FORM 10-Q SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended .................. September 30, 2001 ------------------ [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to ---------------- ------------------ Commission File Number 0-26584 ------------------- BANNER CORPORATION ------------------ (Exact name of registrant as specified in its charter) WASHINGTON 91-1691604 -------------------------------- ------------------- (State or other jurisdiction of (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) (Former name, former address and former fiscal year, if changed since last report.) 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. (1) Yes [X] No [ ] APPLICABLE ONLY TO CORPORATE ISSUERS Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Title of class: As of October 31, 2001 --------------- ------------------- Common Stock, $.01 Par Value 11,838,570 shares * * Includes 633,278 shares held by employee stock ownership plan (ESOP) that have not been released, committed to be released, or allocated to participant accounts.
Banner Corporation and Subsidiaries Table of Contents PART I - FINANCIAL INFORMATION ITEM 1 - Financial Statements. The Consolidated Financial Statements of Banner Corporation and Subsidiaries filed as a part of the report are as follows: Consolidated Statements of Financial Condition as of September 30, 2001 and December 31, 2000.......................... 2 Consolidated Statements of Income for the Quarters and Nine Months Ended September 30, 2001 and 2000...... 3 Consolidated Statements of Comprehensive Income for the Quarters and Nine Months Ended September 30, 2001 and 2000...... 4 Consolidated Statements of Changes in Stockholders' Equity for the Nine months Ended September 30, 2001 and 2000................... 5 Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2001 and 2000................... 7 Selected Notes to Consolidated Financial Statements..................... 9 ITEM 2 - Management's Discussion and Analysis of Financial Condition and Results of Operation General................................................................. 15 Recent Developments and Significant Events.............................. 16 Comparison of Financial Condition at September 30, 2001 and December 31, 2000................................................... 16 Comparison of Results of Operations for the Quarters and Nine Months Ended September 30, 2001 and 2000........................... 16 Asset Quality........................................................... 24 Market Risk and Asset/Liability Management.............................. 25 Liquidity and Capital Resources......................................... 28 Capital Requirements.................................................... 29 PART II - OTHER INFORMATION Item 1. Legal Proceedings............................................... 30 Item 2. Changes in Securities........................................... 30 Item 3. Defaults upon Senior Securities................................. 30 Item 4. Submission of Matters to a Vote of Stockholders................. 30 Item 5. Other Information............................................... 30 Item 6. Exhibits and Reports on Form 8-K................................ 30 SIGNATURES................................................................ 31 1
BANNER CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (in thousands, except shares) September 30, 2001 and December 31, 2000 (Unaudited) September 30 December 31 ASSETS 2001 2000 ----------- ----------- Cash and due from banks $ 56,093 $ 67,356 Securities available for sale, cost $309,275 and $310,539 Encumbered 64,462 66,405 Unencumbered 248,996 242,393 ----------- ----------- 313,458 308,798 Securities held to maturity, fair value $15,663 and $18,269 15,546 17,717 Federal Home Loan Bank stock 30,305 28,807 Loans receivable: Held for sale, fair value $22,631 and $8,011 22,150 7,934 Held for portfolio 1,579,502 1,479,149 Allowance for loan losses (18,593) (15,314) ----------- ----------- 1,583,059 1,471,769 Accrued interest receivable 14,832 12,963 Real estate owned, held for sale, net 2,871 3,287 Property and equipment, net 17,919 17,746 Costs in excess of net assets acquired (goodwill), net 32,232 34,617 Deferred income tax asset, net 1,209 2,337 Bank owned life insurance 19,968 14,190 Other assets 7,341 3,244 ----------- ----------- $ 2,094,833 $ 1,982,831 =========== =========== LIABILITIES Deposits: Non-interest-bearing $ 173,061 $ 140,779 Interest-bearing 1,125,653 1,051,936 ----------- ----------- 1,298,714 1,192,715 Advances from Federal Home Loan Bank 513,783 507,098 Other borrowings 73,370 74,538 Accrued expenses and other liabilities 13,307 10,857 Deferred compensation 2,595 2,293 Income taxes payable -- 1,535 ----------- ----------- 1,901,769 1,789,036 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, 13,201,418 shares issued: 11,838,570 shares and 12,005,302 shares outstanding at September 30, 2001 and December 31, 2000, respectively. 129,987 133,839 Retained earnings 65,724 66,893 Accumulated other comprehensive income: Unrealized gain (loss) on securities available for sale 2,698 (1,125) Unearned shares of common stock issued to Employee Stock Ownership Plan (ESOP) trust: 633,278 and 633,278 restricted shares out- standing at September 30, 2001 and December 31, 2000, respectively, at cost (5,234) (5,234) Carrying value of shares held in trust for stock related compensation plans (2,713) (3,130) Liability for common stock issued to deferred, stock related, compensation plan 2,602 2,552 ----------- ----------- (111) (578) ----------- ----------- 193,064 193,795 ----------- ----------- $ 2,094,833 $ 1,982,831 =========== =========== See notes to consolidated financial statements 2
BANNER CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Unaudited) (in thousands except for per share amounts) Quarters Ended Nine Months Ended September 30 September 30 ------------------- ------------------- 2001 2000 2001 2000 -------- -------- -------- -------- INTEREST INCOME: Loans receivable $ 34,468 $ 34,060 $103,387 $ 96,206 Mortgage-backed securities 2,940 3,826 9,217 11,732 Securities and deposits 2,450 3,037 7,571 8,723 -------- -------- -------- -------- 39,858 40,923 120,175 116,661 INTEREST EXPENSE: Deposits 13,342 13,986 41,553 38,676 Federal Home Loan Bank advances 7,463 8,412 22,969 23,142 Other borrowings 739 1,292 2,674 3,634 -------- -------- -------- -------- 21,544 23,690 67,196 65,452 -------- -------- -------- -------- Net interest income before provision for loan losses 18,314 17,233 52,979 51,209 PROVISION FOR LOAN LOSSES 5,959 651 9,859 2,015 -------- -------- -------- -------- Net interest income 12,355 16,582 43,120 49,194 OTHER OPERATING INCOME: Loan servicing fees 308 264 903 744 Other fees and service charges 1,228 1,297 4,159 3,676 Gain on sale of loans 1,327 558 3,410 1,027 Gain (loss) on sale of securities -- 44 360 59 Miscellaneous 451 62 982 172 -------- -------- -------- -------- Total other operating income 3,314 2,225 9,814 5,678 OTHER OPERATING EXPENSES: Salary and employee benefits 7,817 6,822 22,821 19,604 Less capitalized loan origination costs (1,146) (874) (3,582) (2,566) Occupancy and equipment 2,026 1,764 5,770 5,208 Information/computer data services 1,718 623 3,220 1,824 Advertising 269 220 687 549 Check kiting loss 1,900 -- 8,100 -- Amortization of goodwill 795 793 2,385 2,377 Miscellaneous 2,222 2,338 7,112 6,785 -------- -------- -------- -------- Total other operating expenses 15,601 11,686 46,513 33,781 -------- -------- -------- -------- Income before provision for income taxes 68 7,121 6,421 21,091 PROVISION FOR INCOME TAXES 212 2,515 2,637 7,517 -------- -------- -------- -------- NET INCOME (LOSS) $ (144) $ 4,606 $ 3,784 $ 13,574 ======== ======== ======== ======== Net income (loss) per common share, see Note 5: Basic $ (.01) $ .41 $ .34 $ 1.20 Diluted $ (.01) $ .40 $ .32 $ 1.18 Cumulative dividends declared per common share: $ .14 $ .13 $ .42 $ .38 See notes to consolidated financial statements 3
BANNER CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited) (in thousands) Quarters Ended Nine Months Ended September 30 September 30 2001 2000 2001 2000 -------- -------- -------- -------- NET INCOME: $ (144) $ 4,606 $ 3,784 $ 13,574 OTHER COMPREHENSIVE INCOME (LOSS), NET OF INCOME TAXES: Unrealized holding gain (loss) during the period, net of deferred income tax (benefit) of $945, $706 1,740 1,267 4,057 1,170 $2,227 and $639; respectively. Less adjustment for (gains)/ losses included in net income, net of income tax (benefit) of $-0-, $15, $284 and $126; respectively. -- (29) (234) (39) -------- -------- -------- -------- Other comprehensive income (loss) 1,740 1,238 3,823 1,131 -------- -------- -------- -------- COMPREHENSIVE INCOME $ 1,596 $ 5,844 $ 7,607 $ 14,705 ======== ======== ======== ======== See notes to consolidated financial statements 4
BANNER CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (Unaudited) (in thousands) For the Nine Months Ended September 30, 2001 and 2000 2001 2000 --------- --------- Common stock and Additional paid-in capital: Balance, beginning of period $ 133,839 $ 123,204 Adjustment of and/or issuance of stock in connection with acquisitions -- 53 Recognition of tax benefit due to vesting of MRP shares 259 2 Issuance of shares to MRP 52 62 Purchase of forfeited shares from MRP (3) (25) Net proceeds (cost) of treasury stock reissued for exercised stock options 1,380 139 Purchase and retirement of treasury stock (5,540) (2,780) --------- --------- Balance, end of period 129,987 120,655 Retained earnings: Balance, beginning of period 66,893 69,170 Net income 3,784 13,574 Cash dividends (4,953) (4,591) Adjustment of stock issued and related stock dividend in connection with acquisitions -- (7) --------- --------- Balance, end of period 65,724 78,146 ACCUMULATED OTHER COMPREHENSIVE INCOME: Balance, beginning of period (1,125) (5,331) Other comprehensive income (loss), net of related income taxes 3,823 1,131 --------- --------- Balance, end of period 2,698 (4,200) UNEARNED, RESTRICTED ESOP SHARES AT COST: Balance, beginning of period (5,234) (6,162) Release of earned ESOP shares -- -- --------- --------- Balance, end of period (5,234) (6,162) CARRYING VALUE OF SHARES HELD IN TRUST FOR STOCK-RELATED COMPENSATION PLANS: Balance, beginning of period (578) (1,708) Issuance of treasury stock for MRP grant (52) (62) Net change in number and/or valuation of shares held in trust 3 25 Amortization of compensation related to MRP 516 844 --------- --------- Balance, end of period (111) (901) --------- --------- TOTAL STOCKHOLDERS' EQUITY $ 193,064 $ 187,538 ========= ========= See notes to consolidated financial statements 5
