10-K 1 ffnw-20191231x10k.htm 10-K Document
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-K
 
[X]
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
 
For the Fiscal Year Ended December 31, 2019
 
 
[   ]
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
Commission File Number: 001-33652
 
FIRST FINANCIAL NORTHWEST, INC.
(Exact name of registrant as specified in its charter)
 
Washington
 
26-0610707
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification Number)
 
 
 
201 Wells Avenue South, Renton, Washington
 
98057
(Address of principal executive offices)
 
(Zip Code)
 
 
 
Registrant’s telephone number, including area code:
 
(425) 255-4400
 
 
 
Securities registered pursuant to Section 12(b) of the Act:
 
 
 
 
 
Common Stock, $0.01 par value per share
 
The Nasdaq Stock Market LLC
(Title of Each Class)
 
(Name of Each Exchange on Which Registered)
 
 
 
Securities registered pursuant to Section 12(g) of the Act:
 
 
None
 
 
Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
YES         NO   X   
Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
YES         NO   X   
Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES   X    NO         
Indicate by check mark whether the Registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).
YES   X     NO       

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer”, “smaller reporting company”, and “emerging growth company” in Rule 12b-2 of the Exchange Act:
Large accelerated filer _____
Accelerated filer   X     
  Non-accelerated filer _____
Smaller reporting company    X   
Emerging growth company _____
 
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. _____

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act). YES          NO    X  

The aggregate market value of the Common Stock outstanding held by nonaffiliates of the Registrant based on the closing sales price of the Registrant’s Common Stock as quoted on The Nasdaq Stock Market LLC on June 30, 2019, was $128,570,975 (9,086,288 shares at $14.15 per share). For purposes of this calculation, common stock held only by executive officers, the employee stock ownership plan and directors of the Registrant is considered to be held by affiliates. As of March 11, 2020, the Registrant had 10,196,611 shares of common stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
1. Portions of Registrant’s Definitive Proxy Statement for the 2019 Annual Meeting of Shareholders (Part III).


FIRST FINANCIAL NORTHWEST, INC.
2019 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
                                                                    
 
 
Page
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
  Employees

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Overview
 
 
 
 
 
 
  Comparison of Financial Condition at December 31, 2019, and December 31, 2018
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

 
 

 
 
 

 

 

 

 

 
 
 
 
 
 
 
 

i

 
 


ii

Forward-Looking Statements
Certain matters discussed in this Annual Report on Form 10-K constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements relate to our financial condition, results of operations, plans, objectives, future performance or business. Forward-looking statements are not statements of historical fact, are based on certain assumptions and are generally identified by use of the words “believes,” “expects,” “anticipates,” “estimates,” “forecasts,” “intends,” “plans,” “targets,” “potentially,” “probably,” “projects,” “outlook” or similar expressions or future or conditional verbs such as “may,” “will,” “should,” “would” and “could.” Forward-looking statements include statements with respect to our beliefs, plans, objectives, goals, expectations, assumptions and statements about, among other things, expectations of the business environment in which we operate, projections of future performance or financial items, perceived opportunities in the market, potential future credit experience, and statements regarding our mission and vision. These forward-looking statements are based upon current management expectations and may, therefore, involve risks and uncertainties. Our actual results, performance, or achievements may differ materially from those suggested, expressed, or implied by forward-looking statements as a result of a wide variety or range of factors including, but not limited to: the credit risks of lending activities, including changes in the level and trend of loan delinquencies and write-offs, that may be affected by deterioration in the housing and commercial real estate markets, and may lead to increased losses and nonperforming assets in our loan portfolio, and may result in our allowance for loan losses not being adequate to cover actual losses, and require us to materially increase our reserves; changes in general economic conditions, either nationally or in our market areas; changes in the levels of general interest rates, and the relative differences between short and long term interest rates, deposit interest rates, our net interest margin and funding sources; fluctuations in the demand for loans, the number of unsold homes and other properties and fluctuations in real estate values in our market areas; results of examinations of us by the Federal Reserve Bank of San Francisco (“FRB”) and our bank subsidiary by the Federal Deposit Insurance Corporation (“FDIC”), the Washington State Department of Financial Institutions, Division of Banks (“DFI”) or other regulatory authorities, including the possibility that any such regulatory authority may initiate an enforcement action against the Company or the Bank which could require us to increase our reserve for loan losses, write-down assets, change our regulatory capital position, affect our ability to borrow funds or maintain or increase deposits, or impose additional requirements or restrictions on us, any of which could adversely affect our liquidity and earnings; our ability to pay dividends on our common stock; our ability to attract and retain deposits; increases in premiums for deposit insurance; our ability to control operating costs and expenses; the use of estimates in determining the fair value of certain of our assets, which estimates may prove to be incorrect and result in significant declines in valuation; difficulties in reducing risk associated with the loans on our balance sheet; staffing fluctuations in response to product demand or the implementation of corporate strategies that affect our work force and potential associated charges; disruptions, security breaches, or other adverse events, failures or interruptions in, or attacks on, our information technology systems or on the third-party vendors who perform several of our critical processing functions; our ability to retain key members of our senior management team; costs and effects of litigation, including settlements and judgments; our ability to implement a branch expansion strategy; our ability to successfully integrate any assets, liabilities, customers, systems, and management personnel we have acquired or may in the future acquire into our operations and our ability to realize related revenue synergies and cost savings within expected time frames and any goodwill charges related thereto; our ability to manage loan delinquency rates; costs and effects of litigation, including settlements and judgments; increased competitive pressures among financial services companies; changes in consumer spending, borrowing and savings habits; legislative or regulatory changes that adversely affect our business including changes in regulatory policies and principles, including the interpretation of regulatory capital or other rules, including as a result of Basel III; the impact of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”) and the implementing regulations; the availability of resources to address changes in laws, rules, or regulations or to respond to regulatory actions; adverse changes in the securities markets; inability of key third-party providers to perform their obligations to us; changes in accounting policies and practices, as may be adopted by the financial institution regulatory agencies or the Financial Accounting Standards Board, including additional guidance and interpretation on accounting issues and details of the implementation of new accounting methods; the economic impact of war or any terrorist activities; other economic, competitive, governmental, regulatory, and technological factors affecting our operations; pricing, products and services, including the potential effects of coronavirus on international trade (including supply chains and export levels), and other risks detailed in this Form 10-K and our other reports filed with the U.S. Securities and Exchange Commission (“SEC”). Any of the forward-looking statements that we make in this Form 10-K and in the other public reports and statements we make may turn out to be wrong because of the inaccurate assumptions we might make, because of the factors illustrated above or because of other factors that we cannot foresee. Because of these and other uncertainties, our actual future results may be materially different from those expressed in any forward‑looking statements made by or on our behalf. Therefore, these factors should be considered in evaluating the forward‑looking statements, and undue reliance should not be placed on such statements. We undertake no responsibility to update or revise any forward-looking statements.
As used throughout this report, the terms “Company”, “we”, “our”, or “us” refer to First Financial Northwest, Inc. and its consolidated subsidiaries, including First Financial Northwest Bank and First Financial Diversified Corporation.

iii


Internet Website

The information contained on our website, www.ffnwb.com, is not included as a part of, or incorporated by reference into, this Annual Report on Form 10-K. Other than an investor’s own Internet access charges, we make available free of charge through our website, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to these reports, proxy statements and other SEC filings on our investor relations page. All of our reports, proxy statements, and other SEC filings are posted as soon as reasonably practicable after they are electronically filed with the SEC and are also available free of charge at the SEC’s website at www.sec.gov.

iv

PART I

Item 1.  Business

General

First Financial Northwest, Inc. (“First Financial Northwest” or the “Company”), a Washington corporation, was formed on June 1, 2007, for the purpose of becoming the holding company for First Financial Northwest Bank (“the Bank”) in connection with the Bank’s conversion from a mutual holding company structure to a stock holding company structure which was completed on October 9, 2007. At December 31, 2019, the Company had total assets of $1.3 billion, net loans of $1.1 billion, deposits of $1.0 billion and stockholders’ equity of $156.3 million. First Financial Northwest’s business activities generally are limited to passive investment activities and oversight of its investment in First Financial Northwest Bank. Accordingly, the information set forth in this report, including consolidated financial statements and related data, relates primarily to First Financial Northwest Bank.

The Bank was organized in 1923 as a Washington state-chartered savings and loan association, converted to a federal mutual savings and loan association in 1935 and to a Washington state-chartered mutual savings bank in 1992. In 2002, First Savings Bank reorganized into a two-tier mutual holding company structure, became a stock savings bank, and the wholly-owned subsidiary of First Financial of Renton, Inc. In connection with the 2002 conversion, First Savings Bank changed its name to First Savings Bank Northwest. Subsequently, in August 2015, the Bank changed its name to First Financial Northwest Bank to better reflect the commercial banking services it provides beyond those typically provided by a traditional savings bank. In February 2016, the Bank officially changed its charter from a Washington chartered stock savings bank to a Washington chartered commercial bank.

First Financial Northwest became a bank holding company, after converting from a savings and loan holding company on March 31, 2015, and is subject to regulation by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board” or “Federal Reserve”) through the FRB. The change was consistent with First Financial Northwest Bank’s shift in focus from a traditional savings and loan association towards a full service, commercial bank. Additionally, First Financial Northwest Bank is examined and regulated by the DFI and by the FDIC. First Financial Northwest Bank is required to maintain reserves at a level set by the Federal Reserve Board. The Bank is a member of the Federal Home Loan Bank (“FHLB”) of Des Moines, which is one of the 11 regional banks in the Federal Home Loan Bank System (“FHLB System”). For additional information, see “How We are Regulated - Regulation and Supervision of First Financial Northwest Bank - Federal Home Loan Bank System.”

In February 2016, First Financial Northwest Bank converted its charter from a community-based savings bank to a commercial bank as a way of better serving its customer needs. The Bank’s largest concentration of customers is in King County, with additional concentrations in Snohomish, Pierce, and Kitsap counties, Washington. The Bank is headquartered in Renton, in King County, where it has a full-service branch as well as a smaller branch located in a commercial development known as “The Landing”. The Bank has additional smaller branches in King County located in Bellevue, Woodinville, Bothell, Kent and Kirkland. In Snohomish County, Washington, the Bank has five additional smaller branches located in Mill Creek, Edmonds, Clearview, Smokey Point, and Lake Stevens. In addition, the Bank opened a branch in University Place, in Pierce County, Washington, in March 2020. These smaller branches are focused on efficiency through the extensive use of the latest banking technology. First Financial Northwest Bank’s business consists of attracting deposits from the public and utilizing these funds to originate one-to-four family residential, multifamily, commercial real estate, construction/land, business and consumer loans.

The principal executive office of First Financial Northwest is located at 201 Wells Avenue South, Renton, Washington, 98057; our telephone number is (425) 255-4400.

Market Area

We consider our primary market area to be the Puget Sound Region that consists primarily of King, Snohomish and, to a lesser extent, Pierce and Kitsap counties. During 2019, the Region experienced slowing appreciation in residential real estate prices compared to the increases experienced in 2018. Price appreciation was strongest in areas with lower median home prices. Price appreciation in more expensive areas of King County such as Seattle and Bellevue have slowed due primarily to affordability issues. Home prices in Snohomish, Pierce and Kitsap counties have continued to experience price appreciation higher than the national average. Lower mortgage rates helped stimulate demand in the fourth quarter of 2019 with sales up over last year and a decline in housing inventory at the end of the year. The number of homes listed for sale in King County, Pierce, Snohomish and Kitsap counties at the end of 2019 have all declined over 30% compared to December 2018 and there was less than one month of inventory available at December 31, 2019.

1


King County has the largest population of any county in the state of Washington and covers approximately 2,100 square miles. It has a population of approximately 2.23 million residents and a median household income of approximately $89,400, according to U.S. Census estimates. King County has a diversified economic base with many nationally recognized firms including the Boeing Company (“Boeing”), Microsoft, Amazon, Starbucks, Nordstrom, Costco and Paccar. According to the Washington State Employment Security Department, the unemployment rate for King County was 2.1% at December 31, 2019, compared to 3.3% at December 31, 2018, and the national average of 3.5% at December 31, 2019. The median sales price of a residential home in King County for December 2019 was $615,000, an increase of 3.0% from 2018, according to the Northwest Multiple Listing Service ("MLS"). Residential sales volumes increased 2.1% in 2019 compared to 2018 and inventory levels as of December 31, 2019 were at 0.9 months according to the MLS.

Pierce County, covering approximately 1,700 square miles, has the second largest population of any county in the state of Washington. It has approximately 891,000 residents and a median household income of approximately $67,900, according to U.S. Census estimates. The Pierce County economy is diversified with the presence of military-related government employment (Joint Base Lewis-McChord), transportation and shipping employment (Port of Tacoma), and aerospace-related employment (Boeing). According to the Washington State Employment Security Department, the unemployment rate for Pierce County was 4.8% in December 2019, compared to 5.3% at year-end 2018. The median sales price of a residential home in Pierce County was $369,000 for December 2019, an 8.6% increase compared to 2018, according to the MLS. Residential sales volumes declined by 4.4% in 2019 compared to 2018 and inventory levels as of December 31, 2019 were at 0.9 months according to the MLS.

Snohomish County has the third largest population of any county in the state of Washington and covers approximately 2,100 square miles. It has approximately 815,000 residents and a median household income of approximately $82,800, according to U.S. Census estimates. The economy of Snohomish County is diversified with the presence of military-related government employment (Naval Station Everett), aerospace-related employment (Boeing), and retail trade. According to the Washington State Employment Security Department, the unemployment rate for Snohomish County was 2.4% in December 2019 compared to 3.6% in December 2018. The median sales price of a residential home in Snohomish County was $495,900 for December 2019, an 8.8% increase compared to December 2018, according to the MLS. Residential sales volumes rose by 2.1% in 2019 compared to 2018 and inventory levels as of December 31, 2018 were at 0.9 months according to the MLS.

Kitsap County has the seventh largest population of any county in the state of Washington and covers approximately 400 square miles. It has approximately 270,000 residents and a median household income of approximately $71,600, according to U.S. Census estimates. The Kitsap County economy is diversified with the presence of military-related government employment (Naval Base Kitsap, Puget Sound Naval Shipyard), health care, retail trade and education. According to the Washington State Employment Security Department, the unemployment rate for Kitsap County was 4.1% in December 2019, compared to 4.9% for December of 2018. The median sales price of a residential home was $385,000 for December 2019 an increase of 12.2% over December of 2018, according to the MLS. Residential sales volumes declined by 3.4% in 2019 compared to 2018 and inventory levels as of December 31, 2019 were at 0.8 months according to the MLS.

For a discussion regarding competition in our primary market area, see “- Competition” later in Item 1 of this report.


Lending Activities

General. We focus our lending activities primarily on loans secured by commercial real estate, construction/land, first mortgages on one-to-four family residences, multifamily, and business lending. We offer a variety of secured consumer loans, including savings account loans, auto loans and home equity loans that include lines of credit and second mortgage term loans. As of December 31, 2019, our net loan portfolio totaled $1.1 billion and represented 82.6% of our total assets.

Our current loan policy generally limits the maximum amount of loans we can make to one borrower to 15% of the Bank’s total risk-based capital, or $22.2 million at December 31, 2019. Exceptions to this policy are allowed only with the prior approval of the Board of Directors and if the borrower exhibits financial strength or sufficient, measurable compensating factors exist after consideration of the loan-to-value ratio, borrower’s financial condition, net worth, credit history, earnings capacity, installment obligations, and current payment history. The regulatory limit of loans we can make to one borrower is 20% of total risk-based capital, or $29.6 million, at December 31, 2019. At this date, our single largest lending relationship, totaled $21.5 million.

During 2019, the concentration of loans to our five largest lending relationships increased. At December 31, 2019, loans to our five largest lending relationships totaled $86.9 million compared to $79.9 million at December 31, 2018, an increase of $7.0 million, or 8.8%. While the total of these relationships increased during 2019, their percentage of total loans, net of loans in process (“LIP”) remained at 7.7% at December 31, 2019, and 2018. The total number of loans comprising these relationships

2

decreased slightly to 16 at December 31, 2019 from 19 at December 31, 2018. The following table details the types of loans to our five largest lending relationships at December 31, 2019.

Borrower (1)
 
Number of Loans
 
One-to-Four Family Residential(2)
 
Multifamily
 
Commercial Real Estate(2)
 
Aggregate Balance of Loans
 
 
(Dollars in thousands)
Real estate investor
 
5

 
$
—

 
$
8,448

 
$
13,018

 
$
21,466

Real estate investor
 
6

 
432

 
—

 
19,285

 
19,717

Real estate investor
 
2

 
—

 
—

 
18,707

 
18,707

Real estate investor
 
1

 
—

 
—

 
14,000

 
14,000

Real estate investor
 
2

 
—

 
—

 
13,022

 
13,022

Total
 
16

 
$
432

 
$
8,448

 
$
78,032

 
$
86,912

________
(1) The composition of borrowers represented in the table may change between periods.
(2) The one-to-four family residential loans for these borrowers are all owner occupied. The commercial real estate loans are for non-owner occupied, income producing properties.

The composition of loans to our five largest borrowers has changed at December 31, 2019, as compared to December 31, 2018, with an increase in commercial real estate loans of $35.0 million. Partially offsetting this increase, total multifamily loans decreased by $5.2 million and construction/land development loans and business loans decreased by $12.5 million and $9.8 million, respectively, to none. At December 31, 2019, all of the borrowers listed in the table above were in compliance with the original repayment terms of their respective loans.


3

Loan Portfolio Analysis. The following table sets forth the composition of our loan portfolio by type of loan at the dates indicated.
 
December 31,
 
2019
 
2018
 
2017
 
2016
 
2015
 
Amount
 
Percent
 
Amount
 
Percent
 
Amount
 
Percent
 
Amount
 
Percent
 
Amount
 
Percent
 
(Dollars in thousands)
One-to-four family residential:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Permanent owner occupied
$
210,898

 
18.8
%
 
$
194,141

 
18.7
%
 
$
148,304

 
14.8
%
 
$
137,834

 
16.6
%
 
$
147,229

 
21.1
%
Permanent non-owner occupied
161,630

 
14.4

 
147,825

 
14.3

 
130,351

 
13.0

 
111,601

 
13.5

 
106,543

 
15.3

 
372,528

 
33.2

 
341,966

 
33.0

 
278,655

 
27.8

 
249,435

 
30.1

 
253,772

 
36.4

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Multifamily real estate
172,915

 
15.4

 
169,355

 
16.3

 
184,902

 
18.5

 
123,250

 
14.9

 
122,747

 
17.6

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial real estate
395,152

 
35.2

 
373,798

 
36.0

 
361,299

 
36.0

 
303,694

 
36.7

 
244,211

 
35.0

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Construction/land: (1)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
One-to-four family residential
44,491

 
4.0

 
51,747

 
5.0

 
40,522

 
4.0

 
34,909

 
4.2

 
20,142

 
2.9

Multifamily
40,954

 
3.6

 
40,502

 
3.9

 
66,210

 
6.6

 
72,030

 
8.7

 
26,524

 
3.8

Commercial real estate
19,550

 
1.7

 
9,976

 
1.0

 
2,481

 
0.3

 
—

 
—

 
—

 
—

Land
8,670

 
0.8

 
6,629

 
0.6

 
36,405

 
3.6

 
29,983

 
3.6

 
15,437

 
2.2

 
113,665

 
10.1

 
108,854

 
10.5

 
145,618

 
14.5

 
136,922

 
16.5

 
62,103

 
8.9

Business
37,779

 
3.4

 
30,486

 
3.0

 
23,087

 
2.3

 
7,938

 
1.0

 
7,604

 
1.1

Consumer
30,199

 
2.7

 
12,970

 
1.2

 
9,133

 
0.9

 
6,922

 
0.8

 
6,979

 
1.0

Total loans
1,122,238

 
100.0
%
 
1,037,429

 
100.0
%
 
1,002,694

 
100.0
%
 
828,161

 
100.0
%
 
697,416

 
100.0
%
Less:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

 
 

Deferred loan fees, net
558

 
 
 
1,178

 
 
 
1,150

 
 
 
2,167

 
 
 
2,881

 
 
Allowance for loan and lease losses (“ALLL”)
13,218

 
 
 
13,347

 
 
 
12,882

 
 
 
10,951

 
 
 
9,463

 
 
Loans receivable, net
$
1,108,462

 
 
 
$
1,022,904

 
 
 
$
988,662

 
 
 
$
815,043

 
 
 
$
685,072

 
 


_____________ 
(1) Included in the construction/land category are “rollover” loans, which are loans that will convert upon completion of the construction period to permanent loans. At December 31, 2019, we included rollover loans of $3.5 million of one-to-four family residential loans, $38.6 million of multifamily loans and $18.3 million of commercial real estate loans in the construction/land category. In addition, the construction/land category included $8.7 million of loans for raw land or buildable lots where the Company does not intend to finance the construction.

4

The following table shows the composition of our loan portfolio by fixed- and adjustable-rate loans at the dates indicated.
 
December 31,
 
2019
 
2018
 
2017
 
2016
 
2015
 
Amount
 
Percent
 
Amount
 
Percent
 
Amount
 
Percent
 
Amount
 
Percent
 
Amount
 
Percent
FIXED-RATE LOANS
(Dollars in thousands)
Real estate:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
  One-to-four family residential
$
184,174

 
16.4
%
 
$
185,755

 
18.0
%
 
$
177,086

 
17.7
%
 
$
169,523

 
20.5
%
 
$
172,951

 
24.8
%
  Multifamily
54,762

 
4.9

 
68,737

 
6.6

 
77,824

 
7.8

 
72,593

 
8.7

 
82,767

 
11.9

  Commercial real estate
185,503

 
16.5

 
179,838

 
17.3

 
208,899

 
20.8

 
211,054

 
25.5

 
199,101

 
28.5

  Construction/land
32,880

 
2.9

 
22,552

 
2.2

 
29,516

 
2.9

 
28,287

 
3.4

 
3,857

 
0.6

Total real estate
457,319


40.7


456,882


44.1


493,325


49.2


481,457


58.1


458,676


65.8

Business
18,787

 
1.7

 
13,760

 
1.3

 
9,097

 
0.9

 
640

 
0.1

 
243

 
—

Consumer
19,422

 
1.7

 
1,018

 
0.1

 
136

 
—

 
432

 
0.1

 
558

 
0.1

Total fixed-rate loans
495,528


44.1


471,660


45.5


502,558


50.1


482,529


58.3


459,477


65.9

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
ADJUSTABLE-RATE LOANS
 
 
 
 
 
 
 

 
 

 
 

 
 

 
 

 
 

 
 

Real estate:
 
 
 
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

  One-to-four family residential
188,354

 
16.8

 
156,211

 
15.1

 
101,569

 
10.1

 
79,912

 
9.6

 
80,821

 
11.6

  Multifamily
118,153

 
10.5

 
100,618

 
9.7

 
107,078

 
10.7

 
50,657

 
6.1

 
39,980

 
5.7

  Commercial real estate
209,649

 
18.7

 
193,960

 
18.7

 
152,400

 
15.2

 
92,640

 
11.2

 
45,110

 
6.5

  Construction/land
80,785

 
7.2

 
86,302

 
8.3

 
116,102

 
11.6

 
108,635

 
13.1

 
58,246

 
8.4

Total real estate
596,941

 
53.2

 
537,091

 
51.8

 
477,149

 
47.6

 
331,844

 
40.0

 
224,157

 
32.2

Business
18,992

 
1.7

 
16,726

 
1.5

 
13,990

 
1.4

 
7,298

 
0.9

 
7,361

 
1.1

Consumer
10,777

 
1.0

 
11,952

 
1.2

 
8,997

 
0.9

 
6,490

 
0.8

 
6,421

 
0.8

Total adjustable-rate loans
626,710

 
55.9

 
565,769

 
54.5

 
500,136

 
49.9

 
345,632

 
41.7

 
237,939

 
34.1

Total loans
1,122,238

 
100.0
%
 
1,037,429

 
100.0
%
 
1,002,694

 
100.0
%
 
828,161

 
100.0
%
 
697,416

 
100.0
%
Less:
 
 
 
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

   Deferred loan fees, net
558

 
 
 
1,178

 
 
 
1,150

 
 
 
2,167

 
 

 
2,881

 
 

   ALLL
13,218

 
 
 
13,347

 
 
 
12,882

 
 
 
10,951

 
 

 
9,463

 
 

Loans receivable, net
$
1,108,462

 
 
 
$
1,022,904

 
 

 
$
988,662

 
 

 
$
815,043

 
 

 
$
685,072

 
 


5

Geographic Distribution of our Loans. The following table shows the geographic distribution of our loan portfolio in dollar amounts and percentages at December 31, 2019.

 
Puget Sound Region (1)
 
Other Washington Counties
 
Total in Washington State
 
All Other States (2)
 
Total
 
Amount
 
% of Total in Category
 
Amount
 
% of Total in Category
 
Amount
 
% of Total in Category
 
Amount
 
% of Total in Category
 
Amount
 
% of Total in Category
Real estate:
(Dollars in thousands)
One-to-four family
    residential
$
359,384

 
96.5
%
 
$
9,770

 
2.6
%
 
$
369,154

 
99.1
%
 
$
3,374

 
0.9
%
 
$
372,528

 
100.0
%
Multifamily
111,588

 
64.6

 
24,457

 
14.1

 
136,045

 
78.7

 
36,870

 
21.3

 
172,915

 
100.0
%
Commercial
264,125

 
66.8

 
47,683

 
12.1

 
311,808

 
78.9

 
83,344

 
21.1

 
395,152

 
100.0
%
Construction/land
112,055

 
98.6

 
1,610

 
1.4

 
113,665

 
100.0

 
—

 
—

 
113,665

 
100.0
%
Total real estate
847,152


80.4


83,520


7.9


930,672


88.3


123,588


11.7


1,054,260

 
100.0
%
Business
18,038

 
47.7

 
1,248

 
3.3

 
19,286

 
51.0

 
18,493

 
49.0

 
37,779

 
100.0
%
Consumer
11,650

 
38.5

 
414

 
1.4

 
12,064

 
39.9

 
18,135

 
60.1

 
30,199

 
100.0
%
Total Loans
$
876,840

 
78.1
%
 
$
85,182

 
7.6
%
 
$
962,022

 
85.7
%
 
$
160,216

 
14.3
%
 
$
1,122,238

 
100.0
%
____________ 
(1) Includes King, Snohomish, Pierce and Kitsap counties.
(2) Includes loans in California, Utah, Oregon, Georgia, and 36 other states.


6

One-to-Four Family Residential Lending. As of December 31, 2019, $372.5 million, or 33.2% of our total loan portfolio consisted of loans secured by one-to-four family residences.

First Financial Northwest Bank is a traditional portfolio lender when it comes to financing residential home loans. In 2019, we originated $91.8 million and purchased $653,000 in one-to-four family residential loans. At December 31, 2019, $210.9 million, or 56.6% of our one-to-four family residential portfolio consisted of owner occupied loans with the remaining $161.6 million, or 43.4% consisting of non-owner occupied loans. In addition, at December 31, 2019, $184.2 million, or 49.4% of our one-to-four family residential loan portfolio consisted of fixed-rate loans. Substantially all of our one-to-four family residential loans require monthly principal and interest payments.

Our fixed-rate, one-to-four family residential loans are generally originated with 15 to 30 year terms, although such loans typically remain outstanding for substantially shorter periods, particularly in the current low interest rate environment. We also originate hybrid loans with initial fixed-rate terms of five to ten years that convert to variable-rate which adjusts annually thereafter. In addition, substantially all of our one-to-four family residential loans contain due-on-sale clauses that allow us to declare the unpaid amount due and payable upon the sale of the property securing the loan. Typically, we enforce these due‑on‑sale clauses to the extent permitted by law and as a standard course of business. The average period of time a loan is outstanding is a function of, among other factors, the level of purchase and sale activity in the real estate market, prevailing interest rates, and the interest rates payable on outstanding loans.

Our lending policy generally limits the maximum loan-to-value ratio on mortgage loans secured by one-to-four family residential properties to 85% of the lesser of the appraised value or the purchase price. Properties securing our one-to-four family residential loans are appraised by independent appraisers approved by us. We require the borrowers to obtain title insurance and if necessary, flood insurance. We generally do not require earthquake insurance due to competitive market factors.

Loans secured by rental properties represent potentially higher risk and, as a result, we adhere to more stringent underwriting guidelines. Of primary concern in non-owner occupied real estate lending is the consistency of rental income of the property. Payments on loans secured by rental properties depend primarily on the tenants’ continuing ability to pay rent to the property owner, the character of the borrower or, if the property owner is unable to find a tenant, the property owner’s ability to repay the loan without the benefit of a rental income stream. In addition, successful operation and management of non-owner occupied properties, including property maintenance standards, may affect repayment. As a result, repayment of such loans may be subject to adverse conditions in the real estate market or the economy. We request that borrowers and loan guarantors, if any, provide annual financial statements, a budget factoring in a rental income cash flow analysis of the borrower as well as the net operating income of the property, information concerning the borrower’s expertise, credit history and profitability, and the value of the underlying property. These loans are generally secured by a first mortgage on the underlying collateral property along with an assignment of rents and leases. If the borrower has multiple rental property loans with us, the loans are typically not cross‑collateralized. At December 31, 2019, a $95,000 one-to-four family residential loan was in nonaccrual status and was performing in accordance with its repayment terms at that date.

Multifamily and Commercial Real Estate Lending. As of December 31, 2019, $172.9 million, or 15.4% of our total loan portfolio was secured by multifamily and $395.2 million, or 35.2% of our loan portfolio was secured by commercial real estate properties. Our commercial real estate loans are typically secured by office and medical buildings, retail shopping centers, hotels, mini-storage facilities, industrial use buildings and warehouses. Commercial real estate and multifamily loans are subject to similar underwriting standards and processes. These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate.

Typically, multifamily and commercial real estate loans have higher balances, are more complex to evaluate and monitor, and involve a greater degree of risk than one-to-four-family residential loans. In an attempt to compensate for and mitigate this risk, these loans are generally priced at higher interest rates than one-to-four family residential loans and generally have a maximum loan-to-value ratio of 80% of the lesser of the appraised value or purchase price. We generally require loan guarantees by any parties with a property ownership interest of 20% or more. If the borrower is a corporation or partnership, we generally require personal guarantees from the principals based upon a review of their personal financial statements and individual credit reports.


7

The following table presents a breakdown of our multifamily and commercial real estate loan portfolio at December 31, 2019, and 2018:
 
December 31, 2019
 
December 31, 2018
 
Amount
 
% of Total in Portfolio
 
Amount
 
% of Total in Portfolio
 
(Dollars in thousands)
Multifamily real estate:
 
 
 
 
 
 
 
Multifamily, general
$
159,106

 
92.0
%
 
$
155,279

 
91.7
%
Micro-unit apartments
13,809

 
8.0

 
14,076

 
8.3

Total multifamily
$
172,915

 
100.0
%
 
$
169,355

 
100.0
%
 
 
 
 
 
 
 
 
Commercial real estate:
 
 
 
 
 
 
 
Office
$
100,744

 
25.5
%
 
$
100,495

 
26.9
%
Retail
133,094

 
33.7

 
131,222

 
35.1

Storage
37,190

 
9.4

 
32,462

 
8.7

Hotel
42,971

 
10.9

 
28,035

 
7.5

Warehouse
17,595

 
4.4

 
25,398

 
6.8

Nursing home
11,831

 
3.0

 
16,315

 
4.4

Mobile home park
26,099

 
6.6

 
16,003

 
4.3

Other non-residential
25,628

 
6.5

 
23,868

 
6.3

Total non-residential
$
395,152

 
100.0
%
 
$
373,798

 
100.0
%

The average loan size in our multifamily and commercial real estate loan portfolios was $1.0 million and $2.0 million, respectively, as of December 31, 2019. At this date, $61.3 million, or 35.5%, of our multifamily loans and $131.0 million, or 33.2%, of our commercial real estate loans were located outside of our primary market area. We currently target individual multifamily, and commercial real estate loans between $1.0 million and $5.0 million. The largest multifamily loan as of December 31, 2019, was a 105-unit apartment complex with a net outstanding principal balance of $9.7 million located in King County, Washington. As of December 31, 2019, the largest commercial real estate loan had a net outstanding balance of $14.0 million and was secured by a hotel located in King County, Washington. Both of these loans were performing according to their respective loan repayment terms as of December 31, 2019.

The credit risk related to multifamily and commercial real estate loans is considered to be greater than the risk related to one-to-four family residential loans because the repayment of multifamily and commercial real estate loans typically is dependent on the income stream from the real estate securing the loan as collateral and the successful operation of the borrower’s business, that can be significantly affected by adverse conditions in the real estate markets or in the economy. For example, if the cash flow from the borrower’s project is reduced due to leases not being obtained or renewed, the borrower’s ability to repay the loan may be impaired. In addition, many of our multifamily and commercial real estate loans are not fully amortizing and contain large balloon payments upon maturity. These balloon payments generally require the borrower to either refinance or occasionally sell the underlying property in order to make the balloon payment.

If we foreclose on a multifamily or commercial real estate loan, our holding period for the collateral typically is longer than for one-to-four family residential mortgage loan foreclosures because there are fewer potential purchasers of the collateral. Our multifamily and commercial real estate loans generally have relatively large balances to single borrowers or related groups of borrowers. Accordingly, if we make any errors in judgment in the collectability of our multifamily or commercial real estate loans, any resulting charge-offs may be larger on a per loan basis than those incurred in our one-to-four family residential or consumer loan portfolios. At December 31, 2019, there were no multifamily or commercial real estate loans past due 90 days or more, or in nonaccrual status. In addition, there were no multifamily or commercial real estate loans charged-off during the years ended December 31, 2019, 2018, and 2017.

Construction/Land Loans. We originate construction/land loans primarily to residential builders for the construction of single-family residences, condominiums, townhouses, multifamily properties and residential developments located in our market area. Land loans include land non-development loans for the purchase or refinance of unimproved land held for future residential development, improved residential lots held for speculative investment purposes or lines of credit secured by land, and land

8

development loans. Construction/land loans to builders generally require the borrower to have an existing relationship with the Bank and a proven record of successful projects. At December 31, 2019, our total construction/land loans increased to $113.7 million, or 10.1% of our total loan portfolio, from $108.9 million, or 10.5% of our total loans, at December 31, 2018. The Company’s strategic plan projects continued growth in construction loan origination activity in 2020 in support of our overall loan growth. The Bank’s lending policy sets forth the guideline that the balance of our net acquisition, development, and construction loans and deferred fees and costs, not exceed 100% of the Bank’s risk-based capital. The Bank was in compliance with this policy at December 31, 2019, with a balance equal to 81.9% of the Bank’s risk-based capital. Management intends to maintain levels near this guideline, however the uncertainty of the timing associated with construction loan draws occasionally results in the actual concentration exceeding the guideline. There were no construction/land loans classified as nonaccrual at either December 31, 2019 or 2018. There were no construction/land loan charge-offs during the years ended December 31, 2019, 2018, and 2017, respectively. At December 31, 2019, the LIP balance on construction/land loans was $89.6 million.

Following is the composition of our total construction/land loan portfolio, which excludes LIP, at the dates indicated. All of the loans represented were performing:
 
December 31,
 
2019
 
2018
 
(In thousands)
Construction speculative:
 
 
 
One-to-four family residential
$
40,993

 
$
51,145

Multifamily
2,394

 
15,285

Commercial real estate
1,227

 
—

Total construction speculative
44,614

 
66,430

Construction permanent: (1)
 
 
 
One-to-four family residential
3,498

 
602

Multifamily
38,560

 
25,217

Commercial real estate
18,323

 
9,976

Total construction permanent
60,381

 
35,795

Land:
 
 
 
Land development
—

 
389

Land non-development
8,670

 
6,240

Total land
8,670

 
6,629

Total construction/land loans
$
113,665

 
$
108,854

_____________
(1) Includes loans where the builder does not intend to sell the property after the construction phase is completed.

The following table includes construction/land loans by county at December 31, 2019:
County
 
Loan Balance
 
Percent of Construction/Land Loan Balance
 
 
(Dollars in thousands)
King
 
$
102,347

 
90.0
%
Snohomish
 
1,135

 
1.0

Pierce
 
6,324

 
5.6

Kitsap
 
2,249

 
2.0

All other
 
1,610

 
1.4

Total
 
$
113,665

 
100.0
%

Loans to finance the construction of single-family homes, subdivisions and land loans are generally offered to builders in our primary market areas. Loans that are termed “speculative” are those where the builder does not have, at the time of loan origination, a signed contract with a buyer for the home or lot who has a commitment for permanent financing with either us or another lender. The buyer may be identified either during or after the construction period, with the risk that the builder may have to fund the debt service on the speculative loan along with real estate taxes and other carrying costs for the project for a significant

9

period of time after completion of the project until a buyer is identified. The maximum loan-to-value ratio applicable to these loans is generally 100% of the actual cost of construction, provided that the loan-to-completed value does not exceed 80%, with approval required from the Chief Credit Officer (“CCO”) for loan-to-value ratios over 80%. In addition, a minimum of 20% verified equity is generally also required. Verified equity refers to cash equity invested in the project. Development plans are required from builders prior to committing to the loan. We require that builders maintain adequate title insurance and other appropriate insurance coverage, and, if applicable, appropriate environmental data report(s) that the land is free of hazardous or toxic waste. While maturity dates for residential construction loans are largely a function of the estimated construction period of the project and typically do not exceed one year, land loans generally are for 12 to 18 months. Substantially all of our residential construction loans have adjustable-rates of interest based on The Wall Street Journal prime rate. During the term of construction, the accumulated interest on the loan is either added to the principal of the loan through an interest reserve or billed monthly. At December 31, 2019, the LIP balance on construction/land loans included $5.4 million set aside for interest reserves. When these loans exhaust their original reserves set up at origination, no additional reserves are permitted unless the loan is re-analyzed and it is determined that the additional reserves are appropriate, based on the updated analysis. Construction loan proceeds are disbursed periodically as construction progresses and as inspections by our approved inspectors warrant. At December 31, 2019, our three largest construction/land loans consisted of a $12.5 million commercial real estate construction/land loan, an $8.4 million multifamily construction loan, and a $6.4 million multifamily construction loan. All three loans will rollover to a permanent loan at the completion of the construction period and all three properties are located in King County.

Our residential construction loans to borrowers for one-to-four family, non-owner occupied residences typically are structured to be converted to fixed-rate permanent loans at the end of the construction phase with one closing for both the construction loan and the permanent financing. Prior to making a commitment to fund a construction loan, we require an appraisal of the post‑construction value of the project by an independent appraiser. During the construction phase, which typically lasts 12 to 18 months, an approved inspector or designated Bank employee makes periodic inspections of the construction site to certify construction has reached the stated percentage of completion. Typically, disbursements are made in monthly draws and interest-only payments are required. These loans are converted to fixed-rate permanent loans at the end of the construction phase. At December 31, 2019, there was a $3.5 million non-owner occupied construction loan that will rollover to a permanent non-owner occupied one‑to‑four family residential loan in 2020.

We also make construction loans for commercial development projects. The projects include multifamily, retail, office/warehouse, hotels and office buildings. These loans typically have an interest-only payment phase during construction and generally convert to permanent financing when construction is complete. Disbursement of funds is at our sole discretion and is based on the progress of construction. The Bank uses an independent third party or Bank employee to conduct monthly inspections to certify that construction has reached the stated percentage of completion and that previous disbursements are reflected in the degree of work performed to date. Generally, the maximum loan-to-value ratio applicable to these loans is 90% of the actual cost of construction or 80% of the prospective value at completion. At December 31, 2019, $56.9 million of multifamily and commercial real estate construction loans will rollover to permanent loans with the Bank at the end of their construction period.

Land development loans are generally made to builders for preparation of a building site and do not include the construction of buildings on the property. The maximum loan-to-value ratio for these loans is 75%. Land non-development loans are generally for raw land where we do not finance the cost of preparing the site for building and are subject to a maximum loan‑to‑value ratio of 65%.

Our construction/land loans are based upon estimates of costs in relation to values associated with the completed project. Construction/land lending involves additional risks when compared with permanent residential lending because funds are advanced upon the collateral for the project based on an estimate of costs that will produce a future value at completion. Because of the uncertainties inherent in estimating construction costs, as well as the market value of the completed project and the effects of governmental regulation on real property, it is relatively difficult to evaluate accurately the total funds required to complete a project and the completed project loan-to-value ratio. Changes in the demand, such as for new housing and higher than anticipated building costs may cause actual results to vary significantly from those estimated. For these reasons, this type of lending also typically involves higher loan principal amounts and is often concentrated with a small number of builders. These loans often involve the disbursement of funds with repayment substantially dependent on the success of the ultimate project and the ability of the borrower to sell or lease the property or obtain permanent take-out financing, rather than the ability of the borrower or guarantor to repay principal and interest. If our appraisal of the value of a completed project proves to be overstated, we may have inadequate security for the repayment of the loan upon completion of construction of the project and may incur a loss. Because construction loans require active monitoring of the building process, including cost comparisons and on-site inspections, these loans are more difficult and costly to monitor. Increases in market rates of interest may have a more pronounced effect on construction loans by rapidly increasing the end-purchasers’ borrowing costs, thereby reducing the overall demand for the project. Properties under construction are often difficult to sell and typically must be completed in order to be successfully sold which also complicates the process of working out problem construction loans. This may require us to advance additional funds and/or contract with

10

another builder to complete construction. Furthermore, in the case of speculative construction loans, there is the added risk associated with identifying an end-purchaser for the finished project. Land loans also pose additional risk because of the lack of income being produced by the property and the potential illiquid nature of the collateral. These risks can also be significantly influenced by supply and demand conditions.

Business Lending. Business loans totaled $37.8 million, or 3.4% of the loan portfolio at December 31, 2019. Business loans are generally secured by business equipment, accounts receivable, inventory or other property. Loan terms typically vary from one to five years. The interest rates on such loans are either fixed-rate or adjustable-rate. The interest rates for the adjustable‑rate loans are indexed to the prime rate published in The Wall Street Journal plus a margin. Our business lending policy includes credit file documentation and requires analysis of the borrower’s background, capacity to repay the loan, the adequacy of the borrower’s capital and collateral, as well as an evaluation of other conditions affecting the borrower. Analysis of the borrower’s past, present and future cash flows is also an important aspect of our credit analysis. We generally obtain personal guarantees on our business loans. The largest business loan had an outstanding balance of $11.2 million at December 31, 2019 and was performing according to its repayment terms. At December 31, 2019, we did not have any business loans delinquent in excess of 90 days or in nonaccrual status.

At December 31, 2019, the Bank’s aircraft loan portfolio had an outstanding balance of $14.0 million, or 37.1% of total business loans. These loans are collateralized by new or used, single‑engine piston aircraft to light jets for business or personal use. Our aircraft loans will generally range in size from $250,000 to $3.0 million with the primary focus of our underwriting guidelines on the asset value of the collateral rather than the ability of the borrower to repay the loan. The average loan size in our aircraft loan portfolio was $667,000 and the largest loan was $2.8 million at December 31, 2019. For additional information regarding these loans, see Item 1A. Risk Factors- “We engage in aircraft and classic car financing transactions, in which high-value collateral is susceptible to potential catastrophic loss. If any of these transactions becomes nonperforming, we could suffer a loss on some or all of our value in the assets.”

During 2019, the Company began originating Small Business Administration (“SBA”) loans. These loans are partially guaranteed by the SBA. At December 31, 2019, the balance of SBA loans was $362,000, of which $271,000 is guaranteed by the SBA. At that date, the loans were not held for sale. However, the Company may elect to sell off the guaranteed portion of these loans in the future.

Repayments of business loans are often dependent on the cash flows of the borrower, which may be unpredictable, and the collateral securing these loans may fluctuate in value. Our business loans, other than aircraft loans, are originated primarily based on the identified cash flow of the borrower and secondarily on the underlying collateral provided by the borrower. Credit support provided by the borrower for most of these loans and the probability of repayment is based on the liquidation of the pledged collateral and enforcement of a personal guarantee, if any. As a result, in the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers. The collateral securing business loans may depreciate over time, may be difficult to appraise, or may fluctuate in value based on the success of the business.

Consumer Lending. We offer a limited variety of consumer loans to our customers, consisting primarily of home equity loans and savings account loans. Generally, consumer loans have shorter terms to maturity and higher interest rates than one‑to‑four family residential loans. Consumer loans are offered with both fixed and adjustable interest rates and with varying terms. At December 31, 2019, consumer loans were $30.2 million, or 2.7% of the total loan portfolio.

At December 31, 2019, the largest component of the consumer loan portfolio consisted of purchased indirect consumer loans to finance classic and collectible cars with a balance of $18.5 million, or 61.1% of the total consumer loan portfolio. The Bank will lend up to 90% of the estimated value of the car. These fixed rate loans typically have maturity periods of five to twelve years. The Bank intends to grow this portfolio of loans up to an internal limit of $40.0 million. Included in these loans are classic cars, defined as a vehicle in excess of 25 years old, and collectible cars, with a retail price in excess of $150,000. At December 31, 2019, our largest car loan was $486,000 and the average loan was $78,000. For additional information regarding these loans see Item 1A. Risk Factors- “We engage in aircraft and classic or collectible car financing transactions, in which high-value collateral is susceptible to potential catastrophic loss. If any of these transactions becomes nonperforming, we could suffer a loss on some or all of our value in the assets.”

At December 31, 2019, home equity loans, primarily home equity lines of credit totaled $10.6 million, or 35.2% of the total consumer loan portfolio. The home equity lines of credit include $2.4 million of equity lines of credit in first lien position and $8.2 million of second liens on residential properties. At December 31, 2019, unfunded commitments on our home equity lines of credit totaled $15.4 million. Home equity loans are made for purposes such as the improvement of residential properties, debt consolidation and education expenses. At origination, the loan-to-value ratio is generally 90% or less, when taking into account

11

both the balance of the home equity loans and the first mortgage loan. Home equity loans are originated on a fixed-rate or adjustable-rate basis. The interest rate for the adjustable-rate second lien loans is indexed to the prime rate published in The Wall Street Journal and may include a margin. Home equity loans generally have a 10 to 30- year term, with a 10- year draw period, and either convert to principal and interest payments with no further draws or require a balloon payment due at maturity.

Consumer loans entail greater risk than one-to-four family residential mortgage loans, particularly in the case of consumer loans that are unsecured or secured by rapidly depreciating assets. In these cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. The remaining deficiency often does not warrant further collection efforts against the borrower beyond obtaining a deficiency judgment. In addition, consumer loan collections are dependent on the borrower’s continuing financial stability and are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount that can be recovered on these loans. Home equity lines of credit have greater credit risk than one-to-four family residential mortgage loans because they are generally secured by mortgages subordinated to the existing first mortgage on the property that we may or may not hold in our portfolio. We do not have private mortgage insurance coverage on these loans. Classic car loans have greater risk than other consumer loans primarily due to their high value which may fluctuate significantly. Adjustable-rate loans may experience a higher rate of default in a rising interest rate environment due to the increase in payment amounts when interest rates reset higher. If current economic conditions deteriorate for our borrowers and their home prices fall, we may also experience higher credit losses from this loan portfolio. For our home equity loans that are in a second lien position, it is unlikely that we will be successful in recovering our entire loan principal outstanding in the event of a default. At December 31, 2019, no consumer loans were in nonaccrual status or delinquent more than 30 days. During the years ended December 31, 2019, 2018, and 2017, there were no consumer loans charged-off.

Loan Maturity and Repricing. The following table sets forth certain information at December 31, 2019, regarding the amount of total loans in our portfolio based on their contractual terms to maturity, not including prepayments.
 
Within One Year
 
After One Year Through Three Years
 
After Three Years Through Five Years
 
After Five Years Through Ten Years
 
Beyond Ten Years
 
Total
 
(In thousands)
Real estate:
 
 
 
 
 
 
 
 
 
 
 
   One-to-four family residential
$
16,811

 
$
6,397

 
$
2,135

 
$
10,009

 
$
337,176

 
$
372,528

   Multifamily
20,299

 
15,903

 
19,628

 
62,186

 
54,899

 
172,915

   Commercial
28,625

 
36,097

 
68,121

 
218,304

 
44,005

 
395,152

   Construction/land
46,633

 
21,005

 
14,132

 
14,262

 
17,633

 
113,665

Total real estate
112,368

 
79,402

 
104,016

 
304,761

 
453,713

 
1,054,260

Business
18,341

 
7,379

 
7,148

 
4,911

 
—

 
37,779

Consumer
1,004

 
25

 
350

 
6,501

 
22,319

 
30,199

Total
$
131,713

 
$
86,806

 
$
111,514

 
$
316,173

 
$
476,032

 
$
1,122,238

    
    

12

The following table sets forth the amount of total loans due after December 31, 2020, with fixed or adjustable interest rates.
 
