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
September 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 October 30, 1998
------------------------------ ------------------------------------
Common Stock ($1.00 par value) 7,605,612
<PAGE>
STERLING FINANCIAL CORPORATION
FORM 10-Q
For the Quarter Ended September 30, 1998
TABLE OF CONTENTS
PART I - Financial Information
Item 1 - Financial Statements
Consolidated Balance Sheets
Consolidated Statements of Income
Consolidated Statements of Cash Flows
Consolidated Statements of Comprehensive Income
Notes to Consolidated Financial Statements
Item 2 - Management's Discussion and Analysis of Financial
Condition and Results of Operations
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)
<TABLE>
<CAPTION>
September 30, December 31,
1998 1997
------------- ------------
(Dollars in thousands)
<S> <C> <C>
ASSETS
Cash and cash equivalents:
Interest bearing $ 6,076 $ 15,858
Non-interest bearing and vault 56,786 33,564
Restricted 13,218 2,988
Loans receivable (net of allowance for
losses of $14,197 and $8,959) 1,313,739 1,069,591
Loans held-for-sale 8,836 5,225
Investments and mortgage-backed
securities ("MBS"):
Available for sale 520,778 656,236
Held-to-maturity 13,411 12,750
Accrued interest receivable
(including $4,334 and $6,295 on
investments and MBS) 14,054 14,058
Office properties and equipment, net 50,506 37,956
Real estate owned, net 6,676 8,817
Intangible assets, net 62,628 7,789
Purchased mortgage servicing rights, net 25 1,170
Prepaid expenses and other assets 15,449 10,248
---------- ----------
Total assets $2,082,182 $1,876,250
========== ==========
LIABILITIES AND SHAREHOLDERS' EQUITY
Deposits $1,517,845 $1,036,408
Advances from the Federal Home Loan Bank
of Seattle ("FHLB Seattle") 201,319 455,085
Securities sold subject to repurchase
agreements and funds purchased 114,996 180,077
Other borrowings (Note 4) 97,240 72,240
Cashiers checks issued and payable 13,612 11,260
Borrowers' reserves for taxes and insurance 2,692 1,264
Accrued interest payable 5,128 5,855
Accrued expenses and other liabilities 17,354 11,198
---------- ----------
Total liabilities 1,970,186 1,773,387
---------- ----------
</TABLE>
<PAGE>
PART I - Financial Information
Item 1 - Financial Statements
STERLING FINANCIAL CORPORATION
Consolidated Balance Sheets, Continued
(Unaudited)
<TABLE>
<CAPTION>
September 30, December 31,
1998 1997
------------- ------------
(Dollars in thousands)
<S> <C> <C>
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 income (loss):
Unrealized gain (loss) on investments
and MBS available for sale, net of
deferred income tax provision (benefit)
of $1,750 and ($540) 3,247 (1,003)
Retained earnings 31,350 26,884
---------- ----------
Total shareholders' equity 111,996 102,863
---------- ----------
Total liabilities and shareholders'
equity $2,082,182 $1,876,250
========== ==========
</TABLE>
The accompanying notes are an integral part of the consolidated
financial statements.
<PAGE>
STERLING FINANCIAL CORPORATION
Consolidated Statements of Income
(Unaudited)
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------- --------------------
1998 1997 1998 1997
--------- --------- --------- ---------
(Dollars in thousands,
except per share data)
<S> <C> <C> <C> <C>
Interest income:
Loans $ 29,346 $ 23,400 $ 79,986 $ 67,410
MBS 5,677 7,872 19,815 20,184
Investments and cash equivalents 3,889 3,529 10,736 7,624
--------- --------- --------- ---------
Total interest income 38,912 34,801 110,537 95,218
--------- --------- --------- ---------
Interest expense:
Deposits 15,818 11,852 40,387 33,547
Short-term borrowings 4,458 7,979 21,337 17,600
Long-term borrowings 3,192 3,413 8,449 10,425
--------- --------- --------- ---------
Total interest expense 23,468 23,244 70,173 61,572
--------- --------- --------- ---------
Net interest income 15,444 11,557 40,364 33,646
Provision for loan losses (800) (675) (4,500) (1,775)
--------- --------- --------- ---------
Net interest income after provision
for loan losses 14,644 10,882 35,864 31,871
--------- --------- --------- ---------
Other income:
Fees and service charges 2,305 1,264 5,347 3,761
Mortgage banking operations 431 442 1,508 1,530
Loan servicing fees 176 311 600 968
Net gain on sales of securities 655 582 1,233 1,154
Net gain (loss) on sale and operation
of real estate owned (41) 33 (233) (60)
--------- --------- --------- ---------
Total other income 3,526 2,632 8,455 7,353
--------- --------- --------- ---------
Operating expenses 13,814 9,432 37,383 27,783
Income before income taxes 4,356 4,082 6,936 11,441
Income tax provision 1,610 1,551 2,470 4,348
Net income 2,746 2,531 4,466 7,093
Less preferred stock dividends 0 0 0 (940)
--------- --------- --------- ---------
Net income available to common shares $ 2,746 $ 2,531 $ 4,466 $ 6,153
========= ========= ========= =========
</TABLE>
<PAGE>
STERLING FINANCIAL CORPORATION
Consolidated Statements of Income, Continued
(Unaudited)
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------- --------------------
1998 1997 1998 1997
--------- --------- --------- ---------
(Dollars in thousands,
except per share data)
<S> <C> <C> <C> <C>
Income per common share - basic $ 0.36 $ 0.41 $ 0.59 $ 1.07
========= ========= ========= =========
Income per common share - diluted $ 0.36 $ 0.33 $ 0.58 $ 0.92
========= ========= ========= =========
Weighted average common shares
outstanding - basic 7,605,612 6,148,920 7,594,983 5,748,837
========= ========= ========= =========
Weighted average common shares
outstanding - diluted 7,727,174 7,712,628 7,760,142 7,711,949
========= ========= ========= =========
</TABLE>
The accompanying notes are an integral part of the consolidated
financial statements.
