U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED
June 30, 1998
--------------
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD
TO .
------------ ------------
Commission file number 0-20800
-------
STERLING FINANCIAL CORPORATION
------------------------------------------------------
(Exact name of registrant as specified in its charter)
Washington 91-1572822
------------------------------- -------------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
111 North Wall Street
Spokane, Washington 99201
------------------------------------------------------
(Address of principal executive offices) (Zip Code)
(509) 458-2711
------------------------------------------------------
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all
reports required to be filed by Sections 13 or 15(d) of the Securities
Exchange Act of 1934 during the preceding 12 months (or for such
shorter period that the registrant was required to file such reports),
and (2) has been subject to such filing requirements for the past
90 days. Yes X No
----- -----
Indicate the number of shares outstanding of each of the issuer's
classes of common stock as of the latest practicable date:
Class Outstanding as of July 31, 1998
------------------------------ ------------------------------------
Common Stock ($1.00 par value) 7,605,612
<PAGE>
STERLING FINANCIAL CORPORATION
FORM 10-Q
For the Quarter Ended June 30, 1998
TABLE OF CONTENTS
PART I - Financial Information
Item 1 - Financial Statements
Consolidated Balance Sheets
Consolidated Statements of Operations
Consolidated Statements of Cash Flows
Consolidated Statements of Comprehensive Income
(Loss)
Notes to Consolidated Financial Statements
Item 2 - Management's Discussion and Analysis of Financial
Condition and Results of Operation
Item 3 - Quantitative and Qualitative Disclosures About
Market Risk
PART II - Other Information
Item 1 - Legal Proceedings
Item 2 - Changes in Securities
Item 3 - Defaults upon Senior Securities
Item 4 - Submission of Matters to a Vote of Security Holders
Item 5 - Other Information
Item 6 - Exhibits and Reports on Form 8-K
SIGNATURE
<PAGE>
PART I - Financial Information
Item 1 - Financial Statements
STERLING FINANCIAL CORPORATION
Consolidated Balance Sheets
(Unaudited)
June 30, December 31,
1998 1997
---------- ------------
(Dollars in thousands)
ASSETS
Cash and cash equivalents:
Interest bearing $ 119 $ 15,858
Non-interest bearing and vault 51,464 33,564
Restricted 17,740 2,988
Loans receivable (net of allowance for
losses of $13,912 and $8,959) 1,259,899 1,069,591
Loans held-for-sale 7,982 5,225
Investments and mortgage-backed securities
("MBS"):
Available-for-sale 583,304 656,236
Held-to-maturity 13,317 12,750
Accrued interest receivable (including
$5,595 and $6,295 on investments
and MBS) 15,036 14,058
Office properties and equipment, net 49,810 37,956
Real estate owned, net 6,471 8,817
Intangible assets, net 64,077 7,789
Purchased mortgage servicing rights, net 31 1,170
Prepaid expenses and other assets 7,509 10,248
---------- ----------
Total assets $2,076,759 $1,876,250
========== ==========
LIABILITIES AND SHAREHOLDERS' EQUITY
Deposits $1,519,250 $1,036,408
Advances from the Federal Home Loan Bank
of Seattle ("FHLB Seattle") 266,268 455,085
Securities sold subject to repurchase
agreements and funds purchased 53,387 180,077
Other borrowings (Note 4) 97,240 72,240
Cashiers checks issued and payable 14,595 11,260
Borrowers' reserves for taxes and insurance 1,578 1,264
Accrued interest payable 4,276 5,855
Accrued expenses and other liabilities 14,467 11,198
---------- ----------
Total liabilities 1,971,061 1,773,387
---------- ----------
<PAGE>
PART I - Financial Information
Item 1 - Financial Statements
STERLING FINANCIAL CORPORATION
Consolidated Balance Sheets, Continued
(Unaudited)
June 30, December 31,
1998 1997
---------- ------------
(Dollars in thousands)
LIABILITIES AND SHAREHOLDERS' EQUITY,
CONTINUED
Preferred stock, $1 par value; 10,000,000
shares authorized; 0 shares issued and
outstanding
Common stock, $1 par value; 20,000,000
shares authorized; 7,605,612 and
7,569,791 shares issued and outstanding $ 7,606 $ 7,570
Additional paid-in capital 69,793 69,412
Accumulated comprehensive loss:
Unrealized loss on investments and MBS
available-for-sale, net of deferred
income tax benefits of $163 and $540 (305) (1,003)
Retained earnings 28,604 26,884
---------- ----------
Total shareholders' equity 105,698 102,863
---------- ----------
Total liabilities and share-
holders' equity $2,076,759 $1,876,250
========== ==========
The accompanying notes are an integral part of the consolidated
financial statements.
<PAGE>
STERLING FINANCIAL CORPORATION
Consolidated Statements of Operations
(Unaudited)
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
----------------------- -----------------------
1998 1997 1998 1997
---------- ---------- ---------- ----------
(Dollars in thousands, except per share data)
<S> <C> <C> <C> <C>
Interest income:
Loans $ 26,049 $ 22,286 $ 50,640 $ 44,010
MBS 7,114 6,325 14,138 12,311
Investments and cash equivalents 3,693 2,158 6,847 4,096
---------- ---------- ---------- ----------
Total interest income 36,856 30,769 71,625 60,417
---------- ---------- ---------- ----------
Interest expense:
Deposits 12,643 11,195 24,569 21,696
Short-term borrowings 8,588 5,094 16,879 9,621
Long-term borrowings 2,575 3,443 5,257 7,011
---------- ---------- ---------- ----------
Total interest expense 23,806 19,732 46,705 38,328
---------- ---------- ---------- ----------
Net interest income 13,050 11,037 24,920 22,089
Provision for loan losses (2,900) (550) (3,700) (1,100)
---------- ---------- ---------- ----------
Net interest income after provision
for loan losses 10,150 10,487 21,220 20,989
---------- ---------- ---------- ----------
Other income:
Fees and service charges 1,663 1,288 3,042 2,497
Mortgage banking operations 410 582 1,078 1,088
Loan servicing fees 178 320 424 656
Net gain (loss) on sales of
securities (133) 487 578 572
Net loss on sale and operation of
real estate owned (110) (10) (192) (92)
---------- ---------- ---------- ----------
Total other income 2,008 2,667 4,930 4,721
---------- ---------- ---------- ----------
Operating expenses 13,730 9,463 23,570 18,351
---------- ---------- ---------- ----------
Income (loss) before income taxes (1,572) 3,691 2,580 7,359
Income tax provision (benefit) (613) 1,403 860 2,797
---------- ---------- ---------- ----------
Net income (loss) (959) 2,288 1,720 4,562
Less preferred stock dividends 0 (469) 0 (940)
---------- ---------- ---------- ----------
Net income (loss) available to common
shares $ (959) $ 1,819 $ 1,720 $ 3,622
========== ========== ========== ==========
</TABLE>
<PAGE>
STERLING FINANCIAL CORPORATION
Consolidated Statements of Operations, Continued
(Unaudited)
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
----------------------- -----------------------
1998 1997 1998 1997
---------- ---------- ---------- ----------
(Dollars in thousands, except per share data)
<S> <C> <C> <C> <C>
Income (loss) per common share - basic $ (0.13) $ 0.33 $ 0.23 $ 0.65
========== ========== ========== ==========
Income (loss) per common share - diluted $ (0.13) $ 0.30 $ 0.22 $ 0.59
========== ========== ========== ==========
Weighted average common shares
outstanding - basic 7,602,155 5,550,144 7,589,580 5,545,480
========== ========== ========== ==========
Weighted average common shares
outstanding - diluted 7,792,861 7,707,818 7,760,554 7,706,196
========== ========== ========== ==========
</TABLE>
The accompanying notes are an integral part of the consolidated
financial statements.
