10-Q 1 q303f.txt BANNER CORPORATION FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q --------- (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2003. ------------------ OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM _________ to _________ : Commission File Number 0-26584 BANNER CORPORATION (Exact name of registrant as specified in its charter) ------------------------------------------------------ Washington 91-1691604 (State or other jurisdiction of incorporation (I.R.S. Employer or organization) Identification Number) 10 South First Avenue, Walla Walla, Washington 99362 (Address of principal executive offices and zip code) Registrant's telephone number, including area code: (509) 527-3636 -------------------------------------------------- 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 is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes [X] No [ ] ----- ----- APPLICABLE ONLY TO CORPORATE ISSUERS Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Title of class: As of October 31, 2003 --------------- ---------------------- Common Stock, $.01 par value per share 11,421,719 shares* * Includes 515,960 shares held by employee stock ownership plan (ESOP) that have not been released, committed to be released, or allocated to participant accounts. BANNER CORPORATION AND SUBSIDIARIES Table of Contents PART I - FINANCIAL INFORMATION Item 1 - Financial Statements. The Consolidated Financial Statements of Banner Corporation and Subsidiaries filed as a part of the report are as follows: Consolidated Statements of Financial Condition as of September 30, 2003 and December 31, 2002 . . . . . . . . . . . . . . 2 Consolidated Statements of Income for the Quarters and Nine Months Ended September 30, 2003 and 2002 . . . . 3 Consolidated Statements of Comprehensive Income for the Quarters and Nine Months Ended September 30, 2003 and 2002 . . . . 4 Consolidated Statements of Changes in Stockholders' Equity for the Nine Months Ended September 30, 2003 and 2002. . . . . . . . . . . 5 Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2003 and 2002. . . . . . . . . . . 7 Selected Notes to Consolidated Financial Statements. . . . . . . . . . . . 9 Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operation Special Note Regarding Forward-Looking Statements. . . . . . . . . . . . . 13 General. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 Recent Developments and Significant Events . . . . . . . . . . . . . . . . 13 Comparison of Financial Condition at September 30, 2003 and December 31, 2002 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 Comparison of Results of Operations for the Quarters and Nine Months Ended September 30, 2003 and 2002. . . . . . . . . . . . . . . . . . . . . . . . 14 Asset Quality. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Liquidity and Capital Resources. . . . . . . . . . . . . . . . . . . . . . 21 Capital Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 Item 3 - Quantitative and Qualitative Disclosures About Market Risk Market Risk and Asset/Liability Management . . . . . . . . . . . . . . . . 23 Sensitivity Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Item 4 - Controls and Procedures . . . . . . . . . . . . . . . . . . . . . . 27 PART II - OTHER INFORMATION Item 1 - Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . 28 Item 2 - Changes in Securities and Use of Proceeds . . . . . . . . . . . . . 28 Item 3 - Defaults upon Senior Securities . . . . . . . . . . . . . . . . . . 28 Item 4 - Submission of Matters to a Vote of Stockholders . . . . . . . . . . 28 Item 5 - Other Information . . . . . . . . . . . . . . . . . . . . . . . . . 28 Item 6 - Exhibits and Reports on Form 8-K. . . . . . . . . . . . . . . . . . 28 SIGNATURES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 1 BANNER CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (in thousands, except shares) September 30, 2003 (Unaudited) and December 31, 2002 (Unaudited) September 30 December 31 ASSETS 2003 2002 ------- ------- Cash and due from banks $ 72,320 $ 132,910 Securities available for sale, cost $588,123 and $415,855 Encumbered 37,994 32,955 Unencumbered 554,836 388,267 --------- --------- 592,830 421,222 Securities held to maturity, fair value $13,719 and $13,414 Encumbered 216 -- Unencumbered 12,312 13,253 --------- --------- 12,528 13,253 Federal Home Loan Bank stock 34,262 32,831 Loans receivable: Held for sale, fair value $23,925 and $39,984 23,593 39,366 Held for portfolio 1,668,392 1,534,100 Allowance for loan losses (26,161) (26,539) --------- --------- 1,665,824 1,546,927 Accrued interest receivable 13,944 13,689 Real estate owned, held for sale, net 6,849 6,062 Property and equipment, net 22,074 20,745 Goodwill and other intangibles, net 36,563 36,714 Deferred income tax asset, net 1,391 2,786 Bank-owned life insurance 33,218 31,809 Other assets 10,563 4,224 --------- --------- $ 2,502,366 $ 2,263,172 LIABILITIES ========= ========= Deposits: Non-interest-bearing $ 203,596 $ 200,500 Interest-bearing 1,502,124 1,297,278 --------- --------- 1,705,720 1,497,778 Advances from Federal Home Loan Bank 461,552 465,743 Trust preferred securities 55,000 40,000 Other borrowings 58,764 41,202 Accrued expenses and other liabilities 19,139 24,700 Deferred compensation 4,006 3,372 Income taxes payable -- -- --------- --------- 2,304,181 2,072,795 COMMITMENTS AND CONTINGENCIES -- -- STOCKHOLDERS' EQUITY Preferred stock - $0.01 par value per share, 500,000 shares authorized, no shares issued -- -- Common stock - $0.01 par value per share, 27,500,000 shares authorized, 13,201,418 shares issued: 11,415,636 shares and 11,306,977 shares outstanding at September 30, 2003 and December 31, 2002, respectively. 121,383 120,554 Retained earnings 77,411 70,813 Accumulated other comprehensive income: Unrealized gain on securities available for sale 4,166 3,488 Unearned shares of common stock issued to Employee Stock Ownership Plan (ESOP) trust: 515,960 and 515,707 restricted shares outstanding at September 30, 2003 and December 31, 2002, respectively, at cost (4,264) (4,262) Carrying value of shares held in trust for stock related compensation plans (3,602) (3,190) Liability for common stock issued to deferred, stock related, compensation plans 3,091 2,974 --------- --------- 198,185 190,377 --------- --------- $ 2,502,366 $ 2,263,172 ========= ========= See notes to consolidated financial statements 2 BANNER CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Unaudited) (in thousands except for per share amounts) Quarters Ended Nine Months Ended September 30 September 30 -------------- ----------------- 2003 2002 2003 2002 ------ ------ ------ ------ INTEREST INCOME: Loans receivable $ 29,260 $ 30,907 $ 87,500 $ 92,860 Mortgage-backed securities 2,227 2,770 8,462 8,212 Securities and cash equivalents 3,035 2,672 8,690 7,571 ------ ------ ------ ------ 34,522 36,349 104,652 108,643 INTEREST EXPENSE: Deposits 8,889 9,733 26,611 29,751 Federal Home Loan Bank advances 5,339 5,791 16,786 18,490 Trust preferred securities 446 380 1,559 718 Other borrowings 188 366 563 1,258 ------ ------ ------ ------ 14,862 16,270 45,519 50,217 ------ ------ ------ ------ Net interest income before provision for loan losses 19,660 20,079 59,133 58,426 PROVISION FOR LOAN LOSSES 1,400 4,000 5,900 11,000 ------ ------ ------ ------ Net interest income 18,260 16,079 53,233 47,426 OTHER OPERATING INCOME: Loan servicing fees 241 239 688 996 Other fees and service charges 1,895 1,525 5,392 4,331 Mortgage banking revenues 2,924 1,602 8,230 4,021 Gain (loss) on sale of securities 15 10 18 27 Miscellaneous 464 555 1,412 1,323 ------ ------ ------ ------ Total other operating income 5,539 3,931 15,740 10,698 OTHER OPERATING EXPENSES: Salary and employee benefits 12,495 9,973 35,295 27,757 Less capitalized loan origination costs (2,028) (1,438) (5,578) (4,043) Occupancy and equipment 2,447 2,141 7,168 6,263 Information/computer data services 930 925 2,636 2,262 Miscellaneous 4,024 3,699 12,679 10,227 ------ ------ ------ ------ Total other operating expenses 17,868 15,300 52,200 42,466 ------ ------ ------ ------ Income before provision for income taxes 5,931 4,710 16,773 15,658 PROVISION FOR INCOME TAXES 1,778 1,329 5,070 4,841 ------ ------ ------ ------ NET INCOME $ 4,153 $ 3,381 $ 11,703 $ 10,817 Net income per common share (see ====== ====== ====== ====== (see Note 5): Basic $ .38 $ .31 $ 1.08 $ .98 Diluted $ .37 $ .30 $ 1.05 $ .95 Cumulative dividends declared per common share: $ .15 $ .15 $ .45 $ .45 See notes to consolidated financial statements 3 BANNER CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited) (in thousands) Quarters Ended Nine Months Ended September 30 September 30 -------------- ----------------- 2003 2002 2003 2002 ------ ------ ------ ------ NET INCOME: $ 4,153 $ 3,381 $ 11,703 $ 10,817 OTHER COMPREHENSIVE INCOME (LOSS), NET OF INCOME TAXES: Unrealized holding gain (loss) during the period, net of deferred income tax (benefit) of $449, $576, $371 and $727 respectively. 836 1,067 690 1,348 Less adjustment for (gains)/losses included in net income, net of income tax (benefit) of $5, $4, $6 and $10; respectively (10) (6) (12) (17) ------ ------ ------ ------ Other comprehensive income (loss) 826 1,061 678 1,331 ------ ------ ------ ------ COMPREHENSIVE INCOME $ 4,979 $ 4,442 $ 12,381 $ 12,148 ====== ====== ====== ====== See notes to consolidated financial statements 4 BANNER CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (Unaudited) (In thousands, except per share amounts) For the Nine Months Ended September 30, 2003 and 2002 Carrying Value Of Shares Held in Trust for Common Stock Accumulated Unearned Stock-Related And Additional Other Restricted Compensation Total Paid-in Retained Comprehensive ESOP Plans Stockholders' Capital Earnings Income Shares Net of Liability Equity --------- -------- ------------- -------- ---------------- ------------ BALANCE, January 1, 2002 $126,844 $ 68,104 $ 2,264 $ (4,769) $ (103) $ 192,340 Net income 10,817 10,817 Change in valuation of securities available for sale, net of income taxes 1,331 1,331 Cash dividend on common stock ($ .45/share cumulative) (5,188) (5,188) Purchase and retirement of common stock (7,285) (7,285) Proceeds from issuance of common stock for exercise of stock options 1,138 1,138 Recognition of tax benefit related to release or MRP shares 4 4 Release of treasury stock from MRP grant 135 (135) -- Amortization of compensation related to MRP 27 27 --------- -------- ------------- -------- ---------------- ------------ BALANCE, September 30, 2002 $ 120,836 $ 73,733 $ 3,595 $ (4,769) $ (211) $ 193,184 ========= ======== ============= ======== ================ ============ BALANCE, January 1, 2003 $ 120,554 $ 70,813 $ 3,488 $ (4,262) $ (216) $ 190,377 Net income 11,703 11,703 Change in valuation of securities available for sale, net of income taxes 678 678 Cash dividend on common stock ($ .45/share cumulative) (5,105) (5,105) Proceeds from reissued common stock for exercise of stock options 437 437 Adjust prior year release of earned ESOP shares (3) (2) (5) Release of stock for MRP grant 443 (443) -- Amortization of compensation related to MRP 100 100 Forfeiture or net change in the number and/or carrying value of shares held in trust for compensation plans (48) 48 -- --------- -------- ------------- -------- ---------------- ------------ BALANCE, September 30, 2003 $ 121,383 $ 77,411 $ 4,166 $ (4,264) $ (511) $ 198,185 ========= ======== ============= ======== ================ ============ See selected notes to consolidated financial statements 5
