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EX-99.2 - SECTION 111 CERTIFICATION - STERLING FINANCIAL CORP /WA/dex992.htm
EX-12.1 - RETURN ON AVERAGE SHAREHOLDERS EQUITY - STERLING FINANCIAL CORP /WA/dex121.htm
EX-31.1 - SECTION 302 CERTIFICATION - STERLING FINANCIAL CORP /WA/dex311.htm
EX-23.1 - CONSENT OF BDO SEIDMAN, LLP - STERLING FINANCIAL CORP /WA/dex231.htm
EX-10.8 - FORM OF AMENDED AND RESTATED DEFERRED COMPENSATION PLAN - STERLING FINANCIAL CORP /WA/dex108.htm
EX-31.2 - SECTION 302 CERTIFICATION - STERLING FINANCIAL CORP /WA/dex312.htm
EX-10.7 - 1998 LONG TERM INCENTIVE PLAN - STERLING FINANCIAL CORP /WA/dex107.htm
EX-12.2 - RETURN ON AVERAGE ASSETS - STERLING FINANCIAL CORP /WA/dex122.htm
EX-32.1 - SECTION 906 CERTIFICATION - STERLING FINANCIAL CORP /WA/dex321.htm
EX-32.2 - SECTION 906 CERTIFICATION - STERLING FINANCIAL CORP /WA/dex322.htm
EX-12.3 - RATIO OF EARNINGS TO FIXED CHARGES AND PREFERRED DIVIDENDS - STERLING FINANCIAL CORP /WA/dex123.htm
EX-99.1 - SECTION 111 CERTIFICATION - STERLING FINANCIAL CORP /WA/dex991.htm
EX-21.1 - LIST OF SUBSIDIARIES - STERLING FINANCIAL CORP /WA/dex211.htm
EX-10.9 - 2001 LONG TERM INCENTIVE PLAN - STERLING FINANCIAL CORP /WA/dex109.htm
EX-10.12 - FORM OF SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN - STERLING FINANCIAL CORP /WA/dex1012.htm
EX-10.10 - 2003 LONG TERM INCENTIVE PLAN - STERLING FINANCIAL CORP /WA/dex1010.htm
Table of Contents

 

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

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

 

    For the year ended DECEMBER 31, 2009

 

    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 0-20800

STERLING FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

 

Washington   91-1572822

(State or other jurisdiction of

incorporation or organization)

  (IRS Employer Identification No.)

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:

 

None    None
(Title of each class)    (Name of each exchange on which registered)

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

Common Stock ($1.00 par value)

(Title of class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨        No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨        No  x

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x        No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨        No  ¨

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.    ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer    ¨        Accelerated filer    x        Non-accelerated filer    ¨        Smaller Reporting Company    ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨        No  x

As of June 30, 2009, 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 Global Select Market, was $147 million.

The number of shares outstanding of the registrant’s common stock, par value $1.00 per share, as of January 31, 2010 was 52,167,895.

DOCUMENTS INCORPORATED BY REFERENCE

Specific portions of the registrant’s Proxy Statement for its 2010 annual meeting of shareholders are incorporated by reference into Part III hereof.

 

 

 


Table of Contents

STERLING FINANCIAL CORPORATION

DECEMBER 31, 2009 ANNUAL REPORT ON FORM 10-K

TABLE OF CONTENTS

 

          Page

PART I

   1

Item 1.

  

Business

   1
  

General

   1
  

Recent Developments

   1
  

Business Strategy

   3
  

Profitability Drivers

   5
  

Segment Results

   5
  

Lending Activities

   7
  

Investments and Mortgage-Backed Securities

   21
  

Sources of Funds

   22
  

Subsidiaries

   26
  

Competition

   27
  

Personnel

   27
  

Environmental Laws

   27
  

Regulation

   28
  

Forward-Looking Statements

   35
  

Where You Can Find More Information

   37

Item 1A.

  

Risk Factors

   38

Item 1B.

  

Unresolved Staff Comments

   51

Item 2.

  

Properties

   51

Item 3.

  

Legal Proceedings

   52

Item 4.

  

(Reserved)

   52

PART II

   53

Item 5.

  

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

   53
  

Stock Market and Dividend Information

   53

Item 6.

  

Selected Financial Data

   55


Table of Contents
          Page

Item 7.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   57
  

Executive Summary and Highlights

   57
  

Key Financial Measures

   57
  

Critical Accounting Policies

   57
  

Results of Operations

   62
  

Financial Position

   74
  

Asset and Liability Management

   77
  

Liquidity and Capital Resources

   79
  

Off-Balance Sheet Arrangements and Aggregate Contractual Obligations

   82
  

Capital

   83
  

Regulatory Agreements

   84
  

Goodwill Litigation

   85
  

Recent Accounting Pronouncements

   85
  

Effects of Inflation and Changing Prices

   86

Item 7A.

  

Quantitative and Qualitative Disclosures About Market Risk

   86

Item 8.

  

Financial Statements and Supplementary Data

   86

Item 9.

  

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

   86

Item 9A.

  

Controls and Procedures

   87
  

Management’s Report on Internal Control Over Financial Reporting

   87
  

Report of Independent Registered Public Accounting Firm

   88

Item 9B.

  

Other Information

   89

PART III

   89

Item 10.

  

Directors, Executive Officers and Corporate Governance

   89

Item 11.

  

Executive Compensation

   89

Item 12.

  

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

   89

Item 13.

  

Certain Relationships and Related Transactions, and Director Independence

   89

Item 14.

  

Principal Accounting Fees and Services

   89

PART IV

   90

Item 15.

  

Exhibits, Financial Statement Schedules

   90

SIGNATURES

   91


Table of Contents
PART I

This report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. For a discussion of the risks and uncertainties inherent in such statements, see “BusinessForward-Looking Statements” and “Risk Factors.”

 

Item 1.    Business

General

Sterling Financial Corporation (“Sterling”) is a bank holding company, organized under the laws of Washington State in 1992. The principal operating subsidiaries of Sterling are Sterling Savings Bank and Golf Savings Bank. Sterling Savings Bank, headquartered in Spokane, Washington, commenced operations in 1983 as a Washington State-chartered federally insured stock savings and loan association, and in 2005 converted to a commercial bank. Sterling Savings Bank offers commercial banking products and services, mortgage lending, construction financing and investment products to individuals, small business, commercial organization and corporations. The main focus of Golf Savings Bank, a Washington State-chartered savings bank acquired by Sterling in July 2006, is the origination and sale of residential mortgage loans.

At December 31, 2009, Sterling had total assets of $10.9 billion, total liabilities, including deposits, of $10.6 billion and total shareholders’ equity of $323.2 million and operated 178 deposit-taking branches throughout the Western region of the United States, including the states of Washington, Oregon, Idaho, Montana and California. Our common stock is listed on the Nasdaq Global Select Market under the symbol “STSA.” Our principal offices are located at 111 North Wall Street, Spokane, Washington 99201 and our telephone number at that address is (509) 227-5389. We maintain an Internet website at www.sterlingfinancialcorporation-

spokane.com. Neither this website nor the information on this website is included or incorporated in, or is a part of, this Annual Report on Form 10-K.

Recent Developments

Sterling faces a number of challenges resulting from current and prior year losses, driven by credit quality issues, and is categorized as being undercapitalized by regulatory guidelines. In the fourth quarter of 2009, Sterling Savings Bank entered into a Stipulation and Consent to the Issuance of an Order to Cease and Desist (the “SSB Consent Agreement”) with the Federal Deposit Insurance Corporation (“FDIC”) and the Washington State Department of Financial Institutions (“WDFI”). Under the terms of the agreement, Sterling Savings Bank has agreed to, among other things, raise capital of at least $300 million, and maintain a Tier 1 leverage ratio of not less than 10%. The agreement set a deadline of December 15, 2009 for meeting these capital requirements, which Sterling was not able to meet. During the fourth quarter, Sterling and the Federal Reserve Bank of San Francisco (the “Reserve Bank”) entered into a written agreement (the “Reserve Bank Agreement”) to enhance Sterling’s ability to act as a source of strength to Sterling Savings Bank and Golf Savings Bank. Substantially all of the requirements of the Reserve Bank Agreement are similar to those imposed on Sterling Savings Bank by the FDIC. Sterling Savings Bank has failed to increase its Tier 1 capital to the levels required by the SSB Consent Agreement and does not comply with certain of the

 

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requirements of the Reserve Bank Agreement and the SSB Consent Agreement. The uncertainty around Sterling’s ability to comply with these agreements has raised substantial doubts about Sterling’s ability to continue as a going concern. See “—Risk Factors,” “—Forward-Looking Statements,” “Regulation—Federal and State Regulation of Banking Activities” and Note 25 of “Notes to Consolidated Financial Statements.”

During the fourth quarter, Sterling announced a management change that resulted in the appointment of a new President and Chief Executive Officer, a new Chief Operating Officer, as well as a new Chairman of the Board. This new Executive management team developed several strategies to address the capital and liquidity needs of the organization. In March 2010, the following Directors of Sterling Savings Bank were appointed to serve as Directors of Sterling: Ned M. Barnes, Rodney W. Barnett, Thomas H. Boone, Kermit K. Houser and Dianne E. Spires.

Sterling is in active negotiations with several private equity investors, two of its major stakeholders and its regulators about various strategic alternatives designed to put Sterling on a sound financial footing and allow it to recapitalize and grow its business.

Sterling’s recovery plan is expected to include a restructuring of its capital and liabilities. As such, Sterling has been actively engaged with two of its major stakeholders, the owners of its outstanding trust preferred securities (“TruPS”) and U.S. Department of the Treasury (“Treasury”), which holds preferred stock that Sterling issued as part of Treasury’s Capital Purchase Program, which was designed to support the health of the nation’s banking sector.

As part of that plan, Sterling requested and received a letter from the Treasury expressing conditional support for a plan to convert the Sterling preferred stock that Treasury holds into Sterling common stock. In addition, Sterling has received several non-binding proposals from private equity firms, and has entered into a non-binding letter of intent with one of these firms to provide additional capital to recapitalize Sterling.

In its letter, Treasury set forth several conditions for its approval of the conversion of Treasury-owned securities to common equity. Among other things, Sterling must obtain the consent for the redemption of Sterling’s TruPS by a substantial portion of the holders of those securities; must raise at least $650 million of additional capital through the issuance of new common equity at not greater than 20 cents per share; and must execute a definitive agreement for that conversion with Treasury. As a result of these alternatives, current shareholders are expected to have no more than a minimal stake in Sterling in the future.

Sterling also continues to consider and explore these and other alternatives, including the raising of capital through public or private equity offerings; the potential sale of Sterling or some or all of its assets; or other substantial adjustments to Sterling’s balance sheet. All proposals received by Sterling to date, contemplate a conversion of the Treasury’s preferred stock at a discount to the face value, and the exchange of a substantial portion of the TruPS into cash at a significantly reduced price.

In February 2010, Sterling began making cash offers to repurchase its outstanding series of TruPS at an 80% discount from the stated value. Formal offers have been extended to registered owners of Sterling’s managed TruPS series, who have until March 23, 2010 to consent to the terms of Sterling’s cash tender offer. Owners of Sterling’s unmanaged TruPS series have until March 31, 2010 to consent to the terms of Sterling’s cash offer. Sterling’s cash tender offer is conditioned upon a successful capital raise, as well as the receipt of all applicable approvals from the Reserve Bank.

Sterling is being assisted in its exploration of these various alternatives by financial advisors Sandler O’Neill + Partners, Barclays Capital and FBR Capital Markets.

There can be no assurance that any of these efforts will be successful, and if Sterling were to be unsuccessful, its ongoing viability would be in doubt. Such uncertainty is reflected in the opinion given by our auditors on our year-end financial statements, “Forward-Looking Statements” and “Risk Factors.” Regardless of the outcome, Sterling depositors continue to be protected by FDIC insurance up to $250,000 per account, and non- interest-bearing and certain interest-bearing

 

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transaction accounts are fully protected regardless of dollar amount under the FDIC’s Transaction Account Guarantee (“TAG”) program. See “Risk Factors—The uncertainty of our financial viability could result in a loss of access to funding sources, which would have a negative impact on our liquidity and may cause our regulators to place us in receivership before we have implemented our strategic alternatives” and “Regulation.-Recent Legislative and Regulatory Initiatives to address Financial and Economic Crises.”

Business Strategy

Sterling’s goal is to be the leading community bank in the West by offering customers a range of highly personalized sales and service consistent with our “Hometown Helpful”® philosophy. This strategy centers on bringing the full product suite of a large regional institution to customers with the personalized service of a local community bank. The four tenets of this philosophy are:

 

  Ÿ  

Knowledgeable bankers—We are committed to ensuring our employees are highly trained and talented bankers who capably serve consumers and commercial customers across our five-state footprint. Our employee development, training, and compensation initiatives are designed to support the strongest team of bankers in the region.

 

  Ÿ  

Fair pricing—No one likes to be nickel and dimed. We are dedicated to providing value-driven pricing that generates the appropriate risk-adjusted rate of return and supports our market-driven competitive funding cost advantage. We have eliminated nuisance fees and are focused on creating meaningful value for our customers.

 

  Ÿ  

Convenience and ease of use—We have 178 retail banking locations and more than 30 mortgage loan origination offices; customer- oriented hours; full-service net banking and bill pay. We have the largest team of commercial bankers in the region and the highest commitment to personalized service. Our goal is to meet our customers where they want to be met.

 

  Ÿ  

Competitive products and services—We have one of the most advanced and user-friendly Remote Deposit Capture offerings in the western United States. Our treasury management products rival those of the largest banks operating in our area. We offer a full range of consumer, small business, commercial, corporate, wealth and mortgage banking products and services across our five-state footprint.

Sterling believes that its dedication to personalized service and relationship banking has enabled it to grow both its retail deposit base and its lending portfolio in the western United States. Sterling originates loans and attracts FDIC insured and uninsured deposits from the general public throughout its five state footprint through its two subsidiary banks, Sterling Savings Bank and Golf Savings Bank, and through its commercial real estate division INTERVEST-Mortgage Investment Company (“INVERVEST”). Sterling also markets fixed income and equity products, mutual funds, fixed and variable annuities and other financial products through wealth management representatives located throughout Sterling’s financial service center network.

Historically, we have focused on growing our institution both organically and through acquisitions (we have completed eight whole bank acquisitions since our founding). Beginning in mid-2008, and in light of the current economic environment, we shifted our focus to internal improvements with an emphasis on the areas of credit management, operating efficiency and optimally sizing the balance sheet. Our business philosophy transformed from the traditionally effective asset growth model to the “back to basics banking” model built around development of core relationships. We realigned our organization to increase our profitability by adding seasoned and talented individuals to our operations and by incorporating the following strategies:

 

  Ÿ  

Strengthening Asset Quality Oversight and Resolution.    To address the deteriorating economic environment in early 2008, Sterling established a credit administration group to focus specifically on the identification and resolution of construction and commercial real estate-related assets that are currently or expected to become problem assets. This group operates independently from a parallel credit administration team dedicated to monitoring

 

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the performing loans in Sterling’s loan portfolio. This separation of duties has allowed Sterling to continue its strategic goal of achieving targeted levels of loan portfolio diversification while addressing issues related to problem assets. In addition, the creation of a sales team to proactively handle the sale of other real estate owned (“OREO”) has facilitated efficient asset resolution which, in turn, has reduced the negative impact of carrying nonperforming assets on the balance sheet.

 

  Ÿ  

Emphasizing Growth in Commercial Business and Consumer Lending While Reducing Exposure to Construction and Commercial Real Estate Loans.    Sterling continues to optimize its balance sheet mix to achieve increased risk adjusted returns by rebalancing loan-portfolio concentrations, aligning loan pricing with credit risk and improving the overall mix of earning assets. Since December 31, 2008, construction loans have declined $1.0 billion, or 40%.

 

  Ÿ  

Originating Lower-Cost Core Deposits with Relationship Banking Initiatives.    We have implemented a number of relationship-focused deposit initiatives over the last two years, resulting in growth of core deposits including non-interest bearing checking accounts. The change in our deposit mix has contributed to Sterling’s cost of funds decreasing from 3.13% as of December 31, 2008 to 2.28% as of December 31, 2009. In addition, we expect to realize an increase in deposit-related fee income with the increase in transaction deposit account activity. We expect the growth in core deposits to reduce our reliance on wholesale borrowings as a funding source.

 

  Ÿ  

Expanding and Diversifying Our Fee Income.    Sterling continues to explore opportunities to grow fee income through existing products and services as well as new sources, including deposit fees, transaction fees and fees from mortgage banking. These activities center around relationship banking and our Hometown Helpful value proposition. We are committed to providing our customers with knowledgeable bankers delivering valuable products and services at a fair price and in a convenient and accessible fashion. Income from mortgage banking operations has grown by $19.6 million, or 71.0%, during the year ended 2009, compared with the same period in 2008.

 

  Ÿ  

Improving Operating Efficiency Through Improved Expense Management.    In an effort to maximize core earnings and offset credit-related expenses incurred in today’s deteriorating credit environment, Sterling has implemented expense savings initiatives. Earlier this year, Sterling Savings Bank revised its branch staffing model and eliminated redundant positions. Through these and other efforts during 2009, Sterling Savings Bank reduced its full-time equivalent branch and administrative staffing by approximately 4.8%.

 

  Ÿ  

Improving Capital Levels.    For a discussion of the strategic alternatives designed to put Sterling on a sound financial footing and allow it to recapitalize and grow its business, see “—Recent Developments.”

As we complete the organizational shift away from asset-driven growth to profit-driven core relationship banking, we will continue to emphasize maximizing the effectiveness of our funding costs. Initially, our priorities are balanced, aggressive, deposit growth and timely, cost-effective, asset resolution. In the future, increasing larger low-cost core funding sources will enable us to generate profitable, high quality assets. We have improved all of our core funding ratios with loans-to-deposits declining 11 percentage points to 94% as of December 31, 2009. We continue to emphasize progress in the realignment of our asset concentrations and the restructuring of our balance sheet.

Sterling’s revenues are derived primarily from interest earned on loans and mortgage-backed securities (“MBS”), fees and service charges, and mortgage banking operations. Sterling’s earnings per share and performance ratios for 2009 continued to be impacted by the major disruption in the housing market and downturn in the economy. For the year ended December 31, 2009, Sterling recorded a loss of $855.5 million, or $16.48 per common share, reflecting a $681.4 million provision for credit losses compared with $333.6 million for 2008, and recorded non-cash charges of $227.6 million to

 

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reflect impairment of Sterling’s goodwill, and of $269.0 million to establish a valuation allowance against its deferred tax asset. During the third quarter of 2009, Sterling announced that, as part of its ongoing strategy to manage through the current economic cycle, it deferred regularly scheduled interest payments on its outstanding junior subordinated notes relating to its trust preferred securities. Sterling also announced the deferral of quarterly cash dividend payments on its $303 million in preferred stock. Sterling is allowed to defer payments of interest on the junior subordinated notes for up to 20 consecutive quarterly periods without default. Failure to pay dividends on CPP preferred stock for six dividend periods would trigger preferred shareholder board appointment rights.

The operations of Sterling, and banking institutions generally, are influenced significantly by general economic conditions and by policies of its primary regulatory authorities, the Board of Governors of the Federal Reserve System (the “Federal Reserve”), the FDIC and the WDFI.

Profitability Drivers

We intend to return to profitability by:

 

  Ÿ  

Growing our core deposits, particularly commercial, consumer and public sector transaction deposits.

 

  Ÿ  

Expanding full banking relationship products and services for commercial and public sector customers, including depository and treasury management services such as lockbox, online net banking, merchant services, analyzed and sweep accounts, remote deposit capture and international services.

 

  Ÿ  

Improving asset quality through robust underwriting and credit approval functions, and the reduction of non-performing assets.

