<PAGE>
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 8-K/A
CURRENT REPORT
PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
October 26, 1999
----------------
Date of Report
(Date of earliest event reported)
FIRST MUTUAL BANCSHARES, INC.
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(Exact name of registrant as specified in charter)
Washington 005-57091 91-2005970
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(State or Other Jurisdiction Commission File Number) (I.R.S. Employer
of Incorporation) Identification No.)
400 108th Avenue N.E., Bellevue, WA 98004
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(Address of Principal Executive Offices) (Zip Code)
Registrant's telephone number, including area code: (425) 455-7300
N/A
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(Former Name or Former Address, if Changed Since Last Report)
<PAGE>
ITEM 5. OTHER EVENTS.
On October 26, 1999, First Mutual Savings Bank reorganized into the
holding company form of ownership through the following steps: (1) the
formation by First Mutual Savings Bank of First Mutual Bancshares, Inc. as a
wholly-owned, first-tier subsidiary, incorporated under Title 23B, RCW; (2) the
formation of First Interim Bank, which was wholly-owned by First Mutual
Bancshares, Inc. immediately prior to the reorganization; and (3) the merger
of First Interim Bank with and into First Mutual Savings Bank under the
Amended Charter and Articles of Incorporation of First Mutual Savings Bank.
The name of the banking corporation resulting from the merger of First
Interim Bank and First Mutual Savings Bank is "First Mutual Bank."
Pursuant to the reorganization of First Mutual Savings Bank into the
holding company form of ownership, among other things, all of the issued and
outstanding shares of common stock, $1.00 par value per share, of First
Mutual Savings Bank were automatically converted by operation of law on a
one-for-one basis into an equal number of issued and outstanding shares of
First Mutual Bancshares, Inc. In addition, First Mutual Bancshares, Inc.
became the sole shareholder of First Mutual Bank. The shares of First Mutual
Bancshares, Inc. will trade on the Nasdaq Stock Market under the symbol
"FMSB." This Form 8-K/A is being filed for the purpose of filing as exhibits
First Mutual Savings Bank's 1998 Annual Report and application to the
Washington Director of Financial Institutions in the form of Notice of
Intention to Organize a Stock Savings Bank (including Agreement and Plan of
Reorganization and Merger).
ITEM 7. FINANCIAL STATEMENTS AND EXHIBITS.
(c) Exhibits. The exhibits accompanying this report are listed in the
accompanying Exhibit Index.
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned hereunto duly authorized.
Date: November 19, 1999 FIRST MUTUAL BANCSHARES, INC.
By: /s/ John R. Valaas
-------------------------------------
John R. Valaas
President and Chief Executive Officer
<PAGE>
EXHIBIT INDEX
<TABLE>
<CAPTION>
Exhibit Number Description
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<S> <C>
3.1* Articles of Incorporation (First Mutual Savings Bank)
3.2* Articles of Incorporation (First Mutual Bancshares, Inc.)
3.3* Bylaws (First Mutual Savings Bank)
3.4* Bylaws (First Mutual Bancshares, Inc.)
13.1* First Mutual Savings Bank's Annual Report on Form 10-K
for the fiscal year ended December 31, 1998, filed with
the FDIC on March 31, 1999.
13.2* First Mutual Savings Bank's Quarterly Report on Form 10-Q
for the quarter ended March 31, 1999, filed with the FDIC
on May 14, 1999.
13.3* First Mutual Savings Bank's Quarterly Report on Form 10-Q
for the quarter ended June 30, 1999, filed with the FDIC
on August 12, 1999.
13.4 First Mutual Savings Bank's 1998 Annual Report.
99.1* Press Release dated October 26, 1999.
99.2* First Mutual Savings Bank's Proxy Statement dated
March 19, 1999. (previously filed as Exhibit 13.4)
99.3 Notice of Intention to Organize a Stock Savings Bank
(including Agreement and Plan of Reorganization and
Merger).
</TABLE>
* Previously filed with First Mutual Bancshares, Inc.'s Form 8-K, filed with
the Commission on November 10, 1999, SEC File No. 005-57091.
<PAGE>
CORPORATE PROFILE
First Mutual Savings Bank is based on the Eastside, the area
immediately east of Seattle and Lake Washington that includes parts of King
and Snohomish counties. Our primary lending market serves citizens of the
Eastside and the I-5 corridor, which stretches from Bellingham, Washington,
on the north to Portland, Oregon, on the south. The nine branches of this
state-chartered, FDIC-insured bank are located in Bellevue (three), Ballard,
Bellingham, Redmond, Issaquah, Monroe and West Seattle. In addition, a
commercial real estate loan production office is located in Tacoma,
Washington.
Operating income is derived primarily from real estate lending
activities. First Mutual also makes consumer and small business loans and
sells a range of depository and other financial services.
First Mutual converted to an FDIC-insured mutual savings bank in
1968. It originally was chartered as a savings and loan association when it
opened in 1953. In December 1985 the Bank converted to a stock FDIC savings
bank and completed its initial public offering of common stock.
In 1998 the Bank's net income increased 15.2 percent to $5.2
million, or $1.20 diluted earnings per share, up from $4.5 million, or $1.07
diluted earnings per share, in 1997. Net interest income for 1998 was $17.4
million, while deposits totaled $411 million, and total assets were $489
million at yearend 1998.
First Mutual is regulated by the State of Washington's Department of
Financial Institutions as well as by the FDIC. The Bank's common stock trades
on The NASDAQ Stock Market under the symbol FMSB.
FINANCIAL HIGHLIGHTS
<TABLE>
<CAPTION>
1998 1997 1996 1995
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<S> <C> <C> <C> <C>
Total assets $489,230,139 $ 445,762,440 $ 416,832,072 $ 361,525,779
Net income $ 5,207,696 $ 4,518,680 $ 3,914,648 $ 3,427,745
Net interest income* $ 16,646,362 $ 14,829,996 $ 11,850,706 $ 10,437,471
Diluted earnings per share** $ 1.20 $ 1.07 $ .94 $ .84
Book value per share** $ 8.16 $ 7.43 $ 6.77 $ 5.87
Return on average assets 1.11% 1.05% 1.01% 1.03%
Return on average equity 15.95% 15.57% 15.33% 15.40%
Shares outstanding** 4,247,275 4,125,227 4,048,155 4,037,298
</TABLE>
*AFTER PROVISION FOR LOAN LOSSES
**ADJUSTED FOR A 10% STOCK DIVIDEND PAID AUGUST 16, 1995, A 20% STOCK
DIVIDEND PAID APRIL 3, 1996, A 10% STOCK DIVIDEND PAID JULY 2, 1997, AND A
THREE-FOR-TWO STOCK SPLIT PAID NOVEMBER 5, 1997.
page 1
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LETTER TO SHAREHOLDERS
DEAR FELLOW SHAREHOLDER:
First Mutual Bank ended 1998 with its 25th consecutive quarter of
record year-over-year earnings growth and record net income for the year. Net
income for 1998 rose 15.2 percent, to $5.2 million, and diluted earnings per
share increased to $1.20, compared with $1.07 for the year earlier.
The Bank also continued its strong asset growth while maintaining
outstanding loan quality. By the end of 1998, First Mutual had posted assets
of $489 million, compared with $446 million a year ago. Nonperforming assets
again remained notably low at $336,000 in 1998, or .07 percent of total
assets. Also during the year, deposits grew 10 percent to $411 million.
Return on shareholders' equity, a measure of how efficiently
shareholder funds are used, continued to demonstrate excellent results:
15.95%.
A full discussion of First Mutual's financial performance may be
found in the Management's Discussion and Analysis section, beginning on page
4.
GROWTH FOR A STRONG FUTURE
Approximately 35 percent of First Mutual's stock is held by
management and board members, in addition to the eight percent held by
employees through an employee stock ownership plan; more than many other
financial institutions, First Mutual's investors have a personal stake both
in the Bank and in the communities which it serves. As a result, we have a
solid and strategic focus not only on the growth of our institution, but on
the continued quality of that growth.
We are pleased to report that throughout 1998 First Mutual achieved
strong growth in a range of product lines. Our Business Banking Department
has continued to define and successfully make gains in its market. And
commercial lending continues to form a highly substantial and valuable part
of First Mutual's business; in the last three years, income property and
business loans have nearly doubled and now account for 64.6 percent of First
Mutual's portfolio. In part, this was accomplished through First Mutual's
position as a well-established community bank: our high-caliber loan officers
build informed, long-term customer relationships. In addition, the Bank's
commercial lending strategy takes into consideration the ongoing needs of our
communities. Approximately half of First Mutual's commercial portfolio is
comprised of housing units, such as apartment buildings and mobile home parks.
The commercial lending portion of First Mutual's portfolio has
historically performed exceptionally well. We believe it will continue to do
so as a result of our very capable and professional lending team and a proven
lending strategy which focuses on the business acumen
page 2
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of our customers and the merits of individual projects.
Also for the past several years, the Consumer Lending Department has
been developing a number of product lines, beginning with home equity loans,
followed by our sales finance program and, early in 1999, introducing direct
consumer lending for items such as cars, boats and RVs. By the end of 1998,
consumer loans made up nearly five percent of the portfolio. In addition, it
attracted approximately 1,000 new customers to the Bank, expanding our
customer profile to include younger customers.
While residential loans, as interest-earning assets, have decreased
in importance in the Bank's portfolio, origination of residential loans has
increased significantly, up 77.1 percent to $203 million in 1998 compared to the
previous year. A refinancing boom, spurred by record-low interest rates,
contributed to strong residential loan originations from both our wholesale
and retail lending departments.
THE ECONOMIC OUTLOOK
As both the local and national economies begin to feel the effects
of international pressures, there is likely to be some leveling off of growth
in our markets. Yet, despite projected layoffs in aerospace employment, we
expect there will still be positive growth in our region. This, combined with
the expanding diversification of First Mutual's products and geographical
markets, cause us to remain confident that the Bank will continue to find
opportunities for steady, quality growth.
As we noted at the beginning of this letter, a substantial
percentage of First Mutual's managers, directors and employees are
shareholders in its day-to-day operations and its future growth; their
commitment is revealed in the quality of First Mutual's customer
relationships and its solid banking philosophy. We look to the people who
define this Bank to continue its exceptional level of performance, and we
would like to take this opportunity to thank them for their exemplary efforts.
/s/ Kemper Freeman, Jr.
F. Kemper Freeman, Jr.
Chairman of the Board
/s/ John R. Valaas
John R. Valaas
President/CEO
February 1, 1999
page 3
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MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
First Mutual Bank's performance in 1998 reflects another year of
record earnings, solid asset growth, and excellent credit quality.
Net income was up 15.2%, totaling $5,208,000, or $1.20 per diluted
share, which compares to $4,519,000, $1.07 per diluted share, in 1997, and
$3,915,000, $.94 per diluted share, in 1996. Net income in 1998 was
influenced by a favorable increase in both net interest income and other
operating income. Net interest income in 1998 improved to $17.4 million from
$15.8 million in 1997, an increase of 10.1%, compared to an increase of $2.3
million, or 16.6%, from 1996 to 1997. Net interest income in 1996 totaled
$13.6 million, up 26.8% from the previous year. Other operating income jumped
89.3%, from $1,706,000 in 1997 to $3,230,000 in 1998. In prior years the
results were more modest, with a $65,000, or 3.9%, increase from 1996 to
1997, and a decline of $4,000, or .2%, in 1996.
Contributing to record earnings for 1998 was the successful growth
in assets, which increased $43 million, or 9.8%. By comparison, the growth in
assets in 1997 was $29 million, or 6.9%. Those figures compare to the
national average for asset growth for FDIC-insured savings institutions of a
decline of .21% for 1997 and an increase of 3.4% for the 12 months ending
September 1998. The growth in assets occurred principally in investment
securities and loans held for sale. Investment securities increased 25.4%,
from $65,492,000 in 1997 to $82,101,000 in 1998. The growth in securities
from 1996 to 1997 was $6.2 million, or 10.4%. Loans held for sale, which are
loans pending delivery into the mortgage-backed secondary market, rose
dramatically in 1998 to $27,371,000, an increase of 225% from 1997's balance
of $8,422,000. In 1997 loans held for sale actually declined $4 million, or
32.3%, from the yearend 1996 balance.
The Bank's nonperforming assets continued to remain at exceptionally
low levels. Nonperforming assets declined to $336,000 in 1998 from $674,000
in 1997. As a percent of assets, nonperforming assets totaled .07% in 1998
versus .15% the previous year.
RESULTS OF OPERATIONS
NET INTEREST INCOME
Net interest income, which increased 10.1% from the prior year, is
influenced by changes in the volume and mix of earning assets and funding
sources and the market rate of interest.
96--------------------$3,915
97--------------------------$4,519
98--------------------------------$5,208
NET INCOME/DOLLARS IN THOUSANDS
page 4
<PAGE>
Earning assets rose $44 million, or 10.1%, in 1998, following
increases of 6% and 15% in 1997 and 1996, respectively. The contribution to
net interest income from the growth in assets totaled $2,591,000 in 1998.
Offsetting that contribution was a decrease of $1,001,000, resulting from an
unfavorable change in interest rates.
Although the effect from interest rates was negative in 1998, the
net interest margin increased to 3.85% from 3.78% the previous year. The
cause of this anomaly is principally the change in mix between the loan and
securities portfolios. The securities portfolio average balance by quarter was
$65 million in 1997, falling in 1998 to an average quarterly balance of $63.5
million. During the same period the average quarterly balance for the loan
portfolio increased from $348.1 million in 1997 to $391.6 million in 1998.
The negative decline of 2.4% in low-rate securities, occurring simultaneously
with a 12.5% rise in the substantially higher-rate loan portfolio, created a
condition in which the net interest margin increased on a year-to-year
comparison while the overall impact from interest rates was adverse.
A trend that has emerged over the last few years, and which has
significantly improved the net interest margin, is the change in the Bank's
loan-type mix. Residential permanent loans, which constituted 47.4% of the
portfolio at yearend 1995, have declined to 24.3% at yearend 1998.
Commercial real estate, construction and consumer loans, which contribute a
higher yield to the Bank, have increased from 52.6% in 1995 to 75.7% at
December 1998. The portfolio yield differences among the various loan types
is material. For example, conventional residential adjustable-rate loans paid
an average rate to the Bank of 7.8% at yearend 1998. By comparison,
commercial multifamily adjustable-rate real estate loans returned an average
yield of 8.3%, and construction multifamily loans paid an average of 9.3%.
Although 83% of the Bank's loan portfolio is comprised of
adjustable-rate loans, the balance of the portfolio is invested in fixed-rate
instruments. In addition, 80% of the securities portfolio is invested in
fixed-rate instruments. During periods of rapidly rising interest rates, the
net interest margin is compressed as funding costs rise faster than yields on
assets. Furthermore, during periods when the relationship between short-term
and long-term rates is relatively "narrow," the Bank's net interest margin is
also subject to a decline in spread.
The outlook for 1999 is influenced by the effect of trends in
interest rates and the Bank's ability to both successfully increase earning
assets and continue, at a modest level, the favorable trend in the portfolio
mix.
page 5
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<TABLE>
<CAPTION>
RATE VOLUME ANALYSIS 1998 vs. 1997 1997 vs. 1996
(DOLLARS IN THOUSANDS) Increase (decrease) due to Increase (decrease) due to
Total Total
Volume Rate Change Volume Rate Change
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<S> <C> <C> <C> <C> <C> <C>
INTEREST INCOME
Investments:
Mortgage-backed and related securities $ (376) $ (42) $ (418) $ (455) $ 33 $ (422)
Interest-earning deposits with banks (408) 1 (407) 473 (44) 429
Other equity investments 26 (1) 25 24 (5) 19
U.S. treasury, government agencies, and others 319 (17) 302 1,018 139 1,157
------- ------- ------- ------- ------- ------
Total investments (439) (59) (498) 1,060 123 1,183
Loans:
Residential (523) (376) (899) (1,052) 126 (926)
Residential construction 761 (82) 679 382 153 535
Multifamily 1,942 (348) 1,594 1,138 (40) 1,098
Multifamily construction (115) 22 (93) 320 23 343
Commercial and commercial real estate 1,398 (264) 1,134 1,967 51 2,018
Commercial real estate construction 353 (30) 323 (40) (97) (137)
Consumer and other 526 53 579 370 60 430
------- ------- ------- ------- ------- ------
Total loans 4,342 (1,025) 3,317 3,085 276 3,361
------- ------- ------- ------- ------- ------
Total interest income 3,903 (1,084) 2,819 4,145 399 4,544
INTEREST EXPENSE
Deposits:
Money market deposit and checking 573 43 616 266 38 304
Regular savings (97) (25) (122) (100) (2) (102)
Time deposits 1,670 (63) 1,607 2,939 (235) 2,704
------- ------- ------- ------- ------- ------
Total deposits 2,146 (45) 2,101 3,105 (199) 2,906
FHLB advances and other (834) (38) (872) (672) 55 (617)
------- ------- ------- ------- ------- ------
Total interest expense 1,312 (83) 1,229 2,433 (144) 2,289
------- ------- ------- ------- ------- ------
Net interest income $ 2,591 $(1,001) $ 1,590 $ 1,712 $ 543 $ 2,255
------- ------- ------- ------- ------- ------
------- ------- ------- ------- ------- ------
</TABLE>
<TABLE>
<CAPTION> 1996 vs. 1995
RATE VOLUME ANALYSIS Increase (decrease) due to
(DOLLARS IN THOUSANDS)
Total
Volume Rate Change
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<S> <C> <C> <C>
INTEREST INCOME
Investments:
Mortgage-backed and related securities $ (48) $ 223 $ 175
Interest-earning deposits with banks (281) (5) (286)
Other equity investments 19 48 67
U.S. treasury, government agencies, and others 622 145 767
------- ------- -------
Total investments 312 411 723
Loans:
Residential (124) 282 158
Residential construction 208 2 210
Multifamily 1,882 (59) 1,823
Multifamily construction 116 (74) 42
Commercial and commercial real estate 1,849 (211) 1,638
Commercial real estate construction 135 (20) 115
Consumer and other 251 (28) 223
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Total loans 4,317 (108) 4,209
------- ------- -------
Total interest income 4,629 303 4,932
INTEREST EXPENSE
Deposits:
Money market deposit and checking 301 (275) 26
Regular savings (119) (1) (120)
Time deposits 2,291 (665) 1,626
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Total deposits 2,473 (941) 1,532
FHLB advances and other 422 115 537
------- ------- -------
Total interest expense 2,895 (826) 2,069
------- ------- -------
Net interest income $ 1,734 $ 1,129 $ 2,863
------- ------- -------
------- ------- -------
</TABLE>
If short-term interest rates should quickly rise, it is likely that the net
interest margin would decline. Management, however, is cautiously optimistic
that some or all of that decline could be offset through the growth of assets
and the possible further improvement in loan mix. Although future results
cannot be predicated on past performance, the Bank has increased its assets
by 12.8%, compounded per year, for the past five years.
Other operating income was up sharply in 1998 to $3,230,000 from
$1,706,000 the previous year.
The comparable figure for 1996 was $1,642,000. The improvement in 1998 was
primarily due to increased mortgage banking activities and the resulting gain
on sales of loans. Adversely affecting all three years was the decline in
service fee income, which has decreased from $879,000 in 1996 to $474,000 in
1998.
GAIN ON SALES OF LOANS
Gain on sales of loans is composed of three elements; sale of
mortgage servicing rights, secondary market fees, and capitalization of
mortgage servicing rights.
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The net gain on sale of servicing rights amounted to $1,982,000 in
1998. There were no sales of a similar nature in either 1997 or 1996. In the
fall of 1997, the Bank identified a potential risk to the servicing portfolio
from accelerated loan prepayments. To partially mitigate that risk, the Bank
initiated the process of selling approximately one-third of its then $300
million residential servicing portfolio. The sale was executed in the first
quarter of 1998, with about $93 million remaining, after prepayments, of the
$100 million originally set to be sold. The Bank's concern over the potential
for a "refinance boom" did in fact materialize, and the actions initiated in
the fall of 1997 helped to reduce the economic loss from the early repayment
of loans serviced for others. Throughout the year loan prepayments remained
high and management believed that it was prudent to continue the sale of
servicing rights. In addition to the $93 million loan servicing sale in the
first quarter, sales totaling $85 million were executed in the subsequent
three quarters.
Although the Bank has sold servicing on occasion in prior years,
1998 was the first year in which gains realized were so significant. It is
management's current intent to continue the sale of servicing rights in 1999,
and the Bank has signed a best-efforts contract to sell servicing rights on a
quarterly basis. The amount and profit of sales executed in 1999 will depend
on residential loans originated, both in terms of amount and mix of loans.