BANNER CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (Unaudited) (continued) (in thousands) For the Nine Months Ended September 30, 2001 and 2000 2001 2000* --------- --------- COMMON STOCK , SHARES ISSUED: Number of shares, beginning of period 13,201 13,201 --------- --------- Number of shares, end of period 13,201 13,201 --------- --------- LESS Treasury stock PURCHASED AND RETIRED: Number of shares, beginning of period (1,196) (864) Purchase of shares forfeited from MRP -- (2) Reissuance of treasury stock to deferred compensation plan and/or exercised stock options 127 31 Shares reissued in connection with acquisitions 2 Purchase and retirement of treasury stock (293) (212) --------- --------- Number of shares retired/repurchased, end of period (1,362) (1,045) --------- --------- Shares issued and outstanding, end of period 11,839 12,156 ========= ========= UNEARNED, RESTRICTED ESOP SHARES: Number of shares, beginning of period (633) (746) Release of earned shares -- -- --------- --------- Number of shares, end of period (633) (746) ========= ========= *Adjusted for stock dividend, see note 2 See notes to consolidated financial statements 6
BANNER CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (in thousands) For the Nine Months Ended September 30, 2001 and 2000 2001 2000 --------- --------- OPERATING ACTIVITIES Net income $ 3,784 $ 13,574 Adjustments to reconcile net income to net cash provided by operating activities: Deferred taxes (714) 678 Depreciation 2,181 2,013 Loss (gain) on sale of securities (360) (59) Net amortization of premiums and discounts on investments 14 72 Increase in cash surrender value of bank owned life insurance (778) (188) Amortization of costs in excess of net assets acquired 2,385 2,377 Amortization of MRP compensation liability 516 844 Loss (gain) on sale of loans (3,318) (990) Net changes in deferred loan fees, premiums and discounts (418) 961 Loss (gain) on disposal of real estate held for sale 31 52 Loss (gain) on disposal of property and equipment 167 8 Amortization of mortgage servicing rights 365 186 Capitalization of mortgage servicing rights from sale of mortgages with servicing retained (92) (37) Provision for losses on loans and real estate held for sale 9,950 2,036 FHLB stock dividend (1,498) (1,247) Net change in: Loans held for sale (14,216) (758) Accrued interest receivable (1,869) (2,475) Other assets (4,323) (63) Deferred compensation 313 192 Accrued expenses and other liabilities 2,476 6,325 Income taxes payable (1,535) (616) --------- --------- Net cash provided (used) by operating activities (6,939) 22,885 --------- --------- INVESTING ACTIVITIES: Purchases of securities available for sale (100,985) (11,351) Principal repayments and maturities of securities available for sale 101,219 32,908 Proceeds from sales of securities available for sale 1,372 4,131 Purchases of securities held to maturity -- (4,662) Principal repayments and maturities of securities held to maturity 2,175 188 Net sales (purchases) of FHLB stock -- (2,257) Origination of loans, net of principal repayments (307,498) (220,467) Purchases of loans and participating interest in loans (2,736) (10,382) Proceeds from sales of loans and participating interest in loans 204,389 71,402 Purchases of property and equipment (2,544) (2,731) Proceeds from sale of property and equipment 23 10 Additional capitalized costs of real estate held for sale, net of insurance proceeds (257) (62) Proceeds from sale of real estate held for sale 3,302 1,301 Funds transferred to deferred compensation plan trusts (58) (101) Investment in bank owned life insurance (5,000) (6) --------- --------- Net cash used by investing activities (106,598) (142,079) --------- --------- (Continued on next page) 7 BANNER CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (in thousands) For the Nine Months Ended September 30, 2001 and 2000 (Continued from prior page) 2001 2000 --------- --------- FINANCING ACTIVITIES Increase (decrease) in deposits $ 105,999 $ 93,988 Proceeds from FHLB advances 180,965 724,479 Repayment of FHLB advances (174,280) (660,705) Proceeds from repurchase agreement borrowings 9,430 935 Repayments of repurchase agreement borrowings (11,893) (2,929) Increase (decrease) in other borrowings 1,192 (2,265) Cash dividends paid (4,979) (4,398) Net (cost) proceeds of exercised stock options 1,380 139 Repurchases of stock, net of forfeitures (5,540) (2,781) --------- --------- Net cash provided by financing activities 102,274 146,463 --------- --------- NET INCREASE (DECREASE) IN CASH AND DUE FROM BANKS (11,263) 27,269 CASH AND DUE FROM BANKS, BEGINNING OF PERIOD 67,356 44,769 --------- --------- CASH AND DUE FROM BANKS, END OF PERIOD $ 56,093 $ 72,038 ========= ========= SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Interest paid $ 67,063 $ 64,848 Taxes paid $ 7,678 $ 7,455 Non-cash transactions: Loans, net of discounts, specific loss allowances and unearned income, transferred to real estate owned $ 2,751 $ 1,439 Net change in accrued dividends payable $ 26 $ 195 Net change in unrealized gain (loss) in deferred compensation trust and related liability $ 39 $ 47 Treasury stock forfeited by MRP $ 3 $ 35 Treasury stock issued to MRP $ 52 $ 62 Tax benefit of vested MRP shares $ 259 $ 2 Fair value of stock issued and options assumed in connection with acquisitions $ -- $ 48 See notes to consolidated financial statements 8
BANNER CORPORATION AND SUBSIDIARIES SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1: BASIS OF PRESENTATION Banner Corporation (BANR or the Company) is a bank holding company incorporated in the State of Washington. The Company is primarily engaged in the business of planning, directing and coordinating the business activities of its wholly-owned subsidiary, Banner Bank (BB or the Bank). BB is a Washington-chartered commercial bank the deposits of which are insured by the Federal Deposit Insurance Corporation (FDIC) under both the Bank Insurance Fund (BIF) and the Savings Association Insurance Fund (SAIF). BB conducts business from its main office in Walla Walla, Washington, and its 38 branch offices and six loan production offices located in Washington, Oregon and Idaho. The Company is subject to regulation by the Federal Reserve Board (FRB). The Bank is subject to regulation by the State of Washington Department of Financial Institutions Division of Banks and the Federal Deposit Insurance Corporation (FDIC). In the opinion of management, the accompanying consolidated statements of financial condition and related interim consolidated statements of income, comprehensive income, changes in stockholders' equity and cash flows reflect all adjustments (which include reclassifications and normal recurring adjustments) that are necessary for a fair presentation in conformity with generally accepted accounting principles ("GAAP"). The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect amounts reported in the financial statements. Actual results could differ from these estimates and may have a material impact on the financial statements. Certain reclassifications have been made to the 2000 financial statements and/or schedules to conform to the 2001 presentation. These reclassifications may have affected certain ratios for the prior periods. The effect of such reclassifications is considered immaterial. All significant intercompany transactions and balances have been eliminated. The information included in this Form 10-Q should be read in conjunction with Banner Corporation's 2000 Annual Report on Form 10-K filed with the Securities and Exchange Commission. Interim results are not necessarily indicative of results for a full year. Note 2: RECENT DEVELOPMENTS AND SIGNIFICANT EVENTS Restatement of Financial Statements: As explained in Note 6, on September 17, 2001, Banner Corporation announced that it had become aware of irregularities associated with a former senior lending officer. The irregularities included a check kiting scheme of a single commercial loan customer of Banner Bank, as well as activities designed to conceal credit weaknesses of several loan customers. Upon further review, the Company determined that it would be necessary to file amended quarterly reports on Form 10-Q/A for each of the quarters ended March 31, 2001 and June 30, 2001, to recognize charges in those periods which appropriately reflect the timing of losses incurred as a result of the check kiting and credit manipulation activities. The Company also recorded charges in the quarter ended September 30, 2001, as a result of these irregularities. (See Note 6 for additional details.) Mergers and Acquisitions: The Company recently signed a definite agreement to acquire Oregon Business Bank of Lake Oswego, Oregon, in an all cash transaction valued at approximately $10.0 million. Opened in October 1999, Oregon Business Bank is an Oregon state-chartered commercial community bank with $41.5 million in assets, $32.5 million in gross loans, $35.8 million in deposits and shareholders equity of $4.7 million at August 31, 2001. The acquisition, which has been approved by the Board of Directors of each company, is subject to, among other contingencies, approval by regulators and Oregon Business Bank's shareholders. The transaction is expected to close in the first quarter of 2002. Name Change/Consolidation of Banking Operations: On October 30, 2000 First Washington Bancorp, Inc. (FWWB) changed its name to Banner Corporation in conjunction with a consolidation of banking operations affecting its banking subsidiaries. Towne Bank (TB) merged with First Savings Bank of Washington (FSBW), FSBW converted from a Washington state-chartered savings bank to a Washington state-chartered commercial bank and changed its name, along with the names of its divisions, Whatcom State Bank and Seaport Citizens Bank, to Banner Bank. At the same time, Inland Empire Bank (IEB) changed its name to Banner Bank of Oregon (BBO). 9
