UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED
June 30, 1999
--------------
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM
__________________ 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 (I.R.S. Employer
of incorporation or organization) Identification No.)
111 North Wall Street, Spokane, Washington 99201
----------------------------------------------------
(Address of principal executive offices) (Zip Code)
(509) 458-2711
----------------------------------------------------
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all
reports required to be filed by Sections 13 or 15(d) of the Securities
Exchange Act of 1934 during the preceding 12 months (or for such
shorter period that the registrant was required to file such reports),
and (2) has been subject to such filing requirements for the past 90
days. Yes [X] No [ ]
Indicate the number of shares outstanding of each of the issuer's
classes of common stock as of the latest practicable date:
Class Outstanding as of July 30, 1999
------------------------------ --------------------------------
Common Stock ($1.00 par value) 8,089,844
<PAGE>
STERLING FINANCIAL CORPORATION
FORM 10-Q
For the Quarter Ended June 30, 1999
TABLE OF CONTENTS
PART I - Financial Information
Item 1 - Financial Statements
Consolidated Balance Sheets
Consolidated Statements of Operations
Consolidated Statements of Cash Flows
Consolidated Statements of Comprehensive Income (Loss)
Notes to Consolidated Financial Statements
Item 2 - Management's Discussion and Analysis of Financial Condition
and Results of 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)
June 30, December 31,
1999 1998
---------- ------------
(Dollars in thousands)
ASSETS
Cash and cash equivalents:
Interest bearing $ 7,382 $ 26,977
Non-interest bearing and vault 93,674 61,354
Restricted 542 8,775
Loans receivable, net 1,710,414 1,468,534
Loans held for sale 4,853 15,881
Investments and mortgage-backed
securities ("MBS"):
Available for sale 520,869 566,372
Held to maturity 14,389 20,033
Accrued interest receivable (including
$4,440 and $4,954 on investments and
MBS) 15,812 14,938
Real estate owned, net 6,120 6,232
Office properties and equipment, net 53,173 51,771
Intangible assets, net 58,284 61,180
Prepaid expenses and other assets, net 20,850 12,540
---------- ----------
Total assets $2,506,362 $2,314,587
========== ==========
LIABILITIES AND SHAREHOLDERS' EQUITY
Deposits $1,611,444 $1,545,425
Advances from Federal Home Loan Bank
Seattle ("FHLB Seattle") 390,460 319,540
Securities sold subject to repurchase
agreements and federal funds purchased 246,373 195,074
Other borrowings (Note 3) 110,000 97,240
Cashiers checks issued and payable 15,403 17,512
Borrowers' reserves for taxes and insurance 2,063 1,826
Accrued interest payable 6,138 5,639
Accrued expenses and other liabilities 7,506 13,314
---------- ----------
Total liabilities 2,389,387 2,195,570
---------- ----------
<PAGE>
PART I - Financial Information
Item 1 - Financial Statements
------------------------------
STERLING FINANCIAL CORPORATION
Consolidated Balance Sheets, Continued
(Unaudited)
June 30, December 31,
1999 1998
---------- ------------
(Dollars in thousands)
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 provision
(benefit) of $(4,022) and $424 (7,470) 788
Retained earnings 46,016 39,944
---------- ----------
Total shareholders' equity 116,975 119,017
---------- ----------
Total liabilities and shareholders'
equity $2,506,362 $2,314,587
========== ==========
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 Six Months Ended
June 30, June 30,
--------------------- ---------------------
1999 1998 1999 1998
--------- --------- --------- ---------
(Dollars in thousands, except per share data)
<S> <C> <C> <C> <C>
Interest income:
Loans $ 35,360 $ 26,850 $ 68,106 $ 52,265
MBS 5,326 7,250 11,260 14,413
Investments and cash equivalents 2,797 3,942 5,623 7,319
--------- --------- --------- ---------
Total interest income 43,483 38,042 84,989 73,997
--------- --------- --------- ---------
Interest expense:
Deposits 14,937 13,231 29,606 25,734
Short-term borrowings 2,687 7,959 5,543 15,628
Long-term borrowings 7,074 3,272 13,312 6,643
--------- --------- --------- ---------
Total interest expense 24,698 24,462 48,461 48,005
--------- --------- --------- ---------
Net interest income 18,785 13,580 36,528 25,992
Provision for losses on loans (1,000) (2,907) (1,900) (3,715)
--------- --------- --------- ---------
Net interest income after
provision for losses on loans 17,785 10,673 34,628 22,277
--------- --------- --------- ---------
Other income:
Fees and service charges 2,605 1,680 5,073 3,088
Mortgage banking operations 239 410 592 1,078
Loan servicing fees 217 180 414 428
Net gains (losses) on sales of
securities 0 (133) 593 578
Real estate owned operations 2 (90) (90) (158)
