-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, P7jlkadJfmLXrD0fP6OQbMuDU3iOyc2Bpl5rDVTbnwJXeNvrtHvhpOJ4BNNc3Xg4 HT2nwmuDxSB/Ll4at3BGWg== 0000939057-99-000070.txt : 19990630 0000939057-99-000070.hdr.sgml : 19990630 ACCESSION NUMBER: 0000939057-99-000070 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19990331 FILED AS OF DATE: 19990629 FILER: COMPANY DATA: COMPANY CONFORMED NAME: FIRST WASHINGTON BANCORP INC /WA/ CENTRAL INDEX KEY: 0000946673 STANDARD INDUSTRIAL CLASSIFICATION: SAVINGS INSTITUTIONS, NOT FEDERALLY CHARTERED [6036] IRS NUMBER: 911691604 STATE OF INCORPORATION: WA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K405 SEC ACT: SEC FILE NUMBER: 000-26584 FILM NUMBER: 99655389 BUSINESS ADDRESS: STREET 1: 10 S FIRST AVENUE CITY: WALLA WALLA STATE: WA ZIP: 99362 BUSINESS PHONE: 5095273636 MAIL ADDRESS: STREET 1: 10 S FIRST AVENUE CITY: WALLA WALLA STATE: WA ZIP: 99362 FORMER COMPANY: FORMER CONFORMED NAME: FIRST SAVINGS BANK OF WASHINGTON BANCORP INC DATE OF NAME CHANGE: 19950614 10-K405 1 FIRST WASHINGTON BANCORP FORM 10-K FORM 10-K SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 (Mark One) ============================================================================== X ============================================================================== ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended ............. MARCH 31, 1999 -------------- 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 ------- FIRST WASHINGTON BANCORP, INC. ------------------------------ (Exact name of registrant as specified in its charter) WASHINGTON 91-1691604 ---------- ------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 10 S. FIRST AVENUE WALLA WALLA, WASHINGTON 99362 ------------------------------------------------ (Address of principal executive offices and zip code) (509) 527-3636 -------------- (Registrant's telephone number, including area code) N/A -------------------------- (Former name, former address and former fiscal year, if changed since last report.) Securities registered pursuant to Section 12(b) of the Act: NONE Securities registered pursuant to section 12(g) of the Act: COMMON STOCK $.01 PAR VALUE PER SHARE (Title of class) 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 if disclosure of delinquent files pursuant to Item 405 of Regulations S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this form 10-K or any amendment to this form 10-K. X ----- The aggregate market value of the voting stock held by nonaffiliates of the registrant as of May 31, 1999: COMMON STOCK - $224,478,399 The number of shares outstanding of the issuer's classes of common stock as of May 31, 1999: COMMON STOCK, $.01 PAR VALUE - 11,330,440 shares DOCUMENT INCORPORATED BY REFERENCE PORTIONS OF PROXY STATEMENT FOR ANNUAL MEETING OF SHAREHOLDERS TO BE HELD JULY 23, 1999 ARE INCORPORATED BY REFERENCE INTO PART III. FIRST WASHINGTON BANCORP, INC., AND SUBSIDIARIES TABLE OF CONTENTS PART I PAGE # Item 1. Business .................................................. 3 General....................................................3 Acquisition and Mergers................................... 4 Adoption of Dividend Reinvestment and Stock Purchase Plan..5 Lending Activities........................................ 5 Asset Quality.............................................13 Allowance for Loan Losses.................................16 Investment Activities.....................................20 Deposit Activities and Other Sources of Funds.............26 Personnel.................................................28 Taxation..................................................28 Environmental Regulation..................................30 Competition...............................................30 Regulation................................................31 Management Personnel......................................36 Item 2. Properties.................................................37 Item 3. Legal Proceedings..........................................37 Item 4. Submission of Matters to a Vote of Security Holders .......37 PART II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters................................38 Item 6. Selected Financial Data....................................39 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation........................41 Comparison of Results of Operations March 31, 1999 vs. 1998.................................44 March 31, 1998 vs. 1997.................................47 Market Risk and Asset/ Liability Management..............52 Liquidity and Capital Resources..........................57 Capital Requirements.....................................58 Effect of Inflation and Changing Prices..................58 Recent Accounting Standards Not Yet Audited..............58 Item 8. Financial Statements and Supplementary Data................59 Item 9. Changes in and Disagreements with Accountant on Accounting and Financial Disclosure.....................59 PART III Item 10.Directors and Executive Officers of the Registrant.........59 Item 11.Executive Compensation.....................................59 Item 12.Security Ownership of Certain Beneficial Owners and Management.............................................59 Item 13.Certain Relationships and Related Transactions.............59 PART IV Item 14.Exhibits, Financial Statement Schedules, and Reports on Form 8-K..................... .................62 SIGNATURES..........................................................61 2 PART 1 ITEM 1 - BUSINESS GENERAL First Washington Bancorp, Inc. (the Company or FWWB), a Washington corporation, is primarily engaged in the business of planning, directing and coordinating the business activities of its wholly owned subsidiaries, First Savings Bank of Washington (FSBW), Inland Empire Bank (IEB) and Towne Bank (TB) (together, the Banks). FSBW is a Washington-chartered savings bank the deposits of which are insured by the Federal Deposit Insurance Corporation (FDIC) under the Savings Association Insurance Fund (SAIF). FSBW conducts business from its main office in Walla Walla, Washington and its 16 branch offices and three loan production offices located in southeast, central, north central and western Washington. Effective January 1, 1999, FWWB completed the acquisition of Whatcom State Bancorp whose wholly owned subsidiary, Whatcom State Bank (WSB), was merged with FSBW and operates as Whatcom State Bank, a Division of First Savings Bank of Washington. WSB, which is based in Bellingham, operates five full service branches and a loan office in northwest Washington. IEB is an Oregon-chartered commercial bank whose deposits are insured by the FDIC under the Bank Insurance Fund (BIF). IEB conducts business from its main office in Hermiston, Oregon and its five branch offices and two loan production offices located in northeast Oregon. TB is a Washington- chartered commercial bank whose deposits are insured by the FDIC under BIF. TB conducts business from six full service branches in the Seattle, Washington, metropolitan area. The Company's main office is located at 10 S. First Avenue, Walla Walla, Washington 99362 and its telephone number is (509) 527-3636. The operating results of the Company depend substantially on its net interest income, which is the difference between interest income on interest-earning assets, consisting of loans and securities, and interest expense on interest- bearing liabilities, composed primarily of deposits and borrowings. Net interest income is 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. 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 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. First Savings Bank of Washington is a community oriented savings bank which has traditionally offered a wide variety of deposit products to its retail customers while concentrating its lending activities on real estate loans. Lending activities have been focused primarily on the origination of loans secured by one-to four-family residential dwellings, including emphasis on loans for construction of residential dwellings. To a lesser extent, lending activities also have included the origination of multi-family, commercial real estate and consumer loans. FSBW's primary business has been that of a traditional thrift institution, originating loans for portfolio in its primary market area. FSBW has also been an active participant in the secondary market, originating residential loans for sale and on occasion acquiring loans for portfolio. More recently, FSBW has begun making non-mortgage commercial and agribusiness loans to small businesses and farmers. In addition to loans, FSBW has maintained a significant portion of its assets in marketable securities. The securities portfolio has been weighted toward mortgage-backed securities secured by one-to four-family residential properties. This portfolio also has included a significant amount of tax exempt municipal securities, primarily issued by entities located in the State of Washington. In addition to interest income on loans and investment securities, FSBW receives other income from deposit service charges, loan servicing fees and from the sale of loans and investments. FSBW has sought to increase its other income by retaining loan servicing rights on some of the loans that it has sold. FSBW also has a wholly-owned subsidiary, Northwest Financial Corporation, which serves as the trustee under FSBW's mortgage loan documents, is engaged in real estate sales, and receives commissions from the sale of annuities. Inland Empire Bank is a community oriented commercial bank which historically has offered a wide variety of deposits and loan products to its consumer and commercial customers. Lending activities have included origination of consumer, commercial, agribusiness and real estate loans. IEB also has engaged in mortgage banking activity with respect to residential lending within its local markets, originating loans for sale generally on a servicing released basis. Additionally, IEB has maintained a significant portion of its assets in marketable securities, particularly U.S. Treasury and government agency securities as well as tax exempt municipal securities issued primarily by entities located in the State of Oregon. IEB operates a division, Inland Financial Services, which offers insurance and brokerage services to its customers. IEB has two wholly owned subsidiaries: Pioneer American Property Company, which owns a building that is leased to IEB, and Inland Securities Corporation, which previously made a market for IEB's stock but is currently inactive. 3 TB is a community oriented commercial bank chartered in the State of Washington. TB's lending activities consist of granting commercial loans, including commercial real estate, land development and construction loans, and consumer loans to customers throughout King and Snohomish counties in western Washington. TB is a "Preferred Lender" with the Small Business Administration (SBA) and the Bank generates a large volume of SBA guaranteed loans for resale. The Company and the Banks are subject to regulation by the Federal Reserve Board (FRB) and the FDIC, the State of Washington Department of Financial Institutions, Division of Banks (Division), and the State of Oregon Department of Consumer and Business Services and the State of Idaho, Department of Finance. The Board of Directors of the Company passed a resolution on October 22, 1998 changing its fiscal year end from March 31st to December 31st. It will be effective for the year ending 1999. ACQUISITIONS AND MERGERS TOWNE BANK On April 1, 1998 FWWB completed the acquisition of Towne Bancorp, Inc. FWWB paid $28.2 million in cash and common stock for all of the outstanding common shares and stock options of Towne Bancorp, Inc., which was the holding company for Towne Bank (TB), headquartered in Woodinville, Washington, a Seattle suburb. As a result of the merger of Towne Bancorp, Inc. into FWWB, TB became a wholly owned subsidiary of FWWB. The acquisition was accounted for as a purchase and resulted in the recording of $19.2 million of costs in excess of the fair value of Towne Bancorp, Inc. net assets acquired (goodwill). Goodwill assets are being amortized over a 14-year period resulting in a current charge to earnings of $343,800 per quarter or $1,375,000 per year. Founded in 1991, TB is a community business bank which had, before recording of goodwill, approximately $146 million in total assets, $134 million in deposits, $120 million in loans and $9.3 million in shareholders' equity at March 31, 1998. TB operates six full service branches in the Seattle, Washington, metropolitan area--in Woodinville, Kirkland, Redmond, Bellevue, Renton and Bothell. WHATCOM STATE BANCORP, INC. On January 1, 1999 FWWB completed the acquisition of Whatcom State Bancorp, Inc. FWWB paid $12.1 million in common stock for all the outstanding common shares and stock options of Whatcom State Bancorp, Inc., which was the holding company, for Whatcom State Bank (WSB), headquartered in Bellingham, Washington. As a result of the merger of Whatcom State Bancorp, Inc. into FWWB, WSB became a division of FSBW. The acquisition was accounted for as a purchase and resulted in the recording of approximately $6.3 million of costs in excess of the fair value of Whatcom State Bancorp, Inc. net assets acquired (goodwill). Goodwill assets are being amortized over a 14-year period resulting in a current charge to earnings of approximately $114,300 per quarter or $457,000 per year. Founded in 1980, WSB is a community commercial bank which had, before recording of goodwill, approximately $99 million in total assets, $85 million in deposits, $79 million in loans, and $5.4 million in shareholders' equity at December 31, 1998. WSB operates five full service branches in the Bellingham, Washington, area--Bellingham, Ferndale, Lynden, Blaine and Point Roberts. SEAPORT CITIZENS BANK Subsequent to year end, on April 1, 1999 FWWB and FSBW completed the acquisition of Seaport Citizens Bank (SCB). FSBW paid $10.1 million in cash for all the outstanding common shares of SCB, which is headquartered in Lewiston, Idaho. As a result of the merger of SCB into FSBW, SCB became a division of FSBW. The acquisition will be accounted for as a purchase and result in the recording of approximately $6.2 million of costs in excess of the fair value of SCB's net assets acquired (goodwill). Goodwill assets will be amortized over a 14-year period and will result in a current charge to earnings of approximately $107,200 per quarter, beginning in the first quarter of fiscal 2000, or $429,000 per year. Founded in 1979, SCB is a commercial bank which had, before recording of goodwill, approximately $45 million in total assets, $41 million in deposits, $27 million in loans, and $4.1 million in shareholders' equity at March 31, 1999. SCB operates two full service branches in the Lewiston, Idaho, area. 4 ADOPTION OF DIVIDEND REINVESTMENT AND STOCK PURCHASE PLAN In October 1997, the Company adopted a dividend reinvestment and stock purchase plan. Under the terms of the plan all registered stockholders with 100 or more shares of stock may automatically reinvest all or a portion of their cash dividends in additional shares of the Company's common stock. In addition, qualifying participants may also make optional monthly cash payments of $50 to $1,500 to purchase additional shares of Company stock. LENDING ACTIVITIES General: Historically, the Banks have offered a wide range of loan products to meet the demands of their customers. The Banks originate loans for both their own loan portfolios and for sale in the secondary market. Management's strategy has been to maintain a significant percentage of assets in these loan portfolios in loans with more frequent interest rate repricing terms or shorter maturities than traditional long term fixed-rate mortgage loans. As part of this effort, the Banks have developed a variety of floating or adjustable-interest rate products that correlate closer with the Banks cost of funds. In response to customer demand, however, the Banks continue to originate fixed-interest rate loans including fixed-rate mortgage loans with terms up to 30 years. The relative amount of fixed-rate loans and adjustable-rate loans that can be originated at any time is largely determined by the demand for each in a competitive environment. FSBW's primary lending focus is on the origination of loans secured by first mortgages on owner-occupied, one- to four-family residences and loans for the construction of one- to four-family residences. FSBW also originates, to a lesser degree, consumer, commercial real estate, multi-family real estate and land loans. More recently, FSBW has begun marketing non-mortgage commercial and agribusiness loans to small businesses and farmers. Management expects this type of lending to increase at FSBW. At March 31, 1999, FSBW's net loan portfolio totaled $773.5 million. Over 68% of FSBW's first mortgage loans are secured by properties located in the State of Washington. The aggregate amount of loans that FSBW is permitted to make under applicable federal regulations to any one borrower, including related entities, is the greater of 20% of unimpaired capital and surplus or $500,000. At March 31, 1999, the maximum amount which FSBW could have lent to any one borrower and the borrower's related entities was $21.6 million. At March 31, 1999, FSBW had no loans to one borrower with an aggregate outstanding balance in excess of this amount. FSBW had 47 borrowers with total loans outstanding in excess of $2.0 million at March 31, 1999. At that date, the largest amount outstanding to any one borrower and the borrower's related entities totaled $12.0 million, which consisted of 39 single family, land development and lot loans in the Tacoma, Bellevue and Tri-Cities, Washington; and Portland, Oregon areas. At March 31, 1999, all except $2.8 million of these loans were performing in accordance with their terms. The $2.8 million is a series of loans on multiple four-plex developments (and one five-plex) in Hermiston, Oregon. The loans have been classified as impaired and loan loss reserves of $551,000 have been allocated to absorb potential losses. Lending activities at Inland Empire Bank have included origination of consumer, commercial, agribusiness and commercial real estate loans. In particular, IEB has developed significant expertise and market share with respect to small business and agricultural loans within its local markets. In addition, IEB has originated one-to four-family residential real estate loans for sale in the secondary market. At March 31, 1999, IEB's net loan portfolio totaled $142.2 million. The aggregate amount of loans that IEB is permitted to make under applicable state and federal regulations to any one borrower, including related entities, is 15% of the aggregate paid-up and unimpaired capital and surplus. At March 31, 1999, the maximum amount IEB could have lent to any one borrower and the borrower's related entities was $2.9 million ($4.7 million if secured by real estate). At that date, the largest amount outstanding to any one borrower of IEB totaled $3.3 million and was made to an alfalfa food processor and exporter. Lending activities at Towne Bank have included origination of consumer, commercial, commercial real estate and construction loans. In particular, TB has developed significant expertise and growing market share with respect to small business loans within its local markets. 5 At March 31, 1999, TB's net loan portfolio totaled $187.0 million. The aggregate amount of loans TB is permitted to make under applicable state and federal regulations to any one borrower, including related entities, is 20% of the aggregate paid-up and unimpaired capital and surplus. At March 31, 1999, the maximum amount TB could have lend to any one borrower and the borrower's related entities was $3.3 million. At that date, the largest amount outstanding to any one borrower of TB totaled $2.5 million which is a two motel operation in the Seattle area. One-to Four-Family Residential Real Estate Lending: The Banks originate loans secured by first mortgages on owner-occupied, one- to four-family residences and loans for the construction of one- to four-family residences in the communities where they have established full service branches. In addition, the Banks operate loan production offices in Bellevue, Puyallup, Oak Harbor and Spokane, Washington and LaGrande and Condon, Oregon. FSBW also has a significant relationship with a mortgage loan broker in the greater Portland, Oregon market. At March 31, 1999, $407.7 million, or 34.2% of the Company's loan portfolio, consisted of permanent loans on one-to four-family residences. Historically, FSBW has originated both fixed-rate loans and adjustable-rate residential loans for its portfolio. Since the early 1980s, FSBW has restructured its loan portfolio to reflect a larger percentage of adjustable- rate loans. Fifteen and 30-year fixed-rate residential loans generally have been sold into the secondary market; however, a portion of the fixed-rate loans originated by FSBW have been retained in the loan portfolio to meet asset/liability management objectives. The number of fixed-rate loans retained by FSBW increased substantially during 1996 and remained high in fiscal years 1997 and 1998 in response to the capital deployment and growth objectives of the Company. For the past year FSBW has been selling a larger portion of its newly originated fixed rate loans as a part of its interest rate risk management strategy. Both before and after their acquisition by the Company, WSB and SCB engaged in residential lending, including secondary market activities, in a fashion very similar to FSBW. Historically, Inland Empire Bank has sold most of its residential loans into the secondary market and has continued to so do subsequent to its acquisition by the Company. Generally IEB has sold loans on a servicing-released basis such that no revenue is realized by IEB after the sale. Generally, Towne Bank has not engaged in one-to four-family residential lending. In the loan approval process, the Banks assess the borrower's ability to repay the loan, the adequacy of the proposed security, the employment stability of the borrower and the creditworthiness of the borrower. As part of the loan application process, qualified independent appraisers inspect and appraise the security property. All appraisals are subsequently reviewed by a loan underwriter and, if necessary, by the Banks' chief appraiser. The Banks' residential loans are generally underwritten and documented in accordance with the guidelines established by Freddie Mac and Fannie Mae. Government insured loans are generally underwritten and documented in accordance with the guidelines established by the Department of Housing and Urban Development (HUD) and the Veterans Administration (VA). The Banks' loan underwriters are approved as underwriters under HUD's delegated underwriter program. The Banks sell whole loans on either a servicing-retained or servicing- released basis. All loans are sold without recourse. Occasionally, the Banks will sell a participation interest in a loan or pool of loans to an investor. In these instances, the Banks retain a small percentage of the loan(s) and pass through a net yield to the investor on the percentage sold. The decision to hold or sell loans is based on asset/liability management goals and policies and market conditions. Recently, FSBW has sold a significant portion of its conventional fixed-rate mortgage originations and all of its government insured loans into the secondary market. IEB has continued to sell most of its residential loan originations. 6 The Banks offer adjustable-rate mortgages (ARMs) at rates and terms competitive with market conditions. The Banks offer several ARM products which adjust annually after an initial period ranging from one to five years subject to a limitation on the annual increase of 1.0% to 2.0% and an overall limitation of 5.0% to 6.0%. Certain ARM loans are originated with an option to convert the loan to a 30-year fixed-rate loan at the then prevailing market interest rate. Generally these ARM products utilize the weekly average yield on one-year U.S. Treasury securities adjusted to a constant maturity of one year plus a margin of 2.75% to 3.25%. ARM loans held in the Banks' portfolios do not permit negative amortization of principal and carry no prepayment restrictions. Borrower demand for ARM loans versus fixed-rate mortgage loans is a function of the level of interest rates, the expectations of changes in the level of interest rates and the difference between the initial interest rates and fees charged for each type of loan. In recent years borrower demand for ARM loans has been limited and the Banks have chosen not to aggressively pursue ARM loans by offering minimally profitable deeply discounted teaser rates. As a result ARM loans have represented only a very small portion of loans originated during this period. The retention of ARM loans in the Banks' loan portfolios can help reduce the Company's exposure to changes in interest rates. There are, however, unquantifiable credit risks resulting from the potential of increased interest to be paid by the customer due to increases in interest rates. It is possible that, during periods of rising interest rates, the risk of default on ARM loans may increase as a result of repricing and the increased costs to the borrower. Furthermore, because the ARM loans originated by the Banks generally provide, as a marketing incentive, for initial rates of interest below the rates which would apply were the adjustment index plus the margin used for pricing initially, these loans are subject to increased risks of default or delinquency. The Banks attempt to reduce the potential for delinquencies and defaults on ARM loans by qualifying the borrower based on the borrower's ability to repay the ARM loan assuming that the maximum interest rate that could be charged at the first adjustment period remains constant during the loan term. Another consideration is that although ARM loans allow the Banks to increase the sensitivity of their asset bases to changes in the interest rates, the extent of this interest sensitivity is limited by the periodic and lifetime interest rate adjustment limits (caps). Because of these considerations, the Company has no assurance that yields on ARM loans will be sufficient to offset increases in its cost of funds. It is the Banks' normal policy to lend up to 95% of the lesser of the appraised value of the property or purchase price of the property on conventional loans, although ARM loans are normally restricted to not more than 90%. Higher loan-to-value ratios are available on certain government insured programs and on a recently introduced limited program strictly underwritten and insured by United Guaranty Insurance Corporation. The Banks generally require private mortgage insurance on residential loans with a loan-to-value ratio at origination exceeding 80%. Construction and Land Lending: FSBW and TB invest a significant proportion of their loan portfolio in residential construction loans to professional home builders. This activity has been prompted by favorable economic conditions in the Northwest, lower long-term interest rates and an increased demand for housing units as a result of the migration of people from other parts of the country to the Northwest. To a lesser extent, FSBW and TB also originates land loans. IEB also originates construction and land loans although to a much smaller degree than FSBW and TB. At March 31, 1999, construction and land loans totaled $217.1 million, or 18.2% of total loans of the Company. Construction loans made by the Banks include both those with a sale contract or permanent loan in place for the finished homes and those for which purchasers for the finished homes may be identified either during or following the construction period. The Banks monitor the number of unsold homes in their construction loan portfolios, and generally maintain the portfolios so that no more than 60-70% of their construction loans are secured by homes for which there is not a sale contract in place. 7 Construction and land lending affords the Banks the opportunity to achieve higher interest rates and fees with shorter terms to maturity than does single-family permanent mortgage lending. Construction and land lending, however, is generally considered to involve a higher degree of risk than single-family permanent mortgage lending because of the inherent difficulty in estimating both a property's value at completion of the project and the estimated cost of the project. The nature of these loans is such that they are generally more difficult to evaluate and monitor. If the estimate of construction cost proves to be inaccurate, the Banks may be required to advance funds beyond the amount originally committed to permit completion of the project. If the estimate of value upon completion proves to be inaccurate, the Banks may be confronted at, or prior to, the maturity of the loan with a project whose value is insufficient to assure full repayment. Projects may also be jeopardized by disagreements between borrowers and builders and by the failure of builders to pay subcontractors. Loans to builders to construct homes for which no purchaser has been identified carry more risk because the payoff for the loan is dependent on the builder's ability to sell the property prior to the time that the construction loan is due. The Banks have sought to address these risks by adhering to strict underwriting policies, disbursement procedures, and monitoring practices. The maximum number of speculative loans approved for each builder is based on a combination of factors, including the financial capacity of the builder, the market demand for the finished product, and the ratio of sold to unsold inventory the builder maintains. The Banks have chosen to diversify the risk associated with speculative construction lending by doing business with a large number of smaller builders spread over a relatively large geographic area. Loans for the construction of one-to four-family residences are generally made for a term of 12 months. The Banks' loan policies include maximum loan-to- value ratios of up to 80% for speculative loans. Each individual speculative loan request is supported by an independent appraisal of the property and the loan file includes a set of plans, a cost breakdown and a completed specifications form. All speculative construction loans must be approved by senior loan officers. At March 31, 1999, the Company's speculative construction portfolio included loans to 221 individual builders in 90 separate communities. At March 31, 1999, the Company had 29 home builders, who individually in the aggregate, had construction loans outstanding with balances exceeding $1.0 million. The Company regularly monitors the construction loan portfolio and the economic conditions and housing inventory in each of its markets and will decrease construction lending if it perceives there are unfavorable market conditions. The Company believes that the internal monitoring system in place mitigates many of the risks inherent in its construction lending. To a much lesser extent, the Banks make land loans to developers, builders and individuals to finance the acquisition and/or development of improved lots or unimproved land. In making land loans the Banks follow underwriting policies and disbursement procedures similar to those for construction loans. The initial term on land loans is typically one to three years with interest only payments, payable monthly, and provisions for principal reduction as lots are sold and released. Multifamily and Commercial Real Estate Lending: The Banks also originate loans secured by multifamily and commercial real estate. At March 31, 1999, the Company's loan portfolio included $57.5 million in multifamily and $267.4 million in commercial real estate loans (including commercial real estate construction lending). Multifamily and commercial real estate lending affords the Banks an opportunity to receive interest at rates higher than those generally available from one- to four-family residential lending. However, loans secured by such properties are generally greater in amount, more difficult to evaluate and monitor and, therefore, involve a greater degree of risk than one-to four-family residential mortgage loans. Because payments on loans secured by multifamily and commercial properties are often dependent on the successful operation and management of the properties, repayment of such loans may be affected by adverse conditions in the real estate market or the economy. In all multifamily and commercial real estate lending, the Banks consider the location, marketability and overall attractiveness of the properties. The Banks current underwriting guidelines for commercial real estate loans require an appraisal from a qualified independent appraiser and an economic analysis of each property with regard to the annual revenue and expenses, debt service coverage and fair value to determine the maximum loan amount. In the approval process the Banks assess the borrowers willingness and ability to repay and the adequacy of the collateral. 8 Multifamily and commercial real estate loans originated by the Banks are predominately fixed rate loans with intermediate terms of 10 years. More recently originated multifamily and commercial loans are linked to various constant maturity U.S. Treasury indices or certain prime rates. Rates on these ARM loans generally adjust annually after an initial period ranging from one to ten years. Rate adjustments for the more seasoned ARM loans in the portfolio predominantly reflect changes in the Federal Home Loan Bank (FHLB) National Monthly Median Cost of Funds index. The Banks' commercial real estate portfolios consist of loans on a variety of property types including motels, nursing homes, office buildings, and mini-warehouses. Multifamily loans generally are secured by small to medium sized projects. At March 31, 1999, the Banks' loan portfolio included 136 multifamily loans, the average loan balance of which was $407,000. At March 31, 1999, the Banks had 59 multifamily or commercial real estate loans with balances over $3.3 million, the largest of which was $5.3 million. Most of the properties securing these multifamily and commercial real estate loans are located in the Northwest however the Company has acquired some participation loans on properties located in California. Agriculture/commercial Lending. Inland Empire Bank has been very active in small business and agricultural lending, Towne Bank has also been very active in commercial lending, however TB generally has not engaged in agricultural lending. IEB and TB's management have devoted a great deal of effort to developing customer relationships and the ability to serve this type of borrower. It is management's belief that many very large banks have in the past neglected small business lending, thus contributing to IEB's and TB's success. IEB and TB will continue to emphasize this segment of lending in their market areas. Management intends to leverage their past success and local decision making ability to continue to expand this market niche. Historically, Towne Bank has sold most of its small business administration loans into the secondary market, servicing retained, and has continued to so do subsequent to its acquisition by the Company. First Savings Bank has recently begun making non-mortgage agricultural and commercial loans. FSBW has staffed its Walla Walla, Tri-Cities, Clarkston, Yakima and Wenatchee offices with experienced commercial bankers and anticipates a steady growth in the origination of small business and agricultural loans. It is expected the growth will come primarily from FSBW's existing customer base and referrals from officers and Directors. In addition to providing higher yielding assets, it is anticipated that this type of lending will increase the deposit base of these branches. Expanding non--mortgage agricultural/commercial lending is currently an area of significant effort at FSBW. Similar to IEB and TB, WSB and SCB have been active in commercial lending. Similar to consumer loans, agricultural and commercial loans may entail greater risk than do residential mortgage loans. Agricultural and commercial loans may be unsecured or secured by special purpose or rapidly depreciating assets, such as equipment, crops, live stock, inventory and receivables which may not provide an adequate source of repayment on defaulted loans. In addition, agricultural and commercial loans are dependent on the borrower's continuing financial stability and management ability as well as market conditions for various products, services and commodities. For these reasons, agricultural and commercial loans generally provide higher yields than residential loans but also require more administrative and management attention. Interest rates on agricultural and commercial loans may be either fixed or adjustable. Loan terms including the fixed or adjustable interest rate, the loan maturity and the collateral considerations vary significantly and are negotiated on an individual loan basis. At March 31, 1999, agribusiness/commercial loans totaled $196.7 million, or 16.5% of total loans of the Company. In all agricultural and commercial lending, the Banks consider the borrowers credit worthiness and ability to repay and the adequacy of the offered collateral. Current underwriting guidelines for agricultural/commercial loans require an economic analysis with regard to annual revenue and expenses, debt service coverage, collateral and fair value to determine the maximum loan amount. Before the Banks make a commercial loan, the borrower must obtain the approval of various levels of Bank personnel, depending on the size and characteristics of the loan. Consumer and Other Lending: The Banks originate a variety of consumer loans, including secured second mortgage loans, automobile loans, credit card loans and loans secured by deposit accounts. Consumer and other lending has traditionally been a small part of FSBW's and TB's business. However, recent efforts at FSBW have led to a substantial increase in credit card loans to its existing customer base. Inland Empire Bank, on the other hand, has been an active originator of consumer loans. At March 31, 1999, the Company had $44.4 million, or 3.7% of its loans receivable, in outstanding consumer and other loans. 9 Consumer loans often entail greater risk than do residential mortgage loans, particularly in the case of consumer loans which are unsecured or secured by rapidly depreciating assets such as automobiles. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. The remaining deficiency often does not warrant further substantial collection efforts against the borrower beyond obtaining a deficiency judgment. In addition, consumer loan collections are dependent on the borrower's continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans. Such loans may also give rise to claims and defenses by a consumer loan borrower against an assignee of such loans such as the Banks, and a borrower may be able to assert against such assignee claims and defenses that it has against the seller of the underlying collateral. Loan Solicitation and Processing: The Banks originate real estate loans by direct solicitation of real estate brokers, builders, depositors, and walk-in customers. Loan applications are taken by the Banks' loan officers and are processed in each branch location. Most underwriting and all audit functions are performed by loan administration personnel at each Bank's main office. Applications for fixed-rate and adjustable-rate mortgages on one-to four-family properties are generally underwritten and closed based on Freddie Mac/Fannie Mae standards, and other loan applications are underwritten and closed based on the Banks' own written guidelines. Consumer loans are originated through various marketing efforts directed primarily toward existing deposit and loan customers of the Banks. Consumer loan applications may be processed at branch locations or by administrative personnel at the Banks' main offices. Commercial and agricultural loans are solicited by loan officers of each Bank by means of call programs focused on local businesses and farmers. Credit decisions on significant commercial and agricultural loans are made by senior loan officers or in certain instances by the Board of Directors of each Bank or the Company. LOAN ORIGINATIONS, SALES AND PURCHASES While the Banks originate a variety of loans, their ability to originate loans and their ability to originate each type of loan is dependent upon the relative customer demand and competition for loans in each market. For the years ended March 31, 1999, 1998 and 1997, the Banks originated $734.1 million, $513.5 million and $330.3 million of loans, respectively. The Company's net loan portfolio grew $345.8 million or 45.7% in fiscal 1999 ($146.4 million excluding acquisitions) compared to $111.0 million of growth in fiscal 1998 and $230.6 million of growth in fiscal 1997 ($90.5 million excluding acquisitions). In recent years prior to 1996 the Company generally sold most of its 30-year fixed-rate one- to four-family residential mortgage loans to secondary market purchasers. For the years ended March 31, 1996 and 1997 the Company sold a smaller portion of its fixed-rate loan originations choosing to retain loans in response to its capital deployment and growth objectives. In the second half of fiscal year 1999 the Company increased the amount of new fixed-rate residential loan sold as part of its interest rate risk management strategy. Sales of loans by the Company for the years ended March 31, 1999, 1998 and 1997 totaled $125.7 million, $80.6 million and $36.6 million, respectively. Sales of whole loans generally are beneficial to the Company since these sales may generate income at the time of sale, provide funds for additional lending and other investments and increase liquidity. The Company sells loans on both a servicing-retained and a servicing-released basis. See "Loan Servicing-Loan Servicing Portfolio." At March 31, 1999, the Company had $12.4 million in loans held for sale. The Banks, especially FSBW, purchase whole loans and loan participation interests primarily during periods of reduced loan demand in their primary market. Any such purchases are made consistent with the Banks' underwriting standards; however, the loans may be located outside of the Banks' normal lending area. During the years ended March 31, 1999, 1998 and 1997, the Company purchased $86.2 million, $51.1 million and $74.1 million, respectively, of loans and loan participation interests. 10 LOAN PORTFOLIO ANALYSIS.. The following table sets forth the composition of the Company's loan portfolio (including loans held for sale) by type of loan as of the dates indicated. MARCH 31 -------------------------------------------------------------------------------------- 1999 1998 1997 1996 1995 ----------------- ---------------- --------------- --------------- --------------- Amount Percent Amount Percent Amount Percent Amount Percent Amount Percent ------ ------- ------ ------- ------ ------- ------ ------- ------ ------- (Dollars in thousands) TYPE OF LOAN: ------------- One-to four-family real estate $ 407,673 34.24% $423,850 51.53% $395,418 55.86% $311,472 68.24% $199,585 59.81% Commercial and multifamily properties 324,858 27.28 167,859 20.41 129,198 18.25 77,613 16.99 73,443 22.01 Construction and land 217,094 18.23 132,409 16.10 110,262 15.58 62,177 13.62 57,913 17.36 Agriculture/ commercial 196,743 16.52 67,611 8.22 47,846 6.76 871 .19 902 .27 Consumer and other 44,346 3.73 30,842 3.74 25,092 3.55 4,333 .96 1,842 .55 --------- ------ ------- ------ -------- ------ ------- ------ -------- ------ Total loans 1,190,714 100.00% 822,571 100.00% 707,816 100.00% 456,466 100.00% 333,685 100.00% --------- ====== ------- ====== -------- ====== ------- ====== ------- ====== Undisbursed funds for loans in progress 71,638 54,500 52,412 35,244 28,507 Deferred loan fees and discounts 4,146 3,297 2,775 1,876 2,226 Allowance for loan losses 12,261 7,857 6,748 4,051 3,549 ---------- -------- -------- -------- -------- Total loans receivable, net $1,102,669 $756,917 $645,881 $415,295 $299,403 ========== ======== ======== ======== ======== 11
