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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
[X] Quarterly Report Pursuant to Section 13 or 15(d) of The Securities
Exchange Act of 1934 For the quarterly period ended March 31, 2003
OR
[_] Transition Report Pursuant to Section 13 or 15(d) of The Securities
Exchange Act of 1934 For the transition period from ________ to ________
Commission File Number 005-57091
FIRST MUTUAL BANCSHARES, INC.
(Exact name of registrant as specified in its charter)
WASHINGTON 91-2005970
---------- ----------
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification Number)
400 108th Avenue N.E., Bellevue, WA 98004
-----------------------------------------
(Address of principal executive offices) (Zip code)
Registrant's telephone number, including area code: (425) 453-5301
--------------
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [_]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [_] No [X]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date. May 14, 2003 4,281,140
------------ ---------
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FIRST MUTUAL BANCSHARES, INC.
QUARTERLY REPORT ON FORM 10-Q
MARCH 31, 2003
TABLE OF CONTENTS
Page
----
PART I: FINANCIAL INFORMATION.............................................. 1
Forward-Looking Statements Disclaimer................. 1
Item 1. Financial Statements............................................ 1
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations............................ 15
General.................................................... 15
Results of Operations...................................... 15
Net Income............................................... 15
Net Interest Income...................................... 15
Other Operating Income................................... 17
Operating Expenses....................................... 19
Financial Condition........................................ 20
Asset Quality.............................................. 21
Portfolio Information...................................... 22
Deposit Information........................................ 22
Business Segments............................................. 23
Consumer Lending........................................... 24
Commercial Lending......................................... 24
Investment Securities...................................... 25
Liquidity and Capital Reserves............................. 26
Branch Expansion and Purchase of the 400 Building.......... 27
Trust Preferred Securities Issuance........................ 27
Item 3. Quantitative and Qualitative Disclosures About Market Risk...... 28
Item 4. Controls and Procedures......................................... 33
PART II: OTHER INFORMATION................................................. 34
Item 1. Legal Proceedings............................................... 34
Item 2. Changes in Securities and Use of Proceeds....................... 34
Item 3. Defaults Upon Senior Securities................................. 35
Item 4. Submission of Matters to a Vote of Security-Holders............. 35
Item 5. Other Information............................................... 36
Item 6. Exhibits and Reports on Form 8-K................................ 36
SIGNATURES................................................................. 36
CERTIFICATIONS............................................................. 37
i
PART I : FINANCIAL INFORMATION
FORWARD-LOOKING STATEMENTS DISCLAIMER
- -------------------------------------
Our Form 10-Q contains statements concerning future operations, trends,
expectations, plans, capabilities, and prospects of First Mutual Bancshares,
Inc. and First Mutual Bank (together, the "Bank") that are forward-looking
statements for the purposes of the safe harbor provisions under the Private
Securities Litigation Reform Act of 1995. Such forward-looking statements
include references to our expectations regarding future interest rate margins,
loan quality, banking center expansion, trends in income and expenses, the
outlook for deposit growth and funding sources, loan growth, and anticipated
sales of loans and investment securities, observations pertaining to the
potential disparate movement of assets and liabilities, our approach to fixed
rate vs variable rate lending and information based on our market risk models
and analysis. Although we believe that the expectations expressed in these
forward-looking statements are based on reasonable assumptions within the bounds
of our knowledge of our business, operations, and prospects, these
forward-looking statements are subject to numerous uncertainties and risks, and
actual events, results, and developments will ultimately differ from the
expectations and may differ materially from those expressed or implied in such
forward-looking statements. Factors which could affect actual results include
economic conditions in our market area and the nation as a whole, interest rate
fluctuations, the impact of competitive products, services, and pricing, credit
risk management, our ability to control our costs and expenses, loan delinquency
rates, and the legislative and regulatory changes affecting the banking
industry. There are other risks and uncertainties that could affect us which are
discussed from time to time in our filings with the Securities and Exchange
Commission. These risks and uncertainties should be considered in evaluating the
forward-looking statements, and undue reliance should not be placed on such
statements. We are not responsible for updating any such forward-looking
statements.
ITEM 1. FINANCIAL STATEMENTS
- ----------------------------
In the opinion of management, the accompanying consolidated statements of
financial condition and related interim consolidated statements of income,
comprehensive income, stockholders' equity and cash flows reflect all
adjustments (which include reclassifications and normal recurring adjustments)
that are necessary for a fair presentation in conformity with accounting
principles generally accepted in the United States of America ("GAAP"). The
preparation of financial statements in conformity with GAAP requires management
to make estimates and assumptions that affect amounts reported in the financial
statements. Changes in these estimates and assumptions are considered reasonably
possible and may have a material impact on the financial statements.
Certain reclassifications have been made to the 2002 financial statements to
conform to the 2003 presentation. All significant intercompany transactions and
balances have been eliminated.
The information included in this Form 10-Q should be read in conjunction with
the First Mutual Bancshares, Inc. Year 2002 Annual Report on Form 10-K to the
Securities and Exchange Commission. Interim results are not necessarily
indicative of results for a full year.
Consolidated Financial Statements of the Company begin on page 2.
1
Item 1. Financial Statements
FIRST MUTUAL BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
March 31, December 31,
2003 2002
------------- -------------
ASSETS: (Unaudited)
CASH AND CASH EQUIVALENTS:
Interest-earning deposits $ 1,139,117 $ 6,203,843
Noninterest-earning demand deposits
and cash on hand 6,373,622 8,767,684
------------- -------------
7,512,739 14,971,527
MORTGAGE-BACKED AND OTHER SECURITIES
AVAILABLE-FOR-SALE 74,341,796 58,380,204
LOANS RECEIVABLE, HELD-FOR-SALE 9,013,505 12,699,004
MORTGAGE-BACKED AND OTHER SECURITIES
HELD-TO-MATURITY 14,420,232 16,358,042
LOANS RECEIVABLE 654,293,835 622,374,515
RESERVE FOR LOAN LOSSES (7,829,184) (7,754,106)
------------- -------------
LOANS RECEIVABLE, net 646,464,651 614,620,409
ACCRUED INTEREST RECEIVABLE 3,523,294 3,435,343
LAND, BUILDINGS AND EQUIPMENT, net 22,895,564 10,964,441
FEDERAL HOME LOAN BANK (FHLB) STOCK, 10,617,000 10,443,200
at cost
MORTGAGE SERVICING RIGHTS 57,812 49,914
REAL ESTATE OWNED 39,733
OTHER ASSETS 1,295,033 3,373,168
------------- -------------
TOTAL $ 790,181,359 $ 745,295,252
============= =============
2
FIRST MUTUAL BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(Continued)
March 31, December 31,
2003 2002
------------- -------------
(Unaudited)
LIABILITIES:
Deposits:
Money market deposit and
checking accounts $ 146,185,874 $ 134,247,575
Regular savings 9,339,588 8,386,918
Time deposits 349,791,819 354,735,126
------------- -------------
Total deposits 505,317,281 497,369,619
Drafts payable 575,076 369,034
Accounts payable and other liabilities 34,038,286 8,080,632
Advance payments by borrowers for
taxes and insurance 2,884,127 1,798,233
FHLB advances 187,475,333 184,143,897
Other advances -- 250,000
Federal income taxes 934,106 --
Trust preferred securities 13,000,000 9,000,000
------------- -------------
Total liabilities 744,224,209 701,011,415
STOCKHOLDERS' EQUITY:
Common stock, $1 par value-
Authorized, 10,000,000 shares
Issued and outstanding, 4,281,140
and 4,247,166 shares, respectively 4,281,140 4,247,166
Additional paid-in capital 24,363,885 24,028,610
Retained earnings 17,002,229 15,214,220
Accumulated other comprehensive income:
Unrealized gain on securities
available-for-sale and interest
rate swap, net of federal income tax 309,896 793,841
------------- -------------
Total stockholders' equity 45,957,150 44,283,837
------------- -------------
TOTAL $ 790,181,359 $ 745,295,252
============= =============
3
FIRST MUTUAL BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF INCOME
Quarters ended March 31,
--------------------------------
2003 2002
------------- -------------
(Unaudited)
INTEREST INCOME:
Loans Receivable $ 10,953,833 $ 10,798,506
Interest on AFS Securities 511,210 774,208
Interest on HTM Securities 338,235 365,013
Interest Other 204,784 148,458
------------- -------------
12,008,062 12,086,185
INTEREST EXPENSE:
Deposits 3,071,008 3,579,134
FHLB advances and other 1,861,806 2,000,939
------------- -------------
4,932,814 5,580,073
------------- -------------
Net interest income 7,075,248 6,506,112
PROVISION FOR LOAN LOSSES 135,000 50,000
------------- -------------
Net interest income, after provision
for loan losses 6,940,248 6,456,112
OTHER OPERATING INCOME:
Gain on sales of loans 195,265 251,715
Servicing fees, net of amortization 14,834 22,550
Gain on sales of investments 387,069 --
Fees on deposits 123,310 102,310
Other 265,225 287,368
------------- -------------
Total other operating income 985,703 663,943
BALANCE, carried forward 7,925,951 7,120,055
4
FIRST MUTUAL BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF INCOME
(Continued)
Quarters ended March 31,
--------------------------------
2003 2002
------------- -------------
(Unaudited)
BALANCE, brought forward $ 7,925,951 $ 7,120,055
OPERATING EXPENSES:
Salaries and employee benefits 2,972,492 2,477,087
Occupancy 588,316 578,681
Other 1,211,425 1,086,232
------------- -------------
Total other operating expenses 4,772,233 4,142,000
------------- -------------
Income before federal income taxes 3,153,718 2,978,055
FEDERAL INCOME TAXES 1,066,560 1,007,247
------------- -------------
NET INCOME 2,087,158 1,970,808
============= =============
PER SHARE DATA:
Basic earnings per common share $ 0.49 $ 0.38
Earnings per common share, assuming dilution $ 0.48 $ 0.37
WEIGHTED AVERAGE SHARES OUTSTANDING 4,260,194 5,201,312
============= =============
WEIGHTED AVERAGE SHARES OUTSTANDING
INCLUDING DILUTIVE STOCK OPTIONS 4,375,816 5,257,930
============= =============
5
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(Unaudited)
Common stock Additional
---------------------------- Paid-In Retained
Shares Amount Capital Earnings
------------ ------------ ------------ ------------
BALANCE, December 31, 2000 4,671,286 $ 4,671,286 $ 31,118,545 $ 10,140,569
============ ============ ============ ============
Options exercised, including tax benefit of $117,015 54,680 54,680 292,751
Repayment of ESOP debt
Cash dividends declared ($0.22 per share) (1,036,847)
Comprehensive income:
Net income 6,922,131
Other comprehensive income(loss)--Change
in unrealized gain on securities
available-for-sale, net of
federal income tax
------------ ------------ ------------ ------------
BALANCE, December 31, 2001 4,725,966 $ 4,725,966 $ 31,411,296 $ 16,025,853
============ ============ ============ ============
Options exercised, including tax benefit of $169,903 67,573 67,573 551,848
Retirement of shares repurchased (1,019,256) (1,019,256) (13,963,793) (815,419)
10% stock dividend 472,883 472,883 6,029,259 (6,502,142)
Cash dividends declared ($0.28 per share) (1,291,442)
Comprehensive income:
Net income 7,797,370
Other comprehensive income(loss)--Change
in unrealized gain on securities
available-for-sale, and interest rate
swap, net of federal income tax
------------ ------------ ------------ ------------
BALANCE, December 31, 2002 4,247,166 $ 4,247,166 $ 24,028,610 $ 15,214,220
============ ============ ============ ============
Options exercised, including tax benefit of $125,946 32,588 32,588 311,658
Issuance of stock through employees' stock plans 1,386 1,386 23,617
Cash dividends declared ($0.07 per share) (299,149)
Comprehensive income:
Net income 2,087,158
Other comprehensive income(loss)--Change
in unrealized gain on securities
available-for-sale, and interest rate
swap, net of federal income tax
------------ ------------ ------------ ------------
BALANCE, March 31, 2003 $ 4,281,140 $ 4,281,140 $ 24,363,885 $ 17,002,229
============ ============ ============ ============
Employee Stock Accumulated
Ownership Comprehensive
Plan Debt Income (Loss) Total
------------ ------------ ------------
BALANCE, December 31, 2000 $ (97,821) $ 84,692 $ 45,917,271
============ ============ ============
Options exercised, including tax benefit of $117,015 347,431
Repayment of ESOP debt 97,821 97,821
Cash dividends declared ($0.22 per share) (1,036,847)
Comprehensive income:
Net income 6,922,131
Other comprehensive income(loss)--Change
in unrealized gain on securities
available-for-sale, net of
federal income tax (276,510) (276,510)
------------ ------------ ------------
BALANCE, December 31, 2001 $ -- $ (191,818) $ 51,971,297
============ ============ ============
Options exercised, including tax benefit of $169,903 619,421
Retirement of shares repurchased (15,798,468)
10% stock dividend --
Cash dividends declared ($0.28 per share) (1,291,442)
Comprehensive income:
Net income 7,797,370
Other comprehensive income(loss)--Change
in unrealized gain on securities
available-for-sale, and interest rate
swap, net of federal income tax 985,659 985,659
------------ ------------ ------------
BALANCE, December 31, 2002 $ -- $ 793,841 $ 44,283,837
============ ============ ============
Options exercised, including tax benefit of $125,946 344,246
Issuance of stock through employees' stock plans 25,003
Cash dividends declared ($0.07 per share) (299,149)
Comprehensive income:
Net income 2,087,158
Other comprehensive income(loss)--Change
in unrealized gain on securities
available-for-sale, and interest rate
swap, net of federal income tax (483,945) (483,945)
------------ ------------ ------------
BALANCE, March 31, 2003 $ -- $ 309,896 $ 45,957,150
============ ============ ============
6
FIRST MUTUAL BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Three months ended March 31,
----------------------------
2003 2002
------------ ------------
(Unaudited)
OPERATING ACTIVITIES:
Net income $ 2,087,158 $ 1,970,808
Adjustments to reconcile net income to net cash
from operating activities:
Provision for loan losses 135,000 50,000
Depreciation and amortization 266,465 214,297
Deferred loan origination fees, net of accretion (213,347) (120,040)
Amortization of mortgage servicing rights 12,591 11,816
Gain on sales of loans (195,266) (251,715)
Gain on sale of securities available-for-sale (387,069) --
FHLB stock dividends (173,800) (144,700)
Changes in operating assets & liabilities:
Loans receivable held-for-sale 3,685,499 1,925,206
Accrued interest receivable (87,951) (164)
Other assets (238,255) (88,085)
Drafts payable 206,042 (379,423)
Accounts payable and other liabilities 28,533,500 (577,007)
Advance payments by borrowers for taxes
and insurance 1,085,894 1,231,634
Federal income taxes 672,804 999,134
------------ ------------
Net cash provided by operating activities 35,389,265 4,841,761
------------ ------------
INVESTING ACTIVITIES:
Loan originations (80,790,701) (53,079,521)
Loan principal repayments 46,188,221 46,819,841
Increase in undisbursed loan proceeds 3,880,010 4,204,821
Principal repayments & redemptions on
mortgage-backed and other securities 15,026,744 4,215,045
Purchase of securities held-to-maturity (1,098,881) (250,000)
Purchase of securities available-for-sale (42,715,626) (19,958,706)
Purchases of premises and equipment (12,182,522) (462,464)
Purchase of FHLB stock -- (62,600)
Proceeds from sale of securities 13,869,603 --
------------ ------------
Net cash (used) by investing activities (57,823,152) (18,573,584)
7
FIRST MUTUAL BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Continued)
Three months ended March 31,
----------------------------
2003 2002
------------ ------------
(Unaudited)
FINANCING ACTIVITIES:
Net increase in deposit accounts 5,001,044 12,224,410
Interest credited to deposit accounts 2,946,618 3,579,459
Proceeds from trust preferred securities 4,000,000 --
Issuance of stock through employees's stock plans 25,003 --
Proceeds from advances 120,091,254 79,290,754
Repayment of advances (117,009,818) (89,188,000)
Dividends paid (297,302) (330,818)
Proceeds from exercise of stock options 218,300 22,175
------------ -----------
Net cash provided by financing activities 14,975,099 5,597,980
------------ -----------
NET (DECREASE) IN CASH AND CASH
EQUIVALENTS (7,458,788) (8,133,843)
CASH & CASH EQUIVALENTS:
Beginning of year 14,971,527 14,615,303
------------ -----------
End of quarter 7,512,739 6,481,460
============ ===========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Loans originated for mortgage banking activities 22,764,744 14,432,383
============ ===========
Loans originated for investment activities 80,790,701 53,079,521
============ ===========
Proceeds from sales of loans held-for-sale 26,450,242 16,357,588
============ ===========
Cash paid during the three months ended March 31 for:
Interest 5,052,566 5,522,864
============ ===========
Income taxes -- --
============ ===========
SUPPLEMENTAL DISCLOSURES OF NONCASH
INVESTING ACTIVITIES:
Loans transferred to real estate
held-for-sale, net 39,733 --
============ ===========
8
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 1.
The results of operations for the interim periods shown in this report are not
necessarily indicative of results to be expected for the fiscal year. In the
opinion of management, the information contained herein reflects all adjustments
necessary to make the results of operations for the interim periods a fair
statement of such operations.
Stock-Based Compensation Plans - Statement of Financial Accounting Standards
(SFAS) No. 148, Accounting for Stock-Based Compensation - Transition and
Disclosure, became effective for financial statements for fiscal years ending
after December 15, 2002. The new accounting standard amends APB Opinion No. 28,
Interim Financial Reporting and SFAS No. 123, Accounting for Stock-Based
Compensation, to require prominent disclosure about the effects on reported net
income of an entity's accounting policy decisions with respect to stock-based
compensation and to require disclosures about those effects in interim financial
information. Management has elected to continue to use the intrinsic value
method of accounting and as a result the provisions of this statement are not
expected to have a material effect on the Bank's financial position or results
of operations.
At March 31, 2003, the Bank had three stock-based employee/director compensation
plans, which are described more fully in the 2002 annual report. The plans are
accounted for under the recognition and measurement principles of APB Opinion
No. 25, Accounting for Stock Issued to Employees, and related interpretations.
No stock-based employee or director compensation cost is reflected in net
income, as all options granted under those plans had an exercise price equal to
the market value of the underlying common stock on the date of grant. The
following table illustrates the effect on net income and earnings per share if
the fair value recognition provisions of FASB Statement No. 123, Accounting for
Stock-Based Compensation, had been adopted.
Quarters Ended March 31,
----------------------------
2003 2002
------------ ------------
Net Income, as reported $ 2,087,158 $ 1,970,808
Deduct: Total stock-based employee/
director compensation expense
determined under fair value based
method for all awards, net of related
tax effects (48,860) (22,972)
------------ ------------
Pro forma net income $ 2,038,298 $ 1,947,836
============ ============
Earnings per share:
Basic - as reported $ 0.49 $ 0.38
Basic - pro forma $ 0.48 $ 0.37
Diluted - as reported $ 0.48 $ 0.37
Diluted - pro forma $ 0.47 $ 0.37
Weighted average shares outstanding:
Basic 4,260,194 5,201,312
Diluted 4,375,816 5,257,930
The compensation expense included in the pro forma net income and net income per
share figures in the previous table are 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.
9
NOTE 2.
MORTGAGE-BACKED AND OTHER SECURITIES AVAILABLE-FOR-SALE
The amortized cost and estimated fair value of securities available-for-sale at
March 31, 2003, and December 31, 2002 are summarized as follows:
Gross Gross Estimated
Amortized unrealized unrealized fair
cost gains losses value
------------ ------------ ------------ ------------
MARCH 31, 2003
Freddie Mac securities $ 18,425,591 $ 143,224 $ 93,506 $ 18,475,309
Fannie Mae securities 41,121,027 939,331 -- 42,060,358
US agency securities 13,678,381 128,228 480 13,806,129
------------ ------------ ------------ ------------
$ 73,224,999 $ 1,210,783 $ 93,986 $ 74,341,796
============ ============ ============ ============
DECEMBER 31, 2002
Freddie Mac securities $ 4,085,161 $ 175,273 $ -- $ 4,260,434
Fannie Mae securities 39,485,379 1,553,171 -- 41,038,550
US agency securities 12,963,967 117,253 -- 13,081,220
------------ ------------ ------------ ------------
$ 56,534,507 $ 1,845,697 $ -- $ 58,380,204
============ ============ ============ ============
NOTE 3.
MORTGAGE-BACKED AND OTHER SECURITIES HELD-TO-MATURITY
The amortized cost and estimated fair value of mortgage-backed and other securities are
summarized as follows:
Gross Gross Estimated
Amortized unrealized unrealized fair
cost gains losses value
------------ ------------ ------------ ------------
MARCH 31, 2003
Fannie Mae securities $ 12,439,722 $ 458,040 $ -- $ 12,897,762
Freddie Mac securities 629,556 10,015 -- 639,571
Municipal bonds 1,333,263 -- 30,640 1,302,623
CMOs 17,691 261 -- 17,952
------------ ------------ ------------ ------------
$ 14,420,232 $ 468,316 $ 30,640 $ 14,857,908
============ ============ ============ ============
DECEMBER 31, 2002:
Fannie Mae securities $ 14,265,994 $ 594,144 $ -- $ 14,860,138
Freddie Mac securities 729,270 14,146 -- 743,416
Municipal bonds 1,337,161 -- 40,936 1,296,225
CMOs 25,617 468 -- 26,085
------------ ------------ ------------ ------------
$ 16,358,042 $ 608,758 $ 40,936 $ 16,925,864
============ ============ ============ ============
10
NOTE 4.
NONPERFORMING ASSETS
The Bank had nonperforming assets as follows:
March 31, December 31,
2003 2002
------------ ------------
Nonperforming loans $ 407,789 $ 2,073,525
Real Estate and Repossessed assets held-for-sale 84,921 45,188
------------ ------------
Total Nonperforming Assets $ 492,710 $ 2,118,713
============ ============
At March 31, 2003, and December 31, 2002, the Bank had two impaired loans
totaling $16,684, defined under Statement of Financial Accounting Standards
(SFAS) No. 114, "Accounting by Creditors for Impairment of a Loan."