--------- --------- --------- ---------
Total other income 3,063 2,047 6,582 5,014
--------- --------- --------- ---------
Operating expenses 15,714 14,152 31,576 24,317
--------- --------- --------- ---------
Income (loss) before income taxes 5,134 (1,432) 9,634 2,974
Income tax provision (benefit) 1,900 (559) 3,562 1,021
--------- --------- --------- ---------
Net income (loss) $ 3,234 $ (873) $ 6,072 $ 1,953
========= ========= ========= =========
</TABLE>
<PAGE>
STERLING FINANCIAL CORPORATION
Consolidated Statements of Income, Continued
(Unaudited)
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
--------------------- ---------------------
1999 1998 1999 1998
--------- --------- --------- ---------
(Dollars in thousands, except per share data)
<S> <C> <C> <C> <C>
Income (loss) per share - basic $ 0.40 $ (0.11) $ 0.75 $ 0.24
========= ========= ========= =========
Income (loss) per share - diluted $ 0.40 $ (0.11) $ 0.74 $ 0.24
========= ========= ========= =========
Weighted average shares outstanding -
basic 8,088,299 8,029,425 8,076,096 8,016,850
========= ========= ========= =========
Weighted average shares outstanding -
diluted 8,150,463 8,261,690 8,171,131 8,246,902
========= ========= ========= =========
</TABLE>
The accompanying notes are an integral part of the consolidated
financial statements.
<PAGE>
STERLING FINANCIAL CORPORATION
Consolidated Statements of Cash Flows
(Unaudited)
Six Months Ended
June 30,
----------------------
1999 1998
---------- ----------
(Dollars in thousands)
Cash flows from operating activities:
Net income $ 6,072 $ 1,953
Adjustments to reconcile net income to
net cash provided by (used in) operating
activities:
Provisions for loan and real estate
owned losses 2,105 3,786
Stock dividends on FHLB Seattle stock (1,213) (1,162)
Net gain on sales of loans, securities
and mortgage servicing rights (1,124) (1,481)
Net gain on sales of real estate owned (154) (46)
Depreciation and amortization 3,689 2,825
Deferred income tax provision 0 (92)
Compensation expense associated with
stock grants 0 33
Change in:
Accrued interest receivable (874) 208
Prepaid expenses and other assets (4,092) 2,351
Cashiers checks issued and payable (2,109) 3,335
Accrued interest payable 499 (2,315)
Accrued expenses and other
liabilities (5,808) 3,528
Proceeds from sales of loans 48,741 65,476
Loans originated for sale (48,412) (67,429)
---------- ----------
Net cash provided by (used in)
operating activities (2,680) 10,970
---------- ----------
Cash flows from investing activities:
Change in restricted cash 8,233 (14,752)
Loans disbursed (717,580) (561,253)
Loan principal received 484,056 488,899
Purchase of investments (29,823) (307,130)
Proceeds from maturities of investments 48,461 280,162
Proceeds from sales of available-for-sale
investments 542 0
Purchase of MBS (60,128) (190,217)
Principal payments on MBS 51,628 47,568
Proceeds from sales of MBS 29,104 246,892
Purchase of office properties and equipment (1,402) (1,607)
<PAGE>
STERLING FINANCIAL CORPORATION
Consolidated Statements of Cash Flows, Continued
(Unaudited)
Six Months Ended
June 30,
----------------------
1999 1998
---------- ----------
(Dollars in thousands)
Cash flows from investing activities,
continued:
Improvements and other changes to real
estate owned $ (213) $ (108)
Proceeds from sales and liquidation of
real estate owned 1,249 3,840
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 (185,873) 320,600
---------- ----------
Cash flows from financing activities:
Net change in checking, passbook and
money market deposits (12,521) 19,059
Proceeds from issuance of certificates
of deposit 435,998 453,729
Payments for maturing certificates of
deposit (386,650) (532,468)
Interest credited to deposits 29,192 26,199
Advances from FHLB Seattle 135,877 30,000
Repayment of FHLB Seattle advances (65,058) (219,042)
Net change in securities sold subject to
repurchase agreements and funds purchased 51,299 (126,690)
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 237 469
---------- ----------
Net cash provided by (used in)
financing activities 201,278 (323,327)
---------- ----------
Net change in cash and cash equivalents 12,725 8,243
Cash and cash equivalents, beginning of
period 88,331 52,439
---------- ----------
Cash and cash equivalents, end of period $ 101,056 $ 60,682
========== ==========
<PAGE>
STERLING FINANCIAL CORPORATION
Consolidated Statements of Cash Flows, Continued
(Unaudited)
Six Months Ended
June 30,
----------------------
1999 1998
---------- ----------
(Dollars in thousands)
Supplemental disclosures:
Cash paid during the period for:
Interest $ 47,962 $ 48,284
Income taxes 3,497 1,266
Noncash financing and investing activities:
Loans converted into real estate owned 975 1,411
The accompanying notes are an integral part of the consolidated
financial statements.