LOAN MATURITY AND REPRICING The following table sets forth certain information at March 31, 1999 regarding the dollar amount of loans maturing in the Company's portfolio based on their contractual terms to maturity, but does not include scheduled payments or potential prepayments. Demand loans, loans having no stated schedule of repayments and no stated maturity, and overdrafts are reported as due in one year or less. Loan balances are net of undisbursed loan proceeds, unamortized premiums and discounts, and exclude the allowance for loan losses (in thousands): Maturing Maturing Maturing Maturing within within within Maturing Within 1 to 3 to 5 to Beyond One Year 3 Years 5 Years 10 Years 10 Years Total -------- -------- --------- --------- -------- ---------- One-to four- family real estate $ 3,549 $ 3,645 $ 6,098 $ 15,774 $360,418 $ 389,484 Commercial and multifamily properties 24,235 50,053 60,833 116,501 67,823 319,445 Construction and land 141,881 13,313 1,955 3,968 4,138 165,255 Agriculture/ commercial 96,955 20,000 36,009 35,213 8,189 196,366 Consumer and other 16,555 9,239 11,421 2,549 4,616 44,380 -------- -------- --------- --------- -------- ---------- Total loans $283,175 $ 96,250 $ 116,316 $ 174,005 $445,184 $1,114,930 ======== ======== ========= ========= ======== ========== Scheduled contractual principal repayments of loans do not reflect the actual life of such assets. The average life of loans is substantially less than their contractual terms because of prepayments. In addition, due-on-sale clauses on loans generally give the Company the right to declare loans immediately due and payable in the event that the borrower sells the real property subject to the mortgage and the loan is not repaid. The average life of mortgage loans tends to increase, however, when current mortgage loan market rates are substantially higher than rates on existing mortgage loans and, conversely, decreases when rates on existing mortgage loans are substantially higher than current mortgage loan market rates. The following table sets forth the dollar amount of all loans due after March 31, 2000, which have fixed interest rates and floating or adjustable interest rates (in thousands). Fixed Floating or Rates Adjustable Rates Total ----- ---------------- ----- One-to four-family real estate $315,081 $ 70,854 $385,935 Commercial and multifamily properties 190,606 104,604 295,210 Construction and land 7,965 15,409 23,374 Agriculture/commercial 42,759 56,652 99,411 Consumer and other 21,238 6,587 27,825 -------- -------- -------- Total $577,649 $254,106 $831,755 ======== ======== ======== 12 LOAN SERVICING General: The Banks receive fees from a variety of institutional owners in return for performing the traditional services of collecting individual payments and managing portfolios of sold loans. At March 31, 1999, the Banks were servicing $268.8 million of loans for others. Loan servicing includes processing payments, accounting for loan funds and collecting and paying real estate taxes, hazard insurance and other loan-related items such as private mortgage insurance. When the Banks receive the gross loan payment from individual borrowers, they remit to the investor a predetermined net amount based on the yield on that loan. The difference between the coupon on the underlying loan and the predetermined net amount paid to the investor is the gross loan servicing fee. In addition, the Banks retain certain amounts in escrow for the benefit of the lender for which the Banks incur no interest expense but are able to invest the funds into earning assets. At March 31, 1999, the Banks held $4.1 million in escrow for their portfolios of loans serviced for others. Loan Servicing Portfolio: The loan servicing portfolio at March 31, 1999 was composed primarily of $32.8 million of Fannie Mae mortgage loans and $198.0 million of Freddie Mac mortgage loans. The balance of the loan servicing portfolio at March 31, 1999, consisted of loans serviced for a variety of private investors. At March 31, 1999, the portfolio included loans secured by property located primarily in the states of Washington or Oregon. For the year ended March 31, 1999, $798,000 of loan servicing fees, net of $278,000 of servicing rights amortization, were recognized in operations. Mortgage Servicing Rights: In addition to the origination of mortgage servicing rights (MSRs) on the loans that FSBW originates and sells in the secondary market on a servicing retained basis, FSBW has also purchased mortgage servicing rights. The cost of MSRs is capitalized and amortized in proportion to, and over the period of, the estimated future net servicing income. For the years ending March 31, 1999 and 1998 FSBW capitalized $981,000 and $442,000, respectively, of mortgage servicing rights relating to loans sold with servicing retained, in addition, $270,000 of MSR's were obtained in the acquisition of WSB. No MSRs were purchased in fiscal years 1999, 1998 and 1997. Amortization of MSR's for the year ended March 31, 1999 was $278,000 compared to $100,000 for the year ended March 31, 1998. Management periodically evaluates the estimates and assumptions used to determine the carrying values of MSRs and the amortization of MSRs. These carrying values are adjusted when the valuation indicates the carrying value is impaired. At March 31, 1999, MSRs were carried by FSBW at a value, net of amortization, of $1,671,000, and no valuation allowance for impairment was considered necessary. MSRs generally are adversely affected by current and anticipated prepayments resulting from decreasing interest rates. ASSET QUALITY Each Bank's asset classification committee meets at least monthly to review all classified assets, to approve action plans developed to resolve the problems associated with the assets and to review recommendations for new classifications, any changes in classifications and recommendations for reserves. The committee reports to the Board of Directors quarterly as to the current status of classified assets and action taken in the preceding quarter. State and federal regulations require that the Banks review and classify their 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. There are three classifications for problem assets: substandard, doubtful and loss. Substandard assets must have one or more defined weaknesses and are characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected. Doubtful assets have the weaknesses of substandard assets with the additional characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions and values questionable, and there is a significant possibility of loss. An asset classified loss is considered uncollectible and of such little value that continuance as an asset of the institution is not warranted. The regulations have also created a special mention category, described as assets which do not currently expose an insured institution to a sufficient degree of risk to warrant classification but do possess credit deficiencies or potential weaknesses deserving management's close attention. If an asset or portion thereof is classified loss, the insured institution establishes specific allowances for loan losses for the full amount of the portion of the asset classified loss. A portion of general loan loss allowances established to cover possible losses related to assets classified substandard or doubtful may be included in determining an institution's regulatory capital, while specific valuation allowances for loan losses generally do not qualify as regulatory capital. 13 At March 31, 1999, 1998 and 1997, the aggregate amounts of the Banks' classified assets (as determined by the Banks) were as follows (in thousands): At March 31 --------------------------------------- 1999 1998 1997 ---- ---- ---- Loss $ 60 $ - - $ - - Doubtful 58 - - - - Substandard assets 8,302 2,776 4,175 Special mention 3,008 - - - - NON-PERFORMING ASSETS AND DELINQUENCIES. Real Estate Loans: When a borrower fails to make a required payment when due, the Banks follow established collection procedures. The first notice is mailed to the borrower within 10 to 17 days after the payment due date and attempts to contact the borrower by telephone begin within five to ten days after the late notice is mailed to the borrower. If the loan is not brought current by 30 days after the payment due date, the Banks will mail a second written notice to the borrower. If a satisfactory response is not obtained, continuous follow-up contacts are attempted until the loan has been brought current. Generally, for residential loans within 30 to 45 days into the delinquency procedure, the Banks notify the borrower that home ownership counseling is available. In most cases, delinquencies are cured promptly; however, if after 90 days of delinquency no response has been received nor an approved reinstatement plan established, foreclosure according to the terms of the security instrument and applicable law is initiated. Interest income on loans after 90 days of delinquency is no longer accrued and the full amount of accrued and uncollected interest is reversed. Agriculture/commercial and Consumer Loans: When a borrower fails to make payments as required, a late notice is sent to the borrower. If payment is still not made the responsible loan officer is advised and contact is made my telephone or letter. Continuous follow-up contacts are attempted until the loan has been brought current. Generally, if the loan is not current within 45 to 60 days, action is taken to take possession of the security. A small claims or lawsuit is normally filed on unsecured loans or deficiency balances at 90 to 120 days. Loans over 90 days delinquent, repossessions, loans in foreclosure and bankruptcy no longer accrue interest unless a satisfactory repayment plan has been agreed upon, the loan is a full recourse contract or fully secured by a deposit account. 14 The following table sets forth information with respect to the Banks' 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). At March 31 --------------------------------- 1999 1998 1997 1996 1995 ---- ---- ---- ---- ---- Loans accounted for on a nonaccrual basis: Real estate One- to four-family $3,564 $ 448 $1,644 $ 526 $336 Commercial and multifamily 351 -- 187 -- -- Construction and land 767 367 -- -- -- Agriculture/commercial 1,439 414 206 -- -- Consumer and other 17 41 45 -- 5 ------ ------ ------ ------ ---- Total 6,138 1,270 2,082 526 341 ------ ------ ------ ------ ---- Accruing loans which are contractually past due 90 days or more: Real estate One-to four family 20 52 -- -- -- Commercial and multifamily 384 33 -- -- Construction and land -- 32 -- -- -- Agriculture/commercial 1,052 -- -- -- -- Consumer and other 82 33 30 12 -- ------ ------ ------ ------ ---- Total 1,538 150 30 12 -- ------ ------ ------ ------ ---- Total non-performing loans 7,676 1,420 2,112 538 341 Real estate/repossessed assets held for sale 1,644 882 1,057 712 588 ------ ------ ------ ------ ---- Total non-performing assets $9,320 $2,302 $3,169 $1,250 $929 ====== ====== ====== ====== ==== Restructured loans (1) $ 380 $ 305 $ 238 $ 156 $ 165 Total non-performing loans to net loans 0.69% 0.19% 0.33% 0.13% 0.11% Total non-performing loans to total assets 0.47% 0.20% 0.21% 0.07% 0.07% Total non-performing assets to total assets 0.57% 0.20% 0.31% 0.17% 0.19% (1) These loans are performing under their restructured terms but are classified substandard. For the year ended March 31, 1999, $269,000 in interest income would have been recorded had nonaccrual loans been current, and no interest income on such loans was included in net income for such period. 15 ALLOWANCE FOR LOAN LOSSES General: In originating loans, the Banks recognize that losses will be experienced and that the risk of loss will vary with, among other things, the type of loan being made, the creditworthiness 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 Banks maintain an allowance for loan losses consistent with the generally acceptable accounting principles (GAAP) guidelines outlined in SFAS No. 5, Accounting for Contingencies. The Banks have established systematic methodologies for the determination of the adequacy of their 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 Banks increase their allowance for loan losses by charging provisions for possible loan losses against the Bank's income. On April 1, 1995, the Company and its subsidiary Banks adopted 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 Disclosures, an amendment of SFAS No. 114. These statements require that impaired loans that are within their scope be 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 measurement of impaired loans shall be 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. The adoption of these statements had no material impact on the Company's or Banks' financial condition or results of operations. Prior to the adoption of these statements a reserve for specific losses was provided for loans when any significant, permanent decline in value was deemed to have occurred. As of March 31, 1999, the Company and its subsidiary Banks had identified $3.7 million of impaired loans as defined by the statement and had established $739,000 of allocated reserves for these loans. The statements also apply to all loans that are restructured in a troubled debt restructuring, subsequent to the adoption of SFAS No. 114, as defined by SFAS No. 15. A troubled debt restructuring is a restructuring in which the creditor grants a concession to the borrower that it would not otherwise consider. At March 31, 1999, the Company had $380,000 of restructured loans that, though performing, were classified substandard. 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 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. Additions to these allowances are charged to earnings. Realized losses and charge-offs that are related to specific loans are applied as a reduction of the carrying value of the assets and charged immediately against the allowance for losses. 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. 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. 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. 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 Bank's control. 16 At March 31, 1999, the Company had an allowance for loan losses of $12.3 million which represented 1.10% of net loans and 160% of non-performing loans compared to 1.03% and 533%, respectively, at March 31, 1998. The provision for loan losses for the year ended March 31, 1999, increased by $1.2 million to $2.8 million compared to $1.6 million for fiscal 1998. This increase is reflective of the growth in loans receivable which, excluding loans acquired through business combination, increased by $165.7 million for the 1999 fiscal year compared to an increase of $111.0 million in the 1998 period. The increase also is reflective of changes in the portfolio mix which resulted in the need for a higher level of loss allowance as well as the impact of a greater amount of non-performing loans and net charge-offs for the year. Specifically, excluding loans acquired through acquisitions, changes in the loan mix included increases of $119.8 million in commercial and multifamily real estate loans, $59.3 million in construction and land loans, and $27.9 million in commercial and agricultural loans, while one- to four-family loans declined by $40.3 million and consumer loans declined by $1 million. Income producing real estate loans, construction and land loans, commercial and agricultural loans are generally riskier than one- to four-family residential loans resulting in a higher provision for losses. Adding to the need for the increased provision for loan losses for the year ended March 31, 1999 was an increase in the amount of non-performing loans which grew to $7.7 million compared to $1.4 million a year earlier. Further adding to the increase in the provision for loan losses was an increase in the level of net charge-offs which increased from $519,000 for the year ended March 31, 1998, to $1.1 million for the year ended March 31, 1999 (see Notes 7 and 8 to the Consolidated Financial Statements for further analysis of the loan portfolio mix and allowance for loan losses). While the Company believes that the Banks have established their existing allowance for loan losses in accordance with Generally Accepted Accounting Principles (GAAP), there can be no assurance that regulators, in reviewing the Banks' loan portfolio, will not request the Banks to increase significantly their allowance for loan losses. In addition, because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing allowance for loan losses is adequate or that substantial increases will not be necessary should the quality of any loans deteriorate as a result of the factors discussed above. Any material increase in the allowance for loan losses may adversely affect the Company's financial condition and results of operations. Real Estate Held for Sale, Repossessed Assets: Real estate acquired by the Company as a result of foreclosure or by deed-in-lieu of foreclosure is classified as real estate held for sale until it is sold. When property is acquired it is recorded at the lower of its cost (the unpaid principal balance of the related loan plus foreclosure costs), or net realizable value. Subsequent to foreclosure, the property is carried at the lower of the foreclosed amount or net realizable value. Upon receipt of a new appraisal and market analysis, the carrying value is written down through the establishment of a specific reserve to the anticipated sales price less selling and holding costs. At March 31, 1999, the Company had $1.4 million of real estate owned and $205,000 of other repossessed assets. 17 The following table sets forth an analysis of the Company's gross allowance for possible loan losses for the periods indicated. Years Ended March 31 ------------------------------------------- 1999 1998 1997 1996 1995 ---- ---- ---- ---- ---- (Dollars in thousands) Allowance at beginning of period $ 7,857 $6,748 $4,051 $3,549 $3,429 ------- ------ ------ ------ ------ Acquisitions 2,693 -- 1,416 -- -- ------- ------ ------ ------ ------ Provision for loan losses 2,841 1,628 1,423 524 391 ------- ------ ------ ------ ------ Recoveries: Secured by real estate One - to four-family -- 6 38 -- -- Commercial and multifamily 60 -- -- -- -- Construction and land -- -- -- -- -- Agriculture/commercial 144 29 -- -- -- Consumer and other 21 16 16 -- -- ------- ------ ------ ------ ------ Total recoveries 225 51 54 -- -- ------- ------ ------ ------ ------ Charge-offs: Secured by real estate One - to four-family 25 359 127 -- -- Commercial and multifamily 35 -- -- -- 271 Construction and land 69 11 -- -- -- Agriculture/commercial 916 19 3 -- -- Consumer and other 310 181 66 22 -- ------- ------ ------ ------ ------ Total charge-offs 1,355 570 196 22 271 ------- ------ ------ ------ ------ Net charge-offs 1,130 519 142 22 271 ------- ------ ------ ------ ------ Balance at end of period $12,261 $7,857 $6,748 $4,051 $3,549 ======= ====== ====== ====== ====== Ratio of allowance to net loans outstanding at the end of the period 1.10% 1.03% 0.94% 0.97% 1.17% Ratio of net loan charge-offs to the average net book value of loans outstanding during the period 0.14% 0.08% 0.04% 0.01% 0.10% 18 The following table sets forth the breakdown of the allowance for loan losses by loan category for the periods indicated. At March 31 --------------------------------------------------------------------------------------- 1999 1998 (2) 1997 1996 1995 --------------- ----------------- --------------- -------------- ----------------- Percent Percent Percent Percent Percent of Loans of Loans of Loans of Loans of Loans in Each in Each in Each in Each in Each Category Category Category Category Category to to to to to Total Total Total Total Total Amount Loans Amount Loans Amount Loans Amount Loans Amount Loans ------ ----- ------ ----- ------ ----- ------ ----- ------ ----- (Dollars in thousands) Specific or allocated loss allowances: Secured by real estate One-to four- family $ 2,757 34.24% $ 1,059 51.53% $ 1,098 55.86% $ -- 68.24%$ 11 59.81% Commercial and multifamily 3,567 27.28 849 20.41 547 18.25 -- 16.99 46 22.01 Construction and land 1,597 18.23 856 16.10 844 15.58 -- 13.62 -- 17.36 Agriculture/ commercial 2,522 16.52 835 8.22 422 6.76 -- .19 -- .27 Consumer and other 841 3.73 307 3.74 237 3.55 -- .96 -- .55 Unallocated general loss allowance (1) (2) 977 N/A 3,951 N/A 3,600 N/A 4,051 N/A 3,492 N/A Total allowance -------- ------ ------- ------ ------- ------ ------- ------ ------- ------ for loan losses $ 12,261 100.00% $ 7,857 100.00% $ 6,748 100.00% $ 4,051 100.00% $ 3,549 100.00% ======== ====== ======= ====== ======= ====== ======= ====== ======= ====== - ------------------- (1) The Company establishes specific loss allowances when individual loans are identified that present a possibility of loss (i.e., that full collectibility is not reasonably assured). The remainder of the allowance for loan losses is established for the purpose of providing for estimated losses which are inherent in the loan portfolio. (2) For 1997 the Company has not changed how it determines the adequacy of its allowance for loan losses other than to allocate the non-specific loan loss reserves to loan categories that were the basis for its accrual. In the periods prior to 1997, it was not the Company's practice to allocate general loan loss allowances to specific loan categories. 19
INVESTMENT ACTIVITIES Under Washington and Oregon state law, banks are permitted to invest in various types of marketable securities. Authorized securities include but are not limited to U.S. Treasury obligations, securities of various federal agencies, mortgage-backed securities, certain certificates of deposit of insured banks and savings institutions, banker's acceptances, repurchase agreements, federal funds, commercial paper, corporate debt and equity securities and obligations of states and their political sub-divisions. The investment policies of the Banks are designed to provide and maintain adequate liquidity and to generate favorable rates of return without incurring undue interest rate or credit risk. The Banks' policies generally limit investments to U.S. Government and agency securities, municipal bonds, certificates of deposit, marketable corporate debt obligations and mortgage-backed securities. Investment in mortgage-backed securities includes those issued or guaranteed by Freddie Mac (FHLMC), Fannie Mae (FNMA), Government National Mortgage Association (GNMA) and privately-issued collateralized mortgage-backed securities that have an AA credit rating or higher. A high credit rating indicates only that the rating agency believes there is a low risk of loss or default. However, all of the Banks' investment securities, including those that have high credit ratings, are subject to market risk in so far as a change in market rates of interest or other conditions may cause a change in an investment's market value. At March 31, 1999, the Company's consolidated investment portfolio totaled $364.2 million and consisted principally of U.S. Government and agency obligations, mortgage-backed securities, municipal bonds, corporate debt obligations, and stock of FNMA and FHLMC. From time to time, investment levels may be increased or decreased depending upon yields available on investment alternatives, and management's projections as to the demand for funds to be used in the Banks' loan originations, deposits and other activities. During fiscal 1999 investments and securities increased by $61.6 million (including $45.7 million obtained in the acquisitions of TB and WSB). Holdings of mortgage-backed securities increased $45.7 million and U.S. Treasury and agency obligations decreased $9.1 million. Ownership of corporate and other securities increased $20.0 million. Municipal bonds increased $5.0 million primarily from acquisitions. Mortgage-Backed and Mortgage-Related Securities: The Company purchases mortgage-backed securities in order to: (i) generate positive interest rate spreads on large principal balances with minimal administrative expense; (ii) lower the credit risk of the Company as a result of the guarantees provided by FHLMC, FMNA, and GNMA; (iii) enable the Company to use mortgage-backed securities as collateral for financing; and (iv) increase liquidity. The Company invests primarily in federal agency mortgage-backed securities, principally FNMA, FHLMC and GNMA. The Company also invests in agency sponsored and corporate collateralized mortgage obligations (CMOs) and real estate mortgage investment conduits (REMICs). At March 31, 1999, net mortgage-backed securities totaled $242.8 million, or 14.9% of total assets. At March 31, 1999, 47.6% of the mortgage-backed securities were adjustable-rate and 52.5% were fixed-rate. The estimated fair value of the Company's mortgage-backed securities at March 31, 1999, was $242.8 million, which is $607,000 less than the amortized cost of $243.4 million. At March 31, 1999, the Company's portfolio of mortgage-backed securities had a weighted average coupon rate of 6.53%. The estimated weighted average remaining life of the portfolio was 3.2 years based on the last 3 months"constant prepayment rate" (CPR) or the most recent CPR if less than 3 months history is available. Mortgage-backed securities known as PC's or mortgage pass-through certificates generally represent a participation interest in a pool of single-family mortgages. The principal and interest payments on these mortgages are passed from the mortgage originators, through intermediaries (generally U.S. Government agencies and government sponsored enterprises) that pool and resell the participation interests in the form of securities, to investors such as the Company. Mortgage participation certificates generally yield less than the loans that underlie such securities because of the cost of payment guarantees and credit enhancements. In addition, PC's are usually more liquid than individual mortgage loans and may be used to collateralized certain liabilities and obligations of the Company. These types of securities also permit the Company to optimize its regulatory capital because of their low risk weighting. 20 CMOs and REMICs are mortgage-related obligations and may be considered as derivative financial instruments because they are created by redirecting the cash flows from the pool of mortgages or mortgage-backed securities underlying these securities into two or more classes (or tranches) with different maturity or risk characteristics. Management believes these securities may represent attractive alternatives relative to other investments due to the wide variety of maturity, repayment and interest rate options available. At March 31, 1999 the Company held CMOs and REMICs with a net carrying value of $209.9 million. Of the Company's $242.8 million mortgage-backed securities portfolio at March 31, 1999, $120.0 million with a weighted average yield of 5.52% had contractual maturities or period to repricing within ten years and $122.8 million with a weighted average yield of 6.85% had contractual maturities or period to repricing over ten years. However, the actual maturity of a mortgage-backed security is usually less than its stated maturity due to prepayments of the underlying mortgages. Prepayments that are faster than anticipated may shorten the life of the security and may result in rapid amortization of premiums or discounts and thereby affect the net yield on such securities. Although prepayments of underlying mortgages depend on many factors, including the type of mortgages, the coupon rate, the age of mortgages, the geographical location of the underlying real estate collateralizing the mortgages and general levels of market interest rates, the difference between the interest rates on the underlying mortgages and the prevailing mortgage interest rates generally is the most significant determinant of the rate of prepayments. During periods of declining mortgage interest rates, if the coupon rate of the underlying mortgages exceeds the prevailing market interest rates offered for mortgage loans, refinancing generally increases and accelerates the prepayment of the underlying mortgages and the related security. Under such circumstances, the Company may be subject to reinvestment risk because, to the extent that the Company's mortgage-backed securities amortize or prepay faster than anticipated, the Company may not be able to reinvest the proceeds of such repayments and prepayments at a comparable rate. In contrast to mortgage-backed securities in which cash flow is received (and hence, prepayment risk is shared) pro rata by all securities holders, the cash flow from the mortgages or mortgage-backed securities underlying REMICs or CMOs is segmented and paid in accordance with a predetermined priority to investors holding various tranches of such securities or obligations. A particular tranche of REMICs and CMOs may therefore carry prepayment risk that differs from that of both the underlying collateral and other tranches. Municipal Bonds: The Company's tax exempt municipal bond portfolio, which at March 31, 1999, totaled $32.3 million at estimated fair value ($33.0 million at amortized cost), was comprised of general obligation bonds (i.e., backed by the general credit of the issuer) and revenue bonds (i.e., backed by revenues from the specific project being financed) issued by various authorities, hospitals, water and sanitation districts located in the states of Washington, Oregon and Idaho. At March 31, 1999, general obligation bonds and revenue bonds had total estimated fair values of $19.9 million and $14.4 million, respectively. The company also acquired taxable revenue bonds in fiscal year 1999 totaling $2.8 million at estimated fair value ($2.7 million at amortized cost). Many bank qualifying municipal bonds are not rated by a nationally recognized credit rating agency (e.g., Moody's or Standard and Poor's) due to their smaller size. At March 31, 1999, the Company's municipal bond portfolio had a weighted average maturity of approximately 10.2 years and an average coupon rate of 6.38%. The largest security in the portfolio was an industrial revenue bond issued by the City of Kent, Washington, with an amortized cost of $3.6 million and a fair value of $3.6 million. Corporate Bonds: The Company's corporate bond portfolio, which totaled $24.3 million at fair value ($24.7 million at amortized cost) at March 31, 1999, was composed of short and long-term fixed-rate and adjustable-rate securities. At March 31, 1999, the portfolio had a weighted average maturity of 18.8 years and a weighted average coupon rate of 6.58%. The longest term security, has an amortized cost of $3.2 million and a term to maturity of 28.0 years. U.S. Government and Agency Obligations: The Company's portfolio of U.S. Government and agency obligations had a fair value of $56.5 million ($56.5 million at amortized cost) at March 31, 1999. The Company's subsidiary, FSBW, has invested a small portion of its securities portfolio in structured notes. The structured notes in which FSBW has invested provide for periodic adjustments in coupon rates or prepayments based on various indices and formulae. At March 31, 1999, structured notes, which totaled $4.0 million at fair value ($4.0 million at amortized cost), consisted of a U.S. Government agency obligation which mature in 2004 and 2005. In addition, most of the U.S. Government agency obligations owned by the Company include call features which allow the issuing agency the right to call the securities at various dates prior to the final maturity. 21 Off Balance Sheet Derivatives: Derivatives include "off balance sheet" financial products whose value is dependent on the value of an underlying financial asset, such as a stock, bond, foreign currency, or a reference rate or index. Such derivatives include "forwards," "futures," "options" or "swaps." The Company generally has not invested in "off balance sheet" derivative instruments, although investment policies authorize such investments. On March 31, 1999 the Company had no off balance sheet derivatives and no outstanding commitments to purchase or sell securities. 22 The following tables sets forth certain information regarding carrying values and percentage of total carrying values, which is estimated market value, of the Company's consolidated portfolio of securities classified as available for sale and held to maturity (in thousands). At March 31 ------------------------------------------------------- Available for Sale: 1999 1998 1997 - ------------------- ------------------ ------------------ ----------------- Percent Percent Percent Carrying of Carrying of Carrying of Value Total Value Total Value Total -------- ----- -------- ------ -------- ------ U.S. Government Treasury and agency obligations $ 56,518 15.61% $ 65,594 21.69% $ 67,417 24.45% Municipal bonds (tax exempt) 32,259 8.91 32,093 10.61 33,969 11.81 Municipal bonds (taxable) 2,833 0.78 -- .-- -- .-- Corporate bonds 24,335 6.72 4,304 1.42 7,997 2.78 Other 3,441 0.95 3,298 1.09 3,758 1.31 Mortgage-backed or related securities Mortgage-backed securities: GNMA 22,508 6.22 16,862 5.58 20,273 7.05 FHLMC 3,502 0.97 3,361 1.11 3,868 1.35 FNMA 6,841 1.89 6,048 2.00 7,281 2.53 ------- ----- -------- ------ -------- ------ Total mortgage- backed securities 32,851 9.08 26,271 8.69 31,422 10.93 Mortgage-related securities CMOs-agency backed 145,299 40.14 146,300 48.38 117,212 40.77 CMOs-Non-agency 64,485 17.81 24,559 8.12 25,741 8.95 ------- ----- -------- ------ -------- ------ Total mortgage- related securities 209,784 57.95 170,859 56.50 142,953 49.72 ------- ----- -------- ------ -------- ------ Total 242,635 67.03 197,130 65.19 174,375 60.65 ------- ----- -------- ------ -------- ------ Total securities available for sale $362,021 100.00% $302,419 100.00% $287,516 100.00% ======== ====== ======== ====== ======== ====== HELD TO MATURITY: Municipal bonds (tax exempt) $ 1,991 92.39% $ -- --% -- --% CMOs - agency backed 164 7.61 -- -- -- -- Certificates of deposit -- -- 194 100.00% 987 100.00 -------- ----- -------- ------ -------- ------ Total $ 2,155 100.00% $ 194 100.00% $ 987 100.00% ======== ====== ======== ====== ======== ====== Estimated market value $ 2,235 $ 194 $ 987 ======== ======== ======== 23 The following table shows the maturity or period to repricing of the Company's consolidated portfolio of securities (dollars in thousands): At March 31 1999 ------------------------------------------------------------------------------------------------- Over One to Over Five to Over Ten to Over One Year or Less Five Years Ten Years Twenty Years Twenty Years Total ---------------- --------------- --------------- --------------- ---------------- ---------------- Weight- Weight- Weight- Weight- Weight- Weight- Carry- ed Carry- ed Carry- ed Carry- ed Carry- ed Carry- ed ing Average ing Average ing Average ing Average ing Average ing Average Value Yield Value Yield Value Yield Value Yield Value Yield Value Yield ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- Available for sale -------- U. S. Government Treasury and agency obligations Fixed- rate $ 5,519 5.59% $43,836 5.86% $ 2,999 6.14% $ -- --% $ -- -- % $ 52,354 5.93% Adjustable- rate 4,164 5.69 -- -- -- -- -- -- -- -- 4,164 5.69 -------- ---- ------- ---- ------- ---- ------- ---- -------- ---- -------- ---- 9,683 5.63 43,836 5.86 2,999 6.14 -- -- -- -- 56,518 5.91 Municipal bonds- taxable -- -- -- -- 1,029 6.68 1,555 8.08 249 5.05 2,833 7.29 Municipal bonds- exempt 1,878 5.29 4,875 5.59 12,854 6.32 9,230 6.94 3,422 5.52 32,259 6.23 -------- ---- ------- ---- ------- ---- ------- ---- -------- ---- -------- ---- 1,878 5.29 4,875 5.59 13,883 6.35 10,785 7.10 3,671 5.49 35,092 6.32 Corporate bonds Fixed-rate 11,380 5.90 4,021 5.81 3,005 6.49 -- -- 5,929 7.26 24,335 5.51 Mortgage-backed obligations: Fixed-rate -- -- 406 6.12 371 9.04 1,466 10.12 23,841 6.70 26,084 6.92 Adjustable- rate 6,135 6.71 632 6.54 -- -- -- -- -- -- 6,767 6.70 -------- ---- ------- ---- ------- ---- ------- ----- -------- ---- -------- ---- 6,135 6.71 1,038 6.38 371 9.04 1,466 10.12 23,841 6.70 32,851 6.87 Mortgage-related obligations: Fixed-rate 422 10.55 -- -- 3,535 6.89 5,525 6.09 91,800 6.89 101,282 6.86 Adjustable- rate 108,502 5.37 -- -- -- -- -- -- -- -- 108,502 5.37 -------- ---- ------- ---- ------- ---- ------- ---- -------- ---- -------- ---- 108,924 5.39 -- -- 3,535 6.89 5,525 6.09 91,800 6.89 209,784 6.09 -------- ---- ------- ---- ------- ---- ------- ---- -------- ---- -------- ---- Total mortgage- backed or related obliga- tions 115,059 5.46 1,038 6.38 3,906 7.09 6,991 6.94 115,641 6.85 242,635 6.20 Other-- stock 37 6.25 3,404 8.80 -- -- -- -- -- -- 3,441 8.77 -------- ---- ------- ---- ------- ---- ------- ---- -------- ---- -------- ---- Total securities available for sale-- carrying value $138,037 5.54% $57,174 6.02% $23,793 6.17% $17,776 6.33% $125,241 6.82% $362,021 6.08% ======== ======= ======= ======= ======== ======== Total securities available for sale-- amortized cost $194,654 $ 35,833 $24,888 $18,472 $ 24,499 $298,346 ======== ======= ======= ======= ======== ======== 24