NOTE 5.
EARNINGS PER SHARE
Basic Earnings Per Share is computed by dividing net income by the
weighted-average number of shares outstanding during the year. Diluted EPS
reflects the potential dilutive effect of stock options and is computed by
dividing net income by the weighted-average number of shares outstanding during
the year, plus the dilutive common shares that would have been outstanding had
the stock options been exercised.
The following is a reconciliation of the numerators and denominators of the
basic and diluted earnings per share computations for quarters ending March 31,
2003, and March 31, 2002:
Income Shares Per share
(numerator) (denominator) amount
--------------------------------------------
Quarter ended March 31, 2003
Basic EPS:
Income available to common shareholders $ 2,087,158 4,260,194 $ 0.49
============
Effect of dilutive stock options -- 115,622
------------ ------------
Diluted EPS:
Income available to common shareholders
plus assumed stock options exercised $ 2,087,158 4,375,816 $ 0.48
============ ============ ============
Quarter ended March 31, 2002
Basic EPS:
Income available to common shareholders $ 1,970,808 5,201,312 $ 0.38
============
Effect of dilutive stock options -- 56,618
------------ ------------
Diluted EPS:
Income available to common shareholders
plus assumed stock options exercised $ 1,970,808 5,257,930 $ 0.37
============ ============ ============
11
NOTE 6.
RATE VOLUME ANALYSIS FIRST QUARTER 2003
(Dollars in thousands) VS
FIRST QUARTER 2002
INCREASE (DECREASE) DUE TO
TOTAL
VOLUME RATE CHANGE
- ------------------------------------------------------------------------------------------
INTEREST INCOME
Investments:
Available-for-sale securities $ 155 $ (418) $ (263)
Held-to-maturity securities (141) 114 (27)
Other equity investments 13 43 56
--------------------------------------------
Total investments 27 (261) (234)
--------------------------------------------
Loans:
Residential $ 228 $ (202) $ 26
Residential construction 273 59 332
Multifamily 211 (388) (177)
Multifamily construction (67) (15) (82)
Commercial real estate and business 450 (690) (240)
Commercial real estate construction (4) 25 21
Consumer & other 333 (61) 272
--------------------------------------------
Total loans 1,424 (1,272) 152
--------------------------------------------
Total interest income 1,451 (1,533) (82)
INTEREST EXPENSE
Deposits:
Money market deposit and checking $ 108 $ (85) $ 23
Regular savings 2 (9) (7)
Time deposits 340 (867) (527)
--------------------------------------------
Total deposits 450 (961) (511)
FHLB advances and other 21 (161) (140)
--------------------------------------------
Total interest expense 471 (1,122) (651)
Net interest income $ 980 $ (411) $ 569
============================================
12
NOTE 7.
SEGMENTS
The management reporting process measures the performance of the operating
segments based on the management structure of the Bank and is not necessarily
comparable with similar information for any other financial institution. The
operating segments are defined by product type and customer segments. We
continue to enhance our segment reporting process methodologies. These
methodologies are based on the management reporting process, which assigns
certain balance sheet and income statement items to the responsible operating
segment. Methodologies that are now applied to the measurement of segment
profitability include:
A funds transfer pricing system, which allocates actual net interest income
between fund users, is based upon the funding needs and the relative
duration of the loans or securities within each segment.
The retail deposit-gathering banking center network income and expenses are
allocated to the business segments based on their asset size.
The calculation for the provision for loan losses is allocated to the
business segments.
Operating income and expenses are allocated to segments whenever they can
be directly attributed to their activities. Indirect income and overhead
costs are credited or charged to the segments whenever they are
specifically identified as providers or users of the ancillary internal
service, or are allocated based on some common denominator.
The reportable segments include the following:
Consumer Lending - Consumer lending includes residential and home equity
lending, direct consumer loans, and consumer dealer financing contracts.
Residential lending offers loans to borrowers to purchase, refinance, or
build homes secured by one-to-four-unit family dwellings. Consumer loans
include lines of credit and loans for purposes other than home ownership.
Included within the consumer lending segment is a mortgage banking
operation, which sells loans in the secondary mortgage market. The mortgage
banking operation may choose to retain or sell the right to service the
loans sold (i.e., collection of principal and interest payments) depending
upon market conditions.
Commercial Lending - Commercial lending offers permanent and interim
construction loans for multifamily housing (over four units) and commercial
real estate properties, and loans to small and medium-sized businesses for
financing inventory, accounts receivable, and equipment, among other
things. The underlying real estate collateral or business asset being
financed typically secures these loans.
Investment Securities - The investment securities segment includes the
investment securities portfolio. Although management does not consider this
to be an operating business line, security investments are a necessary part
of liquidity management for the Bank.
These segments are managed separately because each business unit requires
different processes and different marketing strategies to reach the customer
base that purchases those products and services. All three segments derive a
majority of their revenue from interest, and management relies primarily on net
interest revenue in managing these segments. No single customer provides more
than 10% of the Bank's revenues.
13
Financial information for the Bank's segments is shown below for March 31, 2003,
2002 and 2001:
Consumer Commercial Security
Quarter ended March 31: Lending Lending Investments Totals
- ----------------------- ------------ ------------ ------------ ------------
Interest income 2003 $ 3,561,022 $ 7,392,677 $ 1,054,363 $ 12,008,062
2002 2,889,508 7,908,807 1,287,870 12,086,185
2001 2,883,339 8,704,481 2,021,568 13,609,388
Interest Expense 2003 1,381,844 2,670,445 880,525 4,932,814
2002 1,297,687 3,148,031 1,134,355 5,580,073
2001 1,827,651 4,843,386 1,779,286 8,450,323
Net Interest Income 2003 2,179,178 4,722,232 173,838 7,075,248
2002 1,591,821 4,760,776 153,515 6,506,112
2001 1,055,688 3,861,095 242,282 5,159,065
Provision for loan losses 2003 46,424 88,576 -- 135,000
2002 15,455 34,545 -- 50,000
2001 66,458 148,542 -- 215,000
Net interest income, after 2003 2,132,754 4,633,656 173,838 6,940,248
provision for loan losses 2002 1,576,366 4,726,231 153,515 6,456,112
2001 989,230 3,712,553 242,282 4,944,065
Other operating income 2003 302,488 241,697 441,518 985,703
2002 316,189 323,886 23,868 663,943
2001 881,801 191,942 497,228 1,570,971
Other operating expense 2003 1,981,303 2,509,188 281,742 4,772,233
2002 1,453,767 2,398,293 289,940 4,142,000
2001 1,204,058 2,132,756 326,767 3,663,581
Income before federal income 2003 453,939 2,366,165 333,614 3,153,718
taxes and cumulative effect 2002 438,788 2,651,824 (112,557) 2,978,055
of adoption of New Accounting 2001 666,973 1,771,739 412,743 2,851,455
principle
Federal income taxes 2003 154,339 804,496 107,725 1,066,560
2002 149,188 901,620 (43,561) 1,007,247
2001 226,771 602,391 135,908 965,070
Income before Cumulative 2003 299,600 1,561,669 225,889 2,087,158
Effect of Adoption of New 2002 289,600 1,750,204 (68,996) 1,970,808
Accounting Principle 2001 440,202 1,169,348 276,835 1,886,385
Cumulative effect of Adoption 2003
of New Accounting Principle, 2002
net of federal income tax 2001 (155,247) (155,247)
Net income 2003 299,600 1,561,669 225,889 2,087,158
2002 289,600 1,750,204 (68,996) 1,970,808
2001 284,955 1,169,348 276,835 1,731,138
Total Interest Earning assets 2003 206,776,111 456,366,514 100,518,145 763,660,770
(ending period balances) 2002 154,780,642 418,051,179 98,295,406 671,127,227
2001 147,463,298 383,988,026 121,912,340 653,363,664
14
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
GENERAL
- -------
First Mutual Bancshares, Inc. (the "Company"), a Washington corporation, is a
holding company owning all of the equity of its wholly owned subsidiary, First
Mutual Bank. The Company is subject to regulation by the Federal Reserve Bank of
San Francisco. This discussion refers to the consolidated statements of the
Company and the Bank, and therefore the references to "Bank" in this discussion
refer to both entities.
First Mutual Bank is a Washington-chartered savings bank subject to regulation
by the State of Washington Department of Financial Institutions and the Federal
Deposit Insurance Corporation ("FDIC"). The Bank conducts business from its
headquarters in Bellevue, Washington, and has ten full-service facilities
located in Bellevue (3), Kirkland (2), Redmond, Seattle (2), Issaquah, and
Monroe. The Bank also has income property loan production offices located in
Bellingham and Tacoma, Washington and a consumer loan office located in
Jacksonville, Florida. The Bank's business consists mainly of attracting
deposits from the general public as well as wholesale funding sources, and
investing those funds primarily in real estate loans, small and mid-sized
business loans, and consumer loans. In addition to portfolio lending, the Bank
conducts a mortgage banking operation.
RESULTS OF OPERATIONS
- ---------------------
Net Income
----------
Net income increased 5.9%, from $1.97 million in the first quarter of 2002 to
$2.09 million in the same period of 2003. Net interest income after provision
for loan losses rose $484,000, and fee income increased $322,000. Partially
offsetting the growth in revenue was a rise of $630,000 in operating expenses.
Net Interest Income
-------------------
Net interest income after provision for loan losses increased $484,000, or
7.50%, in the first quarter of 2003 as contrasted with the same quarter in 2002.
The net interest margin on a sequential quarterly comparison is as follows:
Quarters Ended Net Interest Margin
- -------------- -------------------
March 31, 2002 3.94%
June 30, 2002 3.94%
September 30, 2002 3.95%
December 31, 2002 3.78%
March 31, 2003 3.84%
Our margin improved modestly over fourth quarter 2002, from 3.78% to 3.84%.
Contributing to the increase in margin was the amortization of fee income from
construction loans, in particular custom construction loans. We anticipate that
the amortization of loan fees from construction loans will decline in subsequent
quarters. Although the margin increased as compared to the
15
previous quarter, it is down substantially from first quarter 2002. The issue
for the Bank continues to be one of the yield on our assets dropping faster than
our cost of funds. The yield on average earning assets was 7.32% in the first
quarter of 2002, declining to 6.52% this year, a difference of 0.80%. The same
ratio for cost of funds was 3.38% last year and 2.68% in the first quarter of
2003, a drop of 0.70%. While the yields on both assets and cost of funds fell,
the yield on assets declined an additional 10 basis points, squeezing the
margin. There are three significant factors that influence our net interest
margin: (1) lagging deposit rates, (2) the gap position, and (3) interest rate
floors on loans.
