UNITED STATES SECURITIES AND EXCHANGE COMMISSION

 

Washington, D.C.  20549

 

FORM 10-K

 

(Mark One)

ý         ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the year ended  December 31, 2004

 

OR

 

o         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   0-20800

 

STERLING FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

 

 

111 North Wall Street, Spokane, Washington 99201

(Address of principal executive offices) (Zip code)

 

Registrant’s telephone number, including area code: (509) 458-3711

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:

 

Common Stock ($1.00 par value)

(Title of class)

 

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 ý    No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).

 Yes ý    No o

 

As of June 30, 2004, the aggregate market value of the common equity held by non-affiliates of the registrant, computed by reference to the average of the bid and asked prices on such date as reported by The NASDAQ National Market, was $686,997,728.

 

The number of shares outstanding of the registrant’s common stock, par value $1.00 per share, as of January 31, 2005 was 22,951,164.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Specific portions of the registrant’s Proxy Statement dated March 25, 2005, are incorporated by reference into Part III hereof.

 

 

STERLING FINANCIAL CORPORATION

 

DECEMBER 31, 2004 ANNUAL REPORT ON FORM 10-K

TABLE OF CONTENTS

 

PART I
Item 1.	Business
	General
	Company Growth
	Profitability Drivers
	Lending Activities
	Investments and Asset-Backed Securities
	Sources of Funds
	Subsidiaries
	Competition
	Personnel
	Environmental Laws
	Regulation
	Forward-Looking Statements
	Where You Can Find More Information
Item 2.	Properties
Item 3.	Legal Proceedings
Item 4.	Submission of Matters to a Vote of Security Holders
PART II
Item 5.	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
	Stock Market and Dividend Information
Item 6.	Selected Financial Data
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Executive Summary and Highlights
	Critical Accounting Policies
	Results of Operations for the Years Ended December 31, 2004 and 2003
	Results of Operations for the Years Ended December 31, 2003 and 2002
	Financial Position
	Asset and Liability Management
	Liquidity and Capital Resources
	Off-Balance Sheet Arrangements and Aggregate Contractual Obligations
	Capital
	Goodwill Litigation
	New Accounting Policies
	Effects of Inflation and Changing Prices
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk
Item 8.	Financial Statements and Supplementary Data
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Item 9A.	Controls and Procedures
	Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures
	Management’s Report on Internal Control Over Financial Reporting
	Report of Independent Registered Public Accounting Firm
Item 9B.	Other Information
PART III
Item 10.	Directors and Executive Officers of the Registrant
Item 11.	Executive Compensation
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Item 13.	Certain Relationships and Related Transactions
Item 14.	Principal Accounting Fees and Services
PART IV
Item 15.	Exhibits, Financial Statement Schedules
SIGNATURES

 

 

PART I

 

Item 1.    Business

 

General

 

Sterling Financial Corporation (“Sterling”) is a unitary savings and loan holding company, the significant operating subsidiary of which is Sterling Savings Bank.  The principal operating subsidiaries of Sterling Savings Bank are Action Mortgage Company (“Action Mortgage”), INTERVEST-Mortgage Investment Company (“INTERVEST”) and Harbor Financial Services, Inc. (“Harbor Financial”).  Sterling Savings Bank commenced operations in 1983 as a Washington State-chartered, federally insured stock savings and loan association headquartered in Spokane, Washington.

 

Sterling provides personalized, quality financial services to its customers as exemplified by its Hometown Helpful^® philosophy.  Sterling believes that this dedication to personalized service has enabled it to grow both its retail deposit base and its lending portfolio in the Pacific Northwest region.  With $6.94 billion in total assets at December 31, 2004, Sterling attracts Federal Deposit Insurance Corporation (the “FDIC”) insured deposits from the general public through 135 retail branches located in Washington, Oregon, Idaho and Montana.  Sterling originates loans through its branch offices, as well as Action Mortgage residential loan production offices in the four-state area and through INTERVEST commercial real estate lending offices in Washington, Oregon, Arizona and California.  Sterling also markets fixed income and equity products, mutual funds, fixed and variable annuities and many other financial products through Harbor Financial.

 

Sterling continues to enhance its presence as a leading community bank by increasing its commercial real estate, business banking, consumer and construction lending while also increasing its retail deposits, particularly transaction accounts.  Commercial real estate, business banking, consumer and construction loans generally produce higher yields than residential loans.  Management believes that a community bank mix of assets and liabilities will enhance its net interest income (“NII”) (the difference between the interest earned on loans and investments and the interest paid on deposits and borrowings) and will increase other fee income, although there can be no assurance in this regard.  Such loans, however, generally involve a higher degree of risk than financing residential real estate.  Sterling’s revenues are derived primarily from interest earned on loans and asset-backed securities (“ABS”), fees and service charges, and mortgage banking operations.  The operations of Sterling Savings Bank, and savings institutions generally, are influenced significantly by general economic conditions and by policies of its primary regulatory authorities, the Office of Thrift Supervision (“OTS”), the FDIC and the State of Washington Department of Financial Institutions (“Washington Supervisor”).