The combination was designed to strengthen the Company by more effectively sharing the resources of the existing subsidiaries, improving operating efficiency and developing a broader regional brand identity. The banks used one name, Banner Bank, and were united under the leadership of an experienced management team. The same ten individuals became members of the Board of Directors of the Company and each of the banks. Final integration of all data processing into a common system is scheduled for completion by December 31, 2001. In light of the Gramm-Leach-Bliley financial modernization legislation, the Company chose to retain a separate charter for Banner Bank of Oregon (formerly IEB) and to operate two banking subsidiaries. That legislation enacted Federal Home Loan Bank System reforms that affected community financial institutions. The intent was for Banner Bank of Oregon to qualify as a community financial institution allowing it to obtain long-term Federal Home Loan Bank advances to fund small business and small agribusiness loans and to offer those loans as collateral for such borrowings. A community financial institution is defined as a "member of the Federal Home Loan Bank (FHLB) System, the deposits of which are insured by the FDIC and that has average total assets (over the preceding three years) of less than $500 million." However, with release of the FHLB's implementing procedures, including rules expanding eligible collateral for members not qualifying as community financial institutions, the Company determined that the potential benefits of additional borrowing capacity were not as substantial as the efficiencies it may derive by operating under a single bank charter. Therefore, on June 29, 2001, the Company announced its plans to merge the two subsidiary banks. The merger of BB and BBO was completed on September 1, 2001, with the surviving entity operating as a Washington state-chartered commercial bank. Declaration of 10% Stock Dividend: On October 19, 2000 BANR's Board of Directors declared a 10% stock dividend payable November 10, 2000 to shareholders of record on October 31, 2000. All earnings per share and share data have been adjusted to reflect the 10% stock dividend. Mortgage Lending Subsidiary: On April 1, 2000 BB opened a new mortgage lending subsidiary, Community Financial Corporation (CFC), located in the Lake Oswego area of Portland, Oregon, with John Satterberg as President. Primary lending activities for CFC are in the area of construction and permanent financing for one- to four-family residential dwellings. CFC, an Oregon corporation, functions as a wholly-owned subsidiary of BB. BB has capitalized CFC with $2 million of equity capital and provides funding support for CFC's lending operations. Accounting Standards Recently Adopted: In June 1998 the Financial Accounting Standards Board (FASB) issued Statements of Financial Accounting Standards (SFAS) No. 133, Accounting for Derivative Instruments and Hedging Activities. In June 2000, the FASB issued SFAS No. 138, which amends certain provisions of SFAS No. 133 to clarify specific areas causing difficulties in implementation. The Company has not historically engaged in any hedging activities, and does not anticipate that it will enter into any transactions that will qualify for hedge accounting as defined by SFAS No. 133. The Company adopted SFAS No. 133 and the corresponding amendments under SFAS No. 138 effective on January 1, 2001. The adoption of SFAS No. 133, as amended by SFAS No. 138, did not have a material impact on the Company's consolidated results of operations, financial position or cash flows. In September 2000, the FASB issued SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, which revises the standards for accounting for securitizations and other transfers of financial assets and collateral and requires certain disclosures, but carries over most of the provisions of SFAS No. 125 without reconsideration. SFAS No. 140 is effective for transfers and servicing of financial assets and extinguishments of liabilities occurring after March 31, 2001. The provisions of this statement did not have a material effect on the Company's financial position or results of operations. Recent Accounting Standards Not Yet Adopted: In July 2001, the FASB issued SFAS No. 141, Business Combinations, which applies to all business combinations initiated after June 30, 2001. This statement requires that all business combinations be accounted for using the purchase method of accounting; the use of the pooling-of-interests method is no longer permitted. The purchase method of accounting requires goodwill to be measured as the excess of the cost of an acquired entity over the estimated fair value of net amounts assigned to assets acquired and liabilities assumed. This statement also addressees the disclosures required in the financial statements pertaining to business combinations. The adoption of this statement is not expected to have a material impact on the Company's financial condition or results of operations. In July 2001, the FASB issued SFAS No. 142, Goodwill and Other Intangible Assets, which applies to all acquired intangible assets whether acquired singly, as part of a group, or in a business combination. This statement requires that goodwill not be amortized; however, goodwill for each reporting unit must be evaluated for impairment on at least an annual basis using a two-step 10
approach. The first step used to identify potential impairment compares the estimated fair value of a reporting unit to its carrying amount, including goodwill. If the fair value of a reporting unit is less than its carrying amount, the second step of the impairment evaluation which compares the implied fair value of goodwill to its carrying amount must be performed to determine the amount of the impairment loss, if any. This statement also provides standards for financial statement disclosures of goodwill and other intangible assets and related impairment losses. The Company will be required to adopt this statement on January 1, 2002. The adoption of this statement is expected to have a material impact on the Company's results of operation. Goodwill will no longer be amortized, which will reduce other operating expenses by an estimated $793,000 per quarter, or $3.2 million a year, with a corresponding increase in net income. Note 3: BUSINESS SEGMENTS The Company has been managed by legal entity or bank, not by lines of business. Each bank has been managed by its management team that was responsible for its own lending, deposit operations, information systems and administration. Marketing support, sales training assistance, and human resource services were provided from a central source at BB, and costs were allocated to the individual banks using appropriate methods based on usage. In addition, corporate overhead and centralized administrative costs were allocated to each bank. In prior periods, business segment reporting included results for each subsidiary bank; however, over the past year all of the subsidiary banks have been merged into a single legal entity, BB, with a consolidated management team. For comparative purposes prior period segment information has been regrouped to match current business segments/grouping after merger of the bank subsidiaries. All of the executive officers of BANR are members of the BB management team. BB is a community oriented commercial bank chartered in the State of Washington. As explained above under Consolidation of Banking Operations in Note 2, BB includes the operations of the former First Savings Bank of Washington and its divisions, Whatcom State Bank and Seaport Citizens Bank, the former Towne Bank and BBO (formerly IEB). BB offers a wide variety of deposit products to its consumer and commercial customers. Lending activities include the origination of real estate, commercial/agriculture business and consumer loans. BB's primary business is that of a traditional banking institution, gathering deposits and originating loans for portfolio in its primary market area. BB is also an active participant in the secondary market, originating residential loans for sale on both a servicing released and servicing retained basis. In addition to interest income on loans and investment securities, BB receives other income from deposit servicing charges, loan servicing fees and from the sale of loans and investments. BB also has a mortgage lending subsidiary, CFC, located in the Lake Oswego area of Portland, Oregon, that was established in fiscal 2000. CFC's primary lending activities are in the area of construction and permanent financing for one- to four-family residential dwellings. BBO (formerly IEB) was a community oriented commercial bank chartered in the State of Oregon which historically offered a wide variety of deposit and loan products to its consumer and commercial customers. Lending activities included origination of consumer, commercial, agribusiness and real estate loans. BBO also engaged in mortgage banking activity with respect to residential lending within its local markets and originating loans for sale generally on a servicing released basis. BBO operated a division, Inland Financial Services, which offered insurance and brokerage services to its customers. BBO was merged into BB on September 1, 2001. The performance of the Bank is reviewed by the Company's executive management team and the Board of Directors on a monthly basis. 11
Note 3: BUSINESS SEGMENTS (continued) Financial highlights by legal entity were as follows: Quarter Ended September 30, 2001 --------------------------------------- (dollars in thousands) Condensed Income Statement BBO (now merged BB into BB) Other* Total ------ ------ ------ ------ Net interest income $ 18,259 $ -- $ 55 $ 18,314 Provision for loan losses 5,959 -- -- 5,959 Other operating income 3,345 -- (31) 3,314 Other operating expenses 14,959 -- (642) 15,601 ------ ------ ------ ------ Income (loss) before income taxes 686 -- (618) 68 Income taxes (benefit) 363 -- (151) 212 ------ ------ ------ ------ Net income (loss) $ 323 $ -- $(467) $ (144) ====== ====== ====== ====== Quarter Ended September 30, 2000 (1) --------------------------------------------- (dollars in thousands) Condensed Income Statement BBO TB (Now merged (Now merged BB into BB) into BB) Other* Total ------ ------ ------ ------ ------ Net interest income $ 17,222 $ -- $ -- $ 11 $ 17,233 Provision for loan losses 651 -- -- - 651 Other operating income 2,243 -- -- (18) 2,225 Other operating expenses 11,191 -- -- 495 11,686 ------ ----- ------ ------ ------ Income (loss) before income taxes 7,623 -- -- (502) 7,121 Income taxes (benefit) 2,691 - -- (176) 2,515 ------ ------ ------ ------ ------ Net income (loss) $ 4,932 $ -- $ -- $(326) $ 4,606 ====== ====== ====== ====== ====== * Includes intercompany eliminations and holding company amounts. (1) For comparative purposes prior period segment information has been regrouped to match current business segments/grouping after merger of subsidiaries. 12
Note 3: BUSINESS SEGMENTS, CONTINUED: Nine Months Ended September 30, 2001 --------------------------------------- (dollars in thousands) Condensed Income Statement BBO (now merged BB into BB) Other* Total ------ ------ ------ ------ Net interest income (loss) $ 52,925 $ -- $ 54 $ 52,979 Provision for loan losses 9,859 -- - 9,859 Other operating income 9,814 - -- 9,814 Other operating expenses 45,046 -- 1,467 46,513 ------ ------ ------ ------ Income (loss) before income taxes 7,834 -- (1,413) 6,421 Income taxes (benefit) 3,130 -- (493) 2,637 ------ ------ ------ ------ Net income (loss) $ 4,704 $ -- $(920) $ 3,784 ====== ====== ====== ====== Nine Months Ended September 30, 2000(1) --------------------------------------------- (dollars in thousands) Condensed Income Statement BBO TB (Now merged (Now merged BB into BB) into BB) Other* Total ------ ------ ------ ------ ------ Net interest income (loss) $ 51,171 $ -- $ -- $ 38 $ 51,209 Provision for loan losses 2,015 -- - -- 2,015 Other operating income 5,730 -- -- (52) 5,678 Other operating expenses 32,320 -- - 1,461 33,781 ------ ------ ------ ------ ------ Income (loss) before income taxes 22,566 -- - (1,475) 21,091 Income taxes (benefit) 8,028 -- -- (511) 7,517 ------ ------ ------ ------ ------ Net income (loss) $ 14,538 $ -- $ - $(964) $ 13,574 ====== ====== ====== ====== ====== Condensed Income Statement BBO TB (Now merged (Now merged BB into BB) into BB) Other* Total ---------- ------- ------ ------ ------ September 30, 2000 ---------------------------------------------------- Total Assets $2,093,970 $ -- $ 863 $2,094,833 ========== ======= ====== ========== September 30, 2000 (1) ---------------------------------------------------- Total Assets $ 1,986,929 $ -- $ -- $ 865 $1,987,794 ========== ======= ======= ====== ========== *Includes intercompany eliminations and holding company amounts. (1) For comparative purposes prior period segment information has been regrouped to match current business segments/grouping after merger of subsidiaries. 13
