================================================================================
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
[X] Quarterly Report Pursuant to Section 13 or 15(d) of
The Securities Exchange Act of 1934
For the quarterly period ended June 30, 2004
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.
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(Exact name of registrant as specified in its charter)
WASHINGTON 91-2005970
---------------------------- ----------------
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification Number)
400 108th Avenue N.E., Bellevue, WA 98004
---------------------------------------------------
(Address of principal executive offices) (Zip code)
Registrant's telephone number, including area code: (425) 453-5301
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes [X] No [_]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes [X] No [_]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date. August 5, 2004 5,278,441
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FIRST MUTUAL BANCSHARES, INC.
QUARTERLY REPORT ON FORM 10-Q
June 30, 2004
TABLE OF CONTENTS
Page
----
PART I: FINANCIAL INFORMATION............................................... 1
Forward-Looking Statements Disclaimer...................... 1
ITEM 1. Financial Statements........................................... 2
ITEM 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations.......................... 16
General.................................................... 16
Overview................................................... 16
Results of Operations...................................... 18
Net Income............................................ 18
Net Interest Income................................... 18
Non-Interest Income................................... 20
Operating Expenses.................................... 23
Financial Condition........................................ 27
Asset Quality.............................................. 29
Portfolio Information...................................... 30
Deposit Information........................................ 32
Business Segments.......................................... 32
Consumer Lending...................................... 33
Residential Lending................................... 35
Business Banking Lending.............................. 36
Income Property Lending............................... 38
Liquidity.................................................. 38
Planned Expenditures for Plant and Equipment............... 40
Capital.................................................... 41
Critical Accounting Policies............................... 42
ITEM 3. Quantitative and Qualitative Disclosures About Market Risk..... 46
ITEM 4. Controls and Procedures........................................ 53
PART II: OTHER INFORMATION.................................................. 54
ITEM 1. Legal Proceedings.............................................. 54
ITEM 2. Changes in Securities, Use of Proceeds and Issuer
Purchases of Equity Securities............................. 54
ITEM 3. Defaults Upon Senior Securities................................ 54
ITEM 4. Submission of Matters to a Vote of Security Holders............ 54
ITEM 5. Other Information.............................................. 55
ITEM 6. Exhibits and Reports on Form 8-K............................... 56
SIGNATURES.................................................................. 57
CERTIFICATIONS..............................................................
i
PART I: FINANCIAL INFORMATION
FORWARD-LOOKING STATEMENTS DISCLAIMER
Our Form 10-Q contains statements concerning future operations, trends,
expectations, plans, capabilities, and prospects of First Mutual Bancshares,
Inc. and First Mutual Bank (together, the "Bank") that are forward-looking
statements for the purposes of the safe harbor provisions under the Private
Securities Litigation Reform Act of 1995. Such forward-looking statements
include references to our expectations regarding our goals for net income and
return on equity, interest rate margins, loan production and quality, banking
center expansion, trends in income and expenses, loan and servicing assets
growth, anticipated sales of loans and investment securities, observations
pertaining to the potential disparate movement and repricing 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 2003 financial statements to
conform to the 2004 presentation. All significant intercompany transactions and
balances have been eliminated.
The information included in this Form 10-Q should be read in conjunction with
the First Mutual Bancshares, Inc. Year 2003 Annual Report on Form 10-K to the
Securities and Exchange Commission. Interim results are not necessarily
indicative of results for a full year.
Consolidated Financial Statements of the Company begin on page 2.
1
Item 1. Financial Statements
FIRST MUTUAL BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
June 30, December 31,
2004 2003
------------ ------------
ASSETS: (Unaudited)
CASH AND CASH EQUIVALENTS:
Interest-earning deposits $ 641,263 $ 845,607
Noninterest-earning demand deposits
and cash on hand 10,639,555 6,581,448
------------ ------------
11,280,818 7,427,055
MORTGAGE-BACKED AND OTHER SECURITIES
AVAILABLE-FOR-SALE 112,400,222 77,623,789
LOANS RECEIVABLE, HELD-FOR-SALE 2,939,859 10,143,319
MORTGAGE-BACKED AND OTHER SECURITIES
HELD-TO-MATURITY 8,731,393 8,903,441
LOANS RECEIVABLE 793,498,904 723,710,645
RESERVE FOR LOAN LOSSES (8,864,729) (8,406,198)
------------ ------------
LOANS RECEIVABLE, net 784,634,175 715,304,447
ACCRUED INTEREST RECEIVABLE 3,915,148 3,649,032
LAND, BUILDINGS AND EQUIPMENT, net 24,651,223 24,180,509
FEDERAL HOME LOAN BANK (FHLB) STOCK, 12,533,100 11,035,500
at cost
SERVICING ASSETS 877,561 468,413
OTHER ASSETS 1,740,254 2,108,572
------------ ------------
TOTAL $963,703,753 $860,844,077
============ ============
2
FIRST MUTUAL BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(Continued)
June 30, December 31,
2004 2003
------------ ------------
(Unaudited)
LIABILITIES:
Deposits:
Money market deposit and
checking accounts $215,690,224 $191,948,350
Regular savings 8,526,795 8,710,867
Time deposits 412,602,446 383,231,431
------------ ------------
Total deposits 636,819,465 583,890,648
Drafts payable 541,460 357,256
Accounts payable and other liabilities 7,613,474 12,899,194
Advance payments by borrowers for
taxes and insurance 1,918,162 1,727,345
FHLB advances 244,313,219 193,642,878
Other advances 500,000 500,000
Deferred tax liability 186,641 --
Current tax liability 40,391 --
Long term debentures payable 17,000,000 17,000,000
------------ ------------
Total liabilities 908,932,812 810,017,321
STOCKHOLDERS' EQUITY:
Common stock, $1 par value-
Authorized, 10,000,000 shares
Issued and outstanding, 5,276,662
and 4,729,693 shares, respectively 5,276,662 4,729,693
Additional paid-in capital 45,459,124 33,678,181
Retained earnings 5,385,280 12,832,652
Accumulated other comprehensive
income(loss):
Unrealized gain(loss) on securities
available-for-sale and interest rate
swap, net of federal income tax (1,350,125) (413,770)
------------ ------------
Total stockholders' equity 54,770,941 50,826,756
------------ ------------
TOTAL $963,703,753 $860,844,077
============ ============
3
FIRST MUTUAL BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF INCOME
Quarters ended June 30, Six months ended June 30,
------------------------------ ------------------------------
2004 2003 2004 2003
----------- ----------- ----------- -----------
(Unaudited) (Unaudited)
INTEREST INCOME:
Loans Receivable $12,322,025 $11,239,837 $24,202,951 $22,193,670
Interest on AFS Securities 885,339 689,844 1,662,287 1,337,041
Interest on HTM Securities 107,718 170,969 216,359 373,217
Interest Other 146,942 176,390 284,067 381,174
----------- ----------- ----------- -----------
13,462,024 12,277,040 26,365,664 24,285,102
INTEREST EXPENSE:
Deposits 2,977,822 2,959,303 5,858,845 6,030,311
FHLB advances and other 1,627,415 1,880,793 3,159,967 3,742,599
----------- ----------- ----------- -----------
4,605,237 4,840,096 9,018,812 9,772,910
Net interest income 8,856,787 7,436,944 17,346,852 14,512,192
PROVISION FOR LOAN LOSSES 440,000 325,000 690,000 460,000
----------- ----------- ----------- -----------
Net interest income, after provision
for loan losses 8,416,787 7,111,944 16,656,852 14,052,192
OTHER OPERATING INCOME:
Gain on sales of loans 321,884 183,792 667,263 379,057
Servicing fees, net of amortization 80,767 14,663 113,641 29,497
Gain on sales of investments -- 86,454 70,870 473,523
Fees on deposits 147,551 127,978 291,165 251,288
Other 378,149 470,302 683,100 735,527
----------- ----------- ----------- -----------
Total other operating income 928,351 883,189 1,826,039 1,868,892
4
FIRST MUTUAL BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF INCOME
(Continued)
Quarters ended June 30, Six months ended June 30,
------------------------------ ------------------------------
2004 2003 2004 2003
----------- ----------- ----------- -----------
(Unaudited) (Unaudited)
OPERATING EXPENSES:
Salaries and employee benefits $ 3,392,481 $ 3,014,391 $ 6,655,193 $ 5,986,883
Occupancy 648,804 571,696 1,344,513 1,160,012
Other 1,998,988 1,342,462 3,680,594 2,553,887
----------- ----------- ----------- -----------
Total other operating expenses 6,040,273 4,928,549 11,680,300 9,700,782
----------- ----------- ----------- -----------
Income before federal income taxes 3,304,865 3,066,584 6,802,591 6,220,302
----------- ----------- ----------- -----------
FEDERAL INCOME TAXES 1,118,014 1,036,967 2,301,599 2,103,527
----------- ----------- ----------- -----------
NET INCOME $ 2,186,851 $ 2,029,617 $ 4,500,992 $ 4,116,775
=========== =========== =========== ===========
PER SHARE DATA:
Basic earnings per common share $ 0.42 $ 0.39 $ 0.86 $ 0.79
Earnings per common share, assuming dilution $ 0.40 $ 0.38 $ 0.82 $ 0.78
WEIGHTED AVERAGE SHARES OUTSTANDING 5,268,108 5,180,655 5,245,374 5,167,817
WEIGHTED AVERAGE SHARES OUTSTANDING
INCLUDING DILUTIVE STOCK OPTIONS 5,511,304 5,359,266 5,493,889 5,327,073
5
FIRST MUTUAL BANCSHARES, INC, AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME
Accumulated
Common Stock Additional Comprehensive
------------------------ Paid-in Retained Income
Shares Amount Capital Earnings (Loss) Total
----------- ----------- ----------- ----------- ----------- -----------
BALANCE, December 31, 2001 4,725,966 $ 4,725,966 $31,411,296 $16,025,853 $ (191,818) $51,971,297
----------- ----------- ----------- ----------- ----------- -----------
Comprehensive income:
Net income 7,797,370 7,797,370
Other comprehensive income
(loss), net of tax:
Unrealized gain on securities available-for-sale 1,391,521 1,391,521
Unrealized (loss) on interest rate swap (405,862) (405,862)
-----------
Total comprehensive income 8,783,029
Options exercised, including tax benefit of $169,903 67,573 67,573 551,848 619,421
Retirement of shares repurchased (1,019,256) (1,019,256) (13,963,793) (815,419) (15,798,468)
10% stock dividend 472,883 472,883 6,029,259 (6,502,142) --
Cash dividend declared ($0.28 per share) (1,291,442) (1,291,442)
----------- ----------- ----------- ----------- ----------- -----------
BALANCE, December 31, 2002 4,247,166 4,247,166 24,028,610 15,214,220 793,841 44,283,837
----------- ----------- ----------- ----------- ----------- -----------
Comprehensive income:
Net income 8,395,738 8,395,738
Other comprehensive income (loss), net of tax:
Unrealized gain on securities available-for-sale 87,186 87,186
Unrealized (loss) on interest rate swap (1,294,797) (1,294,797)
-----------
Total comprehensive income 7,188,127
Options exercised, including tax benefit of $219,124 53,040 53,040 571,618 624,658
Issuance of stock through employees' stock plans 1,386 1,386 23,617 25,003
10% stock dividend 428,101 428,101 9,054,336 (9,482,437) --
Cash dividend declared ($0.28 per share) (1,294,869) (1,294,869)
----------- ----------- ----------- ----------- ----------- -----------
BALANCE, December 31, 2003 4,729,693 4,729,693 33,678,181 12,832,652 (413,770) 50,826,756
=========== =========== =========== =========== =========== ===========
Comprehensive income:
Net income 4,500,992 4,500,992
Other comprehensive income (loss), net of tax:
Unrealized gain on securities available-for-sale 148,595 148,595
Unrealized (loss) on interest rate swap (1,084,950) (1,084,950)
-----------
Total comprehensive income 3,564,637
Options exercised, including tax benefit of $175,275 68,870 68,870 1,002,108 1,070,978
Issuance of stock through employees' stock plans 2,019 2,019 47,992 50,011
10% stock dividend 476,080 476,080 10,730,843 (11,206,923) --
Cash dividend declared ($0.14 per share) (741,441) (741,441)
----------- ----------- ----------- ----------- ----------- -----------
BALANCE, June 30, 2004 5,276,662 $ 5,276,662 $45,459,124 $ 5,385,280 $(1,350,125) $54,770,941
=========== =========== =========== =========== =========== ===========
6
FIRST MUTUAL BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Six months ended June 30,
-----------------------------------
2004 2003
------------- -------------
(Unaudited)
OPERATING ACTIVITIES:
Net income $ 4,500,992 $ 4,116,775
Adjustments to reconcile net income to net cash
from operating activities:
Provision for loan losses 690,000 460,000
Depreciation and amortization 642,563 516,993
Deferred loan origination fees, net of accretion (99,833) (658,069)
Amortization of servicing assets 312,003 26,758
Gain on sales of loans (667,263) (379,057)
Gain on sale of securities available-for-sale (70,870) (473,523)
Loss on sale of repossed assets 7,200 --
FHLB stock dividends (228,200) (312,700)
Changes in operating assets & liabilities:
Loans receivable held-for-sale 7,203,460 1,405,865
Accrued interest receivable (266,116) (105,423)
Other assets 368,318 (297,401)
Drafts payable 184,204 436,085
Accounts payable and other liabilities (5,096,976) 8,930,031
Advance payments by borrowers for taxes and insurance 190,817 (11,966)
------------- -------------
Net cash provided by operating activities 7,670,299 13,654,368
INVESTING ACTIVITIES:
Loan originations (183,350,623) (168,157,504)
Loan principal repayments 119,422,652 98,674,299
Increase (decrease) in undisbursed loan proceeds (5,148,958) 19,597,030
Principal repayments & redemptions on
mortgage-backed and other securities 5,979,602 26,670,861
Purchase of securities held-to-maturity (1,126,983) (1,098,881)
Purchase of securities available-for-sale (43,282,952) (57,704,405)
Purchases of premises and equipment (1,110,551) (12,829,840)
Purchase of FHLB stock (1,269,400) --
Proceeds from sale of securities 2,228,958 18,773,622
------------- -------------
Net cash (used) by investing activities (107,658,255) (76,074,818)
7
FIRST MUTUAL BANCSHARES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Continued)
Six months ended June 30,
-----------------------------------
2004 2003
------------- -------------
(Unaudited)
FINANCING ACTIVITIES:
Net increase in deposit accounts $ 47,397,620 $ 15,535,782
Interest credited to deposit accounts 5,531,197 5,744,921
Proceeds from long-term debentures (trust preferred securities) -- 4,000,000
Issuance of stock through employees's stock plans 50,011 25,003
Proceeds from advances 436,328,196 271,343,754
Repayment of advances (385,657,855) (241,589,800)
Dividends paid (703,153) (596,451)
Proceeds from exercise of stock options 895,703 238,169
------------- -------------
Net cash provided by financing activities 103,841,719 54,701,378
------------- -------------
NET INCREASE (DECREASE) IN CASH AND CASH
EQUIVALENTS $ 3,853,763 $ (7,719,072)
CASH & CASH EQUIVALENTS:
Beginning of year 7,427,055 14,971,527
------------- -------------
End of quarter $ 11,280,818 $ 7,252,455
============= =============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW
INFORMATION:
Loans originated for mortgage banking activities $ 42,262,903 $ 45,232,764
============= =============
Loans originated for investment activities $ 183,350,623 $ 168,157,504
============= =============
Proceeds from sales of loans held-for-sale $ 49,466,363 $ 46,638,629
============= =============
Cash paid during the year for:
Interest $ 9,004,628 $ 9,924,360
============= =============
Income taxes $ 1,457,000 $ 2,028,000
============= =============
SUPPLEMENTAL DISCLOSURES OF NONCASH
INVESTING ACTIVITIES:
Loans transferred to real estate
held-for-sale, net $ -- $ 39,733
============= =============
8
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
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.
