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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 September 30, 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
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(State or other jurisdiction of (I.R.S. Employer
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. November 10, 2003 4,718,443
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FIRST MUTUAL BANCSHARES, INC.
QUARTERLY REPORT ON FORM 10-Q
SEPTEMBER 30, 2003
TABLE OF CONTENTS
Page
----
PART I: FINANCIAL INFORMATION............................................... 1
Forward-Looking Statements Disclaimer..................................... 1
Item 1. Financial Statements.............................................. 1
Critical Accounting Policies...................................... 2
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations......................................... 17
General....................................................... 17
Results of Operations......................................... 18
Net Income.................................................. 18
Net Interest Income......................................... 18
Other Operating Income...................................... 19
Operating Expenses.......................................... 23
Key Financial Ratios........................................ 25
Financial Condition........................................... 26
Asset Quality................................................. 27
Portfolio Information......................................... 29
Deposit Information........................................... 30
Business Segments............................................. 30
Consumer Lending............................................ 31
Commercial Lending.......................................... 33
Investment Securities....................................... 34
Liquidity and Capital Reserves.................................... 35
Banking Center Expansion.......................................... 36
Item 3. Quantitative and Qualitative Disclosures About Market Risk........ 37
Item 4. Controls and Procedures........................................... 41
PART II: OTHER INFORMATION.................................................. 42
Item 1. Legal Proceedings................................................. 42
Item 2. Changes in Securities and Use of Proceeds......................... 42
Item 3. Defaults Upon Senior Securities................................... 42
Item 4. Submission of Matters to a Vote of Security-Holders............... 42
Item 5. Other Information................................................. 42
Item 6. Exhibits and Reports on Form 8-K.................................. 42
SIGNATURES.................................................................. 44
CERTIFICATIONS..............................................................
i
PART I: FINANCIAL INFORMATION
FORWARD-LOOKING STATEMENTS DISCLAIMER
- -------------------------------------
Our Form 10-Q contains statements concerning anticipated future operations,
trends, 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 our future interest rate margins and
the simulated effects of changes in interest rates on our interest income and
expenses, the anticipated growth of our home improvement portfolio and the sale
of a portion of that portfolio, our current belief about the quality of our loan
portfolio and our expectations regarding write-offs and factors affecting loan
loss reserves, trends in income and expenses, the outlook for deposit growth and
funding sources, and anticipated sales of investment securities; observations
pertaining to the potential disparate movement of assets and liabilities, 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.
1
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.
Critical Accounting Policies
- ----------------------------
Various elements of the Bank's accounting policies, by their nature, are
inherently subject to estimation techniques, valuation assumptions and other
subjective assessments. In particular, management has identified several
accounting policies that, due to the judgments, estimates, and assumptions
inherent in those policies, are critical to an understanding of the Bank's
financial statements. These policies relate to the methodology for the
determination of the provision and allowance for loan losses, deferred taxes,
valuation of interest rate locks, valuation of stock options, amortization of
deferred loan fees and costs, valuation and amortization of mortgage and
deferred servicing rights, and valuation of repossessed assets and real estate
held-for-sale. These policies and the judgments, estimates, and assumptions are
described in greater detail in subsequent sections of the Management Discussion
and Analysis and in the consolidated financial statements and footnotes thereto
included in the Bank's annual report on Form 10-K for the year ended December
31, 2002. Management believes that the judgments, estimates, and assumptions
used in the preparation of the financial statements are appropriate given the
factual circumstances at the time. However, given the sensitivity of the
financial statements to these critical accounting policies, the use of other
judgments, estimates, and assumptions could result in material differences in
the results of operations or financial condition.
Consolidated Financial Statements of the Company begin on page 3.
2
Item 1. Financial Statements
FIRST MUTUAL BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
September 30, December 31,
2003 2002
------------- -------------
ASSETS: (Unaudited)
CASH AND CASH EQUIVALENTS:
Interest-earning deposits $ 4,215,934 $ 6,203,843
Noninterest-earning demand deposits
and cash on hand 5,632,506 8,767,684
------------- -------------
9,848,440 14,971,527
MORTGAGE-BACKED AND OTHER SECURITIES
AVAILABLE-FOR-SALE 71,915,048 58,380,204
LOANS RECEIVABLE, HELD-FOR-SALE 11,668,475 12,699,004
MORTGAGE-BACKED AND OTHER SECURITIES
HELD-TO-MATURITY 9,882,238 16,358,042
LOANS RECEIVABLE 703,010,292 622,374,515
RESERVE FOR LOAN LOSSES (8,201,362) (7,754,106)
------------- -------------
LOANS RECEIVABLE, net 694,808,930 614,620,409
ACCRUED INTEREST RECEIVABLE 3,653,037 3,435,343
LAND, BUILDINGS AND EQUIPMENT, net 23,952,528 10,964,441
FEDERAL HOME LOAN BANK (FHLB) STOCK,
at cost 10,898,200 10,443,200
DEFERRED SERVICING RIGHTS 116,243 --
MORTGAGE SERVICING RIGHTS 86,292 49,914
REAL ESTATE OWNED 214,703 --
OTHER ASSETS 985,045 3,373,168
------------- -------------
TOTAL $ 838,029,179 $ 745,295,252
============= =============
See accompanying notes to the financial statements.
3
FIRST MUTUAL BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(Continued)
September 30, December 31,
2003 2002
------------- -------------
LIABILITIES: (Unaudited)
Deposits:
Money market deposit and
checking accounts $ 170,839,782 $ 134,247,575
Regular savings 8,467,324 8,386,918
Time deposits 376,619,120 354,735,126
------------- -------------
Total deposits 555,926,226 497,369,619
Drafts payable 385,381 369,034
Accounts payable and other liabilities 4,334,521 8,080,632
Advance payments by borrowers for
taxes and insurance 3,082,394 1,798,233
FHLB advances 211,867,819 184,143,897
Other advances 500,000 250,000
Trust preferred securities 13,000,000 9,000,000
------------- -------------
Total liabilities 789,096,341 701,011,415
STOCKHOLDERS' EQUITY:
Common stock, $1 par value-
Authorized, 10,000,000 shares
Issued and outstanding, 4,718,443
and 4,247,166 shares, respectively 4,718,443 4,247,166
Additional paid-in capital 33,515,722 24,028,610
Retained earnings 11,153,993 15,214,220
Accumulated other comprehensive income:
Unrealized gain(loss) on securities available-for-sale
and interest rate swap, net of federal income tax (455,320) 793,841
------------- -------------
Total stockholders' equity 48,932,838 44,283,837
------------- -------------
TOTAL $ 838,029,179 $ 745,295,252
============= =============
See accompanying notes to the financial statements.
4
FIRST MUTUAL BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF INCOME
Quarters ended Nine Months ended
September 30, September 30,
2003 2002 2003 2002
----------- ----------- ----------- -----------
(Unaudited)
INTEREST INCOME:
Loans Receivable $11,491,346 $10,868,309 $33,685,016 $32,259,697
Interest on AFS Securities 722,572 823,104 2,059,613 2,683,591
Interest on HTM Securities 138,640 291,523 511,857 988,659
Interest Other 171,534 223,934 552,708 532,211
----------- ----------- ----------- -----------
12,524,092 12,206,870 36,809,194 36,464,158
INTEREST EXPENSE:
Deposits 2,965,163 3,482,694 8,995,474 10,637,202
FHLB advances and other 1,648,206 1,912,267 5,390,805 5,808,397
----------- ----------- ----------- -----------
4,613,369 5,394,961 14,386,279 16,445,599
----------- ----------- ----------- -----------
Net interest income 7,910,723 6,811,909 22,422,915 20,018,559
PROVISION FOR LOAN LOSSES 350,000 650,000 810,000 785,000
----------- ----------- ----------- -----------
Net interest income, after provision
for loan losses 7,560,723 6,161,909 21,612,915 19,233,559
OTHER OPERATING INCOME:
Gain on sales of loans 281,978 522,670 661,035 980,194
Servicing fees, net of amortization 17,574 34,064 47,071 86,405
Gain on sales of investments 189,041 129,383 662,564 286,826
Fees on deposits 132,123 118,478 383,411 348,370
Other 336,527 274,615 1,072,054 789,750
----------- ----------- ----------- -----------
Total other operating income 957,243 1,079,210 2,826,135 2,491,545
See accompanying notes to the financial statements.
5
FIRST MUTUAL BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF INCOME
(Continued)
Quarters ended Nine Months ended
September 30, September 30,
2003 2002 2003 2002
----------- ----------- ----------- -----------
(Unaudited) (Unaudited)
OPERATING EXPENSES:
Salaries and employee benefits $ 2,955,713 $ 2,400,765 $ 8,942,596 $ 7,588,177
Occupancy 620,437 590,131 1,780,449 1,727,371
Other 1,512,191 1,072,649 4,066,078 3,359,005
----------- ----------- ----------- -----------
Total other operating expenses 5,088,341 4,063,545 14,789,123 12,674,553
----------- ----------- ----------- -----------
Income before federal income taxes 3,429,625 3,177,574 9,649,927 9,050,551
FEDERAL INCOME TAXES 1,160,400 1,074,639 3,263,927 3,060,410
----------- ----------- ----------- -----------
NET INCOME $ 2,269,225 $ 2,102,935 $ 6,386,000 $ 5,990,141
=========== =========== =========== ===========
PER SHARE DATA:
Basic earnings per common share $ 0.48 $ 0.42 $ 1.36 $ 1.09
Earnings per common share, assuming dilution $ 0.46 $ 0.41 $ 1.32 $ 1.07
WEIGHTED AVERAGE SHARES OUTSTANDING 4,714,463 4,980,625 4,703,558 5,473,433
=========== =========== =========== ===========
WEIGHTED AVERAGE SHARES OUTSTANDING
INCLUDING DILUTIVE STOCK OPTIONS 4,885,930 5,102,992 4,841,649 5,573,377
=========== =========== =========== ===========
See accompanying notes to the financial statements.
6
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/(loss) 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/(loss) 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 $165,707 41,790 41,790 409,159
Issuance of stock through employees' stock plans 1,386 1,386 23,617
10% stock dividend 428,101 428,101 9,054,336 (9,482,437)
Cash dividends declared ($0.21 per share) (963,790)
Comprehensive income:
Net income 6,386,000
Other comprehensive income(loss)--Change in
unrealized gain/(loss) on securities available-for-sale,
and interest rate swap, net of federal income tax
------------ ------------ ------------ ------------
BALANCE, Sept 30, 2003 4,718,443 $ 4,718,443 $ 33,515,722 $ 11,153,993
============ ============ ============ ============
See accompanying notes to the financial statements.
7
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(Unaudited)(Continued)
Accumulated
Employee Stock Other
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/(loss) 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/(loss) 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 $165,707 450,949
Issuance of stock through employees' stock plans 25,003
10% stock dividend --
Cash dividends declared ($0.21 per share) (963,790)
Comprehensive income:
Net income 6,386,000
Other comprehensive income(loss)--Change in
unrealized gain/(loss) on securities available-for-sale,
and interest rate swap, net of federal income tax (1,249,161) (1,249,161)
------------ ------------ ------------
BALANCE, Sept 30, 2003 $ -- $ (455,320) $ 48,932,838
============ ============ ============
See accompanying notes to the financial statements.