The total number of loans closed and type of loans originated is heavily
influenced by the nature of the interest rate yield curve and whether or not
long-term rates are generally rising or falling. Rising rates usually have an
adverse effect upon the amount of residential loans originated.
Although it is the Bank's intent to sell servicing rights in 1999,
sales in subsequent years could be materially reduced or eliminated if the
Bank believed that it was in the best interests of the institution to retain
the servicing rights and the annuity-like fee income attendant with those
rights.
96----------------------$189
97------------------------$213
98----------------------------------------------$380
LOAN PRODUCTION/DOLLARS IN MILLIONS
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Secondary market fees are the cash gains or losses from the sale of
loans into the secondary market. Cash losses in 1998 totaled $426,000 on loan
sales of $198 million. In 1997 the cash losses amounted to $5,000 on sales of
$98 million. The comparable figure for 1996 was a gain of $20,000 on sales of
$87 million. The more favorable results achieved in 1996 and 1997 are
attributable to fewer loan sales than in 1998, better execution of sales into
the secondary market, and in 1997 the benefit of a sale of $4 million in
income property loans. The margin for income property loans is significantly
greater than that realized for residential loans.
Beginning in 1996 the Bank adopted a new accounting procedure that
requires the capitalization of mortgage servicing rights. The amount
recognized as income in 1998 totaled $197,000, which compares to $145,000 in
1997, and $180,000 in 1996. The increase in 1998 is largely the result of
greater loan sales.
SERVICING FEES, NET OF AMORTIZATION
Servicing fee revenue is sensitive to amortization expense, the
spread realized on the servicing portfolio, and, of course, the size of the
portfolio.
In 1998 gross fee income (net of guarantor fees) received from the
mortgage servicing portfolio totaled $742,000. Deducted from those gross fees
was amortization expense of $268,000. In 1997 gross fees totaled $1,055,000
and amortization expense amounted to $250,000. The comparable figures for
1996 were $1,129,000 and $250,000, respectively.
Amortization expense is largely impacted by the early prepayment of
loans. In 1998 principal prepayments totaled $78 million, or 21% of the
yearend 1997 servicing portfolio balance. The prepayment rates were
substantially less in the two previous years, with $50 million in loan
principal repaid in 1997, an amount equal to 13% of the 1996 yearend
servicing balances. The results for 1996 are comparable to 1997 - principal
prepayments totaled $45 million and represented 13% of the 1995 yearend
servicing portfolio.
Also impacting servicing fee income is the spread realized from the
servicing portfolio. The spread is the difference between the total loan
interest received from the borrower and the amount remitted to the investor.
The Bank retains the spread as compensation for servicing the loan on behalf
of the investor. In 1998 the spread on the $324 million average servicing
portfolio equaled .23%. In contrast, the servicing portfolio averaged $375
million in 1997 and carried a spread of .28%. The comparable figures for 1996
96----------------------------------------------$371
97-------------------------------------------------$379
98--------------------------$268
SERVICING PORTFOLIO/DOLLARS IN MILLIONS
page 8
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were $355 million for the servicing portfolio and .32% for the servicing
spread. The narrowing spread over the past three years is a result of both
increased competition and higher guarantor fees. Contributing to higher
guarantor fees is a practice instituted in the last few years of exchanging
reduced losses in the secondary market for increased guarantor fees. This
practice produces improved financial results in the current year, but lowers
service fee spreads in following years. Management anticipates that servicing
spreads will most likely stabilize at the current level.
The drop in the servicing portfolio in 1998 contributed to the decline
in service fee income. As was noted earlier, the Bank's decision to sell $178
million in mortgage servicing rights was prompted by a concern that loan
repayments would remain high in 1998. The Bank needs a number of years of
service fee income to recover its investment in servicing which is retained,
and will experience a loss if loans prepay before that investment can be
recovered.
Whether or not conditions will be favorable in the future for the
retention of servicing rights is dependent on interest rate trends, the
borrowers' propensity to prepay loans, management's expectations for future
interest rate directions, and the estimated lives of loans in the servicing
portfolio.
FEES ON DEPOSIT SERVICES AND OTHER INCOME
Deposit fee income has risen 30% in the last three years, from $160,000
in 1996 to $167,000 in 1997 and $208,000 this year. The increase in all three
years is largely attributable to fee income from checking accounts. Revenue
from checking accounts amounted to $70,000 in 1996, increasing to $85,000
last year, and further rising to $95,000 in 1998.
Other income is composed of a variety of fee sources of which loan fees,
late payment assessments (late charges) and rental income constitute the most
significant items. Loan fees, those that were not deferred, increased from
$126,000 to $240,000 and $385,000 for years 1996, 1997, and 1998,
respectively. The rise in fee income is a result of both increased loan sales
to investors where the Bank functioned as a broker and construction loans
that were financed by other lenders after construction and lease-up of the
project.
With commercial construction loans the Bank typically negotiates a
standby fee which is immediately recognized into income if the borrower
finances with another lender after the construction is completed. Because of
the current "flat" yield curve, short-term and long-term rates are almost at
the same rate. As a result a number of borrowers in the past year have
elected to finance their projects after construction with lenders that offer
long-term, fixed-rate financing.
page 9
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The Bank, because of interest rate risk inherent in long-term, fixed-rate
lending, generally limits its portfolio loans to short-term adjustable-rate
loans.
Late charges declined $29,000, or 24.3%, in 1998. In the two previous
years, late charges had risen from $106,000 in 1996 to $118,000 last year.
The sudden drop in late payment assessments is due in part to the emphasis
that the Bank places on asset management and in part to the favorable Puget
Sound economy in 1998.
Another relatively modest source of fee revenue is office rental income.
With the acquisition of the second office in Bellevue in 1997, the Bank's
rental income increased from $27,000 in 1996 to $46,000 last year, and
$66,000 in 1998.
OTHER OPERATING EXPENSES
SALARIES AND EMPLOYEE BENEFITS. Salaries and employee benefits expense
has grown rapidly in the last three years. Employee costs in 1998 increased
$1,541,000, or 25.9%, as compared to $1,356,000, or 29.4%, from 1996 to 1997,
and $553,000, or 13.7%, from 1995 to 1996. Salaries and employee benefits
expense was affected by the rapid expansion of the Bank and a jump in
commission expense, offset by the deferral of loan origination expenses.
Employee compensation increased as a result of both a growth in staffing
levels and commission compensation expense. Full time equivalent (F.T.E.)
staff increased from 125 in 1997 to 133 in 1998. The F.T.E. count in 1996 was
103. In the last two years the Bank's staff has increased by 29.1%. In 1998
the Bank added its ninth full-service office in Bellingham, and increased the
number of administrative personnel to support the operating offices and
departments, to include a new compliance officer, data processing personnel
and several methods analysts. The previous year the Bank had added the
Bellevue West Office and two new consumer lending departments.
Nineteen-ninety-six was also a year of business expansion. That year the
Bank opened the West Seattle Office, established loan production offices in
Bellingham and Tacoma, Washington, and Portland, Oregon, increased the number
of residential loan officers, and introduced the Business Banking Department.
Employee compensation expense was further increased in 1997 and 1998 by
discretionary bonuses paid to directors and senior management. These bonuses
totaled $465,000 in 1997 and $808,000 in 1998. The Bank anticipates that any
discretionary bonuses paid to the directors and senior management in 1999
will be less than that paid in either of the two previous years.
Also impacting compensation expense were
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<PAGE>
commissions paid to loan officers. Residential loan officers are compensated
primarily by commission, and income property loan officers are partially
compensated through commission payments. Loans originated in 1998 totaled
$380 million as compared to $213 million and $189 million in 1997 and 1996,
respectively. Since commission payments are graduated based on loan
production levels, the commission rates paid, on average, also went up.
Accordingly, loan officer commissions rose from $180,000 in 1996 to $339,000
in 1997 to $929,000 in 1998.
Offsetting the increase in compensation expenses was the deferral of
loan origination expenses. In accordance with the current accounting
literature, standard loan origination costs are deferred and amortized over
the life of the loan. The standard loan costs, which are determined for
common loan types, are then deducted from operating expense, with the net
figures reported in the financial statements. Loan originations in the last
three years have increased 101.1%, from $189 million in 1996 to $380 million
in 1998. Loan production totaled $213 million in 1997. The accounting benefit
(See Note 14 to the Financial Statements.) from increased loan originations
has also risen consistently over the same period, and amounted to $760,000
three years ago, increased to $1,093,000 in 1997, and reached $1,622,000 in
1998.
OCCUPANCY EXPENSE. Occupancy expense of $1,379,000 in 1998 was up 18.3%
from $1,165,000 the previous year. The comparative figure for 1996 was
$831,000. The increases in both 1998 and 1997 were principally due to opening
new offices and corporate expansion at the Bellevue headquarters. In 1998 the
Bank opened a new office in Bellingham and incurred a full year's operating
expense from the Bellevue West Branch. The previous year the Bank had
purchased a two-story office in Bellevue and opened its eighth full-service
branch. Additional lease space was also acquired at the corporate
headquarters to accommodate separate facilities for the residential lending
staff. The jump in occupancy expense in 1996 was the result of opening three
new loan production offices in Bellingham and Tacoma, Washington, and
Portland, Oregon, and a new full-service office in Seattle.
OTHER EXPENSES. Other expenses rose 21.1% from $2,566,000 in 1997 to
$3,108,000 in 1998. The increase from 1996 to 1997 was $468,000, or 22.3%. A
number of items contributed to the growth in other operating expenses, to
include legal expenses, supplies, postage and telephone, outside service
costs, and business and occupation (B&O) taxes.
The Bank's legal fees were up sharply from $81,000 in 1997 to $148,000
in 1998, an increase of
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<PAGE>
83.3%. Legal expenses in 1996 were comparable to 1997 at $60,000. The Bank
encountered several issues in 1998 related to residential construction
lending that were difficult to litigate. Those issues have since been settled
and the Bank does not anticipate any further legal expenses regarding those
particular matters.
Because of the dramatic increase in loan volume, from $213 million in
1997 to $380 million in 1998, the cost of everyday items such as supplies,
telephone and postage rose substantially in 1998. Expenses for those three
categories amounted to $598,000 in 1998, up $163,000, or 37.5%, from $435,000
in 1997. Expenses for 1996 totaled $375,000.
In July of 1998 the Bank engaged independent consultants to review the
operating procedures of the Bank and to implement improvements as needed. The
project is expected to last until late spring of 1999. As a consequence of
this initiative, outside service expense totaled $379,000 in 1998, an
increase of 375.8% from 1997's figure of $80,000. The comparable level of
costs for 1996 was $62,000.
B&O state taxes have risen steadily in the last three years, from
$168,000 in 1996 to $215,000 the following year, and reaching $287,000 in
1998. In addition to greater operating income, the Bank's gradual shift from
residential loans, which are generally exempt from B&O tax, to income
property, business banking and consumer loans, which are not exempt, has
increased the amount of B&O tax paid.
RESERVE AND PROVISION FOR LOAN LOSSES
The provision for loan losses reflects the amount deemed appropriate to
produce an adequate reserve for estimated losses that exist based on the
inherent risk characteristics of the Bank's loan portfolio. In determining
the appropriate reserve balance, the Bank takes into consideration the
profile of the loan portfolio, the local and national economic outlook, and
the current and historical performance of the loan portfolio.
The determination of the level of reserves, and thus any additional
provision, is arrived at through a process that begins with the Asset
Management Department. That department analyzes the loan portfolio from a
historical credit perspective and a composition and geographic concentration
viewpoint. The Asset Management Department then prepares an economic analysis
of the Puget Sound region to include employment forecasts, housing sales,
vacancy rates, commercial real estate analysis, and comments on the area's
major employers. That information is then reviewed by the
96 --------------------------- .07%
97 -------------------------------------------------- .15%
98 --------------------------- .07%
NONPERFORMING ASSETS/PERCENTAGE OF TOTAL ASSETS
page 12
<PAGE>
<TABLE>
<CAPTION>
1998 1997 1996
------------------------ -------------------------- -----------------------------
Balance % of total Balance % of total Balance % of total
- -----------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Single family residential (SFR)
including loans held for sale $ 94,050,246 24.3% $115,657,378 32.1% $130,103,441 39.1%
Commercial, commercial real estate,
and multifamily residential loans 236,656,479 61.2 203,524,241 56.5 171,921,666 51.7
Construction loans 38,609,709 10.0 29,347,102 8.1 23,229,214 7.0
Consumer loans 17,589,195 4.5 11,801,888 3.3 7,191,827 2.2
------------ ----- ------------ ----- ------------ ------
Subtotal - loans other than SFRs 292,855,383 75.7 244,673,231 67.9 202,342,707 60.9
------------ ----- ------------ ----- ------------ ------
Total loans, receivable, net,
including loans held for sale $386,905,629 100.0% $360,330,609 100.0% $332,446,148 100.0%
============ ===== ============ ===== ============ =====
</TABLE>
Bank's Senior Loan Committee, which further evaluates national and international
trends and establishes the appropriate level of reserve.
A $750,000 provision for loan losses was charged to operations in 1998.
The Bank's reserve balance was $5,569,000 at December 31, 1998. At yearend 1997
the reserve balance was $4,858,000, which in turn was an increase of $976,000
over 1996's balance of $3,882,000.
Several factors in the last few years have contributed to the Bank's
substantial provision for loan losses. First of all, the mixture of residential
loans to income property, construction, business banking, and consumer loans has
changed materially since 1996. In 1996 residential permanent loans amounted to
39.1% of the total loans receivable, including loans held for sale, of $332
million. Two years later, at the end of 1998, residential permanent loans
equaled 24.3% of the total portfolio of $387 million.
The risk inherent in construction, business banking, income property,
and consumer loans is materially greater than that experienced in residential
lending. The third quarter 1998 FDIC Quarterly Banking Profile illustrates the
difference in risks among loan types. For FDIC-insured savings institutions, the
ratio of noncurrent loans as a percent of residential loans is .88%. That figure
compares to 1.07% for construction loans, 1.30% for commercial real estate
loans, and 1.20% for business banking loans.
Although the Bank has enjoyed a period of modest charge-offs and low
nonperforming asset ratios to total loans, the change in loan mix from 60.9%
high-risk loans in 1996 to 75.7% at yearend 1998 has added significantly to the
risk embedded within the portfolio.
Secondly, the Puget Sound area in which most of the Bank's loans are
concentrated has experienced a long period of economic prosperity. The risk
associated with originating loans in such an environment is
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<PAGE>
that assets are portfolioed at or near their peak valuations. A similar peak
economic valuation occurred in the Puget Sound area in 1990 - subsequent to
which real estate valuations were significantly lower for a number of years.
In addition, the Boeing Company, the largest employer in the Puget
Sound area, and one of the largest in the Northwest, has announced a 46,000
reduction in employees over the next two years. Boeing staffing levels at
yearend 1998 were 231,000, and are scheduled to decline 31,000, or 13.4%, in
1999, with a further drop to 185,000 in the year 2000. Aircraft production,
which is anticipated to reach 620 in 1999, is forecasted to plummet to 480 in
the following year. Furthermore, the Boeing Company's collective bargaining
agreements with its largest unions expire in 1999. Unfortunately,
renegotiating new collective bargaining agreements in the midst of a major
employee layoff and decline in airplane production may further disrupt the
region's economy.
The impact of a decrease of 22.6% in airplane production, from 1999 to
2000, extends beyond the Boeing Company. Although it is difficult to be precise
as to the effect of a major reduction in employees on other employers, an
often-quoted informal "rule of thumb" is three to one. Thus, for every employee
that no longer works at the Boeing Company, three other people will probably
also be adversely affected.
In summary, the Bank's allowance for loan loss reserves has taken into
consideration the Bank's historical losses, the trend in loan portfolio mix,
the recent valuations of real estate, and the announcement by the area's largest
employer of a major decline in staffing levels.
Another perspective to the Bank's allowance for loan loss reserves is
the level of reserves established by similar institutions. At yearend 1998 the
ratio at First Mutual Bank of reserves to total loans was 1.42%. That figure
compares to the national average for commercial banks (third quarter 1998 FDIC
Quarterly Banking Profile) of 1.82% and for savings institutions of .98%.
Although the Bank is classified as a savings institution, its mix of loans is
more closely aligned with that of a commercial bank. The national norm for a
savings institution is 72.2% residential loans and 27.8% commercial, consumer,
etc. The comparable ratio for the average commercial bank is 23.9% residential
loans and 76.1% commercial, consumer, etc. First Mutual Bank's ratio of 24.3% of
permanent residential loans is almost identical, at yearend 1998, with the
national commercial bank norm.
96------------------------------- $417
97----------------------------------$446
98--------------------------------------$489
ASSETS/DOLLARS IN MILLIONS.
page 14
<PAGE>
The Bank uses neither local nor national ratios to determine the
appropriate provision or level of reserves. However, the Bank's ratio of 1.42%
reserves to total loans would appear to be reasonable in light of national
norms, the nature of the Bank's loan portfolio, and the current events
surrounding the state's largest employer.
REVIEW OF FINANCIAL CONDITION
INVESTMENT SECURITIES
Investment securities increased from $65 million at yearend 1997 to $82
million as of December 31, 1998, a growth of 25.4% in yearend balances. Those
figures are deceptive in that average quarterly balances actually declined from
$65 million in 1997 to $63.5 million in 1998.
In the fourth quarter of 1998, and again in the first quarter of 1999,
the Bank substantially increased its investment in securities. Management
perceived this period to be opportune for security purchases because of the
source of the Bank's funding and the current status of the institution's various
capital components.
LOANS
The loan portfolio is segregated into two components, loans held for
sale and loans receivable. Loans held for sale is that portion of the loan
portfolio which is pending sale and delivery into the secondary market.
Loans receivable are loans held in the Bank's portfolio of which
the largest component is commercial real estate.
Loans held for sale totaled $8 million at December 31, 1997, a decline
of $4 million from the previous yearend. At December 31, 1998, loans held for
sale had risen to $27 million, reflecting the sudden increase in mortgage
banking activity in 1998. It is not unusual for the balance in loans held for
sale to change dramatically from year to year. At yearend 1993, another year of
vigorous mortgage-banking activity, the yearend balance for loans held for sale
totaled $24 million; the following year, 1994, the loan totals fell to $4
million. The normal balance for loans held for sale is in the range of $4 to $12
million, but would vary with refinancing activity.
Portfolio loans increased slightly, 2.3%, in 1998, from $357 million at
December 31, 1997, to $365 million at yearend 1998. Although loan originations
for portfolio loans were at record levels, $163 million in 1998 as compared to
$120 million in 1997, and $102 million in 1996, principal repayments were a
staggering $137 million in 1998. Principal repayments totaled $84 million and
$64 million in 1997 and 1996, respectively.
96----------------------------- 15.3%
97-------------------------------- 15.6%
98-----------------------------------16.0%
RETURN ON AVERAGE EQUITY/PERCENTAGES
page 15
<PAGE>
Contributing to the increase in portfolio loan repayments in 1998
was the emergence of commercial real estate lenders with fixed-intermediate
and long-term rates that were in some cases more favorable than the Bank's
short-term variable rates. The "flat yield" curve referred to earlier was in
large measure the cause of the more difficult competition that the Bank faced
in portfolio lending.
The future shape of the yield curve is difficult to predict, and,
consequently, so is the prospect of whether loans will continue to prepay at
such high rates. Nevertheless, management is guardedly optimistic that it can
continue to grow assets under adverse conditions. Nineteen-ninety-eight was a
year of record portfolio lending, which helped to offset early loan repayments,
and the Bank is reasonably hopeful that 1999 will exceed the results of 1998.
DEPOSITS
Total deposits grew 10.3%, from $372,829,000 at yearend 1997 to
$411,251,000 in 1998. The positive growth in deposits in 1998 was particularly
encouraging as the year was again characterized by aggressive marketing activity
from both financial institutions and non-insured competitors. The Bank believes
that its emphasis on service, customer rapport and competitively priced savings
instruments permitted it to acquire funds in a market that nationally has only
increased on a modest basis. The third quarter 1998 issue of the FDIC Quarterly
Banking Profile reported that deposits for all FDIC-insured institutions rose
only 4.8% from September 1997 through September 1998.
MARKET RISK SENSITIVE INSTRUMENTS
Market risk is the risk of loss from adverse changes in market prices
and rates. A significant market risk for the Bank arises from interest rate risk
inherent in its lending, deposit and mortgage banking activities. To that end,
management actively monitors and manages its interest rate risk exposure.
The Bank's profitability is affected by fluctuations in interest rates.