Note 4: ADDITIONAL INFORMATION REGARDING INTEREST-BEARING DEPOSITS AND SECURITIES The following table sets forth additional detail on BANR's interest-bearing deposits and securities at the dates indicated (at carrying value) (in thousands): September 30 December 31 2001 2000 --------- --------- Interest-bearing deposits included in cash and due from banks $ 2,400 $ 15,661 Mortgage-backed securities 221,181 194,073 Other securities-taxable 77,034 100,261 Other securities-tax exempt 27,239 28,212 Other stocks with dividends 3,550 3,969 --------- --------- Total securities 329,004 326,515 Federal Home Loan Bank (FHLB) stock 30,305 28,807 --------- --------- $ 361,709 $ 370,983 ========= ========= The following table provides additional detail on income from deposits and securities for the periods indicated (in thousands): Quarters Ended Nine Months Ended September 30 September 30 ------------------ ------------------ 2001 2000 2001 2000 -------- -------- -------- -------- Mortgage-backed securities $ 2,940 $ 3,826 $ 9,217 $ 11,732 -------- -------- -------- -------- Taxable interest and dividends 1,515 2,134 4,836 6,043 Tax-exempt interest 410 458 1,237 1,411 Federal Home Loan Bank stock-dividends 525 445 1,498 1,269 -------- -------- -------- -------- 2,450 3,037 7,571 8,723 -------- -------- -------- -------- $ 5,390 $ 6,863 $ 16,788 $ 20,455 ======== ======== ======== ======== Note 5: CALCULATION OF WEIGHTED AVERAGE SHARES OUTSTANDING FOR EARNINGS PER SHARE (EPS) (IN THOUSANDS) Quarters Ended Nine Months Ended September 30 September 30 ------------------ ----------------- 2001 2000 2001 2000 ------- ------- ------- ------- Total shares originally issued 13,201 13,201 13,201 13,201 Less retired shares and treasury stock plus unvested shares allocated to MRP (1,393) (1,142) (1,363) (1,127) Less unallocated shares held by the ESOP (633) (746) (633) (746) ------- ------- ------- ------- Basic weighted average shares outstanding 11,175 11,313 11,205 11,328 Plus unvested MRP and stock option incremental shares considered outstanding for diluted EPS calculations 488 147 451 181 ------- ------- ------- ------- Diluted weighted average shares outstanding 11,663 11,460 11,656 11,509 ======= ======= ======= ======= 14
Note 6: RESTATEMENT OF FINANCIAL STATEMENTS On September 17, 2001, the Company announced that it had become aware of irregularities associated with a former senior lending officer. The irregularities included a check kiting scheme of a single commercial loan customer of BB, as well as activities designed to conceal credit weaknesses of several loan customers. Upon further review, the Company determined that it would be necessary to file amended quarterly reports on Form 10-Q/A for each of the quarters ended March 31, 2001 and June 30, 2001, to recognize charges in those periods which appropriately reflect the timing of losses incurred as a result of the check kiting and credit manipulation activities. For the restated quarter ended March 31, 2001, the Company has recorded an expense of $3.6 million ($2.3 million after tax) as a result of the check kiting scheme. During the restated quarter ended June 30, 2001, the Company recorded $2.6 million ($1.7 after tax) of expense related to the check kiting scheme and an additional $2.0 million ($1.3 million after tax) was added to the provision for loan losses. The Company recorded an additional expense of $1.9 million in the quarter ended September 30, 2001, with respect to the check kiting scheme and also recognized $4.2 million of additional provision for loan losses associated with the credit manipulation. The changes in the financial statements resulted in restated net income of $1.6 million for the quarter ended June 30, 2001, compared to $4.6 million as previously reported. For the six months ended June 30, 2001, restated net income was $3.9 million compared to $9.2 million as previously reported. ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS Management's Discussion and Analysis (MD&A) and other portions of this report contain certain "forward-looking statements" concerning the future operations of Banner Corporation. Management desires to take advantage of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995 and is including this statement for the express purpose of availing the Company of the protections of such safe harbor with respect to all "forward-looking statements" contained in this report and our Annual Report. We have used "forward-looking statements" to describe future plans and strategies, including our expectations of the Company's future financial results. Management's ability to predict results or the effect of future plans or strategies is inherently uncertain. Factors which could 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 Company's ability to successfully complete consolidation and conversion activities, successfully resolve outstanding credit issues and/or recover check kiting losses, 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 Banner Corporation (the Company or BANR), a Washington corporation, is primarily engaged in the business of planning, directing and coordinating the business activities of its wholly owned subsidiary, Banner Bank (BB). Prior to the consolidation and name change, which occurred on October 30, 2000, the Company's subsidiaries included First Savings Bank of Washington (FSBW), Inland Empire Bank (IEB) and Towne Bank (TB) (together, the Banks). As of September 30, 2001, BB is a Washington-chartered commercial bank the deposits of which are insured by the FDIC under both the BIF and the SAIF. BB conducts business from its main office in Walla Walla, Washington, and its 38 branch offices and six loan production offices located in Washington, Idaho and Oregon. Prior to merging with FSBW on October 30, 2000, TB was a Washington-chartered commercial bank and its deposits were insured by the FDIC under BIF. As of October 30, 2000, TB conducted business from seven full service branches in the Seattle, Washington, metropolitan area. An eighth Seattle area office opened in November 2000. Prior to merging with BB on September 1, 2001, Banner Bank of Oregon (BBO) was an Oregon-chartered commercial bank whose deposits were insured by the FDIC under BIF. BBO conducted business from its main office in Hermiston, Oregon, and its six branch offices and one loan production office located in northeast Oregon. The Company completed its merger of BBO with and into BB as of September 1, 2001. The operating results of BANR 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 BANR'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, BANR's net interest income increased for the quarter ended September 30, 2001 compared to the same period a year earlier, reflecting a 12 basis point increase in the interest rate spread and growth in interest bearing assets and liabilities. The net interest margin also increased, expanding four basis points for the quarter ended September 30, 2001, when compared to the same period one year prior, reflecting the improved interest rate spread which was somewhat offset by the increased use of interest-bearing liabilities relative to interest-earning assets. While the Company's interest rate spread declined four basis points for the nine months ended September 30, 2001, net interest income for the first nine 15
months increased from the year earlier period as a result of the significant asset and liability growth that occurred at BANR. Net interest margin declined by seven basis points for the nine months ended September 30, 2001, compared to the same period a year earlier. BANR's net income also is affected by provisions for loan losses and the level of its other income, including deposit service charges, loan origination and servicing fees, and gains and losses on the sale of loans and securities, as well as its non- interest operating expenses and income tax provisions. The provision for loan losses increased sharply for both the quarter and nine months ended September 30, 2001, compared to the same periods ended September 30, 2000. As explained more fully below and in Notes 2 and 6 of the Selected Notes to the Consolidated Financial Statements, much of this increase reflects impaired loans associated with a former senior commercial loan officer that had been manipulated to conceal credit weaknesses. Other operating income increased significantly for both the quarter and nine months ended September 30, 2001, largely as a result of increased gain on the sale of loans, although other non-interest revenues also increased. Other operating expenses also increased significantly for the quarter and nine months ended September 30, 2001, compared to the same periods ended September 30, 2000. As explained below and in Notes 2 and 6 of the Selected Notes to the Consolidated Financial Statements, non-interest expenses for the quarter and nine months ended September 30, 2001, included check kiting losses of $1.9 million and $8.1 million, respectively. Other operating expenses (excluding the check kiting losses) also increased compared to the year earlier amounts, reflecting the continued growth of the Company and costs associated with conversion of the company's core data processing system. 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 Notes to the Consolidated Financial Statements. 16
