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, 1999
------------------
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 29, 1999
------------------------------ ------------------------------------
Common Stock ($1.00 par value) 8,089,844
<PAGE>
STERLING FINANCIAL CORPORATION
FORM 10-Q
For the Quarter Ended September 30, 1999
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 (Loss)
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 and Use of Proceeds
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,
1999 1998
------------- ------------
(Dollars in thousands)
<S> <C> <C>
ASSETS:
Cash and cash equivalents:
Interest bearing $ 2,947 $ 26,977
Non-interest bearing and vault 64,911 61,354
Restricted 931 8,775
Loans receivable, net 1,769,534 1,468,534
Loans held for sale 3,737 15,881
Investments and mortgage-backed
securities ("MBS"):
Available for sale 503,628 566,372
Held to maturity 13,922 20,033
Accrued interest receivable (including
$3,548 and $4,954 on investments
and MBS) 15,312 14,938
Real estate owned, net 5,922 6,232
Office properties and equipment, net 53,376 51,771
Intangible assets, net 56,886 61,180
Prepaid expenses and other assets, net 22,687 12,540
---------- ----------
Total assets $2,513,793 $2,314,587
========== ==========
LIABILITIES AND SHAREHOLDERS' EQUITY
Deposits $1,615,312 $1,545,425
Advances from Federal Home Loan Bank
Seattle ("FHLB Seattle") 430,481 319,540
Securities sold subject to repurchase
agreements and federal funds
purchased 206,319 195,074
Other borrowings (Note 3) 110,000 97,240
Cashiers checks issued and payable 9,188 17,512
Borrowers' reserves for taxes and
insurance 3,427 1,826
Accrued interest payable 6,238 5,639
Accrued expenses and other liabilities 14,696 13,314
---------- ----------
Total liabilities 2,395,661 2,195,570
---------- ----------
</TABLE>
<PAGE>
STERLING FINANCIAL CORPORATION
Consolidated Balance Sheets, Continued
(Unaudited)
<TABLE>
<CAPTION>
September 30, December 31,
1999 1998
------------- ------------
(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 0 0
Common stock, $1 par value;
20,000,000 shares authorized;
8,089,844 and 8,056,072 shares issued
and outstanding 8,090 8,056
Additional paid-in capital 70,339 70,229
Accumulated other comprehensive
income (loss):
Unrealized gains (losses) on invest-
ments and MBS available for sale,
net of deferred income tax provi-
sion (benefit) of $(5,192) and
$424 (9,642) 788
Retained earnings 49,345 39,944
---------- ----------
Total shareholders' equity 118,132 119,017
---------- ----------
Total liabilities and share-
holders' equity $2,513,793 $2,314,587
========== ==========
</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,
-------------------- -------------------
1999 1998 1999 1998
--------- --------- --------- --------
(Dollars in thousands,
except per share data)
<S> <C> <C> <C> <C>
Interest income:
Loans $ 36,903 $ 30,113 $ 105,008 $ 82,378
MBS 5,844 5,809 17,104 20,222
Investments and cash equivalents 2,497 4,172 8,121 11,491
--------- --------- --------- ---------
Total interest income 45,244 40,094 130,233 114,091
--------- --------- --------- ---------
Interest expense:
Deposits 15,352 16,437 44,958 42,171
Short-term borrowings 2,585 3,825 8,128 19,453
Long-term borrowings 7,994 3,894 21,306 10,537
--------- --------- --------- ---------
Total interest expense 25,931 24,156 74,392 72,161
--------- --------- --------- ---------
Net interest income 19,313 15,938 55,841 41,930
Provision for losses on loans (1,000) (807) (2,900) (4,522)
--------- --------- --------- ---------
Net interest income after pro-
vision for losses on loans 18,313 15,131 52,941 37,408
--------- --------- --------- ---------
Other income:
Fees and service charges 2,885 2,324 7,958 5,412
Mortgage banking operations 271 431 862 1,508
Loan servicing fees 194 178 608 606
Net gains on sales of securities 0 655 593 1,233
Real estate owned operations (27) (19) (117) (177)
--------- --------- --------- ---------
Total other income 3,323 3,569 9,904 8,582
--------- --------- --------- ---------
Operating expenses 16,352 14,182 47,928 38,498
--------- --------- --------- ---------
Income before income taxes 5,284 4,518 14,917 7,492
--------- --------- --------- ---------
Income tax provision (1,955) (1,672) (5,516) (2,693)
--------- --------- --------- ---------
Net income $ 3,329 $ 2,846 $ 9,401 $ 4,799
========= ========= ========= =========
Income per share - basic $ 0.41 $ 0.35 $ 1.16 $ 0.60
========= ========= ========= =========
Income per share - diluted $ 0.41 $ 0.35 $ 1.15 $ 0.58
========= ========= ========= =========
Weighted average shares outstanding -
basic 8,089,844 8,032,882 8,080,729 8,022,253
Weighted average shares outstanding -
diluted 8,158,607 8,188,326 8,166,483 8,224,740
</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,
----------------------
1999 1998
---------- ----------
(Dollars in thousands)
Cash flows from operating activities:
Net income $ 9,401 $ 4,799
Adjustments to reconcile net income to net
cash provided by operating activities:
Provisions for loan and real estate
owned losses 3,105 4,594
Stock dividends on FHLB Seattle stock (1,826) (1,751)
Net gain on sales of loans, securities
and mortgage servicing rights (1,267) (2,459
Net gain on sales of real estate owned (172) (84)
Depreciation and amortization 8,485 6,135
Deferred income tax provision 0 (113)
Compensation expense associated with
stock grants 0 49
Change in:
Accrued interest receivable (374) 1,235
Prepaid expenses and other assets (4,813) (7,512)
Cashiers checks issued and payable (8,324) 2,352
Accrued interest payable 599 (1,463)
Accrued expenses and other liabilities 1,382 6,170
Proceeds from sales of loans 63,238 91,772
Loans originated for sale (62,908) (90,649)
--------- ---------
Net cash provided by operating
activities 6,526 13,075
--------- ---------
Cash flows from investing activities:
Change in restricted cash 7,844 (10,230)
Loans disbursed (984,169) (826,456)
Loan principal received 691,393 696,571
Purchase of investments (29,823) (347,827)
Proceeds from maturities of investments 48,906 331,502