8
FIRST MUTUAL BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Nine months ended September 30,
-----------------------------
2003 2002
------------- -------------
(Unaudited)
OPERATING ACTIVITIES:
Net income $ 6,386,000 $ 5,990,141
Adjustments to reconcile net income to net cash
from operating activities:
Provision for loan losses 810,000 785,000
Depreciation and amortization 809,027 576,275
Deferred loan origination fees, net of accretion (1,080,520) (601,023)
Amortization of mortgage servicing rights 40,859 35,589
Gain on sales of loans (661,037) (980,194)
Gain on sale of securities available-for-sale (662,563) (286,826)
FHLB stock dividends (455,000) (446,600)
Changes in operating assets & liabilities:
Loans receivable held-for-sale 1,030,529 (1,555,291)
Accrued interest receivable (217,694) 137,697
Other assets 71,733 (1,449,404)
Drafts payable 16,347 (522,493)
Accounts payable and other liabilities (1,462,700) 3,818,985
Advance payments by borrowers for taxes and insurance 1,284,161 1,492,334
------------- -------------
Net cash provided by operating activities 5,909,142 6,994,190
------------- -------------
INVESTING ACTIVITIES:
Loan originations (259,630,209) (170,589,494)
Loan principal repayments 154,774,527 140,517,563
Increase in undisbursed loan proceeds 27,310,743 7,164,336
Principal repayments & redemptions on
mortgage-backed and other securities 33,711,894 13,204,561
Purchase of securities held-to-maturity (1,098,881) (250,000)
Purchase of securities available-for-sale (67,699,719) (39,526,461)
Purchases of premises and equipment (13,752,620) (2,236,384)
Purchase of FHLB stock -- (62,600)
Proceeds from sale of loans -- 306,104
Proceeds from sale of securities 25,442,072 25,836,655
------------- -------------
Net cash (used) by investing activities (100,942,193) (25,635,720)
See accompanying notes to the financial statements.
9
FIRST MUTUAL BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Continued)
Nine months ended September 30,
-----------------------------
2003 2002
------------- -------------
(Unaudited)
FINANCING ACTIVITIES:
Net increase in deposit accounts $ 50,000,917 $ 44,621,347
Interest credited to deposit accounts 8,555,690 10,358,534
Proceeds from trust preferred securities 4,000,000 9,000,000
Repurchase/Retirement of Common Stock -- (15,798,468)
Issuance of stock through employees' stock plans 25,003 --
Proceeds from advances 365,860,754 134,198,892
Repayment of advances (337,886,832) (163,922,449)
Dividends paid (930,810) (1,026,509)
Proceeds from exercise of stock options 285,242 193,918
------------- -------------
Net cash provided by financing activities 89,909,964 17,625,265
------------- -------------
NET (DECREASE) IN CASH AND CASH
EQUIVALENTS $ (5,123,087) $ (1,016,265)
CASH & CASH EQUIVALENTS:
Beginning of year 14,971,527 14,615,303
------------- -------------
End of quarter $ 9,848,440 $ 13,599,038
============= =============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW
INFORMATION:
Loans originated for mortgage banking activities $ 67,009,444 $ 53,797,048
============= =============
Loans originated for investment activities $ 259,630,209 $ 170,589,494
============= =============
Proceeds from sales of loans held-for-sale $ 68,039,973 $ 52,241,757
============= =============
Cash paid during the nine months ended September 30 for:
Interest $ 14,604,857 $ 16,541,852
============= =============
Income taxes $ 2,566,000 $ 2,490,000
============= =============
SUPPLEMENTAL DISCLOSURES OF NONCASH
INVESTING ACTIVITIES:
Loans securitized into securities available-for-sale $ -- $ 14,485,309
============= =============
Loans transferred to real estate
held-for-sale, net $ 214,703 $ --
============= =============
10
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.
At September 30, 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 September 30, Years Ended September 30,
---------------------------- ----------------------------
2003 2002 2003 2002
----------- ----------- ----------- -----------
Net Income, as reported $ 2,269,225 $ 2,102,935 $ 6,386,000 $ 5,990,141
Deduct: Total stock-based employee/
director compensation expense
determined under fair value based
method for all awards, net of related
tax effects (111,274) (62,835) (216,187) (110,945)
----------- ----------- ----------- -----------
Pro forma net income $ 2,157,951 $ 2,040,100 $ 6,169,813 $ 5,879,196
=========== =========== =========== ===========
Earnings per share:
Basic - as reported $ 0.48 $ 0.42 $ 1.36 $ 1.09
Basic - pro forma $ 0.46 $ 0.41 $ 1.31 $ 1.07
Diluted - as reported $ 0.46 $ 0.41 $ 1.32 $ 1.07
Diluted - pro forma $ 0.44 $ 0.40 $ 1.27 $ 1.05
Weighted average shares outstanding:
Basic 4,714,463 4,980,625 4,703,558 5,473,433
Diluted 4,885,930 5,102,992 4,841,649 5,573,377
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.
11
NOTE 2.
MORTGAGE-BACKED AND OTHER SECURITIES AVAILABLE-FOR-SALE
The amortized cost and estimated fair value of securities available-for-sale at
September 30, 2003, and December 31, 2002 are summarized as follows:
Gross Gross Estimated
Amortized unrealized unrealized fair
cost gains losses value
----------- ----------- ----------- -----------
September 30, 2003
Freddie Mac securities $16,252,345 $ 65,939 $ 247,195 $16,071,089
Fannie Mae securities 44,762,836 354,268 323,104 44,794,000
US agency securities 10,980,014 116,845 46,900 11,049,959
----------- ----------- ----------- -----------
$71,995,195 $ 537,052 $ 617,199 $71,915,048
=========== =========== =========== ===========
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
----------- ----------- ----------- -----------
September 30, 2003
Fannie Mae securities $ 7,993,364 $ 242,523 $ -- $ 8,235,887
Freddie Mac securities 556,443 4,214 668 559,989
Municipal bonds 1,327,325 334 25,665 1,301,994
REMICS 5,106 11 -- 5,117
----------- ----------- ----------- -----------
$ 9,882,238 $ 247,082 $ 26,333 $10,102,987
=========== =========== =========== ===========
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
REMICs 25,617 468 -- 26,085
----------- ----------- ----------- -----------
$16,358,042 $ 608,758 $ 40,936 $16,925,864
=========== =========== =========== ===========
12
NOTE 4.
NONPERFORMING ASSETS
The Bank had nonperforming assets as follows:
September 30, 2003 December 31, 2002
------------- -------------
Nonperforming loans $ 225,928 $ 2,073,525
Real Estate and Repossessed assets held-for-sale 230,391 45,188
------------- -------------
Total Nonperforming Assets $ 456,319 $ 2,118,713
============= =============
At September 30, 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 September
30, 2003, and September 30, 2002:
Income Shares Per share
(numerator) (denominator) amount
----------------------------------------
Quarter ended September 30, 2003
- --------------------------------
Basic EPS:
Income available to common shareholders $2,269,225 4,714,463 $ 0.48
==========
Effect of dilutive stock options -- 171,467
---------- ----------
Diluted EPS:
Income available to common shareholders
plus assumed stock options exercised $2,269,225 4,885,930 $ 0.46
========================================
Nine months ended September 30, 2003
- ------------------------------------
Basic EPS:
Income available to common shareholders $6,386,000 4,703,558 $ 1.36
==========
Effect of dilutive stock options -- 138,091
---------- ----------
Diluted EPS:
Income available to common shareholders
plus assumed stock options exercised $6,386,000 4,841,649 $ 1.32
========================================
Quarter ended September 30, 2002
- --------------------------------
Basic EPS:
Income available to common shareholders $2,102,935 4,980,625 $ 0.42
==========
Effect of dilutive stock options -- 122,367
---------- ----------
Diluted EPS:
Income available to common shareholders
plus assumed stock options exercised $2,102,935 5,102,992 $ 0.41
========================================
Nine months ended September 30, 2002
- ------------------------------------
Basic EPS:
Income available to common shareholders $5,990,141 5,473,433 $ 1.09
==========
Effect of dilutive stock options -- 99,944
---------- ----------
Diluted EPS:
Income available to common shareholders
plus assumed stock options exercised $5,990,141 5,573,377 $ 1.07
========================================
13
NOTE 6.
RATE VOLUME ANALYSIS THIRD QUARTER 2003 NINE MONTHS ENDED SEPTEMBER 30, 2003
(Dollars in thousands) VS VS
THIRD QUARTER 2002 NINE MONTHS ENDED SEPTEMBER 30, 2002
INCREASE (DECREASE) DUE TO INCREASE (DECREASE) DUE TO
TOTAL TOTAL
VOLUME RATE CHANGE VOLUME RATE CHANGE
--------------------------------- ---------------------------------
INTEREST INCOME
Investments:
Available-for-sale securities $ 188 $ (288) $ (100) $ 316 $ (939) $ (623)
Held-to-maturity securities (144) (9) (153) (411) (67) (478)
Other equity investments (47) (6) (53) (32) 51 19
--------------------------------- ---------------------------------
Total investments (3) (303) (306) (127) (955) (1,082)
--------------------------------- ---------------------------------
Loans:
Residential $ 516 $ (275) $ 241 $ 1,106 $ (592) $ 514
Residential construction 387 (57) 330 951 (67) 884
Multifamily 125 (452) (327) 541 (1,203) (662)
Multifamily construction (8) 33 25 (110) 60 (50)
Commercial real estate and business 382 (637) (255) 1,240 (1,796) (556)
Commercial real estate construction (15) (30) (45) (38) (47) (85)
Consumer & other 512 143 655 1,267 115 1,382
--------------------------------- ---------------------------------
Total loans 1,899 (1,275) 624 4,957 (3,530) 1,427
--------------------------------- ---------------------------------
Total interest income $ 1,896 $(1,578) $ 318 $ 4,831 $(4,489) $ 342
INTEREST EXPENSE
Deposits:
Money market deposit and checking $ 141 $ (77) $ 64 $ 392 $ (300) $ 92
Regular savings -- (6) (6) 5 (25) (20)
Time deposits 128 (703) (575) 586 (2,301) (1,715)
--------------------------------- ---------------------------------
Total deposits 269 (786) (517) 983 (2,626) (1,643)
FHLB advances and other 623 (887) (264) 1,110 (1,527) (417)
--------------------------------- ---------------------------------
Total interest expense 892 (1,673) (781) 2,093 (4,153) (2,060)
Net interest income $ 1,004 $ 95 $ 1,099 $ 2,738 $ (334) $ 2,404
================================= =================================
14
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 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 weighted-average life 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 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
(sales finance). 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. In addition, this segment also sells loans into the
secondary market. We 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 we do 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 income, and we rely primarily on net
interest revenue in managing these segments. No single customer provides more
than 10% of the Company's revenues.