RECENT DEVELOPMENTS AND SIGNIFICANT EVENTS See Notes 2 and 6 to Consolidated Financial Statements COMPARISON OF FINANCIAL CONDITION AT SEPTEMBER 30, 2001 AND DECEMBER 31, 2000 Total assets increased $112.0 million, or 5.6%, from $1.983 billion at December 31, 2000, to $2.095 billion at September 30, 2001. The growth of $112.0 million occurred substantially at BB and was funded primarily with deposit growth. This growth reflects the economic conditions in the markets where BANR operates. Net loans receivable (gross loans less loans in process, deferred fees and discounts, and allowance for loan losses) grew $111.0 million, or 7.6%, from $1.472 billion at December 31, 2000, to $1.583 billion at September 30, 2001. This loan growth included an increase of $14.2 million in loans held for sale which increased to $22.2 million at September 30, 2001, reflecting increased mortgage banking activity in the current low interest rate environment. Loans held for sale are generally sold in the secondary market within sixty days following the loan closing date. The increase in net loans included growth of $30.5 million of mortgages secured by commercial real estate, $69.6 million of construction and land loans, and $28.6 million of non-mortgage commercial and agricultural loans. Partially offsetting these increases were declines of $8.0 million of one to four-family and $3.0 million of multi-family real estate loans and a decline of $3.2 million in non-mortgage consumer loans. These balances reflect the Company's continuing effort to increase the portion of its assets invested in loans and more specifically the portion of loans invested in commercial real estate, construction and land development, and non-mortgage loans. While these loans are of inherently higher risk than residential mortgages, management believes they can produce higher credit-adjusted returns to the Company and provide better opportunities to develop comprehensive banking relationships with the borrowers than most residential mortgages. The majority of the increase in loans was funded by a net increase of $106.0 million in deposits. Increased borrowings and net income from operations also helped to fund asset growth. Deposits grew $106.0 million, or 8.9%, from $1.193 billion at December 31, 2000, to $1.299 billion at September 30, 2001. FHLB advances increased $6.7 million from $507.1 million at December 31, 2000, to $513.8 million at September 30, 2001. Other borrowings, primarily reverse repurchase agreements with securities dealers, decreased $1.1 million, from $74.5 million at December 31, 2000, to $73.4 million at September 30, 2001. Securities available for sale and held to maturity increased $2.5 million, or 0.8%, from $326.5 million at December 31, 2000, to $329.0 million at September 30, 2001. FHLB stock increased $1.5 million as a result of the regular quarterly stock dividends paid by the FHLB. The Company's investment in bank owned life insurance increased by $5.8 million reflecting $800,000 of accumulated earnings from increased cash surrender value and an initial premium of $5.0 million for the purchase of additional insurance. COMPARISON OF RESULTS OF OPERATIONS FOR THE QUARTERS AND NINE MONTHS ENDED SEPTEMBER 30, 2001 AND 2000 GENERAL. For the quarter ended September 30, 2001, the Company had a net loss of $144,000, or $.01 per share (diluted), compared to net income of $4.6 million, or $.40 per share (diluted), for the quarter ended September 30, 2000, a decrease of $4.8 million. Net income for the first nine months of the current year was $3.8 million, a decrease of $9.8 million from the nine months ended September 30, 2000. The decreases in net income resulted from the expenses associated with the check kiting scheme and additional loan loss provision described in Notes 2 and 6. Excluding those charges and the related tax effect, net income for the quarter and nine months ended September 30, 2001, would have decreased $135,000 and increased $340,000, respectively, compared to the same periods a year earlier. BANR's operating results (excluding the check kiting and credit manipulation charges) reflect significant growth of assets and liabilities which was offset by a higher level of loan loss provision and other operating expenses. As explained below, provision for loan losses increased for reasons other than the credit manipulation activities and other operating expense included certain unusual data processing conversion and related technology expenses. Net interest margin increased four basis points for the quarter yet decreased by seven basis points for the nine-month period reflecting changes in the level of market rates and the increased use of interest-bearing liabilities relative to interest-earning assets. The Company's operating results also reflect a significant increase in other operating revenues, particularly gain on sale of loans, and other operating expenses including costs associated with the conversion of its data processing systems and expenses incurred as a result of increased mortgage lending. Compared to levels a year ago, total assets increased 5.4%, to $2.095 billion, at September 30, 2001, net loans rose 8.1%, to $1.583 billion, deposits grew 10.8%, to $1.299 billion, and borrowings decreased 3.4%, to $587.2 million. Average equity was 9.49% of average assets for the quarter ended September 30, 2001, compared to 9.43% of average assets for the quarter ended September 30, 2000. The modest changes in net interest spread and net interest margin are notable in light of the significant volatility and changes in the level of market interest rates over the past twelve months. 17
INTEREST INCOME. Interest income for the quarter ended September 30, 2001, was $39.9 million compared to $40.9 million for the quarter ended September 30, 2000, a decrease of $1.0 million, or 2.6%. The decrease in interest income occurred despite an $88.8 million, or 4.8%, growth in average balances of interest-earning assets as a result of a 64 basis point decrease in the average yield on those assets. The yield on average interest-earning assets decreased to 8.08% for the quarter ended September 30, 2001, compared to 8.72% for the same period a year earlier. Average loans receivable for the quarter ended September 30, 2001, increased by $144.3 million, or 9.9%, when compared to the quarter ended September 30, 2000, reflecting the Banks' significant internal growth. Interest income on loans increased by $408,000, or 1.2%, compared to the prior year, as the impact of the increase in average loan balances was substantially offset by a 76 basis point decrease in the average yield. The decrease in average loan yield reflects the significant decline in the level of market interest rates, particularly the prime rate, compared to prior year levels, which offset continued changes in the mix of the loan portfolio. The loan mix continued to change as the portion of the portfolio invested in lower yielding one- to four-family residential loans declined, while the portion invested in higher yielding construction, land development and commercial loans increased. Loans yielded 8.51% for the quarter ended September 30, 2001, compared to 9.27% for the quarter ended September 30, 2000. While the level of market interest rates continued a steep decline during the quarter, loan yields were supported to a degree by certain loans with rate floors and by changes in the portfolio mix. The average balance of mortgage-backed securities, investment securities, daily interest-bearing deposits and FHLB stock decreased by $55.5 million for the quarter ended September 30, 2001, and the interest and dividend income from those investments decreased $1.5 million, compared to the quarter ended September 30, 2000. The average yield on mortgage-backed securities decreased from 6.80% for the quarter ended September 30, 2000, to 5.86% for the comparable period in 2001. Yields on mortgage-backed securities were lower in the 2001 period reflecting the affect of lower market rates on the interest rates paid on the significant portion of those securities that have adjustable rates and more rapid prepayments on certain higher-yielding portions of the portfolio. The average yield on investment securities and short term cash investments decreased from 6.67% for the quarter ended September 30, 2000, to 6.30% for the comparable quarter in 2001, also reflecting the lower level of market rates. Earnings on FHLB stock increased by $81,000, resulting from an increase of $2.6 million in the average balance of FHLB stock for the quarter ended September 30, 2001, and a higher dividend yield. The dividend yield on FHLB stock was 6.99% for the quarter ended September 30, 2001, compared to 6.49% for the quarter ended September 30, 2000. Dividends on FHLB stock are established on a quarterly basis by vote of the Directors of the FHLB. Interest income for the nine months ended September 30, 2001, increased $3.5 million, or 3.0%, from the comparable period in 2000. Interest income from loans increased $7.2 million, or 7.5%, from the comparable period in 2000. The increase in loan interest income reflected the effect of a $155.6 million growth in average loans receivable balances and occurred despite a 29 basis point decrease in the yield on the loan balances. Interest income from mortgage-backed and investment securities and FHLB stock for the nine months ended September 30, 2001, decreased $1.1 million, from $8.7 million in 2000, to $7.6 million in the current period, reflecting a $22.2 million decrease in average balances along with a four basis point decrease in yield. The yield on average earning assets decreased from 8.62% for the nine months ended September 30, 2000, to 8.42% for the nine months ended September 30, 2001, as a result of declines in the level of market interest rates, which more than offset changes in the relative amount of loans and investments. INTEREST EXPENSE. Interest expense for the quarter ended September 30, 2001, was $21.5 million compared to $23.7 million for the comparable period in 2000, a decrease of $2.2 million, or 9.1%. The decrease in interest expense was due to a decrease in the average cost of all interest-bearing liabilities from 5.33% to 4.57%. The $127.3 million increase in average interest-bearing deposits for the quarter ended September 30, 2001, compared to September 30, 2000, reflects the solid deposit growth throughout the Company over the past twelve months. Deposit interest expense decreased $644,000 for the quarter ended September 30, 2001, compared to the same quarter a year ago. Average deposit balances increased from $1.161 billion for the quarter ended September 30, 2000, to $1.288 billion for the quarter ended September 30, 2001, while, at the same time, the average rate paid on deposit balances decreased 68 basis points. To a significant degree, deposit costs for a quarter reflect market interest rates and pricing decisions made three to twelve months prior to the end of that quarter. Generally, market interest rates for deposits were declining and lower for the nine months preceding the quarter ended September 30, 2001, than for the same period preceding the September 30, 2000, quarter. The reduction in deposit costs, which tends to lag declines in market rates, accelerated during the most recent quarter as a result of the cumulative effect of declining rates in the two preceding quarters as well as sharply lower rates in the current quarter. Average FHLB advances totaled $509.3 million during the quarter ended September 30, 2001, compared to $530.9 million during the quarter ended September 30, 2000, a decrease of $21.6 million that, combined with a 49 basis point decrease in the average cost of advances, resulted in a $949,000 decrease in related interest expense. The average rate paid on those advances decreased to 5.81% for the quarter ended September 30, 2001, from 6.30% for the quarter ended September 30, 2000. 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 decreased $3.1 million from $76.4 million for 18
