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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
/x/ QUARTERLY REPORT PURSUANT TO SECTION 13
OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 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 000-15540
FRONTIER FINANCIAL CORPORATION
(Exact Name of Registrant as Specified in its Charter)
Washington 91-1223535
(State or Other Jurisdiction of (IRS Employer Identification
Incorporation or Organization) Number)
332 SW Everett Mall Way
P.O. Box 2215
Everett, Washington 98203
(Address of Principal Executive Offices) (Zip Code)
(425) 514-0700
(Registrant's Telephone Number, Including Area Code)
(Former name, former address and former fiscal year, if changed since last
report)
------------
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 a check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act) [X] Indicate the number of shares outstanding
of each of the issuer's classes of common stock, as of the latest practicable
date.
Class Outstanding at October 27, 2004
- -------------------------- --------------------------------------------
Common Stock, no par value 18,651,168
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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
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INDEX TO QUARTERLY REPORT ON FORM 10-Q
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PART I - Financial Information Page
- ------------------------------ ----
Item 1. Financial Statements
Consolidated Balance Sheet -September 30, 2004
and Year End 2003 1
Consolidated Statement of Income - Three and nine months
Ended September 30, 2004 and 2003 2
Consolidated Statement of Cash Flows - Nine months
Ended September 30, 2004 and 2003 3-4
Notes to the Consolidated Financial Statements 5-8
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 9-22
Item 3. Quantitative and Qualitative Disclosures about
Market Risk 22
Item 4. Controls and Procedures 23-24
PART II - Other Information
Item 1. Legal Proceedings 25
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases 25
of Equity Securities
Item 4. Submission of Matters to a Vote by Security Holders 25
Item 5. Other Information 26
Item 6. Exhibits and Reports on Form 8-K 26
Signatures 27
Certifications 29-32
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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
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CONSOLIDATED BALANCE SHEET
- --------------------------------------------------------------------------------
(In thousands, except shares)
- -----------------------------
September 30, December 31,
ASSETS 2004 2003
---------------- -----------------
Cash & due from banks $77,357 $74,552
Federal funds sold 22,656 8
Securities:
Available for sale-fair value 142,664 175,726
Held to maturity-amortized cost 10,515 12,189
---------------- -----------------
Total securities 153,179 187,915
Loans receivable:
Held for sale, fair value $3,428 and $1,984 3,382 1,953
Held for portfolio, net of unearned income 1,940,055 1,769,763
Less allowance for loan losses (31,569) (29,556)
---------------- -----------------
Net loans 1,911,868 1,742,160
Premises & equipment, net 29,475 28,756
Other real estate owned 1,013 4,162
Intangible assets 6,476 6,476
Bank owned life insurance 17,220 16,653
Other assets 13,806 14,711
---------------- -----------------
TOTAL ASSETS $2,233,050 $2,075,393
================ =================
LIABILITIES
Deposits:
Noninterest bearing $309,679 $271,389
Interest bearing 1,474,758 1,395,628
---------------- -----------------
Total deposits 1,784,437 1,667,017
Federal funds purchased and
securities sold under repurchase agreements 8,762 10,015
Federal Home Loan Bank advances 185,092 170,104
Other liabilities 12,868 8,851
---------------- -----------------
TOTAL LIABILITIES 1,991,159 1,855,987
---------------- -----------------
SHAREOWNERS' EQUITY
Common stock, no par value; 100,000,000 shares
authorized; 18,646,764 and 18,550,060 shares issued
and outstanding at September 30, 2004
and December 31, 2003 121,093 118,693
Retained earnings 117,904 97,221
Accumulated other comprehensive income,
net of tax effect 2,894 3,492
---------------- -----------------
TOTAL SHAREOWNERS' EQUITY 241,891 219,406
---------------- -----------------
TOTAL LIABILITIES AND SHAREOWNERS' EQUITY $2,233,050 $2,075,393
================ =================
The accompanying notes are an integral part of these financial statements.
-1-
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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
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CONSOLIDATED STATEMENT OF INCOME
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(In thousands, except for per share amounts) Three Months Ended Nine Months Ended
- -------------------------------------------- ---------------------------- ------------------------------
September 30, September 30, September 30, September 30,
2004 2003 2004 2003
------------- -------------- ------------- ----------------
INTEREST INCOME
Interest and fees on loans $33,744 $31,226 $97,206 $95,301
Interest on investments 1,612 2,264 5,446 6,249
------------- -------------- ------------- ----------------
Total interest income 35,356 33,490 102,652 101,550
------------- -------------- ------------- ----------------
INTEREST EXPENSE
Interest on deposits 6,571 7,173 19,213 23,268
Interest on borrowed funds 2,141 1,937 6,347 5,864
------------- -------------- ------------- ----------------
Total interest expense 8,712 9,110 25,560 29,132
------------- -------------- ------------- ----------------
Net interest income 26,644 24,380 77,092 72,418
------------- -------------- ------------- ----------------
PROVISION FOR LOAN LOSSES (1,000) (850) (2,500) (2,600)
Net interest income after provison for loan
losses 25,644 23,530 74,592 69,818
------------- -------------- ------------- ----------------
NONINTEREST INCOME
Gain on sale of securities 10 99 27 190
Gain on sale of secondary mortgage loans 200 622 736 1,785
Service charges on deposit accounts 1,238 1,169 3,771 3,354
Other noninterest income 1,788 1,550 5,414 4,404
------------- -------------- ------------- ----------------
Total noninterest income 3,236 3,440 9,948 9,733
------------- -------------- ------------- ----------------
NONINTEREST EXPENSE
Salaries and employee benefits 8,056 7,142 23,463 20,916
Occupancy expense 1,618 1,499 5,230 4,684
State business taxes 438 446 1,306 1,387
Other noninterest expense 2,237 2,198 6,741 6,714
------------- -------------- ------------- ----------------
Total noninterest expense 12,349 11,285 36,740 33,701
------------- -------------- ------------- ----------------
INCOME BEFORE INCOME TAX 16,531 15,685 47,800 45,850
PROVISION FOR INCOME TAX (5,534) (5,208) (16,214) (15,564)
------------- -------------- ------------- ----------------
NET INCOME $10,997 $10,477 $31,586 $30,286
============= ============== ============= ================
Weighted average number of
shares outstanding for the period 18,635,445 18,505,346 18,618,199 18,561,698
Basic earnings per share $0.59 $0.57 $1.70 $1.63
============= ============== ============= ================
Weighted average number of diluted shares
outstanding for period 18,752,550 18,619,111 18,731,188 18,648,682
Diluted earnings per share $0.59 $0.56 $1.69 $1.62
============= ============== ============= ================
The accompanying notes are an integral part of these financial statements.
-2-
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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
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CONSOLIDATED STATEMENT OF CASH FLOWS
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(In thousands)
- --------------
CASH FLOWS FROM OPERATING ACTIVITIES September 30, 2004 September 30, 2003
- ------------------------------------ ------------------ ------------------
Net Income $31,586 $30,286
Adjustments to reconcile net income to net cash
provided by operating activities
Depreciation and amortization 2,950 2,817
Provision for loan losses 2,500 2,600
Gain on sale of other real estate owned 53 30
Gain (loss) on sale of fixed assets 13 (12)
Gain on sale of securities 27 190
Gain on sale of secondary mortgage loans 736 1,785
Deferred taxes (229) -
Changes in operating assets and liabilities
Income taxes payable (601) 2,338
Interest receivable 840 (49)
Interest payable 661 (803)
Proceeds from sales of mortgage loans 46,961 202,594
Origination of mortgage loans held for sale (48,390) (197,980)
Dividend income from Federal Home Loan Bank (397) (609)
Other operating activities 687 (5,337)
------------------ ---------------
Net cash provided by operating activities 37,397 37,850
------------------ ---------------
CASH FLOWS FROM INVESTMENT ACTIVITIES
Net cash flows from fed funds sold (22,647) 10,479
Proceeds from the maturities of AFS securities 49,518 23,675
Proceeds from maturities HTM securities 145 33,480
Proceeds from the sale of AFS securities 1,086 4,381
Purchase of AFS securities (17,239) (116,537)
Purchase of HTM securities - (26,565)
Net cash flows from loan activities (171,721) (67,350)
Purchases of premises and equipment (2,612) (1,582)
Proceeds from the sale of OREO 4,133 251
Proceeds from sale of property and equipment 1 31
Increase in surrender value of bank
owned life insurance (567) (638)
Increase in other investing activities 290 3,189
------------------ --------------
Net cash used by investing activities (159,613) (137,186)
------------------ --------------
CASH FLOWS FROM FINANCING ACTIVITIES
Net change in core deposits 76,059 168,444
Net change in certificates of deposit 41,361 (56,067)
Stock options exercised 1,872 896
Purchase of common shares - (9,148)
Cash dividends paid (10,607) (9,490)
Advances from FHLB 35,000 -
Repayment of FHLB advances (20,012) (10,013)
Net change in Federal Funds purchased and securities
sold under repurchase agreements (1,253) (1,065)
Increase (decrease) in other financing activities 2,602 (868)
------------------ --------------
Net cash provided by financing activities 125,022 82,689
------------------ --------------
The accompanying notes are an integral part of these financial statements.
