UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended June 30, 2011.
For the transition period from to .
Commission File Number 0-20288
COLUMBIA BANKING SYSTEM, INC.
(Exact name of issuer as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification Number)
1301 “A” Street
Tacoma, Washington
(253) 305-1900
(Issuer’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. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
The number of shares of common stock outstanding at July 31, 2011 was 39,496,663.
TABLE OF CONTENTS
Item 1.
Consolidated Condensed Statements of Changes in Shareholders’ Equity - three and six months ended June 30, 2011 and 2010
Item 2.
Item 3.
Item 4.
Item 1A.
Item 5.
Item 6.
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PART I - FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS
CONSOLIDATED CONDENSED STATEMENTS OF INCOME
Columbia Banking System, Inc.
(Unaudited)
(in thousands except per share)
Interest Income
Loans
Taxable securities
Tax-exempt securities
Federal funds sold and deposits in banks
Total interest income
Interest Expense
Deposits
Federal Home Loan Bank advances
Long-term obligations
Other borrowings
Total interest expense
Net Interest Income
Provision for loan and lease losses
Provision for losses on covered loans
Net interest income after provision for loan and lease losses
Noninterest Income (Loss)
Service charges and other fees
Gain on bank acquisitions
Merchant services fees
Gain on sale of investment securities, net
Bank owned life insurance
Change in FDIC loss sharing asset
Other
Total noninterest income (loss)
Noninterest Expense
Compensation and employee benefits
Occupancy
Merchant processing
Advertising and promotion
Data processing and communications
Legal and professional fees
Taxes, licenses and fees
Regulatory premiums
Net cost of operation of other real estate owned
Amortization of intangibles
FDIC clawback liability
Total noninterest expense
Income before income taxes
Income tax provision
Net Income
Net Income Applicable to Common Shareholders
Earnings per common share
Basic
Diluted
Dividends paid per common share
Weighted average number of common shares outstanding
Weighted average number of diluted common shares outstanding
See accompanying notes to unaudited consolidated condensed financial statements.
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CONSOLIDATED CONDENSED BALANCE SHEETS
(in thousands)
Cash and due from banks
Interest-earning deposits with banks
Total cash and cash equivalents
Securities available for sale at fair value (amortized cost of $956,125 and $743,928, respectively)
Federal Home Loan Bank stock at cost
Loans held for sale
Loans, excluding covered loans, net of deferred loan fees of ($3,454) and ($3,490), respectively
Less: allowance for loan and lease losses
Loans, excluding covered loans, net
Covered loans, net of allowance for loan losses of ($7,948) and ($6,055), respectively
Total loans, net
FDIC loss sharing asset
Interest receivable
Premises and equipment, net
Other real estate owned ($24,239 and $14,443 covered by FDIC loss share, respectively)
Goodwill
Core deposit intangible, net
Other assets
Total Assets
Deposits:
Noninterest-bearing
Interest-bearing
Total deposits
Securities sold under agreements to repurchase
Long-term subordinated debt
Other liabilities
Total liabilities
Commitments and contingent liabilities
Shareholders’ equity:
Common Stock (no par value)
Authorized shares
Issued and outstanding
Retained earnings
Accumulated other comprehensive income
Total shareholders’ equity
Total Liabilities and Shareholders’ Equity
2
CONSOLIDATED CONDENSED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
RetainedEarnings
Balance at January 1, 2010
Comprehensive income:
Net income
Other comprehensive income, net of tax:
Net unrealized gain from securities, net of reclassification adjustments
Net change in cash flow hedging instruments
Net pension plan liability adjustment
Other comprehensive income
Comprehensive income
Accretion of preferred stock discount
Issuance of common stock, net of offering costs
Issuance of common stock - stock option and other plans
Issuance of common stock - restricted stock awards, net of cancelled awards
Tax benefit deficiency associated with share-based compensation
Preferred dividends
Cash dividends paid on common stock
Balance at June 30, 2010
Balance at January 1, 2011
Repurchase of shares
Balance at June 30, 2011
3
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
Cash Flows From Operating Activities
Adjustments to reconcile net income to net cash provided by operating activities
Provision for loan and lease losses and losses on covered loans
Stock-based compensation expense
Depreciation, amortization and accretion
Net realized gain on FDIC assisted bank acquisitions
Net realized gain on sale of securities
Net realized gain on sale of other assets
Net realized gain on sale of other real estate owned
Gain on termination of cash flow hedging instruments
Write-down on other real estate owned
Deferred income tax benefit
Net change in:
FDIC loss-sharing asset, net of cash received
Interest payable
Net cash provided by operating activities
Cash Flows From Investing Activities
Loans originated and acquired, net of principal collected
Purchases of:
Securities available for sale
Premises and equipment
Proceeds from:
FDIC reimbursement on loss-sharing asset
Sales of securities available for sale
Principal repayments and maturities of securities available for sale
Disposal of premises and equipment
Sales of covered other real estate owned
Sales of other real estate and other personal property owned
Capital improvements on other real estate properties
Decrease in Small Business Administration secured borrowings
Net cash acquired in business combinations
Net cash (used in) provided by investing activities
Cash Flows From Financing Activities
Net decrease in deposits
Issuance of common stock
Exercise of stock options
Federal Reserve Bank borrowings
Payment for:
Repayment of Federal Home Loan Bank advances
Repayment of Federal Reserve Bank borrowings
Preferred stock dividends
Common stock dividends
Repurchase of common stock
Net decrease in other borrowings
Net cash used in financing activities
(Decrease) Increase in cash and cash equivalents
Cash and cash equivalents at beginning of period
Cash and cash equivalents at end of period
Supplemental Information:
Cash paid during the year for:
Cash paid for interest
Non-cash investing activities
Assets acquired in FDIC assisted acquisitions (excluding cash and cash equivalents)
Liabilities assumed in FDIC assisted acquisitions
Loans transferred to other real estate owned
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NOTES TO UNAUDITED CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
1. Basis of Presentation and Significant Accounting Policies
Basis of Presentation
The interim unaudited consolidated condensed 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. Accordingly, certain financial information and footnotes have been omitted or condensed. The consolidated condensed financial statements include the accounts of the Company, and its wholly owned banking subsidiary Columbia Bank (the “Bank”). All intercompany transactions and accounts have been eliminated in consolidation. In the opinion of management, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair statement of the results for the interim periods presented have been included. The results of operations for the six months ended June 30, 2011 are not necessarily indicative of results to be anticipated for the year ending December 31, 2011. The accompanying interim unaudited consolidated condensed financial statements should be read in conjunction with the financial statements and related notes contained in the Company’s 2010 Annual Report on Form 10-K.
Significant Accounting Policies
The significant accounting policies used in preparation of our consolidated financial statements are disclosed in our 2010 Annual Report on Form 10-K. There have not been any changes in our significant accounting policies compared to those contained in our 2010 10-K disclosure for the year ended December 31, 2010.
2. Accounting Pronouncements Recently Issued
In April 2011, the Financial Accounting Standards Board (“the FASB”) issued Accounting Standards Update (“ASU”) 2011-02, A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring (Topic 310). ASU 2011-02 clarifies the criteria for a restructuring to be classified as a Troubled Debt Restructuring. The effective date of ASU 2011-02 will be the first interim or annual period beginning after June 15, 2011 and should be applied retrospectively to the beginning of the annual period of adoption. The Company is evaluating the impact this ASU will have on its financial condition and results of operations.
In April 2011, the FASB issued ASU 2011-03, Reconsideration of Effective Control for Repurchase Agreements (Topic 860). ASU 2011-03 attempts to improve the accounting for repurchase agreements and other agreements that both entitle and obligate a transferor to repurchase or redeem financial assets before maturity. The effective date of ASU 2011-03 will be the first interim or annual period beginning after December 15, 2011 and should be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date. Early adoption is not permitted. The Company is evaluating the impact this ASU will have on its financial condition and results of operations.
In May 2011, the FASB issued ASU 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. Generally Accepted Accounting Principles (“GAAP”) and International Financial Reporting Standards (“IFRS”) (Topic 820). ASU 2011-04 developed common requirements between GAAP and IFRS for measuring fair value and for disclosing information about fair value measurements. The effective date of ASU 2011-04 will be during interim or annual period beginning after December 15, 2011 and should be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date. Early adoption is not permitted. The Company is evaluating the impact this ASU will have on its financial condition and results of operations.
In June 2011, the FASB issued ASU 2011-05, Presentation of Comprehensive Income (Topic 220). ASU 2011-05 attempts to improve the comparability, consistency, and transparency of financial reporting and to increase the prominence of items reported in other comprehensive income. The effective date of ASU 2011-05 will be the first interim or fiscal period beginning after December 15, 2011 and should be applied retrospectively. Early adoption is permitted. The Company will apply the disclosure requirements of ASU 2011-05 for its first interim period beginning after December 15, 2011.
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3. Earnings per Common Share
Basic Earnings per Share (“EPS”) is computed by dividing income applicable to common shareholders by the weighted average number of common shares outstanding for the period. Common shares outstanding include common stock and vested restricted stock awards where recipients have satisfied the vesting terms. Diluted EPS reflects the assumed conversion of all dilutive securities, applying the treasury stock method. The Company calculates earnings per share using the two-class method as described in the Earnings per Share topic of the FASB Accounting Standards Codification (“ASC”). The following table sets forth the computation of basic and diluted earnings per share for the three and six months ended June 30, 2011 and 2010:
Basic EPS:
Less: Preferred dividends and accretion of issuance discount for preferred stock
Net income applicable to common shareholders
Less: Earnings allocated to participating securities
Earnings allocated to common shareholders
Weighted average common shares outstanding
Basic earnings per common share
Diluted EPS:
Dilutive effect of equity awards and warrants
Weighted average diluted common shares outstanding
Diluted earnings per common share
Potentially dilutive share options that were not included in the computation of diluted EPS because to do so would be anti-dilutive.
4. Business Combinations
Summit Bank
On May 20, 2011 the Bank acquired certain assets and assumed certain liabilities of Summit Bank from the Federal Deposit Insurance Corporation (“FDIC”) in an FDIC-assisted transaction. As part of the Purchase and Assumption Agreement, the Bank and the FDIC entered into loss-sharing agreements (each, a “loss-sharing agreement” and collectively, the “loss-sharing agreements”), whereby the FDIC will cover a substantial portion of any future losses on loans (and related unfunded commitments), OREO and certain accrued interest on loans for up to 90 days. We refer to the acquired loans and OREO subject to the loss-sharing agreements collectively as “covered assets.” Under the terms of the loss-sharing agreements, the FDIC will absorb 80% of losses and share in 80% of loss recoveries. The loss-sharing provisions of the agreements for commercial and single family residential mortgage loans are in effect for five years and ten years, respectively, from the May 20, 2011 acquisition date and the loss recovery provisions for such loans are in effect for eight years and ten years, respectively, from the acquisition date.
Summit Bank was a full service community bank headquartered in Burlington, Washington that operated three branch locations in Skagit County. We entered into this transaction to assist us with filling in our geographic footprint between Seattle and Bellingham, Washington and to support our recently expanded Bellingham banking team. We believe participating with the FDIC in this assisted transaction was, from an economical standpoint, advantageous to expansion through de novo branching.