The Bank had three stock-based employee/director compensation plans, which are
described more fully in the 2003 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 June 30, Six Months Ended June 30,
------------------------------- -------------------------------
2004 2003 2004 2003
----------- ----------- ----------- -----------
Net Income, as reported $ 2,186,851 $ 2,029,617 $ 4,500,992 $ 4,116,775
Deduct: Total stock-based employee/
director compensation expense
determined under fair value based
method for all awards, net of related
tax effects (98,984) (56,053) (197,135) (104,913)
----------- ----------- ----------- -----------
Pro forma net income $ 2,087,867 $ 1,973,564 $ 4,303,857 $ 4,011,862
=========== =========== =========== ===========
Earnings per share:
Basic - as reported $ 0.42 $ 0.39 $ 0.86 $ 0.79
Basic - pro forma $ 0.40 $ 0.38 $ 0.82 $ 0.78
Diluted - as reported $ 0.40 $ 0.38 $ 0.82 $ 0.78
Diluted - pro forma $ 0.38 $ 0.37 $ 0.78 $ 0.75
Weighted average shares outstanding:
Basic 5,268,108 5,180,655 5,245,374 5,167,817
Diluted 5,511,304 5,359,266 5,493,889 5,327,073
The compensation expense included in the pro forma net income and net income per
share figures in the previous table are not likely to be representative of the
effect on reported net income for future years because options vest over several
years and additional awards generally are made each year.
9
NOTE 2.
MORTGAGE-BACKED AND OTHER SECURITIES AVAILABLE-FOR-SALE
The amortized cost and estimated fair value of securities available-for-sale at
June 30, 2004, and December 31, 2003 are summarized as follows:
Gross Gross
Gross unrealized unrealized Estimated
Amortized unrealized losses less losses greater fair
cost gains than 1 Year than 1 Year value
------------ --------- ---------- ----- ------------
JUNE 30, 2004
Freddie Mac securities $ 16,558,542 $ 39,032 $ 585,054 $ -- $ 16,012,520
Fannie Mae securities 42,487,655 72,141 1,215,304 -- 41,344,492
Ginnie Mae securities 44,159,507 100,391 32,578 -- 44,227,320
US agency securities 10,982,465 -- 166,575 -- 10,815,890
------------ --------- ---------- ----- ------------
$114,188,169 $ 211,564 $1,999,511 $ -- $112,400,222
============ ========= ========== ===== ============
DECEMBER 31, 2003
Freddie Mac securities $ 15,708,833 $ 60,174 $ 222,620 $ -- $ 15,546,387
Fannie Mae securities 43,069,484 292,309 324,031 -- 43,037,762
Ginnie Mae securities 8,010,938 -- 24,688 -- 7,986,250
US agency securities 10,980,831 105,409 32,850 -- 11,053,390
------------ --------- ---------- ----- ------------
$ 77,770,086 $ 457,892 $ 604,189 $ -- $ 77,623,789
============ ========= ========== ===== ============
Certain investment securities shown above currently have fair values less
than amortized cost and therefore contain unrealized losses. The Bank has
evaluated these securities and has determined that the decline in value is
temporary and is related to the change in market interest rates since purchase.
The decline in value is not related to any company or industry specific event.
At June 30, 2004 and December 31, 2003, there were 21 and 8 investment
securities with unrealized losses, respectively. The Bank anticipates full
recovery of amortized cost with respect to these securities at maturity or
sooner in the event of a more favorable market interest rate environment.
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
Gross unrealized unrealized Estimated
Amortized unrealized losses less losses greater fair
cost gains than 1 Year than 1 Year value
------------ --------- ---------- ----- ------------
June 30, 2004
Fannie Mae securities $ 6,950,655 $ 146,634 $ 46,877 $ -- $ 7,050,412
Freddie Mac securities 502,687 7,735 -- -- 510,422
Municipal bonds 1,278,051 -- 2,070 19,134 1,256,847
------------ --------- ---------- ------- ------------
$ 8,731,393 $ 154,369 $ 48,947 $19,134 $ 8,817,681
============ ========= ========== ======= ============
December 31, 2003
Fannie Mae securities $ 7,028,766 $ 217,292 $ 2,118 $ -- $ 7,243,940
Freddie Mac securities 549,870 11,925 -- -- 561,795
Municipal bonds 1,324,283 2,598 -- 23,503 1,303,378
REMICs 522 -- -- -- 522
------------ --------- ---------- ------- ------------
$ 8,903,441 $ 231,815 $ 2,118 $23,503 $ 9,109,635
============ ========= ========== ======= ============
Certain investment securities shown above currently have fair values less
than amortized cost and therefore contain unrealized losses. The Bank has
evaluated these securities and has determined that the decline in value is
temporary and is related to the change in market interest rates since purchase.
The decline in value is not related to any company or industry specific event.
At June 30, 2004 and December 31, 2003, there were 4 and 2 investment securities
with unrealized losses, respectively. The Bank anticipates full recovery of
amortized cost with respect to these securities at maturity or sooner in the
event of a more favorable market interest rate environment.
10
NOTE 4.
NONPERFORMING ASSETS
The Bank had nonperforming assets as follows:
June 30, 2004 December 31, 2003
------------- -----------------
Nonperforming loans $ 1,150,720 $ 526,869
Real Estate and Repossessed assets
held-for-sale 3,000 11,200
----------- ---------
Total Nonperforming Assets $ 1,153,720 $ 538,069
=========== =========
At June 30, 2004 and December 31, 2003, the Bank had two impaired loans totaling
$15,135 and $16,445, respectively, 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 and six months
ending June 30, 2004 and June 30, 2003:
Income Shares Per share
(numerator) (denominator) amount
----------- ------------- ----------
Quarter ended June 30, 2004
Basic EPS:
Income available to common shareholders $ 2,186,851 5,268,108 $ 0.42
==========
Effect of dilutive stock options -- 243,196
----------- ----------
Diluted EPS:
Income available to common shareholders
plus assumed stock options exercised $ 2,186,851 5,511,304 $ 0.40
=========== ========== ==========
Six months ended June 30, 2004
Basic EPS:
Income available to common shareholders $ 4,500,992 5,245,374 $ 0.86
==========
Effect of dilutive stock options -- 248,515
----------- ----------
Diluted EPS:
Income available to common shareholders
plus assumed stock options exercised $ 4,500,992 5,493,889 $ 0.82
=========== ========== ==========
Quarter ended June 30, 2003
Basic EPS:
Income available to common shareholders $ 2,029,617 5,180,655 $ 0.39
==========
Effect of dilutive stock options -- 178,611
----------- ----------
Diluted EPS:
Income available to common shareholders
plus assumed stock options exercised $ 2,029,617 5,359,266 $ 0.38
=========== ========== ==========
Six months ended June 30, 2003
Basic EPS:
Income available to common shareholders $ 4,116,775 5,167,817 $ 0.79
==========
Effect of dilutive stock options -- 159,256
----------- ----------
Diluted EPS:
Income available to common shareholders
plus assumed stock options exercised $ 4,116,775 5,327,073 $ 0.78
=========== ========== ==========
11
NOTE 6.
RATE VOLUME ANALYSIS SECOND QUARTER 2004 SIX MONTHS ENDED JUNE 30, 2004
(Dollars in thousands) VS VS
SECOND QUARTER 2003 SIX MONTHS ENDED JUNE 30, 2003
INCREASE (DECREASE) DUE TO INCREASE (DECREASE) DUE TO
TOTAL TOTAL
VOLUME RATE CHANGE VOLUME RATE CHANGE
- --------------------------------------------------------------------------------------- ---------------------------------------
INTEREST INCOME
Investments:
Available-for-sale securities $ 321 $ (126) $ 195 $ 465 $ (140) $ 325
Held-to-maturity securities (67) 5 (62) (156) 1 (155)
Other equity investments 16 (45) (29) 16 (113) (97)
--------------------------------------- ---------------------------------------
Total investments 270 (166) 104 325 (252) 73
--------------------------------------- ---------------------------------------
Loans:
Residential $ 699 $ (92) $ 607 $ 1,328 $ (264) $ 1,064
Residential construction 573 69 642 1,157 (19) 1,138
Multifamily 91 (440) (349) 166 (859) (693)
Multifamily construction 78 (60) 18 123 (46) 77
Commercial real estate and business (14) (417) (431) (35) (878) (913)
Commercial real estate construction (2) 52 50 (10) 33 23
Consumer & other 440 104 544 936 376 1,312
--------------------------------------- ---------------------------------------
Total loans 1,865 (784) 1,081 3,665 (1,657) 2,008
--------------------------------------- ---------------------------------------
Total interest income $ 2,135 $ (950) $ 1,185 $ 3,990 $(1,909) $ 2,081
INTEREST EXPENSE
Deposits:
Money market deposit and checking $ 181 $ (25) $ 156 $ 344 $ (39) $ 305
Regular savings (1) (1) (2) -- (1) (1)
Time deposits 364 (500) (136) 626 (1,101) (475)
--------------------------------------- ---------------------------------------
Total deposits 544 (526) 18 970 (1,141) (171)
FHLB advances and other 213 (467) (254) 612 (1,195) (583)
--------------------------------------- ---------------------------------------
Total interest expense 757 (993) (236) 1,582 (2,336) (754)
Net interest income $ 1,378 $ 43 $ 1,421 $ 2,408 $ 427 $ 2,835
======================================= =======================================
12
NOTE 7.
SEGMENTS
Beginning January 1, 2004 we changed the presentation of our Business Segments
to more accurately reflect the way these segments are managed within the Bank.
Prior to 2004 we had 3 segments: 1) Consumer Lending, 2) Commercial Lending, and
3) Investment Securities. We have made some changes to the original 3 segments
by:
Separating Residential Lending from the Consumer Segment
Splitting the Commercial Segment into two separate segments:
Business Banking and Income Property Lending
Allocating the income and expenses from the former Investment
Securities Segment to the new segments based upon asset size
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. Our
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.
The reportable segments include the following:
Consumer Lending - Consumer lending includes home equity lending,
direct consumer loans, and indirect home improvement loans (Sales
Finance). These loans include lines of credit and loans for primarily
consumer purposes. 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.
Residential Lending - Residential lending offers loans to borrowers to
purchase, refinance, or build homes secured by one-to-four-unit family
dwellings. 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.
Business Banking - Business Banking offers a full range of banking
services to small and medium size businesses including deposit and cash
management products, loans for financing receivables, inventory,
equipment as well as permanent and interim construction loans for
commercial real estate. The underlying real estate collateral or
business asset being financed typically secures these loans.
Income Property Lending - Income Property lending offers permanent and
interim construction loans for multifamily housing (over four units)
and commercial real estate properties. The underlying real estate
collateral being financed typically secures these loans.
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. The 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.
13
Financial information for the Bank's segments is shown below for June 30, 2004,
2003, and 2002:
CONSUMER RESIDENTIAL BUSINESS BANKING INCOME PROPERTY
QUARTER ENDED JUNE 30: LENDING LENDING LENDING LENDING TOTALS
- ---------------------- ------- ------- ------- ------- ------
Interest income 2004 $ 2,059,604 $ 3,951,681 $ 1,295,871 $ 6,154,868 $ 13,462,024
2003 1,507,423 2,673,307 1,398,463 6,697,847 12,277,040
2002 1,070,003 2,219,179 1,323,878 7,558,043 12,171,103
Interest Expense 2004 546,897 1,532,006 303,382 2,222,952 4,605,237
2003 595,946 1,131,325 467,886 2,644,939 4,840,096
2002 492,237 1,072,261 522,923 3,383,144 5,470,565
Net Interest Income 2004 1,512,707 2,419,675 992,489 3,931,916 8,856,787
2003 911,477 1,541,982 930,577 4,052,908 7,436,944
2002 577,766 1,146,918 800,955 4,174,899 6,700,538
Provision for loan losses 2004 156,535 47,125 55,935 180,405 440,000
2003 83,068 36,062 44,693 161,177 325,000
2002 16,958 9,035 7,991 51,016 85,000
Net interest income, after
provision for loan losses 2004 1,356,172 2,372,550 936,554 3,751,511 8,416,787
2003 828,409 1,505,920 885,884 3,891,731 7,111,944
2002 560,808 1,137,883 792,964 4,123,883 6,615,538
Other operating income 2004 377,095 190,428 84,624 276,204 928,351
2003 84,382 323,539 97,742 377,526 883,189
2002 138,180 150,344 65,994 393,874 748,392
Other operating expense 2004 1,429,173 1,429,456 1,283,620 1,898,024 6,040,273
2003 982,727 1,140,533 983,335 1,821,954 4,928,549
2002 783,336 783,372 730,036 2,172,264 4,469,008
Income (loss) before federal
income taxes 2004 304,094 1,133,522 (262,442) 2,129,691 3,304,865
2003 (69,936) 688,926 291 2,447,303 3,066,584
2002 (84,348) 504,855 128,922 2,345,493 2,894,922
Federal income taxes 2004 102,766 383,672 (89,781) 721,357 1,118,014
2003 (24,422) 232,875 (574) 829,088 1,036,967
2002 (29,170) 170,633 43,147 793,914 978,524
Net income (loss) 2004 201,328 749,850 (172,661) 1,408,334 2,186,851
2003 (45,514) 456,051 865 1,618,215 2,029,617
2002 (55,178) 334,222 85,775 1,551,579 1,916,398
Total Interest Earning assets
(ending period balances) 2004 106,368,450 273,980,679 99,436,965 447,499,013 927,285,107
2003 82,619,989 180,249,319 89,418,052 430,892,240 783,179,600
2002 57,249,644 131,738,876 77,358,242 436,531,426 702,878,188
14
NOTE 7.
SEGMENTS (continued)
CONSUMER RESIDENTIAL BUSINESS BANKING INCOME PROPERTY
YEAR-TO-DATE ENDED JUNE 30: LENDING LENDING LENDING LENDING TOTALS
- --------------------------- ------- ------- ------- ------- ------
Interest income 2004 $ 4,085,733 $ 7,534,509 $ 2,607,009 $12,138,413 $ 26,365,664
2003 2,752,513 5,316,185 2,730,613 13,485,791 24,285,102
2002 2,044,725 4,484,137 2,539,641 15,188,785 24,257,288
Interest Expense 2004 1,097,506 2,912,392 632,151 4,376,763 9,018,812
2003 1,135,390 2,246,725 903,927 5,486,868 9,772,910
2002 946,058 2,224,557 1,044,681 6,835,342 11,050,638
Net Interest Income 2004 2,988,227 4,622,117 1,974,858 7,761,650 17,346,852
2003 1,617,123 3,069,460 1,826,686 7,998,923 14,512,192
2002 1,098,667 2,259,580 1,494,960 8,353,443 13,206,650
Provision for loan losses 2004 249,634 69,404 81,394 289,568 690,000
2003 115,495 50,059 59,289 235,157 460,000
2002 27,491 13,957 13,559 79,993 135,000
Net interest income, after
provision for loan losses 2004 2,738,593 4,552,713 1,893,464 7,472,082 16,656,852
2003 1,501,628 3,019,401 1,767,397 7,763,766 14,052,192
2002 1,071,176 2,245,623 1,481,401 8,273,450 13,071,650
Other operating income 2004 747,002 362,513 173,588 542,936 1,826,039
2003 206,896 629,761 205,916 826,319 1,868,892
2002 310,809 310,699 107,630 683,197 1,412,335
Other operating expense 2004 2,625,406 2,822,546 2,386,135 3,846,213 11,680,300
2003 1,892,865 2,288,440 1,952,486 3,566,991 9,700,782
2002 1,511,781 1,597,835 1,379,977 4,121,415 8,611,008
Income before federal income taxes 2004 860,189 2,092,680 (319,083) 4,168,805 6,802,591
2003 (184,341) 1,360,722 20,827 5,023,094 6,220,302
2002 (129,796) 958,487 209,054 4,835,232 5,872,977
Federal income taxes 2004 291,159 708,211 (109,668) 1,411,897 2,301,599
2003 (63,854) 460,052 5,759 1,701,570 2,103,527
2002 (45,033) 323,839 69,860 1,637,105 1,985,771
Net income 2004 569,030 1,384,469 (209,415) 2,756,908 4,500,992
2003 (120,487) 900,670 15,068 3,321,524 4,116,775
2002 (84,763) 634,648 139,194 3,198,127 3,887,206
Total Interest Earning assets (Averages) 2004 102,336,690 259,761,399 97,826,002 439,899,861 899,823,952
2003 77,036,185 173,371,863 88,051,444 434,960,693 773,420,185
2002 54,525,966 130,721,876 72,216,301 429,538,565 687,002,708
15
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
bank 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 12 full-service facilities located
in Bellevue (3), Issaquah, Kirkland (2), Monroe, Redmond, Sammamish, Seattle
(2), and Woodinville. We also have 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.
