UNITED STATES SECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
/X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Commission File Number 0-20288
COLUMBIA BANKING SYSTEM, INC.
(253) 305-1900
Indicate by check mark whether the issuer: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes [X] No [ ]
The number of shares of the issuer’s Common Stock outstanding atJuly 31, 2002 was 13,266,135
TABLE OF CONTENTS
CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS
See accompanying notes to consolidated condensed financial statements.
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CONSOLIDATED CONDENSED BALANCE SHEETS
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CONSOLIDATED CONDENSED STATEMENTS OF SHAREHOLDERS’ EQUITY
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CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
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NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
Columbia Banking System, Inc. (the “Company” or “CBSI”) is a registered bank holding company whose wholly owned subsidiary, Columbia State Bank (“Columbia Bank”), conducts a full-service commercial banking business. Headquartered in Tacoma, Washington, the Company provides a full range of banking services to small and medium-sized businesses, professionals and other individuals through 35 banking offices located in the Tacoma metropolitan area and contiguous parts of the Puget Sound region of Washington, as well as the Longview and Woodland communities in southwestern Washington. Substantially all of the Company’s loans, loan commitments and core deposits are geographically concentrated in its service areas.
1. Basis of Presentation
The interim unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for condensed interim financial information and with instructions to Form 10-Q and Article 10 of Regulation S-X. In the opinion of management, all adjustments consisting only of normal recurring accruals necessary for a fair presentation of the financial condition and the results of operations for the interim periods included herein have been made. The results of operations for the three and six months ended June 30, 2002 are not necessarily indicative of results to be anticipated for the year ending December 31, 2002. For additional information, refer to the consolidated financial statements and footnotes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2001.
2. Earnings Per Share
Earnings per share (“EPS”) is computed using the weighted average number of common and diluted common shares outstanding during the period. Basic EPS is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. The only reconciling item affecting the calculation of earnings per share is the inclusion of stock options and restricted stock awards increasing the shares outstanding in diluted earnings per share of 154,000 and 229,000 for the three months ended June 30, 2002 and 2001, respectively, and 152,000 and 236,000 for the six months ended June 30, 2002 and 2001, respectively.
3. Stock Dividend
On April 2, 2002, the Company announced a 5% stock dividend payable on April 30, 2002, to shareholders of record as of April 16, 2002. Average shares outstanding and net income per share for all periods presented have been retroactively adjusted to give effect to this transaction.
4. New Accounting Pronouncements
In July 2001, the Financial Accounting Standards Board issued Statement of Financial Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets.” Under SFAS No. 142, goodwill is no longer subject to amortization over its estimated useful life. The Statement also establishes a new method of testing goodwill for impairment. The Company implemented SFAS No. 142 on January 1, 2002, and the adoption of this Statement did not have a material impact on the Company’s financial condition or results of operations.
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In August 2001, the Financial Accounting Standards Board issued SFAS No. 143, “Accounting for Asset Retirement Obligations”, which takes effect for fiscal years beginning after June 15, 2002. SFAS No. 143 establishes the initial and subsequent accounting for legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and/or normal operation of a long-lived asset. The Company will adopt SFAS No. 143 as of January 1, 2003. The adoption of SFAS No. 143 is not expected to materially impact the Company’s consolidated results of operations, financial position, or cash flows.
In October 2001, the Financial Accounting Standards Board issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”, which supercedes SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of.” SFAS No. 144 retains the fundamental provisions of SFAS No. 121 but sets forth new criteria for asset classification and broadens the scope of qualifying discontinued operations. The new standard is effective for fiscal years beginning after December 15, 2001. The Company adopted SFAS No. 144 as of January 1, 2002 and the impact to its consolidated results of operations and financial condition was not material.
5. Business Segment Information
The Company is managed along three major lines of business: commercial banking, retail banking, and real estate lending. The treasury function of the Company, although not considered a line of business, is responsible for the management of investments and interest rate risk.
The principal activities conducted by commercial banking are the delivery of commercial business and private banking services with the emphasis on commercial business loans. Retail banking includes all deposit products, with their related fee income, and all consumer loan products as well as certain commercial loan products offered in the Bank’s branch offices. Real estate lending includes single-family residential, multi-family residential, commercial real estate loans, and the associated loan servicing activities.
The financial results of each segment were derived from the Company’s general ledger system. Since the Company is not specifically organized around lines of business, most reportable segments are comprised of more than one operating segment. Expenses incurred directly by marketing and back office support functions are not allocated to the major lines of business.