 

Company Growth

 

In January 2004, Sterling completed its acquisition of Klamath First Bancorp, Inc. (“KFBI”), in which KFBI was merged with and into Sterling, with Sterling being the surviving corporation, and KFBI’s wholly owned subsidiary, Klamath First Federal Savings and Loan Association, was merged with and into Sterling’s wholly owned subsidiary, Sterling Savings Bank, with Sterling Savings Bank being the surviving institution.

 

Under the terms of the KFBI acquisition, each share of KFBI common stock was converted into 0.77 shares of Sterling common stock.  Sterling issued 5,431,067 shares of common stock in exchange for all of the stock of KFBI and assumed all outstanding KFBI options, which were converted into options to purchase 433,529 shares of Sterling’s common stock.  Sterling added approximately $988 million in deposits, $778 million in investments and ABS, $564 million in loans and $145 million in capital as a result of the KFBI acquisition, while adding approximately 450 employees to its work force.  See Note 25 of “Notes to Consolidated Financial Statements.”

 

With this expanded branch network, Sterling has strengthened its position as a leading regional community bank.  This acquisition is consistent with Sterling’s strategy to become the leading community bank in the Pacific Northwest.  KFBI’s strong deposit base has complemented Sterling’s asset growth strategy, while the combined branch network and access to capital have given Sterling the opportunity to continue its growth in the region.

 

In November 2004, INTERVEST acquired Peter W. Wong Associates, Inc. (“PWWA”), a commercial real estate lending entity, by merging PWWA with and into INTERVEST, with INTERVEST being the surviving entity in the merger.  This acquisition expanded Sterling’s capacity to originate commercial real estate loans and increased Sterling’s

 

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commercial real estate servicing portfolio by $392.2 million.  See Note 25 of “Notes to Consolidated Financial Statements.”

 

Sterling intends to continue to pursue an aggressive growth strategy to become the leading community bank in the Pacific Northwest.  This strategy may include acquiring other financial businesses or branches thereof, or other substantial assets or deposit liabilities.  Sterling may not be successful in identifying further acquisition candidates, integrating acquisitions or preventing such acquisitions from having an adverse effect on Sterling.  There is significant competition for acquisitions in Sterling’s market area, and Sterling may not be able to acquire other businesses on attractive terms.  Furthermore, the success of Sterling’s growth strategy will depend on increasing and maintaining sufficient levels of regulatory capital, obtaining necessary regulatory approvals, generating appropriate growth and the existence of favorable economic and market conditions.  There can be no assurance that Sterling will be successful in implementing its growth strategy.

 

Profitability Drivers

 

We expect to increase our profitability in the future by:

 

•                  continuing to change the mix of our loans to higher-yielding business banking, corporate banking and consumer loans.

•                  growing our core deposits, particularly noninterest bearing consumer and commercial transaction deposits.

•                  diversifying and growing our fee income through existing and new fee income sources, including deposit fees, fees from mortgage banking and other fees.

•                  maintaining strong asset quality through robust underwriting and credit approval functions.

•                  managing interest rate risk to protect net interest margin in a changing interest rate environment.

 

Together, we believe these strategies will contribute to increasing high quality earnings and maximizing shareholder value.  The effect of these strategies on our financial results is discussed further in Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”).

 

Lending Activities

 

Focus on Community Lending.  In recent years, Sterling has become more similar to a community bank by increasing its commercial real estate, business banking, consumer and construction lending.  Commercial real estate, business banking, consumer and construction loans generally produce higher yields than residential permanent mortgage loans.  Such loans, however, generally involve a higher degree of risk than financing residential real estate.

 

Business Lending.  Sterling has structured its business lending in three groups:  Business Banking, Corporate Banking and Private Banking.  Sterling’s Business Banking Group provides a full range of credit products to small- and medium-sized businesses and to individuals.  Credit products include lines of credit, receivable and inventory financing, equipment loans, and permanent and construction real restate financing.  Loans may be made unsecured, partially secured or fully secured based on certain credit criteria.  The credit product line for both businesses and individuals includes standardized products, as well as customized accommodations.

 

Sterling’s Corporate Banking Group provides a full line of financial services to middle market companies in its service area.  Credit products include lines of credit, receivable and inventory financing, equipment loans and permanent and construction financing.  Loans may be made on an unsecured, partially secured or fully secured basis.  The Corporate Banking Group also serves the needs of the owners and key employees of its business customers.

 

Sterling’s Private Banking Group provides services to higher-net-worth and higher-income borrowers by originating a variety of consumer and business banking loans.  Such loans generally, but do not always, meet the same underwriting requirements or have the same terms as general consumer loans of the same type.

 

Sterling has established minimum underwriting standards, which delineate criteria for sources of repayment, financial strength and credit enhancements such as guarantees.  Typically, the primary source of repayment is recurring cash flow of the borrower or cash flow from the business or project being financed.  Depending on the type of loan, underwriting standards include minimum financial requirements, maximum loan-to-collateral value ratios, minimum cash flow coverage of debt service, debt-to-income ratios and minimum liquidity requirements.  Exceptions to the minimum

 

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underwriting standards may be made depending upon the type of loan and financial strength of the borrower.  Exceptions are reported to the appropriate level of authority up to and including the board of directors.  Common forms of collateral pledged to secure business banking loans include real estate, accounts receivable, inventory, equipment, agricultural crops or livestock and marketable securities. Most loans have maximum terms of one to ten years and loan-to-value ratios in the range of 65% to 80%, based on an analysis of the collateral pledged.