the quarter ended September 30, 2000, to $73.3 million for the same period in 2001, while the related interest expense decreased $553,000 from $1.3 million to $739,000 for the respective periods. The average rate paid on other borrowings was 4.00% in the quarter ended September 30, 2001 compared to 6.73% for the same quarter in 2000. Similar to deposits, the cost of FHLB advances reflects to a degree a lagged effect from prior period market interest rate levels, while the Company's other borrowings generally have relatively short terms and therefore reprice to current market levels more quickly. Total interest expense for the nine months ended September 30, 2001, increased $1.7 million, or 2.7%, from the comparable period in September 2000. The increase in interest expense reflects an increase in average deposits of $105.1 million combined with a $566,000 decrease in FHLB advances and other borrowings. The effect on interest expense of the $104.5 million increase in average interest-bearing liabilities was offset by a 16 basis point decrease in the interest rate paid on those liabilities. 19
The following tables provide additional comparative data on the Company's operating performance: Quarters Ended Nine Months Ended AVERAGE BALANCES September 30 September 30 ---------------- ---------------------- ---------------------- (in thousands) 2001 2000 2001 2000 ---------- ---------- ---------- ---------- Investment securities and deposits $ 121,191 $ 154,646 $ 124,521 $ 149,979 Mortgage-backed obligations 199,083 223,699 196,743 230,159 Loans 1,606,375 1,462,106 1,558,183 1,402,539 FHLB stock 29,796 27,231 29,298 26,063 ---------- ---------- ---------- ---------- Total average interest- earning asset 1,956,445 1,867,682 1,908,745 1,808,740 Non-interest-earning assets 127,244 96,998 119,582 95,665 ---------- ---------- ---------- ---------- Total average assets $2,083,689 $1,964,680 $2,028,327 $1,904,405 ========== ========== ========== ========== Deposits 1,288,163 1,160,889 $1,235,583 1,130,528 Advances from FHLB 509,331 530,906 507,577 504,415 Other borrowings 73,328 76,365 72,372 76,100 ---------- ---------- ---------- ---------- Total average interest- bearing liabilities 1,870,822 1,768,160 1,815,532 1,711,043 Non-interest-bearing liabilities 15,079 11,184 15,153 10,970 ---------- ---------- ---------- ---------- Total average liabilities 1,885,901 1,779,344 1,830,685 1,722,013 Equity 197,788 185,336 197,642 182,392 ---------- ---------- ---------- ---------- Total average liabilities and equity $2,083,689 $1,964,680 $2,028,327 $1,904,405 ========== ========== ========== ========== INTEREST RATE YIELD/EXPENSE (RATES ARE ANNUALIZED) -------------------------------------------------- Interest Rate Yield: Investment securities and deposits 6.30% 6.67% 6.52% 6.64% Mortgage-backed obligations 5.86% 6.80% 6.26% 6.81% Loans 8.51% 9.27% 8.87% 9.16% FHLB stock 6.99% 6.49% 6.84% 6.50% ---------- --------- --------- --------- Total interest rate yield on interest-earning assets 8.08% 8.72% 8.42% 8.62% ---------- --------- --------- --------- Interest Rate Expense: Deposits 4.11% 4.79% 4.50% 4.57% Advances from FHLB 5.81% 6.30% 6.05% 6.13% Other borrowings 4.00% 6.73% 4.94% 6.38% ---------- --------- --------- --------- Total interest rate expense on interest-bearing liabilities 4.57% 5.33% 4.95% 5.11% ---------- --------- --------- --------- Interest spread 3.51% 3.39% 3.47% 3.51% ========== ========= ========= ========= Net interest margin on interest earning assets 3.71% 3.67% 3.71% 3.78% ---------- --------- --------- --------- ADDITIONAL KEY FINANCIAL RATIOS (RATIOS ARE ANNUALIZED) ------------------------------------------------------- Return on average assets (0.03%) 0.93% 0.25% 0.95% Return on average equity (0.29%) 9.89% 2.56% 9.94% Average equity / average assets 9.49% 9.43% 9.74% 9.58% Average interest-earning assets / interest-bearing liabilities 104.58% 105.63% 105.13% 105.71% Non-interest [other operating] expenses / average assets Excluding amortization of costs in excess of net assets acquired (goodwill) 2.86% 2.25% 2.96% 2.25% Including amortization of costs in excess of net assets acquired (goodwill) 2.97% 2.37% 3.07% 2.37% Efficiency ratio [non-interest (other operating) expenses / revenues] Excluding amortization of costs in excess of net assets acquired (goodwill) 68.46% 55.98% 70.28% 55.20% Including amortization of costs in excess of net assets acquired (goodwill) 72.13% 60.06% 74.07% 59.38% 20
PROVISION FOR LOAN LOSSES. During the quarter ended September 30, 2001, the provision for loan losses was $6.0 million, compared to $651,000 for the quarter ended September 30, 2000, an increase of $5.3 million. A comparison of the provision for loan losses for the nine-month periods ended September 30, 2001, and 2000, shows an increase of $7.9 million from $2.0 million to $9.9 million. The increase in the provision for losses reflects the amount required to maintain the allowance for losses at an appropriate level based upon management's evaluation of the adequacy of general and specific loss reserves as more fully explained in the following paragraphs. The higher provisions in the current periods reflect changes in the portfolio mix, higher levels of non-performing loans and net charge offs, and concerns about the current economic environment. The provision for loan losses for the quarter and nine months ended September 30, 2001, includes $4.2 million and $6.2 million, respectively, of charges associated with credit manipulation activities of a former senior commercial loan officer which were designed to conceal weaknesses of several loan customers. Non-performing loans increased to $13.4 million at September 30, 2001, compared to $11.9 million at September 30, 2000. Non-performing loans at September 30, 2001, include $6.3 million of non-accrual loans associated with the credit manipulation activities. Net charge offs were $4.1 million for the current quarter compared to $118,000 for the same quarter a year earlier. Net charge offs for the nine months ended September 30, 2001, were $6.6 million compared to $532,000 for the nine months ended September 30, 2000. Net charge offs for the quarter and nine months ended September 30, 2001, included $3.4 million and $4.9 million associated with the credit manipulation activities. A comparison of the allowance for loan losses at September 30, 2001, and 2000, shows an increase of $3.6 million from $15.0 million at September 30, 2000, to $18.6 million at September 30, 2001. The allowance for loan losses as a percentage of net loans (loans receivable excluding allowance for losses) was 1.16% and 1.02% at September 30, 2001, and September 30, 2000, respectively. The allowance for loan losses equaled 138% of non-performing loans at September 30, 2001, compared to 127% of non-performing loans at September 30, 2000. 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, actual loan loss experience, current and anticipated economic conditions, detailed analysis of individual loans for which full collectibility may not be assured, and determination of the existence and realizable value of the collateral and guarantees securing the loans. Additions to the allowance are charged to earnings. Losses that are related to specific assets are usually applied as a reduction of the carrying value of the assets and charged immediately against the allowance for loan loss reserve. Recoveries on previously charged off loans are credited to the allowance. The reserve is based upon factors and trends identified by management at the time financial statements are prepared. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the 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 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 are included within the provision for loan losses in the same manner in which impairment initially was recognized or as a reduction in the provision that would otherwise be reported. 21
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. 22
The following tables are provided to disclose additional detail on the Banks' loans and allowance for loan losses (in thousands): September 30 December 31 2001 2000 ----------- ----------- Loans (including loans held for sale): Secured by real estate One- to four-family $ 410,018 $ 408,613 Commercial 396,539 366,071 Multifamily 81,286 84,282 Construction and land 340,907 271,273 Commercial business 254,716 228,676 Agricultural business 70,444 67,809 Consumer 47,742 60,359 ----------- ----------- Total Loans $ 1,601,652 $ 1,487,083 Less allowance for loan losses 18,593 15,314 ----------- ----------- Total net loans at end of period $ 1,583,059 $ 1,471,769 =========== =========== Allowance for loan losses as a percentage of net loans outstanding 1.16% 1.03% Quarters Ended Nine Months Ended September 30 September 30 ---------------------- ---------------------- 2001 2000 2001 2000 ---------- ---------- ---------- ---------- Balance, beginning of the period $ 16,775 $ 14,491 $ 15,314 $ 13,541 Provision 5,959 651 9,859 2,015 Recoveries of loans previously charged off: Secured by real estate One- to four-family -- -- 1 2 Commercial -- 1 -- 1 Multifamily -- -- -- -- Construction and land -- -- -- -- Commercial business 45 5 72 31 Agricultural business -- -- -- -- Consumer 16 26 21 127 --------- ---------- ---------- ---------- 61 32 94 161 Loans charged off: Secured by real estate One- to four-family -- (4) (97) (65) Commercial -- (16) -- (16) Multifamily -- -- -- -- Construction and land -- -- (14) (12) Commercial business (3,984) (75) (6,026) (248) Agricultural business -- -- (100) -- Consumer (218) (55) (437) (352) --------- ---------- ---------- ---------- (4,202) (150) (6,674) (693) --------- ---------- ---------- ---------- Net charge offs (4,141) (118) (6,580) (532) --------- ---------- ---------- ---------- Balance, end of period $ 18,593 $ 15,024 $ 18,593 $ 15,024 ========= ========== ========== ========== Net charge offs as a percentage of average net book value of loans outstanding for the period 0.26% 0.01% 0.42% 0.04% --------- ---------- ---------- ---------- 23