<PAGE>
STERLING FINANCIAL CORPORATION
Consolidated Statements of Cash Flows
(Unaudited)
Nine Months Ended
September 30,
----------------------
1998 1997
---------- ----------
(Dollars in thousands)
Cash flows from operating activities:
Net income $ 4,466 $ 7,093
Adjustments to reconcile net income to net
cash provided by operating activities:
Provisions for loan and real estate
owned losses 4,571 1,832
Stock dividends on FHLB Seattle stock (1,635) (1,499)
Net gain on sales of loans, securities
and mortgage servicing rights (2,459) (2,332)
Net loss on sales of office property
and equipment 0 6
Net gain on sales of real estate owned (84) (185)
Depreciation and amortization 6,078 5,742
Change in:
Accrued interest receivable 1,131 (1,586)
Prepaid expenses and other assets (7,656) (923)
Cashiers checks issued and payable 2,352 4,264
Accrued interest payable (1,463) 645
Accrued expenses and other
liabilities 6,156 2,449
Proceeds from sales of loans 91,772 88,468
Loans originated for sale (90,649) (86,665)
--------- ---------
Net cash provided by operating
activities 12,580 17,309
--------- ---------
Cash flows from investing activities:
Change in restricted cash (10,230) (1,170)
Loans disbursed (822,729) (617,407)
Loan principal received 690,312 515,677
Purchase of investments (346,686) (155,450)
Proceeds from maturities of investments 327,307 80,000
Purchase of MBS (189,717) (385,086)
Principal payments on MBS 62,920 44,017
Proceeds from sales of MBS 289,776 204,371
Purchase of office properties and equipment (3,920) (993)
Proceeds from sales of office properties
and equipment 0 12
Improvements and other changes to real
estate owned (66) (480)
Proceeds from sales and liquidation of
real estate owned 3,950 1,745
<PAGE>
STERLING FINANCIAL CORPORATION
Consolidated Statements of Cash Flows, Continued
(Unaudited)
Nine Months Ended
September 30,
----------------------
1998 1997
---------- ----------
(Dollars in thousands)
Cash flows from investing activities,
Continued:
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 329,223 (314,764)
--------- ---------
Cash flows from financing activities:
Net change in checking, passbook and money
market deposits 28,970 39,481
Proceeds from issuance of certificates of
deposit 572,181 310,624
Payments for maturing certificates of
deposit (678,007) (286,492)
Interest credited to deposits 40,792 33,614
Advances from FHLB Seattle 30,000 355,000
Repayment of FHLB Seattle advances (284,063) (250,061)
Net change in securities sold subject to
repurchase agreements and funds purchased (65,081) 73,776
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 28
Payments to redeem preferred stock and
fractional shares 0 (113)
Cash dividends on preferred stock 0 (940)
Other 1,428 1,289
--------- ---------
Net cash provided by (used in)
financing activities (328,363) 316,206
--------- ---------
Net change in cash and cash equivalents 13,440 18,751
Cash and cash equivalents, beginning of
period 49,422 32,675
--------- ---------
Cash and cash equivalents, end of period $ 62,862 $ 51,426
========= =========
<PAGE>
STERLING FINANCIAL CORPORATION
Consolidated Statements of Cash Flows, Continued
(Unaudited)
Nine Months Ended
September 30,
----------------------
1998 1997
---------- ----------
(Dollars in thousands)
Supplemental disclosures:
Cash paid during the period for:
Interest $ 70,900 $ 60,927
Income taxes 1,885 2,850
Non-cash financing and investing
activities:
Loans converted into real estate owned 1,730 1,359
Preferred stock converted to common stock 0 24,523
The accompanying notes are an integral part of the consolidated
financial statements.