<PAGE>
STERLING FINANCIAL CORPORATION
Consolidated Statements of Cash Flows
(Unaudited)
Six Months Ended
June 30,
-----------------------
1998 1997
---------- ----------
(Dollars in thousands)
Cash flows from operating activities:
Net income $ 1,720 $ 4,562
Adjustments to reconcile net income to
net cash provided by operating
activities:
Provisions for loan and real estate
owned losses 3,771 1,148
Stock dividends on FHLB Seattle stock (1,085) (957)
Net gain on sales of loans, securities
and mortgage servicing rights (1,481) (1,385)
Net loss on sales of office property
and equipment 0 6
Net gain on sales of real estate owned (46) (72)
Depreciation and amortization 2,788 3,825
Change in:
Accrued interest receivable 149 (1,644)
Prepaid expenses and other assets 2,253 (2,779)
Cashiers checks issued and payable 3,335 1,655
Accrued interest payable (2,315) 801
Accrued expenses and other liabilities 3,269 748
Proceeds from sales of loans 65,476 61,642
Loans originated for sale (67,429) (62,774)
---------- ----------
Net cash provided by operating
activities 10,405 4,776
---------- ----------
Cash flows from investing activities:
Change in restricted cash (14,752) 2,330
Loans disbursed (558,914) (400,324)
Loan principal received 485,062 351,972
Purchase of investments (306,186) (55,438)
Proceeds from maturities of investments 276,317 10,000
Purchase of MBS (189,717) (174,825)
Principal payments on MBS 47,282 26,785
Proceeds from sales of MBS 246,892 86,684
Purchase of office properties and equipment (1,607) (499)
Proceeds from sales of office properties
and equipment 0 12
Improvements and other changes to real
estate owned (108) (367)
<PAGE>
STERLING FINANCIAL CORPORATION
Consolidated Statements of Cash Flows, Continued
(Unaudited)
Six Months Ended
June 30,
-----------------------
1998 1997
---------- ----------
(Dollars in thousands)
Cash flows from investing activities,
Continued:
Proceeds from sales and liquidation of
real estate owned $ 3,840 $ 869
Proceeds from sales of mortgage
servicing rights 1,123 0
Net cash received from branch
acquisition 327,183 0
---------- ----------
Net cash provided by (used in)
investing activities 316,415 (152,801)
---------- ----------
Cash flows from financing activities:
Net change in checking, passbook and
money market deposits 19,029 21,814
Proceeds from issuance of certificates
of deposit 447,501 216,249
Payments for maturing certificates of
deposit (526,080) (198,134)
Interest credited to deposits 24,892 21,691
Advances from FHLB Seattle 30,000 175,000
Repayment of FHLB Seattle advances (219,042) (60,041)
Net change in securities sold subject
to repurchase agreements and funds
purchased (126,690) (74,450)
Proceeds from other borrowings 40,000 40,000
Repayment of other borrowings (15,000) 0
Proceeds from exercise of stock options,
net of repurchases 417 29
Cash dividends on preferred stock 0 (940)
Other 314 197
---------- ----------
Net cash provided by (used in)
financing activities (324,659) 141,415
---------- ----------
Net change in cash and cash equivalents 2,161 (6,610)
Cash and cash equivalents, beginning of
period 49,422 32,675
---------- ----------
Cash and cash equivalents, end of period $ 51,583 $ 26,065
========== ==========
<PAGE>
STERLING FINANCIAL CORPORATION
Consolidated Statements of Cash Flows, Continued
(Unaudited)
Six Months Ended
June 30,
-----------------------
1998 1997
---------- ----------
(Dollars in thousands)
Supplemental disclosures:
Cash paid during the period for:
Interest $ 48,284 $ 37,527
Income taxes 1,185 1,576
Non-cash financing and investing
activities:
Loans converted into real estate
owned 1,411 775
The accompanying notes are an integral part of the consolidated
financial statements.
<PAGE>
STERLING FINANCIAL CORPORATION
Consolidated Statements of Comprehensive Income (Loss)
(Unaudited)
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
----------------------- -----------------------
1998 1997 1998 1997
---------- ---------- ---------- ----------
(Dollars in thousands, except per share data)
<S> <C> <C> <C> <C>
Net income (loss) $ (959) $ 2,288 $ 1,720 $ 4,562
Other comprehensive income (loss),
before income taxes:
Change in unrealized losses on
investment and MBS available-
for-sale 1,070 7,404 1,075 934
---------- ---------- ---------- ----------
Other comprehensive income (loss),
before income taxes 1,070 7,404 1,075 934
Less deferred income tax provision 375 2,591 377 325
Net other comprehensive income 695 4,813 698 609
---------- ---------- ---------- ----------
Comprehensive income (loss) $ (264) $ 7,101 $ 2,418 $ 5,171
========== ========== ========== ==========
The accompanying notes are an integral part of the consolidated
financial statements.
<PAGE>
STERLING FINANCIAL CORPORATION
Notes to Consolidated Financial Statements
1. GENERAL:
Notes to the December 31, 1997 consolidated financial statements,
as set forth in Sterling Financial Corporation's ("Sterling's")
December 31, 1997 Annual Report on Form 10-K, substantially apply
to these interim consolidated financial statements as of and for
the three and six months ended June 30, 1998 and are not repeated
here. All financial statements presented are unaudited. However,
the December 31, 1997 consolidated balance sheet was derived from
the audited balance sheet as of that date.
2. INTERIM FINANCIAL STATEMENTS:
The financial information set forth in the unaudited interim
consolidated financial statements reflects the adjustments, all of
which are of a normal and recurring nature, which, in the opinion
of management, are necessary for a fair presentation of the
periods reported.
3. RECLASSIFICATIONS:
Certain June 30, 1997 balances have been reclassified to conform
with the June 30, 1998 presentation. These reclassifications had
no effect on net income or retained earnings as previously
reported.
4. OTHER BORROWINGS:
The following table details Sterling's other borrowings.
June 30, December 31,
1998 1997
--------- ------------
(Dollars in thousands)
Term note $ 0 $15,000
Advances on line of credit (1) 40,000 0
8.75% Subordinated Notes Due 2000 17,240 17,240
Sterling-obligated mandatorily
redeemable preferred securities
of subsidiary trust holding solely
junior subordinated deferrable
interest debentures of Sterling (2) 40,000 40,000
------- -------
$97,240 $72,240
======= =======
<PAGE>
STERLING FINANCIAL CORPORATION
Notes to Consolidated Financial Statements, Continued
4. OTHER BORROWINGS, CONTINUED:
(1) In June 1998, Sterling entered into a line of credit
agreement with KeyBank National Association ("KeyBank").
Interest accrues at the London InterBank Offering Rate index
plus 2.0% (currently 7.69%) and is payable quarterly. This
line of credit is for twelve months and may be renewed for an
additional six months.
(2) Sterling has outstanding $41.2 million of 9.50% junior
subordinated deferrable interest debentures (the "Junior
Subordinated Debentures") to Sterling Capital Trust I (the
"Trust"), a Delaware business trust in which Sterling owns
all of the common equity. The sole asset of the Trust is the
Junior Subordinated Debentures. The Trust issued $40.0
million of 9.50% Cumulative Capital Securities (the "Trust
Preferred Securities") to investors. Sterling's obligations
under the Junior Subordinated Debentures and related
documents, taken together, constitute a full and
unconditional guarantee by Sterling of the Trust's
obligations under the Trust Preferred Securities. The Trust
Preferred Securities are treated as debt of Sterling.