<PAGE>
STERLING FINANCIAL CORPORATION
Consolidated Statements of Comprehensive Income
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
------------------- -------------------
1999 1998 1999 1998
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Net income (loss) $ 3,234 $ (873) $ 6,072 $ 1,953
-------- -------- -------- --------
Other comprehensive income (loss):
Change in unrealized gains or losses on
investments and MBS available for sale (9,427) 1,091 (12,704) 1,139
Less deferred income tax provision
(benefit) (3,299) 382 (4,446) 399
-------- -------- -------- --------
Net other comprehensive income (loss) (6,128) 709 (8,258) 740
-------- -------- -------- --------
Comprehensive income (loss) $ (2,894) $ (164) $ (2,186) $ 2,693
======== ======== ======== ========
</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
six months ended June 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 six months ended June 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.
June 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
---------- -----------
$ 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% (6.99% at June 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
(8.00% at June 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% (7.54% until September 15, 1999) and is adjustable
and payable quarterly commencing September 15, 1999. The
notes mature on June 15, 2006 and may be redeemed under
certain conditions after June 15, 2002.
4. INCOME (LOSS) PER SHARE:
The following table presents the basic and diluted income (loss)
per share computations.
<TABLE>
<CAPTION>
Three Months Ended June 30,
---------------------------------------------------------------------------
1999 1998
------------------------------------ ------------------------------------
Weighted Per Share Weighted Per Share
Net Income Avg. Shares Amount Net Income Avg. Shares Amount
---------- ----------- --------- ---------- ----------- ---------
<S> <C> <C> <C> <C> <C> <C>
Basic computations $3,234,000 8,088,299 $ 0.40 $ (873,000) 8,029,425 $ (0.11)
Effect of dilutive securities:
Common stock options 0 62,164 0 232,265
---------- ----------- ---------- -----------
Diluted computations $3,234,000 8,150,463 $ 0.40 $ (873,000) 8,261,690 $ (0.11)
========== =========== ========== ===========
Antidilutive options not included
in diluted income per share(1) 194,000 232,265
</TABLE>
<PAGE>
STERLING FINANCIAL CORPORATION
Notes to Consolidated Financial Statements, Continued
4. INCOME (LOSS) PER SHARE, CONTINUED:
<TABLE>
<CAPTION>
Six Months Ended June 30,
---------------------------------------------------------------------------
1999 1998
------------------------------------ ------------------------------------
Weighted Per Share Weighted Per Share
Net Income Avg. Shares Amount Net Income Avg. Shares Amount
---------- ----------- --------- ---------- ----------- ---------
<S> <C> <C> <C> <C> <C> <C>
Basic computations $6,072,000 8,076,096 $ 0.75 $1,953,000 8,016,850 $ 0.24
Effect of dilutive securities:
Common stock options 0 95,035 0 230,052
---------- ----------- ---------- -----------
Diluted computations $6,072,000 8,171,131 $ 0.74 $1,953,000 8,246,902 $ 0.24
========== =========== ========== ===========
Antidilutive options not included
in diluted income per share 180,000 68,000
</TABLE>
(1) Common stock options were antidilutive for the three months
ended June 30, 1998. Therefore, basic income (loss) per
share is presented.