Proceeds from sales of available-for-sale
investments 542 0
Purchase of MBS (60,128) (190,217)
Principal payments on MBS 65,999 63,360
Proceeds from sales of MBS 29,104 289,776
Purchase of office properties and equipment (4,733) (3,920)
Improvements and other changes to real
estate owned 43 (66)
<PAGE>
STERLING FINANCIAL CORPORATION
Consolidated Statements of Cash Flows, Continued
(Unaudited)
Nine Months Ended
September 30,
----------------------
1999 1998
---------- ----------
(Dollars in thousands)
Cash flows from investing activities,
Continued:
Proceeds from sales and liquidation of
real estate owned 1,599 3,950
Proceeds from sales of mortgage
servicing rights 0 1,123
Net cash received from branch acquisition 0 327,183
--------- ---------
Net cash provided by (used in)
investing activities (233,423) 334,749
--------- ---------
Cash flows from financing activities:
Net change in checking, passbook and money
market deposits $ (15,157) $29,652
Proceeds from issuance of certificates of
deposit 649,692 580,244
Payments for maturing certificates of
deposit (609,393) (686,466)
Interest credited to deposits 44,745 42,790
Advances from FHLB Seattle 205,877 30,000
Repayment of FHLB Seattle advances (95,090) (284,063)
Net change in securities sold subject to
repurchase agreements and funds
purchased 11,245 (65,081)
Proceeds from other borrowings 35,000 40,000
Repayment of other borrowings (22,240) (15,000)
Proceeds from exercise of stock options,
net of repurchases 144 417
Other 1,601 1,778
--------- ---------
Net cash provided by (used in)
financing activities 206,424 (325,729)
--------- ---------
Net change in cash and cash equivalents (20,473) 22,095
Cash and cash equivalents, beginning of
period 88,331 52,439
--------- ---------
Cash and cash equivalents, end of period $ 67,858 $ 74,534
========= =========
<PAGE>
STERLING FINANCIAL CORPORATION
Consolidated Statements of Cash Flows, Continued
(Unaudited)
Nine Months Ended
September 30,
----------------------
1999 1998
---------- ----------
(Dollars in thousands)
Supplemental disclosures:
Cash paid during the period for:
Interest $ 73,792 $ 70,900
Income taxes 3,497 2,049
Noncash financing and investing activities:
Loans converted into real estate owned 1,364 1,730
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,
-------------------- --------------------
1999 1998 1999 1998
--------- --------- --------- ---------
(Dollars in thousands)
<S> <C> <C> <C> <C>
Net income $ 3,329 $ 2,846 $ 9,401 $ 4,799
Other comprehensive income (loss):
Change in unrealized gains or losses
on investments and MBS available
for sale (3,343) 5,415 (16,046) 6,554
Less deferred income tax (provision)
benefit 1,170 (1,895) 5,616 (2,294)
--------- --------- --------- ---------
Net other comprehensive income (loss) (2,173) 3,520 (10,430) 4,260
--------- --------- --------- ---------
Comprehensive income (loss) $ 1,156 $ 6,366 $ (1,029) $ 9,059
========= ========= ========= =========
</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, 1998, consolidated financial statements,
as set forth in Sterling Financial Corporation's ("Sterling's")
December 31, 1998 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, 1999 and are not repeated
here. All financial statements presented are unaudited. However,
the December 31, 1998 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. The unaudited interim consolidated financial statements
for the three and nine months ended September 30, 1998 have been
restated to reflect the November 1998 acquisition of Big Sky Bancorp,
Inc. ("Big Sky"), which was accounted for as a pooling of interests.
3. Other Borrowings:
The following table details Sterling's other borrowings.
September 30, December 31,
1999 1998
------------- ------------
(Dollars in thousands)
Advances on non-revolving line of
credit(1) $ 40,000 $ 40,000
Advances on revolving line of
credit(2) 0 0
8.75% Subordinated Notes Due
2000(3) 0 17,240
Sterling obligated mandatorily
redeemable preferred securities
of subsidiary trust holding
solely junior subordinated
deferrable interest debentures
of Sterling (4) 40,000 40,000
Floating Rate Notes Due 2006 (5) 30,000 0
-------- --------
Total other borrowings $110,000 $ 97,240
======== ========
<PAGE>
STERLING FINANCIAL CORPORATION
Notes to Consolidated Financial Statements, Continued
3. Other Borrowings, Continued:
(1) In June 1998, Sterling entered into a one-year variable rate
non-revolving line-of-credit agreement with KeyBank National
Association ("KeyBank"). In May 1999, KeyBank agreed to extend
this borrowing to May 31, 2001 and to increase the balance to
$50.0 million. Interest accrues at the 30-day London Interbank
Offering Rate ("LIBOR") Index plus 2.00% (7.44% at September 30,
1999) and is payable monthly. The line of credit may be renewed
for an additional twelve months subject to certain conditions.
(2) Sterling has available $5.0 million on a revolving line of
credit from KeyBank which matures on June 1, 2000. The interest
rate is adjustable monthly at KeyBank's prime interest rate
(8.25% at September 30, 1999).
(3) On June 30, 1999, Sterling redeemed the outstanding balance of
its 8.75% Subordinated Notes Due 2000, including accrued
interest thereon in the aggregate amount of $17.4 million.
Sterling incurred a charge of approximately $97,000 upon early
extinguishment of these notes.
(4) 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 becomes regulated as
a bank holding company. The Junior Subordinated Debentures and
related 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.
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
3. Other Borrowings, Continued:
(5) In May 1999, Sterling issued $30.0 million of Floating Rate
Notes Due 2006. Interest accrues at the three-month LIBOR plus
2.50% (8.01% until December 15, 1999) and is adjustable and
payable quarterly. The notes mature on June 15, 2006 and may be
redeemed under certain conditions after June 15, 2002.
<PAGE>
STERLING FINANCIAL CORPORATION
Notes to Consolidated Financial Statements, Continued
4. Income Per Share:
The following table presents the basic and diluted income per
share computations.