OVERVIEW
As general corporate goals we seek to obtain a 15% or greater year over year
increase in net income and a 15% or better return on equity (ROE), although, as
would be expected, our net income and ROE will vary from period to period and
year to year. These are corporate goals and not forecasts. Our actual results
from the past four years are as follows:
YEAR-OVER-YEAR ANNUALIZED
INCREASE IN NET INCOME RETURN ON EQUITY
---------------------- ----------------
Second Quarter 2001 7% 14.21%
Second Quarter 2002 11% 13.99%
Second Quarter 2003 6% 17.27%
Second Quarter 2004 8% 16.08%
YEAR-OVER-YEAR ANNUALIZED
INCREASE IN NET INCOME RETURN ON EQUITY
---------------------- ----------------
Year-to-Date 2001 6% 14.53%
Year-to-Date 2002 13% 14.40%
Year-to-Date 2003 6% 17.83%
Year-to-Date 2004 9% 17.05%
Although our ROE ratio has nearly met or exceeded our corporate target, our net
income growth for the last few years has lagged our profit objectives. During
that period we have utilized part
16
of our earnings in the investment in new business lines. About five years ago we
realized that for the Bank to continue to achieve its goal of consistent
earnings we needed to expand our business lines from two to four. At that time
our operations consisted of residential and income property (commercial real
estate) lending. Those business lines were, and continue to be, solid
operations. However, for the Bank to continue to produce consistent earnings we
needed to broaden the operating base by two new lines, Business Banking and
Consumer Lending. The process of developing those lines has been expensive and
has added to both our staff and operating costs. The encouraging news is that
the Consumer business line appears to have "turned the corner" and is now
contributing to the Bank's profit goals. Although the second quarter ROE for
that business line was 10.29%, down sharply from first quarter's 18.42% results,
the year-to-date return on equity is 14.40%. In the second quarter we accrued an
additional $162,000 of retroactive credit insurance premium, which accounted for
most of the decline in return on equity. Absent that additional insurance
accrual the ROE in the second quarter for Consumer Lending would have been about
16%. We anticipate that the results for the remaining two quarters of the year
for that business line will be closer to our corporate goal of 15%. The
important point, however, is that the results so far this year for Consumer
Lending are dramatically improved from prior years when negative returns on
investment were common. Please see the "Business Segments" and "Operating
Expenses" sections for a further discussion of this topic.
Our business lines obtain most of their revenue from net interest income, and a
key ratio that measures net interest income is the net interest margin. Over the
last five quarters that ratio has trended upward from 3.89% for the second
quarter of 2003 to a high of 4.09% in the fourth quarter of last year and then a
drop to 3.97% this quarter. We are forecasting for third quarter 2004 a range of
3.95% to 4.05%. In the first quarter of the year we extended the maturities of
our funding sources in anticipation of rising rates, and in the second quarter
we funded a $31.4 million purchase of securities with longer-term liabilities.
The combination of these two activities has helped to stabilize our net interest
margin however, at a lower level than at what would have occurred if we had been
less conservative with our asset/liability management.
The second key component of net interest income is the growth of earning assets
in the business lines. In the second quarter earning assets increased $146
million, as compared to the same quarter last year, with most of that growth
occurring in the loan portfolio, which has risen $111 million. In the last 12
months our assets have increased 19% which compares to the national average of
8.96% for FDIC insured institutions for the 12 months ending March 31, 2004.*
Please see the "Net Interest Income" and "Asset and Liability Management"
sections for a further discussion of net interest income and the processes by
which we manage that source of revenue.
A secondary source of revenue is other operating income, which constituted 10%
of both our second quarter and first half revenue. Loan sales accounted for 35%
of fee income in the second quarter and 37% year-to-date. Deposit fee income,
which has steadily grown over the last few years, contributed 16% in both the
second quarter and first half. The miscellaneous category, which amounted to 41%
of the fee income in the second quarter and 37% year-to-date, is heavily
influenced by rental income. Rental income, primarily from our corporate
headquarters, constituted 44% of our miscellaneous fee revenue in the second
quarter and 49% in the first six months. Within our corporate headquarters we
occupy 42% of the space, lease 31% and offer for lease the remaining 27%. If we
were able to lease most or all of that space, our rental income would improve
substantially. Please refer to the "Non-Interest Income" section for a further
discussion of this subject.
17
A critical factor in achieving our goal of consistent earnings is the credit
quality of our loan portfolio. That portfolio constitutes 82% of our assets, and
thus a deterioration in the performance of that asset class would quickly
undermine our earnings. Fortunately, for many years we have enjoyed credit
quality that has exceeded the national average. In the second quarter 2004, we
again experienced solid credit quality as measured by the non-performing assets
to total assets ratio of 0.12%. That figure compares to the national average of
0.67% for FDIC insured institutions as of March 31, 2004.* For additional
information regarding our credit quality, please refer to the "Asset Quality"
section.
*FDIC QUARTERLY BANKING PROFILE, FIRST QUARTER 2004
RESULTS OF OPERATIONS
NET INCOME
Net income increased approximately 8%, from $2.0 million in the second quarter
of 2003 to $2.2 million in the same period of 2004. Net interest income rose
$1.4 million, and non-interest income increased $45,000 on a second quarter
comparison. Partially offsetting the growth in revenue was a rise of $1.1
million in operating expenses.
NET INTEREST INCOME
Our net interest income for the quarter and six months ended June 30, 2004
increased $1.4 million and $2.8 million, or 19% and 20%, over the same periods
for the prior year. Relative to the second quarter of 2003, the improvement in
net interest income was almost entirely attributable to the earning assets added
to the balance sheet compared to the prior year. On a year-to-date basis,
additional earning assets again accounted for the vast majority of the
improvement in net interest income, though a net benefit of liability costs
declining more than asset yields also contributed $427,000 to net interest
income over the six-month period. The following table illustrates the effects to
our net interest income of balance sheet growth and rate changes on our assets
and liabilities, with the results attributable to the level of earning assets
classified as "volume" and the effects of asset and liability repricing labeled
"rate."
- ---------------------------------------------------------------------------------------------------------------
Six Months Ended June 30, 2004
Rate/Volume Analysis 2Q2004 vs. 2Q2003 vs. Six Months Ended June 30, 2003
(All dollars in 000s) Increase/(Decrease) due to Increase/(Decrease) due to
- ---------------------------------------------------------------------------------------------------------------
Volume Rate Total Volume Rate Total
- ---------------------------------------------------------------------------------------------------------------
Interest Income
- ---------------------------------------------------------------------------------------------------------------
Total Investments $ 270 $ (166) $ 104 $ 325 $ (252) $ 73
- ---------------------------------------------------------------------------------------------------------------
Total Loans 1,865 (784) 1,081 3,665 (1,657) 2,008
- ---------------------------------------------------------------------------------------------------------------
Total Interest Income 2,135 (950) 1,185 3,990 (1,909) 2,081
- ---------------------------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------------------------
Interest Expense
- ---------------------------------------------------------------------------------------------------------------
Total Deposits 544 (526) 18 970 (1,141) (171)
- ---------------------------------------------------------------------------------------------------------------
FHLB and Other 213 (467) (254) 612 (1,195) (583)
- ---------------------------------------------------------------------------------------------------------------
Total Interest Expense 757 (993) (236) 1,582 (2,336) (754)
- ---------------------------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------------------------
Net Interest Income $ 1,378 $ 43 $ 1,421 $ 2,408 $ 427 $ 2,835
- ---------------------------------------------------------------------------------------------------------------
18
The growth in our earning assets contributed $2.1 million and $4.0 million in
incremental interest income for the quarter and six-months ended June 30, 2004
compared with the same periods in the prior year. Partially offsetting this
income, however, was additional interest expense incurred from the funding
sources used to accommodate the asset growth. The additional expense associated
with these funding sources totaled $757,000 and $1.6 million for the respective
three- and six-month periods. The net of these two factors resulted in an
improvement in net interest income of $1.4 million, or 97% of the total
improvement for the quarter, and $2.4 million, or 85% of the total increase for
the first six months of 2004.
(All dollars in 000's)
- --------------------------------------------------------------------------------
QUARTER ENDED AVERAGE EARNING ASSETS AVERAGE NET LOANS AVERAGE DEPOSITS
- --------------------------------------------------------------------------------
June 30, 2003 $ 765,815 $ 666,173 $ 511,984
September 30, 2003 789,511 691,672 537,288
December 31, 2003 813,622 715,963 569,908
March 31, 2004 844,439 742,498 594,141
June 30, 2004 893,451 773,561 620,606
Based primarily on continued growth in our loan portfolio, average earning
assets in second quarter 2004 totaled $893 million, an increase of 17%, or $128
million, over the second quarter of 2003. For the six months ended June 30,
2004, average earning assets totaled $873 million, an increase of $126 million
over the same period last year. In addition to the loan growth illustrated in
the table above, we had a number of securities trades settle in late June. Due
to the delivery date of these securities being near the quarter-end, these
securities did not contribute significantly to second quarter interest income,
but should do so starting with the third quarter. With these additional
securities our portfolio totaled $121 million at June 30, 2004, compared to $93
million at the start of the quarter, $87 million at year-end 2003, and $88
million at June 30, 2003. Please refer to the "Financial Condition" section for
a discussion of our outlook for loan and securities growth in the third quarter
of 2004.
Primarily additional deposits, to include certificates issued in institutional
markets through deposit brokerage services, funded this asset growth.
Additionally, we utilize wholesale borrowings, primarily advances from the
Federal Home Loan Bank of Seattle (FHLB), to facilitate asset growth beyond that
which our deposit growth will accommodate, as well as to match fund specific
asset categories, such as securities purchases, as described below. For the
second quarter of 2004, our deposits averaged $621 million, representing growth
of $109 million over the second quarter 2003 average level. Results for the six
months ended June 30 were similar, with average deposits rising from $508
million for 2003 to $610 million this year. On a quarter-end basis, deposits
grew $118 million with checking and money market balances accounting for $63
million, or 54% of the total growth. The growth of these deposit products going
forward is an important facet of our overall funding strategy.
QUARTER ENDED NET INTEREST MARGIN
------------- -------------------
June 30, 2003 3.89%
September 30, 2003 4.01%
December 31, 2003 4.09%
March 31, 2004 4.03%
June 30, 2004 3.97%
19
Our net interest margin totaled 3.97% for the second quarter, declining from
that of the first quarter, but remaining above the prior year second quarter
level. The reductions in our net interest margin over the first six months of
2004 were attributable, in part, to various strategic decisions. In the first
quarter, we made the decision to extend the terms of some of our funding
sources, thus reducing the mismatch between our asset and liability durations
while locking in some longer-term funding rates at the levels prevailing at that
time. Additionally, in late 2003, we shifted our investment portfolio
concentration away from seven-year balloon and 15-year fixed-rate instruments,
and instead we began focusing on hybrid adjustable-rate mortgage (ARM)
securities for new portfolio acquisitions.
These hybrid ARM instruments bear a fixed interest rate for an initial period,
typically three to seven years, after which their rates become adjustable
annually based on a set margin over a major market index. These securities offer
shorter durations than the above-mentioned balloon and fixed-rate instruments,
as well as eventual adjustments in their coupon rates based on movements in the
underlying indexes. Some of these securities are also eligible for an
advantageous regulatory risk-adjusted capital treatment, which positively
impacts our ROE. In consideration for these advantages, however, the yields on
these securities, particularly those with an initial three-year fixed term,
which account for the majority of our purchases, are generally lower than those
of the balloon and fixed-rate instruments. Additionally, the hybrid ARM
securities purchased in 2004 have typically been match funded, or acquired using
wholesale funding sources with durations equal to those of the securities
acquired. Consequently, while related interest rate risks are reduced, the
funding costs associated with these securities purchases have been higher than
they would have been using mismatched, shorter-term funding sources.
Further impacting the margin have been the lags between the trade and settlement
dates for securities purchased. Oftentimes, the delivery date for the securities
purchased follows the trade date by a period of one to three months. During that
time, it is possible for the rates on funding sources to rise, resulting in
compression in the margin between the rates on the security and funding source.
To manage this risk and lock in our margin on the transaction, we take down the
corresponding funding sources prior to deliveries of the related securities. As
a result, during the second quarter of 2004, there were times when we were
carrying FHLB advances structured to match various hybrid ARM securities that
had been purchased but would not be delivered until nearly the end of the
quarter. Thus, we were paying the related funding expense before we began
receiving income for the securities.
Between the lower initial interest rate on the securities, the borrowing costs
associated with matching the funding sources, and the lag between the takedown
of funding sources and the delivery of securities, our securities purchases had
a negative impact on our second quarter net interest margin. Had we not elected
to extend the terms for some funding sources or match fund our securities
purchases, we believe we would have seen a greater "rate" related reduction in
our interest expense than indicated in the above "Rate/Volume" table, as
shorter-term borrowings would have carried a lower rate of interest. It then
follows that we would have expected to see an even more significant improvement
in net interest income and, consequently, higher net interest margins than the
4.03% and 3.97% shown for the first two quarters of 2004.
NON-INTEREST INCOME
Non-interest income increased $45,000, or 5%, for the second quarter of 2004 as
compared to the like quarter in 2003. In contrast, the year-to-date results show
a decline of $43,000, or 2%. The
20
increase for the quarter was mainly attributable to the rise in gain on sales of
loans which was somewhat offset by the decline in gain on sales of investments.
The year-to-date results were affected by the same two factors but with a much
larger impact on the decline in sales of investments.
GAIN ON SALES OF LOANS
----------------------
GAIN ON LOAN SALES 2ND QUARTER 2004 2ND QUARTER 2003 YTD JUNE 2004 YTD JUNE 2003
- ---------------------------------------- ---------------- ---------------- ------------- -------------
Consumer (Sales Finance) Loan Sale Gains $258,000 $26,000 $532,000 $79,000
Commercial Loan Sale Gains 28,000 25,000 71,000 45,000
Residential Loan Sale Gains 36,000 133,000 64,000 255,000
-------- -------- -------- --------
TOTAL GAINS $322,000 $184,000 $667,000 $379,000
======== ======== ======== ========
LOANS SOLD
- ----------------------------------------
Consumer Loans Sold $7,592,000 $954,000 $15,264,000 $3,034,000
Commercial Loans Sold 6,718,000 5,346,000 17,546,000 10,326,000
Residential Loans Sold 8,336,000 13,889,000 16,656,000 33,278,000
----------- ----------- ----------- -----------
TOTAL LOANS SOLD $22,646,000 $20,189,000 $49,466,000 $46,638,000
=========== =========== =========== ===========
Our gains on loan sales totaled $322,000 for the second quarter, an increase of
$138,000, or 75% over the second quarter 2003 level. On a year-to-date basis, a
similar trend was observed, with gains of $667,000 through the first six months
of 2004 exceeding the prior year level by $288,000, or 76%. These increases in
gains on sales of loans for 2004 were driven by a change in the mix of loans
sold, rather than increased total sales volumes, as the total loans sold
increased only 12% for the second quarter and 6% on a year-to-date basis.
Consumer loan sales, particularly sales finance loans, contributed the most
significant impact on our loan sale gains this year. In 2003, the vast majority
of these loans were retained with the objective of growing the portfolio. As
loan production increased and the portfolio gained in size, the decision was
made to manage the portfolio's size through quarterly sales of sales finance
loans. For the quarter and six months ended June 30, 2004, we realized gains of
$258,000 and $532,000 on loan sales totaling $7.6 million and $15.3 million.
These exceeded several times over the $26,000 and $79,000 in gains realized on
sales of $1.0 million and $3.0 million for the same periods last year. Our
current plan is to continue selling approximately $8 million to $11 million in
sales finance loans each quarter.
Commercial loans sales, and gains thereon, also increased relative to the prior
year, though not nearly to the same extent as consumer loans. For the quarter
and six months ended June 30, 2004, we realized gains of $28,000 and $71,000,
representing increases of 12% and 58% over prior year levels. Additionally, 2004
loan sales totaling $6.7 million and $17.5 million for the quarter and six
months ended June 30 represented increases of 26% and 70% over 2003. Typically,
the purpose of commercial loan sales is to accommodate additional loan requests
from existing borrowers. To limit our credit exposure to the borrowers, we may
sell their loan in whole or in part as participations. As with consumer loans,
we will typically continue to service those loans sold from the portfolio and
remain the point of contact for the borrower following the sale.