(Continued on next page)
-3-
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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
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CONSOLIDATED STATEMENT OF CASH FLOWS
- --------------------------------------------------------------------------------
INCREASE (DECREASE) IN CASH AND DUE FROM BANKS $2,805 ($16,647)
CASH AND DUE FROM BANKS AT BEGINNING
OF YEAR 74,552 88,647
------------------ --------------
CASH AND DUE FROM BANKS AT END
OF PERIOD $77,357 $72,000
==================== ==============
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
- ------------------------------------------------
Cash paid during the period for interest $24,899 $29,935
Cash paid during the period for income taxes 16,550 14,337
SUPPLEMENTAL INFORMATION ABOUT NONCASH INVESTING AND FINANCING ACTIVITIES
- -------------------------------------------------------------------------
Other real estate acquired in settlement of loans in 2004 and 2003 were $954
thousand and $869 thousand, respectively.
The accompanying notes are an integral part of these financial statements.
-4-
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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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NOTE 1. PRINCIPLES OF CONSOLIDATION - RESULTS OF OPERATIONS
The consolidated financial statements of Frontier Financial Corporation ("FFC"
or the "Corporation") include the accounts of Frontier Financial Corporation and
its subsidiaries Frontier Bank (the "Bank") and FFP, Inc. All significant
intercompany accounts and transactions have been eliminated. The consolidated
financial statements have been prepared substantially consistent with the
accounting principles applied in the 2003 Annual Report on Form 10-K for the
year ended December 31, 2003. In the opinion of management, the consolidated
financial statements reflect all adjustments necessary for a fair statement of
the results for the interim periods presented. Operating results for the nine
months ending September 30, 2004 are not necessarily indicative of the results
that may be expected for year-end December 31, 2004.
At September 30, 2004, the Corporation has a stock-based employee compensation
plan. The Corporation accounts for the plan under recognition and measurement
principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and
related interpretations. No stock based employee compensation costs are
reflected in net income, as all options granted under this plan 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 Corporation had applied the fair value recognition provisions of
FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based
employee compensation.
(In thousands)
- --------------
For the quarter ended September 30,
-----------------------------------
Proforma disclosures 2004 2003
---- ----
Net income as reported $10,997 $10,477
Additional compensation for
fair value of stock options - -
------- -------
Proforma net income $10,997 $10,477
======= =======
Earnings per share
Basic
As reported $0.59 $0.57
Proforma $0.59 $0.57
===== =====
Diluted
As reported $0.59 $0.56
Proforma $0.59 $0.56
===== =====
The Corporation did not grant any options in the quarters ending September 30,
2004 and 2003. As of September 30, 2004 there were outstanding options to
purchase 402,268 shares under the plan, representing 2.2% of total shares
outstanding.
-5-
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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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NOTE 2. INVESTMENT SECURITIES
The investment portfolio of the Corporation is classified in one of two groups:
1) securities Held-to-Maturity (HTM), and 2) securities Available-For-Sale
(AFS). Securities that are classified as HTM, are carried at cost, adjusted for
amortization of premiums and accretion of discounts which are recognized as
adjustments to income.
Securities that are classified as AFS, are carried at fair value. Unrealized
gains and losses are excluded from earnings and reported as a separate component
of equity capital. AFS securities may be sold at any time.
As of September 30, 2004, there were no issuers of these securities with an
aggregate book value that exceeds 10% of shareowner equity.
Gains and losses on both HTM and AFS securities that are disposed of prior to
maturity, are based on the net proceeds and the adjusted carrying amount of the
specific security sold.
The tables below displays the characteristics of the AFS and HTM portfolios as
of September 30, 2004:
AGGREGATE FAIR VALUE AND AMORTIZED COST OF INVESTMENTS
- ------------------------------------------------------
(In thousands)
- --------------
Less than 12 months
12 months or more
Gross Gross Gross
Amortized Unrealized Unrealized Unrealized Aggregate
Cost Gains Losses Losses Fair Value
------------- -------------- --------------- --------------- -------------
AFS SECURITIES
--------------
Equities $27,034 $3,941 ($150) ($302) $30,523
U.S. Treasuries 13,236 67 (20) - 13,283
U.S. Agencies 49,768 49 (86) - 49,731
Corporate securities 48,129 992 - (37) 49,084
Municipal securities 45 - - (2) 43
------------- -------------- --------------- --------------- -------------
Totals 138,212 5,049 (256) (341) 142,664
------------- -------------- --------------- --------------- -------------
HTM SECURITIES
--------------
Municipal securities 8,986 305 - - 9,291
Corporate securities 1,529 175 - - 1,704
------------- -------------- --------------- --------------- -------------
Totals 10,515 480 - - 10,995
------------- -------------- --------------- --------------- -------------
Totals $148,727 $5,529 ($256) ($341) $153,659
============= ============== =============== =============== =============
MATURITY SCHEDULE OF SECURITIES
--------------------------------------------
Available for Sale Held to Maturity
Amortized Fair Amortized Fair
MATURITY Cost Value Cost Value
-------------------------- -------------- --------------- ---------------
0-1 Yr $66,634 $70,495 $875 $879
1-5 Yrs 66,763 66,974 7,434 7,649
5-10 Yrs 2,000 2,002 677 764
Over 10 Yrs 2,815 3,193 1,529 1,703
------------- -------------- --------------- ---------------
$138,212 $142,664 $10,515 $10,995
============= ============== =============== ===============
-6-
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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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NOTE 2 - (Continued)
We currently hold three types of securities in our available-for-sale portfolio
that have had an unrealized loss for more than one year.
The first is a Housing Finance Commission municipal bond with a book value of
$45 thousand. The reason for the sub-par performance of this bond is mainly due
to the underlying collateral, which is housing. This collateral will cause the
bond to act like a CMO in that the prepayment speed of the underlying mortgages
could increase, causing the bond to be paid off sooner than originally
anticipated. The State has the right to fully redeem this bond on July 1st of
any year. The bond is AAA rated, all coupon payments have been made and we do
not anticipate the municipality to default paying the principal at maturity.
Therefore, we do not consider any portion of this bond to be
other-than-temporarily impaired, and we have the ability and intent to hold the
bond until maturity.
The next type of security is 35,100 shares of Federal Home Loan Mortgage
Corporation (Freddie Mac) preferred stock, DRD, with a book value of $2.2
million and Federal National Mortgage Association (FNMA) preferred stock, DRD,
with a book value of $2.0 million. These situations are not related to credit
deterioration, but changes in interest rates. If rates were to move downward in
the future, the market value would rise accordingly. They are rated AA- and all
dividend payments have been made. We do have the ability and intent to hold the
investment for a period of time sufficient for a market price recovery.
Therefore we do not consider any portion of this investment to be
other-than-temporarily impaired and we have the ability and intent to hold the
bond until maturity.