Fixed-Rate
 
Adjustable-Rate
 
Total
 
(In thousands)
Real estate:
 
 
 
 
 
   One-to-four family residential
$
180,423

 
$
175,294

 
$
355,717

   Multifamily
43,660

 
108,956

 
152,616

   Commercial
174,326

 
192,201

 
366,527

Construction/land
30,880

 
36,152

 
67,032

Total real estate
429,289


512,603


941,892

Business
17,788

 
1,650

 
19,438

Consumer
18,454

 
10,741

 
29,195

Total
$
465,531

 
$
524,994

 
$
990,525

           
Loan Solicitation and Processing. The majority of our consumer and residential mortgage loan originations are generated through the Bank and from time to time through outside brokers and correspondent relationships we have established with select mortgage companies or other financial institutions. We originate multifamily, commercial real estate, construction/land and business loans primarily using the Bank’s loan officers, with referrals coming from builders, brokers and existing customers.

Upon receipt of a loan application from a prospective borrower, we obtain a credit report and other data to verify specific information relating to the loan applicant’s employment, income, and credit standing. All real estate loans requiring an appraisal are done by an independent third-party appraiser. All appraisers are approved by us, and their credentials are reviewed annually, as is the quality of their appraisals.

We use a multi-level approval matrix which establishes lending targets and tolerance levels depending on the loan type being approved. The matrix also sets minimum credit standards and approval limits for each of the loan types.

Lending Authority. The Directors’ Loan Committee consists of at least three members of the Board of Directors. The Directors’ Loan Committee recommends for approval by the Board of Directors exceptions to the aggregate loan limit to one borrower of 15% of total risk-based capital, or $22.2 million at December 31, 2019. The Board of Directors approves exceptions to such aggregate loan limit to one borrower up to 20% of total risk-based capital, or $29.6 million at December 31, 2019.
 
Officer Lending Authority. Individual signing authority has been delegated to two lending officers. Our Senior Credit Approval Officer (“SCAO”) has authority from the Board of Directors to approve loans and aggregate relationships up to and including $5.0 million. The Board of Directors has given our Chief Credit Officer (“CCO”) authority to approve credit to one borrower not to exceed our aggregate loan limit of 15% of total risk-based capital.

Loan Originations, Servicing, Purchases, Sales and Repayments. For the years ended December 31, 2019, 2018, and 2017, our total loan originations and purchases were $396.8 million, $370.8 million, and $430.7 million, respectively.

One-to-four family residential loans are generally originated in accordance with the guidelines established by Freddie Mac and Fannie Mae, with the exception of our special community development loans originated to satisfy compliance with the Community Reinvestment Act. Our loans are underwritten by designated real estate loan underwriters internally in accordance with standards as provided by our Board-approved loan policy. We require title insurance on all loans and fire and casualty insurance on all secured loans and home equity loans where real estate serves as collateral. Flood insurance is also required on all secured loans when the real estate is located in a flood zone.


13

The following table shows total loans originated, purchased, repaid and other changes during the periods indicated.
 
Year Ended December 31,
 
2019
 
2018
 
2017
 
(In thousands)
Loan originations:
 
 
 
 
 
Real estate:
 
 
 
 
 
One-to-four family residential
$
91,811

 
$
119,946

 
$
89,622

Multifamily
39,967

 
8,363

 
20,612

Commercial
74,283

 
47,332

 
49,524

Construction/land
109,989

 
118,237

 
138,591

Total real estate
316,050

 
293,878

 
298,349

Business
10,031

 
21,361

 
23,438

Consumer
24,325

 
14,524

 
9,379

Total loans originated
350,406

 
329,763

 
331,166

Loan purchases and participations:
 
 
 
 
 
One-to-four family residential
653

 
1,230

 
3,087

Multifamily
28

 
3,705

 
45,340

Commercial
17,408

 
21,546

 
46,802

Construction/land
8,727

 
4,582

 
1,100

Business
—

 
10,000

 
3,177

Consumer
19,553

 
—

 
—

Total loan purchases and participations (1)
46,369

 
41,063

 
99,506

Principal repayments
(308,849
)
 
(342,136
)
 
(235,667
)
Charge-offs
—

 
—

 
—

Loans transferred to other real estate owned (“OREO”)
—

 
—

 
—

Change in LIP, net deferred fees, and ALLL
(2,368
)
 
5,552

 
(21,386
)
Net increase in loans
$
85,558

 
$
34,242

 
$
173,619

_______________
(1) Includes $38.0 million, $19.9 million, and $76.2 million in loan purchases during 2019, 2018, and 2017, respectively.

Loan Origination and Other Fees. In some instances, we receive loan origination fees on real estate-related products. Loan fees generally represent a percentage of the principal amount of the loan and are paid by the borrower. The amount of fees charged to the borrower on one-to-four family residential loans and multifamily and commercial real estate loans can range from 0% to 2%. United States generally accepted accounting principles require that certain fees received, net of certain origination costs, be deferred and amortized over the contractual life of the loan. Net deferred fees or costs associated with loans that are prepaid or sold are recognized in income at the time of prepayment or sale. We had $558,000 and $1.2 million of net deferred loan fees at December 31, 2019, and 2018, respectively.

Loan purchases generally include a premium, which is deferred and amortized into interest income with net deferred fees over the contractual life of the loan. During 2019, total premiums of $1.4 million, or 2.9% of the purchased principal, were paid on purchased loans. In comparison, premiums of $630,000, or 3.2% of the purchased principal were paid on purchased loans during 2018.

One-to-four family residential and consumer loans are generally originated without a prepayment penalty. The majority of our multifamily and commercial real estate loans, however, have prepayment penalties associated with the loans. Most of the multifamily and commercial real estate loan originations with interest rates fixed for the first five years will adjust thereafter and have a prepayment penalty of 2% - 3% of the principal balance in year one, with decreasing penalties in subsequent years. Longer initial fixed rate terms generally have correspondingly longer prepayment penalty periods.

14

Asset Quality

As of December 31, 2019, we had one owner occupied one-to-four family residential loan of $79,000 and one multifamily real estate loan of $2.1 million past due 30 days or more. These loans represented 0.19% of total loans. We generally assess late fees or penalty charges on delinquent loans of up to 5.0% of the monthly payment. The borrower is given up to a 15 day grace period from the due date to make the loan payment.

We handle collection procedures internally or with the assistance of outside legal counsel. Late charges are incurred when the loan exceeds 10 to 15 days past due depending upon the loan product. When a delinquent loan is identified, corrective action takes place immediately. The first course of action is to determine the cause of the delinquency and seek cooperation from the borrower in resolving the issue. Additional corrective action, if required, will vary depending on the borrower, the collateral, if any, and whether the loan requires specific handling procedures as required by the Washington State Deed of Trust Act.
    
If the borrower is chronically delinquent and all reasonable means of obtaining payments have been exhausted, we will seek to foreclose on the collateral securing the loan according to the terms of the security instrument and applicable law. The following table shows our delinquent loans by the type of loan and the number of days delinquent at December 31, 2019:
 
Loans Delinquent
 
Total
 
30-59 Days
 
60-89 Days
 
90 Days and Greater
 
Delinquent Loans
 
Number
of Loans
 
Principal
Balance
 
Number
of Loans
 
Principal
Balance
 
Number
of Loans
 
Principal
Balance
 
Number
of Loans
 
Principal
Balance
 
(Dollars in thousands)
One-to-four family residential
1

 
$
79

 
—

 
$
—

 
—

 
$
—

 
1

 
$
79

Multifamily
1

 
2,105

 
—

 
—

 
—

 
—

 
1

 
2,105

Total
2

 
$
2,184

 
—

 
$
—

 
—

 
$
—

 
2

 
$
2,184

    
Construction/land, commercial real estate, and multifamily loans generally have larger individual loan amounts that have a greater single impact on asset quality in the event of delinquency or default. We continue to monitor our loan portfolio and believe additions to nonperforming loans, charge-offs, provisions for loan losses, and/or OREO are possible in the future, particularly if the housing market and other economic conditions decline.
    
    

15

The following table sets forth information with respect to our nonperforming assets and troubled debt restructured loans (“TDRs”) for the periods indicated.
 
 
December 31,
 
 
2019
 
2018
 
2017
 
2016
 
2015
 
 
(Dollars in thousands)
Loans accounted for on a nonaccrual basis:
 
 
 
 
 
 
 
 
 
 
Real estate:
 
 
 
 
 
 
 
 
 
 
   One-to-four family residential
 
$
95

 
$
382

 
$
128

 
$
798

 
$
996

   Commercial
 
—

 
326

 
—

 
—

 
—

Consumer
 
—

 
44

 
51

 
60

 
89

Total loans accounted for on a nonaccrual basis
 
95

 
752

 
179

 
858

 
1,085

 
 
 
 
 
 
 
 
 
 
 
Total nonperforming loans
 
95

 
752

 
179

 
858

 
1,085

OREO
 
454

 
483

 
483

 
2,331

 
3,663

Total nonperforming assets
 
$
549

 
$
1,235

 
$
662

 
$
3,189

 
$
4,748

 
 
 
 
 
 
 
 
 
 
 
TDRs:
 
 

 
 

 
 

 
 

 
 

   Nonaccrual (1)
 
$
—

 
$
—

 
$
—

 
$
174

 
$
131

   Performing
 
5,246

 
9,399

 
17,805

 
30,083

 
42,128

Total TDRs
 
$
5,246

 
$
9,399

 
$
17,805

 
$
30,257

 
$
42,259

Nonperforming loans as a percent of total loans
 
0.01
%
 
0.07
%
 
0.02
%
 
0.10
%
 
0.16
%
Nonperforming loans as a percent of total assets
 
0.01

 
0.06

 
0.01

 
0.08

 
0.11

Nonperforming assets as a percent of total assets
 
0.04

 
0.10

 
0.05

 
0.31

 
0.48

Total loans
 
$
1,122,238

 
$
1,037,429

 
$
1,002,694

 
$
828,161

 
$
697,416

Foregone interest on nonaccrual loans
 
12

 
18

 
26

 
51

 
103

_______
(1) These loans are also included in the appropriate loan category above under the caption: “Loans accounted for on a nonaccrual basis.”
        
Nonperforming Loans. When a loan becomes 90 days past due, we generally place the loan on nonaccrual status unless the credit is well secured and in the process of collection. Loans may be placed on nonaccrual status prior to being 90 days past due if there is an identified problem such as an impending foreclosure or bankruptcy or if the borrower is unable to meet their scheduled payment obligations. Our nonperforming loans decreased by $657,000, or 87.4%, at December 31, 2019, as compared to December 31, 2018, as a result of payoffs on these loans during 2019. During 2019, there were no charge offs to nonperforming loans.
    
Other Real Estate Owned. Real estate acquired by us as a result of foreclosure or by deed-in-lieu of foreclosure is classified as OREO until it is sold. When the property is acquired, it is recorded at the lower of its cost or fair market value of the property, less selling costs. We had $454,000 and $483,000 of OREO at December 31, 2019, and 2018, respectively, comprised of undeveloped lots. During 2019, appraisals of our OREO properties resulted in a $29,000 write-down on the carrying value of this portfolio. Our special assets department’s primary focus is the prompt and effective management of our troubled, nonperforming assets, and expediting their disposition to minimize any potential losses. During 2019 and 2018, we did not foreclose or accept deeds-in-lieu of foreclosure on any loans. In the future, we may experience foreclosure, deed-in-lieu of foreclosure, and short sale activity while we work with our nonperforming loan customers to minimize our loss exposure.
 
Because of our structure, we believe we are able to make decisions regarding offers on OREO and the real estate underlying our nonperforming loans very quickly compared to larger institutions where decisions could take six to twelve months. This distinction has historically worked to our benefit in reducing our nonperforming assets and disposing of OREO.

Troubled Debt Restructured Loans. We account for certain loan modifications or restructurings as TDRs. In general, the modification or restructuring of a debt is considered a TDR if, for economic or legal reasons related to the borrower’s financial

16

difficulties, we grant a concession to the borrower that we would not otherwise consider. These loans are all considered to be impaired loans. At December 31, 2019, we had $5.2 million in TDRs as compared to $9.4 million at December 31, 2018.

The largest TDR relationship at December 31, 2019 was a $1.3 million commercial property located in King County. At December 31, 2019, there was no LIP in connection with our TDRs. For additional information regarding our TDRs, see Note 4 of the Notes to Consolidated Financial Statements contained in Item 8 of this report.
    
The following table summarizes our total TDRs:
 
December 31,
 
2019
 
2018
 
(In thousands)
Performing TDRs:
 

 
 

   One-to-four family residential
$
3,979

 
$
6,941

   Commercial real estate
1,267

 
2,415

Consumer
—

 
43

Total performing TDRs
5,246

 
9,399

Total TDRs
$
5,246

 
$
9,399

 
Classified Assets. Federal regulations provide for the classification of lower quality loans and other assets as substandard, doubtful or loss. An asset is considered substandard if it is inadequately protected by the current net worth and payment capacity of the borrower or of any collateral pledged. Substandard assets include those characterized by the distinct possibility that we will sustain some loss if the deficiencies are not corrected. Assets classified as doubtful have all the weaknesses inherent in those classified substandard with the added characteristic that the weaknesses present make collection or liquidation in full highly questionable and improbable, on the basis of currently existing facts, conditions and values. Assets classified as loss are those considered uncollectible and of such little value that their continuance as assets without the establishment of a specific loss reserve is not warranted.

When we classify problem assets as either substandard or doubtful, we may establish a specific allowance in an amount we deem prudent. General allowances represent loss allowances that have been established to recognize the inherent risk associated with lending activities, but unlike specific allowances, have not been specifically allocated to particular problem assets. When an insured institution classifies problem assets as a loss, it is required to charge-off those assets in the period in which they are deemed uncollectible. Our determinations as to the classification of our assets and the amount of our valuation allowances are subject to review by the FDIC and the DFI that can order the establishment of additional loss allowances or the charge-off of specific loans against established loss reserves. Assets that do not currently expose us to sufficient risk to warrant classification in one of the aforementioned categories but possess weaknesses are designated as special mention. At December 31, 2019, special mention loans totaled $15.7 million including a $12.5 million construction/land loan that was technically in default and classified as impaired. The Bank is closely monitoring the loan, however, it is well collateralized and the Bank does not expect to incur a loss. At December 31, 2019, the loan was current on its payments and was in compliance with the original loan terms.
 
In connection with the filing of periodic reports with the FDIC and in accordance with our loan policy, we regularly review the problem loans in our portfolio to determine whether any loans require classification in accordance with applicable regulations. The decrease in our classified loans during the year ended December 31, 2019 was a result of loan repayments as well as our efforts to work with our borrowers to bring their loans current when possible or restructure the loan when appropriate. During 2019, we continued our aggressive approach to reduce nonperforming assets and improve asset quality.

Classified loans consisting solely of substandard loans, were as follows at the dates indicated:
 
December 31,
 
2019
 
2018
 
(In thousands)
One-to-four family residential
$
629

 
$
919

Commercial real estate
—

 
326

Consumer
—

 
44

Total classified loans
$
629

 
$
1,289


17

 
With the exception of these substandard loans, of which $95,000 were accounted for as nonaccrual loans at December 31, 2019, management is not aware of any loans as of December 31, 2019, where the known credit problems of the borrower would cause us to have serious doubts as to the ability of such borrowers to comply with their present loan repayment terms and which may result in the future inclusion of such loans in the nonperforming loan categories.
 
Allowance for Loan Losses. Management recognizes that loan losses may occur over the life of a loan and that the ALLL must be maintained at a level necessary to absorb specific losses on impaired loans and probable losses inherent in the loan portfolio. Our methodology for analyzing the ALLL consists of two components: general and specific allowances. The general allowance is determined by applying factors to our various groups of loans. Management considers factors such as charge-off history, the prevailing economy, the borrower’s ability to repay, the regulatory environment, competition, geographic and loan type concentrations, policy and underwriting standards, nature and volume of the loan portfolio, managements’ experience level, our loan review and grading systems, the value of underlying collateral, and the level of problem loans in assessing the ALLL. The specific allowance component is created when management believes that the collectability of a specific loan has been impaired and a loss is probable. The specific reserves are computed using current appraisals, listed sales prices and other available information, less costs to complete, if any, and costs to sell the property. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available or as future events differ from predictions. In addition, specific reserves may be created upon a loan’s restructuring, based on a discounted cash flow analysis comparing the present value of the anticipated repayments under the restructured terms to the outstanding principal balance of the loan.
 
Quarterly, our Board of Directors’ Internal Asset Review Committee reviews and recommends approval of the allowance for loan losses and any provision or recapture of provision for loan losses, and the full Board of Directors approves the provision or recapture after considering the Committee’s recommendation. The allowance is increased by the provision for loan losses which is charged against current period earnings. If the analysis of our loan portfolio indicates the risk of loss is less than the balance of the ALLL, a recapture of provision of loan loss is added to current period earnings.

For the year ended December 31, 2019, we recorded a $300,000 recapture of provision for loan losses from our ALLL, as compared to a $4.0 million recapture of provision for loan losses for the year ended December 31, 2018. The recapture of provision for loan losses in 2019 was primarily a result of a single $12.5 million construction/land loan that was technically in default and classified as impaired, however, the Bank’s impairment analysis concluded that there were no anticipated losses from the loan, therefore funds previously allocated in the ALLL were recaptured. Partially offsetting the amount of the recapture was the ALLL increase required as a result of an $84.8 million increase in total loans receivable. The quality of our loan portfolio was stable in 2019, with decreases in TDRs and nonperforming loans, partially due to improved economic conditions as well as our efforts working with our borrowers to bring their loan payments current whenever possible. The ALLL was $13.2 million, or 1.18% of total loans at December 31, 2019, as compared to $13.3 million, or 1.29% at December 31, 2018. The level of the ALLL is based on estimates and the ultimate losses may vary from the estimates. Management reviews the adequacy of the ALLL on a quarterly basis.
 
A loan is considered impaired when, based on current information and events, it is probable we will be unable to collect the scheduled payments of principal or interest when due, according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, market conditions, rent rolls, and the borrower’s and guarantor’s, if any, financial strength. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and shortfalls on a case‑by‑case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including length of the delay, the reasons for the delay, the borrower’s prior payment record and the amounts of the shortfall in relation to the principal and interest owed. Loans are evaluated for impairment on a loan-by-loan basis. As of December 31, 2019 and 2018, impaired loans were $20.0 million and $10.1 million, respectively. The increase in 2019 was primarily due to the $12.5 million construction/land loan discussed above. At December 31, 2019, the loan was current on its payments, no longer in technical default, and considered to be well collateralized. There was $3.1 million committed to be advanced on this loan at that date.

18

The following table summarizes the distribution of the ALLL by loan category, at the dates indicated.
 
December 31,
 
2019
 
2018
 
2017
 
2016
 
2015
 
Loan
Balance
 
Allowance
 by Loan Category
 
Percent of Loans
to Total Loans
 
Loan
Balance
 
Allowance
 by Loan Category
 
Percent of Loans
to Total Loans
 
Loan
Balance
 
Allowance
 by Loan Category
 
Percent of Loans
to Total Loans
 
Loan
Balance
 
Allowance
 by Loan Category
 
Percent of Loans
to Total Loans
 
Loan
Balance
 
Allowance
 by Loan Category
 
Percent of Loans
to Total Loans
Real estate:
(Dollars in thousands)
  One-to-four family
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
     residential
$
372,528

 
$
3,034

 
33.2
%
 
$
341,966

 
$
3,387

 
33.0
%
 
$
278,655

 
$
2,837

 
27.8
%
 
$
249,435

 
$
2,551

 
30.1
%
 
$
253,772

 
$
3,028

 
36.4
%
  Multifamily
172,915

 
1,607

 
15.4

 
169,355

 
1,680

 
16.3

 
184,902

 
1,820

 
18.5

 
123,250

 
1,199

 
14.9

 
122,747

 
1,193

 
17.6

  Commercial real
     estate
395,152

 
4,559

 
35.2

 
373,798

 
4,777

 
36.0

 
361,299

 
4,418

 
36.0

 
303,694

 
3,893

 
36.7

 
244,211

 
3,395

 
35.0

Construction/land
113,665

 
2,222

 
10.1

 
108,854

 
2,331

 
10.5

 
145,618

 
2,816

 
14.5

 
136,922

 
2,792

 
16.5

 
62,103

 
1,193

 
8.9

Total real estate
1,054,260

 
11,422

 
93.9

 
993,973

 
12,175

 
95.8

 
970,474

 
11,891

 
96.8

 
813,301

 
10,435

 
98.2

 
682,833

 
8,809

 
97.9

Business
37,779

 
1,140

 
3.4

 
30,486

 
936

 
3.0

 
23,087

 
694

 
2.3

 
7,938

 
237

 
1.0

 
7,604

 
229

 
1.1

Consumer
30,199

 
656

 
2.7

 
12,970

 
236

 
1.2

 
9,133

 
297

 
0.9

 
6,922

 
279

 
0.8

 
6,979

 
425

 
1.0

Total
$
1,122,238

 
$
13,218

 
100.0
%
 
$
1,037,429

 
$
13,347

 
100.0
%
 
$
1,002,694

 
$
12,882

 
100.0
%
 
$
828,161

 
$
10,951

 
100.0
%
 
$
697,416

 
$
9,463

 
100.0
%



19

We believe that the ALLL as of December 31, 2019 was adequate to absorb the probable and inherent losses in the loan portfolio at that date. While we believe the estimates and assumptions used in our determination of the adequacy of the ALLL are reasonable, there can be no assurance that such estimates and assumptions will be proven correct in the future, or that the actual amount of future provisions will not exceed the amount of past provisions, or that any increased provisions that may be required will not adversely impact our financial condition and results of operations. Future additions to the ALLL may become necessary based upon changing economic conditions, the level of problem loans, business conditions, credit concentrations, increased loan balances or changes in the underlying collateral of the loan portfolio. In addition, the determination of the amount of the ALLL is subject to review by bank regulators as part of the routine examination process that may result in the establishment of additional loss reserves or the charge-off of specific loans against established loss reserves based upon their judgment of information available to them at the time of their examination.

The following table sets forth an analysis of our ALLL at the dates and for the periods indicated.
 
At or For the Year Ended December 31,
 
2019
 
2018
 
2017
 
2016
 
2015
 
(Dollars in thousands)
ALLL at beginning of period
$
13,347

 
$
12,882

 
$
10,951

 
$
9,463

 
$
10,491

(Recapture of provision) provision for loan losses
(300
)
 
(4,000
)
 
(400
)
 
1,300

 
(2,200
)
Charge-offs:
 
 
 
 
 
 
 
 
 

   One-to-four family residential
—

 
—

 
—

 
—

 
(27
)
   Multifamily
—

 
—

 
—

 
—

 
(281
)
   Consumer
—

 
—

 
—

 
(83
)
 
(54
)
Total charge-offs
—

 
—

 
—

 
(83
)
 
(362
)
Total recoveries
171

 
4,465

 
2,331

 
271

 
1,534

Net recoveries (charge-offs)
171

 
4,465

 
2,331

 
188

 
1,172

ALLL at end of period
$
13,218

 
$
13,347

 
$
12,882

 
$
10,951

 
$
9,463

 
 
 
 
 
 
 
 
 
 
ALLL as a percent of total loans
1.18
 %
 
1.29
 %
 
1.28
 %
 
1.32
 %
 
1.36
 %
Net recoveries to average loans receivable
(0.02
)
 
(0.45
)
 
(0.27
)
 
(0.02
)
 
(0.18
)
ALLL as a percent of nonperforming loans
13,913.68
 %
 
1,774.87
 %
 
7,196.65
 %
 
1,276.34
 %
 
872.17
 %

Investment Activities

General. Under Washington State law, commercial banks are permitted to invest in various types of liquid assets, including U.S. Treasury obligations, securities of various federal agencies, certain certificates of deposit of insured banks and savings institutions, banker’s acceptances, repurchase agreements, federal funds, commercial paper, investment grade corporate debt securities, and obligations of states and their political sub-divisions.

The Investment, Asset/Liability Committee (“ALCO”), consisting of the Chief Executive Officer, Chief Financial Officer, and Controller of First Financial Northwest Bank, other members of management and the Board of Directors, has the authority and responsibility to administer our investment policy, monitor portfolio strategies, and recommend appropriate changes to policy and strategies to the Board of Directors. On a monthly basis, management reports to the Board a summary of investment holdings with respective market values and all purchases and sales of investment securities. The Chief Financial Officer has the primary responsibility for the management of the investment portfolio and considers various factors when making decisions, including the marketability, maturity, liquidity, and tax consequences of proposed investments. The maturity structure of investments will be affected by various market conditions, including the current and anticipated slope of the yield curve, the level of interest rates, the trend of new deposit inflows, and the anticipated demand for funds via deposit withdrawals and loan originations and purchases.

The general objectives of the investment portfolio are to provide liquidity when loan demand is high, to assist in maintaining earnings when loan demand is low, and to maximize earnings while satisfactorily managing risk, including credit risk, reinvestment risk, liquidity risk and interest rate risk.

At December 31, 2019, our investment portfolio consisted principally of mortgage-backed securities, municipal bonds, U.S. government agency obligations, and corporate bonds. From time to time, investment levels may increase or decrease depending upon yields available on investment opportunities and management’s projected demand for funds for loan originations, net deposit

20

flows, and other activities. At December 31, 2019, we did not hold securities of any single issuer (other than government-sponsored entities) that exceeded 10% of our shareholders’ equity. We currently do not have any investments held to maturity or for trading.

Other than our utilization of interest rate swaps, we do not currently participate in other hedging programs, stand-alone contracts for interest rate caps or floors or other activities involving the use of off-balance sheet derivative financial instruments, however, these options are evaluated on occasion. As of December 31, 2019, we had three interest rate swaps with an aggregate notional amount of $75.0 million and a fair value of $426,000. For additional information, see Item 1A. Risk Factors -“If interest rate swaps we entered into prove ineffective, it could result in volatility in our operating results, including potential loses, which could have a material adverse effect on our results of operations and cash flows,” Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Asset and Liability Management,” and Note 10 of the Notes to Consolidated Financial Statements contained in Item 8 of this report.

Mortgage-Backed Securities. The mortgage-backed securities in our portfolio were primarily comprised of Fannie Mae, Freddie Mac, and Ginnie Mae issued mortgage-backed securities. These issuers guarantee the timely payment of principal and interest in the event of default. In addition, at December 31, 2019, our mortgage-backed securities included $11.4 million of other “private label” mortgage-backed securities. The mortgage-backed securities portfolio had a weighted-average yield of 3.04% at December 31, 2019.

U.S. Government Agency Obligations. The agency securities in our portfolio were comprised of Fannie Mae, Freddie Mac, Ginnie Mae, U.S. Small Business Administration (“SBA”) and FHLB agency securities. These issuers guarantee the timely payment of principal and interest in the event of default. At December 31, 2019, the portfolio of government agency securities had a weighted-average yield of 4.26%.

The guarantees of the SBA, as a U.S. government agency and Ginnie Mae, as part of a U.S. government agency are backed by the full faith and credit of the United States. Fannie Mae, Freddie Mac, and the Federal Home Loan Banks are U.S. government-sponsored entities. Although their guarantees are not backed by the full faith and credit of the United States, they may borrow from the U.S. Treasury, which has taken other steps to ensure these U.S. government-sponsored entities can fulfill their financial obligations.
Corporate Bonds. The corporate bond portfolio was primarily comprised of variable rate securities issued by various financial institutions. At December 31, 2019, the corporate bond portfolio had a weighted-average yield of 5.82%.
Municipal Bonds. The municipal bond portfolio is comprised of tax-exempt municipal bonds. The pre-tax weighted-average yield on the municipal bond portfolio was 2.78% at December 31, 2019.
Federal Home Loan Bank Stock. As a member of the FHLB Des Moines, we are required to own capital stock. The required amount of capital stock is based on a percentage of our previous year-end assets and our outstanding FHLB advances. The redemption of any excess stock we hold is at the discretion of the FHLB Des Moines. During 2019, our FHLB of Des Moines stock holdings decreased by $301,000, primarily as a result of the $8.8 million decrease in our FHLB advances during 2019. The carrying value of our FHLB of Des Moines stock totaled $7.0 million at December 31, 2019. During the years ended December 31, 2019 and 2018, we received FHLB of Des Moines cash dividends of $362,000 and $458,000, respectively.
    
    

21

The following table sets forth the composition of our investment portfolio at the dates indicated.
 
December 31,
 
2019
 
2018
 
2017
 
Amortized
Cost
 
Fair
Value
 
Amortized
Cost
 
Fair
Value
 
Amortized Cost
 
Fair
 Value
 
(In thousands)
Available-for-sale:
 
 
 
 
 
 
 
 
 
 
 
Mortgage-backed securities:
 
 
 
 
 
 
 
 
 
 
 
   Fannie Mae
$
15,605

 
$
15,629

 
$
24,276

 
$
23,643

 
26,961

 
26,564

   Freddie Mac
4,196

 
4,292

 
6,351

 
6,287

 
5,510

 
5,472

   Ginnie Mae
23,239

 
23,050

 
23,311

 
22,061

 
22,288

 
21,576

   Other
11,407

 
11,448

 
8,983

 
8,979

 
—

 
—

Municipal bonds
10,675

 
10,911

 
10,615

 
10,544

 
13,126

 
13,395

U.S. government agencies
46,672

 
45,750

 
48,190

 
47,438

 
43,088

 
42,633

Corporate bonds
25,500

 
25,521

 
23,490

 
23,218

 
22,502

 
22,602

Total available-for-sale
$
137,294

 
$
136,601

 
$
145,216

 
$
142,170

 
133,475

 
132,242


At December 31, 2019, 2018, and 2017, there were no investments held to maturity.

During the year ended December 31, 2019, gross proceeds from the call, maturity and sale of investments was $14.3 million, with net realized gains of $151,000.

Management reviews investment securities on an ongoing basis for the presence of other than temporary impairment (“OTTI”) or permanent impairment, taking into consideration current market conditions, fair value in relationship to cost, extent and nature of the change in fair value, issuer rating changes and trends, whether management intends to sell a security or if it is likely that we will be required to sell the security before recovery of the amortized cost basis of the investment, which may be maturity, and other factors. For debt securities, if management intends to sell the security or it is likely that we will be required to sell the security before recovering its cost basis, the entire impairment loss would be recognized in earnings as an OTTI. If management does not intend to sell the security and it is not likely that we will be required to sell the security, but management does not expect to recover the entire amortized cost basis of the security, only the portion of the impairment loss representing credit losses would be recognized in earnings. The credit loss on a security is measured as the difference between the amortized cost basis and the present value of the cash flows expected to be collected. Projected cash flows are discounted by the original or current effective interest rate, depending on the nature of the security being measured for potential OTTI. The remaining impairment related to all other factors, the difference between the present value of the cash flows expected to be collected and fair value, is recognized as a charge to other comprehensive income (loss). Impairment losses related to all other factors are presented as separate categories within other comprehensive income (loss). There were no losses related to OTTI at December 31, 2019 and 2018. For additional information regarding our investments, see Note 3 of the Notes to Consolidated Financial Statements contained in Item 8 of this report.


22

The table below sets forth information regarding the carrying value and weighted-average yield by contractual maturity of our investment portfolio at December 31, 2019. Mortgage-backed securities are presented in the totals column as a result of the variable nature of their principal reductions.
 
December 31, 2019
 
Within One Year
 
After One Year
Through Five Years
 
After Five
Through Ten Years
 
Thereafter
 
Totals
 
Carrying
Value
 
Weighted-
Average
Yield
 
Carrying
Value
 
Weighted-
Average
Yield
 
Carrying
Value
 
Weighted-
Average
Yield
 
Carrying
Value
 
Weighted-
Average
Yield
 
Carrying
Value
 
Weighted-
Average
Yield
 
(Dollars in thousands)
Available-for-sale:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Mortgage-backed securities
$
—

 
—
%
 
$
—

 
—
%
 
$
—

 
—
%
 
$
—

 
—
%
 
$
54,419

 
3.04
%
Municipal bonds
—

 
—

 
—

 
—

 
1,163

 
2.31

 
9,748

 
2.83

 
10,911

 
2.78

U.S. government agencies
498

 
2.58

 
613

 
2.91

 
50

 
5.77

 
44,589

 
3.20

 
45,750

 
4.26

Corporate bonds
—

 
—

 
6,125

 
11.38

 
17,400

 
4.16

 
1,996

 
3.73

 
25,521

 
5.82

Total available-for-sale
$
498

 
2.58
%
 
$
6,738

 
10.60
%
 
$
18,613

 
4.06
%
 
$
56,333

 
3.16
%
 
$
136,601

 
3.95
%



23

Deposit Activities and Other Sources of Funds

General. Deposits and loan repayments are the major sources of our funds for lending and other investment purposes. Scheduled loan repayments are a relatively stable source of funds, while deposit inflows and outflows and loan prepayments are influenced significantly by general interest rates and market conditions. Borrowings from the FHLB are used to supplement the availability of funds from other sources and also as a source of term funds to assist in the management of interest rate risk.

Our deposit composition reflects a mixture of various deposit products. We rely on marketing activities, customer service, and the availability of a broad range of products and services to attract and retain customer deposits.

Deposits. We offer a competitive range of deposit products within our market area, including noninterest bearing accounts, interest-bearing demand accounts, money market accounts, statement savings accounts, and certificates of deposit. Deposit account terms vary according to the minimum balance required, the time periods the funds must remain on deposit, and the interest rate, among other factors. In determining the terms of our deposit accounts, we consider the development of long-term profitable customer relationships, current market interest rates, current maturity structures, deposit mix, our customer preferences, and the profitability of acquiring customer deposits compared to alternative funding sources. As part of our strategy to shift our deposit mix to lower cost funds, we continued to better align our pricing with competitors in our local market to meet our goals. To supplement local deposits, funds are also generated through national brokered certificates of deposit. At December 31, 2019, $94.5 million, or 9.1% of total deposits were brokered certificates of deposit, with remaining maturities ranging from one month to thirteen months. These funds cannot be withdrawn early except in the case of the death or adjudication of incompetence of the depositor. However, the Bank has a quarterly call option six months after issuance on $12.0 million of these brokered deposits that allows the Bank to close the certificate of deposit and return the deposit to the customer if the Bank determines it is in its best interest to do so. The long term nature of these brokered deposits, along with the enhanced features of these deposits as compared to retail certificates of deposit, assists us in our interest rate risk management efforts.

The following table sets forth our total deposit activity for the periods indicated.

 
Year Ended December 31,
 
2019
 
2018
 
2017
 
(In thousands)
Total deposits, beginning balance
$
939,032

 
$
839,502

 
$
717,476

Increase in retail deposits
97,855

 
77,193

 
122,026

(Decrease) increase in brokered funds
(3,353
)
 
22,337

 
—

Net increase in deposits
94,502

 
99,530

 
122,026

Total deposits, ending balance
$
1,033,534

 
$
939,032

 
$
839,502


At December 31, 2019, deposits totaled $1.0 billion. We had $352.4 million of jumbo (greater than or equal to $100,000) certificates of deposit, which were 34.1% of total deposits at December 31, 2019. Of these jumbo deposits, $130.6 million were greater than or equal to $250,000. At that date, included in the jumbo certificates of deposit, were public funds totaling $29.7 million, or 3.3% of total deposits, of which $31.5 million was in excess of the $250,000 standard FDIC insurance coverage. Under Washington State law, in order to participate in the public funds program, we are required to pledge eligible securities of a minimum of 50% of the public deposits in excess of $250,000.


24

The following table sets forth information regarding our certificates of deposit and other deposits at December 31, 2019.
Weighted-Average Interest Rate
 
Term
 
Category
 
Amount
 
Percentage
of Total
Deposits
(Dollars in thousands)
—
%
 
N/A
 
Noninterest bearing demand deposits
 
$
52,849

 
5.1
%
0.15

 
N/A
 
Interest-bearing demand
 
65,897

 
6.4

0.13

 
N/A
 
Statement savings
 
17,447

 
1.7

1.53

 
N/A
 
Money market
 
377,766

 
36.6

 
 
 
 
 
 
 
 
 
 

 
 
 
Certificates of deposit, retail
 
 
 
 
1.73

 
Three months or less
 
 
 
11,508

 
1.1

1.05

 
Over three through six months
 
 
 
1,354

 
0.1

1.62

 
Over six through twelve months
 
 
 
26,881

 
2.6

2.43

 
Over twelve months
 
 
 
385,388

 
37.3

 
 
 
 
Retail certificates of deposit, fair value adjustment
 
(28
)
 
—

2.36

 
 
 
Total certificates of deposit, retail
 
425,103

 
41.1

 
 
 
 
 
 
 
 
 
1.93

 
Over twelve months
 
Total certificates of deposit, brokered
 
94,472

 
9.1

 
 
 
 
 
 
 
 
 
 
 
 
 
Total deposits
 
$
1,033,534

 
100.0
%

Certificates of Deposit. The following table sets forth the amount and maturities of certificates of deposit at December 31, 2019.
 
Within
One Year
 
After One Year Through Two Years
 
After Two Years Through Three Years
 
After Three Years Through Four Years
 
Thereafter
 
Total
 
(In thousands)
0.00 - 1.00%
$
6,080

 
$
1,209

 
$
96

 
$
33

 
$
10

 
$
7,428

1.01 - 2.00%
139,001

 
46,632

 
8,988

 
4,345

 
2,796

 
201,762

2.01 - 3.00%
69,932

 
126,675

 
29,638

 
16,829

 
11,293

 
254,367

3.01 - 4.00%
7,062

 
10,701

 
8,356

 
29,013

 
914

 
56,046

Retail certificates
  of deposit, fair
  value adjustment
(16
)
 
(9
)
 
(3
)
 
—

 
—

 
(28
)
Total
$
222,059

 
$
185,208

 
$
47,075

 
$
50,220

 
$
15,013

 
$
519,575



25

The following table sets forth the amount of our jumbo certificates of deposit by remaining maturity as of December 31, 2019.

Maturity Period
 
Certificates of Deposit
 
 
(In thousands)
Three months or less
 
$
34,682

Over three months through six months
 
15,902

Over six months through twelve months
 
52,202

Over twelve months
 
249,574

Total
 
$
352,360


Deposit Flow. The following table sets forth the deposit balances by the types of accounts we offered at the dates indicated.

 
December 31,
 
2019
 
2018
 
2017
 
Amount
 
Percent of Total
 
Amount
 
Percent of Total
 
Amount
 
Percent of Total
 
(Dollars in thousands)
Noninterest bearing
$
52,849

 
5.1
%
 
$
46,108

 
4.9
%
 
$
45,434

 
5.4
%
Interest-bearing demand
65,897

 
6.4

 
40,079

 
4.3

 
38,224

 
4.5

Statement savings
17,447

 
1.7

 
24,799

 
2.6

 
28,456

 
3.4

Money market
377,766

 
36.6

 
339,047

 
36.1

 
318,636

 
38.0

Certificates of deposit, retail:
 
 
 
 
 
 
 
 
 
 
 
0.00 - 1.00%
7,428

 
0.7

 
15,790

 
1.7

 
79,323

 
9.4

1.01 - 2.00%
131,252

 
12.7

 
191,294

 
20.4

 
247,517

 
29.5

2.01 - 3.00%
230,405

 
22.3

 
131,328

 
14.0

 
6,531

 
0.8

3.01 - 4.00%
56,046

 
5.4

 
52,820

 
5.6

 
—

 
—

Retail certificates of deposit, fair value adjustment
(28
)
 
—

 
(58
)
 
—

 
(107
)
 
—

Total certificates of deposit, retail
425,103

 
41.1

 
391,174

 
41.7

 
333,264

 
39.7

Certificates of deposit, brokered
 
 
 
 
 
 
 
 
 
 
 
0.00 - 1.00%
—

 
—

 
121

 
—

 
1,038

 
0.1

1.01 - 2.00%
70,510

 
6.8

 
43,221

 
4.6

 
68,965

 
8.2

2.01 - 3.00%
23,962

 
2.3

 
45,835

 
4.9

 
5,485

 
0.7

3.01 - 4.00%
—

 
—

 
8,648

 
0.9

 
—

 
—

Total certificates of deposit, brokered
94,472

 
9.1

 
97,825

 
10.4

 
75,488

 
9.0

Total deposits
$
1,033,534

 
100.0
%
 
$
939,032

 
100.0
%
 
$
839,502

 
100.0
%

Borrowings. Customer deposits are the primary source of funds for our lending and investment activities. We use advances from the FHLB and to a lesser extent federal funds (“Fed Funds”) purchased to supplement our supply of lendable funds, to meet short-term deposit withdrawal requirements and to provide longer term funding to better match the duration of selected loan and investment maturities. In addition, at December 31, 2019, we had supplemental funding sources of $80.1 million available at the FRB and $35.0 million available between two other financial institutions.

As a member of the FHLB, we are required to own capital stock in the FHLB and are authorized to apply for advances on the security of that stock and certain of our mortgage loans, provided that certain creditworthiness standards have been met.

26

Advances are individually made under various terms pursuant to several different credit programs, each with its own interest rate and range of maturities. Depending on the program, limitations on the amount of advances are based on the financial condition of the member institution and the adequacy of collateral pledged to secure the credit. We maintain a credit facility with the FHLB that provides for immediately available advances, subject to acceptable collateral. At December 31, 2019, our remaining FHLB credit capacity was $451.0 million and outstanding advances from the FHLB totaled $137.7 million.

The following table sets forth information regarding FHLB advances at the end of and during the periods indicated. The table includes both long- and short-term borrowings.
 
At or for the Year Ended December 31,
 
2019
 
2018
 
2017
 
(Dollars in thousands)
Maximum amount of borrowings outstanding at any month end
$
184,500

 
$
224,000

 
$
231,500

Average borrowings outstanding
129,899

 
183,667

 
192,227

Average rate paid during the year
2.09
%
 
1.92
%
 
1.30
%
Balance outstanding at end of the year
$
137,700

 
$
146,500

 
$
216,000

Weighted-average rate paid at end of the year
1.84
%
 
2.62
%
 
1.60
%

Subsidiaries and Other Activities

First Financial Northwest, Inc. First Financial Northwest has two wholly-owned subsidiaries, First Financial Northwest Bank and First Financial Diversified Corporation. First Financial Diversified Corporation held a small portfolio of loans during 2019, however, these loans were paid in full as of December 31, 2019.

First Financial Northwest Bank. First Financial Northwest Bank is a community-based commercial bank. The Bank primarily serves the greater Puget Sound region of King and to a lesser extent, Pierce, Snohomish and Kitsap Counties, Washington through our full-service banking office in Renton, Washington and eleven additional branches in King and Snohomish Counties, Washington. We are in the business of attracting deposits from the public and utilizing those deposits to originate loans.

Competition

The Bank operates in the highly competitive Puget Sound region of Western Washington. We face competition in originating loans and attracting deposits within our geographic market area. The competitive environment is impacted by changes in the regulatory environment, technology and product delivery systems as well as consolidation in the industry creating larger, more diversified competitors. We compete by consistently delivering high-quality personal service to our customers seeking to achieve a high level of customer satisfaction.

The Bank attracts deposits primarily through its branch office system. The competition is primarily from commercial banks, savings institutions and credit unions in the same geographic area. Based on the most current FDIC market share data dated June 30, 2019, the top five banks in the Seattle-Tacoma-Bellevue metropolitan statistical area (comprised of Bank of America, Wells Fargo, JP Morgan Chase, US Bancorp and KeyBank) controlled 72% of the deposit market. In addition to the FDIC insured competitors, credit unions, insurance companies and brokerage firms also compete for consumer deposit relationships. According to FDIC statistical data, the Bank’s share of aggregate deposits in the market area is less than 1%.

Our competition for loans comes principally from commercial banks, mortgage brokers, thrift institutions, credit unions and finance companies. Several other financial institutions compete with us for banking business in our market area. These institutions have substantially more resources than the Bank and, as a result, are able to offer a broader range of services, such as trust departments and enhanced retail services. Among the advantages of some of these institutions are their ability to make larger loans, initiate extensive advertising campaigns, access lower cost funding sources, and allocate their investable assets in regions of highest yield and demand. The challenges posed by such large competitors may impact our ability to originate loans secure low cost deposits and establish product pricing levels that support our net interest margin goals that may limit our future growth and earnings potential.



27

Employees

At December 31, 2019, we had 158 full-time employees. Our employees are not represented by any collective bargaining group. We consider our employee relations to be good.

How We Are Regulated

The following is a brief description of certain laws and regulations that are applicable to First Financial Northwest and First Financial Northwest Bank. On March 31, 2015, First Financial Northwest converted from a registered savings and loan holding company to a bank holding company. As a bank holding company, First Financial Northwest is subject to examination and supervision by, and is required to file certain reports with, the FRB. First Financial Northwest also is subject to the rules and regulations of the SEC under the federal securities laws. First Financial Northwest Bank, which changed its charter from a Washington-chartered savings bank to a Washington-chartered commercial bank effective on February 11, 2016, is subject to regulation and oversight by the DFI, the applicable provisions of Washington law and by the regulations of the DFI adopted thereunder. First Financial Northwest Bank also is subject to regulation and examination by the FDIC, which insures its deposits to the maximum extent permitted by law.

The laws and regulations affecting depository institutions and their holding companies have changed significantly, particularly in connection with the enactment of the Dodd-Frank Act. Among other changes, the Dodd-Frank Act established the Consumer Financial Protection Bureau (“CFPB”) as an independent bureau of the Federal Reserve. The CFPB assumed responsibility for the implementation of the federal financial consumer protection and fair lending laws and regulations and has authority to impose new requirements.

In May 2018, the Economic Growth, Regulatory Relief and Consumer Protection Act (the “EGRRCPA”), was enacted to modify or remove certain financial reform rules and regulations, including some of those implemented under the Dodd-Frank Act. While the ECRRCPA maintains most of the regulatory structure established by the Dodd-Frank Act, it amends certain aspects of the regulatory framework for small depository institutions with assets of less than $10 billion and for large banks with assets of more than $50 billion.

The EGRRCPA, among other matters, expands the definition of qualified mortgages which may be held by a financial institution and simplifies the regulatory capital rules for financial institutions and their holding companies with total consolidated assets of less than $10 billion by instructing the federal banking regulators to establish a single “Community Bank Leverage Ratio” of between 8 and 10 percent. Any qualifying depository institution or its holding company that exceeds the “community bank leverage ratio” will be considered to have met generally applicable leverage and risk-based regulatory capital requirements and any qualifying depository institution that exceeds the new ratio will be considered to be “well capitalized” under the prompt corrective action rules.

The EGRRCPA also expands the category of holding companies that may rely on the Federal Reserve’s “Small Bank Holding Company and Savings and Loan Holding Company Policy Statement” by raising the maximum amount of assets a qualifying holding company may have from $1 billion to $3 billion. A major result of this change is to exclude most such holding companies from the minimum capital requirements of the Dodd-Frank Act. The Federal Reserve made this change effective August 30, 2018. In addition, the Act includes regulatory relief for community banks regarding regulatory examination cycles, call reports, mortgage disclosures and risk weights for certain high-risk commercial real estate loans.

The Company continues to assess how any new standards under the EGRRCPA will ultimately be applied to us or what specific impact that Act and the forthcoming implementing rules and regulations will have.

In addition, the laws and regulations governing us may be amended from time to time by the relevant legislative bodies and regulators. Any such legislative action or regulatory changes in the future could adversely affect us. We cannot predict whether any such changes may occur.

Regulation and Supervision of First Financial Northwest Bank

General. As a state-chartered commercial bank, First Financial Northwest Bank is subject to applicable provisions of Washington state law and regulations of the DFI in addition to federal law and regulations of the FDIC applicable to state banks that are not members of the Federal Reserve System. State law and regulations govern First Financial Northwest Bank’s ability to take deposits and pay interest, to make loans on or invest in residential and other real estate, to make consumer loans, to invest in securities, to offer various banking services to its customers and to establish branch offices. Under state law, commercial banks

28

in Washington also generally have all of the powers that federal commercial banks have under federal laws and regulations. First Financial Northwest Bank is subject to periodic examination by and reporting requirements of the DFI.