The assets acquired and liabilities assumed have been accounted for under the acquisition method of accounting (formerly the purchase method). The assets and liabilities, both tangible and intangible, were recorded at their estimated fair values as of the May 20, 2011 acquisition date. Initial accounting for acquired loans and the related indemnification asset for the Summit Bank acquisition was incomplete as of June 30, 2011. The amounts currently recognized in the financial statements have been determined provisionally as we are completing a fair value analysis of those assets utilizing an income approach. The application of the acquisition method of accounting resulted in the recognition of $3.8 million of goodwill and a core deposit intangible of $509 thousand. The goodwill represents the excess of the estimated fair value of the liabilities assumed over the estimated fair value of the assets acquired and is influenced significantly by the FDIC-assisted transaction process. All of the goodwill and core deposit intangible assets recognized are deductible for income tax purposes.
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The operating results of the Company include the operating results produced by the acquired assets and assumed liabilities for the period May 21, 2011 to June 30, 2011. Due primarily to the significant amount of fair value adjustments and the FDIC loss-sharing agreements put in place, historical results of Summit Bank are not meaningful to the Company’s results and thus no pro forma information is presented.
The table below displays the amounts recognized as of the acquisition date for each major class of assets acquired and liabilities assumed:
Assets
Interest-earning deposits with banks and federal funds sold
Investment securities
Federal Home Loan Bank stock
Acquired loans
Accrued interest receivable
FDIC receivable
Other real estate owned covered by loss sharing
Core deposit intangible
FDIC indemnification asset
Total assets acquired
Liabilities
Accrued interest payable
Total liabilities assumed
First Heritage Bank
On May 27, 2011 the Bank acquired certain assets and assumed certain liabilities of First Heritage Bank from the FDIC in an FDIC-assisted transaction. As part of the Purchase and Assumption Agreement, the Bank and the FDIC entered into loss-sharing agreements (each, a “loss-sharing agreement” and collectively, the “loss-sharing agreements”), whereby the FDIC will cover a substantial portion of any future losses on loans (and related unfunded commitments), OREO and certain accrued interest on loans for up to 90 days. We refer to the acquired loans and OREO subject to the loss-sharing agreements collectively as “covered assets.” Under the terms of the loss-sharing agreements, the FDIC will absorb 80% of losses and share in 80% of loss recoveries. The loss-sharing provisions of the agreements for commercial and single family residential mortgage loans are in effect for five years and ten years, respectively, from the May 27, 2011 acquisition date and the loss recovery provisions for such loans are in effect for eight years and ten years, respectively, from the acquisition date.
First Heritage Bank was a full service community bank headquartered in Snohomish, Washington that operated five branch locations in King and Snohomish Counties. We entered into this transaction to assist us with filling in our geographic footprint between Seattle and Bellingham, Washington and to support our recently expanded Bellingham banking team. We believe participating with the FDIC in this assisted transaction was, from an economical standpoint, advantageous to expansion through de novo branching.
The assets acquired and liabilities assumed have been accounted for under the acquisition method of accounting (formerly the purchase method). The assets and liabilities, both tangible and intangible, were recorded at their estimated fair values as of the May 27, 2011 acquisition date. The initial accounting for acquired loan’s and the related indemnification asset for the First Heritage Bank acquisition was incomplete as of June 30, 2011. The amounts currently recognized in the financial statements have been determined provisionally as we are completing a fair value analysis of those assets utilizing an income approach. The application of the acquisition method of accounting resulted in the recognition in $5.9 million of goodwill and a core deposit intangible of $1.3 million. The goodwill represents the excess of the estimated fair value of the liabilities assumed over the estimated fair value of the assets acquired and is influenced significantly by the FDIC-assisted transaction process. All of the goodwill and core deposit intangible assets recognized are deductible for income tax purposes.
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The operating results of the Company include the operating results produced by the acquired assets and assumed liabilities for the period May 28, 2011 to June 30, 2011. Due primarily to the significant amount of fair value adjustments and the FDIC loss-sharing agreements put in place, historical results of First Heritage Bank are not meaningful to the Company’s results and thus no pro forma information is presented.
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5. Securities
The following table summarizes the amortized cost, gross unrealized gains and losses and the resulting fair value of securities available for sale:
June 30, 2011:
U.S. government agency and government-sponsored enterprise mortgage-backed securities and collateralized mortgage obligations
State and municipal securities
U.S. government agency securities
Other securities
Total
December 31, 2010:
The scheduled contractual maturities of investment securities available for sale at June 30, 2011 are presented as follows:
Due within one year
Due after one year through five years
Due after five years through ten years
Due after ten years
Total investment securities available-for-sale
The following table summarizes the carrying value of securities pledged as collateral at June 30, 2011:
Washington and Oregon State public deposits
Repurchase agreement
Interest rate contracts
Total securities pledged as collateral
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The following tables show the gross unrealized losses and fair value of the Company’s investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at June 30, 2011 and December 31, 2010:
The unrealized losses on the above securities are primarily attributable to increases in market interest rates subsequent to their purchase by the Company. Management does not intend to sell any impaired securities nor does available evidence suggest it is more likely than not that management will be required to sell any impaired securities. The Company’s securities portfolio does not include any private label mortgage backed securities or investments in trust preferred securities. Management believes the nature of securities in the Company’s investment portfolio present a very high probability of collecting all contractual amounts due, as the majority of the securities held are backed by government agencies or government-sponsored enterprises. However, this recovery in value may not occur for some time, perhaps greater than the one-year time horizon or perhaps even at maturity.
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6. Noncovered Loans
The following is an analysis of the noncovered loan portfolio by major types of loans (net of deferred loan fees):
Noncovered loans:
Commercial business
Real Estate:
One-to-four family residential
Commercial and five or more family residential properties
Total real estate
Real estate construction:
Total real estate construction
Consumer
Less: deferred loan fees
Total noncovered loans, net of deferred fees
Less: Allowance for loan and lease losses
At June 30, 2011 and December 31, 2010, the Company had no loans to foreign domiciled businesses or foreign countries, or loans related to highly leveraged transactions. Substantially all of the Company’s loans and unfunded commitments are geographically concentrated in its service areas within the states of Washington and Oregon.
The Company and its banking subsidiary have granted loans to officers and directors of the Company and related interests. These loans are made on the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated persons and do not involve more than the normal risk of collectability. The aggregate dollar amount of these loans was $9.8 million and $12.9 million at June 30, 2011 and December 31, 2010, respectively. During the first six months of 2011, advances on related party loans were $3.1 million and repayments totaled $6.2 million.
At June 30, 2011 and December 31, 2010, $366.1 million and $426.6 million of commercial and residential real estate loans were pledged as collateral on Federal Home Loan Bank borrowings.
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The following is an analysis of noncovered, nonaccrual loans as of June 30, 2011 and December 31, 2010:
Commercial Business
Secured
Unsecured
Real Estate 1-4 Family
Residential RE Perm
Real Estate Commercial & Multifamily
Commercial RE Land
Income Property Multifamily Perm
Owner Occupied RE Perm
Construction 1-4 Family
Land & Acquisition
Residential Construction
Construction Commercial & Multifamily
Income Property Multifamily Construction
Owner Occupied RE Construction
12
The following is an analysis of the aged loan portfolio as of June 30, 2011 and December 31, 2010:
June 30, 2011
Income Property Multifamily
Construction
December 31, 2010
13
The following is an analysis of impaired loans as of June 30, 2011 and December 31, 2010:
7. Allowance for Loan and Lease Losses and Unfunded Commitments and Letters of Credit
We maintain an allowance for loan and lease losses (“ALLL”) to absorb losses inherent in the loan portfolio. The size of the ALLL is determined through quarterly assessments of the probable estimated losses in the loan portfolio. Our methodology for making such assessments and determining the adequacy of the ALLL includes the following key elements:
The general valuation allowance is systematically calculated quarterly using quantitative and qualitative information about specific loan classes. The minimum required level in which an entity develops a systematic methodology to determine its allowance for loan and lease losses is at the segment level. However, the Company’s systematic methodology in determining its allowance for loan and lease losses is prepared at the class level, which is more detailed than the segment level. The quantitative information uses historical losses from a specific loan class and incorporates the loan’s risk rating migration from origination to the point of loss. A loan’s risk rating is primarily determined based upon the borrower’s ability to fulfill its debt obligation from a cash flow perspective. In the event there is financial deterioration of the borrower, the borrower’s other sources of income or repayment are also considered, including recent appraisal values for collateral dependent loans. The qualitative information takes into account general economic and business conditions affecting our market place, seasoning of the loan portfolio, duration of the business cycle, etc. to ensure our methodologies reflect the current economic environment and other factors as using historical loss information exclusively may not give an accurate estimate of inherent losses within the Company’s loan portfolio.
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The specific valuation allowance is a reserve for each loan determined to be impaired and the value of the impaired loan is less than its recorded investment. The Company measures the impairment based on the discounted expected future cash flows, observable market price, or the fair value of the collateral less selling costs if the loan is collateral dependant or if foreclosure is probable. The specific reserve for each loan is equal to the difference between the recorded investment in the loan and its determined impairment value.
The ALLL is increased by provisions for loan and lease losses (“provision”) charged to expense, and is reduced by loans charged off, net of recoveries. While the Company’s management believes the best information available is used to determine the ALLL, changes in market conditions could result in adjustments to the ALLL, affecting net income, if circumstances differ from the assumptions used in determining the ALLL.
We have used the same methodology for ALLL calculations during the three and six months ended June 30, 2011 and 2010. Adjustments to the percentages of the ALLL allocated to loan categories are made based on trends with respect to delinquencies and problem loans within each pool of loans. The Company reviews the ALLL quantitative and qualitative methodology on a quarterly basis and makes adjustments when appropriate. The Company continues to strive towards maintaining a conservative approach to credit quality and will continue to prudently add to our ALLL as necessary in order to maintain adequate reserves. The Company carefully monitors the loan portfolio and continues to emphasize the importance of credit quality while continuously strengthening loan monitoring systems and controls.
15
The following table shows a detailed analysis of the allowance for loan and lease losses for noncovered loans as of the three and six months ended June 30, 2011:
Three months ended June 30, 2011
Unallocated
Six months ended June 30, 2011
16
The three and six months changes as of June 30, 2011 and 2010 are summarized as follows:
Beginning balance
Provision charged to expense
Loans charged off
Recoveries
Ending balance
Changes in the allowance for unfunded commitments and letters of credit are summarized as follows:
Net changes in the allowance for unfunded commitments and letters of credit
Risk Elements
The extension of credit in the form of loans to individuals and businesses is one of our principal commerce activities. Our policies and applicable laws and regulations require risk analysis as well as ongoing portfolio and credit management. We manage our credit risk through lending limit constraints, credit review, approval policies and extensive, ongoing internal monitoring. We also manage credit risk through diversification of the loan portfolio by type of loan, type of industry, type of borrower and by limiting the aggregation of debt to a single borrower.
The monitoring process for the loan portfolio includes periodic reviews of individual loans with risk ratings assigned to each loan. Based on the analysis, loans are given a risk rating of 1-10 based on the following criteria:
Loans with a risk rating of 1-6 are considered Pass loans and loans with risk ratings of 7, 8, 9 and 10 are considered Special Mention, Substandard, Doubtful and Loss, respectively. Loans with a risk rating of Substandard or worse are reported as classified loans in our allowance for loan and lease losses analysis. We review these loans to assess the ability of our borrowers to service all interest and principal obligations and, as a result, the risk rating may be adjusted accordingly. Risk ratings are reviewed and updated whenever appropriate, with more periodic reviews as the risk and dollar value of loss on the loan increases. In the event full collection of principal and interest is not reasonably assured, the loan is appropriately downgraded and, if warranted, placed on non-accrual status even though the loan may be current as to principal and interest payments. Additionally, we assess whether an impairment of a loan warrants specific reserves or a write-down of the loan.