The last type are corporate bonds. There are two securities that have a par
value of $1.0 million each, and a combined book value of $2.1 million. Both
bonds are investment grade securities and have 2008 maturity. One of these bonds
carries a 3.25% coupon, which has been below market rate for some time. The
other bond has a 6.50% coupon which has a par-to-market value of a profit.
However, a premium was paid at the time the bond was purchased, so the book
value exceeds the market value. Therefore, we do not consider any portion of
these securities to be other than temporarily impaired and we do have the
ability and intent to hold these securities until maturity.
CHANGES IN AFS AND HTM SECURITIES
(In thousands)
- --------------
For the Quarter Ended September 30: 2004 2003
----------------- -----------------
AFS SECURITIES
Proceeds from sales $1,060 $2,031
Gross realized gains 54 99
Gross realized losses (44) -
Gross gains & losses included in earnings
transfers to the trading category - -
Net change in unrealized holding gains or
losses included in the separate
components of shareowners' equity ($598) ($42)
-7-
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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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NOTE 3. LOANS
The following is an analysis of the loan portfolio by major type of loans:
(In thousands)
- --------------
September 30, 2004 December 31, 2003
------------------ -----------------
Loans (including loans held for sale):
Commercial and agriculture $286,151 $269,354
Real Estate:
Commercial 856,329 809,799
Construction and land development 600,167 516,131
Residential 167,139 146,454
Installment and other 46,869 40,132
----------------- -----------------
1,956,655 1,781,870
Unearned Fee Income (13,218) (10,154)
----------------- -----------------
Total Loans $1,943,437 $1,771,716
================= =================
NOTE 4. Please see Item 5, page 26 for dividend information.
NOTE 5. IMPACT OF NEW ACCOUNTING PRONOUNCEMENTS
None
-8-
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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
- --------------------------------------------------------------------------------
AND RESULTS OF OPERATIONS
- --------------------------------------------------------------------------------
HIGHLIGHTS
- ----------
Consolidated net income of Frontier Financial Corporation (the "Corporation"),
for the third quarter of 2004 was $11.0 million versus $10.5 million for the
third quarter of 2003, or up 5.0%. Net interest income increased $2.3 million,
or 9.3%; noninterest income decreased $204 thousand, or 5.9% and the provision
for loan losses increased $150 thousand, or 17.6% from a year ago. Earnings per
diluted share were $.59 in the current quarter as compared to $.56 in the third
quarter of 2003. The largest contributing factor to net income was the increase
in net interest income. In the discussion below, comparison is with the third
quarter of 2004 and 2003, unless otherwise stated.
The year to date return on average assets (ROA) was 1.96% in 2004 as compared to
2.02% in 2003. Annualized return on average shareowners' equity (ROE) in 2004
was 18.29%, as compared to 19.93% in 2003.
FINANCIAL REVIEW
- ----------------
MARKET AREA
- -----------
Frontier Financial Corporation, headquartered in Everett, Washington, located
approximately 20 miles north of Seattle, is the parent of Frontier Bank, which
operates thirty-eight banking offices in Clallam, Jefferson and Kitsap counties
located on the Olympic Peninsula, King, Pierce, Snohomish, Skagit and Whatcom
counties, located on the east side of Puget Sound. These eight counties are
considered the market or service area of the Corporation and comprise the area
referred to as the Puget Sound Region. The Puget Sound Region is home to
approximately 60% of the population of Washington State. Its economy has become
more diversified over the past years with company headquarters for Amazon,
Costco, Starbucks, Weyerhauser and Microsoft located in the region.
BALANCE SHEET - September 30, 2004/December 31, 2003
- ----------------------------------------------------
Loan growth for the first three quarters of 2004 was $171.7 million, or 9.7%.
Investment securities for the same time period decreased $34.7 million, or
18.5%. Federal funds sold increased $22.6 million. The shift in the asset mix
was due to strong loan growth and calls and maturities in the investment
portfolio.
Loans, net of unearned income and allowance for loan losses, increased $169.7
million, or 9.7% to a balance of $1.91 billion at September 30, 2004 compared to
$1.74 billion at December 31, 2003. For the first nine months of 2004, new loan
originations were $999.5 million as compared to $724.8 million for the same
period 2003, representing a 37.9% increase. This is the fifth consecutive
quarter of loan growth in excess of $50 million. The growth in the third quarter
continues to be attributable to the strong real estate demand in the Puget Sound
region along with the additions to lending staff.
-9-
FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
- --------------------------------------------------------------------------------
ITEM 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
- --------------------------------------------------------------------------------
Balance Sheet - (Continued)
- --------------------------------------------------------------------------------
The Bank's loan mix has remained relatively unchanged in the principal areas of
lending which include: commercial and agriculture, real estate commercial, real
estate construction, residential, and installment. At September 30, 2004, 14.7%
of our loan portfolio was in commercial and agriculture loans, 44.0% was in real
estate commercial, 30.4% was in real estate construction, 8.5% was in
residential, and 2.4% installment.
On the liability side of the balance sheet, noninterest bearing deposits
increased $38.3 million, or 14.1% and interest bearing deposits increased $79.1
million, or 5.7%. NOW, Money Market, and sweep accounts increased $16.2 million,
or 6.4%; savings accounts increased $21.6 million, or 3.4%; and Time Deposits,
(cd's) increased $41.4 million, or 8.0%. Due to an increase in general interest
rates set by the FRB, the deposit growth mix has changed, with savings account
balances declining $20.3 million and cd's increased $36.7 million.
BALANCE SHEET -September 30, 2004/September 30, 2003
- ----------------------------------------------------
Below are abbreviated balance sheets at the end of the respective quarters which
indicates the changes that have occurred in our major portfolios over the past
year:
(In thousands)
- --------------
September 30, 2004 2003 $Change % Change
- ------------- ------------ ------------ ------------ ------------
ASSETS
Loans:
Commercial and agriculture $285,724 $280,570 $5,154 1.8%
Real Estate:
Commercial 854,918 760,848 94,070 12.4%
Construction and land development 590,803 495,321 95,482 19.3%
Residential 165,087 142,365 22,722 16.0%
Installment and other loans 46,905 40,219 6,686 16.6%
------------ ------------ ------------ ------------
Total loans 1,943,437 1,719,323 $224,114 13.0%
Investments 153,179 221,532 (68,353) -30.9%
Federal funds sold 22,656 3,049 19,607 643.1%
------------ ------------ ------------ ------------
Total earning assets $2,119,272 $1,943,904 $175,368 9.0%
============ ============ ============ ============
Total assets $2,233,050 $2,059,906 $173,144 8.4%
============ ============ ============ ============
LIABILITIES
Noninterest bearing deposits $309,679 $274,021 $35,658 13.0%
Interest bearing deposits:
NOW and money market accounts 267,588 271,805 (4,217) -1.6%
Savings accounts 647,400 631,166 16,234 2.6%
Time certificates 559,770 496,261 63,509 12.8%
------------ ------------ ------------ ------------
Total interest bearing deposits 1,474,758 1,399,232 75,526 5.4%
------------ ------------ ------------ ------------
Total deposits $1,784,437 $1,673,253 $111,184 6.6%
============ ============ ============ ============
Federal funds purchased and securities
sold under repurchase agreements 8,762 10,744 (1,982) -18.4%
FHLB advances 185,092 150,108 34,984 23.3%
Shareowners' equity $241,891 $213,123 $28,768 13.5%
-10-
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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
- --------------------------------------------------------------------------------
ITEM 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
- --------------------------------------------------------------------------------
Balance Sheet - (Continued)
- --------------------------------------------------------------------------------
Loans, investments, and federal funds sold are the components of earning assets.
One of the challenges of management is to allocate liquidity from the liability
side of the balance sheet to those earning assets which maximize yield in
concert with the degree of risk.
At September 30, 2004, loans were up $224.1 million, or 13.0% over the previous
year. The increase in loans over the previous year's corresponding quarter was
due, for the most part, to continued emphasis on loan growth and the strong real
estate demand in the Puget Sound region. Investments decreased $68.4 million, or
30.9% for the period and federal funds sold increased $19.6 million, or 643%.