In contrast, residential loan sale gains were down significantly from the prior
year, declining 73% for the quarter, to $36,000, and 75% for the six months
ended June 30. The declines in gains occurred as residential loan sales fell to
$8.3 million for the second quarter, compared to
21
$13.9 million in the same period last year. This followed an even more
significant decline in sales volume for the first quarter versus the prior year,
and resulted in year-to-date loan sales for 2004 of approximately half the prior
year volume. We believe that the sales volumes observed in the first half of
2003 were a product of the high level of refinancing activity that occurred
during that time and that the substantial reduction in sales volumes in 2004
represents movement to a more normalized residential lending environment.
- --------------------------------------------------------------------------------
2nd Quarter 2nd Quarter YTD YTD
2004 2003 June 2004 June 2003
- --------------------------------------------------------------------------------
Servicing Fee Income $ 81,000 $ 15,000 $ 114,000 $ 29,000
- --------------------------------------------------------------------------------
With the additional consumer loan sales this year, our income from servicing
loans for others has increased dramatically, with income rising 440% from the
second quarter of 2003, and 293% on a year-to-date basis. Servicing fees earned
on the sales finance loans sold totaled $88,000 for the first half of 2004, of
which $65,000 was earned in the second quarter. These fees are expected to
continue to grow as additional loans are sold each quarter to manage the sales
finance loan portfolio.
Commercial loans serviced for others account for virtually all of the remaining
servicing fee income. As noted above, we sell commercial loans, or parts
thereof, typically to limit our credit exposure to the borrower, but we continue
to service those loans and remain the point of contact for the borrower
following the sale. By comparison, residential loans are typically sold
servicing released, which means we no longer service those loans once they are
sold. Consequently, servicing fees from residential loans sold would not be
considered a significant source of fee income. As we have no plans at this time
to include servicing these loans following their sales, we do not expect
servicing income from residential loans sold to become a significant part of
total servicing income.
GAIN ON SALES OF INVESTMENTS
----------------------------
- --------------------------------------------------------------------------------
2nd Quarter 2nd Quarter YTD YTD
2004 2003 June 2004 June 2003
- --------------------------------------------------------------------------------
Gain on Sales of Investments $ 0 $ 86,000 $ 71,000 $ 473,000
- --------------------------------------------------------------------------------
Security Sales $ 0 $5,000,000 $2,000,000 $19,000,000
- --------------------------------------------------------------------------------
Gains on sales of investments are opportunistic in nature, and we will not
generally make any attempt to forecast future securities sales or gains thereon.
Furthermore, with interest rates apparently trending upward, the opportunity to
realize any future gains on securities sales is unlikely. For the second quarter
of 2004, we did not sell any securities from our portfolio. For the six months
ended June 30, 2004, gains on investment sales totaled $71,000 based on a $2
million sale in the first quarter. By comparison, in the lower interest rate
environment of 2003, second quarter gains totaled $86,000 on sales of $5
million, while first half gains for 2003 totaled $473,000 on sales of $19
million. We do not currently have any sales pending, nor do we anticipate at
this time any sales in the third quarter.
22
OTHER FEE INCOME
----------------
2ND QUARTER 2004 2ND QUARTER 2003 YTD JUNE 2004 YTD JUNE 2003
---------------- ---------------- ------------- -------------
Rental Income $167,000 $260,000 $335,000 $364,000
Loan Fees 84,000 106,000 105,000 128,000
ATM/Wire Transfers/Safe
Deposit Fees 49,000 35,000 87,000 62,000
Late Charges 38,000 29,000 74,000 60,000
Miscellaneous 40,000 40,000 82,000 122,000
-------- -------- -------- --------
TOTAL $378,000 $470,000 $683,000 $736,000
======== ======== ======== ========
Other operating income declined $92,000 and $53,000 for the quarter and six
months ended June 30, 2004 relative to the prior year, as rental income and loan
fees each declined from prior year levels.
For the second quarter, the decline was largely attributable to a $93,000
reduction in rental income. In the third quarter of 2003, we lost several large
tenants at First Mutual Center, our corporate headquarters. As of the second
quarter of this year, we had not replaced those tenants, and thus decided to use
the opportunity to reconfigure our use of the space in the building. We have now
developed a plan to consolidate bank-occupied space onto single floors wherever
possible. Those plans will be implemented in late 2004 and early 2005. Although
we currently do not have any serious negotiations underway with potential
tenants, these planning efforts now allow our leasing agent to actively market
the space that we know will be available after our consolidation. We presently
occupy 42% of the building, lease 31%, and offer for lease the remaining 27%. On
a year-to-date basis, rental income was down $29,000 relative to last year. We
acquired the First Mutual Center building in March of 2003, and consequently
little rental income was received in the first quarter of last year.
Loan fees declined $22,000 on a quarter-to-quarter basis and $23,000 on a
year-to-date comparison basis, based on a reduction in loan brokerage fees to $0
this year, versus $43,000 in the second quarter and $60,000 in the first half of
2003. The decline in broker fees is a combination of a sharp reduction in
refinance loan activity from last year and a preference by our loan officers for
bank products over those offered by other financial institutions. We don't
anticipate a change in that trend in the last half of 2004.
OPERATING EXPENSES
------------------
SALARIES AND EMPLOYEE BENEFITS
------------------------------
Expenses rose by $378,000, or 13%, on a quarter-versus-quarter basis, from $3.0
million in the second quarter of 2003 to almost $3.4 million in 2004, accounting
for approximately 34% of the total increase in operating expenses. On a
year-to-date basis, the increase was $668,000, or 11%, over the six-month period
ended June 30, 2003.
SALARIES AND EMPLOYEE BENEFITS
- ------------------------------
QUARTER ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
2004 2003 2004 2003
------------ ------------ ------------ ------------
Salaries $ 2,239,000 $ 1,982,000 $ 4,438,000 $ 3,895,000
Commissions and Incentive Bonuses 441,000 428,000 774,000 823,000
Employment Taxes & Insurance 221,000 191,000 481,000 407,000
Temporary Office Help 48,000 70,000 83,000 172,000
Benefits 443,000 343,000 879,000 690,000
------------ ------------ ------------ ------------
Total Salary & Benefit Expenses $ 3,392,000 $ 3,014,000 $ 6,655,000 $ 5,987,000
============ ============ ============ ============
23
Most of the increase in salary and benefit expense was the result of a net
increase of 8% in the number of employees. These additions to our employee count
accounted for approximately $220,000 of compensation and benefit expenses for
the current quarter versus second quarter of 2003. Our staffing level, as
measured by full-time-equivalent (FTE) employee count, increased from 186 FTE on
June 30, 2003, to 201 FTE on the same date in 2004.
QUARTER ENDED FTE AT QUARTER END
------------- ------------------
June 30, 2003 186
September 30, 2003 188
December 31, 2003 201
March 31, 2004 204
June 30, 2004 201
The departments that most significantly increased employee count were Sales
Finance and Residential Lending. Additionally, the new Sammamish banking center,
which opened in the fourth quarter of 2003, accounted for four of the new
employees.
Contributing to the growth in compensation expense was an increase of $99,000
from the second quarter of 2003, and an increase of $189,000 year-to-date from
the prior year for employee benefits. Those costs include health care insurance,
employee stock ownership plan (ESOP) expense and 401(k) plan matching costs. Due
to the combination of more employees and higher premiums per employee, we have
experienced a 29% increase on a quarterly comparison and 33% increase on a
six-month comparison in health care costs as compared to 2003. Also, our
contribution to the ESOP has doubled since last year. Year-to-date the
contribution totaled $50,000 as compared to $12,500 last year. Partially
offsetting the increase in employee staffing expense was a $23,000 reduction in
temporary staffing in the second quarter and an $89,000 reduction on a
year-to-date basis. This decrease is due to higher than usual temporary staffing
requirements during the first half of 2003, which included special projects such
as the reorganization of our loan production support departments and the
temporary hiring of personnel with the intent of permanent employment at a later
date.
An issue that complicates the reporting of our compensation expense is the
deferral of loan origination costs. In accordance with current accounting
literature, certain loan origination costs are deferred and amortized over the
life of the loan. Each year costs associated with loan origination activities
are analyzed to determine a standard loan cost. Standard loan costs, which are
determined for each loan type, are then deducted from operating expense, with
the net figures reported in the financial statements. Compensation expense can
vary based upon loan origination volumes, the mix of different loan types and
changes in the valuation of standard loan costs from year to year.
24
EFFECT OF DEFERRED LOAN ORIGINATION COSTS
- ----------------------------------------- QUARTER ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
2004 2003 2004 2003
------------ ------------ ------------ ------------
Salaries and Employee Benefits $ 4,030,000 $ 3,556,000 $ 7,828,000 $ 7,050,000
Deferred Loan Origination Costs (638,000) (542,000) (1,173,000) (1,063,000)
------------ ------------ ------------ ------------
Net Salaries and Employee Benefits $ 3,392,000 $ 3,014,000 $ 6,655,000 $ 5,987,000
============ ============ ============ ============
Loan Originations $123,409,000 $110,434,000 $225,614,000 $213,390,000
============ ============ ============ ============
OCCUPANCY EXPENSE
-----------------
Occupancy expense increased $77,000, or 14%, from $572,000 in the second quarter
of 2003 to $649,000 in 2004. For the six months ended June 30, 2004, occupancy
expenses increased $185,000, or 16%, from the same period in 2003.
OCCUPANCY EXPENSES
- ------------------ QUARTER ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
2004 2003 2004 2003
------------ ------------ ------------ ------------
Rent Expense $ 78,000 $ 51,000 $ 161,000 $ 197,000
Utilities and Maintenance 139,000 144,000 313,000 236,000
Depreciation Expense 319,000 245,000 633,000 494,000
Other Occupancy Costs 113,000 132,000 238,000 233,000
------------ ------------ ------------ ------------
Total Occupancy Expenses $ 649,000 $ 572,000 $ 1,345,000 $ 1,160,000
============ ============ ============ ============
Occupancy costs in 2004 were affected by the growth in capital expenditures over
the past year, which resulted in $74,000 of higher depreciation expense and
leasehold improvement amortization for the second quarter and $139,000 for the
six months ended June 30, 2004. Also, the new Sammamish banking center, which
opened in the fourth quarter of 2003, accounted for $26,000 of additional rent
expense in the second quarter of 2004 compared to the prior year. Additional
maintenance, repair and utilities expense of $77,000 was incurred in the first
six months of 2004 over the same period in 2003 due to the purchase of First
Mutual Center, which occurred in March of 2003 and due to the vacancy within the
building which prevents us from passing on these costs to the tenants.
Other Operating Expense
-----------------------
Other operating expense increased by $657,000, or 49%, from $1.3 million in the
second quarter of 2003 to $2.0 million for the same period in 2004. This
accounted for approximately 59% of the total increase in non-interest expenses.
For the six months ended June 30, 2004, other operating expenses grew
$1,126,000, or 44%, over the same six-month period in 2003.
25
OTHER OPERATING EXPENSES
- ------------------------
QUARTER ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
2004 2003 2004 2003
----------- ----------- ----------- -----------
Marketing & Public Relations $ 302,000 $ 306,000 $ 588,000 $ 480,000
Credit & Servicing 391,000 48,000 635,000 105,000
Outside Services 168,000 116,000 317,000 204,000
Taxes 108,000 104,000 235,000 207,000
Informations Systems 284,000 156,000 499,000 290,000
Telephone 52,000 (9,000) 100,000 45,000
Legal 140,000 92,000 258,000 211,000
Supplies/Postage/Dues 177,000 205,000 337,000 360,000
Other 377,000 324,000 711,000 652,000
----------- ----------- ----------- -----------
Total Other Operating Expenses $ 1,999,000 $ 1,342,000 $ 3,680,000 $ 2,554,000
=========== =========== =========== ===========
The most significant growth in other operating expenses, at $306,000 for the
second quarter, came from credit insurance premiums for our sales finance loan
portfolio, included in Credit & Servicing expenses. This same expense increased
by $444,000 in the six months ended June 30, 2004 compared to the same period in
2003. In the fourth quarter of 2002, we began to insure against default risk on
loans to borrowers with credit scores below 720. Our insurance contract
contained a variable premium that ranged between a low of 0.60% and a ceiling of
2.70%. The most likely premium was estimated to be 2.16%, with the final premium
to be determined at a later date based on our actual loan loss history. In the
second quarter of this year, the insurer reviewed our loss record dating back to
the inception of the program and indicated that unless our claims experience
improved they would assess us, under the terms of the contract, the full premium
of 2.70%. Although we have not been officially assessed the extra premium, we
revised the estimate of our premium expense for the quarter to include an
additional retroactive assessment of $162,000. Going forward, we are assuming
that our insurance premiums will be assessed at the maximum rate of 2.70%, which
in July was $87,000, on an insured balance of $38.5 million. There is the
possibility that in future periods our experience will be more favorable and we
will receive a rebate on premiums paid. However, based on our loss experience in
the last couple of quarters, we are not optimistic about any future rebates.
Please refer to the "Sales Finance (Home Improvement) Loans" section for a
further discussion of this topic.
Also contributing to the increase in expenses for second quarter and
year-to-date 2004 were costs related to external service provider fees,
information systems, telephone and legal services. Outside services expenses
increased by $52,000 on a quarter-versus-quarter basis and $113,000 on a
year-to-date basis, due primarily to security-related and sales finance
consulting projects. The increase in information systems expenses for the second
quarter was largely attributable to an upgrade to the company-wide operations
software and greater bandwidth internet access, which combined for $70,000 of
additional expense over the second quarter of 2003. Also, the deferral of loan
origination costs related to loan origination outside services helped to create
negative variances for the current quarter and six months ended June 30, 2004. A
higher rate of deferral for the second quarter and six months ended June 30,
2003 increased the variance by $31,000 and $77,000, respectively. Telephone
expense for the second quarter 2004 rose significantly compared to the same
period in 2003, increasing $61,000 from the prior-year level. The entire
variance, however, resulted from a refund obtained from the telephone company in
the second quarter of 2003 for an over billing in the prior year. Legal expense
increased from the second quarter 2003 level, based upon the greater utilization
of legal services by our business banking, income property, and home equity
lending divisions as well as for real estate owned (REO) activities.
26
FINANCIAL CONDITION
Assets. Assets increased 12%, from $860.8 million at year-end 2003 to $963.7
million as of June 30, 2004. The change in assets is principally the result of
an increase in the investment securities and loan portfolios.
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
June 30, 2004, the balance of the unrealized loss, net of federal income taxes,
was $1.2 million, which compares to an unrealized gain at year-end 2003 of
$95,000. Generally, falling interest rates will increase the amount recorded as
unrealized gain, and rising rates will decrease any unrealized gains, as the
market value of securities inversely adjusts to the change in interest rates.
PERCENTAGE OF
(All dollars in 000's) TOTAL SECURITIES TOTAL ASSETS TOTAL ASSETS
---------------- ------------ ------------
December 31, 1999 $105,431 $581,116 18%
December 31, 2000 123,690 643,231 19%
December 31, 2001 72,347 678,349 11%
December 31, 2002 74,738 745,295 10%
December 31, 2003 86,527 860,844 10%
June 30, 2004 121,132 963,704 13%
Security investments (available-for-sale and held-to-maturity) increased $34.6
million, or 40%, from December 31, 2003, to the end of the second quarter 2004
as a result of security purchases that were executed during the quarter. As can
be seen in the above table, prior to 2001 our securities portfolio represented a
much larger component of our total asset mix than in the last three years. As
rates declined in 2001, 2002 and 2003, prepayments on securities held in our
portfolio accelerated, typically due to the underlying mortgages being
refinanced at lower rates. Additionally, the falling interest rates resulted in
many securities trading at premiums to their par values. Consequently, some
securities were sold from the portfolio during this timeframe to recognize the
gains on those investments before the securities paid off at their par values.
The volume of new securities acquired during these periods was typically well
below the value of securities paid off and/or sold, as we were reluctant to add
significant volumes of securities to the balance sheet with interest rates
approaching historical lows. With rates finally starting to move upward in 2004,
the decision was made to build up the portfolio with short-term hybrid ARM
securities. With the additional securities purchased in the second quarter, we
believe the size of our portfolio to be adequate at this time, and consequently
we do not anticipate additional securities purchases in the foreseeable future.
Loans. Loans receivable, excluding loans held-for-sale, rose from $723.7 million
at year-end 2003 to $784.6 million, an increase of $60.9 million in six months.