An immediate and substantial increase in interest rates may adversely impact the
Bank's earnings to the extent that the interest rates borne by assets and
liabilities do not change at the same speed, to the same extent, or on the same
basis. Increases in the level of interest also may adversely affect the fair
value of the Bank's securities and other earning assets. Generally, the fair
value of fixed-rate
96------------------------------ $328
97--------------------------------- $373
98-------------------------------------$411
DEPOSITS/DOLLARS IN MILLIONS
page 16
<PAGE>
<TABLE>
<CAPTION>
1998 Percentage Change 1997 Percentage Change
Immediate Change ------------------------------ -----------------------------
in Interest Rates Net Interest Net Portfolio Net Interest Net Portfolio
(in basis points) Income Value Income Value
- ---------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
+400........... 7 % -11% 1% -9%
+300........... 7 -6 2 -3
+200........... 6 -1 4 2
+100........... 4 0 3 5
- -100........... -5 -2 -4 -4
- -200........... -10 -8 -8 -10
- -300........... -15 -13 -11 -12
- -400........... -20 -18 -15 -15
</TABLE>
instruments fluctuates inversely with changes in interest rates. As a result,
increases in interest rates could result in decreases in the fair value of the
Bank's interest-earning assets, which could adversely affect the Bank's results
of operations if such assets were sold. If the case of interest-earning
securities classified as available for sale, the Bank's stockholders' equity
could sustain significant unrealized losses if such assets were retained.
The Bank uses a number of measures to monitor and manage interest rate
risks, including income simulation and interest "gap" analysis (further
discussed under the subhead Asset and Liability Management). An income
simulation model is primarily used to assess the direction and magnitude of
changes in interest rates. Key assumptions in the model include prepayment
speeds on mortgage-related assets, cash flows and maturity of financial
instruments held for purposes other than trading, changes in market conditions,
loan volumes and pricing, deposit sensitivity, customer preferences, and
management's financial capital plans. These assumptions are inherently
uncertain; therefore, the model cannot precisely estimate net interest income or
precisely predict the impact of higher or lower interest rates on net interest
income. Actual results may significantly differ from simulated results due to
timing, magnitude and frequency of interest rate changes, and changes in market
conditions and management strategies, among other factors.
Based on the results of simulations as of December 31, 1998 and 1997,
the estimated impact of immediate changes in interest rates is as shown in the
table. The percentages shown represent changes over a 12-month period in the
Bank's net interest income and net portfolio value under a stable interest rate
environment compared to the various rate scenarios. Net portfolio value is
defined as the net market value of the Bank's assets and liabilities, which has
been estimated by calculating the present value of their cash flows. The cash
flows have been adjusted to account for projected amortization, prepayments,
core deposit decay rates, and other factors.
The percentage changes in net interest income and in net portfolio
value widened in 1998, as compared to the prior year. Adjustable-rate loans, as
a percent of total loans, decreased from 88% in 1997 to 83% in 1998, and
reflects in this simulation as an increase in the Bank's sensitivity to interest
rate fluctuations.
The Bank's primary objective in managing
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<PAGE>
interest rate risk is to minimize the adverse impact of changes in interest
rates on the Bank's net interest income and capital, while structuring the
Bank's asset and liability components to obtain the maximum net interest
margin. The Bank relies primarily on its asset and liability structure to
control interest rate risk.
ASSET AND LIABILITY MANAGEMENT
Asset and liability management is the responsibility of the
Asset/Liability Committee, which acts within policy directives established by
the Board of Directors. The Asset/Liability Committee meets regularly to monitor
the composition of the balance sheet, to assess projected earnings trends, and
to formulate strategies consistent with the objectives for liquidity, interest
rate risk, and capital adequacy. The objective of asset/liability management is
to maximize long-term shareholder returns by optimizing net interest income
within the constraints of credit quality, interest rate risk policies, levels of
capital leverage, and adequate liquidity.
The Bank manages assets and liabilities by matching maturities and
repricing in a systematic manner. In addition to simulation models, an interest
"gap" analysis is used to measure the effect interest rate changes have on net
interest income. The interest gap is the difference between the amount of
interest-earning assets maturing or repricing within a specific time period and
the amount of interest-bearing liabilities maturing or repricing in that same
time period. A gap is considered positive when the amount of
interest-rate-sensitive assets exceed the amount of interest-rate-sensitive
liabilities. A gap is considered negative in the reverse situation.
The following table shows the Bank's one-year interest-rate-sensitive
gap by contractual repricing or maturity at December 31:
<TABLE>
<CAPTION>
1998 1997
- ----------------------------------------------------------------------------------------
<S> <C> <C>
One year repricing assets $ 311,261,831 $ 326,036,089
One year repricing liabilities 315,375,840 330,298,150
------------- -------------
One year gap $ (4,114,009) $ (4,262,061)
============= =============
Total assets $ 489,230,139 445,762,440
============= =============
Interest rate sensitivity
gap as a percent of assets (.84)% (.96)%
============= =============
</TABLE>
During a period of rising interest rates, the net earnings of an
institution with a negative gap may be adversely affected due to its
interest-bearing liabilities repricing to a greater extent than its
interest-earning assets. Conversely, during a period of falling interest rates,
net earnings may increase. At December 31, 1998 and 1997, the Bank was able to
achieve a matched one-year-gap position of minus .84% and minus .96%,
respectively.
The Bank has managed its interest rate risk through the marketing and
funding of adjustable-rate
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<PAGE>
loans. As of December 31, 1998, 83% of the Bank's loan portfolio had adjustable
rates. The Bank also originates and sells long-term, fixed-rate mortgage loans,
which have been written to specifications of the Federal Home Loan Mortgage
Corporation and the Federal National Mortgage Association. Over the past several
years the Bank has expanded its net interest margin by focusing on commercial
real estate, construction, business banking, and consumer lending. Collectively,
these loans comprised 75.7% of the Bank's loan portfolio as of December 31,
1998, compared to 60.9% at the end of 1996.
The Bank's management reviews, on a monthly basis, interest rate
trends. Where appropriate, hedging techniques are employed. These techniques may
include financial futures, options on financial futures, and extended
commitments on future lending activities and interest rate exchange agreements.
During 1998, 1997, and 1996, the Bank did not enter into any off-balance-sheet
derivative agreements, nor were any agreements held at December 31, 1998, 1997,
and 1996.
LIQUIDITY AND CAPITAL RESOURCES
The Bank's primary sources of funds are: 1) deposits, 2) principal
repayments of both loans and investment securities, 3) loan sales, and 4)
borrowings from the Federal Home Loan Bank (FHLB) of Seattle.
The principal use of funds is to invest in securities and loans. Security
purchases amounted to $68 million in 1998, up substantially from $29 million in
purchases in 1997, and $24 million in 1996. Loan originations, including loans
held for sale, totaled $380 million, $213 million, and $189 million during 1998,
1997, and 1996, respectively. Principal repayments on portfolio loans totaled
$137 million, $84 million, and $64 million, for the same periods. Funds obtained
from loan sales amounted to $198 million in 1998, $98 million in 1997, and $87
million in 1996.
The Bank's line of credit with the FHLB has been established at 35% of
assets. Borrowings totaled $32 million, $34 million, and $54 million, at
December 31, 1998, 1997, and 1996, respectively. These borrowings represented 7%
of the yearend assets in 1998, 8% in 1997, and 13% in 1996.
Shareholders' equity at December 31, 1998, was $34,662,000 compared
with $30,652,000 a year earlier. First Mutual's leverage capital ratio at
yearend 1998 was 7.2%, which compared to 6.9% the previous year. The FDIC
requirement to be "well capitalized" under "prompt corrective action"
provisions is a 5.0% ratio.
BUSINESS SEGMENTS
The Bank has identified three distinct segments of business for the
purposes of management reporting.
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<PAGE>
(See Note 21 to the Financial Statements.) Segment results are determined based
on the Bank's management accounting process, which assigns balance sheet and
income statement items to each responsible business unit. This process is
dynamic and somewhat subjective. Unlike financial accounting, there is no body
of guidance for management accounting equivalent to generally accepted
accounting principles.
The management accounting process measures the performance of the
business segments based on the management structure of the Bank and is not
necessarily comparable with similar information for any other financial
institution. Changes in management structure and/or the allocation process may
result in changes in allocations, transfers and assignments.
CONSUMER BANKING
This segment provides depositor banking services, and offers consumer
loans on automobiles, boats, individual lines of credit, loans for home
improvements, etc.
Net income before tax declined $548,000, or 25.9%, from $2,114,000 in
1997 to $1,566,000 in 1998. Although total revenues rose in 1998 to $6,522,000
from $6,326,000 the previous year, and the same trend was evident in net
interest income, up $212,000, or 3.4%, operating expenses more than offset the
benefits of increased revenues.
The fall in net income before tax is principally the result of adding
new banking offices in both 1997 and 1998. The period required to develop a
branch office that meets the Bank's profit objectives is exceedingly long. For
example, the Ballard Office, which opened in 1994 and has experienced excellent
deposit growth, has yet to meet the Bank's targeted return on capital.
The outlook for the consumer segment is not optimistic. Management
believes that it will need to continue to open full-service offices to meet the
funding needs of its asset growth. Each new office opened will burden this
segment until such time as the total and mix of deposits for new branches reach
the minimum desired objectives.
RESIDENTIAL LENDING
Residential lending is a segment encompassing the mortgage banking
operations, permanent single family loans, and construction residential lending.
Net income before taxes increased from $1,094,000 in 1997 to $2,017,000
in 1998. The favorable results in 1998 were largely the effect from a rise in
mortgage banking activity. Loan originations related to the mortgage banking
operation more than doubled from $94 million in 1997 to $217 million in 1998, an
increase of 132.3%. In addition to the growth in loan
page 20
<PAGE>
closings was a corresponding rise in loan sales. Proceeds from loan sales
totaled $198 million, up 103.3% from 1997's sales of $98 million.
Gains from the sale of loans and servicing amounted to $1,753,000 in
1998, a dramatic increase of 1,151% from $140,000 in 1997. Partially offsetting
the gain on sale of loans was a $331,000, or 41.2%, drop in servicing fee
income. The Bank's sale of $178 million in servicing rights in 1998 contributed
to the sharp decline in servicing fee revenue.
COMMERCIAL LENDING
Commercial lending activities include multi-family housing, commercial
real estate properties, and business banking loans.
Commercial lending is the most profitable segment, contributing 62.7%
of the Bank's income before federal income taxes. Earnings before income taxes
in 1998 were $6,025,000, an increase of $988,000, or 19.6%, from 1997.
The improvement in 1998 is principally the result of increased assets,
from $235 million in 1997 to $274 million in 1998, a growth of 16.6%.
Particularly encouraging was the increase in business banking assets, which rose
from less than $4 million in 1997 to over $16 million in 1998.
YEAR 2000 ISSUES
The Bank relies on third-party vendors for almost all of its data
processing and telecommunications systems. Consequently, its efforts to ensure
that the Bank is ready for Year 2000 and that there are no meaningful
interruptions to its operations are necessarily dependent on the performance of
those vendors and adequate testing by the vendors and the Bank.
To date, the Bank has conducted a comprehensive review of its computer
systems to identify applications that could be affected by Year 2000. It has
surveyed its vendors to find out their status in addressing Year-2000 issues and
is monitoring their progress.
The Bank's primary data processor supports its deposit, loan, general
ledger, customer information file, accounts payable, and fixed-assets accounting
systems. This processor completed its programming efforts during the second
quarter of 1998 and indicated that the Bank was now running on what the
processor believed to be Year-2000-ready software and hardware. During the third
quarter the Bank conducted an extensive test of the software on a separate test
computer provided by the processor to its clients. The computer was set ahead to
the end of 1999 and rolled through January 3, 2000; in addition, it was also run
through the end of February 2000 to test for leap year. Only a few minor errors
were identified, and not all of them
page 21
<PAGE>
were date related. The processor has reported that all errors discovered by its
clients during testing have been corrected. This processor will not be charging
the Bank, nor its other clients, for expenses related to remediating its
software to address Year-2000 issues.
Most of the Bank's other third-party vendors have indicated that they
are in the process of ensuring that their systems were Year-2000 ready by the
end of 1998. The Bank will need to test those systems judged to be critical to
its operations after the programming is completed. Many of these services (such
as check processing, automated teller machine transactions, automated
clearinghouse transactions, and investor reporting) interface with the Bank's
primary data processor and will have to be tested in conjunction with that
processor. Most of that testing is expected to take place during the first half
of 1999. The Bank's primary data processor is coordinating the effort and has
provided the Bank a report on its progress, which will be updated periodically.
In its most current report the data processor indicated that 17% of testing with
these vendors had been completed; individual reports on the results of the
testing will be provided to those clients using the particular vendors.
While the Bank does not operate any mainframe computers, it does run
several local area networks to support personal-computer workstations running
standardized word processing, spreadsheet, and database software to support its
operations. All models of the personal-computer workstations, and most of the
individual workstations, have been tested for Year-2000 functionality. Most of
the workstations are Year-2000 ready. A total of six personal computers will be
replaced through normal attrition; one of the servers for a local area network
likewise needed replacement. The Bank anticipates no other material expense
related to their replacement. Likewise, much of the standardized software has
been tested and found to be Year-2000 ready. Testing will continue on the
remaining software; any versions found to be non-compliant will be replaced. The
Bank does not expect that any additional material investment will be required to
replace any of the personal-computer hardware or software at this point in time.
If it becomes advisable to replace one or more of these systems, the investment
would likely be a material amount.
In addition to computer software, it is possible that computer hardware
and other equipment used in the Bank's operations or buildings may have
microprocessors with Year-2000 issues. Most of the hardware involved in the
Bank's networks and workstations has been replaced over the past several years
for reasons unrelated to Year 2000. In addition, surveys have been completed of
items such as heating and cooling
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<PAGE>
systems, vault doors, automated teller machines, and security systems. No
material investments are expected related to Year-2000 readiness for these
ancillary systems.
Most of the Bank's costs in this effort has involved the time of its
existing staff; no one has been hired whose job is primarily related to
Year-2000 issues. The Bank does not expect the cost of this project to have a
material effect on its financial position or results of operations. The costs of
changing to alternate vendors, or replacement of one or more in-house systems,
would be material and, while not expected, could be incurred if the testing
provides results which are unacceptable to the Bank.
The Bank's efforts so far have been concentrated on identifying its
significant vendors, determining where they are in the process of ensuring their
services will be Year-2000 ready, and monitoring their progress. A contingency
plan to deal with vendors who may not be ready before Year 2000 or to deal with
systems that may unexpectedly fail once Year 2000 arrives has not yet been
developed. Such a plan should be completed by the end of second quarter 1999.
The Bank's operations are very dependent on the availability of utility
services such as electrical power and telephone services. The Bank has received
only limited information from those service providers about their Year-2000
preparedness so far.
The Bank operates within the lending and banking community, including
the check clearing houses. In common with other financial institutions, it has
the inherent risk that a failure of any significant system of interchange among
the financial institutions, or the failure of a system within one or more large
banks in the Bank's geographic area, could have a material adverse effect on the
Bank.
While the Bank currently believes that Year 2000 will not pose
significant operational problems, there can be no assurance that its systems and
the systems of other companies on which the Bank relies will be timely converted
or that any conversion failures would not have a material impact on the
operations of the Bank.
INFLATION AND CHANGING PRICES
Generally accepted accounting principles require the measurement of
financial position and operating results in terms of historical dollars, without
consideration for change in relative purchasing power over time due to
inflation. Virtually all assets and liabilities of a financial institution are
monetary in nature; therefore, interest rates generally have a more significant
impact on a bank's performance than does the effect of inflation. Over short
periods of time, interest rates may not necessarily move in the same direction
or in the same magnitude as inflation.
page 23
<PAGE>
SELECTED FINANCIAL DATA
<TABLE>
<CAPTION>
December 31,
-------------------------------------------------------------------------
1998 1997 1996 1995 1994
- -------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Total assets $ 489,230,139 $ 445,762,440 $ 416,832,072 $ 361,525,779 $ 306,011,209
Loans outstanding, net, including loans held for sale 386,905,629 360,330,609 332,446,147 302,690,822 249,524,124
Cash and investments 87,630,187 71,400,689 73,471,099 49,009,383 45,898,156
Savings deposits 312,331,832 296,296,151 267,117,248 220,550,828 166,743,973
Other deposits 98,919,316 76,532,403 61,278,247 53,956,008 47,763,256
FHLB advances 31,765,000 34,230,000 54,180,000 55,325,000 66,057,000
Stockholders' equity 34,661,953 30,651,828 27,396,063 23,673,567 20,835,732
<CAPTION>
Years ended December 31,
-------------------------------------------------------------------------
1998 1997 1996 1995 1994
- -------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Interest income $ 39,215,036 $ 36,395,958 $ 31,851,577 $ 26,919,219 $ 20,534,302
Interest expense (21,818,674) (20,589,962) (18,300,871) (16,231,748) (10,775,240)
Net interest income 17,396,362 15,805,996 13,550,706 10,687,471 9,759,062
Other income 3,230,006 1,706,382 1,641,898 1,645,405 2,449,228
Noninterest expense (11,987,138) (9,689,756) (7,532,531) (6,942,353) (6,907,986)
Provision for loan losses (750,000) (976,000) (1,700,000) (250,000) (574,000)
Income before taxes 7,889,230 6,846,622 5,960,073 5,140,523 4,726,304
Federal income tax (2,681,534) (2,327,942) (2,045,425) (1,712,778) (1,595,834)
Net income 5,207,696 4,518,680 3,914,648 3,427,745 3,130,470
Return on average assets 1.11% 1.05% 1.01% 1.03% 1.09%
Return on average equity 15.95% 15.57% 15.33% 15.40% 16.13%
</TABLE>
NOTE: EXCEPT FOR THE HISTORICAL INFORMATION IN THIS ANNUAL REPORT, THE
MATTERS DESCRIBED HEREIN ARE FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF
THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 AND ARE SUBJECT TO RISKS
AND UNCERTAINTIES THAT COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY. SOME
EXAMPLES ARE: THE BANK NECESSARILY BASES SOME OPERATING DECISIONS IN PART ON
ITS EXPECTATIONS CONCERNING FUTURE INTEREST RATE CHANGES. THESE CHANGES ARE
INHERENTLY UNPREDICTABLE FOR THE BANK. THE BANK'S GOAL OF MOVEMENT TOWARD
NONRESIDENTIAL LENDING INCREASES THE RISKS OF LENDING AND MAY NOT BE POSSIBLE
DURING PERIODS OF GENERAL ECONOMIC STAGNATION OR DECLINE WITHIN THE PUGET
SOUND AREA. SIMILARLY, GROWTH THROUGH INCREASED DEPOSITS WOULD BE ADVERSELY
IMPACTED BY ANY GENERAL ECONOMIC DECLINE, AND PROBABLY ALSO BY ANY SUSTAINED
PERIODS OF SIGNIFICANT MONETARY INFLATION. EXPECTATIONS CONCERNING Y2K ISSUES
COULD BE ADVERSELY IMPACTED BY ANY SIGNIFICANT PROBLEMS AT OTHER
INSTITUTIONS, OR WITHIN THE BANKING INDUSTRY GENERALLY, AS WELL AS BY ANY
UNFORESEEN PROBLEM DIRECTLY AFFECTING THE BANK. ALSO, THERE ARE OTHER RISKS
AND UNCERTAINTIES DISCUSSED FROM TIME TO TIME IN FIRST MUTUAL SAVINGS BANK'S
FDIC SECURITIES FILINGS. FIRST MUTUAL SAVINGS BANK DISCLAIMS ANY OBLIGATION
PUBLICLY TO ANNOUNCE FUTURE EVENTS OR DEVELOPMENTS WHICH AFFECT THE
FORWARD-LOOKING STATEMENTS HEREIN.