Held to Maturity - -------- Mortgage- related obligation fixed rate -- -- -- -- -- -- -- 164 5.73 164 5.73 Municipal bonds- exempt 285 6.54 1,172 7.45 434 7.80 100 10.00 -- -- 1,991 7.52 Fixed- rate $ 285 6.54% $ 1,172 7.45% $ 434 7.80% $ 100 10.00% $ 164 5.73% $ 2,155 7.39% ======== ======= ======= ======= ======== ======== 25
DEPOSIT ACTIVITIES AND OTHER SOURCES OF FUNDS General: Deposits, FHLB advances (or borrowings) and loan repayments are the major sources of the Banks' funds for lending and other investment purposes. Scheduled loan repayments are a relatively stable source of funds, while deposit inflows and outflows and loan prepayments are influenced significantly by general interest rates and money market conditions. Borrowings may be used on a short-term basis to compensate for reductions in the availability of funds from other sources. They may also be used on a longer-term basis for general business purposes. The Banks do not currently solicit brokered deposits. Deposit Accounts: Deposits are attracted from within the Banks' primary market areas through the offering of a broad selection of deposit instruments, including demand checking accounts, NOW accounts, money market deposit accounts, regular savings accounts, certificates of deposit and retirement savings plans. Deposit account terms vary according to the minimum balance required, the time periods the funds must remain on deposit and the interest rate, among other factors. In determining the terms of their deposit accounts, the Banks consider current market interest rates, profitability to the Banks, matching deposit and loan products and their customer preferences and concerns. The Banks generally review their deposit mix and pricing weekly. The Banks compete with other financial institutions and financial intermediaries in attracting deposits. Competition from mutual funds has been particularly strong in recent years due to the performance of the stock market. In addition, there is strong competition for savings dollars from commercial banks, credit unions, and nonbank corporations, such as securities brokerage companies and other diversified companies, some of which have nationwide networks of offices. The Banks, especially FSBW, have been most successful in attracting a broad range of retail time deposits and, at March 31, 1999, the Banks had a total of $580.0 million in retail time deposits, of which $276.7 million had original maturities of one year or longer. As illustrated in the following table, certificates of deposit have accounted for a larger percentage of the deposit portfolio than have other transaction accounts. However, as reflected in the balances and percentages for March 31, 1999, 1998 and 1997, the acquisition of IEB, TB and WSB has added significantly to demand, NOW and Money Market accounts for the Company. 26 The following table sets forth the balances of deposits in the various types of accounts offered by the Banks at the dates indicated (in thousands). AT MARCH 31 ------------------------------------------------------------------------------ 1999 1998 1997 ----------------------------- ----------------------------- ------------------ % OF INCREASE % OF INCREASE % OF AMOUNT TOTAL (DECREASE) AMOUNT TOTAL (DECREASE) AMOUNT TOTAL -------- ------ -------- -------- ------ --------- ------- ------ Demand and NOW checking $179,609 18.89% 67,420 $112,189 18.62% $7,820 $104,369 18.78% Regular savings accounts 59,133 6.22 17,049 42,084 6.99 (2,047) 44,131 7.94 Money market accounts 132,077 13.89 55,435 76,642 12.72 (227) 76,869 13.83 Certificates which mature: Within 1 year 405,306 42.63 165,232 240,074 39.84 27,221 212,853 38.31 After 1 year, but within 2 years 93,343 9.82 18,824 74,519 12.37 20,966 53,553 9.64 After 2 years, but within 5 years 71,832 7.55 28,327 43,505 7.32 2,542 40,963 7.37 Certificates maturing thereafter 9,548 1.00 (3,961) 13,509 2.24 (9,459) 22,968 4.13 -------- ------ ------- -------- ------ ------- -------- ------ Total $950,848 100.00% 348,326 $602,522 100.00% $46,816 $555,706 100.00% ======== ======= -====== ======== ====== ======= ======== ======
The following table sets forth the deposit activities of the Banks for the periods indicated (in thousands). YEAR ENDED MARCH 31, ---------------------------- 1999 1998 1997 ------ ------ ------ Beginning balance $602,522 $555,706 $383,070 Acquisitions 218,368 - 134,610 Net increase (decrease) before interest credited 95,939 21,527 16,290 Interest credited 34,019 25,289 21,736 -------- -------- -------- Net increase in savings deposits 348,326 46,816 172,636 -------- -------- -------- Ending balance $950,848 $602,522 $555,706 ======== ======== ======== The following table indicates the amount of the Banks' jumbo certificates of deposit by time remaining until maturity as of March 31, 1999. Jumbo certificates of deposit require a minimum deposit of $100,000 and rates paid on such accounts are negotiable (in thousands). Jumbo MATURITY PERIOD Certificates of Deposits ----------- Six months or less $ 90,248 Six through twelve months 51,946 Over twelve months 43,895 --------- Total $ 186,089 ========= 27 Borrowings: Deposits are the primary source of funds for the Banks' lending and investment activities and for their general business purposes. FSBW also uses borrowings to supplement its supply of lendable funds, to meet deposit withdrawal requirements and to more effectively leverage its capital position. The FHLB-Seattle serves as FSBW's primary borrowing source. Advances from the FHLB-Seattle are typically secured by FSBW's first mortgage loans. At March 31, 1999, FSBW had $408.3 million of borrowings from the FHLB-Seattle at a weighted average rate of 5.74%. FSBW has been authorized by the FHLB-Seattle to borrow up to 45% of it's total assets under a blanket floating lien security agreement, permitting a borrowing capacity of $537.1 million at March 31, 1999. Additional funds may be obtained through commercial banking credit lines. The FHLB-Seattle functions as a central reserve bank providing credit for member financial institutions. As a member, FSBW is required to own capital stock in the FHLB-Seattle and is authorized to apply for advances on the security of such stock and certain of its mortgage loans and other assets (principally securities which are obligations of, or guaranteed by, the U.S. Government) provided certain creditworthiness standards have been met. Advances are made pursuant to several different credit programs. Each credit program has its own interest rate and range of maturities. Depending on the program, limitations on the amount of advances are based on the financial condition of the member institution and the adequacy of collateral pledged to secure the credit. FSBW also uses retail repurchase agreements due generally within 90 days as a source of funds. At March 31, 1999, retail repurchase agreements totaling $5.8 million with interest rates from 4.90% to 7.18% were secured by a pledge of certain FNMA, GNMA and FHLMC mortgage-backed securities with a market value of $9.8 million. FSBW also borrows funds through the use of secured wholesale repurchase agreements with securities brokers. The broker holds FSBW's securities while FSBW continues to receive the principal and interest payments from the security. FSBW's outstanding borrowings at March 31, 1999, under wholesale repurchase agreements, totaled $72.7 million and were collateralized by mortgage-backed securities with a fair value of $75.2 million. (See "Management's Discussion and Analysis of Financial Position and Results of Operations -- Liquidity and Capital Resources," and Notes 11 and 12 of the consolidated Financial Statements) PERSONNEL As of March 31, 1999, the Company had 429 full-time and 72 part-time employees. The employees are not represented by a collective bargaining unit. The Company believes its relationship with its employees is good. TAXATION FEDERAL TAXATION General. For tax reporting purposes, the Company and the Banks report their income on a calendar year basis using the accrual method of accounting. The Company and the Banks are subject to federal income taxation in the same manner as other corporations with some exceptions including particularly the reserve for bad debts discussed below. The following discussion of tax matters is intended only as a summary and does not purport to be a comprehensive description of the tax rules applicable to the Company and the Banks. Bad Debt Reserve. Historically, savings institutions such as FSBW which met certain definitional tests primarily related to their assets and the nature of their business ("qualifying thrift") were permitted to establish a reserve for bad debts and to make annual additions thereto, which may have been deducted in arriving at their taxable income. FSBW's deductions with respect to "qualifying real property loans," which are generally loans secured by certain interests in real property, were computed using an amount based on FSBW's actual loss experience, or a percentage equal to 8% of FSBW's taxable income, computed with certain modifications and reduced by the amount of any permitted additions to the non-qualifying reserve. Due to FSBW's loss experience, it generally recognized a bad debt deduction equal to 8% of taxable income. 28 In August 1996, provisions repealing the current thrift bad debt rules were enacted by Congress as part of "The Small Business Job Protection Act of 1996." The new rules eliminate the 8% of taxable income method for deducting additions to the tax bad debt reserves for all thrifts for tax years beginning after December 31, 1995. These rules also require that all institutions recapture all or a portion of their bad debt reserves added since the base year (last taxable year beginning before January 1, 1988). FSBW has previously recorded a deferred tax liability equal to the bad debt recapture and as such the new rules will have no effect on the net income or federal income tax expense. For taxable years beginning after December 31, 1995, because FSBW is a "large" bank (i.e., assets in excess of $500 million), FSBW's bad debt deduction will be determined on the basis of net charge-offs during the taxable year. The new rules also require FSBW to recapture its $1.5 million post-1987 additions to tax basis bad debt reserves ratably over a six taxable year period beginning with fiscal year March 1999. The recapture of the post-1987 additions to tax basis bad debt reserves will require FSBW to pay approximately $85,000 a year in federal income taxes (based upon current federal income tax rates). This will not result in a charge to earnings as these amounts are included in the deferred tax liability at March 31, 1999. The unrecaptured base year reserves will not be subject to recapture as long as the institution qualifies as a bank as defined by the statute. In addition, the balance of the pre-1988 bad debt reserves continues to be subject to provisions of present law referred to below that require recapture in the case of certain excess distributions to shareholders. DISTRIBUTIONS. To the extent that FSBW makes "nondividend distributions" to the Company, such distributions will be considered to result in distributions from the balance of their bad debt reserves as of December 31, 1987 (or a lesser amount if FSBW's loan portfolio decreased since December 31, 1987) and then from the supplemental reserve for losses on loans ("Excess Distributions"), and an amount based on the Excess Distributions will be included in FSBW's taxable income. Nondividend distributions include distributions in excess of FSBW's current and accumulated earnings and profits, distributions in redemption of stock and distributions in partial or complete liquidation. However, dividends paid out of FSBW's current or accumulated earnings and profits, as calculated for federal income tax purposes, will not be considered to result in a distribution from FSBW's bad debt reserves. The amount of additional taxable income created from an Excess Distribution is an amount that, when reduced by the tax attributable to the income, is equal o the amount of the distribution. Thus, approximately one and one-half times the Excess Distribution would be includable in gross income for federal income tax purposes, assuming a 34% federal corporate income tax rate. FSBW does not intend to pay dividends that would result in a recapture of any portion of their tax bad debt reserve. Corporate Alternative Minimum Tax. The Code imposes a tax on alternative minimum taxable income ("AMTI") at a rate of 20%. AMTI is increased by an amount equal to 75% of the amount by which the corporation's adjusted current earnings exceeds its AMTI (determined without regard to this preference and prior to reduction for net operating losses). For taxable years beginning after December 31, 1986, and before January 1, 1996, an environmental tax of .12% of the excess of AMTI (with certain modification) over $2.0 million is imposed on corporations, including the Banks, whether or not an Alternative Minimum Tax ("AMT")is paid. Under President Clinton's 1999 budget proposal, the corporate environmental income tax would be reinstated for taxable years beginning after December 31, 1996 and before January 1, 2008. Dividends-Received Deduction and Other Matters. The Company may exclude from its income 100% of dividends received from the Banks as a member of the same affiliated group of corporations. The corporate dividends-received deduction is generally 70% in the case of dividends received from unaffiliated corporations with which the Company and the Banks will not file a consolidated tax return, except that if the Company or the Banks own more than 20% of the stock of a corporation distributing a dividend, then 80%of any dividends received may be deducted. There have not been any IRS audits of the Company's or the Banks' federal income tax returns during the past five years. 29 ENVIRONMENTAL REGULATION The business of the Company is affected from time to time by federal and state laws and regulations relating to hazardous substances. Under the federal Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), owners and operators of properties containing hazardous substances may be liable for the costs of cleaning up the substances. CERCLA and similar state laws can affect the Company both as an owner of branches and other properties used in its business and as a lender holding a security interest in property which is found to contain hazardous substances. While CERCLA contains an exemption for holders of security interests, the exemption is not available if the holder participates in the management of a property, and some courts have broadly defined what constitutes participation in management of property. Moreover, CERCLA and similar state statutes can affect the Company's decision of whether or not to foreclose on a property. Before foreclosing on commercial real estate, it is the Company's general policy to obtain an environmental report, thereby increasing the costs of foreclosure. In addition, the existence of hazardous substances on a property securing a troubled loan may cause the Company to elect not to foreclose on the property, thereby reducing the Company's flexibility in handling the loan. COMPETITION The Banks encounter significant competition both in attracting deposits and in originating real estate loans. Their most direct competition for deposits has come historically from other commercial and savings banks, savings associations and credit unions in their market areas. More recently, the Banks have experienced an increased level of competition from securities firms, insurance companies, money market and mutual funds, and other investment vehicles. The Banks expect continued strong competition from such financial institutions and investment vehicles in the foreseeable future. The ability of the Banks to attract and retain deposits depends on their ability to provide investment opportunities that satisfy the requirements of investors as to rate of return, liquidity, risk of loss of principal, convenience of locations and other factors. The Banks compete for deposits by offering depositors a variety of deposit accounts and financial services at competitive rates, convenient business hours, and a high level of personal service and expertise. The competition for loans comes principally from commercial banks, loan brokers, mortgage banking companies, other savings banks and credit unions. The competition for loans has increased substantially in recent years as a result of the large number of institutions competing in the Banks' market areas as well as the increased efforts by commercial banks and credit unions to expand mortgage loan originations. The Banks compete for loans primarily through offering competitive rates and fees and providing excellent services to borrowers and home builders. Factors that affect competition include general and local economic conditions, current interest rate levels and the volatility of the mortgage markets. 30 REGULATION THE BANKS General: As state-chartered, federally insured financial institutions, the Banks are subject to extensive regulation. Lending activities and other investments must comply with various statutory and regulatory requirements, including prescribed minimum capital standards. The Banks are regularly examined by the FDIC and their state banking regulators and file periodic reports concerning their activities and financial condition with their regulators. The Banks' relationship with depositors and borrowers also is regulated to a great extent by both federal and state law, especially in such matters as the ownership of savings accounts and the form and content of mortgage documents. Federal and state banking laws and regulations govern all areas of the operation of the Banks, including reserves, loans, mortgages, capital, issuance of securities, payment of dividends and establishment of branches. Federal and state bank regulatory agencies also have the general authority to limit the dividends paid by insured banks and bank holding companies if such payments should be deemed to constitute an unsafe and unsound practice. The respective primary federal regulators of the Company and the Banks have authority to impose penalties, initiate civil and administrative actions and take other steps intended to prevent banks from engaging in unsafe or unsound practices. State Regulation and Supervision: As a state-chartered savings bank, FSBW is subject to applicable provisions of Washington law and regulations. As a state chartered commercial bank TB is subject to applicable provisions of Washington law and regulation. As a state-chartered commercial bank, IEB is subject to applicable provisions of Oregon law and regulations. State law and regulations govern the Banks' ability to take deposits and pay interest thereon, to make loans on or invest in residential and other real estate, to make consumer loans, to invest in securities, to offer various banking services to its customers, and to establish branch offices. Under state law, savings banks in Washington also generally have all of the powers that federal mutual savings banks have under federal laws and regulations. The Banks are subject to periodic examination and reporting requirements by and of their state banking regulators. Deposit Insurance: The FDIC is an independent federal agency that insures the deposits, up to prescribed statutory limits, of depository institutions. The FDIC currently maintains two separate insurance funds: the BIF and the SAIF. As insurer of the Banks' deposits, the FDIC has examination, supervisory and enforcement authority over the Banks. FSBW's accounts are insured by the SAIF and IEB's and TB's accounts are insured by the BIF to the maximum extent permitted by law. The Banks pay deposit insurance premiums based on a risk-based assessment system established by the FDIC. Under applicable regulations, institutions are assigned to one of three capital groups that are based solely on the level of an institution's capital-- "well capitalized," "adequately capitalized," and "undercapitalized" -- which are defined in the same manner as the regulations establishing the prompt corrective action system, as discussed below. These three groups are then divided into three subgroups which reflect varying levels of supervisory concern, from those which are considered to be healthy to those which are considered to be of substantial supervisory concern. The matrix so created results in nine assessment risk classifications. Pursuant to the Deposit Insurance Funds Act of 1996 (the "DIF Act"), which was enacted on September 30, 1996, the FDIC imposed a special assessment on each depository institution with SAIF-assessable deposits which resulted in the SAIF achieving its designated reserve ratio. In connection therewith, the FDIC reduced the assessment schedule for SAIF members, effective January 1, 1997, to a range of 0% to 0.27%, with most institutions, including FSBW, paying 0%. This assessment schedule is the same as that for the BIF, which reached its designated reserve ratio in 1995. In addition, since January 1, 1997, SAIF members are charged an assessment of .065% of SAIF-assessable deposits for the purpose of paying interest on the obligations issued by the Financing Corporation ("FICO") in the 1980s to help fund the thrift industry cleanup. BIF-assessable deposits will be charged an assessment to help pay interest on the FICO bonds at a rate of approximately .013% until the earlier of December 31, 1999 or the date upon which the last savings association ceases to exist, after which time the assessment will be the same for all insured deposits. The DIF Act provides for the merger of the BIF and the SAIF into the Deposit Insurance Fund on January 1, 1999, but only if no insured depository institution is a savings association on that date. 31 The FDIC may terminate the deposit insurance of any insured depository institution if it determines after a hearing that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, order or any condition imposed by an agreement with the FDIC. It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance, if the institution has no tangible capital. If insurance of accounts is terminated, the accounts at the institution at the time of termination, less subsequent withdrawals, shall continue to be insured for a period of six months to two years, as determined by the FDIC. Management is aware of no existing circumstances that could result in termination of the deposit insurance of the Banks. Prompt Corrective Action: Under Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), each federal banking agency is required to implement a system of prompt corrective action for institutions which it regulates. The federal banking agencies have promulgated substantially similar regulations to implement this system of prompt corrective action. Under the regulations, an institution shall be deemed to be: (i) "well capitalized" if it has a total risk-based capital ratio of 10.0% or more, has a Tier I risk-based capital ratio of 6.0% or more, has a Tier I leverage capital ratio of 5.0% or more and is not subject to specified requirements to meet and maintain a specific capital level for any capital measure; (ii) "adequately capitalized" if it has a total risk-based capital ratio of 8.0% or more, has a Tier I risk-based capital ratio of 4.0% or more, has a Tier I leverage capital ratio of 4.0% or more (3.0% under certain circumstances) and does not meet the definition of "well capitalized;" (iii) "undercapitalized" if it has a total risk-based capital ratio that is less than 8.0%, has a Tier I risk-based capital ratio that is less than 4.0% or has a Tier I leverage capital ratio that is less than 4.0% (3.0% under certain circumstances); (iv) "significantly undercapitalized" if it has a total risk-based capital ratio that is less than 6.0%, has a Tier I risk-based capital ratio that is less than 3.0% or has a Tier I leverage capital ratio that is less than 3.0%; and (v) "critically undercapitalized" if it has a ratio of tangible equity to total assets that is equal to or less than 2.0%. A federal banking agency may, after notice and an opportunity for a hearing, reclassify a well capitalized institution as adequately capitalized and may require an adequately capitalized institution or an undercapitalized institution to comply with supervisory actions as if it were in the next lower category if the institution is in an unsafe or unsound condition or engaging in an unsafe or unsound practice. (The FDIC may not, however, reclassify a significantly undercapitalized institution as critically undercapitalized.) An institution generally must file a written capital restoration plan which meets specified requirements, as well as a performance guaranty by each company that controls the institution, with the appropriate federal banking agency within 45 days of the date that the institution receives notice or is deemed to have notice that it is undercapitalized, significantly undercapitalized or critically undercapitalized. Immediately upon becoming undercapitalized, an institution shall become subject to various mandatory and discretionary restrictions on its operations. At March 31, 1999, the Banks were categorized as "well capitalized" under the prompt corrective action regulations of the FDIC. Standards for Safety and Soundness: The federal banking regulatory agencies have prescribed, by regulation, standards for all insured depository institutions relating to: (i) internal controls, information systems and internal audit systems; (ii) loan documentation; (iii) credit underwriting; (iv) interest rate risk exposure; (v) asset growth; (vi) asset quality; (vii) earnings and (viii) compensation, fees and benefits (Guidelines). The Guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired. If the FDIC determines that either Bank fails to meet any standard prescribed by the Guidelines, the agency may require the Bank to submit to the agency an acceptable plan to achieve compliance with the standard. FDIC regulations establish deadlines for the submission and review of such safety and soundness compliance plans. Capital Requirements: The FDIC's minimum capital standards applicable to FDIC-regulated banks and savings banks require the most highly-rated institutions to meet a "Tier 1" leverage capital ratio of at least 3% of total assets. Tier 1 (or "core capital") consists of common stockholders' equity, noncumulative perpetual preferred stock and minority interests in consolidated subsidiaries minus all intangible assets other than limited amounts of purchased mortgage servicing rights and certain other accounting adjustments. All other banks must have a Tier 1 leverage ratio of at least 100-200 basis points above the 3% minimum. The FDIC capital regulations establish a minimum leverage ratio of not less than 4% for banks that are not highly rated or are anticipating or experiencing significant growth. 32 Any insured bank with a Tier 1 capital to total assets ratio of less than 2% is deemed to be operating in an unsafe and unsound condition unless the insured bank enters into a written agreement, to which the FDIC is a party, to correct its capital deficiency. Insured banks operating with Tier 1 capital levels below 2% (and which have not entered into a written agreement) are subject to an insurance removal action. Insured banks operating with lower than the prescribed minimum capital levels generally will not receive approval of applications submitted to the FDIC. Also, inadequately capitalized state nonmember banks will be subject to such administrative action as the FDIC deems necessary. FDIC regulations also require that banks meet a risk-based capital standard. The risk-based capital standard requires the maintenance of total capital (which is defined as Tier 1 capital and Tier 2 or supplementary capital) to risk weighted assets of 8% and Tier 1 capital to risk-weighted assets of 4%. In determining the amount of risk-weighted assets, all assets, plus certain off balance sheet items, are multiplied by a risk-weight of 0% to 100%, based on the risks the FDIC believes are inherent in the type of asset or item. The components of Tier 1 capital are equivalent to those discussed above under the 3% leverage requirement. The components of supplementary capital currently include cumulative perpetual preferred stock, adjustable-rate perpetual preferred stock, mandatory convertible securities, term subordinated debt, intermediate-term preferred stock and allowance for possible loan and lease losses. Allowance for possible loan and lease losses includable in supplementary capital is limited to a maximum of 1.25% of risk-weighted assets. Overall, the amount of capital counted toward supplementary capital cannot exceed 100% of Tier 1 capital. FDIC capital requirements are designated as the minimum acceptable standards for banks whose overall financial condition is fundamentally sound, which are well-managed and have no material or significant financial weaknesses. The FDIC capital regulations state that, where the FDIC determines that the financial history or condition, including off-balance sheet risk, managerial resources and/or the future earnings prospects of a bank are not adequate and/or a bank has a significant volume of assets classified substandard, doubtful or loss or otherwise criticized, the FDIC may determine that the minimum adequate amount of capital for that bank is greater than the minimum standards established in the regulation. The Company believes that, under the current regulations, the Banks will continue to meet their minimum capital requirements in the foreseeable future. However, events beyond the control of the Banks, such as a downturn in the economy in areas where the Banks have most of their loans, could adversely affect future earnings and, consequently, the ability of the Banks to meet their capital requirements. Activities and Investments of Insured State-Chartered Banks: Federal law generally limits the activities and equity investments of FDIC-insured, state-chartered banks to those that are permissible for national banks. Under regulations dealing with equity investments, an insured state bank generally may not directly or indirectly acquire or retain any equity investment of a type, or in an amount, that is not permissible for a national bank. An insured state bank is not prohibited from, among other things, (i) acquiring or retaining a majority interest in a subsidiary, (ii) investing as a limited partner in a partnership the sole purpose of which is direct or indirect investment in the acquisition, rehabilitation or new construction of a qualified housing project, provided that such limited partnership investments may not exceed 2% of the bank's total assets, (iii) acquiring up to 10% of the voting stock of a company that solely provides or reinsures directors', trustees' and officers' liability insurance coverage or bankers' blanket bond group insurance coverage for insured depository institutions, and (iv) acquiring or retaining the voting shares of a depository institution if certain requirements are met. Federal law provides that an insured state-chartered bank may not, directly, or indirectly through a subsidiary, engage as "principal" in any activity that is not permissible for a national bank unless the FDIC has determined that such activities would pose no risk to the insurance fund of which it is a member and the bank is in compliance with applicable regulatory capital requirements. Any insured state-chartered bank directly or indirectly engaged in any activity that is not permitted for a national bank must cease the impermissible activity. 33 Federal Reserve System: In 1980, Congress enacted legislation which imposed Federal Reserve requirements (under "Regulation D") on all depository institutions that maintain transaction accounts or nonpersonal time deposits. These reserves may be in the form of cash or non-interest-bearing deposits with the regional Federal Reserve Bank. NOW accounts and other types of accounts that permit payments or transfers to third parties fall within the definition of transaction accounts and are subject to Regulation D reserve requirements, as are any nonpersonal time deposits at a bank. Under Regulation D, a bank must establish reserves equal to 3% of the first $47.8 million of transaction accounts, of which the first $4.4 million is exempt, and 10% on the remainder. The reserve requirement on nonpersonal time deposits with original maturities of less than 1-1/2 years is 0%. As of March 31, 1999, the Banks met their reserve requirements. Affiliate Transactions: The Company and the Banks are legal entities separate and distinct. Various legal limitations restrict the Banks from lending or otherwise supplying funds to the Company (an "affiliate"), generally limiting such transactions with the affiliate to 10% of the Bank's capital and surplus and limiting all such transactions to 20% of the Bank's capital and surplus. Such transactions, including extensions of credit, sales of securities or assets and provision of services, also must be on terms and conditions consistent with safe and sound banking practices, including credit standards, that are substantially the same or at least as favorable to the Banks as those prevailing at the time for transactions with unaffiliated companies. Federally insured banks are subject, with certain exceptions, to certain restrictions on extensions of credit to their parent holding companies or other affiliates, on investments in the stock or other securities of affiliates and on the taking of such stock or securities as collateral from any borrower. In addition, such banks are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit or the providing of any property or service. Community Reinvestment Act: Banks are also subject to the provisions of the Community Reinvestment Act of 1977, which requires the appropriate federal bank regulatory agency, in connection with its regular examination of a bank, to assess the bank's record in meeting the credit needs of the community serviced by the bank, including low and moderate income neighborhoods. The regulatory agency's assessment of the bank's record is made available to the public. Further, such assessment is required of any bank which has applied, among other things, to establish a new branch office that will accept deposits, relocate an existing office or merge or consolidate with, or acquire the assets or assume the liabilities of, a federally regulated financial institution. Dividends: Dividends from the Banks will constitute the major source of funds for dividends which may be paid by the Company. The amount of dividends payable by the Banks to the Company will depend upon the Banks' earnings and capital position, and is limited by federal and state laws, regulations and policies. Federal law further provides that no insured depository institution may make any capital distribution (which would include a cash dividend) if, after making the distribution, the institution would be "undercapitalized," as defined in the prompt corrective action regulations. Moreover, the federal bank regulatory agencies also have the general authority to limit the dividends paid by insured banks if such payments should be deemed to constitute an unsafe and unsound practice. THE COMPANY General: The Company is a bank holding company registered with the Federal Reserve. Bank holding companies are subject to comprehensive regulation by the Federal Reserve under the Bank Holding Company Act of 1956, as amended (BHCA) and the regulations of the Federal Reserve. The Company is required to file with the Federal Reserve annual reports and such additional information as the Federal Reserve may require and is subject to regular examinations by the Federal Reserve. The Federal Reserve also has extensive enforcement authority over bank holding companies, including, among other things, the ability to assess civil money penalties, to issue cease and desist or removal orders and to require that a holding company divest subsidiaries (including its bank subsidiaries). In general, enforcement actions may be initiated for violations of law and regulations and unsafe or unsound practices. Under the BHCA, a bank holding company must obtain Federal Reserve approval before: (1) acquiring, directly or indirectly, ownership or control of any voting shares of another bank or bank holding company if, after such acquisition, it would own or control more than 5% of such shares (unless it already owns or controls the majority of such shares); (2) acquiring all or substantially all of the assets of another bank or bank holding company; or (3) merging or consolidating with another bank holding company. 