Financial information for the Bank's segments is shown below for September 30,
2003, 2002, and 2001:
Consumer Commercial Investment
Quarter ended September 30: Lending Lending Securities Totals
- -------------------------- ------------- ------------- ------------- -------------
Interest income 2003 $ 4,377,746 $ 7,113,490 $ 1,032,856 $ 12,524,092
2002 3,155,948 7,712,257 1,338,665 12,206,870
2001 3,131,627 8,654,362 1,417,076 13,203,065
Interest expense 2003 1,518,967 2,183,377 911,025 4,613,369
2002 1,347,044 2,988,975 1,058,942 5,394,961
2001 1,754,520 4,539,101 1,716,305 8,009,926
Net interest income 2003 2,858,779 4,930,113 121,831 7,910,723
2002 1,808,904 4,723,282 279,723 6,811,909
2001 1,377,107 4,115,261 (299,229) 5,193,139
Provision for loan losses 2003 133,091 216,909 -- 350,000
2002 197,867 452,133 -- 650,000
2001 15,455 34,545 -- 50,000
Net interest income, after provision for loan losses 2003 2,725,688 4,713,204 121,831 7,560,723
2002 1,611,037 4,271,149 279,723 6,161,909
2001 1,361,652 4,080,716 (299,229) 5,143,139
Other operating income 2003 406,193 325,596 225,454 957,243
2002 600,482 325,138 153,590 1,079,210
2001 163,879 263,297 449,799 876,975
Other operating expense 2003 2,068,070 2,759,411 260,860 5,088,341
2002 1,488,742 2,415,842 158,961 4,063,545
2001 1,124,503 1,811,287 409,941 3,345,731
Income before federal income taxes and cumulative 2003 1,063,811 2,279,389 86,425 3,429,625
effect of adoption of new accounting 2002 722,777 2,180,445 274,352 3,177,574
principle 2001 401,028 2,532,726 (259,371) 2,674,383
Federal income taxes 2003 361,695 774,993 23,712 1,160,400
2002 245,744 741,351 87,544 1,074,639
2001 136,418 861,126 (92,658) 904,886
Net income 2003 702,116 1,504,396 62,713 2,269,225
2002 477,033 1,439,094 186,808 2,102,935
2001 264,610 1,671,600 (166,713) 1,769,497
Total interest earning assets (ending period balances) 2003 261,030,846 456,661,847 96,911,420 814,604,113
2002 178,564,252 420,559,806 94,018,011 693,142,069
2001 140,385,812 411,784,692 103,975,891 656,146,395
15
NOTE 7.
SEGMENTS (CONTINUED)
Consumer Commercial Investment
Year-to-date ended Sept 30: Lending Lending Securities Totals
- -------------------------- ------------- ------------- ------------- -------------
Interest income 2003 $ 11,752,835 $ 21,931,822 $ 3,124,537 $ 36,809,194
2002 8,919,520 23,339,671 4,204,967 36,464,158
2001 9,217,289 25,936,731 5,101,373 40,255,393
Interest expense 2003 4,299,077 7,395,070 2,692,132 14,386,279
2002 3,875,485 9,105,918 3,464,196 16,445,599
2001 5,530,072 14,049,100 5,040,171 24,619,343
Net interest income 2003 7,453,758 14,536,752 432,405 22,422,915
2002 5,044,035 14,233,753 740,771 20,018,559
2001 3,687,217 11,887,631 61,202 15,636,050
Provision for loan losses 2003 298,645 511,355 -- 810,000
2002 239,315 545,685 -- 785,000
2001 97,368 217,632 -- 315,000
Net interest income, after provision for loan losses 2003 7,155,113 14,025,397 432,405 21,612,915
2002 4,804,720 13,688,068 740,771 19,233,559
2001 3,589,849 11,669,999 61,202 15,321,050
Noninterest income 2003 1,061,062 961,997 803,076 2,826,135
2002 1,183,925 942,850 364,770 2,491,545
2001 1,518,108 677,254 1,121,315 3,316,677
Noninterest expense 2003 6,068,634 7,885,108 835,381 14,789,123
2002 4,445,199 7,428,205 801,149 12,674,553
2001 3,631,703 5,936,528 941,155 10,509,386
Income before federal income taxes and cumulative 2003 2,147,541 7,102,286 400,100 9,649,927
effect of adoption of new accounting principle 2002 1,543,446 7,202,713 304,392 9,050,551
2001 1,476,254 6,410,725 241,362 8,128,341
Federal income taxes 2003 730,164 2,414,777 118,986 3,263,927
2002 524,772 2,448,922 86,716 3,060,410
2001 501,927 2,179,646 68,820 2,750,393
Income before cumulative effect of adoption 2003 1,417,377 4,687,509 281,114 6,386,000
of new accounting principle 2002 1,018,674 4,753,791 217,676 5,990,141
2001 974,327 4,231,079 172,542 5,377,948
Cumulative effect of adoption of new accounting 2003 -- -- -- --
principle, net of federal income tax 2002 -- -- -- --
2001 (155,247) -- -- (155,247)
Net income 2003 1,417,377 4,687,509 281,114 6,386,000
2002 1,018,674 4,753,791 217,676 5,990,141
2001 819,080 4,231,079 172,542 5,222,701
Total interest earning assets (Averages) 2003 232,641,778 455,774,402 98,731,981 787,148,161
2002 164,526,006 424,519,312 100,003,843 689,049,161
2001 146,427,757 400,357,693 107,896,235 654,681,685
16
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 eleven full-service facilities
located in Bellevue (3), Kirkland (2), Redmond, Seattle (2), Issaquah, Monroe,
and Woodinville. 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.
17
RESULTS OF OPERATIONS
- ---------------------
Net Income
----------
Net income increased 7.9%, from $2.10 million in the third quarter of 2002 to
$2.27 million in the same period of 2003. Net interest income, after provision
for loan losses, rose $1.40 million, and fee income declined $122,000 while
operating expenses increased $1.02 million.
Net Interest Income
-------------------
Quarter Ended Net Interest Margin
------------- -------------------
September 30, 2002 3.95%
December 31, 2002 3.78%
March 31, 2003 3.84%
June 30, 2003 3.89%
September 30, 2003 4.01%
Net interest income increased $1.1 million and $2.4 million, or 16% and 12%, for
the three- and nine-month periods ending September 30, 2003, respectively, as
compared with the same periods in 2002. This year's growth in net interest
income was primarily attributable to the higher level of earning assets in 2003
versus the prior year.
Earning assets rose to $803 million as of September 30, 2003, an increase of
$118 million over the third quarter in 2002, largely based on growth in the loan
portfolio. Average earning assets for the quarter increased by $99 million to
$790 million, compared to $691 million for the third quarter of 2002. Loan
balances, including loans held-for-sale, totaled $706 million as of quarter end,
net of an $8.2 million reserve for loan losses, up 19% from $592 million at
September 30, 2002. The overall loan growth was driven by a substantial
expansion in several different loan types. Most notably, residential
adjustable-rate loans rose 46% from year ago levels to $93 million at the
quarter-end, home improvement loans grew to $56 million, net of a $3 million
loan sale during the quarter, an increase of 108%, and custom construction loans
increased 68% to $56 million.
Asset growth was funded by increases in deposits and wholesale borrowings
totaling $130 million on a quarter-end versus quarter-end comparison, as well as
the issuance of an additional $4 million in trust preferred securities in early
2003. This growth exceeded the $118 million increase in earning assets between
September 30, 2002 and 2003. The borrowings helped facilitate fixed asset
acquisitions, including $12 million for First Mutual Center (formerly the 400
Building) in the first quarter of 2003.
The yield on earning assets declined 0.77% to 6.04% for the quarter ended
September 30, 2003, compared to 6.81% for the third quarter last year, as
adjustable-rate assets continued to reprice near historically low rates. These
falling-asset yields typically result in the compression of the Banks' net
interest margin, as adjustable-rate loans are systematic in their repricing
while time deposit rates tend to lag the downward movement in major-rate
indices. As a result of the several factors detailed below, however, we were
able to substantially reduce our overall cost of funds and negate such effects.
As of September 30, 2002, deposits totaled $484 million, while Federal Home Loan
Bank ("FHLB") and other wholesale borrowings totaled $162 million. Over the
following year, deposit growth totaled 15%, or $72 million, bringing the level
of total deposits to $556 million at
18
September 30, 2003. Approximately 69% of this deposit growth was in checking and
money market accounts, which contributed to the reduction in the overall cost of
funds. Because we were unable to fully support the asset growth with this level
of new deposits, we relied more heavily upon wholesale funds, particularly FHLB
advances, as a funding mechanism to support asset growth. We increased our
wholesale borrowings 31% from year-ago levels to $212 million in order to
accommodate the additional assets. Consequently, wholesale borrowings accounted
for a larger percentage of total funding as of September 30, 2003 than at the
end of the third quarter last year, with two primary implications for net
interest income. First, as interest rates fell, time deposit rates typically
lagged the market indices, and frequently exceeded the wholesale market rates
for funding. As a result, increasing the relative level of wholesale borrowings
in the low-rate environment earlier this year frequently resulted in a lower
cost of funds than relying on additional retail time deposits for funding.
Secondly, on a forward-looking basis, as these wholesale borrowings are tied to
major market indices, they should reprice in a systematic fashion, similar to
index-linked adjustable-rate loans. These borrowings also provide sufficient
flexibility in their terms such that, when we decide to do so, we can coordinate
the maturities and repricing dates of advances to coincide with the terms of our
loans. This should contribute to a more stable net interest margin over time,
relative to the margin compression and expansion that would occur were retail
time deposits used as the funding mechanism.
With deposit pricing declining in response to the change in overall mix,
combined with the additional use of wholesale funds, the cost on interest
bearing liabilities totaled 2.30% for the quarter ended September 30, 2003, down
81 basis points ("bps") from 3.11% in the third quarter of 2002. Because of the
interplay of these factors, the net interest margin totaled 4.01% for the
quarter ended September 30, 2003, improving from 3.89% in the previous quarter
and 3.95% in the third quarter of 2002.
Also affecting the net interest margin were interest rate floors embedded in the
commercial real estate loan portfolio. As of September 30, 2003, approximately
$148 million of the $398 million in loans in our commercial real estate
portfolio were subject to interest rate floors, with an average floor rate of
6.88%. Of the $148 million, about $91 million were subject to floors of 7.50% or
greater. The majority of these loans are not subject to prepayment penalty, and
their balances have declined. In September 2002, approximately $177 million of
the $376 million commercial portfolio included interest rate floors, with an
average floor rate of 7.48%, and $156 million subject to floors of 7.50% or
greater. While the level of such loans is falling on a monthly basis, the
presence of such floors at interest rates well above current market rates on a
substantial percentage of the commercial loan portfolio has helped to offset the
margin compression that arises from falling asset yields.
Other Operating Income
----------------------
Other operating income consisted of the following:
Three Months Nine Months
Ended September 30, Ended September 30,
------------------------- -------------------------
2003 2002 2003 2002
---------- ---------- ---------- ----------
Home Improvement (Sales Finance)
Loan Sale Gain $ 103,000 $ 141,000 $ 183,000 $ 404,000
Residential Loan Sale Gain 147,000 371,000 401,000 540,000
19
Commercial Loan Sale Gain 32,000 11,000 77,000 36,000
---------- ---------- ---------- ----------
GAIN ON SALES OF LOANS $ 282,000 $ 523,000 $ 661,000 $ 980,000
GAIN ON SALES OF INVESTMENTS $ 189,000 $ 129,000 $ 663,000 $ 287,000
SERVICING FEES $ 18,000 $ 34,000 $ 47,000 $ 86,000
FEES ON DEPOSITS $ 132,000 $ 118,000 $ 383,000 $ 348,000
OTHER INCOME:
Rental Income 182,000 25,000 546,000 75,000
Loan & Prepayment Fees 47,000 162,000 169,000 388,000
Visa/ATM Fee Income 22,000 15,000 61,000 44,000
Other 85,000 73,000 296,000 283,000
---------- ---------- ---------- ----------
SUBTOTAL $ 336,000 $ 275,000 $1,072,000 $ 790,000
========== ========== ========== ==========
TOTAL $ 957,000 $1,079,000 $2,826,000 $2,491,000
========== ========== ========== ==========
Other operating income decreased to $957,000 in the third quarter of 2003 as
compared to $1.1 million in the same quarter in 2002. Year-to-date other
operating income rose from $2.5 million for the nine months ended September 30,
2002, to $2.8 million for the like period this year. The 11% decline for the
quarter resulted from a drop in gain on sales of loans, and the 13% increase for
the first nine months of the year was mainly attributable to the increase in
gain on sales of investments.