 

Business, private and corporate banking loans generally involve a higher degree of risk than financing real estate, primarily because collateral is more difficult to appraise, the collateral may be difficult to obtain or liquidate following an uncured default and it is difficult to accurately predict the borrower’s ability to generate future cash flows.  These loans, however, typically offer relatively higher yields and variable interest rates.  The availability of such loans enables potential depositors to establish full-service banking relationships with Sterling.

 

Multifamily Residential and Commercial Real Estate Lending.  Sterling offers multifamily residential and commercial real estate loans as both construction and permanent loans collateralized by real property.  Although Sterling’s market for such loans is primarily in the Pacific Northwest, Sterling has production offices in Phoenix, Arizona and Sacramento, California.  Construction loans on such properties typically have terms of 12 to 24 months and have variable interest rates. Permanent fixed- and adjustable-rate loans on existing properties typically have maturities of three to ten years. Multifamily residential and commercial real estate loans generally involve a higher degree of risk than one- to four-family residential real estate loans, because they typically involve large loan balances to single borrowers or groups of related borrowers.  The payment experience on such loans typically is dependent on the successful operation of the real estate project and is subject to certain risks not present in one- to four-family residential mortgage lending.  These risks include excessive vacancy rates or inadequate operating cash flows.  Construction lending is subject to risks such as construction delays, cost overruns, insufficient values and an inability to obtain permanent financing in a timely manner.  Sterling attempts to reduce its exposure to these risks by limiting loan amounts to the amounts readily accepted in the secondary market, by closely monitoring the construction disbursement process, by investigating the borrowers’ finances and, depending on the circumstances, requiring annual financial statements from the borrowers, requiring operating statements on the properties or acquiring personal guarantees from the borrowers.

 

One- to Four-Family Residential Lending.  Sterling originates fixed- and adjustable-rate residential mortgages (“ARMs”), which have interest rates that adjust annually or every three, five or seven years and are indexed to a variety of market indices.

 

Sterling continues to originate conventional and government-insured residential loans for sale into the secondary mortgage market.  Within the secondary mortgage market for conventional loans, Sterling sells its residential loans both on a servicing-released and servicing-retained basis.  Sterling also sells loans to the Federal Home Loan Mortgage Corporation (“FHLMC”), the Federal Home Loan Bank (“FHLB Seattle”) and the Federal National Mortgage Association (“FNMA”). Sterling endeavors to underwrite residential loans in compliance with these agencies’ underwriting standards.  Loans sold into the secondary market are all sold without recourse to Sterling, except that Sterling may be obligated to repurchase any loans that are not underwritten in accordance with these agencies’ or applicable investor underwriting guidelines.

 

Conventional residential mortgage loans are originated for up to 103% of the appraised value or selling price of the mortgaged property, whichever is less.  Borrowers must purchase private mortgage insurance from approved third parties so that Sterling’s risk is limited to approximately 80% of the appraised value on all loans with loan-to-value ratios in excess of 80%.  Sterling’s residential lending programs are designed to comply with all applicable regulatory requirements.  For a discussion of Sterling’s management of interest rate risk (“IRR”) on conventional loans, see “– Secondary Market Activities.”

 

Sterling originates residential construction loans on custom homes, presold homes and spec homes.  Sterling also provides acquisition and development loans for residential subdivisions.  Construction financing is generally considered to involve a higher degree of risk than long-term financing on improved, occupied real estate.  Sterling’s risk of loss on construction loans depends largely upon the accuracy of the initial estimate of the property’s value at completion of construction or development and the estimated cost (including interest) of construction.  If the estimate of construction costs proves to be inaccurate, Sterling might have to advance funds beyond the amount originally committed to permit completion of the development and to protect its security position.  Sterling also might be confronted, at or prior to maturity of the loan, with a project with insufficient value to ensure full repayment. Sterling’s underwriting, monitoring

 

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and disbursement practices with respect to construction financing are intended to ensure that sufficient funds are available to complete construction projects.  Sterling endeavors to limit its risk through its underwriting procedures by using only approved, qualified appraisers and by dealing only with qualified builders/borrowers.  The properties that serve as underlying collateral for these construction loans are located primarily in the states of Washington, Oregon, Idaho and Montana.

 

As of December 31, 2004, approximately 39% of Sterling’s one- to four-family residential construction loans consisted of loans for spec properties.  Further, as of December 31, 2004, approximately 33% and 24% of Sterling’s one- to four-family residential construction loan portfolio is concentrated in the greater Portland, Oregon and Seattle, Washington markets, respectively.  A reduction in market value or in demand for residential housing, particularly in the aforementioned markets, could lead to higher delinquencies and foreclosures and have a negative impact on Sterling.

 

Consumer Lending.  Consumer loans and lines of credit are originated directly through Sterling’s retail branches and Private Banking Group, and indirectly through Sterling’s Dealer Banking Department.  Sterling finances purchases of consumer goods including automobiles, boats and recreational vehicles, and lines of credit for personal use.  Generally, consumer loans are originated for terms ranging from six months to ten years.  Interest rates may be either fixed or adjustable based on a contractual formula tied to established external indices.  Sterling also makes loans secured by borrowers’ savings accounts and equity loans collateralized by residential real estate.  Equity loans may have maturities of up to 15 years.