Investments were primarily purchased in the third quarter of 2003 after two
quarters of slow loan growth. This shift in the asset mix enabled us to
partially mitigate the continued decline of the yield on assets, by reducing
federal funds sold, and increasing loans and investments.
Noninterest bearing deposits increased $35.7 million, or 13.0% to $309.7
million. Interest bearing deposits increased $75.5 million, or 5.4%, with most
of the increase attributable to growth in time certificates.
At September 30, 2004, NOW, Money Market and Sweep accounts made up 18.1% of
total interest bearing deposits. At September 30, 2003 those deposits made up
19.4%. In 2004, savings deposits made up 43.9% of total interest bearing
deposits versus 45.1% in 2003 and time deposits made up 38.0% in 2004 versus
35.5% in 2003.
Over the last year, NOW, Money Market and Sweep deposits decreased $4.2 million,
or 1.6%; savings deposits increased $16.2 million, or 2.6%; and time deposits
increased $63.5 million or 12.8%. The reason for the significant change in the
mix over the last year was due mainly to the increasing rates being paid on
certificates of deposits in the last quarter.
FHLB borrowings increased $35.0 million, or 23.3% over the year. The reason for
these advances was to take advantage of the lower rates available and to fund
loan growth.
Capital has increased $28.8 million over the past year, or 13.5%. Almost all of
the increase was due to retained earnings. There have been no stock repurchases
since the 2nd quarter of 2003. Please see page 26 for information regarding cash
dividends paid.
NET INTEREST INCOME
- -------------------
Net interest income is the difference between total interest income and total
interest expense. Several factors contribute to changes in net interest income.
These include the effects of changes in average balances, changes in rates on
earning assets and rates paid for interest bearing liabilities, the level of
noninterest bearing deposits, shareowners' equity, and the level of nonaccrual
loans.
The earnings from certain assets are exempt from federal income tax, and it is
customary in the financial services industry to analyze changes in net interest
income on a "tax equivalent" ("TE") or fully taxable basis. Under this method,
nontaxable income from loans and investments is adjusted to an amount which
would have been earned if such income were subject to federal income tax. The
discussion below presents an analysis based on TE amounts at a 35% tax rate.
(However, there are no tax equivalent additions to interest expense or
noninterest income and expense amounts discussed on the next page.)
-11-
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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
- --------------------------------------------------------------------------------
ITEM 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
- --------------------------------------------------------------------------------
Net Interest Income
- --------------------------------------------------------------------------------
Determination of Tax Equivalent Amounts:
(In thousands)
- --------------
FOR THE QUARTER
- ----------------
At September 30, 2004 2003 $Change % Change
------------ -------------- ----------- ---------
Total interest income, as reported $35,356 $33,490 $1,866 5.6%
Effect of tax exempt loans and
municipal bonds 193 237 (44) -18.6%
------------ -------------- ----------- ---------
Tax equivalent (TE) interest income 35,549 33,727 1,822 5.4%
Total interest expense 8,712 9,110 (398) -4.4%
------------ -------------- ----------- ---------
TE net interest income $26,837 $24,617 $2,220 9.0%
============ ============== =========== =========
Calculation of TE Net Interest Margin
(quarterly annualized)
TE interest income $142,196 $134,908 $7,288 5.4%
Total interest expense 34,848 36,440 (1,592) -4.4%
------------ -------------- ----------- ---------
TE net interest income $107,348 $98,468 $8,880 9.0%
============ ============== =========== =========
Average earning assets $2,083,592 $1,930,756 $152,836 7.9%
------------ -------------- ----------- ---------
TE NIM 5.15% 5.10% 0.05%
============ ============== ===========
FOR THE YEAR-TO-DATE PERIOD
- ---------------------------------------
At September 30, 2004 2003 $Change % Change
------------ -------------- ----------- ---------
Total interest income, as reported $102,652 $101,550 $1,102 1.1%
Effect of tax exempt loans and
municipal bonds 523 728 (205) -28.2%
------------ -------------- ----------- ---------
Tax equivalent (TE) interest income 103,175 102,278 897 0.9%
Total interest expense 25,560 29,132 (3,572) -12.3%
------------ -------------- ----------- ---------
TE net interest income $77,615 $73,146 $4,469 6.1%
============ ============== =========== =========
Calculation of TE Net Interest Margin
(quarterly annualized)
TE interest income $137,567 $136,371 $1,196 0.9%
Total interest expense 34,080 38,843 (4,763) -12.3%
------------ -------------- ----------- ---------
TE net interest income $103,487 $97,528 $5,959 6.1%
============ ============== =========== =========
Average earning assets $2,039,879 $1,888,358 $151,521 8.0%
------------ -------------- ----------- ---------
TE NIM 5.07% 5.16% -0.09%
============ ============== ===========
TE is a nonGAAP performance measurement used by management in operating the
business, which management believes provides financial statement users with a
more accurate picture of the net interest margin for comparative purposes.
-12-
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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
- --------------------------------------------------------------------------------
ITEM 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
- --------------------------------------------------------------------------------
Net Interest Income
- --------------------------------------------------------------------------------
Abbreviated quarterly average balance sheets and net interest income data for
the periods are shown below:
(In thousands)
- --------------
$ % Current
For quarter ended September 30, 2004 2003 Change Change Yield/Cost
- ------------------------------- ---------- ---------- --------- -------- -----------
ASSETS
Loans:
Commercial and agriculture $291,716 $275,391 $16,325 5.9% 6.37%
Real Estate:
Commercial 845,842 754,421 91,421 12.1% 6.74%
Construction and land development 575,652 475,019 100,633 21.2% 7.53%
Residential 163,173 138,077 25,096 18.2% 7.41%
Installment and other loans 44,651 40,333 4,318 10.7% 8.25%
---------- ---------- --------- -------- -----------
Total loans 1,921,034 1,683,241 237,793 14.1% 7.02%
Investments* 154,192 170,147 (15,955) -9.4% 4.24%
Federal funds sold 8,366 77,368 (69,002) -89.2% 1.38%
---------- ---------- --------- -------- -----------
Total earning assets 2,083,592 1,930,756 152,836 7.9% 6.79%
========== ========== ========= ======== ===========
Total assets $2,197,823 $2,043,891 $153,932 7.5%
=========== =========== ========= ========
LIABILITIES
Noninterest bearing deposits $308,371 $261,975 46,396 17.7%
Interest bearing deposits:
NOW & money market 250,233 277,090 (26,857) -9.7% 0.67%
Savings 658,019 614,313 43,706 7.1% 1.38%
Time certificates 537,781 508,639 29,142 5.7% 2.87%
---------- ---------- --------- -------- -----------
Total interest bearing deposits 1,446,033 1,400,042 45,991 3.3% 1.81%
---------- ---------- --------- -------- -----------
Total deposits $1,754,404 1,662,017 $92,387 5.6% 1.49%
=========== ========== ========= ======== ===========
Federal funds purchased
and repurchase agreements $12,589 $10,797 $1,792 16.6% 1.20%
FHLB advances 182,919 150,653 32,266 21.4% 4.57%
Total interest bearing liabilities 1,641,541 1,561,492 80,049 5.1% 2.11%
Shareowners' equity* $237,610 $208,236 $29,374 14.1%
*Shown at amortized cost, or adjusted for unrealized gain (loss).
In the third quarter of 2004, average total earning assets as a percent of
average total assets were 94.8% and 94.5% in 2003. This ratio indicates how
efficiently assets are being utilized. Average loans were 87.4% and 82.4% of
average assets, respectively and investments were 7.0% and 8.3%, for the same
periods. Average federal funds sold were .4% and 3.8% over the period. Average
total loan-to-deposits ratios were 109.5% and 101.3%. Shown in the table are the
components of interest bearing deposits. For the period ending September 30,
2004 average NOW, Sweep and Money Market accounts were 15.2% of total interest
bearing liabilities ("IBL"); savings accounts were 40.1% of total IBL and time
certificates were 32.8% of total IBL. Average borrowings were 11.9% of total
IBL. Tax equivalent net interest income increased $4.5 million, or 6.1% on a
year-to-date comparison.
