FORM 10-K
Amendment No. 1
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
(Mark One):
[ ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 [Fee required]
For the fiscal year ended
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OR
[X] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 [No fee required]
For the transition period from July 1, 1996 to December 31, 1996
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COMMISSION FILE NUMBER 0-20800
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STERLING FINANCIAL CORPORATION
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(Exact name of registrant as specified in its charter)
Washington 91-1572822
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
111 North Wall Street, Spokane, Washington 99201
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(Address of principal executive offices) (Zip code)
Registrant's telephone number, including area code:
(509) 458-2711
Securities registered pursuant to Section 12(b) of the Act:
None None
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(Title of class) (Name of each exchange
on which registered)
Securities registered pursuant to Section 12(g) of the Act:
Common Stock ($1.00 par value)
$1.8125 Cumulative Convertible Preferred Stock ($1.00 par value)
8.75% Subordinated Notes Due 2000
(Title of class)
<PAGE>
Indicate by check mark whether the registrant (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities
Exchange Act of 1934 during the preceding 12 months (or for such
shorter period that the registrant was required to file such reports),
and (2) has been subject to such filing requirements for the past 90
days.
Yes X No
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Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be
contained, to the best of registrant's knowledge, in definitive proxy
or information statements incorporated by reference in Part III of
this Form 10-K or any amendment to this Form 10-K. Yes X No
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As of February 28, 1997, the aggregate market value of the voting
stock held by non-affiliates of the registrant, computed by reference
to the average of the bid and asked prices on such date as reported by
the Nasdaq National Market, was $91,261,961.
The number of shares outstanding of the Registrant's Common Stock, par
value $1.00 per share, as of February 28, 1997 was 5,543,007.
DOCUMENTS INCORPORATED BY REFERENCE
Specific portions of the Registrant's Proxy Statement dated March 21,
1997 are incorporated by reference into Part III hereof.
<PAGE>
STERLING FINANCIAL CORPORATION
DECEMBER 31, 1996 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
PART I
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Item 1. Business
General
Lending Activities
Investments and Mortgage-Backed Securities
Sources of FundsSubsidiaries
Competition
Personnel
Regulation
PART II
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Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations
General
Net Interest Income
Asset and Liability Management
Mortgage-Backed Securities
Results of Operations for the Six Months Ended
December 31, 1996 and 1995
Results of Operations for Fiscal Years Ended June 30,
1996 and 1995
Liquidity and Sources of Funds
Capital Resources
New Accounting Standards
Effects of Inflation and Changing Prices
SIGNATURES
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<PAGE>
ANY TREND OR FORWARD-LOOKING INFORMATION DISCUSSED IN THIS REPORT IS
SUBJECT TO NUMEROUS POSSIBLE RISKS AND UNCERTAINTIES. THESE INCLUDE
BUT ARE NOT LIMITED TO: THE POSSIBILITY OF ADVERSE ECONOMIC
DEVELOPMENTS WHICH MAY, AMONG OTHER THINGS, INCREASE DEFAULT AND
DELINQUENCY RISKS IN STERLING'S LOAN PORTFOLIOS; SHIFTS IN INTEREST
RATES WHICH MAY RESULT IN LOWER INTEREST RATE MARGINS; CHANGING
ACCOUNTING POLICIES; CHANGES IN THE MONETARY AND FISCAL POLICIES OF
THE FEDERAL GOVERNMENT; THE CONSTANTLY CHANGING REGULATORY AND
COMPETITIVE ENVIRONMENT, AND OTHER RISKS. STERLING'S FUTURE RESULTS
MAY DIFFER MATERIALLY FROM HISTORICAL RESULTS AS WELL AS FROM ANY
TREND OR FORWARD-LOOKING INFORMATION INCLUDED IN THIS REPORT.
PART I
Item 1. BUSINESS
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General
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Sterling Financial Corporation ("Sterling") is a unitary savings and
loan holding company, the significant operating subsidiary of which is
Sterling Savings Association ("Sterling Savings"). The significant
operating subsidiaries of Sterling Savings are Action Mortgage Company
("Action Mortgage"), INTERVEST-Mortgage Investment Company
("INTERVEST") and Harbor Financial Services, Inc. ("Harbor
Financial"). Sterling Savings commenced operations in 1983 as a State
of Washington-chartered, federally insured stock savings and loan
association headquartered in Spokane, Washington. Sterling, with
$1.5 billion in total assets at December 31, 1996, attracts Federal
Deposit Insurance Corporation ("FDIC") insured deposits from the
general public through 41 retail branches located primarily in rural
and suburban communities in Washington and Oregon. Sterling
originates loans through its branch offices as well as 10 Action
Mortgage residential loan production offices in the Spokane and
Seattle, Washington; Portland, Oregon and Boise, Idaho metropolitan
areas and three INTERVEST commercial real estate lending offices
located in the metropolitan areas of Seattle and Spokane, Washington
and Portland, Oregon. Sterling also markets tax-deferred annuities,
mutual funds and other financial products through Harbor Financial.
Sterling's revenues are derived primarily from interest earned on
loans and mortgage-backed securities, from fees and service charges
and from mortgage banking operations. The operations of Sterling
Savings, and savings institutions generally, are influenced
significantly by general economic conditions and by policies of its
primary thrift regulatory authorities, the Office of Thrift
Supervision ("OTS"), the FDIC and the State of Washington Department
of Financial Institutions ("Washington Supervisor").
Recently, Sterling has reorganized and focused its efforts on becoming
more like a community retail bank by increasing its business banking,
consumer and construction lending while increasing its retail
deposits. Sterling changed its fiscal year end from June 30 to
December 31, effective December 31, 1996. Accordingly, results of
operations included herein have been presented for the six months
ended December 31, 1996 and 1995.
<PAGE>
On September 30, 1996, federal legislation was enacted which included
provisions regarding the recapitalization of the Savings Association
Insurance Fund ("SAIF"), which is operated by the FDIC and provides
deposit insurance for thrift institutions. The new legislation
required SAIF-insured savings institutions, like Sterling Savings, to
pay a one-time special assessment of $0.657 for every $100 of deposits
as of March 31, 1995. Sterling's SAIF assessment resulted in a pre-
tax charge to earnings of $5.8 million during the six months ended
December 31, 1996. The special assessment is designed to capitalize
the SAIF up to the prescribed 1.25% of SAIF-insured deposits.
Deposits insured by SAIF are currently assessed at the rate of zero to
$0.27 per $100 of domestic deposits. The SAIF assessment rate may
increase or decrease as is necessary to maintain the designated SAIF
reserve ratio of 1.25% of insured deposits.
Effective January 1, 1997, all FDIC-insured depository institutions
must pay an annual assessment to provide funds for the payment of
interest on bonds issued by the Financing Corporation, a federal
corporation chartered under the authority of the Federal Housing
Finance Board. The bonds ("FICO Bonds") were issued to capitalize the
Federal Savings and Loan Insurance Corporation. Until December 31,
1999 or when the last savings and loan association ceases to exist,
whichever occurs first, depository institutions will pay approximately
$.064 per $100 of SAIF-assessable deposits and approximately $.013 per
$100 of Bank Insurance Fund ("BIF") assessable deposits.
The new legislation contemplates a unification of the charters
presently available to banks and thrifts. The Treasury Department is
required to make recommendations regarding unification of the
available charters and the merger of the insurance funds by March 31,
1997. The legislation requires a merger of the SAIF with BIF on
January 1, 1999 if the unification of the charters for all insured
institutions has, in fact, occurred. SAIF and BIF will continue to
operate as separate funds, if this unification of charters has not
taken place, until such time as additional federal legislation is
passed requiring a merger of the funds.
Sterling Savings may be required to convert its charter to either a
national bank charter, a state depository institution charter, or a
newly designed charter. Sterling may also become regulated at the
holding company level by the Board of Governors of the Federal Reserve
System ("Federal Reserve") rather than by the OTS. Regulation by the
Federal Reserve could subject Sterling to capital requirements that
are not currently applicable to Sterling as a thrift holding company
under OTS regulation and may result in statutory limitations on the
type of business activities in which Sterling may engage at the
holding company level, which business activities currently are not
restricted. At this time, Sterling Savings is unable to predict
whether a charter change will be required and, if it is, whether the
charter change will significantly impact Sterling Savings' operations.
See "Regulation."
<PAGE>
Sterling intends to continue to pursue its growth strategy by focusing
on internal growth as well as acquisition opportunities. As part of
this strategy, Sterling is changing the mix of its assets and
liabilities to become more like a community-based retail bank.
Sterling may acquire (i) other financial institutions or branches
thereof, (ii) branch facilities, (iii) mortgage loan servicing
portfolios or mortgage banking operations, or (iv) other substantial
assets or deposit liabilities, all of which would be subject to prior
regulatory approval. As part of this growth strategy, Sterling
engages from time to time in discussions concerning possible
acquisitions. There can be no assurance, however, that Sterling will
be successful in identifying, acquiring or assimilating appropriate
acquisition candidates or be successful in implementing its internal
growth strategy or that these activities will result in improved
financial performance. See "Competition" and "Regulation."
Lending Activities
------------------
GENERAL. Sterling originates permanent and construction mortgage
loans collateralized by residential and commercial real estate,
business banking and consumer loans. The following table sets forth
information on loan origination and sale activities for the periods
indicated.
<TABLE>
<CAPTION>
Six Months Ended December 31, Fiscal Years Ended June 30,
---------------------------------- --------------------------------
1996 1995 1996 1995
--------------- ----------------- --------------------------------
Amount % Amount % Amount % Amount %
-------- ------ -------- ------ -------- ------ -------- ------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Mortgage--permanent:
One- to four-family
residential $72,524 23.0% $124,246 35.2% $216,968 31.7% $286,033 43.7%
Multifamily residential 2,200 0.7 9,875 2.8 11,094 1.6 19,398 3.0
Commercial property 16,790 5.3 25,861 7.3 28,761 4.2 11,460 1.7
Mortgage--construction:
One- to four-family
residential 94,331 29.9 76,137 21.6 177,606 26.0 144,136 22.0
Multifamily residential 12,735 4.0 29,303 8.3 68,169 10.0 29,945 4.6
Commercial property 10,925 3.5 17,455 5.0 35,234 5.1 21,850 3.3
Non-mortgage:
Consumer 33,333 10.6 25,934 7.4 48,764 7.1 61,769 9.4
Business banking 72,676 23.0 44,015 12.4 97,822 14.3 80,330 12.3
-------- ----- -------- ----- -------- ----- -------- -----
Total loans originated $315,514 100.0% $352,826 100.0% $684,418 100.0% $654,921 100.0%
======== ===== ======== ===== ======== ===== ======== =====
Residential mortgage
loans sold $ 77,856 $122,797 $232,061 $ 98,192
======== ======== ======== ========
</TABLE>
One- to Four-Family Residential Lending. Sterling originates
primarily fixed-rate mortgages. Sterling also originates adjustable-
rate mortgages ("ARMs"), which have interest rates that adjust
annually and are indexed to either the weekly average yield on one-
year U.S. Treasury securities or the Federal Home Loan Bank of Seattle
<PAGE>
Eleventh or Twelfth District Cost of Funds Indices. Sterling also
originates one- to four-family residential construction loans.
Since fiscal year 1994, there has been a significant decrease in the
volume of Sterling's permanent residential mortgage lending, primarily
due to a shrinking market. During the six months ended December 31,
1996 and the fiscal years ended June 30, 1996 and 1995, Sterling's
residential lending arm, Action Mortgage, increased its residential
construction lending in an effort to offset this decline in permanent
residential lending and to improve its operating margins. Sterling has
also placed greater emphasis on business banking and consumer lending.
Sterling continues to originate conventional and government-insured
residential loans for sale into the secondary mortgage market. Within
the secondary mortgage market for conventional loans, Sterling sells
its residential loans primarily on a servicing-released basis to
others. Sterling also sells loans to the Federal Home Loan Mortgage
Corporation (the "FHLMC") and the Federal National Mortgage
Association (the "FNMA"). Loans sold into the secondary market are
all sold without recourse to Sterling, except that Sterling may be
obligated to repurchase any loans which are not underwritten in
accordance with FHLMC and FNMA or applicable investor underwriting
guidelines. Sterling endeavors to underwrite residential loans in
compliance with FHLMC and FNMA underwriting standards. During the six
months ended December 31, 1996 and 1995, the number and amount of
loans repurchased from the FHLMC and the FNMA were not significant in
light of the number and amount of loans sold to the FHLMC and the
FNMA.
Conventional residential mortgage loans are originated for up to 95%
of the appraised value or selling price of the mortgaged property,
whichever is less. All loans with loan-to-value ratios in excess of
80% carry a requirement that the customer purchase private mortgage
insurance from approved third parties so that Sterling's risk is
limited to approximately 80% of the appraised value. Sterling's
residential lending programs are designed to comply with all
applicable regulatory requirements. For a discussion of Sterling's
management of interest rate risk ("IRR") on conventional loans, see "-
Secondary Market Activities."
Sterling makes residential construction loans on custom homes, pre-
sold homes and homes that are not pre-sold. Construction financing is
generally considered to involve a higher degree of risk than long-term
financing on improved, occupied real estate. Sterling's risk of loss
on construction loans depends largely upon the accuracy of the initial
estimate of the property's value at completion of construction or
development and the estimated cost (including interest) of
construction. If the estimate of construction costs proves to be
inaccurate, Sterling might have to advance funds beyond the amount
originally committed to permit completion of the development and to
protect its security position. Sterling also might be confronted, at
or prior to maturity of the loan, with a project with insufficient
value to ensure full repayment. Sterling's underwriting, monitoring
and disbursement practices with respect to construction financing are
intended to ensure that sufficient funds are available to complete
construction projects. Sterling endeavors to limit its risk through
its underwriting procedures, by using only approved, qualified
appraisers and by dealing only with qualified builders/borrowers.
<PAGE>
MULTIFAMILY RESIDENTIAL AND COMMERCIAL PROPERTY LENDING. Sterling
offers multifamily residential and commercial real estate loans as
both construction and permanent loans collateralized by real property
in the Pacific Northwest. Construction loans on such properties
typically have terms of 12 to 18 months and provide for variable
interest rates. Permanent loans on existing property typically have
maturities of 3 to 10 years. Multifamily residential and commercial
property loans generally involve a higher degree of risk than the
financing of one- to four-family residential real estate because they
typically involve large loan balances to single borrowers or groups of
related borrowers. The payment experience on such loans is typically
dependent on the successful operation of the real estate project, and
is subject to certain risks not present in one- to four-family
residential mortgage lending. These risks include excessive vacancy
rates or inadequate rental income levels. Construction lending is
subject to risks such as construction delays, cost overruns,
insufficient values and an inability to obtain permanent financing in
a timely manner. Sterling attempts to reduce its exposure to these
risks, typically by investigating the borrowers' finances, by
requiring financial statements from the borrowers and requiring such
statements to be updated at least annually, by requiring operating
statements on the properties and by acquiring personal guarantees from
the borrowers.
CONSUMER LENDING. Sterling's consumer lending program provides loans
for home improvement, automobiles, personal lines of credit, boats and
certain other purposes. Generally, consumer loans are originated for
terms ranging from six months to ten years. Interest rates are either
fixed or adjustable monthly, quarterly or semiannually, based on a
contractual formula at a margin over an established external index.
Sterling also makes loans collateralized by savings accounts and
second mortgage loans collateralized by real estate. Fixed-rate
secured financing is available with amortization terms up to 15 years
although Sterling typically has the right to demand a balloon payment
at five years.
BUSINESS BANKING LENDING. Sterling offers business banking loans
primarily collateralized by property. Such collateral is typically
comprised of accounts receivable, inventory and equipment. Business
lending is generally considered to involve a higher degree of risk
than the financing of real estate, primarily because security
interests in the collateral are more difficult to perfect and the
collateral may be difficult to obtain or liquidate following an
uncured default. Business banking loans typically offer relatively
higher yields, short maturities and variable interest rates. The
availability of such loans enables potential depositors to establish a
full-service banking relationship with Sterling. Sterling attempts to
reduce the risk of loss associated with business lending by closely
monitoring the financial condition and performance of its customers.
Sterling's Private Banking Group provides services to higher net worth
and higher income borrowers by originating a variety of consumer and
business banking loans to meet their needs. Such loans generally meet
the same underwriting requirements as similar loans of the same type
but typically involve larger balances and may have nonstandard terms.
As a result of the BIF/SAIF legislation, financial institutions, like
Sterling, are permitted to increase the volume of business banking
loans held in its portfolio from 10% of assets to 20% of assets.
<PAGE>
LOAN PORTFOLIO ANALYSIS. The following table sets forth the
composition of Sterling's loan portfolio by type of loan at the dates
indicated.
<TABLE>
<CAPTION>
June 30,
------------------------------------------------------------------------------
December 31, 1996 1996 1995 1994 1993
------------------- ------------------ ------------------ ------------------ ------------------
Amount % Amount % Amount % Amount % Amount %
---------- ------- ---------- ------ ---------- ------ ---------- ------ ---------- ------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Mortgage--permanent:
One- to four-family
residential $ 274,757 26.6% $ 302,526 30.0% $ 600,438 53.0% $ 575,363 64.3% $ 389,177 63.4%
Multifamily residential 69,728 6.8 64,305 6.4 59,776 5.3 45,188 5.1 50,543 8.2
Commercial property 102,279 9.9 101,243 10.1 85,511 7.5 78,822 8.8 76,125 12.4
Land and other 361 0.0 374 0.0 2,271 0.2 2,702 0.3 4,406 0.7
---------- ----- ---------- ----- ---------- ----- ---------- ----- ---------- -----
447,125 43.3 468,448 46.5 747,996 66.0 702,075 78.5 520,251 84.7
---------- ----- ---------- ----- ---------- ----- ---------- ----- ---------- -----
Mortgage--construction:
One- to four-family
residential 148,252 14.3 137,930 13.7 113,531 10.0 37,054 4.1 14,014 2.3
Multifamily residential 77,743 7.5 79,048 7.8 42,158 3.7 31,856 3.6 6,499 1.1
Commercial property 37,875 3.7 40,003 4.0 22,630 2.0 833 0.1 375 0.1
---------- ----- ---------- ----- ---------- ----- ---------- ----- ---------- -----
263,870 25.5 256,981 25.5 178,319 15.7 69,743 7.8 20,889 3.5
---------- ----- ---------- ----- ---------- ----- ---------- ----- ---------- -----
Total mortgage loans 710,995 68.8 725,429 72.0 926,315 81.7 771,818 86.3 541,140 88.2
Consumer 123,340 11.9 111,507 11.1 108,182 9.5 69,316 7.8 43,870 7.2
Business banking 199,848 19.3 169,830 16.9 99,528 8.8 52,700 5.9 28,507 4.6
---------- ----- ---------- ----- ---------- ----- ---------- ----- ---------- -----
Total loans receivable 1,034,183 100.0% 1,006,766 100.0% 1,134,025 100.0% 893,834 100.0% 613,517 100.0%
Undisbursed portion of ===== ===== ===== ===== =====
loans in process (91,791) (112,325) (73,584) (44,148) (13,009)
Deferred loan origination
costs (fees) 468 891 3,153 2,082 (177)
Discount on loans acquired
pursuant to purchase
transactions (629) (776) (1,122) (1,508) (1,943)
Allowance for loan losses (7,891) (7,889) (7,361) (5,740) (4,719)
---------- ---------- ---------- ---------- ----------
Loans receivable $ 934,340 $ 886,667 $1,055,111 $ 844,520 $ 593,669
========== ========== ========== ========== ==========
</TABLE>
<PAGE>
CONTRACTUAL PRINCIPAL PAYMENTS. The following table sets forth the
scheduled contractual principal repayments for Sterling's loan
portfolio at December 31, 1996. Demand loans, loans having no stated
repayment schedule and no stated maturity, and overdrafts are reported
as due in one year or less. Loan balances do not include undisbursed
loan proceeds, unearned discounts, deferred loan origination fees or
allowances for loan losses.
