home Loan Bank and Federal Reserve stock, at cost...................... 2,725 2,911
Accrued interest receivable.................................................... 3,693 3,196
Prepaid expenses and other assets.............................................. 2,779 2,731
Goodwill....................................................................... 7,217 6,640
-------- --------
$573,530 $609,643
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits....................................................................... $460,234 $515,080
Advances from Federal Home Loan Bank........................................... 23,125 8,000
Other borrowings............................................................... 1,000 --
Advance payments by borrowers for taxes and insurance.......................... 363 49
Accrued expenses and other liabilities......................................... 5,037 7,390
Deferred Federal income taxes, net............................................. 766 596
-------- --------
490,525 531,115
-------- --------
Stockholders' equity:
Common stock, no par, 15,000,000 shares authorized; 8,222,988 and 7,534,232
shares outstanding at December 31, 2000 and 2001, respectively............ 54,080 45,686
Unearned compensation--ESOP and Other....................................... (1,074) (975)
Retained earnings, substantially restricted................................. 30,000 33,775
Accumulated other comprehensive income, net................................. (1) 42
-------- --------
Total stockholders' equity.............................................. 83,005 78,528
Commitments and Contingencies............................................... -- --
-------- --------
$573,530 $609,643
======== ========
See accompanying notes to consolidated financial statements.
F-3
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
For the years ended December 31, 1999, 2000 and 2001
(Dollars in thousands, except per share amounts)
1999 2000 2001
----------- ---------- ----------
Interest income:
Loans............................................................. $ 32,886 $ 41,510 $ 43,111
Mortgage backed securities........................................ 227 180 301
Investment securities and Federal Home Loan Bank dividends........ 2,591 2,393 1,406
Interest on federal funds sold and overnight deposits............. 820 159 372
----------- ---------- ----------
Total interest income......................................... 36,524 44,242 45,190
----------- ---------- ----------
Interest expense:
Deposits.......................................................... 13,008 18,630 17,555
Other borrowings.................................................. 58 771 1,003
----------- ---------- ----------
Total interest expense........................................ 13,066 19,401 18,558
----------- ---------- ----------
Net interest income........................................ 23,458 24,841 26,632
Provision for loan losses............................................ 408 787 1,193
----------- ---------- ----------
Net interest income after provision for loan losses........ 23,050 24,054 25,439
----------- ---------- ----------
Noninterest income:
Gains on sales of loans, net...................................... 1,079 684 1,669
Commissions on sales of annuities and securities.................. 184 196 92
Services charges on deposits...................................... 1,378 1,590 1,989
Rental income..................................................... 205 239 267
Other income...................................................... 1,192 1,481 1,908
----------- ---------- ----------
Total noninterest income...................................... 4,038 4,190 5,925
----------- ---------- ----------
Noninterest expense:
Salaries and employee benefits.................................... 9,616 10,105 10,293
Building occupancy................................................ 2,870 3,066 3,346
FDIC premiums and special assessment.............................. 155 85 90
Data processing................................................... 1,226 1,195 1,048
Marketing......................................................... 450 401 392
Office supplies and printing...................................... 473 410 438
Goodwill amortization............................................. 577 577 577
Other............................................................. 3,406 3,484 4,440
----------- ---------- ----------
Total noninterest expense..................................... 18,773 19,323 20,624
----------- ---------- ----------
Income before Federal income tax expense................... 8,315 8,921 10,740
Federal income tax expense........................................... 2,958 2,947 3,778
----------- ---------- ----------
Net income................................................. $ 5,357 $ 5,974 $ 6,962
=========== ========== ==========
Basic earnings per common share...................................... $ 0.50 $ 0.66 $ 0.87
Basic weighted average shares........................................ 10,763,066 9,098,604 7,964,521
Diluted earnings per common share.................................... $ 0.49 $ 0.65 $ 0.86
Diluted weighted average shares...................................... 10,935,397 9,238,888 8,135,341
See accompanying notes to consolidated financial statements.
F-4
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME
For the years ended December 31, 1999, 2000 and 2001
(Dollars and shares in thousands)
Unrealized
gain on
Number of Unearned securities Total stock-
common Common compensation-- Retained available holders'
shares stock ESOP earnings for sale equity
--------- -------- -------------- -------- ---------- ------------
Balance at December 31, 1998........... 10,845 $ 77,476 $(1,242) $24,199 $ 126 $100,559
Earned ESOP shares..................... 9 (13) 88 -- -- 75
Exercise of stock options.............. 92 252 -- 19 -- 271
Stock repurchased...................... (921) (7,878) -- -- -- (7,878)
Net income............................. -- -- -- 5,357 -- 5,357
Net increase in unrealized gain on
securities available for sale, net of
taxes................................ -- -- -- -- (471) (471)
Cash dividends declared................ -- -- -- (2,649) -- (2,649)
------ -------- ------- ------- ----- --------
Balance at December 31, 1999........... 10,025 $ 69,837 (1,154) 26,926 (345) 95,264
Earned ESOP shares..................... 9 (5) 80 -- -- 75
Exercise of stock options.............. 41 200 -- -- -- 200
Stock repurchased...................... (1,852) (15,952) -- -- -- (15,952)
Net income............................. -- -- -- 5,974 -- 5,974
Net increase in unrealized gain on
securities available for sale, net of
taxes................................ -- -- -- -- 344 344
Cash dividends declared................ -- -- -- (2,900) -- (2,900)
------ -------- ------- ------- ----- --------
Balance at December 31, 2000........... 8,223 $ 54,080 (1,074) 30,000 (1) 83,005
Earned ESOP shares..................... 9 5 99 -- -- 104
Exercise of stock options.............. 102 411 -- -- -- 411
Stock repurchased...................... (800) (8,810) -- -- -- (8,810)
Net income............................. -- -- -- 6,962 -- 6,962
Net increase in unrealized gain on
securities available for sale, net of
taxes................................ -- -- -- -- 43 43
Cash dividends declared................ -- -- -- (3,187) -- (3,187)
------ -------- ------- ------- ----- --------
Balance at December 31, 2001........... 7,534 $ 45,686 $ (975) $33,775 $ 42 $ 78,528
====== ======== ======= ======= ===== ========
Comprehensive Income 1999 2000 2001
-------------------- ------ ------ ------
Net income............................................................................ $5,357 $5,974 $6,962
Increase (decrease) in unrealized gain on securities available for sale, net of tax of
$(243), 179 and 22.................................................................. (471) 344 43
------ ------ ------
Comprehensive income.................................................................. $4,886 $6,318 $7,005
====== ====== ======
See accompanying notes to consolidated financial statements.
F-5
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the years ended December 31, 1999, 2000 and 2001
(Dollars in thousands)
1999 2000 2001
-------- -------- --------
Cash flows from operating activities:
Net income........................................................................ $ 5,357 $ 5,974 $ 6,962
Adjustments to reconcile net income to net cash provided by operating activities,
net of effect of acquisition:
Depreciation and amortization.................................................... 2,267 2,256 2,303
Gain on sale of investment securities available for sale......................... -- -- (41)
Gain on sale of other investments................................................ -- -- (157)
Deferred loan fees, net of amortization.......................................... (193) (71) 28
Provision for loan losses........................................................ 408 787 1,193
Net decrease (increase) in loans held for sale................................... 7,029 (1,342) (4,344)
Deferred Federal income tax expense (benefit).................................... (53) (271) (192)
Federal Home Loan Bank stock dividends and Federal Reserve Stock................. (156) (153) (186)
Recognition of compensation related to ESOP...................................... 75 75 104
Net change in accrued interest receivable, prepaid expenses and other assets,
and accrued expenses and other liabilities..................................... 444 (2,670) 2,889
-------- -------- --------
Net cash provided by operating activities..................................... 15,178 4,585 8,559
-------- -------- --------
Cash flows from investing activities, net of effect of acquisition:
Loans originated, net of principal payments and loan sales........................ (97,747) (63,248) (13,728)
Maturities of investment securities available for sale............................ 8,860 3,329 48,649
Sales of investment securities available for sale................................. -- -- 6,041
Maturities of investment securities held to maturity.............................. 10,005 1,093 1,679
Purchase of investment securities held to maturity................................ (265) -- (325)
Purchase of investment securities available for sale.............................. (14,258) (476) (47,370)
Proceeds from sale of other investments........................................... -- -- 157
Purchase of premises and equipment................................................ (2,441) (2,319) (1,181)
-------- -------- --------
Net cash used in investing activities......................................... (95,846) (61,621) (6,078)
-------- -------- --------
Cash flows from financing activities, net of effect of acquisition:
Net increase in deposits.......................................................... 37,964 55,166 54,846
Net increase (decrease) in FHLB advances.......................................... 2,113 20,325 (15,125)
Net increase (decrease) in other borrowed funds................................... (9) 992 (1,000)
Net (decrease) in advance payments by borrowers for taxes and insurance........... (101) (12) (314)
Cash dividends paid............................................................... (2,438) (2,863) (3,178)
Exercise of stock options......................................................... 271 200 411
HFC Stock repurchased............................................................. (7,435) (15,952) (8,810)
-------- -------- --------
Net cash provided by financing activities..................................... 30,365 57,856 26,830
-------- -------- --------
Net increase (decrease) in cash and cash equivalents.......................... (50,303) 820 29,311
Cash and cash equivalents at beginning of year...................................... 70,948 20,645 21,465
Cash and cash equivalents at end of year............................................ $ 20,645 $ 21,465 $ 50,776
======== ======== ========
Supplemental disclosures of cash flow information:
Cash payments for:
Interest expense................................................................. $ 12,692 $ 19,159 $ 19,161
Federal income taxes............................................................. 2,883 3,492 2,962
Supplemental disclosure of noncash investing activities:
Mortgage loans transferred to real estate owned................................... $ -- $ -- $ 1,269
See accompanying notes to consolidated financial statements.