34 The BHCA also prohibits a bank holding company, with certain exceptions, from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company that is not a bank or bank holding company and from engaging directly or indirectly in activities other than those of banking, managing or controlling banks, or providing services for its subsidiaries. The principal exceptions to these prohibitions involve certain nonbank activities which, by statute or by Federal Reserve regulation or order, have been identified as activities closely related to the business of banking or managing or controlling banks. The list of activities permitted by the Federal Reserve includes, among other things: operating a savings institution, mortgage company, finance company, credit card company or factoring company; performing certain data processing operations; providing certain investment and financial advice; underwriting and acting as an insurance agent for certain types of credit-related insurance; leasing property on a full-payout, non-operating basis; selling money orders, travelers' checks and U.S. Savings Bonds; real estate and personal property appraising; providing tax planning and preparation services; and, subject to certain limitations, providing securities brokerage services for customers. Interstate Banking and Branching.. The Federal Reserve must approve an application of an adequately capitalized and adequately managed bank holding company to acquire control of, or acquire all or substantially all of the assets of, a bank located in a state other than such holding company's home state, without regard to whether the transaction is prohibited by the laws of any state. The Federal Reserve may not approve the acquisition of a bank that has not been in existence for the minimum time period (not exceeding five years) specified by the statutory law of the host state. Nor may the Federal Reserve approve an application if the applicant (and its depository institution affiliates) controls or would control more than 10% of the insured deposits in the United States or 30% or more of the deposits in the target bank's home state or in any state in which the target bank maintains a branch. Federal law does not affect the authority of states to limit the percentage of total insured deposits in the state which may be held or controlled by a bank holding company to the extent such limitation does not discriminate against out-of-state banks or bank holding companies. Individual states may also waive the 30% state-wide concentration limit contained in the federal law. The Federal banking agencies are authorized to approve interstate merger transactions without regard to whether such transaction is prohibited by the law of any state, unless the home state of one of the banks adopted a law prior to June 1, 1997 which applies equally to all out-of-state banks and expressly prohibits merger transactions involving out-of-state banks. Interstate acquisitions of branches will be permitted only if the law of the state in which the branch is located permits such acquisitions. Interstate mergers and branch acquisitions will also be subject to the nationwide and statewide insured deposit concentration amounts described above. Dividends: The Federal Reserve has issued a policy statement on the payment of cash dividends by bank holding companies, which expresses the Federal Reserve's view that a bank holding company should pay cash dividends only to the extent that the company's net income for the past year is sufficient to cover both the cash dividends and a rate of earning retention that is consistent with the company's capital needs, asset quality and overall financial condition. The Federal Reserve also indicated that it would be inappropriate for a company experiencing serious financial problems to borrow funds to pay dividends. Bank holding companies, except for certain "well-capitalized" bank holding companies, are required to give the Federal Reserve prior written notice of any purchase or redemption of its outstanding equity securities if the gross consideration for the purchase or redemption, when combined with the net consideration paid for all such purchases or redemptions during the preceding 12 months, is equal to 10% or more of their consolidated net worth. The Federal Reserve may disapprove such a purchase or redemption of it determines that the proposal would constitute an unsafe or unsound practice or would violate any law, regulation, Federal Reserve order, or any condition imposed by, or written agreement with, the Federal Reserve. Capital Requirements: The Federal Reserve has established capital adequacy guidelines for bank holding companies that generally parallel the capital requirements of the FDIC for the Banks. The Federal Reserve regulations provide that capital standards will be applied on a consolidated basis in the case of a bank holding company with $150 million or more in total consolidated assets. The Company's total risk based capital must equal 8% of risk-weighted assets and one half of the 8% (4%) must consist of Tier 1 (core) capital. As of March 31, 1999 the Company's total risk based capital was 15.15% of risk-weighted assets and its risk based capital of Tier 1 (core) capital was 13.99% of risk-weighted assets. 35 MANAGEMENT PERSONNEL EXECUTIVE OFFICERS The following table sets forth information with respect to the executive officers of the Company. NAME AGE (1) POSITION WITH COMPANY POSITION WITH BANKS - ---- ------- --------------------- ------------------- Gary Sirmon 55 Chief Executive Officer, FSBW-Chief Executive President and Director Officer, President and Director, IEB, TB-Director D. Allan Roth 62 Secretary/Treasurer FSBW - Executive Vice Executive Vice President President and Chief Financial Officer Michael K. Larsen 56 Executive Vice President FSBW - Executive Vice President and Chief Lending Officer Jesse G. Foster 60 Director IEB-Chief Executive Officer, President and Director Lloyd Baker 50 Senior Vice President FSBW-Senior Vice President S. Rick Meikle 51 Director TB-Chief Executive Officer, President and Director - ---------------- (1) As of March 31, 1999. BIOGRAPHICAL INFORMATION Set forth is certain information regarding the executive officers of the Company, directors or executive officers. There are no family relationships among or between the directors or executive officers. Gary Sirmon is Chief Executive Officer, President and a Director of the Company and FSBW; and a Director of IEB and TB. He joined FSBW in 1980 as an Executive Vice President and assumed his current position in 1982. D. Allan Roth is Executive Vice President and Chief Financial Officer of FSBW and is Secretary/Treasurer and an Executive Vice President of the Company. He joined FSBW in 1965. Michael K. Larsen is Executive Vice President and Chief Lending Officer of FSBW and is an Executive Vice President of the Company. He joined FSBW in 1981. Jesse G. Foster is the Chief Executive Officer, President and a Director of IEB and a Director of the Company. He joined IEB in 1962. Lloyd Baker is a Senior Vice President with FSBW and is an Senior Vice President of the Company. He joined FSBW in 1995 as a Vice President. S. Rick Meikle is Chief Executive Officer, President and a Director of TB and a Director of the Company. He helped form TB in 1991. 36 ITEM 2 - Properties The Company's home office, which is owned by the Company, is located in Walla Walla, Washington. First Savings has, in total, 21 branch offices, including five WSB offices, all of which are located in the State of Washington. These offices are located in the cities of Walla Walla (4), Kennewick (2), Richland, Clarkston, Sunnyside, Yakima (4), Selah, Wenatchee, Dayton, Bellingham, Ferndale, Lynden, Blaine and Point Roberts. Of these offices, 14 are owned by the Company and seven are leased. The leases expire from 2000 through 2002. In addition to these, First Savings has four leased loan production offices in Bellevue, Spokane, Puyallup, and Oak Harbor, Washington. The leases expire from 1999 through 2000. The acquisition of Seaport Citizens' Bank on April 1, 1999 added two more branch offices which are owned located in Lewiston, Idaho. IEB's main office is located in Hermiston, Oregon and is owned by the Company. IEB has, in total, four branch offices and a drive-up facility, all of which are located in the State of Oregon. These offices, which are owned by the Company, are located in Pendleton, Umatilla, Boardman and Stanfield. IEB also has a remote drive-up facility in Hermiston, which is owned, and two loan production offices in Condon and La Grande, which are on month-to-month leases. IEB also leases two facilities in Hermiston for its mortgage division and for its information systems. Towne Bank operates from six branch locations all of which are leased TB offices and are located in Woodinville, Bellevue, Redmond, Bothell, Renton and Kirkland, Washington. The Company's net investment in its offices, premises, equipment and leaseholds was $16.0 million at March 31, 1999. ITEM 3 - LEGAL PROCEEDINGS Periodically, there have been various claims and lawsuits involving the Banks, mainly as a defendant, such as claims to enforce liens, condemnation proceedings on properties in which the Banks hold security interests, claims involving the making and servicing of real property loans and other issues incident to the Banks' business. The Company and the Banks are not a party to any pending legal proceedings that it believes would have a material adverse effect on the financial condition or operations of the Company. ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. 37 PART II ITEM 5 - MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Stock Listing First Washington Bancorp, Inc. common stock is traded over-the-counter on the Nasdaq National Market under the symbol "FWWB." Newspaper stock tables list the company as "FSBWA." Stockholders of record at March 31, 1999 totaled 781. This total does not reflect the number of persons or entitles who hold stock in nominee or "street" name through various brokerage firms. The following tables show the reported high and low sale prices of the Company's common stock for the four year period ended March 31, 1999. CASH DIVIDENDS FISCAL 1999 HIGH LOW DECLARED ----------- ----- ----- -------- First quarter(1) $25.34 $21.81 $0.082 Second quarter 23.64 19.38 0.090 Third quarter 24.00 19.88 0.090 Fourth quarter 24.00 18.38 0.120 CASH DIVIDENDS FISCAL 1998(1) HIGH LOW DECLARED ----------- ---- --- -------- First quarter $20.23 $17.05 $0.064 Second quarter 22.62 19.66 0.064 Third quarter 25.96 21.14 0.064 Fourth quarter 25.12 21.36 0.082 CASH DIVIDENDS FISCAL 1997(1) HIGH LOW DECLARED ----------- ---- --- -------- First quarter $14.21 $12.16 $0.045 Second quarter 15.68 13.18 0.045 Third quarter 17.27 15.05 0.045 Fourth quarter 20.12 16.36 0.064 CASH DIVIDENDS FISCAL 1996 *(1) HIGH LOW DECLARED ----------- ---- --- -------- Third quarter $12.05 $11.31 $0.045 Fourth quarter 12.27 11.25 0.045 * Year of Conversion (1) Restated to reflect 10% stock dividend granted in August 1998, see Note 1 38 ITEM 6 - SELECTED CONSOLIDATED FINANCIAL AND OTHER DATA These tables set forth selected consolidated financial and other data of the Company at the dates and for the periods indicated. This information is derived from and is qualified in its entirety by reference to the detailed information and Consolidated Financial Statements and Notes thereto presented elsewhere in this or prior filings. Information for the March 31, 1995 fiscal year is for FSBW's former mutual holding company. FINANCIAL CONDITION DATA: At March 31 (2) ----------------------------------------------------- (In thousands) 1999 1998 1997 1996 1995 ---- ---- ---- ---- ---- Total assets $1,631,900 $1,154,072 $1,007,633 $743,176 $491,368 Loans receivable, net 1,102,669 756,917 645,881 415,295 299,403 Cash and securities (1) 436,679 345,142 312,991 302,772 175,505 Deposits 950,848 602,522 555,706 383,070 367,368 Borrowings 486,719 389,272 293,700 199,071 70,338 Equity 183,608 150,184 148,636 154,142 50,251 Shares outstanding excluding unearned, restricted shares held in ESOP 10,902 10,160 10,718 11,085 N/A OPERATING DATA: At or for the Years Ended March 31 (2) -------------------------------------------------- (In thousands, except per share data) 1999 1998 1997 1996 1995 ---- ---- ---- ---- ---- Interest income $112,292 $85,147 $67,292 $41,409 $33,652 Interest expense 60,442 46,651 36,372 23,287 18,230 ------- ------- ------- ------- ------- Net interest income 51,850 38,496 30,920 18,122 15,422 Provision for loan losses 2,841 1,628 1,423 524 391 ------- ------- ------- ------- ------- Net interest income after provision for loan losses 49,009 36,868 29,497 17,598 15,031 Gains (losses) from sale of loans and securities 2,895 1,379 686 387 (121) Other operating income 4,558 3,341 2,384 1,216 1,180 Other operating expense 31,745 21,020 19,330 10,318 9,983 ------- ------- ------- ------- ------ Income before provision for income taxes and cumulative effect of change in accounting 24,717 20,568 13,237 8,883 6,107 Provision for income taxes 9,277 7,446 3,923 2,631 1,335 ------- ------- ------- ------- ------- Income before cumulative effect of change in accounting 15,440 13,122 9,314 6,252 4,772 Cumulative effect of change in accounting (3) -- -- -- -- 396 -------- -------- -------- ------- -------- Net income $15,440 $13,122 $9,314 $6,252 $5,168 ======= ======= ======== ======= ====== PER SHARE DATA (4): Net income: Basic $ 1.46 $ 1.30 $ 0.88 N/A N/A Diluted 1.40 1.25 0.87 Stockholders' equity (5) 16.84 14.78 13.87 Cash dividends 0.38 0.27 0.20 Dividend payout ratio (diluted) 27.14% 21.60% 22.99% (footnotes on following page) 39 KEY FINANCIAL RATIOS: AT OR FOR THE YEARS ENDED MARCH 31(2) ------------------------------------- 1999 1998 1997 1996 1995 ---- ---- ---- ---- ---- Performance Ratios: Return on average assets (6) 1.08% 1.21% 1.04% 1.11% 1.12% Return on average equity (7) 8.91 8.70 6.30 6.62 10.85 Average equity to average assets 12.07 13.86 16.58 16.75 10.34 Interest rate spread (8) 3.45 3.13 2.88 2.49 3.05 Net interest margin (9) 3.83 3.68 3.59 3.33 3.47 Non-interest income to average assets 0.52 0.43 0.34 0.28 0.24 Non-interest expense to average assets 2.21 1.93 2.17 1.83 2.16 Efficiency ratio (10) 53.53 48.64 56.87 52.31 60.57 Average interest-earning assets to interest-bearing liabilities 108.30 112.53 116.97 119.80 110.31 Asset Quality Ratios: Allowance for loan losses as a percent of net loans at end of period 1.10 1.03 0.94 0.97 1.17 Net charge-offs as a percent of average outstanding loans during the period 0.14 0.08 0.04 0.01 0.10 Non-performing assets as a percent of total assets 0.57 0.20 0.31 0.17 0.19 Ratio of allowance for loan losses as a percent of non-performing loans (11) 1.60 5.53 3.20 7.53 10.41 Consolidated Capital Ratio: Tier 1 leverage capital ratio 9.44 12.17 13.68 20.78 10.19 - --------------- Footnotes: (1) Includes securities available for sale and held to maturity. (2) Certain amounts in the prior periods' financial statements have been reclassified to conform to the current period's presentation. These reclassifications have affected certain ratios for the prior periods. The effect of such reclassifications is immaterial. (3) Adjustment net of taxes of $204,000 due to the adoption of SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. (4) FSBW converted from mutual to stock ownership on October 31, 1995, therefore data is not meaningful for fiscal years prior to March 31, 1996. Per share data have been adjusted for the 10% stock dividend paid in August 1998. (5) Calculated using shares outstanding excluding unearned restricted shares held in ESOP. (6) Net income divided by average assets. (7) Net income divided by average equity. (8) Difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities. (9) Net interest income before provision for loan losses as a percent of average interest-earning assets. (10) Other operating expenses divided by the total of net interest income before loan losses and other operating income (non-interest income). (11) Non-performing loans consist of nonaccrual and 90 days past due loans. 40 ITEM 7 - MANAGEMENT'S DISCUSSION & 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 First Washington Bancorp, Inc. 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 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 affect actual results include interest rate trends, the general economic climate in the Company's market area and the country as a whole, the ability of the Company to control costs and expenses, the ability of the Company to efficiently incorporate acquisitions into its operations, the ability of the Company to successfully address Year 2000 (Y2K) issues, competitive products and pricing, loan delinquency rates, and changes in federal and state regulation. These factors should be considered in evaluating the "forward-looking statements," and undue reliance should not be placed on such statements. GENERAL First Washington Bancorp, Inc. (the Company or FWWB), a Washington corporation, is primarily engaged in the business of planning, directing and coordinating the business activities of its wholly owned subsidiaries, First Savings Bank of Washington (FSBW), Inland Empire Bank (IEB) and Towne Bank (TB) (together, the Banks). FSBW is a Washington-chartered savings bank the deposits of which are insured by the Federal Deposit Insurance Corporation (FDIC) under the Savings Association Insurance Fund (SAIF). FSBW conducts business from its main office in Walla Walla, Washington and its 16 branch offices and three loan production offices located in southeast, central, north central and western Washington.. Effective January 1, 1999, FWWB completed the acquisition of Whatcom State Bancorp whose wholly owned subsidiary, Whatcom State Bank (WSB), was merged with FSBW and operates as Whatcom State Bank, a Division of First Savings Bank of Washington. WSB, which is based in Bellingham, operates five full service branches and a loan office in northwest Washington. IEB is an Oregon-chartered commercial bank whose deposits are insured by the FDIC under the Bank Insurance Fund (BIF). IEB conducts business from its main office in Hermiston, Oregon and its five branch offices and two loan production offices located in northeast Oregon. TB is a Washington-chartered commercial bank whose deposits are insured by the FDIC under BIF. TB conducts business from six full service branches in the Seattle, Washington, metropolitan area. The operating results of FWWB 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 savings deposits and Federal Home Loan Bank (FHLB) advances. Net interest income is primarily a function of FWWB'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, FWWB's net interest income significantly increased for the year ended March 31, 1999, when compared to the same periods for the prior years. This increase in net interest income was largely due to the substantial growth in average asset and liability balances from the acquisition of TB on April 1, 1998, although significant asset and liability growth also occurred at IEB and FSBW, especially with the acquisition of Whatcom State Bancorp on January 1, 1999. FWWB'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. FWWB's net income also significantly increased when compared to the same periods for the prior year. 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 Consolidated Financial Statements. 41 RECENT DEVELOPMENTS AND SIGNIFICANT EVENTS SINCE MARCH 31, 1998 Reincorporation: The stockholders of First Savings Bank of Washington Bancorp, Inc., a Delaware corporation and herein referred to as "FSBWB," approved the reincorporation of FSBWB from Delaware to Washington on July 24, 1998. The reincorporation was effected July 24, 1998 by merging FSBWB into a wholly owned subsidiary which had been recently formed solely for the purpose of effecting the reincorporation. The surviving corporation is known as First Washington Bancorp, Inc., a Washington corporation. Upon consummation of the merger, each share of Common Stock of FSBWB, par value $.01 per share, was automatically converted into one share of common stock of FWWB, par value $.01 per share. The merger was consummated under the terms and conditions of a Plan of Merger pursuant to which FSBWB ceased to exist as a Delaware corporation, the stockholders of FSBWB became shareholders of FWWB, FWWB succeeded to all the assets, liabilities, subsidiaries and other properties of FSBWB to the full extent provided by law, and the rights of the shareholders and internal affairs of FWWB are to be governed by the articles of incorporation and bylaws of FWWB and the Washington Business Corporation Act, as amended. As a result of the merger, FWWB has the same business, management, benefit plans, location, assets, liabilities and net worth as did FSBWB. Declaration of 10% Stock Dividend: On July 24, 1998 FWWB's Board of Directors declared a 10% stock dividend payable August 17, 1998 to shareholders of record on August 10, 1998. All earnings per share and share data have been adjusted to reflect the 10% stock dividend. Acquisition of Towne Bancorp, Inc.: On April 1, 1998 FWWB completed the acquisition of Towne Bancorp, Inc. FWWB paid $28.2 million in cash and common stock for all of the outstanding common shares and stock options of Towne Bancorp, Inc., which was the holding company for Towne Bank (TB), headquartered in Woodinville, Washington, a Seattle suburb. As a result of the merger of Towne Bancorp, Inc. into FWWB, TB became a wholly owned subsidiary of FWWB. TB operates six full service branches in the Seattle, Washington, metropolitan area--in Woodinville, Kirkland, Redmond, Bellevue, Renton and Bothell. TB's results of operations for the full year ended March 31, 1999 are included in the Company's consolidated results of operations for the year ended March 31, 1999. Acquisition of Whatcom State Bancorp, Inc.: On January 1, 1999 FWWB completed the acquisition of Whatcom State Bancorp Inc. FWWB paid $12.1 million in common stock for all the outstanding common shares and stock options of Whatcom State Bancorp, Inc., which was the holding company for Whatcom State Bank (WSB), headquartered in Bellingham, Washington. WSB operates five full service branches in the Bellingham, Washington, area--Bellingham, Ferndale, Lynden, Blaine and Point Roberts. WSB's results of operations for three months ended March 31, 1999 are included in the Company's consolidated results of operations for the year ended March 31, 1999. Acquisition of Seaport Citizens Bank: Subsequent to year end, on April 1, 1999, FWWB and FSBW completed the acquisition of Seaport Citizens Bank (SCB). FSBW paid $10.1 million in cash for all the outstanding common shares of SCB, which is headquartered in Lewiston, Idaho. As a result of the merger of SCB into FSBW, SCB became a division of FSBW. The acquisition will be accounted for as a purchase in fiscal 2000 and will result in the recording of approximately $6.2 million of costs in excess of the fair value of SCB's net assets acquired (goodwill). Goodwill assets will be amortized over a 14-year period and will result in a current charge to earnings of approximately $107,200 per quarter, beginning in the first quarter of fiscal 2000, or $429,000 per year. Founded in 1979, SCB is a commercial bank which had, before recording of goodwill, approximately $45 million in total assets, $41 million in deposits, $27 million in loans, and $4.1 million in shareholders' equity at March 31, 1999. SCB operates two full service branches in Lewiston, Idaho. 42 YEAR 2000 COMPLIANCE The "Year 2000" (Y2K) issue is the result of older computer programs being written using two digits rather than four to define the applicable year.A computer program that has date sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000.This could result in a system failure or miscalculations causing disruption of operations, including, among other things, a temporary inability to process transactions, send statements, or engage in similar normal business activities. Based on an assessment of computer hardware, software and other equipment operated by FWWB and its subsidiary Banks, FWWB presently believes that all equipment and programs are Y2K compliant. A program for addressing the Y2K issue through awareness, assessment, renovation and testing has been developed and implemented. The testing phase has been completed on all internal operations and mission critical outside vendors. The results of the testing disclosed only insignificant items that needed to be resolved, all of which have since been corrected. The program also provided for awareness and assessment of customer Y2K issues which is ongoing. The Banks have adopted business contingency plans for the computer systems and facilities that they have determined to be most critical. These plans conform to guidance from the FFIEC on business contingency planning for Year 2000 readiness. Contingency plans include, among other actions, manual workarounds and identification of resource requirements and alternative solutions for resuming critical business processes in the event of a Year 2000-related failure. The three Bank subsidiaries have budgeted approximately $900,000, including $550,000 to cover soft and hard costs such as upgrading ATMs, contacting and monitoring vendors, contacting customers, providing information regarding our preparations and testing the systems identified as critical and non-critical, and $350,000 for unidentified contingencies. FWWB and its Bank subsidiaries have incurred and expensed approximately $304,000 of Y2K-related costs in the current fiscal year ended March 31, 1999. Costs incurred and expensed in prior fiscal years were not significant. FWWB and its subsidiary Banks are continuing to contact and monitor all significant suppliers to determine the extent to which they are vulnerable to those third parties' failures to remedy their own Y2K impact issues. Third party responses have indicated satisfactory progress in addressing any needs for equipment or software renovation. The Banks are contacting their large loan and deposit customers to build Y2K awareness and encourage early development of contingency plans and solutions in an effort to prevent potential business disruption due to Y2K processing failures. Loan and deposit customers are being updated regularly about the Banks' preparations and information is being provided to create a much greater awareness of the issue with some ideas about how to assess and prepare for their own Y2K vulnerability. There can be no guarantee that the systems of other companies on which the Banks' systems rely will be fully functional, or timely converted, or that a failure to convert by another company, or a conversion that is incompatible with the Banks' systems would not have a material adverse effect on the Banks. However, the Banks have tested for the Y2K preparedness of all internal functions and external functions provided by third parties whenever possible and do not expect to experience any significant failures. In addition, contingency or alternate sources of support have been identified for each critical function and many non-critical functions. In the event that the Banks' data processing providers' systems prove not to be Y2K compliant and FWWB is not able to switch to an alternative provider or an in-house system in a timely manner, resulting computer malfunctions could interrupt the operations of the Banks and have a significant adverse effect on FWWB's financial condition and results of operations. 43 COMPARISON OF FINANCIAL CONDITION AT MARCH 31, 1999 AND MARCH 31, 1998 Total assets increased $477.8 million, or 41.4%, from $1.154 billion at March 31, 1998, to $1.632 billion at March 31, 1999. The majority of the increase, $271.0 million, was from the acquisitions of TB and WSB, including $25.6 million of goodwill resulting from the use of purchase accounting. The remaining growth of $206.8 million was spread among all three subsidiary Banks and was funded primarily with deposit growth, advances from the FHLB and other borrowings. This growth represented a continuation of management's plans to further leverage FWWB's capital and reflects the solid economic conditions in the markets where FWWB operates. Loans receivable (gross loans less loans in process, deferred fees and discounts, and allowance for loan losses) grew $345.8 million, or 45.7%, from $756.9 million at March 31, 1998, to $1.103 billion at March 31, 1999. The increase in gross loans of $368.1 million from $822.6 million at March 31, 1998, to $1.191 billion at March 31, 1999, consisted of $157.0 million of mortgages secured by commercial and multifamily real estate, $84.7 million of construction and land loans and $142.6 million of non-mortgage loans such as commercial, agricultural and consumer loans. This was offset by a $16.2 million decrease in residential mortgages resulting from repayments and sales of residential mortgages which were in excess of originations and acquisitions of new loans. The acquisitions of TB and WSB provided $202.4 million of gross loans consisting of $37.1 million of commercial and multifamily mortgages, $25.4 million of construction and land loans, $24.1 million of residential mortgages and $115.8 million of commercial and consumer loans. Over half of the increase in assets, excluding the TB and WSB acquisitions, was funded by a net increase of $110.8 million, or 37.2%, in FHLB advances from $297.5 million at March 31, 1998, to $408.3 million on March 31, 1999. Asset growth was also funded by increased deposits and net income from operations. Deposits grew $348.3 million, or 57.8%, from $602.5 million at March 31, 1998, to $950.8 million at March 31, 1999. Other borrowings, primarily reverse repurchase agreements with securities dealers, decreased $13.3 million, from $91.7 million at March 31, 1998, to $78.5 million at March 31, 1999. Bank acquisitions provided $218.4 million of deposits and $9.0 million of FHLB advances. Securities available for sale and held to maturity increased $61.6 million, or 20.3%, from $302.6 million at March 31, 1998, to $364.0 million at March 31, 1999. FHLB stock increased $7.1 million ($1.0 million from acquisitions), as FSBW was required to purchase more stock as a result of its increased use of FHLB advances. Real estate held for sale increased $557,000, primarily as a result of completed foreclosures. Equity increased $33.4 million largely resulting from the issuance of $32.5 million of stock and options in connection with acquisitions. Net income of $15.4 million for fiscal 1999 was offset by stock repurchases of $15.5 million and cash dividend payments of $3.6 million. COMPARISON OF RESULTS OF OPERATIONS FOR THE YEARS ENDED MARCH 31, 1999 AND MARCH 31, 1998 GENERAL. Net income for fiscal 1999 was $15.4 million, or $1.40 per share (diluted), compared to net income of $13.1 million, or $1.25 per share (diluted), recorded in fiscal 1998. Net income for fiscal 1999 increased $2.3 million from the comparable period in fiscal 1998. FWWB's improved operating results reflect the significant growth of assets and liabilities as well as improvements in net interest margin and non-interest revenues which were offset somewhat by increased operating expenses and amortization of goodwill. Compared to year ago levels, total assets increased 41.4% to $1.632 billion at March 31, 1999, total loans rose 45.7% to $1.103 billion, deposits grew 57.8% to $950.8 million and borrowings increased 25.0% to $486.7 million. Net interest margin improved, despite the adverse effects of a flattening yield curve and declining market rates and loan pricing spreads, reflecting the acquisitions of TB and WSB and continuing changes in the asset and liability mix. 44 INTEREST INCOME. Interest income for the year ended March 31, 1999, was $112.3 million compared to $85.1 million for the year ended March 31, 1998, an increase of $27.1 million, or 31.9%. The increase in interest income was a result of a $310.2 million, or 29.7%, growth in average balances of interest- earning assets combined with a 13 basis point increase in the average yield on those assets. The yield on average assets rose to 8.28% in fiscal 1999 compared to 8.15% in fiscal 1998. Average loans receivable for fiscal 1999 increased by $252.3 million, or 34.5%, when compared to fiscal 1998, reflecting previously discussed acquisitions. Interest income on loans increased by $24.9 million, or 38.5%, compared to the prior year, reflecting the impact of the increase in average loan balances and a 26 basis point increase in the average yield, largely resulting from the addition of higher yielding loans held by TB and WSB, but also reflecting higher yields on the expanding balances of commercial and multifamily real estate, construction and land, and non-mortgage loans at FSBW. Loans yielded 9.12% for fiscal 1999 compared to 8.86% for fiscal 1998. The average balance of mortgage-backed securities, investment securities, daily interest-bearing deposits and FHLB stock increased by $57.9 million in fiscal 1999, causing the interest and dividend income from those investments to increase $2.2 million for fiscal 1999 compared to fiscal 1998 despite a 42 basis point decline in the average yield on those investments. The average yield on mortgage-backed securities decreased from 6.61% for the year ended March 31, 1998, to 5.96% in 1999, reflecting both paydowns in certain higher yielding securities and lower yields on most adjustable-rate securities as market rates declined. The average yield on investment securities and short term cash investments decreased from 6.13% for fiscal 1998 to 6.05% in 1999. Earnings on FHLB stock increased by $398,000, reflecting an increase of $5.4 million in the average balance of FHLB stock for the year ended March 31, 1999, offset by a 12 basis point decrease in the dividend yield on that stock. INTEREST EXPENSE. Interest expense for the year ended March 31, 1999, was $60.4 million compared to $46.7 million for the comparable period in 1998, an increase of $13.8 million, or 29.6%. The increase in interest expense was due to the $322.6 million growth in average interest-bearing liabilities which was offset somewhat by the average cost of all interest-bearing liabilities declining to 4.83% from 5.02%. The increase in average interest-bearing liabilities in fiscal 1999 was largely due to $218.4 million ($158.5 million average balance) of deposits acquired in the acquisitions of TB and WSB along with $9.0 million ($3.7 million average balance) of FHLB borrowings. Deposit interest expense increased $8.7 million for the year ended March 31, 1999. Average deposit balances increased from $523.5 million for the year ended March 31, 1998, to $799.4 million for the year ended March 31, 1999, while, at the same time, the average rate paid on deposit balances decreased 15 basis points. The decline in the rate paid on deposits primarily reflects the acquisition of TB and WSB's $42.1 million of non-interest-bearing deposits as well as generally lower rates paid on interest-bearing accounts resulting from declining market rates. Average FHLB advances totaled $363.3 million during the year ended March 31, 1999, as compared to $214.6 million during the year ended March 31, 1998, resulting in a $4.6 million increase in related interest expense. The average rate paid on those advances decreased to 5.90% for fiscal 1999 from 6.07% for fiscal 1998. Other borrowings consist of retail repurchase agreements with customers and repurchase agreements with investment banking firms secured by certain investment securities. The average balance for other borrowings increased $9.8 million from $79.2 million for the year ended March 31, 1998, to $89.0 million for the same period in 1999, and the related interest expense increased $413,000 from $4.6 million to $5.0 million for the respective periods. 