<TABLE>
<CAPTION>
Principal Payments Contractually
Balance Due in Fiscal Years
Outstanding at -----------------------------------
December 31, 1996 1997 1998-2001 Thereafter
----------------- ---------- ---------- ----------
(Dollars in thousands)
<S> <C> <C> <C> <C>
Mortgage--permanent:
Fixed-rate $ 137,600 $ 14,256 $ 65,087 $ 58,257
Variable-rate 309,525 10,872 62,049 236,604
Mortgage--construction 263,870 146,577 107,584 9,709
Consumer 123,340 30,159 36,636 56,545
Business banking 199,848 52,771 47,512 99,565
---------- ----------- ---------- ----------
$1,034,183 $ 254,635 $ 318,868 $ 460,680
========== ========== ========== ==========
</TABLE>
LOAN SERVICING. Sterling services its own loans as well as loans
owned by others. Loan servicing includes collecting and remitting
loan payments, accounting for principal and interest, holding escrow
funds for the payment of real estate taxes and insurance premiums,
contacting delinquent borrowers and supervising foreclosures in the
event of unremedied defaults.
Sterling receives a fee, generally ranging from 0.25% to 0.375% of the
unpaid principal balance of each loan serviced for others, to
compensate it for the costs of performing the servicing function. If
such fee exceeds the standard for that type of loan, the net present
value of the excess servicing fee is capitalized as an asset and,
subsequently, amortized into servicing fee income, using an
appropriate discount rate and certain prepayment assumptions. The
majority of conventional, Federal Housing Administration ("FHA") and
Veteran's Administration ("VA") insured loans are sold into the
secondary market on a loan-by-loan servicing-released basis. Sterling
generally receives a fee of approximately 1.0% to 2.0% of the
principal balance of such loans for releasing the servicing.
At December 31, 1996 and June 30, 1996 and 1995, Sterling serviced
for itself and for other investors mortgage loans totaling $1.5
billion, $1.5 billion and $1.7 billion, respectively. Of such
mortgage loans, Sterling serviced $530.5 million, $574.6 million and
$632.7 million, respectively, at these dates for the FHLMC and the
FNMA. Sterling's ability to continue as a seller/servicer for the
FHLMC and the FNMA is dependent upon meeting the qualifications of
these agencies. Sterling currently meets all applicable requirements
and anticipates meeting such requirements in the future.
<PAGE>
From time to time, Sterling has sold portfolios of servicing rights
primarily to improve earnings and to increase its regulatory capital
ratios. During the six months ended December 31, 1996, Sterling did
not sell any portfolio of servicing rights. During the fiscal years
ended June 30, 1996 and 1995, Sterling sold bulk rights to service
conventional loans for others of approximately $172.2 million and
$437.8 million, respectively. Further, during the six months ended
December 31, 1996 and the fiscal years ended June 30, 1996 and 1995,
sales of loans into the secondary market were made primarily on a
servicing-released basis. These activities, while improving near-term
earnings, reduce the servicing portfolio and will result in lower
mortgage servicing income being reported in future periods. See
"Management's Discussion and Analysis of Financial Condition and
Results of Operations" hereafter referred to as "Management's
Discussion and Analysis" "- Results of Operations - Other Income."
SECONDARY MARKET ACTIVITIES. Sterling has developed correspondent
relationships with a number of independent brokers and financial
institutions to facilitate the origination or purchase and sale of
mortgage loans in the secondary market on either a participation or
whole loan basis. Substantially all of such purchased loans or
participations are secured by real estate located in the Pacific
Northwest. Those agents who present loans to Sterling for purchase
are required to provide a processed loan package prior to commitment.
Sterling then underwrites the loan in accordance with its established
lending standards. Sterling endeavors to underwrite residential loans
in compliance with FHLMC and FNMA underwriting standards. Although
management has the authority to purchase loans secured by real estate
located outside of its general lending areas, it generally has not
done so.
In originating one- to four-family residential mortgage loans for sale
in the secondary market, Sterling incurs market risk from the time of
the loan commitment until such time as the loan (or resulting
mortgage-backed security received in exchange for a pool of loans) is
sold. To help minimize this risk, Sterling obtains commitments from
investors to purchase loans or mortgage-backed securities at specified
yields or utilizes hedging techniques such as purchasing put options
which give Sterling the right to sell mortgage-backed securities at a
fixed price with respect to a portion of its loan commitments. These
actions are based upon estimated closings of loans. FHA/VA-insured
loans are usually sold immediately into the secondary market,
resulting in very little market risk exposure to Sterling. There can
be no assurance that such funding and hedging techniques will always
be successful.
LOAN COMMITMENTS. Sterling uses commitments to individual borrowers
and mortgage brokers for the purposes of originating and purchasing
loans. These commitments establish the terms and conditions under
which Sterling will fund the loans and closing must occur within a
specified period of time. Sterling had outstanding commitments to
originate or purchase loans aggregating $64.1 million at December 31,
1996. Sterling also had secured and unsecured commercial and personal
lines of credit totaling approximately $93.2 million, of which the
undisbursed portion is approximately $40.7 million at December 31,
1996. See Note 16 of "Notes to Consolidated Financial Statements"
included herein.
<PAGE>
CLASSIFIED ASSETS, REAL ESTATE OWNED AND DELINQUENT LOANS. To measure
the quality of assets, including loans and real estate owned ("REO"),
Sterling has established guidelines for classifying assets and
determining provisions for anticipated loan and REO losses. Under
these guidelines, an allowance for anticipated loan and REO losses is
established when certain conditions exist. This system for
classifying and reserving for loans and REO is administered by
Sterling's Special Assets Department, which is responsible for
minimizing loan deficiencies and losses therefrom. An oversight
committee, comprised of senior management, monitors the activities and
progress of the Special Assets Department and reports results to
Sterling's Board of Directors.
Under this system, Sterling classifies loans and other assets it
considers of questionable quality. Sterling's system employs the
classification categories of "substandard," "doubtful" and "loss."
Substandard assets have deficiencies which give rise to the distinct
possibility that Sterling will sustain some loss if the deficiencies
are not corrected. Doubtful assets have the weaknesses of substandard
assets with the additional characteristic that the weaknesses make
collection or liquidation in full, on the basis of currently existing
facts, conditions and values, questionable, and there is a high
probability of loss. An asset classified as loss is considered
uncollectible and of such little value that it should not be included
as an asset of Sterling. Total classified assets increased to $16.1
million at December 31, 1996 from $8.1 million and $9.7 million at
June 30, 1996 and 1995, respectively. As a percentage of total
assets, classified assets were 1.0%, 0.6% and 0.6%, respectively, for
these periods. See "-Major Classified Loans."
Assets classified as substandard or doubtful require the establishment
of general valuation allowances in amounts considered by management to
be adequate under generally accepted accounting principles ("GAAP").
Assets classified as loss require either a specific valuation
allowance of 100% of the amount classified or a write-off of such
amount. At December 31, 1996, Sterling's assets classified as loss
totaled $598,000. Judgments regarding the adequacy of a general
valuation allowance are based on continual evaluation of the nature,
volume and quality of the loan portfolio, REO and other assets,
specific problem assets and current economic conditions that may
affect the recoverability of recorded amounts.
REO is recorded at the lower of estimated fair value, less estimated
selling expenses or cost at foreclosure. Fair value is defined as the
amount in cash or cash-equivalent value of other consideration that a
real estate asset would yield in a current sale between a willing
buyer and a willing seller. Development and improvement costs
relating to the property are capitalized to the extent they are deemed
to be recovered upon disposal. The carrying value of acquired
property is continuously evaluated and, if necessary, an allowance is
established to reduce the carrying value to net realizable value
(which considers, among other things, estimated direct holding costs
and selling expenses). Loans are treated as in-substance foreclosed
if (i) the borrower has little or no equity in the collateral, (ii)
proceeds for repayment of the loan can only be expected from the
operation or sale of the collateral and (iii) the borrower has given
up control of the collateral to Sterling or has retained control but
does not appear to be able to rebuild equity in the collateral in the
near future.
<PAGE>
The following table sets forth the activity in Sterling's REO for the
periods indicated.
Fiscal Years Ended June 30,
Six Months Ended ---------------------------
December 31, 1996 1996 1995
----------------- ------- -------
(Dollars in thousands)
Balance at beginning
of period $ 4,874 $ 5,298 $ 7,298
Loan foreclosures and
other additions 1,839 1,628 1,568
Capitalized expenses 181 124 0
Sales and other
reductions (2,889) (2,108) (3,534)
Provisions for loss (31) (68) (34)
------- ------- -------
Balance at end of
period $ 3,974 $ 4,874 $ 5,298
======= ======= =======
MAJOR CLASSIFIED LOANS. Each of Sterling's classified loans with
a net carrying value at December 31, 1996 of more than $400,000 is
described below. The following loans are classified as substandard at
December 31, 1996.
Sterling Savings originated four loans secured by deeds of trust on
commercial property located in Spokane, Washington, accounts
receivable, inventory and a first lien on equipment and fixtures. The
loans are current, but are classified due to inadequate working
capital and operating performance. The aggregate carrying value on
these loans at December 31, 1996 was $4.9 million. No specific
allowance has been established for these loans.
INTERVEST originated a commercial construction loan secured by two 2-
story office buildings in Richland, Washington. The borrower has
filed for Chapter 11 bankruptcy, and Sterling is currently preparing a
motion for relief from stay in order to foreclose. The carrying value
on this loan at December 31, 1996 was approximately $1.6 million. No
specific allowance has been established for this loan.
Sterling Savings acquired a loan secured by a deed of trust on a
pyrolysis (tire recycling) plant located in Chehalis, Washington and
by deeds of trust on residential properties and assignments of real
estate contracts. This nonperforming loan was acquired through
Sterling's past acquisition of an insolvent thrift association. The
carrying value on the loan at December 31, 1996 was $1.0 million. No
specific allowance has been established for this loan.
Sterling Savings originated two commercial loans secured by first and
second deeds of trust on an office/retail property located in Spokane,
Washington. These loans are current but are classified for not
meeting restrictive covenants. The carrying value on these loans at
December 31, 1996 was approximately $458,000. No specific allowance
has been established for these loans.
<PAGE>
MAJOR REAL ESTATE OWNED. Each of Sterling's REO properties with a net
carrying value at December 31, 1996 of more than $400,000 is described
below.
Sterling is a 99.5% partner in a partnership which owns a commercial
office building in Renton, Washington acquired through an assignment
of interest from a bankrupt Spokane borrower. The carrying value at
December 31, 1996 was $2.5 million, net of a specific loss allowance
of $192,000. The project consists of a five-story office building
with 30,510 square feet of rentable area and adjoining undeveloped
property. The office building is currently 41.7% leased, with active
marketing and negotiations being pursued to lease the remaining 17,800
square feet. An effort is being made to sell the entire project.
Sterling acquired a three-story office/retail/restaurant building
located in Olympia, Washington through foreclosure in August 1991.
The restaurant space has been converted to office space, and leasing
efforts are proceeding. The carrying value on this property at
December 31, 1996 was $632,000, net of a specific loss allowance of
$196,000.
DELINQUENT LOAN PROCEDURES. Delinquent and problem loans are part of
any lending business. If a borrower fails to make a required payment
when due, Sterling institutes internal collection procedures. For
residential mortgage loans, Sterling's collection procedures generally
provide that an initial mailing requesting payment be made to the
borrower when the loan is 15 days past due. At 25 days past due, the
borrower is contacted by telephone and payment is requested orally.
In most cases, deficiencies are cured promptly. At 30 days past due,
Sterling tracks the loan as a delinquency. At 45 days past due, a
notice of intent to foreclose is mailed. If the loan is still
delinquent 30 days following the mailing of the notice of intent to
foreclose, Sterling generally initiates foreclosure proceedings. In
certain instances, Sterling may modify the loan or grant a limited
moratorium on loan payments to enable the borrower to reorganize his
or her financial affairs.
The following table summarizes the principal balance of nonperforming
assets at the dates indicated.
<TABLE>
<CAPTION>
June 30,
December 31, -------------------------------------
1996 1996 1995 1994 1993
------------ ------- ------- ------- -------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C>
Nonaccrual loans $ 2,329 $ 3,352 $ 3,395 $ 2,262 $ 5,065
Restructured loans 215 240 254 188 283
------- ------- ------- ------- -------
Total nonperforming loans 2,544 3,592 3,649 2,450 5,348
Real estate owned (1) 3,974 4,874 5,298 7,298 6,979
------- ------- ------- ------- -------
Total nonperforming assets $ 6,518 $ 8,466 $ 8,947 $ 9,748 $12,327
======= ======= ======= ======= =======
Ratio of total nonperforming
assets to total assets 0.4% 0.6% 0.6% 0.7% 1.2%
======= ======= ======= ======= =======
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
June 30,
December 31, -------------------------------------
1996 1996 1995 1994 1993
------------ ------- ------- ------- -------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C>
Ratio of total nonperforming
loans to total loans 0.3% 0.4% 0.3% 0.3% 0.9%
======= ======= ======= ======= =======
Ratio of allowance for
estimated losses on loans
to total nonperforming
loans (2) 305.3% 224.15% 205.7% 234.4% 86.0%
======= ======= ======= ======= =======
</TABLE>
(1) Amount is net of the allowance for REO losses.
(2) Excludes loans classified as loss from allowance for loan losses
and from total nonperforming loans. Loans classified as loss
excluded from allowance for loan losses were $262,000, $213,000,
$145,000, $7,000 and $314,000 at December 31, 1996 and June 30,
1996, 1995, 1994 and 1993, respectively. Loans classified as loss
excluded from total nonperforming loans were $45,000, $167,000,
$141,000, $4,000 and $223,000 at December 31, 1996 and
June 30, 1996, 1995, 1994 and 1993, respectively.
Sterling regularly reviews the collectibility of accrued interest
income and generally ceases to accrue interest on a loan when either
principal or interest is past due by 90 days or more. Any accrued and
uncollected interest is eliminated from income at that time. Loans may
be placed in nonaccrual status earlier if, in management's judgment,
the loan may be uncollectible. Interest on such a loan is then
recognized as income only if collected or if the loan is restored to
performing status. Additional interest income of $86,000, $151,000,
$224,000 and $231,000 would have been recorded during the six months
ended December 31, 1996 and 1995 and the fiscal years ended June 30,
1996 and 1995, respectively, if nonaccrual and restructured loans had
been current in accordance with their original contractual terms.
Sterling's quality control staff reviews various aspects of residential
real estate loans originated and acquired by Sterling to ensure
compliance with appropriate underwriting criteria. The results of
these reviews assist Sterling in monitoring the performance of its
personnel and independent appraisers. Sterling's mortgage loan quality
control function is intended to conform to guidelines and standards
established by the FNMA and the FHLMC, and as applicable, by other
private investors.
Sterling's quality control staff reviews other types of loans
(consumer, business banking and commercial real estate) and reports its
results to Sterling's Senior Loan Committee, which includes the Senior
Vice President of Loan Administration. The quality control staff checks
for appropriate documentation as well as conformance to Sterling's
underwriting criteria.
<PAGE>
ALLOWANCE FOR LOAN AND REAL ESTATE OWNED LOSSES. Generally, Sterling
establishes specific allowances for the difference between the
anticipated fair value (market value less selling costs, foreclosure
costs and projected holding costs), adjusted for other possible sources
of repayment, and the book balance (loan principal or carrying value of
REO) of its loans classified as loss and REO. Each classified loan and
REO property is reviewed at least monthly. Allowances are established
or periodically increased, if necessary, based on the review of
information obtained through on-site inspections, market analysis,
appraisals and purchase offers. See Note 6 of "Notes to Consolidated
Financial Statements."
Management believes that the allowance for loan losses is adequate
given the composition and risks of the loan portfolio, although there
can be no assurance that the allowance will be adequate to cover all
contingencies. The following table sets forth information regarding
changes in Sterling's allowance for estimated losses on loans for the
periods indicated.