<PAGE>
STERLING FINANCIAL CORPORATION
Consolidated Statements of Comprehensive Income
(Unaudited)
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------- --------------------
1998 1997 1998 1997
--------- --------- --------- ---------
(Dollars in thousands)
<S> <C> <C> <C> <C>
Net income $ 2,746 $ 2,531 $ 4,466 $ 7,093
--------- --------- --------- ---------
Other comprehensive income, before
income taxes:
Change in unrealized gains and
losses on investments an and
MBS available for sale 5,465 3,620 6,540 4,554
Less deferred income tax provision (1,913) (1,267) (2,290) (1,592)
Net other comprehensive income 3,552 2,353 4,250 2,962
--------- --------- --------- ---------
Comprehensive income $ 6,298 $ 4,884 $ 8,716 $ 10,055
========= ========= ========= =========
</TABLE>
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 nine months ended September 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 September 30, 1997 balances have been reclassified to
conform with the September 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.
September 30, December 31,
1998 1997
------------- ------------
(Dollars in thousands)
Term note (1) $ 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 paid off the term note and entered
into a $40.0 million line of credit agreement with KeyBank
National Association ("KeyBank"). Interest accrues at the
London InterBank Offering Rate index plus 2.0% (7.56% at
September 30, 1998) 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 Per Share:
-----------------
The following table presents the basic and diluted income per share
computations.
<TABLE>
<CAPTION>
Three Months Ended September 30,
-----------------------------------------------------------------------
1998 1997
---------------------------------- ----------------------------------
Weighted Weighted
Avg. Per Share Avg. PerShare
Net Income Shares Amount Net Income Shares Amount
---------- --------- --------- ---------- --------- ---------
<S> <C> <C> <C> <C> <C> <C>
Net income $2,746,000 $2,531,000
Less preferred stock dividends 0 0
---------- --------- ----- ---------- --------- -----
Income per common share-basic 2,746,000 7,605,612 $0.36 2,531,000 6,148,920 $0.41
Effect of dilutive securities:
Convertible preferred stock 0 0 0 1,424,172
Common stock options 0 121,562 0 139,536
---------- --------- ----- ---------- --------- -----
Income per common share-diluted $2,746,000 7,727,174 $0.36 $2,531,000 7,712,628 $0.33
========== ========= ===== ========== ========= =====
<CAPTION>
Nine Months Ended September 30,
-----------------------------------------------------------------------
1998 1997
---------------------------------- ----------------------------------
Weighted Weighted
Avg. Per Share Avg. PerShare
Net Income Shares Amount Net Income Shares Amount
---------- --------- --------- ---------- --------- ---------
<S> <C> <C> <C> <C> <C> <C>
Net income $4,466,000 $7,093,000
Less preferred stock dividends 0 (940,000)
---------- --------- ----- ---------- --------- -----
Income per common share-basic 4,466,000 7,594,983 $0.59 6,153,000 5,748,837 $1.07
Effect of dilutive securities:
Convertible preferred stock 0 0 940,000 1,823,576
Common stock options 0 165,159 0 139,536
---------- --------- ----- ---------- --------- -----
Income per common share -diluted $4,466,000 7,760,142 $0.58 $7,093,000 7,711,949 $0.92
========== ========= ===== ========== ========= =====
</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 Nine Months Ended
September 30, September 30,
------------------ -----------------
1998 1997 1998 1997
------- -------- ------- -------
(Dollars in thousands)
<S> <C> <C> <C> <C>
Employee compensation and benefits $ 6,189 $ 4,026 $15,370 $11,872
Occupancy and equipment 2,065 1,562 5,198 4,460
Depreciation 875 767 2,366 2,325
Amortization of intangibles 1,448 536 2,523 1,702
Advertising 610 452 1,429 1,362
Data processing 1,100 521 2,493 1,747
Insurance 276 286 750 882
Legal and accounting 291 346 1,065 1,104
Travel and entertainment 310 267 888 789
Acquisition and conversion costs (a) 0 0 3,210 0
Other 650 669 2,091 1,540
------- ------- ------- -------
Total operating expenses $13,814 $ 9,432 $37,383 $27,783
======= ======= ======= =======
</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. Presentation of
segment information is not presently required in interim periods.