About 65% of that growth was from residential loans, an area that has proven to
be consistent from quarter-to-quarter. Approximately 26% was from commercial
real estate and business banking loans, which are variable from one period to
the next.
27
Our loan production and portfolio growth in the first two quarters of 2004 have
exceeded our expectations. For the second quarter of 2004, loan originations
increased 12%, to $123 million, compared to $110 million in the second quarter
of 2003. On a year-to-date basis through June 30, loan production exceeded the
prior year by 6%. We believe the higher than expected volumes observed earlier
this year may have been attributable, in part, to expectations of future
interest rates.
We anticipate that our loan production volume and portfolio growth rate will
decline in the third quarter. In June and July loan fundings in our Income
Property division, which had earlier exceeded our expectations, slowed
considerably while payoffs within the portfolio remained high. Due to the
combination of these factors we experienced a contraction in the Income Property
portfolio of approximately $6 million for the month of June, with a similar
contraction observed in July. At the same time, our Residential portfolio, which
accounted for most of the growth in the first half of the year, remained
essentially flat in July, as did our Business Banking portfolio. Finally, as
previously noted, we currently utilize loan sales of $8 - $11 million on a
quarterly basis as a mechanism to control the size of our sales finance loan
portfolio. Because of these sales we would not expect the sales finance
portfolio to grow significantly during the third quarter. Based on these
developments, we have revised our estimate for the third quarter 2004 loan
portfolio growth down from the previously expected $15 - $20 million to a
reduced level of $5 - $15 million.
Servicing Assets. Servicing assets have grown $409,000, or 87%, since year-end
2003. Although this increase was not a major factor in the quarter's asset
growth, this area is expected to continue to increase rapidly with the planned
sales of sales finance loans.
2nd Qtr. 2004 1st Qtr. 2004 4th Qtr. 2003 3rd Qtr. 2003
------------- ------------- ------------- -------------
Servicing Assets:
Income Property $ 115,000 $ 114,000 $ 94,000 $ 86,000
Residential 21,000 27,000 36,000 --
Sales Finance 742,000 572,000 338,000 116,000
---------- ---------- ---------- ----------
Total $ 878,000 $ 713,000 $ 468,000 $ 202,000
========== ========== ========== ==========
Serviced For Others
Loan Balances $ 97,177,000 $ 90,745,000 $ 76,424,000 $ 60,432,000
============ ============ ============ ============
As illustrated in the above table, the majority of the growth in the servicing
asset balance is coming from the Sales Finance area due to the quarterly sales
of loans sold servicing retained. In the third quarter of 2003 we began selling
sales finance loans servicing retained, and as a result we have been adding to
the servicing asset. The servicing asset is a combination of the assets
generated from the sale of loans sold servicing retained netted with the
amortization expense that is calculated quarterly.
Liabilities. Deposits rose $52.9 million, or 9.1%, in the first six months of
2004, totaling $637 million as compared to $584 million at year-end 2003.
Brokered deposits accounted for approximately half of that increase. During the
first six months of the year brokered deposits increased $28.4 million, of which
$27.4 million were purchased during the second quarter to fund the $43.4 million
in security purchases. (Please refer to the "Deposits Information" section under
"Results of Operations" for more information.) The remaining increase in
deposits combined with the growth in FHLB borrowings, were used to fund the
growth in the loan portfolio.
28
The FHLB advances increased from $194 million at year-end 2003 to $244 million
as of the end of the second quarter this year. As of June 30, 2004, we had the
authority to borrow up to a total of $385 million in FHLB advances, subject to
sufficient collateral to support those advances.
ASSET QUALITY
Provision and Reserve for Loan Losses. The provision for loan losses increased
from $325,000 in the second quarter of 2003 to $440,000 in the like period in
2004 increasing our reserve level from $8.1 million to $8.9 million this year.
The provision is also up sequentially from $250,000 in the first quarter of
2004. The provision for loan losses reflects the amount deemed appropriate to
produce an adequate reserve for possible loan losses inherent in the risk
characteristics of the loan portfolio. In determining the appropriate reserve
balance, we consider the amount and type of new loans added to the portfolio,
our level of non-performing loans, the amount of loans charged off, and the
economic conditions that we currently operate within.
The increase is due, in part, to the sharp rise in the loan portfolio since the
beginning of the year. The loan portfolio (excluding loans held for sale) has
grown $70 million, or 9.6% (19.3% annualized). Also affecting the level of
reserve for loan losses is the increase in net loan charge-offs, which have
risen from $73,000 in the second quarter of last year to $161,000 this year. The
year-to-date comparison is $231,000 this year and $132,000 in 2003. The
charge-offs are largely related to our home improvement (sales finance) loan
portfolio. In the second quarter of this year, net charge-offs for sales finance
loans constituted 84% of the total, and that figure compares to 97% of the total
last year. Year-to-date, sales finance loans accounted for 80% of the total net
charge-offs this year and 99% last year.
Although sales finance loans only constitute 8% of the total portfolio, because
of the characteristics of these loans they comprise the bulk of our loan
write-offs. Please see the section, "Sales Finance (Home Improvement) Loans" for
a further discussion of this business line.
Our non-performing assets have increased from $538,000 at year-end 2003 to $1.2
million at the end of the second quarter 2004. The current level of
non-performing assets is an improvement over the first quarter figure of $1.6
million. The ratio of non-performing assets to total assets was 0.12% at June
30, 2004, which compares to 0.06% at year-end 2003 and 0.17% at March 31, 2004.
Those ratios compare to 0.75% for FDIC insured institutions at December 31,
2003* and 0.67% at March 31, 2004.**
* FDIC Quarterly Banking Profile, Fourth Quarter 2003; ** FDIC Quarterly Banking
Profile, First Quarter 2004
Noted below is a summary of our exposure to non-performing loans and repossessed
assets:
29
NON-PERFORMING ASSETS
---------------------
One single-family residence, Western WA. No
anticipated loss. $ 60,000
One single-family residence, Western WA. A partial
charge-off is reasonably possible in the third
quarter. 300,000
One single-family residence in OR. No anticipated loss. 422,000
One land loan in Western WA. No anticipated loss. 98,000
Two consumer loans. A partial charge-off of
$16,000 is reasonably possible in the third quarter. 30,000
One small business loan. Full recovery received in July. 43,000
Thirteen consumer loans. Full recovery anticipated
from insurance claims. 82,000
Fifteen consumer loans. No anticipated loss. 116,000
----------
TOTAL NON-PERFORMING LOANS $1,151,000
TOTAL REPOSSESSED ASSETS $ 3,000
----------
TOTAL NON-PERFORMING ASSETS $1,154,000
==========
PORTFOLIO INFORMATION
- ---------------------
Commercial Real Estate Loans. The average loan size (excluding construction
loans) in the Commercial Real Estate portfolio was $733,800 as of June 30, 2004,
with an average loan-to-value ratio of 65%. At quarter-end, none of these
commercial loans were delinquent for 30 days or more. Small individual investors
or their limited liability companies and business owners typically own the
properties securing these loans. The portfolio is split between residential use
(multi-family or mobile home parks) and commercial use. At quarter-end, the
breakdown was 48% residential and 52% commercial.
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 15%
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 $10 million of the commercial real estate
portfolio, or 3%, has been purchased in this manner.
Sales Finance (Home Improvement) Loans.* The sales finance portfolio grew at a
steady pace throughout 2003. Even though loan production rose substantially in
2004, the portfolio growth has slowed. We are selling a greater percentage of
the portfolio, and loan prepayment speeds on our existing portfolio continue at
a rate of approximately 40%.
Insured Balance (Bank
Bank Portfolio Servicing Portfolio and Servicing
Balance Balance Balance)
- -------------------- -------------- ----------- -----------------------
June 30, 2003 $ 48 million $ 0 million $ 12 million
September 30, 2003 56 million 3 million 20 million
December 31, 2003 62 million 10 million 27 million
March 31, 2004 63 million 16 million 32 million
June 30, 2004 67 million 22 million 39 million
30
During the second quarter 2004, the average new loan amount was $10,700. We
insured 39% of the Bank portfolio balance for credit risk, and 46% of total new
loans in the second quarter.
Noted below is the charge-off table for the uninsured Bank only portfolio and
the claims experience table for the entire insured portfolio:
UNINSURED BANK ONLY PORTFOLIO
-----------------------------
Charge-offs as Percent (%)
Net a Percent (%) Delinquent
Loan Balance Charge-Offs of Portfolio Loans
------------------ ------------ ----------- -------------- -----------
June 30, 2003 $34 million $69,000 0.20% N/A
September 30, 2003 38 million 73,000 0.19% 0.89%
December 31, 2003 40 million 100,000 0.25% 0.76%
March 31, 2004 40 million 50,000 0.13% 0.81%
June 30, 2004 41 million 136,000 0.33% 0.51%
TOTAL INSURED PORTFOLIO
-----------------------
Claims as a Percent (%) of Insured
Claims Paid Average Balances
------------------ ----------- ----------------------------------
June 30, 2003 $13,000 0.15%
September 30, 2003 33,000 0.21%
December 31, 2003 89,000 0.38%
March 31, 2004 351,000 1.18%
June 30, 2004 315,000 0.89%
Our portfolio at June 30, 2004, totaled $67 million, of which $26 million is
insured. The $41 million of uninsured loans with an average credit score of 727
has performed at a fairly consistent level, in terms of loan losses as a percent
of the portfolio, over the last four quarters; ranging from 0.20% in the second
quarter of last year to 0.33% this year. The significant change has occurred in
the lower credit score portfolio, the insured portfolio, which has an average
credit score of 666. Losses incurred in that portfolio are submitted to our
credit insurer for reimbursement. The claims experience in the last 12 months
has jumped from 0.15% (claims as a percent of insured average balances) in the
second quarter of last year to a high of 1.18% in the first quarter of 2004, and
then dropping to 0.89% in the second quarter. The actual claims submitted have
risen accordingly from $13,000 a year ago to $315,000 in the second quarter this
year. The insurer has indicated that this increase in claims will likely result
in our premium assessments being raised to the maximum permitted in the contract
of 2.70%. We have to date paid 2.16% annually, and have accrued the probable
retroactive assessment.
31
The contract with the credit insurer also has a maximum exposure limit to the
insurer of 10% of the loan balances. Each year's loan production that is insured
is treated as a separate portfolio in terms of the 10% limit. The first pool
that was insured included loans closed between October 2002 and September 2003
and totaled $21.8 million with a maximum loss that could be claimed of $2.2
million. That pool currently has a balance of $15.3 million, and we have a
remaining lifetime loss credit of $1.4 million. Because of the prepayment of
loans in that pool our loss credit is still 9.2% of the remaining balance even
though we have submitted claims totaling $777,000. The comparable figures for
the 2003 pool (loans insured between October 2003 and June 2004) is $26 million
in insured balances for a credit limit of $2.6 million. Our remaining insured
balance is $23.2 million, and our credit limit is $2.5 million. We have to date
submitted $82,000 in claims against the pool.
The steps that we are taking to reduce our claims experience include a change in
collection procedures and a recent increase in our asset management staff. We
are also reviewing our underwriting procedures, and examining the demographic
characteristics of the loans that have defaulted.
*Note - - the balances and ratios noted in this section are for home improvement
loans only. Loans collateralized by titled assets, such as motorcycles, are
excluded from the totals. However, those loans which amounted to $666,000 at
June 30, 2004, are included in the Consumer Lending segment.
DEPOSIT INFORMATION
- -------------------
The number of business checking accounts increased 38%, from 1,264 at June 30,
2003, to 1,750 as of June 30, 2004, a gain of 486 accounts. The deposit balances
for those accounts grew 62%. Consumer checking accounts also increased, from
5,045 in the second quarter of 2003 to 6,244 this year, an increase of 1,199
accounts, or 24%. Our total balances for consumer checking accounts rose 61%.
MONEY
TIME DEPOSITS CHECKING MARKET ACCOUNTS REGULAR SAVINGS
- ------------------ ------------- -------- --------------- ---------------
June 30, 2003 69% 9% 20% 2%
September 30, 2003 68% 10% 21% 1%
December 31, 2003 66% 10% 22% 2%
March 31, 2004 64% 11% 23% 2%
June 30, 2004 65% 12% 22% 1%
During the second quarter we acquired $27.4 million in broker deposits, bringing
our total broker deposits to $47.5 million. The purpose of the new deposits is
to indirectly fund the $31.4 million of 3/1 GNMA MBS securities that we
purchased in the same quarter. The broker deposits represented the second step
of a two-step process that began with our approximate duration matching of the
new securities with FHLB borrowings. We then acquired the broker deposits to
restore our total FHLB borrowings to their prior level.
BUSINESS SEGMENTS
- -----------------
Beginning January 1, 2004, we changed the presentation of our Business Segments
to more accurately reflect the way these segments are managed within the Bank.
Prior to 2004 we had three segments: 1) Consumer Lending, 2) Commercial Lending,
and 3) Investment Securities. We have made some changes to the original three
segments by:
32
o Separating Residential Lending from the Consumer segment
o Splitting the Commercial segment into two separate segments: Business
Banking Lending and Income Property Lending
o Allocating the income and expenses from the Investment Securities segment
to the new segments based upon asset size.
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 reportable segments include the following:
o CONSUMER LENDING - Consumer lending includes home equity lending, direct
consumer loans, and indirect home improvement loans (Sales Finance). These
loans include lines of credit and loans for primarily consumer purposes.
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.
o RESIDENTIAL LENDING - Residential lending offers loans to borrowers to
purchase, refinance, or build homes secured by one-to-four-unit family
dwellings. 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.
o BUSINESS BANKING LENDING - Business Banking offers a full range of banking
services to small and medium size businesses including deposit and cash
management products, loans for financing receivables, inventory, equipment
as well as permanent and interim construction loans for commercial real
estate. The underlying real estate collateral or business asset being
financed typically secures these loans.
o INCOME PROPERTY LENDING - Income Property Lending offers permanent and
interim construction loans for multifamily housing (over four units) and
commercial real estate properties. The underlying real estate collateral
being financed typically secures these loans.
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. The 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
----------------
Quarter Ended Six Months Ended
Net Income Return on Equity Net Income Return on Equity
---------- ---------------- ---------- ----------------
June 30, 2002 ($55,000) (4.25%) ($85,000) (3.40%)
June 30, 2003 (46,000) (3.15%) (120,000) (4.49%)
June 30, 2004 201,000 10.29% 569,000 14.40%
33
Net income for the Consumer Lending segment totaled $201,000 and $569,000 for
the quarter and six months ended June 30, 2004, marking significant improvement
from net losses of $46,000 and $120,000 for the same periods last year and
$55,000 and $85,000 in 2002. The profitability achieved in 2004 was primarily a
result of earning asset growth and the related incremental net interest income,
combined with additional gains on loan sales compared to the prior year. The
increase in revenue was partially offset by rising operating expenses.
Net interest income for the Consumer segment, net of the provision for loan
losses, totaled $1,356,000 and $2,739,000 for the three and six months ended
June 30, 2004, representing improvement of 64% and 82% over the same periods in
2003. While 29% and 33% increases in quarterly and year-to-date average earning
assets accounted for the majority of this improvement, the fact that much of the
growth was centered in sales finance loans also contributed to the overall
result, as those loans typically command higher interest rates than other loan
categories.
The Consumer segment's average earning assets totaled $106 million and $102
million for the three and six months ended June 2004, up from $83 million and
$77 million in 2003. Earning asset growth over the last year was largely
attributable to our sales finance (home improvement) loan portfolio and our
decision to retain within the portfolio a greater portion of the loans
originated outside the Northwest. With these additional assets and higher
yields, interest income earned on the portfolio totaled $2,060,000 in second
quarter 2004, up nearly 37% from the same period in 2003, which was in turn 41%
over the second quarter 2002 level. On a year-to-date basis, interest income
totaled $4,086,000, an increase of 48% over the prior year level.
In contrast, interest expense for the quarter declined $49,000, or 8%, compared
to the second quarter of 2003, to $547,000, as the impact of reductions in
funding rates more than offset the cost of the additional funds that was
required to support the growth in earning assets. On a year-to-date basis, a
similar variance was observed, with interest expense declining 3% from the prior
year level. Funding costs bank-wide declined over the last three years as rates
on our time deposits gradually repriced at lower levels after the Federal
Reserve cut rates 11 times in 2001, and once in each of 2002 and 2003. Based on
the "lagging" nature of time deposit pricing, the 11 cuts in 2001 were the
primary driver of the substantial reduction in funding costs in 2002. Later rate
reductions then contributed to the continued funding cost reductions in 2003 and
the first half of 2004. Funding costs were further reduced as a result of growth
in lower-cost checking and money market product balances, as well as the
strategic use of FHLB advances during times when pricing on these advances
presented a competitive advantage compared to running promotional rate
time-deposit campaigns.