F-6
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands)
(1) Summary of Significant Accounting Policies
(a) Description of Business
Heritage Financial Corporation (the Company) is a bank holding company
incorporated in the State of Washington in August 1997. The Company is
primarily engaged in the business of planning, directing and coordinating the
business activities of its wholly owned subsidiaries: Heritage Bank, and
Central Valley Bank. Heritage Bank is a Washington-chartered savings bank whose
deposits are insured by the Federal Deposit Insurance Corporation (FDIC) under
the Savings Association Insurance Fund (SAIF). Heritage Bank conducts business
from its main office in Olympia, Washington and its eleven branch offices
located in Thurston, Pierce and Mason Counties. Central Valley Bank is a
National Bank whose deposits are insured by the Federal Deposit Insurance
Corporation (FDIC) under the Bank Insurance Fund (BIF). Central Valley Bank
conducts business from its main office in Toppenish, Washington, and its five
branch offices located in Yakima and Kittitas Counties.
The Company's business consists primarily of focusing on lending and deposit
relationships with small businesses including agribusiness and their owners in
its market area, attracting deposits from the general public and originating
for sale or investment purposes first mortgage loans on residential properties
located in western and central Washington. The Company also makes residential
construction loans, income property loans and consumer loans.
(b) Basis of Presentation
The accounting and reporting policies of the Company and its subsidiaries
conform to accounting principles generally accepted in the United States of
America. In preparing the consolidated financial statements, management makes
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
financial statements and the reported amounts of income and expense during the
reporting periods. Material estimates that are particularly susceptible to
significant change relate to the determination of the allowance for loan losses
and the valuation of real estate owned. Actual results could differ from these
estimates.
The accompanying consolidated financial statements include the accounts of
the Company and its wholly owned subsidiaries.
Effective March 5, 1999, the company acquired all of the outstanding common
stock of Washington Independent Bancshares, Inc., (whose wholly owned
subsidiary is Central Valley Bank, N.A., Toppenish, Washington) in exchange for
1,058,009 shares of Heritage common stock. This transaction was accounted for
as a pooling of interests and, accordingly, the Company's financial information
reported herein has been restated to include the accounts and results of
operations of Washington Independent Bancshares, Inc., for all periods
presented. All significant intercompany balances and transactions among the
Company and its subsidiaries have been eliminated in consolidation. Certain
amounts in the consolidated financial statements for prior years have been
reclassified to conform to the current consolidated financial statement
presentation.
(c) Cash and Cash Equivalents
For purposes of reporting cash flows, cash and cash equivalents includes
cash on hand and in banks, interest bearing deposits, and federal funds sold.
The Company is required to maintain an average reserve balance with the
Federal Reserve Bank in the form of cash. For the years ended December 31, 2000
and 2001 the Company maintained adequate levels of cash to meet the Federal
Reserve Bank requirement.
F-7
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
(d) Investment Securities
The Company identifies investments as held to maturity or available for sale
at the time of acquisition. Securities are classified as held to maturity when
the Company has the ability and positive intent to hold them to maturity.
Securities classified as available for sale are available for future liquidity
requirements and may be sold prior to maturity.
Investment securities held to maturity are recorded at cost, adjusted for
amortization of premiums or accretion of discounts using the straight-line
method. Securities available for sale are carried at fair value. Unrealized
gains and losses on securities available for sale are excluded from earnings
and are reported in other comprehensive income. Realized gains and losses on
sale are computed on the specific identification method.
(e) Loans Receivable and Loans Held for Sale
Loans are generally recorded at their outstanding principal balance adjusted
for charge-offs, the allowance for loan losses and deferred fees or any costs
on originated loans. Interest on loans is calculated using the simple interest
method based on the daily balance of the principal amount outstanding and is
credited to income as earned.
The accrual of interest on mortgage and commercial loans is discontinued at
the time the loan is 90 days delinquent unless the credit is well secured and
in the process of collection. Credit card loans and other personal loans are
typically charged-off no later than 180 days past due. In all cases, loans are
placed on non-accrual or charged-off at an earlier date if collection of
principal or interest is doubtful.
All interest accrued but not collected on loans that are placed on
non-accrual or charged-off is reversed against interest income. The interest on
these loans is accounted for on the cash-basis or cost-recovery method, until
qualifying for return to accrual. Loans are returned to accrual status when all
principal and interest amounts contractually due are brought current and future
payments are reasonably assured.
Discounts and premiums on purchased loans are amortized using the effective
interest method over the remaining contractual lives, adjusted for actual
prepayments. Mortgage loans held for sale are carried at the lower of amortized
cost or market value determined on an aggregate basis. Any loan that management
determines will not be held to maturity is classified as held for sale at the
time of origination, purchase or securitization, or when such decision is made.
Unrealized losses on such loans are included in income.
(f) Loan Fees
Loan origination fees and certain direct origination costs are deferred and
amortized as an adjustment of the yields of the loans over their contractual
lives, adjusted for prepayment of the loans, using the effective interest
method. In the event loans are sold, the deferred net loan origination fees or
costs are recognized as a component of the gains or losses on the sales of
loans.
(g) Allowance for Loan Losses
The allowance for loan losses is established as losses are estimated to have
occurred through a provision for loan losses charged to earnings. Losses are
charged against the allowance when management believes the uncollectibility of
a loan balance is confirmed. Subsequent recoveries, if any, are credited to the
allowance.
F-8
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
The allowance for loan losses is evaluated on a regular basis by management
and is based upon management's periodic review of the collectibility of the
loans in light of historical experience, the nature and volume of the loan
portfolio, adverse situations that may affect the borrower's ability to repay,
estimated value of any underlying collateral and prevailing economic
conditions. The evaluation is inherently subjective, as it requires estimates
that are susceptible to significant revision as more information becomes
available.
While management uses available information to recognize losses on loans,
future additions to the allowance may be necessary based on changes in economic
conditions. In addition, various regulatory agencies, as an integral part of
their examination process, periodically review the Bank's allowance for loan
losses. Such agencies may require the Bank to make additions to the allowance
based on their judgments about information available to them at the time of
their examinations.
(h) Impaired Loans
A loan is considered impaired when, based on current information and events,
it is probable the Company will be unable to collect the scheduled payments of
principal or interest when due according to the contractual terms of the loan
agreement. Factors considered by management in determining impairment include
payment status, collateral value, and the probability of collecting scheduled
principal and interest payments when due. Loans that experience insignificant
payment delays and payment shortfalls generally are not classified as impaired.
Management determines the significance of payment delays and payment shortfalls
on a case-by-case basis, taking into consideration all of the circumstances
surrounding the loan and the borrowers, including length of the delay, the
reasons for the delay, the borrower's prior payment record, and the amounts of
the shortfall in relation to the principal and interest owned. Impairment is
measured on a loan by loan basis for commercial and construction loans by
either the present value of expected future cash flows discounted at the loan's
effective interest rate, the loan's obtainable market price, or the fair value
of the collateral if the loan is collateral dependent.
Large groups of smaller balance homogeneous loans are collectively evaluated
for impairment. Accordingly, the Company does not separately identify
individual consumer and residential loans for impairment disclosures.