<TABLE>
<CAPTION>
Fiscal Years Ended June 30,
Six Months Ended ------------------------------
December 31, 1996 1996 1995 1994 1993
----------------- ------ ------ ------ ------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C>
Balance at beginning
of period $ 7,889 $ 7,361 $ 5,740 $ 4,719 $ 4,745
Charge-offs:
Mortgage--permanent (767) (751) (795) (565) (1,575)
Mortgage--
construction (7) 0 0 0 0
Consumer (382) (408) (216) (57) (4)
Business banking (19) (5) (9) (3) (7)
------- ------- ------ ------- -------
Total charge-offs (1,175) (1,164) (1,020) (625) (1,586)
------- ------- ------ ------- -------
Recoveries:
Mortgage--permanent 30 23 61 39 57
Consumer 39 45 23 7 2
Business banking 8 24 5 0 1
------- ------- ------ ------- -------
Total recoveries 77 92 89 46 60
------- ------- ------ ------- -------
Net charge-offs (1,098) (1,072) (931) (579) (1,526)
Provisions for loan
losses 1,100 1,600 1,600 1,600 1,500
Allowance for losses
on assets acquired 0 0 952 0 0
------- ------- ------ ------- -------
Balance at end of
period $ 7,891 $ 7,889 $ 7,361 $ 5,740 $ 4,719
======= ======= ======= ======= =======
Allowances allocated
to loans classified
as loss $ 262 $ 213 $ 145 $ 7 $ 314
======= ======= ======= ======= =======
Ratio of net charge-offs
to average loans out-
standing during the
period 0.12% 0.11% 0.09% 0.08% 0.29%
======= ======= ======= ======= =======
</TABLE>
<PAGE>
Allowances are provided for individual loans that are contractually
past due where ultimate collection is considered questionable by
management. Such allowances are based, among other factors, upon the
net realizable value of the security of the loan or guarantees, if
applicable. The following table sets forth the allowances for
estimated losses on loans by loan category, based upon management's
assessment of the risk associated with such categories, at the dates
indicated, and summarizes the percentage of gross loans in each
category to total gross loans.
<TABLE>
<CAPTION>
June 30,
--------------------------------------------------------
December 31, 1996 1996 1995
--------------------------- --------------------------- ---------------------------
Loans in Category Loans in Category Loans in Category
as a Percentage of as a Percentage of as a Percentage of
Amount Total Gross Loans Amount Total Gross Loans Amount Total Gross Loans
------- ------------------ ------- ------------------ ------- ------------------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C> <C>
Mortgage-
permanent $ 3,156 43.3% $ 3,047 46.5% $ 3,375 66.0%
Mortgage-
construction 2,380 25.5 1,969 25.5 1,369 15.7
Consumer 334 11.9 403 11.1 366 9.5
Business banking 1,196 19.3 1,075 16.9 856 8.8
Unallocated 825 N/A 1,395 N/A 1,395 N/A
------- ----- ------- ----- ------- -----
$ 7,891 100.0% $ 7,889 100.0% $ 7,361 100.0%
======= ===== ======= ===== ======= =====
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
June 30,
--------------------------------------------------------
1994 1993
--------------------------- ---------------------------
Loans in Cateogry Loans in Category
as a Percentage of as a Percentage of
Amount Total Gross Loans Amount Total Gross Loans
------- ------------------ ------- ------------------
(Dollars in thousands)
<S> <C> <C> <C> <C>
Mortgage-
permanent $ 3,309 78.5% $ 3,035 84.7%
Mortgage-
construction 969 7.8 569 3.5
Consumer 359 7.8 209 7.2
Business banking 660 5.9 463 4.6
Unallocated 443 N/A 443 N/A
------- ----- ------- -----
$ 5,740 100.0% $ 4,719 100.0%
======= ===== ======= =====
</TABLE>
<PAGE>
Investments and Mortgage-backed Securities
------------------------------------------
Sterling invests primarily in mortgage-backed securities issued by the
FHLMC and the Government National Mortgage Association, U.S.
Government and agency obligations and stock in the Federal Home Loan
Bank of Seattle ("FHLB Seattle"). Such investments provide Sterling
with liquidity, a source of interest income and collateral which can
be used to secure borrowings. Sterling has, since its inception,
invested in investment-grade securities; it does not invest in high-
yield, below investment-grade securities. See Note 2 of "Notes to
Consolidated Financial Statements."
The following table provides the carrying values, maturities and
weighted average yields of Sterling's investment and mortgage-backed
securities portfolio at December 31, 1996.
<TABLE>
<CAPTION>
Maturity
------------------------------------------------------
Less than One to Five to Over
One Year Five Years Ten Years Ten Years Total
--------- ---------- --------- --------- ---------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C>
Mortgage-backed
securities, at fair
value(1):
Balance $ 0 $108,246 $ 11,147 $257,547 $376,940
Weighted average
yield 0.00% 5.86% 6.55% 6.62% 6.40%
U.S. government and
agency obligations,
at fair value(1):
Balance 0 66,919 0 0 66,919
Weighted average
yield 0.00 6.67 0.00 0.00 6.67
FHLB Seattle stock,
at cost:
Balance 0 0 0 25,923 25,923
Weighted average
yield(2) 0.00 0.00 0.00 7.00 7.00
Municipal bonds(3):
Balance 598 7,005 4,243 0 11,846
Weighted average
yield 4.26 4.40 4.73 0.00 4.51
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
Maturity
------------------------------------------------------
Less than One to Five to Over
One Year Five Years Ten Years Ten Years Total
--------- ---------- --------- --------- ---------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C>
Other:
Balance $ 0 $ 0 $ 0 $ 33 $ 33
Weighted average
yield 0.00% 0.00% 0.00% 0.11% 0.11%
-------- -------- -------- -------- --------
Total carrying value $ 598 $182,170 $ 15,390 $283,503 $481,661
======== ======== ======== ======== ========
Weighted average
yield 4.26% 6.10% 6.05% 6.65% 6.42%
======== ======== ======== ======== ========
</TABLE>
(1) Based on contractual maturities.
(2) The weighted average yield on FHLB Seattle stock is based upon
the dividends received for the six months ended December 31,
1996.
(3) The weighted average yields on municipal bonds reflects the
actual yields on the bonds and is not tax effected.
The following tables set forth the carrying values and classifications
for financial statement reporting purposes of Sterling's investment
and mortgage-backed securities portfolio at the dates indicated.
<TABLE>
<CAPTION>
June 30,
------------------
December 31, 1996 1996 1995
----------------- -------- --------
(Dollars in thousands)
<S> <C> <C> <C>
Mortgage-backed securities $376,940 $399,893 $280,776
U.S. Government and agency
obligations 66,919 35,244 41,177
FHLB Seattle stock 25,923 24,911 23,151
Municipal bonds 11,846 11,854 12,223
Other 33 38 25
-------- -------- --------
Total $481,661 $471,940 $357,352
======== ======== ========
Available-for-sale $469,790 $460,061 $119,729
Held-to-maturity 11,871 11,879 237,623
-------- -------- --------
Total $481,661 $471,940 $357,352
======== ======== ========
Weighted average yield 6.42% 6.26% 6.16%
======== ======== ========
</TABLE>
<PAGE>
Sources of Funds
----------------
GENERAL. Sterling's primary sources of funds for use in lending and
for other general business purposes are deposits, loan repayments,
proceeds from sales of loans, proceeds from sales of mortgage-backed
and investment securities, FHLB Seattle advances and secured lines of
credit and other borrowings. Scheduled loan repayments are a
relatively stable source of funds, while other sources of funds are
influenced significantly by prevailing interest rates, interest rates
available on other investments and other economic conditions.
Borrowings may be used on a short-term basis to compensate for
reductions in other sources of funds (such as deposit inflows at less
than projected levels). Borrowings may also be used on a longer-term
basis to support expanded lending activities and to match repricing
intervals of assets. See "Lending Activities" and "Investments and
Mortgage-Backed Securities."
DEPOSIT ACTIVITIES. Sterling offers a variety of accounts for
depositors designed to attract both short-term and long-term deposits
from the general public. These accounts include certificates of
deposit ("CDs"), regular savings accounts and checking accounts,
including negotiable order of withdrawal ("NOW") accounts. These
accounts earn interest at rates established by management and are
based on a competitive market analysis. The method of compounding
varies from simple interest credited at maturity to daily compounding,
depending on the type of account.
With the exception of certain promotional CDs and variable-rate, 18-
month Individual Retirement Account certificates, all CDs carry a
fixed-rate of interest for a defined term from the opening date of the
account. Substantial penalties are imposed if principal is withdrawn
from most CDs prior to maturity.
Sterling supplements its retail deposit gathering by soliciting funds
from State of Washington public entities. Public funds were 5.7%,
6.2% and 8.5% of deposits for the six months ended December 31, 1996
and the fiscal years ended June 30, 1996 and 1995, respectively.
Public funds are generally obtained by competitive bidding among
qualifying financial institutions.
<PAGE>
The primary retail deposit vehicles being utilized by Sterling's
customers are CDs with terms of one year or less, regular savings
accounts, money market accounts and NOW accounts. The following table
presents the average balance outstanding and weighted average interest
rate paid for each major category of deposits for the periods
indicated.
<TABLE>
<CAPTION>
Six Months Ended December 31,
-----------------------------------------
Weighted Weighted
Average Average
Average Interest Average Interest
Balance Rate Balance Rate
-------- -------- -------- --------
(Dollars in thousands)
<S> <C> <C> <C> <C>
Certificates of deposit $578,738 5.64% $629,828 6.01%
Regular savings accounts and
money market accounts 222,223 3.82 175,479 3.68
Checking accounts:
NOW accounts 70,944 1.41 66,426 1.50
Non-interest-bearing demand
accounts 24,875 0.00 26,297 0.00
-------- ---- --------- ----
$896,780 4.70% $898,030 5.05%
======== ==== ========= ====
<CAPTION>
Six Months Ended December 31,
--------------------------------------
Weighted Weighted
Average Average
Average Interest Average Interest
Balance Rate Balance Rate
-------- -------- -------- --------
(Dollars in thousands)
<S> <C> <C> <C> <C>
Certificates of deposit $610,297 5.90% $626,952 5.23%
Regular savings accounts and
money market accounts 194,346 3.72 163,490 3.56
Checking accounts:
NOW accounts 67,507 1.52 66,060 1.80
Non-interest-bearing demand
accounts 24,346 0.00 21,961 0.00
-------- ---- --------- ----
$896,496 4.94% $878,463 4.53%
======== ==== ======== ====
</TABLE>
<PAGE>
The following table shows the amounts and maturities of CDs that had
balances of $100,000 or more at December 31, 1996.
(Dollars in thousands)
Remaining maturity:
Less than three months $ 66,917
Three to six months 41,551
Six to 12 months 32,742
Over 12 months 24,406
--------
$165,616
========
The following table presents, at December 31, 1996, the types of
deposit accounts offered by Sterling Savings and the balance in such
accounts:
<TABLE>
<CAPTION>
December 31, 1996
------------------------------------------------
Percent of Interest Rate
Minimum Minimum Total Offered at
Term Category Balance Amount Deposits December 31, 1996
--------- -------------------------- -------- -------- ---------- -----------------
(Dollars in thousands, except minimum amounts)
<S> <C> <C> <C> <C> <C>
Transaction Accounts:
None NOW checking $ 100 $ 72,686 8.0% 1.50%
None Commercial checking 100 24,180 2.7 0.00
None Regular savings 100 72,243 8.0 2.55
None Money market demand 2,500 148,696 16.5 3.20
-------- -----
317,805 35.2
-------- -----
Certificates of Deposit:
3 months Fixed term, fixed rate 500 1,048 0.1 3.50
6 months Fixed term, fixed rate 500 13,695 1.6 4.83
9 months Fixed term, adjustable rate 5,000 63,954 7.1 4.89
12 months Fixed term, fixed rate 500 104,909 11.6 5.14
12 months Fixed term, fixed rate 5,000 1,253 0.1 2.75
12 months Fixed term, adjustable rate 5,000 10,694 1.2 4.87
15 months Fixed term, adjustable rate 5,000 71,744 8.0 5.22
18 months Fixed term, fixed rate 500 66,877 7.4 5.60
24 months Fixed term, fixed rate 500 92,322 10.2 5.32
36 months Fixed term, fixed rate 500 12,673 1.4 5.37
36 months Zero coupon, fixed term(1) N/A 2,102 0.2 N/A
18 months Variable Rate, IRA 100 5,582 0.6 5.58
18 months Fixed Rate, IRA 500 1,867 0.2 5.22
36 months Variable Rate, IRA 2,000 15,879 1.8 5.60
7 days Jumbos 100,000 119,874 13.3 5.00
-------- -----
584,473 64.8
-------- -----
Total deposits $902,278 100.0%
======== =====
</TABLE>
(1) Not offered as of December 31, 1996.
<PAGE>
The following table sets forth the composition of Sterling's deposit
accounts at the dates indicated.
<TABLE>
<CAPTION>
December 31, June 30, 1996
-------------------- --------------------
Percent of Percent of
Total Total
Amount Deposits Amount Deposits
-------- ---------- -------- ----------
<S> <C> <C> <C> <C>
NOW checking $ 72,686 8.0% $ 69,125 7.7%
Commercial checking 24,180 2.7 20,468 2.3
Regular savings 72,243 8.0 74,413 8.3
Money market demand 148,696 16.5 152,874 17.0
Variable-rate certificates:
18 months 5,582 0.6 5,478 0.6
Fixed-rate certificates:
1-11 months 208,976 23.2 201,481 22.4
12-35 months 209,606 29.9 270,120 30.1
36-240 months 100,309 11.1 104,428 11.6
-------- ----- -------- -----
902,278 100.0 898,387 100.0
Deposit premium 0 0.0 7 0.0
-------- ----- -------- -----
Total deposits $902,278 100.0% $898,394 100.0%
======== ===== ======== =====
</TABLE>
Substantially all of Sterling's depositors are residents of the States
of Washington or Oregon. Sterling had no brokered deposits at
December 31, 1996.
Sterling is a member of The Exchange, an automated teller machine
system ("ATM") that allows participating customers to deposit or
withdraw from NOW accounts, money market demand accounts and savings
accounts at over 18,000 Exchange system machines located throughout
the United States and Canada. Sterling is also a member of the Plus
System ATM network, with numerous locations in the United States and
internationally. Sterling has installed automated teller machines in
21 of its branches to better serve customers in those markets.
Customers in these areas can access the system through automated
teller machines operated by other financial institutions.
BORROWINGS. Deposit accounts are Sterling's primary source of funds.
Sterling does, however, rely upon advances from the FHLB Seattle and
reverse repurchase agreements to supplement its funding and to meet
deposit withdrawal requirements. See "Management's Discussion and
Analysis - Sources of Funds."
<PAGE>
The FHLB Seattle is part of a system, which consists of 12 regional
Federal Home Loan Banks (the "FHL Banks") each subject to Federal
Housing Finance Board supervision and regulation, that functions as a
central reserve bank providing credit to thrift institutions. As a
member, Sterling is required to own stock of the FHLB Seattle in an
amount determined by a formula based upon Sterling's loans outstanding
and advances from the FHLB Seattle. At December 31, 1996, Sterling
exceeded its FHLB Seattle stock ownership requirement of $13.0 million
by $12.9 million. The stock of the FHLB Seattle has always been
redeemable at par value, but there can be no assurance that this will
always be the case.
As a member of the FHLB Seattle, Sterling is authorized to apply for
advances on the security of its FHLB Seattle stock and certain of its
mortgage loans and other assets (principally securities which are
obligations of, or guaranteed by, the United States or its agencies),
provided certain standards related to creditworthiness are met. Each
credit program has its own interest rate and range of maturities. At
December 31, 1996, Sterling had advances totaling $259.6 million from
the FHLB Seattle which mature from fiscal years 1997 through 2015 at
interest rates ranging from 4.88% to 8.40%. See "Management's
Discussion and Analysis - Liquidity and Sources of Funds" and Note 9
of "Notes to Consolidated Financial Statements."
Sterling also borrows funds under reverse repurchase agreements
pursuant to which it sells securities (generally treasury and
mortgage-backed securities) under an agreement to buy them back at a
specified price at a later date. These agreements to repurchase are
deemed to be borrowings collateralized by the securities sold.
Sterling uses these borrowings to supplement deposit gathering for
funding the origination of loans. Sterling had $229.8 million and
$195.8 million in reverse repurchase agreements outstanding at
December 31, 1996 and June 30, 1996, respectively. The use of reverse
repurchase agreements may expose Sterling to certain risks not
associated with other borrowings, including IRR and the possibility
that additional collateral may have to be provided if the market value
of the pledged collateral declines. For additional information
regarding reverse repurchase agreements, see "Management's Discussion
and Analysis - Asset and Liability Management," "Management's
Discussion and Analysis - Liquidity and Sources of Funds" and Note 10
of "Notes to Consolidated Financial Statements."
During fiscal year 1994, Sterling issued $17.2 million of 8.75%
Subordinated Notes due on January 31, 2000 ("the Subordinated Notes").
These Subordinated Notes are unsecured general obligations of Sterling
and are subordinated to certain other existing and future
indebtedness. Under the terms of the Subordinated Notes, Sterling is
limited by the amount of certain long-term debt that it can incur and
restricted, under certain circumstances, from paying of cash dividends
and from making other capital distributions. At December 31, 1996,
Sterling has the authority to incur approximately $39.2 million of
additional long-term debt within the covenants of the Subordinated
Notes. Interest on the Subordinated Notes is due the first day of
each month. Sterling may, at its option, redeem the Subordinated
Notes in whole or in part at par plus accrued interest. See Note 11
of "Notes to Consolidated Financial Statements."
<PAGE>
In addition to the borrowings described above, Sterling has a $5.0
million line-of-credit agreement with Key Bank of Washington ("Key
Bank"). Advances under the line of credit accrue interest at Key
Bank's prime interest rate plus 0.50% (8.75% at December 31, 1996) and
the line of credit matures in October 1997. Management expects that
the line of credit will be renewed at that time on substantially the
same terms, although there can be no assurance in this regard.
Borrowings under this line of credit are secured by a pledge of
certain shares of Sterling Savings Preferred Stock which are owned by
Sterling. No amounts were outstanding on this line of credit at
December 31, 1996 and June 30, 1996. In August 1996, Sterling
completed a $15.0 million six-year loan with Key Bank. The proceeds
of this loan were used to purchase $3.0 million of Preferred Stock of
Sterling Savings and for general corporate purposes. Interest at a
variable rate (7.0% at December 31, 1996) is payable quarterly on this
loan. Principal is repayable in five annual payments of $3.0 million
each, commencing September 1998.
Sterling Savings has an unsecured $10.0 million line of credit
agreement with Key Bank. Advances under the line of credit accrue
interest at Key Bank's federal funds rate plus an incremental
negotiated rate and the line matures on October 1, 1997. Management
expects that the line of credit will be renewed at that time on
substantially the same terms, although there can be no assurance in
this regard. No amounts were outstanding on this line of credit at
December 31, 1996 and June 30, 1996.
The following table sets forth certain information regarding
Sterling's short-term borrowings as of and for the periods indicated.