Although Sterling, as a savings and loan holding company, is
not subject to the Federal Reserve capital requirements for
bank holding companies, the Trust Preferred Securities have
been structured to qualify as Tier 1 capital, subject to
certain limitations, if Sterling were to become regulated as
a bank holding company. The Junior Subordinated Debentures
and related Trust Preferred Securities mature on June 30,
2027, or are redeemable at the option of Sterling on June 30,
2002, or earlier in the event the deduction of related
interest for federal income taxes is prohibited, treatment as
Tier 1 capital is no longer permitted, or certain other
contingencies arise. The Trust Preferred Securities must be
redeemed upon maturity of the Junior Subordinated Debentures
in 2027.
<PAGE>
STERLING FINANCIAL CORPORATION
Notes to Consolidated Financial Statements, Continued
5. INCOME (LOSS) PER SHARE:
The following table presents the basic and diluted income (loss)
per share computations.
</TABLE>
<TABLE>
<CAPTION>
Three Months Ended June 30,
---------------------------------------------------------------------------
1998 1997
------------------------------------ ------------------------------------
Net Income Weighted Per Share Weighted Per Share
(Loss) Avg. Shares Amount Net Income Avg. Shares Amount
---------- ----------- --------- ---------- ----------- ---------
<S> <C> <C> <C> <C> <C> <C>
Net income (loss) $ (959,000) $2,288,000
Less preferred stock
dividends 0 (469,000)
Income (loss) per common
share - basic (959,000) 7,602,155 $ (0.13) 1,819,000 5,550,144 $ 0.33
Effect of dilutive
securities:
Convertible Preferred
Stock 0 0 469,000 2,023,546
Common stock options 0 190,706 0 134,128
---------- ----------- --------- ---------- ----------- ---------
Income (loss) per common
share - diluted (a) $ (959,000) 7,792,861 $ (0.13) $2,288,000 7,707,818 $ 0.30
========== =========== ========= ========== =========== =========
</TABLE>
(a) Common stock options were anti-dilutive for the three months
ended June 30, 1998. Therefore, basic income (loss) per share
is presented.
<PAGE>
STERLING FINANCIAL CORPORATION
Notes to Consolidated Financial Statements, Continued
5. INCOME (LOSS) PER SHARE:
The following table presents the basic and diluted income (loss)
per share computations.
<TABLE>
<CAPTION>
Six Months Ended June 30,
---------------------------------------------------------------------------
1998 1997
------------------------------------ ------------------------------------
Weighted Per Share Weighted Per Share
Net Income Avg. Shares Amount Net Income Avg. Shares Amount
---------- ----------- --------- ---------- ----------- ---------
<S> <C> <C> <C> <C> <C> <C>
Net income $1,720,000 $4,562,000
Less preferred stock
dividends 0 (940,000)
---------- ----------- --------- ---------- ----------- ---------
Income per common share -
basic 1,720,000 7,589,580 $ 0.23 3,622,000 5,545,480 $ 0.65
Effect of dilutive
securities:
Convertible Preferred
Stock 0 0 940,000 2,026,588
Common stock options 0 170,974 0 134,128
---------- ----------- --------- ---------- ----------- ---------
Income per common share -
diluted $1,720,000 7,760,554 $ 0.22 $4,562,000 7,706,196 $ 0.59
========== =========== ========= ========== =========== =========
</TABLE>
<PAGE>
STERLING FINANCIAL CORPORATION
Notes to Consolidated Financial Statements, Continued
6. OPERATING EXPENSES:
The following table details Sterling's components of total
operating expenses.
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
------------------ -----------------
1998 1997 1998 1997
------- ------- ------- -------
(Dollars in thousands)
<S> <C> <C> <C> <C>
Employee compensation and benefits $ 4,621 $ 3,944 $ 9,181 $ 7,846
Occupancy and equipment 1,576 1,452 3,132 2,898
Depreciation 749 774 1,491 1,558
Amortization of unidentified intangibles 154 201 308 402
Amortization of core deposit premium 383 377 766 767
Advertising 548 673 819 910
Data processing 672 588 1,393 1,226
Insurance 239 283 474 596
Legal and accounting 398 378 774 758
Travel and entertainment 286 279 579 522
Acquisition and conversion costs (a) 3,210 0 3,210 0
Other 894 514 1,443 868
------- ------- ------- -------
Total operating expenses $13,730 $ 9,463 $23,570 $18,351
======= ======= ======= =======
</TABLE>
(a) Includes costs associated with mailing customer notices;
issuing new checks and ATM cards; training new employees,
including related travel; equipping branches with office
supplies; implementing a targeted marketing campaign and
converting computer systems.
7. OTHER ACCOUNTING POLICIES:
In June 1998, the Financial Accounting Standards Board (the
"FASB") issued Statement of Financial Accounting Standards
("SFAS") No. 133, Accounting for Derivative Instruments and
Hedging Activities. SFAS No. 133 establishes accounting and
reporting standards for derivative instruments, including certain
derivative instruments embedded in other contracts (collectively
referred to as derivatives), and for hedging activities. It
requires that an entity recognize all derivatives as either assets
or liabilities in the statement of financial position and measure
those instruments at fair value. SFAS No. 133 is effective for
all fiscal quarters of fiscal years beginning after June 15, 1999;
however, earlier application of all of the provisions of this
Statement is encouraged as of the beginning of any fiscal quarter.
Sterling has not yet determined the effect, if any, of
implementing SFAS No. 133 on its consolidated financial
statements.
<PAGE>
STERLING FINANCIAL CORPORATION
Notes to Consolidated Financial Statements, Continued
7. OTHER ACCOUNTING POLICIES, CONTINUED:
In June 1997, the FASB issued SFAS No. 131, Disclosures about
Segments for an Enterprise and Related Information. Sterling
adopted this Statement effective January 1, 1998 with no material
effect on its consolidated financial statements. Presentation of
segment information is not required in interim periods.
In June 1997, the FASB issued SFAS No. 130, Reporting
Comprehensive Income. This Statement requires that comprehensive
income be reported in a financial statement that is displayed with
the same prominence as other financial statements. Comprehensive
income is defined as the change in equity arising from non-owner
sources. Comprehensive income under current accounting standards
includes foreign currency items, minimum pension liability
adjustments, and unrealized gains and losses on certain
investments in debt and equity securities. This Statement was
adopted on January 1, 1998. See "Consolidated Statements of
Comprehensive Income."
8. OTHER EVENTS:
Acquisition
-----------
On April 23, 1998, Sterling entered into a definitive merger
agreement ("Agreement") with Big Sky Bancorp, Inc. ("Big Sky"),
pursuant to which Big Sky will be merged into Sterling and Big
Sky's wholly owned subsidiary, First Federal Savings and Loan
Association of Montana ("First Federal"), will be merged into
Sterling's wholly owned subsidiary Sterling Savings Bank. At
December 31, 1997, First Federal had three branch offices in
western Montana with deposits of approximately $48 million and
approximately $63 million in total assets.
The Agreement provides that each share of Big Sky's common stock
will be exchanged for 1.384 shares of Sterling's common stock,
or up to 497,545 shares of Sterling common stock, depending on
the exercise of Big Sky options. The merger is intended to
constitute a tax-free reorganization and to be accounted for as
a pooling of interests.
The merger is subject to regulatory approvals, approval of Big
Sky's shareholders and other conditions of closing and is
scheduled to be completed in the fourth quarter of 1998.