The Consumer Lending segment's quarterly non-interest income rose 347%, from
$84,000 in the second quarter of 2003 to $377,000 this year. On a year-to-date
basis, a similar increase was observed, with non-interest income rising 261% to
$747,000. The improvement was primarily a result of increased gains on sales of
consumer loans, specifically home improvement loans. In 2003, sales of consumer
loans declined relative to 2002 as a result of a change in strategy from selling
loans originated outside the Northwest to retaining these loans in our portfolio
with the objective of growing the portfolio. As loan production increased and
the portfolio gained in size, the decision was made to manage the portfolio's
size through quarterly sales of sales finance loans. For the quarter and six
months ended June 30, 2004, we realized gains of $258,000 and $532,000 on loan
sales totaling $7.6 million and $15.3 million. These exceeded several times over
the $26,000 and $79,000 in gains realized on sales of $1.0 million and $3.0
million for the same periods last year. Our current plan is to continue selling
approximately $8 million to $11 million in sales finance loans each quarter.
34
Additionally, with the higher level of consumer loan sales this year, our income
from servicing loans for others has increased dramatically, with income rising
440% from the second quarter of 2003, and 293% on a year-to-date basis.
Servicing fees earned on the sales finance loans sold totaled $88,000 for the
first half of 2004, of which $65,000 was earned in the second quarter. These
fees are expected to continue to grow as additional loans are sold each quarter.
The Consumer Lending segment's non-interest expense increased $446,000 and
$733,000, or 45% and 39%, for the three and six months ended June 30, 2004
compared to the prior year. The growth in costs this year was due largely to
credit insurance premiums on the insured part of the sales finance portfolio.
Rising compensation, administrative, and other allocated costs also contributed
to the increase.
The most significant growth in operating expenses, at $305,000 for the second
quarter, came from credit insurance premiums for our sales finance loan
portfolio. In the fourth quarter of 2002, we began to insure against default
risk on loans to borrowers with credit scores below 720. Our insurance contract
contained a variable premium that ranged between a low of 0.60% and a ceiling of
2.70%. The most likely premium was estimated to be 2.16%, with the final premium
to be determined at a later date based on our actual loan loss history. In the
second quarter of this year, the insurer reviewed our loss record dating back to
the inception of the program and indicated that unless our claims experience
improved they would assess us, under the terms of the contract, the full premium
of 2.70%. Although we have not been officially assessed the extra premium, we
revised the estimate of our premium expense for the quarter to include an
additional retroactive assessment of $162,000. Going forward, we are assuming
that our insurance premiums will be assessed at the maximum rate of 2.70%, which
in July 2004 was $87,000, based on an insured balance of $38.5 million. There is
the possibility that in future periods our experience will be more favorable and
we will receive a rebate on premiums paid. However, based on our loss experience
in the last couple of quarters, we are not optimistic about any future rebates.
Among other expense categories, compensation expense for the Consumer segment
increased relative to 2003, based largely upon higher support and
production-driven compensation in the Sales Finance operations. Sales Finance
loan originations totaled over $36.5 million through the six months ended June
30, 2004, up from $31.9 million in the first half of 2003. Accompanying the
additional loan volumes has been the need for expanded support to service these
loans. Consequently, administrative and support costs allocated to this segment
have increased since the prior year.
RESIDENTIAL LENDING
-------------------
Quarter Ended Six Months Ended
Net Income Return on Equity Net Income Return on Equity
---------- ---------------- ---------- ----------------
June 30, 2002 $334,000 20.77% $635,000 19.70%
June 30, 2003 456,000 26.49% 901,000 27.42%
June 30, 2004 750,000 28.80% 1,384,000 27.35%
Net income for the Residential Lending segment totaled $750,000 and $1,384,000
for the quarter and six months ended June 30, 2004 compared to $456,000 and
$901,000 for the same periods in
35
the prior year. This year's increase in net income was a result of substantial
growth in earning assets and net interest income, which was partly offset by a
reduction in non-interest income and rising operating expenses.
Net interest income for the Residential segment, net of the provision for loan
losses, totaled $2,373,000 and $4,553,000 for the quarter and six months ended
June 30, 2004. These represented increases of 58% and 51% over the $1,506,000
and $3,019,000 earned in 2003, as well as continued improvement over the 2002
levels of $1,138,000 and $2,246,000. This improvement in net interest income was
primarily attributable to a 52% quarter-over-quarter increase in the Residential
segment's average earning assets, which totaled $274 million for second quarter
2004, up from $180 million for the same period in 2003 and $132 million in 2002.
On a year-to-date basis, earning assets averaged $260 million, up 50% from the
first six months of 2003. With these additional assets, interest income earned
on the portfolio totaled $3,952,000 in second quarter 2004, up nearly 48% from
second quarter 2003. In contrast, interest expense rose $401,000, or 35%, for
second quarter 2004, to $1,532,000 due to the reductions in funding rates
described above. Similarly, for the six months ended June 30, 2004, interest
income rose nearly 42%, more than offsetting a 30% increase in interest expense.
The Residential Lending segment's second quarter non-interest income fell
$133,000 or 41%, from $324,000 for 2003 to $190,000 this year, based primarily
on a significant reduction in residential loan sales. On a year-to-date basis,
non-interest income was down $267,000, or 42%. Residential loan sale gains were
down significantly from the prior year, declining 73% for the quarter, to
$36,000, and 75% for the six months ended June 30. The declines in gains
occurred as residential loan sales fell to $8.3 million for the second quarter,
compared to $13.9 million in the same period last year. This followed an even
more significant decline in sales volume for the first quarter versus the prior
year, and resulted in year-to-date loan sales for 2004 of approximately half the
prior year volume. We believe that the sales volumes observed in the first half
of 2003 were a product of the high level of refinancing activity that occurred
during that time, and that the substantial reduction in sales volumes in 2004
represents movement to a more normalized residential lending environment.
The Residential Lending segment's non-interest expense increased $289,000 and
$534,000, or 25% and 23%, for the three and six months ended June 30, 2004,
compared to the same periods in the prior year. The growth in costs this year
has been attributable to rising compensation, loan administration and other
allocated costs. Compensation expense for the Residential segment increased
based largely upon higher production-driven compensation in the Wholesale
Lending division. Loan closings for that division totaled nearly $80.9 million
in the first six months of this year, up from $75.3 million in the like period
of 2003. Accompanying the additional loan volumes has been the need for expanded
support to service these loans. Consequently, loan administration and support
costs allocated to this segment increased relative to the prior year.
BUSINESS BANKING LENDING
------------------------
Quarter Ended Six Months Ended
Net Income Return on Equity Net Income Return on Equity
---------- ---------------- ---------- ----------------
June 30, 2002 $ 86,000 4.66% $139,000 4.03%
June 30, 2003 1,000 0.05% 15,000 0.46%
June 30, 2004 (173,000) (9.55%) (209,000) (5.63%)
36
Net income for the Business Banking segment declined $174,000 and $224,000 for
the three and six months ended June 30, 2004, as increasing net interest income
was more than offset by reductions in non-interest income and rising operating
expenses. In the first half of 2003 the segment's net income had also declined
from 2002 levels, as again improvements in net interest and non-interest income
were insufficient to offset higher operating expenses.
The Business Banking segment's net interest income after provision for loan
losses rose $51,000, or nearly 6%, for the second quarter of 2004, as a
$165,000, or 35%, reduction in interest expense compensated for a $103,000, or
7%, decline in interest income and an $11,000 increase in the provision for loan
losses. Year-to-date, the $272,000 reduction in interest expense was partially
offset by a $124,000 decline in interest income and $22,000 in additional
allowances for loan losses.
Although not to the same extent as the Consumer and Residential segments, the
Business Banking segment also succeeded in building incremental assets over the
prior year. The Business Banking segment's average earning assets totaled $99
million for the second quarter and $98 million for the first six months of 2004,
each period representing an increase of 11% compared to the same period in 2003.
This constituted, however, a significant reduction from the prior year's growth
rates compared to the same periods in 2002. The modest growth of the Business
Banking segment was in keeping with our expectations, given the soft local
economy of the last year and the resulting decline in the number of quality
commercial banking relationship opportunities in the market.
The Business Banking segment's other operating income for the quarter and six
months ended June 30, 2004 totaled $85,000 and $174,000, declining 13% and 16%
compared to the same periods in 2003. The decline for 2004 was partially
attributable to a reduction in gains on security investment sales compared to
the first half of 2003. Gains on sales from our securities portfolio are
allocated out to the four business segments. In total, $19 million in securities
were sold in the first half of 2003, generating $473,000 in gains, which were
allocated to the business lines. By comparison, only one security was sold in
the first half of 2004, generating a gain of $71,000. The significant reduction
in gains on sales between the two periods impacted non-interest income for all
business segments. Further contributing to the decline in non-interest income
was a reduction in rental income received from the First Mutual Center, which is
also allocated out to the various business segments. As a smaller business line
relative to others, the Business Banking segment lags the other segments in
generating non-interest income. Consequently, the impact of reductions in
allocated non-interest income, such as rental income and gains on securities
sales, is more noticeable for Business Banking than for other business lines
that generate higher non-interest income from their own operations.
Second quarter and year-to-date 2004 non-interest expense rose $300,000 and
$434,000, or 31% and 22%, over the same periods in 2003. The additional expenses
this year were largely driven by increases in the retail banking center expenses
allocated to the Business Banking segment. These expenses, which are allocated
to each of the four business segments, have increased based on our deposit
growth over the past year. The expense allocated to the Business Banking segment
has seen a particularly significant increase as a result of the strong growth of
our business checking and other commercial deposit accounts, costs which are
allocated almost entirely to the Business Banking segment.
37
INCOME PROPERTY LENDING
-----------------------
Quarter Ended Six Months Ended
Net Income Return on Equity Net Income Return on Equity
---------- ---------------- ---------- ----------------
June 30, 2002 $1,552,000 16.78% $3,198,000 17.55%
June 30, 2003 1,618,000 22.65% 3,322,000 23.32%
June 30, 2004 1,408,000 19.23% 2,757,000 19.06%
For the three and six months ended June 30, 2004, net income for the Income
Property segment declined $210,000 and $565,000, or 13% and 17%, relative to the
same periods in 2003, based on declines in both net interest and non-interest
income, as well as rising operating expenses.
The Income Property segment's net interest income after provision for loan loss
fell $140,000, or 4%, for the second quarter of 2004, as a $422,000, or 16%,
reduction in interest expense was insufficient to offset a $543,000, or 8%,
decline in interest income and a $19,000 increase in the provision for loan
loss. On a year-to-date basis, similar results were observed, as a $1,110,000
reduction in funding costs failed to offset a $1,347,000 reduction in interest
income and a $54,000 increase in the provision for loan loss. Unlike the other
segments, the Income Property segment did not benefit from double-digit growth
in average earning assets compared to 2003. The Income Property segment's
average earning assets totaled $447 million for the second quarter and $440
million for the first six months of 2004, representing growth of 4% and 1%
versus the same periods last year.
The Income Property segment's other operating income declined significantly
compared to 2003, falling $101,000 for the second quarter and $283,000 for the
first six months. A significant part of this reduction was attributable to the
above-mentioned reduction in gains on securities sales. As the Income Property
segment accounted for nearly half of all earning assets in the first half of
2004, and more than half for the first six months of 2003, it was the recipient
of the largest allocation of these gains. The greatest reduction in the level of
these gains compared to the prior year then appears in the non-interest income
for this segment.
Non-interest expense rose $76,000 and $279,000, or 4% and 8%, for the second
quarter and first six months of 2004. This followed expense reductions from the
second quarter and first six months of 2002 to the same periods in 2003. The
additional costs in 2004 were largely attributable to a decline in cost-reducing
benefits derived from our loan production. Certain expenses tied to the
production of new loans are classified as "standard loan costs." As loans are
originated, these costs can be capitalized, thus reducing current period
expenses. As these costs are tied to loan production, the greater the number of
loans originated, the greater the benefits realized. While the loan production
was comparable in both years, the number of loans was considerably less this
year.
LIQUIDITY
- ---------
Our primary sources of liquidity are loan and security sales and repayments,
deposits, and wholesale funds. A secondary source of liquidity is cash from
operations. Our principal uses of liquidity are the origination and acquisition
of loans and securities and the purchases of facilities and equipment.
In the first half of 2004 we originated $226 million in loans, purchased $43
million in securities and funded $5 million of draws on credit lines.
38
2nd Quarter 2nd Quarter YTD YTD
(Dollars in 000's) 2004 2003 June 2004 June 2003
---------- ---------- --------- ---------
Loan Originations $ 123,000 $ 110,000 $ 226,000 $ 213,000
Security Purchases 33,000 15,000 43,000 59,000
Draws on Lines of Credit 1,000 (16,000) 5,000 (20,000)
---------- ---------- --------- ---------
Total Originations and
Purchases $ 157,000 $ 109,000 $ 274,000 $ 252,000
Loan and Security Repayments $ 78,000 $ 64,000 $ 125,000 $ 125,000
Sale of Securities 0 5,000 2,000 19,000
Sale of Loans 23,000 20,000 49,000 47,000
---------- ---------- --------- ---------
Total Repayments and Sales $ 101,000 $ 89,000 $ 176,000 $ 191,000
Net Difference $ 56,000 $ 20,000 $ 98,000 $ 61,000
========== ========== ========= =========
Our primary sources of funding, loan and security sales and repayments, are
heavily influenced by trends in mortgage rates. When rates trend downward, our
prepayment speeds increase. The loan portfolio, excluding loans sold into the
secondary market and spec construction loans, experienced an annual prepayment
rate of 25% in 2002, and 27% last year. Through June 2004, our annualized
year-to-date rate was 30%. With the recent upward movement in various interest
rate indexes and rate increase by the Federal Reserve, we would expect
prepayment speeds to decelerate in the second half of the year. Given the
volatility of interest rates and various macroeconomic variables, however, we
recognize that a significant probability exists that actual results may vary
from this expectation. Security sales are also influenced by rising interest
rates. In low or falling rate environments, we often sell securities to capture
the market gain before the security prepays at par. With the recent increase in
rates we would not expect to execute any significant amount of security sales.
Our preferred method of funding the net difference in loan and security
purchases is with deposits.
2nd Quarter 2nd Quarter YTD YTD
(Dollars in 000's) 2004 2003 June 2004 June 2003
--------- --------- --------- ---------
Deposits $ 30,000 $ 11,000 $ 47,000 $ 16,000
Advances 20,000 27,000 51,000 30,000
--------- --------- --------- ---------
Total $ 50,000 $ 38,000 $ 98,000 $ 46,000
========= ========= ========= =========
The inflow of deposits varies from period-to-period. Our ability to raise
liquidity from this source is dependent on our effectiveness in competing with
other financial institutions. That competition tends to focus on rate and
service and although we control the quality of service that we provide, we have
no control over the prevailing rates in our marketplace.
Our other major source of liquidity is wholesale funds, which include FHLB
borrowings, brokered deposits, reverse repurchase lines of credit, and a
revolving line of credit at the First Mutual Bancshares holding company level.
We rely significantly upon these wholesale funds as sources of liquidity, as
doing so allows us to avoid maintaining balances of lower-yielding liquid assets
for potential liquidity requirements.
39
The most utilized source is the FHLB advances which totaled $244 million at June
30, 2004. Our credit line with the FHLB is reviewed annually and is currently
set at 40% of assets. As a percentage of quarter-end assets, our FHLB borrowings
were 25% at June 30, 2004, which compares to 23% at year-end 2003 and 26% at
June 30, 2003. The risks associated with this funding source include the
reduction or non-renewal of the line and insufficient collateral to utilize the
line. We try to mitigate the risk of non-renewal of the line by maintaining the
credit quality of our loans and securities and attending to the quality and
consistency of our earnings.