GAIN ON SALES OF LOANS. Gain on sales of loans totaled $282,000 for the third
quarter as compared to $523,000 for the quarter ended September 30, 2002.
Year-to-date gain on sales of loans declined $319,000, from $980,000 at the end
of September last year to $661,000 this year. The reduction in gains for the two
periods is largely the result of a decline in home improvement and residential
loan sales.
HOME IMPROVEMENT LOAN SALES - The gain on home improvement (Sales Finance) loan
sales fell $38,000, or 27%, on a quarter-to-quarter comparison, and $221,000, or
55%, on a year-over-year basis. In the third quarter of 2003, loan sales totaled
$3.1 million, a 39% decline from $5.1 million in the like quarter last year. The
same trend held for the year-to-date sales. In the first nine months of 2003,
sales amounted to $6.1 million compared to $12.6 million in 2002.
In the second half of last year we announced a strategy to keep a greater
portion of the home improvement loans in our portfolio. We were, at that time
and continue to be, pleased with the performance of the home improvement loan
portfolio and felt that the earnings of the Bank would be improved if we
retained those loans as opposed to selling them. In the ensuing year the home
improvement loan portfolio has increased $29 million, or 108%, and accounted for
25% of our total loan growth.
Because of the rapid increase in the home improvement portfolio, we have
inquired into potential investor interest in the ongoing sale of a portion of
the loans. Early in that inquiry process we found some preliminary interest and
put together a sale totaling $3 million. The gain from that sale contributed
$101,000 in the third quarter. If we can make the necessary accommodations, we
would like to sell $5-$7 million a quarter. That pace would allow the home
improvement
20
portfolio to grow at a solid tempo, although at a slower rate than that
experienced in the last 12 months.
RESIDENTIAL LOAN SALES - The gains from residential loan sales were down sharply
in the third quarter, $224,000, or 60%, and down $139,000, or 26%, year-to-date
as compared to the same periods last year. The results in 2002 benefited from
both a mark-to-market of financial derivatives and the bulk sale of $19 million
in mortgage servicing rights.
Residential lending derivatives are primarily composed of: (1) commitments on
loans that are held-for-sale, but have not closed, and on which we have granted
a rate lock; and (2) forward commitments that we have bought on the secondary
market to hedge our loans held-for-sale pipeline. The mark-to-market adjustments
for these derivatives were a loss of $3,000 in the third quarter of 2003 as
compared to a gain of $62,000 last year. In the first three quarters of this
year, we experienced a loss of $11,000 versus a gain of $93,000 in 2002.
We executed a bulk mortgage servicing rights sale of $19 million in the third
quarter of last year on which we realized a net gain of $189,000. Absent that
sale, the year-to-date 2002 gain would have been $351,000, or 12% below this
year's income of $401,000. That sale was the only bulk mortgage servicing rights
sale in 2002, and there have been no comparable sales this year.
COMMERCIAL LOAN SALES - The gains from commercial loan sales are up modestly
over last year, $21,000 on a quarter-to-quarter basis and $41,000 on a
year-over-year comparison. Actual loan sales totaled $7.1 million and $2.7
million for the third quarter of 2003 and 2002, respectively, and $17.4 million
for the first nine months of 2003 and $13.0 million for the like period last
year. The gains from these sales tend to be diminutive because of the narrow
servicing spreads and costs to service. Most of these sales are prompted by our
desire to accommodate our customers by increasing our capacity to lend to any
given individual. Although the gains from this lending area are currently
modest, we expect those gains to increase over time as the Bank grows its
customer base.
GAIN ON SALES OF INVESTMENTS. Gain on sales of investments totaled $189,000 for
the third quarter of 2003 as compared to $129,000 for the same quarter in 2002.
Year-to-date the gains were $663,000 this year and $287,000 for the period ended
September 30, 2002. Security sales for the third quarter of 2003 amounted to
$6.5 million book value ($15.0 million par value) and $25.3 million book value
($38.6 million par value) for the first nine months of the year. On a
comparative basis, sales of investment securities for the third quarter and
first nine months of 2002 totaled $14.9 million book value ($15.2 million par
value) and $25.6 million book value ($25.9 million par value), respectively.
Because security sales tend to be related to the movement of interest rates and
loan prepayments, we generally don't anticipate security sale gains in our
planning activities. However, when rates decline and loan prepayments increase,
we often sell mortgage-backed securities before the underlying loans are prepaid
at par. Since long-term rates have risen in the last four months, we don't
expect to sell securities in the fourth quarter.
SERVICING FEES, NET OF AMORTIZATION. Servicing fees have decreased $16,000, or
48%, for the third quarter of 2003 as compared to the like quarter last year and
$39,000, or 46%, year-to-date. The loans serviced for others portfolio, on the
other hand, has increased from $44.5 million at September 30, 2002 to $60.4
million at the end of the third quarter in 2003.
21
SEPTEMBER 30, SEPTEMBER 30,
2003 2002
------------- -------------
SERVICING PORTFOLIO $ 60,400,000 $ 44,500,000
============= =============
3RD QUARTER 3RD QUARTER
2003 2003 YTD 2003 YTD 2002
-------- -------- -------- --------
SERVICE FEE INCOME $ 18,000 $ 34,000 $ 47,000 $ 86,000
Adjustment for Service
Fees from the Servicing
Rights Sale on
September 30, 2002 -- (21,000) -- (51,000)
-------- -------- -------- --------
Adjusted Service Fee
Income $ 18,000 $ 13,000 $ 47,000 $ 35,000
======== ======== ======== ========
This anomaly with the service fee income decreasing and the servicing portfolio
increasing was the result of a bulk sale of servicing rights in the third
quarter of 2002. We sold the servicing rights underlying $19 million in loans at
the end of the quarter last year. Absent the fees collected from the sale of the
servicing rights, the adjusted service fee income for both the third quarter and
first nine months of 2002 would have been $13,000 and $35,000, respectively.
Thus, service fee income on an adjusted quarterly basis would have increased
from $13,000 for the third quarter of 2002 to $18,000, or 34%, for the like
period this year. As for the year-to-date results, the increase in adjusted
service fee income would have been $35,000 for the first three quarters last
year, jumping to $47,000, or 36%, this year. These increases are in-line with
the portfolio of loans serviced for others which increased 36% on a yearly
comparison.
We have sold $3 million in home improvement loans and retained the servicing
rights during the third quarter of 2003. As a result of this sale and our
intention to sell $5-$7 million per quarter in the future, we anticipate that
our service fee income will grow in subsequent quarters. However, because these
loans have such a rapid prepayment rate, well in excess of traditional home
loans, it is difficult to predict the growth of the servicing portfolio. A
rising rate environment would slow the pace of prepayments and would contribute
to an increase in the servicing portfolio.
FEE INCOME ON DEPOSITS. Fee income from deposits has increased both on a
quarterly and year-to-date basis. For the third quarter of 2003, deposit fees
totaled $132,000, up from $118,000, or $14,000 as compared to the like quarter
last year. For the first nine months of 2003, deposit fees amounted to $383,000,
up from $348,000, or $35,000 for the same period in 2002. The rise in deposit
fees for both periods is mainly attributable to an increase in checking account
fees as a result of the positive change in the number of checking accounts as
compared to the prior year. The number of business and consumer checking
accounts increased 26%, from September 30, 2002 to September 30, 2003.
OTHER INCOME. Other income totaled $336,000 compared to $275,000 in the third
quarter of last year. For the first nine months of 2003, other income amounted
to $1.1 million as compared to
22
$790,000 for the like period the previous year. The rise in other income is
mainly due to the increase in rental income which was partially offset by a drop
in loan and prepayment fees.
Rental income for the quarter is up $157,000 and $471,000 year-to-date. We lease
out office space in our Bellevue West and Monroe banking centers and Bellevue
Corporate Headquarters. The source of most of the rental income is our Corporate
Headquarters, First Mutual Center. We purchased the seven-story building in
March, and currently occupy 39% of the building. The remainder of the building
is available for lease, and of that portion 67% is presently occupied.
Loan fees and prepayment fees have fallen $115,000, or 71%, in the third quarter
and $219,000, or 56%, year-to-date. The sharp spike in long-term rates in third
quarter 2003 has influenced the fee income from early loan prepayments,
extension fees, etc. The trend for the rest of the year will most likely mirror
the results for third quarter.
Operating Expenses
------------------
SALARIES AND EMPLOYEE BENEFITS rose $555,000, or 23%, on a quarter-to-quarter
comparison. On a year-to-date basis, the increase is $1.4 million, or 18%. A
number of items contributed to our increased employee costs, including a rise in
loan officer commissions, 18% growth in staff, an increase in incentive pay (for
the quarter), and a rise in temporary help costs (year-to-date).
Commission expense increased $197,000, or 111%, for the quarter and $436,000, or
64%, for the first nine months of this year as compared to last year. The rise
is principally a result of greater loan originations. Loan originations on a
third quarter comparison jumped from $67 million to $113 million, a rise of 68%.
The year-to-date results are similar. For the first nine months of the year,
loan originations totaled $327 million, up from $224 million last year, or 46%.
The increased production was centered in the Income Property, Residential and
Sales Finance lending areas.
We have added 29 new employees in the last 12 months. The new Woodinville
banking center was opened in July and accounted for four of the additions. The
majority of the other positions added were in customer service support for the
loan and deposit areas, as well as a few additions in the Information Systems,
Human Resources, and Executive departments.
We are continuing to expand our retail banking center network. The Sammamish
Plateau banking center is scheduled to open during the fourth quarter and the
Canyon Park location is on track to open in 2005. During 2004, we plan on
remodeling four of our existing banking centers to continue with the open and
inviting retail atmosphere format that we have adopted in our new banking
facilities. At this time we do not anticipate opening a new office in 2004,
although we will continue our search, and if a promising site becomes available
we will pursue the opportunity.
Incentive pay has increased from $48,000 to $100,000, a rise of $52,000 for the
quarter as compared to the same period last year. For the first nine months of
2003, incentive pay totaled $230,000, up $41,000 from $189,000 the prior year.
The increase, for both the quarter and year-to-date, is mainly due to the change
in our incentive plan for the banking center staff, coupled with the positive
growth in deposits. The incentive plan was recently restructured to focus the
attention of the banking centers on low-cost deposits and loan production.
Deposits have increased $72 million, or 15% as compared to September 30, 2002.
Year-to-date deposits rose $59 million, or
23
12%. These expenses will likely increase in future quarters if the banking
centers continue to excel at acquiring loans and deposits.