page 24
<PAGE>
FIRST MUTUAL SAVINGS BANK AND SUBSIDIARY CONSOLIDATED STATEMENTS OF
FINANCIAL CONDITION
<TABLE>
<CAPTION>
December 31,
---------------------------------
ASSETS 1998 1997
- ----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
Cash and cash equivalents:
Interest-earning deposits with banks $ 216,953 $ 166,635
Noninterest-earning demand deposits and cash on hand 5,312,192 5,742,530
------------ ------------
5,529,145 5,909,165
Mortgage-backed and other securities available for sale 20,336,611 1,334,709
Loans receivable held for sale, fair value of $27,578,835 and $8,421,713 27,370,815 8,421,713
Mortgage-backed and other securities held to maturity, fair value $62,467,023 and $65,252,724 61,764,431 64,156,815
Loans receivable, net:
Loans receivable 365,104,245 356,767,272
Reserve for loan losses (5,569,431) (4,858,376)
------------ ------------
359,534,814 351,908,896
Accrued interest receivable 3,311,122 3,148,413
Mortgage servicing rights 356,585 601,435
Land, buildings, and equipment, net 5,536,748 5,451,565
Federal Home Loan Bank (FHLB) stock, at cost 4,876,500 4,519,200
Other assets 613,368 310,529
------------ ------------
TOTAL $489,230,139 $445,762,440
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
- ----------------------------------------------------------------------------------------------------------------------------------
Liabilities:
Deposits:
Investor custodial checking $ 8,146,226 $ 6,194,110
Money market deposit and checking accounts 90,773,090 70,338,293
Regular savings 12,247,457 14,649,485
Time deposits 300,084,375 281,646,666
------------ ------------
Total deposits 411,251,148 372,828,554
Drafts payable 4,382,611 1,863,744
Accounts payable and other liabilities 5,465,700 4,437,700
Advance payments by borrowers for taxes and insurance 1,517,253 1,587,278
FHLB advances 31,765,000 34,230,000
Federal income taxes 186,474 163,336
------------ ------------
Total liabilities 454,568,186 415,110,612
Stockholders' equity:
Common stock, $1 par value - Authorized,
10,000,000 shares; issued and outstanding,
4,247,275 and 4,125,227 shares 4,247,275 4,125,227
Additional paid-in capital 25,848,681 24,882,773
Employee Stock Ownership Plan debt (603,738) (871,570)
Retained earnings 5,181,720 2,520,178
Accumulated other comprehensive loss:
Unrealized loss on securities available for sale,
net of federal income tax (11,985) (4,780)
------------ ------------
Total stockholders' equity 34,661,953 30,651,828
------------ ------------
TOTAL $489,230,139 $445,762,440
============ ============
</TABLE>
SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
page 25
<PAGE>
FIRST MUTUAL SAVINGS BANK AND SUBSIDIARY CONSOLIDATED STATEMENTS OF
INCOME
<TABLE>
<CAPTION>
Years ended December 31,
------------------------------------------------
1998 1997 1996
- -------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
INTEREST INCOME:
Loans receivable $34,518,508 $31,201,837 $27,840,938
Mortgage-backed and related securities 1,651,771 2,069,627 2,491,470
U.S. treasury, government agency, and other securities 2,624,756 2,322,780 1,166,091
Interest-earning deposits with banks 62,476 470,254 40,752
FHLB stock dividends 357,525 331,460 312,326
----------- ----------- -----------
39,215,036 36,395,958 31,851,577
INTEREST EXPENSE:
Deposits 19,879,653 17,779,162 14,873,814
FHLB advances and other 1,939,021 2,810,800 3,427,057
----------- ----------- -----------
21,818,674 20,589,962 18,300,871
----------- ----------- -----------
Net interest income 17,396,362 15,805,996 13,550,706
PROVISION FOR LOAN LOSSES 750,000 976,000 1,700,000
----------- ----------- -----------
Net interest income after provision for loan losses 16,646,362 14,829,996 11,850,706
OTHER OPERATING INCOME (EXPENSE):
Servicing fees, net of amortization 473,678 805,049 878,819
Gain on sales of loans 1,753,397 140,161 199,593
Fees on deposit services 207,948 167,107 159,926
Other 794,983 594,065 403,560
----------- ----------- -----------
Total other operating income 3,230,006 1,706,382 1,641,898
OTHER OPERATING EXPENSES:
Salaries and employee benefits 7,500,148 5,958,712 4,603,003
Occupancy 1,378,519 1,164,847 830,870
Other 3,108,471 2,566,197 2,098,658
----------- ----------- -----------
Total other operating expenses 11,987,138 9,689,756 7,532,531
----------- ----------- -----------
Income before federal income taxes 7,889,230 6,846,622 5,960,073
FEDERAL INCOME TAXES:
Current 3,206,350 2,602,726 2,396,544
Deferred (524,816) (274,784) (351,119)
----------- ----------- -----------
2,681,534 2,327,942 2,045,425
----------- ----------- -----------
NET INCOME $ 5,207,696 $ 4,518,680 $ 3,914,648
=========== =========== ===========
PER SHARE DATA(1)
Basic earnings per common share $1.24 $1.11 $0.97
=========== =========== ===========
Earnings per common share - assuming dilution $1.20 $1.07 $0.94
=========== =========== ===========
WEIGHTED AVERAGE SHARES OUTSTANDING 4,215,764 4,062,824 4,043,985
=========== =========== ===========
WEIGHTED AVERAGE SHARES OUTSTANDING
INCLUDING DILUTIVE STOCK OPTIONS 4,327,378 4,234,677 4,165,432
=========== =========== ===========
</TABLE>
(1) Comparative EPS data for all years presented conforms with Statement of
Financial Accounting Standards (SFAS) No. 128.
SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
page 26
<PAGE>
FIRST MUTUAL SAVINGS BANK AND SUBSIDIARY CONSOLIDATED STATEMENTS OF
STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
Years ended December 31, 1998, 1997, and 1996
Employee
Stock Accumulated
Common stock(2) Additional Ownership comprehensive
----------------------- paid-in Retained Plan income
Shares Amount capital(2) earnings (ESOP) debt (loss)(4) Total
- ----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
BALANCE, January 1, 1996 3,058,558 $ 3,058,558 $ 13,867,953 $ 8,007,740 $ (1,193,452) $(67,232) $23,673,567
Options exercised 10,040 10,040 60,035 70,075
20% stock dividend 611,543 611,543 6,013,502 (6,625,045)
Repayment of ESOP debt 169,341 169,341
Cash dividends declared
($0.12 per share(3)) (492,048) (492,048)
Comprehensive income:
Net income 3,914,648 3,914,648
Other comprehensive
income (loss) - Change in
unrealized loss on
securities available for
sale, net of federal
income tax(5) 60,480 60,480
-----------
Total comprehensive income 3,975,128
--------- ----------- ------------ ------------ ------------ -------- -----------
BALANCE, December 31, 1996 3,680,141 3,680,141 19,941,490 4,805,295 (1,024,111) (6,752) 27,396,063
Options exercised 76,890 76,890 552,607 629,497
10% stock dividend 368,196 368,196 4,388,676 (4,756,872)
Repayment of ESOP debt 152,541 152,541
Cash dividends declared
($0.50 per share(3)) (2,046,925) (2,046,925)
Comprehensive income:
Net income 4,518,680 4,518,680
Other comprehensive
income (loss) - Change in
unrealized loss on
securities available for
sale, net of federal
income tax(5) 1,972 1,972
-----------
Total comprehensive income 4,520,652
--------- ----------- ------------ ------------ ------------ -------- -----------
BALANCE, December 31, 1997 4,125,227 4,125,227 24,882,773 2,520,178 (871,570) (4,780) 30,651,828
Options exercised 122,048 122,048 965,908 1,087,956
Repayment of ESOP debt 267,832 267,832
Cash dividends declared
($0.60 per share(3)) (2,546,154) (2,546,154)
Comprehensive income:
Net income 5,207,696 5,207,696
Other comprehensive
income (loss) - Change in
unrealized loss on
securities available for
sale, net of federal
income tax(5) (7,205) (7,205)
-----------
Total comprehensive income 5,200,491
--------- ----------- ------------ ------------ ------------ -------- -----------
BALANCE, December 31, 1998 4,247,275 $ 4,247,275 $ 25,848,681 $ 5,181,720 $ (603,738) $(11,985) $34,661,953
========= =========== ============ ============ ============ ======== ===========
</TABLE>
(2) The amount of common stock issued and outstanding for 1996 and 1997 has been
adjusted to show the effect of the three-for-two stock split paid November
5, 1977.
(3) Cash dividends declared divided by weighted average shares outstanding of
4,043,985 in 1996, 4,062,824 in 1997, and 4,215,764 in 1998.
(4) Income tax benefit netted against accumulated comprehensive losses were
$3,478, $2,462, and $6,174 for the years ended December 31, 1996, 1997, and
1998, respectively.
(5) There were no reclassification adjustments to other comprehensive income
(loss).
SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
page 27
<PAGE>
FIRST MUTUAL SAVINGS BANK AND SUBSIDIARY CONSOLIDATED STATEMENTS OF
CASH FLOWS
<TABLE>
<CAPTION>
Years Ended December 31,
------------------------------------------------
OPERATING ACTIVITIES: 1998 1997 1996
- --------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Net Income $ 5,207,696 $ 4,518,680 $ 3,914,648
Adjustments to reconcile net income to net cash
provided (used) by operating activities:
Provision for loan losses 750,000 976,000 1,700,000
Depreciation 545,020 428,075 288,078
Deferred loan origination fees, net of accretion 171,310 (173,756) 13,650
Amortization of mortgage servicing rights 268,257 250,270 249,942
Loss (gain) on sales of loans (1,938,900) (140,161) (199,593)
Loss (gain) on securities available for sale (753)
Loss (gain) on sale of repossessed real estate (46,332)
FHLB stock dividends (357,300) (331,300) (312,100)
Deferred federal income tax provision (benefit) (524,816) (274,784) (351,119)
Cash provided (used) by changes in
operating assets and liabilities:
Loans receivable held for sale (18,949,102) 4,023,464 (8,604,685)
Accrued interest receivable (162,709) (315,268) (424,605)
Other assets (302,839) 24,512 (153,867)
Drafts payable 2,518,867 (397,925) 92,511
Accounts payable and other liabilities 659,679 170,088 (236,612)
Advance payments by borrowers for
taxes and insurance (70,025) 71,858 (125,383)
Federal income taxes 547,954 (26,634) (50,218)
------------- ------------- -------------
Net cash provided (used) by operating activities (11,683,240) 8,802,366 (4,199,353)
INVESTING ACTIVITIES:
- --------------------------------------------------------------------------------------------------------------------------
Loan originations (162,849,964) (119,652,687) (102,008,271)
Loan principal repayments 137,747,107 84,331,634 63,789,062
Increase in undisbursed loan proceeds 6,830,982 2,650,908 4,464,973
Principal repayments on mortgage-backed and other securities 61,066,514 22,491,981 20,586,120
Purchase of mortgage-backed and other securities held to maturity (50,178,401) (28,644,099) (24,018,125)
Purchase of mortgage-backed securities available for sale (17,881,548)
Purchase of premises and equipment (675,318) (3,031,631) (551,387)
Proceeds from sale of loans 2,341,219
Proceeds from sale of securities available for sale 6,090
Proceeds from sale of real estate held for sale 418,743 59,130 82,580
------------- ------------- -------------
BALANCE, net cash used by investing activities, (23,180,666) (41,788,674) (37,655,048)
CARRIED FORWARD
</TABLE>
SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
page 28
<PAGE>
<TABLE>
<CAPTION>
Years ended December 31,
--------------------------------------------
1998 1997 1996
<S> <C> <C> <C>
Net cash used by investing activities, BROUGHT FORWARD $ (23,180,666) $ (41,788,674) $ (37,655,048)
FINANCING ACTIVITIES:
- -------------------------------------------------------------------------------------------------------------------------
Net increase in deposit accounts 18,620,774 26,635,899 38,910,982
Interest credited to deposit accounts 19,801,820 17,797,160 14,977,678
Proceeds from FHLB advances 212,647,000 40,693,000 198,618,000
Repayment of FHLB advances (215,112,000) (60,643,000) (199,763,000)
Dividends paid (2,283,821) (520,655) (981,089)
Proceeds from exercise of stock options 542,281 629,497 70,075
Repayment of Employee Stock Ownership Plan debt 267,832 152,541 169,341
------------- ------------- -------------
Net cash provided by financing activities 34,483,886 24,744,442 52,001,987
------------- ------------- -------------
NET INCREASE (DECREASE) IN CASH
AND CASH EQUIVALENTS (380,020) (8,241,866) 10,147,586
CASH AND CASH EQUIVALENTS:
Beginning of year 5,909,165 14,151,031 4,003,445
------------- ------------- -------------
End of year $ 5,529,145 $ 5,909,165 $ 14,151,031
============= ============= =============
SUPPLEMENTAL DISCLOSURES OF CASH
FLOW INFORMATION:
Loans originated for mortgage banking activities $ 217,334,219 $ 93,553,864 $ 86,926,387
Loans originated for investment activities 162,849,964 119,652,687 102,008,271
------------- ------------- -------------
Total loans originated for mortgage banking
activities and investment activities $ 380,184,183 $ 213,206,551 $ 188,934,658
============= ============= =============
Proceeds from sales of loans held for sale $ 198,385,117 $ 97,577,328 $ 87,209,791
============= ============= =============
Cash paid during the year for:
Interest $ 21,712,686 $ 20,673,000 $ 18,294,131
============= ============= =============
Income taxes $ 2,110,000 $ 2,305,030 $ 2,460,200
============= ============= =============
SUPPLEMENTAL DISCLOSURES OF NONCASH
INVESTING ACTIVITIES:
Loans transferred to real estate held for sale, net $ 21,922 $ $ 58,132
============= ============= =============
Loans securitized into securities held to maturity
and available for sale $ 9,574,060 $ $ 10,802,360
============= ============= =============
</TABLE>
SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
page 29
<PAGE>
FIRST MUTUAL SAVINGS BANK AND SUBSIDIARY CONSOLIDATED STATEMENTS
NOTES
Years ended December 31, 1998, 1997, and 1996
NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION AND BASIS OF PRESENTATION: The consolidated
financial statements include the accounts of First Mutual Savings Bank and
its wholly owned subsidiary, First Mutual Services, Inc. (collectively, the
Bank). All significant intercompany transactions have been eliminated.
Certain reclassifications have been made to the 1997 and 1996 financial
statements to conform to the 1998 presentation.
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Changes in these estimates and assumptions are considered reasonably possible
and may have a material impact on the financial statements.
NATURE OF BUSINESS: The Bank is a community oriented savings bank offering a
variety of savings products to retail customers while concentrating its
lending activities on housing and commercial real estate loans. The Bank
conducts business from its main office in Bellevue, Washington, and its nine
branches in the greater Puget Sound area. The Bank accepts deposits from the
general public and provides lending services to citizens of the Eastside and
the I-5 corridor stretching from Bellingham, Washington, to Portland, Oregon.
In addition to portfolio lending, the Bank operates a mortgage banking
operation, which encompasses the selling of primarily fixed-rate loans in the
secondary mortgage market. The Bank generally retains the servicing of the
loans sold (i.e., collection of principal and interest payments) for which it
receives a monthly fee based on the unpaid balances of the sold loans.
CASH AND CASH EQUIVALENTS: For purposes of the consolidated statements of
cash flows, the Bank considers all deposits and investment securities with
an original term to maturity of three months or less to be cash equivalents.
SECURITIES: The Bank classifies its securities at acquisition into three
categories: held to maturity, available for sale, or held for trading.
Securities are classified as held to maturity when the Bank has the ability
and positive intent to hold them to maturity. Securities classified as
available for sale are maintained for future liquidity requirements and may
be sold prior to maturity. The Bank did not have securities classified as
held for trading during 1998, 1997, and 1996.
Securities held to maturity are carried at cost, adjusted for amortization of
premiums and accretion of discounts to maturity. Unrealized losses on
securities held to maturity caused by fluctuations in fair value are
recognized when it is determined that an other-than-temporary decline in
value has occurred. Unrealized gains and losses on securities available for
sale are excluded from earnings and are reported net of tax as a separate
component of comprehensive income until realized. Realized gains and losses
on sale are computed on the specific identification method and are included
in operations on the date sold.
LOANS RECEIVABLE, LOANS RECEIVABLE HELD FOR SALE, AND RESERVE FOR LOAN
LOSSES: Loans receivable are stated at unpaid principal balances less the
reserve for loan losses and deferred loan origination fees. Mortgage loans
securitized and transferred into the security portfolio are transferred at
amortized cost.
The reserve for loan losses is maintained at a level that is sufficient to
provide for estimated losses based on evaluating known and inherent risks in
the loan portfolio. This reserve is provided for based upon management's
continuing analysis of the factors underlying the quality of the loan
portfolio.
For income property and business loans, the Bank evaluates loan quality on an
individual basis and assigns an appropriate grade. The grades range from
3-or-better, for the better quality loans, to grades 4, 5, and 6 for loans
with potential problems. Loss reserves are then computed on the loan balance
for each grade using ratios developed from the Bank's historical loss
experience. For the residential and consumer loans, the Bank computes loss
reserves on a portfolio-wide basis, but provides higher reserves for specific
loans that are delinquent or are known to have problems.
The Bank then considers other factors in evaluating the adequacy of the
reserve for loan losses. These factors include: changes in the size and
composition of the loan portfolio; actual loan loss experience; current and
anticipated economic conditions; detailed analysis of individual loans for
which full collectibility may not be assured; and determination of the
existence and realizable value of the collateral and guarantees securing the
loans. The reserve is based upon factors and trends identified by management
at the time financial statements are prepared. The ultimate recovery of loans
is susceptible to future market factors beyond the Bank's control, which may
result in losses or recoveries differing significantly from those provided in
the financial statements.
The Bank also evaluates income property and business loans for impairment on
an individual basis. A loan is considered impaired when it is probable that a
creditor will not collect all amounts due (principal and interest) under the
terms of a loan agreement. The valuation of impaired loans is based on the
present value of expected future cash flows using the loan's effective
interest rate or the loan's observable market price or fair value of the
collateral, if the loan is collateral dependent. The amount by which the
recorded investment in the loan exceeds market price or the fair value of the
collateral is included in the Bank's allocated reserve for loan losses. Any
portion of an impaired loan classified as loss under regulatory guidelines is
charged off. The remaining groups of smaller-balance homogeneous loans are
evaluated collectively for impairment.
Mortgage loans originated and held for sale are carried at the lower of
aggregate cost of estimated fair value. Net unrealized losses on loans
receivable held for sale are recognized in a valuation allowance by charges
to operations.
REAL ESTATE HELD FOR SALE (INCLUDED IN OTHER ASSETS): Real estate held for
sale includes properties acquired through foreclosure. These properties are
initially recorded at the lower of cost or fair value and are subsequently
evaluated to determine that the carrying value does not exceed the then
current fair value of the property. Losses that result from ongoing periodic
valuation of these properties are charged to operations in the period in
which they are identified. The amounts the Bank will ultimately recover from
real estate held for sale may differ substantially from the carrying value of
the assets because of future market factors beyond the Bank's control.
NOTE 1 CONTINUED ON NEXT PAGE.
page 30
<PAGE>
NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
LAND, BUILDINGS, AND EQUIPMENT: Bank premises and equipment are stated at
cost less accumulated depreciation. Depreciation is computed on the
straight-line method over the estimated useful lives as follows:
Buildings and improvements 15 to 40 years
Leasehold improvements 5 to 20 years
Furniture, fixtures, and equipment 1 to 20 years
The Bank follows the policy of capitalizing expenditures for betterments and
major renewals, and expenses ordinary maintenance and repairs as incurred.
MORTGAGE SERVICING RIGHTS: Originated servicing rights are recorded when
mortgage loans are originated and subsequently sold or securitized (and held
as available-for-sale securities) with the servicing rights retained. The
total cost of the mortgage loans is allocated between servicing rights and
the loans (without the servicing rights) based on their relative fair values.
The cost relating to the mortgage servicing rights is capitalized and
amortized in proportion to, and over the period of, estimated future net
servicing income. Amounts capitalized are recorded at cost, net of
accumulated amortization and valuation allowance.
In order to determine the fair value of servicing rights, the Bank uses a
valuation model that calculates the present value of future cash flows.
Assumptions used in the valuation model include market discount rates and
anticipated prepayment speeds. The prepayment speeds are based on loan
prepayment forecasts derived from the consensus of investment banking firms
as reported by on-line fixed-income quotation systems. In addition, the Bank
uses estimates of the cost of servicing per loan, an inflation rate,
ancillary income per loan, and default rates.
The Bank assesses impairment of the capitalized mortgage servicing rights
based on recalculations of the present value of remaining future cash flows
using updated market discount rates and prepayment speeds. Subsequent loan
prepayments and changes in prepayment assumptions in excess of those
forecasted can adversely impact the carrying value of the servicing rights.
Impairment is assessed on a stratum-by-stratum basis with any impairment
recognized through a valuation allowance for each impaired stratum. The
servicing rights are stratified based on the predominant risk characteristics
of the underlying loans: fixed-rate loans and adjustable-rate loans.
EMPLOYEE STOCK OWNERSHIP PLAN: The Bank sponsors a leveraged Employee Stock
Ownership Plan (ESOP). Statement of Position (SOP) No. 93-6, EMPLOYERS'
ACCOUNTING FOR EMPLOYEE STOCK OWNERSHIP PLANS, was effective for the Bank as
of January 1994. As is allowed under SOP No. 93-6, the Bank continues to
account for ESOP transactions for shares purchased by the ESOP prior to 1994
under SOP No. 76-3. Accordingly, the Bank records compensation expense based
on the amounts contributed by the Bank to the ESOP and includes unallocated
ESOP shares as outstanding for purposes of its earnings per share calculation.
ESOP stock purchases have been insignificant since January 1994. At such time
that the ESOP purchases material amounts of stock in future periods, such
transactions will be accounted for in accordance with the provisions of SOP
No. 93-6 as described below.