 

The following table sets forth information on loan originations for the periods indicated:

 

 

		Years Ended December 31,
		2004					2003					2002
		Amount			%		Amount			%		Amount			%
		(Dollars in thousands)
Mortgage - permanent:
One- to four-family residential		$	400,391		13.7		$	504,169		22.2		$	350,973		19.2
Multifamily residential		43,395			1.5		71,962			3.2		77,761			4.3
Commercial real estate		241,754			8.3		114,487			5.0		66,492			3.6
		685,540			23.5		690,618			30.4		495,226			27.1
Mortgage - construction:
One- to four-family residential		719,146			24.6		531,875			23.4		481,328			26.3
Multifamily residential		102,970			3.5		79,463			3.5		62,498			3.4
Commercial property		203,401			7.0		96,213			4.2		54,621			3.0
		1,025,517			35.1		707,551			31.1		598,447			32.7
Total mortgage loans		1,711,057			58.6		1,398,169			61.5		1,093,673			59.8
Commercial and consumer:
Corporate banking		352,767			12.1		204,733			9.0		121,348			6.6
Business banking		465,827			16.0		386,521			17.0		403,181			22.1
Consumer - direct		332,076			11.4		211,505			9.3		146,575			8.0
Consumer - indirect		56,403			1.9		73,046			3.2		64,333			3.5
Total commercial and consumer loans		1,207,073			41.4		875,805			38.5		735,437			40.2
Total loans originated		$	2,918,130		100.0		$	2,273,974		100.0		$	1,829,110		100.0

 

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Loan Portfolio Analysis.  The following table sets forth the composition of Sterling’s loan portfolio by type of loan at the dates indicated:

 

 

		December 31,
		2004					2003					2002					2001					2000
		Amount			%		Amount			%		Amount			%		Amount			%		Amount			%
		(Dollars in thousands)
Mortgage - permanent:
One- to four-family residential		$	794,632		18.4		$	407,999		13.8		$	358,359		14.8		$	315,242		14.8		$	409,592		20.6
Multifamily residential		184,754			4.3		167,220			5.7		161,547			6.7		155,250			7.3		163,675			8.2
Commercial real estate		699,879			16.3		463,191			15.7		458,712			18.9		438,594			20.5		347,654			17.5
Land and other		0			0.0		0			0.0		0			0.0		925			0.0		956			0.0
		1,679,265			39.0		1,038,410			35.2		978,618			40.4		910,011			42.6		921,877			46.3
Mortgage - construction:
One- to four-family residential		356,644			8.3		271,480			9.2		280,514			11.6		214,849			10.1		215,844			10.9
Multifamily residential		102,166			2.4		127,424			4.3		96,297			4.0		88,977			4.2		80,728			4.1
Commercial real estate		194,085			4.5		154,061			5.2		104,108			4.3		92,089			4.3		81,347			4.1
		652,895			15.2		552,965			18.7		480,919			19.9		395,915			18.6		377,919			19.1
Total mortgage loans		2,332,160			54.2		1,591,375			53.9		1,459,537			60.3		1,305,926			61.2		1,299,796			65.4
Commercial and consumer:
Business, private and corporate banking		1,311,197			30.4		948,304			32.2		655,727			27.0		520,866			24.3		435,284			21.9
Consumer - direct		543,895			12.6		309,931			10.5		246,578			10.2		244,097			11.4		235,423			11.8
Consumer - indirect		120,894			2.8		99,697			3.4		62,896			2.5		65,169			3.1		17,682			0.9
Total commercial and consumer loans		1,975,986			45.8		1,357,932			46.1		965,201			39.7		830,132			38.8		688,389			34.6
Total loans receivable		4,308,146			100.0		2,949,307			100.0		2,424,738			100.0		2,136,058			100.0		1,988,185			100.0
Deferred loan origination fees, net of costs		(6,907		)			(7,276		)			(6,450		)			(5,980		)			(5,518		)
Gross loans receivable		4,301,239					2,942,031					2,418,288					2,130,078					1,982,667
Allowance for loan losses		(49,362		)			(35,605		)			(27,866		)			(20,599		)			(16,740		)
Loans receivable, net		$	4,251,877				$	2,906,426				$	2,390,422				$	2,109,479				$	1,965,927

 

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Contractual Principal Payments.  The following table sets forth the scheduled contractual principal repayments for Sterling’s loan portfolio at December 31, 2004.  Demand loans, loans having no stated repayment schedule and no stated maturity, and overdrafts are reported as due in one year or less. Loan balances do not include undisbursed loan proceeds, deferred loan origination costs and fees, or allowances for loan losses.