Since SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” requires no segmentation or methodology standardization, the organizational structure of the Company and its business line financial results are not necessarily comparable across companies. As such, the Company’s business line performance may not be directly comparable with similar information from other financial institutions. Financial highlights by lines of business:
Condensed Statements of Operations:
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6. Stock Repurchase
In March 2002 the Board of Directors approved a stock repurchase program whereby the Company may systematically repurchase up to 500,000 of its outstanding shares of Common Stock, representing approximately 4% of the 12.6 million common shares outstanding at the time of the repurchase program announcement. The Company intends to repurchase shares from time to time in the open market or in private transactions, under conditions which allow such repurchases to be accretive to earnings while maintaining capital ratios that exceed the guidelines for a well-capitalized financial institution. As of June 30, 2002 the Company had not repurchased any shares of common stock in this current stock repurchase program.
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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This discussion should be read in conjunction with the unaudited consolidated condensed financial statements of Columbia Banking System, Inc. (the “Company”) and notes thereto presented elsewhere in this report. In the following discussion, unless otherwise noted, references to increases or decreases in average balances in items of income and expense for a particular period and balances at a particular date refer to the comparison with corresponding amounts for the period or date one year earlier.
This Form 10-Q includes forward looking statements, which management believes are a benefit to shareholders. These forward looking statements describe Columbia’s management’s expectations regarding future events and developments such as future operating results, growth in loans and deposits, continued success of Columbia’s style of banking and the strength of the local economy. The words “will,” “believe,” “expect,” “should,” and “anticipate” and words of similar construction are intended in part to help identify forward looking statements. Future events are difficult to predict, and the expectations described above are necessarily subject to risk and uncertainty that may cause actual results to differ materially and adversely. In addition to discussions about risks and uncertainties set forth from time to time in Columbia’s filings with the SEC, factors that may cause actual results to differ materially from those contemplated by such forward looking statements include, among others, the following possibilities: (1) local and national general and economic conditions, including the impact of the events of September 11, 2001, or any similar events, are less favorable than expected or have a more direct and pronounced effect on Columbia than expected and adversely affect Columbia’s ability to continue its internal growth at historical rates and maintain the quality of its earning assets; (2) changes in interest rates reduce interest margins more than expected and negatively affect funding sources; (3) projected business increases following strategic expansion or opening or acquiring new branches are lower than expected; (4) costs or difficulties related to the integration of acquisitions are greater than expected; (5) competitive pressure among financial institutions increases significantly; (6) legislation or regulatory requirements or changes adversely affect the businesses in which Columbia is engaged, and (7) the Company’s ability to realize the efficiencies it expects to receive from its investments in personnel and infrastructure.
Overview
Columbia Banking System, Inc. (the “Company”) is a registered bank holding company whose wholly owned subsidiary, Columbia State Bank (“Columbia Bank”), conducts a full-service commercial banking business. Headquartered in Tacoma, Washington, the Company provides a full range of banking services to small and medium-sized businesses, professionals and other individuals through 35 banking offices located in the Tacoma metropolitan area and contiguous parts of the Puget Sound region of Washington, as well as the Longview and Woodland communities in southwestern Washington. Substantially all of the Company’s loans, loan commitments and core deposits are geographically concentrated in its service areas. Columbia Bank is a Washington state-chartered commercial bank, the deposits of which are insured by the Federal Deposit Insurance Corporation (the “FDIC”). Columbia Bank is subject to regulation by the FDIC and the Washington State Department of Financial Institutions (“Division of Banks”). Although Columbia Bank is not a member of the Federal Reserve System, the Board of Governors of the Federal Reserve System has certain supervisory authority over the Company, which can also affect Columbia Bank.
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The Company’s goal is to become the leading community bank headquartered in the Pacific Northwest while establishing a significant presence in selected northwest markets and to achieve superior financial performance at the earliest practical date, consistent with development of its northwest franchise. Strategic business combinations may augment internal growth. The Company intends to build on its reputation for excellent customer service in order to be recognized in all markets it serves as the bank of choice for retail deposit customers, small to medium-sized businesses and affluent households.
Management believes the consolidation among financial institutions in the northwest part of the U.S. has created significant gaps in the ability of large banks operating in the states comprising that area to serve certain customers, particularly the Company’s target customer base of small and medium-sized businesses, professionals and other individuals. The Company’s business strategy is to provide its customers with the financial sophistication and breadth of products of a regional banking company while retaining the appeal and service level of a community bank. Management believes that as a result of the Company’s strong commitment to highly personalized relationship-oriented customer service, its varied products, its strategic branch locations and the long-standing community presence of its managers, lending officers and branch personnel, it is well positioned to attract new customers and to increase its market share of loans, deposits, and other financial services in the markets it now serves and in areas contiguous to those markets. The Company has closely followed the significant changes to federal banking laws, which allow financial institutions to engage in a broader range of activities than previously permitted. That legislation also authorized the creation of financial holding companies to facilitate such expanded activity. As the Company pursues its growth strategy, it is possible that the Company will utilize the financial holding company structure to accommodate an expansion of its products and services.