The following is a schedule of the Company's allocation of the allowance for loan losses: September 30 December 31 2001 2000 ---------- ---------- Specific or allocated loss allowances: Secured by real estate: One- to four-family $ 2,292 $ 2,256 Commercial 4,119 4,556 Multifamily 615 731 Construction and land 3,755 2,738 Commercial business 4,957 2,859 Agricultural business 979 851 Consumer 777 879 ---------- ---------- Total allocated 17,494 14,870 Unallocated 1,099 444 ---------- ---------- Total allowance for loan losses $ 18,593 $ 15,314 ========== ========== Ratio of allowance for loan losses to non-performing loans 138% 183% Allowance for loan losses as a percent of net loans (loans receivable excluding allowance for losses) 1.16% 1.03% Other Operating Income. Other operating income was $3.3 million for the quarter ended September 30, 2001, an increase of $1.1 million from the quarter ended September 30, 2000. This included a $769,000 increase in the gain on sale of loans for the current quarter. Loan sales for the quarter ended September 30, 2001 totaled $70.0 million, including $12.9 million of loans sold by CFC, compared to $32.7 million for the quarter ended September 30, 2000. Gain on sale of loans for BANR included $119,000 of fees on $11.7 million of loans brokered by CFC, which are not reflected in the volume of loans sold. Other fee and service charge income for BANR decreased by $69,000 to $1.2 million for the quarter ended September 30, 2001, compared to $1.3 million for the quarter ended September 30, 2000. Miscellaneous income increased by $389,000 in large part reflecting the Company's increased investment in bank owned life insurance and the resulting increase in cash surrender value. Other operating income for the nine months ended September 30, 2001, increased $4.1 million from the comparable period in 2000. This includes a $2.4 million increase in the gain on sale of loans, $483,000 increase in other fee and service charge income, $301,000 increase in gain on sale of securities and an $810,000 increase in miscellaneous income. Loan sales increased from $71.4 million for the nine months ended September 30, 2000, to $204.4 million for the nine months ended September 30, 2001. Miscellaneous income includes an increase of $800,000 of cash surrender value for bank owned life insurance. Other Operating Expenses. Other operating expenses increased $3.9 million from $11.7 million for the quarter ended September 30, 2000, to $15.6 million for the quarter ended September 30, 2001. As noted above, other operating expense for the quarter ended September 30, 2001, includes a charge of $1.9 million associated with a check kiting scheme that had been concealed by a former senior lending officer of BB. Excluding the check kiting charge, other operating expense increased $2.0 million compared to the same quarter a year earlier. Increases in other operating expenses, excluding the check kiting charge, reflect the overall growth in assets and liabilities, customer relationships and complexity of operations as BANR continues to expand. The increase in expenses reflects the inclusion of two new bank branches opened subsequent to September 30, 2000. The increase also reflects expenses associated with the expanding operations at BB's lending subsidiary, CFC. The increase in other operating expenses was partially offset by a $272,000 increase in capitalized loan origination costs reflecting a greater level of loan origination activity. Additionally, during the quarter ended September 30, 2001, the Company incurred approximately $800,000 of expenses associated with the conversion of the Company's core data processing system and an additional $200,000 for other technology enhancements. The Company expects to incur about $300,000 of conversion related expenses during the fourth quarter. The higher operating expenses associated with BANR's transition to more of a commercial bank profile, coupled with the recognition of the check kiting loss, caused BANR's efficiency ratio, excluding the amortization of goodwill, to increase to 68.46% (72.13% including goodwill), for the quarter ended September 30, 2001, from 55.98% (60.06% including goodwill) for the comparable period ended September 30, 2000. Other operating expenses as a percentage of average assets increased to 2.97% (2.86% excluding the amortization of goodwill) for the quarter ended September 30, 2001, compared to 2.37% (2.25% excluding the amortization of goodwill) for the 24
quarter ended September 30, 2000. BANR's efficiency ratio adjusted to exclude amortization of goodwill, the check kiting loss and the unusual conversion and technology expenses, would have been 55.05% for the quarter and, excluding the same items, adjusted operating expenses as a percentage of average assets would have been 2.27%. Other operating expenses for the nine months ended September 30, 2001, increased $12.7 million from $33.8 million for the first nine months of 2000 to $46.5 million in the current period. As explained earlier, the increase is largely due to the previously noted check kiting loss ($8.1 million) and conversion and technology expenses ($1.3 million) as well as growth in BANR's operations for the current nine month period. Income Taxes. Income tax expense was $212,000 for the quarter ended September 30, 2001, compared to $2.5 million for the comparable period in 2000. The Company's effective tax rates for the quarters ended September 30, 2001 and 2000 were 312% and 35%, respectively. The higher effective tax rate in the current quarter is primarily a result of a larger relative effect of the non-deductible goodwill amortization expense compared to the quarter one year earlier. Income tax expense for the nine months ended September 30, 2001 decreased to $2.6 million, compared to $7.5 million in the comparable period in 2000. The Company's effective tax rates for the nine months ended September 30, 2001 and 2000 were 41% and 36%, respectively. Similar to the quarterly results the higher effective tax rate in the current period is primarily a result of a larger relative effect of the non-deductible goodwill amortization expense compared to the same period a year earlier. 25
Asset Quality The following tables are provided to disclose additional details on asset quality (in thousands): September 30 December 31 2001 2000 ---------- ---------- Non-performing assets at end of the period: Nonaccrual Loans: Secured by real estate One- to four-family $ 1,021 $ 873 Multifamily real estate 750 1,741 Commercial real estate 52 -- Construction and land 2,370 2,937 Commercial business 7,977 1,734 Agricultural business 188 529 Consumer 314 18 ---------- ---------- 12,672 7,832 Loans more than 90 days delinquent, still on accrual: Secured by real estate One- to four-family 75 20 Multifamily real estate -- -- Commercial real estate 372 -- Construction and land -- -- Commercial business 49 1 Agricultural business 127 467 Consumer 151 54 ---------- ---------- 774 542 ---------- ---------- Total non-performing loans 13,446 8,374 Real estate owned, held for sale, net (REO), and other repossessed assets 2,871 3,287 ---------- ---------- Total non-performing assets at the end of the period $ 16,317 $ 11,661 ========== ========== Non-performing loans as a percentage of total net loans before allowance for loan losses at end of the period 0.84% 0.56% Ratio of allowance for loan losses to non-performing loans at end of the period 138% 183% Non-performing assets as a percentage of total assets at end of the period. 0.78% 0.59% Troubled debt restructuring [TDRs] at end of the period $ 302 $ 337 ========== ========== Troubled debt restructuring as a percentage of: Total gross principal of loans outstanding at end of the period 0.02% 0.02% Total assets at end of the period 0.01% 0.02% 26
Market Risk and Asset/Liability Management The financial condition and operation of the Company are influenced significantly by general economic conditions, including the absolute level of interest rates as well as changes in interest rates and the slope of the yield curve. The Company's profitability is dependent to a large extent on its net interest income, which is the difference between the interest received from its interest-earning assets and the interest expense incurred on its interest-bearing liabilities. The activities of the Company, like all financial institutions, inherently involve the assumption of interest rate risk. Interest rate risk is the risk that changes in market interest rates will have an adverse impact on the institution's earnings and underlying economic value. Interest rate risk is determined by the maturity and repricing characteristics of an institution's assets, liabilities, and off-balance-sheet contracts. Interest rate risk is measured by the variability of financial performance and economic value resulting from changes in interest rates. Interest rate risk is the primary market risk affecting the Company's financial performance. The greatest source of interest rate risk to the Company results from the mismatch of maturities or repricing intervals for rate sensitive assets, liabilities and off-balance-sheet contracts. This mismatch or gap is generally characterized by a substantially shorter maturity structure for interest-bearing liabilities than interest-earning assets. 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. 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. 27
Sensitivity Analysis The table of Interest Rate Risk Indicators sets forth, as of September 30, 2001, the estimated changes in the Company's net interest income over a one year time horizon and the estimated changes in market value of equity based on the indicated interest rate environments. Table of Interest Rate Risk Indicators Estimated Change in ------------------------------------------------ Change (In Basis Points) Net Interest Income in Interest Rates (1) Next 12 Months Net Market Value - ------------------------ ------------------- ---------------------- (Dollars in thousands) +400 $ 2,628 3.4% $ (59,536) (30.1%) +300 2,777 3.6% (32,781) (16.6%) +200 2,050 2.7% (13,625) (6.9%) +100 719 0.9% (1,783) (0.9%) 0 0 0 0 0 -100 (848) (1.1%) (7,177) (3.6%) -200 (2,766) (3.6%) (22,992) (11.6%) -300 (7,909) (10.3%) (27,657) (14.0%) -400 $ N/A N/A $ N/A N/A - ---------- (1) Assumes an instantaneous and sustained uniform change in market interest rates at all maturities. Another although less reliable monitoring tool for assessing interest rate risk is "gap analysis." The matching of the repricing characteristics of assets and liabilities may be analyzed by examining the extent to which such assets and liabilities are "interest sensitive" and by monitoring an institution's interest sensitivity "gap." An asset or liability is said to be interest sensitive within a specific time period if it will mature or reprice within that time period. The interest rate sensitivity gap is defined as the difference between the amount of interest-earning assets anticipated, based upon certain assumptions, to mature or reprice within a specific time period and the amount of interest-bearing liabilities anticipated to mature or reprice, based upon certain assumptions, within that same time period. A gap is considered positive when the amount of interest sensitive assets exceeds the amount of interest sensitive liabilities. A gap is considered negative when the amount of interest sensitive liabilities exceeds the amount of interest sensitive assets. Generally, during a period of rising rates, a negative gap would tend to adversely affect net interest income while a positive gap would tend to result in an increase in net interest income. During a period of falling interest rates, a negative gap would tend to result in an increase in net interest income while a positive gap would tend to adversely affect net interest income. Certain shortcomings are inherent in gap analysis. For example, although certain assets and liabilities may have similar maturities or periods of repricing, they may react in different degrees to changes in market rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market rates, while interest rates on other types may lag behind changes in market rates. Additionally, certain assets, such as 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. The table of Interest Sensitivity Gap presents the Company's interest sensitivity gap between interest-earning assets and interest-bearing liabilities at September 30, 2001. The table sets forth the amounts of interest-earning assets and interest-bearing liabilities which are anticipated by the Company, based upon certain assumptions, to reprice or mature in each of the future periods shown. At September 30, 2001, total interest-bearing liabilities maturing or repricing within one year exceeded total interest-earning assets maturing or repricing in the same time period by $3.9 million, representing a one-year gap to total assets ratio of 0.18%. 28