Management anticipates securing regulatory approvals, obtaining
Big Sky shareholders' approval and meeting other conditions of
closing, although there can be no assurance in this regard.
<PAGE>
STERLING FINANCIAL CORPORATION
Notes to Consolidated Financial Statements, Continued
8. OTHER EVENTS, CONTINUED:
Name Change
-----------
Effective June 15, 1998, Sterling's wholly owned subsidiary
Sterling Savings Association changed its name to Sterling
Savings Bank.
9. SIGNIFICANT TRANSACTIONS:
On June 15, 1998, Sterling assumed approximately $518 million in
deposit liabilities corresponding to 33 branch offices of KeyBank.
Upon acquisition, the weighted average interest rate on deposits
assumed was approximately 3.42%. Sterling incurred approximately
$57 million in core deposit premium and other intangible assets
associated with the deposits. Sterling has not yet completed the
allocation of the excess purchase price to specific intangible
assets. Sterling anticipates amortizing the intangible assets
over an average period of 12 to 15 years. With the net cash
received from the branch acquisition, Sterling repaid
approximately $322 million of certain reverse repurchase
borrowings and FHLB Seattle advances. As a result of this
transaction, Sterling's total assets increased by approximately
$197 million.
The following table shows the estimated allocation of the KeyBank
branch transaction.
(Dollars in thousands)
Liabilities assumed:
Certificates of deposit $233,864
NOW accounts 79,887
Non-interest bearing demand accounts 76,419
Savings and money market accounts 127,330
--------
517,500
--------
Accrued interest payable 736
--------
Total liabilities assumed 518,236
--------
Less assets acquired:
Loans receivable, net $121,569
Office properties and equipment 10,996
Accrued interest on loans 1,126
Intangible assets 57,362
--------
Total assets acquired 191,053
--------
Net cash received from branch acquisition $327,183
========
<PAGE>
PART I - Financial Information (continued)
Item 2 - Management's Discussion and Analysis of Financial Condition
and Results of Operations
STERLING FINANCIAL CORPORATION
Comparison of the Three and Six Months Ended June 30, 1998 and 1997
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; CHANGES IN THE
QUALITY OR COMPOSITION OF STERLING'S LOAN AND INVESTMENT PORTFOLIOS;
SHIFTS IN THE DEMAND FOR STERLING'S LOAN AND OTHER PRODUCTS; LOWER
THAN EXPECTED REVENUE OR COST-SAVINGS IN CONNECTION WITH ACQUISITIONS;
CHANGES IN ACCOUNTING POLICIES; CHANGES IN THE MONETARY AND FISCAL
POLICIES OF THE FEDERAL GOVERNMENT; CHANGES IN LAWS, REGULATIONS AND
THE COMPETITIVE ENVIRONMENT. STERLING'S FUTURE RESULTS MAY DIFFER
MATERIALLY FROM HISTORICAL RESULTS AS WELL AS FROM ANY TREND OR
FORWARD-LOOKING INFORMATION INCLUDED IN THIS REPORT.
Results of Operations
---------------------
OVERVIEW. After acquisition and conversion charges associated with
the KeyBank National Association ("KeyBank") branch acquisition,
increases in loan loss provisions and losses from the sale of
securities, Sterling Financial Corporation ("Sterling") recorded a net
loss for the three months ended June 30, 1998 of $959,000, or ($0.13)
per diluted share. This compares to net income for the three months
ended June 30, 1997 of $2.3 million, or $0.30 per diluted share.
Although Sterling's earnings before conversion costs associated with
the purchase of 33 Northwest KeyBank branches and certain other
charges continue to be on a positive trend, net income for the quarter
was negatively affected by the KeyBank transaction, which was
completed on June 15, 1998. After-tax branch conversion costs were
approximately $2.0 million. These costs were within Sterling's range
of estimates and included costs associated with mailing customer
notices; issuing new checks and ATM cards; training new employees,
including related travel; equipping branches with office supplies;
implementing a targeted marketing campaign and converting computer
systems. During the three months ended June 30, 1998, Sterling
provided approximately $2.9 million for loan losses as it reflected a
more critical and conservative view of the factors used to provide
such reserves, including impacts on its Pacific Northwest customers
resulting from a slowdown of trade with Asia. As a result, Sterling's
reserves for loan losses are more in line with the level of allowances
maintained by commercial banks. In addition, to improve asset and
liability management associated with the effects of the acquisition of
the KeyBank branches, a loss of approximately $581,000 was incurred on
the sale of certain securities.
<PAGE>
After these same charges, net income for the six months ended
June 30, 1998 was $1.7 million, or $0.22 per diluted share. This
compares to net income for the six months ended June 30, 1997 of $4.6
million, or $0.59 per diluted share.
The annualized return on average assets was negative 0.20% and 0.57%
for the three months ended June 30, 1998 and 1997, respectively. For
the six months ended June 30, 1998 and 1997, the annualized return on
average assets was 0.18% and 0.58%, respectively. The decrease in
both periods was due primarily to lower net income. The annualized
return on average equity was negative 3.6% and 11.5% for the three
months ended June 30, 1998 and 1997, respectively. The annualized
return on average equity was 3.3% and 11.3% for the six month period
ending June 30, 1998 and 1997, respectively. The decreases were due
primarily to the lower net income in both periods and a 58.5% increase
in average common equity, reflecting the conversion of preferred stock
to common stock in September 1997.
To further enhance its presence in the Pacific Northwest market,
Sterling is working to expand its community bank delivery system,
focusing primarily on deposit gathering and on lending. On
June 15, 1998, Sterling completed the acquisition of 33 branch offices
in Washington, Idaho and Oregon from KeyBank. See Note 9 of "Notes to
Consolidated Financial Statements."
Effective with the KeyBank branch acquisition, Sterling's wholly owned
subsidiary Sterling Savings Association changed its name to Sterling
Savings Bank.
NET INTEREST INCOME. The most significant component of earnings for a
financial institution typically is net interest income, which is the
difference between interest income, primarily from loan, mortgage-
backed securities ("MBS") and investment portfolios, and interest
expense, primarily on deposits and borrowings ("NII"). During the
three months ended June 30, 1998 and 1997, NII was $13.1 million and
$11.0 million, respectively, an increase of 18.2%. During the six
months ended June 30, 1998 and 1997, NII was $24.9 million and
$22.1 million, respectively, an increase of 12.8%. Changes in NII
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 and the rate
paid on interest-bearing liabilities. Net interest margin refers to
NII divided by total interest-earning assets and is influenced by the
level and relative mix of interest-earning assets and interest-bearing
liabilities. The increase in NII during both periods ended
June 30, 1998 was due primarily to an increase in the volume of
average interest-earning assets.
<PAGE>
During the three months ended June 30, 1998 and 1997, the volume of
average interest-earning assets was $1.83 billion and $1.52 billion,
respectively. Net interest spread during these periods was 2.68% and
2.66%, respectively. The net interest margin for the three months
ended June 30, 1998 and 1997 was 2.86% and 2.91%, respectively. Net
interest spread increased due primarily to a lower cost of deposits.
Net interest margin decreased due primarily to an increase in the
volume of lower-yielding interest-earning assets coupled with an
increase in the volume of borrowings. During the six months ended
June 30, 1998 and 1997, the volume of average interest-earning assets
was $1.78 billion and $1.50 billion, respectively. For the six months
ended June 30, 1998 and 1997, net interest spread was 2.63% and 2.73%,
respectively. Net interest margin was 2.82% and 2.97%, during the
same periods. The decrease in net interest spread was due primarily
to higher rates paid on other borrowings. The decrease in net
interest margin was due primarily to an increase in the volume average
interest-bearing liabilities relative to the volume of average
interest-earning assets.