<TABLE>
<CAPTION>
Three Months Ended September 30,
-----------------------------------------------------------------------
1999 1998
---------------------------------- ----------------------------------
Weighted Weighted
Avg. Per Share Avg. Per Share
Net Income Shares Amount Net Income Shares Amount
---------- --------- --------- ---------- --------- ---------
<S> <C> <C> <C> <C> <C> <C>
Basic computations $3,329,000 8,089,844 $0.41 $2,846,000 8,032,882 $0.35
Effect of dilutive securities:
Common stock options 0 68,763 0 155,444
---------- --------- ----- ---------- --------- -----
Diluted computations $3,329,000 8,158,607 $0.41 $2,846,000 8,188,326 $0.35
========== ========= ===== ========== ========= =====
Antidilutive options not included
in diluted income per share 194,000 70,500
<CAPTION>
Nine Months Ended September 30,
-----------------------------------------------------------------------
1999 1998
---------------------------------- ----------------------------------
Weighted Weighted
Avg. Per Share Avg. Per Share
Net Income Shares Amount Net Income Shares Amount
---------- --------- --------- ---------- --------- ---------
<S> <C> <C> <C> <C> <C> <C>
Basic computations $9,401,000 8,080,729 $1.16 $4,799,000 8,022,253 0 .60
Effect of dilutive securities:
Common stock options 0 85,754 0 202,487
---------- --------- ----- ---------- --------- -----
Diluted computations $9,401,000 8,166,483 $1.15 $4,799,000 8,224,740 $0.58
========== ========= ===== ========== ========= =====
Antidilutive options not included
in diluted income per share 194,000 0
</TABLE>
<PAGE>
STERLING FINANCIAL CORPORATION
Notes to Consolidated Financial Statements, Continued
5. 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,
------------------ -----------------
1999 1998 1999 1998
------- -------- ------- -------
(Dollars in thousands)
<S> <C> <C> <C> <C>
Employee compensation and benefits $ 7,521 $ 6,372 $21,581 $15,918
Occupancy and equipment 2,541 2,093 7,443 5,276
Depreciation 1,119 895 3,128 2,426
Amortization of intangible assets 1,398 1,448 4,294 2,523
Advertising 779 617 2,095 1,456
Data processing 1,405 1,125 4,026 2,569
Insurance 257 289 730 789
Legal and accounting 448 324 1,267 1,179
Travel and entertainment 373 311 1,177 895
Acquisition and conversion costs (1) 0 0 0 3,210
Other 511 708 2,187 2,257
------- ------- ------- -------
Total operating expenses $16,352 $14,182 $47,928 $38,498
======= ======= ======= =======
</TABLE>
(1) Includes costs associated with mailing customer notices;
issuing new checks and ATM cards; training new employees,
including related travel; equipp ing branches; implementing
a targeted marketing campaign; and converting computer
systems.
6. 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, as amended by SFAS No. 137, "Deferral of the
Effective Date of FASB Statement No. 133," is effective for all
fiscal quarters of fiscal years beginning after June 15, 2000;
<PAGE>
STERLING FINANCIAL CORPORATION
Notes to Consolidated Financial Statements, Continued
6. Other Accounting Policies, Continued :
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.
7. Mortgage Banking Operations:
Sterling operates ten residential loan production offices
primarily in the Spokane and Seattle, Washington; Portland,
Oregon; and Boise, Idaho metropolitan areas through its subsidiary
Action Mortgage. Mortgage banking operations include revenues
from servicing released and servicing retained sales of originated
residential loans, bulk sales of loan servicing rights and other
fees.
The following table summarizes information related to Sterling's
mortgage banking operations:
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
------------------ -----------------
1999 1998 1999 1998
------- -------- ------- -------
(Dollars in thousands)
<S> <C> <C> <C> <C>
Revenues:
Gains on sales of originated
residential loans $ 143 $ 323 $ 674 $ 1,126
Other fees and income 1,344 1,169 3,871 3,369
------- ------- ------- -------
Total revenues 1,487 1,492 4,545 4,495
Identifiable expenses 875 510 2,483 1,858
------- ------- ------- -------
Income before adjustments, elimina-
tions and income taxes 612 982 2,062 2,637
Adjustments and eliminations 0 0 0 0
------- ------- ------- -------
Income before income taxes $ 612 $ 982 $ 2,062 $ 2,637
======= ======= ======= =======
Identifiable assets $10,793 $ 7,703 $10,793 $ 7,703
======= ======= ======= =======
Depreciation and amortization
expense $ 30 $ 36 $ 95 $ 107
======= ======= ======= =======
Capital expenditures for office
properties and equipment $ 20 $ 3 $ 62 $ 226
======= ======= ======= =======
</TABLE>
<PAGE>
STERLING FINANCIAL CORPORATION
Notes to Consolidated Financial Statements, Continued
7. Mortgage Banking Operations, Continued:
The following is a reconciliation of certain mortgage banking
operations to the amounts reported in the consolidated financial
statements:
<TABLE>
<CAPTION>
Mortgage
Banking Banking
Operations Operations Total
---------- ---------- ----------
<S> <C> <C> <C>
(Dollars in thousands)
As of and for the three months
ended September 30, 1999:
Other income $ 3,052 $ 271 $ 3,323
Income before income taxes 4,672 612 5,284
Total assets 2,503,000 10,793 2,513,793
As of and for the three months
ended September 30, 1998:
Other income $ 3,138 $ 431 $ 3,569
Income before income taxes 3,536 982 4,518
Total assets 2,139,622 7,703 2,147,325
As of and for the nine months
ended September 30, 1999:
Other income $ 9,042 $ 862 $ 9,904
Income before income taxes 12,855 2,062 14,917
Total assets 2,503,000 10,793 2,513,793
As of and for the nine months
ended September 30, 1998:
Other income $ 7,074 $ 1,508 $ 8,582
Income before income taxes 4,855 2,637 7,492
Total assets 2,139,622 7,703 2,147,325
</TABLE>
<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, 1999 and
1998
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; 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.