<PAGE>
STERLING FINANCIAL CORPORATION
Notes to Consolidated Financial Statements, Continued
5. OPERATING EXPENSES:
The following table details Sterling's components of total
operating expenses:
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
------------------ -----------------
1999 1998 1999 1998
------- -------- ------- -------
(Dollars in thousands)
<S> <C> <C> <C> <C>
Employee compensation and benefits $ 7,119 $ 4,810 $14,060 $ 9,546
Occupancy and equipment 2,540 1,600 4,902 3,182
Depreciation 1,004 769 2,009 1,531
Amortization of intangibles 1,448 537 2,896 1,074
Advertising 697 560 1,316 839
Data processing 1,343 697 2,621 1,444
Insurance 198 252 473 500
Legal and accounting 429 459 819 855
Travel and entertainment 424 290 804 585
Acquisition and conversion costs(1) 0 3,210 0 3,210
Other 512 968 1,676 1,551
------- ------- ------- -------
Total operating expenses $15,714 $14,152 $31,576 $24,317
======= ======= ======= =======
</TABLE>
(1) Includes costs associated with mailing customer notices;
issuing new checks and ATM cards; training new employees,
including related travel; equipping 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; 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. 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 Six Months Ended
June 30, June 30,
------------------ -----------------
1999 1998 1999 1998
------- -------- ------- -------
(Dollars in thousands)
<S> <C> <C> <C> <C>
Revenues:
Gains on sales of originated
residential loans $ 213 $ 421 $ 531 $ 803
Other fees and income 1,288 1,163 2,527 2,200
------- ------- ------- -------
Total revenues 1,501 1,584 3,058 3,003
Identifiable expenses 799 613 1,608 1,348
------- ------- ------- -------
Income before adjustments,
eliminations and income taxes 702 971 1,450 1,655
Adjustments and eliminations 0 0 0 0
------- ------- ------- -------
Income before income taxes $ 702 $ 971 $ 1,450 $ 1,655
======= ======= ======= =======
Identifiable assets $10,158 $ 6,732 $10,158 $ 6,732
======= ======= ======= =======
Depreciation and amortization
expense $ 32 $ 37 $ 65 $ 71
======= ======= ======= =======
Capital expenditures for office
properties and equipment $ 14 $ 219 $ 42 $ 223
======= ======= ======= =======
</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
---------- ---------- ----------
(Dollars in thousands)
<S> <C> <C> <C>
As of and for the three months ended
June 30, 1999:
Other income $ 2,824 $ 239 $ 3,063
Income before income taxes 4,432 702 5,134
Total assets 2,496,204 10,158 2,506,362
As of and for the three months ended
June 30, 1998:
Other income $ 1,637 $ 410 $ 2,047
Income (loss) before income taxes (2,403) 971 (1,432)
Total assets 2,134,050 6,732 2,140,782
As of and for the six months ended
June 30, 1999:
Other income $ 5,990 $ 592 $ 6,582
Income before income taxes 8,184 1,450 9,634
Total assets 2,496,204 10,158 2,506,362
As of and for the six months ended
June 30, 1998:
Other income $ 3,936 $ 1,078 $ 5,014
Income before income taxes 1,319 1,655 2,974
Total assets 2,134,050 6,732 2,140,782
</TABLE>
<PAGE>
PART 1 - FINANCIAL INFORMATION (CONTINUED)
Item 2 - Management's Discussion and Analysis of Financial Condition
and Results of Operations
STERLING FINANCIAL CORPORATION
Comparison of the Three and Six Months Ended June 30, 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 June 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 is focusing 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. Sterling completed the acquisition of
Big Sky Bancorp, Inc. ("Big Sky") and its subsidiary, First Federal
Savings and Loan Association of Montana ("First Federal"), in November
1998. 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.
During the quarter, Sterling began processing checks for its customers
in-house rather than out-sourcing this function. This change will
increase 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 assurances 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 $3.2 million, or $0.40 per
diluted share, for the three months ended June 30, 1999. This
compares with a net loss of $873,000, or a negative $0.11 per diluted
share, for the three months ended June 30, 1998. Core earnings, which
are defined as earnings before acquisition costs, conversion costs and
other charges, for the three months ended June 30, 1998 were $2.8
million or $0.34 per diluted share. Sterling recorded net income of
$6.1 million, or $0.74 per diluted share, for the six months ended
June 30, 1999. This compares with net income of $2.0 million, or
$0.24 per diluted share, for the six months ended June 30, 1998. Core
earnings for the six months ended June 30, 1998 were $5.6 million, or
$0.68 per diluted share. The increases in net income were 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 0.54% and a negative 0.17%
for the three months ended June 30, 1999 and 1998, respectively. For
the six months ended June 30, 1999 and 1998, the annualized return on
average assets was 0.51% and 0.20%, respectively. The increases in
the ratios were primarily due to increases in net income.