A concern that affects all banks is the repricing nature of deposits and
adjustable-rate loans. Adjustable-rate loans tend to be mechanical in their
repricing, that is they are tied to indexes that adjust with a wholesale funds
rate such as the London Interbank Offering Rate (LIBOR). Deposits, on the other
hand, and in particular time deposits, usually lag those markets. For example,
we currently offer one-year time deposits at 2.00% and money market accounts at
1.85%. In comparison, the one-year wholesale rate is 1.36% (Federal Home Loan
Bank one-year advance rate), 49 basis points lower than even our money market
rates (all rates as of April 29, 2003). In time, our retail deposit rates should
approach the wholesale funds rate, but in the interim the margin is compressed.
The second issue is that we have $121 million more in assets that reprice in the
next 12 months than we do liabilities. Our gap position, which was 15% positive
at March 31, 2003, has been positive for a number of quarters. The one-year gap
was positive by 13.7% at year-end 2001, 21.4% at September 30, 2002, and 16.5%
at the end of 2002. Several conditions have contributed to the positive
position, including declining mortgage rates and our reluctance to add
significant fixed-rate assets at 41-year rate lows.
Falling mortgage rates, which have decreased year-over-year from 7.18% to
today's 5.79%, prompted a heavy repayment of loans totaling $181 million last
year. In addition, our investment portfolio, which is virtually all fixed-rate
securities, totaled $89 million at both March 31, 2002 and 2003. However, the
current security balance contains $30 million in securities that will not be
funded until second quarter. If the unfunded securities are backed out of this
year's figures, the balance is $59 million, or 33% below the first quarter 2002
number.
We continue to be reticent to aggressively add fixed-rate investments at these
historically low rates. Although we have taken steps to reduce our positive gap
position, such as funding our securities portfolio to its former level and
offering more attractive loan programs with three- and five-year terms, we
remain cautious in this rate environment.
On a positive note, $153 million of our $407 million commercial real estate
portfolio have interest rate floors of 7.5%. That figure compares to $207
million at March 31, 2002. The number of loans with 7.5% floors declines monthly
as the current rate for loans of comparable quality is 4.80%. Nevertheless, the
presence of any significant amount of loans with rates materially higher than
market rates helps to retard the narrowing of the margin. How much longer those
loans will retain the favorable pricing is open to conjecture, although we have
found that on average about 6% of the remaining balance prepays each quarter.
However, if 50% of those loans were to immediately reprice, our net interest
income would decline by an estimated 7.1%.
16
Other Operating Income
----------------------
Other operating income increased to $986,000 in the first quarter of 2003 as
compared to $664,000 in the same quarter in 2002. The 48% increase was mainly
attributable to a rise in the gain on sales of investments which was partially
offset by the decline in gain on sales of loans.
GAIN ON SALES OF INVESTMENTS. Gain on sales of investment securities
available-for-sale totaled $387,000 in the first quarter of 2003. There were no
comparable gains in the first quarter of 2002. In the second, third, and fourth
quarters of 2002, we executed sales of securities that amounted to $30 million
($35 million par value), and so far this year our sales have totaled $14 million
($19 million par value). Because of the decline in mortgage rates and the early
prepayments resulting from those lower rates, we believe that it is prudent for
us to sell securities at a premium rather than wait and be repaid early at par.
If the prepayment rate remains at the present levels, we will probably continue
to sell selected securities.
GAIN ON SALES OF LOANS. The major components for this income category are as
follows:
FIRST QUARTER 2003 FIRST QUARTER 2002
- -------------------------------- ----------------------- ---------------------
Home Improvement Loan Sales $ 53,000 $ 155,000
- -------------------------------- ----------------------- ---------------------
Residential Loan Sales 99,000 77,000
- -------------------------------- ----------------------- ---------------------
SFAS 133 Gain 23,000 2,000
- -------------------------------- ----------------------- ---------------------
Mortgage Servicing Rights 20,000 18,000
- -------------------------------- ----------------------- ---------------------
Total $ 195,000 $ 252,000
----------- ----------
Gain on sales of loans totaled $195,000 for the quarter as compared to $252,000
for the first quarter ended March 31, 2002. The difference between the two
periods is largely the result of a decline in home improvement loan sales
partially offset by an increase in residential loan sales.
HOME IMPROVEMENT LOAN SALES - In the first quarter of 2002, our sales finance,
or home improvement loan sales, totaled $3.8 million, compared to $2.1 million
this year. Although the origination of sales finance loans has increased 76%
this year, we are reducing loan sales and retaining more of the loan production
in our portfolio. We continue to be pleased with the performance of these loans
and plan to reduce loan sales even further in the forthcoming quarter.
RESIDENTIAL LOAN SALES - Both residential loan originations and sales were up
sharply. On a quarter-to-quarter comparison, loan closings rose 64%, and loan
sales increased 94%. Our current forecast is that both sales and loan
originations will continue into the second quarter at a pace comparable to what
we experienced in the first quarter. However, we expect that gains from loan
sales to be less than first quarter, but greater than the results for the like
quarter in 2002.
SFAS 133 - MARK-TO-MARKET OF FINANCIAL DERIVATIVES - Financial Accounting
Standard No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES,
is the accounting guidance applicable to derivative financial instruments. This
standard requires that all interest rate locks (IRLs) on loans pending sale and
forward sale commitments, which are considered to be derivatives, be marked to
market. The net gain realized from these two activities totaled $2,000 in the
first quarter of 2002 as compared to $23,000 for 2003. Market gains or losses
occur whenever there is a change in mortgage rates. If interest rates decline,
the mark-to-market of forward commitments results in a loss. Just the opposite
is true for interest-rate locks. The
17
amount of gain/loss at the end of a financial statement period depends on which
direction interest rates have moved and the relative totals of forward
commitments to interest-rate locks.
MORTGAGE SERVICING RIGHTS - Contributing to the gain on sales of loans was the
slight increase in the capitalization of mortgage servicing rights (MSRs).
Pursuant to Statement of Financial Accounting Standards (SFAS) No. 140,
ACCOUNTING FOR TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND EXTINGUISHMENTS
OF LIABILITIES, the Bank is required to capitalize internally generated
servicing rights. The amount of MSRs capitalized and recognized in income
totaled $20,000 for the first quarter of 2003 as compared to $18,000 for the
like quarter in 2002.
SERVICING FEES, NET OF AMORTIZATION. Servicing fee income for the first quarter
of 2003 totaled $15,000 as compared to $23,000 for the same period in 2002. The
servicing portfolio totaled $48.6 million at March 31, 2003 as compared to $48.5
million a year ago. The servicing fee income has decreased from a year ago even
though the servicing portfolio of loans has increased slightly due to the mix of
loans and the range of service fees that we collect on any given loan. During
the year many of the loans with larger servicing spreads have paid off, and the
new loans being added have had much smaller spreads. It is anticipated that the
level of service fee income will be comparable to the first quarter throughout
the remainder of 2003.
FEE INCOME ON DEPOSITS. Fee income from deposits is up $21,000, or 21%, on a
quarter-to-quarter comparison. Much of that increase is a result of the growth
in checking accounts which have increased 21% since the first quarter of 2002.
The retail banking centers and the business banking department have placed a
greater emphasis on bringing in transaction accounts in order to help reduce our
cost of funds. As can be seen from the percentage increase in accounts, their
efforts have been successful although this change in mix of deposits will take
some time to have a significant impact on the cost of funds of the Bank as a
whole.
OTHER INCOME. Other income decreased 8%, from $287,000 in the first quarter of
2002 to $265,000 this year. Loan prepayment fees decreased by $95,000, or 95%,
while rental income increased from $25,000 to $103,000.
Loan prepayment fees can be erratic, as most of our loans do not carry a
prepayment penalty. Those loans that do have a prepayment penalty are typically
fixed-rate commercial real estate loans with three- to five-year terms.
Rental income jumped in the first quarter due to the purchase of our corporate
headquarters, the 400 Building (now known as First Mutual Center) in Bellevue.
The 400 Building is a seven-story structure built in 1968. We currently occupy
38% of the building and lease the remainder of the space. March was our first
month of ownership, and we received $78,000 in rental income. We also collect
about $8,000 a month from tenants in our Bellevue West and Monroe offices. For
the 400 Building, we anticipate rental income of about $200,000 in the second
quarter and then dropping to approximately $160,000 in the third and fourth
quarters. We expect that several of our tenants will vacate their space, and it
will take us some time to re-lease their premises.
We anticipate that operating expenses for the building will cost about $55,000 -
$60,000 a month. Our rental costs in the 400 Building before we purchased it
were approximately $60,000 a month. Thus, occupancy expense should be about the
same as past quarters. What will increase is our cost of funds. We paid about
$12 million for the building, and our funding expense is presently 1.36%, for a
quarterly increase of $41,000. The net benefit before tax from the 400 Building
is estimated
18
at $115,000 - $155,000 per quarter. There will be some reduction in our income
tax obligation due to the depreciation of the building. However, because of the
age of the building most of the value is in the land, which is not depreciable.
Operating Expenses
------------------
Salaries and employee benefits costs rose $495,000, or 20% on a
quarter-to-quarter comparison. A number of items contributed to our increased
employee costs, including annual salary raises of 3.67%, an 18% growth in staff,
a 79% rise in commission expense, and a 401% increase in temporary-help costs.
We have added 26 new employees in the last 12 months, with 67% of them assigned
to the Business Banking and Residential Lending Departments. Of the remaining
nine positions, four were assigned to the Income Property and Sales Finance
Departments. We increased the banking center staff by one individual and the
Loan Servicing and Information Systems Departments by two each.
The ratio of new loan officers to new support employees is about 1 to 2.5; that
is, support staff accounted for 60% of the new hires. Bank wide, loan officers
and banking center managers constitute 21% of our total staff.
It is our intention to continue to expand our lending departments and open new
retail banking centers. We anticipate that the Woodinville and Sammamish Plateau
Banking Centers will open later this year, and additional banking centers are
planned for next year. We continue to recruit new loan officers and would like
to further expand our Sales Finance franchise. Increased sales personnel
necessitated additional support staff, which currently constitutes about 80% of
our employees.
Commission expense is principally up as a result of increased loan originations,
which jumped 53% from $68 million to $104 million. The increased production was
largely centered in the Residential and Income Property Departments, which saw
their originations increase by 64% and 75%, respectively. The rise in production
for the Residential Department is probably sustainable into the next couple of
quarters, while the increase in Income Property loans is not an indication of a
trend. Loan originations in that department tend to vary widely from
quarter-to-quarter, although there is some consistency on a year-to-year basis.
Our temporary-help expenses have grown from $20,000 in the first quarter of last
year to $102,000 in 2003. Those costs include permanent employees hired on a
temporary basis pending a review of their capabilities and temporary staff
employed for special projects such as the reorganization of our loan production
support departments. We expect those expenses to remain above last year's levels
but to drop from the first quarter's expense of $102,000, to a range of $40,000
- - $60,000 per quarter.
Occupancy expenses are up $10,000, or 2% on a quarter-to-quarter comparison.
Rent costs are down $52,000, while building depreciation expenses have grown by
$35,000. Both items were impacted by our purchase of the 400 Building in March
2003.
Other costs increased by $125,000, or 12%, from $1,086,000 in the first quarter
of 2002 to $1,211,000 this year. The growth in other expense was largely
attributable to marketing, insurance premiums on sales finance loans, office
supplies and data processing.