BANNER CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (Unaudited) (continued) ( in thousands) For the Nine Months Ended September 30, 2003 and 2002 2003 2002 COMMON STOCK, SHARES ISSUED: ------ ------ Number of shares, beginning of period 13,201 13,201 ------ ------ Number of shares, end of period 13,201 13,201 ------ ------ LESS COMMON stock RETIRED: Number of shares, beginning of period (1,894) (1,567) Purchase and retirement of common stock (9) (364) Issuance of common stock to deferred compensation plan and/or exercised stock options 117 89 ------ ------ Number of shares retired, end of period (1,786) (1,842) ------ ------ Shares issued and outstanding, end of period 11,415 11,359 ====== ====== UNEARNED, RESTRICTED ESOP SHARES: Number of shares, beginning of period (516) (577) Release of earned shares -- -- ------ ------ Number of shares, end of period (516) (577) ====== ====== See notes to consolidated financial statements 6 BANNER CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (in thousands) For the Nine Months Ended September 30, 2003 and 2002 2003 2002 OPERATING ACTIVITIES ------ ------ Net income $ 11,703 $ 10,817 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 5,304 2,802 Loss (gain) on sale of securities (18) (27) Increase in cash surrender value of bank owned life insurance (1,409) (1,052) Gain on sale of loans, excluding capitalized servicing rights (6,872) (3,405) Loss (gain) on disposal of real estate held for sale and property and equipment (170) 454 Provision for losses on loans and real estate held for sale 6,405 11,000 Federal Home Loan Bank stock dividend (1,431) (1,408) Net change in: Loans held for sale 15,773 14,191 Other assets (5,163) 3,641 Other liabilities (4,759) (2,810) ------- ------- Net cash provided (used) by operating activities 19,363 34,203 ------- ------- INVESTING ACTIVITIES: Purchases of securities (600,642) (208,012) Principal repayments and maturities of securities 382,747 135,017 Proceeds from sales of securities 44,298 4,670 Origination of loans, net of principal repayments (596,528) (213,239) Purchases of loans and participating interest in loans (29,030) (22,650) Proceeds from sales of loans and participating interest in loans 486,013 245,311 Purchases of property and equipment-net (3,844) (3,002) Proceeds from sale of real estate held for sale-net 5,422 1,679 Investment in bank-owned life insurance -- (10,000) Cash (used for) provided by acquisitions -- (6,519) Other (46) (134) ------- ------- Net cash used by investing activities (311,610) (76,879) ------- ------- FINANCING ACTIVITIES Increase in deposits 207,942 156,372 Proceeds from FHLB advances 567,850 255,231 Repayment of FHLB advances (572,041) (312,970) Proceeds from issuance of trust preferred securities 15,000 25,000 Increase (decrease) in repurchase agreement borrowings 5,058 (13,958) Increase (decrease) in other borrowings 12,504 1,556 Cash dividends paid (5,088) (5,118) Repurchases of stock, net of forfeitures -- (7,285) ESOP shares earned (5) -- Exercise of Stock Options 437 1,138 ------- ------- Net cash provided by financing activities 231,657 99,966 ------- ------- NET INCREASE (DECREASE) IN CASH AND DUE FROM BANKS (60,590) 57,290 CASH AND DUE FROM BANKS, BEGINNING OF PERIOD 132,910 67,728 ------- ------- CASH AND DUE FROM BANKS, END OF PERIOD $ 72,320 $125,018 ======= ======= (Continued on next page) 7 BANNER CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (in thousands) For the Nine Months Ended September 30, 2003 and 2002 (Continued from prior page) 2003 2002 ------ ------ SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Interest paid in cash $ 45,781 $ 50,110 Taxes paid in cash $ 5,000 $ 4,900 Non-cash transactions: Loans, net of discounts, specific loss allowances and unearned income, transferred to real estate owned and other repossessed assets $ 6,859 $ 4,470 Net change in accrued dividends payable $ 17 $ 70 Stock issued to Rabbi Trust/MRP $ 395 $ 135 Recognize tax benefit of vested MRP shares $ -- $ 4 Fair value of derivatives issued on loan rate lock commitments and offsetting commitments to sell $ 193 $ 600 Other assets/liabilities $ 68 $ 64 The following summarizes the non-cash activities relating to acquisitions: Fair value of assets and intangibles acquired $ -- $(44,544) Fair value of liabilities assumed -- 34,453 Fair value of stock issued and options assumed to acquisitions' shareholders -- -- ------- ------- Cash paid out in acquisition (10,091) Less cash acquired -- 3,572 ------- ------- Net cash acquired (used) $ -- $ (6,519) ======= ======= See notes to consolidated financial statements 8 BANNER CORPORATION AND SUBSIDIARIES SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1: Basis of Presentation and Critical Accounting Policies Banner Corporation (BANR or the Company) is a bank holding company incorporated in the State of Washington. The Company is primarily engaged in the business of planning, directing and coordinating the business activities of its wholly-owned subsidiary, Banner Bank (BB or the Bank). The Bank is a Washington-chartered commercial bank that conducts business from its main office in Walla Walla, Washington, and its 42 branch offices and nine loan production offices located in Washington, Oregon and Idaho. The Company is subject to regulation by the Federal Reserve Board (FRB). The Bank is subject to regulation by the State of Washington Department of Financial Institutions Division of Banks and the Federal Deposit Insurance Corporation (FDIC). In the opinion of management, the accompanying consolidated statements of financial condition and related interim consolidated statements of income, comprehensive income, changes in stockholders' equity and cash flows reflect all adjustments (which include reclassifications and normal recurring adjustments) that are necessary for a fair presentation in conformity with generally accepted accounting principles (GAAP). The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect amounts reported in the financial statements. Actual results could differ from these estimates and may have a material impact on the financial statements. Various elements of the Company's accounting policies, by their nature, are inherently subject to estimation techniques, valuation assumptions and other subjective assessments. In particular, management has identified several accounting policies that, due to the judgments, estimates and assumptions inherent in those policies, are critical to an understanding of the financial statements. These policies relate to the methodology for the determination of the provision and allowance for loan and lease losses, the valuation of goodwill, estimation of deferred taxes, valuation and amortization of deferred loan fees and mortgage servicing rights, and valuation of real estate held for sale. These policies and the judgments, estimates and assumptions are described in greater detail in Management's Discussion and Analysis of Financial Condition and Results of Operations and in Note 1 of the Notes to the Consolidated Financial Statements in the Company's Annual Report on Form 10-K for the year ended December 31, 2002 filed with the Securities and Exchange Commission. Management believes that the judgments, estimates and assumptions used in the preparation of the Company's financial statements are appropriate given the factual circumstances at the time. However, given the sensitivity of the financial statements to these critical accounting policies, the use of other judgments, estimates and assumptions could result in material differences in the Company's results of operations or financial condition. Stock Compensation Plans: The Company measures its employee stock-based compensation arrangements under the provisions outlined in Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees. Accordingly, no compensation cost has been recognized for its stock option plans. If the compensation cost for the Company's compensation plans had been determined consistent with Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, the Company's net income available to common stockholders on a diluted basis and diluted earnings per common share would have been reduced to the pro forma amounts indicated below (in thousands except per share amounts): Quarters Ended Nine Months Ended September 30 September 30 -------------- ----------------- 2003 2002 2003 2002 ---- ---- ---- ---- Net income available to common stockholders: Basic: As reported $ 4,153 $ 3,381 $11,703 $10,817 Pro forma 3,873 3,063 10,875 10,235 Diluted: As reported $ 4,153 $ 3,381 $11,703 $10,817 Pro forma 3,873 3,063 10,875 10,235 Net income per common share: Basic: As reported $ 0.38 $ 0.31 $ 1.08 $ 0.98 Pro forma 0.36 0.28 1.01 0.93 Diluted: As reported $ 0.37 $ 0.30 $ 1.05 $ 0.95 Pro forma 0.34 0.27 0.98 0.89 The compensation expense included in the pro forma net income available to common stockholders on a diluted basis and diluted earnings per common share is not likely to be representative of the effect on reported net income for future years because options vest over several years and additional awards generally are made each year. 9 The fair value of options granted under the Company's stock option plans (SOPs) is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for grants: 2003 2002 ------------- ------------- Annual dividend yield 2.79 to 3.76% 2.58 to 3.56% Expected volatility 29.5 to 49.6% 40.2 to 64.8% Risk free interest rate 2.94 to 4.44% 2.63 to 5.21% Expected lives 5 to 9 yrs 5 to 9 yrs Certain reclassifications have been made to the 2002 financial statements and/or schedules to conform to the 2003 presentation. These reclassifications may have affected certain ratios for the prior periods. The effect of such reclassifications is considered immaterial. All significant intercompany transactions and balances have been eliminated. The information included in this Form 10-Q should be read in conjunction with Banner Corporation's 2002 Annual Report on Form 10-K for the year ended December 31, 2002 filed with the Securities and Exchange Commission. Interim results are not necessarily indicative of results for a full year. Note 2: Recent Developments and Significant Events Sale of $55 Million of Trust Preferred Securities: During fiscal 2002, the Company completed the issuance of $40 million of trust preferred securities (TPS) in private placements of $25 million in April 2002 and $15 million in December 2002. On September 25, 2003, the Company completed the issuance of an additional $15 million of TPS, also in a private placement. The TPS were issued by special purpose business trusts owned by the Company and sold to pooled investment vehicles sponsored and marketed by investment banking firms. The TPS have been recorded as a liability on the statement of financial condition but, under current Federal Reserve guidelines, qualify as Tier 1 capital for regulatory capital purposes. A portion of the proceeds from these offerings was used to augment the Bank's capital with the remainder expected to be used primarily to fund growth, including acquisitions. Remaining proceeds may also be used to fund the Company's stock repurchase program and for other general corporate purposes as necessary. Under the terms of the transactions, the TPS have a maturity of 30 years and are redeemable after five years with certain exceptions. The holders of the TPS are entitled to receive cumulative cash distributions at a variable annual rate. The initial issue, of $25 million, has a current interest rate of 4.92% (4.99% at the most recent quarter end), which is reset semi-annually to equal six-month LIBOR plus 3.70%. The second issue, of $15 million, has a current rate of 4.50% (4.64% at the most recent quarter end), which is reset quarterly to equal three-month LIBOR plus 3.35%. The third issue, of $15 million, has a current rate of 4.04% (4.04% at the most recent quarter end), which is reset quarterly to equal three-month LIBOR plus 2.90%. Accounting Standards Recently Adopted or Issued: On May 31, 2003, the Financial Accounting Standards Board (FASB) issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity. This statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of those instruments were previously classified as equity. Some of the provisions of this statement are consistent with the current definition of liabilities in FASB Concepts Statement No. 6, Elements of Financial Statements. The remaining provisions of this statement are consistent with FASB's proposal to revise the definition to encompass certain obligations that a reporting entity can or must settle by issuing its own equity shares, depending on the nature of the relationship established between the holder and the issuer. This statement was effective for financial instruments entered into or modified after May 31, 2003, and otherwise was effective at the beginning of the first interim period beginning after June 15, 2003, except for mandatorily redeemable financial instruments of nonpublic entities. The adoption of SFAS No. 150 has not had a material impact on the Company's financial statements. On April 30, 2003, FASB issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. SFAS No. 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133. The new guidance amends SFAS No. 133 for decisions made as part of the Derivatives Implementation Group "DIG" process that effectively required amendments to SFAS No. 133, and decisions made in connection with other FASB projects dealing with financial instruments and in connection with implementation issues raised in relation to the application of the definition of a derivative and characteristics of a derivative that contains financing components. In addition, it clarifies when a derivative contains a financing component that warrants special reporting in the statement of cash flows. SFAS No. 149 was effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. The Bank's adoption of SFAS No. 149 did not result in a material impact on the Company's financial statements. In June 2002, FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. This statement requires recording costs associated with exit or disposal activities at their fair values when a liability has been incurred. Under previous guidance, certain exit costs were accrued upon management's commitment to an exit plan, which is generally before an actual liability has been incurred. The Company adopted SFAS No. 146 as of January 1, 2003. The adoption of SFAS No. 146 has not had a material impact on the Company's consolidated results of operations, financial position or cash flows. 