 

  Ÿ  

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

 

  Ÿ  

Changing the mix of the loan portfolio to increase the volume of higher-yielding commercial banking and consumer loans.

 

  Ÿ  

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

 

  Ÿ  

Controlling expenses and increasing operating efficiency.

Together, we believe these strategies will contribute to a return to 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”).

Segment Results

For purposes of measuring and reporting financial results, Sterling is divided into five business segments:

 

  Ÿ  

The Community Banking segment provides retail, commercial banking, and wealth management services and products through Sterling’s subsidiary, Sterling Savings Bank.

 

  Ÿ  

The Residential Construction Lending segment has historically originated and serviced loans through the real estate division of Sterling’s subsidiary, Sterling Savings Bank. Activity in this segment has been curtailed, and realigned with an emphasis on credit resolution.

 

  Ÿ  

The Residential Mortgage Banking segment originates and sells servicing-retained and servicing-released residential loans through loan production offices of Sterling’s subsidiary, Golf Savings Bank.

 

  Ÿ  

The Commercial Mortgage Banking segment originates, sells and services commercial real estate loans and participation interests in commercial real estate loans through offices in the western region primarily through Sterling Savings Bank’s subsidiary INTERVEST.

 

  Ÿ  

The Other and Eliminations segment represents the parent company expenses and intercompany eliminations of revenue and expenses.

On May 1, 2009, Sterling Savings Bank’s subsidiary, Harbor Financial Services, Inc., which provides certain wealth management services, was renamed Sterling Savings Banc Financial Services, Inc.

 

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The following table presents certain financial information regarding Sterling’s segments and provides a reconciliation to Sterling’s consolidated totals as of and for the years ended December 31, 2009, 2008 and 2007 (in thousands):

 

     As of and for the Year Ended December 31, 2009  
     Community
Banking
    Residential
Construction
Lending
    Residential
Mortgage
Banking
    Commercial
Mortgage
Banking
    Other and
Eliminations
    Total  

Interest income

  $ 538,503      $ 7,951      $ 29,058      $ 22,912      $ 923      $ 599,347   

Interest expense

    (194,836     (39,633     (13,587     0        (7,314     (255,370
                                                 

Net interest income (expense)

    343,667        (31,682     15,471        22,912        (6,391     343,977   

Provision for losses on loans

    (389,293     (267,835     (24,243     0        0        (681,371

Noninterest income

    77,465        304        54,771        2,891        (11,617     123,814   

Noninterest expense

    (309,280     (7,273     (39,565     (8,299     (5,557     (369,974

Goodwill impairment

    (227,558     0        0        0        0        (227,558
                                                 

Income (loss) before income taxes

  $ (504,999   $ (306,486   $ 6,434      $ 17,504      $ (23,565   $ (811,112
                                                 

Total assets

  $ 9,302,660      $ 969,935      $ 586,765      $ 18,074      $ (11   $ 10,877,423   

 

     As of and for the Year Ended December 31, 2008  
     Community
Banking
    Residential
Construction
Lending
    Residential
Mortgage
Banking
    Commercial
Mortgage
Banking
    Other and
Eliminations
    Total  

Interest income

  $ 565,767      $ 99,027      $ 30,559      $ 18,962      $ 747      $ 715,062   

Interest expense

    (262,637     (62,492     (17,570     0        (12,811     (355,510
                                                 

Net interest income (expense)

    303,130        36,535        12,989        18,962        (12,064     359,552   

Provision for losses on loans

    (105,915     (221,135     (6,547     0        0        (333,597

Noninterest income

    70,444        3,234        23,672        3,803        (9,258     91,895   

Noninterest expense

    (253,189     (9,766     (29,005     (9,463     (4,094     (305,517

Goodwill impairment

    (192,695     0        (31,070     0        0        (223,765
                                                 

Income (loss) before income taxes

  $ (178,225   $ (191,132   $ (29,961   $ 13,302      $ (25,416   $ (411,432
                                                 

Total assets

  $ 10,721,836      $ 1,526,416      $ 517,728      $ 14,958        9,778      $ 12,790,716   

 

     As of and for the Year Ended December 31, 2007  
     Community
Banking
    Residential
Construction
Lending
    Residential
Mortgage
Banking
    Commercial
Mortgage
Banking
    Other and
Eliminations
    Total  

Interest income

  $ 548,815      $ 185,090      $ 23,863      $ 9,000      $ 210      $ 766,978   

Interest expense

    (274,100     (104,758     (14,462     0        (18,298     (411,618
                                                 

Net interest income (expense)

    274,715        80,332        9,401        9,000        (18,088     355,360   

Provision for losses on loans

    11,047        (35,752     (383     0        0        (25,088

Noninterest income

    81,663        6,945        21,012        7,496        (23,710     93,406   

Noninterest expense

    (230,753     (10,395     (30,584     (10,970     (2,763     (285,465
                                                 

Income (loss) before income taxes

  $ 136,672      $ 41,130      $ (554   $ 5,526      $ (44,561   $ 138,213   
                                                 

Total assets

  $ 9,999,348      $ 1,847,344      $ 399,306      $ 10,445      $ (106,668   $ 12,149,775   

 

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Lending Activities

Sterling provides both secured and unsecured loans to businesses and individuals. Our focus on superior service and relationship banking incorporates a de-emphasis on transactional lending, especially construction and investor or non-owner occupied commercial real estate lending.

Commercial Lending.    Sterling has structured its commercial lending into three groups: Commercial and Corporate Banking, Private Banking and Small Business Administration (“SBA”) Lending.

Sterling’s Commercial and Corporate Banking Group provides a full range of credit products to small- and medium-sized businesses. Credit products include lines of credit, receivable and inventory financing, equipment loans, and term real estate financing for owner-occupied properties. Loans may be fully secured, partially secured or unsecured, based on certain credit criteria. The credit product line for both businesses and individuals includes standardized products as well as customized accommodations.

Sterling’s Private Banking Group provides a full line of financial and credit services to higher-net-worth and higher-income borrowers, including a wide variety of consumer and commercial banking loans. The Private Banking Group also serves the needs of the owners and key employees of the commercial and corporate business customers.

Sterling’s Small Business Administration Group consists of business development officers strategically located in Sterling’s key business markets of Seattle, WA, Portland, OR, Spokane, WA and Santa Rosa, CA. Sterling’s business development officers assist small start-up and existing businesses with their financing, cash management and general business planning needs, primarily by helping them access the Small Business Administration’s guaranteed 7(a) and 504 lending programs. These guaranteed lending programs provide small businesses with critical and flexible funding for establishing a new business, or for the operation, acquisition or expansion of an existing business. From their four primary locations, Sterling’s business development officers support small businesses’ banking requirements throughout Sterling’s Commercial and Retail branch network.

 

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 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 subsidiary banks’ board of directors. Common forms of collateral pledged to secure commercial 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.

Commercial, corporate and private banking loans generally are backed by collateral that may be difficult to obtain or liquidate following a default, and it is difficult to accurately predict the borrower’s ability to generate future cash flows. These loans, however, typically offer higher yields than residential loans, and variable interest rates. The availability of such loans generally encourages 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. 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

 

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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 has seen a slowdown in the rate at which newly constructed commercial properties are able to obtain tenants, which has impacted some of its borrowers’ ability to obtain permanent financing. 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, as well as interest only residential mortgages. Sterling focuses its residential lending on traditional amortizing loans for owner occupied homes, second homes and investment properties per guidelines. Sterling also has interest only loan programs available that are underwritten according to the borrower’s ability to make fully amortized payments. To a lesser extent, Sterling originates non-owner occupied residential mortgages. With the slowdown in the real estate market, Sterling has experienced a substantial increase in classified and non-performing loans in its non-owner occupied residential loan portfolio.

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 to correspondent institutions that include the Federal Home Loan Mortgage Corporation (“FHLMC”) and to 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 with limited recourse to Sterling, meaning that Sterling may be obligated to repurchase any loans that are not underwritten in accordance with these agencies’ or applicable investor underwriting guidelines. Historically, these repurchases have been very limited. Sterling continues to originate residential loans to be held in its portfolio. The maximum loan to value ratio is generally 80% on portfolio lending products.

Conventional residential mortgage loans are originated for up to 100% 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 most 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 presold and spec homes, as well as townhouses and condominiums and provides land, lot, and acquisition and development loans for residential subdivisions. However, in the current economic environment, the number of viable residential construction projects that meet Sterling’s underwriting standards is limited. 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 and disbursement practices with respect to construction financing are intended to ensure that sufficient funds are available to complete construction projects. Sterling has seen a deterioration of the credit quality of its residential construction portfolio as evidenced by the increase

 

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in classified and non-performing construction loans. Sterling endeavors to limit its risk through its underwriting procedures by using only approved, qualified appraisers and by dealing only with qualified builders/borrowers. See “—Classified and Non-performing Assets.”

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 20 years.

 

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

 

      Years Ended December 31,
      2009    2008    2007
      Amount    %    Amount    %    Amount    %
      (Dollars in thousands)

Mortgage:

                   

One- to four-family residential

   $ 3,047,380    76.5    $ 1,464,673    40.4    $ 1,492,026    27.2

Multifamily residential

     82,696    2.1      170,975    4.7      35,870    0.7

Commercial real estate

     176,256    4.4      326,853    9.0      163,315    3.0
                                     

Total mortgage loans

     3,306,332    83.0      1,962,501    54.1      1,691,211    30.9
                                     

Construction:

                   

One- to four-family residential

     32,692    0.8      383,922    10.6      1,584,449    28.9

Multifamily residential

     0    0.0      25,374    0.7      118,799    2.2

Commercial real estate

     31,968    0.8      192,755    5.3      488,372    8.9
                                     

Total construction loans

     64,660    1.6      602,051    16.6      2,191,620    40.0
                                     

Total mortgage and construction loans

     3,370,992    84.6      2,564,552    70.7      3,882,831    70.9
                                     

Commercial and consumer:

                   

Commercial banking

     318,544    8.0      541,978    15.0      995,732    18.2

Consumer—direct

     191,789    4.8      326,763    9.0      359,338    6.6

Consumer—indirect

     99,813    2.6      190,177    5.3      242,309    4.3
                                     

Total commercial and consumer loans

     610,146    15.4      1,058,918    29.3      1,597,379    29.1
                                     

Total loans originated

   $ 3,981,138    100.0    $ 3,623,470    100.0    $ 5,480,210    100.0

Construction loan originations were lower for both 2009 and 2008, as compared to 2007, reflecting both Sterling’s strategic efforts to reduce the concentration of these loans in its loan portfolio, and current economic conditions that have caused a decline in demand for these loans.

 

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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,
     2009   2008   2007   2006   2005
     Amount     %   Amount     %   Amount     %   Amount     %   Amount     %
     (Dollars in thousands)

Mortgage:

                     

One- to four-family residential

  $ 839,170      10.9   $ 867,384      9.6   $ 703,826      7.8   $ 654,661      9.2   $ 488,633      9.9

Multifamily residential

    517,408      6.7     477,615      5.3     389,388      4.3     263,053      3.7     332,211      6.7

Commercial real estate

    1,403,560      18.2     1,364,885      15.1     1,223,036      13.5     795,386      11.2     792,219      16.0
                                                             

Total mortgage loans

    2,760,138      35.8     2,709,884      30.0     2,316,250      25.6     1,713,100      24.1     1,613,063      32.6
                                                             
   

Construction:

                     

One- to four-family residential

    720,964      9.4     1,455,860      16.1     1,933,125      21.3     1,429,772      20.1     591,362      11.9

Multifamily residential

    233,501      3.0     324,818      3.6     263,873      2.9     189,819      2.7     143,272      2.9

Commercial real estate

    561,643      7.3     754,017      8.4     747,913      8.2     671,291      9.4     286,868      5.8
                                                             

Total construction loans

    1,516,108      19.7     2,534,695      28.1     2,944,911      32.4     2,290,882      32.2     1,021,502      20.6
                                                             

Total mortgage and construction loans

    4,276,246      55.5     5,244,579      58.1     5,261,161      58.0     4,003,982      56.3     2,634,565      53.2
   

Commercial and consumer:

                     

Commercial banking

    2,301,944      29.9     2,532,158      28.1     2,639,196      29.1     2,069,086      29.1     1,531,079      30.9

Consumer—direct

    792,957      10.3     859,222      9.5     798,519      8.8     749,626      10.5     618,528      12.5

Consumer—indirect

    323,565      4.3     389,298      4.3     376,937      4.1     288,704      4.1     166,143      3.4
                                                             

Total commercial and consumer loans

    3,418,466      44.5     3,780,678      41.9     3,814,652      42.0     3,107,416      43.7     2,315,750      46.8
                                                             

Total loans receivable

    7,694,712      100.0     9,025,257      100.0     9,075,813      100.0     7,111,398      100.0     4,950,315      100.0
                               

Deferred fees, net

    (7,070       (9,798       (16,480       (12,308       (8,916    
                                                     

Gross loans receivable

    7,687,642          9,015,459          9,059,333          7,099,090          4,941,399       

Allowance for loan losses

    (343,443       (208,365       (111,026       (77,849       (52,033    
                                                     

Loans receivable, net

  $ 7,344,199          $ 8,807,094          $ 8,948,307          $ 7,021,241          $ 4,889,366       

 

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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, 2009. 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 credit losses.

 

     Balance
Outstanding at
December 31, 2009
  Principal Payments
Contractually Due in Fiscal Years
       2010   2011-2014   Thereafter
     (in thousands)
     fixed   variable   fixed   variable   fixed   variable   fixed   variable

Mortgage

  $ 990,193   $ 1,769,945   $ 84,465   $ 368,298   $ 308,570   $ 674,252   $ 597,158   $ 727,395

Construction:

                 

Residential

    32,322     688,642     22,591     481,317     8,924     190,136     807     17,189

Multifamily

    19,465     214,036     15,095     165,980     4,370     48,056     0     0

Commercial

    40,096     521,547     28,301     368,124     11,664     151,723     131     1,700
                                                 

Total Construction

    91,883     1,424,225     65,987     1,015,421     24,958     389,915     938     18,889

Consumer—direct

    444,374     348,583     33,200     13,501     115,519     20,599     295,655     314,483

Consumer—indirect

    323,565     0     78,870     0     230,547     0     14,148     0

Commercial banking

    654,368     1,647,576     218,429     691,477     268,349     545,583     167,590     410,516
                                                 
    $ 2,504,383   $ 5,190,329   $ 480,951   $ 2,088,697   $ 947,943   $ 1,630,349   $ 1,075,489   $ 1,471,283

 

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 for 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 5 to 25 basis points of the unpaid principal balance. At December 31, 2009 and 2008, Sterling serviced for itself and for other investors, residential mortgage loans totaling $1.88 billion and $1.29 billion, respectively. Of such mortgage loans, $1.09 billion in 2009 and $501.6 million in 2008 were primarily serviced for FHLMC and FNMA. Sterling’s ability to continue as a seller/servicer for these agencies is dependent upon meeting their qualifications. As a result of Sterling’s capitalization, there can be no assurance that Sterling will be able to continue as a seller/servicer for these agencies.

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, 2009 and 2008, Sterling serviced for itself and other investors, commercial and multifamily real estate loans totaling $3.45 billion and $3.44 billion, respectively.

Secondary Market Activities.    Sterling has developed correspondent relationships with a number of mortgage companies and financial institutions to facilitate the origination and sale of mortgage loans in the secondary market on either a participation or whole loan basis. Substantially all of these loans are secured by real estate. On a limited basis, Sterling has purchased mortgage loans in the secondary market. 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. During 2009 and 2008, Sterling did not purchase any loans in the secondary market.

In 2009, 74% of Sterling’s sales of residential mortgage loans were sold into the secondary market on a servicing-released basis, while in 2008, nearly all were. Sterling generally receives a fee of approximately 100 to 200 basis points of the principal balance of mortgage loans for releasing the servicing. For sales of loans on a servicing-retained

 

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basis, Sterling records a servicing asset of approximately 100 to 142 basis points of the principal balance. At December 31, 2009 and 2008, Sterling had recorded $12.1 million and $5.7 million in servicing rights, respectively. See Note 5 of “Notes to Consolidated Financial Statements.”

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, 2009, 2008 and 2007, Sterling sold approximately $20.9 million, $15.8 million and $56.0 million in loans under participation agreements, resulting in net gains of $1.6 million, $24,000 and $3.0 million, respectively.

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 $167.9 million and $809.3 million at December 31, 2009 and 2008, respectively. Sterling also had secured and unsecured commercial and personal lines of credit, the undisbursed portion of which was approximately $844.2 million and $1.00 billion at December 31, 2009 and 2008, respectively. See Note 17 of “Notes to Consolidated Financial Statements.”

Derivatives and Hedging.    As part of its mortgage banking activities, Sterling issues interest rate lock commitments to prospective borrowers on residential mortgage loan applications. Pricing for the sale of these loans is fixed with various qualified investors under both non-binding (“best-efforts”) and binding (“mandatory”) delivery programs. For mandatory delivery programs, Sterling hedges interest rate risk by entering into offsetting forward sale agreements on mortgage-backed securities (“MBS”) with third parties. Risks inherent in mandatory delivery programs include the risk that if Sterling does not close the loans subject to interest rate lock commitments, it is nevertheless obligated to deliver MBS to the counterparty under the forward sale agreement. Sterling could incur significant costs in acquiring replacement loans or MBS and such costs could have a material adverse effect on mortgage banking operations in future periods. See Note 10 of “Notes to Consolidated Financial Statements.”

 

Interest rate lock commitments and loan delivery commitments are off balance sheet commitments that are considered to be derivatives. As of December 31, 2009, Sterling had $110.0 million of interest rate lock commitments, $119.7 million of warehouse loans held for sale that were not committed to investors, and held offsetting forward sale agreements on MBS valued at $234.0 million. In addition, Sterling had mandatory delivery commitments to sell mortgage loans to investors valued at $29.5 million as of December 31, 2009. As of December 31, 2008, Sterling had $75.4 million of interest rate lock commitments, $71.8 million of warehouse loans held for sale that were not committed to investors, and held offsetting forward sale agreements on MBS valued at $114.4 million. In addition, Sterling had mandatory delivery commitments to sell mortgage loans to investors valued at $1.4 million as of December 31, 2008. As of December 31, 2009 and December 31, 2008, Sterling had entered into best efforts forward commitments to sell $51.6 million and $71.0 million of mortgage loans, respectively.

In addition, Sterling enters into interest rate swap derivative contracts with customers. The interest rate risk on these contracts is managed by entering into offsetting interest rate swap agreements with various counterparties (“broker-dealers” or “dealers”). The counterparty agreements include certain representations, warranties and covenants, which include terms that allow for an early termination in the event of default. Failure to maintain a well capitalized position is one event that may be considered a default, and counterparties to the derivative instruments could require an early termination settlement or an increase in the collateralization on derivative instruments in net liability positions. During the fourth quarter of 2009, one dealer counterparty terminated three swap positions that had a $4.8 million notional amount. The market values of interest rate swaps fluctuate based upon interest rate movements. At the time of termination, these swaps had a market value of $254,000. The “make whole” provision of the contracts resulted in Sterling reimbursing the counterparty and recording a charge equal to the value of the swaps at termination. As of March 16, 2010, no other counterparties have terminated any positions or requested additional collateral. The aggregate fair value of all derivative instruments with credit risk

 

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related contingent features that are in a liability position on December 31, 2009 was $4.3 million for which Sterling had already posted collateral with a market value of $6.1 million. Both customer and dealer related interest rate derivatives are carried at fair value by Sterling.