19
Our marketing costs have risen from $90,000 in the first quarter of year 2002 to
$159,000 for the first quarter this year. We believe that our current level of
marketing support is adequate and don't anticipate those expenses to rise
materially from their present levels.
Insurance premiums on sales finance loans were diminutive in the first quarter
of last year, but amounted to $16,000 in 2003. We insure a portion of the sales
finance loans, originated outside the Pacific Northwest, for default risk that
have credit scores below a certain cutoff level. That cutoff score is generally
set in a range between 680 and 740. Our current insured balances total $6
million, and we are insuring between 30% - 35% of new production each month.
Office supply expense, which increased $23,000, or 31%, and data processing
costs, which rose $20,000, or 15%, are largely the result of the growth in
staff.
FINANCIAL CONDITION
- -------------------
Assets. Assets increased 6%, from $745,295,000 at year-end 2002 to $790,181,000
as of March 31, 2003. The change in assets is principally the result of an
increase in the investment securities portfolio and the loan portfolio.
Securities. We classify investment securities in one of the following
categories: 1) trading, 2) available-for-sale, or 3) held-to-maturity.
Securities classified as available-for-sale are reviewed regularly. Any
unrealized gains or losses are recorded in the shareholders' equity account
along with the gain or loss from the mark-to-market of the interest rate swap
that was entered into in conjunction with the $9 million trust preferred
securities issuance in June 2002. At March 31, 2003, the balance of the
unrealized gain, net of federal income taxes, was $310,000, which compares to an
unrealized gain at year-end 2002 of $794,000. Generally, falling interest rates
will increase the amount recorded as unrealized gain, and rising rates will
decrease any unrealized gains, as the market value of securities inversely
adjusts to the change in interest rates.
Security investments (available-for-sale and held-to-maturity) increased $14.0
million, or 18.8%, from December 31, 2002, to the end of the first quarter 2003.
During the quarter $43.8 million (book and par value) in securities were
purchased; $14.1 million ($18.6 million par value) were sold; and $7.1 million
($8.0 million par value) matured or were called by the issuer. Thirty million
dollars of the security purchases that occurred during the first quarter do not
settle until April or May of 2003. These purchases were accounted for under
"trade date accounting," meaning that the securities were recorded on our
balance sheet on the date the trade occurred, which was in March 2003. The
related net loss of $2,000 was also included in comprehensive income, in the
equity section of the balance sheet. The purchases during the period have helped
to grow assets as well as increase the securities portfolio.
Loans. Loans receivable, excluding loans held-for-sale, rose from $622,375,000
at year-end 2002 to $654,294,000, an increase of $32 million in three months.
About one-half of that growth was from consumer and residential loans, two areas
that have proven to be consistent from quarter-to-quarter. The other half was
from commercial real estate and business banking loans, which are variable from
one period to the next. Our estimate is that the loan portfolio will increase by
$15-$30 million next quarter.
20
Liabilities. Deposits increased $7.9 million, or 1.6%, in the first three months
of 2003, totaling $505 million as compared to $497 million at year-end 2002.
This increase in deposits was used principally to fund the asset growth in the
loan portfolio.
The Federal Home Loan Bank of Seattle (FHLB) advances increased from $184
million at year-end 2002 to $187 million as of the end of the first quarter this
year. As of March 31, 2003, we had the authority to borrow up to a total of $316
million in FHLB advances, subject to sufficient collateral to support those
advances.
ASSET QUALITY
- -------------
Provision and Reserve for Loan Losses. The provision for loan losses increased
from $50,000 in the first quarter of 2002 to $135,000 in the like period in
2003. The provision for loan losses reflects the amount deemed appropriate to
produce an adequate reserve for possible loan losses inherent in the risk
characteristics of the loan portfolio. In determining the appropriate reserve
balance, we consider the amount and type of new loans added to the portfolio,
our level of non-performing loans, the amount of loans charged off, and the
economic conditions that we currently operate within.
Our portfolio loans have increased by $32 million since year-end 2002, with most
of the growth attributable to our Income Property and Residential sectors. Both
of these portfolios continue to perform at a very satisfactory level, and we do
not anticipate any change in the foreseeable future.
Our non-performing assets dropped from $2.1 million at year-end 2002 to $493,000
at the end of the first quarter. The ratio of non-performing assets to total
assets declined from 0.28% to 0.06%. The comparable ratio for other banks at
year-end 2002 is 0.90% (Fourth Quarter 2002 FDIC Quarterly Banking Profile, All
Institutions). Net loans charged off for the quarter amounted to $60,000; we
charged-off $17,000 for the like quarter last year and $188,000 in all of 2002.
Most of the charge-offs are related to our consumer loan portfolio, which would
indicate that we could continue to expect an increase in the level of
charge-offs as the sales finance portfolio grows. Charge-offs, as a percentage
of our net loan portfolio, were 0.04%, compared to 0.97% (Fourth Quarter 2002
FDIC Quarterly Banking Profile, All Institutions) for other financial
institutions as of December 31, 2002. Noted below is a summary of our exposure
to non-performing loans and repossessed assets:
NON-PERFORMING ASSETS Amount
--------------------- ------------
Single-Family residence in Idaho - No anticipated loss. $ 66,000
Two duplexes in Puget Sound area - No anticipated loss. 253,000
One consumer loan - Paid in full, subsequent to quarter-end. 9,000
Six consumer loans - No anticipated loss. 54,000
One consumer loan - 100% recovery anticipated through
an insurance claim. 13,000
Three consumer loans - We anticipate charging off
these loans in the second quarter. 13,000
------------
Total Non-Performing Loans 408,000
We have 16 items of repossessed property,
principally spas and motorcycles. 85,000
------------
Total Non-Performing Assets $ 493,000
============
21
PORTFOLIO INFORMATION
- ---------------------
The commercial real estate portfolio comprises 62% of the loan portfolio. Not
only is that sector the largest, but it is also considered by many to represent
a greater risk to asset quality than residential loans.
The average loan size (excluding construction loans) in the commercial real
estate portfolio was $709,675 as of March 31, 2003, with an average
loan-to-value ratio of 65%. At quarter-end, none of these commercial loans were
delinquent for 30 days or more. Small individual investors, or their limited
liability companies, and business owners typically own the properties securing
these loans. The portfolio is split between residential use (multifamily or
mobile home parks) and commercial use. At quarter-end, the breakdown was 47%
residential and 53% commercial. Adjustable-rate loans account for 92% of our
total loan portfolio.
The loans in our commercial real estate portfolio are well diversified, secured
by small retail shopping centers, office buildings, warehouses, mini-storage
facilities, restaurants, and gas stations, multifamily housing structures,
mobile home parks, as well as other properties classified as general commercial
use.
To diversify our risk and to continue serving our customers, we sell
participation interests in some loans to other financial institutions. About 9%
of the commercial real estate loan balances originated by the Bank have been
sold in this manner. We continue to service the customer's loan and are paid a
servicing fee by the participant. Likewise, we occasionally buy an interest in
loans originated by other lenders. About $14 million of the portfolio (4%) has
been purchased in this manner.
DEPOSIT INFORMATION
- -------------------
The number of business checking accounts increased from 769 at March 31, 2002,
to 1,106 at March 31, 2003, a gain of 337 accounts, or 44%. Consumer checking
accounts also increased, from 4,100 in first quarter 2002 to 4,798 this year, a
growth in the number of accounts of 698, or 17%.
The mix of deposits as of March 31, 2003 is as follows:
Time Deposits 69%
Checking 9%
Money Market Accounts 20%
Statement Savings 2%
22
BUSINESS SEGMENTS
- -----------------
The management reporting process measures the performance of the operating
segments based on the management structure of the Bank and is not necessarily
comparable with similar information for any other financial institution. The
operating segments are defined by product type and customer segments. We
continue to enhance our segment reporting process methodologies. These
methodologies are based on the management reporting process, which assigns
certain balance sheet and income statement items to the responsible operating
segment. Methodologies that are applied to the measurement of segment
profitability include:
o A funds-transfer pricing system, which allocates actual net interest
income between fund users and is based upon the funding needs and the
relative duration of the loans or securities within each segment.
o The retail deposit-gathering banking center network income and
expenses are allocated to the business segments based on their asset
size.
o The calculation for the provision for loan losses is allocated to the
business segments.
o Operating income and expenses are allocated to segments whenever they
can be directly attributed to their activities. Indirect income and
overhead costs are credited or charged to the segments whenever they
are specifically identified as providers or users of the ancillary
internal service, or are allocated based on some common denominator.
The reportable segments include the following:
o CONSUMER LENDING - Consumer lending includes residential and home
equity lending, direct consumer loans, and consumer dealer financing
contracts. Residential lending offers loans to borrowers to purchase,
refinance, or build homes secured by one-to-four-unit family
dwellings. Consumer loans include lines of credit and loans for
purposes other than home ownership. Included within the consumer
lending segment is a mortgage banking operation, which sells loans in
the secondary mortgage market. The mortgage banking operation may
choose to retain or sell the right to service the loans sold (i.e.,
collection of principal and interest payments) depending upon market
conditions.
o COMMERCIAL LENDING - Commercial lending offers permanent and interim
construction loans for multifamily housing (over four units) and
commercial real estate properties, and loans to small- and
medium-sized businesses for financing inventory, accounts receivable,
and equipment, among other things. The underlying real estate
collateral or business asset being financed typically secures these
loans.
o INVESTMENT SECURITIES - The investment securities segment includes the
investment securities portfolio. Although management does not consider
this to be an operating business line, security investments are a
necessary part of liquidity management for the Bank.
These segments are managed separately because each business unit requires
different processes and different marketing strategies to reach the customer
base that purchases the products and services. All three segments derive a
majority of their revenue from interest, and management relies primarily on net
interest revenue in managing these segments. No single customer provides more
than 10% of the Bank's revenues.
23
Consumer Lending
----------------
Net income for the consumer lending segment increased slightly from $290,000 in
the first quarter of 2002 to $300,000 in the same quarter in 2003. The increase
in net income was a result of an improvement in net interest income partially
offset by a drop in non-interest income and increased operating expenses.
Net interest income, after provision for loan losses, was up $556,000,
increasing from $1.6 million in the first quarter of 2002 to $2.1 million this
year. This improvement was largely due to the rise in interest income which
increased $672,000 as compared to the first quarter of 2002. The growth in
interest income was principally due to an increase in portfolio balances of
residential and other consumer loans. Residential loans increased $22.0 million
and consumer loans, of which the sales finance loans accounted for the majority
of the increase, rose $18.0 million. Custom construction loans comprised a
little over one-half of the increase in residential loans. Those loans earn a
higher rate of interest because of the greater level of risk assumed as compared
to a permanent mortgage. We have also begun to portfolio a greater portion of
the sales finance loans that are originated outside the Northwest and which
typically command a higher interest rate.
Non-interest income declined from $316,000 in the three months ending March 2002
to $302,000 in the same quarter this year. The decline from quarter to quarter
is principally a reflection of the decrease in loan sale gains from sales
finance loans. Our current emphasis is on portfolioing those loans and reducing
loan sales.