Fiscal Years Ended
June 30,
Six Months Ended ------------------
December 31, 1996 1996 1995
----------------- -------- --------
(Dollars in thousands)
Maximum amount outstanding
at any month end during
the period:
Reverse repurchase
agreements $232,885 $195,785 $148,055
Short-term advances 95,000 171,000 223,000
Average amount outstanding
during the period:
Reverse repurchase
agreements 213,560 156,578 118,064
Short-term advances 90,833 140,917 201,250
<PAGE>
Fiscal Years Ended
June 30,
Six Months Ended ------------------
December 31, 1996 1996 1995
----------------- -------- --------
(Dollars in thousands)
Weighted average interest rate
paid during the period:
Reverse repurchase
agreements 5.60% 5.91% 6.02%
Short-term advances 5.79 5.88 5.13
Weighted average interest rate
paid at end of period:
Reverse repurchase
agreements 5.62% 5.65% 6.67%
Short-term advances 5.75 6.42 5.41
The following table sets forth certain information concerning
Sterling's outstanding borrowings.
December 31, 1996 June 30, 1996
----------------- -----------------
Amount % Amount %
-------- ------ -------- ------
FHLB Seattle advances:
Short-term $ 90,000 17.3% $ 90,000 19.1%
Long-term 169,626 32.5 169,410 35.9
Securities sold subject to
reverse repurchase agreements 229,797 44.0 195,785 41.4
Subordinated Notes payable 17,240 3.3 17,240 3.6
Note payable 15,000 2.9 0 0.0
-------- ----- -------- -----
Total borrowings $521,663 100.0% $472,435 100.0%
======== ===== ======== =====
Weighted average interest rate 6.21% 6.25%
===== =====
Subsidiaries
------------
Sterling's principal subsidiary is Sterling Savings Association.
Sterling Savings has three principal subsidiaries which have been
previously described: Action Mortgage, Harbor Financial and INTERVEST.
Additionally, Sterling Financial Corporation and Sterling Savings have
the following wholly owned subsidiaries that are either inactive or
exist solely for the purpose of holding and owning specific assets or
properties and that are described below:
<PAGE>
Sterling Financial Corporation
------------------------------
(1) Tri-Cities Mortgage Corporation ("TCMC") was obtained as part of
an acquisition in April 1988. The corporation's principal asset
is a 99.5% partnership interest in Renton Plaza Investors (a
partnership which owns a five-story office building near Renton,
Washington). See "Lending Activities - Classified Assets, Real
Estate Owned and Delinquent Loans - Major Real Estate Owned."
Sterling Savings Association
----------------------------
(1) Fidelity Service Corporation was organized in 1983 to acquire and
sell real and personal property in eastern Washington and Idaho.
The corporation's assets consist principally of office furniture
and equipment used by Sterling Savings.
(2) Evergreen Environmental Development Corporation ("EEDC") was
organized to engage in real estate development and was obtained in
an acquisition in December 1988. EEDC's assets include a 33%
interest in the Grapetree Partnership, which owns a parcel of raw
land in Spokane, Washington that it intends to develop into
single-family residential lots. Sterling Savings' investment in
the Grapetree Partnership has been deemed by its primary federal
regulators to be an impermissible investment. Accordingly,
Sterling Savings' investment has been deducted from tangible, core
and risk-based capital.
(3) Tri-West Mortgage, Inc. was obtained in an acquisition in 1988 and
was originally engaged in mortgage banking. The corporation is
now inactive.
Evergreen First Service Corporation was obtained in an acquisition
in 1988 and owns all of the outstanding capital stock of Harbor
Financial, through which Sterling offers tax-deferred annuities,
mutual funds and other financial products.
Competition
-----------
Sterling faces strong competition, both in attracting deposits and in
originating, purchasing and selling real estate and other loans, from
savings and loan associations, mutual savings banks, credit unions
and commercial banks and other institutions, many of which have
greater resources than Sterling. Sterling also faces strong
competition in marketing financial products such as annuities, mutual
funds and other financial products and in pursuing acquisition
opportunities. Some or all of these competitive institutions operate
in Sterling's market areas.
In September 1994, the Riegle-Neal Interstate Banking and Branching
Efficiency Act of 1994 (the "Interstate Banking Act") was enacted.
The Interstate Banking Act allows adequately capitalized and well-
managed bank holding companies to acquire banks in any state,
regardless of whether such an acquisition would be prohibited by
applicable state law. The Interstate Banking Act also allows
interstate merger transactions beginning June 1, 1997. Through such
merger transactions, banks will be able to acquire branches of out-of-
<PAGE>
state banks by converting their offices into branches of the resulting
bank. Each state may enact a law before June 1, 1997, expressly
prohibiting merger transactions with out-of-state banks. If a state
"opts out" in this manner, no bank in any other state may establish a
branch in that state. Moreover, a bank whose home state "opts out" of
interstate branching may not participate in any interstate merger
transaction. As a result of the Interstate Banking Act, Sterling's
competitors may be able to conduct extensive interstate banking
operations and thereby gain competitive advantages.
Personnel
---------
As of December 31, 1996, Sterling, including its subsidiaries, had 495
full-time equivalent employees. Employees are not represented by a
collective bargaining unit. Sterling believes its relationship with
its employees is excellent.
Regulation
----------
INTRODUCTION. The following is not intended to be a complete
discussion but is intended to be a summary of some of the most
significant provisions of laws applicable to Sterling.
Sterling is a savings and loan holding company and as such is subject
to OTS regulations, examinations and reporting requirements. Sterling
Savings is chartered by the State of Washington and its savings
deposits are insured by the FDIC. Sterling Savings is subject to
comprehensive regulation, examination and supervision by the OTS, the
FDIC and the Washington Supervisor. Furthermore, certain transactions
and savings deposits are subject to regulations and controls
promulgated by the Federal Reserve Board (the "Fed").
SAVINGS AND LOAN HOLDING COMPANY REGULATION. Sterling is registered
as a savings and loan holding company under the Home Owners' Loan Act
(the "HOLA"). The HOLA generally permits a savings and loan holding
company to engage in activities which are unrelated to the operation
of a savings and loan association, provided the holding company
controls only one savings and loan association and such savings and
loan association meets the Qualified Thrift Lender Test (the "QTL
Test"). Sterling presently controls only one savings and loan
association, Sterling Savings, which at December 31, 1996 exceeded the
requirements to meet the QTL Test.
If Sterling Savings fails to meet the QTL Test in the future, Sterling
will become subject to restrictions on the activities in which it may
engage. Such activities would generally be limited to any activity
that the Fed by regulation has determined is permissible for bank
holding companies pursuant to Section 4(c) of the Bank Holding Company
Act of 1956, as amended (unless limited or prohibited by the OTS by
regulation), and certain other limited services and activities.
Sterling currently has no plans to engage in any new activity that
would be restricted if Sterling Savings were to fail to meet the QTL
Test in the future. Although Sterling Savings expects to remain in
compliance with the QTL Test in the future, there can be no assurance
in this regard.
<PAGE>
Under the HOLA, no person may acquire control of a savings association
or a savings and loan holding company without the prior approval of
the OTS. In addition, as a savings and loan holding company, Sterling
would be prohibited from acquiring (i) control of another savings
association or a savings and loan holding company without the prior
approval of the OTS, (ii) by merger, consolidation or purchase, the
assets of another savings association, or savings and loan holding
company, without the prior approval of the OTS, (iii) more than 5% of
the voting shares of a savings association or a savings and loan
holding company which is not a subsidiary of Sterling or (iv) control
of a depository institution the accounts of which are not insured by
the FDIC.
The HOLA authorizes the OTS to issue a directive to a savings and loan
holding company and any of its subsidiaries if the OTS determines that
there is reasonable cause to believe that the continuation by the
holding company of any activity constitutes a serious risk to the
financial safety, soundness or stability of the holding company's
subsidiary savings association. The OTS may impose restrictions
through such directive to limit such risk, including limiting (i) the
payment of dividends by the savings association, (ii) transactions
between the savings association, the holding company and the
subsidiaries or affiliates of either and (iii) any activities of the
savings association that might create a serious risk that the
liabilities of the holding company and its other affiliates may be
imposed on the savings association. Such a directive has the same
effect as a final cease and desist order. The issuance of the
directive can be appealed to the Director of the OTS.
THE FEDERAL DEPOSIT INSURANCE CORPORATION IMPROVEMENT ACT OF 1991.
The Federal Deposit Insurance Corporation Improvement Act of 1991
("FDICIA") provides for expanded regulation of depository institutions
and their affiliates, including parent holding companies. FDICIA
further provides the OTS with broad powers to take "prompt corrective
action" to resolve problems of insured depository institutions. The
extent of these powers depends upon whether the institution in
question is "well capitalized," "adequately capitalized,"
"undercapitalized," "significantly undercapitalized" or "critically
undercapitalized."
Under OTS regulations which implement the "prompt corrective action"
system mandated by FDICIA, an institution is "well capitalized" if its
ratio of total capital to risk-weighted assets is 10% or more, its
ratio of core capital to risk-weighted assets is 6% or more, its ratio
of core capital to total assets is 5% or more and it is not subject to
any written agreement, order or directive to meet a specified capital
level. At December 31, 1996 Sterling Savings met the standards for a
"well capitalized" institution.
An institution which is "undercapitalized" must submit a capital
restoration plan to the OTS. The plan may be approved only if the OTS
determines it is likely to succeed in restoring the institution's
capital and will not appreciably increase the risks to which the
institution is exposed. The institution's performance under the plan
must be guaranteed by any company which controls the institution, up
<PAGE>
to a maximum of 5% of the institution's assets. The OTS may also
require the institution to take various actions deemed appropriate to
minimize the potential losses to the deposit insurance fund. A
"significantly undercapitalized" institution is subject to additional
sanctions and a "critically undercapitalized" institution generally
must be placed in receivership or conservatorship.
FDICIA directs each bank regulatory agency and the OTS to review its
capital standards every two years to determine whether those standards
require sufficient capital to facilitate prompt corrective action to
prevent or minimize loss to the deposit insurance funds. FDICIA, as
amended, also requires the OTS to prescribe minimum operational and
managerial standards and standards for asset quality, earnings and
stock valuation for savings institutions. Any savings institution
which fails to meet the standards may be required to submit a plan for
corrective action. If a savings institution fails to submit or
implement an acceptable plan, the OTS may require the institution to
take any action the OTS determines will best carry out the purpose of
prompt corrective action.
Under FDICIA, only a "well capitalized" depository institution may
accept brokered deposits without prior regulatory approval. FDICIA
also requires annual examinations of all insured depository
institutions by the appropriate federal banking agency, with some
exceptions for small, well-capitalized institutions and state-
chartered institutions examined by state regulators. The federal
banking agencies are required to set compensation standards for
insured depository institutions that prohibit excessive compensation,
fees or benefits to officers, directors, employees and principal
shareholders. FDICIA also contains a number of consumer banking
provisions, including disclosure requirements and substantive
contractual limitations with respect to deposit accounts. FDICIA has
also greatly expanded the range of merger, purchase and assumption,
and deposit transfer transactions involving banks and savings
associations that are exempt from payment of exit and entry fees as
transfers of deposits between the FDIC's BIF and its SAIF. Many of
the provisions of FDICIA have been implemented through the adoption of
regulations by the federal banking agencies.
Sterling anticipates that it will continue to enhance its capital
resources and the regulatory capital ratios of Sterling Savings
through the retention of earnings, the amortization of intangible
assets and the management of the level and mix of assets, although
there can be no assurance in this regard.
REGULATORY CAPITAL REQUIREMENTS. Pursuant to the Financial
Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA"),
the OTS has adopted regulations implementing new capital standards
applicable to all savings associations, including Sterling Savings.
Such capital standards include (i) a requirement that savings
associations maintain tangible capital of not less than 1.5% of
adjusted total assets, (ii) a leverage (or core) ratio requirement
that savings associations maintain core capital of not less than 3.0%
of adjusted total assets, and (iii) a requirement that savings
associations maintain total capital of not less than 8.0% of risk-
weighted assets. As of December 31, 1996, Sterling Savings met all
<PAGE>
regulatory capital requirements. For additional information, see
"Management's Discussion and Analysis - Liquidity and Sources of
Funds" and "Management's Discussion and Analysis - Capital Resources."
TANGIBLE CAPITAL. Tangible capital consists of common Shareholders'
equity, including retained earnings, non-cumulative perpetual
preferred stock and related surplus and minority interests in equity
accounts of fully consolidated subsidiaries. In calculating tangible
capital certain items must be deducted. These items are goodwill and
other intangible assets, nonqualifying purchased mortgage servicing
rights and investments (whether debt or equity) in subsidiaries
engaged in activities which are not permissible for national banks
(except for a declining amount of grandfathered investments as
described below). With respect to purchased mortgage servicing
rights, the amount that qualifies to be included in tangible capital
is the lower of (a) 90% of fair market value if determinable, (b) 90%
of original cost or (c) the current amortized book value. With
respect to investments in subsidiaries, if a subsidiary was engaged in
an activity not permissible for a national bank as of April 12, 1989,
the association's investments in such subsidiary must be excluded from
tangible capital. See "Subsidiaries" and "Lending Activities -
Classified Assets, Real Estate Owned and Delinquent Loans - Major Real
Estate Owned."
LEVERAGE (OR CORE) CAPITAL. "Core capital" is defined, essentially,
as tangible capital plus certain other qualifying intangible assets
(of up to 25% of core capital) which meet a three-part test of
separatability, marketability and market valuation.
RISK-BASED CAPITAL. FIRREA and the OTS capital regulations also
impose a risk-based capital requirement which is a percentage of
capital to risk-adjusted assets. A risk weight is assigned to both
the on-balance sheet assets and off-balance sheet commitments of a
savings association. Representative risk weights include: 0% for
assets that are backed by the full faith and credit of the United
States; 20% for stock, agency securities not backed by the full faith
and credit of the United States and certain mortgage-related
securities; 50% for qualifying mortgage loans and certain
mortgage-related securities; 100% for consumer, commercial and other
loans; and 200% for delinquent or repossessed assets.
Both core capital and "supplementary capital," as defined below, may
be used to meet the risk-based capital requirement, although
supplementary capital cannot be used in an amount greater than 100% of
core capital. For purposes of the risk-based capital requirement,
supplementary capital includes permanent capital instruments such as
cumulative perpetual preferred stock, perpetual or mandatory
convertible subordinated debt, maturing capital instruments such as
subordinated debt, intermediate-term preferred stock, commitment notes
and certain grandfathered mandatory redeemable preferred stock
(although the amount included declines as the instrument approaches
maturity), and general valuation loan and lease loss allowances up to
a maximum of 1.25% of risk-weighted assets. The risk-based capital
requirement was equal to 8.00% of risk-weighted assets at
December 31, 1996.
<PAGE>
The following tables set forth Sterling Savings' tangible, core and
risk-based capital positions as reported to the OTS on the quarterly
Thrift Financial Report at December 31, 1996, computed in accordance
with the OTS capital regulations.
Tangible Capital
December 31, 1996
--------------------
Dollars Ratio (1)
-------- ---------
(Dollars in thousands)
Total Shareholders' equity: $106,300 6.94%
Adjustment:
Unrealized losses on certain available-
for-sale securities 6,020 0.39
Less:
Intangibles 10,147 0.66
Excess qualifying purchased mortgage
loan servicing 214 0.01
Investment in non-includable subsidiaries 370 0.02
-------- -----
Total tangible capital 101,589 6.64
Tangible capital requirement 22,934 1.50
-------- -----
Tangible capital excess $ 78,655 5.14%
======== =====
Core Capital
December 31, 1996
-------------------
Dollars Ratio (1)
-------- ---------
(Dollars in thousands)
Total tangible capital: $101,589 6.64%
Add:
Qualifying identified intangibles up
to 25% of other core capital 0 0.00
-------- -----
Total core capital 101,589 6.64
Core capital requirement 45,868 3.00
-------- -----
Core capital excess $ 55,721 3.64%
======== =====
<PAGE>
Risk-Based Capital
December 31, 1996
--------------------
Dollars Ratio (1)
-------- ---------
(Dollars in thousands)
Total core capital: $101,589 10.99%
General valuation allowances 7,628 0.83
Assets required to be deducted (183) (0.02)
-------- -----
Total risk-based capital 109,034 11.80
Risk-based capital requirement 74,870 8.00
-------- -----
Risk-based capital excess $ 34,164 3.80%
======== =====
(1) Ratio of capital to total adjusted assets for tangible and core
capital and ratio of capital to risk-weighted assets for risk-
based capital.
The OTS has adopted a regulation that adds an IRR component to the
risk-based capital requirement for thrift institutions. Currently,
the OTS has waived inclusion of the IRR component in the risk-based
capital calculation, pending the issuance by the OTS of guidelines
regarding the appeal of such inclusion or calculation. Under the
rule, thrift institutions meeting or exceeding a base level of
interest rate exposure must take a deduction from the total capital
available to meet their risk-based capital requirement. That
deduction is equal to one-half of the difference between the
institution's actual measured exposure and the base level of exposure.
The institution's actual measured IRR is expressed as the change that
occurs in its net present value ("NPV") as a result of a hypothetical
200 basis point increase or decrease in interest rates (whichever
leads to the lower NPV) divided by the estimated economic value of its
assets. The base level of IRR which would require inclusion of a
capital component is defined as a decline in NPV which exceeds 2.0% of
an institution's assets expressed in terms of economic value. Using a
computer model, the OTS will calculate changes in each institution's
NPV based on financial data the institution submits on its Thrift
Financial Report. The OTS will then advise each institution of its
IRR capital requirement. The OTS, using December 31, 1996 financial
information, calculated that no IRR capital component would have been
required to be added to Sterling Savings' risk-based capital.
Savings associations which fail to meet the tangible, core or risk-
based capital requirements are subject to a number of sanctions or
restrictions. Under FIRREA, the OTS must prohibit any asset growth,
except that the OTS may permit growth in an amount not in excess of
net interest credited to the savings association's deposit liabilities
if (i) the savings association obtains the prior approval of the OTS;
(ii) any increase in assets is accompanied by an increase in tangible
capital in an amount not less than 3.0% of the increase in assets;
(iii) any increase in assets is accompanied by an increase in capital
<PAGE>
not less in percentage amount than required under the risk-based
capital standards then applicable; (iv) any increase in assets is
invested in low-risk assets; and (v) the savings association's ratio
of core capital to total assets is not less than the ratio existing on
January 1, 1991.
The OTS also may require any savings association not in compliance
with capital standards (including any individual minimum capital
requirement) to comply with a capital directive issued by the OTS.