The Company intends to effect its long-term growth strategy through a combination of growth at existing branch offices, new branch openings (usually following the hiring of an experienced branch manager and/or lending officer with strong community ties and banking relationships), Columbia On Call™ telephone banking, Columbia OnLine™ internet banking, development of complementary lines of business, and acquisitions. In particular, the Company anticipates continued growth in its market areas of Pierce, King, Thurston, Cowlitz and Kitsap Counties through its existing branch network.
The Company has 35 branches: 20 in Pierce County, 10 in King County, three in Cowlitz County, one in Kitsap County, and one in Thurston County. Since beginning its major Pierce County expansion in August 1993, the Company has expanded from four branches primarily through internal growth. During the second quarter of 2002, an expansion of the Summit branch in Puyallup was opened. In light of the soft economy in the Pacific Northwest, the Company has recently moderated its branch growth with only one additional branch opening planned for 2002. Management intends to balance future branch expansion with improved financial results. New branches normally do not contribute to net income for many months after opening.
In addition to its branch network, the Company continuously reviews new products and services to give its customers more financial service options. New technology and services are reviewed for business development and cost saving purposes. The Company’s online banking service, “Columbia On-Line ™” enables customers to conduct a full range of services on a real time basis, including balance inquiries, transfers, bill paying, loan information, and check image viewing. This online service has also enhanced the delivery of cash management services to commercial customers.
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In order to fund its lending activities and to allow for increased contact with customers, the Company has established a branch system catering primarily to retail depositors, supplemented by business customer deposits and other borrowings. The Company believes this mix of funding sources will enable it to expand lending activities while attracting a stable core deposit base. In order to support its strategy of growth, without compromising its personalized banking approach or its commitment to asset quality, the Company has made significant investments in experienced branch, lending and administrative personnel and has incurred significant costs related to its branch expansion. Management anticipates that the Company’s expense ratios will decline, but will remain relatively high by industry standards for the foreseeable future due to the Company’s emphasis on convenience and personal service, and on its new branch additions in 2001 and 2002.
The economy of the Company’s principal market areas, while primarily dependent upon aerospace, foreign trade and natural resources, including agriculture and timber, has become more diversified over the past decade as a result of the success of software companies such as Microsoft and the establishment of numerous research and biotechnology firms. Additionally, four military bases are located in the market areas. The Washington economy and that of the Puget Sound region generally have experienced strong growth and stability through 2000; however, growth slowed noticeably during 2001, and continued to be slow in the first half of 2002. Washington state economists believe the mixed economic indicators for the Puget Sound region signal the end of the economic decline; however, the region’s growth and recovery is expected to continue to be slow throughout the remainder of 2002 and into 2003. The commercial airline and aerospace industries have contracted in the Puget Sound region and were significantly impacted by September 11, 2001 terrorism experienced on the East Coast. After September 11, Boeing Company press releases estimated a 25% to 27% decline of its 2002 commercial airplane deliveries from deliveries forecasted in the first half of 2001. Consequently, Boeing announced employment layoffs approximating 30,000 by mid-2002, with 28,300 layoffs occurring nationwide through June 21, 2002. Approximately 67% of the layoffs to date have affected Western Washington employees. Boeing’s second quarter 2002 earnings release noted that its employment reductions are continuing on schedule. The full impact and timing of these job reductions on the Puget Sound economy are not yet known; however, economic activity in many areas served by Columbia Bank is expected to remain relatively weak into 2003.
RECENT EVENTS
In early July, 2002, the Company’s Vice Chairman and Chief Executive Officer resigned, although he will continue to serve as a consultant to the Company. The Chairman of the Board of Directors has assumed the Chief Executive Officer duties in an interim role. See Item 6 on page 22 of this Form 10-Q for more detailed information. The Company is currently working to complete a severance package for Mr. Gallagher. Effective July 30, 2002, Don Hirtzel, Executive Vice President, left the Company and Hal Russell, Executive Vice President, has assumed Mr. Hirtzel’s loan production responsibilities on an interim basis.
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RESULTS OF OPERATIONS
The results of operations of the Company are dependent to a large degree on the Company’s net interest income. The Company also generates noninterest income through service charges and fees, merchant services fees, and income from mortgage banking operations. The Company’s operating expenses consist primarily of compensation and employee benefits costs, and occupancy expense. Similar to most financial institutions, the Company’s interest income and cost of funds are affected significantly by general economic conditions, particularly changes in market interest rates, and by government policies and actions of regulatory authorities.