10 In January 2003, FASB issued Financial Accounting Standards Board Interpretation Number (FIN) 46, Consolidation of Certain Variable Interest Entities An Interpretation of ARB No. 51, to clarify when an entity should consolidate another entity known as a Variable Interest Entity (VIE), more commonly referred to as a special purpose entity or SPE. A VIE is an entity in which equity investors do not have characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties, and may include many types of SPEs. FIN 46 requires that an entity consolidate a VIE if that entity has a variable interest that will absorb a majority of the VIE's expected losses if they occur, receive a majority of the VIE's expected residual returns if they occur, or both. FIN 46 was effective for newly created VIEs beginning February 1, 2003. The effective date for existing VIEs was deferred by FASB until the fourth quarter of 2003. The Company is currently evaluating the impact of the interpretation on its financial statements and, except for the possible effect related to its trust preferred obligation, and possible related regulatory effects, does not currently believe the interpretation will have significant effects. In November 2002, FASB issued FIN 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, which requires the guarantor to recognize as a liability the fair value of the obligation at the inception of the guarantee. The disclosure requirements in FIN 45 were effective for financial statements of interim or annual periods ending after December 15, 2002. Management believes that the Company has no material guarantees that are required to be disclosed in the financial statements. The recognition provisions are to be applied on a prospective basis to guarantees issued after December 31, 2002. The adoption of the recognition provisions of FIN 45 did not have a material impact on the Company's financial statements. Note 3: Business Segments The Company is managed by legal entity and not by lines of business. The Bank is a community oriented commercial bank chartered in the State of Washington. The Bank's primary business is that of a traditional banking institution, gathering deposits and originating loans for portfolio in its primary market area. The Bank offers a wide variety of deposit products to its consumer and commercial customers. Lending activities include the origination of real estate, commercial/agriculture business and consumer loans. The Bank is also an active participant in the secondary market, originating residential loans for sale on both a servicing released and servicing retained basis. In addition to interest income on loans and investment securities, the Bank receives other income from deposit service charges, loan servicing fees and from the sale of loans and investments. The performance of the Bank is reviewed by the Company's executive management and Board of Directors on a monthly basis. All of the executive officers of the Company are members of the Bank's management team. Generally accepted accounting principles establish standards to report information about operating segments in annual financial statements and require reporting of selected information about operating segments in interim reports to stockholders. The Company has determined that its current business and operations consist of a single business segment. 11 Note 4: Additional Information Regarding Interest-Bearing Deposits and Securities Encumbered Securities: Securities labeled "Encumbered" are pledged securities that are subject to certain agreements which may allow the secured party to either sell and replace them with similar but not the exact same security or otherwise pledge the securities. In accordance with SFAS No. 140, the amounts have been separately identified in the Consolidated Statements of Financial Condition as "Encumbered." The following table sets forth additional detail on BANR's interest-bearing deposits and securities at the dates indicated (at carrying value) (in thousands): September 30 December 31 September 30 2003 2002 2002 Interest-bearing deposits included -------- -------- -------- in cash and due from banks $ 128 $ 42,921 $ 51,736 -------- -------- -------- Mortgage-backed securities 331,485 269,153 225,872 Other securities--taxable 240,968 141,404 138,257 Other securities--tax exempt 29,342 21,107 21,000 Equity securities with dividends 3,563 2,811 2,702 -------- -------- -------- Total securities 605,358 434,475 387,831 Federal Home Loan Bank (FHLB) stock 34,262 32,831 32,282 -------- -------- -------- $639,748 $510,227 $471,849 ======== ======== ======== The following table provides additional detail on income from deposits and securities for the periods indicated (in thousands): Quarters Ended Nine Months Ended September 30 September 30 -------------- ----------------- 2003 2002 2003 2002 ------ ------ ------ ------ Mortgage-backed securities interest $ 2,227 $ 2,770 $ 8,462 $ 8,212 ------ ------ ------ ------ Taxable interest and dividends 2,292 1,877 6,400 5,187 Tax-exempt interest 296 310 859 973 FHLB stock dividends 447 485 1,431 1,411 ------ ------ ------ ------ 3,035 2,672 8,690 7,571 ------ ------ ------ ------ $ 5,262 $5,442 $17,152 $15,783 ====== ====== ====== ====== Note 5: Calculation of Weighted Average Shares Outstanding for Earnings Per Share (EPS) The following table reconciles total shares originally issued to weighted shares outstanding used to calculate earnings per share data (in thousands): Quarters Ended Nine Months Ended September 30 September 30 -------------- ----------------- 2003 2002 2003 2002 ------ ------ ------ ------ Total shares originally issued 13,201 13,201 13,201 13,201 Less retired weighted average shares plus unvested weighted average shares allocated to MRP (1,842) (1,732) (1,873) (1,626) Less unallocated shares held by the ESOP (516) (577) (516) (577) ------ ------ ------ ------ Basic weighted average shares outstanding 10,843 10,892 10,812 10,998 Plus unvested MRP and stock option incremental shares considered outstanding for diluted EPS calculations 426 395 335 440 ------ ------ ------ ------ Diluted weighted average shares outstanding 11,269 11,287 11,147 11,438 ====== ====== ====== ====== 12 ITEM 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations Special Note Regarding Forward-Looking Statements Management's Discussion and Analysis (MD&A) and other portions of this report contain certain "forward-looking statements" concerning the future operations of the Company. Management desires to take advantage of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995 and is including this statement for the express purpose of availing the Company of the protections of such safe harbor with respect to all "forward-looking statements" contained in this report and our Annual Report. We have used "forward-looking statements" to describe future plans and strategies, including our expectations of the Company's future financial results. Management's ability to predict results or the effect of future plans or strategies is inherently uncertain. Factors which could cause actual results to differ materially include, but are not limited to, regional and general economic conditions, management's ability to generate continued improvement in asset quality and profitability, changes in interest rates, deposit flows, demand for mortgages and other loans, real estate values, competition, loan delinquency rates, changes in accounting principles, practices, policies or guidelines, changes in legislation or regulation, other economic, competitive, governmental, regulatory and technological factors affecting operations, pricing, products and services and the Company's ability to successfully resolve the outstanding credit issues. Accordingly, these factors should be considered in evaluating the "forward-looking statements," and undue reliance should not be placed on such statements. The Company undertakes no responsibility to update or revise any "forward-looking statements." General Banner Corporation, a Washington corporation, is primarily engaged in the business of planning, directing and coordinating the business activities of its wholly owned subsidiary, Banner Bank. The Bank is a Washington-chartered commercial bank the deposits of which are insured by the Federal Deposit Insurance Corporation (FDIC). The Bank is a regional bank which offers a wide variety of commercial banking services and financial products to both businesses and individuals in its primary market areas. The Bank conducts business from its main office in Walla Walla, Washington, and its 42 branch offices and nine loan production offices located in 20 counties in Washington, Oregon and Idaho. The operating results of the Company depend primarily on its net interest income, which is the difference between interest income on interest- earning assets, consisting of loans and investment securities, and interest expense on interest-bearing liabilities, composed primarily of customer deposits and FHLB advances. Net interest income is primarily a function of the Company's interest rate spread, which is the difference between the yield earned on interest-earning assets and the rate paid on interest-bearing liabilities, as well as a function of the average balance of interest-earning assets as compared to the average balance of interest-bearing liabilities. As more fully explained below, the Company's net interest income decreased for the quarter ended September 30, 2003, compared to the same period a year earlier, as a result of a decrease of 59 basis points in the interest rate spread and despite growth in interest-bearing assets and liabilities. By contrast, for the nine months ended September 30, 2003, the Company's net interest income increased, despite a decrease of 35 basis points in the interest rate spread, as a result of growth in interest-bearing assets and liabilities. The net interest margin also decreased 63 and 41 basis points, respectively, for the quarter and nine months ended September 30, 2003, compared to the same periods one year ago. The Company's net income also is affected by provisions for loan losses and the level of its other income, including deposit service charges, loan origination and servicing fees, and gains and losses on the sale of loans and securities, as well as its non-interest operating expenses and income tax provisions. The provision for loan losses decreased $2.6 million to $1.4 million for the quarter ended September 30, 2003, compared to $4.0 million for the quarter ended September 30, 2002. For the nine months ended September 30, 2003, the provision for loan losses was $5.9 million, compared to $11.0 million for the same period a year earlier. Other operating income increased significantly for the quarter and nine months ended September 30, 2003, largely as a result of increased mortgage banking activity and resulting gain on the sale of loans, although other non-interest revenues also increased significantly. Other operating expenses also increased for the quarter and nine months ended September 30, 2003, compared to the same periods ended September 30, 2002, reflecting the continued growth of the Company as detailed below in the Comparison of Financial Condition and Operating Results sections of this report. Management's discussion and analysis of results of operations is intended to assist in understanding the financial condition and results of operations of the Company. The information contained in this section should be read in conjunction with the Consolidated Financial Statements and accompanying Selected Notes to the Consolidated Financial Statements. Recent Developments and Significant Events See Note 2 to the Consolidated Financial Statements. Comparison of Financial Condition at September 30, 2003 and December 31, 2002 General: Total assets increased $239.2 million, or 10.6%, from $2.263 billion at December 31, 2002, to $2.502 billion at September 30, 2003. The growth largely resulted from an increase in securities, and growth in the loan portfolio, and was funded