Non-interest expense increased $528,000, or 36%, on a quarter-to-quarter
comparison. Loan officer commissions, temporary office help, and data processing
expenses were the primary contributors to the increase in other operating
expenses. Loan officer commissions have risen from $132,000 for the first
quarter of 2002 to $279,000 for the same period this year. Temporary office help
has also increased due to the reorganization in our loan production support
departments as well as special projects. For the Bank as a whole, temporary
office expense totaled $20,000 during the first quarter of 2002, rising to
$102,000 this year. We expect this expense to remain above last year's level but
to decline from the first quarter 2003 level to a range of $40,000 - $60,000 per
quarter. As a result of the increase in the number of employees, data processing
expense has also contributed to the rise in non-interest expense. Data
processing expense increased $20,000, or 15%, on a quarter-to-quarter comparison
for the Bank.
Commercial Lending
------------------
Net income for the commercial segment declined $189,000, or 11%, from $1,750,000
in the first quarter of 2002 to $1,562,000 in the like period of 2003. Net
interest income and non-interest income dropped $39,000 and $82,000,
respectively, while non-interest expense increased $111,000.
Net interest income was adversely impacted by a drop in the margin, which was
partially offset by an increase in earning assets. The margin for this segment
has declined from 4.56% for the first quarter of 2002 to 4.14% this year.
Contributing to the margin compression was a steady decrease of the commercial
real estate loans with floors of 7.50%. At March 31, 2002, the commercial real
estate loans with 7.50% floors totaled $207 million, declining to $153 million
at the end of the first quarter this year. We have found that on average about
6% of the remaining
24
balance of these loans prepay each quarter. While the margin for this segment
has continued to compress, earning assets have risen. Total earning assets
increased 9%, or $38.3, million as compared to first quarter 2002.
Other operating income fell $82,000, or 25%, as compared to first quarter last
year. This drop was mainly due to the reduction in loan prepayment and extension
fees. Loan prepayment and extension fees totaled $156,000 for the first quarter
2002 as compared to $46,000 for the like quarter this year. Loan prepayment fee
income was especially high in the first three months of 2002, slightly exceeding
$100,000, as compared to $5,000 this year. Most of the loans in our commercial
lending segment are not subject to prepayment penalties. Because only a limited
number of commercial loans carry prepayment penalties, fees from the early
repayment of those loans can vary greatly from one period to the next.
Non-interest expense increased $111,000, or 5%, over the same quarter last year.
Compensation and marketing expenses were the two largest contributors to this
increase. Over the past year, we have added approximately nine new employees to
this segment, four of whom are in sales and five in the support departments.
These new additions have significantly increased our compensation expense over
the past year. With the increased emphasis of our Business Banking and Community
Business Banking product lines, the marketing dollars associated with these
areas have also increased. Marketing expense for this segment for the first
quarter of 2002 totaled $11,000 as compared to $33,000 for the like quarter this
year. We believe that the current level of marketing support will remain at the
level experienced in the first quarter for the remainder of 2003.
Investment Securities
---------------------
Net income increased sharply for the investment securities segment, from a loss
of $69,000 in the first quarter of 2002 to a gain of $226,000 in 2003. This
segment benefited by both an increase in net interest income and non-interest
income.
Net interest income rose for this business segment from $154,000 in the first
quarter of 2002 to $174,000 this year. Interest expense fell by $254,000 and
more than compensated for the drop in interest income resulting from the decline
in year-over-year interest rates.
Non-interest income increased dramatically from $24,000 in the first three
months of 2002 to $442,000 in the same period this year. During the first
quarter of 2003, gains from the sale of securities amounted to $387,000. There
were no comparable gains recorded in the first three months of 2002. Sales of
securities so far this year have totaled $14 million ($19 million par value).
Over the past year we have taken advantage of the decline in interest rates by
selling securities that were above market rates as opposed to waiting for them
to prepay without the benefit of a premium. If interest rates remain at the
present levels, we will probably continue to sell selected securities in the
future.
Operating expenses declined slightly by $8,000, to $282,000, in the first
quarter this year. This decline is largely due to the manner in which the
banking center operating expenses are allocated to each segment. The amount of
banking center non-interest expense allocated to each segment is based on the
balance of its earning assets. At March 31, 2003, the earning assets balance for
the investment securities segment totaled $100.5 million, up slightly from $98.3
million a year ago. The balance of the assets for this section have increased
but not at the pace of the other segments. As a result, the amount of
non-interest expense allocated to this segment declined.
25
LIQUIDITY AND CAPITAL RESERVES
Net cash, as reported in the Statement of Cash Flows, decreased by $7.5 million,
or 50%, in the first three months of 2003. Cash inflows from principal
repayments on loans and securities, trust preferred securities, deposits and
wholesale funds, and the net proceeds from the sale of securities were exceeded
by the cash outflows for loan originations and the purchases of securities.
During the quarter, loan principal repayments totaled $46.2 million while
principal repayments and redemptions on securities amounted to $15.0 million.
Proceeds from the sale of securities available-for-sale totaled $13.9 million
while the net increase in deposit accounts, including interest credited, totaled
$7.9 million. During the quarter we also issued $4.0 million in trust preferred
securities.
Cash inflows were used mainly to fund loan originations, which amounted to $80.8
million during the first quarter of 2003, and to purchase securities totaling
$43.8 million, of which $30 million will settle in April and May 2003. These
purchases are not included in the cash flow numbers above but are included in
the "change in accounts payable and other liabilities" line item on the
Statement of Cash Flows. Since the purchases of securities took place in the
first quarter but do not settle until the second quarter, we have applied "trade
date accounting" and included the securities on our balance sheet. As a result,
we have increased our payable account to reflect the outflow of cash that will
occur in the second quarter upon settlement of the security purchases. During
the first quarter we also purchased the 400 Building, which was included in the
cash outflow of $12.2 million, for premises and equipment on the Statement of
Cash Flows.
Our long-term liquidity objective is to fund growth through consumer deposits.
Whenever that source is inadequate to meet asset growth requirements, FHLB
advances are normally accessed. The current ratio of FHLB advances to assets is
23.7%, which is below our credit limit of 40% of assets. Other sources of
liquidity include the sale of loans into the secondary market, net income after
the payment of dividends, and reverse repurchase agreement credit lines of $50
million. The Holding Company was also recently approved for a $5 million line of
credit with a national financial institution. This funding source is in addition
to the sources available at the banking subsidiary level. The Holding Company
line can be used to provide capital to the banking subsidiary as well as provide
liquidity to the Holding Company.
The FDIC's statutory framework for capital requirements establishes five
categories of capital strength, ranging from a high of well capitalized to a low
of critically under-capitalized. An institution's category depends upon its
capital level in relation to relevant capital measures, including a risk-based
capital measure, a leverage capital measure, and certain other factors. At March
31, 2003, we exceeded the capital levels required to meet the definition of a
well-capitalized institution:
26
For Capital Well Capitalized
Actual Adequacy Minimum Minimum Ratio
------------ ---------------- ----------------
Total capital (to risk-weighted assets):
First Mutual Bancshares, Inc. 11.37% 8.00% N/A
First Mutual Bank 11.01 8.00 10.00
Tier I capital (to risk-weighted assets):
First Mutual Bancshares, Inc. 9.86 4.00 N/A
First Mutual Bank 9.76 4.00 6.00
Tier I capital (to average assets):
First Mutual Bancshares, Inc. 7.49 4.00 N/A
First Mutual Bank 7.55 4.00 5.00
BANKING CENTER EXPANSION AND PURCHASE OF THE 400 BUILDING
- ---------------------------------------------------------
The Woodinville banking center site is under construction with an anticipated
grand opening during August 2003. We are also committed to acquire and build a
banking center on the Issaquah Plateau within the city of Sammamish. This
banking center location is expected to be operational by the end of 2003.
Another banking center location has been identified in the Canyon Park area of
Bothell. At this site we plan to build a 3-story office building which will
include a banking center. The upper two stories will be leased space. We believe
that the opening date of this office will likely occur in year 2005. The
anticipated additional capital costs of these three banking centers is $5.2
million. In addition, during the first quarter of 2003, we purchased the office
building in which our headquarters is located at 400 108th Avenue NE in
Bellevue. The acquisition price was approximately $12 million, and the purpose
of the purchase is to provide office space for retail banking, lending, and our
administrative personnel. The building was formerly known as the 400 Building
and in conjunction with the purchase we have changed the name to First Mutual
Center.
We have not presently identified banking center sites for year 2004, although we
continue to seek opportunities to expand our banking center franchise in our
primary market area east of Lake Washington, from Renton to the Bothell/Kenmore
area. We anticipate that we will open two new sites in year 2004 and we have
found that the initial investment for new banking centers can range from
$170,000 for leased sites to $720,000 for owned locations. This expansion will
continue to have an impact on expenses as banking centers are opened. Income
from banking center operations often requires a number of years before it equals
operating expenses.
TRUST PREFERRED SECURITIES ISSUANCE
- -----------------------------------
During the first quarter of 2003, First Mutual Bancshares, Inc. formed a
subsidiary (First Mutual Capital Trust II) whose sole purpose was to issue $4.0
million in trust preferred securities through Trapeza Funding LLC. Cohen Bros. &
Company served as advisor on the transaction. Under the terms of the
transaction, the trust preferred securities have a maturity of 30 years and are
redeemable after five years with certain exceptions. The securities have a fixed
rate of 6.87% for the first five years, which will then reset quarterly
thereafter at 3.30% over the three-month LIBOR index. The trust preferred
securities are recorded as a liability on the Statement of Financial Condition,
but qualify as Tier I capital for regulatory capital purposes. The proceeds from
this offering were partially used to acquire the 400 Building and will be used
to support future asset growth.
27
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
- ------------------------------------------------------------------
Market risk is defined as the sensitivity of income and capital from changes in
interest rates, foreign currency exchange rates, commodity prices, and other
relevant market rates or prices. The primary market risk to which we are exposed
is interest rate risk. Our profitability is dependent to a large extent on our
net interest income, which is the difference between the interest received from
interest-earning assets and the interest expense incurred on interest-bearing
liabilities. Our objectives in asset/liability management are to utilize capital
effectively, provide adequate liquidity, and enhance net interest income,
without taking unreasonable risks subjecting the Bank unduly to interest rate
fluctuations.
Assumptions regarding interest rate risk are inherent in all financial
institutions. Interest rate risk is the risk to earnings or capital resulting
from adverse movements in interest rates. Interest rate sensitivity is the
relationship between market interest rates and net interest income due to the
repricing characteristics of assets and liabilities. We monitor interest rate
sensitivity by examining our one-year-and-longer gap positions on a regular
basis. Gap analysis and an income simulation model are used to manage interest
rate risk.
Gap Analysis
The interest rate sensitive gap is defined as the difference between
interest-earning assets and interest-bearing liabilities anticipated to mature
or reprice during the same period. The gap analysis quantifies the mismatch
between these assets and liabilities in like time periods. Certain shortcomings
are inherent in gap analysis. For example, some assets and liabilities may have
similar maturities or repricing characteristics, but they may react differently
to changes in interest rates. Assets such as adjustable-rate mortgage loans may
have features that limit the effect that changes in interest rates have on the
asset in the short term and/or over the life of the loan. Due to the limitations
of the gap analysis, these features are not taken into consideration.