The annualized return on average equity was 10.69% and a negative
3.06% for the three months ended June 30, 1999 and 1998, respectively.
The annualized return on average equity was 10.13% and 3.48% for the
six months ended June 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,
mortgage-backed securities ("MBS") and investment portfolios, and
interest expense, primarily on deposits and borrowings. During the
three months ended June 30, 1999 and 1998, NII was $18.8 million and
$13.6 million, respectively, an increase of 38.3%. During the six
months ended June 30, 1999 and 1998, NII was $36.5 million and $26.0
million, respectively, an increase of 40.5%.
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
increases in NII during the three and six months ended June 30, 1999
were primarily due to increases in the volume of loans and lower
funding costs.
<PAGE>
During the three months ended June 30, 1999 and 1998, the volume of
average interest-earnings assets was $2.22 billion and $1.89 billion,
respectively. Net interest spread during these periods was 3.25% and
2.70%, respectively. The net interest margin for the three months
ended June 30, 1999 and 1998 was 3.39% and 2.88%, 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 six months ended June 30, 1999 and 1998, the
volume of average interest-earning assets was $2.19 billion and $1.84
billion, respectively. Net interest spread during these periods was
3.23% and 2.64%, respectively. The net interest margin for the six
months ended June 30, 1999 and 1998 was 3.37% and 2.85%, respectively.
The reasons for the increases in net interest spread and net interest
margin were similar to those for 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 provision for loan losses of $1.0 million and $2.9
million for the three months ended June 30, 1999 and 1998,
respectively. Sterling recorded provisions of $1.9 million and $3.7
million for the six months ended June 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 June 30, 1999,
Sterling's total classified assets were $21.8 million, compared with
$17.7 million at December 31, 1998. At June 30, 1999, Sterling's loan
delinquency rate as a percentage of total loans was 0.55%, compared
with 0.51% at June 30, 1998. Total nonperforming loans were $7.3
million at June 30, 1999, compared with $4.3 million at June 30, 1998.
Management believes the loan loss provisions for the three and six
months ended June 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>
OTHER INCOME. The following table summarizes the components of other
income for the periods indicated.
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
------------------ -----------------
1999 1998 1999 1998
------- -------- ------- -------
(Dollars in thousands)
<S> <C> <C> <C> <C>
Fees and service charges $ 2,605 $ 1,680 $ 5,073 $ 3,088
Mortgage banking operations 239 410 592 1,078
Loan servicing fees 217 180 414 428
Net gain (loss) on sales of securities 0 (133) 593 578
Real estate owned operations 2 (90) (90) (158)
------- ------- ------- -------
Total other income $ 3,063 $ 2,047 $ 6,582 $ 5,014
======= ======= ======= =======
</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, commissions on sales of mutual funds
and annuity products and late charges on loans. The increases in such
fees and service charges for the three and six months ended June 30,
1999, compared with the three and six months ended June 30, 1998, were
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 Six Months Ended
June 30, June 30,
------------------ -----------------
1999 1998 1999 1998
------- -------- ------- -------
(Dollars in millions)
<S> <C> <C> <C> <C>
Originations of one- to four-family
permanent mortgage loans $ 41.2 $ 52.9 $ 105.8 $ 100.5
Sales of residential loans 18.7 38.4 48.4 64.7
Principal balances of mortgage loans
serviced for others 210.6 270.0 210.6 270.0
</TABLE>
The decreases in income from mortgage banking operations for the three
and six months ended June 30, 1999 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 June 30, 1999, Sterling did not sell any
investments and MBS. Sterling sold approximately $72.9 million of
investments and MBS in the prior year's comparable period, resulting
in net losses of $133,000. In an effort to reposition the portfolio,
during the six months ended June 30, 1999, Sterling sold approximately
$29.1 million of investments and MBS, resulting in net gains of
$593,000. During the six months ended June 30, 1998, Sterling sold
approximately $246.3 million of investments and MBS, resulting in net
gains of $578,000.
OPERATING EXPENSES. Operating expenses were $15.7 million and $14.2
million for the three months ended June 30, 1999 and 1998,
respectively. During the six months ended June 30, 1999 and 1998,
operating expenses were $31.6 million and $24.3 million, respectively.
The three and six months ended June 30, 1998 included acquisition and
conversion costs and other charges of $3.2 million. Exclusive of
these charges, the increases during the three-month and six-month
periods were primarily due to increased staffing levels, occupancy
costs, intangible amortization and data processing costs.