(i) Mortgage Banking Operations
Heritage Bank sells mortgage loans primarily on a servicing released basis
and recognizes a cash gain or loss. A cash gain or loss is recognized to the
extent that the sales proceeds of the mortgage loans sold exceed or are less
than the net book value at the time of sale.
Loan servicing income is recorded when earned. Loan servicing costs are
charged to expense as incurred.
(j) Real Estate Owned
Real estate acquired by the Bank in satisfaction of debt is held for sale
and recorded at fair value at time of foreclosure and is carried at the lower
of the new cost basis or fair value less estimated costs to sell.
(k) Premises and Equipment
Premises and equipment are stated at cost less accumulated depreciation and
amortization. Depreciation and amortization are computed using the
straight-line method over the estimated useful lives of the assets. The
F-9
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
estimated useful lives used to compute depreciation and amortization for
buildings and building improvements, is 30 to 40 years; and for furniture,
fixtures and equipment, 3 to 10 years.
(l) Goodwill
Goodwill represents the costs in excess of net assets acquired arising from
the purchase of North Pacific Bank and was being amortized on a straight-line
basis over 15 years. Accumulated amortization of goodwill amounted to $1,443
and $2,020 as of December 31, 2000 and 2001, respectively. As a result of the
new accounting standards SFAS No. 141--Business Combinations and SFAS No.
142--Goodwill and Other Intangibles, effective January 1, 2002 goodwill will no
longer be amortized. Instead, goodwill is reviewed for impairment and written
down and charged to income during the periods in which the recorded value is
more than its fair value. The Company does not expect to have impairment of
goodwill.
(m) Federal Income Taxes
The Company files a consolidated federal income tax return. Deferred tax
assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amounts of
existing assets and liabilities and their respective tax bases. Deferred tax
assets and liabilities are measured using enacted tax rates expected to apply
to taxable income in the periods in which those temporary differences are
expected to be recovered or settled. The effect on deferred tax assets and
liabilities of a change in tax rate is recognized in income in the period that
includes the enactment date.
(n) Employee Stock Ownership Plan
Heritage Bank sponsors an Employee Stock Ownership Plan (ESOP). The ESOP
purchased 2% of the common stock issued in the January 1998 stock offering and
borrowed from the Company in order to fund the purchase of the Company's common
stock. The loan to the ESOP will be repaid principally from the Bank's
contributions to the ESOP. The Bank's contributions will be sufficient to
service the debt over the 15 year loan term at the interest rate of 8.5%. As
the debt is repaid, shares are released and allocated to plan participants
based on the proportion of debt service paid during the year. As shares are
released, compensation expense is recorded equal to the then current market
price of the shares and the shares become outstanding for earnings per share
calculations. Cash dividends on allocated shares are recorded as a reduction of
retained earnings and paid or distributed directly to participants' accounts.
Cash dividends on unallocated shares are recorded as a reduction of debt and
accrued interest.
(o) Stock Based Compensation
The Company measures its employee stock-based compensation arrangements
using the provisions outlined in Accounting Principles Board (APB) Opinion No.
25, Accounting for Stock Issued to Employees, which is an intrinsic value-based
method of recognizing compensation costs. The Company has adopted the
disclosure-only provisions of SFAS No. 123, Accounting for Stock-based
Compensation. As none of the Company's stock options have any intrinsic value
at grant date, no compensation cost has been recognized for its stock option
plan activity.
(p) Recent Financial Accounting Pronouncements
In September 2000, The Financial Accounting Standards Board issued SFAS No.
140, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities," and replaced SFAS No. 125 of
F-10
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
the same title. This statement revises the standards for accounting for
securitizations and other transfers of financial assets and collateral and
requires certain disclosures, but carries over most of SFAS No. 125's
provisions without reconsideration. This statement is effective for transfers
and servicing of financial assets and extinguishments of liabilities occurring
after March 31, 2001 and is effective for recognition and reclassification of
collateral and for disclosures relating to securitization transactions and
collateral for fiscal years ending after December 15, 2000. We adopted SFAS
Statement No. 140 and it did not have a material impact on our consolidated
financial statements.
In July 2001, the Financial Accounting Standards Board (FASB) issued SFAS
No. 141 "Business Combinations" and SFAS No. 142 "Goodwill and Other Intangible
Assets". SFAS No. 141 requires business combinations initiated after June 30,
2001 to be accounted for using the purchase method of accounting, and broadens
the criteria for recording intangible assets separate from goodwill. Recorded
goodwill and intangibles will be evaluated against this new criteria and may
result in certain intangibles being included in goodwill. Alternatively,
certain amounts initially recorded as goodwill may be separately identified and
recognized apart from goodwill. SFAS No. 142 requires the use of a
nonamortization approach to account for purchased goodwill and certain
intangibles. Under a nonamortization approach, goodwill and certain intangibles
will not be amortized into results of operations, but instead would be reviewed
for impairment and written down and charged to results of operations only in
the periods in which the recorded value of goodwill and certain intangibles is
more than its fair value. The provisions of each statement, which apply to
goodwill and intangible assets acquired prior to June 30, 2001 will be adopted
by the Company on January 1, 2002. Nonamortized goodwill in the amount of
$6,640 is subject to the transition provisions of SFAS 141 and 142.
In June 2001, the Financial Accounting Standards Board issued Statement No.
143, "Accounting for Asset Retirement Obligations", which addresses financial
accounting and reporting for obligations associated with the retirement of
tangible long-lived assets and the associated asset retirement costs. The
standard applies to legal obligations associated with the retirement of
long-lived assets that result from the acquisition, construction, development
and (or) normal use of the asset. Statement No. 143 requires that the fair
value of a liability for an asset retirement obligation be recognized in the
period in which it is incurred if a reasonable estimate of fair value can be
made. The fair value of the liability is added to the carrying amount of the
associated asset and this additional carrying amount is depreciated over the
life of the asset. The liability is accreted at the end of each period through
charges to operating expense. If the obligation is settled for other than the
carrying amount of the liability, the Company will recognize a gain or loss on
settlement. The Company is required and plans to adopt the provisions of
Statement No. 143 for the quarter ending March 31, 2003. Management does not
expect this Statement to materially effect the results of operations or the
financial position of the Company.
In August 2001, the Financial Accounting Standards Board (FASB or the Board)
issued FASB Statement No. 144, "Accounting for the Impairment or Disposal of
Long-Lived Assets", which addresses financial accounting and reporting for the
impairment or disposal of long-lived assets. While Statement No. 144 supersedes
FASB Statement No. 121, "Accounting for the Impairment of Long-Lived Assets and
for Long-Lived Assets to Be Disposed Of", it retains many of the fundamental
provisions of that Statement. Statement No. 144 also supersedes the accounting
and reporting provisions of APB Opinion No. 30, "Reporting the Results of
Operations--Reporting the Effects of Disposal of a Segment of a Business, and
Extraordinary, Unusual and Infrequently Occurring Events and Transactions", for
the disposal of a segment of a business. However, it retains the requirement in
Opinion No. 30 to report separately discontinued operations and extends that
reporting to a component of an entity that either has been disposed of (by
sale, abandonment, or in a distribution to owners) or is classified as held for
sale. This statement was adopted January 1, 2002 and did not have a material
effect on the results of operations or the financial position of the Company.
F-11
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
(2) Loans Receivable and Loans Held for Sale
Loans receivable and loans held for sale at December 31, 2000 and 2001
consist of the following:
2000 2001
-------- -------
Commercial loans................................................ $234,166 263,063
Real estate mortgages:
One to four family residential............................... 107,501 91,189
Five or more family residential and commercial real estate... 109,560 107,450
-------- -------
Total real estate mortgage............................... 217,061 198,639
Real estate construction:
One to four family residential............................... 27,412 32,494
Five or more family residential and commercial real estate... -- 83
-------- -------
Total real estate construction........................... 27,412 32,577
Consumer........................................................ 5,466 5,794
-------- -------
Subtotal................................................. 484,105 500,073
Unamortized yield adjustments................................... (1,670) (1,368)
-------- -------
Total loans receivable and loans held for sale........ $482,435 498,705
======== =======
As of December 31, 2000 and 2001, the Company had loans to persons serving
as Directors and Executive Officers, and entities related to such individuals,
aggregating $1,207 and $3,299, respectively. All loans were made on essentially
the same terms and conditions as comparable transactions with other persons,
and did not involve more than the normal risk of collectibility.