The risk of insufficient collateral to fully utilize the line is a more
strategic concern. Our long-term goal is to increase the relative level of our
business banking loan portfolio. In the last year we have also increased the
relative percentage of our consumer loans. As a general rule, both of those
types of loans are not eligible as collateral at the FHLB. Construction loans
and many types of commercial real estate loans are also not eligible as
collateral. The two principal sources of collateral are residential and
multi-family loans. As we continue to evolve towards a community bank, we lower
the source of our FHLB collateral. We presently have sufficient collateral to
meet any foreseeable funding needs; however, the long-term trend is an item of
continuing management attention.
Brokered deposits, which are included in the deposit totals, amounted to $47
million as of June 30, 2004, following the issue of $28 million in such
instruments during the second quarter. This represented an unusually high usage
of these deposits, which were issued to reduce our level of FHLB borrowings
following our use of one-, two-, and three-year FHLB advances to match fund our
second quarter purchases of hybrid ARM securities. Internal policies limit our
total usage of these deposits to no more than 10% of all deposits, and we do not
have plans at this time to substantially increase our use of these deposits
above their current levels.
Reverse repurchase lines are lines of credit collateralized by securities. We
currently have lines totaling $60 million, of which the full amount is currently
available. These lines were not used during the quarter ended June 30, 2004. The
risks attendant with these lines are the withdrawal of the lines based on credit
standing of the Bank and the potential lack of sufficient collateral to support
the lines.
An additional source of liquidity is cash from operations, which, though not a
significant source of liquidity, is a consistent source, based upon the quality
of our earnings. On a very limited basis it can be viewed as cash from
operations adjusted for items such as the provision for loan loss and
depreciation. See the "Consolidated Statements of Cash Flows" in the financial
statements section of this filing for a calculation of net cash provided by
operating activities.
In addition to using liquidity to fund loans and securities, we routinely invest
in facilities and equipment. In the first half of 2004 we purchased $1.1 million
of those assets. Our plans for 2004 include the remodeling of four banking
centers and the acquisition of land to build a new facility in West Seattle.
PLANNED EXPENDITURES FOR PLANT AND EQUIPMENT
- --------------------------------------------
THIRD QUARTER 2004 FOURTH QUARTER 2004
------------------ -------------------
Remodel of Banking Centers $ 800,000 $ 1,150,000
West Seattle Banking Center 50,000 1,000,000
------------ --------------
TOTAL PURCHASES $ 850,000 $ 2,150,000
============ ==============
40
During the first quarter of 2004 we began implementing plans for the extensive
remodeling of four banking centers, to include the construction of an entire new
facility for one of the offices. We currently anticipate all remodel activity to
be completed by second quarter 2005. The capital cost of the updates is expected
to be approximately $3.2 million.
Since year-end, the Bank has entered into a purchase and sale agreement for land
in West Seattle, where we intend to build a full-service banking center. Our
existing banking center in West Seattle currently resides in leased storefront
space. The expenditure listed above for the West Seattle Banking Center is for
unimproved land and initial development expenses. The full-service banking
center, which is scheduled to be completed in 2005, is expected to cost an
additional $1.2 million to $1.4 million. We have begun the due diligence and
permitting process for the new office and hope to begin construction by fourth
quarter 2004 or first quarter 2005. The above chart assumes construction begins
in 2005.
The Bank is currently developing a long-term maintenance and upgrade plan for
its seven story corporate headquarters. This plan involves a few major capital
expenditures, including an expansion of the heating and cooling system, a
sprinkler system, and upgrades to common areas. It is possible some of these
expenses could occur in 2004, but more likely they will occur in 2005. The total
capital costs could range from $750,000 to $1.0 million, and that projection is
subject to several variables that are yet unknown.
In addition, a property acquisition that has been under consideration for
several years is the Canyon Park site. If that banking center and three-story
office building were to be completed in 2005, the capital costs would approach
$4.3 million.
CAPITAL
- -------
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 June
30, 2004, we exceeded the capital levels required to meet the definition of a
well-capitalized institution:
41
For Capital Well Capitalized
Actual Adequacy Minimum Minimum Ratio
------ ---------------- -------------
Total capital (to risk-weighted assets):
First Mutual Bancshares, Inc. 12.03% 8.00% 10.00%
First Mutual Bank 11.67 8.00 10.00
Tier I capital (to risk-weighted assets):
First Mutual Bancshares, Inc. 10.29 4.00 6.00
First Mutual Bank 10.42 4.00 6.00
Tier I capital (to average assets):
First Mutual Bancshares, Inc. 7.30 4.00 5.00
First Mutual Bank 7.53 4.00 5.00
CRITICAL ACCOUNTING POLICIES
- ----------------------------
We prepare our Consolidated Financial Statements in conformity with accounting
principles generally accepted in the United States of America ("GAAP"). In
accordance with GAAP, management is required to make a number of judgments,
estimates, and assumptions that affect the reported amounts of assets,
liabilities, income, and expenses in our Consolidated Financial Statements and
accompanying footnotes. We have identified four policies as being critical
because they require management to make particularly difficult, subjective
and/or complex judgments about matters that are inherently uncertain and because
the likelihood that materially different amounts would be reported under
different conditions or using different assumptions. The four critical
accounting policies that we have identified are related to the allowance for
loan losses, determining the fair value of servicing assets, determining the
value and amortization methods regarding loan origination fees and costs, and
estimating the premiums for credit loss insurance. We believe that the
judgments, estimates, and assumptions used in the preparation of our
Consolidated Financial Statements are appropriate given the factual
circumstances as of June 30, 2004. However, given the sensitivity of our
Consolidated Financial Statements to these critical accounting policies, the use
of other judgments, estimates, and assumptions could result in material
differences in our results of operations or financial condition. Management has
discussed these critical accounting policies with the Audit Committee of our
Board of Directors.
The table below represents information about the nature of and rational for
our critical accounting policies:
- --------------------------------------------------------------------------------------------------------------------------------
Critical Consolidated Consolidated
Accounting Balance Income
Policy Sheet Statement
Caption Caption Nature of Estimates Required Reference
- --------------------------------------------------------------------------------------------------------------------------------
Allowance for Reserve for Provision for The allowance for loan losses The estimates and judgments are
loan losses loan losses loan losses represents management's estimate of described in further detail in the
credit losses inherent in the Management's Discussion and
Bank's loan portfolio as of the Analysis - "Reserve and Provision
balance sheet date. The estimation for Loan Losses" and in Note 1 to
of the allowance is based on a the Consolidated Financial
variety of factors, including the Statements - "Summary of
profile of the loan portfolio, the Significant Accounting Policies."
local and national economic
outlook, and the current and
- --------------------------------------------------------------------------------------------------------------------------------
42
- --------------------------------------------------------------------------------------------------------------------------------
historical performance of the loan
portfolio. The Bank's methodology
for assessing the adequacy of the
allowance includes the evaluation
of three distinct elements: the
formula allowance, the specific
allowance and the unallocated
allowance. The ultimate recovery of
all loans is susceptible to future
market factors beyond the Bank's
control.
- --------------------------------------------------------------------------------------------------------------------------------
Fair value Servicing assets Other operating Determining the fair value of See further discussion in the
of servicing income, servicing servicing assets requires us to Management's Discussion and
assets fees, net of formulate conclusions about Analysis section of the Annual
amortization anticipated changes in future Report - "Other Operating Income",
market conditions, including "Gain on Sales of Loans",
interest rates. Our servicing "Servicing Fees, Net of
portfolio is subject to prepayment Amortization" as well as Note 1 to
risk, which subjects our servicing the Consolidated Financial
assets to impairment risk. We use a Statements in the Annual Report -
valuation model to calculate the "Servicing Assets".
present value of the future cash
flows to determine the value of our
servicing assets. Assumptions used
in the valuation model include
market discount rates and
anticipated prepayment speeds. The
prepayment speeds are based upon
loan prepayment forecasts derived
from the consensus of investment
banking firms as reported by online
quotation systems for the income
property participations and for the
sales finance loans the actual
previous 3-month prepayment history
- --------------------------------------------------------------------------------------------------------------------------------
43
- --------------------------------------------------------------------------------------------------------------------------------
is utilized. Additionally,
estimates of the cost of servicing
a loan, an inflation rate,
ancillary income per loan, and
default rates are used in the
valuation process. We assess
impairment of the capitalized
servicing assets based on
recalculations of the present value
of the remaining future cash flows
using updated prepayment speeds.
Impairment is assessed on a
stratum-by-stratum basis with any
impairment recognized through a
valuation for each impaired
stratum.
- --------------------------------------------------------------------------------------------------------------------------------
Credit Accounts payable Other expenses Credit insurance is purchased to See further discussion in the
insurance and other cover credit losses on certain Management Discussion and Analysis
premiums liabilities pools of sales finance loans on a section under "Results of
yearly basis. The cost of the Operations, Operating Expenses" and
credit insurance is based upon under "Portfolio Information, Sales
various factors such as actual loss Finance (Home Improvement) Loans".
experience, the size of the pool,
etc. The contract with the credit
insurer also includes a maximum
exposure limit to the insurer of
10% of the loan balances. As a
result, the monthly premiums paid
are based on an estimate at the
beginning of the contract year and
any additional premiums are not due
until the end of the contract year.
We have analyzed the contract and
accrue on a monthly basis the
estimated amount payable at the end
of the contract year.
- --------------------------------------------------------------------------------------------------------------------------------
Loan Loans receivable Interest income, Loan origination fees and costs are See further discussion in Note 1 to
origination loans receivable netted and deferred over the life the Consolidated Financial
fees and costs of each loan. These net fees and Statements, in the annual report -
costs are amortized into income "Loan fee income and interest
over the life of the underlying income on loans receivable" as well
loan using one of two methods: the as Note 5 - "Loans Receivable",
straight-line method or the Net" and "Loans Receivable
constant level yield method. If the Held-for-Sale".
loan is prepaid prior to maturity,
the remaining net fees/costs are
recognized when the loan is paid
off. Included in these deferred
fees/costs is a standard loan cost.
- --------------------------------------------------------------------------------------------------------------------------------
44
- --------------------------------------------------------------------------------------------------------------------------------
The standard loan cost is
calculated for each loan class
using a model that incorporates the
costs associated with originating
and processing a loan. This cost is
netted against the qualifying fees
received from the borrower to
determine the net deferred fee or
cost associated with each loan. The
amortization of these net
fees/costs is then recognized into
income as the loan matures.
Estimates and assumptions are used
to determine the cost of each
process that is essential to
process the loan request and
originate it on our books. These
estimates mainly include the number
of hours and rate of compensation
paid to all parties involved in the
origination process of a loan.
These estimates are updated on a
yearly basis to ensure that any new
loan classes have been added and
any new processes have been
incorporated as well as
incorporating any changes in the
average compensation rates. These
estimates can vary significantly
from year to year depending upon
demand and overall mix of the
varying loan types from year to
year as well as the changes in the
processes involved in the various
kinds of loans.
- --------------------------------------------------------------------------------------------------------------------------------
45
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 and other relevant market rates or prices. Our profitability is
largely dependent on our net interest income. Consequently, our primary exposure
to market risk arises from the interest rate risk inherent in our lending,
mortgage banking, deposit, and borrowing activities. Interest rate risk is the
risk to earnings or capital resulting from adverse movements in interest rates.
To that end, we actively monitor and manage our exposure to interest rate risk.
A number of measures are utilized to monitor and manage interest rate risk,
including net interest income and economic value of equity simulation models, as
well as traditional "gap" models, each of which is described below. We prepare
these models on a monthly basis for review by our Asset Liability Committee
(ALCO), senior management, and Board of Directors. The use of these models
requires us to formulate and apply assumptions to various balance sheet items.
Assumptions regarding interest rate risk are inherent in all financial
institutions, and may include prepayment speeds on loans and mortgage-backed
securities, cash flows and maturities of financial instruments held for purposes
other than trading, changes in market conditions, loan volumes and pricing,
deposit sensitivities, consumer preferences, and management's capital leverage
plans. We believe that the data and assumptions used for our models are
reasonable representations of our portfolio and possible outcomes under the
various interest rate scenarios. Nonetheless, these assumptions are inherently
uncertain; therefore, the models cannot precisely estimate net interest income
or predict the impact of higher or lower interest rates on net interest income.
Actual results may differ significantly from simulated results due to timing,
magnitude, and frequency of interest rate changes, and changes in market
conditions and specific strategies, among other factors.
ASSET AND LIABILITY MANAGEMENT
Our primary objective in managing interest rate risk is to minimize the adverse
impact of changes in interest rates on our net interest income and capital,
while structuring the asset and liability components to maximize net interest
margin, utilize capital effectively, and provide adequate liquidity. We rely
primarily on our asset and liability structure to control interest rate risk.
Asset and liability management is the responsibility of the Asset Liability
Committee, which acts within policy directives established by the Board of
Directors. This committee meets regularly to monitor the composition of the
balance sheet, assess projected earnings trends, and formulate strategies
consistent with the objectives for liquidity, interest rate risk, and capital
adequacy. The objective of asset/liability management is to maximize long-term
shareholder returns by optimizing net interest income within the constraints of
credit quality, interest rate risk policies, levels of capital leverage, and
adequate liquidity. Assets and liabilities are managed by matching maturities
and repricing characteristics in a systematic manner.
46
HEDGING TECHNIQUES
We review interest rate trends on a monthly basis and employ hedging techniques
where appropriate. These techniques may include financial futures, options on
financial futures, interest rate caps and floors, interest rate swaps, and
extended commitments on future lending activities. Typically, the extent of our
off-balance-sheet derivative agreements has been the use of forward loan
commitments, which are used to hedge our loans held-for-sale. Additionally, in
2002 we entered into an interest rate swap with the FHLB. The purpose of the
swap is to protect against potential adverse interest rate volatility that could
be realized from the Trust Preferred Securities (TPS) issued in June 2002. The
swap accomplishes this by fixing the interest rate payable for the first five
years of the TPS' life.
NET INTEREST INCOME (NII) AND ECONOMIC VALUE OF EQUITY (EVE) SIMULATION MODEL
RESULTS
June 30, 2004 December 31, 2003
Percentage Percentage
Change Change
- -----------------------------------------------------------------------------
Change in Net Economic Net Economic
Interest Rates Interest Value of Interest Value of
(in basis points) Income Equity Income Equity
- ---------------------------------------------------------------------------
+200 (0.01%) (3.96%) 1.14% (8.50%)
+100 n/a (1.79%) n/a (5.06%)
-100 (0.70%) 0.87% (1.18%) 2.34%
-200 * * * *
* Because a large percentage of our loan portfolio is tied to indexes that are
at historic low levels, a downward 200 bps scenario could not be computed.
NET INTEREST INCOME SIMULATION
The "Net Interest Income" figures in the above table refer to changes from a
"base case" scenario, and they assume a zero-growth balance sheet and a steady
increase or decrease in interest rates in the magnitudes specified over a
twelve-month period. The "base case" represents our forecast of net interest
income under the simulation assumptions if rates were to remain unchanged from
the current rates. In the event the simulation model demonstrates that a gradual
200 basis point increase or 100 basis point (200 basis point when applicable)
decrease in interest rates over the next 12 months would adversely affect our
net interest income over the same period by more than 10% relative to the "base
case" scenario, we would consider the indicated risk to have exceeded our
internal policy limit. As illustrated in the above results, we are operating
within the 10% internal policy limit.
The June 30, 2004 results of our income simulation model indicate that our net
interest income would be expected to decline from its "base case" level in
environments where interest rates are assumed to rise by 200 basis points (bps)
or fall by 100 bps. The magnitudes of these changes, however, suggest that there
is little sensitivity in net interest income over a 12-month horizon,
47
with less than a one percent change in net interest income from the base case
projection indicated in either the rising or falling rate ramp scenario.
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 increase. In all interest rate scenarios, the size of the
balance sheet is assumed to remain stable, regardless of interest rate
movements. Implicit in this assumption are additional assumptions for increased
new securities purchases and loan originations 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 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, and then discounting these cash flows back to
their present values. The assumed discount rate used for each projected cash
flow is a current market rate, such as a LIBOR, FHLB, or swap curve rate, and
from alternative instruments of comparable risk and duration. In the event the
simulation model demonstrates that a 200 basis point increase or 100 basis point
(200 basis point when applicable) decrease in rates would adversely affect our
EVE by more than 25%, we consider the indicated risk to have exceeded our
internal policy limit. Again, as illustrated in the above results, we are
operating within the 25% internal policy limit.