17
The following is an analysis of the credit quality of our noncovered loan portfolio as of June 30, 2011 and December 31, 2010:
(dollars in thousands)
Total recorded investment of noncovered loans
18
8. Covered Assets and FDIC Loss-sharing Asset
Covered Assets
Covered assets consist of loans and OREO acquired in FDIC assisted acquisitions during 2010 and 2011, for which the Bank entered into loss-sharing agreements, whereby the FDIC will cover a substantial portion of any future losses on loans (and related unfunded loan commitments), OREO and certain accrued interest on loans. Under the terms of the loss-sharing agreements, the FDIC will absorb 80% of losses and share in 80% of loss recoveries up to specified amounts and, with respect to loss-sharing agreements for two acquisitions completed in 2010, will absorb 95% of losses and share in 95% of loss recoveries thereafter. The loss-sharing provisions of the agreements for commercial and single-family mortgage loans are in effect for five and ten years, respectively, from the acquisition dates and the loss recovery provisions are in effect for eight and ten years, respectively, from the acquisition dates.
Ten years and forty-five days after the acquisition dates, the Bank shall pay to the FDIC a clawback in the event the losses from the acquisitions fail to reach stated levels. This clawback shall be in the amount of 50% of the excess, if any, of 20% of the stated threshold amounts, less the sum of 25% of the asset premium (discount), 20% or 25% of the cumulative loss-sharing payments (depending on the particular agreement), and the cumulative servicing amount. As of June 30, 2011, the net present value of the Bank’s estimated clawback liability is $2.1 million, which is included in other liabilities on the consolidated condensed financial statements.
The following is an analysis of our covered loans, net of related allowance for losses on covered loans as of June 30, 2011 and December 31, 2010:
Subtotal of covered loans
Less:
Valuation discount resulting from acquisition accounting
Allowance for loan losses
Covered loans, net of allowance for loan losses
Acquired loans are accounted for under ASC 310-30 and initially measured at fair value based on expected future cash flows over the life of the loans or market-based information for comparable loans. Management monitors and estimates expected future cash flows of acquired loans on a quarterly basis. Acquired loans are also subject to the Company’s internal and external credit review and are risk rated using the same criteria as loans originated by the Company. However, risk ratings are not a clear indicator of losses on acquired loans as a majority of the losses are recoverable from the FDIC under the loss-sharing agreements.
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Draws on acquired loans, advanced subsequent to the loan acquisition date, are accounted for under ASC 450-20 and those amounts are also subject to the Company’s internal and external credit review. An allowance for loan losses is estimated in a similar manner as the originated loan portfolio, and a provision for loan losses is charged to earnings as necessary.
During the six months ended June 30, 2011, the Company recorded a provision expense for losses on covered loans of $1.9 million. Of this amount, $2.3 million was impairment expense calculated in accordance with ASC 310-30 and $462 thousand was a negative provision to adjust the allowance for loss calculated under ASC 450-20 for draws on acquired loans. The impact to earnings of the $1.9 million of provision expense for covered loans was partially offset through noninterest income by a $1.5 million increase in the FDIC loss-sharing asset.
The following table shows the changes in accretable yield for acquired loans for three and six months ended June 30, 2011. Due to the provisional measurement of loans acquired from Summit Bank and First Heritage Bank acquisitions, the table below does not include accretable yield arising from those two acquisitions:
Balance at beginning of period
Accretion
Cash receipts, disposals and change in cash flows
Balance at end of period
The excess of cash flows expected to be collected over the initial fair value of acquired loans is referred to as the accretable yield and is accreted into interest income over the estimated life of the acquired loans using the effective yield method. Other adjustments to the accretable yield include changes in the estimated remaining life of the acquired loans, changes in expected cash flows and changes of indices for acquired loans with variable interest rates.
The following table sets forth activity in covered OREO at carrying value for the three and six months ended June 30, 2011:
Covered OREO:
Balance, beginning of period
Established through acquisitions
Transfers in, net of write-downs ($23 and $441, respectively)
OREO improvements
Additional OREO write-downs
Proceeds from sale of OREO property
Gain on sale of OREO
Total covered OREO, end of period
The covered OREO is covered by loss-sharing agreements with the FDIC in which the FDIC will assume 80% of additional write-downs and losses on covered OREO sales, or 95%, if applicable, of additional write-downs and losses on covered OREO sales if the minimum loss share thresholds are met.
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FDIC Loss-sharing Asset
The FDIC loss-sharing asset as of June 30, 2011 is comprised of a $199.3 million FDIC indemnification asset and a $6.9 million FDIC receivable. The indemnification is the present value of the cash flows the Company expects to collect from the FDIC under the loss-sharing agreements and the FDIC receivable represents 80% of reimbursable amounts from the FDIC that have not yet been received.
Adjustments not reflected in income
Established through acquistions
Cash received from the FDIC
FDIC share of additional estimated losses
Adjustments reflected in income
(Amortization) accretion
Loan loss provision
9. Changes in Noncovered Other Real Estate Owned
The following table sets forth activity in noncovered OREO for the period:
Noncovered OREO:
Transfers in, net of write-downs ($18 and $108, respectively)
Total noncovered OREO, end of period
10. Goodwill and Intangible Assets
In accordance with the Intangibles – Goodwill and Other topic of the FASB ASC, goodwill is not amortized but is reviewed for potential impairment at the reporting unit level during the third quarter on an annual basis and between annual tests in certain circumstances such as material adverse changes in legal, business, regulatory and economic factors. An impairment loss is recorded to the extent that the carrying amount of goodwill exceeds its implied fair value. The Company completed its annual goodwill impairment test during the third quarter of 2010 and determined the fair value of the Company’s single reporting unit exceeded its carrying value.
The core deposit intangible (“CDI”) is evaluated for impairment if events and circumstances indicate a possible impairment. The CDI is amortized on an accelerated basis over an estimated life of approximately 10 years.
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The following table sets forth activity for goodwill and intangible assets for the period:
Total goodwill, beginning of period
Total goodwill, end of period
Gross core deposit intangible balance, beginning of period
Accumulated amortization, beginning of period
Core deposit intangible, net, beginning of period
CDI current period amortization
Total core deposit intangible, end of period
Total goodwill and intangible assets, end of period
The following table provides the estimated future amortization expense of core deposit intangibles for the remaining six months ending December 31, 2011 and the succeeding four years:
Year ending December 31,
2011
2012
2013
2014
2015
11. Shareholders’ Equity
Common Stock. On February 3, 2011, the Company declared a quarterly cash dividend of $0.03 per share, payable on March 3, 2011 to shareholders of record as of the close of business on February 17, 2011. On April 27, 2011 the Company declared a quarterly cash dividend of $0.05 per share, payable on May 25, 2011 to shareholders of record at the close of business May 11, 2011. The payment of cash dividends is subject to Federal regulatory requirements for capital levels and other restrictions. In addition, the cash dividends paid by Columbia Bank to the Company are subject to both Federal and State regulatory requirements. Subsequent to quarter end, on July 28, 2011 the Company declared a quarterly cash dividend of $0.06 per share, payable on August 24, 2011 to shareholders of record at the close of business August 10, 2011.
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12. Comprehensive Income
The components of comprehensive income are as follows:
Net income as reported
Unrealized gain from securities:
Net unrealized holding gain from available for sale securities arising during the period, net of tax of ($3,641) and ($1,907)
Reclassification adjustment of net gain from sale of available for sale securities included in income, net of tax of $0 and $0
Net unrealized gain from securities, net of reclassification adjustment
Cash flow hedging instruments:
Reclassification adjustment of net gain included in income, net of tax of $0 and $137
Pension plan liability adjustment:
Net unrealized gain from unfunded defined benefit plan liability arising during the period, net of tax of $0 and $0
Less: amortization of unrecognized net actuarial loss included in net periodic pension cost, net of tax of ($8) and $(4)
Pension plan liability adjustment, net
Total comprehensive income
Net unrealized holding gain from available for sale securities arising during the period, net of tax of ($4,925) and ($3,943)
Reclassification adjustment of net gain from sale of available for sale securities included in income, net of tax of $0 and $20
Reclassification adjustment of net gain included in income, net of tax of $79 and $401
Net unrealized gain from unfunded defined benefit plan liability arising during the period, net of tax of $154 and $(12)
Less: amortization of unrecognized net actuarial loss included in net periodic pension cost, net of tax of $(16) and $(8)
13. Fair Value Accounting and Measurement
The Fair Value Measurements and Disclosures topic of the FASB ASC defines fair value, establishes a consistent framework for measuring fair value and expands disclosure requirements about fair value. We hold fixed and variable rate interest-bearing securities, investments in marketable equity securities and certain other financial instruments, which are carried at fair value. Fair value is determined based upon quoted prices when available or through the use of alternative approaches, such as matrix or model pricing, when market quotes are not readily accessible or available.
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The valuation techniques are based upon observable and unobservable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect our own market assumptions. These two types of inputs create the following fair value hierarchy:
Level 1 – Quoted prices for identical instruments in active markets that are accessible at the measurement date.
Level 2 – Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model derived valuations whose inputs are observable or whose significant value drivers are observable.
Level 3 – Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable.
Fair values are determined as follows:
Securities at fair value are priced using matrix pricing based on the securities’ relationship to other benchmark quoted prices, and under the provisions of the Fair Value Measurements and Disclosures topic of the FASB ASC are considered a Level 2 input method.
Interest rate contract positions are valued in models, which use as their basis, readily observable market parameters and are classified within level 2 of the valuation hierarchy.
The following table sets forth the Company’s financial assets and liabilities that were accounted for at fair value on a recurring basis at June 30, 2011 by level within the fair value hierarchy. Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement:
U.S. government agency
U.S. government agency and sponsored enterprise mortgage-back securities and collateralized mortgage obligations
State and municipal debt securities
Total securities available for sale
Other assets (Interest rate contracts)
Other liabilities (Interest rate contracts)
Certain assets and liabilities are measured at fair value on a nonrecurring basis after initial recognition such as loans measured for impairment and OREO. The following methods were used to estimate the fair value of each such class of financial instrument:
Impaired loans—A loan is considered to be impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due (both interest and principal) according to the contractual terms of the loan agreement. Impaired loans are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, a loan’s observable market price, or the fair market value of the collateral if the loan is collateral-dependent loan. Generally, the Company utilizes the fair market value of the collateral to measure impairment.
Other real estate owned—OREO is real property that the Bank has taken ownership of in partial or full satisfaction of a loan or loans. OREO is recorded at the lower of the carrying amount of the loan or fair value less estimated costs to sell. This amount becomes the property’s new basis. Any write-downs based on the property fair value less estimated cost to sell at the date of acquisition are charged to the allowance for loan and lease losses. Management periodically reviews OREO in an effort to ensure the property is carried at the lower of its new basis or fair value, net of estimated costs to sell. Any write-downs subsequent to acquisition are charged to earnings.
The following table presents information about the Company’s assets measured at fair value on a nonrecurring basis for which a nonrecurring change in fair value has been recorded during the reporting period. The amounts disclosed below represent the fair values at the time the nonrecurring fair value measurements were made and not necessarily the fair value at the reporting date.