Employee compensation and benefits were $7.1 million and $4.8 million
for the three months ended June 30, 1999 and 1998, respectively.
During the six months ended June 30, 1999 and 1998, employee
compensation and benefits were $14.1 million and $9.5 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 June 30, 1999, full-time-equivalent
employees were 799, compared with 687 at June 30, 1998.
Amortization of intangibles was $1.4 million and $537,000 for the
three months ended June 30, 1999 and 1998, respectively. During the
six months ended June 30, 1999 and 1998, amortization was $2.9 million
and $1.1 million, respectively. The increases were due to the
amortization of the intangible asset resulting from the acquisition of
branches.
Data processing expense was $1.3 million and $697,000 for the three
months ended June 30, 1999 and 1998, respectively. During the six
months ended June 30, 1999 and 1998, data processing expense was $2.6
million and $1.4 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.
Occupancy and equipment expenses were $2.5 million and $1.6 million
for the three months ended June 30, 1999 and 1998, respectively.
During the six months ended June 30, 1999 and 1998, occupancy and
equipment expenses were $4.9 million and $3.2 million, respectively.
These increases were primarily due to the addition of branches and
check-processing centers and increases in property taxes and utility
costs related to these facilities.
<PAGE>
INCOME TAX PROVISION. Sterling recorded a federal and state income
tax provision of $1.9 million for the three months ended June 30, 1999
and a federal and state income tax benefit of $559,000 for the three
months ended June 30, 1998. Tax provisions were $3.6 million and $1.0
million for the six months ended June 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 June 30, 1999, Sterling's assets were $2.51 billion, up
8.3% 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 June
30, 1999 was $535.3 million, down $51.1 million from the December 31,
1998 balance of $586.4 million. The decrease was primarily due to net
sales of MBS during the period.
LOANS RECEIVABLE. At June 30, 1999, net loans receivable were $1.71
billion, up $241.9 million (or 16.5%) from $1.47 billion at
December 31, 1998. The increase was primarily due to strong loan
origination activity. During the three months ended June 30, 1999,
total loan originations were $314.3 million compared with
$262.6 million for the prior year's comparable quarter. During the
six months ended June 30, 1999 and 1998, total loan originations were
$655.0 million and $470.3 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.
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>
June 30, 1999 December 31, 1998
------------------ ------------------
Amount % Amount %
---------- ----- ---------- -----
(Dollars in thousands)
<S> <C> <C> <C> <C>
Residential $ 380,384 22.0 $ 342,757 23.1
Multifamily 136,461 7.9 124,656 8.4
Commercial real estate 294,579 17.0 177,912 12.0
Construction 266,455 15.4 233,567 15.7
Consumer - direct 225,859 13.1 224,651 15.1
Consumer - indirect 82,158 4.8 64,764 4.4
Business banking 341,558 19.8 315,614 21.3
---------- ----- ---------- -----
Total loans receivable $1,727,454 100.0 $1,483,921 100.0
========== ===== ========== =====
</TABLE>
<PAGE>
The following table sets forth Sterling's loan originations for the
periods indicated.
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
------------------- -------------------
June 30, % June 30, %
1999 1998 Change 1999 1998 Change
-------- -------- ------ -------- -------- ------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C> <C>
Residential $ 41,186 $ 52,931 (22.2) $105,763 $100,510 5.2
Multifamily 14,109 16,677 (15.4) 43,689 29,922 46.0
Commercial real estate 20,948 4,100 410.9 85,075 14,685 479.3
Construction 86,381 99,705 (13.4) 164,070 160,982 1.9
Consumer - direct 23,445 23,043 1.7 53,234 38,697 37.6
Consumer - indirect 12,880 15,294 (15.8) 26,882 27,521 (2.3)
Business banking 115,333 50,868 126.7 176,286 98,012 79.9
-------- -------- ------ -------- -------- ------
Total loans originated $314,282 $262,618 19.7 $654,999 $470,329 39.3
======== ======== ====== ======== ======== ======
</TABLE>
Management believes its increase in loan originations is primarily due
to the increase in lending staff in its income property and business
banking departments over the last twelve months.
DEPOSITS. Total deposits increased $66.0 million to $1.61 billion at
June 30, 1999 from $1.55 billion at December 31, 1998. For the
quarter ended June 30, 1999, the average cost of total deposits was
3.76%, compared with 4.58% for the quarter ended June 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.