Under SOP No. 93-6, as shares are released from collateral, compensation
expense is recorded equal to the then current market price of the shares, and
the shares become outstanding for purposes of earnings-per-share
calculations. Stock and cash dividends on allocated shares are recorded as a
reduction of retained earnings and paid directly to plan participants or
distributed directly to participants' accounts. Cash dividends on unallocated
shares are recorded as a reduction of debt and accrued interest. Stock
dividends on unallocated shares are recorded as an increase to the unearned
shares issued to the employee stock ownership trust contra-equity account and
distributed to participants over the remaining debt service period.
STOCK OPTION PLAN: In October 1995, the Financial Accounting Standards Board
(FASB) issued Statement of Financial Accounting Standards (SFAS) No. 123,
ACCOUNTING FOR STOCK-BASED COMPENSATION. The statement requires expanded
disclosures of stock-based compensation arrangements with employees and
encourages (but does not require) application of the "fair value" recognition
provisions in the statement. SFAS No. 123 does not rescind or interpret the
existing accounting rules for employee stock-based arrangements. Companies
may continue following those rules to recognize and measure compensation as
outlined in Accounting Principles Board Opinion (APBO) No. 25, but they will
now be required to disclose the pro forma amounts of net income and earnings
per share that would have been reported had they elected to follow the fair
value recognition provisions of SFAS No. 123. Effective January 1, 1996, the
Bank adopted the disclosure requirements of SFAS No. 123, but has determined
that it will continue to measure its employee stock-based compensation
arrangements under the provisions of APBO No. 25.
INCOME TAXES: The Bank files a consolidated tax return which includes income
earned by its subsidiary. The Bank accounts for income taxes on the liability
method. The liability method recognizes the amount of tax currently payable
and deferred at the date of the financial statements as a result of all
events that have been recognized in the financial statements, as measured by
the provisions of current enacted tax law and rates.
LOAN FEE INCOME AND INTEREST INCOME ON LOANS RECEIVABLE: Loan origination
fees and certain direct loan origination costs related to loan origination
activities are deferred. Net deferred fees are amortized into income over the
contractual or actual life of the loan as an adjustment to the loan yield.
Net deferred fees related to loans sold are recognized in income at the time
the loans are sold.
Interest income is accrued on loans receivable until management doubts the
collectibility of the loan or the unpaid interest, at which time the Bank
establishes a reserve for any accrued interest.
INTEREST RATE RISK MANAGEMENT: The Bank may hedge certain mortgage banking
transactions with purchased option contracts and forward sales commitments.
Net gains or losses on these options are considered in the Bank's calculation
of the lower of cost or fair value for loan receivables held for sale.
EARNINGS PER SHARE (EPS) DATA: The Bank displays basic and diluted EPS in the
income statement. Basic EPS is computed by dividing net income by the
weighted average number of shares outstanding during the year. Diluted EPS
reflects the potential dilutive effect of stock options and is computed by
dividing net income by the weighted-average number of shares outstanding
during the year, plus the dilutive common shares that would have been
outstanding had the stock options been exercised. A reconciliation of the
numerator and denominator used for the basic EPS to the numerator and
denominator used for the diluted EPS is provided in Note 13.
NOTE 1 CONTINUED ON NEXT PAGE.
page 31
<PAGE>
NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
New accounting standards:
REPORTING COMPREHENSIVE INCOME: Effective January 1, 1998, the Bank
adopted SFAS No. 130, REPORTING COMPREHENSIVE INCOME. Comprehensive
income is comprised of net income and all other changes to stockholders'
equity, except those due to investments by owners (paid-in capital) and
distributions to owners (dividends). For First Mutual Savings Bank,
comprehensive income consists solely of net income and unrealized gains
and losses on securities available for sale for the years ended December
31, 1998, 1997, and 1996. As is allowed under SFAS No. 130, the Bank
disclosed this information in the statement of stockholders' equity.
Comprehensive income was not materially different from reported net
income for all periods presented.
SEGMENT REPORTING. In June 1997, the FASB issued SFAS No. 131,
DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION. The
Bank adopted SFAS No. 131 starting with this annual financial statement
and has provided information on segments in Note 21. The adoption of
this standard does not have any impact on the results of operations or
financial condition of the Bank.
ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES: In June
1998, the FASB issued SFAS No. 133, ACCOUNTING FOR DERIVATIVE
INSTRUMENTS AND HEDGING ACTIVITIES. SFAS No. 133 establishes accounting
and reporting standards for derivative instruments, including certain
derivative instruments embedded in other contracts (collectively
referred to as derivatives) and for hedging activities. It requires that
an entity should recognize all derivatives as either assets or
liabilities in the statement of financial position and measure those
instruments at fair value. If certain conditions are met, a derivative
may be specifically designated as (a) a hedge of exposure to changes in
the fair value of a recognized asset or liability or an unrecognized
firm commitment, (b) a hedge of the exposure to variable cash flows of a
forecasted transaction, or (c) a hedge of the foreign currency exposure
of a net investment in a foreign operation, an unrecognized firm
commitment, an available-for-sale security, or a foreign-currency-
denominated forecasted transaction. The accounting for changes in the
fair value of a derivative (gains and losses) depends on the intended
use of the derivative and the resulting designation.
This statement is effective for all fiscal quarters of all fiscal years
beginning after June 15, 1999, and will be adopted by the Bank starting
on January 1, 2000. The adoption of this standard is not anticipated to
have a material impact on the results of operations or financial
condition of the Bank.
ACCOUNTING FOR MORTGAGE-BACKED SECURITIES: SFAS No. 65, ACCOUNTING FOR
CERTAIN MORTGAGE BANKING ACTIVITIES, as amended by SFAS No. 115 and 125,
required that after the securitization of a mortgage loan held for sale,
an entity engaged in mortgage banking activities classify the resulting
mortgage-backed security as a trading security. In October 1998, the
FASB issued SFAS No. 134, ACCOUNTING FOR MORTGAGE-BACKED SECURITIES
RETAINED AFTER THE SECURITIZATION OF MORTGAGE LOANS HELD FOR SALE BY A
MORTGAGE BANKING ENTERPRISE. SFAS No. 134 further amends SFAS No. 65 to
require that after the securitization of a mortgage loan held for sale,
an entity engaged in mortgage banking activities should classify the
resulting retained mortgage-backed securities using the classification
criteria in SFAS No. 115 (i.e., held-to-maturity, available-for-sale, or
trading). However, a mortgage banking entity must classify as trading
any retained mortgage-backed securities described above that it has
committed to sell before or during the securitization process. This
statement is effective for fiscal quarters beginning after December 15,
1998. The adoption of this standard is not anticipated to have a
material impact on the results of operations or financial condition of
the Bank.
NOTE 2. RESERVE BALANCES
The Bank is required to maintain an average reserve balance of $25,000 in its
account with the Federal Reserve. For the years ended December 31, 1998 and
1997, the Bank complied with this requirement.
NOTE 3: MORTGAGE-BACKED AND OTHER SECURITIES AVAILABLE FOR SALE
The amortized cost and estimated fair value of securities available for sale
at December 31, 1998 and 1997, are summarized as follows:
<TABLE>
<CAPTION>
Gross Gross
Amortized unrealized unrealized Estimated
cost gains losses fair value
- ---------------------------------------------------------------------------
<S> <C> <C> <C> <C>
1998: FHLMC securities $ 648,646 $17,941 $ $ 666,587
FNMA securities 17,679,888 35,825 41,675 17,674,038
GNMA securities 1,996,385 399 1,995,986
----------- ------- ------- -----------
$20,324,919 $53,766 $42,074 $20,336,611
----------- ------- ------- -----------
----------- ------- ------- -----------
1997: FHLMC securities $ 1,280,011 $54,698 $ $ 1,334,709
----------- ------- ------- -----------
----------- ------- ------- -----------
</TABLE>
Proceeds from the sale of securities available for sale during 1998, 1997,
and 1996, were $-0-, $6,090, and $-0-, respectively. Gross gains on those
sales were $-0-, $753, and $-0-, respectively. No gross losses were realized
on sales during 1998, 1997, or 1996. The securities available for sale at
December 31, 1998 have contractual maturities of over 10 years.
page 32
<PAGE>
NOTE 4: MORTGAGE-BACKED AND OTHER SECURITIES HELD TO MATURITY
The amortized cost and estimated fair value of mortgage-backed and other
securities are summarized as follows:
<TABLE>
<CAPTION>
Gross Gross
Amortized unrealized unrealized Estimated
cost gains losses fair value
- ----------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
December 31, 1998:
FNMA certificates $14,241,885 $ 238,948 $ 14,235 $14,466,598
FHLMC certificates 3,555,875 14,470 4,180 3,566,165
U.S. government agency securities 38,643,616 656,784 151,235 39,149,165
Merrill Lynch corporate bond 2,544,950 33,450 2,511,500
Municipal bonds 627,083 36,313 590,770
REMICs 1,151,194 31,631 1,182,825
U.S. treasury securities 999,828 172 1,000,000
----------- ---------- --------- -----------
$61,764,431 $ 942,005 $ 239,413 $62,467,023
=========== ========== ========= ===========
December 31, 1997:
FNMA certificates $11,746,070 $ 499,055 $ 26,981 $12,218,144
FHLMC certificates 5,976,663 138,248 12,730 6,102,181
U.S. government agency securities 41,132,201 493,718 26,473 41,599,446
REMICs 4,305,099 44,672 9,618 4,340,153
U.S. treasury securities 996,782 3,982 992,800
----------- ---------- --------- -----------
$64,156,815 $1,175,693 $ 79,784 $65,252,724
=========== ========== ========= ===========
</TABLE>
The amortized cost and estimated fair value of mortgage-backed and other
securities held to maturity at December 31, 1998, by contractual maturity,
are shown below. Expected maturity may differ from contractual maturity
because borrowers may have the right to call or prepay obligations with or
without call or prepayment penalties:
<TABLE>
<CAPTION>
Amortized Estimated
cost fair value
- ------------------------------------------------------------------------
<S> <C> <C>
Due within one year $ 2,026,184 $ 2,025,541
Due after one year through five years 25,343,118 25,980,611
Due after five years through ten years 19,645,588 19,484,554
Due after ten years 14,749,541 14,976,317
----------- -----------
$61,764,431 $62,467,023
=========== ===========
</TABLE>
page 33
<PAGE>
NOTE 5: LOANS RECEIVABLE, NET AND LOANS RECEIVABLE HELD FOR SALE
Loans receivable consisted of the following as of December 31:
<TABLE>
<CAPTION>
1998 1997
- ----------------------------------------------------------------
<S> <C> <C>
Real estate
Single-family residential $ 95,807,396 $117,285,036
Single-family construction 38,640,163 31,824,937
Income property:
Commercial construction 12,740,000 5,426,694
Commercial real estate 121,257,209 105,012,231
Multifamily construction 9,260,369 7,242,625
Multifamily residential 118,014,727 101,316,828
Consumer and other loans 17,464,747 11,831,077
Business loans 2,629,590 1,583,111
------------ ------------
415,814,201 381,522,539
Less:
Deferred loan origination fees (1,574,473) (1,399,868)
Undisbursed loan proceeds (21,764,668) (14,933,686)
Reserve for loan losses (5,569,431) (4,858,376)
------------ ------------
386,905,629 360,330,609
Loans receivable held for sale (27,370,815) (8,421,713)
------------ ------------
Loans receivable, net $359,534,814 $351,908,896
============ ============
</TABLE>
A substantial portion of the Bank's revenues are derived from the origination
of loans in the Puget Sound region of Washington State. The customers'
ability to honor their commitments to repay such loans is dependent upon the
region's economy and, to a certain extent, the dominant industries in that
region such as aerospace, international trade, and high technology.
Single-family residential, permanent, and construction loans are primarily
secured by collateral located in Western Washington. Income property loans, by
county or state in which the property resides, are as follows at December 31,
1998:
<TABLE>
<CAPTION>
King Snohomish Pierce Whatcom
County County County County Oregon Other Total
- -------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
Income property:
Commercial construction $ 3,950,000 $ 4,650,000 $ 4,140,000 $ $ $ $ 12,740,000
Commercial real estate 68,857,448 14,803,879 9,011,685 3,305,764 12,482,384 12,796,049 121,257,209
Multifamily construction 4,386,500 1,770,000 1,260,000 350,000 1,493,869 9,260,369
Multifamily residential 63,142,502 6,906,315 18,095,219 7,706,947 6,163,111 16,000,633 118,014,727
------------ ----------- ----------- ----------- ----------- ----------- ------------
$140,336,450 $26,360,194 $33,016,904 $12,272,711 $18,995,495 $30,290,551 $261,272,305
============ =========== =========== =========== =========== =========== ============
</TABLE>
The Bank originates both adjustable and fixed interest rate loans. At
December 31, 1998, the composition of those loans was as follows:
<TABLE>
<CAPTION>
Term to maturity or rate adjustment Fixed rate Adjustable rate Total
- --------------------------------------------------------------------------------------
<S> <C> <C> <C>
Due within one year $ 8,325,424 $267,654,398 $275,979,822
After one but within three years 1,058,061 23,681,909 24,739,970
After three but within five years 2,984,588 22,663,945 25,648,533
After five but within ten years 8,695,748 6,825,104 15,520,852
After ten years 44,748,969 267,483 45,016,452
----------- ------------ ------------
$65,812,790 $321,092,839 $386,905,629
=========== ============ ============
</TABLE>
Single-family adjustable-rate loans have both period and lifetime adjustment
limitations. Income property adjustable-rate loans typically only have
lifetime adjustment limitations. Both types of adjustable-rate loans are
generally indexed to either the one-, three-, or five-year Treasury constant
maturity or the Federal Home Loan Bank's 11th District cost of funds. Future
market factors may affect the correlation of the interest rate adjustment with
the rates the Bank pays on the short-term deposits that have been primarily
utilized to fund these loans.
NOTE 5 CONTINUED ON NEXT PAGE.
page 34
<PAGE>
NOTE 5: LOANS RECEIVABLE, NET AND LOANS RECEIVABLE HELD FOR SALE (CONTINUED)
An analysis of the changes in the reserve for loan losses is as follows for
the years ended December 31:
<TABLE>
<CAPTION>
1998 1997 1996
- ----------------------------------------------------------------------
<S> <C> <C> <C>
Balance, beginning of year $4,858,376 $3,882,376 $2,223,342
Provision for loan losses 750,000 976,000 1,700,000
Writeoffs (38,945) (40,966)
---------- ---------- ----------
Balance, end of year $5,569,431 $4,858,376 $3,882,376
========== ========== ==========
</TABLE>
The Bank had the following nonperforming loans (loans over 90 days delinquent)
as of December 31:
<TABLE>
<CAPTION>
1998 1997
- ------------------------------------------------------------
<S> <C> <C>
Nonperforming loans $298,503 $674,188
======== ========
Percentage of total loans 0.08% 0.19%
======== ========
</TABLE>
The Bank had no impaired loans (previously discussed in the SUMMARY OF
SIGNIFICANT ACCOUNTING POLICIES) during the years and at year-end 1998, 1997,
and 1996.
The Bank serviced loans owned by other investors with aggregate principal
balances of $268,246,425 and $379,197,613 as of December 31, 1998, and 1997,
respectively.
Outstanding commitments to borrowers for loans totalled $65,071,309 and
$39,847,100 at December 31, 1998 and 1997, respectively. Outstanding
commitments to sell loans to investors, which totalled $34,811,000 and
$11,135,000 at December 31, 1998 and 1997, respectively, hedge against
interest rate fluctuations from the time of loan commitment until the date at
which loans are sold, which is generally within 60 days.
Commitments to extend credit generally have fixed expiration dates. Since
portions of the commitments are expected to expire without being drawn upon,
the total commitment amounts do not necessarily represent future cash
requirements. Prior to extending commitments, the Bank evaluates each
customer's creditworthiness on a case-by-case basis. The amount of collateral
obtained upon extension of credit is based on management's credit evaluation
of the borrower. Collateral held includes residential and income producing
properties.
NOTE 6: ACCRUED INTEREST RECEIVABLE
Accrued interest receivable at December 31 is summarized as follows:
<TABLE>
<CAPTION>
1998 1997
- ------------------------------------------------------------------------------
<S> <C> <C>
Loans receivable $2,359,489 $2,357,278
Mortgage-backed securities available for sale 113,668 16,067
Mortgage-backed and other securities held to maturity 837,965 775,068
---------- ----------
$3,311,122 $3,148,413
========== ==========
</TABLE>
NOTE 7: MORTGAGE SERVICING RIGHTS AND SERVICING FEES
Changes in the mortgage servicing rights balance for the years ended
December 31:
<TABLE>
<CAPTION>
1998 1997
- -------------------------------------------------------
<S> <C> <C>
Balance, beginning of year $ 601,435 $ 706,409
Additions 197,054 145,296
Sales (173,647)
Amortization (185,759) (212,542)
Provision for impairment (82,498) (37,728)
--------- ---------
Balance, end of year $ 356,585 $ 601,435
========= =========
</TABLE>
Changes in the valuation for impairment of mortgage servicing rights for the
years ended December 31:
<TABLE>
<CAPTION>
1998 1997 1996
- ----------------------------------------------------------------
<S> <C> <C> <C>
Balance, beginning of year $ 37,728 $ $ -
Additions 82,498 37,728
Recoveries
Direct writedowns
-------- ------- -------
Balance, end of year $120,226 $37,728 $
======== ======= =======
</TABLE>
NOTE 7 CONTINUED ON NEXT PAGE.
page 35
<PAGE>
NOTE 7: MORTGAGE SERVICING RIGHTS AND SERVICING FEES (CONTINUED)
Servicing fee income, net of amortization, consisted of the following for the
years ended December 31:
<TABLE>
<CAPTION>
1998 1997 1996
- ---------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Servicing fees $ 741,935 $ 1,055,319 $ 1,128,761
Amortization and provision for impairment
of mortgage servicing rights (268,257) (250,270) (249,942)
----------- ----------- -----------
Loan servicing fees, net $ 473,678 $ 805,049 $ 878,819
=========== =========== ===========
</TABLE>
At December 31, 1998, the Bank had a contract to sell mortgage servicing rights
in 1999, at specific rates to a single purchaser, of up to $180 million of loans
originated and sold to investors. The Bank believes that it can sell the
mortgage servicing rights to other buyers in the event of default by the
purchaser and therefore does not anticipate any loss resulting from
nonperformance of the contract.
NOTE 8: LAND, BUILDINGS, AND EQUIPMENT
The following is a summary of land, buildings, and equipment at December 31:
<TABLE>
<CAPTION>
1998 1997
- ------------------------------------------------------------------------------------------
<S> <C> <C>
Land $1,921,349 $1,859,757
Buildings 3,580,105 3,444,519
Furniture, fixtures, and equipment 2,390,291 2,030,391
Leasehold improvements 527,449 454,324
---------- ----------
8,419,194 7,788,991
Less accumulated, depreciation and amortization 2,882,446 2,337,426
---------- ----------
$5,536,748 $5,451,565
========== ==========
</TABLE>
The Bank leases six of its office locations under operating leases. Total lease
obligations are as follows:
<TABLE>
<S> <C>
1999 $ 308,792
2000 206,035
2001 51,428
2002 22,905
2003 1,913
----------
$ 591,073
==========
</TABLE>
Total lease expenses were $338,871, $307,349, and $258,371, for the years ended
December 31, 1998, 1997, and 1996, respectively.
NOTE 9: DEPOSITS
Deposits consisted of the following at December 31:
<TABLE>
<CAPTION>
Weighted
average rate at 1998 1997
December 31, ----------------------- ----------------------
Terms 1998 Amount % Amount %
- --------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Money market deposit and checking accounts,
including noninterest-bearing deposits of
$13,775,959 (1998) and $9,648,321 (1997) 3.1% $ 98,919,316 24.0% $ 76,532,403 20.5%
Regular savings 3.0 12,247,457 3.0 14,649,485 3.9
Time deposits:
1 to 6 month 4.8 30,246,949 7.4 31,589,955 8.5
7 to 12 month 5.4 145,937,279 35.5 158,472,941 42.5
13 to 18 month 5.4 75,458,401 18.3 56,998,486 15.3
2 to 10 year 5.9 48,441,746 11.8 34,585,284 9.3
------------ ----- ------------ -----
Total time deposits 5.4 300,084,375 73.0 281,646,666 75.6
------------ ----- ------------ -----
Total deposits 4.8% $411,251,148 100.0% $372,828,554 100.0%
============ ===== ============ =====
</TABLE>
NOTE 9 CONTINUED ON NEXT PAGE,
page 36
<PAGE>
NOTE 9: DEPOSITS (CONTINUED)
Deposits at December 31, 1998 and 1997, included public funds of $7,134,255
and $4,324,511, respectively. Mortgage-backed securities with a book value of
$1,255,260 and $422,677 were pledged as collateral on these deposits at
December 31, 1998 and 1997, respectively, which exceeds the minimum
collateral requirements established by the Washington Public Deposit
Protection Commission.