Classified and Nonperforming Assets.    To measure the quality of loans and other real estate owned (“OREO”), Sterling has established guidelines for classifying and determining provisions for anticipated losses. Sterling’s system employs the classification categories of “substandard,” “doubtful” and “loss” for its classified assets. 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 same weaknesses as substandard assets, and on the basis of currently existing facts, are also deemed to have 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 increased to $1.65 billion at December 31, 2009, from $984.9 million at December 31, 2008. As a percentage of total assets, classified assets increased to 15.15% at December 31, 2009 from 7.70% at December 31, 2008. The credit quality of Sterling’s residential and commercial construction loans has deteriorated, and delinquencies have increased due to declining market values and weakness in housing sales, as well as slower lease-ups of commercial properties in certain of its markets.

 

The following table describes classified assets by asset type at the dates indicated:

 

      December 31,
2009
   September 30,
2009
   June 30,
2009
   March 30,
2009
   December 31,
2008
      (Dollars in thousands)

Residential real estate

   $ 128,561    $ 74,448    $ 62,785    $ 31,400    $ 34,333

Multifamily real estate

     44,258      31,921      22,290      15,814      16,741

Commercial real estate

     154,859      81,754      62,184      41,364      37,890

Construction

                

Residential construction

     487,789      527,630      521,984      558,170      548,384

Multifamily and commercial construction

     462,088      275,817      256,192      145,629      119,348
                                    

Total construction

     949,877      803,447      778,176      703,799      667,732
                                    

Consumer—direct and indirect

     11,996      9,016      7,908      6,816      4,556

Commercial banking

     269,521      168,790      192,207      170,678      143,748
                                    

Total classified loans

     1,559,072      1,169,376      1,125,550      969,871      905,000

OREO

     91,478      81,361      89,721      100,512      79,875
                                    

Total classified assets

   $ 1,650,550    $ 1,250,737    $ 1,215,271    $ 1,070,383    $ 984,875

 

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The following table provides additional information regarding the classified assets of the largest 30 borrowers as of December 31, 2009, which together constituted 28% of all classified assets at year end:

 

Description

  

Location

   December 31, 2009
           (Dollars in thousands)

Commercial Construction: 3 loans

   Puget Sound, WA & Other WA    $ 36,441

Multifamily & Commercial Construction: 5 loans

   Puget Sound, WA & Other OR      35,016

Residential Construction: A&D, land, specs and lots: 11 loans

   Puget Sound, WA, OR, CA & UT      29,831

Residential Construction: A&D, land, specs and lots: 53 loans

   Portland, OR & Other WA      26,622

Residential Construction: A&D, land: 2 loans

   Other OR      22,813

Residential Construction and Commercial: 6 loans

   Other OR      20,096

Residential Construction: A&D, land: 3 loans

   Puget Sound, WA      19,263

Commercial Real Estate: 1 loan

   Northern CA      19,042

Residential Construction: A&D, land, specs and lots: 170 loans

   Portland, OR & Vancouver, WA      18,948

Multifamily Construction: 1 loan

   Puget Sound, WA      18,050

Commercial Construction: 2 loans

   Other OR      17,627

Multifamily: 1 loan

   Portland, OR      16,630

Residential Construction: A&D, land, specs and lots: 104 loans

   Puget Sound, WA      14,000

Commercial: 1 loan

   Other OR      13,000

Commercial & residential mix use: 4 loans

   Other WA      12,862

Multifamily & commercial: 3 loans

   Puget Sound, WA      11,493

Multifamily: 1 loan

   Other ID      10,758

Residential Construction: specs & lots: 20 loans

   Puget Sound, WA      10,615

Commercial Construction: 1 loan

   WA & OR      10,473

Commercial Construction: land: 1 loan

   Northern CA      10,166

Multifamily: 1 loan

   Puget Sound, WA      10,099

Residential Construction: specs & lots: 2 loans

   Portland, OR      9,907

Residential Construction: specs & lots: 27 loans

   Other WA      9,549

Residential Construction: specs & lots & Commercial: 9 loans

   Other OR      9,463

Commercial: 1 loan

   Northern CA      9,375

Commercial: 2 loans

   Puget Sound, WA & Other WA      9,106

Commercial: 1 loan

   Puget Sound, WA      8,801

Commercial: 1 loan

   Northern CA      8,725

Commercial: 2 loans

   Northern CA      8,359

Commercial: 1 loan

   Northern CA      8,190
           

Total—Classified Assets of top 30 borrowers

        $ 465,320

 

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Since early 2008, Sterling has been adding resources to manage the increased volume of classified assets. The credit administration group focuses on identifying and resolving problem credits before they become classified. When an asset becomes classified, management of the relationship is assumed by Sterling’s special assets department. Sterling actively engages the borrower and guarantor to remedy the situation by requiring current financial information from the borrower(s) and guarantor(s) to determine a course of action. In addition, new collateral values are requested in order for Sterling’s management to perform evaluations for regulatory and decision making purposes and updated title information is obtained to determine the status of encumbrances on the collateral. When possible, Sterling will require the borrower to provide additional collateral or capital. In conjunction with the receipt of additional collateral, Sterling will sometimes modify the terms of the loan. Often the new modified terms of the loan are consistent with terms that Sterling would offer a new borrower. If the modification of terms is considered concessionary, Sterling classifies the loan as a Troubled Debt Restructure and reports it as a nonperforming loan.

 

Sterling also may consider allowing a borrower to sell the underlying collateral for less than the outstanding balance on the loan if the current collateral evaluation supports the offer price. In such situations, Sterling typically requires the borrower to sign a new note for the resulting deficiency or bring cash to closing. In some situations Sterling releases the collateral only in a sale transaction, preserving its right to seek monetary judgments against the borrowers and guarantors.

If Sterling and a borrower are unable to achieve an acceptable resolution, Sterling may take a deed in lieu of foreclosure or initiate foreclosure on the underlying collateral. Under such circumstances, Sterling also simultaneously evaluates legal action for recovery against the borrowers and guarantors. After obtaining the collateral, Sterling actively works to sell the collateral.

 

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Nonperforming assets are a subset of classified assets, and consist of nonaccrual loans, restructured loans and OREO. The following table summarizes the principal balances of nonperforming assets at the dates indicated:

 

      December 31,  
      2009     2008     2007     2006     2005  
      (Dollars in thousands)  

Past due 90 days

   $ 0      $ 0      $ 0      $ 0      $ 0   

Nonaccrual loans

     824,652        474,172        123,790        8,486        8,701   

Restructured loans

     71,279        56,618        350        0        1,081   
                                          

Total nonperforming loans

     895,931        530,790        124,140        8,486        9,782   

OREO

     91,478        79,875        11,075        4,052        779   
                                          

Total nonperforming assets

     987,409        610,665        135,215        12,538        10,561   

Specific reserves

     (35,334     (19,535     (8,678     (1,379     (2,159
                                          

Net nonperforming assets

   $ 952,075      $ 591,130      $ 126,537      $ 11,159      $ 8,402   
                                          

Nonperforming loans with charge-offs, gross

   $ 1,202,660      $ 462,511      $ 0      $ 0      $ 0   

Charge-offs on nonperforming loans

     (500,183     (165,906     0        0        0   
                                          

Nonperforming loans carried at fair value

     702,477        296,605        0        0        0   

Nonperforming loans with no charge-offs

     193,454        234,185        124,140        8,486        9,782   
                                          

Total nonperforming loans

   $ 895,931      $ 530,790      $ 124,140      $ 8,486      $ 9,782   
                                          

Nonperforming assets to total assets

     9.08     4.77     1.11     0.13     0.14

Nonperforming loans to loans

     11.65     5.89     1.37     0.12     0.20

Nonperforming loans carried at fair value to total nonperforming loans

     78.4     55.9     N/A        N/A        N/A   

Charge-offs to gross nonperforming loans

     41.6     35.9     N/A        N/A        N/A   

Loan loss allowance to nonperforming loans

     38.3     39.3     89.4     917.4     531.9

Loan loss allowance to nonperforming loans excluding loans carried at fair value

     163.5     89.0     89.4     917.4     531.9

 

As of December 31, 2009, Sterling has recognized confirmed losses totaling $500.2 million on collateral dependent nonperforming loans held in its portfolio. These confirmed losses have written down the carrying value of these loans to the appraisal value of their underlying collateral. The loan loss coverage ratio, excluding these loans for which the full loss to date has been charged off, was 163.5% of nonperforming loans at December 31, 2009. Further declines in real estate appraisal values could result in additional losses on these loans. Prior to 2008, Sterling set aside specific reserves for its nonperforming loans, and did not record confirmed losses until foreclosure.

 

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The following table describes nonperforming assets by asset type at the dates indicated:

 

      December 31,
      2009    2008    2007    2006    2005
      (Dollars in thousands)

Residential real estate

   $ 71,642    $ 46,043    $ 1,557    $ 1,729    $ 856

Multifamily real estate

     20,478      4,757      2,268      3,356      4,302

Commercial real estate

     69,540      7,753      1,418      1,340      2,579

Construction:

                

Residential

     439,478      410,338      102,373      96      0

Multifamily

     75,331      3,894      0      0      0

Commercial

     167,867      70,607      3,042      0      0
                                    

Total construction

     682,676      484,839      105,415      96      0

Consumer—direct

     5,803      5,053      1,716      1,069      821

Consumer—indirect

     806      700      836      154      164

Commercial banking

     136,464      61,520      22,005      4,794      1,839
                                    

Total nonperforming assets

   $ 987,409    $ 610,665    $ 135,215    $ 12,538    $ 10,561

 

Weakness in the overall economy has contributed to increased levels of nonperforming assets. Recent increases in nonperforming assets have been driven by increases in nonperforming construction, commercial real estate, and commercial banking loans.

 

At the applicable foreclosure date, other real estate owned is recorded at the fair value of the real estate, less the costs to sell the real estate. The carrying value of OREO is regularly evaluated and, if necessary, an allowance is established to reduce the carrying value to net realizable value. The following table sets forth the activity in Sterling’s OREO for the periods indicated:

 

      Years Ended December 31,  
      2009     2008     2007  
      (Dollars in thousands)  

Balance at beginning of period

   $ 62,320      $ 11,075      $ 4,052   

Loan foreclosures and other additions

     201,005        124,610        11,418   

Loss at foreclosure

     (44,556     (43,710     (3,166

Improvements and other changes

     1,654        (1,819     119   

Sales

     (106,130     (10,208     (1,348

Provisions for losses

     (31,021     (17,628     0   
                          

Balance at end of period

   $ 83,272      $ 62,320      $ 11,075   

 

Allowance for Credit Losses.    Sterling regularly reviews its classified assets for impairment. If a loan is determined to be impaired, Sterling performs a valuation analysis on the loan. Valuation analysis compares the fair value (market value less selling costs, foreclosure costs and projected holding costs), and the book balance (loan principal and accrued interest or carrying value of OREO). For loans that are considered collateral dependent, the difference between the fair value and the book value is charged off as a confirmed loss. For certain non-collateral dependent loans, Sterling establishes

 

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a specific reserve for the difference between fair value and book value of these loans, as the loss is not defined as a confirmed loss because it is not based solely on collateral values. Allowances are established and periodically adjusted, if necessary, based on the review of information obtained through on-site inspections, market analysis, appraisals and purchase offers. During the fourth quarter of 2009, primarily as a result of the large decline in real estate values during 2009, Sterling began to record a specific reserve for impaired loans for which an updated valuation analysis has not been completed within the last quarter. The specific reserve is calculated by applying an estimated market adjustment to each loan based on market and property type.

Sterling maintains an allowance for credit losses at a level deemed appropriate by management to adequately provide for probable losses related to specifically identified loans and probable losses in the remaining portfolio, as well as unfunded commitments. The allowance is based upon historical loss experience, loan migration analysis, delinquency trends, portfolio size, concentrations of risk, prevailing and anticipated economic conditions, industry experience, estimated collateral values, management’s assessment of credit risk inherent in the portfolio, specific problem loans and other relevant factors. The portfolio is grouped into standard industry categories for homogeneous loans based on characteristics such as loan type, borrower and collateral. Annual and quarterly loan migration to loss data is used to determine the probability of default. Historically, Sterling had used both one-year and three-year losses to establish the expected loss rate on loans. During the fourth quarter of 2009, as a result of the higher loss rates experienced during 2009, Sterling began using loss experience from the most recent twelve months to estimate the amount that would be lost if a default were to occur, which is termed the loss given default. The probability of default is multiplied by the loss given default to calculate the expected losses for each loan category.

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 be a confirmed loss. Because the allowance for credit losses is based on estimates, ultimate losses may materially differ from the estimates. See Note 4 of “Notes to Consolidated Financial Statements.”

 

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Management believes that the allowance for credit 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 credit losses for the periods indicated:

 

     Years Ended December 31,  
     2009     2008     2007     2006     2005  
     (Dollars in thousands)  

Allowance—loans, January 1

  $ 208,365      $ 111,026      $ 77,849      $ 52,034      $ 47,352   

Charge-offs:

           

Residential real estate

    (31,401     (6,187     (30     (32     (37

Multifamily real estate

    (3,510     (1,806     0        0        (3

Commercial real estate

    (50,733     (17,023     (70     (902     (2,315

Construction

    (420,539     (168,471     (3,430     (12     (19

Consumer—direct

    (9,652     (4,053     (1,268     (619     (1,107

Consumer—indirect

    (5,744     (5,864     (1,884     (823     (449

Commercial banking

    (45,085     (19,920     (1,000     (2,017     (5,721
                                         

Total charge-offs

    (566,664     (223,324     (7,682     (4,405     (9,651
                                         

Recoveries:

           

Residential real estate

    306        66        5        5        6   

Multifamily real estate

    5        0        0        0        0   

Commercial real estate

    348        69        41        157        42   

Construction

    6,803        221        3        20        0   

Consumer—direct

    364        272        261        193        238   

Consumer—indirect

    1,303        1,370        495        310        200   

Commercial banking

    1,875        80        128        68        86   
                                         

Total recoveries

    11,004        2,078        933        753        572   
                                         

Net charge-offs

    (555,660     (221,246     (6,749     (3,652     (9,079

Provision

    690,738        318,585        24,632        16,312        13,761   

Acquired

    0        0        15,294        13,155        0   
                                         

Allowance—loans, December 31

    343,443        208,365        111,026        77,849        52,034   
                                         

Allowance—unfunded commitments, January 1

    21,334        6,306        5,840        3,449        2,010   

Provision

    (9,367     15,074        466        2,391        1,439   

Amounts written off

    0        (46     0        0        0   
                                         

Allowance—unfunded commitments, December 31

    11,967        21,334        6,306        5,840        3,449   
                                         

Balance at end of period

  $ 355,410      $ 229,699      $ 117,332      $ 83,689      $ 55,483   
                                         

Allowances allocated to specific reserve loans

  $ 27,129      $ 1,980      $ 8,678      $ 1,379      $ 2,159   

Ratio of net charge-offs to average loans outstanding during the period

    6.17     2.37     0.08     0.06     0.20

 

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During 2008 and 2009, Sterling increased its provision for credit losses in response to an increase in the level of classified loans and charge-offs, with higher loss rates related to the decline in collateral values, particularly in the Construction, Commercial Real Estate and Residential Real Estate portfolios.

The following table sets forth the loan loss allowance by category and summarizes the percentage of total loans in each category to total loans:

 

     December 31,
     2009   2008   2007   2006   2005
     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)

Residential real estate

  $ 28,319   10.9   $ 8,147   9.6   $ 965   7.8   $ 1,405   9.2   $ 1,039   9.9

Multifamily real estate

    8,984   6.7     4,795   5.3     659   4.3     671   3.7     790   6.7

Commercial real estate

    69,487   18.2     24,720   15.1     21,244   13.5     17,565   11.2     12,748   16.0

Construction

    185,222   19.7     118,279   28.1     50,109   32.4     12,098   32.2     4,566   20.6

Consumer—direct

    13,544   10.3     7,207   9.5     7,274   8.8     8,205   10.5     6,795   12.5

Consumer—indirect

    5,654   4.3     7,401   4.3     5,056   4.1     2,880   4.1     1,205   3.4

Commercial banking

    31,945   29.9     29,019   28.1     23,830   29.1     34,209   29.1     23,626   30.9

Unallocated

    288   N/A     8,797   N/A     1,889   N/A     816   N/A     1,265   N/A
                                                   
    $ 343,443   100.0   $ 208,365   100.0   $ 111,026   100.0   $ 77,849   100.0   $ 52,034   100.0

In response to higher charge-offs and loss rates experienced during 2009, Sterling has increased its loan loss allowance on Construction, Commercial Real Estate and Residential Real Estate loans.

 

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Investments and Mortgage-Backed Securities

Investments and MBS 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, 2009 and 2008, investments classified as held to maturity were $17.6 million and $175.9 million, respectively. See “MD&A—Critical Accounting Policies—Investments and MBS.”

At December 31, 2009 and 2008, investments and MBS classified as available for sale were $2.16 billion and $2.64 billion, respectively. The carrying value of these investments and MBS at December 31, 2009 includes net unrealized gains of $25.8 million, compared with net unrealized losses of $28.4 million as of December 31, 2008. 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 MBS.”

Sterling invests primarily in MBS issued by the Federal Home Mortgage Corporation (“FHLMC”), the Federal National Mortgage Corporation (“FNMA”) and the Government National Mortgage Association (“GNMA”), and has limited investments in other non-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 MBS. See “MD&A—Results of Operations—Non-Interest Income and Non-Interest Expense” and Note 2 of “Notes to Consolidated Financial Statements.”

 

The following table provides the carrying values, contractual maturities and weighted average yields of Sterling’s investment and MBS portfolio at December 31, 2009. 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)  

Mortgage-backed securities

            

Balance

   $ 175      $ 0      $ 100,085      $ 1,844,729      $ 1,944,989   

Weighted average yield

     0.00     0.00     4.49     4.47     4.47

Municipal bonds

            

Balance

   $ 203      $ 1,154      $ 20,505      $ 173,420      $ 195,282   

Weighted average yield (1)

     2.89     2.60     5.14     4.39     4.46

Other

            

Balance

   $ 750      $ 0      $ 0      $ 36,950      $ 37,700   

Weighted average yield

     0.00     0.00     0.00     1.13     1.11
                                          

Total carrying value

   $ 1,128      $ 1,154      $ 120,590      $ 2,055,099      $ 2,177,971   
                                          

Weighted average yield

     0.52     2.60     4.60     4.40     4.41

 

(1)

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

 

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The following table sets forth the carrying values and classifications for financial statement reporting purposes of Sterling’s investment and MBS portfolio at the dates indicated:

 

     December 31,  
     2009     2008     2007  
     (Dollars in thousands)  

Mortgage-backed securities

  $ 1,944,989      $ 2,420,012      $ 1,785,031   

U.S. government and agency obligations

    0        0        9,994   

Municipal bonds

    195,282        260,873        143,063   

Short term commercial paper

    0        99,117        0   

Other

    37,700        35,118        47,976   
                         

Total

  $ 2,177,971      $ 2,815,120      $ 1,986,064   
                         

Available for sale

  $ 2,160,325      $ 2,639,290      $ 1,853,271   

Held to maturity

    17,646        175,830        132,793   
                         

Total

  $ 2,177,971      $ 2,815,120      $ 1,986,064   
                         

Weighted average yield

    4.41     5.19     4.95

 

Sources of Funds

General.    Sterling’s primary sources of funds are: customer deposits; wholesale funds from the Federal Home Loan Bank (“FHLB”) and the Federal Reserve; and the collection of principal and interest primarily from loans, as well as from mortgage backed securities. Additionally, loans are sold into the secondary market in connection with Sterling’s mortgage banking activities. The availability and volume of these funds are influenced significantly by prevailing interest rates and other economic conditions, as well as regulatory statutes. Borrowings may be used on a short-term basis to compensate for reductions in other sources of funds (such as deposit inflows at less than projected levels). Borrowings may also be used on a longer-term basis to support expanded lending activities and to match repricing intervals of assets. See “—Lending Activities” and “—Investments and Mortgage-Backed Securities.”