Insurance of Accounts and Regulation by the FDIC. First Financial Northwest Bank’s deposits are insured up to $250,000 per separately insured deposit ownership right or category by the Deposit Insurance Fund of the FDIC. As insurer, the FDIC imposes deposit insurance premiums and is authorized to conduct examinations of, and to require reporting by, FDIC-insured institutions. The FDIC also may prohibit any insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious risk to the deposit insurance fund. The FDIC also has the authority to initiate enforcement actions against commercial institutions and may terminate the deposit insurance if it determines that the institution has engaged in unsafe or unsound practices or is in an unsafe or unsound condition.

Under the FDIC’s rules, the assessment base for a bank is equal to its total average consolidated assets less average tangible equity capital. Currently, the FDIC’s base assessment rates are 3 to 30 basis points and are subject to certain adjustments. For institutions with less than $10 billion in assets, rates are determined based on supervisory ratings and certain financial ratios. No institution may pay a dividend if it is in default on its federal deposit insurance assessment. 

In addition, federally insured institutions have been required to pay a Financing Corporation (“FICO”) assessment in order to fund the interest on bonds issued to resolve thrift failures in the 1980s. The final assessment was collected in March 2019. In addition, previously issued small bank assessment credits of $282,000 were applied to our FDIC assessments paid during 2019, reducing the Bank’s FDIC and FICO expense for the year to $307,000.

The FDIC may terminate the deposit insurance of any insured depository institution, including First Financial Northwest Bank, if it determines after a hearing that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or any condition imposed by an agreement with the FDIC. It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance if the institution has no tangible capital. If insurance of accounts is terminated, the accounts at the institution at the time of the termination, less subsequent withdrawals, shall continue to be insured for a period of six months to two years, as determined by the FDIC. We are not aware of any practice, condition or violation that might lead to termination of First Financial Northwest Bank’s deposit insurance.

A significant increase in insurance premiums would likely have an adverse effect on the operating expenses and results of operations of the Bank. There can be no prediction as to what changes in insurance assessment rates may be made in the future.

Standards for Safety and Soundness. The federal banking regulatory agencies have prescribed, by regulation, guidelines for all insured depository institutions relating to: internal controls, information systems and internal audit systems, loan documentation, credit underwriting, interest rate risk exposure, asset growth, asset quality, earnings and compensation, fees and benefits. The guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired. Each insured depository institution must implement a comprehensive written information security program that includes administrative, technical and physical safeguards appropriate to the institution’s size and complexity and the nature and scope of its activities. The information security program also must be designed to ensure the security and confidentiality of customer information, protect against any unanticipated threats or hazards to the security or integrity of such information, protect against unauthorized access to or use of such information that could result in substantial harm or inconvenience to any customer and ensure the proper disposal of customer and consumer information. Each insured depository institution must also develop and implement a risk-based response program to address incidents of unauthorized access to customer information in customer information systems. If the FDIC determines that an institution fails to meet any of these guidelines, it may require an institution to submit to the FDIC an acceptable plan to achieve compliance. We are not aware of any conditions relating to these safety and soundness standards that would require submission of a plan of compliance by First Financial Northwest Bank.

Capital Requirements. Federally insured financial institutions, such as First Financial Northwest Bank, and their holding companies, are required to maintain a minimum level of regulatory capital.

First Financial Northwest Bank is subject to capital regulations adopted by the FDIC, which establish minimum required ratios for common equity Tier 1 capital (“CET1”), Tier 1 capital and total capital, and the leverage ratio; set out risk-weights for assets and certain off-balance sheet items for purposes of the risk-based capital ratios, require an additional capital conservation buffer over the minimum risk-based ratios’ and define what qualifies as capital for purposes of meeting the capital requirements. These regulations implement the regulatory capital reforms required by the Dodd-Frank Act and the “Basel III” requirements. First Financial Northwest was also subject to the parallel regulations of the Federal Reserve until August 30, 2018, pursuant to the EGRRCPA as discussed above.

29


Under the capital regulations, the minimum capital ratios are: (1) a CET1 capital ratio of 4.5% of risk-weighted assets; (2) a Tier 1 capital ratio of 6.0% of risk-weighted assets; (3) a total risk-based capital ratio of 8.0% of risk-weighted assets; and (4) a leverage ratio (the ratio of Tier 1 capital to average total adjusted assets) of 4.0%. CET1 generally consists of common stock, retained earnings, accumulated other comprehensive income (“AOCI”) unless an institution has elected to exclude AOCI from regulatory capital, and certain minority interests, all subject to applicable regulatory adjustments and deductions. Tier 1 capital generally consists of CET1 and noncumulative perpetual preferred stock. Tier 2 capital generally consists of other preferred stock and subordinated debt meeting certain conditions plus an amount of the allowance for loan and lease losses up to 1.25% of assets. Total capital is the sum of Tier 1 and Tier 2 capital.

Mortgage servicing assets and deferred tax assets over designated percentages of CET1 are deducted from capital. In addition, Tier 1 capital includes AOCI, which includes all unrealized gains and losses on available for sale debt and equity securities. However, because of our asset size, we were eligible for the one-time option of permanently opting out of the inclusion of unrealized gains and losses on available for sale debt and equity securities in our capital calculations. We elected this option in the first quarter of 2015.

For purposes of determining risk-based capital, assets and certain off-balance sheet items are risk-weighted from 0% to 1,250%, depending on the risk characteristics of the asset or item. These risk weights include, for example, a 150% risk weight for certain high volatility commercial real estate acquisition, development and construction loans and for non‑residential mortgage loans that are 90 days past due or otherwise in nonaccrual status; and a 20% credit conversion factor for the unused portion of a commitment with an original maturity of one year or less that is not unconditionally cancellable.

In addition to the minimum CET1, Tier 1, and total capital ratios, the capital regulations require a capital conservation buffer consisting of additional CET1 capital greater than 2.5% of risk-weighted assets above the required minimum levels in order to avoid limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses.
 
To be considered “well capitalized,” a depository institution must have a Tier 1 risk-based capital ratio of at least 8%, a total risk-based capital ratio of at least 10%, a CET1 capital ratio of at least 6.5% and a leverage ratio of at least 5%, and not be subject to an individualized order, directive or agreement under which its primary federal banking regulator requires it to maintain a specific capital level. As of December 31, 2019, First Financial Northwest Bank met the requirements to be “well capitalized” and met the fully phased-in capital conservation buffer requirement. Effective January 1, 2020, a bank that elects to use the Community Bank Leverage Ratio will generally be considered well-capitalized and to have met the risk-based and leverage capital requirements of the capital regulations if it has a leverage ratio greater than 9.0%. To be eligible to elect the Community Bank Leverage Ratio, the bank also must have total consolidated assets of less than $10 billion, off-balance sheet exposures of 25% or less of its total consolidated assets, and trading assets and trading liabilities of 5.0% or less of its total consolidated assets, all as of the end of the most recent quarter. Although the Bank qualifies to make this election, at December 31, 2019, management does not intend to elect the Community Bank Leverage Ratio as the Bank’s margin above the current minimum levels to be well-capitalized is greater than our margin would be under the Community Bank Leverage Ratio.
    
    

30

The table below sets forth First Financial Northwest Bank’s capital position at December 31, 2019 and 2018, based on FDIC thresholds to be well-capitalized.
 
December 31,
 
2019
 
2018
 
Amount
 
Ratio
 
Amount
 
Ratio
 
(Dollars in thousands)
Bank equity capital under U.S. Generally Accepted Accounting Principles
  (“GAAP”)
$
135,656

 
 
 
$
128,008

 
 
 
 
 
 
 
 
 
 
Tier 1 leverage capital
$
135,170

 
10.27
%
 
$
128,257

 
10.37
%
Tier 1 leverage capital requirement
65,787

 
5.00

 
61,863

 
5.00

Excess
$
69,383

 
5.27
%
 
$
66,394

 
5.37
%
 
 
 
 
 
 
 
 
Common equity tier 1
$
135,170

 
13.13
%
 
$
128,257

 
13.43
%
Common equity tier 1 capital requirement
66,917

 
6.50

 
62,089

 
6.50

Excess
$
68,253

 
6.63
%
 
$
66,168

 
6.93
%
 
 
 
 
 
 
 
 
Tier 1 risk-based capital
$
135,170

 
13.13
%
 
$
128,257

 
13.43
%
Tier 1 risk-based capital requirement
82,359

 
8.00

 
76,417

 
8.00

Excess
$
52,811

 
5.13
%
 
$
51,840

 
5.43
%
 
 
 
 
 
 
 
 
Total risk-based capital
$
148,048

 
14.38
%
 
$
140,220

 
14.68
%
Total risk-based capital requirement
102,949

 
10.00

 
95,521

 
10.00

Excess
$
45,099

 
4.38
%
 
$
44,699

 
4.68
%

The FDIC also has authority to establish individual minimum capital requirements in appropriate cases upon a determination that an institution’s capital level is or may become inadequate in light of particular risks or circumstances. Management of First Financial Northwest Bank believes that, under the current regulations, First Financial Northwest Bank will continue to meet its minimum capital requirements into the foreseeable future.

For a complete description of First Financial Northwest Bank’s required and actual capital levels on December 31, 2019, see Note 13 of the Notes to Consolidated Financial Statements contained in Item 8 of this report.

The Financial Accounting Standards Board has adopted a new accounting standard for US Generally Accepted Accounting Principles that will be effective for us for our first fiscal year beginning after December 15, 2022. This standard, referred to as Current Expected Credit Loss, or CECL, requires FDIC-insured institutions and their holding companies (banking organizations) to recognize credit losses expected over the life of certain financial assets. CECL covers a broader range of assets than the current method of recognizing credit losses and generally results in earlier recognition of credit losses. Upon adoption of CECL, a banking organization must record a one-time adjustment to its credit loss allowances as of the beginning of the fiscal year of adoption equal to the difference, if any, between the amount of credit loss allowances under the current methodology and the amount required under CECL. For a banking organization, implementation of CECL is generally likely to reduce retained earnings, and to affect other items, in a manner that reduces its regulatory capital.

The federal banking regulators (the Federal Reserve, the Office of the Comptroller of the Currency and the FDIC) have adopted a rule that gives a banking organization the option to phase in over a three-year period the day-one adverse effects of CECL on its regulatory capital.

Prompt Corrective Action. Federal statutes establish a supervisory framework for FDIC-insured institutions based on five capital categories:  well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. An institution’s category depends upon where its capital levels are in relation to relevant capital measures. The well-capitalized category is described above. An institution that is not well capitalized is subject to certain restrictions on brokered deposits, including restrictions on the rates it can offer on its deposits, generally. To be considered adequately capitalized, an

31

institution must have the minimum capital ratios described above. Any institution which is neither well capitalized nor adequately capitalized is considered undercapitalized.

Undercapitalized institutions are subject to certain prompt corrective action requirements, regulatory controls and restrictions which become more extensive as an institution becomes more severely undercapitalized. Failure by First Financial Northwest Bank to comply with applicable capital requirements would, if unremedied, result in progressively more severe restrictions on its activities and lead to enforcement actions, including, but not limited to, the issuance of a capital directive to ensure the maintenance of required capital levels and, ultimately, the appointment of the FDIC as receiver or conservator. Banking regulators will take prompt corrective action with respect to depository institutions that do not meet minimum capital requirements. Additionally, approval of any regulatory application filed for their review may be dependent on compliance with capital requirements.

At December 31, 2019, First Financial Northwest Bank was categorized as “well capitalized” under the prompt corrective action regulations of the FDIC. For additional information, see Note 13 of the Notes to Consolidated Financial Statements contained in Item 8 of this report.

Federal Home Loan Bank System. First Financial Northwest Bank is a member of the FHLB of Des Moines, one of 11 regional FHLBs that administer the home financing credit function of savings institutions. The FHLBs are subject to the oversight of the Federal Housing Finance Agency (“FHFA”) and each FHLB serves as a reserve or central bank for its members within its assigned region. The FHLBs are funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB System and make loans or advances to members in accordance with policies and procedures established by the Board of Directors of the FHLB, which are subject to the oversight of the FHFA. All advances from the FHLB of Des Moines are required to be fully secured by sufficient collateral as determined by the FHLB of Des Moines. In addition, all long-term advances are required to provide funds for residential home financing. See “Business – Deposit Activities and Other Sources of Funds – Borrowings.”

At December 31, 2019, the Bank held $7.0 million in FHLB of Des Moines stock that was in compliance with the holding requirements. The Bank purchased 508 shares of additional membership stock in March 2019 as a result of the increase in assets as of December 31, 2018. In addition, a reduction in our outstanding advances at December 31, 2019 as compared to December 31, 2019, resulted in net decrease in activity stock of 3,520 shares. The FHLB pays dividends quarterly, and First Financial Northwest Bank received $362,000 in dividends during the year ended December 31, 2019.

The FHLBs continue to contribute to low- and moderately-priced housing programs through direct loans or interest subsidies on advances targeted for community investment and low- and moderate-income housing projects. These contributions have adversely affected the level of FHLB dividends paid and could continue to do so in the future. These contributions could also have an adverse effect on the value of FHLB of Des Moines stock in the future. A reduction in value of First Financial Northwest Bank’s FHLB of Des Moines stock may result in a decrease in net income and possibly capital.

Commercial Real Estate Lending Concentrations. The federal banking agencies have issued guidance on sound risk management practices for concentrations in commercial real estate lending. The particular focus is on exposure to commercial real estate loans that are dependent on the cash flow from the real estate held as collateral and that are likely to be sensitive to conditions in the commercial real estate market (as opposed to real estate collateral held as a secondary source of repayment or as an abundance of caution). The purpose of the guidance is not to limit a bank’s commercial real estate lending but to guide banks in developing risk management practices and capital levels commensurate with the level and nature of real estate concentrations. The guidance directs the FDIC and other federal bank regulatory agencies to focus their supervisory resources on institutions that may have significant commercial real estate loan concentration risk. A bank that has experienced rapid growth in commercial real estate lending, has notable exposure to a specific type of commercial real estate loan, or is approaching or exceeding the following supervisory criteria may be identified for further supervisory analysis with respect to real estate concentration risk:

•
Total reported loans for construction, land development and other land represent 100% or more of the bank’s total regulatory capital; or

•
Total commercial real estate loans (as defined in the guidance) represent 300% or more of the bank’s total regulatory capital and the outstanding balance of the bank’s commercial real estate loan portfolio has increased 50% or more during the prior 36 months.

The guidance provides that the strength of an institution’s lending and risk management practices with respect to such concentrations will be taken into account in supervisory guidance on evaluation of capital adequacy. As of December 31, 2019, First Financial Northwest Bank’s aggregate recorded loan balances for construction, land development and land loans were 81.9%

32

of regulatory capital. In addition, at December 31, 2019, First Financial Northwest Bank’s loans on commercial real estate, as defined by the FDIC, were 449.7% of regulatory capital.

Activities and Investments of Insured State-Chartered Financial Institutions. Federal law generally limits the activities and equity investments of FDIC-insured, state-chartered banks to those that are permissible for national banks. An insured state bank is not prohibited from, among other things, (1) acquiring or retaining a majority interest in a subsidiary, (2) investing as a limited partner in a partnership the sole purpose of which is direct or indirect investment in the acquisition, rehabilitation or new construction of a qualified housing project, provided that such limited partnership investments may not exceed 2% of the bank’s total assets, (3) acquiring up to 10% of the voting stock of a company that solely provides or reinsures directors’, trustees’ and officers’ liability insurance coverage or bankers’ blanket bond group insurance coverage for insured depository institutions and (4) acquiring or retaining the voting shares of a depository institution owned by another FDIC-insured institution if certain requirements are met.

Washington State has enacted a law regarding financial institution parity. Primarily, the law affords Washington state‑chartered commercial banks the same powers as Washington state-chartered savings banks and provides that Washington chartered commercial banks may exercise any of the powers that the Federal Reserve has determined to be closely related to the business of banking and the powers of national banks, subject to the approval of the Director of the DFI in certain situations. Finally, the law provides additional flexibility for Washington state-chartered commercial and savings banks with respect to interest rates on loans and other extensions of credit. Specifically, they may charge the maximum interest rate allowable for loans and other extensions of credit by federally-chartered financial institutions to Washington residents.

Environmental Issues Associated With Real Estate Lending. The Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA”) is a federal statute that generally imposes strict liability on all prior and present “owners and operators” of sites containing hazardous waste. However, Congress acted to protect secured creditors by providing that the term “owner and operator” excludes a person whose ownership is limited to protecting its security interest in the site. Since the enactment of the CERCLA, this “secured creditor exemption” has been the subject of judicial interpretations that have left open the possibility that lenders could be liable for cleanup costs on contaminated property that they hold as collateral for a loan. To the extent that legal uncertainty exists in this area, all creditors, including First Financial Northwest Bank, that have made loans secured by properties with potential hazardous waste contamination (such as petroleum contamination) could be subject to liability for cleanup costs that often are substantial and can exceed the value of the collateral property.

Federal Reserve System. The Federal Reserve requires that all depository institutions maintain reserves on transaction accounts and non-personal time deposits. These reserves may be in the form of cash or deposits with the regional Federal Reserve Bank. Interest-bearing demand accounts and other types of accounts that permit payments or transfers to third parties fall within the definition of transaction accounts and are subject to reserve requirements, as are any non-personal time deposits at a savings bank. As of December 31, 2019, First Financial Northwest Bank satisfied its reserve of $750,000 required by the FRB.

Affiliate Transactions. First Financial Northwest and First Financial Northwest Bank are separate and distinct legal entities. First Financial Northwest (and any non-bank subsidiary of First Financial Northwest) is an affiliate of First Financial Northwest Bank. Federal laws strictly limit the ability of banks to engage in certain transactions with their affiliates. Transactions deemed to be a “covered transaction” under Section 23A of the Federal Reserve Act and between a bank and an affiliate are limited to 10% of the bank’s capital and surplus and, with respect to all affiliates, to an aggregate of 20% of the bank’s capital and surplus. Further, covered transactions that are loans and extensions of credit generally are required to be secured by eligible collateral in specified amounts. Federal law also requires that covered transactions and certain other transactions listed in Section 23B of the Federal Reserve Act between a bank and its affiliates be on terms as favorable to the bank as transactions with nonaffiliates. For additional information, see “– Regulation and Supervision of First Financial Northwest – Limitations on Transactions with Affiliates” below.

In addition, Sections 22(g) and (h) of the Federal Reserve Act place restrictions on loans to executive officers, directors and principal shareholders. Under Section 22(h), loans to a director, executive officer or greater than 10% shareholder of a bank and certain affiliated interests, generally may not exceed, together with all other outstanding loans to such person and affiliated interests, 15% of the institution’s unimpaired capital and surplus. Section 22(h) also requires that loans to directors, executive officers and principal shareholders be made on terms substantially the same as offered in comparable transactions to other persons unless the loans are made pursuant to a benefit or compensation program that (1) is widely available to employees of the institution and (2) does not give preference to any director, executive officer or principal shareholder, or certain affiliated interests, over other employees of the bank. Section 22(h) also requires prior board approval for certain loans. In addition, the aggregate amount of extensions of credit by a bank to all insiders cannot exceed the bank’s unimpaired capital and surplus. Furthermore, Section 22(g) places additional restrictions on loans to executive officers. At December 31, 2019, First Financial Northwest Bank was in compliance with these restrictions.

33


Community Reinvestment Act. First Financial Northwest Bank is subject to the provisions of the Community Reinvestment Act of 1977 (“CRA”), which require the appropriate federal bank regulatory agency to assess a bank’s performance under the CRA in meeting the credit needs of the community serviced by the bank, including low and moderate income neighborhoods. The regulatory agency’s assessment of the bank’s record is made available to the public. Further, a bank’s CRA performance must be considered in connection with a bank’s application, to among other things, establish a new branch office that will accept deposits, relocate an existing office or merge or consolidate with, or acquire the assets or assume the liabilities of, a federally regulated financial institution. First Financial Northwest Bank received a “satisfactory” rating during its most recent CRA examination.

Dividends. The amount of dividends payable by First Financial Northwest Bank to First Financial Northwest depends upon First Financial Northwest Bank’s earnings and capital position, and is limited by federal and state laws, regulations and policies. According to Washington law, First Financial Northwest Bank may not declare or pay a cash dividend on its capital stock if it would cause its net worth to be reduced below (1) the amount required for liquidation accounts or (2) the net worth requirements, if any, imposed by the Director of the DFI. In addition, dividends may not be declared or paid if First Financial Northwest Bank is in default in payment of any assessments due to the FDIC. Dividends on First Financial Northwest Bank’s capital stock may not be paid in an aggregate amount greater than the aggregate retained earnings of First Financial Northwest Bank, without the approval of the Director of the DFI.

The amount of dividends actually paid during any one period is affected by First Financial Northwest Bank’s policy of maintaining a strong capital position. Federal law further restricts dividends payable by an institution that does not meet the capital conservation buffer requirement and provides that no insured depository institution may pay a cash dividend if it would cause the institution to be “undercapitalized,” as defined in the prompt corrective action regulations. Moreover, the federal bank regulatory agencies also have the general authority to limit the dividends paid by insured banks if such payments are deemed to constitute an unsafe and unsound practice.

Privacy Standards. First Financial Northwest Bank is subject to FDIC regulations implementing the privacy protection provisions of the Gramm-Leach-Bliley Financial Services Modernization Act of 1999. These regulations require First Financial Northwest Bank to disclose its privacy policy, including informing consumers of its information sharing practices and informing consumers of their rights to opt out of certain practices.

Anti-Money Laundering and Customer Identification.  The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (USA Patriot Act) was signed into law on October 26, 2001.  The USA PATRIOT Act and the Bank Secrecy Act requires financial institutions to develop programs to prevent financial institutions from being used for money laundering and terrorist activities. If such activities are detected, financial institutions are obligated to file suspicious activity reports with the U.S. Treasury’s Office of Financial Crimes Enforcement Network. These rules require financial institutions to establish procedures for identifying and verifying the identity of customers seeking to open new financial accounts, and, effective in 2018, the beneficial owners of accounts. Bank regulators are directed to consider a holding company’s effectiveness in combating money laundering when ruling on Bank Holding Company Act and Bank Merger Act applications.

Other Consumer Protection Laws and Regulations. The Dodd-Frank Act established the CFPB and empowered it to exercise broad regulatory, supervisory and enforcement authority with respect to both new and existing consumer financial protection laws. First Financial Northwest Bank is subject to consumer protection regulations issued by the CFPB, but as a financial institution with assets of less than $10 billion, First Financial Northwest Bank is generally subject to supervision and enforcement by the FDIC with respect to its compliance with federal consumer financial protection laws and CFPB regulations.

First Financial Northwest Bank is subject to a broad array of federal and state consumer protection laws and regulations that govern almost every aspect of its business relationships with consumers. While not exhaustive, these laws and regulations include the Truth-in-Lending Act, the Truth in Savings Act, the Electronic Fund Transfer Act, the Expedited Funds Availability Act, the Equal Credit Opportunity Act, the Fair Housing Act, the Real Estate Settlement Procedures Act, the Home Mortgage Disclosure Act, the Fair Credit Reporting Act, the Fair Debt Collection Practices Act, the Right to Financial Privacy Act, the Home Ownership and Equity Protection Act, the Consumer Leasing Act, the Fair Credit Billing Act, the Homeowners Protection Act, the Check Clearing for the 21st Century Act, laws governing flood insurance, laws governing consumer protections in connection with the sale of insurance, federal and state laws prohibiting unfair and deceptive business practices and various regulations that implement some or all of the foregoing. These laws and regulations mandate certain disclosure requirements and regulate the manner in which financial institutions must deal with customers when taking deposits, making loans, collecting loans and providing other services. Failure to comply with these laws and regulations can subject First Financial Northwest Bank to various penalties,

34

including but not limited to, enforcement actions, injunctions, fines, civil liability, criminal penalties, punitive damages and the loss of certain contractual rights.


Regulation and Supervision of First Financial Northwest

General. First Financial Northwest, as sole shareholder of First Financial Northwest Bank, is a bank holding company registered with the Federal Reserve. Bank holding companies are subject to comprehensive regulation by the Federal Reserve under the Bank Holding Company Act of 1956, as amended (“BHCA”), and the regulations of the FRB. Accordingly, First Financial Northwest is required to file semi-annual reports with the Federal Reserve and provide additional information as the Federal Reserve may require. The Federal Reserve may examine First Financial Northwest, and any of its subsidiaries, and charge First Financial Northwest for the cost of the examination. The Federal Reserve also has extensive enforcement authority over bank holding companies, including, among other things, the ability to assess civil money penalties, to issue cease and desist or removal orders and to require that a holding company divest subsidiaries (including its bank subsidiaries). In general, enforcement actions may be initiated for violations of law and regulations and unsafe or unsound practices. First Financial Northwest is also required to file certain reports with, and otherwise comply with the rules and regulations of the SEC.

The Bank Holding Company Act.  Under the BHCA, First Financial Northwest is supervised by the Federal Reserve. The Federal Reserve has a policy that a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary bank and may not conduct its operations in an unsafe or unsound manner. In addition, the Dodd-Frank Act and earlier Federal Reserve policy provide that a bank holding company should serve as a source of strength to its subsidiary bank by having the ability to provide financial assistance to its subsidiary bank during periods of financial distress to the bank. A bank holding company’s failure to meet its obligation to serve as a source of strength to its subsidiary bank will generally be considered by the Federal Reserve to be an unsafe and unsound banking practice or a violation of the Federal Reserve’s regulations or both. No regulations have yet been proposed by the Federal Reserve to implement the source of strength provisions required by the Dodd-Frank Act. First Financial Northwest and any subsidiaries that it may control are considered “affiliates” within the meaning of the Federal Reserve Act, and transactions between First Financial Northwest Bank and affiliates are subject to numerous restrictions. With some exceptions, First Financial Northwest and its subsidiaries are prohibited from tying the provision of various services, such as extensions of credit, to other services offered by First Financial Northwest or by its affiliates.

Acquisitions.  The BHCA prohibits a bank holding company, with certain exceptions, from acquiring ownership or control of more than 5% of the voting shares of any company that is not a bank or bank holding company and from engaging in activities other than those of banking, managing or controlling banks, or providing services for its subsidiaries. Under the BHCA, the Federal Reserve may approve the ownership of shares by a bank holding company in any company, the activities of which the Federal Reserve has determined to be so closely related to the business of banking or managing or controlling banks as to be a proper incident thereto. These activities include:  operating a savings institution, mortgage company, finance company, credit card company or factoring company; performing certain data processing operations; providing certain investment and financial advice; underwriting and acting as an insurance agent for certain types of credit-related insurance; leasing property on a full-payout, non-operating basis; selling money orders, travelers’ checks and U.S. Savings Bonds; real estate and personal property appraising; providing tax planning and preparation services; and, subject to certain limitations, providing securities brokerage services for customers. The Federal Reserve must approve the acquisition (or acquisition of control) of a bank or other FDIC-insured depository institution by a bank holding company, and the appropriate federal banking regulator must approve a bank’s acquisition (or acquisition of control) of another bank or other FDIC-insured institution.

Acquisition of Control of a Bank Holding Company. Under federal law, a notice or application must be submitted to the appropriate federal banking regulator if any person (including a company), or group acting in concert, seeks to acquire “control” of a bank holding company. An acquisition of control can occur upon the acquisition of 10% or more of the voting stock of a bank holding company or as otherwise defined by federal regulations. In considering such a notice or application, the Federal Reserve takes into consideration certain factors, including the financial and managerial resources of the acquirer and the anti-trust effects of the acquisition. Any company that acquires control becomes subject to regulation as a bank holding company. Depending on circumstances, a notice or application may be required to be filed with appropriate state banking regulators and may be subject to their approval or non-objection.

Regulatory Capital Requirements. As discussed above, pursuant to EGRRCPA, effective August 30, 2018, bank holding companies with less than $3 billion in consolidated assets were generally no longer subject to the Federal Reserve’s capital regulations, which are generally the same as the capital regulations applicable to First Financial Northwest Bank. At the time of this change, First Financial Northwest was considered “well capitalized” (as defined for a bank holding company), with a total risk-based capital ratio of 10.0% or more and a Tier 1 risk-based capital ratio of 8.0% or more, and was not subject to an individualized order, directive or agreement under which the Federal Reserve requires it to maintain a specific capital level.

35


Restrictions on Dividends. The Federal Reserve has issued a policy statement on the payment of cash dividends by bank holding companies which expresses its view that a bank holding company must maintain an adequate capital position and generally should not pay cash dividends unless the company’s net income for the past year is sufficient to fully fund the cash dividends and that the prospective rate of earnings appears consistent with the company’s capital needs, asset quality, and overall financial condition.  The Federal Reserve policy statement also indicates that it would be inappropriate for a company experiencing serious financial problems to borrow funds to pay dividends. For additional information, see Item 1.A. “Risk Factors – Certain regulatory restrictions are imposed on us and lack of compliance could result in monetary penalties and/or additional regulatory actions.” in this report.

Stock Repurchases.  A bank holding company, except for certain “well-capitalized” and highly rated bank holding companies, is required to give the Federal Reserve prior written notice of any purchase or redemption of its outstanding equity securities if the gross consideration for the purchase or redemption, when combined with the net consideration paid for all such purchases or redemptions during the preceding twelve months, is equal to 10% or more of its consolidated net worth. The Federal Reserve may disapprove such a purchase or redemption if it determines that the proposal would constitute an unsafe or unsound practice or would violate any law, regulation, Federal Reserve order or any condition imposed by, or written agreement with, the Federal Reserve. During the year ended December 31, 2019, First Financial Northwest repurchased 479,052 shares of its common stock.

Federal Securities Laws. First Financial Northwest’s common stock is registered with the SEC under Section 12(b) of the Securities Exchange Act of 1934, as amended (“Exchange Act”). We are subject to information, proxy solicitation, insider trading restrictions and other requirements under the Exchange Act.

The Dodd-Frank Act. Among other requirements, the Dodd-Frank Act requires public companies, like First Financial Northwest, to (i) provide their shareholders with a non-binding vote (a) at least once every three years on the compensation paid to executive officers and (b) at least once every six years on whether they should have a “say on pay” vote every one, two or three years; (ii) have a separate, non-binding shareholder vote regarding golden parachutes for named executive officers when a shareholder vote takes place on mergers, acquisitions, dispositions or other transactions that would trigger the parachute payments; (iii) provide disclosure in annual proxy materials concerning the relationship between the executive compensation paid and the financial performance of the issuer; and (iv) require companies to disclose the ratio of the Chief Executive Officer’s annual total compensation to the median annual total compensation of all other employees. For certain of these changes, the implementing regulations have not been promulgated, so the full impact of the Dodd-Frank Act on public companies cannot be determined at this time.

The federal banking agencies have issued final rules to implement the provisions of the Dodd-Frank Act commonly referred to as the Volcker Rule. The regulations contain prohibitions and restrictions on the ability of financial institutions holding companies and their affiliates to engage in proprietary trading and to hold certain interests in, or to have certain relationships with, various types of investment funds, including hedge funds and private equity funds. Management believes First Financial Northwest’s investment portfolio and investment strategies are in compliance with the various provisions of the Volcker Rule regulations.

Sarbanes-Oxley Act of 2002. As a public company that files periodic reports with the SEC under the Exchange Act, First Financial Northwest, is subject to the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley Act”), which addresses, among other issues, corporate governance, auditing and accounting, executive compensation, and enhanced and timely disclosure of corporate information. The Sarbanes-Oxley Act represents significant federal involvement in matters traditionally left to state regulatory systems, such as the regulation of the accounting profession, and to state corporate law, such as the relationship between a board of directors and management and between a board of directors and its committees. Our policies and procedures have been updated to comply with the requirements of the Sarbanes-Oxley Act.

Taxation

Federal Taxation

General. First Financial Northwest and First Financial Northwest Bank are subject to federal income taxation in the same general manner as other corporations, with some exceptions discussed below. The following discussion of federal taxation is intended only to summarize certain pertinent federal income tax matters and is not a comprehensive description of the tax rules applicable to First Financial Northwest or First Financial Northwest Bank. The tax years still open for review by the Internal Revenue Service are 2016 through 2019.


36

First Financial Northwest files a consolidated federal income tax return with First Financial Northwest Bank. Accordingly, any cash distributions made by First Financial Northwest to its shareholders are considered to be taxable dividends and not as a non-taxable return of capital to shareholders for federal and state tax purposes.

Method of Accounting. For federal income tax purposes, First Financial Northwest currently reports its income and expenses on the accrual method of accounting and uses a fiscal year ending on December 31 for filing its federal income tax return.

Net Operating Loss Carryovers. A financial institution may carryforward net operating losses indefinitely. The Company had no net operating loss carryforwards at December 31, 2019.

Corporate Dividends-Received Deduction. First Financial Northwest may eliminate from its income dividends received from First Financial Northwest Bank as a wholly-owned subsidiary of First Financial Northwest that files a consolidated return with First Financial Northwest Bank. The corporate dividends-received deduction is 100%, or 80%, in the case of dividends received from corporations with which a corporate recipient does not file a consolidated tax return, depending on the level of stock ownership of the payer of the dividend. Corporations that own less than 20% of the stock of a corporation distributing a dividend may deduct 70% of dividends received or accrued on their behalf.

For additional information regarding our federal income taxes, see Note 12 of the Notes to Consolidated Financial Statements contained in Item 8 of this report.

State Taxation

First Financial Northwest and its subsidiaries are subject to a business and occupation tax imposed under Washington state law at the rate of 1.50% of gross receipts. In addition, various municipalities also assess business and occupation taxes at differing rates. Interest received on loans secured by first lien mortgages or deeds of trust on residential properties, rental income from properties, and certain investment securities are exempt from this tax. An audit by the Washington State Department of Revenue was completed for the years 2010 through 2013, resulting in no material tax revisions.

The Bank has purchased and originated loans in California. The Company no longer had employees or real estate located in California in 2018, so therefore, filed its final California state tax return for 2018.

Executive Officers of First Financial Northwest, Inc.

The business experience for at least the past five years for the executive officers of First Financial Northwest and its primary subsidiary First Financial Northwest Bank is set forth below.

Joseph W. Kiley III, age 64, has served as President and Chief Executive Officer of First Financial and First Financial Diversified since September 2013; as director of First Financial and First Financial Diversified since December 2012; and as President, Chief Executive Officer and director of First Financial Northwest Bank since September 2012. He previously served as President, Chief Executive Officer, and director of Frontier Bank, F.S.B., Palm Desert, California, and its holding company, Western Community Bancshares, Inc. Mr. Kiley has over 25 years of executive experience at banks, thrifts and their holding companies that includes, but is not limited to, serving as president, chief executive officer, chief financial officer, and director. Mr. Kiley holds a Bachelor of Science degree in Business Administration (Accounting) from the California State University, Chico, and is a former California certified public accountant. Mr. Kiley is a member of the Renton Rotary Club, City of Renton Mayor’s Business Executive Forum, City of Renton Mayor’s Blue Ribbon Panel, and past Chair of the Board of Directors of the Renton Chamber of Commerce. He currently serves on the Board of the Washington Bankers’ Association (WBA), WBA Chair Elect, WBA Government Relations Co-Chair, and American Bankers Association Government Relations Council - Administrative Committee. In addition, he currently serves on the Board of the WBA and its Executive Committee.

Richard P. Jacobson, age 56, has served as Chief Operating Officer of First Financial Northwest Bank since July 2013, and as Chief Financial Officer of First Financial Northwest, First Financial Diversified, and the Bank since August 2013. He was appointed as a director of First Financial, First Financial Diversified and the Bank effective September 2013. Mr. Jacobson served as a consultant to First Financial from April 2010 to April 2012. Subsequently, he worked as a mortgage loan originator in Palm Desert, California from July 2012 to July 2013. Previously, he had been employed by Horizon Financial Corp. and Horizon Bank, Bellingham, Washington, for 23 years, and had served as President, Chief Executive Officer and a director of Horizon Financial Corp. and Horizon Bank from January 2008 to January 2010. Mr. Jacobson also served as Chief Financial Officer of Horizon Financial Corp. and Horizon Bank from March 2000 until October 2008. Between 1985 and 2008, Mr. Jacobson served in several other positions at Horizon Financial Corp. and Horizon Bank and spent two years as a Washington state licensed real estate appraiser from 1992 to 1994. Mr. Jacobson received his Bachelor’s degree in Business Administration (Finance) from the University of

37

Washington. In addition, Mr. Jacobson graduated with honors from the American Bankers Association’s National School of Banking. Mr. Jacobson is a past president of the Whatcom County North Rotary Club and has served on the boards of his church, the United Way, Boys and Girls Club, and Junior Achievement.

Simon Soh, age 55, was appointed Senior Vice President and Chief Credit Officer in December 2019, a position he held on an interim basis since November 2019, and between August 2017 and December 2018. Mr. Soh served as Senior Vice President and Chief Lending Officer from October 2012 to December 2019. From August 2010 until October 2012, Mr. Soh served as Vice President and Loan Production Manager of First Financial Northwest Bank. Prior to that, he was First Vice President and Commercial Lending Manager at East West Bank. In 1998, Mr. Soh was a founding member of Pacifica Bank in Bellevue, Washington that merged with United Commercial Bank in 2005, later becoming East West Bank in 2009. Mr. Soh has over 30 years of experience in commercial banking.

Ronnie J. Clariza, age 39, was appointed Chief Risk Officer and Senior Vice President of First Financial Northwest Bank in November 2013. Mr. Clariza previously served as Vice President and Risk Management Officer since May 2008, and prior to that, as Assistant Vice President and Compliance Officer, as well as serving in various other compliance and internal audit roles since he began with the Bank in 2003. Mr. Clariza is a graduate of the University of Washington where he received his Bachelor of Arts degree in Business Administration, Finance, and is a certified regulatory Compliance Officer. Mr. Clariza is an active member of the Washington Bankers’ Association Education Committee. He is also a past member of the Washington Bankers’ Association Enterprise Risk Management Committee, and served as a Volunteer Compliance Manager for the Seattle Children’s Hospital Guild Association.

Dalen D. Harrison, age 60, was promoted to appointed Chief Banking Officer of First Financial Northwest Bank in December 2019. She was appointed Senior Vice President in July 2014 and previously served as Chief Deposit Officer of First Financial Northwest Bank from March 2014 to December 2019. Ms. Harrison served as Senior Vice President and Director of Retail Banking at Peoples Bank in Bellingham, Washington from 2010 until 2014. Prior to that, she served as Vice President of Rainier Pacific Bank, Tacoma, Washington, from 1994 until 2010. Ms. Harrison received a Bachelor of Arts degree in Business Administration from Saint Mary’s College in Moraga, California. Ms. Harrison has served on the boards of Rainier Pacific Foundation, First Place for Children, Gig Harbor Rotary Foundation and Renton Downtown Partnership, and currently serves on the board of the Renton Area Youth and Family Services.

Christine A. Huestis, age 54, is First Vice President and Controller of First Financial Northwest and First Financial Northwest Bank. Prior to joining First Financial Northwest in October 2013, she was employed by Realty in Motion, LLC, a holding company for several mortgage default service companies in Bellevue, Washington. From 1999 until joining First Financial Northwest, Ms. Huestis held key accounting positions at affiliated companies within Realty in Motion, with her most recent position being that of Controller. Ms. Huestis received a Bachelor of Science degree in Accounting from Central Washington University. She is a certified public accountant and is a member of the American Institute of Certified Public Accountants.

Item 1A. Risk Factors.

An investment in our common stock is subject to risks inherent in our business. Before making an investment decision, you should carefully consider the risks and uncertainties described below together with all of the other information included in this report and our other filings with the SEC. In addition to the risks and uncertainties described below, other risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially and adversely affect our business, financial condition, capital levels, cash flows, liquidity, results of operations and prospects. The risks discussed below also include forward-looking statements, and our actual results may differ substantially from those discussed in these forward-looking statements. The market price of our common stock could decline significantly due to any of these identified or other risks and you could lose some or all of your investment. This report is qualified in its entirety by these risk factors.

Our business may be adversely affected by downturns in the national economy and in the economies in our market areas.

Our loans are primarily to businesses and individuals in the state of Washington with 85.7% of loans to borrowers or secured by properties located in Washington and 14.3% of loans to borrowers or secured by properties in other states. Through our efforts to geographically diversify our loan portfolio, our portfolio includes $160.2 million of loans to borrowers or secured by properties located in 40 other states, including at December 31, 2019, $48.3 million, or 4.3% of loans secured by properties or to borrowers in California. A decline in the national economy or the economies of the four counties which we consider to be our primary market area could have a material adverse effect on our business, financial condition, results of operations, and prospects. Weakness in the global economy has adversely affected many businesses operating in our markets that are dependent upon international trade and it is not known how tariffs being imposed on international trade may also affect these businesses. Changes in agreements or relationships between the United States and other countries may also affect these businesses.

38


While real estate values and unemployment rates have remained strong, a deterioration in economic conditions in the market areas we serve, in particular the Puget Sound area of Washington State, could result in the following consequences, any of which could have a materially adverse impact on our business, financial condition, results of operations:

•
loan delinquencies, problem assets and foreclosures may increase;
•
we may increase our allowance for loan losses;
•
demand for our products and services may decline resulting in a decrease in our total loans or assets;
•
collateral for loans, especially real estate, may decline in value, exposing us to increased risk of loss on existing loans, reducing customers’ borrowing power, and reducing the value of assets and collateral associated with existing loans;
•
the net worth and liquidity of loan guarantors may decline, impairing their ability to honor commitments to us; and
•
the amount of our low-cost or noninterest-bearing deposits may decrease and the composition of our deposits may be adversely affected.

A decline in local economic conditions may have a greater effect on our earnings and capital than on the earnings and capital of larger financial institutions whose real estate loan portfolios are geographically diverse. Many of the loans in our portfolio are secured by real estate. Deterioration in the real estate markets where collateral for a mortgage loan is located could negatively affect the borrower’s ability to repay the loan and the value of the collateral securing the loan. Real estate values are affected by various other factors, including changes in general or regional economic conditions, governmental rules or policies and natural disasters such as earthquakes and tornadoes. If we are required to liquidate a significant amount of collateral during a period of reduced real estate values, our financial condition and profitability could be adversely affected.

In this regard, Boeing has a significant presence in our market area and the production facility for the 737 MAX commercial jet aircraft is located in Renton. The 2019 grounding and decline in production of the 737 MAX commercial jet aircraft (production of which was suspended entirely in January 2020), has adversely affected Boeing, its employees and its suppliers, as well as other local businesses and their employees. Until production resumes and production rates return to pre-grounding levels, there may be an adverse impact on the ability of those borrowers impacted by the suspension of the production of the 737 MAX commercial jet to repay their existing loans to the Bank and demand for new loans may be reduced which could adversely affect the level of our nonperforming loans, deposits, financial condition and profitability.    

Adverse changes in the regional and general economy could reduce our growth rate, impair our ability to collect loans and generally have a negative effect on our financial condition and results of operations.

The coronavirus outbreak may have an adverse impact on the Company’s customers and employees.

The coronavirus outbreak may have an adverse impact on certain of the Company's customers directly or indirectly engaged in international trade, travel and tourism. Their businesses may be adversely affected by quarantines and travel restrictions in countries most affected by the coronavirus. In addition, entire industries such as agriculture, may be adversely impacted due to lower exports caused by reduced economic activity in the affected countries.

The Bank may be negatively impacted by reduced attendance from employees impacted by the virus. While the Bank has contingency plans in place for significant outbreaks, the uncertainty of the coronavirus creates risk that cannot be fully assessed.

Our results of operations, liquidity and cash flows are subject to interest rate risk.

Our earnings and cash flows are largely dependent upon our net interest income. Interest rates are highly sensitive to many factors that are beyond our control, including general economic conditions and policies of various governmental and regulatory agencies, and, in particular, the Federal Reserve Board. After steadily increasing the targeted federal funds rate in 2018 and 2017, the Federal Reserve decreased the targeted federal funds rate 25 basis points three times during 2019 to 1.50% - 1.75% at December 31, 2019, in response to some recent weaknesses in economic data and indicated possible further decreases, subject to economic conditions. If the Federal Reserve instead increases the targeted federal funds rate, overall interest rates will likely rise, which may negatively impact both the housing markets by reducing refinancing activity and new home purchases and the U.S. economy. In addition, deflationary pressures, while possibly lowering our operating costs, could have a significant negative effect on our borrowers, especially our business borrowers, and the values of collateral securing loans, which could negatively affect our financial performance.


39

We principally manage interest rate risk by managing our volume and mix of our earning assets and funding liabilities. Changes in monetary policy, including changes in interest rates, could influence not only the interest we receive on loans and investments and the amount of interest we pay on deposits and borrowings, but these changes could also affect (i) our ability to originate and/or sell loans and obtain deposits, (ii) the fair value of our financial assets and liabilities, which could negatively impact shareholders’ equity, and our ability to realize gains from the sale of such assets, (iii) our ability to obtain and retain deposits in competition with other available investment alternatives, (iv) the ability of our borrowers to repay adjustable or variable rate loans, and (v) the average duration of our investment securities portfolio and other interest-earning assets. In a changing interest rate environment, we may not be able to manage this risk effectively. If we are unable to manage interest rate risk effectively, our business, financial condition and results of operations could be materially affected.

Changes in interest rates could also have a negative impact on our results of operations by reducing the ability of borrowers to repay their current loan obligations or by reducing our margins and profitability. Our net interest margin is the difference between the yield we earn on our assets and the interest rate we pay for deposits and our other sources of funding. Changes in interest rates-up or down-could adversely affect our net interest margin and, as a result, our net interest income. Although the yield we earn on our assets and our funding costs tend to move in the same direction in response to changes in interest rates, one can rise or fall faster than the other, causing our net interest margin to expand or contract. Our liabilities tend to be shorter in duration than our assets, so they may adjust faster in response to changes in interest rates. As a result, when interest rates rise, our funding costs may rise faster than the yield we earn on our assets, causing our net interest margin to contract until the yields on interest-earning assets catch up. Changes in the slope of the “yield curve”, or the spread between short-term and long-term interest rates-could also reduce our net interest margin. Normally, the yield curve is upward sloping, meaning short-term rates are lower than long-term rates. Because our liabilities tend to be shorter in duration than our assets, when the yield curve flattens or even inverts, we could experience pressure on our net interest margin as our cost of funds increases relative to the yield we can earn on our assets. Also, interest rate decreases can lead to increased prepayments of loans and mortgage-backed securities as borrowers refinance their loans to reduce borrowing costs. Under these circumstances, we are subject to reinvestment risk as we may have to redeploy such repayment proceeds into lower yielding investments, which would likely hurt our income.

A sustained increase in market interest rates could adversely affect our earnings. As is the case with many banks and savings institutions, our emphasis on increasing the development of core deposits, those deposits bearing no or a relatively low rate of interest with no stated maturity date, has resulted in an increasing percentage of our deposits being comprised of deposits bearing no or a relatively low rate of interest and having a shorter duration than our assets. We would incur a higher cost of funds to retain these deposits in a rising interest rate environment. If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other investments, our net interest income, and therefore earnings, could be adversely affected

In addition, a portion of our adjustable-rate loans have interest rate floors below which the loan’s contractual interest rate may not adjust. At December 31, 2019, 55.8% of our net loans were comprised of adjustable-rate loans. At that date, $359.0 million, or 57.3%, of these loans with an average interest rate of 4.80% were at their floor interest rate. The inability of our loans to adjust downward can contribute to increased income in periods of declining interest rates, although this result is subject to the risks that borrowers may refinance these loans during periods of declining interest rates. Also, when loans are at their respective floor, which is above the fully-indexed rate, there is a further risk that our interest income may not increase as rapidly as our cost of funds during periods of increasing interest rates and could have a material adverse effect on our results of operations.

Changes in interest rates also affect the value of our interest-earning assets, including our securities portfolio. Generally, the fair value of fixed-rate securities fluctuates inversely with changes in interest rates. Unrealized gains and losses on securities available for sale are reported as a separate component of equity, net of tax. Decreases in the fair value of securities available for sale resulting from increases in interest rates could have an adverse effect on stockholders’ equity.

Although management believes it has implemented effective asset and liability management strategies to reduce the potential effects of changes in interest rates on our results of operations, any substantial, unexpected or prolonged change in market interest rates could have a material adverse effect on our financial condition and results of operations. Also, our interest rate risk modeling techniques and assumptions likely may not fully predict or capture the impact of actual interest rate changes on our balance sheet or projected operating results. For further discussion of how changes in interest rates could impact us, see Item 7A. “Quantitative and Qualitative Disclosures About Market Risk” for additional information about our interest rate risk management.
Our construction/land loans are based upon estimates of costs and the value of the completed project.