<TABLE> 6 Months As of September 30, 2001 Within to 1-3 3-5 5-10 Over 10 6 Months One Year Years Years Years Years Total -------- --------- -------- -------- -------- ------- ---------- (dollars in thousands) <s> <c> <c> <c> <c> <c> <c> <c> Interest-earning assets(1): Construction loans $263,561 $ 5,771 $ 2,857 $ 1,308 $ -- $ -- $ 273,497 Fixed-rate mortgage loans 78,633 66,108 183,191 117,374 126,894 38,743 610,943 Adjustable-rate mortgage loans 186,910 57,556 72,700 4,824 -- -- 321,990 Fixed-rate mortgage-backed securities 11,322 12,381 53,382 24,514 21,119 13,815 136,533 Adjustable-rate mortgage-backed securities 80,620 4,875 -- -- -- -- 85,495 Fixed-rate commercial / agriculture loans 28,921 10,102 32,457 25,552 5,639 1,611 104,282 Adjustable-rate commercial/ agriculture loans 233,290 -- -- -- -- -- 233,290 Consumer and other loans 23,322 7,416 18,064 9,970 1,966 2,325 63,063 Investment securities and interest-bearing deposits 24,846 6,820 25,305 16,110 7,200 56,467 136,748 -------- --------- -------- -------- -------- -------- ---------- Total rate-sensitive assets 931,425 171,029 387,956 199,652 162,818 112,961 1,965,841 -------- --------- -------- -------- -------- -------- ---------- Interest-bearing liabilities(2): Regular savings and NOW accounts 18,197 18,197 42,459 42,459 -- - 121,312 Money market deposit accounts 78,799 47,279 31,520 -- -- -- 157,598 Certificates of deposit 448,591 233,280 131,861 26,854 6,288 124 846,998 FHLB advances 106,900 76,370 106,984 97,600 125,079 849 513,782 Other borrowings 60,927 -- -- -- -- -- 60,927 Retail repurchase agreements 9,422 626 2,395 -- -- -- 12,443 -------- --------- -------- -------- -------- -------- ---------- Total rate-sensitive liabilities 722,836 375,752 315,219 166,913 131,367 973 1,713,060 -------- --------- -------- -------- -------- -------- ---------- Excess (deficiency) of interest-sensitive assets over interest-sensitive liabilities $208,589 $(204,723) $ 72,737 $ 32,739 $ 31,451 $111,988 $ 252,781 ======== ========= ======== ======== ======== ======== ========== Cumulative excess (deficiency) of interest-sensitive assets $208,589 $ 3,866 $ 76,603 $109,342 $140,793 $252,781 $ 252,781 ======== ========= ======== ======== ======== ======== ========== Cumulative ratio of interest-earning assets to interest-bearing liabilities 128.86% 100.35% 105.42% 106.92% 108.22% 114.76% 114.76% ======== ========= ======== ======== ======== ======== ========== Interest sensitivity gap to total assets 9.96% (9.77%) 3.47% 1.56% 1.50% 5.35% 12.07% ======== ========= ======== ======== ======== ======== ========== Ratio of cumulative gap to total assets 9.96% 0.18% 3.66% 5.22% 6.72% 12.07% 12.07% ======== ========= ======== ======== ======== ======== ========== (footnotes on following page) 29 </TABLE>
Footnotes for Table of Interest Sensitivity Gap - ----------------------------------------------- (1) Adjustable-rate assets are included in the period in which interest rates are next scheduled to adjust rather than in the period in which they are due to mature, and fixed-rate assets are included in the periods in which they are scheduled to be repaid based upon scheduled amortization, in each case adjusted to take into account estimated prepayments. Mortgage loans and other loans are not reduced for allowances for loan losses and non-performing loans. Mortgage loans, mortgage-backed securities, other loans, and investment securities are not adjusted for deferred fees and unamortized acquisition premiums and discounts. (2) Adjustable- and variable-rate liabilities are included in the period in which interest rates are next scheduled to adjust rather than in the period they are due to mature. Although the Banks' regular savings, NOW, and money market deposit accounts are subject to immediate withdrawal, management considers a substantial amount of such accounts to be core deposits having significantly longer maturities. For the purpose of the gap analysis, these accounts have been assigned decay rates to reflect their longer effective maturities. If all of these accounts had been assumed to be short-term, the one year cumulative gap of interest-sensitive assets would have been negative $112.6 million or (5.37%) of total assets. Interest-bearing liabilities for this table exclude certain non-interest bearing deposits which are included in the average balance calculations in the table included in the comparison of Results of Operations section of this document. 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 nine months ended September 30, 2001, the Company purchased loans in the amount of $2.7 million while loan originations, net of repayments, totaled $307.5 million. This activity was funded primarily by principal repayments on securities, sales of loans, and deposit growth. During the nine months ended September 30, 2001, the Company sold $204.4 million of loans. Net deposit growth was $106.0 million for the nine months ended September 30, 2001. FHLB advances increased $6.7 million for the nine months ended September 30, 2001. Other borrowings decreased $1.2 million for the nine months ended September 30, 2001. The Bank must maintain an adequate level of liquidity to ensure the availability of sufficient funds to accommodate deposit withdrawals, to support loan growth, to satisfy financial commitments and to take advantage of investment opportunities. During the nine months ended September 30, 2001, the Banks used their sources of funds primarily to fund loan commitments, to purchase securities, to repay FHLB advances and other borrowings, and to pay maturing savings certificates and deposit withdrawals. At September 30, 2001, BB had outstanding loan commitments totaling $243.3 million. BB generally maintains sufficient cash and readily marketable securities to meet short-term liquidity needs. BB maintains a credit facility with the FHLB-Seattle, which provides for advances which, in aggregate, may equal the lesser of 45% of BB's assets or unencumbered qualifying collateral, which as of September 30, 2001 could give a maximum total credit line of $942 million. Advances under this credit facility totaled $513.8 million, or 25% of BB's assets at September 30, 2001. At September 30, 2001, savings certificates amounted to $847.0 million, or 65%, of the Bank's total deposits, including $681.9 million which were scheduled to mature within one year. Historically, the Bank has been able to retain a significant amount of its deposits as they mature. Management believes it has adequate resources to fund all loan commitments from savings deposits, FHLB-Seattle advances, other borrowings and sale of mortgage loans and that it can adjust the offering rates for savings certificates to retain deposits in changing interest rate environments. 30
Capital Requirements Federally-insured state-chartered banks are required to maintain minimum levels of regulatory capital. Under current FDIC regulations, insured state-chartered banks generally must maintain (i) a ratio of Tier 1 leverage capital to total assets of at least 3.0% (4.0% to 5.0% for all but the most highly rated banks), (ii) a ratio of Tier 1 capital to risk-weighted assets of at least 4.0% and (iii) a ratio of total capital to risk-weighted assets of at least 8.0%. At September 30, 2001, BANR's banking subsidiaries exceeded all current regulatory capital requirements to be classified as well capitalized institutions, the highest regulatory standard. In order to be categorized as a well capitalized institution, the FDIC requires banks it regulates to maintain a leverage ratio, defined as Tier 1 capital divided by total regulatory assets, of at least 5.00%; Tier 1 (or core) capital of at least 6.00% of risk-weighted assets; and total capital of at least 10.00% of risk-weighted assets. BANR, as a bank holding company, is regulated by the Federal Reserve Board (FRB). The FRB has established capital requirements for bank holding companies that generally parallel the capital requirements of the FDIC for banks with $150 million or more in total consolidated assets. BANR's total regulatory capital must equal 8% of risk-weighted assets and one half of the 8% (4%) must consist of Tier 1 (core) capital. The actual regulatory capital ratios calculated for BANR along with the minimum capital amounts and ratios for capital adequacy purposes were as follows (dollars in thousands): Minimum for capital Actual adequacy purposes ----------------- ------------------- Amount Ratio Amount Ratio ------ ----- ------ ----- September 30, 2001: BANR consolidated Total capital to risk- weighted assets $177,574 11.60% $122,481 8.00% Tier 1 capital to risk- weighted assets 157,989 10.32 61,240 4.00 Tier 1 leverage capital average assets 157,989 7.74 81,625 4.00 31
PART II - OTHER INFORMATION Item 1. Legal Proceedings From time to time BANR or its subsidiaries are engaged in legal proceedings in the ordinary course of business, none of which is considered to have a material impact on the BANR's financial position or results of operations. Item 2. Changes in Securities Not Applicable Item 3. Defaults Upon Senior Securities Not Applicable Item 4. Submission of Matters to a Vote of Stockholders Not Applicable Item 5. Other Information Not Applicable Item 6. Exhibits and Reports on Form 8K Report (s) on Form 8-K filed during the quarter ended September 30, 2001, are as follows: Date Filed Purpose ---------- ------- September 7, 2001 Announcement of consummation of merger of the company's wholly owned subsidiary banks, Banner Bank and Banner Bank of Oregon. September 18, 2001 Announcement of irregularities associated with a former senior lending officer. The irregularities include a check kiting scheme and will result in the recognition of a loss and recording of additional loan loss provision. September 26, 2001 Announcement of entering into an agreement and plan of merger between wholly-owned subsidiary, Banner Bank, and Oregon Business Bank. 32
SIGNATURES - ---------- Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Banner Corporation November 14, 2001 /s/ Gary Sirmon ------------------------------------- Gary Sirmon President and Chief Executive Officer November 14, 2001 /s/ Lloyd W. Baker ------------------------------------- Lloyd W. Baker Treasurer and Executive Vice President 33