primarily by deposit growth. Net loans receivable (gross loans less loans in process, deferred fees and discounts, and allowance for loan losses) increased $118.9 million, or 7.7%, from $1.547 billion at December 31, 2002, to $1.666 billion at September 30, 2003. Despite decreases of $52.5 million in one- to four-family residential mortgages and $2.4 million in consumer loans as a result of accelerated prepayments in the current low interest rate environment, the balance of the loan portfolio experienced net growth, including an increase of $54.7 million in mortgages secured by commercial real estate loans, an increase of $4.1 million in multifamily real estate loans, an increase of $53.3 million in construction and land loans and an increase of $61.4 million in non-mortgage commercial and agricultural loans. These increased balances reflect the Company's continuing effort to increase the portion of its loans invested in commercial real estate, construction, land development, and commercial 13 business and agricultural loans. While these loans are inherently of higher risk than residential mortgages, management believes they can produce higher credit-adjusted returns to the Company and provide better opportunities to develop comprehensive banking relationships with borrowers than most residential mortgages. Securities available for sale and held to maturity increased $170.9 million, or 39.3%, from $434.5 million at December 31, 2002, to $605.4 million at September 30, 2003, as a result of additional investing. FHLB stock increased $1.4 million as a result of dividends paid by the FHLB in the form of additional shares of stock. The Company also had an increase of $1.4 million in bank-owned life insurance from the growth of cash surrender values on existing policies. Other assets increased $6.3 million, largely as a result of the Company recording a $5 million commitment to invest in limited partnerships focused on providing affordable housing for low and moderate income families. The majority of the increase in assets was funded by a growth in deposits. Asset growth was also funded by additional borrowings, the issuance of trust preferred securities and net income from operations. Deposits grew $207.9 million, or 13.9%, from $1.498 billion at December 31, 2002, to $1.706 billion at September 30, 2003. Non-interest-bearing deposits increased $3.1 million, or 1.5%, and interest-bearing deposits increased by $204.8 million, or 15.8%, from the prior year-end amounts. While FHLB advances decreased $4.2 million from $465.7 million at December 31, 2002, to $461.6 million at September 30, 2003, trust preferred securities increased $15.0 million to $55.0 million and other borrowings increased $17.6 million to $58.8 million at September 30, 2003. Comparison of Results of Operations for the Quarters and Nine Months Ended September 30, 2003 and 2002 General. For the quarter ended September 30, 2003, the Company had net income of $4.2 million, or $.37 per share (diluted), compared to net income of $3.4 million, or $.30 per share (diluted), for the quarter ended September 30, 2002, an increase of $772,000. The Company's operating results reflect the significant growth of assets and liabilities, which was generally offset by a narrower net interest margin. The Company's operating results also reflect significant increases in other operating income and other operating expenses. Compared to levels a year ago, total assets increased 12.2%, to $2.502 billion at September 30, 2003, net loans increased 5.9%, to $1.666 billion, deposits grew 14.8%, to $1.706 billion, and borrowings, including trust preferred securities, increased 7.7%, to $575.3 million. Average interest earning assets were $2.327 billion for the quarter ended September 30, 2003, an increase of $326.8 million, or 16.3%, compared to the same period a year earlier. Average equity was 7.87% of average assets for the quarter ended September 30, 2003, compared to 9.14% of average assets for the quarter ended September 30, 2002. Net Interest Income. Net interest income before provision for loan losses decreased to $19.7 million for the quarter ended September 30, 2003, compared to $20.1 million for the quarter ended September 30, 2002. Net interest margin decreased 63 basis points for the quarter, reflecting a 59 basis point decrease in net interest rate spread and an increased use of interest-bearing liabilities relative to interest-earning assets. Net interest income before provision for loan losses increased to $59.1 million for the nine months ended September 30, 2003, compared to $58.4 million for the same period ended September 30, 2002. For the nine-month period, the net interest margin decreased 41 basis points, reflecting a 35 basis point decrease in net interest rate spread and a similar increased use of interest-bearing liabilities relative to interest-earning assets. The changes in net interest spread and net interest margin reflect the impact of the current very low level of market interest rates as well the effects of changes in the asset and liability mix. Interest Income. Interest income for the quarter ended September 30, 2003 was $34.5 million, compared to $36.3 million for the quarter ended September 30, 2002, a decrease of $1.8 million, or 5.0%. The decrease in interest income occurred despite a $326.8 million, or 16.3%, growth in average balances of interest-earning assets as a result of a 132 basis point decrease in the average yield on those assets. The yield on average interest-earning assets decreased to 5.89% for the quarter ended September 30, 2003, compared to 7.21% for the same period a year earlier. Average loans receivable for the quarter ended September 30, 2003 increased by $125.9 million, or 8.0%, when compared to the quarter ended September 30, 2002. Nonetheless, interest income on loans for the quarter decreased by $1.6 million, or 5.3%, compared to the prior year, as the impact of the increase in average loan balances was more than offset by a 97 basis point decrease in the average yield. The decrease in average loan yield reflects the significant decline in the level of market interest rates compared to prior year levels, particularly the prime rate, which affects a large portion of construction, commercial and agricultural loans, and lower mortgage rates, which have led to a significant amount of prepayments of real estate loans. The loan mix continued to change as the portion of the portfolio invested in one- to four-family residential loans declined, while the portion invested in construction, land development and commercial loans increased. Loans yielded 6.83% for the quarter ended September 30, 2003, compared to 7.80% for the quarter ended September 30, 2002. While the level of market interest rates was significantly lower than a year earlier, loan yields were supported to a degree by certain loans with rate floors and by changes in the portfolio mix. The combined average balance of mortgage-backed securities, investment securities, daily interest-bearing deposits and FHLB stock increased by $200.8 million for the quarter ended September 30, 2003, while the interest and dividend income from those investments decreased $180,000 compared to the quarter ended September 30, 2002. The average yield on mortgage-backed securities decreased to 2.73% for the quarter ended September 30, 2003, from 5.31% for the comparable period in 2002, reflecting significantly accelerated amortization of purchase premiums on certain portions of the portfolio as a result of the rapid prepayments as well as the effect of lower market rates on the interest rates paid on the portion of those securities that have adjustable rates, prepayments on certain higher-yielding portions of the portfolio, and reinvestment and growth at current market rates. The average yield on investment securities and short-term cash investments decreased to 3.78% for the quarter ended September 30, 2003, from 4.60% for the comparable quarter in 2002, also reflecting the lower level of market rates. Earnings on FHLB stock decreased by $37,000, to $448,000, in the quarter ended September 30, 2003, from $485,000 in the comparable quarter in 2002, despite a $2.0 million increase in the average balance held, as a result of a 79 basis point decrease in the yield received. The dividend yield on FHLB stock was 5.26% for the quarter ended September 30, 2003, compared to 6.05% for the quarter ended September 30, 2002. Dividends on FHLB stock are established on a quarterly basis by vote of the Directors of the FHLB. Interest income for the nine months ended September 30, 2003 decreased by $4.0 million, or 3.7%, to $104.7 million from $108.6 million for the comparable period in 2002. Interest income from loans decreased $5.4 million, or 5.8%, from the comparable period in 2002. The decrease in loan interest income reflects the impact of a 67 basis point decrease in the yield on the loan balances and occurred despite a $49.7 million growth in the average balance of loans receivable. Interest income from mortgage-backed and investment securities and FHLB stock for the 14 nine months ended September 30, 2003 increased $1.4 million, from $15.8 million in 2002 to $17.2 million in the current period, reflecting a substantial $206.1 million increase in average balances, offset by a 149 basis point decrease in yield. Similar to the quarter just ended, yields for the nine months ended September 30, 2003 reflect the significant effect of the low level of market interest rates and rapid prepayments on loans and securities. Interest Expense. Interest expense for the quarter ended September 30, 2003 was $14.9 million, compared to $16.3 million for the comparable period in 2002, a decrease of $1.4 million, or 8.7%. The decrease in interest expense was the result of a decrease in the average cost of all interest-bearing liabilities to 2.59% from 3.32%, primarily reflecting the lower levels of market interest rates. Deposit interest expense decreased $844,000 for the quarter ended September 30, 2003, compared to the same quarter a year ago, despite the solid deposit growth throughout the Company over the past twelve months, as a result of a continuing decline in the cost of deposits. Average deposit balances increased $279.4 million, or 19.8%, to $1.691 billion for the quarter ended September 30, 2003, from $1.412 billion for the quarter ended September 30, 2002, while, at the same time, the average rate paid on deposit balances decreased 65 basis points. To a significant degree, deposit costs for a quarter reflect market interest rates and pricing decisions made three to twelve months prior to the end of that quarter. Despite some modest upward movement during the current quarter, market interest rates for deposits generally were declining and lower for the nine months preceding the quarter ended September 30, 2003, than for the same period preceding the quarter ended September 30, 2002. The reduction in deposit costs, which tends to lag declines in market rates, continued in the most recent quarter as a result of the cumulative effect of declining rates in preceding quarters as well as very low rates in the current quarter. Average FHLB advances totaled $495.0 million during the quarter ended September 30, 2003, compared to $444.6 million during the quarter ended September 30, 2002, an increase of $50.4 million that, combined with a 89 basis point decrease in the average cost of advances, resulted in a $452,000 decrease in related interest expense. The average rate paid on those advances decreased to 4.28% for the quarter ended September 30, 2003, from 5.17% for the quarter ended September 30, 2002. FHLB advances are generally fixed-rate, fixed-term borrowings with rates on many of those advances having been established in periods when market rates were considerably higher than are currently available. Funding was also provided in the third quarter of 2003 by trust preferred securities (TPS) which had an average balance of $40.2 million and an average cost of 4.41% (including amortization of prepaid underwriting costs) for the quarter ended September 30, 2003. TPS outstanding in the third quarter of the prior year had an average balance of $25.0 million and an average rate of 6.03%. Other borrowings consist of retail repurchase agreements with customers and reverse repurchase agreements with investment banking firms secured by certain investment securities. The average balance for other borrowings decreased $13.2 million, to $51.8 million for the quarter ended September 30, 2003, from $65.0 million for the same period in 2002, while the related interest expense decreased $178,000, to $188,000, from $366,000 for the respective periods. The average rate paid on other borrowings was 1.44% in the quarter ended September 30, 2003, compared to 2.24% for the same quarter in 2002. The Company's other borrowings generally have relatively short terms and therefore reprice to current market levels more quickly than FHLB advances, which generally lag current market rates. 