We make construction/land loans to contractors and builders primarily to finance the construction of single and multifamily homes, subdivisions, as well as commercial properties. We originate these loans whether or not the collateral property underlying the loan is under contract for sale. At December 31, 2019, construction/land loans totaled $113.7 million, or 10.1% of our total

40

loan portfolio, an increase of $4.8 million or 4.4% since December 31, 2018. At December 31, 2019, $44.5 million were one-to-four family construction loans, $41.0 million were multifamily construction loans, and $19.6 million were commercial construction loans. Land loans, which are loans made with land as security, totaled $8.7 million, or less than one percent of our total loan portfolio at December 31, 2019. Land loans include land non-development loans for the purchase or refinance of unimproved land held for future residential development, improved residential lots held for speculative investment purposes and lines of credit secured by land, and land development loans.

Construction/land lending involves additional risks when compared with permanent residential lending because funds are advanced upon the collateral for the project based on an estimate of costs that will produce a future value at completion. Because of the uncertainties inherent in estimating construction costs, as well as the market value of the completed project and the effects of governmental regulation on real property, it is relatively difficult to evaluate accurately the total funds required to complete a project and the completed project loan-to-value ratio. Changes in the demand, such as for new housing and higher than anticipated building costs, may cause actual results to vary significantly from those estimated. For these reasons, this type of lending also typically involves higher loan principal amounts and is often concentrated with a small number of builders. A downturn in housing, or the real estate market, could increase loan delinquencies, defaults and foreclosures, and significantly impair the value of our collateral and our ability to sell the collateral upon foreclosure. Some of our builders have more than one loan outstanding with us and also have residential mortgage loans for rental properties with us. Consequently, an adverse development with respect to one loan or one credit relationship can expose us to a significantly greater risk of loss.

In addition, during the term of most of our construction loans, no payment from the borrower is required since the accumulated interest is added to the principal of the loan through an interest reserve. As a result, these loans often involve the disbursement of funds with repayment substantially dependent on the success of the ultimate project and the ability of the borrower to sell or lease the property or obtain permanent take-out financing, rather than the ability of the borrower or guarantor to repay principal and interest. If our appraisal of the value of a completed project proves to be overstated, we may have inadequate security for the repayment of the loan upon completion of construction of the project and may incur a loss. Because construction loans require active monitoring of the building process, including cost comparisons and on-site inspections, these loans are more difficult and costly to monitor. Increases in market rates of interest may have a more pronounced effect on construction loans by rapidly increasing the end-purchasers’ borrowing costs, thereby reducing the overall demand for the project. Properties under construction are often difficult to sell and typically must be completed in order to be successfully sold which also complicates the process of working out problem construction loans. This may require us to advance additional funds and/or contract with another builder to complete construction. Furthermore, in the case of speculative construction loans, there is the added risk associated with identifying an end-purchaser for the finished project. Land loans also pose additional risk because of the lack of income being produced by the property and the potential illiquid nature of the collateral. These risks can also be significantly impacted by supply and demand conditions.

At December 31, 2019, $44.6 million of our construction/land loans were for speculative construction loans. All of our permanent construction loans have a take-out commitment for a permanent loan with us. At December 31, 2019, all of our construction/land loans were classified as performing.

Our level of commercial and multifamily real estate loans may expose us to increased lending risks.

While commercial and multifamily real estate lending may potentially be more profitable than single-family residential lending, it is generally more sensitive to regional and local economic conditions, making loss levels more difficult to predict. Collateral evaluation and financial statement analysis in these types of loans requires a more detailed analysis at the time of loan underwriting and on an ongoing basis. At December 31, 2019, we had $395.2 million of commercial real estate loans, representing 35.2% of our total loan portfolio and $172.9 million of multifamily loans, representing 15.4% of our total loan portfolio. These loans typically involve higher principal amounts than other types of loans and some of our commercial borrowers have more than one loan outstanding with us. Consequently, an adverse development with respect to one loan or one credit relationship can expose us to a significantly greater risk of loss compared to an adverse development with respect to a one‑to‑four family residential loan. Repayment on these loans is dependent upon income generated, or expected to be generated, by the property securing the loan in amounts sufficient to cover operating expenses and debt service that may be adversely affected by changes in the economy or local market conditions. For example, if the cash flow from the borrower’s project is reduced as a result of leases not being obtained or renewed, the borrower’s ability to repay the loan may be impaired. Commercial and multifamily loans also expose a lender to greater credit risk than loans secured by one-to-four family residential real estate because the collateral securing these loans typically cannot be sold as easily as residential real estate. In addition, many of our commercial and multifamily real estate loans are not fully amortizing and contain large balloon payments upon maturity. Such balloon payments may require the borrower to either sell or refinance the underlying property in order to make the payment that may increase the risk of default or non-payment.


41

A secondary market for most types of commercial and multifamily real estate loans is not readily available, so we have less opportunity to mitigate credit risk by selling part or all of our interest in these loans. As a result of these characteristics, if we foreclose on a commercial or multifamily real estate loan, our holding period for the collateral typically is longer than for one‑to‑four family residential loans because there are fewer potential purchasers of the collateral. Accordingly, charge-offs on commercial real estate loans may be larger on a per loan basis than those incurred with our residential or consumer loan portfolios.

The level of our commercial real estate loan portfolio may subject us to additional regulatory scrutiny.

The FDIC, the Federal Reserve Board and the Office of the Comptroller of the Currency have promulgated joint guidance on sound risk management practices for financial institutions with concentrations in commercial real estate lending. Under this guidance, a financial institution that, like us, is actively involved in commercial real estate lending should perform a risk assessment to identify concentrations. A financial institution may have a concentration in commercial real estate lending if, among other factors (i) total reported loans for construction, land development, and other land represent 100% or more of total capital, or (ii) total reported loans secured by multifamily and non-farm residential properties, loans for construction, land development and other land, and loans otherwise sensitive to the general commercial real estate market, including loans to commercial real estate related entities, represent 300% or more of total capital. Based on the FDIC criteria, the Bank has a concentration in commercial real estate lending as total loans for multifamily, non-farm/non-residential, construction, land development and other land represented 449.7% of total risk-based capital at December 31, 2019. The particular focus of the guidance is on exposure to commercial real estate loans that are dependent on the cash flow from the real estate held as collateral and that are likely to be at greater risk to conditions in the commercial real estate market (as opposed to real estate collateral held as a secondary source of repayment or as an abundance of caution). The purpose of the guidance is to guide banks in developing risk management practices and capital levels commensurate with the level and nature of real estate concentrations. The guidance states that management should employ heightened risk management practices including board and management oversight and strategic planning, development of underwriting standards, risk assessment and monitoring through market analysis and stress testing. While we believe we have implemented policies and procedures with respect to our commercial real estate lending consistent with this guidance, bank regulators could require us to implement additional policies and procedures consistent with their interpretation of the guidance that may result in additional costs to us.

Expansion of our business loans may expose the Company to greater risk of loss.

The Company’s strategic plan includes growth in originations of business loans that are collateralized by non-real estate assets. Our business loans are primarily made based on the cash flow of the borrower and secondarily on the underlying collateral provided by the borrower. The borrowers’ cash flow may prove to be unpredictable, and collateral securing these loans may fluctuate in value. Most often, this collateral is accounts receivable, inventory, or equipment. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers. Other collateral securing loans may depreciate over time, may be difficult to appraise, may be illiquid and may fluctuate in value based on the success of the business. Further, the borrowers’ ability to repay these loans may be impacted more from general economic conditions as compared to real estate secured loans.

Our non-owner occupied real estate loans may expose us to increased credit risk.

At December 31, 2019, $161.6 million, or 43.4% of our one-to-four family residential loan portfolio and 14.4% of our total loan portfolio, consisted of loans secured by non-owner occupied residential properties. At December 31, 2019, all of our non-owner occupied one-to-four family residential loans were performing in accordance with their repayment terms. Loans secured by non-owner occupied properties generally expose a lender to greater risk of non-payment and loss than loans secured by owner occupied properties because repayment of such loans depend primarily on the tenant’s continuing ability to pay rent to the property owner, who is our borrower, or, if the property owner is unable to find a tenant, the property owner’s ability to repay the loan without the benefit of a rental income stream. In addition, the physical condition of non-owner occupied properties is often below that of owner occupied properties due to lenient property maintenance standards that negatively impact the value of the collateral properties. Furthermore, some of our non-owner occupied residential loan borrowers have more than one loan outstanding with us. At December 31, 2019, we had 88 non-owner occupied residential loan relationships with an outstanding balance over $500,000 and an aggregate balance of $129.8 million. Consequently, an adverse development with respect to one credit relationship may expose us to a greater risk of loss compared to an adverse development with respect to an owner occupied residential mortgage loan.

Our business may be adversely affected by credit risk associated with residential property.

At December 31, 2019, $372.5 million, or 33.2% of our total loan portfolio, was secured by first liens on one‑to‑four family residential loans. In addition, at December 31, 2019, our home equity lines of credit totaled $10.6 million. A significant

42

portion of our one‑to‑four family residential real estate loan portfolio consists of jumbo loans that do not conform to secondary market mortgage requirements, and therefore are not immediately salable to Fannie Mae or Freddie Mac because such loans exceed the maximum balance allowable for sale (generally $484,000 to $727,000 for single‑family homes in our primary market areas in 2019). Jumbo one‑to‑four family residential loans may expose us to increased risk because of their larger balances, and because they cannot be immediately sold to government sponsored enterprises.

In addition, one-to-four family residential loans are generally sensitive to regional and local economic conditions that significantly impact the ability of borrowers to meet their loan payment obligations, making loss levels difficult to predict. A decline in residential real estate values resulting from a downturn in the housing market may reduce the value of the real estate collateral securing these types of loans and increase our risk of loss if borrowers default on their loans. Recessionary conditions or declines in the volume of real estate sales and/or the sales prices coupled with elevated unemployment rates may result in higher than expected loan delinquencies or problem assets, and a decline in demand for our products and services. These potential negative events may cause us to incur losses, adversely affect our capital and liquidity and damage our financial condition and business operations.
    
To meet our growth objectives we may originate or purchase loans outside of our market area which could affect the level of our net interest margin and nonperforming loans.

In order to achieve our desired loan portfolio growth, we have and may continue to opportunistically originate or purchase loans outside of our market area either individually, through participations, or in bulk or “pools”. We perform certain due diligence procedures and may re-underwrite these loans to our underwriting standards prior to purchase, and anticipate acquiring loans subject to customary limited indemnities, however, we may be exposed to a greater risk of loss as we acquire loans of a type or in geographic areas where management may not have substantial prior experience and which may be more difficult for us to monitor. Further, when determining the purchase price we are willing to pay to acquire loans, management will make certain assumptions about, among other things, how borrowers will prepay their loans, the real estate market and our ability to collect loans successfully and, if necessary, to dispose of any real estate that may be acquired through foreclosure. To the extent that our underlying assumptions prove to be inaccurate or the basis for those assumptions change (such as an unanticipated decline in the real estate market), the purchase price paid may prove to have been excessive, resulting in a lower yield or a loss of some or all of the loan principal. For example, if we purchase “pools” of loans at a premium and some of the loans are prepaid before we anticipate, we will earn less interest income on the acquired loans than expected. Our success in increasing our loan portfolio through loan purchases will depend on our ability to price the loans properly and on general economic conditions in the geographic areas where the underlying properties or collateral for the loans acquired are located. Inaccurate estimates or declines in economic conditions or real estate values in the markets where we purchase loans could significantly adversely affect the level of our nonperforming loans and our results of operations. At December 31, 2019, our loan portfolio included $85.2 million, or 7.6% of total loans, located in counties within Washington State that are outside of our primary market area. In addition, our portfolio included $160.2 million, or 14.3% of total loans, in loans located outside of Washington State.

We engage in aircraft, classic and collectible car financing transactions, in which high-value collateral is susceptible to potential catastrophic loss. Consequently, if any of these transactions becomes nonperforming, we could suffer a loss on some or all of our value in the assets.

Because our primary focus for aircraft, classic and collectible car loans is on the asset value of the collateral, the collectability of these loans ultimately may be dependent on the value of the underlying collateral. Aircraft values have from time to time experienced sharp decreases due to a number of factors including, but not limited to, the availability of used aircraft, decreases in passenger and air cargo demand, increases in fuel costs, government regulation and the comparative value of newly manufactured similar aircraft. Classic and collectible car values are similarly affected by availability and demand. An aircraft, classic or collectible car as collateral also presents unique risks because of its high-value and being susceptible to rapid movement across different locations and potential catastrophic loss. Although the loan documentation for these transactions will include insurance covenants and other provisions to protect us against risk of loss, there can be no assurance that the insurance proceeds would be sufficient to ensure our full recovery of the loan. Moreover, a relatively small number of nonperforming loans could have a significant negative impact on the value of our loan portfolio. If we are required to liquidate a significant amount of aircraft or classic car collateral during a period of reduced values, our financial condition and profitability could be adversely affected. At December 31, 2019, our loan portfolio included $18.5 million in classic and collectible car loans and $14.0 million in aircraft loans.


43

If interest rate swaps we entered into prove ineffective, it could result in volatility in our operating results, including potential losses, which could have a material adverse effect on our results of operations and cash flows.

We are exposed to the effects of interest rate changes as a result of the borrowings we use to maintain liquidity and fund our expansion and operations. To limit the impact of interest rate changes on earnings, prepayment penalties and cash flows and to lower overall borrowing costs while taking into account variable interest rate risk, we may borrow at fixed rates or variable rates depending upon prevailing market conditions. We may also enter into derivative financial instruments such as interest rate swaps in order to mitigate our interest rate risk on a related financial instrument.
    
Our interest rate contracts expose us to:

•
basis or spread risk, which is the risk of loss associated with variations in the spread between the interest rate contract and the hedged item;

•
credit or counter-party risk which is the risk of the insolvency or other inability of another party to the transaction to perform its obligations;

•
interest rate risk;

•
volatility risk which is the risk that the expected uncertainty relating to the price of the underlying asset differs from what is anticipated; and

•
liquidity risk.

If we suffer losses on our interest rate contracts, our business, financial condition and prospects may be negatively affected, and our net income will decline.

We record the swaps at fair value and designate them as an effective cash flow hedge under ASC 815, Derivatives and Hedging. Each quarter, we measure hedge effectiveness using the “hypothetical derivative method” and record in earnings any gains or losses resulting from hedge ineffectiveness. The hedge provided by our swaps could prove to be ineffective for a number of reasons, including early retirement of the debt, as is allowed under the debt, or in the event the counterparty to the interest rate swaps were determined to not be creditworthy. Any determination that the hedge created by the swaps was ineffective could have a material adverse effect on our results of operations and cash flows and result in volatility in our operating results. In addition, any changes in relevant accounting standards relating to the swaps, especially ASC 815, Derivatives and Hedging, could materially increase earnings volatility.

As of December 31, 2019, we had interest rate swaps outstanding with an aggregate notional amount of $75.0 million.  At December 31, 2019, the fair value of our interest rate swaps was $426,000. For additional information, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Asset and Liability Management”.

Uncertainty relating to the London Interbank Offered Rate ("LIBOR") calculation process and potential phasing out of LIBOR may adversely affect our results of operations.

On July 27, 2017, the Chief Executive of the United Kingdom Financial Conduct Authority, which regulates LIBOR, announced that it intends to stop persuading or compelling banks to submit rates for the calibration of LIBOR to the administrator of LIBOR after 2021. The announcement indicates that the continuation of LIBOR on the current basis cannot and will not be guaranteed after 2021. It is impossible to predict whether and to what extent banks will continue to provide LIBOR submissions to the administrator of LIBOR or whether any additional reforms to LIBOR may be enacted in the United Kingdom or elsewhere. At this time, no consensus exists as to what rate or rates may become acceptable alternatives to LIBOR and it is impossible to predict the effect of any such alternatives on the value of LIBOR-based securities and variable rate loans, or other securities or financial arrangements, given LIBOR's role in determining market interest rates globally. The Federal Reserve Board, in conjunction with the Alternative Reference Rates Committee, a steering committee comprised of large U.S. financial institutions, is considering replacing U.S. dollar LIBOR with a new index calculated by short-term repurchase agreements, backed by Treasury securities ("SOFR"). SOFR is observed and backward looking, which stands in contrast with LIBOR under the current methodology, which is an estimated forward-looking rate and relies, to some degree, on the expert judgment of submitting panel members. Given that SOFR is a secured rate backed by government securities, it will be a rate that does not consider bank credit risk (as is the case with LIBOR). SOFR is therefore likely to be lower than LIBOR and is less likely to correlate with the funding costs of financial institutions. Whether or not SOFR attains market traction as a LIBOR replacement tool remains in question, although some transactions using SOFR have been completed in 2019, including some by Fannie Mae. Both Fannie Mae and Freddie Mac have

44

recently announced that they will cease accepting adjustable rate mortgages tied to LIBOR by the end of 2020 and will soon begin accepting mortgages based on SOFR. Continued uncertainty as to the nature of alternative reference rates and as to potential changes or other reforms to LIBOR may adversely affect LIBOR rates and the value of LIBOR-based loans, and to a lesser extent, securities in our portfolio, and may impact the availability and cost of hedging instruments and borrowings. If LIBOR rates are no longer available, and we are required to implement substitute indices for the calculation of interest rates under our loan agreements with our borrowers or our existing borrowings, we may incur significant expenses in effecting the transition, and may be subject to disputes or litigation with customers and creditors over the appropriateness or comparability to LIBOR of the substitute indices, which could have an adverse effect on our results of operations.

Our allowance for loan losses may prove to be insufficient to absorb losses in our loan portfolio.

While conditions in the housing and real estate markets and economic conditions in our market areas have remained strong, if slow economic conditions return or real estate values and sales deteriorate, we may experience higher delinquencies and credit losses. As a result, we could be required to increase our provision for loan losses and to charge-off additional loans in the future. If charge-offs in future periods exceed the ALLL, we may need additional provisions to replenish the ALLL.

The determination of the appropriate level of the ALLL inherently involves a high degree of subjectivity and requires us to make various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans. In determining the amount of the ALLL, we review our loans and the loss and delinquency experience and evaluate economic conditions and make significant estimates of current credit risks and future trends, all of which may undergo material changes. If our estimates are incorrect, the ALLL may not be sufficient to cover losses inherent in our loan portfolio, resulting in the need for increases in our provision for loan losses which is charged against income. Deterioration in economic conditions, new information regarding existing loans, identification of additional problem loans or relationships, and other factors, both within and outside of our control, may increase our loan charge‑offs and/or may otherwise require an increase in the ALLL. Management also recognizes that significant new growth in loan portfolios, new loan products and the refinancing of existing loans can result in portfolios comprised of unseasoned loans that may not perform in a historical or projected manner and will increase the risk that our allowance may be insufficient to absorb losses without significant additional provisions. In addition, bank regulatory agencies periodically review our allowance for loan losses and may require an increase in the provision for possible loan losses or the recognition of further loan charge‑offs based on their judgment about information available to them at the time of their examination. Any increases in the provision for loan losses will result in a decrease in net income and may have a material adverse effect on our financial condition, results of operations, and capital.

In addition, the Financial Accounting Standards Board has adopted a new accounting standard referred to as Current Expected Credit Loss, or CECL, which will require financial institutions to determine periodic estimates of lifetime expected credit losses on loans, and recognize the expected credit losses as allowances for credit losses. This will change the current method of providing allowances for credit losses only when they have been incurred and are probable, which may require us to increase our allowance for loan losses, and may greatly increase the types of data we would need to collect and review to determine the appropriate level of the allowance for credit losses. This accounting pronouncement is expected to be applicable to us for our first fiscal year after December 15, 2022. We are evaluating the impact the CECL accounting model will have on our accounting, but expect to recognize a onetime cumulative-effect adjustment to the allowance for loan losses as of the beginning of the first reporting period in which the new standard is effective. We cannot yet determine the magnitude of any such one-time cumulative adjustment or of the overall impact of the new standard on our financial condition or results of operations. The federal banking regulators, including the Federal Reserve and the FDIC, have adopted a rule that gives a banking organization the option to phase in over a three-year period the day-one adverse effects of CECL on its regulatory capital. For more on this new accounting standard, see Note 1 of the Notes to Consolidated Financial Statements contained in Item 8 of this report.
 
We may incur losses on our securities portfolio as a result of changes in interest rates.

Factors beyond our control can significantly influence the fair value of securities in our portfolio and can cause potential adverse changes to the fair value of these securities. These factors include, but are not limited to, rating agency actions in respect of the securities, defaults by, or other adverse events affecting, the issuer or with respect to the underlying securities, and changes in market interest rates and continued instability in the capital markets. Any of these factors, among others, could cause other-than-temporary impairments and realized and/or unrealized losses in future periods and declines in other comprehensive income, which could have a material effect on our business, financial condition and results of operations. The process for determining whether impairment of a security is other-than-temporary usually requires complex, subjective judgments about the future financial performance and liquidity of the issuer and any collateral underlying the security to assess the probability of receiving all contractual principal and interest payments on the security. There can be no assurance that the declines in market value will not result in other-than-temporary impairments of these assets, and would lead to accounting charges that could have a material adverse effect on

45

our net income and capital levels. For the year ended December 31, 2019, we did not incur any other-than-temporary impairments on our securities portfolio.

Conditions in the financial markets may limit our access to additional funding to meet our liquidity needs.

Liquidity is essential to our business, therefore, the inability to obtain adequate funding may negatively affect growth and, consequently, our earnings capability and capital levels. We rely on a number of different sources in order to meet our potential liquidity demands. We require sufficient liquidity to meet customer loan requests, customer deposit maturities and withdrawals, payments on our debt obligations as they come due and other cash commitments under both normal operating conditions and other unpredictable circumstances, including events causing industry or general financial market stress. An inability to raise funds through deposits, borrowings, the sale of loans or investment securities, or other sources could have a substantial negative effect on our liquidity.  Our access to funding sources in amounts adequate to finance our activities on terms that are acceptable to us could be impaired by factors that affect us specifically or the financial services industry or economy in general. Factors that could detrimentally impact our access to liquidity sources include a decrease in the level of our business activity as a result of a downturn in the Washington markets in which our loans are concentrated, negative operating results, or adverse regulatory action against us. Our ability to borrow could also be impaired by factors that are not specific to us, such as a disruption in the financial markets or negative views and expectations about the prospects for the financial services industry and the continued uncertainty in credit markets. In particular, our liquidity position could be significantly constrained if we are unable to access funds from the FHLB Des Moines, the FRB or other wholesale funding sources, or if adequate financing is not available at acceptable interest rates. Finally, if we are required to rely more heavily on more expensive funding sources, our revenues may not increase proportionately to cover our costs. Any decline in available funding could adversely impact our ability to originate loans, invest in securities, meet our expenses, or fulfill obligations such as repaying our borrowings or meeting deposit withdrawal demands, any of which could, in turn, have a material adverse effect on our business, financial condition and results of operations. Additionally, collateralized public funds are bank deposits of state and local municipalities. These deposits are required to be secured by certain investment grade securities to ensure repayment that, on the one hand, tends to reduce our contingent liquidity risk by making these funds somewhat less credit sensitive, but on the other hand, reduces standby liquidity by restricting the potential liquidity of the pledged collateral. Although these funds historically have been a relatively stable source of funds for us, availability depends on the individual municipality’s fiscal policies and cash flow needs. At December 31, 2019 we held $34.0 million in public funds.

If limitations arise in our ability to utilize the national brokered deposit market or to replace short-term deposits, our ability to replace maturing deposits on acceptable terms could be adversely impacted.

First Financial Northwest Bank utilizes the national brokered deposit market for a portion of our funding needs. At December 31, 2019, the balance of brokered certificates of deposit was $94.5 million, with remaining maturities of 1 to 13 months. Under FDIC regulations, in the event we are deemed to be less than well-capitalized, we would be subject to restrictions on our use of brokered deposits and the interest rate we can offer on our deposits. If this happens, our use of brokered deposits and the rates we would be allowed to pay on deposits may significantly limit our ability to use deposits as a funding source. If we are unable to participate in this market for any reason in the future, our ability to replace these deposits at maturity could be adversely impacted.

Further, there may be competitive pressures to pay higher interest rates on deposits, which would increase our funding costs. If deposit clients move money out of the Bank deposits and into other investments (or into similar products at other institutions that may provide a higher rate of return), we could lose a relatively low cost source of funds, increasing our funding costs and reducing our net interest income and net income. Additionally, any such loss of funds could result in reduced loan originations, which could materially negatively impact our growth strategy and results of operations.

Our limited branch locations limit our ability to attract deposits and as a result, a large portion of our deposits are certificates of deposit, including “jumbo” certificates that may not be as stable as other types of deposits.

With twelve branch locations in operation during 2019, our ability to compete with larger institutions for noninterest bearing deposits is limited as these institutions have a larger branch network providing greater convenience to customers. As a result, we are dependent on more interest rate sensitive deposits. At December 31, 2019, $425.1 million, or 41.1%, of our total deposits were retail certificates of deposit and, of that amount, $352.4 million were “jumbo” certificates greater than or equal to $100,000, with $130.6 million of these certificates greater than or equal to $250,000. In addition, deposit inflows are significantly influenced by general interest rates. Our money market accounts and jumbo certificates of deposit and the retention of these deposits are particularly sensitive to general interest rates, making these deposits traditionally a more volatile source of funding than other deposit accounts. In order to retain our money market accounts and jumbo certificates of deposit, we may have to pay a higher rate, resulting in an increase in our cost of funds. In a rising rate environment, we may be unwilling or unable to pay a competitive rate because of the resulting compression in our interest rate spread. To the extent that such deposits do not remain

46

with us, they may need to be replaced with borrowings or other deposits that could increase our cost of funds and negatively impact our interest rate spread and financial condition.

Our branching strategy may cause our expenses to increase faster than revenues.
During 2019, we opened two new branch offices in Kent, Washington and Kirkland, Washington. In addition, the Bank secured a lease and opened our thirteenth branch in March 2020, in University Place, Washington. Our current business strategy includes continued similar branch expansion in areas to enhance our market presence. These offices are much smaller than traditional bank branch offices, utilizing the improved technology available with our core data processor. This allows us to maintain management’s focus on efficiency, while working to expand the Bank’s presence into new markets. The success of our expansion strategy into new markets, however, is contingent upon numerous factors, such as our ability to select suitable locations, assess each market’s competitive environment, secure managerial resources, hire and retain qualified personnel and implement effective marketing strategies. The opening of new offices may not increase the volume of our loans and deposits as quickly or to the degree that we hope, and opening new offices will increase our operating expenses. On average, de novo branches do not become profitable until three to four years after opening. We currently expect to lease rather than own the additional branch properties. Further, the projected time line and the estimated dollar amounts involved in opening de novo branches could differ significantly from actual results. The success of our acquired branches is dependent on retention of existing customers’ deposits as well as expanding our market presence in these locations. We may not successfully manage the costs and implementation risks associated with our branching strategy. Accordingly, any new branch may negatively impact our earnings for some period of time until the branch reaches certain economies of scale. Finally, there is a risk that our new branches will not be successful even after they have been established or acquired.

We may be required to raise additional capital in the future, but that capital may not be available when it is needed, or it may only be available on unacceptable terms, which could adversely affect our financial condition and results of operations.

We are required by federal and state regulatory authorities to maintain adequate levels of capital to support our operations. We may at some point, however, need to raise additional capital to support continued growth or be required by our regulators to increase our capital resources. Any capital we obtain may result in the dilution of the interests of existing holders of our common stock. Our ability to raise additional capital, if needed, will depend on conditions in the capital markets at that time, which are outside of our control, and on our financial performance. Accordingly, we may not be able to raise additional capital, if needed, on terms acceptable to us. If we cannot raise additional capital when needed, our ability to further expand our operations and pursue our growth strategy could be materially impaired and our financial condition and liquidity could be materially and adversely affected. In addition, if we are unable to raise additional capital when required by our bank regulators, we may be subject to adverse regulatory action.

Development of new products and services may impose additional costs on us and may expose us to increased operational risk.

Our financial performance depends, in part, on our ability to develop and market new and innovative services and to adopt or develop new technologies that differentiate our products or provide cost efficiencies, while avoiding increased related expenses. This dependency is exacerbated in the current “FinTech” environment, where financial institutions are investing significantly in evaluating new technologies, such as “Blockchain,” and developing potentially industry-changing new products, services and industry standards. The introduction of new products and services can entail significant time and resources, including regulatory approvals. Substantial risks and uncertainties are associated with the introduction of new products and services, including technical and control requirements that may need to be developed and implemented, rapid technological change in the industry, our ability to access technical and other information from our clients, the significant and ongoing investments required to bring new products and services to market in a timely manner at competitive prices and the preparation of marketing, sales and other materials that fully and accurately describe the product or service and its underlying risks. Our failure to manage these risks and uncertainties also exposes us to enhanced risk of operational lapses which may result in the recognition of financial statement liabilities. Regulatory and internal control requirements, capital requirements, competitive alternatives, vendor relationships and shifting market preferences may also determine if such initiatives can be brought to market in a manner that is timely and attractive to our clients. Failure to successfully manage these risks in the development and implementation of new products or services could have a material adverse effect on our business and reputation, as well as on our consolidated results of operations and financial condition.


47

Non-compliance with the USA PATRIOT Act, Bank Secrecy Act, or other laws and regulations could result in fines or sanctions.
 
The USA PATRIOT Act and Bank Secrecy Acts and related regulations require financial institutions to develop programs to prevent financial institutions from being used for money laundering and terrorist activities. If such activities are detected, financial institutions are obligated to file suspicious activity reports with the U.S. Treasury’s Office of Financial Crimes Enforcement Network. These rules require financial institutions to establish procedures for identifying and verifying the identity of customers seeking to open new financial accounts and beneficial owners of accounts. Failure to comply with these regulations could result in fines or sanctions. During the last few years, several banking institutions have received large fines for non-compliance with these laws and regulations. While we have developed policies and procedures designed to assist in compliance with these laws and regulations, no assurance can be given that these policies and procedures will be effective in preventing violations of these laws and regulations. If our policies and procedures are deemed deficient, we would be subject to liability, including fines and regulatory actions, which may include restrictions on our ability to pay dividends and the denial of regulatory approvals to proceed with certain aspects of our business plan, including acquisitions.

Failure to maintain and implement adequate programs to combat money laundering and terrorist financing could also have serious reputational consequences for us. Any of these results could have a material adverse effect on our business, financial condition, results of operations and growth prospects.

We rely on other companies to provide key components of our business infrastructure.

We rely on numerous external vendors to provide us with products and services necessary to maintain our day-to-day operations. Accordingly, our operations are exposed to risk that these vendors will not perform in accordance with the contracted arrangements under service level agreements. The failure of an external vendor to perform in accordance with the contracted arrangements under service level agreements because of changes in the vendor's organizational structure, financial condition, support for existing products and services or strategic focus or for any other reason, could be disruptive to our operations, which in turn could have a material negative impact on our financial condition and results of operations. We also could be adversely affected to the extent such an agreement is not renewed by the third party vendor or is renewed on terms less favorable to us. Additionally, the bank regulatory agencies expect financial institutions to be responsible for all aspects of our vendors’ performance, including aspects which they delegate to third parties. Disruptions or failures in the physical infrastructure or operating systems that support our business and customers, or cyber-attacks or security breaches of the networks, systems or devices that our customers use to access our products and services could result in client attrition, regulatory fines, penalties or intervention, reputational damage, reimbursement or other compensation costs, and/or additional compliance costs, any of which could materially adversely affect our results of operations or financial condition.

We are subject to certain risks in connection with our use of technology.
    
Our security measures may not be sufficient to mitigate the risk of a cyber-attack. Communications and information systems are essential to the conduct of our business, as we use such systems to manage our customer relationships, our general ledger and virtually all other aspects of our business. Our operations rely on the secure processing, storage, and transmission of confidential and other information in our computer systems and networks. Although we take protective measures and endeavor to modify them as circumstances warrant, the security of our computer systems, software, and networks may be vulnerable to breaches, fraudulent or unauthorized access, denial or degradation of service attacks, misuse, computer viruses, malware or other malicious code and cyber-attacks that could have a security impact. If one or more of these events occur, this could jeopardize our or our customers’ confidential and other information processed and stored in, and transmitted through, our computer systems and networks, or otherwise cause interruptions or malfunctions in our operations or the operations of our customers or counterparties. We may be required to expend significant additional resources to modify our protective measures or to investigate and remediate vulnerabilities or other exposures, and we may be subject to litigation and financial losses that are either not insured against or not fully covered through any insurance maintained by us. We could also suffer significant reputational damage.

Security breaches in our internet banking activities could further expose us to possible liability and damage our reputation. Increases in criminal activity levels and sophistication, advances in computer capabilities, new discoveries, vulnerabilities in third party technologies (including browsers and operating systems), or other developments could result in a compromise or breach of the technology, processes and controls that we use to prevent fraudulent transactions and to protect data about us, our clients and underlying transactions. Any compromise of our security also could deter customers from using our internet banking services that involve the transmission of confidential information. We rely on standard internet security systems to provide the security and authentication necessary to effect secure transmission of data. Although we have developed and continue to invest in systems and processes that are designed to detect and prevent security breaches and cyber-attacks and periodically test our security, these precautions may not protect our systems from compromises or breaches of our security measures, and could result in losses to us

48

or our customers, our loss of business and/or customers, damage to our reputation, the incurrence of additional expenses, disruption to our business, our inability to grow our online services or other businesses, additional regulatory scrutiny or penalties, or our exposure to civil litigation and possible financial liability, any of which could have a material adverse effect on our business, financial condition and results of operations.

Our security measures may not protect us from system failures or interruptions. While we have established policies and procedures to prevent or limit the impact of systems failures and interruptions, there can be no assurance that such events will not occur or that they will be adequately addressed if they do. In addition, we outsource certain aspects of our data processing and other operational functions to certain third-party providers. While we select third-party vendors carefully, we do not control their actions. If our third-party providers encounter difficulties, including those resulting from breakdowns or other disruptions in communication services provided by a vendor, failure of a vendor to handle current or higher transaction volumes, cyber-attacks and security breaches, or if we otherwise have difficulty in communicating with them, our ability to adequately process and account for transactions could be affected, and our ability to deliver products and services to our customers and otherwise conduct business operations could be adversely impacted. Replacing these third-party vendors could also entail significant delay and expense. Threats to information security also exist in the processing of customer information through various other vendors and their personnel.

We cannot assure you that such breaches, failures or interruptions will not occur or, if they do occur, that they will be adequately addressed by us or the third parties on which we rely. We may not be insured against all types of losses as a result of third party failures and insurance coverage may be inadequate to cover all losses resulting from breaches, system failures or other disruptions. If any of our third-party service providers experience financial, operational or technological difficulties, or if there is any other disruption in our relationships with them, we may be required to identify alternative sources of such services, and we cannot assure you that we could negotiate terms that are as favorable to us, or could obtain services with similar functionality as found in our existing systems without the need to expend substantial resources, if at all. Further, the occurrence of any systems failure or interruption could damage our reputation and result in a loss of customers and business, could subject us to additional regulatory scrutiny, or could expose us to legal liability. Any of these occurrences could have a material adverse effect on our financial condition and results of operations.

The board of directors oversees the risk management process including the risk of cybersecurity and engages with management on cybersecurity issues.

If our enterprise risk management framework is not effective at mitigating risk and loss to us, we could suffer unexpected losses and our results of operations could be materially adversely affected.

Our enterprise risk management framework seeks to achieve an appropriate balance between risk and return, which is critical to optimizing stockholder value. We have established processes and procedures intended to identify, measure, monitor, report, analyze and control the types of risk to which we are subject. These risks include liquidity risk, credit risk, market risk, interest rate risk, operational risk, legal and compliance risk, and reputational risk, among others. We also maintain a compliance program to identify measure, assess, and report on our adherence to applicable laws, policies and procedures. While we assess and improve these programs on an ongoing basis, there can be no assurance that our risk management or compliance programs, along with other related controls, will effectively mitigate all risk and limit losses in our business. However, as with any risk management framework, there are inherent limitations to our risk management strategies as there may exist, or develop in the future, risks that we have not appropriately anticipated or identified. If our risk management framework proves ineffective, we could suffer unexpected losses and our business, financial condition and results of operations could be materially adversely affected.

We are subject to certain risks in connection with our data management or aggregation.

We are reliant on our ability to manage data and our ability to aggregate data in an accurate and timely manner to ensure effective risk reporting and management. Our ability to manage data and aggregate data may be limited by the effectiveness of our policies, programs, processes and practices that govern how data is acquired, validated, stored, protected and processed. While we continuously update our policies, programs, processes and practices, many of our data management and aggregation processes are manual and subject to human error or system failure. Failure to manage data effectively and to aggregate data in an accurate and timely manner may limit our ability to manage current and emerging risks, as well as to manage changing business needs.

Our business may be adversely affected by an increasing prevalence of fraud and other financial crimes.

As a bank, we are susceptible to fraudulent activity that may be committed against us or our customers which may result in financial losses or increased costs to us or our customers, disclosure or misuse of our information or our customer’s information, misappropriation of assets, privacy breaches against our customers, litigation ,or damage to our reputation. Such fraudulent activity

49

may take many forms, including check fraud, electronic fraud, wire fraud, phishing, social engineering and other dishonest acts. Nationally, reported incidents of fraud and other financial crimes have increased. We have also experienced losses due to apparent fraud and other financial crimes. While we have policies and procedures designed to prevent such losses, there can be no assurance that such losses will not occur.

We are dependent on key personnel and the loss of one or more of those key personnel may materially and adversely affect our prospects.

Competition for qualified employees and personnel in the banking industry is intense and there are a limited number of qualified persons with knowledge of, and experience in, the community banking industry where First Financial Northwest Bank conducts its business. The process of recruiting personnel with the combination of skills and attributes required to carry out our strategies is often lengthy. Our success depends to a significant degree upon our ability to attract and retain qualified management, loan origination, finance, administrative, marketing, and technical personnel and upon the continued contributions of our management and personnel. In particular, our success has been and continues to be highly dependent upon the abilities of key executives, including our President, and certain other employees. In addition, our success has been and continues to be highly dependent upon the services of our directors, many of whom are at or nearing retirement age, and we may not be able to identify and attract suitable candidates to replace such directors.

We participate in a multiple employer defined benefit pension plan for the benefit of our employees. If we were to withdraw from this plan, or if Pentegra, the multiple employer defined benefit pension plan sponsor, requires us to make additional contributions, we could incur a substantial expense in connection with the withdrawal or the request for additional contributions.

We participate in the Pentegra Defined Benefit Plan for Financial Institutions, a multiple employer pension plan for the benefit of our employees. Effective March 31, 2013, we did not allow additional employees to participate in this plan. On March 31, 2013, we froze the future accrual of benefits under this plan with respect to those participating employees. In connection with our decision to freeze our benefit accruals under the plan, and since then, we considered withdrawing from the plan.

The actual expense that would be incurred in connection with a withdrawal from the plan is primarily dependent upon the timing of the withdrawal, the total value of the plan’s assets at the time of withdrawal, general market interest rates at that time, expenses imposed on withdrawal, and other conditions imposed by Pentegra as set forth in the plan. If we choose to withdraw from the plan in the future, we could incur a substantial expense in connection with the withdrawal.

Even if we do not withdraw from the plan, Pentegra, as sponsor of the plan, may request that we make an additional contribution to the plan, in addition to contributions that we are regularly required to make, or obtain a letter of credit in favor of the plan, if our financial condition worsens to the point that it triggers certain criteria set out in the plan. If we fail to make the contribution or obtain the requested letter of credit, then we may be forced to withdraw from the plan and establish a separate, single employer defined benefit plan that we anticipate would be underfunded to a similar extent as under the multiple employer plan.

We rely on dividends from the Bank for substantially all of our revenue at the holding company level.

We are an entity separate and distinct from our principal subsidiary, First Financial Northwest Bank, and derive substantially all of our revenue at the holding company level in the form of dividends from that subsidiary. Accordingly, we are, and will be, dependent upon dividends from the Bank to pay the principal of and interest on our indebtedness, to satisfy our other cash needs and to pay dividends on our common stock. First Financial Northwest Bank’s ability to pay dividends is subject to its ability to earn net income and to meet certain regulatory requirements, including the capital conservation buffer requirement. In the event the Bank is unable to pay dividends to us, we may not be able to pay dividends on our common stock or continue our stock repurchases. Also, our right to participate in a distribution of assets upon a subsidiary’s liquidation or reorganization is subject to the prior claims of the subsidiary’s creditors.

Item 1B. Unresolved Staff Comments

First Financial Northwest has not received any written comments from the SEC regarding its periodic or current reports under the Securities Exchange Act of 1934, as amended.

50

Item 2. Properties

The corporate office for First Financial Northwest and First Financial Northwest Bank is located at 201 Wells Avenue South, Renton, Washington and is owned by us. The Bank’s full service retail operation is also at this location. In addition, the Bank owns a retail office located at 17424 SR 9, Snohomish, Washington. At December 31, 2019, the Bank had ten leased locations in Washington currently in operation: Mill Creek, Edmonds, “The Landing” in Renton, Bellevue, Bothell, Woodinville, Smokey Point, Lake Stevens, Kent, and Kirkland. In addition, the Bank opened a location in University Place, Washington, in March 2020. The lending division operations of First Financial Northwest Bank are at our owned location at 207 Wells Avenue South, Renton, Washington. This location is also the site for the operations of First Financial Northwest’s wholly-owned subsidiary, First Financial Diversified. The lease terms for our properties are for an initial term of three to five years with the option to extend for additional three to five year periods. In the opinion of management, all properties are adequately covered by insurance, are in a good state of repair and are appropriately designed for their present and future use. For additional information on our lease commitments, see Note 14- “Leases” of the Notes to Consolidated Financial Statements in Item 8 of this report.

Item 3. Legal Proceedings

From time to time, we are involved as plaintiff or defendant in various legal actions arising in the normal course of business. As of December 31, 2019, we were not involved in any significant litigation and do not anticipate incurring any material liability as a result of any such litigation.

Item 4. Mine Safety Disclosures

Not applicable.
PART II

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Our common stock is traded on The Nasdaq Stock Market LLC’s Global Select Market (“NASDAQ”), under the symbol “FFNW.” As of December 31, 2019, there were 10.3 million shares of common stock issued and outstanding and we had 519 shareholders of record, excluding persons or entities that hold stock in nominee or “street name” accounts with brokers. Our cash dividend payout policy is reviewed regularly by management and the Board of Directors. As of December 31, 2019, our board of directors had declared 27 consecutive quarterly cash dividends on our common stock. Any dividends declared and paid in the future would depend upon a number of factors, including capital requirements, our financial condition and results of operations, tax considerations, statutory and regulatory limitations, and general economic conditions. No assurances can be given that any dividends will be paid or that, if paid, will not be reduced or eliminated in future periods. Our future payment of dividends may depend, in part, upon receipt of dividends from the Bank, which are restricted by federal regulations.

Stock Repurchases

The Company’s Board of Directors authorized a stock repurchase plan that began on November 5, 2018 and expired on May 3, 2019. The plan authorized the repurchase of up to 550,000 shares of the Company’s stock. At completion of the plan on May 3, 2019, the Company had repurchased all 550,000 shares authorized, including 346,100 shares purchased during 2019 at an average price of $15.89 per share.

In addition, the Company’s Board of Directors authorized a stock repurchase plan that began on July 30, 2019 and expired on December 17, 2019. At the completion of this plan, the Company had repurchased 132,952 shares at an average price of $14.21 per share.


51

The following table represents the share repurchased during the fourth quarter ended December 31, 2019.
Period
 
Total Number of Shares Purchased
 
Average Price Paid per Share
 
Total Number of Shares Purchased as Part of Plan
 
Maximum Number of Shares that May be Repurchased Under the Plan
October 1 - October 31, 2019
 
1,400

 
$
14.02

 
1,400

 
430,748

November 1 - November 30, 2019
 
21,700

 
14.26

 
21,700

 
409,048

December 1 - December 31, 2019
 
22,000

 
14.82

 
22,000

 
387,048

Total
 
45,100

 
14.52

 
45,100

 
—


Subsequently, in January 2020 the Company’s Board of Directors authorized the repurchase of up to five percent (5%) of the Company’s outstanding common stock, or approximately 513,000 shares beginning no earlier than January 27, 2020 and ending no later than July 27, 2020. The Company will purchase the shares from time to time in the open market or through privately negotiated depending on market conditions and other corporate considerations.

Equity Compensation Plan Information

The equity compensation plan information presented under subparagraph (d) in Part III, Item 12 of this report is incorporated herein by reference.


52

Performance Graph

The following graph compares the cumulative total shareholder return on First Financial Northwest’s Common Stock with the cumulative total return on the Russell 2000 Index, the SNL Micro CAP U.S. Bank Index, and the SNL Thrift Index, a peer group index.

The graph assumes that total return includes the reinvestment of all dividends and that the value of the investment in First Financial Northwest’s common stock and each index was $100 on December 31, 2014, and is the base amount used in the graph. The closing price of First Financial Northwest’s common stock on December 31, 2019 was $14.94.

chart-431f242bc27e5e96893.jpg
 
Period Ended
Index
12/31/2014
 
12/31/2015
 
12/31/2016
 
12/31/2017
 
12/31/2018
 
12/31/2019
First Financial Northwest, Inc.
100.00

 
118.22

 
170.04

 
135.73

 
137.84

 
136.31

Russell 2000 Index
100.00

 
95.59

 
115.95

 
132.94

 
118.30

 
148.49

SNL Thrift Index
100.00

 
112.45

 
137.74

 
136.74

 
115.17

 
141.80

SNL Micro Cap U.S. Bank Index
100.00

 
111.20

 
136.72

 
167.25

 
158.70

 
177.20


53



Item 6. Selected Financial Data

The following table sets forth certain information concerning our consolidated financial position and results of operations at and for the dates indicated and has been derived from our audited consolidated financial statements. The information below is qualified in its entirety by the detailed information included elsewhere herein and should be read along with Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 8. “Financial Statements and Supplementary Data” included in this Form 10-K.
 
At or For the Year Ended December 31,
 
2019
 
2018
 
2017
 
2016
 
2015
FINANCIAL CONDITION DATA:
(In thousands, except share data)
 
 
 
 
 
 
 
 
 
 
Total assets
$
1,341,885

 
$
1,252,424

 
$
1,210,229

 
$
1,037,584

 
$
979,913

Investments available-for-sale
136,601

 
142,170

 
132,242

 
129,260

 
129,565

Loans receivable, net (1)
1,108,462

 
1,022,904

 
988,662

 
815,043

 
685,072

Deposits
1,033,534

 
939,032

 
839,502

 
717,476

 
675,407

Advances from the FHLB
137,700

 
146,500

 
216,000

 
171,500

 
125,500

Stockholders’ equity
156,319

 
153,738

 
142,634

 
138,125

 
170,673

 
 
 
 
 
 
 
 
 
 
OPERATING DATA:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest income
$
59,620

 
$
55,913

 
$
47,644

 
$
41,709

 
$
37,197

Interest expense
20,712

 
14,738

 
10,022

 
7,507

 
6,751

Net interest income
38,908

 
41,175

 
37,622

 
34,202

 
30,446

(Recapture of provision) provision for loan losses
(300
)
 
(4,000
)
 
(400
)
 
1,300

 
(2,200
)
Net interest income after (recapture of provision) provision for loan losses
39,208

 
45,175

 
38,022

 
32,902

 
32,646

Noninterest income
4,141

 
2,878

 
2,208

 
2,651

 
1,279

Noninterest expense
30,418

 
29,461

 
26,809

 
22,949

 
19,878

Income before provision for federal income taxes
12,931

 
18,592

 
13,421

 
12,604

 
14,047

Provision for federal income taxes
2,562

 
3,693

 
4,942

 
3,712

 
4,887

Net income
$
10,369

 
$
14,899

 
$
8,479

 
$
8,892

 
$
9,160

Basic earnings per share
$
1.04

 
$
1.44

 
$
0.82

 
$
0.75

 
$
0.67

Diluted earnings per share
$
1.03

 
$
1.43

 
$
0.81

 
$
0.74

 
$
0.67

___________________
(1) Net of ALLL, LIP and deferred loan fees and costs. 


54

 
At or For the Year Ended December 31,
KEY FINANCIAL RATIOS:
2019
 
2018
 
2017
 
2016
 
2015
Performance Ratios:
 
 
 
 
 
 
 
 
 
Return on assets
0.80
 %
 
1.21
 %
 
0.76
 %
 
0.88
 %
 
0.96
 %
Return on equity
6.73

 
9.86

 
5.94

 
5.55

 
5.15

Dividend payout ratio
33.65

 
21.53

 
32.93

 
32.02

 
35.57

Equity-to-assets ratio
11.65

 
12.28

 
11.79

 
13.31

 
17.42

Net interest margin
3.19

 
3.56

 
3.60

 
3.60

 
3.38

Average interest-earning assets to average interest-bearing
   liabilities
113.44

 
114.28

 
114.07

 
117.11

 
120.45

Efficiency ratio
70.66

 
66.88

 
67.31

 
62.27

 
62.66

Noninterest expense as a percent of average total assets
2.35

 
2.40

 
2.42

 
2.27

 
2.07

Book value per common share
$
15.25

 
$
14.35

 
$
13.27

 
$
12.63

 
$
12.40

Capital Ratios: (1)
 
 
 
 
 
 
 
 
 
Tier 1 leverage
10.27
 %
 
10.37
 %
 
10.20
 %
 
11.17
 %
 
11.61
 %
Common equity tier 1
13.13

 
13.43

 
12.52

 
14.36

 
16.36
Tier 1 capital ratio
13.13

 
13.43

 
12.52

 
14.36

 
16.36

Total capital ratio
14.38

 
14.68

 
13.77

 
15.61

 
17.62

Asset Quality Ratios: (2)
 
 
 
 
 
 
 
 
 
Nonperforming loans as a percent of total loans
0.01

 
0.07

 
0.02

 
0.10

 
0.16

Nonperforming assets as a percent of total assets
0.04

 
0.10

 
0.05

 
0.31

 
0.48

ALLL as a percent of total loans
1.18

 
1.29

 
1.28

 
1.32

 
1.36

ALLL as a percent of nonperforming loans
13,913.68

 
1,774.87

 
7,196.65

 
1,276.34

 
872.17

Net recoveries to average loans receivable, net
(0.02
)
 
(0.45
)
 
(0.27
)
 
(0.02
)
 
(0.18
)
_______________
(1) Capital ratios are for First Financial Northwest Bank only.
(2) Loans are reported net of LIP.