As of December 31, 1998, scheduled maturities of time deposits were as follows;
<TABLE>
<CAPTION>
Year ending December 31,
------------------------
<S> <C>
1999 $227,970,653
2000 50,207,079
2001 7,881,732
2002 7,558,482
2003 4,433,680
Thereafter 2,032,749
------------
$300,084,375
============
</TABLE>
Included in deposits are time deposits greater than or equal to $100,000 of
$98,656,486 and $87,440,088 at December 31, 1998 and 1997, respectively.
Interest on time deposits greater than or equal to $100,000 totalled $5,229,314,
$4,506,761, and $4,021,328 for the years ended December 31, 1998, 1997, and
1996, respectively.
Deposit interest expense by type for the years ended December 31 was as follows:
<TABLE>
<CAPTION>
1998 1997 1996
- ------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Time deposits $16,672,427 $15,065,475 $12,360,714
Money market deposit and checking 2,802,074 2,187,329 1,883,455
Regular savings 405,152 526,358 629,645
----------- ----------- -----------
$19,879,653 $17,779,162 $14,873,814
=========== =========== ===========
</TABLE>
NOTE 10. FHLB ADVANCES
The Bank's borrowings consisted of the following at December 31:
<TABLE>
<CAPTION>
1998 1997
- --------------------------------------------------------------------------------------------------------
<S> <C> <C>
FHLB advances $31,765,000 $34,230,000
=========== ===========
FHLB advances:
Maximum outstanding at any month end $39,755,000 $54,180,000
Average outstanding 33,441,310 47,184,477
Weighted average interest rates:
Annual 5.798% 5.960%
End of year 5.236 6.050
</TABLE>
Under the terms of the advances, in addition to FHLB stock held, the Bank must
maintain unencumbered collateral of at least 120% of outstanding advances if the
collateral is 1 to 4 family permanent mortgages, 110% if the collateral is
agency issued mortgage-backed securities, and 105% if the collateral is U.S.
treasury and agency securities. At December 31, 1998, the minimum book value of
eligible collateral pledged for these borrowings was $33,353,250. The Bank has
an available line of credit with the FHLB in the amount equal to 35% of total
assets, less current outstanding advances.
FHLB advances at December 31, 1998, mature as follows:
<TABLE>
<CAPTION>
Interest rates Amount
- ---------------------------------------------------------------
<S> <C>
1999 4.56 - 5.55% $23,265,000
2000 5.00 - 5.40% 7,500,000
2006 6.25 1,000,000
-----------
$31,765,000
===========
</TABLE>
page 37
<PAGE>
NOTE 11: FEDERAL TAXES ON INCOME
The Bank qualifies as a thrift under provisions of the Internal Revenue Code
which, prior to August 1996, permitted as a deduction from taxable income an
allowance for bad debts based on a percentage of taxable income or on actual
experience. Each year, qualified thrifts were allowed to select whichever
method results in the most savings. The Bank used the percentage of taxable
income method in 1995.
In August 1996, the President of the United States signed the Small Business Job
Protection Act of 1996 (the Act). Under the Act, the percentage of taxable
income method of accounting for tax basis bad debts is no longer available for
the years ended after December 31, 1995. As a result, the Bank is required to
use the specific charge-off method of accounting for tax basis bad debts for
1996 and later years. In addition, the Bank is also required to recapture its
post-1987 additions to its bad debt reserves made pursuant to the percentage of
taxable income method. As of December 31, 1997, these additions were $1,973,380,
which, pursuant to the Act, are included in taxable income ratably over a
six-taxable-year period beginning with the year ending December 31, 1998. The
recapture of the post-1987 additions to tax basis bad debt reserves does not
result in a charge to earnings as these amounts have been provided for in the
deferred tax liability.
If bad debt deductions taken for federal income tax purposes before 1987 are
later used for purposes other than bad debt losses, they will be subject to
federal income taxes at the prevailing corporate rates. Retained earnings
included $640,000 at December 31, 1997, for which no federal taxes had been
provided in the financial statements. The Bank does not anticipate that
retained earnings will be used in any way which would result in payment of
taxes.
Deferred federal income taxes are provided for differences in the reporting of
income and expense for financial statement and income tax purposes. The
components of deferred income tax expense (benefit) are as follows for the years
ended December 31:
<TABLE>
<CAPTION>
1998 1997 1996
- ---------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Mortgage servicing rights $(120,856) $ (35,327) $ 9,229
Loan origination fees and costs (14,115) 143,900 (7,679)
FHLB stock dividends 121,558 112,620 106,191
Reserve for loan losses (375,948) (433,533) (552,209)
Other (135,455) (62,444) 93,349
--------- --------- ---------
$(524,816) $(274,784) $(351,119)
========= ========= =========
</TABLE>
At December 31, the significant components of the Bank's net deferred tax asset
(liability) were as follows:
<TABLE>
<CAPTION>
1998 1997
- -------------------------------------------------------------------------------
<S> <C> <C>
Deferred tax assets:
Reserve for loan losses $ 1,356,847 $ 980,899
Other, net 101,095 (34,360)
----------- -----------
1,457,942 946,539
Deferred tax liabilities:
Mortgage servicing rights 21,773 142,629
Loan origination fees and costs 460,841 474,956
FHLB stock dividends 825,653 704,095
----------- -----------
1,308,267 1,321,680
----------- -----------
Not deferred tax asset (liability) $ 149,675 $ (375,141)
=========== ===========
</TABLE>
NOTE 12: STOCKHOLDERS' EQUITY AND REGULATORY CAPITAL REQUIREMENTS
STOCK DIVIDENDS AND STOCK SPLITS: The Bank's Board of Directors declared a 20%
stock dividend in February 1996, a 10% stock dividend in May 1997, and a
three-for-two stock split in September 1997.
RESTRICTED RETAINED EARNINGS: Under Washington State law, preconversion
retained earnings are restricted for the protection of preconversion
depositors. Restricted retained earnings at December 31, 1998, totalled
$181,344.
REGULATORY CAPITAL REQUIREMENTS: The Bank is subject to various regulatory
capital requirements administered by the Federal Deposit Insurance
Corporation (FDIC) and the Washington State Department of Financial
Institutions. Failure to meet minimum capital requirements can initiate
certain mandatory and possibly additional discretionary action by regulators
that, if undertaken, could have a direct material effect on the Bank's
financial statements. Under capital adequacy guidelines and the regulatory
framework for prompt corrective action, the Bank must meet specific capital
guidelines that involve quantitative measures of the Bank's assets,
liabilities, and certain off-balance-sheet items as calculated under
regulatory accounting practices. The Bank's capital amounts and
classifications are also subject to qualitative judgments by the regulators
about components, risk-weightings, and other factors.
Quantitative measures established by regulators to ensure capital adequacy
require the Bank to maintain minimum amounts and ratios (set forth in the table
below) of total and Tier I capital to risk-weighted assets, and of Tier I
capital to average assets. Management believes, as of December 31, 1998, that
the Bank meets all capital adequacy requirements to which it is subject.
NOTE 12 CONTINUED ON NEXT PAGE
page 38
<PAGE>
NOTE 12: STOCKHOLDERS' EQUITY AND REGULATORY CAPITAL REQUIREMENTS (CONTINUED)
As of December 31, 1998 and 1997, the FDIC categorized the Bank as well
capitalized under the regulatory framework for prompt corrective action. To
be categorized as well capitalized, the Bank must maintain minimum total
risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the
table. There are no conditions or events since that notification that
management believes have changed the Bank's category.
The Bank's management believes that under the current regulations the Bank
will continue to meet its minimum capital requirements in the foreseeable
future. However, events beyond the control of the Bank, such as a downturn in
the economy in areas where the Bank has most of its loans, could adversely
affect future earnings and, consequently, the ability of the Bank to meet its
future minimum capital requirements.
The Bank's actual capital amounts and ratios are presented in the table
below. The actual amounts are compared to the capital levels for capital
adequacy purposes and for categorizing well capitalized banks, using the same
amount of risk-weighted assets and average assets that the Bank carried at
December 31, 1998 and 1997.
<TABLE>
<CAPTION>
To be categorized as well
For capital capitalized under prompt
Actual adequacy purposes corrective action provisions
-------------------------------------------------------------------------------
Amount Ratio Amount Ratio Amount Ratio
- -----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
As of December 31, 1998:
Total capital (to risk-weighted assets) $38,909,518 11.5% $27,031,580 >8.0% $33,789,475 >10.0%
- -
Tier I capital (to risk-weighted assets) 34,685,834 10.3 13,515,790 >4.0 20,273,685 > 6.0
- -
Tier I capital (to average assets) 34,685,834 7.2 19,378,224 >4.0 24,222,781 > 5.0
- -
As of December 31, 1997:
Total capital (to risk-weighted assets) $34,400,328 11.5% $23,959,809 >8.0% $29,949,761 >10.0%
- -
Tier I capital (to risk-weighted assets) 30,656,608 10.2 11,979,904 >4.0 17,969,856 > 6.0
- -
Tier I capital (to average assets) 30,656,608 6.9 17,422,431 >4.0 21,778,038 > 5.0
- -
</TABLE>
NOTE 13: EARNINGS PER SHARE
The following is a reconciliation of the numerators and denominators of the
basic and diluted earnings per share computations:
<TABLE>
<CAPTION>
Income Shares Per share
(numerator) (denominator) amount
- --------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Year ended December 31, 1998:
Basic EPS:
Income available to common shareholders $5,207,696 4,215,764 $ 1.24
========
Effect of dilutive stock options 111,614
---------- ---------
Diluted EPS:
Income available to common shareholders
plus assumed stock options exercise $5,207,696 4,327,378 $ 1.20
========== ========= ========
Year ended December 31, 1997:
Basic EPS:
Income available to common shareholders $4,518,680 4,062,824 $ 1.11
========
Effect of dilutive stock options 171,853
---------- ---------
Diluted EPS:
Income available to common shareholders
plus assumed stock options exercise $4,518,680 4,234,677 $ 1.07
========== ========= ========
Year ended December 31, 1996:
Basic EPS:
Income available to common shareholders $3,914,648 4,043,985 $ 0.97
========
Effect of dilutive stock options 121,447
---------- ---------
Diluted EPS:
Income available to common shareholders
plus assumed stock options exercise $3,914,648 4,165,432 $ 0.94
========== ========= ========
</TABLE>
page 39
<PAGE>
NOTE 14: OTHER OPERATING EXPENSES
Salaries and employee benefits consisted of the following for the years ended
December 31:
<TABLE>
<CAPTION>
1998 1997 1996
- ----------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Salaries and employee benefits incurred $ 9,122,196 $ 7,051,486 $ 5,363,079
Amounts deferred with loan origination fees (1,622,048) (1,092,774) (760,076)
----------- ----------- -----------
$ 7,500,148 $ 5,958,712 $ 4,603,003
=========== =========== ===========
</TABLE>
Direct costs of originating loans are deferred and capitalized with the
related loan origination fees collected. Deferral of costs varies directly
with the volume of loan originations, which increased substantially from 1996
to 1998.
NOTE 15: RETIREMENT PLAN AND TRUST
The Bank has a 401(k) retirement plan and trust for employees. All employees
who have completed one year of service and meet the minimum hours-worked
requirement are eligible for the plan. The Bank funds the annual cost of the
plan as accrued. Employees may contribute up to 12% of their salaries to the
plan. The Bank matches 75% of the employees' contributions up to 6% of the
employees' compensation. At plan year-end, the Bank contributes an additional
3% of the employees' compensation. Participants are fully vested in employer
contributions to the plan upon six years of employment.
The Bank's contributions to the 401(k) retirement plan and trust were
$324,641, $255,658, and $214,473 for the years ended December 31, 1998, 1997,
and 1996, respectively. There were no significant changes in the rate of
contributions to the plan between these years.
NOTE 16: EMPLOYEE STOCK OWNERSHIP PLAN
In 1985, the Bank established an ESOP to provide benefits to all employees
who have completed one year of service and meet the minimum hours-worked
requirement. The plan is noncontributory on the part of the participants and
provides for full vesting upon completion of five years of service. The plan
provides for the distribution of accumulated benefits to the employees or
their beneficiaries upon death, termination or retirement. The Bank loaned
the ESOP's trustee $200,000 for purchase of the Bank's common stock at the
initial offering price in 1985. During 1990, the Bank's Board of Directors
authorized the trustee to borrow an additional $1,464,375 from the Bank to
purchase 139,600 more shares (unadjusted for subsequent stock dividends and
stock splits) of the Bank's common stock in the open market. Shares of stock
are allocated to employees as the loans are repaid. The outstanding loan
balance at December 31, 1998, was $603,738. During 1998, the ESOP sold 5,470
shares in the open market.
Shares held by the ESOP at December 31, 1998, were as follows:
<TABLE>
<CAPTION>
Average
Number Price range price
of shares per share per share
- ----------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Allocated:
Vested 242,777
Nonvested 8,234
-------
251,011 $1.32 - $5.09 $ 1.98
Non-allocated 102,270
-------
353,281
=======
</TABLE>
Contributions to the ESOP during the years ended December 31, 1998, 1997, and
1996, were $65,109, $-0-, and $-0-, respectively.
page 40
<PAGE>
NOTE 17: STOCK OPTION PLAN
The Bank has a stock option plan for directors and employees. Options have a
term of six or ten years and are granted at fair market value on the grant
date. The Bank's Board of Directors determines vesting of the options.
Options generally become exercisable in one or more installments during their
term, and the right to exercise may be cumulative. At December 31, 1998,
126,950 shares of common stock, adjusted for stock dividends, were available
for grant under the plan. A total of 87,508 shares are currently exercisable
at December 31, 1998. All schedules presented in this footnote are adjusted
for stock dividends and stock splits.
A summary of the Bank's stock option plan as of December 31, 1998, 1997, and
1996, and changes during the years ended on those dates is presented below:
<TABLE>
<CAPTION>
Range of Weighted average Weighted average
Shares exercise price* exercise price* fair value*
- -----------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
BALANCE, January 1, 1996 336,598 $3.72-$6.56 $ 4.42
Options granted 41,910 7.88 7.88 $ 3.19
Options exercised (11,043) 4.74 4.74
Options terminated (2,171) 4.88 4.88
--------
BALANCE, December 31, 1996 365,294 3.72-7.88 4.80
Exercisable at yearend: 183,294 shares 4.02
Options granted 43,050 12.08 12.08 4.33
Options exercised (77,352) 3.72-4.88 3.93
Options terminated (6,522) 4.88-12.08 5.83
--------
BALANCE, December 31, 1997 324,470 3.72-12.08 5.96
Exercisable at yearend: 152,642 shares 4.34
Options granted 104,240 17.44-17.50 17.48 5.47
Options exercised (122,048) 3.72-7.88 4.45
Options terminated (995) 7.88-17.44 11.07
--------
BALANCE, December 31, 1998 305,667 3.72-17.50 10.47
========
Exercisable at year end: 87,508 shares 4.98
</TABLE>
*per share
The following table summarizes information about stock options outstanding at
December 31, 1998:
<TABLE>
<CAPTION>
Options outstanding Options exercisable
- ----------------------------------------------------------------------------------------- -----------------------------------
Range of Number of Weighted average Weighted average Number of Weighted average
exercise price* shares outstanding exercise price* remaining life shares exercisable exercise price*
- ------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
$3.00-$6.00 117,362 $ 4.63 6.3 years 74,528 $4.50
6.01-9.00 41,965 7.80 7.4 years 12,980 7.75
9.01-12.00
12.01-15.00 42,300 12.08 8.5 years
15.01-18-00 104,040 17.48 7.0 years
------- ------
305,667 $10.47 7.0 years 87,508 $4.98
======= ======
</TABLE>
*per share
The Bank applies APBO No. 25 and related interpretations in accounting for
its stock option plan. Accordingly, no compensation cost has been recognized
for its stock option plan for the years ending December 31, 1998, 1997, and
1996. Had compensation cost for the Bank's stock option plan been determined
based on the fair value at the grant dates for awards under those plans
consistent with the method of SFAS No. 123, the Bank's net income and
earnings per share for the years ended December 31, 1998, 1997, and 1996,
would have been reduced to the pro forma amounts indicated below:
<TABLE>
<CAPTION>
1998 1997 1996
- ---------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Net income:
As reported $ 5,207,696 $ 4,518,680 $ 3,914,648
Pro forma 5,038,625 4,419,924 3,805,223
Basic earnings per common share:
As reported $1.24 $1.11 $0.97
Pro forma 1.20 1.09 0.94
Earnings per common share - assuming dilution:
As reported $1.20 $1.07 $0.94
Pro forma 1.17 1.05 0.92
</TABLE>
NOTE 17 CONTINUED ON NEXT PAGE.
page 41
<PAGE>
NOTE 17: STOCK OPTION PLAN (CONTINUED)
The compensation expense included in the pro forma net income and net income per
share figures above are not likely to be representative of the effect on
reported net income for future years because options vest over several years and
additional awards generally are made each year.
The fair value of options granted under the Bank's stock option plan was
estimated on the date of grant using the Black-Scholes option-pricing model with
the following weighted-average assumptions used: Annual dividend yield of 3.14%
for 1998, 1.10% for 1997 and 1.76% for 1996; expected volatility of 33% for
1998, 33% for 1997, and 32% for 1996; and expected lives of 6.5 years for 1998
and five years for 1997 and 1996. The risk free interest rate assumptions used
were 5.79%, 6.19%, and 6.70%, for 1998, 1997, and 1996, respectively.
NOTE 18: CONTINGENCIES
In the normal course of business, the Bank has various legal claims and other
contingent matters outstanding. Bank management believes that any ultimate
liability arising from these actions will not have a material adverse effect on
the Bank's financial condition or results of operations.
NOTE 19: FAIR VALUE OF FINANCIAL INSTRUMENTS
The following disclosure of the estimated fair value of financial instruments is
made in accordance with the requirements of SFAS No. 107, DISCLOSURES ABOUT FAIR
VALUE OF FINANCIAL INSTRUMENTS. The estimated fair value amounts have been
determined by the Bank using available market information and appropriate
valuation methodologies. However, considerable judgment is necessary to
interpret market data in the development of the estimates of fair value.
Accordingly, the estimates presented herein are not necessarily indicative of
the amounts the Bank could realize in a current market exchange. The use of
different market assumptions and/or estimation methodologies may have a material
effect on the estimated fair value amounts. The estimated fair value of
financial instruments is as follows at December 31, 1998 and 1997 (in
thousands):
<TABLE>
<CAPTION>
1998 1997
------------------------------------------ -------------------------------------
Estimated Favorable Estimated Favorable
Carrying fair (unfavorable) Carrying fair (unfavorable)
value value variance value value variance
- -----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Assets:
Cash and cash equivalents $ 5,529 $ 5,529 $ $ 5,909 $ 5,909 $
Securities held for sale 20,337 20,337 1,335 1,335
Loans held for sale 27,371 27,579 208 8,422 8,422
Mortgage-backed and other securities 61,764 62,467 703 64,157 65,253 1,096
Loans receivable 359,535 361,849 2,314 351,909 352,221 312
Accrued interest receivable 3,311 3,311 3,148 3,148
Mortgage servicing portfolio 357 2,076 1,719 601 4,149 3,548
FHLB stock 4,877 4,877 4,519 4,519
--------- -------
Favorable variance 4,944 4,956
Liabilities:
Demand, savings, and money market deposits 111,167 111,167 91,182 91,182
Time deposits 300,084 301,427 (1,343) 281,647 282,390 (743)
Drafts payable 4,383 4,383 1,864 1,864
Advance payments by borrowers
for taxes and insurance 1,517 1,517 1,587 1,587
Short-term FHLB advances 23,265 23,296 (31) 33,230 33,272 (42)
Long-term FHLB advances 8,500 8,550 (50) 1,000 1,002 (2)
--------- -------
Unfavorable variance (1,424) (787)
Off-balance-sheet financial instruments:
Commitments to sell loans (25) (25) (23) (23)
--------- -------
Favorable (unfavorable) variance (25) (23)
--------- -------
Net favorable variance $ 3,495 $ 4,146
========= =======
</TABLE>
NOTE 19 CONTINUED ON NEXT PAGE.
page 42
<PAGE>
NOTE 19: FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED)
Fair value estimates, methods, and assumptions are set forth below for the
Bank's financial and off-balance-sheet instruments.
SECURITIES, LOANS HELD FOR SALE, AND COMMITMENTS TO SELL LOANS: The fair value
of securities and loans receivable held for sale, and forward commitments, are
based on quoted market rates and dealer quotes.