Earning Assets
- --------------
Using a 366/365-day base, the TE yield on total earning assets decreased 14
basis points in the third quarter of 2004 to 6.79% compared to 6.93% in 2003.
The drop is due to loans originated or refinanced at lower rates. Also,
additions to the investment portfolio have been at much lower rates than before,
and municipal bond calls have reduced that portion of the portfolio by
approximately
-13-
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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
- --------------------------------------------------------------------------------
ITEM 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
- --------------------------------------------------------------------------------
Earning Assets (continued)
- --------------------------------------------------------------------------------
50%. Most of the bonds that were called had a TE yield of 8.0% plus. The cost of
total interest bearing liabilities decreased 20 basis points from 2.31% in 2003
to 2.11% in 2004. For the first time in several quarters, the decline in the
cost of interest bearing liabilities (20 bps) has exceeded the decline in the
yield on earning assets (14 bps), which makes the current quarter most
noteworthy. Additionally, the net interest margin was 5.02% in the first quarter
of 2004, 5.05% in the second quarter of 2004 as compared to 5.15% in the current
quarter. This increase in the net interest margin in the current quarter is
attributable to the increased volume of loans. Our current net interest margin
is considered to be very good relative to our peer commercial banks in the $1-10
billion range.
On a quarterly TE basis, net interest income was $26.8 million in 2004, versus
$24.6 million in 2003, for an increase in net interest income of $2.2 million,
or 9.0%. This increase was the result of total interest income increasing $1.8
million, and total interest expense decreasing $.4 million. The increase of
$152.8 million in the average balance of earning assets increased interest
income by $4.0 million and a decrease in interest rates decreased interest
income by $2.2 million, for a net increase of $1.8 million.
The annualized yield on total loans decreased from 7.38% in 2003 to 7.02% in
2004. Commercial and agriculture loans decreased in yield from 6.63% to 6.37%;
real estate commercial loans decreased in yield from 7.25% to 6.74%; real estate
construction and land development loans decreased in yield from 7.83% to 7.53%;
real estate residential loans decreased in yield from 7.69% to 7.41%; and
installment loans decreased in yield from 8.55% to 8.25%.
The yield on investments decreased from 5.19% in 2003 to 4.24% in 2004 and the
yield on federal funds sold increased from .92% in 2003 to 1.38% in 2004.
Interest Bearing Liabilities
- ----------------------------
The increase in the average balance of interest bearing deposits of $46.0
million increased interest expense by $.4 million, and the rate paid on interest
bearing deposits decreased interest expense by $1.0 million, for a net decrease
of $.6 million.
The increase in the average balance of other borrowings (federal funds purchased
and securities sold under repurchase agreements plus Federal Home Loan Bank
advances) of $34.1 million increased interest expense by $414 thousand and the
rates paid on these borrowings decreased interest expense by $210 thousand, for
a net increase of $204 thousand.
The cost of NOW, Money Market and Sweep accounts decreased from .80% in 2003, to
..67% in 2004. Savings account costs were 1.66% in 2003, and 1.38% in 2004. Time
cd's decreased in cost from 3.15% in 2003 to 2.87% in 2004. The cost of
short-term borrowings increased from .55% to 1.20%, and the cost of FHLB
borrowings decreased from 5.06% in 2003 to 4.57% in 2004.
NONINTEREST INCOME AND EXPENSE - September 30, 2004/September 30, 2003
- ----------------------------------------------------------------------
Total noninterest income decreased $204 thousand in the third quarter of 2004,
or 5.9% from a year ago. Service charges increased $69 thousand to $1.2 million,
or 5.9%. The increase in service charges was due to increased business service
charges of $56 thousand and increased NSF/OD fees of $19 thousand. Other
noninterest income increased $238 thousand or 15.4% in the current quarter. Our
Trust Department's revenues were up $86 thousand and Insurance and Financial
Services Department's revenues were up by $65 thousand.
-14-
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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
- --------------------------------------------------------------------------------
ITEM 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
- --------------------------------------------------------------------------------
Noninterest income and expenses (continued)
- --------------------------------------------------------------------------------
Offsetting these increases was a decline in gain on the sale of mortgage loans
of $422 thousand reflecting a slow down in secondary market operations.
The market value of trust assets at quarter-end September 2004 was $291.2
million, as compared to $250.6 million in 2003, an increase of $40.6 million, or
16.2%. Trust assets are not included in the Corporation's consolidated balance
sheet.
Total noninterest expenses increased $1.1 million or 9.4% for the period.
Salaries and benefits increased $914 thousand or 12.8%. During the past year,
the number of employees increased by 6.3%, and the remainder of the increase
represents merit raises. There were 641 FTE employees at September 30, 2004.
Occupancy expense increased $119 thousand, or 7.9%. Depreciation expense was 39%
of occupancy expense for 2004 and 36% for 2003. The increase in depreciation
expense of $85 thousand was the majority of the increase in this category. Other
expense was up only $39 thousand year-over-year.
Banks and bank holding companies use a computation called the "efficiency ratio"
to measure overhead. This ratio is then compared to others in the industry. The
ratio is calculated by dividing total noninterest expense, less intangible
amortization expense, certain losses and other nonrecurring charges, by the sum
of net interest income, on a taxable equivalent basis, and other noninterest
income, less the same type of non-recurring items. The lower the number, the
more efficient the organization. The Corporation's efficiency ratio for the
third quarter was 41% for 2004 and 40% for 2003. The Corporation's ratio places
it among the performance leaders in the industry.
ASSET QUALITY
- -------------
The Corporation manages its credit risk through diversification of its loan
portfolio and the application of prudent underwriting policies, procedures, and
monitoring practices. Delinquent and problem loans, however, are a part of any
lending enterprise. When a borrower fails to make payments, the Corporation
implements procedures with an organized practical approach to collection of
delinquent loans.
-15-
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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
- --------------------------------------------------------------------------------
ITEM 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
- --------------------------------------------------------------------------------
Noninterest income and expenses (continued)
- --------------------------------------------------------------------------------
The loan loss allowance, charge offs and loan recoveries are summarized as
follows:
(In thousands)
- -------------- Three months Nine months
ended ended Twelve months
Sept 30, Sept 30, ended
2004 2004 December 31, 2003
-------------- -------------- -------------------
Balance at beginning of period $31,099 $29,556 $28,175
Charge offs:
Commercial and agriculture (363) (510) (1,617)
Real estate:
Commercial real estate - - (1,486)
Construction and land development - - (48)
Residential (242) (242) (120)
Installment and other (106) (343) (351)
-------------- -------------- -------------------
Total charge offs (711) (1,095) (3,622)
-------------- -------------- -------------------
Recoveries:
Commercial and agriculture 136 277 620
Real estate:
Commercial - 150 6
Construction and land development - 86 -
Residential 26 49 62
Installment and other 19 46 65
-------------- -------------- -------------------
181 608 753
Net charge offs (530) (487) (2,869)
-------------- -------------- -------------------
Provision for loan losses 1,000 2,500 4,250
-------------- -------------- -------------------
Balance at end of period $31,569 $31,569 $29,556
============== ============== ===================
Average loans for the period $1,921,034 $1,860,405 $1,691,051
============== ============== ===================
Ratio of net charge offs to average
loans outstanding during the period 0.03% 0.03% 0.17%
============== ============== ===================
IMPAIRED ASSETS
- ---------------
Loans are considered impaired, based on current information and events when it
is probable that the Corporation will be unable to collect all amounts due
according to the contractual terms of the loan agreement, including scheduled
interest payments.
The assessment of impairment occurs when and while such loans are on nonaccrual,
or the loan has been restructured. When a loan with unique characteristics has
been identified as being impaired, the Corporation will measure the amount of
the impairment. If the measurement is less than the recorded investment in the
loan, impairment is recognized by creating or adjusting an existing allocation
of the allowance for loan losses. In cases where a borrower experiences
financial difficulties and the Corporation makes certain concessionary
modifications to the contractual terms, the loan is classified as a restructured
accruing loan. Loans restructured at an interest rate equal to or greater than
that of a new loan with comparable risk at the time the contract is modified may
be excluded from the impairment assessment and may cease to be considered
impaired.