PROVISION FOR LOAN LOSSES. Management's policy is to establish
valuation allowances for estimated losses by charging corresponding
provisions against income. The evaluation of the adequacy of specific
and general valuation allowances is an ongoing process.
Sterling recorded provisions for loan losses of $2.9 million and
$550,000 for the three months ended June 30, 1998 and 1997,
respectively. Sterling recorded provisions of $3.7 million and $1.1
million for the six months ended June 30, 1998 and 1997, respectively.
Sterling's provision for the three months ended June 30, 1998
reflected a higher concern that the Pacific Northwest economy may be
adversely affected by a slowdown in the Asian economy. It also
reflected the potentially higher levels of risk from its expanded
construction, business banking and consumer lending activities.
Management anticipates that its provisions for loan losses will
increase in the future as Sterling continues to expand its portfolio
of higher yielding, higher risk loans. At June 30, 1998, Sterling's
total classified assets were $18.4 million, compared with $16.2
million at June 30, 1997. Total 60-day plus delinquent loans
increased to approximately $7.6 million at June 30, 1998 from
approximately $6.9 million at June 30, 1997. Total nonperforming
loans were $4.3 million at June 30, 1998, compared with $6.0 million
at June 30, 1997.
Management believes the loan loss provisions for the three and six
months ended June 30, 1998 and 1997 represented appropriate additions
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 as
well as 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.
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
------------------ -----------------
1998 1997 1998 1997
------- ------- ------- -------
(Dollars in thousands)
<S> <C> <C> <C> <C>
Fees and service charges $ 1,663 $ 1,288 $ 3,042 $ 2,497
Mortgage banking operations 410 582 1,078 1,088
Loan servicing fees 178 320 424 656
Net gain (loss) on sales of securities (133) 487 578 572
Net loss on sales and operations of real
estate owned (110) (10) (192) (92)
------- ------- ------- -------
$ 2,008 $ 2,667 $ 4,930 $ 4,721
======= ======= ======= =======
</TABLE>
Fees and service charges consist primarily of service charges on
deposit accounts, fees for certain customer services, commissions on
sales of credit life insurance, late charges on loans, escrow fees and
commissions on sales of mutual funds and annuity products. The
increase for the three and six months ended June 30, 1998, compared
with the three and six months ended June 30, 1997, was due primarily
to increases in service charges and fees.
The decrease in income from mortgage banking operations for the three
and six months ended June 30, 1998, compared with the three months
ended June 30, 1997, was due primarily to the bulk sale of a
$62.4 million servicing portfolio during the second quarter of 1998,
which resulted in a loss of approximately $106,000.
The following table summarizes loan originations and sales of loans
for the periods indicated.
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
------------------ -----------------
1998 1997 1998 1997
------- ------- ------- -------
(Dollars in thousands)
<S> <C> <C> <C> <C>
Originations of one- to four-family permanent
mortgage loans $ 51.2 $ 35.3 $ 97.5 $ 61.5
Sales of residential loans 38.4 35.7 64.7 60.8
Principal balances of mortgage loans serviced
for others 267.9 512.4 267.9 512.4
</TABLE>
<PAGE>
Loan servicing fees decreased for the three and six months ended
June 30, 1998, compared with the prior year's comparable periods,
reflecting the $244.5 million decrease in the balance of mortgage
loans serviced for others since June 1997. Sterling's average loan
servicing portfolios for the six months ended June 30, 1998 and 1997,
were approximately $326.8 million and $525.2 million, respectively.
During the three months ended June 30, 1998, Sterling recorded a net
loss of $133,000 on sales of $72.9 million of investments and MBS.
This compares to net gains of $487,000 for the three months ended
June 30, 1997. During the six months ended June 30, 1998, Sterling
sold approximately $246.3 million of MBS, resulting in net gains of
$578,000. Sterling sold approximately $86.1 million of MBS in the
prior year's comparable period, resulting in net gains of $572,000.
OPERATING EXPENSES. Operating expenses were $13.7 million and
$9.5 million for the three months ended June 30, 1998 and 1997,
respectively. During the six months ended June 30, 1998 and 1997,
operating expenses were $23.6 million and $18.4 million, respectively.
The increase during these periods was due primarily to conversion
expenses of $3.2 million due to the acquisition of 33 KeyBank branches
as of June 15, 1998. The acquisition charges included costs
associated with mailing customer notices; issuing new checks and ATM
cards; training new employees, including related travel; equipping
branches with office supplies; implementing a targeted marketing
campaign and converting computer systems. In addition, employee
compensation and benefits were $4.8 million and $3.9 million for the
three months ended June 30, 1998 and 1997, respectively. During the
six months ended June 30, 1998 and 1997, employee compensation and
benefits were $9.3 million and $7.8 million, respectively. The
increases were due primarily to increased lending staff in the
commercial real estate, business banking and consumer lending areas
and an overall higher level of personnel. The increase in other
expenses reflected loan processing expenses related to a home equity
loan campaign. Further, management anticipates that intangible
amortization expense will increase in subsequent periods due to the
branch acquisition.
INCOME TAX PROVISION. The federal and state income tax benefit was
$613,000 for the three months ended June 30, 1998. The federal and
state income tax provision was $1.4 million for the three months ended
June 30, 1997. Tax provisions were $860,000 and $2.8 million for the
six months ended June 30, 1998 and 1997, respectively. The effective
tax rates during these periods were 33.3% and 38.0%, respectively.
The effective tax rates were 39.0% and 38.0% for the three months
ended June 30, 1998 and 1997, respectively, which approximated the
applicable statutory rates. The changes reflected in the three and
six months ended June 30, 1998, were due to adjustments to state
income tax provisions.
<PAGE>
Financial Position
------------------
ASSETS. At June 30, 1998, Sterling's assets were $2.08 billion, up
10.7% from $1.88 billion at December 31, 1997. The increase was due
primarily to increases associated with the KeyBank branch acquisition
as well as internal generation of loans.
INVESTMENTS AND MBS. Sterling's investment and MBS portfolio at June
30, 1998 was $596.6 million, down $72.4 million from the December 31,
1997 balance of $669.0 million. The decrease was due primarily to net
sales of MBS during the period.
LOANS RECEIVABLE. At June 30, 1998, net loans receivable were
$1.26 billion, up $190.3 million from $1.07 billion at December 31,
1997. Most of the increase was due to the acquisition of $123.7
million of KeyBank loans on June 15, 1998. These loans were comprised
of consumer and business banking portfolios of $79.9 million and
$43.8 million, respectively. Exclusive of the loans received in the
KeyBank branch acquisition, total loans receivable increased $154.0
million from December 31, 1997. The most significant area of increase
in loan originations was in construction lending. During the three
months ended June 30, 1998, total loan originations were
$259.7 million, compared with $176.4 million for the prior year's
comparable quarter. During the six months ended June 30, 1998 and
1997, loan originations were $465.9 million and $347.7 million,
respectively, a 34.0% increase.
The following table sets forth the composition of Sterling's loan
portfolio at the dates indicated. Loan balances do not include
undisbursed loan proceeds, unearned discounts, deferred loan
origination costs and fees, or allowances for loan losses.