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Impaired loans
Non-covered OREO
The losses on impaired loans disclosed above represent the amount of the specific reserve and/or charge-offs during the period applicable to loans held at period end. The amount of the specific reserve is included in the allowance for loan and lease losses. The losses on non-covered OREO disclosed above represent the writedowns taken at foreclosure that were charged to the allowance for loan and lease losses, as well as subsequent writedowns from updated appraisals that were charged to earnings.
14. Fair Value of Financial Instruments
Because broadly traded markets do not exist for most of the Company’s financial instruments, the fair value calculations attempt to incorporate the effect of current market conditions at a specific time. These determinations are subjective in nature, involve uncertainties and matters of significant judgment and do not include tax ramifications; therefore, the results cannot be determined with precision, substantiated by comparison to independent markets and may not be realized in an actual sale or immediate settlement of the instruments. There may be inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results. For all of these reasons, the aggregation of the fair value calculations presented herein do not represent, and should not be construed to represent, the underlying value of the Company.
The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:
Cash and due from banks and interest-earning deposits with banks—The fair value of financial instruments that are short-term or reprice frequently and that have little or no risk are considered to have a fair value that approximates carrying value.
Securities available for sale—Securities at fair value are priced using matrix pricing based on the securities’ relationship to other benchmark quoted prices.
Federal Home Loan Bank stock—The fair value is based upon the par value of the stock which equates to its carrying value.
Loans—Loans are not recorded at fair value on a recurring basis. Nonrecurring fair value adjustments are periodically recorded on impaired loans that are measured for impairment based on the fair value of collateral. For most performing loans, fair value is estimated using expected duration and lending rates that would have been offered on June 30, 2011 for loans which mirror the attributes of the loans with similar rate structures and average maturities. Commercial loans and construction loans, which are variable rate and short-term are reflected with fair values equal to carrying value. The fair values resulting from these calculations are reduced by an amount representing the change in estimated fair value attributable to changes in borrowers’ credit quality since the loans were originated. For nonperforming loans, fair value is estimated by applying a valuation discount based upon loan sales data from the FDIC.
FDIC loss-sharing asset —The FDIC loss-sharing asset is considered to have a fair value that approximates carrying value.
Interest rate contracts—Interest rate swap positions are valued in models, which use as their basis, readily observable market parameters.
Deposits—For deposits with no contractual maturity, the fair value is equal to the carrying value. The fair value of fixed maturity deposits is based on discounted cash flows using the difference between the deposit rate and current market rates for deposits of similar remaining maturities.
FHLB and FRB borrowings—The fair value of Federal Home Loan Bank of Seattle (the “FHLB”) advances and Federal Reserve Bank of San Francisco (the “FRB”) borrowings are estimated based on discounting the future cash flows using the market rate currently offered.
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Repurchase Agreements—The fair value of securities sold under agreement to repurchase are estimated based on discounting the future cash flows using the market rate currently offered.
Long-term subordinated debt—The fair value of long-term subordinated debt are estimated based on discounting the future cash flows using an estimated market rate.
Other Financial Instruments—The majority of our commitments to extend credit and standby letters of credit carry current market interest rates if converted to loans, as such, carrying value is assumed to equal fair value.
The following table summarizes carrying amounts and estimated fair values of selected financial instruments as well as assumptions used by the Company in estimating fair value:
FHLB stock
FDIC loss-sharing asset
FHLB Advances
Repurchase agreements
15. Derivatives and Hedging Activities
The Company periodically enters into certain commercial loan interest rate swap agreements in order to provide commercial loan customers the ability to convert from variable to fixed interest rates. Under these agreements, the Company enters into a variable-rate loan agreement with a customer in addition to a swap agreement. This swap agreement effectively converts the customer’s variable rate loan into a fixed rate. The Company then enters into a corresponding swap agreement with a third party in order to offset its exposure on the variable and fixed components of the customer agreement. As the interest rate swap agreements with the customers and third parties are not designated as hedges under the Derivatives and Hedging topic of the FASB ASC, the instruments are marked to market in earnings.
The following table presents the fair value of derivative instruments at June 30, 2011 and 2010:
Derivatives not designated as hedging instruments
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16. Subsequent Events
On July 7, 2011, the Company redeemed the junior subordinated debentures and terminated Town Center Bancorp Trust I with a cash payment of $3.1 million consisting of principal, interest and fees. On July 29, 2011, The Company redeemed the junior subordinated debentures and terminated Columbia (WA) Statutory Trust I with a cash payment of $22.9 million consisting of principal, interest and fees.
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This discussion should be read in conjunction with the unaudited consolidated condensed financial statements of Columbia Banking System, Inc. (referred to in this report as “we”, “our”, and “the Company”) and notes thereto presented elsewhere in this report and with the December 31, 2010 audited consolidated financial statements and its accompanying notes included in our Annual Report on Form 10-K. 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.
CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
This quarterly report on Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include, but are not limited to, statements about our plans, objectives, expectations and intentions that are not historical facts, and other statements identified by words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “should,” “projects,” “seeks,” “estimates” or words of similar meaning. These forward-looking statements are based on current beliefs and expectations of management and are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control. In addition, these forward-looking statements are subject to assumptions with respect to future business strategies and decisions that are subject to change. In addition to the factors set forth in the sections “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this report, the following factors, among others, could cause actual results to differ materially from the anticipated results:
local and national economic conditions could be less favorable than expected or could have a more direct and pronounced effect on us than expected and adversely affect our ability to continue internal growth at historical rates and maintain the quality of our earning assets;
the local housing/real estate market could continue to decline;
the risks presented by a continued challenging economy, which could adversely affect credit quality, collateral values, including real estate collateral, investment values, liquidity and loan originations and loan portfolio delinquency rates;
the effects of the U.S. government’s management of the federal budget and debt crises;
the efficiencies and enhanced financial and operating performance we expect to realize from investments in personnel, acquisitions and infrastructure could not be realized;
interest rate changes could significantly reduce net interest income and negatively affect funding sources;
projected business increases following strategic expansion or opening of new branches could be lower than expected;
the scope and cost of FDIC insurance and other coverages could increase;
changes in accounting principles, policies, and guidelines applicable to bank holding companies and banking could increase costs or adversely affect our financial results;
competition among financial institutions could increase significantly;
the goodwill we have recorded in connection with acquisitions could become impaired, which may have an adverse impact on our earnings and capital;
we may not be able to effectively manage credit risk, interest rate risk, market risk, operational risk, legal risk, liquidity risk and regulatory and compliance risk; and
our profitability measures could be adversely affected if we are unable to effectively deploy the capital we raised in 2010.
Please take into account that forward-looking statements speak only as of the date of this report. We do not undertake any obligation to publicly correct or update any forward-looking statement whether as a result of new information, future events or otherwise.
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CRITICAL ACCOUNTING POLICIES
Management has identified the accounting policies related to the allowance for loan and lease losses, business combinations, acquired impaired loans, FDIC loss sharing asset and the valuation and recoverability of goodwill as critical to an understanding of our financial statements. These policies and related estimates are discussed in “Item 7. Management Discussion and Analysis of Financial Condition and Results of Operation” under the headings “Allowance for Loan and Lease Losses”, “Business Combinations”, “Acquired Impaired Loans”, FDIC Loss Sharing Asset” and “Valuation and Recoverability of Goodwill” in our 2010 Annual Report on Form 10-K. There have not been any material changes in our critical accounting policies as compared to those disclosed in our 2010 Annual Report on Form 10-K.
Earnings Summary
The Company reported net income for the second quarter of $8.6 million applicable to common shareholders or $0.22 per diluted common share, compared to $3.9 million or $0.11 per diluted common share for the second quarter of 2010. The increase in net income from the prior year period was attributable to an increase in net interest income, as well as a reduction in the provision for loan losses, partially offset by a decline in noninterest income and an increase in noninterest expense. Return on average assets and return on average common equity were 0.80% and 4.81%, respectively, for the second quarter of 2011, compared with returns of 0.47% and 2.59%, respectively for the same period of 2010.
The Company reported net income for the first six months of $14.4 million applicable to common shareholders or $0.36 per diluted common share, compared to $10.8 million or $0.34 per diluted common share for the first six months of 2010. The increase in net income from the prior year period was attributable to an increase in net interest income, as well as a reduction in the provision for loan losses, partially offset by a decline in noninterest income and an increase in noninterest expense. Return on average assets and return on average common equity were 0.68% and 4.07%, respectively, for the first six months of 2011, compared with returns of 0.63% and 4.03%, respectively for the same period of 2010.
Revenue (net interest income plus noninterest income) for the three months ended June 30, 2011 was $52.9 million, 2% less than the same period in 2010. The decrease was primarily a result of the $6.4 million change in the FDIC loss sharing asset during the second quarter of 2011. The noninterest income decline was partially offset by an increase in net interest income as a result of recording incremental accretion income of $8.9 million on the acquired loan portfolios. The incremental accretion income represents the amount of income recorded on the acquired loans above the contractual rate stated in the individual loan notes.
Revenue (net interest income plus noninterest income) for the six months ended June 30, 2011 was $97.9 million, 12% less than the same period in 2010. The decrease was primarily a result of a decline in noninterest income due to the gain recorded on the acquisition of American Marine Bank during the first quarter of 2010, as well as the $21.2 million change in the FDIC loss sharing asset. The noninterest income decline was partially offset by an increase in net interest income as a result of recording incremental accretion income of $21.3 million on the acquired loan portfolios. The incremental accretion income represents the amount of income recorded on the acquired loans above the contractual rate stated in the individual loan notes.
Total noninterest expense for the quarter ended June 30, 2011 was $37.2 million, a 7% increase from the second quarter of 2010. The increase was primarily due to the additional operating expenses of the two FDIC assisted acquisitions during the second quarter of 2011.
Total noninterest expense for the six months ended June 30, 2011 was $74.5 million, a 9% increase from the same period in 2010. The increase was primarily due to the additional operating expenses of the two FDIC assisted acquisitions during the second quarter of 2011, as well as establishing a clawback liability for the FDIC loss-sharing agreements.
The Company acquired the banking operations of Burlington, Washington-based Summit Bank in a purchase and assumption agreement with the FDIC on May 20, 2011. The Company acquired tangible assets with a fair value of $126.9 million, including $71.5 million of loans (net of acquisition accounting adjustments) and assumed $123.3 million in deposits. The operating results of the Company include the operating results produced by the acquired assets and assumed liabilities for the period May 21, 2011 to June 30, 2011.
The Company acquired the banking operations of Snohomish, Washington-based First Heritage Bank in a purchase and assumption agreement with the FDIC on May 27, 2011. The Company acquired tangible assets with a fair value of $157.7 million, including $81.9 million of loans (net of acquisition accounting adjustments) and assumed $159.5 million in deposits. The operating results of the Company include the operating results produced by the acquired assets and assumed liabilities for the period May 28, 2011 to June 30, 2011.