Critical Accounting Policies
Various elements of the Company’s accounting policies, by their nature, are inherently subject to estimation techniques, valuation assumptions and other subjective assessments. In particular, management has identified several accounting policies that, due to the judgments, estimates and assumptions inherent in those policies, are critical to an understanding of the Company’s financial statements. These policies relate to the methodology for the determination of the allowance for loan losses and the valuation of real estate owned. These policies and the judgments, estimates and assumptions are described in greater detail in subsequent sections of Management’s Discussion and Analysis and in the consolidated financial statements and footnotes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2001. Management believes that the judgments, estimates and assumptions used in the preparation of the financial statements are appropriate given the factual circumstances at the time. However, given the sensitivity of the financial statements to these critical accounting policies, the use of other judgments, estimates and assumptions could result in material differences in the results of operations or financial condition.
Net Income
Net income for the second quarter of 2002 was $3.2 million, or $0.24 per diluted share, compared to $2.7 million, or $0.20 per diluted share, for the second quarter of 2001, an increase in net income of 15%. Net income for the six months ended June 30, 2002, was $2.7 million, or $0.20 per diluted share, a decrease of 54% compared to $5.9 million, or $0.42 per diluted share for the same period in 2001. The net income increase for the second quarter is due to a higher net interest margin and increased noninterest income. The net income decrease for the six-month period is due primarily to a large loan loss provision leading to a loss in the first quarter 2002.
Total Revenue
During the second quarter of 2002, total revenue (net interest income plus noninterest income), increased $2.3 million, or 13% to $20.5 million from $18.2 million in the second quarter of 2001. Total revenue for the first six months of 2002 increased $4.3 million, or 12%, to $40.2 million from $35.8 million for the first six months of 2001. These increases are due to a higher net interest margin and increased noninterest income during the second quarter and first six months of 2002 as compared to the same periods a year ago.
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Net Interest Income
Net interest income for the second quarter of 2002 increased 11% to $15.9 million, from $14.4 million in the second quarter of 2001. For the six months ended June 30, 2002, net interest income increased 10% to $31.5 million from $28.6 million for the same period in 2001. Stable interest rates and the Company’s management of its deposit costs in the first six months of 2002 provided improved net interest income as compared to the first six months of 2001. During the first six months of 2001 interest rates decreased dramatically as the “prime rate” declined 275 basis points. As a result, the Company’s loan yields, approximately 40% of which adjust immediately with a change in the prime rate, decreased rapidly. The Company’s cost of funding was also higher a year ago. Since reductions in deposit and other funding costs lag reductions in interest-earning asset yields, when interest rates declined during the first six months of 2001, the yield on interest-earning assets declined faster than the cost of interest-bearing liabilities.
Net interest margin (net interest income divided by average interest-earning assets) increased to 4.54% in the second quarter of 2002 from 4.31% in the second quarter of 2001. Average interest-earning assets grew to $1.43 billion, or 6%, during the second quarter of 2002, compared with $1.35 billion for the same period in 2001. The yield on average interest-earning assets decreased 159 basis points (a basis point is 1/100th of 1 percent) to 6.51% during the second quarter of 2002 compared with 8.10% during the same period of 2001. In comparison, average interest-bearing liabilities grew to $1.2 billion, or 9%, compared with $1.1 billion for the same period in 2001, and the average cost of interest-bearing liabilities decreased 229 basis points to 2.35% during the second quarter of 2002 from 4.64% in the same period of 2001.
For the first six months of 2002, net interest margin increased to 4.54% from 4.27% for the same period in 2001. Average interest-earning assets grew 5% to $1.42 billion during the first six months of 2002, compared with $1.36 billion for the same period in 2001. The yield on average interest-earning assets decreased 168 basis points to 6.61% during the first six months of 2002 from 8.29% in the same period of 2001. In comparison, average interest-bearing liabilities grew 6% to $1.19 billion, compared with $1.12 billion for the same period in 2001, and the cost of average interest-bearing liabilities decreased to 2.48% during the first six months of 2002 from 4.89% in the same period of 2001.
Management expects the net interest margin to remain stable or slightly increase during the third quarter 2002 as the Company expects interest rates to remain stable in the upcoming quarter. Average interest-earning assets increased $13.8 million, or 1%, in the second quarter 2002 to $1.43 billion compared with the first quarter of 2002. An increase of $38 million in investments was partially offset by a decrease of $16.9 million in average loans. The yield on average interest-earning assets decreased 20 basis points to 6.51% during the second quarter from 6.71% in the first quarter of 2002. During the second quarter 2002, average interest bearing liabilities increased $22.7 million, or 2%, to $1.2 billion compared with the first quarter of 2002, including an increase of $14.0 million in interest-bearing deposits and an increase of $8.7 million in borrowings. The cost of average interest-bearing liabilities decreased 27 basis points to 2.35% during the second quarter of 2002 from 2.62% in the first quarter of 2002.