-16-
FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
- --------------------------------------------------------------------------------
ITEM 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
- --------------------------------------------------------------------------------
Impaired Assets (continued)
- --------------------------------------------------------------------------------
Nonperforming loans and impaired assets are summarized as follows:
(In thousands)
- --------------
Period ended September 30, 2004 2003
- -------------------------- ---- ----
Nonaccruing loans:
Commercial and agriculture $55 $246
Real estate: - -
Commercial 6,235 6,187
Construction and land development 1,853 108
Residential 7,277 1,449
Installment and other 6 16
----------------- -----------------
Total nonaccruing loans 15,426 8,006
Other real estate owned 1,013 7,544
----------------- -----------------
Total nonperforming assets $16,439 $15,550
================= =================
Restructured loans - $6,178
Total loans at end of period $1,943,437 $1,719,323
Total assets at end of period $2,233,050 $2,059,906
Total nonperforming assets to total loans 0.85% 0.90%
Total nonperforming assets to total assets 0.74% 0.75%
Total impaired assets to total assets 0.74% 1.05%
For nonaccrual loans, it is the Corporation's practice to discontinue accruing
interest on virtually all loans that are delinquent in excess of 90 days
regardless of risk of loss, collateral, etc. Some problem loans which are less
than 90 days delinquent are also placed into nonaccrual status if the success of
collecting full principal and interest in a timely manner is in doubt and some
loans will remain in nonaccrual even after improved performance until a
consistent timely payment pattern is exhibited and/or timely performance is
considered to be reliable.
The table above reflects nonaccrual loans increased by $7.4 million to $16.4
million as of September 30, 2004. This increase was due primarily to one real
estate residential loan in the amount of $6.0 million. As of quarter end this
balance included 13 loans ranging in size from $6.0 million to nominal amounts.
Subsequent to quarter end, two loans totaling $1.4 million were paid in full.
Efforts are continuing to collect these loans with many involving some measure
of legal action. Ninety-nine percent of these loans are real estate secured and,
while there is always some risk of loss present, management feels it is not
substantial as a proportion of the overall portfolio.
Other real estate owned (OREO) is carried at the lesser of book value or market
value less selling costs. The costs related to completion, repair, maintenance,
or other costs of such properties, are generally expensed with any gains or
inadvertent shortfalls from the ultimate sale of OREO being shown as other
income or expense.
-17-
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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
- --------------------------------------------------------------------------------
ITEM 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
- --------------------------------------------------------------------------------
Other Real Estate Owned (continued)
- --------------------------------------------------------------------------------
OTHER REAL ESTATE OWNED
- -----------------------
OREO ended the quarter with a portfolio of two properties totaling $1.0 million.
The significant decrease over the previous year's OREO balance reflects the
transition of troubled assets through an orderly collection process. Since
December 31, 2003 five OREO properties have been sold and closed. The remaining
property is being actively managed for timely sale.
Certain other loans, currently in nonaccrual are in the process of foreclosure
and there is a likelihood these foreclosures will be completed and the loans
will then become OREO. Management views this as an ordinary part of the
collection process and efforts are maintained to reduce and minimize such
non-performing assets.
CREDIT CONCENTRATIONS
- ---------------------
The table below indicates the changes to the loan portfolio mix as of the dates
indicated, net of deferred loan fees:
(In thousands) September 30, 2004 December 31, 2003
--------------------------------- ---------------------------------
Amount % of total Amount % of total
---------------- --------------- ---------------- ---------------
Commercial and agriculture $285,724 14.7% $268,963 15.2%
Real estate loans:
Commercial 854,918 44.0% 809,307 45.7%
Construction and land development 590,803 30.4% 507,872 28.6%
Residential 165,087 8.5% 145,373 8.2%
Installment and other 46,905 2.4% 40,201 2.3%
---------------- --------------- ---------------- ---------------
Total $1,943,437 100.0% $1,771,716 100.0%
================ =============== ================ ===============
As shown in the table above the Corporation emphasizes commercial real estate
and construction and land development related lending. The commercial real
estate, including construction and land development, portfolio generally
consists of a wide cross-section of retail, small office, warehouse, and
industrial type properties. These loans are principally secured by first trust
deeds with maturities from 3 to 10 years and original loan to value ratios
generally from 65% to 75%. A substantial number of these properties are owner
occupied. While we have had significant balances within this lending category,
we believe that our lending policies and underwriting standards are sufficient
to minimize risk even during these uncertain economic times. To date, our
lending activities have avoided those real estate sectors that have been most
impacted by the current economic slump. We devote considerable time and
attention to the risks associated with the loan portfolio and continually
monitor the effects of current and expected market conditions, and other factors
that may influence the repayment of these loans.
At September 30, 2004 and 2003, we had an immaterial amount of foreign loans and
no loans related to highly leveraged transactions.
-18-
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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
- --------------------------------------------------------------------------------
ITEM 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
- --------------------------------------------------------------------------------
Allowance for Possible Loan Losses (continued)
- --------------------------------------------------------------------------------
ALLOWANCE FOR POSSIBLE LOAN LOSSES - QUALITATIVE FACTORS
- --------------------------------------------------------
For the nine months ending September 30, 2004, the reserve for possible loan
loss balance totaled $31.6 million, or 1.62% of total loans, as compared to
$28.7 million, or 1.67% of total loans at quarter-end 2003. Year-to-date net
loan losses were $487 thousand.
Management and the Board review policies and procedures annually, or more often,
and changes are made to reflect the current operating environment integrated
with regulatory requirements. Partly out of these policies has evolved an
internal credit risk review process. During this process the quality grade of
loans are reviewed and loans are assigned a dollar value of the loan loss
reserve by degree of risk. This analysis is performed quarterly and reviewed by
senior management who makes the determination if the risk is reasonable, and if
the reserve is adequate.
Taken into consideration when the analysis is performed is the national and
local economic trends and conditions. The analysis also takes into consideration
the level of, or trends in, delinquencies and non-accruing loans. Management
monitors delinquencies monthly and reports are prepared for the Board of
Directors to review. Delinquencies for commercial, personal and real estate
loans are charted separately by their types and by portfolio geographic
locations.
Another consideration is the volume and terms of loans. Management reviews the
growth and terms of loans so that the allowance can be adjusted for current and
anticipated future needs.
QUANTITATIVE FACTORS
The allowance for loan losses is the amount which, in the opinion of management,
is necessary to absorb loan losses. Management's evaluation of the adequacy of
the allowance is based on the market area served, local and national economic
conditions, the growth and composition of the loan portfolio and the related
risk characteristics, by continual review by management of the quality of the
portfolio.
The Corporation has an active ongoing credit review function. When a loan has
degradation in quality as evidenced by an internal watch rating its internal
rating is downgraded. An assessment of these loans is performed to determine
whether it is appropriate to establish a specific allocation reserve or write
down as directed by FAS 114, Accounting by Creditors for Impairment of a Loan.
If appropriate, such allocation reserve or write down is made. For the remainder
of these loans that which no specific allocation reserve or write down is
necessary we establish a background reserve. The background reserves are
reviewed quarterly to determine if these background reserve percentages are
appropriate.
All other loans which have not been identified with degradation in quality have
background reserves based upon our experience and information concerning actual
industry losses by loan types.
Every quarter certain qualitative facts are evaluated to determine if certain
adjustments are indicated for any of the background reserves established. This
is accomplished through an internal narrative and the tracking of statistics
including but not limited to unemployment rates, historical charge offs, job
growth, effects of changing interest rates, housing starts, trends in volume and
terms of loans, levels of, and trends in, delinquencies and nonaccruals, and
other real estate owned trends.