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This discussion and analysis reviews our consolidated financial statements and other relevant statistical data for the years ending December 31, 2019 and 2018, and is intended to enhance your understanding of our financial condition and results of operations. The information in this section has been derived from the Consolidated Financial Statements and footnotes thereto that appear in Item 8 of this Form 10-K. The information contained in this section should be read in conjunction with these Consolidated Financial Statements and footnotes and the business and financial information provided in this Form 10-K. Unless otherwise indicated, the financial information presented in this section reflects the consolidated financial condition and results of operations of First Financial Northwest and its subsidiaries. For a discussion and review of our consolidated financial statements and other relevant statistical data for the years ending December 31, 2018 and 2017 see “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of the Company’s Form 10-K for the fiscal year ended December 31, 2018.

Overview

First Financial Northwest Bank is a wholly-owned subsidiary of First Financial Northwest and, as such, comprises substantially all of the activity for First Financial Northwest. First Financial Northwest Bank was a community-based savings bank until February 4, 2016, when the Bank converted to a Washington state chartered commercial bank reflecting the commercial banking services it now provides to its customers. The Bank primarily serves King, Snohomish, Pierce and Kitsap counties, Washington through its full-service banking office and headquarters in Renton, Washington, as well as six retail branches in King County, Washington and five retail branches in Snohomish County, Washington at December 31, 2019. The Bank purchased four of these branches in 2017 and acquired $74.7 million in deposits (the “Branch Acquisition”). The Branch Acquisition expanded our retail footprint and provided an opportunity to extend our unique brand of community banking into those communities. In addition, the Bank opened a new branch office in University Place, Washington in March 2020.
 

55

The Bank’s business consists predominantly of attracting deposits from the general public, combined with borrowing from the Federal Home Loan Bank of Des Moines (“FHLB”) and raising funds in the wholesale market, then utilizing these funds to originate one-to-four family residential, multifamily, commercial real estate, construction/land, business, and consumer loans.

Our current business strategy emphasizes commercial real estate, construction, one-to-four family residential, and multifamily lending. With the current low interest rate environment, we are not aggressively pursuing longer term assets, but rather are focused on financing shorter term loans and loans with adjustable interest rates. During 2019, originations of new loans and refinances modestly outpaced repayments, resulting in net loans receivable of $1.11 billion at December 31, 2019, as compared to $1.02 billion at December 31, 2018. Originations and purchases of construction/land loans were $110.0 million in 2019 as compared to $118.2 million in 2018. However, payoffs were higher in 2018 than in 2019, resulting in this portfolio increasing modestly to $113.7 million at December 31, 2019 as compared to $108.9 million at December 31, 2018. We anticipate that construction/land lending will continue to be a strong element of our total loan portfolio in future periods. We will continue to take a disciplined approach in our construction/land lending by concentrating our efforts on residential loans to builders known to us, including multifamily loans to developers with proven success in this type of construction. These loans typically mature in six to eighteen months and funding is usually not fully disbursed at origination, therefore the impact to net loans receivable is generally minimal in the short term.
 
We have also geographically expanded our loan portfolio through loan purchases or loan participations of commercial and multifamily real estate loans that are outside of our primary market area. Through our efforts to geographically diversify our loan portfolio with direct loan originations, loan participations, or loan purchases, our portfolio includes $160.2 million of loans to borrowers or secured by properties located in 40 other states, including concentrations in California, Utah, Oregon and Georgia of $48.3 million, $16.1 million, $12.2 million and $8.2 million, respectively at December 31, 2019.

Net income for the year ended December 31, 2019, was $10.4 million, or $1.03 per diluted share, compared to $14.9 million, or $1.43 per diluted share, for the year ended December 31, 2018. The most significant contributor to this decrease was a $3.7 million decrease in the recapture of provision for loan losses in 2019, primarily as a result of net recoveries in 2018 of $4.5 million on previously charged-off loans. Net interest income also decreased by $2.3 million, primarily as a result of higher rate increases on our deposit liabilities as compared to our interest-earning assets. Noninterest expenses increased by $957,000, reflecting continued growth in our operations.

Our primary source of revenue is interest income, which is the income that we earn on our loans and investments. Interest expense is the interest that we pay on our deposits and borrowings. Net interest income is the difference between interest income and interest expense. Changes in levels of interest rates affect interest income and interest expense differently and, thus, impacts our net interest income. First Financial Northwest Bank is generally liability-sensitive, meaning our interest-bearing liabilities reprice at a faster rate than our interest-earning assets. Primarily as a result of increasing interest rates during 2019, our net interest margin decreased to 3.19% for the year ended December 31, 2019, as compared to 3.56% for the year ended December 31, 2018.
 
An offset to net interest income is the provision for loan losses, or the recapture of the provision for loan losses, that is required to establish the ALLL at a level that adequately provides for probable losses inherent in our loan portfolio. As our loan portfolio increases, or due to an increase for probable losses inherent in our loan portfolio, our ALLL may increase, resulting in a decrease to net interest income. Improvements in loan risk ratings, increases in property values, or receipt of recoveries of amounts previously charged off may partially or fully offset any increase to ALLL due to loan growth or an increase in probable loan losses. For the year ended December 31, 2019, we had a recapture of provision of $300,000 as compared to a recapture of $4.0 million for the year ended December 31, 2018. The recapture was primarily the result of a construction/land loan with a balance of $12.5 million at December 31, 2019, that was technically in default and classified as impaired, however, the Bank’s impairment analysis concluded there were no anticipated losses from the loan at this time, and therefore, funds previously allocated in the ALLL to this loan were recaptured. All payments on the loan were current as of December 31, 2019, and the loan is well collateralized. In addition, although total loans increased, the impact to the provision from this loan growth was offset by a shift in our loan concentrations to lower risk categories and reduction in the risk factor related to the collateral on certain loan types. Further impacting the ALLL, our total adversely classified loans decreased to $629,000 at December 31, 2019 from $1.3 million at December 31, 2018. The recapture of provision for loan losses in 2018 was primarily the result of $4.5 million of loan recoveries received on previously charged off loans, partially offset by the provision necessary for the $34.2 million increase in net loans receivable. We will continue to monitor our loan portfolio and make adjustments to our ALLL as we deem necessary.

Noninterest income is generated from various loan or deposit fees, increases in the cash surrender value of bank owned life insurance (“BOLI”), and revenue earned on our wealth management brokerage services. This income is increased or partially offset by any net gain or loss on sales of investment securities. Our noninterest income increased $1.3 million during the year ended December 31, 2019 as compared to 2018. The increase was primarily attributable to a $576,000 increase in loan related

56

fees, a $268,000 increase in the wealth management revenue, $180,000 increase in the cash surrender value of our BOLI policies and a $171,000 change from a loss to a $151,000 net gain on sales of investments.

Our noninterest expenses consist primarily of salaries and employee benefits, professional fees, regulatory assessments, occupancy and equipment, and other general and administrative expenses. Salaries and employee benefits consist primarily of the salaries and wages paid to our employees, payroll taxes, expenses for retirement, and other employee benefits. OREO-related expenses consist primarily of maintenance and costs of utilities for the OREO inventory, market valuation adjustments, build-out expenses, gains and losses from OREO sales, legal fees, real estate taxes, and insurance related to the properties included in the OREO inventory. Professional fees include legal services, auditing and accounting services, computer support services, and other professional services in support of strategic plans. Occupancy and equipment expenses, which are the fixed and variable costs of buildings and equipment, consist primarily of lease expenses, real estate taxes, depreciation expenses, maintenance, and costs of utilities. Also included in noninterest expense are changes to the Company’s unfunded commitment reserve which are reflected in general and administrative expenses. This unfunded commitment reserve expense can vary significantly each quarter, based on the amount believed by management to be sufficient to absorb estimated probable losses related to unfunded credit facilities, and reflects changes in the amounts that the Company has committed to fund but has not yet disbursed. Our noninterest expenses increased $957,000 during the year ended December 31, 2019 as compared to 2018. The increase was primarily attributable to a $639,000 increase in data processing expenses, a $429,000 increase in occupancy and equipment expenses, a $293,000 increase in salaries and employee benefits, partially offset by a $315,000 decrease in other general and administrative expenses.

Business Strategy

Our long-term business strategy is to operate and grow First Financial Northwest Bank as a well-capitalized and profitable community bank, offering one-to-four family residential, commercial and multifamily, construction/land, consumer and business loans along with a diversified array of deposit and other products and services to individuals and businesses in our market areas. We intend to accomplish this strategy by leveraging our established name and franchise, capital strength, and loan production capability by:
•
Capitalizing on our intimate knowledge of our local communities to serve the convenience and needs of customers, and delivering a consistent, high-quality level of professional service;
•
Offering competitive deposit rates and developing customer relationships to diversify our deposit mix, growing lower cost deposits, attracting new customers, and expanding our footprint in the geographical area we serve;
•
Utilizing wholesale funding sources, including but not limited to FHLB advances and acquiring deposits in the national brokered certificate of deposit market, to assist with funding needs and interest rate risk management efforts, as needed;
•
Managing our loan portfolio to minimize concentration risk and diversify the types of loans within the portfolio;
•
Managing credit risk to minimize the risk of loss and interest rate risk to optimize our net interest margin; and
•
Improving profitability through disciplined pricing, expense control and balance sheet management, while continuing to provide excellent customer service.    

Critical Accounting Policies

Critical accounting policies are those that involve significant judgments and assumptions by management and that have, or could have, a material impact on our income or the carrying value of our assets. The following are our critical accounting policies.

Allowance for Loan Losses. Management recognizes that loan losses may occur over the life of a loan and that the ALLL must be maintained at a level necessary to absorb specific losses on impaired loans and probable losses inherent in the loan portfolio. Our methodology for analyzing the ALLL consists of two components: general and specific allowances. The general allowance is determined by applying factors to our various groups of loans. Management considers factors such as charge-off history, the current and expected economic conditions, borrower’s ability to repay, the regulatory environment, competition, geographic and loan type concentrations, policy and underwriting standards, nature and volume of the loan portfolio, management’s experience level, our loan review and grading systems, the value of underlying collateral, and the level of problem loans in assessing the ALLL. Specific allowances result when management performs an impairment analysis on a loan when it determines it is probable that all contractual amounts of principal and interest will not be paid as scheduled. The analysis usually occurs when a loan has been classified as substandard or placed on nonaccrual status or is a TDR because the borrower has been granted a rate concession. If the market value less costs to sell (“market value”) of the impaired loan is less than the recorded investment in the loan, impairment is recognized by establishing a specific reserve in the ALLL for the loan or by adjusting an existing reserve amount. The amount of the specific reserve is computed using current appraisals, listed sales prices, and other available information

57

less costs to complete, if any, and costs to sell the property. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available or as future events differ from predictions. In addition, specific reserves may be created upon a loan’s restructuring, based on a discounted cash flow analysis, comparing the present value of the anticipated repayments under the restructured terms to the outstanding principal balance of the loan.

Our Board of Directors’ Internal Asset Review Committee reviews and recommends for approval the allowance for loan losses on a quarterly basis, and any related provision or recapture of provision for loan losses, and the full Board of Directors approves the provision or recapture after considering the Committee’s recommendations. The allowance is increased by the provision for loan losses which is charged against current period earnings. When analysis of the loan portfolio warrants, the allowance is decreased and a recapture of provision of loan losses is included in current period earnings.

We believe that the ALLL is a critical accounting estimate because it is highly susceptible to change from period‑to‑period requiring management to make assumptions about probable losses inherent in the loan portfolio. The impact of an unexpected large loss could deplete the allowance and potentially require increased provisions to replenish the allowance, thereby reducing earnings. For additional information see Item 1A. “Risk Factors – Our allowance for loan losses may prove to be insufficient to absorb losses in our loan portfolio,” in this Form 10-K.

Valuation of OREO. Real estate properties acquired through foreclosure or by deed-in-lieu of foreclosure are recorded at fair value less estimated costs to sell. Fair value is generally determined by management based on a number of factors, including third-party appraisals of fair value in an orderly sale. Accordingly, the valuation of OREO is subject to significant external and internal judgment. If the carrying value of the loan at the date a property is transferred into OREO exceeds the fair value less estimated costs to sell, the excess is charged to the ALLL. Management periodically reviews OREO values to determine whether the property continues to be carried at the lower of its recorded book value or fair value, net of estimated costs to sell. Any further decreases in the value of OREO are considered valuation adjustments and are charged to noninterest expense in the Consolidated Income Statements. Expenses and income from the maintenance and operations and any gains or losses from the sales of OREO are included in noninterest expense.

Deferred Taxes.  Deferred tax assets arise from a variety of sources, the most significant being expenses recognized in our financial statements but disallowed in the tax return until the associated cash flow occurs, and write-downs in the value of assets for financial statement purposes that are not deductible for tax purposes until the asset is sold or deemed worthless.

When warranted, we record a valuation allowance to reduce our deferred tax assets to the amount that can be recognized in line with the relevant accounting standards. The level of deferred tax asset recognition is influenced by management’s assessment of our historic and future profitability profile. At each balance sheet date, existing assessments are reviewed and, if necessary, revised to reflect changed circumstances. In a situation where income is less than projected or recent losses have been incurred, the relevant accounting standards require convincing evidence that there will be sufficient future tax capacity. For additional information regarding our deferred taxes, see Note 12 of the Notes to Consolidated Financial Statements contained in Item 8.

Other-Than-Temporary Impairments on the Market Value of Investments. Declines in the fair value of available‑for‑sale or held-to-maturity investments below their cost that is deemed to be other-than-temporary results in a reduction in the carrying amount of such investments to their fair value. A charge to earnings and an establishment of a new cost basis for the investment is made. Unrealized investment losses are evaluated at least quarterly to determine whether such declines should be considered other-than-temporary and therefore be subject to immediate loss recognition. Although these evaluations involve significant judgment, an unrealized loss in the fair value of a debt security is generally deemed to be temporary when the fair value of the investment security is below the carrying value primarily due to changes in interest rates and there has not been significant deterioration in the financial condition of the issuer. Other factors that may be considered in determining whether a decline in the value of a debt security is other-than-temporary include ratings by recognized rating agencies; the extent and duration of an unrealized loss position; actions of commercial banks or other lenders relative to the continued extension of credit facilities to the issuer of the security; the financial condition, capital strength and near-term prospects of the issuer and recommendations of investment advisers or market analysts. Therefore, deterioration of market conditions could result in impairment losses recognized within the investment portfolio.

Fair Value. FASB ASC 820, Fair Value Measurements and Disclosures, establishes a hierarchical disclosure framework associated with the level of pricing observability utilized in measuring financial instruments at fair value. The degree of judgment utilized in measuring the fair value of financial instruments generally correlates to the level of pricing observability. Financial instruments with readily available active quoted prices or for which fair value can be measured from actively quoted prices generally will have a higher degree of pricing observability and a lesser degree of judgment utilized in measuring fair value. Conversely, financial instruments rarely traded or not quoted will generally have little or no pricing observability and a higher degree of judgment utilized in measuring fair value. Pricing observability is impacted by a number of factors, including the type of financial

58

instrument, whether the financial instrument is new to the market and not yet established and the characteristics specific to the transaction. See Note 6 of the Notes to Consolidated Financial Statements contained in Item 8 for additional information about the level of pricing transparency associated with financial instruments carried at fair value.
Derivatives and Hedge Accounting. The Bank recognizes its interest rate swaps as cash flow hedge derivative instruments, and as such, reports the net fair value as an asset or liability. Fair value is based on dealer quotes, pricing models, discounted cash flow methodologies or similar techniques for which the determination of fair value may require significant management judgment or estimation. The derivatives are marked to their fair value through other comprehensive income. The net gain or loss on derivatives is reclassified into earnings in the same income statement line item that is used to present the earnings effect of hedged items.

Intangible Assets. The Company incurred goodwill and a core deposit intangible asset through the Branch Acquisition during 2017. These assets were booked at fair value at the time of the acquisition. Goodwill is evaluated annually for impairment, with any impairment recognized as noninterest expense. The core deposit intangible is amortized into noninterest expense.

Comparison of Financial Condition at December 31, 2019 and December 31, 2018

Assets. The following table details the changes in the composition of our assets at December 31, 2019 from December 31, 2018.
 
Balance at
December 31, 2019
 
Change from December 31, 2018
 
Percentage
Change
 
(Dollars in thousands)
Cash on hand and in banks                                           
$
10,094

 
$
1,972

 
24.3
 %
Interest-earning deposits                                           
12,896

 
4,008

 
45.1

Investments available-for-sale, at fair value
136,601

 
(5,569
)
 
(3.9
)
Loans receivable, net                                           
1,108,462

 
85,558

 
8.4

Premises and equipment, net
22,466

 
1,135

 
5.3

FHLB stock, at cost                                
7,009

 
(301
)
 
(4.1
)
Accrued interest receivable
4,138

 
70

 
1.7

Deferred tax assets, net
1,501

 
(343
)
 
(18.6
)
OREO
454

 
(29
)
 
(6.0
)
BOLI
31,982

 
2,141

 
7.2

Prepaid expenses and other assets
2,216

 
(1,242
)
 
(35.9
)
ROU
2,209

 
2,209

 
—

Goodwill
889

 
—

 
—

Core deposit intangible
968

 
(148
)
 
(13.3
)
Total assets                                
$
1,341,885

 
$
89,461

 
7.1
 %

The $89.5 million increase in total assets during 2019 was primarily a result of our deploying the funds available from $94.5 million of deposit growth after repayment of $8.8 million of FHLB advances, to increase our loan portfolio by $85.6 million. Additional factors in our asset growth are described below.

Interest-earning deposits with banks. Our interest-earning deposits with banks, consisting primarily of funds held at the Federal Reserve Bank of San Francisco, increased by $4.0 million to $12.9 million at December 31, 2019 from December 31, 2018. We monitor the balance of these funds daily in relation to our expected funding needs and adjust accordingly. Excess funds are generally used to pay down overnight funding at the FHLB.

Investments available-for-sale. Our investments available-for-sale decreased by $5.6 million, or 3.9%, during 2019. To enhance the income from our investment portfolio, we had sales, maturities, and calls on $14.3 million of our securities, with an average yield of 2.08%. The sales of investments available-for-sale generated a net gain of $151,000 for the year ended December 31, 2019. The proceeds were partially reinvested in $14.4 million of investments with an expected yield of 2.79%. Continued restructuring of our available-for-sale investments in 2019 combined with increases in the target federal funds rate throughout 2018 that outpaced decreases in the targeted federal funds rate in the second half of 2019 contributed to an increase in the average yield on investment securities to 3.11% for 2019 from 2.92% in 2018. Securities purchased in 2019 included

59

$7.6 million in fixed rate and $6.5 million in variable rate securities. In addition to the purchase and redemption activity, we received principal repayments of $7.4 million on our investments available-for-sale during 2019.

The effective duration of our securities portfolio decreased to 2.54% at December 31, 2019 as compared to 3.00% at December 31, 2018. Effective duration is a measure that attempts to quantify the anticipated percentage change in the value of an investment (or portfolio) in the event of a 100 basis point change in market yields. Since the Bank’s portfolio includes securities with embedded options (including call options on bonds and prepayment options on mortgage-backed securities), management believes that effective duration is an appropriate metric to use as a tool when analyzing the Bank’s investment securities portfolio, as effective duration incorporates assumptions relating to such embedded options, including changes in cash flow assumptions as interest rates change.

Loans receivable. Net loans receivable increased by $85.6 million during 2019 to $1.11 billion. The most significant increase occurred in one-to-four family residential loans, with a $30.6 million, or 8.9% increase. In addition, commercial real estate loans increased by $21.4 million, or 5.7%. Commercial real estate and one‑to‑four family residential loans continue to be the largest concentrations in our loan portfolio at 35.2% and 33.2%, respectively, of total loans. Growth occurred in all of our loan types, with a $17.2 million increase in consumer loans, a $7.3 million increase in business loans, a $4.8 million increase in construction/land loans, and a $3.6 million increase in multifamily loans. During 2019, we supplemented our loan originations and participations by purchasing $38.0 million in loans, which primarily included performing commercial real estate loans, classic or collectible car and construction/land loans. The loans were purchased at an average premium of 3.1% and included $16.6 million of loans secured by commercial real estate properties located in Arizona, California, Colorado, and Illinois, reflecting our efforts to geographically diversify our loan portfolio with loans meeting our investment and credit quality objectives.

The quality of our loan portfolio remained stable during 2019, with a decrease in nonperforming loans to $95,000 at December 31, 2019 from $752,000 at December 31, 2018, primarily as a result of payoffs on all but one of our nonperforming properties. Nonperforming loans as a percent of our total loans remained low at 0.01% and 0.07% at December 31, 2019 and 2018, respectively. Adversely classified loans, defined as substandard or below, decreased to $629,000 at December 31, 2019, from $1.3 million at December 31, 2018. The following table presents a breakdown of our nonperforming assets:
 
 
December 31,
 
Amount of
Change
 
Percent of
Change
 
 
2019
 
2018
 
 
(Dollars in thousands)
Nonperforming loans:
 
 
 
 
 
 
 
 
   One-to-four family residential
 
$
95

 
$
382

 
$
(287
)
 
(75.1
)%
   Commercial real estate
 
—

 
326

 
(326
)
 
(100.0
)%
   Consumer
 
—

 
44

 
(44
)
 
(100.0
)
Total nonperforming loans
 
95

 
752

 
(657
)
 
(87.4
)
OREO
 
454

 
483

 
(29
)
 
(6.0
)
Total nonperforming assets
 
$
549

 
$
1,235

 
$
(686
)
 
(55.5
)%

We continued to focus on reducing our nonperforming assets through loan work outs or pursuing foreclosure. Foregone interest during the year ended December 31, 2019 relating to nonperforming loans totaled $12,000. There was no LIP related to nonperforming loans at December 31, 2019 or 2018. OREO decreased to $454,000 at December 31, 2019 as a result of $29,000 in write-downs reflecting market value decreases on the two properties in this portfolio. We did not foreclose on any properties during either 2019 or 2018. The stability in our nonperforming assets reflects the quality of our loan portfolio and our commitment to identify any problem loans and take prompt actions to turn nonperforming assets into performing assets.

Allowance for loan and lease losses. We believe that we use the best information available to establish the ALLL, and that the ALLL as of December 31, 2019 was adequate to absorb the probable and inherent losses in the loan portfolio at that date. While we believe the estimates and assumptions used in our determination of the adequacy of the allowance are reasonable, there can be no assurance that such estimates and assumptions will not be proven incorrect in the future, or that the actual amount of future provisions will not exceed the amount of past provisions, or that any increased provisions that may be required will not adversely impact our financial condition and results of operations. Future additions to the allowance may become necessary based upon changing economic conditions, the level of problem loans, business conditions, credit concentrations, increased loan balances, or changes in the underlying collateral of the loan portfolio. In addition, the determination of the amount of our ALLL is subject to review by bank regulators as part of the routine examination process that which may result in the establishment of additional

60

loss reserves or the charge-off of specific loans against established loss reserves based upon their judgment of information available to them at the time of their examination.

The ALLL was $13.2 million, or 1.18% of total loans receivable at December 31, 2019, as compared to $13.3 million, or 1.29% of total loans receivable at December 31, 2018. The following table details activity and information related to the ALLL for the years ended December 31, 2019 and 2018.
 
At or For the Years Ended
December 31,
 
2019
 
2018
 
(Dollars in thousands)
ALLL balance at beginning of year
$
13,347

 
$
12,882

Recapture of provision for loan losses
(300
)
 
(4,000
)
Recoveries
171

 
4,465

ALLL balance at end of year
$
13,218

 
$
13,347

ALLL as a percent of total loans
1.18
%
 
1.29
%
ALLL as a percent of nonperforming loans
13,913.68

 
1,774.87

Total nonperforming loans
$
95

 
$
752

Nonperforming loans as a percent of total loans
0.01
%
 
0.07
%
Total loans receivable
$
1,122,238

 
$
1,037,429

Total loans originated
350,406

 
329,763


Intangible assets. As a result of our Branch Acquisition in 2017, the Bank recognized goodwill of $889,000 and a core deposit intangible (“CDI”) of $1.3 million. Goodwill was calculated as the excess purchase price of the branches over the fair value of the assets acquired and liabilities assumed at August 25, 2017.

The CDI was provided by a third party valuation service and represents the fair value of the customer relationships that provide a low-cost source of funding. The analysis was performed on the acquired noninterest-bearing checking, interest-bearing checking, savings, and money market accounts. The initial ratio of CDI to the acquired balances of core deposits was 2.23%. This amount will amortize into noninterest expense on an accelerated basis over ten years and had a balance of $968,000 at December 31, 2019.

Deposits. During the year ended December 31, 2019, deposits increased $94.5 million from December 31, 2018. Details of deposit balances and their concentrations are as follows:
 
December 31,
 
2019
 
2018
 
(Dollars in thousands)
Noninterest-bearing demand deposits
$
52,849

 
5.1
%
 
$
46,108

 
4.9
%
Interest-bearing demand
65,897

 
6.4

 
40,079

 
4.3

Statement savings
17,447

 
1.7

 
24,799

 
2.6

Money market
377,766

 
36.6

 
339,047

 
36.1

Certificates of deposit, retail (1)
425,103

 
41.1

 
391,174

 
41.7

Certificates of deposit, brokered
94,472

 
9.1

 
97,825

 
10.4

Total deposits
$
1,033,534

 
100.0
%
 
$
939,032

 
100.0
%
____________________
(1) Retail certificates of deposit are shown net of a $28,000 and $58,000 fair value adjustment at December 31, 2019, and 2018, respectively, from acquired deposits.

The $97.9 million growth in retail deposits during 2019 was primarily the result of continued focus on core deposit growth. During 2019, with the enhancements in treasury management products offered to our customers and the focus of our retail team, we were very successful in acquiring core deposits by building business checking and money market relationships. As a result, money market accounts grew by $38.7 million, retail certificates of deposit grew by $33.9 million and interest-bearing

61

demand accounts grew by $25.8 million. The growth in retail deposits allowed us to reduce our borrowings and enhance our liquidity.

Our portfolio of brokered certificates of deposit decreased by $3.4 million to $94.5 million at December 31, 2019. During 2019, the Bank exercised its call option on $27.7 million of certain higher rate brokered certificates of deposit, replacing the funds in the short term with lower rate fed funds advances from the FHLB. While brokered certificates of deposit may carry a higher cost than our retail certificates, the enhanced call features of a portion of these deposits assist us in our efforts to manage interest rate risk.

At December 31, 2019 and December 31, 2018, we held $34.0 million and $28.5 million in public funds, respectively, nearly all of which were retail certificates of deposit. These funds were secured at December 31, 2019 with the Washington State Public Deposit Protection Commission by $19.0 million in pledged investment securities.

Advances. We use advances from the FHLB as an alternative funding source to manage interest rate risk and to leverage our balance sheet. Total FHLB advances at December 31, 2019 were $137.7 million as compared to $146.5 million at December 31, 2018. During 2019, as part of our ongoing liquidity management efforts, we restructured our FHLB advances to include $60.0 million of fixed-rate three-month advances that renew quarterly, and a $15.0 million fixed-rate one-month advance that renews monthly, that are utilized in cash flow hedge agreements, as described below. In addition, at December 31, 2019, we had a $36.0 million fixed-rate 21-day advance. At December 31, 2019, we held $26.7 million of purchased FHLB Fed Funds. The short-term nature of our advances and overnight FHLB advances provides us flexibility to adjust the level of our borrowings as our customer deposit balances change consistent with our asset/liability objectives. Our average borrowings during 2019 were $129.9 million. At December 31, 2019, all of our FHLB advances were due to mature in less than two months.

Cash Flow Hedge. To assist in managing interest rate risk, the Bank entered into three interest rate swap agreements with qualified institutions designated as cash flow hedge instruments: a five-year, $50 million notional, pay fixed, receive floating cash flow hedge on October 25, 2016, at 1.34%; a five-year, $15.0 million notional, pay fixed, receive floating cash flow hedge on September 27, 2019, at 1.44%; and a four-year, $10.0 million notional, pay fixed, receive floating cash flow hedge on November 20, 2019, at 1.585%. Under the terms of the interest rate swap agreements, the Bank pays a fixed interest rate and in return receives an interest payment based on the corresponding LIBOR index, which resets quarterly or monthly, depending on the hedge term. Concurrently, the Bank borrowed a fixed rate FHLB advance that will be renewed quarterly or monthly, as designated by the hedge agreement, at the fixed interest rate at that time. Effectiveness of the interest rate swap is evaluated quarterly with any ineffectiveness recognized as a gain or a loss on the income statement in noninterest income. A change in the fair value of the cash flow hedge created by the interest rate swap agreements is recognized as an other asset or other liability on the balance sheet with the tax-effected portion of the change included in other comprehensive income. At December 31, 2019, we recognized a $426,000 fair value asset as a result of the increase in market value of the interest rate swap agreements.

Stockholders’ Equity. Total stockholders’ equity increased $2.6 million, or 1.7% to $156.3 million at December 31, 2019 from $153.7 million at December 31, 2018. The increase in stockholders’ equity was primarily a result of $10.4 million in net income partially offset by the repurchase of 479,052 shares of stock at an aggregate cost of $7.4 million and $3.5 million in shareholder cash dividends. In addition, net stock-based compensation totaled $2.2 million and other comprehensive loss, net of tax, decreased $882,000 during the year ended December 31, 2019. Additional shares of common stock were issued from authorized shares due to the exercise of stock options and restricted stock awards in 2019 totaling 21,349 shares, resulting in a net decrease to stockholders’ equity of $72,000.

Comparison of Operating Results for the Years Ended December 31, 2019 and December 31, 2018

Net Interest Income. Net interest income in 2019 was $38.9 million, a $2.3 million or 5.5% decrease from $41.2 million in 2018, due primarily to an $6.0 million increase in interest expense partially offset by a $3.7 million increase in interest income. Interest income increased during the year ended December 31, 2019, primarily as a result of the $65.6 million growth in the average balance of net loans receivable and in particular, one-to-four family, commercial real estate and consumer loans. In addition, the average yield of interest-earning assets increased to 4.88% for the year ended December 31, 2019 from 4.83% for the year ended December 31, 2018. The increase in average assets was funded by a $63.8 million increase in average interest-bearing liabilities. The average cost of these funds increased to 1.92% for the year ended December 31, 2019 from 1.46% for the year ended December 31, 2018, primarily as a result of an increase in the targeted federal funds rate during the first six months of 2019, and to a lesser extent, higher deposit balances. Our interest-bearing liabilities reprice faster than our interest‑earning assets in response to changes in market interest rates, resulting in a 37 basis point reduction in our net interest margin to 3.19% for the year ended December 31, 2019, from 3.56% for the year ended December 31, 2019. For more information on this, see “Asset and Liability Management and Market Risk.”


62

The following table compares average interest-earning asset balances, associated yields, and resulting changes in interest and dividend income for the years ended December 31, 2019 and 2018:
 
Year Ended December 31,
 
2019
 
2018
 
Change in Interest and Dividend Income
 
Average
Balance
 
Yield
 
Average
Balance
 
Yield
 
 
(Dollars in thousands)
Loans receivable, net                                           
$
1,061,367

 
5.15
%
 
$
995,810

 
5.13
%
 
$
3,509

Investments available-for-sale
139,354

 
3.11

 
141,100

 
2.92

 
203

Interest-earning deposits                                           
13,634

 
2.15

 
11,628

 
1.74

 
91

FHLB stock                      
6,684

 
5.42

 
8,748

 
5.24

 
(96
)
Total interest-earning assets                                                      
$
1,221,039

 
4.88
%
 
$
1,157,286

 
4.83
%
 
$
3,707


During the year ended December 31, 2019, the $3.5 million increase in loan interest income was the result of a $65.6 million increase in the average balance of net loans receivable combined with a slight increase in the average loan yield of two basis points. The loan yield for the year ended December 31,2018, benefited from repayments of previously charged off notes, which contributed $1.0 million to loan interest income on loans with a zero book balance at the time of payoff.

Interest income from investments available-for-sale increased $203,000 during 2019 as a combined result of a $1.7 million increase in the average balance of our investments and a 19 basis point increase in the average yield to 3.11% from 2.92% during 2018. Our variable rate available-for-sale investments benefited from the increases in the targeted Fed Funds rate that occurred throughout 2018 and that outpaced the decreases in the targeted federal funds rate in the second half of 2019.

Interest income on interest-earning deposits increased $91,000 during the year ended December 31, 2019, primarily as a result of a $2.0 million increase in the average balance of these deposits, combined with a 41 basis point increase in the average yield to 2.15% for the year ended December 31, 2019 from 1.74% for the year ended December 31, 2018. The rate increase was the result of the increase in the Federal Reserve’s targeted federal funds rate during the initial six months of 2019.

The following table details average balances, cost of funds and the resulting increase in interest expense for the years ended December 31, 2019 and 2018:
 
Year Ended December 31,
 
2019
 
2018
 
Change in
Interest
Expense
 
Average
Balance
 
Cost
 
Average
Balance
 
Cost
 
 
(Dollars in thousands)
Interest-bearing demand accounts                                
$
50,519

 
0.21
%
 
$
40,360

 
0.20
%
 
$
29

Statement savings accounts                                                      
21,920

 
0.13

 
25,724

 
0.13

 
(5
)
Money market accounts                                           
329,008

 
1.53

 
326,075

 
1.09

 
1,477

Certificates of deposit, retail                                     
410,992

 
2.32

 
350,603

 
1.66

 
3,724

Certificates of deposit, brokered
134,045

 
2.45

 
86,203

 
2.01

 
1,553

Advances from the FHLB                                           
129,899

 
2.09

 
183,667

 
1.92

 
(804
)
Total interest-bearing liabilities                                                      
$
1,076,383

 
1.92
%
 
$
1,012,632

 
1.46
%
 
$
5,974


Interest expense increased $6.0 million to $20.7 million for the year ended December 31, 2019 from $14.7 million for the year ended December 31, 2018. The increase in interest expense during 2019 was primarily a result of the increase in the average cost of interest-bearing deposits of 55 basis points and the increase in the average cost of our FHLB borrowings of 17 basis points reflecting higher market interest rates. In support of our asset growth, the average balances of interest-bearing deposits increased by $117.5 million. The growth in our deposits more than met our funding needs, allowing the Bank to pay down certain FHLB advances, resulting in a $53.8 million decrease in the average balance of these borrowings for 2019.


63

The average cost of our retail deposits increased as a result of the continued strength in market interest rates that occurred during 2019. Money market interest expense increased by $1.5 million as a result of a $2.9 million increase in the average balance primarily due to continued branch growth, combined with a 44 basis point increase in the average cost of these funds. The cost of retail and brokered certificates of deposit increased by 66 and 44 basis points, respectively, as the rates required to compete for these deposits in the marketplace have increased in response to increases in the targeted federal funds rate. Our average balance of brokered certificates of deposit increased by $47.8 million during 2019 as opportunities to obtain short-term funding were utilized.

Provision for Loan Losses. Our recapture of provision for loan losses was $300,000 for the year ended December 31, 2019 as compared to $4.0 million for the year ended December 31, 2018, resulting in a decrease in the ALLL to total loans to 1.18% at December 31, 2019, as compared to 1.29% at December 31, 2018. The recapture in 2019 was primarily the result of a construction/land loan with a balance of $12.5 million at December 31, 2019, that was technically in default and classified as impaired, however, the Bank’s impairment analysis concluded there were no anticipated losses from the loan at this time, and therefore funds previously allocated in the ALLL to this loan were recaptured. In addition, although total loans increased, the impact to the provision from this loan growth was offset by a shift in our loan concentrations to lower risk categories and reduction in the risk factor related to the collateral on certain loan types. Further, our total adversely classified loans decreased to $629,000 at December 31, 2019 from $1.3 million at December 31, 2018. In comparison, the recapture of provision in 2018 was primarily the result of $4.5 million in net recoveries of previously charged off loans, partially reduced by the provision for loan losses required as a result of the $34.2 million increase in net loans receivable. Although our total loans evaluated for specific reserves increased by $9.8 million as impaired loans increased, the related specific reserves after evaluation declined to $31,000 at December 31, 2019 from $62,000 at December 31, 2018.

Noninterest Income. Noninterest income increased $1.3 million to $4.1 million for the year ended December 31, 2019 from $2.9 million for the year ended December 31, 2018. The following table provides a detailed analysis of the changes in the components of noninterest income:
 
Year Ended
December 31, 2019
 
Change from
December 31, 2018
 
Percentage
Change
 
(Dollars in thousands)
Deposit related fees
$
733

 
$
52

 
7.6
 %
Loan related fees
1,344

 
576

 
75.0

Gain on sale of investments, net
151

 
171

 
(855.0
)
BOLI change in cash surrender value
994

 
180

 
22.1

Wealth management revenue
879

 
268

 
43.9

Other           
40

 
16

 
66.7

Total noninterest income                                           
$
4,141

 
$
1,263

 
43.9
 %

The largest change to our noninterest income was the $576,000 increase on loan related fees primarily as a result of a $320,000 increase in interest rate swap servicing fees. The Bank has an interest rate swap program for commercial loan customers, under which the customer participates in an interest rate swap with a third party broker institution for which the Bank receives a servicing fee that is recognized at the time the loan is originated. In addition, loan prepayment penalties increased by $290,000 for the year ended December 31, 2019, as compared to the year ended December 31, 2018.

Wealth management revenue increased by $268,000 as a result of an increase in assets we manage and as a result of normal fluctuations in the timing and mix of commissions received on serviced accounts due to the nature and timing of the underlying investments. This line of business assists the Bank with providing options to our customers to better meet their financial needs. Total assets managed by our wealth management division increased to $96.0 million at December 31, 2019, from $64.8 million at December 31, 2018.
  
Our BOLI noninterest income increased by $180,000 for the year ended December 31, 2019, primarily as a result of the timing in recognizing policy expenses and dividends on new policies purchased in 2017 and 2018. Policy expenses were deducted from earnings over the first year subsequent to the purchase date of certain policies, partially reducing the noninterest income on our BOLI policies we otherwise would recognize. We recognized the net $994,000 increase in cash surrender value of these policies as noninterest income, which assists in offsetting expenses for employee benefits.

The Bank sold certain available-for-sale securities during the year ended December 31, 2019, resulting in a $151,000 gain. In comparison, sales of investments for the year ended December 31, 2018, resulted in a $20,000 loss. During 2019, selected

64

securities were strategically sold, with the funds reinvested in securities and loans that were expected to improve the Company’s total return on investments. The timing of these sales resulted in net gains, and in most instances, with proceeds reinvested into securities with superior anticipated yields.

Deposit related fees of $733,000 were recorded for the year ended December 31, 2019, a $52,000 increase over the prior year. As a result of our deposit growth and corresponding increase in customer transactions, our transactional based fee revenue also increased.

Noninterest Expense. Noninterest expense increased $957,000 to $30.4 million for the year ended December 31, 2019 from $29.5 million for the year ended December 31, 2018. The following table provides a detailed analysis of the changes in the components of noninterest expense:
 
Year Ended
December 31, 2019
 
Change from
December 31, 2018
 
Percentage
Change
 
(Dollars in thousands)
Salaries and employee benefits
$
19,595

 
$
293

 
1.5
 %
Occupancy and equipment                                           
3,712

 
429

 
13.1

Professional fees                                
1,690

 
152

 
9.9

Data processing                                
2,031

 
639

 
45.9

OREO related expenses, net
34

 
27

 
385.7

Regulatory assessments
307

 
(195
)
 
(38.8
)
Insurance and bond premiums                                           
375

 
(68
)
 
(15.3
)
Marketing
339

 
(5
)
 
(1.5
)
Other general and administrative
2,335

 
(315
)
 
(11.9
)
Total noninterest expense                                           
$
30,418

 
$
957

 
3.2
 %

The primary contributor to the increase in noninterest expense was our continued focus on product and branch expansion. For the year ended December 31, 2019, salaries and employee benefits increased by $293,000, as compared to the previous year, to $19.6 million partially as a result of $541,000 in normal wage increases combined with severance and related benefits for a terminated employee. These increases were partially offset by a $357,000 reduction in stock based compensation.

Occupancy and equipment expense increased $429,000 to $3.7 million during 2019 primarily as a result of the addition of two new branch locations in 2019. Lease expense increased by $188,000 and depreciation expense increased by $134,000, primarily as a result of additional leasehold improvements and fixed assets related to opening the new branches.

Data processing expense increased by $639,000 in support of continued growth of our loan and deposit accounts. In addition, the completion of our new online banking platform, incurred both one-time costs and an increase in monthly core processor service fees.

Partially offsetting these increases, our regulatory expenses decreased by $195,000 for 2019, as compared to 2018, as a result of the application of $282,000 in small bank assessment credits to offset a portion of our quarterly expense. Further reducing our noninterest expense for 2019, as compared to 2018, the Bank received a $125,000 insurance settlement for a $225,000 wire related fraud that was recognized in other general and administrative expense in 2019.

Federal Income Tax Expense. We recorded a $2.6 million federal income tax provision for 2019, compared to $3.7 million for 2018. The decrease in federal income tax provision for 2019 was primarily the result of a $5.7 million decrease in pretax net income.

65


Average Balances, Interest and Average Yields/Cost

The following table presents information regarding average balances of assets and liabilities as well as interest income from average interest-earning assets and interest expense on average interest-bearing liabilities, resultant yields, interest rate spreads, net interest margins and the ratio of average interest-earning assets to average interest-bearing liabilities. Average balances have been calculated using the average daily balances during the period. Interest and dividends are not reported on a tax equivalent basis.
 
Year Ended December 31,
 
2019
 
2018
 
2017
 
Average Balance (1)
 
Interest and Dividends
 
Yield/Cost
 
Average Balance (1)
 
Interest and Dividends
 
Yield/Cost
 
Average Balance (1)
 
Interest and Dividends
 
Yield/Cost
 
(Dollars in thousands)
Interest-earnings assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loans receivable, net                                           
$
1,061,367

 
$
54,636

 
5.15
%
 
$
995,810

 
$
51,127

 
5.13
%
 
$
878,449

 
$
43,607

 
4.96
%
Investments available-for-sale
139,354

 
4,329

 
3.11

 
141,100

 
4,126

 
2.92

 
134,105

 
3,504

 
2.61

Interest-earning deposits
13,634

 
293

 
2.15

 
11,628

 
202

 
1.74

 
22,194

 
237

 
1.07

FHLB stock
6,684

 
362

 
5.42

 
8,748

 
458

 
5.24

 
8,914

 
296

 
3.32

Total interest-earning assets
1,221,039

 
59,620

 
4.88

 
1,157,286

 
55,913

 
4.83

 
1,043,662

 
47,644

 
4.57

Noninterest earning assets
73,125

 
 
 
 
 
70,110

 
 
 
 
 
64,994

 
 
 
 
Total average assets
$
1,294,164

 
 
 
 
 
$
1,227,396

 
 
 
 
 
$
1,108,656

 
 
 
 
Interest-bearing liabilities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing demand accounts
$
50,519

 
$
108

 
0.21
%
 
$
40,360

 
$
79

 
0.20
%
 
$
25,267

 
$
73

 
0.29
%
Statement savings accounts
21,920

 
29

 
0.13

 
25,724

 
34

 
0.13

 
28,160

 
42

 
0.15

Money market accounts
329,008

 
5,027

 
1.53

 
326,075

 
3,550

 
1.09

 
247,770

 
1,779

 
0.72

Certificates of deposit, retail
410,992

 
9,549

 
2.32

 
350,603

 
5,825

 
1.66

 
345,981

 
4,362

 
1.26

Certificates of deposit, brokered
134,045

 
3,283

 
2.45

 
86,203

 
1,730

 
2.01

 
75,488

 
1,261

 
1.67

Total deposits
946,484

 
17,996

 
1.90

 
828,965

 
11,218

 
1.35

 
722,666

 
7,517

 
1.04

Advances from the FHLB and other borrowings
129,899

 
2,716

 
2.09

 
183,667

 
3,520

 
1.92

 
192,227

 
2,505

 
1.30

Total interest-bearing liabilities
1,076,383

 
20,712

 
1.92

 
1,012,632

 
14,738

 
1.46

 
914,893

 
10,022

 
1.10

Noninterest bearing liabilities
63,689

 
 
 
 
 
63,619

 
 
 
 
 
51,116

 
 
 
 
Average equity
154,092

 
 
 
 
 
151,145

 
 
 
 
 
142,647

 
 
 
 
Total average liabilities and equity
$
1,294,164

 
 
 
 
 
$
1,227,396

 
 
 
 
 
$
1,108,656

 
 
 
 
Net interest income
 
 
$
38,908

 
 
 
 
 
$
41,175

 
 
 
 
 
$
37,622

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net interest margin
 
 
 
 
3.19
%
 
 
 
 
 
3.56
%
 
 
 
 
 
3.60
%
Ratio of average interest-
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
  earning assets to average
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
  interest-bearing liabilities
113.44
%
 
 
 
 
 
114.28
%
 
 
 
 
 
114.07
%
 
 
 
 
________________ 
(1) The average loans receivable, net balances include nonaccruing loans and deferred fees.

66


Yields Earned and Rates Paid

The following table presents the weighted-average yields earned on our assets and the weighted-average interest rates paid on our liabilities, together with the net yield on interest-earning assets and liabilities, for the dates indicated.
 
Weighted Average Yield at
December 31, 2019
 
Net Yield
Year Ended December 31,
 
2019
 
2018
 
2017
Yield on interest-earning assets:
 
 
 
 
 
 
 
Loans receivable, net                                           
4.84
%
 
5.15
%
 
5.13
%
 
4.96
%
Investment securities available-for-sale                                                                
2.94

 
3.11

 
2.92

 
2.61

Interest-earning deposits
1.52

 
2.15

 
1.74

 
1.07

FHLB stock
—

 
5.42

 
5.24

 
3.32

Total interest-earning assets                                                      
4.57

 
4.88

 
4.83

 
4.57

Rate paid on interest-bearing liabilities:
 
 
 
 
 
 
 
Interest-bearing demand accounts                                
0.18

 
0.21

 
0.20

 
0.29

Statement savings accounts                                                      
0.13

 
0.13

 
0.13

 
0.15

Money market accounts                                           
1.53

 
1.53

 
1.09

 
0.72

Certificates of deposit, retail                                           
2.36

 
2.32

 
1.66

 
1.26

Certificates of deposit, brokered
1.93

 
2.45

 
2.01

 
1.67

Total interest-bearing deposits
1.81

 
1.90

 
1.35

 
1.04

Advances from the FHLB and other borrowings                                    
1.63

 
2.09

 
1.92

 
1.30

Total interest-bearing liabilities                                                                
1.79

 
1.92

 
1.46

 
1.10

Interest rate spread
2.78

 
2.96

 
3.37

 
3.47

Net interest margin                                
N/A
 
3.19

 
3.56

 
3.60


Rate/Volume Analysis

The following table presents the effects of changing rates and volumes on our net interest income. Information is provided with respect to: (1) effects on interest income attributable to changes in volume (changes in volume multiplied by prior rate); and (2) effects on interest income attributable to changes in rate (changes in rate multiplied by prior volume). Changes in rate/volume are allocated proportionately to the changes in rate and volume.