Temporary staffing expenses rose $38,000, from $27,000 to $65,000 on a third
quarter comparison. Year-to-date these costs have jumped $176,000, from $61,000
for the first nine months of 2002 to $237,000 this year. The temporary help
expense, for both the quarter and year-to-date periods, centered in our business
and consumer loan servicing support areas. Those departments were unable, with
their existing staff, to meet the increased loan volume. The year-to-date
increase also includes a temporary employee who was subsequently hired as
permanent staff in our Information Systems Department. We expect the temporary
help expenses to remain above last year's levels and similar to what we
experienced in the third quarter of 2003.
OCCUPANCY expenses are up $30,000, or 5%, on a quarter-to-quarter comparison and
$53,000, or 3%, for the first nine months as compared to last year. The key
elements of this increase relate to our office building maintenance and repairs,
building depreciation, utilities, and real estate property tax expenses.
Combined, all four of these expense items have increased $143,000, or 143%, for
the third quarter as compared to last year. On a year-to-date basis the increase
is $340,000, or 112%. The rise in these expenses on a quarterly and year-to-date
basis is largely the result of the purchase of the First Mutual Center building
in March of this year. The operating costs of the building are prorated between
the Bank and the other tenants. Those expenses assigned to other tenants are
typically recouped through the leasing agreements. However, shortly after we
acquired the building several large tenants chose to relocate. As a result we
have had to bear the costs of utilities and property taxes associated with the
vacant office space. Our property management firm is currently in the process of
marketing the available office space in order to attract new tenants.
OTHER costs increased by $440,000, or 41%, from $1.1 million in the third
quarter of 2002 to $1.5 million this year. On a year-to-date comparison, other
expenses have risen by $707,000, or 21%, from $3.4 million to $4.1 million this
year. The growth in expense for the quarter was largely attributable to legal
fees, insurance premiums on sales finance loans, and marketing. The year-to-date
increase also included a rise in office supplies expense which was somewhat
offset by the decline in telephone expense.
Our legal expenses have increased from $35,000 for the third quarter last year
to $127,000 this year. For the first nine months of 2002, legal costs rose from
$295,000 to $338,000 this year. The increase in legal expenses is principally
due to updating our deposit contracts.
Insurance premiums on sales finance loans rose from zero for the third quarter
of last year to $77,000 in the third quarter of this year and to $128,000 for
the first nine months of 2003. We insure sales finance loans for default risk
for borrowers with credit scores below a certain level. We began insuring these
loans in the fourth quarter of 2002. The insured loans now constitute 35% of the
sales finance loan portfolio, and represent about 50% of all new loans. The cost
of insurance premiums has grown with those loan balances. Credit insurance
expense in the first quarter of 2003 was $14,000, increasing to $37,000 in the
second quarter, and to $77,000 in the third quarter. The current monthly run
rate is $35,000, which implies a cost of $105,000 for the fourth quarter, even
if there was no further growth in the portfolio.
The credit insurance for these loans is designed to reimburse us for credit
losses up to a set amount for each pool of loans (for additional information see
"Sales Finance Loans" in the "Portfolio Information" section).
24
Marketing expenses have risen from $156,000 in the third quarter of 2002 to
$230,000 this year. Year-to-date these expenses have increased from $408,000
last year to $631,000 this year. We believe our current level of marketing
support is adequate and don't anticipate those costs to rise materially from
their present levels.
Office supply expense increased $45,000, or 83%, on a quarterly comparison and
$139,000, or 66%, on a year-to-date comparison. The increase is largely a result
of the rise in the need for preprinted forms used in the consumer loan
origination process. Consumer loan originations, specifically home improvement
loan originations, have increased 78% and 91% for the third quarter this year
and the first nine months of this year, respectively, as compared to the
previous year.
Telephone expense declined $33,000, or 39%, as compared to third quarter last
year and $151,000, or 61%, for the first nine months of this year. In the second
quarter of this year, we received a $61,000 refund check from our long distance
telephone service provider for charges that occurred in prior periods.
Key Financial Ratios
--------------------
The following tables provide additional comparative data regarding operating
performance:
- --------------------------------------------------------------------------------
INTEREST RATE YIELD / EXPENSE
- -----------------------------
QUARTERS ENDED SEPTEMBER 30,
----------------------------
2003 2002
---- ----
Interest Rate Yield:
Investment securities 4.57% 5.62%
FHLB stock 5.25% 6.00%
Loans 6.21% 6.98%
Total interest rate yield on
interest-earning assets
6.04% 6.81%
Interest Rate Expense:
Deposits 2.14% 2.77%
Interest rate swap 3.42% 2.66%
Trust preferred securities 5.41% 5.52%
Borrowings 2.49% 4.03%
Total interest rate expense on
interest-bearing liabilities
2.30% 3.11%
Interest spread 3.74% 3.70%
- --------------------------------------------------------------------------------
25
Net interest margin on
interest-earning assets
4.01% 3.95%
- --------------------------------------------------------------------------------
Return on average assets 1.10% 1.18%
Return on average equity 18.72% 17.11%
Average equity / average assets
7.84% 9.19%
Annualized operating expenses
/ average assets 2.47% 2.28%
Efficiency ratio 57.38% 51.50%
- --------------------------------------------------------------------------------
FINANCIAL CONDITION
- -------------------
Assets. Assets increased 12%, from $745 million at year-end 2002 to $838 million
as of September 30, 2003. The change in assets is principally the result of an
increase in the loan and investment securities portfolios and the purchase of
the First Mutual Center building.
Loans. Loans receivable, including loans held-for-sale, rose from $635 million
at year-end 2002 to $715 million, an increase of $80 million, or 13%, in nine
months. Eighty-two percent of that growth was from sales finance and residential
loans with the remaining 18% coming from commercial real estate and business
banking loans.
The home improvement loans (Sales Finance) portfolio, year-to-date 2003, has
grown at an annualized rate of 78%. In the third quarter of 2003, that portfolio
increased at an annualized rate of 65%. Because of that rapid growth, we
recently sold $3 million of Sales Finance loans servicing retained, and are
currently seeking investors for future sales of $5-$7 million per quarter.
In a change of strategy several years ago, we decreased our focus on the sale of
conforming residential loans and redirected our attention to custom construction
and non-conforming residential permanent loans. This strategic change has
provided strong loan growth in the residential portfolio at returns that exceed
our return on equity targets. Annualized growth in residential loans
year-to-date is 43%, and annualized growth in residential loans in the third
quarter of 2003 was 53%. The annualized growth in the custom construction loan
portfolio in the third quarter of 2003 was 89%. Custom construction loans are
loans to qualified buyers who are building a home on land they either own or
purchase at the time the loan is originated.
Business investment, as opposed to consumer activity, has been slow. Our
Business Banking/Income Property loan portfolio grew at an annualized pace of 4%
in the first nine months of 2003 and an annualized pace of 2% in the third
quarter of 2003.
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, and any
unrealized gains or losses are recorded in the shareholders' equity account. At
September 30, 2003, the balance of the unrealized loss, net of federal income
taxes, was $455,000 of which $53,000 was the loss related to the securities
available-for-sale and $402,000
26
was the loss related to the interest rate swap purchased in connection with the
$9 million trust preferred securities issuance last year. The comparable figure
for September 30, 2002 was a net unrealized gain of $669,000 ($1,063,000 gain
related to the securities available-for-sale and a loss of $394,000 from the
interest rate swap). Generally, for securities, 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. Just the opposite is true for interest rate swaps.
Security investments (available-for-sale and held-to-maturity) increased $7.1
million, or 9.4%, from December 31, 2002, to the end of the third quarter of
2003. During the quarter, $10.0 million (book and par value) in securities were
purchased and $6.5 million book value ($15.0 million par value) were sold.
Liabilities. Deposits increased $58.6 million, or 11.8%, in the first nine
months of 2003, totaling $556 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.
FHLB advances have increased $27.7 million from year-end 2002 to $212 million as
of the end of the third quarter this year. As of September 30, 2003, we had the
authority to borrow up to a total of $335 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 was
$350,000 in the third quarter. Our provisions in prior quarters were $325,000,
$135,000, and $125,000 in the second and first quarters of 2003 and the fourth
quarter of 2002, respectively. 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
provision, we considered 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 increased $29 million in the third quarter, with most of the
growth attributable to our consumer and residential portfolios. Both of these
portfolios continue to perform at a 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 $456,000
at the end of the third quarter. The ratio of non-performing assets to total
assets declined from 0.28% to 0.05%. The comparable ratio for other banks at
June 30, 2003 was 0.81% (1). Net loans charged off for the quarter amounted to
$230,000 and $363,000 for the first nine months of 2003; we charged off $113,000
for the third quarter last year and $188,000 in all of 2002. Most of the
charge-offs year-to-date were related to our consumer loan portfolio, which
would indicate that we should continue to expect an increase in the level of
charge-offs if the consumer loan portfolio grows. Annualized charge-offs as a
percentage of our total loan portfolio was 0.07%, compared to 0.80% for other
financial institutions as of June 30, 2003 (1).
27
The local and national economies continue to be a concern to us. We believe,
however, that economic conditions have not changed appreciably since the end of
fourth quarter 2002.
The provision is determined at the end of each quarter when the makeup of the
portfolio and economic conditions affecting the portfolio can be ascertained.
Although we are concerned about the economy, we do not currently foresee any
economic conditions developing in the next quarter that would require us to make
an additional provision directly attributable to the economy. We still expect to
provide for loan growth and any material change in the character of the
portfolio.
Non-Performing Assets. Our exposure to non-performing loans and repossessed
assets as of September 30, 2003 was:
NON-PERFORMING ASSETS
---------------------
Single family residence, Idaho. No anticipated loss $ 65,000
An unsecured line of credit. No anticipated loss 25,000
Four consumer loans. We expect a full recovery from credit
insurance 32,000
Eight consumer loans. No anticipated loss 93,000
One consumer loan. We anticipate charging this loan off in
the fourth quarter 11,000
--------
TOTAL NON-PERFORMING LOANS $226,000
Real Estate Owned and Repossessed Assets:
Single family residence in Eastern WA. No loss anticipated 40,000
Two condominiums in Western WA. No loss anticipated 175,000
The Bank has a number of items of repossessed property,
principally spas and motorcycles 15,000
--------
TOTAL REAL ESTATE OWNED AND REPOSSESSED
ASSETS $230,000
--------
TOTAL NON-PERFORMING ASSETS $456,000
========
Subsequent to quarter-end the real estate owned in Eastern WA has been sold and
the two condominiums in Western WA are pending sale at this time, all at no
expected loss.
(1) Source: Second quarter 2003 FDIC Quarterly Banking Profile, All FDIC-Insured
Institutions
28
The following table provides summary information concerning asset quality as of
September 30, 2003 and December 31, 2002:
SEPTEMBER 30, DECEMBER 31,
2003 2002
---- ----
Non-performing assets to total assets 0.05% 0.28%
Non-performing loans to total loans
outstanding 0.03% 0.33%
Allowance for loan losses to total loans 1.15% 1.22%
Net charge-offs to total loans (annualized) 0.07% 0.03%
PORTFOLIO INFORMATION
- ---------------------
COMMERCIAL REAL ESTATE LOANS. The average loan size (excluding construction
loans) in the commercial real estate portfolio was $647,000 as of September 30,
2003, with an average loan-to-value ratio of 65%. At quarter-end, only one of
these commercial loans was 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 45% residential and 55% commercial.