-19-
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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
- --------------------------------------------------------------------------------
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
- --------------------------------------------------------------------------------
Allowance for Possible Loan Losses (continued)
- --------------------------------------------------------------------------------
The allocation of the allowance for loan losses at September 30, 2004 is as
follows:
Percent of Loans
(In thousands) in Each Category
Amount to Total Loans
----------------- --------------------
Commercial and agriculture $9,112 14.7%
Real Estate:
Commercial 11,324 44.0%
Construction and land development 5,278 30.4%
Residential 2,292 8.5%
Installment and other 1,106 2.4%
Unallocated 2,457
----------------- --------------------
Total $31,569 100.0%
================= ====================
In addition, regulatory agencies, as an integral part of their examination
process, periodically review the estimated losses on loans. Such agencies may
require the Corporation to change the allowance based on their judgment about
information available to them at the time of their examination. It is the
Corporation's policy to be in compliance with all accounting and regulatory
standards related to loan loss reserves and all accounting policies promulgated
by GAAP.
LIQUIDITY AND INTEREST RATE RISK
- --------------------------------
LIQUIDITY
- ---------
The primary function of asset/liability management is to ensure adequate
liquidity and maintain an appropriate balance between interest sensitive earning
assets and liabilities. Liquidity management involves the ability to meet the
cash flow requirements of customers who may be either depositors wanting to
withdraw funds, or depositors who have credit needs.
The statement of cash flows on pages 3 and 4 of this report provides information
on the sources and uses of cash for the respective year-to-date periods ending
September 30, 2004 and 2003. This discussion addresses those periods of time.
When comparing the cash flows from operating activities for the two years, the
most prominent items are mortgage loans originated and sold. This function is
dependent on the level of long-term interest rates and represents refinancing
activity. As indicated, the activity in this area was approximately one-fourth
of the 2004 activity. The slowing of the secondary real estate market activity
so far this year is expected to continue.
Cash flows from investment activities had a major change in 2004. The purchase
of AFS securities, mainly in the third quarter of 2003 was eight times that of
the current period. As previously stated we had a substantial amount of
liquidity going into the third quarter of 2003, and purchased over $143 million
in investment securities during that period. Loan growth only required $67
million, or 2 1/2 times less than 2004's funding needs of $171 million. The
degree of funding sources changed in 2004. Core deposit growth provided
substantial funding for 2003, while cd's ran off by $56 million. In 2004, the
bulk of the funding came from core deposits and cd's, assisted by increased net
FHLB advances of $15 million.
Management has the ability to access many sources of liquidity, such as the sale
of AFS securities, additional borrowings from the FHLB, increased participation
in the Treasury department's short-term note program, borrowings from the
Federal Reserve Bank, or additional borrowings at correspondent
-20-
FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
- --------------------------------------------------------------------------------
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
- --------------------------------------------------------------------------------
Interest Rate Risk (continued)
- --------------------------------------------------------------------------------
banks. The Corporation has a policy that liquidity to total assets of 12.5% be
maintained as a minimum and has done so.
INTEREST RATE RISK
- ------------------
Interest rate risk refers to the exposure of earnings and capital arising from
changes in interest rates. Management's objectives are to control interest rate
risk and to ensure predictable and consistent growth of earnings and capital.
Interest rate risk management focuses on fluctuations in net interest income
identified through computer simulations to evaluate volatility under varying
interest rate, spread and volume assumptions. The risk is quantified and
compared against tolerance levels.
The Corporation uses a simulation model to estimate the impact of changing
interest rates on the Corporation's earnings and capital. The model calculates
the change in net interest income under various rate shocks. As of June 30, 2004
the model predicted that net interest income will increase if interest rates
rise and decline if rates fall. This behavior is heavily influenced by loans
going on and off interest rate floors. On a one-year horizon, if rates decline
by 1%, net interest income would increase by approximately .4%, due to the
convexity impact of approximately $1.5 million. Convexity assumptions are those
which estimate changes in customer and bank behavior which may occur when
interest rates change. Without the convexity assumptions, a 1% decline in rates
would result in a decline in net interest income of 1.1%. Similarly, without
convexity assumptions, an increase in rates by 1% would increase net interest
income by 1.1%. If rates increase by 1%, net interest income will increase by
1.8% and 8.6% if rates increased 2%. The actual change in earnings will be
dependent upon the dynamic changes that occur when rates change. Many of these
changes are predictable, but the exact amount is difficult to predict and actual
events may vary substantially from the simulation model results.
MANAGEMENT DOES NOT USE INTEREST RATE RISK MANAGEMENT PRODUCTS SUCH AS INTEREST
RATE SWAPS, OPTIONS, HEDGES, OR DERIVATIVES, NOR DOES MANAGEMENT CURRENTLY HAVE
ANY INTENTION TO USE SUCH PRODUCTS IN THE FUTURE.
CAPITAL - September 30, 2004/December 31, 2003
- ----------------------------------------------
Consolidated capital of the Corporation for financial statement purposes at
third quarter end 2004 was $241.9 million. This amount compares to $219.4
million at December 31, 2003, an increase of $22.5 million, or 10.2%. During the
third quarter of 2004 the Corporation did not repurchase shares of common stock
in the open market, but paid a third quarter dividend of $3.6 million. Please
see page 11, paragraph 7, for information regarding stock repurchases.
-21-
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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
- --------------------------------------------------------------------------------
Item 2 Management's Discussion and Analysis of Financial Conditions and
Results of Operations
- --------------------------------------------------------------------------------
Capital (continued)
- --------------------------------------------------------------------------------
The Corporation's regulatory capital ratios as of September 30, 2004 were as
follows:
Tier I Tier 2 Leverage
(Core) Capital (Total) Capital Capital
----------------- ----------------- -----------------
GAAP Capital $241,891 $241,891 $241,891
Net unrealized (gain) loss on AFS securities (2,894) (2,894) (2,894)
Less:
Unrealized loss on equity securities (294) (294) (294)
Goodwill (6,476) (6,476) (6,476)
Add:
Allowance for loan losses (1) - 28,582 -
----------------- ----------------- -----------------
Total regulatory capital (numerator) $232,227 $260,809 $232,227
----------------- ----------------- -----------------
Total risk weighted assets (denominator) $2,283,566 $2,283,566
----------------- ----------------- -----------------
Total average assets, for the quarter
less Goodwill (denominator) $2,191,347
----------------- ----------------- -----------------
Capitial as a percent of risk
weighted assets and/or average assets 10.17% 11.42% 10.60%
================= ================= =================
Minimum ratio for "well
capitalized" purposes 6.00% 10.00% 5.00%
================= ================= =================
Actual at December 31, 2003 10.26% 11.51% 10.15%
================= ================= =================
(1) Not to exceed 1.25% of risk weighted assets
It is the policy of the Corporation that capital be maintained above the point
where, for regulatory purposes, it would continue to be classified as "well
capitalized".
Management constantly monitors the level of capital of the Corporation,
considering, among other things, the present and anticipated needs of the
Corporation, current market conditions, and other relevant factors, including
regulatory requirements which may necessitate changes in the level of capital.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
- -------------------------------------------------------------------
Management considers interest rate risk to be a market risk that could have a
significant effect on the financial condition of the Corporation. There have
been no material changes in the reported market risks faced by the Corporation
since the end of the most recent fiscal year-end that have not been included in
this discussion.
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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
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Item 4. Controls and Procedures
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ITEM 4. CONTROLS AND PROCEDURES
- --------------------------------
(a) The Corporation's management, including the Corporation's Chief
Executive Officer and Chief Financial Officer, evaluated the
effectiveness of its disclosure controls and procedures as of
September 30, 2004. Based on this evaluation, the Chief Executive
Officer and the Chief Financial Officer each concludes that as of
September 30, 2004, the Corporation maintained effective disclosure
controls and procedures in all material respects, including those to
ensure that information required to be disclosed in reports filed or
submitted with the SEC is recorded, processed, and reported within
the time periods specified by the SEC, and is accumulated and
communicated to management, including the Chief Executive Officer
and the Chief Financial Officer, as appropriate to allow for timely
decision regarding required disclosure.
(b) Changes in Internal Controls: In the quarter ended September 30,
2004, other than the improvements described on page 24, paragraph 1,
the Registrant did not make any significant changes in, nor take any
corrective actions regarding, its internal controls or other factors
that could significantly affect these controls.