GENERAL
Sterling Financial Corporation ("Sterling") is a unitary savings and
loan holding company, the significant operating subsidiary of which is
Sterling Savings Bank. The significant operating subsidiaries of
Sterling Savings Bank are Action Mortgage Company ("Action Mortgage"),
INTERVEST-Mortgage Investment Company ("INTERVEST") and Harbor
Financial Services, Inc. ("Harbor Financial").
Sterling endeavors to provide personalized, quality financial services
to its customers as exemplified by its "Hometown Helpful" philosophy.
Sterling believes that this dedication to personalized service has
enabled it to maintain a stable retail deposit base. Sterling, with
$2.51 billion in total assets at September 30, 1999, attracts Federal
Deposit Insurance Corporation ("FDIC") insured deposits from the
general public through 77 retail branches located primarily in rural
and suburban communities in Washington, Oregon, Idaho and Montana.
Sterling originates loans through its branch offices as well as ten
Action Mortgage residential loan production offices in the
metropolitan areas of Spokane and Seattle, Washington; Portland,
Oregon; and Boise, Idaho; and four INTERVEST commercial real estate
lending offices located in the metropolitan areas of Spokane and
Seattle, Washington; and Portland, Oregon. Sterling also markets
tax-deferred annuities, mutual funds and other financial products
through Harbor Financial.
Sterling continues to focus its efforts on becoming more like a
community bank by increasing its commercial real estate, business
banking, consumer and construction lending while increasing its retail
deposits, particularly transaction accounts. Commercial real estate,
<PAGE>
business banking, consumer and construction loans generally produce
higher yields than residential loans. Such loans, however, generally
involve a higher degree of risk than financing residential real
estate. Sterling's revenues are derived primarily from interest
earned on loans, investments and mortgage-backed securities ("MBS"),
from fees and service charges and from mortgage banking operations.
The operations of Sterling Savings Bank, and savings institutions
generally, are influenced significantly by general economic conditions
and by policies of its primary regulatory authorities, the Office of
Thrift Supervision ("OTS"), the FDIC and the State of Washington
Department of Financial Institutions ("Washington Supervisor").
To further enhance its presence in the Pacific Northwest market,
Sterling has been working to expand its community bank delivery
system, focusing primarily on deposit gathering and lending. In June
1998, Sterling acquired 33 branch offices in Washington, Idaho and
Oregon from a commercial bank. Also, in November 1998, Sterling
completed the acquisition of Big Sky Bancorp, Inc. ("Big Sky") and its
subsidiary, First Federal Savings and Loan Association of Montana
("First Federal"). The merger with Big Sky was accounted for as a
pooling of interests and accordingly, all historical amounts have been
restated to include the results of Big Sky.
Sterling is now processing checks for its customers in-house rather
than out-sourcing this function. This change has increased staffing
and occupancy expenses. Management believes that this change will
improve its float management, thereby increasing net interest income
and other income and enhancing service to deposit customers in future
periods, although there can be no assurance in this regard.
Management believes that by changing the mix of its assets and
liabilities to be more like a community bank, its net interest income
(the difference between the interest earned on loans and investments
and the interest paid on liabilities) and other fee income will
increase, although there can be no assurance in this regard. Sterling
intends to continue to pursue an aggressive growth strategy, which may
include acquiring other financial institutions or branches thereof or
other substantial assets or deposit liabilities. Sterling may not be
successful in identifying further acquisition candidates, integrating
acquired institutions or preventing deposit erosion or loan quality
deterioration at acquired institutions. There is significant
competition for acquisitions in Sterling's market area, and Sterling
may not be able to acquire other institutions on attractive terms.
Furthermore, the success of Sterling's growth strategy will depend on
increasing and maintaining sufficient levels of regulatory capital,
obtaining necessary regulatory approvals, generating appropriate
growth and favorable economic and market conditions. There can be no
assurance that Sterling will be successful in implementing its growth
strategy.
<PAGE>
RESULTS OF OPERATIONS
OVERVIEW. Sterling recorded net income of $3.3 million, or $0.41 per
diluted share, for the three months ended September 30, 1999. This
compares with net income of $2.8 million, or $0.35 per diluted share,
for the three months ended September 30, 1998. The increase in net
income reflected higher net interest income. Sterling recorded net
income of $9.4 million, or $1.15 per diluted share, for the nine
months ended September 30, 1999. This compares with net income of
$4.8 million, or $0.58 per diluted share, for the nine months ended
September 30, 1998. Core earnings, which are defined as earnings
before acquisition costs, conversion costs and other charges, for the
nine months ended September 30, 1998 were $8.5 million, or $1.03 per
diluted share. The increase in net income was primarily due to
increases in net interest and other income, coupled with the non-
recurrence of branch conversion costs.
The annualized return on average assets was 0.53% and 0.52% for the
three months ended September 30, 1999 and 1998, respectively. For the
nine months ended September 30, 1999 and 1998, the annualized return
on average assets was 0.52% and 0.32%, respectively. The increases in
the ratios were primarily due to increases in net income and the non-
recurrence of branch conversion costs which were incurred during the
nine-month period ended September 30, 1998.
The annualized return on average equity was 11.15% and 9.82% for the
three months ended September 30, 1999 and 1998, respectively. The
annualized return on average equity was 10.47% and 5.64% for the nine
months ended September 30, 1999 and 1998, respectively. The increases
in the ratios were primarily due to increases in net income.
NET INTEREST INCOME. The most significant component of earnings for a
financial institution typically is net interest income (ANII@), which
is the difference between interest income, primarily from loan, MBS
and investment portfolios, and interest expense, primarily on deposits
and borrowings. During the three months ended September 30, 1999 and
1998, NII was $19.3 million and $15.9 million, respectively, an
increase of 21.2%. During the nine months ended September 30, 1999
and 1998, NII was $55.8 million and $41.9 million, respectively, an
increase of 33.2%.
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 the three months ended September 30, 1999 was
primarily due to an increase in the volume of loans. The increase in
NII during the nine months ended September 30, 1999 was primarily due
to an increase in the volume of loans coupled with lower funding
costs.