Adjustable-rate loans account for 90% of our total 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, 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 11%
of 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 $13 million of the portfolio, or 3%, has been
purchased in this manner.
SALES FINANCE (HOME IMPROVEMENT) LOANS. Our sales finance portfolio had a
balance of $55.8 million at the end of the third quarter of 2003, an increase
from $48.0 million at June 30, 2003, and $31.4 million at the end of 2002. The
total servicing portfolio contains 6,800 loans, with an average balance of
$8,650. The average loan amount for loans originated so far in 2003 is $9,900.
We experienced rapid prepayments throughout 2003, with an annualized prepayment
rate of 51%. The prepayment speed for the third quarter of 2003 was 48%, and we
expect the prepayment rate to continue to decline as the effect of the recent
residential refinance boom diminishes.
The net credit charge-offs for the third quarter of 2003 were $83,000, or 0.64%
(annualized) of the outstanding balances. Total 2003 charge-offs year-to-date
amounted to $213,000, or 0.65% (annualized).
The sales finance portfolio can be segmented into three sub-portfolios. The
first sub-portfolio consists of uninsured loans, in which we have not filed a
UCC Financing Statement. The weighted average credit score for this
sub-portfolio is 745 and constitutes 20% of our sales finance servicing
portfolio. The second sub-portfolio is composed of uninsured loans in which we
have filed UCC Financing Statements. The weighted average credit score is 713
and this sub-portfolio makes up 45% of the portfolio. The third group, the
insured loans, has a weighted average credit score of 664, and represents the
remaining 35% of the portfolio.
29
The third group, insured loans, currently accounts for about 50% of all new
loans. Because of the short weighted-average life of the existing portfolio, one
to two years, and the present mix of new loans, we expect the level of insured
loans to increase over time.
DEPOSIT INFORMATION
- -------------------
The number of business checking accounts increased from 862 at September 30,
2002, to 1,364 as of September 30, 2003, a gain of 502 accounts, or 58%.
Consumer checking accounts also increased from 4,439 in the third quarter of
2002 to 5,341 this year, a growth in the number of accounts of 902, or 20%.
DEPOSIT MIX
-----------
Time Deposits 71%
Checking 6%
Money Market Accounts 21%
Regular Savings 2%
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
segments. 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, is based upon the funding needs and the
relative weighted-average life 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 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 (sales finance). 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. In addition,
this segment also sells loans into the secondary market. We may choose
to retain or sell
30
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 we do 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 income, and we rely primarily on net
interest revenue in managing these segments. No single customer provides more
than 10% of the Bank's revenues.
Consumer Lending
----------------
Net income for the Consumer lending segment rose from $477,000 in the third
quarter of 2002 to $702,000 in the same quarter in 2003. The increase in net
income was a result of improvements in both net interest and non-interest
income, which were partially offset by rising operating expenses.
Net interest income for the Consumer Lending segment, net of the provision for
loan losses, totaled $2.7 million for the quarter ended September 30, 2003, an
increase of $1.1 million, or 69% over the $1.6 million earned in the third
quarter of 2002. Driving this improvement in net interest income was a 46%
increase in the Consumer Lending segment's earning assets, from $179 million at
September 30, 2002 to $261 million at the end of the third quarter of 2003,
centered in residential adjustable-rate mortgage ("ARM") balances, sales finance
(home improvement) loans, custom construction ARMs, and land loans. The growth
in home improvement loans was facilitated by our decision to retain, within our
portfolio, a greater portion of the new loans. In addition to providing
incremental earning assets, the growth of custom construction and sales finance
loans as a percentage of total loans contributed to net interest income growth
due to the higher margins earned on these loans. Custom construction loans
generally earn higher rates of interest because of the greater level of risk
assumed by the Bank as compared to a permanent residential mortgage.
Additionally, sales finance loans also typically command higher interest rates
than most other loan categories. With these additional assets, net interest
income earned on the portfolio rose $1.1 million from the previous year's level.
The Consumer Lending segment's non-interest income declined from $600,000 for
the three months ended September 30, 2002 to $406,000 in the same quarter this
year, largely as a result of reductions in gains on residential and sales
finance (home improvement) loan sales. The gains from residential loan sales
totaled $147,000 for the third quarter of 2003, down sharply from $371,000 in
the same period last year. It should be noted that the 2002 results benefited
from both a mark-to-market of financial derivatives as well as a bulk sale of
$19 million in mortgage servicing rights. The derivatives consist of commitments
on held-for-sale loans with interest rate
31
locks, as well as forward commitments, purchased on the secondary market to
hedge our loans held-for-sale pipeline. The mark-to-market adjustments on these
instruments resulted in a loss of $3,000 for the third quarter of 2003, compared
to a gain of $62,000 last year. Gains realized from the sales of home
improvement loans fell $38,000, or 27%, versus the third quarter last year,
because of a change in strategy from selling loans originated outside the
Pacific Northwest to retaining these loans in our portfolio. Additionally, the
sale of mortgage servicing rights totaling $19 million in the third quarter of
2002 resulted in a net gain of $189,000. No comparable sale occurred in the
third quarter of 2003. These reductions in gains on sales were partially offset
by the rental income allocated to the Consumer Lending segment. The allocated
rental income has become a significant source of non-interest income for the
various business lines since the March 2003 acquisition of the First Mutual
Center building. Rental income allocated to the Consumer Lending segment totaled
$50,000 for the third quarter this year.
Non-interest expense for the third quarter totaled $2.07 million, rising
$579,000, or 39%, on a quarter-to-quarter comparison driven by rising
compensation, loan administration and support, and credit and servicing costs.
Third quarter compensation expense for this segment rose $133,000 to $568,000,
partially attributable to higher production-driven compensation in the wholesale
lending and sales finance operations. Accompanying the additional loan volumes
has been the need for expanded support to service these loans. Loan
administration and support costs allocated to this segment rose $114,000, or
159% over the same period last year. Credit and servicing costs totaled $123,000
in the third quarter, rising $98,000 from the third quarter 2002 level of
$25,000. The increase in this expense was primarily attributable to the credit
insurance purchased on those sales finance loans to borrowers with credit scores
below a certain level. The cost of this credit insurance rose from zero in the
third quarter of 2002 to $77,000 for the third quarter this year.
The year-to-date results are similar to the quarterly results, with net income
increasing $399,000, from $1.02 million in the nine months ending September 30,
2002, to $1.42 million for the same period in 2003.
Net interest income, after provision for loan losses, for the first nine months
of 2003 rose $2.35 million, or 49% over the same period last year. As mentioned
previously, the principal component of this improvement was the growth in
earning assets over the prior year, which contributed an additional $2.8 million
in interest income, an increase of 32% over the same period last year.
For the first nine months of 2003, non-interest income declined $123,000 from
the 2002 level of $1.18 million, totaling $1.06 million through September 30,
2003, based primarily on the above mentioned reductions in gains on loan sales.
Through the first three quarters of 2003, gains on residential loan sales were
down $139,000, or 26%, compared to the same period in 2002, while gains on home
improvement loan sales were off $221,000, or 55%, from prior year levels. Again,
partially offsetting the reduction in gains on loan sales was rental fee income
generated from the First Mutual Center building, which contributed $143,000 to
the Consumer Lending segment's non-interest income through September 30 of this
year. There was no comparable income for 2002.
Year-to-date non-interest expense increased to $6.1 million for the first three
quarters of 2003 as compared to $4.4 million for the like period last year. As
noted above, the additional expense in 2003 was primarily the result of rising
compensation, credit and servicing, and loan
32
administration and support costs. Consumer segment compensation expense
increased $497,000, or 43%, through September of this year compared to the same
period last year, based largely upon higher production-driven compensation.
Year-to-date credit and servicing expense rose $150,000, or 148%, compared with
the prior year based on the credit insurance purchased on sales finance loans.
Through the first three quarters of 2003, this credit insurance expense totaled
$128,000. The current run rate for this expense is approximately $35,000 per
month, and this cost will continue to increase as the sales finance loan
portfolio grows. With the additional loan volume comes the need for more support
to service these loans. Loan administration and support costs allocated to this
segment rose $415,000, or 202%, over the same period last year.
Commercial Lending
------------------
Net income for the Commercial Lending segment increased $65,000, or 4.5%, from
$1.44 million in the third quarter of 2002 to $1.50 million in the same period
of 2003. The growth in net interest income was partially offset by rising
operating expenses, while non-interest income was virtually flat compared to the
same quarter in the prior year.
The Commercial Lending segment's net interest income, after provision for loan
losses, rose $442,000, or 10.3%, to $4.71 million compared to $4.27 million for
the quarter ended September 30, 2002. An $806,000 (27%) reduction in interest
expense and $235,000 (52%) reduction in provision more than offset a $599,000
(7.8%) decline in interest income. Funding costs bank-wide have declined
compared to last year due to the repricing of time deposits as well as an
increased reliance on FHLB advances, which have proven less expensive than
comparable maturity retail time deposits at various times earlier this year (see
"Results of Operations, Net Interest Income" section for more information).
While extraordinary asset growth - as seen in the Consumer Lending segment - was
not observed in this segment, the Commercial Lending segment did succeed in
expanding most major loan types and building incremental assets over the last
year. As of the end of the third quarter in 2003, the Commercial segment's
earning assets totaled $457 million, compared to $421 million at September 30,
2002. The relatively less dramatic growth of the Commercial Lending segment
relative to the Consumer Lending segment results was in line with expectations,
given the soft local economy of the last year and resulting reduction in the
number of quality commercial banking relationship opportunities in the market.
The Commercial Lending segment's other operating income remained flat for the
quarter at $326,000.
Third quarter non-interest expense for the commercial segment rose $344,000 over
the prior year level, totaling $2.76 million, with the increase largely
attributable to the additional infrastructure put in place to administer and
support the commercial portfolio, as well as an increase in the retail banking
center expenses allocated to the Commercial Lending segment.
On a year-to-date basis through the first three quarters of 2003, net income for
the Commercial Lending segment declined $66,000, or 1.4%, from $4.75 million to
$4.69 million, with net interest income, non-interest income, and non-interest
expense all increasing.
Net interest income, after provision, through the first three quarters of the
year rose from $13.7 million in 2002 to $14.0 million this year, an increase of
2.5%. Again, the reduction in interest expense had a greater impact on the net
interest margin than the decline in interest income, with interest expense
declining $1.7 million, or 18.8%, on a year-to-date basis comparison over last
33
year. As noted above, the reduction in interest expense was a product of the
repricing of time deposits and an increased reliance on FHLB advances, which
have proven less expensive than comparable maturity retail time deposits at
various times earlier this year.
As with the three months ended September 30, 2003, other operating income was
essentially flat on a year-to-date basis, increasing $19,000, or 2.0%, to
$962,000.
Non-interest expense rose $457,000, or 6.2%, for the first three quarters of
2003, compared to the like period last year, driven primarily by the previously
mentioned increases in the loan administration and support costs allocated to
this segment. Additionally, marketing expense for the commercial segment rose
approximately $104,000 based on expenditures for the Business Banking and
Community Business Banking divisions.
Investment Securities
---------------------
Net income decreased sharply for the Investment Securities segment, from
$187,000 in the third quarter of 2002 to $63,000 in 2003 as the segment was
affected by both declining net interest income and rising operating expenses.