Disclosure Controls and Internal Controls. Disclosure controls are
procedures that are designed with the objective of ensuring that
information required to be disclosed in the Corporation's reports
filed under the Securities Exchange Act of 1934 (Exchange Act) is
recorded, processed, summarized and reported within the time periods
specified in the Securities and Exchange Commission's (SEC) rules and
forms. Disclosure controls are also designed with the objective of
ensuring that such information is accumulated and communicated to our
management, as appropriate to allow timely decisions regarding
required disclosure. Internal Controls are procedures which are
designed with the objective of providing reasonable assurance that
(1) transactions are properly authorized; (2) assets are safeguarded
against unauthorized or improper use; and (3) transactions are
properly recorded and reported, all to permit the preparation of
financial statement in conformity with accounting principles
generally accepted in the United States of America.
Limitations on the Effectiveness of Controls. The Corporation's
management does not expect that our disclosure controls or our
internal controls will prevent all errors and all fraud. A control
system, no matter how well conceived and operated, can provide only
reasonable, not absolute, assurance that the objectives of the control
system are met. Further, the design of control system must reflect the
fact that there are resource constraints, and the benefits of controls
must be considered relative to their costs. Because of the inherent
limitations in all control systems, no evaluation of controls can
provide absolute assurance that all control issues and instances of
fraud, if any, within the Corporation have been detected. These
inherent limitations include the realities that judgments in
decision-making can be faulty, and that breakdowns can occur because
of simple error or mistake. Additionally, controls can be circumvented
by the individual acts of some persons, by collusion of two or more
people, or by management override of the control. The design of any
system of controls also is based in part upon certain assumptions
about the likelihood of future events, and there can be no assurance
that any design will succeed in achieving its stated goals under all
potential future conditions; over time, controls may become inadequate
because of changes in conditions, or the degree of compliance with the
policies or procedures may deteriorate. Because of the inherent
limitations in a cost-effective control system, misstatements due to
error or fraud may occur and not be detected.
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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
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Item 4. Controls and Procedures (continued)
- --------------------------------------------------------------------------------
Internal Controls over Financial Reporting. We are currently undergoing a
comprehensive effort to ensure compliance with Section 404 of the Sarbanes-Oxley
Act of 2002 for our fiscal year ending December 31, 2004. This effort includes
internal control documentation and review under the direction of senior
management. During the course of these activities, we have identified certain
internal control issues which management believed would benefit from
improvement. These control issues are, in large part, the result of our
increased size and need for documentation. The review has not identified any
material weakness in internal control as defined by the Public Company
Accounting and Oversight Board. However, we have made improvements to our
internal controls over financial reporting as a result of our review efforts and
will continue to do so. These improvements include formalization of policies and
procedures, improved segregation of duties, and additional monitoring controls.
FORWARD-LOOKING INFORMATION
- ---------------------------
Except for historical financial information contained herein, the matters
discussed in this report of the Corporation may be considered "forward-looking
statements" within the meaning of Section 27A of the Securities Act of 1993, as
amended, and Section 21E of the Securities Exchange Act of 1934, as amended and
subject to the safe harbor created by the Private Securities Litigation Reform
Act of 1995. Forward-looking statements are subject to risks and uncertainties
that may cause actual future results to differ materially. Sentences containing
words such as "may", "will", "expect", "anticipate", "believe", "estimate",
"should", "projected", or similar words may constitute forward-looking
statements. The Corporation may have used these statements to describe
expectations and estimates in various areas, including, but not limited to:
changes in the economy of the markets in which it operates; interest rate
movements; future acquisition and growth strategies; system conversions and
integration activities; the impact of competitive products, services and
pricing; and legislative, regulatory and accounting changes affecting the
banking and financial service industry. Actual results could vary materially
from the future results covered in forward-looking statements. Factors such as
interest rate trends and loan delinquency rates, as well as the general state of
the economy in Washington state and the United States as a whole, could also
cause actual results to vary materially from the future results anticipated in
such forward-looking statements. These factors should be considered in
evaluating the forward-looking statements and undue reliance should not be
placed on such statements. The Corporation shall not be responsible to update
any such forward-looking statements.
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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
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PART II - OTHER INFORMATION
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Item 1. Legal Proceedings
The Corporation is involved in ordinary routine litigation arising in
the normal course of business. In the opinion of management,
liabilities (if any) arising from such claims will not have a
material effect on the business, results of operations or financial
condition of the Corporation.
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity
Securities
(d) Maximum number
(or approximate
(c) Total number dollar value) of
(a) Total number (b) Average price of shares (or units) shares (or units)
of shares (or paid per share purchased as a part of that may be
Period units) purchased (or unit) publicly announced purchased under the
plans or programs plan or programs
- --------------------------- ---------------------- ---------------------- ----------------------- -----------------------
July 1, 2004
through
July 31, 2004 - N/A 2,332,100 591,050
- --------------------------- ---------------------- ---------------------- ----------------------- -----------------------
August 1, 2004
through
August 31, 2004 - N/A 2,332,100 591,050
- --------------------------- ---------------------- ---------------------- ----------------------- -----------------------
Sepember 1, 2004
through
September 14, 2004 N/A 2,332,100 591,050
- --------------------------- ---------------------- ---------------------- ----------------------- -----------------------
September 15, 2004
through
September 30, 2004 - N/A 2,332,100 932,270
- --------------------------- ---------------------- ---------------------- ----------------------- -----------------------
Total - - 2,332,100 932,270
====================== ====================== ======================= =======================
Date plan expired Date plan
Number of during period was terminated
Repurchase Date share (units) Expiration covered by if prior
Plan No. announced approved date above date to expiration
- ----------------- ----------------- ------------------ ------------------ ------------------ -------------------
1 01/20/2000 990,251 09/11/2001 N/A 3/16/2000 (1)
2 10/18/2001 989,743 10/18/2003 N/A 10/17/2002
3 10/17/2002 943,156 10/17/2004 N/A 9/15/2004
4 9/16/2004 932,270 9/15/2006 N/A (2)
------------------
3,855,420
==================
(1) Plan was cancelled on 3/16/00 due to a pending merger.
(2) Action taken to start a new plan.
Item 4. Submission of Matters to a Vote of Security Holders
There were no matters submitted to a vote of security holders in the third
quarter of 2004.
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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
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PART II - OTHER INFORMATION
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Item 5. Other Information
On September 15, 2004, the Board of Directors of the Corporation
declared a $.20 per share fourth quarter 2004 cash dividend to
shareowners of record as of October 12, 2004 and payable October 25,
2004.
Item 6. Exhibits and Reports on Form 8-K
(a) THE FOLLOWING EXHIBITS ARE FILED AS A PART OF THIS QUARTERLY
REPORT ON FORM 10-Q.
11 Computation of basic and diluted earnings per share is
attached as Exhibit 11.
31.1 Certification of Chief Executive Officer Pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002 attached
as Exhibit 31.1.
31.2 Certification of Chief Financial Officer Pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002 attached
as Exhibit 31.2.
32.1 Certification of Chief Executive Officer Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002 attached
as Exhibit 32.1.
32.2 Certification of Chief Financial Officer Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002 attached
as Exhibit 32.2.
(a) Reports on Form 8-K:
On July 20, 2004 the Corporation filed Form 8-K announcing second
quarter 2004 earnings.
On September 16, 2004 the Corporation filed Form 8-K announcing a
fourth quarter 2004 cash dividend and approved a stock repurchase
program.
-26-
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FRONTIER FINANCIAL CORPORATION AND SUBSIDIARIES
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SIGNATURE
- --------------------------------------------------------------------------------
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.
FRONTIER FINANCIAL CORPORATION
Date: October 27, 2004 /s/ Michael J. Clementz
---------------- ---------------------------------------
Michael J. Clementz
President and CEO
Date: October 27, 2004 /s/ Carol E. Wheeler
---------------- ---------------------------------------
Carol E. Wheeler
Chief Financial Officer
-27-