45 PROVISION FOR LOAN LOSSES. The provision for loan losses for the year ended March 31, 1999, increased by $1.2 million to $2.8 million compared to $1.6 million for fiscal 1998. This increase is reflective of the growth in loans receivable which, excluding loans acquired through business combination, increased by $165.7 million for the 1999 fiscal year compared to an increase of $111.0 million in the 1998 period. The increase also is reflective of changes in the portfolio mix which resulted in the need for a higher level of loss allowance as well as the impact of a greater amount of non-performing loans and net charge-offs for the year. Specifically, excluding loans acquired through acquisitions, changes in the loan mix included increases of $119.8 million in commercial and multifamily real estate loans, $59.3 million in construction and land loans, and $27.9 million in commercial and agricultural loans, while one- to four-family loans declined by $40.3 million and consumer loans declined by $1 million. Income producing real estate loans, construction and land loans, commercial and agricultural loans are generally riskier than one- to four- family residential loans resulting in a higher provision for losses. Adding to the need for the increased provision for loan losses for the year ended March 31, 1999 was an increase in the amount of non-performing loans which grew to $7.7 million compared to $1.4 million a year earlier. Further adding to the increase in the provision for loan losses was an increase in the level of net charge-offs which increased from $519,000 for the year ended March 31, 1998, to $1.1 million for the year ended March 31, 1999 (see Notes 7 and 8 to the Consolidated Financial Statements for further analysis of the loan portfolio mix and allowance for loan losses). 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 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. Additions to these allowances are charged to earnings. Realized losses and charge-offs that are related to specific loans are applied as a reduction of the carrying value of the assets and charged immediately against the allowance for losses. 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. 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. 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. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Banks' allowance for loan losses. Such agencies may require the Banks to provide additions 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 Banks' control. The allowance for loan losses equaled 1.10% of gross loans and 160% of non-performing loans at March 31, 1999, compared to 1.03% and 533%, respectively, at March 31, 1998. OTHER OPERATING INCOME. Other operating income increased $2.7 million from $4.7 million for the year ended March 31, 1998, to $7.5 million for the year ended March 31, 1999. The increase included a $1.1 million increase in other fees and service charges due largely to the addition of TB operations. Fee and service charge income also increased at FSBW and IEB, reflecting deposit growth, pricing adjustments, and the fourth quarter acquisition of WSB. There also was a $1.5 million increase in net gains on loans sold in fiscal 1999, as compared to the same period in 1998. This increase primarily reflects increased sales of loans by FSBW, with servicing retained, and by IEB which increased the volume of loans sold in the secondary market over the comparable period in the prior year. In addition, gains on loans sold for fiscal year 1999 include $250,000 of gains on the sale of SBA guaranteed loans originated by TB. The volume of loan sales and related net gain on sale of loans increased from $80.6 million and $1.4 million, respectively, for the year ended March 31, 1998, to $125.7 million and $2.9 million, respectively, for the year ended March 31, 1999. Increased sales of loans at FSBW were designed to curtail the rate of growth in relatively low yielding fixed-rate residential mortgages during this period of low market rates and to reduce the Bank's exposure to the risk of rising interest rates. The $96,000 increase in miscellaneous other income reflects a gain on the sale of IEB real property in the second quarter of fiscal 1999. 46 OTHER OPERATING EXPENSES. Other operating expenses increased $10.7 million from $21.0 million for the year ended March 31, 1998, to $31.7 million for the year ended March 31, 1999. The increase in expenses was largely due to the inclusion of $7.2 million of TB's operating expenses in fiscal 1999 that were not present in fiscal 1998 and the additional expenses of five branches from WSB's acquisition in the last quarter of fiscal 1999. The increase in other operating expenses was partially offset by a $620,000 increase in capitalized loan origination costs resulting from an increased volume in loan originations. In addition to the acquisitions of TB and WSB, increases in other operating expenses reflect the overall growth in assets and liabilities, customer relationships and complexity of operations as FWWB continues to expand. Despite the higher operating expenses associated with transitioning FWWB to more of a commercial bank profile, FWWB's efficiency ratio, excluding the amortization of goodwill, increased only 2.94 percentage points, to 49.50% (53.53% including goodwill), for fiscal 1999, from 46.56% (48.64% including goodwill) for the same period in fiscal 1998. Other operating expenses as a percentage of average assets were 2.21% (2.04% excluding the amortization of goodwill) for the year ended March 31, 1999, compared to 1.93% (1.85% excluding the amortization of goodwill) for the year ended March 31, 1998. INCOME TAXES. Income tax expense was $9.3 million for the year ended March 31, 1999, compared to $7.4 million for the comparable period in 1998. The $1.8 million increase in the provision for income taxes reflects the higher level of income being taxed at higher effective rates due to the phase out of the 34% surtax exemption; the net effect of IEB paying Oregon state income taxes; and the fact that the expenses from the amortization of goodwill acquired in purchasing IEB, TB and WSB and part of the expense recorded in the release of the Employee Stock Ownership Plan (ESOP) shares are not deductible for tax purposes. The Company's effective tax rates for the year ended March 31, 1999 and 1998, were 38% and 36%, respectively. COMPARISON OF RESULTS OF OPERATIONS FOR THE YEARS ENDED MARCH 31, 1998 AND MARCH 31, 1997 GENERAL. Net income for fiscal 1998 was $13.1 million, or $1.25 per share (diluted), compared to net income of $9.3 million, or $0.87 per share (diluted), recorded in fiscal 1997. Net income for fiscal 1997 was significantly affected by the $2.4 million ($1.6 million after tax) SAIF assessment. In addition, fiscal 1998 included $3.0 million of net income from a full year of operations at IEB, which the Company acquired on August 1, 1996, compared to $1.5 million for eight months in the comparable fiscal 1997 period. The Company's improved operating results reflect the significant growth of assets and liabilities as well as improvements in net interest margin and non-interest revenues. The substantial increase in the asset and liability balances during the year since March 31, 1997, resulted from the continued deployment and leveraging of the $98.6 million in net proceeds raised in the Company's conversion from mutual to stock ownership on October 31, 1995. This growth helped to increase the Company's return on average equity from 7.36% (excluding the SAIF assessment of $1.6 million after tax, 6.30% when the SAIF assessment is included) for fiscal 1997 to 8.70% for fiscal 1998. INTEREST INCOME. Interest income for the year ended March 31, 1998, was $85.1 million compared to $67.3 million for the year ended March 31, 1997, an increase of $17.8 million, or 26.5%. The increase in interest income was a result of a $183.2 million, or 21.3%, growth in average balances of interest-earning assets combined with a 34 basis point increase in the average yield on those assets. The yield on average assets rose to 8.15% in fiscal 1998 compared to 7.81% in fiscal 1997. Average loans receivable for fiscal 1998 increased by $185.3 million, or 34.0%, when compared to fiscal 1997. Interest income on loans increased by $18.1 million, or 39.0%, compared to the prior year, reflecting the impact of the increase in average loan balances and a 32 basis point increase in the average yield largely resulting from the addition of higher yielding loans held by IEB, but also reflecting higher yields on the expanding balances of commercial and multifamily real estate, construction and land, and non-mortgage loans at FSBW. Loans yielded 8.86% for fiscal 1998 compared to 8.54% for fiscal 1997. The average balance of mortgage-backed securities, investment securities, daily interest-bearing deposits and FHLB stock decreased by $2.1 million in fiscal 1998, causing the interest and dividend income from those investments to decrease a modest $291,000 for fiscal 1998 compared to fiscal 1997. The average yield on mortgage-backed securities decreased from 6.86% for the year ended March 31, 1997, to 6.61% in 1998 reflecting both paydowns in certain higher yielding securities and lower yields on most adjustable-rate securities as market rates generally declined. FHLB stock dividend income increased by $279,000, reflecting an increase of $3.4 million in the average balance of FHLB stock for the year ended March 31, 1998, and a 9 basis point increase in the dividend yield on that stock. 47 INTEREST EXPENSE. Interest expense for the year ended March 31, 1998, was $46.7 million compared to $36.4 million for the comparable period in 1997, an increase of $10.3 million, or 28.3%. The increase in interest expense was due to the $191.8 million growth in average interest-bearing liabilities. The increase in average interest-bearing liabilities in fiscal 1998 was largely due to a $61.8 million increase in the average balance of FHLB advances and other borrowings. Average FHLB advances totaled $276.3 million during the year ended March 31, 1998, as compared to $214.6 million during the year ended March 31, 1997, resulting in a $4.3 million increase in related interest expense. The average rate paid on those advances increased to 6.07% for fiscal 1998 from 5.83% for fiscal 1997. Other borrowings consist of retail repurchase agreements with customers and repurchase agreements with investment banking firms secured by certain investment securities. The average balance for other borrowings increased $41.2 million from $38.0 million for the year ended March 31, 1997, to $79.2 million for the same period in 1998, and the related interest expense increased $2..5 million from $2.1 million to $4.6 million for the respective periods. The bulk of this growth in other borrowings reflects a $45.6 million increase in repurchase agreements with investment banking firms that were used to finance a portion of the Company's assets. The repurchase agreements with investment banking firms generally carry higher rates than retail agreements; therefore, as they constituted a greater portion of other borrowings, the weighted average rate increased. Deposit interest expense increased $3.6 million for the year ended March 31, 1998. Average deposit balances increased from $477.4 million for the year ended March 31, 1997, to $566.2 million for the year ended March 31, 1998, while, at the same time, the average rate paid on deposit balances decreased 8 basis points. The decline in the rate paid on deposits primarily reflects the acquisition of IEB's $32.1 million of non- interest-bearing deposits as well as generally lower rates paid on interest- bearing accounts of IEB, which impacted the full twelve month period in 1998 in contrast to only eight months in 1997. PROVISION FOR LOAN LOSSES. The provision for loan losses for the year ended March 31, 1998, increased by $205,000 to $1.6 million compared to $1.4 million for fiscal 1997. This increase is reflective of the need to provide a higher allowance level as a result of the $114.8 million growth in gross loans receivable for the fiscal year as well as changes in the mix of the loan portfolio. In particular, growth in commercial and multifamily real estate loans, which increased by $38.7 million, commercial and agricultural loans, which increased by $19.8 million, and consumer and credit card loans, which increased $5.8 million, resulted in an increased level of loss provision. Somewhat mitigating these changes in the loan mix was a modest decline in the amount of non-performing loans which declined to $1.4 million at March 31, 1998 compared to $2.1 million at March 31, 1997. The allowance for loan losses equaled 1.03% to net loans and 553% of non-performing loans at March 31, 1998 compared to 0.94% and 320%, respectively, at March 31, 1997. OTHER OPERATING INCOME. Other operating income increased from $3.1 million for the year ended March 31, 1997, to $4.7 million for the year ended March 31, 1998. Part of the increase was due to a $921,000 increase in other fees and service charges due largely to IEB operations earning higher fees as a commercial bank combined with increased fee income at FSBW reflecting deposit growth and pricing adjustments. In addition there was a $693,000 increase in net gains on securities and loans sold in fiscal 1998 as compared to 1997. This increase primarily reflects inclusion of a full year of activity from IEB's residential mortgage banking operations and increased sales of loans, with servicing retained, by FSBW which increased the volume of loans sold in the secondary market over the prior year. OTHER OPERATING EXPENSES. Other operating expenses for the year ended March 31, 1998 increased $1.7 million from the prior period in fiscal 1997. The decrease in the $2.4 million special SAIF assessment for the year ended March 31, 1998 was more than offset by a $4.3 million increase in other operating expenses, which among other increases included a full year of IEB's operations in the fiscal 1998 period compared to eight months in the comparable period in fiscal 1997. In addition to the full year impact of IEB, increases in other operating expenses reflected overall growth in assets and liabilities, customer relationships and complexity of operations as the Company continued to expand. The Company's efficiency ratio, excluding the amortization of goodwill and the $2.4 million one-time special SAIF assessment, improved to 46.56% (48.64% including goodwill) for the year ended March 31, 1998, from 48.11% (56.87% including goodwill) for fiscal 1997. Other operating expenses as a percentage of average assets declined to 1.93% (1.85% excluding the amortization of goodwill) for the year ended March 31, 1998, compared to 2.17% (1.90% excluding the SAIF assessment) (1.83% excluding the amortization of goodwill) for the year ended March 31, 1997. 48 INCOME TAXES. Income tax expense was $7.4 million for the year ended March 31, 1998, compared to $3.9 million for fiscal 1997. The $3.5 million increase in the provision for income taxes reflects the higher level of income being taxed at higher effective rates due to the phase out of the 34% surtax exemption; the net effect of IEB's state taxes and non-deductible goodwill expense and the fact that part of the expense recorded in the release of the ESOP shares was not deductible for tax purposes. The Company's effective tax rates for the years ended March 31, 1998 and 1997, were 36% and 30%, respectively. YIELDS EARNED AND RATES PAID The earnings of the Company depend largely on the spread between the yield on interest-earning assets (primarily loans and investment securities) and the cost of interest-bearing liabilities (primarily deposit accounts and FHLB advances), as well as the relative size of the Company's interest-earning assets and interest-bearing liability portfolio. Table I, Analysis of Net Interest Spread, sets forth, for the periods indicated, information regarding average balances of assets and liabilities as well as the total dollar amounts of interest income from average interest- earning assets and interest expense on average interest-bearing liabilities, resultant yields, interest rate spread, net interest margin, and ratio of average interest-earning assets to average interest-bearing liabilities. Average balances for a period have been calculated using the daily average during such period. Changes in the economic and interest rate environment, competition in the marketplace and changes in asset and liability mix can cause the Company's average interest rate spread to increase or decrease. While strong competition and a generally unfavorable interest rate environment (a relatively flat yield curve brought about largely by declining intermediate and long term interest rates) have had negative effects on the Company's interest rate spread in recent periods, for the past two years the most significant impact on the Company's interest rate spread has come from changes in its asset and liability mix. On balance, those changes in mix have resulted in an expanding interest rate spread which has increased from 2.88% in 1997 to 3.13% in 1998 and again to 3.45% in 1999. Contributing to this increased spread has been a decline in the relative portion of the Company's assets invested in securities which was 36.8% of average earning assets in 1997, 30.1% in 1998, and 27.5% in 1999. In addition to the relative decline in investment securities and commensurate increase in loans, the mix of the loan portfolio has changed to include more higher yielding loans. Changes in the portfolio mix are evident in the higher yields on mortgage loans which increased from 8.38% in 1997 to 8.69% in 1998 and to 8.95% in 1999. Changes in the portfolio mix are also reflected in the increased portion of non-mortgage loans which increased from 5.4% of earning assets in 1997 to 8.1% of earning assets in 1998 and to 14.6% in 1999. Also contributing to an improved interest rate spread has been a decline in the cost of deposits primarily brought about by the substantial increase in the amount of checking and NOW account balances. Deposit costs declined from 4.49% in 1997 to 4.41% in 1998 and to 4.26% in 1999. Substantially offsetting the decline in deposit costs has been an increase in the use of more expensive FHLB advances and other borrowings. As a result, the cost of total interest-bearing liabilities increased from 4.93% in 1997 to 5.02% in 1998, and then declined to 4.83% in 1999. The acquisition of IEB, TB and WSB significantly contributed to the changes in loan and deposit portfolio mix. Improvement in the Company's net interest margin over this same period mostly reflects the same changes associated with the increased net interest rate spread. However, counterbalancing to a degree this increased spread is the somewhat adverse impact on net interest margin resulting from the increased use of leverage which can be seen in the declining ratio of average interest-earning assets to average interest-bearing liabilities. Nonetheless, net interest margin increased from 3.59% in 1997 to 3.68% in 1998 and to 3.83% in 1999. Management believes that in the future increased net interest income will come primarily from increased volumes, although continued changes in asset and liability mix and a slightly more favorable interest rate environment may also add to net interest income. 49 TABLE I: ANALYSIS OF NET INTEREST SPREAD Years Ended March 31 (dollars in thousands) 1999 1998 (1) 1997(1) -------------------------- -------------------------- -------------------------- Average Interest & Yield/ Average Interest & Yield/ Average Interest & Yield/ Balance Dividends Cost Balance Dividends Cost Balance Dividends Cost ------- ---------- ---- ------- ---------- ---- ------- ---------- ---- Interest-earning assets: Mortgage loans $ 784,534 $ 70,193 8.95% $ 645,576 $ 56,111 8.69% $ 498,578 $ 41,797 8.38% Commercial/agricul- tural loans 153,706 15,047 9.79 57,516 5,587 9.71 30,120 2,829 9.39 Consumer and other loans 44,568 4,375 9.82 27,412 2,997 10.93 16,494 1,923 11.66 ---------- -------- ---- ---------- -------- ---- -------- -------- ---- Total loans (2) 982,808 89,615 9.12 730,505 64,695 8.86 545,192 46,549 8.54 Mortgage-backed securities 218,648 13,025 5.96 189,572 12,522 6.61 181,148 12,420 6.86 Securities and deposits 134,014 8,107 6.05 110,625 6,783 6.13 124,592 7,455 5.98 FHLB stock 20,066 1,545 7.70 14,661 1,147 7.82 11,222 868 7.73 ---------- -------- ---- ---------- -------- ---- -------- -------- ---- Total investment securities 372,728 22,671 6.08 314,858 20,452 6.50 316,962 20,743 6.54 ---------- -------- ---- ---------- -------- ---- -------- -------- ---- Total interest- earning assets 1,355,536 112,292 8.28 1,045,362 85,147 8.15 862,154 67,292 7.81 -------- ---- -------- ---- -------- ---- Non-interest-earning assets 80,038 43,256 30,217 ---------- ---------- -------- Total assets $1,435,574 $1,088,618 $892,371 ========== ========== ======== Interest-bearing liabilities: Savings accounts $ 47,487 1,356 2.86 $ 42,937 1,248 2.91 $ 41,114 1,183 2.88 Checking and NOW accounts(3) 154,108 1,110 0.72 103,426 899 0.87 76,691 864 1.13 Money market accounts 109,379 4,154 3.80 76,048 3,073 4.04 61,426 2,077 3.38 Certificates of deposit 488,377 27,399 5.61 351,042 20,069 5.72 305,336 17,612 5.77 ---------- -------- ---- ---------- -------- ---- -------- -------- ---- Total deposits 799,351 34,019 4.26 573,453 25,289 4.41 484,567 21,736 4.49 Other interest-bearing liabilities: FHLB advances 363,279 21,430 5.90 276,328 16,782 6.07 214,563 12,504 5.83 Other borrowings 88,967 4,993 5.61 79,210 4,580 5.78 37,952 2,132 5.61 ---------- -------- ---- ---------- -------- ---- -------- -------- ---- Total interest- bearing liabilities 1,251,597 60,442 4.83 928,991 46,651 5.02 737,082 36,372 4.93 -------- ---- -------- ---- -------- ---- Non-interest-bearing liabilities 10,682 8,783 7,360 ---------- ---------- -------- Total liabilities 1,262,279 937,774 744,442 ---------- ---------- -------- Equity 173,295 150,844 147,929 ---------- ---------- -------- Total liabilities and equity $1,435,574 $1,088,618 $892,371 ========== ========== ======== Net interest income $ 51,850 $ 38,496 $ 30,920 ======== ======== ======== 3.45% 3.13% 2.88% ===== ===== ===== Net interest margin 3.83% 3.68% 3.59% ===== ===== ===== Ratio of average interest-earning assets to average interest-bearing liabilities 108.30% 112.53% 116.97% ======= ======= ======= - ---------- (1) Restated to be comparable to current year's presentation. (2) Average balances include loans accounted for on a nonaccrual basis and loans 90 days or more past due. Amortized net deferred loan fees are included with interest and dividends on loans. (3) Average balances include non-interest-bearing deposits. 50
Table II, Rate/Volume Analysis, sets forth the effects of changing rates and volumes on net interest income of the Company. Information is provided with respect to (i) effects on interest income attributable to changes in volume (changes in volume multiplied by prior rate); (ii) effects on interest income attributable to changes in rate (changes in rate multiplied by prior volume); and (iii) effects on interest income attributable to changes in rate and volume (changes in rate multiplied by changes in volume). TABLE II: RATE/VOLUME ANALYSIS Year Ended March 31, 1999 Year Ended March 31, 1998 Compared to March 31, 1998 Compared to March 31, 1997 Increase (Decrease) Due to Increase (Decrease) Due to (1) ------------------------------ ------------------------------- (dollars in thousands) Rate/ Rate/ Rate Volume Volume Net Rate Volume Volume Net ---- ------ ------ --- ---- ------ ------ --- Interest-earning assets: Mortgage loans $1,646 $12,075 $ 361 $14,082 $1,540 $12,318 $ 456 $14,314 Commercial/agricultural loans 43 9,340 77 9,460 98 2,572 88 2,758 Consumer and other loans (307) 1,875 (190) 1,378 (119) 1,273 (80) 1,074 ------ ------ ------- ------ ------- ------- ------ ------- Total loans(2) 1,382 23,290 248 24,920 1,519 16,163 464 18,146 Mortgage-backed securities (1,230) 1,922 (189) 503 (455) 578 (21) 102 Securities and deposits (91) 1,434 (19) 1,324 184 (835) (21) (672) FHLB stock (19) 423 (6) 398 10 266 3 279 ------ ------ ------- ------ ------- ------- ------ ------- Total net change in interest income on interest-earning assets 42 27,069 34 27,145 1,258 16,172 425 17,855 ------ ------ ------- ------ ------- ------- ------ ------- Interest-bearing liabilities: Deposits (893) 9,962 (339) 8,730 (367) 3,991 (71) 3,553 FHLB advances (482) 5,278 (148) 4,648 529 3,601 148 4,278 Other borrowings (156) 586 (17) 413 63 2,319 66 2,448 ------ ------ ------- ------ ------- ------- ------ ------- Total net change in interest expense on interest-bearing liabilities (1,531) 15,826 (504) 13,791 225 9,911 143 10,279 ------ ------ ------- ------ ------- ------- ------ ------- Net change in net interest income $1,573 $11,243 $ 538 $13,354 $1,033 $ 6,261 $ 282 $ 7,576 ====== ======= ======= ======= ======= ======= ====== ======= - ------- (1) Restated to be comparable to current year's presentation. (2) Does not include interest on loans 90 days or more past due. 51
MARKET RISK AND ASSET/LIABILITY MANAGEMENT The financial condition and operations 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 impacting 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. 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. 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 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. Tables III and III (a), Interest Rate Risk Indicators, set forth as of March 31, 1999 and 1998, the estimated changes in the 52 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 III: INTEREST RATE RISK INDICATORS As of March 31, 1999 Estimated Change in ----------------------------------------- Change (In Basis Points) Net Interest Income In Interest Rates (1) Next 12 Months Net Market Value ------------------------ ------------------- -------------------- (Dollars in thousands) +400 $ (1,677) (3.0%) $ (72,990) (37.4%) +300 (649) (1.2%) (55,433) (28.4%) +200 (81) (0.1%) (34,919) (17.9%) +100 194 0.3% (14,526) (7.4%) 0 0 0 0 0 -100 (1,440) (2.6%) 83 0.0% -200 (3,582) (6.4%) (7,140) (3.7%) -300 (6,568) (11.6%) (20,441) (10.5%) -400 (9,495) (16.8%) (31,427) (16.1%) TABLE III (A): INTEREST RATE RISK INDICATORS As of March 31, 1998 Estimated Change in ----------------------------------------- Change (In Basis Points) Net Interest Income In Interest Rates (1) Next 12 Months Net Market Value ------------------------ ------------------- -------------------- (Dollars in thousands) +400 $ (570) (1.5%) $ (51,291) (32.2%) +300 355 0.9% (38,352) (24.1%) +200 902 2.4% (22,884) (14.4%) +100 728 1.9% (8,715) (5.5%) 0 0 0 0 0 -100 (1,129) (3.0%) (311) (0.2%) -200 (2,748) (7.3%) (2,791) (1.8%) -300 (4,747) (12.5%) (9,102) (5.7%) -400 (7,057) (18.6%) (17,535) (11.0%) - --------- (1) Assumes an instantaneous and sustained uniform change in market interest rates at all maturities. 53 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 ARM 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. Tables IV and IV (a), Interest Sensitivity Gap, present the Company's interest sensitivity gap between interest-earning assets and interest-bearing liabilities at March 31, 1999 and 1998. The tables set forth the amounts of interest-earning assets 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 March 31, 1999, total interest-earning assets maturing or repricing within one year exceeded total interest-bearing liabilities maturing or repricing in the same time period by $9.1 million, representing a one-year gap to total assets ratio of 0.56%. Management is aware of the sources of interest rate risk and in its opinion actively monitors and manages it to the extent possible. The interest rate risk indicators and interest sensitivity gaps for the Company as of March 31, 1999 and 1998 are within policy guidelines. Management considers that the Company's current level of interest rate risk is reasonable. 54 TABLE IV: INTEREST SENSITIVITY GAP as of March 31, 1999 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 $ 98,302 $ 33,841 $ 813 $ 588 $ -- $ -- $ 133,544 Fixed-rate mortgage loans 45,106 41,823 144,842 113,687 130,154 61,775 537,387 Adjustable-rate mortgage loans 103,894 50,506 27,494 25,518 -- -- 207,412 Fixed-rate mortgage-backed securities 13,554 14,674 62,831 24,087 10,968 1,182 127,296 Adjustable-rate mortgage-backed securities 108,001 6,880 -- -- -- - 114,881 Fixed-rate commercial/agricultural loans 9,431 7,484 12,599 15,482 11,528 701 57,225 Adjustable-rate commercial/ agricultural loans 139,292 -- -- -- -- -- 139,292 Consumer and other loans 12,400 3,485 10,330 6,140 1,468 10,235 44,058 Investment securities and interest-bearing deposits 60,360 8,250 23,062 26,410 15,295 30,166 163,543 -------- -------- -------- -------- -------- ------- ---------- Total rate sensitive assets 590,340 166,943 281,971 211,912 169,413 104,059 1,524,638 -------- -------- -------- -------- -------- ------- ---------- Interest-bearing liabilities(2): Regular savings and NOW accounts 22,620 22,620 52,780 52,780 -- -- 150,800 Money market deposit accounts 66,039 39,623 26,415 -- -- -- 132,077 Certificates of deposit 272,316 134,609 130,451 33,105 9,527 21 580,029 FHLB advances 105,000 34,414 109,499 102,990 55,500 849 408,252 Other borrowings 47,690 -- 25,000 -- -- -- 72,690 Retail repurchase agreements 2,993 237 1,455 1,092 -- -- 5,777 -------- -------- -------- -------- -------- ------- ---------- Total rate sensitive liabilities 516,658 231,503 345,600 189,967 65,027 870 1,349,625 -------- -------- -------- -------- -------- ------- ---------- Excess (deficiency) of interest- sensitive assets over interest- sensitive liabilities $ 73,683 $(64,560) $(63,629) $ 21,945 $104,386 $103,189 $ 175,013 ========= ========= ========= ======== ======== ======== ========== Cumulative excess (deficiency) of interest-sensitive assets $ 73,683 $ 9,122 $(54,507) $(32,562) $ 71,824 $175,013 $ 175,013 ========= ========= ========= ========= ======== ======== ========== Cumulative ratio of interest- earning assets to interest- bearing liabilities 114.26% 101.22% 95.02% 97.46% 105.33% 112.97% 112.97% ========= ========= ========= ========= ======== ======== ========== Interest sensitivity gap to total assets 4.52% (3.96%) (3.90%) 1.34% 6.40% 6.32% 10.72% ========= ========= ========= ========= ======== ======== ========== Ratio of cumulative gap to total assets 4.52% 0.56% (3.34%) (2.00%) 4.40% 10.72% 10.72% ========= ========= ========= ========= ======== ======== ========== (footnotes follow tables) 55
TABLE IV (A): INTEREST SENSITIVITY GAP as of March 31, 1998 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 $ 40,697 $ 29,262 $ -- $ -- $ -- $ -- $ 69,959 Fixed-rate mortgage loans 38,603 32,601 105,036 80,656 94,440 61,203 412,539 Adjustable-rate mortgage loans 108,398 56,386 12,791 10,072 -- -- 187,647 Fixed-rate mortgage-backed securities 4,364 4,331 15,540 7,197 4,860 829 37,121 Adjustable-rate mortgage-backed securities 153,107 4,832 1,062 -- -- -- 159,001 Fixed-rate commercial/agricultural loans 4,497 3,539 7,981 4,319 1,668 277 22,281 Adjustable-rate commercial/ agricultural loans 45,198 -- -- -- -- -- 45,198 Consumer and other loans 16,190 2,610 7,086 3,918 1,039 -- 30,843 Investment securities and interest-bearing deposits 61,749 9,895 18,770 6,385 13,370 24,460 134,629 --------- --------- --------- -------- -------- -------- --------- Total rate sensitive assets 472,803 143,456 168,266 112,547 115,377 86,769 1,099,218 --------- --------- --------- -------- -------- -------- --------- Interest-bearing liabilities(2): Regular savings and NOW accounts 14,672 14,673 34,236 34,236 -- -- 97,817 Money market deposit accounts 38,204 22,922 15,281 -- -- -- 76,407 Certificates of deposit 154,260 92,171 81,725 29,691 13,760 -- 371,607 FHLB advances 108,946 23,250 103,163 61,190 1,000 -- 297,549 Other borrowings 60,451 -- 25,000 -- -- -- 85,451 Retail repurchase agreements 3,403 810 739 1,318 -- -- 6,270 --------- --------- --------- -------- -------- -------- --------- Total rate sensitive liabilities 379,936 153,826 260,144 126,435 14,760 -- 935,101 --------- --------- --------- -------- -------- -------- --------- Excess (deficiency) of interest- sensitive assets over interest- sensitive liabilities $ 92,867 $(10,370) $ (91,878)$(13,888) $100,617 $ 86,769 $ 164,117 ========= ========= ========= ======== ======== ======== ========= Cumulative excess (deficiency) of interest-sensitive assets $ 92,867 $ 82,497 $ (9,381)$(23,269) $ 77,348 $164,117 $ 164,117 ========= ========= ========= ======== ======== ======== ========= Cumulative ratio of interest- earning assets to interest- bearing liabilities 124.44% 115.46% 98.82% 97.47% 108.27% 117.55% 117.55% ========= ========= ========= ======== ======== ======== ========= Interest sensitivity gap to total assets 8.05% (0.90%) (7.96%) (1.20%) 8.72% 7.52% 14.22% ========= ========= ========= ======== ======== ======== ========= Ratio of cumulative gap to total assets 8.05% 7.15% (0.81%) (2.02%) 6.70% 14.22% 14.22% ========= ========= ========= ======== ======== ======== ========== (footnotes follow tables) 56
FOOTNOTES FOR TABLES IV AND IV (A): 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 period 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-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 Banks' regular savings, demand, 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 $(122.9) million, or (7.53%) of total assets at March 31, 1999 and $(1.3) million, or (0.11%) at March 31, 1998. Interest-bearing liabilities for this table exclude certain non-interest bearing deposits which are included in the average balance calculations in the earlier Table I, Analysis of Net Interest Spread. 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 amortization 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. During the years ended March 31, 1999, 1998 and 1997, the Company closed or purchased loans in the amounts of $938.5 million, $562.4 million and $387.8 million, respectively. This activity was funded primarily by principal repayments on loans and securities, sales of loans, increases in FHLB advances, other borrowings, and deposit growth. For the years ended March 31, 1999, 1998 and 1997, principal repayments on loans totaled $521.0 million, $375.9 million and $207.5 million, respectively. During the three years ended March 31, 1999, 1998 and 1997, the Company sold $127.5 million, $82.0 million and $36.9 million, respectively, of loans. FHLB advances increased $101.7 million, $66.0 million and $52.1 million, respectively, for the same three years. During the three years ended March 31, 1999, other borrowings decreased $13.3 million for 1999, and increased $29.5 million and $41.9 million for 1998 and 1997. Net deposit growth was $130.0 million (excluding $218.4 million of deposits acquired with TB and WSB), $46.6 million, and $36.3 million (excluding $134.6 million of deposits acquired with IEB) for the years ended March 31, 1999, 1998 and 1997, respectively. The Banks 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 fiscal years 1999, 1998 and 1997, the Banks used their sources of funds primarily to fund loan commitments, to purchase securities, and to pay maturing savings certificates and deposit withdrawals. At March 31, 1999, the Banks had outstanding loan commitments totaling $147.1 million and undisbursed loans in process totaling $71.6 million. The Banks generally maintain sufficient cash and readily marketable securities to meet short term liquidity needs. FSBW maintains a credit facility with the FHLB-Seattle, which provides for advances which in aggregate may equal up to 45% of FSBW's assets, which as of March 31, 1999, could give a total credit line of $537.1 million. Advances under this credit facility totaled $402.7 million, or 33.7% of FSBW's assets at March 31, 1999. IEB and TB also maintain credit lines with various institutions that would allow them to borrow up to $20.8 million. At March 31, 1999, savings certificates amounted to $580.0 million, or 61%, of the Banks' total deposits, including $405.3 million which were scheduled to mature by March 31, 2000. Historically, the Banks have been able to retain a significant amount of their deposits as they mature. Management believes it has adequate resources to fund all loan commitments from savings deposits and FHLB-Seattle advances and sale of mortgage loans and that it can adjust the offering rates of savings certificates to retain deposits in changing interest rate environments. 57 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 (BHCA), and the regulations of the Federal Reserve. Each of the Banks, as state-chartered federally insured institutions, 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 its subsidiary Banks 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 Banks to maintain minimum ratios of Tier 1 total capital to risk-weighted assets as well as Tier 1 leverage capital to average assets (see further discussion in Note 17 to the Consolidated Financial Statements). At March 31, 1999 the Company and its banking subsidiaries, FSBW, IEB and TB, exceeded all current regulatory capital requirements and the Banks were categorized at the highest regulatory standard, "well-capitalized." Table V, Regulatory Capital Ratios, shows the regulatory capital ratios of the Company, FSBW, IEB and TB and minimum regulatory requirements for the Banks to be categorized as "well-capitalized." TABLE V: REGULATORY CAPITAL RATIOS The "Well-capitalized" Capital Ratios Company FSBW IEB TB Minimum Ratio - -------------- ------- ---- --- -- ------------- Total capital to risk- weighted assets 15.15% 17.01% 12.69% 10.03% 10.00% Tier 1 capital to risk- weighted assets 13.99 15.80 11.65 8.90 6.00 Tier 1 leverage capital to average assets 9.44 9.41 9.60 8.87 5.00 EFFECT OF INFLATION AND CHANGING PRICES The consolidated financial statements and related financial data presented herein have been prepared in accordance with generally accepted accounting principles, which require the measurement of financial position and operating results in terms of historical dollars, without considering the changes in relative purchasing power of money over time due to inflation. The primary impact of inflation on operations of the Company is reflected in increased operating costs. Unlike most industrial companies, virtually all the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates generally have a more significant impact on a financial institution's performance than do general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services. RECENT ACCOUNTING STANDARDS NOT YET ADOPTED SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, was issued in June 1998 and establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. FWWB will implement this statement on January 1, 2000. The impact of the adoption of the provisions of this statement on the results of operations or financial condition of FWWB has not yet been determined. SFAS No. 134, Accounting for Mortgage-Backed Securities Retained after the Securitization of Mortgage Loans Held for Sale by a Mortgage Banking Enterprise, was issued in October 1998. Prior to issuance of SFAS No. 134, when a mortgage banking company securitized mortgage loans held for sale but did not sell the security in the secondary market, the security was classified as trading. SFAS No. 134 requires that the security be classified either trading, available for sale or held to maturity according to the Company's intent, unless the Company has already committed to sell the security before or during the securitization process. The statement is effective for all fiscal years beginning after December 15, 1998. This statement is not expected to have a material impact on the results of operations or financial condition of the Company. 