 

		Balance			Principal Payments
		Outstanding at			Contractually Due in Fiscal Years
		December 31, 2004			2005			2006-2009			Thereafter
		(Dollars in thousands)
Mortgage - permanent:
Fixed rate		$	730,998		$	24,981		$	131,812		$	574,205
Variable rate		948,267			64,414			317,111			566,742
Mortgage - construction		652,895			374,264			237,525			41,106
Consumer - direct		543,894			216,791			99,964			227,139
Consumer - indirect		120,895			25,422			87,702			7,771
Business, private and corporate banking		1,311,197			672,563			322,789			315,845
		$	4,308,146		$	1,378,435		$	1,196,903		$	1,732,808

 

Loan Servicing.  Sterling services its own loans, as well as loans owned by others.  Loan servicing includes collecting and remitting loan payments, accounting for principal and interest, holding escrow funds for the payment of real estate taxes and insurance premiums, contacting delinquent borrowers and supervising foreclosures in the event of unremedied defaults.  For loans serviced by others, Sterling generally receives a fee based on the unpaid principal balance of each loan to compensate for the costs of performing the servicing function.

 

For residential mortgage loans serviced for other investors, Sterling receives a fee, generally ranging from 24 to 37 basis points of the unpaid principal balance.  At December 31, 2004 and 2003, Sterling serviced for itself and for other investors, residential mortgage loans totaling $1.17 billion and $737.6 million, respectively.  Of such mortgage loans, Sterling serviced $373.6 million and $329.4 million, respectively, at these dates for FHLMC, FHLB and FNMA. Sterling’s ability to continue as a seller/servicer for these agencies is dependent upon meeting their qualifications.  Sterling currently meets all applicable requirements.  In November 2004, INTERVEST acquired PWWA, expanding Sterling’s commercial real estate servicing portfolio by $392.2 million.

 

Sterling receives a fee for servicing commercial and multifamily real estate loans for other investors.  This fee generally ranges from 5 to 25 basis points of the unpaid principal balance.  At December 31, 2004 and 2003, Sterling serviced for itself and other investors, commercial and multifamily real estate loans totaling $1.48 billion and $842.0 million, respectively.

 

Sterling also receives a fee of 50 basis points of the unpaid principal balance of each loan for servicing automobile loans for other investors.  At December 31, 2004 and 2003, Sterling serviced $7.8 million and $25.9 million of such loans, respectively.

 

Secondary Market Activities.  Sterling has developed correspondent relationships with a number of mortgage companies and financial institutions to facilitate the origination or purchase and sale of mortgage loans in the secondary market on either a participation or whole loan basis.  Substantially all of such purchased loans or participations are secured by real estate.  Those agents who present loans to Sterling for purchase are required to provide a processed loan package prior to commitment.  Sterling then underwrites the loan in accordance with its established lending standards.

 

Sterling, from time to time, sells participations in certain commercial real estate loans to investors on a servicing-retained basis.  During the years ended December 31, 2004 and 2003, Sterling sold approximately $16.3 million and $35.9 million in loans under participation agreements, resulting in net gains of $44,000 and $328,000, respectively.

 

Sterling generally receives a fee of approximately 100 to 200 basis points of the principal balance of mortgage loans for releasing the servicing.  In 2004, 64% of Sterling’s sales of Federal Housing Administration (“FHA”) and Department of Veterans Affairs (“VA”) insured loans were sold into the secondary market on a loan-by-loan, servicing-released basis, compared with 41% in 2003.

 

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In 2004, 36% of Sterling’s sales of conventional, FHA and VA insured loans were sold into the secondary market on a servicing-retained basis, compared with 59% in 2003.  Sterling records a valuation of approximately 100 to 115 basis points of the principal balance of such loans for retaining the servicing.  At December 31, 2004 and 2003, Sterling had recorded as net assets $4.1 million and $3.5 million in servicing rights, respectively.  See Note 3 of “Notes to Consolidated Financial Statements.”

 

Loan Commitments.  Sterling makes written commitments to individual borrowers and mortgage brokers for the purposes of originating and purchasing loans.  These loan commitments establish the terms and conditions under which Sterling will fund the loans.  Sterling had outstanding commitments to originate or purchase loans, the undisbursed portion of which aggregated $485.2 million and $279.0 million at December 31, 2004 and 2003, respectively.  Sterling also had secured and unsecured commercial and personal lines of credit, the undisbursed portion of which was approximately $623.1 million and $370.8 million at December 31, 2004 and 2003, respectively.  See Note 17 of “Notes to Consolidated Financial Statements.”

 

Derivatives and Hedging.  Sterling, through its subsidiary Action Mortgage, enters into interest rate lock commitments to prospective residential mortgage borrowers.  Action Mortgage hedges IRR by entering into nonbinding (“best-efforts”) forward sales agreements with third parties.  In addition, to improve and protect the profit margin on loans sold into the secondary market, Action Mortgage hedges IRR by entering into binding (“mandatory”) forward sales agreements on ABS with third parties.

 

The risks inherent in such mandatory forward sales agreements include the risk that, if for any reason Action Mortgage does not close and sell the loans in question, it is nonetheless obligated to deliver ABS to the counterparty on the agreed terms.  Action Mortgage could incur significant costs in acquiring replacement loans or ABS and such costs could have a material adverse impact on mortgage banking operations in future periods, especially in rising interest rate environments.  During the years ended December 31, 2004 and 2003, Sterling recorded $231,000 and $1.1 million in revenue from forward sales agreements and similar transactions, respectively.  This revenue is a component of income from mortgage banking operations in the income statement.