67

 
Year Ended December 31, 2019 Compared to December 31, 2018 Change in Interest
 
Year Ended December 31, 2018 Compared to December 31, 2017 Change in Interest
 
2019
 
2018
 
Rate
 
Volume
 
Total
 
Rate
 
Volume
 
Total
 
(In thousands)
Interest-earning assets:
 
 
 
 
 
 
 
 
 
 
 
Loans receivable, net
$
143

 
$
3,366

 
$
3,509

 
$
1,694

 
$
5,826

 
$
7,520

Investments available-for-sale
254

 
(51
)
 
$
203

 
439

 
183

 
$
622

Interest-earning deposits
56

 
35

 
$
91

 
78

 
(113
)
 
$
(35
)
FHLB stock
12

 
(108
)
 
$
(96
)
 
168

 
(6
)
 
$
162

Net change in interest income
465

 
3,242

 
3,707

 
2,379

 
5,890

 
8,269

 
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing liabilities:
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing demand accounts
$
9

 
$
20

 
$
29

 
$
(38
)
 
$
44

 
$
6

Statement savings accounts
—

 
(5
)
 
$
(5
)
 
(4
)
 
(4
)
 
$
(8
)
Money market accounts
1,445

 
32

 
$
1,477

 
1,209

 
562

 
$
1,771

Certificates of deposit, retail
2,721

 
1,003

 
$
3,724

 
1,405

 
58

 
$
1,463

Certificates of deposit, brokered
593

 
960

 
$
1,553

 
290

 
179

 
$
469

Advances from the FHLB
226

 
(1,030
)
 
$
(804
)
 
1,127

 
(112
)
 
$
1,015

Net change in interest expense
4,994

 
980

 
5,974

 
3,989

 
727

 
4,716

Net change in net interest income
$
(4,529
)
 
$
2,262

 
$
(2,267
)
 
$
(1,610
)
 
$
5,163

 
$
3,553


Asset and Liability Management and Market Risk

General. Our Board of Directors has approved an asset/liability management policy to guide management in maximizing interest rate spread by managing the differences in terms between interest-earning assets and interest-bearing liabilities while maintaining acceptable levels of liquidity, capital adequacy, interest rate risk, credit risk, and profitability. The policy established an Investment, Asset/Liability Committee (“ALCO”) comprised of certain members of senior management and the Board of Directors. The Committee’s purpose is to communicate, coordinate and manage our asset/liability position consistent with our business plan and Board-approved policies. The ALCO meets quarterly to review various areas including:
•
economic conditions;
•
interest rate outlook;
•
asset/liability mix;
•
interest rate risk sensitivity;
•
current market opportunities to promote specific products;
•
historical financial results;
•
projected financial results; and
•
capital position.

The Committee also reviews current and projected liquidity needs. As part of its procedures, the Committee regularly reviews interest rate risk by forecasting the impact that changes in interest rates may have on net interest income and the market value of portfolio equity, which is defined as the net present value of an institution’s existing assets, liabilities and off-balance sheet instruments and evaluating such impacts against the maximum potential change in the market value of portfolio equity that is authorized by the Board of Directors.

Our Risk When Interest Rates Change. The rates of interest we earn on assets and pay on liabilities generally are established contractually for a period of time. Market interest rates change over time. Our loans generally have longer maturities than our deposits. Accordingly, our results of operations, like those of other financial institutions, are impacted by changes in

68

interest rates and the interest rate sensitivity of our assets and liabilities. The risk associated with changes in interest rates and our ability to adapt to these changes is known as interest rate risk and is our most significant market risk.

We have utilized the following strategies in our efforts to manage interest rate risk:
•
we are originating shorter term, higher yielding loans, whenever possible;
•
we have attempted, where possible, to extend the maturities of our deposits which typically fund our long-term assets;
•
we have invested in securities with relatively short average lives, generally less than eight years;
•
we have added adjustable-rate loans to our loan portfolio;
•
we have added brokered certificates of deposit with a call option as a funding source; and
•
we have utilized interest rate swaps to effectively fix the rate on $75.0 million of FHLB advances.

How We Measure the Risk of Interest Rate Changes. We monitor our interest rate sensitivity on a quarterly basis by measuring the impact of changes to net interest income in multiple rate environments. Management retains the services of a third party consultant with over 30 years of experience in asset-liability management to assist in its interest rate risk and asset-liability management. Management uses various assumptions to evaluate the sensitivity of our operations to changes in interest rates. Although management believes these assumptions are reasonable, the interest rate sensitivity of our assets and liabilities on net interest income and the market value of portfolio equity could vary substantially if different assumptions were used or actual results differ from these assumptions. Although certain assets and liabilities may have similar maturities or periods of repricing, they may react differently to changes in market interest rates. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types of assets and liabilities lag behind changes in market interest rates. Non-uniform changes and fluctuations in market interest rates across various maturities will also affect the results presented. In addition, certain assets, such as adjustable-rate mortgage loans, have features which restrict changes in interest rates on a short-term basis and over the life of the asset. Further, a portion of our adjustable-rate loans have interest rate floors below which the loan’s contractual interest rate may not adjust. Approximately 55.8% of our net loans were adjustable-rate loans at December 31, 2019. At that date, $359.0 million, or 57.3%, of these loans with a weighted-average interest rate of 4.80% were at their floor interest rate. The inability of our loans to adjust downward can contribute to increased income in periods of declining interest rates. However, when loans are at their floors, there is a further risk that our interest income may not increase as rapidly as our cost of funds during periods of increasing interest rates. Further, in the event of a significant change in interest rates, prepayment and early withdrawal levels would likely deviate from those assumed. Finally, the ability of many borrowers to service their debt may decrease in the event of an interest rate increase. We consider all these factors in monitoring our interest rate exposure.

The assumptions we use are based upon a combination of proprietary and market data that reflect historical results and current market conditions. These assumptions relate to interest rates, prepayments, deposit decay rates and the market value of certain assets under the various interest rate scenarios. We use market data to determine prepayments and maturities of loans, investments and borrowings and use our own assumptions on deposit decay rates except for time deposits. Time deposits are modeled to reprice to market rates upon their stated maturities. We also assume that non-maturity deposits can be maintained with rate adjustments not directly proportionate to the change in market interest rates, based upon our historical deposit decay rates, which are substantially lower than market decay rates. We have observed in the past that our deposit accounts during changing rate environments have relatively lower volatility and less than market rate changes. When interest rates rise, we do not have to raise interest rates proportionately on less rate sensitive accounts to retain these deposits. These assumptions are based upon our analysis of our customer base, competitive factors, and historical experience.

Our income simulation model examines changes in net interest income in scenarios where interest rates were assumed to remain at their base level, instantaneously increase by 100, 200 and 300 basis points or decline immediately by 100 basis points. A decline by 200 and 300 basis points is not reported as the current targeted federal funds rate is between 1.50% and 1.75%.

The following table illustrates the estimated change in our net interest income over the next 12 months from December 31, 2019, that would occur in the event of an immediate change in interest rates equally across all maturities, with no effect given to any steps that we might take to counter the effect of that interest rate movement.


69

            
Interest Rate Simulation Impact on Net Interest Income
for the year ended December 31, 2019
Basis Point Change in Rates
 
Net Interest Income
 
% Change
(Dollars in thousands)
+300
 
$
38,752

 
0.22
 %
+200
 
38,682

 
0.04

+100
 
38,604

 
(0.16
)
Base
 
38,666

 
—

(100)
 
38,664

 
(0.01
)

The following table illustrates the change in our net portfolio value (“NPV”) at December 31, 2019 that would occur in the event of an immediate change in interest rates equally across all maturities, with no effect given to any steps that we might take to counter the effect of that interest rate movement.
Basis Point
Change in Rates (1)
 
Net Portfolio Value (2)
 
Net Portfolio as % of Portfolio Value of Assets
 
Market Value
of Assets (6)
Amount
 
$ Change (3)
 
% Change
NPV Ratio (4)
 
% Change (5)
 
(Dollars in thousands)
 
 
+300
 
$
118,480

 
$
(27,621
)
 
(18.91
)%
 
9.48
%
 
(2.07
)%
 
$
1,250,209

+200
 
127,775

 
(18,326
)
 
(12.54
)
 
10.00

 
(1.37
)
 
1,278,287

+100
 
138,549

 
(7,552
)
 
(5.17
)
 
10.59

 
(0.56
)
 
1,308,880

Base
 
146,101

 
—

 
—

 
10.92

 
—

 
1,337,311

(100)
 
147,786

 
1,685

 
1.15

 
10.85

 
0.13

 
1,361,592

__________
(1) 
No rates in the model are allowed to go below zero. Given the relatively low level of market interest rates, a calculation for a decrease of greater than 100 basis points has not been prepared.
(2) 
The net portfolio value is the difference between the present value of the discounted cash flows of assets and liabilities and represents the market value of the Company’s equity for any given interest rate scenario. Net portfolio value is useful for determining, on a market value basis, how equity changes in response to various interest rate scenarios. Large changes in net portfolio value reflect increased interest rate sensitivity and generally more volatile earnings streams.
(3) 
The increase or decrease in the estimated net portfolio value at the indicated interest rates compared to the net portfolio value assuming no change in interest rates.
(4) 
Net portfolio value divided by the market value of assets.
(5) 
The increase or decrease in the net portfolio value divided by the market value of assets.
(6) 
The market value of assets represents the value of assets under the various interest rate scenarios and reflects the sensitivity of those assets to interest rate changes.

The net interest income and net portfolio value tables presented above are predicated upon a stable balance sheet with no growth or change in asset or liability mix. In addition, the net portfolio value is based upon the present value of discounted cash flows using our estimates of current replacement rates to discount the cash flows. The effects of changes in interest rates in the net interest income table are based upon a cash flow simulation of our existing assets and liabilities and assuming that delinquency rates would not change as a result of changes in interest rates, although there can be no assurance that this will be the case. Delinquency rates may change when interest rates change as a result of changes in the loan portfolio mix, underwriting conditions, loan terms or changes in economic conditions that have a delayed effect on the portfolio. Even if interest rates change in the designated amounts, there can be no assurance that our assets and liabilities would perform as assumed. Also, a change in U.S. Treasury rates in the designated amounts accompanied by a change in the shape of the Treasury yield curve would cause changes to the net portfolio value and net interest income other than those indicated above.

Liquidity

We are required to have enough cash flow in order to maintain sufficient liquidity to ensure a safe and sound operation. We maintain cash flows above the minimum level believed to be adequate to meet the requirements of normal operations, including potential deposit outflows. On a daily basis, we review and update cash flow projections to ensure that adequate liquidity is maintained.


70

Our primary sources of funds are customer deposits, scheduled loan and investment repayments, including interest payments, maturing loans and investment securities, and advances from the FHLB. These funds, together with equity, are used to fund loans, acquire investment securities and other assets, and fund continuing operations. While maturities and the scheduled amortization of loans are a predictable source of funds, deposit flows and mortgage prepayments are greatly influenced by the level of interest rates, economic conditions and competition. We believe that our current liquidity position, and our forecasted operating results are sufficient to fund all of our existing commitments.

Liquidity management is both a daily and long-term function of business management. Excess liquidity is generally invested in short-term investments such as overnight deposits or agency or mortgage-backed securities. On a longer term basis, we maintain a strategy of investing in various lending products as described in greater detail under Item 1. “Business – Lending Activities.” At December 31, 2019, the undisbursed portion of construction LIP totaled $89.6 million and unused lines of credit were $38.1 million. In addition, we had commitments to originate loans of $2.0 million that includes a $230,000 standby letter of credit. We use our sources of funds primarily to meet ongoing commitments, to pay maturing certificates of deposit and withdrawals on other deposit accounts, to fund loan commitments, and to maintain our portfolio of investment securities. Certificates of deposit scheduled to mature in one year or less at December 31, 2019 totaled $222.1 million. Management’s policy is to maintain deposit rates at levels that are competitive with other local financial institutions. Based on historical experience, we believe that a significant portion of maturing certificates of deposit will remain with First Financial Northwest Bank. As further funding sources, we had the ability at December 31, 2019 to borrow an additional $451.0 million from the FHLB, $80.1 million from the FRB and $35.0 million from unused lines of credit with other financial institutions to meet commitments and for liquidity purposes. See the Consolidated Statements of Cash Flows in Item 8 of this report for further details on our cash flow activities.

We measure our liquidity based on our ability to fund our assets and to meet liability obligations when they come due. Liquidity (and funding) risk occurs when funds cannot be raised at reasonable prices, or in a reasonable time frame, to meet our normal or unanticipated obligations. We regularly monitor the mix between our assets and our liabilities to manage our liquidity and funding requirements.

Our primary source of funds is our retail deposits. When retail deposits are not available to provide the funds for our assets, we use alternative funding sources. These sources include, but are not limited to, advances from the FHLB, wholesale funding, brokered deposits, federal funds purchased, and dealer repurchase agreements, as well as other short-term alternatives. We may also liquidate assets to meet our funding needs.

On a monthly basis, we estimate our liquidity sources and needs for the next twelve months. Also, we determine funding concentrations and our need for sources of funds other than deposits. This information is used by our Asset/Liability Management Committee in forecasting funding needs and investing opportunities.

Capital

Our total stockholders’ equity was $156.3 million at December 31, 2019. Consistent with our goal to operate a sound and profitable financial organization we will actively seek to maintain the Bank as a “well capitalized” institution in accordance with regulatory standards. As of December 31, 2019, First Financial Northwest Bank exceeded all regulatory capital requirements. Regulatory capital ratios for First Financial Northwest Bank were as follows as of December 31, 2019: Total capital to risk-weighted assets was 14.38%; Tier 1 capital and Common equity tier 1 capital to risk-weighted assets was 13.13%; and Tier 1 capital to total assets was 10.27%. At December 31, 2019, First Financial Northwest Bank met the financial ratios to be considered well-capitalized under the regulatory guidelines. See Item 1. “Business – How We Are Regulated – Regulation and Supervision of First Financial Northwest Bank – Capital Requirements.”

Commitments and Off-Balance Sheet Arrangements

We are a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit and the unused portions of lines of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated statements of financial condition. Commitments to extend credit and lines of credit are not recorded as an asset or liability by us until the instrument is exercised. At December 31, 2019 and 2018, we had no commitments to originate loans for sale.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the loan agreement. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. We evaluate each customer’s creditworthiness on a case-by-case basis. The

71

amount of collateral obtained, if deemed necessary by us upon extension of credit, is based on our credit evaluation of the customer. The amount and type of collateral required varies, but may include real estate and income-producing commercial properties.

The following table summarizes our outstanding commitments to advance additional amounts pursuant to outstanding lines of credit, and to disburse funds related to our construction loans at December 31, 2019.
 
 
 
Amount of Commitment Expiration - Per Period
 
Total Amounts Committed
 
Through One Year
 
After One Through Three Years
 
After Three Through Five Years
 
After Five Years
 
(In thousands)
Commitments to originate loans
$
2,038

 
$
1,808

 
$
230

 
$
—

 
$
—

Unused portion of lines of credit                                                      
38,120

 
14,203

 
5,993

 
2,476

 
15,448

Undisbursed portion of construction loans
89,570

 
39,281

 
48,362

 
1,927

 
—

Total commitments                                           
$
129,728

 
$
55,292

 
$
54,585

 
$
4,403

 
$
15,448


First Financial Northwest and its subsidiaries from time to time are involved in various claims and legal actions arising in the ordinary course of business. There are currently no matters that in the opinion of management would have a material adverse effect on First Financial Northwest’s consolidated financial position, results of operation or liquidity.

We anticipate that we will continue to have sufficient funds and alternative funding sources to meet our current commitments.

The following table presents a summary of significant contractual obligations as of December 31, 2019, maturing as indicated:
 
Less Than One Year
 
One to Three Years
 
Three to Five Years
 
More Than Five Years
 
Total
 
(In thousands)
Deposits (1)
$
222,589

 
$
232,295

 
$
65,233

 
$
—

 
$
520,117

Term debt
137,700

 
—

 
—

 
—

 
137,700

Other long-term liabilities (2)
138

 
276

 
309

 
738

 
1,461

Lease commitments
609

 
832

 
521

 
532

 
2,494

Total contractual obligations
$
361,036

 
$
233,403

 
$
66,063

 
$
1,270

 
$
661,772

___________
(1) 
Deposit accounts with indeterminate maturities, such as noninterest bearing, interest-bearing demand, savings and money market accounts are reflected as obligations due in less than one year.
(2) 
Includes maximum payments related to employee benefit plans, assuming all future vesting conditions are met. Additional information about employee benefit plans is provided in Note 11 of the Notes to Consolidated Financial Statements included in Item 8 of this report.

Impact of Inflation

The Consolidated Financial Statements and related financial data presented herein have been prepared in accordance with accounting principles generally accepted in the United States of America. These principles generally require the measurement of financial position and operating results in terms of historical dollars, without considering changes in the relative purchasing power of money over time due to inflation.

Unlike most industrial companies, virtually all the assets and liabilities of a financial institution are monetary in nature. The primary impact of inflation is reflected in the increased cost of our operations. As a result, interest rates generally have a more significant impact on a financial institution’s performance than do general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services. In a period of rapidly rising interest rates, the liquidity and maturity structures of our assets and liabilities are critical to the maintenance of acceptable performance levels.

The principal effect of inflation on earnings, as distinct from levels of interest rates, is in the area of noninterest expense. Expense items such as employee compensation, employee benefits, and occupancy and equipment costs may be subject to increases

72

as a result of inflation. An additional effect of inflation is the possible increase in dollar value of the collateral securing loans that we have made. Our management is unable to determine the extent, if any, to which properties securing loans have appreciated in dollar value due to inflation.

Recent Accounting Pronouncements

See Note 1 of the Notes to Consolidated Financial Statements included in Item 8 of this Form 10-K.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

The information contained under Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Asset and Liability Management and Market Risk” of this Form 10-K is incorporated herein by reference.

Item 8. Financial Statements and Supplementary Data

Index to Consolidated Financial Statements
 
Page
 
 
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets as of December 31, 2019, and 2018
Consolidated Income Statements for the Years Ended December 31, 2019, and 2018
Consolidated Statements of Comprehensive Income for the Years Ended December 31, 2019, and 2018
Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2019, and 2018
Consolidated Statements of Cash Flows For the Years Ended December 31, 2019, and 2018
Notes to Consolidated Financial Statements

73


[Letterhead of Moss Adams LLP]


Report of Independent Registered Public Accounting Firm


To the Shareholders and the Board of Directors of
First Financial Northwest, Inc.

Opinions on the Financial Statements and Internal Control over Financial Reporting
We have audited the accompanying consolidated balance sheets of First Financial Northwest, Inc. and Subsidiaries (the “Company”) as of December 31, 2019 and 2018, the related consolidated statements of income, comprehensive income, stockholders’ equity, and cash flows for the years then ended, and the related notes (collectively referred to as the “consolidated financial statements”). We also have audited the Company’s internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company as of December 31, 2019 and 2018, and the consolidated results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control - Integrated Framework (2013) issued by COSO.

Basis for Opinions
The Company’s management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management Report on Internal Control over Financial Reporting included in Item 9A. Our responsibility is to express an opinion on the Company’s consolidated financial statements and an opinion on the Company’s internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects.

Our audits of the consolidated financial statements included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures to respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

Definition and Limitations of Internal Control Over Financial Reporting
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

74


Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

/s/ Moss Adams, LLP

Everett, Washington
March 12, 2020

We have served as the Company’s auditor since 2009.


75
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
(Dollars in thousands, except share data)

 
December 31,
 
2019
 
2018
Assets
 
 
 
 
 
 
 
Cash on hand and in banks
$
10,094

 
$
8,122

Interest-earning deposits with banks
12,896

 
8,888

Investments available-for-sale, at fair value
136,601

 
142,170

Loans receivable, net of allowance of $13,218 and $13,347
1,108,462

 
1,022,904

Federal Home Loan Bank (“FHLB”) stock, at cost
7,009

 
7,310

Accrued interest receivable
4,138

 
4,068

Deferred tax assets, net
1,501

 
1,844

Other real estate owned (“OREO”)
454

 
483

Premises and equipment, net
22,466

 
21,331

Bank owned life insurance (“BOLI”), net
31,982

 
29,841

Prepaid expenses and other assets
2,216

 
3,458

Right of use asset (“ROU”)
2,209

 
—

Goodwill
889

 
889

Core deposit intangible
968

 
1,116

Total assets
$
1,341,885

 
$
1,252,424

 
 
 
 
Liabilities and Stockholders’ Equity
 

 
 

 
 
 
 
Deposits
 
 
 
Noninterest-bearing deposits
$
52,849

 
$
46,108

Interest-bearing deposits
980,685

 
892,924

Total deposits
$
1,033,534


$
939,032

FHLB advances
137,700

 
146,500

Advance payments from borrowers for taxes and insurance
2,921

 
2,933

Lease liability
2,279

 
—

Accrued interest payable
285

 
478

Other liabilities
8,847

 
9,743

Total liabilities
$
1,185,566


$
1,098,686

 
 
 
 
Commitments and contingencies (Note 15)


 


 
 
 
 
Stockholders’ Equity
 

 
 

Preferred stock, $0.01 par value; authorized 10,000,000 shares, no shares issued or outstanding
—

 
—

Common stock, $0.01 par value; authorized 90,000,000 shares; issued and outstanding 10,252,953 shares at December 31, 2019, and 10,710,656 shares at December 31, 2018
103

 
107

Additional paid-in capital
87,370

 
93,773

Retained earnings, substantially restricted
73,321

 
66,343

Accumulated other comprehensive loss, net of tax benefit
(1,371
)
 
(2,253
)
Unearned Employee Stock Ownership Plan (“ESOP”) shares
(3,104
)
 
(4,232
)
Total stockholders’ equity
$
156,319

 
$
153,738

Total liabilities and stockholders’ equity
$
1,341,885

 
$
1,252,424

See accompanying notes to consolidated financial statements.

76
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
Consolidated Income Statements
(Dollars in thousands, except share data)

 
Year Ended December 31,
 
2019
 
2018
Interest income
 
 
 
Loans, including fees
$
54,636

 
$
51,127

Investments available-for-sale
4,329

 
4,126

Interest-earning deposits
293

 
202

Dividends on FHLB stock
362

 
458

Total interest income
$
59,620

 
$
55,913

Interest expense
 
 
 

Deposits
17,996

 
11,218

FHLB advances
2,716

 
3,520

Total interest expense
$
20,712

 
$
14,738

Net interest income
38,908

 
41,175

Recapture of provision for loan losses
(300
)
 
(4,000
)
Net interest income after recapture of provision for loan losses
$
39,208

 
$
45,175

Noninterest income
 
 
 

Net gain (loss) on sale of investments
151

 
(20
)
BOLI income
994

 
814

Wealth management revenue
879

 
611

Deposit related fees
733

 
681

Loan related fees
1,344

 
768

Other
40

 
24

Total noninterest income
$
4,141

 
$
2,878

Noninterest expense
 
 
 

Salaries and employee benefits
19,595

 
19,302

Occupancy and equipment
3,712

 
3,283

Professional fees
1,690

 
1,538

Data processing
2,031

 
1,392

OREO related expenses, net
34

 
7

Regulatory assessments
307

 
502

Insurance and bond premiums
375

 
443

Marketing
339

 
344

Other general and administrative
2,335

 
2,650

Total noninterest expense
$
30,418

 
$
29,461

Income before provision for federal income taxes
12,931

 
18,592

Federal income tax provision
2,562

 
3,693

Net income
$
10,369

 
$
14,899

 
 
 
 
Basic earnings per common share
$
1.04

 
$
1.44

Diluted earnings per common share
$
1.03

 
$
1.43

Basic weighted average number of common shares outstanding
9,976,056

 
10,306,835

Diluted weighted average number of common shares outstanding
10,075,906

 
10,424,187


See accompanying notes to consolidated financial statements.

77
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
Consolidated Statements of Comprehensive Income
(In thousands)

 
 
Year Ended December 31,
 
 
2019
 
2018
 
 
(In thousands)
Net income
 
$
10,369

 
$
14,899

Other comprehensive income (loss), net of tax:
 
 
 
 
Unrealized holding gains (losses) on available-for-sale securities
 
2,504

 
(1,834
)
Tax (provision) benefit
 
(526
)
 
385

Reclassification adjustment for net (gains) losses realized in income
 
(151
)
 
20

Tax benefit (provision)
 
32

 
(4
)
(Losses) gains on cash flow hedge
 
(1,237
)
 
137

Tax benefit (provision)
 
260

 
(29
)
Other comprehensive income (loss), net of tax
 
$
882

 
$
(1,325
)
Total comprehensive income
 
$
11,251

 
$
13,574


See accompanying notes to consolidated financial statements.



78
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
Consolidated Statements of Stockholders’ Equity
(In thousands, except share data)

 
Shares
 
Common 
Stock
 
Additional 
Paid-in
Capital
 
Retained
Earnings
 
Accumulated Other Comprehensive (Loss) Income, net of tax
 
Unearned
ESOP
Shares
 
Total
Stockholders’ Equity
Balances at December 31, 2017
10,748,437

 
$
107

 
$
94,173

 
$
54,642

 
$
(928
)

$
(5,360
)
 
142,634

Net income
—

 
—

 
—

 
14,899

 
—


—

 
14,899

Other comprehensive loss
—

 
—

 
—

 
—

 
(1,325
)
 
—

 
(1,325
)
Exercise of stock options
137,940

 
1

 
1,364

 
—

 
—

 
—

 
1,365

Issuance of common stock - restricted stock awards, net
30,179

 
1

 
(41
)
 
—

 
—

 
—

 
(40
)
Compensation related to stock options and restricted stock awards
—

 
—

 
650

 
—

 
—

 
—

 
650

Allocation of 112,853 ESOP shares
—

 
—

 
778

 
—

 
—

 
1,128

 
1,906

Repurchase and retirement of common stock
(203,900
)
 
(2
)
 
(3,151
)
 
—

 
—

 
—

 
(3,153
)
Canceled common stock - restricted stock awards
(2,000
)
 
—

 
—

 
—

 
—


—

 
—

Cash dividends declared and paid ($0.31 per share)
—

 
—

 
—

 
(3,198
)
 
—


—

 
(3,198
)
Balances at December 31, 2018
10,710,656


107


93,773


66,343


(2,253
)

(4,232
)
 
153,738

Net income
—

 
—

 
—

 
10,369

 
—

 
—

 
10,369

Other comprehensive income
—

 
—

 
—

 
—

 
882


—

 
882

Exercise of stock options
2,000

 
—

 
21

 
—

 
—

 
—

 
21

Issuance of common stock - restricted stock awards, net
25,278

 
—

 
(93
)
 
—

 
—

 
—

 
(93
)
Compensation related to stock options and restricted stock awards
—

 
—

 
501

 
—

 
—

 
—

 
501

Allocation of 112,853 ESOP shares
—

 
—

 
570

 
—

 
—

 
1,128

 
1,698

Repurchase and retirement of common stock
(479,052
)
 
(4
)
 
(7,402
)
 
—

 
—

 
—

 
(7,406
)
Canceled common stock - restricted stock awards
(5,929
)
 
—

 
—

 
—

 
—

 
—

 
—

Cash dividends declared and paid ($0.35 per share)
—

 
—

 
—

 
(3,478
)
 
—

 
—

 
(3,478
)
Beginning balance adjustment from adoption of Topic 842
—

 
—

 
—

 
87

 
—

 
—

 
87

Balances at December 31, 2019
10,252,953

 
$
103

 
$
87,370

 
$
73,321


$
(1,371
)
 
$
(3,104
)
 
$
156,319


See accompanying notes to consolidated financial statements.

79
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(In thousands)

 
Year Ended December 31,
 
2019
 
2018
Cash flows from operating activities:
 
 
 
Net income
$
10,369

 
$
14,899

Adjustments to reconcile net income to net cash provided by operating activities
 
 
 

Recapture of provision for loan losses
(300
)
 
(4,000
)
OREO market value adjustments
29

 
—

Net amortization of premiums and discounts on investments
835

 
1,022

(Gain) loss on sale of investments available-for-sale
(151
)
 
20

Depreciation of premises and equipment
1,840

 
1,630

Loss on sale of premises and equipment
5

 
—

Decrease (increase) in deferred federal income taxes
109

 
(281
)
Allocation of ESOP shares
1,698

 
1,906

Stock compensation expense
501

 
650

Increase in cash surrender value of BOLI
(994
)
 
(814
)
Changes in operating assets and liabilities:
 
 
 
Prepaid expenses and other assets
153

 
2,567

Right of use asset
(2,209
)
 
—

Advance payments from borrowers for taxes and insurance
(12
)
 
418

Accrued interest receivable
(70
)
 
16

Lease liability
2,279

 
—

Accrued interest payable
(193
)
 
152

Other liabilities
(809
)
 
491

Net cash provided by operating activities
$
13,080

 
$
18,676

Cash flows from investing activities:
 
 
 
Proceeds from sales and call of investments
14,260

 
17,159

Principal repayments on investments
7,395

 
7,078

Purchases of investments
(14,417
)
 
(37,021
)
Net increase in loans receivable
(85,258
)
 
(30,242
)
Purchases of premises and equipment
(2,980
)
 
(2,347
)
Redemption of FHLB stock
301

 
2,572

Proceeds from BOLI
310

 
—

Purchase of BOLI
(1,457
)
 
—

Net cash used in investing activities
$
(81,846
)
 
$
(42,801
)
Cash flows from financing activities:
 
 
 
Net increase in deposits
94,502

 
99,530

Advances from the FHLB
350,200

 
187,500

Repayments of advances from the FHLB
(359,000
)
 
(257,000
)
Proceeds from stock options exercises
21

 
1,365

Net share settlement of stock awards
(93
)
 
(40
)
Repurchase and retirement of common stock
(7,406
)
 
(3,153
)
Dividends paid
(3,478
)
 
(3,198
)
Net cash provided by financing activities
$
74,746

 
$
25,004

continued

80
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(In thousands)

 
Year Ended December 31,
 
2019
 
2018
Net increase in cash and cash equivalents
$
5,980

 
$
879

Cash and cash equivalents at beginning of year
17,010

 
16,131

Cash and cash equivalents at end of year
$
22,990

 
$
17,010

 
 
 
 
Supplemental disclosures of cash flow information:
 
 
 

Cash paid during the period for:
 
 
 

Interest
$
21,383

 
$
14,586

Federal income taxes
2,175

 
3,890

Noncash transactions:
 
 
 

Change in unrealized gain (loss) on investments available-for-sale
2,353

 
(1,814
)
Change in unrealized (losses) gain on cash flow hedge
(1,237
)
 
137

Initial recognition of right-of-use asset
2,762

 
—

Initial recognition of lease liability
2,762

 
—


See accompanying notes to consolidated financial statements.


81

FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Note 1 - Summary of Significant Accounting Policies

Nature of Operations and Principles of Consolidation

First Financial Northwest, Inc. (“First Financial Northwest”), a Washington corporation, was formed on June 1, 2007 for the purpose of becoming the holding company for First Financial Northwest Bank (“the Bank”) in connection with the conversion from a mutual holding company structure to a stock holding company structure completed on October 9, 2007. First Financial Northwest’s business activities generally are limited to passive investment activities and oversight of its investment in First Financial Northwest Bank. Accordingly, the information presented in the consolidated financial statements and related data, relates primarily to First Financial Northwest Bank. First Financial Northwest converted from a savings and loan holding company to a bank holding company in 2015 and is subject to regulation by the Board of Governors of the Federal Reserve Bank of San Francisco (“FRB”). First Financial Northwest Bank is regulated by the Federal Deposit Insurance Corporation (“FDIC”) and the Washington State Department of Financial Institutions (“DFI”).

First Financial Northwest Bank was organized in 1923 as a Washington state-chartered savings and loan association, converted to a federal mutual savings and loan association in 1935, and converted to a Washington state-chartered mutual savings bank in 1992. In 2002, First Financial Northwest Bank reorganized into a two-tier mutual holding company structure, became a stock savings bank and became the wholly-owned subsidiary of First Financial of Renton, Inc. In connection with the mutual to stock conversion in 2007, the Bank changed its name to First Savings Bank Northwest. In August 2015, the Bank changed its name to First Financial Northwest Bank to support the expansion of focus to being more than a traditional “savings” bank. In February 2016, the Bank changed its charter from a Washington chartered stock savings bank to a Washington chartered commercial bank.

First Financial Northwest Bank is a community-based commercial bank primarily serving King and Snohomish Counties, and to a lesser extent, Pierce and Kitsap Counties, Washington. In King County, the headquarters and full-service banking office, as well as one branch office, are located in Renton. Additional King County branch offices are located in Bellevue, Woodinville, Bothell, and Kent. In Snohomish County, five additional branch offices serve Mill Creek, Edmonds, Clearview, Smokey Point, and Lake Stevens. First Financial Northwest Bank’s business consists of attracting deposits from the public and utilizing these deposits to originate one-to-four family residential, multifamily, commercial real estate, construction/land, business and consumer loans.

First Financial Diversified Corporation (“FFD”), a wholly-owned subsidiary of First Financial Northwest, held a portfolio of one-to-four family, land and consumer loans that were serviced by the Bank, however, at December 31, 2019, FFD’s loan portfolio had been fully paid off.

The accompanying consolidated financial statements include the accounts of First Financial Northwest and its wholly‑owned subsidiaries First Financial Northwest Bank and First Financial Diversified Corporation (collectively, “the Company”). All significant intercompany balances and transactions between First Financial Northwest and its subsidiaries have been eliminated in consolidation.

Basis of Presentation and Use of Estimates

The accounting and reporting policies of First Financial Northwest and its subsidiaries conform to U.S. generally accepted accounting principles (“GAAP”). In preparing the consolidated financial statements, management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided. Actual results could differ from these estimates. Material estimates particularly subject to change include the allowance for loan and lease losses (“ALLL”), other real estate owned (“OREO”), deferred tax assets and the fair values of financial instruments.

Subsequent Events
    
The Company has evaluated events and transactions subsequent to December 31, 2019 for potential recognition or disclosure. For more information, see Note 19 - Subsequent Events.


82
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Cash and Cash Equivalents

For purposes of reporting cash flows, cash and cash equivalents include cash on hand and in banks, interest-bearing deposits and federal funds sold all with maturities of three months or less.

The Bank is required to maintain an average reserve balance with the FRB or maintain such reserve balance in the form of cash. At December 31, 2019, a $750,000 reserve was required and was maintained with the FRB. At December 31, 2018, cash balances were sufficient where no additional reserve was required.

Investments

Investments are classified into one of three categories: (1) held-to-maturity, (2) available-for-sale, or (3) trading. We had no held-to-maturity or trading securities at December 31, 2019, or 2018. Investments are categorized as held-to-maturity when we have the positive intent and ability to hold them to maturity.

Investments are classified as available-for-sale if the Company intends to hold the securities for an indefinite period of time, but not necessarily to maturity. Investments available-for-sale are reported at fair value. Unrealized holding gains and losses on investments available-for-sale are excluded from earnings and are reported in other comprehensive income (loss), net of applicable taxes. Gains and losses on sales are recorded on the trade date and determined using the specific identification method. Amortization or accretion of purchase premiums and discounts are included in investment income using the level-yield method over the remaining period to contractual maturity. Dividend or interest income is recognized when it is earned.

The estimated fair value of investments is based on quoted market prices for investments traded in active markets or dealer quotes. Mortgage-backed investments represent participation interest in pools of first mortgage loans originated and serviced by the issuers of the investments.

Management makes an assessment to determine whether there have been any events or economic circumstances to indicate that a security on which there is an unrealized loss is impaired on an other-than-temporary basis. Management considers many factors including the severity and duration of the impairment, recent events specific to the issuer or industry, and for debt securities, external credit ratings and recent downgrades. Securities on which there is an unrealized loss that is deemed to be an other-than-temporary impairment (“OTTI”) are written down to fair value. For equity securities, the write-down is recorded as a realized loss in noninterest income in the Consolidated Income Statements. For debt securities, if management intends to sell the security or it is likely that management will be required to sell the security before recovering its cost basis, the entire impairment loss would be recognized in earnings as an OTTI. If management does not intend to sell the security and it is not likely that management will be required to sell the security but management does not expect to recover the entire amortized cost basis of the security, only the portion of the impairment loss representing credit losses would be recognized in earnings. The credit loss on a security is measured as the difference between the amortized cost basis and the present value of the cash flows expected to be collected. Projected cash flows are discounted by the original or current effective interest rate depending on the nature of the security being measured for potential OTTI. The remaining impairment related to all other factors, the difference between the present value of the cash flows expected to be collected and fair value, is recognized as a charge to other comprehensive income (“OCI”). Impairment losses related to all other factors are presented as separate categories within OCI.

Loans Receivable

Loans are recorded at their outstanding principal balance adjusted for charge-offs, the ALLL and net deferred fees or costs. Interest on loans is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized in interest income using the level-yield method without anticipating prepayments.

The accrual of interest on loans is discontinued at the time the loan is 90 days delinquent unless the loan is well secured and in the process of collection. Consumer and other loans are typically managed in the same manner. In all cases, loans are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is doubtful.

All interest accrued but not collected on loans that are placed on nonaccrual is reversed against interest income. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured. In order to return a nonaccrual loan to accrual status, each loan is evaluated on a case-by-case basis. We evaluate the borrower’s financial condition to ensure that future loan payments are reasonably assured. We also take into consideration the borrower’s willingness and ability to make the loan payments and historical repayment performance. We require the borrower to make the loan payments consistently for a period of at least six months as agreed to under the terms of any modified loan agreement before we will consider reclassifying the loan to accrual status.

83
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Impaired Loans

A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, market conditions, rent rolls and the financial strength of the borrower(s) and guarantor(s), if any. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired.

Management determines the significance of payment delays and shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrowers, including the length of the delay, the reasons for the delay, the borrower’s prior payment history and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured by the fair value method on a loan-by-loan basis.

When a loan is identified as impaired, its impairment is measured using the present value of expected future cash flows, discounted at the loan’s effective interest rate, except when the sole (remaining) source of repayment for the loan is the operation or liquidation of the collateral. In these cases, the Company uses an observable market price or current fair value of the collateral, less certain completion costs and closing costs when foreclosure is probable, instead of discounted cash flows. The Company obtains annual updated appraisals for impaired collateral dependent loans that exceed $1.0 million. In addition, the Company may order appraisals on properties not included within these guidelines when there are extenuating circumstances where the Company is not otherwise able to determine the fair value of the property. Appraised values may be discounted based on management’s historical knowledge, changes in market conditions from the time of valuation and/or management’s expertise and knowledge of the borrower. If management determines that the value of the impaired loan is less than the recorded investment in the loan, an impairment is recognized through an allowance estimate or a charge-off to the ALLL.

Troubled Debt Restructurings

Certain loan modifications or restructurings are accounted for as troubled debt restructurings (“TDR”). In general, the modification or restructuring of a debt is considered a TDR if, for economic or legal reasons related to the borrower’s financial difficulties, a concession is granted to the borrower that the Company would not otherwise consider. Examples of these modifications or restructurings include advancement of maturity date, accepting interest only payments for a period of time, or granting an interest rate concession for a period of time. The impaired portion of the loan with an interest rate concession and/or interest-only payments for a specific period of time are calculated based on the present value of expected future cash flows discounted at the loan’s effective interest rate. The effective interest rate is the rate of return implicit on the original loan. This impaired amount reduces the ALLL and a valuation allowance is established to reduce the loan balance. As loan payments are received in future periods, the ALLL entry is reversed and the valuation allowance is reduced utilizing the level-yield method over the modification period. A loan that is determined to be classified as a TDR is generally reported as a TDR until the loan is paid in full or otherwise settled, sold, or charged-off.

Allowance for Loan and Lease Losses

The allowance for loan and lease losses (“ALLL”) is a valuation allowance for probable incurred credit losses. Losses are charged against the allowance when management believes the uncollectability of a loan balance is confirmed. Any subsequent recoveries are credited to the allowance.

The ALLL is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans and factors such as the nature and volume of the loan portfolio, historical loss considerations, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, and prevailing economic conditions. The evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available.

While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions or changes to the credit quality of the loan portfolio. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s ALLL. Such agencies may require management to make adjustments to the allowance based on their judgments about information available to them at the time of their examination.


84
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Premises and Equipment

Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of the assets. The estimated useful lives used to compute depreciation and amortization is 15 to 40 years for buildings and building improvements, and is three to seven years for furniture, fixtures, and equipment. Leasehold improvements are amortized over the life of the lease. Management reviews buildings, improvements and equipment for impairment on an annual basis or whenever events or changes in the circumstances indicate that the undiscounted cash flows for the property are less than its carrying value. If identified, an impairment loss is recognized through a charge to earnings based on the fair value of the property.

Federal Home Loan Bank Stock

As a member of the Federal Home Loan Bank System, the Bank is required to maintain a minimum level of investment in the Federal Home Loan Bank of Des Moines (“FHLB”) stock, based on specified percentages of total assets and the Bank’s outstanding FHLB advances. Ownership of FHLB stock is restricted to the FHLB and member institutions. The Bank’s investment in FHLB stock is carried at par value ($100 per share), which reasonably approximates its fair value.

Transfer of Financial Assets

Transfers of an entire financial asset, a group of entire financial assets, or participating interest in an entire financial asset are accounted for as sales when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Bank, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Bank does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.

Other Real Estate Owned

OREO consists principally of properties acquired through foreclosure and is stated at the lower of cost or estimated market value less selling costs. Losses arising from the acquisition of property, in full or partial satisfaction of loans, are charged to the ALLL.

Subsequent to the transfer of foreclosed assets held for sale, the assets continue to be recorded at the lower of cost or fair value (less estimated costs to sell), based on periodic evaluations. Subsequent write-downs in value are charged to noninterest expense. Generally, legal and professional fees associated with foreclosures are expensed as incurred. Costs incurred to improve property prior to sale are capitalized; however, in no event are recorded costs allowed to exceed estimated fair value. Subsequent gains, losses, or expenses recognized on the sale of these properties are included in noninterest expense. The amounts that will ultimately be recovered from foreclosed assets may differ substantially from the carrying value of the assets because of future market factors beyond management’s control.

Bank-Owned Life Insurance

The Company has purchased life insurance on certain key executives and officers. Bank-owned life insurance (“BOLI”) is recorded at the amount that can be realized under the insurance contract at the balance sheet date, which is the cash surrender value adjusted for other charges or other amounts due that are probable at settlement. Increases to the cash surrender value are recorded as noninterest income and partially offset expenses for employee benefits. Certain BOLI contracts contain endorsement split-dollar life agreements. In these circumstances, the Bank accrues a reserve liability and related compensation expense for the expected future benefit payout.

Loan Commitments and Related Financial Instruments

Financial instruments include off-balance sheet credit instruments, such as unused lines of credit and commercial letters of credit issued to meet customer financing needs. The face amount of these items represents the exposure to loss before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded.

Reserve for Unfunded Commitments

Management maintains a reserve for unfunded commitments to absorb probable losses associated with our off-balance sheet commitments to lend funds such as unused lines of credit and the undisbursed portion of construction loans. Management determines the adequacy of the reserve based on reviews of individual exposures, current economic conditions, and other relevant

85
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

factors. The reserve is based on estimates and ultimate losses may vary from the current estimates. The reserve is evaluated on a regular basis and necessary adjustments are reported in earnings during the period in which they become known. The reserve for unfunded commitments is included in the other liabilities section of the consolidated balance sheets.

Stock-Based Compensation

Compensation cost is recognized for stock options and restricted stock awards, based on the fair value of these awards at the grant date. A Black-Scholes model is utilized to estimate the fair value of stock options, while the market price of the Company’s common stock at the grant date is used for restricted stock awards. Compensation cost is recognized over the required service period, generally defined as the vesting period. For awards with graded vesting, compensation cost is recognized on a straight-line basis over the requisite service period for the entire award.

Federal Income Taxes

The Company files a consolidated Federal income tax return and records its provision for income taxes under the asset and liability method. Deferred taxes result from temporary differences in the recognition of certain income and expense amounts between the Company’s financial statements and its tax return. The principal items giving rise to these differences include net operating losses, valuation adjustments on foreclosed properties, and allowance for credit losses. Deferred tax assets and liabilities are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. Valuation allowances are established to reduce the net carrying amount of deferred tax assets if it is determined to be more likely than not that all or some portion of the potential deferred tax asset will not be realized. The Company’s policy is to recognize interest and penalties associated with income tax matters in income tax expense.

Employee Stock Ownership Plan

The cost of shares issued to the Employee Stock Ownership Plan (“ESOP”), but not yet allocated to participants, is shown as a reduction of stockholders’ equity. Compensation expense is based on the market price of shares as they are committed to be released to participant accounts. Dividends on allocated ESOP shares reduce retained earnings; dividends on unearned ESOP shares reduce debt and accrued interest.

Earnings Per Share

Nonvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents are participating securities and are included in the computation of earnings per share (“EPS”) pursuant to the two-class method. The two-class method is an earnings allocation formula that determines EPS for each class of common stock and participating security according to dividends declared or accumulated and participation rights in undistributed earnings. Certain shares of the Company’s nonvested restricted stock awards qualify as participating securities.

Net income is allocated between the common stock and participating securities pursuant to the two-class method, based on their rights to receive dividends, participate in earnings or absorb losses. Basic earnings per common share is computed by dividing net earnings available to common shareholders by the weighted average number of common shares outstanding during the period, excluding participating nonvested restricted shares. As ESOP shares are committed to be released, they are included in the outstanding shares used in the basic EPS calculation.

Diluted earnings per share is computed in a similar manner, except that first the denominator is increased to include the number of additional shares that would have been outstanding if potentially dilutive shares, excluding the participating securities, were issued using the treasury stock method. For all periods presented, stock options and certain restricted stock awards are potentially dilutive non-participating instruments issued by the Company.

Undistributed losses are not allocated to the nonvested share-based payment awards (the participating securities) under the two-class method as the holders are not contractually obligated to share in the losses of the Company.

Comprehensive Income

Comprehensive income consists of net income and unrealized gains and losses on investments available-for-sale and derivatives, which are also recognized as separate components of equity, net of tax.


86
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Advertising Expenses

Advertising costs are generally expensed as incurred and are not material.

Fair Value of Financial Instruments

Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in a separate note. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates.

Segment Information

The Company’s activities are considered to be a single industry segment for financial reporting purposes. The Company is engaged in the business of attracting deposits from the general public and providing lending services. Substantially all income is derived from a diverse base of investments and commercial, construction, mortgage, and consumer lending activities.

Reclassification

Certain amounts in the consolidated financial statements for prior years have been reclassified to conform to the current consolidated financial statement presentation. The results of the reclassifications are not considered material and have no effect on previously reported net income or stockholders’ equity.

Derivatives

The Company designates certain interest rate swap agreements as a cash flow hedge, and as such, reports the net fair value as an asset or liability. The hedge is utilized to mitigate the risk of variability in future interest payments. The fair value of the cash flow hedge is based on dealer quotes, pricing models, discounted cash flow methodologies or similar techniques for which the determination of fair value may require significant management judgment or estimation. The derivative is marked to its fair value, with the change in fair value recorded as other comprehensive income or loss. The gain or loss on the derivative is reclassified into earnings in the same income statement line item that is used to present the earnings effect of the hedged item.

Goodwill

Goodwill is recorded from a business combination as the difference in purchase price and fair value of the assets acquired and liabilities assumed. Goodwill has an indefinite useful life, and as such, is not amortized. The Company performs a goodwill impairment analysis on an annual basis as of December 31. Additionally, the Company performs an impairment analysis as needed when circumstances indicate impairment potentially exists. Any impairment will be recorded as a noninterest expense and corresponding reduction in intangible asset on the consolidated financial statements.

Core Deposit Intangible

A core deposit intangible (“CDI”) asset is recognized from the assumption of core deposit liabilities in connection with the acquisition of four branches from Opus Bank, a California state-chartered commercial bank (the “Branch Acquisition”). The asset was valued by a third party and is amortized into noninterest expense over ten years. The CDI is evaluated for impairment annually with any additional decline recorded as a noninterest expense on the Consolidated Income Statement.