Deposit Activities.    Sterling offers a wide variety of deposit products and related services to businesses, individuals, and public sector entities throughout its primary market areas. Deposit accounts include transaction (checking) accounts, savings accounts, money market demand accounts (“MMDA”), and certificates of deposit (“CDs”) accounts. These deposit products and services are marketed by its 178 depository banking offices and each of its private and commercial banking offices. Sterling offers both interest- and non-interest-bearing checking accounts, MMDA, CDs and savings accounts that earn interest at rates established by management and are based on a competitive market analysis, as well as regulatory guidelines. The method of compounding varies from simple interest credited at maturity to daily compounding, depending on the type of account.

With the exception of certain promotional CDs and variable-rate products, most CDs carry a fixed rate of interest for a defined term from the opening date of the account. Penalties are imposed if principal is withdrawn from most CDs prior to maturity.

Sterling competes with other financial institutions and financial intermediaries in attracting deposits. There is strong competition for transaction, money market and time deposit balances from commercial banks, credit unions and nonbank corporations, such as securities brokerage companies, mutual funds and other diversified companies, some of which have nationwide networks of offices. Much of Sterling’s marketing efforts have been directed toward attracting additional deposit customer relationships and balances. Sterling provides electronic banking products, including debit card, online Internet banking, bill pay, merchant services and treasury

 

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management services, which include remote deposit capture. All of these products and services are intended to enhance customer relationships and attract and increase retail deposit balances.

Sterling has 168 automated teller machines (“ATM”). Customers also can access ATMs operated by other financial institutions. Sterling is a member of the Plus System ATM network that allows participating customers to deposit or withdraw funds from transaction accounts, MMDA and savings accounts at numerous locations in the United States and internationally.

Sterling supplements its retail deposit gathering by soliciting funds from public entities and, prior to the SSB Consent Agreement, through the acquisition of brokered deposits. Since Sterling Savings Bank is no longer deemed to be well capitalized, it must comply with limitations on the interest rate that can be paid on retail deposits, and cannot accept or renew brokered deposits. Public funds are generally obtained by competitive bidding among qualifying financial institutions. Public funds were 11% and 10% of deposits at December 31, 2009 and 2008, respectively. Brokered deposits were 14% and 18% of deposits at December 31, 2009 and 2008, respectively. In 2009, certain states increased the collateralization requirements for uninsured public deposits. The increased collateralization requirements required Sterling to pledge additional collateral, which reduced Sterling’s collateral available for liquidity.

 

The following table presents the average balance outstanding and weighted average interest rate paid for each major category of deposits for the periods indicated:

 

      Years Ended December 31,  
      2009     2008     2007  
      Average
Balance
   Weighted
Average
Interest
Rate
    Average
Balance
   Weighted
Average
Interest
Rate
    Average
Balance
   Weighted
Average
Interest
Rate
 
      (Dollars in thousands)  

Transaction accounts:

                 

Interest-bearing

   $ 844,154    0.30   $ 441,708    0.31   $ 463,337    0.55

Noninterest-bearing

     980,021    0.00        880,224    0.00        895,729    0.00   

Savings and MMDA

     1,758,678    0.91        2,173,133    2.13        2,078,984    3.45   

Time deposits

     4,718,946    3.20        4,553,160    4.10        4,039,152    5.04   
                                         
     $ 8,301,799    2.04   $ 8,048,225    2.91   $ 7,477,202    3.71

The following table shows the amounts and remaining maturities of time deposits that had balances of $100,000 or more at December 31, 2009 and 2008:

 

      December 31,
      2009    2008
      (Dollars in thousands)

Three months or less

   $ 374,185    $ 535,399

After three months through six months

     198,309      297,665

After six months through twelve months

     417,420      648,334

After twelve months

     600,190      253,489
               
     $ 1,590,104    $ 1,734,887

 

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Borrowings.    Deposit accounts are Sterling’s primary source of funds. Sterling does, however, use wholesale funds to supplement its funding requirements and to meet deposit withdrawal requirements. These borrowings include advances from the FHLB, reverse repurchase agreements, primary credits and term auction facilities from the Federal Reserve, as well as federal funds purchased. During 2009, these borrowings decreased as Sterling reduced the level of total assets to manage its capital position. See “MD&A—Liquidity and Capital Resources.”

The FHLB of Seattle is part of a system that consists of 12 regional Federal Home Loan Banks that provide credit to financial institutions. As a condition of membership in the FHLB of Seattle, Sterling’s subsidiary banks are required to own stock of the FHLB of Seattle in an amount determined by a formula based upon the larger of their total qualifying mortgages and MBS, or total advances from the FHLB of Seattle. At December 31, 2009, Sterling Savings Bank and Golf Savings Bank held more than the minimum FHLB of Seattle stock ownership requirement.

As members of the FHLB of Seattle, Sterling Savings Bank and Golf Savings Bank can apply for collateralized borrowings using certain loans or securities, provided certain standards related to creditworthiness are met. Each available credit product has its own interest rate and range of maturities. At December 31, 2009, Sterling had advances totaling $1.24 billion from the FHLB of Seattle, which mature from 2010 through 2018. At December 31, 2009, the interest rates ranged from 0.11% to 8.08%. Additionally, as of December 31, 2009, Sterling had $100.2 million of advances from the FHLB of San Francisco, which were assumed in the Northern Empire acquisition. Sterling, as a non member shareholder, does not have access to additional funds from the FHLB of San Francisco. At December 31, 2009 and December 31, 2008, Sterling’s credit lines with the FHLB of Seattle represented a total borrowing capacity of $2.43 billion and $2.92 billion, of which $967.5 million and $1.33 billion was available, respectively. In the first quarter of 2010, Sterling Savings Bank started transitioning from a blanket pledge collateral agreement with the FHLB of Seattle to a custodial agreement. Additionally, Sterling’s future borrowings from the FHLB of Seattle are limited to overnight cash management advances (“CMA”), which automatically rollover each day. Sterling Savings Bank has the ability to increase or decrease the CMA borrowings on a daily basis.

The economic difficulties that have plagued the financial markets during this business cycle had a significant impact on the Federal Home Loan Banks. Given the negative impacts from other-than-temporary impairment (“OTTI”) charges on certain non-agency MBS and the current market uncertainty, both the FHLB of Seattle and the FHLB of San Francisco announced that they would cease paying dividends and would not redeem or repurchase capital stock. Both the FHLB of Seattle and the FHLB of San Francisco also announced that they would monitor their capital levels, the OTTI issue, overall financial performance and developments in the financial markets as a basis for determining the status of dividends and capital stock redemptions or repurchases in future quarters. The FHLB of Seattle, Sterling’s current source of FHLB advances, continues to provide Sterling with a readily available source of liquidity, although there can be no assurance that this will always be the case. See “MD&A—Liquidity and Capital Resources” and Note 9 of “Notes to Consolidated Financial Statements.”

Sterling also borrows funds under reverse repurchase agreements with major broker/dealers and financial entities pursuant to which it sells investments (generally, U.S. agency obligations and MBS) under an agreement to buy them back at a specified price at a later date. These agreements to repurchase are deemed to be borrowings collateralized by the investments and MBS sold. Sterling uses these borrowings to supplement deposit gathering for funding the origination of loans. Sterling had $1.03 billion and $1.09 billion in wholesale and retail reverse repurchase agreements outstanding at December 31, 2009 and 2008, respectively. The use of reverse repurchase agreements may expose Sterling to certain risks not associated with other borrowings, including interest rate risk and the possibility that additional collateral may have to be provided if the market value of the pledged collateral declines. Sterling may be required to repay these borrowings prior to maturity, with penalties, if an event of default has been deemed to have occurred. At December 31, 2009, Sterling was not “well capitalized,” which may trigger an event of default under certain of these borrowings. See

 

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“MD&A—Asset and Liability Management,” “MD&A—Liquidity and Capital Resources” and Note 10 of “Notes to Consolidated Financial Statements.”

As of December 31, 2009 and 2008, Sterling also had $16.7 million and $69.0 million, respectively, of funds from the Federal Reserve discount window, which are short-term borrowings. Sterling uses this source of funds to the extent that these funds are more competitive than other sources. In 2008, in an effort to increase liquidity, the Federal Reserve, among other measures, lowered the rate on the funds that are available from its discount window to 25 basis points above the federal funds target rate. In February 2010, the Federal Reserve increased the discount rate, for the first time since June 2006, by 25 basis points to 75 basis points.

 

The following table sets forth certain information regarding Sterling’s short-term borrowings as of and for the periods indicated:

 

     Years Ended December 31,  
     2009     2008     2007  
     (Dollars in thousands)  

Maximum amount outstanding at any month-end during the period:

       

Short-term reverse repurchase agreements and funds purchased

  $ 60,465      $ 118,343      $ 288,845   

Short-term advances

    653,000        594,614        826,045   
   

Average amount outstanding during the period:

       

Short-term reverse repurchase agreements and funds purchased

  $ 43,027      $ 100,924      $ 158,852   

Short-term advances

    613,520        444,806        539,635   
   

Weighted average interest rate paid during the period:

       

Short-term reverse repurchase agreements and funds purchased

    4.09     1.51     4.62

Short-term advances

    2.68     3.76     5.19
   

Weighted average interest rate paid at end of period:

       

Short-term reverse repurchase agreements and funds purchased

    0.50     2.03     4.31

Short-term advances

    1.63     3.87     4.48

The following table sets forth certain information concerning Sterling’s outstanding borrowings for the periods indicated:

 

     December 31,  
     2009     2008     2007  
     Amount   %     Amount   %     Amount   %  
     (Dollars in thousands)  

FHLB advances:

             

Short-term

  $ 635,182   24.1      $ 548,819   17.5      $ 399,617   12.7   

Long-term

    701,985   26.6        1,177,730   37.5        1,288,372   41.0   

Securities sold subject to reverse repurchase agreements and funds purchased:

             

Short-term

    49,146   1.9        163,023   5.2        288,845   9.2   

Long-term

    1,000,000   38.0        1,000,000   31.9        890,000   28.4   

Trust Preferred Securities

    245,281   9.3        245,276   7.8        270,015   8.6   

Other

    3,000   0.1        3,000   0.1        3,000   0.1   
                                     

Total borrowings

  $ 2,634,594   100.0      $ 3,137,848   100.0      $ 3,139,849   100.0   
                                     

Weighted average interest rate at end of period

        2.68         3.34         4.63

 

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Subsidiaries

Sterling’s principal operating subsidiaries are Sterling Savings Bank and Golf Savings Bank. Sterling Savings Bank’s principal subsidiary is INTERVEST. Additionally, Sterling and Sterling Savings Bank have the following other wholly owned, direct subsidiaries:

Sterling Financial Corporation.

 

(1) Golf Escrow Corporation was acquired in July 2006 and offers a full range of escrow closing services.

 

(2) Sterling Capital Trust III (“SCT-III”) was organized in April 2003 as a Delaware business trust. Sterling owns all the common equity of SCT-III. The sole asset of SCT-III is the Junior Subordinated Debentures-III issued by Sterling. See Note 11 of “Notes to Consolidated Financial Statements.”

 

(3) Sterling Capital Trust IV (“SCT-IV”) was organized in May 2003 as a Delaware business trust. Sterling owns all the common equity of SCT-IV. The sole asset of SCT-IV is the Junior Subordinated Debentures-IV issued by Sterling. See Note 11 of “Notes to Consolidated Financial Statements.”

 

(4) Sterling Capital Statutory Trust V (“SCT-V”) was organized in May 2003 as a Connecticut business trust. Sterling owns all the common equity of SCT-V. The sole asset of SCT-V is the Junior Subordinated Debentures -V issued by Sterling. See Note 11 of “Notes to Consolidated Financial Statements.”

 

(5) Sterling Capital Trust VI (“SCT-VI”) was organized in June 2003 as a Delaware business trust. Sterling owns all the common equity of SCT-VI. The sole asset of SCT-VI is the Junior Subordinated Debentures-VI issued by Sterling. See Note 11 of “Notes to Consolidated Financial Statements.”

 

(6) Sterling Capital Trust VII (“SCT-VII”) was organized in June 2006 as a Delaware business trust. Sterling owns all the common equity of SCT-VII. The sole asset of SCT-VII is the Junior Subordinated Debentures-VII issued by Sterling. See Note 11 of “Notes to Consolidated Financial Statements.”

 

(7) Sterling Capital Trust VIII (“SCT-VIII”) was organized in September 2006 as a Delaware business trust. Sterling owns all the common equity of SCT-VIII. The sole asset of SCT-VIII is the Junior Subordinated Debentures-VIII issued by Sterling. See Note 11 of “Notes to Consolidated Financial Statements.”

 

(8) Sterling Capital Trust IX (“SCT-IX”) was organized in July 2006 as a Delaware business trust. Sterling owns all the common equity of SCT-IX. The sole asset of SCT-IX is the Junior Subordinated Debentures-IX issued by Sterling. See Note 11 of “Notes to Consolidated Financial Statements.”

 

(9) Klamath First Capital Trust I (“KCT-I”) was organized in July 2001 as a Delaware business trust. Sterling owns all the common equity of KCT-I. The sole asset of KCT-I is the Junior Subordinated Debentures-I issued by KFBI and assumed by Sterling. See Note 11 of “Notes to Consolidated Financial Statements.”

 

(10) Lynnwood Financial Statutory Trust I (“LCT-I”) was organized in March 2004 as a Connecticut business trust. Sterling owns all the common equity of LCT-I. The sole asset of LCT-I is the Junior Subordinated Debentures-I issued by Lynnwood and assumed by Sterling. See Note 11 of “Notes to Consolidated Financial Statements.”

 

(11) Lynnwood Financial Statutory Trust II (“LCT-II”) was organized in June 2006 as a Delaware business trust. Sterling owns all the common equity of LCT-II. The sole asset of LCT-II is the Junior Subordinated Debentures-II issued by Lynnwood and assumed by Sterling. See Note 11 of “Notes to Consolidated Financial Statements.”

 

(12) Tri-Cities Mortgage Corporation was organized to engage in real estate development.

Sterling Savings Bank.

 

(1) Action Mortgage Company was organized to originate residential loans. During 2008, its operations were realigned into the real estate division of Sterling Savings Bank.

 

(2) The Dime Service Corporation was acquired as part of a merger in February 2004. The corporation was organized to provide

 

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commercial and consumer insurance products and is currently inactive.

 

(3) Evergreen Environmental Development Corporation was organized to engage in real estate development and is currently inactive.

 

(4) Evergreen First Service Corporation owns all of the outstanding capital stock of Sterling Savings Banc Financial Services, Inc.

 

(5) Sterling Savings Banc Financial Services, Inc., formerly known as Harbor Financial Services, Inc., offers wealth management services.

 

(6) Fidelity Service Corporation acts as a trustee in the reconveyance of deeds of trust originated by Sterling Savings Bank and Action.

 

(7) Mason-McDuffie Financial Corporation, a subsidiary of INTERVEST, conducts mortgage banking operations.

 

(8) Peter W. Wong Associates, Inc. was organized to offer alternative financial services, and is currently inactive.

 

(9) Source Capital Corporation was acquired in September 2001. The corporation was organized to hold and service loans, and is currently inactive.

 

(10) Source Capital Leasing Corporation was acquired in September 2001. The corporation was organized to engage in corporate leasing and is currently inactive.

Competition

Sterling faces strong competition, both in attracting deposits and in originating, purchasing and selling loans, from commercial banks, savings and loan associations, mutual savings banks, credit unions and other institutions, many of which have greater resources than Sterling. Sterling also faces strong competition in marketing financial products such as annuities, mutual funds and other financial products and in pursuing acquisition opportunities. Some or all of these competitive businesses operate in Sterling’s market areas.

 

Personnel

As of December 31, 2009, Sterling, including its subsidiaries, had 2,641 full-time equivalent employees. Employees are not represented by a collective bargaining unit. Sterling believes it has good relations with its employees.

Environmental Laws

Environmentally related hazards have become a source of high risk and potentially unlimited liability for financial institutions relative to their loans. Environmentally contaminated properties owned by an institution’s borrowers may result in a drastic reduction in the value of the collateral securing the institution’s loans to such borrowers, high environmental clean-up costs to the borrower affecting its ability to repay the loans, the subordination of any lien in favor of the institution to a state or federal lien securing clean-up costs, and liability to the institution for clean-up costs if it forecloses on the contaminated property or becomes involved in the management of the borrower. To minimize this risk, Sterling may require an environmental examination and report with respect to the property of any borrower or prospective borrower if circumstances affecting the property indicate a potential for contamination, taking into consideration the potential loss to the institution in relation to the burdens to the borrower. This examination must be performed by an engineering firm experienced in environmental risk studies and acceptable to the institution, with the costs of such examinations and reports being the responsibility of the borrower. These costs may be substantial and may deter a prospective borrower from entering into a loan transaction with Sterling. Sterling is not aware of any borrower who is currently subject to any environmental investigation or clean-up proceeding that is likely to have a material adverse effect on the financial condition or results of operations of Sterling.

 

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Regulation

The following is not intended to be a complete discussion but is intended to be a summary of some of the more significant provisions of laws applicable to Sterling and its subsidiaries. This regulatory framework is intended to protect depositors, federal deposit insurance funds and the banking system as a whole, and not to protect security holders. To the extent that the information describes statutory and regulatory provisions, it is qualified in its entirety by reference to those provisions. Further, such statutes, regulations and policies are continually under review by Congress and state legislatures, and federal and state regulatory agencies. A change in statutes, regulations or regulatory policies applicable to Sterling, including changes in interpretation or implementation thereof, could have a material effect on Sterling’s business.

General

Sterling is a bank holding company and as such is subject to comprehensive examination and regulation by the Federal Reserve. Sterling Savings Bank is a Washington State-chartered commercial bank and Golf Savings Bank is a Washington State-chartered savings bank. The deposits of both banks are insured by the FDIC. Sterling Savings Bank and Golf Savings Bank are subject to comprehensive regulation, examination and supervision by the FDIC and the WDFI. Furthermore, certain transactions and savings deposits are subject to regulations and controls promulgated by the Federal Reserve. Sterling’s subsidiaries are also subject to regulation by the applicable federal and state agencies for the states in which they conduct business.

These laws and regulations could restrict Sterling’s ability to diversify into other areas of financial services, acquire depository institutions, and pay dividends on its capital stock. Sterling may also be required to provide financial support to one or more of its subsidiary banks, maintain capital balances in excess of those desired by management, and pay higher deposit insurance premiums as a result of a general deterioration in the financial condition of depository institutions.

Recent Legislative and Regulatory Initiatives to Address Financial and Economic Crises .    The U.S. Congress, the U.S. Department of the Treasury (the “Treasury Department”) and the federal banking regulators, including the FDIC, have taken broad action since early September 2008 to address volatility in the U.S. banking system.

In October 2008, the Emergency Economic Stabilization Act of 2008 (“EESA”) was enacted. The EESA authorizes the Treasury Department to purchase from financial institutions and their holding companies up to $700 billion in mortgage loans, mortgage-related securities and certain other financial instruments, including debt and equity securities issued by financial institutions and their holding companies in the Troubled Assets Relief Program (“TARP”). EESA also increased FDIC deposit insurance on most accounts from $100,000 to $250,000 through December 31, 2013. On January 1, 2014, the standard insurance amount will return to $100,000 per depositor for all account categories except IRAs and other certain retirement accounts, which will remain at $250,000 per depositor.