Accrued interest on loans receivable amounted to $3,276 and $2,923 as of
December 31, 2000 and 2001, respectively. The weighted average interest rate on
loans was 9.0% and 7.8% for December 31, 2000 and 2001, respectively. The
Company had $1,607 and $1,962 of impaired loans, which were nonaccruing as of
December 31, 2000 and 2001, respectively. The annual average balance of
impaired loans for the years ended December 31, 2000 and 2001 were $1,820 and
$1,655, respectively. The allowance for loan losses specifically allocated to
impaired loans at December 31, 2000 and 2001 totaled $241 and $345,
respectively. Interest recognized on impaired loans for the years ended
December 31, 2000 and 2001 totaled $23 and $26, respectively. Interest on
nonaccrual loans foregone was $60, $130, and $173 for the years ended December
31, 1999, 2000 and 2001, respectively. The Company has no commitments to extend
additional credit on loans that are nonaccrual or impaired at December 31, 2001.
Details of certain mortgage banking activities at December 31, 2000 and 2001
are as follows:
2000 2001
------ ------
Loans held for sale at lower of cost or market................................... $1,931 6,275
Loans serviced for others........................................................ 7,883 6,349
Commitments to sell mortgage loans............................................... 2,831 10,465
Commitments to fund mortgage loans (at interest rates approximating market rates)
Fixed rate.................................................................... 4,241 6,747
Variable or adjustable rate................................................... -- 412
F-12
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
Servicing fee income from mortgage loans serviced for others amounted to
$34, $27 and $22 for the years ended December 31, 1999, 2000 and 2001,
respectively.
Commitments to sell mortgage loans are made primarily during the period
between the taking of the loan application and the closing of the mortgage
loan. The timing of making these sale commitments is dependent upon the timing
of the borrower's election to lock-in the mortgage interest rate and fees prior
to loan closing. Most of these sale commitments are made on a best-efforts
basis whereby the Bank is only obligated to sell the mortgage if the mortgage
loan is approved and closed by the Bank.
As of December 31, 2001, the Company had commitments of $56.0 million in
other commercial lines of credit, $19.3 million in real estate commitments
(both construction and lines of credit), and $12.1 million in other commitments
(including consumer credit lines and letters of credit).
(3) Allowance for Loan Losses
Activity in the allowance for loan losses is summarized as follows for the
years ended December 31,:
1999 2000 2001
------ ----- -----
Balance at beginning of period $3,957 4,264 5,063
Provision.................. 408 787 1,193
Recoveries................. 146 52 2
Charge offs................ (247) (40) (507)
------ ----- -----
Balance at end of period...... $4,264 5,063 5,751
====== ===== =====
F-13
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
(4) Investment Securities Available For Sale
The amortized cost and fair values of investment securities available for
sale at the dates indicated are as follows:
Gross Gross
Amortized unrealized unrealized Fair
cost gains losses value
--------- ---------- ---------- ------
December 31, 1999
U.S. Government and its agencies....... $33,192 -- (669) 32,523
Mortgage backed and related securities:
Collateralized mortgage obligations. 1,611 -- (28) 1,583
Other............................... 1,100 184 (8) 1,276
Corporate notes........................ 1,000 1 (5) 996
------- --- ---- ------
Totals.......................... $36,903 185 (710) 36,378
======= === ==== ======
December 31, 2000
U.S. Government and its agencies....... $30,796 19 (126) 30,689
Mortgage backed and related securities:
Collateralized mortgage obligations. 1,377 -- (19) 1,358
Other............................... 1,022 127 (4) 1,145
Corporate notes........................ 500 1 -- 501
------- --- ---- ------
Totals.......................... $33,695 147 (149) 33,693
======= === ==== ======
December 31, 2001
U.S. Government and its agencies....... $19,317 95 (115) 19,297
Mortgage backed and related securities:
Collateralized mortgage obligations. 2,159 9 (37) 2,131
Other............................... 4,941 140 (30) 5,051
------- --- ---- ------
Totals.......................... $26,417 244 (182) 26,479
======= === ==== ======
The amortized cost and fair value of securities available for sale, by
contractual maturity, at December 31, 2001 are shown below:
Amortized Fair
cost value
--------- ------
Due in one year or less............... $ 775 921
Due after one year through three years 5,570 5,592
Due after three through five years.... 12,997 12,937
Due after five years through ten years 498 491
Due after ten years................... 6,577 6,538
------- ------
Totals................................ $26,417 26,479
======= ======
There were no sales of investment securities available for sale during the
years ended December 31, 1999, and 2000. During the year ended December 31,
2001 there were sales of investment securities available for sale resulting in
a $41 gain.
F-14
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
Accrued interest on investment securities available for sale amounted to
$385, $380 and $231 as of December 31, 1999, 2000 and 2001, respectively.
At December 31, 1999, 2000 and 2001, investment securities available for
sale with fair values of $14,608, $18,859 and $9,989, respectively, were
pledged to secure public deposits and for other purposes as required or
permitted by law.
We had no securities available for trading at December 31, 1999, 2000 or
2001.
(5) Investment Securities Held to Maturity
The amortized cost and fair values of investment securities held to maturity
are as follows:
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses value
--------- ---------- ---------- -----
December 31, 1999
U.S. Government and its agencies $1,200 -- (6) 1,194
Mortgage backed securities:
FNMA certificates............ 433 15 (1) 447
FHLMC certificates........... 544 15 -- 559
GNMA certificates............ 1,422 65 -- 1,487
Municipal bonds................. 2,566 4 (38) 2,532
------ --- --- -----
$6,165 99 (45) 6,219
====== === === =====
December 31, 2000
U.S. Government and its agencies $ 900 -- (1) 899
Mortgage backed securities:
FNMA certificates............ 318 9 -- 327
FHLMC certificates........... 437 13 -- 450
GNMA certificates............ 1,211 68 -- 1,279
Municipal bonds................. 2,210 14 (5) 2,219
------ --- --- -----
$5,076 104 (6) 5,174
====== === === =====
December 31, 2001
U.S. Government and its agencies $ -- -- -- --
Mortgage backed securities:
FNMA certificates............ 232 15 -- 247
FHLMC certificates........... 350 21 -- 371
GNMA certificates............ 976 85 -- 1,061
Municipal bonds................. 2,145 60 -- 2,205
------ --- --- -----
$3,703 181 -- 3,884
====== === === =====
F-15
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
The amortized cost and fair value of investment securities held to maturity,
by contractual maturity, at December 31, 2001 are shown below:
Amortized Fair
cost value
--------- -----
Due in one year or less................. $ 425 432
Due after one year through three years.. 704 730
Due after three years through five years 684 706
Due after five years through ten years.. 577 598
Due after ten years..................... 1,313 1,418
------ -----
Totals.................................. $3,703 3,884
====== =====
There were no sales of investment securities held to maturity during the
years ended December 31, 1999, 2000 and 2001.
Accrued interest on investment securities held to maturity amounted to $33,
$34 and $23 as of December 31, 1999, 2000 and 2001, respectively.
At December 31, 1999, 2000 and 2001, investment securities held to maturity
with amortized cost values of $700, $820 and $5,157, respectively, were pledged
to secure public deposits and for other purposes as required or permitted by
law.
(6) Premises and Equipment
A summary of premises and equipment at December 31, 2000 and 2001 follows:
2000 2001
------- ------
Land............................... $ 4,519 4,548
Buildings and building improvements 16,628 16,437
Furniture, fixtures and equipment.. 11,207 12,629
------- ------
32,354 33,614
Less accumulated depreciation...... 12,844 14,630
------- ------
$19,510 18,984
======= ======
(7) Deposits
Deposits at December 31, 2000 and 2001 consist of the following:
2000 2001
--------------- ---------------
Amount Percent Amount Percent
-------- ------- -------- -------
Non interest demand deposits $ 51,298 11.1% $ 54,157 10.5%
NOW accounts................ 47,315 10.3 65,232 12.7
Money market accounts....... 59,790 13.0 68,523 13.3
Savings accounts............ 54,830 11.9 88,543 17.2
Certificate accounts........ 247,001 53.7 238,625 46.3
-------- ----- -------- -----
$460,234 100.0% $515,080 100.0%
======== ===== ======== =====
F-16
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
The combined weighted average interest rate of deposits was 4.46% and 2.42%
at December 31, 2000 and 2001, respectively. Accrued interest payable on
deposits was $890 and $319 at December 31, 2000 and 2001, respectively.