 

Rate lock commitments and forward sales agreements are considered to be derivatives. Sterling has recorded the estimated fair values of the rate lock commitments and forward sales agreements on its balance sheet in either other assets or other liabilities. Changes in the fair values of these derivative instruments are recorded in income from mortgage banking operations in the income statement as the changes occur.  The estimated fair value of rate lock commitments and forward sales agreements were greater than the contracted amounts, which resulted in assets of $76,000 and $12,000, respectively, at December 31, 2004.  Rate lock commitments and forward sales agreements were a liability of $84,000 and an asset of $73,000, respectively, at December 31, 2003.

 

Classified Assets, Real Estate Owned and Delinquent Loans.  To measure the quality of assets, including loans and real estate owned (“REO”), Sterling has established guidelines for classifying assets and determining provisions for anticipated loan and REO losses. Under these guidelines, an allowance for anticipated loan and REO losses is established when certain conditions exist. This system for classifying and reserving for loans and REO is administered by Sterling’s Special Assets Department, which is responsible for minimizing loan deficiencies and losses therefrom.  An oversight committee, comprised of senior management, monitors the activities of the Special Assets Department and reports results to Sterling’s Board of Directors.

 

Under this system, Sterling classifies loans and other assets it considers of questionable quality.  Sterling’s system employs the classification categories of “substandard,” “doubtful” and “loss.” Substandard assets have deficiencies, which give rise to the distinct possibility that Sterling will sustain some loss if the deficiencies are not corrected.  Doubtful assets have the weaknesses of substandard assets, and on the basis of currently existing facts, there is a high probability of loss.  An asset classified as loss is considered uncollectible and of such little value that it should not be included as an asset of Sterling.  Total classified assets decreased to $68.3 million at December 31, 2004, from $84.8 million at December 31, 2003.  As a percentage of total assets, classified assets decreased from the prior year.  The percentage of classified assets to total assets was 0.98% and 1.98% at December 31, 2004 and 2003, respectively.  See “– Major Classified Loans.”

 

Assets classified as substandard or doubtful require the establishment of valuation allowances in amounts considered by management to be adequate under accounting principles generally accepted in the United States of America (“GAAP”).  Assets classified as loss require either a specific valuation allowance of 100% of the amount classified or a write-off of

 

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such amount.  At December 31, 2004, Sterling’s assets classified as loss totaled $3.6 million compared to $3.3 million at December 31, 2003.  Judgments regarding the adequacy of a valuation allowance are based on ongoing evaluations of the nature, volume and quality of the loan portfolio, REO and other assets, specific problem assets and current economic conditions that may affect the recoverability of recorded amounts.

 

REO is recorded at the lower of estimated fair value, less estimated selling expenses, or carrying value at foreclosure. Fair value is defined as the amount in cash or other consideration that a real estate asset would yield in a current sale between a willing buyer and a willing seller.  Development and improvement costs relating to the property are capitalized to the extent they are deemed to be recoverable upon disposal.  The carrying value of REO is continuously evaluated and, if necessary, an allowance is established to reduce the carrying value to net realizable value, which considers, among other things, estimated direct holding costs and selling expenses.

 

The following table sets forth the activity in Sterling’s REO for the periods indicated:

 

 

Major Classified Loans.  Sterling’s classified loans, with a net carrying value at December 31, 2004 of more than     $4.0 million each, which together constitute 34.2% of classified assets, included the following:

 

Sterling holds an income property loan secured by a specialized care facility located in Arizona.  The aggregate carrying value of this loan at December 31, 2004, was $8.1 million.  This loan remains current as to interest, and the term has been extended through the end of March 2005.

 

Sterling holds two income property construction loans and a commercial line of credit secured by a hotel in western Washington.  The aggregate carrying value of these loans at December 31, 2004 was $5.7 million.  Borrowers are performing under the terms of a conditional forbearance agreement, and negotiations regarding a revised forbearance agreement are in progress.

 

Sterling holds an income property loan secured by a specialized care facility located in western Washington.  The aggregate carrying value of this loan at December 31, 2004 was $5.2 million.  The loan has been classified due to the facility’s low occupancy rates, but continues to perform as agreed and is being closely monitored.

 

Sterling holds an income property loan secured by four hotel properties located in the Pacific Northwest.  The aggregate carrying value of this loan at December 31, 2004 was $4.3 million.  Sterling believes potential losses are reserved sufficiently.  These hotels are operating under receivership, and the receiver continues to actively market the properties with prospective buyers.

 

Major Real Estate Owned.  At December 31, 2004, the aggregate value of outstanding REO properties was $1.9 million.  None of the REO properties had a carrying value of more than $1.0 million.

 

Delinquent Loan Procedures.  Delinquent and problem loans are part of any lending business. If a borrower fails to make a required payment when due, Sterling institutes internal collection procedures. For residential mortgage and consumer loans, Sterling’s collection procedures generally require that an initial request for payment be mailed to the borrower when the loan is 15 days past due. At 25 days past due, the borrower is contacted by telephone and payment is requested orally.  At 30 days past due, Sterling records the loan as a delinquency. In the case of delinquent residential

 

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mortgage loans, a notice of intent to foreclose is mailed at 45 days past due. If the loan is still delinquent 30 days following the mailing of the notice of intent to foreclose, Sterling generally initiates foreclosure proceedings.