Recent Accounting Pronouncements Adopted in 2019

In February 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2016-02, Leases (Topic 842). ASU No. 2016-02 requires lessees to recognize on the balance sheet the assets and liabilities arising from operating leases. In July 2018, FASB issued ASU No. 2018-11, Leases (Topic 842) to address the comparative reporting requirements when this ASU is adopted. In March 2019, FASB issued ASU 2019-01, Leases (Topic 842), Codification Improvements. Under these ASUs, a lessee should recognize a liability to make lease payments and a right-of-use asset representing its right to use the underlying asset for the lease term. A lessee should include payments to be made in an optional period only if the lessee is reasonably certain to exercise an option to extend the lease or not to exercise an option to terminate the lease. For a finance lease, interest payments should be recognized separately from amortization of the right-of-use asset in the statement of comprehensive income. For operating leases, the lease cost should be allocated over the lease term on a generally straight-line basis. The Company adopted this ASU on January 1, 2019, and according to ASU 2018-11, elected to recognize the related

87
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

cumulative-effect adjustment as an adjustment to the opening balance of retained earnings. Adoption of ASU 2016-02 resulted in the addition of a right-of-use asset and lease liability related to certain banking offices under noncancelable operating lease agreements. The resulting increase did not have a material impact on the Company’s consolidated financial statements or regulatory capital ratios. For more information see Note 10 - Leases.

In March 2017, FASB issued ASU No. 2017-08, Receivables - Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities. The ASU shortens the amortization period for certain callable debt securities held at a premium. The Company adopted this ASU as of January 1, 2019, with no material impact on the Company’s consolidated financial statements.

Recently Issued Accounting Pronouncements
    
ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326) as amended by ASU 2018-19, ASU 2019-04 and ASU 2019-05, was originally issued in June 2016. This ASU replaces the existing incurred loss impairment methodology that recognizes credit losses when a probable loss has been incurred with new methodology where loss estimates are based upon lifetime expected credit losses. The amendments in this ASU require a financial asset that is measured at amortized cost to be presented at the net amount expected to be collected. The income statement would then reflect the measurement of credit losses for newly recognized financial assets as well as changes to the expected credit losses that have taken place during the reporting period. The measurement of expected credit losses will be based on historical information, current conditions, and reasonable and supportable forecasts that impact the collectability of the reported amount. Available-for-sale securities will bifurcate the fair value mark and establish an allowance for credit losses through the income statement for the credit portion of that mark. The interest portion will continue to be recognized through accumulated other comprehensive income or loss. The change in allowance recognized as a result of adoption will occur through a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the ASU is adopted. This ASU is effective for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years, with early adoption permitted for smaller reporting companies, such as the Company. The Company is evaluating its current expected loss methodology on the loan and investment portfolios to identify the necessary modifications in accordance with this standard and expects a change in the processes and procedures to calculate the ALLL, including changes in assumptions and estimates to consider expected credit losses over the life of the loan versus the current accounting practice that utilizes the incurred loss model. A valuation adjustment to the ALLL or investment portfolio that is identified in this process will be reflected as a one-time adjustment in equity rather than earnings. ASU 2019-05 issued in April 2019 further provides that entities that have certain financial instruments measured at amortized cost that has credit losses, to irrevocably elect the fair value option in Subtopic 825-10, upon adoption of Topic 326. The fair value option applies to available-for-sale debt securities. This ASU is effective upon adoption of ASU 2016-13, and should be applied on a modified-retrospective basis as a cumulative-effect adjustment to the opening balance of retained earnings in the statement of financial condition as of the adoption date. The Company is in the process of compiling historical and industry data that will be used to calculate expected credit losses on the loan portfolio to ensure that it is fully compliant with the ASU at the adoption date and is evaluating the potential impact adoption of this ASU will have on its consolidated financial statements. The Company intends to adopt ASU 2016-13 in the first quarter of 2023, and as a result, the ALLL may increase. Until the evaluation is complete, however, the magnitude of the increase will not be known.
        
In August 2018, FASB issued ASU No. 2018-13, Fair Value Measurement (Topic 820) - Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement. The amendments in this ASU remove certain disclosure requirements regarding transfers between Level 1 and Level 2 of the fair value hierarchy and changes in unrealized gains and losses for recurring Level 3 fair value measurements. In addition, the amendments modified and added certain disclosure requirements for Level 3 fair value measurements. This ASU is effective for fiscal years beginning after December 15, 2019, and early adoption is permitted. Entities are permitted to early adopt any removed or modified disclosures and adopt the additional disclosures at the effective date. Adoption of ASU 2018-13 is not expected to have a material impact on the Company’s consolidated financial statements.

In April 2019, FASB issued ASU 2019-04, Codification Improvements to Topic 326, Financial Instruments--Credit Losses, Topic 815, Derivatives and Hedging, and Topic 825, Financial Instruments. This ASU provides clarification and guidance on recently issued ASUs regarding recognition and measurement of financial assets, credit losses on financial instruments and accounting for derivatives and hedging activities. This ASU is effective for fiscal years beginning after December 15, 2019 for the portions related to topics 326 and 825. For the portion related to topic 815, this ASU is effective for concurrent adoption with ASU 2016-13. Adoption of ASU 2019-04 is not expected to have a material impact on the Company’s consolidated financial statements.

In April 2019, FASB issued ASU 2019-05, Financial Instruments--Credit Losses (Topic 326), Targeted Transition Relief. The amendments in this ASU provide entities that have certain financial instruments measured at amortized cost that have credit losses, to irrevocably elect the fair value option in Subtopic 825-10, upon adoption of Topic 326. The fair value option applies to

88
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

available-for-sale debt securities. This ASU is effective when ASU 2016-13 is adopted, and will be applied on a modified-retrospective basis as a cumulative-effect adjustment to the opening balance of retained earnings in the statement of financial condition as of the adoption date. Adoption of ASU 2019-05 is not expected to have a material impact on the Company’s consolidated financial statements.

In December 2019, the FASB issued ASU No. 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes (ASU 2019-12). This ASU simplifies the accounting for income taxes by removing the exception to the incremental approach for intra-period tax allocation when there is a loss from continuing operations and income or a gain from other items, removing the requirement to recognize a deferred tax liability for equity method investments when a foreign subsidiary becomes an equity method investment, and removing the general methodology for calculating income taxes in an interim period when a year-to-date loss exceeds the anticipated loss for the year. This ASU is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020. The Company does not expect the adoption of ASU 2019-12 to have a material impact on its consolidated financial statements.

Note 2 - Investments

The following tables summarize the amortized cost and fair value of investments available-for-sale at December 31, 2019 and 2018, and the corresponding amounts of gross unrealized gains and losses. 
 
December 31, 2019
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair Value
 
(In thousands)
Mortgage-backed investments:
 
 
 
 
 
 
 
Fannie Mae
$
15,605

 
$
128

 
$
(104
)
 
$
15,629

Freddie Mac
4,196

 
96

 
—

 
4,292

Ginnie Mae
23,239

 
140

 
(329
)
 
23,050

Other
11,407

 
66

 
(25
)
 
11,448

Municipal bonds
10,675

 
272

 
(36
)
 
10,911

U.S. Government agencies
46,672

 
13

 
(935
)
 
45,750

Corporate bonds
25,500

 
372

 
(351
)
 
25,521

 
$
137,294

 
$
1,087

 
$
(1,780
)
 
$
136,601

 
December 31, 2018
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair Value
 
(In thousands)
Mortgage-backed investments:
 
 
 
 
 
 
 
Fannie Mae
$
24,276

 
$
24

 
$
(657
)
 
$
23,643

Freddie Mac
6,351

 
10

 
(74
)
 
6,287

Ginnie Mae
23,311

 
—

 
(1,250
)
 
22,061

Other
8,983

 
17

 
(21
)
 
8,979

Municipal bonds
10,615

 
49

 
(120
)
 
10,544

U.S. Government agencies
48,190

 
73

 
(825
)
 
47,438

Corporate bonds
23,490

 
399

 
(671
)
 
23,218

 
$
145,216

 
$
572

 
$
(3,618
)
 
$
142,170


There were no investments classified as held-to-maturity at December 31, 2019 or 2018.

The amortized cost and estimated fair value of investments available-for-sale at December 31, 2019, by expected maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or

89
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

prepay obligations with or without call or prepayment penalties. Investments not due at a single maturity date, primarily mortgage‑backed investments are shown separately.
 
December 31, 2019
 
Amortized Cost
 
Fair Value
 
(In thousands)
Due within one year
$
496

 
$
498

Due after one year through five years
6,597

 
6,738

Due after five years through ten years
18,664

 
18,613

Due after ten years
57,090

 
56,333

 
82,847

 
82,182

Mortgage-backed investments
54,447

 
54,419

 
$
137,294

 
$
136,601

 
Under Washington State law, in order to participate in the public funds program the Company is required to pledge eligible securities as collateral in an amount equal to 50% of the public deposits held. Investments with a carrying value of $19.0 million and $15.6 million were pledged as collateral for public deposits at December 31, 2019, and 2018, respectively, both of which exceeded the minimum collateral requirements established by the Washington Public Deposit Protection Commission. At December 31, 2019, and 2018, there were no investments pledged as collateral for FHLB advances.

Sales and other redemptions of available-for-sale investments were as follows: 
 
Year Ended December 31,
 
2019
 
2018
 
(In thousands)
Proceeds
$
14,260

 
$
17,159

Gross gains
190

 
9

Gross losses
(39
)
 
(29
)
 
The following tables summarize the aggregate fair value and gross unrealized loss by length of time those investments have been continuously in an unrealized loss position at December 31, 2019 and 2018.
 
December 31, 2019
 
Less Than 12 Months
 
12 Months or Longer
 
Total
 
Fair Value
 
Unrealized
Loss
 
Fair Value
 
Unrealized
Loss
 
Fair Value
 
Unrealized
Loss
 
(In thousands)
Mortgage-backed investments:
 
 
 
 
 
 
 
 
 
 
 
Fannie Mae
$
8,340

 
$
(104
)
 
$
—

 
$
—

 
$
8,340

 
$
(104
)
Freddie Mac
—

 
—

 
—

 
—

 
—

 
—

Ginnie Mae
156

 
—

 
12,921

 
(329
)
 
13,077

 
(329
)
Other
2,843

 
(7
)
 
6,000

 
(18
)
 
8,843

 
(25
)
Municipal bonds
3,257

 
(36
)
 
—

 
—

 
3,257

 
(36
)
U.S. Government agencies
12,266

 
(201
)
 
31,490

 
(734
)
 
43,756

 
(935
)
Corporate bonds
1,996

 
(12
)
 
7,161

 
(339
)
 
9,157

 
(351
)
 
$
28,858

 
$
(360
)
 
$
57,572

 
$
(1,420
)
 
$
86,430

 
$
(1,780
)


90
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 
December 31, 2018
 
Less Than 12 Months
 
12 Months or Longer
 
Total
 
Fair Value
 
Unrealized
Loss
 
Fair Value
 
Unrealized
Loss
 
Fair Value
 
Unrealized
Loss
 
(In thousands)
Mortgage-backed investments:
 
 
 
 
 
 
 
 
 
 
 
Fannie Mae
$
5,480

 
$
(32
)
 
$
16,721

 
$
(625
)
 
$
22,201

 
$
(657
)
Freddie Mac
1,994

 
(23
)
 
3,185

 
(51
)
 
5,179

 
(74
)
Ginnie Mae
2,867

 
(8
)
 
19,194

 
(1,242
)
 
22,061

 
(1,250
)
Other
6,008

 
(21
)
 
—

 
—

 
6,008

 
(21
)
Municipal bonds
4,161

 
(46
)
 
934

 
(74
)
 
5,095

 
(120
)
U.S. Government agencies
5,985

 
(13
)
 
30,779

 
(812
)
 
36,764

 
(825
)
Corporate bonds
—

 
—

 
6,828

 
(671
)
 
6,828

 
(671
)
 
$
26,495

 
$
(143
)
 
$
77,641

 
$
(3,475
)
 
$
104,136

 
$
(3,618
)

At December 31, 2019, and 2018, the Company had 37 and 51 securities, respectively, with a gross unrealized loss position. Management reviewed the financial condition of the entities underlying the securities at both December 31, 2019, and December 31, 2018, and determined that no OTTI was required. Management believes that, while actual fluctuation in unrealized losses will occur over the life of an investment security, the temporary impairment on the investment securities that were in an unrealized loss position at December 31, 2019 and 2018, will be incrementally relieved as the individual investment securities approach their respective contractual maturity dates. The unrealized losses relate principally to the general change in interest rate and illiquidity, and not credit quality. As management does not intend to sell the security, and it is likely that it will not be required to sell the security before its anticipated recovery, no declines are deemed to be other-than-temporary.


91
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 3 - Loans Receivable

Loans receivable net of loans in process (“LIP”) at December 31, 2019, and 2018 are summarized as follows: 
 
December 31,
 
2019
 
2018
 
(In thousands)
One-to-four family residential:
 
 
 
Permanent owner occupied
$
210,898

 
$
194,141

Permanent non-owner occupied
161,630

 
147,825

 
372,528

 
341,966

Multifamily:
 

 
 

Permanent
172,915

 
169,355

 
172,915

 
169,355

Commercial real estate:
 

 
 

Permanent
395,152

 
373,798

 
395,152

 
373,798

Construction/land: (1)
 

 
 

One-to-four family residential
44,491

 
51,747

Multifamily
40,954

 
40,502

Commercial
19,550

 
9,976

Land
8,670

 
6,629

 
113,665

 
108,854

 
 
 
 
Business
37,779

 
30,486

Consumer
30,199

 
12,970

Total loans
1,122,238

 
1,037,429

Less:
 

 
 

Deferred loan fees, net
558

 
1,178

Allowance for loan and lease losses ("ALLL")
13,218

 
13,347

Loans receivable, net
$
1,108,462

 
$
1,022,904

____________
(1) 
Included in the construction/land category are “rollover” loans, which are loans that will convert upon completion of the construction period to permanent loans. At that time, the loans will be classified according to the underlying collateral. In addition, raw land or buildable lots, where the Company does not intend to finance the construction are included in the construction/land category. At December 31, 2019, we classified $38.6 million of multifamily loans, $8.7 million of commercial land loans, $3.5 million of one-to-four family residential and $18.3 million of commercial real estate loans as construction/land loans to facilitate the review of the composition of our loan portfolio. At December 31, 2018, $25.2 million of multifamily loans, $6.2 million of commercial land loans, $602,000 one-to-four family residential and $10.0 million of commercial real estate loans were reclassified to the construction/land category.

At December 31, 2019, and 2018, there were no loans classified as held for sale.

Concentrations of credit. Most of the Bank’s lending activity occurs within the state of Washington. The primary market areas include King and to a lesser extent Pierce, Snohomish and Kitsap counties. At December 31, 2019, the Company’s loan portfolio consists of one-to-four family residential loans which comprised 33.2%, commercial real estate and multifamily loans were 35.2% and 15.4%, respectively, and construction/land loans were 10.1% of the total loan portfolio. Consumer and business loans accounted for the remaining 6.1% of the loan portfolio. Included in the one-to-four family residential, multifamily, and commercial real estate loan portfolios at December 31, 2019 were $432,000, $8.4 million, and $78.0 million, respectively, to the Company’s five largest borrowing relationships.


92
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The Company originates both adjustable and fixed interest rate loans. The composition of loans receivable at December 31, 2019, and 2018, was as follows:
December 31, 2019
Fixed Rate
 
Adjustable Rate
Term to Maturity
 
Principal Balance
 
Term to Rate Adjustment
 
Principal Balance
(In thousands)
Due within one year
 
$
29,997

 
Due within one year
 
$
297,221

After one year through three years
 
63,055

 
After one year through three years
 
102,248

After three years through five years
 
68,659

 
After three years through five years
 
137,487

After five years through ten years
 
126,762

 
After five years through ten years
 
86,404

Thereafter
 
207,055

 
Thereafter
 
3,350

 
 
$
495,528

 
 
 
$
626,710

 
December 31, 2018
Fixed Rate
 
Adjustable Rate
Term to Maturity
 
Principal Balance
 
Term to Rate Adjustment
 
Principal Balance
(In thousands)
Due within one year
 
$
44,445

 
Due within one year
 
$
248,739

After one year through three years
 
53,076

 
After one year through three years
 
98,652

After three years through five years
 
56,194

 
After three years through five years
 
105,929

After five years through ten years
 
125,884

 
After five years through ten years
 
112,449

Thereafter
 
192,061

 
Thereafter
 
—

 
 
$
471,660

 
 
 
$
565,769


Our adjustable-rate loans are tied to various indexes, including LIBOR, the prime rate as published in The Wall Street Journal, and the FHLB. Certain adjustable‑rate loans have interest rate adjustment limitations and are generally indexed to the FHLB Long-Term Bullet advance rates published by the FHLB. Future market factors may affect the correlation of the interest rate adjustment with the rates paid on short‑term deposits that have been primarily utilized to fund these loans.

Credit Quality Indicators. The Company assigns a risk rating to all credit exposures based on the risk rating system designed to define the basic characteristics and identified risk elements of each credit extension. The Company utilizes a nine‑point risk rating system. A description of the general characteristics of the risk grades is as follows:

•
Grades 1 through 5: These grades are considered to be “pass” credits. These include assets where there is virtually no credit risk, such as cash secured loans with funds on deposit with the Bank. Pass credits also include credits that are on the Company’s watch list, where the borrower exhibits potential weaknesses, which may, if not checked or corrected, negatively affect the borrower’s financial capacity and threaten their ability to fulfill debt obligations in the future.

•
Grade 6: These credits, classified as ”special mention”, possess weaknesses that deserve management’s close attention. Special mention assets do not expose the Company to sufficient risk to warrant adverse classification in the substandard, doubtful or loss categories. If left uncorrected, these potential weaknesses may result in deterioration in the Company’s credit position at a future date.
 
•
Grade 7: These credits, classified as “substandard”, present a distinct possibility that the Company will sustain some loss if the deficiencies are not corrected. These credits have well defined weaknesses which jeopardize the orderly liquidation of the debt and are inadequately protected by the current net worth and payment capacity of the borrower or of any collateral pledged.

•
Grade 8: These credits are classified as “doubtful” have well defined weaknesses which make the full collection or liquidation of the loan highly questionable and improbable. This classification is used where significant risk exposures are perceived but the exact amount of the loss cannot yet be determined due to pending events.


93
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

•
Grade 9: Assets classified as “loss” are considered uncollectible and cannot be justified as a viable asset for the Company. There is little or no prospect of near term recovery and no realistic strengthening action of significance is pending.

As of December 31, 2019, and 2018, the Company had no loans rated as doubtful or loss. The following tables represent a summary of loans at December 31, 2019, and 2018 by type and risk category: 
 
December 31, 2019
 
One-to-Four
Family
Residential
 
Multifamily
 
Commercial
Real Estate
 
Construction/ 
Land
 
Business
 
Consumer
 
Total
 
(In thousands)
Risk Rating:
 
 
 
 
 
 
 
 
 
 
 
 
 
   Pass
$
371,363

 
$
170,810

 
$
394,627

 
$
101,141

 
$
37,779

 
$
30,199

 
$
1,105,919

   Special mention
536

 
2,105

 
525

 
12,524

 
—

 
—

 
15,690

   Substandard
629

 
—

 
—

 
—

 
—

 
—

 
629

Total
$
372,528

 
$
172,915

 
$
395,152

 
$
113,665

 
$
37,779

 
$
30,199

 
$
1,122,238


 
December 31, 2018
 
One-to-Four
Family
Residential
 
Multifamily
 
Commercial
Real Estate
 
Construction /
Land
 
Business
 
Consumer
 
Total
 
(In thousands)
Risk Rating:
 
 
 
 
 
 
 
 
 
 
 
 
 
   Pass
$
339,310

 
$
169,355

 
$
372,690

 
$
108,854

 
$
30,486

 
$
12,926

 
$
1,033,621

   Special mention
1,737

 
—

 
782

 
—

 
—

 
—

 
2,519

   Substandard
919

 
—

 
326

 
—

 
—

 
44

 
1,289

Total
$
341,966

 
$
169,355

 
$
373,798

 
$
108,854

 
$
30,486

 
$
12,970

 
$
1,037,429


ALLL. When the Company classifies problem assets as either substandard or doubtful, pursuant to Federal regulations, it may establish a specific reserve in an amount deemed prudent to address the risk specifically or may allow the loss to be addressed in the general allowance. General allowances represent loss allowances which have been established to recognize the inherent risk associated with lending activities, but which, unlike specific allowances, have not been specifically allocated to the particular problem assets. When an insured institution classifies problem assets as a loss, pursuant to Federal regulations, it is required to charge-off such assets in the period in which they are deemed uncollectible. The determination as to the classification of the Company’s assets and the amount of valuation allowances is subject to review by bank regulators, who can require the establishment of additional loss allowances.

Loan grades are used by the Company to identify and track potential problem loans which do not rise to the levels described for substandard, doubtful, or loss. The grades for watch and special mention are assigned to loans which have been criticized based upon known characteristics such as periodic payment delinquency or stale financial information from the borrower and/or guarantors. Loans identified as criticized (watch and special mention) or classified (substandard, doubtful or loss) are subject to problem loan reporting every three months.

The following tables summarize changes in the ALLL and loan portfolio by type of loan and reserve method for the periods indicated. 

94
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 
At or For the Year Ended December 31, 2019
 
One-to-Four
Family
Residential
 
Multifamily
 
Commercial 
Real Estate
 
Construction/
Land
 
Business
 
Consumer
 
Total
ALLL:
(In thousands)
Beginning balance
$
3,387

 
$
1,680

 
$
4,777

 
$
2,331

 
$
936

 
$
236

 
$
13,347

   Charge-offs
—

 
—

 
—

 
—

 
—

 
—

 
—

   Recoveries
73

 
45

 
—

 
—

 
—

 
53

 
171

   (Recapture)
     provision
(426
)
 
(118
)
 
(218
)
 
(109
)
 
204

 
367

 
(300
)
Ending balance
$
3,034

 
$
1,607

 
$
4,559

 
$
2,222

 
$
1,140

 
$
656

 
$
13,218

 
 
 
 
 
 
 
 
 
 
 
 
 
 
General reserve
$
3,003

 
$
1,607

 
$
4,559

 
$
2,222

 
$
1,140

 
$
656

 
$
13,187

Specific reserve
31

 
—

 
—

 
—

 
—

 
—

 
31

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loans:
 
 
 
 
 
 
 
 
 
 
 
 
 

Total Loans
$
372,528

 
$
172,915

 
$
395,152

 
$
113,665

 
$
37,779

 
$
30,199

 
$
1,122,238

Loans collectively evaluated for impairment (1)
$
368,453

 
170,810

 
393,886

 
101,141

 
37,779

 
30,199

 
1,102,268

Loans individually evaluated for impairment (2)
4,075

 
2,105

 
1,266

 
12,524

 
—

 
—

 
19,970

____________ 
(1) Loans collectively evaluated for general reserves.
(2) Loans individually evaluated for specific reserves.
 
At or For the Year Ended December 31, 2018
 
One-to-Four Family Residential
 
Multifamily
 
Commercial 
Real Estate
 
Construction/
Land
 
Business
 
Consumer
 
Total
ALLL:
 (In thousands)
Beginning balance
$
2,837

 
$
1,820

 
$
4,418

 
$
2,816

 
$
694

 
$
297

 
$
12,882

   Charge-offs
—

 
—

 
—

 
—

 
—

 
—

 
—

   Recoveries
4,279

 
—

 
14

 
171

 
—

 
1

 
4,465

   (Recapture)
     provision
(3,729
)
 
(140
)
 
345

 
(656
)
 
242

 
(62
)
 
(4,000
)
Ending balance
$
3,387

 
$
1,680

 
$
4,777

 
$
2,331

 
$
936

 
$
236

 
$
13,347

 
 
 
 
 
 
 
 
 
 
 
 
 
 
General reserve
$
3,328

 
$
1,680

 
$
4,774

 
$
2,331

 
$
936

 
$
236

 
$
13,285

Specific reserve
59

 
—

 
3

 
—

 
—

 
—

 
62

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loans:
 
 
 
 
 
 
 
 
 
 
 
 
 

Total Loans
$
341,966

 
$
169,355

 
$
373,798

 
$
108,854

 
$
30,486

 
$
12,970

 
$
1,037,429

Loans collectively evaluated for impairment (1)
334,644

 
169,355

 
371,058

 
108,854

 
30,486

 
12,883

 
1,027,280

Loans individually evaluated for impairment (2)
7,322

 
—

 
2,740

 
—

 
—

 
87

 
10,149

_____________ 
(1) Loans collectively evaluated for general reserves.
(2) Loans individually evaluated for specific reserves.

95
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Past Due Loans. At December 31, 2019, total past due loans comprised 0.19% of total loans as compared to 0.08% at December 31, 2018.

The following tables represent a summary at December 31, 2019, and 2018, of the aging of loans by type: 

 
Loans Past Due as of December 31, 2019
 
 
 
 
 
30-59 Days
 
60-89 Days
 
90 Days and Greater
 
Total
 
Current
 
Total 
Loans (1)
 
(In thousands)
Real estate:
 
 
 
 
 
 
 
 
 
 
 
One-to-four family residential:
 
 
 
 
 
 
 
 
 
 
 
Owner occupied
$
79

 
$
—

 
$
—

 
$
79

 
$
210,819

 
$
210,898

Non-owner occupied
—

 
—

 
—

 
—

 
161,630

 
161,630

Multifamily
2,105

 
—

 
—

 
2,105

 
170,810

 
172,915

Commercial real estate
—

 
—

 
—

 
—

 
395,152

 
395,152

Construction/land
—

 
—

 
—

 
—

 
113,665

 
113,665

Total real estate
2,184

 
—

 
—

 
2,184

 
1,052,076

 
1,054,260

Business
—

 
—

 
—

 
—

 
37,779

 
37,779

Consumer
—

 
—

 
—

 
—

 
30,199

 
30,199

Total
$
2,184

 
$
—

 
$
—

 
$
2,184

 
$
1,120,054

 
$
1,122,238

_________________________ 
(1) There were no loans 90 days past due and still accruing interest at December 31, 2019.

 
Loans Past Due as of December 31, 2018
 
 
 
 
 
30-59 Days
 
60-89 Days
 
90 Days and Greater
 
Total
 
Current
 
Total 
Loans (1)
 
(In thousands)
Real estate:
 
 
 
 
 
 
 
 
 
 
 
One-to-four family residential:
 
 
 
 
 
 
 
 
 
 
 
Owner occupied
$
223

 
$
—

 
$
272

 
$
495

 
$
193,646

 
$
194,141

Non-owner occupied
—

 
—

 
—

 
—

 
147,825

 
147,825

Multifamily
—

 
—

 
—

 
—

 
169,355

 
169,355

Commercial real estate
—

 
—

 
326

 
326

 
373,472

 
373,798

Construction/land
—

 
—

 
—

 
—

 
108,854

 
108,854

Total real estate
223

 
—

 
598

 
821

 
993,152

 
993,973

Business
—

 
—

 
—

 
—

 
30,486

 
30,486

Consumer
—

 
—

 
—

 
—

 
12,970

 
12,970

Total
$
223

 
$
—

 
$
598

 
$
821

 
$
1,036,608

 
$
1,037,429

________________________ 
(1) There were no loans 90 days past due and still accruing interest at December 31, 2018.


96
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Nonaccrual Loans. The following table is a summary of nonaccrual loans at December 31, 2019, and 2018, by type of loan:    
 
December 31,
 
2019
 
2018
 
(In thousands)
One-to-four family residential
$
95

 
$
382

Commercial real estate
—

 
326

Consumer
—

 
44

Total nonaccrual loans
$
95

 
$
752


Nonperforming loans were $95,000 and $752,000 at December 31, 2019, and 2018, respectively. Foregone interest on nonaccrual loans for the years ended December 31, 2019, and 2018, were $12,000 and $18,000, respectively.
 
The following tables summarize the loan portfolio at December 31, 2019, and 2018, by type and payment activity:
 
December 31, 2019
 
One-to-Four
Family
Residential
 
Multifamily
 
Commercial
Real Estate
 
Construction /
Land
 
Business
 
Consumer
 
Total
 
(In thousands)
Performing (1)
$
372,433

 
$
172,915

 
$
395,152

 
$
113,665

 
$
37,779

 
$
30,199

 
$
1,122,143

Nonperforming (2)
95

 
—

 
—

 
—

 
—

 
—

 
95

Total
$
372,528

 
$
172,915

 
$
395,152

 
$
113,665

 
$
37,779

 
$
30,199

 
$
1,122,238

____________ 
(1) There were $210.8 million of owner-occupied one-to-four family residential loans and $161.6 million of non-owner occupied one to-four family residential loans classified as performing.
(2) There were $95,000 of owner-occupied one-to-four family residential loans and no non-owner occupied one-to-four family residential loans classified as nonperforming.

 
December 31, 2018
 
One-to-Four
Family
Residential
 
Multifamily
 
Commercial
Real Estate
 
Construction/
Land
 
Business
 
Consumer
 
Total
 
(In thousands)
Performing (1)
$
341,584

 
$
169,355

 
$
373,472

 
$
108,854

 
$
30,486

 
$
12,926

 
$
1,036,677

Nonperforming (2)
382

 
—

 
326

 
—

 
—

 
44

 
752

Total
$
341,966

 
$
169,355

 
$
373,798

 
$
108,854

 
$
30,486

 
$
12,970

 
$
1,037,429

_____________ 
(1) There were $193.8 million of owner-occupied one-to-four family residential loans and $147.8 million of non-owner occupied one-to-four family residential loans classified as performing.
(2) There were $382,000 of owner-occupied one-to-four family residential loans and no non-owner occupied one-to-four family residential loans classified as nonperforming.

Impaired loans. The loan portfolio is constantly being monitored by management for delinquent loans and changes in the financial condition of each borrower. When an issue is identified with a borrower and it is determined that the loan needs to be classified as nonperforming and/or impaired, an evaluation of the collateral is performed prior to the end of the financial reporting period and, if necessary, an appraisal is ordered in accordance with the Company’s appraisal policy guidelines. Based on this evaluation, any additional provision for loan loss or charge-offs that may be needed is recorded prior to the end of the financial reporting period.

At December 31, 2019, there was $3.1 million committed to be advanced on an impaired $12.5 million construction loan. At December 31, 2018, there were no commitments to advance funds related to impaired loans.

97
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


The following tables present a summary of loans individually evaluated for impairment at December 31, 2019, and 2018, by the type of loan:
 
At December 31, 2019
 
Recorded Investment (1)
 
Unpaid Principal Balance (2)
 
Related Allowance
 
(In thousands)
Loans with no related allowance:
 
 
 
 
 
One-to-four family residential:
 
 
 
 
 
Owner occupied
$
437

 
$
582

 
$
—

Non-owner occupied
1,486

 
1,486

 
—

Multifamily
2,105

 
2,105

 
—

Commercial real estate
1,266

 
1,266

 
—

Construction/land
12,524

 
15,650

 
—

Total
17,818

 
21,089

 
—

Loans with an allowance:
 

 
 

 
 

One-to-four family residential:
 

 
 
 
 

Owner occupied
505

 
552

 
13

Non-owner occupied
1,647

 
1,647

 
18

Total
2,152

 
2,199

 
31

Total impaired loans:
 

 
 

 
 

One-to-four family residential:
 

 
 

 
 

Owner occupied
942

 
1,134

 
13

Non-owner occupied
3,133

 
3,133

 
18

Multifamily
2,105

 
2,105

 
—

Commercial real estate
1,266

 
1,266

 
—

Construction/land
12,524

 
15,650

 
—

Total
$
19,970

 
$
23,288

 
$
31

_________________ 
(1) Represents the loan balance less charge-offs.
(2) Contractual loan principal balance.

98
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 
At December 31, 2018
 
Recorded Investment (1)
 
Unpaid Principal
Balance (2)
 
Related Allowance
 
(In thousands)
Loans with no related allowance:
 
 
 
 
 
One-to-four family residential:
 
 
 
 
 
Owner occupied
$
1,308

 
$
1,477

 
$
—

Non-owner occupied
2,375

 
2,375

 
—

Commercial real estate
2,499

 
2,499

 
—

Consumer
87

 
141

 
—

Total
6,269

 
6,492

 
—

Loans with an allowance:
 

 
 

 
 

One-to-four family residential:
 

 
 

 
 

Owner occupied
513

 
560

 
22

Non-owner occupied
3,126

 
3,148

 
37

Commercial real estate
241

 
241

 
3

Total
3,880

 
3,949

 
62

Total impaired loans:
 

 
 

 
 

One-to-four family residential:
 

 
 

 
 

Owner occupied
1,821

 
2,037

 
22

Non-owner occupied
5,501

 
5,523

 
37

Commercial real estate
2,740

 
2,740

 
3

Consumer
87

 
141

 
—

Total
$
10,149

 
$
10,441

 
$
62

_____________ 
(1) Represents the loan balance less charge-offs.
(2) Contractual loan principal balance.
 

99
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The following table presents a summary of the average recorded investment in impaired loans, and interest income recognized on impaired loans for the years ended December 31, 2019 and 2018, by the type of loan:
 
Year Ended December 31,
 
2019
 
2018
 
Average Recorded Investment
 
Interest Income Recognized
 
Average Recorded Investment
 
Interest Income Recognized
 
 (In thousands)
Loans with no related allowance:
 
 
 
 
 
 
 
   One-to-four family residential:
 
 
 
 
 
 
 
      Owner occupied
$
852

 
$
36

 
$
1,207

 
$
82

      Non-owner occupied
1,833

 
94

 
5,583

 
146

Multifamily
421

 
111

 
900

 
—

Commercial real estate
2,038

 
90

 
1,885

 
172

Construction/land
7,143

 
834

 
—

 
—

Consumer
43

 
—

 
91

 
8

Total
12,330

 
1,165

 
9,666

 
408

 
 
 
 
 
 
 
 
Loans with an allowance:
 
 
 
 
 
 
 
   One-to-four family residential:
 
 
 
 
 
 
 
      Owner occupied
509

 
34

 
518

 
35

      Non-owner occupied
2,092

 
93

 
3,211

 
162

Commercial real estate
48

 
—

 
1,046

 
27

Total
2,649

 
127

 
4,775

 
224

 
 
 
 
 
 
 
 
Total impaired loans:
 
 
 
 
 
 
 
   One-to-four family residential:
 
 
 
 
 
 
 
      Owner occupied
1,361


70


1,725


117

      Non-owner occupied
3,925


187


8,794


308

Multifamily
421


111


900


—

Commercial real estate
2,086


90


2,931


199

Construction/land
7,143


834


—


—

Consumer
43


—


91


8

Total
$
14,979

 
$
1,292

 
$
14,441

 
$
632



100
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Troubled Debt Restructurings. The following is a summary of information pertaining to TDRs:
 
December 31,
 
2019
 
2018
 
(In thousands)
Performing TDRs
$
5,246

 
$
9,399

Nonaccrual TDRs
—

 
—

Total TDRs
$
5,246

 
$
9,399


The accrual status of a loan may change after it has been classified as a TDR. Management considers the following in determining the accrual status of restructured loans: (1) if the loan was on accrual status prior to the restructuring, the borrower has demonstrated performance under the previous terms, and a credit evaluation shows the borrower’s capacity to continue to perform under the restructured terms (both principal and interest payments), the loan will remain on accrual at the time of the restructuring; (2) if the loan was on nonaccrual status before the restructuring, and the Company’s credit evaluation shows the borrower’s capacity to meet the restructured terms, the loan would remain as nonaccrual for a minimum of six months until the borrower has demonstrated a reasonable period of sustained repayment performance (thereby providing reasonable assurance as to the ultimate collection of principal and interest in full under the modified terms).
    
The following table presents for the periods indicated TDRs and their recorded investment prior to the modification and after the modification:
 
Year Ended December 31,
 
2019
 
2018
 
Number
of Loans
 
Pre-Modification Outstanding
Recorded
Investment
 
Post-Modification Outstanding
Recorded
Investment
 
Number
of Loans
 
Pre-Modification Outstanding
Recorded
Investment
 
Post-Modification Outstanding
Recorded
Investment
 
(Dollars in thousands)
TDRs that occurred during the period:
 
 
 
 
 
 
 
 
 
 
 
One-to-four family residential:
 
 
 
 
 
 
 
 
 
 
 
Principal and interest with interest rate
  concession
7

 
$
1,360

 
$
1,360

 
1

 
$
563

 
$
563

  Advancement of maturity date
3

 
694

 
694

 
—

 
—

 
—

Commercial real estate:
 
 
 
 
 
 
 
 
 
 
 
  Advancement of maturity date
1

 
855

 
855

 
—

 
—

 
—

Total
11

 
$
2,909

 
$
2,909

 
1


$
563


$
563


At December 31, 2019 and 2018, the Company had no commitments to extend additional credit to borrowers whose loan terms have been modified in a TDR. All TDRs are also classified as impaired loans and are included in the loans individually evaluated for impairment in the calculation of the ALLL.

TDRs resulted in no charge-offs to the ALLL for the years ended December 31, 2019 and 2018. For the years ended December 31, 2019 and 2018, there were no payment defaults on loans modified as TDRs within the previous 12 months.
    
At December 31, 2019, and 2018, the Bank had no loans outstanding with executive officers or directors. The change in the aggregate dollar amount of these loans outstanding to related parties is summarized as follows:
 
Year Ended December 31,
 
2019
 
2018
 
(In thousands)
Balance at beginning of year
$
—

 
$
9

   Repayments
—

 
(9
)
Balance at end of year
$
—

 
$
—


101
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



Note 4 - Other Real Estate Owned

The following table is a summary of OREO activity for the periods indicated: 
 
Year Ended December 31,
 
2019
 
2018
 
(In thousands)
Balance at beginning of year
$
483

 
$
483

   Market value adjustments
(29
)
 
—

Balance at end of year
$
454

 
$
483

 
OREO at December 31, 2019, consisted of $454,000 in commercial real estate properties. At December 31, 2019, there were no mortgage loans secured by residential real estate in the process of foreclosure.

Note 5 - Premises and Equipment

Premises and equipment consisted of the following at December 31, 2019, and 2018: 
 
December 31,
 
2019
 
2018
 
(In thousands)
Land
$
2,226

 
$
2,226

Buildings and improvements
20,213

 
19,566

Leasehold improvements
4,040

 
3,076

Furniture, fixtures and equipment
5,506

 
4,971

Computer hardware and software
3,297

 
2,342

 
35,282

 
32,181

Less accumulated depreciation and amortization
(13,043
)
 
(11,357
)
Construction in process
227

 
507

Total premises and equipment, net
$
22,466

 
$
21,331


Depreciation and amortization expense was $1.8 million and $1.6 million for the years ended December 31, 2019 and 2018, respectively.

102
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



Note 6 - Fair Value of Financial Instruments

The Company has adopted ASU 2016-01, and therefore, is measuring the fair value of loans receivable under the exit price notion. The methodology used to estimate the fair values of other financial instruments did not change from the adoption of ASU 2016-01. Under the exit price notion used at December 31, 2019, and 2018, the fair value estimate of loans receivable was based on similar techniques, with the addition of current origination spreads, liquidity premiums, or credit adjustments. The fair value of nonperforming loans is based on the underlying value of the collateral for periods prior to and after adoption of ASU 2016-01.

The Company determines the fair values of its financial instruments based on the fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair values. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect its estimate for market assumptions.

Valuation inputs refer to the assumptions market participants would use in pricing a given asset or liability using one of the three valuation techniques. Inputs can be observable or unobservable. Observable inputs are those assumptions that market participants would use in pricing the particular asset or liability. These inputs are based on market data and are obtained from an independent source. Unobservable inputs are assumptions based on the Company’s own information or estimate of assumptions used by market participants in pricing the asset or liability. Unobservable inputs are based on the best and most current information available on the measurement date.

All inputs, whether observable or unobservable, are ranked in accordance with a prescribed fair value hierarchy:

•
Level 1 - Quoted prices for identical instruments in active markets.

•
Level 2 - Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable.

•
Level 3 - Instruments whose significant value drivers are unobservable.
 
The Company used the following methods to measure fair value on a recurring or nonrecurring basis.

•
Investments available-for-sale: The fair value of all investments, excluding FHLB stock, was based upon quoted market prices for similar investments in active markets, identical or similar investments in markets that are not active, and model-derived valuations whose inputs are observable.

•
OREO: The fair value of OREO properties is measured at the lower of the carrying amount or fair value, less costs to sell. Fair values are generally based on third party appraisals of the property, resulting in a Level 3 classification. In cases where the carrying amount exceeds the fair value, less costs to sell, an impairment loss is recognized.

•
Derivatives: The fair value of derivatives is based on dealer quotes, pricing models, discounted cash flow methodologies or similar techniques for which the determination of fair value may require significant management judgment or estimation.


103
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The tables below present the balances of assets and liabilities measured at fair value on a recurring basis (there were no transfers between Level 1, Level 2 and Level 3 recurring measurements during the periods presented):
 
December 31, 2019
 
Fair Value Measurements
 
Quoted Prices in Active Markets for Identical Assets (Level 1)
 
Significant Other Observable Inputs (Level 2)
 
Significant Unobservable Inputs (Level 3)
 
(In thousands)
Available-for-sale investments:
 
 
 
 
 
 
 
Mortgage-backed investments:
 
 
 
 
 
 
 
Fannie Mae
$
15,629

 
$
—

 
$
15,629

 
$
—

Freddie Mac
4,292

 
—

 
4,292

 
—

Ginnie Mae
23,050

 
—

 
23,050

 
—

Other
11,448

 
—

 
11,448

 
—

Municipal bonds
10,911

 
—

 
10,911

 
—

U.S. Government agencies
45,750

 
—

 
45,750

 
—

Corporate bonds
25,521

 
—

 
25,521

 
—

Total available-for-sale investments
136,601

 
—

 
136,601

 
—

Derivative fair value asset
426

 
—

 
426

 
—

 
$
137,027

 
$
—

 
$
137,027

 
$
—

 
 
December 31, 2018
 
Fair Value Measurements
 
Quoted Prices in Active Markets for Identical Assets (Level 1)
 
Significant Other Observable Inputs (Level 2)
 
Significant Unobservable Inputs (Level 3)
 
(In thousands)
Available-for-sale investments:
 
 
 
 
 
 
 
Mortgage-backed investments:
 
 
 
 
 
 
 
Fannie Mae
$
23,643

 
$
—

 
$
23,643

 
$
—

Freddie Mac
6,287

 
—

 
6,287

 
—

Ginnie Mae
22,061

 
—

 
22,061

 
—

Other
8,979

 
—

 
8,979

 
 
Municipal bonds
10,544

 
—

 
10,544

 
—

U.S. Government agencies
47,438

 
—

 
47,438

 
—

Corporate bonds
23,218

 
—

 
23,218

 
—

Total available-for-sale investments
142,170

 
—

 
142,170

 
$
—

Derivative fair value asset
1,662

 
—

 
1,662

 
—

 
$
143,832

 
$
—

 
$
143,832

 
—


The estimated fair value of Level 2 investments is based on quoted prices for similar investments in active markets, identical or similar investments in markets that are not active, and model-derived valuations whose inputs are observable.    

    

104
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The tables below present the balances of assets and liabilities measured at fair value on a nonrecurring basis at December 31, 2019, and 2018. 
 
December 31, 2019
 
Fair Value
Measurements
 
Quoted Prices in
Active Markets
for Identical
Assets (Level 1)
 
Significant
Other
Observable
Inputs (Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
 
(In thousands)
Impaired loans (included in loans receivable, net)(1)
$
19,939

 
$
—

 
$
—

 
$
19,939

OREO
454

 
—

 
—

 
454

        Total
$
20,393

 
$
—

 
$
—

 
$
20,393

_______________ 
(1) Total value of impaired loans is net of $31,000 of specific reserves on performing TDRs.

 
December 31, 2018
 
Fair Value
Measurements
 
Quoted Prices in
Active Markets
for Identical
Assets (Level 1)
 
Significant
Other
Observable
Inputs (Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
 
(In thousands)
Impaired loans (included in loans receivable, net)(1)
$
10,087

 
$
—

 
$
—

 
$
10,087

OREO
483

 
—

 
—

 
483

        Total
$
10,570

 
$
—

 
$
—

 
$
10,570

________________ 
(1) Total value of impaired loans is net of $62,000 of specific reserves on performing TDRs.

The following tables present quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a nonrecurring basis at December 31, 2019 and 2018.
 
December 31, 2019
 
Fair Value
 
Valuation Technique(s)
 
Unobservable Input(s)
 
Range (Weighted Average Change in Fair Value)
 
(Dollars in thousands)
Impaired Loans
$
19,939

 
Market approach
 
Appraised value discounted by market or
borrower conditions
 
0.0% (0.00%)
 
 
 
 
 
 
 
 
OREO
$
454

 
Market approach
 
Appraised value less selling costs
 
0.0% (0.00%)
 
December 31, 2018
 
Fair Value
 
Valuation Technique(s)
 
Unobservable Input(s)
 
Range (Weighted Average Change in Fair Value)
 
(Dollars in thousands)
Impaired Loans
$
10,087

 
Market approach
 
Appraised value discounted by market or
borrower conditions
 
0.0% (0.00%)
 
 
 
 
 
 
 
 
OREO
$
483

 
Market approach
 
Appraised value less selling costs
 
0.0% (0.00%)


105
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The fair value calculation of the Company’s financial instruments are an attempt to incorporate market conditions at a specific point in time. The underlying assumptions are generally subjective and involve uncertainties. Therefore, these fair value estimates are not intended to represent the underlying value of the Company as a whole.

The carrying amounts and estimated fair values of financial instruments at December 31, 2019, and 2018, were as follows: 
 
December 31, 2019
 
Fair Value Measurements Using:
 
Carrying Value
 
Estimated Fair Value
 
Level 1
 
Level 2
 
Level 3
 
(In thousands)
Financial Assets:
 
 
 
 
 
 
 
 
 
Cash on hand and in banks
$
10,094

 
$
10,094

 
$
10,094

 
$
—

 
$
—

Interest-earning deposits
12,896

 
12,896

 
12,896

 
—

 
—

Investments available-for-sale
136,601

 
136,601

 
—

 
136,601

 
—

Loans receivable, net
1,108,462

 
1,096,499

 
—

 
—

 
1,096,499

FHLB stock
7,009

 
7,009

 
—

 
7,009

 
—

Accrued interest receivable
4,138

 
4,138

 
—

 
4,138

 
—

Derivative fair value asset
426

 
426

 
—

 
426

 
—

 
 
 
 
 
 
 
 
 
 
Financial Liabilities:
 
 
 
 
 

 
 

 
 
Deposits
513,959

 
513,959

 
513,959

 
—

 
—

Certificates of deposit, retail
425,103

 
430,418

 
—

 
430,418

 
—

Certificates of deposit, brokered
94,472

 
94,556

 
—

 
94,556

 
—

Advances from the FHLB
137,700

 
137,706

 
—

 
137,706

 
—

Accrued interest payable
285

 
285

 
—

 
285

 
—


 
December 31, 2018
 
Fair Value Measurements Using:
 
Carrying Value
 
Estimated Fair Value
 
Level 1
 
Level 2
 
Level 3
 
(In thousands)
Financial Assets:
 
 
 
 
 
 
 
 
 
Cash on hand and in banks
$
8,122

 
$
8,122

 
$
8,122

 
$
—

 
$
—

Interest-earning deposits
8,888

 
8,888

 
8,888

 
—

 
—

Investments available-for-sale
142,170

 
142,170

 
—

 
142,170

 
—

Loans receivable, net
1,022,904

 
1,012,114

 
—

 
—

 
1,012,114

FHLB stock
7,310

 
7,310

 
—

 
7,310

 
—

Accrued interest receivable
4,068

 
4,068

 
—

 
4,068

 
—

Derivative fair value asset
1,662

 
1,662

 
—

 
1,662

 
—

 
 
 
 
 
 
 
 
 
 
Financial Liabilities:
 
 
 
 
 

 
 

 
 
Deposits
450,033

 
450,033

 
450,033

 
—

 
—

Certificates of deposit, retail
391,174

 
390,101

 
—

 
390,101

 
—

Certificates of deposit, brokered
97,825

 
97,466

 
—

 
97,466

 
—

Advances from the FHLB
146,500

 
146,357

 
—

 
146,357

 
—

Accrued interest payable
478

 
478

 
—

 
478

 
—


Fair value estimates are based on existing balance sheet financial instruments without attempting to estimate the value of anticipated future business. The fair value has not been estimated for assets and liabilities that are not considered financial instruments.