In the simulated 200 bps upward shift of the yield curve, 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, when
interest rates rise, the cash flows on our assets will typically decelerate as
borrowers become less likely to prepay their loans. As the cash flows on these
assets are shifted further into the future, their present values are further
reduced. Based on our June 30, 2004 model results, the effects of rising rates
were more pronounced for our assets, which would have declined in value by an
estimated 2.99% versus an approximately 2.88% decline in the value of
liabilities. Consequently, the economic value of our equity was negatively
impacted in this scenario by 3.96%.
The opposite occurs when rates decline, as the discount rates used to calculate
the present values of assets and liabilities decrease causing the present values
of both assets and liabilities to rise. We would expect our EVE to be positively
impacted in this scenario. Counteracting this effect, however, is the tendency
of cash flows to accelerate in a falling rate environment, as borrowers
refinance their existing loans at lower interest rates. These loan prepayments
prevent the present values of these assets from increasing in a declining rate
scenario, illustrating 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 June 30, 2004 were
positively impacted when rates were assumed to fall by 100 bps, assets by 1.46%
and liabilities by 1.53%. This resulted in a positive impact to the economic
value of our equity of 0.87%.
48
The Net Interest Income and Economic Value of Equity sensitivity analyses do not
necessarily represent forecasts. As previously noted, there are numerous
assumptions inherent in the simulation models as well as in the gap report,
including the nature and timing of interest levels, the shape of the yield
curve, loan and deposit growth, prepayments on loans and securities, deposit
decay rates, pricing decisions on loans and deposits, reinvestment/replacement
of asset and liability cash flows, customer preferences, and competitor and
economic influences.
GAP MODEL
The gap model, which represents a traditional view of interest rate sensitivity,
quantifies the mismatch between assets maturing, repricing, or prepaying within
a period, and liabilities maturing or repricing within the same period. A gap is
considered positive when the amount of interest-rate-sensitive assets exceeds
the amount of interest-rate-sensitive liabilities within a given period. A gap
is considered negative in the reverse situation.
Certain shortcomings are inherent in gap analysis. For example, some assets and
liabilities may have similar maturities or repricing characteristics, but they
may react differently to changes in interest rates. This illustrates a facet of
interest rate exposure referred to as "basis risk." Additionally, assets such as
adjustable-rate mortgage loans may have features that limit the effect that
changes in interest rates have on the asset in the short-term and/or over the
life of the loan, for example a limit on the amount by which the interest rate
on the loan is allowed to adjust each year. This illustrates another area of
interest rate exposure referred to as "option risk." Due to the limitations of
the gap analysis, these features are not taken into consideration. Additionally,
in the event of a change in interest rates, prepayment and early withdrawal
penalties could deviate significantly from those assumed in the gap calculation.
As a result, we utilize the gap report as a complement to our income simulation
and economic value of equity models.
Our 12-month interest rate sensitivity gap, expressed as a percentage of assets,
fell from 7.9% at year-end 2003 to 2.7% at June 30, 2004. These results indicate
that we remain asset sensitive, or positively gapped, with more assets than
liabilities expected to mature, reprice, or prepay within the next year. 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 caused by the mix of the
additional assets and liabilities to each side of the balance sheet, as well as
the overall balance sheet growth.
ONE-YEAR INTEREST RATE SENSITIVITY GAP
(in thousands)
6/30/2004 12/31/2003
--------- ---------
One Year Repricing / Maturing Assets $651,339 $632,428
One Year Repricing / Maturing Liabilities 625,422 564,707
--------- ---------
One Year Gap $ 25,917 $ 67,721
========= =========
Total Assets $ 972,704 $ 860,844
========= =========
(June 30, 2004 figure includes off-balance-sheet item)
One Year Interest Rate Gap as a
Percentage of Assets 2.7% 7.9%
49
Consistent with the trend observed over the last year, asset growth of $112
million in the first half of 2004 was centered in assets that would not be
subject to maturity or repricing in the following 12 months. These assets
consisted largely of new single- and multi-family residential ARMs, typically
with rates tied to one-year LIBOR or FHLB indexes, but for which the interest
rate is fixed for the first three to ten years of the loan, as well as
fixed-rate home improvement loans. In addition to the loan growth, we had a
number of hybrid ARM securities trades settle in late June. These instruments
bear a fixed interest rate for an initial period, typically three to seven
years, after which their rates become adjustable annually based on a set margin
over a major market index. Overall, those assets not subject to maturity or
repricing within 12 months rose nearly $93 million over the first six months of
2004, accounting for roughly 83% of asset growth. Assets expected to mature or
reprice within a 12-month time horizon increased approximately $19 million from
their level as of December 2003.
A change in modeling procedure, rather than actual asset growth, accounted for
$9 million of this $19 million repricing in the next twelve months. In 2004, we
changed our methodology to reflect the interest rate swap in the gap report. In
doing so, the trust preferred securities (TPS) were reclassified as variable
rate liabilities, offset by the asset side of the swap, under which the Bank
receives payments tied to the same quarterly adjustable rate as the TPS
issuances.
Liabilities subject to maturity or repricing in the next 12 months rose
approximately $61 million over the year-end level, including the $9 million
increase that resulted from moving the 2002 TPS issue into the
less-than-one-year category, as described above. By comparison, liabilities with
maturities or expected repricing dates in excess of one year rose by $51 million
compared to their year-end levels. This represented a slight departure from the
trend observed last year, when roughly 75% of liability growth was subject to
maturity or repricing within one year. Beginning in the first quarter of this
year, we decided to extend the terms of some of our funding sources, thus
locking in some longer-term funding costs at current rates and reducing the
mismatch between our overall asset and liability durations. Based on this
decision, our first quarter 2004 promotional deposit rates focused on 15- to
24-month certificates, rather than the seven-month term, which was promoted for
most of 2003. Additionally, while our FHLB advances are typically structured
with one-year terms, during the first half of 2004, we expanded our usage of
advances with terms longer than 12-months, largely to match fund the previously
mentioned securities settled in the second quarter.
The greater increase of liabilities maturing/repricing in the next 12 months
versus assets resulted in a net $42 million reduction in our dollar gap. This
gap ratio was further reduced by the overall growth in the balance sheet during
the period, which increased from $861 million to $973 million, including the
addition of $9 million in the off-balance-sheet interest rate swap. The combined
effect of these two factors led to the decline in the one-year gap ratio from
7.9% to 2.7% of total assets.
50
SECURITIES
ITEM 3
------
The following table sets forth certain information regarding carrying values and
percentage of total carrying values of the Bank's consolidated portfolio of
securities classified as available-for-sale and held-to-maturity (dollars in
thousands).
--------------------------------------------------------------------------------
June 30,
--------------------------------------------------------------------------------
2004 2003
--------------------------------------- ---------------------------------------
Available-for-Sale: Carrying Value Percent of Total Carrying Value Percent of Total
--------------------------------------- ---------------------------------------
US Government Treasury and agency obligations $ 10,816 10% $ 11,346 15%
Mortgage backed securities:
Freddie Mac 16,013 14% 17,944 24%
Ginnie Mae 44,227 39% - 0%
Fannie Mae 41,344 37% 46,887 61%
------------------------------------ ----------------------------------
Total mortgage-backed securities 101,584 90% 64,831 85%
--------------------------------------------------------------------------------------- ----------------------------------
Total securities available-for-sale $ 112,400 100% $ 76,177 100%
--------------------------------------------------------------------------------------- ----------------------------------
--------------------------------------------------------------------------------
June 30,
--------------------------------------------------------------------------------
2004 2003
--------------------------------------- ---------------------------------------
Held-to-Maturity: Carrying Value Percent of Total Carrying Value Percent of Total
--------------------------------------- ---------------------------------------
Municipal Bonds $ 1,278 15% $ 1,330 11%
Mortgage backed securities:
Freddie Mac 503 6% 624 5%
Fannie Mae 6,950 79% 9,870 84%
------------------------------------- ----------------------------------
Total mortgage-backed securities 7,453 85% 10,494 89%
CMO's -- 0% 10 0%
------------------------------------- ----------------------------------
--------------------------------------------------------------------------------------- ----------------------------------
Total securities held-to-maturity $ 8,731 100% $ 11,834 100%
--------------------------------------------------------------------------------------- ----------------------------------
------------------------------------------------------------------- ---------------
Estimated Market Value $ 8,818 $ 12,213
------------------------------------------------------------------- ---------------
51
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 June 30, 2004
---------------------------------------------------------------------------
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:
Ginnie Mae -- -- 7,863 3.75% 1,500 4.50%
Freddie Mac 346 3.29% -- 0.00% 903 5.50%
Fannie Mae 532 3.34% -- 0.00% 1,789 5.50%
---------------------------------------------------------------------------
Total mortgage-backed securities 878 3.32% 7,863 3.75% 4,192 5.14%
---------------------------------------------------------------------------
Total securities available-for-sale - Carrying Value $ 878 3.32% $7,863 3.75% $ 4,192 5.14%
---------------------------------------------------------------------------
---------------------------------------------------------------------------
Total securities available-for-sale - Amortized Cost $ 854 3.32% $7,888 3.75% $ 4,104 5.13%
---------------------------------------------------------------------------
---------------------------------------------------------------------------
Available-for-sale at June 30, 2004
---------------------------------------------------------------------------
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 $ 5,911 4.08% $ 4,905 4.00% $ -- 0.00%
Mortgage backed securities:
Ginnie Mae -- 0% -- 0% 34,864 4.16%
Freddie Mac 4,283 3.50% 8,523 4.50% 1,958 3.77%
Fannie Mae -- 0.00% 34,143 4.31% 4,880 4.13%
---------------------------------------------------------------------------
Total mortgage-backed securities 4,283 3.50% 42,666 4.49% 41,702 4.14%
---------------------------------------------------------------------------
Total securities available-for-sale - Carrying Value $10,194 3.84% $ 47,571 4.31% $ 41,702 4.14%
---------------------------------------------------------------------------
---------------------------------------------------------------------------
Total securities available-for-sale - Amortized Cost $10,464 3.83% $ 49,156 4.31% $ 41,722 4.13%
---------------------------------------------------------------------------
-----------------------
Available-for-sale at
June 30, 2004
-----------------------
Total
-----------------------
Weighted
Carrying Average
Value Yield
-----------------------
AVAILABLE-FOR-SALE:
US Government Treasury and agency obligations $ 10,816 4.05%
Mortgage backed securities:
Ginnie Mae 44,227 4.10%
Freddie Mac 16,013 4.17%
Fannie Mae 41,344 4.32%
-----------------------
Total mortgage-backed securities 101,584 4.26%
-----------------------
Total securities available-for-sale - Carrying Value $ 112,400 4.19%
-----------------------
-----------------------
Total securities available-for-sale - Amortized Cost $ 114,188 4.19%
-----------------------
52
---------------------------------------------------------------------------
Held-to-Maturity at June 30, 2004
---------------------------------------------------------------------------
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 503 3.48% -- 0.00% -- 0.00%
Fannie Mae 2,361 4.27% 1,628 5.66% 2,026 2.45%
---------------------------------------------------------------------------
Total mortgage-backed securities 2,864 4.13% 1,628 5.66% 2,026 2.45%
---------------------------------------------------------------------------
Total securities held-to-maturity - Carrying Value $ 2,864 4.13% $ 1,628 5.66% $ 2,026 2.45%
---------------------------------------------------------------------------
---------------------------------------------------------------------------
Total securities held-to-maturity - Fair Market Value $ 2,941 4.12% $ 1,672 5.66% $ 2,039 2.52%
---------------------------------------------------------------------------
---------------------------------------------------------------------------
Held-to-Maturity at June 30, 2004
---------------------------------------------------------------------------
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% $ 1,058 6.20%
Mortgage backed securities:
Freddie Mac -- 0.00% -- 0.00% -- 0.00%
Fannie Mae -- 0.00% 935 4.50% -- 0.00%
---------------------------------------------------------------------------
Total mortgage-backed securities -- 0.00% 935 4.50% -- 0.00%
---------------------------------------------------------------------------
Total securities held-to-maturity - Carrying Value $ -- 0.00% $ 1,155 4.66% $ 1,058 6.20%
---------------------------------------------------------------------------
---------------------------------------------------------------------------
Total securities held-to-maturity - Fair Market Value $ -- 0.00% $ 1,127 4.67% $ 1,039 6.22%
---------------------------------------------------------------------------
-----------------------
Held-to-Maturity
at June 30, 2004
-----------------------
Total
-----------------------
Weighted
Carrying Average
Value Yield
-----------------------
HELD-TO-MATURITY:
Municipal Bonds $ 1,278 6.06%
Mortgage backed securities:
Freddie Mac 503 3.48%
Fannie Mae 6,950 4.09%
-----------------------
Total mortgage-backed securities 7,453 4.07%
-----------------------
Total securities held-to-maturity - Carrying Value $ 8,731 4.34%
-----------------------
-----------------------
Total securities held-to-maturity - Fair Market Value $ 8,818 4.36%
-----------------------
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
53
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 June 30, 2004 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 June 30, 2004, the Company was not engaged in any litigation, which in the
opinion of management, after consultation with its legal counsel, would be
material to the Company.
ITEM 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity
Securities
None.
ITEM 3. Defaults Upon Senior Securities
None.
ITEM 4. Submission of Matters to a Vote of Security Holders
The Annual Meeting of Shareholders of First Mutual Bancshares, Inc. was held on
April 22, 2004. The results of votes on the matter presented at the Meeting are
as follows:
The following individuals were elected as directors for the term noted:
Votes Votes
CLASS III DIRECTORS Votes For Withheld Abstained Term
- ------------------- --------- -------- --------- ----
Mary Case Dunnam 4,576,677 25,310 146,399 3 years
George W. Rowley, Jr. 4,544,319 57,668 146,399 3 years
John R. Valaas 4,569,279 32,708 146,399 3 years
The terms of the Class I and II directors expire at the Annual Meeting of
Shareholders for 2005 and 2006, respectively.
54
CLASS I DIRECTORS, term expires in 2005
- ---------------------------------------
Janine Florence
F. Kemper Freeman, Jr.
Robert J. Herbold
Victor E. Parker
CLASS II DIRECTORS, term expires in 2006
- ----------------------------------------
James J. Doud, Jr.
Richard S. Sprague
Robert C. Wallace
ITEM 5. Other Information
(a) On June 24, 2004 our Board of Directors approved amendments to our Bylaws
that eliminated some provisions that were applicable to the Bank, but not the
Company as a holding company, that incorporated some new corporate governance
provisions into the Bylaws and that made some "housekeeping" modifications.
Among other items, the new Bylaws:
(i) Provide that shareholders who wish to bring a proper corporate
business proposal before any annual or special meeting must provide information
to the Company with the proposal regarding the business to be brought before the
meeting, the name of the proposing shareholder(s) and any substantial interest
of such shareholder in the proposed business. The provision that any such
proposal must be received by the Company at least 120 calendar days before the
meeting was not modified.
(ii) Provide that a majority of the outstanding shares of the
Company need be present or represented at a shareholders meeting in order to
constitute a quorum. The Company's Articles and Bylaws have previously provided
that only one-third of the outstanding shares would constitute a quorum. The
Board intends to seek shareholder approval for a similar change in the Articles
of Incorporation at the next annual meeting.
(iii) Eliminated a provision that any shares voted by a director had
to be in his or her name.
(iv) Added a provision that any transactions between the Company and
a director or officer or an affiliate of a director or officer must be fair and
reasonable to the Company and must be approved by either the shareholders or the
disinterested members of the Board after a disclosure of the material aspects of
the relationship or must otherwise be determined to have been fair to the
Company.
(v) Provide for certain corporate governance elements involving the
Company's Audit, Nominations and Compensation Committees which incorporate
certain matters be applicable to the Company pursuant to the NASDAQ Guidelines.
A copy of the amended and restated Bylaws is attached to this Quarterly Report
as Exhibit 3.3.
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ITEM 6. Exhibits and Reports on Form 8-K
(a)
(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, incorporated by
reference on Form 10-Q filed with the SEC on May 13, 2002.
(3.3) Bylaws (as amended and restated), effective as of June 24, 2004.
(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.
(b) No reports were filed on form 8K this period.
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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: August 13, 2004 FIRST MUTUAL BANCSHARES, INC.
/s/ John R. Valaas
---------------------------------------
John R. Valaas
President and Chief Executive Officer
/s/ Roger A. Mandery
---------------------------------------
Roger A. Mandery
Executive Vice President
(Principal Financial Officer)
57