Such capital directive may order the savings association to (a)
achieve its minimum capital requirements by a specified date; (b)
adhere to a compliance schedule for achieving its minimum capital
requirements; (c) submit and adhere to a capital plan acceptable to
the OTS; and/or (d) take other actions including reducing its assets
or rate of liability growth and/or restricting its payment of
dividends in order to reach the required capital levels. The OTS, by
such capital directive, enforcement proceedings or otherwise, may
require an association not in compliance with the capital requirements
to (i) increase the amount of its regulatory capital to a specified
level; (ii) convene a meeting with the OTS supervision staff for the
purpose of accomplishing the objectives of the regulations; (iii)
reduce or limit the rate of interest that may be paid on savings
accounts; (iv) limit the receipt of deposits to those made to existing
accounts; (v) cease or limit lending or the making of a particular
loan or category of loan; (vi) cease or limit the purchase of loans or
the making of specified other investments; (vii) limit operational
expenditures to specific levels; (viii) increase liquid assets and
maintain such increased liquidity at specified levels; or (ix) take
such other action or actions as the OTS may deem necessary or
appropriate for the safety and soundness of the savings association or
the protection of its depositors. The material failure of a savings
association to comply with any plan, regulation, written agreement,
order or directive issued will be treated as an unsafe or unsound
practice which could result in the imposition of certain penalties or
sanctions including, but not limited to, the assessment of civil
monetary penalties, the issuance of a cease and desist order, or the
appointment of a conservator or receiver.
Any savings association which does not meet its regulatory capital
requirements may not accept brokered deposits if such deposits,
together with any existing brokered deposits outstanding, would exceed
5% of the association's total deposits, without a written waiver from
the OTS. In addition, the FDIC prohibits, with certain exceptions, an
"insolvent institution" from accepting any brokered deposits. An
insolvent institution is defined as any insured depository institution
which does not meet the minimum capital requirements applicable with
respect to such institution. This prohibition includes any renewal of
an account in any insolvent institution and any rollover of any amount
on deposit. The FDIC may waive this restriction upon application by
an insured depository institution and a finding that the acceptance of
such deposits does not constitute an unsafe or unsound practice with
respect to such institution. Sterling had no brokered deposits at
December 31, 1996.
<PAGE>
A savings association which is not in compliance with its capital
requirements may apply to the OTS for an exemption from the sanctions
and penalties imposed upon a savings association for failure to comply
with its minimum capital standards. Pursuant to FIRREA, the OTS may
approve an application for a capital exemption if such exemption would
pose no significant risk to the affected insurance fund, the savings
association's management is competent, the savings association is in
compliance with all applicable statutes, regulations, orders and
supervisory agreements and directives, and the savings association's
management has not engaged in insider dealing, speculative practices
or any other activities that could have jeopardized the association's
safety and soundness or contributed to impairing the association's
capital. Any application for a capital exemption must be accompanied
by an acceptable capital plan. If a savings association receives
approval of capital exemption and operates in accordance with an
acceptable capital plan, it will be deemed to be in compliance with
its capital standards for purposes of OTS capital regulation only.
The savings association must request and receive approval of specific,
express exemptions from the provisions of other rules, regulations and
policy statements as part of the accepted capital plan to be deemed in
capital compliance for purposes of such other rules, regulations and
policy statements.
FEDERAL DEPOSIT INSURANCE CORPORATION. Sterling's deposits are
insured up to $100,000 per insured depositor (as defined by law and
regulations) by the FDIC through the SAIF. The SAIF is administered
and managed by the FDIC. The FDIC is authorized to conduct
examinations of and to require reporting by SAIF member institutions.
The FDIC may prohibit any SAIF member institution from engaging in any
activity the FDIC determines by regulation or order poses a serious
threat to the SAIF. The FDIC also has the authority to initiate
enforcement actions against savings associations.
On September 30, 1996, federal legislation was enacted which included
provisions regarding the recapitalization of the SAIF, which is
operated by the FDIC and provides deposit insurance for thrift
institutions. The new legislation required SAIF-insured savings
institutions, like Sterling Savings, to pay a one-time special
assessment of $0.657 for every $100 of deposits as of March 31, 1995.
The special assessment is designed to capitalize the SAIF up to the
prescribed 1.25% of SAIF-insured deposits. Sterling's SAIF assessment
resulted in a pre-tax charge to earnings of $5.8 million during the
six months ended December 31, 1996.
Deposits insured by SAIF are currently assessed at the rate of zero to
$0.27 per $100 of domestic deposits. The SAIF assessment rate may
increase or decrease as is necessary to maintain the designated SAIF
reserve ratio of 1.25% of insured deposits.
Effective January 1, 1997, all FDIC-insured depository institutions
must pay an annual assessment to provide funds for the payment of
interest on bonds issued by the Financing Corporation, a federal
corporation chartered under the authority of the Federal Housing
Finance Board. The FICO Bonds were issued to capitalize the Federal
Savings and Loan Insurance Corporation. Until December 31, 1999 or
<PAGE>
when the last savings and loan association ceases to exist, whichever
occurs first, depository institutions will pay approximately $.064 per
$100 of SAIF-assessable deposits and approximately $.013 per $100 of
BIF-assessable deposits.
The new legislation contemplates a unification of the charters
presently available to banks and thrifts. The Treasury Department
is required to make recommendations regarding unification of the
available charters and the merger of the insurance funds by March 31,
1997. The legislation requires a merger of the SAIF with the BIF on
January 1, 1999 if the unification of the charters for all insured
institutions has, in fact, occurred. SAIF and BIF will continue to
operate as separate funds, if this unfication of charters has not
taken place, until such time as additional federal legislation is
passed requiring a merger of the funds.
Sterling Savings may be required to convert its charter to either a
national bank charter, a state depository institution charter, or a
newly designed charter. Sterling may also become regulated at the
holding company level by the Federal Reserve rather than by the OTS.
Regulation by the Federal Reserve could subject Sterling to capital
requirements that are not currently applicable to Sterling as a thrift
holding company under OTS regulation and may result in statutory
limitations on the type of business activities in which Sterling may
engage at the holding company level, which business activities
currently are not restricted. At this time, Sterling Savings is
unable to predict whether a charter change will be required and, if it
is, whether the charter change will significantly impact Sterling
Savings' operations.
The FDIC is empowered to initiate a termination of insurance
proceeding in cases where the Board of Directors of the FDIC
determines that an insured depository institution has engaged in
unsafe or unsound practices, is in an unsafe or unsound condition to
continue operations, or has violated an applicable law, regulation,
order or condition imposed by the FDIC. The FDIC may deem failure to
comply with applicable regulatory capital requirements an unsafe and
unsound practice. If the FDIC terminates a savings association's
deposit insurance, funds then on deposit continue to be insured for at
least six months and up to two years after notice of such termination
is provided to the account holders. Furthermore, if the FDIC
initiates an insurance termination proceeding against a savings
association that has no tangible capital, the FDIC may issue a
temporary order immediately suspending deposit insurance on all
deposits received by such savings association.
RESOLUTION FUNDING CORPORATION. FIRREA provides for substantial
contributions by the FHL Banks to the Resolution Funding Corporation,
which was created under FIRREA to raise funds to be used to resolve
cases involving failed savings associations. The funding obligations
that FIRREA imposes on the FHL Banks may reduce the dividends paid by
the FHL Banks to their savings association shareholders', increase the
cost to FHL Bank members of the services provided by the FHL Banks, or
both. Each of these provisions may increase Sterling's cost of doing
business.
<PAGE>
LOANS TO AFFILIATES. FIRREA amended the statutory provisions
governing transactions between a savings association and its
affiliates. Such transactions are subject to the restrictions of
Sections 23A and 23B of the Federal Reserve Act (the "FRA") in the
same manner and to the same extent as if the savings association were
a member bank as defined in the FRA, except that a savings association
may not (i) extend credit to any affiliate engaged in activities that
are impermissible for a bank holding company or (ii) purchase or
invest in any securities of an affiliate other than shares of a
subsidiary.
Section 23A of the FRA limits the aggregate amount of "covered
transactions" with any one affiliate to 10% of the capital stock and
surplus of the member bank. "Covered transactions" are defined in
Section 23A to include extending credit to, purchasing the assets of,
issuing a guarantee, acceptance or letter of credit on behalf of, or
investing in the stock or securities of, any affiliate. Section 23A
also requires a bank to obtain specified levels of collateral for any
extension of credit to an affiliate. Section 23B, in general,
requires that any transaction with an affiliate be on terms and
conditions no less favorable to the member bank than those applicable
to transactions with unaffiliated entities. The OTS has recently
adopted regulations further defining and clarifying the applicability
of Section 23A and 23B to savings associations. The Director of the
OTS has the authority to impose any additional restrictions on any
transaction between a savings association and an affiliate that he
determines are necessary to protect the safety and soundness of the
association.
In addition, FIRREA provides that extensions of credit to executive
officers, directors and principal shareholders of a savings
association are governed by Section 22(h) of the FRA. Section 22(h)
requires prior approval by the Board of Directors of the bank before a
loan can be made to an executive officer, director or 10% shareholder.
In addition, such loan or extension of credit must be made on
substantially the same terms, including interest rates and collateral,
as those prevailing at the time for comparable transactions with
unaffiliated persons that do not involve more than the normal risk of
repayment or present other unfavorable features. Section 22(h) also
prohibits any loan or extension of credit to an executive officer or a
controlling shareholder if such loan or extension of credit (when
aggregated with the amount of all other loans or extensions of credit
then outstanding to such individual) would exceed the limits on loans
to a single borrower applicable to national banks. The Director of
the OTS may impose additional restrictions for safety and soundness
reasons.
LIQUIDITY. All savings associations, including Sterling, are required
to maintain an average daily balance of liquid assets equal to a
certain percentage of the sum of average daily balances of net
withdrawable deposit accounts and borrowings payable in one year or
less. The liquidity requirement may vary from time to time (between
4% and 10%) depending upon economic conditions and savings flows of
all savings associations. At the present time, the required liquid
asset ratio is 5%. Short-term liquid assets currently must constitute
<PAGE>
at least 1% of the institution's average daily balance of net
withdrawable deposit accounts and current borrowings. Sterling's
liquidity ratios for the month of December 1996 and June 1996 were
10.91% and 7.31%, respectively.
LOANS-TO-ONE-BORROWER. Under FIRREA, the permissible amount of
loans-to-one-borrower follows the national bank standard for all loans
made by savings associations (except that loans-to-one-borrower not in
excess of $500,000 may be made in any event). OTS regulations
generally do not permit loans-to-one-borrower to exceed 15% of
unimpaired capital and unimpaired surplus. Loans in an amount equal
to an additional 10% of unimpaired capital and unimpaired surplus also
may be made to a borrower if the loans are fully secured by readily
marketable collateral. In addition, institutions which meet
applicable capital requirements may make domestic residential housing
development loans in an amount up to the lesser of $30.0 million or
30% of the institution's unimpaired capital and unimpaired surplus,
subject to certain conditions. At December 31, 1996, Sterling's
loans-to-one-borrower limit equals $15.2 million, which management
believes is adequate to allow for loan originations.
QUALIFIED THRIFT LENDER. Under the QTL Test, as revised by the
FDICIA, an institution generally is required to invest at least 65% of
its portfolio assets (as defined in the OTS regulations) in "qualified
thrift investments" on a monthly average basis in nine out of every
twelve months. Qualified thrift investments include, in general,
loans, securities and other investments that are related to housing.
At December 31, 1996, Sterling's qualified thrift investments were
77.8% of portfolio assets. An institution's failure to remain a
qualified thrift lender ("QTL") may result in: (1) limitations on new
investments and activities; (2) imposition of branching restrictions;
(3) loss of borrowing privileges at the FHLB Seattle and (4)
limitations on the payment of dividends.
COMMUNITY REINVESTMENT. Under the Community Reinvestment Act ("CRA"),
as implemented by the OTS regulations, a savings institution has a
continuing and affirmative obligation consistent with its safe and
sound operation to help meet the credit needs of its entire community,
including low and moderate income neighborhoods. The CRA does not
establish specific lending requirements or programs for financial
institutions nor does it limit an institution's discretion to develop
the types of products and services that it believes are best suited to
its particular community, consistent with the CRA. The CRA requires
the OTS, in connection with its examination of a financial
institution, to assess the institution's record of meeting the credit
needs of its community and to take such record into account in its
evaluation of certain applications by such institutions. The CRA
requires public disclosure of an institution's CRA rating and requires
the OTS to provide a written evaluation of an institution's CRA
performance utilizing a four-tiered descriptive rating system of
"outstanding," "satisfactory," "needs to improve" or "substantial
noncompliance." Sterling's current CRA rating is "outstanding."
<PAGE>
CHANGE OF CONTROL. Under applicable statutes and regulations, a
person may not acquire control of a savings association without the
prior approval of the OTS and the Washington State Department of
Savings and Loans. Control is conclusively deemed to be acquired
when, among other things, a person, either alone or acting in concert
with others, acquires more than 25% of any class of voting stock of a
savings association. Under federal statutes and regulations, a
rebuttable presumption of control arises if a person acquires, either
alone or acting in concert with others, more than 10% of any class of
voting stock of a savings association and is subject to a "control
factor," or acquires more than 25% of any class of non-voting stock,
and is subject to a "control factor." A person is subject to a
control factor as a result of specified ownership levels of the
savings association's debt or equity or as a result of certain
relationships with the savings association.
As indicated above, if a person's ownership of the savings association
stock is below the threshold levels for control, such person may
nevertheless be deemed to be "acting in concert" with one or more
other persons that own stock in the savings association, in which case
all of the stock ownership of each person acting in concert will be
aggregated and attributed to each member of the group, thereby putting
each one over the control threshold. Under certain circumstances,
acquirers will be presumed to be acting in concert. The most commonly
applicable circumstances include (i) a company will be presumed to be
acting in concert with a controlling shareholder or management
official; (ii) a company controlling or controlled by another company
and companies under common control will be presumed to be acting in
concert; and (iii) persons will be presumed to be acting in concert
where they constitute a group under Section 13 of the Securities
Exchange Act of 1934, as amended.
RESTRICTIONS ON ACTIVITIES OF STATE-CHARTERED ASSOCIATIONS. FIRREA
prohibits a state-chartered savings association from engaging in any
type of activity or any activity in an amount that is not permissible
for a federal savings association unless (i) the FDIC has determined
that such activity poses no threat to the insurance fund and (ii) the
savings association continues to be in compliance with the fully
phased-in capital standards imposed by FIRREA. If the FDIC determines
that the amount of such activity does not pose a significant threat to
the insurance fund, an association which is in compliance with
FIRREA's fully phased-in capital requirements may engage in activities
in an amount greater than that permissible for a federal savings
association. FIRREA also prohibits a state-chartered savings
association from acquiring or retaining any equity investment (other
than shares in certain service corporations) of a type or in an amount
not permissible for a federal savings association. A savings
association must divest any such equity investment as quickly as can
be prudently done. For a discussion of such investments currently
held by Sterling. Pursuant to applicable equity investment rules,
Sterling has excluded its investment in assets totaling $370,000 from
its calculation of risk-based capital as of December 31, 1996.
Sterling is actively marketing these properties. See "-Subsidiaries."
<PAGE>
RESTRICTIONS ON CAPITAL DISTRIBUTIONS BY SAVINGS ASSOCIATIONS. The
OTS has adopted a capital distribution regulation which limits the
ability of savings institutions to make capital distributions.
Certain factors are considered by the OTS in determining whether to
permit a savings institution to pay dividends, including, among other
things, whether an institution meets fully phased-in capital
requirements. Those savings institutions which meet the fully phased-
in capital requirements have discretion in making capital
distributions, while those with lower capitalization have less
discretion in this regard and, in some cases, are required to seek the
approval of the OTS.
Sterling's income is derived primarily from dividends to the extent
they are declared and paid by Sterling Savings. Current OTS
regulations require Sterling Savings to give the OTS 30 days advance
notice of any proposed declaration of dividends to Sterling, as its
holding company. The OTS has approved all of Sterling Savings
Preferred Stock dividend payments to Sterling, but there can be no
assurance as to the approval of future dividends.
FEDERAL RESERVE SYSTEM. Sterling Savings is subject to various
regulations promulgated by the Fed, including, among others,
Regulation B (Equal Credit Opportunity), Regulation D (Reserves),
Regulation E (Electronic Fund Transfers), Regulation Z (Truth in
Lending), Regulation CC (Availability of Funds) and Regulation DD
(Truth in Savings). Regulation D requires non-interest-bearing reserve
maintenance in the form of either vault cash or funds on deposit at
the Federal Reserve Bank of San Francisco or another designated
depository institution in an amount calculated by formula. The
balances maintained to meet the reserve requirements imposed by the
Federal Reserve may be used to satisfy liquidity requirements.
Under the provisions of the Depository Institutions Deregulation and
Monetary Control Act of 1980, savings and loan associations, like
Sterling Savings, also have authority to borrow from the Federal
Reserve Bank "discount window," but Federal Reserve regulations
require associations to exhaust all FHL Bank sources before borrowing
from the Federal Reserve Bank.
FEDERAL TAXATION. Sterling is subject to federal income taxation
under the Internal Revenue Code of 1986 as amended (the "Code"), in
the same manner as other corporations, except for the application of
the bad debt reserve rules discussed below and certain other
provisions. Sterling files consolidated federal income tax returns on
the accrual basis.
Under applicable provisions of the Code, a savings institution that
meets certain definitional tests relating to the composition of its
assets and the sources of its income ("qualifying savings
institution") is permitted to establish reserves for bad debts and to
make annual additions thereto under the experience method, which
generally permits an annual deduction based upon the institution's
historical loan loss experience. Alternatively, such an institution
may elect on an annual basis to use the percentage of taxable income
method to compute its allowable addition to its bad-debt reserve on
<PAGE>
qualifying real property loans (generally, loans secured by an
interest in improved real property). For qualifying savings
associations, these methods generally allow for greater deductions
than other financial institutions such as commercial banks which are
allowed a deduction only for actual bad-debt losses.