Interest expense, by category, for the years ended December 31, 1999, 2000 and
2001 are as follows:
1999 2000 2001
------- ------ ------
NOW accounts......... $ 767 990 1,045
Money market accounts 2,872 2,972 2,888
Savings accounts..... 1,098 1,050 825
Certificate accounts. 8,271 13,618 12,797
------- ------ ------
$13,008 18,630 17,555
======= ====== ======
At December 31, 2001, the scheduled maturities of certificates of deposit
are as follows:
Within one year............. $215,886
Between one and two years... 20,070
Between two and three years. 2,349
Between three and four years 233
Between four and five years. 87
--------
$238,625
========
Certificates of deposit issued in denominations equal to or in excess of
$100,000 totaled $96,069 and $97,054 at December 31, 2000 and 2001,
respectively.
(8) FHLB Advances and Stock
The Federal Home Loan Bank of Seattle (FHLB) functions as a central reserve
bank providing credit for member financial institutions. As members, Heritage
Bank and Central Valley Bank are required to own capital stock in the FHLB and
are authorized to apply for advances on the security of such stock and certain
of its mortgage loans and other assets (principally securities which are
obligations of, or guaranteed by, the United States) provided certain standards
related to creditworthiness have been met. Advances are made pursuant to
several different programs. Each credit program has its own interest rate and
range of maturities. Depending on the program, limitations on the amount of
advances are based either on a fixed percentage of an institution's net worth
or on the FHLB's assessment of the institution's creditworthiness. Under its
current credit policies, the FHLB of Seattle limits advances to 20.0% of assets
for Heritage Bank and 10% of assets for Central Valley Bank. At December 31,
2001, the Banks maintained a credit facility with the FHLB of Seattle for $122
million (of which $8.0 million was outstanding at that date).
The Company is required to maintain an investment in the stock of FHLB in an
amount equal to at least 1% of the unpaid principal balances of the Bank's
residential mortgage loans or 5% of its outstanding advances from the FHLB,
whichever is greater. At December 31, 2001, the Company was required to
maintain an investment in the stock of FHLB of Seattle of at least $1.8
million. Purchases and sales of stock are made directly with the FHLB at par
value.
F-17
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
A summary of FHLB Advances is summarized as follows:
1999 2000 2001
------ ------- -------
Balance at period end...................... $2,800 $23,125 $ 8,000
Average balance............................ 958 10,451 17,924
Maximum amount outstanding at any month end 3,300 23,125 33,300
Average interest rate:
During the period....................... 5.90% 6.58% 5.33%
At period end........................... 5.70% 6.81% 5.01%
At December 31, 2000 the Company had overnight advances of $7,125 at 6.81%
from FHLB. At December 31, 2001 the Company did not have any overnight advances
from the FHLB.
FHLB advances other than overnight advances require interest only payments
monthly, principal due at maturity and are summarized as follows at December
31,:
2000 2001
------ ------
Note payable, interest at 6.52% due January 19, 2001. $5,000 --
Note payable, interest at 6.40% due January 24, 2001. 5,000 --
Note payable, interest at 6.45% due March 21, 2001... 1,000 --
Note payable, interest at 5.88% due December 24, 2001 5,000 --
Note payable, interest at 5.22% due January 18, 2002. -- $2,000
Note payable, interest at 5.16% due February 12, 2002 -- 2,000
Note payable, interest at 4.92% due March 1, 2002.... -- 2,000
Note payable, interest at 4.75% due March 15, 2002... -- 2,000
Advances from the FHLB are collateralized by a blanket pledge on FHLB stock
owned by the Company, deposits at the FHLB and all mortgages or deeds of trust
securing such properties. In accordance with the pledge agreement, the Company
must maintain unencumbered collateral in an amount equal to varying percentages
ranging from 100% to 125% of outstanding advances depending on the type of
collateral. At December 31, 2001 the Company was required to maintain $166,137
in collateral to meet the collateral requirements of FHLB.
The Heritage Bank and Central Valley Bank may borrow from the FHLB in
amounts up to 20% and 10% of their total assets, respectively.
(9) Federal Funds Purchased
The maximum and average outstanding balances and average interest rates on
federal funds purchased are summarized as follows:
1999 2000 2001
----- ------ -----
Maximum outstanding at any month-end $ -- $1,300 $ 175
Average outstanding................. 20 501 82
Weighted average interest rate:
For the period................... 5.41% 6.84% 6.52%
End of period.................... -- 7.13% --
Central Valley Bank maintains a federal funds line with Key Bank for $3,700.
This line is renewed annually, and currently matures July 1, 2002. As of
December 31, 2001 there were no overnight federal funds purchased.
F-18
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
(10) Key Bank Line of Credit
At the holding company level we maintain a line of credit for $5 million
with Key Bank to supplement any cash needs not covered by dividends from the
banks or earnings from investments retained from proceeds of the conversion.
This line is renewed annually, and currently matures in March 2002. The line
has an annual commitment fee of $25,000 and if required levels of borrowings
are not maintained then a $12,500 fee is due in March 2002. The minimum
borrowings were not maintained during 2001 and therefore this fee will be
required to be paid. There were no outstanding balances with the Key Bank line
of credit as of December 31, 2000 or 2001.
The holding company maintains a line of credit with Key Bank for short-term
corporate funding needs. The usage on the Key Bank line of credit is summarized
as follows:
1999 2000 2001
---- ------ -----
Balance at period end.......................... $ -- $ -- $ --
Average balance during the period. . . . ...... -- 380 118
Maximum amount outstanding at any month end . . -- 2,043 168
Average interest rate:
During the period........................... -- 9.86% 7.12%
At period end............................... -- 9.50% 4.75%
(11) Federal Income Taxes
Federal income tax expense (benefit) consists of the following for the years
ended December 31,:
1999 2000 2001
------ ----- -----
Current. $3,011 3,218 3,970
Deferred (53) (271) (192)
------ ----- -----
$2,958 2,947 3,778
====== ===== =====
Federal income tax expense differs from that computed by applying the
Federal statutory income tax rate of 34% and 35% for income in excess of $10
million for the years ended December 31,:
1999 2000 2001
------ ----- -----
Income tax expense at Federal statutory rate $2,827 3,033 3,652
Goodwill.................................... 199 196 196
Other, net.................................. (68) (282) (70)
------ ----- -----
$2,958 2,947 3,778
====== ===== =====
F-19
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
The following table presents major components of the deferred Federal income
tax liability resulting from differences between financial reporting and tax
bases for the years ended December 31,:
2000 2001
------- ------
Deferred tax assets:
Allowance for loan losses................... $(1,224) (1,604)
Management bonus............................ (68) (56)
Vacation benefits........................... (101) (88)
Other....................................... (92) (122)
------- ------
Total deferred tax assets............... (1,485) (1,870)
Deferred tax liabilities:
Deferred loan fees.......................... 700 704
Premises and equipment...................... 975 1,101
FHLB stock.................................. 576 639
Other....................................... -- 22
Total deferred tax liabilities.......... 2,251 2,466
------- ------
Deferred Federal taxes payable, net..... $ 766 596
======= ======
The realization of the Company's deferred tax assets is dependent upon the
Company's ability to generate taxable income in future periods. Management has
evaluated available evidence supporting the realization of its deferred tax
assets and determined it is more likely than not that deferred tax assets will
be realized.
The Company has qualified under provisions of the Internal Revenue Code to
compute federal income taxes after deductions of additions to the bad debt
reserves. At December 31, 2001, the Company had a taxable temporary difference
of approximately $2.8 million that arose before 1988 (base-year amount). In
accordance with Statement of Financial Accounting Standards No. 109, a deferred
tax liability has not been recognized for the temporary difference. Management
does not expect this temporary difference to reverse in the foreseeable future.
(12) Stockholders' Equity
(a) Stock Repurchase Program
On April 26, 1999 the board of directors of the Company authorized the
repurchase in the open market of 100,000 of its outstanding common shares. This
was accomplished in the second quarter of 1999 for $0.8 million, or $8.56 per
share. In October of 1999, the Company began the first of four stock repurchase
programs. The first totaling 1,082,389 shares, or 10% of the then outstanding
shares was commenced in October 1999 and completed in February 2000. The second
totaling 976,748 shares, or 10% of the then outstanding shares was commenced in
February 2000 and completed in August 2000. The third program for a total of
890,000 shares representing 10% of the then outstanding shares was commenced in
August 2000 and completed in May 2001. The fourth program commenced during May
2001 for a total of 800,000 shares, representing 10% of the then outstanding
shares, of which 521,089 shares were repurchased as of December 31, 2001.