June 30, 1998 December 31, 1997
------------------- -------------------
Amount % Amount %
---------- ------ ---------- ------
(Dollars in thousands)
Residential $ 267,859 19.0% $ 282,894 24.2%
Multifamily 72,974 5.2 65,621 5.6
Commercial real estate 151,158 10.7 118,622 10.1
Construction 341,490 24.3 302,279 25.9
Consumer 269,401 19.1 157,277 13.5
Business banking 305,408 21.7 241,808 20.7
---------- ----- ---------- -----
Total loans receivable $1,408,290 100.0% $1,168,501 100.0%
========== ===== ========== =====
<PAGE>
The following table sets forth the composition of Sterling's loan
originations for the dates indicated.
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
---------------------------- ----------------------------
% %
1998 1997 Change 1998 1997 Change
-------- -------- ------ -------- -------- ------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C> <C>
Residential $ 51,159 $ 35,500 44.9% $ 97,538 $ 61,502 58.6%
Multifamily 16,035 2,650 505.1 29,145 12,815 127.4
Commercial real estate 4,100 12,000 (65.8) 14,685 25,000 (41.3)
Construction 99,300 66,650 49.0 160,577 142,837 12.4
Consumer 38,255 19,600 95.2 65,968 32,508 102.9
Business banking 50,868 40,214 26.5 98,012 73,074 34.1
-------- -------- ----- -------- -------- -----
Total loans receivable $259,717 $176,414 47.2% $465,925 $347,736 34.0%
======== ======== ===== ======== ======== =====
</TABLE>
DEPOSITS. Total deposits increased $482.8 million to $1.52 billion at
June 30, 1998 from $1.04 billion at December 31, 1997. Sterling
assumed $517.5 million in deposits associated with the KeyBank branch
acquisition in June 1998.
The following table sets forth the composition of Sterling's deposits
at the dates indicated.
June 30, 1998 December 31, 1997
------------------- -------------------
Amount % Amount %
---------- ------ ---------- ------
(Dollars in thousands)
Certificates of deposit $ 844,543 55.6% $ 670,137 64.7%
Checking 279,477 18.4 119,359 11.5
Savings and money market 395,230 26.0 246,912 23.8
---------- ----- ---------- -----
Total deposits $1,519,250 100.0% $1,036,408 100.0%
========== ===== ========== =====
BORROWINGS. Sterling's primary sources of borrowing are the FHLB
Seattle advances, securities sold under agreements to repurchase and
other borrowings. At June 30, 1998, total borrowings were
$416.9 million, compared with $707.4 million at December 31, 1997, a
decrease of $290.5 million. The decrease reflects repayments of
certain borrowings with the net cash acquired with the KeyBank branch
acquisition, thereby replacing wholesale funds with lower cost deposit
funding sources. See "Liquidity and Sources of Funds."
<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
market values and the monetary and fiscal policies of the federal
government. Like all financial institutions, Sterling's NII and the
net present value of assets, liabilities and off-balance sheet
contracts ("NPV") or estimated fair value, are subject to fluctuations
in interest rates. For example, Sterling's adjustable rate mortgages
are primarily indexed to the weekly average yield on one-year U.S.
Treasury securities. When interest-earning assets such as loans are
funded by interest-bearing liabilities such as deposits, FHLB Seattle
advances and other borrowings, a changing interest rate environment
may have a dramatic effect on Sterling's results of operations.
Currently, Sterling's interest-bearing liabilities, consisting
primarily of savings deposits, 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 NII 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
NII.
Sterling maintains an asset and liability management program intended
to manage NII 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 NII and NPV to
changes in interest rates. This simulation model is designed to
enable Sterling to generate a forecast of NII and NPV given various
interest rate forecasts and alternative strategies. The model is
designed to also 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. The model calculates the
present value of assets, liabilities, off-balance sheet financial
instruments, and equity at current interest rates and at hypothetical
higher and lower interest rates at various intervals. The present
value of each major category of financial instruments is calculated
using estimated cash flows based on weighted-average contractual rates
and terms, then discounted at the estimated current market interest
rate for similar financial instruments. The present value of longer
term fixed rate financial instruments is more difficult to estimate
because such instruments are susceptible to changes in market interest
rates. Present value estimates of adjustable rate financial
<PAGE>
instruments are more reliable since they represent the difference
between the contractual and discounted rates until the next interest
rate repricing date.
The calculations of present value have certain shortcomings. The
discount rates utilized for loans and MBS are based on estimated
nationwide market interest rate levels for similar loans and
securities, with prepayment assumptions based on historical experience
and market forecasts. The unique characteristics of Sterling's loans
and MBS may not necessarily parallel those in the model. The discount
rates utilized for deposits and borrowings are based upon available
alternative types and sources of funds which are not necessarily
indicative of the market value of deposits and FHLB Seattle advances
since such deposits and advances are unique to, and have certain price
and customer relationship advantages for, depository institutions.
The present values are determined based on the discounted cash flows
over the remaining estimated lives of the financial instruments on the
assumption that the resulting cash flows are reinvested in financial
instruments with virtually identical terms.
The total measurement of Sterling's exposure to interest rate risk
("IRR") as presented in the following table may not be representative
of the actual values which might result from a higher or lower
interest rate environment. A higher or lower interest rate
environment will most likely result in different investment and
borrowing strategies by Sterling designed to further mitigate the
effect on the value of and the net earnings generated from Sterling's
net assets from any change in interest rates.
With the acquisition of the KeyBank branches, Sterling's NPV declined
by approximately $23.8 million, primarily reflecting the increase in
intangible assets, thereby reflecting a higher profile of IRR.
Sterling is continuing to pursue strategies to manage the level of its
IRR while increasing its NII and NPV 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, and by increasing the level of its
core deposits, which are generally a lower cost funding source than
borrowings. 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 or increasing NII.
The following table presents Sterling's estimates of changes in NPV
for the periods indicated. The results indicate the impact of
instantaneous, parallel shifts in the market yield curve. These
calculations which are highly subjective and technical are relative
measurements of IRR, do not reflect any expected rate movement and may
differ materially from regulatory calculations.
<PAGE>
<TABLE>
<CAPTION>
At June 30, 1998 At December 31, 1997
--------------------------------------------------------------- --------------------------------------
Change in Interest Ratio of NPV to Ratio of NPV to
Rates in Basis Points the Present Value % Change the Present Value % Change
(Rate Shock) NPV of Total Assets in NPV NPV of Total Assets in NPV
--------------------- -------- ----------------- -------- -------- ----------------- --------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C> <C>
+300 $ 30,827 1.63% (67.1)% $ 56,193 3.18% (50.9)%
+200 56,698 2.99 (39.5) 80,857 4.47 (29.4)
+100 74,490 3.76 (20.5) 104,439 5.65 (8.8)
Static 93,659 4.64 N/A 114,503 6.09 N/A
-100 79,649 3.82 (15.0) 107,104 5.64 (6.5)
-200 63,706 3.10 (32.0) 90,190 4.72 (21.2)
-300 64,518 3.12 (31.1) 69,152 3.60 (39.6)
</TABLE>
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 calculated its one- and three-year
cumulative gap positions to be a negative 12.1% and negative 7.9% at
June 30, 1998. This compares with Sterling's one- and three-year gap
positions of negative 6.1% and negative 10.7% at June 30, 1997. The
negative one-year gap position widened during the current period as
short-term borrowings were used to finance the purchase of branches. The
three-year gap position narrowed as longer term fixed rate MBS were sold
and replaced with adjustable rate securities and shorter term consumer
and business banking loans. Management attempts to maintain Sterling's
gap position between negative 5% and negative 20%. At June 30, 1998,
Sterling's gap positions were within limits established by its Board of
Directors. Management is pursuing strategies to increase its NII without
significantly increasing its cumulative gap positions in future periods.