The purpose of TARP is to restore confidence and stability to the U.S. banking system and to encourage financial institutions to increase their lending to customers and to each other. The Treasury Department initially allocated $250 billion towards the TARP Capital Purchase Program (“CPP”). Under the CPP, the Treasury Department purchases debt or equity securities from participating institutions. The TARP also allows for direct purchases or guarantees of troubled assets of financial institutions. Participants in the CPP are subject to executive compensation limits and are encouraged to expand their lending and mortgage loan modifications. On December 5, 2008, Sterling completed the sale of 303,000 shares of preferred stock and issued a warrant to purchase 6,437,677 shares of Sterling’s common stock to the U.S. Department of the Treasury, raising total proceeds of $303 million. In connection with Sterling’s participation in the CPP, certain executive officers of Sterling entered into amended employment agreements with Sterling.

Following a determination that the banking industry faced systemic risk, the FDIC established a Temporary Liquidity Guarantee Program (“TLGP”) on October 14, 2008. The TLGP includes the Transaction Account Guarantee Program (“TAG”), which provides depositors with unlimited coverage for noninterest bearing transaction accounts at participating FDIC

 

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insured institutions. Noninterest bearing checking accounts include Demand Deposit Accounts (“DDAs”) and any transaction account that has unlimited withdrawals and that cannot earn interest. Also included are low interest NOW accounts (NOW accounts that cannot earn more than 0.5% interest) and IOLTA accounts. Coverage under the TAG program is in addition to, and separate from, the coverage available under the FDIC’s standard deposit insurance amount.

When the FDIC first introduced the temporary TAG program, it announced an original expiration date of December 31, 2009 and implemented an annual assessment rate of 10 basis points on the balance of each covered account in excess of $250,000. In August 2009, the FDIC announced a voluntary extension of the TAG program for an additional six months, through June 30, 2010, for any insured depository institution then participating in the program. Sterling is participating in this extension. Effective January 1, 2010, the annual assessment rate that applies to participating institutions during the extension period is either 15 basis points, 20 basis points or 25 basis points, depending on the Risk Category assigned to the institution under the FDIC’s risk-based premium system.

Bank Holding Company Regulation

The Fair and Accurate Credit Transactions Act.    In December 2003, the Fair and Accurate Credit Transactions Act of 2003 (the “FACT”) was signed into law. The FACT includes many provisions concerning national credit reporting standards and permits consumers, including Sterling’s customers, to opt out of information sharing among affiliated companies for marketing purposes. The FACT also requires financial institutions to provide consumers certain information regarding the consumer’s credit score. Additionally, financial institutions must notify their customers if they report negative information about them to credit bureaus or if the credit terms offered to a customer are materially less favorable than the most favorable terms offered to a substantial portion of customers because of information in the customer’s credit report. The FACT also contains provisions intended to help detect identity theft.

The Sarbanes-Oxley Act.    In July 2002, the Sarbanes-Oxley Act of 2002 (“SOX”) was enacted in response to public concerns regarding corporate accountability. The stated goals of SOX are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws. SOX represents a comprehensive revision of laws affecting corporate governance, accounting obligations and corporate reporting. SOX generally applies to all companies that file or are required to file periodic reports with the Securities and Exchange Commission (“SEC”) under the Securities Exchange Act of 1934, as amended (“Exchange Act”).

SOX includes new disclosure requirements and corporate governance rules, requires the SEC and securities exchanges to adopt extensive additional disclosure, corporate governance and other related rules, and mandates further studies of certain issues by the SEC and the Comptroller General. In particular, SOX establishes: new requirements for audit committees; additional responsibilities regarding financial statements of reporting companies; new standards for auditors and regulation of audits; increased disclosure and reporting obligations for a reporting company and its directors and executive officers; and new civil and criminal penalties for violation of the securities laws. The SEC has enacted rules to implement various of the provisions with respect to, among other matters, disclosure in periodic filings pursuant to the Exchange Act.

The U.S.A. Patriot Act.    In December 2001, the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “Patriot Act”) became effective. The Patriot Act is designed to combat money laundering and terrorist financing while protecting the U.S. financial system. The Patriot Act imposes enhanced policy, record keeping and due diligence requirements on domestic financial institutions. The Patriot Act also amended the Bank Secrecy Act to facilitate access to customer account information by government officials while immunizing banks from liability for releasing such information.

The Gramm-Leach-Bliley Act.    In November 1999, the Gramm-Leach-Bliley Act (the “GLBA”) was

 

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enacted. The GLBA is also known as the Financial Services Modernization Act due to its sweeping overhaul of the financial services industry. Enactment of the GLBA allows banks, securities firms and insurance companies to affiliate. The GLBA allows financial institutions to act as financial “supermarkets” offering customers “one stop shopping” for bank accounts, insurance policies and securities transactions.

The GLBA, among other things, provides customers with greater financial privacy by requiring financial institutions to safeguard their nonpublic personal information. Financial institutions must advise customers of their policies regarding sharing nonpublic personal information with non-affiliated third parties and allow customers to “opt-out” of such sharing (subject to several exceptions related mainly to processing customer-initiated transactions and compliance with current law).

The Riegle-Neal Interstate Banking and Branching Efficiency Act.    The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the “Interstate Act”) permits nationwide interstate banking and branching under certain circumstances. This legislation generally authorizes interstate branching and relaxes federal law restrictions on interstate banking. Currently, bank holding companies may purchase banks in any state, and states may not prohibit these purchases. Additionally, banks are permitted to merge with banks in other states, as long as the home state of neither merging bank has opted out under the legislation. The Interstate Act requires regulators to consult with community organizations before permitting an interstate institution to close a branch in a low-income area.

Washington enacted “opting in” legislation in accordance with the Interstate Act, allowing banks to engage in interstate merger transactions, subject to certain “aging” requirements. Washington restricts an out-of-state bank from opening de novo branches. However, once an out-of-state bank has acquired a bank within the state, either through merger or acquisition of all or substantially all of the bank’s assets, the out-of-state bank may open additional branches within the state.

The Bank Holding Company Act.    As a bank holding company, Sterling is governed by The Bank Holding Company Act of 1956, as amended (the “BHCA”), and is therefore subject to supervision and examination by the Federal Reserve. Sterling files annual reports of operations with the Federal Reserve.

In general, the BHCA limits bank holding company business to owning or controlling banks and engaging in other banking-related activities. Bank holding companies must obtain the Federal Reserve’s approval before they: (1) acquire direct or indirect ownership or control of any voting shares of any bank that results in total ownership or control, directly or indirectly, of more than 5 percent of the voting shares of such bank; (2) merge or consolidate with another bank holding company; or (3) acquire substantially all of the assets of any additional banks. Subject to certain state laws, such as age and contingency restrictions, a bank holding company that is adequately capitalized and adequately managed may acquire the assets of both in-state and out-of-state banks. With certain exceptions, the BHCA prohibits bank holding companies from acquiring direct or indirect ownership or control of voting shares in any company that is not a bank or a bank holding company unless the Federal Reserve determines that the activities of such company are incidental or closely related to the business of banking. If a bank holding company is well-capitalized and meets certain criteria specified by the Federal Reserve, it may engage de novo in certain permissible non-banking activities without prior Federal Reserve approval.

The Change in Bank Control Act .    Pursuant to The Change in Bank Control Act of 1978, as amended, a person (or group of persons acting in concert) acquiring “control” of a bank holding company is required to provide the Federal Reserve with 60 days prior written notice of the proposed acquisition. Following receipt of this notice, the Federal Reserve has 60 days within which to issue a notice disapproving the proposed acquisition, but the Federal Reserve may extend this time period for up to another 30 days. An acquisition may be completed before expiration of the disapproval period if the Federal Reserve issues written notice of its intent not to disapprove the transaction. In addition, any “company” must obtain the Federal Reserve’s approval before acquiring 25% (5% if the “company” is a bank holding company) or more of the outstanding shares or otherwise obtaining control over Sterling.

 

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The Federal Reserve Act.    Sterling and its subsidiaries are deemed affiliates within the meaning of the Federal Reserve Act, and transactions between affiliates are subject to certain restrictions. Accordingly, Sterling and its subsidiaries must comply with Sections 23A and 23B of the Federal Reserve Act. Sections 23A and 23B (1) limit the extent to which a financial institution or its subsidiaries may engage in “covered transactions” with an affiliate, as defined, to an amount equal to 10% of such institution’s capital and surplus and an aggregate limit on all such transactions with all affiliates to an amount equal to 20% of such capital and surplus, and (2) require all transactions with an affiliate, whether or not “covered transactions,” to be on terms substantially the same, or at least as favorable to the institution or subsidiary, as those provided to a non-affiliate. The term “covered transaction” includes the making of loans, purchase of assets, issuance of a guarantee and other similar types of transactions. Section 23A includes a number of exemptions for certain transactions between banks and their affiliates. The most important exemption is for transactions that are between banks where 80 percent or more of each bank’s stock is owned by the same company.

Transactions with Affiliates.    Subsidiary banks of a bank holding company are subject to restrictions imposed by the Federal Reserve Act on extensions of credit to the holding company or its subsidiaries, on investments in their securities, and on the use of their securities as collateral for loans to any borrower. These regulations and restrictions may limit Sterling’s ability to obtain funds from its banking subsidiaries for its cash needs, including funds for payment of dividends, interest and operational expenses.

Tying Arrangements.    Sterling is prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, sale or lease of property or furnishing of services. For example, with certain exceptions, neither Sterling nor its subsidiaries may condition an extension of credit to a customer on either (1) a requirement that the customer obtain additional services provided by Sterling or (2) an agreement by the customer to refrain from obtaining other services from a competitor.

 

Support of Subsidiary Banks.    Under Federal Reserve policy, Sterling is expected to act as a source of financial and managerial strength to its banking subsidiaries. This means that Sterling is required to commit, as necessary, resources to support Sterling Savings Bank and Golf Savings Bank. Any capital loans a bank holding company makes to its subsidiary banks are subordinate to deposits and to certain other indebtedness of those subsidiary banks.

Federal and State Regulation of Banking Activities

General.    The deposits of Sterling Savings Bank and Golf Savings Bank are insured by the FDIC. As a result, they are subject to supervision and regulation by the FDIC as well as the WDFI. These agencies have the authority to prohibit banks from engaging in what they believe constitute unsafe or unsound banking practices.

Community Reinvestment.    The Community Reinvestment Act requires that, in connection with examinations of financial institutions within their jurisdiction, the Federal Reserve or the FDIC evaluate the record of the financial institution in meeting the credit needs of its local communities, including low and moderate income neighborhoods, consistent with the safe and sound operation of the institution. These factors are also considered in evaluating mergers, acquisitions and applications to open a branch or facility.

Insider Credit Transactions.    Banks are also subject to certain restrictions imposed by the Federal Reserve Act on extensions of credit to executive officers, directors, principal shareholders or any related interests of such persons. Extensions of credit (1) must be made on substantially the same terms, including interest rates and collateral as, and follow credit underwriting procedures that are not less stringent than, those prevailing at the time for comparable transactions with persons not covered above and who are not employees, and (2) must not involve more than the normal risk of repayment or present other unfavorable features. Banks are also subject to certain lending limits and restrictions on overdrafts to insiders. A violation of these restrictions may result in the assessment of substantial civil monetary penalties, the imposition of a cease and desist order, and other regulatory sanctions.

 

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Regulation of Management.    Federal law: (1) sets forth circumstances under which officers or directors of a bank may be removed by the institution’s federal supervisory agency; (2) places restraints on lending by a bank to its executive officers, directors, principal shareholders, and their related interests; and (3) prohibits management personnel of a bank from serving as a director or in a management position of another financial institution whose assets exceed a specified amount or which has an office within a specified geographic area.

Safety and Soundness Standards .    The Federal Deposit Insurance Corporation Act of 1991 requires the FDIC to impose upon banks certain non-capital safety and soundness standards. These standards cover, among other things, internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation and benefits. Additional standards apply to asset quality, earnings and stock valuation. An institution that fails to meet these standards must develop a plan acceptable to its regulators, specifying the steps that the institution will take to meet the standards. Failure to submit or implement such a plan may subject the institution to regulatory sanctions.

Lending Restrictions and Disclosure Requirements.     The Federal Reserve has adopted amendments to the Home Ownership and Equity Protection Act of 1994 (“HOEPA”), which expand the protections of HOEPA to cover more transactions and prohibit certain practices deemed harmful to borrowers. If a loan qualifies as a HOEPA loan, certain practices and terms on high-cost mortgages are restricted and require special consumer disclosures. The interest rate trigger on first-time liens used to determine whether a loan qualifies as a HOEPA loan has been lowered from 10% to 8% and the cost of single-premium credit insurance products has been added to the points and fees test. As a result, more of Sterling’s loans are expected to be subject to HOEPA restrictions and disclosure requirements.

The Real Estate Settlement Procedures Act (“RESPA”) requires lenders to provide borrowers with disclosures regarding the nature and cost of real estate settlements. RESPA restricts how and when disclosed fees may change. The Act also prohibits certain abusive practices, such as kickbacks and fee-splitting without providing settlement services. Penalties under the above laws may include fines, reimbursements, and other penalties.

Credit Card Regulation.    The Credit Card Accountability Responsibility and Disclosure Act (the “Credit Card Act”) bans retroactive rate increases, requires that bills be due no less than 21 days from the time of mailing, requires that credit card contracts be accessible on the Internet, and allows consumers to opt-in if they choose to use a card issuer’s over-limit protection.

Loan Modifications.    The U.S. Department of the Treasury has instituted a Home Affordable Modification Program (“HAMP”) as part of its Making Home Affordable program that is focused on reducing the number of foreclosures and making it easier for customers to refinance loans. The HAMP provides guidelines on loan modifications that are intended to help certain at-risk homeowners avoid foreclosure by reducing monthly mortgage payments and providing incentives to lenders to modify all eligible loans that fall under the guidelines of this program.

Deposit Insurance Assessments.    During 2007, the FDIC merged the Bank Insurance Fund (“BIF”) and the Savings Association Insurance Fund (“SAIF”) into a new Deposit Insurance Fund (“DIF”). The DIF and FDIC insure deposits of Sterling Savings Bank and Golf Savings Bank up to the prescribed limits for each depositor. In October 2008, the basic limit on federal deposit insurance coverage of interest bearing transaction accounts increased from $100,000 to $250,000 per depositor under the EESA. In November 2008, the FDIC offered a voluntary expanded insurance program to depository institutions, which provides, without charge to depositors, full guarantee on all non-interest bearing transaction accounts held by any depositor, regardless of dollar amount. Sterling Savings Bank and Golf Savings Bank are participating in this program. The FDIC maintains the DIF by assessing each depository institution an insurance premium. The amount of FDIC assessments paid by a DIF member institution is based on its relative risk of default as measured by a company’s FDIC supervisory rating, and other various measures, such as the level of brokered deposits, unsecured debt, and debt issuer ratings.

 

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On February 27, 2009, the FDIC adopted an amended restoration plan for the DIF that was originally established and implemented on October 7, 2008. The plan was further amended on September 29, 2009 and requires the DIF reserve ratio to be 1.15% within eight years of the original restoration plan. On May 22, 2009, the FDIC adopted a final rule imposing a 5 basis point special assessment on each insured depository institution’s assets minus Tier 1 capital as of June 30, 2009. The amount of the special assessment for any institution will not exceed 10 basis points multiplied by the institution’s assessment base for the second quarter of 2009.

The DIF assessment base rate currently ranges from 12 to 45 basis points for institutions that do not trigger factors for brokered deposits and unsecured debt, and higher rates for those that do trigger those risk factors. On September 29, 2009, the FDIC announced plans to maintain assessment rates at their current levels through the end of 2010. In addition, the FDIC adopted a uniform 3 basis point increase in assessment rates effective January 1, 2011. At least semi-annually going forward the FDIC will assess whether to increase or decrease the assessment rate schedule. An increase in the assessment rate could have a material adverse effect on Sterling’s earnings, depending on the amount of the increase. The FDIC is authorized to terminate a depository institution’s deposit insurance upon a finding by the FDIC that the institution’s financial condition is unsafe or unsound, or that the institution has engaged in unsafe or unsound practices, or has violated any applicable rule, regulation, order or condition enacted or imposed by the institution’s regulatory agency. The termination of deposit insurance for Sterling’s subsidiaries, Sterling Savings Bank or Golf Savings Bank, could have a material adverse effect on Sterling’s earnings.

All FDIC-insured depository institutions must pay an annual assessment to provide funds for the payment of interest on bonds issued by the Financing Corporation, a federal corporation chartered under the authority of the Federal Housing Finance Board. The bonds, which are referred to as FICO bonds, were issued to capitalize the Federal Savings and Loan Insurance Corporation. FDIC-insured depository institutions paid between 1.02 cents to 1.14 cents per $100 of DIF-assessable deposits in 2009. The FDIC established the FICO assessment rate effective for the first quarter of 2010 at approximately 1.06 cents annually per $100 of assessable deposits.

Dividend Restrictions.    Sterling is a legal entity separate and distinct from its subsidiary banks and other subsidiaries. Its principal source of funds to pay dividends on its common and preferred stock and principal and interest on its debt is dividends from its subsidiaries. Various federal and state statutory provisions and regulations limit the amount of dividends Sterling, Sterling Savings Bank, Golf Savings Bank and certain other subsidiaries may pay without regulatory approval.

Pursuant to the Reserve Bank Agreement, Sterling is prohibited from paying any dividends without the prior written approval of the Reserve Bank. Sterling is also prohibited from directly or indirectly taking dividends, or any other form of payment that would represent a reduction in capital from Sterling Savings Bank or Golf Savings Bank, without the prior written approval of the Reserve Bank.

Federal bank regulatory agencies have the authority to prohibit Sterling Savings Bank and Golf Savings Bank from engaging in unsafe or unsound practices in conducting their business and the payment of dividends, depending on each bank’s financial condition, could be deemed an unsafe or unsound practice. Pursuant to the SSB Consent Agreement, Sterling Savings Bank is prohibited from paying dividends without the prior written consent of the FDIC and the WDFI. The ability of Sterling Savings Bank and Golf Savings Bank to pay dividends in the future will continue to be influenced by bank regulatory policies and capital guidelines.

Pursuant to the terms of Sterling’s participation in the CPP program of the Treasury Department, Sterling is also prohibited from paying dividends on its common stock so long as Sterling’s payments on its preferred stock remain deferred. Sterling is further prohibited from increasing the dividends to be paid to shareholders above the $0.10 per share quarterly dividend paid for the quarter ended September 30, 2008. This restriction on Sterling’s ability to increase its dividends will continue until either Sterling redeems all of the preferred shares sold to the Treasury Department, or December 2011, whichever is earliest.

 

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Federal Reserve System.    Sterling Savings Bank and Golf Savings Bank are subject to various regulations promulgated by the Federal Reserve, including, among others, Regulation B (Equal Credit Opportunity), Regulation D (Reserves), Regulation E (Electronic Fund Transfers), Regulation Z (Truth in Lending), Regulation CC (Availability of Funds) and Regulation DD (Truth in Savings). Regulation D requires non-interest-bearing reserve maintenance in the form of either vault cash or funds on deposit at the Federal Reserve Bank of San Francisco or another designated depository institution in an amount calculated by formula. The balances maintained to meet the reserve requirements imposed by the Fed may be used to satisfy liquidity requirements. As of December 31, 2009, Sterling Savings Bank and Golf Savings Bank met these requirements.

Federal Taxation.    Sterling is subject to federal income taxation under the Internal Revenue Code of 1986, as amended, in the same manner as other corporations. Sterling files consolidated federal income tax returns on the accrual basis. See Note 12 of “Notes to Consolidated Financial Statements.”