<PAGE>
During the three months ended September 30, 1999 and 1998, the volume
of average interest-earning assets was $2.30 billion and $1.96
billion, respectively. Net interest spread during these periods was
3.18% and 3.10%, respectively. The net interest margin for the three
months ended September 30, 1999 and 1998 was 3.33% and 3.22%,
respectively. Net interest margin increased primarily due to the
wider spreads and an improved mix of interest-earning assets relative
to interest-bearing liabilities. During the nine months ended
September 30, 1999 and 1998, the volume of average interest-earning
assets was $2.22 billion and $1.88 billion, respectively. Net
interest spread during these periods was 3.22% and 2.81%,
respectively. The net interest margin for the nine months ended
September 30, 1999 and 1998 was 3.36% and 2.98%, respectively. The
reasons for the increases in net interest spread and net interest
margin were the same as those for the increases in the quarterly
periods.
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 $1.0 million and
$807,000 for the three months ended September 30, 1999 and 1998,
respectively. Sterling recorded provisions of $2.9 million and $4.5
million for the nine months ended September 30, 1999 and 1998,
respectively. Management anticipates that its provisions for
loan losses will continue to increase in the future as Sterling
originates more construction, business banking and consumer loans. At
September 30, 1999, Sterling's total classified assets were $19.4
million, compared with $17.7 million at December 31, 1998. At
September 30, 1999, Sterling's loan delinquency rate (60 days or more)
as a percentage of total loans was 0.61%, compared with 0.55% at
September 30, 1998. Total nonperforming loans were $9.4 million at
September 30, 1999, compared with $5.3 million at September 30, 1998.
The increase in nonperforming loans was primarily attributable to
certain construction and agricultural loans.
Management believes the loan loss provisions for the three and nine
months ended September 30, 1999 represent appropriate allowances based
upon its evaluation of factors affecting the adequacy of valuation
allowances, although there can be no assurance in this regard. Such
factors include locations and concentrations of loans, loan loss
experience and economic factors affecting the Pacific Northwest
economy.
<PAGE>
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
------------------ -----------------
1999 1998 1999 1998
------- -------- ------- -------
(Dollars in thousands)
<S> <C> <C> <C> <C>
Fees and service charges $ 2,885 $ 2,324 $ 7,958 $ 5,412
Mortgage banking operations 271 431 862 1,508
Loan servicing fees 194 178 608 606
Net gains on sales of securities 0 655 593 1,233
Real estate owned operations (27) (19) (117) (177)
------- ------- ------- -------
Total other income $ 3,323 $ 3,569 $ 9,904 $ 8,582
======= ======= ======= =======
</TABLE>
OTHER INCOME. The following table summarizes the components of other
income for the periods indicated.
Fees and service charges primarily consist of service charges on
deposit accounts, fees for certain customer services, commissions on
sales of credit life insurance, commissions on sales of mutual funds
and annuity products and late charges on loans. The increase in fees
and service charges for the three months ended September 30, 1999,
compared with the three months ended September 30, 1998, was primarily
due to the increase of fees associated with the acquisition of KeyBank
branches. The increase for the nine months ended September 30, 1999,
compared with the nine months ended September 30, 1998, was primarily
due to the growth in transaction accounts from the acquisition of
branches.
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,
------------------ -----------------
1999 1998 1999 1998
------- -------- ------- -------
(Dollars in millions)
<S> <C> <C> <C> <C>
Originations of one- to four-family
permanent mortgage loans $ 43.7 $ 53.4 $ 149.5 $ 153.9
Sales of residential loans 14.5 22.1 62.9 86.8
Principal balances of mortgage loans
serviced for others 201.7 245.1 201.7 245.1
</TABLE>
The decreases in income from mortgage banking operations for the three
and nine months ended September 30, 1999 compared to the same periods
in 1998 were primarily due to a lower volume of loan sales. Sterling
anticipates increasing income from its mortgage servicing portfolio
over the next twelve months by generating a greater volume of loan
sales with the retention of servicing.
<PAGE>
During the three months ended September 30, 1999, Sterling did not
sell any investments and MBS. Sterling sold approximately $42.2
million of investments and MBS in the prior year=s comparable period,
resulting in net gains of $655,000. During the nine months ended
September 30, 1999, Sterling sold approximately $29.1 million of
investments and MBS, resulting in net gains of $593,000. During the
nine months ended September 30, 1998, Sterling sold approximately
$288.5 million of investments and MBS, resulting in net gains of $1.2
million.
OPERATING EXPENSES. Operating expenses were $16.4 million and $14.2
million for the three months ended September 30, 1999 and 1998,
respectively. The increase for these periods was primarily due to
increased staffing levels, occupancy costs and data processing costs.
During the nine months ended September 30, 1999 and 1998, operating
expenses were $47.9 million and $38.5 million, respectively. The nine
months ended September 30, 1998 included acquisition and conversion
costs and other charges of $3.2 million. Exclusive of these charges,
the increase during the nine-month period was primarily due to
increased staffing levels, occupancy costs, intangible asset
amortization and data processing costs.
Employee compensation and benefits were $7.5 million and $6.4 million
for the three months ended September 30, 1999 and 1998, respectively.
During the nine months ended September 30, 1999 and 1998, employee
compensation and benefits were $21.6 million and $15.9 million,
respectively. The increases during the current year reflect increased
community bank lending staff, the addition of staff from the
acquisition of branches and the addition of staff for Sterling's new
check-processing centers. At September 30, 1999, full-time-equivalent
employees were 804, compared with 715 at September 30, 1998.
Amortization of intangibles was $1.4 million for the three months
ended September 30, 1999 and 1998. During the nine months ended
September 30, 1999 and 1998, amortization was $4.3 million and $2.5
million, respectively. The increase in the nine-month period was due
to the amortization of the intangible asset resulting from the
acquisition of branches.
Data processing expense was $1.4 million and $1.1 million for the
three months ended September 30, 1999 and 1998, respectively. The
increase for these periods was primarily attributable to costs
associated with the check-processing centers and internal computer
network upgrades. During the nine months ended September 30, 1999 and
1998, data processing expense was $4.0 million and $2.6 million,
respectively. These increases were primarily due to the costs
incurred to process the substantial increase in deposit and loan
transactions since the acquisition of branches.