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CONSOLIDATED AVERAGE BALANCES— NET CHANGES
Noninterest Income
Noninterest income increased $763,000, or 20% in the second quarter of 2002, and $1.5 million, or 21%, for the first six months of 2002 as compared with the same periods in 2001. Increases during the second quarter and the first six months of 2002 were primarily centered in service charges and other fees, merchant services income, and investments in Bank Owned Life Insurance. Increases in service charges and other fees reflect growth in core deposits. Increases in merchant services income is due to the overall growth of the customer base and the continued emphasis on expanding the market for that product. For both the second quarter and first six months of 2002, the Company recorded net gains on sale of investment securities of $234,000 as compared to $60,000 and $37,000 for the same periods of 2001. Noninterest income increased 14% from the first quarter of 2002 to the second quarter of 2002.
Noninterest Expense
Total noninterest expense increased $994,000, or 8%, for the second quarter of 2002, and $2.8 million, or 11%, for the first six months of 2002, compared with the same periods in 2001. The increases were primarily due to personnel and occupancy costs associated with the Company’s branch expansion and other expenses. The personnel cost increases reflect the full operations of the Company’s recent expansion in King and Pierce counties. The Company’s efficiency ratio (noninterest expense divided by the sum of net interest income plus noninterest income) was 69.7% for both the second quarter and first six months of 2002, compared to 72.4% and 70.1% for the same respective periods in 2001.
Income Taxes
The Company recorded income tax provisions of $1.3 million and $551,000 for the second quarter and first six months of 2002, respectively, compared with provisions of $1.4 million and $3.1 million for the same periods in 2001.
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Credit Risk Management
The extension of credit in the form of loans or other credit products to individuals and businesses is a major portion of the Company’s principal business activity. Company policies and applicable laws and regulations require risk analysis as well as ongoing portfolio and credit management. The Company manages its credit risk through lending limit constraints, credit review, approval policies and extensive, ongoing internal monitoring. The Company also manages credit risk through diversification of the loan portfolio by type of loan, type of industry, aggregation of debt limits to a single borrower and the type of borrower.
In analyzing its existing portfolio, the Company reviews its consumer and residential loan portfolios by risk rating each loan and analyzing their performance as a pool of loans since no single loan is individually significant or judged by its risk rating size or potential risk of loss. In contrast, the monitoring process for the commercial business, private banking, real estate construction, and commercial real estate portfolios includes periodic reviews of individual loans with risk ratings assigned to each loan and performance judged on a loan by loan basis. The Company reviews these loans to assess the ability of the borrower to service all of its interest and principal obligations and, as a result, the risk rating may be adjusted accordingly. In the event that full collection of principal and interest is not reasonably assured, the loan is appropriately downgraded and placed on nonaccrual status even though the loan may be current as to principal and interest payments. Additionally, the Company assesses whether an impairment of a loan as provided in SFAS No. 114, “Accounting by Creditors for Impairment of a Loan”, warrants specific reserves or a write-down of the loan. See “Provision and Allowance For Loan Losses” on page 17.
Loan policies, credit quality criteria, portfolio guidelines and other controls are established under the guidance of the Company’s Chief Credit Officer and approved, as appropriate, by the Board. Credit Administration, together with appropriate loan committees, has the responsibility for administering the credit approval process. As another part of its control process, the Company uses an independent internal credit review and examination function to provide assurance that loans and commitments are made and maintained as prescribed by its credit policies. This includes a review of documentation when the loan is initially extended and subsequent examination to ensure continued performance and proper risk assessment.
Loan Portfolio Analysis
The Company is a full service commercial bank, which originates a wide variety of loans, and concentrates its efforts on originating commercial business and commercial real estate loans. The following table sets forth the Company’s loan portfolio composition by type of loan for the dates indicated:
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Total loans (excluding loans held for sale) at June 30, 2002 decreased $9.8 million, or 1%, to $1.16 billion from $1.17 billion at year-end 2001. The decrease in commercial and real estate loans was partially offset by increases in real estate construction and consumer loans.
Commercial Loans: As of June 30, 2002, commercial loans decreased $15.6 million, or 3%, to $451.0 million from $466.6 million at year-end 2001, representing 38.9% of total loans at June 30, 2002 as compared with 39.9% of total loans at December 31, 2001. The Company is committed to providing competitive commercial lending in its market areas. Management believes the slowdown in commercial lending in 2001 and continuing through the second quarter of 2002 was primarily due to the slow economy as businesses reduced inventories and paid down debt. The Company plans to remain competitive yet cautious with its commercial lending products due to the current state of the economy and will continue to emphasize in particular its relationship banking with businesses, business owners and affluent individuals.
Real Estate Loans: Residential one-to-four family loans increased $1.1 million, or 2%, to $54.0 million at June 30, 2002, representing 4.7% of total loans, compared with $52.9 million, or 4.5% of total loans at December 31, 2001. These loans are used by the Company to collateralize advances from the FHLB. The Company’s underwriting standards require that one-to-four family portfolio loans generally be owner-occupied. The loan amounts may not exceed 80% (90% with private mortgage insurance) of the appraised value or cost, whichever is lower, of the underlying collateral at origination. Generally, the Company’s policy is to originate for sale to third parties residential loans secured by properties located within the Company’s primary market areas.