58 ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK See pages 52-57 of MD&A ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA For financial statements, see index on page 61. ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not Applicable PART III ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information contained under the section captioned "Proposal I - Election of Directors" in the Registrant's Proxy Statement is incorporated herein by reference. Information regarding the executive officers of the Registrant is provided herein in Part I, Item 1 hereof. Reference is made to the cover page of this Annual Report and the section captioned "Compliance with Section 16(a) of the Exchange Act" of the Proxy Statement for the Annual Meeting of the Stockholders regarding compliance with Section 16(a) of the Securities Exchange Act of 1934. ITEM 11- EXECUTIVE COMPENSATION Information regarding management compensation and transactions with management and others is incorporated by reference to the section captioned "Proposal I - Election of Directors" in the Proxy Statement for the Annual Meeting of Stockholders. ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT {a} Security Ownership of Certain Beneficial Owners Information required by this item is incorporated herein by reference to the section captioned "Securities Ownership of Certain Beneficial Owners and Management" in the Proxy Statement for the Annual Meeting of Stockholders. {b} Security Ownership of Management Information required by this item is incorporated herein by reference to the section captioned "Securities Ownership of Certain Beneficial Owners and Management" in the Proxy Statement for the Annual Meeting of Stockholders. {c} Changes in Control The Company is not aware of any arrangements, including any pledge by any person of securities of the Company, the operation of which may at a subsequent date result in a change in control of the Company. ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information contained under the sections captioned "Transactions with Management" in the Proxy Statement for the Annual Meeting of Stockholders is incorporated herein by reference. 59 PART IV ITEM 14 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K {a} {1} Financial Statements See Index to Consolidated Financial Statements on page 62. {2} Financial Statement Schedules All financial statement schedules are omitted because that are not applicable or not required, or because the required information is included in the consolidated financial statements or the notes thereto or in Part 1, Item 1. {b} Reports on 8-K: Reports on Form 8-K filed during the quarter ended March 31, 1999 are as follows: Date Filed Purpose ----------- ------- January 1, 1999 Announcement of consummation of previously announced acquisition of Whatcom State Bancorp and its wholly-owned subsidiary, Whatcom State Bank January 7, 1999 Announcement of entering into an Agreement and Plan of Merger with Seaport Citizens' Bank {c} Exhibits See Index of Exhibits on page 107. 60 SIGNATURES OF REGISTRANT Pursuant to the requirements of the Section 13 of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on June 26, 1999. FIRST WASHINGTON BANCORP, INC. /s/ GARY SIRMON ------------------------------------- Gary Sirmon President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities indicated on June 26, 1999. /S/Gary Sirmon /s/D. Allan Roth - -------------------------------------- ------------------------------------- Gary Sirmon D. Allan Roth President and Chief Executive Officer; Executive Vice President and Chief Director Financial Officer (Principle Executive Officer) (Principle Financial and Accounting Officer) /s/Wilber Pribilsky /s/Robert D. Adams - -------------------------------------- ------------------------------------- Wilber Pribilsky Robert D. Adams Director Chairman of the Board /s/David Casper /s/Morris Ganguet - -------------------------------------- ------------------------------------- David Casper Morris Ganguet Director Director /s/R. R. "Pete" Reid /s/Marvin Sundquist - -------------------------------------- ------------------------------------- R. R. "Pete" Reid Marvin Sundquist Director Director /s/Dean W. Mitchell /s/Jesse G. Foster - -------------------------------------- ------------------------------------- Dean W. Mitchell Jesse G. Foster Director Director /s/S. Rick Meikle /s/Brent A. Orrico - -------------------------------------- ------------------------------------- S. Rick Meikle Brent A. Orrico Director Director 61 INDEX TO CONSOLIDATED FINANCIAL STATEMENTS FIRST WASHINGTON BANCORP, INC. AND SUBSIDIARIES (ITEM 8 AND ITEM 14 (A) (1)) Report of Management.....................................................63 Report of Audit Committee................................................63 Independent Auditors' Report.............................................64 Consolidated Statements of Financial Condition as of March 31, 1999 and 1998...................................................................65 Consolidated Statements of Income for the Years Ended March 31, 1999, 1998 and 1997..........................................................66 Consolidated Statements of Comprehensive Income for the Years ended March 31, 1999, 1998 and 1997....................................67 Consolidated Statements of Changes in Stockholders' Equity for the Years Ended March 31, 1999, 1998 and 1997..............................68 Consolidated Statements of Cash Flows for the Years Ended March 31, 1999, 1998 and 1997..........................................70 Notes to the Consolidated Financial Statements...........................72 62 June 10, 1999 Report of Management: To the Stockholders: The management of First Washington Bancorp, Inc. ("the Company) is responsible for the preparation, integrity, and fair presentation of its published financial statements and all other information presented in this annual report. The financial statements have been prepared in accordance with generally accepted accounting principles and, as such, include amounts based on informed judgments and estimates made by management. In the opinion of management, the financial statements and other information herein present fairly the financial condition and operations of the Company at the dates indicated in conformity with generally accepted accounting principles. Management is responsible for establishing and maintaining an effective internal control over financial reporting. The internal control system is augmented by written policies and procedures and by audits performed by an internal audit staff which reports to the Audit Committee of the Board of Directors. Internal auditors monitor the operation of the internal control system and report findings to management and the Audit Committee. When appropriate, corrective actions are taken to address identified control deficiencies and other opportunities for improving the system. The Audit Committee provides oversight to the financial reporting process. There are inherent limitations in the effectiveness of any system of internal control, including the possibility of human error and circumvention or overriding of controls. Accordingly, even an effective internal control system can provide only reasonable assurance with respect to financial statement preparation. Further, because of changes in conditions, the effectiveness of an internal control system may vary over time. The Audit Committee of the Board of Directors is comprised entirely of outside directors who are independent of the Bank's management. The Audit Committee is responsible for recommending to the Board of Directors the selection of independent auditors. It meets periodically with management, the independent auditors and the internal auditors to ensure that they are carrying out their responsibilities. The Committee is also responsible for performing an oversight role by reviewing and monitoring the financial, accounting, and auditing procedures of the Bank in addition to reviewing the Bank's financial reports. The independent auditors and the internal auditors have full and free access to the Audit Committee, with or without the presence of management, to discuss the adequacy of the internal control structure for financial reporting and any other matters which they believe should be brought to the attention of the Committee. /s/ Gary Sirmon /s/ D. Allan Roth Gary Sirmon, Chief Executive Officer D. Allan Roth, Chief Financial Officer June 10, 1999 Report of the Audit Committee of the Board of Directors The Audit Committee of the Board of Directors is comprised of all directors who are not employees of the Company. The Audit Committee has reviewed the audited financial statements of First Washington Bancorp, Inc. with management of the Company, including a discussion of the quality of the accounting principles applied and significant judgments and estimates affecting the financial statements. The Audit Committee has also discussed with the outside auditors the auditors' opinion of the quality of those principles and significant judgments as applied by management in preparation of the financial statements. In addition, the members of the Audit Committee have discussed among themselves, without management or the outside auditors present, the information disclosed to the committee by management and the outside auditors and have met regularly with the internal audit staff, without management present, to review compliance with approved policies and procedures. In reliance on these reviews and discussions, the Audit Committee believes that the financial statements of First Washington Bancorp, Inc. are fairly presented in conformity with generally accepted accounting principles in all material respects. /s/ Robert D. Adams Robert D. Adams Audit Committee Chairman 63 INDEPENDENT AUDITORS' REPORT Board of Directors First Washington Bancorp, Inc. and Subsidiaries Walla Walla, Washington We have audited the accompanying consolidated statements of financial condition of First Washington Bancorp, Inc. and subsidiaries (the Company) as of March 31, 1999 and 1998, and the related consolidated statements of income, comprehensive income, changes in stockholders' equity, and cash flows for each of the three years in the period ended March 31, 1999. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial condition of First Washington Bancorp, Inc. and subsidiaries as of March 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended March 31, 1999 in conformity with generally accepted accounting principles. /s/Deloitte and Touche LLP DELOITTE & TOUCHE LLP June 10, 1999 Seattle, Washington 64 FIRST WASHINGTON BANCORP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (in thousands, except shares) March 31, 1999 and 1998 ASSETS 1999 1998 ---- ---- Cash and due from banks $ 72,503 $ 42,529 Securities available for sale, cost $358,540 and $298,346 362,021 302,419 Securities held to maturity, fair value $2,235 and $194 2,155 194 Federal Home Loan Bank stock 23,137 16,050 Loans receivable: Held for sale, fair value $11,256 and $12,436 11,256 12,436 Held for portfolio 1,103,674 752,338 Allowance for loan losses (12,261) (7,857) ---------- ---------- 1,102,669 756,917 Accrued interest receivable 9,898 7,569 Real estate held for sale, net 1,439 882 Property and equipment, net 15,960 11,379 Costs in excess of net assets acquired (goodwill), net 34,182 11,007 Deferred income tax asset, net 758 -- Other assets 7,178 5,126 ---------- ---------- $1,631,900 $1,154,072 ========== ========== LIABILITIES Deposits: Non-interest-bearing $ 97,062 $ 56,691 Interest-bearing 853,786 545,831 ---------- ---------- 950,848 602,522 Advances from Federal Home Loan Bank 408,252 297,549 Other borrowings 78,467 91,723 Accrued expenses and other liabilities 7,928 5,475 Deferred compensation 1,691 3,798 Deferred income tax liability, net -- 541 Income taxes payable 1,106 2,280 ---------- ---------- 1,448,292 1,003,888 STOCKHOLDERS' EQUITY Preferred stock - $0.01 par value, 500,000 shares authorized, no shares issued -- -- Common stock - $0.01 par value, 27,500,000 shares authorized, 12,001,562 shares issued: * 11,647,615 shares and 10,948,123 shares outstanding * at March 31, 1999 and 1998, respectively. 130,770 108,994 Retained earnings 59,958 72,962 Accumulated other comprehensive income: Unrealized gain (loss) on securities available for sale 2,296 2,680 Treasury stock, at cost: none and 1,053,439 shares * at March 31, 1999 (see Note 1) and 1998, respectively -- (20,979) Unearned shares of common stock issued to Employee Stock Ownership Plan (ESOP) trust: 745,918 and 787,897 restricted shares outstanding * at March 31, 1999 and 1998, respectively, at cost (6,781) (7,163) Carrying value of shares held in trust for stock related compensation plans (4,785) (6,310) Liability for common stock issued to deferred, stock related, compensation plan 2,150 -- ---------- ---------- (2,635) (6,310) ---------- ---------- 183,608 150,184 ---------- ---------- $1,631,900 $1,154,072 ========== ========== *Adjusted for stock dividend: see Note 2. See notes to consolidated financial statements 65 FIRST WASHINGTON BANCORP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (In thousands except for per share data) For the years ended March 31, 1999, 1998 and 1997 1999 1998 1997 ---- ---- ---- INTEREST INCOME: Loans receivable $ 89,615 $ 64,695 $ 46,549 Mortgage-backed securities 13,025 12,522 12,420 Securities and cash equivalents 9,652 7,930 8,323 --------- --------- --------- 112,292 85,147 67,292 --------- --------- --------- INTEREST EXPENSE: Deposits 34,019 25,289 21,736 Federal Home Loan Bank advances 21,430 16,782 12,504 Other borrowings 4,993 4,580 2,132 --------- --------- --------- 60,442 46,651 36,372 --------- --------- --------- Net interest income before provision for loan losses 51,850 38,496 30,920 PROVISION FOR LOAN LOSSES 2,841 1,628 1,423 --------- --------- --------- Net interest income 49,009 36,868 29,497 OTHER OPERATING INCOME: Loan servicing fees 798 815 746 Other fees and service charges 3,574 2,436 1,532 Gain on sale of loans 2,884 1,377 684 Gain (loss) on sale of securities 11 2 2 Miscellaneous 186 90 106 --------- --------- --------- Total other operating income 7,453 4,720 3,070 OTHER OPERATING EXPENSES: Salary and employee benefits 18,644 13,117 10,574 Less capitalized loan origination costs (2,689) (2,069) (1,666) Occupancy and equipment 4,816 2,983 2,429 Information/computer data services 1,603 1,169 912 Advertising 590 450 415 Savings Association Insurance Fund (SAIF) special assessment -- -- 2,387 Deposit insurance 338 280 497 Amortization of goodwill 2,389 899 592 Miscellaneous 6,054 4,191 3,190 --------- --------- --------- Total other operating expenses 31,745 21,020 19,330 --------- --------- --------- Income before provision for income taxes 24,717 20,568 13,237 PROVISION FOR INCOME TAXES 9,277 7,446 3,923 --------- --------- --------- NET INCOME $ 15,440 $ 13,122 $ 9,314 ========= ========= ========= Earnings per common share: see Notes 2 and 25 Basic $ 1.46 $ 1.30 $ 0.88 Diluted $ 1.40 $ 1.25 $ 0.87 Cumulative dividends declared per common share $ 0.38 $ 0.27 $ 0.20 See notes to consolidated financial statements 66 FIRST WASHINGTON BANCORP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (In thousands) For the years ended March 31, 1999, 1998 and 1997 1999 1998 1997 ---- ---- ---- NET INCOME: $ 15,440 $ 13,122 $ 9,314 OTHER COMPREHENSIVE INCOME (LOSS), NET OF INCOME TAXES: Unrealized holding gain (loss) during the period, net of deferred income tax (benefit) of $(194), $1,588 and $(606) (377) 3,082 (1,176) Less adjustment for gains included in net income, net of income tax of $4, $1 and $1 7 1 1 --------- --------- --------- Other comprehensive income (loss) (384) 3,081 (1,175) --------- --------- --------- COMPREHENSIVE INCOME $ 15,056 $ 16,203 $ 8,139 ========= ========= ========= See notes to consolidated financial statements 67 FIRST WASHINGTON BANCORP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (in thousands) For the years ended March 31, 1999, 1998 and 1997 1999 1998 1997 ---- ---- ---- COMMON STOCK: Balance, beginning of year $108,994 $107,953 $107,479 Issuance of stock in connection with acquisitions 12,776 -- -- Assumption of options in connection with acquisitions 2,546 -- -- Excess of basis over proceeds of stock reissued for exercised stock options (265) (29) -- Record 10% stock dividend: see Note 2 24,371 -- -- Repurchase and retirement of stock subsequent to reincorporation (7,926) -- -- Repurchase of forfeited shares, subsequent to reincorporation (29) -- -- Retirement of treasury stock resulting from reincorporation in State of Washington: see Note 1 (11,116) -- -- Release of earned ESOP shares 542 839 417 Issuance of stock to fund stock related compensation plans 601 -- 57 Recognition of tax benefit related to release of MRP shares 276 231 -- -------- --------- --------- Balance, end of year 130,770 108,994 107,953 RETAINED EARNINGS: Balance, beginning of year 72,962 62,572 55,343 Net income 15,440 13,122 9,314 Record 10% stock dividend (24,371) -- -- Cash dividends (4,073) (2,732) (2,085) -------- --------- --------- Balance, end of year 59,958 72,962 62,572 ACCUMULATED OTHER COMPREHENSIVE INCOME: Balance, beginning of year 2,680 (401) 774 Other comprehensive income (loss), net of related income taxes (384) 3,081 (1,175) -------- --------- --------- Balance, end of year 2,296 2,680 (401) TREASURY STOCK: Balance, beginning of year (20,979) (6,954) -- Issuance of stock in connection with acquisitions 17,206 -- -- Purchases of treasury stock, prior to reincorporation (7,340) (13,993) (12,905) Purchases of treasury stock for exercised stock options (409) (74) -- Issuance of treasury stock for MRP and/ or exercised stock options 409 74 5,957 Repurchase of forfeited shares from MRP (3) (32) (6) Retirement of treasury shares resulting from reincorporation in State of Washington: see Note 1 11,116 -- - -------- --------- --------- Balance, end of year -- (20,979) (6,954) UNEARNED, RESTRICTED ESOP SHARES AT COST: Balance, beginning of year (7,163) (7,751) (8,331) Release of earned ESOP shares 382 588 580 -------- --------- --------- Balance, end of year (6,781) (7,163) (7,751) CARRYING VALUE OF SHARES HELD IN TRUST FOR STOCK RELATED COMPENSATION PLANS: Balance, beginning of year (6,310) (6,783) (1,123) Cumulative effect of change in accounting for Rabbi Trust: see Note 1 1,095 -- -- Stock issued to fund Rabbi Trust plans (601) -- -- Net change in number and/or valuation of shares held in trust 1,987 (740) (548) Issuance of treasury stock for MRP -- -- (6,014) Amortization of compensation related to MRP 1,194 1,213 902 -------- --------- --------- Balance, end of year (2,635) (6,310) (6,783) -------- --------- --------- TOTAL STOCKHOLDERS' EQUITY $183,608 $ 150,184 $ 148,636 ======== ========= ========= See notes to consolidated financial statements 68 FIRST WASHINGTON BANCORP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (in thousands) For the years ended March 31, 1999, 1998 and 1997 1999* 1998* 1997* ----- ----- ----- COMMON STOCK, SHARES ISSUED: Number of shares, beginning of year 12,002 12,002 12,002 ------- ------- ------- Number of shares, end of year 12,002 12,002 12,002 ------- ------- ------- LESS TREASURY STOCK RETIRED/ REPURCHASED: see Note 1: Number of shares, beginning of year (1,054) (431) -- Repurchase stock (675) (621) (875) Repurchase stock for exercised stock options (18) (3) -- Issuance of stock to deferred compensation plan and/or exercised stock options 34 3 445 Stock issued in acquisitions 1,361 -- -- Repurchase of stock forfeited from MRP (2) (2) (1) -------- -------- -------- Shares of stock retired/repurchased, end of year (354) (1,054) (431) -------- -------- -------- SHARES OUTSTANDING, END OF YEAR 11,648 10,948 11,571 ======== ======== ======== UNEARNED, RESTRICTED ESOP SHARES: Number of shares, beginning of year (788) (853) (917) Release of earned shares 42 65 64 -------- -------- -------- Number of shares, end of year (746) (788) (853) ======== ======== ======== * Adjusted for stock dividend: see Note 2. See notes to consolidated financial statements 69 FIRST WASHINGTON BANCORP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) FOR THE Years ended March 31, 1999, 1998 and 1997 1999 1998 1997 ---- ---- ---- OPERATING ACTIVITIES: Net income $15,440 $13,122 $ 9,314 Adjustments to reconcile net income to net cash provided by operating activities: Deferred taxes (144) 374 (315) Depreciation 1,901 1,135 744 Loss (gain) on sale of securities (11) (2) (2) Net amortization of premiums and discounts on investments 1,017 287 (595) Amortization of costs in excess of net assets acquired 2,389 899 592 Amortization of MRP compensation liability 1,194 1,213 902 Loss (gain) on disposal of equipment (95) (7) -- Loss (gain) on sale of loans (1,903) (933) (699) Net change in deferred loan fees, premiums and discounts 46 523 792 Loss (gain) on disposal of real estate held for sale 35 30 62 Amortization of mortgage servicing rights 277 100 72 Capitalization of mortgage servicing rights from sale of mortgages with servicing retained (981) (442) -- Provision for loan losses 2,841 1,628 1,423 FHLB stock dividend (1,545) (1,146) (868) Cash provided (used) in operating assets and liabilities: Loans held for sale 3,306 (9,496) 665 Accrued interest receivable (1,111) (619) (335) Other assets 865 (482) 90 Deferred compensation 380 288 258 Accrued expenses and other liabilities 170 1,038 546 Income taxes payable (1,709) (38) (256) -------- -------- -------- Net cash provided by operating activities 22,362 7,472 12,390 -------- -------- -------- INVESTING ACTIVITIES: Purchases of securities available for sale (353,354) (233,660) (485,548) Principal repayments and maturities of securities available for sale 301,393 221,766 534,177 Sales of securities available for sale 2,637 1,405 769 Principal repayments and maturities of securities held to maturity 647 793 1,092 Loans originated and closed, net (716,952) (511,398) (270,240) Purchases of loans and participating interest in loans (86,165) (51,049) (117,584) Sales of loans and participating interest in loans 127,452 81,575 36,942 Principal repayments on loans 521,958 375,868 207,526 Purchases of FHLB stock (3,437) (2,097) (2,909) Proceeds from sale of property, equipment and real estate acquired for development 373 13 5 Purchases of property and equipment (3,067) (1,986) (1,463) Additional investment in real estate held for sale, net of insurance proceeds (165) (26) -- Proceeds from sale of real estate held for sale 2,661 2,417 652 Funds transferred to deferred compensation plans (494) (91) (94) Acquisitions, net of cash acquired 13,877 -- (17,289) -------- -------- -------- Net cash used by investing activities $(192,636) $(116,470) $(113,964) -------- -------- -------- Continued on next page 70 FIRST WASHINGTON BANCORP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) For the years ended March 31, 1999, 1998 and 1997 (Continued from prior page) 1999 1998 1997 ---- ---- ---- FINANCING ACTIVITIES: Compensation expense recognized for shares released for allocation to participants of the ESOP: Original basis of shares $ 382 $ 588 $ 580 Excess of fair value of released shares over basis 542 839 417 Increase (decrease) in deposits 129,998 46,645 36,842 Proceeds from FHLB advances 300,807 640,025 600,327 Repayment of FHLB advances (199,099) (573,991) (548,231) Proceeds from repurchase agreement borrowings 268 33,687 42,444 Repayment of repurchase agreement borrowings (13,008) (431) (133) Cash dividends paid (3,595) (2,583) (1,907) Increase (decrease) in other borrowings (516) (3,718) (398) Net cost of exercised stock options (265) (29) -- Repurchases of stock (15,266) (13,993) (12,905) -------- -------- ------- Net cash provided by financing activities 200,248 127,039 117,036 -------- -------- ------- NET INCREASE (DECREASE) IN CASH AND DUE FROM BANKS 29,974 18,041 15,462 CASH AND DUE FROM BANKS, BEGINNING OF PERIOD 42,529 24,488 9,026 -------- -------- ------- CASH AND DUE FROM BANKS, END OF PERIOD $ 72,503 $ 42,529 $24,488 ======== ======== ======= SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Interest paid $59,407 $ 46,311 $35,744 Taxes paid $10,619 $ 7,108 $ 4,494 Non-cash transactions: Loans, net of discounts, specific loss allowances and unearned income trans- ferred to real estate held for sale $ 3,007 $ 2,246 $ 1,059 Net change in accrued dividends payable $ 477 $ 149 $ 178 Net change in unrealized gain (loss) in deferred compensation trust and related liability $ 3,498 $ 707 $ 475 Stock issued to Rabbi Trust/MRP $ 601 $ -- $ 6,014 Stock forfeited by MRP $ 32 $ 32 $ 6 Recognize tax benefit of vested MRP shares $ 276 $ 231 $ -- Fair value of stock issued and options assumed in connection with the acquisitions $32,527 $ -- $ -- Non-cash portion of 10% stock dividend $24,360 $ -- $ -- See notes to consolidated financial statements 71 FIRST WASHINGTON BANCORP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED MARCH 31, 1999, 1998 AND 1997 NOTE 1: REINCORPORATION AND SUMMARY OF ACCOUNTING POLICIES Reincorporation: The stockholders of First Savings Bank of Washington Bancorp, Inc., a Delaware corporation and herein referred to as "FSBWB," approved the reincorporation of FSBWB from Delaware to Washington on July 24, 1998. The purpose of the reincorporation was to save higher costs incurred as a result of being a Delaware corporation. The reincorporation was effected July 24, 1998 by merging FSBWB into a wholly-owned subsidiary which had been recently formed solely for the purpose of effecting the reincorporation. The surviving corporation is known as First Washington Bancorp, Inc., a Washington corporation, and is hereafter referred to as "FWWB" or "the Company." Upon consummation of the merger, each share of Common Stock of FSBWB, par value $.01 per share, was automatically converted into one share of Common Stock of FWWB, par value $.01 per share. The merger was consummated under the terms and conditions of a Plan of Merger pursuant to which FSBWB ceased to exist as a Delaware corporation, the stockholders of FSBWB became shareholders of FWWB, FWWB succeeded to all the assets, liabilities, subsidiaries and other properties of FSBWB to the full extent provided by law, and the rights of the shareholders and internal affairs of FWWB are to be governed by the articles of incorporation and bylaws of FWWB and the Washington Business Corporation Act, as amended. As a result of the merger, FWWB has the same recorded basis, business, management, benefit plans, location, assets, liabilities and net worth as did FSBWB. However, because the State of Washington treats all treasury stock as retired upon purchase, all purchases of treasury stock reduce stock issued and the cost of treasury stock acquired is charged to par value and paid-in capital. Basis for Presentation: The Company is a bank holding company incorporated in the State of Washington. The Company was originally organized for the purpose of acquiring all of the capital stock of First Savings Bank of Washington (FSBW) upon its reorganization from the mutual holding company form of organization to the stock holding company form of organization. The Company is primarily engaged in the business of planning, directing and coordinating the business activities of its wholly owned subsidiaries, FSBW, Inland Empire Bank (IEB), and Towne Bank (TB) (together, the Banks). FSBW is a Washington-chartered savings bank the deposits of which are insured by the Federal Deposit Insurance Corporation (FDIC) under the Savings Association Insurance Fund (SAIF). FSBW conducts business from its main office in Walla Walla, Washington and its sixteen branch offices and three loan production offices located in southeast, central, north central and western Washington. FSBW also conducts business through its division, WSB, which has five branch offices and one loan production office located in northwest Washington in Bellingham, Washington, and Whatcom and Island counties. IEB is an Oregon-chartered commercial bank whose deposits are insured by the FDIC under the Bank Insurance Fund (BIF). IEB conducts business from its main office in Hermiston, Oregon, and its five branch offices and two loan production offices located in northeast Oregon. TB operates six full service branches in the Seattle, Washington, metropolitan area--in Woodinville, Redmond, Bellevue, Renton, Kirkland and Bothell. The Company's only significant assets are the capital stock of its subsidiaries, its loan to the Company's Employee Stock Ownership Plan (ESOP) (see Note 15) and the portion of the net proceeds retained from the offering. The Company has no significant liabilities. The Company and its Bank subsidiaries are subject to regulation by the Federal Reserve Board (FRB) and the FDIC. In addition FSBW, IEB and TB are subject to the state banking regulations applicable to their state charters. Nature of Business: 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 securities, and interest expense on interest-bearing liabilities, composed primarily of savings deposits, Federal Home Loan Bank (FHLB) advances and repurchase agreements. Net interest income is 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. 72 In addition to interest income on loans and securities, the Banks receive other income from deposit service charges, loan origination and servicing fees and from the sale of loans and investments. Principles of Consolidation: The consolidated financial statements include the accounts of FWWB and its wholly owned subsidiaries, FSBW, IEB and TB. All material intercompany transactions, profits and balances have been eliminated. Use of Estimates: The preparation of the financial statements in conformity with generally accepted accounting principles (GAAP) requires management to make estimates and assumptions that affect amounts reported in the financial statements. Changes in these estimates and assumptions are considered reasonably possible and may have a material impact on the financial statements. The Company has used significant estimates in determining reported reserves and allowances for loan losses, mortgage servicing rights, goodwill, tax liabilities and other contingencies. Securities: Securities are classified as held to maturity when the Company has the ability and positive intent to hold them to maturity. Securities classified as available for sale are available for future liquidity requirements and may be sold prior to maturity. Securities held to maturity are carried at cost, adjusted for amortization of premiums and accretion of discounts to maturity. Unrealized losses on securities held to maturity due to fluctuations in fair value are recognized when it is determined that an other than temporary decline in value has occurred. Securities available for sale are carried at fair value. Unrealized gains and losses on securities available for sale are excluded from earnings and are reported net of tax as accumulated other comprehensive income, a component of stockholders' equity, until realized. Realized gains and losses on sale are computed on the specific identification method and are included in operations on the trade date sold. Loans Receivable: The Banks originate mortgage loans for both portfolio investment and sale in the secondary market. At the time of origination, mortgage loans are designated as held for sale or held for investment. Loans held for sale are stated at lower of cost or estimated fair value determined on an aggregate basis. The Banks also originate commercial, financial, agribusiness and installment credit loans for portfolio investment. Loans receivable not designated as held for sale are recorded at the principal amount outstanding, net of allowance for loan losses, deferred fees, discounts, and premiums. Premiums, discounts and deferred loan fees are amortized to maturity using the level-yield methodology. Interest is accrued as earned unless management doubts the collectibility of the loan or the unpaid interest. Interest accruals are generally discontinued when loans become 90 days past due for interest. All previously accrued but uncollected interest is deducted from interest income upon transfer to nonaccrual status. Future collection of interest is included in interest income based upon an assessment of the likelihood that the loans will be repaid or recovered. A loan may be put in nonaccrual status sooner than this policy would dictate if, in management's judgment, the loan may be uncollectible. Such interest is then recognized as income only if it is ultimately collected. Costs in Excess of Net Assets Acquired: Costs in excess of net assets acquired (goodwill) is an intangible asset arising from the purchase of IEB, TB and WSB. It is being amortized on a straight-line basis over the 14-year period of expected benefit. The Company periodically evaluates goodwill for impairment. Mortgage Servicing Rights: Purchased servicing rights represent the cost of acquiring the right to service mortgage loans. Originated servicing rights are recorded when mortgage loans are originated and subsequently sold or securitized with the servicing rights retained. The total cost of mortgage loans sold is allocated to the servicing rights and the loans (without the servicing rights) based on relative fair values. The cost relating to purchased and originated servicing is capitalized and amortized in proportion to, and over the period of, estimated future net servicing income. The Banks assess the fair value of unamortized remaining servicing rights for impairment on a stratum by stratum basis every quarter by using secondary market quotes for comparable packages of serviced loans and a valuation model that calculates the present value of future cash flows using market discount rates and market based assumptions for prepayment speeds, servicing costs and ancillary income for those pools of serviced mortgages for which secondary market quotes are not readily available. For purposes of measuring impairment, the servicing rights are stratified based on their interest rate, original and remaining terms to maturity and balances outstanding. 73 In June 1996, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard (SFAS) No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, effective for transactions occurring after December 31, 1996. SFAS No. 125 superseded SFAS No. 122, Accounting for Mortgage Servicing Rights, and amended SFAS No. 65, Accounting for Certain Mortgage Banking Activities, to eliminate the distinction between normal and excess servicing rights. The Banks adopted SFAS No. 125 on January 1, 1997, and account for their mortgage servicing rights accordingly. The adoption did not have a material impact. Allowances for Loan Losses: 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. Large groups of smaller-balance homogeneous loans are collectively evaluated for impairment. Loans that are collectively evaluated for impairment by the Banks 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 shall be 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. 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 Banks' loan portfolios 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. Real Estate Held for Sale: Property acquired by foreclosure or deed in lieu of foreclosure is recorded at the lower of estimated fair value, less cost to sell, or the principal balance of the defaulted loan. Development, improvement, and direct holding costs relating to the property are capitalized. The carrying value of such property is periodically evaluated by management and, if necessary, allowances are established to reduce the carrying value to net realizable value. Gains or losses at the time the property is sold are charged or credited to operations in the period in which they are realized. The amounts the Banks will ultimately recover from real estate held for sale may differ substantially from the carrying value of the assets because of future market factors beyond the Banks' control or because of changes in the Banks' strategy for recovering the investment. Depreciation: The provision for depreciation is based upon the straight-line method applied to individual assets and groups of assets acquired in the same year at rates adequate to charge off the related costs over their estimated useful lives. Buildings and improvements...............................10-30 years Furniture and equipment...................................3-10 years Routine maintenance, repairs, and replacement costs are expensed as incurred. Expenditures which materially increase values or extend useful lives are capitalized. 