State Law and Regulation.    Sterling Savings Bank and Golf Savings Bank, as Washington State-chartered institutions, are subject to regulation by the WDFI, which conducts regular examinations to ensure that Sterling Savings Bank’s and Golf Savings Bank’s operations and policies conform with sound industry practice. The liquidity and other requirements set by the WDFI are generally no stricter than the liquidity and other requirements set by the Federal Reserve. State law regulates the amount of credit that can be extended to any one person or marital community and the amount of money that can be invested in any one property. Without the WDFI’s approval, Sterling Savings Bank and Golf Savings Bank currently cannot extend credit to any one person or marital community in an amount greater than 2.5% of Sterling Savings Bank’s or Golf Savings Bank’s total assets. State law also regulates the types of loans Sterling Savings Bank and Golf Savings Bank can make. Without the WDFI’s approval, Sterling Savings Bank and Golf Savings Bank cannot currently invest more than 10% of their total assets in other corporations. Sterling Savings Bank also operates depository branches within the states of Oregon, Idaho, California and Montana and therefore its operations in these states are subject to the supervision of the Oregon Department of Consumer and Business Services, the Idaho Department of Finance, the California Department of Financial Institutions and the Montana Department of Finance, as applicable. Golf Savings Bank’s depository branch is located in the state of Washington. Sterling and its subsidiaries are also required to comply with applicable laws and regulations for activities in Arizona, Utah and Colorado. In addition, Golf Savings Bank is also required to comply with applicable laws and regulations for activities in Oregon, Idaho, Utah and Montana.

Capital Adequacy

Regulatory Capital Guidelines.    Federal bank regulatory agencies use capital adequacy guidelines in the examination and regulation of bank holding companies and banks. The guidelines are “risk-based,” meaning that they are to: (i) make capital requirements more sensitive to differences in risk profiles among banks and bank holding companies; (ii) factor off-balance sheet exposure into the assessment of capital adequacy; (iii) minimize disincentives to holding liquid low risk assets; and (iv) achieve greater consistency in the evaluation of the capital adequacy of major banking organizations throughout the world.

Tier I and Tier II Capital.    Under the guidelines, an institution’s capital is divided into two broad categories, Tier I capital and Tier II capital. Tier I capital consists, in part, of common qualifying stockholders’ equity, qualifying cumulative perpetual preferred stock, including related surplus, and qualifying trust preferred securities. Tier II capital may consist of the allowance for loan and lease losses, hybrid capital instruments, perpetual preferred stock and related surplus, term subordinated debt and intermediate-term preferred stock, including related surplus, and unrealized holding gains on equity securities. The sum of Tier I capital and Tier II capital represents a banking organization’s total capital. Tier I capital must represent at least 50% of qualifying total capital.

Risk-based Capital Ratios.    The adequacy of an institution’s capital is gauged primarily with reference to the institution’s risk-weighted assets.

 

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The guidelines assign risk weightings to an institution’s assets in an effort to quantify the relative risk of each asset and to determine the minimum capital required to support that risk. An institution’s risk-weighted assets are then compared with its Tier I capital and total capital to arrive at a Tier I risk-based ratio and a total risk-based ratio, respectively. The guidelines provide that a bank must have a minimum Tier I risk-based ratio of 4% and a minimum total risk-based ratio of 8%.

Leverage Ratio.    The guidelines also employ a leverage ratio, which is calculated by dividing Tier I capital by the average total consolidated assets. The principal objective of the leverage ratio is to constrain the maximum degree to which a bank holding company may leverage its equity capital base. It is intended to be used as a supplement to the risk based capital measure. The minimum Tier I leverage ratio is 3% for bank holding companies that have received a risk rating of “1,” the highest possible rating. For all other bank holding companies, including Sterling, the minimum Tier I leverage ratio is 4%.

Prompt Corrective Action.    Under the guidelines, a bank is assigned to one of five capital categories depending on its total risk-based capital ratio, Tier I risk-based capital ratio, and leverage ratio, together with certain other subjective and objective factors. The categories range from “well capitalized” to “critically undercapitalized.” Institutions that are “adequately capitalized” or lower may be subject to certain mandatory or discretionary supervisory corrective actions. At December 31, 2009, Sterling maintained a total risk-based capital ratio of 7.9%, a tier 1 risk-based capital ratio of 4.9% and a tier 1 leverage ratio of 3.5%. As a result, Sterling has been categorized as “undercapitalized” and is subject to various restrictions, including restrictions on asset growth, acquisitions, new activities and new branches.

Forward-Looking Statements

From time to time, Sterling and its senior managers have made and will make forward-looking statements that are not historical facts and that are intended to be covered by the safe harbor for “forward-looking statements” provided by the Private Securities Litigation Reform Act of 1995. These forward-looking statements may include, but are not limited to, statements about Sterling’s plans, objectives, expectations and intentions and other statements contained in this release that are not historical facts and pertain to Sterling’s future operating results. When used in this report, the words “expects,” “anticipates,’’ ‘‘intends,’’ ‘‘plans,’’ ‘‘believes,’’ ‘‘seeks,’’ ‘‘estimates’’ and similar expressions are generally intended to identify forward-looking statements. We make forward-looking statements regarding projected sources of funds, use of proceeds, availability of acquisition and growth opportunities, ability to repay government funds, payment of dividends, adequacy of our allowance for loan and lease losses and provision for loan and lease losses, our real estate portfolio and subsequent charge-offs. Such statements may be contained in this report and in other documents that Sterling files with the Securities and Exchange Commission. Such statements may also be made by Sterling and its senior managers in oral or written presentations to analysts, investors, the media and others.

Actual results may differ materially from the results discussed in these forward-looking statements because such statements are inherently subject to significant assumptions, risks and uncertainties, many of which are difficult to predict and are generally beyond Sterling’s control. These include but are not limited to:

 

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our ability to successfully implement our alternative strategies for recapitalization;

 

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our ability to maintain adequate liquidity;

 

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our viability as a going concern

 

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our ability to comply with the Reserve Bank Agreement and the SSB Consent Agreement;

 

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our ability to attract and retain deposits and loans;

 

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demand for financial services in our market areas;

 

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competitive market pricing factors;

 

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further deterioration in economic conditions that could result in increased loan and lease losses;

 

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risks associated with concentrations in real estate-related loans;

 

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  Ÿ  

market interest rate volatility;

 

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stability of funding sources and continued availability of borrowings;

 

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changes in legal or regulatory requirements or the results of regulatory examinations that could restrict growth;

 

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our ability to comply with the requirements of regulatory orders issued to us and/or our banking subsidiaries;

 

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our ability to recruit and retain key management and staff;

 

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risks associated with merger and acquisition integration;

 

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continued decline in the market value of the Company;

 

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our ability to incur debt on reasonable terms;

 

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regulatory limits on our subsidiary banks’ ability to pay dividends to the Company;

 

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effectiveness of legislative and regulatory reform of the financial sector;

 

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future legislative or administrative changes to the TARP Capital Purchase Program; and

 

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the impact of EESA and ARRA and related rules and regulations on Sterling’s business operations and competitiveness, including the impact of executive compensation restrictions, which may affect Sterling’s ability to retain and recruit executives in competition with other firms who do not operate under those restrictions.

Other factors that could cause actual conditions, events or results to differ significantly from those described in the forward-looking statements may be found under the headings “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” below, as updated periodically in Sterling’s filings with the SEC. Unless legally required, Sterling disclaims any obligation to update any forward-looking statements. You should consider any forward-looking statements in light of this explanation, and we caution you about relying on forward-looking statements.

 

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Where You Can Find More Information

The periodic reports Sterling files with the SEC are available on Sterling’s website at www.sterlingfinancialcorporation-spokane.com after the reports are filed with the SEC. The SEC maintains a website located at www.sec.gov that also contains this information. The information on Sterling’s website and the SEC’s website is not part of this annual report on Form 10-K. Sterling will provide you with copies of these reports, without charge, upon request made to:

Investor Relations

Sterling Financial Corporation

111 North Wall Street

Spokane, Washington 99201

(509) 458-3711

 

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Item 1A. Risk Factors

Set forth below and elsewhere in this Annual Report on Form 10-K and in other documents Sterling files with the SEC are risks and uncertainties that could cause actual results to differ materially from the results contemplated by the forward-looking statements contained in this Annual Report on Form 10-K.

We are undercapitalized and face a number of challenges in the near term future.

Sterling faces a number of challenges resulting from current and prior year losses driven by credit quality issues and is categorized as undercapitalized by regulatory guidelines. While Sterling’s new management is in active negotiations with several private equity investors, its stakeholders and its regulators about strategic alternatives, there can be no assurance that any of these alternatives will be implemented in a timely manner that will allow Sterling to recapitalize and grow its business. See “Recent Developments.”

We may fail to raise additional capital, which may result in our filing for bankruptcy and/or our banking subsidiaries entering FDIC receivership, and our Independent Registered Public Accounting Firm has expressed substantial doubt about our ability to continue as a going concern.

There can be no assurance that we will be successful in completing any or all of our current strategic initiatives to raise additional capital and strengthen our balance sheet. If we are unsuccessful, our ongoing financial viability would be in doubt. To reflect this uncertainty, our Independent Registered Public Accounting Firm has added an explanatory paragraph in their audit opinion issued in connection with our year-end financial statements, expressing substantial doubt regarding our ability to continue as a going concern. If we are unable to successfully execute on our strategic initiatives, we expect that we would file for bankruptcy and/or the FDIC would put our subsidiary banks into receivership. See “Recent Developments” and Note 25 of “Notes to Consolidated Financial Statements.”

 

The uncertainty of our financial viability could result in a loss of access to funding sources, which would have a negative impact on our liquidity and may cause our regulators to place us in receivership before we have implemented our strategic alternatives.

Liquidity is essential to our business. An inability to raise funds through deposits, borrowings, the sale or pledging as collateral of loans and other assets could have a substantial negative effect on our liquidity. Public perception of safety and soundness, as well as the availability of FDIC deposit insurance protection, are important to financial institutions that obtain deposits from retail, commercial and public customers. The uncertainty of our financial viability may be perceived by some customers or prospective customers to offset the protection their deposits receive through the FDIC deposit insurance fund and may negatively impact the decisions of customers who hold deposits in excess of the FDIC insurance limits. There can be no assurance that this continued uncertainty will not negatively impact Sterling’s ability to attract new deposits or that it will not result in additional deposit outflows, both of which could have a material adverse impact on our liquidity. Our liquidity may also be adversely affected if the FDIC’s temporary transaction account guarantee program is not extended. The program is currently scheduled to expire on June 30, 2010.

We incurred significant losses over the last five quarters, and may continue do so in the future, and we can make no assurances as to when we will be profitable.

Cumulatively, since the fourth quarter of 2008, we have incurred a net loss available to common shareholders of $1.21 billion, or a loss of $23.35 per common share, primarily due to a $909.9 million provision for credit losses, a $451.3 million charge for goodwill impairment and the establishment of a $269.0 million deferred tax asset valuation allowance. In light of the current economic environment, significant additional provisions for credit losses may be necessary to supplement the allowance for loan and lease losses in the future. As a result, we may incur significant credit costs throughout 2010, which would continue to have an adverse impact on our financial condition and results of operations and the value of our common

 

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stock. Additional credit losses or impairment charges could cause us to incur a net loss in the future and could adversely affect the price of, and market for, our common stock.

Sterling’s stock price has declined and Treasury’s letter requires that capital be raised at no more than $0.20 cents per share, which is likely to impact the price.

Sterling’s stock price has declined substantially, and the requirement in the Treasury letter that capital be raised at no more than $0.20 per share is likely to significantly impact the market price in the near term. In addition, the stock price could be impacted by a variety of factors, including: uncertainty over our financial viability; actual or anticipated variations in quarterly operating results; changes in shareholder dividend policy; recommendations by securities analysts; and news reports relating to trends, concerns and other issues in the financial services industry. Other factors include new technology used or services offered by Sterling’s competitors; operating and stock price performance of other companies that investors deem comparable to us; and changes in government regulations.

General market fluctuations, industry factors and general economic and political conditions and events, such as future terrorist attacks and activities, economic slowdowns or recessions, interest rate changes or credit loss trends, also could cause Sterling’s stock price to decrease regardless of its operating results.

Any recapitalization would have a significant dilutive effect.

Sterling is currently exploring various options for recapitalization, as a part of which it anticipates that it will need to raise at least $650 million in new capital. In connection with its plans for recapitalization, sales of a substantial number of shares of our common stock in the public markets and the availability of those shares would have a significant dilutive effect on the market for Sterling common stock. Under all strategic alternatives under consideration, current shareholders would have no more than a minimal stake in Sterling after recapitalization.

 

Our banking subsidiary, Sterling Savings Bank, has entered into a consent agreement with the FDIC and the WDFI, and Sterling has entered into a written agreement with the Federal Reserve.

On October 9, 2009, Sterling Savings Bank consented to the issuance of the SSB Consent Agreement by the FDIC and the WDFI. Pursuant to the SSB Consent Agreement, Sterling Savings Bank is required to take certain actions, including: raising additional capital; reducing the number of nonperforming assets; reducing the number of commercial real estate and land development loans; restricting extensions of additional credit to borrowers with classified loans; implementing a liquidity and funds management policy that addresses liquidity needs and reduces reliance on non-core funding sources; restricting cash dividend payments; and complying with interest rate limitations on deposits.

On December 24, 2009, Sterling entered into the Reserve Bank Agreement. This Agreement is intended to enhance Sterling’s ability to act as a source of strength to Sterling Savings Bank and Golf Savings Bank. Substantially all of the requirements of the Reserve Bank Agreement are similar to those imposed on Sterling Savings Bank by the FDIC and the WDFI, including restrictions on the payment of dividends and prohibitions on the purchase or redemption by Sterling of any shares of its stock.

The requirements and restrictions of the SSB Consent Agreement and the Reserve Bank Agreement are judicially enforceable and the failure of Sterling or Sterling Savings Bank to comply with such requirements and restrictions may subject Sterling and Sterling Savings Bank to additional regulatory restrictions including: the imposition of civil monetary penalties; the issuance of directives to increase capital or enter into a strategic transaction, whether by merger or otherwise, with a third party; the appointment of a conservator or receiver for Sterling Savings Bank; the termination of insurance of deposits; the issuance of removal and prohibition orders against institution-affiliated parties; and the enforcement of such actions through injunctions or restraining orders.

 

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Sterling has not complied with the deadline established by the FDIC and the WDFI to raise additional capital.

Pursuant to the SSB Consent Agreement, the FDIC and WDFI directed Sterling Savings Bank to increase its Tier 1 capital by at least $300 million by December 15, 2009 and thereafter maintain a Tier 1 leverage ratio of not less than 10%. To date, Sterling Savings Bank has not yet increased its Tier 1 capital and although it is continuing to work closely with its regulators and financial advisors in order to comply with the SSB Consent Agreement, there can be no assurance that Sterling will be successful in this regard. As a result of Sterling’s failure to comply with the SSB Consent Agreement, Sterling’s regulators may decide to impose more severe restrictions upon Sterling, including the appointment of a conservator or receiver for Sterling Savings Bank.

The SSB Consent Agreement limits the types of funding sources on which we may rely and may have a negative impact on our liquidity.

Pursuant to the terms of the SSB Consent Agreement, we may not accept, renew or roll over any brokered deposits, and are required to submit a plan that reduces our reliance on non-core funding sources and reduces our level of brokered deposits. The reduction in the level of brokered deposits, even according to their regular maturity dates, may have a negative impact on our liquidity within the near term. Furthermore, we are now required to provide a higher level of collateral for any funds that we borrow from the Federal Reserve, and we may be required to provide additional collateral to our other funding sources as well. Any additional collateral requirements or limitations on our ability to access additional funding sources are expected to have a negative impact on our liquidity.

We may be deemed to be in default with regard to certain of our borrowing agreements as a result of the receipt of the SSB Consent Agreement and the Reserve Bank Agreement.

Certain borrowing agreements that we have entered into require Sterling to remain well capitalized under regulatory requirements. Under the terms of the SSB Consent Agreement and the Reserve Bank Agreement, Sterling agreed to, among other things, a capital maintenance provision, which by definition, excluded Sterling from well capitalized status. As of December 31, 2009, Sterling has been deemed to be “undercapitalized,” which may trigger an event of default with regard to its reverse repurchase agreements. A declaration of default by the counterparties to these agreements could result in the counterparties requesting an early termination payment, which could subject Sterling to additional costs based on the fair value of the borrowings at the date of the early termination.

Our estimated allowance for losses in our loan portfolio may be inadequate, which would cause our results of operations and financial condition to be adversely affected.

We maintain an allowance for credit losses, which is a reserve established through a provision for credit losses charged as an expense and represents management’s best estimate of incurred losses within our existing portfolio of loans, which has been increasing in light of recent economic conditions. The level of the allowance reflects management’s estimates based upon various assumptions and judgments as to specific credit risks, evaluation of industry concentrations, loan loss experience, current loan portfolio quality, present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio. The determination of the appropriate level of the allowance for loan and lease losses inherently involves a high degree of subjectivity and requires management to make significant estimates and judgments regarding current credit risks and future trends, all of which may undergo material changes. If our estimates prove to be incorrect, our allowance for credit losses may not be sufficient to cover losses in our loan portfolio and our expense relating to the additional provision for credit losses could increase substantially. In addition, bank regulatory agencies periodically review the adequacy of our allowance for credit losses as part of their examination process, and may require an increase in the provision for possible credit losses or the recognition of further loan charge-offs. Any such increases in the allowance for credit losses may have a material adverse effect on our results of operations, financial condition and the value of our common stock.

 

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We have received a notice of noncompliance from the NASDAQ Stock Market and our common stock may be subject to delisting.

On December 7, 2009, Sterling received a letter from The NASDAQ Stock Market (“NASDAQ”) notifying Sterling that it no longer meets NASDAQ’s continued listing requirement under Listing Rule 5450(a)(1) (the “Bid Price Rule”) because the bid price for its common stock has closed below $1.00 per share for 30 consecutive business days. If compliance with the Bid Price Rule cannot be established prior to June 7, 2010, Sterling’s common stock will be subject to delisting from the NASDAQ Global Select Market. Sterling may, however, be eligible for an additional grace period if it satisfies the initial listing standards (with the exception of the Bid Price Rule) for listing on The NASDAQ Capital Market, and it submits a timely application to NASDAQ to transfer the listing of its common stock to the NASDAQ Capital Market. Sterling is evaluating its options following receipt of the notification and intends to take appropriate actions in order to retain the listing of its common stock on the NASDAQ stock market. There can be no assurance that Sterling will be successful at reestablishing compliance with the Bid Price Rule and a delisting from NASDAQ would have a negative impact on the value and liquidity of our common stock and our ability to access the capital markets.

The effects of the current economic recession have been particularly severe in our primary market areas in the Pacific Northwest and Northern California.

Substantially all of our loans are to businesses and individuals in Washington, Oregon, Idaho, Montana and California. The Pacific Northwest is home to some of the nation’s highest unemployment rates and major employers in Washington, Oregon and Idaho have recently implemented substantial employee layoffs or scaled back growth plans. Severe declines in housing prices and property values have been particularly acute in our primary market areas. The State of California continues to face fiscal challenges, the long-term effects of which on California’s economy cannot be predicted. A further deterioration in the economic conditions or a prolonged delay in economic recovery in our primary market areas could result in the following consequences, any of which could materially and adversely affect our business: collateral for loans made by us, especially real estate, may decline further in value, in turn reducing customers’ borrowing power, and further reducing the value of assets and collateral associated with our existing loans, loan delinquencies may increase; problem assets and foreclosures may increase; demand for our products and services may decrease; and access to low cost or noninterest bearing deposits may decrease.

A large percentage of our loan portfolio is secured by real estate. Continued deterioration in the real estate market or other segments of our loan portfolio would lead to additional losses, which could have a material adverse effect on our business, financial condition and results of operations.