Additionally, in the event of a change in interest rates, prepayment and early
withdrawal penalties would likely deviate significantly from those assumed in
the gap calculation. As a result, we utilize the gap report as a complement to
the simulation model.
Simulation Model
The simulation model calculates the change to net interest income and the net
market value of equity based upon increases and decreases of 100 and 200 basis
point movements in interest rates. The model is based on a number of assumptions
such as the maturity, repricing, amortization, and prepayment characteristics of
loans and other interest-earning assets and the repricing of deposits and other
interest-bearing liabilities. The rate ramp (a monthly pro rata
increase/decrease over a one-year period) simulation model is run monthly for
review by the ALCO (Asset Liability Committee), senior management, and the Board
of Directors. We believe that the data and assumptions are realistic
representations of our portfolio and possible outcomes under the various
interest rate scenarios. Nonetheless, the interest rate sensitivity of our net
interest income and net market value of equity could vary substantially if
different assumptions were used or if actual experience differs from the
assumptions used.
28
ONE-YEAR INTEREST RATE SENSITIVE GAP
------------------------------------
(in thousands)
March 31, 2003 December 31, 2002
-------------- -----------------
One-Year Repricing Assets $ 615,847 $ 600,577
One-Year Repricing Liabilities 494,777 477,932
--------- ---------
One-year Gap $ 121,070 $ 122,645
--------- ---------
Total Assets $ 790,181 $ 745,295
========= =========
One-Year Interest Rate Sensitive
Gap as a Percent of Assets 15.3% 16.5%
RATE RAMP ESTIMATES
Net Interest Income and Net Market Value
March 31, 2003 December 31, 2002
Percentage Percentage
Change Change
- ------------------- ------------------------- -------------------------
Ratable Change in Economic Economic
Interest Rates Net Interest Value of Net Interest Value of
(in basis points) Income Equity Income Equity
- ------------------- -------------- ---------- -------------- ----------
+200 1% (13%) 2% (11%)
+100 n/a (5%) n/a (4%)
-100 (1%) 1% (1%) 0%
-200 n/a n/a n/a n/a
The above table refers to changes for the 12-month periods beginning March 31,
2003 and December 31, 2002, respectively.
Gap Model
While the interest rate sensitive gap, expressed as a percentage of assets, fell
from 16.5% at December 31, 2002, to 15.3% at March 31, 2003, the results
indicate that we remain asset sensitive. That is, more assets than liabilities
will mature or reprice within the next year. The change in the gap was driven by
the mix of the additions to each side of the balance sheet during the first
quarter as well as the overall balance sheet growth.
Approximately 76% of the net growth in assets for the first quarter consisted of
assets that would not mature or reprice within the next 12 months. These assets
included $12 million in new fixed assets, in the form of the 400 Building in
Bellevue, which we purchased during the first quarter, as well as $30 million in
long-term fixed-rate securities, which will fund in the second quarter. The
remaining 24% of net new asset growth was subject to maturity/repricing dates
within one year. This growth was centered in new residential ARM balances, in
both the single and multi-family classes, with annually adjustable loans tied to
the one-year CMT, LIBOR, and FHLB rates. By comparison, approximately 38% of the
growth in liabilities was subject to a maturity or repricing date in the next 12
months. This included growth in the six- and 12-month term
29
time deposits, which increased from $11.4 and $147.5 million at December 31,
2002 to $18.5 and $159.4 million at March 31, 2003, respectively. Additionally,
the volume of our FHLB borrowings scheduled to mature within 12 months increased
by $5.6 million as long-term fixed-rate advances continued to roll forward.
Overall, a higher growth rate for liabilities maturing/repricing in the next 12
months than assets repricing in the same period resulted in a net $1.6 million
reduction in our dollar gap, reducing the numerator of the
gap-as-a-percentage-of-assets ratio. This gap ratio was further reduced by the
overall growth in the balance sheet during the quarter, which increased the
denominator of the gap ratio. The combined effect of these two factors was the
reduction in the one-year gap ratio from 16.5% to 15.3% of total assets.
Net Interest Income (NII) Simulation
The simulation model for the period further indicates results typically
associated with an asset sensitive institution, in that our net interest income
is projected to increase in a rising rate environment and decline in a falling
interest rate scenario. The results of the NII simulation, however, suggest a
less pronounced exposure than do the results of the gap position.
The NII simulation for the quarter ended March 31, 2003, projected higher net
interest income for the next 12-month period than did the same model as of
December 31, 2002. In the base case, which assumes a stable interest rate
environment, net interest income rose from $26.0 million in the December 2002
simulation to $27.7 million in the March 2003 projection. The increase was
primarily attributable to balance sheet growth, as earning assets grew from
$726.5 million at the time of the December 2002 projection to $763.8 million at
the March 2003 simulation.
When analyzing the impacts of two separate interest rate ramp scenarios, a 100
basis point decline and a 200 basis point increase in interest rates over the
next 12 months, the volatility of net interest income was reduced modestly in
the March 2003 projection when compared to the December 2002 simulation.
Contributing to this reduction in volatility was the model's incorporation of
the above-mentioned fixed-rate securities purchases as well as reductions in
overnight FHLB investments for the period ending March 31, 2003. The new assets
purchased were offset in the model by longer-term FHLB borrowings, which
represented the expected funding method for securities purchases, as well as
growth in Platinum MMDA accounts, which was observed in the first quarter. As
both the securities and the offsetting borrowings used to fund the purchases,
which are expected to settle in the second quarter, were long-term fixed-rate
instruments, the addition of these items to the balance sheet reduced the
expected net interest income volatility over the next 12 months.
In all interest rate scenarios of the income simulation, the balance sheet is
assumed to remain stable with no balance sheet growth or contraction regardless
of interest rate movements. Implicit in this assumption are additional
assumptions for higher new securities purchases and loan production volumes at
lower interest rate levels, and reduced securities purchases and loan production
when rates increase. These additional assumptions are a result of the observed
tendency, and model assumptions, that loan and securities prepayments will tend
to accelerate in falling interest rate scenarios and slow when interest rates
rise.
30
Economic Value of Equity (EVE) Simulation
The EVE analysis goes beyond simulating earnings for a specified time period to
estimating the present value of all financial instruments in our portfolio, and
then analyzing how the economic value of the portfolio would be affected by
various alternative interest rate scenarios. The portfolio's economic value is
calculated by generating principal and interest cash flows for the entire life
of all assets and liabilities, then discounting these cash flows back to their
present values. The assumed discount rate used for each projected cash flow is
the yield currently available from alternative instruments of comparable risk
and duration.
Contributing significantly to the EVE simulation results are our fixed-rate
loans and securities, which comprised approximately 17.5% of the total modeled
rate sensitive assets as of March 31, 2003. In a simulated upward shift of the
yield curve, the EVE is expected to decline. As interest rates rise, the
discount rates used to calculate the present values of assets and liabilities
will increase, causing the present values of both assets and liabilities to
fall. Additionally, as noted above, when interest rates rise, the cash flows on
our assets will typically decelerate as borrowers become less likely to
refinance or prepay their loans. As a result, less cash is available to reinvest
at the higher market rates. As these effects are more pronounced for our assets,
which would have declined in value by an estimated 3.7% versus an approximately
2.8% decline in the value of liabilities, the economic value of our equity is
negatively impacted in this scenario, declining 13%. Furthermore, the additional
long-term fixed-rate assets and liabilities mentioned above that were added to
the simulation in the first quarter of 2003 increased the balance sheet
sensitivity to an increase in interest rates. As of the December 2002
projections, a 200 basis point increase in interest rates would have led to a
3.3% decrease in the economic value of assets and a 2.6% decline in liabilities,
implying an overall 11% negative impact to the value of our equity position.
The opposite occurs when rates decline, as the discount rates used to calculate
the present values of assets and liabilities will decrease, causing the present
values of both assets and liabilities to rise. In keeping consistent with the
explanation above, the EVE would be expected to be positively impacted in this
scenario. Counteracting this effect, however, cash flows on our assets will tend
to accelerate in a falling rate scenario, as borrowers refinance their existing
loans at lower interest rates. We must then reinvest these cash flows at the
lower market rates. Consequently, in a downward shift, EVE may either decline or
rise at a rate significantly lower than that of the decline in the rising rate
scenario. These results are attributable to an effect referred to as negative
convexity. Taking this negative convexity into account, the simulation results
indicated that the impact to EVE was less pronounced in the falling rate
scenario. In this case, the economic values of both assets and liabilities at
March 31, 2003 were each positively impacted by approximately 1.4% when rates
were assumed to fall by 100 basis points. This resulted in a positive impact to
the economic value of our equity of less than 1%. Again, however, the additional
long-term fixed-rate assets and liabilities that were added to the simulation in
the first quarter of 2003 increased the balance sheet sensitivity to the change
in interest rates. As of the December 2002 projections, a 100 basis point
decrease in interest rates would have led to a 1.3% increase in the economic
value of assets and a 1.4% increase in liabilities, implying an overall positive
impact to EVE of less than two-tenths of 1%.
The sensitivity analysis does not necessarily represent a forecast. There are
numerous assumptions inherent in the simulation model as well as in the gap
report. Some of these assumptions include the nature and timing of interest rate
levels, including the shape of the yield curve, prepayments on loans and
securities, deposit decay rates, pricing decisions on loans and
31
deposits, and reinvestment/replacement of asset and liability cash flows.
Customer preferences and competitor and economic influences are impossible to
predict, and therefore we cannot make any assurances as to the outcomes of these
analyses.
Securities
ITEM 3
The following table sets forth certain information regarding carrying values and
percentage of total carrying values of the Bank's consolidated portfolio of
securities classified as available-for-sale and held-to-maturity (in thousands).