The following table sets forth the composition of Sterling's deposits
at the dates indicated.
<TABLE>
<CAPTION>
June 30, 1999 December 31, 1998
------------------ ------------------
Amount % Amount %
---------- ----- ---------- -----
(Dollars in thousands)
<S> <C> <C> <C> <C>
Certificates of deposit $ 885,057 54.9 $ 814,957 52.8
Checking 292,567 18.2 297,290 19.2
Savings and money market 433,820 26.9 433,178 28.0
---------- ----- ---------- -----
Total deposits $1,611,444 100.0 $1,545,425 100.0
========== ===== ========== =====
</TABLE>
<PAGE>
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 June 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.
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
<PAGE>
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.
<PAGE>
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.
<TABLE>
<CAPTION>
At June 30, 1999 At December 31, 1998
---------------------------------- ----------------------------------
Change in Ratio of NPV Ratio of NPV
Interest Rate to the Present % to 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 $ 1,922 0.08% (98.0) $ 11,384 0.53% (86.5)
+200 37,977 1.59 (61.3) 37,950 1.72 (55.1)
+100 65,219 2.68 (33.5) 59,814 2.66 (29.3)
Static 98,099 3.95 N/A 84,568 3.70 N/A
-100 102,934 4.11 4.9 71,197 3.10 (15.8)
-200 88,194 3.51 (10.1) 50,677 2.20 (40.1)
-300 75,483 2.99 (23.1) 40,966 1.77 (51.6)
</TABLE>
At June 30, 1999, Sterling calculated that its NPV was $98.1 million
and that its NPV would decrease by 61.3% and 98.0% 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 a negative 17.6% and negative 12.1% at June 30, 1999 and 1998,
respectively. Sterling calculated its three-year gap positions to be
negative 20.7% and negative 7.9% at June 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
June 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
<PAGE>
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.
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 $1.61 billion at June 30, 1999 from $1.55
billion at December 31, 1998. Advances from the FHLB Seattle
increased to $390.5 million at June 30, 1999 from $319.5 million at
December 31, 1998. At June 30, 1999 and December 31, 1998, securities
sold subject to repurchase agreements were $246.4 million and $195.1
million, respectively. The increases in these borrowings were
primarily used to supplement loan growth during the last six 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 six months ended June 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 six months ended June 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 June 30, 1999, this
credit line represented a total borrowing capacity of $757.0 million,
of which $366.6 million was available. Sterling Savings Bank also
borrows on a secured basis from major broker/dealers and financial
entities by selling securities subject to repurchase agreements. At
June 30, 1999, Sterling Savings Bank had $193.6 million in outstanding
borrowings under reverse repurchase agreements and had securities
available for additional secured borrowings of approximately $213.7
million. Sterling Savings Bank also had a secured line-of-credit
agreement from a commercial bank of approximately $10.0 million as of
June 30, 1999 but had no funds drawn on this line of credit.
<PAGE>
In May 1999, Sterling issued $30.0 million of Floating Rate Notes Due
2006. Interest accrues at the three-month LIBOR plus 2.50% (7.54%
until September 15, 1999) and is adjustable and payable quarterly
commencing September 15, 1999. The notes mature on June 15, 2006 and
may be redeemed under certain conditions after June 15, 2002.
Sterling used the net proceeds from 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 $3.5 million at June 30, 1999. At June 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 (8.00% at June 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 June 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 $4.6 million during the six months
ended June 30, 1999. 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 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 June 30,
1999 and December 31, 1998, Sterling Savings Bank's liquidity ratios
were 9.7% and 11.5%, respectively. The lower level of liquidity at
June 30, 1999 was primarily due to a decrease in the balance of
eligible securities. 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 $117.0 million at June 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 six-month period.
Shareholders' equity at June 30, 1999 was 4.7% of total assets, as
compared with 5.1% at December 31, 1998.
At June 30, 1999, Sterling had an unrealized loss of $7.5 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 could continue to cause volatility in this component of
shareholders' equity 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
$700,000 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
resources and regulatory capital ratios of Sterling Savings Bank
through the retention of earnings, the amortization of intangible
<PAGE>
assets and the management of the level and mix of assets, although
there can be no assurance in this regard. At June 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. Management believes the government will
appeal these judgments. 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.
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.
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 recently
commenced an audit of Sterling's returns for the periods ended June
30, 1997, 1996 and 1995. Management believes Sterling's returns will
be confirmed. Due to the preliminary nature of the audit, however,
there can be no assurances in this regard.