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
September 30, 1998, First Federal had three branch offices in
western Montana with deposits of approximately $50 million and
approximately $66 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 scheduled to be completed in mid-
November 1998, although there can be no assurance in this regard.
NAME CHANGE
-----------
Effective June 15, 1998, Sterling's wholly owned subsidiary
changed its name to Sterling Savings Bank.
SIGNIFICANT TRANSACTIONS
------------------------
On June 15, 1998, Sterling assumed approximately $518 million in
deposit liabilities and acquired certain branch assets
corresponding to 33 branch offices of KeyBank. Upon acquisition,
the weighted average interest rate on deposits assumed was
approximately 3.42%. Sterling incurred an approximately
$57 million intangible asset associated with the branch
acquisition. Sterling is amortizing the intangible asset over a
period of 15 years using the straight-line method. With the net
cash received from the branch acquisition, Sterling repaid
approximately $322 million of certain reverse repurchase
borrowings and FHLB Seattle advances.
<PAGE>
STERLING FINANCIAL CORPORATION
Notes to Consolidated Financial Statements, Continued
8. Other Events, Continued:
------------------------
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 asset 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 Nine Months Ended September 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. Sterling Financial Corporation ("Sterling") recorded net
income of $2.7 million, or $0.36 per diluted share, for the three
months ended September 30, 1998. This compares with net income of
$2.5 million, or $0.33 per diluted share, for the prior year's
comparable period. Sterling recorded net income for the nine months
ended September 30, 1998 of $4.5 million, which reflects after-tax
acquisition costs, conversion costs and other charges of $3.6 million,
or $0.58 per diluted share. Core earnings, which are defined as
earnings before these acquisition costs, conversion costs and other
charges, were $8.1 million, or $1.05 per diluted share. This compares
with net income of $7.1 million, or $0.92 per diluted share, for the
nine months ended September 30, 1997.
The annualized return on average assets was 0.52% and 0.56% for the
three months ended September 30, 1998 and 1997, respectively. The
decrease was due primarily to an increase in average assets relative
to net income. For the nine months ended September 30, 1998 and 1997,
the annualized return on average assets was 0.30% and 0.57%,
respectively. The decrease was due primarily to the $3.6 million in
after-tax acquisition and conversion costs recorded in the second
quarter of 1998. The annualized return on average equity was 10.2%
and 13.0% for the three months ended September 30, 1998 and 1997,
respectively. The decrease for these periods was due primarily to a
38.5% increase in average common equity due to conversion of preferred
stock to common stock in September 1997. The annualized return on
average equity was 5.7% and 12.0% for the nine month period ended
September 30, 1998 and 1997, respectively. The changes were due
primarily to lower net income and a 53.8% increase in average common
equity, reflecting the conversion of preferred stock to common stock
in September 1997.
<PAGE>
SIGNIFICANT TRANSACTIONS. Sterling is scheduled to complete the
acquisition of Big Sky Bancorp, Inc. and its subsidiary, First Federal
Savings and Loan Association of Montana ("First Federal") in mid-
November 1998. At September 30, 1998, First Federal had approximately
$66 million in total assets and deposits of approximately $50 million.
On June 15, 1998, Sterling assumed approximately $518 million in
deposit liabilities and acquired certain branch assets corresponding
to 33 branch offices of KeyBank. Upon acquisition, the weighted
average interest rate on deposits assumed was approximately 3.42%.
Sterling incurred an approximately $57 million intangible asset
associated with the acquisition. Sterling is amortizing the
intangible asset over a period of 15 years using the straight-line
method. With the net cash received from the branch acquisition,
Sterling repaid approximately $322 million of certain reverse
repurchase borrowings and FHLB Seattle advances.
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 September 30, 1998 and 1997, NII was $15.4 million
and $11.6 million, respectively, an increase of 33.6%. During the
nine months ended September 30, 1998 and 1997, NII was $40.4 million
and $33.6 million, respectively, an increase of 20.0%. 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 September 30, 1998 was due
primarily to the increase in average interest-earning assets and a
shift in the mix from investments and MBS to higher-yielding loans.
During the three months ended September 30, 1998 and 1997, the volume
of average interest-earning assets was $1.90 billion and
$1.72 billion, respectively. Net interest spread during these periods
was 3.18% and 2.41%, respectively. The net interest margin for the
three months ended September 30, 1998 and 1997 was 3.22% and 2.66%,
respectively. Net interest spread and net interest margin increased
significantly from a year ago, due primarily to a lower cost of funds.