As part of the Small Business, Health Insurance and Welfare Reform
Acts of 1996, the tax treatment of the bad-debt reserves will change
substantially. Effective for years beginning after December 31, 1995,
the special rules for bad-debt reserves of thrift institutions no
longer apply. Thrift institutions, like Sterling Savings, will be
treated as banks for purposes of accounting for bad debts. The
percentage of income method is no longer available. Thrifts that
would be treated as "small banks" are allowed to utilize the
experience method applicable to such institutions, while thrifts that
are treated as "large banks" are required to use the specific charge-
off method. The Code defines a "large bank" as one whose average
adjusted basis of all assets exceed $500 million. Sterling Savings
will be classified as a "large bank" for purposes of tax accounting
for bad debts. The new law requires that a thrift's "applicable
excess reserves" be recaptured over a period of six to eight years
depending on whether the thrift meets certain tests. In Sterling
Savings' case, the "applicable excess reserve" is the amount by which
its reserves at December 31, 1996 exceed the reserves at December 31,
1988. This amount is estimated to be approximately $670,000.
Further, if Sterling Savings ever fails to qualify as a bank, the
balance of its June 30, 1988 reserves are also subject to recapture
over a six-year period beginning in the taxable year the taxpayer no
longer qualifies as a bank.
A savings institution organized in stock form may be subject to
recapture taxes on its reserves if it makes certain types of
distributions to its shareholders. Dividends may be paid out of
retained earnings without the imposition of any tax on the savings
institution to the extent that the amounts paid as dividends do not
exceed both the savings institution's current and accumulated earnings
and profits as calculated for federal income tax purposes. Dividends
in excess of the savings institution's current and accumulated
earnings and profits as calculated for federal income tax purposes,
and any redemption or liquidation distributions, are however, deemed
under Section 593(e) of the Code to be made from the savings
institution's tax bad-debt reserves to the extent that such reserves
exceed the additions that would have been made under the experience
method and thereafter from its supplemental reserves. The amount of
tax that would be payable upon any distribution that is treated as
having been made from the savings institution's tax bad-debt reserves
is also deemed to have been paid from these reserves. As a result,
distributions, if any, that are treated as having been made from
Sterling Savings' bad-debt reserves could result in a federal
recapture tax.
<PAGE>
STATE LAW AND REGULATION. Sterling Savings is a State of Washington-
chartered institution and is subject to regulation by the Washington
Supervisor, which conducts regular examinations to ensure that
Sterling Savings' operations and policies conform with sound industry
practice. The liquidity and other requirements set by the Washington
Supervisor are generally no stricter than the liquidity and other
requirements set by the OTS. State law regulates the amount of credit
that can be extended to any one person or marital community, and the
amount of money that can be invested in any one property. Without the
Washington Supervisor's approval, Sterling Savings currently cannot
extend credit to any one person or marital community in an amount
greater than 2.5% of Sterling Savings' total assets. State law also
regulates the types of loans Sterling Savings can make. Without the
Washington Supervisor's approval, Sterling Savings cannot currently
invest more than 10% of its total assets in other corporations.
Sterling Savings is currently subject to a supervisory directive from
the Washington Supervisor. The directive requires Sterling Savings to
provide monthly reports, maintain its current "well capitalized"
status, obtain prior approval for significant transactions and take
certain other actions. Sterling Savings operates three branches
within the State of Oregon and is therefore subject to the supervision
of the Oregon Department of Consumer and Business Services.
PART II
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATION
General
-------
Sterling Financial Corporation ("Sterling") is a unitary savings and
loan holding company, the significant operating subsidiary of which is
Sterling Savings Association ("Sterling Savings"). The significant
operating subsidiaries of Sterling Savings are Action Mortgage Company
("Action Mortgage"), INTERVEST-Mortgage Investment Company
("INTERVEST") and Harbor Financial Services, Inc. ("Harbor
Financial"). Sterling's revenues are derived primarily from interest
earned on loans and mortgage-backed securities, from fees and service
charges and from mortgage banking operations. The operations of
Sterling Savings, and savings institutions generally, are influenced
significantly by general economic conditions and by policies of its
primary thrift regulatory authorities, the Office of Thrift
Supervision ("OTS"), the FDIC and the State of Washington Department
of Financial Institutions ("Washington Supervisor").
Sterling changed its fiscal year end from June 30 to December 31,
effective December 31, 1996. Accordingly, results of operations have
been presented for the six months ended December 31, 1996 and 1995.
During the six months ended December 31, 1996, interest rates were
relatively stable. During this period, Sterling continued to change
the mix of its interest-earning assets by continuing to emphasize its
community lending activities, which resulted in increased yields.
Additionally, during this period Sterling's cost of deposits and
borrowings declined. See "Asset and Liability Management," and "Net
Interest Income."
<PAGE>
During the fiscal year ended June 30, 1996, interest rates were more
volatile. During the first half of fiscal year 1996, prevailing
short- and long-term interest rates had declined, primarily in
response to a shift in policies of the Fed toward easing of short-term
interest rates. During this period, the Fed had lowered the Federal
Funds rate from 6.00% to 5.25%. In the second half of fiscal year
1996, prevailing long-term interest rates rose by approximately .50%
to .75%. This increase resulted in a higher cost of funds than
anticipated. Also, as a consequence of this rising interest rate
environment, the market value of longer-term assets significantly
declined.
Further, in anticipation of the BIF/SAIF legislation, Sterling
constrained the growth in its loan portfolio during fiscal year 1996.
This resulted in a slower growth in net interest income. See "Asset
and Liability Management," "Mortgage-Backed Securities" and "Capital
Resources."
In response to these factors, Sterling reorganized and focused its
efforts on becoming more like a community retail bank by increasing
its business banking, consumer and construction lending while
increasing its retail deposits.
On September 30, 1996, federal legislation was enacted which included
provisions regarding the recapitalization of the SAIF, which is
operated by the FDIC and provides deposit insurance for thrift
institutions. The new legislation required SAIF-insured savings
institutions, like Sterling Savings, to pay a one-time special
assessment of $0.657 for every $100 of deposits as of March 31, 1995.
The special assessment is designed to capitalize the SAIF up to the
prescribed 1.25% of SAIF-insured deposits. Sterling's SAIF assessment
resulted in a pre-tax charge to earnings of $5.8 million during the
six months ended December 31, 1996.
Deposits insured by SAIF are currently assessed at the rate of zero to
$0.27 per $100 of domestic deposits. The SAIF assessment rate may
increase or decrease as is necessary to maintain the designated SAIF
reserve ratio of 1.25% of insured deposits.
Effective January 1, 1997, all FDIC-insured depository institutions
must pay an annual assessment to provide funds for the payment of
interest on bonds issued by the Financing Corporation, a federal
corporation chartered under the authority of the Federal Housing
Finance Board. The FICO Bonds were issued to capitalize the Federal
Savings and Loan Insurance Corporation. Until December 31, 1999 or
when the last savings and loan association ceases to exist, whichever
occurs first, depository institutions will pay approximately $.064 per
$100 of SAIF-assessable deposits and approximately $.013 per $100 of
BIF-assessable deposits.
<PAGE>
The new legislation contemplates a unification of the charters
presently available to banks and thrifts. The Treasury Department is
required to make recommendations regarding unification of the
available charters and the merger of the insurance funds by March 31,
1997. The legislation requires a merger of the SAIF with the BIF on
January 1, 1999 if the unification of the charters for all insured
institutions has, in fact, occurred. SAIF and BIF will continue to
operate as separate funds, if this unification of charters has not
taken place, until such time as additional federal legislation is
passed requiring a merger of the funds.
Sterling Savings may be required to convert its charter to either a
national bank charter, a state depository institution charter, or a
newly designed charter. Sterling may also become regulated at the
holding company level by the Federal Reserve rather than by the OTS.
Regulation by the Federal Reserve could subject Sterling to capital
requirements that are not currently applicable to Sterling as a thrift
holding company under OTS regulation and may result in statutory
limitations on the type of business activities in which Sterling may
engage at the holding company level, which business activities
currently are not restricted. At this time, Sterling Savings is
unable to predict whether a charter change will be required and, if it
is, whether the charter change will significantly impact Sterling
Savings' operations. See "Regulation."
Sterling intends to continue to pursue its growth strategy by focusing
on internal growth, as well as acquisition opportunities. As part of
this strategy, Sterling is changing the mix of its assets and
liabilities to become more like a community-based retail bank.
Sterling may acquire (i) other financial institutions or branches
thereof, (ii) branch facilities, (iii) mortgage loan servicing
portfolios or mortgage banking operations, or (iv) other substantial
assets or deposit liabilities, all of which would be subject to prior
regulatory approval. As part of this growth strategy, Sterling
engages from time to time in discussions concerning possible
acquisitions. There can be no assurance, however, that Sterling will
be successful in identifying, acquiring or assimilating appropriate
acquisition candidates or be successful in implementing its internal
growth strategy or that these activities will result in improved
financial performance. See "Competition" and "Regulation."
Net Interest Income
-------------------
The most significant component of earnings for a financial institution
typically is net interest income. Net interest income is the
difference between interest income, primarily from loan, mortgage-
backed securities and investment portfolios, and interest expense,
primarily on deposits and borrowings. During the six months ended
December 31, 1996 and 1995, and the fiscal years ended June 30, 1996
and 1995, net interest income was $20.2 million, $17.0 million,
$35.5 million and $35.4 million, respectively. Changes in net
interest income result from changes in volume, net interest spread and
net interest margin. Volume refers to the dollar level of interest-
earning assets and interest-bearing liabilities. Net interest spread
refers to the difference between the yield on interest-earning assets
<PAGE>
and the rate paid on interest-bearing liabilities. Net interest
margin refers to net interest income divided by total interest-earning
assets and is influenced by the level and relative mix of interest-
earning assets and interest-bearing liabilities. During the six
months ended December 31, 1996 and 1995 and for the fiscal years ended
June 30, 1996 and 1995, the volume of average interest-earning assets
was $1.43 billion, $1.46 billion, $1.44 billion and $1.45 billion,
respectively. Net interest spread during these periods was 2.58%,
2.06%, 2.24% and 2.26%, respectively. During these same periods, the
net interest margin was 2.80%, 2.31%, 2.46% and 2.44%, respectively.
During the six months ended December 31, 1996, the increase in net
interest income was due primarily to an increase in the interest
earned on all interest-earning assets coupled with a decrease in the
cost of deposits and borrowings. During the fiscal year ended
June 30, 1996, the increase in net interest income was due to a mix
change in the volume of interest-earning assets towards higher yielding
assets, which helped increase the net interest margin.
The following table sets forth, for the periods indicated, information
with regard to average balances of interest-earning assets and
interest-bearing liabilities, the total dollar amounts of interest
income from interest-earning assets and interest expense on interest-
bearing liabilities, resultant yields or costs, net interest income,
net interest spread, net interest margin and ratio of average
interest-earning assets to average interest-bearing liabilities.
<TABLE>
<CAPTION>
Six Months Ended December 31,
----------------------------------------------------------------------
1996 1995
---------------------------------- ----------------------------------
Interest Average Interest Average
Average Earned Yield or Average Earned Yield or
Balance(1) or Paid Cost (2) Balance(1) or Paid Cost (2)
---------- ---------- ---------- ---------- --------- -----------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C> <C>
Interest-earning
assets:
Loans $ 925,494 $ 41,702 8.94% $1,069,712 $ 46,599 8.67%
Mortgage-backed
securities 386,019 12,574 6.46 296,761 8,436 5.65
Investments and
cash equivalents 122,926 3,338 5.39 98,131 2,483 5.03
---------- ---------- ---- ---------- ---------- ----
Total interest-
earning assets $1,434,439 $ 57,614 7.97% $1,464,604 $ 57,518 7.81%
========== ========== ==== ========== ========== ====
Interest-bearing
liabilities:
Deposits and check-
ing accounts:
Certificates
of deposit $ 578,738 $ 16,329 5.60% $ 629,828 $ 18,934 5.98%
Regular savings
accounts and
money market
accounts 222,223 4,243 3.79 175,479 3,233 3.66
Interest-bearing
demand accounts 70,959 499 1.39 66,426 499 1.49
---------- --------- ---- ---------- ---------- ----
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
Six Months Ended December 31,
---------------------------------------------------------------------
1996 1995
------------------------------- -----------------------------------
Interest Average Interest Average
Average Earned Yield or Average Earned Yield or
Balance(1) or Paid Cost (2) Balance(1) or Paid Cost (2)
---------- ---------- ---------- ---------- ----------- ----------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C> <C>
Total deposits and
checking accounts $ 871,920 $ 21,071 4.79% $ 871,733 $ 22,666 5.17%
FHLB Seattle advances 258,089 8,849 6.80 348,108 11,577 6.62
Other borrowings 229,593 6,659 5.75 164,573 5,411 6.54
Subordinated Notes 17,240 832 9.57 17,240 832 9.60
---------- ---------- ---- ---------- ---------- ----
Total interest-bearing
liabilities $1,376,842 $ 37,411 5.39% $1,401,654 $ 40,486 5.75%
========== ========== ==== ========== ========== ====
Net interest income $ 20,203 $ 17,032
========== ===========
Net interest spread 2.58% 2.06%
==== ====
Net interest margin 2.80% 2.31%
==== ====
Ratio of average
interest-earning
assets to average
interest-bearing
liabilities 104.0% 104.5%
===== =====
</TABLE>
(1) Average balances exclude nonaccrual loans.
(2) The yield information for the available-for-sale portfolio does
not give effect to changes in fair value that are reflected as a
component of Shareholders' equity.
<PAGE>
The following table sets forth, for the periods indicated, information
with regard to average balances of interest-earning assets and
interest-bearing liabilities, the total dollar amounts of interest
income from interest-earning assets and interest expense on interest-
bearing liabilities, resultant yields or costs, net interest income,
net interest spread, net interest margin and ratio of average
interest-earning assets to average interest-bearing liabilities.
<TABLE>
<CAPTION>
Six Months Ended December 31,
-----------------------------------------------------------------------
1996 1995
----------------------------------- ---------------------------------
Interest Average Interest Average
Average Earned Yield or Average Earned Yield or
Balance(1) or Paid Cost (2) Balance(1) or Paid Cost (2)
---------- ---------- ---------- ---------- ---------- ----------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C> <C>
Interest-earning
assets:
Loans $ 988,077 $ 86,235 8.73% $1,004,297 $ 79,858 7.95%
Mortgage-backed
securities 354,596 22,044 6.22 347,949 22,386 6.43
Investments and
cash equivalents 98,215 4,802 4.89 100,237 5,011 5.00
---------- ---------- ---- ---------- ---------- ----
Total interest-
earning assets $1,440,888 $ 113,081 7.85% $1,452,483 $ 107,255 7.38%
========== ========== ==== ========== ========== ====
Interest-bearing
liabilities:
Deposits and check-
ing accounts:
Certificates of
deposit $ 610,297 $ 35,996 5.90% $ 626,952 $ 32,800 5.23%
Regular savings
accounts and money
market accounts 194,346 7,233 3.72 163,490 5,826 3.56
Interest-bearing
demand accounts 67,507 1,029 1.52 66,060 1,189 1.80
---------- ---------- ---- ---------- ---------- ----
Total deposits and
checking accounts 872,150 44,258 5.07 856,502 39,815 4.65
FHLB Seattle advances 325,804 21,679 6.65 396,829 22,509 5.67
Other borrowings 167,087 9,994 5.98 133,075 7,866 5.91
Subordinated Notes 17,240 1,680 9.74 17,246 1,674 9.71
---------- ---------- ---- ---------- ---------- ----
Total interest-bearing
liabilities $1,382,281 $ 77,611 5.61% $1,403,652 $ 71,864 5.12%
========== ========== ==== ========== ========== ====
Net interest income $ 35,470 $ 35,391
========== ==========
Net interest spread 2.24% 2.26%
==== ====
Net interest margin 2.46% 2.44%
==== ====
Ratio of average
interest-earning
assets to average
interest-bearing
liabilities 104.0% 103.2%
===== =====
</TABLE>
<PAGE>
(1) Average balances exclude nonaccrual loans.
(2) The yield information for the available-for-sale portfolio does
not give effect to changes in fair value that are reflected as a
component of Shareholders' equity.
The following table illustrates the changes in Sterling's net interest
income due to changes in volume (change in volume multiplied by
initial rate), changes in interest rate (change in rate multiplied by
initial volume) and changes in rate/volume (change in rate multiplied
by change in average volume) for the periods indicated.
<TABLE>
<CAPTION>
Six Months Ended December 31, 1996 Fiscal Year 1996
vs. Six Months Ended December 31, 1995 vs. Fiscal Year 1995
Increase (Decrease) Due to: Increase (Decrease) Due to:
-------------------------------------- -------------------------------------
Rate/ Rate/
Volume Rate Volume Total Volume Rate Volume Total
-------- ------- -------- -------- -------- ------- -------- -------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Interest income on:
Loans (1) $(6,300) $ 1,474 $ (71) $(4,897) $(1,290) $ 7,793 $ (126) $ 6,377
Mortgage-backed
securities 2,544 1,207 387 4,138 428 (755) (15) (342)
Investments and cash
equivalents 629 175 51 855 (101) (110) 2 (209)
------- ------- ------- ------- ------- -------- -------- --------
Total interest income (3,127) 2,856 367 96 (963) 6,928 (139) 5,826
------- ------- ------- ------- ------- -------- -------- --------
Deposits and checking
accounts:
Certificates of
deposit (1,540) (1,215) 150 (2,605) (871) 4,178 (111) 3,196
Regular savings
accounts and money
market accounts 864 109 37 1,010 1,100 259 48 1,407
Interest-bearing
demand accounts 34 (33) (1) 0 26 (182) (4) (160)
------- ------- ------- ------- ------- -------- ------- -------
Total deposits and
checking accounts (642) (1,139) 186 (1,595) 255 4,255 (67) 4,443
FHLB Seattle advances (3,002) 327 (53) (2,728) (4,029) 3,896 (697) (830)
Other borrowings 2,144 (653) (243) 1,248 2,010 94 24 2,128
Subordinated Notes 0 (2) 2 0 (1) 7 0 6
------- ------- ------- ------- ------- ------- ------- -------
Total interest expense 1,500 (1,467) (108) (3,075) (1,765) 8,252 (740) 5,747
------- ------- ------- ------- ------- ------- ------- -------
Net interest income $(1,627) $ 4,323 $ 475 $ 3,171 $ 802 $(1,324) $ 601 $ 79
======= ======= ======= ======= ======= ======= ======= =======
</TABLE>
(1) The effects of nonaccrual loans are excluded.