<PAGE>
Occupancy and equipment expenses were $2.5 million and $2.1 million
for the three months ended September 30, 1999 and 1998, respectively.
The increase for these periods reflected costs associated with the
check-processing centers. During the nine months ended September 30,
1999 and 1998, occupancy and equipment expenses were $7.4 million and
$5.3 million, respectively. The increase was primarily due to the
addition of branches and check-processing centers and increases in
property taxes and utility costs related to these facilities.
Advertising expenses were $779,000 and $617,000 for the three months
ended September 30, 1999 and 1998, respectively. During the nine
months ended September 30, 1999 and 1998, advertising expenses were
$2.1 million and $1.5 million, respectively. The increases in both
periods were primarily due to an enhanced image campaign.
INCOME TAX PROVISION. Sterling recorded a federal and state income
tax provision of $2.0 million and $1.7 million for the three months
ended September 30, 1999 and 1998, respectively. Tax provisions were
$5.5 million and $2.7 million for the nine months ended September 30,
1999 and 1998, respectively. The effective tax rates during these
periods approximated the applicable statutory federal and state income
tax rates.
FINANCIAL POSITION
ASSETS. At September 30, 1999, Sterling's assets were $2.51 billion,
up 8.6% from $2.31 billion at December 31, 1998. The increase was
primarily due to growth in net loans receivable.
INVESTMENTS AND MBS. Sterling's investment and MBS portfolio at
September 30, 1999 was $517.6 million, down $68.8 million from the
December 31, 1998 balance of $586.4 million. The decrease was
primarily due to principal repayments, net sales of MBS during the
period and reduction in market value.
LOANS RECEIVABLE. At September 30, 1999, net loans receivable were
$1.77 billion, up $300.0 million (or 20.5%) from $1.47 billion at
December 31, 1998. The increase was primarily due to strong loan
origination activity. During the three months ended September 30,
1999, total loan originations were $265.9 million compared with
$222.3 million for the prior year=s comparable quarter. During the
nine months ended September 30, 1999 and 1998, total loan originations
were $920.9 million and $692.6 million, respectively. The most
significant increases in loan originations during both periods were in
commercial real estate and business banking. See the loan origination
table below.
<PAGE>
The following table sets forth the composition of Sterling's loan
portfolio at the dates indicated. Total loan balances do not include
unearned discounts, deferred loan origination costs and fees or
allowances for loan losses.
<TABLE>
<CAPTION>
September 30, 1999 December 31, 1998
------------------- -------------------
Amount % Amount %
---------- ------ ---------- ------
(Dollars in thousands)
<S> <C> <C> <C> <C>
Residential $ 394,569 22.1 $ 342,757 23.1
Multifamily 135,289 7.6 124,656 8.4
Commercial real estate 315,186 17.6 177,912 12.0
Construction 284,951 16.0 233,567 15.7
Consumer - direct 222,908 12.5 224,651 15.1
Consumer - indirect 91,707 5.1 64,764 4.4
Business banking 341,899 19.1 315,614 21.3
---------- ----- ---------- -----
Total loans receivable $1,786,509 100.0 $1,483,921 100.0
========== ===== ========== =====
</TABLE>
The following table sets forth Sterling's loan originations for the
periods indicated.
Management believes its increase in loan originations is primarily due
to the increase in lending staff in its income property and business
banking departments. The weighted average yield on total loans was
8.31% and 8.92% for the three months ended September 30, 1999 and
1998, respectively. The decrease in the weighted average yield was
primarily due to a decline in prevailing interest rates.
DEPOSITS. Total deposits increased $70.0 million to $1.62 billion at
September 30, 1999 from $1.55 billion at December 31, 1998. For the
quarter ended September 30, 1999, the weighted average cost of total
deposits was 3.78%, compared with 4.17% for the quarter ended
September 30, 1998. The decrease in the average cost of deposits was
primarily due to the increase in transaction accounts and the
implementation of bank-like pricing of certificates of deposit.
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------ ------------------------------
1999 1998 % Change 1999 1998 % Change
-------- -------- -------- -------- -------- --------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C> <C>
Residential $ 43,715 $ 53,436 (18.2) $149,478 $153,946 (2.9)
Multifamily 7,100 12,098 (41.3) 50,789 42,020 20.9
Commercial real estate 8,384 3,700 126.6 93,459 18,385 408.3
Construction 115,883 85,551 35.5 279,953 246,533 13.6
Consumer - direct 17,248 23,815 (27.6) 70,482 62,512 12.7
Consumer - indirect 15,221 13,115 16.1 42,103 40,636 3.6
Business banking 58,346 30,592 90.7 234,632 128,604 82.4
-------- -------- ------- -------- -------- --------
Total loans originated $265,897 $222,307 19.6 $920,896 $692,636 33.0
======== ======== ======== ========
</TABLE>
<PAGE>
The following table sets forth the composition of Sterling's deposits
at the dates indicated.
<TABLE>
<CAPTION>
September 30, 1999 December 31, 1998
------------------- -------------------
Amount % Amount %
---------- ------ ---------- ------
(Dollars in thousands)
<S> <C> <C> <C> <C>
Certificates of deposit $ 887,293 54.9 $ 814,957 52.8
Checking 309,594 19.2 297,290 19.2
Savings and money market 418,425 25.9 433,178 28.0
---------- ----- ---------- -----
Total deposits $1,615,312 100.0 $1,545,425 100.0
========== ===== ========== =====
</TABLE>
BORROWINGS. Deposit accounts are Sterling's primary source of funds.
Sterling does, however, rely upon advances from the Federal Home Loan
Bank Seattle ("FHLB Seattle") and reverse repurchase agreements to
supplement its funding and to meet deposit withdrawal requirements.
At September 30, 1999, total borrowings were $746.8 million, compared
with $611.9 million at December 31, 1998, an increase of $134.9
million. 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, some of Sterling's
adjustable-rate mortgages are 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.
<PAGE>
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 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
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.
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 are highly subjective and technical and are relative
measurements of IRR which do not necessarily reflect any expected rate
movement.