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The provision for loan and lease losses for the second quarter of 2011 was $2.2 million for the noncovered loan portfolio and 2.3 million for the covered loan portfolio compared with $13.5 million for the noncovered loan portfolio and $0 for the covered loan portfolio during second quarter of 2010. Net charge-offs for the current quarter were $3.4 million compared to $10.7 million for the second quarter of 2010. The provision for loans and lease losses for the first six months of 2011 was $2.2 million for the noncovered loan portfolio and $1.9 million for the covered loan portfolio compared with $28.5 million for the noncovered loan portfolio and $0 for the covered loan portfolio during the first six months of 2010. Net charge-offs for the first six months were $9.1 million compared to $22.2 million for the same period in 2010. As discussed in more detail elsewhere in this report, the provision decision is made quarterly, based on a detailed process to determine the adequacy and appropriateness of the Company’s allowance for loan losses. Accordingly, the level of provisioning in the second quarter of 2011 does not necessarily signal a trend. As a result of recording a noncovered loan provision of $2.2 million, the Company’s total allowance for loan and lease losses was 2.72% of net noncovered loans at June 30, 2011 compared to 3.18% at year-end 2010 and 3.07% at the end of the second quarter 2010. The reduction in the allowance for loan and lease losses to noncovered loans is due primarily to loan growth experienced throughout the second quarter of 2011 and improved asset quality. Net charge-offs for the current quarter were $3.4 million compared to $10.7 million for the second quarter of 2010.
RESULTS OF OPERATIONS
Our results of operations are dependent to a large degree on our net interest income. We also generate noninterest income through service charges and fees, merchant services fees, and bank owned life insurance. Our operating expenses consist primarily of compensation and employee benefits, occupancy, merchant card processing, data processing and legal and professional fees. Like most financial institutions, our 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.
Net interest income for the second quarter of 2011 was $49.4 million, an increase of 21% from $40.7 million for the same quarter in 2010. The Company’s net interest margin increased to 5.49% in the second quarter of 2011, from 4.66% for the same quarter last year. The increases in net interest income and margin were primarily due to the impact of income accretion on the acquired loan portfolios. The incremental accretion income represents the amount of income recorded on the acquired loans above the contractual rate stated in the individual loan notes. The additional income stems from the discount established at the time these loan portfolios were acquired, and increases net interest income and the net interest margin. The incremental accretion income had a positive impact of approximately 0.96% on the second quarter’s net interest margin. For the same period last year, the incremental accretion income had a positive impact of approximately 0.07% on the net interest margin.
The following table sets forth the average balances of all major categories of interest-earning assets and interest-bearing liabilities, the total dollar amounts of interest income on interest-earning assets and interest expense on interest-bearing liabilities, the average yield earned on interest-earning assets and average rate paid on interest-bearing liabilities by category and in total net interest income and net interest margin.
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ASSETS
Loans, net (1) (2)
Tax exempt securities(2)
Total interest-earning assets
Other earning assets
Noninterest-earning assets
Total assets
LIABILITIES AND SHAREHOLDERS’ EQUITY
Certificates of deposit
Savings accounts
Interest-bearing demand
Money market accounts
Total interest-bearing deposits
Federal Home Loan Bank and Federal Reserve Bank borrowings
Total interest-bearing liabilities
Noninterest-bearing deposits
Other noninterest-bearing liabilities
Shareholders’ equity
Total liabilities & shareholders’ equity
Net interest income (2)
Net interest margin
Net interest income for the first six months of 2011 was $99.8 million, an increase of 26% from $79.0 million for the same period in 2010. The Company’s net interest margin increased to 5.64% in the first six months of 2011, from 4.72% for the same period last year. The increases in net interest income and margin were primarily due to the impact of income accretion on the acquired loan portfolios.
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The following tables set forth the total dollar amount of change in interest income and interest expense. The changes have been segregated for each major category of interest-earning assets and interest-bearing liabilities into amounts attributable to changes in volume, changes in rates and changes in rates multiplied by volume. Changes attributable to the combined effect of volume and interest rates have been allocated proportionately to the changes due to volume and the changes due to interest rates:
Interest earning assets
Loans (1)(2)
Tax exempt securities (2)
Interest earning deposits with banks and federal funds sold
Interest income (2)
Interest bearing liabilities
Total interest on deposits
FHLB and Federal Reserve Bank borrowings
Interest expense
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Loans (1)
Other borrowings and interest bearing liabilities
Provision for Loan and Lease Losses
During the second quarter of 2011, the Company recorded a $2.2 million provision for loan and lease losses on noncovered loans, compared to $13.5 million for the same period in 2010. The amount of provision was calculated in accordance with the Company’s methodology for determining the ALLL, discussed in Note 6 to the Company’s consolidated condensed financial statements presented elsewhere in this report, and was based upon improving credit metrics in the noncovered loan portfolio in conjunction with modest growth of the portfolio. The Company’s total allowance for loan losses was 2.72% of noncovered loans at June 30, 2011 compared to 3.18% and 3.07% of noncovered loans at December 31, 2010 and June 30, 2010 respectively. For the covered loan portfolio, the Company recorded a provision for loan losses of $2.3 million for the quarter ended June 30, 2011.
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Noninterest Income
Noninterest income was $3.5 million for the second quarter of 2011, compared to income of $13.2 million for the prior-year period. The decrease was primarily due to the $6.4 million change in the FDIC loss sharing asset recorded as a reduction in income during the current quarter. During the same period in 2010, noninterest income was impacted favorably due to a $3.4 million change in the FDIC loss sharing asset recorded as an increase in income. The change in the FDIC loss sharing asset in the current period recognizes the decreased amount that Columbia expects to collect from the FDIC under the terms of its loss sharing agreements due to loan prepayments and removals activity during the quarter.
Total noninterest expense for the second quarter of 2011 was $37.2 million, an increase of 7% from $34.7 million a year earlier. The increase is primarily within compensation and benefits expense and is generally attributed to the May 2011 Summit Bank and First Heritage Bank FDIC-assisted transactions as well as the late 2010 addition of three new banking teams and a new team hired in early 2011. Also contributing to the increase in noninterest expense was the Company recording an additional $448 thousand to its clawback liability and increased net OREO expense. The Company’s Purchase & Assumption agreement with the FDIC requires the Company to reimburse the FDIC at the conclusion of the loss share agreement period, February 2020 for the Columbia River Bank and American Marine Bank transactions, a calculated amount if total losses on the acquired loan portfolios fail to reach a minimum threshold level. The $448 thousand liability recorded in the second quarter increased the accrual to $2.1 million, which represents the net present value of management’s clawback liability estimate of $3.3 million. The clawback liability is evaluated at the individual portfolio level each quarter and adjusted upward or downward according to the total expected losses over the loss share period. Net OREO expense for the second quarter 2011 was $214 thousand, an increase of $886 thousand over the net OREO recovery of $672 thousand for the second quarter 2010.
The following table presents the significant components of noninterest expense and the related dollar and percentage change from period to period:
Compensation
Employee benefits
Contract labor
All other noninterest expense:
Legal and professional services
Taxes, license and fees
FDIC clawback expenses
Total all other noninterest expense
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The following table presents selected items included in other noninterest expense and the associated change from period to period:
Postage
Software support & maintenance
Supplies
Insurance
ATM Network
Travel
Employee expenses
Sponsorships and charitable contributions
Directors fees
Federal Reserve Bank processing fees
CRA partnership investment expense
Investor relations
Miscellaneous
Total other noninterest expense
In managing our business, we review the efficiency ratio, on a fully taxable-equivalent basis. Our efficiency ratio (noninterest expense, excluding net cost of operation of other real estate and FDIC clawback liability expense, divided by the sum of net interest income and noninterest income on a tax equivalent basis, excluding any gain/loss on sale of investment securities, gain on bank acquisition, incremental accretion income on the acquired loan portfolio and the change in the FDIC indemnification asset) was 69.49% compared to 68.15% for the second quarter 2010.
Income Taxes
We recorded an income tax provision of $2.7 million for the second quarter of 2011, compared to expense of $668 thousand for the same period in 2010. Our effective tax rate remains lower than the statutory tax rate due to our nontaxable income generated from tax-exempt loans and municipal bonds, investments in bank owned life insurance, and low income housing credits. For additional information, please refer to the Company’s annual report on Form 10-K for the year ended December 31, 2010.
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BUSINESS COMBINATIONS
On May 20, 2011 the Company acquired certain assets and assumed certain liabilities of Summit Bank from the FDIC in an FDIC-assisted transaction. A summary of the fair value of assets acquired and liabilities assumed from the FDIC is as follows:
On May 27, 2011 the Company acquired certain assets and assumed certain liabilities of First Heritage Bank from the FDIC in an FDIC-assisted transaction. A summary of the fair value of assets acquired and liabilities assumed from the FDIC is as follows:
For complete discussion and disclosures see footnote 4 in the condensed consolidated financial statements included in Part 1, Item 1 of this report.
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FINANCIAL CONDITION
Total assets increased $172.8 million, or 4.1%, to $4.43 billion as of June 30, 2011, compared to $4.26 billion as of December 31, 2010. The increase in total assets was primarily due to the FDIC-assisted acquisitions completed in the second quarter as disclosed in footnote 4 of the unaudited consolidated condensed financial statements.
Investment Securities
At June 30, 2011, the Company held investment securities totaling $989.8 million compared to $763.9 million at December 31, 2010. All of our securities are classified as available for sale and carried at fair value. The increase in the investment securities portfolio from year-end is due to the Company actively investing funds with a focus on short-term, high quality debt instruments with a very high degree of certainty to their cash flows, with maturities laddered over a period of twelve to thirty-six months. These securities are used by the Company as a component of its balance sheet management strategies. From time to time securities may be sold to reposition the portfolio in response to strategies developed by the Company’s asset liability committee. In accordance with our investment strategy, management monitors market conditions with a view to realize gains on its available for sale securities portfolio when prudent.
At June 30, 2011, the market value of securities available for sale had an unrealized gain, net of tax, of $21.5 million compared to an unrealized gain, net of tax, of $12.7 million at December 31, 2010. The change in market value of securities available for sale is due primarily to fluctuations in interest rates subsequent to purchase. The Company does not consider these investment securities to be other than temporarily impaired. In the future, if the impairment is judged to be other than temporary, the cost basis of the individual impaired securities will be written down to fair value; the amount of the write-down could be included in earnings as a realized loss.
The following table sets forth our securities portfolio by type for the dates indicated:
Securities Available for Sale
Credit Risk Management
The extension of credit in the form of loans or other credit products to individuals and businesses is one of our principal business activities. Our policies and applicable laws and regulations require risk analysis as well as ongoing portfolio and credit management. We manage our credit risk through lending limit constraints, credit review, approval policies, and extensive, ongoing internal monitoring. We also manage credit risk through diversification of the loan portfolio by type of loan, type of industry, type of borrower and by limiting the aggregation of debt limits to a single borrower. The monitoring process for our loan portfolio includes periodic reviews of individual loans with risk ratings assigned to each loan. We review 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, if warranted, placed on nonaccrual status even though the loan may be current as to principal and interest payments. Additionally, we review these types of loans for impairment in accordance with the Receivables topic of the FASB ASC. Impaired loans are considered for nonaccrual status and will typically remain as such until all principal and interest payments are brought current and the prospects for future payments in accordance with the loan agreement appear relatively certain.
Loan policies, credit quality criteria, loan portfolio guidelines and other credit approval processes are established under the guidance of our Chief Credit Officer and approved, as appropriate, by the Board. The Company’s Credit Administration
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department and loan committee have the responsibility for administering the credit approval process. As another part of its control process, we use an independent internal credit review and examination function to provide assurance that loans and commitments are made and maintained as prescribed by our credit policies. This includes a review of documentation when the loan is initially extended and subsequent monitoring to assess continued performance and proper risk assessment.
Loan Portfolio Analysis
We are a full service commercial bank, originating a wide variety of loans, but concentrating our lending efforts on originating commercial business and commercial real estate loans.