The acquisition of retail deposits from the KeyBank branch acquisition
allowed Sterling to shift from higher-cost FHLB Seattle advances and
other borrowings to relatively lower-cost deposits. Net interest
margin increased due primarily to the wider spreads, which more than
offset the increase in average interest-bearing liabilities. During
the nine months ended September 30, 1998 and 1997, the volume of
<PAGE>
average interest-earning assets was $1.82 billion and $1.58 billion,
respectively. For the nine months ended September 30, 1998 and 1997,
net interest spread was 2.83% and 2.60%, respectively. Net interest
margin was 2.96% and 2.85% during the same periods. The increases in
net interest spread and net interest margin were due primarily to the
lower rates paid on deposits.
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 $800,000 and $675,000
for the three months ended September 30, 1998 and 1997, respectively.
Sterling recorded provisions of $4.5 million and $1.8 million for the
nine months ended September 30, 1998 and 1997, respectively.
Sterling's provisions for the three and nine months ended September
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 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 September 30, 1998, Sterling's total
classified assets were $22.2 million, compared with $15.9 million at
September 30, 1997. Total loans delinquent more than 60 days or more
decreased to approximately $8.1 million at September 30, 1998, from
approximately $9.4 million at September 30, 1997. Total nonperforming
loans were $5.3 million at September 30, 1998, compared with $4.7
million at September 30, 1997.
Management believes the loan loss provisions for the three and nine
months ended September 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 Nine Months Ended
September 30, September 30,
------------------ -----------------
1998 1997 1998 1997
------- -------- ------- -------
(Dollars in thousands)
<S> <C> <C> <C> <C>
Fees and service charges $ 2,305 $ 1,264 $ 5,347 $ 3,761
Mortgage banking operations 431 442 1,508 1,530
Loan servicing fees 176 311 600 968
Net gain on sales of securities 655 582 1,233 1,154
Net gain (loss) on sales and operations
of real estate owned (41) 33 (233) (60)
------- ------- ------- -------
$ 3,526 $ 2,632 $ 8,455 $ 7,353
======= ======= ======= =======
</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
increases in such fees and service charges for the three and nine
months ended September 30, 1998, compared with the three and nine
months ended September 30, 1997, were due primarily to the increase in
fee-related transaction accounts resulting from the KeyBank branch
acquisition.
The following table summarizes loan originations and sales of loans
for the periods indicated.
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
------------------ -----------------
1998 1997 1998 1997
------- -------- ------- -------
(Dollars in millions)
<S> <C> <C> <C> <C>
Originations of one- to four-family
permanent mortgage loans $ 52.0 $ 52.0 $ 149.6 $ 113.5
Sales of residential loans 22.1 26.5 86.8 87.3
Principal balances of mortgage loans
serviced for others 243.3 484.4 243.3 484.4
</TABLE>
Loan servicing fees decreased for the three and nine months ended
September 30, 1998, compared with the prior year's comparable periods,
reflecting the $241.1 million decrease in the balance of mortgage
loans serviced for others since September 1997. Sterling's average
loan servicing portfolios for the nine months ended September 30, 1998
and 1997, were approximately $301.3 million and $516.5 million,
respectively.
<PAGE>
During the three months ended September 30, 1998, Sterling sold
approximately $42.2 million of MBS, resulting in net gains of
$655,000. This compares with net gains of $582,000 for the three
months ended September 30, 1997. These sales were prompted by
management's desire to capture value on securities exhibiting rising
prepayment exposure. During the nine months ended September
30, 1998, Sterling sold approximately $288.5 million of MBS, resulting
in net gains of $1.2 million. Sterling sold approximately
$203.1 million of MBS in the prior year's comparable period, resulting
in net gains of $1.2 million.
OPERATING EXPENSES. Operating expenses were $13.8 million and
$9.4 million for the three months ended September 30, 1998 and 1997,
respectively. The increase was due primarily to increased staffing
levels, increased intangible amortization and increased data
processing and occupancy costs, resulting from the KeyBank branch
acquisition. During the nine months ended September 30, 1998 and
1997, operating expenses were $37.4 million and $27.8 million,
respectively. The increase during the nine-month period was due
primarily to increased staffing levels, increased intangible
amortization, increased data processing and occupancy costs, and to
acquisition and conversion expenses of $3.2 million, all resulting
from the KeyBank branch acquisition. The acquisition and conversion
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.
Employee compensation and benefits were $6.2 million and $4.0 million
for the three months ended September 30, 1998 and 1997, respectively.
During the nine months ended September 30, 1998 and 1997, employee
compensation and benefits were $15.4 million and $11.9 million,
respectively. The increases in both periods reflected the personnel
hired ion connection with the new branches and increased community
bank lending staff. At September 30, 1998, full-time-equivalent
employees were 700, compared with 502 at September 30, 1997.