<PAGE>
<TABLE>
<CAPTION>
At September 30, 1999 At December 31, 1998
-------------------------------- -------------------------------
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)
<S> <C> <C> <C> <C> <C> <C>
+300 $ 9,195 0.39% (91.2) $11,384 0.53% (86.5)
+200 43,506 1.82 (58.2) 37,950 1.72 (55.1)
+100 71,344 2.93 (31.5) 59,814 2.66 (29.3)
Static 104,193 4.18 N/A 84,568 3.70 N/A
-100 109,713 4.36 5.3 71,197 3.10 (15.8)
-200 97,513 3.86 (6.4) 50,677 2.20 (40.1)
-300 84,640 3.34 (18.8) 40,966 1.77 (51.6)
</TABLE>
At September 30, 1999, Sterling calculated that its NPV was $104.2
million and that its NPV would decrease by 58.2% and 91.2% if interest
rate levels generally were to increase by 2% and 3%, respectively.
This compares with an NPV of $84.6 million at December 31, 1998, which
would decline by 55.1% and 86.5% if interest rates generally were to
increase by 2% and 3%, respectively.
Sterling also uses gap analysis, a traditional analytical tool
designed to measure IRR. Gap analysis focuses on 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-year cumulative gap positions to
be negative 15.7% and negative 10.3% at September 30, 1999 and 1998,
respectively. Sterling calculated its three-year gap positions to be
negative 20.5% and negative 4.8% at September 30, 1999 and 1998,
respectively. The increase in the negative three-year gap position is
largely due to increases in fixed-rate loan originations funded by
shorter-term deposits and borrowings. Management attempts to maintain
Sterling's gap position between positive 10% and negative 25%. At
September 30, 1999, 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.
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, by the sale of certain long-term
fixed rate loans and investments 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.
<PAGE>
LIQUIDITY AND SOURCES OF FUNDS
As a financial institution, Sterling's primary sources of funds are
operating, investing and financing activities, including the
collection of loan principal and interest payments. Financing
activities consist primarily of customer deposits, advances from the
FHLB Seattle and other borrowings. The level of advances from the
FHLB Seattle and other borrowings fluctuate with the level of assets.
Deposits increased to $1.62 billion at September 30, 1999 from $1.55
billion at December 31, 1998. Advances from the FHLB Seattle
increased to $430.5 million at September 30, 1999 from $319.5 million
at December 31, 1998. At September 30, 1999 and December 31, 1998,
securities sold subject to repurchase agreements were $206.3 million
and $195.1 million, respectively. The increases in these borrowings
were primarily used to supplement loan growth during the last nine
months. 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. 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, 1999, cash provided by
investing activities consisted of principal and interest payments on
loans and MBS, maturities of investments 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, 1999, net
cash was used in investing activities primarily to purchase $90.0
million in investments and MBS and to fund loans.
Sterling Savings Bank's credit line with the FHLB Seattle provides for
borrowings of up to 30% of its total assets. At September 30, 1999,
this credit line represented a total borrowing capacity of $759.7
million, of which $329.3 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 September 30, 1999, Sterling Savings Bank had $193.2
million in outstanding borrowings under reverse repurchase agreements
and had securities available for additional secured borrowings of
approximately $173.7 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, 1999 but had no funds
drawn on this line of credit.
In May 1999, Sterling issued $30.0 million of Floating Rate Notes Due
2006. Interest accrues at the three-month LIBOR plus 2.50% (8.01%
until December 15, 1999) and is adjustable and payable quarterly. The
notes mature on June 15, 2006 and may be redeemed under certain
conditions after June 15, 2002. Sterling used the net proceeds from
<PAGE>
the sale of the notes (i) to prepay Sterling's 8.75% Subordinated
Notes Due 2000 plus accrued and unpaid interest thereon, for a total
of $17.4 million, (ii) to contribute $5.0 million to Sterling Savings
Bank to further improve Sterling Savings Bank's regulatory capital
ratios, (iii) to repay an existing line of credit of $5.0 million, and
(iv) for general corporate purposes.
Excluding its subsidiaries, Sterling had cash and other resources of
approximately $3.6 million at September 30, 1999. At September 30,
1999, Sterling had drawn $40.0 million of a $50.0 million commercial
bank non-revolving line of credit which matures on May 31, 2001.
Additionally, Sterling has a $5.0 million revolving line of credit on
which no funds have been drawn. Advances under this line of credit
accrue interest at KeyBank's prime interest rate (8.25% at September
30, 1999), and this line of credit matures on June 1, 2000. These
lines of credit are secured by all of the stock of Sterling Savings
Bank. At September 30, 1999, Sterling had an investment of $95.1
million in the Preferred Stock of Sterling Savings Bank, compared with
$88.6 million at December 31, 1998. Sterling received cash dividends
on Sterling Savings Bank Preferred Stock of $7.1 million during the
nine months ended September 30, 1999. These resources were sufficient
to meet the operating needs of Sterling, including interest expense on
the Floating Rate Notes Due 2006, the 8.75% Subordinated Notes Due
2000 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 OTS.
See Note 3 of "Notes to Consolidated Financial Statements."
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, 1999 and December 31, 1998, Sterling Savings Bank's liquidity
ratios were 7.8% and 11.5%, respectively. The lower level of
liquidity at September 30, 1999 was primarily due to a decrease in the
balance of cash and cash equivalents. 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
Sterling Savings Bank 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 $118.1 million at
September 30, 1999 compared with $119.0 million at December 31, 1998.
The decrease in total shareholders' equity was primarily due to a
decrease in the market value of available-for-sale investments and
MBS, partially offset by an increase in retained earnings for the
nine-month period. Shareholders' equity at September 30, 1999 was
4.7% of total assets, as compared with 5.1% at December 31, 1998.
At September 30, 1999, Sterling had an unrealized loss of $9.6
million, net of related income taxes, on investments and MBS
classified as available for sale. At December 31, 1998, Sterling had
an unrealized gain of $788,000 on investments and MBS. Fluctuations
in prevailing interest rates continue to cause volatility in this
component of shareholders' equity and may continue to do so in future
periods.