The Company makes multi-family and commercial real estate loans in its market areas. Multi-family and commercial real estate lending decreased $3.6 million, or 1%, to $428.8 million at June 30, 2002, representing 36.9% of total loans, from $432.4 million, or 37.0% of total loans at December 31, 2001. The decrease in multi-family and commercial real estate lending during the second quarter of 2002 reflects a mix of owner occupied and income property transactions. Generally, multi-family and commercial real estate loans are made to borrowers who have existing banking relationships with the Company. The Company’s underwriting standards generally require that the loan-to-value ratio for multi-family and commercial loans not exceed 75% of appraised value, cost, or discounted cash flow value, as appropriate, and that commercial properties maintain debt coverage ratios (net operating income divided by annual debt servicing) of 1.2 or better. However, underwriting standards can be influenced by competition and other factors. The Company endeavors to maintain the highest practical underwriting standards while balancing the need to remain competitive in its lending practices.
Real Estate Construction Loans: The Company originates a variety of real estate construction loans. One-to-four family residential construction loans are originated for the construction of custom homes (where the home buyer is the borrower) and provide financing to builders for the construction of pre-sold homes and speculative residential construction. Construction loans on one-to-four family residences decreased $3.2 million, or 16%, to $17.5 million at June 30, 2002, representing 1.5% of total loans, from $20.7 million, or 1.8% of total loans at December 31, 2001. Multi-family and commercial real estate construction loans increased $9.1 million, or 10%, to $100.2 million at June 30, 2002, representing 8.5% of total loans, from $91.1 million, or 7.7% of total loans at December 31, 2001.
The Company endeavors to limit its construction lending risk through adherence to strict underwriting procedures.
Consumer Loans: At June 30, 2002, the Company had $112.1 million of consumer loans outstanding, representing 9.7% of total loans, an increase of $2.2 million, or 2%, compared with $109.8 million, at December 31, 2001. Consumer loans made by the Company include automobile loans, boat and recreational vehicle financing, home equity and home improvement loans and miscellaneous personal loans.
Foreign Loans: Columbia Bank is not involved with loans to foreign companies or foreign countries.
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Nonperforming Assets
Nonperforming assets consist of: (i) nonaccrual loans, which are loans placed on a nonaccrual basis when the loan becomes past due 90 days or when there are otherwise serious doubts about the collectibility of principal or interest; (ii) restructured loans, for which concessions, including the reduction of interest rates below a rate otherwise available to that borrower or the deferral of interest or principal, have been granted due to the borrower’s weakened financial condition (interest on restructured loans is accrued at the restructured rates when it is anticipated that no loss of original principal will occur); (iii) real estate owned; and (iv) personal property owned.
Total nonperforming assets increased 31% in the first six months of 2002 to $24.3 million, or 1.53% of period-end assets at June 30, 2002, compared to $18.5 million, or 1.24% of period-end assets at December 31, 2001. The following tables set forth, at the dates indicated, information with respect to nonaccrual loans, restructured loans, total nonperforming loans (nonaccrual loans plus restructured loans), real estate owned, other personal property owned, and total nonperforming assets of the Company:
Nonperforming Loans. The consolidated financial statements are prepared according to the accrual basis of accounting. This includes the recognition of interest income on the loan portfolio, unless a loan is placed on a nonaccrual basis. The policy of the Company generally is to discontinue the accrual of interest on all loans past due 90 days or more and place them on nonaccrual status.
Nonperforming loans were $16.4 million, or 1.41% of total loans (excluding loans held for sale) at June 30, 2002, compared to $18.4 million, or 1.57% of total loans at December 31, 2001. Nonaccrual loans and other nonperforming assets are centered in a relatively small number of lending relationships which management considers adequately reserved. Nonaccrual loans decreased $1.7 million, or 10% from year end 2001 to $16.0 million at June 30, 2002 as uncollectible loans were charged-off and other loans foreclosed and transferred to real estate owned. Loans placed into nonaccrual during the second quarter 2002 were not concentrated in any one loan category. Restructured loans remained unchanged at $425,000 at June 30, 2002, from first quarter 2002, and decreased 41% from $716,000 at December 31, 2001.
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The Company will continue its collection efforts and liquidation of collateral to recover as large a portion of the nonaccrual assets as possible. Substantially all nonperforming loans are to borrowers within the State of Washington.