15 A comparison of total interest expense for the nine months ended September 30, 2003, shows a decrease of $4.7 million, or 9.4%, from the comparable period in September 2002. The interest expense reflects an increase in average deposits of $221.1 million combined with a $50.6 million increase in FHLB advances, trust preferred securities and other borrowings. The effect on interest expense of the $271.1 million increase in average interest-bearing liabilities was offset by a 72 basis point decrease in the interest rate paid on those liabilities. The following tables provide additional comparative data on the Company's operating performance: Quarters Ended Nine Months Ended September 30 September 30 ---------------------- ----------------------- Average Balances 2003 2002 2003 2002 ---------------- ------ ------ ------ ------ (in thousands) Investment securities and deposits $ 271,189 $ 188,744 $ 244,046 $ 163,318 Mortgage-backed obligations 323,477 207,117 328,178 204,848 Loans 1,698,796 1,572,856 1,638,508 1,588,842 FHLB stock 33,819 31,806 33,350 31,351 --------- --------- --------- --------- Total average interest-earning assets 2,327,281 2,000,523 2,244,082 1,988,359 Non-interest-earning assets 170,972 157,773 162,623 144,041 --------- --------- --------- --------- Total average assets $2,498,253 $2,158,296 $2,406,705 $2,132,400 ========= ========= ========= ========= Deposits $1,691,159 $1,411,767 $1,599,482 $1,378,411 Advances from FHLB 494,959 444,585 507,384 456,831 Trust preferred securities 40,163 25,000 40,055 15,842 Other borrowings 51,772 64,956 46,853 71,640 Total average interest-bearing --------- --------- --------- --------- liabilities 2,278,053 1,946,308 2,193,774 1,922,724 Non-interest-bearing liabilities 23,470 14,687 17,840 12,719 --------- --------- --------- --------- Total average liabilities 2,301,523 1,960,995 2,211,614 1,935,433 Equity 196,730 197,301 195,091 196,957 --------- --------- --------- --------- Total average liabilities and equity $2,498,253 $2,158,296 $2,406,705 $2,132,400 ========= ========= ========= ========= Interest Rate Yield/Expense (rates are annualized) ------------------------------------------------- Interest Rate Yield: Investment securities and deposits 3.78% 4.60% 3.98% 5.04% Mortgage-backed obligations 2.73% 5.31% 3.45% 5.36% Loans 6.83% 7.80% 7.14% 7.81% FHLB stock 5.26% 6.05% 5.74% 6.02% Total interest rate yield on ------ ------ ------ ------ interest-earning assets 5.89% 7.21% 6.24% 7.31% ------ ------ ------ ------ Interest Rate Expense: Deposits 2.09% 2.74% 2.22% 2.89% Advances from FHLB 4.28% 5.17% 4.42% 5.41% Trust preferred securities 4.41% 6.03% 5.20% 6.06% Other borrowings 1.44% 2.24% 1.61% 2.35% Total interest rate expense on ------ ------ ------ ------ interest-bearing liabilities 2.59% 3.32% 2.77% 3.49% ------ ------ ------ ------ Interest spread 3.30% 3.89% 3.47% 3.82% ====== ====== ====== ====== Net interest margin on interest earning assets 3.35% 3.98% 3.52% 3.93% ------ ------ ------ ------ Additional Key Financial Ratios (ratios are annualized) ------------------------------- Return on average assets 0.66% 0.62% 0.65% 0.68% Return on average equity 8.38% 6.80% 8.02% 7.34% Average equity / average assets 7.87% 9.14% 8.11% 9.24% Average interest-earning assets / interest-bearing liabilities 102.16% 102.79% 102.29% 103.41% Non-interest(other operating) expenses/ average assets 2.84% 2.81% 2.90% 2.66% Efficiency ratio [non-interest (other operating) expenses / revenues] 70.91% 63.72% 69.72% 61.43% 16 Provision and Allowance for Loan Losses. During the quarter ended September 30, 2003, the provision for loan losses was $1.4 million, compared to $4.0 million for the quarter ended September 30, 2002, a decrease of $2.6 million. For the nine months ended September 30, 2003, the provision for loan losses was $5.9 million, compared to $11.0 million for the same period ended September 30, 2002. As noted in Note 1 to the Consolidated Financial Statements, the provision and allowance for loan losses is one of the most critical accounting estimates included in the Company's financial statements. The decrease in the provision for loan losses reflects the amount required to maintain the allowance for losses at an appropriate level based upon management's evaluation of the adequacy of general and specific loss reserves as more fully explained in the following paragraphs. Despite slightly higher levels of non-performing loans than a year earlier and continued concerns about the current economic environment, the provision in the current periods is lower largely as a result of the recognition of the deterioration of the portfolio through the very large provisions recorded in the fourth quarter of 2002, which significantly added to the allowance for loan losses, and clear improvement in the Company's credit quality ratios in recent periods. Non-performing loans increased to $24.4 million at September 30, 2003, compared to $22.7 million at September 30, 2002, but declined from $28.1 million and $36.1 million, respectively, at June 30, 2003 and December 31, 2002. Non-performing loans are primarily concentrated in the Puget Sound region where continued economic weakness has diminished certain borrowers' ability to meet loan obligations. Net charge-offs were $1.3 million for the current quarter, compared to $1.5 million for the same quarter a year earlier. Net charge-offs declined to $6.3 million for the first nine months of 2003, compared to $9.9 million for the nine months ended September 30, 2002. A comparison of the allowance for loan losses at September 30, 2003 and 2002, shows an increase of $7.0 million, to $26.2 million at September 30, 2003, from $19.2 million at September 30, 2002. The allowance for loan losses as a percentage of total loans (loans receivable excluding allowance for losses) was 1.55% and 1.20% at September 30, 2003 and September 30, 2002, respectively. In originating loans, the Company recognizes that losses will be experienced and that the risk of loss will vary with, among other things, the type of loan being made, the credit worthiness of the borrower over the term of the loan, general economic conditions and, in the case of a secured loan, the quality of the security for the loan. As a result, the Company maintains an allowance for loan losses consistent with the GAAP guidelines outlined in SFAS No. 5, Accounting for Contingencies. The Company has established systematic methodologies for the determination of the adequacy of its allowance for loan losses. The methodologies are set forth in a formal policy and take into consideration the need for an overall general valuation allowance as well as specific allowances that are tied to individual problem loans. The Company increases its allowance for loan losses by charging provisions for probable loan losses against the Company's income and values impaired loans consistent with the guidelines in SFAS No. 114, Accounting by Creditors for Impairment of a Loan, and SFAS No. 118, Accounting by Creditors for Impairment of a Loan Income Recognition and Disclosure. The allowance for losses on loans is maintained at a level sufficient to provide for estimated losses based on evaluating known and inherent risks in the loan portfolio and upon management's continuing analysis of the factors underlying the quality of the loan portfolio. These factors include changes in the size and composition of the loan portfolio, delinquency rates, actual loan loss experience, current and anticipated economic conditions, detailed analysis of individual loans for which full collectibility may not be assured, and determination of the existence and realizable value of the collateral and guarantees securing the loans. Realized losses related to specific assets are applied as a reduction of the carrying value of the assets and charged immediately against the allowance for loan loss reserve. Recoveries on previously charged off loans are credited to the allowance. The reserve is based upon factors and trends identified by management at the time financial statements are prepared. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the allowance for loan losses. These agencies may require changes to the allowance based upon judgments different from management. Although management uses the best information available, future adjustments to the allowance may be necessary due to economic, operating, regulatory and other conditions beyond the Company's control. The adequacy of general and specific reserves is based on management's continuing evaluation of the pertinent factors underlying the quality of the loan portfolio, including changes in the size and composition of the loan portfolio, delinquency rates, actual loan loss experience and current economic conditions, as well as individual review of certain large balance loans. Large groups of smaller-balance homogeneous loans are collectively evaluated for impairment. Loans that are collectively evaluated for impairment include residential real estate and consumer loans. Smaller balance non-homogeneous loans also may be evaluated collectively for impairment. Larger balance non- homogeneous residential construction and land, commercial real estate, commercial business loans and unsecured loans are individually evaluated for impairment. Loans are considered impaired when, based on current information and events, management determines that it is probable that the Bank will be unable to collect all amounts due according to the contractual terms of the loan agreement. Factors involved in determining impairment include, but are not limited to, the financial condition of the borrower, value of the underlying collateral and current status of the economy. Impaired loans are measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or, as a practical expedient, at the loan's observable market price or the fair value of collateral if the loan is collateral dependent. Subsequent changes in the value of impaired loans are included within the provision for loan losses in the same manner in which impairment initially was recognized or as a reduction in the provision that would otherwise be reported. As of September 30, 2003, the Company had identified $23.2 million of impaired loans as defined by SFAS 114 and had established $4.0 million of specific loss allowances for these loans. The Company's methodology for assessing the appropriateness of the allowance consists of several key elements, which include specific allowances, an allocated formula allowance, and an unallocated allowance. Losses on specific loans are provided for when the losses are probable and estimable. General loan loss reserves are established to provide for inherent loan portfolio risks not specifically provided for. The level of general reserves is based on analysis of potential exposures existing in the Bank's loan portfolio including evaluation of historical trends, current market conditions and other relevant factors identified by management at the time the financial statements are prepared. The formula allowance is calculated by applying loss factors to outstanding loans, excluding loans with specific allowances. Loss factors are based on the Company's historical loss experience adjusted for significant factors including the experience of other banking organizations that, in management's judgment, affect the collectibility of the portfolio as of the evaluation date. The unallocated allowance is based upon management's evaluation of various factors that are not directly measured in the determination of the formula and specific allowances. This methodology may result in losses or recoveries differing significantly from those provided in the financial statements. 