Amortization of intangibles was $1.4 million and $536,000 for the
three months ended September 30, 1998 and 1997, respectively. During
the nine months ended September 30, 1998 and 1997, amortization was
$2.5 million and $1.7 million, respectively. The increase was due
primarily to the amortization of the KeyBank intangible asset that is
being amortized over 15 years using the straight-line method..
Data processing expense was $1.1 million and $521,000 for the three
months ended September 30, 1998 and 1997, respectively. During the
nine months ended September 30, 1998 and 1997, data processing expense
was $2.5 million and $1.7 million, respectively. These increases
were due primarily to the costs incurred to process the substantial
increase in deposit and loan transactions.
<PAGE>
Occupancy and equipment expenses increased as a result of building
maintenance, property taxes and utility costs due associated with the
addition of 33 branches. As a result, occupancy and equipment costs
were $2.1 million compared with $1.6 million for the quarters ended
September 30, 1998 and 1997, respectively. During the nine months
ended September 30, 1998 and 1997, occupancy and equipment costs were
$5.2 million and $4.5 million, respectively.
INCOME TAX PROVISION. Sterling recorded federal and state income tax
provisions of $1.6 million for both the three months ended September
30, 1998 and 1997. Tax provisions were $2.5 million and $4.3 million
for the nine months ended September 30, 1998 and 1997, respectively.
The effective tax rates during these periods approximated the
applicable statutory rates.
Financial Position
------------------
ASSETS. At September 30, 1998, Sterling's assets were $2.08 billion,
up 11.0% 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
September 30, 1998 was $534.2 million, down $134.8 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 September 30, 1998, net loans receivable were
$1.31 billion, up $244.1 million from $1.07 billion at December 31,
1997. Approximately half 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. Internal loan originations
resulted in total loans receivable increasing $168.1 million from
December 31, 1997. The most significant area of increase in loan
originations for the three months ended September 30, 1998 was in
consumer lending. See the loan origination table below.
<PAGE>
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.
<TABLE>
<CAPTION>
September 30, 1998 December 31, 1997
------------------- -------------------
Amount % Amount %
---------- ------ ---------- ------
(Dollars in thousands)
<S> <C> <C> <C> <C>
Residential $ 279,289 19.1% $ 282,894 24.2%
Multifamily 88,957 6.1 65,621 5.6
Commercial real estate 146,285 10.0 118,622 10.1
Construction 355,008 24.3 302,279 25.9
Consumer 277,520 19.0 157,277 13.5
Business banking 313,287 21.5 241,808 20.7
---------- ----- ---------- -----
Total loans receivable $1,406,346 100.0% $1,168,501 100.0%
========== ===== ========== =====
</TABLE>
The following table sets forth Sterling's loan originations for the
periods indicated.
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------ ------------------------------
1998 1997 % Change 1998 1997 % Change
-------- -------- -------- -------- -------- --------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C> <C>
Residential $ 52,025 $ 52,034 0.0% $149,563 $113,536 31.7%
Multifamily 11,345 1,000 1,034.5 40,490 13,815 193.1
Commercial real estate 3,700 3,600 2.8 18,385 28,600 (35.7)
Construction 85,426 78,021 9.5 246,003 220,858 11.4
Consumer 36,748 28,609 28.4 102,716 61,117 68.1
Business banking 30,592 42,465 (28.0) 128,604 115,539 11.3
-------- -------- ------- -------- -------- --------
Total loans receivable $219,836 $205,729 6.9% $685,761 $553,465 23.9%
======== ======== ======= ======== ======== ========
</TABLE>
DEPOSITS. Total deposits increased $481.4 million to $1.52 billion at
September 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. For the quarter ended September 30, 1998,
the average cost of deposits was 4.36%, compared with 4.92% for the
quarter ended September 30, 1997.
<PAGE>
The following table sets forth the composition of Sterling's deposits
at the dates indicated.
<TABLE>
<CAPTION>
September 30, 1998 December 31, 1997
------------------- -------------------
Amount % Amount %
---------- ------ ---------- ------
(Dollars in thousands)
<S> <C> <C> <C> <C>
Certificates of deposit $ 828,954 54.6% $ 670,137 64.7%
Checking 280,558 18.5 119,359 11.5
Savings and money market 408,333 26.9 246,912 23.8
---------- ----- ---------- -----
Total deposits $1,517,845 100.0% $1,036,408 100.0%
========== ===== ========== =====
</TABLE>
BORROWINGS. Sterling's primary sources of borrowing are the FHLB
Seattle advances, securities sold under agreements to repurchase and
other borrowings. At September 30, 1998, total borrowings were
$413.6 million, compared with $707.4 million at December 31, 1997, a
decrease of $293.8 million. The decrease reflects the repayment of
certain borrowings with the net cash acquired with the KeyBank branch
acquisition, thereby replacing wholesale funds with lower cost deposit
funding sources. FHLB Seattle advances outstanding have decreased by
$253.8 million since December 31, 1997. See "Liquidity and Sources of
Funds."