LOANS RECEIVABLE: For variable-rate loans that reprice frequently and with no
significant change in credit risk, fair values are based on carrying values.
The fair value of the loans that have fixed interest rates or variable rates
which do not reprice frequently is estimated using discounted cash flow
analysis, using interest rates currently being offered for loans with similar
terms to borrowers or similar credit quality. The fair value of
nonperforming loans is estimated using discounted cash flow analysis, using
applicable risk adjusted spreads to the Bank's contractual interest rates
applicable to each category of loan.
No adjustment was made to the market interest rates for changes in credit of
performing loans for which there are no known credit concerns. Management
believes that the risk factor embedded in the market interest rates along with
the general reserves applicable to the loan portfolio for which there are not
known credit concerns results in a fair valuation of such loans.
DEPOSIT LIABILITIES: Under SFAS No. 107, the fair value of deposits with no
stated maturity, such as noninterest-bearing demand deposits, savings, NOW
accounts, and money market and checking accounts, is equal to the amount
payable on demand. The fair value of time deposits is based on the discounted
value of contractual cash flows. The discount rate is estimated using market
rates for deposits of similar maturity of the top 25 local deposit-ranked
institutions.
FHLB ADVANCES: The fair value of FHLB advances and other borrowings is
estimated based on discounting the estimated future cash flows using
rates currently available to the Bank for debt with similar remaining
maturity.
OTHER: The carrying value of other financial instruments his been determined
to be a reasonable estimate of their fair value.
MORTGAGE SERVICING PORTFOLIO: The carrying value of the mortgage servicing
portfolio is mortgage servicing rights as defined by SFAS No. 125. The fair
value of the mortgage servicing portfolio represents the fair value of the
total servicing portfolio, and is based upon an independent appraisal and a
valuation model that calculates the present value of future cash flows.
COMMITMENTS TO ORIGINATE LOANS: Based on the short terms of these instruments,
the unrealized gains or losses are expected to be insignificant.
LIMITATIONS: The fair value estimates presented herein are based on pertinent
information available to management as of December 31, 1998 and 1997. Although
management is not aware of any factors that would significantly affect the
estimated fair value amounts, such amounts have not been comprehensively
revalued for purposes of these financial statements since that date and,
therefore, current estimates of fair value may differ significantly from the
amounts presented herein.
NOTE 20: SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
<TABLE>
<CAPTION>
Year ended December 31, 1998
--------------------------------------------------------------------------------------
First Second Third Fourth
quarter quarter quarter quarter Total
- ----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Interest income $ 9,551,242 $ 9,807,688 $ 9,948,913 $ 9,907,193 $39,215,036
Interest expense 5,344,232 5,505,230 5,488,352 5,480,860 21,818,674
----------- ----------- ----------- ----------- -----------
Net interest income $ 4,207,010 $ 4,302,458 $ 4,460,561 $ 4,426,333 $17,396,362
=========== =========== =========== =========== ===========
Provision for loan losses $ 100,000 $ 100,000 $ 385,000 $ 165,000 $ 750,000
=========== =========== =========== =========== ===========
Other operating income and expenses, net $(2,227,700) $(2,267,161) $(2,038,211) $(2,224,060) $(8,757,132)
=========== =========== =========== =========== ===========
Net income $ 1,240,344 $ 1,277,296 $ 1,344,651 $ 1,345,405 $ 5,207,696
=========== =========== =========== =========== ===========
Basic earnings per share $ 0.30 $ 0.30 $ 0.32 $ 0.32 $ 1.24
=========== =========== =========== =========== ===========
Endings per share assuming dilution $ 0.29 $ 0.29 $ 0.31 $ 0.31 $ 1.20
=========== =========== =========== =========== ===========
Weighted shares outstanding 4,137,389 4,232,395 4,245,191 4,246,558 4,215,764
=========== =========== =========== =========== ===========
Weighted shares outstanding
including effect of dilutive stock
options 4,298,127 4,341,526 4,338,346 4,329,990 4,327,378
=========== =========== =========== =========== ===========
</TABLE>
NOTE 20 CONTINUED ON NEXT PAGE.
page 43
<PAGE>
NOTE 20: SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) (CONTINUED)
<TABLE>
<CAPTION>
Year ended December 31, 1997
-----------------------------------------------------------------------------------
First Second Third Fourth
quarter quarter quarter quarter Total
- ----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Interest income $ 8,637,359 $ 8,976,443 $ 9,322,745 $ 9,459,411 $ 36,395,958
Interest expense 4,893,696 5,039,491 5,308,418 5,348,357 20,589,962
------------ ------------ ------------ ------------ ------------
Net interest income $ 3,743,663 $ 3,936,952 $ 4,014,327 $ 4,111,054 $ 15,805,996
============ ============ ============ ============ ============
Provision for loan losses $ 270,000 $ 290,000 $ 221,000 $ 195,000 $ 976,000
============ ============ ============ ============ ============
Other operating income and expenses, net $ (1,844,441) (1,966,402) $ (2,025,800) $ (2,146,731) $ (7,983,374)
============ ============ ============ ============ ============
Net income $ 1,075,196 $ 1,109,163 $ 1,166,568 $ 1,167,753 $ 4,518,680
============ ============ ============ ============ ============
Basic earnings per shire $ 0.27 $ 0.27 $ 0.29 $ 0.29 $ 1.11
============ ============ ============ ============ ============
Earnings per share assuming dilution $ 0.26 $ 0.26 $ 0.28 $ 0.27 $ 1.07
============ ============ ============ ============ ============
Weighted shares outstanding 4,048,155 4,051,136 4,061,252 4,090,690 4,062,824
============ ============ ============ ============ ============
Weighted shares outstanding
including effect of dilutive stock options 4,206,641 4,210,595 4,239,135 4,282,274 4,234,677
============ ============ ============ ============ ============
</TABLE>
NOTE 21: SEGMENTS
The Bank is organized based on the products and services that it offers. Under
this organizational structure, the Bank has three reportable segments, consumer
banking, residential lending, and commercial lending.
Residential lending offers conventional or government-insured loans to
borrowers to purchase, refinance, or build homes, secured by
one-to-four-unit family dwellings. Embedded within the residential
lending segment is a mortgage banking operation, which sells loans in
the secondary mortgage market. The mortgage banking operation generally
retains the right to service the loans sold (i.e., collection of
principal and interest payments) for which it receives a fee based on
the unpaid principal balance. The servicing rights may be resold at
opportune market conditions.
Commercial lending offers permanent and interim (construction) loans
for multifamily housing (over four units), commercial real estate
properties, and loans to small- and medium-sized businesses for
financing inventory, accounts receivables, and equipment, among other
things. The underlying real estate collateral or business asset being
financed typically secures these loans.
Consumer banking offers depositor banking services, home equity
lending, direct consumer loans, and consumer dealer financing contracts.
These segments are managed separately because each business requires different
processes and different marketing strategies to reach the customer base that
buys those products and services. All three segments derive a majority of their
revenue from interest, and management relies primarily on net interest revenue
in managing these segments. No single customer provides more than 10% of the
company's revenues.
BASIS OF ACCOUNTING FOR REPORTABLE SEGMENTS:
Starting in 1997, the Bank adopted business unit profitability reporting, which
measures the performance of segments as self-standing business entities. As
self-standing entities, the segments have fully income-allocated and
cost-burdened profit and loss statements. Except for the allocations and the
funds transfer-pricing mechanism described below, the accounting policies for
the segments are the same as those described in the Summary of Significant
Accounting Policies.
Allocations and funds transfer-pricing mechanism:
- Operating income and expenses are allocated to segments whenever they
can be directly attributed to their activities. Indirect income and
overhead costs are credited or charged to the segments whenever they
are specifically identified as providers or users of the ancillary
internal service, or are allocated based on some common denominator.
For certain services, intersegment user fees are assessed at
agreed-upon prices.
- A funds transfer-pricing method has been utilized to allocate interest
income for the deposits held in the branch banks. The deposit-gathering
activities contribute to the Bank's profitability by reducing borrowing
costs. The deposits are therefore presumed to generate revenues for
consumer banking through reinvestments in low-risk securities (inferred
interest-earning assets). The interest earnings are calculated using an
internal, proxy-market interest rate. The loan-producing units in the
residential, commercial, and consumer segments are also presumed to
borrow money to fund their loans using an internal, proxy-market
interest rate.
- Equity capital commensurate with the risk weight of segment assets has
been allocated to simulate the operating capital level required by the
Bank's regulators. The allocated capital provides the segments with
interest-free funding.
NOTE 21 CONTINUED ON NEXT PAGE.
page 44
<PAGE>
NOTE 21: SEGMENTS (CONTINUED)
Financial information for the Bank's segments is shown below for the years
December 31, 1998 and 1997. Prior to 1997, the Bank used a different format
for measuring business unit profitability which is incompatible with the
current format. It is impracticable to provide comparative information for
1996. The data needed to compile that information is unavailable and the cost
to develop it would be excessive.
<TABLE>
<CAPTION>
Year ending December 31
----------------------------------------------------------------
Consumer Residential Commercial
Banking Lending Lending Totals
- -------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Revenues from external customers 1998 $ 6,521,653 $ 10,718,074 $ 24,156,802 $ 41,396,529
1997 6,326,339 10,068,321 20,810,023 37,204,683
Revenues from other segments of the Bank 1998 21,051,822 428,300 1,482,378 22,962,500
1997 18,505,479 467,586 1,303,662 20,276,727
Total revenues 1998 27,573,475 11,146,374 25,639,180 64,359,029
1997 24,831,818 10,535,907 22,113,685 57,481,410
Net interest revenue 1998 6,446,931 1,967,849 8,838,699 17,253,479
1997 6,235,391 2,098,386 7,254,032 15,587,809
Income before federal income taxes 1998 1,565,589 2,017,212 6,025,083 9,607,884
1997 2,113,629 1,093,807 5,037,563 8,244,999
Total assets as of December 31: 1998 414,809,598 107,019,912 274,234,989 796,064,499
1997 373,687,398 124,405,900 235,318,964 733,412,262
</TABLE>
Revenues from external customers is comprised of interest income and other
operating income. Revenues from other segments of the Bank include the
interest-free benefit of allocated equity capital, the interest revenue from the
inferred earning assets on branch deposits, and intersegment user fees and
charges.
NOTE 21 CONTINUED ON NEXT PAGE.
page 45
<PAGE>
NOTE 21: SEGMENTS (CONTINUED)
Reconciliations of segment data to the Bank consolidated financial statements
are shown in the table below. The amounts for the segments would differ from the
actual consolidated financial statements due to the use of internal,
proxy-market interest rates, and various methods for allocating costs. The
provision for loan losses and the reserve for loan losses have not been
allocated to the segments. Total segment assets include inferred
interest-earning assets on branch deposits, which are essentially the same
assets from the lending segments, but credited with a proportionate interest
yield.
<TABLE>
<CAPTION>
1998 1997
- ---------------------------------------------------------------------------------------------------------------
<S> <C> <C>
TOTAL REVENUES FOR YEAR ENDED DECEMBER 31:
Segment total revenues $ 64,359,029 $ 57,481,410
Back out or add back:
Revenues from other segments of the Bank (22,962,500) (20,276,727)
Revenues of administrative departments netted against
overhead costs and reallocated as net costs 1,048,513 897,657
------------- -------------
Consolidated Bank total revenues $ 42,445,042 $ 38,102,340
NET INTEREST REVENUE FOR YEAR ENDED DECEMBER 31:
Segment net interest revenue $ 17,253,479 $ 15,587,809
Back out or add back:
Difference between actual Bank interest expense
and intersegment funding allocation (653,030) (291,096)
Interest revenues of administrative departments netted
against overhead costs and reallocated as net costs 795,913 509,283
------------- -------------
Consolidated Bank net interest revenues $ 17,396,362 $ 15,805,996
INCOME BEFORE FEDERAL INCOME TAXES FOR YEAR ENDED DECEMBER 31:
Segment pre-tax income $ 9,607,884 $ 8,244,999
Back out or add back:
Unallocated loan loss provision (750,000) (976,000)
Difference between actual total Bank funding cost
and total intersegment funding allocation (81,573) 66,053
Unallocated net expenses of administrative departments (887,081) (488,430)
------------- -------------
Consolidated Bank pre-tax income $ 7,889,230 $ 6,846,622
TOTAL ASSETS AS OF DECEMBER 31:
Segment total assets $ 796,064,499 $ 733,412,262
Back out or add back:
Inferred intersegment interest-earning assets on branch deposits (308,525,629) (290,256,005)
Unallocated reserve for loan loss (5,569,431) (4,858,376)
Unallocated nonearning assets of administrative departments 7,260,700 7,464,559
------------- -------------
Consolidated Bank total assets $ 489,230,139 $ 445,762,440
</TABLE>
page 46
<PAGE>
INDEPENDENT AUDITORS' REPORT
Board of Directors
First Mutual Savings Bank
Bellevue, Washington
We have audited the accompanying consolidated statements of financial
condition of First Mutual Savings Bank and subsidiary (the Bank) as of
December 31, 1998 and 1997, and the related consolidated statements of
income, stockholders' equity, and cash flows for each of the three years in
the period ended December 31, 1998. These financial statements are the
responsibility of the Bank's management. Our responsibility is to express an
opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements.
An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial condition of the Bank as of December 31, 1998
and 1997, and the results of its operations and its cash flows for each of the
three years in the period ended December 31, 1998, in conformity with generally
accepted accounting principles.
/s/ Deloitte & Touche LLP
January 29,1999
Deloitte & Touche LLP
Seattle, Washington
STOCK INFORMATION
The Bank sold 966,000 shares of common stock in its initial public offering on
December 23, 1985. As of December 31, 1998, there were 4,247,275 shares
outstanding. The shares are held by approximately 1,200 shareholders of record
and persons or entities who hold their stock in nominee or "street" name through
various brokerage firms or other depositories.
First Mutual Savings Bank's common stock trades on The Nasdaq Stock Market
under the symbol FMSB. The following data are based on the reported sale prices
on the NASDAQ National Market System for the quarters indicated, as reported by
the National Association of Securities Dealers.
<TABLE>
<CAPTION>
QUARTER ENDING HIGH* LOW*
- -------------------------------------------------------------------------------
<S> <C> <C>
March 31, 1997 $12.58 $10.61
June 30, 1997 12.67 10.61
September 30, 1997 19.00 11.50
December 31, 1997 20.58 17.00
March 31, 1998 19.50 17.50
June 30, 1998 18.25 16.50
September 30, 1998 17.69 11.88
December 31, 1998 15.13 12.31
</TABLE>
*ADJUSTED TO REFLECT THE 10% STOCK DIVIDEND PAID JULY 2, 1997 AND A
THREE-FOR-TWO STOCK SPLIT PAID NOVEMBER 5, 1997.
Annual per share cash dividends paid to shareholders of record as of record
dates:
<TABLE>
<S> <C>
1994 $.20
1995 $.45 (includes a one-time, special cash dividend of 25 cents)
1996 $.20
1997 $.20
1998 $.55 (includes a one-time, special cash dividend of 35 cents)
</TABLE>
page 47
<PAGE>
<TABLE>
<S><C>
GENERAL INFORMATION
BOARD OF DIRECTORS BANK OFFICERS (CONTINUED) FIRST MUTUAL BANK OFFICES
F. Kemper Freeman, Jr. ASSISTANT VICE PRESIDENTS Ballard
CHAIRMAN Lorna g. Dykes 2038 NW Market Street
H. Scott Wallace UNDERWRITING Seattle, Washington 98107
VICE CHAIRMAN Glenn R. Wells (206) 706-0894
John R. Valaas RETAIL RESIDENTIAL LENDING
PRESIDENT, CEO Bellevue Financial Center
James J. Doud, Jr. FIRST MUTUAL BANK CORPORATE 400 - 108th Avenue NE
Mary Case Dunnam HEADQUARTERS AND MAIN OFFICE Bellevue, Washington 98004
Janine Florence 400 - 108th Avenue NE (425) 453-2801
Victor E. Parker Bellevue, Washington 98004
George W. Rowley, Jr. (425) 455-7300 Bellevue West
Richard S. Sprague 10001 NE 8th Street
William E. Tremper ANNUAL MEETING Bellevue, Washington 98004
Robert C. Wallace The annual meeting is scheduled to (425) 453-9434
be held April 22, 1999, 3 p.m., at the
BANK OFFICERS Hyatt Regency Bellevue, Bellingham
PRESIDENT 900 Bellevue Way NE, 1100 Harris Street
John R. Valaas Bellevue, Washington. Bellingham, Washington 98225
CHIEF EXECUTIVE OFFICER (360) 714-0433
EXECUTIVE VICE PRESIDENT TRANSFER AGENT AND REGISTRAR
Roger A. Mandery ChaseMellon Shareholder Services, L.L.C. Crossroads
CHIEF FINANCIAL OFFICER Shareholder Relations 15635 NE Eighth Street
SENIOR VICE PRESIDENT P.O. Box 3315 Bellevue, Washington 98008
James R. Boudreau South Hackensack, NJ 07606 (425) 644-4214
CHIEF CREDIT OFFICER (800) 522-6645
VICE PRESIDENTS www.chasemellon.com Issaquah
Robin R. Carey 855 Rainier Boulevard N
OPERATIONS AND ADMINISTRATION INDEPENDENT CERTIFIED PUBLIC Issaquah, Washington 98027
Nancy Chermak ACCOUNTANTS (425) 392-2673
LOAN ADMINISTRATION Deloitte & Touche
Pamela S. Drexler Monroe
LOAN SERVICING LEGAL COUNSEL 19265 State Route 2
Carolyn F. Ellingson Preston, Gates & Ellis Monroe, Washington 98272
CENTRAL BANKING OPERATIONS (360) 794-8686
Robert J. Everett INVESTOR RELATIONS COUNSEL
INCOME PROPERTY LENDING Len Cereghino & Co. Redmond
Scott B. Harlan 2605 Western Avenue 16900 Redmond Way
RESIDENTIAL AND CONSUMER LENDING Seattle, Washington 98121 Redmond, Washington 98052
Tony S. Icasiano (206) 448-1996 (425) 883-4700
CONTROLLER
Kenneth J. Walkky FORM 10-K West Seattle
INCOME PROPERTY LENDING A copy of form 10-K, including the financial 4520 California Avenue SW
Ronald P. Werth statements as filed with the Federal Deposit Seattle, Washington 98116
BUSINESS BANKING Insurance Corporation, will be furnished (206) 932-6299
J. Robert Wicks without charge to shareholders of record
BRANCH ADMINISTRATION upon written request to: LOAN PRODUCTION OFFICE
James D. Young Tacoma
ASSET MANAGEMENT Tony S. Icasiano 2323 N 31st Street
CORPORATE SECRETARY Vice President and Controller Tacoma, Washington 98403
Phyllis A. Easterlin First Mutual Bank (253) 759-3559
ASSISTANT VICE PRESIDENTS P.O. Box 1647
Jackie A. Bartl Bellevue, Washington 98009-1647
INCOME PROPERTY LENDING
Michele R. Darrington
RESIDENTIAL LENDING OPERATIONS
</TABLE>
page 48
<PAGE>
NOTICE OF INTENTION TO ORGANIZE
A STOCK SAVINGS BANK
(FIRST INTERIM BANK)
The undersigned, as proposed incorporators, being natural persons and
citizens of the United States of America, hereby notify the Director of
Financial Institutions of their intent to organize an interim stock savings bank
to facilitate a plan of reorganization and the formation of bank holding company
pursuant to the Agreement and Plan of Merger enclosed herewith. The undersigned
incorporators, in light of the requirements set forth in RCW 32.08.020, hereby
certify the following:
1. The name of the proposed bank is First Interim Bank.
2. The place where the bank is to be located and its business
transacted is 400 - 108th Avenue NE, Bellevue, Washington 98004.
3. The names of each of the incorporators is set forth below:
NAME
- ------------------------- ------------------------- -------------------------
James J. Doud, Jr. Mary Case Dunnam Janine Florence
- ------------------------- ------------------------- -------------------------
F. Kemper Freeman, Jr. Victor E. Parker Richard S. Sprague
- ------------------------- ------------------------- -------------------------
George W. Rowley, Jr. William E. Tremper John R. Valaas
- ------------------------- ------------------------- -------------------------
H. Scott Wallace Robert C. Wallace
- ------------------------- ------------------------- -------------------------
The undersigned incorporators have executed this Notice of Intention to
Organize a Stock Savings Bank in triplicate signed originals on April 22, 1999.
/s/ James J. Doud, Jr. /s/ George W. Rowley, Jr.
- ------------------------- -------------------------
James J. Doud, Jr. George W. Rowley, Jr.