The following table sets forth the Company’s loan portfolio by type of loan for the dates indicated:
Real estate:
Subtotal
Less: Deferred loan fees
Noncovered loans, net
Covered loans, net of allowance of ($7,948) and ($6,055), respectively
Loans Held for Sale
Total noncovered loans increased $71.7 million, or 4%, from year-end 2010. However, moderate economic growth and limited loan demand may limit overall average loan growth. The noncovered loan portfolio continues to be diversified, with the intent to mitigate risk by minimizing concentration in any one segment.
Commercial Loans: We are committed to providing competitive commercial lending in our primary market areas. Management expects a continued focus within its commercial lending products and to emphasize, in particular, relationship banking with businesses, and business owners.
Real Estate Loans: These loans are used to collateralize outstanding advances from the FHLB. Those residential loans are secured by properties located within our primary market areas, and typically have loan-to-value ratios of 80% or lower.
Generally, commercial and five-or-more family residential real estate loans are made to borrowers who have existing banking relationships with us. Our underwriting standards generally require that the loan-to-value ratio for these 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. We endeavor to maintain the highest practical underwriting standards while balancing the need to remain competitive in our lending practices.
Real Estate Construction Loans: We originate 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 to provide financing to builders for the construction of pre-sold homes and speculative residential construction. Underwriting guidelines for these loans vary by loan type but include loan-to-value limits, term limits and loan advance limits, as applicable.
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Our underwriting guidelines for commercial and five-or-more family residential real estate construction loans generally require that the loan-to-value ratio not exceed 75% and stabilized debt coverage ratios (net operating income divided by annual debt servicing) of 1.2 or better. As noted above, underwriting standards can be influenced by competition and other factors. However, we endeavor to maintain the highest practical underwriting standards while balancing the need to remain competitive in our lending practices.
Consumer Loans: Consumer loans include automobile loans, boat and recreational vehicle financing, home equity and home improvement loans and miscellaneous personal loans.
Foreign Loans: Our banking subsidiaries are not involved with loans to foreign companies or foreign countries.
Nonperforming Assets
Nonperforming assets consist of: (i) nonaccrual loans; (ii) in most cases 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) other real estate owned; and (iv) other personal property owned. Collectively, nonaccrual and restructured loans are considered nonperforming loans.
Nonaccrual noncovered 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, which occurs when there are serious doubts about the collectability of principal or interest. Generally our policy is to discontinue the accrual of interest on all loans past due 90 days or more and place them on nonaccrual status. When a noncovered loan is placed on nonaccrual status, any accrued but unpaid interest on that date is removed from interest income.
Covered loans: We consider covered loans to be performing due to the application of the yield accretion method under ASC Topic 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality. Topic 310-30 allows us to aggregate credit-impaired loans acquired in the same fiscal quarter into one or more pools, provided the loans have common risk characteristics. A pool is then accounted for as a single asset with a single composite interest rate and an aggregate expectation of cash flows. The covered loans acquired are and will continue to be subject to the Company’s internal and external credit review and monitoring. Any credit deterioration experienced subsequent to the initial acquisition will result in a provision for loan losses being charged to earnings. These provisions will be mostly offset by an increase to the FDIC loss sharing asset and will be recognized in noninterest income.
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The following tables set forth, at the dates indicated, information with respect to our nonaccrual loans, restructured loans, total nonperforming loans and total nonperforming assets:
Nonperforming assets, excluding covered assets
Nonaccrual loans:
Commercial and five or more family residential real estate
Total nonaccrual loans
Restructured loans:
One-to-four family residential construction
Total restructured loans
Total nonperforming loans
Other real estate owned and other personal property owned
Total nonperforming assets, excluding covered assets
As of June 30, 2011, nonperforming noncovered assets were $103.2 million, compared to $126.7 million at December 31, 2010. The percent of nonperforming, noncovered assets to period-end noncovered assets at June 30, 2011 was 2.72% compared to 3.40% for December 31, 2010. For additional discussion and disclosure see Note 7 to the Company’s Consolidated Financial Statements presented elsewhere in this report.
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Allowance for Loan and Lease Losses
On a quarterly basis our Chief Credit Officer reviews with Executive Management and the Board of Directors the various additional factors that management considers when determining the adequacy of the ALLL, including economic and business condition reviews. Factors which influenced management’s judgment in determining the amount of the additions to the ALLL charged to operating expense include the following as of the applicable balance sheet dates:
The ALLL is increased by provisions for loan and lease losses (“provision”) charged to expense, and is reduced by loans charged off, net of recoveries. While we believe the best information available is used by us to determine the ALLL, changes in market conditions could result in adjustments to the ALLL, affecting net income, if circumstances differ from the assumptions used in determining the ALLL.
In addition to the ALLL, we maintain an allowance for unfunded commitments and letters of credit. We report this allowance as a liability on our Consolidated Balance Sheet. We determine this amount using estimates of the probability of the ultimate funding and losses related to those credit exposures. This methodology is similar to the methodology we use for determining the adequacy of our ALLL. For additional information on our allowance for unfunded commitments and letters of credit, see Note 6 to the Consolidated Condensed Financial Statements presented elsewhere in this report.
At June 30, 2011, our allowance for loan and lease losses for noncovered loans was $54.1 million, or 2.72% of total noncovered loans (excluding loans held for sale) and 82% of nonperforming, noncovered loans. This compares with an allowance of $61.0 million, or 3.18% of the total loan portfolio (excluding loans held for sale), 64% of nonperforming loans at December 31, 2010.
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The following table provides an analysis of the Company’s allowance for loan and lease losses for noncovered loans at the dates and the periods indicated:
Charge-offs:
Commercial and five-or-more family residential
Commercial and five-or-more family residential construction
Total charge-offs
Total recoveries
Net charge-offs
Total loans, net at end of period, excluding covered loans and loans held for sale (1)
Allowance for loan and lease losses to period-end loans, excluding covered loans
Allowance for unfunded commitments and letters of credit
Liquidity and Sources of Funds
Our primary sources of funds are customer deposits. Additionally, we utilize advances from the FHLB of Seattle, the FRB of San Francisco, and wholesale repurchase agreements to supplement our funding needs. 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
Our deposit products include a wide variety of transaction accounts, savings accounts and time deposit accounts. Core deposits (demand deposit, savings, money market accounts and certificates of deposit less than $100,000) increased $144.5 million, or approximately 5%, since year-end 2010 while certificates of deposit greater than $100,000 increased slightly to $282.8 million from year-end 2010.
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We have established a branch system to serve our consumer and business depositors. In addition, management’s strategy for funding asset growth is to make use of brokered and other wholesale deposits on an as-needed basis. At June 30, 2011 brokered and other wholesale deposits (excluding public deposits) totaled $48.9 million, or 1% of total deposits, compared to $61.5 million, or 2% of total deposits, at year-end 2010. The brokered deposits have varied maturities.
The following table sets forth the Company’s deposit base by type of product for the dates indicated:
Core deposits:
Demand and other non-interest bearing
Interest bearing demand
Money market
Savings
Certificates of deposit less than $100,000
Total core deposits
Certificates of deposit greater than $100,000
Certificates of deposit insured by CDARS®
Wholesale certificates of deposit
Premium resulting from acquisition date fair value adjustment
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Borrowings
We rely on FHLB advances and FRB borrowings as another source of both short and long-term funding. FHLB advances and FRB borrowings are secured by bonds within our investment portfolio, one-to-four family real estate mortgages, and other loans. At June 30, 2011, we had FHLB advances of $120.2 million, before acquisition date fair value adjustments, compared to $119.4 million at December 31, 2010. The slight increase in FHLB advances was primarily due to the borrowings assumed from the Summit and First Heritage acquisitions.
We also utilize wholesale repurchase agreements as a supplement to our funding sources. Our wholesale repurchase agreements are secured by mortgage-backed securities. At June 30, 2011 and December 31, 2010 we had repurchase agreements of $25.0 million. Management anticipates we will continue to rely on FHLB advances, FRB borrowings, and wholesale repurchase agreements in the future and we will use those funds primarily to make loans and purchase securities.
During 2001, the Company, through a special purpose trust (“the Trust”) participated in a pooled trust preferred offering, whereby the Trust issued $22.0 million of 30-year floating rate capital securities. The capital securities constitute guaranteed preferred beneficial interests in debentures issued by the Trust. The debentures had an initial rate of 7.29% and a rate of 3.85% at June 30, 2011. The floating rate is based on the 3-month LIBOR plus 3.58% and is adjusted quarterly. Through the Trust, we may call the debentures at any time for a premium and after ten years at par, allowing us to retire the debt early if market conditions are favorable. Through the 2007 Town Center Bancorp acquisition, the Company assumed an additional $3.0 million in floating rate trust preferred obligations; these debentures had a rate of 4.03% at June 30, 2011. The floating rate is based on the 3-month LIBOR plus 3.75% and is adjusted quarterly.
The trust preferred obligations are classified as long-term subordinated debt and our related investment in the Trust is recorded in other assets on the consolidated balance sheets. The balance of the long-term subordinated debt was $25.8 million and $25.7 million at June 30, 2011 and December 31, 2010, respectively. The subordinated debt payable to the Trust is on the same interest and payment terms as the trust preferred obligations issued by the Trust.
Subsequent to quarter-end, on July 7, 2011, we redeemed the junior subordinated debentures and terminated Town Center Bancorp Trust I with a cash payment of $3.1 million consisting of principal, interest and fees. On July 29, 2011, we redeemed the junior subordinated debentures and terminated Columbia (WA) Statutory Trust I with a cash payment of $22.9 million consisting of principal, interest and fees. The decision to redeem these debentures, which was subject to approval by the Federal Reserve Bank, was based upon an evaluation of the Company’s liquidity position and capital levels.
Contractual Obligations & Commitments
We are party to many contractual financial obligations, including repayment of borrowings, operating and equipment lease payments, commitments to extend credit and investments in affordable housing partnerships. At June 30, 2011, we had commitments to extend credit of $644.2 million compared to $612.0 million at December 31, 2010.
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Capital Resources
Shareholders’ equity at June 30, 2011 was $727.7 million, up from $706.9 million at December 31, 2010. Shareholders’ equity was 16.4% and 16.6% of total period-end assets at June 30, 2011 and December 31, 2010, 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 preferred stock, 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% to be considered “adequately capitalized”.
Federal Deposit Insurance Corporation regulations set forth the qualifications necessary for a bank to be classified as “well capitalized”, 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.
The Company and its subsidiaries qualify as “well-capitalized” at June 30, 2011 and December 31, 2010.
Total risk-based capital ratio
Tier 1 risk-based capital ratio
Leverage ratio
Stock Repurchase Program
In March 2002 the Board of Directors approved a common stock repurchase program whereby the Company may systematically repurchase up to 500,000 of its outstanding shares of common stock. The Company may 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. No shares were repurchased under this current stock repurchase program during the first six months of 2011, and as of June 30, 2011 we have repurchased 66,317 shares of common stock under the program.
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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, 2011, 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, 2010. For additional information, refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations” referenced in the Company’s 2010 Annual Report on Form 10-K.
Evaluation of Disclosure Controls and Procedures
An evaluation was carried out under the supervision and with the participation of the Company’s management, including the Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934). Based on that evaluation, the CEO and CFO have concluded that as of the end of the period covered by this report, our disclosure controls and procedures are effective in ensuring that the information required to be disclosed by us in the reports we file or submit under the Securities Exchange Act of 1934 is (i) accumulated and communicated to our management (including the CEO and CFO) to allow timely decisions regarding required disclosure, and (ii) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.