<PAGE>
Asset and Liability Management
------------------------------
The results of operations for savings institutions may be materially
and adversely affected by changes in prevailing economic conditions,
including rapid changes in interest rates, declines in real estate
3 market values and the monetary and fiscal policies of the federal
government. Like all financial institutions, Sterling's net interest
income and its NPV (the net present value of assets, liabilities and
off-balance sheet contracts) are subject to fluctuations in interest
rates. Currently, Sterling's interest-bearing liabilities, consisting
primarily of savings deposits, the FHLB Seattle advances and other
borrowings, mature or reprice more rapidly, or on different terms,
than do its interest-earning assets. The fact that liabilities mature
or reprice more frequently on average than assets may be beneficial in
times of declining interest rates; however, such an asset/liability
structure may result in declining net interest income during periods
of rising interest rates. Additionally, the extent to which borrowers
prepay loans is affected by prevailing interest rates.
When interest rates increase, borrowers are less likely to prepay
loans; whereas when interest rates decrease, borrowers are more likely
to prepay loans. Prepayments may affect the levels of loans retained
in an institution's portfolio, as well as its net interest income.
Sterling maintains an asset and liability management program intended
to manage net interest income through interest rate cycles and to
protect its NPV by controlling its exposure to changing interest
rates.
Sterling uses a simulation model designed to measure the sensitivity
of net interest income and NPV to changes in interest rates. This
simulation model is designed to enable Sterling to generate a forecast
of net interest income and NPV given various interest rate forecasts
and alternative strategies. The model is also designed to measure the
anticipated impact that prepayment risk, basis risk, customer maturity
preferences, volumes of new business and changes in the relationship
between long- and short-term interest rates have on the performance of
Sterling. At December 31, 1996, Sterling calculated that its NPV was
$97.4 million, as compared with $80.7 million at June 30, 1996, and
that its NPV would decrease by 24.2% and 52.8% if interest rate levels
generally were to increase by 2% and 4%, respectively. These
calculations, which are highly subjective and technical, may differ
materially from regulatory calculations. See "Regulation - Regulatory
Capital Requirements - Risk-based Capital."
Sterling also uses gap analysis, a traditional analytical tool
designed to measure the difference between the amount of interest-
earning assets and the amount of interest-bearing liabilities expected
to mature or reprice in a given period. Sterling attempts to maintain
its asset and liability gap position between positive 10% and negative
25% at both the one-year and three-year pricing intervals. Sterling
calculated its one-year cumulative gap position to be a negative 4.4%
and negative 14.9% at December 31, 1996 and June 30, 1996,
respectively. Sterling calculated its three-year gap position to be a
negative 6.6% and negative 11.3% at December 31, 1996 and June 30,
1996, respectively. The narrowing in the negative gap positions at
<PAGE>
December 31, 1996 was due primarily to a reduction in longer term
fixed-rate assets. While Sterling's gap positions are within limits
established by its Board of Directors, management is evaluating
strategies to reduce its cumulative gap positions in future periods.
There can be no assurance that Sterling will be successful in either
decreasing its liability costs or reducing its gap positions and that
its net interest income will not decline. See "Capital Resources" and
"Results of Operations - Net Interest Income."
During the six months ended December 31, 1996 and the fiscal years
ended June 30, 1996 and 1995, management pursued strategies to
increase its NPV and to reduce the impact of changes in interest rates
on the NPV. These strategies included extending maturities of
deposits and borrowings, originating and retaining variable-rate
mortgages and non-mortgage loans with frequent repricing features,
selling fixed-rate loans and mortgage-backed securities currently held
in the available-for-sale portfolio, and acquiring servicing
portfolios. They also resulted in higher costs of funds, realized
losses on certain mortgage-backed securities sales and lower net
interest income. During the fiscal year ended June 30, 1996, NPV
declined, due primarily to a decrease in the value of long-term assets
resulting from an increase in long-term interest rates. During the
six months ended December 31, 1996, NPV increased, due primarily to an
increase in the value of long-term assets and a change in the loan
mix.
Sterling is continuing to pursue strategies to reduce the level of IRR
while also endeavoring to increase its net interest income through the
origination and retention of variable-rate consumer, business banking,
construction and commercial real estate loans which generally have
higher yields than residential permanent loans. There can be no
assurance that Sterling will be successful implementing any of these
strategies or that, if these strategies are implemented, they will
have the intended effect of reducing IRR.
The following table sets forth the estimated maturity/repricing and
the resulting gap between Sterling's interest-earning assets and
interest-bearing liabilities at December 31, 1996. The estimated
maturity/repricing amounts reflect contractual maturities and
amortizations, assumed loan prepayments based upon Sterling's
historical experience, estimates from secondary market sources such as
the FHLMC and estimated passbook deposit decay rates (the rate of
transfer to higher-yielding CDs). Management believes these
assumptions and estimates are reasonable based on Sterling's
experience, but there can be no assurance in this regard.
<PAGE>
The classification of mortgage loans and mortgage-backed securities is
based upon regulatory reporting formats and, therefore, may not be
consistent with the financial information reported in accordance with
GAAP and contained elsewhere in this Report on Form 10-K.
<TABLE>
<CAPTION>
Maturity or Repricing
------------------------------------------------------------------------
Over Over Over
Zero to 3 Months One Year 3 Years Over
3 Months to 1 Year to 3 Years to 5 Years Five Years Total
---------- ---------- ---------- ---------- ---------- ---------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C> <C>
Interest-earning assets:
Mortgage loans and
mortgage-backed
securities:
ARM and balloon mortgage
loans $ 262,755 $ 206,585 $ 130,008 $ 74,162 $ 1,453 $ 674,963
Fixed-rate mortgage
loans 13,059 30,443 72,142 56,980 140,284 312,908
Loans held-for-sale 6,116 0 0 0 0 6,116
---------- ---------- ---------- ---------- ---------- ----------
Total mortgage loans
and mortgage-backed
securities 281,930 237,028 202,150 131,142 141,737 993,987
Non-mortgage loans:
Consumer 30,775 34,115 37,643 10,283 10,524 123,340
Commercial 185,448 2,721 5,004 4,225 2,672 200,070
---------- ---------- ---------- ---------- ---------- ----------
Total loans and mortgage-
backed securities 498,153 273,864 244,797 145,650 154,933 1,317,397
Cash and investment
securities 40,954 27,284 34,429 3,897 4,409 110,973
---------- ---------- ---------- ---------- ---------- ----------
Total rate-sensitive
assets $ 539,107 $ 301,148 $ 279,226 $ 149,547 159,342 1,428,370
Cash on hand and in banks 29,652 29,652
Other non-interest-earning
assets 78,322 78,322
---------- ----------
Total assets $ 267,316 $1,536,344
========== ==========
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
Maturity or Repricing
--------------------------------------------------------------------------
Over Over Over
Zero to 3 Months One Year 3 Years Over
3 Months to 1 Year to 3 Years to 5 Years Five Years Total
---------- ---------- ---------- ---------- ---------- ----------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C> <C>
Interest-bearing
liabilities:
Deposits:
Certificates of deposit $ 153,456 $ 275,498 $ 109,736 $ 14,921 $ 30,862 $ 584,473
Checking accounts 2,403 6,853 16,002 13,129 58,479 96,866
Money market accounts 148,696 0 0 0 0 148,696
Passbook accounts 4,421 11,707 18,757 12,577 24,781 72,243
---------- ---------- ---------- ---------- ---------- ----------
Total deposits 308,976 294,058 144,495 40,627 114,122 902,278
FHLB Seattle advances 45,000 45,000 139,000 19,000 11,626 259,626
Other borrowings 148,119 66,678 30,000 17,240 0 262,037
---------- ---------- ---------- ---------- ---------- ----------
Total interest-bearing
liabilities 502,095 405,736 313,495 76,867 125,748 1,423,941
Impact of liability
commitments and hedging 0 0 0 0 0 0
---------- ---------- ---------- ---------- ---------- ----------
Total rate-sensitive
liabilities $ 502,095 $ 405,736 $ 313,495 $ 76,867 125,748 1,423,941
========== ========== ========== ==========
Other non-interest-bearing
liabilities 23,183 23,183
Shareholders' equity 89,220 89,220
--------- ----------
Total liabilities and
Shareholders' equity $ 238,151 $1,536,344
========== ==========
Net gap $ 37,012 $ (104,588) $ (34,269) $ 72,680 $ 29,165 $ 0
========== ========== ========== ========== ========== ==========
Cumulative gap $ 37,012 $ (67,576) $ (101,845) $ (29,165) $ 0 $ 0
========== ========== ========== ========== ========== ==========
Cumulative gap to total
assets 2.4% (4.4)% (6.6)% (1.9)% 0.00% 0.00%
========== ========== ========== ========== ========= ==========
</TABLE>
<PAGE>
Mortgage-Backed Securities
--------------------------
Sterling classifies specific mortgage-backed securities and
investments as available-for-sale and periodically sells these
securities to assist in managing its IRR. These securities may be sold
in response to changes in market interest rates and related changes in
the securities' prepayment risk, needs for liquidity, changes in the
availability, the yield on alternative investments and changes in
funding sources and terms. Securities classified as available-for-sale
are carried at fair value. Unrealized gains and losses are excluded
from earnings and are reported net of deferred income tax as a
separate component of Shareholders' equity until such securities
mature or are actually sold. Fluctuations in prevailing interest
rates had the effect of increasing the fair value of these securities
and Shareholders' equity at December 31, 1996, and will likely cause
volatility in this component of Shareholders' equity in future
periods. In November 1995, Sterling transferred $214.1 million of
investments and mortgage-backed securities to available-for-sale from
held-to-maturity as allowed by the Financial Accounting Standards
Board ("FASB"). At December 31, 1996 and June 30, 1996, mortgage-
backed securities and investments classified as available-for-sale
were $469.8 million and $460.1 million, respectively. The carrying
value of these securities includes a net unrealized loss of $6.0
million (net of a $3.2 million related tax benefit) and $10.3 million
(net of a $5.5 million related tax benefit), respectively. The
increase in fair value since June 30, 1996 is due primarily to a
decrease in long-term interest rates.
Mortgage-backed securities and investments that management has the
positive intent and ability to hold to maturity are classified as
held-to-maturity and carried at amortized cost. At December 31, 1996
and June 30, 1996, mortgage-backed securities and investments
classified as held-to-maturity were $11.9 million. Any unrealized
gains and losses on such securities are not required to be reported in
the Consolidated Financial Statements as these securities are held for
investment purposes. Management does not believe the net unrealized
loss on investments classified as held-to-maturity of $28,000 at
December 31, 1996 will be realized, but there can be no assurances in
this regard. See "Results of Operations - Other Income and Capital
Resources."
From time to time, depending upon its asset and liability management
strategy, Sterling converts a portion of its mortgage production into
either FHLMC participation certificates or FNMA conventional mortgage-
backed securities, primarily for sale in the secondary market. This
securitization of its loans provides Sterling with increased liquidity
both because the mortgage-backed securities are typically more readily
marketable than the underlying loans and because they can usually be
used as collateral for borrowings. During the fiscal year ended
June 30, 1996, Sterling converted approximately $241.9 million of its
fixed-rate residential loans into FHLMC participation certificates.
Sterling subsequently sold $7.8 million of these FHLMC participation
certificates into the secondary market, realizing a gain of
approximately $274,000. Sterling used the proceeds to repay maturing
borrowings.
<PAGE>
Results of Operations for the Six Months Ended December 31, 1996
and 1995
----------------------------------------------------------------
OVERVIEW. Sterling's SAIF assessment resulted in a pre-tax charge to
earnings of $5.8 million during the six months ended December 31,
1996. Primarily as a result of this charge and an increase in other
operating expenses, Sterling reported a net loss of $1.1 million, or
$0.37 per fully diluted share, for the six months ended December 31,
1996, compared with net income of $3.2 million, or $0.42 per fully
diluted share, for the six months ended December 31, 1995.
The annualized return on average assets was (0.14)% and 0.41% for the
six months ended December 31, 1996 and 1995, respectively. The return
on common Shareholders' equity was (6.6)% and 6.8% for the six months
ended December 31, 1996 and 1995, respectively. This decrease is due
primarily to the SAIF assessment and the increase in other operating
expenses.
NET INTEREST INCOME. Net interest income for the six months ended
December 31, 1996 was $20.2 million, compared to $17.0 million for the
six months ended December 31, 1995. During these same periods, the
net interest margins were 2.80% and 2.31%, respectively, and the
volumes of interest-earning assets were $1.43 billion and $1.46
billion, respectively. The increase in net interest income primarily
reflects an increase in the rates earned on interest-earning assets
coupled with a decrease in the cost of deposits and other borrowings.
See "Net Interest Income."
PROVISION FOR LOAN LOSSES. Management's policy is to establish
valuation allowances for estimated losses by charging income. The
evaluation of the adequacy of specific and general valuation
allowances is an ongoing process. Sterling recorded provisions for
loan losses of $1.1 million and $800,000 for the six months ended
December 31, 1996 and 1995, respectively. Sterling increased its
provision for loan losses in anticipation of potentially higher levels
of loss from its expanded consumer and commercial lending activities.
At December 31, 1996, Sterling's loan delinquency rate as a percentage
of total loans was 0.53%, compared with 0.58% at December 31, 1995.
Total nonperforming loans were $2.5 million at December 31, 1996,
compared with $4.5 million at December 31, 1995. As a percentage of
total loans, nonperforming loans were 0.25% at December 31, 1996,
compared with 0.47% at December 31, 1995. Management believes the
loan loss provisions represent appropriate allowances for loan losses
based upon its evaluation of factors affecting the adequacy of
valuation allowances, although there can be no assurance in this
regard. Such factors include concentrations of the types of loans and
associated risks within the loan portfolio and economic factors
affecting the Pacific Northwest economy.
<PAGE>
OTHER INCOME. The following table summarizes the components of other
income for the periods indicated:
Six Months Ended
December 31,
----------------
1996 1995
------ -------
(Dollars in thousands)
Fees and service charges $2,431 $1,777
Mortgage banking operations 1,686 1,761
Loan servicing fees 633 459
Net gain on sales of securities 0 451
Net loss on sales and operations of REO (102) (114)
------ ------
$4,648 $4,334
====== ======
Fees and service charges consist primarily of service charges on
deposit accounts, fees for certain customer services, commissions on
sales of credit life insurance and late charges on loans, as well as
escrow fees, commissions on sales of mutual funds and annuity
products. The increase for the six months ended December 31, 1996,
compared with the six months ended December 31, 1995 was due primarily
to an increase in service charges on deposit accounts, fees for
certain customer services and commissions on sales of credit life
insurance. This increase in service charges on deposit accounts and
fees for certain customer services is due to the change in the mix of
Sterling's deposit accounts.
The decrease in income from mortgage banking operations for the six
months ended December 31, 1996, compared with the six months ended
December 31, 1995 primarily resulted from a decrease in the volume of
loans sold during the six months ended December 31, 1996, as compared
with the six months ended December 31, 1995.
The following table summarizes loan originations and sales of loans
for the periods indicated:
Six Months Ended
December 31,
----------------
1996 1995
------ ------
(Dollars in Millions)
Originations of one- to four-family
mortgage loans $166.8 $208.5
Sales of residential loans 77.8 122.8
Principal balances at end of period
of mortgage loans serviced for others 542.2 837.1
<PAGE>
The increase in loan servicing fees for the six months ended
December 31, 1996 compared with the six months ended December 31, 1995
reflects a decrease in the balance of loans serviced that have
amortization of a related acquisition premium, offsetting the loan
servicing income.
Sterling's average loan servicing portfolio for the six months ended
December 31, 1996 and 1995, was approximately $562.3 million and
$625.2 million, respectively. Sterling anticipates retaining a
significant portion of the current balance of loans serviced for
others, although there can be no assurances in this regard.
During the six months ended December 31, 1995, Sterling sold
approximately $55.9 million of mortgage-backed securities and
investments. No such sales were made in the same period in 1996.
Sterling used the majority of the proceeds from the 1995 sales to
invest in one- to four-family loans and intermediate-term mortgage-
backed securities.
OPERATING EXPENSES. Operating expenses were $24.7 million and $15.5
million for the six months ended December 31, 1996 and 1995,
respectively. The significant increase is due primarily to the one-
time SAIF assessment and increases in employee compensation and
benefits, legal and accounting costs, and other expenses.
Employee compensation and benefits were $6.9 million and $6.1 million
for the six months ended December 31, 1996 and 1995, respectively.
The increase primarily reflects an increase in the number of
employees. Occupancy and equipment expenses were $2.9 million and $2.6
million for the six months ended December 31, 1996 and 1995,
respectively. Depreciation expense was $1.5 million and $1.3 million
for the six months ended December 31, 1996 and 1995, respectively.
The increases in occupancy and equipment and depreciation expenses
primarily reflect higher computer and data processing costs following
a conversion to a new data processing system in October 1995.
Insurance expenses were $1.3 million and $1.1 million for the six
months ended December 31, 1996 and 1995, respectively. The increase
primarily represents the initiation of liability coverage for
directors and officers and for increased premiums on property and
casualty policies. The one-time SAIF assessment of $5.8 million
represents $0.657 for every $100 of deposits on March 31, 1995. Legal
and accounting expense was $1.2 million and $507,000 during the six
months ended December 31, 1996 and 1995, respectively. The increase
primarily reflects costs incurred to pursue Sterling's breach of
contract claim against the U.S. Government and higher levels of
accounting and regulatory examination costs. Other expenses were $1.6
million and $835,000 for the six months ended December 31, 1996 and
1995, respectively. The increase in other expenses primarily reflects
a reduction in the deferral of loan origination costs, increased
business and occupation taxes, and increased provisions for various
other expense items. See "General" and "Capital Resources." See Note
18 of "Notes to Consolidated Financial Statements."
<PAGE>
Sterling measures the efficiency of its operations by its operating
efficiency ratio (the ratio of total operating expenses to total
revenues, which includes net interest income and total other income).
Sterling's operating efficiency ratio was 99.6% and 72.6% for the six
months ended December 31, 1996 and 1995, respectively. The increase is
due primarily to the significant increase in operating expenses
described above. Management is pursuing strategies to reduce the
operating efficiency ratio below 65%, although there can be no
assurances in this regard.
INCOME TAX PROVISION. For the six months ended December 31, 1996,
Sterling's income tax provision of $112,000 consists of a benefit from
the current operating loss which is more than offset by a provision
related to a change in the estimate of prior period income taxes. For
the six months ended December 31, 1995, Sterling's income tax
provision of $1.8 million represents 36.5% of income before income
taxes, which approximates the statutory tax rate.