On June 30, 1999, Sterling redeemed the outstanding balance of its
8.75% Subordinated Notes Due 2000, including accrued interest thereon
in the aggregate amount of $17.4 million.
Sterling has outstanding $30.0 million of Floating Rate Notes Due
2006. The notes mature on June 15, 2006 and may be redeemed subject
to certain conditions after June 15, 2002. These notes are general
unsecured obligations of Sterling and are subordinate to certain other
existing and future indebtedness. The indenture governing the notes
limits the ability of Sterling under certain circumstances to incur
additional indebtedness, to pay cash dividends or to make other
capital distributions.
Sterling has 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 to
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 anticipates total capital expenditures of approximately
$452,000 for the remainder of the year ending December 31, 1999.
Sterling anticipates continuing to fund these expenditures from
various sources, including retained earnings and borrowings with
various arrangements. 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
<PAGE>
resources and regulatory capital ratios of Sterling Savings Bank
through the retention of earnings, the amortization of intangible
assets and the management of the level and mix of assets, although
there can be no assurance in this regard. At September 30, 1999,
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 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.
Recently, several similar cases have resulted in substantial judgments
against the government. The government has appealed these judgments
and appellate decisions are expected to be rendered some time in 2000.
Sterling is encouraged by these decisions, although it is uncertain
when a trial to determine Sterling's damages will be held or when a
judgment, if any, will be paid. Sterling's case has entered the
discovery phase, and management anticipates that Sterling's litigation
expenses will increase substantially in future periods.
REGULATION AND COMPLIANCE
Sterling, as a registered thrift holding company, is subject to
comprehensive examination and regulation by the OTS. Sterling Savings
Bank, as a State of Washington-chartered savings association, is
subject to comprehensive regulation and examination by the Washington
Supervisor as its chartering authority, the OTS as its primary federal
regulator, and by the FDIC, which administers the Savings Association
Insurance Fund, which insures Sterling Savings Bank's deposits to the
maximum extent permitted by law. Sterling Savings Bank is a member of
the FHLB Seattle, which is one of the 12 regional banks which comprise
the FHLB System. Sterling Savings Bank is further subject to
regulations of the Board of Governors of the Federal Reserve System
governing reserves required to be maintained against deposits and
certain other matters. As of November 1999, financial services
legislation pending in Congress was expected to be approved by
Congress, signed by the President and enacted into law. Until such
time as a final bill is enacted into law and Sterling has an
opportunity to analyze the law, it is difficult for Sterling to
predict the impact of such a law on Sterling's business and
operations.
Sterling is subject to federal income taxation under the Internal
Revenue Code of 1986. Sterling's returns may therefore be audited
from time to time by the Internal Revenue Service, which has commenced
an audit of Sterling's returns for the periods ended June 30, 1997,
1996 and 1995. Management does not anticipate incurring additional
material expenses as a result of the audit. Due to the preliminary
nature of the audit, however, there can be no assurance in this
regard.
<PAGE>
One of the continuing challenges for Sterling, especially as it
transforms Sterling Savings Bank from a traditional thrift association
to a community bank, is to ensure compliance with the many laws and
regulations applicable to banking. These laws and regulations include
the federal Home Mortgage Disclosure Act, Expedited Funds Availability
Act, Flood Disaster Protection Act, Electronic Fund Transfers Act,
Real Settlement and Procedures Act, Bank Secrecy Act and many others.
During the quarter ended June 30, 1999, Sterling entered into an
agreement with the OTS pursuant to which Sterling has developed a
comprehensive compliance program. As part of the compliance program,
management and the Board of Directors will jointly work to ensure that
Sterling's policies and procedures regarding compliance with pertinent
laws are appropriate, compliance staffing is increased and compliance
staff members are adequately trained. Management is committed to
meeting and exceeding the requirements of the compliance program.
YEAR 2000 ISSUES
The Year 2000 problem concerns the inability of information systems to
recognize properly and to 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 created a Year 2000 Action Plan that
focuses on identifying, testing and implementing solutions for Year
2000 processing. At June 30, 1999, Sterling had completed the
awareness, assessment and testing 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 fourth quarter of
1999. Sterling has determined that alternative sources of funds
should be available so that adequate funding will not be a problem.
<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 continues to
evaluate and monitor its allowances for loan losses with its review of
Year 2000 concerns in relation to its borrowers.
Sterling's Year 2000 testing, renovation and/or replacement of
hardware, proprietary programs, security systems, facility systems and
non-BISYS software was completed by June 30, 1999. Testing of BISYS-
supported software and systems was completed in June 1999.
It is currently estimated that the aggregate cost of Sterling's Year
2000 Action Plan will be approximately $875,000, of which
approximately $665,000 has been spent. These costs are being expensed
as they are incurred and are being funded through operating cash flow.
The aggregate Year 2000 cost estimates include costs associated with
the implementation of contingency plans. In addition, Sterling
expects the costs associated with the replacement of computer hardware
or equipment to be approximately $400,000.
Sterling has finalized contingency plans that will be implemented as
part of its efforts to identify and correct Year 2000 problems
affecting its internal operations. Year 2000 contingency plans are
designated to supplement Sterling's existing disaster recovery plan.
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.
Testing of the Year 2000 Contingency Plan was completed in September
1999.
The discussion of Sterling's efforts and management's expectations
relating to Year 2000 readiness include 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
issues 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, no one can
accurately predict how many Year 2000-related failures will occur
generally or specifically with respect to Sterling and its customers
and suppliers. Nor can anyone accurately predict the severity,
duration or financial consequences of these perhaps inevitable
failures.
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.
There can, however, be no assurance in this regard.
<PAGE>
PART I - Financial Information (continued)
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 and Use of Proceeds
---------------------------------------------------
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
------- --------------------------------------------------------
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 through 3.3.
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.
(b) Reports on Form 8-K. A report on Form 8-K (Item 5) was filed on
July 22, 1999.
<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 9, 1999 By: /s/ Daniel G. Byrne
-------------------------------- -----------------------------
Date Daniel G. Byrne
Senior Vice President -
Finance; Treasurer and
Assistant Secretary;
Principal Financial Officer
and Chief Accounting Officer
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