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.
<PAGE>
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 also
designed to also 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. 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 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
<PAGE>
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
decreased, 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.
<TABLE>
<CAPTION>
At September 30, 1998 At December 31, 1997
------------------------------------------------ --------------------------------
<S> <C> <C> <C> <C> <C> <C>
Ratio of Ratio of
Change in NPV to NPV to
Interest Rates the Present % the Present %
in Basis Points Value of Change Value of Change
(Rate Shock) NPV Total Assets in NPV NPV Total Assets in NPV
--------------- -------- ------------ ------- -------- ------------ -------
(Dollars in thousands)
+300 $ 33,047 1.67% (61.8)% $ 56,193 3.18% (50.9)%
+200 51,160 2.55 (40.9) 80,857 4.47 (29.4)
+100 73,278 3.59 (15.4) 104,439 5.65 (8.8)
Static 86,593 4.20 N/A 114,503 6.09 N/A
-100 69,479 3.38 (19.8) 107,104 5.64 (6.5)
-200 60,419 2.94 (30.2) 90,190 4.72 (21.2)
-300 64,268 3.10 (25.8) 69,152 3.60 (39.6)
</TABLE>
<PAGE>
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 10.3% and
negative 4.8% at September 30, 1998. This compares with Sterling's
one- and three-year gap positions of negative 12.2% and negative 12.8%
at September 30, 1997. The one- and three-year gap positions have
narrowed due to the replacement of short-term borrowings with longer
maturity deposits and faster prepayments in the loan and investment
portfolios caused by the lower interest rate environment. Management
attempts to maintain Sterling's gap position between negative 5% and
negative 20%. At September 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.
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 September
30, 1998, from $1.04 billion at December 31, 1997. Advances from the
FHLB Seattle decreased to $201.3 million at September 30, 1998 from
$455.1 million at December 31, 1997. At September 30, 1998 and
December 31, 1997, securities sold subject to repurchase agreements
were $115.0 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.
In connection with its Year 2000 compliance plan, Sterling is focusing
on identifying potential demand for funds from its loan and deposit
customers. See "Year 2000 Issues."
During the nine months ended September 30, 1998, Sterling received net
cash from the KeyBank branch acquisition of approximately $327.2
million. Other cash was provided by investing activities consisting
of principal and interest payments on loans and MBS and sales of MBS.
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 nine months ended September 30,
1998, net cash was used in investing activities primarily to purchase
investments and MBS and to fund loans.
Sterling Savings Bank's credit line with the FHLB Seattle provides for
borrowings of up to 35% of its total assets. At September 30, 1998,
this credit line represented a total borrowing capacity of
approximately $772.2 million, of which $570.9 million was available.
<PAGE>
Sterling Savings Bank also borrows on a secured basis from major
broker/dealers and financial entities by selling securities subject to
repurchase agreements. At September 30, 1998, Sterling Savings Bank
had $115.0 million in outstanding borrowings under reverse repurchase
agreements and securities available for additional secured borrowings
of approximately $258.5 million. Sterling Savings Bank also had a
secured line of credit agreement from a commercial bank of
approximately $10.0 million as of September 30, 1998, but had no
funds drawn on this line of credit.
Excluding its subsidiaries, Sterling had cash and other resources of
approximately $2.2 million and a line of credit from a commercial bank
of approximately $5.0 million at September 30, 1998, but had no funds
drawn on this line of credit. At September 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 September 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
$5.8 million during the nine months ended September 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 September
30, 1998 and December 31, 1997, Sterling Savings Bank's liquidity
ratios were 12.8% and 13.0%, respectively. The lower level of
liquidity at September 30, 1998 was due primarily to an increase in
the balance of net withdrawable deposits. 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.
<PAGE>
Capital Resources
-----------------
Sterling's total shareholders' equity was $112.0 million at
September 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 nine-month period and the
increase in the market value of available for sale investments and
MBS. At September 30, 1998 and December 31, 1997, shareholders'
equity was 5.4% and 5.5% of total assets, respectively.
At September 30, 1998, Sterling had an unrealized gain of $3.2
million, net of related income taxes, on investments and MBS
classified as available for sale. At December 31, 1997, Sterling had
a net unrealized loss of $1.0 million on investments and MBS. The
increase of $4.2 million since the beginning of the year is
attributable to the sharp decrease in long-term interest rates over
the past nine months. 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 $1.9 million for the remainder of the year ending
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
<PAGE>
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 September 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.