74 Loan Origination and Commitment Fees: Loan origination fees, net of certain specifically defined direct loan origination costs, are deferred and recognized as an adjustment of the loans' interest yield using the level-yield method over the contractual term of each loan adjusted for actual loan prepayment experience. Net deferred fees or costs related to loans held for sale are recognized in income at the time the loans are sold. Loan commitment fees are deferred until the expiration of the commitment period unless management believes there is a remote likelihood that the underlying commitment will be exercised, in which case the fees are amortized to fee income using the straight-line method over the commitment period. If a loan commitment is exercised, the deferred commitment fee is accounted for in the same manner as a loan origination fee. Deferred commitment fees associated with expired commitments are recognized as fee income. Income Taxes: The Company files a consolidated income tax return including all of its wholly owned subsidiaries on a calendar year basis. Income taxes are accounted for using the asset and liability method. Under this method, a deferred tax asset or liability is determined based on the enacted tax rates which will be in effect when the differences between the financial statement carrying amounts and tax bases of existing assets and liabilities are expected to be reported in the Company's income tax returns. The effect on deferred taxes of a change in tax rates is recognized in income in the period of change. Where state income tax laws do not permit consolidated income tax returns, applicable state income tax returns are filed. Employee Stock Ownership Plan: The Company sponsors an ESOP. The ESOP purchased 8% of the shares of common stock issued in the reorganization and initial public stock offering pursuant to the subscription rights granted under the ESOP plan. The ESOP borrowed $8,728,500 from the Company in order to fund the purchase of common stock. The loan to the ESOP will be repaid principally from the Company's contribution to the ESOP, and the collateral for the loan is the Company's common stock purchased by the ESOP. As the debt is repaid, shares are released from collateral based on the proportion of debt service paid in the year and allocated to participants' accounts. As shares are released from collateral, compensation expense is recorded equal to the average current market price of the shares, and the shares become outstanding for earnings-per-share calculations. Stock and cash dividends on allocated shares are recorded as a reduction of retained earnings and paid or distributed directly to participants' accounts. Stock and cash dividends on unallocated shares are recorded as a reduction of debt and accrued interest (see additional discussion in Note 15). Average Balances: Average balances are obtained from the best available daily, weekly or monthly data, which FWWB's management believes approximate the average balances calculated on a daily basis. New Accounting Standards Adopted in These Financial Statements: SFAS No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, was issued in June 1996 and established, among other things, new criteria for determining whether a transfer of financial assets in exchange for cash or other consideration should be accounted for as a sale or as a pledge of collateral in a secured borrowing. As issued, SFAS No. 125 was effective for all transfers and servicing of financial assets and extinguishments of liabilities occurring after December 31, 1996. In December 1996, FASB issued SFAS No. 127, Deferral of the Effective Date of Certain Provisions of FASB Statement No. 125, which deferred the adoption date of certain collateral recognition provisions of SFAS No. 125 until January 1, 1998. FWWB adopted the relevant provisions of SFAS No. 125 effective January 1, 1997, and the deferred provisions effective January 1, 1998. There was no material impact on FWWB's results of operations or financial condition due to the adoption of these statements. SFAS No. 130, Reporting Comprehensive Income, was issued in June 1997 and requires businesses to disclose comprehensive income and its components in their financial statements. This statement does not affect the results of operations or financial condition of FWWB or its subsidiaries. FWWB and its subsidiaries adopted SFAS No. 130 on April 1, 1998. SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information, was issued in June 1997 and redefines how operating segments are determined and requires disclosure of certain financial and descriptive information about a company's operating segments. This statement does not affect the results of operations or financial condition of FWWB or its subsidiaries. SFAS No. 131 was adopted by FWWB and its subsidiaries on April 1, 1998 (see Note 27). 75 In July 1998, the Emerging Issues Task Force (EITF) of FASB reached a consensus on the accounting treatment for deferred compensation arrangements where amounts earned are held in a Rabbi Trust and invested. The consensus position (EITF 97-14) was applied as of September 30, 1998 for all awards granted, and existing plans were required to be amended prior to September 30, 1998. Application of the consensus is reflected as a change in accounting principle under which the Company stock purchased for a Rabbi Trust obligation and the related liability for deferred compensation are recorded at acquisition cost. Prior to this change the stock was recorded at fair market value. The effect of this change in accounting increased equity by $1.1 million and reduced the related liability for deferred compensation by the same amount. Recent Accounting Standards Not Yet Adopted: SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, was issued in June 1998 and establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. FWWB will implement this statement on January 1, 2000. The impact of the adoption of the provisions of this statement on the results of operations or financial condition of FWWB has not yet been determined. SFAS No. 134, Accounting for Mortgage-Backed Securities Retained after the Securitization of Mortgage Loans Held for Sale by a Mortgage Banking Enterprise, was issued in October 1998. Prior to issuance of SFAS No. 134, when a mortgage banking company securitized mortgage loans held for sale but did not sell the security in the secondary market, the security was classified as trading. SFAS No. 134 requires that the security be classified either trading, available for sale or held to maturity according to the Company's intent, unless the Company has already committed to sell the security before or during the securitization process. The statement is effective for all fiscal years beginning after December 15, 1998. This statement is not expected to have a material impact on the results of operations or financial condition of the Company. Reclassification: Certain amounts in the prior years' financial statements have been reclassified to conform to the current year's presentation. NOTE 2: RECENT DEVELOPMENTS AND ACQUISITIONS Declaration of 10% Stock Dividend: On July 24, 1998 FWWB's Board of Directors declared a 10% stock dividend payable August 17, 1998 to shareholders of record on August 10, 1998. All earnings per share and share data have been adjusted to reflect the 10% stock dividend. Acquisition of Towne Bancorp, Inc.: On April 1, 1998 FWWB completed the acquisition of Towne Bancorp, Inc. FWWB paid $28.2 million in cash and common stock for all of the outstanding common shares and stock options of Towne Bancorp, Inc., which was the holding company for Towne Bank (TB), headquartered in Woodinville, Washington, a Seattle suburb. As a result of the merger of Towne Bancorp, Inc. into FWWB, TB became a wholly owned subsidiary of FWWB. The acquisition was accounted for as a purchase and resulted in the recording of $19.2 million of costs in excess of the fair value of Towne Bancorp, Inc. net assets acquired (goodwill). Goodwill assets are being amortized over a 14-year period resulting in a current charge to earnings of $343,800 per quarter or $1,375,000 per year. Founded in 1991, TB is a community business bank which had, before recording of goodwill, approximately $146 million in total assets, $134 million in deposits, $120 million in loans and $9.3 million in shareholders' equity at March 31, 1998. TB operates six full service branches in the Seattle, Washington, metropolitan area--in Woodinville, Kirkland, Redmond, Bellevue, Renton and Bothell. 76 Acquisition of Whatcom State Bancorp, Inc.: On January 1, 1999 FWWB completed the acquisition of Whatcom State Bancorp, Inc. FWWB paid $12.1 million in common stock for all the outstanding common shares and stock options of Whatcom State Bancorp, Inc., which was the holding company for Whatcom State Bank (WSB), headquartered in Bellingham, Washington. As a result of the merger of Whatcom State Bancorp, Inc. into FWWB, WSB became a division of FSBW. The acquisition was accounted for as a purchase and resulted in the recording of approximately $6.3 million of costs in excess of the fair value of Whatcom State Bancorp, Inc. net assets acquired (goodwill). Goodwill assets are being amortized over a 14-year period resulting in a current charge to earnings of approximately $114,300 per quarter or $457,000 per year. Founded in 1980, WSB is a community commercial bank which had, before recording of goodwill, approximately $99 million in total assets, $85 million in deposits, $79 million in loans, and $5.4 million in shareholders' equity at December 31, 1998. WSB operates five full service branches in the Bellingham, Washington, area Bellingham, Ferndale, Lynden, Blaine and Point Roberts. The results of operations of TB and WSB from the completion dates of each acquisition are included in the financial statements for the year ended March 31, 1999. The following information presents the pro forma results of operations for the year ended March 31, 1998, as though the acquisitions had occurred on April 1, 1997. The pro forma results do not necessarily indicate the actual results that would have been obtained, nor are they necessarily indicative of the future operations of the combined companies. The pro forma results for the year ended March 31, 1999 would not materially differ from actual results as TB has been included for the entire year and the pro forma results of operations of WSB would not significantly differ from actual results. Year ended March 31 Pro Forma (unaudited) ------------------------------------- (in thousands except per share amounts) 1998 ---- Net interest income before provision for loan loss $50,312 Net income 13,766 Net income per share: Basic 1.28 Diluted 1.23 Acquisition of Inland Empire Bank: The Company completed the acquisition of IEB effective August 1, 1996. The Company paid the former shareholders of IEB $60.8951 per share, in cash, for a total acquisition price of $32.8 million. The acquisition of IEB was treated as a purchase for accounting purposes. The assets and liabilities of IEB have been recorded on the books of the Company at their respective fair market values at the effective date the acquisition was consummated. Goodwill was recorded at $12.5 million. Amortization of goodwill over a 14-year period results in a charge to earnings of approximately $893,000 per year. Acquisition of Seaport Citizens Bank: Subsequent to year end, on April 1, 1999 FWWB and FSBW completed the acquisition of Seaport Citizens Bank (SCB). FSBW paid $10.1 million in cash for all the outstanding common shares of SCB, which is headquartered in Lewiston, Idaho. As a result of the merger of SCB into FSBW, SCB became a division of FSBW. The acquisition will be accounted for as a purchase and resulted in the recording of approximately $6.2 million of costs in excess of the fair value of SCB's net assets acquired (goodwill). Goodwill assets will be amortized over a 14-year period and will result in a current charge to earnings of approximately $107,200 per quarter, beginning in the first quarter of fiscal 2000, or $429,000 per year. Founded in 1979, SCB is a commercial bank which had, before recording of goodwill, approximately $45 million in total assets, $41 million in deposits, $27 million in loans, and $4.1 million in shareholders' equity at March 31, 1999. SCB operates two full service branches in the Lewiston, Idaho, area. 77 Note 3: CASH AND DUE FROM BANKS Cash and due from banks consisted of the following (in thousands): March 31 -------------------- 1999 1998 Cash on hand and demand deposits $ 51,126 $ 26,942 Cash equivalents: Short-term cash investments 2,562 10,342 Federal funds sold 18,815 5,245 -------- -------- $ 72,503 $ 42,529 ======== ======== For the purpose of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, overnight investments and short-term deposits with original maturities less than 90 days. FRB regulations require depository institutions to maintain certain minimum reserve balances. Included in cash and demand deposits were reserves required by the FRB of $6.4 million and $2.8 million at March 31, 1999 and 1998, respectively. Note 4: SECURITIES AVAILABLE FOR SALE The amortized cost and estimated fair value of securities available for sale are summarized as follows (in thousands): March 31, 1999 ------------------------------------------- Gross Gross Estimated Amortized unrealized unrealized fair cost gains losses value ---- ----- ------ ----- U.S. Government and agency obligations $ 56,477 $ 205 $ (164) $ 56,518 Municipal bonds: Taxable 2,737 97 (1) 2,833 Tax exempt 30,994 1,338 (73) 32,259 Corporate bonds 24,729 117 (511) 24,335 Mortgage-backed securities: FHLMC certificates 3,446 63 (7) 3,502 GNMA certificates 22,446 199 (137) 22,508 FNMA certificates 6,823 68 (50) 6,841 Collateralized mortgage obligations 210,526 619 (1,361) 209,784 FHLMC stock 49 2,971 -- 3,020 FARMERMAC stock 10 27 -- 37 FNMA stock 303 81 -- 384 -------- ------- ------- -------- $358,540 $ 5,785 $(2,304) $362,021 ======== ======= ======= ======== Proceeds from sales of securities during fiscal 1999 were $2,637,000. Gross gains of $11,000 and gross losses of $0 were realized on those sales. 78 Note 4: SECURITIES AVAILABLE FOR SALE (continued) At March 31, 1999, the Company's investment portfolio did not contain any securities of an issuer (other than the U.S. Government and agencies thereof) which had an aggregate book value in excess of 10% of the Company's stockholders' equity at that date. March 31, 1998 ------------------------------------------- Gross Gross Estimated Amortized unrealized unrealized fair cost gains losses value ---- ----- ------ ----- U.S. Government and agency obligations $ 65,414 $ 232 $ (52) $ 65,594 Municipal bonds, tax exempt 30,607 1,489 (3) 32,093 Corporate bonds 4,279 43 (18) 4,304 Mortgage-backed securities: FHLMC certificates 3,308 74 (21) 3,361 GNMA certificates 16,499 363 -- 16,862 FNMA certificates 6,010 82 (44) 6,048 Collateralized mortgage obligations 171,367 1,074 (1,582) 170,859 FHLMC stock 549 2,335 -- 2,884 FARMERMAC stock 10 28 -- 38 FNMA stock 303 73 -- 376 -------- ------- -------- -------- $298,346 $ 5,793 $ (1,720) $302,419 ======== ======= ======== ======== Proceeds from sales of securities during fiscal 1998 were $1,405,000. Gross gains of $1,800 and gross losses of $0 were realized on those sales. At March 31, 1998, the Company's investment portfolio did not contain any securities of an issuer (other than the U.S. Government and agencies thereof) which had an aggregate book value in excess of 10% of the Company's stockholders' equity at that date. The amortized cost and estimated fair value of securities available for sale at March 31, 1999, by contractual maturity, are shown below (in thousands). Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. March 31, 1999 --------------------- Amortized Estimated cost fair value ---- ---------- Due in one year or less $ 8,575 $ 6,004 Due after one year through five years 58,001 61,102 Due after five years through ten years 37,999 38,687 Due after ten years 253,162 252,787 -------- -------- 357,737 358,580 Equity securities 803 3,441 -------- -------- $358,540 $362,021 ======== ======== 79 Note 5: SECURITIES HELD TO MATURITY The amortized cost and estimated fair value of securities held to maturity are summarized as follows (in thousands): March 31, 1999 ------------------------------------------- Gross Gross Estimated Amortized unrealized unrealized fair cost gains losses value ---- ----- ------ ----- Municipal bonds tax exempt $ 1,991 $ 81 $ -- $ 2,072 Collateralized mortgage obligations 164 -- (1) 163 -------- ------ ------- -------- $ 2,155 $ 81 $ (1) $ 2,235 ======== ====== ======= ======== March 31, 1998 ------------------------------------------- Gross Gross Estimated Amortized unrealized unrealized fair cost gains losses value ---- ----- ------ ----- Certificates of deposit $ 194 $ -- $ -- $ 194 ======== ====== ======= ======== The amortized cost and estimated fair value of securities held to maturity at March 31, 1999, by contractual maturity, are shown below (in thousands): March 31, 1999 --------------------- Amortized Estimated cost fair value ---- ---------- Due in one year or less $ 285 $ 287 Due after one year through five years 1,172 1,215 Due after five years through ten years 434 451 Due after ten years 264 282 ------- ------- $ 2,155 $ 2,235 ======= ======= Note 6: ADDITIONAL INFORMATION REGARDING COMPOSITION OF SECURITIES AND CASH EQUIVALENT INTEREST INCOME The following table sets forth the composition of income from securities and deposits for the periods indicated (in thousands): Years ended March 31 ------------------------------ 1999 1998 1997 Taxable interest income $ 6,069 $ 4,647 $ 5,227 Tax-exempt interest income 1,967 2,031 2,033 Other stock dividend income 71 105 195 Federal Home Loan Bank stock dividend income 1,545 1,147 868 ------- ------- ------- Total securities and cash equivalent interest income $ 9,652 $ 7,930 $ 8,323 ======= ======= ======= 80 Note 7: LOANS RECEIVABLE Loans receivable at March 31 are summarized as follows (in thousands) (includes loans held for sale): 1999 1998 One- to four-family real estate loans $ 407,673 $ 423,850 Commercial and multifamily real estate loans 324,858 167,859 Construction and land 217,094 132,409 Commercial 149,943 30,599 Agricultural 46,800 37,052 Consumer, credit card and other 44,346 30,842 ---------- ---------- 1,190,714 822,571 Less: Loans in process (71,638) (54,500) Deferred loan fees, discounts and premiums (4,146) (3,297) Allowance for loan losses (12,261) (7,857) ---------- ---------- $1,102,669 $ 756,917 ========== ========== Loans serviced for others totaled $268,756,000 and $211,662,000 at March 31, 1999 and 1998, respectively. Custodial accounts maintained in connection with this servicing totaled $4,088,000 and $4,169,000 at March 31, 1999 and 1998, respectively. The Banks' outstanding loan commitments totaled $147,122,000 and $74,087,000 at March 31, 1999 and 1998, respectively. In addition, the Banks had outstanding commitments to sell loans of $3,791,000 at March 31, 1999. Loans held for sale at March 31, 1999, and 1998 of $11,256,000 and $12,436,000, respectively, are stated net of any unrealized losses, undisbursed loans in process and deferred loan fees. The amount of impaired loans and the related allocated reserve for loan losses were as follows (in thousands): March 31 -------------------------------------------- 1999 1998 ---- ---- Loan Allocated Loan Allocated Amount reserves amount reserves ------ -------- ------ -------- Nonaccrual loans $ 3,695 $ 739 $ -- $ -- Other impaired loans -- -- -- -- -------- -------- ------- -------- $ 3,695 $ 739 $ -- $ -- ======== ======== ======= ======== The average balance of impaired loans and the related interest income recognized were as follows: Years ended March 31 ------------------------ 1999 1998 1997 ---- ---- ---- Average balance of impaired loans $ 622 $ -- $ -- Interest income recognized -- -- -- 81 The Banks originate both adjustable- and fixed-rate loans. At March 31, 1999, the maturity and repricing composition of those loans, less undisbursed amounts and deferred fees, were as follows (in thousands): Fixed-rate (term to maturity): Less than one year $ 46,727 One to three years 68,728 Three to five years 90,371 Five to ten years 99,937 Over ten years 318,599 -------- $624,362 ======== Adjustable-rate (term to rate adjustment): Less than one year $393,594 One to three years 29,567 Three to five years 58,100 Five to ten years 1,321 Over ten years 7,986 -------- $490,568 ======== The adjustable-rate loans have interest rate adjustment limitations and are generally indexed to the Banks' internal cost of funds, the FHLB's National Cost of Funds Index and 11th District Cost of Funds, One Year Constant Maturity Treasury Index, or Prime Rate (The Wall Street Journal). Future market factors may affect the correlation of the interest rate adjustment with the rates the Banks pay on the short-term deposits that primarily have been utilized to fund these loans. 82 NOTE 8: ALLOWANCE FOR LOAN LOSSES AND NON-PERFORMING LOANS An analysis of the changes in the allowances for loan losses for the three years ended March 31, 1999 (in thousands) is as follows: Years ended March 31 ---------------------------- 1999 1998 1997 ---- ---- ---- Balance, beginning of the year $ 7,857 $ 6,748 $ 4,051 Allowances added through business combinations 2,693 -- 1,416 Provision 2,841 1,628 1,423 Recoveries of loans previously charged off: Residential real estate -- -- -- Commercial/multifamily real estate 60 6 38 Construction/land -- -- -- Commercial business 143 27 -- Agribusiness 1 2 -- Consumer finance 15 14 8 Credit cards 6 2 7 ------ ------- ------- 225 51 53 Loans charged off: Residential real estate (25) (359) (127) Commercial/multifamily real estate (35) -- -- Construction/land (69) (11) -- Commercial business (911) (19) -- Agribusiness (5) -- (2) Consumer finance (126) (89) (28) Credit cards (184) (92) (38) ------ ------- ------- (1,355) (570) (195) ------ ------- ------- Net charge offs (1,130) (519) (142) ------ ------- ------- Balance, end of year $12,261 $ 7,857 $ 6,748 ======= ======= ======= 83 The following is a schedule of the Company's allocation of the allowance for loan losses: March 31 ---------------------------- (in thousands) 1999 1998 1997 ---- ---- ---- Specific or allocated loss allowances: Secured by real estate: One- to four-family real estate loans $ 2,757 $ 1,059 $ 1,098 Multifamily and commercial 3,567 849 547 Construction 1,597 856 844 Commercial/agricultural 2,522 835 422 Consumer, credit card and other 841 307 237 ------- ------- ------- Total allocated 11,284 3,906 3,148 Unallocated 977 3,951 3,600 ------- ------- ------- Total allowance for loan losses $12,261 $ 7,857 $ 6,748 ======= ======= ======= Ratio of allowance for loan losses to non-performing loans 1.60 5.53 3.20 Allowance for loan losses as a percent of net loans (loans receivable excluding allowance for losses) 1.10% 1.03% 0.94% The following is a schedule of the Company's non-performing loans: March 31 ---------------------------- (in thousands) 1999 1998 1997 ---- ---- ---- Nonaccrual Loans: One- to four-family real estate loans $3,564 $ 448 $ 1,644 Multifamily real estate 351 -- -- Commercial real estate -- -- 187 Construction 767 367 -- Commercial business 1,392 410 206 Agricultural business 47 4 -- Consumer, credit card and other 17 41 45 ------ ------- ------- 6,138 1,270 2,082 Loans more than 90 days delinquent, still on accrual: One- to four-family real estate loans 20 52 -- Multifamily real estate -- -- -- Commercial real estate 384 33 -- Construction -- 32 -- Commercial business -- -- -- Agricultural business 1,052 -- -- Consumer, credit card and other 82 33 30 ------ ------- ------- 1,538 150 30 ------ ------- ------- Total non-performing loans $7,676 $ 1,420 $ 2,112 ====== ======= ======= Non-performing loans to net loans 0.69% 0.19% 0.33% Loans are normally placed on nonaccrual status when interest is 90 days past due; however, certain loans with third party guarantees from government sponsored enterprises or readily accessible cash collateral may remain on an accrual basis beyond 90 days past due. 84 NOTE 9: PROPERTY AND EQUIPMENT Land, buildings and equipment owned by the Company and its subsidiaries at March 31 are summarized as follows (in thousands): 1999 1998 ---- ---- Buildings and leasehold improvements $ 15,260 $ 11,458 Furniture and equipment 12,249 7,508 -------- ------- 27,509 18,966 Less accumulated depreciation 13,820 9,786 -------- ------- 13,689 9,180 Land 2,271 2,199 -------- -------- $ 15,960 $ 11,379 ======== ======== The Company periodically evaluates long-lived assets for impairment in accordance with SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. NOTE 10: DEPOSITS Customer deposits consist of the following at March 31 (in thousands): 1999 1998 ---- ---- Demand, NOW and Money Market accounts, including non-interest-bearing deposits in 1999 and 1998 of $97,062 and $56,691, respectively, 0% to 6% $311,686 $188,831 Regular savings, 2% to 6% 59,133 42,084 Certificate accounts: 2.01% to 4% 6,292 1,338 4.01% to 6% 508,830 299,463 6.01% to 8% 63,617 68,214 8.01% to 10% 1,284 2,587 10.01% to 12% 6 5 -------- ---------- 580,029 371,607 -------- --------- $950,848 602,522 ======== ========= Deposits at March 31, 1999 and 1998 include public funds of $48,383,000 and $14,576,000, respectively. Securities with a carrying value of $9,956,000 and $9,137,000 were pledged as collateral on these deposits at March 31, 1999 and 1998, respectively, which exceeds the minimum collateral requirements established by state regulations. 85 Scheduled maturities of certificate accounts at March 31 are as follows (in thousands): 1999 1998 ---- ---- Due in less than one year $405,306 $240,074 One to two years 93,343 74,519 Two to three years 38,721 13,565 Three to four years 19,621 11,288 Four to five years 13,490 18,652 Over five years 9,548 13,509 -------- -------- $580,029 $371,607 ======== ======== Included in deposits are certificates of deposit in excess of $100,000 of $186,089,000 and $80,608,000 at March 31, 1999 and 1998, respectively. Interest on certificates in excess of $100,000 totaled $7,568,000, $3,901,000 and $2,945,000 for the years ended March 31, 1999, 1998 and 1997, respectively. Deposit interest expense by type for the years ended March 31 is as follows (in thousands): 1999 1998 1997 ---- ---- ---- Certificates $27,407 $20,069 $17,314 Demand, NOW and Money Market accounts 5,256 3,972 3,239 Regular savings 1,356 1,248 1,183 ------- ------- ------- $34,019 $25,289 $21,736 ======= ======= ======= NOTE 11: ADVANCES FROM FEDERAL HOME LOAN BANK OF SEATTLE FSBW has entered into borrowing arrangements with the FHLB to borrow funds under a short-term cash management advance program and long-term loan agreements. All borrowings are secured by stock of, and cash held by, the FHLB. Additionally, mortgage loans receivable and securities issued, insured, or guaranteed by the U.S. Government or agencies thereof are pledged as security for the loans. At March 31, 1999, FHLB advances were scheduled to mature as follows (in thousands): Adjustable-rate Fixed-rate Total Advances Advances Advances -------------- ------------- ------------- Rate* Amount Rate* Amount Rate* Amount ----- ------ ----- ------ ----- ------ Due in less than one year 5.20% $ 6,000 5.97% $117,300 5.93% $123,300 One to two years 4.97 3,400 5.60 60,213 5.56 63,613 Two to three years 5.04 1,000 6.09 59,600 6.07 60,600 Three to four years -- -- -- -- -- -- Four to five years -- -- 5.79 59,890 5.79 59,890 Over five years 4.78 12,000 5.49 88,849 5.40 100,849 ------- -------- -------- 4.93% $22,400 5.79% $385,852 5.74% $408,252 ======= ======== ======== * Weighted average interest rate The maximum and average outstanding balances and average interest rates on advances from the FHLB were as follows for the year ended March 31 (in thousands): 1999 1998 1997 ---- ---- ---- Maximum outstanding at any month end $410,304 $299,377 $235,098 Average outstanding 363,279 276,328 214,563 Weighted average interest rates: Annual 5.90% 6.07% 5.83% End of year 5.74 6.04 5.96 Interest expense during the year $21,430 $16,782 $12,504 86 NOTE 12: OTHER BORROWINGS Retail Repurchase Agreements are included in other borrowings. At March 31, 1999, retail repurchase agreements carry interest rates ranging from 3.25% to 7.20%, payable at maturity, and are secured by the pledge of certain FNMA, GNMA and FHLMC mortgage-backed securities with a fair value of $15,121,000 as of March 31, 1999. A summary of retail repurchase agreements at March 31 by the period remaining to maturity is as follows (in thousands): 1999 1998 ---------------- ---------------- Weighted Weighted average average rate Balance rate Balance ------- ------- ------- ------- Due in less than one year 4.90% $3,230 5.39% $4,466 Two to three years 5.94 1,455 6.10 738 Three to four years 7.18 1,092 - - - - Four to five years - - - - 7.18 1,066 Over five years - - - - - - - - ------ ------ 5.59% $5,777 5.78% $6,270 ====== ====== The maximum and average outstanding balances and average interest rates on retail repurchase agreements were as follows for the year ended March 31 (in thousands): 1999 1998 1997 ---- ---- ---- Maximum outstanding at any month end $17,300 $10,206 $11,119 Average outstanding 10,404 6,934 11,322 Weighted average interest rates: Annual 5.61% 5.77% 4.80% End of year 5.59 5.78 5.76 Interest expense during the year $ 584 $ 400 $ 543 Wholesale Repurchase Agreements: The table below outlines the wholesale repurchase agreements as of March 31, 1999 and 1998. The agreements to repurchase are secured by mortgage-backed securities with a fair value of $75,612,000 at March 31, 1999. The broker holds the security while FSBW continues to receive the principal and interest payments from the security. Upon maturity of the agreement the pledged securities will be returned to FSBW. A summary of wholesale repurchase agreements at March 31 by the period remaining to maturity is as follows (in thousands): 1999 1998 ----------------- ----------------- Weighted Weighted average average rate Balance rate Balance ---- ------- ---- ------- Due in less than one year 5.20% $72,690 5.64% $60,430 One to two years - - - - 5.68 25,000 ------- ------- 5.20% $72,690 5.65% $85,430 ======= ======= 87 The maximum and average outstanding balances and average interest rates on wholesale repurchase agreements were as follows for the year ended March 31 (in thousands): 1999 1998 1997 ---- ---- ---- Maximum outstanding at any month end $85,430 $85,430 $52,174 Average outstanding 78,563 72,276 26,649 Weighted average interest rates: Annual 5.61% 5.78% 5.96% End of year 5.20 5.65 5.53 Interest expense during the year $ 4,409 $ 4,180 $ 1,589 NOTE 13: INCOME TAXES Tax law requires that the Company recapture, for federal income tax purposes, certain of its tax basis bad debt reserves. Such recaptured amounts are to be generally taken into ordinary income ratably over a four- to six-year period beginning in fiscal 1999. The Company is recapturing its post-1987 additions to its tax basis bad debt reserves, which totaled $2.4 million, ratably over a four- to six-taxable-year period, resulting in approximately $170,000 a year in federal income taxes (based upon current federal income tax rates). This will not result in a charge to earnings as these amounts are included in the deferred tax liability at March 31, 1999. Retained earnings at March 31, 1999, include $5,318,000 of earnings which represent pre-1987 federal income tax basis bad debt reserve deductions taken by FSBW, for which no provisions for federal income taxes have been made. If the accumulated amount that qualified as deductions for federal income taxes is later used for purposes other than to absorb bad debt losses or FSBW no longer qualifies as a bank, the accumulated reserve will be subject to federal income tax at the then current tax rates. The provision for income taxes for the years ended March 31 differs from that computed at the statutory corporate tax rate as follows (in thousands): 1999 1998 1997 ---- ---- ---- Taxes at statutory rate $ 8,651 $ 7,199 $ 4,501 Increase (decrease) in taxes: Tax-exempt interest (597) (620) (608) Amortization of cost in excess of assets acquired 822 315 201 Difference in fair market value versus basis of released ESOP shares 34 328 184 State income taxes net of federal tax benefit 279 271 148 Other 88 (47) (503) ------ ------ ------ $9,277 $7,446 $3,923 ====== ====== ====== 88 The provision for income tax expense for the year ended March 31 is composed of the following (in thousands): 1999 1998 1997 ---- ---- ---- Current $9,696 $7,303 $4,238 Deferred (296) 34 (286) Change in valuation allowance (123) 109 (29) ------ ------ ------ $9,277 $7,446 $3,923 ====== ====== ====== Income taxes are provided for the temporary differences between the tax basis and financial statement carrying amounts of assets and liabilities. Components of the Company's net deferred tax assets (liabilities) at March 31 consisted of the following (in thousands): 1999 1998 ---- ---- Deferred tax assets: Loan loss reserves per books $ 4,226 $ 2,675 Deferred compensation and vacation 1,704 1,168 Timing of deductibility of ESOP contributions -- 86 Other 221 150 ------ ------- 6,151 4,079 Deferred tax liabilities: ------ ------- Change in method of accounting for amortization of premium and discount on investments 116 116 Tax basis bad debt reserves--post 1987 606 509 FHLB stock dividends 2,342 1,599 Depreciation 695 638 Deferred loan fees and servicing rights 403 146 Other 34 83 ------ ------- 4,196 3,091 ------ ------- 1,955 988 Valuation allowance (13) (136) ------ ------- 1,942 852 Income taxes related to valuation reserve on securities available for sale (1,184) (1,393) ------ ------- Deferred tax asset (liability), net $ 758 $ (541) ====== ======= 89 NOTE 14: EMPLOYEE BENEFIT PLANS The Banks have their own profit sharing plans for all eligible employees. The plans are funded annually at the discretion of the individual Banks' Boards of Directors. Contributions charged to operations for the years ended March 31, 1999, 1998 and 1997 were $5,500, $269,000 and $253,000, respectively. FSBW has entered into a salary continuation agreement with certain of its senior management. This program was funded by purchasing single premium life insurance contracts. The program provides for aggregate continued annual compensation for all participants totaling $240,000 for life with a 15-year guarantee. Participants vest ratably each plan year until retirement, termination, death or disability. FSBW is recording the salary obligation over the estimated remaining service lives of the participants. Expenses related to this program were $139,000, $129,000 and $119,300 for the years ended March 31, 1999, 1998 and 1997, respectively. The plan's projected benefit obligation is $2,031,000, of which $438,000 was vested at March 31, 1999. The assumed discount rate was 7% for 1999 and 1998. At March 31, 1999, an obligation of $643,400 and cash value of life insurance of $2,252,000 were recorded. At March 31, 1998, an obligation of $504,600 and cash value of life insurance of $2,144,500 were recorded. Increases in cash surrender value and related net earnings from the life insurance contracts partially offset the expenses of this program resulting in a net cost of $31,000, $21,000 and $15,000 for the years ended March 31, 1999, 1998 and 1997, respectively. IEB also has a non-qualified, non-contributory retirement compensation plan for certain bank employees whose benefits are based upon a percentage of defined participant compensation. Expenses related to this plan included in fiscal 1999, 1998 and 1997 operations were $80,000, $54,000 and $27,000, respectively. The Company and its subsidiaries also offer non-qualified deferred compensation plans to members of their Boards of Directors and certain bank employees. The plans permit each participant to defer a portion of director fees, non-qualified retirement contributions, salary or bonuses until the future. Compensation is charged to expense in the period earned. In order to fund the plans' future obligations the Company has purchased life insurance polices, contributed to money market investments and purchased common stock of the Company. As described in Note 1, during fiscal year 1999, the Company adopted the EITF consensus requiring the Company's stock held in the Rabbi Trust and resulting obligation be recorded at acquisition cost (fair value at time of purchase). In addition, the obligation relating to the purchased shares was reclassified from liabilities to stockholders' equity. As the Company is the owner of the investments and beneficiary of life insurance contracts, and in order to reflect the Company's policy to pay benefits equal to accumulations, the assets and liabilities under the plans are reflected in the consolidated balance sheets of the Company. Common stock of the Company held for such plans is reported as a contra-equity account and was recorded at original cost of $1,912,551 at March 31, 1999. Prior to adoption of the EITF consensus, common stock of the Company held for such plans was recorded at fair value of $2,449,000 at March 31, 1998. The money market investments and cash surrender value of the life insurance policies are included in other assets. NOTE 15: EMPLOYEE STOCK OWNERSHIP PLAN AND TRUST The Company established for eligible employees an ESOP and related trust that became effective upon the former mutual holding company's conversion to a stock-based holding company. Eligible employees of FSBW as of January 1, 1995 and eligible employees of the Company employed after such date who have been credited with at least 1,000 hours during a 12-month period will become participants. The ESOP borrowed $8,728,500 from the Company in order to purchase the common stock. The loan will be repaid principally from the Company's contributions to the ESOP over a period not to exceed twenty five years, and the collateral for the loan will be the unreleased, restricted common stock purchased by the ESOP. Contributions to the ESOP will be discretionary; however, the Company intends to make annual contributions to the ESOP in an aggregate amount at least equal to the principal and interest requirements of the debt. The interest rate for the loan is 8.75%. 90 Participants generally become 100% vested in their ESOP account after seven years of credited service or if their service was terminated due to death, early retirement, permanent disability or a change in control. Prior to the completion of one year of credited service, a participant who terminates employment for reasons other than death, retirement, disability, or change in control of the Company will not receive any benefit. Forfeitures will be reallocated among remaining participating employees in the same proportion as contributions. Benefits are payable upon death, retirement, early retirement, disability or separation from service. The contributions to the ESOP are not fixed, so benefits payable under the ESOP cannot be estimated. ESOP compensation expense for March 31, 1999, 1998 and 1997 was $924,000, $1,427,000 and $997,000, respectively. As of March 31, 1999, the Company has 745,918 unearned, restricted shares remaining to be released to the ESOP. The fair value of unearned, restricted shares held by the ESOP trust was $14,499,000 at March 31, 1999. NOTE 16: STOCK BASED COMPENSATION PLANS AND STOCK OPTIONS The Company operates the following stock based compensation plans as approved by the shareholders: the 1996 Management Recognition and Development Plan (MRP), the 1996 Stock Option Plan and 1998 Stock Option Plan (together, SOPs). Under the MRP the Company is authorized to grant up to 480,068 shares of restricted stock to directors, officers and employees of FSBW. The initial grant of 444,710 shares with a total cost of $6.0 million vests over a five-year period starting from the July 26, 1996, MRP approval date. The consolidated statements of income for the years ended March 31, 1999, 1998 and 1997 reflect an accrual of $1,307,000, $1,308,000 and $971,000, respectively, in compensation expense for the MRP including $113,900, $95,800 and $69,000, respectively, of expense for dividends on the allocated, restricted stock. A summary of the changes in the granted, but not vested, MRP shares for the years ended March 31 follows: 1999* 1998* 1997* ---------- ---------- --------- Shares granted--not vested, beginning of year 352,228 444,270 - - Shares granted--July 26, 1996 - - - - 444,710 Shares vested (88,258) (89,666) - - Shares forfeited (2,376) (2,374) (440) ---------- --------- -------- Shares granted--not vested, end of year 261,594 352,228 444,270 ========== ========= ======== * Adjusted for stock dividend: see Note 2 Under the 1996 and 1998 SOPs the Company has reserved 1,640,169 shares (adjusted for 10% stock dividend) for issuance pursuant to the exercise of stock options which may be granted to directors and employees. The exercise price of the stock options is set at 100% of the fair market value of the stock price at date of grant. Such options will vest ratably over a five-year period and any unexercised options will expire ten years after vesting or 90 days after employment or service ends. 91 NOTE 16: STOCK BASED COMPENSATION (CONTINUED) Details of stock options granted, vested, exercised, forfeited or terminated are as follows (adjusted for 10% stock dividend): Weighted Weighted average average Number of option shares fair value at exercise ------------------------------------ date of grant price Total Granted Exercisable ------------- ------ ------- ------- ----------- For the year ended March 31, 1997: Options granted $ 4.49 $13.67 1,004,789 1,004,789 -- Options vested -- -- -- Options forfeited -- -- -- Options exercised -- -- -- Options terminated -- -- -- --------- --------- ------- Number of option shares at March 31, 1997 $13.67 1,004,789 1,004,789 -- --------- --------- ------- For the year ended March 31, 1998: Options granted $ 9.34 $21.43 19,800 19,800 -- Options vested -- (201,947) 201,947 Options forfeited 14.39 (5,170) (5,170) -- Options exercised 13.86 (3,295) -- (3,295) Options terminated -- -- -- --------- -------- ------- Number of option shares at March 31, 1998 $13.83 1,016,124 817,472 198,652 --------- -------- ------- For the year ended March 31, 1999: Options granted $ 9.88 $23.89 277,112 277,112 -- Options assumed in acquisitions 15.64 6.26 162,810 -- 162,810 Options vested -- (204,368) 204,368 Options forfeited 13.52 (2,817) (2,817) -- Options exercised 7.67 (25,855) -- (25,855) Options terminated -- -- -- --------- -------- ------- Number of option shares at March 31, 1999 $ 15.05 1,427,374 887,399 539,975 ========= ======== ======= 92