Collectively as of December 31, 2001, the Company repurchased 3,573,380 shares
of our stock representing 33% of the total outstanding as of March 31, 1999 at
an average price of $9.13.
F-20
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
(b) Earnings Per Common Share
The following table illustrates the reconciliation of weighted average
shares used for earnings per share computations for the years ended December
31,:
1999 2000 2001
---------- --------- ---------
Basic:
Weighted average shares................... 10,763,066 9,098,604 7,964,521
Diluted:
Basic weighted average shares outstanding. 10,763,066 9,098,604 7,964,521
Incremental shares from stock options..... 172,331 140,284 170,820
---------- --------- ---------
Weighted average shares outstanding....... 10,935,397 9,238,888 8,135,341
========== ========= =========
For purposes of calculating basic and diluted EPS, the numerator of net
income is the same.
There were 96,150 shares and 72,600 shares of common stock outstanding at
December 31, 1999 and December 31, 2000, respectively, whose share price were
greater than the market price of the common stock and therefore not included in
the computation of diluted earnings per share. There were no antidilutive
outstanding options to purchase common stock December 31, 2001.
(c) Cash Dividend Declared
On December 19, 2001, the Company announced a quarterly cash dividend of 11
cents per share payable on January 31, 2002, to shareholders of record on
January 15, 2002.
(d) Restrictions on Dividends
Dividends from the Company depend, in part, upon receipt of dividends from
its subsidiary banks because the Company currently has no source of income
other than dividends from Heritage Bank, Central Valley Bank, and earnings from
the investment of the net proceeds from the Conversion retained by the Company.
The FDIC and the Washington State Department of Financial Institutions
("DFI") have the authority under their supervisory powers to prohibit the
payment of dividends by Heritage Bank to the Company. For a period of ten years
after the Conversion, Heritage Bank may not, without prior approval of the DFI,
declare or pay a cash dividend in an amount in excess of one-half of (i) the
greater of the Bank's net income for the current fiscal year or (ii) the
average of the Bank's net income for the current fiscal year and not more than
two of the immediately preceding fiscal years. In addition, Heritage Bank may
not declare or pay a cash dividend on its common stock if the effect thereof
would be to reduce the net worth of the Bank below the amount required for the
liquidation account. Other than the specific restrictions mentioned above,
current regulations allow the Company and its subsidiary banks to pay dividends
on their common stock if the Company's or Bank's regulatory capital would not
be reduced below the statutory capital requirements set by the Federal Reserve
and the FDIC.
At Central Valley Bank the approval of the Comptroller of the Currency is
required if the total of all dividends declared by Central Valley Bank in any
calendar year exceeds the total of its net income of that year combined with
its retained net income of the preceding two years, less any required transfers
to surplus or a fund for the retirement of any preferred stock.
(13) Regulatory Capital Requirements
The Company is a bank holding company under the supervision of the Federal
Reserve Bank. Bank holding companies are subject to capital adequacy
requirements of the Federal Reserve under the Bank Holding Company Act of 1956,
as amended, and the regulations of the Federal Reserve. Heritage Bank and
Central
F-21
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
Valley Bank are federally insured institutions and thereby subject to the
capital requirements established by the Federal Deposit Insurance Corporation
(FDIC). The Federal Reserve requirements generally parallel the FDIC
requirements. Failure to meet minimum capital requirements can initiate certain
mandatory, and possibly additional discretionary, actions by regulators that,
if undertaken, could have a direct material effect on the Company's financial
statements.
Pursuant to minimum capital requirements of the FDIC, Heritage Bank and
Central Valley Bank are required to maintain a leverage ratio (capital to
assets ratio) of 3% and risk-based capital ratios of Tier 1 capital and total
capital (to total risk-weighted assets) of 4% and 8%, respectively. As of
December 31, 2000 and December 31, 2001, Heritage Bank and Central Valley Bank
were both classified as "well capitalized" institutions under the criteria
established by the FDIC Act. There are no conditions or events since that
notification that management believes have changed the Bank's classification as
a well capitalized institution.
Minimum Well-capitalized
Requirements Requirements Actual
----------- --------------- ------------
$ % $ % $ %
------- - ------- -- ------- ----
As of December 31, 2000:
The Company consolidated
Tier 1 leverage capital to average assets. $16,205 3% $27,008 5% $75,788 14.0%
Tier 1 capital to risk-weighted assets.... 18,955 4 28,433 6 75,788 16.0
Total capital to risk-weighted assets..... 37,911 8 47,389 10 80,851 17.1
Heritage Bank
Tier leverage capital to average assets... 14,542 3 24,236 5 67,711 14.0
Tier 1 capital to risk-weighted assets.... 16,674 4 25,010 6 67,711 16.2
Total capital to risk-weighted assets..... 33,347 8 41,684 10 72,291 17.3
Central Valley Bank
Tier leverage capital to average assets... 2,131 3 3,552 5 5,843 8.2
Tier 1 capital to risk-weighted assets.... 2,261 4 3,391 6 5,843 10.3
Total capital to risk-weighted assets..... 4,521 8 5,652 10 6,325 11.2
Minimum Well-capitalized
Requirements Requirements Actual
----------- --------------- ------------
$ % $ % $ %
------- - ------- -- ------- ----
As of December 31, 2001:
The Company consolidated
Tier 1 leverage capital to average assets. $17,644 3% $29,406 5% $71,846 12.2%
Tier 1 capital to risk-weighted assets.... 19,535 4 29,302 6 71,846 14.7
Total capital to risk-weighted assets..... 39,069 8 48,837 10 77,681 15.9
Heritage Bank
Tier leverage capital to average assets... 15,211 3 25,352 5 62,818 12.4
Tier 1 capital to risk-weighted assets.... 17,277 4 25,916 6 62,818 14.5
Total capital to risk-weighted assets..... 34,555 8 43,193 10 68,000 15.7
Central Valley Bank
Tier leverage capital to average assets... 2,436 3 4,060 5 6,245 7.7
Tier 1 capital to risk-weighted assets.... 2,315 4 3,473 6 6,245 10.8
Total capital to risk-weighted assets..... 4,630 8 5,788 10 6,814 11.8
F-22
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
(14) Stock Option Plans
In September 1994, Heritage Bank's stockholders approved the adoption of the
1994 stock option plan, providing for the award of a restricted stock award to
a key officer, incentive stock options to employees and nonqualified stock
options to directors of the Bank at the discretion of the Board of Directors.
On September 24, 1996, Heritage Bank's stockholders approved the adoption of
the 1997 stock option plan, which is generally similar to the 1994 plan. On
October 15, 1998, the Company's stockholders approved the adoption of the 1998
stock option plan, which is similar to the 1994 and 1997 plans. The 1998 plan
does not affect any options granted under the 1994 or 1997 plans.
Under these stock option plans, on the date of grant, the exercise price of
the option must at least equal the market value per share of the Company's
common stock. The 1994 plan provides for the grant of options and stock awards
up to 344,996 shares. The 1997 plan provides for the granting of options and
stock awards up to 257,460 common shares. The 1998 plan provides for the grant
of stock options and stock awards for up to 461,125 shares.
Stock options generally vest ratably over three years and expire five years
after they become exercisable which amounts to an average term of seven years.
The following table summarizes stock option activity for the year ended June
30, 1998, the six months ended December 31, 1998, and years ended December 31,
1999 and December 31, 2000. Option activity for the periods prior to the stock
offering January 8, 1998 has been restated using the exchange ratio of one
share of the Bank's common stock for 5.1492 shares of the Company's common
stock.
Outstanding Options Exercisable Options
------------------- -------------------
Avg. Avg.