 

For consumer loans, a demand letter is sent when the account becomes delinquent for two payments. Additional collection work or repossession may follow. In certain instances, Sterling may modify the loan or grant a limited moratorium on loan payments to enable the borrower to reorganize his or her financial affairs. Collection procedures similar to those used for consumer and residential mortgage loans are followed for commercial, construction and income property loans, with the exception that these accounts are generally handled as a joint effort between the originating loan officer and the Special Assets Department during initial stages of delinquency. On or before 60 days of delinquency, the collection effort is typically shifted from the originating loan officer to the Special Assets Department.

 

The following table summarizes the principal balances of nonperforming assets at the dates indicated:

 

		December 31,
		2004			2003			2002			2001			2000
		(Dollars in thousands)
Nonaccrual loans		$	10,738		$	16,208		$	16,278		$	21,102		$	8,385
Restructured loans		1,305			1,164			594			886			0
Total nonperforming loans		12,043			17,372			16,872			21,988			8,385
Real estate owned (1)		1,865			4,226			3,953			2,982			6,407
Total nonperforming assets		$	13,908		$	21,598		$	20,825		$	24,970		$	14,792
Ratio of total nonperforming assets to total assets		0.20		%	0.50		%	0.59		%	0.82		%	0.56		%
Ratio of total nonperforming loans to gross loans		0.28		%	0.59		%	0.70		%	1.03		%	0.42		%
Ratio of allowance for estimated losses on loans to total nonperforming loans (2)		538.3		%	216.6		%	174.3		%	91.9		%	190.1		%

 

(1)   Amount is net of the allowance for REO losses.

 

(2)          Excludes loans classified as loss. Loans classified as loss that are excluded from allowance for loan losses were $3,528,000, $2,897,000, $2,067,000, $1,843,000 and $803,000 at December 31, 2004, 2003, 2002, 2001 and 2000, respectively.  There were no loans classified as loss that are excluded from total nonperforming loans in any of the periods.

 

Sterling regularly reviews the collectibility of accrued interest and generally ceases to accrue interest on a loan when either principal or interest is past due by 90 days or more. Any accrued and uncollected interest is reversed from income at that time. Loans may be placed in nonaccrual status earlier if, in management’s judgment, the loan may be uncollectible. Interest on such a loan is then recognized as income only if collected or if the loan is restored to performing status. Interest income of $659,000, $1,025,000 and $1,103,000 was recorded on these loans during the years ended December 31, 2004, 2003 and 2002, respectively.  Additional interest income of $1,348,000, $1,487,000 and $778,000 would have been recorded during the years ended December 31, 2004, 2003 and 2002, respectively, if nonaccrual and restructured loans had been current in accordance with their original contractual terms.

 

Allowance for Loan and Real Estate Owned Losses.  Generally, Sterling establishes specific allowances for the difference between the anticipated fair value (market value less selling costs, foreclosure costs and projected holding costs), adjusted for other possible sources of repayment, and the book balance (loan principal and accrued interest or carrying value of REO) of its loans classified as loss and REO.  Each classified loan and REO property is reviewed at least monthly. Allowances are established or periodically adjusted, if necessary, based on the review of information obtained through on-site inspections, market analysis, appraisals and purchase offers.

 

The allowance for loan losses is maintained at a level deemed appropriate by management to adequately provide for known and probable losses and inherent risks in the loan portfolio.  The allowance is based upon a number of factors, including prevailing and anticipated economic trends, industry experience, estimated collateral values, management’s assessment of credit risk inherent in the portfolio, delinquency trends, historical loss experience, specific problem loans and other relevant factors.

 

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Additions to the allowance, in the form of provisions, are reflected in current operating results, while charge-offs to the allowance are made when a loss is determined to have occurred.  Because the allowance for loan losses is based on estimates, ultimate losses may materially differ from the estimates.  See Note 5 of “Notes to Consolidated Financial Statements.”

 

Management believes that the allowance for loan losses is adequate given the composition and risks of the loan portfolios, although there can be no assurance that the allowance will be adequate to cover all contingencies.  The following table sets forth information regarding changes in Sterling’s allowance for estimated losses on loans for the periods indicated:

 

 

		Years Ended December 31,
		2004			2003			2002			2001			2000
		(Dollars in thousands)
Balance at beginning of period		$	35,605		$	27,866		$	20,599		$	16,740		$	15,603
Charge-offs:
Mortgage - permanent		(59		)	(165		)	(48		)	(270		)	(209		)
Mortgage - construction		(645		)	(106		)	(868		)	(756		)	(618		)
Consumer - direct		(1,373		)	(1,146		)	(954		)	(1,011		)	(1,181		)
Consumer - indirect		(370		)	(445		)	(407		)	(544		)	(1,048		)
Business, private and corporate banking		(3,036		)	(2,391		)	(2,776		)	(2,016		)	(835		)
Total charge-offs		(5,483		)	(4,253		)	(5,053		)	(4,597		)	(3,891		)
Recoveries:
Mortgage - permanent		25			42			19			9			27
Mortgage - construction		2			3			2			31			1
Consumer - direct		214			160			208			203			165
Consumer - indirect		111			149			170			184			209
Business, private and corporate banking		16			268			54			29			26
Total recoveries		368			622			453			456			428
Net charge-offs		(5,115		)	(3,631		)	(4,600		)	(4,141		)	(3,463		)
Provisions for loan losses		12,150			10,500			11,867			8,000			4,600
Allowance for losses on assets acquired		6,722			870			0			0			0
Balance at end of period		$	49,362		$	35,605		$	27,866		$	20,599		$	16,740
Allowances allocated to loans classified as loss		$	3,528		$	2,897		$	2,067		$	1,843		$	803
Ratio of net charge-offs to average loans outstanding during the period		0.13		%	0.13		%	0.21		%	0.21		%	0.18		%