Results of Operations for Fiscal Years Ended June 30, 1996 and 1995
-------------------------------------------------------------------
OVERVIEW. Sterling reported net income of $6.8 million, or $0.90 per
fully diluted share, for the fiscal year ended June 30, 1996, compared
with the fiscal year ended June 30, 1995, when net income was
$9.3 million or $1.27 per share. In the fiscal year ended June 30,
1996, the decrease in net income was due primarily to a decrease in
income from mortgage banking operations. All per share amounts have
been adjusted for all Common Stock dividends declared and/or paid.
See "- Other Income" and "- Operating Expenses."
For fiscal years ended June 30, 1996 and 1995, the annualized return
on average assets was 0.45% and 0.48%, respectively. The decrease is
due primarily to the decline in net interest margin and the increased
levels of average assets. The return on common Shareholders' equity
was 7.4% for the fiscal year ended June 30, 1996 compared with 13.1%
for the fiscal year ended June 30, 1995. This decrease is due
primarily to a decline in income from mortgage banking operations.
NET INTEREST INCOME. Net interest income was $35.5 million for the
fiscal year ended June 30, 1996 compared with net interest income of
$35.4 million for the fiscal year ended June 30, 1995. During this
same period, the net interest margins were 2.46% and 2.44%,
respectively, and the volumes of interest-earning assets were $1.44
billion and $1.45 billion, respectively. The increase in net interest
income primarily reflects a change in the mix of interest-earning
assets as the net interest margin increased to 2.46% from 2.44% for
the fiscal year ended June 30, 1995. See "Net Interest Income."
PROVISION FOR LOAN LOSSES. Management's policy is to establish
valuation allowances for estimated losses on loans by charging income.
The evaluation of the adequacy of specific and general valuation
allowances is an ongoing process. Sterling recorded provisions for
loan losses of $1.6 million for each of the fiscal years ended
June 30, 1996 and 1995.
<PAGE>
At June 30, 1996, Sterling's loan delinquency rate was 0.36% compared
with 0.34% at June 30, 1995. Total nonperforming loans were
$3.6 million at June 30, 1996 and June 30, 1995. As a percentage of
total loans, nonperforming loans were 0.36% at June 30, 1996 compared
with 0.32% at June 30, 1995. Management believes the loan loss
provisions represent appropriate allowances for loan losses based upon
its evaluation of the factors affecting the adequacy of valuation
allowances, although there can be no assurance in this regard. Such
factors include concentrations of the types of loans and associated
risks within the loan portfolio and economic factors affecting the
Pacific Northwest economy.
OTHER INCOME. The following table summarizes the components of other
income for the periods indicated.
Six Months Ended
December 31,
----------------
1996 1995
------- -------
(Dollars in thousands)
Fees and service charges $ 4,408 $ 3,945
Mortgage banking operations 3,054 6,416
Loan servicing fees 921 1,271
Net gain on sales of securities 458 246
Net loss on sales and operations of REO (171) (491)
------- -------
$ 8,670 $11,387
======= =======
Fees and service charges consist primarily of service charges on
deposit accounts, fees for certain customer services, commissions on
sales of credit life insurance and late charges on loans, as well as
escrow fees, commissions on sales of mutual funds and annuity
products. The increase for the fiscal year ended June 30, 1996 was
due primarily to an increase in service charges on deposit accounts,
fees for certain customer services, and commissions on sales of credit
life insurance.
The decrease in income from mortgage banking operations for the fiscal
year ended June 30, 1996 primarily resulted from lower levels of bulk
sales of servicing rights. During the fiscal year ended June 30, 1996
there were no gains on bulk sales of loan servicing rights compared
with a gain of $5.6 million for the fiscal year ended June 30, 1995.
Sterling sold bulk servicing during the fiscal year ended June 30,
1995 primarily to offset the reduction in residential loan
originations and related gains on sales of loans. Residential loan
originations declined in response to a reduction in refinance
activities and increases in short-term interest rates. See "General."
<PAGE>
The following table summarizes loan originations and sales of loans
and bulk servicing rights for the periods indicated:
Six Months Ended
December 31,
----------------
1996 1995
------ ------
(Dollars in Millions)
Originations of one- to four-family
mortgage loans $394.5 $430.2
Sales of residential loans 232.1 98.2
Principal balances of servicing portfolios
sold in bulk during the period 172.2 437.8
Principal balances of servicing portfolios
acquired 0.0 451.4
Principal balances at end of period of
mortgage loans serviced for others 587.8 647.0
The decrease in loan servicing fees for the fiscal year ended June 30,
1996, compared with the fiscal year ended June 30, 1995, primarily
reflects a decrease in the average size of the loan servicing
portfolio. During the fiscal years ended June 30, 1996 and 1995,
Sterling sold in bulk rights to service conventional loans for others
with principal balances of $172.2 million and $437.8 million,
respectively. Gains on these sales are included in income from
mortgage banking operations. Sterling's average loan servicing
portfolio for the fiscal years ended June 30, 1996 and 1995 was
approximately $677.4 million and $671.4 million, respectively.
Sterling anticipates retaining a significant portion of the current
balance of loans serviced for others and, therefore, there can be no
assurance that bulk sales of servicing rights will continue to
contribute to Sterling's income to the extent they have in the past.
During the fiscal years ended June 30, 1996 and 1995, Sterling sold
approximately $55.6 million and $166.2 million, respectively, of
mortgage-backed securities and investments. In the fiscal years ended
June 30, 1996 and 1995, Sterling used the majority of the sales
proceeds to repay maturing borrowings and jumbo deposits. See "Asset
and Liability Management."
The decrease in net losses from sales and operation of REO primarily
reflects a higher level of income from the operations of REO.
OPERATING EXPENSES. Operating expenses were $31.7 million and $31.3
million for the fiscal years ended June 30, 1996 and 1995,
respectively. The increase in operating expenses of 1.3% primarily
reflects increases in depreciation, employee compensation and
benefits, insurance, and occupancy and equipment, offset by decreases
in advertising, data processing and amortization of intangibles. See
Note 18 of "Notes to Consolidated Financial Statements."
<PAGE>
Sterling measures the efficiency of its operations by its operating
efficiency ratio (the ratio of total operating expenses to total
revenues, which includes net interest income and total other income.)
Sterling's operating efficiency ratio was 71.8% and 66.9% for the
fiscal years ended June 30, 1996 and 1995, respectively. The increase
primarily reflects lower levels of net interest income and income from
mortgage banking operations. In addition, the operating efficiency
ratio reflects a decrease in cost efficiency of the residential
lending operations due primarily to a decrease in loan originations.
Management is pursuing strategies to reduce the operating efficiency
ratio below 65%, although there can be no assurance that it will be
successful in this regard.
INCOME TAX PROVISION. Income tax provisions were $4.1 million and
$4.6 million for the fiscal years ended June 30, 1996 and 1995,
respectively. For the fiscal years ended June 30, 1996 and 1995, the
effective tax rates on income before income taxes were 37.4% and
33.2%, respectively. The effective tax rate for the fiscal year ended
June 30, 1996 was influenced by higher sources of income being derived
from states with state income taxes.
Liquidity and Sources of Funds
------------------------------
As a financial institution, Sterling's primary sources of funds are
derived from financing and operating activities. Financing activities
consist primarily of customer deposits, advances from the FHLB Seattle
and other borrowings. Deposits increased $3.9 million to $902.3
million at December 31, 1996, from $898.4 million at June 30, 1996.
Retail deposits, which exclude deposits over $100,000, decreased $5.3
million, or 0.67%, during the six months ended December 31, 1996. At
December 31, 1996, approximately $51.3 million of deposits consisted
of public funds that generally have maturities of 60 days or less.
Advances from the FHLB Seattle increased to $259.6 million at December
31, 1996 from $259.4 million at June 30, 1996. At December 31, 1996
and June 30, 1996, securities sold subject to repurchase agreements
were $229.8 million and $195.8 million, respectively. These
borrowings are secured by investments and mortgage-backed securities
with a market value exceeding the face value of the borrowings. Under
certain circumstances, Sterling could be required to pledge additional
securities or reduce the borrowings. Additionally, the maturities of
reverse repurchase agreements are generally less than twelve months
and are subject to more frequent repricing than are other types of
borrowings. Management plans to continue to rely upon the FHLB Seattle
advances and reverse repurchase agreements to help fund its
operations.
Cash provided or used by investing activities consists primarily of
principal and interest payments on loans and mortgage-backed
securities and sales of mortgage-backed securities. The levels of
these payments and sales increase or decrease depending on the size of
the loan and mortgage-backed securities portfolios and the general
trend and level of interest rates, which influences the level of
refinancing and mortgage prepayments. During the six months ended
December 31, 1996, net cash was used in investing activities primarily
to fund new loans and to purchase investments.
<PAGE>
Cash provided or used by operating activities is determined largely by
changes in the level of loan sales. Proceeds from sales of loans
decreased in the six months ended December 31, 1996 due primarily to a
reduction in residential loan origination activities. The level of
loans held for sale depends on the level of loan originations and the
time within which investors fund the purchase of loans from Sterling.
A majority of conventional loans held for sale are sold within 10 days
of the closing while the sale of certain FHA- and VA- insured loans
may take up to 60 days. Sterling typically offsets fluctuations in
the level of loans held for sale by changing the level of advances
from the FHLB Seattle, reverse repurchase agreements or cash.
Management believes that proceeds from loans sold and advances from
the FHLB Seattle and reverse repurchase agreements will be sufficient
to fund loan commitments in the future.
Sterling Savings' credit line with the FHLB Seattle is 35% of its
total assets. At December 31, 1996, this credit line represented a
total borrowing capacity of approximately $536.4 million, of which
$259.6 million was outstanding. Sterling Savings also borrows on a
secured basis from major broker/dealers and financial entities by
selling securities subject to repurchase agreements. At December 31,
1996, Sterling Savings had $229.8 million in outstanding borrowings
under reverse repurchase agreements and securities available for
additional secured borrowings of approximately $158.4 million.
Sterling Savings also had a secured line of credit agreement from a
commercial bank of approximately $10.0 million as of December 31,
1996. At December 31, 1996, Sterling Savings had no funds drawn on
this line of credit.
Excluding its subsidiaries, Sterling Financial had cash and other
resources of approximately $13.0 million and a line of credit from a
commercial bank of approximately $5.0 million at December 31, 1996.
At December 31, 1996, Sterling Financial had no funds drawn on this
line of credit. At September 30, 1996, Sterling Financial also
secured a $15.0 million six-year term variable-rate loan from a
commercial bank. Proceeds of $10.0 million of this term loan were
contributed to Sterling Savings to enhance its capital. At December
31, 1996, Sterling Financial had an investment of $51.1 million in the
Preferred Stock of Sterling Savings. Sterling Financial received cash
dividends on Sterling Savings Preferred Stock of $2.5 million during
the six months ended December 31, 1996. These resources were
sufficient to meet the operating needs of Sterling Financial,
including interest expense on the Subordinated Notes and dividends on
the Preferred Stock. Sterling Savings' ability to pay dividends is
limited by its earnings, financial condition and capital requirements,
as well as rules and regulations imposed by the OTS. See "Capital
Resources" and Note 15 of "Notes to Consolidated Financial
Statements."
OTS regulations require savings institutions such as Sterling Savings
to maintain an average daily balance of liquid assets equal to or
greater than a specific percentage (currently 5%) of the average daily
balance of net withdrawable accounts and borrowings payable on demand
in one year or less during the preceding calendar month. At December
31, 1996, Sterling Savings' liquidity ratio was 10.91%, compared with
<PAGE>
7.31% at June 30, 1996. The higher level of liquidity at December 31,
1996 was due primarily to the retention of qualifying securities.
Sterling Savings' strategy generally is to maintain its liquidity
ratio at or near the required minimum in order to maximize its yield
on alternative investments. The regulatory liquidity ratio does not
take into account certain other sources of liquidity, such as funds
invested through Sterling Savings' subsidiaries, potential borrowings
against mortgage-backed securities or investment securities and other
potential financing alternatives. The required minimum liquidity
ratio may vary from time to time, depending on economic conditions,
savings flows and loan funding needs.
Capital Resources
-----------------
Sterling's total Shareholders' equity was $89.2 million at
December 31, 1996, compared with $85.7 million at June 30, 1996. At
December 31, 1996 and June 30, 1996, Shareholders' equity was 5.8% of
total assets. The increase in total Shareholders' equity primarily
reflects the higher market value associated with the available-for-
sale securities and an increase in Common Stock, partially offset by a
decrease in retained earnings. See "General."
Sterling recorded at December 31, 1996, an unrealized loss of
$6.0 million, net of related income taxes, on investment and debt
securities classified as available-for-sale. The decrease in the
unrealized loss of $4.3 million from the June 30, 1996 balance of a
$10.3 million primarily reflects an increase in the market valuation
of mortgage-backed securities and treasury securities due to the
recent decline in long-term interest rates. Fluctuations in
prevailing interest rates could continue to cause volatility in this
component of Shareholders' equity in future periods. See "Mortgage-
Backed Securities."
In connection with the acquisition of servicing rights in 1994,
Sterling issued warrants to purchase 99,985 shares of Sterling's
Common Stock at $11.82 per share. All of such warrants were exercised
in July 1996, thereby increasing Sterling's Shareholders' equity by
approximately $1.2 million.
At December 31, 1996, Sterling has 1.04 million shares of Preferred
Stock. The Preferred Stock has a liquidation value of $25 per share,
plus any accumulated and unpaid dividends, and each share is
convertible at any time at a rate of 1.9516 shares of Common Stock,
subject to adjustment under certain conditions. Annual dividends of
$1.8125 per share of Preferred Stock are cumulative and payable
quarterly in arrears and must be paid before any distributions to
holders of Common Stock. The Preferred Stock is non-voting except
under certain limited circumstances. The Preferred Stock is also
redeemable, in whole or in part, at the option of Sterling at any time
on or after April 30, 1997 at a price of $26 per share, which
gradually declines each year to $25 per share on or after April 30,
2001.
<PAGE>
Sterling has issued and outstanding $17.2 million of 8.75%
Subordinated Notes due on January 31, 2000. These notes are unsecured
general obligations of Sterling and are subordinated to certain other
existing and future indebtedness. The indenture governing the
Subordinated Notes limits the ability of Sterling under certain
circumstances to incur additional indebtedness, to pay cash dividends
or to make other capital distributions. See Note 11 of "Notes to
Consolidated Financial Statements."
In order to improve and expand branch locations, Sterling anticipates
that its future capital expenditures will be approximately $1.0
million to $2.0 million for the year ended December 31, 1997.
Sterling intends to fund these capital expenditures from various
sources, including retained earnings and borrowings with various
maturities. Sterling is exploring opportunities to sell certain
developed properties and enter into lease arrangements, but there can
be no assurance that any of these transactions will occur.
Sterling Savings is required by applicable regulations to maintain
certain minimum capital levels with respect to tangible capital, core
leverage capital and risk-based capital. At December 31, 1996,
Sterling Savings exceeded all such regulatory capital requirements.
See Note 15 of "Notes to Consolidated Financial Statements."
Sterling continues to proactively manage its claim against the U.S.
government for breach of contract on three supervisory goodwill
acquisition contracts. On July 1, 1996, the U.S. Supreme Court ruled
in three similar cases that the U.S. Government was liable for having
breached its acquisition contracts with certain thrift associations.
Sterling is encouraged by the Supreme Court's decision, although it is
uncertain when a trial to determine Sterling's damages will be held or
when an award, if any, will be appropriated by Congress.
New Accounting Standards
------------------------
In March 1995, the Financial Accounting Standards Board ("FASB")
issued Statement of Financial Accounting Standards ("SFAS") No. 121,
Accounting for the Impairment of Long-lived Assets and for Long-lived
Assets to be Disposed of. SFAS No. 121 requires that long-lived
assets and certain identifiable intangibles being held and used by an
entity be reviewed for impairment by estimating future cash flows from
the use and disposition of the assets whenever circumstances indicate
that the carrying amount of such assets may not be recoverable.
Sterling adopted this new standard on July 1, 1996, and such adoption
did not have any effect on its consolidated financial statements.
In May 1995, the FASB issued SFAS No. 122 Accounting for Mortgage
Servicing Rights. This standard applies to transactions involving
sales or securitizations of mortgage loans with servicing rights
retained. This standard must also be applied to impairment
evaluations of all amounts capitalized as mortgage servicing rights,
including those purchased before adoption of this statement. Sterling
adopted this standard on July 1, 1996, and such adoption did not have
any effect on its consolidated financial statements.
<PAGE>
In June 1996, the FASB issued SFAS No. 125 Accounting for Transfers
and Servicing of Financial Assets and Extinguishment of Liabilities.
This standard also applies to transactions involving sales or
securitizations of financial assets, such as mortgage loans. Sterling
adopted the provisions of this standard on January 1, 1997. Management
does not believe that adoption of this statement will have a material
effect on the consolidated financial statements.
In October 1995, the FASB issued SFAS No. 123, Accounting for Stock-
Based Compensation. SFAS No. 123 establishes financial accounting and
reporting standards for stock-based employee compensation plans and
encourages all entities to adopt the fair value method of accounting
for all of their employee stock compensation plans. However, it also
allows an entity to continue to measure compensation costs for those
plans using the intrinsic value method of accounting. Entities
electing to retain the current accounting under the intrinsic method
must make pro forma disclosures of net income and earnings per share,
as if the fair value method of accounting under SFAS No. 123 had been
applied. Sterling adopted the disclosure only provisions of this
standard on July 1, 1996 and continues using the intrinsic method of
accounting for employee stock options. See Note 13 of "Notes to
Consolidated Financial Statements."
Effects of Inflation and Changing Prices
----------------------------------------
A savings institution has an asset and liability structure that is
interest-rate sensitive. As a holder of monetary assets and
liabilities, a savings institution's performance may be significantly
influenced by changes in interest rates. Although changes in the
prices of goods and services do not necessarily move in the same
direction as interest rates, increases in inflation generally have
resulted in increased interest rates, which may have an adverse effect
on Sterling's business.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
as amended, this report has been signed below by the following persons
on behalf of the Registrant and in the capacities and on the dates
indicated.
May 21, 1997 /s/ Daniel G. Byrne
---------------------------------------
Daniel G. Byrne, Senior Vice President,
Chief Financial Officer, Principal
Financial Officer, Principal Accounting
Officer
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