Real Estate and Other Personal Property Owned. Real estate owned (REO), which is comprised of property from foreclosed real estate loans, increased $6.5 million to $6.7 million at June 30, 2002, from $197,000 at December 31, 2001. During the quarter, the Company sold two properties and foreclosed three loans, transferring the real estate to REO. At June 30, 2002, REO consisted of four properties, one of which is a $4.9 million commercial real estate property previously charged down and reported in the first quarter 2002. The Company also foreclosed on two loan relationships, resulting in the ownership of $1.3 million in other personal, non-real estate property at quarter end June 30, 2002. The Company intends to liquidate this other personal property as quickly as possible to maximize recovery.
Provision and Allowance for Loan Losses
The Company maintains an allowance for loan losses to absorb losses inherent in the loan portfolio. The size of the allowance is determined through quarterly assessments of the probable estimated losses in the loan portfolio. The Company’s methodology for making such assessments and determining the adequacy of the allowance includes the following key elements:
On a quarterly basis (semi-annual in the case of economic and business conditions reviews) the senior credit officers of the Company review with Executive Management and the Board of Directors the various additional factors that management considers when determining the adequacy of the allowance. These factors include the following as of the applicable balance sheet date:
The allowance is increased by provisions charged to expense, and is reduced by loans charged off, net of recoveries.
While management believes it uses the best information available to determine the allowance for loan losses, unforeseen market conditions could result in adjustments to the allowance, and net income could be significantly affected, if circumstances differ substantially from the assumptions used in determining the allowance.
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At June 30, 2002, the Company’s allowance for loan losses was $15.8 million, or 1.36% of the total loans (excluding loans held for sale), and 96.25% of nonperforming loans. This compares with an allowance of $14.7 million, or 1.26% of the total loan portfolio, and 80.29% of nonperforming loans, at December 31, 2001. Second quarter 2002 additions to the loan loss allowance totaled $2.0 million, compared to $900,000 in the second quarter 2001. During the first six months of 2002, the Company set aside $9.0 million as a provision for loan losses, an increase of $7.2 million over the same period in 2001. In the first quarter 2002, the Company allocated $7.1 million to its allowance for loan losses to reflect the deterioration of a troubled credit relationship reported in the first quarter 2002. As discussed above, the loan balance was transferred to real estate owned during the second quarter 2002.
Net loan charge-offs amounted to $1.4 and $8.0 million for the second quarter and first six months of 2002, respectively, compared with net loan charge-offs of $634,000 and $1.4 million for the same periods in 2001. The $1.4 million charged-off during the quarter was comprised of several loans charged down and charged-off, the largest of which was $1.0 million.
The Company increased its provision for loan losses during the first six months of 2002 due to the level of charge-off activity and softness in the economy of its market area. At June 30, 2002, management believes the Company’s allowance for loan losses provides adequate reserves for its loan portfolio, including the nonaccrual loans and nonperforming assets. Management regularly evaluates the necessity of any additions to the allowance for loan losses based upon the Company’s credit quality, loan growth, the economy and other factors.
The following table provides an analysis of the Company’s allowance for loan losses at the dates and the periods indicated:
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Securities
At quarter end June 30, 2002, the Company’s securities (securities available for sale and securities held to maturity) increased $80.3 million, or 53% from its balance at year-end 2001. The Company purchased $2.8 million of available for sale securities and sold $7.3 million of securities during the second quarter 2002, for realized gains of $234,000. For the first six months of 2002, the Company purchased $106.2 million of available for sale securities and sold $7.3 million for realized gains of $234,000. Approximately 97% of the Company’s securities are classified as available for sale and carried at fair value. These securities are used by management as part of its asset/liability management strategy and may be sold in response to changes in interest rates and/or significant prepayment risk. In accordance with the Company’s investment strategy, management monitors market conditions with a view to realize gains on its available for sale securities portfolio as market conditions allow.
Liquidity and Sources of Funds
The Company’s primary sources of funds are customer deposits and advances from the Federal Home Loan Bank of Seattle (the “FHLB”). These funds, together with loan repayments, loan sales, retained earnings, equity and other borrowed funds, are used to make loans, to acquire securities and other assets and to fund continuing operations.
Deposit Activities
The Company’s deposit products include a wide variety of transaction accounts, savings accounts and time deposit accounts. Total deposits increased $39.4 million, or 3%, to $1.35 billion at June 30, 2002 from $1.31 billion at December 31, 2001. Core deposits increased $34.5 million, or 4% during the first six months of 2002 and certificates of deposit balances increased $5.0 million compared to year-end 2001. Average core deposits (demand deposit, savings, and money market accounts) increased to $858 million during the second quarter of 2002, from $836 million in the first quarter of 2002 and from $786 million during the fourth quarter 2001.