<PAGE>
Liquidity and Sources of Funds
------------------------------
Sterling's primary sources of funds are derived from financing and
investing activities. Financing activities consist primarily of
customer deposits, advances from the FHLB Seattle and other
borrowings. Deposits increased to $1.52 billion at June 30, 1998,
from $1.04 billion at December 31, 1997. Advances from the FHLB
Seattle decreased to $266.3 million at June 30, 1998 from
$455.1 million at December 31, 1997. At June 30, 1998 and
December 31, 1997, securities sold subject to repurchase agreements
were $53.3 million and $180.1 million, respectively. These borrowings
are collateralized by investments and MBS 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. 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.
During 1997, Sterling instituted a program of entering into repurchase
agreements with selected retail customers. These borrowings are
generally overnight borrowings.
Sterling repaid approximately $322 million of FHLB Seattle advances
and reverse repurchase agreements. Management will continue to use
FHLB Seattle advances and repurchase agreements to help fund its
operations, but anticipates doing so to a lesser extent than in prior
years. See " - Results of Operations."
In connection with its Year 2000 compliance plan, Sterling is focusing
on identifying potential risks in its customer deposit base and other
short-term sources of funds. See "Year 2000 Issues."
During the six months ended June 30, 1998, other cash provided by
investing activities consisted of principal and interest payments on
loans and MBS and sales of MBS. Sterling acquired net cash from the
KeyBank branch acquisition of approximately $327.2 million. The
levels of these payments and sales increase or decrease depending on
the size of the loan and MBS portfolios and the general trend and
level of interest rates, which influences the level of refinancing and
mortgage prepayments. During the six months ended June 30, 1998, net
cash was used in investing activities primarily to repurchase
investments and MBS and to fund loans.
Sterling Savings Bank's credit line with the FHLB Seattle provides for
borrowings up to 35% of its total assets. At June 30, 1998, this
credit line represented a total borrowing capacity of approximately
$730.1 million, of which $464.2 million was available. Sterling
Savings Bank also borrows on a secured basis from major broker/dealers
and financial entities by selling securities subject to repurchase
agreements. At June 30, 1998, Sterling Savings Bank had $53.2 million
in outstanding borrowings under reverse repurchase agreements and
securities available for additional secured borrowings of
approximately $264.0 million. Sterling Savings Bank also had a
secured line of credit agreement from a commercial bank of
approximately $10.0 million as of June 30, 1998 but had no funds drawn
on this line of credit.
<PAGE>
Excluding its subsidiaries, Sterling had cash and other resources of
approximately $1.6 million and a line of credit from a commercial bank
of approximately $5.0 million at June 30, 1998 but had no funds drawn
on this line of credit. At June 30, 1998, Sterling had drawn all the
funds on a $40.0 million twelve-month line of credit from a commercial
bank. Sterling has the option of renewing this line of credit for an
additional six months. All of the proceeds of this loan were
contributed to Sterling Savings Bank to enhance its regulatory capital
ratios and to substantially offset the intangible asset incurred in
connection with the KeyBank branch acquisition. The line of credit is
secured by all of the stock of Sterling Savings Bank. At
June 30, 1998, Sterling had an investment of $88.6 million in the
Preferred Stock of Sterling Savings Bank, compared with $66.1 million
at December 31, 1997. Sterling received cash dividends on Sterling
Savings Bank Preferred Stock of $3.5 million during the six months
ended June 30, 1998. These resources were sufficient to meet the
operating needs of Sterling, including interest expense on its 8.75%
Subordinated Notes Due 2000 (the "Subordinated Notes") and other
borrowings. Sterling Savings Bank's ability to pay dividends is
limited by its earnings, financial condition and capital requirements,
as well as rules and regulations imposed by the Office of Thrift
Supervision ("OTS").
OTS regulations require savings institutions such as Sterling Savings
Bank to maintain an average daily balance of liquid assets equal to or
greater than a specific percentage (currently 4%) 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
June 30, 1998 and December 31, 1997, Sterling Savings Bank's liquidity
ratios were 11.7% and 13.0%, respectively. The lower level of
liquidity at June 30, 1998 was due primarily to the structuring of
short-term borrowings in anticipation of the KeyBank branch
acquisition. Sterling Savings Bank's strategy generally is to
maintain its liquidity ratio at or near the level necessary to support
expected and potential loan fundings and deposit withdrawals.
Sterling Savings Bank tries to minimize liquidity levels 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 subsidiaries, potential
borrowings against investments and MBS 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 $105.7 million at
June 30, 1998 compared with $102.9 million at December 31, 1997. The
increase in total shareholders' equity was due primarily to an
increase in retained earnings for the six month period and a decrease
in the unrealized loss on available-for-sale investments and MBS. At
June 30, 1998 and December 31, 1997, shareholders' equity was 5.1% and
5.5% of total assets, respectively.
<PAGE>
At June 30, 1998 and December 31, 1997, Sterling had an unrealized
loss of $305,000 and $1.0 million, net of related income taxes, on
investments and MBS classified as available-for-sale. Fluctuations in
prevailing interest rates could continue to cause volatility in this
component of shareholders' equity in future periods.
Sterling has issued and outstanding $40.0 million of Trust Preferred
Securities. The indenture governing the Trust Preferred Securities
limits the ability of Sterling under certain circumstances to pay
dividends or make other capital distributions. The Trust Preferred
Securities are treated as debt of Sterling. The Trust Preferred
Securities mature on June 30, 2027 and are redeemable at the option of
Sterling on June 30, 2002, or earlier in the event the deduction of
related interest for federal income taxes is prohibited, treatment as
Tier 1 capital is no longer permitted, or certain other contingencies
arise.
Sterling has issued and outstanding $17.2 million of 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.
In order to integrate the newly acquired branches and expand branch
locations, Sterling anticipates total capital expenditures of
approximately $1.7 million for the remainder of the year ended
December 31, 1998. Sterling anticipates continuing to fund these
capital expenditures from various sources, including retained earnings
and borrowings with various maturities. There can be no assurance
that Sterling's estimates of capital expenditures or the funding
thereof are accurate.
Sterling Savings Bank is required by applicable regulations to
maintain certain minimum capital levels with respect to tangible
capital, core leverage capital and risk-based capital. Sterling
Savings Bank anticipates that it will continue to enhance its capital
resources and regulatory capital ratios through sales of stock to
Sterling, 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. At June 30, 1998, Sterling
Savings Bank exceeded all applicable regulatory capital requirements.
Sterling continues to proactively manage its claim against the U.S.
government for breach of contract on three supervisory goodwill
acquisition contracts. In July 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 savings 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 a judgment, if any, will be received.
<PAGE>
Year 2000 Issues
----------------
Throughout the information technology industry, the use of two-digit
year fields was common practice in the design of hardware, system
software, proprietary applications and system interfaces. The Year
2000 problem is pervasive and complex as virtually every computer
operation will be affected in some way by the rollover of the two-
digit year value to 00. The issue is whether computer systems will
properly recognize date-sensitive information when the year changes to
2000. Systems that do not properly recognize such information could
generate erroneous data or fail. The potential failure on January 1,
2000 of computer systems that use two-digit calendar notations has
developed into a major concern for financial institutions. Sterling
has created a Year 2000 compliance plan that focuses on identifying,
testing and implementing solutions for Year 2000 processing. A
preliminary estimate of the total cost to complete the Year 2000
compliance plan is approximately $825,000. Maintenance or
modification costs will be expensed as incurred, while the costs of
new software will be capitalized and amortized over the software's
useful life.