Approximately 74% of our loan portfolio is secured by real estate. The secured loans include construction loans which comprise 20% of our total real estate secured loans. As a result of increased levels of commercial and consumer delinquencies and declining real estate values, we have experienced increasing levels of net charge-offs and provisions for credit losses. Continued increases in commercial and consumer delinquency levels or continued declines in real estate market values would require increased net charge-offs and increases in the provision for loan and lease losses, which could have a material adverse effect on our business, financial condition and results of operations and prospects. Acts of nature, including earthquakes, floods and fires, which may cause uninsured damage and other loss of value to real estate that secures these loans, may also have a negative impact on our financial condition. In addition, we may face risks associated with our real estate lending under various federal, state and local environmental laws that impose certain requirements on the owner or operator of a property.

We have a concentration in higher risk non owner occupied commercial real estate loans.

Approximately 18% of our real estate secured loans are secured by non-owner-occupied commercial real estate. Commercial real estate loans generally involve a higher degree of credit risk than residential mortgage lending due, among other

 

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things, to the large amounts loaned to individual borrowers. In addition, unlike residential mortgage loans, commercial real estate loans generally depend on the cash flow from the property to service the debt. Cash flow may be significantly affected by general economic conditions. Losses incurred on loans to a small number of borrowers could have a material adverse impact on our income and financial condition. Also, many of our commercial real estate borrowers have more than one loan outstanding with us. Consequently, an adverse development with respect to one loan or one credit relationship can expose us to a significantly greater risk of loss compared to an adverse development with respect to a one- to four-family residential mortgage loan.

Commercial loans may involve a higher degree of risk.

Sterling’s Commercial Banking Group provides a full range of credit products to small and medium-sized businesses and to individuals, including lines of credit, receivable and inventory financing, equipment loans and owner occupied commercial real estate. At December 31, 2009, approximately 30% of our loan portfolio can be classified as commercial lending. Commercial loans generally involve a higher degree of credit risk than residential mortgage lending due, among other things, to the large amounts loaned to individual borrowers. In addition, unlike residential mortgage loans, commercial loans generally depend on the cash flow from the business to service the debt. Cash flow may be significantly affected by general economic conditions. Losses incurred on loans to a small number of borrowers could have a material adverse impact on our income and financial condition. Also, many of our commercial borrowers have more than one loan outstanding with us. Consequently, an adverse development with respect to one loan or one credit relationship can expose us to a significantly greater risk of loss compared to an adverse development with respect to a one- to four-family residential mortgage loan.

A rapid change in interest rates could make it difficult to maintain our current net interest income spread and could result in reduced earnings.

Our earnings are largely derived from net interest income, which is interest income earned on loans and investments, less interest paid on deposits and other borrowings. Interest rates are highly sensitive to many factors that are beyond the control of our management, including general economic conditions and the policies of various governmental and regulatory authorities. As interest rates change, net interest income is affected. With fixed rate assets (such as fixed rate loans and most investment securities) and liabilities (such as certificates of deposit), the effect on net interest income depends on the cash flows associated with the maturity of the asset or liability. Asset/liability management policies may not be successfully implemented and from time to time our risk position is not balanced. An unanticipated rapid decrease or increase in interest rates could have an adverse effect on the spreads between the interest rates earned on assets and the rates of interest paid on liabilities, and therefore on the level of net interest income. For instance, any rapid increase in interest rates in the future could result in interest expense increasing faster than interest income because of fixed rate loans and longer-term investments. Further, substantially higher interest rates generally reduce loan demand and may result in slower loan growth than previously experienced. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Asset and Liability Management”.

Our cost of funds may increase as a result of many factors, which may reduce our profitability.

Our cost of funds may increase because of general economic conditions, unfavorable conditions in the capital markets, changes in interest rates, government intervention and support of competitors, government price controls, and competitive pressures. We have traditionally obtained funds principally through deposits and to a lesser extent, other borrowings, including repurchase agreements. As a general rule, deposits are a cheaper and more stable source of funds than borrowings. Checking and savings account balances and other forms of deposits can decrease when our deposit customers perceive alternative investments, such as the stock market or other non-depository investments, as providing superior expected returns, or seek to spread their deposits over several banks to maximize FDIC insurance coverage. Furthermore, technology and other changes have made it more convenient for bank customers to transfer funds into

 

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alternative investments, including products offered by other financial institutions or non-bank service providers. Additional increases in short-term interest rates could increase transfers of deposits to higher yielding deposits. Efforts and initiatives we undertake to retain and increase deposits, including deposit pricing, can increase our costs. When bank customers move money out of bank deposits in favor of alternative investments or into higher yielding deposits, or spread their accounts over several banks, we can lose a relatively inexpensive source of funds, thus, increasing our funding costs.

If, as a result of general economic conditions, market interest rates, competitive pressures, or other factors, our level of deposits decreases relative to our overall banking activities, we may need to rely more heavily on borrowings and/or wholesale funding as a source of funds, and this may negatively impact our net interest margin and subject Sterling to additional liquidity and funding risks.

We may have reduced access to wholesale funding sources.

As a part of our liquidity management, we use a number of funding sources in addition to core deposit growth and repayments and maturities of loans and investments. Our financial flexibility will be severely constrained if we are unable to maintain our access to funding at acceptable interest rates. If we are required to rely more heavily on more expensive funding sources, our revenues may not increase proportionately to cover our costs, and our profitability would be adversely affected. In addition, Sterling Savings Bank may not accept, renew or roll over any brokered deposit unless it has requested and received non-objection from the FDIC and pursuant to the SSB Consent Agreement, must eliminate its reliance on brokered deposits. Sterling Savings Bank also would be required to receive written prior approval from the FDIC as a condition to any issuance of guaranteed debt under the FDIC’s Temporary Liquidity Guarantee Program.

Our banking operations are subject to extensive governmental regulation and further regulatory actions against us may impair our operations or restrict our growth.

We and our subsidiaries are subject to extensive regulation under federal and state laws. These laws and regulations are primarily intended to protect customers, depositors and the Deposit Insurance Fund, rather than shareholders. Sterling Savings Bank is a Washington state-chartered commercial bank and Golf Savings Bank is a Washington state-chartered savings bank, both of which are primarily regulated by the Washington Department of Financial Institutions. Our banking subsidiaries are also subject to the supervision by and the regulations of the FDIC, and the state agencies for the states in which they conduct business. In addition, Sterling is subject to regulation and supervision by the Board of Governors of the Federal Reserve System and the SEC, and subject to the listing standards of the NASDAQ Global Select Market.

Statutes and regulations affecting our business may be changed at any time and the interpretation of these statutes and regulations by examining authorities may also change. Within the last several years, Congress and the President have passed and enacted significant changes to these statutes and regulations. There can be no assurance that such changes to the statutes and regulations or to their interpretation will not adversely affect our business. In addition to governmental supervision and regulation, we are subject to changes in other federal and state laws, including changes in tax laws, which could materially affect the banking industry. We are subject to the rules and regulations of the Federal Reserve, the FDIC and the WDFI. The regulators may continue to limit our activities or growth, and may impose monetary penalties, which could severely limit or end our operations. Banking laws and regulations change from time to time. Bank regulations can hinder our ability to compete with financial services companies that are not regulated in the same manner or are less regulated.

Bank regulatory authorities have the authority to bring enforcement actions against banks and bank holding companies for unsafe or unsound practices in the conduct of their businesses or for violations of any law, rule or regulation, any condition imposed in writing by the appropriate bank regulatory agency or any written agreement with the authority. As discussed above, Sterling Savings Bank consented to the issuance of the SSB Consent Agreement and Sterling has entered into a written agreement with the Federal Reserve. These and other regulatory actions may have a material

 

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adverse effect on our ability to operate our bank subsidiaries and execute our recapitalization strategies.

Difficult market conditions have adversely affected and may continue to have an adverse effect on our industry.

The capital and credit markets have been experiencing unprecedented volatility and disruption for more than two years. Dramatic declines in the housing market over the past two years, with falling home prices and increasing foreclosures, unemployment and under-employment, have had a negative impact on the performance of mortgage loans and have resulted in significant write-downs of asset values by financial institutions, including government-sponsored entities as well as major commercial and investment banks. These write-downs have caused many financial institutions to seek additional capital, to merge with larger and stronger institutions and, in some cases, to fail. Reflecting concern about the stability of the financial markets generally and the strength of counterparties, many lenders and institutional investors have reduced or ceased providing funding to borrowers, including to other financial institutions. This market turmoil and tightening of credit have led to an increased level of commercial and consumer delinquencies, lack of consumer confidence, increased market volatility and widespread reduction of business activity generally. The resulting economic pressure on consumers and lack of confidence in the financial markets has adversely affected our business, financial condition and results of operations. We do not expect that the difficult conditions in the financial markets are likely to improve in the near future. A worsening of these conditions would likely exacerbate the adverse effects of these difficult market conditions on us and others in the financial institutions industry. In particular, we may face the following risks in connection with these events:

 

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We expect to face increased regulation of our industry. Compliance with such regulation may increase our costs and limit our ability to pursue business opportunities.

 

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Our ability to assess the creditworthiness of our customers may be impaired if the models and approaches we use to select, manage, and underwrite our customers become less predictive of future behaviors.

 

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The process we use to estimate losses inherent in our loan portfolio requires difficult, subjective, and complex judgments, including forecasts of economic conditions and how these economic predictions might impair the ability of our borrowers to repay their loans, which may no longer be capable of accurate estimation and may, in turn, have a negative impact on the reliability of the process.

 

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We will be required to pay significantly higher FDIC premiums because market developments have significantly depleted the insurance fund of the FDIC and reduced the ratio of reserves to insured deposits.

 

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There may be additional downward pressure on our stock price.

 

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Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions and government sponsored entities.

 

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We may face increased competition due to intensified consolidation of the financial services industry.

If current levels of market disruption and volatility continue or worsen, there can be no assurance that we will not experience an adverse effect, which may be material, on our ability to access capital and on our business, financial condition and results of operations.

Sterling has deferred regularly scheduled interest payments on its outstanding junior subordinated notes relating to its trust preferred securities (collectively, the “TruPS”) and may be deemed to be in default on the TruPS if payment is not made prior to the end of the deferral period.

During the third quarter of 2009, Sterling began deferring regularly scheduled interest payments on its outstanding junior subordinated notes relating to its TruPS. Under the terms of the junior subordinated notes and the trust documents, Sterling is allowed to defer payments of interest on

 

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the notes for up to 20 consecutive quarterly periods without default. During the deferral period, the respective trusts will likewise suspend the declaration and payment of dividends on the trust preferred securities. Also during the deferral period, Sterling generally may not pay cash dividends on or repurchase its common stock or preferred stock, including the preferred stock issued by Sterling to the U.S. Treasury under the TARP Capital Purchase Program. If Sterling fails to bring the deferred payments current prior to the end of the deferral period, then Sterling may be deemed to be in default under the terms of the notes and subject to various penalties, including seizure of the collateral that secures the TruPS notes.

Sterling may be required to bring its deferred TruPS payments current in order repurchase some or all of its outstanding TruPS obligations and/or may be unable to complete its tender offer for the TruPS.

In February 2010, Sterling commenced a tender offer to the holders of Sterling’s TruPS, seeking to repurchase the TruPS at a significant discount to the principal amount of the TruPS. Sterling’s tender offer is conditioned on receipt of consent from the holders of the TruPS sufficient to approve the proposed transactions, including the removal or waiver of covenants that prohibit Sterling from purchasing any series of TruPS while other series of TruPS are in deferral. If some holders of the TruPS accept the offer but the amendments described above are not approved with respect to one or more series of TruPS, then subject to approval by banking regulators, Sterling may be required to pay the accrued interest due under the indentures underlying those series of TruPS in order to address restrictions on repurchases during interest deferral periods. There can be no assurance that Sterling’s regulators will permit such a payment, nor can there be any assurance that the payment of accrued payments or the failure of Sterling to successfully complete the tender offer for the TruPS will not have a material adverse effect on Sterling’s capital position.

 

Sterling may realize losses on its investment securities in future periods if management decides not to hold the investments to recovery, there is a change in management’s or the rating agencies’ assessment of credit risk on individual securities, or a change in regulatory or accounting requirements.

As of December 31, 2009, Sterling held positions in classes of securities considered impaired because their fair value was less than their amortized cost basis. These securities included a single-issuer trust preferred security with an amortized cost of $24.7 million compared with an $18.8 million market value, and private label collateralized mortgage obligations with an aggregate amortized cost of $163.3 million compared with a $155.2 million market value. All are stress-tested monthly for both credit quality and collateral strength, and are investment grade according to at least one rating agency. Subsequent to December 31, 2009, S&P downgraded one of these securities below investment grade, while Moody’s maintained its investment grade rating on the same security. At December 31, 2009, this security had an amortized cost of $17.4 million and a market value of $15.3 million. Although Sterling has no intent to sell the securities and it is not more likely than not that Sterling will be required to sell the securities before their anticipated recovery, there is no assurance that events may not occur where Sterling would choose to or may be required to sell the securities. If Sterling chooses to or is required to sell these investments before a recovery of the entire cost basis of the securities, then Sterling may recognize a loss on the securities.

As a bank holding company that conducts substantially all of our operations through our banking subsidiaries, Sterling Savings Bank and Golf Savings Bank, our ability to pay dividends, repurchase our shares or to repay our indebtedness depends upon liquid assets held by the holding company and the results of operations of our subsidiaries.

Sterling is a separate and distinct legal entity from our subsidiaries and it receives substantially all of its revenue from dividends paid from our banking subsidiaries. There are legal limitations on the extent to which our banking subsidiaries may extend

 

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credit, pay dividends or otherwise supply funds to, or engage in transactions with, us. Our continued inability to receive dividends from our banking subsidiaries would adversely affect our business, financial condition, results of operations and prospects.

Our net income depends primarily upon our banking subsidiaries’ net interest income, which is the income that remains after deducting from total income generated by earning assets the expense attributable to the acquisition of the funds required to support earning assets (primarily interest paid on deposits). The amount of interest income is dependent on many factors including the volume of earning assets, the general level of interest rates, the dynamics of changes in interest rates and the levels of nonperforming loans. All of those factors affect our banking subsidiaries’ ability to pay dividends to the holding company.

Various statutory provisions restrict the amount of dividends our banking subsidiaries can pay to us without regulatory approval. Our banking subsidiaries may not pay cash dividends if that payment could reduce the amount of its capital below that necessary to meet the “adequately capitalized” level in accordance with regulatory capital requirements. It is also possible that, depending upon the financial condition of our banking subsidiaries and other factors, regulatory authorities could assert that payment of dividends or other payments, including payments to us, is an unsafe or unsound practice. Under Washington law, our banking subsidiaries may make a distribution, including payment of dividends, only if, after giving effect to the distribution, in the judgment of the board of directors: (a) the corporation would be able to pay its debts as they become due in the usual course of business; and (b) the corporation’s total assets would at least equal the sum of its total liabilities plus, unless the articles of incorporation permit otherwise, the amount that would be needed if the corporation were to be dissolved at the time of the distribution to satisfy the preferential rights upon dissolution of shareholders whose preferential rights are superior to those receiving the distribution. Under the SSB Consent Agreement, Sterling Savings Bank is currently required to obtain the prior written consent of the FDIC and the WDFI before paying any cash dividend or any other form of payment or distribution representing a reduction of capital. Under our written agreement with the Reserve Bank, Sterling is required to obtain Reserve Bank approval before taking dividends from Sterling Savings Bank or Golf Savings Bank.

Emergency measures designed to stabilize the U.S. financial markets are beginning to wind down.

Since mid-2008, a host of government actions have been implemented in response to the financial crisis and the recession. Some of the programs are beginning to expire and the impact of the wind-down of these programs on the financial sector and on the nascent economic recovery is unknown. As government support schemes are cancelled, changed or withdrawn, there is a possibility that Sterling, in common with other financial institutions, may have insufficient access to, or incur higher costs associated with, funding alternatives, which could have a material adverse effect on Sterling’s business, financial condition, results of operations and prospects. In particular, the termination of the TAG program on June 30, 2010 could adversely affect us, especially in light of the concerns about our financial viability. In addition, a stall in the economic recovery or continuation or worsening of current financial market conditions could exacerbate these effects.

We are currently precluded from making any dividend payments on our common stock.

On August 19, 2009, Sterling announced the deferral of dividend payments on the Series A Preferred Stock and we are therefore currently restricted from paying dividends on our common stock. Failure to pay dividends on the Series A Preferrred Stock for six dividend periods would trigger preferred shareholder board appointment rights. Even if we were to bring our preferred dividend payments current, as long as the Series A Preferred Stock is outstanding, our payment of common stock dividends would be limited to $0.10 per common share, the amount we paid prior to October 14, 2008, unless Treasury were to consent to a higher amount. We are also currently prohibited from paying any dividends pursuant to the SSB Consent Agreement from the FDIC and the Reserve Bank Agreement. There can be no assurance as to when or if we will be able to pay dividends on our common stock.

 

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Because of our participation in TARP, we are subject to restrictions on compensation paid to our executives.

Pursuant to the terms of the TARP CPP, we adopted certain standards for executive compensation and corporate governance for the period during which the U.S. Treasury holds an investment in us. These standards generally apply to our five most highly compensated senior executive officers, including our Chief Executive Officer and Chief Financial Officer, and certain of these restrictions also apply to our ten most highly compensated senior executives. The standards include, among other things:

 

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ensuring that incentive compensation for senior executives does not encourage unnecessary and excessive risks that threaten the value of the financial institution;

 

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a required clawback of any bonus or incentive compensation paid to a senior executive officer or one of the next twenty most highly compensated employees based on statements of earnings, gains or other criteria that are later proven to be materially inaccurate;

 

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a prohibition on making golden parachute payments to senior executive officers;

 

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an agreement not to deduct for tax purposes annual compensation in excess of $500,000 for each senior executive officer; and

 

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limitations on bonuses and incentive compensation.

In particular, the change to the deductibility limit on executive compensation may increase the overall cost of our compensation programs in future periods and may make it more difficult to attract suitable candidates to serve as executive officers.

Sterling may not be able to replace key members of management or attract and retain qualified relationship managers in the future.

Sterling depends on the services of existing management to carry out its business and investment strategies. In order for Sterling to implement its strategy to emphasize relationship banking, it will need to continue to attract and retain additional management and other qualified staff. Competition for such personnel is significant in Sterling’s geographic market areas. The loss of the services of any management personnel, or the inability to recruit and retain qualified personnel in the future, could have an adverse effect on our results of operations, financial conditions and prospects.

Because of our participation in TARP, we are subject to restrictions on our ability to repurchase our shares.

Because of our participation in TARP, our ability to repurchase our shares is restricted. The U.S. Treasury’s consent generally is required for us to make any stock repurchase until the third anniversary of the investment by the U.S. Treasury unless all of the Series A Preferred Stock has been redeemed or transferred. Further, common, junior preferred or pari passu preferred shares may not be repurchased if we are in arrears on the Series A Preferred Stock dividends. On August 19, 2009, Sterling announced the deferral of dividend payments on the Series A Preferred Stock and we are therefore currently restricted from repurchasing our shares.

The financial services industry is subject to extensive regulation.

The financial services industry is subject to extensive regulation, which is undergoing major changes. As a financial institution, Sterling is subject to laws, regulations, administrative actions and policies that govern financial institutions in each location in which it operates. In 2009, as many emergency government programs slowed or wound down, global regulatory and legislative focus generally moved to a second phase of broader reform and a restructuring of financial institution regulation. Legislators and regulators in the United States are currently considering a wide range of proposals that, if enacted, could result in major changes to the way banking operations are regulated. Some of these major changes may take effect as early as 2010, and could materially impact the profitability of our business, the value of assets we hold or the collateral available for our loans, require changes to business practices or force us to

 

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discontinue businesses and expose us to additional costs, taxes, liabilities, enforcement actions and reputational risk.