Option Option
Shares Under Option Shares Price Shares Price
------------------- -------- ------ -------- ------
Balance at December 31, 1998... 480,141 $ 4.76 194,264 $3.01
Options granted................ 144,900 8.52 -- --
Became exercisable............. -- -- 131,649 5.35
Less: Exercised................ (91,636) 2.75 (91,636) 2.80
Expired or canceled......... (32,148) 7.37 (24,818) 5.86
-------- ------ -------- -----
Balance at December 31, 1999... 501,257 6.06 209,459 4.24
======== ====== ======== =====
Options granted................ 123,900 9.23 -- --
Became exercisable............. -- -- 165,802 6.17
Less: Exercised................ (41,181) 3.24 (41,181) 2.49
Expired or canceled......... (13,800) 9.37 (1,003) 8.94
-------- ------ -------- -----
Balance at December 31, 2000... 570,176 6.87 333,077 5.40
======== ====== ======== =====
Options granted................ 35,100 10.14 -- --
Became exercisable............. -- -- 106,250 9.43
Less: Exercised................ (102,340) 4.02 (102,340) 4.02
Expired or canceled......... (35,675) 9.04 (35,675) 9.04
-------- ------ -------- -----
Balance at December 31, 2001... 467,261 $ 7.57 301,312 $6.85
======== ====== ======== =====
F-23
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
Financial data pertaining to outstanding stock options at December 31, 2001
follows:
Weighted Average
Remaining Contractual
Exercise Price Number of Option Shares Life (in years)
-------------- ----------------------- ---------------------
$ 1.94.... 859 0.1
$ 3.11.... 18,881 1.0
$ 3.58.... 127,771 2.6
$ 8.50.... 5,800 4.8
$11.13.... 62,000 5.3
$ 9.00.... 13,650 4.4
$ 8.75.... 6,900 4.7
$ 8.13.... 2,100 4.7
$ 8.56.... 1,200 4.8
$ 8.50.... 2,200 4.8
$ 8.25.... 9,000 4.9
$ 8.44.... 78,800 5.4
$ 7.72.... 13,950 5.7
$ 7.50.... 1,500 5.7
$ 7.81.... 7,600 5.8
$ 8.00.... 1,200 5.9
$ 9.75.... 81,150 6.3
$10.15.... 30,300 6.7
$10.05.... 2,400 6.8
------- ---
467,261 4.1
======= ===
The Company has adopted the disclosure-only provisions of SFAS No. 123,
Accounting for Stock-based Compensation, but applies APB Opinion No. 25 and
related interpretations in accounting for its plans. Accordingly, no
compensation cost has been recognized for its stock option plans. If the
Company had elected to recognize compensation cost on the fair value at the
grant dates for awards under its plans, consistent with the method prescribed
by SFAS No. 123, net income and earnings per share would have been changed to
the pro forma amounts for the years ended December 31,:
1999 2000 2001
------ ------ ------
Net income:
As reported............ $5,357 $5,974 $6,962
Pro forma.............. 5,176 5,709 6,639
Earnings per common share:
Basic:
As reported............ 0.50 0.66 0.87
Pro forma.............. 0.48 0.63 0.83
Diluted:
As reported............ 0.49 0.65 0.86
Pro forma.............. 0.47 0.62 0.82
The compensation expense included in the pro forma net income is not likely
to be representative of the effect on reported net income for future years
because options vest over several years and additional awards generally are
made each year.
F-24
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
The fair value of options granted during the years ended December 31, 1999,
2000 and 2001 is estimated on the date of grant using the Black-Scholes options
pricing model. The following assumptions were used to calculate the fair value
of the options granted:
Risk
Free Expected Weighted
Interest Expected Life Expected Dividend Average
Grant period ended Rate (in years) Volatility Yield Fair Value
------------------ -------- ------------- ---------- -------- ----------
December 31, 1999. 6.50% 7 37% 3.60% 2.76
December 31, 2000. 5.16% 7 32% 4.21% 2.41
December 31, 2001. 5.00% 7 19% 4.04% 1.69
(15) Employee Benefit Plans
Effective October 1, 1999 the Company combined three retirement plans, a
money purchase pension plan, a 401k plan, and an employee stock ownership plan
(ESOP) at Heritage Bank, and the 401k plan at Central Valley Bank into one plan
(KSOP).
The pension portion of the KSOP is a defined contribution retirement plan.
The plan allows participation to all employees upon completion of one year of
service and the attainment of 21 years of age. It is the Company's policy to
fund plan costs as accrued. Employee vesting occurs over a period of seven
years, at which time they become fully vested. Charges of approximately $252,
$257, and $316 are included in the consolidated statements of income for the
years ended December 31, 1999, 2000 and 2001, respectively. Prior to October 1,
1999, Central Valley Bank did not participate.
The KSOP also maintains the Company's salary savings 401(k) plan for its
employees. All persons employed as of July 1, 1984 automatically participate in
the plan. All employees hired after that date who are at least 21 years of age
and with one year of service to the Company may participate in the plan.
Employees who participate may contribute a portion of their salary, which is
matched by the employer at 50% up to certain specified limits. Employee vesting
in employer portions is similar to the retirement plan described above.
Employer contributions for the years ended December 31, 1999, 2000 and 2001
were $148, $161, and $154, respectively.
The third portion of the KSOP is the employee stock ownership plan (ESOP).
Heritage Bank established for eligible employees the ESOP and related trust
effective July 1, 1994, which became active upon the former mutual holding
company's conversion to a stock-based holding company in January 1995. Eligible
participants include eligible employees of the Company who are at least 21
years of age and with one year of service. The ESOP is funded by employer
contributions in cash or common stock. Employee vesting occurs over a period of
seven years. Central Valley Bank employees became eligible to participate in
this plan effective October 1, 1999. Prior to the January 8, 1998 stock
offering, the ESOP owned the common stock of Heritage Bank with no related debt.
In January 1998, the ESOP borrowed $1,323 from the Company to purchase
additional common stock of the Company. The loan will be repaid principally
from the subsidiary bank's contributions to the ESOP over a period of fifteen
years. The interest rate on the loan is 8.5% per annum. ESOP compensation
expense was $126, $126 and $64 for the years ended December 31, 1999, 2000 and
2001, respectively.
For the year ended December 31, 2001, the Company has allocated or committed
to be released to the ESOP 8,817 earned shares and has 97,718 unearned,
restricted shares remaining to be released. The fair value of unearned,
restricted shares held by the ESOP trust was $1,166 at December 31, 2001.
F-25
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
(a) Severance Agreements
The Company has entered into contracts with certain senior officers that
provide benefits under certain conditions following termination without cause,
following a change of control of the Company.
(16) Fair Value of Financial Instruments
Because broadly traded markets do not exist for most of the Company's
financial instruments, the fair value calculations attempt to incorporate the
effect of current market conditions at a specific time. Fair valuations are
management's estimates of values. These determinations are subjective in
nature, involve uncertainties and matters of significant judgment and do not
include tax ramifications; therefore, the results cannot be determined with
precision, substantiated by comparison to independent markets and may not be
realized in an actual sale or immediate settlement of the instruments. There
may be inherent weaknesses in any calculation technique, and changes in the
underlying assumptions used, including discount rates and estimates of future
cash flows, could significantly affect the results. For all of these reasons,
the aggregation of the fair value calculations presented herein do not
represent, and should not be construed to represent, the underlying value of
the Company.
(a) Financial Instruments With Book Value Equal to Fair Value
The fair value of financial instruments that are short-term or reprice
frequently and that have little or no risk are considered to have a fair value
equal to book value.
(b) Investment Securities
The fair value of all investment securities excluding Federal Home Loan Bank
(FHLB) stock was based upon quoted market prices. FHLB stock is not publicly
traded, however it may be redeemed on a dollar-for-dollar basis, for any amount
the Bank is not required to hold. The fair value is therefore equal to the book
value.
(c) Loans
For most loans, fair value is estimated using the Company's lending rates
that would have been quoted on December 31, 2001 for loans, which mirror the
attributes of the loans with similar rate structures and average maturities.
Commercial loans and construction loans, which are variable rate and short-term
are reflected with fair values equal to book value.
(d) Deposits
For deposits with no contractual maturity, the fair value is equal to the
book value. The fair value of fixed maturity deposits is based on discounted
cash flows using the difference between the deposit rate and an alternative
cost of funds rate.
(e) FHLB Advances
The fair value of FHLB advances are estimated based on discounting the
future cash flows using the rate currently offered on similar borrowings with
similar maturities.
(f) Other Borrowings
Other borrowings consist of overnight Federal Funds purchased and are
considered at fair value.
F-26
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
(g) Commitments to Extend Credit and Standby Letters of Credit
The fair value of commitments to extend credit can be estimated using the
fees currently charged to enter into similar agreements, taking into account
the remaining terms of the agreements and the present creditworthiness of the
counter parties. It is not practicable to estimate fair value on these
instruments.