Year 2000 Issues
----------------
The Year 2000 problem concerns the inability of information systems to
properly recognize and process date-sensitive information beginning on
January 1, 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 and other entities.
To address this concern, Sterling has created a Year 2000 Action Plan
that focuses on identifying, testing and implementing solutions for
Year 2000 processing. At September 30, 1998, Sterling had completed
the awareness and assessment phases of its Year 2000 Action Plan. 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. This assessment
included critical functions and systems not generally included in the
information systems category, such as fax machines, telephone
switches, elevators, vaults, ATMs and security systems. Certain
vendors were contacted and asked to submit certification letters
stating that they are adequately addressing Year 2000 conversion
issues. An assessment of our data service provider, The BISYS Group,
Inc. ("BISYS"), was conducted by federal regulatory agencies.
Sterling has completed an evaluation of its deposit base and
identified potential problems due to concentrations. Management will
assess whether those concentrations are at risk due to Year 2000
problems. All financial institutions are considering the possibility
of some level of reduction in deposits during the month of December
1999. Sterling has determined that several borrowing sources are and
will be available so adequate funding in December 1999 will not be a
problem, although there can be no assurance in this regard.
<PAGE>
In conjunction with its review of Year 2000 issues, Sterling has
endeavored to assess the impact of the Year 2000 event on significant
borrowers and their ability to repay loans. Sterling is currently
evaluating its allowances for loan losses with its review of Year 2000
concerns in relation to its borrowers.
Sterling estimates that testing, renovation and/or replacement of
hardware, proprietary programs, security systems, facility systems and
non-BISYS software will be largely completed by December 31, 1998.
Testing of BISYS-supported software and systems is scheduled to be
completed in early 1999.
It is currently estimated that the aggregate cost of Sterling's Year
2000 readiness efforts will be approximately $870,000, of which
approximately $284,000 has been spent. The costs associated with the
replacement of computerized hardware or equipment (currently estimated
to be approximately $305,000), substantially all of which will be
capitalized, are included in the estimate. Costs relating to recent
acquisitions and mergers are also included in the estimate. All other
costs are being expensed as they are incurred and are being funded
through operating cash flow. These costs do not include any costs
associated with the implementation of contingency plans, which are in
the process of being developed.
Sterling is currently developing contingency plans to be implemented
as part of its efforts to identify and correct Year 2000 problems
affecting its internal operations. Sterling expects to substantially
complete its contingency planning by the end of 1998. Depending on
the systems affected, these plans could include short to medium-term
use of backup equipment and software, increased work hours for
Sterling personnel, implementation of manual workarounds for
information systems or department functions, or similar approaches.
The discussion of Sterling's efforts and management's expectations
relating to Year 2000 readiness included forward-looking statements.
Although Sterling expects to identify and resolve all Year 2000 issues
that could materially adversely affect its business operations, it is
not possible to determine with complete certainty that all Year 2000
problems affecting the company will be identified or corrected. The
number of devices that could be affected and the interactions among
these devices are simply too numerous. In addition, one cannot
accurately predict how many Year 2000 problem-related failures will
occur or the severity, duration, or financial consequences of these
perhaps inevitable failures. As a result, management expects that
Sterling could likely suffer the following consequences:
1. a significant number of operational inconveniences and
inefficiencies for Sterling and its customers that may divert
management's time and attention and financial and human resources
from its ordinary business activities; and
2. a lesser number of serious system failures that may require
significant efforts by Sterling or its customers to prevent or
alleviate material business disruptions.
<PAGE>
Sterling's Year 2000 Action Plan is expected to significantly reduce
Sterling's level of uncertainty about the Year 2000 event and, in
particular, about the Year 2000 compliance and readiness of its
external vendors and major customers. Sterling believes that, with
the implementation of its Action Plan as scheduled, the possibility of
significant interruptions of normal operations should be reduced,
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."
<PAGE>
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.
Item 4 - Submission of Matters to a Vote of Security Holders
None.
Item 5 - Other Information
None.
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.
<PAGE>
(a) Exhibit No. Exhibit
--------------- -----------------------------------------------------
4.1 Reference is made to Exhibits 3.1 and 3.2.
4.2 The Registrant has outstanding certain long-term
debt. None of such debt exceeds ten percent of
Registrant's total assets; therefore, copies of the
constituent instruments defining the rights of the
holders of such debt are not included as exhibits.
Copies of instruments with respect to such long-term
debt will be furnished to the Securities and Exchange
Commission upon request.
27.1 Financial Data Schedule. Filed herewith.
Reports on Form 8-K. No reports were filed during the three months
ended September 30, 1998.
<PAGE>
STERLING FINANCIAL CORPORATION
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.
November 13, 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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