The Investment Securities segment's non-interest income rose $72,000 compared to
the third quarter 2002 level, but this increase was insufficient to offset the
changes in net interest income and operating expenses.
Net interest income earned on the securities portfolio fell from $280,000 in the
third quarter of 2002 to $122,000 this year, based on a $306,000 (23%) decline
in interest income versus a $148,000 (14%) reduction in interest expense. The
decline in interest income was principally due to turnover within the portfolio.
As rates declined and loan prepayments increased, we made the decision to sell
some of our higher yielding securities and realize the gains inherent in them
before the underlying loans prepaid at par. The securities sold were then
replaced with lower yielding instruments issued in the current rate environment.
Consequently, the margin on this segment has been negatively affected. It should
be noted, however, that a part of the impact to the portfolio margin has been
recovered through gains on sales of those securities sold at premiums in the
fourth quarter of 2002 and the first three quarters of 2003.
Non-interest income increased from $154,000 in the third quarter of 2002 to
$225,000 in the same period this year. The additional income was primarily
attributable to increased gains from sales of investments, which totaled
$189,000 for the quarter ended September 30, 2003, up from $129,000 for the
third quarter of last year. Also contributing to the increase in non-interest
income was $18,000 in rental income from the First Mutual Center building
allocated to the Investment Securities segment.
Operating expenses rose by $102,000 to $261,000 in the third quarter this year.
This increase was largely attributable to the manner in which some operating
expenses were allocated to the various segments. In the third quarter of 2002,
the Investment Securities segment benefited from an allocation that effectively
reduced its operating expenses by $128,000. Were it not for this item in 2002,
third quarter operating expenses would have declined modestly compared to the
year-ago level.
Net income for the first nine months of 2003 increased $63,000, or 29%, over the
prior year level, primarily as a result of higher non-interest income.
34
Net interest income on the investment portfolio declined from $741,000 for the
first nine months of 2002 to $432,000 for the same period this year, with
interest income declining $1.08 million (26%) while interest expense dropped
$772,000 (22%). Again, the reduction in the portfolio's net interest income was
primarily a result of our decision to sell some higher yielding securities,
realizing gains before the underlying loans prepaid at par, then replacing those
securities with lower yielding instruments issued in the current rate
environment. As noted above, however, part of the impact to the portfolio's net
interest income has been recovered through the gains on sales of those
securities sold at premiums in the fourth quarter of 2002 and the first three
quarters of 2003.
Non-interest income rose $438,000, or 120%, on a year-to-date comparison. Like
the quarterly comparison, much of this increase was due to the gains realized
from the sale of securities during the first three quarters of 2003 as compared
to last year, as well as the allocation of rental income associated with the
purchase of the First Mutual Center building. Gains realized from the sale of
securities in the first nine months of 2003 totaled $663,000, compared to
$287,000 last year. Additionally, rental income allocated to the Investment
Securities segment totaled $79,000 through September of this year. There was no
comparable income last year.
Similar to the third quarter results, non-interest expense rose by $34,000 due
to the methods used to allocate certain operating expenses to the various
segments in 2002 and 2003. Were it not for the $128,000 item in 2002, the
year-to-date operating expenses would have declined by approximately $94,000
compared to year-ago level.
LIQUIDITY AND CAPITAL RESERVES
- ------------------------------
Net cash, as reported in the Statement of Cash Flows, decreased by $5.1 million,
or 34%, in the first nine months of 2003. Our cash inflows included the
principal repayments of loans and securities, deposit growth, net FHLB advances,
proceeds from the sale of securities, and the issuance of trust preferred
securities. Our outflows were largely composed of loan originations, security
purchases and the acquisition of our corporate headquarters.
In the first nine months of the year, loan principal repayments totaled $154.8
million. In addition, contractual repayments and redemptions on securities
amounted to $33.7 million. Proceeds from FHLB borrowings totaled $28.0 million,
net of repayment of advances. The sale of securities in the first three quarters
of the year contributed $25.4 million and deposits increased by $58.6 million.
We also received $4.0 million in funds from a trust preferred security offering.
We used these cash inflows to fund loan originations, which amounted to $259.6
million during the first nine months of 2003, and to purchase securities
totaling $67.7 million. In addition, in March of this year we purchased the
First Mutual Center building, which required a cash outlay of $12 million.
Our long-term liquidity objective is to fund 70% of our 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 25.3%, which is below our credit limit of 40% of assets. Other sources
of liquidity include the sale of loans into the secondary market and net income
after the payment of dividends. The Company is also
35
approved for a $5 million line of credit of which we have drawn down $500,000
and a $50 million reverse repurchase line of credit of which we have not yet
accessed.
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
September 30, 2003, we exceeded the capital levels required to meet the
definition of a well-capitalized institution:
For Well
Capital Capitalized
Adequacy Minimum
Actual Minimum Ratio
------ ------- -----
Total capital (to risk-weighted assets):
First Mutual Bancshares, Inc.
First Mutual Bank 11.37% 8.00% 10.00%
11.13 8.00 10.00
Tier I capital (to risk-weighted assets):
First Mutual Bancshares, Inc.
First Mutual Bank
9.99 4.00 6.00
Tier I capital (to average assets): 9.88 4.00 6.00
First Mutual Bancshares, Inc.
First Mutual Bank
7.27 4.00 5.00
7.31 4.00 5.00
The Bank is also planning on issuing $4 million in trust preferred securities
during the fourth quarter of 2003.
BANKING CENTER EXPANSION
- ------------------------
We are continuing to expand our retail banking center network. The Sammamish
Plateau banking center, a leased facility, is scheduled to open later this
quarter and the Canyon Park location, currently planned as a three-story office
building, is on track to open in 2005. The anticipated additional capital cost
for these two banking centers is $4.2 million. During 2004 we are planning on
remodeling four of our existing banking centers to continue with our open and
inviting retail atmosphere format that we have adopted in our new banking
facilities. The capital expenditures for the remodels are estimated to be $2.7
million.
At this time we do not anticipate opening a new office in 2004, although we will
continue our search and if a promising site becomes available we would pursue
the opportunity. Our banking center franchise primary market area is east of
Lake Washington, from Renton to the Bothell/Kenmore area. Continued expansion
will 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.
36
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK
Market risk is defined as the sensitivity of income and capital to 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 MODEL
The Gap Report, which indicates the difference between assets maturing,
repricing, or prepaying within a period and total liabilities maturing or
repricing within the same period, is a traditional view of interest rate
sensitivity. Our twelve-month interest rate sensitivity gap, expressed as a
percentage of assets, fell from 16.5% at December 31, 2002 to 5.7% at September
30, 2003. These results indicate that we remain asset sensitive, with more
assets than liabilities maturing or repricing within the next year, though
significantly less than at year-end 2002. The gap report has implied an asset
sensitive position for a number of quarters, dating back to September 2001. The
change in the gap was driven by the mix of the additions to each side of the
balance sheet during the first nine months of 2003, as well as the overall
balance sheet growth.
One-Year Interest Rate Sensitivity Gap
(In thousands)
SEPTEMBER 30, DECEMBER 31,
2003 2002
-------- --------
One-Year Repricing / Maturing Assets $626,691 $600,577
One-Year Repricing / Maturing Liabilities 578,993 477,932
-------- --------
One-Year Gap $ 47,698 $122,645
======== ========
Total Assets $838,029 $745,295
======== ========
One-Year Interest Rate Gap as a
Percentage of Assets 5.7% 16.5%
37
Asset growth of $93 million, or 12%, in the first nine months of 2003 was
centered in assets that would not be subject to maturity or repricing in the
following twelve months. These assets included $12 million in new fixed assets,
in the form of the First Mutual Center building in Bellevue, purchased during
the first quarter of 2003, and $23 million of growth in fixed-rate consumer
loans. Also falling into this category were new single- and multi-family
residential and commercial real estate ARMs, often tied to one-year FHLB or
London Interbank Offering Rate ("LIBOR") indexes, but for which the interest
rate is fixed for the first three to ten years of the loan. Overall, those
assets not subject to maturity or repricing within twelve months rose $67
million over the nine-month period, while assets expected to mature or reprice
within the time horizon increased $26 million from their level as of December
31, 2002. Much of the latter $26 million was centered in new land and
construction loans, as well as single- and multi-family residential and
commercial real estate ARM balances. The interest rates on these loans are
typically adjustable annually, with the new loans generally tied to either the
one-year LIBOR or FHLB rate.
By comparison, liabilities subject to maturity or repricing in the next twelve
months rose $101 million over the nine-month period. This increase was driven by
a combination of growth in money market accounts subject to repricing over the
time horizon, a shift in volumes from longer-term time deposits to six- and
seven-month certificates, and the rolling forward of long-term, fixed-rate FHLB
advances. Money market account balances have risen significantly through the
first nine months of the year, driven largely by the Platinum money market
account, which was up nearly $32 million from the December 31, 2002 level.
Balances of six- and seven-month time deposits increased from $11 million and
$21 million at December 2002 to $45 million and $55 million at September 30,
2003, respectively, in response to promotional rates offered in the second and
third quarters. As total retail time deposits showed little change from December
levels, the growth in six- and seven-month certificates also represented a shift
from other accounts, in this case longer-term time deposits. This shift from
longer-term to shorter-term certificates contributed to the reduction in gap.
Additionally, the volume of our FHLB borrowings scheduled to mature within
twelve months increased by $32 million as long-term, fixed-rate advances
continued to roll forward.
Overall, this combination of a greater increase for liabilities
maturing/repricing in the next twelve months than assets repricing in the same
period resulted in a net $75 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 period, which
increased the denominator of the gap ratio from $745 million to $838 million.
The combined effect of these two factors was the reduction in the one-year gap
ratio from 16.5% to 5.7% of total assets.
38
NET INTEREST INCOME (NII) SIMULATION
Rate Ramp Estimates
Net Interest Income and Net Market Value
SEPTEMBER 30, 2003 DECEMBER 31, 2002
PERCENTAGE PERCENTAGE
CHANGE CHANGE
- ------------------------ ------------- --------------- ------------ --------------
Change in Interest Rates Net Interest Economic Value Net Interest Economic Value
(In basis points) Income of Equity Income of Equity
- ------------------------ ------------- --------------- ------------ --------------
+200 (0.51%) (18.97%) 1.94% (10.58%)
+100 n/a (9.61%) n/a (3.89%)
-100 (0.44%) 7.18% (1.44%) 0.18%
-200 n/a n/a n/a n/a
The above table refers to changes in net interest income for the twelve-month
periods beginning September 30, 2003 and December 31, 2002, respectively.
The September 30, 2003 results of our simulation model indicate that our net
interest income ("NII") would be expected to decline in both rising and falling
interest rate environments, contracting 0.51% as rates increase by 200 bps, and
0.44% with a 100 bps drop in rates. The magnitudes of these changes, less than
1.00% from the baseline in either scenario, suggest that little sensitivity
exists with regard to changes in interest rates, with relatively consistent net
interest income in the base case projection and the rising and falling rate ramp
scenarios. In both scenarios, differences in velocity (the timeframe and/or
frequency of repricing within the twelve month period), index rates, optionality
such as rate floors, and prepayment characteristics result in a change in the
NII profile different than might be expected based on our asset sensitivity.