/s/ Mary Case Dunnam /s/ William E. Tremper
- ------------------------- -------------------------
Mary Case Dunnam William E. Tremper
/s/ Janine Florence /s/ John R. Valaas
- ------------------------- -------------------------
Janine Florence John R. Valaas
/s/ F. Kemper Freeman, Jr. /s/ H. Scott Wallace
- ------------------------- -------------------------
F. Kemper Freeman, Jr. H. Scott Wallace
/s/ Victor E. Parker /s/ Robert C. Wallace
- ------------------------- -------------------------
Victor E. Parker Robert C. Wallace
/s/ Richard S. Sprague
- -------------------------
Richard S. Sprague
<PAGE>
FIRST MUTUAL SAVINGS BANK
Bellevue, Washington
AGREEMENT AND PLAN OF REORGANIZATION
AND MERGER
THIS AGREEMENT AND PLAN OF REORGANIZATION AND MERGER ("Agreement"),
dated as of May 12, 1999, is made by and between First Mutual Savings Bank
("First Mutual"), a stock savings bank chartered under Title 32 of the Revised
Code of Washington as amended ("RCW 32"); the corporation formed as a subsidiary
of First Mutual to become its bank holding company and which will sign below
("Holding Company"), a Washington corporation; and First Interim Bank
("Interim"), a to-be-formed interim savings bank chartered under RCW 32.
The parties hereto desire to enter into this Agreement and Plan of
Reorganization whereby First Mutual will reorganize into the holding company
form of ownership. The reorganization will be accomplished by the following
steps: (i) the formation by First Mutual of a wholly-owned, first-tier
subsidiary (Holding Company), incorporated under Title 23B, RCW; (ii) the
formation of Interim, which will be wholly-owned by Holding Company immediately
prior to the reorganization; and (iii) the merger of Interim with and into First
Mutual ("Merger") under the Amended Charter and Articles of Incorporation of
First Mutual. The separate existence of Interim and First Mutual shall cease as
a result of the Merger and the name of the surviving banking corporation after
the Merger will be "First Mutual Bank" ("Resulting Bank").
Pursuant to the Merger: (a) all of the issued and outstanding shares of
common stock, $1.00 par value per share, of Holding Company ("Holding Company
Common Stock") held by First Mutual will be canceled; (b) all of the issued and
outstanding shares of common stock, $1.00 par value per share, of First Mutual
("First Mutual Common Stock") will automatically be converted by operation of
law on a one-for-one basis into an equal number of issued and outstanding shares
of Holding Company Common Stock; (c) all of the issued and outstanding shares of
common stock, $1.00 par value per share of Interim ("Interim Common Stock") will
automatically be converted by operation of law into a number of issued and
outstanding shares of common stock $1.00 par value per share of Resulting Bank
equal to the number of shares of common stock of First Mutual on the effective
date of the Merger ("Resulting Bank Common Stock"), which will be all the issued
and outstanding shares of Resulting Bank Common Stock.
NOW, THEREFORE, in order to consummate this Agreement, and in
consideration of the mutual covenants herein set forth, the parties agree as
follows:
<PAGE>
ARTICLE 1
MERGER OF INTERIM INTO FIRST MUTUAL AND RELATED MATTERS
1.1 MERGER. On the Effective Date, Interim will merge with and into
First Mutual pursuant to the authority given by and in accordance with the
provisions of RCW 32, as amended, and the separate existence of Interim will
cease. The surviving banking corporation after the Merger will be named "First
Mutual Bank" and is referred to herein as the "Resulting Bank".
1.2 ARTICLES OF INCORPORATION AND BYLAWS. The Amended Charter and
Articles of Incorporation of First Mutual prior to the Effective Date shall be
the Articles of Incorporation of Resulting Bank , except that Article I of the
Articles of Incorporation of Resulting Bank shall be amended and restated as
follows:
THE NAME OF THE CORPORATION SHALL BE FIRST MUTUAL BANK.
The Bylaws of First Mutual as in effect immediately prior to the
Effective Date shall be the Bylaws of the Resulting Bank.
1.3 TRANSFER OF INTERESTS. All rights, franchises and interests of
First Mutual and Interim in and to every type of property (real, personal and
mixed) and choses in action shall be transferred to and vested in Resulting Bank
by virtue of the Merger without any deeds or other documents of transfer;
Resulting Bank, without any order or other action on the part of any court or
otherwise, shall hold and enjoy all rights of property, franchises and
interests, including powers, appointments, designations and nominations and all
other rights and interests as trustee, executor, administrator, agent registrar
of stocks and bonds, guardian of estates, assignee, receiver, and in every other
fiduciary capacity, in the same manner and to the same extent as such rights,
franchises and interests were held and enjoyed by First Mutual or Interim at the
time the Merger became effective.
1.4 LIABILITIES. Resulting Bank shall be liable for all of the
liabilities of First Mutual and Interim, and all deposits, debts, liabilities,
obligations and contracts of First Mutual or Interim, matured or unmatured,
accrued, absolute, contingent or otherwise, whether or not reflected or reserved
against on the books of account or records of First Mutual or Interim, shall be
those of Resulting Bank and shall not be released or impaired by the Merger; and
all rights of creditors and other obligees and all liens on property of First
Mutual or Interim shall be preserved unimpaired.
1.5 CONTINUATION OF BUSINESS. From and after the Effective Date, and
subject to the actions of the Board of Directors of First Mutual, the business
presently conducted by First Mutual (whether directly or through any
subsidiaries) will be conducted by Resulting Bank, as a wholly-owned subsidiary
of Holding Company. The home office and branch offices, if any, of First Mutual
in existence immediately prior to the Effective Date shall be the home office
and branch offices of Resulting Bank from and after the Effective Date.
-2-
<PAGE>
1.6 BOARD OF DIRECTORS AND OFFICERS OF RESULTING BANK. The directors of
First Mutual immediately prior to the Effective Date, as named on Schedule
1.6(a), will be the members of the board of directors of Resulting Bank unless,
prior to the Effective Date any one or more of the persons named in Schedule
1.6(a) shall die or resign or become unable to serve, in which event the
remaining persons named in Schedule 1.6(a) shall be the directors of Resulting
Bank as of the Effective Date. Unless otherwise agreed by the parties, the
executive officers of Resulting Bank at the Effective Date of the Merger shall
be those persons whose names are set forth on Schedule 1.6(b).
1.6 BOARD OF DIRECTORS OF HOLDING COMPANY. The board of directors of
Holding Company existing prior to the Effective Date shall continue in that
capacity.
ARTICLE 2
CONVERSION OF STOCK
2.1 CANCELLATION, CONVERSION AND ISSUANCE OF SHARES. The terms and
conditions of the Merger, the mode of carrying the same into effect, and the
manner and basis of converting the respective common stock of the parties
pursuant to this Agreement shall be as follows:
2.1.1 CANCELLATION OF SHARES. On the Effective Date, all
shares of Holding Company Common Stock held by First Mutual shall be canceled
and shall no longer be deemed to be issued and outstanding for any purpose.
2.1.2 CONVERSION OF FIRST MUTUAL SHARES. On the Effective Date,
each share of First Mutual Common Stock issued and outstanding immediately prior
to the Effective Date shall automatically by operation of law be converted into
and shall become one share of Holding Company Common Stock. All shares of
Holding Company Common Stock into which shares of First Mutual Common Stock
shall have been converted pursuant to this Article 2 shall be deemed to have
been issued in full satisfaction of all rights pertaining to such converted
shares.
2.1.3 CONVERSION OF INTERIM SHARES. All shares of Interim Common
Stock issued and outstanding immediately prior to the Effective Date shall be
owned by Holding Company and shall, on the Effective Date, automatically by
operation of law be converted into and become a number of shares of Resulting
Bank Common Stock equal to the number of shares of common stock of First Mutual
outstanding on the effective date of the Merger, and all of such shares will be
held by Holding Company.
2.1.4 FRACTIONAL SHARES. No fractional shares of common stock
shall be issued by Holding Company. All fractional shares of Holding Company
Common Stock to which a holder of First Mutual Common Stock would otherwise be
entitled shall be aggregated. Except as otherwise provided in this paragraph, if
a fractional share results from such aggregation, such stockholder, after the
later of the Effective Time or the surrender of such shareholder's certificate
or certificates which represented such shares, shall be entitled to receive from
Holding Company, in lieu of such fractional shares of stock, an amount in cash,
without interest, which is equal to the product of such fraction multiplied by
the mean of the closing "bid" price per share for First Mutual Common Stock for
the 20 trading days immediately preceding the Closing as reported by the
National Association of Securities Dealers, Inc.
-3-
<PAGE>
2.1.5 EXCHANGE OF FIRST MUTUAL SHARE CERTIFICATES. After the
Effective Date of the Merger, the holders of certificates formerly representing
First Mutual Common Stock shall cease to have any rights with respect to First
Mutual, other than any applicable rights derived through ownership of Holding
Company shares. After the Effective Date, each certificate that represented
shares of First Mutual Common Stock shall, for all purposes, be automatically
deemed to evidence an equal number of shares of Holding Company Common Stock.
Holders of existing First Mutual certificates will not be required to exchange
their Common Stock certificates for new certificates evidencing the same number
of shares of Holding Company Common Stock. The current transfer agent and
registrar for First Mutual Common Stock will act in the same capacity for
Holding Company Common Stock.
2.1.5 SURRENDER OF INTERIM SHARE CERTIFICATES. After the Effective
Date, each certificate that represented shares of Interim Common Stock shall,
for all purposes, be automatically deemed to evidence an equal number of shares
of Resulting Bank Common Stock. Holding Company will not be required to exchange
its Interim Common Stock certificates for new certificates evidencing the same
number of shares of Resulting Bank Common Stock. If, in the future, Resulting
Bank determines to effect an exchange of stock certificates, instructions will
be sent to all then holders of record. The transfer agent and registrar for the
Interim Common Stock will act in the same capacity for the Resulting Bank Common
Stock.
ARTICLE 3
EMPLOYEES
3.1 EMPLOYEES. It is the desire and intent of the parties hereto that
all the present employees of First Mutual shall continue, after this merger, in
the service of Resulting Bank, subject to applicable personnel policies.
3.2 EMPLOYEE BENEFITS. The parties agree that Resulting Bank will
provide benefits for Resulting Bank employees that are in the aggregate
substantially equivalent to the benefits provided to First Mutual employees,
except to the extent that Holding Company chooses to provide and administer such
benefits; provided, however, that nothing contained herein shall be considered
as requiring Holding Company or Resulting Bank to continue any specific plan or
benefit or as precluding amendments to any specific plan or benefit; and
provided further, that nothing expressed or implied in this Agreement shall
confer upon any employee, beneficiary, dependent, legal representative or
collective bargaining agent of such employee any right or remedy of any nature
or kind whatsoever under or by reason of this Agreement, including without
limitation any right to employment or to continued employment for any specified
period, at any specified location or under any specified job category.
-4-
<PAGE>
ARTICLE 4
CONDITIONS
4.1 CONDITIONS PRECEDENT TO CLOSING. The respective obligations of
First Mutual, Holding Company and Interim to effect the Merger and otherwise
consummate the transactions contemplated by this Agreement shall be subject to
the satisfaction of the following conditions:
4.1.1 BOARD APPROVAL. The Boards of Directors of First Mutual,
Holding Company and Interim must each approve the Merger by a two-thirds vote.
4.1.2 REGISTRATION AND COMPLIANCE WITH "BLUE SKY" LAWS. If
required by applicable law, the shares of Holding Company Common Stock to be
issued to the holders of First Mutual Common Stock pursuant to the Merger shall
have been duly registered pursuant to Section 5 of the Securities Act of 1933,
as amended; and the Holding Company shall have complied with all applicable
state securities or "blue sky" laws relating to the issuance of the Holding
Company Common Stock.
4.1.3 GOVERNMENTAL APPROVAL. Any and all approvals from the
Federal Reserve Board ("FRB"), the Federal Deposit Insurance Corporation
("FDIC"), the Washington Department of Financial Institutions ("Department"),
the Securities and Exchange Commission ("SEC") and any other person or
governmental agency having jurisdiction necessary for the lawful consummation of
the reorganization or Merger and the issuance and delivery of the Holding
Company Common Stock as contemplated by this Agreement shall have been applied
for and obtained.
4.1.4 TAX OPINION. To the extent required by applicable law,
rules and regulations, First Mutual shall have received either: (i) a ruling
from the Internal Revenue Service or (ii) an opinion from its legal counsel, to
the effect that the Merger will be treated as a non-taxable transaction under
Section 368 or other applicable provisions of the Internal Revenue Code and that
no gain or loss will be recognized by the stockholders of First Mutual upon the
exchange of First Mutual Common Stock held by them for Holding Company Common
Stock.
ARTICLE 5
TERMINATION
5.1 CONDITIONS NOT MET; MUTUAL CONSENT. This Agreement may be
terminated at the election of any of the parties hereto if any one or more of
the conditions to the obligations of any of them hereunder shall not have been
satisfied and shall have become incapable of fulfillment and shall not be
waived. This Agreement may also be terminated at any time prior to the Effective
Date by the mutual consent of the respective Boards of Directors of the parties.
5.2 NO FURTHER LIABILITY OR OBLIGATION. In the event of the termination
of this Agreement pursuant to any of the foregoing provisions, no party shall
have any further liability or obligation of any nature to any other party under
this Agreement.
-5-
<PAGE>
ARTICLE 6
EFFECTIVE DATE OF MERGER
6.1 EFFECTIVE DATE. Applications shall be made for necessary regulatory
approvals. Upon satisfaction or waiver (in accordance with the provisions of
this Agreement) of each of the conditions set forth in Article 4, the parties
hereto shall establish a closing and effective date, and execute and cause to be
filed such certificates or further documents as shall be required by the FRB,
FDIC, SEC or Department and with such other state or federal regulatory agencies
as may be required. Upon approval by and expiration of any applicable waiting
periods of the FRB, FDIC, and the Department and endorsement of such
certificates, the Merger and other transactions contemplated by this Agreement
shall become effective. The Effective Date for all purposes hereunder shall be
the date of such endorsements by the Office of the Secretary of State of the
State of Washington.
ARTICLE 7
MISCELLANEOUS
7.1 WAIVER OF CONDITIONS. Any of the terms or conditions of this
Agreement, which may legally be waived, may be waived at any time by any party
hereto which is entitled to the benefit thereof, or any of such terms or
conditions may be amended or modified in whole or in part at any time, to the
extent allowed by applicable law, by an agreement in writing, executed in the
same manner as this Agreement.
7.2 AMENDMENTS. Any of the terms or conditions of this Agreement may be
amended or modified in whole or in part at any time, to the extent permitted by
applicable law, rules and regulations, by an amendment in writing, provided that
any such amendment or modification is not materially adverse to First Mutual,
Interim, the Holding Company or their stockholders. In the event that any
governmental agency requests or requires that the transactions contemplated
herein be modified in any respect as a condition of providing a necessary
regulatory approval or favorable ruling, or that in the opinion of counsel such
modification is necessary to obtain such approval or ruling or any opinion, the
Agreement may be modified, at any time by an instrument in writing, provided
that the effect of such amendment would not be materially adverse to First
Mutual, Interim, Holding Company or their respective stockholders.
7.3 NOTICES. All notices and other communications hereunder shall be in
writing and shall be deemed given upon receipt if delivered personally, sent by
electronic mail or facsimile (receipt confirmed) or delivered by a nationally
recognized overnight courier to the parties at the following addresses (or at
such other address for a party as shall be specified by like notice):
(a) if to First Mutual, to:
First Mutual Savings Bank
400 108th Avenue NE
Bellevue, WA 98004
Attention: Phyllis Easterlin
Facsimile No.: (425) 455-7330
-6-
<PAGE>
with copies to:
Preston Gates & Ellis LLP
5000 Columbia Center
701 Fifth Avenue, Suite 5000
Seattle, WA 98104
Attention: Alan B. Wicks
Facsimile No.: (206) 623-7022
(b) if to Holding Company, to:
John Valaas for Holding Company
c/o First Mutual Savings Bank
400 108th Avenue NE
Bellevue, WA 98004
Attention: Chief Executive Officer
Facsimile No.: (425) 455-7330
(c) if to Interim, to:
First Interim Bank
400 108th Avenue NE
Bellevue, WA 98004
Attention: Chief Executive Officer
Facsimile No.: (425) 455-7330
7.4 MISCELLANEOUS. This Agreement and the documents referred to herein
(a) constitute the entire agreement among the parties with respect to the
subject matter hereof and supersede all prior agreements and understandings,
both written and oral, among the parties with respect to the subject matter
hereof; (b) are not intended to confer upon any other person any rights or
remedies hereunder; and (c) shall not be assigned by operation of law or
otherwise except as otherwise specifically provided.
7.5 GOVERNING LAW. This Agreement shall be governed by and construed
under the laws of the State of Washington except insofar as Federal law is
deemed to apply.
7.6 COUNTERPARTS. This Agreement may be executed in one or more
counterparts, all of which shall be considered one and the same agreement and
shall become effective when one or more counterparts have been signed by each of
the parties and delivered to each the other parties, it being understood that
all parties need not sign the same counterpart.
7.7 HEADINGS. The headings of the several articles and sections herein
are inserted for the convenience of reference only and are not intended to be a
part of or to affect the meaning or interpretation of this Agreement.
-7-
<PAGE>
7.8 ATTORNEYS' FEES. If any legal action is brought for the enforcement
of this Agreement or because of an alleged dispute, breach, default, or
misrepresentation in connection with any provision of this Agreement, the
successful or prevailing party or parties will be entitled to recover reasonable
attorneys' fees and other costs incurred in that action or proceeding, in
addition to any other relief to which it or they may be entitled.
7.9 FURTHER ACTIONS. The officers of Holding Company and each merging
bank shall, in the name and on behalf of Holding Company and the respective
banks, make all such arrangements, do and perform all such acts and things, and
execute and deliver all such certificates and such other instruments and
documents as may be reasonably necessary or appropriate in order to fully
consummate the transaction herein described.
IN WITNESS WHEREOF, the parties hereto have duly executed this
Agreement and Plan of Reorganization as of the date first written.
ATTEST: FIRST MUTUAL SAVINGS BANK
/s/ Phyllis A. Easterlin /s/ John Valaas
- ------------------------------- ----------------
By John Valaas, President
-8-
<PAGE>
ATTEST: FIRST INTERIM BANK (in formation)
/s/ Phyllis A. Easterlin
- ------------------------
By
/s/ Mary Case Dunnam
-------------------------
Mary Case Dunnam, Incorporator
/s/ George W. Rowley, Jr.
-------------------------
George W. Rowley, Jr., Incorporator
/s/ John R. Valaas
-------------------------
John R. Valaas, Incorporator
/s/ H. Scott Wallace
-------------------------
H. Scott Wallace, Incorporator
/s/ Janine Florence
-------------------------
Janine Florence, Incorporator
/s/ F. Kemper Freeman, Jr.
-------------------------
F. Kemper Freeman, Jr., Incorporator
/s/ Victor E. Parker
-------------------------
Victor E. Parker, Incorporator
/s/ William E. Tremper
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William E. Tremper, Incorporator
/s/ James J. Doud, Jr.
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James J. Doud, Jr., Incorporator
/s/ Richard S. Sprague
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Richard S. Sprague, Incorporator
/s/ Robert C. Wallace
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Robert C. Wallace, Incorporator
<PAGE>
ATTEST: /s/ Phyllis A. Easterlin FIRST MUTUAL BANCSHARES, INC.
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/s/ John R. Valaas
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By John Valaas, President
<PAGE>
SCHEDULE 1.6(a)
DIRECTORS OF FIRST MUTUAL SAVINGS BANK
GROUP I
Janine Florence
F. Kemper Freeman, Jr.
Victor E. Parker
William E. Tremper
GROUP II
Mary Case Dunnam
George W. Rowley, Jr.
John R. Valaas
H. Scott Wallace
GROUP III
James J. Doud, Jr.
Richard S. Sprague
Robert C. Wallace
<PAGE>
SCHEDULE 1.6(b)
EXECUTIVE OFFICERS OF FIRST MUTUAL SAVINGS BANK
NAME POSITION HELD
John R. Valaas President, Chief Executive Officer
Roger A. Mandrey Executive Vice President, Chief Financial Officer
James R. Boudreau Senior Vice President, Chief Credit Officer
Robin R. Carey Vice President Operations and Administration
Nancy Chermak Vice President Loan Administration
Pamela S. Drexler Vice President Loan Servicing
Carolyn F. Ellingson Vice President Central Banking Operations
Robert J. Everett Vice President Income Property Lending
Scott B. Harlan Vice President Residential and Consumer Lending
Tony S. Icasiano Vice President Controller
Kenneth J. Walkky Vice President Income Property Lending
Ronald P. Werth Vice President Business Banking
J. Robert Wicks Vice President Branch Administration
James D. Young Vice President Asset Management