NOTE 16: STOCK BASED COMPENSATION (CONTINUED) Financial data pertaining to outstanding stock options granted at March 31, 1999 were as follows: Weighted Weighted average average exercise exercise Weighted price Number of Number of price average of option option option shares of option remaining Exercise shares shares vested and shares contractual price granted granted exercisable exercisable life --------------- ---------- ---------- ------------ ------------ --------- $ 1.30 to 11.56 $ 6.47 138,495 138,495 $ 6.47 9.2 yrs 13.52 to 16.82 13.68 992,474 397,520 13.68 8.8 yrs 19.26 to 22.78 21.43 19,800 3,960 21.43 9.3 yrs 19.63 to 24.52 23.88 276,605 -- N/A N/A --------- ------- 1,427,374 539,975 ========= =======
In October 1995, FASB issued SFAS No. 123, Accounting for Stock-based Compensation. The statement requires expanded disclosures of stock-based compensation arrangements with employees and encourages (but does not require) application of the fair value recognition provisions in the statement. SFAS No. 123 does not rescind or interpret the existing accounting rules for employee stock-based arrangements. Companies may continue following those rules to recognize and measure compensation as outlined in Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, but they are now required to disclose the pro forma amounts of net income and earnings per share that would have been reported had the company elected to follow the fair value recognition provisions of SFAS No. 123. Effective April 1, 1996, the Company has determined that it will continue to measure its employee stock-based compensation arrangements under the provisions of APB Opinion No. 25. Accordingly, no compensation cost has been recognized for its stock option plans. Had compensation cost for the Company's compensation plan been determined consistent with SFAS No. 123, the Company's net income available to diluted common stock and diluted earnings per share would have been reduced to the pro forma amounts indicated below: Years ended March 31 ---------------------------- 1999 1998 1997 --------- ------- -------- (dollars in thousands, except per share amounts) Net income attributable to common stock: Basic: As reported $15,440 $ 13,122 $ 9,314 Pro forma 14,113 12,088 8,429 Diluted: As reported $15,440 $ 13,122 $ 9,314 Pro forma 14,113 12,088 8,429 Net income per common share: Basic: As reported $ 1.46 $ 1.30 $ 0.88 Pro forma 1.34 1.19 0.80 Diluted: As reported $ 1.40 $ 1.25 $ 0.87 Pro forma 1.28 1.15 0.79 The compensation expense included in the pro forma net income attributable to diluted common stock and diluted earnings per 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. 93 The fair value of options granted under the Company's stock option plans is estimated on the date of grant using the Black-Scholes options-pricing model with the following weighted average assumptions used for grants in fiscal 1999: annual dividend yield of 1.20% to 1.75%, expected volatility of 23.9% to 35.7%, risk-free interest rates of 4.96% to 6.79% and expected lives of 8.5 to 12.5 years. Note 17: REGULATORY 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 (BHCA), and the regulations of the Federal Reserve. Each of the Banks as state-chartered federally insured institutions is subject to the capital requirements established by the FDIC. The capital adequacy requirements are quantitative measures established by regulation that require the Company, FSBW, IEB and TB 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 Banks to maintain minimum ratios of total capital and Tier 1 capital to risk-weighted assets as well as Tier 1 leverage capital to average assets. The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) created a statutory framework that increased the importance of meeting applicable capital requirements. For FSBW, IEB and TB, FDICIA established five capital categories: well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. An institution's category depends upon where its capital levels are in relation to relevant capital measures, which include a risk-based capital measure, a leverage ratio capital measure, and certain other factors. The federal banking agencies (including the FDIC) have adopted regulations that implement this statutory framework. Under these regulations, an institution is treated as well-capitalized if its ratio of total capital to risk-weighted assets is 10.00% or more, its ratio of core capital to risk- weighted assets is 6.00% or more, its ratio of core capital to adjusted total assets is 5.00% or more and it is not subject to any federal supervisory order or directive to meet a specific capital level. In order to be adequately capitalized, an institution must have a total risk-based capital ratio of not less than 8.00%, a Tier 1 risk-based capital ratio of not less than 4.00%, and leverage ratio of not less that 4.00%. Any institution which is neither well-capitalized nor adequately capitalized will be considered undercapitalized. Undercapitalized institutions are subject to certain prompt corrective action requirements, regulatory controls and restrictions which become more extensive as an institution becomes more severely undercapitalized. Failure by the Banks, individually, to comply with applicable capital requirements would, if unremedied, result in restrictions on their activities and lead to enforcement actions against FSBW, IEB or TB by the FDIC, including, but not limited to, the issuance of a capital directive to ensure the maintenance of required capital levels. FDICIA requires the federal banking regulators to take prompt corrective action with respect to depository institutions that do not meet minimum capital requirements. Additionally, FDIC approval of any regulatory application filed for its review may be dependent on compliance with capital requirements. Federal law requires that the federal banking agencies' risk-based capital guidelines take into account various factors including interest rate risk, concentration of credit risk, risks associated with nontraditional activities, and the actual performance and expected risk of loss of multifamily mortgages. In 1994, the federal banking agencies jointly revised their capital standards to specify that concentration of credit and nontraditional activities are among the factors that the agencies will consider in evaluating capital adequacy. In that year, the FDIC amended its risk-based capital standards with respect to the risk weighting of loans made to finance the purchase or construction of multifamily residences. Management believes that the effect of including such an interest rate risk component in the calculation of risk-adjusted capital will not cause the Company and the Banks to cease to be well-capitalized. In June 1996, the FDIC and certain other federal banking agencies issued a joint policy statement providing guidance on prudent interest rate risk management principles. The agencies stated that they would determine banks' interest rate risk on a case-by-case basis, and would not adopt a standardized measure or establish an explicit minimum capital charge for interest rate risk. 94 NOTE 17: REGULATORY CAPITAL REQUIREMENTS (CONTINUED) The actual regulatory capital ratios calculated for the Company and the Banks, along with the minimum capital amounts and ratios for capital adequacy purposes and to be categorized as well-capitalized under the regulatory framework for prompt corrective action were as follows: 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) MARCH 31, 1999: The Company--consolidated Total capital to risk- weighted assets $159,221 15.15% $84,063 8.00% N/A N/A Tier 1 capital to risk- weighted assets 146,961 13.99 42,032 4.00 N/A N/A Tier 1 leverage capital to average assets 146,961 9.44 62,274 4.00 N/A N/A FSBW Total capital to risk- weighted assets 118,576 17.01 55,773 8.00 $69,716 10.00% Tier 1 capital to risk- weighted assets 110,161 15.80 27,886 4.00 41,829 6.00 Tier 1 leverage capital to average assets 110,161 9.41 46,817 4.00 58,521 5.00 IEB Total capital to risk- weighted assets 20,165 12.69 12,714 8.00 15,893 10.00 Tier 1 capital to risk- weighted assets 18,521 11.65 6,357 4.00 9,536 6.00 Tier 1 leverage capital to average assets 18,521 9.60 7,717 4.00 9,647 5.00 TB Total capital to risk- weighted assets 19,450 10.03 15,510 8.00 19,387 10.00 Tier 1 capital to risk- weighted assets 17,249 8.90 7,755 4.00 11,632 6.00 Tier 1 leverage capital to average assets 17,249 8.87 7,779 4.00 9,723 5.00 95 NOTE 17: REGULATORY CAPITAL REQUIREMENTS (CONTINUED) 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) March 31, 1998: The Company--consolidated Total capital to risk- weighted assets $144,284 22.64% $50,987 8.00% N/A N/A Tier 1 capital to risk- weighted assets 136,427 21.41 25,493 4.00 N/A N/A Tier 1 leverage capital to average assets 136,427 12.17 44,850 4.00 N/A N/A FSBW Total capital to risk- weighted assets 93,324 18.67 40,003 8.00 $50,003 10.00% Tier 1 capital to risk- weighted assets 87,073 17.42 20,001 4.00 30,002 6.00 Tier 1 leverage capital to average assets 87,073 9.30 37,459 4.00 46,824 5.00 IEB Total capital to risk- weighted assets 17,545 13.14 10,685 8.00 13,357 10.00 Tier 1 capital to risk- weighted assets 16,118 12.07 5,343 4.00 8,014 6.00 Tier 1 leverage capital to average assets 16,118 8.97 7,187 4.00 8,984 5.00 Company management believes that as of March 31, 1999, the Company, FSBW, IEB and TB individually met all capital adequacy requirements to which they were subject. Additionally, as of March 31, 1999, the most recent notification from the FDIC individually categorized the Banks as "well-capitalized" under the regulatory framework for prompt corrective action. To be categorized as "well- capitalized," a bank must maintain minimum total risk-based, Tier 1 risk- based, and Tier 1 leverage ratios as set forth in the table above. There are no conditions or events since that notification that management believes have changed any Bank's individual category. 96 NOTE 18: CONTINGENCIES In the normal course of business, the Company and/or its subsidiaries have various legal claims and other contingent matters outstanding. The Company believes that any liability ultimately arising from these actions would not have a material adverse effect on the results of operations or consolidated financial position at March 31, 1999. NOTE 19: INTEREST RATE RISK 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 impacting 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. Additional interest rate risk results from mismatched repricing indices and formulae (basis risk and yield curve risk), 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. 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 and net market value resulting from those movements under different rate environments. Another monitoring tool used by the Company to assess interest rate risk is "gap analysis." The matching of 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 the Company's interest sensitivity "gap." Management is aware of the sources of interest rate risk and in its opinion actively monitors and manages it to the extent possible, and considers that the Company's current level of interest rate risk is reasonable. NOTE 20: GOODWILL Costs in excess of net assets acquired (goodwill) consisted of the following: MARCH 31 (in thousands) 1999 1998 -------- --------- Acquisitions of IEB, TB and WSB, net of accumulated amortization of $3,880,000 and $1,491,000, respectively $ 34,182 $ 11,007 ========= ========= Costs in excess of net assets acquired result from business combinations accounted for as a purchase of assets and an assumption of liabilities. The Company's acquisitions of TB and WSB in fiscal 1999 recorded under the purchase accounting method created $25.6 million of goodwill. Goodwill is amortized using the straight-line method over the period that is expected to be benefited of 14 years. The Company periodically evaluates goodwill for impairment. 97 NOTE 21: FAIR VALUE OF FINANCIAL INSTRUMENTS The following disclosure of the estimated fair value of financial instruments is made in accordance with the requirements of SFAS No. 107, Disclosures About Fair Value of Financial Instruments. The estimated fair value amounts have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is necessary to interpret market data in the development of the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. The estimated fair value of financial instruments is as follows at March 31 (in thousands): 1999 1998 ----------------------- --------------------- Carrying Estimated Carrying Estimated value fair value value fair value ---------- ---------- --------- ---------- Assets: Cash $ 72,503 $ 72,503 $ 42,529 $ 42,529 Securities available for sale 362,021 362,021 302,418 302,419 Securities held to maturity 2,155 2,235 194 194 Loans receivable held for sale 11,256 11,256 12,436 12,436 Loans receivable 1,091,413 1,098,161 744,481 752,420 Accrued interest receivable 9,898 9,898 7,569 7,569 FHLB stock 23,137 23,137 16,050 16,050 Mortgage servicing rights 1,671 1,853 698 836 Liabilities: Demand, NOW and Money Market accounts 311,686 311,686 188,831 188,831 Regular savings 59,133 59,133 42,084 42,084 Certificates of deposit 580,029 583,084 371,607 373,635 FHLB advances 408,252 407,553 297,549 299,153 Other borrowings 78,467 78,503 91,723 91,709 Off-balance-sheet financial instruments: Commitments to sell loans $ -- $ -- $ -- $ -- Commitments to originate loans -- -- -- -- Commitments to purchase securities -- -- -- -- Commitments to sell securities -- -- -- -- 98 Fair value estimates, methods, and assumptions are set forth below for the Company's financial and off-balance-sheet instruments: Cash: The carrying amount of these items is a reasonable estimate of their fair value. Securities: The estimated fair values of investment securities and mortgaged- backed securities available for sale and held to maturity are based on quoted market prices or dealer quotes. Loans Receivable: Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as multifamily real estate, residential mortgage, nonresidential, commercial/ agricultural, consumer and other. Each loan category is further segmented into fixed- and adjustable-rate interest terms and by performing and non- performing categories. The fair value of performing residential mortgages held for sale is estimated based upon secondary market sources by type of loan and terms such as fixed or variable interest rates. For performing loans held in portfolio, the fair value is based on discounted cash flows using as a discount rate the current rate offered on similar products. Fair value for significant non-performing loans is based on recent appraisals or estimated cash flows discounted using rates commensurate with risk associated with the estimated cash flows. Assumptions regarding credit risk, cash flows, and discount rates are judgmentally determined using available market information and specific borrower information. FHLB Stock: The fair value is based upon the redemption value of the stock which equates to its carrying value. Deposit Liabilities: The fair value of deposits with no stated maturity, such as savings, checking and NOW accounts, is equal to the amount payable on demand. The market value of certificates of deposit is based upon the discounted value of contractual cash flows. The discount rate is determined using the rates currently offered on comparable instruments. FHLB Advances and Other Borrowings: The fair value of FHLB advances and other borrowings is estimated based on discounting the estimated future cash flows using rates currently available to the Company for debt with similar remaining maturities. Commitments: Commitments to sell loans with a notional balance of $3,791,000 and $6,037,000 at March 31, 1999 and 1998, respectively, have a carrying value of zero, representing the cost of such commitments. Commitments to originate loans, $147,122,000 and $74,087,000 at March 31, 1999 and 1998, respectively, also have a carrying value of zero. There were no commitments to purchase or sell securities at March 31, 1999. The fair value of such commitments is also estimated to be zero based upon current market rates for similar loans and any fees received to enter into similar agreements. Limitations: The fair value estimates presented herein are based on pertinent information available to management as of March 31, 1999. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since that date and, therefore, current estimates of fair value may differ significantly from the amounts presented herein. Fair value estimates are based on existing on- and off-balance-sheet financial instruments without attempting to estimate the value of anticipated future business. The fair value has not been estimated for assets and liabilities that are not considered financial instruments. Significant assets and liabilities that are not financial instruments include the mortgage banking operations; deferred tax assets/liabilities; land, buildings and equipment; costs in excess of net assets acquired; and real estate held for sale. 99 NOTE 22: FIRST WASHINGTON BANCORP, INC. (FWWB) (PARENT COMPANY ONLY) Summary financial information as of March 31 (in thousands): FWWB BALANCE SHEETS March 31, 1999 and 1998 1999 1998 ---- ---- ASSETS Cash $ 110 $ 13,177 Investments available for sale -- 11,978 Loan receivable, ESOP -- 7,414 Investment in subsidiaries 182,578 116,946 Deferred tax asset 273 194 Other assets 2,376 2,120 --------- --------- $ 185,337 $ 151,829 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities $ 1,730 $ 1,645 Stockholders' equity 183,607 150,184 --------- --------- $ 185,337 $ 151,829 ========= ========= FWWB STATEMENTS OF INCOME For the years ended March 31, 1999, 1998 and 1997 1999 1998 1997 ---- ---- ---- INTEREST INCOME: Certificates and time deposits $ 56 $ 107 $ 62 Investments 401 553 1,403 ESOP loan 325 678 724 ------- ------- ------- 782 1,338 2,189 OTHER INCOME: Equity in undistributed income of subsidiaries 16,010 13,201 8,719 Miscellaneous -- -- 25 ------- ------- ------- 16,792 14,539 10,933 OTHER EXPENSE 1,653 1,460 1,297 ------- ------- ------- 15,139 13,079 9,636 PROVISION FOR (BENEFIT FROM) INCOME TAXES (301) (43) 322 ------- ------- ------- NET INCOME $15,440 $13,122 $ 9,314 ======= ======= ======= 100 FWWB STATEMENTS OF CASH FLOWS For the years ended March 31, 1999, 1998 and 1997 1999 1998 1997 ---- ---- ---- OPERATING ACTIVITIES: Net income $15,440 $ 13,122 $ 9,314 Adjustments to reconcile net income to net cash provided by operating activities: Equity in undistributed earnings of subsidiaries (16,010) (13,201) (8,719) Net amortization of investment discounts (394) (553) (1,403) Amortization of MRP liability 339 339 254 (Increase) decrease in deferred taxes -- 101 (230) (Increase) decrease in other assets 44 (327) (486) Increase (decrease) in other liabilities (123) 22 199 ------- ------- -------- Net cash provided (used) by operating activities (704) (497) (1,071) ------- ------- -------- INVESTING ACTIVITIES: Purchase of securities available for sale (136,831) (164,686) (446,308) Principal repayments and maturities of securities available for sale 149,200 167,290 486,739 Funds transferred to deferred compensation trust (80) (80) (75) Acquisitions of subsidiaries (7,824) -- (32,833) Dividends received from subsidiaries 6,914 26,545 4,515 Payments received on loan to ESOP for release of shares 633 542 475 Additional investment in subsidiaries (5,730) (216) (166) Net cash provided (used) by ------- ------- -------- investing activities 6,282 29,395 12,347 ------- ------- -------- FINANCING ACTIVITIES: Repurchases of stock (15,266) (13,993) (12,905) Repurchase of forfeited MRP shares (32) (38) -- Proceeds from sale of stock to FSBW 250 -- 4,320 Cash dividends paid (3,597) (2,583) (1,907) ------- ------- -------- Net cash provided (used) by financing activities (18,645) (16,614) (10,492) ------- ------- -------- NET INCREASE (DECREASE) IN CASH (13,067) 12,284 784 CASH, BEGINNING OF PERIOD 13,177 893 109 ------- ------- -------- CASH, END OF PERIOD $ 110 $13,177 $ 893 ======= ======= ======== 101 FWWB STATEMENTS OF CASH FLOWS For the years ended March 31, 1999, 1998 and 1997 (continued) 1999 1998 1997 ---- ---- ---- OPERATING ACTIVITIES: Net income $15,440 $ 13,122 $ 9,314 SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Interest paid $ - - $ - - $ - - Taxes paid $ - - $ 16 $ 505 Non-cash transactions: Net change in accrued dividends payable $ 477 $ 149 $ 178 Increase of investment in subsidiary for shares released to ESOP participants as compensation $ 291 $ 1,642 $ 417 Net change in unrealized gain (loss) in deferred compensation trust and related liability, including subsidiaries $ 5,516 $ 1,536 $ 493 Stock forfeited by MRP, including subsidiaries $ - - $ 6 $ 6 Recognize tax benefit of vested MRP shares, including subsidiaries $ 276 $ 231 $ - - Fair value of stock issued and options assumed in connection with the acquisitions $ 32,527 $ - - $ - - Non-cash portion of 10% stock dividend $ 24,360 $ - - $ - - NOTE 23: CONVERSION TO CAPITAL STOCK FORM OF OWNERSHIP In October 1995, the Company converted from the mutual holding company to the stock holding company form of organization. At the time, the Company established a liquidation account in an amount equal to its equity, as reflected in the latest statement of financial condition used in the final conversion prospectus. The liquidation account will be maintained for the benefit of eligible account holders who continue to maintain their accounts at FSBW after the conversion. The liquidation account will be reduced annually to the extent that eligible account holders have reduced their qualifying deposits as of each anniversary date. Subsequent increases will not restore an eligible account holder's interest in the liquidation account. In the event of a complete liquidation of the Company, each FSBW eligible account holder will be entitled to receive a distribution from the liquidation account in an amount proportionate to the current adjusted qualifying balances for accounts then held. Subsequent to the conversion, the Company may not declare or pay cash dividends on, or repurchase, any of its shares of common stock if the effect thereof would cause equity to be reduced below applicable regulatory capital maintenance requirements or if such declaration and payment would otherwise violate regulatory requirements. NOTE 24: STOCK REPURCHASE On November 19, 1996, the Company completed its stock repurchase program initiated in April 1996 which authorized the repurchase of 600,077 shares of its outstanding common stock. On November 20, 1996, the Company's Board of Directors approved continuance of the stock repurchase program authorizing the purchase of up to 10% of total shares outstanding over the next 12 months. Similar authorizations were approved by the Board of Directors in November 1997 and October 1998. As of March 31, 1999, the Company has repurchased a total of 2,188,198 shares at an average price of $19.27 per share. The Company has reserved 480,067 shares for its MRP of which 439,520 shares were awarded as of March 31, 1999 (see Note 16 to financial statements). The remaining 40,547 unallocated shares are held as authorized but unissued shares reserved for the MRP. Management reissued 853,472 shares in connection with the acquisition of TB, and 507,053 shares in connection with the acquisition of WSB (see Note 2). 102 NOTE 25: CALCULATION OF WEIGHTED AVERAGE SHARES OUTSTANDING USED TO CALCULATE EARNINGS PER SHARE Years ended March 31 (IN THOUSANDS) 1999* 1998* 1997* ------- --------- -------- Total shares issued 12,002 12,002 12,002 Less stock repurchased/retired including shares allocated to MRP (681) (1,059) (537) Less unallocated shares held by the ESOP (772) (824) (891) ------- --------- -------- Basic weighted average shares outstanding 10,549 10,119 10,574 ------- --------- -------- Plus MRP and stock option incremental shares considered outstanding for diluted EPS calculations 476 411 139 ------- --------- -------- Diluted weighted average shares outstanding 11,025 10,530 10,713 ======= ========= ======== * Weighted average shares, restated for 10% stock dividend NOTE 26: SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) Results of operations on a quarterly basis were as follows (in thousands): YEAR ENDED MARCH 31, 1999 ------------------------------------------- First Second Third Fourth Quarter Quarter Quarter Quarter ------- ------- ------- ------- Interest income $ 25,799 $ 27,676 $ 28,347 $ 30,470 Interest expense 13,940 14,919 15,424 16,159 -------- -------- -------- -------- Net interest income 11,859 12,757 12,923 14,311 Provision for loan losses 667 703 840 631 -------- -------- -------- -------- Net interest income after provision for loan losses 11,192 12,054 12,083 13,680 Non-interest income 1,593 1,792 1,971 2,097 Non-interest expense 7,073 7,487 7,834 9,351 -------- -------- -------- -------- Income before provision for income taxes 5,712 6,359 6,220 6,426 Provision for income taxes 2,164 2,392 2,324 2,397 -------- -------- -------- -------- Net operating income $ 3,548 $ 3,967 $ 3,896 $ 4,029 ======== ======== ======== ======== * Basic earnings per share $ 0.33 $ 0.38 $ 0.38 $ 0.37 * Diluted earnings per share $ 0.32 $ 0.36 $ 0.36 $ 0.36 * Cash dividends declared $ 0.08 $ 0.09 $ 0.09 $ 0.12 103 NOTE 26: SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED), CONTINUED Results of operations on a quarterly basis were as follows (in thousands): YEAR ENDED MARCH 31, 1998 ------------------------------------------- First Second Third Fourth Quarter Quarter Quarter Quarter ------- ------- ------- ------- Interest income $ 20,062 $ 21,311 $ 21,837 $ 21,937 Interest expense 10,721 11,754 12,038 12,138 -------- -------- -------- -------- Net interest income 9,341 9,557 9,799 9,799 Provision for loan losses 355 400 375 498 -------- -------- -------- -------- Net interest income after provision for loan losses 8,986 9,157 9,424 9,301 Non-interest income 956 1,113 1,249 1,402 Non-interest expense 4,912 5,136 5,517 5,455 -------- -------- -------- -------- Income before provision for income taxes 5,030 5,134 5,156 5,248 Provision for income taxes 1,785 1,837 1,951 1,873 -------- -------- -------- -------- Net operating income $ 3,245 $ 3,297 $ 3,205 $ 3,375 ======== ======== ======== ======== * Basic earnings per share $ 0.32 $ 0.32 $ 0.32 $ 0.34 * Diluted earnings per share $ 0.30 $ 0.31 $ 0.30 $ 0.33 * Cash dividends declared $ 0.06 $ 0.06 $ 0.06 $ 0.08 YEAR ENDED MARCH 31, 1997 ------------------------------------------- First Second Third Fourth Quarter Quarter Quarter Quarter ------- ------- ------- ------- Interest income $ 13,785 $ 16,648 $ 18,264 $ 18,595 Interest expense 7,566 9,007 9,791 10,008 -------- -------- -------- -------- Net interest income 6,219 7,641 8,473 8,587 Provision for loan losses 513 407 231 272 -------- -------- -------- -------- Net interest income after provision for loan losses 5,706 7,234 8,242 8,315 Non-interest income 435 575 1,173 887 Non-interest expense 2,864 6,842 4,865 4,759 -------- -------- -------- -------- Income before provision for income taxes 3,277 967 4,550 4,443 Provision for income taxes 884 164 1,444 1,431 -------- -------- -------- -------- Net operating income $ 2,393 $ 803 $ 3,106 $ 3,012 ======== ======== ======== ======== * Basic earnings per share $ 0.22 $ 0.08 $ 0.29 $ 0.29 * Diluted earnings per share $ 0.22 $ 0.08 $ 0.29 $ 0.28 * Cash dividends declared $ 0.05 $ 0.05 $ 0.05 $ 0.06 * Restated to reflect 10% stock dividend declared to stockholders of record as of August 10, 1998. 104 NOTE 27: BUSINESS SEGMENTS The Company is managed by legal entity or Bank, not by lines of business. Each Bank is managed by its executive management team that is responsible for its own lending, deposit operations, information systems and administration. Marketing, sales training assistance and credit card administration is provided from a central source at FSBW, and costs are allocated to the individual Banks using appropriate methods based on usage. In addition, corporate overhead and centralized administrative costs are allocated to each Bank. The accounting policies followed by each Bank are the same as those described in Note 1 to the Consolidated Financial Statements. FSBW is a community oriented savings bank which has traditionally offered a wide variety of deposit products to its retail customers while concentrating its lending activities on real estate loans. Lending activities have been focused primarily on the origination of loans secured by one- to four-family residential dwellings, including an emphasis on loans for construction of residential dwellings. FSBW's primary business is originating loans for portfolio in its primary market area, which consists of southeast, central, north central, and western Washington state. FSBW's wholly owned subsidiary, Northwest Financial Corporation, provides trustee services for FSBW, is engaged in real estate sales and receives commissions from the sale of annuities. IEB is a community oriented commercial bank chartered in the State of Oregon. IEB's lending activities consist of granting agribusiness, commercial and consumer loans to customers throughout the northeastern Oregon region. IEB has two wholly owned subsidiaries: Pioneer American Property Company, which owns a building that is leased to IEB, and Inland Securities Corporation, which previously made a market for IEB's stock but is currently inactive. TB is a community oriented commercial bank chartered in the State of Washington. TB's lending activities consist of granting commercial and consumer loans to customers throughout the Seattle, Washington, metropolitan area. The performance of each Bank is reviewed by the Company's executive management team and the Board of Directors on a monthly basis. Financial highlights by legal entity were as follows: YEAR ENDED MARCH 31, 1999 --------------------------------------------------- (dollars in thousands) CONDENSED INCOME STATEMENT FSBW IEB TB OTHER* TOTAL ---------- -------- -------- ----- ---------- Net interest income (loss) $ 30,712 $ 10,114 $ 10,242 $ 782 $ 51,850 Provision for loan losses 1,870 226 745 -- 2,841 Other income 3,875 2,528 1,071 (21) 7,453 Other expenses 16,049 6,841 7,223 1,632 31,745 ---------- -------- -------- ------ ---------- Income (loss) before income taxes 16,668 5,575 3,345 (871) 24,717 Income taxes (benefit) 5,442 2,490 1,646 (301) 9,277 ---------- -------- -------- ------ ---------- Net income (loss) $ 11,226 $ 3,085 $ 1,699 $ (570) $ 15,440 ========== ======== ======== ====== ========== MARCH 31, 1999 -------------------------------------------------- TOTAL ASSETS $1,193,269 $204,539 $233,485 $ 607 $1,631,900 ========== ======== ======== ====== ========== 105 NOTE 27: BUSINESS SEGMENTS (CONTINUED) YEAR ENDED MARCH 31, 1998 --------------------------------------------------- (dollars in thousands) CONDENSED INCOME STATEMENT FSBW IEB TB OTHER* TOTAL ---------- -------- -------- ----- ---------- Net interest income (loss) $ 27,417 $ 9,741 $ N/A $1,338 $ 38,496 Provision for loan losses 1,559 69 -- 1,628 Other income 2,556 2,164 -- 4,720 Other expenses 13,163 6,397 1,460 21,020 ---------- -------- ----- ---------- Income (loss) before income taxes 15,251 5,439 (122) 20,568 Income taxes (benefit) 5,098 2,391 (43) 7,446 ---------- -------- ----- ---------- Net income (loss) $ 10,153 $ 3,048 $ (79) $ 13,122 ========== ======== ===== ========== MARCH 31, 1998 -------------------------------------------------- TOTAL ASSETS $ 952,644 $183,321 $ N/A $18,107 $1,154,072 ========== ======== ======= ======= ========== YEAR ENDED MARCH 31, 1997 --------------------------------------------------- (dollars in thousands) CONDENSED INCOME STATEMENT FSBW IEB TB OTHER* TOTAL ---------- -------- -------- ----- ---------- Net interest income (loss) $ 23,073 $ 5,659 $ N/A $ 2,188 $ 30,920 Provision for loan losses 1,399 24 -- 1,423 Other income 1,751 1,293 26 3,070 Other expenses 13,874 4,159 1,297 19,330 ---------- -------- ------- ---------- Income (loss) before income taxes 9,551 2,769 917 13,237 Income taxes (benefit) 2,373 1,228 322 3,923 ---------- -------- ----- ---------- Net income (loss) $ 7,178 $ 1,541 $ 595 $ 9,314 ========== ======== ===== ========== MARCH 31, 1997 -------------------------------------------------- TOTAL ASSETS $ 813,800 $179,478 $ N/A $14,355 $1,007,633 ========== ======== ======= ======= ========== * Includes intercompany eliminations and holding company amounts. 106 FIRST WASHINGTON BANCORP, INC. INDEX OF EXHIBITS EXHIBIT - ------------------------------------------------------------------------------ 3{a} Certificate of Incorporation of Registrant [incorporated by reference to Registration Statement on Form S-1, as amended (File No. 33-93386)]. 3{b} Bylaws of Registrant [incorporated by reference to exhibits filed with the Quarterly Report on Form 10-Q for the quarter ended December 31, 1997 (file No. 0-26584)]. 10{a} Employment Agreement with Gary L. Sirmon [incorporated by reference to exhibits filed with the Annual Report on Form 10-k dated March 31, 1996 (File No. 0-26584)]. 10{b} Executive Salary Continuation Agreement with Gary L. Sirmon [incorporated by reference to exhibits filed with the Annual Report on Form 10-k dated March 31, 1996 (File No. 0-26584)]. 10{c} Employment Agreement with D. Allan Roth [incorporated by reference to exhibits filed with the Annual Report on Form 10-k dated March 31, 1996 (File No. 0-26584)]. 10{d} Executive Salary Continuation Agreement with D. Allan Roth [incorporated by reference to exhibits filed with the Annual Report on Form 10-k dated March 31, 1996 (File No. 0-26584)]. 10{e} Employment Agreement with Michael K. Larsen [incorporated by reference to exhibits filed with the Annual Report on Form 10-k dated March 31, 1996 (File No. 0-26584)]. 10{f} Executive Salary Continuation Agreement with Michael K. Larsen. [incorporated by reference to exhibits filed with the Annual Report on Form 10-k dated March 31, 1996 (File No. 0-26584)]. 10{g} 1996 Stock Option Plan (incorporated by reference to Exhibit A to the Proxy Statement for the Annual Meeting of Stockholders held on July 26, 1996). 10{h} 1996 Management Recognition and Development Plan (incorporated by reference to Exhibit B to the Proxy Statement for the Annual Meeting of Stockholders held on July 26, 1996). 10{i} Employment and Non-competition Agreement with Jesse G. Foster [incorporated by reference to exhibits filed with the Annual Report on Form 10-K dated March 31, 1997 (file No. 0-26584)]. 10{j} Supplemental Retirement Plan as Amended with Jesse G. Foster [incorporated by reference to exhibits filed with the Annual Report on Form 10-K dated March 31, 1997 (file No. 0-26584)]. 10{k} Towne Bank of Woodinville 1992 Stock Option Plan [incorporated by reference to exhibits filed with the Registration Statement on Form S-8 dated April 2, 1999 (file No. 333-49193)]. 21 Subsidiaries of the Registrant. 23 Independent Auditors Consent. 27 Financial Data Schedule. 107 Exhibit 21 Subsidiaries of the Registrant Parent - ------ First Washington Bancorp, Inc. Percentage of Jurisdiction of Subsidiaries ownership State of Incorporation - ------------ ------------- ---------------------- First Savings Bank of Washington (1) 100% Washington Inland Empire Bank (1) 100% Oregon Towne Bank (1) 100% Washington Northwest Financial Corporation (2) 100% Washington Pioneer American Property Company (3) 100% Oregon - ------------ (1) Wholly-owned by First Washington Bancorp, Inc. (2) Wholly-owned by First Savings Bank of Washington (3) Wholly-owned by Inland Empire Bank EXHIBIT 23 [Deloitte & Touche LLP Letterhead] INDEPENDENT AUDITORS' CONSENT - ----------------------------- We consent to the incorporation by reference in Registration Statement Nos. 333-10819, 333-49193 and 333-71625 of First Washington Bancorp, Inc. on Form S-8 of our report dated June 10, 1999, appearing in the Annual Report on Form 10-K of First Washington Bancorp, Inc. for the year ended March 31, 1999. /s/Deloitte & Touche LLP DELOITTE & TOUCHE LLP Seattle, Washington June 29, 1999 EX-27 2
9 0000946673 FIRST WASHINGTON BANCORP EXHIBIT 27 1,000 YEAR MAR-31-1999 MAR-31-1999 72503 2562 18815 0 362201 2155 2235 1102669 12261 1631900 950848 199220 10725 287499 0 0 130770 0 1631900 89615 21357 1320 112292 34019 60442 51850 2821 11 31745 24717 15440 0 0 15440 1.46 1.40 3.83 6138 1538 380 0 7857 1355 225 12261 11284 0 841
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