Certain reform proposals under consideration could result in Sterling becoming subject to stricter capital requirements and leverage limits, and could also affect the scope, coverage, or calculation of capital, all of which could require us to reduce business levels or to raise capital, including in ways that may adversely impact our creditors. In addition, we anticipate the enactment of certain reform proposals under consideration that would introduce stricter substantive standards, oversight and enforcement of rules governing consumer financial products and services, with particular emphasis on retail extensions of credit and other consumer-directed financial products or services including an impact on mortgage modifications and foreclosures.

The financial services industry is highly competitive.

We face pricing competition for loans and deposits. We also face competition with respect to customer convenience, product lines, accessibility of service and service capabilities. Our most direct competition comes from other banks, brokerages, mortgage companies and savings institutions. We also face competition from credit unions, government-sponsored enterprises, mutual fund companies, insurance companies and other non-bank businesses. A number of these banks and other financial institutions are significantly larger than we are and have substantially greater access to capital and other resources, as well as larger lending limits and branch systems, and offer a wider array of banking services. Many of our non-bank competitors are not subject to the same extensive regulations that govern us. As a result, these non-bank competitors have advantages over us in providing certain services. This significant competition in attracting and retaining deposits and making loans as well as in providing other financial services throughout our market area may have an adverse impact on future earnings and growth.

The value of the securities in our investment securities portfolio may be negatively affected by continued disruptions in securities markets.

The market for some of the investment securities held in our portfolio has become extremely volatile over the past two years. Volatile market conditions may detrimentally affect the value of these securities, such as through reduced valuations due to the perception of heightened credit and liquidity risks. There can be no assurance that the declines in market value associated with these disruptions will not result in other-than-temporary or permanent impairments of these assets, which would lead to accounting charges that could have a material adverse effect on our net income and capital levels.

A substantial decline in the value of our FHLB common stock may result in an other-than-temporary impairment charge.

We own common stock of the FHLB in order to qualify for membership in the FHLB system, which enables us to borrow funds under the FHLB advance program. The carrying value of our FHLB common stock was approximately $100.7 million as of December 31, 2009, the majority of which was with the FHLB of Seattle. The FHLB Seattle has experienced losses from credit-related charges associated with projected losses on their investments in private-label mortgage-backed securities, and is currently unable to repurchase or redeem capital stock or to pay dividends. Consequently, for this and other reasons, there is a risk that our investment in common stock of the FHLB could be deemed other than temporarily impaired at some time in the future, which would adversely affect our earnings and the value of, or market for, our common stock.

Current and future increases in FDIC insurance premiums, including the FDIC special assessment imposed on all FDIC-insured institutions, will decrease our earnings.

In May 2009, the FDIC announced that it had voted to levy a special assessment on insured institutions in order to facilitate the rebuilding of the Deposit Insurance Fund. The assessment is equal to five basis points of Sterling’s total assets minus Tier 1 capital as of June 30, 2009. This represents a charge of approximately $5.6 million, which was included in noninterest expense during the second quarter of 2009. On September 29, 2009, the FDIC voted to adopt an increase in the risk-based assessment rate effective beginning January 1, 2011, by three-basis points. The FDIC will continue to assess the need for

 

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changes to the assessment rates at least semi-annually. Any such future increases in assessments will decrease our earnings and could have a material adverse effect on the value of, or market for, our common stock.

Our business is highly reliant on technology and our ability to manage the operational risks associated with technology.

We depend on internal and outsourced technology to support all aspects of our business operations. Interruption or failure of these systems creates a risk of business loss such as civil fines or damage claims from privacy breaches and adverse customer experience. Risk management programs are expensive to maintain and will not protect Sterling from all risks associated with maintaining the security of customer information, proprietary data, external and internal intrusions, disaster recovery and failures in the controls used by vendors.

Changes in accounting standards may have a material impact on how we report our financial condition and results of operations.

Our accounting policies and methods are fundamental to how we record and report our financial condition and results of operations. From time to time the Financial Accounting Standards Board (“FASB”) changes the financial accounting and reporting standards that govern the preparation of our financial statements. These changes can be difficult to predict and can have a material impact on how we record and report our financial condition and results of operations. In some cases, we could be required to apply a new or revised standard retroactively, resulting in a restatement of prior period financial statements.

We may be required to repurchase mortgage loans in some circumstances, which could harm our liquidity, results of operations and financial condition.

When we sell mortgage loans, whether as whole loans or pursuant to a securitization, we are required to make customary representations and warranties to the purchaser about the mortgage loans and the manner in which they were originated. Our whole loan sale agreements require us to repurchase or substitute mortgage loans in the event we breach any of these representations or warranties. In addition, we may be required to repurchase mortgage loans as a result of borrower fraud or in the event of early payment default of the borrower on a mortgage loan. Likewise, we are required to repurchase or substitute mortgage loans if we breach a representation or warranty in connection with our securitizations. The remedies available to us against the originating broker or correspondent may not be as broad as the remedies available to a purchaser of mortgage loans against us, and we face the further risk that the originating broker or correspondent may not have the financial capacity to perform remedies that otherwise may be available to us. Therefore, if a purchaser enforces its remedies against us, we may not be able to recover our losses from the originating broker or correspondent. If repurchase and indemnity demands increase, our liquidity, results of operations and financial condition will be adversely affected.

Sterling operations could be interrupted if its third-party service providers experience difficulty, terminate their services or fail to comply with banking regulations.

Sterling depends, and will continue to depend, to a significant extent, on a number of relationships with third-party service providers. Specifically, Sterling receives core systems processing, essential web hosting and other Internet systems and deposit and other processing services from third-party service providers. If these third-party service providers experience difficulties or terminate their services and Sterling is unable to replace them with other service providers, its operations could be interrupted. If an interruption were to continue for a significant period of time, business, financial condition and results of operations could be materially adversely affected.

Sterling’s internal control systems could fail to detect certain events.

Sterling is subject to certain operations risks, including but not limited to data processing system failures and errors and customer or employee fraud. Sterling maintains a system of internal controls to mitigate against such occurrences and maintain insurance coverage for such risks, but should such an event occur that is not prevented or detected by

 

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Sterling’s internal controls, uninsured or in excess of applicable insurance limits, it could have a significant adverse impact on its business, financial condition or results of operations.

The network and computer systems on which Sterling depends could fail or experience a security breach.

Sterling’s computer systems could be vulnerable to unforeseen problems. Because Sterling conducts part of its business over the Internet and outsources several critical functions to third parties, operations will depend on the ability, as well as that of third-party service providers, to protect computer systems and network infrastructure against damage from fire, power loss, telecommunications failure, physical break-ins or similar catastrophic events. Any damage or failure that causes interruptions in operations could have a material adverse effect on business, financial condition and results of operations.

In addition, a significant barrier to online financial transactions is the secure transmission of confidential information over public networks. Sterling’s Internet banking system relies on encryption and authentication technology to provide the security and authentication necessary to effect secure transmission of confidential information. Advances in computer capabilities, new discoveries in the field of cryptography or other developments could result in a compromise or breach of the algorithms its third-party service providers use to protect customer transaction data. If any such compromise of security were to occur, it could have a material adverse effect on Sterling’s business, financial condition and results of operations.

Sterling could be held responsible for environmental liabilities of properties acquired through foreclosure.

If Sterling is forced to foreclose on a defaulted mortgage loan to recover its investment, it may be subject to environmental liabilities related to the underlying real property. Hazardous substances or wastes, contaminants, pollutants or sources thereof may be discovered on properties during its ownership or after a sale to a third party. The amount of environmental liability could exceed the value of real property. There can be no assurance that Sterling would not be fully liable for the entire cost of any removal and clean-up on an acquired property, that the cost of removal and clean-up would not exceed the value of the property, or that costs could be recovered from any third party. In addition, Sterling may find it difficult or impossible to sell the property prior to or following any environmental remediation.

We are currently subject to certain pending shareholder litigation and may be subject to similar claims in the future.

A securities class action lawsuit has been filed against Sterling and certain of our current and former officers alleging that the defendants violated sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and SEC Rule 10b-5 by making false and misleading statements concerning our business and financial results. A shareholder derivative suit also has been filed against certain of our current and former officers and directors, and Sterling as a nominal defendant, alleging breaches of fiduciary duty, waste of corporate assets, and unjust enrichment. Class actions also have been filed against Sterling and certain of our current and former officers and directors alleging violations of the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), by breaching their fiduciary duties to participants in the Sterling Savings Bank Employee Savings and Investment Plan and Trust. These lawsuits are all premised on similar allegations that: 1) the defendants failed to adequately disclose the extent of Sterling’s delinquent commercial real estate, construction and land development loans, properly record losses for impaired loans, properly reserve for loan losses, and properly account for our goodwill and deferred tax assets, thereby causing Sterling’s stock price to be artificially inflated during the purported class period; or 2) failed to prevent Sterling from issuing improper financial statements, maintain a sufficient allowance for loan and lease losses, and establish effective credit risk management and oversight mechanisms. It is possible that additional suits will be filed with respect to these same matters and also naming Sterling and/or our current and former officers and directors.

We cannot predict the outcome of any of these lawsuits. These lawsuits could divert the attention and resources of our management and cause Sterling to incur significant expenses for legal fees and

 

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costs, including those associated with Sterling’s advancement of fees and costs on behalf of our current and former officers and directors. Since the legal responsibility and financial impact with respect to these lawsuits and claims, if any, cannot currently be ascertained, we have not established any reserves for any potential liability relating to the lawsuits. An unfavorable outcome in these lawsuits could result in the payment of substantial damages in connection with a settlement or judgment and have a material adverse effect on our business, financial condition, results of operations or cash flows.

 

Item 1B.    Unresolved Staff Comments

Not applicable.

Item 2.    Properties

Sterling owns the building in which its headquarters are located in Spokane, Washington. As of December 31, 2009, Sterling also owned 101 of its 178 depository banking offices, while leasing the remainder of the properties. These facilities are located throughout Sterling’s banking network, primarily in the Pacific Northwest. Additionally, Sterling operates 37 non-depository loan production offices throughout the western United States, the majority of which are leased. See Note 6 of “Notes to Consolidated Financial Statements.”

 

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Item 3.    Legal Proceedings

Securities Class Action Litigation

On December 11, 2009, a putative securities class action complaint was filed in the United States District Court for the Eastern District of Washington against Sterling and certain of our current and former officers. The complaint alleges that the defendants violated sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and SEC Rule 10b-5 by making false and misleading statements concerning our business and financial results. The complaint alleges that defendants failed to disclose the extent of Sterling’s delinquent commercial real estate, construction and land loans, properly record losses for impaired loans, properly reserve for loan losses, and properly account for our goodwill and deferred tax assets. The complaint seeks, on behalf of persons who purchased our common stock during the period from July 23, 2008 to January 13, 2009, damages of an unspecified amount and attorneys’ fees and costs. Failure by Sterling to obtain a favorable resolution of the claims set forth in the complaint could have a material adverse effect on our business, results of operations and financial condition. Currently, the amount of such material adverse effect cannot be reasonably estimated.

ERISA Class Action Litigation

On January 20 and 22, 2010, two putative class action complaints were filed in the United States District Court for the Eastern District of Washington against Sterling and certain of our current and former officers and directors. The complaints allege that defendants violated sections 404 and 405 of the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), by breaching their fiduciary duties to participants in the Sterling Savings Bank Employee Savings and Investment Plan and Trust (the “Plan”). The complaints allege that defendants breached their fiduciary duties from July 23, 2008 to the date the complaints were filed by investing Plan assets in Sterling’s securities when defendants knew or should have known that the price of Sterling’s securities were inflated because Sterling had failed to disclose the extent of Sterling’s delinquent commercial real estate, construction and land loans, properly record losses for impaired loans, properly reserve for loan losses, and properly account for our goodwill and deferred tax assets. The complaints seek damages of an unspecified amount and attorneys’ fees and costs. Failure by Sterling to obtain a favorable resolution of the claims set forth in the complaints could have a material adverse effect on our business, results of operations and financial condition. Currently, the amount of such material adverse effect cannot be reasonably estimated.

Derivative Class Action Litigation

On February 10, 2010, a stockholder derivative action was filed in the Superior Court for Spokane County, Washington, allegedly on behalf of and for the benefit of Sterling, against certain of our current and former officers and directors. The complaint alleges, among other claims, breach of fiduciary duty, waste of corporate assets, and unjust enrichment. The complaint names Sterling as a nominal defendant. The complaint seeks unspecified damages, restitution, disgorgement of profits, equitable and injunctive relief, attorneys’ fees, costs, and expenses. The complaint alleges that the individual defendants failed to prevent Sterling from issuing improper financial statements, maintain a sufficient allowance for loan and lease losses, and establish effective credit risk management and oversight mechanisms regarding Sterling’s commercial real estate, construction and land development loans, losses and reserves recorded for impaired loans, and accounting for goodwill and deferred tax assets. Because the complaint is derivative in nature, it does not seek monetary damages from Sterling. However, Sterling may be required throughout the pendency of the action to advance the legal fees and costs incurred by the individual defendants and to incur other financial obligations, which could have a material adverse effect on our business, results of operations and financial condition. Currently, the amount of such material adverse effect cannot be reasonably estimated.

Item 4.    (Reserved)

 

 

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PART II

 

Item 5.    Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Stock Market and Dividend Information

Sterling’s common stock is listed on The NASDAQ Global Select Market under the symbol “STSA.” On December 7, 2009, Sterling received a letter from The NASDAQ Stock Market (“NASDAQ”) notifying Sterling that it no longer meets NASDAQ’s continued listing requirement under Listing Rule 5450(a)(1) (the “Bid Price Rule”) because the bid price for its common stock has closed below $1.00 per share for 30 consecutive business days. If compliance with the Bid Price Rule cannot be established prior to June 7, 2010, Sterling’s common stock will be subject to delisting from the NASDAQ Global Select Market. Sterling may, however, be eligible for an additional grace period if it satisfies the initial listing standards (with the exception of the Bid Price Rule) for listing on The NASDAQ Capital Market, and it submits a timely application to NASDAQ to transfer the listing of its common stock to the NASDAQ Capital Market. Sterling is evaluating its options following receipt of the notification and intends to take appropriate actions in order to retain the listing of its common stock on the NASDAQ stock market. There can be no assurance that Sterling will be successful at reestablishing compliance with the Bid Price Rule and a delisting from NASDAQ would have a negative impact on the value and liquidity of our common stock.

 

As of January 31, 2010, Sterling’s common stock was held by 2,069 shareholders of record. The following table sets forth certain per share information for Sterling’s common stock for the periods indicated:

 

      2009 Quarters Ended
      December 31    September 30    June 30    March 31

Dividends declared per common share

   $ 0.000    $ 0.000    $ 0.000    $ 0.000

Dividends paid per common share

     0.000      0.000      0.000      0.000

Market price per share:

             

High

     1.92      3.44      5.00      8.87

Low

     0.53      1.97      2.14      1.00

Quarter end

     0.62      2.00      2.91      2.07
           
      2008 Quarters Ended
      December 31    September 30    June 30    March 31

Dividends declared per common share

   $ 0.000    $ 0.100    $ 0.100    $ 0.100

Dividends paid per common share

     0.100      0.100      0.100      0.095

Market price per share:

             

High

     15.00      17.50      16.59      19.72

Low

     3.50      2.36      4.02      12.21

Quarter end

     8.80      14.50      4.14      15.61

 

The board of directors of Sterling from time to time evaluates the payment of cash dividends. The timing and amount of any future dividends will depend upon earnings, cash and capital requirements, the financial condition of Sterling and its subsidiaries, applicable government regulations and other factors deemed relevant by Sterling’s board of directors. Pursuant to the SSB Consent Agreement and the written agreement with the Reserve Bank, Sterling is not to pay cash dividends or make any other payments or distributions representing a reduction of Sterling Savings Bank capital without the prior written consent from its regulators. Pursuant to the terms of Sterling’s participation in the CPP program of the U.S. Department of the Treasury (“Treasury”), Sterling is also prohibited from paying dividends on its common

 

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stock so long as Sterling’s payments on its preferred stock remain deferred. Sterling is further prohibited from increasing the dividends to be paid to shareholders above the $0.10 per share quarterly dividend paid for the quarter ended September 30, 2008. This restriction on Sterling’s ability to increase its dividends will continue until either Sterling redeems all of the preferred shares sold to Treasury, or December 2011, whichever is earliest.

 

Performance Graph

The following graph compares our cumulative total stockholder return since December 31, 2004 with the Russell 2000 Index and the SNL NASDAQ Bank Index. The graph assumes that the value of the investment in our common stock and each index (including reinvestment of dividends) was $100.00 on December 31, 2004.

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Item 6.    Selected Financial Data

The following selected financial data is derived from Sterling’s audited financial statements. Comparability among particular amounts may be affected by past acquisitions:

 

     Years Ended December 31,  
     2009     2008     2007     2006     2005  
     (Dollars in thousands, except per share amounts)  

Income Statement Data:

           

Interest income

  $ 599,347      $ 715,062      $ 766,978      $ 550,855      $ 387,811   

Interest expense

    (255,370     (355,510     (411,618     (286,943     (171,276
                                         

Net interest income

    343,977        359,552        355,360        263,912        216,535   

Provision for credit losses

    (681,371     (333,597     (25,088     (18,703     (15,200
                                         

Net interest income after provision for credit losses

    (337,394     25,955        330,272        245,209        201,335   

Non-interest income

    123,814        91,895        93,406        69,164        59,092   

Non-interest expenses

    (369,974     (305,517     (285,465     (206,197     (169,804

Goodwill impairment

    (227,558     (223,765     0        0        0   
                                         

Total non-interest expenses

    (597,532     (529,282     (285,465     (206,197     (169,804
                                         

Income before income taxes

    (811,112     (411,432     138,213        108,176        90,623   

Income tax benefit (provision)

    (26,982     75,898        (44,924     (34,230     (29,404
                                         

Net income (loss)

    (838,094     (335,534     93,289        73,946        61,219   

Preferred stock dividend

    (17,369     (1,208     0        0        0   
                                         

Net income (loss) applicable to common shareholders

  $ (855,463   $ (336,742   $ 93,289      $ 73,946      $ 61,219   
                                         

Earnings per common share:

           

Basic

  $ (16.48   $ (6.51   $ 1.87      $ 2.03      $ 1.77   

Diluted

    (16.48     (6.51     1.86        2.01        1.75   

Dividends declared per common share

  $ 0.000      $ 0.300      $ 0.350      $ 0.270      $ 0.105   

Weighted average shares outstanding:

           

Basic

    51,922,275        51,721,671        49,786,349        36,423,095        34,633,952   

Diluted

    51,922,275        51,721,671        50,217,515        36,841,866        35,035,029   
   

Other Data:

           

Book value per common share

  $ 0.56      $ 16.29      $ 23.04      $ 18.63      $ 14.54   

Tangible book value per common share

  $ 0.14      $ 11.41      $ 13.61      $ 12.07      $ 10.80   

Return on assets

    -6.81     -2.65     0.83     0.88     0.87

Return on common equity

    -129.8     -28.8     8.6     13.0     12.4

Shareholders’ equity to total assets

    3.0     8.9     9.8     8.0     6.7

Operating efficiency

    127.7     117.2     63.6     61.9     61.6

Tax equivalent net interest margin

    2.92     3.08     3.42     3.33     3.30

Nonperforming assets to total assets

    9.08     4.77     1.11     0.13     0.14

Employees (full-time equivalents)

    2,641        2,481        2,571        2,405        1,789   

Depository branches

    178        178        178        166        140   

 

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Item 6.    Selected Financial Data (continued)

 

     December 31,  
     2009     2008     2007     2006     2005  
     (Dollars in thousands)  

Balance Sheet Data:

           

Total assets

  $ 10,877,423      $ 12,790,716      $ 12,149,775      $ 9,834,