At June 30, 1998, Sterling had completed the awareness training and
assessment phases of its Year 2000 compliance plan and was well into
the testing phase. The awareness phase included gaining understanding
and support, committing resources to the plan, establishing a project
team consisting of senior managers and department heads, and
developing a strategy to address all internal and external systems.
The assessment phase involved attempting to identify all critical
business processes and determining the impact of the Year 2000 issues
on all computer systems throughout the organization. Vendors were
contacted and asked to submit certification letters stating that they
are in compliance with Year 2000 conversion issues. To ensure
compliance, third-party reviews of vendors that provide critical
services to Sterling may be required.
Sterling estimates that testing programming changes (including
converting, replacing or eliminating all software and databases as
necessary) will be largely completed by December 31, 1998.
Contingency plans are being developed in the event modifications
cannot be completed in time, or in the event unforeseen problems
develop in spite of Sterling's efforts to ensure compliance with Year
2000 standards.
Financial institutions also must consider the possibility of some
level of reduction in deposits during the month of December 1999.
Sterling has developed a contingency plan for potential additional
liquidity needs during this period.
<PAGE>
Sterling will assess its deposit base over the next twelve months to
identify potential problems due to concentrations. If such
concentrations are identified, Sterling will assess whether those
concentrations are at risk due to Year 2000 problems. Management
estimates that this deposit assessment will be largely completed by
September 30, 1998. Sterling has determined that several borrowing
sources are and will be available so that adequate funding in December
1999 will not be a problem. In conjunction with its review of Year
2000 issues, Sterling also is assessing the impact of the Year 2000
problem on significant borrowers and their ability to repay loans.
Sterling also is evaluating its allowances for loan losses with its
review of Year 2000 concerns in relation to its borrowers. Management
believes that its Year 2000 plan will be effective in identifying and
resolving any Year 2000 problems although there can be no assurance in
this regard.
ITEM 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
For a discussion of Sterling's market risks, see "Management's
Discussion and Analysis - Asset and Liability Management."
PART II - Other Information
STERLING FINANCIAL CORPORATION
ITEM 1 - LEGAL PROCEEDINGS
Periodically, various claims and lawsuits are brought against Sterling
and its subsidiaries, such as claims to enforce liens, condemnation
proceedings involving properties on which Sterling holds security
interests, claims involving the making and servicing of real property
loans and other issues incidental to Sterling's business. No material
loss is expected from any of such pending claims or lawsuits.
ITEM 2 - CHANGES IN SECURITIES
None.
ITEM 3 - DEFAULTS UPON SENIOR SECURITIES
None.
<PAGE>
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Sterling's Annual Meeting of Shareholders ("the Meeting") was held on
April 28, 1998. The following matters were submitted to a vote of the
security holders of Sterling at the Meeting:
(1) Elect three Directors to serve for terms of three years expiring
at the Meeting in the year 2001. The Directors received the
following votes:
Term expiring in the year 2001 at the Meeting:
Ned M. Barnes For: 6,620,962 Withheld: 21,987
Approximate Broker Non-votes: 0
James P. Fugate For: 6,620,696 Withheld: 22,253
Approximate Broker Non-votes: 0
Robert D. Larrabee For: 6,620,696 Withheld: 22,253
Approximate Broker Non-votes: 0
(2) Approve the 1998 Long-Term Incentive Plan. The proposal received
the following votes:
For: 3,067,029 Against: 1,388,242
Abstain: 84,347 Approximate Broker Non-votes: 0
(3) Ratify the selection of Coopers & Lybrand L.L.P. as independent
public accountants for the year ending 1998 and any interim
periods. The proposal received the following votes:
For: 6,388,207 Against: 28,587
Abstain: 25,829 Approximate Broker Non-votes: 0
There was no solicitation in opposition to management's proposals
or nominees.
ITEM 5 - OTHER INFORMATION
None.
<PAGE>
ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibit No. Exhibit
--------------- ---------------------------------------------------
2.1 Agreement and Plan of Merger, by and Between
Sterling Financial Corporation and Big Sky Bancorp,
Inc., dated as of April 23, 1998. Filed as Appendix
C to Registrant's Form S-4, dated June 24, 1998 and
incorporated by reference herein.
3.1 Restated Articles of Incorporation of Registrant.
Filed as Exhibit 3.1 to Registrant's Form S-4 dated
November 7, 1994 and incorporated by reference
herein.
3.2 Articles of Amendment of Restated Articles of
Incorporation of Registrant. Filed as Exhibit 3.2
to Registrant's Form S-4 dated November 7, 1994 and
incorporated by reference herein.
3.3 Copy of Amended and Restated Bylaws of Registrant.
Filed as Exhibit 3.3 to Registrant's Form S-4 dated
June 24, 1998 and incorporated by reference herein.
4.1 Reference is made to Exhibits 3.1 and 3.2.
10.1 Copy of Sterling Savings Bank Incentive Stock Option
Plan dated July 25, 1984. Filed as Exhibit 10.1 to
Registrant's Form S-4 dated August 28, 1992 and
incorporated by reference herein.
10.2 Copy of Sterling Financial Corporation 1992
Incentive Stock Option Plan. Filed as Exhibit 10.2
to Registrant's Form S-4 dated August 28, 1992 and
incorporated by reference herein.
10.3 Copy of Sterling Financial Corporation 1998 Long-
Term Incentive Plan dated March 24, 1998. Filed as
Exhibit A to Registrant's Proxy Statement in
connection with the Annual Meeting of Shareholders
held on April 28, 1998 and incorporated by reference
herein.
10.4 Copy of Sterling Savings Bank Deferred Compensation
Plan, effective July 1, 1984. Filed as Exhibit 10.3
to Registrant's Form S-4 dated August 28, 1992 and
incorporated by reference herein.
10.5 Copy of Sterling Savings Bank Employment Savings and
Incentive Plan and Trust dated September 21, 1990.
Filed as Exhibit 10.4 to Registrant's Form S-4 dated
August 28, 1992 and incorporated by reference
herein.
<PAGE>
(a) Exhibit No. Exhibit
--------------- ---------------------------------------------------
10.6 Copy of Employment Agreement, dated July 1, 1995,
between Registrant and Harold B. Gilkey. Filed as
Exhibit 10.1 to Registrant's Form 10-Q dated
March 31, 1996 and incorporated by reference herein.
10.7 Copy of Amendment to Employment Agreement, dated
June 30, 1996, between Registrant and Harold B.
Gilkey. Filed as Exhibit 10.6 to Registrant's Form
10-Q dated March 31, 1997 and incorporated by
reference herein.
10.8 Copy of Employment Agreement, dated July 1, 1995,
between Registrant and William W. Zuppe. Filed as
Exhibit 10.2 to Registrant's Form 10-Q dated
March 31, 1996 and incorporated by reference herein.
10.9 Copy of Amendment to Employment Agreement, dated
June 30, 1996, between Registrant and William W.
Zuppe. Filed as Exhibit 10.8 to Registrant's Form
10-Q dated March 31, 1997 and incorporated by
reference herein.
(b) Reports on Form 8-K. A report on Form 8-K (Items 5 and 7) was
filed on May 24, 1998. A report on Form 8-K (Item 5) was filed
on June 24, 1998.
<PAGE>
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf
by the undersigned thereunto duly authorized.
STERLING FINANCIAL CORPORATION
(Registrant)
August 14, 1998 By: /s/ Daniel G. Byrne
--------------- --------------------------------------------
Date Daniel G. Byrne, Senior Vice President -
Finance; Treasurer and Assistant Secretary;
Principal Financial Officer and Chief
Accounting Officer
<PAGE>
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