 

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Allowances are provided for individual loans when management considers ultimate collection to be questionable. Such allowances are based, among other factors, upon the estimated net realizable value of the collateral of the loan or guarantees, if applicable. The following table sets forth the allowances for estimated losses on loans by category and summarizes the percentage of total loans in each category to total loans:

 

 

		December 31,
		2004					2003					2002					2001					2000
		Allowance Amount			Loans in Category as a Percentage of Total Loans		Allowance Amount			Loans in Category as a Percentage of Total Loans		Allowance Amount			Loans in Category as a Percentage of Total Loans		Allowance Amount			Loans in Category as a Percentage of Total Loans		Allowance Amount			Loans in Category as a Percentage of Total Loans
		(Dollars in thousands)
Mortgage - permanent		$	10,632		39.0		$	4,902		35.2		$	2,881		40.4		$	2,285		42.6		$	3,801		46.3
Mortgage - construction		6,264			15.2		6,336			18.7		6,199			19.9		3,601			18.6		3,903			19.1
Consumer - direct		7,247			12.6		3,843			10.5		2,986			10.2		2,812			11.4		2,907			11.8
Consumer - indirect		1,156			2.8		1,676			3.4		1,349			2.5		1,202			3.1		760			0.9
Business, private and corporate banking		23,710			30.4		17,979			32.2		14,014			27.0		10,211			24.3		5,166			21.9
Unallocated		353			N/A		869			N/A		437			N/A		488			N/A		203			N/A
		$	49,362		100.0		$	35,605		100.0		$	27,866		100.0		$	20,599		100.0		$	16,740		100.0

 

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Investments and Asset-Backed Securities

 

Investments and ABS that management has the positive intent and ability to hold to maturity are classified as held to maturity and carried at amortized cost.  At December 31, 2004 and 2003, investments and ABS classified as held to maturity were $47.4 million and $2.2 million, respectively.  See “MD&A – Critical Accounting Policies – Investments and ABS.”

 

At December 31, 2004 and 2003, investments and ABS classified as available for sale were $2.16 billion and $1.07 billion, respectively.  The carrying value of these investments and ABS at December 31, 2004 and 2003 includes net unrealized losses of $14.8 million and $23.4 million, respectively.  Fluctuations in prevailing interest rates continue to cause volatility in this component of accumulated comprehensive income and may continue to do so in future periods.  See “MD&A – Critical Accounting Policies – Investments and ABS.”

 

Sterling invests primarily in ABS issued by FHLMC and FNMA and other agency obligations.  Such investments provide Sterling with a relatively liquid source of interest income and collateral, which can be used to secure borrowings. Sterling invests primarily in investment-grade investments and ABS.  See “MD&A – Results of Operations – Other Income/Expense” and Note 1 of “Notes to Consolidated Financial Statements.”

 

The following table provides the carrying values, contractual maturities and weighted average yields of Sterling’s investment and ABS portfolio at December 31, 2004.  Actual maturities may differ from the contractual maturities, because issuers may have the right to call or prepay obligations with or without prepayment penalties.

 

		Maturity
		Less than One Year			One to Five Years			Over Five to Ten Years			Over Ten Years			Total
		(Dollars in thousands)
Asset-backed securities
Balance		$	0		$	0		$	172,074		$	1,864,846		$	2,036,920
Weighted average yield		0.00		%	0.00		%	4.14		%	4.67		%	4.62		%
U.S. government and agency obligations
Balance		$	5,007		$	23,063		$	0		$	0		$	28,070
Weighted average yield		2.77		%	2.95		%	0.00		%	0.00		%	2.87		%
FHLB Seattle stock, at cost
Balance		$	0		$	0		$	0		$	74,846		$	74,846
Weighted average yield (1)		0.00		%	0.00		%	0.00		%	2.66		%	2.66		%
Municipal bonds
Balance		$	326		$	2,642		$	4,507		$	39,974		$	47,449
Weighted average yield (2)		4.89		%	3.90		%	3.44		%	4.50		%	4.37		%
Other (3)
Balance		$	715		$	80		$	0		$	16,505		$	17,300
Weighted average yield		1.83		%	3.20		%	0.00		%	0.00		%	0.09		%
Total carrying value		$	6,048		$	25,785		$	176,581		$	1,996,171		$	2,204,585
Weighted average yield		2.77		%	3.05		%	4.12		%	4.56		%	4.50		%

 

(1)          The weighted average yield on FHLB Seattle stock is based upon the dividends received for the year ended December 31, 2004.  Sterling expects the dividends in 2005 to be substantially lower than those in 2004.

(2)          The weighted average yields on municipal bonds reflect the actual yields on the bonds and are not presented on a tax-equivalent basis.

(3)          Other investments relate primarily to limited partnership interests in low-income housing projects.

 

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