At March 31,
------------------------------------------
2003 2002
------------------- -------------------
Available-for-Sale: Carrying Percent Carrying Percent
Value of Total Value of Total
-------- -------- -------- --------
US agency securities $ 13,806 19% $ -- 0%
Mortgage backed securities:
Freddie Mac 18,475 25% 5,194 8%
Fannie Mae (includes Fannie
Mae stock) 42,060 56% 59,385 92%
-------- -------- -------- --------
Total mortgage-backed securities 60,535 81% 64,579 100%
-------- -------- -------- --------
Total securities available-for-sale $ 74,341 100% $ 64,579 100%
======== ======== ======== ========
At March 31,
------------------------------------------
2003 2002
------------------- -------------------
Held-to-Maturity: Carrying Percent Carrying Percent
Value of Total Value of Total
-------- -------- -------- --------
Municipal Bonds $ 1,333 9% $ 1,346 6%
Mortgage backed securities:
Freddie Mac 630 4% 1,097 5%
Fannie Mae 12,440 87% 21,168 89%
-------- -------- -------- --------
Total mortgage-backed securities 13,070 91% 22,265 94%
CMO's 17 0% 55 0%
-------- -------- -------- --------
Total securities held-to-maturity $ 14,420 100% $ 23,666 100%
======== ======== ======== ========
Estimated Market Value $ 14,858 $ 24,092
======== ========
32
ITEM 3A
The following table shows the maturity or period to repricing of the Company's
consolidated portfolio of securities available-for-sale and held-to-maturity
(dollars in thousands):
Available-for-sale at March 31, 2003
---------------------------------------------------------------------------------
Over One Over Three Over Five
One Year or Less to Three Years to Five Years to Ten Years
---------------------------------------------------------------------------------
Weighted Weighted Weighted Weighted
Carrying Average Carrying Average Carrying Average Carrying Average
Value Yield Value Yield Value Yield Value Yield
---------------------------------------------------------------------------------
AVAILABLE-FOR-SALE:
- ------------------
US Government securities $ -- 0.00% $ -- 0.00% $ -- 0.00% $ 7,291 4.07%
Mortgage backed securities:
Freddie Mac 363 4.46% -- 0.00% -- 0.00% 8,230 4.28%
Fannie Mae 659 4.37% -- 0.00% -- 0.00% 17,130 5.38%
-------- -------- -------- -------- -------- -------- -------- --------
Total mortgage-backed securities 1,022 4.40% -- 0.00% -- 0.00% 25,360 5.02%
Total securities available-for-sale --
Carrying Value $ 1,022 4.40% $ -- 0.00% $ -- 0.00% $ 32,651 4.81%
---------------------------------------------------------------------------------
Total securities available-for-sale --
Amortized Cost $ 989 4.40% $ -- 0.00% $ -- 0.00% $ 31,758 4.80%
---------------------------------------------------------------------------------
Available-for-sale at March 31, 2003
------------------------------------------------------------
Over Ten
to Twenty Years Over Twenty Years Total
------------------------------------------------------------
Weighted Weighted Weighted
Carrying Average Carrying Average Carrying Average
Value Yield Value Yield Value Yield
------------------------------------------------------------
AVAILABLE-FOR-SALE:
- ------------------
US Government securities $ 6,515 4.00% $ -- 0.00% $ 13,806 4.27%
Mortgage backed securities:
Freddie Mac 9,882 4.50% -- 0.00% 18,475 4.40%
Fannie Mae 24,271 4.67% -- 0.00% 42,060 4.95%
-------- -------- -------- -------- -------- --------
Total mortgage-backed securities 34,153 4.62% -- 0.00% 60,535 4.78%
Total securities available-for-sale --
Carrying Value $ 40,668 4.52% $ -- 0.00% 74,341 4.65%
------------------------------------------------------------
Total securities available-for-sale --
Amortized Cost $ 40,477 4.52% $ -- 0.00% 73,224 4.64%
------------------------------------------------------------
Held-to-Maturity at March 31, 2003
---------------------------------------------------------------------------------
Over One Over Three Over Five
One Year or Less to Three Years to Five Years to Ten Years
---------------------------------------------------------------------------------
Weighted Weighted Weighted Weighted
Carrying Average Carrying Average Carrying Average Carrying Average
Value Yield Value Yield Value Yield Value Yield
---------------------------------------------------------------------------------
HELD-TO-MATURITY:
- ----------------
Municipal Bonds $ -- 0.00% $ -- 0.00% $ -- 0.00% $ -- 0.00%
Mortgage backed securities:
Freddie Mac 629 4.95% -- 0.00% -- 0.00% -- 0.00%
Fannie Mae 3,191 5.25% 5,393 5.50% 2,762 5.83% -- 0.00%
-------- -------- -------- -------- -------- -------- -------- --------
Total mortgage-backed securities 3,820 5.20% 5,393 5.50% 2,762 5.83% -- 0.00%
CMO's -- 0.00% -- 0.00% -- 0.00% -- 0.00%
---------------------------------------------------------------------------------
Total securities held-to-maturity --
Carrying Value $ 3,820 5.20% $ 5,393 5.50% $ 2,762 5.83% $ -- 0.00%
---------------------------------------------------------------------------------
Total securities held-to-maturity --
Fair Market Value $ 3,959 5.21% $ 5,587 5.50% $ 2,893 5.82% $ -- 0.00%
---------------------------------------------------------------------------------
Held-to-Maturity at March 31, 2003
------------------------------------------------------------
Over Ten
to Twenty Years Over Twenty Years Total
------------------------------------------------------------
Weighted Weighted Weighted
Carrying Average Carrying Average Carrying Average
Value Yield Value Yield Value Yield
------------------------------------------------------------
HELD-TO-MATURITY:
- ----------------
Municipal Bonds $ 220 5.38% $ 1,113 6.16% $ 1,333 6.03%
Mortgage backed securities:
Freddie Mac -- 0.00% -- 0.00% 629 4.95%
Fannie Mae 1,095 4.50% -- 0.00% 12,441 5.42%
-------- -------- -------- -------- -------- --------
Total mortgage-backed securities 1,095 4.50% -- 0.00% 13,070 5.40%
CMO's 17 6.50% -- 0.00% 17 6.50%
------------------------------------------------------------
Total securities held-to-maturity --
Carrying Value $ 1,332 4.67% $ 1,113 6.16% 14,420 5.46%
------------------------------------------------------------
Total securities held-to-maturity --
Fair Market Value $ 1,333 4.67% $ 1,085 6.16% 14,857 5.46%
------------------------------------------------------------
33
ITEM 4. CONTROLS AND PROCEDURES
The Bank's Chief Executive Officer and Chief Financial Officer and other
appropriate officers have evaluated the Bank's disclosure controls and
procedures designed to ensure that information required to be disclosed in our
filings under the Securities Exchange Act of 1934 is recorded, processed,
summarized and reported within the time periods specified in the Securities
Exchange Commission's rules and forms, and have concluded that, although there
are inherent limitations in all control systems and although we apply certain
reasonable cost/benefit considerations to the design of our disclosure controls
and procedures, as of March 31, 2003 those disclosure controls and procedures
are effective.
There have been no changes in the Bank's internal controls or in other factors
known to us that could significantly affect these controls subsequent to their
evaluation, including any corrective actions with regard to significant
deficiencies and material weaknesses.
While we believe that our existing disclosure controls and procedures have been
effective to accomplish these objectives, we intend to continue to examine,
refine, and formalize our disclosure controls and procedures and to monitor
ongoing developments in this area.
PART II
OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
At March 31, 2003, we were not engaged in any litigation, which in the opinion
of management, after consultation with our legal counsel, would be material to
the Bank.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
a. On January 15, 2003, the holding company issued a $4 million Junior
Subordinated Deferrable Interest Debenture due January 14, 2033, to a
business trust subsidiary which issued $4 million in trust preferred
securities based upon this debenture and a guarantee from the Bank.
Interest is payable quarterly at a rate of 6.87% for the first five
years. The Debenture matures on January 14, 2033, and may be redeemed
on or after January 31, 2008, or if certain conditions are met. The
debenture and trust preferred securities provide that we have the
right to elect to defer the payment of interest on the debenture and
trust preferred securities for up to an aggregate of 20 quarterly
periods; however, if the Bank should defer the payment of interest or
default on the payment of interest on the debenture, we may not
declare or pay any dividends on our common stock during any such
period. The issuance of the debenture and the trust preferred
securities were exempt from registration under the Securities Act
34
pursuant to Section 4(2) there under. We utilized the proceeds of the
debenture in connection with our purchase of the 400 Building and for
future asset growth.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY-HOLDERS
The Annual Meeting of Shareholders of First Mutual Bancshares, Inc. was held on
April 24, 2003. The results of votes on the matter presented at the Meeting are
as follows:
The following individuals were elected as directors for the term noted:
Votes Votes
Director Votes For Withheld Abstained Term
- -------- --------- -------- --------- ----
James J. Doud, Jr. 3,986,184 56,691 230,686 3 years
Richard S. Sprague 4,010,078 32,797 230,686 3 years
Robert C. Wallace 3,980,390 62,485 230,686 3 years
The terms of the Class III and I directors expire at the Annual Meeting of
Shareholders for 2004 and 2005, respectively.
CLASS III DIRECTORS, term expires in 2004
- -----------------------------------------
Mary Case Dunnam
George W. Rowley, Jr.
John R. Valaas
CLASS I DIRECTORS, term expires in 2005
- ---------------------------------------
Janine Florence
F. Kemper Freeman, Jr.
Victor E. Parker
Robert J. Herbold
The First Mutual Bancshares, Inc. Board of Directors also announced at the
annual meeting that Robert J. Herbold had been elected by the Board to fill a
newly created position for a tenth director, Class I, for the Boards of
Directors of both the Company and the Bank. Mr. Herbold has accepted the
position effective May 1, 2003.
After nearly seven years at Microsoft as COO, Herbold retired in February 2001
and is currently working part time for Microsoft as Executive Vice President
assisting in the government, industry, and customer areas. He is a highly
sought-after public speaker and is Managing Director of The Herbold Group LLC, a
consulting company focused on improving profitability. Prior to joining
Microsoft, Herbold spent 26 years at Procter & Gamble (NYSE: PG), culminating in
five years as Senior Vice President, Advertising and Information Services. He
has a Bachelor of Science degree from the University of Cincinnati, and both a
Master's Degree in Mathematics and a Ph.D. in Computer Science from Case Western
Reserve University. Herbold serves on the Board of Directors of Weyerhaeuser
Corporation (NYSE: WY), Agilent Technologies (NYSE: A), and Cintas Corporation
(NYSE:CTAS). He was also recently appointed by President Bush to the President's
Council of Advisors on Science and Technology.
35
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(3.1) Articles of Incorporation, Incorporated by reference to the Current
Report on Form 8-K filed with the SEC on September 21, 2000.
(3.2) Amendment to Articles of Incorporation effective May 16, 2001.
(3.3) Bylaws (as amended and restated), Incorporated by reference from the
Form 10-K filed with the SEC on March 31, 2003.
(11) Statement regarding computation of per share earnings. Reference is
made to the Company's Consolidated Statements of Income attached
hereto as part of Item I Financial Statements, which are
incorporated herein by reference.
(99.1) Certification by President and Chief Executive Officer Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002
(99.2) Certification by Executive Vice President and Principal Financial
Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Date: May 15, 2003 FIRST MUTUAL BANCSHARES, INC.
/s/ John R. Valaas
-----------------------------------
John R. Valaas
President and Chief Executive Officer
/s/ Roger A. Mandery
-----------------------------------
Roger A. Mandery
Executive Vice President
(Principal Financial Officer)
36
CERTIFICATION
I, John R. Valaas, President and Chief Executive Officer of the Company certify
that:
1. I have reviewed this quarterly report on Form 10-Q of First Mutual
Bancshares, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this quarterly report is being
prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors:
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and material
weaknesses.
Date: May 15, 2003 By: /s/ John R. Valaas
----------------------------------
John R. Valaas
President and Chief Executive Officer
37
CERTIFICATION
I, Roger A. Mandery, Principal Financial Officer of the Company certify that:
1. I have reviewed this quarterly report on Form 10-Q of First Mutual
Bancshares, Inc;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly
report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors:
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and material
weaknesses.
Date: May 15, 2003 By: /s/ Roger A. Mandery
--------------------------
Roger A. Mandery
Principal Financial Officer
38