Changes in Internal Controls Over Financial Reporting
There was no change in our internal controls over financial reporting during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting.
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PART II - OTHER INFORMATION
The Company and its banking subsidiaries are parties to routine litigation arising in the ordinary course of business. Management believes that, based on the information currently known to them, any liabilities arising from such litigation will not have a material adverse impact on the Company’s financial condition, results of operations or cash flows.
Our business exposes us to certain risks. The following is a discussion of what we currently believe are the most significant risks and uncertainties that may affect our business, financial condition and future results.
A protracted economic recovery could adversely affect our future results of operations or market price of our stock.
The national economy and the financial services sector in particular continue to face significant challenges. We cannot accurately predict how quickly or strongly the economy will recover from the recent recession, which has adversely impacted the markets we serve. The U.S. economy has also experienced substantial volatility in the financial markets. Any further deterioration in the economies of the nation as a whole or in our markets would have an adverse effect, which could be material, on our business, financial condition, results of operations and prospects, and could also cause the market price of our stock to decline. While it is impossible to predict how long adverse economic conditions may exist, a slow or fragile recovery could continue to present risks for some time for the industry and our company.
Economic conditions in the market areas we serve may continue to adversely impact our earnings and could increase our credit risk associated with our loan portfolio and the value of our investment portfolio.
Substantially all of our loans are to businesses and individuals in Washington and Oregon, and a continuing decline in the economies of these market areas could have a material adverse effect on our business, financial condition, results of operations and prospects. There has been a decline in housing prices and unemployment is a continued concern in both Washington and Oregon. A further deterioration in the market areas we serve could result in the following consequences, any of which could have an adverse impact, which could be material, on our business, financial condition, results of operations and prospects:
commercial and consumer loan delinquencies may increase;
problem assets and foreclosures may increase;
collateral for loans made may decline further in value, in turn reducing customers’ borrowing power, reducing the value of assets and collateral associated with existing loans;
certain securities within our investment portfolio could become other than temporarily impaired, requiring a write-down through earnings to fair value, thereby reducing equity;
low cost or non-interest bearing deposits may decrease; and
demand for our loan and other products and services may decrease.
Our loan portfolio mix, which has a concentration of loans secured by real estate, could result in increased credit risk in a challenging economy.
Our loan portfolio is concentrated in commercial real estate and commercial business loans. These types of loans, as well as real estate construction loans and land development loans, acquisition and development loans related to the for-sale housing industry, generally are viewed as having more risk of default than residential real estate loans or certain other types of loans or investments. In fact, the FDIC has issued pronouncements alerting banks of its concern about heavy loan concentrations. Because our loan portfolio contains a significant number of construction, commercial business and commercial real estate loans with relatively large balances, the deterioration of one or a few of these loans may cause a significant increase in our non-performing loans. An increase in non-performing loans could result in a loss of earnings from these loans, an increase in the provision for loan losses, or an increase in loan charge-offs, which could have an adverse impact on our results of operations and financial condition.
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A further downturn in the economies or real estate values in the markets we serve could have a material adverse effect on both borrowers’ ability to repay their loans and the value of the real property securing such loans. Our ability to recover on defaulted loans would then be diminished, and we would be more likely to suffer losses on defaulted loans.
Our Allowance for Loan and Lease Losses (“ALLL”) may not be adequate to cover future loan losses, which could adversely affect earnings.
We maintain an ALLL in an amount that we believe is adequate to provide for losses inherent in our portfolio. While we strive to carefully monitor credit quality and to identify loans that may become non-performing, at any time there are loans in the portfolio that could result in losses, but that have not been identified as non-performing or potential problem loans. We cannot be sure that we will be able to identify deteriorating loans before they become non-performing assets, or that we will be able to limit losses on those loans that have been identified. Additionally, the process for determining the ALLL requires different, subjective and complex judgments about the future impact from current economic conditions that might impair the ability of borrowers to repay their loans. As a result, future significant increases to the ALLL may be necessary. Additionally, future increases to the ALLL may be required based on changes in the composition of the loans comprising the portfolio, deteriorating values in underlying collateral (most of which consists of real estate) and changes in the financial condition of borrowers, such as may result from changes in economic conditions, or as a result of actual future events differing from assumptions used by management in determining the ALLL. Additionally, banking regulators, as an integral part of their supervisory function, periodically review our ALLL. These regulatory agencies may require us to increase the ALLL which could have a negative effect on our financial condition and results of operation. Any increase in the ALLL would have an adverse effect, which could be material, on our financial condition and results of operations.
Nonperforming assets take significant time to resolve and adversely affect our results of operations and financial condition.
Our nonperforming assets adversely affect our net income in various ways. Until economic and market conditions improve to pre-recession levels, we expect to continue to incur additional losses relating to elevated levels of nonperforming loans. We do not record interest income on non-accrual loans, thereby adversely affecting our income, and increasing loan administration costs. When we receive collateral through foreclosures and similar proceedings, we are required to mark the related loan to the then fair market value of the collateral if the collateral less selling costs is lower than the carrying amount of the related loan, which may result in a loss. An increase in the level of nonperforming assets also increases our risk profile and may impact the capital levels our regulators believe is appropriate in light of such risks. We utilize various techniques such as loan sales, workouts, and restructurings to manage our problem assets. Decreases in the value of these problem assets, the underlying collateral, or in the borrowers’ performance or financial condition, could adversely affect our business, results of operations and financial condition. In addition, the resolution of nonperforming assets requires significant commitments of time from management and staff, which can be detrimental to performance of their other responsibilities. There can be no assurance that we will not experience further increases in nonperforming loans in the future.
Our acquisitions and the integration of acquired businesses may not result in all of the benefits anticipated, and future acquisitions may be dilutive to current shareholders.
We have in the past and may in the future seek to grow our business by acquiring other businesses. There can be no assurance that our acquisitions will have the anticipated positive results, including results relating to: correctly assessing the asset quality of the assets being acquired; the total cost of integration including management attention and resources; the time required to complete the integration successfully; the amount of longer-term cost savings; being able to profitably deploy funds acquired in an acquisition; or the overall performance of the combined entity.
We also may encounter difficulties in obtaining required regulatory approvals and unexpected contingent liabilities can arise from the businesses we acquire. Integration of an acquired business can be complex and costly, sometimes including combining relevant accounting and data processing systems and management controls, as well as managing relevant relationships with employees, clients, suppliers and other business partners. Integration efforts could divert management attention and resources, which could adversely affect our operations or results.
Given the continued market volatility and uncertainty, notwithstanding our loss-sharing arrangements with the FDIC, we may continue to experience increased credit costs or need to take additional markdowns and allowances for loan losses on the assets and loans acquired that could adversely affect our financial condition and results of operations in the
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future. We may also experience difficulties in complying with the technical requirements of our loss-sharing agreements with the FDIC, which could result in some assets which we acquire in FDIC-assisted transactions losing their coverage under such agreements. There is no assurance that as our integration efforts continue in connection with these transactions, other unanticipated costs, including the diversion of personnel, or losses, will not be incurred.
Acquisitions may also result in business disruptions that cause us to lose customers or cause customers to remove their accounts from us and move their business to competing financial institutions. It is possible that the integration process related to acquisitions could result in the disruption of our ongoing businesses or inconsistencies in standards, controls, procedures and policies that could adversely affect our ability to maintain relationships with clients, customers, depositors and employees. The loss of key employees in connection with an acquisition could adversely affect our ability to successfully conduct our business.
We may engage in future acquisitions involving the issuance of additional common stock and/or cash. Any such acquisitions and related issuances of stock may have a dilutive effect on earnings per share and the percentage ownership of current shareholders. The use of cash as consideration in any such acquisitions could impact our capital position and may require us to raise additional capital.
Furthermore, notwithstanding our recent acquisitions, we cannot provide any assurance as to the extent to which we can continue to grow through acquisitions as this will depend on the availability of prospective target opportunities at valuations we find attractive and the competition for such opportunities from other parties.
Our decisions regarding the fair value of assets acquired, including the FDIC loss-sharing assets, could be inaccurate which could materially and adversely affect our business, financial condition, results of operations, and future prospects.
Management makes various assumptions and judgments about the collectability of the acquired loans, including the creditworthiness of borrowers and the value of the real estate and other assets serving as collateral for the repayment of secured loans. In FDIC-assisted acquisitions that include loss-sharing agreements, we may record a loss-sharing asset that we consider adequate to absorb the indemnified portion of future losses which may occur in the acquired loan portfolio. The FDIC loss-sharing asset is accounted for on the same basis as the related acquired loans and OREO and primarily represents the present value of the cash flows the Company expects to collect from the FDIC under the loss-sharing agreements.
If our assumptions are incorrect, significant earnings volatility can occur and the balance of the FDIC loss-sharing asset may at any time be insufficient to cover future loan losses, and credit loss provisions may be needed to respond to different economic conditions or adverse developments in the acquired loan portfolio. Any increase in future loan losses could have a material adverse effect on our operating results.
Our profitability measures could be adversely affected if we are unable to effectively deploy the capital we raised in 2010.
We may use the net proceeds of our capital raise completed in May 2010 for selective acquisitions that meet our disciplined acquisition criteria, to fund internal growth, or for general corporate purposes. Although we are periodically engaged in discussions with potential acquisition candidates, we are not currently a party to any purchase or merger agreement. There can be no assurance that we will be able to negotiate future acquisitions on terms acceptable to us. Investing the proceeds of our recent offering in securities until we are able to deploy the proceeds would provide lower margins than we generally earn on loans, potentially adversely impacting shareholder returns, including earnings per share, net interest margin, return on assets and return on equity.
If the goodwill we have recorded in connection with acquisitions becomes impaired, it could have an adverse impact on our earnings and capital.
Accounting standards require that we account for acquisitions using the acquisition method of accounting. Under acquisition accounting, if the purchase price of an acquired company exceeds the fair value of its net assets, the excess is carried on the acquirer’s balance sheet as goodwill. In accordance with generally accepted accounting principles, our goodwill is evaluated for impairment on an annual basis or more frequently if events or circumstances indicate that a potential impairment exists. Such evaluation is based on a variety of factors, including the quoted price of our common stock, market prices of common stock of other banking organizations, common stock trading multiples, discounted cash flows, and data from comparable acquisitions. There can be no assurance that future evaluations of goodwill will not result in impairment and ensuing write-down, which could be material, resulting in an adverse impact on our earnings and capital.
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Fluctuating interest rates could adversely affect our business.
Significant increases in market interest rates on loans, or the perception that an increase may occur, could adversely affect both our ability to originate new loans and our ability to grow. Conversely, decreases in interest rates could result in an acceleration of loan prepayments. An increase in market interest rates could also adversely affect the ability of our floating-rate borrowers to meet their higher payment obligations. If this occurred, it could cause an increase in nonperforming assets and charge offs, which could adversely affect our business.
Further, our profitability is dependent to a large extent upon net interest income, which is the difference (or “spread”) between the interest earned on loans, securities and other interest-earning assets and the interest paid on deposits, borrowings, and other interest-bearing liabilities. Because of the differences in maturities and repricing characteristics of our interest-earning assets and interest-bearing liabilities, changes in interest rates do not produce equivalent changes in interest income earned on interest-earning assets and interest paid on interest-bearing liabilities. Accordingly, fluctuations in interest rates could adversely affect our interest rate spread, and, in turn, our profitability.