The table below presents the book value amount of the Bank's financial
instruments and their corresponding fair values:
December 31, 2000 December 31, 2001
----------------- -----------------
Book Fair Book Fair
value value value value
-------- -------- -------- --------
Financial Assets
----------------
Cash on hand and in banks............... $ 20,187 $ 20,187 $ 24,465 $ 24,465
Interest bearing deposits............... 1,278 1,278 21,311 21,311
Federal funds sold...................... -- -- 5,000 5,000
Investment securities available for sale 33,771 33,771 26,479 26,479
Investment securities held to maturity.. 5,076 5,174 3,703 3,884
FHLB stock.............................. 2,647 2,647 2,911 2,911
Loans receivable, net................... 477,372 483,295 492,954 497,195
Financial Liabilities
---------------------
Deposits:
Savings, money market and demand..... $213,233 $213,233 $276,455 $276,455
Time certificates.................... 247,001 248,056 238,625 240,137
-------- -------- -------- --------
Total deposits................... 460,234 461,289 515,080 516,592
======== ======== ======== ========
FHLB advances........................... 23,125 23,126 8,000 8,000
Other borrowed funds.................... 1,000 1,000 -- --
(17) Contingencies
The Company is involved in numerous business transactions, which, in some
cases, depend on regulatory determination as to compliance with rules and
regulations. Also, the Company has certain litigation and negotiations in
progress. All such matters are attributable to activities arising from normal
operations. In the opinion of management, after review with legal counsel, the
eventual outcome of the aforementioned matters is unlikely to have a materially
adverse effect on the Company's consolidated financial statements or its
financial position.
(18) Heritage Financial Corporation (Parent Company Only)
Heritage Financial Corporation (HFC) was established in connection with a
January 1998 stock conversion and stock offering.
F-27
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
HERITAGE FINANCIAL CORPORATION
(PARENT COMPANY ONLY)
Condensed Statements of Financial Condition
December 31,
---------------
2000 2001
------- -------
ASSETS
------
Cash and interest earning deposits.. $ 1,540 $ 1,985
Loans receivable--ESOP.............. 1,178 1,119
Investment in subsidiary banks...... 80,754 75,620
Other assets........................ 441 914
------- -------
$83,913 $79,638
======= =======
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
Liabilities......................... $ 908 $ 1,110
Total stockholders' equity.......... 83,005 78,528
------- -------
$83,913 $79,638
======= =======
HERITAGE FINANCIAL CORPORATION
(PARENT COMPANY ONLY)
Condensed Statements of Income
Years Ended December 31,
-----------------------
1999 2000 2001
------ ------ ------
Interest income:
Interest income................................ $ 421 $ 70 $ 26
ESOP loan...................................... 106 102 98
Other income:
Other income................................... 15 -- --
Equity in undistributed income of subsidiaries. 5,462 6,284 7,264
------ ------ ------
Total income............................... 6,004 6,456 7,388
Interest expense.................................. 12 47 41
Other expenses.................................... 667 595 541
------ ------ ------
Total expense.............................. 679 642 582
------ ------ ------
Income before federal income taxes......... 5,325 5,814 6,806
Provision (benefit) for income taxes.............. (32) (160) (156)
------ ------ ------
Net income..................................... $5,357 $5,974 $6,962
====== ====== ======
Basic earnings per common share................... $ 0.50 $ 0.66 $ 0.87
Diluted earnings per common share................. 0.49 0.65 0.86
F-28
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
HERITAGE FINANCIAL CORPORATION
(PARENT COMPANY ONLY)
Condensed Statements of Cash Flows
Years Ended December 31,
---------------------------
1999 2000 2001
------- -------- --------
Cash flows from operating activities:
Net income.................................................................... $ 5,357 $ 5,974 $ 6,962
Adjustments to reconcile net income to net cash provided by (used in)
operating activities:
Undistributed income of subsidiaries...................................... (5,462) (6,284) (7,264)
Dividends from subsidiaries............................................... 2,150 16,600 12,400
Recognition of compensation related to ESOP............................... 75 75 104
Other..................................................................... 97 (19) --
Net change in accrued interest receivable, prepaid expenses and other
assets, and accrued expenses and other liabilities...................... (662) 275 (238)
------- -------- --------
Net cash provided by operations........................................ 1,555 16,621 11,964
Cash flows from investing activities:
ESOP loan net of principal repayments......................................... 49 54 58
Sales (Purchase) of Premises & Equipment...................................... (16) (1) --
------- -------- --------
Net cash provided by investing activities.............................. 33 53 58
Cash flows from financing activities:
Net (increase) decrease in borrowed funds..................................... 19 -- --
Cash dividends paid........................................................... (2,438) (2,863) (3,178)
Exercise of stock options..................................................... 271 200 411
Stock repurchase.............................................................. (7,439) (15,952) (8,810)
------- -------- --------
Net cash used in financing activities.................................. (9,587) (18,615) (11,577)
------- -------- --------
Net increase (decrease) in cash and cash equivalents................... (7,999) (1,941) 445
Cash and cash equivalents at beginning of period................................. 11,480 3,481 1,540
------- -------- --------
Cash and cash equivalents at end of period....................................... $ 3,481 $ 1,540 $ 1,985
======= ======== ========
F-29
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
(19) Selected Quarterly Financial Data (Unaudited)
Results of operations on a quarterly basis were as follows (dollars in
thousands, except for per share amounts):
Year ended December 31, 2001
-------------------------------
First Second Third Fourth
Quarter Quarter Quarter Quarter
------- ------- ------- -------
Interest income........................................ $11,706 11,445 11,212 10,821
Interest expense....................................... 5,509 4,948 4,434 3,662
------- ------ ------ ------
Net interest income................................. 6,197 6,497 6,778 7,159
Provision for loan losses.............................. 277 240 290 385
------- ------ ------ ------
Net interest income after provision for loan losses. 5,920 6,257 6,488 6,774
Non-interest income.................................... 1,424 1,363 1,509 1,528
Non-interest expense................................... 5,179 5,613 4,786 4,945
------- ------ ------ ------
Income before provision for income taxes............ 2,165 2,007 3,211 3,357
Provision for income taxes............................. 776 723 1,132 1,147
------- ------ ------ ------
Net income...................................... $ 1,389 1,284 2,079 2,210
======= ====== ====== ======
Basic earnings per share............................... $ 0.17 0.16 0.27 0.29
Diluted earnings per share............................. 0.16 0.16 0.26 0.28
Cash dividends declared................................ 0.095 0.100 0.105 0.110
Year ended December 31, 2000
-------------------------------
First Second Third Fourth
Quarter Quarter Quarter Quarter
------- ------- ------- -------
Interest income........................................ $10,289 10,878 11,298 11,777
Interest expense....................................... 3,997 4,666 5,165 5,573
------- ------ ------ ------
Net interest income................................. 6,292 6,212 6,133 6,204
Provision for loan losses.............................. 195 195 195 202
------- ------ ------ ------
Net interest income after provision for loan losses. 6,097 6,017 5,938 6,002
Non-interest income.................................... 880 1,074 1,149 1,086
Non-interest expense................................... 4,813 4,909 4,825 4,775
------- ------ ------ ------
Income before provision for income taxes............ 2,164 2,182 2,262 2,313
Provision for income taxes............................. 704 709 756 778
------- ------ ------ ------
Net income.......................................... $ 1,460 1,473 1,506 1,535
======= ====== ====== ======
Basic earnings per share............................... $ 0.15 0.16 0.17 0.18
Diluted earnings per share............................. 0.14 0.16 0.17 0.18
Cash dividends declared................................ 0.075 0.080 0.085 0.090
F-30
Exhibit
No.
- -------
3.1 Articles of Incorporation(1)
3.2 Bylaws of the Company(1)
10.1 1998 Stock Option and Restricted Stock Award Plan(2)
10.5 Form of Severance Agreement entered into between the Company and seven additional
executives, effective as of October 1, 1997.(1)
10.6 1997 Stock Option and Restricted Stock Award Plan(3)
10.7 Employment Agreement between the Company and Michael Broadhead, effective September 28,
1998(4)
10.8 Employment Agreement between the Company and Brian L. Vance, effective June 1, 2001.
10.9 Employment Agreement between the Company and Donald V. Rhodes, effective June 1, 2001.
21.0 Subsidiaries of the Company
23.0 Consent of KPMG LLP
24.0 Power of Attorney dated March 19, 2002
---
(1) Incorporated by reference to the Registration Statement on Form S-1
(Reg. No. 333-35573) declared effective on November 12, 1997.
(2) Incorporated by reference to the definitive Proxy Statement dated
September 14, 1998 for the Annual Meeting of Shareholders held on
October 15, 1998.
(3) Incorporated by reference to the Registration Statement on Form S-8
(Reg. No. 333-57513).
(4) Incorporated by reference to the Registration Statement on Form S-4
dated January 20, 1999.