The Company has established a branch system catering primarily to retail depositors, supplemented by business customer deposits and other borrowings. The branch system deposits are intended to provide a stable core funding base for the Company. Together with that stable core deposit base, management’s strategy for funding growth includes brokered and other wholesale deposits. At June 30, 2002, brokered and other wholesale deposits (excluding public deposits) totaled $40.6 million, or 3.0% of total deposits, compared with $40.2 million, or 3.1% of total deposits at December 31, 2001. The brokered deposits have varied maturities up to three years.
Borrowings
The Company relies on FHLB advances to supplement its funding sources, and the FHLB serves as a source of both short and long-term borrowings. One-to-four family real estate mortgages and certain other assets secure FHLB advances. At June 30, 2002, the Company had short-term advances of $7.1 million compared to no short-term advances at December 31, 2001. At June 30, 2002, the Company had $84.8 million of FHLB advances with terms expiring after one year. Management anticipates that the Company will continue to rely on the same sources of funds in the future, and will use those funds primarily to make loans and purchase securities.
The Company has a $20 million line of credit with a large commercial bank. The interest rate on the line is indexed to LIBOR and at June 30, 2002, there was no balance outstanding. In the event of discontinuance of the line by either party, the Company has up to two years to repay any outstanding balance.
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Trust preferred obligations
The Company’s $22 million of trust preferred obligations are at a quarterly adjusted floating rate based on the 3-month LIBOR plus 3.58%. At June 30, 2002 the rate on the Company’s trust preferred obligations was 5.50%. The Company can call the debt in 2006 for a premium and in 2011 at par, allowing the Company to retire the debt early if conditions are favorable.
Capital
Shareholders’ equity at June 30, 2002 was $123.0 million, up 3% from $119.0 million at December 31, 2001. The increase is due primarily to net income of $2.7 million during the first six months of 2002 and unrealized gains in its securities available for sale portfolio. Shareholders’ equity was 7.73%, and 7.94% of total period-end assets at June 30, 2002, and December 31, 2001, respectively.
Capital Ratios
Banking regulations require bank holding companies to maintain a minimum “leverage” ratio of core capital to adjusted quarterly average total assets of at least 3%. In addition, banking regulators have adopted risk-based capital guidelines, under which risk percentages are assigned to various categories of assets and off-balance sheet items to calculate a risk-adjusted capital ratio. Tier I capital generally consists of common shareholders’ equity and trust preferred obligations less goodwill and certain identifiable intangible assets, while Tier II capital includes the allowance for loan losses and subordinated debt, both subject to certain limitations.
Regulatory minimum risk-based capital guidelines require Tier I capital of 4% of risk-adjusted assets and total capital (combined Tier I and Tier II) of 8% of risk-adjusted assets to be considered “adequately capitalized”. The FDIC published the qualifications necessary to be classified as a “well capitalized” bank, primarily for assignment of FDIC insurance premium rates. To qualify as “well capitalized,” banks must have a Tier I risk-adjusted capital ratio of at least 6%, a total risk-adjusted capital ratio of at least 10%, and a leverage ratio of at least 5%. Failure to qualify as “well capitalized” can negatively impact a bank’s ability to expand and to engage in certain activities.
Columbia Bank qualified as “well-capitalized” at June 30, 2002 and December 31, 2001.
Dividends
On April 2, 2002, the Company announced a 5% stock dividend payable on April 30, 2002, to shareholders of record as of April 16, 2002. Applicable federal and Washington State regulations restrict cash capital distributions by institutions such as Columbia Bank, including dividends. Such restrictions are tied to the institution’s capital levels after giving effect to distributions. The Company’s ability to pay cash dividends is substantially dependent upon receipt of dividends from the Bank.
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Stock Repurchase Program
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
A number of measures are used to monitor and manage interest rate risk, including income simulations and interest sensitivity (gap) analyses. An income simulation model is the primary tool used to assess the direction and magnitude of changes in net interest income resulting from changes in interest rates. Basic assumptions in the model include prepayment speeds on mortgage-related assets, cash flows and maturities of other investment securities, loan and deposit volumes and pricing. These assumptions are inherently subjective and, as a result, the model cannot precisely estimate net interest income or precisely predict the impact of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes and changes in market conditions and management strategies, among other factors. At June 30, 2002, based on the measures used to monitor and manage interest rate risk, there has not been a material change in the Company’s interest rate risk since December 31, 2001. For additional information, refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations” referenced in the Company’s annual report on Form 10-K for the year ended December 31, 2001.
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PART II — OTHER INFORMATION
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Company held its annual shareholders meeting on April 2, 2002, for the purpose of electing the Board of Directors.
All twelve persons nominated were elected to hold office for the ensuing year.
Item 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
(b) Reports on Form 8-K
On July 2, 2002, the Company filed an 8-K dated July 1, 2002 announcing that the Company had accepted the resignation of J. James Gallagher as Vice Chairman and Chief Executive Officer of Columbia Banking System, Inc. and Vice Chairman of Columbia State Bank.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
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