The FDIC has increased insurance premiums to restore and maintain the federal deposit insurance fund, which has increased our costs and could adversely affect our business.
In 2009, the FDIC imposed a special deposit insurance assessment of five basis points on all insured institutions, and also required insured institutions to prepay estimated quarterly risk-based assessments through 2012.
The Dodd-Frank Act established 1.35% as the minimum deposit insurance fund reserve ratio. The FDIC has determined that the fund reserve ratio should be 2.0% and has adopted a plan under which it will meet the statutory minimum fund reserve ratio of 1.35% by the statutory deadline of September 30, 2020. The Dodd-Frank Act requires the FDIC to offset the effect on institutions with assets less than $10 billion of the increase in the statutory minimum fund reserve ratio to 1.35% from the former statutory minimum of 1.15%.
On February 7, 2011, the FDIC issued final rules, effective April 1, 2011, implementing changes to the assessment rules resulting from the Dodd-Frank Act. The adopted regulations: (1) modify the definition of an institution’s deposit insurance assessment base; (2) alter certain adjustments to the assessment rates; (3) revise the assessment rate schedules in light of the new assessment base and altered adjustments; and (4) provide for the automatic adjustment of the assessment rates in the future when the reserve ratio reaches certain milestones.
Despite the FDIC’s actions to restore the deposit insurance fund, the fund will suffer additional losses in the future due to failures of insured institutions. There can be no assurance that there will not be additional significant deposit insurance premium increases, special assessments or prepayments in order to restore the insurance fund’s reserve ratio. Any significant premium increases or special assessments could have a material adverse effect on the Company’s financial condition and results of operations.
We operate in a highly regulated environment and changes of or increases in, or supervisory enforcement of, banking or other laws and regulations or governmental fiscal or monetary policies could adversely affect us.
We are subject to extensive regulation, supervision and examination by federal and state banking authorities. In addition, as a publicly-traded company, we are subject to regulation by the Securities and Exchange Commission. Any change in applicable regulations or federal, state or local legislation or in policies or interpretations or regulatory approaches to compliance and enforcement, income tax laws and accounting principles could have a substantial impact on us and our operations. Changes in laws and regulations may also increase our expenses by imposing additional fees or taxes or restrictions on our operations. Additional legislation and regulations that could significantly affect our powers, authority and operations may be enacted or adopted in the future, which could have a material adverse effect on our financial condition and results of operations. Failure to appropriately comply with any such laws, regulations or principles could result in sanctions by regulatory agencies, or damage to our reputation, all of which could adversely affect our business, financial condition or results of operations.
In that regard, the Dodd-Frank Wall Street Reform and Consumer Protection Act was enacted in July 2010. Among other provisions, the new legislation (i) creates a new Bureau of Consumer Financial Protection with broad powers to regulate consumer financial products such as credit cards and mortgages, (ii) creates a Financial Stability Oversight Council comprised of the heads of other regulatory agencies, (iii) will lead to new capital requirements from federal banking agencies, (iv) places new limits on electronic debt card interchange fees and (v) requires the Securities and Exchange Commission and national stock exchanges to adopt significant new corporate governance and executive compensation reforms. The new legislation and regulations are expected to increase the overall costs of regulatory compliance.
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Further, regulators have significant discretion and authority to prevent or remedy unsafe or unsound practices or violations of laws or regulations by financial institutions and holding companies in the performance of their supervisory and enforcement duties. Recently, these powers have been utilized more frequently due to the serious national, regional and local economic conditions we are facing. The exercise of regulatory authority may have a negative impact on our financial condition and results of operations. Additionally, our business is affected significantly by the fiscal and monetary policies of the U.S. federal government and its agencies, including the Federal Reserve Board.
We cannot accurately predict the full effects of recent legislation or the various other governmental, regulatory, monetary and fiscal initiatives which have been and may be enacted on the financial markets, on the Company and on the Bank. The terms and costs of these activities, or any worsening of current financial market and economic conditions could materially and adversely affect our business, financial condition, results of operations, and the trading price of our common stock.
We may be required, in the future, to recognize impairment with respect to investment securities, including the FHLB stock we hold.
Our securities portfolio currently includes securities with unrecognized losses. We may continue to observe declines in the fair market value of these securities. Securities issued by certain states and municipalities have recently come under scrutiny due to concerns about credit quality. Although management believes the credit quality of the Company’s state and municipal securities portfolio to be good, there can be no assurance that the credit quality of these securities will not decline in the future. We evaluate the securities portfolio for any other than temporary impairment each reporting period, as required by generally accepted accounting principles in the United States of America, and as of June 30, 2011, we did not recognize any securities as other-than-temporarily impaired. There can be no assurance, however, that future evaluations of the securities portfolio will not require us to recognize an impairment charge with respect to these and other holdings.
In addition, as a condition to membership in the FHLB, we are required to purchase and hold a certain amount of FHLB stock. Our stock purchase requirement is based, in part, upon the outstanding principal balance of advances from the FHLB. At June 30, 2011 we had stock in the FHLB totaling $18.8 million. The FHLB stock held by us is carried at cost and is subject to recoverability testing under applicable accounting standards. The FHLB has discontinued the repurchase of their stock and discontinued the distribution of dividends. As of June 30, 2011, we did not recognize an impairment charge related to our FHLB stock holdings. There can be no assurance, however, that future negative changes to the financial condition of the FHLB may not require us to recognize an impairment charge with respect to such holdings.
Substantial competition in our market areas could adversely affect us.
Commercial banking is a highly competitive business. We compete with other commercial banks, savings and loan associations, credit unions, finance, insurance and other non-depository companies operating in our market areas. We also experience competition, especially for deposits, from internet-based banking institutions, which have grown rapidly in recent years. We are subject to substantial competition for loans and deposits from other financial institutions. Some of our competitors are not subject to the same degree of regulation and restriction as we are. Some of our competitors have greater financial resources than we do. Some of our competitors have severe liquidity issues, which could impact the pricing of deposits in our marketplace. If we are unable to effectively compete in our market areas, our business, results of operations and prospects could be adversely affected.
Changes in accounting standards could materially impact our financial statements.
From time to time the Financial Accounting Standards Board and the SEC change the financial accounting and reporting standards that govern the preparation of our financial statements. These changes can be very difficult to predict and can materially impact how we record and report our financial condition and results of operations. In some cases, we could be required to apply a new or revised standard retroactively, resulting in our restating prior period financial statements.
There can be no assurance as to the level of dividends we may pay on our common stock.
Holders of our common stock are only entitled to receive such dividends as our Board of Directors may declare out of funds legally available for such payments. Although we have historically declared cash dividends on our common stock, we are not required to do so and there may be circumstances under which we would eliminate our common stock dividend in the future. This could adversely affect the market price of our common stock.
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Significant legal or regulatory actions could subject us to substantial uninsured liabilities and reputational harm and have a material adverse effect on our business and results of operations.
We are from time to time subject to claims and proceedings related to our operations. These claims and legal actions, which could include supervisory or enforcement actions by our regulators, or criminal proceedings by prosecutorial authorities, could involve large monetary claims, including civil money penalties or fines imposed by government authorities, and significant defense costs. To mitigate the cost of some of these claims, we maintain insurance coverage in amounts and with deductibles that we believe are appropriate for our operations. However, our insurance coverage does not cover any civil money penalties or fines imposed by government authorities and may not cover all other claims that might be brought against us or continue to be available to us at a reasonable cost. As a result, we may be exposed to substantial uninsured liabilities, which could adversely affect our business, prospects, results of operations and financial condition. Substantial legal liability or significant regulatory action against us could have material adverse financial effects or cause significant reputational harm to us, which in turn could seriously harm our business prospects.
We are subject to a variety of operational risks, including reputational risk, legal risk and compliance risk, and the risk of fraud or theft by employees or outsiders, which may adversely affect our business and results of operations.
We are exposed to many types of operational risks, including reputational risk, legal and compliance risk, the risk of fraud or theft by employees or outsiders, and unauthorized transactions by employees or operational errors, including clerical or record-keeping errors or those resulting from faulty or disabled computer or telecommunications systems.
If personal, non-public, confidential or proprietary information of customers in our possession were to be mishandled or misused, we could suffer significant regulatory consequences, reputational damage and financial loss. Such mishandling or misuse could include, for example, if such information were erroneously provided to parties who are not permitted to have the information, either by fault of our systems, employees, or counterparties, or where such information is intercepted or otherwise inappropriately taken by third parties.
Because the nature of the financial services business involves a high volume of transactions, certain errors may be repeated or compounded before they are discovered and successfully rectified. Our necessary dependence upon automated systems to record and process transactions and our large transaction volume may further increase the risk that technical flaws or employee tampering or manipulation of those systems will result in losses that are difficult to detect. We also may be subject to disruptions of our operating systems arising from events that are wholly or partially beyond our control (for example, computer viruses or electrical or telecommunications outages, or natural disasters, disease pandemics or other damage to property or physical assets) which may give rise to disruption of service to customers and to financial loss or liability. We are further exposed to the risk that our external vendors may be unable to fulfill their contractual obligations (or will be subject to the same risk of fraud or operational errors by their respective employees as we are) and to the risk that we (or our vendors’) business continuity and data security systems prove to be inadequate. The occurrence of any of these risks could result in a diminished ability of us to operate our business (for example, by requiring us to expend significant resources to correct the defect), as well as potential liability to clients, reputational damage and regulatory intervention, which could adversely affect our business, financial condition and results of operations, perhaps materially.
We may pursue additional capital, which may not be available on acceptable terms or at all, could dilute the holders of our outstanding common stock and may adversely affect the market price of our common stock.
In the current economic environment, we believe it is prudent to consider alternatives for raising capital when opportunities to raise capital at attractive prices present themselves, in order to further strengthen our capital and better position ourselves to take advantage of opportunities that may arise in the future. Such alternatives may include issuance and sale of common or preferred stock, or borrowings by the Company, with proceeds contributed to our banking subsidiary, Columbia State Bank (the “Bank”). Our ability to raise additional capital, if needed, will depend on, among other things, conditions in the capital markets at the time, which are outside of our control, and our financial performance. We cannot assure you that such capital will be available to us on acceptable terms or at all. Any such capital raising alternatives could dilute the holders of our outstanding common stock, and may adversely affect the market price of our common stock and our performance measures such as earnings per share.
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We have various anti-takeover measures that could impede a takeover.
Our articles of incorporation include certain provisions that could make more difficult the acquisition of us by means of a tender offer, a proxy contest, merger or otherwise. These provisions include certain non-monetary factors that our board of directors may consider when evaluating a takeover offer, and a requirement that any “Business Combination” be approved by the affirmative vote of no less than 66 2/3% of the total shares attributable to persons other than a “Control Person.” These provisions may have the effect of lengthening the time required for a person to acquire control of us though a tender offer, proxy contest or otherwise, and may deter any potentially hostile offers or other efforts to obtain control of us. This could deprive our shareholders of opportunities to realize a premium for their Columbia common stock, even in circumstances where such action is favored by a majority of our shareholders.
None.
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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.
/s/ MELANIE J. DRESSEL
President and Chief Executive Officer
(Principal Executive Officer)
/s/ GARY R. SCHMINKEY
Executive Vice President and
Chief Financial Officer
(Principal Financial Officer)
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INDEX TO EXHIBITS
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