17 The following tables are provided to disclose additional detail on the Company's loans and allowance for loan losses (in thousands): September 30 December 31 September 30 2003 2002 2002 Loans (including loans held for sale): ------------ ----------- ------------ Secured by real estate: One- to four-family $ 274,723 $ 329,314 $ 350,016 Consumer secured by one- to four-family 28,243 26,195 26,541 ---------- ---------- ---------- Total one- to four-family 302,966 355,509 376,557 Commercial 433,800 379,099 379,416 Multifamily 76,397 72,333 81,919 Construction and land 392,819 339,516 335,411 Commercial business 326,368 285,231 278,713 Agricultural business 122,890 102,626 99,899 Consumer 36,745 39,152 40,918 ---------- ---------- ---------- Total loans outstanding 1,691,985 1,573,466 1,592,833 Less allowance for loan losses 26,161 26,539 19,150 ---------- ---------- ---------- Total net loans outstanding at end of period $1,637,955 $1,546,927 $1,573,683 ========== ========== ========== Quarters Ended Nine Months Ended September 30 September 30 ---------------- ---------------- 2003 2002 2003 2002 ------ ------ ------ ------ Balance, beginning of the period $ 26,075 $ 16,646 $ 26,539 $ 17,552 Acquisitions -- -- -- 460 Provision for loan losses 1,400 4,000 5,900 11,000 Recoveries of loans previously charged off: Secured by real estate: One- to four-family -- -- -- -- Commercial -- -- -- -- Multifamily - -- -- -- Construction and land 78 -- 78 -- Commercial business 481 41 794 54 Agricultural business -- 1 12 3 Consumer 7 4 36 60 ------ ------ ------ ------ 566 46 920 117 Loans charged off: Secured by real estate: One- to four-family (346) -- (357) (11) Commercial (368) -- (2,247) -- Multifamily -- -- -- -- Construction and land (1) (120) (530) (607) Commercial business (1,067) (1,376) (3,708) (8,665) Agricultural business -- -- -- (142) Consumer (98) (46) (356) (554) ------ ------ ------ ------ (1,880) (1,542) (7,198) (9,979) ------ ------ ------ ------ Net charge-offs (1,314) (1,496) (6,278) (9,862) ------ ------ ------ ------ Balance, end of the period $ 26,161 $ 19,150 $ 26,161 $ 19,150 ====== ====== ====== ====== Net charge-offs as a percentage of average net book value of loans outstanding for the period 0.08% 0.10% 0.38% 0.62% 18 The following is a schedule of the Company's allocation of the allowance for loan losses: September 30 December 31 September 30 2003 2002 2002 ------------ ----------- ------------ Specific or allocated loss allowances: Secured by real estate: One- to four-family $ 676 $ 670 $ 711 Commercial 4,801 5,284 2,814 Multifamily 382 361 414 Construction and land 5,254 5,892 4,011 Commercial business 7,911 8,788 9,192 Agricultural business 2,942 2,164 945 Consumer 499 698 642 --------- -------- --------- Total allocated 22,465 23,857 18,729 Estimated allowance for undisbursed commitments 240 36 34 Unallocated 3,456 2,646 387 --------- -------- --------- Total allowance for loan losses $ 26,161 $ 26,539 $ 19,150 ========= ======== ========= Allowance for loan losses as a percentage of total loans outstanding(loans receivable excluding allowance for losses) 1.55% 1.69% 1.20% Other Operating Income. Other operating income was $5.5 million for the quarter ended September 30, 2003, an increase of $1.6 million from the quarter ended September 30, 2002. This included a $1.3 million increase in the gain on sale of loans for the current quarter as lower interest rates led to increased mortgage banking activity. Loan sales for the quarter ended September 30, 2003 totaled $190.8 million, compared to $84.9 million for the quarter ended September 30, 2002. Gain on sale of loans for the Company included $179,000 of fees on $13.2 million of loans which were brokered and are not reflected in the volume of loans sold. Other fee and service charge income increased by $370,000, to $1.9 million for the quarter ended September 30, 2003, compared to $1.5 million for the quarter ended September 30, 2002, primarily reflecting growth in customer transaction accounts, although increased fees also reflect changes in the Company's overdraft protection program that have been implemented in the current year. Other operating income for the nine months ended September 30, 2003 increased $5.0 million from the comparable period in 2002. This includes a $4.2 million increase in the gain on sale of loans reflecting the current year's strong mortgage banking activity and a $1.1 million increase in other fee and service charge income primarily reflecting growth in customer transaction accounts, as well as increased fees related to customer overdraft protection. Loan sales increased from $245.6 million for the nine months ended September 30, 2002, to $486.0 million for the nine months ended September 30, 2003. Loan servicing fees declined by $308,000 compared to the same nine-month period a year earlier largely as a result of accelerated loan prepayments in the current low interest rate environment. Other Operating Expenses. Other operating expenses increased $2.6 million, to $17.9 million for the quarter ended September 30, 2003, from $15.3 million for the quarter ended September 30, 2002. Other operating expenses reflect the overall growth in assets and liabilities, customer relationships and complexity of operations as the Company continues to expand. The higher level of operating expenses in the current year includes significant increases in compensation for credit examination and special assets personnel as well as additional executive management and production staff hired to re-position the Company for future growth. In addition, compensation was higher as a result of increased incentive compensation and staffing caused by the elevated level of mortgage banking activity in the current year. The higher level of mortgage banking activity is also reflected in the increase in capitalized loan origination costs. The Company also significantly increased its commitment to advertising and marketing expenditures which were $195,000 greater in the quarter ended September 30, 2003 than in the same period in the prior year. The increase in expenses includes operating costs associated with opening new branch offices in Spokane and Pasco, Washington and new commercial lending centers in Portland, Oregon and Bellevue (greater Seattle), Spokane and the Tri-Cities, Washington. The increase in other operating expenses was partially offset by a $590,000 increase in capitalized loan origination costs, reflecting a greater level of loan origination activity. Higher operating expenses, as well as a reduction in the net interest margin, caused the Company's efficiency ratio to increase to 70.91% for the quarter ended September 30, 2003, from 63.72% for the comparable period ended September 30, 2002. Other operating expenses as a percentage of average assets increased slightly to 2.84% for the quarter ended September 30, 2003, compared to 2.81% for the quarter ended September 30, 2002. Other operating expenses for the nine months ended September 30, 2003 increased $9.7 million, from $42.5 million for the first nine months of 2002 to $52.2 million in the current period. As explained earlier, the increase is largely due to the increases in compensation, occupancy and advertising expenses as the volume of activity has expanded and the Bank positions itself for future growth. The increased expenses in the current period also reflect a higher level of cost associated with the collection and disposition of non-performing assets. Income Taxes. Income tax expense was $1.8 million for the quarter ended September 30, 2003, compared to $1.3 million for the comparable period in 2002. The Company's effective tax rates for the quarters ended September 30, 2003 and 2002 were 30% and 28%, respectively. The higher effective tax rate in the quarter ended September 30, 2003 is primarily a result of an increase in the relative amount of taxable income versus tax-exempt income compared to the third quarter of 2002, largely as a result of the lower provision for loan losses in the current quarter. Income tax expense for the nine months ended September 30, 2003 increased to $5.1 million, compared to $4.8 million in the comparable period 19 in 2002. The Company's effective tax rates for the nine months ended September 30, 2003 and 2002 were 30% and 31%, respectively. The lower effective tax rate in the current period is primarily a result of an increase in the relative effect of the tax-exempt income and the recording of $49,000 of tax credits associated with investments in limited partnerships focused on providing affordable housing for low and moderate income families. Asset Quality Classified Assets: State and federal regulations require that the Bank review and classify its problem assets on a regular basis. In addition, in connection with examinations of insured institutions, state and federal examiners have authority to identify problem assets and, if appropriate, require them to be classified. The Bank's Credit Policy Division reviews detailed information with respect to the composition and performance of the loan portfolio, including information on risk concentrations, delinquencies and classified assets. The Credit Policy Division approves all recommendations for new classified assets or changes in classifications, and develops and monitors action plans to resolve the problems associated with the assets. The Credit Policy Division also approves recommendations for establishing the appropriate level of the allowance for loan losses. Significant problem loans are transferred to the Bank's Special Assets Department for resolution or collection activities. The Board of Directors is given a detailed report on classified assets and asset quality at least quarterly. Allowance for Loan Losses: In originating loans, the Bank recognizes that losses will be experienced and that the risk of loss will vary with, among other things, the type of loan being made, the credit worthiness of the borrower over the term of the loan, general economic conditions and, in the case of a secured loan, the quality of the security for the loan. As a result, the Bank maintains an allowance for loan losses consistent with the generally acceptable accounting principles guidelines. The Company increases its allowance for loan losses by charging provisions for probable loan losses against the Company's income. The allowance for losses on loans is maintained at a level which, in management's judgment, is sufficient to provide for estimated losses based on evaluating known and inherent risks in the loan portfolio and upon continuing analysis of the factors underlying the quality of the loan portfolio. At September 30, 2003, the Company had an allowance for loan losses of $26.2 million, which represented 1.55% of total loans and 107% of non-performing loans, compared to 1.69% and 74%, respectively, at December 31, 2002. During the year ended December 31, 2002, the Bank experienced deterioration in asset quality, which had a significant effect on operating results, primarily through increased loan loss provisioning and increased loan collection costs. Collection costs have remained high for the first nine months of 2003; however, non-performing assets decreased to $31.6 million, or 1.26% of total assets, at September 30, 2003, compared to $42.2 million, or 1.86% of total assets, at December 31, 2002. Problem loans are primarily due from borrowers located in the Puget Sound region and are the result of poor risk assessment at the time they were originated, coupled with weakened economic conditions in that area. For the quarter ended September 30, 2003, non-performing loans decreased by $3.7 million while real estate owned and other repossessed asset decreased by $1.9 million. At September 30, 2003, the Bank's largest non-performing asset exposure consisted of two related land development loans totaling $7.0 million secured by property located in the greater Seattle, Washington area, one of which had been converted to real estate owned at that date. On October 31, 2003, the Company closed a sale on a significant portion of this development, which resulted in a $5.2 million reduction in the real estate owned balance. The Company's next largest non-performing loan exposure encompasses loans totaling $4.1 million to an agricultural-related business operating in northeastern Oregon which are primarily secured by non-farm real estate and processing equipment. Balances for these loans are reflected in the non-accrual loan totals for commercial real estate and commercial business loans at September 30, 2003, in the table on the following page of this report. The Company had three additional non-performing credit relationships with balances in excess of $1.0 million, the largest of which had an aggregate carrying value of $1.6 million at September 30, 2003. While meaningful progress was made in the two most recent quarters, reducing non-performing loans and improving asset quality will be important activities to enhance the Bank's operating performance in future periods. 