106
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Note 7 - Accrued Interest Receivable

Accrued interest receivable consisted of the following at December 31, 2019 and 2018:
 
December 31,
 
2019
 
2018
 
(In thousands)
Loans receivable
$
3,518

 
$
3,366

Investments
603

 
699

Interest-earning deposits
17

 
3

 
$
4,138

 
$
4,068


Note 8 - Deposits

Deposit accounts consisted of the following at December 31, 2019 and 2018:
 
December 31,
 
2019
 
2018
 
(In thousands)
Noninterest-bearing
$
52,849

 
$
46,108

Interest-bearing demand
65,897

 
40,079

Statement savings
17,447

 
24,799

Money market
377,766

 
339,047

Certificates of deposit, retail (1)
425,103

 
391,174

Certificates of deposit, brokered
94,472

 
97,825

 
$
1,033,534

 
$
939,032

_______________
(1) Shown net of $28,000 and $58,000 fair value adjustment on December 31, 2019 and 2018, respectively. 

At December 31, 2019, scheduled maturities of certificates of deposit were as follows:
December 31,
 
Amount
 
 
(In thousands)
2020
 
$
222,059

2021
 
185,208

2022
 
47,075

2023
 
50,220

2024
 
15,013

thereafter
 
—

 
 
$
519,575


Deposits included public funds of $34.0 million and $28.5 million at December 31, 2019 and 2018, respectively.
 
Certificates of deposit equal to or exceeding the FDIC insured amount of $250,000 included in deposits at December 31, 2019, and 2018, were $130.6 million and $129.3 million, respectively. Interest expense on certificates equal to or exceeding $250,000 totaled $2.9 million and $1.8 million for the years ended December 31, 2019 and 2018, respectively.

Included in total deposits are accounts of $2.1 million and $16.0 million at December 31, 2019, and 2018, respectively which are controlled by related parties.


107
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Interest expense on deposits for the periods indicated was as follows:
 
Year Ended December 31,
 
2019
 
2018
 
(In thousands)
Interest-bearing demand
$
108

 
$
79

Statement savings
29

 
34

Money market
5,027

 
3,550

Certificates of deposit, retail
9,549

 
5,825

Certificates of deposit, brokered
3,283

 
1,730

 
$
17,996

 
$
11,218


Note 9 - Other Borrowings

At December 31, 2019, and 2018, the Bank maintained credit facilities with the FHLB totaling $588.7 million and $554.8 million, respectively. The credit facility was collateralized by $240.8 million of single-family residential mortgages, $186.9 million of commercial real estate loans and $79.0 million of multifamily loans under a blanket lien arrangement at December 31, 2019. At December 31, 2018, the credit facility was collateralized by $216.4 million of single-family residential mortgages, $180.8 million of commercial real estate loans, and $74.2 million of multifamily loans under a blanket lien arrangement. The Bank also had $115.1 million unused line-of-credit facilities with other financial institutions at December 31, 2019, with interest payable at the then stated rate.

Summary information related to outstanding advances at the FHLB during the years ended December 31, 2019, and 2018 consisted of the following:
 
 
Year ended December 31,
 
 
2019
 
2018
 
 
(Dollars in thousands)
Maximum borrowing outstanding at any month end
 
$
184,500

 
$
224,000

Average borrowing outstanding during year
 
129,899

 
183,667

Balance outstanding at end of year
 
137,700

 
146,500

Average rate paid during the year
 
2.09
%
 
1.92
%
Weighted-average rate paid at end of year
 
1.84

 
2.62

 
 
 
 
 

Scheduled maturities of Federal Home Loan Bank outstanding advances at December 31, 2019, were as follows:
Year Ended December 31,
 
Balance Due
 
Weighted Average Interest Rate at December 31, 2019
(Dollars in thousands)
FHLB overnight Fed Funds
 
$
26,700

 
1.73
%
2020
 
111,000

 
1.87

 
 
$
137,700

 
 

Note 10 - Leases

The Company adopted ASU 2016-02 and ASU 2018-11 using the modified retrospective approach with an effective date of January 1, 2019, and recognized on the consolidated balance sheets a right-of-use asset (“ROU”) included in prepaid expenses and other assets and lease liabilities included in other liabilities. As such, prior year financial statements were not restated under the new standard. At December 31, 2019, the Company had ten operating leases for retail branch locations. The remaining initial lease terms range from 8 months to 5.25 years, with most leases carrying optional extensions of 3-5 years. The Company will include optional lease term extensions in the ROU assets and lease liabilities when management believes it is reasonably certain that the term extension will be exercised, and will be determined based on indicators that the Company would have an economic incentive to extend the lease. The Company has elected to not apply ASU 2016-02 to short term leases, which are those that have

108
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

a term of one year or less. To calculate the present value of lease payments not yet paid, the Company uses the incremental borrowing rate, which is equal to the FHLB advance rate for the remaining term of the lease that was in place at January 1, 2019, or for leases added after that date, at the time of lease inception.

The minimum monthly lease payments are generally based on square footage of the leased premises, with escalating minimum rent over the lease term. At December 31, 2019, the Company was committed to paying $53,000 per month in minimum monthly lease payments. The minimum monthly lease payment over the initial lease term, including any free rent period, was used to calculate the ROU and lease liability. The Company’s current leases do not include any non-lease components.

Total lease expense included in the Company’s Consolidated Income Statement for the year ended December 31, 2019, was $752,000. Lease expense includes the amortized lease expense under ASU 2016-02 combined with variable lease expenses for maintenance or other expenses as defined in the individual lease agreements. At December 31, 2019, the Company’s consolidated balance sheet included a $2.2 million right-of-use asset and a $2.3 million lease liability. The lease liability is amortizing over a weighted-average remaining term of 6.1 years. The weighted-average discount rate used to calculate the present value of future minimum lease payments was 2.94% at December 31, 2019.    

The following table provides a reconciliation between the undiscounted minimum lease payments at December 31, 2019 and the discounted lease liability at that date:

 
 
December 31, 2019
 
 
(in thousands)
Due through one year
 
$
609

Due after one year through two years
 
433

Due after two years through three years
 
399

Due after three years through four years
 
291

Due after four years through five years
 
230

Due after five years
 
532

Total minimum lease payments
 
2,494

Less: present value discount
 
215

Lease liability
 
$
2,279


The Company has secured a lease for a new retail branch in University Place, Washington, which commenced in March 2020. The initial lease term is for 65 months and includes options to extend the lease. The minimum rent will be determined at commencement and will increase annually thereafter. This lease was not included in the calculation of discounted lease payments at December 31, 2019.

Note 11 - Derivatives

The Company uses derivative financial instruments in the form of interest rate swap agreements, which qualify as cash flow hedges, to manage the risk of changes in future cash flows due to interest rate fluctuations. The hedged items have a total notional amount of $75.0 million, and consist of rolling one-month or three-month FHLB advances that are renewed at the fixed interest rate at each renewal date. The hedging instruments have four to five years terms and stipulate that the counterparty will pay the Company interest at one-month or three-month LIBOR and the Company will pay fixed interest of 1.34% on a $50.0 million notional amount, 1.44% on a $15.0 million notional amount, and 1.585% on a $10.0 million notional amount. The Company pays or receives the net interest amount quarterly based on the respective hedge agreement and includes this amount as part of FHLB advances interest expense on the Consolidated Income Statement.

Quarterly, the effectiveness evaluation is based upon the fluctuation of the interest the Company pays to the FHLB for the debt as compared to the one-month or three-month LIBOR interest received from the counterparty. At December 31, 2019, the $426,000 fair value of the cash flow hedges was reported with other assets. The tax effected amount of $336,000 was included in Accumulated Other Comprehensive Income. There were no amounts recorded in the Consolidated Income Statements for the years ended December 31, 2019 or 2018, related to ineffectiveness.

Fair value for these derivative instruments, which generally changes as a result of changes in the level of market interest rates, is estimated based on dealer quotes and secondary market sources.

109
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


The following table presents the fair value of derivative instruments as of December 31, 2019 and 2018:
 
Balance Sheet Location
 
 2019 Fair Value
 
 2018 Fair Value
 
(In thousands)
Interest rate swaps on FHLB debt designated as cash flow hedges
Other assets
 
$
426

 
$
1,662

Total derivatives
 
 
$
426

 
$
1,662

 
 
 
 
 
 
The following table presents the net unrealized gains (losses) on derivative instruments included on the Consolidated Statements of Comprehensive Income for the years ended December 31, 2019 and 2018:
 
Balance Sheet Location
 
 2019 Amount of Loss Recognized In OCI
 
 2018 Amount of Gain Recognized In OCI
 
(In thousands)
Interest rate swaps on FHLB debt designated as cash flow hedge
Equity
 
$
(977
)
 
$
108

 
 
 
 
 
 

Note 12 - Benefit Plans

Multi-employer Pension Plans

The Company participates in the Pentegra Defined Benefit Plan for Financial Institutions (“The Pentegra DB Plan”), a tax-qualified defined-benefit pension plan that covers substantially all employees after one year of continuous employment. Pension benefits vest over a period of five years of credited service. The Pentegra DB Plan’s Employer Identification Number is 13-5645888 and the Plan Number is 333. The Pentegra DB Plan operates as a multi-employer plan for accounting purposes and as a multiple-employer plan under the Employee Retirement Income Security Act of 1974 and the Internal Revenue Code. There are no collective bargaining agreements in place that require contributions to the Pentegra DB Plan.

The Pentegra DB Plan is a single plan under Internal Revenue Code Section 413(c) and, as a result, all of the assets stand behind all of the liabilities. Accordingly, under the Pentegra DB Plan, contributions made by a participating employer may be used to provide benefits to participants of other participating employers.

As of March 31, 2013, the Pentegra DB Plan was frozen, eliminating all future benefit accruals for employees. Each employee’s accrued benefit was determined as of March 31, 2013.
    
The funding target is the present value of all benefits that have accrued as of the first day of the current plan year (July 1). Because interest rates used to calculate the present value of all benefits (5.51% for 2019 and 5.71% for 2018) is significantly higher than current market rates, the funding target does not represent the Company’s actual liability upon withdrawal from participation in the Pentegra DB Plan, which is significantly larger than the funding target. The table below presents the funded status (market value of plan assets divided by funding target) of the plan as of July 1:
 
2019
 
2018
Source
Valuation Report
 
Valuation Report
First Financial Northwest’s Plan(1)
101.7
%
 
102.7
%
_________________ 
(1) Market value of plan assets reflects any contributions received through June 30, 2019, or 2018, respectively.

Total contributions made to the Pentegra DB Plan, as reported on Form 5500, equal $164.6 million and $367.1 million for the plan years ended June 30, 2018 and June 30, 2017 respectively. The Company’s contributions to the Pentegra DB Plan are not more than 5% of the total contributions to the Pentegra DB Plan. The Company’s policy is to fund pension costs as accrued.


110
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Total contributions during the years ended December 31, 2019 and 2018 were: 
2019
 
2018
Date Paid
 
Amount
 
Date Paid
 
Amount
(in thousands)
10/8/2019
 
$
37

 
10/9/2018
 
$
43

12/6/2019
 
503

 
11/13/2018
 
497

Total
 
$
540

 
Total
 
$
540


Supplemental Executive Retirement Plan

The Company has entered into post-employment agreements with certain key officers to provide supplemental retirement benefits. The Company recorded $74,000 and $18,000 of compensation expense for the years ended December 31, 2019, and 2018, respectively.

401(k) Plan

The Company has a savings plan under Section 401(k) of the Internal Revenue Code, covering substantially all employees after 90 days of continuous employment. Under the plan, employee contributions up to 6% will be matched 50% by the Company. Such matching becomes vested over a period of five years of credited service. Employees may make investments in various stock, money market, or fixed income plans. The Company contributed $333,000 and $312,000 to the plan for the years ended December 31, 2019, and 2018, respectively.

Employee Stock Ownership Plan

The Company provides an ESOP for the benefit of substantially all employees. The ESOP borrowed $16.9 million from First Financial Northwest and used those funds to acquire 1,692,800 shares of First Financial Northwest’s stock at the time of the initial public offering at a price of $10.00 per share. The loan matures on October 8, 2022 and has a fixed interest rate of 4.88%.

Shares purchased by the ESOP with the loan proceeds are held in a suspense account and are allocated to ESOP participants on a pro rata basis as principal and interest payments are made by the ESOP to First Financial Northwest. The loan is secured by shares purchased with the loan proceeds and will be repaid by the ESOP with funds from the Company’s discretionary contributions to the ESOP and earnings on the ESOP assets. Annual principal and interest payments of $1.6 million were made by the ESOP during 2019, and 2018.

As shares are committed to be released from collateral, the Company reports compensation expense equal to the daily average market prices of the shares and the shares become outstanding for EPS computations. The compensation expense is accrued throughout the year.

A summary of key transactions for the ESOP for the periods indicated follows:
 
 
 
2019
 
2018
 
(in thousands)
ESOP contribution expense
$
1,698

 
$
1,906

Dividends on unallocated ESOP shares used to reduce ESOP contribution
148

 
166

    

111
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Shares held by the ESOP at December 31, 2019 and 2018, are as follows: 
 
December 31,
 
2019
 
2018
 
(Dollars in thousands, except share data)
Allocated shares
1,382,453

 
1,269,600

Unallocated shares
310,347

 
423,200

Total ESOP shares
1,692,800

 
1,692,800

Fair value of unallocated shares
$
4,637

 
$
6,547

 
Stock-Based Compensation

In June 2016, First Financial Northwest’s shareholders approved the First Financial Northwest, Inc. 2016 Equity Incentive Plan (“2016 Plan”). This plan provides for the granting of incentive stock options (“ISO”), non-qualified stock options (“NQSO”), restricted stock and restricted stock units. The 2016 Plan expires in June 2026. The 2016 Plan established 1,400,000 shares available to grant with a maximum of 400,000 of these shares available to grant as restricted stock awards. Each share issued as a restricted stock award counts as two shares towards the total shares available to be awarded.

As a result of the approval of the 2016 Plan, the First Financial Northwest, Inc. 2008 Equity Incentive Plan (“2008 Plan”) was frozen and no additional awards will be made. Restricted stock awards and stock options that were granted under the 2008 Plan will continue to vest and be available for exercise, subject to the 2008 Plan provisions. At December 31, 2019, there were 1,240,114 total shares available for grant under the 2016 Plan, including 320,057 shares available to be granted as restricted stock.

Under the 2016 Plan, the vesting date for each option award or restricted stock award is determined by an award committee and specified in the award agreement. In the case of restricted stock awards granted in lieu of cash payments of directors’ fees, the grant date is used as the vesting date.

Total compensation expense for the both the 2008 Plan and 2016 Plan for the years ended December 31, 2019, and 2018, was $501,000 and $650,000, respectively. The related income tax benefit was $105,000 and $137,000 for the years ended December 31, 2019, and 2018, respectively.

Stock Options

Under the 2008 Plan, stock option awards were granted with an exercise price equal to the market price of First Financial Northwest's common stock at the grant date. These option awards have a vesting period of five years, with 20% vesting on the anniversary date of each grant date, and a contractual life of ten years. Any unexercised stock options will expire ten years after the grant date, or sooner in the event of the award recipient’s death, disability or termination of service with the Company.

Under the 2016 Plan, the exercise price and vesting period for stock options are determined by the award committee and specified in the award agreement, however, the exercise price shall not be less than the fair market value of a share as of the grant date. Any unexercised stock option will expire 10 years after the award date or sooner in the event of the award recipient’s death, disability, retirement, or termination of service.

A cashless exercise of vested stock options may occur by the option holder surrendering the number of options valued at the current stock price at the time of exercise to cover the total cost to exercise. The surrendered options are canceled and are unavailable for reissue.

The fair value of each option award is estimated on the grant date using a Black-Scholes model that uses the assumptions noted in the table below. The dividend yield is based on the current quarterly dividend in effect at the time of the grant. Historical employment data is used to estimate the forfeiture rate. The historical volatility of the Company’s stock price over a specified period of time is used for the expected volatility assumption. First Financial Northwest bases the risk-free interest rate on the U.S. Treasury Constant Maturity Indices in effect on the date of the grant. First Financial Northwest elected to use the “simplified” method permitted by the U.S. Securities and Exchange Commission to calculate the expected term. This method uses the vesting term of an option along with the contractual term, setting the expected life at the midpoint.
        
There were 50,000 stock options granted in 2019, however, these shares were forfeited later in the year. There were no stock options granted in 2018.

112
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

    
A summary of the Company’s stock option plan awards activity for the year ended December 31, 2019 follows: 
 
Shares
 
Weighted-
Average
Exercise Price
 
Weighted-
Average
Remaining
Contractual
Term in Years
 
Aggregate
Intrinsic Value
Outstanding at December 31, 2018
315,000

 
$
10.34

 
 
 
$
1,615,600

Granted
50,000

 
15.80

 

 
—

Exercised
(2,000
)
 
10.77

 
 
 
7,240

Forfeited or expired
(50,000
)
 
15.80

 
 
 
—

Outstanding at December 31, 2019
313,000

 
10.34

 
3.98
 
$
1,440,310

Expected to vest assuming a 3% forfeiture rate over the vesting term
312,760

 
10.34

 
3.98
 
1,439,854

Exercisable at December 31, 2019
305,000

 
10.27

 
3.93
 
1,425,110


As of December 31, 2019, there was $32,000 of total unrecognized compensation cost related to nonvested stock options. The cost is expected to be recognized over the remaining weighted-average vesting period of 11 months.

Restricted Stock Awards

A summary of changes in nonvested restricted stock awards for the year ended December 31, 2019, follows: 
Nonvested Shares
 
Shares
 
Weighted Average Grant Date  Fair Value
Nonvested at December 31, 2018
 
20,987

 
$
15.90

Granted
 
25,278

 
15.88

Vested
 
(29,567
)
 
15.53

Nonvested at December 31, 2019
 
16,698

 
16.53

 
 
 
 
 
Expected to vest assuming a 3% forfeiture rate over the vesting term
 
16,197

 
16.53


As of December 31, 2019, there was $46,000 of total unrecognized compensation costs related to nonvested shares granted as restricted stock awards. The cost is expected to be recognized over the remaining weighted-average vesting period of two months. The total fair value of shares vested during the years ended December 31, 2019, and 2018 were $459,000 and $238,000, respectively.

Note 13 - Federal Income Taxes

The components of income tax expense for the years indicated are as follows: 
 
Year Ended December 31,
 
2019
 
2018
 
(In thousands)
Current
$
2,453

 
$
3,973

Deferred
109

 
(280
)
Total income tax expense
$
2,562

 
$
3,693

 

113
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

A reconciliation of the tax provision based on the statutory corporate rate of 21% for the year ended December 31, 2019, and 2018, on pretax income is as follows:
 
Year Ended December 31,
 
2019
 
2018
 
(In thousands)
Income tax expense at statutory rate
$
2,715

 
$
3,904

Income tax effect of:
 
 
 
   Tax exempt interest, net
(25
)
 
(53
)
BOLI income, net
(203
)
 
(150
)
   Other, net
75

 
(8
)
Total income tax expense
$
2,562

 
$
3,693


The deferred tax assets and liabilities, included in the accompanying consolidated balance sheets, consisted of the following at the dates indicated: 
 
December 31,
 
2019
 
2018
 
(In thousands)
Deferred tax assets:
 
 
 
   ALLL
$
2,775

 
$
2,801

   Reserve for unfunded commitments
90

 
96

   Deferred compensation
272

 
293

   Net unrealized loss on investments available-for-sale
146

 
640

   Employee benefit plans
487

 
527

   OREO market value adjustments
10

 
4

   Accrued expenses
93

 
111

Core deposit intangible
30

 
18

Expenses to facilitate branch acquisition
24

 
26

Split dollar life insurance
67

 
51

Deferred lease
—

 
18

Lease liability
479

 
—

Total deferred tax assets
$
4,473


$
4,585

Deferred tax liabilities:
 

 
 

FHLB stock dividends
16

 
110

Loan origination fees and costs
940

 
903

Gain on fair value of cash flow hedge
89

 
349

Fixed assets
1,387

 
1,271

Goodwill
29

 
17

Right of use asset
464

 
—

Other, net
47

 
91

Total deferred tax liabilities
$
2,972

 
$
2,741

Deferred tax assets, net
$
1,501

 
$
1,844


Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. These calculations are based on many complex factors including estimates of the timing of reversals of temporary differences, the interpretation of federal income tax laws, and a

114
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

determination of the differences between the tax and the financial reporting basis of assets and liabilities. Actual results could differ significantly from the estimates and interpretations used in determining the current and deferred income tax assets and liabilities.

At December 31, 2019 and 2018, the Company had no net operating loss carryforward.

As a result of the bad debt deductions taken in years prior to 1988, retained earnings includes accumulated earnings of approximately $4.5 million, on which federal income taxes have not been provided. If, in the future, this portion of retained earnings is used for any purpose other than to absorb losses on loans or on property acquired through foreclosure, federal income taxes may be imposed at the then-prevailing corporate tax rates. The Bank does not contemplate that such amounts will be used for any purpose that would create a federal income tax liability; therefore no provision has been made.

Under GAAP, a valuation allowance is required to be recognized if it is “more likely than not” that a portion of the deferred tax asset will not be realized. In order to support a conclusion that a valuation allowance is not needed, management evaluates both positive and negative evidence under the “more likely than not” standard. The weight given to the potential effect of negative and positive evidence should be commensurate with the extent to which the strength of the evidence can be objectively verified. As of December 31, 2019, it was determined the full deferred tax asset would be realized in future periods and a valuation allowance would not be necessary.

The Company had no unrecognized tax benefits at December 31, 2019 or 2018, and recognized no interest or tax penalties. The Company has filed U.S. federal income tax returns as well as California state income tax returns. Income tax returns filed are subject to examination by the U.S. federal, state, and local income tax authorities. While no income tax returns are currently being examined, the Company is no longer subject to tax examination by tax authorities for years prior to 2016.

Note 14 - Regulatory Capital Requirements

Under Federal regulations, pre-conversion retained earnings are restricted for the protection of pre-conversion depositors.

The Company is a bank holding company under the supervision of the Federal Reserve Bank of San Francisco. Bank holding companies are subject to capital adequacy requirements of the Board of Governors of the Federal Reserve System (the “Federal Reserve”) under the Bank Holding Company Act of 1956, as amended, and the regulations of the Federal Reserve Board, except that, pursuant to the Economic Growth, Regulatory Relief and Consumer Protection Act, effective August 30, 2018, a bank holding company with consolidated assets of less than $3 billion is generally not subject to the Federal Reserve’s capital regulations, which parallel the FDIC’s capital regulations. The Bank is a federally insured institution and thereby is subject to the capital requirements established by the FDIC. Failure to meet minimum capital requirements can initiate certain mandatory and, possibly, additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital regulations that involve quantitative measures of their assets, liabilities, and certain off-balance- sheet items as calculated under regulatory accounting practices, and until August 30, 2018, First Financial Northwest was subject to similar capital regulations. The Company was not subject to regulatory requirements for bank holding companies at December 31, 2019, and 2018, as its assets were less than the $3.0 billion threshold.

The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Prompt corrective action provisions are not applicable to bank holding companies.

Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the table that follows) of total and Tier 1 capital to risk-weighted assets (as defined in the regulations) and of Tier 1 capital to average assets.

As of December 31, 2019, according to the most recent notification from the FDIC, the Bank was categorized as well‑capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since the notification that management believes have changed the Bank’s category.
    
    

115
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

First Financial Northwest Bank’s actual capital amounts and ratios at December 31, 2019, and 2018, are presented in the following table.
 
 
 
 
 
 
 
 
 
 
To be Well Capitalized
 
 
 
 
 
 
For Capital Adequacy
 
Under Prompt Corrective
 
 
Actual
 
Purposes
 
Action Provisions
 
 
Amount
 
Ratio
 
Amount
 
Ratio
 
Amount
 
Ratio
 
 
(Dollars in thousands)
December 31, 2019:
 
 
 
 
 
 
 
 
 
 
 
 
Total risk-based capital
 
$
148,048

 
14.38
%
 
$
82,359

 
8.00
%
 
$
102,949

 
10.00
%
 
 
 
 
 
 
 
 
 
 
 
 
 
Tier 1 risk-based capital
 
135,170

 
13.13

 
61,769

 
6.00

 
82,359

 
8.00

 
 
 
 
 
 
 
 
 
 
 
 
 
Common equity tier 1 capital (“CET1”)
 
135,170

 
13.13

 
46,327

 
4.50

 
66,917

 
6.50

 
 
 
 
 
 
 
 
 
 
 
 
 
Tier 1 leverage capital
 
135,170

 
10.27

 
52,630

 
4.00

 
65,787

 
5.00

 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2018:
 
 

 
 

 
 

 
 

 
 

 
 

Total risk-based capital
 
$
140,220

 
14.68
%
 
$
76,417

 
8.00
%
 
$
95,521

 
10.00
%
 
 
 
 
 
 
 
 
 
 
 
 
 
Tier 1 risk-based capital
 
128,257

 
13.43

 
57,313

 
6.00

 
76,417

 
8.00

 
 
 
 
 
 
 
 
 
 
 
 
 
Common equity tier 1 capital
 
128,257

 
13.43

 
42,985

 
4.50

 
62,089

 
6.50

 
 
 
 
 
 
 
 
 
 
 
 
 
Tier 1 leverage capital
 
128,257

 
10.37

 
49,491

 
4.00

 
61,863

 
5.00


In addition to the minimum CET1, Tier 1, total capital and leverage ratios, the Bank must maintain a capital conservation buffer consisting of additional CET1 capital greater than 2.5% of risk-weighted assets above the required minimum levels in order to avoid limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses based on percentages of eligible retained income that could be utilized for such actions. As of December 31, 2019, the Bank’s conservation buffer was 6.38%.

Note 15 - Commitments and Contingencies

Financial Instruments with Off-Balance-Sheet Risk. In the normal course of business, the Company makes loan commitments, typically unfunded loans and unused lines of credit, to accommodate the financial needs of its customers. These arrangements have credit risk essentially the same as that involved in extending loans to customers and are subject to the Company’s normal credit policies, including collateral requirements, where appropriate. Commitments to extend credit are agreements to lend to customers in accordance with predetermined contractual provisions. These commitments are for specific periods or, may contain termination clauses and may require the payment of a fee. The total amounts of unused commitments do not necessarily represent future credit exposure or cash requirements, in that commitments can expire without being drawn upon. Unfunded commitments to originate loans or extend credit totaled $129.7 million at December 31, 2019, and $126.1 million at December 31, 2018.

Lease Commitments. First Financial Northwest Bank has entered into lease commitments for its branches located in Mill Creek, Edmonds, Renton, Bellevue, Woodinville, Smokey Point, Lake Stevens, Bothell, Kent and Kirkland, all in Washington. For more information on the Company’s lease commitments, see Note 10 - Leases.

Legal Proceedings. The Company and its subsidiaries are from time to time defendants in and are threatened with various legal proceedings arising from their regular business activities. Management, after consulting with legal counsel, is of the opinion that the ultimate liability, if any, resulting from these pending or threatened actions and proceedings will not have a material effect on the consolidated financial statements of the Company.


116
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Employment Contracts and Severance Agreements. The Company has change in control severance agreements with key officers that offer specified terms of salary coverage. In addition, the Company has employment contracts with certain executives that include specified terms of salary coverage as a result of involuntary termination due to change in control or other circumstances. At December 31, 2019, the Company had a $238,000 liability under a severance agreement that will be fully paid during 2020.

Note 16 - Parent Company Only Financial Statements

Presented below are the condensed balance sheets, income statements and statements of cash flows for First Financial Northwest.

FIRST FINANCIAL NORTHWEST, INC.
Condensed Balance Sheets 
 
December 31,
 
2019
 
2018
 
(In thousands)
Assets
 
 
 
Cash and cash equivalents
$
235

 
$
140

Interest-bearing deposits
18,456

 
22,362

Investment in subsidiaries
136,907

 
130,209

Receivable from subsidiaries
990

 
1,207

Other assets
46

 
52

Total assets
$
156,634

 
$
153,970

 
 
 
 
Liabilities and Stockholders’ Equity
 

 
 

Liabilities:
 

 
 

Payable to subsidiaries
$
128

 
$
47

Deferred tax liability, net
2

 
2

Other liabilities
185

 
183

Total liabilities
315

 
232

Stockholders’ equity
156,319

 
153,738

Total liabilities and stockholders’ equity
$
156,634

 
$
153,970

 FIRST FINANCIAL NORTHWEST, INC.
Condensed Income Statements
 
Year Ended December 31,
 
2019
 
2018
 
(In thousands)
Operating income:
 
 
 
Interest income:
 
 
 
  Interest-bearing deposits with banks
$
153

 
$
157

   Total operating income
153

 
157

Operating expenses:
 

 
 

   Other expenses
1,732

 
1,557

Total operating expenses
1,732

 
1,557

Loss before benefit for federal income taxes and equity in undistributed
  earnings of subsidiaries
(1,579
)
 
(1,400
)
Federal income tax benefit
(363
)
 
(311
)
Loss before equity in undistributed loss of subsidiaries
(1,216
)
 
(1,089
)
Equity in undistributed earnings of subsidiaries
11,585

 
15,988

Net income
$
10,369

 
$
14,899


117
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


FIRST FINANCIAL NORTHWEST, INC.
Condensed Statements of Cash Flows
 
Year Ended December 31,
 
2019
 
2018
 
(In thousands)
Cash flows from operating activities:
 
 
 
   Net income
$
10,369

 
$
14,899

   Adjustments to reconcile net income to net cash from operating
 
 
 
      activities:
 
 
 
     Equity in undistributed earnings of subsidiaries
(11,585
)
 
(15,988
)
     Dividends received from subsidiary
6,525

 
10,858

ESOP, stock options, and restricted stock compensation
19

 
28

     Change in deferred tax liability, net
—

 
(7
)
     Change in receivables from subsidiaries
(9
)
 
7

     Change in payables to subsidiaries
81

 
(50
)
     Change in other assets
6

 
(5
)
     Changes in other liabilities
2

 
(47
)
Net cash provided by operating activities
5,408

 
9,695

Cash flows from investing activities:
 

 
 

   Investments in subsidiaries
277

 
334

   ESOP loan repayment
1,354

 
2,833

Net cash provided in investing activities
1,631

 
3,167

Cash flows from financing activities:
 

 
 

   Proceeds from exercise of stock options
21

 
1,365

   Proceeds for vested awards
106

 
206

   Net share settlement of stock awards
(93
)
 
(40
)
   Repurchase and retirement of common stock
(7,406
)
 
(3,153
)
   Dividends paid
(3,478
)
 
(3,198
)
Net cash used by financing activities
(10,850
)
 
(4,820
)
Net increase (decrease) in cash
(3,811
)
 
8,042

Cash and cash equivalents at beginning of year
22,502

 
14,460

Cash and cash equivalents at end of year
$
18,691

 
$
22,502

 



118
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 17 - Earnings Per Share

The following table presents a reconciliation of the components used to compute basic and diluted EPS for the periods indicated. 
 
Year Ended December 31,
 
2019
 
2018
 
(Dollars in thousands, except share data)
Net income
$
10,369

 
$
14,899

Earnings allocated to participating securities
(16
)
 
(28
)
Earnings allocated to common shareholders
$
10,353

 
$
14,871

 
 
 
 
Basic weighted-average common shares outstanding
9,976,056

 
10,306,835

Dilutive effect of stock options
93,446

 
108,503

Dilutive effect of restricted stock grants
6,404

 
8,849

Diluted weighted-average common shares outstanding
10,075,906

 
10,424,187

 
 
 
 
Basic earnings per share
$
1.04

 
$
1.44

Diluted earnings per share
$
1.03

 
$
1.43


Potential dilutive shares are excluded from the computation of EPS if their effect is anti-dilutive. For the years ended December 31, 2019 and 2018 there were no anti-dilutive shares outstanding related to options to acquire common stock.

Note 18 - Revenue Recognition

In accordance with Topic 606, revenues are recognized when goods or services are transferred to the customer in exchange for the consideration the Company expects to be entitled to receive. To determine the appropriate recognition of revenue for transactions within the scope of Topic 606, the Company performs the following five steps: (i) identify the contract(s) with the customer; (ii) identify the separate performance obligations in the contract; (iii) determine the transaction price; (iv) allocate the transaction price to the separate performance obligations in the contract; and (v) recognize revenue when the entity satisfies a performance obligation. A contract may not exist if there are doubts as to collectability of the amounts the Company is entitled to in exchange for the goods or services transferred. If a contract is determined to be within the scope of Topic 606, the Company recognizes revenue as it satisfies a performance obligation. The largest portion of the Company’s revenue is from net interest income which is not within the scope of Topic 606.

Disaggregation of Revenue

The following table includes the Company’s noninterest income disaggregated by type of service for the years ended December 31, 2019 and 2018:
 
Year Ended December 31,
 
2019
 
2018
 
(In thousands)
Gain (loss) on sales of investment securities (1)
$
151

 
$
(20
)
BOLI income (1)
994

 
814

Wealth management revenue
879

 
611

Deposit servicing fees
284

 
265

Debit card and ATM fees
449

 
416

Loan servicing fees
681

 
425

Loan interest swap servicing fees
663

 
343

Other
40

 
24

Total noninterest income
$
4,141

 
$
2,878

____________
(1) Not in scope of Topic 606

119
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


For the year ended December 31, 2019, substantially all of the Company’s revenues under the scope of Topic 606 are for performance obligations satisfied at a specified date.

Revenues recognized within scope of Topic 606

Wealth management revenue: Our wealth management revenue consists of commissions received on the investment portfolio managed by Bank personnel but held by a third party. Commissions are earned on brokerage services and advisory services based on contract terms at the onset of a new customer’s investment agreement or quarterly for ongoing services. Commissions are paid by the third party to the Bank when the performance obligation has been completed by both entities.

Deposit related fees: Fees are earned on our deposit accounts for various products or services performed for our customers. Fees include business account fees, non-sufficient fund fees, stop payment fees, wire services, safe deposit box, and others. These fees are recognized on a daily, monthly or annual basis, depending on the type of service.

Debit card and ATM fees: Fees are earned when a debit card issued by the Bank is used or when other bank’s customers use our ATM services. Revenue is recognized at the time the fees are collected from the customer’s account or remitted by the VISA interchange network.

Loan related fees: Noninterest fee income is earned on our loans for servicing or annual fees on certain loan types. Fees are also earned on the prepayment of certain loans, and are recognized at the time the loan is paid off.

Loan interest swap fees: For loans participating in an interest rate swap agreement, servicing fees are earned at the onset of the agreement and are not contingent on any future performance or term length of the loan itself. The performance obligation is satisfied by entering into the contract and receipt of the fees from the counterparty.

Other: Fees earned on other services, such as merchant services or occasional non-recurring type services, are recognized at the time of the event or the applicable billing cycle.

Contract Balances

At December 31, 2019, the Company had no contract liabilities where the Company had an obligation to transfer goods or services for which the Company had already received consideration. In addition, the Company had no material performance obligations as of this date.     

Note 19 - Subsequent Events
    
On January 6, 2020, the Company’s Board of Directors authorized the repurchase of up to five percent (5%) of the Company’s outstanding common stock, or approximately 513,000 shares beginning no earlier than January 27, 2020 and ending no later than July 27, 2020. The Company will purchase the shares from time to time in the open market or through privately negotiated depending on market conditions and other corporate considerations.
    
On January 10, 2020, the Company entered into new post-employment benefit agreements with certain key officers to provide supplemental retirement benefits. Under the terms of the agreement, total annuities of $2.4 million were purchased. These annuities will be reported as held-to-maturity investments on the Company’s balance sheet. In addition, a rider endorsement is attached to the annuity policy which provides continued benefit payments for the life of the annuitant. The annual cost of the rider will be offset against the annuity balance. Post-retirement benefits will be paid out of the annuity until the balance is exhausted. At that time, the rider endorsement continues payments for the life of the annuitant.

During the remaining service period of each officer covered by these agreements, a benefit liability will accrue and a compensation expense will be recognized. A deferred tax asset will also be recognized at 21% of the compensation expense. As post-retirement benefits are paid from the annuity, the benefit liability will amortize until it is fully depleted when the policy rider is activated. The deferred compensation recognized in the deferred tax asset will be recognized as a tax benefit during the post-retirement payment period.

On February 14, 2020, the Company announced that its Board of Directors has declared a quarterly cash dividend of $0.10 per share on the Company’s outstanding common stock, an increase of $0.01 per share from its previous quarterly payout. The payout results in an annualized dividend yield of approximately 2.63% based on the stock price as of February 13, 2020. The cash dividend will be payable on March 27, 2020, to shareholders of record on March 13, 2020.

120
FIRST FINANCIAL NORTHWEST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



On March 2, 2020, the Bank entered into three $15.0 million cash flow hedges wherein the Bank will pay a fixed rate and receive a floating rate based on one month LIBOR (or an alternative substitute if LIBOR becomes unavailable in the future.) Specific terms are as follows:
Notional amount
 
Fixed rate
 
Term
$
15,000,000

 
0.911
%
 
6 years
15,000,000

 
0.937

 
7 years
15,000,000

 
0.984

 
8 years
    
On March 10, 2020, the Bank entered into two forward starting cash flow hedges, totaling $25.0 million, that provide for the Bank to pay a fixed rate and received a floating rate based on one-month LIBOR (or alternative substitute if LIBOR becomes unavailable in the future.) These cash flow hedges have a start date of October 25, 2021 and will partially replace the $50.0 million notional cash flow hedge that matures on on that date, wherein we pay 1.34% and receive three-month LIBOR. Specific terms are as follows:
Notional amount
 
Fixed rate
 
Term
$
15,000,000

 
0.793
%
 
7 years
10,000,000

 
0.800

 
8 years

Management entered into the above agreements as part of its ongoing efforts to manage interest rate risk and lower the Bank’s cost of funds. However, no assurances can be made that these transactions will ultimately assist in these efforts.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

None.

Item 9A. Controls and Procedures

(i) Disclosure Controls and Procedures.

An evaluation of our disclosure controls and procedures (as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) was carried out as of December 31, 2019 under the supervision and with the participation of our Chief Executive Officer (“CEO”), Chief Financial Officer (“CFO”), and several other members of our senior management. The CEO (Principal Executive Officer) and CFO (Principal Financial Officer) concluded that, as of December 31, 2019, First Financial Northwest’s disclosure controls and procedures were effective in ensuring that information we are required to disclose in the reports we file or submit under the Exchange Act is (1) recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and (2) accumulated and communicated to First Financial Northwest management, including its CEO and CFO, as appropriate to allow timely decisions regarding required disclosure, specified in the SEC’s rules and forms.

(a) Management’s report on internal control over financial reporting.

First Financial Northwest’s management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) of the Securities Exchange Act of 1934. First Financial Northwest’s internal control system is designed to provide reasonable assurance to our management and the Board of Directors regarding the preparation and fair presentation of published financial statements for external purposes in accordance with generally accepted accounting principles.

This process includes policies and procedures that: (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions of First Financial Northwest; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of First Financial Northwest are being made only in accordance with authorizations of management and directors of First Financial Northwest; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of First Financial Northwest’s assets that could have a material effect on the financial statements. A control procedure, no matter how well conceived and operated, can provide only reasonable, not

121

absolute, assurance that the objectives of the control system are met. Also, because of the inherent limitations in all control procedures, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. Additionally, in designing disclosure controls and procedures, our management was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. As a result of these inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Furthermore, projections of any evaluation of effectiveness to future periods are subject to risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate.

First Financial Northwest’s management assessed the effectiveness of First Financial Northwest’s internal control over financial reporting as of December 31, 2019. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control-Integrated Framework (2013 Framework). Based on that assessment, First Financial Northwest’s management believes that, as of December 31, 2019, First Financial Northwest’s internal control over financial reporting is effective based on those criteria.

Moss Adams LLP, an independent registered public accounting firm, has audited the Company’s consolidated financial statements and the effectiveness of our internal control over financial reporting as of December 31, 2019, which is included in Item 8. Financial Statements and Supplementary Data.

(b) Attestation report of the registered public accounting firm.

The “Report of Independent Registered Public Accounting Firm” included in Item 8 of this Annual Report on Form 10‑K is incorporated herein by reference.

(c) Changes in internal control over financial reporting.

There were no significant changes in First Financial Northwest’s internal control over financial reporting during First Financial Northwest’s most recent fiscal quarter that have materially affected or are reasonably likely to materially affect, First Financial Northwest’s internal control over financial reporting.

Item 9B. Other Information

There was no information to be disclosed by us in a report on Form 8-K during the fourth quarter of fiscal 2019 that was not so disclosed.

PART III

Item 10. Directors, Executive Officers and Corporate Governance

The information required under the section captioned “Proposal 1 - Election of Directors” in First Financial Northwest’s Definitive Proxy Statement for the 2019 Annual Meeting of Shareholders (“Proxy Statement”) is incorporated herein by reference.

For information regarding the executive officers of First Financial Northwest and the Bank, see the information contained herein under the section captioned “Item 1. Business - Personnel - Executive Officers of the Registrant.”

Audit Committee Financial Expert

At December 31, 2019 our Audit Committee was composed of Directors Joann E. Lee (Chairman), Richard M. Riccobono and Ralph C. Sabin. Each member of the Audit Committee is “independent” as defined in listing standards of The Nasdaq Stock Market LLC. Our Board of Directors has designated Directors Joann E. Lee, Richard M. Riccobono and Ralph C. Sabin as the Audit Committee financial experts, as defined in the SEC’s Regulation S-K. Directors Joann E. Lee, Richard M. Riccobono and Ralph C. Sabin are independent as that term is used in Item 407(d)(5)(i)(B) of SEC’s Regulation S-K.
 

122

Code of Business Conduct and Ethics

A copy of the Code of Business Conduct and Ethics is available on our website at www.ffnwb.com under Investor Relations – Corporate Overview – Governance Documents. Additionally, any material amendments to, or waiver from a provision of the Code of Business Conduct and Ethics will be posted to the same website.

Item 11. Executive Compensation

The information required by this item under the sections captioned “Executive Compensation” and “Directors’ Compensation” in the Proxy Statement are incorporated herein by reference.

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
 
(a)
Security Ownership of Certain Beneficial Owners and Management.

The information required by this item under the section captioned “Security Ownership of Certain Beneficial Owners and Management” in the Proxy Statement is incorporated herein by reference.

(b)     Security Ownership of Management.

The information required by this item under the section captioned “Security Ownership of Certain Beneficial Owners and Management” in the Proxy Statement is incorporated herein by reference.
    
(c)    Change In Control
    
First Financial Northwest is not aware of any arrangements, including any pledge by any person of securities of First Financial Northwest, the operation of which may at a subsequent date result in a change in control of First Financial Northwest.

(d)    Equity Compensation Plan Information

The following table summarizes share and exercise price information about First Financial Northwest’s equity compensation plans as of December 31, 2019.

Plan category
 
Number of securities to be issued upon exercise of outstanding options, warrants, and rights
 
Weighted-average exercise price of outstanding options, warrants, and rights
 
Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a))
 
 
(a)
 
(b)
 
(c)
Equity compensation plans (stock options) approved by security holders:
 
 
 
 
 
 
2008 Equity Incentive Plan
 
313,000

 
$
10.34

 
—

2016 Equity Incentive Plan (1)
 
—

 
—

 
1,240,114

Equity compensation plans not approved by security holders
 
N/A

 
N/A

 
N/A

Total
 
313,000

 
$
10.34

 
1,240.114

___________________
(1) The shares available for grant under the 2016 Equity Incentive Plan include 320,057 shares of restricted stock. Each share granted as restricted stock reduces the total available shares for grant by two shares.


Item 13. Certain Relationships and Related Transactions and Director Independence

The information required by this item under the sections captioned “Meetings and Committees of the Board of Directors and Corporate Governance Matters - Corporate Governance - Transactions with Related Persons,” and “Meetings and Committees

123

of the Board of Directors and Corporate Governance Matters - Corporate Governance - Director Independence” in the Proxy Statement are incorporated herein by reference.    


Item 14. Principal Accounting Fees and Services

The information required by this item under the section captioned "Proposal 4- Ratification of the appointment of Moss Adams as our independent auditor for 2020” in the Proxy Statement is incorporated herein by reference.

PART IV
Item 15. Exhibits and Financial Statement Schedules
(a)       Exhibits
3.1
3.2
4.1
4.2
+10.1
+10.2
+10.3
+10.4
+10.5
+10.6
+10.7
+10.8
+10.9
+10.10
+10.11
+10.12
+10.13
+10.14
+10.15
+10.16
+10.17
14
21
23
31.1
31.2
32.1
32.2
101
The following materials from First Financial Northwest’s Annual Report on Form 10-K for the year ended December 31, 2019, formatted in Extensible Business Reporting Language (XBRL): (1) Consolidated Balance Sheets; (2) Consolidated Income Statements; (3) Consolidated Statements of Comprehensive Income; (4) Consolidated Statements of Stockholders’ Equity; (5) Consolidated Statements of Cash Flows; and (6) Notes to Consolidated Financial Statements.
______________
(1)    Filed as an exhibit to First Financial Northwest’s Registration Statement on Form S-1 on June, 6, 2007 (333-143539)
(2)    Filed as an exhibit to First Financial Northwest’s Current Report on Form 8-K dated December 3, 2019.

124

(3)    Filed as an exhibit to First Financial Northwest’s Current Report on Form 8-K dated December 5, 2013.
(4)    Filed as an exhibit to First Financial Northwest’s Current Report on Form 8-K dated September 9, 2014.
(5)    Filed as an exhibit to First Financial Northwest’s Current Report on Form 8-K dated January 15, 2020.
(6)    Filed as Appendix A to First Financial Northwest’s definitive proxy statement dated April 15, 2008.
(7)    Filed as an exhibit to First Financial Northwest’s Current Report on Form 8-K dated June 15, 2016.
(8)    Filed as an exhibit to First Financial Northwest’s Current Report on Form 8-K dated July 1, 2008.
(9)    Filed as an exhibit to First Financial Northwest’s Quarterly Report on Form 10-Q for March 31, 2018 filed on
May 8, 2018.
(10)    Filed as an exhibit to First Financial Northwest’s Registration Statement on Form S-8 on June 15, 2016 (333-212029).
(11) Filed as an exhibit to First Financial Northwest’s Quarterly Report on Form 10-Q for September 30, 2018 filed November 7, 2018.
(12)    Filed as an exhibit to First Financial Northwest’s Current Report on Form 8-K dated December 20, 2018.
(13)    Filed as an exhibit to First Financial Northwest’s Current Report on Form 8-K dated January 3, 2019.
(14)    Filed as an exhibit to First Financial Northwest’s Current Report on Form 8-K dated January 15, 2020.
(15)    Filed as an exhibit to First Financial Northwest’s Current Report on Form 8-K dated January 15, 2020.

“+” indicates management contract, compensatory plan, or arrangement.

Item 16. Form 10-K Summary.
None.


125

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) 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.
 
FIRST FINANCIAL NORTHWEST, INC. 
 
 
 
 
 
Date: March 12, 2020
By: 
/s/ Joseph W. Kiley III
 
 
Joseph W. Kiley III
 
 
President and Chief Executive Officer
 
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

Signature
 
Title
 
Date
 
 
 
 
 
/s/ Daniel L. Stevens
 
Chairman of the Board and Director
 
March 12, 2020
Daniel L. Stevens
 
 
 
 
 
 
 
 
 
/s/ Joseph W. Kiley III
 
President, Chief Executive Officer and Director
 
March 12, 2020
Joseph W. Kiley III
 
(Principal Executive Officer)
 
 
 
 
 
 
 
/s/ Richard P. Jacobson
 
Chief Financial Officer and Director
 
March 12, 2020
Richard P. Jacobson
 
(Principal Financial Officer)
 
 
 
 
 
 
 
/s/ Christine A. Huestis
 
First Vice President and Controller
 
March 12, 2020
Christine A. Huestis
 
(Principal Accounting Officer)
 
 
 
 
 
 
 
/s/ Joann E. Lee
 
Director
 
March 12, 2020
Joann E. Lee
 
 
 
 
 
 
 
 
 
/s/ Roger H. Molvar
 
Director
 
March 12, 2020
Roger H. Molvar
 
 
 
 
 
 
 
 
 
/s/ Richard M. Riccobono
 
Director
 
March 12, 2020
Richard M. Riccobono
 
 
 
 
 
 
 
 
 
/s/ Ralph C. Sabin
 
Director
 
March 12, 2020
Ralph C. Sabin
 
 
 
 

126