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.
<PAGE>
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 has 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.
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 and monitoring 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.
<PAGE>
It is currently estimated that the aggregate cost of Sterling's Year
2000 Action Plan will be approximately $870,000, of which
approximately $585,000 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, which are in the process of
being finalized. In addition, Sterling expects the costs associated
with the replacement of computer hardware or equipment to be
approximately $400,000.
Sterling is currently finalizing contingency plans to 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 is scheduled to be completed
by September 30, 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.
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>
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
Sterling's Annual Meeting of Shareholders ("the Meeting") was held on
April 27, 1999. The following matters were submitted to a vote of the
security holders of Sterling at the Meeting:
(1) Elect two Directors to serve for terms of three years expiring at
the Meeting in the year 2002. The Directors received the
following votes:
Term expiring in the year 2002 at the Meeting:
Harold B. Gilkey For: 7,152,879 Withheld: 85,402
Approximate Broker Non-votes: 0
Robert E. Meyers For: 7,146,989 Withheld: 91,292
Approximate Broker Non-votes: 0
(2) Ratify the selection of PricewaterhouseCoopers LLP as independent
public accountants for the year ending 1999 and any interim
periods. The proposal received the following votes:
For: 7,166,006 Against: 40,075
Abstain: 32,200 Approximate Broker Non-votes: 0
There was no solicitation in opposition to management's proposals
or nominees.
Item 5 - Other Information
None.
<PAGE>
Item 6 - Exhibits and Reports on Form 8-K
(a) Exhibit No. Exhibit
---------------- ----------------------------------------------------
3.1 Restated Articles of Incorporation of Registrant.
Filed as Exhibit 3.1 to Registrant's Form S-4 dated
November 7, 1994 and incorporated by reference
herein.
3.2 Articles of Amendment of Restated Articles of
Incorporation of Registrant. Filed as Exhibit 3.2
to Registrant's Form S-4 dated November 7, 1994 and
incorporated by reference herein.
3.3 Copy of Amended and Restated Bylaws of Registrant.
Filed as Exhibit 3.3 to Registrant's Form S-4 dated
June 24, 1998 and incorporated by reference herein.
4.1 Reference is made to Exhibits 3.1 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
April 22, 1999. A report on Form 8-K (Items 5 and 7) was filed
on June 2, 1999.
<PAGE>
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf
by the undersigned thereunto duly authorized.
STERLING FINANCIAL CORPORATION
(Registrant)
August 11, 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
<TABLE> <S> <C>
<ARTICLE> 9
<MULTIPLIER> 1000
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-END> JUN-30-1999
<CASH> 94216
<INT-BEARING-DEPOSITS> 7382
<FED-FUNDS-SOLD> 0
<TRADING-ASSETS> 0
<INVESTMENTS-HELD-FOR-SALE> 520869
<INVESTMENTS-CARRYING> 14389
<INVESTMENTS-MARKET> 14696
<LOANS> 1725756
<ALLOWANCE> 15342
<TOTAL-ASSETS> 2506362
<DEPOSITS> 1611444
<SHORT-TERM> 0
<LIABILITIES-OTHER> 667943
<LONG-TERM> 110000
0
0
<COMMON> 8090
<OTHER-SE> 108885
<TOTAL-LIABILITIES-AND-EQUITY> 2506362
<INTEREST-LOAN> 35360
<INTEREST-INVEST> 8123
<INTEREST-OTHER> 0
<INTEREST-TOTAL> 43483
<INTEREST-DEPOSIT> 14937
<INTEREST-EXPENSE> 24698
<INTEREST-INCOME-NET> 18785
<LOAN-LOSSES> 1000
<SECURITIES-GAINS> 0
<EXPENSE-OTHER> 15714
<INCOME-PRETAX> 5134
<INCOME-PRE-EXTRAORDINARY> 5134
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 3234
<EPS-BASIC> 0.40
<EPS-DILUTED> 0.40
<YIELD-ACTUAL> 3.39
<LOANS-NON> 7206
<LOANS-PAST> 0
<LOANS-TROUBLED> 78
<LOANS-PROBLEM> 14563
<ALLOWANCE-OPEN> 14899
<CHARGE-OFFS> 602
<RECOVERIES> 45
<ALLOWANCE-CLOSE> 15342
<ALLOWANCE-DOMESTIC> 15342
<ALLOWANCE-FOREIGN> 0
<ALLOWANCE-UNALLOCATED> 0
</TABLE>