20 The following tables set forth information with respect to the Bank's non-performing assets and restructured loans within the meaning of SFAS No. 15, Accounting by Debtors and Creditors for Troubled Debt Restructuring, at the dates indicated (dollars in thousands): September 30 December 31 September 30 2003 2002 2002 ------------ ----------- ------------ Non-performing assets at end of the period: Nonaccrual Loans: Secured by real estate: One- to four-family $ 283 $ 455 $ 852 Commercial 6,790 7,421 2,745 Multifamily -- -- -- Construction and land 7,578 16,030 7,276 Commercial business 8,187 9,894 11,028 Agricultural business 305 194 -- Consumer 66 255 381 -------- -------- --------- 23,209 34,249 22,282 Loans more than 90 days delinquent, still on accrual: Secured by real estate: One- to four-family 734 343 48 Commercial -- -- -- Multifamily -- -- -- Construction and land -- 1,283 156 Commercial business 476 163 30 Agricultural business -- -- -- Consumer 17 70 197 -------- -------- --------- 1,227 1,859 431 -------- -------- --------- Total non-performing loans 24,436 36,108 22,713 Real estate owned, held for sale, and other repossessed assets, net 7,164 6,062 5,362 -------- -------- --------- Total non-performing assets at the end of the period $ 31,600 $ 42,170 $ 28,075 ======== ======== ========= Non-performing loans as a percentage of total net loans before allowance for loan losses at end of the period 1.44% 2.29% 1.43% Non-performing assets as a percentage of total assets at end of the period. 1.26% 1.86% 1.26% Troubled debt restructuring (TDRs) at end of the period $ 646 $ 2,057 $ 598 Liquidity and Capital Resources The Company's primary sources of funds are deposits, borrowings, proceeds from loan principal and interest payments and sales of loans, and the maturity of and interest income on mortgage-backed and investment securities. While maturities and scheduled repayments of loans and mortgage-backed securities are a predictable source of funds, deposit flows and mortgage prepayments are greatly influenced by market interest rates, economic conditions and competition. The primary investing activity of the Company, through its subsidiaries, is the origination and purchase of loans and purchase of investment securities. During the nine months ended September 30, 2003, the Company purchased loans in the amount of $29.0 million while loan originations, net of principal repayments, totaled $596.5 million. For the nine months ended September 30, 2003, securities purchases net of principal repayments totaled $217.9 million. This activity was funded primarily by principal repayments on loans and securities, sales of loans, deposit growth and borrowings. During the nine months ended September 30, 2003, the Company sold $486.0 million of loans, net deposit growth was $207.9 million, FHLB advances decreased $4.2 million and other borrowings increased $17.6 million. The Bank must maintain an adequate level of liquidity to ensure the availability of sufficient funds to accommodate deposit withdrawals, to support loan growth, to satisfy financial commitments and to take advantage of investment opportunities. During the quarter ended September 30, 2003, the Bank used its sources of funds primarily to fund loan commitments, to purchase securities, to repay FHLB advances and other borrowings, and to pay maturing savings certificates and deposit withdrawals. At September 30, 2003, the Bank had outstanding loan commitments totaling $530.3 million, including undisbursed loans in process totaling $480.1 million. The Bank generally maintains sufficient cash and readily marketable securities to meet short-term liquidity needs. The Bank maintains a credit facility with the FHLB-Seattle, which provides for advances which, in aggregate, may equal the lesser of 35% of the Bank's assets or unencumbered qualifying collateral, up to a total possible credit line of $875 million. Advances under this credit facility totaled $461.6 million, or 18% of the Bank's assets, at September 30, 2003. At September 30, 2003, certificates of deposit amounted to $1.035 billion, or 61% of the Bank's total deposits, including $771.7 million which were scheduled to mature within one year. Historically, the Bank has been able to retain a significant amount of its deposits as they mature. Management believes it has adequate resources to fund all loan commitments from customer deposits, FHLB-Seattle advances, other borrowings, principal and 21 interest payments and sale of mortgage loans and that it can adjust the offering rates for savings certificates to retain deposits in changing interest rate environments. Capital Requirements The Company is a bank holding company registered with the Federal Reserve. Bank holding companies are subject to capital adequacy requirements of the Federal Reserve under the Bank Holding Company Act of 1956, as amended, and the regulations of the Federal Reserve. The Bank, as a state-chartered, federally insured commercial bank, is subject to the capital requirements established by the FDIC. The capital adequacy requirements are quantitative measures established by regulation that require the Company and the Bank to maintain minimum amounts and ratios of capital. The Federal Reserve requires the Company to maintain capital adequacy that generally parallels the FDIC requirements. The FDIC requires the Bank to maintain minimum ratios of Tier 1 total capital to risk-weighed assets as well as Tier 1 leverage capital to average assets. At September 30, 2003 and December 31, 2002, the Company and the Bank exceeded all current regulatory capital requirements. (See Item 1, "Business Regulation," and Note 18 of the Notes to the Consolidated Financial Statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 2002 filed with the Securities and Exchange Commission, for additional information regarding the Company's and the Bank's regulatory capital requirements.) The actual regulatory capital ratios calculated for the Company and the Bank as of September 30, 2003, along with the minimum capital amounts and ratios, were as follows (dollars in thousands): Minimum to be categorized as Minimum "well-capitalized" for capital under prompt adequacy corrective action Actual purposes provisions ------------- ------------- --------------- Amount Ratio Amount Ratio Amount Ratio ------ ----- ------ ----- ------ ----- (dollars in thousands) September 30, 2003: The Company - consolidated Total capital to risk- weighted assets $236,200 12.71% $148,683 8.00% N/A N/A Tier 1 capital to risk- weighted assets 212,246 11.42 74,342 4.00 N/A N/A Tier 1 leverage capital to average assets 212,246 8.64 98,293 4.00 N/A N/A The Bank Total capital to risk- weighted assets 208,842 11.26 148,400 8.00 $185,499 10.00% Tier 1 capital to risk- weighted assets 184,932 9.97 74,200 4.00 111,300 6.00 Tier 1 leverage capital to average assets 184,932 7.53 98,220 4.00 122,775 5.00 22 ITEM 3 - Quantitative and Qualitative Disclosures About Market Risk Market Risk and Asset/Liability Management The financial condition and operation of the Company are influenced significantly by general economic conditions, including the absolute level of interest rates as well as changes in interest rates and the slope of the yield curve. The Company's profitability is dependent to a large extent on its net interest income, which is the difference between the interest received from its interest-earning assets and the interest expense incurred on its interest-bearing liabilities. The activities of the Company, like all financial institutions, inherently involve the assumption of interest rate risk. Interest rate risk is the risk that changes in market interest rates will have an adverse impact on the institution's earnings and underlying economic value. Interest rate risk is determined by the maturity and repricing characteristics of an institution's assets, liabilities, and off-balance-sheet contracts. Interest rate risk is measured by the variability of financial performance and economic value resulting from changes in interest rates. Interest rate risk is the primary market risk affecting the Company's financial performance. The greatest source of interest rate risk to the Company results from the mismatch of maturities or repricing intervals for rate sensitive assets, liabilities and off-balance-sheet contracts. This mismatch or gap is generally characterized by a substantially shorter maturity structure for interest- bearing liabilities than interest-earning assets; however, in the current low interest rate environment, accelerated prepayments and calls on loans and securities have resulted in shorter expected lives on many interest-earning assets than has historically been the case, reversing this general characterization. Additional interest rate risk results from mismatched repricing indices and formulae (basis risk and yield curve risk), and product caps and floors and early repayment or withdrawal provisions (option risk), which may be contractual or market driven, that are generally more favorable to customers than to the Company. An additional exception to these generalizations in the current market environment has been the beneficial effect of interest rate floors on many of the Company's floating rate loans which have helped maintain higher loan yields despite declining levels of market interest rates. However, in the current low interest rate environment, management anticipates that these rate floors will decline over time. Further, because these rate floors exceed what would otherwise be the note rate on certain variable or floating rate loans, those loans will be less responsive to increasing market rates than has historically been the case, injecting an additional element of interest rate risk into the Company's operations. The principal objectives of asset/liability management are to evaluate the interest-rate risk exposure of the Company; to determine the level of risk appropriate given the Company's operating environment, business plan strategies, performance objectives, capital and liquidity constraints, and asset and liability allocation alternatives; and to manage the Company's interest rate risk consistent with regulatory guidelines and approved policies of the Board of Directors. Through such management, the Company seeks to reduce the vulnerability of its earnings and capital position to changes in the level of interest rates. The Company's actions in this regard are taken under the guidance of the Asset/Liability Management Committee, which is comprised of members of the Company's senior management. The committee closely monitors the Company's interest sensitivity exposure, asset and liability allocation decisions, liquidity and capital positions, and local and national economic conditions, and attempts to structure the loan and investment portfolios and funding sources of the Company to maximize earnings within acceptable risk tolerances. Sensitivity Analysis The Company's primary monitoring tool for assessing interest rate risk is asset/liability simulation modeling which is designed to capture the dynamics of balance sheet, interest rate and spread movements and to quantify variations in net interest income resulting from those movements under different rate environments. The sensitivity of net interest income to changes in the modeled interest rate environments provides a measurement of interest rate risk. The Company also utilizes market value analysis, which addresses changes in estimated net market value of equity arising from changes in the level of interest rates. The net market value of equity is estimated by separately valuing the Company's assets and liabilities under varying interest rate environments. The extent to which assets gain or lose value in relation to the gains or losses of liability values under the various interest rate assumptions determines the sensitivity of net equity value to changes in interest rates and provides an additional measure of interest rate risk. The interest rate sensitivity analysis performed by the Company incorporates beginning-of-the-period rate, balance and maturity data, using various levels of aggregation of that data, as well as certain assumptions concerning the maturity, repricing, amortization and prepayment characteristics of loans and other interest-earning assets and the repricing and withdrawal of deposits and other interest-bearing liabilities into an asset/liability computer simulation model. The Company updates and prepares simulation modeling at least quarterly for review by senior management and the Board of Directors. The Company believes the data and assumptions are realistic representations of its portfolio and possible outcomes under the various interest rate scenarios. Nonetheless, the interest rate sensitivity of the Company's net interest income and net market value of equity could vary substantially if different assumptions were used or if actual experience differs from the assumptions used. 23 The table of Interest Rate Risk Indicators sets forth, as of September 30, 2003, the estimated changes in the Company's net interest income over a one-year time horizon and the estimated changes in market value of equity based on the