In the base case, forecasted twelve month NII rose to $30.7 million at September
30, from $26.0 million for December 31, 2002, driven by the above mentioned
asset growth, which included approximately $79 million in net loan growth. Also
contributing to the increase in projected net interest income was a modest
improvement in the modeled net interest spread. While the simulation model's
yield on assets fell 50 bps compared to December 2002, liabilities costs saw a
51 bps reduction over the period.
The rate floors on our loan portfolio also affect net interest income
sensitivity. If the fully indexed rate on one of these loans reaches a level
significantly below the level of the rate floor, the loan effectively becomes a
fixed-rate instrument and may not reprice upwards in a rising rate scenario.
Consequently in the rising rate scenario, the revenue generated on a significant
percentage of the loan portfolio remains constant as funding costs rise.
Incorporated into the model assumptions is the observed tendency for loan and
investment prepayments to accelerate in falling interest rate scenarios and slow
when interest rates rise. 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. Therefore, implicit
in this assumption are additional assumptions for higher new securities
purchases and loan production volumes at lower interest rate levels to offset
accelerated prepayments, and conversely, reduced securities purchases and loan
production when rates increase and prepayments slow.
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.
39
The assumed discount rate used for each projected cash flow is the yield
currently available from alternative instruments of comparable risk and
duration.
In the simulated 200 bps upward shift of the yield curve, 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, with more prominent effects on
longer-term, fixed-rate instruments. 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 were more
pronounced for our assets, which would have declined in value by an estimated
3.8% versus an approximately 2.6% decline in the value of liabilities, the
economic value of our equity is negatively impacted in this scenario, declining
18.9%. The additional long-term, fixed-rate assets mentioned above that were
added to the simulation in the first nine months of 2003, including those ARMs
with rate floors that effectively became fixed-rate instruments in the current
rate environment, increased the balance sheet sensitivity to an increase in
interest rates relative to the December 31, 2002 calculations.
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. These results illustrate 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
September 30, 2003 were positively impacted when rates were assumed to fall by
100 basis points, assets by 1.8% and liabilities by 1.3%. This resulted in a
positive impact to the economic value of our equity of nearly 7.2%. Again, the
additional long-term, fixed-rate assets incorporated in the simulation after the
first nine months of 2003 increased the balance sheet sensitivity to the change
in interest rates.
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
levels, including the shape of the yield curve, prepayments on loans and
securities, deposit decay rates, pricing decisions on loans and deposits, and
reinvestment/replacement of asset and liability cash flows. Customer preferences
and competitor and economic influences are impossible to predict; therefore, we
cannot make any assurances as to the outcomes of these analyses.
Securities
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 September 30,
-------------------------------------------------------------------------
2003 2002
----------------------------------- -----------------------------------
AVAILABLE-FOR-SALE: Carrying Value Percent of Total Carrying Value Percent of Total
- ------------------- ----------------------------------- -----------------------------------
US Government Treasury and agency obligations $ 11,050 15% $ -- 0%
Mortgage backed securities:
Freddie Mac 16,071 23% 4,902 9%
Fannie Mae (includes FNMA stock) 44,794 62% 51,083 91%
----------------------------------- -----------------------------------
Total mortgage-backed securities 60,865 85% 55,985 100%
----------------------------------- -----------------------------------
------------------------------------------------------------------------------------ -----------------------------------
Total securities available-for-sale $ 71,915 100% $ 55,985 100%
------------------------------------------------------------------------------------ -----------------------------------
-------------------------------------------------------------------------
At September 30,
-------------------------------------------------------------------------
2003 2002
----------------------------------- -----------------------------------
HELD-TO-MATURITY: Carrying Value Percent of Total Carrying Value Percent of Total
- ----------------- ----------------------------------- -----------------------------------
Municipal Bonds $ 1,327 13% $ 1,340 7%
Mortgage backed securities:
Freddie Mac 556 6% 948 5%
Fannie Mae 7,994 81% 16,904 88%
----------------------------------- -----------------------------------
Total mortgage-backed securities 8,550 87% 17,852 93%
CMO's 5 0% 35 0%
----------------------------------- -----------------------------------
------------------------------------------------------------------------------------ -----------------------------------
Total securities held-to-maturity $ 9,882 100% $ 19,227 100%
------------------------------------------------------------------------------------ -----------------------------------
Estimated Market Value $10,103 $ 19,798
------------------------------------------------------------------------------------ -----------------------------------
40
ITEM 3A
The following table shows the maturity or period to repricing of the Bank's
consolidated portfolio of securities available-for-sale and held-to-maturity
(dollars in thousands):
-------------------------------------------------------------------------
Available-for-sale at September 30, 2003
-------------------------------------------------------------------------
One Year or Less Over One to Three Years Over Three to Five Years
-------------------------------------------------------------------------
Weighted Weighted Weighted
Carrying Average Carrying Average Carrying Average
Value Yield Value Yield Value Yield
-------------------------------------------------------------------------
Available-for-Sale:
- -------------------
US Government Treasury and agency obligations $ -- 0.00% $ -- 0.00% $ -- 0.00%
Mortgage backed securities:
Freddie Mac 355 3.29% -- 0.00% 1,634 5.50%
Fannie Mae 637 3.74% -- 0.00% 1,706 5.50%
------- ------- ------- ------- ------- -------
Total mortgage-backed securities 992 3.58% -- 0.00% 3,340 5.50%
-------------------------------------------------------------------------
Total securities available-for-sale -- Carrying Value $ 992 3.58% $ -- 0.00% $ 3,340 5.50%
-------------------------------------------------------------------------
-------------------------------------------------------------------------
Total securities available-for-sale -- Amortized Cost $ 965 3.58% $ -- 0.00% $ 3,215 5.50%
-------------------------------------------------------------------------
-------------------------------------------------------------------------
Held-to-Maturity at September 30, 2003
-------------------------------------------------------------------------
One Year or Less Over One to Three Years Over Three to Five Years
-------------------------------------------------------------------------
Weighted Weighted Weighted
Carrying Average Carrying Average Carrying Average
Value Yield Value Yield Value Yield
-------------------------------------------------------------------------
Held-to-Maturity:
- -----------------
Municipal Bonds $ -- 0.00% $ -- 0.00% $ -- 0.00%
Mortgage backed securities:
Freddie Mac 556 3.61% -- 0.00% -- 0.00%
Fannie Mae 2,788 4.85% 2,903 5.65% -- 0.00%
------- ------- ------- ------- ------- -------
Total mortgage-backed securities 3,344 4.64% 2,903 5.65% -- 0.00%
CMO's -- 0.00% -- 0.00% -- 0.00%
-------------------------------------------------------------------------
Total securities held-to-maturity -- Carrying Value $ 3,344 4.65% $ 2,903 5.65% $ -- 0.00%
-------------------------------------------------------------------------
-------------------------------------------------------------------------
Total securities held-to-maturity -- Fair Market Value $ 3,448 4.51% $ 2,988 5.49% $ -- 0.00%
-------------------------------------------------------------------------
-------------------------------------------------------------------------
Available-for-sale at September 30, 2003
-------------------------------------------------------------------------
Over Five to Ten Years Over Ten to Twenty Years Over Twenty Years
-------------------------------------------------------------------------
Weighted Weighted Weighted
Carrying Average Carrying Average Carrying Average
Value Yield Value Yield Value Yield
-------------------------------------------------------------------------
Available-for-Sale:
- -------------------
US Government Treasury and agency obligations $ 6,097 4.08% $ 4,953 4.00% $ -- 0.00%
Mortgage backed securities:
Freddie Mac 4,736 3.50% 9,346 4.50% -- 0.00%
Fannie Mae 1,407 5.50% 41,044 4.38% -- 0.00%
------- ------- ------- ------- ------- -------
Total mortgage-backed securities 6,143 3.96% 50,390 4.40% -- 0.00%
-------------------------------------------------------------------------
Total securities available-for-sale -- Carrying Value $12,240 4.02% $55,343 4.37% $ -- 0.00%
-------------------------------------------------------------------------
-------------------------------------------------------------------------
Total securities available-for-sale -- Amortized Cost $12,193 4.01% $55,622 4.36% $ -- 0.00%
-------------------------------------------------------------------------
-------------------------------------------------------------------------
Held-to-Maturity at September 30, 2003
-------------------------------------------------------------------------
Over Five to Ten Years Over Ten to Twenty Years Over Twenty Years
-------------------------------------------------------------------------
Weighted Weighted Weighted
Carrying Average Carrying Average Carrying Average
Value Yield Value Yield Value Yield
-------------------------------------------------------------------------
Held-to-Maturity:
- -----------------
Municipal Bonds $ -- 0.00% $ 220 5.38% $ 1,107 6.16%
Mortgage backed securities:
Freddie Mac -- 0.00% -- 0.00% -- 0.00%
Fannie Mae 1,332 5.50% 971 4.50% -- 0.00%
------- ------- ------- ------- ------- -------
Total mortgage-backed securities 1,332 5.50% 971 4.50% -- 0.00%
CMO's -- 0.00% 5 6.50% -- 0.00%
-------------------------------------------------------------------------
Total securities held-to-maturity -- Carrying Value $ 1,332 5.50% $ 1,196 4.66% $ 1,107 6.16%
-------------------------------------------------------------------------
-------------------------------------------------------------------------
Total securities held-to-maturity -- Fair Market Value $ 1,388 5.28% $ 1,196 4.67% $ 1,082 6.31%
-------------------------------------------------------------------------
----------------------------------------
Available-for-sale at September 30, 2003
----------------------------------------
Total
----------------------
Weighted
Carrying Average
Value Yield
----------------------
Available-for-Sale:
- -------------------
US Government Treasury and agency obligations $11,050 4.05%
Mortgage backed securities:
Freddie Mac 16,071 4.28%
Fannie Mae 44,794 4.45%
------ -------
Total mortgage-backed securities 60,865 4.40%
----------------------
Total securities available-for-sale -- Carrying Value $71,915 4.35%
----------------------
----------------------
Total securities available-for-sale -- Amortized Cost $71,995 4.34%
----------------------
--------------------------------------
Held-to-Maturity at September 30, 2003
--------------------------------------
Total
----------------------
Weighted
Carrying Average
Value Yield
----------------------
Held-to-Maturity:
- -----------------
Municipal Bonds $ 1,327 6.03%
Mortgage backed securities:
Freddie Mac 556 3.61%
Fannie Mae 7,994 5.21%
------ -------
Total mortgage-backed securities 8,550 5.10%
CMO's 5 6.50%
----------------------
Total securities held-to-maturity -- Carrying Value $ 9,882 5.23%
----------------------
----------------------
Total securities held-to-maturity -- Fair Market Value $10,103 5.11%
----------------------
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
41
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 September 30, 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 September 30, 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
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY-HOLDERS
None.
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.
42
(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.
(31.1) Certification by President and Chief Executive Officer pursuant
to Section 302 of the Sarbanes-Oxley Act.
(31.2) Certification by Executive Vice President and Chief Financial
Officer pursuant to Section 302 of the Sarbanes-Oxley Act.
(32) Certification by Chief Executive Officer and Chief Financial
Officer pursuant to Section 906 of the Sarbanes-Oxley Act.
43
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: November 10, 2003 FIRST MUTUAL BANCSHARES, INC.
/s/ John R. Valaas
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John R. Valaas
President and Chief Executive Officer
/s/ Roger A. Mandery
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Roger A. Mandery
Executive Vice President
(Principal Financial Officer)
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