indicated interest rate environments. Table of Interest Rate Risk Indicators Estimated Change in --------------------------------------- Change (in Basis Points) Net Interest Income in Interest Rates (1) Next 12 Months Net Market Value ------------------------ ------------------- ---------------- (Dollars in thousands) +300 (996) (1.2%) (63,151) (32.8%) +200 (1,376) (1.6%) (35,978) (18.7%) +100 (1,375) (1.6%) (10,585) (5.5%) 0 0 0 0 0 -100 (2,492) (2.9%) (11,187) (5.8%) -200 (7,289) (8.6%) (15,683) (8.2%) __________ (1) Assumes an instantaneous and sustained uniform change in market interest rates at all maturities. Another, although less reliable, monitoring tool for assessing interest rate risk is "gap analysis." The matching of the repricing characteristics of assets and liabilities may be analyzed by examining the extent to which such assets and liabilities are "interest sensitive" and by monitoring an institution's interest sensitivity "gap." An asset or liability is said to be interest sensitive within a specific time period if it will mature or reprice within that time period. The interest rate sensitivity gap is defined as the difference between the amount of interest-earning assets anticipated, based upon certain assumptions, to mature or reprice within a specific time period and the amount of interest-bearing liabilities anticipated to mature or reprice, based upon certain assumptions, within that same time period. A gap is considered positive when the amount of interest sensitive assets exceeds the amount of interest sensitive liabilities. A gap is considered negative when the amount of interest sensitive liabilities exceeds the amount of interest sensitive assets. Generally, during a period of rising rates, a negative gap would tend to adversely affect net interest income while a positive gap would tend to result in an increase in net interest income. During a period of falling interest rates, a negative gap would tend to result in an increase in net interest income while a positive gap would tend to adversely affect net interest income. Certain shortcomings are inherent in gap analysis. For example, although certain assets and liabilities may have similar maturities or periods of repricing, they may react in different degrees to changes in market rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market rates, while interest rates on other types may lag behind changes in market rates. Additionally, certain assets, such as adjustable-rate loans, have features that restrict changes in interest rates on a short-term basis and over the life of the asset. Further, in the event of a change in interest rates, prepayment and early withdrawal levels would likely deviate significantly from those assumed in calculating the table. Finally, the ability of some borrowers to service their debt may decrease in the event of a severe interest rate increase. The table of Interest Sensitivity Gap presents the Company's interest sensitivity gap between interest-earning assets and interest-bearing liabilities at September 30, 2003. The table sets forth the amounts of interest-earning assets and interest-bearing liabilities which are anticipated by the Company, based upon certain assumptions, to reprice or mature in each of the future periods shown. At September 30, 2003, total interest-bearing assets maturing or repricing within one year exceeded total interest-earning liabilities maturing or repricing in the same time period by $116.9 million, representing a one-year gap to total assets ratio of 4.67%. 24 Table of Interest Sensitivity Gap As of September 30, 2003 Within 6 Months 1-3 3-5 5-10 Over 10 6 Months to One Year Years Years Years Years Total -------- ----------- ------- ------- ------- ------- ------- (dollars in thousands) Interest-earning assets (1): Construction loans $271,190 $ 9,439 $ 6,399 $ -- $ -- $ -- $287,028 Fixed-rate mortgage loans 68,377 44,795 111,822 99,402 133,032 36,949 494,377 Adjustable-rate mortgage loans 220,825 56,343 89,548 64,192 3,727 -- 434,635 Fixed-rate mortgage-backed securities 38,877 26,522 79,276 49,050 57,240 22,677 273,642 Adjustable-rate mortgage-backed securities 57,846 -- -- -- -- -- 57,846 Fixed-rate commercial/agriculture loans 51,571 27,836 32,027 17,147 6,904 103 135,588 Adjustable-rate commercial/ agriculture loans 269,959 4,000 6,120 6,855 325 -- 287,259 Consumer and other loans 31,804 6,714 13,365 5,093 1,969 229 59,174 Investment securities and --------- -------- -------- -------- -------- -------- --------- interest-bearing deposits 191,545 15,830 18,285 3,405 15,718 63,479 308,262 Total rate-sensitive assets 1,201,994 191,479 356,842 245,144 218,915 123,437 2,337,811 --------- -------- -------- -------- -------- -------- --------- Interest-bearing liabilities (2): Regular savings and NOW accounts 42,122 42,122 98,285 98,285 -- -- 280,814 Money market deposit accounts 93,480 56,088 37,392 -- -- - 186,960 Certificates of deposit 653,472 118,195 164,204 83,693 14,938 49 1,034,551 FHLB advances 106,594 51,500 137,600 69,930 95,328 600 461,552 Other borrowings 35,519 -- -- -- -- -- 35,519 Trust preferred 55,000 -- -- -- -- -- 55,000 Retail repurchase agreements 20,652 1,836 274 -- 483 -- 23,245 --------- -------- -------- -------- -------- -------- --------- Total rate-sensitive liabilities 1,006,839 269,741 437,755 251,908 110,749 649 2,077,641 --------- -------- -------- -------- -------- -------- --------- Excess (deficiency) of interest- sensitive assets over interest- sensitive liabilities $ 195,155 $(78,262) $(80,913) $ (6,764) $108,166 $122,788 $260,170 Cumulative excess (deficiency) of ========= ======== ======== ======== ======== ======== ======== interest-sensitive assets $ 195,155 $116,893 $ 35,980 $ 29,216 $137,382 $260,170 $260,170 ========= ======== ======== ======== ======== ======== ======== Cumulative ratio of interest-earning assets to interest-bearing liabilities 119.38% 109.16% 102.10% 101.49% 106.61% 112.52% 112.52% ========= ======== ======== ======== ======== ======== ======== Interest sensitivity gap to total assets 7.80% (3.13%) (3.23%) (0.27%) 4.32% 4.91% 10.40% ========= ======== ======== ======== ======== ======== ======== Ratio of cumulative gap to total assets 7.80% 4.67% 1.44% 1.17% 5.49% 10.40% 10.40% ========= ======== ======== ======== ======== ======== ======== (footnotes on following page)
25 Footnotes for Table of Interest Sensitivity Gap ----------------------------------------------- (1) Adjustable-rate assets are included in the period in which interest rates are next scheduled to adjust rather than in the period in which they are due to mature, and fixed-rate assets are included in the periods in which they are scheduled to be repaid based upon scheduled amortization, in each case adjusted to take into account estimated prepayments. Mortgage loans and other loans are not reduced for allowances for loan losses and non-performing loans. Mortgage loans, mortgage-backed securities, other loans, and investment securities are not adjusted for deferred fees and unamortized acquisition premiums and discounts. (2) Adjustable- and variable-rate liabilities are included in the period in which interest rates are next scheduled to adjust rather than in the period they are due to mature. Although the Bank's regular savings, NOW, and money market deposit accounts are subject to immediate withdrawal, management considers a substantial amount of such accounts to be core deposits having significantly longer maturities. For the purpose of the gap analysis, these accounts have been assigned decay rates to reflect their longer effective maturities. If all of these accounts had been assumed to be short-term, the one year cumulative gap of interest-sensitive assets would have been negative $117.1 million, or (4.68%) of total assets. Interest-bearing liabilities for this table exclude certain non-interest-bearing deposits which are included in the average balance calculations in the table included in the Comparison of Results of Operations section of this document. 26 ITEM 4 - Controls and Procedures (a) Evaluation of Disclosure Controls and Procedures: An evaluation of Company disclosure controls and procedures (as defined in Section 13(a)-15(e) of the Securities Exchange Act of 1934 (the Act)) was carried out under the supervision and with the participation of the Company's Chief Executive Officer, Chief Financial Officer and several other members of the Company's senior management as of the end of the period covered by this report. The Company's Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures as currently in effect are effective in ensuring that the information required to be disclosed by the Company in the reports it files or submits under the Act is (i) accumulated and communicated to the Company's management (including the Chief Executive Officer and Chief Financial Officer) in a timely manner, and (ii) recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms. (b) Changes in Internal Controls: In the quarter ended September 30, 2003, there was no change in the Company's internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. 27 PART II - OTHER INFORMATION Item 1. Legal Proceedings In the normal course of business, the Company and the Bank have various legal proceedings and other contingent matters outstanding. These proceedings and the associated legal claims are often contested and the outcome of individual matters is not always predictable. These claims and counter claims typically arise during the course of collection efforts on problem loans or with respect to action to enforce liens on properties in which the Bank holds a security interest. Presently the Company has four such counter claims by borrowers or involved parties. The Company and the Bank are not a party to any pending legal proceedings that management believes would have a material adverse effect on the financial condition or operations of the Company. Item 2. Changes in Securities and Use of Proceeds Not Applicable Item 3. Defaults Upon Senior Securities Not Applicable Item 4. Submission of Matters to a Vote of Stockholders None Item 5. Other Information Not Applicable Item 6. Exhibits and Reports on Form 8K (a) Exhibits 31.1 Certificates of Chief Executive Officer and Chief Financial Officer pursuant to the Securities Exchange Act Rules 13a-15(e) 31.2 and 15d-15(e) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 dated November 13, 2003. 32 Certificate of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 dated November 13, 2003. (b) Report(s) on Form 8-K filed during the quarter ended September 30, 2003, are as follows: Date Filed Purpose ---------- ------- July 23, 2003 Announce Banner Corporation financial results for the quarter ended June 30, 2003. 28 SIGNATURES ---------- Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Banner Corporation November 13, 2003 /s/D. Michael Jones ---------------------- D. Michael Jones President and Chief Executive Officer (Principal Executive Officer) November 13, 2003 /s/ Lloyd W. Baker ---------------------- Lloyd W. Baker Treasurer and Chief Financial Officer (Principal Financial and Accounting Officer) 29 Exhibit 31.1 CERTIFICATION I, D. Michael Jones, certify that: 1. I have reviewed this Quarterly Report on Form 10-Q of Banner Corporation; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. November 13, 2003 /s/D. Michael Jones ------------------------ D. Michael Jones Chief Executive Officer 30 Exhibit 31.2 CERTIFICATION I, Lloyd W. Baker, certify that: 1. I have reviewed this Quarterly Report on Form 10-Q of Banner Corporation; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. November 13, 2003 /s/Lloyd W. Baker ------------------------ Lloyd W. Baker Chief Financial Officer 31 Exhibit 32 CERTIFICATION OF CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER OF BANNER CORPORATION PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 The undersigned hereby certify, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and in connection with this Quarterly Report on Form 10-Q, that: - the report fully complies with the requirements of Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended, and - the information contained in the report fairly presents, in all material respects, the company's financial condition and results of operations. November 13, 2003 /s/D. Michael Jones ------------------------- D. Michael Jones Chief Executive Officer November 13, 2003 /s/Lloyd W. Baker ------------------------- Lloyd W. Baker Chief Financial Officer A signed original of the written statement required by Section 906 has been provided to Banner Corporation and will be retained by Banner Corporation and furnished to the Securities and Exchange Commission or its staff upon request. 32